Beware: the first section of this note, dedicated to that ever-so-hot-topic, the liquidity trap (rate 0%), may lead to prolonged bouts of snoring.
While Ben Bernanke was repeating his well known mantra before Congress yesterday, without adding much in his op-ed piece in the WSJ the day before, it was in Northern Europe that the masks really fell.
In effect, Mr Svensson expressed some fairly explosive things in an interview with the WSJ yesterday. This influential member of Sweden’s Riksbank had argued for a lowering of the ECB’s benchmark rate directly to 0% during the last meeting. As it was, markets were already surprised by the 25 bp cut in this rate to 0.25%, and even more surprised by the deposit rate’s decline into negative territory at -0.25%, a rather iconoclastic move to which we dedicated the 13 July Thaler’s Corner (Orphanidès dreamt it, the Riksbank did it!).
At the time, our text provoked enough outrage for me to advance gingerly on the subject today. In my entire professional life, I have never seen a period in which macroeconomic debates have been so virulent as players lean on “political” fundamentals far removed from normal and supposedly objective discussions of economics.
Mr Svensson is a long-time expert in issues relating to 0% interest rates, also known as the Liquidity Trap (Mr Trichet’s nightmare subject about which he never talks), and is a fervent partisan of the official inflation targets. The Swedish central bank has the honour of being the only central bank in the world to have gone even further with the adoption between 1931 and 1937 of an absolute price target, as opposed to an inflation target!
This measure, which is the object of an excellent paper written by Mr McCulley (PIMCO), recommended by us on 15 July, is the subject of an enormous controversy begun by Paul Krugman in 1998 via his study, Japan’s Trap. It is this paper to which we owe the expression in vogue in recent days, “credibly promise to be irresponsible”.
And that is not all, since, as McCulley pointed out in Global Central Bank Focus, Ben Bernanke, as the uncontested expert on the issue of fighting deflation (we cannot emphasise this point enough because it has huge implications on asset allocation decisions), dealt with the issue in Price Targeting.
In his papers published in 2002 (Deflation: making sure it doesn’t happen here) and in 2003 (Some thoughts on monetary Policy in Japan), Mr Bernanke indeed returned to the subject, declaring himself in favour of having the central bank set a price target, in the context of a fight against deflation, as opposed to inflation.
This means that if prices have remained flat or fallen during a certain time period, the central bank must do everything it can to boost prices by 5% per annum if need be (or even 10% or 15%, depending on the duration and magnitude of the deflation to catch up with).
As such, Mr Svensson, who may get an invitation from Mr Orphanidès to spend his holidays in Cyprus any day now (my attempt to wake you up), has also taken a keen interest in the matter. Check out this text from last 17 February: Monetary Policy with a zero interest rate.
I have taken the liberty of providing this new link so that you can get a glimpse of the measures to come, if the Riksbank were to become more worried about a Deflationist Trap. Given that rates are already at -0.25% to +0.25%, it may first set up a US/UK style quantitative easing. But, above all, as it does not view this as the most efficient way of attaining its price target (thus reflation), and that seems to be confirmed by the US example, it would above all force a devaluation of its currency of the same magnitude of its targeted price hike. That is what Switzerland is already doing!
As such, we remain convinced that benchmark interest rates will remain low overall, at least, until mid-2010, and that if there is a hike, it will be small and gradual.
Some clients ask me about what they see as an inconsistency in the asset allocation scenario. They ask why, if I am so convinced of the quality/clear-sightedness of our monetary authorities and if we must avoid the deflationist trap, I do not move to a positive stance on stock markets?
Two points seem to undermine this understandably optimistic outlook which, as some of the usual disclaimers point out, do not necessarily guarantee future performance:
- First, these purposefully reflationary measures unfortunately finesse the influence of the now powerful Bond Vigilantes, so named by Mr Yardeni in 1984.
We no longer limit ourselves to mutual funds, insurance firms or pension funds, but also include the major international creditors, like China and Middle Eastern countries.
Unlike Japan, which is blessed with substantial reserves of, often quasi-administered, household savings (e.g. postal funds), if a country like the United States were to commit to one or two years of excessive inflation or intervene on markets to depreciate their currency, bond investors would immediately demand extra compensation to buy government bonds from the countries in question.
The initial effect would be to dramatically push up real interest rates (it is not so easy as all that to promise inflation!) and kill in the nest any movement toward an economic recovery.
This would thus pose a real problem for risky assets …
- Moreover, China‘s reaction poses an additional problem for the monetary policy of Western central banks.
Given its desire to control the impact of the economic slump, which logically should have affected it, in light of the collapse of foreign demand and the contraction in world trade, has effectively taken its own Minsky framework, whose potential consequences are hard to deny.
In China, asset prices are continuously rising, fuelled by the explosive growth in money supply and by government instructions to banks “to loan baby, loan!”, as if they intended to absorb their NPL (defaults) with the dollar reserves from SAFE in the coming years.
I can’t imagine why, but I don’t have much confidence in the CPC’s Political Bureau to get the economy out of the woods.
Check out this very good study of the current real estate situation in China; It will make your head spin!
While it is true that we can shrug off the Chinese real estate and stock markets, which are sufficiently isolated from the rest of the world for them to do us much harm, the intervention of Chinese importers poses a huge problem for our central banks.
While all the experts agree on the importance of the current unbalance between the (abundant) production and (reduced, outside China) demand for commodities, with tankers supposedly filled to the brim with strategic oil reserves, Chinese purchases continue to fuel commodity markets.
Check out the graph of copper prices, which speaks for itself.
As we noted in 2008 with the ECB’s reaction to the spike in oil prices by raising interest rates in July (!), there is little margin for maneuver, if the Chinese continue on this path.
Copper = China?
Keep an eye out…
As such, Europe may have to contend with a big, toxic cocktail:
- The honour of having the world’s most orthodox central bank, depriving of the same arms used by our British, American, Swedish, Swiss and Japanese peers;
- A very steep yield curve, which does not include this Austrian specificity, but stupidly copies the evolution of that of the United States, thus inflicting unbearable real interest rates on loans to economic agents;
- A lack of central coordination by fiscal authorities and thus of stimulus plans;
- Absence of coordination between fiscal and monetary policies;
- The most expensive currency in the world.
Depressing, isn’t it?
As you know, I am an ardent European, so I will leave it to you to imagine the diagnostic of those who are more sceptical …
The reading of industrial orders released this morning for the eurozone came to 30.1% y-o-y for May 2009, vs expectations of -27.90%. This green shoot month did not turn out to be a month lift of 1.9%, but a decline of 0.2%.
What a contrast with our Asian friends as Taiwan’s commercial sales declined 5.32% in June, vs consensus forecasts of -9% y-o-y. Although that is still 7% below the peak of July 2008, it still represents a 20% rebound since February 2009!
Unemployment climbed to 5.91%, its highest level since 1978, but leave it up to Chinese money supply to remedy the problem by flowing into the South China Sea.
No change in asset allocation biases: favourable to eurozone 5-year bonds, negative on risky assets.
The implied of Bobl options had become too cheap!
Disclosure : long 0 couposn OAT and EDF corp 4.5% 5 years.