Well, we're only 16 days into 2015 and it's already proving to be a humdinger. Market volatility is pretty intense with daily market moves exceeding 1% almost every day, all but one it looks. Oil keeps dropping, rising, dropping in big swings, and now there is a flight to safety into treasuries because people are afraid. When I talked about Godzilla moments to look for in 2015, I guess I forgot to mention Switzerland. It seems everybody else forgot to mention Switzerland as well, judging from headlines, for the Swiss National Bank just pulled a fast one on the Market, providing investors with a nice little wtf? moment.
But it looks like the SNB move is not quite a big enough stick to poke Godzilla to wakefulness. He may be scratching his side, or rubbing his nose, or somehow reacting to whatever part of his body was poked, but he is not awake. Regardless of his status, what the SNB did is instructive, and it would bode us well to glean some appropriate lessons from this move.
First of all, the move. For four years the SNB has peg the Swiss franc to the value of the Euro. Currency pegs are commonly used for the purpose of stabilizing exchange rates to smooth out import and export markets. The peg is achieved through bond purchases so that the pegger can regulate the flow of money into and out of the country. For example, China has pegged the yuan to the dollar for only Godzilla knows how long. The Swiss pegged the franc to the euro to keep the value of the franc from rising so that its exports (watches, pocket knives, and chocolate) would be more competitive. But there's more to it. In Switzerland, Godzilla has a different name, and that name is Deflation. The Swiss held the value artificially low compared to the euro so that prices in francs would stay high, thereby keeping asset values, like a house or stock portfolio, high. Now the prices of those assets are plummeting throughout Swiss markets as the value of the franc rises.
The U.S. Federal Reserve did essentially the same thing, only less so. Even Japan didn't out-QE the Swiss. The battle of the currencies has been an ongoing feature of the global economy since 2008 as nations sought to defend their exports. The U.S., with the recent discontinuation of the formal bond purchasing known as QE, has caused the value of the dollar to rise against other major currencies. Now there is an anticipated raising of the prime interest rate in the U.S. by the Federal Reserve with the announced date being sometime midyear, which would cause the dollar to go up even further. Whether that happens or not is anybody's guess, it is up to the Fed after all, but a rate rise is to be perceived as a message of strength and hope that the U.S. economy is truly on the mend. This notion isn't entirely without justification if you look at the numbers, but there is, naturally, more to the story.
This other part of the story is deflation. Deflation has been bought off through the various burnt offerings dished up and out by the Fed and other central banks, to the tune of $16 trillion dollars. $16 trillion dollars is an interesting number. It is roughly equal to the entire U.S. GDP. It is also roughly equivalent in percentage terms to the amount the SNB has relative to Swiss GDP. The SNB has $400 billion booked on the balance sheet, which amounts to 85% of GDP. Is this 85% of GDP a magic number signifying the upper limits to QE? Does global QE still have $40-odd trillion left to go before central banks have to collectively pull out? These probably aren't the right questions.
These numbers show how tenacious the deflationary force is throughout the entire global economy. It's taken the equivalent of the American GDP over five years to stabilize markets and to keep them from selling off everything they own. We can thank Ben Bernanke for that, and I'm being somewhat sincere in saying that. But as they, or They, say, there's no free lunch. Somebody pays, and in this case it is the future that pays. But, as we all know, the future becomes the present. The future has become painfully the present in Switzerland, and migrating towards Europe, who will have to respond in short order. The concern is that the future might be too expensive. In fact, that could serve as a subtitle for this blog: The Future is too Expensive. And this gets me to what some in the media are saying about this.
The video below is from "Bloomberg Surveillance" on Bloomberg TV and the guests are Robert Albertson and Drew Matus, two fellas I didn't know existed until this morning. They are both market creatures and live their market beliefs through their jobs. The questions, answers, and statements here are packed with significance. Everything they say says a lot about the situation and their own assumptions regarding what is and what should be. Underlying it all, of course, is the problem of economic growth, that which cannot be allowed to falter. Being good market people, they blame QE and government intervention as the primary, and only, barrier to achieving economic growth. "It (QE) doesn't work", they proclaim, without stating clearly what QE is not working to do. But that is just one of many points which could be made about the interview. Here's the vid:
Bloomberg Surveillance
There's too much that I'd like to comment on, so I'll be self-limiting. Two observations, though, will satisfy me for now. The first is that Albertson and Matus, when giving their perspectives on employment, contradicted each other. Albertson said at the opening in his assessment of the effectiveness of QE cited labor force participation to support his judgement of QE. His statement was accurate. Labor force participation is indeed down to levels last seen in the early 80's. Matus, in defending his position that U.S. interest rates should rise cited the unemployment rate which does not count people who have left the labor force. The difference between them is great and begs the question of their value as statistics. A low unemployment rate can justify all sorts of policy decisions, but the labor force participation rate says the U.S. economy has not recovered at all in terms of employment since 2008.
The other observation I had was about a minute into the video when Matus talked of normal investor behavior and normal central bank behavior. He is talking about the Fed's interest rate, which is forever important to talk about. During the clip he uses some form of the word "normal" three times. This is his bias. He believes in a normal growth rate for any economy that is unfettered, period. A foundation for market fundamentalists is that, if one allows price discovery, the market will correct itself. As a consequence of this belief, he advises, or would advise any government who asked for advice from him, to end government supports. The question that naturally follows is: What would happen?
The blindness for people who think this way comes from a lack of appreciation for the power of deflation. The Swiss event gives us the picture. Absent QE or other government support for the economy, the market would scream "get rid of money!". This happens to be the same thing as saying "get rid of debt!". One exclamation sounds horrifically undesirable, something no sane person would ever say. The other is perfectly reasonable, even admirable, to say. How can they be the same thing? It is because money is credit. Stop borrowing and watch the economy spiral down the toilet. Ben Bernanke understood at least that, which is why he ratcheted up the Fed's balance sheet, saving the economy from a slow grind global depression. A depression is a place from which money has taken a vacation. So these investor's, if they get what they wish for, would soon find out they have no money to invest. This is not a radical notion, because any historical view of the economy can only lead to the conclusion that depressions are normal, if infrequent. The abnormal has been the very period in which the government has been most involved in the economy, namely, the post-War period.
A depression is probably like what Switzerland has entered into. Switzerland is a small country with a small GDP. It also happens to be a thoroughly connected country in the global banking system with an importance far beyond what its size would suggest. Nevertheless, it appears containable. We shall see, of course. But what it gives us a glimpse into is the matrix of how the global economy operates and why it is struggling. No market fixes are gonna fix it. It is something that needs to be managed on the way down. With QE we bought time. We used the time to prop up a failing system. Nothing has been done to address it during this time. Now the problem is worse.
In the end, it's misleading to call it a problem. The Swiss National Bank was faced with a dilemma. They couldn't keep going and they couldn't stop. However, they had to make a decision. Either way a disaster was bound to occur. They chose one way. Really, the only way if they were to salvage anything from the future. So, the lesson I take from this is that trust in a powerful institution has been seriously damaged. Trust in institutions is the necessary precondition for functioning markets. That is the story to watch.
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