by Stephen S. Roach
Project Syndicate
October 24, 2016

NEW HAVEN – Is the Chinese economy about to implode? With its debt overhangs and property bubbles, its zombie state-owned enterprises and struggling banks, China is increasingly portrayed as the next disaster in a crisis-prone world.

I remain convinced that such fears are overblown, and that China has the strategy, wherewithal, and commitment to achieve a dramatic structural transformation into a services-based consumer society while successfully dodging daunting cyclical headwinds. But I certainly recognize that this is now a minority opinion.

For example, US Treasury Secretary Jacob J. Lew continues to express the rather puzzling view that the United States “can’t be the only engine in the world economy.” Actually, it’s not: the Chinese economy is on track to contribute well over four times as much to global growth as the US this year. But maybe Lew is already assuming the worst for China in his assessment of the world economy.

So what if the China doubters are right? What if China’s economy does indeed come crashing down, with its growth rate plunging into low single digits, or even negative territory, as would be the case in most crisis economies? China would suffer, of course, but so would an already-shaky global economy. With all the handwringing over the Chinese economy, it’s worth considering this thought experiment in detail.

For starters, without China, the world economy would already be in recession. China’s growth rate this year appears set to hit 6.7% – considerably higher than most forecasters have been expecting. According to the International Monetary Fund – the official arbiter of global economic metrics – the Chinese economy accounts for 17.3% of world GDP (measured on a purchasing-power-parity basis). A 6.7% increase in Chinese real GDP thus translates into about 1.2 percentage points of world growth. Absent China, that contribution would need to be subtracted from the IMF’s downwardly revised 3.1% estimate for world GDP growth in 2016, dragging it down to 1.9% – well below the 2.5% threshold commonly associated with global recessions.

Of course, that’s just the direct effect of a world without China. Then there are cross-border linkages with other major economies.

The so-called resource economies – namely, Australia, New Zealand, Canada, Russia, and Brazil – would be hit especially hard. As a resource-intensive growth juggernaut, China has transformed these economies, which collectively account for nearly 9% of world GDP. While all of them argue that they have diversified economic structures that are not overly dependent on Chinese commodity demand, currency markets say otherwise: whenever China’s growth expectations are revised – upward or downward – their exchange rates move in tandem. The IMF currently projects that these five economies will contract by a combined 0.7% in 2016, reflecting ongoing recessions in Russia and Brazil and modest growth in the other three. Needless to say, in a China implosion scenario, this baseline estimate would be revised downward significantly.

The same would be the case for China’s Asian trading partners – most of which remain export-dependent economies, with the Chinese market their largest source of external demand. That is true not only of smaller Asian developing economies such as Indonesia, the Philippines, and Thailand, but also of the larger and more developed economies in the region, such as Japan, Korea, and Taiwan. Collectively, these six China-dependent Asian economies make up another 11% of world GDP. A China implosion could easily knock at least one percentage point off their combined growth rate.

The United States is also a case in point. China is America’s third-largest and most rapidly growing export market. In a China-implosion scenario, that export demand would all but dry up – knocking approximately 0.2-0.3 percentage points off already subpar US economic growth of around 1.6% in 2016.

Finally, there is Europe to consider. Growth in Germany, long the engine of an otherwise sclerotic Continental economy, remains heavily dependent on exports. That is due increasingly to the importance of China – now Germany’s third-largest export market, after the European Union and the United States. In a China implosion scenario, German economic growth could also be significantly lower, dragging down the rest of a German-led Europe.

Interestingly, in its just-released October update of the World Economic Outlook, the IMF devotes an entire chapter to what it calls a China spillover analysis – a model-based assessment of the global impacts of a China slowdown. Consistent with the arguments above, the IMF focuses on linkages to commodity exporters, Asian exporters, and what they call “systemic advanced economies” (Germany, Japan, and the US) that would be most exposed to a Chinese downturn. By their reckoning, the impact on Asia would be the largest, followed closely by the resource economies; the sensitivity of the three developed economies is estimated to be about half that of China’s non-Japan Asian trading partners.

The IMF research suggests that China’s global spillovers would add about another 25% to the direct effects of China’s growth shortfall. That means that if Chinese economic growth vanished into thin air, in accordance with our thought experiment, the sum of the direct effects (1.2 percentage points of global growth) and indirect spillovers (roughly another 0.3 percentage points) would essentially halve the current baseline estimate of 2016 global growth, from 3.1% to 1.6%. While that would be far short of the record 0.1% global contraction in 2009, it wouldn’t be much different than two earlier deep world recessions, in 1975 (1% growth) and 1982 (0.7%).

I may be one of the only China optimists left. While I am hardly upbeat about prospects for the global economy, I think the world faces far bigger problems than a major meltdown in China. Yet I would be the first to concede that a post-crisis world economy without Chinese growth would be in grave difficulty. China bears need to be careful what they wish for.

October 19, 2016

More haunting even than the terrified screams of lambs being led was the silence that followed their slaughter.

Such was the searing pain of relentless recollection for FBI agent Clarice Starling, the tortured lead played to Oscar perfection by Jodie Foster. In an agonizingly whispered scene that has forever left its imprint on the minds of horrified audiences, we hear the bleating of Starling’s long-dead tormentors.

Clarice’s hushed revelations to Hannibal reveal a desperate act by her young orphaned self. Unable to bear the horror, she’s running away from the bloodbath of spring lambs being slaughtered and her cousin’s sheep ranch. Desperate to do something, anything, she struggles to drive them from their pens to freedom: “I tried to free them…I opened the gate of their pen – but they wouldn’t run. They just stood there confused. They wouldn’t run…”

A recent, reluctant re-viewing of the film, only the third in history to win the “Big Five” Oscars, Best Picture, Actor, Actress, Director and Screenplay, fed fresh food for thought. The image of captives rejecting their freedom brought to mind another flock of corralled and stunned lambs — bond market investors. They too have been given the opportunity to escape their fate. But so many choose instead to stay. Such is the reality of a world devoid of options, with time ticking ruthlessly by.

Against the cynical backdrop of bulls and bears manipulating data to plead their case, Salient Partners’ Ben Hunt’s insights stand out for their indisputability. In his latest missive he points to one chart that’s incapable of being “fudged,” to borrow his term – that of U.S. household net worth over time vis-à-vis U.S. nominal gross domestic product. Suffice it to say we’re farther off trend than we were even during the dotcom and housing manias.

Hunt asks in what should be rhetoric but is lost on so many: “Is it possible for the growth of household wealth to outstrip the growth of our entire economy? In short bursts or to a limited extent, sure. But it can’t diverge by a lot and for a long time. We can’t be a lot richer than our economy can grow.”

And yet we are. The culprit, which too few identify as such, is runaway asset price inflation led by debt markets that have grown to be unfathomably immense in size and scope. At $100 trillion, the size of the global bond market eclipses that of the $64 trillion stock market. A bigger discussion for another day comes from McKinsey data that tell us the worldwide credit market is over $200 trillion in size.

Zero in on Corporate America and you really start to get a picture of pernicious growth. According to New Albion Partners’ Brian Reynolds, U.S. commercial paper and corporate bonds have swelled by $3.1 trillion, or 63 percent, since the 2008 financial crisis. “This compares to nominal GDP growth of only 27 percent, so we are leveraging the heck out of the economy.”

