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Erwan Mahe
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Erwan Mahe is an asset allocation and options strategies adviser for the largest European Asset Management firms. Publishing macro-economic research, he has been managing leading European financial brokers since 1987, and sold his company, Paresco Futures, to the OTCexgroup in 2005. He is now... More
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  • The unintended Consequences of unconventional monetary policies on the volatility of macro variables…  1 comment
    Oct 23, 2009 11:27 AM | about stocks: TLT, SPY
          I imagine – no, I know – that many will be less than thrilled with the number of links in today’s Thaler’s Corner, but these same links allow readers to go to the source of the cited information and analyses. It should make for some interesting reading this weekend. J
     
     
          One of the most widespread methods used to forecast the economic outlook in G5 countries, mainly the United States, is sub-optimal growth.
          Unfortunately, this theory appears to be both light in terms of depth and heavy-laden with dangerous consequences for those who succumb to its charms.
     
          Aside from the macro considerations used to back it up, which I will cite below, this theory is the simple consequence of two well-known phenomena:
     
    -         Certain “experts” continue to use economic models, which suspiciously resemble that of the finger-in-the-air weatherman, leading to the conviction that the best forecast we can make for tomorrow is that conditions will be the same tomorrow as today.
    It is worth noting that the reality of weather modelisation is far removed from any such notion, as evidenced by the fractal structure of the Lorenz Attractor, often assimilated with the Butterfly effect of which I have inserted a nice image at the end of today’s note.
    This mathematical structure is used by the highly regarded Australian researcher, Steve Keen, whose ideas I have discussed in this daily note, which is only logical for a believer in Minksy’s Financial Instability Hypothesis.
    For those who want to dig a little deeper, check out this article, from Mr Keen’s web site (where you can make a donation to his research starting at AUS$5). As you may know, he is in a hot dispute with Paul Krugman, the man viewed as the icon of modern-day Keynesianism.
     
    -         Other “experts” prefer to simply use a more or less weighted average of existing anticipations. The least we can say is that, these days, the latter show huge gaps between the aficionados of the V, W, L, square root and other esoteric lines (“Major differences in economic viewpoints“).
    The end result is of these averages is soft growth whereby inflation rates naturally climb toward the target ranges set by central banks of between 1.5% and 2%
    ...
     
     
          The more serious studies, which also put forward this style of macroeconomic outlook, base themselves on the postulate that the economy will be affected by numerous crosswinds, which will enable it to return to the ideal economic growth pace experienced during the days of the Great Moderation.
     
          This period, which is said to have begun in the 1980s and end in 2008, was thusly named by Harvard professor and NBER member James H. Stock in 2003 in his expose, Has the Business Cycle Changed? Evidence and Explanations, presented at the annual retreat organised by the Kansas City Fed at Jackson Hole.
          This theme was then taken up by Ben Bernanke in February 2004 in his expose, The Great Moderation.
     
          In short, this theory holds that the independence of central banks, earned by Volcker’s hard drive to kill the “great” inflation of the 1970s by hiking the Fed Funds rate up to 19% in 1981, led to a sharp decline in the volatility of the various macroeconomic indicators in the following 25 years.
          As such, the GDP variance in France, Germany, Italy, Japan, the UK and the US plunged 50% to 80%, based on a comparison between the periods 1960-1983 and 1984-2002.
          One of the main reasons for such a change was the adoption by all central banks of counter-cyclical monetary rules, based on the Taylor laws and adapted to the various domestic economies.
         
          As a result, economic agents became accustomed in those 20+ years to central banks gradually adjusting monetary policy in response to changes in the economic situation, like during the Fed’s and ECB’s incremental rate hikes of 25 basis points between 2004 and 2006 and later between 2005 and 2008.
          Central banks could afford to gradually hike rates, because despite the economic growth, inflation remained under control, thanks to the deflationary impact of globalisation.
          This was all the more true in that central banks did not take into consideration “asset deflation” at the time.
          Economic agents were also used to steeper rate cuts (asymmetry), in case of major turbulence on financial markets, like during the crash of 1987, the Asian crisis and the attacks of 9/11.
     
     
          However, many things have changed in the past 18 months, which means we can count on very different future monetary policies than those practiced in past crises.
     
    -     In the first place, based on the comments by central banks, I think asset prices will be increasingly considered in the setting of monetary policy in the years ahead, given the heightened relevancy of Minsky’s texts.
    This is one of the reasons some fear an early tightening of interest rates by Chinese monetary authorities, who may be tempted to put a brake on creeping stock-market “speculation”. I do not consider such an eventuality as a foregone conclusion at all, despite the 85% rally in the past 12 months on the Chinese stock market, since it is still 50% below its peak of two years ago.
     
     
    -          Moreover, the introduction of the China factor into the equation implies a high level of uncertainty in the economic outlook of Western countries for a whole slew of reasons, as examined in yesterday’s daily note (World in love with China: unpredictability ahead!).
    Some gloomy souls might also add that we need to consider the degree of credibility in statistics emanating from that part of the globe...
     
     
    -          Above all, central bank policy, whose predictability is what made the “Great Moderation” possible, has become much less readable!
     
    ·        The first major point of uncertainty is the duration, magnitude and consequences of quantitative monetary policies.
     
