Mauldin - Central Bank Smackdown

Central Bank Smackdown
By John Mauldin
July 5, 2014

Smackdown: smack·down, ˈsmakˌdoun/, noun, US informal
1.  a bitter contest or confrontation.
"the age-old man versus Nature smackdown"
2.  a decisive or humiliating defeat or setback.

The term “smackdown” was first used by professional wrestler Dwayne Johnson (AKA The Rock) in 1997. Ten years later its use had become so ubiquitous that Merriam-Webster felt compelled to add it to their lexicon. It may be Dwayne Johnson’s enduring contribution to Western civilization, notwithstanding and apart from his roles in The Fast and The Furious movie series. All that said, it is quite the useful word for talking about confrontations that are more for show than actual physical altercations.

And so it is that on a beautiful July 4 weekend we will amuse ourselves by contemplating the serious smackdown that central bankers are visiting upon each other. If the ramifications of their antics were not so serious, they would actually be quite amusing. This week’s shorter than usual letter will explore the implications of the contretemps among the world’s central bankers and take a little dive into yesterday’s generally positive employment report.

BIS: The Opening Riposte

The opening riposte came from the Bank for International Settlements, the “bank for central banks.” In their annual report, released this week, they talked about “euphoric” financial markets that have become detached from reality. They clearly – clearly in central banker-speak, that is – fingered the culprit as the ultralow monetary policies being pursued around the world. These are creating capital markets that are “extraordinarily buoyant.”

The report opens with this line: “A new policy compass is needed to help the global economy step out of the shadow of the Great Financial Crisis. This will involve adjustments to the current policy mix and to policy frameworks with the aim of restoring sustainable and balanced economic growth.”

The Financial Times weighed in with this summary: “Leading central banks should not fall into the trap of raising rates ‘too slowly and too late,’ the BIS said, calling for policy makers to halt the steady rise in debt burdens around the world and embark on reforms to boost productivity. In its annual report, the BIS also warned of the risks brewing in emerging markets, setting out early warning indicators of possible banking crises in a number of jurisdictions, including most notably China.”

“The risk of normalizing too late and too gradually should not be underestimated,” the BIS said in a follow-up statement on Sunday. “Particularly for countries in the late stages of financial booms, the trade-off is now between the risk of bringing forward the downward leg of the cycle and that of suffering a bigger bust later on,” the BIS report said.

The Financial Times noted that the BIS “has been a longstanding sceptic about the benefits of ultra-stimulative monetary and fiscal policies, and its latest intervention reflects mounting concern that the rebound in capital markets and real estate is built on fragile foundations.”

The New York Times delved further into the story:

There is a disappointing element of déjà vu in all this,” Claudio Borio, head of the monetary and economic department at the BIS, said in an interview ahead of Sunday’s release of the report. He described the report “as a call to action.”

The organization said governments should do more to improve the performance of their economies, such as reducing restrictions on hiring and firing. The report also urged banks to raise more capital as a cushion against risk and to speed efforts to deal with past problems. Countries that are growing quickly, like some emerging markets, must be alert to the danger of overheating, the group said.

The signs of financial imbalances are there,” Mr. Borio said. “That’s why we are emphasizing it is important to take further action while the time is still there.”

The B.I.S. report said debt levels in many emerging markets, as well as Switzerland, “are well above the threshold that indicates potential trouble.” (Source: New York Times)

Casual observers will be forgiven if they come away with the impression that the BIS document was seriously influenced by supply-siders and Austrian economists. Someone at the Bank for International Settlements seems to have channeled their inner Hayek. They pointed out that despite the easy monetary policies around the world, investment has remained weak and productivity growth has stagnated. There is even talk of secular (that is, chronic) stagnation. They talk about the need for further capitalization of many banks (which can be read, of European banks). They decry the rise of public and private debt.

