What about higher rates? David Dodge

There has been many articles written in the last eight years about monetary policy being the only game in town.  Depending on who is writing the piece, we should either drop to our knees and thank the monetary gods for our economic salvation or maybe be less awe struck and thank them for the role that they played as lender (or market maker) of last resort.  The role that was originally bestowed upon them. 

One could argue that in terms of their other responsibilities that Central banks have inherited over the last number of years, they have been less god like, and the report card has not been stellar.  Growth has consistently been disappointing and inflation targets have not been met over a reasonable time frame.  For the first seven years after the crisis, the disappointment has been met with more and more monetary stimulus in different forms.  Still, the results were less than expected.  

Many central bankers now say that the monetary accommodation needed additional fiscal policy stimulus to be able to achieve the targets in a more timely manner.  I would point out that the economic projections that the central banks based their decisions on included government spending levels that existed at that point in time and their economic projections showed output gaps closing and inflation returning to target in response to the level of monetary stimulus that the central bank determined as appropriate.  At the given level of fiscal stimulus, our central banks were telling us that the level of monetary accommodation they were providing was sufficient to get inflation back to target over a reasonable timeframe.  It turned out to be wrong.

Now in hindsight, the academic in all central bankers will respond that this is understandable.  The lowering of the neutral rate of interest in response to very valid reasons, like low productivity and an aging work force, does not give them sufficient room to lower rates by enough to generate the needed economic expansion.  

But this was supposedly offset by alternative tools like quantitative easing which effectively lowered and twisted the yield curves to levels that could only be justified by overnight rates that were much lower than they were in reality.

The bottom line is that monetary policy, new tools and all, has been less effective than projected over the last seven years.

With this in mind, it was refreshing to see some out-of-the box thinking by David Dodge, an ex-Governor of the Bank of Canada.  Bloomberg recently reported that he delivered a speech suggesting that there should be a co-ordinated increase in rates by the central banks of the developed world.  I can imagine the gasps and guffaws from the hallowed halls and some questions on his mental well being.  In their world, and with their models, it is predetermined that higher rates would cause lower inflation or even deflation.  Moreover, the amount of fiscal expansion that you would need to offset the monetary stimulus would be politically unpalatable.   

Even those that have not been taught in the finest universities know that if the central bank raised rates 100 or 200 basis points, borrowing rates would go up and the economy would slow. 

Dodge argues that the world has changed significantly in the last ten years and the potential output of the economy is lower than the previous two decades.  He asks policy makers to rethink policies to deal with the low growth disequilibrium that economies are currently facing.  Since 2011 monetary policy has not been successful in restoring growth to its long term potential citing a lower natural rate of interest as the major challenge.  However, instead of suggesting that even more monetary stimulus should be applied, this ex Governor suggests the opposite.  Dodge argues that low interest rates may actually be doing harm to the economy, sighting the impact on savers and the lower incentive to spend and invest that “lower for longer” actually engenders.  The thought process for many could be, “Yes rates are low, but I have been told they will be at these levels for a long time.  I will wait to see how things unfold.” He also suggests that investment decisions may be delayed as business leaders are wary of a central bank with little ammo when the next downturn comes along.  

He concludes that price and financial sector stability would be better served by somewhat higher policy rates combined with more expansionary fiscal policy and that employment or growth need not be sacrificed if calibrated appropriately.  

Central bankers are trying to encourage risk taking in the economy.  Maybe they will have to take some risks with outside the box thinking to get the economy to where it should be.  

Don’t hold your breath.  

Changing corporate market liquidity in Canada

The BIS released their quarterly review at the beginning of December.  In the lead article, the authors noted the resilience of the major capital markets as they digested the surprising news of Brexit and the Trump election.   In the case of the US election, initial moves in some markets amounted to approximately five standard deviations of daily price changes.  In the case of the US 10 year, the abrupt 20 bp increase was greater than all but 1% of one-day movements in this yield over the last 25 years.  The authors declared that “market functioning proved resilient despite large price moves overnight and over the following days.   Market liquidity remained adequate.”

In the Bank of Canada’s most recent Financial Stability Report, they too came to the same conclusion saying “that there was no widespread, long lasting disruption in fixed-income markets” and that liquidity remained resilient.

