Bond Refugees Flee to Stock Lands

Tension is building among stock investors.

Stock prices have levitated, but the most fundamental determinant of stock price support — an uplift in corporate earnings — has gone soft.  The S&P 500 earnings actually declined 7.1% year-over-year and the US and moreover global economies that support it are sputtering on all cylinders.

Additionally, given the economic recovery from the Great Recession’s lows, wages are rising modestly — but with zero productivity, there is not much to offset these costs suggesting that profit margins will not hold up.

This comes on top of a seven-year run of stock prices that has outpaced the recovery of corporate earnings (as shown below), making for a relatively high price/earnings ratio as compared to historical benchmarks. All this concerns stock mavens and for good reason.

But on the other side of the ledger is the resolve of the central bank to provide a wealth effect for consumers to keep on consuming. While it’s quite clear that ultra-expansionary monetary policy carried out via bond purchases has elevated bond valuations and, in turn, produced low market yields, what support does monetary policy have for stock prices?


Since the onset of Fed QE, there’s been a relationship between the money base and a broad stock price index (see below), but what’s the link that caused them to move together- as they have?

First, and most fundamentally, a central bank purchase of bonds from private parties is financed by new money. Hence, the other side of the bond purchase is liquidity in the hands of a portfolio manager, who then scans the financial landscape for a replacement asset that includes stocks. This is the process by which bond buying, paid for with new money, ripples out to affect prices of other assets.

From there, internal portfolio dynamics lead to increased stock purchases in the following way. When bond appreciation generates a wealth effect for investors’ portfolios (particularly institutional investors), then managers must re-balance assets and, in the process, redistribute the bond gains to other risk assets not purchased by the Fed.

Institutional rebalancing is further motivated these days when ultra-low-yield bonds create pressure to generate investment income somewhere else in the markets. This hunt for investment income can take the form of stock dividends or stock appreciation, both of which have generated total returns over the last seven years.

This is say, there is pressure to switch to assets that have become known as “alternatives,” and this has included equities, real estate, and (for a time) commodities. In essence, income investors have become bond migrants who have been forced from their preferred habitat to other asset classes.


However, there is a simpler way to look at this process of spreading out the price increase. There is a cross-elasticity of demand among alternative assets in a portfolio — much like when a government supports meat prices, the price of fish also rises, even though the government didn’t actually buy any fish. This occurs because the expensive meat drives consumers to purchase more fish, which in turn causes fish prices to increase as well.

To an economist, this so called cross-price elasticity of demand, causes more intensive buying of substitutes when one item becomes expensive.

Another factor that leads to stock demand and levitated prices is a lower discount rate in the market. Institutional investors are not indifferent as to when income arrives: they discount future income to present day terms by discounting at the rate that could be earned on the asset if it were in-hand today — that is, what they are giving up when income arrives later in time.

In this regard, eight years of depressed yields has likely caused the discount rate applied to future earning to be reduced, which, in turn, causes the present value of future income to rise.

As an example, for a single dollar of corporate earnings that is projected to arrive in 10 years, if discounted by today’s low yields of 2%, would have a present value of 81 cents, whereas the same dollar discounted at a 5% rate would, in present value terms, be reduced to 62 cents. Hence, lower market yields boost the valuation of future income even if the future income is not projected to grow. In this case, there is a 31% increase in today’s value for 10-year out income when yields fall as far as they have.

The ultra-low interest rates further work to support stock prices as they induce companies to issue bonds with low yields and apply the proceeds to purchasing their own equity shares. While this doesn’t generate future corporate income, it does increase income per share and enhance stock prices as long as investors ignore adverse effects from a more leveraged future.

Equity share repurchases recently got a further boost when the European Central Bank took up the practice of purchasing corporate bonds at issuance, even for Euro subsidiaries of US companies.  This is likely to add to the pool of additional buy-backs of US-issued company stock. And why not when McDonald’s was able to place a 12-year maturity at a .75% rate that would make the US Treasury Department envious?

Last, in this description of stock price levitation, one should muse on the thought that maintaining stock prices at high levels has occurred despite an absence of Fed bond purchases since October 2014.

While foreign central banks keep at it (and, in the case of Japan and China, actually purchase stocks in addition to bonds), something else must be providing stock price support in the absence of additional Federal Reserve buying.

Not much thought has been given to relative scarcity as a result of bonds being purchased by central banks and stock being purchased by the issuing corporation. These assets will not see the light of day again as there is no way for them to be offered (without a change in policy) on secondary markets.

Hence, with stock and bond issues being locked up, relatively higher prices do not elicit as much of a supply response that would reduce market prices. The historical description for this is a market “cornering,” implying control over price from collecting a significant proportion of an asset — and the central banks are cornering the government bond issues. Thus scarcity allows prices to continue to be levitated thought the Fed buying has stopped.

Indeed, with this in mind, the central banks have vowed to purchase no more than 70% of any government bond issue so as to allow some private suppliers to establish a market price without being able to put much of a dent in its level.

All this is not to say that the unease felt by the stocks mavens can’t bring more supply to the market than the bond migrants will absorb if their expectations go sour.

This would push stock prices downward. But the pent-up demand by the bond migrants for stocks, together with relatively more scarce corporate shares, has changed what we think of as the fundamental yardstick for pricey risk assets.

Thus, historical stock P/E ratios as a metric for an expensive market needs revision, as we are in a whole new history of a higher ratio of money relative to asset values along with more restrictive supplies of both high quality bonds and stocks.


Sign up to receive the Spellman Report. Bracing financial and economic insight. Now with free delivery!

Click to Email Dr. Spellman

The Point of No Return for Government Debt

Economic growth in the developed world is falling well short of the post-WWII experience, and there are identifiable causes.

Globalism — the opening of global trade — has caused developed economies to lose exports to lower-wage emerging nations and is but one factor. Another is the slowing of population and labor force growth (and, in some cases, both are shrinking). This contributes to the problem of slow economic growth as it restrains both aggregate supply and demand.

