The Only Game in Town?

Ray Dalio, founder of Bridgewater, wrote an op-ed for the Financial Times, Pay attention to long-term debt cycle:

I have a controversial view that is based on my alternative economic template, and I feel a responsibility to share at this precarious time.

In brief, the Federal Reserve’s template, and that of most economists and market participants, reflects the business cycle.

Based on it, tightening should occur when a) the rate of growth in demand is greater than the rate of growth in capacity and b) the usage of capacity (as measured by indicators such as the GDP gap and the unemployment rate) is becoming high.

As a result, tightening now makes sense.

However, as I see it, there are two important cycles to pay attention to — the business cycle, or short-term debt cycle, and the debt supercycle, or long-term debt cycle.

We are seven years into the expansion phase of the business/short-term debt cycle — which typically lasts about eight to 10 years — and near the end of the expansion phase of a long-term debt cycle, which typically lasts about 50 to 75 years.

It is because of the long-term debt cycle dynamics that we are seeing global weakness and deflationary pressures that warrant global easing rather than tightening.

Since the dollar is the world’s most important currency, the Fed is the most important central bank for the world as well as the central bank for Americans, and as the risks are asymmetric on the downside, it is best for the world and for the US for the Fed not to tighten.

Since the long-term debt cycle issue is the biggest issue that separates my view from others, I’d like to briefly focus on its mechanics.

What I am contending is that there are limits to spending growth financed by a combination of debt and money. When these limits are reached, it marks the end of the upward phase of the long-term debt cycle. In 1935, this scenario was dubbed “pushing on a string”.

This scenario reflects the reduced ability of the world’s reserve currency central banks to be effective at easing when both interest can’t be lowered and risk premia are too low to have quantitative easing be effective.

Since we commonly understand why lowering interest rates stimulates debt and economic growth, and less commonly understand how QE works, I’d like to explain it.

QE works because those “risk premia” — which are the spreads between the expected return on cash and the expected returns on other assets such as bonds, stocks, real estate and private equity — draw the buying of investors who sell their bonds to the central banks during QE.

You see, our whole capital allocation system — banking and investing — is driven by spreads so that when they are large, QE works better than when they are small.

When there are good spreads — in other words a large risk premia — and those who sold their bonds take their newly acquired cash to buy those assets that offer attractive spreads, bid up their prices and drive down those expected return spreads (ie risk premia) of those assets.

That is where things now stand across the world’s reserve currencies, where the expected returns of bonds (and most asset classes) are relatively low in relation to the expected returns of cash.

As a result, it is difficult to push the prices of these assets up and it is easy to have them fall. And when they fall, there is a negative impact on economic growth.

When this configuration exists — and it is also the case that debt and debt service costs are high in relation to income, so that debt levels cannot be increased without reducing spending — stimulating demand is more difficult, and restraining demand is easier, than is normally the case.

At such times the risks are asymmetric on the downside and it behoves central banks to err on the side of waiting until they see the whites of the eyes of inflation before tightening.

That, in my opinion, is now the case.

This is an important op-ed by the founder of the world's largest hedge fund. The key passage for me was that last one I highlighted where Dalio states: "it behoves central banks to err on the side of waiting until they see the whites of the eyes of inflation before tightening."

In September 2012, I wrote a comment looking at whether the titanic battle over deflation will sink bonds where I noted: "I'm far from convinced that the bond bull market has ended and see this 'titanic battle over deflation' playing out for several more years, leading to more volatility in the stock market."

Interestingly, in that comment, I embedded a clip at the end where Dalio warned too much monetization could trigger inflation and a possible downturn in the US. Also, Mohamed El-Erian, then Pimco's co-CIO and CEO, weighed in with his thoughts on the outlook on the US economy. More on El-Erian and the only game in town below.

In December 2013, I openly worried that Fed tapering will lead to deflation and a year later I wrote about deflation coming to America where I noted:

...Europe is already spiraling into deflation, and if Chinese deflation gets worse and they are forced to devalue the yuan, it will flood their economies with cheap imports, exacerbating the euro deflation crisis at the worst possible time.

Then, exactly one year ago, I warned my readers to prepare for global deflation and then in September warned there is no end to the deflation suspercycle and investors better prepare for an era of lower returns. This all led up to my recent Outlook 2016 where I warned the deflation tsunami is coming and there's not much we can do to stop it.

Importantly, deflation is a central theme of mine and it's been so long before I started this blog. I was talking about deflation/ deleveraging and the bursting of the U.S. housing bubble when Gordon Fyfe and I met Ray Dalio and Bob Prince back in 2004 when I pushed Dalio on it and he blurted out: "Son, what's your track record???"

