Markets React to 1930s Style Errors
For more than half a decade now, the mighty economic hopes of all of Europe have been almost totally dependent on Germany (the UK to a lesser extent). When the continent fell into recession in 2012, it was relatively mild in blended terms because Germany only slowed. That meant the ECB could focus its massive intrusions on the "periphery", the PIIGS mostly, aiming squarely at its very own banks to somehow force them to stop paying attention to national boundaries.
None of it worked, as the ECB has now implicitly admitted (see Mario Draghi's latest press conference). Instead of fostering actual lending to people and businesses these very banks turned Draghi's unspecified promise to save the euro into an epic opportunity to bank and scalp some financial rent in the form of sovereign bond price appreciation. This was, of course, not limited to European financial firms, as it was a global affair of "free money" in way that only central banks can "pay for."
The global banking system is the connective tissue which ensures that imbalance in one place, or currency, is alleviated by contrary forces - or, at least, that is what we are told. In reality, the global financial system has become the opposite of that, instead of reigning back speculation it serves to heighten it as a means of monetary expression emanating from central banks typically moving in unison. Thus banks no longer arbitrage imbalances, they jump into them and turn them into biblical disproportions that belie the stability evident on the surface (on the way up).
Nowhere is that more evident than the global pile of "reserves", which are nothing like actual reserves. These are financial accounts at global banks, in mostly "dollars", attached to some kind of liability. Thus the global financial system is not a network of payment systems but rather an unending and unravelable series of traded liabilities. True money is self-extinguishing, thus limiting the scope of finance; the modern wholesale system must expand geometrically to maintain that appearance of order.
That is why, in no small part, central banks have taken to despising "deflation." The lower turn of "prices", often far too narrowly defined, is a signal of lack of such financial advance. To counteract that, as the ECB has done steadily for more than four years now, the central bank takes over as "market of last resort."
The condition of "inflation" was already dire, in the orthodox terms, in December as the overall EU inflation rate fell to -0.2%. Germany, again the last hope of somehow pulling out of this depression (if we are being honest about descriptions), just released its latest estimates for "inflation", finding it tumbling well below "economists" (statisticians, not experts on an economy) estimates at the surprising depth of -0.5%. Thus the ECB does its version of QE in the vain hopes that size was the key variable.
That monetary "necessity" curiously contrasts with the same process playing out on this side of the Atlantic. There is no doubt that the utter collapse in the global price of oil is responsible for the dramatic downturn in even German generalized prices, as is always the case under highly recessionary conditions. Yet in Europe this turn in commodity pressures is treated as highly dangerous while the Federal Reserve is calling it nothing but "transitory." As the latest FOMC meeting made plain, they view the economy as "booming" but curiously absent the "inflation" they expect to accompany such fortune.
The perceived relative difference in the US economy versus the European economy cannot account for this disparity, or at least in nothing meaningful. The FOMC may believe, outwardly anyway, that the American business climate is now robust enough to withstand a "deflationary" shock where the European economy is not, but that is just bluster. If that were so it would show up somewhere other than the front page of the Wall Street Journal.
Watching eurodollar trading yesterday, it was very striking in how funding market agents essentially defied that very narrative. The FOMC made very plain, again, at least outwardly, that rate hikes were coming as they see more than enough solid economic progress. Such public confidence should have led to selling of eurodollar futures in the front months and years, but instead the entire eurodollar curve was bought all the way down into the current year. The June 2016 contract was priced (CME) at 98.87 about an hour before the FOMC statement, but had shot up 6 bps to 98.93 just before the close (about an hour after). Likewise, the June 2017 contract gained 10 bps to 98.33, amounting to a significant expectation against rate hikes.
I realize these amounts seem very small, but in the short space of time and given the orthodox expectations of how "money" should react to policy, especially in the wholesale space, this was quite remarkable. And while those were knee-jerk reactions to the announcement, those eurodollar prices held up all through yesterday, too.
This is not something especially surprising to anyone paying attention to credit markets going back more than a year now. The more the American economy purportedly improves, the less credit markets are convinced that it has. This is not to say that all credit market agents harbor serious doubts about the current state of GDP or the unemployment rate (as I do) but rather they likely see it at best as artificial and thus temporary.
In other words, credit markets are positioning very much against the FOMC based on one of two interpretations. The first is straightforward: throw GDP out the window as it is designed to be most charitable toward representing the economy, while the unemployment rate is falling only because the economy really is badly underperforming, and therefore people are still dropping out of the labor force (since this "unassailable" payroll expansion supposedly began in March 2014, the potential labor pool has grown by 1.77 million while the actual labor force shrank by 51k; no one entered the labor force during this massive "boom"?).
