Central Banks Are Hiding the True Price of Risk

If you invest your money, you will have to deal with numerous risks. For instance, if you buy a bond, you run the risk of the borrower defaulting or being repaid with debased money. As a stock investor, you face the risk that the company's business model will not live up to expectations, or that it, at the extreme, will go bankrupt. In an unhampered financial market, prices are formed for these and other risk factors.

For instance, a bond with a high default risk will typically carry a high yield. The same goes for debt denominated in an unsound currency. Stocks of companies that are deemed risky tend to trade at a lower valuation level than those considered low risk. All these risk premiums, if determined in the unhampered market, constitute a portion of an asset’s price, be it a bond or a share. They play a vital role in the way capital is allocated in an economy.

Risk premiums are meant to compensate investors for the risk of losses resulting from adverse developments. If you buy a stock at a depressed price relative to the firm’s earnings power, it tends to reduce your downside (while offering the chance of great gains). At the same time, risk premiums increase investors’ cost of capital. This, in turn, discourages them from engaging in overly risky investments.

Decline in risk premiums:


In other words, risk premiums determined in an unhampered market align the interests of savers and investors. Of course, one cannot be sure that ex ante risk premiums are always correct. Sometimes it turns out that risks were overestimated, sometimes they were underestimated. However, the unhampered market is still the best and most efficient means to determine the price of risk.

Central Banks Suppress Risk Premiums

Central banks, however, interfere and corrupt the best practice of the formation of the price of risk. In the last financial and economic crisis, central banks had lowered interest rates to unprecedented low levels and ramped up the quantity of (base) money to keep financially ailing governments and banks afloat and the economy going. In fact, they effectively put out a ‘safety net’, providing insurance to financial markets against potential systemic losses.

Decline in risk premiums:


By doing so, central banks have put investor risk aversion to sleep: Under their guidance, financial markets are now betting on, and have high confidence in, monetary policy makers successfully fending off any new problems in the economic and financial system. This seems to be the message the price action in financial markets is conveying to us. For instance, stock price fluctuations have returned to very low levels, accompanied by strong stock market gains and high valuations.

The yield spread of risky corporate bonds over US Treasuries has returned to levels last seen in early 2008. Or look at the prices for credit default insurance for bank bonds. They also have returned to pre-crisis levels, suggesting investor credit concerns have markedly declined. In other words, investors are back again, eagerly taking on additional credit risk and willingly financing corporates’ investments at suppressed costs of capital.

Central banks have thus not only artificially reduced interest rates by lowering credit costs, they have also artificially reduced risk premiums by (explicitly or implicitly) signaling to the financial markets that they are prepared to basically ‘do whatever it takes’ to prevent another meltdown as witnessed in 2008/2009. The consequence is that financial markets and economies depend on central bank action more than ever before.

There is no easy way out of this situation. If interest rates go up — be it through rate hikes or the elimination of the ‘safety net’ — the current recovery will most likely come to a halt, if it does not turn into a bust straight away: With higher interest rates, the economic structure, built on artificially low interest rates, would run into serious trouble. The idea of central banks ‘normalizing’ interest rates without output losses or even a recession appears illusionary at best.

Against this backdrop, it is interesting to see that, for instance, the US Federal Reserve and the European Central Bank (ECB) may want to bring short-term interest rates back up (further). At the same time, however, there is no evidence that monetary policymakers have any plans to remove the ‘safety net’ that has so successfully brought down risk premiums in asset markets and thus the cost of capital.

That said, even an increase of central banks’ short-term funding will not bring about a normalization of the cost of capital — as risk premiums will most likely remain artificially suppressed. Capital misallocation will continue and the artificial boom is kept alive and well. Investors, therefore, face quite a challenge: Malinvestments continue, and downside risks increase, while it might be too early to jump ship.

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Can Japan End its Easy-Money Addiction?

07/16/2017Brendan Brown

The shock landslide defeat of PM Shinzo Abe’s Liberal Democratic Party (LDP) in the recent Tokyo metropolitan elections — and the triumph there of Tokyo Governor Koike’s new party (Tomin First) — has lit a faint hope that the radical Japanese monetary expansion policy could be on its way out. The flickering light though is not strong enough to soothe the mania in Japan’s carry trades and so the yen continued to slide in the aftermath of the elections. Between mid-June and early July the Japanese currency depreciated by some 5% against the US dollar and 10% against the euro. 

The perception in currency markets is that Japan will not be embarking on monetary normalization this year or next, in contrast to Europe where ECB Chief Draghi has hinted that the train (to monetary normalization) will start next year, even though the journey promises to be very slow. The US train to normalization continues at a glacially slow pace including some periods of reverse movement. Moreover the monetary climate prior to the journey commencing is even more extreme in the case of Japan than in Europe or the US.

