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: –


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.

A world of debt – where are the risks?

A world of debt – where are the risks?

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Macro Letter – No 108 – 18-01-2019

A world of debt – where are the risks?

  • Private debt has been the main source of rising debt to GDP ratios since 2008
  • Advanced economies have led the trend
  • Emerging market debt increases have been dominated by China
  • Credit spreads are a key indicator to watch in 2019

Since the financial crisis of 2008/2009 global debt has increased to reach a new all-time high. This trend has been documented before in articles such as the 2014 paper from the International Center for Monetary and Banking Studies – Deleveraging? What deleveraging? The IMF have also been built a global picture of the combined impact of private and public debt. In a recent publication – New Data on Global Debt – IMF – the authors make some interesting observations: –

Global debt has reached an all-time high of $184 trillion in nominal terms, the equivalent of 225 percent of GDP in 2017. On average, the world’s debt now exceeds $86,000 in per capita terms, which is more than 2½ times the average income per-capita.

The most indebted economies in the world are also the richer ones. You can explore this more in the interactive chart below. The top three borrowers in the world—the United States, China, and Japan—account for more than half of global debt, exceeding their share of global output.

The private sector’s debt has tripled since 1950. This makes it the driving force behind global debt. Another change since the global financial crisis has been the rise in private debt in emerging markets, led by China, overtaking advanced economies. At the other end of the spectrum, private debt has remained very low in low-income developing countries.

Global public debt, on the other hand, has experienced a reversal of sorts. After a steady decline up to the mid-1970s, public debt has gone up since, with advanced economies at the helm and, of late, followed by emerging and low-income developing countries.

The recent picture suggests that the old world order, dominated by advanced economies, may be changing. For investors, this is an important consideration. Total debt in 2017 had exceeded the previous all-time high by more than 11%, however, the global debt to GDP ratio fell by 1.5% between 2016 and 2017, led by developed nations.

Setting aside the absolute level of interest rates, which have finally begun to rise from multi-year lows, it makes sense for rapidly aging, developed economies, to begin reducing their absolute level of debt, unfortunately, given that unfunded pension liabilities and the escalating cost of government healthcare provision are not included in the data, the IMF are only be portraying a partial picture of the state of developed economy obligations.

For emerging markets, the trauma of the 1998 Asian Crisis has finally waned. In the decade since the great financial recession of 2008 emerging economies, led by China, have increased their borrowing. This is clearly indicated in the chart below: –


Source: IMF

The decline in the global debt to GDP ratio in 2017 is probably related to the change in Federal Reserve policy; the largest proportion of global debt is still raised in US$. Rather like the front-loaded US growth which transpired due the threat of tariff increases on US imports, I suspect, debt issuance spiked in expectation of a reversal of quantitative easing and an end to ultra-low US interest rates.

The IMF goes on to show the breakdown of debt by country, separating them into three groups; advanced economies, emerging markets and low income countries. The outlier is China, an emerging market with a debt to GDP ratio comparable to that of an advanced economy. The table below may be difficult to read (an interactive one is available on the IMF website): –

imf chart of debt by country december 2018

Source: IMF

At 81%, China’s private debt is much greater than its public debt, meanwhile its debt to GDP ratio is 254% – comparable with the US (256%). Fortunately, the majority of Chinese private debt is denominated in local currency. Advanced economies have higher debt to GDP ratios but their government debt ratios are relatively modest, excepting Japan. The Economist – Economists reconsider how much governments can borrow – provides food for thought on this subject.

Excluding China, emerging markets and low income countries have relatively similar levels of debt relative to GDP. In general, the preponderance of government debt in lower ratio countries reflects the lack of access to capital markets for private sector borrowers.

Conclusions and Investment Opportunities

Setting aside China, which, given its control on capital flows and foreign exchange reserves is hard to predict, the greatest risk to world financial markets appears to be from the private debt of advanced economies.

Following the financial crisis of 2008, corporate credit spreads narrowed, but not by as much as one might have anticipated, as interest rates tended towards the zero bound. The inexorable quest for yield appears to have been matched by equally enthusiastic issuance. The yield-quest also prompted the launch of a plethora of private debt investment products, offering enticing returns in exchange for illiquidity. An even more sinister trend has been the return of many of the products which exacerbated the financial crisis of 2008 – renamed, repackaged and repurposed. These investments lack liquidity and many are leveraged in order to achieve acceptable rates of return.

The chart below shows the 10yr maturity Corporate Baa spread versus US Treasuries since March 2007: –

baa 10yr spread 2007 to 2019

Source: Federal Reserve Bank of St Louis

The Baa spread has widened since its low of 1.58% in January 2018, but, at 2.46%, it is still only halfway between the low of 2018 and the high of February 2016 (3.6%).

The High Yield Bond spread experienced a more dramatic reaction into the close of 2018, but, since the beginning of January, appears to have regained its composure. The chart shows the period since September 2015: –

high yield spread 10yr 2016 to 2019

Source: Federal Reserve Bank of St Louis

Nonetheless, this looks more like a technical break-out. The spread may narrow to retest the break of 4% seen on November 15th, but the move looks impulsive. A return to the 3.25% – 3.75% range will be needed to quell market fears of an imminent full-blown credit-crunch.

If the next crisis does emanate from the private debt markets, governments will still be in a position to intervene; the last decade has taught us to accept negative government bond yields as a normal circumstance. Demographic trends have even led long dated interest rate swaps to trade even lower than risk-free assets.

A decade after the financial crisis, markets are fragile and, with an ever increasing percentage of capital market transactions dictated by non-bank liquidity providers, liquidity is ever more transitory. Credit spreads have often been the leading indicator of recessions, they may not provide the whole picture this time, but we should watch them closely during 2019.

Emerging Market Sensitivity to US Monetary Policy – What does the Fed think?

