Friday, January 16, 2015

Is OMERS Worried About Deflation?

Ontario Pension Manager’s Top Trade Is Bonds as Economy Weakens:
The pension fund that manages retirement savings for Ontario’s municipal employees is joining investors who say the bond market will defy Wall Street forecasters a second year to rally on concern the global economy is flagging.

“I actually do think it’s bonds,” Michael Latimer, chief executive officer of Ontario Municipal Employees Retirement System, said when asked on stage today at an event in Toronto for his top investment idea. “We’ve got weak growth and weak inflation, and I think that’s going to gravitate capital over to bonds, which will surprise everybody.”

Latimer, whose Toronto-based pension fund manager oversees C$65 billion ($54.3 billion) of assets, joins firms such as Texas-based Hoisington Investment Management Co., Jeffrey Gundlach’s DoubleLine Capital LP and HSBC Holdings Plc in saying fixed-income gains have more room to run after the global bond market had its best performance last year in more than a decade.

The call is playing out. Global sovereign yields have reached record lows in Canada, the U.S., the U.K., France and Japan as a collapse in crude oil slows inflation, adds to concern global growth is flagging and pushes out forecasts for when the Federal Reserve will raise interest rates. Futures trading, which last month pointed to an increase in September, now show a likelihood U.S. rates won’t go up until December.

Projections last year that economic gains would spur a bond selloff failed to materialize, and economists had estimated yields would rise this year amid U.S. strength.

The European Central Bank meets next week to discuss introducing new monetary stimulus, including purchases of sovereign bonds, which may lead bonds to rally further.
Michael Latimer is a smart man and he's right, this time it's different and bonds will once again defy all Wall Street economists and strategists and surprise everyone with very decent gains in 2015.

The Swiss currency tsunami is the latest example of a central bank that has succumbed to global deflation, a point underscored by the Telegraph's Ambrose Evans-Pritchard in his latest comment:
The SNB’s Mr Jordan said the end of an exchange floor inevitably requires subterfuge. "You can only end a policy like this by surprise. It is not something you can debate for weeks,” he said.

That may be true. Less justifiable is the failure to come clean after the event and explain exactly why the SNB now judges the damage of eternal currency intervention to be even more dangerous than the threat of a systemic deflationary shock. We are left guessing.

Ernst Baltensperger, the doyen of Swiss monetary policy, flagged the move in an interview with the Neue Zurcher Zeitung on Sunday. He said the peg worked well at first but then became toxic.

1) It has created a flood of excess liquidity within Switzerland that will be increasingly hard to mop up once the tide turns, and velocity rises. The monetary base has exploded from 80bn francs to almost 400bn since mid-2011.

2) It has set off a property boom. Flat prices have risen almost 60pc since early 2007 on the Wüest & Partner index. Bank lending has jumped from an historic average of 145pc of GDP to a new peak of nearly 170pc. Such surges usually end badly.

3) It is provoking a populist backlash from the cantons. Voters are worried that the bank faces mounting liabilities on its books, tantamount to a fiscal liability. The headline figure put about today was a "loss" of 60bn francs - whatever that means in the world of money creation and fictitious central bank accounting.

The SNB’s balance sheet has ballooned to 85pc of GDP. At one point it was buying half the entire sovereign bond issuance of the eurozone. While this reserve accumulation subsided for a while, it is has been building up to a new crescendo as money pours in to Switzerland from Russia, and Greek tensions return to the eurozone. Foreign reserves rose 7.5pc in the single month of December. The Swiss franc floor was already untenable.

The eurozone’s slide into deflation in December – with 5Y/5Y swap contracts showing inflation expectations in freefall – is the last straw for the Swiss authorities.

It means that the European Central Bank can no longer keep dragging its feet on QE. Whether the ECB announces a €1 trillion blitz next week, or just €500bn, funds are already flooding into Switzerland from the eurozone.

