Shadows and 1 big black hole over Wyoming as markets look to central banks for calm.

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shadows.

This week, in the shadow of the Tetons, the Kansas City Federal Reserve will host its annual economic symposium at Jackson Hole, Wyoming.

However, there will be a few other shadows cast over the proceedings, this year.

One will be cast from as far as Washington, and it will belong to Donald Trump.

Central Bank Independence.

Left Mario Draghi, Outgoing ECB President. Right Jerome Powell, US Federal Reserve Chair.

Left Mario Draghi, Outgoing ECB President. Right Jerome Powell, US Federal Reserve Chair.

Fed Chair Jerome Powell has been accused of buckling under pressure from the President, so it’s likely he will be looking for moral support and courage from other central bankers at Jackson Hole, specifically on the topic of central bank independence.

Standing with his counterpart, Draghi wants to see the Fed act independently of the White House, but somewhat at odds with this is that he would also like to see the Euro weaken against the USD so that Euro originated exports become cheaper in USD terms.

That aside, Draghi and Powell seem to agree that the Fed needs to make decisions free from, and independent of any pressure from the White House.

Still, the Don wants to see rates as low as possible and his own trade war has seemingly provided justification for using Powell as a punching bag on this topic. Nothing like manufacturing your own proof!

Recently, Powell dropped interest rates (the first in 10 years), explaining it as a ‘mid-cycle adjustment’ with no promise of further easing. Powell’s actions point to a position of: but for tariffs, probably no reason to lower interest rates. But that’s just speculation.

I’m also speculating when I say it would not surprise me if during the symposium the Fed offers up some proof of the adverse effect of tariffs on US firms. But don’t hold you breath.

It will be interesting to see whether Draghi again shows public support for Powell on this issue.

Draghi’s retirement casts an even larger shadow.

Mario Draghi.

Mario Draghi.

His is a large shadow - and it’s his impending absence as a safe pair of hands for the past 8 years (agree or not with his 5 trillion plus lake of free and easy euros) which has increased the surface area of his shadow.

This will be his last Jackson Hole as Head of the ECB – and in about three weeks from now he will for the last time on his watch call together the ECB’s Governing Council to set EU monetary policy.

Most likely as a parting shot he will warn EU members to get ready to provide fiscal stimulus in the event of another crisis - to take the pressure off monetary policy.

Will he confirm the likely restarting of QE in Europe, or will he opt for a graceful exit and leave it to his successor? He has after all been the dove for all seasons.

Thereafter, Draghi is to be replaced by ex-IMF boss and lawyer, Christine Lagarde (yet to be confirmed).

QE - 1 big Black hole.

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The quantitative easing (QE) shadow is no longer a shadow, but a stubborn black hole hoovering up more food, growing larger, and slowing down the economic clock.

QE means Central banks cannot be repaid in the ordinary course.

Attribution: Yardeni Research, Inc.

Attribution: Yardeni Research, Inc.

The ECB purchased an eye-watering €5.1 trillion (US$5.3 trillion) over 5 QE programs, the first of which started in March 2015, before it halted purchases. This together with banks refusing to lend to businesses and the related cost of parking money with the ECB has led to negative interest rates (neg 0.4%). Effectively an upfront agreement to take a haircut and receive back less than what you lent.

Next in line is the Bank of Japan (also a negative rate jurisdiction) with assets of US$5.2 trillion.

Then, the US Fed which bought more than US$4 trillion but has had some time under Yellen and Powell to run some of those assets off, with current assets of US$3.7 trillion.

These add to US$14.2 trillion, with negative interest applicable in Japan and the EU.

But wait, the above excludes the People’s Bank of China, which has stacked up a similar amount of assets as the BoJ.

Attribution: Yardeni Research, Inc.

Attribution: Yardeni Research, Inc.

The four balance sheets total US$19.4 trillion, which is broadly equivalent to 25% of world GDP.

Japan’s debt is widely known to be mostly held internally.

Earlier this month (instead of in October as expected), Powell announced a stop to Janet Yellen’s quantitative tightening (QT) program, referred to as the balance sheet run-off. As a result, the US Fed retains a US$3.7 trillion asset portfolio.

