Thoughts through the cycle: W2 June ’20

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  • With ‘WFH’ the new acronym of choice to describe pandemic working arrangements, everything is a little different. It can’t have been easy for Fed Chairman, Jay Powell, to command the room at the 10th June FOMC press conference via a Zoom-style remote link-up. He has a nervous tick which means he coughs when he is struggling. The market sensed the strain. This was another instance of ‘buy the statement, sell the presser’ as US equities faded and long-end bonds rallied during the Q&A session.
  • Central banks have carried the day so far during the crisis, and the performance of the top dog at the post rate-decision press conference is a key determinant for market confidence. The ECB’s Christine Lagarde has taken to reading from notes with ‘no improv’, tetchily repeating the entry from her script for ‘what to say if asked about the German Constitutional Court’ when asked the same question at the June 4th meeting in two different ways. A moment of levity almost arose when a German journalist asked whether Lagarde’s reading from a script was an example of her imposing her style on proceedings.
  • At the FOMC press conference on 10th June, Powell talked nostalgically about how unemployment had been so low before the Covid-19 crisis in the sort of way Adam might have wistfully remembered the garden of Eden before the Fall. To do him justice, Powell was forthright about how the US jobless claims data from the 5th June may have been nearer 16% rather than the 13.3% headline figure presented by the Bureau of Labour Statistics and lionised by President Trump. He also clearly expressed how other measures of unemployment, notably U-3 and U-6, may well mean that the real number of people who need to find work is in the region of 24m. This is a huge figure, and the overwhelming feeling has to be that Powell could no longer disguise the enormity of this task, if indeed that was what he was trying to do.
  • Even with Treasury bond and bill issuance set to rise and with no increase in Fed quantitative easing (QE), bond yields fell sharply as Powell spoke. The graph below show US 5y5y inflation (5yr inflation in 5yrs time). This very much looks to be rolling over. Earlier in the day, US CPI inflation for May came in at 1.2% (vs. 1.3% est. and 1.4% prior). Any inflation in the economy appears at present only to be coming from food prices. Worryingly, core inflation is falling.

Source: Bloomberg, 11th June 2020

  • The Fed is done for now, with QE likely to continue at current rates ($4b per day) for the foreseeable future. Yield-curve control (YCC) was discussed but not acted upon – this seems to be a tool still in the tool-box for now. There was also a hint that more lifting needed to be done through fiscal policy, hence by Congress. Powell awkwardly dodged two questions about frothy stock prices – one senses that he knows there is a bubble. By having to resort to QE rather than rate cuts, Powell has been trapped by the pavlovian response of markets (QE = rip stocks up) meaning that the usual beneficial effect of lower rates isn’t reaching main street, thus a higher rate of QE now would only stoke the bubble further while not helping the real economy at all.
  • The global economic recovery is increasingly looking like a long-haul job. The ECB has revised its projections for Euro area GDP to a fall of 8.7% in 2020 and a rise of 5.2% in 2021 and 3.3% in 2022. Perhaps by 2023, GDP will return to 2019 levels. This would mean countries such as Italy carrying a debt to GDP in excess of 160%, levels which generally severely retard growth of any sort. The severe effect of the lockdown is starting to be revealed – Italy’s industrial production for April was down 42.5% YoY. Auto registrations for May are at 49.61% of prior-year levels, higher than April’s almost inconceivable -97.55% print.
  • There is now a political problem in all countries – the lockdown rightly necessitated governments to step in and provide furloughed workers with money in lieu of wages given the nature of the pandemic and the measures needed to halt its spread. Furloughs have end-dates, and end-dates mean cliffs. The date for the US is currently the end of July. The UK furlough tapers in August then ends in October. Already UK firms are saying they are going to struggle to top-up workers’ wages by the required 20% during the transition period. A sudden increase in unemployment is a political shock which few governments can survive, especially if it is the government’s own decision to actualise the increase by ending the furlough.
  • Unfortunately for many, furlough means a sort of Schrodinger’s cat situation where one can seem both employed and potentially unemployed at the same time. Not only does this put an intolerable strain on individuals in that unfortunate position, but it also means that the extent of overall economic damage cannot be assessed in a meaningful way. This may in part be why the stock market has reacted in the way it has during April and May.
  • In reality, it is politically and probably socially unacceptable to engineer a sudden stop to an economy by ending furloughs ‘just like that’. This reveals the true dilemma for governments across the world, and also therefore for bond markets and capital markets in general. France will serve as an example for this. In an article in the Financial Times, France’s labour minister, Muriel Penicaud, described how the problem would be dealt with (‘France to extend crisis jobs scheme for up to two years’, FT, 08/06/2020):

“We are going to put in place a long-term partial-activity scheme… through which employees could have fewer working hours and be partly supported by the state. [The scheme]  is likely to last a year or two”

