ECB, Euro and more stimulus

ECB headlines_08092017

The above is a screen shot from the website of Credit Bubble Bulletin (http://creditbubblebulletin.blogspot.sg/) this morning. Ignore the first headline. Look at the next three. If a central bank raised its GDP growth forecast, it cannot be talking of more stimulus. It is inconsistent. If GDP growth were being revised higher, it is time to remove and not add stimulus. Then, why is the ECB doing it? They are not stupid.

The answer is in the last headline. I think they are concerned about the strength of the EURO. To me, it is surprising. I thought that a strong Euro suits Germany. Germany does not want to stimulate the economy to deflect criticism of its large external surplus. A strong Euro would suit the country fine. If you remember, that is the argument that Mervyn King (former Governor, BoE) made in a speech in May. The Eurozone exchange rate is dysfunctional.

But, notwithstanding the German situation that favours a strong Euro, if the ECB were to resist Euro strength – and that is why they are still talking of continuing with stimulus – then it shows the fragility of the so-called recovery of the peripheral countries – Greece, Italy, Spain, Portugal and France too.

My two cents worth.

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ECB Meeting Minutes

The Minutes of the European Central Bank (ECB) meeting held in the first week of August were released on August 17. Members had expressed concern over the strength of the Euro, overshooting further.[1] That was a surprise. One thought that Germany would tolerate a stronger Euro in return for less pressure on its high current account surplus. Further, even for other countries (the Southern European or peripheral countries), the real effective exchange rate is not overvalued. The Eurozone enjoys a current account surplus, even if modest. Not just Germany.

Instead, the ECB Governing Council was worried that the strength of the Euro would undermine its progress towards a 2% inflation rate, from below.

In fact, the Minutes reiterated the need for continued monetary policy accommodation more than once. It stressed that interest rates could remain at the present levels well past the end of the asset purchase programme:

The Governing Council decided to keep the interest rates on the Eurosystem’s main refinancing operations, the marginal lending facility and the deposit facility unchanged at 0.00%, 0.25% and ‑0.40% respectively. The Governing Council expected the key ECB interest rates to remain at their present levels for an extended period of time, and well past the horizon of the net asset purchases. [Link]

Vague concerns were expressed about the low volatility in financial markets. Other than that, the ECB Governing Council had nothing to say about its monetary policy distorting global asset prices. Not just the Euro, but the ECB monetary policy is another bubble that needs to burst for the world to return to normalcy.

They should read what Howard Marks had written about the low volatility in his recent newsletter. [Page 5 – Link]

Bad writing

A bad FT article on the monetary policy of the European Central Bank and the impact on savers in the Eurozone. One small problem: the article deliberately conflates impact on savers vs. interest cost savings for sovereigns.

As many commentators caught on, it was either a financially illiterate but bona fide article. Or, it is a mala fide article. Very bad conflation of issues and very misleading headline. Does no credit to FT at all.

Household savers may have even increased the amount they had saved over the years. But, the truth is that low interest rates have forced them to earn little on their savings. That is a fact.

A Bank of England discussion paper acknowledged this in the context of the UK. That was in 2012 or in 2013. Last year, OECD published as part of its mid-year economic outlook, that retirees’ incomes from their savings had dropped 40% from 2000. Check out page 13 of the link.

Nothing of what has been written in this FT article is consistent with this.

In the meantime, from the resourceful Twitter handle of Jeroen Blokland (many thanks to him for some wonderful charts) comes this table of what ECB had wrought. I am unimpressed. 40 bp. drop in the unemployment rate per year for all the money printing and negative rates? Inflation is lower. The EURUSD should be a lot weaker than this. But, that would be too hot for Germany.

ECB score card

No more crisis in our life times

Well, that is not what I believe. But, that is what Ms. Janet Yellen, chairperson of the Federal Reserve believes. When I read it in a blog post by Gavyn Davies, I could not believe my eyes. Why would anyone say that? It is bad risk management. If it did not happen, no one would remember the prediction. If it happened, her predictions would be played over and over again. Ask Chuck Prince. Perhaps, he has stopped dancing now.

