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Why are the markets so
excited that the smartest guy in the room takes his name out of the running
for the (second?) most powerful job in the world? With Larry Summers no
longer holding back the markets, what's next for the dollar, currencies and
gold?
While pundits debated
what a Summers Fed would have looked like, the truth is that little was known
about his views on monetary policy. Our own take was that given his highly
political disposition, he may be more effective in his current role where he
can call President Obama any time to offer his advice. Yet the markets
rallied because uncertainty is reduced: with Janet Yellen as the
front-runner, the odds of continued ultra-loose monetary policy has
increased. Indeed, aside from a rallying stock market, the more noteworthy
reaction is a global bond rally, especially on short to medium term
maturities. That is, the markets expect lower interest rates for longer with
a Yellen Fed. Of course, a wrench can still be thrown into this calculus, as
a Yellen nomination is no certainty. In our assessment, Roger Ferguson, best known
for past work on financial stability, could be the left-of-field candidate in
case President Obama feels Ms. Yellen should not get the job.
As no event ever happens in a vacuum, the potential "tapering"
of the Federal Reserve's QE program is still on the table. Before we get too
carried away about a potentially more "hawkish" Fed, let's put the
move into perspective. Below is a chart depicting relative growth of central
bank balance sheets since August 2008. This growth is often referred to as
the amount of money that's been printed, even if no actual banknotes are
issued. When money is "printed" to buy, say $1 billion in
Treasuries, the Fed credits the account of, say, Goldman Sachs, with said $1
billion. In return, the Fed's balance sheet now carries the Treasuries on the
asset side, growing by $1 billion, and the $1 billion credit to Goldman on
the liability side. In total, the Fed balance sheet now stands at over $3
trillion. On the chart below, tapering refers to the rate at which the growth
of the Fed's balance sheet will level off, i.e. when the black line moves
horizontally, rather than upward:
Contrast that with the European Central Bank (ECB) that's actually mopping
up liquidity. It's not that the ECB is so hawkish, but their printing press
is wired differently: instead of buying some seemingly random amount every
month, the ECB's balance sheet is demand driven. That is, when banks request
liquidity (cash), the ECB provides it in return for qualifying collateral.
The very reason the crisis in the Eurozone erupted may be because the ECB
didn't print a boatload of money to patch up the system. It was only in late
2011 that the ECB ramped up its lending facilities dramatically, most notably
with what amounted to approximately ?1 trillion in 3 year financing (known as
the 3 year LTRO). The reason the ECB balance sheet is now shrinking is that
banks are allowed to return their money early. So while we talk about
tapering, the ECB is not only tapering, but mopping up liquidity.
Should it come as a surprise that the euro is the best performing currency
year-to-date? Last year, by the way, with all the trouble in the Eurozone,
the euro also outperformed the U.S. dollar. That's how well the cleanest of
the dirty shirts has been performing. It seems to me that the seemingly clean
shirt has been trading on unrealistic expectations that it might outshine the
rest of the laundry.
There's more at work than printing presses around the globe. In the U.S.,
we have been told that tapering must be good for the dollar. We challenge
that notion. Indeed, historically speaking, early to mid phases of tightening
cycles have been dollar negative. That's because purchases of Treasury
securities by foreigners might be reduced as the bond market turns into bear
market territory. It's during late phases of a tightening cycle that the
dollar historically benefits as the next bull market in bonds is anticipated.
The one caveat with this theory is that this is certainly no
"normal" environment.
In today's environment, we would like to point to a much bigger threat.
Some may think it's inflation, and indeed we are concerned about inflation.
But the market appears complacent about inflation. What the market does
appear to be concerned about is economic growth: when good economic
indicators are released, the bond market has tumbled of late. Now imagine an
environment where we get good economic growth. What would happen if so-called
pro growth policies actually worked? Pundits might applaud rising rates as a
sign of an improving economy. However, at some point, someone is going to
look more closely at the cost of financing government debt. The average cost
of marketable U.S. government debt has slipped below 2%, down from over 6% in
2001. Where will we be in 5 or 10 years? As the cost of servicing the
national debt rises, other government spending will likely be crowded out.
