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December 16, 2014

Central Banks, Two Wrongs Don't Make It Right!

·         Inflation is out of sight in terms of Treasury bond yields, dollar exchange rates and demographic outlook – let’s not even mention energy costs!
·         Much of the FED’s monetary base expansion did not flow into consumption or, more importantly, entrepreneurial productive investments!
·         Money multiplier is more like a fractional now, since not even credit increased the money available for Main Street the way it used to.
·         Why raise interest rates if new dollars did not really filter through to the aggregate money stock readily accessible for spending?
·         The only worry in sight is probably financial assets inflation due to carry trade and Wall Street’s more speculative moves.

Lately, I have my eyes focused on interest rates. This should not be a surprise. October has just put an end to yet another spree of money printing and Central Bank interference on the market.

I have been hearing and reading a lot of comments on some imminent rate hike by the FOMC in thecoming year of 2015. Well, when it comes to interest rates, we should break that down instead of taking it all as just one single thing.

The Federal Open Market Committee (FOMC) gathers eight times a year to deliberate on the targeted Federal Funds rate (Fed Funds). By trading government securities, the New York Fed affects the federal funds rate. This rate is just a target rate that guides overnight loans. Depository institutions are required to keep a fraction of their deposits as reserve at central banks. Those that have a surplus balance lend it to institutions that are short of their reserve requirements. These routine transactions are very brief loans that involve no collaterals. As the term overnight indicates, they are usually settled in the next day. It is just a way of redistributing reserves between banks. So banks may borrow these Fed Funds to avoid an overdraft on their reserve account. Fed Funds are immediately available as cash for spending, unlike checks that must be cleared before being accessible as money. Though these loans are extremely short-lived, the Fed Fund rate is obviously annualized as reference. When the FOMC raises this target rate, to a certain extent, it discourages banks to move money so freely, and this affects the economy. The weighted average of all Fed Fund transaction rates is calculated as the Fed Fund effective rate.

But for us, interest rates involve a lot more than that. In corporate finance, there are certificates of indebtedness, also called debentures, bonds or notes, which are medium- to long-term debt instruments used by large companies to borrow money at some rate of interest. National debt securities are usually seen as less risky than many private debt instruments. It may be ironic that governments with not so responsible politicians may borrow money cheaper (paying less interest) than more responsibly managed companies, but the reasoning is that countries do not go bankrupt disappearing from the map. And the tradable debt securities that offer the best liquidity are the U.S. Treasuries, not just because of the sheer size of the U.S. economy, but also due to the unrivaled size of the U.S. public debt. These Treasuries are also seen as very low-risk instruments, since they are secured by the full faith and credit of the United States government.

These Treasuries are issued with different maturities and sold in auctions. There are short-term Treasury Bills (with maturities up to 1 year) Treasury Notes (with longer maturities up to 10 years) and finally Treasury Bonds (with maturities greater than 10 years). Just as there are different maturities, there are also different interest rates. Short-term T-Bills normally involve less risk and therefore lower interest rates (yield). On the other hand, longer-term T-Bonds usually pay more interest because more time involves more unforeseeable variables in the economy.

So maybe the FOMC raises the Fed Funds rate a tad. It is currently at 0 to 0.25% annualized. Last month’s effective rate was 0.09%. But if this happens, I would see it more as a bluff or an attempt to probe the markets’ response. I do not see any fundamentals for a progression of rate hikes. And if a move occurs, I do not believe it would be that relevant on the longer end of the yield curve. The market has already been narrowing the spread between short- and long-term interest rates by lowering the long end of the curve. Every time a QE ended, T-Bond demand has increased, suggesting its popularity among investors, institutions and even foreign central banks. Usually, the long end of the yield curve is way higher than the short end. When long-term interest rates get closer to short-term rates, this signals worries. Buyers fear that the economy may face problems ahead, so they are willing to settle for lower interest rates right now.

This is already noticeable since the tapering of QE3 began in January. 

I believe we will continue to see the flattening of the yield curve, but much more due to the lowering of the long end (20- and 30-year-Bond yields), than actually a rise in the short end of the T-Bills.

