3/2/21: Monetary Easing and Stock Market Valuation

There has been quite a puzzling development in recent years in the monetary policy universe. A decade plus of ultra low interest rates has been associated with rising, not falling, risk premium in investment markets. In other words, a dramatically lower cost of new and carried debt induced by lower interest rates - a driver for lower risk, is being offset by something else. What?

Laine, Olli-Matti paper "Monetary Policy and Stock Market Valuation" (September 18, 2020, Bank of Finland Research Discussion Paper No. 16/2020: https://ssrn.com/abstract=3764721) tries to explain. 

To start with, some theory - especially for my students in the Investment and Financial Systems courses. Per author, "the value of a stock is the present value of its expected future dividends... Hence, the changes in stock prices must be explained by 

• either changes in dividend expectations or 
• changes in discount rates. 

The discount rate, or (approximately) expected rate of return, can be thought as a sum of a risk-free rate and a risk premium. Theoretically, monetary policy should have an effect on stock prices through the risk-free rates. In addition, monetary policy should affect dividend expectations, for example, through the output or debt interest payments of firms. The effect on the risk premium (not to mention the term structure of risk premia), however, is less clear."

Looking at Eurostoxx50 index components, Laine shows "...that the average expected premium has increased considerably since the global financial crisis. This change is explained by the change in long-horizon expected premia. ... monetary policy easing has had a positive impact on the expected average premium."

Specifically (emphasis added): "a negative shock to the shadow rate is estimated to increase average expected premium persistently. Instead, the results show that monetary policy easing temporarily decreases short-term expected [risk] premia. This means that expansionary monetary policy steepens the slope of the term structure of risk premia."

This is not exactly new, as Bernanke and Kuttner (2005) observed that "expansionary monetary policy generates an immediate rise in equity prices followed by a period of lower-than-normal excess returns. ...However, Bernanke and Kuttner (2005) do not study the effect on the long-run excess returns. My results show that effect on long-horizon expected premia has a different sign. This effect on long-horizon premia seems to more than offset the effect on short-horizon premia."

Interestingly, "Contractionary monetary policy increases the short-term premia temporarily, but decreases long-horizon premia persistently. The effect on average expected premium is negative. Thus, monetary policy tightening actually makes stocks expensive relative to the expected stream of dividends. The results provide no evidence that expansionary monetary policy causes stock market bubbles..."

Here is (annotated by me) a chart showing evolution of implied and actual risk premia:

From theory perspective, therefore, monetary policy "can affect equity prices through the dividend expectations, expected risk-free rates or expected premia":

• "The effect of expansionary monetary policy on the dividend expectations is probably positive, because expansionary monetary policy can be expected to increase output and firms’ earnings.
• "Expansionary policy probably lowers the risk-free rates, but it is also possible that the effect is totally different. Central bank’s rate cut can increase risk-free rates, if people think that the rate cut eventually increases inflation. 
• "As for the expected premium, the sign of the effect is unclear. ... Gust and López-Salido (2014) show theoretically that expansionary monetary policy lowers the premium ... where asset and goods markets are segmented. When it comes to quantitative easing, ... investors who have sold their assets to the central bank rebalance their portfolios into riskier assets, which lowers their expected returns. ... Theoretically, it is also possible to argue that monetary policy easing actually increases the expected premium. If one assumes that there exists mispricing like Galí (2014) and Galí and Gambetti (2015), then the sign of the response is ambiguous. ... This means that monetary policy easing increases the expected premium implied by dividend discount model (see Galí and Gambetti, 2015, p. 250-252)."

So, onto the empirical results by Laine: 

1. "Interest rates have declined considerably since the global financial crisis, yet the expected average stock market return has remained quite stable at around 9 percent. This implies that expected average stock market premium has increased remarkably. This rise is mainly explained by the premia over a discounting horizon of four years.
2. "These results may seem unintuitive as the prices of stocks have risen, and ratios like price-to-earnings have been historically high. However, high price-to-earnings ratios do not necessarily mean that stocks are expensive, because the value of a stock is the present value of its expected future dividends.
3. "When it comes to the role of monetary policy, the results show that monetary policy easing decreases short-horizon required premia, but increases longer-horizon premia. 
4. "The effect on expected average premium is positive, i.e. expansionary monetary policy lowers the prices of stocks in relation to the expected dividend stream."

