Gold – is it all that glisters?

Gold – is it all that glisters?

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Macro Letter – No 116 – 14-06-2019

Gold – is it all that glisters?

  • Uncertainty about US trade policy has truncated the rally in stocks
  • Gold remains supported by central bank buying and fears of a US$ collapse
  • Gold miners look best placed to reap the benefits regardless of direction
  • A collapse in the U$ is needed for gold to rally substantially

In Q4 2018, as stocks declined, gold rallied 8.1% and gold mining stocks 13.7%. It was a prescient reminder of the value of gold as a portfolio diversifier. There have, however, been some other developments both for gold and gold mining stocks which are worthy of closer investigation.

Central Banks

Central bank net purchases of gold reached 651.5 tons in 2018, up 74% from 2017, when 375 tons were bought. The Russian central bank, perhaps fearing US sanctions, sold almost all of its US Treasury bonds to buy 274.3 tons of gold last year. For probably similar reasons, the Turkish central bank bought 51.5 tons, down from the 88 tons purchased the previous year. Other big central bank buyers included Kazakhstan, India, Iraq, Poland and Hungary.

In the first quarter of 2019 central banks purchased a further 145.5 tons, up 68% on Q1 2018. The trend is not new, central bank purchases have been rising since 2009: –

Central Banks Gold Holdings - BIS, IMF GEMS, Reuters

Source: BIS, IMF, GEMS, Reuters

Putting global reserve holdings in perspective, here is the central bank world ranking as at March 2019: –

statistic_id267998_value-of-gold-reserves-2019-by-country

Source: IMF, Statistica

Despite the substantial buying from central banks the price of gold has been broadly range bound for the past five years.

commodity-gold 10 year

Source: Trading Economics

The absence of a sustained rally suggests that many investors have forsaken the barbarous relic, however, concern that the gold price will collapse have to be tempered by the cost of mining an ounce of gold. Mining costs have increased substantially since the early 2000’s due to increasingly expensive exploration costs and a general decline in ore quality. In the chart below Money Metals Exchange shows Barrick (GOLD) and Newmont (NEM) average cost of production since 2000: –

saupload_Barrick-Newomnt-Production-Cost-vs-Gold-Price_thumb1

Source: SRSrocco Report, Kitco

In a July 2018 post for Seeking Alpha – Money Metals Exchange –  Never Before Seen Charts: Gold Mining Industry’s Costs Are Higher Than Market Realizes show that the amount of ore needed to produce an ounce of gold at Barrick’s (GOLD) Nevada Goldstrike and Cortez Mines has increased four-fold since 1998: –

saupload_barrick-nevada-goldstrike-cortez-mines

Source: SRSrocco Report, Barrick

The market capitalisation of the sector has halved since 2012, leading to understandable consolidation and deleveraging. Gold, however, is an unusual commodity in that its stock is far larger than its annual production. About 3000 tons of gold is mined annually, this is dwarfed by the 190,000 tons that have been mined throughout history according to World Gold Council estimates. Since it has little industrial use, almost all the gold ever mined remains in existence: central bank reserves are a key determinant of its price. Interesting research on the subject of what drives gold prices can be found in this article from the London Bullion Market Association – Do Extraction Costs Drive Gold Prices? They conclude that, due to the large stock relative to production, the price of gold is the principal influence on the mining industry.

The US$ and inflation expectations

The rally in the gold price in 2011-2012 was linked to the Eurozone crisis, the moderation since then has coincided with a recovery in the US Dollar Index. Other factors which traditionally drive gold higher include inflation expectations, these fears have continually failed to materialise whilst the inexorable increase in debt has led some to speculate about a debt deflation spiral; an environment in which gold would not be expected to excel: –

united-states-currency DXY 2000 - 2019

Source: Trading Economics

A different approach to gold valuation is the ratio of the gold price to the total-return index for ten-year US government bonds. This ratio has been moving steadily higher, suggesting a shift to an era of structural inflation, according to Gavekal Research. Other evidence of inflation remains muted, however.

Is gold perfectly priced or do the central banks know something we do not?

A look back at the decade after the end of gold reserve standard is a good starting point. The Bretton Woods agreement collapsed in 1971. In the years that followed currency fluctuations were substantial and the US$ lurched steadily lower: –

USD Index 1971 - 1981

Source: Trading Economics

The US$ was so little revered that in 1978 the US Treasury had to issue foreign currency denominated Carter Bonds in Swiss Francs and German Marks, such was the level of distrust in the mighty greenback.

Confidence was finally restored when Paul Volker took the helm of the Federal Reserve. Volker did what his predecessor but three, William McChesney Martin, had only talked about – taking away the punch bowl just as the party got started – he hiked interest rates and managed to subdue inflation: the fiat US$ was back in favour.

Today the US$ is undoubtedly the first reserve currency. In the era of digital money and crypto currencies the barbarous relic has stiff competition. Added to which it is traditionally an unexpected inflation hedge and traditionally affords scant protection in a deflationary environment. Given the global overhang of US$ denominated debt, many believe this is the next challenge to the international order.

Considering the conflagration of factors alluded to above, I believe gold is destined to remain a much watched side-line. Gold mining stocks may fare better, as S&P Global Market Intelligence – Outlook 2019: US$3.9B Increase In Earnings For Majors – explains: –

…rising production in 2019, higher metals prices and lower costs could increase free cash flow by US$1.3 billion, or 19%, year over year. Companies will use this increased cash flow to lower net debt, which is expected to fall 19% year over year in 2019, placing the majors at their lowest level of leverage in five years. The majors have been focusing on returns to shareholders. Higher earnings have led to dividend payouts increasing 103% to US$2.0 billion in 2017 from US$1.0 billion in 2016 and remaining at about US$2.0 billion in 2018.

As for price of gold itself? The attractive fundamentals underpinning mining stocks is likely to cap the upside, whilst continued central bank buying will insure the downside is muzzled too. When I have little fundamental conviction I am inclined to follow the trend. A break to the upside maybe closer, but the long period of price consolidation favours a break to the downside in the event of a global crisis.

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Trade Wars, the prospects for freer trade and the impact on asset prices

Trade Wars, the prospects for freer trade and the impact on asset prices

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Macro Letter – No 115 – 24-05-2019

Trade Wars, the prospects for freer trade and the impact on asset prices

  • Will the Sino-US trade war breed contagion?
  • Will the dispute trigger a global recession?
  • Has the era of freer trade ended?
  • Will asset prices suffer?

As Sino-US trade talks ended, not only, without a deal, but with another sharp increase in tariffs, it is worth looking at what has happened and why. During 2018 the US reversed 38 years of tariff reduction with a radical abruptness, imposing tariffs on 50% of Chinese imports, China retaliated in kind, imposing tariffs on 70% of US imports. The Peterson Institute – The 2018 US-China Trade Conflict after 40 Years of Special Protection – published before the recent tariff increases, reviews the situation in detail. The author, Chad Brown, begins by looking at the tariff reductions since the late 1980’s. For the US, these tariffs had fallen from 5% to 3%, whilst for China they declined from 40% to 8% by 2017. Over the same period China’s share of US imports rose from near to zero in 1978 to 20% by 2014. By contrast, Chinese imports from the US rose steadily, reaching 10% in 2001 – which coincided with their ascension to the World Trade Organisation (WTO) – however, since then, imports from the US have declined, dipping to 8.5% by 2017. In bilateral terms Chinese imports from the US are about a quarter of her exports to the land of the free.