The second alternative builds upon the financial reality of November 20, 2013. That was the day the yield curve began its current, epic bearish trend and likely saw more than a little irregularity in MBS if not broader "dollar" trading. To that point, credit markets had taken "taper" at face value; the yield curve was steepening amidst broadly rising interest rates. In short, credit markets were acting out the proclamations from the FOMC that the economy was getting better. The only missing ingredient, as far as the FOMC and orthodox economics would like to see, was that inflation expectations remained muted (entering a curious fourteen month range where inflation expectations essentially flatlined).
With well over a year now to view the effects of that day, it seems even more clear that credit markets saw the disruption in November 2013 as a direct consequence of what the Fed was trying to do (under Bernanke first, and then Yellen), thus seeing an "exit" from monetarism as highly disorderly. The broader implication is where we are now, namely that if the Fed ends its "support" of the economy everything will fall apart. This is not, mind you, a reference to the assumed power of monetary instrusiveness, but rather an indictment of it as reasoned speculation that what QE built was entirely unstable, and thus nothing like a true economic recovery. Removing the support of first QE and then ZIRP will not highlight the successful end of the program, but rather reveal all of the ways in which it has failed.
That would include the "lack" of inflation as it is commonly understood. While credit market indications of inflation expectations (breakevens and such) remained on the sidelines since taper were first introduced, starting in late June/early July they began to collapse with the price of oil (tightness in global "dollars"). That isn't unexpected since there is much of oil prices guiding inflation expectations, but that is precisely the point. Credit markets view oil prices as "credible" whereas the FOMC can only supply useless platitudes. Inflation breakevens are now as low as they have been since the Great Recession, in some cases matching the worst parts of it.
Credit is pleading and warning against the FOMC's interpretations of an economy that isn't there or one that is there but as fragile and hollow as the monetary means it took to project it. As much as that may seem to be a modern phenomenon, we have seen this before.
In December 1935, the FOMC made the very same proclamations about the US economy, beginning to fear more of "inflation" than the devastation that was only a few years behind. And like now, the FOMC then was aware that the recovery to that point was "aided" by monetary expansion in the form of defaulting on dollar convertibility (the devaluation of the dollar had brought about tremendous gold inflows that ended up in bank "reserve" accounts). From the official minutes of the FOMC meeting in December 1935:
"In discussing the motion, Governor Norris pointed out that while action was not necessary, it was highly desirable as the excess reserves constituted a source of danger. He indicated that even now there was some evidence of inflationary results from the excess reserves, especially in the bond market, where a 2 3/4 % bond of a rural county seat could be sold at a premium."
The credit markets of the mid-1930's very much matched the conditions that dominate today, as interest rates were repressed by this kind of financialism. After all, the FOMC in December 1935 was discussing above the potentially harmful effects of what would now be called "reach for yield."
"In the course of the discussion Mr. Miller pointed out that the powers granted by the law to raise reserve requirements were granted ‘to prevent injurious credit expansion.' Mr. Miller raised the question how far action under this law could be justified at a time when no injurious expansion had yet taken place, and there was some brief discussion of this question in the course of which Dr. Goldenweiser suggested that the discussions at the time the legislation was passed made it clear that the legislation was specifically directed to dealing with the problem of excess bank reserves. Others pointed out that the power was one of prevention rather than correction and this implied action in advance of expansion."
The FOMC could not come to a decision about what to do about the potential inflationary problem of bank reserves, so it was tabled until later in 1936 when policy shifted toward a higher reserve requirement effective December 1936.
By March 1937, the FOMC's associate economist was no longer worried about the expansion faltering, but rather seriously concerned about overheating (not unlike moving from "considerable time" to "patient").
"In response to a request for a statement as to present business and credit conditions Mr. Williams said that conditions had undergone a change since the meeting of the Committee in March at which time he was fearful that the recovery movement was proceeding too rapidly and that it might turn into a disorderly upward movement which might result in price spirals and dislocations which would be distinctly harmful. He stated that, during the interim since the last meeting of the Committee, the movement had leveled out with some reduction in prices both at home and abroad and a more orderly condition had appeared, so that there seemed to be much less likelihood of a runaway movement than was the case a month or two ago."
As usual, economists were so confident in the business expansion they saw nothing other than historical norm as being problematic.