Emerging Market Sensitivity to US Monetary Policy – What does the Fed think?

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Macro Letter – No 107 – 04-01-2019

Emerging Market Sensitivity to US Monetary Policy – What does the Fed think?

  • Emerging market currencies have suffered from US interest rate increases
  • The Dallas Fed proposes reserve/GDP ratio as a simple indicator of stress
  • If tightening is nearly complete their may be buying opportunities in EM stocks

In Macro Letter – No 96 – 04-05-2018 – Is the US exporting a recession? I speculated on whether US tightening of monetary policy and the reversal of QE was causing more difficulty for emerging markets – and even perhaps Europe – than it was for the domestic US economy. I was therefore delighted to receive an update on 9th December from the Federal Reserve Bank of Dallas, entitled, Reserve Adequacy Explains Emerging-Market Sensitivity to U.S. Monetary Policy. The authors, J. Scott Davis, Dan Crowley and Michael Morris, remind readers that Past-Chairman Greenspan made the following observations after the Asian crisis of 1997/98: –

In a 1999 speech to the World Bank, Greenspan summarized the rule stating “that countries should manage their external assets and liabilities in such a way that they are always able to live without new foreign borrowing for up to one year.

Personally I find the choice of one year to be a conveniently arbitrary time period, but the remark was probably more concerned with prudence, after the event, than an attempt to model the sudden-stop over time. It also ties in with the generally agreed definition of a country’s short-term debt, that which has to be repaid or rolled over within a year.

The authors go on to discuss reserve balances: –

Reserves are a safety net to guard against currency instability when major advanced economy central banks tighten policy.

The burning question is, what level of reserves is necessary to insure the stability of one’s currency? The authors suggest that this should be the following equation: –

FX reserves – Short-term foreign-currency denominated external debt + current account deficit

Their solution is to observe daily changes in the interest rate spread between the Corporate Emerging Market Bond Index (CEMBI) and 12 month Fed Fund Futures. To relate this to the level of central bank reserves an ‘interaction term’ is constructed which describes to relationship between reserve levels and credit spreads. An iterative process arrives at a level of reserves relative to a countries GDP. One may argue about the flaws in this simple model, however, it arrives at the conclusion that a 7.1% central bank currency reserve adequacy to GDP ratio is the inflection point: –

To that end, a range of possible threshold values is tested—from reserve adequacy of -10 percent of GDP to 20 percent of GDP. The threshold value most supported is 7.1 percent of GDP. When reserve adequacy is less than that, the sensitivity of the CEMBI spread to changes in fed funds futures is proportional to a country’s reserve adequacy, with the CEMBI spread becoming more sensitive as reserve adequacy declines. Reserve adequacy above 7.1 percent doesn’t much affect CEMBI sensitivity to expectations of U.S. monetary policy— sensitivity is similar whether reserve adequacy is 9 percent or 29 percent.

The chart below shows the level of reserves for selected EM countries since 2010, the colour coding shows in red those countries with reserves less than 7.1% of GDP and in blue those above the threshold: –

heat map of reserve to gdp ratio

Sources: International Monetary Fund; Bank for International Settlements; World Bank; Haver Analytics

China has maintained extremely high reserves despite maintaining fairly tight currency controls. The table above shows PBoC reserves gently declining but they remain well above the 7.1% inflection point.

Observations and recommendations

The Fed model is elegantly simple, it would be interesting to investigate its applicability to smaller developed economies; I imagine a similar pattern may be observed, although the reserve requirement inflection point might be lower, a reflection of the depth of their domestic capital markets. I also wonder about the effect of the absolute level of interest rates and the interest rate differential between one country and its reserve currency comparator – not all emerging markets peg themselves to the US$.

This study could also be applied to frontier economies although it may not necessarily be so effective in measuring risk when the statistical basis of GDP and other statistical measurements is suspect – consider the recent upward revisions of the economic size of countries such as Nigeria and Ghana. This paper from World Economics – Measuring GDP in Africa – March 2016 – has more detail.

As part of an initial screening of EM markets for potential risk, the central bank reserve to GDP ratio is easy to calculate. It will not reveal the exact timing of a currency depreciation but it is an excellent sanity check when one is tempted, for other reasons, to invest.

Last year Turkey and Argentina both saw a sudden depreciation, but, with the Federal Reserve now indicating that its tightening phase may have run its course, now is the time to look for value even among the casualties of the Fed. India is, of course, my long-term EM of choice, but as a shorter-term, speculative, recovery trade Turkish or Argentine bonds are worthy of consideration. With inverted curves, shorter duration bonds are their own reward. Argentine 4yr bonds spiked to yield 36% in November and currently offer a 33% yield. Turkish 1yr bonds are even more beguiling, they spiked to a yield of 32% in October but still offer a 22% return. Momentum still favours a short exposure so there is time to take advantage of these elevated returns.

Not waving but drowning – Stocks, debt and inflation?

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Macro Letter – No 103 – 26-10-2018

Not waving but drowning – Stocks, debt and inflation?

  • The US stock market is close to being in a corrective phase -10% off its highs
  • Global debt has passed $63trln – well above the levels on 2007
  • Interest rates are still historically low, especially given the point in the economic cycle
  • Predictions of a bear-market may be premature, but the headwinds are building

The recent decline in the US stock market, after the longest bull-market in history, has prompted many commentators to focus on the negative factors which could sow the seeds of the next recession. Among the main concerns is the inexorable rise in debt since the great financial recession (GFR) of 2008. According to May 2018 data from the IMF, global debt now stands at $63trln, with emerging economy debt expansion, over the last decade, more than offsetting the marking time among developed nations. The IMF – Global Debt Database: Methodology and Sources WP/18/111 – looks at the topic in more detail.

The title of this week’s Macro letter comes from the poet Stevie Smith: –

I was much further out than you thought

And not waving but drowning.