19/5/20: German Hawks vs ECB Doves?

My article for The Currency on the German Constitutional Court ruling regarding ECB's PSPP program: https://www.thecurrency.news/articles/17028/german-courts-are-fighting-with-the-ecb-what-does-it-mean-for-ireland.

29/9/19: Divided ECB

Divided they stand...

Source: https://www.bloomberg.com/news/articles/2019-09-29/lagarde-inherits-ecb-tinged-by-bitterness-of-draghi-stimulus

The ECB is more divided than ever on the 'new' direction of QE policies announced earlier this month, as its severely restricted 'political mandate' comes hard against the reality of VUCA environment the euro area is facing, with:

1.  Reduced forward growth forecasts (net positive uncertainty factor for QE)
2. Anaemic inflation expectations (net positive risk factor for QE), but reduced expectations as to the effectiveness of the QE measures in their ability to lift these expectations (net negative uncertainty factor)
3. Low unemployment and long duration of the current recovery period (net negative uncertainty factor for QE)
4. Relative strength of the euro, as per chart below, going into QE (net positive risk factor for QE)
5. Related to (5), deteriorating global growth and trade outlooks, with the euro area being a beneficiary of the Trump Trade Wars so far (ambiguous support for QE)
6. Expectations concerning the Fed, Bank of Japan, Bank of England etc policy directions (a complexity factor in favour of QE), and
7. Expectations concerning the potential impact of Brexit on euro area economy (another complexity factor supporting QE).

Here is a chart showing exchange rate evolution for the euro area, and key QE programs timings (higher values denote stronger euro):

Meanwhile, for the measures of monetary policy effectiveness (lack thereof) see upcoming analysis of the forward forecasts for euro area growth on this blog in relation to Eurocoin data.

31/7/19: Fed rate cut won't move the needle on 'Losing Globally' Trade Wars impacts

Dear investors, welcome to the Trump Trade Wars, where 'winning bigly' is really about 'losing globally':

As the chart above, via FactSet, indicates, companies in the S&P500 with global trading exposures are carrying the hefty cost of the Trump wars. In 2Q 2019, expected earnings for those S&P500 firms with more than 50% revenues exposure to global (ex-US markets) are expected to fall a massive 13.6 percent. Revenue declines for these companies are forecast at 2.4%.

This is hardly surprising. U.S. companies trading abroad are facing the following headwinds:

1. Trump tariffs on inputs into production are resulting in slower deflation in imports costs by the U.S. producers than for other economies (as indicated by this evidence: https://trueeconomics.blogspot.com/2019/07/22719-what-import-price-indices-do-not.html).
2. At the same time, countries' retaliatory measures against the U.S. exporters are hurting U.S. exports (U.S. exports are down 2.7 percent in June).
3. U.S. dollar is up against major currencies, further reducing exporters' room for price adjustments.

Three sectors are driving S&P500 earnings and revenues divergence for globally-trading companies:

• Industrials,
• Information Technology,
• Materials, and 
• Energy.

What is harder to price in, yet is probably material to these trends, is the adverse reputational / demand effects of the Trump Administration policies on the ability of American companies to market their goods and services abroad. The Fed rate cut today is a bit of plaster on the gaping wound inflicted onto U.S. internationally exporting companies by the Trump Trade Wars. If the likes of ECB, BoJ and PBOC counter this move with their own easing of monetary conditions, the trend toward continued concentration of the U.S. corporate earnings and revenues in the U.S. domestic markets will persist. 

10/1/19: QE or QT? Look at the markets for signals

With U.S. Fed entering the stage where the markets expectations for a pause in monetary tightening is running against the Fed statements on the matter, and the ambiguity of the Fed's forward guidance runs against the contradictory claims from the individual Fed policymakers, the real signals as to the Fed's actual decisions factors can be found in the historical data.