          Confronted with Barrier Zero, the great majority of major central bank officials decided to carry out unconventional monetary policies, otherwise known as quantitative easing or credit easing, by buying up assets from diverse asset classes, via long-term liquidity injections in unlimited quantity or via currency interventions.
    These sometimes spectacular interventions had become necessary, given the Taylor rules used until now, which said that benchmark interest rates should fall into negative territory, including to -5% for a while in the United States.
    Based on numerous works on the Liquidity Trap (this page cites a lot of them), notably the work by Bennet T.McCallum from Carnegie Mellon University, monetary decision-makers moved to intervene directly on money supply via QE, rendered all the more necessary by the halt in money circulation and the major deflationary risks observed (with the notable exceptions of Stark and Weber, obviously!).
     
          Now that they have been carried out, investors are wondering about the timing and feasibility of exit plans, as central banks try to reassure the financial community that such plans are ready (and even tested regularly, as with the New York Fed’s reverse repos) so as to avoid feeding suspicions of negligence.
     
          However, before worrying about the timing/conditions of such QEs (even though I am one of the most reticent to view such a possibility as likely in the near future), we had better be certain that such moves do not amplify current trends, leading us straight into the jaws of a deflationist trap, as exemplified by Japan’s painful experience: nominal GDP still at level of … 1992, with the Nikkei at the level of … 1984!
     
          In any case, the only thing that is certain is that these uncertainties reduce enormously the medium-term visibility of the major economic aggregates.
     
     
    ·        The second point of uncertainty, with respect to central bank policy, is the changing attitude toward the TBTF financial institutions.
     
          We saw some spectacular turnabouts in 2008, as exemplified by the misadventures, leading to very different outcomes, of Bear Sterns, Lehman Brothers, AIG, Fannie and Freddie Mac, not to mention the support provided major banks via the guaranteed debt issuance programmes, capital injections, liquidity payments, while regional banks were allowed to go under one after the other (94 so far this year in the US, FDIC list).
         
          Not only do these different reactions heighten investor uncertainty, of which the volatility of bank stocks is a good illustration, but what really stands out, a year after the Lehman bankruptcy, is that no specific regulatory structure has yet been established or even proposed in concrete terms in any of the concerned countries!
     
          If we listen to the cries of alarm emanating from central banks, be it from Plosser or Kohn in the US or Trichet and especially Bini Smaghi in Europe, this situation is beginning to fray nerves!
          The latter has, for the first time, designated the black sheep of the eurozone, the German Landesbank, whom he encourages to restructure and recapitalise as soon as possible!
     
          All central bankers are worried about the crucial issue of the efficient transmission of their monetary policies to the real economy and the persistence of zombie banks, whose toxicity is illustrated by the case of Japan.
     
     
          **********************************************************************************************
     
     
          Given all these points of uncertainty, we can easily understand why current anticipations of inflation, but also of economic growth, deficits and financial markets, are so incredibly divergent.
     
         This is one of the reasons why the rate-hike part of the swaptions volatility curve has richened so much in the past year. In such a context, out-of-the-money options must be worth a lot more than in the past.
     
          As such, despite the consensus view as expressed by “at-the-money” option volatility on the different asset classes, look for the years ahead to be not quite as calm as some would have us believe. Keep a watch on the short volatility structured products which have return of late.
         
     
          ***********************************************************************************************
         
     
          That’s enough for theory; here’s some hard macro data to bring us back to earth:
     
    -          In Italy, retail sales for August, out this morning, which were expected to be positive, ended up in negative territory.
          Check out the graph, below: no need for me to comment on the reality of the recovery on the eurozone …
     
    Retail sales in Italy
    Did someone say recovery?
     
     
     
    -          In China, all the good figures we were hoping for are there.
          Just one glitch: Core CPI came in at -1.9% for September, illustrating the ferocious struggle between monetary (and fiscal) stimulus measures and creeping deflation.
     
     
    -          In Japan, one of our favourite indicators, foreign trade, was published.
          What a terrible disappointing for all those green shoot spotters: As seen in the first graph, below, exports have nudged up by a mere 7% from their recent plunge!
     
    Japan foreign trade
    The recovery isn’t all that certain over there either
     
     
     
     
          But the worst part about these figures communicated by the Japanese government is that the devil, as usual, is comfortably embedded in the details.
     
          Trade has stabilised somewhat in the past few months for one simple reason: the impact of the stimulus plan by the neighbouring giant, China.
     
         As you can see in the following graph, the spectacular rebound of imports and exports to/from China represents by itself more than the changes in the overall figures!
     
          They are now no more than 25% off the peak of a year ago while the total figures are still 42% of this peak
    .
          I am not exaggerating when I insist on the importance of China as an unpredictable variable.
     
    Japan foreign trade with China
    Luckily, the neighbours are always there!
     
     
     
          I am sure that people are going to say that, given my message, there is no need to offer my investment biases.
    Stocks: TLT, SPY
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  • robert.b.ferguson
    , contributor
    Comments (10491) | Send Message
     
    Erwhan: Greetings. Excellent article and data points. I too am expecting range bound volatility and am looking at commodity stocks as I think they may be a good bet going forward. For now I am building my cash position (Dry powder) for use in new acquisitions or building on current ones in the coming year. Thank you once again.
    25 Nov 2009, 05:08 PM Reply Like
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