It seems an appropriate metaphor for valuation and leverage in asset markets. In 2013 Thomas Pickety published ‘Capital in the 21st Century’ in which he observed that income inequality was rising due to the higher return on unearned income relative to labour. He and his co-authors gathering together one of the longest historical data-set on interest rates and wages – an incredible achievement. Their conclusion was that the average return on capital had been roughly 5% over the very long run.

This is not the place to argue about the pros and cons of Pickety’s conclusions, suffice to say that, during the last 50 years, inflation indices have tended to understate what most of us regard as our own personal inflation rate, whilst the yield offered by government bonds has been insufficient to match the increase in our cost of living. The real rate of return on capital has diminished in the inflationary, modern era. Looked at from another perspective, our current fiat money and taxation system encourages borrowing rather than lending, both by households, corporates, for whom repayment is still an objective: and governments, for whom it is not.

Financial innovation and deregulation has helped to oil the wheels of industry, making it easier to service or reschedule debt today than in the past. The depth of secondary capital markets has made it easier to raise debt (and indeed equity) capital than at any time in history. These financial markets are underpinned by central banks which control interest rates. Since the GFR interest rates have been held at exceptionally low levels, helping to stimulate credit growth, however, that which is not seen, as Bastiat might have put it, is the effect that this credit expansion has had on the global economy. It has led to a vast misallocation of capital. Companies which would, in an unencumbered interest rate environment, have been forced into liquidation, are still able to borrow and continue operating; their inferior products flood the market place crowding out the market for new innovative products. New companies are confronted by unfair competition from incumbent firms. Where there should be a gap in the market, it simply does not exist. At a national and international level, productivity slows and the trend rate of GDP growth declines.

We are too far out at sea and have been for decades. Markets are never permitted to clear, during economic downturns, because the short-term pain of recessions is alleviated by the rapid lowering of official interest rates, prolonging the misallocation of capital and encouraging new borrowing via debt – often simply to retire equity capital and increase leverage. The price of money should be a determinant of the value of an investment, but when interest rates are held at an artificially low rate for a protracted period, the outcome is massively sub-optimal. Equity is replaced by debt, leverage increases, zombie companies limp on and, notwithstanding the number of technology start-ups seen during the past decade, innovation is crushed before it has even begun.

In an unencumbered market with near price stability, as was the case prior to the recent inflationary, fiat currency era, I suspect, the rate of return on capital would be approximately 5%. On that point, Pickety and I are in general agreement. Today, markets are as far from unencumbered as they have been at any time since the breakdown of the Bretton Woods agreement in 1971.

Wither the stock market?

With US 10yr bond yields now above 3%, stocks are becoming less attractive, but until real-yields on bonds reach at least 3% they still offer little value – US CPI was at 2.9% as recently as August. Meanwhile higher oil prices, import tariffs and wage inflation all bode ill for US inflation. Nonetheless, demand for US Treasuries remains robust while real-yields, even using the 2.3% CPI data for September, are still exceptionally low by historic standards. See the chart below which traces the US CPI (LHS) and US 10yr yields (RHS) since 1971. Equities remain a better bet from a total return perspective: –

united-states-inflation-cpi 1970 to 2018

Source: Trading Economics

What could change sentiment, among other factors, is a dramatic rise in the US$, an escalation in the trade-war with China, or a further increase in the price of oil. From a technical perspective the recent weakness in stocks looks likely to continue. A test of the February lows may be seen before the year has run its course. Already around ¾ of the stocks in the S&P 500 have suffered a 10% plus correction – this decline is broad-based.

Many international markets have already moved into bear territory (declining more than 20% from their highs) but the expression, ‘when the US sneezes the world catches a cold,’ implies that these markets may fall less steeply, in a US stock downturn, but they will be hard-pressed to ignore the direction of the US equity market.

Conclusions and investment opportunities

Rumours abound of another US tax cut. Federal Reserve Chairman, Powell, has been openly criticised by President Trump; whilst this may not cause the FOMC to reverse their tightening, they will want to avoid going down in history as the committee that precipitated an end to Federal Reserve independence.

There is a greater than 50% chance that the S&P 500 will decline further. Wednesday’s low was 2652. The largest one month correction this year is still that which occurred in February (303 points). We are not far away, however, a move below 2637 will fuel fears. I believe it is a breakdown through the February low, of 2533, which will prompt a more aggressive global move out of risk assets. The narrower Dow Jones Industrials has actually broken to new lows for the year and the NASDAQ suffered its largest one day decline in seven years this week.

A close below 2352 for the S&P 500 would constitute a 20% correction – a technical bear-market. If the market retraces to the 2016 low (1810) the correction will be 38% – did someone say, ‘Fibonacci’ – if we reach that point the US Treasury yield curve will probably be close to an inversion: and from a very low level of absolute rates. Last week the FRBSF – The Slope of the Yield Curve and the Near-Term Outlook – analysed the recession predicting power of the shape of the yield curve, they appear unconcerned at present, but then the current slope is more than 80bp positive.

If the stock correction reaches the 2016 lows, a rapid reversal of Federal Reserve policy will be required to avoid accusations that the Fed deliberately engineered the disaster. I envisage the Fed calling upon other central banks to render assistance via another concert party of quantitative, perhaps backed up by qualitative, easing.

At this point, I believe the US stock market is consolidating, an immanent crash is not on the horizon. The GFR is still too fresh in our collective minds for history to repeat. Longer term, however, the situation looks dire – history may not repeat but it tends to rhyme. Among the principal problems back in 2008 was an excess of debt, today the level of indebtedness is even greater…

We are much further out than we thought,

And not waving but drowning.

Is the US exporting a recession?

Is the US exporting a recession?

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Macro Letter – No 96 – 04-05-2018

Is the US exporting a recession?

