Seeking Alpha

Central Banks Need To Preserve Their Credibility, But More Policy Coordination Would Be Ideal

by: Claudio Brocado
Summary

The Fed is likely to continue (and perhaps accelerate) interest rate cuts, but not for direct political considerations.

Central bank independence remains an important factor behind currency stability.

Key global central banks should step away from quantitative easing, and let market-driven price discovery reclaim their role in setting of long-term interest rates.

More (global) policy coordination would be desirable and productive, in my view, though the imminent prospects of that are low.

The credibility of an independent central bank is something way too valuable to squander. The US’s Federal Reserve Board (the Fed) is one of the most reputable institutions not only in the America, but worldwide. I have written in the past that a solid reputation is difficult and takes time and effort to build up, but it can be lost very quickly, and regaining it is nearly impossible.

The Fed continues to enjoy strong credibility among most global sophisticated market participants. This is, in my view, part of the reason why the US dollar remains the undisputed global reserve currency. Thus, it is sad and frustrating to see the current administration use the Fed as its proverbial ‘whipping boy’.

I recently wrote that the US president may indeed succeed in having the Fed do ‘his bidding’, pushing interest rates lower. Still, I do not believe the US central bank’s Federal Open Market Committee (FOMC – its policymaking arm) will lower interest rates out of direct political considerations. The administration’s tough stance on trade contributes enough market gyrations that a tightening of financial conditions may push the FOMC to perhaps aggressively cut short-term (policy) rates in the near future. Thus, the Fed would reduce borrowing costs only indirectly as a result of presidential interference with the workings of free markets, in my view.

One of my main fears is that, as a result of short-term oriented, political considerations, the hard-earned reputation of the Fed as an ‘apolitical’ institution is being put at risk. The long-term results would be quite negative. This is happening from both sides of the spectrum: from the presidential tweets questioning Jerome Powell’s competence, to calls by former Fed officials for the independent central bank to try to influence the outcome of next year’s presidential election. Both are wrong.

The legendary Fed Chairman Paul Volcker ‘broke the back’ of inflation, earning the central bank even more global credibility and ushering in the multi-decades-long bull market in US Treasury bonds that arguably continues to this day.

Let’s hope for more long-term thinking that will not endanger the Fed’s political independence. Indeed, it is precisely this attempted political meddling with monetary policy that, in my view, has contributed to only a relatively small portion of the funds freed by the 2017 tax cuts to actually flow to long-term investing in US property, plant and equipment (PP&E/capital expenditures).

Central banks should return their focus to short-term, policy rates and away from QE

Whereas more long-term thinking is generally needed in both the public and private sectors, I believe the Fed and other key global central banks should refocus on short-term,policy interest rates. Quantitative easing (QE), a practice that has been adopted in recent years by a growing number of central banks, entails buying longer-term securities.

As I have argued in recent articles and posts, there is enough free-market demand for long-term bonds (high global appetite for duration risk) as to negate any ‘need’ for central banks to bid up sovereign long-term bonds any further.

The recent inversion in the US yield curve is a function of the high demand for long-term Treasury securities. In that sense, arguments to the effect of the Fed being ‘behind the curve’ are true to the extent that the markets have pushed long-term interest rates lower at a faster pace than the Fed (which only recently cut short-term rates for the first time in over a decade).

Thus, I have a high level of conviction that an inverted yield curve under current conditions is not presaging impending recession in the US, let alone globally. This is particularly the case since the inverted yield curve is not accompanied by some of the other predictors of recession, notably widening credit spreads. Appetite for credit risk, if anything, appears to be on the rise.

I follow Bridgewater’s Ray Dalio closely, given his extraordinary long-term success and his keen knowledge of the history of cycles, globally. He has recently raised questions as to whether we may be very close to the end of both the short and long-term debt cycles. While we agree we must be near, there are signs that it may only be the beginning of the end. I personally see no excesses, and stand by my statement that we are currently in the era of the bubble in ‘bubble calling’.

