WATCH: What’s Wrong Mr Bernanke? (Epic Rick Santelli Rant)

“Where does it say in the Constitution that stock prices have to go up?” – CNBC commentator Rick Santelli on an epic rant in the aftermath of Ben Bernanke’s FOMC comments on tapering and QE and how the Fed has no idea about what they’re doing.

When you add in Bill Gross saying on Bloomberg that the Federal Reserve is “walking around in a fog”, we have to laugh. His PIMCO Total Return fund took a bath yesterday as financial markets took a hit on the back of Bernanke’s comments. When Bill Gross “the king of bonds” basically said “WTF are you doing Mr Chairman!” you know that central banks playing central planner has opened a massive can of worms for the global financial markets.

On A Cross Of Bonds (An Interest Rate Is A Price)

The goal of quantitative easing was to keep interest rates low so households and firms would go out, borrow money and spend like there is no tomorrow.

Because consumption drives the debt fuelled economy, central bankers around the world were happy to crucify price signals in the form of interest rates that reflect risk and the time value of money on a cross of bonds.

One of the most basic concepts in economics is diminishing marginal returns. When you consume more of something, you get less and less satisfaction until some point where you’re getting negative utility from consuming more of it. I think that quantitative easing has hit diminishing returns and no there is nothing central banks can do in order to restore valid price signals in the form of interest rates.

Just like an exchange rate is a price, an interest rate is a price. It’s a price of how much it will cost for us to bring consumption forward to today. It’s an exchange rate across time. By keeping interest rates low, central banks were trying to change the way we thought about borrowing for more consumption today to be repaid with interest tomorrow. Even firms have been paying down debt and returning cash in dividends or buybacks.

But the household balance sheet restructuring of the past few years has changed something. Private sector demand for credit has declined. The velocity of money is low so that monetary base ain’t going anywhere than financial institutions balance sheets. Sure, we’ve got a resurgent housing boom, but there are big supply side backlogs that need to be cleared in New Zealand. Banks will lend to home buyers, but they won’t lend to builders or developers.

When you realise that banks get a decent proportion of their funding on the wholesale money markets, where the rates they’ve been paying have been artificially low since the GFC hit, and then realise that macro-prudential tools just introduced by the Reserve Bank and Basel III mean that banks need lower reserves for housing lending than they do for business lending, you’ll get some sort of idea of how stuffed we are when rates rise.

An interest rate is a price, and one of the reasons the financial markets are producing dramatic movements is that investors are trying to sort out whether the recovery is real or if it’s just the response of people whose preferences have been twisted far enough by central banks to make them willing to lend or willing to buy bonds that they wouldn’t have touched a decade ago.

An example of this is high yield corporate bonds in the US – also referred to as junk bonds. These low rated bonds that are very risky in terms of default potential have reached yields as low as 5% in the past few months. When there is a speculative reach for yield, anything with a yield will do as long as it has some sort of rating attached.

One of the problems with central bankers is that they live in a bubble. In their interactions with the financial community, the media, the corporate executives they meet at conferences and the people who sit next to them in private jet terminals and airport lounges around the world – quantitative easing is doing wonders for their household net worth.

But the problem of living in a bubble is that for pretty much anyone who does not own a substantial amount of assets, the economy sucks. Household wealth has gone down for most people, with tarnished credit ratings they can’t borrow even though they might have a good cheap business idea. That means that quantitative easing can only succeed if the banks pass on the implicit subsidy they’re getting from everyone else in the world.

Inflation has not emerged like some said it would. That’s because although the monetary base has expanded dramatically, velocity of money has declined – even plummeted in some economies. After Cyprus, people are aware that a bank deposit is an unsecured deposit and it’s not yours. This means that moving from cash into anything but a bank account pushes asset prices even higher.

How does this all end? Well, if interest rates rise suddenly, enormous capital losses are imposed on bondholders. The mantra of the global financial crisis has been “Thou shalt protect the bondholders” – same for the Wall Street bailout that used AIG as a conduit. How leveraged have hedge funds been in taking advantage of QE? How bad will the margin calls be? How will the prime brokerage desks handle a potential repeat of 1994?

I don’t know, and am smart enough to realise that at this point, the most honest thing economists can do is tell the truth. The central bank playing around in ways that were never conceptualised at the outset of monetarism has opened a whole new can of worms. Using the S&P500 as an indicator of economic performance does not lead to broad prosperity.

