Fed may be reducing easy money, but here’s why Sensex will keep soaring

yellen_janet_040512_8x10Vivek Kaul

In theory there is no difference between theory and practice. In practice there is.

Yogi Berra

A question I am often asked is why are the stock markets around the world still rallying despite the Federal Reserve of United States going slow on printing money. In a statement released yesterday the Fed decided to cut down further on money printing.
It will now print $15 billion per month instead of the earlier $25 billion. This was the seventh consecutive cut of $10 billion. Since December 2012, the Federal Reserve had been printing $85 billion per month. This money was pumped into the financial system by buying mortgage backed securities and government bonds. The idea was that by increasing the amount of money in the financial system, long term interest rates could be driven lower. The hope was that at lower interest rates, people would borrow and spend more.
From January 2014, the Federal Reserve decided to buy bonds worth $75 billion a month, instead of the earlier $85 billion. This meant that the Fed would be printing $75 billion a month instead of the earlier $85 billion. This cut in money printing came to be referred to as “tapering”, which means getting progressively smaller. Since then the amount of money being printed by the Federal Reserve has been tapered to $15 billion per month. At this pace the Federal Reserve should be done at dusted with its money printing by next month i.e. October 2014.
A lot of this printed money instead of being lent out to consumers has found its way around into stock markets and other financial markets around the world. The Dow Jones Industrial Average, America’s premier stock market index, has rallied more than 30% since October, 2012. This when the American economy hasn’t been in the best of shape.
The FTSE 100, the premier stock market index in the United Kindgom, has given a return of 15% during the same period. The Nikkei 225, the premier stock market index of Japan has rallied by 53% during the same period. Closer to home, the BSE Sensex has rallied by around 43% during the same period.
Stock markets around the world have given fabulous returns, despite the global economy being down in the dumps. The era of easy money unleashed by the Federal Reserve has obviously helped.
Nevertheless, the question is with the Fed clearly signalling that the easy money era is now coming to an end, why are stock markets still holding strong? One reason is the fact that even though the Fed might be winding down its money market operations, other central banks are still continuing with it.
The Bank of Japan, the Japanese central bank is printing around ¥5-trillion per month and is expected to do so till March 2015. The European Central Bank is also preparing to print €500-billion to €1-trillion over the next few years. What this means is that interest rates in large parts of the Western world will continue to remain low. Hence, big institutional investors can borrow from these financial markets and invest the money in stock markets around the world.
The second and more important reason is that the Federal Reserve does not plan to shrink its balance sheet any time soon. Before the financial crisis started in September 2008, the size of the Federal Reserve balance sheet stood at $925.7 billion. Since then it has ballooned and as on August 27, 2014, it stood at $4.42 trillion.
The size of the Fed balance sheet has exploded by close to 378% over the last six years. This has happened primarily because the Fed has printed money and pumped it into the financial system by buying bonds, in the hope of keeping interest rates low and getting people to borrow and spend.
Janet Yellen, the current Chairperson of the Federal Reserve made it very clear yesterday that the Fed was in no hurry to withdraw this money from the financial system. It could take to the “end of the decade” to shrink the Fed’s huge balance sheet
“to the lowest levels consistent with the efficient and effective implementation of policy.”
What this essentially means is that the money that the Fed has printed and pumped into the financial system by buying bonds, will not be suddenly withdrawn from the financial system. When a bond matures, the institution which has issued the bond, repays the money invested to the institution that has invested in it.
If the investor happens to be the Federal Reserve, the maturing proceeds are paid to it. This leads to the amount of money in the financial system going down, and could lead to interest rates going up, as money becomes dearer.
This is something that the Fed does not want, in order to ensure that individuals continue borrow and spend money, and this, in turn, leads to economic growth. Hence, the Fed will use the money that comes back to on maturity, to buy more bonds and in that way ensure that total amount of money floating in the financial system does not go down.
This means that long term interest rates will continue to remain low. Hence, investors can continue to borrow money at low interest rates and invest that money in different parts of the world.
Yellen also clarified that short-term interest rates are also not going to go up any time soon. As she said “economic conditions may for some time warrant keeping the target federal funds rate below levels the committee views as normal in the longer run.”
The federal funds rate is the interest rate that banks charge each other to borrow funds overnight, in order to maintain their reserve requirement at the Federal Reserve. This interest rate acts as a benchmark for short-term loans.
Given these reasons, the stock markets around the world will continue to rally, at least in the near term, as the era of easy money will continue. These rallies will happen, despite global growth being down in the dumps and the fact that the global economy is still to recover from the financial crisis that started just about six years and three days back, when the investment bank Lehman Brothers went bust on September 15, 2008.
To conclude, Ben Hunt who writes the Epsilon Theory newsletter put it best in a recent newsletter dated September 8, 2014, and titled
The Ministry of Markets: “No one doubts the omnipotence of central banks. No one doubts that market outcomes are fully determined by central bank policy. No one doubts that central banks are large and in charge. No one doubts that central banks can and will inflate financial asset prices. And everyone hates it.”
The article appeared originally on www.FirstBiz.com on Sep 18, 2014

