A little goes a long way

On the face of it, a 25 basis point (bp) increase in the US federal funds rate (the interest rate at which banks trade their excess reserves) looks pretty benign and inconsequential. Janet Yellen appeared to play down the consequences, but any student of economics knows that a little bit of tightening can go a long way under extreme circumstances.

Unfortunately, these are extreme circumstances and, in combination with liquidity developments outside the US, the US Fed just tightened global liquidity conditions very aggressively.

The first chart shows the relationship between the monetary base (under the control of the Fed: notes and coins + required bank reserves + excess bank reserves) and the short term interest rate.

On the vertical axis is the interest rate and on the horizontal axis something economists call the “liquidity preference”, which is simply the amount of monetary base per unit of GDP (or, in other words, how much “money” supports each dollar of gross domestic product).

  • At very low levels of interest rates the opportunity cost of holding money becomes trivial/near zero and so more money is willingly held.
  • At very high levels of interest rates the opportunity cost of holding money is very punitive so less money is willingly held.

Money moves faster around the economy (works harder) when interest rates are high and more slowly around the economy (works less hard) when interest rates are low.

2015.12.17.alittlegoesalongway

Where are we now?

Well, unfortunately for the Fed, we are out at the far right of the chart with rates near 0 and liquidity preference at a record 22/23 cents per dollar of GDP.

So what?

Well, as we noted, money works harder when interest rates go up so for the Fed to actually tighten monetary policy they need to remove liquidity (“monetary base”) from the system. Otherwise, paradoxically, by raising rates they will have eased monetary policy (made money work harder).

How much liquidity do they need to remove?

Well, let’s look at the chart. A 25 bp short rate implies liquidity preference (money/GDP) about 30% below the current level, around 16 cents from 22/23 cents per dollar.

Given that excess bank reserves held at the Fed are $2.58 trillion, or 65% of the total monetary base, it would imply that the Fed needs to remove around $800 billion in liquidity from the system.

Note: the relationship between interest rates and liquidity (the size of the Fed’s balance sheet) is non-linear. In short, each successive 25 bp of tightening requires less liquidity removal; the liquidity removal is highly front-loaded (this was noted by former Fed Board member Professor Charles Plosser as far back as 2011). So, the first 25 bp is the hardest, requiring the better part of $1 trillion of liquidity removal. The next 25 bp are a further $200 billion (approximately) and so on.

Wow.

Indeed, that’s a lot of liquidity taken out of the system. That must have an impact on market liquidity, asset prices and the US dollar.

However, it gets worse. Look at the drawdown in global foreign exchange reserves (essentially, capital leaving the emerging markets).

2015.12.17.alittlegoesalongway2

Emerging markets are losing liquidity at an almost unprecedented rate just at the point where the US Fed is likely to be taking the best part of $1 trillion out of the system – global liquidity conditions are tightening severely.

As always, we will observe and respond as/when/if the Fed follows the path.

 

MONOGRAM CAPITAL MANAGEMENT

Deflation and the Fed… what would Greenspan say?

September 24, 2015

For those of us that have been around a while, and can remember, back in May 2003 (in the aftermath of the burst of the greatest equity market bubble since 1929) Alan Greenspan, then Federal Reserve Board Chairman said the following:

  • “We at the Federal Reserve recognize that deflation is a possibility. Even though we perceive the risks as minor, the potential consequences are very substantial and could be quite negative”  (Alan Greenspan, Congressional Testimony, May 2003)

At the time, this came as something of a bombshell, for the Chairman of the Fed even to entertain the possibility of deflation was quite a surprise to markets.

We thought it might be interesting to look at the parallels between today’s US inflation picture and that of the Spring of 2003. The comparison is quite striking.

