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Neil MacKinnon, global macro strategist, VTB Capital
Is it the end of “cheap money”? Yes, the process is beginning. The Fed started the ball rolling in spring last year when then-chairman Ben Bernanke hinted there might be a “tapering” of the Fed’s monthly bond purchases.
We all know what happened next. The markets threw a “taper tantrum”. The S&P 500 index lost 7.5% and the US 10-year Treasury yield jumped 100 basis points. Emerging markets (EM) went into meltdown on the prospect that investors “seeking yield” financed by a Fed-sponsored “carry trade” would head back home enticed by a rising US dollar and a return to more “normal” bond yields.
The “taper tantrum” revealed the markets’ addiction to “cheap money” and their reliance on an endless supply of liquidity from the Fed. Bernanke himself ran for cover and all of a sudden by September, the taper turned into a non-taper. Normal service was resumed, it seemed, and the US equity market soared to a record high in grateful response to the Fed’s accommodation. What Bernanke should have done was let the markets take their medicine.
It was not as though there was a “Great Crash” just because the Fed might have started to reduce its monthly bond purchases, never mind jack up interest rates. However, the Fed is certainly guilty of the charge both under Alan Greenspan and Bernanke that it permitted the idea of a “put” which ensured that any equity market corrections were always brief and mild.
This has created a massive distortion and perpetuated a credit cycle in the US economy in which the requirements of Wall Street have trumped the needs of Main Street. The S&P 500 index went up 30% last year while real wages remained stagnant. Income and wealth inequality are now at extreme levels and the Fed’s quantitative easing (QE) policy has contributed a key part in this.
Now there is a growing recognition the costs of QE outweighs any benefits, which in terms of the impact on the real economy it has to be said are pretty marginal. The Fed looks like it is adept at creating bubbles that can end up being exported elsewhere, such as EMs.
No wonder some emerging-economy policymakers feel there is a breakdown in international monetary co-operation. Economists will undoubtedly continue to debate the effectiveness of monetary and fiscal policy as they have done since the time of John Maynard Keynes, and many still believe the major economies are at risk from liquidity traps, debt deflation and secular stagnation.
However, there are signs the US and UK economies are now releveraging rather than deleveraging. Professors Carmen Reinhart and Kenneth Rogoff, in their excellent research on the aftermath of financial crises, told us exactly what to expect. Credit bubbles always burst and when they do the economy takes several years to recover as households, corporates and governments pay down debt and repair their balance sheets.
Now that process seems to be over, though government debt/GDP ratios remain elevated and in the case of the eurozone economies are continuing to rise. Without an expansion in nominal GDP growth above the trend rate, it is a matter of arithmetic that debt/GDP rises. Thus, at some stage, active pro-growth policies will be required i.e. a reversal in the eurozone of the obsession with “austerity” or the only way to reduce debt/GDP is through inflation or debt restructuring.
In the US and UK, both economies grew by 2% in 2013 and reflect what turned out to be the “right mix” of monetary and fiscal policies aided by exchange-rate depreciation. In contrast, the eurozone is in an economic “straitjacket” and policymakers seem condemned to repeat 1930s-style mistakes of deflation and mass unemployment.
This is a recipe for political and social tensions, and the rise of extreme political parties. It also puts a question mark over the longer-term viability of monetary union, with Germany refusing to exercise its proper role as the creditor economy at a time when its current-account surplus is 7% of GDP. This is now a major source of global imbalances as well as presenting a major deflationary risk.
For the US and UK economies, the end of deleveraging means the demand for money as a safe asset is now starting to decline. Short-term treasury yields are rising (from an extremely low base) and the velocity of money is starting to increase.
Fed chair Janet Yellen, at the March Federal Open Market Committee (FOMC) meeting, suggested that once the Fed had unwound its QE programme there might be a six-month gap prior to the first hike in the Fed funds rate. FOMC members expect the Fed funds rate to be 1.00% by the end of 2015 and the money markets are discounting an earlier move in the first quarter of next year.
If you believe the US economy will snap-back from the recent adverse effects of the cold weather and that the private sector is set to spend rather than save (especially cash-rich corporates) then it is quite possible the first rate hike could come later this year. A more “normal” term structure of interest rates is actually quite healthy and is good news in ensuring a return to a healthier interbank lending market as well as helping to improve longer-term savings and investment decisions.
In the UK, a similar story is taking place and chancellor George Osborne’s strategy is paying off and economic recovery has been under way for a year now. The UK’s corporate cash ratio is at a 50-year high at a time when investment is 20% below pre-crisis levels. Watch out for an investment boom. A boom is already taking place in the housing market.
If he’s not careful, Mark Carney, the Bank of England governor, might end up having the dubious privilege of being the only central bank governor to have created two housing bubbles in two separate countries. Household debt as a percentage income, already just above 40%, is forecast by the government to reach nearly 170% by 2019.
The message is clear, I think. UK interest rates have to go up and sooner rather than later. The idea this might not happen until after the May 2015 election is a dangerous one. Carney should think about raising rates now. It doesn’t have to be much and it won’t ruin his chances of a knighthood from Her Majesty. After all, even Greenspan got one.