For a bit more historic context, consider that U.S firms are more levered today than they were at the precipice of the financial crisis. According to Moody’s data, the median debt/earnings before interest, taxes, depreciation and amortization (EBITDA) is five times today vs. 4.2-times in 2008 for high yield companies. For comparison purposes, investment grade companies’ median debt/EBITDA is 2.6-times today compared to 2.2-times in 2008.

Michael Lewitt, the leading authority on all things credit and creator of The Credit Strategist, worries that companies are sitting on this pile of debt with not much more to show for it than, well, being in hock up to their eyeballs. “Much of this debt was incurred for unproductive purposes – buybacks, dividends to private equity owners, etc. – rather than for things that grow these businesses. Many high yield companies are not generating much, if any, free cash flow and are dependent on the ability to roll over their debt.”

On that count, there’s trouble brewing. Moody’s publishes a Refunding Index which gauges the bond market’s ability to absorb high yield bonds maturing over the next 12 and 36-month periods at the current pace of issuance. In the quarter ending in September, the one-year index was down 50 percent over the prior year while that of the three-year index was off by 40 percent continuing a protracted two-year slide. In dollar figures, three-year high yield maturities are up 45 percent year-over-year; they now total $156 billion vs. $108 billion a year ago. The flip side of these coins is that issuance is down by $13 billion.

“Debt maturities continue to increase at a rapid rate and are expected to rise to historic peaks within the next couple of years,” said Moody’s Senior Analyst Tiina Siilaberg. “And defaults are getting up there. Along with weak refinancing conditions, default rates for US speculative-grade issuers have been above five percent since May and ended at 5.4 percent in September. This compares to just 1.9% in May 2015.” Siilaberg expects defaults to peak at six percent in the coming months.

We can only hope Siilaberg is not being overly optimistic. A separate data set released by Standard & Poor’s (S&P) tallies the “weakest links,” or companies that are 10-times more likely than the broad high yield universe to default. In September, this count hit a seven-year high. For the moment, with an eye on recovering oil prices, investors seem to be operating under the assumption that stress in the pipeline is dissipating. Fair enough. But only one-quarter of the weakest links are energy firms. Chances are defaults, already at the highest level since 2009, will continue to climb.

As for the much bigger investment grade (IG) market, it’s not an energy story but rather one entangling the financial sector that promises to capture headlines in the coming months. S&P Managing Director Dianne Vazza recently warned that financials dominate the fallen angel universe, as in IG firms likely to be downgraded to high yield. The culprits include their exposure to energy firms, the fallout from municipal mayhem in Puerto Rico and weakness in global growth.

The immediate fallout for these fallen firms is a spike in borrowing costs. But even for those that manage to remain in the celestial, expenses could be poised to rise.

“The market is not waiting for Janet Yellen to raise rates on corporate debt,” warned Lewitt. “The risk is not default, but lower earnings as these investment grade companies borrowed enormous amounts to fund buybacks and dividends and have enjoyed an interest rate holiday that will sooner or later come to an end.”

That’s saying something considering that even with interest rates near their lowest on record, the interest expense among companies in the benchmark S&P 500 Industrials has been on the rise since bottoming at four percent of nonfinancial earnings in the third quarter of 2010. According to data compiled by S&P’s Howard Silverblatt, interest expense first topped six percent in the quarter ended March of this year. It remains above that level, the highest since recordkeeping began in 1993. Since then, we know borrowing costs have started to tick back up. With record debt loads, it’s safe to say many companies can simply not afford interest rates to rise off the floor.

As tenuous as the situation appears, this credit cycle may have one last rally in its gas tank. “I don’t think this is the big one,” said George Goncalves, Nomura’s Head of U.S. Rates Strategy. “However, I do view any sort of unwind of the ‘portfolio rebalancing effect’ hurting both stocks and corporate and sovereign bonds initially.” Once that panic sets in, though, expect sovereigns to regain the flight-to-quality status and stage a rally.

Goncalves does foresee one potential fly in the ointment of the relatively happy ending: “Ironically, a second Fed rate hike could trigger more currency devaluations from overseas, notably China. If the secondary markets cannot handle the volumes, it could lead to broad-based selling.”

New Albion Partners’ Reynolds doesn’t figure even an exogenous event could put the brakes on the current credit cycle. Pensions and insurers simply have too much in the way of fresh funds to deploy to allow that to happen; they’ve absorbed half of the $3.1 trillion in new issuance. Given more funds are expected to flow into pension coffers in the coming years as Baby Boomers retire in droves, there should only be more to come. So we go from the mammoth to the monumental when it’s game over.

“The cherry on top of the sundae of this credit boom is the shift away from money market funds to cash funds that take ten times the risk to get ten times the yield,” cautioned Reynolds. If you’re still game for a bit more irony, “This shift has nothing to do with the fundamentals. It is occurring solely because of the money market rule changes.”

It would appear to be only a matter of timing, and in turn, magnitude. The outcome though is undeniable. With defaults on the rise, refinancing capability in increasing danger and more distress building in the pipeline, you would think we would be hearing investors screaming. But we don’t. Just the deafening sound of silence as most in the herd refuse to be early, even if waiting with the gate to the pen open offers them ultimate salvation.

by Luke Smolinski
Risk.net
30 September, 2016

Asset managers are disregarding the chances of a lasting shift in correlation between bond and equity prices, according to experts, with pension funds particularly unprepared.  Negative correlations have been the theoretical underpinning for investors diversifying their assets for 20 years. While some are optimistic about pension funds' resilience to correlations spiking, saying their liabilities drop more than the value of the stocks and bonds they own, others suggest pension funds are less prepared for falling bond prices than at any time in the past eight years.

Jack Goss, consultant for Imagine Software, a risk management technology firm in London, thinks many on the buy side are assuming a stable correlation in their value-at-risk models and will be ignoring stress tests that forecast big losses in the eventuality that correlations shift.  "We see people at the moment fearing that correlation will suddenly start to spike… If you get high inflation, low growth, both equities and bonds will fall together and that is an issue playing on people's minds," he says.  "The market in general is assuming correlation will not return to the levels of the 1970s and 80s."

Goss suggests that rather than plugging a different correlation number into VAR, risk managers should use some form of multivariate test, in which they can assume a range of probabilities of different correlations. Expected losses here would be determined mostly by the probability of a shift, he thinks.  For example, with a model assuming a one-in-five chance of correlation moving to +0.4, the risk manager's degree of conviction would have a greater effect than the precise change in correlation expected, he points out.

Concerns are heightened by the correlation turning positive in recent months. Three-month correlation between the S&P 500 and 10-year US Treasury bond prices switched from –0.66 immediately after the UK's EU referendum to +0.27 in the last month, according to analysts from Bank of America Merrill Lynch.  In early September, both bonds and equities sold off heavily, with the S&P 500 falling 2% on September 9 and US 10-year treasury yields hitting their highest levels since June.

Meanwhile, rolling yearly world equity-bond correlations have been negative with one exception since 1998, at an average of –0.35, before which they were mostly positive with an average of +0.24 since August 1962, according to quant fund Winton.  Goss also suggests risk managers are quietly disregarding stress tests they perform, as correlation spikes are thought to be unlikely. "[Stress testing] is being done at the moment," he says, "But a lot of people sort of say, ‘Well if it happens, we're in a fairly bad way', then they shrug their shoulders and move on. A lot of the time the result is so bad, what else can you do?"  Stress tests alone in this situation fail to impel asset managers to reallocate, whereas multivariate analysis would, he thinks.

