Posted on August 3rd, 2011
♦ The pace of global economic growth started to slow down at the beginning of the year and is now close to zero.
♦ The main cause of this slowdown in growth is an almost universal tightening of economic policy. In the developing world, interest rates were raised to stop inflation. In the developed world, government spending was cut in order to reduce the debt. Thus, irrespective of its motives, tightening of monetary or fiscal policy has caused a slowdown around the world.
Posted on March 31st, 2011
Having despaired halfway through listing just the major risks to the stock market (as well as to the US economy, to the world economy, and generally to the world as we know it – - see Part 1) the question arises why own any stocks. Why not get out or go short? The answer, as usual, was given by the market. It has gone up over one percent since I wrote Part 1 two days ago against the background of news that the Japanese found plutonium in the ground near the Fukushima nuclear power plant, house prices went down again in January and February, consumer confidence declined in both the US and Europe, Gaddafi forces advanced again despite NATO action, and Fitch threatened to downgrade both Ireland and Portugal. Bad news it is, but apparently not bad enough to stop the rally.
So why does the market persist in its effort to move higher and is only 2% off its recent high (basis S&P futures) and a few percent off the all time highs made in 2000 and again in 2007? (See charts 1-3). After all there is no bubble in high tech or housing markets now and if there is a bubble in commodities now it probably has little net effect on the stock market.
The detailed solution to this enigma is somewhat involved but the gist of it is simple: sharply lower interest rates and higher corporate profits.
Lower Interest rates
Posted on March 28th, 2011
A well known Wall Street adage says that the market likes to climb a wall of worries. This sounds strange but is true for a very simple reason: If there is no wall of worries the market is probably too high and/or too overbought to go up. Even so, I have never in my professional life (which is a long time) seen the market climb such a long series of very tall walls as it is doing today.
Yet the market does want to go up, and, if none of the possible horror scenarios now materializes, it will. How do I know that? Well, on any day that the news is not awful but just bad – - a day when oil prices go up only $1 or the minuscule housing starts just fall another twenty odd percent – - the market does go up. (more…)
Posted on March 16th, 2011
1. Now that Treasury deposits at the Fed have fallen closer to normal levels it is easier to see the effect of Quantitative Easing 2. As can be seen from charts 1&2, practically all the funds injected by the Fed through its purchases of treasury securities ended up in the banks’ excess reserves, i.e. reserves not needed to make loans. There is no surprise there. Excess bank reserves before the operation started were about a $ trillion so the availability of reserves did not pose an effective limit on growth of bank loans.
Chart 1: Quantitative Easing 2
Posted on February 18th, 2011
Quantitative easing 2 was explicitly intended to boost the economy through three channels: First it was supposed to increase bank reserves and the monetary base (reserves+ currency), inducing the banks to increase lending. However, much of the injected reserves somehow found their way into Treasury deposits at the Fed (which are not bank reserves), so the monetary base today is no higher than it was in Feb. of last year. (Chart 1).
This would have been an interesting subject to discuss if it were not for the fact that excess reserves, i.e. reserves not used for lending, are over a trillion dollars. (Chart 2). Clearly, if the banks hesitate to lend it is not for lack of reserves but due to shortage of capital and the fact that they are shell shocked by events in the past couple of years. As a result, the funds injected by the Fed that did accumulate in bank reserves just added to excess reserves. (Charts 1, 2)
The second avenue for quantitative easing to boost the economy is by reducing intermediate and long term interest rates, and particularly mortgage rates. But while the purchase of bonds by the Fed tends to increase their price and reduce yields it also increases inflation expectations. And against the background of huge budget deficit, commodity prices that are shooting up and high inflation rates in the developing world it is no surprise that the latter has been the dominant result. (Chart 3). As a result mortgage rates increased 80 basis points and the rate on 10 years treasuries – - the regularly auctioned note closest in duration to 30 year mortgages- – increased over one percent. (Charts 4, 5).
A third way of helping the economy by quantitative easing – - and one strongly emphasized by Bernanke- – is by increasing public confidence in the economy, be it consumers, investors, lenders and any other sector. On that, however, see below.
Quantitative easing could also boost the economy by weakening the dollar and raising stock prices. These were not explicitly stated as objectives of the operation because the Fed is not supposed to manipulate these markets but they were mentioned in the FOMC minutes.
As for the dollar, the FOMC worried about “unwanted” depreciation. In fact, the dollar declined by almost 5 percent between Bernanke’s announcement of his quantitative easing plans in Jackson Hole and the FOMC decision to initiate the plan but hasn’t changed since. (chart 6). This, however, is not due to lack of impact of the program but to the inherent weakness of the Euro and the manipulation of the Yuan. The stock market, on the other hand, started a strong rally after Jackson Hole that has continued to date. It is difficult to dissect all the influences on the market but it is clear from observing the market at the time and from the discussion above that at least the first leg of the up move – - to the beginning of the easing – - was motivated mostly by psychology. Investors simply looked at past experience in QE1 and in Japan and were encouraged to buy. (chart 7). Other factors, such as an improvement in the economy, strong economies of the developing world, strong fiscal stimulus, the shift of Obama after the elections from left to center and yes, even the statement by the Fed that it will follow a policy intended to raise inflation, have all joined to push the market higher.
All told, it appears that the stock market rally is boosting the economy more than the other way around, and the economy still needs a strong push by policy. Given that some major structural problems – - mainly in the state and local government budgets and in the housing sector – - have not been seriously addressed, the European problem still unresolved and rising commodity prices, inflation and interest rates in the developing world, the US and world economy are still highly unstable. But the continuing process of increasing productivity in the US can keep corporate profits rising and drive the stock market to new highs, possibly after a more serious correction that is long overdue.