FINANCIAL CONDITIONS WATCH JULY 25, 2012 Bloomberg GLOBAL MACRO TRENDS AND STRATEGIES MICHAEL R. ROSENBERG Volume 5 No. 3 Available on the Bloomberg at FCW <go> and FCON <go> Negative Real Yields on Safe Assets, Coupled With Heightened Investor Risk Aversion toward Risky Assets, Pose a Dilemma for Policymakers and Asset-Allocators Alike and What’s Left in the Fed’s Arsenal? “Monetary policy works in the first instance by affecting financial conditions, including the levels of interest rates and asset prices. Changes in financial conditions in turn influence a variety of decisions by households and firms, including choices about how much to consume, to produce, and to invest.” Federal Reserve Chairman Ben S. Bernanke, March 2, 2007 Inside This Issue:
This document is posted to help you gain knowledge. Please leave a comment to let me know what you think about it! Share it to your friends and learn new things together.
Transcript
Financial Conditions WatchJuly 25, 2012
1
Bloomberg
FINANCIAL CONDITIONS WATCHJULY 25, 2012
Bloomberg
GLOBAL MACRO TRENDS AND STRATEGIES
MICHAEL R. ROSENBERG
Volume 5 No. 3
Available on the Bloomberg at FCW <go> and FCON <go>
Negative Real Yields on Safe Assets, Coupled With Heightened Investor Risk Aversion toward Risky Assets, Pose a Dilemma for Policymakers and Asset-Allocators Alike
andWhat’s Left in the Fed’s Arsenal?
“Monetary policy works in the fi rst instance by affecting fi nancial conditions, including the levels of interest rates and asset prices. Changes in fi nancial conditions in turn infl uence a variety of decisions by households and fi rms, including choices about how much to consume, to produce, and to invest.” Federal Reserve Chairman Ben S. Bernanke, March 2, 2007
Inside This Issue:
Financial Conditions Watch July 25, 2012
2
Bloomberg
Table of ContentsYield Spread/Volatility Watch ...........................................3
Negative Real Yields on Safe Assets, Coupled With Heightened Investor Risk Aversion toward Risky Assets, Pose a Dilemma for Policymakers and Asset-Allocators Alike
Special Focus ................................................................10
What’s Left in the Fed’s Arsenal?
Bloomberg’s U.S. Financial Condition Index .................19U.S. Financial Condition Indicators ...............................20
Bloomberg’s Euro-Area Financial Condition Index ........24Euro-Area Financial Conditions Indicators ....................25
Japan Financial Conditions Indicators ...........................26UK Financial Conditions Indicators................................27
Federal Reserve Policy Watch ......................................28G-10 Economic Outlook ................................................29EMEA Economic Outlook ..............................................45Asia Economic Outlook .................................................52Latin America Economic Outlook...................................63
Yield Pick-Up of Currency Hedged Foreign Bonds .......69
Keeping Up With the Financial Crisis ............................70
Financial Conditions Relative to the Pre-Crisis Period
---- 52-Week ---- Latest Avg. Std. Dev. Z-Score
Financial Conditions Relative to the Past 52 Weeks
Notes:Unless noted otherwise, all indicators are basis-point yield spreads.Indicators highlighted in orange are signifi cantly above or below their January 7, 2000-June 29, 2008 aver-age levels.
Notes:Unless noted otherwise, all indicators are basis-point yield spreads.Indicators highlighted in orange are signifi cantly above or below their 52-week average levels.
Negative Real Yields on Safe Assets, Coupled With Heightened Investor Risk Aversion toward Risky Assets, Pose a Dilemma for Policymakers and Asset-Allocators Alike
When discussing the impact that risk appetite consider-ations are having on the fi nancial markets and the broader trend in economic activity, it is useful to distinguish between the level of risk appetite and changes in risk appetite. For example, as shown in Figure 1, not only is the level of fi nancial conditions lower than its pre-crisis average, but the volatility of fi nancial conditions has increased signifi -cantly as well.
As the stylized diagram in Figure 2 illustrates, the level of risk appetite in the pre-crisis period was fairly high as evidenced by the run-up in the prices of housing and other risky assets. Around that higher level of risk appetite,
monthly changes in risk appetite tended to be muted as evi-denced by the persistently narrow Baa corporate-Treasury bond spread (see Figure 3) and the persistently low level of the VIX Index (see Figure 4).
The post-crisis period portrays a very different picture for both the level and changes in risk appetite. As illustrated in Figure 2, not only is the level of risk appetite in the post-crisis period considerably lower than the levels that prevailed in the pre-crisis period, but changes in risk ap-petite around the new lower level are now considerably more volatile as well. Evidence of this pattern can be found in Figure 3, where the Baa corporate-Treasury spread in
the post-crisis period is not only higher than the pre-crisis average, but the volatility in that spread is now consider-ably greater as well. Figure 4 shows that the VIX Index in the post-crisis period is exhibiting signifi cantly larger and more frequent volatility spikes than was the case in the pre-crisis era.
Distinguishing between the level and change in risk appetite provides insights into the dilemma facing households and fund managers in deciding how much of investor funds should be allocated to safe assets such as Treasuries, and how much to risky assets such as equities. With the overall level of risk appetite now considerably lower than it was pre-crisis, there has been a signifi cant shift in how economic agents are now allocating their portfolios be-tween equities and bonds.
For example, a recent Towers Watson survey of life insur-ance company CFOs found that a whopping 87% believed that “there is a 50% or greater likelihood of a major disrup-tion to the economy in the next 12 to 18 months.” Given such extensive fears of potentially large downside risks, life insurance company CFOs are altering their business strategies in terms of exiting or altering existing product lines, and are at the same time adjusting their asset al-locations accordingly.