Here is the history of the monetary easing by the Fed, the ECB, the Bank of England and the BOJ since the start of the Global Financial Crisis in two charts:

Chart 1: looking at the timeline of various QE programs against the Fed's balancesheet and the St. Louis Fed Financial Stress Index:

There is a strong correlation between adverse changes in the financial stress index and the subsequent launches of new QE programs, globally.

Chart 2: looking at the timeline for QE programs and the evolution of S&P 500 index:

Once again, financial markets conditions strongly determine monetary authorities' responses.

Which brings us to the latest episode of increases in the financial stress, since the end of 3Q 2018 and the questions as to whether the Fed is nearing the point of inflection on its Quantitative Tightening  (QT) policy.

17/6/18: ECB's Shift of Gears Presents Another Set of Risks

My article for Business Post from Friday covering ECB's latest announcements on QE and interest rates: https://www.businesspost.ie/opinion/ecbs-shift-gears-presents-another-set-risks-418797.

21/11/17: ECB loads up on pre-Christmas sales of junk

Holger Zschaepitz @Schuldensuehner posted earlier today the latest data on ECB’s balance sheet. Despite focusing its attention on unwinding the QE in the medium term future, Frankfurt continues to ramp up its purchases of euro area debt. Amidst booming euro area economic growth, total assets held by the ECB rose by another €24.1 billion in October, hitting a fresh life-time high of €4.4119 trillion.

Thus, currently, ECB balance sheet amounts to 40.9% of Eurozone GDP. The ‘market economy’ of neoliberal euro area is now increasingly looking more and more like some sort of a corporatist paradise. On top of ECB holdings, euro area government expenditures this year are running at around 47.47% of GDP, accord to the IMF, while Government debt levels are at 87.37% of GDP. General government net borrowing stands at 1.276% of GDP, while, thanks to the ECB buying up government debt, primary net balance is in surplus of 0.589% of GDP.

Meanwhile, based on UBS analysis, the ECB is increasingly resorting to buying up ‘bad’ corporate debt. So far, the ECB has swallowed some 255 issues of BB-rated and non-rated corporate bonds, with Frankfurt’s largest corporate debt exposures rated at BBB+. AA to A-rated bonds count 339 issues, with mode at A- (148 issues).

It would be interesting to see the breakdown by volume and issuer names, as ECB’s corporate debt purchasing programme is hardly a very transparent undertaking.

All in, there is absolutely no doubt that Frankfurt is heavily subsidising both sovereign and corporate debt markets in Europe, largely irrespective of risks and adverse incentives such subsidies may carry.

22/6/17: Unwinding Monetary Excesses: FocusEconomics

Focus Economics are running my comment (amongst other analysts') on the Fed and ECB paths for unwinding QE: http://www.focus-economics.com/blog/how-will-fed-reduce-balance-sheet-how-will-ecb-end-qe.

15/4/17: Unconventional monetary policies: a warning

Just as the Fed (and now with some grumbling on the horizon, possibly soon, ECB) tightens the rates, the legacy of the monetary adventurism that swept across both advanced and developing economies since 2007-2008 remains a towering rock, hard to climb, impossible to shift.

Back in July last year, Claudio Borio, of the BIS, with a co-author Anna Zabai authored a paper titled “Unconventional monetary policies: a re-appraisal” that attempts to gauge at least one slope of the monetarist mountain.

In it, the authors “explore the effectiveness and balance of benefits and costs of so-called “unconventional” monetary policy measures extensively implemented in the wake of the financial crisis: balance sheet policies (commonly termed “quantitative easing”), forward guidance and negative policy rates”.

The authors reach three main conclusions:

1. “there is ample evidence that, to varying degrees, these measures have succeeded in influencing financial conditions even though their ultimate impact on output and inflation is harder to pin down”. Which is sort of like telling a patient that instead of a cataract surgery he got a lobotomy, but now that he is awake and out of the coma, everything is fine. Why? Because the monetary policy was not supposed to trigger financial conditions improvements. It was supposed to deploy such improvements in order to secure real economic gains.
2. “the balance of the benefits and costs is likely to deteriorate over time”. Which means that the full cost of the monetary adventurism will be greater that the currently visible distortions suggest. And it will be long run.
3. “the measures are generally best regarded as exceptional, for use in very specific circumstances. Whether this will turn out to be the case, however, is doubtful at best and depends on more fundamental features of monetary policy frameworks”. Wait, what? Ah, here it is explained somewhat better: “They were supposed to be exceptional and temporary – hence the term “unconventional”. They risk becoming standard and permanent, as the boundaries of the unconventional are stretched day after day.”

