Friday, October 31, 2014

Japan shakes things up

Back in early January of last year I had a post titled "The biggest news is the weaker yen." Japan had shocked the world with news that it was finally getting serious about stimulating its economy. Perhaps most important was the news that the BoJ wanted to reverse the decades-long, relentless strengthening of the yen. The perpetually strong and stronger yen was the source of Japan's deflationary slump (even though there wasn't much actual deflation). A continually rising yen was strangling Japan's manufacturers and exporters, since they were continually forced to lower their prices to compete with overseas rivals. A weaker, more reasonably-priced and more-stable yen would be a significant first step to reinvigorating Japan's economy.

Today the yen dropped significantly, returning to levels last seen about seven years ago, on news that the BoJ was redoubling its efforts to provide monetary stimulation by aggressively expanding the monetary base. The stock market responded by also jumping to levels last seen seven years ago. The tight, inverse correlation between the value of the yen and the value of the stock market confirms that the strong yen was a big problem for the Japanese economy.

According to my calculations, the yen is now back to levels that are very close to what I consider "Purchasing Power Parity" with the dollar. It's reasonably priced. It's not weak, and it's not strong. It's now a neutral, rather than a negative factor for the economy. The future of the Japanese economy looks brighter. What will really make a difference, however, is a decision by the Japanese government to also adopt genuine fiscally-stimulative measures such as lower marginal tax rates, reduced government spending, and reduced regulatory burdens.

In the meantime, the world was also shocked this morning to learn that the investment guidelines of Japan's (and the world's) biggest pension fund, which currently holds most of its $1.3 trillion in assets in very low-yielding bonds. At least half of this sum will be departing bond land in the direction of equity land, and that is a pretty aggressive move. It's a solid chunk of evidence that the world is becoming less risk averse. That's the broader and most important trend to be found in economies and stock markets around the world these days.

Thursday, October 30, 2014

$2 trillion GDP shortfall

Third quarter real GDP grew somewhat faster than expected (3.5% vs. 3.0%), and on top of the 2nd quarter's 4.6%, that gives us annualized growth of just over 4%. Wow: has economic growth really ramped up than much? I'd like to think things have improved a bit of late, but in any event it's premature to reach that conclusion—we'll need to see at least another quarter's worth of stronger growth to be sure.

Abstracting from the quarterly numbers, which are always volatile, real GDP growth over the past two years has been 2.3% annualized (see chart above). It's also been 2.3% annualized since the recovery began in mid 2009. This has been a 2.3% growth rate recovery for over 5 years. Nothing much has changed, at least so far.

As the chart above shows, this has been the weakest recovery in history. The economy is now about 10% below its long-term trend growth potential. In other words, nominal GDP today would have to be $2 trillion higher to get us back on the economy's long-term trend. Due to a variety of factors (e.g., too much income redistribution, high marginal tax rates, too many additions to regulatory burdens, Obamacare, geopolitical uncertainty, unusually strong and persistent risk aversion, the retirement of the baby boomers), we are missing out on $2 trillion of annual income and 10 million or so jobs.

This is a big deal, and this is why the electorate is upset. We've made some terrible decisions and left an awful lot of money on the table.

But I do think it's likely that the economy is gaining strength on the margin. One reason for that is the big decline in government spending relative to GDP, which has dropped from a high of 24.4% to 20.3% in the past five years (see chart above), mainly because spending has not increased at all during this recovery. Spending is taxation, so what we've seen in the past five years is a huge decline in expected tax burdens. A considerable amount of weight has been lifted from taxpayers' shoulders. The private sector now has more breathing room. The private sector is now spending a larger share of its own money, and that means that spending in aggregate will be smarter, more efficient, and more productive. (Keynesians, by the way, get this all wrong: they think the economy has suffered because the government has not spent more and because the deficit has declined—that fiscal austerity is the culprit behind weak growth.)

Meanwhile, it seems increasingly likely that the electorate next week will repudiate the current administration's policies. At the very least we are likely to see congressional gridlock, which could keep spending from growing and reduce the burden of government further. More likely, we'll seen Congress make progress on reducing our onerous corporate tax rate, which could result in more new investment and more new jobs. We might even see some much-needed reform of our absurdly distorted tax code, and some sensible, market-based reforms to healthcare.

You can already feel the policy winds shifting. Instead of headwinds, we are starting to get tailwinds. This is very good news. There is a lot of ground to make up, and a lot of upside potential if we get things right in the next few years. It pays to remain optimistic.

Wednesday, October 29, 2014

QE3 R.I.P.

Today the Federal Reserve confirmed what the bond market has been expecting for many months: QE3 has ended, effective this week. What we don't know yet, however, is whether the end of QE3 will lead to another round of economic and financial market distress like we saw after the end of QE1 and QE2. I think we'll be OK this time around, because several key indicators today look a lot healthier than they did when QE1 and QE2 ended.