  • The Federal Reserve continue to raise rates as S&P earnings beat estimates
  • The ECB and BoJ maintain QE
  • Globally, corporations rely on US$ financing, nonetheless
  • Signs of a slowdown in growth are clearer outside the US

After last week’s ECB meeting, Mario Draghi gave the usual press conference. He confirmed the continuance of stimulus and mentioned the moderation in the rate of growth and below-target inflation. He also referred to the steady expansion in money supply. When it came to the Q&A he revealed rather more:-

It’s quite clear that since our last meeting, broadly all countries experienced, to different extents of course, some moderation in growth or some loss of momentum. When we look at the indicators that showed significant, sharp declines, we see that, first of all, the fact that all countries reported means that this loss of momentum is pretty broad across countries.

It’s also broad across sectors because when we look at the indicators, it’s both hard and soft survey-based indicators. Sharp declines were experienced by PMI, almost all sectors, in retail, sales, manufacturing, services, in construction. Then we had declines in industrial production, in capital goods production. The PMI in exports orders also declined. Also we had declines in national business and confidence indicators.

I quote this passage out of context because the entire answer was more nuanced. My reason? To highlight the difference between the situation in the EU and the US. In Europe, money supply (M3) is growing at 4.3% yet inflation (HICP) is a mere 1.3%. Meanwhile in the US, inflation (CPI) is running at 2.4% and money supply (M2) is hovering a fraction above 2%. Here is a chart of Eurozone M3 since 1999:-

EU M3 Money Supply

Source: Eurostat

The recent weakening of momentum is a concern, but the absolute level is consistent with a continued expansion.

Looked at over a rather longer time horizon, here is a chart of US M2 since 1900:-

M2 since 1900 - Hoisington

Source: Hoisington Asset Management, Federal Reserve

The letters A, B, C, D denote the only occasions, during the last 118 years, when a decline in the expansion (or, during the 1930’s, contraction) of M2 did not lead to a recession. 17 out of 21 is a quite compelling record.

Another concern for markets is the flatness of the US yield curve. Here is the 2yr – 10yr yield differential since 1990:-

US 2yr - 10yr Factset Mauldin

Source: Factset, Mauldin Economics

More importantly, for international borrowers, the 6-month LIBOR rate has risen by more than 60 basis points since the start of the year (from 1.8% to 2.5%) whilst 30yr Swap rates have increased by only 40 basis points (2.6% to 3%). The 10yr – 30yr Swap curve is now practically flat.

Also worthy of comment, as US Treasury yields have risen, the relationship between Bonds and Swaps has begun to normalise – 30yr T-Bond yields are only 40 basis points above their level of January and roughly at the same level as in the spring of last year. In April 2017 I wrote in Macro Letter – No 74 – US 30yr Swaps have yielded less than Treasuries since 2008 – does it matter?:-

Today the IRS market increasingly determines the cost of finance, during the next crisis IRS yields may rise or fall by substantially more than the same maturity of US T-bond, but that is because they are the most liquid instruments and are only indirectly supported by the Central Bank.

It looks like I may have to eat my words, here is the Bond vs Swap table revisited:-


Source: Investing.com, Interestrateswaps.com, BBA

What is evident is that the Bond/Swap inversion in the longer maturities has closed substantially even as shorter maturity spreads have narrowed. Federal Reserve policy has been the dominate factor.

Why is it, however, that the effect of higher US rates is, seemingly, felt more poignantly in Europe than the US? Does this bring us back to protectionism? Perhaps, but in less contentious terms, the US has run a capital account surplus for many years. Outside the US investment is closely tied to LIBOR financing costs, these have remained higher, except in the longest maturities, and these rates have risen most precipitously this year. Looked at another way, the higher interest rate policies of the Federal Reserve, despite the continued largesse of other central banks, is exporting the next recession to the rest of the world.

I ended Macro Letter – No 74 back in April 2017 – saying:-

Meanwhile, although interest rates have risen from historic lows they remain far below their long run average. Pension funds and other long-term investors still require 7% or more in annualised returns in order to meet their liabilities. They are being forced to continuously increase their investment risk and many have chosen to use the swap market. The next crisis is likely to see an even more pronounced unravelling than in 2008/2009. The unravelling may not happen for some while but the stresses are likely to be focused on the IRS market.

One year on, cracks in the capital markets edifice are beginning to become more evident. GDP growth has started to rollover in the US, Eurozone and Japan. Yields are still relatively low but the absolute increase in rates for shorter maturities (e.g. the near doubling of US 2yr yields from 1.25% to 2.5% in a single year) is guaranteed to take its toll on corporate interest servicing costs. US capital markets are the envy of the world. They are deep and allow borrowers to finance far into the future. The rest of the world is forced to borrow at shorter tenors. A three basis point narrowing of 5yr spreads between Swaps and Bonds is hardly compensation for the near 1% increase in interest rates, or, put in starker terms, a 46% increase in absolute borrowing costs.

Conclusion and investment opportunities

How is the rise in borrowing costs impacting the US stock market? Volatility is back, but earnings are robust. Factset – S&P 500 Earnings Season Update: April 27, 2018 – described it thus:-

To date, 53% of the companies in the S&P 500 have reported actual results for Q1 2018. In terms of earnings, more companies are reporting actual EPS above estimates (79%) compared to the five-year average. If 79% is the final percentage for the quarter, it will mark the highest percentage of S&P 500 companies reporting actual EPS above estimates since FactSet began tracking this metric in Q3 2008. In aggregate, companies are reporting earnings that are 9.1% above the estimates, which is also above the five-year average. In terms of sales, more companies (74%) are reporting actual sales above estimates compared to the five-year average. In aggregate, companies are reporting sales that are 1.7% above estimates, which is also above the five-year average. If 1.7% is the final percentage for the quarter, it will mark the largest revenue surprise percentage since FactSet began tracking this metric in Q3 2008.