When the central bankers want to sacrifice everything on a cross of bonds, the demand for physical assets and financial assets that will benefit from inflation is clear. There’s a demand side story on top of the monthly bond purchases by central banks around the world. And if the fundamentals improve, who knows where asset prices could go?

Richard Koo Thinks Abenomics Honeymoon Is Over

Nomura economist Richard Yoo, who’s produced a lot of really good analysis of the Japanese economy over the past decade, thinks the Abenomics honeymoon is over.

Check his comments out at ZeroHedge.

Basically, despite the Bank of Japan injecting enormous liquidity into the Japanese financial system through their 20th something iteration of QE, private sector demand for credit has barely budged.

The whole point of QE is to keep interest rates low, but if the velocity of money is low then that monetary base is not moving around the economy spreading fairy dust in the form of investment, consumption and job creation.

There is an interesting Bank of Japan paper that explains the low velocity of money since the Japanese economy went into decline over 20 years ago.

In order for Abenomics to be successful three things have to happen:

  1. Overseas investors have to stick around
  2. Private sector credit demand has to increase
  3. All of the supply-side reforms he wants to implement can’t be held up

Because all of these three are unlikely – even though there’s reasonable evidence to suggest the Nikkei 225 at 15,000 wouldn’t be unreasonable, the Abenomics experiment could soon be filed under “Stuff Japan Tried And Failed Dismally At”.

It’s not their economy’s first time at the QE rodeo – and the jitters it is sending through their financial markets are something to be concerned about.

The Search For Yield

The effect of quantitative easing on asset yields is clear. When central banks buy bonds and other private sector assets, they bid up the price and push the yield down.

Last week, junk bonds in the United States dropped below 5% yield. This is because when almost every other asset class has a low yield, anything with a higher yield will be purchased by those who need to own assets with yield.

Pension funds in the United States have substantial unfunded liabilities becaused they are “defined benefit” retirement schemes. These corporations, states and unions made promises to their members. They have suffered investment losses and thus need to earn more than the market is currently offering if they want to have any hope of reaching the level of assets needed to deliver on promises made in the past.

The search for yield in the current low interest rate environment presents a whole new level of risk. Higher yields are traditionally linked to higher credit risk if we are talking about bonds. But if high risk bonds suddenly become low yield as a second-order effect of quantitative easing, then there is effectively a mis-pricing of risk.

What this does is create a dilemma for the bond markets. If lower yields let more bonds into the “lower risk” screen, and pension funds can purchase these bonds because at a lower yield “they’re less risky”, and corporates like Apple can issue bonds to return cash to shareholders, what happens when interest rates rise eventually?

Private sector demand for credit has not recovered from the global financial crisis. We have no way of knowing how dramatic the change in interest rates could be if demand shocks or supply shocks flow through to demand for credit and end up performing what the central banks have failed to do with quantitative easing.

Thus, the search for yield is a double-edged sword that runs the risk of capital writedowns if interest rates rise. If they rise dramatically, or central banks end quantitative easing abruptly, we could find ourselves in another money market liquidity crisis because a lot of borrowing uses bonds as collateral for repo transactions and the like.

Lowering The Cash Rate Is No Panacea

Last week the Reserve Bank of Australia lowered its cash rate to a record low.The Australian dollar tumbled, and there are rumours that George Soros bet US$1 billion against the Aussie in expectation of that. But just because the central bank lowered the cash rate does not mean that Australia will have softening demand from China offset by a domestic recovery.

At the onset of the global financial crisis, the Federal Reserve quickly slashed the fed funds rate and injected enormous amounts of liquidity into the financial system. Even the RBNZ received a few billion dollars in Fed largesse. Not long after, the Bank of England joined the party of quantitative easing. The UK even nationalised most of its banking sector.

Fast forward to today. The European Central bank has been doing its own form of quantitative easing and sovereign debt restructuring since 2010. While there is enormous liquidity in the financial system, private sector demand for credit is nowhere near pre-crisis levels. The Bank of Japan is doubling down on quantitative easing in the vain hope that higher inflation will somehow kickstart the Japanese economy.

If everyone is engaging in quantitative easing, the country that does not will quickly find its exports uncompetitive. The New Zealand dollar is currently at record highs – not because New Zealand is an economic miracle but because there is a global reach for yield. It just so happens that our interest rates – and dividend yields – are very attractive in a low interest rate environment.

