Economy Archives - Page 63 of 136 - the patient investor

December 8, 2014

Murray has endorsed macroprudential | Macrobusiness.com.au

Posted by Houses and Holes
At 12:52pm on December 8, 2014
Published with permission from Macrobusiness.com.au.

The one glaring problem with the Financial System Inquiry is that it didn’t push hard for the introduction of macroprudential policies. That takes the heat off both the RBA and APRA.

The truth is that higher capital requirements — combined with higher risk weighting on mortgages and tax reform — would have a similar (potentially larger) effect as macroprudential policies. In the long term financial system and tax reform is clearly the better approach to creating an efficient and sustainable housing and financial sector, but these reforms will take longer to implement.

That’s right. Murray’s principle recommendations are macroprudential. APRA is now free (and is being urged) to implement higher capital requirements. They do not require anything from government to go ahead. This is basically the model of MP envisaged by Prof Ross Garnaut.

A more interesting question is whether or not APRA will still act on specific areas of risk such as interest-only loans. These are a menace, as the US bust showed, and are surging. Murray did not mention them, being too granular, but said the following on MP more particularly:

The global financial crisis (GFC) prompted policy makers and regulators around the world to reconsider their approach to maintaining financial stability. Some countries at the epicentre of the crisis have since expanded their prudential perimeters and adopted more formal and centralised institutional arrangements. This includes establishing single entities with responsibility for macro-prudential regulation. Australia has long adopted what could be called a ‘macro-prudential’ approach to supervision under the rubric of financial stability. Yet, Australia’s institutional structure is relatively informal and decentralised. The Reserve Bank of Australia (RBA) and APRA each have responsibility for financial stability. However, most macro-prudential tools can only be deployed by APRA. This places a strong premium on cooperation between the two agencies.

Against the background of developments overseas, the Inquiry has considered whether Australia should change its institutional arrangements for making and implementing financial stability policy.

However, the Inquiry does not see a strong case for change in this area. Although approach has advantages and disadvantages, alternative institutional approaches are yet to be tested — as indeed is the effectiveness of many macro-prudential tools. For this reason, the Inquiry recommends no fundamental change to the current institutional arrangements for financial stability policy and no change to the prudential perimeter at this time.

That is neither here nor there and APRA will still be free to raise capital requirements for specific loans if it sees fit.

December 8, 2014

Economics is just politics masquerading as science | Pragmatic Capitalism

From Cullen Roche:

….much of economics is just politics masquerading as science

In an earlier blog, Roche discusses the reasons for this (emphasis added):

Most of economics involves conforming a political bias with a world view. For instance, most Keynesians start with government spending and taxing, how those government policies can influence the economy and then interpret a “model” in such a way that confirms their political bias. Monetarists start with the central bank and interpret a more laissez-faire view of a “model” to interpret how policy can impact the economy. Austrians start with the private sector and build a “model” that seeks to eliminate government. So on and so forth. Every “school” of economics has a very specific ideology and the political lines are very clearly drawn. This doesn’t even approach “science”. It’s more like religion.

If economics were more of a science it would start with stylized fact. It would start purely with how the system works and how it functions at the operational level instead of looking at how a certain political entity can use certain policies to conform to a particular world view.

Why did most economists fail to predict the crisis or prescribe the right cures? Because they’re not working from the foundation of stylized fact. They’re working from a policy bias position that renders their world view inapplicable much of the time.

So, what is economics good for? Unfortunately, not very much given that so much of it is really just a policy debate masquerading as a scientific debate. And until we start getting more scientific, like say, trying to figure out how key institutions (like banks) in our monetary system operate, then we’re just chasing our own tails thinking that economics is useful.

Read more at Economists are Politically Biased and That’s a Good Thing | Pragmatic Capitalism.

December 8, 2014

Australian banks rally on Murray Report

The ASX 200 Financial sector (ex-REITs) responded well to release of David Murray’s report into the financial services industry. As the largest constituent of the ASX 200 index, comprising more than one-third of market capitalization, sector performance is critical in determining future direction of the broader index. Breach of resistance at 7220 suggests that the correction is over. Follow-through above 7400 would confirm a fresh primary advance.