… The blended (combines actual results for companies that have reported and estimated results for companies that have yet to report), year-over-year earnings growth rate for the first quarter is 23.2% today, which is higher than the earnings growth rate of 18.5% last week. Positive earnings surprises reported by companies in multiple sectors (led by the Information Technology sector) were responsible for the increase in the earnings growth rate for the index during the past week. All 11 sectors are reporting year-over-year earnings growth. Nine sectors are reporting double-digit earnings growth, led by the Energy, Materials, Information Technology, and Financials sectors.

We are more than halfway through Q1 earnings (I’m writing this letter on Wednesday 2nd May). Results have generally been above forecast and now the Fed seems conscious that they must not be too hasty to reverse the effects of both zero rates and QE. Added to which, while US stocks have been languishing mid-range, European stocks have recently broken out of their recent ranges to the upside, despite discouraging economic data.

The US stock market looks less expensive than it did in January 2017, when I wrote Macro Letter – 68 – Equity valuation in a de-globalising world. Then I was looking for stock markets with a low correlation to the US: they were (and remain) hard to find.

Other indicators to watch which exert a strong influence on stocks include the US PMI Index – last at 54.8 up from 54.2 in March. Above 50 there is little cause for concern. For the Eurozone it is even higher at 55.2, whilst throughout G20 no economy is recording a PMI below 50.

The chart below shows the Citigroup Economic Surprises Index (blue) vs the S&P500 Forward P/E estimates (red):-

Citi Economic Surprises vs SandP - Yardeni 27-4-18

Source: Yardeni Research, S&P, Thompson Reuters, Citigroup

Economic surprises remain positive rather than negative for the US. In the Eurozone it is quite another matter:-

Citigroup Economic Surprises Index - Eurozone

Source: Bloomberg, Citigroup

A number of economic indicators are pointing to a slowdown, yet US stocks are beating estimates. To judge from price action, the market appears to be unimpressed by earnings. I am reminded of the old adage, ‘When all the buyers are in the market it’s time to sell.’ From a technical perspective it makes sense to be patient, but the market has failed to rise substantially on a positive slew of earnings news. This may be because there is a more important factor driving sentiment: the direction of US rates. It certainly appears to have engendered a revival of the US$. It rallied last month having been in a downtrend since January 2017 despite a steadily tightening Federal Reserve. For EURUSD the move from 1.10 to 1.25 appears to have taken its toll. On the basis of the CESI chart, above, if Wall Street sneezes, the Eurozone might catch pneumonia.

Inflation or Employment

Inflation or Employment

In the Long Run - small colour logo

Macro Letter – No 95 – 20-04-2018

Inflation or Employment

  • Inflationary fears are growing and US rates continue to rise
  • Employment has become more flexible since the crisis of 2008/2009
  • Commodity prices have risen but from multi-year lows
  • During the next recession job losses will rapidly temper inflationary pressures

Given the official policy response to the Great Financial Recession – a mixture of central bank balance sheet expansion, lower for longer interest rates and a general lack of fiscal rectitude on the part of developed nation governments – I believe there are two factors which are key for stock markets over the next few years, inflation and employment. The fact that these also happen to be the two mandated targets of the Federal Reserve – full employment and price stability – is more than coincidental. My struggle is in attempting to decide whether demand-pull inflation can survive the impact of a rapid rise in unemployment come the next recession.

Inflation and the Central Bankers response is clearly the new narrative of the financial markets. In his latest essay, Ben Hunt of Salient Partners makes some fascinating observations – Epsilon Theory: The Narrative Giveth and The Narrative Taketh Away:-

This market, like all markets, cares about two things and two things only — the price of money and the real return on invested capital. Or, as they are typically represented in cartoon form, interest rates and growth.

…This market, like all markets, needs a positive narrative on risk (the price of money) or reward (the real return on capital) to go up. Any narrative will do! But when neither risk nor reward is represented with a positive narrative, this market, like all markets, will go down. And that’s where we are today. 

Does the Fed have our back? No, they do not. They’ve told us and told us that they’re going to keep raising rates. And they will. The market still doesn’t fully believe them, and that’s going to be a constant source of market disappointment over the next few years. In the same way that markets go up as they climb a wall of worry, so do markets go down as they descend a wall of hope. The belief that central bankers care more about the stock market than the price stability of money is that wall of hope. It’s a forlorn hope.

The author goes on to discuss the way that inflation and the war on trade has derailed the global synchronized growth narrative. Dr Hunt writes at length about narratives; those who have been reading my letters for a while will know I regularly quote from his excellent Epsilon Theory.

The narrative has not yet become flesh, to coin a phrase, but in the author’s opinion it will:-

My view: the inflation narrative will surge again, as wage inflation is, in truth, not contained at all.

The trade war narrative hit markets in force in late February with the White House announcement on steel and aluminum tariffs. It subsided through mid-March as hope grew that Trump’s bark was worse than his bite, then resurfaced in late March with direct tariff threats against China, then subsided again on hopes that direct negotiations would contain the conflict, and has now resurfaced this past week with still more direct tariff threats against and from China. Already this weekend you’ve got Kudlow and other market missionaries trying to rekindle the hope of easy negotiations. But being “tough on trade” is a winning domestic political position for both Trump and Xi, and domestic politics ALWAYS trumps (no pun intended) international economics. 

My view: the trade war narrative will be spurred on by BOTH sides, and is, in truth, not contained at all.

The two charts below employ natural language processing techniques. They show how the inflation narrative has rapidly increased during the last 12 months. I shall leave Dr Hunt to elucidate:-

… analysis of a large set of market relevant articles — in this case everything Bloomberg has published that talks about inflation — where linguistic similarities create clusters of articles with similar meaning (essentially a linguistic “gravity model”), and where the dynamic relationships between and within these clusters can be measured over time.


