Goundhog May?

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The last few weeks feel a lot like Q2. Recall that in Q2 Greece blew up, and risk assets tanked.

You may have forgotten, as the Fed pulled a classic shell game trick – distracting you with QE and giving Europe time to fix itself.  Well, Europe didn’t fix anything…

So here we go again …

We have a Euro-peripheral blow-up … that keeps blowing up

A bailout that treats a solvency issue as a liquidity issue; which the market rejects … that morphs into a funding issue (it’s EU banks that hold the bonds).

Stress in funding markets leads to a USD squeeze, which impairs EU banks’s ability to raise USD cash. The below chart shows a manifestitation of this pressure in the EUR/USD cross currency swap market.

What it shows is that European names are willing to lend EUR at ~55bps under the benchmark EUR 3m rate to borrow 3m USDs at LIBOR (flat).

Just like in May, this hunt for USDs (by bad names) is pushing LIBOR-OIS wider, even after the bailout…

And just like in Q2, the pressure was first evident in the forwards – and is now migrating down toward the spot fixing.

Risk assets (here I’ve used AUD ITRAXX – a corporate CDS index) are only just figuring it out…

… but they appear to be catching up just now.

This tightening of monetary conditions is undoing the good work that was done by the Fed’s QE.

As you can see above, the weakness of the USD (v. the EUR) was coincident with the strengthening of equities – suggesting to me that it was a monetary phenomenon — see prior post on this, here

Finally, just as in May, the PBOC may start tighteing once again (did they ever stop?).  History suggests the PBoC tends to increase the RRR / benchmark rates when real deposit rates are negative (as in this case there is no incentive to hold real money balances). They are very negative right now, and falling.

CPI was 4.4% in October and activity data suggests it’s more likely to accelerate than decline. The Nov Chinese Manu PMI showed a broader acceleration of activity (+0.5pts to 55.2), accompanied by a broader increase in input prices (+3.6pts to 73.5). This suggests to me that inflation is likely to accelerate.

For mine, the Chinese economy needs real tightening – probably a few rate hikes. Central banks don’t often get out of bed for 25bps — as even in the over-leveraged west an economy isn’t all that sensitive to interest rates.

China hiked once recently – so I’d expect a few more!

Given this, my short term forecast is that the EU will keep crackling, and that China will tighten some more …

That’s probably going to be bad for equities, commodities and the AUD… next stop looks to be ~0.92 for the battler!


  1. Sorry to pester, but am on the vino and on a roll.

    Really nice post, particularly the emphasis on short term markets’ stress and tying in China.

    Two things though:

    – add Belgium to your chart, they wafflers are getting a wallop too
    – you mention the good work of QE2 being undone….what good work exactly? I find QE to be an horrendous joke….a maturity transformation, of no discernible benefit to the economy (banks will lend whenever they find it profitable irrespective of the level of reserves, which includes creditworthiness as well as collateral value), and when the deleveraging stops. And therefore not an ounce inflationary. Works that way in practice, and the BIS seem to agree which is nice, but still interested in your thoughts.

    1. @apj:
      • “And therefore not an ounce inflationary.” – breakevens on TIPS increased a tad (50bps?) on QE2. So market thinks its somewhat inflationary. However market was expecting something like 2tn QE2 after FOMC meeting in Aug (see one of mcooganj’s previous post). Also, without clear CPI level target, this whole thing will not work well, or at all. Bernanke wrote a paper about that a few years ago. Prob is that CPI level target will not happen because loud voices are screaming that hyperinflation is looming.
      • perhaps more generally, when has a central bank never been able to generate inflation when it has wanted to? the fed will be able to generate inflationary expectations and actual inflation if and when fomc hawks shut the hell up. possibly because of fomc’s resulting equivocation (and lack of level target), sufficient inflationary expectations are not being generated.
      • if fed can generate requisite inflationary expectations so that the wicksellian rate of interest will drop below rate of return capital, banks will lend. this situation corresponds to higher ngdp expectations. i reckon that they won’t want ior rate if they expect to make much more than this by intermediating.
      • the other effect of higher inflationary expectations are lower expected real wages. this will help clear the labour mkt. if people have jobs, they are less likely to fall delinquent on loans and more likely to invest in housing or increase their consumption.
      • one of the nice things about qe2 was devaluation of usd. US was getting choked by undervaluation of bric currencies, particularly China. the usd being overvalued is like having a millstone tied to the neck of us economy. this happened in 1930s when usd was still on gold standard. as gold fled US to europe, inflation tanked and ngdp got smashed. as soon as US debased their currency by getting off gold standard, things stabilised.

  2. 1. Sorry, but TIPS are implying no such thing. They’re not even back to the bottom of the BE range that existed from 2004-2008 (220-280bps), so not worth looking at in this context because that doesn’t describe a market that is worried about inflation.

