Yearly Archives: 2013

Many people are asking why the financial markets have so far been unruffled by the political crisis which is playing itself out in Washington. That is a very good question. Yesterday was a case in point. The Financial Times website led with a story by Martin Wolf headlined “America is flirting with self destruction”. Yet equities were up on the day, and gold fell sharply.

The explanation for this conundrum, I believe, is twofold. Part of it is connected to the nature of markets, and part to the nature of this particular episode.

To start with the nature of markets, it has become very clear in recent years that asset prices are not necessarily very good at reacting in a smooth manner to changes in the perceived risk of extremely unlikely events taking place. For long periods, the markets do not react at all, and then they suddenly react in a discontinuous manner. The manner in which asset prices reacted to the risk of sovereign defaults in the euro area before and during the crisis of 2011-12 was a good example of this.

For many years, the markets acted as if there was no risk at all of default. Then, in the summer of 2011, they suddenly started to price a risk of 30 per cent or more that several sovereigns would default within the next 5 years, an assessment which now appears to have been a significant over-reaction. So the fact that markets do not price these risks for very long periods of deteriorating newsflow does not imply that the risks are in fact non existent, or that they will not suddenly appear in asset prices.

Why do markets behave in this way when, after all, the major participants are fairly rational, most of the time?

 Read more

One of the main motors behind the growth of the world economy in recent decades, the expansion of world trade, seems to have entirely lost its mojo. In the next few weeks, there will be vital multilateral negotiations ahead of the WTO’s Ninth Ministerial Conference in Bali on 3-6 December, which will attempt to salvage something from the Doha Round. And there will be further negotiations towards the US-inspired Trans Pacific Partnership, which is still supposed to be completed this year. With protectionism now on the rise, it is crucial that something is salvaged from these talks.

World trade volume has been virtually stagnant in the 12 months ended mid 2013. Zero growth in world trade is normally a sign of impending global recession, not of a sluggish expansion. Furthermore, there are extremely strong reasons for believing that growth in trade is one of the principal contributors to supply-side gains in global GDP, so a slow-down in underlying trade growth involves permanent losses in welfare. What has gone wrong, and what does it mean for the future? Read more

The Fed’s actions last Wednesday created more outrage than usual from investors, some of whom clearly felt that they had been misled, inadvertently or not, by the FOMC’s botched attempts at forward guidance during the summer months.

Challenged at his press conference, Mr Bernanke said that he makes monetary policy for the good of the economy, not to ratify the expectations of investors. In this, he is fully justified. The fact that a minority of investors might have lost money as a result of the so-called “broken contract” should not concern the Fed one jot. Caveat emptor!  Read more

The financial markets, after many months of forward guidance and supposedly “transparent” communication from the Fed, were very surprised by the FOMC’s latest decision to delay the start of tapering its asset purchases. This can be seen most clearly in the immediate 0.15 per cent drop in the yield on ten year treasuries, which reflects the extent of the lurch towards dovishness shown by the committee.

Prior to the announcements, the market thought that it knew two things with a high degree of confidence. First, the Fed chairman had said explicitly that the start of tapering was likely “in the next few meetings” and then clarified that this meant “before the end of the year”. Second, he had given explicit guidance that the end of tapering would occur around the middle of 2014, by which time the unemployment rate was expected to be below 7.0 per cent.

Given that the starting and ending dates for tapering were well pinned down, only the pace in between seemed to be up for debate. This left little room for manoeuvre on the final total for the Fed balance sheet, which was thought to be around $4.1 trillion (or 24 per cent of GDP).

All of this has now been thrown into considerable uncertainty following the chairman’s latest press conference. It is no longer as likely that the start of tapering will come this year, though December now seems to be the best single bet. Not can it be assumed that the 7 per cent unemployment rate is a good guide about the end point. Although the FOMC’s economic projections still show unemployment dropping below this rate somewhere around mid-2014, the chairman seemed to pour cold water on the importance of the 7 per cent figure, a consideration he himself had voluntarily introduced in the June press conference. Read more

“Not until after the German elections” became a very familiar refrain during the darkest hours of the euro crisis in 2012. Sometimes it meant that Greece could not be expelled from the single currency until then. More frequently, it implied that Germany would not be ready to make larger fiscal transfers to the deficit economies until Angela Merkel was safely installed in the Chancellery for four more years. There is still some optimism in eurozone political circles, and even in the financial markets, that the reform process, painfully slow even when the single currency looked like breaking up, will now accelerate.

