A dialogue based on Q&A with Dr. Brendan Brown, October 8 , 2019 (Stephen Martus moderator)
Q1 What is next for European rates (is Europe becoming Japanized)?
In fact, Japan is headed for Europeanization rather than Europe to Japanization, at least in the context of monetary policy. Europe has been “ahead” of Japan in the driving of interest rates into sub-zero territory. As Japan now moves into recession, we are likely to see a Japan catch-up.
Back to European rates, most likely money market rates have already bottomed. Further cuts below zero would add to the pressures on weak European banks and there are adverse political currents to consider (even though these remain quite tame so far, even in Germany).
Bond yields – that is another story.
In core European bond markets these could head still lower under two influences – first, fear of banking crisis and second, speculation on a new harder euro (with less members) or resurrection of the Deutsche mark.
As of now, interest rates on deposits in euro-zone banks (even the riskier ones) are pinned down at zero by ECB policies (in particular huge excess reserves and generous lending facilities); that means safer assets than deposits, in particular core sovereign bonds, are priced such as their yields are negative. If bank deposits become riskier, then these yields become more negative.
As to a new hard euro, the focus should be on the German political arena (more to follow).
Q1A With the memorandum published last Friday by ex-leading European Central Bankers strongly questioning the soundness of ECB policy during the past 5 years, coupled with serious dissent at the last ECB meeting from the national central bank presidents of Germany, Austria, France and the Netherlands, regarding further QE, what do you think the implications will be for Lagarde, and how will she manage to maintain a majority in favour of continuing the radical monetary policies?
Central banks are essentially highly political institutions – never mind the propaganda from the central bankers’ club about their independence (and the sacrosanct nature of that independence).
Let’s note that several of the signers of that memorandum never once voted against key policies on the road to present unsound money when they were in office.
Just think of Otmar Issing, who took Europe on to the 2 per cent inflation standard (in 1998 and 2003); or Christian Noyer, head of the dossier at the ECB for approving Greece’s entry into EMU; or Juergen Stark, who remained at his post at the ECB right up to 2011 despite serious reservations; or Helmut Schlesinger, who was so ineffective as Bundesbank chief or chief economist in halting the fast train on which Chancellor Kohl had put Germany to a disastrous monetary union.
Turning to the national central bank presidents who voted against (as members of the ECB Governing Council) the recent resumption of QE. One of them, Bundesbank President Weidmann has the reputation of being “Mr. Softy” (based on weich – mann) amongst German critics of the ECB. More generally, all the ECB board members (as distinct from national central bank presidents) vote en bloc with the ECB chief. True, board member Sabine Lautenschlaeger (German national) has just resigned, some say out of dissatisfaction with policy; but we can trust Chancellor Merkel to work to replace her with a loyalist.
The dominant political direction for the ECB is set in Berlin. Chief Draghi was an expert at consummating this relationship. He cleared every radical monetary policy step first with Chancellor Merkel. One could speak of the Draghi-Merkel axis. Will chief-to-be (from end-October) Christine Lagarde have such a great relationship with Chancellor Merkel?
Most likely yes: at least judging from the warmth of their relationship on display at the recent doctoral prize giving (for Dr. Merkel) at Leipzig and by the fact that Merkel went along with the choice of this ex-French politico as ECB chief undoubtedly against the views of the right wing within her own party (and the allied CSU). A good relationship with Dr. Merkel, however, is no big guarantee that Lagarde can persevere with radical monetary policies in their present form.
The key issue is whether Angela Merkel’s eurocentrism will remain in the German political ascendant.
Or at some stage will the CDU turn to the right (rather than unsuccessfully attempting to win votes from the Greens), in the process adopting euro-critical policy positions and striving to win back disaffected voters now abstaining or supporting the AfD? If such a change in course were to be triumphant (without Merkel of course), Lagarde might become a growingly isolated figure, who in fact turns out to be a red rag to the bull of German nationalism.
Q2 What will be required for nominal interest rates to become positive?
One can think of several possible scenarios.
First, Washington could put growing pressure on Europe and Japan to abandon negative rates, arguing (correctly) that these are a form of currency manipulation. The stick would be tariffs and other trade restrictions – to be removed when negative rates are abandoned. Evidently so far the Trump Administration has been reluctant to go down this route, most probably out of concern that the abandonment of negative rates could bring a stock market crash before the 2020 elections.