The SNB has to pick its poison. It is damned for one set of reasons if it holds the currency peg, and damned for another set if it ditches the peg. Welcome to the world of horrible dilemmas facing modern central banks.
No doubt, the ECB is way behind the deflation curve and needs to react swiftly, but as Alen Mattich of the Wall Street Journal rightly notes, it's fighting a losing battle against deflation:
That’s because while some of the region’s deflationary pressures are domestically produced, others are being driven by global economic forces against which the ECB has only limited tools.

The domestic deflationary forces are fairly clear: very substantial output gaps across most of the single currency region. Which is another way of saying demand is too low because too many people are out of work and too many existing resources aren’t being used. The ECB’s rate cuts and now efforts to boost its balance sheet as a way of forcing more liquidity into the economy, getting people and firms to borrow and spend.

But the other deflationary force comes from abroad.

Most notably, this is being driven by a collapse in commodity prices, especially oil and industrial metals. Some of these reflect supply issues. During the commodities boom of the past decade, massive investment was made into oil and mineral extraction. Since the cost of producing the marginal barrel of oil or ingot of copper from an existing well or mine tends to be reasonably low and since these investments need to be financed many producers will keep producing even at these substantially lower prices.

On the face of it, this is good disinflation. Because eurozone economies tend to be substantial importers of natural resources, lower costs here mean more disposable spending on other, often domestically produced, goods and services–which should boost domestic demand.

But for the ECB, there’s a bigger worry. Incipient deflation threatens to produce a negative cycle–even if it is produced by these good forces. Weak and declining inflation now encourage expectations of weak inflation in future, which acts to supress business and household demand.

That, though, isn’t–or shouldn’t be–the ECB’s only concern. The collapse in commodity prices isn’t just a supply phenomenon. It’s also being driven by weak global demand. What’s more, this weak global demand for commodities suggests weak demand for eurozone exports too.

China is at the heart of this weakness. Chinese investment, fed by ultra-cheap money, has been running at 50% of GDP–a vast and unsustainably high rate–which has fuelled its commodity consumption. But as the Chinese authorities turn the liquidity taps off, this has also cut commodity demand.

That’s a big problem for the economies that are big commodity producers. But it’s also bad for China–these same countries have been big consumers of Chinese goods. Which spells further weakness for the Chinese economy.

Meanwhile, China’s real trade-weighted exchange rate has been rising sharply during recent years, making its producers increasingly uncompetitive.

And that’s a problem for the eurozone. Because China’s response is likely to be to devalue its currency. As Japan has been doing. Asian devaluations will make the euro increasingly uncompetitive and hurt exports.

The ECB seems to want to launch quantitative easing, perhaps later this month–something that’s likely to have been made easier by the European Court of Justice’s latest ruling on ECB policy. The aim, at least in part, is to drive down the currency’s exchange rate. But compared with Chinese and Japanese central banks, the ECB is hamstrung by politics. It will never be allowed to pursue as aggressive liquidity creation as other central banks and so will continue to struggle to devalue its way to growth.

The ECB’s biggest hope is for a global growth recovery to lift the single currency region. But worldwide deflationary trends suggest this isn’t going to happen anytime soon.
Indeed, the ECB is hamstrung by politics and can never engage in aggressive quantitative easing like its global counterparts. The big worry is that it will disappoint markets once again next week, which will send gold prices and gold shares (GLD) lower (conversely, if the ECB manages to do some aggressive QE, expect gold and gold shares to rally temporarily).

Also, the mighty greenback keeps threatening the emerging markets' carry trades and this too will reinforce global deflation.  The carry trade is a multi trillion dollar hidden market and we only saw a glimpse of how it can wreak havoc on global markets on Thursday.

But the big elephant in the room isn't the eurozone, China or emerging markets. I've long argued that deflation is coming to America and now even the Wall Street Journal is admitting the U.S. may soon join the club.

And this worries smart economists like the American Enterprise Institute's John Makin who thinks the Fed is too complacent on US deflation damage:
The Fed is in an awkward position, as was clear from Janet Yellen’s tough slog through her December 17 press conference. The Fed’s main message – that monetary tightening (interest rate boosts) will probably start in June of this year – squares well with strong growth and falling unemployment but is bizarre given falling inflation and the additional deflationary impulse (from falling energy and commodity prices and a stronger dollar). The Fed has decided simply to assert that US deflation won’t materialize, so it will continue on its current path toward mid-year tightening. This is a dangerous course to follow, especially in view of rising global deflation pressure.