At first sight, it might seem as if the trade tensions between China and the US are new, but relations have been deteriorating since the bursting of the US Tech bubble in 2001, if not before. Looking at the chart below, which measures antidumping and countervailing tariffs, it appears as if the Chinese did not begin to retaliate until 2006: –

US China countervaling tariffs 1980 to 2018

Source: Peterson Institute

Analysing anti-dumping and countervailing tariffs in isolation, however, gives a misleading impression of the US response to China. Peterson research attempts to assess the entire scope of the Sino-US trade dispute, by incorporating all forms of US special protection against China over the entire period. The next chart shows the true scale of US tariff reduction on Chinese imports; seen in this light, the extent of the recent policy shift is even more dramatic: –

US special prtections against China

Source: Peterson Institute

Using this combined metric, US special protection peaked at 39% in 1986, after which these barriers declined rapidly reaching a nadir at 4.3% in 2005. On the eve of the trade war in 2017 barriers had risen to 8.1%. Prior to the May 10th tariff increase, that figure had jumped to 50%. An updated version of the Peterson chart of shown below: –

Sino-US Tariff update since May 1oth 2019

Source: Peterson Institute

The additional tariffs imposed this month will raise the average US tariff on Chinese goods to 18.3%. If Trump follows through with his threat to impose a 25% tariff on most of the rest of US imports from China, the average US tariff toward China would increase to 27.8%.

Sino-US Tariffs 2017 - 2019

Source: Peterson Institute

What is the likely impact of these actions on trade and prices? For the US, import prices will increase, but given that US inflation has tended to be below the Fed target, this is manageable; corporates and consumers will pay the cost of tariffs, the tax receipts will help to finance the cost of recent US tax cuts. In China, whilst the impact is still negative, as this recent article from CFR – China Never Stopped Managing its Trade makes clear, the majority of imports are made by state owned enterprises or by companies which have a government permit to import such goods, added to which Chinese inflation has also been reasonably subdued, despite impressive continued economic expansion: –

When the state controls the firms that are doing the importing, a few phone calls can have a big impact. That’s why China can shut down trade in canola with Canada without formally introducing any tariffs.

That’s why China can scale back its purchases of Australian coal without filing a “dumping” or “national security” tariffs case.

And that’s why—when the trade war with the United States started—U.S. exports in a number of goods simply went to zero (normally, a 25 percent tariff would reduce imports by more like 50 percent or something…]

For US companies the four largest exports to China are aircraft, automobiles, soybeans and oil and gas. Of these, only automobiles are sold directly to the private sector. Here are three charts which explain why, for the US (at least in the near-term) there may be less to lose in this global game of chicken: –

Auto Exports to China

Source: US Census Bureau, Haver Analytics

Soybean Exports to China

Source: US Census Bureau, Haver Analytics

Ooil and Gas Exports to China

Source: US Census Bureau, Haver Analytics

The decline in US imports has been driven by a combination of substitution for imports from other sources and a rising domestic capability to manufacture intermediate goods. Faced with a dwindling market for their exports, the US might be forgiven for wishing to retire from the fray whilst it still has the advantage of being the ‘consumer of last resort’.

To date, US government receipts from tariff increases have amounted to an estimated $2bln. A study by the World Bank and the International Finance Corporation, however, estimates the true cost the US economy has been nearer to $6.4bln or 0.03% of GDP. The chart below shows the already substantial divergence between prices for tariff versus non-tariff goods: –

tariffs-inflation

Source: Financial Sense, US Department of Labor, Commerce department, Goldman Sachs

The impact on China is more difficult to measure since Chinese statistics are difficult interpret, however, only 18% of Chinese exports are to the US – that equates to $446bln out of a total of $2.48trln in 2018, added to which, exports represent only 20% of Chinese GDP – all US imports amount to 3.6% of Chinese GDP.

The scale of the dispute (bilateral rather than multilateral) should not detract from its international significance. One institution which seen its credibility undermined by the imposition of US tariffs is the World Trade Organisation (WTO) – Chatham House – The Path Forward on WTO Reform provides an excellent primer to this knotty issue. Another concern, for economists, is that history is repeating itself. They fear Trump’s policies are a redux of the infamous Smoot-Hawley tariffs, imposed during the great depression. Peterson – Does Trump Want a Trade War? from March 2018 and Trump’s 2019 Protection Could Push China Back to Smoot-Hawley Tariff Levels published this month are instructive on this topic. These tariffs were implemented on 17th June 1930 and applied to hundreds of products. To put today’s dispute in perspective, the 1930’s tariff increase was only from 38% to 45% – a mere 18% increase – this month tariffs have increased from 10% to 25%: a 150% increase. Those who note that 25% is still well below 1930’s levels should not be complaisant, China remains a WTO member, were it not, US average tariffs would now be 38%. Back in 2016 President Trump talked of raising tariffs on Chinese imports to 45%, a number cunningly lifted from the Smoot-Hawley playbook.

One of the counter-intuitive effects of the 1930’s tariff increase was price deflation, in part due to many tariffs being imposed on a per unit cost basis. Today, per unit tariffs apply to only around 8% of goods, added to which, due to monetary engineering, by central banks, and the issuance of fiat currency by governments, the threat of real deflation is less likely.

Another risk is that the Sino-US spat engulfs other countries. The EU (especially Germany) has already suffered the ire of the US President. Recent trade deals between the EU and both Canada and Japan, have been heralded as a triumph for free-trade, however, they are an echo of the trading blocs which formed during the 1930’s. To judge by Trump’s recent tweets, for the moment, China has been singled out, on 13th May the President said: –

“Also, the Tariffs can be completely avoided if you buy from a non-Tariffed Country, or you buy the product inside the USA (the best idea). That’s Zero Tariffs. Many Tariffed companies will be leaving China for Vietnam and other such countries in Asia. That’s why China wants to make a deal so badly!”

Even if the trade dispute remains a Sino-US affair, there are other unseen costs to consider, on productivity and investment, Bruegal – Implications of the escalating China-US trade dispute takes up the discussion (emphasis mine): –

The direct aggregate effect of the tariffs on the welfare of the US and Chinese, while negative, is likely to be very small… because they represent a transfer from consumers, importers and partner exporters to the government… sooner or later, the American consumer will bear much of the cost of the tariff though higher prices, but also that tariff revenue will return to American residents in some form. The negative aggregate welfare effect of tariffs thus arises because, at the margin, they displace more efficient producers by less efficient ones… because, at the margin, tariffs artificially reduce the consumption or use of imports in favour of domestic goods or goods imported from third parties…

The distributional effect of tariffs is likely to be very uneven and severely negative on some people and sectors… while the Treasury will see increased revenue, and some producers who compete with imports will gain, small companies that depend on imported parts from China are likely to be very badly affected by tariffs…

Larger importers will also be adversely affected… US farmers who depend on Chinese markets have already been badly hurt by Chinese retaliation…

The biggest adverse effects of tariffs on aggregate economic activity is through investment. Lower investment is the natural result of the tariffs’ big distributional effects… and the uncertainty they engender. This effect on ‘animal spirits’ is difficult to model and impossible to quantify with precision… The extraordinary sensitivity of stock markets to trade news and their volatility is just one manifestation of this effect. The widening growth gap between the global manufacturing and services sectors evident in recent quarters is another, as is the slowdown in investment in many countries.

