There's Been No Recovery, and There Cannot Be One
The economic and financial history of the last eleven years has been so extraordinary that all the bases have been covered. There really isn’t a situation that might arise today that we can’t see in the outlines of that past. The Federal Reserve is raising rates because it views more upside inflation risks? Been there in Europe and China.
What’s more, the world’s bond markets are responding in this very fashion. The US CPI this week was figured to be 2.87% year-over-year, the highest inflation rate since February 2012. The 30-year long bond, the farthest US Treasury security out on the curve, was entirely unmoved. At ~2.95% interest, the long end’s so-called real rate is only 8 bps or so from being negative. Count that as outright rejection.
The reason is simple. Practical experience. Economists like those working at central banks have no idea what’s going in their economies. To start with, they treat them like totally separated systems. Europe’s economy is viewed as European alone. The Fed is raising rates because of its modeled stochastic projections of the US system in isolation.
Crashes or downturns are not single events. The Panic of 2008 took more than a year and a half to complete, closer to two and a half years since the first warning signs. The media always states these things are “unexpected” when they are not. They are only written that way because Economists and central bankers (redundant) ignore the plethora of warnings always preceding them.
The global experience in 2011 is instructive. Measured consumer price inflation then as now was rising in key places. In China, for one, that country’s CPI would make its way to a high of 6.5%, more than double the Communist government’s mandate for price stability. In response, the PBOC, China’s central bank, raised interest rates but more importantly increased the amount of bank reserves (RRR) the largest banks were required to set aside.
Between November 2010 and June 2011, the RRR was raised nine times. Starting at 17%, the proportion of locked up reserves would rise to 21.5% by the middle of that eventful year. The Chinese were not alone in their consumer price vigilance.
In April 2011, the European Central Bank (ECB) raised its benchmark money rates by 25 bps for the first time since the Global Crisis (hint: global crisis). The move shocked markets because of the still burning PIIGS emergency. Central bankers, however, were increasingly confident of a truly positive outcome largely because they felt an emerging economic recovery was going to solve it for them (and everyone). They just needed to get the financial system right first.
Making these intentions very plain and obvious, the ECB raised rates for a second time that July. On July 7, the day of the additional rate hike, Europe’s chief central banker Jean-Claude Trichet stood in front of the assembled media and told them in no uncertain terms:
“The positive underlying momentum of economic activity in the euro area remains in place. Euro area exports should continue to be supported by the ongoing expansion in the world economy.”
As say central bankers, so say all the economic “experts.” From financial analysts to Economists, they all lined up behind the main DSGE model seekers. One such analyst at BNP Paribas in London told the UK’s Guardian newspaper on the same day as the ECB’s second hike:
“Risks to price stability should remain on the upside, implying a bias to tighten ... We expect the ECB to press on with rate hikes beyond July, assuming that the problems in Greece do not turn systemic.”
Yet, throughout that day’s press affair Trichet was badgered over and over about Greece and Portugal. After being asked whether or not the ECB’s credibility was at risk in buying up Greek and Portuguese debt as it had been doing since the year before, Jean-Claude grew curt. The central bank had been “without exception” taking “nonstandard measures” so as to ensure “our monetary policy transmission mechanism return to a more normal functioning.”
“So, I have to say that we are credible in this respect – very credible! And a central bank that, over the last 12 years has delivered average yearly inflation less than 2%, which betters the achievements of every other big central bank in Europe over the last 50 years, does not need to receive a lecture on credibility!”
The goal was valid; robust economic growth indeed does solve almost every form of imbalance, even the more dangerous ones. Had it been occurring at that moment, who knows what might have come out of Greece, Portugal, and especially Italy.
Not quite three months later, however, Trichet was basically shown the door. On October 6, 2011, he again appeared in front of the cameras this time with his retirement already sealed and announced. His tone was very different, as was his message.