Gordon Fyfe got a real kick out of that response but Dalio didn't say it to shut me up or piss me off, he said it to explain why he's agnostic on the future and why he thinks risk parity strategies and his All Weather portfolio are the best thing since sliced cheese. He was basically peddling his investment philosophy and his all-weather approach.

But last year proved to be a difficult one for Bridgewater's All Weather fund which was down 7% as mad money wreaked havoc on risk parity strategies. I think Dalio is worried about his track record and rightfully so as his fund manages billions of pension and sovereign wealth fund money.

Let me not be too tough on Ray, after all, I agree with him, there's no "locomotive" to drive global growth, the world is awash in debt and there's a real risk we're heading into a long debt-deflation cycle à la Japan or worse.

In this environment, the Fed would be foolish to continue tightening and Jeffrey Gundlach is right, if it does continue raising rates, the market will humiliate Janet Yellen, Stanley Fisher and company.

Importantly, there's no reason to raise rates at a time when global deflation remains the clear and present danger. I don't give a damn what the Fed says, if it continues raising rates, it will all but ensure the next financial and economic crisis and a long period of global deflation. 

The market is telling the Fed: "Back off stupid or we will force you to back down." Period. Anyone who thinks otherwise better be prepared for those asymmetric downside risks Dalio is warning of.

Right now, the Fed and other central banks are the only game in town, to borrow the title from Mohamed El-Erian's latest book which I picked up over the weekend. I'm not done reading it but it's a brilliant book you should all read to understand the macro deficiencies that plague this world and what can be done to address them.

 El-Erian wrote this exclusive excerpt for the UAE's National:

Reinvigorated path

The well-being of current and future generations depends on successfully addressing the 10 big issues just outlined. By now, I suspect or at least hope that they are on the radar screens of every major central bank around the world. If they had the tools, they would be addressing them more effectively, conscious of how much is at stake. I would even venture that central bankers would willingly embark on a reinvigorated policy path even if they were initially incapable of identifying the entirety of the required response and its consequences.

I also suspect that central banks agree that time is of the essence. The longer these issues persist, the more entrenched they become in the global economy, the greater the adverse feedback loops and, consequently, the harder the solutions become. The longer we wait, the harder it gets.

Self-interest also plays a role here. Being “the only game in town” means that central banks are especially vulnerable to the winds of political backlash should economic mediocrity continue and financial instability return. This is particularly important in a world in which unconventional monetary policy is also altering the configuration of financial services, actively taxing one segment of the population to subsidise another, and visibly inserting public sector institutions in the pricing of financial markets and the resulting allocation of resources. Rather than just act as referees, central banks have also taken the field in quite a range of sports.

In the United States, there are already mounting legislative attempts – unsuccessful so far – to subject the Federal Reserve to greater scrutiny, auditing and accountability. Should any of these attempts gain traction, these institutions’ operational autonomy and policy responsiveness would almost certainly be undermined. With that, yet another important component of policy management would be unduly constrained, limiting the ability of the system to address challenges to its economic and financial well-being. It would be the equivalent of a boxer competing with both hands tied behind his back.

Across the Atlantic, an even greater sense of irritation is visible and growing, fuelled by economic underperformance and the horrid crisis in Greece. In Germany, for instance, politicians increasingly feel that the ECB has gone too far in constantly trying to support governments that delay reforms and instead are enabled to act on their inclination to overspend. They also do not like the way that the ECB is perceived to be following the Fed in taxing savers in order to subsidise borrowers. And being inherent savers, they lament the extent to which artificially repressed interest rates are undermining institutions that provide longer-term financial services, be it life insurance or pensions.

Rumblings are also evident within the halls of monetary institutions themselves. Already, some “hawkish” central bankers on both sides of the Atlantic have publicly expressed concerns about institutional mission creep. For them it is not just about the extent to which central banks have had to venture into experimental policy space, using untested instruments and doubling down on them. It is also about what they perceive as a tendency by the central banks to expand beyond their traditional policy purview, taking on too many responsibilities.

Before stepping down in March 2015 as president of the Philadelphia Fed, Charles Plosser stated that he worries about “the longer-term implications for the institution. Part of my criticism has been that we have pushed the boundaries into fiscal rather than monetary policy ... What happens to our independence? What happens to our ability to do things effectively?” Other figures, including some not already known for hawkish tendencies, stated similar opinions.

Speaking in London on March 23, 2015, James Bullard, the thoughtful president of the St Louis Fed, warned on the risk of artificially low interest rates causing damaging financial bubbles. “Zero is too low in that kind of environment.” In saying so, he was reinforcing one of the messages that Fed vice chair Stanley Fischer had delivered on several occasions; indeed, Stanley Fischer had just reiterated it that week in his speech to the Economic Club of New York, warning that markets would be ill-advised to behave as if zero rates were anything other than an anomaly that needs to be corrected.