Six years after the collapse of Lehman Brothers, we still see a down trend of long-term interest rates. And this is not because of the FED buying long bonds, it is actually in spite of the FED’s asset purchases. During the last three episodes of quantitative easing, interest rates of long bonds have actually gone higher. That is correct! 20- and 30-year Treasuries got less expensive and their yields went up! Not exactly what we expected from the Fedspeak we all heard.  But every time the FED withdrew its QE, the market came right back to buying bonds and lowering long-term rates. I do expect we will see more of the same behavior in 2015. This move of institutions, investors and central banks into the long end of the yield curve, buying long bonds and accepting lower yields, suggest confidence in the U.S. Dollar. Any dollar devaluation would imply in more inflation in the U.S. and higher interest rates, devaluing prices of 20- and 30-year Treasury Bonds. So the market seems to believe that the dollar will hold its value and maybe appreciate.

There are two popular sayings that I find very instructive when following the market with all those marketeers out there, the first one is “Put your money where your mouth is!” and the second is “When money talks, bullshit walks!” So, instead of paying too much attention to all the noise, chatter and hubris from a crowd of talking heads, I find it more productive to see what the market is really doing with the money. (I must mention that I am NOT a believer in the Rational Expectations or Efficient Market theories, I just try to pay more attention to what is being done, instead of what is mostly being said)

One way I try to observe and analyze any inflation expectations already implicit in the behavior of investors is comparing interest rates. For that I use the interest rate of long U.S. Treasury Bonds with constant maturity (for all their trustworthiness) and divide them by the interest rates of lower quality debt instruments that are referred to as High Yield or Junk Bonds and do not hold investment grade from rating agencies. For the numerator, I’m using the 20-year Treasury constant maturity rate just because the 30-year bonds were not issued from 2002 to 2006. For the denominator, I adopted an index published by Bank of America Merrill Lynch that tracks corporate debt with a CCC or worse rating (BofA Merrill Lynch US Corporate C Index). These are bonds of lower quality that offer higher yields.

The underlying logic is that when the economy is growing, there are fewer worries about the quality of the debt. A higher tide lifts all boats. More confident, investors buy junk bonds with higher yields instead of T-Bonds that pay less interest. But the growing demand for higher risk and higher yields happen to raise junk bond prices and drive down their yields. If the economy prospers, inflation usually picks up and that hurts those people that have safer T-Bonds but lower yields. Inflation may bite a big chunk off those already lower interest rates. This tends to hurt the demand for Treasuries and, with their falling prices, their rates tend to move up. The following diagram summarizes the idea:

From what I have noticed, the ratio between interest rates of these different groups of debt securities tends to anticipate the behavior of inflation in the U.S. by several months!

The inflation lags in these charted lines seem to have been affected by the collapse of Lehman Brothers in September 2008. Before Lehman, the yields ratio used to anticipate the general course of inflation to come by more than a year. Apparently, the panic and the Fed’s QE have disturbed the average time divergence, shortening it to just a few or several months. I find this anticipation observed in the interest rates ratio very interesting, since people tend to believe that interest rates move as a consequence of the observed inflation, that is: after the fact. But, as the chart above suggests, inflation seems to be more like a delayed manifestation. Investors, institutions and companies have perceptions and form expectations for the economy that seem to guide their behavior in the bond market much faster than the consumer price index can externalize it.

In spite of that, the chart shows a last wave that started to move up in June 2012 and reached a top around the end of 2013 (mostly in lockstep with Quantitative Easing Three) and then drops during the course of 2014 (again in lockstep with the Tapering of QE3, when the Fed gradually withdrew its interference in the market and in the U.S. monetary base). This last wave did not manifest itself in any measurable inflation. Not yet, at least. But we have seen roughly 30 months go by since that trough in June 2012, and such a long time lag seems odd. It is more likely that we will not see an echo manifestation in consumer prices. Therefore, that ratio’s last wobbly behavior may have been more of a distortion initiated by QE3 and then corrected by this year’s Tapering.