Bruegal go on to discuss the risk to the international trading system and the damage to the credibility of the WTO. Finally they suggest that the trade dispute is a kind of proxy-war between the two super-powers: this is much more than just a trade dispute.

Putting the Sino-US dispute in an historical context, a number of commentators have drawn comparisons between China today and Japan in the 1980’s. I believe the situation is quite different, as will be the outcome. Again, I defer to Bruegal – Will China’s trade war with the US end like that of Japan in the 1980s?  The author’s argue that Japan chose to challenge the US when it was close to its economic peak and its productivity was stagnating. China, by contrast, has a younger population, rapidly improving productivity and, most importantly, remains a significant way below its economic peak: –

…Because China is at an earlier stage of economic development, it is expected to challenge the US hegemony for an extended period of time. Therefore, the US-China trade war could last longer than the one with Japan. With China’s growth prospects still relatively solid –  it will soon overtake the US economy in size and it does not depend on the US militarily – China will likely challenge US pressure in the ongoing negotiations for a settlement to the trade war. This also means that any deal will only be temporary, as the US will not be able to contain China as easily as it contained Japan.

If you are looking for a more global explanation of the current dispute between the US and China, then this article from CFR – The Global Trading System: What Went Wrong and How to Fix It is instructive: –

As economist Richard Baldwin lays out in his book The Great Convergence, the Industrial Revolution of the 19th century had launched Europe, the US, Japan and Canada on a trajectory that would see their wealth surge ahead of the rest of the world. In 1820, for example, incomes in the US were about three times those of China; by 1914 Americans would be 10 times as wealthy as Chinese. Manufacturing clustered in the technologically advanced countries, while advances in containerized shipping and the lowering of tariffs through trade negotiations made it possible for these countries to specialize and trade in the classic Ricardian fashion.

The information technology revolution of the 1990s turned that story upside down. With the advent of cheap, virtually instant global communications via the Internet, it became possible – and then imperative for competitive success – for multinational companies to take their best technologies and relocate production in lower-wage countries. Manufacturing output rose in middle-income countries like China, India, Thailand, Poland and others, while falling sharply in the US, Japan, France, the UK and even Germany…

The global great convergence, however, coincided with a great divergence within the wealthy countries (and many developing countries as well). The new technologies and the disappearance of trade barriers upended the balance between labor and capital in the advanced industrialized countries, and contributed to soaring economic inequality…

In the US in 1979, an American with a college degree or higher earned about 50% more than one who had only a high school education or less. By 2018, American workers with a four-year college degree earned almost twice as much as those with just a high-school education, and were unemployed half as often, while those with a professional degree earned nearly three times as much.

The author goes on to liken today’s tension between the US and China with the situation which existed between the UK and US at the beginning of the 20th century: –

The world today again faces the same governance gap – a US that no longer has the economic muscle nor the political will to organize the global system, and a rising China that is reluctant to play a greater role.

CFR ask what the prospects maybe for renewed globalization? They identify three key elements which need to be addressed in order for de-globalisation to be reversed: a trade war truce (once both sides wake up to the extent of the empasse they have engineered), a filling the Leadership Vacuum (caused by both sides turning their backs on the WTO – they need to reengage and lead the world towards a solution) and, especially for the US, meeting the challenges at home (Trump cannot rely on a trade war in the long-run to solve the problem of inequality within the US).

Conclusions and investment opportunities

What is the likely impact on financial markets? To answer this question one needs to know whether the current trade war will escalate or dissipate: and if it escalates, will it be short and sharp or protracted and pernicious?

Alisdair Macleod of Gold Money – Post-tariff considerations identifies the following factors: –

The effect of the new tariff increases on trade volumes

The effect on US consumer prices

The effect on US production costs of tariffs on imported Chinese components

The consequences of retaliatory action on US exports to China

The recessionary impact of all the above on GDP

The consequences for the US budget deficit, allowing for likely tariff income to the US Treasury

Leading, in MacLeod’s opinion, to: –

Reassessment of business plans in the light of market information

A tendency for bank credit to contract as banks anticipate heightened lending risk

Liquidation of financial assets held by banks as collateral

Foreign liquidation of USD assets and deposits

The government’s borrowing requirement increasing unexpectedly

Bond yields rising to discount increasing price inflation

Banks facing increasing difficulties and the re-emergence of systemic risk

The author suggests that, all other things equal, tariffs should lead to price increases, but, with the US consumer already heavily burdened with debt, consumption demand will suffer.

I am less bearish than MacLeod because, if the Sino-US trade war threatens to puncture the decade long equity bull-market, we will see a combination of qualitative and quantitative easing from the largest central banks and aggressive fiscal stimulus from the governments of G20 and beyond. I wrote about this scenario (though without reference to the trade war) earlier this month in Macro Letter – No 114 – 10-05-2019 – Debasing the Baseless – Modern Monetary Theory. My, perhaps overly simple, prediction for assets in the longer-term is: bonds up, stocks up and real estate up.

In an alternative scenario, we might encounter asset price deflation and consumer price inflation occurring simultaneously. Worse still, this destructive combination of forces might coinciding with a global recession. The severity of any recession – and the inevitable correction to financial markets that such an economic downturn would precipitate – will depend entirely on the time it takes for US and Chinese trade negotiators to realise the danger and reach a compromise. I believe they will do so relatively quickly.

Attempting to predict what President Trump might do next is fraught with danger, but, due to the inherent weakness of the democratic process, I expect the US administration to concede. The US President has an election to win in November 2020; the President of China has been elected for life.

Debasing the Baseless – Modern Monetary Theory

Debasing the Baseless – Modern Monetary Theory

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Macro Letter – No 114 – 10-05-2019

Debasing the Baseless – Modern Monetary Theory

  • Populist politicians are turning to Modern Monetary Theory
  • Fiscal stimulus has not led to significant inflation during the last decade
  • MMT is too radical to be adopted in full but the allure of fiscal expansion is great
  • Asset markets will benefit over the medium-term

A recent post from the Peterson Institute – Further Thinking on the Costs and Benefits of Deficits – follows on from the Presidential Lecture given by Olivier Blanchard at the annual gathering of the American Economic Association (AEA) Public Debt and Low Interest Rates . The article discusses a number of issues which are linked to Blanchard’s speech: –

  1. Is the political system so biased towards deficit increases that economists have a responsibility to overemphasize the cost of deficits?

  2. Do the changing economics of deficits mean that anything goes and we do not need to pay attention to fiscal constraints, as some have inferred from modern monetary theory (MMT)?

