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Eye of a Very Long Storm var addthis_config = { services_compact: 'email, favorites, facebook, twitter, blogger', services_expanded:'blogger,delicious,digg,email,facebook,favorites,google buzz,linkedin,myspace,pdfonline,print,twitter,wordpress' } November 02, 2010
If you're reading this Salvo on the day it is posted, then you are likely holding your breath on a number of fronts: the outcome of the election tonight, the FOMC announcement tomorrow afternoon and the policy meetings of the Bank of England, European Central Bank and the Bank of Japan and the new jobs numbers, due later this week. It is a day of anticipation and, for some, it is a day of positioning portfolios for short-term volatility based on likely outcomes. Indeed, there may be volatility if market expectations are unrequited, i.e., if the Republicans don't take the House in convincing fashion, if the Fed disappoints on details for QE2, if foreign central banks decide to be passive or aggressive in the face of Fed maneuvering, or if the non-farm payroll number comes in significantly over or under the consensus of +60 thousand.
If you are holding your breath, exhale and focus on a few longer-term trends that aren't going to change very much once the immediate questions from this week get answered. First, rates. In case it is lost on anyone pulling a monetary policy lever, rate and liquidity are not holding back the global economy, and haven't been for some time. Behold the graph below, which is one-month LIBOR. Don't let the scale fool you, the unsecured inter-bank lending market has been flat as a pancake for many months.
Second, the dollar. The Reserve Bank of Australia was the first central bank out of the gate this week, and it decided at its meeting yesterday to raise its overnight cash rate by 25 basis points to 4.75%. According to the policy statement, the country is experiencing strong labor demand, the effects of stronger-than-expected growth in China and "the prices most important to Australia remain at very high levels, with the result that the terms of trade are at their highest since the early 1950s."? The Australian dollar now flirts with parity to the US Dollar.
Australia may be an outlier, but it's not alone: The Reserve Bank of India also raised its overnight repo rate by 25 basis points to 6.25%. In its policy statement, the RBI addressed global pressures. "The slowing momentum of recovery has prompted the central banks of some advanced economies to initiate (or consider initiating) a second round of quantitative easing to further stimulate private demand. While the ultra loose monetary policy of advanced economies may benefit the global economy in the medium-term, in the short-term it will trigger further capital inflows into emerging market economies (EMEs) and put upward pressure on global commodity prices."? The so-called advanced economies are engaged in a battle to devalue their own currencies while the rest of the world compensates.
Third"â?and this is all related"â?gold vaults in Manhattan, many of which were turned into clubs or shuttered during the "?80s and "?90s, are back in demand. JP Morgan recently announced they were re-opening a gold vault that had been mothballed. For the first time in history, according to GFMS, private investors now own more gold (30 thousand metric tons) than central banks, and they have the high-grade problem of finding a place to store it.
The markets may be volatile depending on how things break over the next few days, but longer-term trends may not be deflected by whether John Boehner or Nancy Pelosi is sitting in the Speaker's chair in January.
Comments [0] | Current Events
Government Sponsored Spending var addthis_config = { services_compact: 'email, favorites, facebook, twitter, blogger', services_expanded:'blogger,delicious,digg,email,facebook,favorites,google buzz,linkedin,myspace,pdfonline,print,twitter,wordpress' } October 29, 2010
The first reading of 3rd quarter GDP was released this morning, with the headline coming in right on top of estimates at 2%. The happy surprise of the report was personal consumption expenditures (PCE), which were better than expectations at 2.6% annualized growth. The strength in PCE, which is now effectively back at its former peak (4Q of 2007), is impressive. PCE as a percentage of GDP seems to have continued its uptrend during this recession, despite a deleveraging household and millions of jobs lost.
Part of PCE is non-cyclical, but part is purely discretionary. Look at spending on recreation: it represents just 8.5% of total PCE, yet it accounted for 30% of the gain in PCE from its lows in mid-2009 and is currently 5.3% above its previous high.
It's obvious that there are people out there spending on non-discretionary things. This could be related to the weak dollar "staycation"? phenomenon (i.e. people traveling less overseas, spending more money at home even though they are spending less overall).
However, without government assistance, incomes to support PCE are still weak. The expiration of extended unemployment benefits has been receiving some media attention lately (see this 60 minutes report, and this from HuffPo). With over 9 million people on regular continuing claims or extended/emergency claims, it's clear that a significant portion of PCE is on government support. This is evidenced by an interesting phenomenon that we first highlighted back in March 2010: For the first time in the history of the data series, consumption expenditures are exceeding ex-transfer income. And the margin is getting wider. The expiration of unemployment benefits could be a tough negative shock for the economy to endure.