Read this from their webpage introduction to the report:

To return to sustainable and balanced growth, policies need to go beyond their traditional focus on the business cycle and take a longer-term perspective – one in which the financial cycle takes centre stage. They need to address head-on the structural deficiencies and resource misallocations masked by strong financial booms and revealed only in the subsequent busts. The only source of lasting prosperity is a stronger supply side. It is essential to move away from debt as the main engine of growth.

“Good policy is less a question of seeking to pump up growth at all costs than of removing the obstacles that hold it back,” the BIS argued in the report, saying the recent upturn in the global economy offers a precious opportunity for reform and that policy needs to become more symmetrical in responding to both booms and busts.

Does “responding to both booms and busts” sound like any central bank in a country near you? No, I thought not. I will admit to being something of a hometown boy. I pull for the local teams and cheered on the US soccer team. But given the chance, based on this BIS document, I would replace my hometown team – the US Federal Reserve High Flyers – with the team from the Bank for International Settlements in Basel in a heartbeat. These guys (almost) restore my faith in the economics profession. It seems there is a bastion of understanding out there, beyond the halls of American academia. Just saying…

Yellen’s Counter-Riposte

On July 2, two days after the release of the BIS report, Janet Yellen took the stage at the IMF conference and basically said (translated into my local Texas patois), “Kiss my grits.” She was having nothing to do with risk and productivity and spent her time defending the low-rate environment she has been fostering in the US. With just a brief hat tip to the fact that monetary policy can contribute to risk-taking by going “too far, thereby contributing to fragility in the financial system,” she proceeded to maintain that monetary policy should “focus primarily on price stability in full employment because the cost to society in terms of deviations from price stability in full employment that would arise would likely be significant.” (You can read the speech here if you have nothing else to do and your recent entertainment options have been limited to watching the microwave cook.)

In other words, Janet has her dual mandate, and the rest of the world can go pound sand. When she did allude to the risk of financial instability, she hastened to say that it was not something that would require a change in monetary policy but would instead call for what she termed a “more robust macroprudential approach.” In fact she used that word macroprudential no fewer than 29 times. For those not fluent in Fedspeak, what she meant is that we can deal with financial instability through increased regulation procedures, whatever the hell that means. Exactly what did macroprudential policy do for us during the last crisis?

Hold that thought as we move on to Mario Draghi, who piled on the next day, as if to reemphasize that the leading central bankers of the world are simply not going to pay any attention to increasing financial instability risk. (Interestingly, the voice recognition software that I use to dictate this letter insists upon transcribing Draghi as druggie. Given what he is pushing, maybe it knows more than the typical software package.)

Immediately following a European Central Bank meeting, Mario gave us the following statement:

The key interest rates will remain at present levels for an extended period ... [and] the combination of monetary policy measures decided last month has led to a further easing of the monetary policy stance. The monetary operations to take place over the coming months will add to this accommodation and will support bank lending.

My friend Dennis Gartman summarized the actual meaning of Draghi’s comments quite succinctly:

In other words, European-style quantitative easing is now the course that the Bank shall take. As we understand it ... and this is a bit confusing and shall take a while to fully comprehend what the ECB has done and shall be doing ... the Bank will be making as much as €1 trillion available to the banks in two early tranches and will make that money available for the next four years as long as the money is being used for direct lending operations.

Mr. Draghi made it clear that the new program is complex and shall take some time for everyone to understand the program but said that he is quite “confident that banks will quickly understand” the program’s details and will embrace it.

My own interpretation is that Mario said, “I’ll see the Fed’s tapering and raise it by €1 trillion.”

Wow! A double-teamed double smackdown! Even The Rock would be impressed.

The Coming Liquidity Crisis

The next crisis is shaping up to look a lot like the last one, just with a different cause. It is going to be a liquidity crisis.

What was the cause of the last crisis? Everybody points to subprime debt, but that was really just a trigger. What happened was that everybody in the financial world became distrustful of everybody else’s balance sheet and so decided to go to cash, but there was so much debt and so much invested in illiquid assets that everybody couldn’t get out of the theater at the same time.

