Similar symptoms, contrasting remedies...

Both the U.S. and Europe are currently experiencing a similar economic environment. Growth is rapidly decelerating, unemployment is rising, commodities sparked inflation is creeping up and the mortgage business is in shambles. About the only stark observable difference between the two economies is regarding their respective currencies that are moving in opposite directions. The difference is reflective of monetary policies that are also moving in opposite directions. If the problems that are being faced are similar in nature, why would the central banks of the U.S. and Europe tackle them in such opposite ways, especially given the perception that there is a lot of cooperation between the two? Part of the answer lies in their economic histories and another part is a direct result of their respective mandates. 

In the case of the U.S., the deflation trauma of the great depression has not been forgotten. It is further kept alive by a Fed chairman who is an avid expert on the topic. It therefore should come as no surprise that in the current economic turmoil, the Fed would have a loosening bias for its interest rate policy.

The ECB, in contrast, has embarked on a tightening bias, citing the growing risk of inflation. Part of the decision is due to its single mandate of price stability (versus the Fed's dual mandate of price stability and employment). History is the other major factor influencing the decision making process of the ECB. More specifically originating from its dominant German Bundesbank heritage. During the interwar years, Germany had suffered a severe bout of hyperinflation. Other European countries were to follow suit during and after the Second World War. We can therefore conclude that the hyperinflation trauma was collectively experienced in Europe.

These differences (historical and political) explain to a large extent why the two central banks, although facing similar issues, have opted to tackle it in opposing ways. What is certain is that both cannot be right and it is unfortunately too early to say who is using the correct antidote.

There is a cost involved in every action...

Pledges and further action from the Fed and the Treasury earlier in the week were clearly designed to avert a total bloodbath in the mortgage business but, as institutions steadily yield more power and influence on market dynamics, two questions come to mind.

1. At what point does interference begin to stifle development, or put another way, at what point does the marginal benefit of regulation begin to be outweighed by the marginal cost of such regulation?

2. At what point does bailing out institutions that are effectively considered bankrupt lead to a significant increase in moral hazard (which just sows the seeds of future bubbles)?

Answering either question with any degree of precision is clearly a futile exercise. Greater regulation and greater intervention are both to some extent actions that counter the very principles of capitalism. By regulating markets, for example, we take away a certain degree of flexibility which can have an adverse effect on economic development. Certainly markets are smart and creative enough to find ways around such regulations (part of the reason why we find ourselves in the current mess is a result of shadow banking activities caused by regulation).

And what about the issue of bailing out businesses that, in normal circumstances, would go bankrupt? We are just emerging from an era in which access to capital was both cheap and very easily obtainable. That environment led to a lot of businesses that would normally go bankrupt to stay afloat. Now that rates are rising, a wave of bankruptcies are exacerbating an already difficult environment. We can draw similarities with the Fed's intervention to avert bankruptcies, but the objective is very different. In the Fed's case, the reason for bailing out is to avert systemic risk from taking hold. But doing so introduces another dilemma, the so called moral hazard put option. 

In the end, it is a delicate balancing act the final outcome of which only the passage of time will tell...  

A sentiment driven game of ping pong...

Markets of late are in a sort of tug of war frenzy, undecided on whether it is the deflationary forces of a worsening housing slump combined with a steadily deteriorating credit market or the inflationary forces of commodity prices that show no end in sight that will drag the world economy into a recession. Complicating matters is the geopolitical risk premium on oil which has been the dominant factor behind the recent volatility in prices. With so much uncertainty out there, it is no wonder that markets are trading on nothing else than emotional impulses, observable from the steady rise in volatility over the last couple of months. For rational behavior to return would first and foremost require a fix of the housing market which, unfortunately, is in such a dismal state that it wouldn’t be realistic to expect a recovery any time soon. It would also require an improvement in the financial sector that has been battered by several waves of mortgage related write-offs and a systemic risk potential resulting from the broad market exposure to derivative instruments such as credit default swaps that are suffering from uncertainty in counterparty risk. The Fed's Bear Sterns intervention back in March was designed to avert the very systemic risk that continues to threaten the global economy. Unfortunately these problems are likely to persist as long as home values continue to deflate and credit becomes increasingly difficult to obtain.

A measure of market sentiment...

With the recent slump in stock markets across the globe, many are now technically considered to be in bear territory (defined as more than a 20% drop from a peak of less than year). This is further confirmed by looking at global sector performances as depicted in the bar chart graph below. The red bars show the one year performances of the various sectors, whilst the blue bars represent the performances since the start of this year. A "defensive" sector rotation can be seen from the performances. We see, for example, utilities, heathcare and consumer staples as amongst the least battered by the current turmoil. We also observe performance characteristics that are highly specific to this particular downturn. Information Technology, a traditionally growth industry, has done relatively well, benefitting from its export orientation and the weaker dollar. Financials have been battered as a result of the subprime crises and all that has ensued. Energy and materials in contrast find themselves in positive territory because of the significant demand and supply imbalances in commodities that have been driving their prices up through the roof.

