Thursday, January 14, 2010

The Great Transition?


TD Economics published a very interesting report this week, The Great Transition. The report begins:
The credit crisis has dominated global market financial trends for almost three years. As we begin 2010, the specter of systemic risk has almost completely disappeared, and we find ourselves reverting to idiosyncratic risk and economic divergences that more typically define market opportunities. In many regards, 2010 will be an underwhelming year for those expecting paradigm shifts. Crises bring opportunity. Recoveries bring banality.

Economic growth will divide along a line separating the 2.7% or so likely in the G3 area, and the almost 6.0% expected in emerging Asia. Economic relegation and promotion dynamics are already defining subtle shifts to policy tack across and between countries in the months ahead.

Monetary policy will not be tightened in a meaningful way globally until 2011, but central banks will continue to tailor interest rates to domestic conditions leading to small but cumulatively important policy differences over the year ahead. The need to hedge against global collapse has gone.

Fiscal policy will not be tightened dramatically anywhere until 2011, but rating agencies will have their say this year on where the dynamics looks untenable. The data flow so far this year is about divergence – regionally, sectorally, and historically – and this is a trend likely to continue so some opportunities will open up even if they are less exciting than the volatile crisis period.

On Thursday, the Financial Post carried an article, Canadian economy will roar 'like a lion,' then fizzle, CIBC says:

But in the biggest change in its forecast, CIBC World Markets now expects the Bank of Canada to boost its benchmark interest rate beginning in the third quarter, by a total of 75 basis points to 1%. Previously, Mr. Shenfeld was among the few analysts arguing the Bank of Canada would remain on the sidelines for all of 2010.

His call that the Fed won’t budge on its funds rate until 2011 remains intact.

The change in the rate forecast is due to the strong first-half growth in Canada. These rate hikes will push the Canadian dollar above parity with its U.S. counterpart, Mr. Shenfeld said, “when resource prices won’t justify that strength.”

So will Canada follow Australia and hike rates? It would be a first since the Bank of Canada always follows the Fed's lead. But as Canada’s red-hot real estate market shows no signs of slowing down in 2010, some economists think the Bank of Canada will have no choice but to hike rates sooner rather than later.

Of course, if the U.S. labor market improves considerably in the first half of 2010, it's possible the Fed will raise rates sooner than what the market currently anticipates, allowing other central banks to follow suit. But not everyone is convinced that jobs are coming back any time soon. My friend, Luc Vallée wrote a comment in the Sceptical Market Observer blog, Where Have All the Jobs Gone?

As I stated before, I am more optimistic on the U.S. labor market. Some jobs are gone forever, but new ones will emerge. The U.S. economy can't go on hemorrhaging jobs forever. Keep an eye on the Conference Board's Leading Economic Index (LEI) for the U.S. economy. From the December report:

Says Ataman Ozyildirim, Economist at The Conference Board: "The Conference Board LEI has been on an uptrend for more than half a year and it is now slightly higher than its latest peak in July 2007. Improving financial conditions, labor market indicators, and housing permits have helped the LEI continue its gains in November. However, its six-month growth rate has slowed somewhat in recent months."

Says Ken Goldstein, Economist at The Conference Board: "The indicators point to a bright new year. The U.S. LEI increased for the eighth consecutive month. Looking ahead, we can expect a slowly improving economy through 2010. The Conference Board Coincident Economic Index™ (CEI) for the U.S. also increased in November. Employment largely held steady, making this the first month since December 2007 that it did not make a negative contribution to the index.

Back to the TD Economics report, The Great Transition. On inflation risks versus expectations:

There is a large divergence in inflation perception versus reality. The spread between various national breakeven inflation rates and actual lagged CPI outturns continues to be wide, even when compared against our forecasts for consumer inflation rates.

The inflation risk premium, rather than just the simple expectation for inflation, has become a strong driver of breakevens. The US five-year, five-year forward break-even now sits at 3.2% compared to about 2.5% prevailing prior to the financial crisis.

Current inflation, production, and labour hiring drive inflation expectations, but the risk premium is driven by uncertainty and the volatility of each of those measures. When you hit a pothole, the ebb and flow of the shock is only partly dissipated over time. Similarly, the sharp decline and resurgence in inflation rates and economic growth is itself increasing the risk premium around inflation.

This positive feedback loop worked in central banks’ favor in the Great Moderation, but the negative feedback loop will now complicate matters during the Great Transition. We can look to the U.S. economy now tracking a near 5% growth rate for GDP in the fourth quarter of 2009 as yet further evidence that this inflation uncertainty premium will remain sticky.

I was speaking with another buddy of mine who trades bonds today and he told me that if headline inflation comes in as expected on Friday, he expects TIPS to rally strongly. He is long real yields and breakevens, and told me the beta (relative to cash) is higher for real yields.

In Japan, over 18 percent of Japanese expect consumer prices to fall in the coming year, the Bank of Japan said in a survey released on Thursday, up from 10 percent who held that view three months earlier.

In Ireland, prices fell
by 4.5 per cent in 2009, the steepest decline seen in the Irish economy in almost 80 years, according to new figures from the Central Statistics Office (CSO).

In England, Jeremy Warner of the Telegraph reports on why the Bank of England will raise interest rates as deflationary threat melts away:

Higher interest rates are on the way back again. The only questions are how quickly they will rise and how far. Admittedly, central bank action in tightening policy has thus far been confined largely to fast-growing emerging markets.

But even in struggling Western economies, long-term rates (the price markets charge governments for their longer-term borrowing) have already shifted markedly higher since their low point last March, despite massive amounts of Quantitative Easing (QE) in both the US and UK. It is surely only a matter of time before short-term rates follow suit. Or so you would assume.

