The Fed’s in Play: What’s in Store?

March 11th, 2015


  • A series of strong jobs reports have lowered the unemployment rate to 5.5%, which could prompt the Fed to begin normalizing interest rates, possibly in the June-September time frame. Nonetheless, the Fed has considerable leeway, because inflation measures are still well below the Fed’s 2% target and wage pressures are absent.
  • Once the Fed makes its move, the markets will focus on the path of future interest rate hikes. The bond market is pricing in a more gradual path than what FOMC participants envision, with the fed funds rate reaching 1.5% by year-end 2016 compared with 2.5% based on FOMC members.
  • My own assessment is the Fed is likely to proceed very cautiously initially, but I expect the funds rate to peak at a higher level than what is priced into the bond market.   

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“Currency Wars”: Real or Imagined?

February 17th, 2015


  • Based on newspaper headlines, people may have the impression central banks today are pursuing actions similar to “beggar-thy-neighbor” policies during the Great Depression, when a series of currency devaluations culminated with protectionism and trade wars. 
  • The situation today, however, is quite different. While monetary policy easing in Japan, the eurozone, and other countries has weakened their respective currencies, officials from the Group of 20 recently endorsed these actions as helping to boost the global economy. In this respect, currency depreciations that result from monetary policy easing are not viewed as a zero-sum game. 
  • At the same time, there are limits to the effectiveness of quantitative easing (QE), and currency depreciation appears to be the primary channel for jump starting the Japanese and eurozone economies.
  • If so, investors need to assess when U.S. officials will object to a stronger dollar. My take is the dollar is fairly valued and will not be viewed as a problem as long as the economy grows satisfactorily and unemployment stays low. Therefore, the path of least resistance is for the dollar to continue to trend higher in 2015.

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The ECB Combats Deflation

January 21st, 2015


  • The European Central Bank (ECB) is expected to announce a program of mass purchases of government bonds this week in an attempt to counter the threat of deflation in the euro-zone. Nonetheless, while this action has long been anticipated, many observers (myself included) question whether it will succeed in jump-starting Europe’s flagging economies, considering how low bond yields in Europe already are.
  • The primary channel for it to operate is the currency markets, where the euro has fallen by more than 15% versus the dollar since last summer. In this regard, the ECB has taken a page out of the Bank of Japan’s (BOJ) playbook for combating deflation.
  • Meanwhile, the debate rages about whether countries such as France and Italy should be permitted to run larger budgetary deficits and whether Greece should receive additional debt relief. Absent any breakthroughs, my take is that the path of least resistance will be taken for the ECB to foster additional depreciation of the euro as a way of countering deflation. However, this will pose challenges for countries such as Switzerland that previously linked its currency to the euro.

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Will Japan Finally Overcome Deflation?

December 23rd, 2014


  • With his re-election as Prime Minister, Shinzo Abe will have a second try at jump-starting Japan’s flagging economy. The prevailing view among economists is there was progress towards combating deflation in the first term, but the decision to boost the national sales tax by 5% in April wound up weakening the economy. 
  • One of the purposes of holding early elections was to lay the groundwork for Abe to postpone a second round of value-added tax (VAT) increases slated for 2015, while the government embarks on a series of structural reforms. However, most economists are skeptical about what will be accomplished on this front. 
  • Meanwhile, the Bank of Japan’s (BOJ) efforts to expand its balance sheet in the past two months has contributed to a further weakening of the yen, which has now depreciated by nearly 45% against the dollar over the past two years. In my view, this is vital to improving Japan’s competitiveness and jump-starting the economy in 2015. 
  • My assessment is that the onset of deflation in Japan in the mid-1990s can be traced to an increase in the yen on a real trade-weighted basis of more than 60% over a ten-year period. Consequently, if the BOJ is able to engineer further yen depreciation, the prospects for ending two decades of deflation will be enhanced.