In addition, investor surveys reveal that households are now allocating a greater share of their assets to fi xed-income products because of the perceived downside (negative tail) risk associated with equities. A recent Belgian central bank survey of Belgian households found that a relatively large number of respondents—70.7%—indicated that they were unwilling to take any fi nancial risk in today’s environment, while 23.9% were willing to only take average risks with the expectation of earning average returns. Only 5.5% were willing to take above-average or substantial risks with the hope of earning above-average returns.
Similar concerns were expressed in a recent survey of Australian households by the Reserve Bank of Australia. According to the RBA, “Australian households’ appetite for risk appears to have declined in recent years with households having actively shifted their portfolios away from riskier assets.”
Evidence of a declining willingness to take on fi nancial risk is evidenced by the declining volume of equity market transactions (see Figure 5) and by the negative real yield on U.S. Treasuries. As shown in Figure 6, the real yield on fi ve-year TIPS has declined from an average positive read-ing of +2.0%-2.5% to a negative reading of -1.2% today.
The fact that investors are willing to accept a negative real yield rather than move into potentially higher-returning riskier assets indicates that they are not confi dent that risky assets will generate signifi cantly attractive risk-adjusted returns to make such an asset-allocation shift worthwhile. Indeed, risk aversion is so pervasive at the moment in Europe that not only are real yields in the core markets in negative territory, but nominal yields in several core markets in the two-year area of the yield curve are negative (see Figure 7) or close to zero.
Economic agents are thus left with a diffi cult choice—how much to allocate to bonds that offer negative real yields, and how much to allocate to equities that entail large perceived negative tail risk. Interestingly, the Financial Analyst Journal recently had a guest editorial by Andre F. Perold, who posed a question to investors on this subject. If investors set a targeted portfolio return of 5% per annum in real terms to fi nance current consumption and allocate their funds along traditional 60% equity/40% bonds lines, and given that U.S. real bond yield returns are presently negative at -1.2%, then equities would need to generate an annual expected real return of 9.1% per annum in order to generate a portfolio expected real return of 5% = (60% x 9.1%) + (40% x -1.2%).
That would amount to an expected equity risk premium of 10.3% per annum in real terms (9.1% - (-1.2%)), which would be roughly 2.5 times its long-run historical average of 4.1%. (Note that the equity risk premium is defi ned as the excess return of equities over bonds.)
If investors do not believe that the equity risk premium will be that high in the future, then they are left with two options. Then can either increase their exposure to risky assets—by increasing the share of equities in their port-folios to greater than 60%—in order to meet their 5% real return target, or they would need to set a lower targeted real return for their portfolio that fi ts more closely with their more risk-averse leanings.
The prospect of anticipated lower real portfolio returns could be having a major bearing on the U.S. economic outlook and could infl uence likely policy steps in the fu-ture. If it is assumed that households have a target for net household wealth, and allocate their savings to meet that target, then how far current wealth levels are deviating from their targeted levels could determine how much households are willing to spend and how much they are willing to save out of their current incomes.
Consider the trend in net household wealth since the onset of the crisis shown in Figure 8. Net household wealth has fallen from a high of $67.5 trillion in the third quarter of 2007 to a low of $51.3 trillion in the fi rst quarter of 2009. Since the 2009 trough, net household wealth has recovered some of its lost ground, edging up to $62.9 trillion in the fi rst quarter of 2012. In real terms, net household wealth is probably down some 15% from its pre-crisis peak.
If households wish to restore their net wealth to its pre-crisis path, but portfolio real returns are expected to be modest at best, then households will have to choose one of two paths: either (1) accept that it will take longer to restore net wealth back to its desired path, or (2) if they wish to speed up the process of restoring net wealth to its desired path and given the current low level of risk appetite, then more of household funds will need to be allocated to savings and less to consumption.
This is an important issue for both the baby boom genera-tion, who are currently saving for retirement, and for the next generation who are saving for a future home and the education of their children. Risk aversion, coupled with negative real yields on safe assets, poses a major hurdle for both of these two large segments of the population—either more of household funds will need to be allocated to savings, or signifi cant shortfalls in desired wealth must inevitably result, which could have consequences for spending in the future.
Figure 8
Source: Bloomberg
U.S. Net Household Worth(1995-2012)
Figure 7German Two-Year Bund Yield
(2004-12)
Source: Bloomberg
Pre-Crisis Period
Post-Crisis Period
Crisis Period
Financial Conditions WatchJuly 25, 2012
7
Bloomberg
The downside risks associated with low real yields dis-cussed here are at odds with conventional macroeconomic theory, which states that lower real yields are needed to boost economic activity when considerable economic slack exists, as it does today. In theory, lower real yields should encourage consumers and businesses to save less and spend more, and at the same time increase investor demand for risky assets.
But with real interest rates already in negative territory, the questions become: Could a further decline of real interest rates actually be counterproductive? And how do you push real interest rates lower when nominal interest rates at both the front and back ends of the yield curve are already at or approaching the zero bound?
One way for the Fed to engineer an even lower real interest rate—which has the support of leading academic econo-mists such as Paul Krugman, Ken Rogoff and Greg Mankiw as well as key IMF economists—is for the Fed to consider raising its implicit target for U.S. infl ation from 2% today to perhaps 4%-6% for a period of time. Raising the infl ation rate temporarily would in theory: (1) help lower the real debt burden of over-indebted households and governments, (2) encourage households to spend more now rather than delay purchases to the future when prices are likely to be signifi cantly higher in a higher infl ation regime, (3) lower the level of U.S. unemployment by rolling up along a downward sloping Phillips (infl ation/unemployment tradeoff) curve (see Figure 9), and (4) lower the real interest rate further to encourage greater investment spending along a downward sloping IS curve (see Figure 10 on the following page).
Figure 9
Short-Run and Long-Run Tradeoffs Between Infl ation and Unemploymentvia the Phillips Curve
Source: Bloomberg
Unemployment Rate
Inflation Rate
A
C
Elastic Short-Run Philips
Curve
In the short-run, an increase in inflation could lower the unemployment rate from U1to U2.