  3. You advocate doing no harm, but is that enough to stabilize the debt at a reasonable level?

  4. Isn’t action on the deficit urgent in order to reduce the risk of a fiscal crisis?

  5. Do you think anything about fiscal policy is urgent?

Their answers are 1. Sometimes, although they question whether it is the role of economists to lean against the political wind. 2. No, which is a relief to those of a more puritanical disposition towards debt. The authors’ argument, however, omits any discussion of the function of interest rates in an unfettered market, to act as a signal about the merit of an investment. When interest rates are manipulated, malinvestment flourishes. They propose: –

…that the political system should adopt a “do no harm” approach, paying for new proposals but not necessarily making it an urgent priority to do any more than that. Adopting this principle would have the benefit of requiring policymakers to think harder about whether to adopt the next seemingly popular tax credit or spending program. Many ideas that seem appealing judged against an unspecified future cost are less appealing when you make their costs explicit today.

  1. Yes. At this point the authors’ make the case for addressing the shortfalls in the social security and health budgets. They make the admirable suggestion that better provision is not only necessary but desirable, however, to achieve their goal they warn more will need to be contributed by individuals. Sadly, I expect politicians to cherry pick from the Modern Monetary Theory (MMT) menu, they will not champion the case for higher individual contributions. 4. No. Here I am in begrudging agreement with their conclusion, although I worry about their projections. Fiat currencies and artificially low interest rates underpin the current political system. It is hardly surprising that developed country government activity, as a share of GDP, has risen. 5. Yes. Again, I agree with the need to think about fiscal policy, though I anticipate that Peterson’s proposals are likely to exacerbate the current problems further.

A prelude to MMT

The reason for highlighting recent Peterson commentary is because it represents the acceptable face of a more dubious set of proposals, known collectively as MMT. These ideas are not particularly modern, beginning with the Chartalist tenet that countries which issue their own fiat currencies can never “run out of money.” For a measured introduction to this topic, Dylan Matthews has published a brilliant essay for Vox – Modern Monetary Theory, explained. Here are some of the highlights: –

[The starting point is]…endogenous money theory, that rejects the idea that there’s a supply of loanable funds out there that private businesses and governments compete over. Instead, they believe that loans by banks themselves create money in accordance with market demands for money, meaning there isn’t a firm trade-off between loaning to governments and loaning to businesses of a kind that forces interest rates to rise when governments borrow too much.

MMTers go beyond endogenous money theory, however, and argue that government should never have to default so long as it’s sovereign in its currency: that is, so long as it issues and controls the kind of money it taxes and spends. The US government, for instance, can’t go bankrupt because that would mean it ran out of dollars to pay creditors; but it can’t run out of dollars, because it is the only agency allowed to create dollars. It would be like a bowling alley running out of points to give players.

A consequence of this view, and of MMTers’ understanding of how the mechanics of government taxing and spending work, is that taxes and bonds do not and indeed cannot directly pay for spending. Instead, the government creates money whenever it spends…

And why does the government issue bonds? According to MMT, government-issued bonds aren’t strictly necessary. The US government could, instead of issuing $1 in Treasury bonds for every $1 in deficit spending, just create the money directly without issuing bonds.

The Mitchell/Wray/Watts MMT textbook argues that the purpose of these bond issuances is to prevent interest rates in the private economy from falling too low. When the government spends, they argue, that adds more money to private bank accounts and increases the amount of “reserves” (cash the bank has stocked away, not lent out) in the banking system. The reserves earn a very low interest rate, pushing down interest rates overall. If the Fed wants higher interest rates, it will sell Treasury bonds to banks. Those Treasury bonds earn higher interest than the reserves, pushing overall interest rates higher…

“In the long term,” they conclude, “the only sustainable position is for the private domestic sector to be in surplus.” As long as the US runs a current account deficit with other countries, that means the government budget has to be in deficit. It isn’t “crowding out” investment in the private sector, but enabling it.

The second (and more profound) aspect of MMT is that it proposes to reverse the roles of fiscal and monetary policy. Taxation is used to control aggregate demand (and thus inflation) whilst government spending (printing money) is used to prevent deflation and to stimulate consumption and employment. Since MMT advocates believe there is no need for bond issuance and that interest rates should reside, permanently, at zero, monetary policy can be controlled entirely by the treasury, making central banks superfluous.

At the heart of MMT is an accounting tautology, that: –

G − T = S – I

Where G = Government spending, T = Taxation, S = Savings and I = Investment

In other words…

Government Budget Deficit = Net Private Saving

wraybook

You may be getting the feeling that something does not quite tally. Robert Murphy of the Mises Institute – The Upside-Down World of MMT explains it like this (the emphasis is mine): –

When I first encountered such a claim — that the government budget deficit was necessary to allow for even the mathematical possibility of net private-sector saving — I knew something was fishy. For example, in my introductory textbook I devote Chapter 4 to “Robinson Crusoe” economics.

To explain the importance of saving and investment in a barter economy, I walk through a simple numerical example where Crusoe can gather ten coconuts per day with his bare hands. This is his “real income.” But to get ahead in life, Crusoe needs to save — to live below his means. Thus, for 25 days in a row, Crusoe gathers his ten coconuts per day as usual, but only eats eight of them. This allows him to accumulate a stockpile of 50 coconuts, which can serve as a ten-day buffer (on half-rations) should Crusoe become sick or injured.

Crusoe can do even better. He takes two days off from climbing trees and gathering coconuts (with his bare hands), in order to collect sticks and vines. Then he uses these natural resources to create a long pole that will greatly augment his labor in the future in terms of coconuts gathered per hour. This investment in the capital good was only possible because of Crusoe’s prior saving; he wouldn’t have been able to last two days without eating had he not been able to draw down on his stockpile of 50 coconuts.

This is an admittedly simple story, but it gets across the basic concepts of income, consumption, saving, investment, and economic growth. Now in this tale, I never had to posit a government running a budget deficit to make the story “work.” Crusoe is able to truly live below his means — to consume less than his income — and thereby channel resources into the production of more capital goods. This augments his future productivity, leading to a higher income (and hence consumption) in the future. There is no trick here, and Crusoe’s saving is indeed “net” in the sense that it is not counterbalanced by a consumption loan taken out by his neighbor Friday…

When MMTers speak of “net saving,” they don’t mean that people collectively save more than people collectively borrow. No, they mean people collectively save more than people collectively invest.

MMT goes on to solve the problem of achieving full employment by introducing a job guarantee and wage controls.

If, by this stage, you feel the need for an antidote to MMT, look no further than, Forty Centuries of Wage and Price Controls: How Not to Fight Inflation by Dr Eamon Butler of the ASI. Published in 1978, it documents the success of these types of policy during the past four thousand years.

Conclusion and Investment Opportunities

The radical ideas contained in MMT are unlikely to be adopted in full, but the idea that fiscal expansion is non-inflationary provides succour to profligate politicians of all stripes. Come the next hint of recession, central banks will embark on even more pronounced quantitative and qualitative easing, safe in the knowledge that, should they fail to reignite their economies, government mandated fiscal expansion will come to their aid. Long-term bond yields will head towards the zero-bound – some are there already. Debt to GDP ratios will no longer trouble finance ministers. If stocks decline, central banks will acquire them: and, in the process, the means of production. This will be justified as the provision of permanent capital. Bonds will rise, stocks will rise, real estate will rise. There will be no inflation, except in the price of assets.

John Mauldin describes the end-game of the debt-explosion as the Great Reset, but if government borrowing costs are zero (or lower) the Great Reset can be postponed, but the economy will suffer from low productivity growth due to malinvestment.

Global Real Estate – Has the tide begun to recede?

