Creative tension to linger for a long time

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By Cees Bruggemans, Chief Economist of FNB.

In America, President Obama proposed a $450bn fiscal boost. IMF Managing Director Lagarde suggested EU banks need urgent recapitalisation, with the ECB all for it. Some want Greece booted but the Merkozy Alliance don’t want it (creating too many instant banking problems and country contagion).

So where does this leave us?


It is breathtaking to see how little of Obama’s fiscal proposal is assumed to survive Congressional politicking in coming months. Dead on arrival, save for a few crumbs.

It is also disconcerting to note the deadening weight of US housing indebtedness, the high unemployment, the ongoing deleveraging, the limited credit growth, the low confidence, the limited hiring, the stagnation of it all.

This indigestion will take a long time working off.

It keeps the Fed as sole stability anchor, with some trade-assist from a still growing world (Eastern led).

Having shot its standard conventional bolt (interest rates to zero) and its main non-conventional bolt (tripling its balance sheet), the Fed is steadily working through its remaining options.

The main attempt is to reduce safe haven space, pushing investors into more risky areas, keeping the risk-taking alive, asset markets elevated, wealth effects positive (rather than negative) and business risk-taking and consumption elevated (rather than giving way).

So far it seems to be working, for the US economy keeps moving forward, income keeps being generated, the data doesn’t show fearful relapses, and double-dipping so far remains a minority view (one-in-three chance).

The Fed meanwhile is steadily going ever deeper into unconventional territory.

The latest mid-August salvo was the suggestion it keeps US interest rates unchanged near zero until mid-2013.

That actually had an impact, even if economic realities made it a blinding certainty even without the promise.

Next comes ‘twisting’.

This week the Fed is expected to start moving its balance sheet once again. But instead of expanding it yet more (now seen politically problematic as well as increasing eventual exit challenges), the trick is going to be to change its composition.

Through next year, as short-run Fed investments run off, it will be buying much longer 10-yr and 30-yr Treasury bonds, in the process dramatically lengthening maturity of its book (currently averaging still only about 3yr).

So what?

By buying 10-yr Treasury bonds, the Fed will be reducing its ‘safe haven’ availability for private investors. The still overwhelming demand will press down on yields (dipping below 2%). Disappointed safe haven seekers will need to direct their flows elsewhere, keeping asset markets elevated, and with it wealth effects, consumption and business risk-taking.

Torturous reasoning? Not really, for that is how modern economies with a financial centre work.

But is it enough?

Apparently not, for 2h2011 is clearly disappointing even the Fed, the Obama fiscal push may not get very far, and the searing unemployment keep lingering like a cancer.

Never mind the European neighbours (such nice, if willful people) episodically threatening to bring down their common roof and creating spillover contagion potential.

And thus the Fed is already exploring what next.

Apparently another communication attempt, for a little can go a long way, as they discovered in August.

So once this week’s balance sheet ‘twist’ has had its run, it may be time for another ‘announcement’, say in November, by then saying the Fed will keep rates unchanged near zero until US unemployment breaks below 7.5% (from 9% now).

That may not sound much like an ambitious objective, but given the snail’s growth pace of the moment, labour force growth of 100 000 monthly, the bigger fiscal restraint next year and the prevailing anxieties, it may in fact take a long time to get there, even well beyond 2013.

And once that message has had its run?

There is always QE3 (expanding the Fed balance sheet anew), but for that the times need to be direr and the politics more promising. Early days for now.


Over in Europe, politics is hamstringing a quick policy breakthrough. If it wasn’t for the ECB backstopping every sovereign and banking crisis you wonder where we would be travelling by now.

The latest game plan refuses to ditch Greece. It would be too costly in terms of causing sovereign contagion, especially infecting Italy and Spain and likely triggering banking stresses potentially contaminating France and even Germany.

French and German banks hold some €900bn of ‘peripheral’ EU debt, nearly equal to their own capital. Sovereign default and spillover contagion would amount to a kiss of death for everybody.

So rather not (yet).

Rather a vague distant playout than immediate catastrophe making Lehman look like a walk in the park.

But that doesn’t mean Greece is given a free lunch. Instead, it is fearfully bullied to do more. After a few heart-stopping Mexican standoffs it seems likely Greece will clear the next fiscal hurdle and get its next instalment of funding (keeping it out of market clutches) with default again averted for now.

Until December, that is, when the next Greek tranche will be needed. And thereafter every few months through 2014. If you think Wimbledon tiebreakers nail-biting, wait until this one is finished (and hope to have any epidermis left).