Second, there could be a surge of domestic discontent with negative rates, most particularly in Germany (but also possibly in Japan). Christine Lagarde might find that abandoning negative rates is essential to sustaining support for European Monetary Union in the German political scene.
Third, an economic miracle could occur. Interest rates would rise in line with strong economic growth.
Fourth, the euro and/or the yen could enter a free fall, driving up inflation expectations and raising the risk of trade war with the US.
Q3 How does Europe, or for that matter, the US and Japan, stop or even reverse the reckless monetary experiment without causing major financial and economic disruption?
Major financial and economic disruption is surely already baked into the cake by all the monetary inflation (albeit camouflaged in goods markets) during the past decade (and before).
Hence the question – and it is not a new question in history – is whether a sound money advocate suddenly promoted to the top of a powerful central bank should immediately go ahead with his or her agenda or be patient.
Perhaps it would be best to allow the present bubbles to burst first.
That dilemma is highlighted by Milton Friedman and Anna Schwartz in their monetary history of the US, with reference to 1928-9. Then the Fed (after the death of Benjamin Strong) embarked on a policy to burst the bubble (and the new President, Herbert Hoover, was strongly in favour). There is no one historical verdict, but these authors and many others have concluded that some patience would have been better (especially because of unfolding political drama in Germany).
I hesitate, therefore, to say the Fed should now at this late stage suddenly embark on tough, though we should note that the Powell Fed’s policies are almost certainly much further away from sound that the Fed’s in 1928. There would be plenty of scope in the US to move to a sounder framework at present without an abrupt tightening of policy (for example reverting to pre-2008 monetary reserve control and slimming down monetary base outstanding).
Q4 What will be the impact of the move to positive nominal interest rates on stock prices?
If the return of interest rates to positive territory occurs in the context of economic miracle, then stock prices could rise. If by contrast the return is under another scenario (as itemized in the answer to question 2) – for example pressure from US, currency collapse, or domestic political pressure – then the direction of pressure would be downward on stock prices at first. Though in the long run sound money should mean greater prosperity and higher stock prices. The channel of influence from interest rates to stock prices might well be strongest through the credit markets, where the hunger for yield has been the most intense.
Q5 When will we see 0% yield on the 10-year note (US)?
Let’s start with a historical pre-amble.
During the Great Depression (1929-33) and its aftermath (say, the economic expansion of 1933-37), 10-year US Treasury yields never sunk below 2%, and that was despite a type of QE policy pursued by the Roosevelt Administration (more passive than present, largely in reaction to gold inflows to the US). And through that period as a whole prices fell. So why did US 10-year yields fall further during a less severe recession and aftermath this time and with a background of rising prices?
The biggest factor in the divergent experience has been the extent of radical monetary policy – including tools not used in the 1930s – and the influence of eventually even more extreme policies in Europe and Japan.
In looking forward to the next recession and aftermath, will US monetary policies become more radical than last time – meaning negative interest rates and more intense bond market manipulation? There are grounds for caution about such prediction. Negative rates are not possible in the US without a change to the Federal Reserve Act. For this to occur, there has to be a super-majority (for such action) in the Senate. That seems implausible without a political earthquake (which might nonetheless occur under extreme economic conditions!).
As of now, several of the Trump appointees to the Fed had concerns last time round about quantitative easing. They are unlikely to be leading the charge again into such policies, especially broad criticism (excluding the Bernanke-ites) that they were ineffective.
Finally, long-term interest rates are not totally subject to manipulation. If the state of expectations shifts to high concern about future inflation or optimism about a faster economic expansion beyond the next recession, then considerable yield curve steepening can take place. There are indeed strong grounds for hypothesizing that goods and services inflation will be higher in the next cycle, no longer enjoying the camouflage of rapid globalization and of digitalization. (The latter has been disinflationary in the present cycle but that may not continue with the same force).
Q6 You’re very negative about the role of central bankers maintaining monetary stability. Isn’t the risk that you overgeneralise because they don’t all operate in lock step?
In fact, most of the time the central bankers around the globe do operate in lock step – under the powerful influence of the US monetary hegemon (the Federal Reserve).
Very rarely in the 100-year history of that hegemon has any foreign central bank defied the US monetary lead. One can think of the Bundesbank from the late 1960s to the late 1970s, and again in the second half of the 1980s, defying US monetary inflation; such defiance took the form of implementing monetarism and promoting the hard Deutsche mark.