It was possible to imagine that the shock election setback for the LDP could have caused Shinzo Abe to withdraw support from his money-printer in chief, Bank of Japan governor Haruhiko Kuroda (whose term ends in April 2018), thereby signaling an early end to negative interest rates and quantitative easing. But markets in their wisdom have concluded this is not to be. Many elderly Japanese are pleased with their stock market and real estate gains even though they complain about negative interest rates and the threat of inflation. In any case it was young voters, responding to the stink of alleged corruption scandals, who turned out en masse for Governor Koike’s new party.

In fact, the widespread prediction is that PM Abe will nominate an even more radical monetary experimenter to the head of the Bank of Japan along with two deputy governors of similar persuasion. Some political pundits in Tokyo suggest that Shinzo Abe could yet face a challenge in an LDP leadership election in September 2018 and that ex-Defence Minister Shigeru Ishiba (also on the nationalist right of the party) could prevail. Ishiba-san would favor, some speculate, a return to monetary orthodoxy. But in market terms this is a long time ahead and much further monetary damage will have been done first.

Three Risks to the Current Easy-Money Orthodoxy

Currency markets are not a one-way bet and there are three main risks confronting speculators on further yen depreciation.

First, Washington could yet get its trade and currency acts together (President Trump’s nominee for the role of Treasury Under-Secretary responsible for international affairs, David Malpass, has not yet been approved by Congress). The US would take aim at currency manipulation by Europe and Japan, now occurring under the camouflage of the global 2% inflation standard and deployment of non-conventional monetary policy tools. In particular the Bank of Japan’s policy of pegging long-term interest rates at barely zero is surely a means of keeping the yen cheap. 

Second, the US economy could enter a growth cycle slowdown and even recession which in turn would narrow the yield gaps which draw capital out of Japan.

Third, the giant carry trades could suddenly go into reverse as global asset price inflation progresses toward its final deadly phase.

Booming carry trades are indeed a top symptom of asset price inflation. As income famine investors hunt for yield, or investors impressed by a series of capital gains become irrationally exuberant, they are unusually susceptible to speculative narratives, discarding normal healthy cynicism. These narratives justify risk-arbitrage positions implicit in all the various forms of carry trade (whether in search of premiums for exchange risk, or term risk, or credit risk, or illiquidity, or equity risk). Japan, due to the extent of monetary distortion there, has become the land of frenzied carry trading.

The Japanese War Against Deflation 

The natural rhythm of prices has been unusually strong in a downward direction in Japan, meaning that the central bank’s targeting of positive inflation creates powerful monetary disequilibrium. The entry of China into the global economy in the case of Japan has meant an integration process which brings persistent strong downward pressure on prices (and on wages via offshoring). Adding to this pressure has been the growth of the “irregular” labor market (temporary contracts as against lifetime employment). And if we consider the core zone of the Japanese economy around Tokyo, productivity growth and technological change have been bearing down on prices (these trends are not apparent in the national data due to the falling behind of regions distant from the capital).

In the age of Abenomics (starting in 2013) the Bank of Japan ramped up the inflation target to the global 2% level. Accordingly, the carry trades in their various forms have boomed. The speculative hypotheses to justify these have waxed and waned through time. Some market critics think the latest to be waning is the FANMGs (equities in Facebook, Apple, Netflix, Microsoft, and Google) into which Japanese investors have poured funds in many cases via so-called structured products (notes which are a hybrid between fixed-interest paper and a kicker in the form of pay-outs related to the performance of a given index or stock price, in effect an option-type product).

The popularity of certain investment tools adds to the momentum of carry trades in Japan. Market practitioners (including hosts of retail investors) study charts and the trend lines there; the trend is the friend, make no mistake, until the trend brakes. Under monetary stability the flaws of such tools would most likely remain contained. But in the vast domestic and global monetary disorder such as now exists and which fans irrationality Japanese carry-trades become even more prominent.

Shinzo Abe if he thinks about this, and he has praised repeatedly the booming Tokyo stock market, must doubtless hope that global asset price inflation including its Japanese component will remain in its present sweet phase through the elections next year, first for LDp President and then for the Lower House of the Diet (December).

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Canadian Interest Rates Set to Rise?

06/27/2017Caleb McMillan

Is the Bank of Canada going to raise its overnight benchmark rate?

Since rising interest rates are decreed by the central bank, the real scarcity of capital in which major financial institutions can borrow and lend out overnight amongst themselves is unknown. Disconnected from any real savings, we expect the Bank of Canada to manually raise rates when the going gets good.

This is flawed thinking. Clearly, the rag-tag team at the BoC has confused cause and effect once again.

Through experience and logic, the idea that central banks can provide a free lunch is rebuffed by a hefty dose of reality. You need capital to have capitalism. Savings and production come before consumption. This is a priori true.