In fact, this is by no means a done deal, and only the brave, among whom I count myself, would unambiguously predict that bank rate in the US and UK will be higher by the end of the year.

At some point, the flood of cheap liquidity created by policymakers to counter the recession will have to be withdrawn, but the operative words are "at some point". Already a lively debate has sprung up in the City on when. At one extreme lie the likes of Ben Broadbent of Goldman Sachs, who believes that UK monetary policy will once more be in tightening mode by the middle of the year. Bolder still is Simon Ward of Henderson New Star, who has suggested that UK rates may rise as soon as March.

He's right to believe that Mervyn King, Governor the Bank of England, would not feel himself at all constrained by the looming general election if he thought such action appropriate. Mr King is said to have formed a gentlemen's agreement with Alistair Darling, the Chancellor, to stop criticising the Government's fiscal policies until after the election, but it seems unlikely this self-denying ordinance stretches to not taking action on rates.

That would defeat the whole purpose of an independently determined monetary policy. In the US, Alan Greenspan was accused of costing President George Bush senior a second term after raising rates prior to the election in 1992. These allegations have instructed an understanding ever since that the Fed should not seek to raise rates in the run up to a presidential election, but the same convention does not exist in Britain.

Luckily for Mr King, it seems quite unlikely that he will be confronted by such a dilemma. In an interview published yesterday, Andrew Sentance, one of four externally appointed members of the Bank of England's Monetary Policy Committee, seemed to hint at higher rates to come.

He saw little chance of the double-dip recession feared by some and felt that enough had already been done to lift the economy out of recession. But this is a long way from saying that the bank rate would be rising within a few months.

At the other extreme are the likes of Roger Bootle of Capital Economics. So worried is he about the private debt overhang that he's gone out on a limb and predicted that the bank rate will remain below 1pc for the next five years. David Owen, chief economist at Jefferies, takes a not dissimilar view, though his prediction that European and UK rates will remain as they are doesn't extend beyond the next year.

As Mr Owen points out, despite the more upbeat data of recent months, the economy is still operating at way below capacity, and he worries that recent buoyancy in retail sales was simply forward spending ahead of the rise in VAT.

Lurking behind most of this bearish analysis are the lessons of past deflationary experiences prompted by financial crises.

Both in Japan in the 1990s and the US in the 1930s, the mistake was made of assuming too early that things were on the mend and that the stimulus could therefore be withdrawn. In both cases, the economy plunged back down again.

The phenomenon common to both was debt deflation, where falling prices have the effect of adding to the real value of the debt burden. In such circumstances, the overindebted tend to spend their hard-earned money on debt reduction, rather than consumption or investment.

The problem becomes not that the banks won't lend, which is the accusation hurled at them by the politicians, but that the punters won't borrow. We've already seen this occur throughout the private sector, from banks to companies and households.

Banks have attempted to restore capital impaired by bad debts by substantially reducing their balance sheet size. This process has in effect been mirrored in the corporate and household sectors, where cash accumulation has taken priority over spending. Once this mentality takes hold, it becomes very hard to break.

And there is some evidence that this is indeed occurring. Broad money, in the US, UK and eurozone, is still not growing as it should given the amount of stimulus that has been thrown at the problem.

If the private sector cannot or won't borrow, governments must fill the gap in demand instead, which is why we have seen fiscal deficits spiralling out of control. Governments are only doing what the private sector won't do.

The key issue for policy is to judge when the switch back to private demand is sufficiently robust to remove the public support, for if both horses are charging down the same road at the same time, the deflationary threat will disappear as quickly as snow in summer and it will be back to inflation again.

It seems to me that we are now approaching that tipping point quite fast. The economy looks as if it will be stronger this year than anyone dared hope for even a few months back. The evidence for this is not just in the renewed buoyancy of the capital markets, but in much of the survey evidence too.

But in anticipating a monetary tightening at some stage this year, we shouldn't get carried away. The exceptionally steep "yield curve" – the difference between short, policy-induced rates and longer rates – points to a sharp increase in the bank rate, but to nothing like the sort of level which we were accustomed to in the past.

Just to put this in context, the Bank of England calculates that such is the extent of the debt overhang that a rise back to 4.5pc would impose the same crushing debt-servicing costs on the economy as ruled during the recession of the early 1990s, when interest rates were in double digits.

Any such regime would pole axe demand. The conclusion that can be drawn from all this is that although the bank rate may rise sooner than generally anticipated, it probably won't rise very far.

David Galland, Managing Director at Casey Research, wrote a comment, What The Deflationists Are Missing. He argues that "Obama and his minions" have political aspirations which pretty much guarantees inflation.

On the other hand, Van R. Hoisington and Lacy Hunt wrote an excellent comment on Ponzi Finance, making a strong case for debt deflation and they do not see rates rising in 2010:

Next year the core GDP deflator will fall to zero, with the possibility of negative levels. Likewise, long-term interest rates, which are highly sensitive to inflation, will continue to move toward lower levels. As stated in previous letters, we see no reason why longer dated Treasury interest rates will not mirror those of Japan, which provides a modern signpost for a deflationary environment. Currently the Japanese ten-year note stands at 1.3% with their thirty-year bond yielding 2.1%.

Finally, Pyramis Global Pension "Pulse" Poll: Leading global pension plans believe future growth to come from active equity management. If you scroll down the article, you will see that deflation concerns were highest amongst plans in the Netherlands (40%). Let's hope the rest of the world doesn't catch a bad case of the Dutch disease.

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