Perhaps as a result of how traumatic the global financial crisis (GFC) was, many market participants continue to behave as if the next bubble is now upon us, and the collapse is nigh. I, on the other hand, see plenty of skepticism and caution in what I call the most hated/distrusted US equity bull market in my investment history.

Admittedly, the large-cap S&P 500 index of mostly blue-chip US stocks is not far from its all-time high, despite a rocky August. Still, the further down you look the market cap spectrum, the poorer generally the performance. Many stock markets outside the US have been behaving rather like vicious bears than anything resembling a bull market.

There has been ‘bubble-like’ price behavior in a few developed-market ultra-long-duration sovereign bonds, but that is still few issues in number. Furthermore, as I discussed in a recent article, I cannot believe a market that is driven by fear rather than greed in a risk-off trade can really be considered a bubble.

Still, Mr. Dalio’s comments cannot be taken lightly, and we should remain vigilant. Obviously, demand has been strong for duration risk. This is probably a sign that we are in the beginning of the end of a debt cycle. Meanwhile, there are relatively few cases of blatant overleverage, which is what we have seen at the end of previous debt cycles.

Inverted yield curve due largely to the plunge in long-term interest rates

The most recent yield curve inversion is a product of the robust price performance of long-term bonds. This ‘bullish’ (in terms of bond prices) yield curve inversion can probably relatively easily be addressed by the Fed aggressively cutting short-term interest rates. In terms of the predictive power of yield curve inversions, I have an intriguing research topic that I am not equipped to address on my own.

I command a research team of a total of one part-time analyst (myself). I invest (and write) solely out of passion, and do not have the research bandwidth for bigger projects. I wonder if there are studies measuring the correlation between past cases of US yield curve inversions and subsequent recessions at times when the yield curve has inverted as a result of a very strong bond market rally (like we are currently having). Especially inversion cases where bond markets have shown high correlations with rallies in risk assets would be worth researching for their predictive power regarding recessions.

Not only have the prices of long-term bonds increased sharply, but that rally has shown unusually high correlations to solid price performance in other asset classes (including high-yield bonds). In recessions, credit quality deteriorates sharply, and high-yield bonds tend to plunge in price. Moreover, while there has arguably been a meaningful decline in global economic policy coordination, the government bond rally is a rather global phenomenon.

The global bull market in sovereign bonds (accompanied/fueled by high appetite for duration risk) is boosting government security prices in countries with solid fiscal positions as well as those with rather questionable public finances, particularly when it comes to advanced economies.

Also, the developed market bond rally does not seem especially discriminating when it comes to the particular phase in the economic cycle of the countries in question. A country widely believed to be very close to recession (Germany) is seeing its bond prices soar in tandem with those of a country with more robust economic data (the US).

While the US president chastises the Fed for not more aggressively cutting short-term rates, the bond market is doing the job of rapidly bringing down long-term rates (also despite the tapering of QE). Again, this is what is really behind the US yield curve inversion, in my view. In the case of Germany, where the ECB has been much more dovish than the Fed, the yield curve is not yet inverted.

The German 2s/10s curve is still positively sloping, albeit very gently. With Germany being universally believed to be closer to recession than the US, should its yield curve not be more inverted than that of the US if the markets really are predicting an economic contraction? Thus, we are seeing unusual and inconclusive signs from various markets, which should challenge anyone’s conviction on the imminence of (particularly a global) recession.

There are plenty of market-driven reasons for the lower for longer interest rate world in which we live, in my view. Global demographics (aging), the savings glut (and related relative lack of monetary velocity and lack of any widespread inflationary pressures), and global economic policy and geopolitical uncertainty, are but a few that immediately come to mind.

I have an ever-higher level of conviction that the central banks of the major economies should step away from QE, and let global free markets do their job. As for the Fed, I remain strongly convinced that it should fiercely continue to defend its independence from political interference. That said, I also believe that the developments of the last few months do call for the US central bank to more aggressively cut policy (short-term) interest rates.