ASX 200 Financial ex Property

David Murray’s Financial System Inquiry

The Final Report of the Financial System Inquiry, led by ex-Commonwealth Bank CEO David Murray, calls on Australian banks to become “unquestionably strong” to prevent another financial crisis. The FSI calls for increased bank capital in the form of common equity, with capital ratios increasing from an average of 9.1% to the 12.2% threshold for the top quartile of international banks. The FSI also proposes that banks increase their average risk-weighting for home mortgages to 25-30% compared to current weightings as low as 15%.

Chris Joye from the AFR estimates that the first proposal would require about $21 billion in new capital, while increased risk-weighting would require an additional $15 billion. There may be some overlap between the two, but the combined requirement is likely to be more that $30 billion.

Impact on consumers is likely to be negligible. The FSI projects that a 1% increase in bank capital ratios would increase the weighted cost of capital by 6 basis points (0.06%) because of the higher cost of equity capital.

Bank Funding Costs with Increased Capital

But this does not take account of lower risk premiums required, for debt and equity, when capital is increased. A reduction of debt funding costs to 3.65% and equity to 14.75% would offset the increase in equity capital; so the actual cost increase may be considerably smaller.

A resilient banking system would not only avoid significant losses of GDP (as high as 158 percent) in the event of a financial crisis, but would save up to 900,000 jobs according to the FSI. In addition, reduced risk of a government bailout would minimize the threat to government debt levels and Australia’s AAA credit rating. Banks would also benefit through improved profitability and stronger growth prospects.

My concerns with FSI are mainly long-term. Raising capital ratios to the top quartile of international banks would certainly improve the resilience of Australian banks, but this is a moving target. We can expect average capital held by international banks to increase as other countries conduct their own reviews into the adequacy of bank funding. Also, leverage ratios (ignoring risk-weighting) remain low and should be progressively lifted towards a long-term goal of 6 to 8 percent. Reliance solely on risk-weighted capital ratios can encourage industry-wide concentration in low-risk-weighted assets which in turn will elevate risk. Lastly, bail-in bonds are dangerous — any attempt at conversion would destroy creditor confidence in the banking system with far-reaching repercussions — and should be discouraged.

I believe that stronger capital ratios are a win for both Australian taxpayers and bank shareholders. Implementation of the FSI recommendations would be a major advance towards building a resilient and sustainable banking sector.

December 7, 2014

A long-term view

Better than expected US jobs data and strong German factory orders helped to rally markets Friday. Also, ECB chief Mario Draghi’s Thursday announcement is seen as supporting broad-based asset purchases (QE) early in 2015. A long-term view of major markets may help to place current activity in perspective.

The S&P 500 continues a strong advance, with rising 13-week Twiggs Money Flow indicating medium-term buying pressure. Long-term and medium targets coincide at 2250* and we should expect further resistance at this level.

S&P 500 Index

* Target calculation: 1500 + ( 1500 – 750 ) = 2250; 2050 + ( 2050 – 1850 ) = 2250

CBOE Volatility Index (VIX) continues to indicate low risk typical of a bull market.

S&P 500 VIX

Germany’s DAX broke resistance at its earlier high of 10000, suggesting a further advance. Recovery of 13-week Twiggs Momentum above zero indicates continuation of the up-trend. The long-term target is 12500*, though I cannot see this being reached until tensions in Eastern Europe are resolved.

DAX

* Target calculation: 7500 + ( 7500 – 2500 ) = 12500

The Footsie is testing long-term resistance at 6900/7000. Respect of the zero line by 13-Week Twiggs Money Flow indicates long-term buying pressure. Breakout above 7000 would signal a fresh primary advance, with a long-term target of 10500*.

FTSE 100

* Target calculation: 7000 + ( 7000 – 3500 ) = 10500

China’s Shanghai Composite Index broke resistance at 2500 and is likely to test the 2009 high at 3500. Rising 13-week Twiggs Money Flow indicates strong (medium-term) buying pressure.

Shanghai Composite Index

Japan’s Nikkei 225 Index is testing resistance at its 2007 high of 18000. 13-Week Twiggs Money Flow respecting the zero line indicates long-term buying pressure. Breakout would signal another primary advance. A long-term target of 28000* seems unachievable unless one factors in rising inflation and continued devaluation of the yen.

Nikkei 225 Index

* Target calculation: 18000 + ( 18000 – 8000 ) = 28000

Weak ASX 200 performance is highlighted by the distance below its 2007 high of 6850. Falling commodity prices have retarded the recovery and are likely to continue for some time ahead.

