Central banking dilemma
The most recent FOMC statement was again an exercise in walking on eggs. Bernanke told the world things were brightening up and at the same time being extremely frustrated about the slow recovery of the labor market. On the latter, he is right : of the more than 8 million jobs lost since this crisis struck, 2 mio have been picked up but the structural problems of the US market still persist. Simultaneously, the Bernanke statement wasn't dovish to the extent that some form of extra monetary stimulus is for now of the table. So no QE3 nor extra help for the housing or student loan market. In the mean time, Operation Twist will continue meaning extending the maturity range of the FED's portfolio in order to keep long term interest rates low. And here is where it starts to go into the wrong direction. Over the past couple of days, we have seen a serious correction on the US Treasury market (cfr infra point 2). Some first considerations.
1) The aggressive monetary policy - and the outlook on zero interest rates - hasn't really generated miracle cures on the demand side of the real economy. It did however created financial leverage and might have fueled inflationary pressures on the wrong side of the equation. When looking at crude oil for instance - partly blame Iran for this - the recent upward move is considerable. And this is bad news for Europe and bad news for central bankers as well. For central bankers, a cost push inflation (supply side shock) is hard to handle. And in the case of Europe, it's even worse. When second round effects (wages etc) start to channel through the real economy, inflation starts a life on its own. Remember that the old ECB - for which the inflation radar was still operational - made interest rate decisions which infuriated the new financial market (the one running on central bank dope). It hiked interest rates mid 2008 and again in 2011. And this year we witness the same problem : crude oil prices and certain commodities going up and translated in EUR now moving to new records (1,60 versus 1,30 EUR/USD 2008-2012). Both central banks have already admitted that the inflation target won't be met this year but this higher than expected level is of a "temporary nature" (of course, as always). And it isn't a mere speculative mood fueled by hedge funds, also managed money funds are part of the game. Why ? Well, negative real interest rates isn't really a bonanza for investors either, now is it ? (PS : a very nice piece on "financial repression and negative interest rates" was recently written by Carmen Reinhard http://www.bloomberg.com/news/2012-03-11/financial-repression-has-come-back-to-stay-carmen-m-reinhart.html)
Charts : Evolution North Sea crude in EUR (96 - 126 in USD) and Long/short position oil NYMEX (swap dealers and managed money accounts)
2) As mentioned, we have had a strong correction on the US bond over the past few days. Last week, 10y US yields were below 2% and are now at 2,30%. Now this correction seems normal, certainly in view of the disconnect between the bond and stock market since the end of 2009 :
Now the disconnect between the stock market (orange S&P) and 10 y bonds (black 10y UST) can easily be explained by market manipulation of central banks : don't fight the FED or ECB amassing government bonds. However, It doesn't explain why the market now suddenly is shaping up to give them a fair fight. Some preliminary conclusions :
1) zero interest rate policy causes asset price inflation, ranging from bonds (intended by central banks) over to commodities (not intended but accomplished), equity and other risk assets (intended). At some point, markets will take this to heart and real world inflation might start to kick in, certainly if the business cycle outlook improves.
2) Another possibility might be that European (speculative) players are starting to unwind their safe haven plays in view of the European sovereign debt crisis now slowly abating. Or LTRO has generated switches from out of safe Sam the eagle - and bunds - into Italian, Spanish and other sovereign debt. May be but that still doesn't explain the timing of the move because LTRO has been going on now for 3 months.
3) Did we overshoot in terms of monetary expansion and liquidity injections ? Possibly. Effects are not to be expected in the short term but markets tend to look further upon the road. And then next to the current climate of persistent negative real interest rates, other worries come to mind for investors :
a) Is a central bank exit road-map available ? I have my doubts
b) Even if an exit road-map is available, will it be used and will it be used in time ? I have my doubts
Now suppose we have a trend reversal here on interest rates in combination with a nasty inflation kicker (supply side/commodities), we have a problem. It might explain why Bernanke isn't that eager any more to add more fuel to the fire in view of what QE and other measures have already produced on the supply side (food/energy).
And in the end, this shouldn't come as a surprise : In economics, you can never have it both ways and the fairy tale Goldilock doesn't exist despite what Alan Greenspan used to tell us some years ago. And therefore QE is a paradox and a fairy tale as well : you fight deflation - or feed inflationary expectations - and you try to keep long term interest rates low. Both targets seem very hard to achieve at the same time. May be markets are finally coming to grips of that. And then central banks balance sheets loaded with government bonds will receive some blows, the point the Bundesbank has been making time after time. But that's a price tag we will shift to the tax payer in a couple of years. In the mean time, Mr Bernanke some months ago voiced support for 0% rates until at least 2014. He - or we - might start regretting this message.