In a week’s time, the polls will be closed, and Mrs Merkel will probably be embarking on her third and likely final term as Europe’s de facto leader. Like a second term American President, she might become hamstrung by her lame duck status. Alternatively, freed from the shackles of electoral politics, she might strike out in a bolder direction, driving banking union, fiscal union and structural reform towards the finishing line. Read more

The Fed has said that it will taper its asset purchases next week if it judges that the labour market outlook has improved “substantially”, and will consider interest rate rises when the unemployment rate falls below 6.5 per cent. Jan Hatzius of Goldman Sachs says that the Fed is suffering from “buyer’s remorse” over the 6.5 per cent threshold, and may reduce it next week. But are they right to use the unemployment rate as their key indicator of labour market conditions? The evidence on this is becoming increasingly murky.

The US unemployment rate has fallen from a peak of 10.0 per cent of the labour force in October 2009 to only 7.3 per cent today, an impressive rate of decline. Yet the employment/population ratio has hardly changed at all over the same period, implying that the whole of the decline in unemployment has been due to a decline in the participation ratio, as disillusioned job seekers have quit the labour force.

On this basis, many Keynesians have argued that the labour market has not improved at all, let alone substantially. The corollary is that the unemployment statistics are giving a seriously misleading indication of the scope for further action to stimulate demand.

This issue has been rumbling along for at least a couple of years, but it came to the fore last week with an important speech by John Williams, President of the San Francisco Fed. He said explicitly that “the preponderance of evidence indicates that the unemployment rate remains the best overall summary statistic”, while “the employment-to-population ratio blurs structural and cyclical influences”.

Mr Williams pointed out that the unemployment rate has consistently been the best single measure of slack in the labour market for many decades, and that it remains very closely correlated with alternative measures of slack derived from other sources. This is supported by the data. The unemployment rate is now about 0.7 standard deviations above its long term mean. The first graph shows three other measures of labour market slack derived from entirely different sources, and all of them are in the region of 0.0-1.0 standard deviations from normal, which substantiates the broad message from the unemployment data. Read more

Harold Macmillan, the former British Prime Minister, famously described the main risks facing his government as “events, dear boy, events”. Investors no doubt feel the same way about the most crucial single element in their deliberations, the future actions of the Federal Reserve.

A week ago, the immediate path ahead for the Fed seemed to be well mapped out for the financial markets. There was a clear consensus that the FOMC would taper its asset purchases in its 17-18 September meeting, and would completely end its asset purchases in mid 2014. Furthermore, it seemed increasingly certain that Lawrence Summers would be nominated by the President to be the next Fed Chairman sometime in October, and that the ratification process would end in time for him to take office on 1 February. Now this timetable has been thrown into much greater doubt. Read more

Pessimism dies hard in the UK. Even so, the startling rise in sentiment in UK business surveys in recent months calls for a rethink of the downbeat view of the British economy which prevailed almost everywhere at the start of 2013. After several years of gloomy economic data, there was a strong consensus that the UK was permanently mired in a severe demand shortfall, and that none of the usual levers – monetary policy, fiscal policy or weaker sterling – were ready or able to remedy the problem.

The outlook appeared so bleak that the government imported Mark Carney from Canada to devise emergency ways of easing monetary conditions.

By the time that Mr Carney took office as governor of the Bank of England in July, however, the economy had already embarked on a completely unexpected recovery. According to Fulcrum Asset Management’s statistical system, which tracks all of the available data sources and combines them into a single composite indicator of activity, economic growth in the third quarter is running at an annualised rate of 4.5 per cent, the highest rate seen since the booms of the 2000s and the 1980s. Read more

Raghuram Rajan‘s arrival in the Governor’s office at the Reserve Bank of India on Wednesday coincides with the worst economic crisis his country has faced since the early 1990s (see this earlier blog). The rupee hit new lows in the foreign exchange markets last week, and there are signs that a gradual erosion of confidence in the currency is turning into a complete rout. The restoration of confidence in the currency is now the sine qua non for any recovery in the economy more generally.