“Ongoing tensions in financial markets and unfavourable effects on financing conditions are likely to dampen the pace of economic growth in the euro area in the second half of this year. The economic outlook remains subject to particularly high uncertainty and intensified downside risks.”
That’s one hell of a contrasting assessment given after such a short period of time. And it was dubiously understated still. Europe’s economy would not be buoyed by “ongoing expansion in the world economy”, instead falling into outright re-recession during the very quarter in which he was later speaking (Q3 2011).
China didn’t fall into contraction as Europe did, but that economy would experience a similar and equally devastating slowdown over the next year and a half. In both cases, everyone was absolutely positive inflation was the only emerging risk. And in both cases, it was shown very quickly that deflation was actually the risk all along.
The problem stems from modern Economics’ total absence of monetary exploration. As such, central bankers simply believe they are central. They incorporate these beliefs into their dynamic stochastic general equilibrium (DSGE) models and the dozens of related variances from them. It amounts to ridiculous confirmation bias that all-too-often overrides common sense, including the arising of textbook deflation.
You would think that after suffering the humiliating defeat of 2008 Economists and central bankers would have grown more circumspect. Instead, they only became bolder (after first convincing themselves, and then trying to convince the wider world, that they had acted courageously and lacked only the will to push beyond conventional limits). The global panic had happened not because they lacked the power, they thought, rather they had been afraid to really open up and use it.
So, starting in late 2008, they did. The models assured them things like ZIRP and QE would work and work very well. When Trichet announced his first April 2011 rate hike, he did so with complete confidence. There was no way they would fail a second time because they had all greatly expanded the limits of central banking, these several “nonstandard measures.”
Markets would occasionally believe in it, too; just not for as long nor as stridently as Economists did and do. Globally, interest rates rose as the world’s CPI’s moved up. There was a uniform sense that things were recovering, maybe not as quickly and as emphatically as might be expected after such a large contraction in 2008 and 2009, but enough for a short while to suggest a plausible path to where Trichet was thinking.
Germany’s 2-year schaetze, or federal bond, had fallen precipitously in yield as the financial crisis progressed. It kept falling after, too. By May 6, 2010, the 2s’ yield was down to just 63 bps. That Thursday was the day of the so-called flash crash in stocks. The next day, the German 2s were down to 48 bps caused by the full eruption of the PIIGS crisis precipitating the ECB’s second, more direct “nonstandard” response the following Monday. Warnings.
The bund market would remain skeptical for another month. It wasn’t until the ECB’s policy meeting on June 10, 2010, that things began to turn around. Trichet during the press conference following it declared, essentially, that the sterilized Securities Market Programme (SMP) put in place on May 10 was working.
“We said very clearly that we would withdraw all the liquidity that was to be supplied through this Securities Markets Programme, and you have been able to observe this withdrawal of liquidity functioning week after week.”
From that point forward, the schaetzes (and bunds) would sell off as inflation rose on the back of the commodities rebound. When Trichet raised rates on April 7, 2011, the 2s yielded 195 bps, or 1.95%. They would not, however, go much farther peaking not quite a month later at 200 bps exactly.
By the time of Europe’s second, and so far final rate hike, the 2s like the 10s had already declined sharply in yield. Trichet had remained confident in his monetary policy actions and their effects on restoring the transmission mechanism. This was supposed to allow for the resumption of robust economic growth but markets weren’t going for it any longer.
It wasn’t just bonds, though. There was much more to it. Commodities like copper had peaked that February, selling off harshly on several occasions by the time real crisis would resume again later in July 2011. Oil registered its top (WTI) on April 29, just a few days before the bund market would turn. The ECB was hiking into a full-blown market rejection.
These market changes were merely confirmation of an increasingly more doubtful baseline sentiment. Yes, markets were moving in the “right” direction in later 2010 but they weren’t really normalizing as they should have been doing. They were still significantly less than pre-crisis levels by early 2011. Everything that went on in 2010, from the flash crash to the SMP were all warning signs that “something” just wasn’t quite right.
