E-piphany

The repudiation didn’t take very long to begin. Despite good economic data and generous central bank action, stock markets sank in Europe and the U.S. and the U.S. bond market rallied with both real and nominal 10-year yields falling 3bps.

The ADP jobs report produced a 176k gain, compared with expectations for +100k, provoking some economists to raise their expectations for tomorrow’s Payrolls gain. ADP is an imperfect measure, but it gets the sign right more often than not. Initial Claims were also slightly stronger than expectations, but more significant were the actions of central bankers globally. The Bank of England announced an expansion of their Quantitative Easing program of another £50bln.  Accounting for the size of UK GDP compared to US GDP, as well as the UK/US exchange rate, that works out to the equivalent of roughly a $500bln increase if the Fed wanted to do the same thing, so it isn’t a small measure. The People’s Bank of China and the ECB acted (apparently coincidentally) in near-unison, with both cutting rates. Significantly, the ECB cut its deposit rate to zero, so all banks that took LTRO and left the money on deposit at the ECB are seeing their negative carry on that deal worsen. Denmark also cut its deposit rate sharply – in that case to a sub-zero rate. More on the zero and sub-zero deposit rates, later.

And yet, global equities dropped, in some cases sharply.

This may be somewhat related to the slow-motion repudiation of the “progress” made at the summit last week. German Chancellor Merkel said the deal cut at the Euro summit last week doesn’t mean that German has taken on any additional liabilities. This echoes what I said on Monday:

What in Merkel’s history or makeup would make you expect that she would cave in to foreign leaders, especially just one day after she had been so hostile to Eurobonds? Isn’t it much more likely that she doesn’t see the new deal as being a big deal, since it doesn’t involve much new money?

The old riddle goes Question: “How can you tell if a politician is lying?” Answer: “Her lips are moving.” Never, never accept the joint statement of a summit meeting as representing anything useful, and certainly not truth. In the wake of the good economic data and the robust central bank actions, Spanish 10-year yields rose 36bps and Italian yields rose 21bps.

The dollar reached one-month highs today, but here is the interesting part: commodities reached two-month highs. Believe it or not, since the end of March the DJ-UBS commodity index has now outperformed stocks, thanks mainly to the rally over the last week.

That rally, to be sure, owes a lot to the energy and grains complexes. Energy is up partly because the “tail risk” of a renewed global depression seems to have receded somewhat in some investors’ minds and partly because of renewed tensions in the Middle East (with Iran drafting a bill that would adjure its military forces to try and stop tankers from passing the Straits of Hormuz en route to countries that are sanctioning the nation, and the US reportedly stepping up its military presence there).  And grains are up primarily to poor weather conditions in the Midwest, which has led to downgrades on the expected crop yields.

Those are the excuses, but remember one advantage that commodities have over stocks is that commodities tend to “crash” upwards (they are statistically positively skewed and positively kurtotic) while stocks more often do the opposite. Sharp moves higher, especially after a long period of being beaten down, are not unusual in commodities.

That said, real grains prices are not at all-time highs. Not even close, although nominal corn prices are near all-time highs and real corn prices are about to reach the highest level since the early 1980s (see Charts, with real wheat prices first. Ignore the absolute level of the y-axis, which is an artifact of the formula “commodity price/CPI price level * 100”).

In fact, the huge rally in corn prices since 2005 has done nothing more than to cause the long-run rise in corn prices to just about exactly equal the long-run rise in prices generally. From December 1969 until now, headline CPI has risen around 509%, while front Corn futures have now risen about 536%. While Corn, since it’s not a storable commodity, doesn’t have the automatic tendency to a zero real return that, say, gold or copper does, in the long run it should still rise in the general direction as the overall price level. The languishing of grain prices for most of the 1980s and the 1990s helped speed the demise of the small farmer although it was beneficial for the development of emerging economies and our own. But, as with other trends that have tended to dampen inflation – apparel prices come to mind – this one seems that it may have run its course. How surprising would it be to find grain prices actually rising with overall inflation again?

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The actions by Denmark and the ECB to cut their deposit rates to or below zero, and the opposite prescription mentioned today by San Francisco Fed President John Williams, recall to my mind the prescription I’ve mentioned many times in these pages. The key link between QE and inflation isn’t base money, but transactional money (I generally use M2). These two have always been closely related, until the Federal Reserve began to pay interest on excess reserves (aka IOER).

IOER is basically the barn door holding the monetary horses in. Traditionally, it has been okay to look at the monetary base with respect to the MV≡PQ equation – not because it was right to do so, but because the relationship between the money base (which the Fed controls directly) and transactional money was very regular. That is why some inflation-phobes got really terrified when the Fed was doing QE, while those of us who focused on the significant part of the relationship perceived that inflation would come, but much more slowly. While base money exploded, M2 did not explode, simply because the Fed was paying banks not to lend it.

Money sitting in vaults, unlent, to a large extent doesn’t act like “money” at all (it is a store of value, but not a medium of exchange!), which means it doesn’t pressure prices since it has never entered the flow of commerce. There may be “too much money” and “too few goods,” but there was no “pushing,” or at least not as much as the rise in base money would have suggested. Because, again, because the Fed was paying IOER and therefore incentivizing banks to be more hesitant to lend.

If excess reserves yielded zero, or especially if there was a penalty rate, all of that money would have been lent and M2 would have exploded. This is the policy that the ECB and (less-significantly) Denmark are following. As noted above, banks have negative expected returns on the LTRO funds sitting at the ECB. Some of those funds will stay there simply because there is an insurance value to liquidity. But at the margin, if a bank can make a loan even if it has an expected loss, as long as the loss is smaller than the guaranteed loss of keeping money at the ECB then it will have a tendency to do so.

The problem with IOER is that we don’t know how sensitive the money multiplier between base money and M2 is to IOER….since we’ve never had IOER before.[1] So – we don’t know whether those reserves will slowly leak into the system, or if a 10bp change in the IOER would have a huge effect, or none at all, or what. The ECB also doesn’t know this, but they obviously sense that it’s now or never, and before they do another QE they ought to free up the first one. It seems like a fairly innocuous move, and will produce fewer fireworks than another LTRO (it may be that disappointment about the lack of an LTRO was part of the reason for weak market reaction today), but in fact it may well be more significant.

All in all, it may be better to be a farmer than to be a policymaker!