Like 2013′s other new central bankers (Governor Kuroda in Japan, and Governor Carney in the UK), Mr Rajan now has the advantages of the new broom, providing him a brief opportunity to seize the initiative and change market perceptions about macro-economic discipline in India. But he does not, by any means, hold all of the cards in his own hand. The Fed’s likely tapering of its asset purchases in September has clearly been the catalyst for the acute phase of the crisis. And the seeds of today’s problems have been sown over many years in which an excessive budget deficit has been partly monetised by the RBI, feeding a credit bubble, and a burgeoning current account deficit. Read more

The financial markets’ love affair with emerging market assets, which peaked in 2010, has plumbed new depths during August. Emerging market equities (in $ terms) are now down by 12.2 per cent so far this year, while developed market equities have risen by 11.2 per cent.

Emerging currencies have been in free fall. As a result, interest rates have been tightening as GDP growth expectations have been persistently marked downwards, which is usually a toxic combination for risk assets. Read more

The appointment of Raghuram Rajan, a Chicago economics professor, to the helm of the Reserve Bank of India is certainly an intriguing one. His arrival comes at a time when the Indian economy stands at the threshold of an outright foreign exchange crisis, more serious than anything seen since Manmohan Singh’s economic reforms of the early 1990s. Mr Singh is now Prime Minister, and seems to have lost his magic touch.

As Rajan himself has commented, central bankers can move from hero to zero in very short order, and so too can entire economies. India’s economy was generally deemed to be a startling success as little as two years ago. Now it is seen more like an old-fashioned emerging market, with severe supply side failures combined with unsustainable fiscal and balance of payments deficits. Read more

Last week, the Chinese authorities created a stir when they announced that they are initiating an urgent review of outstanding debt for all of the various levels of the public sector in China, right down to individual villages. This raised market concerns, because one interpretation of this action is that the authorities may not have a handle on the amount of publicly-guaranteed debt in the economy, particularly in the local government sector, where the growth of debt has recently been extraordinarily rapid.

The authorities do not appear to have decided when (or whether) the results of this survey will be announced and of course there will be the usual suspicions that the eventual numbers will be massaged for public view. Until recently, it had generally been assumed by China watchers that, while the growth in private and corporate credit was running dangerously ahead of GDP growth, there was a major silver lining in the healthy financial condition of the government sector. Read more

The US official statisticians have today issued revised statistics for GDP dating all the way back to 1929. It may be alarming for investors and policy makers to hear that our understanding of economic “truth” needs to be amended for the last 84 years, but the changes have not in fact made much fundamental difference to the debates which matter for the economy today.

In particular, there has been very little change in the Fed’s likely view of the amount of slack which remains in the economy, though the latest version of growth in the last few quarters, including the publication of data for 2013 Q2 for the first time, may persuade them that economic momentum is a little firmer than previously believed.

The most dramatic-sounding news in today’s release is that the level of nominal GDP has been revised up by 3.4 per cent in 2013 Q4. This follows a number of methodological changes, the most important of which is to treat R&D spending as a positive contributor to investment and GDP, rather than as an input to the production process. But since this change impacts GDP levels for decades in the past, it does not make much difference to our understanding of the economy’s capacity to grow in the immediate future. It simply involves viewing the same objective truth through a different coloured lens. For most practical purposes, this change can be ignored.

There are, however, three areas where the revisions could be significant: Read more

As the financial markets begin to wind down for their summer lull, activity surrounding the Federal Reserve is hotting up. Next week, the FOMC will decide whether to give a clear signal that it will begin to taper its asset purchases at its subsequent meeting in September. Furthermore, President Obama has said that the appointment of a new Chairman (yes, he said “Chairman”, though he might have meant “Chair”) will come in the autumn, and controversially dropped broad hints that Lawrence Summers is being seriously considered for the job. Previously, it has been assumed that Janet Yellen was a shoo-in. Not any more.

What are the markets to make of this? Let us start with the easier one, which is the likely action of the FOMC on Wednesday. There is no compelling reason for a major change of language in this week’s statement. The economy has slowed in the second quarter, with many economists now predicting growth in real GDP of only around 0.5 per cent, but there have been signs of firmer activity in July, and the employment numbers due on Friday are expected to be firm. Read more

Macro investors remain very intrigued by Mark Carney‘s arrival at the Bank of England, which could have major implications for sterling and UK equities. The minutes of the new governor’s first MPC meeting showed that the committee voted 9-0 against any immediate easing in monetary policy, but the crunch will come with the publication of the Inflation Report on 7 August. Only then will we discover whether the incomer has persuaded his colleagues to try to shock UK economic expectations towards a new equilibrium.