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Implications of Plummeting Oil Prices

December 5th, 2014


  • Two prominent energy experts – Daniel Yergin of IHS and Edward L. Morse of Citi have issued reports contending the oil market is now being dominated by a much greater than anticipated surge in U.S. production since 2008. It has caught other oil producers by surprise, and the failure of OPEC to cut production at last week’s meeting sent prices for WTI plummeting below $70 a barrel — a decline of nearly 40% since mid-year.
  • Investors currently are assessing who the winners and losers are. Yergin contends the main losers are Venezuela, Iran, and Russia, and he foresees a slowdown in new energy investments around the world. U.S. companies also will look hard at their plans, but Yergin claims new U.S. production is more resilient than anticipated and should continue to increase in 2015.
  • It remains to be seen where oil prices will shake out, but the latest developments are positive for the U.S. on two fronts: (i) the price decline is equivalent to a tax cut for U.S. consumers of about $160 billion, or nearly 1% of GDP, which should propel real GDP growth in 2015 to 3%; and (ii) according to Citi, the U.S. oil import gap will be eliminated before the end of this decade, which bodes well for U.S. trade and the dollar.

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Dollar Worries are Overblown

November 10th, 2014


    • The dollar has appreciated by 8%-9% against the Japanese yen and the euro this year. Thus, reflecting better economic performance in the U.S. and policy actions by the Bank of Japan (BOJ) and the European Central Bank (ECB) to combat deflationary pressures. The dollar has also risen significantly against several currencies that have been affected by falling commodity prices.
    • Worries that the dollar’s rise could weaken the U.S. economy are overstated: The trade-weighted appreciation is 4%, while U.S. trade accounts for just over 10% of GDP.
    • The dollar’s appreciation will impact U.S. multinationals’ profits via translation effects, but the loss in U.S. international competitiveness thus far is modest. Also, U.S. businesses are highly competitive today, so the consequences for the broad market should be limited.
    • Meanwhile, the dollar is likely to trend higher into 2015, especially against the euro, as the ECB will be struggling to overcome deflation while the Fed will contemplate policy tightening. Click here to read more.

Market Gyrations: Sorting News from Noise

October 21st, 2014


  • Volatility in stocks and bonds has surged recently following a period of calm. The common explanation is that investors are worried about a slowdown abroad, especially in Europe, where officials disagree openly about how to respond.
  • Despite these fears, the U.S. economy is not showing signs of slowing thus far, and job market conditions are improving. Weak growth abroad may affect corporate profits at some point, but lower oil prices and financing costs will cushion the impact.
  • Evidence that inflation and inflation expectations are declining around the world is more apparent and could keep bond yields low for a while longer. However, the recent gyrations in yields are largely technical in nature.
  • Our bottom line: A 10% stock market correction is not surprising following two years of steady gains, but a bear market is not in the cards, as there is little risk of recession or resurgent inflation.

Worries about Global Weakness are Exaggerated

Following an unusually calm summer, investors have worked themselves into a frenzy that the U.S. economy is vulnerable to a worldwide slowdown. However, when one looks at the batch of economic releases that have come out this month it is hard to grasp why. The recent IMF/IBRD annual meetings set the tone, as the IMF staff downgraded its forecast for global growth (once again). This was accompanied by disappointing industrial production data for Europe, at a time when officials have disagreed publicly about what needs to be done to jump start the euro-zone.  Read the rest of this entry »

Diverging Economies and Policies

October 9th, 2014

During the past quarter, financial markets were primarily influenced by a divergence in economic performance between the U.S. and U.K. economies, each of which registered solid growth, while the euro-zone and Japan remained weak. This development reinforced expectations that policymakers in the U.S. and U.K. could begin tightening monetary policies by mid-2015, while the European Central Bank (ECB) and Bank of Japan would keep monetary policies accommodative for the foreseeable future.