Yet none of this has been decisive in stopping central banks from being the only game in town – so much so that it has become quite common for them to be even more dovish than what they have conditioned financial markets to expect. Just look at how, to the surprise of many given the controversial nature of the policy step and the divided set-up in the governing council, the ECB opted in January 2015 for a new large-scale asset purchase programme that was larger and more open-ended than consensus market expectations. And look at how, in removing the word “patient” from its policy statement in March 2015, the Fed went out of its way to remind markets that this did not mean it would be impatient.

What can they do?

At every occasion, central banks have erred on the side of short-term caution, almost irrespective of the longer-term consequences. And this will not change any time soon. Indeed, even when they embark on removing all the exceptional monetary policy stimulus – a process that the Federal Reserve will lead given the more advanced stage of economic healing in the United States – the result will be what I have called the “loosest tightening” in the history of modern central banking.

Whichever way you look at it, there should be little doubt about central banks’ motivation and therefore willingness to take action to generally maintain the current path until reinvigorated growth helps address the 10 issues discussed in the previous part. Both are huge. But central banks also know well that these are not just their issues – the global system as a whole is in play and multiple policies are required, including crucial ones that go beyond central banks. And it is just a matter of time before the realisation sinks in that motivation and willingness, no matter how strong, may not be sufficient to deliver effectiveness and, therefore, the desired outcomes.

It needs to be stressed that the fundamental problem confronting central banks is their ability to effect systemic and lasting change. And here there are grave uncertainties.

No one should doubt that if they remain “the only game in town,” there is a very real chance that central banks will go from being part of the solution to being part of the problem. Moreover, the destiny and future standing of central banks are no longer in their own hands.

There isn’t much central banks can do to improve countries’ growth engines. These institutions have neither the expertise nor the mandate to pursue reforms in education and labour markets. They are not in a position to lead national and regional infrastructure drives. They simply do not have the power to influence fiscal reforms, let alone impose them.

So what can they do? A few small things, though they are limited and unlikely to prove decisive as long as other policymaking entities remain on the sidelines.

Central banks can do a little bit more when it comes to the problems of inadequate demand and debt overhangs – though, again, we need to understand that because they are just one part of the required policy response, their efforts come with unintended consequences, including increasing the risk of financial instability down the road.

A few small central banks can also try to facilitate economic recovery by making their individual currencies more competitive – though you will never hear them say so. Indeed, even when some G7 member countries de facto embarked on such an approach, they found it necessary to obfuscate the issue by stating that they were not in fact pursuing such a path!

Despite some obfuscation (meant essentially to stop any talk of “currency wars”), the policy approach is quite straightforward. A weaker exchange rate is meant to boost activities of both export-orientated companies and those whose domestic sales compete with foreign-supplied goods and services. But again, effectiveness is far from complete, and, again, there are costs involved as noted above, including the risks of triggering a currency war. After all, and critically, not every country can devalue at the same time.

Finally, when it comes to policy coordination, the problem is not with central banks. Of all the economic agencies across the globe, they remain the gold standard when it comes to consultation, sharing ideas, and, when needed, applying coordinated action. And what they do is greatly facilitated by one of the best-kept policy secrets in the world of policy coordination – those highly effective and regularly scheduled meetings held in Switzerland.

Having been invited as an external speaker to a few of these meetings, I have come to appreciate their effectiveness, and this despite the fact that I have been only partially exposed to what goes on in that circular building across from the train station in the Swiss city of Basel. Held away from the cameras and fanfare of the press, the BIS (Bank for International Settlements) gatherings are said to provide for a rather candid exchange of views that in recent years has involved a larger number of systemically important countries. They have also greatly facilitated the critical emergency institutional phone calls that are required during periods of crises. Indeed, I have yet to meet a central bank official who has not praised BIS as the best gatherings for frank and effective policy exchanges.

The problem with the central banks is not lack of a venue or a conductor. It’s that those present in the room lack a full orchestra – their instruments are limited. No matter how well they discuss and coordinate, they can offer only partial solutions to vast and deeply entrenched problems.

But one thing they can do, and have been doing, is to continue to try to intelligently buy time for other policymaking entities, with tools better suited to implement the four policy components discussed above to get their act together. As these entities are already quite late, and as central bank bridging is far from a costless or riskless exercise, our current circumstances will yield a rather unusual distribution of potential outcomes for the next few years, ones that will challenge our comfort zones, whether we are individuals, companies or governments.

Go back to read my comments on whether central banks can save the world and whether the Martingale casinos are about to go bust. Also read my comment on why negative rates are coming to Canada and maybe the United States.