A chief risk officer (CRO) at a fixed-income hedge fund says he tends to simply compare the losses in two correlation forecasts. "One can assign probabilities to different correlations, but it's very difficult to combine [them] together in a meaningful fashion that would be easy to explain to others," he says.  A lasting shift in correlation will affect pension funds most, suggests another hedge fund CRO.

Con Keating, head of research at BrightonRock Group, a London-based insurer for pension funds, says many pension funds might overlook the history of positive equity-bond correlations before 1998 as "the market's memory really does not extend beyond about seven years".  Asked how prepared pensions funds would be for a shift in correlation, Keating says: "Not at all. Quite the opposite: bond exposures have never been as high as they are now."  "All those who did liability-driven investment or moved their bond allocations up dramatically – which would be about 80% of them – are going to be hurt, because they're going to be sitting holding a lot of bonds that have performed badly. Their discount rates will go up, which will lower their liabilities, but the aggregate effect is not going to be good," he says.  He thinks pension funds cannot defy pain by diversifying into corporate bonds, commodities or hedge funds, and suggests they hedge bond exposures with options.

Hans den Boer, chief risk officer for the UK's Pension Protection Fund (PPF), which insures around 6,000 defined-benefit pension schemes, is more upbeat about pension funds' resilience.  "If interest rates go up and equity markets stay stable, that would mean asset values would go down, but the liability side would come down quicker, so their deficit situation would improve significantly," he says.  Many pension funds insured by the PPF have fewer than 100 members and would not have the scope to model correlation probabilities, he thinks.

The UK private pension deficit rose to £408 billion ($529 billion) in July, from £222 billion in January. Eighty-four percent of UK company pensions were in deficit and total assets stood at £1.4 trillion at the end of July.  Duncan Lamont, London-based head of research and analytics at Schroders, says high inflation led to positive equity-bond correlations before 2000.  Typically since 2000, interest rates rose as growth was revised up, so bond prices fell at the same time as investors valued company stocks higher. The prospect of central banks putting up rates after years of investors bulk-buying bonds is causing concerns about the correlation switching back to positive.  "Within pension funds, they are working hard to find asset classes which are not correlated," says Lamont, pointing to commodities and insurance-linked securities as non-correlated assets.

CNBC
by Jaff Cox
October 4, 2016

Central bankers have turned investing into a casino game with an unpleasant outcome likely, bond king Bill Gross said in his latest letter to investors.

The Janus Capital fund manager stepped up his criticism of institutions like the Federal Reserve, the European Central Bank and Bank of Japan, charging that the trillions in negative-yielding debt are presenting investors with unpleasant choices.

Recalling his days many years ago as a blackjack counter in Las Vegas, Gross reasons that "central bankers cannot continue to double down bets without risking a 'black' or perhaps 'grey' swan moment in global financial markets."

"At some point investors — leery and indeed weary of receiving negative or near zero returns on their money, may at the margin desert the standard financial complex, for higher returning or better yet, less risky alternatives," he added.

Among those potential choices: Gold, which has been a favorite option for Gross in recent months, and even digital currencies like bitcoin. He does not openly advocate that kind of choice but said it's the type of option investors might consider with central bankers suppressing financial conditions.

His comments come as global central bankers step up their actions to stimulate growth, particularly inflation. For instance, the BOJ recently announced an unconventional plan for "yield curve control," which aims to keep its benchmark 10-year note yield at zero.

Estimates put the total of negative-yielding debt upwards of $11 trillion, though Gross figures it's closer to $15 trillion, posing a looming specter to markets.

"Ultimately though, in broader, more subjective terms, it is capitalism itself that is threatened by the ongoing Martingale strategies of central banks," Gross said, referencing the bettor strategy of doubling down bets in blackjack with the idea that ultimately a winning hand will come along.

"As central bank purchases grow, and negative/zero interest rate policies persist, they will increasingly inhibit capitalism from carrying out its primary function — the effective allocation of resources based upon return relative to risk," he said.

Gross' $1.5 billion Janus Global Unconstrained Fund has gained just shy of 5 percent this year, putting it in the top third of its peers but slightly behind the 5.8 percent S&P 500 return, according to Morningstar.

His most recent comments are a carryover of recent admonitions for investors to ditch most stocks and bonds and instead focus on gold and real assets.

"Central bankers have fostered a casino like atmosphere where savers/investors are presented with a Hobson's Choice, or perhaps a more damaging Sophie's Choice of participating (or not) in markets previously beyond prior imagination," Gross wrote. "Investors/savers are now scrappin' like mongrel dogs for tidbits of return at the zero bound. This cannot end well."

by Danielle Dimartino-Booth
September 14, 2016

Of all the recognized generational cohorts dating from the American Revolution, it is the 13th or the Generation X cohort which demographers find hardest to define. Did the stork deliver the first Gen X-ers as early as 1960 or as late as 1965? Was the end date for their births 1976 or 1984? And what of their collective character? At one time they were considered to be disdainful apathetic slackers, but since have become known as confident, hardworking and extremely entrepreneurial.

What is not in question is their unforgettable movie characters whose reasons for being were to make us laugh, not cry. Think Sixteen Candles’ hysterical foreign exchange student, Long Duck Dong and the impossible, too cute to rebuke truant, Ferris Bueller. And who didn’t harbor a soft spot for Pretty in Pink’s Ducky or Chet in Weird Science? It was the 80s, and even outcasts could be transformed into loveable friends on the big screen. You just can’t deny the affection we all felt for every last recipient of Saturday detention as The Breakfast Club credits rolled along to our anthem, “Don’t You Forget About Me?”

But then there was Less than Zero, which more than made up for the rest of the light-hearted lot. The 1987 hit stands as the Eighties’ testament to Film Noir replete with shoulder-pad wardrobed femme fatales, darkly doomed heroes and even nastier anti-heroes. Can anyone argue James Spader as a debt-collecting drug dealer was his least likeable character? Of course, the movie made an icon out of Robert Downey, Jr., whose stoned character gave new meaning to, ‘Don’t Leave Home Without It,’ when he tried to swipe his American Express card to gain entry to the family mansion’s (open) sliding glass door.

The film’s byline, “It Only Looks Like the Good Life,” summed up the Yuppie era to a tee, a time when U.S. households woke to the idea of aspiration, as in aspirational lifestyles. Longing to break free from their parents’ frugal ways, many Baby Boomers embraced the relatively novel world of easily accessible debt with relentless relish.

Of course, it was a different place from which to take a leap of fiscal faith. Both the saving rate and 5-year jumbo CD rate were 7.9 percent when Less than Zero was released in November 1987. Inflation, meanwhile, had finally been tamed and was running at about half the rate people were setting aside in rainy day funds.

You might be thinking, hmmm, wasn’t something else going on about then? Well, yes, of course. It would be daft to ignore the other thing that had just taken place in the weeks before the afore mentioned less than joyful downer of a movie was released, known to market historians simply as Black Monday.

Unlike the movie though, the markets didn’t end in a funeral scene. In fact, October, November and December 1987 proved to be a splendid time to jump into the markets, which investors were in fact encouraged to do by the new sheriff in town, a soft spoken Federal Reserve Chairman the world would come to revere as The Maestro.

In early May, 2000, the Wall Street Journal took the occasion of the Nasdaq finally capitulating to gravity to publish, “How Alan Greenspan Finally Came to Terms with the Market.”