Again, it is not that I perceive a meaningful risk of impending US recession. However, global market forces do call for lower US short-term interest rates. The US yield curve is inverted due to high American policy rates relative to those of other advanced economies. At the same time, I see no reason for the US (and not even the ECB) to reignite their QE purchases of longer-term securities.

Indeed, I have argued that (at least to some extent) the strong appetite for duration risk (and the accompanying growing pile of negative-yielding debt) rely on the belief in the ‘greater fool theory’. At least some investors must be purchasing negative-yielding long-term debt on the expectation that a ‘greater fool’ will buy it from them at an even higher price (with an even more negative yield).

The widespread expectation that central banks (such as the ECB) will resume their aggressive buying long-term sovereign bonds must make at least some investors believe that the ECB will indeed be the greater fool. This does not have to turn out to be the case. I expect the lower for longer environment to remain in place, although it too will end at some point. In the meantime, central banks should let market forces determine where long-term rates are headed.

With the Fed’s credibility at stake, what’s to come?

Contrary to what many may believe, I am a have a high level of conviction regarding the wisdom of markets. Free markets are the best vehicle the world has ever known to create wealth and welfare for the greatest number of people. Nevertheless, I’m also a big believer in that there is such a thing as ‘too much of a good thing’.

I reject every extreme, and I consider extreme positions to be unsustainable in that they typically carry the seeds of their own destruction. Over the last couple of years I have done a lot of reading and thinking on the issue of cycles. I believe cycles permeate almost everything. In his recent book Mastering the Market Cycle by Howard Marks, the successful money manager discusses the essential ‘synonymity’ between cycles and the pendulum swinging from extreme to extreme.

While I generally believe that the freer the market the better, if carried to the extreme, ‘too’ free a market will inevitably provoke a backlash that will force the pendulum to swing in the opposite direction, I fear. Thus, in my opinion, if one wishes the market to be as humanly possible, the ideal is a market freedom that is sustainable and not at significant risk of political backlash.

Part and parcel of the limitation on the freedom of markets is government or State intervention. Government and policymakers can (and in my opinion occasionally must) nudge markets in order to promote a long-term sustainable equilibrium. This is what I believe some key global central banks have done in their quantitative easing (QE) programs.

Central bankers are supposed to be smarter than most of the rest of us, and market participants often do give them the benefit of the doubt on perhaps knowing something that the rest of us do not. Perhaps some key central bankers did accurately read the effect that aging global demographics would have on global long-term interest rates. In any event, I cannot reiterate enough that it is time for central banks to generally step away from QE, and let true market price-discovery take it from here.

Along the same lines, I hope that the US administration does decide to go through with the issue of long-term Treasury bonds of maturities as long as 100 years. There is some (justified) doubt as to whether regular and predictable issuance of so-called Century Bonds would be likely beyond the first try. I still think it’s best to let the market, with its wisdom, decide. Go through with the issue, and take it from there.

In my admittedly not-so-well-informed opinion, the benefits more than offset the risks of the US issuing 50 and 100-year bonds. Extending the US yield curve (understanding that even Italy has 50-year bonds out) is a good thing, and let the free markets decide which corporates (if any) eventually follow the US Treasury with ultra-long-duration bonds. It is worth mentioning that there are already perpetualcorporate bonds out there.

Is Plaza Accord 2.0 Coming?

On September 22, 1985, the then G-5 (the US, Japan, West Germany, France and the UK) signed the so-called Plaza Accord at the Plaza Hotel in New York. Interestingly, the current US president would come to own and be linked in the public imagination to the hotel just a couple of years later (Donald Trump bought the NY Plaza on March 27, 1988, and in 1995 an investor group bought it from Trump’s creditors). Some people still believe the president owns the Plaza.

In any event, following very sharp appreciation in the US dollar, a coordinated, government-led approach to weakening it did contribute to a sharp reversal. Currency markets (like many other cycle-driven objects) overshoot, and the pendulum eventually does swing in the opposite direction. Government/policymaker nudging can and often has been the catalyst for the pendulum to reverse course.

