What Do Central Banks Do?

by Michael J. Howell11. March 2013 12:11

Prompted by yet another claim, this time by the great house of Goldman that Central Bank QE push up bond prices and push down yields by circa 100-125bp, it is worth looking at the facts and the theory. QE1, QE2 and now QE3 have seen generic 10 year yields rise. The ending of QE1 and QE2 saw 10 year yields fall. It is really that simple. If the 10 year bond represents the risk free asset for many long-term funds, then Central Bank balance sheet expansion will likely lower the risk premia on other risky assets and raise the risk premia on bonds. In short, the yield curve will steepen after each QE: it did and it is again now. Why the fuss? Surely, this is exactly what policy-makers want to do? Falling long-term yields would signal their failure not their success!

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A Peak With A View?

by Michael J. Howell10. March 2013 22:02
New highs on Wall Street have prompted inevitable navel-gazing. A popular repost is the 'lack of correlation between GDP and stock prices'. Another is the artificial '100-150bp drop in bond yields caused by QE policies'. The real questions should be (1) is there a strong correlation between GDP and profits growth, and (2) what governs the valuation of these profits? The first answer is an unequivocal 'yes' and the second comes down to two things - the scale of QE (and other liquidity effects) and the underlying inflation rate. It is clear that more QE reduces risk premia on risk assets. Since bonds are a low risk asset for long-term funds, QE is more likely to raise not lower risk prema on bonds. Therefore, the longer than QE persists, the more that equity risk premia will fall and bond risk premia will rise. Regarding inflation, Central Banks do not create CPI inflation, but governments do. While private sectr debt is high and excess capacity high, there will be no acceleration in inflation. Therefore, based on these 'internal' risk factors, Wall Street et al should rise. But two 'external' risk factors worry us: a too strong US dollar and the recent tightening by the ECB. End-February GLI liquidity data will be published around March 14th. They need to be watched.

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New Report 'Dance of the Dollar'

by Michael J. Howell7. March 2013 17:11

Research published today analyses swings in fortunes of US dollar and how its gyrations affect the global investment cycle

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Emerging Market Strategy March 2013 Published

by Michael J. Howell7. March 2013 14:31

Latest Report 'The Waiting Game' has been published. Main point is sign of rebounding EM liquidity vs. threat from stronger US dollar. Contact us for more information

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Finance and Economics, Or Economics and Finance?

by Michael J. Howell7. March 2013 14:12

It is widely-accepted that financial markets respond to economic phenomenon. However, we see it the other way. Finance is far more important to economics, than economics is to finance. Think of it in terms of flow of funds accounting. Economics focuses on ‘uses of funds’; finance focuses on ‘sources of funds’. Sources naturally lead uses. Thus our research is always more interested in whether the pool of liquidity is actually rising or falling, rather than the prediction of whether or not more will be spent on consumption. Two corollaries of this work are that Central Banks do NOT set interest rates, the market does (2007/08 confirmed this), and that interest rates are not the ‘price of money’. Rather interest rates are the ‘cost of capital’ and they are high or low ultimately depending on the profitability of industry. The ‘price of money’ is the exchange rate. Thus, low US interest rates and a weak US dollar tell us that US profitability is weak and the Fed is loose. In contrast, low Japanese interest rates and a strong Yen tell us that Japanese profitability is weak and the BoJ is tight. This also explains why real interest rates are higher in Emerging Markets.


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Do Central Banks (Really) Create Inflation?

by Michael J. Howell5. March 2013 08:50
It's a provocative title worthy of the John McEnroe stabbing retort 'You cannot be serious?' Indeed, the linkage between Central Banks and inflation must the most accepted 'fact' in economics. However, for some policy-makers right now, perhaps in deflating Eurozone or deflation-weakened Japan, creating inflation would be high on their wish list. Consider the four major crises of the past century: (1) Weimar Germany; (2) 1930s America; (3) 1974/5 Britain, and (4) 1990s Japan. All four suffered banking crises and faced huge debt problems, and all four saw similar policy responses with Central Banks significantly expanding their balance sheets, or much like today's QE. But two cases were inflationary and two were deflationary. Jury out? The defining feature is not the scale of the money printing, but who holds the debt? In the deflationary cases - America and Japan - the private sector was largely the debtor, but in the two inflationary cases - Germany and Britain - the largest debtor was unquestionably the government. Here is the lesson. When the private sector is in debt they will attempt to pay off their debts with any surplus cash printed by the Central Bank. In economic parlance the marginal utility of means of settlement money is high. But when the private sector carries low debts, they have less need for new cash and will tend to spend it, thereby creating inflation. The moral here is two-fold. First, Central Banks are not a sufficient condition for inflation, because they need the government to act as the 'helicopter'. Second, we much watch out for inflation to pick up once private sector debts have been run down and if the Central Banks continue to monetize. That is our risk.