The 2005-2008 Australian commodities boom was squandered, damaging local industry and hampering the current recovery. Norway successfully weathered a similar commodities boom in the 1990s, protecting local industry while establishing a sovereign wealth fund that is the envy of its peers. Their fiscal discipline set a precedent which should be followed by any resource-rich country looking to navigate a sustainable path through a commodities boom and avoid the dreaded “Dutch Disease”.

Respect of support at 5000 would indicate the primary up-trend is intact — but declining 13-week Twiggs Money Flow indicates selling pressure. Reversal of TMF below zero or breach of support at 5000/5150 would warn of a down-trend.

ASX 200

* Target calculation: 5000 + ( 5000 – 4000 ) = 6000

The daily chart shows a slightly improved perspective. 21-Day Twiggs Money Flow oscillating around zero signals indecision. Recovery above 5400 would suggest the correction is over. But reversal below 5200 is as likely and would warn of a test of primary support at 5120/5150.

ASX 200 daily

December 4, 2014

A 3-Sentence Explanation Of What Crashing Oil Prices Mean For America | Business Insider

Charles Schwab’s Liz Ann Sonders offers some simple maths that puts it all into perspective. In three sentences:

Consumer spending represents 68% of the US economy. Oil and gas capex represents about 1% of US GDP and less than 9% of US total capex (which in turn represents about 12% of US GDP). Therefore, the benefit of lower energy prices to the consumer and many businesses greatly outweighs the significant hit to energy companies and/or energy-oriented capex, especially in energy-oriented states.

December 3, 2014

Will falling commodity prices cause deflation?

Some readers expressed concern about falling commodity prices, especially crude oil, and whether this will cause global deflation. This confuses the cause with the symptom.

Crude

Falling prices are largely benign except where caused by a contraction of the money supply. Commodity prices may fall when there is an excess of supply over demand, but this is soon absorbed by changes in consumer behavior. Discretionary spending will rise in response to the savings, so that aggregate demand is unaffected.

A contraction in the money supply, however, is far more serious. Slow growth in the monetary base (below growth of real GDP) results in less money chasing the same goods, driving down prices. Supply and demand in this case are unchanged, but prices fall because of a contraction in the money supply. Wages, however, are sticky and do not fall in line with prices, leading to falling profits, cuts in production and job layoffs. Falling income from lower profits and fewer jobs leads to a contraction in aggregate demand, causing further cuts to production and income.

Contraction of the money supply also places pressure on banks to reduce lending. This danger was highlighted by Irving Fisher in the 1930s. Contracting credit reduces not only new investment but forces existing borrowers to liquidate some of their assets, mainly stocks and property. The surge of selling, and limited availability of credit, drives down asset prices. A feedback loop results, with falling asset prices prompting banks to further contract lending — in turn causing more price falls. That is the central bankers’ equivalent of a perfect storm. The graph below shows how close we came in 2009 to a deflationary spiral.

Working Monetary Base

Slow growth in the monetary base caused a sharp contraction in bank lending (below zero) in 2009. Only prompt action by the Fed averted a 1930’s-style collapse of the financial system.

The Fed indicated in October that it will curtail QE and no longer expand its balance sheet to support money supply growth. Should we expect another contraction of the money supply as in 2008?

The answer is: NO. When we look at the graph of the Fed balance sheet below, we can see that total asset growth [red] is slowing. But bank deposits at the Fed — excess reserves that earn interest at 0.25% p.a. — are slowing at an even faster rate. That means that the actual amount of money flowing into the banking system is not contracting, but increasing.

Fed Total Assets and Excess Reserves

The following graph shows a net growth rate (of Total Assets minus Excess Reserves on Deposit) of more than 20 percent. Expect growth to slow over time, but the Fed can adjust the interest rate payable on excess reserves to ensure that it remains positive.

Fed Total Assets minus Excess Reserves

Deflation is a far bigger problem for the Euro. After a “whatever it takes” surge in 2012, the ECB attempted to contract its balance sheet far too soon — withdrawing treatment before the patient had fully recovered. They also do not have excess reserves on deposit, like the Fed, which could soften the impact.

ECB Total Assets

The result has been faltering economic growth and price levels falling dangerously close to deflation.

ECB Total Assets

The ECB appears to have recognized its error, indicating that it will expand its balance sheet if necessary to avert a monetary contraction. If they learn from their past mistakes, the ECB should be able to avoid any threat of deflation.