Furthermore, when populations stop growing, what outpace economic growth are age-related government entitlements as the age-profile of the population becomes top heavy with retirees. This, in turn, means taxes rise disproportionately on the backs of the relatively fewer workers, or the country — more realistically — resorts to debt financing.

Entitlements accelerate the accumulation of government debt now being piled on top of decades of Keynesian deficit spending that were an attempt to nudge higher growth rates.

It has long been a vague concern that government debt accumulation would be the ruination of an economy, and that sovereign defaults would occur as they have many times in that past. That issue is now front and center in both Europe and Japan, with the U.S. perhaps a decade behind.

Larger debt loads, however accumulated and whether from Keynesian economic stimulus, entitlements, war financing, or financial guarantees, cause tax rates to be higher than would be otherwise be necessary to pay yesterday’s incurred interest. It becomes a struggle for a government to merely pay interest without the possibility of retiring debt.

For example, in Japan, the debt-to-income ratio is a staggering 250 percent. This means that despite very low interest costs on government debt, 43 percent of tax proceeds are devoted to paying interest on its past debt.

Raising tax rates to pay debt service impacts the present as it becomes a negative incentive for investment spending. So past debt retards today’s economic growth.

The great danger of a high debt-to-income ratio is that it becomes self-reinforcing: We induce higher debt ratios not only via higher taxes to pay interest but also because the resulting economic slump unleashes Keynesian automatic stabilizers that have been built into an economy’s spend-and-tax reflexes.

As an economy’s growth rate slows, this kicks in income maintenance programs like unemployment support. At the same time, a slumping economy’s tax revenues erode more than in proportion to the slowdown in economic growth, which is a by-product of a progressive tax structure.

For example, in the first year of the Great Recession, U.S. government debt expanded by 15.8 percent while income declined by 2.8 percent, and together they ratcheted upward the debt-to-income ratio.

The economic slump produced by debt adds to government deficits resulting in yet more government debt and more taxes, which in turn reinforces the slump. The causation runs both ways: debt slows growth, and slow growth widens country deficits and accumulates debt.

What is being described is a self-reinforcing endogenous debt accumulation process in which the debt-to-income ratio rises until it can no longer be financed, resulting in a sovereign default.

The critical threshold when the self-reinforcing process of debt accumulation outpaces income growth has been aptly called thebang pointby Reinhart and Rogoff (R & R). Their research, contained in their book “This Time Is Different,” shows that over many years, for many countries, that the threshold for debt to grow exponentially occurs when the debt-to-income ratio reaches approximately .9 — that is, when a country’s debt is 90 percent of its GDP.

R & R find that on average, for many countries, when that threshold level of the debt ratio has been reached, economic growth becomes retarded by 1 percent. In today’s world, much of Europe (and certainly Japan, too) is well above that point, and income growth has certainly declined and is barely positive.

For the U.S., at a debt-to-income ratio of 100 percent, economic growth is also being sucked into the endogenous web of debt in which, at best so far, GDP growth appears to be have been retarded by 1 percent annually.

The U. S. finds itself this year in a relatively weak cyclical upswing in which the growth of income and debt are both rising at approximately the same 2 percent rate so that the debt ratio is being maintained at the present time, but any slump in growth accelerates the debt ratio.

As a deterrent to debt accumulation, a heroic attempt is taking place in Japan and the U.S. to reduce the interest expense of government debt. Europe, via its European Central Bank (ECB), has recently engaged in a similar battle.

The debt service reduction is being described as Quantitative Easing and is being discussed and sold to the public as being a monetary policy to offer lower interest rates to stimulate interest rate-sensitive private spending. That is, low rates to stimulate growth.

Indeed, many of the central bankers are well trained Keynesians and they think that way, but to the political class, the central bankers are used as pawns to neutralize the government’s debt burden.

There is much debt service to be neutralized at current levels of debt, especially in Japan and Greece. What greatly complicates the problem of maintaining debt service with a high debt ratio is that the government bond market, when it senses that the debt problem is getting out of control, will only finance the government’s debt with elevated interest rates that imbed a sovereign risk premium.

To get a sense for a country’s interest cost exposure to sovereign default pricing, take a simple example of a debt-to-income ratio of 1 and an (unrealistic) interest expense that averages 1 percent on all government debt issues. In this case, taxation would only need to capture 1 percent of a nation’s GDP to service country debt. This expense is manageable.

But to be more realistic, sovereign bond yields on 10-year debt maturities are shown below for several different recent European sovereign bond market eras.



Prior to the common currency that arrived in 1999, when the Euro countries were on their own (in the sense of no support from by each other or by a central bank), sovereign yields were priced to reflect sovereign risk.

At the start of the common currency in 1999, the sovereign rates came together at Germany’s base rate during the honeymoon of the Euro zone when it was presumed that the stronger countries would come to the aid of the weaker if need be — and if not, there was a central bank to provide assistance. Also debt control was a pre-requisite to be a member of the Euro zone.

This presumption of aid to the weak became questioned after the financial crisis, and there was a weakening of country debt control. This relevant era began in 2008, at which time the market priced country vulnerability with little or no help from neighbors or by the central bank because “monetary finance” (or central bank financing of governments) was still taboo.

That environment reveals clearly how hard markets will punish sovereigns with debt problems. High single digit sovereign yields existed, and Greece, which was headed for its first default, experienced a 30 percent market cost of finance for 10-year maturities.

In this case, for a country with debt equal to 250 percent of annual GDP, and if its sovereign average cost of funding for all maturities was merely 10 percent, that country would need to capture fully 25 percent of GDP to pay interest alone without any of the other costs of government being covered. There would be debt cost of that magnitude likely for both Greece and Japan.

That is the process by which default is brought on when the debt-to-income ratio reaches the bang point. It might take a few years, but the process grinds on until the income lost attempting to tax and service the debt becomes impossible to bear.