Bear in mind, the Fed’s mandate was then and remains to maximize employment while minimizing inflation. Becoming an expert on stock market trading patterns isn’t buried anywhere in the fine print of its 1913 charter.

Did it take investors long to catch on to Greenspan’s new and improved mandate? Not hardly. Interest rate moves were not announced back then. Still, investors could plainly see the dramatic decline in yields as the Fed pushed the fed funds rate down by a half a percentage point, to just below seven percent the Tuesday after that fateful Monday in 1987.

As Reuters columnist James Saft wrote on the 25th anniversary of the crash, “The response, like a kid given its first sugary soda, was electric, with a strong rally winning back a small portion of the earlier losses. The Fed kept at it in the coming months, operating quite publicly, and often giving trading desks advance notice, and repeatedly taking overnight interest rates lower.”

With that, the rules of the game changed. Traders began gaming the Fed and profiting from the increased confidence that stock prices were front and center for policymakers.

Of course, households had nothing to complain about as many rode this stock market wave to paper riches. Pray tell, how did they respond to this wealth accumulation? For millions of Yuppies, the answer came down to shopping till they dropped.

Households had piled on upwards of $160 billion in credit card debt as the New Year rang in on 1988. But that was nothing compared to what was to come with the advent of securitization one year later. Care of deregulation, another gift Greenspan bestowed upon the financial markets, lenders began to sell off slices of credit card-backed debt to an investor class that grew hungrier for cash equivalent income as interest rates embarked upon the decline of a lifetime.

The more yields slumped, the stronger the demand for all manner of asset-backed debt. Of course, we all know how this story ends. What began with car loans and credit card balances eventually led to bonds backed by home mortgages and ultimately the subprime crisis.

Households’ response would surely have been a curiosity to those who lived through the Great Depression. But that culture of prudence had long since been written into the history books as a curiosity of its own. What replaced the frugality was in a word, perverse. The more households were worth, the less actual money they had in the bank.

Before all was said and done, credit card debt was pushing $1 trillion and the saving rate had plumbed new lows, as in into negative territory, as home equity was cashed out hand over fist. Americans were spending more than they were taking in at the greatest clip since the Great Depression.

Of course, all of this bad behavior came to a crashing halt with the advent of the other event that merited a ‘Great’ label — the Great Recession of 2009. After peaking north of $1 trillion in December 2008, credit card debt eventually troughed just below $800 billion in April 2012. Until very recently, the growth rate of credit card debt was unremarkable; the total outstanding continuously bumped up against a $900 billion ceiling.

Last year, though, the cycle finally turned and for the better if you ask most economists. According to Standard & Poor’s, at $969 billion, revolving credit is at the highest level since April 2009, before the bottom completely fell out of the economy. This figure, which is once again flirting with a ‘trillion’ handle, is up $54 billion over the last 12 months. This ‘improves’ upon the $12 billion, $34 billion and $46 billion gains over the same 12-month periods ending in 2013, 2014 and 2015 respectively. We are told that increased usage of credit is a sign of confidence, a sure signal that households view the job market’s prospects as healthy looking ahead.

Indeed, consumers’ median household income growth expectations rose to 2.9 percent in August from 2.8 percent in July and 2.75 percent in June according to a report the New York Fed released September 13th. Why then do their expectations for missing a debt payment remain near the highest level in two years? Moreover, why did consumers’ spending growth expectations decline to 3.3 percent in August from 3.8 percent in July and 3.6 percent in June?

According to the NY Fed, the downshift in expectations reflects consumers over the age of 40 and lower income households. That’s intuitive enough if you consider these two cohorts get hit hardest by healthcare and rent inflation, both of which are running at twice the pace of income growth. Perhaps a separate part of the story is rising minimum wages in many parts of the country. Do rising prices for necessities thus connect the dots between rising income and falling spending expectations?

It’s hard to say for sure without conducting a comprehensive survey of every working American. On a more philosophical level, one must stop and ask whether it’s a good thing that car, student and soon-to-be credit card borrowing all surpass $1 trillion?

Surely living within one’s means was once the American way for good reason before low interest rates and lax lending standards encouraged that standard to be stood on its head. Presumably the debate will rage on until the stock market pulls back and/or interest rates rise, or even worse, both.

High income earners dominate consumer spending but can also bring the economy quickly to its knees. A falling stock market could thus trigger a recession given consumption is the only pillar of strength remaining in the current recovery. As for rising interest rates, households, corporations and especially Uncle Sam can hardly afford that prospect to become a reality, especially in the uncontrolled manner they’ve risen since rates bottomed in July with nary a Fed rate hike to catalyze the move.

Falling stock prices and rising interest rates occurring concurrently is thus a central banker’s worst nightmare. Such an impossible scenario unfolding would be a dark ending to a 30-year feature film all about a party that never seems to end, until it does erasing so many facades and leaving the simple reality that it only looked like the good life. Nothing in life is free. And sometimes the payback can be less than zero.

by Michelle Fox
CNBC
Tuesday, 13 Sep 2016

Central banks have created a bubble in the stock market, which will come down "very, very hard" when it finally prices in a series of Federal Reserve rate hikes, Black Swan investor Mark Spitznagel said Tuesday.

While the collapse of the bubble isn't a Black Swan event in the sense that it is not an unforeseen or unpredictable event, Spitznagel said he would still call it one because the market is pricing it as a Black Swan.

"The markets are absolutely not positioned for this," the chief investment officer for Universa Investments said in an interview with CNBC's "Power Lunch."

 And when the collapse happens, it will be across the board, Spitznagel warned.

"There is one big bet out there. So diversification isn't really going to work. Timing this is not going to work," he said. "These low rates and this high valuation means that they're extraordinarily sensitive to changes in rates, extraordinarily sensitive to risk premiums and growth."

The Fed's policymaking committee meets next week and could possibly raise interest rates.

However, Spitznagel believes the market isn't pricing in a rate hike because there is collective psychology that the Fed can keep things going and is in control.

"In fact, central banks are not in control. In many ways central banks are the tails wagging the dog," he said, pointing out that central banks' balance sheets are "minuscule" compared to the whole global and derivatives market.

Spitznagel looks to profit during so-called Black Swan events. Universa Investments, which manages about $6 billion in assets, specializes in protecting investors against sharp market drops.

He said he invests with "extreme asymmetric payoffs, which means very infrequently I want them to have a huge payout, and most of the time I want to just kind of bob around, maybe lose a little bit."

He called it "insurance-like protection."

Spitznagel's bets have paid off handsomely. Last August, his firm made more than $1 billion in a single day after the Dow Jones Industrial Average collapsed more than 1,000 points, according to The Wall Street Journal.

by Ambrose Evans-Pritchard
The Telegraph
14 September, 2016

The growth rate of nominal GDP in the US has fallen to 2.4pc, the lowest level outside recession since the Second World War.

It has been sliding relentlessly for almost two years, a warning signal that underlying deflationary forces may be tightening their grip on the US economy.

Given this extraordinary backdrop, the violent spike in US and global bonds yields over the last four trading days is extremely odd. It is rare for AAA-rated safe-haven debt to fall out of favour at the same time as stock markets, and few explanations on offer make sense.

We can all agree that oxygen is thinning as we enter the final phase of the economic cycle after 86 months of expansion. The MSCI world index of global equities has risen to a forward price-to-earnings ratio of 17, significantly higher than on the cusp of the Lehman crisis.