If with the first two editions of Quantitative Easing (QE1 and QE2) the Fed was indeed able to move first the expectations that guided the bond market and then, secondly, inflation, with QE3 only the bond market participants seemed to react. Inflation just shrugged its shoulders and marched on sideways.

There seems to be an important message here: anti-cyclical monetary policies of the Fed may indeed be losing effect. Even though QE3 was still able to generate expectations and repercussions on Wall Street (which we saw reflected in the yields of different Bonds), the real economy of Main Street (represented by the consumer price index) seemed already unresponsive to the latest Fed’s monetary stimulus. This cannot be neglected! QE3 was indeed the fourth intervention from the Fed in the last 6 years. There were QE1, QE2, Operation TWIST and QE3. QE3 was not just the longest, but also the most expensive of these interferences. Check out below the dimension and chronology of these interventions in the market.

Personally, I am flabbergasted by the fact that the Fed has been acting almost nonstop in the market for the last six years! QE1, QE2, Operation TWIST and QE3 stretched for sixty two months altogether. So in a total of seventy two months since QE1 was announced on November the 25th of 2008, only for measly ten months the markets were not babysat by the Fed.

Just like an organism may develop tolerance and resistance to a particular chemical substance that has regularly been administered, the world may be getting also less sensitive to John Maynard Keynes’ catecheses and the indoctrination of his prominent central bank evangelists.

But if we look elsewhere, we may notice that this weak inflation conundrum seems to be echoing in different indicators. Another one of them is the U.S. Dollar Index, which measures the value of the dollar against a basket of different currencies. If the devaluation of the dollar (that elusive goal of the Fed!) would cause inflation, we must also concede that an appreciation of the U.S. currency shall have a disinflationary effect on consumer prices (or maybe even deflationary). American imports get cheaper with a stronger dollar. Since the U.S. imports more than it exports, the country ends up importing disinflation from abroad! And to illustrate this inverse correlation between the dollar value and consumer price inflation, I have charted the U.S. Dollar Index inverted (upside down) superposed to the U.S. CPI inflation recorded since September 2006. And here too, we see a certain anticipation of the Dollar Index that suggests further disinflation.

Like in 2008, 2010 and 2012, we may see inflation rate reaching down to 1% a year - and this will raise a lot more hair on the Federal Reserve Board this time (and I don’t mean this literally just because Bernanke is out). So far, the Fed’s pattern has been to turn on the presses and start minting dollars for QE as soon as inflation gets scarily close to 1%. But I bet this time they will hesitate a bit more! Besides their own experience showing less effectiveness, other factors may delay any tactical move from the Fed. First, it seems more prudent to let the economy toddle on its own for a while, just to check out the strength of its legs and how far it can get without leaning on the Fed. And second, if the world did not learn enough from Japan’s 1990 demise to prevent a similar crisis, it may be paying more attention to its present dire straits.

Japan is showing us that an exaggeration of monetary stimulus, with faster minting of money and the devaluation of the Yen, is not generating much positive result in its economy. It sure revived Japanese inflation from an overextended comatose state! But annualized GDP growth came out negative for the last two quarters (-6.7% 2ndQ and -1.9% 3rdQ). The same happened to industrial production, its annualized growths were actually retractions of -14% and -7.5% for the same respective quarters of 2014. Despite an inflation of +2.9% in October (assaulting for Japanese standards), the 3rd quarter GDP (Gross Domestic Product by Expenditure in Constant Prices) contracted -1.1% compared to the same quarter of 2013. So Japan may be swapping its deflation for an even more destabilizing stagflation.

The policy of Yen printing acceleration, devaluing the Yen, may have cheapened Japanese exports, but it inflated the costs of imported products and materials for Japanese industries and consumers. This caused a large number of bankruptcies in Japan. The problem did not become worse due to the providential (but expected) bust of the oil bubble.

To forcibly devalue a currency, trying to intimidate a population (that is already ageing and shrinking) into spending and consuming more is an audacious, and seemingly also irresponsible, stake.