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Liquidity Databook Published

by Michael J. Howell27. February 2013 18:53
February Liquidity Databook published today. Key points to look at are (1) reversal of ECB liquidity (2) acceleration of US Fed balance sheet, and (3) strong end-2012 growth in Total US credit.


Britain's Naughty Banks

by Michael J. Howell27. February 2013 18:53
The threat of negative interest rates aka a rap over knuckles of Britain's commercial banks was mooted last night by the Bank of England as a way to stimulate lending. Negative rates are not new to Switzerland where they have been used to dissuade investment in the Swiss Franc, but they seem a strange tool for boosting lending! Sadly it again shows that the Bank has lost its touch. Why penalise the banks? The reason they are not lending is that they can't, and not that they won't. Lending has little these days to do with reserves and everything to do with interest margins and an ability to garner long-term funding. Structurally, the loss of a branch banking culture and the widespread use of 'computer says 'no'' technology means that Britain's banks cannot easily lend to those SMEs that need capital. But even allowing for this, long-term funding remains problematic and a sufficient doubt to constrain new loans. What we have learned in the last decade ( or should have) is that the size of the Central Bank balance sheet controls the size of market risk premia. A bigger balance sheet ( more QE) means smaller risk premia and wider net interest margins, and hence more lending. The US Fed has successfully learnt this lesson. Making a scapegoat of the high street banks yet again will do nothing to boost British lending, and by making funding harder, the BofE proposal could weaken lending still further.

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Does Size Really Matter?

by Michael J. Howell27. February 2013 10:46
According to latest market-talk the BoJ is the 'loosest' Central Bank worldwide simply because its balance sheet now stands at nearly 35% of GDP. Second is the ECB at 28%, while the BoE and the US Fed trail at 25% and 20%, respectively. Of course, this is absolute rubbish! Consider a counterfactual. A poor, cash-based economy, with no developed financial sector may well have a Central Bank balance sheet that is near 100% of GDP. Does this make it very loose? What matters here is the change in the size of the balance sheet. The last decade has (or should have) demonstrated that changes in the size of Central Bank balance sheets move risk premia on risk assets in the opposite direction. Thus QE policies reduce market risk and promote recovery. The size of Central Bank balance sheets relative to GDP is greater (1) the more that cash is used for trade; (2) the greater required reserves, and (3) the smaller the shadow banking sector. Hence, our point that this ratio cannot judge the stance of monetary policy. Rather it is a measure of financial development, if anything. Changes in absolute balance sheets matter way more. And, here is the main point. If the Fed had just shrunk its balance sheet by 15% would Wall Street still be at current levels, or would it be 20% maybe even 30% lower? Risk premia matter. Tell that to the ECB who have just let their balance sheet fall by 15%, and somehow (we scratch our heads) claim this is an easing. Watch out Eurozone!

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Big Week for the BoJ and...

by Michael J. Howell24. February 2013 22:58
Who becomes next BoJ Governor will likely be announced in coming days. The result may matter a lot to markets, at least as a signal. The BoJ has already expanded net liquidity provision well-above the critical Y40 trillion threshold. More importantly they have unusually done so when the Yen is weak. More, probably much more liquidity is coming. The Yen will drop further. Probably through Y100/US$: possibly to Y110/US$. A weaker Yen is part of our stronger US dollar story for 2013: it may also play a part in pushing the Eurozone towards another bout of financial volatility by squeezing competiveness another notch. In markets, there are no unrelated events.

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