It is happening again today. The intense drive for yield is driving down interest rates and volatility, pushing up assets of all kinds, and setting us up for the same song, second verse of the 2008 crisis.
While I have been hinting around about that possibility for some time, it really crystallized for me this last week as I read about the enormous drop in quality of fixed-income paper of all types, coupled with the huge increase in junk paper. Then I read that that Kenya had just broken the African record for a sovereign debt sale. They raised $2 billion for “general budgetary purposes” and at a rate lower than they anticipated (6.875% for ten-year maturities). A commentator in the Financial Time noted wryly, “Kenya’s gotten really, really lucky with the yield…. There’s very strong global demand for African sovereign paper.”

You bet there is, and on the corporate side of things, covenant-lite loans now amount to more than half of all corporate bonds outstanding, notes Barclays (and a dozen other sources). And meanwhile, the spread between AAA and subprime auto loans is the narrowest since 2007. “People just have to reach further and further,” says fund manager David Schawel to Bloomberg. “The objective now is to reach a certain yield target instead of feeling good about the underlying credit.”

French ten-year bonds (OATS) are paying 1.7%. Spanish (2.68%) and Italian (2.83%) debt are paying roughly the equivalent of US debt. German debt, at 1.27%, pays less than half of US debt at 2.64%. Somewhere in that equation, sovereign debt is spectacularly mispriced. Rated ten-year corporate bonds are paying between 3% and 3.4%. That is less than a 1% premium for bonds that are only single-A. Seriously?

The life insurance market is creating special-purpose vehicles (SPVs) for offloading their risk that are then guaranteed by the parent company. This is the subject of a very sobering report from the Minnesota branch of the Federal Reserve. Up to 25% of such debt may be subject to self-guarantees, and this debt is getting very high ratings. Whom are we kidding? (This is actually a very serious problem and needs an entire letter devoted to it. There’s just not enough time on a Friday afternoon, with the grill beckoning.)

And we are going to have to deal with a run on everything, very similar to what happened last time, armed only with “macroprudential policy”? Precisely what additional rules are we going to enact? You are not allowed to sell what you own? Except if you say “Mother may I, with sugar on top?” A liquidity crisis cannot be dealt with by means of any regulatory policy I can think of, short of draconian limits on markets – really nasty limits, which sort of undermines the whole concept of a free market. But then, maybe I just have no imagination.

If I could sit down with Chairwoman Yellen and ask her a few questions, chief among them would be: “What can macroprudential policies do in a liquidity crisis brought on by a reach for yield encouraged by your bank? Can you tell me exactly what those policies are?”

There is a bull market in complacency. The illusion of central bank control is in full force. And one of the chief ironies is that a bull market can last longer than any of us can reasonably expect – and then end more abruptly than even the most cautious bulls suspect. The St. Louis Fed Financial Stress Index is at its lowest ebb since they began calculating the index. How much lower can it realistically go? The answer is that no one really knows.

I don’t know what the trigger for the next debt crisis will be, but whatever it is, it will result in an even deeper liquidity crisis than we saw in ’08. That is just the nature of the beast.

You need to look into your portfolios, deep into your portfolios, and see what your various investments did back in 2008-09. Then take a deep, long, serious look in the mirror. Ask yourself, “Can I withstand another shock like that?” Do you think you are smart enough to pull the trigger to get out in time? Do you have automatic triggers that will cause you to exit without having to be emotionally involved? Are there illiquid assets in your portfolio that you want to own right on through the next crisis? (Let me note that there are a lot of assets about which you might answer positively, with a full-throated yes, in that regard.) Would you rather be biased to cash today, when cash is in a true bear market and at its lowest value in years, if that cash will give you the buying power to purchase assets at prices that will once again look like 2009’s? Think about how you will feel in the wake of the next crisis, when cash will be king!

You should be thinking of cash not as cash per se, but as an option on future deep-value trades. There are few truisms in the investment world that are really valid, but one of them is that you make your money when you buy. That you sold at a profit is just another way of saying that you were smart to buy when you did. There is going to come a time when buying opportunities are once again going to be all around you.