Thoughts through the cycle: W3 June ’20

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Wag the dog – debt and central bank policy decisions

  • In theory at least, in the world of Newtonian physics, if the position, direction and mass of every object in universe is known, then the future can effectively be predicted based on the interaction of forces relating to these bodies. This is what is called a determinist view of physics. The closest parallel in economics is the dialectical materialism of Marxism in which the ownership of the means of production (and therefore political power) acts in the same way gravity does for Newton. The fact that Marxism in practice seems usually to have ended in mass murder has undermined the case for this particular scientific view of history. In both cases, determinism sits at odds with the idea of free will. The framework of choice and free will raises some interesting questions with respect to what central banks around the world are currently doing – are there actually policy choices, or has the die already been cast so that central bankers are merely performing their allotted roles?
  • The Bank of England (BoE) offers a timely case study. On the 18th June the BoE left the base rate unchanged at 0.10% while increasing the size of its quantitative easing (QE) programme by £100b to £745b, in-line with market expectations. BoE Governor Andrew Bailey remarked that negative rates were not currently part of the policy plan. The graph below shows the yield on 2yr gilts at negative 0.03%. This means the 3m-2yr part of the UK rate curve is now inverted, a situation detrimental to ongoing bank lending (banks borrow short-dated and lend longer – this is not profitable when the curve is inverted). 2yr gilt yields are falling because inflation is falling; May core CPI was 1.2% vs. 1.4% in April. If inflation continues to fall, will the BoE be forced into negative base rates to create an upward sloping yield curve? Is this a policy choice or a policy inevitability?

Source: Bloomberg, 19th June 2020

  • There had been some market suggestions that the BoE would announce a larger increase to QE (figures such as £200b had been rumoured), as well as potentially surprising the market with negative rates. This ‘disappointment’ can be seen in the reaction of 30yr gilts to the BoE’s actual announcement (graph below, announcement at noon on 18th June). If central banks do not do as much QE as is expected, the bond market trades off sharply resulting in rising yields, which, all else equal, raises the overall government borrowing cost. With UK debt-to-GDP rising above 100% for the first time since 1963, this is clearly a major issue for the public purse. From the day prior to the policy decision to around midday on the day after, yields rose 12 basis points or nearly 19%.

Source: Bloomberg, 19th June 2020

  • A similar analysis of cable (GBP/USD spot rate, graph below) over a similar time frame shows a sharp weakening of the pound, likely in response to the increase in QE as this effectively means another debasement of the UK’s currency. QE is a policy choice in which the price of money is controlled by central bank buying of own-currency bonds, but the ‘price paid’ is an increase in the monetary base which ultimately ought to mean the currency depreciates. So while QE allows affordable government deficit financing, it also weakens the currency which ought to make exports more competitive and by making imports more expensive, inflation is generated – this helps ultimately to ‘inflate away’ the government debt.

Source: Bloomberg, 19th June 2020

  • Inflating away the real stock of debt is of course attractive for a heavily-indebted sovereign while also helping private-sector exports. This gain however comes at the expense of one’s neighbours – the pejorative term is the ‘race to the bottom’ and the collective enterprise is known as a currency war. This was a key factor in the breakdown of international relations during the inter-war years, especially in the 1930s where those countries which abandoned the gold standard first often faired far less badly in the Great Depression.
  • Devaluation of one’s currency is ultimately something one has to do, not something one wants to do. This is often overlooked during eulogies for ever-greater amounts of QE. The low or even negative real interest rates which characterise QE reflect the long-term destruction of a country’s capital stock. The example of Japan suggests that even over an extended period of time, QE and government fiscal spending do not generate the inflation that the policy desires. Stagnation or debt-deflation appear to be the consequence, with the growing stock of debt resulting in ever-lower rates and ever-more QE to accompany it.
  • Without QE, bond yields tend to rise with an increase in government spending and credit. The graph below shows China’s 10yr nominal rate which is drifting higher as fiscal stimulus and bank lending grows to offset the economic slowdown resulting from the Covid-19 pandemic. Because China’s currency is pegged to the dollar and it has a closed capital account, it is constrained with respect to rate cuts and QE. The possibility of the yuan depreciating or even resetting against the dollar cannot be ruled out at this time. The effect of this would be deeply deflationary on the rest of the world, even if it helped the Chinese economy to reflate.

Source: Bloomberg, 19th June 2020

  • What is particularly interesting is that elsewhere in emerging markets (EM), QE is being adopted by central banks in what is essentially a radical departure from prior practice. Most recently, Indonesia’s finance minister Sri Mulyani Indrawati was quoted as saying, “In this very extraordinary situation when the reliability of the market is in question and capacity to absorb [an] increasing deficit [is needed], then the central bank can play as a standby buyer” adding that this would not happen in the long run as “it was not good policy practice” (‘Jakarta to use QE for as long as needed to tackle pandemic’, Financial Times, 15/06/2020).
  • Indonesia is just one of several EM countries to have adopted QE since the onset of the pandemic. Formerly, ‘best practice’ for an EM country would be to build up a strong foreign-exchange (FX) reserve in the good times through an export-based economy, allowing a degree of currency stability in case of recession. In addition, to defend the currency, rates were often hiked to attract money flows into the country (the carry trade).
  • QE, with its propensity to cause currencies to depreciate due to the monetary base increasing, is clearly the diametric opposite of what EM countries used to do. This is not a critique of EM at all – Ms Indrawati’s comment above belies a reality which is now as true for EM countries as it is for developed markets (DM). Deficit financing leads to a large stock of debt, and it is really the stock of debt which is dictating how all central banks, whether EM or DM, now react in the current recession. To borrow a term from Newtonian physics, it is the balance of debt-to-GDP which is exercising its gravitational pull on policy, and central bankers are having to yield to this. There is no free will or policy choice here at all. This situation was true prior to the pandemic, and the global fiscal response to Covid-19 has only exacerbated the trend. EM countries using QE is merely a symptom of the global build-up of debt.
  • So in this sense, every nation is in the same boat, but it is a strange boat – while the global financial crisis of 2007-2009 saw multilateral action and cooperation culminating in, and typified by, the formation of the G20, the subsequent rise in the global stock of debt has meant that unconventional monetary policy (QE) is now the only option for central bankers as that same growing stock of debt prohibited any rate hikes during the recovery. The US Federal Reserve tried rate hikes and balance-sheet reduction (quantitative tightening or QT), and this ended in the credit market closing and the equity market collapsing in Q4 2018. With global rates already so low, QE was and is the central banker’s only option. It is in fact not really an option at all.
  • By increasing the monetary base, QE eventually causes currencies to depreciate, and whether this is an unintended consequence or beneficial policy outcome, it will nonetheless mark the current crisis as one of unilateral not multilateral action. America First is just one aspect of this trend – elsewhere protectionist instincts are on the rise, not least in Europe where the European Commission is currently moving to restrict foreign takeovers, especially by Chinese firms.
  • The concern then is that central bank QE starts to cause instability in the foreign exchange markets. Rising volatility here will impede trade and the recovery. It will also likely encourage further reversals in globalisation, especially as supply chains are shortened and ‘on-shored’. This will eventually mean the loss of what Ricardo called relative advantage (in terms of production), and rising inflation will be the consequence. The hope is of course that global leaders return to the sort of behaviour that led to the formation of the G20 during the last crisis. Unfortunately, that does not seem to be the direction of travel at present.

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