You can see the permanence emerging in the trends (either continuously expanding or flat) when it comes to simply looking at the Central Banks’ balance sheets:

And the trend in terms of instrumentation:

The above two charts and the rest of Borio-Zabai analysis simply paints a picture of a sugar addicted kid who locked himself in a candy store. Good luck depriving him of that ‘just the last one, honest, ma!’ candy…

16/5/2013: On That Impossible Monetary Policy Dilemma

At last, the IMF has published something beefy on the extraordinary (or so-called 'unconventional') monetary policy instruments unrolled by the ECB, BOJ, BOE and the Fed since the start of the crisis in the context of the question I been asking for some time now: What happens when these measures are unwound?

See http://liswires.com/archives/2102 and http://trueeconomics.blogspot.ie/2012/10/28102012-ecb-and-technocratic-decay.html

The papers: UNCONVENTIONAL MONETARY POLICIES—RECENT EXPERIENCE AND PROSPECTS and UNCONVENTIONAL MONETARY POLICIES—RECENT EXPERIENCE AND PROSPECTS—BACKGROUND PAPER should be available on the IMF website shortly.

Box 2 in the main paper is worth a special consideration as it covers Potential Costs of Exit to Central Banks. Italics are mine.

Per IMF: "Losses to central bank balance sheets upon exit are likely to stem from a maturity mismatch between assets and liabilities. In normal circumstances, higher interest rates—and thus lower bond prices—would lead to an immediate valuation loss to the central bank. These losses, though, would be fully recouped if assets were held to maturity. [In other words, normally, when CBs exit QE operations, they sell the Government bonds accumulated during the QE. This leads to a rise in supply of Government bonds in the market, raising yields and lowering prices of these bonds, with CBs taking a 'loss' on lower prices basis. In normal cases, CBs tend to accumulate shorter-term Government bonds in greater numbers, so sales and thus price decreases would normally be associated with the front end of maturity profile - meaning with shorter-dated bonds. Lastly, in normal cases of QE, some of the shorter-dated bonds would have matured by the time the CBs begin dumping them in the market, naturally reducing some of the supply glut on exits.]

But current times are not normal. "Two things have changed with the current policy environment: (i) balance sheets have grown enormously, and (ii) assets purchased are much longer-dated on average and will likely not roll-off central bank balance sheets before exit begins."

This means that in current environment, as contrasted by normal unwinding of the QE operations. "…valuation losses will be amplified and become realized losses if central banks sell assets in an attempt to permanently diminish excess reserves. But central banks will not be able to shrink their balance sheets overnight. In the interim, similar losses would arise from paying higher interest rates on reserves (and other liquidity absorbing instruments) than earning on assets held (mostly fixed coupon payments). This would not have been the case in normal times, when there was no need to sell significant amounts of longer-dated bonds and when most central bank liabilities were non-interest bearing (currency in circulation)."

The IMF notes that "the ECB is less exposed to losses from higher interest rates as its assets— primarily loans to banks rather than bond purchases—are of relatively short maturity and yields of its loans to banks are indexed on the policy rate; the ECB is thus not included in the estimates of losses that follow." [Note: this does not mean that the ECB unwinding of extraordinary measures will be painless, but that the current IMF paper is not covering these. In many ways, ECB will face an even bigger problem: withdrawing liquidity supply to the banks that are sick (if not permanently, at least for a long period of time) will risk destabilising the financial system. This cost to ECB will likely be compounded by the fact that unwinding loans to banks will require banks to claw liquidity out of the existent assets in the environment where there is already a drastic shortage of credit supply to the real economy. Lastly, the ECB will also face indirect costs of unwinding its measures that will work through the mechanism similar to the above because European banks used much of ECB's emergency liquidity supply to buy Government bonds. Thus unlike say the BOE, ECB unwinding will lead to banks, not the ECB, selling some of the Government bonds and this will have an adverse impact on the Sovereign yields, despite the fact that the IMF does not estimate such effect in the present paper.]

