22-06-2013, 09:33 AM
[attachment=521]
THE MEN TANKING THE MARKET
Andrew Cornell, Angus Grigg and Ben Potter
2366 words
22 Jun 2013
The Australian Financial Review
AFNR
English
Copyright 2013. Fairfax Media Management Pty Limited.
As central bankers try to engineer a safe landing they are scaring investors silly, write Andrew Cornell, Angus Grigg and Ben Potter.
Credit analyst Sean Keane's Thursday note was unambiguously positive: "The strained timbre of Fed chairman Bernanke's voice yesterday was that of a man delivering an important policy announcement, and of being very aware of the magnitude of the words he was speaking," he wrote.
"It seems likely that June 19, 2013 will go down in the history books as the date on which the Federal Reserve effectively declared victory in its fight against deflation and systemic financial collapse. From this point on the Fed's challenge has been formally redefined from being one of propping up the financial system, to one of returning to the status quo ante."
The crisis is dead. Unless you've watched the markets since – long live the crisis!
The collapse of equity markets, the Australian dollar, bond values and credit conditions doesn't look like the dawning of a long awaited morning after but the long, dark night of 2008. ANZ's advice to market clients was "the recent volatility in global markets has an air of crisis about it".
Three men are responsible for this new, acute phase of anxiety: one is Ben Bernanke, the man who speaks for world's largest economy. A second is Japanese Prime Minister Shinzo Abe, who speaks for the third largest. The third, though, is someone few would recognise: Zhou Ziaochuan, governor of the People's Bank of China, the central bank of the world's second largest but arguably most influential economy.
That this week has seen such volatility and wealth destruction is not because the three in unison are pessimistic but that their message is so different. As Keane of Triple T consulting in his widely read note for Credit Suisse identifies, Bernanke was positive. The US is on the path to recovery. The Fed will watch the data but if all goes as planned, the emergency money printing of QE3 will be slowly withdrawn.
James Gorman, the Australian-born head of one of the world's most powerful banks, Morgan Stanley, told The Australian Financial Review this week "These are important issues for the market but they are manageable challenges.
"But the bigger picture is what we see in the US economy and I think the US economy is actually much healthier, growing faster, in much better shape than people think."
Japan is a different matter. Abe sparked a massive rally in equities and debt not just in Japan but globally with his "three arrows" policy of fiscal, monetary and structural stimulus to pull Japan out of two decades of deflation and economic decline.
Arrows one and two hit their mark but the third, the crucial element of structural reform, flopped not far from the bow. As Andrew Smithers of Smithers & Co, probably the most widely respected Japan watcher in the world, said in a report this week Abenomics – the Gap between Rhetoric and Reality, "Abenomics is based on four key assumptions: that Japan's sub-optimal growth has been caused by deflation. That weak domestic demand is cyclical rather than structural. That the yen needs to be weak. That 'reform' is needed. Assumptions one and two are nonsense, three is totally correct and with four the required reforms are so completely misunderstood they are unlikely to be introduced."
Then there was China. While Bernanke's market-shaking pronouncements will be modulated against actual data as it emerges and Japan's history of failed reform meant its conniption was no great shock, the problem with China is darker. Shadowy in fact.
Zhou moved markets not by his words but a high-risk lack of action. As short term interest rates spiked to a seven year high on Thursday, Zhou remained largely idle. Rather than inject more money into the system he allowed markets to sweat.
Without saying a word, the 65-year-old Zhou abruptly changed China's policy direction. In letting the closely watched seven-day repurchase rate to hit 12 per cent – triple its average rate for the year - China's decade of easy credit came to an end. These three vastly different situations in the world's three major economies may not constitute a currency war or even a policy conflict but perhaps the best encapsulation is the ancient Kikuyu proverb "When elephants fight, it is the grass that suffers".
The pasture in Australia has been well and truly flattened, despite a well managed economy, recovering credit demand, low inflation and unemployment and negligible government debt.
As ANZ's market economics team noted on Friday "Markets need to price for reduced quantitative easing (QE) over the coming year. They also need to ascertain what is behind China's current interbank issues." They concluded "In the near term, volatility will remain high, and bonds and the AUD will remain under pressure".
Boiled down it translates as don't get killed in the rush for the entrance: "Given that the Fed will be gradual and deliberate in the removal of QE3 we see recent extreme market moves as transitory. That said, market volatility is likely to remain elevated for some time and could expose weaknesses in the global financial system."
The first inkling the Fed might be contemplating easing up on the QE3 gas pedal came with the release of policy meeting minutes on February 20. The meeting statement confirmed the $US85 billion pace of QE3, and after a blip stocks rose steadily until February 19. But the minutes revealed there was a higher level of dissent on the 19-member Fed Open Market Committee than previously thought.