2
U1
Decrease in Unemployment
B
1
U2
Increase in Inflation
Inelastic Long-Run Philips
Curve
U3
Financial Conditions Watch July 25, 2012
8
Bloomberg
Figure 11
Source: Bloomberg
U.S. Monetary Base (2004-2012)
$824 Billion
$2.615 Trillion
Raising the Fed’s implicit infl ation target faces a number of hurdles, however. First, and foremost, most macro models today posit that the output gap is a key determinant of U.S. infl ation. Therefore, given that the U.S. presently faces a negative output gap, it may not be easy to push the actual infl ation rate higher at a time when substantial economic slack exists.
Second, simply raising the growth rate of the monetary base may not be enough to raise the U.S. infl ation rate. After all, U.S. infl ation has been fairly tame over the past 4-5 years despite the fact that the U.S. monetary base has tripled in size over that period, having risen from $820 billion in 2008 to $2.6 trillion today (see Figure 11).
Third, attempting to reduce the real debt burden of house-holds and governments via higher infl ation may not be that easy if a sizable share of that debt is fl oating rather than fi xed, or if the maturity of that debt is short rather than long. If a large share of the debt is fl oating or has a relatively short maturity, market participants will eventually adjust to the higher infl ation outlook by pushing up the yield on fl oating-rate securities and short-maturity debt. In such a case, the overall debt burden of over-leveraged households and governments would not be signifi cantly reduced, if at all.
Fourth, targeting a higher infl ation rate for a few years and then returning to a lower infl ation rate down the road can pose problems for U.S. fi nancial institutions. In such a scenario, yields at the front end of the maturity spectrum would likely rise sharply to refl ect the higher infl ation rate in the short run, while yields at the longer end of the maturity
spectrum might not rise as much if infl ation is expected to return to its previous low level in the long run. This implies that the yield curve would likely invert, and an inverted yield curve has typically not been very friendly to the profi tability of U.S. fi nancial institutions.
Fifth, neither the Phillips curve nor the IS curve illustrated in Figures 9 and 10 may be as elastic as shown. If both curves were more inelastic, as some studies have sug-gested, the impact of infl ation on employment and the level of economic activity may prove to be far more modest than infl ation-advocates contend.
Figure 10
The Impact of Real Interest Rates on the Level of Outputvia the Investment-Savings Schedule (IS Curve)
Source: Bloomberg
Output
Real Interest Rate
A
C
Elastic Investment-
Savings Curve
In the short-run, an decrease in the real interest rate should increase the level of output from Y1 to Y2.
r2
Y1
Increase in Output
B
r1
Y2
Decrease in Real Interest
Rate
Inelastic Investment-
Savings Curve
Y3
IS1IS2
(+)0(-)
Financial Conditions WatchJuly 25, 2012
9
Bloomberg
Finally, lowering the real interest rate deeper into negative territory could complicate asset allocation decisions further, particularly if investors’ appetite for risk remains depressed. This could have an adverse impact on consumer confi -dence and spending decisions.
All told, deliberately raising the infl ation rate with the hope of boosting the U.S. economy comes with a long list of risks that must be carefully considered before the monetary authorities undertake such a move. Indeed, they need to be aware that the proposed cure could end up being worse than the disease.
This may explain why Fed Chairman Bernanke has ex-pressly ruled out the infl ation option as a realistic policy consideration at this time. A stronger case for targeting a higher infl ation rate could be made if outright defl ation were to present a serious threat. But for now at least, that scenario does not seem to be a near-term risk.
In the article that follows, we consider what other policy options might be available to the Fed to help jumpstart the U.S. economy.
What’s Left in the Fed’s Arsenal? The August FOMC meeting will likely be characterized by a continued debate over the objectives of monetary policy and a debate over Fed tactics during a time of slow growth and elevated unemployment. This latter debate centers on the expected returns of another round of large scale asset purchases by the Federal Reserve, which are generally conceded to be diminished relative to previous efforts.
The Fed faces challenges in meeting its dual mandate of achieving maximum sustainable employment within the context of price stability, while playing the role of the de facto global lender of last resort and attempting to provide a modicum of certainty for investors. As such, the Fed’s affi rmation of its zero interest rate policy until 2014 and continuation of Operation Twist, the latest program in an effort to pressure longer-term interest rates even lower, represented a continuation of tactics rather than a shift in policy. Indeed, the outcome of the June FOMC meeting suggested that the Fed might be buying time in hopes the November election will solve the fi scal gridlock in Washington.
The U.S. fi xed income market had already anticipated the Fed’s June announcement and kept three-month Treasury bills and 10-year Treasury notes well within their trading ranges (see Figure 1). And as of this writing, the futures market now expects the fi rst Fed Funds rate hike to occur in mid-2015.
Bond market bears were left waiting at the alter once again. As reported by Bloomberg News, “the 3 percent return on Treasuries in the second quarter exceeded the 2.25 percent return on company debt and the 1.11 percent gain for mort-gages.” Compare that to the second-quarter 3.3% loss in
the U.S. equity market and the 7.9% loss in the commodity market as the U.S. economic recovery appeared to stall.
Clearly, the global demand for safe-haven assets is hav-ing a profound effect on fi xed-income securities, pushing the yields on Treasuries and Bunds and even Gilts lower. Nevertheless, one would have to argue that at least some of the downward pressure on U.S. longer-term yields is attributable to the Fed’s zero interest-rate policy and to its quantitative easing programs. The question for investors is when will the Fed take its foot off the accelerator and allow both short-term and longer-term interest rates to rise once again?
