Central banks and the next bubble (2)
In the previous bubble blog earlier in the week I wrote that G4 central bank balance sheets are expanding to a whopping 26% of GDP.
In what Nomura’s Bob Janjuah called “Monetary Anarchy”, some analysts worry that central bank liquidity expansion is a timebomb which if/when it explodes would have very negative consequences.
Swiss private bank Lombard Odier, weighing in on the debate, warns that not only has the quality of central bank balance sheets deteriorated, there has been no visible impact on the real economy.
Stephanie Kretz, member of the investment strategy team for private banking at Lombard Odier, points out that a sharp fall in the money multiplier, defined as the ratio of broad money (M3) to the monetary base, means the impact on the real economy has been almost non-existent.
What about the real economy? Ballooning and riskier central bank balance sheets will not generate sustainable growth or reduce unemployment and debt levels, but could well induce at a later stage unintended consequences that include bouts of hyper-inflation, loss of trust in fiat money and loss of central banks’ credibility as to their capacity to maintain strong currencies and stable prices.
The huge increase in the monetary base has not flowed into the real economy, and is sitting in the excess reserves of still reluctant-to-lend banks whilst the world is deleveraging, thus capping the demand for credit.
What happens when a recovery eventually kicks in, interest rates go up, the velocity of circulation of money comes back and real economy is flooded with paper currency that does not correspond to real human production? Monetary base expansion will need to be reversed in large, non-incremental steps if it is to be non-inflationary. This is uncharted territory for central banks and poses significant longer-term policy risks.
Central banks and the next bubble
Central bank balance sheets are expanding at what some say is an alarming pace. Can this cause the next bubble to form and burst?
JP Morgan estimates G4 (U.S., Japan, euro zone and Britain) balance sheets are now around 24% of GDP combined, with around 11% of GDP comprising bonds held for monetary purposes.
“The recent pace of balance sheet expansion is the fastest since the immediate aftermath of Lehman, largely down to the ECB. The increased BOJ purchases, more QE in the UK, and 200 bln euros upwards of increased ECB lending from this month’s LTRO together point to a further $600bln+ rise in G4 central bank balance sheets this year, to around 26% of GDP.”
Outside G4, Switzerland is a country which saw a massive expansion in its central bank balance sheet. And because of its huge holdings, its balance sheet has been very volatile.
The Swiss National Bank suffered a loss of 21 bln francs last year — its biggest ever — due to currency interventions to weaker the Swiss currency. It expects to swing back to a profit of 13 bln francs this year.
Its acting chairman Thomas Jordan himself admitted: “Our profits have been and will be very volatile … because our balance sheet is four to five times as big as it was five years ago.”
from The Great Debate UK:
Is a bubble burbling in financial markets?
-Jane Foley is research director at Forex.com. The opinions expressed are her own.-
The discrediting of the efficient markets theory in the aftermath of the financial crisis appears to have been accompanied with growing support for the view that rather than efficient in nature, financial markets are predisposed towards the formation of bubbles.
A bubble can simply be defined as an occurrence that begins when the price of an asset has been driven significantly above it "fair" value. According to the efficient markets theory this would not happen.
If bubbles are a natural outcome of financial market activity it is relevant to ask whether the very loose fiscal and monetary policies of many central banks and governments are presently sowing the seeds of the next bubble.
Even though the real economies of the U.S., UK, Eurozone and Japan continue to be defined by expectations of rising unemployment and falling real wages, access to cheap money has already helped restore the profitability of many investment banks.
In turn, this has fed risk appetite which is evident in the rally in stocks since the spring, increased demand for "risky" currencies and a recovery in commodities prices. Brent oil has rallied by 128 percent from its 2009 low. The ability of oil to rally despite the existence of oil supplies well above the seasonal average suggests there is already speculative element in this market which could be in danger of driving prices above their fair value.
This week’s meetings of the Federal Reserve, the Bank of England and the European Central Bank have focussed attention not so much on rates, but on the extraordinary policy decisions taken by these central banks in the wake of the financial crisis and whether conditions are ripening in favour of a gradual withdrawal of some of these policies.
Jane, since you assert that the demand for crude was flat while the price was rising, a plausible explanation would be that the whole production curve has been elevated to compensate the loss in US$ value. I think that conditions for spotting a bubble formation stages should be investigated in correlation with the level of affordability for the end consumer. The housing bubble was predicted 2 years in advance, based on this kind of approach.
However, in repeated statements, Middle East suppliers were not shy spelling out that their comfort zone prices were between US$75 and US$80 when the barrel was hovering around US$60. In very short time, prices on the market have been elevated to a plateau of US$80, with no apparent changes in observable factors concurring in price formation. Therefore, what is the mechanism of translating a statement of desire into effective pricing in a market deemed free?
Know when to hold ‘em
If you had bought emerging market stocks exactly at the top of the bubble and sold them exactly at the bottom of the crash, you would have suffered a lot of pain (and probably shouldn’t be in the investment business in the first place). The loss would have been 67 percent of your principal.