Comments [0] |
Deflation, Reflation, Inflation var addthis_config = { services_compact: 'email, favorites, facebook, twitter, blogger', services_expanded:'blogger,delicious,digg,email,facebook,favorites,google buzz,linkedin,myspace,pdfonline,print,twitter,wordpress' } October 26, 2010
In our September 28 Salvo, we imagined an opportunity to ask Chairman Bernanke the following question: "What does the Fed do if it expands its balance sheet to $4 trillion or $6 trillion, drives the 10-year yield down to 2% or less, but unemployment still stands around 10%?"?
The question reverberates more loudly every day closer to the November 3 FOMC meeting, at which we expect the Federal Reserve to provide more details on its plans for another round of large scale asset purchases (LSAP2).
It turns out that Chairman Bernanke anticipated our question back on May 31, 2003, in a speech delivered before the Japan Society of Monetary Economics. The speech, which is overshadowed in central banking lore by Bernanke's infamous 2002 helicopter speech, is a remarkable example of an American policymaker "advising"? the Japanese on how they can fix their problems. The 2002 speech has been used by the market as a roadmap of sorts to understanding Bernanke's thinking regarding the toolbox of unconventional policy methods in a zero interest rate environment. The 2003 speech spells out what to do when all the tools are out of the box. Perhaps a new map for a new road.
He started by saying that the primary objective of monetary policy in a deflationary period is to not only spark inflation but to increase the price level (as measured by an index like CPI) to a level where it would have been if it had continued to rise at the desired rate of, say, 2% per year. This is akin to price-level targeting, not inflation-rate targeting. The Bank of Japan, he said, needs to commit to restoring price levels by initiating asset reflation"â?a period of inflation above the long-run preferred rate of inflation"â?to the targeted level. Importantly, however, that commitment must be made by communicating that the policy stimulus won't be withdrawn as soon as inflation returns to the desired level. He said, "[I]t would be helpful if the zero-interest-rate policy were more explicit about what happens after the deflationary period ends."?
The commitment to reflate the price level must be backed up with action, and this gets us the answer to our question about what the Fed will do if its balance sheet expansion isn't working. A price level target is unforgiving in that the targeted price level marches onward and upward, year after year. If the central bank fails to make the target, the target gets higher. "[T]he public expects the leaders of the central bank to take more aggressive actions, the further they are from their announced objective"?.Thus, failure by the central bank to meet its target in a given period leads to expectations of (and public demands for) increased effort in subsequent periods"â?greater quantities of assets purchased on the open market, for example."?
Perhaps one question to ask Chairman Bernanke at this point is whether reflation, which may be the right idea when there is outright deflation, is still the right idea if in fact there is inflation. Another would be to sketch out the transmission mechanism between reflation and employment. But we digress.
The next thread of the speech focuses on what it means, from a risk perspective, for the central bank to balloon its balance sheet. "[T]he BOJ's most recent financial statement showed that of the 68% of its assets held in the form of government securities, about two-thirds are long-term Japanese government bonds (JGBs). This represents a very substantial increase over customary levels in the BOJ's holdings of long-term government debt. Because yields on government bonds are currently so low, these holdings expose the BOJ's balance sheet to considerable interest-rate risk (although any losses would be partly offset by unrealized capital gains on earlier acquisitions of bonds). Indeed, ironically, if the Bank of Japan were to succeed in replacing deflation with a low but positive rate of inflation, its reward would likely be substantial capital losses in the value of its government bond holdings arising from the resulting increase in long-term nominal interest rates."? The graph below matches up the qualitative easing programs of the Bank of Japan and the Federal Reserve by date of launch. In QE2, the Federal Reserve's line will get another leg up.
Bernanke conceded that a central bank is not a private institution and therefore not subject to the same risk management requirements. "[T]he Bank of Japan is not a private commercial bank. It cannot go bankrupt in the sense that a private firm can, and the usual reasons that a commercial bank holds capital"â?to reduce incentives for excessive risk-taking, for example"â?do not directly apply to the BOJ"?.[O]ne could make an economic case that the balance sheet of the central bank should be of marginal relevance at best to the determination of monetary policy."?
This is cold comfort to the investors who were likely in the same boat as the BOJ"?.and the same can be said for an investor today who is invested in dollar-based fixed income instruments. Bernanke's prescription for the central bank loading up on long duration assets to achieve its policy objective is essentially to enter into massive amounts of interest rate swaps with the Ministry of Finance. Think of it like the Fed swapping with Treasury, where the effects on both sides of the swap are cancelled out.
