If anyone doubted that Ben Benanke’s “we’re convinced the economy is getting better, so take your lumps” press conference after the FOMC statement last week was awfully reminiscent of 1937, the newly-released Bank of International Settlements annual report is tantamount to a kick to the groin. And to change metaphors, if the Fed’s sudden hawkish posture is playing Russian roulette with the real economy, the BIS just voted loudly for putting a couple more bullets in the cylinder.
Investors took the news badly, with 10 year Treasury yields rising from 2.18% before the FOMC statement to 2.53% at the end of Friday. And the selloff continues, with the 10-year yield as up to 2.62% as of this writing.
Some commentators thought the Fed talk was misread, pointing to the various thresholds and triggers the central bank set for for commencing its QE exit and they actually weren’t so terrible. Others refused to believe Bernanke was serious, with Marc Faber saying that bonds, stocks, and equities were “very oversold” and arguing, “We are going to go with the Fed to QE99.”
Unfortunately, the worry warts are looking to have the more accurate reading. Tim Duy zeroed in on a key bit of information, namely, St. Louis Fed James Bullard’s speech on Friday, on his dissent from the FOMC’s vote (Bullard thinks low and falling inflation means the economy is weaker than his colleagues believe). This was Duy’s takeaway:
Why would the Fed lay out a plan to withdraw accommodation – which in and of itself is a withdrawal of accommodation – at a meeting when forecasts were downgraded? Because, as a group, policymakers are no longer comfortable with asset purchases and want to draw the program to a close as soon as possible. And that means downplaying soft data and hanging policy on whatever good data comes in the door. In this case, that means the improvement in the unemployment rate forecast. Just for good measure, let’s add on a new policy trigger, a 7% unemployment rate. In my opinion, it is not a coincidence that they picked a trigger variable where their forecasts have been most accurate or even too pessimistic. They loaded the dice in their favor….
I think market participants clearly heard Bernanke. After weeks of being soothed by analysts saying that the data was key, that low inflation would stay the Fed’s hand, Bernanke laid out clear as day a plan for ending quantitative easing by the middle of next year. Market participants then concluded exactly what Bullard concluded: It’s the date, not the data.
That’s been my reading as well. Something is driving a new-found eagerness to get QE over. Could it be the mid-term elections, that they believe their own PR (that the economy really really is gonna lift off once that little sequester bump is over) and they want any market adjustment (which they also view as temporary) to be over before the fall election? Remember, the Fed was very much criticized for easing on the late side in 1992. Bush senior believed it cost him the election. Yanis Varoufakis presents another theory from one of his correesondents:
What had happened was that interbank lending rates were rising in China. Unlike other credit crunches (e.g. that in Italy now), this particular credit crunch was effected by the Chinese government for the purpose of pricking the gigantic speculative bubble in China before it inflates further with devastating potential. This same bubble is intimately linked to the US economy: both US finance and the midwest mining areas of the US are fully involved. Shortly afterwards Chairman Bernanke started talking about relaxing QE3. If the Chinese government no longer wants to provide unlimited liquidity then the whole burden of sustaining the bubble would fall on the Fed. Mr Bernanke considers this to be far too dangerous and for this reason he may have brought forward the Fed’s exit from QE. In this reading, the Fed’s signal that it is exiting QE has nothingto do with the actual health of the US economy and everything to do with China’s economic situation and government intentions.
I’m not endorsing that view, but it does seem as if something is driving the Fed’s sense of urgency, and what that something is is not readily apparent. Remember that another lesson that the central bank supposedly was well aware of, indeed, this was the practice Greenspan and Bernanke both appeared to adhere to, was that of signaling intentions to tighten interest rates well in advance. When the markets reacted badly to the “t” word, the Fed not only failed to make reassuring noises, but also, in the mind of the market, moved the timetable up.
Now before you say, “This is no big deal, QE didn’t do much for the real economy” bear in mind what it was intended to do: to goose asset prices to help growth. The immediate object was to repair bank balance sheets. By making bond prices higher, they not only made equity levels looked better, but that operation also enabled banks to sell equity, something that would have been impossible if they looked feeble.
Now who gets whacked the hardest when bond prices go down fast? Banks and securities dealers (who are pretty much all banks these days). Banks are structurally long. Derivatives markets aren’t deep enough for them to get net short (and have the bet actually pay off). The best they can do to minimize damage is reduce their inventories, particularly of the long and medium term bonds (yes, and do as much hedging as possible, but that’s only a partial remedy). So Bernanke’s apparent renouncement of the “give banks plenty of warning so they can get out of the way” practice is a great big test of whether the banks are really as healthy as all the regulators have been insisting they are.
Now remember that Treasuries are also the foundation for valuation of all other securities. So hitting the Treasury market hard hits all other financial instruments because it raises the risk-free return rate. As Ambrose Evans-Pritchard points out:
The Swiss-based institution said losses on US Treasury securities alone will reach $1 trillion if average yields rise by 300 basis points, with even greater damage in a string of other countries. The loss could range from 15pc to 35pc of GDP in France, Italy, Japan, and the UK. “Such a big upward move can happen relatively fast,” said the BIS in its annual report, citing the 1994 bond crash.
