Liquidity - questions, not answers

As equity markets continue their charge higher across the globe, confounding the bears yet again, every pundit and blogger is seeking the reason why. Well, I am no different. If I could produce a convincing explanation for the continuing rise I would elevate myself above the rank of plain "blogger" to "pundit". Such is my ambition. However, not having a convincing explanation, all I bring to the party is a lot of questions:

My first is: Does the growth in monetary base in almost all countries have something to do with it? The following excerpt comes from an article on www.freebuck.com

The economist magazine is reporting that money and credit expanded on an average of 18%, in 2006. As Gary Dorsch of www.sirchartsalot.com and Global money trends magazine puts it "Baby step rate hikes by central banks have failed to rein in explosive money growth. In Australia, the M3 money supply is 13% higher from a year ago, British M4 is 13%higher, the Euro Zone's M3 is 9.3% higher, a 16-year high, Korea's M3 is 10.3% higher, China's M2 is 16.9% higher, a 16-year higher, Russia's M2 is 45% higher, and the US M3 has been reconstructed to show 10.7%growth in 2006." This is a prescription for over 1 trillion dollars of new money and credit in the USA by next fall... It is a recipe for explosive growth.

Bernanke, and the other Central Bankers are on a mission, "Whip deflation now" and are being pushed by their local politicians looking to the next election who are willing to do anything to keep the party going. In Japan The LDP under Shinto Abe just stared the Central bank down and an interest rate hike was averted. Central Bank Chairman Fukai was forced to stand down from a well-telegraphed interest rate hike; the politicians are firmly back in charge, as they were before former Prime minister Koizumi took power. Central bank independence is dead in Japan, it is not a recipe for good things. So its off to the races for the carry trade and monetary stimulus. Do you think they would drain liquidity by 40% now like they did last spring when Koizumi was still in Charge? No way, Old school politicians are firmly back in control. So it's GO GO GO for now.

Clearly monetary growth of 18% must go some way to explaining the increase in asset prices, as well as suggesting why we have low single-digit GDP growth with such startling monetary growth.

My second question is: If central banks are on a tightening cycle, why is money supply still growing so strongly? There must be a mechanism which is bypassing the restrictions being imposed by the central banks; this mechanism is probably financial engineering - derivatives, if you prefer a broad term for a loosely-related family of products. On an institutional level the development of Credit Default Swaps and the like has allowed obligations to be parcelled up and moved off balance sheet, thus allowing institutions to increase their lending. On the retail level, the development of interest-only mortgages, ARMs and other types of consumer lending products designed to roll out lending beyond previous norms, has allowed large numbers of new borrowers to run up debt - or put another way, spend money they have not earnt - yet. To me, this retail end of credit creation is where the rubber hits the road, where M3 is getting its afterburner-boost.

As always, the major reference point for this is the US; is it because Americans are the most creative when working out new ways to lend money to fresh consumers, as well as spreading the risk among larger groups of institutions? Or is it because the Federal Reserve has, since the 1929 crash, made it its duty not to let so many fingers get burned again? We have yet to see if the Greenspan Put has become the Bernanke Put, but I know where my money is.

However, although eyes turn to America whenever high levels of consumer debt are mentioned, the figures for money supply growth stated in The Economist show it is happening elsewhere. Here in the UK, whenever global warming or money-for-honours investigations move off the front pages, consumer debt takes up residence. Last week I saw a headline saying Singapore has decided to lower the level of income needed to borrow - not knowing what level they started from means I cannot tell how much difference this makes, but it does indicate that even traditionally thrifty nations are joining the trend.

And then there was this on MNS 2nd Jnuary:

JAPAN: The monetary base fell 21.1% to Y90.05 trillion in January from a year earlier, down for the 11th consecutive month as a result of the
Bank of Japan's ending its ultra-expansionary monetary policy in March 2006, BOJ data show. It has been declining at or over 20% every month
since August 2006.

So, good old Japan is still struggling to rid itself of deflation, yet it is shedding 20% of its monetary base as we speak. Now, I could try to understand the relationship between the monetary base, government borrowing, consumer credit and deficits, but I want to post this and get on with my supper. So, instead, here is my final poser: Is monetarism no longer important? Did the Great Relationship between money supply and inflation die with Milton Friedman? We have huge differentials in growth/shrinking of monetary bases, and very little difference (supposedly) in the things that matter, like inflation, growth etc. Hmmm... I will have to investigate this further.

Toodle pip

Jambutty

The Problem with the Fed's Bet on a Slowdown

Ben Bernanke has laid his cards on the table; by pausing in the rate hike cycle (though explicitly not necessarily halted) he is gambling that slower growth will pull inflation back to acceptable levels, without the need for further - potentially crushing - rate hikes.