  • The scheme is modelled on Germany’s ‘Kurzarbeit’ system which was extremely effective during the global financial crisis as it meant workers stayed in work, keeping their skills (as well as avoiding the psychologically-onerous burden of full unemployment). The current French scheme is operating at 84-100% of net wages for the lower paid. This is not a question of workers being lazy and not wanting to go back because benefits are too ‘cushy’. Many people have genuine fears about the Covid-19 virus, and the event of lockdown has magnified these concerns. The problem comes inevitably from how you pay for it all.
  • In mid-May, the French government said it would likely be running at 2020 deficit of 9% of GDP. The 3%-limit imposed by the Lisbon Treaty has been temporarily lifted by the European Commission. The French furlough plan, if it extends out to the end of 2021 would likely see larger deficits for longer. The ECB has just increased its Pandemic Emergency Purchase Programme (PEPP) by €600b, again with the Germans apparently dissenting. The market logic at present is that governments run deficits to keep things like they were, and central banks just use QE to magic away extra bond issuance. No amount of spending is too much because the pandemic demands it.
  • The political will is there for the print-and-spend pattern to continue. When the Germans are leading the pack in fiscal largesse you know the penny has dropped. Another way of saying this is governments cannot change direction, even if they wanted to. The question then is what the consequences are when everyone is bound into pursuing the same policy simultaneously. This is a twofold question – first, how currencies trade with one another (especially with the dollar), and secondly, how fiat currencies move against ‘hard’ currencies, the last of which is gold.
  • Normally when QE is announced, a currency weakens as the monetary base increases. When the ECB upsized QE on 4th June, the euro actually rallied against the dollar. There are a number of ways of interpreting this. First, it was an assertion of will by the ECB and a statement of continuity that encourages investors back into euro-denominated assets; secondly, that it was reflationary and therefore euro-positive; thirdly, that reflation is under way globally so you just keep selling dollars whatever; fourthly, that US fiscal and monetary policy is the most egregious, hence the weakening dollar; fifthly, that recent rioting in the US has shaken people’s faith in the dollar, and so on. Lots of potential reasons.
  • One thing is for sure. In the absence of capital controls, deficit spending and using QE to absorb issuance and to keep yields low means you are controlling the price but not the quantity of money. This is fine, but it means that you cannot control your currency. Acting aggressively to stimulate domestic demand can lead to devaluation. This is another way of describing a currency war. To win, one’s currency has to lose. This is where the dollar may have a flaw – it is the main reserve currency and the largest currency for trade. People actually want it in a way which no other currency is wanted.
  • The graph below shows the U.S. Dollar Index (DYX) which is at the bottom of its current upward channel, and therefore at a critical juncture. A rise in the dollar from here would signal deflation, and would suggest that the recent market rally was a case of re-leveraging not reflation. The DXY is heavily weighted towards the euro, so issues relating to the forthcoming Euro-area budget or Brexit may start to make themselves felt more as June progresses. A weakening of the euro from here would result in a sharp rise in the DXY.

Source: Bloomberg, 11th June 2020

  • Then there is the wider question of fiat currencies in general. In an era where all countries are printing money at will to accommodate deficit spending, what happens to the only hard currency out there, gold? The graph below shows the price of gold in dollars (yellow) against US M2 money supply in USD trillions (red) from 1960 to the present. It would seem the more they print, the more gold goes up, largely because you can’t print gold. This is the easy bit to show.

Source: Bloomberg, 11th June 2020

  • The next graph is even more interesting, showing the velocity of M2 (blue) against gold in dollars (yellow) between 1960 and 1990. Spikes in the blue line show periods of intense inflation in the dollar, during which the gold price rose sharply (from 1977 to the late-1980 peak it rose from $134.5 to $667, or nearly 500%). The velocity of money is a measure of how quickly money is turned over in the real economy. One reason why QE doesn’t increase the velocity of money is because the money stays trapped in the financial system in stocks and bonds and isn’t actually spent on goods and services – someone probably ought to mention that to central bankers intent on using QE to generate inflation.

Source: Bloomberg, 11th June 2020

  • Studies of periods of intense inflation in the past reveal the following characteristics, the first three of which are necessary, the fourth of which is not obligatory but is more often than not observed; first, a fiat currency rather than a currency attached to a metallic standard; secondly, a central bank lacking independence or a monetary system with insufficient statutory restrictions against government interference; thirdly, large primary fiscal deficits (15%+) over a period of time; finally, a war or war-like situation. Starting to sound familiar?
  • The 1970s was a period of stagflation – low real rates, low GDP growth, high inflation. Debt was much lower relative to now. The current trend is one of deflation due to a large global stock of debt. Should governments overstimulate demand relative to supply while engaging in financial repression (QE to keep real rates low), then stagflation could emerge along with the recovery. Gold will always rise while M2 increases. If the velocity of M2 starts to rise as well, then a repeat of the late 1970s price performance in gold will be likely. If that’s the case, people won’t be talking about heroic robin hood pump-and-dump stories in bankrupted stocks for long.

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