Source: Quid.inc

What this chart shows is the clustering of content in 1,400 Bloomberg articles, which mention US inflation, between April 2016 and March 2017. The graduated colouring – blue earlier and red later in the year – enriches the analysis.

The next chart is for the period April 2017 to March 2018:-


Source: Quid.Inc

During this period there were 2,400 articles (a 75% increase) but, of more relevance is the dramatic increase in clustering.

What is clear from these charts is the rising importance of inflation as a potential driver of market direction. Yet there are contrary signals that suggest that economic and employment growth are already beginning to weaken. Can inflation continue to rise in the face of these headwinds. Writing in The Telegraph, Ambrose Evans-Pritchard has his doubts (this transcript is care of Mauldin Economics) – JP Morgan fears Fed “policy mistake” as US yield curve inverts:-

US jobs growth fizzled to stall-speed levels of 103,000 in March. The worldwide PMI gauge of manufacturing and services has dropped to a 14-month low. The average “Nowcast” tracker of global growth has slid suddenly to a quarterly rate of 3.2pc from 4.1pc as recently as early February.

Analysts at JP Morgan say the forward curve for the one-month Overnight Index Swap rate (OIS) – a market proxy for the Fed policy rate – has flattened and “inverted” two years ahead. This is a collective bet by big institutional investors and fund managers that interest rates may be falling by then.

…The OIS yield curve has inverted three times over the last two decades. In 1998 it proved to be a false alarm because the Greenspan Fed did a pirouette and flooded the system with liquidity. In 2000 it was a clear precursor of recession. In 2005 it signaled that the US housing boom was already starting to deflate.

…Growth of the “broad” M3 money supply in the US has slowed to a 2pc rate over the last three months (annualised)…pointing to a “growth recession” by early 2019. Narrow real M1 money has actually contracted slightly since November.

…RBC Capital Markets says this will drain M3 money by roughly $300bn a year…

…Three-month Libor rates – used to set the cost of borrowing on $9 trillion of US and global loans, and $200 trillion of derivatives – have surged 60 basis points since January.

…The signs of a slowdown are even clearer in Europe…Citigroup’s economic surprise index for the region has seen the worst four-month deterioration since 2008.  A reduction in the pace of QE from $80bn to $30bn a month has removed a key prop. The European Central Bank’s bond purchase programme expires altogether in September.

…The global money supply has been slowing since last September. The Baltic Dry Index measuring freight rates for dry goods peaked in mid-December and has since dropped 45pc.

Which brings us neatly to the commodity markets. Are real assets a safe place to hide in the coming inflationary (or perhaps stagflationary) environment? Will the lack of capital investment, resulting from the weakness in commodity prices following the financial crisis, feed through to cost-push inflation?

The trouble with commodities

Commodities are an excellent portfolio diversifier because they tend to be uncorrelated with stock, bonds or real estate. They have a weakness, however, since to invest in commodities one needs to accept that over the long run they have a negative real-expected return. Why? Because of man’s ingenuity. We improve our processes and invest in new technologies which reduce our production costs. We improve extraction techniques and enhance acreage yields. You cannot simply buy and hold commodities: they are trading assets.

Demand and supply of commodities globally is a complex challenge to measure; for grains, oilseeds and cotton the USDA World Agricultural Supply and Demand Estimates for March offers a fairly balanced picture:-

World 2017/18 wheat supplies increased this month by nearly 3.0 million tons as production is raised to a new record of 759.8 million

Global coarse grain production for 2017/18 is forecast 7.0 million tons lower than last month to 1,315.0 million

Global 2017/18 rice production is raised 1.2 million tons to a new record led by 0.3- million-ton increases each for Brazil, Burma, Pakistan, and the Philippines. Global rice exports are raised 0.8 million tons with a 0.3-million-ton increase for Thailand and 0.2- million-ton increases each for Burma, India, and Pakistan. Imports are raised 0.5 million tons for Indonesia and 0.3 million tons for Bangladesh. Global domestic use is reduced fractionally. With supplies increasing and total use decreasing, world ending stocks are raised 1.4 million tons to 144.4 million and are the second highest stocks on record.

Global oilseed production is lowered 5.7 million tons to 568.8 million, with a 6.1-million-ton reduction for soybean production and slightly higher projections for rapeseed, sunflower seed, copra, and palm kernel. Lower soybean production for Argentina, India, and Uruguay is partly offset by higher production for Brazil.

Cotton – Lower global beginning stocks this month result in lower projected 2017/18 ending stocks despite higher world production and lower consumption. World beginning stocks are 900,000 bales lower this month, largely attributable to historical revisions for Brazil and Australia. World production is about 250,000 bales higher as a larger Brazilian crop more than offsets a decline for Sudan. Consumption is about 400,000 bales lower as lower consumption in India, Indonesia, and some smaller countries more than offsets Vietnam’s increase. Ending stocks for 2017/18 are nearly 600,000 bales lower in total this month as reductions for Brazil, Sudan, the United States, and Australia more than offset an increase for Pakistan.

It is worth remembering that local market prices can be dramatically influenced by small changes in regional supply or demand and the vagaries of supply chain logistics. Added to which, for US grains there is heightened anxiety regarding tariffs: they are expected to be the main target of the Chinese retaliation.

Here is the price of US Wheat since 2007:-

Wheat since 2007

Source: Trading Economics

Crisis? What crisis? It is still near to multi-year lows, although above the nadir of the financial crisis in 2009.

The broader CRB Index shows a more pronounced recovery, it has been rising since the beginning of 2016:-

CRB Index since 2007 Core Commodity Indexes

Source: Reuters, Core Commodity Indexes

Neither of these charts suggest that price momentum is that robust.

Another (and, perhaps, more global) measure of economic activity is the Baltic Dry Freight Index. This chart shows a very different reaction to the synchronised increase in world economic growth:-

Baltic Dry Index - Quandl since 2007

Source: Quandl

In absolute terms the index has more than tripled in price from the 2016 low, nonetheless, it is still in the lower half of the range of the past decade.