The last part of Bernanke's plan is a cooperative effort by monetary and fiscal policymakers to consider a tax cut that is financed by money creation. In other words, increase the wealth of the private sector through the tax cut, increase GDP growth through increased consumption, and debt growth is absorbed by the central bank.
It all works out, in Bernanke's speech, but he mentions one caveat. "Of course, one can never get something for nothing; from a public finance perspective, increased monetization of government debt simply amounts to replacing other forms of taxes with an inflation tax. But, in the context of deflation-ridden Japan, generating a little bit of positive inflation (and the associated increase in nominal spending) would help achieve the goals of promoting economic recovery and putting idle resources back to work, which in turn would boost tax revenue and improve the government's fiscal position."?
To repeat: ""? one can never get something for nothing."?
Comments [0] | Monetary Policy
Dollar Doldrums var addthis_config = { services_compact: 'email, favorites, facebook, twitter, blogger', services_expanded:'blogger,delicious,digg,email,facebook,favorites,google buzz,linkedin,myspace,pdfonline,print,twitter,wordpress' } October 22, 2010
We attended a conference this week hosted by Grant's Interest Rate Observer, which is always a mix of long and short investment ideas and bullish and bearish macroeconomic observations. This one was no different, although if any one theme could be gleaned from it, that theme would be frustration at the way in which policymakers approach the global system of currencies and foreign exchange. The quote that resonated like cold water in the face was by Frank Byrd of Fielder Research & Management, who reminded the assembled, "We have never been here before"â?a global regime of fiat currencies at zero bound interest rates."?
As we listened we referred back to our blog post from last Friday, which examined the insurance value of gold in an inflationary world. The facts on the ground are that the dollar seems to be losing its purchasing power as the market prices in the prospect of large-scale asset purchases by the Federal Reserve. All other things being equal, if the capacity of an economy (like the US) or the supply of a commodity (like gold) doesn't change, but the number of dollars expands, the prices in that economy or that commodity will rise in dollar terms. Hence the rise in gold, copper, and equities, all of which we usually look at priced in dollars. Below we chart these assets in both dollars and euros during their impressive September/October rallies, as inflation expectations rose and the value of the dollar fell.
Gold is actually down in euro terms.
The celebrated and historic rally in equities has been erased.
Doctor Copper's seeming bullish prognostication of future growth is also flattened.
The dollar-based price movements that we've seen in these assets since the beginning of September has been less about expected future real economic growth than it has been about compensating investors for the potential future inflation from a flood of newly printed dollars. What will happen to the prices of risk assets if this expected future inflation doesn't materialize to bring up the nominal price level is an interesting question to consider.
Comments [0] | Macro Economics
FUD for Thought 2: What, Me Worry? var addthis_config = { services_compact: 'email, favorites, facebook, twitter, blogger', services_expanded:'blogger,delicious,digg,email,facebook,favorites,google buzz,linkedin,myspace,pdfonline,print,twitter,wordpress' } October 19, 2010
This is the Golden Age of Fed Watching. And we've done our fair share. On a day when we have speeches from 5 Fed presidents and 1 governor, what more is there to say that hasn't already been said?
Faith in the Fed is high, and capital market FUD (Fear, Uncertainty, and Doubt) seems to be low. We last wrote about FUD in July of 2009, as markets were worrying about the unwinding of Fed emergency support facilities. As it turned out, asset purchases by Bernanke et al. proved to be a very effective tool to calm investors. In retrospect, it should have been reassuring that investors were worried about anything at all. Fast forward to today, and as the reality of another round of QE has become baked in the cake, what we are seeing is:
1. High correlations
2. Low volatility
3. Falling volume
The following chart shows the 2 month rolling correlation between the S&P 500 index and the US dollar index (-0.92), as well as between the S&P and the gold spot price (0.92). If you were bored enough to take the absolute value of each of these two correlations and sum them, you would see that this metric would be at the highest level of at least the last 3 years (but who would be that wonkish?).
The next chart shows two market volatility indices, the MOVE and the VIX. The VIX index measures expected future price volatility in the equity market, while the MOVE index is the corresponding volatility measure for the fixed income market. In short, expectations for future volatility are very low when compared to recent years.
