November 6, 2015. The jobs report crushed it. Non-farm payrolls registered 271k new jobs, much higher than expected. As we shall explain, this good news is terrible news for the bond market. Make that every market sloshing with liquidity. Fears of a global slowdown eased last month. Yellen even sounded hawkish, which I didn’t think was possible. The 2yr sold hard, yields ending at 4 year highs. Interest rates are set to rise for the first time since 2006,
November 4, 2015. The news flash Congress needs to hear: Economic slowdown and tighter liquidity conditions do not sit well together. Ya think?
Congressmen were actually suggesting how Yellen should do her job. This is like Kylie Jenner coaching kids on how to act like responsible adults. Some took Yellen to task for not hiking rates. One dullard, using a truly bizarre diatribe about the Almighty’s change of seasons, implied that God himself wanted rates to stay flat. Every one of them was merely working their angle hoping to make their vested interest love them just a little bit more. It was obvious Yellen was tired of it about 30 seconds in.
There are three reasons why she was tired of it. One, it is tiring to entertain village idiots. Second, no matter how much data and ability one has, no one can predict the future. Yet all those people grandstanding in committee operate as if they can. Poor Janet Yellen: among all those bozos, she alone knew that no one has a clue what to do. She is paralyzed by a raging battle between a massive secular trend and a short-term response that central banks are leaning against it: deflationary pressures of deleveraging and an offsetting central bank intervention. Finally—and this is rather scary one for many—Yellen knows that central banks haven’t been able to move the needle on economic growth no matter what they do.
Japan’s experience over the past quarter-century shows that the monetary policy transmission mechanism breaks down after a deep credit crisis. Economic participants favor savings over spending in order to repair balance sheets that have seen the asset side shrink and liabilities remain the same. Even after balance sheets are in better shape, consumer and business behavior is cautious, reflecting a lack of confidence and government budget expand with little constraint.
Japan has been trying since 2013 to trigger a historic transition towards a booming economy supported by household income growth, stronger corporate governance and deregulation of the labor market and traditionally protected sectors. The Bank of Japan’s quantitative easing program has been double the easing performed by the Federal Reserve as a percentage of GDP. “Reflating” the Japanese economy is vital if the country’s debt level is to be sustainable. It is also crucial for valuations of the nation’s financial markets. It’s not working. In Japan, the Tankan manufacturing index for September confirms that economic growth remains very close to zero.
In fact, nowhere has quantitative easing reflated economies experiencing a credit crisis, unless you count a temporary bubble as reflation. Six years after the Fed introduced a stimulus policy on an unprecedented scale, the United States rate of underlying inflation stands at +0.8%. The ECB is buying EUR 60 billion of assets a month until September 2016. The Bank of Japan will continue fighting against a national inflation rate that is again falling. Now the People’s Bank of China is stepping up its monetary easing in a bid to steady the pace of Chinese economic growth.
Janet Yellen recognizes the weakness of the global economy, and this more than anything prevents any rapid normalization of the Fed’s monetary policy. But the Fed absolutely has to give itself back some monetary policy leeway to be able to counter the next cyclical downswing. But merely small moves to shift expectations towards tighter liquidity conditions in financial markets this year caused major shifts in asset prices. This year began with the recent surge in “risk-free” financial asset price volatility and massive shedding of term risk. Then sharp declines in oil and commodity prices. Next was the increase of capital flows out of the emerging world.
The massive influx of liquidity by central banks acting as price-insensitive buyers have deeply conditioned the markets to expect any bad news to be met with liquidity provision. By crowding out investors, the very high price of “risk-free” bonds gradually spreads to all asset classes. The swollen risk premium (difference between the returns on equities and government bonds) that results from tumbling bond yields is seen as justifying equity markets’ high valuations.
Market valuation rests solely on the belief that weak global economic growth would be the best guarantee of uninterrupted monetary stimulus from central banks in the developed world. In the last five years, any bad economic news is systematically interpreted as good news for the markets. Flooded with liquidity, the markets will therefore continue to benefit from this windfall. Behind both the market rally and the greater fragility of the financial system is that poor results justify a continuation of monetary stimulus wherever necessary and in all its forms. An umpteenth increase in monetary stimulus only restores, like a radioactive isotope with a decaying half-life, financial bubbles.
Now markets are transitioning to the belief that good news will be met with tighter liquidity. It’s a necessary step toward normalization. Investors dread the start of a monetary tightening process but they are also wary of maintaining exceptional monetary conditions, which they rightly see as reflecting ineffective control over the real economy. From the United States to China, Europe to Japan, what the over-indebted global economy needs is to increase its potential growth. Growth is something on which central banks have no grip.