The FOMC now has a policy of clearly letting the market know exactly where it stands in terms of its economic projections and what it thinks will be the most appropriate
Figure 1
Figure 3 U.S. 10-Year Treasury Note Yields
(July 2011-July 2012)
Source: Bloomberg
Figure 2
FOMC Projections of U.S. Real GDP Growth(Projections of % Change in Real GDP as of April and June 2012)
(%)
2.72.9
3.4
2.52.2
2.5
3.3
2.4
0.0
0.5
1.0
1.5
2.0
2.5
3.0
3.5
4.0
2012 2013 2014 Longer-Run
April 2012 Projection June 2012 Projection
Source: Bloomberg
Source: Bloomberg
2.01.8 1.9
2.0
1.5
1.8 1.8
2.0
0.0
0.5
1.0
1.5
2.0
2.5
2012 2013 2014 Longer-Run
April 2012 Projection June 2012 Projection
FOMC Projections of U.S. Infl ation(Projections as of April and June 2012)
(%)
November 2011-February 2012Range Trading
Second Quarter 2012 Bull Market
June 2012Range Trading
Financial Conditions WatchJuly 25, 2012
11
Bloomberg
monetary policy for the next three years. The FOMC also specifi cally defi nes its longer-run targets for real economic growth, infl ation, and unemployment.
In June, the FOMC reaffi rmed that it is looking for a moder-ate recovery from the Global Financial Crisis of 2007-09, with real GDP growth increasing from roughly 2% in 2012 to 3.25% by the end of 2014. The Fed expects infl ation to hover below-target at less than 2% while the unemploy-ment rate remains above-target, falling to 7.4% over the next two years.
As Figures 2-4 illustrate, changes in the FOMC’s June economic projections were fairly predictable, given the Q2 slowdown after a warm winter front-loaded this year’s growth in the early months of the year. The FOMC’s projec-tions for real GDP growth and infl ation were knocked down a peg in 2012 and 2013, with the unemployment rate stuck closer to 8% than previously projected.
Source: Bloomberg
Bloomberg Consumer Comfort Index(2007-12)
Indeed, the Bloomberg Economic Surprise Index {ECSUR-PUS Index} trended lower from the end of February to mid-June 2012 (see Figure 5). As we reported last December, the deviations of analyst forecasts from the actual releases of economic indicators tend to signal shifts in the leading indicators of U.S. economic growth as well as trends in the bond and equity markets.
Consumer confi dence also took a hit in the second quarter of 2012, as illustrated by the trend in the Bloomberg Con-sumer Comfort Index {COMF <go>} (see Figure 6). After being moribund for the four years since the onset of the Financial Market Crisis, U.S. consumer sentiment showed a resurgence earlier in the year as unemployment began to trend lower
Note that since 2011, the BCCI has displayed a fairly direct relationship to the trends in the U.S. equity market (see Figure 7), perhaps indicating an increase in retail demand
Figure 6 Figure 7
Source: Bloomberg
Figure 4 Bloomberg Economic Surprise Index(Analyst Expectations of Economic Data Releases, 2011-12)
Source: Bloomberg
Figure 5
Source: Bloomberg
7.97.5
7.1
5.6
8.17.8
7.4
5.6
0.0
1.0
2.0
3.0
4.0
5.0
6.0
7.0
8.0
9.0
2012 2013 2014 Longer-Run
April 2012 Projection June 2012 Projection
FOMC Projections of U.S. Unemployment(Projections as of April and June 2012)
(%)
7-Month UpswingJuly 2011-February 2012
4-Month DownswingMarch-June
2012
4-Month Downswing
March-July 2011
2008-2011Range Trading
Bloomberg Consumer Comfort Index and the S&P 500(January 2011-July 2012)
Consumer Comfort Index S&P 500 Index
1100
1150
1200
1250
1300
1350
1400
1450
1500
-60
-55
-50
-45
-40
-35
-30
Jan-11 Apr-11 Jul-11 Oct-11 Jan-12 Apr-12 Jul-12
Bloomberg Consumer Comfort Index S&P 500
Financial Conditions Watch July 25, 2012
12
Bloomberg
for higher-yielding equity investments as an alternative to negative real money-market rates and low expected bond-market returns. Indeed, as Figure 8 indicates, the spread between the earnings yield of the U.S. equity market and the yield of 10-year Treasuries is at near-record levels. Despite projections of below-target infl ation and above-target unemployment throughout 2014, the expected tim-ing of the Fed’s fi rst rate hike remains at the end of 2014, according to the poll of FOMC voting members.
So after 4+ years of zero interest-rate policy, massive purchases of mortgage-backed securities to prop up the housing market, two massive rounds of purchases of longer-maturity bonds (Quantitative Easing), and two pro-grams to extend the duration of its portfolio holdings (via Operation Twist), is the Fed confi dent that the economy is on a sustainable recovery path that will allow it to begin rais-ing rates? Or has the Fed simply exhausted all of it options and fi nds itself in a holding pattern, hoping for the best?
Interestingly, there doesn’t seem to be much common ground. There are those who vehemently argue that the Fed has already done too much and there are those who adamantly claim that the Fed has not done nearly enough.
At the one extreme are those that contend that the Fed’s quantitative easing has never been necessary and that the presence of the Fed distorts market activity, leading to booms and busts. One could certainly point to recent history, with the Fed being blamed for being too lax for too long after the 2000 recession.
The Fed’s inordinately low policy rates from 2001-05 are commonly cited as prompting housing market excesses, leading to the Global Financial Crisis of 2008, the U.S. recession, and ultimately to the European Sovereign Debt Crisis. Before that, it was the so-called “Greenspan Put”, in which the Fed indirectly encouraged speculators to believe that the Fed would put a fl oor on any market’s collapse.
Source: Stefan Kanfer, “Booms and Busts”, Wall Street Journal,
Figure 8
Source: Bloomberg
Figure 9S&P 500 Earnings Yield vs. 10-Year Treasury Yield
(1970-2012)
U.S. Booms and Busts A Condensed History of U.S. Booms, Bust, and Financial Panics
from 1792-2012
1792 Alexander Hamilton has the U.S. Treasury purchase securities to stabilize panicked markets.
1830s Gold and silver shortages cause bank runs and the withdrawal of European funds from U.S. banks.
1857-59 Gold shortage and trust fraud spark panic selling of securities.
