Notes From Underground: King Checks, Trichet raises but signals he is not necessarily a serial raiser

As expected, the Bank of England held rates at 50 basis points and the ECB moved to raise rates to 1.25 percent. BOE Governor KING does not hold news conferences post-announcement so we will have to wait to find out if the MONETARY POLICY COMMITTEE (MPC) voted 5-3-1 again. Also, with inflation in the U.K. above the targeted level, Mr.King will be writing another to the ECHEQUER to explain why the BOE kept rates at the present level and held back from raising as prescribed by its mandate.

The ECB and Mr.Trichet held a press briefing after the announcement. Unlike last month’s meeting, Trichet was far less strident in his rhetoric about fighting inflation. Last month Trichet used the word vigilance which the market correctly interpreted to mean a rate rise was forthcoming. This time, the language was softer. In the interview session, Trichet was repeatedly asked if today’s rate increase was the start of a series and several times the ECB PRESIDENT LET IT BE KNOWN THAT THIS WAS NOT THE BEGINNING OF A SERIES OF RATE INCREASES. The softer rhetoric led to an initial selloff of the EURO but by the end of the trading day the EURO recouped most of its losses. The market is now comfortable with the CREDIBILITY OF THE ECB, but rather uncertain about the FED.

Even though the BOE held rates steady, the British POUND was able to hold its recent gains. Again, all markets are FED watching for direction. While I was wrong about the ECB possibly holding off on a rate increase as a quid pro quo to Portugal, it may well be the Portuguese bailout that softened Trichet. As Keynes said: “Wordly wisdom teaches it is better for reputation to fail conventionally, than to succeed unconventionally.”
Yesterday’s BLOG generated some very good questions and comments this morning and I would like to take the time to deal with the general theme of communication. The first e-mail arrived early this morning and was posed as a RIDDLE:
“IF YOU SAY A STEEP CURVE IS A SIGN OF BAD MONETARY POLICY OR BAD ECONOMY, THEN A FLATTER CURVE IS A SIGN OF GOOD. SO BLACK AND WHITE , YES? NOW THAT YOU AGREED, YOU HAVE JUMPED OFF THE CLIFF AS NEGATIVE 2/10 MUST MEAN AN ECONOMY IS IN EXCELLENT SHAPE, HENCE YOU’RE GREECE AND IRELAND. HA!”
Ok, now let’s look at this. First of all, a flatter curve does not mean a good or bad economy. In my mind it answers the question about the responsibility of a central bank and how the market perceives it. A normal curve in its positive slope is a sign of health for the money markets. A flat or negative curve implies that the bank is too tight relative to the underlying economic conditions. A historically steep curve signals that the monetary policy is pushing to be extra stimulative. Now, Greece and Portugal are inverted because the markets have punished them for reasons of  budgetary malfeasance and are making them pay a dear price. Because the PIIGS are part of the EURO, they have no control over their monetary policy as the power resides with the ECB.
The problem of the PIIGS is that they have become very uncompetitive within the EURO ZONE, especially relative to Germany and some other European economies. While Germany was reigning in labor costs and stemming its budgetary problems early in the decade, the PIIGS were enjoying the ultra-low interest rates that the ECB set to aid Germany overcome the costs of unification.
Now, in order for the peripheral nations to regain some sense of competitiveness, they are going to have to ring out the excesses of profligacy and that entails setting themselves on a deflationary course. As the austerity bites, it becomes a question of solvency for the heavily indebted economies. If the Greeks and Irish and Portuguese had control of their currencies, they could devalue while undergoing austerity and regain competitiveness through a cheaper currency and they could lower rates at the same time.
As long as the PIIGS are locked into the EURO, they cannot DEVALUE the CURRENCY so therefore the market says that the deflation that will be needed to correct the imbalances that will possibly place the indebted nations into a DEBT DEFAULT, because domestic politics will demand that the citizens are cared for before the BONDHOLDERS are paid. The INVERTED CURVES IN GREECE AND PORTUGAL are merely the signal of the economic downturn that will take place within these countries.
In September 1992, when the EMU had a major crisis and Britain dropped out of the EUROPEAN MONETARY UNIT, it provides the classic example of the Greek and Portuguese situation. The U.K. was doing all it could to hold its POUND to the D-MARK peg and when the pressure on the POUND kept building, the BOE raised interest rates on a daily basis to try to break the speculators by making it more costly to be short the POUND. Overnight rates were raised to 15 percent while the U.K. economy was struggling and the curve in Britain became very INVERTED. By mid-September when the Brits finally decided they couldn’t withstand the market pressures anymore, they dropped out of the EMU and within a day short interest rates dropped precipitously as the POUND was devalued. There was no longer any need to artificially hold the rates high.
During the next year, the British economy was in turmoil but with low interest rates and a depreciated currency the U.K. economy recovered and began to outperform the rest of Europe. It is the lack of control over the currency that is making it so difficult for Greece, Ireland, Portugal to stimulate their economies, hence the flat to inverted curves. This is what makes the European economic situation so difficult. The question we always have to ask: What if the PIIGS drop out of the EURO in order to gain control of their severely damaged economies, for how much austerity will be enough? And then, what will happen to the EURO without the weakest members?