The chart below "shows the net present value (NPV) estimate of losses in three different scenarios." Here's how to read that chart:

• "Losses are estimated given today’s balance sheet (no expansion) and the balance sheet that would result from expected purchases to end 2013 (end 2014 for the BOJ, accounting for QQME). 
• "Losses are estimated while assuming everything else remains unchanged (notably absent capital gains or income from asset holdings)… [so that] no stance is taken as to the precise path and timing of exit. ...These losses—which may be significant even if spread over several years—would impact fiscal balances through reduced profit transfers to government. 
• "Scenario 1 foresees a limited parallel shift in the yield curve by 100 bps from today’s levels. 
• "Scenario 2, a more likely case corresponding to a stronger growth scenario requiring a steady normalization of rates, suggests a flatter yield curve, 400 bps higher at the short end and 225 bps at the long. The scenario is similar to the Fed’s tightening from November 1993 to February 1995, which saw one year rates increase by around 400bps. Losses in this case would amount to between 2 percent and 4.3 percent of GDP,  depending on the central bank. 
• "Scenario 3 is a tail risk scenario, in which policy has to react to a loss of confidence in the currency or in the central bank’s commitment to price stability, or to a severe commodity price shock with second round effects. The short and long ends of the yield curve increase by 600 bps and 375 bps respectively, and losses rise to between 2 percent and 7.5 percent of GDP. 
• "Scenarios 2 and 3 foresee somewhat smaller hikes for the BOJ, given the persistence of the ZLB.

And now on transmission of the shocks: "The appropriate sequence of policy actions in an eventual exit is relatively clear.

• "A tightening cycle would begin with some forward guidance provided by the central bank on the timing and pace of interest rate hikes. [At which point bond markets will also start repricing forward Government paper, leading to bond markets prices drops and mounting paper losses on the assets side of CBs balance sheets]
• "It would then be followed by higher short-term interest rates, guided over a first (likely lengthy) period by central bank floor rates (which can be hiked at any time, independently of the level of reserves) until excess reserves are substantially removed. [So shorter rates will rise first, implying that shorter-term interbank funding costs will also rise, leading to a rise in lone rates disproportionately for banks reliant on short interbank loans - guess where will Irish banks be by then if the 'reforms' we have for them in mind succeed?] 
• "Term open market operations (“reverse repos” or other liquidity absorbing instruments) would be used to drain excess reserves initially; outright asset sales would likely be more difficult in the early part of the transition, until the price of longer-term assets had adjusted. Higher reserve requirements (remunerated or unremunerated) could also be employed." [All of which mean that whatever credit supply to private sector would have been before the unwinding starts, it will become even more constrained and costlier to obtain once the unwinding begins.]
• For a kicker to that last comment: "The transmission of policy, though, is likely to somewhat bumpy in the tightening cycle associated with exit. Reduced competition for funding in the presence of substantial excess reserve balances tends to weaken the transmission mechanism. Though higher rates paid on reserves and other liquidity absorbing instruments should generally increase other short-term market rates (for example, unsecured interbank rates, repo rates, commercial paper rates), there may be some slippage, with market rates lagging. This could occur because of market segmentation, with cash rich lenders not able to benefit from the central bank’s official deposit rate, or lack of arbitrage in a hardly operating money market flush with liquidity. Also, there may be limits as to how much liquidity the central bank can absorb at reasonable rates, since banks would face capital charges and leverage ratio constraints against repo lending." [But none of these effects - generally acting to reduce immediate pressure of CB unwinding of QE measures - apply to the Irish banks and will unlikely apply to the ECB case in general precisely because the banks own balance sheets will be directly impacted by the ECB unwinding.]
• "There is also a risk that even if policy rates are raised gradually, longer-term yields could increase sharply. While central banks should be able to manage expectations of the pace of bond sales and rise in future short-term rates—at least for the coming 2 to 3 years—through enhanced forward guidance and more solid communication channels, they have less control over the term premium component of long-term rates (the return required to bear interest rate risk) and over longer-term expectations. These could jump because leveraged investors could “run for the door” in the hope of locking in profits, because of expected reverse portfolio rebalancing effects from bond sales, uncertainty over inflation prospects or because of fiscal policy, financial stability or other macro risks emerging at the time of exit. To the extent a rise in long-term rates triggers cross-border flows, exchange rate volatility is bound to increase, further complicating policy decisions." [All of which means two things: (a) any and all institutions holding 'sticky' (e.g. mandated) positions in G7 bonds will be hammered by speculative and book-profit exits (guess what these institutions are? right: pension funds and insurance companies and banks who 'hold to maturity' G7-linked risky bonds - e.g peripheral euro area bonds), and (b) long-term interest rates will rise and can rise in a 'jump fashion' - abruptly and significantly (and guess what determines the cost of mortgages and existent not-fixed rate loans?).]