So, in a last ditch effort to avoid default, the central bank intervenes with quantitative easing to reduce interest rates paid by sovereigns. QE is in process in Europe, but as things currently stand, Greece’s sovereign debt is not investment-grade and, hence, is not eligible for purchase by the ECB unless the rules are bent or the rating is changed which is a likely response in the pragmatic business of saving the sovereign, otherwise known as “Whatever it takes.”

Alternatively, Greece would need to drop out of the currency union, likely default on its debt in whole or in part, and go back to its own currency from which they can continue to play the money game to depress interest expense. In the case of Japan, the pretense continues, but they are past the bang point and — short of some new exogenous source of demand for their products revealing itself — they are sinking deeply into the morass of debt and debt service.

But will central bank QE really contain the debt service problem? The answer has to be no because the side effects of the debt solution becomes its own problem.

With such low investment returns in-county, capital flees to higher-yielding locations and, without capital, there is no financing of private investment and the real physical capital stock becomes a relic of yesterday. This erodes income and raises the debt-to-income ratio further.

Once having reached the bang point, QE is too late and counterproductive


Sign up to receive the Spellman Report. Bracing financial and economic insight. Now with free delivery!

The Deflationary Trap and the Central Bank Game of Chess

chessMy financial start in life came in the 1970s when rent houses seemed to be a good idea. That was because its rental stream was ratcheting upwards in an inflationary environment and could also be acquired with its original fixed-rate mortgage still intact.

What made the investment especially appealing was that the inflationary wind was to my back; rental streams grew while the mortgage’s interest carry remained low and locked at a fixed rate that reflected earlier and more modest inflation.

And as you might think, the combination of inflation-enhancing income streams and cheap fixed rate financing is an environment that promotes the building of more of the same — not only more houses but more importantly corporate plant and equipment that grows jobs and output. Hence, economic performance benefits from inflation, to some degree.

A return to these conditions is what central banks of the world, especially in Europe and Japan, lust for today. Instead, they find themselves on the edge of exactly the opposite — a deflation that neutralizes the benefit of the low fixed rates that central banks have manipulated since the onset of the Great Recession.

But one must appreciate the full extent of the deflationary threat facing many developed countries today that drives policy and markets.

Deflation more than neutralizes the low interest rates provided by central banks because investment in real physical assets is deterred by the prospect of deflating income streams. And that reduces spending on new physical assets which, in turn, reinforces the deflationary environment.

That is, while deflation may be the product of previous soft economic conditions, it inhibits further physical investment in real assets thus reinforcing the existing deflation.

This is known as the deflationary trap.

And that’s not the end of the self-reinforcing deflationary damage. Deflation also shrinks top-line income of the corporate, government, and consumer sectors which diminishes spending and in turn makes it more difficult to repay existing debt. In other words, the real value of debt increases leading to default and default takes down not just the borrower but also the lenders.


The iconic scenes of bank panics of yore in which depositors line up to withdraw their funds tell a story. The depositors believe deflation induced defaults in the banks’ loan portfolios will cause the banks to fail and they had best retrieve their deposits while they can.

The dynamic leaves the banks not only with loan losses but no lendable cash. It still plays out today though not as visibly as deposit withdrawals are on-line as in southern Europe.

That was the story of the l930s.

If both the desire to borrow and the ability to lend go away, the wheels of an economy no longer function in the way we are accustomed, no matter how much money supply the central bank spreads around.

Since the developed countries are on the edge of the deflationary trap, many of their central banks are resorting to quantitative easing (QE). These epic asset purchases do not produce the lending and spending or inflation that monetarism suggests, nor do the QEs reduce interest rates, as they are already at the near-zero floor. Rather, in a great Hail Mary, the QE at this stage is intended to devalue the home currency so that domestic produced goods become relatively cheaper for foreign buyers and they do buy more.

That is the motive for quantitative easing — to gain greater global market share through a cheaper currency and hence goods, which is all that monetary policy contributes these days.

While selling currency on the foreign exchange markets is the direct route to a cheaper currency as practiced by China, it goes against the rules of central bank monetary chess. So the currency selling needs to be more subtle.

The preferred way to accomplish the same is a QE of large-scale asset purchases of domestic financial assets. The central banks claim its domestic monetary policy and leave it up to private investors seeking higher yield to head for the financial markets of other countries where slightly more than microscopic yield still exists.

In the process, the investors heading abroad sell their currency and cause the currency devaluation and do the dirty work for the central bank. It’s not much of a cover-up, but it’s what central banking has come to be these days.

What other reason would cause, for example, Japan to roll out yet another QE in heroic proportions and then, less than a month later at the news of yet another Japanese recession, to increase its very recent QE by 33%?

If successful, a cheaper Yen attracts foreign buyers of Japanese goods and enough demand to turn deflation into inflation that generates inflation streams for home-grown investment in physical capital. It also gives domestic producers pricing power, when the prices of imported goods rise in terms of the Yen.

So the self-reinforcing deflationary depression leads to often contentious policies of currency devaluation via investors in an effort to capture greater global market share and some modicum of inflation. The Fed’s QE3 of the previous two years that ended last month paid dividends for the U.S. in this game at the expense of Europe, Japan, and others, which, in turn, triggered their re-entry into the currency wars just as the Fed ended theirs.

Other countries are now in retaliation mode in this game of central bank monetary chess, hoping to steal some demand back from the U.S. This leads to not just the depreciation of their currency but the ascendency of the U.S. dollar and the value of U.S. assets, which was nice at first until we find out it’s gained at the cost of a now-perceptible slowdown in the U.S. economy.   In this stage of the currency wars, the U. S. is about to lose some of what it previously gained when the Fed was in QE3 mode.

Hence, quantitative easing is no more than a cover-up for currency devaluation: it allows government officials to claim their hands are clean from a practice that is globally frowned upon.