Our politicians don't appear too concerned, as one can always take out more
debt. But the math does not add up, especially with mounting entitlement
obligations. Having said that, we only have to look at Europe to note that
it's the perception that matters even more than the math: Spain, with rather
prudent debt management and an average maturity of approximately 7 years on
its government debt, struggled as investor confidence plummeted. Europe
teaches us another lesson: only when the bond market imposes reform will
politicians get their act together. But different from the Eurozone, we have
a current
account deficit in the U.S., making the greenback potentially far more
vulnerable than the euro has ever been.
Let's look at Europe, as so many have said upcoming German elections may
be a turning point. In our assessment:
- What you see is what
you get. European politics will morph into new phases, but don't expect
miracles, not from German elections, treaty changes or other miracles.
- Last weekend, in
Bavarian state elections, the liberal party (FDP) was kicked out of
parliament, giving the conservatives (CSU) an absolute majority. For conservative
Bavaria, that's not too surprising, but what's relevant for federal
elections this weekend is that it may increase strategic (sympathy)
voting for the FDP, the junior coalition partner in the Merkel
government. As such, while it is a tight race, we believe a status quo
with a continuation of the existing coalition is the most likely
scenario.
- But even if the
government in Germany changes, the social democrats are in no mood to
write blank checks for the rest of Europe. If anything, there may be
different nuances, with increased rhetoric focused on growth.
More important is what
has been hiding in plain sight: risks are increasingly priced where they
belong. That may sound like an abstract statement, but consider what happened
during the peak of the Cyprus debacle: during this time, Spain issued
Treasury bills at the lowest yields since the early 1990s. The then new head
of the Eurogroup, Mr. Dijsselbloem at the time was quoted as saying Cyprus
should be a model for Europe. He later clarified his comments, but did not
budge on substance that the era of bailouts is over. Indeed, Mr.
Dijsselbloem, who is also the finance minister of the Netherlands, allowed a
Dutch bank to fail a few weeks before the Cyprus crisis caused international
headlines. The problem with guarantees is that everything is safe
until the guarantor fails; the way a free market ought to work, however, is
that the risk is spread and the failure of any one player won't wreck the
system. Sure enough, ever since last August, we have had more discriminating
markets. Sure enough, there will be failures going forward, but those risks
ought to be reflected in the respective securities, not necessarily the euro.
Last August we published an analysis entitled Draghi's
Genius that goes into more depth as to why the dynamics in the Eurozone
have changed. At the time we published the analysis it was most
controversial. While we continue to have many skeptics, the market has proven
us right so far. In the meantime, we will change our mind should political
dynamics unfold differently from how we foresee them.
Today's investors in Spanish and Portuguese bonds are different from those
a few years ago. A few years ago, investors viewed these securities as risk
free. That money fled. The money that's piling into Europe's periphery now is
yield-chasing capital, capital that's aware of the risk. That's a much
healthier place to be. As more capital flees emerging market debt where
volatility has exploded, we expect more inflows to the Eurozone periphery.
This is not an investment recommendation, as we don't think one is properly
compensated for the risks; but that's why we refer to such investors as yield
chasers - and there are lots of them.
In a nutshell, don't expect tapering to rock the world. Far more import
will be the vision articulated by Bernanke's successor. Please register to join us for our
upcoming Webinar, "What's
Next for the Dollar? #Taper" to continue the discussion on the
fallout for the U.S. dollar and currencies of Fed policy. Also make sure you subscribe to
our newsletter so you know when the next Merk Insight becomes available.
This report was prepared by Merk
Investments LLC,and reflects the current opinion of the authors. It is
based upon sources and data believed to be accurate and reliable. Merk
Investments LLC makes no representation regarding the advisability of
investing in the products herein. Opinions and forward-looking statements
expressed are subject to change without notice. This information does not
constitute investment advice and is not intended as an endorsement of any
specific investment. The information contained herein is general in nature
and is provided solely for educational and informational purposes. The
information provided does not constitute legal, financial or tax advice. You
should obtain advice specific to your circumstances from your own legal,
financial and tax advisors. As with any investment, past performance is no
guarantee of future performance.
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