In my opinion, the US dollar is not massively overvalued. It of course depends on relative to what, but when it comes to the key cross-rate to the European common currency (the euro), my assessment of fair value based on purchasing power parity -- PPP -- remains at roughly US$1.20 to the euro. I still see the dollar at parity with the Swiss franc, and both at 1.20 to the euro as being very close to fundamental fair value.

The appreciation of the dollar so far this year is, as always, due to multiple factors. Its relative strength has admittedly surprised me, though with the benefit of hindsight it is easy to see why it is where it now trades. The relatively high level of short-term (policy-driven) interest rates in the US does currently provide some support to the US currency.

I do not expect the Fed to explicitly target the value of the dollar and aggressively cut short-term rates in order to weaken the US currency. Still, given that it wouldnot go counter to long-term fundamentals, as I assess them, I think a coordinated statement of support for a slightly weaker dollar would not be a bad thing.

Like essentially almost everything else, in my view, the degree of tightness of a country’s monetary policy can only be accurately evaluated in relative terms. For instance, a specific monetary policy is lax only if it is accommodative relative to that of other countries (notably key trading partners), especially when it comes to the policy’s possible effects on currencies.

Therefore, additional evidence that US monetary policy has indeed now turned relatively tight to that of the rest of the developed world can be seen in the strength of the US dollar against other currencies, and perhaps more importantly, relative to gold. The US currency is the only major fiat one not to yet see a new all-time high in the price of the yellow metal.

I reiterate then that (1) while I normally do not favor policymaker intervention in markets, (2) there is some strong evidence that the US dollar is slightly overvalued versus other currencies (and perhaps even relative to gold) to indicate a relatively laxer monetary policy would be adequate in the US at this point.

Everything else being equal, I prefer governments and policymakers to steer clear of the price discovery process enabled by free markets. As markets do tend to overshoot at extreme points in the cycle (as the pendulum swings excessively in a given direction), intervention is most likely to succeed when it is coordinated, and when it is in the direction supported by long-term economic fundamentals.

When the policymakers of more than one major country agree to nudge the currency markets in a particular direction, free market participants take notice. Such interventions are particularly successful if they go ‘with the grain’ of the market, and the pendulum has already started to reverse course. However, if coordinated multilateral intervention takes place in a way that is credible in the eyes of market participants (and/or enough of them get scared about being positioned the wrong way), such intervention can actually be a key catalyst in the reversal of the pendulum.

Given everything I perceive in the markets at this point in time, I believe coordinated nudging of the dollar towards slightly weaker levels by key policymakers in the developed world would not be inappropriate. Perhaps more importantly, I believe it would be more constructive and productive than intensifying the ongoing trade conflicts.

Because market participants are not expecting something the like of a Plaza Accord 2.0, and because the dollar is somewhat overvalued on a PPP basis against a growing number of currencies, coordinated currency intervention would probably have a high probability of success in the current environment.

Calling for a return of more global policy coordination

Much of my writing attempts (if nothing else) to highlight issues that are not receiving their deserved coverage, in my view, or where I believe I have quite a contrarian viewpoint to offer. Given geopolitical developments of the last few years, coordinated, multilateral action to improve the global economic outlook is not widely expected, to say the least. I personally do not expect it either, but that does not mean I should not advocate for it.

I still believe the United States of America is the greatest country in the world. Admittedly, such a statement is by its very nature subjective, and in the spirit of my mantra that there are no absolutes, one can never state accurately that anything is the greatest (or the worst, for that matter).

It is also impossible in my opinion to say that something is objectively the greatest or the best. Still, trying to come up with an objective standard that includes weighting for different characteristics that may be important for the largest possible number of people, etc., I will say that, by many ‘objective’ measures, the US is arguably the greatest country in the world. Just mentioning a very few factors, the largest economy in the world has the global reserve currency, and enjoys a global critical mass due to the size of its population.

It has also a very large landmass with a broad variety of climates and natural resources. It can feed itself, and export food to the rest of the world. It has a very large middle class, and a reasonably efficient market-based economy. It is quite homogenous in some respects, for example in that it has a language that is spoken throughout the vast land, and which also happens to be a language a very large portion of the world commands, at least as a second tongue. I could go on and on.