According to a Reuters story, this is what she said:

Would I say there will never, ever be another financial crisis? You know probably that would be going too far but I do think we’re much safer and I hope that it will not be in our lifetimes and I don’t believe it will be. [Link]

I was glad to find John Mauldin come out with a strong reaction to her remarks:

I disagree with almost every word in those two sentences, but my belief is less important than Chair Yellen’s. If she really believes this, then she is oblivious to major instabilities that still riddle the financial system. That’s not good. [Link]

His entire post, ‘Prepare for turbulence’ is worth reading.

With amazing consistency, the International Monetary Fund wrote in its Article IV assessment of the Eurozone that the European Central Bank should maintain its current easy money policy and that it should not hasten into a tightening. In the same breath, it added that debt-heavy countries in Europe have not utilised the space afforded by the easy money policy to undertake fiscal consolidation and improvement. See this:

Most high-debt countries have so far not saved the windfall interest reductions from monetary accommodation (text figure). It is important to make decisive progress on fiscal adjustment before monetary accommodation is reduced. Otherwise, countries could face dangerous debt dynamics as interest rates rise—running the risk that self-fulfilling expectations could emerge if markets begin to doubt fiscal sustainability. [page 21-22 – link]

Why would they? When we make bad habits less costly for people, they do not stop them. They persist with them. That is what governments are doing. Central banks are not making it easy for governments to shed debt addiction. They are making it easy to stay addicted. Low interest rates remove pressure to reform. No pain; no gain. No pain; no reform.

I enjoyed writing my MINT column for August 1. I said it was time for the queen to ask intellectuals as to why they were failing to stop another crisis coming. By the time she asks the question again, assuming she does, it might well be too late.

Some thoughts on EURUSD

In the past, when we look at the two episodes of strong U.S. dollar, it happened when the U.S. real interest rates were higher than elsewhere: 1982-85 and in 1995-2001.

Between 2003 and 2008, the dollar was weak when U.S. real rates were broadly lower than in the Eurozone.

Between 2009 and 2010, USD weakness resumed as U.S. reduced nominal rates to zero and real rates were negative, more negative than in the Eurozone.

Between 2010 and 2013, the EURUSD stayed broadly stable but the negative relationship with the USA-Euro real rates was maintained.

Between 2013 and 2016, US dollar was strong not so much because U.S. real rates went up but real rates in the Eurozone were much lower. In other words, the differential moved in favour of the U.S. and hence EURUSD weakened. Again, the negative correlation was maintained. But, the anomaly started in Dec. 2016. The two lines – red and blue are correlated positively!

See the two charts below. One is the long-term chart and the second chart is for the more recent period.

EURUSD - Chart 1

EURUSD - Chart 2

Even though Ms. Yellen has softened her interest rate increase talk, as he writes, the U.S. real rates have trended higher compared to the Eurozone. The Eurozone is nowhere near beginning to think about the matter.

Further, even Fed balance sheet reduction in the U.S. should see a tightening of rates.

So, to sum up, why is EURUSD moving higher even as the real rate differential is moving in favour of US dollar?

(1) Perception of competence, leadership and decisiveness strongly favours Eurozone political leadership than the American leadership, including the Congress.

(2) In political and policy leaderships in both the regions – America and the Eurozone  – there is no constituency that objects to the current trend in EURUSD.  Germany does not mind a stronger EURO. It has a current account surplus of 8.5% of GDP. It does not want to stimulate the economy by spending more. The economy does not need stimulus. It is growing nicely.  Germany hates to become fiscally profligate because of long-term fiscal sustainability. Any faster growth would stoke inflation concerns. Better to let the currency appreciate and it would also make the American President less critical of the exchange rate.