These expectations, in turn, contributed to a strong showing of the U.S. dollar, which appreciated by about 8% against the euro and Japanese yen, respectively, and by 6.5% on a trade-weighted basis. At the same time, U.S. bond yields rebounded off their lows, with the 10-year Treasury closing the quarter at 2.50%, up from an interim low of 2.34%, but well below the 3% threshold at the beginning of this year. Returns for the Barclays Aggregate Index were little changed for the quarter, leaving the year-to-date return at 4.1%. Meanwhile, the U.S. stock market powered to a record high, with the S&P 500 Index at one point surpassing the 2000 level, before closing the quarter near 1975, generating a total return of just under 8% for the first three quarters. Read the rest of this entry »

Assessing China Risks

September 29th, 2014


  • One of the most important challenges for investors is to assess China’s long-term prospects. A recent analysis by a prominent China watcher, Professor Michael Pettis of Peking University, reshapes the debate about whether the economy is headed for a “soft landing” or “hard landing” and offers several insights.1
  • Pettis contends the choice policymakers confront is deciding between a “long landing” strategy, in which China’s growth is allowed to slow over several years to 3%-4% without unemployment surging, versus targeting higher growth of 6%-7% that is unsustainable and likely followed by a collapse.
  • Pettis claims Chinese policymakers understand this dilemma, but it is too early to tell which direction they will take. Conventional wisdom holds that slower growth could be socially disruptive, but Pettis contends that eliminating artificially low interest rates will transfer income from inefficient companies back to households, thereby supporting higher consumption.
  • My reaction is that the scenario Pettis outlines is plausible in theory, but it is highly questionable whether overall growth could fall to 3%-4% without unemployment surging and China’s policymakers responding. Even if his favorable outcome unfolds, the global economy and world equity markets would feel the fallout of markedly weaker Chinese growth.

Reframing the Debate about China’s Growth Prospects
Most analyses of China characterize the debate about its growth prospects in terms of whether economic growth will slow moderately to 6%-7% (the “soft landing” scenario) or more substantially to 3%-4% (the “hard landing” scenario). The prevailing view is that the former outcome is the most likely over the next few years as policymakers seek to buttress the economy. However, a vocal minority foresees the bursting of a property bubble that will result in financial disruption and much weaker growth.

Michael Pettis, a former Wall Street investment professional turned professor at Peking University, contends this is a false dichotomy. In his view, the Chinese economy has only been able to maintain 7%+ growth due to rapid credit expansion, and he believes the economy is now running up against constraints on how much debt is sustainable.

“Rather than hail the soft landing as a signal that Beijing is succeeding in managing the economic adjustment, it should be seen as an indication that Beijing has not been able to implement the reforms it knows it must implement. A “soft landing” should increase our fear of a subsequent “hard landing.” It is not an alternative.”

For the time being, Chinese policymakers are clinging to the official 7.5% target growth rate and are likely to deploy added stimulus should the property sector weaken further. However, Pettis is hopeful the government will eventually adopt a “long landing” strategy in which China’s growth rate is allowed to transition over time to 3%-4%, while household income grows at a faster pace of 5%-7%. If this transition can be achieved, it would imply that income is transferred away from inefficient companies back to Chinese households, thereby lessening the risks of rising unemployment and social disruption.

Implications of Ending Financial Repression
For this transition to occur, the Chinese government will have to embark on reforms to end so-called “financial repression.” This term refers to policies in which rates that depositors receive on their bank accounts are set well below market clearing levels, which enables banks to provide cheap loans to Chinese businesses, many of which are state-owned.

Pettis notes that financial repression was vital to mobilize savings in the early stages of China’s transition from a poor, agrarian based economy to a more industrial economy. Over time, however, the artificially low interest rate policies contributed to a loss of investment discipline, as inefficient firms were able to obtain cheap financing, which in turn contributed to an enormous misallocation of capital over the past decade. Pettis estimates that over the latter period as much as 5%-8% of GDP was transferred from households to borrowers, which explains why the growth in household income lagged the growth in GDP. (Note: Estimates by the IMF are within a comparable range.)