Lastly, volume has been on the decline. Since the equity market bottom in March of 2009, the 60 day moving average of volume on the NYSE is down roughly 30%, even more from the levels of 2006 and 2007.
var addthis_config = { services_compact: 'email, favorites, facebook, twitter, blogger', services_expanded:'blogger,delicious,digg,email,facebook,favorites,google buzz,linkedin,myspace,pdfonline,print,twitter,wordpress' } October 29, 2010
The first reading of 3rd quarter GDP was released this morning, with the headline coming in right on top of estimates at 2%. The happy surprise of the report was personal consumption expenditures (PCE), which were better than expectations at 2.6% annualized growth. The strength in PCE, which is now effectively back at its former peak (4Q of 2007), is impressive. PCE as a percentage of GDP seems to have continued its uptrend during this recession, despite a deleveraging household and millions of jobs lost.
Part of PCE is non-cyclical, but part is purely discretionary. Look at spending on recreation: it represents just 8.5% of total PCE, yet it accounted for 30% of the gain in PCE from its lows in mid-2009 and is currently 5.3% above its previous high.
It's obvious that there are people out there spending on non-discretionary things. This could be related to the weak dollar "staycation"? phenomenon (i.e. people traveling less overseas, spending more money at home even though they are spending less overall).
However, without government assistance, incomes to support PCE are still weak. The expiration of extended unemployment benefits has been receiving some media attention lately (see this 60 minutes report, and this from HuffPo). With over 9 million people on regular continuing claims or extended/emergency claims, it's clear that a significant portion of PCE is on government support. This is evidenced by an interesting phenomenon that we first highlighted back in March 2010: For the first time in the history of the data series, consumption expenditures are exceeding ex-transfer income. And the margin is getting wider. The expiration of unemployment benefits could be a tough negative shock for the economy to endure.
Comments [0] |
Deflation, Reflation, Inflation var addthis_config = { services_compact: 'email, favorites, facebook, twitter, blogger', services_expanded:'blogger,delicious,digg,email,facebook,favorites,google buzz,linkedin,myspace,pdfonline,print,twitter,wordpress' } October 26, 2010
In our September 28 Salvo, we imagined an opportunity to ask Chairman Bernanke the following question: "What does the Fed do if it expands its balance sheet to $4 trillion or $6 trillion, drives the 10-year yield down to 2% or less, but unemployment still stands around 10%?"?
The question reverberates more loudly every day closer to the November 3 FOMC meeting, at which we expect the Federal Reserve to provide more details on its plans for another round of large scale asset purchases (LSAP2).
It turns out that Chairman Bernanke anticipated our question back on May 31, 2003, in a speech delivered before the Japan Society of Monetary Economics. The speech, which is overshadowed in central banking lore by Bernanke's infamous 2002 helicopter speech, is a remarkable example of an American policymaker "advising"? the Japanese on how they can fix their problems. The 2002 speech has been used by the market as a roadmap of sorts to understanding Bernanke's thinking regarding the toolbox of unconventional policy methods in a zero interest rate environment. The 2003 speech spells out what to do when all the tools are out of the box. Perhaps a new map for a new road.
He started by saying that the primary objective of monetary policy in a deflationary period is to not only spark inflation but to increase the price level (as measured by an index like CPI) to a level where it would have been if it had continued to rise at the desired rate of, say, 2% per year. This is akin to price-level targeting, not inflation-rate targeting. The Bank of Japan, he said, needs to commit to restoring price levels by initiating asset reflation"â?a period of inflation above the long-run preferred rate of inflation"â?to the targeted level. Importantly, however, that commitment must be made by communicating that the policy stimulus won't be withdrawn as soon as inflation returns to the desired level. He said, "[I]t would be helpful if the zero-interest-rate policy were more explicit about what happens after the deflationary period ends."?
The commitment to reflate the price level must be backed up with action, and this gets us the answer to our question about what the Fed will do if its balance sheet expansion isn't working. A price level target is unforgiving in that the targeted price level marches onward and upward, year after year. If the central bank fails to make the target, the target gets higher. "[T]he public expects the leaders of the central bank to take more aggressive actions, the further they are from their announced objective"?.Thus, failure by the central bank to meet its target in a given period leads to expectations of (and public demands for) increased effort in subsequent periods"â?greater quantities of assets purchased on the open market, for example."?
Perhaps one question to ask Chairman Bernanke at this point is whether reflation, which may be the right idea when there is outright deflation, is still the right idea if in fact there is inflation. Another would be to sketch out the transmission mechanism between reflation and employment. But we digress.