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10 Responses to “Notes From Underground: King Checks, Trichet raises but signals he is not necessarily a serial raiser”

  1. Jess_T Says:

    Yra: You mention Fed credibility as an emerging issue…

    If we take Bernanke’s highly publicized statement this past week “I think the increase in inflation will be transitory” and consider that he’s making this statement coincident with recent acceleration (momentum increases) in some global inflation measures (such as Swiss CPI this week) then if we fast forward to the end of Summer or end of year and it turns out he’s dead wrong relative to the more inflation hawkish central bankers (Swiss, ECB, China, etc) his credibility is at high risk in this scenario.

    It seems like that statement “I think the increase in inflation will be transitory” is a really dumb statement to make at this juncture and that the odds favor he’ll begin to back it out or modify it in the months to come rather than risk his credibility. Is this the credibility issue you’re referring to?

  2. yra Says:

    First his thinking is wrong the operative word should be “hope” because that seems to be the fallback for all the model builders from Long Term Capital on—he hopes its transitory but that doesn’t mean anything anyway—what will happen to the FED’s book of asset if the market loses faith in them –then the market will show mr. bernanke what transitory truly is—how big will the losses be and how high will long rates go–and then how much of the budget will be eaten up by interest expense on the debt—-the fed chairman who played with fire or kicked the hornet’s nest

  3. Breakfast Links Points and Figures Says:

    […] ECB raised rates, but Trichet’s language after the meeting makes the market think they are not done.  US Treasuries look iffy, and the bond vigilantes seem to be swarming. […]

  4. Kevin Waspi Says:

    Yra and Jess,
    Good discussion! On the inverted curve in the PIIG Pen, I enjoyed the historical perspective going back to the U.K.; those lessons are not to be forgotten if anything is to be learned. I think much of the present inversion in the PIIG Pen is the “crisis at maturity” effect. The crisis is now if the maturity is now, and not if the maturity is 10 years. Markets are pricing for imminent crisis.

    As for the wisdom of the Fed, time will tell on inflation as well as on “tools available” to them to “act accordingly”. Speaking of interest costs, if one of the “new”, powerful tools they plan to use is the rate paid on bank reserves at the Fed, watch the Fed’s income statement implode along with its balance sheet. That’s a double-barrel bet that I think markets are sensing when they would rather buy a Euro (even with the PIIG Pen problems), than a Greenback! Our real risk is not a single man’s “reputation”, but the reserve position of the U.S. Dollar.

  5. yra Says:

    Nice Kevin–you should explain the reserve issue a liitle further especially with the new stance by the FDIC and how it may impact it

  6. Alex Says:

    Yra,

    Firstly, let me thank you for keeping this blog. I really appreciate being able to learn from someone with your experience.

    I’m writing to ask your advice on something quite simple.

    I’m a prop futures trader from Australia. My time horizons are short and I trade solely off of price action and orderbook data.

    I wish to evolve into a global-macro trader – ala PTJ, Louis Bacon etc.