 I will leave it to those that were trading during the events to determine whether their assessments are correct.  I think anyone involved in fixed income markets would suggest that liquidity in these markets has deteriorated since the 2008 crisis.

Liquidity is important to markets. In order to properly protect capital, it is vital to be able to adjust asset portfolios in a timely and cost-effective manner when the economic or political environment changes.   The intent of the regulatory changes phased in post 2008 was to reduce a perceived over-abundance of liquidity that existed prior to the crisis in the financial system.  In the eyes of the regulators, if it is too easy to transact in a security, not enough attention is spent by the holder in understanding the inherent risks in the product.  Why understand the complexity of an asset backed bond when you believe you can easily sell it before it goes bad.  Thus the new rules have made it more costly for intermediaries to trade and to temporarily hold inventory of riskier assets on their balance sheet in order to temper market liquidity.  The regulators are now asking themselves whether they got the amount of reduction right. 

The Canadian Fixed Income Forum recently released their survey results on liquidity that gives us a look at the changing domestic landscape.  The focus of the exercise was to determine the degree of deterioration in fixed-income market liquidity that has occurred over the last two years in fifteen categories.  (This, of course, misses the degree of deterioration that occurred from 2009 to 2014, as they seem to be assuming market participants do not change their behaviour until the rule changes have been enacted.)  They received responses from over 200 firms globally and have posted their analysis on the Bank’s website.

Not surprisingly, the survey showed that respondents want to work in an environment where they can do their job.  They want a consistent level of daily liquidity in order to transact, one where they can deal in reasonable sizes without moving market prices.  More importantly, the respondents want to have liquidity available to them during times of market stress, like a Brexit or Trump win.

In normal times, it looks like the regulators have the level of liquidity about right with regards to government product, but not right with corporates.  Given the regulatory incentives, this should not be surprising.  The results show that there has been a greater deterioration in the ability to transact riskier assets.  While liquidity of government issued benchmark bonds have held in well, products such as non-financial corporate bonds have seen their liquidity decline notably.  In the ranking of markets by liquidity, this latter category ranks 14th out of 15 with only repos of non-government product being less liquid.

The extent of deterioration in corporate bond liquidity is revealed by 70% of respondents noting that they have been unsuccessful in executing an investment grade corporate bond transaction within a reasonable period of time over the last 2 years.  As a result, 75% of survey participants have had to change their corporate bond execution strategy,  the biggest trend being greater reliance on agency trading than 2 years ago.  (This is where the intermediary on behalf of their client attempts to find a buyer or seller for a security instead of having to transact and have the security put on its balance sheet).  The decline in liquidity has also lead to transacting less, needing more time to execute and demanding a higher premium to compensate for the lack of liquidity of the underlying bond.  And this is in normal times.  

While investors struggle, the issuers of securities noted the greater degree of difficulty they had in gauging the market and pricing new issues of benchmark bonds.  They also noted the trend of investors demanding larger, more liquid benchmark bonds.  Great if you are a larger, consistent issuer of bonds but more challenging for smaller, less frequent borrowers. 

When asked how to improve the underlying liquidity, the suggested solutions centred on creating larger benchmarks, having better pre-and post-transparency and having access to more trading platforms.  In fact, 45% believe that being allowed to trade on a all-to-all platform, where both intermediaries and investors have access to transact, would help.  While these steps may marginally increase liquidity, as long as regulation makes it more costly for intermediaries to temporarily hold riskier assets on their balance sheets, the regulators have eliminated a number of sizeable temporary buyers for this type of product in normal times, let alone in a time of crisis.  

The Bank in their Financial System Review said, “the regulatory reforms are designed to make the financial system safer, in part by reducing the risk that dealers take on their balance sheets.”    I would argue it may have made the banks and the dealers safer, but at the expense of the market, specifically the end investor.  It must be very difficult for someone involved in the corporate bond market to feel that the financial system they deal in is safer or that the market is resilient and that liquidity is adequate.  

Holders of corporate bonds, non-financials in particular,  need to understand the degree of illiquidity that this asset class now has.  With the risk-free rate moving off the floor in the US, one should keep in mind that the exit door at the back of the theatre is very narrow in case of fire.  