Pettis sees the low interest rate policies coming to an end, as President Xi appears committed to the process of financial reform. The official lending rate has risen to 7.5% while nominal GDP growth has slowed to 8%-9%. As a result, it is more difficult for borrowers to justify investments in non-productive projects. Also, as the resource transfer from savers to borrowers shrinks, economic growth is likely to transition from being investment-led to consumer-led. At the same time, Pettis acknowledges there are borrowers that are effectively insolvent and which may still receive ongoing support from the Chinese government.

One challenge President Xi faces is vested interests in the Communist Party that are opposed to economic reform. Pettis acknowledges this, but also notes that President Xi is China’s strongest leader since Deng Xiaoping, who pioneered the country’s transition to a more market-oriented economy. He observes:

“China is still vulnerable to a debt crisis, but if President Xi can continue to restrain and frighten vested interests that will inevitably oppose the necessary Chinese economic adjustment, he may in the next one to two years be able to get credit growth under control, before debt levels make an orderly adjustment impossible.”

My Take: Insightful but Unlikely
Pettis’s analysis is both insightful and worth considering, because it challenges conventional thinking about China. His main insight is that by eliminating distortions in capital markets, policymakers can achieve the objective of rebalancing the Chinese economy away from reliance on investments in favor of consumption, and he makes a strong case that the costs of financial repression outweigh the benefits.

That said, I find his favorable outcome, in which growth slows to 3% without unemployment rising, to be very difficult to pull off in practice. It assumes that China’s policymakers have the wherewithal to engineer a controlled slowdown, even though this is rarely the case. Consider some of the dynamics involved; when businesses are forced to cut back on spending due to lack of available credit, some will respond by shredding labor and others may become effectively insolvent, which would create strains for financial institutions. Pettis acknowledges these possibilities, but does not offer a compelling rebuttal. His scenario envisions a wealth transfer to households boosting consumption, especially of services, which tend to be more labor intensive, and he observes the government could mop up unemployed workers by putting them into make-work-jobs. At the same time, he acknowledges this response would not fundamentally address China’s debt problem, but simply roll it forward.

One issue Pettis does not discuss is the impact that substantially lower Chinese growth would have on the global economy and financial markets. Currently, world markets are priced for only a marginal slowdown in China’s economy. Therefore, if China’s growth were to be cut in half in the next few years, world equity markets would likely feel the fallout at some point, with emerging economies that have close trading ties with China taking the biggest hit.

1See Michael Pettis’ blog, China Financial Markets, “What does a “good” Chinese adjustment look like?” September 2014.

How to Better Anticipate and Manage Future Crises

September 4th, 2014

Remarks delivered at the Bretton Woods 2014 Conference: The Founders and Future hosted by the Center for Financial Stability on September 4, 2014.

Thank you for the opportunity to address this topic. It has been an area of interest for me since the 1970s, when I worked on developing an early warning system for detecting debt problems of developing countries at the U.S. Treasury and the Federal Reserve. Thereafter, I worked with financial institutions that had considerable exposures to domestic and foreign markets. My perspective is that of an investment professional whose job is to assess opportunities and risks.

I will begin by saying the task of identifying financial crises is not easy for investors. If it were, they would be fewer and less severe. For investors to do a better job in the future, they will have to overcome the following obstacles:

(1)   Lack of adequate and timely information on exposures of borrowers and lenders. The financial system appears as a “black box” for investors, and while regulatory bodies have the authority to peer inside this box, their track record of identifying potential problems has been poor.

(2)   Lack of a conceptual framework for thinking about financial crises. Until recently, they were considered to be episodic rather than systematic, and with the principal exception of the Bank for International Settlements (BIS), economists did not focus on the credit cycle and its determinants.

(3)   Lack of economic policies to promote financial stability. Investors take their cue of what matters from policymakers; consequently, if policymakers appear unconcerned about financial stability, they will be similarly inclined. Read the rest of this entry »