In the process, central banks have revealed that money growth is not the inflationary threat once thought, at least not in this environment. We have come to the understanding that in the deflationary trap, neither fiscal nor monetary policies are what the textbooks say they are.

Public policy has come down to the sorry state of manipulating growth and inflation at the expense of someone else’s deflation. It’s a zero sum game of redistribution among countries that adds little overall lift to the global economy.

Few who lived through the “runaway” inflation of the 1970s would have dreamed that someday inflation would be a desirable public policy? We have come to find out that it surely beats deflation. But how to achieve inflation has proven to be elusive when lenders are fearful of deflationary induced default and business investment borrowers need more inflationary wind to their back.

Sign up to receive the Spellman Report. Bracing financial and economic insight. Now with free delivery!

Is the Printing Press Engaged for the Duration?

spell1A  printing press is a handy thing to have. When a government or central bank can fund itself with money or claims on money, it can buy a lot of things and solve a host of problems, all without the need to tax. I wish I had one.

Developed world governments have lots of problems these days and hence are using the printing press overtime. And with lots of problems comes the thought, at least to an orderly mind, to somehow prioritize the buying. Or, if there is no order, than the disorder of whatever comes next is the order.

This Great Recession experience of the past five years has been an epic chapter of buying in the nearly 100-year history of the Federal Reserve.

In the modern era, economy-wide sustainable growth has been the Fed’s guiding light. It worked quite well for some 50 years to temper the oscillations of the business cycle, both the highs and the lows. And the modern business cycles orthodoxy and Keynesian upbringing is causing the Fed to turn on the printing press to achieve an unemployment rate of 6.5% in this Great Recession, so they claim.

While defining success in terms of unemployment brings clarity as to what Fed policy is about, it opens up monetary policy to an unintended exit if factors other than economic recovery were to reduce unemployment. And financial markets in a bubble state as a result of the Fed’s buying fear that outcome.

As it happens, labor force dropout due to demographics or inadequate skills is occurring. Furthermore, work is being reorganized and parceled out so employees do not exceed 30 hours per week, lest their employers become subject to the Obama Health Care tax. All these factors are bringing down the unemployment rate more quickly than fundamental economic improvement.

Each month, there is a dread fear in financial markets that unemployment will decline sufficiently to cause the Fed to exit QE as they have pledged. Indeed it is the major risk to investors holding positions in an asset bubble market, whether it be in debt, equity, commodities or real estate.

spell2So as we approach the target unemployment rate without much economic recovery, the question is, can and will the target be redefined to be the unspoken necessity of supporting Treasury debt obligations? 

The last time the priority of Fed buying switched from supporting banks and the economy to supporting the government effort to sell Treasury bonds was at the beginning of WWII.

In the three months following Pearl Harbor, given the expectations of the size of wartime debt issuance and with some inflation expectations thrown in, long Treasury yields ratcheted up.

The Fed then approached Treasury (not the other way around) indicating its willingness to enter an agreement to support Treasury bond prices at the March 1942 level for the “duration” of the war.

The Fed did this by buying enough Treasuries along the yield curve to prevent their prices from falling and the market yields from rising — a policy that became known as the Fed’s interest rate peg. It took a tripling of the Fed balance sheet in four years to do the job, which is roughly in the same league as the Fed balance sheet growth since the commencement of the Great Recession.

When the war concluded, federal government deficits turned into surpluses, and there was no longer pressure for the Fed to be the buyer of net new government debt.  And furthermore, there was high inflation. This caused the Fed to claim the “duration” had arrived and that it was time to exit (there’s that word again).  But there was a catch.

To Treasury Secretary John Snyder, exit in the name of economic stabilization was all academic heresy or a potentially expensive distraction from the core responsibility of a government to finance its debt at the most affordable rates. That is, he didn’t care for the idea that Treasury bonds would not be supported ad infinitum at par in the primary and secondary debt markets. Furthermore, he was backed by a gentleman in the White House by the name of President Harry S. Truman. Such is the core concern of a government as to the cost of its interest expense.

The Fed’s post-WWII exit attempt spilled over into widely followed Congressional hearings conducted by Senator Paul Douglas before the Joint Economic Committee. The core question was, did the Fed’s responsibility for full employment and controlling inflation trump the need for propping up the price of Treasuries so interest rates would not rise?

Despite Congressional support for the Fed to exit, it still took years until the Fed became determined to pursue a path independent of Treasury dictates, as inflation soared at the commencement of the Korean War.

While the brouhaha concerning exit continued from 1946 until 1951, an opportunity to back out of the Treasury bond support agreement occurred in 1951 (almost six years after the “duration”). At that time Treasury Secretary John Snyder was incapacitated and in the hospital and his next-in–line at the Treasury, William McChesney Martin, negotiated an exit agreement with the Fed at the White House with the President presiding. The agreement became known as the Accord and was the monumental turning point that allowed Fed independence to foster economic growth without inflation for the next half century.

However, there was a catch. The Accord set the Fed free to pursue economic stabilization so long as there continued to be a strong tilt to Treasury bond support. To accomplish that, Martin suggested, or perhaps insisted (as the folklore goes) that he be installed as Chairman of the Federal Reserve Board of Governors to represent Treasury’s interests in monetary policy — which required a resignation of the existing Fed Chairman. This was all accomplished before Snyder left the hospital. Such is the difficulty of Fed exit when the government’s ability to sell debt and service the interest expense is at stake. (For a revealing account of that history go here.)

What was most interesting about the 1951 exit is that after becoming Fed Chairman, Martin had a Beckett moment, or more like a Beckett career. In his almost 20 years as Fed Chairman he constantly tilted in the direction of containing inflation and would not peg Treasury rates below market even during the Vietnam War, which caused Lyndon Johnson to unsuccessfully seek his resignation.