"We think that too much complacency has crept in," says Mislav Matejka, equity strategist for JP Morgan.

"After seven years of having a structural overweight stance on global equities, we believe the regime has fundamentally changed. We think that one should not be buying the dips any more, but use any rallies as selling opportunities," he said.

The correlation between bonds and equities has reached unprecedented levels, and that has the coiled the spring. The slightest rise in yields now has a potent magnifying effect across the spectrum of assets. Hence the angst over what is happening to US Treasuries.

Yields on 10-year Treasuries - the benchmark borrowing cost for international finance - have jumped 19 basis points to 1.72pc since the middle of last week. The amount of global government debt trading at rates below zero has suddenly fallen from $10 trillion to $8.3 trillion, with parallel effects for corporate bonds.

You would have thought that inflation was picking up in the US and that the Fed was about to slam on the brakes, but that is not the case. The markets are pricing in a mere 15pc chance of a rate rise next week, and the figure has been falling.

If anything, the US inflation scare has subsided. There were grounds for worrying earlier this year that Fed would have to act. In February, core CPI inflation was steaming ahead at a rate of 2.9pc on a three-month annualized basis. This has since dropped back to 1.8pc. Other core measures are lower.

It is striking that markets do not believe that the Fed will hit its 2pc inflation target for the next 30 years, based on the pricing of the "TIPS" breakeven curve. Michael Darda from MKM Partners says it would be "utterly absurd" for the Fed to give in to the chorus of calls for a rate rise in such circumstances.

Fed governor Lael Brainard clearly agrees. Far from capitulating to the hawks - as many expected - her speech on Monday night warned that business investment has been falling for the last three quarters, and now the housing market is softening too.

She said the real "neutral" rate of interest has fallen to zero, and that there is no margin for error. It would be very hard to extract the US economy from Japanese-style trap if the Fed ever allowed it to happen.  "This asymmetry in risk management in today's "new normal" counsels prudence in the removal of policy accommodation," she said.

Even if the Yellen Fed does raise rates next week, the move will be hedged with such "dovish guidance" as to neutralise the effect. In short, the Fed cannot plausibly be responsible for the global bond rout.

What is true is that markets fear the Bank of Japan and the European Central Bank are reaching their political limits, and may not be allowed to press ahead with their experiments even if they want to.

Japan's Governor Haruhiko Kuroda has had his wings clipped by critics in the ruling party of Shinzo Abe, alarmed that the BoJ is swallowing up the financial system. They forced him to carry out a "comprehensive review" of his policies.  "Japan has reached an inflexion point. The BoJ is clearly cornered," said Stephen Jen from Eurizon SLJ Partners.

The bank already owns 12pc of Fast Retailing and 13pc of the technology group Advantest, and these holdings are heading for 20pc next year as a mathematical effect on current policy. Japan's market economy is being nationalised.

The BoJ will soon hold 50pc of all Japanese government bonds. It is monetising the entire budget deficit. Mr Jen says the central bank is nearing the fateful point where it will have no exit strategy if inflation ever does recover, a worry shared by officials at the International Monetary Fund.

A variant of this political saga is playing out in Europe, where the ECB's Mario Draghi has lost the confidence of the German elites. "Instead of new and always more extreme measures we need a little patience,” were the acid words of Sabine Lautenschläger, Germany's member on the ECB's executive board.

The Bundesbank's balance sheet has surged sixfold to €1.2 trillion and it has built up claims of €660bn on other eurozone central banks through the Target2 payment system. Italy's liabilities have reached an all-time high of €327bn, mostly owed to the Bundesbank.

The ECB's fateful decision to opt for negative rates - now minus 0.4pc - in the face of vehement German protest was a step too far. The savings banks and insurers want Mr Draghi burned at the stake. Finance minister Wolfgang Schauble blames him for the gains of the right-wing AfD party.
It is true that Mr Draghi's €80bn package of bond purchases each month is no more proportionately than prior QE schemes by the Fed and the Bank of England, but the political effects are toxic within the awkward structure of the eurozone.

As markets discovered last week, he may have trouble securing German assent for an extension of QE when it expires in March. Investment funds are already reeling back their QE bets. Less bonds may be bought after all.

This is why yields on 10-year German debt are suddenly above zero again after three months in the underworld, with parallel moves in France, Holland, and Spain - and bigger jumps in Italy and Portugal. The European taper tantrum has begun.

Bond yields in Europe are clearly not rising because growth is picking up and inflation looms.  Industrial output slipped 1.1pc in July. France and Italy are in stagnation. The share of items in the eurozone inflation basket increasing at less than 1pc is spreading, a precursor of deflation. In other words, yields are rising for the "wrong reason" in Europe.

We are entering dangerous waters. Markets are losing faith in the central bank "put", but governments are not yet willing to step into the breach with fiscal stimulus to keep the global show on the road. This is how accidents happen.

by Sophie Shevardnadze
12 September, 2016

Sophie Shevardnadze: Professor Nassim Nicholas Taleb, it’s a real pleasure to have you on our show today.

Nassim Nicholas Taleb: Thank you, I’m honoured to be here. Thanks for inviting me.

SS: You’ve said that there’s no way to control economic cycles and prevent crashes, right? So, basically, I quote: “what we need is citizens to become robust to them and to be immune to their impact”. Now, how does that happen in a real world? How can you make yourself immune?

NNT: So, before that, let’s talk about the error of trying to control economic cycles. It’s sort of like doctor trying to micromanage your body temperature. If you take anything organic and you try to control its variability, you’ll end up with less variability than you started with but the system would become more fragile. Take a forest. If you micromanage a forest to try to extinguish every single fire, you’ll end up with a lot of flammable material and you’ll have a forest with no cycles and the first fire you can’t control will destroy your forest. The same thing will happen with the economy. In order to micromanage the cycle… if you have no volatility for a long time, you never have a dip in economic activity – what happens to businesses that are around? You’re going to have a lot of fragile businesses, and so a lot of flammable material, so to speak, and these businesses… we will have more and more of them, okay, and the first crisis that you can no longer control will be vastly deeper than otherwise. So, a little bit of variability in the economy is very healthy.

SS: So, basically, not ever trying to control or prevent a crisis is what makes you immune to the next one?

NNT: Exactly. So what do you do is, maybe, manage a big crisis, but the small ones – let things take care of themselves.

SS: Do you have a precise example of, like, when that happened in a country?

NNT: Okay. We can talk about the U.S. There’s a fellow called Alan Greenspan, who discovered the business cycles and discovered monetary policy on the job. He came to the Fed in 1980s, around 1987, right before the crisis, the Crash, and he realised that, hey, you can lower rates and inject funds in a system to prevent crisis from happening. In 1987 it was very useful and allowed us to recover from the Big Dip in the stock market – it was the biggest crash ever, a one-day crash. We came back and it was good. So he thought he had the magic formula, and had you given him nature he would eliminate seasons. So he tried to do the same thing – every time the first sign of a problem, he would lower rates. So what happened is that he lowered rates so much that now we have rates at zero, we can no longer lower them, so we lost the effectiveness of that monetary policy. So, not only that, but we can’t bring rates back to their original level because the whole thing may collapse, and everybody is extremely scared of raising back rates. So, here you see what happened – 1987, 1991, 2000, again, 2002, and then again, I think, a couple of times, you know, micro-times after that. So he tried to manage a cycle. The way you should do things is be there for big problems, and let small things to care of themselves.