Global Real Estate – Has the tide begun to recede?

In the Long Run - small colour logo

Macro Letter – No 113 – 19-04-2019

Global Real Estate – Has the tide begun to recede?

  • Despite the fourth quarter shakeout in stocks, real estate values keep rising
  • Financial conditions remain key, especially in a low rate environment
  • Isolated instances of weakness have yet to breed contagion
  • The reversal of central bank tightening has averted a more widespread correction

I last wrote about the prospects for global real estate back in February 2018 in Macro Letter – No 90 – A warning knell from the housing market – inciting a riot? I concluded: –

The residential real estate market often reacts to a fall in the stock market with a lag. As commentators put it, ‘Main Street plays catch up with Wall Street.’ The Central Bank experiment with QE, however, makes housing more susceptible to, even, a small rise in interest rates. The price of Australian residential real estate is weakening but its commodity rich cousin, Canada, saw major cities price increases of 9.69% y/y in Q3 2017. The US market also remains buoyant, the S&P/Case-Shiller seasonally-adjusted national home price index rose by 3.83% over the same period: no sign of a Federal Reserve policy mistake so far.

As I said at the beginning of this article, all property investment is ‘local’, nonetheless, Australia, which has not suffered a recession for 26 years, might be a leading indicator. Contagion might seem unlikely, but it could incite a riot of risk-off sentiment to ripple around the globe.

More than a year later, central bank interest rates seem to have peaked (if indeed they increased at all) bond yields in most developed countries are falling again and, another round of QE is hotly anticipated, at the first hint of a global, or even regional, slowdown in growth.

In the midst of this sea-change from tightening to easing, an article from the IMF – Assessing the Risk of the Next Housing Bust – appeared earlier this month, in which the authors remind us that housing construction and related spending account for one sixth of US and European GDP. A boom and subsequent bust in house prices has been responsible for two thirds of recessions during the past few decades, nonetheless, they find that: –

…in most advanced economies in our sample, weighted by GDP, the odds of a big drop in inflation-adjusted house prices were lower at the end of 2017 than 10 years earlier but remained above the historical average. In emerging markets, by contrast, riskiness was higher in 2017 than on the eve of the global financial crisis. Nonetheless, downside risks to house prices remain elevated in more than 25 percent of these advanced economies and reached nearly 40 percent in emerging markets in our study.

The authors see a particular risk emanating from China’s Eastern provinces but overall they expect conditions to remain reasonably benign in the short-term. The January 2019 IMF – Global Housing Watch – presents the situation as at Q2 and Q3 2018: –

housepricesaroundtheworld IMF, BIS, ECB,Federal Reserve, Savills, Sinyl Real Estate

Source: IMF, BIS, Federal Reserve, ECB, Savills, Sinyl, National Data

Hong Kong continues to boom and Ireland to rebound.

They go on to analyse real credit growth: –

creditgrowth IMF, Haver Analytics

Source: IMF, Haver Analytics

Interestingly, for several European countries (including Ireland) credit conditions have been tightening, whilst Hong Kong’s price rises seem to be underpinned by credit growth.

Then the IMF compare house prices to average income: –

pricetoincome IMF, OECD

Source: IMF, OECD

Canada comes to the fore-front but Ireland is close second with New Zealand and Portugal not far behind.

Finally the authors assess House price/Rent ratios: –

pricetorent IMF, OECD

Source: IMF, OECD

Both Canada, Portugal and New Zealand are prominent as is Ireland.

This one year snap-shot disguises some lower term trends. The following chart from the September 2018 – UBS Global Real Estate Bubble Index puts the housing market into long-run perspective.

ubs-bubbles-index

Source: UBS

UBS go on to rank most expensive cities for residential real estate, pointing out that top end housing prices declined in half of the list:-

real-estate-bubbles list UBS

Source: UBS

Over the 12 months to September 2018 UBS note that house prices declined in Milan, Toronto, Zurich, New York, Geneva, London, Sydney and Stockholm. The chart below shows the one year change (light grey bar) and the five year change (dark grey line): –

housing-bubbles-growth-rates 1yr - 5yr change UBS

Source: UBS

Is a global correction coming or is property, as always, local? The answer? Local, but with several local markets still at risk.

The US market is generally robust. According to Peter Coy of Bloomberg – America Isn’t Building Enough New Housing – the effect of the housing collapse during the financial crisis still lingers, added to which zoning rules are exacerbating an already small pool of construction-ready lots. Non-credit factors are also corroborated by a recent Fannie Mae survey of housing lenders which found only 1% blaming tight credit, whilst 48% pointed to lack of supply.

North of the border, in Canada, the outlook has become less favourable, partly due to official intervention which began in 2017. Since 2012, house price increases in Toronto accelerated away from other cities, Vancouver followed with a late rush after 2015 and price increases only stalled in the last year.

In their February 2019 report Moody Analytics – 2019 Canada Housing Market Outlook: Slower, Steadier – identify the risks as follows: –

Interventions by the BoC, OSFI, and the British Columbia and Ontario governments were by no means a capricious attempt to deflate a house price bubble for the mere sake of deflation. Financial and macroeconomic aggregates point to the possibility that the mortgage credit needed to sustain house price appreciation may be unsustainable. Since 2002, the ratio of mortgage debt service payments to disposable income has gone from a historical low point of little more than 5% in 2003 to almost 6.6% by the end of last year…

The authors go on to highlight the danger of the overall debt burden, should interest rates rise, or should the Canadian economy slow, as it is expected to do next year. They expect the ratio of household interest payments to disposable income to rise and the percentage of mortgage arrears to follow a similar trajectory. In reality the rate of arrears is still forecast to reach only 0.3%, significantly below its historical average.

External factors could create the conditions for a protracted slump in Canadian real estate. Moody’s point to a Chinese real estate crash, a no-deal Brexit, renewed austerity in Europe and a continuation of the US/China trade dispute as potential catalysts. In this scenario 4% of mortgages would be in arrears. For the present, however, Canadian housing prices remain robust.

Switching to China, the CBRE – Greater China Real Estate Market Outlook 2019 – paints a mixed picture of commercial real estate in the year ahead: –

Office: U.S.–China trade conflict and the ensuing economic uncertainty are set to dent office demand in mainland China and Hong Kong. Leasing momentum in Taiwan will be less affected. Office rents will likely soften in oversupplied and trade and manufacturing-driven cities in 2019.

Retail: The amalgamation of online and offline will continue to drive the evolution of retail demand on the mainland. Retailers in Hong Kong and Taiwan will adopt a conservative approach towards expansion due to the diminishing wealth effect. Retail rents are projected to stay flat or grow slightly in most markets across Greater China.

Logistics: Tight land and warehouse supply will translate into steady logistics rental growth in the Greater Bay Area, Yangtze River Delta and Pan-Beijing area. Risks include potential weaker leasing demand stemming from the U.S.-China trade conflict and the gradual migration to self-built warehouses by major e-commerce companies.