In the context of today’s financing strains that will grow over the next four decades due to Boomer entitlements, consider the following: The U.S. gross debt-to-income ratio is in excess of 100%, and the CBO projects that ratio to reach 400% in the out years of entitlement growth. Hence, each hundred-basis-point increase in the average interest rate the U. S. pays to service its debt (above the present 2 percent average carrying cost) requires additional taxes to drain another percentage point from the income stream — a drain we can ill afford. You can do the math for the required tax drain when the debt-to-income ratio approaches 200% or 300% and if interest rates were allowed to reflect sovereign or inflation risk.

The CBO has estimated that in the out years of  Boomer entitlements, tax revenues will need to be as much as 25% of annual income as compared to today’s 2% to merely service the projected interest expense on the debt, (even if market yields were to remain at average historical levels).

spell3Today there is a de facto peg already in place. It goes under the title of zero interest rate policy (ZIRP). It is also known as financial repression, which includes ZIRP along with positive inflation causing real yields to go negative all the way out to almost 20 year maturities and has become the explicit policy of the Japan and implicitly of Europe as well.

Given the perspective of the machinations at the end of WWII, is it reasonable to expect that Treasury (and the President and Congress) will allow the Fed to exit its already existing de facto peg? The new “duration” is the length of the entitlements.

Hence, the only likely exit for Fed QEs is an exit from the pretense that QE is an economic stabilization policy that can go away if unemployment hits the Fed’s target. It’s a cover story that is about to be uncovered. Fed buying is the supporting backbone of the Treasury bond market with $500 billion in annual purchases which, in turn, promotes foreign central bank currency wars. With the proceeds, they are investing as much as the Fed is in U. S. Treasuries.

Hence, current Treasury Secretary Jack Lew will have an important say as did John Snyder, in the selection of the next Fed Chairman (if he doesn’t wish to stand in himself). The change of guard will likely occur before the year’s end, when Bernanke returns to Princeton to write his account of the Great Recession.

Hence, what needs to be built is a graceful institutional transition for the Fed to exit stated economic stabilization priorities in favor of Treasury debt priorities without actually exiting its asset purchase program. Otherwise the Fed will morph from one pretense to another as they have done with a loss of their credibility.

So relax, bond market, interest rates will be pegged until inflation is no longer containable at the 2.5% level and that could well not stop them.


Sign up to receive the Spellman Report. Bracing financial and economic insight. Now with free delivery!

Ben Bernanke and the Implications of The Great Monetary Hail Mary

These are epic times in the developed world’s attempt to deal with the implications of government and consumer over-indebtedness. A general unshakable malaise has set in due to sluggish spending and a deleveraging banking sector, and as a result, employment growth is suffering. Governments in turn are faced with diminished tax yields and deficits remain bloated. As shown in Europe, ultimately they run out of willing buyers of government debt.

Inevitably central banks are called in to treat all these related symptoms of the underlying debt disease. That momentous time has arrived for Europe as the debt symptoms have progressed to adversity in the selling of government bonds. Meanwhile, the more stressful symptom for the U.S. at this time is unemployment.

In the past weeks, the central banks of the developed world have taken the next big step, a monetary Hail Mary, to combat these symptoms. A Hail Mary is an act of desperation associated with putting all the chips on the line when your team is behind and time is running out. The ECB offered to support the bonds of those Euro countries that have lost willing private buyers and Germany — the last holdout — has accepted the offer. This will be a four-decade bond support program given the demographic-related deficits that will occur. For the baby boomer generation, their related entitlement spending has only just begun.

The Fed then made an open-ended Hail Mary of mega asset purchases that will ostensibly continue until the labor market is healed through self-sustaining growth.

This could be a long period of time given Bernanke’s claim that 2 million jobs have been created as a result of $2 trillion of QEs to date. If this estimate is correct — and there is ample evidence that it is an overestimate of monetary effectiveness — it implies that each added job comes at a cost of very close to a million dollars of monetary expansion.  These are very expensive jobs.

The Fed’s estimate is imbedded in its macro model of the economy, which is based on the good old times when the Fed could be effective when not faced with the retardant effects of an over-indebted consumer wishing to deleverage and a banking system that does respond to more base money (See Eisenbeis Critique).

But for the sake of argument, let’s accept the Fed’s estimate of the employment response to base money increases to allow us to ballpark the needed size of the current QE. There are more than 12 million unemployed and 9 million labor force dropouts since the onset of the Great Recession, some of whom would return to the labor force if jobs were forthcoming. Furthermore, in the years ahead there will be new labor force entrants which number over a million per year.

To make this both easy and highly conservative, let’s assume that jobs will be created for only half of the jobless and half of the recent labor force dropouts, setting aside the future labor force entrants. That works out to about 10 million new jobs — a policy victory that the Fed would happily claim.

At the Fed’s implied rate of dollars per job created, this implies an asset purchase/monetary injection of perhaps $10 trillion on top of their original (pre-QE) balance sheet of $1 trillion and a current balance sheet of nearly $3 trillion.  This would take the Fed’s balance sheet to $13 trillion — which, interestingly, is the size of the moribund commercial banking system that contributes no balance sheet expansion in response to the Fed’s base liquidity. Basically a beefed-up Fed would fill the gap of the petrified banking system, at least in term of the quantity of assets held by financial institutions.  Too bad the Fed doesn’t have loan officers to make small business loans to make the effects really comparable.

This lack of commercial banking response to central bank liquidity growth is demonstrated (thanks to Gary Shilling) in the accompanying graph. M2 is approximately the sum of the balance sheets of the commercial banks and the central bank is shown relative to the central bank monetary base. It has shrunk by two-thirds as a result of the tripling of the central bank monetary base without much follow through by the commercial banking system.

Hence, to get the same monetary punch by itself, the central bank would need to expand to be an equally sized banking system as a replacement for the petrified banking system that hopes to survive by not lending.

