Some thoughts on policy at the lower bound

First, a bit of market commentary. Equities are making new highs as I suggested was likely in my last note. We’ll see if it holds, but historical instances suggest reasons for optimism. I think a 5% run-up through year end is fairly likely.

I’ve noted before that global growth pessimism is quite high, and that is of course one reason yields are where they are today. But the fear of a recession, and the resulting decline in yields, seem to have actually decreased the likelihood of a recession, at least in the near term. The irony is that the better the market gets at forecasting the macro, the less likely major economic shocks occur. This suggests the business cycle may well be longer than people think. Potentially the longest expansion in history. I wouldn’t be surprised.

One argument I’ve heard often is that since central banks are out of bullets, confidence is lower / downside risk is bigger and so risk premiums should be higher. I have a fair bit of sympathy for that argument, but I also think that’s an argument that comes into play when the pricing differential between equities and rates are closer; i.e. when the Equity Risk premium is lower. It is currently already at very high levels, so it is likely that such concerns are already priced in here. A corollary to that line of thought is that people who are buying equities simply because yields are too low is stupid and do not understand the risks. But I think that’s an incomplete line of reasoning at best. The fact is, people – both institutions as well as individuals – have to decide what to buy on a daily basis. And a strategy of buying a bit more equities, even with valuations here, rather than a lot more treasuries, is hardly crazy.

OK – on to the next topic.

I’ve been mulling over how policy making is likely to evolve over the coming years, as almost all DM central banks other than the Fed has run out of bullets.

What we have seen so far is rate cuts, followed by asset swap programs. Usually a weakening in the exchange rate also occurs. But for countries with weak domestic demand, the lower discount rates does not do much for domestic growth. This means the increase in the trade balance has a larger relative effect. It also means that the effect is mostly felt by exporters and the employees of exporters, rather than everyone else. It also results in a transfer of savings into foreign countries. (especially the US)

This has been exacerbated by the fact that Japan and Germany has been using an exchange rate that has been excessively weak for years. The weak exchange rates were possible partially because of structural factors, and partially due to monetary policy. With monetary policy ineffective, the result is that the currency should adjust until excess trade balances adjust to sustainable levels. Put differently, in the absence of monetary policy effectiveness, the currency should adjust to a level where the trade balance is offset by sustainable capital flows.

Fiscal stimulus is a remaining option. But that will only occur when the electorate allows it, and there are open question on what the results would be.

A much less discussed option is regulatory easing. One reason that many households have not taken advantage of low rates is that their credit scores preclude them from borrowing. Certainly, that channel should only be used to a limited extent, but the regulatory tightness is clearly at least a part of the explanation for why low yields have not been more stimulative.

For the US:

The foreign savings in aggregate has driven longer dated US yields lower. The nominal spreads are so large in some cases that foreign entities disregard the FX risk. As an example, a Japanese entity can buy 30y treasuries at a spread of ~200bps to 30y JGBs. Over 30 years, that’s a 60% non-compounded difference that they probably think will offset any Yen strengthening.

Usually the response of an optimizing fiscal authority to very low financing costs is more borrowing. For political reasons, that has not occurred, at least not yet. But it may well happen next year.

The lower the long end yields here, the more stimulus there is, and the more likely the Fed is to hike. (or not cut) So the implication for front end is opposite. This recent low yields is likely to nicely support the US economy in 2H, and currently provides a good entry into paid positions in the short end, IMO.

The biggest and most interesting question is what will happen in Japan:

Abe’s election win, which was big enough to support constitutional revisions, and his subsequent promise for more fiscal easing may be the start of a global trend. After all, they were the first to enact massive QE, and the first to hit easing limits. Certainly, the effectiveness of the promised stimulus will depend on how they’re structured, but that may be less important. Some similarities to FDR’s policies during the great depression probably applies. Despite stagnant topline Japanese growth, the electorate believes in Abe’s rhetoric and has given him a mandate to do whatever it takes.

The 10 trillion Yen figure that has been bandied about is roughly 2.5% of GDP. Given that Japan’s deficit for the fiscal year ending in March was 6.7%, this represents a moderate increase in additional stimulus. (remember it is the change in stimulus that matters for change in growth. A budget deficit that does not change should not change GDP) The rally in the Nikkei is certainly pricing in some optimism for the program.

A new wave of JGB issuance to fund the stimulus is also in the cards. But given that the BoJ is currently purchasing assets at a pace of ~16% of GDP per year, the 2.5% figure is not likely to make that much of a dent, especially if it is seen as a one-off. BUT, and here’s a big one, the government may commit to an increase of this size indefinitely until some goal is reached. That would be QUITE a change in policy parameters and introduce a lot of uncertainty. I don’t really know how the markets will take that over the long run, but it’s hard to see it being friendly to either JGBs or the Yen in the short term.

Barring such a (fairly risky) policy change, though, it’s not clear whether a one off fiscal stimulus should weaken the Yen all that much. In a country with declining population levels, it’s hard to make a case that the government can make any sizable investments that will increase long term growth, which means the fiscal multiplier is likely pretty low.

Other Thoughts:

· Will the EU and follow with either fiscal or regulatory easing? For the EU, the first step is seeing if some workaround is allowed to recapitalize the Italian banks. Note that the ECB (in a speech by the vice-president) has already endorsed such a path.

