May 28. Wasted Words

Can you tell me, tell me, friend, just exactly where I’ve been?
Is that so much to ask I’ll pay you back no matter what the task
You seem really sure ’bout something, I don’t know.
   –Allman Bros Band, Wasted Words, 1973

Where have we been in 2017?  The chart below summarizes part of the story. [Chart of 5y5y inflation forward swap, 2/10 treasury spread, and volatility on the TY contract].  For context, the chart goes back a decade, but what I am focused on is simply the last six months.  TY implied volatility started the year high and it’s now near its low at around 4%.  2/10 yield curve spread got up to 135 in December and is now at its low for the year around 95.  One market measure of inflation, noted on this chart as the 5y5y inflation forward swap, surged to around 260 post-election; it is now around 225 bps.  Former Speaker of the House John Boehner has captured the mood.  “I was a little more optimistic about [tax reform] early in the year; now my odds are 60/40.” He added, “Tax reform is just a bunch of happy talk.”

I was just going to end my note right here, and not waste any more words.  The market seems really sure about the Fed hike in June.  Economic data has softened.  The curve has flattened and stocks have risen, with the 10 largest stocks accounting for 54% of the total return in past month.

Can you tell me, tell me, friend, just exactly where I’ve been? 

Former Fed Chairman Ben Bernanke touches upon past history in his blog this week: Some Reflections on Japanese Monetary Policy.

https://www.brookings.edu/wp-content/uploads/2017/05/es_20170523_bernanke_boj_remarks.pdf

It’s this speech that really crystallizes the title of the Allman Brothers Song.  Why does Bernanke bring up the topic of Japan?  Is it that he believes all developed countries are moving in that direction (of persistently low growth and a failure to hit inflation goals)?  It seems to me that the entire subtext of the speech is that debts need to be inflated away.

He starts…  “Why ending deflation and escaping the effective lower bound has proved tougher than I once expected will be one of the themes of my talk today.”  He owns up to some of his previous misconceptions: “In particular, in some of my early writings, I did not always demarcate sharply enough between what monetary policy can achieve on its own, and what requires some degree of coordination with fiscal policy.”

He notes that with the Abe-Kuroda combination, the BoJ’s balance sheet has grown to 88% of Japanese GDP, compared to the Fed at 24% and the ECB at 34%.

“In general, even at the effective lower bound, monetary policy can boost aggregate demand, employment, and inflation in one of two complementary ways – by easing financial conditions (for example, by lowering longer-term interest rates, depreciating the currency, or lifting the stock market) – which stimulates aggregate demand directly; or by raising the public’s expectations of inflation, thereby lowering real interest rates as well as increasing expectations of future growth.”

[This is an important passage as it relates to the US and every other developed economy, I return to it below].

Then he says, “In any case, in Japan both channels of monetary policy transmission seem to be approaching their limits.”

Here are a couple of other snippets:

“Inflation expectations in Japan did rise after the initial announcement of QQE, but overall they have been less responsive than hoped….”

“…understanding the links between central bank talk and the expectations of households, businesses and markets is an increasingly important challenge for monetary policymakers.”

He then mentions Japan’s high debt to GDP, which leads to a discussion of coordination between monetary and fiscal policy.  If there is anywhere in the world where there is the possibility of strong coordination between the central bank and the government, it’s Japan.  It’s certainly not the ECB and the US.  Yet Bernanke insists upon going down this fantasy academic exercise.  But what’s really stunning is the next turn.  He talks about the central bank maintaining its independence as it embarks upon its stimulus with fiscal cooperation, and then says ”…the gov’t has to accept the risk that a future leadership of the bank would renege on the commitment.”

It’s an extraordinary thought process.  Here’s my interpretation of BB’s speech: 1) I didn’t know how hard it would be to stop deflation, 2) Now I know: all we need to do is boost stocks and calibrate the public’s inflation expectations, 3) a strong independent central bank can accomplish the task, but it needs  a subservient government.

That’s a perfect solution, concentrate power in the unelected central bankers.  Wasted Words.

One more note on the embedded passage which I copy below:

“In general, even at the effective lower bound, monetary policy can boost aggregate demand, employment, and inflation in one of two complementary ways – by easing financial conditions (for example, by lowering longer-term interest rates, depreciating the currency, or lifting the stock market) – which stimulates aggregate demand directly; or by raising the public’s expectations of inflation, thereby lowering real interest rates as well as increasing expectations of future growth.” 

Since the beginning of the year, US financial conditions have eased.  It’s as if the Fed is trying to stimulate growth and the economy, in spite of saying that accommodation needs to be removed.  Longer term rates have declined, USD has come off its highs, the stock market has risen.   The public’s expectation of future growth should be higher due to possible tax reform.  Yet inflation expectations appear to be declining.  With Moody’s downgrades of China and Brazil last week, risks from overseas will again be on the radar.

Posted on May 29, 2017 at 12:22 pm by alexmanzara · Permalink
In: Eurodollar Options

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