1869 Fisk and Gould corner gold market, which then collapses under government pressure.
1870s Silver prices plunge and faltering railway investments cause closing of NYSE for 10 days. Unemployed mobs riot as businesses fail.
1893-95 Railway failures cause bank runs and panic selling, depleting the gold in Fort Knox. Real-estate values drop precipitously.
1907 Global shortages of capital, cornering of the copper market, and the failure of New York's third largest trust cause the NYSE to lose half its value in the "Banker's Panic" of 1907. JP Morgan organizes emergency fi nancing.
1929-45 Stocks, that had quadrupled in value during the Roaring Twenties, crash on Black Monday and Black Tuesday, losing 89% of their value. Retaliatory global trade protectionism brings on the Great Depression.
1961 The Kennedy recession is countered by stimulus spending, leading to the largest peace-time expansion.
1970s Stagfl ation — Energy shortages lead to low growth, high unemployment, and high infl ation.
1987 A global stock market crash, attributed to program trading, results in the largest one-day loss in the Dow-Jones Industrials Index.
2008-12 A housing bubble leads to the Lehman collapse, the Global Financial Crisis of 2007-09, the Great Reces- sion, and the European Sovereign Debt Crisis.
But those who contend that the Fed has done more harm than good are ignoring a long history before the Fed was put in charge of managing both the business cycle and the integrity of the fi nancial markets. As Figure 9 shows, U.S. history is replete with bank runs and panics, near disasters, and riots and recessions.
The most interesting example, perhaps, was the Bankers’ Panic of 1907, when J.P. Morgan locked his fellow bank-ers in his mansion until they agreed to bankroll a fi nancial market bailout. Morgan also cajoled the major industrialists of the day to help fund the troubled trusts and arranged for foreign bankers to replenish the gold supply, thereby averting a collapse of the banking system and the New York Stock Exchange. In essence, J.P. Morgan behaved as an ad hoc modern-day Fed at a time when there was no Fed.
Financial Conditions WatchJuly 25, 2012
13
Bloomberg
Then there are those who contend that the Fed has done all that it can in the aftermath of the Financial Crisis and subsequent economic downturn. A forceful argument can be made that the fi nancial shock to the economy resulted in a structural break in the labor market that the Fed is not well suited to address. The onset of “hysteresis”—a one-time shock that permanently affects the path of the economy, in this case through the labor market—cannot be completely discounted, given the long duration of unemployment and job-mismatch facing many who are without work. Hysteresis may be part of the economic ecosystem that the central bank can likely do little to change, similar to what occurred in Western Europe in the 1970s and 1980s, a time that economists refer to as Euro-sclerosis.
Consider a workforce that has become ill-suited to the rapid shift in demand for scientifi c, technological, and technical skill sets. Under such conditions the duration of unemployment increases, causing the skill sets of the job-less to deteriorate, which makes re-entry to the workforce all the more diffi cult. Should the duration of unemployment persist for a long enough period of time, individuals become detached from the workforce as do their expectations and attitudes regarding employment shift.
While the loss of skills that underscore the development of human capital is paramount, shifting expectations regard-ing wages, living standards, and the loss of the stigma of unemployment can lead to longer-term problems in the labor market. In this respect, actual unemployment under conditions roughly approximating hysteresis can cause long-term unemployment to increase, reducing the overall pool of labor, which leads to slower growth and lower tax revenues, thus exacerbating the current fi scal problems of the federal government.
So is hysteresis a problem that now affects the U.S. labor market? The evidence points to a potential problem, but is not yet conclusive. It is diffi cult to precisely identify the
emergence of a structural shift in the labor market in real-time, yet readily available employment data is instructive. In particular the shift outward of the Beveridge curve—which shows the relationship between the unemployment rate and job vacancy rate—suggests a growing problem with job mismatch (see Figure 10). In 2001, a job vacancy rate of 2.7% was associated with an unemployment rate of 5.5%. But in 2012, a 2.7% job vacancy rate is now associated with 8.1% unemployment.
At the same time, both the Federal Reserve and the OECD now estimate that the U.S. natural unemployment rate (NAIRU) has shifted upward from 5% to roughly 5.5%. While economists recognize that NAIRU can shift up or down over time, this could nevertheless suggest a deep-seated labor-market problem.
One additional issue that might be indicative of a structural form of unemployment is “Spatial Lock”, or the inability of workers to relocate due to an inability to sell their homes. The 2.4 million homes on the market (see Figure 11), in addition to a conservative estimate of 4.16 million in shadow inventory—defi ned as foreclosures plus those 90 days late on their mortgages—tend to indicate that the U.S. economy is not profi ting from the type of labor mobility that it has in past recoveries.
The structural problems in the U.S. housing and labor market are inextricably linked. Roughly 23% of mortgage holders sit on negative equity positions in their homes, and another 5% hold near negative equity positions.
The 2.3 million construction jobs that have been lost since the peak in 2007 and the historically subpar 708,000 annu-alized pace of housing starts—which should be 1.3 million to meet basic demographic changes—point not only to the probability of hysteresis in the domestic labor market, but to the apparent loss of effi cacy of monetary policy in stimulat-ing the housing market or bringing down unemployment.
Figure 10
Source: Bloomberg
U.S. Beveridge Curve — 2001-2011 Relationship of U.S. Job Vacancies and the Unemployment Rate
Job Vacancy Rate (%)
Figure 11
Source: Bloomberg
U.S. Housing Inventory Existing and Shadow (Foreclosures and 90-Days Late) Inventory
As we will discuss below, clogged credit channels through which monetary policy traditionally stimulates the housing market are blocked due to tight credit conditions and the massive inventory of unsellable homes, which the offi cial data likely understates.
Although one would need to see 1) a persistent shift in the unemployment rate and 2) an increase in fi rms’ diffi culty in fi lling of open positions before coming to the conclusion that a structural shift in employment is largely to blame for current high levels of unemployment, the direction of the data is not encouraging.