In modern times however there has been no sustained defiance whether by the ECB or by the Bank of Japan (except for a brief period under Governor Shirakawa 2008-12).
We should note that defiance is futile unless it is supported by dominant political forces. In Germay, the SPD/FDP government was fully behind the defiance of the US monetary lead and the Bundesbank’s hard DM policies.
Looking around the globe today it is not possible to see defiant central bankers or governments in the spirit of Otmar Emminger or Willy Brandt.
Could these emerge in the next few years?
Yes – although it is very hard to identify candidates. The change would have to be led from the political arena (with a newly elected government in turn working to install like-minded central bankers or pulling its country out of existing monetary arrangements).
Q7 How likely is a global recession in the next two years given the latest developments in the US/China trade war?
A global recession including the US in the next two years is of say 65% likelihood. This begs the question of how severe the recession – or is this next recession to be followed soon (after a brief recovery) by another deeper recession. Most probably the combination of such downward lurches of the global economy in coming years will be severe given the extent of asset inflation and all the mal-investment plus over-leverage which has accompanied this.
Optimists – including professional optimists (in particular the Fed chief) take a different view. The slowdown of the global economy so far (since early 2018) and the accompanying growth cycle downturn in the US are a mid-cycle phenomenon – analogous to the intermittent slowdowns in previous super-long cycles, whether 1991-2007/8 or 1961-73/4 (the recessions of 2001 and 1969 were so mild not to interrupt the definition of long cycle transcending those events). Chief Powell has repeatedly told audiences that his timely rate cuts will exert the similar magical touch to Fed wands in these earlier cycles. Of course critics would say that these earlier mid-cycle stimuli ended up in various forms of economic calamity – but let’s be realistic here; the all important date is Election Day 2020.
Why is it most likely that this particular stimulus will fail (in the objective of extending an already super-long cycle?). First, the overall economic growth momentum during this long upturn has been remarkably weak (at least in the advanced economies). Second, the persistence throughout of radical monetary experimentation has gone along with the build-up of huge potential financial risks. Third, the driver of economic slowdown from bursting economic miracles or bubbles across Asia and Latin America, joined by German recession, is powerful.
How important in the “US-China trade war” to forecasts of recession. Obviously, this is a powerful narrative in the stock market. Every presidential tweet or equivalent from Washington or Beijing is analysed intently in financial markets and can power big day-to-day moves. More fundamentally though this global economic slowdown has been led by forces which transcend the “trade war”, in which incidentally there are many gainers as well as losers. In the media we only here from the latter.
Q8 What will be the impact of the slowing of growth in China on nominal interest rates?
Slower growth in China has very likely already had a significant impact in lowering global bond yields. The bursting of the Asian economic bubble, which has been one epicentre of asset inflation in the present cycle, and which features largely China, has been a main story since US long-maturity interest rates for example peaked in Summer 2018.
Going forward the big questions are the extent and pace of contagion from those developments in Asia to the US and the rest of the world (beyond what we already see); and the forces of slowdown internal to the advanced economies (for example asset deflation in domestic credit markets – whether focussed on autos, real estate, private equity and so on, and the latter overlap considerably).
Q9 Is the US dollar standing on clay feet?
Yes, the US dollar’s feet are clay (indicating vulnerability to the super strength and dazzle of the structure above); but the feet of the yen are even more clay (a subject below).
What are the principal vulnerabilities of the US dollar?
First, we know (if history is any guide) that in the next US recession, the US Administration (whether Republican or Democrat) will embark on a dollar devaluation campaign. But this could start from a dollar level much higher than today, and the ease of waging the campaign against Europe and Japan ever more engaged in radical monetary experimentation in the context of creaking financial systems should not be exaggerated.
Second, domestic political change: what if Senator Warren becomes US President?
Actually. in terms of currency markets that is not such an easy question to answer. Traditionally Republicans have been as big or bigger wagers of currency war than Democrats. We don’t know what sort of coalition-building the Senator might do (towards the centre) in terms of building a majority (if successful).
And political change in a currency-unsettling direction is possible in Europe and Japan. Imagine here the Greens becoming the largest party in Germany and forming the next coalition government; or all the uncertainty related to an anti-euro majority gaining power. And in Japan, who knows what political earthquake lies behind the calm façade of a one-party democracy?
