OECD and the Euro

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This week, the Organization for Economic Cooperation and Development (OECD) revised down their forecast for global economic growth. What was more telling, however, is the effect that the European Union will have on the rest of the developed world. Inclusive of the 34 member nations, growth is expected to be two tenths of a percent less this year than the year prior. And what is revealing about that estimate is that it accounts for more robust growth out of the US and Japan, thus Europe will once again not only be the scar on the developed economies, but also the rest of the world.

Where some analysts try to tell a story of rising consumer confidence or gains in productivity, the OECD doesn’t pull any punches. It is quite clear to them, as their report states, that “monetary policy will continue to bear most [of the] responsibility for supporting [economic] activity, including through unconventional measures.” As bond prices sold off this week at the continued thought of the Federal Reserve tapering their asset buying program, the OECD believes that these unconventional measures are what will continue to pull the US along. Any tapering or restricting of the Fed’s stimulus will be done so in a fashion not to disrupt or alter the markets.

That really is no secret though. To the academics and policy wonks quantitative easing in the US is going as planned, and efforts from the Bank of Japan are productive despite then being a little late to the party. That’s not necessarily the case for the Eurozone where the situation is dire. The policy suggestions for a deteriorating currency bloc continue to look more and more desperate.

One of the OECD’s suggestions for the European Central Bank is to cut their key interest rate to negative territory in order to discourage banks from parking their funds overnight. The idea is to promote banks to lend out their cash reserves; the uncertainty is whether or not they will do it. Coincidentally, it is a similar situation as with the US during QEI and QEII. It was a crisis of liquidity. Like in Europe, the challenge stems from the transmission of a central bank providing emergency level interest rates so that small and medium size businesses are able to actively participate in credit markets. The risk premium, however, that is priced into borrowing rates for SMB’s remains undistorted (unlike perhaps sovereign bond markets) by this record stimulus.

It is this leg of the cycle that is yet to be fixed in Europe, and that threatens the fate of the Euro. We hear from policy makers about the importance of a banking union and an EU regulator, but that just adds more complexities to an already diverse problem. Where the EU is struggling in their recovery, akin to the US in 2009/2010, is that cash is sitting idle. Credit needs to be transmitted through their financial system to the businesses that will look to provide jobs and create opportunity for economic expansion.

As we learnt from the US, providing confidence to an economy isn’t as easy as providing liquidity. The US Fed had to more than triple their balance sheet and the stock market had to rally for four years before people bought into the idea of another bull market for equities. But as Reinhart and Rogoff point out in their historical masterpiece, “This Time is Different,” economies can take 5 to 7 years to bounce back from currency crises. Maybe in hindsight a negative interest rate or a tax on savings for banks will be the right incentive to make financial institutions lend, but in present time it really comes off more as desperate.

The Rising Greenback

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The movement witnessed in all asset classes on Wednesday more than adequately exemplifies the US Federal Reserve’s influence on financial markets. It was initially Ben Bernanke’s testimony before congress which started the first wave of action, particularly in the stock market, but also allowed gold to briefly breach 1,410 dollars per ounce. Each move was based on the Fed Chairman’s most recent explanation of their outlook for stimulus provided to the markets, and as interpretations changed the markets than changed in accordance.

The final tell for the markets though was not so much the testimony before congress, yet the minutes from the most recent Federal Open Mark Committee meeting released later in the day. For the first time since June of 2011 the policy setting committee reviewed the principles of an exit strategy for how they would slow their asset purchases or unwind their ballooned balance sheet. This effectively is what many have talked about for years as the point where the private sector takes over the economic recovery from the public. But as Bernanke hinted, simply allowing some of the mortgage debt they hold to mature would in itself act to shrink the quantity of assets the Fed holds, but evidently the time or rate in which they proceed is not the issue.

Some of the non-participating and more vocal District Fed Presidents’ have expressed their earnest concern with the long term consequences of this stimulus effort, and in turn the financial media has vocally promoted that the end or tapering of QEIII could really be in sight. But for that to be the case, it’s important to decipher the difference between QEI and QEII, and QEIII. The first two episodes of quantitative easing, although altered during their program were finite and predetermined. The point of this third round of extraordinary stimulus, and it is something Bernanke made clear during his congressional testimony, is that the data and the data only dictate the medicine prescribed.