The Chinese housing market, by contrast, has suffered from speculative over-supply. Estimates last year suggested that 22% of homes, amounting to around 50 million dwellings, are unoccupied. Government intervention has been evident for several years in an attempt to moderate price fluctuations. Earlier this month the National Development and Reform Commission (NDRC) said it aims to increase China’s urbanization rate by at least 1% with the aim of tackling the surfeit of supply. This is part of a longer-term goal to bring 100 million people into the cities over the five years to 2020. As of last year, 59.6% of China’s population lived in urban areas. According to World Bank data high middle income countries average 65% rising to 82% for high income countries. For China to reach the average high middle income average, another 70mln people need to move from rural to urban regions.

The new NDRC strategy will include the scrapping of restrictions on household registration permits for non-residents in cities of one to three million. For cities of three to five million, restrictions will be “comprehensively relaxed,” although the NDRC did not specify the particulars. Banks will be incentivised to provide credit and the agency also stated that it will support the establishing of real estate investment trusts (REITs) in order to promote a deepening of the residential rental market.

The NDRC action might seem unnecessary, average prices of new homes in the 70 largest Chinese cities rose 10.4% in February, up from 10.0% the previous month. This is the 46th straight monthly price increase and the strongest annual gain since May 2017. Critics point to cheap credit as the principal driver of this trend, they highlight the danger to domestic prices should the government decide to constrain credit growth. The key to maintaining prices is to open the market to foreign capital, this month’s NDRC policy announcement is a gradual step in that direction. It is estimated that at least $50bln of foreign capital will flow China over the next five years.

Despite the booming residential property market, the Chinese government has been tightening credit conditions and cracking down on illegal financial outflows. This has had impacted Australia in particular, investment fell more than 36% to $.8.2bln last year, down from $13bln in 2017. Mining investment fell 90%, while commercial real estate investment declined by 32%, to $3bln from $4.4bln the previous year. Investment in the US and Canada fell even more, declining by 83% and 47% respectively. Globally, however, Chinese investment has continued to grow, rising 4.2%.

Australian residential housing prices, especially in the major cities, have suffered from this downdraft. According to a report, released earlier this month by Core Logic – Falling Property Values Drags Household Wealth Lower – the decline in prices, the worst in more than two decades, is beginning to bite: –

According to the ABS (Australian Bureau of Statistics), total household assets were recorded at a value of $12.6 trillion at the end of 2018. Total household assets have fallen in value over both the September and December 2018 quarters taking household wealth -1.6% lower relative to June 2018. While the value of household assets have fallen by -1.6% over the past two quarters, liabilities have increased by 1.5% over the same period to reach $2.4 trillion. As a result of falling assets and rising liabilities, household net worth was recorded at $10.2 trillion, the lowest it has been since September 2017…

As at December 2018, household debt was 189.6% of disposable income, a record high and up from 188.7% the previous quarter. Housing debt was also a record high 140.2% of disposable income and had risen from 139.5% the previous quarter.

In 2018 the Australian Residential Property Price Index fell 5.1%, worst hit was Sydney, down 7.8% followed by Melbourne, off 6.4%, Darwin, down 3.5% and Perth, which has been in decline since 2015, which shed a further 2.5%. The ABS cited tightening credit conditions and reduced demand from investors and owner occupiers.

According to many commentators, Australian property has been ready to crash since the bursting of the tech bubble but, as this chart shows, prices are rich but not excessive: –

AMP Capital - Australian housing since 1926

Source: AMP Capital

Conclusions and Investment Opportunities

The entire second chapter of the IMF – Global Financial Stability Report – published on 10th April, focusses on housing: –

Large house price declines can adversely affect macroeconomic performance and financial stability, as seen during the global financial crisis of 2008 and other historical episodes. These macro-financial links arise from the many roles housing plays for households, small firms, and financial intermediaries, as a consumption good, long-term investment, store of wealth, and collateral for lending, among others. In this context, the rapid increase in house prices in many countries in recent years has raised some concerns about the possibility of a decline and its potential consequences…

Capital inflows seem to be associated with higher house prices in the short term and more downside risks to house prices in the medium term in advanced economies, which might justify capital flow management measures under some conditions. The aggregate analysis finds that a surge in capital inflows tends to increase downside risks to house prices in advanced economies, but the effects depend on the types of flows and may also be region- or city-specific. At the city level, case studies for Canada, China, and the United States find that flows of foreign direct investment are generally associated with lower future risks, whereas other capital inflows (largely corresponding to banking flows) or portfolio flows amplify downside risks to house prices in several cities or regions. Altogether, when nonresident buyers are a key risk for house prices, contributing to a systemic overvaluation that may subsequently result in higher downside risk, capital flow measures might help when other policy options are limited or timing is crucial. As in the case of macroprudential policies, these measures would not amount to targeting house prices but, instead, would be consistent with a risk management approach to policy. In any case, these conditions need to be assessed on a case-by-case basis, and any reduction in downside risks must be weighed against the direct and indirect benefits of free and unrestricted capital flows, including better smoothing of consumption, diversification of financial risks, and the development of the financial sector.

Aside from some corrections in certain cities (notably Vancouver, Toronto, Sydney and Melboune) prices continue to rise in most regions of the world, spurred on by historically low interest rates and generally benign credit conditions. As I said in last month’s Macro Letter – China in transition – From manufacturer to consumer – China will need to open its borders to foreign investment as its current account switches from surplus to deficit. Foreign capital will flow into Chinese property and, when domestic savings are permitted to exit the country, Chinese capital will support real estate elsewhere. The greatest macroeconomic risk to global housing markets stems from a tightening of financial conditions. Central banks appear determined to lean against the headwinds of a recession. In the long run they may fail but in the near-term the global housing market still looks unlikely to implode.

Capital Flows – is a reckoning nigh?

Capital Flows – is a reckoning nigh?

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Macro Letter – No 111 – 15-03-2019

Capital Flows – is a reckoning nigh?

  • Borrowing in Euros continues to rise even as the rate of US borrowing slows
  • The BIS has identified an Expansionary Lower Bound for interest rates
  • Developed economies might not be immune to the ELB
  • Demographic deflation will thwart growth for decades to come

In Macro Letter – No 108 – 18-01-2019 – A world of debt – where are the risks? I looked at the increase in debt globally, however, there has been another trend, since 2009, which is worth investigating as we consider from whence the greatest risk to global growth may hail. The BIS global liquidity indicators at end-September 2018 – released at the end of January, provides an insight: –

The annual growth rate of US dollar credit to non-bank borrowers outside the United States slowed down to 3%, compared with its most recent peak of 7% at end-2017. The outstanding stock stood at $11.5 trillion.

In contrast, euro-denominated credit to non-bank borrowers outside the euro area rose by 9% year on year, taking the outstanding stock to €3.2 trillion (equivalent to $3.7 trillion). Euro-denominated credit to non-bank borrowers located in emerging market and developing economies (EMDEs) grew even more strongly, up by 13%.

The chart below shows the slowing rate of US$ credit growth, while euro credit accelerates: –

gli1901_graph1

Source: BIS global liquidity indicators

The rising demand for Euro denominated borrowing has been in train since the end of the Great Financial Recession in 2009. Lower interest rates in the Eurozone have been a part of this process; a tendency for the Japanese Yen to rise in times of economic and geopolitical concern has no doubt helped European lenders to gain market share. This trend, however, remains over-shadowed by the sheer size of the US credit markets. The US$ has remained preeminent due to structurally higher interest rates and bond yields than Europe or Japan: investors, rather than borrowers, dictate capital flows.