Most people won’t have lost that much, of course, depending on when they bought and sold. But even if an investor did buy exactly at the top, as long as they held on their losses by now would have been pared back considerably.
The graphic above, created by Scott Barber, shows how much of the crash has been clawed back. The full column represents the maximum loss; the green shows the amount recovered. In points terms, 50 percent of the emerging markets crash losses have been recouped.
Other markets have not fared as well. How did you do?
EBRD to puzzle over E.Europe crisis
Ministers and bankers meeting at the European Bank for Reconstruction and Development‘s annual gathering in London tomorrow and Saturday have a sorry mess to scrutinise.
By the bank’s own (revised) forecasts, its region of central and eastern Europe will contract by over 5 percent this year. Many countries in eastern Europe took too much advantage of western banks’ lending spree, and businesses and households are struggling to pay back foreign currency loans.
Falling commodity prices have hit countries like Russia and Kazakhstan, and a burst consumer credit bubble is risking double-digit contraction in the Baltic states and Ukraine.
The bank’s 61 country members together with the European Union and its development bank the European Investment Bank will be discussing how to cope with the crisis and manage any recovery.
They will be looking at whether to continue giving help to several EU member countries which were due to stop receiving EBRD funds next year. Some countries may also be asking for an increase in the EBRD’s capital from its current 20 billion euros, to cope with the crisis.
The EBRD operates in 30 countries, mainly in the former communist bloc, and most recently Turkey. Those countries may be wondering if the bank could have done more to help them through the crisis, and seek more help now.
The EBRD is probably doing all that it can, but with almost 30 countries in distress it sees the bottom of its financial resources.
No black tulip bulbs, no black swans
The world has experienced many crises in the past.
In 1636, during the Dutch Tulip Bulb Bubble, the quest for a perfect black bulb had inflated the price of a black bulb by many hundreds. In a different crisis in 1866, a London wholesale bank Overend, Gurney & Co collapsed with a massive debt, after expanding its investment portfolio beyond its means.
What is common in these events and the present crisis is that investors borrowed and levered themselves, and the eventual bubble burst prompted massive deleveraging and contagion, according to Julian Chillingworth, chief investment officer at London-based asset management firm Rathbones (established in 1742 – 22 years after the South Sea Bubble).
“It’s greed, it’s fear and it’s leverage,” Chillingworth told a group of journalists at a breakfast briefing. He says all the risky and highly leveraged assets were dressed up with “pseudo finance” and the likelihood of contagion and volatility was characterised as a “black swan” event – originally a metaphor for something that could not exist.
But black swans do exist. Just as people in the 17th century reached Australia and found black swans, investors have learned the hard lesson this time.
To all mathematicians save one currently popular one, the phrase “black swan” has always meant the exact opposite of what it now means in the press.
A black swan was a idle curiosity: something had no reason not to exist, and whose nonexistence could only be proved by exhaustive enumeration; conversely, the discovery that such did creatures did exist would not require any rule books to be thrown out, and would only appear to be a major scientific discovery to non-scientists.
I believe the “black swan problem” is discussed in Russell’s Principia.
The Wrong Lesson
Investors learned the wrong lesson from the dotcom bubble, and ended up blowing another.
That’s the view put forward at the CFA Institute’s conference in Amsterdam by Ben Inker, head of asset allocation at GMO. He believes investors became so enamoured of diversification – which seemed to work like a charm for the large US university endowment schemes – that they ran headlong into risk asset classes and blew a giant risk bubble.
Inker argues that because investors rushed into risk asset classes indiscriminately, they ended up paying for the privilege of taking risk.
Are you revolted yet?
Financial markets might be in distress and stocks are falling through the floor, but according to James Montier, global strategist at Societe Generale, we are not in the final stage of bubble burst yet. For one thing, the Financial Times is still too big. At a fund managers conference in London today, Montier — a renowned bear — noted a thesis by economists Hyman Minsky and Charles Kindleberger that bubbles go through five stages — displacement, credit creation, euphoria, critical stage/financial distress and revulsion.
Currently, he says, financial markets are going through the critical/distress stage but we are not in revulsion yet.
“In revulsion, the Financial Times will be three pages long and we will all be ashamed to be working in finance. Stocks will be unambiguously cheap,” he told a group of financial professionals.
I am in revolted at the way the Federal Government is hiding the truth from us.
The truth is, the “elite” around the world, want to make major changes.
The major change that they want in the United States, is to change our currency! The dollar is in decline, and by early next year will be worth nothing. Then they will introduce the “Amero,” where you might get two cents (IF you get that) on the dollar.
When the public comes to this realization, that their savings isn’t worth anything by the value of the American dollar, they will start “dumping it like crazy.”
Of course, they also want to have Canada and Mexico a part of the United States. No more boarders, and we will all have the same currency!
Brilliant idea of Bush Senior.
