The Federal Reserve recants

London-based economist Andrew Hunt reviews the latest developments in international markets and what the US Federal Reserve's latest comments on ending its quantitative easing programme mean.

Tuesday, October 8th 2013, 10:00AM

by Andrew Hunt

In the end, it was not even “tapering-lite” when the Federal Reserve Board (FRB) announced its latest policy statement. The FRB apparently judged that:

the recent sell-off in the government bond markets and associated rise in mortgage rates,
the still uncertain US fiscal outlook,
the ongoing, if still largely unnoticed, regulation-driven credit deflation within the banking system,
the weak underlying state of the labour market, and
the general deflationary global trade environment

outweighed their own staffers’ concerns over the growing indebtedness in the corporate sector, which the Fed is implicitly encouraging through its current policy settings. The recent softer tone in the housing market may also have been a concern for the Fed’s policymakers, although we suspect that this may have been a peripheral factor for the Fed, given that the previous strength in the housing market was being led largely by a change in the way in which people have been saving, rather than borrowing and spending.

Hence, we suspect that the property market has not been quite as important to the real economy as some might have supposed. More important in the FRB’s calculus, we suspect, was the latest regulation-driven downturn in bank credit and the growing signs of stress within the very important, if largely invisible, “repo markets” on which the banks rely to lubricate their day-to-day operations.

For our part, we can sympathise with the Fed’s dilemma – the choice between:

sending more good money after bad by persisting with QE in the hope that this ultimately provides some cyclical support for the economy and the (once again) struggling commercial banking system, and
abandoning QE for longer-term financial stability reasons

It could not have been an easy decision to make and, in the end, the FRB did not only offer more soothing words over the medium-term outlook for interest rates (as expected), it also pledged to continuing adding liquidity. While, unfortunately, we suspect that even the latter may not do that much to benefit the real economy or even capital spending and jobs growth (not least of all because the continued corporate “balance sheet engineering” that it will underwrite will likely continue to crowd out productive investment), the Fed’s actions should at least ensure that the various non-bank forms of credit (such as corporate bonds, student loans and auto finance) will continue to expand – for better or for worse.

This, in turn, should continue to lend support to the asset markets.

Admittedly, the weakness in the banking system and the intra-financial-system credit channels such as the repo markets may imply that markets will have to do without the previously liquidity-generating activities of the banks’ trading desks but the FRB’s continued bond purchases should allow companies to continue to gain easy access to the securitised forms of credit that will allow them to continue to buy in their own equity, offer high dividends to investors and indulge in further M&A activity.

All of this will tend to be supportive of asset prices, even though, as we noted above, the cost of this has already been a very marked increase in overall corporate indebtedness. Indeed, corporate debt ratios are now rising back to – or above – the levels of 2007 but as is usually the case with any credit boom, while the process is expanding it tends to have an inflationary impact on asset prices.

Therefore, although the US real economy is, at best, producing tepid growth (largely as a result of the lack of disposable income growth and the continuing weakness in CAPEX) and there may still be many things that need fixing within the economy itself, the FRB has offered a route by which the asset markets may be able to continue to ignore the fundamentals at least a while longer.

But not just the USA – China
In the case of the USA, we have suggested that although the conventional banking system forms of credit may be shrinking, the non-bank credit system remains quite active as a result of the FRB’s actions. In China, we also find that, over the last month or so, the various non-bank forms of credit such as:

corporate bonds,
“wealth management companies”,
foreign borrowings, and
even the trade credit system

have been expanding very rapidly. It would seem, though, that China is also enjoying something of a boom in more conventional forms of bank credit growth at present as well and, consequently, we have estimated that China’s credit boom is roughly “three times as strong” relative to the country’s GDP as the United States’ 2000s credit boom was at its peak in early 2007. Moreover, in the case of China, we are beginning to see signs that this has led to some revival in steel output, the construction sector and even in imports and this situation is proving predictably supportive for local asset prices.

