Policy:

In December, the ECB extended QE from September 2016 to March 2017. Markets did not think it was sufficient, spreads between peripheral bonds and bunds widened, the EUR strengthened and equity markets sold off.

In late January the BoJ cut rates into negative territory and was rewarded with a stronger JPY and weaker equity markets, and the equivalent of a coronary in its money markets. Fortunately, not all was lost and JGBs rallied.

Last week the ECB was given a second chance to demonstrate determination and did so by cutting rates, increasing QE by 33%, including non-financial corporate IG to the shopping basket, and another dose of TLROs. Markets were skeptical at first but seem to be warming to the measures. This is the 3^rd trading day after the announcement and markets are buoyant so only time will tell.

Tomorrow, the BoJ will announce its policy decisions. It is hard to see what it can do to boost markets. Evidently it can do nothing for the economy.

On Wednesday the Fed announces its decisions and publishes an update on the dot plot. The American economy is robust despite being in a shallow, temporary and controlled slowdown. On domestic data alone, a data dependent Fed would raise rates. The Fed is, however, unwilling to unnerve investors since their behavior impacts market interest rates and credit spreads and is therefore a Fed control variable. The Fed has not signaled strongly that it will act and therefore will likely delay the rate hike into the summer. Hopefully, the USD will be sufficiently weak, equities sufficiently buoyant and spreads sufficiently tight for the Fed to play catch up.

At some stage all these central banks are going to have to start thinking about what they can do for the real economy.

The ECB’s moves were largely expected except for the inclusion of corporate debt on the shopping list. This should at least put a floor under the Euro IG market. The details, however, have not been released so we don’t know what the total or country allocations might be.

The ECB’s best policy has always been its LTRO. Its first incarnation, a 3 year unconstrained program, turned the ECB effectively into a pawnshop. It achieved a number of things:

1. Banks bought government debt when the ECB could not. The ECB had co-opted the banks into its QE. Call it, proxy QE.

2. National banks bought their respective national debt thus unwinding current account deficits very rapidly.

3. Coupled with a rate cut, the ECB provided banks with a profitable business, good for 3 years, consuming no capital. The profits would recapitalize the banks to some degree.

4. Governments’ borrowing costs fell.

The subsequent TLTROs were less effective. Why?

1. Private enterprise is unwilling to borrow. That’s it. The TLTROs were extendable only if the banks were seen to be pivoting their loan books to SMEs and private obligors. These LTROs were not meant for government bond purchases.

2. As one hand of the ECB provided liquidity to fund private loan growth, the other hand increased capital requirements. This placed banks in an untenable position.

What about the latest TLTROs?

The details are still patch but basically, the repo rates are zero with a discount available for compliant banks, banks with a willingness to engage in more active private lending. At a fully discounted rate of -0.4%, the ECB is basically paying the banks to lend. In effect, it is co-opting the banks to grow their loan books. Will it work? Basel III and TLAC rules still hold which will continue to constrain the banks. Assets tendered in repo are not a true sale. And for all these technicalities, demand for credit is simply weak.

The Eurozone economy has weakened in 2016 slipping into deflation with both manufacturing and services PMIs turning south in January and February. After disappointing the market in December 2015 with a mere 6 month extension of the existing QE the ECB will be expected to do more to spur demand and head off deflation.

The market will expect the following:

1. 20 basis point rate cut to take the deposit rate to -0.5%.

2. Additional 10 billion EUR monthly budget for bond purchases.

3. Program extension from Mar 2017 to Sep 2017

4. Additional TLTRO

What might not be effective:

1. A rate cut is not likely to be effective. The problem is not willingness to lend but willingness to borrow. Banks will not be able to pass on the lower rates while incurring costs on their reserves on deposit. They might well raise interest rates to make up for the additional costs.

2. The bond purchases are allocated according to the capital key which means 25.6% of the budget goes to German bunds, 20.1% to OATs, 17.5% to Italian bonds and 12.6% to Spanish bonds. Deflation is worst in Italy, Spain and France. Germany has zero price growth. The money is not going to where it is needed most.

3. TLRO take up has been disappointing.

4. Most of what the ECB can do, the market expects the ECB to do. There is no latitude for shock and awe left.

What might the ECB do to surprise the market?

1. Moving away from the capital key and allocating the budget to the countries which need stimulus most and trying to bring rate convergence between countries’
   bond yields could be more effective and would be taken positively by the market.

2. Currently the ECB buys 8% of the budgeted bond purchases, while the National Central Banks buy a further 12% under a risk sharing program. The other 80% is not commingled and each NCB bears the default risk of their own government’s bonds. The ECB could make all purchases risk-shared. This would pull peripheral and core spreads together bringing down interest rates in Italy, Spain and Portugal.

3. Removing limits on buying debt yielding less than the deposit rate. If the ECB cuts rates by 20 basis points, this point would be academic.

What might get in the way?

1. On Feb 25, 2016, Jens Weidmann, President of the Bundesbank, argued that his Eurozone counterparts are putting too much emphasis on recent weak data. The Bundesbank’s own prognosis for the Eurozone economy was less gloomy. This could be a signal that the Bundesbank, the largest capital contributor to the ECB, is unwilling to do more.

2. Draghi himself might decide that doing more of the same is not rational given that the initial program has not been effective. As long as the ECB was strenuously fighting deflation, governments would be less inclined to pursue fundamental reform.

Speculation.

1. If the ECB simply meets market expectations, it is likely the market will be disappointed.

2. The ECB has little room to surprise the market since the market is expecting a lot.

3. Draghi may, if he so chooses, openly speculate about going off the capital key, or commingling the NCB’s risk, to present the Bundesbank a fait accompli at the Apr 21 meeting.