The EC – Analysis of developments in EU capital flows in the global context from November 2018 concurs: –

The euro area (excluding intra-euro area flows) has been since 2013 the world’s leading net exporter of capital. Capital from the euro area has been invested heavily abroad in debt securities, especially in the US, taking advantage of the interest differential between the two jurisdictions. At the same time, foreign holdings of euro-area bonds fell as a result of the European Central Bank’s Asset Purchase Programme.

This bring us to another issue; a country’s ability to service its debt is linked to its GDP growth rate. Since 2009 the US economy has expanded by 34%, over the same period, Europe has shrunk by 2%. Putting these rates of expansion into a global perspective, the last decade has seen China’s economy grow by 139%, whilst India has gained 96%. Recent analysis suggests that Chinese growth may have been overstated by 2% per annum over the past decade, but the pace is still far in excess of developed economy rates. Concern about Chinese debt is not unwarranted, but with GDP rising by 6% per annum, its economy will be 80% larger in a decade, whilst India’s, growing at 7%, will have doubled.

Another excellent research paper from the BIS – The expansionary lower bound: contractionary monetary easing and the trilemma – investigates the problem of monetary tightening of developed economies on emerging markets. Here is part of the introduction, the emphasis is mine: –

…policy makers in EMs are often reluctant to lower interest rates during an economic downturn because they fear that, by spurring capital outflows, monetary easing may end up weakening, rather than boosting, aggregate demand.

An empirical analysis of the determinants of policy rates in EMs provides suggestive evidence about the tensions faced by monetary authorities, even in countries with flexible exchange rates.

…The results reveal that, even after controlling for expected inflation and the output gap, monetary authorities in EMs tend to hike policy rates when the VIX or US policy rates increase. This is arguably driven by the desire to limit capital outflows and the depreciation of the exchange rate.

…our theory predicts the existence of an “Expansionary Lower Bound” (ELB) which is an interest rate threshold below which monetary easing becomes contractionary. The ELB constrains the ability of monetary policy to stimulate aggregate demand, placing an upper bound on the level of output achievable through monetary stimulus.

The ELB can occur at positive interest rates and is therefore a potentially tighter constraint for monetary policy than the Zero Lower Bound (ZLB). Furthermore, global monetary and financial conditions affect the ELB and thus the ability of central banks to support the economy through monetary accommodation. A tightening in global monetary and financial conditions leads to an increase in the ELB which in turn can force domestic monetary authorities to increase policy rates in line with the empirical evidence presented…

The BIS research is focussed on emerging economies, but aspects of the ELB are evident elsewhere. The limits of monetary policy are clearly observable in Japan: the Eurozone may be entering a similar twilight zone.

The difference between emerging and developed economies response to a tightening in global monetary conditions is seen in capital flows and exchange rates. Whilst emerging market currencies tend to fall, prompting their central banks to tighten monetary conditions in defence, in developed economies the flow of returning capital from emerging market investments may actually lead to a strengthening of the exchange rate. The persistent strength of the Japanese Yen, despite moribund economic growth over the past two decades, is an example of this phenomenon.

Part of the driving force behind developed market currency strength in response to a tightening of global monetary conditions is demographic, a younger working age population borrows more, an ageing populous borrows less.

At the risk of oversimplification, lower bond yields in developing (and even developed) economies accelerate the process of capital repatriation. Japanese pensioners can hardly rely on JGBs to deliver their retirement income when yields are at the zero bound, they must accept higher risk to achieve a living income, but this makes them more likely to drawdown on investments made elsewhere when uncertainty rises. A 2% rise in US interest rates only helps the eponymous Mrs Watanabe if the Yen appreciates by less than 2% in times of stress. Japan’s pensioners face a dilemma, a fall in US rates, in response to weaker global growth, also creates an income shortfall; capital is still repatriated, simply with less vehemence than during an emerging market crisis. As I said, this is an oversimplification of a vastly more complex system, but the importance of capital flows, in a more polarised ‘risk-on, risk-off’ world, is not to be underestimated.

Returning to the BIS working paper, the authors conclude: –

The models highlight a novel inter-temporal trade-off for monetary policy since the level of the ELB is affected by the past monetary stance. Tighter ex-ante monetary conditions tend to lower the ELB and thus create more monetary space to offset possible shocks. This observation has important normative implications since it calls for keeping a somewhat tighter monetary stance when global conditions are supportive to lower the ELB in the future.

Finally, the models have rich implications for the use of alternative policy tools that can be deployed to overcome the ELB and restore monetary transmission. In particular, the presence of the ELB calls for an active use of the central bank’s balance sheet, for example through quantitative easing and foreign exchange intervention. Furthermore, the ELB provides a new rationale for capital controls and macro-prudential policies, as they can be successfully used to relax the tensions between domestic collateral constraints and capital flows. Fiscal policy can also help to overcome the ELB, while forward guidance is ineffective since the ELB increases with the expectation of looser future monetary conditions.

Conclusions and investment opportunities

The concept of the ELB is new, the focus of the BIS working paper is on its impact on emerging markets. I believe the same forces are evident in developed economies too, but the capital flows are reversed. For investors, the greatest risk of emerging market investment is posed by currency, however, each devaluation by an emerging economy inexorably weakens the position of developed economies, since the devaluation makes that country’s exports immediately more competitive.

At present the demographic forces favour repatriation during times of crisis and repatriation, at a slower rate, during times of EM currency appreciation. This is because the ageing economies of the developed world continue to drawdown on their investments. At some point this demographic effect will reverse, however, for Japan and the Eurozone this will not be before 2100. For more on the demographic deficit the 2018 Ageing Report: Europe’s population is getting older – is worth reviewing. Until demographic trends reverse, international demand to borrow in US$, Euros and Yen will remain popular. Emerging market countries will pay the occasional price for borrowing cheaply, in the form of currency depreciations.

For Europe and Japan a reckoning may be nigh, but it seems more likely that their economic importance will gradually diminish as emerging economies, with a younger working age population and higher structural growth rates, eclipse them.

Central bank balance sheet reductions – will anyone follow the Fed?

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Macro Letter – No 110 – 15-02-2019

Central bank balance sheet reductions – will anyone follow the Fed?

  • The next wave of QE will be different, credit spreads will be controlled
  • The Federal Reserve may continue to tighten but few other CB’s can follow
  • ECB balance sheet reduction might occur if a crisis does not arrive first
  • Interest rates are likely to remain structurally lower than before 2008

The Federal Reserve’s response to the great financial recession of 2008/2009 was swift by comparison with that of the ECB; the BoJ was reticent, too, due to its already extended balance sheet. Now that the other developed economy central banks have fallen into line, the question which dominates markets is, will other central banks have room to reverse QE?

Last month saw the publication of a working paper from the BIS – Risk endogeneity at the lender/investor-of-last-resort – in which the authors investigate the effect of ECB liquidity provision, during the Euro crisis of 2010/2012. They also speculate about the challenge balance sheet reduction poses to systemic risk. Here is an extract from the non-technical summary (the emphasis is mine): –

The Eurosystem’s actions as a large-scale lender- and investor-of-last-resort during the euro area sovereign debt crisis had a first-order impact on the size, composition, and, ultimately, the credit riskiness of its balance sheet. At the time, its policies raised concerns about the central bank taking excessive risks. Particular concern emerged about the materialization of credit risk and its effect on the central bank’s reputation, credibility, independence, and ultimately its ability to steer inflation towards its target of close to but below 2% over the medium term.