  

Remember the Supply Side

Stephen Mnuchin, the incoming US Treasury secretary recently said he can’t see why the US economy cannot grow at 3-4% on a sustainable basis.  Fiscal stimulus through tax cuts and infrastructure spending, deregulation and some renegotiated trade deals will unleash the US economy to growth levels not seen in years.  

Global equities, currency and bond markets have bought in. Some market analysts are already suggesting Trump’s plan will be as positive to the American economy as Reagan was to it in the early 1980s.  I would only say, that the starting points, both in terms of the economy and the markets are not even close.

Along with this expected stronger economic performance comes the risk of higher inflation.  The long end of global bond markets and I would assume most central banks are starting to anticipate it.  This outlook is based on economic models that rely on the Phillips curve that suggests that there is a trade off between inflation and economic growth. If an economy is growing faster than its potential growth, then there will be upward price pressure on resources and hence inflation.  Potential output is the amount the economy can grow without putting undo upward or downward pressure on prices in the economy.  Very simplistically, potential growth is based on the growth of the labour force and the productivity of that labour, how much more one worker can produce over that year.  If the labor force grows at 1% a year and productivity grows at 1% a year, then the potential growth of the economy would be somewhere in the neighbourhood of 2%.  If the aggregate demand is growing at 4% a year, the difference between this and potential growth of 2% is creating an output gap and pressuring prices higher. 

 In the case of the Trump’s team pushing aggregate demand of the economy higher, there is little being done to address the supply side of the US economy over the near term and hence the pressure on resources to meet the increase in demand will push up prices quickly and significantly.  This move higher in inflation may even be enhanced if, for instance, the potential labor force is reduced as a result of moves against immigration.   As well, if the new President decides to impose select tariffs, this too could impact inflation dramatically.   

So how high and quickly will inflation increase?   These measures are being introduced when the economy is already near full employment, as defined by the Fed.  They have suggested that once unemployment gets below 5%, the risk to inflation rising increases.  Unemployment is already well under that level at 4.6% and their favourite measure of inflation lies just below their 2% target.  As I said before, just add a few tariffs and you very quickly get to higher levels.  

Given the initial conditions of adding more stimulus to the economy with it already maxing out, the general belief would be we will see inflation picking up notably and soon.  Unfortunately for Mr. Mnuchin, today’s economy is not built for sustained 3-4% growth.  Dump your nominal fixed income products, buy inflation protected securities and brace for a flattening yield curve.

The framework suggests inflation.  The economy will accelerate with the stimulus, the question about the ensuing upward pressure on prices lies on the supply side of the economy, or the  economy’s “potential”.  The issue is that this is an extremely difficult concept to measure.   Demographics and immigration data allow economists to have a relatively good handle on labour input.  The real problem lies with productivity.  The trend in productivity for the last number of years has been poor.  It is just not growing as it has in the past.  Many believe that it is not being measured properly.  Robert Gordon has written extensively on measurement problems while also giving us his downbeat views of productivity growth going forward.   (If you don’t have anything productive to do, I would suggest reading his tome).  However, despite a slowing down of potential growth as a result of a slowing in population growth and poor productivity growth, the accumulated excess supply of the economy amassed since the 2008 financial crisis has kept inflation at bay.  Despite the kick the economy is going to get, we don’t know how large this excess supply gap and the time it will take to fully close.    

Add to that, the underlying dynamics between output and inflation may be changing. Last week, the Governor of the Bank of Canada gave a speech entitled “From Hewers of Wood to Hewers of Code: Canada’s expanding service economy”.  He said “in terms of economic models, it is worth considering whether the relationship between inflation and economic growth could change as the economy evolves.  Certainly the concept of an output gap is gradually changing, as service capacity depends mainly on people and skills rather than industrial capacity…”  He adds that the concept of investing is shifting away from plants and machinery toward human capital and that even the concept of inventories is changing.   The digital age has altered the concept of capacity pressures on resources going up when producing one more “widget”.   This suggests that as the makeup of the economy is evolving, so too is the relationship between inflation and economic growth.

