by Guy Haselmann, Director, Capital Markets Strategy, Scotiabank GBM
· The ECB’s actions last week were described by the press as “all-in”, “bazooka”, or “the kitchen sink option”. After uttering the famous words “whatever it takes”, Draghi was basically cornered into delivering something aggressive. After a brief hesitation, financial markets mildly celebrated the move. However, any celebrations might be premature since the need for aggressive ECB actions is tacit admission that policies to-date have failed. It is also reasonable to assume that doing more of the same might fail even more dramatically.
· There are not many reasons to cheer negative interest rates (NIRP) and larger amounts of Quantitative Easing (QE). These measures act differently than ‘normal’ easing moves (i.e., a cut when nominal interest rates are positive). Evidence is mounting that both of these experimental measures are counter-productive; hence, the rosy market response is likely to be short-lived.
· Bloomberg View posted an article today entitled “The Chilling Math of Inequality” which concludes that rising inequality tends to “undermine economic exchange”. The results are based on a mathematical model developed by some European physicists. Its simple conclusion is that “as inequality gets more pronounced, a larger fraction of the population faces more stringent budget constraints and the spectrum of possible economic interactions open to them narrows”. Many believe that the rise of fringe political parties is motivated by inequality issues too.
· QE is intended to create a wealth effect that trickles down into spending and into the broader economy. However, the physics model suggests that the “trickle up” aspects are far greater than the “trickle down” benefits, thus widening inequality and hurting economic performance. These results make intuitive sense, because richer people (who own stocks and bonds) spend less in incremental benefits, than poorer people.
· According to this model, QE is misguided. QE works differently than “trickle down” supple-side economics. Central bankers, undoubtedly, realize there are limits to assets purchases and how far negative rates can fall. The back-up plan for central bankers appears to be ‘helicopter money’. The physics model would support this option, since it benefits all citizens more evenly.
· However, ‘helicopter money’ has negative potential ramifications. Like sovereign debt forgiveness, it would make it harder for central banks to control inflation, because it would lead to a permanent increase in the monetary base. I’ve said in the past that I doubt central banks can create a little bit of ‘goldilocks’ inflation; but, on the other hand, they have tools to create hyper-inflation through massive printing and debasement. Examples can be found in Venezuela and Zimbabwe. I mentioned that in the unlikely event that ‘helicopter money’ occurs here, it would be the “gold moment”.
· In the meantime, have central banks turned to NIRP as their weapon of choice due to their doubts about the impact of further QE? Or alternatively, is it due to concerns about their eventual ‘exit strategy’ from a large balance sheet? Regardless and unfortunately, NIRP works differently than other types of stimulus because of how it affects bank and consumer behavior. Banks are fearful of passing on negative rate charges to customers who might withdraw deposits. Bank profit margins become a concern. Lending gets curtailed.
· Surveys suggest that ‘zero’ is major a psychological barrier for consumers as well. Consumers view a ‘normal’ interest rate cut merely as a smaller gain, but they perceive a cut into negative territory as a guaranteed loss. Most investors would prefer to hoard money than to lend it for a loss. Those that need a place to park money would prefer a safety deposit bank. At some point, politicians view negative rates as an unfair tax to savers.
· It is difficult to fathom $7 trillion of global debt securities having negative yields. Negative yields imply that the future is more certain than the present. Who are the buyers of negative yields, and can enough of them be found? Some long-only asset managers, or indexers, may have to buy despite the negative yield. A buyer who can lock-up funding (i.e., positive carry) might buy. Some speculators are buying because they believe they can sell the securities back to the central bank, or to a ‘greater fool’, at an even higher price. Buying power is limited.
· Moreover, the higher the price goes of a financial asset, then the lower the future return will be on that asset. The ECB and BoJ have reached a point where they are struggling to push prices higher. If the premise of this note is correct - that current QE and NIRP policies have become counterproductive - then risk assets have very little upside. The risk versus reward is highly skewed to downside risks. (see my March 8th note “The H-Curve”)
· Investors should assess upside potential versus downside risk. In making that assessment, investors should take into account the amount of monetary, fiscal and regulatory ammunition left and their willingness to use it. Few would dispute that central banks effectiveness has been limited primarily because they do not have the support of fiscal and regulatory policies. Unfortunately, the likelihood of getting them all to work together is highly unlikely.
· The initial QE programs were very different, than are those QE programs today under a NIRP regime. Regrettably, many investors are still robotically responding in the same manner by chasing yield and risk; and doing so out of greed and fear of missing the upside. In addition, central banks continue to encourage this behavior at what may turn out to be the worst and most dangerous time. Not enough thought is given to the fact that central banks will have to reverse course someday. Removing accommodation is always more difficult than providing it. The SPX is currently at the same level first reached in 2014 when the Fed’s balance sheet stopped growth (i.e., when additive levels of stimulus ended).
· In a perverse way, the Fed could help the BoJ and ECB by hiking rates tomorrow. It would help to drag them away from the perils and hazards of even more negative rates. It might also help the BoJ and ECB to achieve their implied and elusive goal of weakening their currency. While markets would not like a Fed interest rate hike, the fallout from continuing with QE and NIRP could ultimately be much worse down the road.
· I often hear that the Fed has not warned the market adequately. I disagree. Stan Fischer said last week that the US was “in the vicinity of full employment” and that there were “stirrings of an increase in the inflation rate”. The FOMC has also said that they are “data dependent”. While they have not sufficiently quantified what “data dependency” means in terms of their reaction function, some data, particularly those tied to the Fed’s explicit mandates, are strong enough to justify hiking this week.
· In terms of financial market conditions, a good case can be made for a hike tomorrow given the powerful rallies off of the lows in equities, emerging markets, credit products and commodities. The calendar also works in the Fed’s favor as the FOMC meeting follows: eases by the PBoC, ECB, and BoJ; super-Tuesday voting; a Russia pull-out from Syria; and a period of stability in the trade-weighted US dollar.
· The global political and economic picture might look far less favorable should the Fed choose to wait until April or June. The difficult immigration situation in Europe might magnify. Brexit might be affirmed. China might devalue. Energy-related (or other) defaults might occur. Hiking under calm(ish) political and financial market conditions – like today – should be preferred by Fed officials.
· “When the government fears the people, there is liberty. When the people fear the government there is tyranny” – Thomas Jefferson
P.S. Beware the Ides of March
Guy Haselmann | Capital Markets Strategy
Scotiabank | Global Banking and Markets
250 Vesey Street | New York, NY 10281
T-212.225.6686 | C-917-325-5816
Scotiabank is a business name used by The Bank of Nova Scotia
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