Dear readers,
This is an article I wrote on the 5th of December as part of my research job I am doing at EAB, but I thought it still would be relevant to share. The FED decision earlier this week has made this article even more relevant, and the debate about demonetizing debt will resume.
As we are working ourselves through the credit crisis and the recession we will regularly look back to see what got us into this and try to learn from the past in order to avoid the same mistakes are made. This morning we were discussing Kaletsky’s column in the Times. Apart from which camp you are in, the doom and gloom supporters or the band that kept on playing on the Titanic, the measures that have been taken will take time before they start showing signs of economic improvement.
Kaletsky has a valid point that most of the Central Banks are ahead of the curve this time and flooding the market with liquidity and cutting rates like there is no tomorrow. At least on the monetary front people learned from the mistakes that were made in the past. Japan is in every central bankers text book nowadays how things should NOT been done.
To refresh your memory, let us go back in time and see what exactly happened there, and whether this might give us some insights whether history will repeat itself?
Japan in the eighties was the China of today. It was the economical miracle of the century, even more than the impressive turn around that Germany experienced after WW II. After the Plaza Accord[1] the JPY rallied dramatically against the USD. Especially in the late 80-ties they were using their JPY strength to buy up the world, with the most eye catching move the purchase of the Rockefeller Centre in NY. It was a sign of the times their economy was becoming a bubble. Everything rose on a day-by-day basis. Stocks (Nikkei went from 20.000 to just below 39.000 in 2 years) and real estate went through the roof.
Property became highly inflated due to reckless financing by Japanese banks, similar to what American banks did during the last decade, but with one exception: in Japan there wasn’t subprime involved and even less SIV’s and shadow banking (proving by the way, as I have always said, that one does not need fancy derivatives or synthetic instruments in order to lose money!).
The only similarity with the current crisis was that models assumed that real estate couldn’t drop, or certainly could not drop on a national level. Typical for every bubble the talk of the street was TINA (there is no alternative) or ‘this time it is different’. But it wasn’t. All bubbles pop, one more brutally than the other, but burst they do. What ultimately triggered the sell off in the Nikkei is difficult to say even now, as this is more an area for behavioural finance. Lemmings behaviour is part of the explanation as markets get ahead of themselves. However, usually one can also look at the build up of all this and there one ends up with human error. This is a people business after all, and some people are just better at their jobs than others…
What was the human error in Japan? The reckless behaviour of banks? No. This was only the consequence of a far more serious error. As was pointed out above, the JPY started to strengthen on the back of the Plaza Accord. The Bank of Japan (BoJ), under political pressure, tried to counter the negative impact of JPY strengthening on their export competitiveness by lowering interest rates even all the way to 2.5% at the beginning of 1987. Only 2 years later Japanese officials started to realize the mistake they made, and started to hike aggressively all the way up to 6%. They actually kept on hiking far beyond the burst of their bubble.
The latter is the big difference with today. At this moment especially the FED and BoE – the ECB is more lagging in all this – showed strong signs of leadership., however especially the FED has played its cards on the short term interest rate front, and similar as the BoJ in the late 90-ties, is facing the liquidity trap. Basically this means that a central bank is unable to continue to stimulate the economy with the traditional monetary tools, being the discount rate, as it is already close to zero. As a consequence an even more uglier ghost shows up : DEFLATION.[2]
Let us first explain why the FED doesn’t have a lot of room to manoeuvre anymore with the classical monetary tools, given the fact that FED fund rates are still at 1 %. The simple answer to that question is the money market industry. Especially in the US the business model of money market funds breaks down when rates drop below 0.5 %. The reason for that is because of their fee income.
Money Market Funds Fee structure
Fee bp Assets($bio) %
> 75 235 7%
50-74 613 19%
25-49 736 23%
< 25 1.619 51%
Total 3.203
Source : Bank of America
This is a fee they charge for managing the fund. As a consequence, at a certain point the assets of the fund will not generate enough return to pay the fees of the manager and simultaneously offer a return to the investor/client.
This means that the Fed has still one more bullet of 50 bp to go before the liquidity trap is turning around the corner for them.
However there are other tools that a central bank can use in case of deflation, and Bernanke already gave a hint back in November 2002 :
“To stimulate aggregate spending when short-term interest rates have reached zero, the Fed must expand the scale of its asset purchases or, possibly, expand the menu of assets that it buys. Alternatively, the Fed could find other ways of injecting money into the system--for example, by making low-interest-rate loans to banks or cooperating with the fiscal authorities. Each method of adding money to the economy has advantages and drawbacks, both technical and economic. One important concern in practice is that calibrating the economic effects of nonstandard means of injecting money may be difficult, given our relative lack of experience with such policies. Thus, as I have stressed already, prevention of deflation remains preferable to having to cure it. If we do fall into deflation, however, we can take comfort that the logic of the printing press example must assert itself, and sufficient injections of money will ultimately always reverse a deflation.
So what then might the Fed do if its target interest rate, the overnight federal funds rate, fell to zero? One relatively straightforward extension of current procedures would be to try to stimulate spending by lowering rates further out along the Treasury term structure--that is, rates on government bonds of longer maturities.”[3]
Whether we will be dragged into a deflationary spiral is not clear yet, because there will be other forces into play which can have an influence on this. China for instance will be an important factor in all this. When the Chinese bubble bursts, and trust us it will, it can either result into deflation or inflation. It all depends how the Chinese government would react. Deflation risks would come in case of the consequential economic slowdown. As a result China would have no other choice to dump the stocks of commodities that they have been building up recently and next to that the world markets would be flooded with Chinese finished goods at fire sales prices.
An inflation outcome is also possible in case the Chinese government would act under extreme internal social unrests and withdraw their massive reserves from the global system to use these sources to buy off social riots. This would raise interest rates because one would need to buy off the Chinese bond holdings and central banks would have to increase the money supply. We will pay more attention to the potential social problems of China in one of our following news letters to explain the above.
What we are trying to explain is given the current imbalances it is a very difficult call what the final outcome will be, however for 2009 we think that the chances of dealing with / proactively fighting deflation are quite high, as Bernanke prefers to prevent it instead of to cure it.
Why do we think deflationary forces might be an issue next year?
Recessions and bubbles have per definition a deflationary effect
Financial institutions will have to continue deleveraging
US consumer will be forced to save and cut expenses due to credit limitations
Commodity prices are falling ( China is already reducing their stocks)
Considerable slowdown in the velocity of money
This view is also reflected in the swap market. Since last week we saw a strange phenomenon. The swap spread between the 10 years and 30 years in USD (but also EUR’s) is starting to invert. In the US Treasury market we don’t see this yet. So basically the swap market is already anticipating that the FED somewhere in the future will be forced to start using unorthodox monetary tools to fight the deflation ghost.
Cfr. Bloomberg Chart Swaps USD 10 – 30
Cfr. Bloomberg Chart US Treasuries 10 – 30
I wish you a very good trading week.
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Gino Landuyt
[1] Plaza Accord was put in place to weaken the USD and address the trade imbalances that were build up with the USA
[2] For a more detailed discussion see D. Smick in “The world is curved” – Chapter 5 : “Japanese Housewives take the commanding heights.”
[3] Speech by Governor Ben Bernanke before the National Economists Club, Washington. “Deflation: Making sure ‘it’ doesn’t happen here.”
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