Closing Out 2013 with Plenty to Think About

Fiscal Gridlock: Light at the End of the Tunnel?

The House of Representatives has just passed a budget deal that will, in principle, avert another showdown on fiscal policy for at least two years. The new deal will increase permitted discretionary spending by $48bn over the next two years. This will replace the cuts that would have been imposed by the sequestration process under current law. The increase in discretionary spending is, once again, a triumph for lobbyists. Careful analysis of the deal exposes some shortcomings in terms of supporting aggregate demand in the near-term, mostly notably the failure to extend long-term unemployment benefits.

If passed by the Senate in its current form, the House budget deal will mean that extended unemployment benefits for 1.3 million people will cease on 28 December. The Congressional Budget Office (CBO) estimates that the cost of extending the programme for another two years would be $23bn. Extending the benefits would also have the combined effect of boosting GDP growth by 0.2% and creating 200,000 extra jobs. There is a possibility the Senate may insert another extension of the benefits as part of any compromise agreement. The bottom line is that the stance of fiscal policy in 2014 will be far less restrictive compared to this year. Fiscal policy will be tightened by “only” 0.7% of GDP next year compared to the very high 2.9% during 2013. Given the less stern headwinds from fiscal policy and the anticipation of no more budget showdowns, the backdrop for the private sector to engage in meaningful capital spending and hiring has seemingly been enhanced.

An Important Year Ahead for the Fed

A justification for the third tranche of quantitative easing was the prospect of the US falling off the so-called “fiscal cliff.” With the likely passage of some form of fiscal framework for the next two years, the need for the Fed to keep asset purchases in their current form has seemingly become diluted. The timing of the tapering announcement has fixated financial markets since May. The better-than-expected November Employment Situation report fuelled speculation that the Fed may announce a modest reduction in its monthly asset purchases at the 17-18 Federal Open Market Committee (FOMC) meeting. It is unlikely the FOMC would choose the final meeting of the year to announce such an important inflexion point in policy. Given the onset of the Christmas Holidays, market liquidity will not be as deep as usual: significant policy announcements during this period could have unintended and amplified consequences for financial markets.

The most likely timing of a tapering announcement will be after the arrival of a new FOMC and Fed Chair. Revised unemployment data will be released in early-January. The Fed will probably wish to see the new data profile before making any tapering announcement. Next year will be particularly important for US monetary policy and financial markets. The large number of personnel changes on the FOMC will probably produce amendments to communication policy. While the media has been fixated with tapering, the real crunch for financial markets will be when the Fed is forced to alter its forward guidance. Whatever the outcome with respect to guidance, the task of eventually shrinking the elevated level of excess reserves in the banking system has been complicated by the decision by Congress in 2008 to pay interest on reserves.

Strange Events in the Federal Funds Market

The Fed currently pays 0.25% on excess reserves to depository institutions. The effective federal funds rate has, however, consistently traded below the interest paid on reserves. In a competitive market, the differential should be arbitraged away. The current anomaly would seemingly indicate that the inter-bank borrowing market is still behaving in a somewhat dysfunctional manner five years after the financial crisis. What has happened since 2008?

Depository institutions are no longer the dominant providers of funding to the federal funds market. According to the Federal Reserve Bank of New York, nearly three quarters of the funding is now provided by Federal Home Loan Banks (FHLB’s). In contrast to depository institutions, the FHLB’s are not paid interest on their accounts at the Fed. The effective federal funds rate is currently trading at 8-9 basis points. The FHLB’s can still earn a positive return by lending in the federal funds market versus zero percent at the Fed. What is currently happening?

Commercial banks have been borrowing from the FHLB’s at 8-9 basis points and have been depositing the cash at the Fed to earn 25 basis points. This may partly account for the elevated level of cash assets in the banking system. US banks are making very easy money from the interest rate spread whilst not incurring any counterparty risk. Moreover, the current structure of paying interest on reserves only to depository institutions could spell trouble ahead when the Fed eventually decides to raise the federal funds target, because the interest rate on reserves will also have to increase. This could simply raise the incentive for banks to park even more cash at the Fed, further depressing the velocity of circulation of money. With hindsight, it is clear that the decision to pay interest on reserves only to depository institutions was made with no consideration or allowance for the potential knock-on effects to the monetary transmission mechanism.