China is a Communist model and therefore the Party can do whatever it likes. On the weekend, it announced more stimulus.

However, it is the ECB which never got the chance to lift rates nor run-off the biggest central bank balance sheet of them all.

Assuming Lagarde takes over Draghi’s role as expected, she and her team will inherit a bunch of trouble and pain due to the sheer size of this problem, coupled with a deposit rate already at minus 0.4% (including parking fees with the ECB), and a trade bloc which looks to be moving closer to recession with Germany (the EU’s engine room) shrinking its economy by 0.1% in Q2.

So, if the ECB stops buying paper, who will buy it? Worst still, who wants to buy into an economy in recession?

The answer is that it must continue, and with a hint of some upcoming economic easing in Germany (around the US$55 billion mark) and some further easing in China announced over the weekend, more rocket fuel was added to equities as we witnessed in last night’s bullish trading session in the US. But, just another wallpapering over the trade war cracks.

But, Lagarde also steps out of the IMF at a bad time, politically. Firstly, the Conservative hands of German Chancellor Angela Merkel are soon to disappear as the far right continues to erode the Conservative power base. Secondly, Le Pen’s Nationalists and the Far Right have also gained a significant foothold in French politics.

Essentially, the two largest countries in the EU bloc (which dwarf all others) are going populist and may soon be calling for the guillotine.

In such circumstances it is difficult to see a return to Merkel’s austerity measures, in the event of another crisis.

With disunity, populist challenges from the right and just under 30% of total EU GDP made up of exports; Lagarde and the European Commission (without the steady hands of Mario Draghi and Jean-Claude Juncker) will need a few fresh ideas to stop the EU from being dragged into a long recession.

It is therefore likely that Lagarde will need to keep rates as low as possible and restart QE (that’s if Draghi does not kick start it before he leaves), further weakening the Euro and making EU exports cheaper in relative terms.

In October 2017, I wrote that we were seeing the signs of QE infinity. I sense we are only now starting to see its negative effects.

Brexit.

Yet a further bit of food for the QE black hole is Brexit.

Alexander Boris de Pfeffel Johnson, that is, Boris Johnson is now in control of the UK (for the moment, with Jeremy Corbyn at his throat) and appears quite happy to crash out of the EU with no pre-determined deal. On the other hand, he reportedly believes the EU will back down on the Irish backstop. So which is it? Or, is this simply Trump-style negotiating tactics?

Regardless, the questions over the health of the UK economy after what’s currently shaping up to be a no-deal Brexit, and the consequential requirement for QE, currently swing in the balance.

QE Infinity? Yep, and probably more in the event of a continuing trade war.

And here in the lucky and clever land of Oz? Well, given we are stapled to the US and China and given their punch up seems far from over, let’s just say lower rates for longer and a weak AUD - great for USD denominated hard and soft exports, but bad for builders, machinery and other importers.

Total world debt feeds the hole.

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As I wrote in April, excluding all forms of unregulated/unreported/shadow debt and certain derivative products, the world’s debt stood at about US$243 trillion, or just under one quarter of a quadrillion!

Assuming about US$76 trillion in global GDP, this tells us that the world is about 318% leveraged before taking shadowy/derivative debt into account.

What’s more alarming is that since the GFC an additional $US70 trillion in debt has been originated - 80% of which has been borrowed by Governments and non-bank Corporations.

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Extrapolations from Bloomberg data suggest that in the 10+ years since the GFC, Governments have stacked on an additional US$30 trillion in debt. Think about deficits, QE and deficit funded tax cuts that the world will never be able to repay in full.

And, Modern Monetary Theorists say none of this is a problem. Keep printing money, they say. But what happens when money loses all of its value?

Time value of money.

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Money has lost its value. In finance, the time value of money concept has almost been trashed as discount rates remain crazily low.

The cost of equity capital usually calculated using the capital asset pricing model no longer works without normalising risk (beta), the risk free rate and the return on the market.

