Global Markets: The Great Dissipation - One Year on from Lehman

HIGHLIGHTS

• Global fiscal and monetary support has been immense, and will remain full-on for some time yet.
• Today's financial crisis could easily become a future debt crisis without fiscal retrenchment once private sector growth returns in earnest.
• Looking forward, long, steady, expansions with dampened volatility are likely history, making macro economic life tougher, and risk taking trickier.
• The publication also includes quarterly interest rate and exchange rate forecasts for the U.S., Canada, Australia, and New Zealand, and also offers additional exchange rate forecasts for the Japanese yen, the euro, the U.K. pound, and the Swiss franc.

Growth momentum lifts higher

One year has passed since Lehman Brothers folded, and the global economy has begun to recover. The decision by policy makers to met-out discretionary punishment to some financial firms and not others transformed a financial crisis into a global run on the bank, raising the cost of stabilizing both the global financial system and the global economy.

Fiscal and monetary support for the global economy has been immense, and policy stimulus will remain full-on for some time yet. The global relaxation in fiscal stance has been estimated at 5.5% of global GDP, and has primarily facilitated an increase in the household savings rate to repair balance sheets, limiting the expected damage to demand. With global demand weak but stronger than expected, producers are now increasing production to take the global economy sharply higher in the second half of this year.

The strong impact of policy support was facilitated by an eventual anchoring in inflation expectations in the developed world, and better inflation control in the emerging world. Maintaining inflation control is crucial to economic recovery, and likely to prevail as core inflation begins to decline and the global economy swims upstream against a powerful undertow of economic restructuring.

Monetary policy is in overdrive. Policy interest rates are effectively at zero in most major jurisdictions, accompanied by significant balance sheet expansion to provide liquidity, to allow central banks to be market makers of last resort, and to replace nominal GDP growth lost to recession. With the system barely stabilized, a focus on exit strategies from unusual policy measures is premature.

Most central banks are mindful that the economic recoveries following financial crisis, especially when globally coordinated, are about half as strong as they would normally be, and take twice as long to recover the pre-crisis peak in economic activity.

Confronting and preventing another great depression has been very costly, and cause for reflection - today's financial crisis could easily become a future debt crisis without fiscal retrenchment once private sector growth returns in earnest.

Given the lags in the cycle, disinflationary economic slack will continue to accumulate for a while yet, and the widely expected drift down in core inflation has hardly begun. Monetary tightening in the core countries of the US, Europe and Japan before the middle of next year is unlikely, anchoring longer-term interest rates at low levels to keep the ten-year US yield in a range between 3.0% and 4.0%, and the US$ is likely to trend lower.

Growth-positive policy settings, lots of spare capacity and a core inflation rate that is drifting down to anchor low and stable inflation expectations is good news for risky assets - likely extending the trend established in March.

Financial and Macro Volatility

The Great Moderation defined by falling GDP and inflation volatility gave way to the Great Dissipation in 2008. With inflation low, monetary policy contributed to building excesses by actively limiting the severity of recessions through easing policy stance aggressively. This put off the day of reckoning, so that the sharp and sudden return of macro volatility rendered the global financial system truly fragile.

Policy makers have walked away from the crisis questioning the contribution low inflation made to financial stability, and given the large post-crisis clean-up bill questioning their assumed role in a crisis: to stand ready with the mop and bucket.

The alternative is to lean into an asset price bubble before it inflates to grotesque proportions. Interest rates pushed into the service of asset price constraint rather than hitting an inflation target could have economic costs of foregone growth and sub-target inflation. Central banks had better be sure that the economic cost of preventative action is less than the cost of cleaning-up the mess.

Scarred by the crisis, central bankers will want to see good risk control in capital markets, and will contribute to that by eschewing guidance about their intentions once a trend tightening is initiated - explicit guidance about the pace, extent, and duration of future interest rate increases is likely a dead duck.

Looking forward, the economic cycle will play out quite differently than we have become used to in the inflation targeting period - sheltering the level of long-term interest rates from the impact of monetary tightening is a thing of the past. Long, steady, expansions with dampened volatility are likely history, making macro economic life tougher, and risk taking trickier. GDP volatility has returned.

Leverage and liquidity

The key investment lesson of the 2008 crisis was the need to value liquidity. Financial crises have one common element - the failure to provision for liquidity, largely because the returns to liquidity are low.

The Great Moderation and the re-cycling of excess savings delivered a prolonged period of low nominal investment returns. The need for many institutional investors to meet excessive return expectations and meet liability short-falls led to more and more leverage to amplify insufficient market returns. Many active managers used leverage to lock-up a liquidity premium, leaving them short liquidity by pledging liquid assets to fund illiquid holdings.

