Heterogeneous Central Banks and Markets
David R. Kotok
Cumberland Advisors, April 6, 2015
“From a rates perspective, monetary policy uncertainty has a significant impact on the front end of the yield curve. That is why front end vol is at taper tantrum levels. The long end, on the other hand, is benefiting from low fiscal uncertainty and also from elevated fiscal uncertainty abroad, in particular in Europe. In other words, what matters for US yields is not only the relative stance of Fed and ECB policy but also the relative stance of fiscal policy uncertainty in the US relative to Europe. Or put differently, the downward drag on US rates from abroad will likely continue as long as the ECB does QE and as long as there is elevated policy uncertainty in Europe.” Torsten Slok, Chief International Economist, Deutsche Bank Securities. April 6, 2015.
We thank Torsten for permission to quote him.
Readers, please note that my colleague, Bob Eisenbeis, is working on an extended commentary about the significance of Fed Chair Yellen’s recent message. That will be forthcoming shortly, maybe tomorrow or Wednesday.
Meanwhile, and for me personally, the last three weeks have been remarkable. While in Paris, we were able to spend quality time investigating and discussing central bank policy throughout the world. That meeting was a partnership effort of the Banque de France and the Global Interdependence Center (GIC). Session videos, photos, and presentations from the event are available on the GIC website.
After returning from Paris, we were privileged to attend the “20th Annual Financial Markets Conference: Central Banking in the Shadows: Monetary Policy and Financial Stability Postcrisis” on March 30–April 1, hosted by the Federal Reserve Bank of Atlanta (Atlanta Fed). We have had the opportunity to participate in this conference in the past. It is one of the finest monetary policy research and discussion assemblages in the United States. This one was particularly important and high-powered. Session information and presentations can be viewed on the Atlanta Fed’s website.
We found the Atlanta Fed’s conference to be in perfect sequential timing with the meeting in Paris. From that Atlanta Fed conference at Stone Mountain, Georgia, the takeaways are immense. For me, they build on the outcomes of the previous week’s discussions at the Banque de France.
Let me offer some bullet points, and then we can think about what this all means.
· Aggregate interest rates are falling throughout the world. They have been in a downtrend since the end of 2011. The rate of decline in interest rates accelerated from October 2014 through March 2015, details below.
· Global policy divergence is enormous. This is a new phenomenon. The remarkable difference between US policy, with its slight upward bias toward higher interest rates, and the rest of the world is a key takeaway from these back-to-back, central-bank-hosted conferences. At the end of this commentary we will recap the activities of non-US central banks since October 2014. The activity has been extraordinary.
· US interest rate policy is currently at neutral or with a slight upward bias. The combined takeaway from the two meetings is that the Federal Reserve (Fed) intends to raise its policy interest rate sometime before the end of 2015. Market agents expect the increase to be 25 basis points (0.25%) to 50 basis points (0.50%) by year-end. At Cumberland, our view is that the first hike will come in September 2015. We expect that hike to be a quarter-point movement expressed as a raise of the interest rate on excess reserves (IOER) from 25 to 50 basis points. We also recognize that weakening employment statistics and some evidence of economic deterioration in four US oil-sector states may delay that raise. A further decline in oil prices and an additional surge in the US dollar versus other currencies might also delay it. We do not see anything on the horizon that will accelerate the Fed’s program. All of the apparent evolutionary elements of economic recovery favor delay versus acceleration.
· The real question is what it means to have “heterogeneous” monetary policies at work in the world. There is a strengthening bias in the world’s reserve currency, the US dollar, countered by a weakening bias in the second largest currency block (the Eurozone), and in the Japanese yen, and in many other currencies. In examining this question, remember to look at contiguous or related economies and currencies. For example, the Hong Kong dollar is managed in a structure that keeps it tied to the US dollar. In Europe, Denmark is not part of the Eurozone but is contiguous with Eurozone countries. So are Poland, Sweden, and Switzerland. The fact is that, if a country engages in cross-border trades, participating in an open commercial area as part of an organizational structure such as the European Union, with economic activity that is priced in its own currency, it must defend its economy from divergent currency against its neighbors. Take two villages in the Baltic region, where the national border between them is open but their currencies are different. People in the two villages engage in the same business activities. They compete with each other and hire labor that is somewhat mobile. If one of their currencies is dominant but subject to policies of negative interest rates and monetary easing, it is only a matter of time before the other country with the other currency has to do the same things in self-defense. I have just described, Finland, Sweden, Denmark and Germany.
· Fed Vice Chairman Stanley Fischer spoke at the Atlanta Fed conference and then accepted questions. During the Q&A session he used the term less often. He used it in the context of discussing changes in policy, how one addresses them, and whether there is a way to slowly alter policy and thereby avoid reversals – his implication being that this extraordinary worldwide monetary policy situation requires that policymakers make changes “less often.”
