Tapering ... Bah!

by Michael J. Howell15. August 2013 09:34
'the money here is awful ...and such small flows...' is a Groucho Marx-like reflection on the growing debate over Fed tapering. Fact #1 is that QE3 is no QE1 and never was. The $85 billion monthly Fed injections could easily be trimmed to $75 bn at the September FOMC, but these flows are anyway being swamped by buoyant private sector liquidity inflows. These private flows, not the Fed, explain the firm US dollar; the rebounding US economy and rising bond yields. In short, policy-makers have been fooling the markets this year with their power. Fact #2 most of the Fed cash is effectively going to support the still fragile wholesale money markets. Given the vast increase in OTC bond issuance/ trading since 2008, these wholesale markets are probably still vital in providing funding for market makers. Fact #3 the Fed is internally worried by growing speculative activity and needs to show its hand. We know that the key decision makers anyway prefer 'forward guidance' to 'QE', so the latter is an easy sacrifice. Bottom line? Expect a September move to reduce QE. This will not derail the economic recovery, but it is likely to help the US dollar climb higher, and most importantly it will be yet another factor leading to greater market volatility over the next 12 months. Tapering matters, but not that much.

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Slower China Means Higher World Real Interest Rates

by Michael J. Howell14. August 2013 22:28
The outlook for our least favourite asset class in 2013 - TIPS - still looks poor. China's structural slowdown, in large part the result of tight PBoC liquidity hitting capex spending, will allow capital productivity in other economies, notably Japan and the US, to pick-up. This will push up World real interest rates from the circa 0% level nearer to their 2-3% long-term average. High inflation is not the threat; higher real interest rates are. This will push nominal bonds towards a 4-5% yield base. Equities still look the best asset class, but markets are ultimately moving towards a 1987-like ending. See report: How China Sets World Interest Rates (part II).

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Latest Global Liquidity Data - August Update

by Michael J. Howell14. August 2013 09:40
The latest (end-July) Global Liquidity Index (GLI) hit 73.8% against a 'normal' 0-100 range. This is equivalent to US$145 billion pouring into World financial markets. The distribution of liquidity remains very uneven. The leading markets were again the US, Britain and Japan, with liquidity in the Eurozone and Emerging Markets weak. The data show strongly divergent trends in private sector liquidity, and warn of heightened forex market volatility.

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Global Liquidity Update

Latest GLI - June Liquidity Update

by Michael J. Howell18. July 2013 23:59
Latest end-June 2013 data show our monthly Global Liquidity Index (GLI) hit a reading of 75.4 ('normal' range 0-100). Stripping out the two weak liquidity regions, namely EM and Eurozone, the overall index would exceed 85, or more than two standard deviations above its rolling four-year average.

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Mid-Year Review: The Three Big Events So Far in 2013

by Michael J. Howell8. July 2013 22:24
Believe or not, the big events of 2013 do not nclude either the influx or proposed ending of Fed QE3? We figure that three others are more critical. Together they explain the high current level and uneven distribution of global liquidity. See our research for more information: (1) the jump in US private sector cash flow generation, which is dollar and economy bullish; (2) huge Japan QE, which smashed the Yen, hurt EM economies, but will cause a Japanese economic turnaround, and (3) the decision by the PBoC in China to remain tight, which will cap Chinese growth and limit further large-scale capex.

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Tampering Or Tapering?

by Michael J. Howell8. July 2013 22:23
Two conclusions emerge from recent US and European Central Bank policy comments: (1) the Fed seeks to clearly distinguish (a) 'forward guidance' on Fed Funds from (b) QE, which determines the risk premium on bonds. Thus taken together forward guidance and QE determine bond yields. However, contrary to popular belief we believe that QE raises and does not reduce bond yields. Rather it reduces all other risk premia. The Fed by seeking to taper QE is trying we believe to stop the hunt for yield and likely wants to fatten 'too low' risk spreads on instruments such as junk debt, (2) the decision by the ECB and BoE to include 'forward guidance' is an interesting step. The ECB is admittedly using more 'words ' and according to our earlier points cannot control risk premia without QE. Nonetheless, the important thing here is that a European 'forward guidance' clearly opens the way for monetary policies in the US and Europe to formally diverge significantly. This could be key in 2014.