And so we do  it forget the ECB plight, here's what the technical note had to say about Frankfurt's dilemma:  "The ECB faces relatively little direct interest rate risk, as the bulk of its loan assets are linked to its short-term policy rate. However, it may be difficult for the ECB to shrink its balance sheet, as those commercial banks currently borrowing from the ECB may not easily be able to repay loans on maturity. The ECB could use other instruments to drain surplus liquidity, but could then face some loss of net income as the yield on liquidity-draining open market operations (OMOs) could exceed the rate earned on lending, assuming a positively-sloped yield curve, if draining operations were of a longer maturity." [I would evoke the 'No Sh*t, Sherlock" clause here: who could have thought Euro area's commercial banks "may not easily be able to repay loans on maturity". I mean they are beaming with health and are full of good loans they can call in to cover an ECB unwind call… right?]

Obviously, not the IMF as it does cover the 'geographic' divergence in unwinding risks: "But the ECB potentially faces credit risk on its lending to the banking system for financial stability purposes. In a “benign” scenario, where monetary tightening is a response to higher inflation resulting from economic growth, non-performing loans should fall and bank balance sheets should improve. But even then, some areas of the eurozone may lag in economic recovery. Banks in such areas could come under further pressure in a rising rate environment: weak banks may not be able to pass on to weak customers the rising costs of financing their balance sheets." [No prize for guessing which 'areas' the IMF has in mind for being whacked the hardest with ECB unwinding measures.]

So would you like to take the centre-case scenario at 1/2 Fed impact measure for ECB costs and apply to Ireland's case? Ok - we are guessing here, but it will be close to:

1. Euro area-wide impact of -1.0-1.5% GDP shaved off with most impact absorbed by the peripheral states; and
2. Yields rises of ca 200-220bps on longer term paper, which will automatically translate into massive losses on banks balancesheets (and all balancesheets for institutions holding Government bonds). 
3. The impact of (2) will be more severe for peripheral countries via 2 channels: normal premium channel on peripheral bonds compared to Bunds and via margins hikes on loans by the banks to compensate for losses sustained on bonds.
4. Net result? Try mortgages rates rising over time by, say 300bps? or 350bps? You say 'extreme'? Not really - per crisis historical ECB repo rate averages at 3.10% which is 260bps higher than current repo rate... 

Ooopsy... as some would say. Have a nice day paying that 30 year mortgage on negative equity home in Co Meath (or Dublin 4 for that matter).

2/12/2011: Euro crisis: wrong medicine for a misdiagnosed patient

There's been much talk about the fiscal union and ECB money printing as the two exercises that can resolve the euro area crises. The problem is that all the well-wishers who find solace in these ideas are missing the very iceberg that is about to sink the  Eurotanic.
 (image courtesy of the ZeroHedge.com):

Let's start from the top. Euro area's problem is a simple one:

• There is too much debt - public and private - as detailed here, and
• There is too little growth - including potential growth - as detailed here.

Oh, and in case you think that discipline is a cure to debt, here's the austerity-impacted expected Government debt changes in 2010-2013, courtesy of the OECD:

In other words, it's not the lack of monetary easing or fiscal discipline, stupid. It's the lack of dynamism in European economy.

