US and China tighten in unison, and damn the torpedoes
The world has changed abruptly for investors as the US Federal Reserve and the People's Bank of China both brush aside deflation warnings and press ahead with monetary tightening
By Ambrose Evans-Pritchard, International Business Editor
3:20PM GMT 30 Oct 2014
Mind the monetary gap as the world's two superpowers turn off the liquidity spigot at the same time.
The US Federal Reserve and the People’s Bank of China have both withdrawn from the global bond markets, each for their own entirely different reasons. The combined effect is a shock of sorts for the international financial system.
The Fed’s message on Wednesday night was hawkish. It did not invoke the excuse of a stronger dollar or global market jitters to extened bond purchases. It no longer sees “significant” constraints to the labour market. Instead it spoke of “solid job gains” and a “gradual diminishing” of under-employment.
This a tightening shift, and seen as such by the markets. The euro dropped 1.5 cents against a resurgent dollar within minutes of the release, falling back below $1.26. Rate rises are on track for mid-2015 after all.
The Fed is no longer printing any more money to buy Treasuries, and therefore is not injecting further dollars into an interlinked global system that has racked up $7 trillion of cross-border bank debt in dollars and a further $2 trillion in emerging market bonds. The stock of QE remains the same. The flow has changed. Flow matters.
The Fed has ended QE3 more gently than QE1 or QE2. This helps but it may also have given people a false sense of security. The hard fact is that the Fed has tapered net stimulus from $85bn a month to zero since the start of the year.
The FOMC tried to soften the blow in its statement with pledges to keep interest rates low for a very long time. This assurance has value only if you think QE works by holding down interest rates, as the Yellen Fed professes to believe.
It cuts no ice if you are a classical monetarist and think that QE works its magic through the quantity of money effect, most potently by boosting broad M3/M4 money through purchases of assets outside the banking system.
Pessimists argue that the world economy is so weak that it needs a minimum of $85bn a month of Fed money creation (not to be confused with zero interest rates) just to avoid stalling again.
Or put another way, there is nagging worry that tapering itself may amount to an entire tightening cycle, equivalent to a series of rate rises in the old days. If they are right, rates may never in fact rise above zero in the US or the G10 states before the global economy slides into the next downturn.
It is no great mystery why the world is caught in this "liquidity trap", or "secular stagnation" if you prefer. Fixed capital investment in China is still running at $5 trillion a year, and still overloading the world with excess capacity in everything from solar panels to steel and ships, even after Xi Jinping’s Third Plenum reforms.
Europe has been starving the world of demand by tightening fiscal policy into a depression, running a $400bn current account surplus that is now big enough to distort the global system as a whole. George Saravelos, at Deutsche Bank, dubs it the "Euroglut", the largest surplus in the history of financial markets. The global savings rate has risen to a fresh record of 25.5pc of GDP, the flipside of chronic under-consumption.
Of course, it is not the job of the Fed to run monetary policy for the world, and that is the new problem facing QE-addicted investors. The US economy is growing briskly at a 3pc rate. It can arguably handle monetary tightening, at least for now.
New home building is up 17.8pc over the past year. The Case-Shiller 20-City index of house prices is up 22pc since early 2012. Unemployment has tumbled to 5.9pc. Lay-offs have dropped to a 14-year low.
We are entering a new phase of the monetary cycle where the US is strong (relatively) and the world is weak (relatively). The Fed has switched from a being the friend of global asset prices, to being neutral at best, with a strong hint of menace.
It is a very odd environment. The US Treasury market is pricing in near-depression conditions.
Five-year inflation expectations have suddenly collapsed. You could say it is remarkable that the Fed should be withdrawing any stimulus at all in such circumstances.
Janet Yellen has to navigate a perilous course between the Scylla of deflation and the Charybdis of corrosive asset booms, just the like the Riksbank this week, or indeed the Bank of Canada, or the Bank of England. Yet the precipitous slide in commodities since June may be a warning sign that stress is building.
There are echoes of 1928, when commodity prices buckled even as the boom on Wall Street was still gathering pace, and as the credit bubble in Weimar Germany was still gathering towards a crescendo. Fed hawks, led by Benjamin Strong, chose to ignore the deflation risk, instead raising rates to teach “speculators” a lesson. The move set off a global chain reaction.
