By Doug Noland
I wanted to dive a little deeper into John Taylor's March 29, 2012, Wall Street Journal op-ed, "The Dangers of an Interventionist Fed - A century of experience shows that rules lead to prosperity and discretion leads to trouble." The monetary policy "rules vs discretion" debate is near and dear to my analytical heart, and I again tip my hat to Dr. Taylor for adeptly raising this critical issue. For this Bulletin, I'll shift the focus somewhat.
From John Taylor's article:
"The Fed's discretion is now virtually unlimited. To pay for mortgages and other large-scale securities purchases, all it has to do is credit banks with electronic deposits-called reserve balances or bank money. The result is the explosion of bank money ... Before the 2008 panic, reserve balances were about $10 billion. By the end of 2011 they were about $1,600 billion. If the Fed had stopped with the emergency responses of the 2008 panic, instead of embarking on QE1 and QE2, reserve balances would now be normal.Throughout this elongated credit boom, conventional analysis has misunderstood the nature of inflation and misdiagnosed inflationary risks. As Dr Taylor notes, considerable focus has more recently been directed to the banking system's huge ($1.6 trillion) excess reserve position as monetary fuel for future inflation. As the thinking goes, "If it is not undone, then the bank money will eventually pour out into the economy, causing inflation."
This large expansion of bank money creates risks. If it is not undone, then the bank money will eventually pour out into the economy, causing inflation. If it is undone too quickly, banks may find it hard to adjust and pull back on loans. The very existence of quantitative easing as a policy tool creates unpredictability, as traders speculate whether and when the Fed will intervene again.
That the Fed can, if it chooses, intervene without limit in any credit market - not only mortgage-backed securities but also securities backed by automobile loans or student loans - creates more uncertainty and raises questions about why an independent agency of government should have such power."
I agree with the general premise that Fed policymaking is highly inflationary. I just disagree with the conventional view that the greatest risk lies in future periods when the banks eventually lend reserves currently parked at the Fed. Inflation risk is current as well as latent.
An increase in consumer prices is one type of inflation. Asset inflation is another, as is excess consumption and malinvestment. The key to analyzing inflationary price distortions is to focus on the dynamics of the underlying credit expansion.
What are the primary sources of new credit (ie lending to finance sound investment as opposed to leveraging to finance speculative securities holdings or to buy homes or other assets)? And what are the associated impacts from this newly created purchasing power (ie higher consumer prices, rising asset prices, a spending or investment boom, and so forth) and are these price effects generally sustainable, destabilizing, supportive of economic balance or, instead, imbalances?
To be sure, it is essential to take a very broad-based approach to studying inflationary impacts - including pricing for goods and services, securities markets, commodities, as well as how credit inflation is distorting incomes, government receipts/expenditures, investment and global financial flows.
From the perspective of my analytical framework, the inflation/expansion of credit is the starting point for any meaningful analysis of inflationary effects. As has been the case now for the past two decades, asset inflation has been a predominant inflationary consequence of the rampant expansion of contemporary market-based credit.
A strong case can be made that asset inflation is a much more dangerous and unwieldy strain of inflation than rising consumer prices. Asset inflation is certainly not easily recognized by policymakers - and authorities will tend to view rising asset prices as both a positive development and even a show of confidence in their (loose) policies.
There is the misperception that the trillions of deposits sitting on the Fed, the European Central Bank, and other global central banks' balance sheets have yet to cause an inflationary impact. The truth of the matter is that these trillions have circulated through global securities markets - and with momentous inflationary effect. This liquidity has ensured ongoing global credit and speculative excess, while exacerbating global financial and economic imbalances. These days, the inflationary effects of "activist" central banking foment only greater systemic fragilities.
From Dr Taylor: "The very existence of quantitative easing as a policy tool creates unpredictability, as traders speculate whether and when the Fed will intervene again."
Again, I don't necessarily disagree. Unpredictability and uncertainty are important consequences. Yet the greater issue is that policy interventions over time have a profound impact on market perceptions, specifically nurturing a view that policymaking reduces unpredictability and ensures relative financial and economic stability. Importantly, and at this point this should be beyond dispute, "activist" policymaking works to inflate asset prices and fuel asset bubbles.
The pricing and availability of derivatives and other forms of market insurance are profoundly impacted by the certainty of policy interventions, along with the various measures that are perceived to ensure market liquidity backstops. I would argue that the $1.6 trillion of reserves is reflective of the massive Fed market interventions that have over the years validated deep flaws in the derivatives marketplace.