Global economic growth may have encouraged a rebound in Copper, another industrial bellwether, but it appears to have lost some momentum of late:-

Copper Since 2007

Source: Trading Economics

Brent Crude Oil also appears to be benefitting from the increase in economic activity. It has doubled from its low of two years ago. The US rig count has increased in response but at 800 it remains at half the level of a few years ago:-

Brent Oil Since 2007

Source: Trading Economics

US Natural Gas, which might still manage an upward price spike on account of the unseasonably cold weather in the US, provides a less compelling argument:-

US Nat Gas Since 2007

Source: Trading Economics

Commodity markets are clearly off their multi-year lows, but the strength of momentum looks mixed and, in grains and oil seeds, global supply and demand look fairly balanced. Cost push inflation may be a factor in certain markets, but, without price-pull demand, inflation pressures are likely to be short-lived. Late cycle increases in commodity prices are quite common, however, so we may experience a short-run stagflationary squeeze on incomes.

Conclusions and investment opportunities

When ever I write about commodities in a collective way, I remind readers that each market is unique, pretending they are homogenous is often misleading. The recent rise in Cocoa, after a two-year downtrend resulting from an increase in global supply, is a classic example. The time it takes to grow a Cocoa plant governs the length of the cycle. Similarly, the lead time for producing a new ship is a major factor in determining the length of the freight rate cycle. Nonetheless, at the risk of contradicting myself, what may keep a bid under commodity markets is the low level of capital investment which has been a hall-mark of the long, listless recovery from the great financial recession. I believe an economic downturn is likely and job losses will occur rapidly in response.  

I entitled this letter ‘Inflation or Employment’, these are the factors which will dominate Central Bank policy. Currently commentators view inflation as the greater concern, as Dr Hunt’s research indicates, but I believe those Central Bankers who can (by which I mean the Federal Reserve) will attempt to insure they have raised interest rates to a level from which they can be cut, rather than having to rely on ever more unorthodox monetary policies.

What to expect from Central Bankers

What to expect from Central Bankers

In the Long Run - small colour logo

Macro Letter – No 94 – 06-04-2018

What to expect from Central Bankers

  • The Federal Reserve continues to tighten and other Central Banks will follow
  • The BIS expects stocks to lose their lustre and bond yields to rise
  • The normalisation process will be protracted, like the QE it replaces
  • Macro prudential policy will have greater emphasis during the next boom

As financial markets adjust to a new, higher, level of volatility, it is worth considering what the Central Banks might be thinking longer term. Many commentators have been blaming geopolitical tensions for the recent fall in stocks, but the Central Banks, led by the Fed, have been signalling clearly for some while. The sudden change in the tempo of the stock market must have another root.

Whenever one considers the collective views of Central Banks it behoves one to consider the opinions of the Central Bankers bank, the BIS. In their Q4 review they discuss the paradox of a tightening Federal Reserve and the continued easing in US national financial conditions. BIS Quarterly Review – December 2017 – A paradoxical tightening?:-

Overall, global financial conditions paradoxically eased despite the persistent, if cautious, Fed tightening. Term spreads flattened in the US Treasury market, while other asset markets in the United States and elsewhere were buoyant…

Chicago Fed’s National Financial Conditions Index (NFCI) trended down to a 24-year trough, in line with several other gauges of financial conditions.

The authors go on to observe that the environment is more reminiscent of the mid-2000’s than the tightening cycle of 1994. Writing in December they attribute the lack of market reaction to the improved communications policies of the Federal Reserve – and, for that matter, other Central Banks. These policies of gradualism and predictability may have contributed to, what the BIS perceive to be, a paradoxical easing of monetary conditions despite the reversals of official accommodation and concomitant rise in interest rates.

This time, however, there appears to be a difference in attitude of market participants, which might pose risks later in this cycle:-

…while investors cut back on the margin debt supporting their equity positions in 1994, and stayed put in 2004, margin debt increased significantly over the last year.

At a global level it is worth remembering that whilst the Federal Reserve has ceased QE and now begun to shrink its balance sheet, elsewhere the expansion of Central Bank balance sheets continues with what might once have passed for gusto.

The BIS go on to assess stock market valuations, looking at P/E ratios, CAPE, dividend pay-outs and share buy-backs. By most of these measures stocks look expensive, however, not by all measures:-

Stock market valuations looked far less frothy when compared with bond yields. Over the last 50 years, the real one- and 10-year Treasury yields have fluctuated around the dividend yield. Having fallen close to 1% prior to the dotcom bust, the dividend yield has been steadily increasing since then, currently fluctuating around 2%. Meanwhile, since the GFC, real Treasury yields have fallen to levels much lower than the dividend yield, and indeed have usually been negative. This comparison would suggest that US stock prices were not particularly expensive when compared with Treasuries.

The authors conclude by observing that EM sovereign bonds in local currency are above their long-term average yields. This might support the argument that those stock markets are less vulnerable to a correction – I would be wary of jumping this conclusion, global stocks market correlation may have declined somewhat over the last couple of years but when markets fall hard they fall in tandem: correlations tend towards 100%:-

Credit spreads - BIS

Source: BIS, BOML, EPFR, JP Morgan

The BIS’s final conclusion?-

In spite of these considerations, bond investors remained sanguine. The MOVE* index suggested that US Treasury volatility was expected to be very low, while the flat swaption skew for the 10-year Treasury note denoted a low demand to hedge higher interest rate risks, even on the eve of the inception of the Fed’s balance sheet normalisation. That may leave investors ill-positioned to face unexpected increases in bond yields.

*MOVE = Merrill lynch Option Volatility Estimate

Had you read this on the day of publication you might have exited stocks before the January rally. As markets continue to vacillate wildly, there is still time to consider the implications.