November 17, 2014

Abenomics doing fine | Ambrose Evans-Pritchard

https://twitter.com/AmbroseEP/status/534464198856941569

November 16, 2014

Monetary Base and deflation

The Monetary Base consists of currency in circulation and commercial bank deposits at the Federal Reserve. Currency in circulation includes notes and coins both in circulation and held in the vaults of commercial banks. Commercial bank deposits at the Fed can be further broken down into required reserves and excess reserves. Excess reserves on deposit have soared — since late 2008 when the Fed started paying interest on reserves — to a level of $2.6 Trillion.

By varying the interest rate payable on excess reserves the Fed can manipulate the amount of currency in circulation. It is no longer reliant solely on Treasury and MBS purchases and sales to increase or decrease the money supply: these are merely one tool in the monetary tool-kit. So announcing that QE (security purchases) have ended does not mean that currency in circulation and the working monetary base (excluding excess reserves) will stop growing or will contract. That would cause deflationary pressure similar to the European experience. Growth, instead, is likely to continue provided that excess reserves are drawn down to compensate for cessation of QE.

US Monetary Base minus Excess Reserves and Currency in Circulation ROC

Deflationary pressures are unlikely to surface provided currency in circulation and the working monetary base continue to grow at above 5% a year. Only if real GDP grew at a faster pace (a problem we would like to have) would we encounter a problem.

Australia has similarly been keeping on the right side of 5% growth since early 2012. Provided this continues we should keep out of trouble.

Australia Monetary Base and Currency in Circulation ROC

November 12, 2014

Will the stock market collapse when QE is withdrawn?

This chart in Westpac’s Northern Exposure chart summary implies that US stocks rely on Fed balance sheet expansion (QE) for support.

Fed Securities Held Outright v. S&P 500

The curve shows an almost perfect fit. There are just two things wrong with it. First, the scales on the left and right sides of the chart are not proportionate: the scale on the left compares a 9 times increase to a 3 times increase on the right. Second, while the Fed has expanded its balance sheet to more than $4 Trillion, a large percentage of that money has washed straight back to the Fed — deposited by banks as excess reserves.

Fed Total Assets and Excess Reserves

The impact on the working monetary base (monetary base adjusted for excess reserves) is far smaller: a rise of 66% (or $544 billion) over the past 7 years.

Fed Total Assets minus Excess Reserves compared to Working Monetary Base

A chart since 1985 shows nominal GDP (GDP before adjustment for inflation) normally expanded between 5% and 7.5% a year outside of recessions. But NGDP has not recovered above 5% after 2008. This may be partly attributable to lower inflation, but the Fed would clearly want to see NGDP above 5% — roughly 3% real growth and 2% inflation.

Working Monetary Base Growth compared to NGDP

We can also see that growth of below 5% in the working monetary base is often precursor to a recession, 1995/1996 being one exception. The second is when the Fed took their foot off the gas pedal too early, after QE1 in 2010, but were able to resume in time to head off a major contraction. They have been far more circumspect the second time and are likely to maintain monetary base growth North of 5%. Too sharp a slow-down would be cause for concern.

When we calculate the ratio of total US stock market capitalisation to the working monetary base [blue line] it is apparent that market response to the increase in monetary base is far more cautious than it was in 1998/1999.

Working Monetary Base Growth compared to NGDP

With Forward Price to Earnings Ratios for the S&P 500 and Nasdaq close to their long-term average (Westpac Northern Exposure, Page 118), I consider the likelihood of the QE taper precipitating a major market collapse to be remote.

November 10, 2014

Global Bank Regulator Calls for Larger Capital Cushions | CFO

Matthew Heller reports that the Financial Stability Board, chaired by BOE Governor Mark Carney, is set to table fresh proposals at the upcoming G20 meeting in Brisbane. The world’s top 30 “systemically important” banks will be required to substantially increase their capacity to absorb losses without requiring a bailout.

The new rules would require global systemically important banks to hold minimum capital of 6% of total assets against losses — twice the provisional leverage ratio required by Basel III rules. In addition, banks would be required to have capital equal to at least 16% and as much as 20% of their risk-weighted assets, such as loans.

Even if the big four banks in Australia are not on the list, they are systemically important from an Australian perspective and should hold similar levels of capital.