The dissenters fretted the bond buying program – which aimed to lower long term interest rates paid by homebuyers and business – risked distorting financial markets, encouraging excessive risk taking and complicating an eventual exit. US stocks promptly lost 2 per cent in two days.
That sell-off was just a foretaste. It showed that no matter how carefully the Fed stressed that any exit from QE3 would be dependent on a substantial improvement in the labour market, even a hint of withdrawal sparked a stampede to the exits.
Fear of a Fed withdrawal duelled with a rising tide of optimism about the US economy. New jobs were being created at a brisk clip, unemployment was falling, and the economy grew at an improved pace of 2.4 per cent in the March quarter, in spite of federal tax hikes and spending cuts. As Morgan Stanley's Gorman told the AFR "I see three factors. One, the individual consumer has de-leveraged, so the consumer engine is primed. Two, the housing market is no longer unstable, it is recovering, unquestionably, and that means every dollar going in is a dollar of equity. Three, and maybe most importantly, the US has population growth."
He added a fourth, very significant, element, the shale gas-driven structural change in the US energy industry which was transforming the US. "When you think about the US corporate sector, it is the most successful, the most innovative in the world," Gorman said. "So in the short term, are there anxieties? Sure. The market will be buffeted but in the long term, tapering is a sign of recovery."
The minutes of the Fed March 19-20 meeting showed more evidence that some Fed members were agitating for an earlier withdrawal of QE than the majority controlled official statements seemed to suggest. A 3 per cent retreat ensued.
But then the animal spirits took over again. Investors were impressed that the economy was continuing to grow despite the headwinds from Washington and Europe. When those headwinds dissipated later in the year, they reasoned, the economy would reach a self-sustaining rate of growth. The benchmark S&P500 index hit a record close of 1669.16 on May 21.
The following morning Bernanke delivered his now infamous testimony to Congress, in which he said the Fed could begin to curtail – or 'taper' – the monthly rate of bond purchases "in the next few meetings" – if the substantial improvement in the labour market stipulated by the Fed at the outset of QE3 eventuated.
Bernanke might as well not have added the proviso, for all investors heard. The remarks sparked a month of turbulence in global financial markets, and brought the bond rally to an end.
Had Bernanke blundered? This week he had the opportunity to clarify. Investors hoped for reassurance. Bernanke gave them more clarity. The Fed would likely begin to wind back QE3 later this year, reducing the monthly rate of purchases in measure steps, winding up entirely by mid-2014, by which time Fed members expected unemployment to be about 7 per cent.
Again, he stressed this was all dependent on the economy hitting Fed targets, which struck some as overoptimistic. Again, he may as well have saved his breath. Stocks plunged nearly 4 per cent in two days, erasing nearly two months gains, and 10 year Treasury bond yields jumped to 2.42 per cent, a level not seen since 2011. Oil and gold fell, and most currencies slid against the US dollar.
The prospect of a QE3 withdrawal clearly has investors worried. But are they overreacting to an event they must have known had to come? If you believe the Fed's economic forecasts, the answer is yes. The spike in bond yields, though uncomfortably rapid, could be a healthy response to improving prospects for more robust growth next year, Bernanke argued .
Yet further sharp increases in bond yields "would likely encourage the Fed to delay tapering", High Frequency Economics economist Jim O'Sullivan said. Others think the Fed is skipping too lightly over this year's mid-year slowdown and weak inflation to focus on next year's better prospects. Such hopes have been dashed repeatedly in the limp post-crisis recovery.
Employment is still a long way from acceptable, Nobel-prize-winning economist Paul Krugman argued that the Fed risked snatching the bowl away before the party had started. He fears the Fed has done "more damage than it realised".
Yet for many observers the answer amounted to 'Well, what did you expect?' Or, as closely watched market blog The Big Picture put it succinctly: "Really?!? With Ben and Janet [Yellen, Fed deputy]".
"And this entire Risk On rally — did you really think it was going to last forever? Really? US Equity are up nearly 150 per cent over the past 5 years, didn't you think it had to eventually slow down? Did you actually believe Markets were a uni-directional bet? Really?!? The Fed has a dual mandate – stable prices and maximum employment. Did you really think there was a third component of maximising your risk-free equity returns? Really!?" China is far more opaque. And particularly as Australia's largest trading partner, far more unpredictable and unnerving. Many have called for China to curtail a credit binge, one largely mediated through its "shadow" banking system, considered dangerously similar to the Western world's risk-for-free liquidity bubble prior to 2008. But nobody thought the execution would be so crude.