Fed and BoJ: Different Policy Paths in 2014

The year began with both the Fed and Bank of Japan (BoJ) announcing ambitious schemes to expand their balance sheets. Risky assets have been the major beneficiaries, but the outperformance of Japanese equities is partly based on a sharp recovery in corporate profits. The BoJ has committed itself to an aggressive expansion of its balance sheet until the end of 2014. It will probably be the most unambiguously dovish of the world’s major central banks next year, partly because the Japanese economy faces a major hurdle in April with the imposition of a higher sales tax. The last sales tax hike in 1997 helped to push the economy into recession.

The Fed is expected to moderate its balance sheet expansion in 2014. The exact timing of the cessation of its asset purchases remains uncertain, but it will also be driven by the need to alter forward guidance. The Fed will probably combine any tapering announcement with a change in forward guidance, where the FOMC will probably commit to keep the policy rate low for a longer period. What does this mean for financial markets?

We are at an interesting stage of the global economic cycle. Hitherto, excess liquidity has shown up in financial assets. This could change in 2014 if excess liquidity ends up in the real economy. A major pillar of support will be removed from financial markets. Expectations for global growth in 2014 have recently been improving. Against this backdrop, it is not unreasonable to expect an improvement in private sector credit demand. The extent to which private sector demand increases in 2014 will decide just how much excess liquidity is pulled from financial markets. A large and sudden increase in credit demand due rising “animal spirits” will impart stern competition for excess liquidity, putting financial markets under pressure. In these situations, investors seldom pay attention to asset valuations.

US Equities: Ending the Year in a Bubble?

Some commentators claim quantitative easing has simply produced an environment ripe for financial bubbles. This is partly due to the distorted risk-free rate, against which the equity risk premium is evaluated. The onset of rising interest rates will require a higher equity risk premium, producing a headwind for risky assets. Bubbles are normally associated with periods where valuations have become disconnected with fundamentals. Is the current environment symptomatic of a bubble?

While equities are the riskiest component of the capital structure, they simply constitute claims on the future cash flows of a corporation. Quantitative easing has raised the net present value of future profits and dividends, boosting equity prices. This is a normal development and does not necessarily constitute a bubble. Moving forward, the key issues for US equities are: 1) whether the elevated share of national income attributable to corporate profits is sustainable, and 2) the onset of an appropriate discount rate. Labour’s falling share of national income has helped to raise shareholder returns. Some commentators fear a process of mean reversion, implying a squeeze on profitability. In the current environment, it is difficult to envisage which forces would trigger such a squeeze on profits. The rise in profits’ share of national income has been evident in other major economies. The sheer magnitude of the Great Recession has meant that the onset of cyclical wage pressures during the subsequent recovery has been severely delayed. There are few signs of this changing soon, implying that an elevated share of profits in national income still seems likely for the time being, thereby helping to support equity valuations.

Summary and Conclusions

The House of Representatives has just passed a two year budget deal that permits a higher level of discretionary spending than allowed under current law. The new deal does not, however, extend unemployment benefits due to expire on 28 December. The Senate may seek to amend this omission. Fiscal policy headwinds will not be as intense next year as in 2013.

Less intense headwinds from fiscal policy could reduce the need for the Fed to maintain the current structure of its asset purchase programme. A tapering announcement seems unlikely this year, particularly given the numerous pending changes of personnel on the FOMC. Forward guidance will be an importance feature of Fed policy in 2014, because markets will begin to focus on when excess reserves in the banking system may finally begin to shrink.

The Fed’s task of shrinking excess reserves has been complicated by the decision in 2008 by Congress to pay interest on reserves. Disintermediation in the federal funds market has resulted in a divergence between the effective federal funds rate and interest on reserves. Banks seem content at simply making money on the available interest rate spread. This partly accounts for the elevated levels of cash assets in the banking system.

The Fed and BoJ deployed similar balance sheet strategies in 2013, but the BoJ is likely to be the most dovish central bank next year. The Japanese economy faces a stiff near-term test with the imposition of a higher sales tax. Excess liquidity has been parked in financial assets for a prolonged period. This could change in 2014 if rising private sector credit demand sucks liquidity into the real economy, undermining financial markets.

There is continuing debate as to whether quantitative easing has simply produced a bubble environment for US equities. The low discount rate has raised the net present value of elevated profits and boosted equity prices. The sustainability of a high share of national income attributable to profits is crucial if current equity valuations are to be maintained. The severity of the Great Recession has delayed the recovery in workers’ compensation. This is likely to continue, thereby enhancing the chances of prolonging high profitability and supporting equity valuations.

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