Deflation is dangerous for three reasons: (1) it makes people and firms do things that create more deflation; (2) it boosts real, inflation-adjusted interest rates which in turn deters investment and slows growth; and (3) it boosts trade tensions by forcing countries – like Japan, China, and Europe – that are trying to reflate in a world of weak domestic demand to allow their currencies to weaken, thereby exporting deflation to countries like the US that are exhibiting some modest growth of domestic demand.

The self-reinforcing nature of falling prices in the US is most evident in the goods markets. Falling prices of TV’s, computers, and automobiles (not to mention all residential real estate) have been so widely discussed that some buyers are choosing just to wait for lower prices, thereby cutting demand and creating a self-fulfilling expectation that tomorrow’s prices will be lower than today’s. Some service prices are falling as well. For example, Uber’s lower fares are revolutionizing local transport options globally.

The rising prevalence of falling prices is lowering inflation expectations in a way that can reduce investment. Currently, benchmark US 5-year real interest rates are about zero, with the market rate at 1.4% (which is just about equal to expected inflation). If US expected inflation goes negative, as it already has done in a number of European countries, the cost of borrowing (the real interest rate) would jump, thereby further weakening investment.
Even with market interest rates close to zero, as they are in many European countries, expected deflation at 1% would mean a positive 1% real interest rate. As expected inflation falls more, the real interest rate keeps rising. This is the “zero bound” dilemma where market interest rates stuck at zero mean rising real interest rates – UNLESS the central bank can boost expected inflation through aggressive injections of liquidity or “QE” or “whatever it takes,” to use ECB President Draghi’s term of choice.

Awkward for the Fed is the fact that it is talking primarily about reducing QE just as falling inflation is suggesting the need for more QE. Europe is contemplating more QE, but so far the dilemma has been ignored by simply assuming a rise in inflation will occur.

Rising deflation pressure can also boost trade tension because it begets a stronger US dollar which in turn defines weaker currencies in Japan, China, Europe and many emerging markets. Members of Congress have become more critical of “unfair” currency depreciation in Japan and Asia, but the euro’s continued weakness is also reducing the competitiveness of US producers. American leaders need to emphasize that the trade pressures are really a reflection of a weakening global economy and take steps to boost demand and efficiency.

Deflation is an unusual event that alters behavior in unusual ways. It causes consumers to delay purchase in anticipation of lower prices of consumer durables like curved screen TV’s, iPhones, or residential real estate. Less buying leads to lower prices and larger holdings of cash and short term securities. Deflation pays cash holders since it means that the purchasing power of cash is rising. If deflation continues to intensify, more funds flood into cash, spending is reduced, and deflation intensifies further. A deflationary spiral ensues which is inevitably accompanied by a nasty financial crisis.

The Fed knows all this. It is simply betting, for now, that it won’t happen. Let’s hope they are right while remembering that ignoring a deflation threat makes deflation more likely. Better for the next FOMC statement to draw a line against deflation risks by acknowledging its danger and stating that inflation below 1% will trigger more aggressive QE. Awkward, but the right thing to do.
I want you all to keep Makin's brilliant comment in mind because as I stated in my last comment on the Swiss currency tsunami, I'm betting the Fed won't raise rates this year and might even be forced to engage in more aggressive QE if a financial crisis emerges (that's when the real fun begins!).

Go back to read my comment, Don't Fight the Fed?, where I noted the following:
The key here is whether the market perceives the Fed do be behind the deflation curve, not the inflation curve. As I've repeatedly warned, the real concern is about the Euro deflation crisis and whether it will spread to the United States. For now, global stock markets are not worried, bouncing back vigorously from the latest selloff, but this could change and the future of the eurozone remains very fragile.

In my recent comment on whether it's time to plunge into stocks,  I openly questioned Dallas Fed president Richard Fisher for dismissing the contagion effects from eurozone's deflation crisis and how it's influencing U.S. inflation expectations. 

