The Devil Is In The Double-Entry
Strong Durable Goods Orders, ex-Transportation, of +1.7% will help end Q3 on a strong note (the first look at Q3 GDP is due tomorrow, and the consensus expects 2.5% growth and a 2.2% rise in the Core PCE price index). It does look like September was generally better than was feared in August; the question from here is whether Q4 data will follow the lead of the miserable October Consumer Confidence figure reported on Tuesday. As ever these days, though, the drama in Europe was the driving force behind market action. Bonds fell, with the 10y yield up 9 bps to 2.20%, and stocks rose 1.1% as investors seemed to see the balance of the news as favoring a brokered peace between EU nations fighting to put Humpty Dumpty back together again.
I confess that I don't see what they are seeing. There may be a solution, but if there is then it will be force-fed on banks following the old maxim "If a piece doesn't fit, then you're not using a big enough hammer." The 'plan' being promoted as such discusses fairly serious haircuts on holdings of Greek debt, required recapitalization of banks (although in some reports the recapitalization would have to come from raising money in the market, which has next to no chance of happening in these circumstances), bolstering or levering the EFSF, and various other bells and whistles. The only little problem is that the folks who hold most of the Greek debt, who must be party to any controlled restructuring, don't like it.
This afternoon's Bloomberg headline was "Impasse on Greek Debt Relief With Bankers Threatens EU Crisis Summit Deal." The Institute of International Finance, which speaks for a consortium of banks, said there is no current agreement "on any element of a deal." I find the headline chilling because it makes "bankers" the bad guys. It would not surprise me in the least if the politicians are calculating that by framing this as 'reasonable people vs the bankers' (why not pile on the bankers?) the politicians will bring them to heel without force because banks won't want the bad publ icity on top of what they already have as the villains of the world today. And, if they don't comply, then the politicians can frame the bankers as the road block.
Now, unlike for politicians, publicity isn't everything to banks. What we need to keep in mind is that this argument from the banks' perspective is about accounting. The economic value has been lost already. What is salient to the bankers at the moment is the question of how much of an accounting write-down they can avoid, so that they don't have to take any more of a bailout than is necessary. A second salient point, probably, is that whatever haircut they give Greece will be the starting point for negotiations with Italy, Ireland, Portugal, Spain, and some others. The negotiations over Greece are akin, although of course not planned as such, to the 'targeted negotiations' that the United Auto Workers historically have applied in con tract discussions with the auto industry. The first deal becomes the model for the next deal. This negotiation is about far more than just Greece.
Again, the money is already gone. Nothing can change the fact that Greece will never pay 100% of its current obligations. Nor 80%. Nor 60%, in all likelihood. This is about accounting for the losses. (Do not, in other words, be surprised if any 'solution' includes continued regulatory generosity about the counting of losses, just as every 'stress test' has).
Since this is not just about Greece, banks are not going to concede easily. Since it is not just about Greece, any political agreement is going to be hard to get past vigilant legislatures. That is to say that even if they get Humpty back together again, the trick is going to be keeping him together.
And all of this happens as we motor into conditions of declining market liquidity as the end of the year approaches. Perhaps the recent odd decoupling of some markets (for example, TIPS were strong today, and equities were strong, and inflation swaps widened 5-6bps even though commodities fell 1%) is an early consequence of the declining liquidity. I don't know; it seems early for that but I am keeping an eye on this decoupling.
I noted yesterday that commercial bank credit has finally joined the land of the living and has expanded by more than 1% over the last year (and at a considerably faster pace quarter-on-quarter). This I cited as a small ray of sunshine in the overall gloomy murk that is the financial/credit/sovereign crisis. It is a sign that some of the bank reserves, heretofore sequestered due to the attractiveness of riskless interest-on-excess-reserves (IOER) relative to risky lending at low rates, are making their way into the real economy. This does have a dark side, and that's the fact that - since we have never had excess reserves like this - we have no idea how quickly excess reserves will move into the transactional money supply and put upward pressure on prices. It is foolhardy to rely on a model here, because we've never seen anything like this. It could be gradual, and controllable, or it could be a dam bursting. We simply don't know, no matter what the august Chairman tells you.
But in an attempt to remain cheerful, let me review why QE1 made some sense when it was implemented (it's hard to argue that QE2 made any sense at all while IOER was in place). At the time, a key worry of policymakers was that the economy may have entered into a major deleveraging cycle, which would be associated with a sharp decline in the velocity of money. Since it isn't the quantity of money M, but the quantity times the velocity V, that affects nominal output (mainly through prices unless money illusion is epidemic), policymakers are rational to try and offset a decline in velocity with an increase in money. In full disclosure, I was one of those who at the time thought the plunge in velocity would be far more than could be compensated for by conventional monetary policy, and I doubted that the Fed could prevent def lation although I also said that the deleveraging would provide ideal conditions for an inflationary period thereafter.
So what happened, in the event? Money velocity did in fact decline, but the decline was not particularly severe compared to the severity of the event. The chart below (source: Bloomberg) shows M2 velocity since the 1960s.
Money velocity back to the old standard of normal.
Note that the decline in velocity was no more than was seen in the early-2000s recession. What is more, the level of velocity is not particularly low on a historic basis. The last two decades are the outliers. To me, this suggests that the decline in velocity has very probably run its course, absent a more gut-wrenching financial debacle, and so the current growth in M2 is more worrisome if it lacks that offsetting effect.
Also, the deleveraging that you hear so much about is simply overhyped. The chart below (source: Federal Reserve) shows the debt outstanding, in billions, of domestic financial institutions, households, and businesses.
You can see from this chart that whatever deleveraging there has been has been predominantly done by domestic financial institutions - and much of that, by the way, is because banks were flush with reserves and didn't need to roll as much debt. The terrible household deleveraging you have heard about is mostly mythical. It feels like there has been deleveraging, because we're so used to increasing debt every quarter, but there hasn't been much. And businesses have essentially the same amount of debt now as they did when the crisis began. Almost all of the leverage, that is, is on the bank side. And neither that, nor household indebtedness, is even back to trend.
So I am skeptical that we are in a grand deleveraging cycle. Yes, we are deleveraging, but no, it isn't dramatic. The gross level of debt from these three groups is still up 283% since 1990 (although that should fairly be adjusted for the rise in nominal GDP). There are two sides to that observation. It may be that we have only just begun to deleverage, and so we have much further to go and money velocity will continue to fall while we do so. But it may also be that most of the deleveraging cycle, for now at least, is complete. If that is the case, it is bullish for the economy (although please note this is not a call for Thursday, but something that would be felt in 2012 and 2013), but it also means that the Fed has overstayed its welcome and the uncomfortable rise in inflation over the last year is likely to continue.
As I send this 'to print,' headlines are flashing across the tape that Euro leaders have either reached a deal on a 50% writedown of Greek debt, or that they have reached a deal with banks on that haircut, or that they are 'close' to reaching such a deal. The stock market so far is justifiably hesitant, since only a couple of hours ago - indeed, when I started writing this article - there was 'no element' of a deal in place. I am pretty sure they are close to a dramatic announcement. I would be surprised if they were close to an actual substantive deal, given my observations above. This is not about just Greece, and any 'deal' that trades nothing to the banks that they don't already have (they already have the economic losses) in exchange for an order to go raise more money in the market for themselves isn't much of a deal in my mind! My suspicion is that the banks may have agreed to the idea of 50% but not to any details of structure. Since as my friend Peter Tchir has pointed out the 21% haircut wasn't really a haircut at all, the structure does matter. So the drama continues, the breathtaking headlines and ethereal details continue. It is all getting quite exhausting.