Against this background, we ask: Can central bank liquidity provision or asset purchases during a liquidity crisis reduce risk in net terms? This could happen if risk taking in one part of the balance sheet (e.g., more asset purchases) de-risks other balance sheet positions (e.g., the collateralized lending portfolio) by a commensurate or even larger amount. How economically important can such risk spillovers be across policy operations? Were the Eurosystem’s financial buffers at all times sufficiently high to match its portfolio tail risks? Finally, did past operations differ in terms of impact per unit of risk?…

We focus on three main findings. First, we find that (Lender of last resort) LOLR- and (Investor of last resort) IOLR-implied credit risks are usually negatively related in our sample. Taking risk in one part of the central bank’s balance sheet (e.g., the announcement of asset purchases within the Securities Market Programme – SMP) tended to de-risk other positions (e.g., collateralized lending from previous longer-term refinancing operations LTROs). Vice versa, the allotment of two large-scale (very long-term refinancing operations) VLTRO credit operations each decreased the one-year-ahead expected shortfall of the SMP asset portfolio. This negative relationship implies that central bank risks can be nonlinear in exposures. In bad times, increasing size increases risk less than proportionally. Conversely, reducing balance sheet size may not reduce total risk by as much as one would expect by linear scaling. Arguably, the documented risk spillovers call for a measured approach towards reducing balance sheet size after a financial crisis.

Second, some unconventional policy operations did not add risk to the Eurosystem’s balance sheet in net terms. For example, we find that the initial OMT announcement de-risked the Eurosystem’s balance sheet by e41.4 bn in 99% expected shortfall (ES). As another example, we estimate that the allotment of the first VLTRO increased the overall 99% ES, but only marginally so, by e0.8 bn. Total expected loss decreased, by e1.4 bn. We conclude that, in extreme situations, a central bank can de-risk its balance sheet by doing more, in line with Bagehot’s well-known assertion that occasionally “only the brave plan is the safe plan.” Such risk reductions are not guaranteed, however, and counterexamples exist when risk reductions did not occur.

Third, our risk estimates allow us to study past unconventional monetary policies in terms of their ex-post ‘risk efficiency’. Risk efficiency is the notion that a certain amount of expected policy impact should be achieved with a minimum level of additional balance sheet risk. We find that the ECB’s Outright Monetary Transactions – OMT program was particularly risk efficient ex-post since its announcement shifted long-term inflation expectations from deflationary tendencies toward the ECB’s target of close to but below two percent, decreased sovereign benchmark bond yields for stressed euro area countries, while lowering the risk inherent in the central bank’s balance sheet. The first allotment of VLTRO funds appears to have been somewhat more risk-efficient than the second allotment. The SMP, despite its benefits documented elsewhere, does not appear to have been a particularly risk-efficient policy measure.

This BIS research is an important assessment of the effectiveness of ECB QE. Among other things, the authors find that the ‘shock and awe’ effectiveness of the first ‘quantitative treatment’ soon diminished. Liquidity is the methadone of the market, for QE to work in future, a larger and more targeted dose of monetary alchemy will be required.

The paper provides several interesting findings, for example, the Federal Reserve ‘taper-tantrum’ of 2013 and the Swiss National Bank decision to unpeg the Swiss Franc in 2015, did not appear to influence markets inside the Eurozone, once ECB president, Mario Draghi, had made its intensions plain. Nonetheless, the BIS conclude that (emphasis, once again, is mine): –

…collateralized credit operations imply substantially less credit risks (by at least one order of magnitude in our crisis sample) than outright sovereign bond holdings per e1 bn of liquidity owing to a double recourse in the collateralized lending case. Implementing monetary policy via credit operations rather than asset holdings, whenever possible, therefore appears preferable from a risk efficiency perspective. Second, expanding the set of eligible assets during a liquidity crisis could help mitigate the procyclicality inherent in some central bank’s risk protection frameworks.

In other words, rather than exacerbate the widening of credit spreads by purchasing sovereign debt, it is preferable for central banks to lean against the ‘flight to quality’ tendency of market participants during times of stress.

The authors go on to look at recent literature on the stress-testing of central bank balance sheets, mainly focussing on analysis of the US Federal Reserve. Then they review ‘market-risk’ methods as a solution to the ‘credit-risk’ problem, employing non-Gaussian methods – a prescient approach after the unforeseen events of 2008.

Bagehot thou shouldst be living at this hour (with apologies to Wordsworth)

The BIS authors refer on several occasions to Bagehot. I wonder what he would make of the current state of central banking? Please indulge me in this aside.

Walter Bagehot (1826 to 1877) was appointed by Richard Cobden as the first editor of the Economist. He is also the author of perhaps the best known book on the function of the 19th century money markets, Lombard Street (published in 1873). He is famed for inventing the dictum that a central bank should ‘lend freely, at a penalty rate, against good collateral.’ In fact he never actually uttered these words, they have been implied. Even the concept of a ‘lender of last resort’, to which he refers, was not coined by him, it was first described by Henry Thornton in his 1802 treatise – An Enquiry into the Nature and Effects of the Paper Credit of Great Britain.

To understand what Bagehot was really saying in Lombard Street, this essay by Peter Conti-Brown – Misreading Walter Bagehot: What Lombard Street Really Means for Central Banking – provides an elegant insight: –

Lombard Street was not his effort to argue what the Bank of England should do during liquidity crises, as almost all people assume; it was an argument about what the Bank of England should openly acknowledge that it had already done.

Bagehot was a classical liberal, an advocate of the gold standard; I doubt he would approve of the nature of central banks today. He would, I believe, have thrown his lot in with the likes of George Selgin and other proponents of Free Banking.

Conclusion and Investment Opportunities

Given the weakness of European economies it seems unlikely that the ECB will be able to follow the lead of the Federal Reserve and raise interest rates in any meaningful way. The unwinding of, at least a portion of, QE might be easier, since many of these refinancing operations will naturally mature. For arguments both for and against CB balance sheet reduction this paper by Charles Goodhart – A Central Bank’s optimal balance sheet size? is well worth reviewing. A picture, however, is worth a thousand words, although I think the expected balance sheet reduction may be overly optimistic: –

http___com.ft.imagepublish.upp-prod-eu.s3.amazonaws

Source: IMF, Haver Analytics, Fulcrum Asset Management

Come the next crisis, I expect the ECB to broaden the range of eligible securities and instruments that it is prepared to purchase. The ‘Draghi Put’ will gain greater credence as it encompasses a wider array of credits. The ‘Flight to Quality’ effect, driven by swathes of investors forsaking equities and corporate bonds, in favour of ‘risk-free’ government securities, will be shorter-lived and less extreme. The ‘Convergence Trade’ between the yields of European government bonds will regain pre-eminence; I can conceive the 10yr BTP/Bund spread testing zero.

None of this race to zero will happen in a straight line, but it is important not to lose sight of the combined power of qualitative and quantitative easing. The eventual ‘socialisation’ of common stock is already taking place in Japan. Make no mistake, it is already being contemplated by a central bank near you, right now.