There has been a series of mistakes and irresponsible behavior in the global economy. Especially the excessive credit directed to the most advanced (and already mature) economies (if only a large part of that financing had been directed to research and development of new technology in alternative sources of energy, instead of overconsumption plus real estate and financial speculation, perhaps both the economy and the climate could be in a different state of affairs). It was really unfortunate that regulatory agencies did not exhort the abusive leveraging of the private sector in developed nations, especially in view of Japan’s precedent - an economic jam that dates as far back as 1990. But two wrongs don’t make right. And it seems to me that a massive series of remedial central bank actions that exceed the already excruciating six-year span may very well be another mistake!

Central banks also seem to try to compensate for a several-decade-long drop in nativity rate and a declining young population by pumping new money into the financial system. As if freshly minted dollars in the banks could substitute younger people on the streets! And by saying this, I mean that there is a good correlation too between inflation trends and the number of teenagers and young adults in the economy. We must acknowledge that raising kids involves money – and not just a little of it! Youngsters have a characteristic need to fit into the world. This heightened search for identity, social activity and popularity boosts consumption. Young people crave fashionable clothes, accessories and all sorts of distractions, goods and gadgets. They also start to eat a lot more! Don’t even mention college expenses! This pushes consumption up, but rarely contributes enough for the production output in the economy. The equilibrium between supply and demand is affected, tilting heavier on the latter.  Many economists seem to neglect this demographic and social aspect of the economy. I have shown the relationship before in a text titled “The Rock ‘n’ Roll in the Market”. There, I simply used the number of births for each year in the U.S. (adjusted to immigration) and charted it with a 21-year delay superposed to CPI inflation. The correlation was clear for all to see. In a more recent study I tried yet a different approach. In the chart below, I am representing a wider range of youths, between 16 and 22 years of age, and I am also dividing them by the overall U.S. population to obtain the percentage of these young individuals. The U.S. does not face the same problem that Japan is facing, but still, the demographic profile is yet another fundamental that suggests a period of very modest inflation.

The Fed has been printing dollars and expanding the monetary base. It is moving these dollars forward by buying debt securities. This already expanded monetary base, normally, would yet be multiplied by the credit operations of commercial banks, which happen under the fractional-reserve banking system. This money multiplier effect makes the stock of money readily accessible for spending (M1) greater than the monetary base itself. So M1 is usually a multiple of the monetary base! But then again, that is what normally happened, and not what we are seeing since Lehman’s collapse and all this QE frenzy.

When demand for credit is reduced due to the aging of baby-boomers or an already debt-saturated population, offering more credit to people becomes a real challenge. If monetary policies are efficient in constraining a fast-paced economy and consumption, pushing ahead an economy that is stalling and in need of deleveraging is a much more complicated issue. Thus we hear that famous comparison with pushing on a string. You can use it to pull and hold back the economy, but not to push it forward. This is exactly what we are seeing.

The stock of money readily available for spending (M1) is not a multiple of the monetary base anymore, not since 2008. There has been not enough demand for it! M1 actually became a fraction of the total amount of dollars in the monetary base. In other words, a substantial portion of these minted dollars has never been converted into consumption or entrepreneurial fixed capital formation, and let’s not even mention credit concession!

The question is: if a considerable chunk of the monetary base was never translated into accessible money and much less multiplied by bank credit, then why so much talk about the FOMC raising Fed Fund rates? Why would they print all this money and months after, just render an even larger fraction of it into couch-potato-dollars without letting it work its way into the real economy of Main Street? Under my scrutiny, I have not identified any potential inflationary threat on the horizon. (1) Not in the expectations and behavior reflected in the long-bond market; (2) not in the recent appreciation of the U.S. Dollar; and (3) not in the demographic profile of the United States. I dare to say that the only conceivable, but still speculative reasons for any interest rate hike by the FOMC would be either (A) a bluff or a decoy to sell “inflationary expectations” to the people and see if they bite the bait and behave in a way that may actually produce some real inflation, or (B) simply a way of shaking up the U.S. stock market and try to prevent the expansion of a larger bubble in stocks.

Anyway, based on the Fed’s results and those of the more desperate Bank of Japan, maybe central bankers should act with more modesty and caution when handling their power. After all, it is known that with great power comes also great responsibility!

Copyright © Sebastião Buck Tocalino - De Olho Na Bolsa

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