 (Vivek Kaul is the author of the Easy Money trilogy. He tweets @kaul_vivek)

ECB joins the money printing party and launches QE lite

euro

Vivek Kaul

The European Central Bank (ECB) led by Mario Draghi has decided to cut its main lending rate to 0.05% from the current 0.15%. It has also decided to cut the deposit rate to –0.2%.
European banks need to maintain a certain portion of their deposits with the ECB as a reserve. This is a regulatory requirement. But banks maintain excess reserves with the ECB, over and above the regulatory requirement. This is because they do not see enough profitable lending opportunities.
As of July 2014, the banks needed to maintain reserves of € 104.43 billion with the ECB. Banks had excess reserves of € 109.85 billion over and above these reserves. The ECB was paying a negative interest rate of –0.1% on these reserves. Now it will pay them –0.2% on these reserves. This means that banks will have to pay the ECB for maintaining reserves with it, instead of being paid for it.
These rate cuts have taken the financial markets by surprise. When the ECB had last cut interest rates in June earlier this year, it had indicated that would go no further than what it had at that point of time. Nevertheless it has.
So what has prompted this ECB decision?
In August 2014, inflation in the euro zone (countries which use euro as their currency) dropped to a fresh five year low 0.3%. In fact, in several countries prices have been falling. From March to July 2014, prices fell by –1.5% in Belgium, –0.4% in France, –1.6% in Italy and –1% in Spain.
In an environment of falling prices, people tend to postpone their purchases in the hope of getting a better deal in the future. This, in turn, impacts business revenues and economic growth. Falling business and economic growth leads to an increase in unemployment. And this has an impact on purchasing power of people.
Those unemployed are not in a position to purchase beyond the most basic goods and services. And those currently employed also face the fear of being unemployed and postpone their purchases. The rate of unemployment in the euro zone stood at 11.5% in July 2014. This has improved marginally from July 2013, when it was at 11.9%. The highest unemployment was recorded in Greece (27.2 % in May 2014) and Spain (24.5 %).
Hence, the ECB has cut interest rates in the hope that at lower interest rates, people will borrow and banks will lend. Once this happens, people will borrow and spend money, and that will lead to some economic growth. But is that likely the case?
The numbers clearly prove otherwise. In June 2014, the ECB decided for the first time that it would charge banks for maintaining excess reserves with it. In April 2014, the excess reserves of banks with the ECB had stood at € 91.6 billion. The hope was that banks would withdraw their excess reserves from the ECB and lend that money. The excess reserves have since increased to € 109.85 billion. What does this tell us? Banks would rather maintain excess reserves with the ECB and pay money for doing the same, rather than lend that money.
The ECB had cut the interest rate on excess deposits to 0% in July 2012. Hence, the negative interest rate on excess deposits has been around two years, without having had much impact. In fact, the loans made to companies operating in the euro zone is currently shrinking at 2.3%.
Also, banks always have the option of maintaining their excess reserves in their own vaults than depositing it with the ECB. They can always exercise that option and still not lend. Interestingly, in July 2012, the central bank of Denmark had taken interest rates into the negative territory.
The lending by Danish banks fell after this move.
The Draghi led ECB has also decided to crank up its printing press and buy bonds, though it refused to give out the scale of the operation. The ECB plan, like has been the case with other Western central banks, is to print money and pump that money into the financial system by buying bonds. This method of operating has been named “quantitative easing” by the experts. The Federal Reserve of United States, the Bank of England and the Bank of Japan have operated in this way in the past.
The hope as always is to ensure that with so much money floating around in the financial system, banks will be forced to lend and this, in turn, will rekindle economic growth.
The ECB has plans of printing money and buying covered bonds issued by banks as well as asset backed securities(ABS). Covered bonds are long-term bonds which are “secured,” or “covered,” by some specific assets of the bank like home loans or mortgages. The ABS are essentially bonds which have been created by “securitizing” loans of various kinds.
The size of the ABS market in Europe is too small, feel experts, for these purchases to have much of an impact. Nick Kounis, an economist
at ABN Amro told the Economist that “the likely size of possible purchases would be €100 billion to €
150 billion.” This is too small to make any difference. Bonds covered by home loans and worth buying could amount to another € 500 billion.
Further, the buying of ABS is unlikely to begin at once.
As Ambrose Evans-Pritchard of The Telegraph put it on his blog “Buying may not begin in earnest until early next year since the ABS market is not ready.”
All this makes Evans-Pritchard conclude that “this would be a form of “QE lite” but it would be trivial compared with the huge operations of the Bank of Japan and the US Federal Reserve, together worth €120bn a month at their peak.”
If the ECB has to launch a serious form of quantitative easing it needs to be buying government bonds. But any such move is likely to be opposed by the Bundesbank, the German central bank. As the
Economist put it “such an intervention would be bitterly opposed by the Bundesbank on the grounds that it would redistribute fiscal risks among the 18 member states that belong to the euro.”