But this is not the end of the epic monetary growth story. It didn’t take long for these QE announcements to have expectation changes that will lead to further second-round monetary expansion coming from abroad.

In response to the Fed’s actions, investors imbued with the Milton Friedman Reflex of money causing inflation are known to move wealth to countries with less exposure to what they believe is an inflationary future in the countries receiving the high doses of money.  These dollars run to some alternative port that would cause the recipient country’s currency to appreciate, as occurred with QE2.

In anticipation of this, central banks around the world are stepping in with plans to preempt a loss of export competitiveness that occurs when inflows of foreign capital cause currency to appreciate. As a defensive measure, the central bank sells its currency on foreign exchange markets to offset a currency appreciation. But the same money, when deposited in its still-intact banking system, is parleyed with banking system expansion. All in all, this makes inflation more likely with money flowing from central banks worldwide.

Japan will be the first big domino to fall in this monetary knock-down process, and Brazil, Turkey, and Korea are likely to follow. The Swiss are prone to offset currency appreciation, and so is China if capital washes up on its shores. So, the ripples of mega money expansion from the U.S. and Europe in turn creates mega monetary expansion in countries that were simply minding their own business and wishing to buy some protection their currency appreciation as a byproduct of the developed world’s debt problems.

This phenomenon, last seen in the depression years of the l930s, has a few names associated with it in the history books, but the clearest tag is competitive (currency) devaluations.

So now the monetary Hail Mary is “QE Squared” or “QE to the Third Power” (or more, depending on how many follow suit. So where does that take us?

This scaling up of monetary expansion with so little in the way of positive economic impacts calls into serious question the efficacy of Keynesian economics as it is currently understood, but this will not stop academia from teaching it. Keynesianism will likely remain the gospel for some time, but hopefully it will at least be amended to include the important idea that aggregate demand generation only works if there is not a debt load to scuttle spending and a well-capitalized flexible banking system to ramp up the monetary base. These pre-conditions cannot be taken on faith.

Furthermore, this blatant policy failure scuttles the 60-year era of faith in the efficacy of not just monetary policy but also fiscal policy to smooth out the business cycle. Emphasis is shifting to supply-side issues as opposed to more demand-side fixes that, in the words of David Rosenberg, have gone to infinity without positive effects.

While the Fed intended for QE3 to aid the unemployed, little or no mention was made that it has been financing approximately 60 percent of net new government debt issuance in recent years. So, there are both stated and unstated purposes of this monetary Hail Mary. On the sly, the Fed is doing the same thing the ECB is doing, which is treating both the employment symptom as well as the government finance symptom of the debt overload disease.

While the need to treat the government finance symptom in the U.S. will be more evident in coming years, as it is in Europe today, the more immediate goal is to maintain as near to zero nominal interest rates all along the yield curve with a constrained but positive inflation rate. The net result of that magic is that the real cost of borrowing is negative — hence benefitting debtors both private and public. But this is confined only to those able to refinance into today’s negative real interest rates.

This leaves out perhaps the most important stressed consumers: those with upside-down mortgage debt relative to home values.

While this monetary Hail Mary is good news for some debtors, the flip side to investors is known as financial repression. This does significant damage not just to the “moneyed” class (in today’s class warfare terms) but to everyone with hopes for either a private defined-benefit or defined-contribution retirement plan with income generation based on microscopic yields in the fixed income market. This also includes state and muni pensions (which are seriously underfunded to boot,) as well as the Social Security Fund that to the extent it is funded is 100 percent invested in U.S. Treasuries.

So saving the unemployed and creating the ability to honor entitlements today comes at a high cost to future cash flows for retirees and institutions hoping to survive on a steady income flow. The classic Keynesian marginal investment function is not responding to the lowest interest rates ever available. Few benefits and lots of costs have been the result of this over the top monetary Hail Mary.

But given that the inhibition to run the printing press is now passé, the race to the bottom (the cheapest currency) is a race to produce more money that enters the economic system not as money in our pocket but as money chasing assets that have a chance to appreciate. That has included stocks to some extent, though that movement seems overstretched relative to floundering profit growth tied to a floundering economy.

Taking all this policy action and associated responses, the markets will put premiums on real assets, especially those producing income that have some inflation sensitivity. There are not many assets in this category. As an example, the yield on Treasury TIPs has appreciated to the point where the yields are now negative based on the fixed return component, requiring a 2.7 percent future inflation to have an equivalent positive yield compared to the fixed income equivalent.

The most desirable asset class is the long duration and real income producing variety, especially if financed with fixed rates — which augurs well for income producing real estate or infrastructure. This includes the new respect given dividend paying stocks. Gold and precious metals are also up there despite not producing income.  These are the premium assets in today’s markets, especially if found in the few countries that might not move to offset currency appreciation until seriously burned in the export markets. That might be Canada, for example, given its bent for market-determined exchange rates and financial prices.

There are endless issues raised by these historic and monumental QEs. For now I will note a few of them: The Fed will most certainly lose some of its cherished independence as a result of this overreach, especially in that it has created income redistribution. That is, it has stepped on a Congressional prerogative. The only question is how much Congress will dictate future monetary policy. It depends on how inflationary it actually becomes. As a reminder, in the inflationary 1970s, Congress stepped in to restrain the Fed with the Humphrey-Hawkins Act, even under a Democratic majority and president. For better or worse, Ron Paul’s status as cult hero is growing.

Secondly and perhaps most sadly, given the Fed’s inability to stimulate the economy under the circumstances of a consumer and government debt burden and a petrified banking system that fears future losses and an over-dictatorial FDIC driven by self-defense rules. This means the Fed’s Hail Mary is destined to fail under today’s circumstances. The market will consider the Fed de-fanged even if it is not de-fanged by Congress. It will be considered the toothless tiger of Constitution Avenue.

With such a fall from grace, the intangible but important confidence factor in the Fed as a reliable rudder to the system will be lost for a long time to come. The Fed will cease to be held with reverence but rather will be considered irrelevant.

