26/08/2011: The money supply mystery

A common metaphor compares the economy with a plane. Central bankers and government officials pilot the cockpit and economic statistics blink as warning lights. At present, the US Boeing’s cockpit has many lights flashing red to indicate an imminent nosedive, while in the European Airbus the compass is broken, so the plane circles aimlessly.

Over the pilot's shoulder in the US aircraft, we see that a new warning light has begun to flash over the last two weeks, but its color is hard to distinguish. Is it green or red? The monetary aggregate M2, published on a weekly base by the Federal Reserve, is spiking.

In the US, M2 is broadly defined as the physical currency held by the public, including all checking and savings accounts, time deposits and money market mutual funds held by individual investors. It is the broadest of all official monetary statistics since March 2006, when survey of the even broader monetary aggregate M3 (M2 + institutional money market mutual funds, eurodollar deposits and repurchase agreements) was discontinued.

The M2 surge started in the last week of June and has gained momentum. The money supply went from USD 9 trillion to 9.5 trillion in less than two months (roughly a 5.5% increase, annualized over 40%). The last such surge in M2 occurred in 2008 just after the Lehman bankruptcy. But only by going back to 1983 does one find a proportional surge as large as we currently see. So is this information positive or negative?

We could argue on the positive side that the so-called “money multiplier,” which expresses the transmission of highly powered central bank money into the broader public is finally moving in the right direction. An important criticism by those who saw the growth of the monetary base since 2008 (more than a tripling) as ineffective has been its absence from broader money aggregates. The money printed by the Fed in the quantitative easing programs to purchase US Treasuries ended up in the vaults of financial intermediaries and did not reach firms or consumers. Recent weeks saw only a minimal uptick of the money multiplier from its depressed level, so it is too early to assess whether that is actually the cause of the surge in M2 and therefore a positive evolution.

On the negative side, one could argue that we are seeing something similar, but on a larger scale, to what we experienced in 2008. When the commercial paper market in the US froze after the Lehman bankruptcy, some money market funds “broke the buck;” their share value dropped below one US dollar. This led to a run on them, and the outflow of funds was put in supposedly safe checking and saving accounts, which are part of M2, while the funds are not. Similarly now, due to the European sovereign debt crisis and tensions on the European interbank market, there has been a run on European banks, with money being transferred to US banks.

These two negative developments are however not backed by other statistics. The extended M2 which includes the institutional money market funds shows a similar surge, though not as important, as that in the more restricted M2. As for the story about a run on the European banks, if it were true, then a massive shift of funds from European to American banks should have been reflected in the EURUSD exchange rate. However, the last couple of weeks have not shown this; instead EURUSD moved more or less sideways between 1.40 and 1.45.

So what could be driving this surge? A theoretical explanation which will need empirical grunt work to be confirmed, is that during recent market turmoil investors have capitulated, sold equity positions and placed the money in checking and saving accounts. If this were the case, then short-term this is negative, because it points towards more capitulation in the near future and more depressed equity markets. However, if this explanation is true and circumstances are really similar to what happened in 1983, at that time a local bottom of the equity market expressed in real terms, then this situation could be one of the most positive signals for equities over the longer run. Why? Because the 1983 capitulation marked the starting point for almost two decades of bullish equity markets.

With all the doom and gloom out there, and most of the warning lights flashing red, a true contrarian signal should at least be explored further.

19/08/2011: Words, words, words

Fresh out of a disorienting hailstorm, markets were – are – in need of a firm voice to give direction toward solid ground in the European sovereign debt crisis. The several hours of discussion this week might fade distantly for months or longer as markets listen for the next urgent signal.

Doubts about EU leaders' capability to solve the sovereign debt crisis caused market turmoil two weeks ago, so Tuesday's meeting between Angela Merkel and Nicolas Sarkozy was eagerly awaited. Alas, it disappointed.

The meeting's three conclusions barely convinced market participants: 1) The creation of a European economic council led by Herman Van Rompuy, the current President of the European Council, which will meet at least twice a year; 2) The installment of a balanced budget rule, to be written in the constitution of each Eurozone member country; and 3) The creation of a tax on financial transactions, the so-called Tobin tax.

Market participants were disappointed to hear that the hotly debated Eurobonds were not considered as a first step toward fiscal integration but only as the likely last step once that integration was well advanced, meaning not very soon. Also disheartening, the European Financial Stability Fund will not receive more funds at this stage; it is seen as “well capitalized” despite the fact that the contagion has now reached Spain and Italy. Market participants thus reacted negatively; indices fell. At first glance, though, some of the proposals made by the French President and the German Chancellor can be seen as steps towards the necessary fiscal integration of the European Monetary Union.

Many caveats unfortunately trail these good intentions. To be effective, a European economic council would need power and a means of coercion, thus requiring unanimous agreement of all seventeen Eurozone member countries.

The same would be true for the balanced budget rule. Even in France such a rule could hardly be put into the constitution within a few months. In France this means a popular referendum, which the currently not-so-popular president is far from certain to win, or a three-fifths majority in the French Congress, which is the sum of the National Assembly and the Senate. While Nicolas Sarkozy has the majority in both chambers, but not a three-fifths majority. Hence he would need votes from the French socialist party to change the constitution, but the French socialists are currently seeing this balanced budget rule as a trap ahead of the French presidential elections scheduled for May 2012.