The next thread of the speech focuses on what it means, from a risk perspective, for the central bank to balloon its balance sheet. "[T]he BOJ's most recent financial statement showed that of the 68% of its assets held in the form of government securities, about two-thirds are long-term Japanese government bonds (JGBs). This represents a very substantial increase over customary levels in the BOJ's holdings of long-term government debt. Because yields on government bonds are currently so low, these holdings expose the BOJ's balance sheet to considerable interest-rate risk (although any losses would be partly offset by unrealized capital gains on earlier acquisitions of bonds). Indeed, ironically, if the Bank of Japan were to succeed in replacing deflation with a low but positive rate of inflation, its reward would likely be substantial capital losses in the value of its government bond holdings arising from the resulting increase in long-term nominal interest rates."? The graph below matches up the qualitative easing programs of the Bank of Japan and the Federal Reserve by date of launch. In QE2, the Federal Reserve's line will get another leg up.
Bernanke conceded that a central bank is not a private institution and therefore not subject to the same risk management requirements. "[T]he Bank of Japan is not a private commercial bank. It cannot go bankrupt in the sense that a private firm can, and the usual reasons that a commercial bank holds capital"â?to reduce incentives for excessive risk-taking, for example"â?do not directly apply to the BOJ"?.[O]ne could make an economic case that the balance sheet of the central bank should be of marginal relevance at best to the determination of monetary policy."?
This is cold comfort to the investors who were likely in the same boat as the BOJ"?.and the same can be said for an investor today who is invested in dollar-based fixed income instruments. Bernanke's prescription for the central bank loading up on long duration assets to achieve its policy objective is essentially to enter into massive amounts of interest rate swaps with the Ministry of Finance. Think of it like the Fed swapping with Treasury, where the effects on both sides of the swap are cancelled out.
The last part of Bernanke's plan is a cooperative effort by monetary and fiscal policymakers to consider a tax cut that is financed by money creation. In other words, increase the wealth of the private sector through the tax cut, increase GDP growth through increased consumption, and debt growth is absorbed by the central bank.
It all works out, in Bernanke's speech, but he mentions one caveat. "Of course, one can never get something for nothing; from a public finance perspective, increased monetization of government debt simply amounts to replacing other forms of taxes with an inflation tax. But, in the context of deflation-ridden Japan, generating a little bit of positive inflation (and the associated increase in nominal spending) would help achieve the goals of promoting economic recovery and putting idle resources back to work, which in turn would boost tax revenue and improve the government's fiscal position."?
To repeat: ""? one can never get something for nothing."?
Comments [0] | Monetary Policy
Dollar Doldrums var addthis_config = { services_compact: 'email, favorites, facebook, twitter, blogger', services_expanded:'blogger,delicious,digg,email,facebook,favorites,google buzz,linkedin,myspace,pdfonline,print,twitter,wordpress' } October 22, 2010
We attended a conference this week hosted by Grant's Interest Rate Observer, which is always a mix of long and short investment ideas and bullish and bearish macroeconomic observations. This one was no different, although if any one theme could be gleaned from it, that theme would be frustration at the way in which policymakers approach the global system of currencies and foreign exchange. The quote that resonated like cold water in the face was by Frank Byrd of Fielder Research & Management, who reminded the assembled, "We have never been here before"â?a global regime of fiat currencies at zero bound interest rates."?
As we listened we referred back to our blog post from last Friday, which examined the insurance value of gold in an inflationary world. The facts on the ground are that the dollar seems to be losing its purchasing power as the market prices in the prospect of large-scale asset purchases by the Federal Reserve. All other things being equal, if the capacity of an economy (like the US) or the supply of a commodity (like gold) doesn't change, but the number of dollars expands, the prices in that economy or that commodity will rise in dollar terms. Hence the rise in gold, copper, and equities, all of which we usually look at priced in dollars. Below we chart these assets in both dollars and euros during their impressive September/October rallies, as inflation expectations rose and the value of the dollar fell.
Gold is actually down in euro terms.
The celebrated and historic rally in equities has been erased.
Doctor Copper's seeming bullish prognostication of future growth is also flattened.
The dollar-based price movements that we've seen in these assets since the beginning of September has been less about expected future real economic growth than it has been about compensating investors for the potential future inflation from a flood of newly printed dollars. What will happen to the prices of risk assets if this expected future inflation doesn't materialize to bring up the nominal price level is an interesting question to consider.
Comments [0] | Macro Economics
FUD for Thought 2: What, Me Worry? var addthis_config = { services_compact: 'email, favorites, facebook, twitter, blogger', services_expanded:'blogger,delicious,digg,email,facebook,favorites,google buzz,linkedin,myspace,pdfonline,print,twitter,wordpress' } October 19, 2010
This is the Golden Age of Fed Watching. And we've done our fair share. On a day when we have speeches from 5 Fed presidents and 1 governor, what more is there to say that hasn't already been said?