Sitting next to me at dinner was Dino Kos, now at CLSA and formerly executive vice president and head of the Markets Group at the Federal Reserve Bank of New York (New York Fed). Dino has had a distinguished career at the New York Fed in the areas of global foreign exchange, banking, and economic affairs. Dino and I have gotten to know each other, and we break bread together when we can. Following Stanley Fischer’s speech, Dino and I discussed the matter of “less often.” We thank Dino for permission to cite him. He noted a little history that is sufficient to give pause. He pointed out that in 2000 the Bank of Japan tightened policy and then had to reverse itself; in 2009 Governor Stefan Ingves, head of the Sveriges Riksbank, tightened and then had to reverse himself; and in 2011 Jean-Claude Trichet, then president of the European Central Bank (ECB), did the same. Dino and I discussed reversals and what they mean for policymakers, markets, market agents, and businesses.
What happens if the Fed raises rates once or twice in 2015, the economy continues to slow, and then evidence suggests that the Fed is repeating the 1937 error of tightening too soon after the Great Depression? Imagine that at the same time oil price pressure is downward and the wage-level and labor-force recovery is persistent but slow and not intensifying. Imagine too that the inflation rate still remains below the 2% targets that exist nearly everywhere in the developed world. Under those conditions, would the Fed have to reverse itself? Would the Yellen Fed find itself in the same unenviable position as the central bank organizations mentioned above? This is speculation, but it is certainly a subject of discussion inside central banks. They must manage the risk of waiting too long in order to avoid acting too soon.
· Another takeaway was the dinner speech by Robert (Bob) Rubin. Informally he is a very gracious Bob Rubin who has had a distinguished career, including his tenure as the 70th Secretary of the Treasury (1995–1999), and he currently serves as co-chairman of the Council on Foreign Relations. Bob Rubin is an elder public official who served President Clinton as a Democrat but is now is in a position to set politics aside and assess the world objectively. Former Treasury Secretary Rubin makes the case that fiscal reforms and fiscal systems are broken. We agree. Ask anyone who observes the governments in Washington DC and other capitals about their confidence in the political system. Their answer is that it is broken in the US and abroad.
· Monetary policy, which is essentially a set of rules for banking systems, is being asked to do too much. It can set interest rates, fight or encourage inflation, and have some stimulative effect on growth – although the latter effect is somewhat questionable. It can also make sure there is ample liquidity for systems to operate and exchanges to occur. The purpose of central bankers and monetary policy is to make the money system work. On this there was complete agreement in Paris and in Atlanta.
But monetary policy cannot create reforms or cure broken fiscal systems. It might be able to delay the pain of fiscal-system failures, but it cannot fix them. Today, monetary policy is the only tool that is being applied in most of the developing world. Why? Because it seems that political systems are incapable of implementing reforms, resolving fiscal issues, and achieving positive outcomes.
· Another takeaway came from a different panel at the Atlanta Fed conference. In the old days we had something called the “Greenspan put,” when markets anticipated that the activities of the Fed under Alan Greenspan would prevent a crisis from occurring. Martin Hellwig of Max Planck Institute for Research on Collective Goods discussed the “Draghi put.” He speculated as to whether we have reached the point at which the activities of President Mario Draghi of the ECB have created worldwide market anticipation of a “Eurozone put.” We do not know the answer, but it is quite possible that there is a “Draghi put” at work today and that we will watch it strengthen through mid-2016 or later.
To sum up, we see the following situation in the US. The Fed is a tad above neutral with a slight bias towards tightening. Fed policymakers want to get away from the zero lower bound. They know they have to do it: the zero bound has created distortions. They also know that they must get markets to clear. In order for that to occur, US interest rates must go up, even if only by a small amount.
Elsewhere, nearly the entire developed world and a good part of the developing world are lowering interest rates and easing monetary policy. Barclays has compiled an instructive list of countries and their central banking actions from October 31, 2014, through the middle of March 2015. These countries have eased policy rates and done so in a fashion that is measurable and confirmed. Note that the US and the United Kingdom are the only major countries that are not on the list. (The United Kingdom is proximate to Europe, but it carries out its own independent policy functions through the Bank of England and as a financial center.) Barclay’s list includes Australia, Canada, China (twice), Denmark (twice), the Euro area, Hungary, India (twice), Indonesia, Israel, Japan, Korea, Peru, Poland, Russia, Singapore, Sweden (twice), Switzerland, Thailand, and Turkey. Note that without the US and the UK, I have just listed nearly most of the remaining world’s financial market asset countries and GDP.
The world is engaged in a remarkable worldwide monetary experiment. The takeaways from our two monetary conferences tell us that for the last century there has not been anything like this present environment.
The bottom line for investors is now very complex. We know such policy activity cannot continue forever. We know that monetary easing, falling interest rates, and negative interest rates create upward biases in asset prices. We also know that the benefits of higher asset prices are enjoyed by only a small portion of the population – the wealthier folks, who have accumulated savings and own the assets. The translation of rising asset prices to economic growth, consumer spending, and an eventual credit multiplier is painfully slow. We also know that growth is elusive in many countries. There are deflationary pressures in some sectors, particularly Energy, while other sectors are seeing productivity gains and labor dispersion, allowing cost pressures to be controlled and profit margins to be maintained.
Our bias is to be fully invested and to continue in that mode until such time as policy levels approach some equilibrium. We also recognize that it is necessary to be extraordinarily nimble when it comes to dealing with policy changes. We would not choose the present environment as an ideal investment climate. However, it is one we have to live with as we manage portfolio structures for our clients.
-David R. Kotok, Chairman and Chief Investment Officer
David R. Kotok, Chairman and Chief Investment Officer