We looked at 180 individual line items in the total Consumer Price Index (CPI) and the 106 line items that pretty much make up the Core CPI:

  • The chart shows that currently 43% of the individual core inflation items are in annual deflation, that compares to 48% in the Spring of 2003 and 45% in late 2010
  • The annual core inflation rate is currently 1.8% versus 1.5% in 2003
  • We are currently seeing the same breadth of core deflation that we saw at the bottom of the cycles post 2000 and 2009 bear market crashes

2015.24.09.DeflationandFedGreenspan

We then looked at how annual core inflation for the 106 sub-components had changed over the last 6 and 12 months to see if there was any clear trend:

  • In the Spring of 2003 about 60% of the components had seen year/year inflation decline in the previous 6 and 12 months (a clear downward trend) compared to about 50% today

2015.24.09.DeflationandFedGreenspan2

Interestingly, in 2003 we saw:

  • 48% of core inflation components in deflation and 60% with a clear downward trend

In 2015 we see:

  • 43% in annual deflation and 53% with a clear downward trend

Our thought is then, “What is so different?”

Greenspan was worried about deflation and yet now Janet Yellen appears to be itching to tighten. (Growth was strongly accelerating in 2003/4 and has been stuck at 2.5 – 3.0% in the last year or more, so that can’t be the reason).

Could it be the fabled “tightness of labour markets” argument, the so-called “Phillips curve” fed to generations of economics students purporting to link labour markets to inflation? (Along the way, countless economists seem to have lost sight of the fact that A. W. Phillips’ famous 1958 paper was titled “The Relation between Unemployment and the Rate of Change of Money Wage Rates in the United Kingdom, 1861-1957” and said nothing about unemployment and consumer price inflation).

Well, here is the relationship between the US unemployment rate level and US average hourly earnings over the last 50 years:

  • Clearly, even to an untrained eye, there isn’t one. A lower unemployment rate does not push up wage inflation…
  • There is, truly, nothing in the historical data to show that a lower unemployment rate (a “tighter labour market”) implies faster wage inflation (or, for that matter, faster price inflation)
  • Look at it with lags, as changes, whatever way you like, the “tight labour market/higher inflation” thesis cannot be substantiated… another case, to paraphrase our hero Thomas Huxley, of “a beautiful theory and ugly facts colliding”

2015.24.09.DeflationandFedGreenspan3

Conclusion:

  • If Greenspan was worried about deflation in 2003, why does Yellen not share the same concern (especially with the Chinese banking system in the state it is in and a Yuan devaluation on the way)? Would Greenspan be considering another round of QE here? We are inclined to think it would be foremost in his mind if he were still Fed Chairman.
  • Tight labour markets/faster inflation concerns just cannot be substantiated by the data; that is no reason to tighten.
  • US consumer inflation is determined exogenously (outside the control of the Fed) by the vast global overhang of global supply. Inflation in assets, inflation in balance sheets and surging debt are endogenous (inside the control of the Fed). They should tighten to address the latter and lay to rest old ghosts of Phillips curves. God forbid we get more QE, the consequences will be even worse when the rebalancing and re-pricing of risk takes place…
  • Because Central bankers are raised to believe that consumer price inflation is the target variable, they completely missed the consequences of inflation in asset prices and balance sheets in the last two cycles (confusing a positive supply shock from Chinese over-investment and low shop inflation with a miraculous surge in underlying productivity growth and hence trend GDP growth) and risk making the same mistake again…

 

MONOGRAM CAPITAL MANAGEMENT

It is the US… again!

May 8, 2015

The last two weeks in financial markets have been somewhat of a rollercoaster, with bonds, stocks and the US Dollar selling off in unison, wiping out several hundred billion dollars off global wealth in a matter of days. European bonds took a severe beating, which, as explained in one of our previous blogs, was inevitable considering that a large proportion of them were trading at prices that guaranteed a loss at maturity.

Panics in financial markets always show up unannounced, which makes it all the more interesting to understand ex-post what triggered these brutal moves. Friends of MONOGRAM have heard us mention many times that in essence, this is all about the US. The US drives capital and sentiment, and are therefore more often than not the culprit behind volatility bouts. All major crises in the last 30 years have started in the United States: the 2008 Lehman debacle, the 2000 Tech bubble, the 1998 LTCM bailout, and the 1987 market crash.