"He referred to statements made by some economists that the present uninterrupted recovery movement was the longest on record and that, therefore, a recession could be expected, and stated that while the records of past recoveries and reactions might indicate that a decline in business activity could be expected he did not feel that such a conclusion should be drawn from the present situation. He stated that because of the many uncertain factors in the situation it was difficult, if not impossible, to forecast what the future would bring, but that he felt, because of what appeared to be a strong under lying demand for goods, particularly durable goods, that the continuation of recovery might reasonably be expected."
This FOMC meeting, in May 1937, took place during very similar credit market turmoil as what we have seen of the past few years. Initially, government bonds sold off on the news in 1936 that the Fed was about to increase reserve requirements. By early 1937, that had changed and government bonds were bid in a move toward "safety." By May 1937, the bid in government bonds was strong, as was the concern over more risky securities, and lower quality credit sold off sharply (just as has happened since June 2014).
The recovery "reasonably expected" to continue did not, abruptly meeting a cliff only three months later. The damage was severe, largely because the "recovery" to that point was, again, artificial and driven more by monetary imbalances, intentional and otherwise, than organic business expansion driven by profitable enterprise. Industrial production plummeted 35% from August 1937 through May 1938; factory employment, one of the broadest measures of labor market performance, collapsed by 26%. In what was a total shock to all of them, "deflation" returned despite an "overabundance" of "money supply" and gold.
That depression-within-a-depression was devastating in its own right, given the scale, but coming so close just past the great collapse after 1929 made the 1930's what it is remembered for. Despite all the "great" and "good" things about the recovery after 1933, by 1937 employment levels were still slightly behind the 1929 peak (as they are today; there are still 1.9 million fewer full-time jobs as of December 2014 as compared to the November 2007 peak). An economy that doesn't create jobs isn't much of an economy, just as a recovery that doesn't within a few years reach its prior trend isn't a recovery.
The great mistake of the mid-1930's was to assume "inflation" was the same as recovery, or that "reflation" as a matter of policy was, in the parlance of economics, a perfect substitute for legitimate and organic expansion. Yet, for all that, the current view of the FOMC is one of "aggregate demand" whereby the government or the central bank can, in fact, create the perfect substitution. In other words, policymakers are making the same exact mistake as they did eighty years ago, and markets are reacting almost exactly as they did then.
That observation includes stock prices, as shares continued to move higher despite the looming economic disruption. In fact, most indices reached a cycle peak around March 1937, but did not seriously decline until the recession began that August. The S&P 500 eventually lost about 45% from its cycle high, while other stocks fared much worse - railroad stocks, the 30's version of high flyers, fell by nearly 67% to the lowest point of the decade (some 80% below their equivalent value in 1925).
In that broader historical view, there is something to the orthodox notion that entangles employment and inflation. The mainstream treatment of inflation as a concept is far broader than just commodity prices, with some good reason, as it is believed that generalized and sustained price increases are consistent with rising wages. As a practical matter, that has been the case far more often than not, but the implication for monetary policy is decidedly backward. Since the central bank has labeled 2% inflation as something like "price stability", it essentially undertakes the task to limit wage growth, though not through the means in which it strives to carry out.
The monetary policy regime as it is currently practiced, though altered certainly in China and elsewhere now, is again "aggregate demand." The idea of "reflation" is to create through monetary channels demand that is absent otherwise; without regard to whether organic demand will, on its own, present a purer, and thus sustainable, option eventually. Instead, malformation of asset prices leads to misallocation of resources, including the appearance of asset bubbles. Bubble periods are not conducive to actual wealth creation, instead taking the form of paper, illusory gains, thus limit wage growth opportunity (share repurchases vs. productive investment, for example).
In effect, by engaging in this monetary reflation, the central bank (or government agent, as was the case of the Treasury Dept. in 1933's dollar devaluation) erodes its own baseline for growth even as the economy takes on some elements that appear very much like it. Without wages and actual, profitable payroll expansion the economy is overly susceptible to negative shocks or attrition. Once that is revealed to achieve a critical mass, it all falls apart in recessionary collapse.
Trading in credit markets, especially since December 1, is more and more describing exactly this kind of repeated reflationary folly. Economists continually protest that any concern is of overseas regimes exclusively, as if the global financial system and wholesale "dollar" doesn't exist and connect all of it. GDP may be 5% in the US last quarter, but the lack of actual wage expansion more than suggests, as it has historically, that such a measure is highly misleading and ultimately hollow and unstable.
In that respect, the price of oil is unifying of both the European economic condition and its related American counterpart. The more the FOMC proclaims total confidence in the recovery, the more markets react negatively in outright dismissal or in expectations that history will repeat; with global consequences yet again.