(3) Should the stock market crash in the U.S., and globally, there is a recession or slowdown combined with rising risk aversion, it usually makes the dollar stronger. But, we never know about the future. This time, clearly Yellen would turn around and go back to easing.  But, for the Eurozone, there will be no change in policy. So, therefore, at the margin, the policy would turn easier in the U.S. with no change in the Eurozone. That too is negative for the U.S. dollar.

[Important: this is not an investment recommendation. Just some loud thinking on the EURUSD exchange rate. Nothing more. ]

Sapiens and sperm count

This news-story in FT caused a flutter as it documented that male sperm count has fallen drastically in western countries. It might be truer of other societies too. Stress and chemicals are supposed to have played a role – “prenatal chemical exposure, adult pesticide exposure, smoking, stress and obesity,”

The BBC version of this story said that the sperm count drop could make humans extinct. Well, other living organisms might get a new lease of life. Yuval Harari had written in ‘Sapiens’ that wherever Sapiens set foot, they had destroyed the living organisms that had been existing there for thousands of years. So, may be, this is what Planet Earth needed.

Of course, these stories would prompt granular analysis – geographical, ethnic and religious breakdown of the population that is witnessing sperm count reduction or not, etc.

(2) My friend Nitin Pai wonders (or makes a plaintive appeal to China) why China is willing to alienate 500 million Indians. I doubt if they see the Doklam standoff that way. On his part, the President of PRC has answered him. The question he is asking is why 500 million Indians are alienating 1.3 billion Chinese by not paying homage to them and acknowledging that they have reached a historical turning point?! The article in the ‘South China Morning Post’ reminded me of this.

(3) Little over two weeks ago, I wrote in MINT that the U.S. dollar was still the king. In June, I had questioned the euphoria over Europe.  I am not resiling from both the positions. But, I have to add caveats. Perhaps, I was engaged in cognitive dissonance reduction since I was short Euro vs. U.S. dollar.

After some analysis and reflection today, I have come to the conclusion that, although the U.S. dollar should be supported by the rising real interest rate differential to the Euro, political leadership and policy competence perceptions seem to be tilted in favour of Europe, even if only relatively. Further, in both the regions – America and Europe – there is no interest in their political leaderships to halt the trend in the US dollar – Euro exchange rate. Germany, with its 8.5% current account surplus/GDP ratio is happy to see the currency rise rather than having to undertake fiscal stimulus in an economy that is already operating at full capacity.

American thinking in the present administration favours a weak U.S. dollar. So, for now, the path of least resistance for EURUSD, therefore, is up. But, after reading the Article IV report of the International Monetary Fund on the Euroarea, I was pleased to note that this column of mine still remains valid. The Eurozone is still far from being an Optimal Currency Area.

Same old, same old

From Gavyn Davies’ blog on July 9:

The main impetus for the sudden rise in the growth rate in the AEs [Advanced Economies] in the past 18 months has probably come from the demand side of the global economy. Both fiscal and monetary policy have been accommodative in 2016-17, and financial conditions have been very supportive of demand, even in the US where the Federal Reserve has been raising short term interest rates. [Link]

After six years of pulling on a string, some reaction from the demand side coming from financial conditions turning looser. This does not presage a sustained supply-side response.  It is unsustainable and unbalanced.  Needless to add, unhealthy, too. Policymakers do not appear to have absorbed the lessons of the pre-2008 boom. What about analysts and economists?

Not much to show, I am afraid. The inability of Martin Sandbu to learn from history – recent or distant – and his extraordinarily consistent record of ignoring empirical evidence, marks him out as a quintessential modern economist.

Apparently, Claudio Borio of BIS and the latest BIS annual report (released on June 25, 2017) talk of an extended financial cycle that central banks must respond to. I am yet to read the BIS Annual Report. But, not surprising, coming from BIS. This blogger is aligned with that. But, the Federal Reserve and the European Central Bank are ignoring that warning. As before. Yellen’s testimony on July 12 was inexplicable, to this blogger. My column in MINT tomorrow has a slightly more detailed take on that.

Same old, same old stuff from central banks but the next crisis may not be same old, same old.