Faith in the Fed is high, and capital market FUD (Fear, Uncertainty, and Doubt) seems to be low. We last wrote about FUD in July of 2009, as markets were worrying about the unwinding of Fed emergency support facilities. As it turned out, asset purchases by Bernanke et al. proved to be a very effective tool to calm investors. In retrospect, it should have been reassuring that investors were worried about anything at all. Fast forward to today, and as the reality of another round of QE has become baked in the cake, what we are seeing is:
1. High correlations
2. Low volatility
3. Falling volume
The following chart shows the 2 month rolling correlation between the S&P 500 index and the US dollar index (-0.92), as well as between the S&P and the gold spot price (0.92). If you were bored enough to take the absolute value of each of these two correlations and sum them, you would see that this metric would be at the highest level of at least the last 3 years (but who would be that wonkish?).
The next chart shows two market volatility indices, the MOVE and the VIX. The VIX index measures expected future price volatility in the equity market, while the MOVE index is the corresponding volatility measure for the fixed income market. In short, expectations for future volatility are very low when compared to recent years.
Lastly, volume has been on the decline. Since the equity market bottom in March of 2009, the 60 day moving average of volume on the NYSE is down roughly 30%, even more from the levels of 2006 and 2007.
If we were to create a FUD index for the capital markets, it would seem to be at very low levels. It's worrisome that seemingly few investors are worried, but that could change at any time.
Case in point: we weren't even able to finish this piece before PIMCO, Blackrock, and the New York Fed announced plans to go after Bank of America over mortgage losses, and all of the measures above reversed course: the equity market sold off significantly, bonds rallied, gold dropped nearly $40, the VIX spiked, and equity market volume took off.
Perhaps this is a fragile complacency.
Comments [0] | Bond Markets | Equity Markets
On the Value of Insurance var addthis_config = { services_compact: 'email, favorites, facebook, twitter, blogger', services_expanded:'blogger,delicious,digg,email,facebook,favorites,google buzz,linkedin,myspace,pdfonline,print,twitter,wordpress' } October 15, 2010
How to value gold is an age old frustration. As every schoolboy knows, it yields nothing and so can't be valued on cash flows. It has very little industrial use. There is, however, a natural human tendency toward the use of currency so gold is an obvious candidate for a rare, durable, portable, and transferable form of money. There is no printing press (or helicopter) for gold. Thus, throughout history, the yellow metal has been an indisputable store of value, including during periods of inflation like the 1970s. However, its price is volatile and has certainly managed to lose some money for investors over periods shorter than, say, a few decades. In the chart below, we illustrate the point by plotting the inflation-adjusted gold price versus the year-over-year change in Core CPI.
As inflation came down in the early 1980s, gold fell with it. The relationship between real gold prices and inflation seems to break down during the 2000 recession, where inflation began to decline but gold began a new bull market. Current real gold prices are back to levels not seen since 1980, when inflation was running at over 12%, despite current levels of inflation below 1%. Gold must be in a bubble, right?
Not necessarily. Another way to think about gold is as insurance against the debasement of the currency, and against future inflation. Insurance against policies that debase the currency is worth something, because a falling dollar erodes your global purchasing power just like inflation erodes your purchasing power at home. The next chart plots real gold prices against the US dollar index. The inverse relationship is easily spotted.
The dollar strength that we experienced throughout the late 1990s didn't top out until the Fed got below 2% on the target rate in late 2001. The steep decline in the dollar coincided with the gradual walking down of the Fed Funds rate to 1% over the next 2 years, putting in a durable bottom for gold prices. The dollar has never recovered and has been bouncing along a bottom range ever since; your insurance against policy mistakes has paid off handsomely as real gold prices have since quadrupled.
However, gold as insurance is now a different value proposition than it was back in 2000. It's more expensive, but it seems the risk of monetary blunders has also increased. There is no shortage of opinions about current gold prices (see Mr. T's appearance on Bloomberg TV), but as UK-based money manager Jonathan Ruffer said: "There is now a tax on safety."?
Question: if monetary policy hasn't been effective in generating inflation, what should it cost to insure against it?
Comments [0] | Current Events | Macro Economics
No White Flag in this Currency War var addthis_config = { services_compact: 'email, favorites, facebook, twitter, blogger', services_expanded:'blogger,delicious,digg,email,facebook,favorites,google buzz,linkedin,myspace,pdfonline,print,twitter,wordpress' } October 12, 2010
In recent weeks, the Plaza Accord has been receiving a lot of attention, particularly after the IMF's annual meeting in Washington concluded without making any progress on currency issues. If you recall, the Plaza Accord is the popular name given to an agreement struck in September 1985 by the world's finance ministers"â?who met at New York's Plaza Hotel"â?to engage in large-scale currency intervention.
