1. Home
  2. The Big Conversation
  3. Episode 31: Monetary madness is not the answer
Roger Hurst on a blue background. The words Monetary madness is not the answer sits to his right

Episode 31

Monetary madness is not the answer 

Published on: June 3, 2020 • Duration: 18 minutes

This week we look at the latest conversations about monetary policies that continue to stack the rebound in favor of risk assets and large corporates, at the expense of the real economy. Are these policies continuing to damage the economy despite the recovery in equities? The Chatter looks at the sell-off in the US dollar and puts the bull vs bear debate in historical context. The Whisper looks at the potential rise of both bankruptcies and the zombie company.

  • Last week, the New York Federal Reserve President, John Williams, raised the prospect of yet another form of unorthodox accommodation to try and help juice some economic growth. So far, it would appear that monetary policy over the last decade has hindered rather than helped productivity. So what's this new policy? And will this one work? That's The Big Conversation. 

    Central bankers have been attempting to kick start their economies with a wide range of policy tools. The most noticeable has been the expansion of balance sheets and expansion by the U.S. Federal Reserve remains the most dramatic in absolute terms. Despite this, the Federal Reserve balance sheet as a percentage of GDP at 30 percent, was still lagging that of the ECB, which has reached 44 percent of GDP. Central banks have also been cutting rates, with the Federal Reserve having quickly returned to the zero bound. The ECB is among a handful of banks which have already pushed rates into negative territory. The last two rate cutting cycles did very little for the S&P, which felt throughout both. This time there has been a better response. There is more likely that QE, rather than rate cuts, were the key driver. And whilst the equity market may have benefited from QE, main street and the economy have remained in sluggish territory. The Bank of England is now openly contemplating the possibility of negative rates to complement the UK government's aggressive public spending program. The Bank of England has since 1946 been an arm of the government, even though it was handed greater independence over the last 25 years. The US Federal Reserve, on the other hand, is still a private institution and may be more reluctant to go into negative territory. The new tool that is being contemplated by the US Federal Reserve is one that has already been adopted in Japan, namely Yield Curve Control. On the twenty seventh of May, the New York Federal Reserve President John Williams said that "Yield Curve Control is a tool that could potentially complement forward guidance." So what is Yield Curve Control? And is this any more likely to have a positive impact on economic growth than all the other attempts at monetary policy, which appears to have only helped asset prices and very little else? Well Yield Curve Control sounds quite arcane, but is relatively simple in concept. It attempts to fix the level of government bond yields at specific points along the curve. Yield Curve Control is generally seen as a tool to keep borrowing costs low. However, when the Bank of Japan adopted it in 2016, their yields were already historically low and had been in a tight range for some time, as can be seen in this chart of interest rate comparisons for a number of countries between 2002 and 2020. When they cut rates below zero in January 2016 to try to stop the Yen from rising, yields fell across the curve, destroying further the paltry returns that were being received by many financial institutions, such as pension funds....in what was seen at the time as a negative endorsement of negative interest rates. The Bank of Japan adopted Yield Curve Control eight months later by adding a 0 percent target for its 10 year yield in the hope that they could enjoy low short term rates without completely destroying the returns achieved from longer dated maturities. Part of the problem for the Bank of Japan is that they already own a large chunk of the bond market, and therefore it becomes harder and harder to work with a fixed pace of monthly purchases. It's better to target yields and adjust volume accordingly, although for Japan this often means they're selling bonds when times are bad and yields want to fall, whilst they're buying bonds when growth is picking up, though - they can and have and do tweak the criteria - but it does create communication problems about exactly what loose policy regimes mean. Today, the Bank of Japan are not the only ones adopting Yield Curve Control. In mid-March, as the crisis really began to bite, the Royal Bank of Australia reduced their cash rate to an all time low of 0.25% and also set a target for the three year government bond yield of around 0.25% as well, via purchasing bonds in the secondary market. Australia had experienced an almost 30 year unbroken run without a recession, spurred on by China's rapid growth and demand for commodities. And now the US Federal Reserve is openly discussing the opportunity, although this is less about allegedly capping yields and more about a compliment for the forward guidance on interest rates. For Japan, Yield Curve Control is easier to achieve because they dominate their nine trillion dollar bond market compared to the wide range of participants within the US is 18 trillion dollar bond market. Japan may also feel they need to exert greater control because government debt is two hundred and twenty four percent of GDP versus the U.S., Euro area and the U.K. all closer to 100 percent. One of the biggest concerns about Yield Curve Control is the suppression of price discovery, which is an accusation that can be made across the full suite of monetary weapons that are currently being deployed globally. If central banks are buying up government and corporate bonds, then it's distorting the true price of capital. So what is the informational value of the yield curve under these conditions? Has it been seen on previous occasions? The U.S. Yield curve has dipped into negative territory prior to previous recessions, before then re- steepening, again prior to recessions as the Fed combats a slowdown with rate cuts. The re- steepening is therefore usually led by the front end yield falling whilst the Fed cuts those rates. Recently, we've seen an element of this, but also with interest rates near the zero bound and the sheer size of the fiscal packages that have been announced, yield curves have also been steepening again at the long end. This is the space from roughly 10 years and beyond and can be seen clearly in this chart of the 5 year to 30 year part of the curve. Now, despite this move higher in long dated yields, their ongoing suppression signals that future growth is poor, and this growth outlook will now work to dissuade long term investment, even though the return on savings is also very, very poor. The proponents of this type of monetary stimulus will then say that these policies haven't been administered in sufficient levels of shock and awe to have an impact. It's not that they don't work, but that the programs haven't been big enough. So they find new ways to throw more stimulus at the problem. So we can see the behaviors have changed with suppression of interest rates and yields. The idea with negative rates and suppression of yield is that people would save less and spend more. In some ways, here's the killer. From 1980 to 2008, lower interest rates and yields did coincide with lower savings. But then, when interest rates fell to zero, savings as a percent of disposable income started to tick back up. When there's no income and no prospects of tasting growth, households need to increase their capital base in order to survive in retirement. Bank of America analysis has further suggested that household spending as a percentage of disposable income falls when U.S. 10 year yields drop below four percent. Now, again, this corresponds to the great financial crash. But it suggests that 2008 was already a major turning point for household balance sheets. We can make a reasonable guess that these savings are also concentrated amongst the wealthy. Roughly half of U.S. households have less than one thousand dollars in their savings accounts. And how have recent events affected this trend? We now move forward an additional month, we can see that savings as a percentage of disposable income has exploded higher to levels never seen before. This is an absolutely stunning increase in the savings rate. In many ways, this mirrors many of the charts we've seen previously where data has collapsed to levels that would have been unimaginable just a few months ago. Yes, we can expect savings rates to drop back as economies reopen, but where will it settle? It looks like it's reinforcing the 10 year trend towards higher savings. Household balance sheets have taken a massive hit. Corporate balance sheets have also taken a hit. Though big corporations have been able to offset this directly via government funds or indirectly via the capital markets. For small scale and family businesses, access to this sort of support has been far less easy to achieve. The likelihood is that bankruptcies will increase in the wider economy of small businesses that account for the largest proportion of jobs. Whilst policymakers are hoping that they can stimulate growth and inflation through both fiscal and monetary policy, so far it looks like after a certain point, lower rates lead to lower inflation expectations, leading to yet more accommodation such as QE, bond buying programs and Yield Curve Control, thus reinforcing the vicious spiral in which central banks think they need to do more. The big question is, therefore, whether the addition of fiscal stimulus can turn the tide of monetary policy, which so far appears to be increasingly deflationary. Yield Curve Control is unlikely to change that dynamic. 