My problem with El-Erian's book is that it fails to address some big structural issues that I've been warning of like the global pension crisis and rising inequality, both of which are deflationary. There's also the problem of corporate leaders fixing the game to benefit their needs, something which Roger Martin discusses in his book published a few years ago (read that one too but take his comments on hedge funds with a grain of salt).

But El-Erian is right, central banks remain the only game in town and while we can debate the merits of more quantitative easing (QE), it's hard to see how the Fed will escape such a course of action, especially if global deflation becomes entrenched.

On this last point, Gerard MacDonell, who was an economist at Point72 Asset Management, (previously SAC) from 2004 through 2015, and my former colleague/ sort of boss at BCA Research, wrote a widely read guest comment on Noahpinion, So Much For QE.

Gerard's comment isn't an easy read but it's an important one and he ends it by stating the following:

The only way LSAPs (large scale asset purchases) could be considered a quantitative operation would be if the scale of them communicated something about the tolerable inflation rate. But this was specifically excluded in 2012 when Bernanke and colleagues on the FOMC formalized 2% as the unchanged inflation objective.

The Fed leadership has come a long way from believing that QE had something to do with the power of the printing press to a recognition that the program is a combination of an indirect and transitory rates signal, a confidence game, and a duration take out that probably achieved much less than was advertised. But at least the journey has been made, which has reduced the risk of a contractionary policy error.

I'm not sure the risk of any policy error has been reduced. In fact, quite the opposite, I agree with those who think the Fed making a monumental mistake and will need to reverse course fast to avoid making the greatest policy error of our era.

As far as the merits of QE, in their latest quarterly review and outlook, Van Hoisington and Lacey Hunt note the following:

Since the introduction of unconventional and untested monetary policy operations like quantitative easing (QE) and forward guidance, an impressive amount of empirical evidence has emerged that casts considerable doubt on their efficacy. The historical facts regarding the grand experiment by the Federal Reserve Open Market Committee (Fed) are worth considering.

The trend in economic growth in this expansion has been undeniably weak and perhaps unprecedentedly so. Real per capita GDP grew only 1.3% in the current expansion that began in mid-2009; this is less than one half the growth rate in the expansions since 1790.

All beautiful but none of these economic commentators discuss what other options the Fed had except to engage in massive QE following the 2008 crisis???

A much better understanding of quantitative easing and its advantages and limits was provided by Graham Turner of GFC Economics in his seminal book, No Way to Run an Economy. On page 75 of that important book you all need to read, Turner states the following:

Much of the misunderstanding over quantitative easing reflected the same confusion that bedevilled monetary authorities after the money market crisis had erupted in the summer of 2007. Wrongly, central banks had assumed injecting liquidity would be enough, and ignored the importance of lowering debt servicing costs. Ironically, the Bank of England was guilty of this misapprehension, even though it was the first central bank to commit to quantitative easing. 

More than any other economist, Graham Turner understands the dynamics of debt deflation and what central banks need to do to avoid a total economic collapse. He's been writing on Japan's deflationary woes for years and if you're not subscribed to GFC Economics, get to it already and familiarize yourself with his unique economic commentaries and great chart packs (he's also a very nice and brilliant guy who has a hearing impairment so make sure you talk clearly when you meet him and let him read your lips).

Anyways, as we all await the Fed to deliberate over the next couple of days, I wanted to discuss this topic which I think confuses most people, including many so-called economic experts.

Below, Ray Dalio's favorite economist (mine too), Larry Summers, discusses fracking technology and why we're in a new world where the price of oil will stay low for a very long time.

Summers is bang on: "Globally, the thing people have to look at is what the long term fixed income markets are saying. And they're saying that nowhere in the industrial world are we really going to get solidly to the 2% inflation target over the course of a decade and that real interest rates, the neutral rate, are going to remain epochally low."

Second, Mohamed El-Erian, Allianz chief economic adviser and author of The Only Game in Town, discusses efforts by the Federal Reserve in uncertain economic times and the impact to the financial markets, stating "it's the end of an era and the path we're on is ending."

El-Erian also discusses why more volatility is guaranteed and key issues investors need to keep in mind. Listen to his comments below.

Lastly, while Ray Dalio warned the Fed's next move is QE, not tightening at Davos last week, Yves Lamoureux, president of macroeconomic research firm Lamoureux & Co came out yesterday to say the Dow will reach 25,000 because QE4 is coming.

Yves loves making big, bold calls and he might be right on QE4, but he's dreaming if he thinks the Dow will head to 25,000 when global deflation risks are rising. Read my recent comments on why the bloodbath in the stocks is over and why oil's nightmare dominated Davos to get a more realistic view on where these markets are headed in the short, intermediate and long term.