That’s why the Fed-induced casino reacted to BoC’s Number 2 Carolyn Wilkins’s recent speech. Her words were interpreted in such a way that had a discernible effect on the Canadian loonie, and it surged. 

It’s easy to imagine a financial system where this is not the case. Where “monetary policy” is returned to its rightful owner — the individual buying public.

When the No. 2 at the BoC says, “We are seeing the economy pick up,” and hints at raising rates, this means that the central bankers believe they can make everyone’s debt more expensive without bankrupting everyone in the process.

Since the economy seems to be doing well, how would a quarter-point or two fare?

Former BoC governor and now Bank of England head star Mark Carney succeeded with this back in September 2010.

America’s housing bubble had already burst, the effects were international, but the whole house of cards didn’t come crashing down. The Fed had some wiggle room, the end was near but it wasn’t set, and Canada happened to weather the storm quite nicely.

After all, we had been running federal budget surpluses since the 1990s, and we had yet to import all the finer details of the Southern real-estate easy-money craze.

With propaganda about our large “stable” banks (who have since been downgraded), there was enough global and domestic confidence for Clown Carney to nudge interest rates to 1%.

Ho, hum.

Gains were lost when his successor cut rates in 2015 due to the crash of Alberta oil.

Current BoC governor Stephen Poloz, or Simple Steve, couldn’t let that wild card spill over into other sectors of the economy. Steve told us to go back to buying land since they ain’t making any more of it. Use the low rates to pay back debts while also taking on more, he said. Grow the economy by borrowing to invest and remodel your house. Don’t look at me for the details, I just work here.

Meanwhile, Wilkins’s speech is “preparing markets” for the eventual crawl back to rate hikes.

The Bank of Canada has created a monstrosity of a monetary system. Insomuch that central banks will be around for the foreseeable future, may I suggest rediscovering some of former BoC governor James E. Coyne’s economic speeches? 

Originally posted at mises.ca. 

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Charles Evans: The Risk of Deflation

05/12/2017C.Jay Engel

Chicago Fed President Charles Evans spoke on Friday, expressing his fear that there was risk to the downside on the inflation outlook. These people! Unlike the Austrians, who define inflation and deflation in terms of the supply of money and fiduciary media, the mainstream defines them in terms prices. Thus, when Evans and others like him consider there being risk of too low inflation, what they are saying us that they fear the cost of living either falling or not rising fast enough (2% annually). No wonder the average person can't stand the pompous "let them eat cake" attitude of the global bureaucrats. Who except an overpaid government academician would praise rising price levels?

For this reason, Evans is on the "dove" side of the FOMC's spectrum, stating that one rate hike instead of two seems more prudent. If inflation isn't up where it should be, then we ought to avoid raising interest rates and instead keep the monetary juices flowing. Of course, there's no real difference between one or two .25% rate hikes, especially on the meaningless Fed Funds rate.

Evans also indicated that he thinks the Fed's balance sheet could return to normal levels ($800 billion) if it was trimmed once per month over the next 3-4 years. This is ludicrous if he thinks this can happen without pension pain, market toil, and even massive problems at the Treasury. It took 8 years to quadruple the size of the balance sheet up to $4.5 trillion. And Evans thinks it'll just be wound down in half that time? Yeah right.

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Central Banks are Completely Oblivious

03/31/2017C.Jay Engel

Sometimes, when central bankers talk, they reveal within the very same discussion a sign of complete obliviousness. The ECB's Peter Praet recently gave an overview of monetary policy and price stability. By way of reminder, price stability refers to the central bank's efforts to keep the prices we pay from dropping lower. This would be terrible.

In his overview, he describes what preceded the 2008 crisis with this:

In 2008 the global economy faced a calamity unparalleled since the Second World War. The crisis had been preceded by a mood of over-optimism in several advanced economies. Expectations about future income were at odds with slowing underlying growth, giving rise to an "expectations gap". In the euro area, expectations were reinforced by a revived sense of economic prosperity that was associated with the introduction of monetary union. Firms were borrowing against their future income expectations in some countries; households and governments were doing likewise in other countries.

So the problem, in Praet's view, was too much borrowing/spending based on unrealistic expectations. Then everything turned and there was too much debt and balance sheets everywhere were severely damaged. Following this, the recession reared its ugly head.

Now, consider how Praet describes the central bank's "success:"

Our measures are working their way through the financial system and have led to a major easing of financing conditions for euro area firms and households, benefited credit creation and contributed to a more robust and sustained economic recovery.

Monetary policy is playing a central role in supporting consumption: lower interest rates are ensuring favourable borrowing conditions and encouraging households to bring forward durable consumption as well as firms' investment. Consumption of durable goods has rebounded in recent years, and especially in countries where credit was previously very tight.