In doing so, he is gambling his future on a number of uncertainties, the biggest of which is probably whether slowing growth will bring down inflation. Indeed, he has openly acknowledged he is uncomfortable with inflation as it is, and that it may creep higher, albeit at a slower rate. However, although the economic cycle and the inflation cycle are connected, the relationship is beset with a substantial (and incalculable) time lag.

At present a lot of pundits in the US (as they are in the UK) are focused on the declining spending power of the consumer - we read daily that if all you consume is flat screen TVs, you are laughing, but if you have school fees/a car/central heating - and also eat food now - personal inflation is way way above the officially given figures. Unfortunately for the consumer, wage increases have been held back, ostensibly by advances in globalisation - the ability to shift production to lower wage areas keeps wages elsewhere restrained. However, that may be a fallacy applied to help make a story understandable, and we may be about to see the rise of wage inflation. The reason this may happen is that individual workers can see corporate earnings rising strongly, and although these are historical figures relating to the last quarter, the reaction from workforces will be forward looking - hence the timelag between inflation and the economic cycle. Even if a turndown is in prospect for many firms, unions will carry previous earnings data into the negotiations on wages, and with the pressure on wallets being felt by most of us, I doubt retraint is a word they are going to be comfortable with.

In the US, there are a number of other factors which undermine the lower-growth/lower-inflation gamble, including 3rd quarter spending on defence, potential for a capex rebound, and continuing rises in energy prices. Some do not apply to the UK, but the main point about prospects for wage inflation do. In view of this, I believe the BoE will find it very difficult to resist the pressure for one more hike this year.

WHAT IS GOING ON IN THE MARKETS?

The simple answer to that must be “I am not sure”, as the USD swings up and down in big-figure moves from one trading session to the next, as stocks plunge and then rally, and commodities do their thang with massive one-day swings.

As the dust settles on the last few days, and the bulls and the bears call a truce, how does the price action relate to the fundamentals? Leaving aside the usual rumours – possible defaults by LME clients, yen intervention by the BoJ – where have the markets ended up in relation to the near term outlook?

Focusing on foreign exchange and interest rate markets, it is clear that the mood at the end of the week is almost diametrically opposite that which existed at the beginning; then, inflation was the fear closest to everyone’s trading book, with long end yields set to push through key levels, and the $ losing ground rapidly across the board on fears that the Fed was not going to be rigorous in tackling inflation. By the end of the week traders appear sanguine about the inflation outlook, and happy with the idea of the Fed supporting the economy rather than being hawkish on inflation.

But what do they base this on? It would seem that the Fed talk of a slowdown (particularly as housing cools, and the consumer – finally – reins in his horns) is deemed to point to a reduction in demand, which should cool rising prices. Thus [much] higher rates will not be required to bring CPI back to levels the Fed – and the markets – are more comfortable with.

But what if CPI is not being driven up by demand? For sure, there is evidence that strength of demand has allowed some companies to –finally- pass on some of their cost increases from higher raw material and other input prices (both in Europe and the US). But whether demand has made it possible, or if in fact it is an inevitable increase due to ever-rising input prices is almost irrelevant. Higher prices is higher prices, although it will be interesting to see if slowing demand does have much of an impact. However, although it is appealing to break economics down into simple cause-and-effect equations, in most cases there are far too many interlinked factors for that. Demand-pull might be helping prices rise, but other factors are also at work, and therein lies the dilemma: Should the Fed pause after the next hike, watch the data for a few months, and then decide on the next move? Or should it continue hiking until it knows it is in control?

The markets appear to have decided on the former. If, as I believe, inflation is alive and well and lurking in yours and my pay packets, what does that mean for interest rates and currencies? I think the markets have this one wrong; if the Fed pauses, and inflation is creeping in, it will be behind the curve, and will have to work twice as hard to dampen it again. Once the workforce believes inflation is a reality, it takes on a life of its own.

If the Fed does decide inflation is the bigger evil, and continues to hike beyond current expectations, does it mean that the consequences will be different? I believe not. In the former scenario, inflation becomes steadily more visible, the Fed is deemed to have missed its chance and the USD and $ assets become less and less attractive. The currency falls and long yields will rise – the Fed may be forced to try and protect the USD by raising rates, but by then its impact will be limited.

If the Fed continues to raise, then I think demand-destruction will surely take place. This will not, however, lead to an attractive investment scenario for the US; again $ assets will be unattractive in comparison to those in better-managed (less badly?) economies. Down goes the USD, up go rates.

So, damned if he does, damned if he doesn’t. I say, as I have since the euro/usd was trading on a 120 handle is sell the USD; if you really feel like punt, sell bonds (and bunds) as well.