Trades:

1. The EUR is fundamentally weak,  recent strength being related to the risk of a disappointing ECB announcement. The EUR remains a good short, however, the degree of uncertainty surrounding the Mar 10 ECB meeting recommends moderating this exposure.

2. Under TARGET2, countries are essentially risk-shared and as such peripheral bonds should trade tighter to German and French government bonds. Convergence trades are still rational. Again the uncertainty around the possible outcomes leads us to defer this trade until we have more visibility.

• The world is engaged in a trade war which hits manufacturing and industry more than services and consumption. The composition of the Chinese economy makes it vulnerable. The Chinese are a proud people and will claim that the rebalancing is an intentional project rather than a phenomenon forced upon them.
• China’s markets are still closed albeit becoming more open. A financial crisis in China will have less contagion effects than a financial crisis in a more open economy.
• China’s contagion risk lies in the real economy through trade. But world trade is already stagnating and the world becoming more insular. Also, the weakness in the Chinese economy is over 5 years old and not new. Its effects have already been felt.
• China’s nominal output is some 10 trillion USD per annum. To expect even a balanced economy to grow at 6% is very optimistic. For an economy plagued with overcapacity in heavy industry and state owned enterprises to grow at 6.5%-7.0% will require more stimulus.
• The central bank has been stimulating the economy with Open Market Operations (repo operations), interest rate cuts and reserve ratio cuts. This will accelerate. Even so, monetary policy will be insufficient given the examples of the Bank of Japan and the European Central Bank. The Chinese government recognizes this and will engage fiscal policy, budgeting for a 3% deficit, officially, but in fact more, to boost demand. Other countries may learn from the Chinese experience, positive or negative, as their policy unfolds.
• China’s debt stands at over 2.5X GDP. Government debt is circa 40% of GDP and is not a problem. The bulk of China’s debt is corporate debt and raised in local currency. Being mostly in local currency, China’s debt is less sensitive to exchange rate fluctuations. However, most of the debt was raised by unproductive SOEs and heavy industry and will face increasing defaults. The government has the financial ability to bail out or to absorb debt write-downs on behalf of the banking system and domestic investors without depleting its foreign reserves.
• The government has been encouraging refinancing of USD debt in local currency, with extended maturities, and lowered debt costs by changing collateral rules and capital requirements for specific assets such as municipal bonds and LGFV debt. The total debt may rise before it falls.
• China’s non-manufacturing economy is healthy. Despite declining, non-manufacturing PMI’s hold above 50, whereas manufacturing PMI’s have now been below 50 for close to a year. There are good sectors, industries and companies in China. Unfortunately, investing in China is a very risky endeavour. 90% of capital accounts are owned by retail investors leading to a highly sentiment and technically driven market often subordinating fundamental factors such as earnings and cash flow.
• The macroeconomic conditions in China imply a weakening RMB. The weakness in RMB has not been entirely due to capital flight. The government’s efforts to get corporate China to refinance USD debt in RMB must result in capital outflows and a reduction in foreign reserves, which we have seen. The solution to private capital flight is a sharply weaker RMB which the PBOC is unwilling to allow.

Beware negative interest rates. The intention of central banks imposing negative rates upon an economy is to stimulate growth. But if 10 years of falling rates have done little to stimulate demand, 7 of those at close to zero interest rates, why would negative rates encourage more demand? Taken in the extreme, negative interest rates will encourage owners of money to change the relationship with their depository institutions from one of debtor to custodian. The result would be a withdrawal of money from the money market into a custodian network. There will of course be custody expenses but these are limited and such expenses are, at least for now, beyond the influence of central banks. Negative interest rates could therefore trigger a contraction of the money supply which would maintain the zero bound in market rates of interest while liquidity would overflow out of the money markets. The provision of liquidity to the system will have become waterboarding.

The FOMC meets March 16, the ECB March 10, the BoJ March 15. Confidence in central banks is waning resulting in more volatility surrounding signals they send whether hawkish or dovish. It certainly appears that central banks have reached the limits of policy and that efforts to boost growth will have to be even more innovative, if in fact growth needs boosting. Given the dogmatic pursuit of growth apparently beyond the natural metabolic rate of the global economy, it would not be surprising if fiscal policy were engaged.

In some ways, fiscal policy will be more effective than monetary policy. For all the magnitude of QE, it only supplies credit to the economy, it does not directly increase demand. QE policies assume that there is always demand for credit, but this is clearly not the case. If governments insist on pushing the economy towards a higher target growth rate, in the absence of private demand, it may have to spend. It cannot finance this spending out of taxes as that would sterilize the fiscal expansion. Instead, government would need to run a deficit and monetize it. When economists speak about ‘helicopter cash’, this is what they mean.

There is another way, which is to tax and spend, but to do it in a tax neutral and redistributive way. Imagine a wealth tax of 100% for all wealth over 100m USD. Put aside the practicalities and politics of such a tax for a moment and see what can be done with this. By one estimate (by Boston Consulting Group), this wealth totals 10 trillion USD, basically equal to the current nominal annual output of China. The marginal propensity to consume of these ultra-high net worth people is presumably quite low. Imagine if this, expropriation, to put it candidly, were ‘spent’ by distributing it to the bottom tenth of the global population, a group of households who could not save their income because they might be living below the poverty line, the boost to global output would be substantial. This is an absurd limiting case of course, but it illustrates the cost of inequality.

Economic orthodoxy will not easily relax the need for fiscal rectitude and austerity. Monetary policy has clearly hit a wall. Fiscal policy will eventually need to be engaged, and again, I qualify that this is if we target growth at a level beyond the natural metabolic rate of the real economy. Then countries will begin to tax and spend. Around the world, the people have already signaled their political choices, and it leans that way. Perhaps the masses know something the economists don’t.