The dangerous premise of "liquid and continuous markets" - the bedrock of dynamically-hedged derivative trading strategies - would have long ago been debunked if not for Fed activism. And there is absolutely no doubt that "activist" policies incentivize speculative leveraging. I find it astounding that CPI is stilled viewed as a greater systemic risk than historic speculative bubbles and central banks' role in fanning a global financial mania.
April 19 - Financial Times (Sam Jones): "The global hedge fund industry has seen its assets swell to a new high ... Hedge funds now manage an estimated $2.13tn in assets on behalf of pension funds, governments, asset managers and high net worth individuals, Hedge Fund Research said ... The figures mean that the industry has added more than $700bn in assets since its post-crisis nadir in 2008 - the bulk of which has come thanks to positive recent performance from hedge fund managers."
The ECB's Long-term refinancing operations (LTRO) and concerted central bank liquidity operations rescued global markets in late-2011. Despite the year-end rally, the hedge fund community still suffered one of its worst years (down 5.25%, according to the FT), second only to 2008. I would argue that policy interventions halted what would have otherwise been significant outflows from the leveraged speculating community.
Instead, global markets were spurred higher and the hedge funds enjoyed net first-quarter inflow of about $13 billion. And, according to the above Financial Times article, virtually all ($12.4 billion) the inflows found their way into so-called "relative value funds".
I have recently underscored the strong first-quarter performance of "relative value arbitrage" strategies, many that had positioned aggressively to profit from a LTRO-induced convergence of European bond yields. I have also posited that many of these trades might prove susceptible to renewed market stress and related concerns that the ECB may be less accommodative going forward than previously believed.
I am growing increasingly confident in the view that European debt markets are highly vulnerable to a reversal of speculator leveraged holdings. A bout of market tumult, poor hedge fund performance, and self-reinforcing investor redemptions is not a low probability scenario. Indeed, the market's recent policy-induced upside dislocation has increased the likelihood of such an outcome.
Global markets have again turned unsettled. And while there is some uncertainty as to the timing of additional quantitative easing, the marketplace doesn't doubt that Fed chairman Ben Bernanke will be ready with QE3 as needed. The real unpredictability is instead associated with the size of future interventions and whether such measures will suffice in a world of deepening credit woes. There will come a point when the scope of the global credit crisis finally surpasses the capacity of inflationary monetary policy.
The Spanish bond market persevered through the week (10-yr yield down 2bps). Meanwhile, heightened market nervousness was apparent in Italian and French debt markets. French 10-year yields jumped 14 bps, with the spread to German Bunds widening 17 bps to 137 (high since January). Italian bond yields rose 14 bps, with the spread to bunds widening 17 to 394 bps. French Credit default swap (CDS) prices rose 13 to 200 bps, this week trading above 200 bps for the first time since January 18th. Italian CDS surged 37 to 463 bps, the high since January 20th. Belgium CDS rose 13 to 265 bps (also high since 1/20).
The first round of French presidential elections came Sunday. The top two finishers will then go head-to-head on May 6. It is expected that President Sarkozy will face off against the socialist, Francois Hollande. Mr Sarkozy is unpopular and polls indicate that he is poised to be France's first one-term President in 30 years. Mr Hollande has campaigned against "austerity" and has blamed the European crisis on the ECB's failure to "massively" purchase sovereign debt.
Mr Holland and German Chancellor Angela Merkel will be an interesting pair. There is a lot to concern the marketplace, and expect more attention on the fact that France's debt-to-GDP ratio is rapidly approaching 90%. The stability of the expansive French banking sector is (again) a major market wildcard. Importantly, the European debt crisis this week took a more pronounced shift to the "core".
Here at home, market participants have remained fixated on earnings reports, the latest technology IPO, and daily economic reports. Our markets have for the most part been content to downplay Europe. Markets tend to be forward looking and, I believe, the marketplace is increasingly vulnerable to a tightening of financial conditions.
In somewhat of a replay of 2011, a worsening European debt crisis has again become a clear and present danger as a potential catalyst for another bout of global de-risking/de-leveraging. Last week provided added confirmation for the thesis of a deepening European debt crisis. And, not surprisingly, the week was less than conclusive as to the timing of when de-risking/de-leveraging might pose a significant threat to US markets.
Volatility has certainty returned, and market internals would seem to support my thesis of increasing hedge fund vulnerability. Some of the favored sectors and many of the favored stocks have recently begun to under-perform. Many commonly shorted stocks were especially volatile and seemed, at least as a group, to outperform. There are some indications of positions being unwound and initial indications of risk aversion. This is the type of unsettled backdrop that has in the past whittled away at market confidence....