Finally, the introduction of a so-called Tobin tax on financial transactions is an old hat with no chance of effectiveness without an agreement not only among the Eurozone member countries but also with all other extra-European countries and financial centers.

The apparent closing of ranks between the two European heavyweights France and Germany might be reassuring in the short run. In the long run just talking the talk is not enough anymore.

12/08/2011: That scary 2008 feeling

The worst month on the market in memory, for me and likely for other investors, occurred just in the aftermath of the Lehman Brothers bankruptcy between 15 September and 12 October 2008, when the G20 meeting brought a solution to stabilize markets.

This period was characterized by end-of-the-world sentiments, bouts of enthusiasm in sudden relief rallies and then darkest thoughts about the future. The intraday volatility of the stock markets was mind-boggling, losing 5% from the bell, then dashing far into positive territory by noon and nevertheless closing a couple of percentage points down.

It seems that in the last two weeks we are reliving that market environment. The intraday volatility on equity markets is again staggering. On Tuesday, 9 August the DAX (the main German equity index) opened with a mini rally of almost +1.8% against the previous close, went down to a severe –7%, but finished at almost the same level as the day before.

One cause of these extreme market movements is similar to what drove those in the fall of 2008: serious doubts by investors that the political sphere can solve the extant problems. Back in 2008 the task was to stabilize the distressed financial intermediaries both in the US and in Europe. Especially the US struggled – remember the first vote by Congress on TARP? Only after the G20 meeting in mid-October 2008 did an internationally coordinated approach tackle the problem and basically bail out the most exposed banks.

This time around it is Europe which lacks a solution to end its sovereign debt problem. True, the awful debate on the debt ceiling issue and the subsequent downgrade of the US credit rating by Standard & Poor’s last Friday contributed to the latest market turmoil, but one can say now that until the Presidential elections next year, the US debt issue is on the sideline. Moreover, one can rely on the Federal Reserve to prefer pragmatism over dogmatism.

The same is unfortunately not true for Europe. In my view, market participants are unconvinced that the sovereign debt issue is being addressed correctly, or more worrisome, that European decision-makers grasp the full extent of the problem. Talk of more austerity might reassure markets short-term, but if the austerity measures become too extreme they are not credible anymore. It also seems that European politicians are always fighting the last battle instead of focusing on the current one. This “being behind the curve” attitude exacerbates the crisis, which has spread now from the periphery (Greece, Portugal, and Ireland) to countries considered to be “too-big-to-fail” like Spain and Italy.

The European Central Bank is trying to mitigate the crisis. Buying Italian and Spanish bonds on a large scale has significantly reduced the interest rates of those two countries from over 6% to a more sustainable 5%. But first and foremost, the latitude for maneuvering is smaller for the ECB than for the Fed due to institutional design, and secondly there is strong dissent about policy within the ECB directorate.

Calming market jitters will take more than wordy bromides: the European sovereign debt crisis needs a clear, transparent and really “definitive” solution. We remain pessimistic that this will happen any time soon.

06/08/2011: Happy ending not met with cheers

The eleventh-hour accord on the US debt ceiling, touted with the usual bravado, showed frivolous disregard for market repercussions and left serious issues unaddressed. Small wonder that markets, concerned with a weak US business cycle, did not jump for joy.

It’s finally over. The US debt-ceiling deadlock was broken at the last minute as usual, one is inclined to say. Market participants, already pessimistic, can move on. Even before the deal was signed, worries were focused on the weakness of the business cycle after a dismal US growth pattern in the first half of 2011. Indicators show this hasn’t disappeared.

Party leaders trumpeted the debt ceiling agreement, but though it left no one really satisfied, no US politician will admit to being among the “losers.” As an observer I see at least three major long-term issues.

First and foremost, in my view, the debate blatantly showed a new “immaturity” in US politics. While brinkmanship and stubborn posturing may be good for your own electorate, it does nothing to reassure the international markets. Russian Prime Minister Vladimir Putin’s remark that “the US is living beyond its means like a parasite and the dollar dominance is a threat to the financial markets” echoes a view held by many emerging countries of the superpower international debtor. Chinese leaders advised the US “not to play with fire” but to find a solution. Pretending that the debt issue could be solved without increasing taxes is as childish as insisting that the current unfunded liabilities of the US government are easily manageable.

Second, while the agreement veers away from a technical default resulting in a precipitous tailspin in financial markets, a downgrade of the US credit rating by the major credit agencies has merely been postponed. By the end of this year the US debt-to-GDP ratio will exceed 100%. So far, no country has managed an AAA-rating at those debt levels. Even taking the “special” nature of the US into account as owner of the worldwide reserve currency, the debt-to-GDP level is so high that either the credit of the US must be downgraded or the credibility of the rating agencies will be in jeopardy.

Finally, as mentioned at the outset, the current business cycle situation in the US is dire. While many analysts and economists still believe that we will see a growth rebound in the second half of 2011, this appears more wishful thinking than fact-based forecasting. Moreover, even if the over USD 2 trillion in expenditure cuts inked into the debt ceiling deal do not immediately impact the US economy, the room for further fiscal impulse is almost nil. This makes extraordinary monetary impulses – even a full-blown quantitative easing 3 – more likely, especially if the US labor market does not improve significantly.

So no one should wonder that markets didn’t greet the “happy ending” of the debt ceiling with cheers. They are already focusing on the “ever after,” and it does not look rosy. No it doesn’t.