This is because although quantitative easing has succeeded in keeping interest rates low, it has not flowed through into substantial investment and consumption spending. The United States recently surpassed the “socialist” Eurozone for youth unemployment and underemployment. Household incomes have stagnated since the 1970’s. Corporations are running massive surpluses and can even issue long-term debt to finance dividends to shareholders because that is cheaper than repatriating capital from offshore.

The tragedy of the Australian story is that they have squandered the boom. I shared with you a while back a McKinsey Global Institute report that clearly shows how their economy has had poor productivity growth, pursued resource projects barely economic even at sky high commodity prices and failed to ensure that the whole Australian balance sheet was ready for any inevitable downturn.

My opinion is that the Reserve Bank of Australia will keep cutting interest rates. There will be a change of government and the incoming Liberal government under Tony Abbott will not be able to implement any significant supply side reforms because they will be in a massive slump.

Lowering the cash rate is no panacea for an economy already plagued by malinvestment. Because Australia has a larger balance sheet than New Zealand, it will be interesting to see if they eventually copy the Federal Reserve and join in the quantitative easing party. Australia sure is important for us to watch – our economy depends more on theirs than many in New Zealand want to admit.

Low Interest Rates And Risk

The music is still playing despite global interest rates being very low. Quantitative easing is acting as an interest rate suppressant, bidding up the prices of bonds and therefore lowering yields. When you are earning almost nothing on cash and cash equivalents, anything with higher yield looks like a better bet than a bank account.

The problem with low interest rates is the risk of what will happen when they inevitably change. When we think about debt dynamics, stabilising the debt is a lot more difficult when interest rates rise. The primary surplus required if a government is running a primary deficit will be far higher than it currently is under very low interest rates.

This means that the political costs of achieving a primary surplus are almost impossible if interest rates rise, which they could given higher inflation expectations following the Bank of Japan joining in the QE party in order to keep up with the Federal Reserve and European Central Bank who are injecting enormous amounts of liquidity into the global financial system.

Each additional dollar/yen/euro at the margin is unlikely to be left earning 0% for long. But we don’t know how the QE experiment will wind down. And that means that any sudden increase in interest rates could lead to major problems for global balance sheets. If your solvency is dependent on low interest rates, and you don’t have fixed term debt, and need to constantly issue new debt to rollover old debt, then you will very quickly run into a wall.

Unintended Consequences Of Quantitative Easing

I think it is amazing how so few commentators have linked QE to the unrest in the Middle East. Most of these countries are food importers and high oil prices don’t do much for countries other than Saudi Arabia who can shower cash on their unemployed young men to quell discontent.

The substantial increases in imported food in North Africa and the Middle East are far more important than some nonsense about democracy. If you’ve read the Pew Reports on what Egyptians, Libyans and Syrians actually want from a government you’ll find it’s not democracy.

With the Federal Reserve announcing QE^infinity recently, and aiming for nebulous targets like a 6.5% unemployment rate as reason to change policy directions, what will the unintended consequences of quantitative easing be this time?

We have no idea. And that’s the problem with globalisation. We have no idea how the world being so connected will play out over the coming decades.

Putting all of the benefits of globalisation aside, the world has become so inter-linked that we have no idea what event in what country could trigger other bad events in other countries.

To paraphrase Donald Rumsfeld, the “unknown unknown’s” are really scary. Just think about what quantitative easing has done so far – reinforce wealth inequality and those who hold financial assets.

What would happen to New Zealand if the proceeds of quantitative easing wash up on our shores in the form of bankrolling another housing bubble? Oh wait.

Hong Kong’s Exchange Rate Stability

Since 1983 the Hong Kong dollar has been linked to the US Dollar at a rate of HKD7.8/USD1.00. The Hong Kong Monetary Authority, through the Currency Board, has maintained this stable exchange rate through a plethora of macroeconomic shocks and against rising prosperity in Hong Kong that could easily justify a significant appreciation against the US Dollar.

While Hong Kong can be hurt by changes in US monetary policy, strong economic growth and a reduction in the rate of inflation has been achieved during the peg’s lifetime.

Hong Kong has unique characteristics including substantial assets with which to defend the peg, but in an age where dogmatic adherence to the idea that floating exchange rates are ultimately the best idea, countries with their act together (i.e. NOT New Zealand) are capable of choosing different tools to maintain exchange rate stability and reduce risk for importers and exporters alike.

Because the fundamentals of Hong Kong are strong, any revaluation of the Hong Kong dollar will see substantial increases in purchasing power for Hong Kong residents and firms with assets denominated in Hong Kong dollars.