Why did they"â?James A. Baker III of the U.S., Noburu Takeshita of Japan, Gerhard Stoltenberg of West Germany, Nigel Lawson of the UK and Pierre Beregovoy of France"â?do it? In a word, imbalances. In a sentence, when Paul Volcker made liberal use of the Fed Funds rate to successfully fight inflation, some other consequences were a significant strengthening of the dollar, large trade deficits and reduced US export competitiveness, particularly vis a vis Japan. In a paragraph, the Plaza Accord itself put it best (and, for those accustomed to parsing inscrutable messages from policymakers, the language of the Plaza Accord rings as clear as a bell): "[T]here are large imbalances in external positions which pose potential problems, and which reflect a wide range of factors. Among these are: the deterioration in its external position which the U.S. experienced from its period of very rapid relative growth; the particularly large impact on the U.S. current account of the economic difficulties and the adjustment efforts of some major developing countries; the difficulty of trade access in some markets; and the appreciation of the U.S. dollar. The interaction of these factors-- relative growth rates, the debt problems of developing countries, and exchange rate development-- has contributed to large, potentially destabilizing external imbalances among major industrial countries"?. The Ministers and Governors agreed that exchange rates should play a role in adjusting external imbalances. In order to do this, exchange rates should better reflect fundamental economic conditions than has been the case. They believe that agreed policy actions must be implemented and reinforced to improve the fundamentals further, and that in view of the present and prospective changes in fundamentals, some further orderly appreciation of the main non-dollar currencies against the dollar is desirable. They stand ready to cooperate more closely to encourage this when to do so would be helpful."?
There are many similarities between China/U.S. economic relations today and Japanese/U.S. economic relations in 1985. Both involve an undervalued currency versus the U.S. dollar, trade imbalances as a result of this valuation, and the increased rhetoric of protectionism. And the scale of the imbalances are similar. The Japanese trade deficit was about 1.1% of U.S. GDP in 1985, and the Chinese trade deficit today is about 1.6% of U.S. GDP (nominal dollars). But as the graph below points out, the trend is not America's friend.
Was the Plaza Accord successful as policy? It may still be too early to tell, but it also depends on your perspective. The most obvious net effect of the coordinated efforts of the world's finance ministers was a virtual doubling of the yen in dollar terms over the next two years, from 240 to 120. Viewed on that basis alone, the Plaza Accord was a success. In addition, the rising threats of American protectionism against Japan were avoided. But what about the other imbalances? As it turned out, Japanese exports to the U.S. did not decline despite the Plaza Accord and the U.S. remained a net debtor nation. Other (mostly east Asian) nations picked up manufacturing slack from Japan. The dollar was weaker, and the U.S. stock market was off on a 25-year bull run, but the Japanese, struggling to deal with a sharply and suddenly higher yen, kept their monetary policy relatively loose and fostered a bubble economy that ultimately crashed.
While policymakers at the next G-20 summit, to be held on November 12 in South Korea, will be looking at a problem that is very similar to that of 1985, it is not the same problem. As Mohamed El-Arian reminded people last week at a conference hosted by the Financial Times, while everyone in the U.S. thinks of China as the world's 2nd largest economy, they think of themselves as being 99th in per capita income. If anyone is holding their breath waiting for the Chinese to be as cooperative today as Japan was 25 years ago, they should exhale. We believe the Chinese consider the Plaza Accord to be one of the worst economic decisions ever made by a country. It's not likely to happen again.
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Languishing Labor Force var addthis_config = { services_compact: 'email, favorites, facebook, twitter, blogger', services_expanded:'blogger,delicious,digg,email,facebook,favorites,google buzz,linkedin,myspace,pdfonline,print,twitter,wordpress' } October 08, 2010
Is there a data series more highly anticipated and thoroughly parsed than the monthly nonfarm payroll release by the BLS? Probably not. But we'll throw a few graphs onto the pile anyway.
The headline Establishment Survey number came in at negative 95,000 jobs for the month of September. The "new"? headline number that everyone watches, private jobs, grew by 64,000. This number became more popular during the Census hiring distortions, which are gradually coming to an end. However, it's tough to get excited about private sector hiring when the government is more than offsetting its gains. There were 77,000 Census jobs shed during the month, which were temporary to begin with, but this was actually eclipsed by losses in state and local governments, which cut 83,000 jobs. Presumably, these jobs were permanent. The ex-Census job losses come to a negative 18,000 jobs.