    The U.S. dollar has recently been weakening against a number of global currencies. Perhaps most notable, we have seen many of the underpressure emerging market currencies pulling back from their recent extremes. The Brazilian Real has retraced over 10 percent from recent wides versus the U.S. dollar, despite Covid-19 still spreading aggressively through the country. The US Broad dollar index has also moved back from its highs, but remains well above the breakout levels that emerged earlier this year. Many people still use the US dollar index or DXY as their default. As we've discussed before, roughly 50 percent of the index is comprised of the euro, so we might as well look at the euro to see what's happening. The reality is, is there's not that much. So far, the rally in the euro has been little more than a retraced back to the top of the range that has been in place for a couple of years. It's certainly well within the range that was set in March of this year. Recent influences that have seen the dollar on the back foot have included each announcement of a huge support package from the US Federal Reserve and or the government. The recent bout of U.S. dollar weakness came on the heels of Jerome Powell speech a couple of weeks ago when he said; "There's really no limit to what we can do with these lending programs." And the current civil unrest across the US may also be adding to pressure on the dollar. Though the current move was initiated well before this started to flare up. Perhaps the next date to watch is the 19th of June when the European Union start renegotiating their one point eighty five trillion budget and rescue package. That includes the recently announced five hundred billion euros in grants and 250 billion in loans. But these talks are likely to drag on into the summer. But over the longer term, the trend in the euro has been grinding lower for a number of years, with frequent tests of both ends of the range. The most recent bounce has come off massive supports going back four decades. The current move is well within the realms of normality and also it's often not wise to bet on a major trend change when volatility remains subdued. The Deutsche Bank Currency Volatility Index, also known as the CVIX, has drifted right back into the former range. The recent lows have been around five versus around seven today. And central banks are currently going out of their way to suppress asset price volatility. So the grinding price action is more likely than a sudden surge. But what about positioning? Are people aggressively long or short against the dollar and in particular the euro? Now obviously futures positions, have a buyer and the seller - a long versus a short. The non-commercial category is often considered to be the speculative positioning rather than, for instance, banks hedging client positions. But nonetheless, with all those caveats, we can see this speculative positioning on the euro has increased over the last few weeks. People are betting on a high euro. However, the Fed continues to lag the ECB in terms of balance sheet as a percentage of GDP. In short the Fed has to do a hell of a lot more in order to get the same results as other central banks. And this was clear in 2014 when the dollar surged during the period when both the ECB and the Bank of Japan engaged in simultaneous QE after the Fed had stepped back from its own operations. The speculative positioning on the DXY and the British pound are also in the middle of the 10 year range. Again, nothing out of the ordinary. So was the bullish versus bearish U.S. dollar battle rages within social media, the current reality is a little bit less exciting. Some emerging market currencies have pulled back from the extreme levels, but remain on the back foot and the dollar itself is continuing to bounce within the existing channels whilst volatility drifts lower. The real test will likely take place when the outlook transitions from current hope of re-opening, to future reality of balance sheet recessions, and how regional policymakers react to domestic manifestations of these issues. The risk of a disorderly dollar move has receded. The liquidity risk having been capped by central banks. But a balance sheet recession, on the other hand, is a death by a thousand cuts and will play out over months, if not years, with dollar scarcity still the most likely outcome. 