SS: I just came out of your lecture and you’ve said something very interesting that if you had a choice, you’d rather invest in Russia than Saudi Arabia. Now, for many that sounds odd. Can you explain why?

NNT: Let me explain that idea. The first thing, I’ve always hesitated to talk about the investments I don’t have.

SS: But you’re a philosopher, so you can talk about that.

NNT: My scheme in the game ethics force me to have something at risk – and currently I have nothing at risk in Russia, but thank God, nothing at risk in Saudi Arabia. Let me explain the point – if you look at history, you’ll realise that companies, countries, entities -let’s call them entities – that have sustained more trauma in this recent history, like a stock that bounces back, goes through hell and comes back, generally have given us information about how much heat they can sustain. So, on that account, the fact that Russia went through the problems of early 1990s shows that the system can handle a huge drop in economic activity, a huge rise in unemployment, severe disruptions in the institutional structure without falling apart. Now we have that, okay. We have that evidence. Russia has things that Saudi Arabia doesn’t have, okay. Iran, for example, compared to Saudi Arabia – these countries can take a lot of volatility. So, I’m much more comfortable in a place like that because I know that social order is not likely to collapse, no matter what happens. Saudi Arabia – I don’t know if SA can go through the dip in oil prices, I don’t know what would be the catalyst, but I know that eventually something is going to collapse.

SS: But then there’s another problem – Russia, like you’ve pointed out, has gone through so much chaos and crises and volatile situations that we really built our anti-fragility gene and we have a very high ability to adapt.

NNT: I don’t think Russia is antifragile, yet. I think it is robust.

SS: Let’s talk about that, because I feel like we know how to adapt but then this sort of high-ability to adapt has in some way turned into…

NNT: Complacency.

SS: Indifference, yeah. Like, instead of tackling the problem you’re just accepting it, basically. How do you overcome that?

NNT: It is a problem of Russia. If you take countries like what you see in South East Asia and places like that, these countries went through shocks and they bounce back with a vengeance. They came back with a vengeance. We know that China will have a problem, it will be some kind of economic problem that will lead to some kind of restructuring, maybe organic restructuring, and China will bounce back and impress everyone again. Now, Russia, you have two or three things hindering Russia. Let’s talk about them. When people talk about Russia – I don’t care about geopolitics, geopolitics has absolutely nothing to do with anything – what matters are two things. First one, you need a huge pool of middle-sized companies. You can retain your structure, you need a lot of small companies, the middle market that really made Germany. The second one you need to find ways to stop your brain-drain. In my field – probability theory – out of the 20 top names maybe 14 are Russian – I mean, this is mind-boggling. No field is dominated by any nationality to that extent. So, you don’t see that many Germans, you see few French people, you don’t see that many people from the UK. So where’s that talent? That talent is being exported, right? So that’s the problem of Russia, Russia needs to deal with its brain-drain and with middle-size companies. Now, maybe they’re connected, maybe you can find ways to encourage people to stay, I don’t know, give them some emotional support – whatever. I don’t know how these things are done, but I am saying that this is a problem of Russia.

SS: We keep bringing up China – is it a worrying sign that there are some real problems in Chinese economy, what would that mean for the world economy?

NNT: What you’re saying is journalistic, and let me explain why. I’m going to give you a bit of hard time.

SS: Please.

NNT: You can frame things the way you want – I can look at the story of China, I don’t have the exact numbers, and I can tell you “Well, in the past 10-15 years it rose by that amount”, but I can look at the losses of the past two weeks – right. So, it depends on how you frame China. You’ve got to see where they started, where they’re now. If you frame it journalistically, people are going to take the most sensational. But journalists don’t invest, and investors don’t work for newspapers… So let’s frame it properly – I see zero problem in China so far. I am much more worried about things that have been fuelled by low interest rates, like the U.S., where we created inequality with economic policy that lowered rates monstrously, so assets went up disproportionately, stock market, real estate and luxury areas, and not for the regular American family. This I am more worried about and I am more worried that we may have a more severe effect from a drop in asset prices in U.S. Plus, we have to realize that the Chinese stock market is huge and the other thing for the rest of the world is that the Chinese don’t buy stuff from the rest of the world.

SS: We buy from them.

NNT: I mean, I computed that the entire U.S. export to China is less than what’s sold in Walmart – I mean, it’s still substantial, but it’s few points, one point of GDP or two points… It’s more of a psychological thing than a practical thing. On the other hand, a slowdown in the U.S. would affect the Chinese big time. So you’ve got to worry about the U.S., not about China, if you’re concerned about China.

SS: I want to talk to you about debt. You’ve said that debt actually causes wars, it’s never good, it’s never accumulated in moderation – well, today the world is suffering from vast debt. If you compare it to 2007 it has accumulated $57 trillion. Countries like China and America that we’ve been talking about – how are they going to deal with their debt? Austerity, more borrowing, maybe defaulting? What’s your take.

NNT: That’s what worries me. Governments engage in debt. Why? Not because governments ever say “okay, economic policy means we going to have to borrow” – the point is that, the French government, for example, I think when I wrote “The Black Swan” I looked at 53 out of 54 years – they’ve underestimated their deficit, okay. That’s where debt comes in. So it’s something that civil servants who don’t understand, who underestimate uncertainty, have to face, when they raise what they can’t raise via taxation they raise via debt, and try to inflate things out of the system. So this is why debt is not very good. Now, if you read economic textbooks, they give you some models in which debt works, but then if you put the meta-model on top, much more rigorous analytically and takes into account model errors, then you realise that debt compounds all these problems that you have, beyond certain small amount to help families. This is why debt is not a good thing. Where we are now today? The crisis, the debt crisis, had the huge rise in debt, again, for businesses that do not necessarily need that debt, that’s a speculative thing, and they kept going. After the crisis we had a lot of borrowers who were not… you know, shouldn’t be borrowing. Who paid the price? The taxpayers. How? Because private debt was transformed via magic wands into public debt. That’s not good, you see.

SS: So what now?

NNT: Now that we have a lot of debt, we’re facing situation where shrinking the debt would cause a huge contraction of economic activity. That is where we’re facing problems, so my point is that we should educate people, to undo all this debt we need education, we need to send the message that debt is not good. We can give them examples that Microsoft wasn’t built on debt, Apple is not built on debt. Name a company that is successful and let’s look at its debt history, and name a country that was successful, or the phase when it was successful and let’s look at its debt history , and you can realise that debt is something that economists like to promote simply because it’s good for civil servants, that’s it. So educate people to avoid debt.

SS:You have a recurring theme of forecast and how it’s silly to actually base your predictions analysing history or economics because it gives you a false illusion of knowing the world that you live in today. So, if you can’t really analyse your mistakes, right, you can’t analyse history – is there really no effective way to measure risks to predict the outcome, ever?

NNT: Of course, you can. That was my lecture, that’s my last book, that’s everything I’ve done – I keep explaining that, this, I know, is very fragile, I know what would break it, but I cannot forecast with precision when it would break. But I know this is breakable, much more breakable than a styrofoam cup. So, we know that, we know which companies are likely to go bust, so we can measure fragility. You cannot predict the event, but you can say that company with debt for example cannot sustain the stress that the company without debt would be able to go through. Decentralised system can withstand shocks a lot better than a centralised system. Organic, self-organised system – and that’s complexity theory – let’s take the restaurant business, which is the ideal business. Have you ever had a restaurant crisis in the West?