It’s is foolish to try and pinpoint a date for when the Fed will abruptly halt or alter this stimulus effort because what should be realized by now is that it will be anything but surprising. Over the last few years, the central bank has made concerted efforts to make their actions and policy more open and transparent. In doing so, it’s allowed them to implement policy like asset purchases with investors knowing the intentions are to increase liquidity and certainty in financial markets. The Fed currently purchases 85 billion a month is treasuries and mortgage securities and they can increase or decrease that number depending on the data.

The impact, as many have forecasted will be on the shorter end of the yield curve as inflation expectations have begun to modestly increase. What that could imply for Canada is talks of an interest rate rise could come sooner than anticipated. The simple fact though is that the US dollar and strength it is expected to see in the short term will see most all markets worldwide on the defensive, but particularly the commodity based currencies.

Loonie Under Attack

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If the downward pressure on the loonie from the selloff in commodity prices wasn’t convincing enough to send it below 98 cents, the flat inflation numbers reported Friday morning was definitely the icing on the cake. Over the last few months there has been a tide change in terms of the once robust demand for commodities, and its impact has been visible in the performance of the TSX. Not far behind the lackluster performance of the Canadian equity markets, however, is the deterioration in the Canadian dollar.

A lot of the falloff in our dollar can really be explained by the broad based strength that has come into its US counterpart. With the US dollar soaring to its highest level in three years, it’s once again sparked the debate surrounding how much continued stimulus could come from the US Federal Reserve. Their current bond buying program of 85 billion a month, split between the treasury market and mortgage backed securities is seen by few of the more optimistic District Fed presidents as tapering off by the end of this summer. Although in my opinion, chances of that right now seem quite slim, the Federal Reserve would be in position where they simply reduce asset purchases in a calculated fashion in order to be the least disruptive to the markets.

One major event unfolded this past week that many pundits of the Fed’s QE program were not counting on. That is that the US Treasury’s deficit is looking to be in a lot better shape than many had anticipated. As their finances, for the time being, look to be stronger there is no longer the need for the treasury to issue the same level of debt to finance spending. With Obama’s victory on raising taxes on higher income earners, the treasury’s coffers have been filled for the time being with greater revenues, which has their government spending to appear to be under control. And this as well, has allowed the Congressional Budget Office (a nonpartisan organization) to forecast reduced deficits for the US government in the near term and next few years.

When you describe a situation like the above, it raises the question why wouldn’t we see strength in the US dollar (vis-à-vis Canadian dollar weakness)?

The criticism of the aforementioned rationale for strength in the US dollar is that it paints a very myopic picture of the US economy and does not incorporate a longer term view. For example, there is continued disagreement and debate surrounding how the US Fed will reduce its bond buying program and what affect that will have on the markets. Whether or not the market will actually anticipate some kind of natural rise in long term interests, or if there will be shock and paramount volatility when the day actually comes are questions that are yet to be answered.

What we do know, however, is that the lack of clarity surrounding the approaching finale of the greatest monetary policy experiment in history is yet to be determined. And for this reason, its logical currency markets are very nearsighted as they take in all information they have at the present. This is because there is no answer how this charade will end. With the news of an improving US economy that has surfaced as of late, there should be strength in the US dollar. That was the plan of the US Fed, and the plan is working.

What’s the outlook for the dollar? Well that’s another story.

Tide Change

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As Canadians, we cannot help but shiver a little bit when Stanley Druckenmiller, the man that “broke the bank of England,” with George Soros, calls for an end to the commodities supercycle. In doing so he also added to this call by suggesting shorting the Australian dollar. A bold prediction for a country that hasn’t had a real recession since beginning of the 1990’s, but if the tides are turning for a natural resource and export based economy like Australia, then one could only fathom what the implications could be for us here in Canada.

It’s no secret that the TSX is one of the worst performing global indices since the beginning of this year. That largely can be attributed to the decline in the price of commodities, but if that’s paired with the slump in demand for natural resources—the slide continues. So as the bears come out for the Aussie dollar, the ones for the Canadian dollar follow. Just this week TD revised their forecast for a 90 cent loonie for the fourth quarter of this year. And despite the stability of our economy, and the fact we resembled what might be the least dirty shirt in a laundry basket, the tides have definitely turned in the global outlook.