In fact, that the Federal Reserve felt compelled to undertake a second QE was another such. Though stock markets enthusiastically embraced this additional round of “money printing” there was an underlying uneasiness about it, starting with questions as to what QE really was. We know what the stochastic models say of it, but in practice it wasn’t going nearly so well (the second instance alone as sufficient evidence for the claim).
This striking contrast would be brought home by what started in July 2011. We need only turn to Brian Sack, Head of FRBNY’s Open Market Desk at that moment, for official confirmation. On August 9, 2011, he admitted:
“MR. SACK. Can I add a comment? In terms of your question about reserves, as I noted in the briefing, we are seeing funding pressures emerge. We are seeing a lot more discussion about the potential need for liquidity facilities. I mentioned in my briefing that the FX swap lines could be used, but we’ve seen discussions of TAF-type facilities in market write-ups. So the liquidity pressures are pretty substantial. And I think it’s worth pointing out that this is all happening with $1.6 trillion of reserves in the system.
Alan Greenspan eleven years before had acknowledged central banks couldn’t define money, and that by June of 2000 hadn’t been able to for a long time already. This “proliferation of products”, as he called it, was at the forefront of one global panic, the worst since the Great Depression, and then another shortly thereafter. Economists still continued to view this intellectual deficiency as of no concern as he had. Markets, bond markets, in sharp contrast, really began to wonder.
Especially about the global nature of it all. The word “eurodollar” rarely if ever appears, but banks and traders know that there are trillions upon trillions going on in these offshore shadows. Thus, the potential for undiagnosed monetary disease is poignant.
In many respects, 2017 is proving to have been a lot like 2010. There were warnings all throughout last year but especially September forward. They were completely ignored by central bankers, mostly dismissed by the media, and only partly set aside by bonds and bunds. This is what made the brief inflation hysteria so hysterical; there was scarcely a day that would go by without some screeching guarantee for globally synchronized growth and the huge inflation risks that would bring, all based on nothing more than really minor moves in the “right” direction.
The molehill was much larger in 2010.
UST’s like German bunds and schaetzes sold off and nominal yields rose late last year, but curves collapsed. There was again an uneasiness to it hidden underneath the mainstream’s penchant for uncritically following every word uttered by the Jay Powell’s and the Jean-Claude Trichet’s of the world. Gold and copper began to sell off and decline, curves flattened more threatening to invert, and in January 2018 global liquidations.
None of these have yet registered, at least in unshakable convention. Powell is still mindlessly sticking with his models just as Trichet once did. The warnings multiply and escalate, deflation overtaking more and more reflation that upon honest reflection really wasn’t all that much even at its best. The eurodollar curve, as I noted last week, has now inverted. Doesn’t matter to the FOMC, at least outwardly.
They all say the risks have faithfully shifted to the upside. Through the prowess and determination of the world’s central bankers, self-congratulations all around, the global economy via its various and separate constituent pieces is poised on the precipice of recovery at long last.
The biggest, deepest markets in the world just aren’t buying it. The track record uniformly belongs on the side of the skeptics. Schaetze and bund yields are retreating for yet another time, never having been close to getting within sight of 2011 levels. China’s RRR has been reduced several times already this year and it’s only July.
The US CPI can turn it up to 3%, and the long bond instead acknowledges the growing downside risks of deflation. If, or rather when, the UST curve follows the eurodollar curve into inversion it won’t really be about some incoming future recession. It will be another escalating warning that they really don’t know what they are doing.
Because they don’t, there has been no recovery and, more importantly, there cannot be one.
Powell like Trichet and the PBOC in 2011 doesn’t need to “raise rates” to contain the CPI. The effective eurodollar noose tightens again and before too much longer that’ll take care of it for him. That is, in fact, what the eurodollar curve right now is suggesting. Doesn’t matter China, Europe, or the US. We’ve seen this all before. We’re closing in on the end of the fourth time subprime was contained.
And nobody’s learned a thing from it.