This strategy was increasingly followed by institutional investors who had traditionally played the role of the stabilizing, slow-moving, value player following a crisis. However, with cash holdings below the historical level, slow-moving value players were unable to stabilize the system early and capture value, contributing to, rather than arresting, last year's downside value overshoot. Central banks filled the gap.

Managing one's macro risk taking has never been more important, leaving many active managers and institutional investors to eschew systematic and illiquid investment strategies that lock-up cash to favour previously neglected “global macro” strategies.

Global macro strategies utilize deep, liquid markets, and offer a way out - even in extreme circumstances. Securitized products that levered returns from illiquid underlying assets, products that attempted to transform BBB credit risk to AAA credit risk that left behind bad debt detritus concentrated in the banking system, are unlikely to return.

Global macro is back, and back in a big way. Monitoring the supply of economic and financial surprises, as well as the overall leverage in the system takes on new importance in the period ahead. With central banks now treading a fine line between transparency and guidance, they could well become a key source of surprise.

Central Banks - Finding a Way Out

Much of our understanding of monetary policy has been grounded in a world of sound financial intermediation, but the 2008 financial instability has demanded a new play-book. Significant uncertainty now exists between the change in the stance of monetary policy through quantitative easing and the eventual impact on output and inflation. We should be prepared for outcomes that are significantly different from expectations.

The first objective for the central banks last year was to provide sufficient liquidity to stabilize financial assets under distress. This was successful. The second objective of some central banks was to monetize government debt to replace nominal GDP growth lost to the recession, and to encourage risk taking in capital markets to stabilize risk asset prices. The Bank of England led the charge both intellectually and practically in setting out a framework for QE and its pursuit.

Now that asset prices have recovered, and financial market inflation expectations as measured by break-even rates across countries have turned their back on deflation, attention has turned to central bank exit strategies - premature in our view.

Most of the debt monetization has been paid for with central bank reserve creation. But this is only inflationary if government debt is monetized without limit, or commercial banks transform central bank reserves into excess broad money. Neither is a near term issue.

Any exit strategy must consider both ability and willingness. Central banks have the technical ability to drain reserves very quickly if necessary. Willingness is there so long as inflation targets are owned by the government, and meeting the target has been contracted-out to the central bank with the inflation target the performance standard.

Any constraint on willingness would be political and signal an end to central bank independence - ultimately catastrophic for price and economic stability and contrary to the interest of governments. The large fiscal stimulus now sustaining economies as the private sector restructures itself is only effective if financial markets maintain low and stable inflation expectations.

Historically, large increases in central bank balance sheets tend to persist, and typically inflation tends to be higher than expected. Investors should respect history, but understand that any inflation higher than target in the years ahead - and many years ahead given that the disinflation from last year's shock has yet to get dug-in - will result from simple policy error. The willingness remains intact, but tightening began too late.

Long Live Bretton Woods Two

Policy makers pulled out all the stops in the past twelve months to stabilize the financial sector and the global economy. This has been hugely costly, leaving a legacy of public sector debt which must be worked down through a combination of fiscal discipline and, less likely but yet a risk, inflation that is closer to the upper range of central bank tolerance than the bottom of the range.

The key drivers of the credit debacle were poor regulation and distorted incentives. The recycling of Asian and oil-exporter savings surpluses merely facilitated the process. Constant capital flows to deregulated and sophisticated developed-world financial systems from the highly regulated and undeveloped financial systems in the emerging world, thus facilitated excessive risk taking and excessive leverage in the developed markets. It did not cause it.

The incentive to save in the developing world is intact, and outbound excess savings flows should be expected to continue. China remains focused on using an export platform to absorb excess labour so long as it remains too poor to absorb its productive potential, and fails to provide a sufficient social safety net to discourage excess saving.

Large capital inflows into developed markets will keep up the pressure to manufacture higher returns than are available passively. Financial innovation will continue, but regulators will attempt to dampen excessively risky activity by setting leverage ceilings and higher bank capital requirement on the assumption that financial players can easily game either capital or leverage, but not both.

In the final analysis, the backdrop for risk assets to the end of the year is extremely supportive: the financial system has de-levered significantly and volatility is declining. Moreover, the outlook for volatility over the balance of the year is benign given that the capacity for a big economic surprise this year is small, and the system is not badly exposed to any shock. But, as the recovery gains momentum and the financial system experiences the healing powers of time, financial vulnerability will grow as the scope for economic surprise grows.

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TD Bank Financial Group