SS: Nowhere, not only in the West.

NNT: Nowhere. So, government doesn’t have to bail out restaurants. Why? Because it’s… it seems disorganised, but it’s very well organised, a self-organised system, in which people make their mistakes and go bust early, you see. And then they can start again, and consumers have the optimal price almost all the time, except in form of a payup, and you don’t have bailouts, you don’t have a generalised restaurant crisis, not like the banking crisis or not like a car-maker crisis. This system is not based on prediction, this system operates in a way that is organically very stable. Nature does not predict, what nature does is focus on robustness, and the metaphor I’ve used in the past is that nature or God – depends on your theology – gave you two kidneys. You don’t need two kidneys, you can operate perfectly on one, except that second kidney allows us to not have to predict the environment, so you don’t have to know exactly what will cause you to lose the kidney. So, it’s the same thing with corporations. If you have a buffer, some layers of redundancy, you can withstand economic shocks and you don’t have to hire some economist. And then let’s look at the track record of people in prediction – zero! Let’s go back to the point of forecasting, let me summarise – forecasting is the province of the charlatans. Unless it’s done properly. You can say rigorously that “this is fragile”, “this bridge is going to collapse”, instead of predicting what and where and who. You can build a better bridge. And forecasting makes you fragile because those who forecast develop overconfidence about the future and start to engage in debt and other risky activities. Look at track record of forecasting – pitiful.

SS: Can I ask you something – to what extent should we be accepting our fate?

NNT: I’ve spoken to a lot of people. A lot of people, a lot of successful people, a lot of unsuccessful people. It seems to me that those who have the best control of their environment are those who think that the environment is more random. And those who think that it’s all, you know, we can get the cause and effects and we can see everything, there’s no opacity – these people are the ones who fail. It’s very strange that those who succeed are those who control randomness the best by accepting that it’s there and working the best around the corners of things that are predictable and that other people are not predicting. You see, because, there are some pockets of predictability, I know that something very fragile is going to collapse. If you accept that unpredictability, then you engage in tinkering, so that when you’re wrong it will cost you little and when you’re right, it will make you a lot. It’s not what happened to the world that counts, it’s your strategy of minimising shocks from random events and opening up for the good randomness.

SS: Talking about “Black Swans”, I mean, we live in a very fast-paced world, and it’s very unpredictable. Do you feel like because everything’s happening so fast, there’s going to be more and more “black swans” to come? Are we to expect more of them?

NNT: The only thing that’s happening today in our world is that we have more connectedness, therefore things can happen much faster than before. I wouldn’t worry about one central thing, because it’s not just money, it’s viruses, viral bacteria, germs.

SS: Ebola?

NNT: For example. I was very depressed when I saw reaction to Ebola.

SS: Because that’s more dangerous than spread of ISIS, in your opinion?

NNT: That’s much more dangerous than anything because it multiplies, it multiplies very quickly. The world has had one plague and today  everything seems under control. ISIS is definitely not the danger. They’re good on Youtube, but it’s not… the Millennials, if you’re talking about indigo generation, the millennials seem to care more about what happens on Youtube than reality, alright, and hopefully that would change through selection, but the worry is not Al-Qaeda, it’s not these guys. These guys are less dangerous than… it’s a fraction of suicides in the West, it’s a fraction of people killed falling from ladders – it’s nothing. The point that you have to worry about is the fact that the plague was travelling at the speed of 30 miles a day, maximum speed. Today, what is it?

SS: We don’t know, where’s Ebola now?

NNT: Tomorrow I go back to New York and I’m going to be travelling several thousand miles in 10 hours… So, you realise, it will multiply much faster. So, Ebola was not the problem, but something similar… And what depressed me was the reaction by people, the complacency. They don’t realise that something like that needs to be systematically stopped at its source. You see, you don’t wait for things to multiply. Lucky countries like Singapore, places like that, they understand the point, but we need a little bit more active management of… you know, we need to sit down and say – ok, what if we have another ebola, how do we manage it? The journalists are using what I call “naive empiricism” of comparing it to other bigger diseases – yeah, but cancer is not doubling every week. You don’t have to worry, it’s not an epidemic, it’s just something that we have. Diabetes kills a lot of people, but the odds of that number changing hugely from year to the next are very small. These things are locally predictable. But Ebola has much higher degree of unpredictability because of what I call the “extreme strain” the “fat tail”, so this is a Black Swan domain, the Black Swan territory and we have to take it seriously. So, not Ebola, other things like that, we’re not equipped today. Tomorrow, if there’s an emergency like Ebola, you know… We have a very well organised system to prevent terrorists from travelling, you know, everybody’s blocking them and cooperates, but we don’t have the same level of cooperation to immediately stop the spread of something of this sort. That worries me because, one thing, antibiotic resistance is serious.

SS: Do you have power in you for one more question?

NNT: Yeah, of course.

SS: I know that “Black Swan” has been huge. A lot of world leaders love your book. If politicians were to embrace your thinking, what would that mean for politics?

NNT: I don’t pay attention to politicians. I am blunt about it because I think that politicians play a smaller role than you think. Politicians are more like actors put on a job and then they respond via polling, the environment and stuff like that. I don’t pay attention to politicians, I pay attention to… the structure of political life, unfortunately, has not been very adapted to the nature of the complex system that we have. So, I don’t pay attention to politicians at all. For me they don’t exist. It’s a parallel world and I don’t want to be part of it, I don’t want to go to Davos, I don’t want  to do this or do that, I don’t want to advise anyone, I don’t want to be advised by anyone. It’s a separate world for me.

SS: Alright, hopefully, they will listen more to you, because I still live in a world where politics decide a lot of things. Thank you very much for this interview, it’s been a pleasure.

NNT: Thanks.

by Ambrose Evans-Pritchard
The Telegraph
9 September 2016

Large parts of the eurozone are slipping deeper into a deflationary trap despite negative interest rates and one trillion euros of quantitative easing by the European Central Bank, leaving the currency bloc with no safety buffer when the next global recession hits.

The ECB is close to exhausting its ammunition and appears increasingly powerless to do more under the legal constraints of its mandate. It has downgraded its growth forecast for the next two years, citing the uncertainties of Brexit, and admitted that it has little chance of meeting its 2pc inflation target this decade, insisting that it is now up to governments to break out of the vicious circle.

Mario Draghi, the ECB’s president, said there are limits to monetary policy and called on the rest of the eurozone to act “much more decisively” to lift growth, with targeted spending on infrastructure. “It is abundantly clear that Draghi is played out and we’re in the terminal phase of QE. The eurozone needs a quantum leap in the nature of policy and it has to come from fiscal policy,” said sovereign bond strategist Nicholas Spiro.

Mr Draghi dashed hopes for an expansion of the ECB’s monthly €80bn (£60bn) programme of bond purchases, and offered no guidance on whether the scheme would be extended after it expires in March 2017. There was not a discussion on the subject.

“The bar to further ECB action is higher than widely assumed,” said Ben May from Oxford Economics.

The March deadline threatens to become a neuralgic issue for markets given the experience of the US Federal Reserve, which suggests that an abrupt stop in QE stimulus amounts to monetary tightening and can be highly disruptive.

The ECB has pulled out all the stops to reflate the economy yet core inflation has been stuck at or below 1pc for three years. Officials are even more worried about the underlying trends. Data collected by Marchel Alexandrovich at Jefferies shows that the percentage of goods and services in the inflation basket currently rising at less than 1pc has crept up to 58pc.