Let me explain this in the context of Euro area policies proposals.

• The EU, including member states Governments, believes that causality of the crisis follows as: Loss of market confidence leads to increased funding cost of debt, which in turn causes debt to become unsustainable, which in turn leads to the need for austerity and thus reduces growth rates in the Euro area economies.
• My view is that low growth historically combined with high expectations in terms of social benefits have resulted over the decades in a build up of debt, which was not sustainable even absent the economic recession. Economic recession caused the tipping point in debt sustainability beyond which markets lost confidence in European fundamentals both within the crisis environment, but also, crucially, beyond cyclical recession. My data on structural deficits (linked above) proves the last point.

So while Europe believes that its core malaise is lack of confidence from the markets, I believe that Europe's real disease is lack of growth and resulting high debt levels. Confidence is but a symptom of the disease. 

You can police fiscal neighborhood as much as you want (and some policing is desperately needed), but you can't turn European economy from growth slum to growth engine by doing so. You can also let ECB buy all of the debt of the Euro area members, but short of the ECB then burning the Government bonds on a massively inflationary pyre, you can't do away with the debt overhang. Neither the Euro-bonds (opposed by Germany) nor warehousing these debts on the ECB balance sheet (opposed by Germany & the ECB) will do the trick. Only long-term growth can. And in that department, Europe has no track record to stand on.

Take Italy as an example. Charts below illustrate the country plight today and into 2016. I use two projections scenarios - the mid-range one is from the IMF WEO for September 2011, the adverse one is incorporating OECD forecasts of November 2011, plus the cost of funding Italian debt increasing by 100bps on the current average (quite benign assumption, given that it has increased, per latest auctions by ca 300bps plus).

As chart below shows, Italy is facing a gargantuan-sized funding problem in 2012-2016. Note that the time horizon chosen for the assessment of fiscal sustainability is significant here. You can take two assumptions - the implicit assumption behind the Euro area policy approach that the entire problem of 'lack of markets confidence' in the peripheral states can be resolved fully by 2013, allowing the peripheral countries access to funding markets at costs close to those before the crisis some time around 2013-2014. Or you can make the assumption I am more comfortable with that such access to funding markets for PIIGS is structurally restricted by their debt levels and growth fundamentals. In which case, that date of regaining reasonable access to the funding is pushed well past 2015-2016.

Government deficits form a significant part of the above debt problem in Italy (see below), but what is more important is that even with rosy austerity=success model deployed by the IMF, the rate of decline in Italian public debt envisioned in 2013-2016 is abysmally small (again, see chart below). This rate of decline is driven not by the lack of austerity (deficits are relatively benign), but by the lack of economic growth that deflates debt/GDP and deficit/GDP ratios and contributed to nominal reductions in both debt and deficits.

But the proverbial rabbit hole goes deeper, in the case of Italy. IMF projections - made before September 2011 - were based on rather robust euro area-wide growth of the first quarter of 2011. Since then two things have happened: 

1. There is a massive slowdown in growth in Italy and across the euro area (see here), and
2. Cost of funding Italian debt has risen dramatically (see the second chart below).

These two factors, imperfectly reflected in the forecasts yield my estimation for Italian fiscal sustainability parameters under the 'adverse' scenario.

The above shows why, in the case of Italy, none of the solutions to the crisis presented to-date will work. Alas, pretty much the same applies to all other peripheral countries, including Ireland.

Which means that the latest round of euro area policies activism from Merkozy is simply equivalent to administering wrong medicine in greater doses to the misdiagnosed patient. What can possibly go wrong here?

Economics 23/8/10: Is ECB contradiciting itself on banks stability?

Updated below

Here is a note of the day, to be followed by a question of the day:

ECB's Axel Weber (a 'hawk' in his pre-crisis life) is proposing in the FT today that the ECB should extended unlimited refinancing operations for Eurozone banks up to three months until at least early 2011.

This call, if followed upon, would

1. make it harder for the ECB to execute any serious QE exit strategy,
2. shows that the situation in the EU banking sector remains critical;
3. indicates that forward looking central bankers, like Weber don't really believe that the funding markets are ready to properly price the risks of European (including, of course, German) banks, even in the short run (under 1 year);
4. shows clearly that despite statements to the contrary, ECB governors (at least some) don;t really buy into the idea that Euro area banks will be able to unwind, absent ECB help, the €1.3 trillion in debt coming due in the next 2 years.