Another BIS publication, from January, also caught my eye, it was the transcript of a speech by Claudio Borio’s – A blind spot in today’s macroeconomics? His opening remarks set the scene:-

We have got so used to it that we hardly notice it. It is the idea that, for all intents and purposes, when making sense of first-order macroeconomic outcomes we can treat the economy as if its output were a single good produced by a single firm. To be sure, economists have worked hard to accommodate variety in goods and services at various levels of aggregation. Moreover, just to mention two, the distinctions between tradeables and non-tradeables or, in some intellectual strands, between consumption and investment goods have a long and distinguished history. But much of the academic and policy debate among macroeconomists hardly goes beyond that, if at all.

The presumption that, as a first approximation, macroeconomics can treat the economy as if it produced a single good through a single firm has important implications. It implies that aggregate demand shortfalls, economic fluctuations and the longer-term evolution of productivity can be properly understood without reference to intersectoral and intrasectoral developments. That is, it implies that whether an economy produces more of one good rather than another or, indeed, whether one firm is more efficient than another in producing the same good are matters that can be safely ignored when examining macroeconomic outcomes. In other words, issues concerned with resource misallocations do not shed much light on the macroeconomy.

Borio goes on to suggest that ignoring the link between resource misallocations and macroeconomic outcomes is a dangerous blind spot in marcoeconomic thinking. Having touched on the problem of zombie firms he talks of a possible link between interest rates, resource misallocations and productivity.

The speaker reveals two key findings from BIS research; firstly that credit booms tend to undermine productivity growth and second, that the subsequent impact of the labour reallocations that occur during a financial boom last for much longer if a banking crisis follows. Productivity stagnates following a credit cycle bust and it can be protracted:-

Taking, say, a (synthetic) five-year credit boom and five postcrisis years together, the cumulative shortfall in productivity growth would amount to some 6 percentage points. Put differently, for the period 2008–13, we are talking about a loss of some 0.6 percentage points per year for the advanced economies that saw booms and crises. This is roughly equal to their actual average productivity growth during the same window.

Productivy stagnates - BIS

Source: Borio et al, BIS

Borio’s conclusion is that different sectors of the economy expand and the contract with greater and lesser momentum, suggesting the need for more research in this area.

He then moves to investigate the interest rate productivity nexus, believing the theory that, over long enough periods, the real economy evolves independently of monetary policy and therefore that market interest rates converge to an equilibrium real interest rates, may be overly simplistic. Instead, Borio suggests that causality runs from interest rates to productivity; in other words, that interest rates during a cyclical boom may have pro-cyclical consequences for certain sectors, property in particular:-

During the expansion phase, low interest rates, especially if persistent, are likely to increase the cycle’s amplitude and length. After all, one way in which monetary policy operates is precisely by boosting credit, asset prices and risk-taking. Indeed, there is plenty of evidence to this effect. Moreover, the impact of low interest rates is unlikely to be uniform across the economy. Sectors naturally differ in their interest rate sensitivity. And so do firms within a given sector, depending on their need for external funds and ability to tap markets. For instance, the firms’ age, size and collateral availability matter. To the extent that low interest rates boost financial booms and induce resource shifts into sectors such as construction or finance, they will also influence the evolution of productivity, especially if a banking crisis follows. Since financial cycles can be quite long – up to 16 to 20 years – and their impact on productivity growth quite persistent, thinking of changes in interest rates (monetary policy) as “neutral” is not helpful over relevant policy horizons.

During the financial contraction, persistently low interest rates can contribute to this outcome (Borio (2014)). To be absolutely clear: low rates following a financial bust are welcome and necessary to stabilise the economy and prevent a downward spiral between the financial system and output. This is what the crisis management phase is all about. The question concerns the possible collateral damage of persistently and unusually low rates thereafter, when the priority is to repair balance sheets in the crisis resolution phase. Granted, low rates lighten borrowers’ heavy debt burden, especially when that debt is at variable rates or can be refinanced at no cost. But they may also slow down the necessary balance sheet repair.

Finally, Borio returns to the impact on zombie companies, whose number has risen as interest rates have fallen. Not only are these companies reducing productivity and economic growth in their own right, they are draining resources from the more productive new economy. If interest rates were set by market forces, zombies would fail and investment would flow to those companies that were inherently more profitable. Inevitably the author qualifies this observation:-

Now, the relationship could be purely coincidental. Possible factors, unrelated to interest rates as such, might help explain the observed relationship. One other possibility is reverse causality: weaker profitability, as productivity and economic activity decline in the aggregate, would tend to induce central banks to ease policy and reduce interest rates.

Zombies - BIS

Source: Banerjee and Hoffmann, BIS

Among the conclusions reached by the Central Bankers bank, is that the full impact and repercussions of persistently low rates may not have been entirely anticipated. An admission that QE has been an experiment, the outcome of which remains unclear.

Conclusions and Investment Opportunities

These two articles give some indication of the thinking of Central Bankers globally. They suggest that the rise in bond yields and subsequent fall in equity markets was anticipated and will be tolerated, perhaps for longer than the market anticipate. It also suggests that Central Banks will attempt to use macro-prudential policies more extensively in future, to insure that speculative investment in the less productive areas of the economy do not crowd out investment in the more productive and productivity enhancing sectors. I see this policy shift taking the shape of credit controls and increases in capital requirements for certain forms of collateralised lending.

Whether notionally independent Central Banks will be able to achieve these aims in the face of pro-cyclical political pressure remains to be seen. A protracted period of readjustment is likely. A stock market crash will be met with liquidity and short term respite but the world’s leading Central Banks need to shrink their balance sheets and normalise interest rates. We have a long way to go. Well managed profitable companies, especially if they are not saddled with debt, will still provide opportunities, but stock indices may be on a sideways trajectory for several years while bond yields follow the direction of their respective Central Banks official rates.