    2. Inflation expectations are hard to generate with an output gap the size of Mars, so I can’t see what difference it makes what the likes of Hoenig say. When they begin filling the output gap, then they’ll be closer to generating inflation, and QE (ie- maturity transformation, no net addition of financial assets, reserves sitting in reserve accounts or reserve substitutes, as usual) doesn’t do it.

    3. I don’t know how many bank lending meetings reference old Knut, but banks will generally lend when they are confident the borrower can pay them back, and when the collateral they lend against isn’t deflating like a banchee (or is at least stable)

    4. Not convinced about real wages driving employment, I can’t see the relationship….convince me.

    5. USD deval is over-rated based on the “so-called” debasement…..look at a chart going back 10yrs and it’s not more than a blip.

  3. 1. Well if the breakeven moves up by 50bps on QE, how does that not indicate that the market is pricing in a bit more (I’ll concede – not a lot) of inflation over next 5 yrs? Whether or not thats significant historically is irrelevant. They moved up. If you are saying, by not much, then we agree. If this doesn’t signal higher inflationary expectations, then what does it signal?

    2. I gave an example where inflationary expectations rapidly increased where a much larger output gap existed (25% ue, etc): the US in 1932-3. From the monetary economist of the moment: “As soon as we left the gold standard in March-April 1933, FDR was able to easily create rapid inflation despite 25% unemployment, near zero T-bill yields, and much of the banking system shutdown for many months.” [#1] Decisiveness mattered here as well, because the US dithered for months because of Hoover’s reluctance to leave gold standard. History repeating itself. GOP and their ideological allies crapping their pants about debasement and not worrying enough about output gap. They be-clown themselves yet again.

    3. I agree that not many bank lending policies will mention old Knut. But banks formulate their scorecarding / underwriting decision as follows: is this marginal loan going to meet or exceed the profit based cutoff (which includes cost of capital, risk of default etc)? If expected NGDP increases (and this is driven by the real “Knuttian” interest rate), then the answer is going to be closer to yes, than no. The commercial bankers can happily leave old Knut to the central bankers.

    4. Ok. Suppose a company makes $100 revenue. And its labour cost is its only cost at $50. Then it makes $50 nominal profit. Now suppose that prices (excl labour) rose by 5% and labour rose only 2%. In this case real wages fell ~ 3%. But company’s nominal revenue is now $105, nominal cost base is $51 and nominal profit is $54. More nominal profit and more real profit as well @ ~$51.4 (= 54/(1.05)). Which means that they are marginally more likely to employ more persons to generate more output or invest more which in turn will also result in more output. Either way, unemployment shrinks and output gap shrinks. This is of course, rather simple example. How does that argument sound?

    5. You make a very good point. This is also one of the US’s big problems. The USD is really only falling back to where it was pre crisis (after which point demand for USD funding became extreme and USD skyrocketed). If the EU did some monetary easing (its monetary policy is pretty tight at moment, the short rate be damned) along with US, then we might be getting somewhere. Everytime the EU wobbles, the risk off trade goes into full swing and the USD has an endorphin rush. Exactly not what the doctor ordered.

    Oh well, I ain’t an economist, but I do like thrashing these ideas around.

    [#1] http://www.themoneyillusion.com/?p=7960

  4. Ok that work at Cleveland Fed is very interesting. Thanks for linking it! I’ve read the summary [#1] and skimmed the beginning of the WP 08-10 that details the model. I’m looking forward to reading it more deeply soon. The thing I like most about it is that its motivation for the model seems to be drawn from real-world dynamics (vol behaving in a certain way etc). This is always nice to see.

    Here’s the rub: they are building this multifactor model (seven factors at my count!) for interest rates + inflation + vol factors. Now thats all very nice, speaking as a quant, but I also know that this is fraught with danger, given the intricacies of trying to model just term structure of nom rates. Even in trying to model nom reates, using “nice models” that seems to reflect reality a bit better (in some ways) can result in infinite prices for eurodollar futures (there are other artefacts as well). Take GARCH (the way they model vols). Do you use symmetric GARCH (sharp falls in state variable have same impact as sharp rises in state variable on modelled variance) or asymmetric GARCH (sharp falls / rises in state variable apply different shock to modelled variance)? So complexity breeds uncertainty that isn’t captured endogenously. Model risk if you like.

    So I guess my rambling can be summarised as follows: beware of quants bearing models. Especially when they are complicated and then use these models to attribute market behaviour. There’s a circularity problem here as well: their model choice is driven by their understanding of market behaviour (as I noted above), which then is used to describe market behaviour. Hmmm….

    As one of their conclusions suggests [#1]:
    “So in most instances, a change in the break-even rate can safely be attributed to a change in expectations. In the end, the model ends up supporting the case for using TIPS as a gauge of inflation expectations.”

    So just look at the break-evens, most of the time. Simple.

    I’m looking forward to reading your upcoming post about Feds ability to depress term premium. I don’t understand what your are trying to say. And I suspect this reflects my shallow understanding of the subject area. So please enlighten me!

    Thanks for all this. Loving it.
    [#1] http://www.clevelandfed.org/research/commentary/2009/0809.cfm

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