So in addition to the implementation risk around the measures talked about by the Trump team, what if the potential growth of the US economy is higher than is currently perceived by the market (and the Central bank)?  What if the relationship between inflation and economic growth are changing more than expected due to technology and the quiet shift to more service oriented economies in developed countries.  What if inflation is more global in nature lessening the reliability of looking at a standard output gap framework that focuses on the domestic economy.  

Since the end of the financial crisis, inflation has remained subdued and has continued to surprise people to the downside despite ongoing economic growth(albeit slow).  There is little doubt that inflation looks poised to move higher in the US.  It is doubtful that potential will reach a level that can sustain 3-4% non-inflationary growth.  But there are also risks that the move to higher levels of inflation will be slower than the market currently anticipates with the ensuing ramifications both for Fed policy and the inflation premium demanded by bond holders.

Food for thought.   

   

Inflation target: if it ain't broke...

I recently read the background document that the Bank of Canada released with the renewal of their inflation targeting regime with the Government of Canada.  

Not surprisingly, the Bank’s primary focus on what should be the optimal level of inflation is the one that ensures that they continue to be relevant when it comes to policy potency.  This requires having a level of inflation high enough to give them room to maneuver above the effective lower bound (ELB).  As the name suggests, this is the absolute bottom level that economists believe short term interest rates can base.  For centuries, this level had been assumed to be zero.  This is no longer the case, as is evidenced in many countries.  

To explain, one can imagine nominal interest rates being made up of two components.  The first is the inflation component that compensates the holder of the security for the expected loss of purchasing power incurred by inflation over the holding period.  The remainder can be viewed as the real rate of return that the investor will receive after inflation.  This compensates for, among a few things, the value of the investor not being able to spend his cash immediately.

As an example, if inflation is expected to be 2% and the real rate that the investor needs is 2%, the nominal rate would be at 4%.  If the economy required monetary stimulus when short term rates were at this level, then theoretically the central bank could cut interest rates by 400 basis points before hitting zero.  

In reality, the neutral rate of interest has moved down.  This is the rate that theoretically neither adds stimulus to the economy nor detracts.   Evolving demographics and changes to investment, have led the central bank to lower their estimate of the nominal neutral rate to somewhere around 3% from between 4-5%.  On face value, this suggests that if the Bank needed to add stimulus, there is less room to move.  

What is a central banker suppose to do?  The ones who never leave the building suggest just raising the target level for inflation.  This seems to be hard to swallow, given the difficulty all central bankers are having at attaining their lower inflation targets now in the real world.   

The other response is to assume that zero is no longer the effective lower bound for short term interest rates.  If the lower bound is -1%, then you have just as much room despite the neutral rate having been lowered.  Internal work at the Bank, suggests to them the lower bound in Canada is minus 50 bp.   Moreover, with other monetary tools at the disposal of the central banks, they can influence the yield curve as if front end rates were much lower.  These new tools include forward guidance (where the monetary authority tells you that she will keep rates low for a certain period of time conditional on some target), quantitative easing (where the central bank buys government securities further out the yield curve) and credit easing (where securities issued by non government entities are purchased).

Given the new tools and the lower effective floor for rates, the Bank has decided to leave the inflation target at 2% as they believe they continue to have sufficient monetary policy potency to minimize costly volatility of output.   

But does the Bank still have sufficient policy effectiveness given this new tools?  There is little doubt that these measures have been successful at lowering currencies, rates and yields in other countries but as the Bank notes, “data limitations and economic developments in the wake of the crisis make it difficult to precisely identify the impact of any policy measures.”  Later it states that “they cannot access the longer term effectiveness of these policies, particularly regarding their impact on economic activity and inflation.”

Despite the move down in the neutral rate, the Bank justified leaving the target level of inflation at 2% based on the fact that monetary policy can still be effective given the additional tools at its disposal.   This is despite their admission that these tools, in the longer run may or may not be effective on economic activity and inflation.  I suppose they will get back to us later on that, once they know.  On the margin, the justification seems weak, but I guess if the inflation target ain’t broke, don’t fix it. 

   

Polls and Policy

Pollsters and pundits did not fare well following the results of the American election.  To be honest, their track record of late has been suspect when you think of Brexit and others, including a couple of provincial elections lately in Canada.  They, of course, would counter that the results were within their confidence levels, but the impact of getting the final victor wrong is significant.