The article was published on www.FirstBiz.com on Sep 5, 2014

(Vivek Kaul is the author of the Easy Money trilogy. He tweets @kaul_vivek)

Easy money: Will the ECB have no choice but to be a copycat of the US?

 Special Address: Mario Draghi

Vivek Kaul 

In July 2012, Mario Draghi, president of the European Central Bank (ECB) had said that “the ECB is ready to do whatever it takes to preserve the euro. And believe me, it will be enough.”
Yesterday, the ECB cut its deposit rate to – 0.1%. European banks need to maintain a certain portion of their deposits with the ECB as a reserve. This is a regulatory requirement. But banks maintain excess reserves with the ECB, over and above the regulatory requirement. This is because they do not see enough profitable lending opportunities.
In April 2014, the European banks
had excess reserves amounting to 91.6 billion. This was over and above the reserve of €103.6 billion that they needed to maintain as per regulatory requirement. The ECB currently pays no interest on the excess reserves of banks. With effect from June 11, 2014, it will pay an interest of – 0.1% on the excess reserves. What this means is that the ECB will charge the banks for any excess reserve that they maintain with it.
This has been done to ensure that the banks do not maintain any excess reserves with the ECB and go out and lend that money instead. The lending to the private sector
in Europe has been declining at the rate of 1.8%. Over and above this, the economic growth in the Euro Zone (18 countries in Europe which use Euro as their currency) has been very slow.
During the period of January to March 2014, the economic growth was at a minuscule 0.2%.
The Eurzo Zone managed to avoid an economic contraction primarily due to a strong performance by the German economy.
What this means is that economies of certain countries in Europe are contracting. Economies of Italy, Holland and Portugal contracted during January-March 2014. The economy of France did not grow at all. What makes the situation worse is the latest inflation number. In May 2014, the inflation in the Euro Zone fell to 0.5%. It was at 0.7% in April 2014.
This is well below the ECB’s target inflation of 2%.
If inflation keeps falling, the Euro Zone will soon be experiencing a deflationary scenario in which prices will keep falling. In such a scenario people will postpone consumption in the hope of getting a better deal in the days to come. And this will further impact economic growth.
Due to these factors the Draghi led ECB has decided to cut the deposit rate to – 0.1%. The hope is that banks will withdraw their excess reserves from the ECB and lend that money. But how good are the chances of something like that happening? The ECB had cut the interest rate on excess deposits to 0% in July 2012. Its been around two years since then and as mentioned earlier the lending to the private sector in Europe has been going down at the rate of 1.8%.
Also, banks always have the option of maintaining their excess reserves in their own vaults than depositing it with the ECB. They can always exercise that option and still not lend. Interestingly, in July 2012, the central bank of Denmark had taken interest rates into the negative territory.
The lending by Danish banks fell after this move. Banks will go slow on lending unless they feel that their lending will turn out to be profitable. And that is something the ECB or for that matter any central bank, cannot do much about.
So, that brings us back to the question of why did the ECB take interest rates into the negative territory? The only possible answer seems to be that ECB wants to weaken the euro against other currencies. The euro has appreciated against the yen since October 2012. In October 2012, one euro was worth around 100 yen. Currently, one euro is worth around 140 yen. This has happened because of the massive money printing carried out by by the Bank of Japan, the Japanese central bank, since early 2013.
Germany is the export powerhouse of Europe and competes directly with Japan in many hi-tech sectors. Nevertheless, despite the euro appreciating against the yen, the Eurozone as a whole has been running a trade surplus i.e. its exports have been greater than its imports. In February 2013, the Eurozone ran a trade surplus of €13.6 billion.
This is primarily because a collapse in demand in many Eurozone countries has led to a significant cut down in imports. Also, with a collapse in internal demand businesses have been forced to look for external growth.
Now with the ECB looking to cheapen the euro, it will lead to German exports becoming more competitive than they were in the past and this in turn will push up the trade surplus of the Eurozone further. Whether this will benefit countries in the Eurozone other than Germany, remains to be seen.
In a press conference yesterday, Mario Draghi said “We think this is a significant package…Are we finished? The answer is no. If required, we will act swiftly with further monetary policy easing. The Governing Council is unanimous in its commitment to using unconventional instruments within its mandate should it become necessary to further address risks of prolonged low inflation ”
Speculation is rife that the Draghi led ECB will soon enter the full blown quantitative easing territory and print money to buy bonds, something that the Federal Reserve of the United States and the Bank of Japan have been doing for a while now.
But it may not be so easy to initiate quantitative easing in the Eurozone, given that 18 countries of the Eurozone will have to support the decision.
But as Guntram B. Wolff, director of Bruegel, a research organization in Brussels told The New York Times “The conventional measures are all done…What remains is quantitative easing.”
In short, the era of “easy money” will continue. 