This credit crunch is like making a junkie go cold turkey. And make no mistake China is addicted to credit. Total social financing – the broadest measure of credit – is on track to hit 200 per cent of GDP by the end of this quarter, from 130 per cent in 2008. The rate of increase has been faster than Japan in the 1990s and the US prior to its sub-prime crisis.
But the PBOC's abrupt action has put significant strain on an already brittle financial system.
"By allowing rates to remain high for so long, the PBOC is sending a message that market participants should not take for granted that they will always have access to cheap interbank loans," says Mark Williams, economist for Capital Economics. "The bigger picture is that credit continues to grow at an unsustainable pace."
This is the real target of the China's new economic leadership, led by Prime Minister Li Keqiang. Li, who has a PhD in economics from Peking University, took the unusual step of retaining Zhou as Central Bank governor, even though he had reached the mandatory retirement age.
Now the pair are running a live experiment on the Chinese economy – the central bank is not independent. This first credit crunch is likely to be followed by a wind back of total lending.
"The PBOC seems to have intentionally withheld liquidity in the past two weeks to try to rein in credit growth," says Wang Tao, China economist for UBS. She expects money market rates to stay "elevated" and credit growth to slow. "We also think there is an increased risk of an unintended liquidity crunch as some of the complex off-balance sheet activities unwind."
That narrative remains intact despite the fact that short term interest rates eased back on Friday amid reports the central bank had selectively intervened to provide liquidity.
None of these stories are good for Australia. While disappointment is not unexpected with Japan, it remains Australia's second largest trading partner. A US recovery is clearly good – except that QE funding was also pouring into Australian markets.
But China . . . Not only is there an increased risk of a so called Black Swan event within China's financial markets, but the new policy is also about lower growth.
In trying to gradually deflate China's credit bubble the new leadership is signalling a willingness to accept a slower economic growth rate.
This will surely lead to lower iron ore prices and more falls in the seaborne coal market, which is already struggling as China begins to address its chronic environmental issues. On a more positive note, China's change of direction is really about reform. That means there should more access to the tightly controlled financial services sector and potential opening up of areas like health, transport and energy to private capital.
Green shoots – but for the moment the elephants are still stomping around.
Fairfax Media Management Pty Limited
Document AFNR000020130621e96m0001t
THE MEN TANKING THE MARKET
Andrew Cornell, Angus Grigg and Ben Potter
2366 words
22 Jun 2013
The Australian Financial Review
AFNR
English
Copyright 2013. Fairfax Media Management Pty Limited.
As central bankers try to engineer a safe landing they are scaring investors silly, write Andrew Cornell, Angus Grigg and Ben Potter.
Credit analyst Sean Keane's Thursday note was unambiguously positive: "The strained timbre of Fed chairman Bernanke's voice yesterday was that of a man delivering an important policy announcement, and of being very aware of the magnitude of the words he was speaking," he wrote.
"It seems likely that June 19, 2013 will go down in the history books as the date on which the Federal Reserve effectively declared victory in its fight against deflation and systemic financial collapse. From this point on the Fed's challenge has been formally redefined from being one of propping up the financial system, to one of returning to the status quo ante."
The crisis is dead. Unless you've watched the markets since – long live the crisis!
The collapse of equity markets, the Australian dollar, bond values and credit conditions doesn't look like the dawning of a long awaited morning after but the long, dark night of 2008. ANZ's advice to market clients was "the recent volatility in global markets has an air of crisis about it".
Three men are responsible for this new, acute phase of anxiety: one is Ben Bernanke, the man who speaks for world's largest economy. A second is Japanese Prime Minister Shinzo Abe, who speaks for the third largest. The third, though, is someone few would recognise: Zhou Ziaochuan, governor of the People's Bank of China, the central bank of the world's second largest but arguably most influential economy.
That this week has seen such volatility and wealth destruction is not because the three in unison are pessimistic but that their message is so different. As Keane of Triple T consulting in his widely read note for Credit Suisse identifies, Bernanke was positive. The US is on the path to recovery. The Fed will watch the data but if all goes as planned, the emergency money printing of QE3 will be slowly withdrawn.
James Gorman, the Australian-born head of one of the world's most powerful banks, Morgan Stanley, told The Australian Financial Review this week "These are important issues for the market but they are manageable challenges.
"But the bigger picture is what we see in the US economy and I think the US economy is actually much healthier, growing faster, in much better shape than people think."
Japan is a different matter. Abe sparked a massive rally in equities and debt not just in Japan but globally with his "three arrows" policy of fiscal, monetary and structural stimulus to pull Japan out of two decades of deflation and economic decline.