The BIS poured more gas on the bond bears’ fire. The word most commonly used in polite circles to describe it is “remarkable,” and not in an approving way. From Ryan Avent at the Economist:
The annual report is a remarkable document, one which might well come to serve as the epitaph for an era of central banking spanning the Volcker disinflation and the Great Recession—the epoch of the central banker as oracle, guru, maestro. If the end of this era is upon us, we can credit a series of revelations: that central bankers learned the lessons of economic history less well than they’d thought, that they displayed an unfortunate tendency to set aside economic rigour in favour of an obsessive focus on price stability, and (perhaps most importantly) that they are in more need of democratic accountability than is often assumed. Above all, the report captures what may be the most critical error of the modern central banker: eschewing a focus on his proper domain—demand stabilisation—in favour of an arena in which he has no business sticking his nose—the economy’s supply side.
The article is a full-on shellacking of the BIS’s policy whining. For instance, it takes on the BIS’s call for more “fiscal consolidation” which is Troika-speak for austerity:
Something something fiscal policy. Central bankers have strong views on what governments ought to be doing with their budgets, many of which make most sense when given the least scrutiny. The BIS knows what it wants to say: that fiscal consolidation is almost universally necessary and the only real question is how to pursue it. Picking a path toward this argument that doesn’t immediately cave in under the weight of self-contradiction proves to be a difficult task.
The BIS fails to wrestle with the fact that borrowing costs for sovereigns without central banks have risen while those elsewhere have not; it finds itself relying on discredited ratings agencies for assessments of non-euro-zone sovereign creditworthiness rather than market prices. The BIS also dances around a parallel, uncomfortable fact: that austerity within the euro-zone has often enough been associated with falling market confidence and not the other way around. In other words, where markets are least frightened of sovereigns austerity is most easily tolerated, precisely because central banks are free to pick up the slack. And where markets are most reluctant to lend, austerity is almost entirely self-defeating thanks to the absence of a flexible central bank.
Evans-Pritchard is also gobsmacked by the report’s recommendation:
The call for double-barrelled fiscal and monetary contraction is remarkable, challenging the widely-held view that easy money is crucial to smooth the way for budget cuts and deep reform.
And Evans-Pritchard also points out that history shows that exiting extraordinary monetary measures on the late side isn’t the big deal that inflationistas have made it out to be:
Scott Sumner from Bentley University said the BIS is wrong to argue that delaying exit from QE and zero rates is itself dangerous. The historical record from the US in 1937, Japan in 2000, and other cases, is that acting too soon can lead to a serious economic relapse. When the US did delay in 1951, the damage was minor and easily contained.
And Frances Coppola stresses that the idea that QE caused inflation was a myth:
There is zero chance of domestically-generated inflation while wages are falling, contractionary fiscal policy is depressing real incomes, banks are not lending and corporates are failing to invest. Externally-driven inflation is possible, and we are of course seeing inflation in asset prices as a consequence of QE. But the core trend is disinflation in developed countries – I hesitate to say “deflation”, since inflation is still above zero, but core inflation is on a downwards trend in nearly all developed countries.
Now the wee problem is the super clumsy execution of whatever the Fed intended to do, compounded by the BIS hissy fit in the form of its annual report, means we are not only going to have some serious damage in the bond market. We’ve already seen 30 year mortgages go from under 3.50% as of March to 4.24%, and we’re probably not close to done with this “adjustment”. Pimco’s normally sober Mohamed El-Erian also warns to brace for a wild ride in the Financial Times:
3. Considerable disconnects between asset prices and more sluggish fundamentals make this phase particularly volatile and disorderly. Remember, central banks saw artificially-elevated asset prices as a MEANS to meet their growth, job and inflation objectives. But herd behavior among market participants ended up pricing this as an END itself, inserting an even bigger wedge between valuations and fundamentals.
4. Judging from Chairman Bernanke’s remarks, the Fed is confident that improving fundamentals will overcome current turbulence and validate high prices. With others less sanguine about economic prospects, prices are now converging down to fundamentals rather than the other way around.
Translation: odds favor all sorts of assets being repriced downward. And what do you think that is going to do for the confidence fairy?
Now Faber is likely right and we’ll see a bounce sometimes, but from what level? The one thing that might change the equation is that the Fed thinks it’s really been misread, and dispatches some key folks to give reassuring speeches this week. But remember, the Fed has never cared that much about the real economy, despite its gestures in that direction. The very fact that Board of Governors member Sarah Bloom Raskin had to visit a job fair before she understood how desperate unemployment conditions are speaks volumes as to how out of touch the central bank is.
While Tim Duy concluded that economic data has to be “pretty bad” to persuade the Fed not to taper, it might be even worse than that, that it will take signs of stress in financial markets or financial institutions to get them to relent. So brace yourself for a rough ride.