The number of people unemployed for 27 weeks or longer fell for the 4th straight month and is now at the same level at which it began the year. However, the number of people newly unemployed (for 5 weeks or less) seems to have stopped its decline and has been on an upward trajectory for most of the year. Much like initial jobless claims, this number is much lower than its previous peak, but still above levels considered "normal."?
The U-6 unemployment rate, a more comprehensive view of labor force utilization, ticked up substantially to 17.1% from 16.7%. The increase was due to marginally attached and discouraged workers, which both increased in the month, and a record number of people working part-time due to economic reasons. As a percentage of the labor force, this group of underemployed workers has nearly touched its 1982 peak:
var addthis_config = { services_compact: 'email, favorites, facebook, twitter, blogger', services_expanded:'blogger,delicious,digg,email,facebook,favorites,google buzz,linkedin,myspace,pdfonline,print,twitter,wordpress' } October 26, 2010
In our September 28 Salvo, we imagined an opportunity to ask Chairman Bernanke the following question: "What does the Fed do if it expands its balance sheet to $4 trillion or $6 trillion, drives the 10-year yield down to 2% or less, but unemployment still stands around 10%?"?
The question reverberates more loudly every day closer to the November 3 FOMC meeting, at which we expect the Federal Reserve to provide more details on its plans for another round of large scale asset purchases (LSAP2).
It turns out that Chairman Bernanke anticipated our question back on May 31, 2003, in a speech delivered before the Japan Society of Monetary Economics. The speech, which is overshadowed in central banking lore by Bernanke's infamous 2002 helicopter speech, is a remarkable example of an American policymaker "advising"? the Japanese on how they can fix their problems. The 2002 speech has been used by the market as a roadmap of sorts to understanding Bernanke's thinking regarding the toolbox of unconventional policy methods in a zero interest rate environment. The 2003 speech spells out what to do when all the tools are out of the box. Perhaps a new map for a new road.
He started by saying that the primary objective of monetary policy in a deflationary period is to not only spark inflation but to increase the price level (as measured by an index like CPI) to a level where it would have been if it had continued to rise at the desired rate of, say, 2% per year. This is akin to price-level targeting, not inflation-rate targeting. The Bank of Japan, he said, needs to commit to restoring price levels by initiating asset reflation"â?a period of inflation above the long-run preferred rate of inflation"â?to the targeted level. Importantly, however, that commitment must be made by communicating that the policy stimulus won't be withdrawn as soon as inflation returns to the desired level. He said, "[I]t would be helpful if the zero-interest-rate policy were more explicit about what happens after the deflationary period ends."?
The commitment to reflate the price level must be backed up with action, and this gets us the answer to our question about what the Fed will do if its balance sheet expansion isn't working. A price level target is unforgiving in that the targeted price level marches onward and upward, year after year. If the central bank fails to make the target, the target gets higher. "[T]he public expects the leaders of the central bank to take more aggressive actions, the further they are from their announced objective"?.Thus, failure by the central bank to meet its target in a given period leads to expectations of (and public demands for) increased effort in subsequent periods"â?greater quantities of assets purchased on the open market, for example."?
Perhaps one question to ask Chairman Bernanke at this point is whether reflation, which may be the right idea when there is outright deflation, is still the right idea if in fact there is inflation. Another would be to sketch out the transmission mechanism between reflation and employment. But we digress.
The next thread of the speech focuses on what it means, from a risk perspective, for the central bank to balloon its balance sheet. "[T]he BOJ's most recent financial statement showed that of the 68% of its assets held in the form of government securities, about two-thirds are long-term Japanese government bonds (JGBs). This represents a very substantial increase over customary levels in the BOJ's holdings of long-term government debt. Because yields on government bonds are currently so low, these holdings expose the BOJ's balance sheet to considerable interest-rate risk (although any losses would be partly offset by unrealized capital gains on earlier acquisitions of bonds). Indeed, ironically, if the Bank of Japan were to succeed in replacing deflation with a low but positive rate of inflation, its reward would likely be substantial capital losses in the value of its government bond holdings arising from the resulting increase in long-term nominal interest rates."? The graph below matches up the qualitative easing programs of the Bank of Japan and the Federal Reserve by date of launch. In QE2, the Federal Reserve's line will get another leg up.
Bernanke conceded that a central bank is not a private institution and therefore not subject to the same risk management requirements. "[T]he Bank of Japan is not a pri Read Full Article »