 The article originally appeared on www.firstbiz.com on June 6, 2014

(Vivek Kaul is a writer. He can be reached at [email protected]

Cyprus’ financial repression: when people bail out govts

keynes_395
Vivek Kaul 

John Maynard Keynes (pictured above) was a rare economist whose books sold well even among the common public. The only exception to this was his magnum opus, The General Theory of Employment, Interest and Money, which was published towards the end of 1936.
In this book Keynes discussed the paradox of thrift or saving. What Keynes said was that when it comes to thrift or saving, the economics of the individual differed from the economics of the system as a whole. An individual saving more by cutting down on expenditure made tremendous sense. But when a society as a whole starts to save more then there is a problem. This is primarily because what is expenditure for one person is income for someone else. Hence when expenditures start to go down, incomes start to go down, which leads to a further reduction in expenditure and so the cycle continues. In this way the aggregate demand of a society as a whole falls which slows down economic growth.
This Keynes felt went a long way in explaining the real cause behind The Great Depression which started sometime in 1929. After the stock market crash in late October 1929, people’s perception of the future changed and this led them to cutting down on their expenditure, which slowed down different economies all over the world.
As per Keynes, the way out of this situation was for someone to spend more. The best way out was the government spending more money, and becoming the “
spender of the last resort”. Also it did not matter if the government ended up running a fiscal deficit doing so. Fiscal deficit is the difference between what the government earns and what it spends.
What Keynes said in the General Theory was largely ignored initially. Gradually what Keynes had suggested started playing out on its own in different parts of the world.
Adolf Hitler had put 100,000 construction workers for the construction of Autobahn, a nationally coordinated motorway system in Germany, which was supposed to have no speed limits. Hitler first came to power in 1934. By 1936, the Germany economy was chugging along nicely having recovered from the devastating slump and unemployment
. Italy and Japan had also worked along similar lines.
Very soon Britain would end up doing what Keynes had been recommending. The rise of Hitler led to a situation where Britain had to build massive defence capabilities in a very short period of time. The Prime Minister Neville Chamberlain was in no position to raise taxes to finance the defence expenditure. What he did was instead borrow money from the public and by the time the Second World War started in 1939, the British fiscal deficit was already projected to be around £1billion or around 25% of the national income. The deficit spending which started to happen even before the Second World War started led to the British economy booming.
This evidence left very little doubt in the minds of politicians, budding economists and people around the world that the economy worked like Keynes said it did. Keynesianism became the economic philosophy of the world.
Lest we come to the conclusion that Keynes was an advocate of government’s running fiscal deficits all the time, it needs to be clarified that his stated position was far from that. What Keynes believed in was that on an average the government budget should be balanced. This meant that during years of prosperity the governments should run budget surpluses. But when the environment was recessionary and things were not looking good, governments should spend more than what they earn and even run a fiscal deficit.
The politicians over the decades just took one part of Keynes’ argument and ran with it. The belief in running deficits in bad times became permanently etched in their minds. In the meanwhile they forgot that Keynes had also wanted them to run surpluses during good times. So they ran deficits even in good times. The expenditure of the government was always more than its income.
Thus, governments all over the world have run fiscal deficits over the years. This has been largely financed by borrowing money. With all this borrowing governments, at least in the developed world, have ended up with huge debts to repay. What has added to the trouble is the financial crisis which started in late 2008. In the aftermath of the crisis, governments have gone back to Keynes and increased their expenditure considerably in the hope of reviving their moribund economies.
In fact the increase in expenditure has been so huge that its not been possible to meet all of it through borrowing money. So several governments have got their respective central banks to buy the bonds they issue in order to finance their fiscal deficit. Central banks buy these bonds by simply printing money.
All this money printing has led to the Federal Reserve of United States expanding its balance sheet by 220% since early 2008. The Bank of England has done even better at 350%. The European Central Bank(ECB) has expanded its balance sheet by around 98%. The ECB is the central bank of the seventeen countries which use the euro as their currency. Countries using the euro as their currency are in total referred to as the euro zone.