Third, reversal of carry trade flows as asset market deflate. US assets have been at the centre of attraction during the present global asset inflation, with famished yield-hungry investors in Europe and Japan pouring funds into US investments in search of yield. When asset markets crash, could these funds make for the exit, pulling down the US currency in the process?
Yes, there could be a rush for the exit out of US risky assets into safe US assets (meaning US Treasuries in particular). It is not obvious that safety means bringing funds back to Europe or Japan. And not many investors are lucky enough to get through the gates before they slam shut (meaning the spreads between risky and safe asset yields become so wide, that escape is no longer an attractive option).
Q10 Is the Japanese yen still a safe haven?
For the robots and pavlov-traders who dominate the day-to-day markets the yen is a safe haven. And there are huge positions built up in the yen as a negative beta asset (a protection against equity and credit markets tumbling). Problem: fundamentals do not justify this safe haven reputation and when eventually the yen continues to fall during a risk-off episode, the bloodbath for long-yen investors could be immense (as all the robotic/pavlov/investment positions go into reverse).
The reputation of the yen as safe haven was largely built on one phenomenon – the giant carry trade which built up in the yen from the late 1990s through until 2008. (These were the years when Japan “led” the world in experimenting with zero rate policies and QE; now the rest of the world has caught up). Every time in this earlier period when there were jerks of risk off, the yen carry trade shrank (as the counterpart was usually holdings of risks assets), and the yen jumped. Hence its reputation as safe haven was born.
But in the present long asset inflation (since 2011) the yen has not re-gained ground as a carry trade currency. Perhaps too many people remember the big losses on this carry trade through various risk-off periods, especially 2008-11; and in any case the rate spreads against the yen have not been anything like as favourable as in the earlier periods. Hence investors speculating on the yen leaping during the next asset deflation may well find out that they are plain wrong. And not just because there is no implosion this time of a bubble carry trade. This time Japan is fundamentally more exposed than last to global economic and financial downturn.
What are these exposures?
First, the continuing dominance of Japanese industry by the auto sector and the extent to which this is already signalling a long downturn ahead.
Second, the Japanese banking sector has been the most aggressive during the present cycle in expanding cross-border loans (in part related to its acquisition of loans from European banks during the sovereign debt crisis in Europe) and correspondingly dependent on dollar funding from outside Japan.
Third, Japanese banks have been amongst the most desperate in the search of yield , taking on risky assets around the globe (and including various types of hot real estate inside Japan), for example directly participating in weak credits which in the US would be held outside the banking system. One can think of here exposures to a highly leveraged giant which has been at the forefront of buying assets at the centre of the global bubble.
Fourth, Japan is subject to potential geo and domestic political shock. The China and South Korea “stories” are playing badly for Japan, and who can totally have confidence in the US umbrella especially at a time when the US President has embarked on it seems a series of peace in our time deals ahead of Election Day?
Q11 What would be your Sterling strategy with so many unknowns present?
Sterling strategy would continue to be defensive and at times aggressively negative.
At best of times, democracy is fragile. The change to the UK constitution in effect by the Cameron government (the so-called Fixed Parliament Act) has created a situation now of Parliament and the Executive in deep crisis. Fine for the legislature (parliament) to have greater power – and many would agree that in the UK there had been too little. But if so, elections must be frequent (every two years in the US). There has been no such safety-valve in the UK.
Potential and actual deep political crisis in the UK with highly uncertain outcomes merit Sterling assets being seemingly cheap. And it is not a stretch of the imagination to ask whether the UK could be the first advanced economy in the present era to return to high inflation, under the driving force of currency collapse.
In the short run, the focus is on October 31 and whether the UK will exit the EU then. Perhaps PM Johnson will resign shortly before that date rather than deliver a request as required now by law to delay Brexit. The gambit would be that no one else could form a government which would sustain a vote of confidence in Parliament. A general election would follow amidst huge turmoil.
Here at Macro Hedge Advisors our technical analysis for the pound does suggest an upside potential (under carefully noted conditions). The fundamentals which could go along with this would be a change in the German political climate – including the prospect of a right-wing government coming to power in Berlin; or alternatively there could be unexpected progress towards a US/UK alliance, in effect the strongest lever which London would have in its negotiations ongoing with the EU about a trade deal.
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