Global investors have been in thrall to the central banks ever since quantitative easing (QE) started in 2009 and, of course, all eyes are on the Federal Reserve this week. The Fed has now frozen its QE programme, and may raise rates sometime this year, though perhaps not as early as next Thursday. Nevertheless, global investors have been comforted by the extremely large increases in balance sheets proposed by the Bank of Japan (BoJ) and the ECB, and the overall scale of worldwide QE has seemed likely to remain sizeable for the foreseeable future.
However, in recent months, an ominous new factor has arisen. Capital outflows from the emerging market economies (EMs) have surged, and have resulted in large declines in foreign exchange reserves as EM central banks have intervened to support their exchange rates.
Since these reserves are typically held in government bonds in the developed market economies (DMs), this process has resulted in bond sales by EM central banks. In August, this new factor has more than offset the entire QE undertaken by the ECB and the BoJ, leaving global QE substantially in negative territory.
Some commentators have become concerned that this new form of “quantitative tightening” will result in a significant reversal of total central bank support for global asset prices, especially if the EM crisis gets worse. This blog examines the quantities involved, and discusses the analytical debate about whether any of this matters at all for asset prices. Read more
The extreme turbulence of the financial markets in August resulted in a temporary rise in the Vix measure of US equity market volatility to levels that have been exceeded on only a few occasions since 2008. Markets have now settled down somewhat, but it is far from clear whether the episode is over. In order to reach a judgment on this, we need to form a view on what caused the crisis in the first place.
The obvious answer is “China”. The response of the Chinese authorities to the stock market bubble, and the manner in which the devaluation of the renminbi was handled, raised questions about policy credibility that added to ongoing concerns about hard landing risk in the economy. The conclusion that a China demand shock was the main driving force behind the global financial turbulence was given added credence by the simultaneous collapse in commodity prices, and in exports from many emerging economies linked to China.
It would be absurd to deny that China had an important role in the crisis of August 2015. But was it the only factor involved? After all, China’s growth rate does not seem to have slowed very much. Furthermore, standard econometric simulations of the impact of a China demand shock on the major developed economies suggest that the effects should not be very large, and certainly not large enough to explain the scale of the decline in global equity prices, or in the “break-even” inflation rates built into US and European bond markets.
It is conceivable that bad news from China triggered a sudden rise in risk aversion among global investors that exacerbated the shock itself. It also possible that markets were responding to the fact that the Federal Reserve apparently remained determined to raise US interest rates before year end, regardless of the new deflationary forces that were being triggered by events in China.
New econometric work published today by my colleagues at Fulcrum suggest that the perception of an adverse monetary policy shock may have been important in explaining the financial turbulence, in which case the Fed needs to tread extremely carefully as it approaches lift-off for US rates. Read more
© Getty Images
As the Greek drama dominated news bulletins throughout the first half of 2015, there was generally little impact on global financial markets, outside Greece itself. It is true that eurozone equities underperformed the world equity market after mid April, but the euro actually strengthened over this period, and the yield spreads between peripheral eurozone bond markets and German bunds widened only slightly, at least until this week.
This general aura of market calmness had consequences for the talks themselves, since it emboldened the Germans and other EU negotiators to take an even harder line with the Syriza-led Greek government. With no hint of a concession to take back to Athens, Mr Tsipras had nothing to sell to the left of his party.
Paradoxically, the fact that the markets remained quiet for months has therefore increased the chances of a major accident taking place as political nerves fray.
The prolonged period of market insouciance should not lull any of Europe’s leaders, headed towards Brussels for an emergency summit on Monday, into a false sense of security. There is no guarantee that the markets would remain relaxed in the case of a Greek default or exit from the euro. The real test starts now. Read more
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Ever since the collapse in oil prices started last summer, the behaviour of the global economy and financial markets has been heavily affected by the consequences of lower energy prices. Now, however, there is gathering evidence that the primary effects of the oil shock have been absorbed into the system, and there are signs that other forces are beginning to take control. What are these forces, and how will they affect the global economy in the months ahead?
When the oil shock reached its maximum early in 2015, economists were largely agreed on its likely impact. Since it seemed to stem mainly from the supply side of the oil market, not the demand side (a fact corroborated by IMF research last week), it was thought likely to boost real global GDP growth this year by about 0.5-0.75 per cent, leading to a break-out in global growth to the upside. It also had a dark side, increasing the deflation threat in the eurozone and Japan, but this was likely to be offset by further aggressive monetary easing by their respective central banks. Read more
When the Federal Open Market Committee meets on March 17-18, it will be able to drop the word “patient” from its statement without shocking the markets. After some confusion, the Fed’s intentions on the date of lift off now seem fairly priced, with Fed funds rate contracts showing a probability of more than 50 per cent that the first move will come in June. The behaviour of the dollar, and of core inflation, are likely to determine whether June or September is eventually chosen for lift off.
Once that is out of the way, the markets will turn their attention to a much harder question: how rapidly will rates rise after lift off? The market currently expects a much more gradual path than the median shown in the FOMC’s “dot” chart, but there is huge uncertainty about this question on the committee. As the graph above shows, the interest rate forecasts for individual members of the FOMC, which will be updated on Wednesday, have a very wide range.
According to Fed vice-chairman Stanley Fischer, the rationale for rate rises is that the Fed wants to embark on a process of “normalisation”, and he is adamant that today’s rates are “far from normal”. That, of course, raises the question: how should we define normal? On this, the leadership group on the FOMC is not offering much guidance, but a common way of answering the question among macro economists is to consult the Taylor rule. Read more
Tuesday’s extremely weak German industrial production figures published for August have come an awkward time for the German government. An informal “employment conference” including some EU leaders has been called by Italian Prime Minister Renzi, and it is scheduled to take place, amid little advance publicity, in Milan on Wednesday. This will presumably set the stage for the next European Council meeting on October23. In between will be the International Monetary Fund/World Bank annual meetings in Washington, when the German approach to economic policy in the euro area will be heavily scrutinised.