So if you have to normalise all of the variables in a formula, surely the formula no longer works? Next step - risk the cash flows, but so far the market is refusing to do this.

Also, the Phillips curve is so flat that it barely proves the once strongly inverse relationship between unemployment and inflation, and it’s pretty clear that the near on US$20 trillion in assets held by the 4 largest central banks has still not hit the real economy.

Negative rates are part of the reason, with banks being incredibly discerning about who they will lend to, often preferring to park money with the central at a pre-agreed loss.

Rather, this centrally printed money has found its way into asset inflation in the form of share prices that defy fundamental analysis. This cheap money has enabled corporate debt fueled expansions and share buy-backs.

And, the amazon effect, or the cloud’s role in making more goods and services cheaper for more people with access to the web has brought down the value of goods and services - also contributing to worldwide where’s wally inflation.

This, plus the lack of a meaningful real return on less risky assets favored by Seniors means that they can no longer spend the returns they are not getting.

The yield curve inversion which is normally a harbinger for recession seems to be overshadowed by raging equities markets. There seems to be little to no reckoning of these shadows and the massive QE black hole as investors, traders, punters (and corporate buy-backs) continue to force equities market higher to Icarian levels.

So, in light of all of this, what could possibly be the agenda for the Jackson Hole symposium which starts on Thursday?

Jackson Hole 2019 - “Challenges for monetary policy”.

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This year the Kansas City Fed has adopted the title: “Challenges for Monetary Policy”.

The agenda has not yet been published, but the discourse on the Fed’s site provides some background.

In short, there is an acknowledgement that we are ten years since the financial crisis (actually nearly eleven) and the key central banks are far from achieving normalised monetary policy.

The Kansas City Fed says that the difference between central banks that are approaching a neutral policy setting versus those which are yet to begin the process of removing policy accommodation, apparently comes down to the status of the economic recovery in each jurisdiction.

The Fed goes on to say that the disparity between the problems in each jurisdiction and the relative monetary policy settings are causing some big challenges for policy markets, and it has called out the the following challenges:

  1. First, the different trajectories of monetary policy paths across countries in recent years has contributed to a divergence in interest rates across countries. This divergence has implications for exchange rates, trade, and ultimately economic activity in the global economy.

  2. Second, monetary policy actions and the build-up and eventual unwinding of central banks’ balance sheets from QE also have implications for capital markets and financial flows for advanced and emerging market economies as shifts in monetary policy in one country can create spill overs through financial markets affecting others.

  3. Third, the path for policy normalization looks very different relative to previous normalization periods as the natural rate of interest is viewed by most policymakers as being lower than in the past and many central banks are also faced with unwinding unconventional policy actions taken during the financial crisis.

  4. And finally, in the midst of charting a course for monetary policy to pursue their mandates, policymakers also must take into account influences of commodity and financial markets that can provide headwinds or tailwinds to economic activity and inflation dynamics.

Translation?

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US$243 trillion in global debt + QE infinity + tariffs + trade war + currency wars + amazon effect + flat Phillips curve + populism = cannot raise interest rates and normalise ~US$20 trillion of central bank balance sheets without very big and ugly global meltdown.

Politically, there seems to be no will anywhere in the world (least of all among the baby boomer-led establishment) to monetise the debt, i.e., apply a number one haircut and cash out the balance, reset and start over to allow the cost of money to re-calibrate.

Rather, with elections coming up there is more political appetite for more bail outs and manufactured liquidity.

And, as a result of there not being a more profitable place for investors to park money, an even higher equities market.

But, let’s not get too excited - its unlikely there will be any conclusion or earth shattering revelations on Thursday, or even on Friday when Powell takes the stage to talk about the challenges for monetary policy.

In the absence of a fiscal panacea, we are probably staring down the barrel of more QE and lower rates for longer with negative rates becoming the norm as short dated paper is rolled over/exchanged for longer dated and perhaps worthless paper……….hoot hoot?

Attribution: State of Wyoming. Tetons in the background.

Attribution: State of Wyoming. Tetons in the background.

Stay tuned.

Mike.


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