    In recent weeks, we talked at length about the potential for a balance sheet recession and a wave of bankruptcies. But the outlook could, in fact, be more disappointing. What if we got a wave of bankruptcies in small businesses and also zombification within larger companies? This would obviously be very unhealthy for the long-term prospects of the economy. The companies that were already a drag on output prior to the crisis, but are large enough to tap the various liquidity schemes, will be kept on life support, potentially crowding out newcomers in old industries. So far, a record of over one trillion dollars in new U.S. corporate debt has been issued in the first five months of 2020. Meanwhile, small and family businesses and start up entrepreneurs do not have the same access to support. Some companies may never get the funding to develop and challenge the established order, whilst existing small businesses are unable to cope with changing consumption patterns, forcing them into bankruptcy. Firstly, we can see the concentration has already materialized for large cap tech, who had the ability to take advantage of the current dislocations and had healthy balance sheets prior to Covid-19 striking. This was an acceleration of an existing trend. Goldman Sachs recently calculated that the top five companies in the S&P 500 were up 15 percent year to date. Meanwhile, the other 495 companies were still eight percent down year to date, and the S&P overall down 5 percent year to date. The top five firms account for 20 percent of the S&P 500, superceding the 18 percent that was achieved by the top five in the peak of the tech boom 20 years ago. On a global scale, tech and healthcare accounts for 43 percent of global listed equity, taking a large chunk at the expense of the energy sector. The big five U.S. tech names are now just shy of nine percent of the total. That's five stocks accounting for nine percent of the globally listed equity universe. We've also talked about how buybacks will disappear under the existing regime. Now, this is true for companies who are receiving handouts, but the cash rich tech sector is still buying back their own shares with announced buybacks over the last three months, standing at 65 billion U.S. dollars, according to Deutsche Bank, well in excess of any other U.S. sector. It  would appear that buybacks remain the driving force for the U.S. equity market. It's just that there are fewer stocks doing it, and it is helping drive additional concentration from algos, and a new army of retail traders with hundreds of thousands of new accounts having been opened in March and April. So does this mean tech stocks can rally to infinity and beyond? Well, Goldman Sachs points out that if the top five S&P 500 stocks were to approach 25 percent of the index, then they would be getting close to the maximum five percent allocation per stock that acts as a restriction from any investment firm portfolios. Secondly, EU proposals have suggested taxing tech companies as a good way to try and repay the bills across the European Union, especially if the EU manages to get agreement from all 27 member states to push ahead with grants rather than loans in its proposed rescue package. I've been arguing for a couple of months that cash rich tech stocks will become the target of global governments. In the U.S. we've probably seen the lows in the US corporate tax rate. Julian Brigden of MI2 partners points out that shifting the U.S. tax rate from 21 percent to 35 percent would have taken last year's S&P earnings down from one hundred seventy dollars to one hundred thirty five dollars. If taxes increase, they will do so in small steps, but the positive tax tailwind has certainly peaked. Households with huge levels of job uncertainty and rising auto, student and credit card delinquencies are unlikely to accept ongoing privatization of profits and socialization of losses for a second time in just over 10 years. The current crisis has accelerated the opportunities for tech stocks and the response of central banks will superficially shore up finances of companies that have chosen buybacks in preference to growth and productivity. Lawmakers are very likely to level their sights on these behemoths in order to recoup some of the funds that have recently been flowing into corporate coffers rather than the economy at large