I could not help but think about the similarities between how the pollsters and central banks operate.  Should central banks be at all worried about the declining ability of the pundits to get it right on the political side?   

When calling the likely outcome of the election, the modern day pundit has ample hard polling data.  The data is gathered, sliced and diced put into their models which spits out the most likely scenario.  The results of the ongoing poles throughout the election process are monitored and used to alter the politician’s strategy.  The next poll is used to measure the strategy is working and the message is resonating.   All involved assure themselves that their strategy is being built on a strong foundation of hard polling data being input into robust models.  

Similarly, when setting monetary policy, most central banks heavily rely on hard data and their models.  The ongoing economic data is used to monitor where they stand with respect to their objective (usually an inflation target) and what the most likely outcome will be for the economy and inflation.  They then enact a strategy of adding more or less monetary stimulus to achieve their objective based on this outlook. 

In retrospect, it is obvious that the polls and the pundits’ models did not capture a major driver responsible for the decision of the electorate.   On election day, it suddenly became apparent that the political experts had measured what voters had said but not what they were going to do.

This result from the political sphere raises the question with respect to monetary policy as to whether policy makers are at risk of not putting enough emphasis on listening to economic agents but remain somewhat dogmatic with what the theory and models say should be happening.    

Since the financial crisis, there has been a consistent miss to the downside by almost all central banks for their forecasts of economic output.  Given the continued belief that the models are theoretically robust and the data is sound, the response continues to be to increase stimulus, delivered by various monetary policy tools.  Again the response by the economies to these measures has been less than predicted by the hard data and models. 

I suspect that there are many in the political arena that are going back and having a hard look at what went wrong in early November.  Maybe after eight years, some central banks should do the same and ask themselves what they are not “hearing”.

Two Worlds

Books and degrees can provide an excellent framework, but to truly understand markets, you have to experience them.  I’ve seen my share of tumultuous cycles over 36 years in the world of finance, which some may say has provided me an experienced perspective, while others might argue has made me a jaded, irreverent, grumpy old man. I suspect both are true. 

I learned in the private sector that the trading world is one that is dominated far more by reality and far less by theory. The text book may postulate that markets are rational, but more often than not, the reality of a trader's profit/loss statement at the end of the day would not agree. Further proof of that is looking into the eyes of a trader who has based his strategies on macroeconomic fundamentals but is marked to market daily.  For much of the time, these eyes usually twitch.   

The central bank world is dominated by theory. Here, incoming reality, be it monitoring economic data or listening to market “chatter”, was heralded gloriously if it fit with what theory would have predicted.  Any transgressions, however, would be downplayed or set aside and given more time to allow reality to come to its senses and catch up to the text books.  

The essence of a central bank’s culture was captured beautifully by an article recently sent to me.  The piece was written by W. Ben Hunt and is entitled “Viewing Capital Markets through the lenses of Game Theory and History”.  In the note, Hunt commented on the internal political workings of a central bank.

To paraphrase at a high level, he said that “the spirit, culture and personnel composition of a central bank (Fed) is almost identical to that of a large research university”.   Thus, the motivation for many at a central bank is their academic reputation, not results.  Particularly at the analytical staff levels, I would add that they feel more accountable to following robust economic theory and maintaining rigorous models than to the actual results they produce.

Ben Hunt further wrote, “At the central bank, your internal reputation is entirely based on how academically smart you are.  This is measured by what papers you have had recently published and what conference you presented at, with little weight on anything practical.  Every hour you spend doing outreach to commercial bank staffers is an hour you are not spending impressing your bosses with how smart you are.”   What ensues is “a huge desire to form a consensus with other smart people so each of you is recognized by the other members to be smart enough to be a member.”  Woody Allen could not have said it better.

The two worlds could not be more different.  The markets being dominated by reality which is irrational, bumpy, harsh versus the theoretical world of how the markets work which is rational, smooth, kind.  One world focused on the immediacy of results, versus the other on “in four to six quarters from now.”