Meanwhile markets haven’t been sitting still, making their own sums about Greek non-sustainability, sovereign contagion potential and bank weakness this can activate.

As a consequence, counterparty trust has been fading rather fearfully, with many EU banks unable to service global clients needing Dollars as American Dollar providers play standoffish.

During the past week, the leading central banks activated their major Dollar swop lines, and could the ECB extent whatever Dollar liquidity required.

Meanwhile the focus has been intensifying on getting the weakest EU banks to recapitalise. IMF’s Lagarde is leading the charge in public, with the ECB working over EU politicians to leverage the EFSF lifeboat to take over its role as secondary market support keeping sovereigns afloat and start forced bank recapitalisation (some of this already agreed in principle last July).

But in Europe the democratic process works slowly. The lifeboat’s extended size and job description needs to be approved first by 17 Parliaments, something that may take till mid-October (if it doesn’t get derailed by willful parties along the way).

Until then, the EFSF lifeboat is a nice empty ornament (good only for limited Greek tranches) and is it up to the ECB to keep sovereign markets alive while propping up banks with unlimited liquidity.

In the process, the ECB itself is steadily getting thoroughly contaminated. There is good reason for the German exodus from its ranks.

This ECB contamination will in turn need to be addressed in time. But presumably it may prove easier to bail the ECB than southern sovereign neighbours, so this is the route of least political resistance for now.

Fearful austerity and societal challenges in many distressed EU countries, political realignments in many (core) others, gradual progress in budget governance and lifeboat flexibility, with banks probably next to face a process of forced recapitalisation (for growth prospects have now dimmed to such a degree that own future earnings may not do the job fast enough anymore).

And so Europe keeps stumbling forward while fearfully pummeled by market forces wanting cleaner and immediate solutions rather than this drawnout creative stuff.

But with an unwavering ECB at its centre (for how long?), Europe can keep this up for some time, politics-willing, even if accompanied by fearful market volatility.

Meanwhile, EU banks are grinding their credit extension to a standstill (as in the US if for different reasons), the mood is somber and anxious, business inclined to be more risk averse, with unemployment topping 10% and no hint of a reversal soon.

Core Europe is cyclically slowing down, while peripheral Europe is structurally sinking under its fiscal austerity and lack of growth engines.

More reform and fearful political shifts are needed, with the ECB keeping markets on board. The alternative for many is too awful to contemplate.

One regularly now sees the comment that more crises are needed to get the wanted breakthroughs. The worst may still lie ahead.

Besides its steadily expanding non-conventional policy (buying peripheral sovereign debt and supporting EU bank liquidity to whatever degree needed), the ECB will likely shortly change direction on interest rates.

As in 2008, after initially raising them, the ECB has now scope of 1.5% to lower them. It may not go as far as the Fed, BoJ, BoE or SNB (heaven forbid), but one can see the potential.

And thus the money ‘guardians’ seem to be keeping the world afloat as it munches through its extreme post-crash indigestion.


It is a condition that should remain precious metal-friendly (would that be an understatement?), while asset portfolios will likely keep shifting in composition, between bonds and equity, and between rich stagnating countries and still fast growing emerging countries and commodity producers.

Despite volatile risk appetites (the one moment on, the next off), the drift of events remain Rand positive.

The Western growth struggles favour lower commodity prices, but the monetary responsiveness favours elevated commodity prices, reinforced by Eastern-led growth.

It also has inflation implications for us towards mid-decade, so far as yet perhaps not fully comprehended.

Despite remaining fearful of sudden capital flow reversals (and Rand collapses and inflation shocks) during anxious global crisis episodes, our main prospect remains hot capital inflows and commodity price surges keeping our asset markets supported and even elevated.

Yet it may do little for our growth performance, except to the extent that rich commodity windfalls boost our national income growth and the overheated commodity and capital flow condition keep the Rand elevated, inflation target-bound and interest rates low.

And yet even with these ‘advantages’ (which some term a ‘curse’), we find our domestic inability to reform our supply side performance debilitating.

Slow growth of 3%-3.5% is likely to remain the immediate prospect, with modest employment gains mainly limited to the public sector.

Inflation should mostly remain target bound, interest rates low, corporate earnings growth steady, asset markets reasonably supported, underlying valuations steadily improving.

We also are building a basis for an eventual post-crisis breakout. But as in so many underperforming developed countries it may take a long time coming as we need to reform first.

That will take time.

Source: Cees Bruggemans, FNB, September 18, 2011.

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