At crossroads again...

The billion dollar question on people’s minds at this juncture is whether the economy is improving or actually worsening.
On the positive side we can give credit to a proactive Fed which, through its unprecedented actions has succeeded in nabbing a potentially global systemic risk at its bud. A continuous influx of much needed capital, from both sovereign and other sources have also helped in keeping the sickly financials afloat. We could also mention emerging markets, thanks to being in better economic shape with huge piles of cash and a greater savings rate, providing demand support for the wider economy of developed countries such as the U.S. where a weak dollar is contributing in making goods and services even more attractive.
On the negative side we have the ongoing imbalances in commodities that are threatening to trigger a price/wage spiral and social unrest across the globe. We can also cite the continued free fall in housing prices that the typical central bank toolkit is ineffective towards and a growing number of layoffs that can only contribute to shattering the little confidence that remains.
In our opinion, the most likely scenario will be for commodity prices to drop to more sustainable levels which in turn will relieve the large amount of pressure that has built up and allow the other imbalances, such as in housing, to run their course.

Inflation's many guises...

Inflation comes in different shapes and guises and the way it runs its course depends very much on the underlying environment.
Today we observe two distinct types of inflation across the world, a commodity driven type as observed in developed regions like the U.S. and Europe and a more economic activity driven type as seen in developing markets such as in Asia or the Gulf states. We could argue that the inflation in commodity rich developing countries are also commodity driven as it is the explosion in capital flows to these countries that is pushing their economies to the limit. But there is another factor that is playing a significant role in further fuelling inflation pressure, namely monetary policy. Many of these commodity rich countries happen to have their currencies somewhat pegged to the dollar. In order to maintain that peg, they have had to follow the Fed's switch initiated last September to a more accommodative stance on interest rates. This in turn has resulted in additional stimulus to economies that are already at full capacity. The risk of continuing in this path is that it triggers a wage/price spiral that, once it takes foot, is notoriously difficult to stop. This was the situation that developed countries faced during the oil shocks of the 70's when interest rates were kept dangerously low. Amongst the emerging countries, Brazil seems to be the one that has understood these risks most clearly as the central bank took action to mitigate the inflation pressure arising from economic activity by raising rates earlier in the year.
In developed nations, as mentioned earlier, the main risk comes from commodity prices remaining at record levels. Coupled with a sharp deceleration in economic activity, there is growing risk of fomenting a much dreaded stagflationary environment. Normally, given the positive correlation between economic activity and commodity prices, the economic slowdown should help alleviate some of the pressures that have built up but this is clearly not what seems to be happening. The reason might have something to do with the unprecedented environment in which emerging market economies don't seem to be faltering as they should (at least not yet) when their developed brethren enter a sharp slowdown. Maybe it is a question of time or maybe what we are witnessing is a paradigm shift!

Into the precipice?

Bad news on the economy last Friday sent stocks and the dollar tumbling and led to a surge in oil and gold. The cascade of events went something like this: the labor department reported the economy lost jobs in may (a fifth consecutive month of losses) and that the unemployment rate which was expected be 5.1% turned out worse at 5.5% (apparently more due to a surge in first time employment seekers). The market knee jerk reaction was to sell dollars reflecting a diminishing probability that the Fed would raise rates before the end of the year as the likelihood that the U.S. was in recession grew. In reaction to the dollar selloff, oil began to surge again (further emboldened by an Israeli minister's threatening remarks on Iran), triggering a selloff in global equities and a jump in bond yields as inflation took the front seat of the list of worrisome developments (confirmed by recent Fed remarks).
It is clear by the marked increase in volatility that the markets are trading mainly on sentiment and that when cool heads will eventually prevail, the current "stagflation" like environment will give way to a more sane outlook. This is not to say that the environment won't deteriorate further or that we won't see a sustainable rebound, it is just an observation of an environment that seems to be somewhat detached from reality.

Oil dynamics pt.2...

Debate is raging on whether it is fundamentals or speculation that is driving up commodity prices. It is most certainly a combination of the two but there seems to be increasing evidence that fundamentals are the main reason that most commodities have reached record levels. Take oil, for example, where imbalances are observed in both demand and supply. The secular demand story is linked to the increasing appetite of energy intensive development in emerging markets. The supply side is a result of random geopolitical shock and growing uncertainty regarding future reserves. The uncertainty comes from both the demand side (China, for example, discloses consumption figures with a major lag and the accuracy of the figures are questionable at best) and the supply side (Saudi Arabia, the world's largest producer, has never really been truthful when disclosing existing capacity and/or future potential).
With so much uncertainty in the air, no wonder speculation is playing a role. But in a situation where demand is accelerating and where supply is struggling just to keep up with that extra demand (not to mention shrinking existing capacity), it is becoming increasingly clear that fundamentals are the main drivers.
This is indeed worrisome if confirmed because it would mean that higher prices are here to stay, leading to far greater damage to the global economy/social cohesion than if it were mainly due to speculation in which case a sudden sharp correction would make it more of a short term issue.