There was little sign of this in the minutes, which hinted that the longstanding two thirds majority against further QE has remained intact. Whether that will remain the case once the new mandate has been agreed with the Treasury is the great unknown. Read more

In the past decade, the world’s central banks – first in the emerging and then in the developed world – have embarked on a Great Expansion in their balance sheets which is unprecedented in modern times. This blog sketches the anatomy of the Great Expansion and attempts to project what will happen as the US Federal Reserve tapers its asset purchases in the next 18 months.

The latest episode in the saga has, of course, involved the Fed’s attempt to distinguish between “tapering” and “tightening”, a distinction which the markets have been reluctant to recognise [1]. The US forward interest rate curve shows the first rate increase occurring very close to the time when the Fed is planning to stop buying assets in mid-2014. Whether it intended to do so or not, the Fed has de facto tightened US monetary policy conditions and will have to work hard to reverse this. Read more

The financial shock which has recently hit the emerging markets stemmed in part from a period of severe stress in the Chinese money markets, which has now been brought under control. But the challenges facing China are chronic, not acute. And since the country is much more than “first among equals” in the Brics, a prolonged slowdown in its economy would keep all emerging market assets under pressure for a long while.

Although China is probably not facing anything as dramatic as a “Lehman” moment, it will need to spend several years tackling the combination of excess credit and over-investment that has followed the Rmb4tn ($652bn) stimulus package of 2008. Hailed at the time as a masterstroke, the package has caused a hangover that has now been implicitly acknowledged by the new administration under reformist Premier Li KeqiangRead more

For many years, one of the most enduring mantras of central banking was along the lines of “we never pre-commit to future actions, because all of the information we have about the state of the economy is already contained in the actions we have just announced”. Now that has been completely abandoned. With the ECB and the BoE changes announced today, the central banks are shouting from the rooftops that “we are all forward guiders now”.

In the old days, if the central banks wanted to ease or tighten policy, they just adjusted the size of the change in interest rates at any given meeting, and allowed their actions to speak for themselves. The forward path for short rates was generally very sensitive to any given change in the policy rate, so they did not have to worry too much about the impact of their policy on the yield curve. Read more

Mark Carney will stride into Threadneedle Street on Monday morning, the most powerful governor of the Bank of England since 1945. His responsibilities will include unprecedented regulatory and prudential authority over a global financial centre, and in his spare time he will be expected to set monetary policy for a medium sized developed economy that has gone badly off the rails. He will be the master of all he surveys.

Or not quite. One area where his authority is far from absolute is in his chairmanship of the Monetary Policy Committee. There, he has only one vote out of nine and, as the outgoing Sir Mervyn King has discovered, the other MPC members often act very independently of their leader. The system was established in 1997 with exactly that objective in mind, and it has never been changed.

This is why the markets are very uncertain what to expect from the new governor. Will he introduce a regime change, designed to transform economic expectations throughout the economy, as governor Kuroda has done in Japan? Or will he choose a less radical route, building a consensus on the MPC for a series of smaller steps over a period of months or years? Read more

The declines in the prices of bonds and many risk assets since the Fed’s policy announcements last week have followed a sharp rise in the market’s expected path for US short rates in 2014 and 2015. This seems to have come as surprise to some Fed officials, who thought that their decision to taper the speed of balance sheet expansion in the next 12 months, subject to certain economic conditions, would be seen as entirely separate from their thinking on the path for short rates. Events in the past week have shown that this separation between the balance sheet and short rates has not yet been accepted by the markets.

The FOMC under Chairman Bernanke has worked very hard on its forward policy guidance, so there is probably some frustration that the markets have “misunderstood” the Fed’s intentions. Richard Fisher, the President of the Dallas Fed, said that “big money does organise itself somewhat like feral hogs”, suggesting that markets were deliberately trying to “break the Fed” by creating enough market turbulence to force the FOMC to continue its asset purchases.

This is dubious logic. Investors who dumped bonds after the FOMC meeting would make money if bond prices fell further. They therefore presumably want the Fed to tighten policy, which is the opposite of what Mr Fisher indicates. Nor is it right to suggest that big money “organises itself” at all; investors act in competition with each other, not in collusion.

Nevertheless, it is possible for market prices to become misaligned with the Fed’s intentions on monetary policy, and that may well have happened in the past few days. The key questions are why has it happened, and what can the Fed do about it? Read more