This time around, two factors seem to have been the catalyst behind the coordinated retreat in assets markets. First, a couple of fixed-income investment luminaries, Bill Gross of Janus Capital and Jeffrey Gundlach of DoubleLine Capital (who incidentally are both American), have been vocal about the inflated valuation of European sovereign bonds. Gross going on to call long-dated German bonds “the short of a lifetime”. This means that betting on these bonds going down is effectively almost a sure bet, the closest thing to free money.

Secondly, the US economy is going through a bit of a soft patch. This should in theory be favourable to bonds, and perhaps not so good for equities, but both asset classes have gone down. Why? Mostly because the US Federal Reserve said that this would not change its perception of the overall upwards trajectory of the US economy, and therefore it would not change its plan to tighten monetary conditions by the end of the year.

But perhaps the Federal Reserve is wrong. Perhaps the US, which has been expanding modestly over the last 6 years, is starting to turn the corner for the worst. This of course, would be supportive to bonds, although interest rates are so low that upside here is limited. This would also be a headwind to stock market performance, not only in the US, but also in Europe; and this is even if European economies finally break out of the stagnation world it has been living in for years.

Why is that? Because the US economy actually has a much larger influence on the fate of developed markets than the local economies themselves.  This means that what matters most to the performance of say, UK stocks, is not so much whether the UK is in recession or not, but whether the US is in recession or not.

To show this, we look at the performance of 5 local markets on a quarterly basis, selecting only the quarters when (i) the US was in recession, but not the local markets, and (ii) local economies were in recession, but not the US. Our sample includes France, Germany, Italy, Spain and the UK. Going back to 1992, our findings are crystal clear. The simple average annualised performance of local markets when we observe:

  • Local expansion and US recession is -22.0%
  • Local recession and US expansion is 13.1%.
1992 – 2015 Annualised Local Markets Performance
US recession France expansion -25%
US recession Spain expansion -13%
US recession UK expansion -21%
US recession Germany expansion -30%
US recession Italy expansion -20%
US expansion France recession 21%
US expansion Spain recession -1%
US expansion UK recession 21%
US expansion Germany recession 20%
US expansion Italy recession 5%

In light of these results, it is certainly worth keeping a very close eye on the fundamental US dynamic- and hope that the Federal Reserve is right. As former US President Bill Clinton once famously said- “It is (about) the economy, stupid”. That is right, it is about the economy … of the US.

MONOGRAM CAPITAL MANAGEMENT

Asian borrowers in trouble

March 13, 2015

With the US dollar trading close to a 12-year high, over-leveraged Emerging Market currencies look very vulnerable. This is because Emerging Market financial assets (read debt levels) have approximately doubled since 2008. Asian countries in particular have pilled foreign debt at an accelerating pace with the year-on-year debt growth for the Asian block now reaching 35%.

From the perspective of an Asian investor, leverage makes sense. Borrowing large amounts of money in a depreciating currency means less capital to pay back at maturity. And low interest rates (US rates have been close to zero for 6 years) make for negligible interest payments. Asian countries have gorged on this bonanza and the jury is out as to whether this is going to result in a painful indigestion.

The moment of truth might be near. The US dollar is powering ahead as the US Federal Reserve (the “Fed”) has indicated that its next monetary policy move will be restrictive, not accommodative. The Fed is remarkably lonely here as 9 countries have lowered their main interest rate since the beginning of the year already.  Yesterday again, the Korean Central Bank reduced its key rate to a historical low of 1.75% and the Chinese are considering a similar move. With comparatively fewer dollars and more of other currencies in the system, the value of the greenback has to go up.  This is exactly what is happening, and this is happening quick- the USD trades 10% higher than at the end of 2014.

At MONOGRAM we are staying away from Emerging Market stocks, since a forced de-leveraging caused by a strong dollar will certainly translate into substantial downside in domestic equities. But should the going get tough, these assets will probably trade low enough to present a bargain. Until then, we prefer the safety of the US market.

MONOGRAM CAPITAL MANAGEMENT