The official German line heading into these meetings is that the recovery is proceeding well, both in Germany and in the euro area as a whole, implying that the recent marked weakening in both gross domestic product and inflation data are just a temporary aberration. There is no sign that the Merkel administration is ready to change its longstanding formula for economic success in the eurozone: member states should stick to the fiscal targets in the Stability and Growth Pact, and should accelerate structural reforms, so that the expansionary monetary stance provided by the European Central Bank can bear fruit. Read 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
The initials LTRO, barely ever discussed prior to last December, now form the most revered acronym in the financial markets. Before the first of the ECB’s two Longer Term Refinancing Operations in December, global equity markets lived in fear of widespread bankruptcies in the eurozone financial sector. Since LTRO I was completed on December 21, equities have not only become far less volatile, but have also risen by 11 per cent.
With LTRO II completed last week, over €1tn of liquidity has been injected into the eurozone’s financial system. Private banks were permitted to bid for any amount of liquidity they wanted, the collateral required was defined in the most liberal possible way, and the loans will not fall due for three years. Any bank that might need funds before 2015 should have participated to the hilt, thus eliminating bankruptcy risk fora long time time to come. Read more
ECB headquarters in Frankfurt. Bloomberg
(Updated with comments, below) For those of us trying to follow the progression of the eurozone’s leaders towards their critical summit on Friday, it has been a fascinating but somewhat bewildering week. However, the critical point is that, so far, the game still seems to be taking place on a playing field mainly of the Germans’ choosing, so the inevitable concessions and bargains which are reached at the summit will still leave the final outcome lying well within their preferred territory. (See an earlier blog.)
What is basically under discussion is a tightening in the fiscal rules which will apply to, and indeed within, the member states, in exchange for a provision of a limited amount of liquidity to allow these countries to reach the point at which they can regain market access for their sovereign debt. With eurobonds now effectively ruled out, any permanent transfers of resources within the enhanced fiscal union are strictly limited in size and scope. However, if the settlement is to prove durable, Germany will need to give some ground in the coming hours. Angela Merkel, the German chancellor who is nothing if not an arch pragmatist, undoubtedly realises that. So where will the bargains be struck? Read more
In typical European fashion, a summit deal which seemed out of reach at midnight last night was triumphantly unveiled at 4am. The deal does not, and was not intended to, have any effect on the core problems facing the eurozone. There is still an urgent need to restore growth to economies which are hamstrung by uncompetitive business sectors, and continuous fiscal tightening. Recession still looms, especially in the southern economies.
What the deal is intended to provide is adequate medium term financing for sovereigns and banks which have been facing urgent liquidity problems. On that, it is notable that the summit has not really raised any new money, apart from an increase in the private sector’s write-down of Greek debt by some €80bn.
All of the remaining “new” money, including €106bn to recapitalise the banks and over €800bn to be added to the firepower of the EFSF through leverage, has yet to be raised from the private sector, from sovereign lenders outside the eurozone, and conceivably from the ECB.
There is no guarantee that this can be done. The eventual out-turn of this summit will depend on whether this missing €1,000bn can actually be raised. Read more
Mervyn King. Image by Getty.
A few weeks ago, the big central banks were calmly embarking on their “exit” strategies from unconventional monetary accommodation. Then the global economy slowed but for a while inflation remained too high for the Fed or the ECB to consider further easing. Their hands were tied until inflation peaked. Recognising this, markets collapsed. But now that there are some tentative signs of inflation subsiding, the central banks are rediscovering their ammunition stores.
There are basically three types of action that they are considering. In order of orthodoxy, and stealing some of Mervyn King’s terminology, here is a taxonomy of possible measures:
1. Conventional liquidity injections
This is safe territory for the central banks, and they are willing to act swiftly and decisively if necessary. Yesterday’s injections of dollar liquidity into the European financial system are a case in point. Some European banks, especially those in France, were finding it very difficult to raise dollar financing, which they needed in order to pay down earlier dollar borrowings, and to make loans to customers in dollars. The resulting strains in the money markets were undermining confidence in the ability of these banks to remain liquid, and markets were increasingly unwilling to accept their credit. This presented a classic case for the ECB to inject liquidity, using conventional currency swap arrangements to raise dollars from the Fed. Although the ECB will incur a minimal amount of currency risk in the process, and will also incur some credit risk (which will be collateralised), this is very much business as usual for any central bank, as it was in 2008. Read more
Global equities and other risk assets ended last week near to their high water marks for the year. Once again, markets have reacted favourably to the most important indicators for global activity, all of which have been published in the past week.
There have been some signs that higher oil prices have dampened consumer spending in the US, and the global industrial sector has given further evidence of reaching its peak growth rate. But so far any slowdown has been very minor, and not enough to persuade markets that this is anything more than a temporary correction.
In my regular weekly round-up this week, I will comment on the implications of recent data for the major economies. Read more
The financial markets remain torn between their concerns over “black swans” (exogenous shocks from oil prices, food prices, and the Japanese earthquake) and the improving state of the global economy. Read more
Both the Federal Reserve and the ECB are now purchasing government debt in large scale. Yet neither of them seems at all eager to admit that they are doing anything unconventional with their monetary policy. In fact, some of the recent statements by both Ben Bernanke and Jean-Claude Trichet are not as straightforward and transparent as they might have been. Read more
Jean-Claude Trichet, ECB president, has been here before. Early in his life as governor of the Bank of France in 1993, Mr Trichet faced down a tidal wave of market pressure and prevented the franc from being devalued. Read more