Mrs Yellen is unlikely to repeat that error, but there are many pushing her to do so, and since she is not a monetarist, she may have misjudged the quantity effects of tapering. Note that the growth rate of Divisia M4 – a broad measure of the money supply tracked by the Center for Financial Stability - has dropped to 2pc from 6.2pc in early 2013.
The Fed pivot comes at a delicate moment because China’s (PBOC) is at the same time winding down stimulus, trying to tame China’s $25 trillion credit monster before it is too late. The central bank has not yet blinked - beyond minor short-term liquidity shots - even though bad loans are rising fast at the big state banks.
China became a net seller of global bonds in the third quarter (even adjusting for currency effects). It was buying $35bn a month earlier this year.
The move was well-flagged in advance. Premier Li Keqiang said in May that excess foreign reserves had become a "burden" and were making it impossible for China to run a sovereign monetary policy.
The policy shift automatically entails monetary tightening – vis-à-vis the status quo ante – unless China acts to sterilise the effects. It has not done so. We have seen a sudden stop in China’s “proxy QE”.
Brazil, Malaysia, Singapore and Thailand all cut their foreign reserves in the third quarter. Korea slashed net purchases from $25bn to $9bn, and India from $43bn to $12bn. Russia is now burning through its reserves to defend the rouble. Others oil states will have to do the same to cover their budgets.
Net bond stimulus by all the global central banks together has fallen by roughly $125bn a month since the end of last year, an annualised pace of $1.5 trillion. We have seen an abrupt halt to the $10.2 trillion of net reserve accumulation since 2000 that has played such a role in the asset boom of the modern era. That does not automatically mean asset prices will fall, but it removes a powerful tailwind.
Hopes that the Europe would pick up the QE baton to keep the asset boom going border on wishful thinking. The European Central Bank’s balance sheet has contracted by almost €150bn due to passive tightening since the Mario Draghi first spoke of buying asset-backed securities in June.
There is much chatter from peripheral ECB governors, a talkative lot. Listen instead to Sabine Lautenschläger, Germany’s member of the ECB’s executive board. Her predecessor backed the Draghi rescue plan for Italy and Spain (OMT) in August 2012 against objections from the Bundesbank, and that is what made it possible.
I may be wrong, but it strikes me as implausible that the ECB will risk launching QE on a massive scale as long as both German members are opposed. The bank can dabble at the edges, as it is doing now, but a reflation blitz requires German political assent.
So what is Dr Lautenschläger saying? "I take a more critical view of some areas of the ECB's unconventional measures. If we talk about large-scale purchase programmes of securitised assets, the so-called ABS plan, or even large-scale sovereign bond purchases - then I take a more critical view, because for me the balance between costs and needs is negative at the moment. Those are measures one uses as a last resort if deflation is visible and that is by no means the case.”
The Fed has ended QE3 more gently than QE1 or QE2. This helps but it may also have given people a false sense of security. The hard fact is that the Fed has tapered net stimulus from $85bn a month to zero since the start of the year.
The FOMC tried to soften the blow in its statement with pledges to keep interest rates low for a very long time. This assurance has value only if you think QE works by holding down interest rates, as the Yellen Fed professes to believe.
It cuts no ice if you are a classical monetarist and think that QE works its magic through the quantity of money effect, most potently by boosting broad M3/M4 money through purchases of assets outside the banking system.
Pessimists argue that the world economy is so weak that it needs a minimum of $85bn a month of Fed money creation (not to be confused with zero interest rates) just to avoid stalling again.
Or put another way, there is nagging worry that tapering itself may amount to an entire tightening cycle, equivalent to a series of rate rises in the old days. If they are right, rates may never in fact rise above zero in the US or the G10 states before the global economy slides into the next downturn.
It is no great mystery why the world is caught in this "liquidity trap", or "secular stagnation" if you prefer. Fixed capital investment in China is still running at $5 trillion a year, and still overloading the world with excess capacity in everything from solar panels to steel and ships, even after Xi Jinping’s Third Plenum reforms.
Europe has been starving the world of demand by tightening fiscal policy into a depression, running a $400bn current account surplus that is now big enough to distort the global system as a whole. George Saravelos, at Deutsche Bank, dubs it the "Euroglut", the largest surplus in the history of financial markets. The global savings rate has risen to a fresh record of 25.5pc of GDP, the flipside of chronic under-consumption.
