Global Markets: The Great Dissipation - One Year on from Lehman
- Global fiscal and monetary support has been immense, and will remain full-on for some time yet.
financial crisis could easily become a future debt crisis without
fiscal retrenchment once private sector growth returns in earnest.
forward, long, steady, expansions with dampened volatility are likely
history, making macro economic life tougher, and risk taking trickier.
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
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
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
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
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
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
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
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
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TD Bank Financial Group