That leads us to the other side of the argument, which is that in the absence of fi scal alternatives, the Fed could do more to spark a recovery and rectify the unemployment problem. Here, the argument is that the unemployment problem is less a structural issue than as a result of the most severe downturn since the Great Depression. As shown in Figure
Figure 13
Source: Bloomberg
Figure 14
Source: Bloomberg
Source: Bloomberg
12, the unemployment rate during and after the current recession has behaved much the way it has throughout the post-war period, rising sharply and peaking near the end of the past 10 recessions.
Moreover, the Great Recession has been an equal op-portunity disaster for all segments of the labor force. As shown in Figure 13, education is a major factor in determin-ing whether or not you are unemployed, and the fi nancial crisis and the recession have clearly affected all education levels of society at the same time. Unemployment rose rapidly at the height of the fi nancial crisis and then tapered off once the economic stimulus provided by Congress in 2009 kicked in.
Gender has also been a determinant of unemployment level in the post-war period (see Figure 14). From 1950 to 1975, females were more apt to be unemployed than males. But as the 1972 equal employment-opportunity legislation took effect and then as females became more highly educated than males, males were the more likely to be unemployed. For example, male unemployment reached 11.2% in Octo-ber 2009 while female unemployment peaked a year later at 9% in November 2010.
The non-structural argument says that this is a balance-sheet recession and in the absence of fi scal alternatives, the Fed needs to take extraordinary actions.
As such, there are calls for the Fed to raise infl ation ex-pectations in order to get corporations and households to begin investing, with economists asking the Fed to drop its infl ation-fi ghting mantle until the economy reaches a sustainable level of growth. These voices contend that although the Fed has stated that it will keep the Fed Funds rate at the zero bound for an extended period, the Fed’s projection of below-target infl ation (less than 2%) now and in the distant future suggests that, at the slightest hint of infl ation, the Fed will slam on the brakes.
Figure 12 U.S. Unemployment Rate and Postwar Recessions
(1950-2012)(%)
U.S. Unemployment Rate by Education since 2000(2000-12)
(%)
U.S. Employment Ratio by Gender since 1950(1950-2012)
The growth of U.S. monetary aggregates has slipped of late, which has also dampened infl ation expectations. As shown in Figures 15, growth in the U.S. Monetary Base has declined back to pre-crisis levels, and M1 and M2 money-supply growth has slipped since the start of the year (see Figures 16-17).
If the economy is in a liquidity trap—and with short-term interest rates at the zero bound and long-term yields being pushed steadily lower by the Fed and by the global demand for safe-haven assets—then is the Fed’s inaction a sign that the monetary options have run out?
Certainly, Japan’s experience with quantitative easing dur-ing its lost decades was unremarkable and the economy barely righted itself only after Japan fi nally dealt with its underperforming banks. But even then, an aging popula-tion of net savers and the rise of cheaper labor markets in the rest of Asia consigned Japan to low-growth status for roughly two decades.
As Figure 18 suggests, the Fed’s recent experience with quantitative easing could be suffering from diminishing returns. By the end of the fi rst round of asset purchases by the Fed in 2010, the S&P 500 had shown an 80% increase. But subsequent purchase programs appear to have had a lesser impact, with the S&P 500 gaining 30% by the end of QE2, and then 17% during Operation Twist.
Figure 15
Source: Bloomberg
Figure 16
Source: Bloomberg
U.S. Monetary Base(Year-over-Year Percent Change since 2004)
U.S. M1 Money Supply(Year-over-Year Percent Change since 2004)
Figure 17
Source: Bloomberg
U.S. M2 Money Supply(Year-over-Year Percent Change since 2004)
Figure 18
Source: Bloomberg
Diminshing Wealth Effects from Fed Purchases(Response of the the S&P500 to Fed QE Programs)
If today’s overleveraged U.S. households and underem-ployed population are the corollary to Japan’s aging net savers, then is increasing the money supply or bringing down long-term rates likely to have any effect on U.S. consumption and investment, much less the labor market?
No matter what the cause of the stubbornly high unem-ployment rate—if it is structural or if it is a result of the Financial Crisis and the economic downturn—solutions to solving the pressing labor market problems are likely to be controversial and expensive, and not within the realm of the Federal Reserve. Worker retraining programs such as those in the Scandinavian countries in response to the era of Euro-sclerosis required a sustained bi-partisan commit-ment that appears be absent in the U.S. polity currently.
Fed Chairman Ben Bernanke has clearly called for a fi scal partner in reviving the U.S. economy. But that is probably unrealistic to expect. Nevertheless, should events dictate, one would have to assume that the Fed is unlikely to just sit there. Following are four clusters of possible policy options.
1) Buying Time — The Fed has chosen to lengthen its extended maturity program by $267 billion, with the pace of purchases at $44 billion per month. Since the Fed started its Operation Twist program, the Fed has lengthened the maturity of its portfolio from 6.09 years to 8.87 years.
The Fed could also extend its conditional commitment to keep rates low past 2014 until mid-2015. By extending that conditional commitment, the Fed would nonetheless be making an explicit hedge against further weakness in the domestic economy this year and a potential downdraft associated with the coming fi scal cliff next year.
2) Explicitly Commit — Doves on the FOMC such as Chicago Fed President Charles Evans would prefer a shift in policy from a conditional commitment to explicit pledges linked to specifi c economic variables. For instance, Evans supports linking forward-looking guidance on policy to a decline in the unemployment rate to 7% or an increase in the infl ation rate to above 3%. 3) Aggressive Action — While not a probable outcome yet, FOMC members Bernanke, Dudley and Yellen are more than willing to turn to further asset purchases to calm markets. While, the marginal benefi t of further Large Scale Asset Purchases (LSAP) is open to debate, they would be stabilizing during an external fi nancial shock and therefore cannot be ruled out in coming months. The asset purchases would likely come in two forms: sterilized and unsterilized.