All this invites major Congressional recapture of the monetary compass, which is its Constitutional prerogative and would be the largest setback of all.  For if that were to happen, Congress, not an independent Fed, would at the time of  U. S. government bond market stress be in the driver’s seat to do just as the ECB is doing in Europe. The Fed’s has sadly extended its reach beyond its grasp with ill consequences ahead.

Some will say that academic lessons are sometimes learned well, but not wisely. This could well be the final ultimate test of Keynesianism or more broadly demand generating economic policy. Not only can they not be afforded, but they are also not effective in today’s circumstances, but they will still try.


If you enjoy this blog, please forward it to others who may be interested. Sign up to receive the Spellman Report. Bracing financial and economic insight. Now with free delivery!


The Bond Market Rocket and Fiscal Unsustainability Are On a Collision Path

Recently, the bond market has been in rocket mode. It has achieved liftoff and slipped the surly bonds of earth. And some believe it will keep going.  The price of the U.S. Treasury 10-year bond recently reached an all-time high, generating yields at all-time lows. Moreover, the market yield on the British perpetual bond is reportedly at a 300-year low.  Bond mania has even spread to the sovereign debt of Denmark and Singapore and others where negative yields exist.  More astonishing is the ability of France to issue short-term sovereigns with negative yields!

The U.S. has eclipsed the record interest rates that prevailed when the 1930s Depression era came to an end with the onset of World War II, as shown in the chart to the right.

To get to the previous low yields of early December 1941, the U.S. economy had experienced a decade of depression with cumulative deflation of 30 percent.  With that decade-long trend influencing expectations, the future seemed to call for more of the same.  In that environment, investors favor long-term fixed income that appreciates in real terms as a result of deflation if the long bond is successfully paid and retired despite depression circumstances.  Hence the asset category of choice in a deflationary depression is survivable high quality debt.  In the ’30s, this also included surviving corporate debt that appreciated along with Treasuries, and the AAA-Treasury spread narrowed over the depression years.

Since we presently are in an era of Federal Reserve QEs, you might suspect that the Fed was possibly behind the rising Treasury prices and lowest yields of that era.  However logical it might seem in today’s context, the Fed was nowhere to be found on the buy side of the Treasury market during the depression (something Bernanke seeks to not repeat). Indeed, the money supply declined by 30 percent over the course of the depression, so the bond market did it all on its own, without Fed support. Indeed, being in a pre-Keynesian world, the rationale or desire for manipulating the interest rate or credit conditions was not part of the Fed’s understanding of how to run a central bank.

Then as now, the private market participants price the expected risks and costs of holding a debt instrument over its life, and they require additional yield for each risk and cost they anticipate will materialize.  They generally make this assessment of risk by extrapolating previous trends or by finding a similar historical episode to benchmark the likely gains or losses in value that might take place. Today we find many forecasts (even on this blog) citing the withering force of deleveraging due to over–indebtedness, which takes down an economy and softens demand and prices for goods.  Hence, today’s natural historical model for bond pricing would seem to be the 1930s.

However, while there are similarities, there are also big differences. Today it is the government that is over–leveraged, whereas in the l930s it was the corporate debt sector which makes today’s long Treasury yields suspect.   Though the economy is weak today, we are not in a decade-long depression, and while inflation is low, it is not in a cumulative deflation.  And while the Fed held back this week, they still have a commitment to positive inflation.

The greatest difference is today’s checkmated body politic, which is unable to resolve an ultimately un-financeable Federal deficit. This week we had another episode of kicking the can down the road, with the agreement to run the debt meter another six months before facing the music. This is all in sharp contrast to a much lower government debt load and an obsession to run a balanced fiscal budget despite the depression that prevailed in the 30s.

While the growth/inflation profile is different in the two eras, it is more important to note the difference in long-term fiscal sustainability.  Somewhere during the unfolding drama there will be an unspoken need (not mentioned in legislation or treaties) for the Fed to pull a “Super Mario” Draghi — who, last week, signed up to “do whatever it takes,” which apparently meant ignoring the ECB mandate and directly supporting Spain’s bank and government debt because the market no longer will.

Indeed, in the U. S. at the outset of WWII, the Fed presented the patriotic idea of wartime bond support to the Treasury, not the other way around. Central banks are not shy in the ultimate moment of money needs.

In what should be considered a “white paper,” the Fed’s role in these dire circumstances is recently discussed by Renee Haltom and John A. Weinberg in the Richmond Fed Annual Report, 2011, titled Unsustainable Fiscal Policy: Implications for Monetary Policy. In a rare Fed admission they indicate that “a central bank can reduce the government’s debt burden by creating inflation that was not anticipated by financial markets.  Inflation allows all borrowers, the government included, to repay loans issued in nominal terms with cheaper dollars than the ones they borrowed.”

Indeed, if the Fed were to create inflation, it would not be totally unanticipated.  This is the outcome seen by many observers, including Bill Gross of PIMCO.

And Bill Gross is not alone, as the bond-buying public seems to believe little of the fiscal sustainability story.  Indeed, the flow of funds data, at least for 2011, indicates that the private sector purchased a minority of net new government debt issuance.  Hence, private investors are not the leading purchasers of U.S. Treasuries, causing the all-time depressed bond yields. The graph indicates that the Federal Reserve is buying the lion’s share of net new Federal debt, and foreign investors are in second place. That market thrust no doubt represents a flight from European sovereign exposure, which is in a more advanced state of fiscal decay at the moment.

No doubt some have bought the1930s deflationary depression story as a model outcome to justify buying and holding sovereigns, but this time around it doesn’t lead to the necessary conclusion that sovereigns will appreciate from here.  At today’s entry point of taxable low nominal yields and negative real yields, betting on both a deflationary depression with fiscal sustainability is not only a long shot but is mutually inconsistent.