Arrows one and two hit their mark but the third, the crucial element of structural reform, flopped not far from the bow. As Andrew Smithers of Smithers & Co, probably the most widely respected Japan watcher in the world, said in a report this week Abenomics – the Gap between Rhetoric and Reality, "Abenomics is based on four key assumptions: that Japan's sub-optimal growth has been caused by deflation. That weak domestic demand is cyclical rather than structural. That the yen needs to be weak. That 'reform' is needed. Assumptions one and two are nonsense, three is totally correct and with four the required reforms are so completely misunderstood they are unlikely to be introduced."
Then there was China. While Bernanke's market-shaking pronouncements will be modulated against actual data as it emerges and Japan's history of failed reform meant its conniption was no great shock, the problem with China is darker. Shadowy in fact.
Zhou moved markets not by his words but a high-risk lack of action. As short term interest rates spiked to a seven year high on Thursday, Zhou remained largely idle. Rather than inject more money into the system he allowed markets to sweat.
Without saying a word, the 65-year-old Zhou abruptly changed China's policy direction. In letting the closely watched seven-day repurchase rate to hit 12 per cent – triple its average rate for the year - China's decade of easy credit came to an end. These three vastly different situations in the world's three major economies may not constitute a currency war or even a policy conflict but perhaps the best encapsulation is the ancient Kikuyu proverb "When elephants fight, it is the grass that suffers".
The pasture in Australia has been well and truly flattened, despite a well managed economy, recovering credit demand, low inflation and unemployment and negligible government debt.
As ANZ's market economics team noted on Friday "Markets need to price for reduced quantitative easing (QE) over the coming year. They also need to ascertain what is behind China's current interbank issues." They concluded "In the near term, volatility will remain high, and bonds and the AUD will remain under pressure".
Boiled down it translates as don't get killed in the rush for the entrance: "Given that the Fed will be gradual and deliberate in the removal of QE3 we see recent extreme market moves as transitory. That said, market volatility is likely to remain elevated for some time and could expose weaknesses in the global financial system."
The first inkling the Fed might be contemplating easing up on the QE3 gas pedal came with the release of policy meeting minutes on February 20. The meeting statement confirmed the $US85 billion pace of QE3, and after a blip stocks rose steadily until February 19. But the minutes revealed there was a higher level of dissent on the 19-member Fed Open Market Committee than previously thought.
The dissenters fretted the bond buying program – which aimed to lower long term interest rates paid by homebuyers and business – risked distorting financial markets, encouraging excessive risk taking and complicating an eventual exit. US stocks promptly lost 2 per cent in two days.
That sell-off was just a foretaste. It showed that no matter how carefully the Fed stressed that any exit from QE3 would be dependent on a substantial improvement in the labour market, even a hint of withdrawal sparked a stampede to the exits.
Fear of a Fed withdrawal duelled with a rising tide of optimism about the US economy. New jobs were being created at a brisk clip, unemployment was falling, and the economy grew at an improved pace of 2.4 per cent in the March quarter, in spite of federal tax hikes and spending cuts. As Morgan Stanley's Gorman told the AFR "I see three factors. One, the individual consumer has de-leveraged, so the consumer engine is primed. Two, the housing market is no longer unstable, it is recovering, unquestionably, and that means every dollar going in is a dollar of equity. Three, and maybe most importantly, the US has population growth."
He added a fourth, very significant, element, the shale gas-driven structural change in the US energy industry which was transforming the US. "When you think about the US corporate sector, it is the most successful, the most innovative in the world," Gorman said. "So in the short term, are there anxieties? Sure. The market will be buffeted but in the long term, tapering is a sign of recovery."
The minutes of the Fed March 19-20 meeting showed more evidence that some Fed members were agitating for an earlier withdrawal of QE than the majority controlled official statements seemed to suggest. A 3 per cent retreat ensued.
But then the animal spirits took over again. Investors were impressed that the economy was continuing to grow despite the headwinds from Washington and Europe. When those headwinds dissipated later in the year, they reasoned, the economy would reach a self-sustaining rate of growth. The benchmark S&P500 index hit a record close of 1669.16 on May 21.
The following morning Bernanke delivered his now infamous testimony to Congress, in which he said the Fed could begin to curtail – or 'taper' – the monthly rate of bond purchases "in the next few meetings" – if the substantial improvement in the labour market stipulated by the Fed at the outset of QE3 eventuated.
Bernanke might as well not have added the proviso, for all investors heard. The remarks sparked a month of turbulence in global financial markets, and brought the bond rally to an end.