Importantly, the biggest policy mistake the hawks on the FOMC are making is ignoring global weakness, especially eurozone's weakness, thinking the U.S. domestic economy can withstand any price shock out of Europe. If eurozone and U.S. inflation expectations keep dropping, the Fed will have no choice but to engage in more QE. And if it doesn't, and deflation settles in and markets perceive the Fed as being behind the deflation curve, then there is a real risk of a crisis in confidence which Michael Gayed is warning about. Perhaps this is the real reason why big U.S. banks are loading up on bonds (not just regulatory reasons).

Economists are trained to view inflation as a lagging indicator but in a deflationary environment, inflation becomes a leading indicator. Many will argue against this assertion but this is the biggest risk and I think Bullard and Yellen understand this, which is why the Fed might ease up on QE at their next meeting and leave the door open to more QE down the road.

The basic problem with developed economies today is lack of good paying jobs with benefits and very high public and private debt. In this environment, job insecurity is running high and severe under-employment is masking an even deeper structural problem in the economy. This too is complicating the Fed's decision to raise rates.
That last point on weak labor markets was something Brian Romanchuk discussed in his recent and equally brilliant comment, Fed To Treasury Market: You're Wrong (And Vice-Versa), where he notes:
My view already is that the Fed is too optimistic on the labour market, so I do not want to wallow in confirmation bias here. But there are at least a couple of reasons why the Fed needs to take the message in bond yields seriously.
  • The fall in average hourly earnings, as pictured at the top of the article, has been impressive. The Fed would not hike rates before "mid-year", and so they will have access to more data before hiking. But if the weakness in wages continues, there is almost no justification for a rate hike.
  • Although headline writers get excited about hundreds of thousands of jobs being created according to the Nonfarm Payrolls report, the employment-to-population ratio does not give signs that there is risk that momentum in the labour market will overrun spare capacity (chart below). There had been an acceleration in 2014, but the ratio flatlined in the fourth quarter.
Despite all these valid concerns, I still stick with my forecast in my Outlook 2015, long bonds and stocks knowing full well it will be a rough and tumble year.

One thing that struck me on Thursday when big global macro funds unwound their Swiss franc carry trades was how many high beta biotech stocks got slammed hard (click on image):

This is just a small sample of biotech "high flyers" I monitor every day in my trading activities. One thing I see is when these biotechs get clobbered, the dips are bought hard, which tells me this will be one of the industries leading the Nasdaq to fresh new record high levels.

In fact, look at these very same biotech stocks above as of Friday (just one day later, click on image):

I see another liquidity melt-up in stocks developing led by tech and especially biotech which is experiencing a new dawn based on substance, not hype (watch this clip of Dr. George Scangos, Biogen Idec CEO, as he discusses new therapies in multiple sclerosis, Alzheimer's disease and pain).

Importantly, even though central banks aren't going to halt global deflation in its tracks, there is still plenty of liquidity in the global financial system to drive all risk assets much higher. Enjoy the liquidity party while it lasts, choose your stocks and sectors carefully because when deflation does hit us, it will be a very long and tough slug ahead.

Below, Narayana Kocherlakota, President of the Federal Reserve Bank of Minneapolis, presents his report on goal-based monetary policy in New York City on January 13, 2015. I also embedded the Q&A discussion which took place afterward. Text of speech and slides available here.

Just like James Bullard, Kocherlakota is a dove who is very worried about the slide in inflation expectations. Listen to his comments carefully, especially in the Q&A session. He was one of the dissenting votes at the December Fed meeting.

Also, Jim Rickards, author of The Death of Money, recently appeared on The Exchange with Amanda Lang discussing why the Fed is cornered and won't raise rates. Listen to his comments below.

Finally, let me remind all of you that it takes a lot of work to provide you with timely and excellent comments on pensions and investments. I appreciate your kind words of encouragement but I would appreciate it a lot more if you take the time to donate and subscribe to my blog on the top right-hand side. Thank you and if you have any comments, feel free to email me at

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