Tuesday, July 15, 2014

The Tale of Seven Banks

There once were seven central banks (that I follow), that each had an economy and an actively traded currency, and all was well in the world. Fast forward through a global financial crisis to today and the world economy is recovering, being led by the US.

The US economy being shepherded by the Federal Reserve, is doing OK. Growth is slow but steady, and inflation, as monitored by the Fed, is trending below its long-term averages. Both the previous Fed Chair Bernanke, and the current Fed Chair [and Bernanke disciple], Janet Yellen, have stated that the Fed will be willing to accept inflation above its long-term trend as long as employment and GDP lag behind.

The Bank of Canada is dancing to a similar tune, as wages and other drivers of core price inflation in Canada remain stymied. The same can be said for the Bank of England, and the Bank of Japan where again inflation targets are quantified by the central banks and reflected in their monetary policies . Wages in the US are not increasing because of slack in the labor markets, but that problem is slowly fixing itself. In the United Kingdom, wages are not increasing for a similar reason, but, they are however, dealing with real estate prices that are growing faster than incomes (especially in London) being driven by foreign buyers. The Bank of Japan is in the process of undoing almost 20 years of economic stagnation, and price deflation. Prices, wages, and interest rates have been falling since the early 1990s, but now monetary and fiscal policy are both being aligned to support the intended shift in the macro-economy.

The remaining three banks are the Reserve Bank of Australia, the European Central Bank, and the Swiss National Bank. Each one with its own set of ‘personal’ problems to contend with. In Australia, the issue is the slowdown in Chinese growth in manufacturing, for which Australia exports the bulk of the raw materials it mines. The slowdown is rippling through the Australian labor market which happens to be heavily weighted in the [you guessed it] mining sector. On the European continent, Germany is starting to show signs of exhaustion as its customer -- the rest of Europe -- is not doing so well. The other major players including France, Italy, and Spain and some minor ones are focused on government bond yields while economic growth stagnates and prices fall. In Switzerland, where money goes to hide when there is risk afoot on the continent, the Swiss National Bank has to guard its economy against capital flight from the Euro area to their little haven.

Each of these banks has ended up in a unique position, stemming from global rebalancings due to half a decade plus of emergency monetary policy, but none more precarious than the Fed. Central Bankers around the world are taking their cues indirectly from the Fed; as Chinese domestic consumption is not yet able to replace the shortfall in US consumption. The rest of the world is waiting for someone to step up and buy. Europe needs time to find a new economic equilibrium, as debt and low productivity work their course, while the US, who is on a similar path just has a head-start and a more resilient economic base.

Central Bankers were able to co-ordinate monetary policy stimulus in response to the global financial crisis; but the panic was universal. The timing of the undoing is not so universal now that it’s safe to call an end to the crisis. The Banks must now normalize their policies and let the (somewhat) free markets get back to the tedious work of setting prices from wages, to interest rates, to gold, and real estate.

Tuesday, July 1, 2014

Summer 2014 Part 2

Bond investors have enjoyed the first part of a rollercoaster ride over the past five or six years. Anyone that has been holding onto a portfolio of bonds and other debt instruments that were issued “pre-crisis” have seen their portfolio benefit from interest rates around the world racing to the bottom.

As all good things must come to an end, so must the bull market for debt. Monetary cycles across the globe are normalizing, with the exception of the mainstays of the developed economies. But they too, as growth begets growth, will begin to normalize as well. Leading the way is the Federal Reserve with its hand firmly on the short end of the yield curve holding short term rates low. It is playing the role of buyer of last resort in the long end of the curve as well, to help stimulate the housing market by restraining mortgage and other long term borrowing rates. The Fed has begun consistently tapering its long maturity debt buying and will soon give up its active influence over long term interest rates. At which point, I think it’s safe to assume long term interest rates will start drifting higher.

The next step in the normalization process, would be to raise short term rates. If the Fed lets the long end of the yield curve drift higher and continue to hold short term rates this low, the market might start pricing in higher inflation expectations. If this happens, and the Fed does actually need this to happen, they can raise short term rates to stem price inflation.

As this plays out, bond portfolios will see price depreciation as the securities are re-priced to match the rising interest rates or inflation expectation.

Best course of action for a bond investor sitting on a portfolio of securities that have appreciated; take profits. Starting with the longest maturity securities and work your way backwards. There really isn’t much in the way of hedging the interest rate risk that the average debt portfolio faces from this point going into the next five years. But, since the Fed should not be under any undue pressure to raise short term interest rates until the summer of 2016, the short end of the yield curve (3 – 6 month maturities) would be a safe place to shelter the fallout from the monetary normalization cycle that is in a nascent stage in the US, and a growing list of economies around the world.