The relation between what was described as the problem and what is being offered as proof of success is clear to anyone who is not a professional monetary bureaucrat. They recreated the problem and claimed it as a trophy of achievement!

This is quintessential central banker. They don't see a monetary problem until it punches them in the face. 

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Central Bank Embrace of Blockchain is All About Control

03/08/2017C.Jay Engel

The recent news in the Bitcoin world is China's building attempt to regulate and oversee its use to a point where it is rendered nearly useless for Chinese consumers. They've realized that they can't truly kill it per se, but they can regulate the exchanges to a point where they can effectively stymie ts attractiveness.

Bitcoin, whether one considers it sound money or not, is a challenge to the established system monopolized by central banks everywhere. The War on Cash narrative fits in with the reality that central banks and governing authorities feel a need to address the lack of control and centralization in the currency world. Just as Bitcoin challenges the use of government protected clearing systems, so cash allows some inkling of freedom by consumers to withdraw from central-bank-driven monetary insanity.

It is no surprise that monetary bureaucrats worldwide have all but declared war on these "alternatives." It's all about control — about knowing what everyone is up to at all times. Instead of allowing the individuals to choose on the market, central bankers are all over the budding technology. They want to both challenge the existence of alternatives (Bitcoin) and embrace the technology behind it. 

The New York Times observes, creepily:

For the central banks, the promise of the technology is that it would allow them to track every pound or renminbi on every step of its travels through the financial system in real time — something that is impossible now. The goal would be to make the financial system more transparent, fast, efficient and secure.

Indeed, while declaring war on Bitcoin itself, we discover that Chinese banks are experimenting with their own central-bank-approved version of a purely digital currency:

The digital currency, known to the broader world as “ChinaCoin,” but officially referred to inside China as digital renminbi, or RMB, was developed by the PBOC in partnership with other private and public entities. 

Eventually, Chinese authorities hope digital RMB will help the government strengthen oversight of the country’s banks, while helping to prevent financial crime.

It's not really about fighting crime and promoting stability. It's about total financial domination. Even at the Federal Reserve, Lael Brainard, the Fed governor who oversees new technology, is behind the trend:

We are paying close attention to distributed ledger technology, or blockchain, recognizing this may represent the most significant development in many years in payments, clearing and settlement," Ms. Brainard said.

And Janet Yellen too:

A week before Ms. Brainard of the Fed gave her speech on distributed ledgers, the chairwoman of the Fed, Janet L. Yellen, was asked about the technology at a congressional hearing. She said that “innovation using these technologies could be extremely helpful and bring benefits to society.”

Benefits to society, of course, refers to the benefits to the central bankers and the various cronies who leech on to the monopolization of money and banking. The reality is that any benefits brought on by these centralizations of budding technology is strictly reserved for the crony financial establishment, and it is the poor suckers on main street that will pay the price.

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Central Banking in the Week Ahead

01/31/2017C.Jay Engel

As 2017’s first FOMC meeting approaches this Tuesday and Wednesday, we will once again wait on the edge of our seats for the insight of the “Experts.” Last year’s fourth quarter GDP blew a massive hole into the recovery narrative, but with Donald Trump promising a major infrastructure spending package and large tax cuts, there seems to be a renewed push toward raising the Fed Funds rate target to counter rising prices.

While the odds of a rate hike at this meeting are low, the first meeting under the new administration may give hints to major 2017 themes. FOMC meeting minutes are usually remarkably bland as the Fed balances the task of communicating “everything is peachy” with “the economy still needs our unprecedented interest rate manipulation.” It’s been this way since 2010. But in case you are wondering, yes, you are still to take them Very Seriously.

BOJ assets

On the other side of the Pacific, the Bank of Japan also meets this week. We can wish the BOJ a happy anniversary as this meeting is the one year mark for official negative interest rate policy. We should all resolutely criticize the ludicrous actions of Bernanke and Yellen, but BOJ governor Haruhiko Kuroda makes those two look like Paul Volcker. The Fed has gone haywire in the purchase of bonds and mortgage backed securities, but to the BOJ that’s just adorable child’s play. The BOJ is now  “a top-10 shareholder of 90% of Japan’s stock market.”

The major late 2016 theme for the BOJ has been a “yield curve control policy” in which the BOJ aims to have 10-year Japanese Government Bonds yielding nothing. That’s right: we live in such a bizarro world that it is considered sane and reasonable for over-indebted governments to borrow at no cost for an entire decade. The question of course is how much longer this can continue. Nonetheless, what we expect to see at the meeting this week is both a defense and a continuation of the lunacy.

The BOJ has taken the opposite approach as the Fed in the sense that the former has indicated no sign of truly “tightening.” As the BOJ continues to maintain their loosening monetary policy, this makes it more and more difficult for the Fed to “raise rates” alone. But more will be revealed in this week’s meetings. 

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