Here We Go Again

For the first time since 1993 a basket of six globally significant financial asset indicators has rallied in unison for the first half of the year.
 
The Dow Jones Industrial Average was up 1.7 per cent for the year – hardly spectacular but the fourth consecutive first-half rise.
 
According to the Wall Street Journal, gold notched up a 9.7 per cent lift. The Dow Jones UBS Commodity Index recorded an 8.1 per cent rise, while 10-year US Treasury notes climbed 6.4 per cent. The MSCI World Index of developed–world shares was up by 4.8 per cent and the MSCI Emerging Markets Index by 4.3 per cent. 
 
Such correlation is unusual but not a great surprise when you consider where official short-term rates are presently fixed by central banks.
 
The US short-term rate is 0.25 per cent, United Kingdom, 0.5 per cent; Japan, 0.1 per cent; 
 
Switzerland, 0 per cent, Euro, 0.25 per cent; and Canada, 1.0 per cent.
 
Australia at 2.5 per cent and New Zealand 3.5 per cent are the outliers. 
 
Last week Reserve Bank Governor Glenn Stevens told an economics conference that 
 
Australian interest rates for both savers and borrowers were now at a 50-year low.
 
“Moreover,” he said, “we still have ‘ammunition’ on interest rates – we have not got close to the zero lower bound that has afflicted some other countries.” 

RBA unlikely to cut rate

Despite the fact that the Governor believes our currency to be overvalued – “and not by just a few cents” – he is unlikely to cut the short-term rate as that tactic had not worked back in August.
 
Inflation is not a risk as we transition out of our resource construction boom.
 
Stevens may need that ammunition to soften the landing. 
 
Or he might be looking at the financial markets where he warned investors are “underestimating the likelihood of a significant fall in the Australian dollar at some point”.
 
Just what would tip the dollar more than a few cents is a matter for speculation, but the possibilities have been increased in the last few days by the threat to one of our most valuable economic assets – political stability, where fiscal responsibility resides with the elected government.
 
It has been reported that Treasurer Joe Hockey is interested in the suggestion of former Reserve Bank board member Warwick McKibbin that Australia should take advantage of low international interest rates. This would provide inexpensive ammunition for a coalition facing a dysfunctional senate.
 
The market for sovereign debt has become uber cheap for borrowers.
 
As American commentator John Mauldin pointed out on the weekend: “French ten-year bonds are paying 1.7 per cent, Spanish, 2.68 per cent and Italian, 2.83 per cent, German  debt, at 1.27 per cent pays less than half of US debt at 2.64 per cent. Somewhere in that  equation, sovereign debt is spectacularly mis-priced. Rated ten-year corporate bonds are paying between 3 per cent and 3.4 per cent. That is less than a 1 per cent premium for bonds that are only single A. Seriously?”
 
Those numbers recall Warren Buffett’s observation: “If you charge an inadequate premium, you will get creamed over time.”
 

Interest rate policy success debatable

Low interest rates have been adopted by many central banks as a way of encouraging borrowers to take greater risks. Just how successful this policy has been to date remains a matter of debate.
 
Certainly quantitative easing or unconventional financial action had some immediate success in terms of restoring market confidence in financial systems.
 
But its firepower has diminished with each round of stimulus.
 
QE always had its skeptics, mainly housed at the Bank of International Settlements, also known as the central bankers’ central bank.
 
Last month the BIS issued an annual report that was highly critical of the approach taken by major central banks to the financial crisis that began in 2008.
 
The BIS identified the roots of the GFC as having been nurtured by the monetary policies pursued by central banks in the period leading up to the actual crisis.
 
Basically, it argued that the central banks eased substantially during the downturn period of a cycle, but only moderately in the recovery period.This asymmetrical policy stance had been too easy on average. As a result, we swathe emergence of a long-term upward trend in debt and riskier financial investments.
 
The BIS identified two cyclical drivers, the first being the classic short duration business cycle. 
 
The second with much greater duration between the peaks was the financial cycle.
 
Too little attention had been paid to the recognition, causes and consequences of the financial cycle that can have a duration of 15 to 20 years.
 
The BIS has called for a mixture of structural policies that include deregulating protected sectors such as services, improving labour market flexibility, raising participation rates and trimming public sector bloat – a policy tool-kit familiar, in rhetorical terms at least, to the 
Australian centre right. 
 

BIS advice "foolish"; Wolf

The Financial Times economic editor, Martin Wolf, has rejected the BIS’s recommendations as “foolish”. 
 
He wrote: “The notion that the best way to handle a crisis triggered by over-leveraged balance sheets is to withdraw support for demand and even embrace outright deflation seems grotesque. The result, inevitably, would be even faster rises in real indebtedness and 
so yet bigger waves of bankruptcy that would lead to weaker economies and so to further increases in indebtedness.” 
 
I’ll admit to being surprised by the vigour of Wolf’s condemnation.
 
Wolf is but a journalist albeit an influential one.
 
The important actor in this drama is the new Chair of the Federal Reserve, Janet Yellen, who made her position clear in her first major speech last weekend.
 
The word “macroprudential” was uttered no less than 29 times – always in a positive and supportive fashion.
 
For those unfamiliar with what is meant by macroprudential policies, it refers to supervisory and regulatory banking policy as distinct from monetary policy that is basically interest rate setting.
 
For example, changing the loan-to-value ratio for mortgages would be a macroprudential policy.
 
Ms Yellen told her audience: “I will argue that monetary policy faces significant limitations as a tool to promote financial stability. Its effects on financial vulnerabilities, such as excessive leverage and maturity transformation, are not well understood and are less direct than a regulatory or supervisory approach; in addition, efforts to promote financial stability through adjustments in interest rates would increase the volatility of inflation and employment.” 
 
This is certainly a policy shift for the Fed and suggests the Yellen Fed will be more interventionist than the two previous incumbents.
 
The inference I took from her speech was that low interest rates would remain in place for longer than the market has been expecting.
 
The first test of macroprudential could well be the hosing down of bubbling financial markets.
 
Postscript
I’m taking a first hand but leisurely look at Europe for a few weeks so my next “Thoughts” will 
not be published until early August . . . Max W
 

General Advice Warning:

This advice is general advice only. It has been prepared without taking account of your objectives, financial situation or needs. Therefore, 
before acting on the advice, you should contact your Dixon Advisory Adviser to discuss the appropriateness of the advice, having regard to 
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Max Walsh

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Max Walsh was for many years one of Australia’s top economic and political commentators, highly regarded as a journalist, author and broadcaster. Throughout his career, Max was involved in all dimensions of the media industry, which has encompassed positions with two of Australia’s largest publishing companies and television networks.

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