Had Bernanke blundered? This week he had the opportunity to clarify. Investors hoped for reassurance. Bernanke gave them more clarity. The Fed would likely begin to wind back QE3 later this year, reducing the monthly rate of purchases in measure steps, winding up entirely by mid-2014, by which time Fed members expected unemployment to be about 7 per cent.
Again, he stressed this was all dependent on the economy hitting Fed targets, which struck some as overoptimistic. Again, he may as well have saved his breath. Stocks plunged nearly 4 per cent in two days, erasing nearly two months gains, and 10 year Treasury bond yields jumped to 2.42 per cent, a level not seen since 2011. Oil and gold fell, and most currencies slid against the US dollar.
The prospect of a QE3 withdrawal clearly has investors worried. But are they overreacting to an event they must have known had to come? If you believe the Fed's economic forecasts, the answer is yes. The spike in bond yields, though uncomfortably rapid, could be a healthy response to improving prospects for more robust growth next year, Bernanke argued .
Yet further sharp increases in bond yields "would likely encourage the Fed to delay tapering", High Frequency Economics economist Jim O'Sullivan said. Others think the Fed is skipping too lightly over this year's mid-year slowdown and weak inflation to focus on next year's better prospects. Such hopes have been dashed repeatedly in the limp post-crisis recovery.
Employment is still a long way from acceptable, Nobel-prize-winning economist Paul Krugman argued that the Fed risked snatching the bowl away before the party had started. He fears the Fed has done "more damage than it realised".
Yet for many observers the answer amounted to 'Well, what did you expect?' Or, as closely watched market blog The Big Picture put it succinctly: "Really?!? With Ben and Janet [Yellen, Fed deputy]".
"And this entire Risk On rally — did you really think it was going to last forever? Really? US Equity are up nearly 150 per cent over the past 5 years, didn't you think it had to eventually slow down? Did you actually believe Markets were a uni-directional bet? Really?!? The Fed has a dual mandate – stable prices and maximum employment. Did you really think there was a third component of maximising your risk-free equity returns? Really!?" China is far more opaque. And particularly as Australia's largest trading partner, far more unpredictable and unnerving. Many have called for China to curtail a credit binge, one largely mediated through its "shadow" banking system, considered dangerously similar to the Western world's risk-for-free liquidity bubble prior to 2008. But nobody thought the execution would be so crude.
This credit crunch is like making a junkie go cold turkey. And make no mistake China is addicted to credit. Total social financing – the broadest measure of credit – is on track to hit 200 per cent of GDP by the end of this quarter, from 130 per cent in 2008. The rate of increase has been faster than Japan in the 1990s and the US prior to its sub-prime crisis.
But the PBOC's abrupt action has put significant strain on an already brittle financial system.
"By allowing rates to remain high for so long, the PBOC is sending a message that market participants should not take for granted that they will always have access to cheap interbank loans," says Mark Williams, economist for Capital Economics. "The bigger picture is that credit continues to grow at an unsustainable pace."
This is the real target of the China's new economic leadership, led by Prime Minister Li Keqiang. Li, who has a PhD in economics from Peking University, took the unusual step of retaining Zhou as Central Bank governor, even though he had reached the mandatory retirement age.
Now the pair are running a live experiment on the Chinese economy – the central bank is not independent. This first credit crunch is likely to be followed by a wind back of total lending.
"The PBOC seems to have intentionally withheld liquidity in the past two weeks to try to rein in credit growth," says Wang Tao, China economist for UBS. She expects money market rates to stay "elevated" and credit growth to slow. "We also think there is an increased risk of an unintended liquidity crunch as some of the complex off-balance sheet activities unwind."
That narrative remains intact despite the fact that short term interest rates eased back on Friday amid reports the central bank had selectively intervened to provide liquidity.
None of these stories are good for Australia. While disappointment is not unexpected with Japan, it remains Australia's second largest trading partner. A US recovery is clearly good – except that QE funding was also pouring into Australian markets.
But China . . . Not only is there an increased risk of a so called Black Swan event within China's financial markets, but the new policy is also about lower growth.
In trying to gradually deflate China's credit bubble the new leadership is signalling a willingness to accept a slower economic growth rate.
This will surely lead to lower iron ore prices and more falls in the seaborne coal market, which is already struggling as China begins to address its chronic environmental issues. On a more positive note, China's change of direction is really about reform. That means there should more access to the tightly controlled financial services sector and potential opening up of areas like health, transport and energy to private capital.
Green shoots – but for the moment the elephants are still stomping around.
Fairfax Media Management Pty Limited
Document AFNR000020130621e96m0001t