The problem is that both worlds have become more and more dependent on the other.  Monetary policy is transmitted through markets to the real economy and the markets are priced off of expectations of probable central bank actions.  They need to understand each other, but with different objectives, different risks and different timelines, one could say that the markets are from Venus and the central bankers from Mars.  

Since the financial crisis, this has not been an issue.  Both sides have been rooting for the same thing, higher financial asset prices but obviously for different reasons.  Market practitioners want to protect and grow capital, and central bankers want more accommodative financial conditions to spur economic activity.  This has required extraordinary efforts on behalf of the central banks including pushing reality into the theoretical world of negative interest rates.   This action by some banks, along with other monetary policy tools has suppressed the harsh, bumpy world for markets.  As economies (read US) recover and find their footings, the alignment of the two worlds described above will dissolve.  The clash between the two worlds will become more evident.  

Volatility will increase and importantly, the central bank will have less at stake in constantly rising asset prices.  That is not their mandate and I think this will come as a surprise to many.  I am old enough to assure people that thirty some years ago there was no such thing as a Volcker “put”.  

Central Banking: Wizard-At-Odds

If you’re interested in monetary policy and related capital market issues, as seen through the eyes of a retired market practitioner and Central Banker, you have stumbled across the right blog.  I hope you find some insight here, and if you are a bit of a skeptic, some solace as well.

Experience can be over-rated, but in the case of this blog, I am relying on it extensively.  I started and ended my career at a central bank as a trained economist who focused on capital markets, specifically fixed income securities and derivatives. For 15 years in between, I worked in the belly of the beast, first at a major bank and later with an investment dealer.  I mostly bought and sold government bonds and derivatives, trying to make money trading on minute changes to their prices.  When I returned to the central bank from the trading desk, my private sector exposure and my network of contacts made me an ideal candidate to move into a liaison role between the central bank and those in capital markets.  As a result, within the institution, I was labelled as a “markets’ guy”.  I reached out to many of the stakeholders in the capital markets, hearing their views, answering their questions and assuring them that all was well and that whatever crisis existed at the moment had been anticipated (of course) and policy makers would be responding appropriately, when necessary and in time.

Sitting in this chair, I felt it was my duty to relay the views that I heard on the 'street’, in particular the ones that countered and tested the prevailing internal consensus. It was a great job. You ask questions, you listen, you analyze, you compose, you report back. In theory, they listen, they analyze, they include feedback within future decisions. In practice, however, for many years, it seemed to be viewed just as “nice to know” information as markets were not that important of an input in their models.  Envy of “less educated” but higher paid individuals and the ever-loving drive for academia to rule the institution placed a high hurdle on the admissibility of market input.  If the views from the market participants wasn’t what central bankers had expected or what they wanted, the information was met, at best, with a nod, and usually just with silence. After all, the opinion of market participants was obviously biased by their desire to make money.  Moreover, what could these market people possibly know about monetary policy and the functioning of markets.  They had not written any papers on either topic, at least not seen in a respected journal.  And, some of the things they were saying had just not yet been seen in the data.

Either in religion or central banking, it is very difficult to penetrate the intellectual and philosophical wall put up by a self re-enforcing group.  When everyone who is worth listening to, in their minds, views the economy the same way, by using the same intellectual framework taught at the best schools, it is extremely difficult for them not to apply the same solutions to the same problems regardless of external feedback and results.  I believe Einstein had a quote for that type of behaviour.  ("You're an idiot.") By challenging the status quo, and reminding people that there may be other opinions and solutions, there is repetitional risk that ultimately influences one’s internal standing.  Hence, sadly, the status quo remains largely unchallenged.

The good news? My position let me hear both sides and come to understand what the other side is missing.

My desire for this blog is to discuss ongoing monetary policy and other market related issues and to challenge the internal “norm” with doses from another perspective, most likely the market’s.  A wise friend used to say that the monetary authorities “don’t let facts get in the way of a good story”.  Hopefully, we can keep our eyes on the facts.

I believe central bankers would like to be seen by the public as the all knowing Wizard of Oz.  Like the movie, the truth is that behind the curtain is just a small group of people, supported by the theory-driven munchkins,  looking out at the economy and pulling the one lever they have.  Wizards, they are not.  I propose to call this blog site, “The wizard-at-odds.”

Thanks for reading.