3a) Sterilized LSAP — The objective here is to keep rates low at the long end of the curve without the unintended con-sequences that accompanied the second round of LSAPs (i.e., speculative-driven increases in oil and commodity prices). A sterilized asset purchase program would consist of the Fed purchasing long-term bonds and then draining reserves created via purchases through either reverse
repurchase operations or term deposits, effectively quar-antining the new money created through the purchases.
3b) Unsterilized LSAP — Another full blown asset pur-chase program that would likely lean away from Treasury purchases toward buying of mortgage-backed securities to target the still depressed housing market. In a white paper released by the Fed earlier this year, the central bank clearly indicated it thinks that the effectiveness of monetary policy has been reduced through a blockage of the monetary transmission mechanism due to the problems in mortgage industry and housing market (which we’ll discuss below).
4) Reducing Interest on ReservesThe central bank can reduce interest rate paid on re-serves—currently 0.25 basis points—to zero, in an attempt to spur increased lending by banks, much in the same way the European Central Bank recently has done. The logic of this approach is straightforward: reduced incentives on the parts of banks to hold excess reserves could plausibly lead to an increase in lending to consumers and fi rms, supporting a rise in overall consumption and investment.
While this will most likely be on the agenda at the upcom-ing August 1 FOMC meeting, scholarly work conducted at the New York Federal Reserve (http://tinyurl.com/lh74eo) suggests that a decline in the rate paid on excess reserves would result in a general shifting of reserves around the banking system, rather than reducing the overall level of reserves, and thus only a modest increase in lending.
The quantity of money in the banking system is determined by the central bank. A reduction in that quantity would require reducing a substantial portion of their security hold-ings on the balance sheet, resulting in a net tightening of policy. Although reducing rates paid on excess reserves would result in marginal lower short-term rates, it will likely not do much to alter the quantity of reserves that banks hold on account at the Fed.
Figure 19
Source: OECD, Bloomberg
U.S. Output Gap(1965-2012)
Financial Conditions WatchJuly 25, 2012
17
Bloomberg
Monetary Transmission Mechanism: A Granular Look
Source: Adapted from Kenneth N. Kuttner and Patricia C. Mosser, “The Monetary Transmission Mechanism: Some Answers and Further Questions”, New York Federal Reserve, FRBNY Economic Policy Review, May 2002, http://www.newyorkfed.org/research/epr/02v08n1/0205kutt.pdf.
Figure 20
4) Regime Change — This would involve a temporary lifting of the Fed’s infl ation target from 2% to 5%, and/or targeting growth in nominal GDP, with the central bank taking steps via asset purchases to meet the new policy objective.
Although Fed Chairman Bernanke counseled the Japanese to take extraordinary measures during the most intense portion of their defl ationary trap during the late 1990s, it seems likely that the Fed would only turn to a regime switch in the direst of circumstances.
Targeting nominal GDP might work, but it does carry risks of asset-price distortions. Nevertheless, with the policy rate constrained by the zero boundary and with the U.S. output gap currently estimated in the 3.5%-6% range (see Figure 19), another Lehman moment could tip the central bank in that direction. The Fed would probably only turn to regime change if it felt it needed to stabilize aggregate demand in the event of an outbreak of defl ation triggered by the U.S. slipping back into recession and/or an external fi nancial shock.
The recent lapse in economic activity and the tepid hir-ing do not appear to have convinced policymakers of the necessity of regime change at this time. That implies more quantitative easing for now. That in turn implies the possibility of short-term profi ts for fi xed-income investors and the continued availability of profi ts for banks taking yield-curve carry-trade positions, earning the spread of
borrowing at nearly zero cost and investing in the long end of the Treasury curve.
There are immense potential downsides to the current situ-ation of monetary and fi scal policy inaction, starting with the deleterious impact of long-term unemployment on the economy and on the labor force. While an economy can make up for lost ground after a downturn by increasing investment, each hour of labor lost during a recession can never be recovered. Even more troubling is that long-term unemployment can leave personal scars that lead to dis-tancing from the labor force and therefore an increased burden on the social safety net and a self-perpetuating poverty of ambition.
Now what exactly can the Fed do to bolster employment conditions. Not much. After fi ve years of progressively unorthodox action, it is unclear what marginal economic benefi ts can be derived from further asset purchases. Although purchasing mortgage-backed securities would likely bring down mortgage rates from already historically low levels near 3.6%, that will not unclog the problems in the credit markets, or reduce the backlog of homes offi cially on the market, nor the nearly 30% of mortgage holders sitting on negative or near-negative home equity positions, all of which are blocking the monetary transmission mechanism shown in Figure 20.
If we are in a liquidity trap, and if the expected return on long-term investments is so low, then the amount of in-vestment necessary to get the economy moving again is unlikely to come from the private sector. In fact, it could be argued that in this situation, expectations of low long-term interest rates actually inhibit investments, with investors unwilling to move out along the yield curve for low-returning/higher-risk assets.
While the Fed may ultimately choose to restart its asset purchase program—most likely at the September 13 FOMC meeting—the decline in long-term yields and the boost to asset prices and overall growth is likely to be less than previous efforts.
Monetary policy is a sub-optimal response to the current conditions of high unemployment and insuffi cient invest-ment. Further security purchases under these conditions will likely not achieve much.
Bloomberg’s two composite U.S. Financial Conditions indices track the overall stress in the U.S. money, bond, and equity markets {BFCIUS Index} and trends in selected asset-price movements and real long-term interest rates {BFCIUS+ Index}. These indices are available on the Bloomberg terminal at {FCON <go>}, and provide a use-ful gauge to assess the level of stress in the U.S. fi nancial markets.
The table below lists the components and weights used to calculate the Financial Conditions indices. The spreads and indices are normalized and combined, and then presented as Z-scores (defi ned as the number of standard deviations that fi nancial conditions are above or below the average level of fi nancial conditions observed during the January 1994-June 2008 pre-crisis period).