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Tampering Or Tapering?

by Michael J. Howell8. July 2013 22:09
Two conclusions emerge from recent US and European Central Bank policy comments: (1) the Fed seeks to clearly distinguish (a) 'forward guidance' on Fed Funds from (b) QE, which determines the risk premium on bonds. Thus taken together forward guidance and QE determine bond yields. However, contrary to popular belief we believe that QE raises and does not reduce bond yields. Rather it reduces all other risk premia. The Fed by seeking to taper QE is trying we believe to stop the hunt for yield and likely wants to fatten 'too low' risk spreads on instruments such as junk debt, (2) the decision by the ECB and BoE to include 'forward guidance' is an interesting step. The ECB is admittedly using more 'words ' and according to our earlier points cannot control risk premia without QE. Nonetheless, the important thing here is that a European 'forward guidance' clearly opens the way for monetary policies in the US and Europe to formally diverge significantly. This could be key in 2014.

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EM Head For The Entrance!

by Michael J. Howell25. June 2013 17:57

When everyone else yells 'sell', start to think differently. EM are not yet in a sweet spot but this could come early in Q3. We figure that 'cyclical economic recovery' is the message from skidding bond markets. This is entirely consistent with our data showing rising liquidity. On top, we expect EM currencies to weaken as local policy-makers begin to ease. This may worry EM bonds, but EM equities will benefit. Third, the main historic driver of the Asian business cycle is the Yen. This plunged in Q1 and Q2, but should now stabilise. A flatter Yen is a great base for EM to build upon. What could go wrong? Our main worry concerns a too strong US dollar, but if our hunch that we are in a 'normal' economic recovery proves correct, the US dollar may soften over coming quarters as the US current account deficit again starts to swell.

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Watch Bonds

by Michael J. Howell21. June 2013 08:19
Bond markets nearly always give more sober assessments than equities. The movements in global fixed income markets in the past two months have it right again. QE or simply more liquidity drive up the risk premia on long-dated bonds (the low risk asset) and drive down the risk premia elsewhere. This is Liquidity Theory 101. If policy-makers anchor the short-end (they do) this beomes a bear steepening. The Central Banks pumping in most liquidity, the Japanese and the US, see the greatest yield curve steepening and those pumping least,the ECB, suffer the least (Bunds). On top, think about real interest rates. These are rising in anticipation of better economic growth in the second half 2013 and, if we are correct, stronger capex. The rise is connected to the end of the Great China Cost Shock we have written much about. This will push up marginal returns on capital and cause real rates to rise. 4-5% bond yields are again on the horizon. This is bullish for everyone else!

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Risk Assets ...Time to Exit?

by Michael J. Howell21. June 2013 08:06
The mid-June FOMC spooked markets with Bernanke's exit talk. Actually, we learned nothing new here and in fact if anything the long-tail exit should be reassuring. In our view, this liquidity cycle should last until 2015, and we still rate 2016/17 the mst likely time for the next banking crisis. So what now? The big stories for 2013 are not about the Fed, but three other things (1) strong growth in US private sector cash flows; (2) Bank of Japan QE and (3) lack of any QE in Eurozone and China. In short, liquidity may be high globally but it is skewed first towards the US and Japan and second skewed towards private sectors. Central banks overall including the Fed are not as easy as many assume. Strong private sector liquidity is a sign to us that economies will pick up strongly in the second half 2013. This tension is worrying bond markets. Money now has two directions to go it: real activity and financial assets. This must heighten volatility. The next 18 months should still see rising risk asset markets, but it will be a much bumpier ride.

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