    My knowledge of economics comes from your typical college Economics 101 course and a passing interest in Austrian Economics (due to libertarian leaning ideals). One thing which scares me about subscribing to the Austrian economic theory, is that many of the proponents seem to be gold-bugs and permabears.

    I’d like your advice on how you would go about learning economics/geo-politics/economic history from a standing start.

    Perhaps you could share your favourite books? If you had to pick three news sources, which would they be? Any advice you would have for me?

    Once again – Thankyou very much for keeping this blog, it’s amazing a (comparably) newbie trader from the other side of the world can learn from an oldschool trader.

    Alex

  7. Kevin Waspi Says:

    Thanks Yra, that’s another good point. Dodd-Frank required action relating to FDIC insurance reform. These changes are under FEDERAL DEPOSIT INSURANCE CORPORATION 12 CFR Part 327 RIN 3064- [Assessments, Large Bank Pricing; AGENCY: Federal Deposit Insurance Corporation (FDIC). ACTION: Final rule.], released 2-7-2011, to take effect for the quarter beginning April 1, 2011, and will be reflected in the June 30, 2011 fund balance and the invoices for assessments due September 30, 2011.

    In a nutshell, Dodd-Frank, passed in 2010, required that the FDIC amend its regulations to redefine the assessment base used for calculating deposit insurance assessments, and apply a risk based premium structure. Under Dodd-Frank, the assessment base must, with some possible exceptions, equal average consolidated total assets minus average tangible equity, rather than the historical use of a domestic deposit related assessment base. Bottom line is (with adjustments based on capital and the composition of that capital), the more a bank’s assets are composed of loans and risk adjusted investments rather than zero risk rated deposits at the Fed, the higher the FDIC assessment cost.

    There is logic in this structure, so not everything in Dodd-Frank is bad. One of the axioms in the insurance rate making practice is adjustment for risk; e.g. structures made of wood as opposed to steel may carry higher fire insurance premiums, everything else equal. That said, under this change to the definition of the assessment base, as well as the changes to the definition of the institution’s “average tangible equity”, banks may be incented to lend less (paying lower FDIC insurance by keeping larger reserves at the Fed), and attract capital through the issuance of more unsecured debt, rather than equity raises. We all know that equity capital is the highest cost of capital to a firm (or a bank), but now, adjustments to Tier 1 capital under the new FDIC assessment scheme provides an additional incentive for banks to bolster capital through issuance of debt. What is a very levered industry now has additional incentive to become even more levered, and simultaneously, hold more zero risk weighted reserves (earning interest) at the Fed.
    There is some fascinating reading of these final rules (and the comments received from banks in crafting them) available at: http://www.fdic.gov/news/board/2011rule1.pdf

    In summary, my thesis was and is the following: Fed’s reliance on this “powerful new tool” of paying interest on bank reserves at the Fed in enacting a “tightening” of policy will be very expensive, and probably much less effective than imagined. Given the vast ocean of reserves they have pumped into the banking system, as well as other powerful measures influencing banking activity, I feel reliance on this tool’s effectiveness in tightening may be met with disappointment.

  8. JD Says:

    “What if the PIIGS drop out of the euro…?” Do you mean them all? I think as long as the classical (Italy & Spain) European countries are able stay in the monetary union it will survive, ASSUMING Brussles can perform three mercy killings w/ some amount of grace. The value (vs ???) must rise in this case.
    If they all go it is over one way or another. If the generation in charge at the moment can’t wake from THEIR dream/nightmare; their kids who before the monetary crisis already were nostalgic for the semi-old national currencies will cut the strings themselves.

  9. JD Says:

    I will also add that as far as I know, through out western history all confederacies have failed for the same reasons. The EU joined through the euro may be thought of as the EC; hence it should fail too.

  10. yra Says:

    JD–I will ask a question back to you.If the Greeks ,Irish and portugese were to leave to get their houses in order and devalue their “new” currencies the pressure on Spain,Italy and possibly France will be immense.If the outliers PIIGS are still members of the union they will have a huge advantage over the other peripherals—Remember that post-1992 when Italy came back to the EMU,it was at an artifically high rate on the lira as the French forced it so as not to lose anymore business to Milan

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