The focus right now is continuing to surround the United States and their equity markets. “Smart money,” labeled after the endowment funds for a lot of the major American Universities like Stanford, Princeton, and Yale are reported to have dumped their exposure to US debt. Three years ago would have been a different story when approximately 30 percent of those particular funds exposure would have been to US treasuries; that allocation is no around 5 percent. The bull run in the bond market thanks to the US Fed has definitely served them well, but the looming threat of inflation risk in bonds is getting more and more prevalent, which causes these funds to reach for yield elsewhere.

It’s not inflation risk, however, that is the fear of the US Federal Reserve Chairman Ben Bernanke. When speaking Friday at a lunch in Chicago he addressed the potential danger of asset bubbles. The chairman hinted at reckless speculation triggered from low interest rates and there is no question that has been the concern of many bond market vigilantes since the onset of this quantitative easing program. But as the Bank of Japan has made clear following the actions of the US Fed, it’s not in an investor’s best interest to bet against a central bank. As the Japanese yen surpassed 100 yen to the US dollar earlier this week, Japanese investors are even fleeing their own currency.

As the FT says, Abenomics is kicking in, and for the first time since the BoJ’s ultra-loose monetary policy change Japanese investors became net buyers of foreign debt. They are opting for dollar or euro denominated bonds in lieu of their own. Simply stated, a depreciating currency onset by inflationary policies is a tax on savings. That said, we are definitely in the middle of a shift in the global market place, and whether it’s a secular bear in a long term bull market for commodities, or central banks really are our savors, the tides have turned.

Coyne Affair 2.0

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It was a bold move by the federal Finance Minister Jim Flaherty to pass over Tiff Macklem for the top position at the Bank of Canada, and its implications will tarnish the role and independence of our central bank in the years to come. This is to no discredit to the Governor appointee as Stephen Poloz’s resume clearly makes him a worthwhile candidate, but the breadth of experience that would have influenced Mr. Macklem’s leadership would have likely served to be of greater benefit, and promoting from within the bank itself would have been worth their while.

Although it is not the first time Finance Minister Flaherty has taken the lead in a appointing the Governor of the bank, he will wear the entirety of this appointment because of how much of a shock it was. For many within Canada’s financial institutions and academic space, Mr. Macklem was considered the front runner. This was purely attributed to his experience as Deputy Governor, which had him heavily involved in the banks course of policy through the financial crises. And the central bank’s ability to ensure the liquidity of our financial system gave more than Mr. Carney a sound reputation in the realm of international finance as the entire governing council of the bank was held in high regard.

It seems surprising, given that Mr. Carney did not even complete his full term at the bank that our federal government would imply by this maneuver for a switch in policy direction. Mr. Poloz’s experience stems from his time at Export Development Canada, which is an agency that provides financing for foreign companies that import Canadian goods. There is no question that the appointee’s understanding of export markets is very topical considering the challenge faced by Canadian firms in what has been a sluggish global economy, but considering that the central bank’s mandate is for stable inflation of two percent, it is price level stability that takes precedent to the hindrance of a strengthening currency on exports.

All over the western world we are seeing the actions of central banks influenced by their respective federal governments. This is either in a direct form like in Japan where just recently, the newly elected Prime Minister Abe altered his central bank’s mandate, or indirectly in countries like the US, Eurozone, or Great Britain where central bank stimulus makes up for the shortfall of ineffective and ill-timed fiscal policy. Nonetheless, the freedom and independence on which central banks once operated seems to be days of the past.

This is sad for Canada given the recognition our financial system received following an ultimate collapse elsewhere in the world, and this is not because I think Stephen Poloz’s will be a disappointment as governor. In fact, given his experience he could serve the role just as well as his predecessor, for the job he is assuming is very structured and will not provide him with much opportunity to venture in changes to monetary policy. However, this apparent realization that even now in Canada our central bank has lost their independence given an appointment that seems more political than based on merit puts the Harper government in the same boat as the Diefenbaker camp following the Coyne affair.