Of course, that does not mean the US does not have serious problems. Again, in my own framework of assessing almost everything through the lens of a net positive scoring process, the US ranks quite highly, and trying to be objective, arguably in the top spot. But this, in reality, is a largely subjective exercise. I always say that the net positive score will be different for every individual trying to assess a country, as it depends on many factors that should be weighted according to the individual’s preferences and priorities.

A little less America First, a little more America the Greatest

For the US’s ‘objective’ long-term standing, I would still wish we were seeing more attempts at keeping it the greatest, and less “America First.” Nassim Nicholas Taleb (an outside-the-box thinker and author of The Black Swan and Antifragile (both interesting books) argues that while status is a zero-sum game, wealth, for example is not. I very much agree, and believe that, unfortunately, people like the US president are too concerned with status or relative ranking.

Trade is not a zero-sum game. Both parties can and often do win from engaging in trade. There are many more win-win situations than the US president appears to believe to be the case.

The US is still the richest country in the world and commands the largest economy worldwide. However, China’s population is over four times larger than that of the US. Thus, once Chinese per capita GDP (gross domestic product, in this case divided by the number of people in the country) reaches roughly one-quarter of that in the US, China will match the US’s total economic output.

Assuming that, in the long run, the Chinese will generate more than 25% of the American per capita GDP, the so-called Middle Kingdom will long be the largest economy on the planet. This is essentially unavoidable, and the US must learn to live in a world where it no longer has the largest economy. It could still remain ‘objectively’ the greatest country in the world. In other words, US policymakers should focus on making the very best of a situation where their economy will no longer be the biggest globally.

More cooperation, less confrontation

I believe that a key priority for US policymakers should be to foster an environment that enables the biggest and most sustainable global economy, in which the US enjoys a ‘fair share’, based on markets that are as free as humanly possible. This, admittedly, is a lofty goal and a quite abstract one that will be subject to a lot of different views and interpretations.

Still, for starters I believe that, while the US should assertively negotiate for a level playing field in global trade, it should recognize and accept that the Chinese economy will ‘naturally’ eclipse the American one in the long run.

Based on this assumption, the US administration should be less obsessed with being absolutely first. By contributing to growing the global pie, and ensuring the US gets a fair share, the greatest number of Americans will be better off. This will entail a more collaborative, less confrontational approach than the current US administration is pursuing, in my humble opinion. But it will also improve the chances that the US dollar retains its hegemonic role as the global reserve currency, a huge privilege the American economy enjoys.

Examples of how multilateral (perhaps G-7) cooperation/policy coordination could improve the global economic outlook would be the likes of what I discussed in my articles out this past long Labor Day weekend. A ‘Plaza Accord 2.0’ would be a sign of key collaboration. Counteracting the lack of fiscal policy flexibility (but sufficient monetary policy leeway) in the US and Germany’s lack of monetary policy flexibility (but ample fiscal leeway) with a coordinated plan could be a huge boost for the global economy.

I have recently noted that the US has gotten what I perceive to be ‘precious little bang for the buck’ when it comes to a fiscal policy that now logs a Federal deficit to the tune of 4.5% of GDP on top of accumulated debt (even excluding unfunded liabilities/entitlements) of well over 100% of GDP. The US economy is still growing at a more rapid clip than the average for the developed world, but especially on a per capita basis, its relative outperformance is not significant, given the size of fiscal ‘tailwind’.

The US admittedly has a more restrictive monetary policy than the Eurozone, let alone Japan. Thus, there is room for more international policy coordination, where the Eurozone, led by Germany, could provide more fiscal stimulus even as the US relaxes its monetary policy some, for example.

If this were combined with a substantial reduction in global concerns about trade conflicts intensifying, the market response and the improvement in the outlook for the global economy could be significant, in my opinion. Unfortunately, the current geopolitical environment does not indicate such deep multilateral policy coordination is likely, let alone imminent.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.