This is a classic precursor to deflation and suggests that the eurozone is acutely vulnerable to any external shock. The figure has spiked to 67pc in Italy, and is now significantly higher that it was when the ECB launched QE last year.

The eurozone should have reached economic “escape velocity” by now after a potent brew of stimulus starting last year: cheap energy, a cheaper euro, €80bn a month of QE, and the end of fiscal austerity.

Yet all the eurozone has achieved is growth of 0.3pc a quarter. France and Italy have both slowed to a standstill.

The euro’s trade-weighted exchange rate has crept up by 7pc since QE began, and it has continued to rise even since the ECB cut interest rates to minus 0.4pc.

“The euro is far stronger than they want, and stronger than the economy deserves, but they don’t know how to weaken it. This is exactly what happened to the Japanese,” said Hans Redeker, currency chief at Morgan Stanley.

Mr Redeker said the eurozone’s current account surplus – now running at €350bn, or 3.3pc of GDP – is feeding the deflationary dynamic. Since European banks are shrinking their balance sheets and repatriating money to meet capital rules, they cannot recycle the eurozone surplus abroad. This is creating a chronic bias towards a stronger currency.

Work by the International Monetary Fund shows that “lowflation” – even short of deflation - causes to a host of debilitating pathologies. It holds down nominal GDP and makes it even harder to work off high-debt ratios.

In theory,  Mr Draghi could resort to even more radical measures but the scope is limited and he is walking through a political minefield. Public trust in the ECB has collapsed in several countries and the mood in Germany has turned toxic. The German banking and insurance lobbies have accused the ECB of destroying their business models with negative rates.

Deutsche Bank’s chief economist David Folkerts-Landau said the ECB had gone beyond the point of diminishing returns and was now itself a threat to the eurozone.  “Central bankers can lose the plot. When they do, their mistakes can be catastrophic. After seven years of ever-looser monetary policy there is increasing evidence that following the current dogma risks the long-term stability of the eurozone,” he said.

This is unfair to Mr Draghi. The great macroeconomic errors were made long ago from 2010 to 2012 when drastic austerity and premature rate rises pushed the region into a double-dip recession.

Yet ECB officials confess that they may be close to the “economic lower bound”, where any gains to be eked out from more stimulus are outweighed by poisonous side effects.

The ECB network is running out of assets to buy since it can purchase only in proportion to the size of each national economy, a precaution against backdoor bail-outs of insolvent states.

The eurozone no longer seems to have an activist policy. It is treading water and at the mercy of external forces. The danger is that the next global downturn will strike before the currency bloc has escaped its current malaise and before it has built up any defences against a deflationary shock. Mr Draghi will not be able to rescue them a second time.

by Kevin Warsh, a former member of the Federal Reserve board, is a distinguished visiting fellow in economics at Stanford University’s Hoover Institution.
August 24, 2016


The conduct of monetary policy in recent years has been deeply flawed. U.S. economic growth lags prior recoveries, falling short of forecasts and deteriorating in the most recent quarters. This week in Jackson Hole, Wyo., the Federal Reserve Bank of Kansas City hosts the world’s leading central bankers and academics to consider monetary reform. The task is timely and consequential, but the Fed needs a broader reform agenda.

Policy makers around the world neither predicted nor can adequately explain the reasons for current inflation readings below their targets. So it is puzzling that so many academics are pushing to raise the current 2% inflation target to a higher target of 3% or 4%. In the telling of the economics guild, the Fed’s leaders should descend from the Grand Tetons with supreme assurance that their latest monetary policy invention will remedy the economy’s ills.

The Fed’s leaders should not take the bait. Raising the inflation target is a bad idea being considered at the wrong time for the wrong reasons.

A new inflation target would undermine the Fed’s commitment to any policy framework. It would please the denizens of Wall Street who pine for still-looser Fed policy. And households would be understandably miffed to receive a new lecture on unconventional monetary policy—this one on the benefits of higher prices.

A change in inflation targets would also add to the growing list of excuses that rationalize the economic malaise: the persistent headwinds from the crisis of the prior decade, the high-sounding slogan of “secular stagnation,” and the convenient recent alibi of Brexit.

A numeric change in the inflation target isn’t real reform. It serves more as subterfuge to distract from monetary, regulatory and fiscal errors. A robust reform agenda requires more rigorous review of recent policy choices and significant changes in the Fed’s tools, strategies, communications and governance.

Two major obstacles must be overcome: groupthink within the academic economics guild, and the reluctance of central bankers to cede their new power.

First, the economics guild pushed ill-considered new dogmas into the mainstream of monetary policy. The Fed’s mantra of data-dependence causes erratic policy lurches in response to noisy data. Its medium-term policy objectives are at odds with its compulsion to keep asset prices elevated. Its inflation objectives are far more precise than the residual measurement error. Its output-gap economic models are troublingly unreliable.

The Fed seeks to fix interest rates and control foreign-exchange rates simultaneously—an impossible task with the free flow of capital. Its “forward guidance,” promising low interest rates well into the future, offers ambiguity in the name of clarity. It licenses a cacophony of communications in the name of transparency. And it expresses grave concern about income inequality while refusing to acknowledge that its policies unfairly increased asset inequality.

The Fed often treats financial markets as a beast to be tamed, a cub to be coddled, or a market to be manipulated. It appears in thrall to financial markets, and financial markets are in thrall to the Fed, but only one will get the last word. A simple, troubling fact: From the beginning of 2008 to the present, more than half of the increase in the value of the S&P 500 occurred on the day of Federal Open Market Committee decisions.

The groupthink gathers adherents even as its successes become harder to find. The guild tightens its grip when it should open its mind to new data sources, new analytics, new economic models, new communication strategies, and a new paradigm for policy.

The second obstacle to real reform is no less challenging. Real reform should reverse the trend that makes the Fed a general purpose agency of government. Many guild members believe that central bankers—nonpartisan, high-minded experts—are particularly well-suited to expand their policy remit. They fail to recognize that central bank power is permissible in a democracy only when its scope is limited, its track record strong, and its accountability assured.

The Fed is suffering from a marked downturn in public support. Citizens are rightly concerned about the concentration of economic power at the central bank. Long after the financial crisis, the Fed holds trillions of dollars of assets that would otherwise be in private hands. And it appears to make monetary policy with the purpose of managing financial asset prices, including bolstering the share prices of public companies.

With the enactment of the Dodd-Frank Act, the Fed claims the mantle of reform. It now micromanages big banks and effectively caps their rate of return. The biggest banks’ growth in market share corresponds to that of their principal regulator. They are joint-venture partners with the Fed, serving as quasi-public utilities. As the dispenser of fault and favor, the Fed is contributing to the public perception of an unfair, inequitable economic system. Real reform this is not.

Most gathered in Jackson Hole will judge that the Fed’s aggressive actions are necessary and wise. Even if that were true, the Fed finds itself in an increasingly untenable position. Congress will tag the Fed for its failures, and the public will assail the Fed for favoritism for its ostensible successes.

In the best of circumstances, the U.S. economy will accelerate to “escape velocity.” In that event the Fed might get the benefit of the public doubt.

If, as is more likely, the economy is closer to recession than resurgence, the Fed is poorly positioned to respond with force, efficacy and credibility. The Fed is vulnerable. Its recent centennial as our nation’s central bank should not be confused with its permanent acceptance in the American political system.