According to the BFCIUS index, U.S. fi nancial conditions are roughly 0.2 standard deviations below their neutral level. The BFCIUS+ index remains positive, but slipping to 0.9 standard deviations above its neutral level on the relative strength of tech share prices, the steady improve-ment in home-building share prices, and the extremely low levels of medium-term real and nominal bond yields relative to their norms.
---- Weights ---- BFCIUS BFCIUS+Money Market Ted Spread 11.1% 6.7%Commerical Paper/T-Bill Spread 11.1% 6.7%Libor-OIS Spread 11.1% 6.7% 33.3% 20.0%Bond Market Baa Corporate/Treasury Spread 6.7% 4.0%Muni/Treasury Spread 6.7% 4.0%Swaps/Treasury Spread 6.7% 4.0%High Yield/Treasury Spread 6.7% 4.0%Agency/Treasury Spread 6.7% 4.0% 33.3% 20.0%Equity Market S&P 500 Share Prices 16.7% 10.0%VIX Index 16.7% 10.0% 33.3% 20.0%Asset Bubbles Nasdaq/S&P 500 Ratio 10.0%S&P Homebuilders/S&P 500 Ratio 10.0% 20.0%Equilibrium Yield Gap 5-Yr. Treasury Yield less Nom. GDP Growth 10.0%Real Baa Corporate Yield less Average 10.0% 20.0% Total 100% 100%
Bloomberg’s U.S. Financial Conditions IndexComponents and Weights
Source: Bloomberg
Bloomberg’s U.S. Financial Conditions Indices(BFCIUS and BFCIUS+ Index, Daily Z-Score Values, 2007-2012)
Source: Bloomberg
Bloomberg U.S. Financial Conditions Index
U.S. Financial Conditions Index Components(Normalized Values, January 2007-April 11, 2012)
(Z-Scores)
Money-market conditions are once again barely positive for the fi rst time since last September. Both Ted spreads and commercial paper spreads have improved to the extent that they are now 10 basis points below their pre-crisis norms. The Libor-OIS spread remains about 12 basis points above its norm.
Conditions in the bond market have deteriorated slightly as the various components have not kept up with the safe-haven demand for Treasuries. The recent focus on the fi nancial health of local municipalities and the states appears to be having an effect on the muni spread.
Equity prices have been on a two-month uptrend since the beginning of June, with the VIX index trending lower more or less over that same time period. Nevertheless, the health of the economy is still in question and equity-market conditions are choppy and still below normal levels.
Contributions of the Money, Bond, and Equity Markets to Financial Conditions
Bloomberg’s Euro-area composite Financial Conditions index is now available on the terminal as {BFCIEU Index}and at {FCON <go>}. A counterpart to Bloomberg’s U.S. Financial Condition Index, the BFCIEU index tracks the overall stress in the Euro-area money, bond, and equity markets and provides a useful gauge to assess the level of stress in the Euro-area fi nancial markets.
The table below lists the components and weights used to calculate the Euro Area Financial Conditions Index. The
spreads and indices are normalized and combined, and then presented as Z-scores (defi ned as the number of standard deviations that fi nancial conditions are above or below the average level of fi nancial conditions observed during the January 1999-June 2008 pre-crisis period).
According to the BFCIEU index, Euro-area fi nancial condi-tions are now roughly 1.8 standard deviations below their neutral (pre-crisis) level during this latest phase of the European sovereign debt crisis.
Euro Area Financial Conditions and Components(2007-2012)
(Z-Score)
After deteriorating in the second quarter, Euro area fi nancial conditions appear to be recovering once again. Market anxiety appears to have been ameliorated by Spain’s re-quest for aid in June and by an ECB rate cut early in July.
As the chart indicates, much of this year’s improvement in fi nancial conditions owes to the rebound of money-market spreads. The ECB has pumped liquidity into the market and both the Euro Ted spread and the Euribor/OIS spread are a third of what they were at the depth of the Sovereign Debt Crisis.
Bond-market conditions have lost some ground in recent weeks as the high-yield and swap markets have not been able to keep up with the safe-haven demand for bunds. And the equity market, which appeared to be trending upward, has slipped once again.
Euro Area Financial Conditions and Euro Area Credit Conditions
---- Weights ---- BFCIEU Money Market Euro TED Spread 16.7%Euribor/OIS Spread 16.7% 33.3% Bond Market JP Morgan High-Yield Europe Index 16.7%EU 10-Year Swap Spread 16.7% 33.3% Equity Market Ratio of EuroStoxx to Its 5-Yr. Avg. 16.7%VDAX Index 16.7% 33.3% Total 100%
Bloomberg’s Euro-Area Financial Conditions IndexComponents and Weights
Notes: Three-month rolling hedges. Averages, highs, and lows are based on weekly data for the past year. A Z-score is the number of standard deviations that the latest observation lies away from its average. Yield spreads with Z-scores greater/less than +/-1.96 are considered to be signifi cantly different from their 52-week averages.
Yield Pick-Up of Hedged 10-Year Foreign Gov’t Bonds over Domestic Gov’t Bonds
Financial Conditions Watch July 25, 2012
70
Bloomberg
Keeping Up with the Financial Crisis
Real Time Fixed Income Spreads, Market Volatility, and AnalysisFCON Financial Conditions Monitor
Real-Time IndicesBFCIUS Index U.S. Financial Conditions IndexBFCIUS+ Index U.S. Financial Conditions Plus IndexBFCIEU Index Euro-Area Financial Conditions IndexECSURPUS Index U.S. Economic Surprise Index NewsNI CRUNCH Credit Crunch/Crisis NewsSBPR Subprime News
Credit MarketsBANK Monitor bank prices and CDS ratesGCDS CDS sector graphWDCI Writedowns and credit loss vs. capital raisedCCRU Credit crunch overviewWWCC Worldwide credit crunch menu
Mortgages / Housing / DelinquencyHSST U.S. housing and construction statistics DELQ Credit card delinquency ratesBBMD Mortgage delinquency monitorREDQ Commercial real estate delinquenciesDQLO Delinquency rates by loan originator