Now, question of the day: If the EU stress tests were anything better than a shambolic PR exercise (I don't think they were, but let's entertain the idea), why would ECB need to worry about the banking sector funding situation? After all, the tests, allegedly, have shown that Eurozone banks are well capitalized and present no systemic risk.

So either the tests were useless (in which case Weber is right in his call) or ECB has no business continuing priming the liquidity pump (in which case Weber is wrong in his call).


And a couple of hours after my question of the day note above, Bloomberg weighed in with a mighty crack at the ECB's position (here).

Economics 28/06/2010: G20 to euribor: beware of the central banks

Update: with a slight delay on this blog's timing - Reuters picks up the same thread here.


Another Monday, another set of pear shape stats.

First, we had a farcical conclusion to a farcical meeting of G20. If Pittsburgh summit was a hog wash of disagreements, Toronto summit had a consensus view delivered to us, mere mortals who will pay for G20 policies. This consensus was: G20 leaders called for

• austerity, but not too much (not enough to derail growth, but enough to correct for vast deficits - an impossible task, assuming that public deficit financing has much of stimulating effect in the first place);
• generating economic growth (with no specifics as to how this feat might be achieved);
  
• increased tax intake (to help correct for deficits); and
• no changes to be made to the global trade and savings imbalances.

In other words, G20 decided that it is time to have a 4 course meal without paying for one.

Then , on the heels of these utterly incredible (if not outright incompetent) pronouncements by G20, Bank for International Settlements (BIS) came in with a stern warning to the Governments worldwide to cut their budget deficits "decisively", while raising interest rates. Funny thing, BIS didn't really see any irony in cutting deficits, while raising the overall interest bill on public debt. Talking of Aesopian economics - let's pull the cart North and South, in a hope it might travel West.

In many ways, BIS got a point: “...delaying fiscal policy adjustment would only risk renewed financial volatility, market disruptions and funding stress” said BIS general manager Jaime Caruana. Extremely low real interest rates distort investment decisions. They postpone the recognition of losses by the banks, increase risk-taking in the search for (usually fixed) yield, perpetuating nearly economically reckless financing of sovereigns that cannot get their own finances in order, and encourage excessive levels of borrowing by the banks.

Continued water boarding of the western economies with cheap cash through Quantitative Easing operations by the CBs risks creation of zombie banks and companies with sole purpose in life to suck in liquidity from the markets. Alas, the problem is - shut these zombies down and you have no means for monetizing public debt in many countries, especially in the Eurozone. Boom! Like the main protagonists in Stephen King's movies, governments around the world now need zombies to rush into their disorganized homes before the whole plot of deficit financing blows up in their face.

BIS also warned that many economic experts and central banks are underestimating inflation risks. And this is just fine, assuming you are dealing with short term investment horizons. However, for a Central Bank to ignore the possibility of a restart of global inflation - fueled by the emerging markets growth and later also supported by accelerated inflationary pressures in the advanced economies following the re-flow of liquidity out of the bank vaults into the real economy once writedowns are recognized and banks balancesheets stabilise - is a very dangerous game. inflation, you see, is sticky.

And inflation might be coming. Look no further than the Fed (here) and the US Administration insistence on the need for continued debt-financed stimulus.

Or, look no further than the movements in the interbank lending markets:

So the long term Euribor is up, up and away despite all the Euro area leaders' talk about fiscal solidarity funds and tough austerity measures. Think: why? Either the interbank markets don't believe in Euro area's ability to get its own house in order (which they certainly don't) or they believe that future inflation will be higher (which of course they do)...

Hence, shorter maturities are in an even more pronounced push up:

While dynamically, the trends are deteriorating:
Now, think about the Irish banks (Spanish, Portuguese, Greek - etc) that are on life support of interbank markets and ECB. Can they sustain these credit prices?.. While facing continued writedowns?.. Don't tell I did warn you about these.