More muppets needed
Benanke does some back-peddling on tapering and we’re back to the ‘good’ times again. More easing of course spells a weaker dollar, which after its recent surge, was ripe for some profit taking. On the other side of this trade, Â equities and commodities rose, including at last gold. Â – nice to see life is now back to its simple rules again and is being bounced around by the apparently inconsistent spinning of one man!
But hang on. Â What about June’s supposedly stellar job growth numbers. Surely this points the trajectory closer towards the 6.5% unemployment target and the end of QE given the Oracle’s guidance (spin) for US GDP growth to accelerate to +3-3.5% next year. No problem, Bernanke is making it plain that one should check carefully for wriggle room in the fine print and that the ‘target’ was merely a threshold and definitely not a trigger. Also, he is keen to stress that he remains accommodative in keeping interest rates low and that possible tapering should in no circumstances be misunderstood as meaning actual tightening. Â Blah, blah and blah!Â (translation: Buy suckers!)
A rise in rates and a stronger dollar however would mean that asset price increases and the property revival that Bernanke has been using to engineer the recovery would stall. He still needs the muppets to keep buying and he is well aware that his mouth is the real policy tool.
Pressure is building for capital markets to return to a market driven pricing of capital and risk and the addict must at some stage be weened off its unhealthily dependency on cheap money, at least for the banks. The problem however is that this is a very painful process. For some, the rise in rates will be devastating and it may well be that we have already passed the point of no return. Â Does anyone really know what sort of shit remains lurking on the ‘books’ for the banks. I do not use ‘balance sheet’ deliberately, as the recent exposure that Deutsche Bank has been hiding some bad stuff from Brazil off balance sheet shows how little one can still rely on their published accounts. Â Clearly nothing has been learnt! Banks pass ‘stress tests’ then collapse (remember Bankia) after suckering in another bunch of muppets.
For the past four years, banks have had access to almost ‘free’ money from central banks. Have they used this to repair their balance sheets and restore funding for industry? Â No, the supposed balance sheet repairs have largely been done for them by their central banks pumping up the asset boom while corporate lending is focused at the larger end, leaving many SME’s still starved of capital. So where has all this hot short term money gone? Asset speculation and of course sovereign debt purchases seems to be the answer. Â Central banks needed banks to help buy the debt that their Govts needed to sell to fund their unresolved deficits – in Europe, the ECB’s possibly unconstitutional OMT is an extreme example of this. WhileÂ central banks crushed rates, this was party time for the chosen few with access to cheap money. Â They borrowed cheap and short and lent higher and much longer, not only to take the rate mismatch as income (yes, that’s where the ‘profit recovery’ that has supported the rally in bank shares has partly come from), but also to book the capital appreciation of the bonds already bought. Â This however is not arbitrage but merely another carry-trade which carries a potential time bomb of duration risk. Â As long real rates go negative and a supposed economic recovery removes central banks as the marginal buyer of all that debt which Govts still need to sell to fund their unresolved deficits, what happens next could be very ugly. Â Short term rates could rise to more than the yield of recently bought long bonds which would make the carry trade actually cash flow negative. A rise in the long end could also precipitate massive capital losses on the Govt debt that all these banks have been encouraged to purchase. If this is to be painful in the US, just think what damage it would do to European banks (eg Spanish) whose books are full of the stuff. As the bounce in recent 10 year yields in Portugal demonstrate, the potential rebound in yields can be much greater and faster than expected and that after years of central bank coddling, we have become increasingly complacent to the risks. Â Even in the US, when 10 year rates ‘soared’ to 2.5%, Â there was no shortage of talking heads advising us that this was a great buying opportunity. Quite why a probably sub inflationary return from a bust Govt in a global market flooded with liquidity is supposedly a great buying opportunity beats me. Unless of course you run a bond fund or need the muppets to take the other side of your trade as the banks see the writing on the wall and start to bale out!
Â So where do I think we are? Â QE has not delivered the self-sustaining recovery and is increasingly becoming the problem rather than the cure. Govts seem incapable of tackling their structural deficit issues and QE fixes merely encourages politicians to defer the solutions. Â At some point the patient has become an addict. Do you let him go through cold turkey (ie let asset prices and money find their true market values) or keep feeding his habit until he dies? Unfortunately I see no evidence of resolve from politicians who have nurtured a majority of the electorate to be state dependents. Short term however, there may finally be an appreciation from at least one central banker before he retires to steady the ship and so provide some defense for his legacy and ahead of what is to come. Â He has to initiate a policy to end QE, but he can’t afford for markets to get spooked and unwind the asset inflation that he has supported, hence the laboured attempts to soften the blow with recent dovish commentary. If real rates are to rise however, real asset prices may need to fall, particularly at the long end of the bond market. Â Banks who have built up sizable holdings of the stuff though also control the Fed, so expect more dovish spin until at least they have unwound their positions. Now about the muppets…………..