The ECB and the euro zone have been rather subdued in their money printing operations. In fact, when one of the member countries Cyprus was given a bailout of € 10 billion (or around $13billion), a couple of days back, it was asked to partly finance the deal by seizing deposits of over €100,000 in its second largest bank, the Laiki Bank. This move is expected to generate €4.2 billion. The remaining money is expected to come from privatisation and tax increases, over a period of time.
It would have been simpler to just print and handover the money to Cyprus, rather than seizing deposits and creating insecurities in the minds of depositors all over the Euro Zone.
Spain, another member of the Euro Zone, seems to be working along similar lines. L
oans given to real estate developers and construction companies by Spanish banks amount to nearly $700 billion, or nearly 50 percent of the Spain’s current GDP of nearly $1.4 trillion. With homes lying unsold developers are in no position to repay. And hence Spanish banks are in big trouble.
The government is not bailing out the Spanish banks totally by handing them freshly printed money or by pumping in borrowed money, as has been the case globally, over the last few years. It has asked the shareholders and bondholders of the five nationalised banks in the country, to share the cost of restructuring.
The modus operandi being resorted to in Cyprus and Spain can be termed as an extreme form of financial repression. Russell Napier, a consultant with CLSA, defines this term as “There is a thing called financial repression which is effectively forcing people to lend money to the…government.” In case of Cyprus and Spain the government has simply decided to seize the money from the depositors/shareholders/bondholders in order to fund itself. If the government had not done so, it would have had to borrow more money and increase its already burgeoning level of debt.
In effect the citizens of these countries are bailing out the governments. In case of Cyprus this may not be totally true, given that it is widely held that a significant portion of deposit holders with more than 
€100,000 in the Cyprian bank accounts are held by Russians laundering their black money.
But the broader point is that governments in the Euro Zone are coming around to the idea of financial repression where citizens of these countries will effectively bailout their troubled governments and banks.
Financing expenditure by money printing which has been the trend in other parts of the world hasn’t caught on as much in continental Europe. There are historical reasons for the same which go back to Germany and the way it was in the aftermath of the First World War.
The government was printing huge amounts of money to meet its expenditure. And this in turn led to very high inflation or hyperinflation as it is called, as this new money chased the same amount of goods and services. A kilo of butter cost ended up costing 250 billion marks and a kilo of bacon 180 billion marks. Interest rates as high as 22% per day were deemed to be legally fair.
Inflation in Germany at its peak touched a 1000 million %. This led to people losing faith in the politicians of the day, which in turn led to the rise of Adolf Hitler, the Second World War and the division of Germany.
Due to this historical reason, Germany has never come around to the idea of printing money to finance expenditure. And this to some extent has kept the total Euro Zone in control(given that Germany is the biggest economy in the zone) when it comes to printing money at the same rate as other governments in the world are. It has also led to the current policy of financial repression where the savings of the citizens of the country are forcefully being used to finance its government and rescue its banks.
The question is will the United States get around to the idea of financial repression and force its citizens to finance the government by either forcing them to buy bonds issued by the government or by simply seizing their savings, as is happening in Europe.
Currently the United States seems happy printing money to meet its expenditure. The trouble with printing too much money is that one day it does lead to inflation as more and more money chases the same number of goods, leading to higher prices. But that inflation is still to be seen.
As Nicholas NassimTaleb puts it in 
Anti Fragile “central banks can print money; they print print and print with no effect (and claim the “safety” of such a measure), then, “unexpectedly,” the printing causes a jump in inflation.”
It is when this inflation appears that the United States is likely to resort to financial repression and force its citizens to fund the government. As Russell Napier of CLSA told this writer in an interview I am sure that if the Federal Reserve sees inflation climbing to anywhere near 10% it would go to the government and say that we cannot continue to print money to buy these treasuries and we need to force financial institutions and people to buy these treasuries.” Treasuries are the bonds that the American government sells to finance its fiscal deficit.
“May you live in interesting times,” goes the old Chinese curse. These surely are interesting times.
The article originally appeared on www.firstpost.com on March 27,2013
(Vivek Kaul is a writer. He tweets @kaul_vivek)