The financial markets are increasingly acting like spoiled kids. On Thursday, March 10, the European Central Bank announced new measures aimed at boosting inflation and economic activity. Markets rallied initially, but quickly declined after hints of not getting further negative rate cuts. The fact markets are not even fazed by promises of more free money shows the situation is getting dire.
So what new monetary stimulus measures did the ECB announce? First, an additional 20 billion euros of bond purchases per month, bringing the total monthly purchases up to 80 billion from the current 60 billion. Further, the program is expected to extend into 2017, which should push the ECB balance sheet to over 3 trillion euros.
Remember the Fed tried rounds of QE that reached a similar $80 billion per month, with the same intention of lowering interest rates and trying to spur spending, credit, and growth. It was a grand experiment, which has subsequently been shown to have little benefit and may even have sown the seeds for future problems.
Second, the ECB will expand its quantitative easy program to include high-rated corporate bonds. Yes, the ECB will be purchasing company bonds; in other words, loaning money directly to private corporations with freshly printed money.
The idea of negative interest rates has been given renewed attention with the Bank of Japan being the latest central bank to actually implement negative rates on some deposits. Recently, Bloomberg Business published a cute cartoon featuring Janet Yellen and bunnies to explain the theory of how negative interest rates are supposed to work. Unfortunately, this theory is fatally flawed and a more apt cartoon illustration would be Dr. Seuss’s The Cat in the Hat Comes Back.
We covered negative interest rates a year ago when European bonds started trading at yields below 0%; so for a crash course or refresher on what negative interest rates are and how they work, check out our previous article first.
Bloomberg’s cartoon starts with the fact central bankers want negative interest rates to incentivize spending and borrowing and to deter people from hoarding money. People are not dumb, and if they are charged money on their savings in a bank, they will take it out and stick it under a mattress rather than pay for it to sit in a bank.
Central banks, the theory goes, should instead focus on the big players: the banks. Since they have so much money and need to keep some of it in electronic form with the Federal Reserve, they won’t be able to ‘stick it under a mattress’. If central banks charge them on the margin (in other words, a portion of deposits, but not necessarily all of their deposits), then it should incentivize the big banks to hand out more loans.
More loans will spur businesses to invest, grow and hire more people. In addition, negative rates will drive down the value of the dollar, making exports cheaper, which will also fuel growth. Sounds like cute bunnies and sunshine right? Not quite.
The Reality: The Cat in the Hat Comes Back
The foundational flaw to this entire approach is the Keynesian idea of jump-starting the economy by trying to increase aggregate demand: borrowing and spending is the ultimate goal for central bankers. But sustainable spending can only come after savings, production and wealth creation.
Investors are always looking for indications of an oncoming economic recession, whether it be electricity consumption, Super Bowl wins or even ladies hemlines. However, one indicator that seems to make some intuitive sense is the Skyscraper Index, also known as the Skyscraper Curse.
This theory states that the emergence of record-breaking skyscrapers presages economic recessions. If true, should we be worried that China recently capped the world’s second largest tower, while the world’s next record-breaker is currently rising near the Red Sea?
What Exactly is the Skyscraper Curse?
The Skyscraper Index began with research by property analyst Andrew Lawrence in 1999. He noticed that over the past 100 years in the U.S., record-breaking skyscraper construction correlated to economic recessions, panics and crises. He began his analysis with the Singer Building and Metropolitan Life building, completed in 1908 and 1909 respectively, which were concurrent with the panic of 1907.
How exactly do record-breaking skyscrapers coincide or even predict economic crises? Economist Mark Thornton extended this analysis in 2005, demonstrating that the link between the two is artificially low interest rates. Interest rates are suppressed or kept low due to monetary policies as well as fiscal policies designed to increase credit in an economy. This increase in credit is ‘artificial’ because it is not due to people saving more and consuming less in the present; rather it is effected through money-printing or legislation that distort credit markets.
A recent Vox article has renewed the old adage that ‘housing is a good investment.’ While the author makes some salient points, this statement in general can lead some people into a trap.
Is a House an Investment or Consumption Good?
The author admits home values don’t increase much more than inflation on average, but then he tries to explain how they are still a good investment because if you own a home you can live there rent-free, which is “like a de facto dividend.” Let’s stop right there for a second.
It is a little odd to consider residing in your home as ‘paying you a dividend’ simply because you don’t have to pay rent. If I buy a car with cash, I don’t really consider the car ‘paying me a dividend’ because I do not have to rent or lease one. Yet there is a grain of truth here to untangle.
First, we need to start with a proper definition of the word investment. An investment is an asset purchased with the expectation of creating wealth, either in the form of generating income or appreciating in value. Therefore, it is not purchased for the purpose of consuming it today.
Houses are very much a consumer good, because we use them for shelter and derive a consumption benefit from them. Furthermore, the actual housing structure degrades with time and wear-and-tear, much like a car. Roofs leak, furnaces need to be replaced, and appliances break.
However, there is some truth to housing being an investment because a house is not just the physical brick and mortar structure, but also the land and property rights, which usually do not depreciate and tend to keep up with inflation.
Two big central bank decisions this past week sent the markets down one day and then blasted them higher at the end of the week. I am talking about the Federal Reserve and Bank of Japan announcements, of course. Although the market had different reactions, I believe both point to more central bank easing to come this year.
First, the Federal Reserve concluded its two-day meeting this past Wednesday, deciding to keep rates unchanged. In its statement, the Fed noted that recent data suggest labor markets are improving but economic growth has slowed, while inflation continues to run below their 2% target.
The rest of the statement was quite dovish, hinting at a more accommodative policy, especially noting that the committee is “closely monitoring global and financial developments.” This suggests the Fed is worried about the recent market turmoil and stock market declines in the U.S. and China. Somewhat surprisingly, the markets sold off a bit more than 1%, indicating traders either wanted even more accommodation or at least more clarity.
I previously noted that the Fed’s last rate increase was due to their concern about keeping credibility intact, rather than the Fed actually believing a recovery was under way. The latest move to stay put and not increase seems to confirm this. If economic conditions and data continue to deteriorate, we could easily see a move back to zero or even more quantitative easing.
To say the least, global financial markets are off to a bad start in the New Year. Given all of the headlines surrounding China, we thought we would give a market recap and try to untangle recent events, sorting out the clamor from the meaningful developments.
What’s Up With China?
The facts are easy to see. The Shanghai composite is now down almost 16%, only a few trading days into the New Year. Even the large-cap CSI 300 index is down 15%, signaling big outflows from China’s equity markets.
Chinese regulators tried to arrest the fall by implementing ‘circuit breakers’, similar to what is built in to American markets, where trading is halted for a time if stocks fall more than a certain percentage, and then closed for the rest of the day if they fall even more after reopening. The idea is to make everyone take a break and cool off in times of extreme volatility.
Chinese markets have been blowing up these circuit breakers. On January 4, markets lost 7%, triggering the circuit breaker and closing the market for the day. Then on Thursday, January 7, Chinese markets opened sharply lower in the first few minutes. The 5% drop triggered a 15-minute halt, but when trading resumed, the slide resumed as well, again triggering the 7% loss and market close for the day. Thursday’s trading day lasted only 29 minutes.