A deflationary depression doesn’t generate government tax revenues to reach fiscal sustainability unless the voting public is willing to accept a substantial entitlement haircut. Moreover, if the low bond yields were to be maintained it would systemically cause defined-benefit pension plans to underperform.  They would become forced sellers of sovereign bond holding to meet payouts — as is now finally occurring with Japan’s Government Pension Investment Fund.

The bond market rocket can glide for a time, perhaps years, until it collides with fiscal unsustainability. At that time it will be revealed plain enough for all to see when the private demand evaporates, much as it did with Spain this week. At that time, the U.S. Treasury is no longer a riskless debt instrument, nor is it immune from inflation.

(That being said, it leaves open the question of whether intentional inflation is bravado in the absence of bank lending, which will be addressed in a subsequent blog.)

When the market comes to understand that sovereign bond strength from a central bank is a mixed blessing — as it both purchases government bonds but also intentionally seeks to create “unanticipated” inflation —the bond market rocket is susceptible to the gravitational pull of Earth.

When that happens, there will be a large debris field for those who entered this untenable crowded trade (or stuck with it) so late in the game, supported not by the bond-buying public but only by a central bank wishing to do its patriotic duty — which includes inflation generation.

This indeed is not the 1930s.


If you enjoy this blog, please forward it to others who may be interested. Links to forward and sign up to receive are in the right hand column.

The Stock Market, QE3 and Voodoo Finance

As we look across the economic landscape there is an abundance of reason to anticipate a global economic slowdown. It is already well in the works as reflected in anticipatory data. It would not be a garden-variety recession emanating from some lull in spending but rather the grinding process of over-indebtedness and uncertainty due to tax and health care issues.

At the same time, over-indebtedness also creates a withering of financial valuations, which sets off another chain reaction called systemic financial meltdown.  This reduces the value of assets held by individuals and institutions such as banks, which in turn further dissolves financial wealth when assets are dumped in order to pay off fleeing depositors.

As a result, financial intermediation withers so that the process of matching of savers, if there are any, with investments is impeded. This in turn negates future growth. For example, systemic financial forces causing a recession visited the U.S.  in the late 1980s. At that time large commercial banks were overburdened with Latin American loan defaults and simultaneously savings and loan associations (remember them?) were decimated when inflation depreciated their book of long-term mortgages.  This limited systemic financial event resulted in a prolonged 1990 recession.

Hence whether the over-indebtedness first strikes spending or financial intermediation, it is difficult to discern as they interact and both income flows and financial valuations suffer, whichever occurs first.

Today, the developed world’s over-indebtedness reactions of the combined recessionary forces and bank runs are emanating from Europe’s southern tier. Unemployment numbers in Greece and Spain rival those of the Great Depression.

But the question on the table is the ability of Northern Europe and the U.S. (and, for that matter, the rest of the world) to escape at least temporarily the ill effects of the above degenerative process.

To gauge that, the market looks to the ability of monetary and fiscal policy to come to the rescue, and if the rescue is attempted will it work? Given the succession of bailout funds established but without the means to fund them, it is not a realistic option. To the extent country debt has been carried by other contributing countries, it is extremely limited and if, indeed, the Spanish bank bailout takes place, it exhausts all bailout funds from the Eurozone’s willing contributing countries.

Nonetheless, the contributing countries keep promising more and more, with the latest being a bank deposit insurance fund — and the market somehow believes it.

If fiscal resources from other contributing countries are extraordinary limited, what is the extent of monetary funding to aid both a recession and systemic financial meltdown? Well, there is some defense to the systemic financial event as long as the Fed and the ECB and other central banks are willing to keep expanding their balance sheets. There is no theoretical or legal limit to how much can be purchased to keep financial asset valuations afloat in order to prevent imminent financial meltdown, but to go overboard they are willing to give up all discipline of monetary control, and with it, holders of the currency go elsewhere.

Given the vulnerabilities present, how then can one explain stock price buoyancy? Since the beginning of the year the S&P 500 index is up approximately 6% and FTSE 100 index is up 2 percent despite the onset of recession and bank runs.

If there is any logic to it, it seems to be resting on less than a firm foundation. While equity investors rely on current known information such as earnings, they also project forward the value of the claims they are purchasing, hence making financial pricing a mixture of facts and a learned history to project forward.

What you often hear these days is a general awareness of the economic and debt problems but a faith that the bigger the problem, the bigger the government response will be. That is to say, any investor citing “in my 25 years’ experience” is a candidate to be projecting a future based on the Great Moderation Period of Greenspan Puts and currency solidarity in Europe.

Financial prices are inherently an extrapolation of a history, but it’s certainly not the Great Moderation, though that was the dominant influence in the thinking of the 25-year U.S. veteran stock market investor.

But then there is a newer history called the Bernanke Put, best characterized as a succession of QEs or other outside-the-box monetary stimulus, the latest of which is operation twist.

It’s now a common attitude that if the situation becomes bad enough there will be a response equal to the task needed to keep financial values afloat. Now being cited is the above chart showing how equity markets respond to QEs. It seems that the Fed has well trained stock market investors in Voodoo financial logic. The worse the economic problem, the better it is for stocks despite declines in earnings.

As a side note, QE faith stock valuations are throwing noise into the long term relationship of stock prices to earnings and as an early indicator of a recession. This is one of many structural changes that are occuring which implies that one must be careful of which history is chosen to extrapolate.

Before one relies on Voodoo finance and a faith-based QE3, one should note that additional Fed stimulus is almost certain in the face of a systemic financial institution collapse but is less certain and will be less dramatic due to a softening economy. Systemic financial defense was the raison d’etre for the Fed and remains its number one policy objective, but some token form of monetary aid has now become necessary to prevent a collapse of the Voodoo expectations the Fed has created. If that occurs, expectations have become self-fulfilling.


If you enjoy this blog, please forward it to others who may be interested. Links to forward and sign up to receive are in the right hand column.