Of course, it is not the job of the Fed to run monetary policy for the world, and that is the new problem facing QE-addicted investors. The US economy is growing briskly at a 3pc rate. It can arguably handle monetary tightening, at least for now.
New home building is up 17.8pc over the past year. The Case-Shiller 20-City index of house prices is up 22pc since early 2012. Unemployment has tumbled to 5.9pc. Lay-offs have dropped to a 14-year low.
We are entering a new phase of the monetary cycle where the US is strong (relatively) and the world is weak (relatively). The Fed has switched from a being the friend of global asset prices, to being neutral at best, with a strong hint of menace.
It is a very odd environment. The US Treasury market is pricing in near-depression conditions.
Five-year inflation expectations have suddenly collapsed. You could say it is remarkable that the Fed should be withdrawing any stimulus at all in such circumstances.
Janet Yellen has to navigate a perilous course between the Scylla of deflation and the Charybdis of corrosive asset booms, just the like the Riksbank this week, or indeed the Bank of Canada, or the Bank of England. Yet the precipitous slide in commodities since June may be a warning sign that stress is building.
There are echoes of 1928, when commodity prices buckled even as the boom on Wall Street was still gathering pace, and as the credit bubble in Weimar Germany was still gathering towards a crescendo. Fed hawks, led by Benjamin Strong, chose to ignore the deflation risk, instead raising rates to teach “speculators” a lesson. The move set off a global chain reaction.
Mrs Yellen is unlikely to repeat that error, but there are many pushing her to do so, and since she is not a monetarist, she may have misjudged the quantity effects of tapering. Note that the growth rate of Divisia M4 – a broad measure of the money supply tracked by the Center for Financial Stability - has dropped to 2pc from 6.2pc in early 2013.
The Fed pivot comes at a delicate moment because China’s (PBOC) is at the same time winding down stimulus, trying to tame China’s $25 trillion credit monster before it is too late. The central bank has not yet blinked - beyond minor short-term liquidity shots - even though bad loans are rising fast at the big state banks.
China became a net seller of global bonds in the third quarter (even adjusting for currency effects). It was buying $35bn a month earlier this year.
The move was well-flagged in advance. Premier Li Keqiang said in May that excess foreign reserves had become a "burden" and were making it impossible for China to run a sovereign monetary policy.
The policy shift automatically entails monetary tightening – vis-à-vis the status quo ante – unless China acts to sterilise the effects. It has not done so. We have seen a sudden stop in China’s “proxy QE”.
Brazil, Malaysia, Singapore and Thailand all cut their foreign reserves in the third quarter. Korea slashed net purchases from $25bn to $9bn, and India from $43bn to $12bn. Russia is now burning through its reserves to defend the rouble. Others oil states will have to do the same to cover their budgets.
Net bond stimulus by all the global central banks together has fallen by roughly $125bn a month since the end of last year, an annualised pace of $1.5 trillion. We have seen an abrupt halt to the $10.2 trillion of net reserve accumulation since 2000 that has played such a role in the asset boom of the modern era. That does not automatically mean asset prices will fall, but it removes a powerful tailwind.
Hopes that the Europe would pick up the QE baton to keep the asset boom going border on wishful thinking. The European Central Bank’s balance sheet has contracted by almost €150bn due to passive tightening since the Mario Draghi first spoke of buying asset-backed securities in June.
There is much chatter from peripheral ECB governors, a talkative lot. Listen instead to Sabine Lautenschläger, Germany’s member of the ECB’s executive board. Her predecessor backed the Draghi rescue plan for Italy and Spain (OMT) in August 2012 against objections from the Bundesbank, and that is what made it possible.
I may be wrong, but it strikes me as implausible that the ECB will risk launching QE on a massive scale as long as both German members are opposed. The bank can dabble at the edges, as it is doing now, but a reflation blitz requires German political assent.
So what is Dr Lautenschläger saying? "I take a more critical view of some areas of the ECB's unconventional measures. If we talk about large-scale purchase programmes of securitised assets, the so-called ABS plan, or even large-scale sovereign bond purchases - then I take a more critical view, because for me the balance between costs and needs is negative at the moment. Those are measures one uses as a last resort if deflation is visible and that is by no means the case.”
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