But first, let me point out once again that the real purpose of QE was not to print money or stimulate growth. It was to "transmogrify" notes and bonds into T-bill substitutes (aka bank reserves). QE boils down to the Fed simply swapping bank reserves for notes and bonds. Banks have been happy to hold most of the extra reserves as "excess" reserves, which means that they didn't use their reserves to collateralize a huge increase in lending. There was a huge demand for reserves qua reserves, and QE simply satisfied that demand. Without QE there would have been a critical shortage of safe, risk-free assets, and that would have threatened financial stability.

This time around, it looks like the demand for safe assets like bank reserves has declined and there's more financial stability, which means there is no longer a need for QE. Here's a quick look at the evidence:

The chart above shows the history of QE and 10-yr Treasury yields. Most of the Fed's quantitative easing efforts were focused on longer-term Treasuries, in a professed attempt to artificially depress yields and thus stimulate lending and the economy. But as the chart demonstrates, 10-yr yields rose over the course of each episode of QE. Moreover, 10-yr yields were unchanged during the period of Operation Twist, in spite of the fact that OT placed extra emphasis on bringing down 10-yr yields by buying long bonds and selling short bonds. In short, QE never achieved its intended result. I think that's because monetary policy is incapable of artificially manipulating long-term Treasury yields. Those yields are not determined by the size of Fed bond purchases, but rather by the bond market's perception of underlying economic and inflation fundamentals. Yields rose despite QE purchases because QE addressed a fundamental problem—a shortage of risk-free assets—and thus QE improved the outlook for growth.

It may sound strange, but despite the Fed's massive purchases of notes and bonds (totaling over $3 trillion), the Fed today holds about the same percentage of outstanding Treasuries as it did 10 years ago (see chart above). To be fair, a good portion of the Fed's holdings of Treasuries prior to the Great Recession were T-bills (a little over 30%). The Fed sold almost all of its T-bills in the first half of 2008 as it tried to respond to the market's desperate desire for risk-free assets. But it wasn't enough, and that is one of the reasons the Fed decided to embark on QE1.

In any event, after all those purchases of notes and bonds, 10-yr yields today are right around the same level as they were when QE1 was first launched. As the chart also shows, the correlation between big changes in the Fed's bond holdings and the level of 10-yr yields is not what we were told to expect. Big increases in Fed bond purchases (i.e., periods in which the blue line rose) were supposed to produce big declines in yields, because lots of Fed bond buying would push bond prices up. More often than not, however, the reverse occurred (i.e., both the red and blue lines moved together).

The chart above compares the S&P 500 index to the Euro Stoxx index. Both suffered serious corrections following the (largely unexpected) end of QE1 and QE2. The market is understandably concerned that this might happen again, now that QE3 has ended. Note, however, that equity valuations are significantly better today than they were at the end of QE1 and QE2, even though the end of QE3 has been known with reasonable certainty for many months. QE1 and QE2 were never tapered, by the way, they just ended all of a sudden. In contrast, the Fed has been tapering QE3 for the past 10 months. The end of QE3 cannot be a surprise or a disappointment to anyone at this point. If anything, it's a relief to know that it's over.

The chart above compares the level of 2-yr swap spreads—excellent coincident and leading indicators of systemic risk and economic and financial market health (see longer explanation here)—in both the U.S. and the Eurozone. Note that swap spreads rose significantly in advance of the recession and declined significantly in advance of the beginning of recovery. Note that they also rose following the end of QE1 and QE2. The major source of risk in the past four years has been the Eurozone, which has struggled with sovereign default risk and a double-dip recession. Eurozone banks were desperate to shore up their balance sheets throughout, thus creating significant demand for risk-free assets. Eurozone swap spreads were already elevated—symptomatic of rising systemic risk—in the runup to both QE1 and QE2, and they widened further after they ended. U.S. swap spreads rose in sympathy with Eurozone spreads, but to a lesser degree and starting from a lower base. Today, swap spreads in both regions are comfortably within "normal" territory. This, along with higher equity prices, suggests that the end of QE3 will not be painful.

The chart above compares the price of gold to the price of 5-yr TIPS, using the inverse of their real yield as a proxy for their price. Both of these are unique types of risk-free assets. Gold, because it is a classic refuge from political and monetary risk, and TIPS, because they are protected against inflation, they pay a government guaranteed real yield, and they are relatively short-term in nature. As the chart shows, the prices of both of these risk-free assets have been declining for the past few years. In other words, the market's demand for risk-free assets is lower (and falling on the margin) than it was when QE1 and QE2 were terminated. Again, this suggests that the end of QE3 should not result in tears. The market is no longer in need of more risk-free securities.

QE3, R.I.P.