This latest “mega-injection” of credit will be doing little to solve the economy’s structural imbalances and problems. Raising the supply of credit is unlikely to result in more food output and certainly it is unlikely to cause a rebalancing of the economy towards greater consumption because of the existing structural impediments to such a transformation. Instead, all that the credit will do is keep the old system alive by offering yet more “intensive care” to the cashflow-negative companies that probably should be closed down so as to free up resources for more profitable and productive functions. Moreover, by offering more of the “credit drug”, the authorities are allowing the economy to simply become even more addicted, something that bodes ill for the future and the balance of payments in particular.

In the near term, though, the asset markets will no doubt welcome the news that the Chinese “slowdown” is being delayed by what has possibly become the most aggressive credit boom that we have ever witnessed.

Japan: Doubling Up
In Japan, meanwhile, it is becoming increasingly clear that Abenomics is in trouble. Liquidity and credit growth has begun to slow within the economy and the BoJ’s asset purchases seem only to have succeeded in turning the JGB market into a “fixed price OTC market” in which the central bank is now the only (massive) buyer of bonds and the commercial banks are the dominant sellers. None of this will be benefitting the real economy, as the recent “stagnation” in industrial production and slowdown in consumption growth have revealed. Moreover, with real incomes now being undermined by rising import prices, the prognosis for Japan’s real economy must be for further weakness. Moreover, we also estimate that the BoJ will have exhausted its room for further asset purchases by May-June next year, if not before. By then, the BoJ will have spent what it has said that it wanted to spend and by then its balance sheet will have reached an immense and unwieldy size that will be threatening Japan’s long-term financial stability.

Given this apparent failure of the economy to regain traction and the abject failure of Abe’s “third arrow of the recovery process” (namely economic reform) to even be fired, the Bank of Japan may feel that it may as well extend its own asset-purchase progammes into non-JGB assets such as J-REITS, ETFs and whatever else it chooses in the near term.

Therefore, while on a longer-term view, Abenomics may have set Japan backwards by further undermining not just the country’s fiscal accounts but also its productivity and hence its long-run growth potential (by favouring the relatively unproductive sectors such as construction, while maintaining the status quo in the notoriously low-productivity service sectors), in the near term there must be a high probability that the BoJ will “go for broke” with a higher dose of the same old QE medicine over the next few months. We have a sense that the risk markets will welcome this endeavour.

Europe: An approaching U-turn?

As we have noted in many of our previous Eurozone reviews and other rants, the Euro area is a suboptimal currency area that does not possess the required level of political integration that would allow it the possibility of being a success. Moreover, the Eurozone real economy is also still effectively “bumping along the bottom” with an ongoing credit crunch within its banking system. Admittedly, some of the recent data has looked a little better on the back of a boom in the aerospace industries and a rather strange inventory build in the auto sectors, but we see little sign that these will presage a wider Eurozone recovery.

Against this background, it is quite possible that the German Bundesbank’s concerns over the conduct of Eurozone monetary policy will be swept away or overruled by the newly re-elected Merkel (despite what this will do to the long-term prosperity of the very people who just voted for her...) and the way left open to the ECB’s ever-expansionary Mr Draghi to “do whatever it takes” to save the Euro. What the Euro needs is either to be broken up or for European political integration to be stepped up very dramatically but, since neither of these seem to be possible in the near or medium term, all that we can expect from Draghi will be some new form of LTRO, OMT or simple QE.

The Central Banks Act In Unison?

Therefore, although the Bank of England has (wisely?) chosen to abstain for now, it is looking increasingly likely that the world’s major central banks will continue with an overtly expansionary monetary stance over the next few months that will predominantly benefit the non-bank credit channels and, as such, it may be quite supportive of the financial markets. There may be much that is wrong with the global economy, but with the central banks warming up to provide yet more of the credit “drug”, financial markets may be able to ignore fundamentals for a few months more.

Andrew Hunt International Economist London

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