· Other DM central banks at ZIRP reinforces the idea that the Fed has become the world’s central bank, since it controls most of the remaining monetary levers on FX

· Does fewer active central banks suggest lower volatility going forward, or more?

· If less, this will also make it easier for the PBoC the manage a CNY depreciation.

The low P/B’s for banks is unprecedented, and have often been cited as reasons to be bearish on growth. But another take is that they have simply become socialized utilities, unable to maximize shareholder returns. And that is unlikely to change soon, since the regulators are also the central banks, many of which have run out of policy tools. Which means they do NOT want banks to shrink their balance sheets due to fear that it could tighten financial conditions at a time when they are out of bullets. This is not new information for many bank employees. In this context, banks are likely to still be active in the lending space, even with equity valuations that have historically only been seen during recessions.


7 thoughts on “Some thoughts on policy at the lower bound

  1. Very coherent analysis. Thanks!

    Japan would be an interesting testing ground for the claims of MMT, in contrast to those of Mr Bass. Indeed, like you suggest, one-off fiscal stimulus is perhaps insufficient policy-wise to generate a meaningful move in the yen; or by proxy move the needle on inflation. Nevertheless, it *may* present a step in the right direction.

  2. Thanks CHT! I think that’s right. If they really are ready to do whatever it takes, unlimited fiscal stimulus has to be on the agenda. The size of that tail risk is really hard to estimate. And it’s not even limited to actual expenditures… even a simple suggestion of such a path (which they obviously have been careful to avoid so far) would be a major surprise.

    FWIW, I’ve taken profits on the short CHFJPY trade I recommended in December. I will probably re-engage at some point, but the balance of risks doesn’t look as good right now.

  3. If the Japanese government picks up the easing slack, do you think BoJ will roll back negative rates given how they’ve compressed the curve? In either event, should we expect FX to be driving re-balancing to a significant degree? So being long of Japanese equities FX hedged is the sweet spot for speculating these views?

    1. Hmmm, those are good questions. I don’t have especially strong views, so if you have any thoughts, please do share!

      I’m not sure if the BoJ will do anything that will affect things that much. A one off move from -10bps to zero shouldn’t have too big of an impact, in theory. I do think FX will be a key part of the rebalancing with other policy options exhausted. But I’m not sure about Japanese equities, because the risks of helicopter money is two sided. If they do too much, they could erode confidence and cause systemic issues. If they don’t do enough, nominal growth may not pick up enough for them to get out of the liquidity trap.

      What I have a somewhat stronger view on is the currency. It seems that the initial reaction should be a move out of JGBs into foreign assets on an unhedged basis. The risk is that the momentum gets out of hand. As I alluded to earlier, the big question is really how far Abe is willing to go. If open ended, it’s pretty easy to see some big flows. But maybe incremental steps will do the trick. (By incremental I mean they increase the budget deficit each year. )

      1. Thanks for your response. I’m not especially convicted in terms of views either, still putting my toes in the water! Will be playing the Waiting For Abe game for now.

        Regarding the move out of JGBs into foreign assets, this looks underway going by the latest weekly financial flows figures!

  4. Excellent post. Thank you for sharing your thoughts.

    The idea that lower long-end rates make the Fed likelier to hike is an interesting one. The reasoning makes sense. How would you respond to a counter-argument that, to the extent banks borrow short and lend long, a flattening of the curve actually lessens the incentive to lend and therefore credit creation could be expected to fall and with it the likelihood of Fed hikes?

    The idea that Abe represents the start of a global trend is interesting too. I think many would agree that fiscal stimulus makes a lot of sense and would be far more effective than further monetary stimulus. It would also seem to be very positive for equities, especially if it triggered a rotation out of fixed income. My going assumption is that fiscal stimulus is only used in the next global recession, but if dissatisfaction of electorates could break down resistance to such stimulus before then, we could see much higher levels for equities before the current cycle is over.

    Regarding the banks, my assumption is, as you say, that lower P/Bs reflect growing recognition by markets that these are “socialized utilities” and need to be valued as such. Do you think that’s the story with Deutsche Bank, or is there something more sinister to worry about in that case, like actual (or perceived) solvency issues becoming a liquidity issue?

  5. Thanks johno.

    Curve flattening has historically preceded recessions because front end yields rises, which decreases how much debt borrowers can take on. I think that is the bigger driver of bank lending rather than profitability. The curve flattening we’ve seen this cycle has mostly been driven by a decrease in back end yields – which is stimulative. That is why I think the flatter curve is not a recession signal these days by any means.

    I’ve read many pieces today about coordination of monetary and fiscal policy. It really seems like there is a paradigm shift going on. That it’s occurring at a time when sentiment and expectations are where they are suggest that the effects on prices could be very substantial indeed. Even the Germans seem to be getting on board the easing train – the EU finance ministers recently agreed that further regulator tightening of bank balance sheets & lending should stop.

    I have really very little idea about Deutsche Bank – it’s just not my area of expertise. As a ‘socialized utility,’ perhaps the better instrument to use to gauge solvency issues may be junior debt like the Cocos. Currently, they seem to be holding in – the 6% 2049 bonds are trading at a yield of 6.75% and falling, vs pre-Brexit levels of 6.2%.

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