Wednesday, February 22, 2012

central banks, money, and the global economy

Here are two weekly forex bar charts. The top chart shows the price of the euro in US dollars, while the bottom chart shows the price of the US dollar in yen.

The past four years have seen three distinct episodes of world wide fears of possible bank panics in the US and in Europe in 2008, 2010 and 2011. In each case there were fundamental economic problems that lay underneath the banking problems - in 2008 bad real estate loans and associated derivative products and in 2010 and 2011 uncompetitive economies in Greece, Portugal, Spain, Italy, Ireland, .....

Monetary policy cannot solve economic problems, but it can buy time to solve such problems by allaying fears of a banking panic and bank collapses. During the past three years the Fed, the European Central Bank, the Bank of England, and the Bank of Japan have all attempted to provide markets with necessary liquidity through programs of quantitative easing.

This quantitative easing was necessary because economic uncertainties and risks had increased the demand for short term, safe and liquid assets. Absent central bank action this increased demand for liquidity would have led to the collapse in the value of longer term assets (loans and bonds) held by commercial banks. Indeed such a collapse occurred during the second half of 2008 before central banks even realized there was a problem. A collapse in asset prices is always associated with economic weakness and this makes it harder for governments to do something about underlying economic problems.

Quantitative easing by a country's central bank generally leads to a depreciation in that country's currency. Indeed, this is the single most important indication that the central bank's action has been effective.

You can see in the charts above that the Fed (and the Bank of England) took the lead in implementing quantitative easing programs. The first effort by the Fed lasted about a year from March 2009 to April 2010. The second phase started in October 2010 and ended in May 2011. Both phases were associated with significant depreciating of the US dollar against the euro and against the yen (green arrows on both charts).

Next up was the Bank of Japan which sold yen against foreign currencies to stop yen appreciation which is an effective tightening of monetary policy unless counteracted. On four separate occasions, starting in March 2011 around the time of the big earthquake in Japan, the Bank of Japan intervened dramatically in the currency markets (four purple arrows on upper chart).

Late last year the European Central Bank began a program of buying sovereign bonds from commercial banks. This program is scheduled to end on February 28 and has had a modest effect on the euro (blue arrow).

I personally think the central banks have not provided nearly enough liquidity to the markets but at least their hearts are in the right place as these charts show. They have warded off the imminent threat of a banking panic which would have done terrible economic damage above and beyond the damage we have already seen. Looking forward I think their efforts will be reflected in higher stock prices in the US, in Europe, and in Asia over at least the next year or so.


Anonymous said...

Great summary but just my 2 cents: Ever since Reagan replaced Volker with Greenspan (and now Bernanke, 'Greenspan Jr'), the Federal Reserve has been artificially inflating equity prices by printing money. As a result, nominal prices have increased, but the real value has been decreasing. Although traders may think they are making money (and they are in terms of nominal value), many are probably just treading water in terms of real value. Also, the increased demand in liquidity did not caused the collapse in long term loans and bonds value, the collapse occurred because their value was junk -- bad mortgages, etc. The collapse led to the increased demand for liquidity.

Nav said...

Great reading .Thanks for making my day by giving this article in a dull & difficult market.

marcusbalbus said...

why should the central banks "provide liquidity to the markets"? what is given in return? why not just give money to everyone, rather than the charade of "purchases" and "loans" thru fin intermediaries, most of who siphon off the spread. give the money directly to the people.

Nav said...

S+P 500 Sentiment gauges:
1)Daily Sentiment Index (DSI) (Feb 21): 71% bulls,
(70% 5 day avg, 70% 10 day avg). Nears overbought
,after the oversold 17% bulls 10 day avg in late-Dec.
Peaks above 85% bulls 10 day over the last three years.
2)Investors Intelligence readings (Feb 21): 51.1% bulls
(vs 54.8%), 25.8% bears (vs 25.8%), 22.3% correction.
Dip is a small plus, as its away from the 56-62% bulls
historical danger zone. Last week was the highest since
May 2 ‘11. Last year’s high was 57.3% bulls on Apr 5.

Win said...


Thanks for this. Basic economic theory, but something the bears who scream from zero hedge and almost every other bear blog don't understand. It's a damn shame that I have to take money from these poor people. NOT.;)

Joking aside, your post, like this blog, is a public service to all traders who read it.

Thank you,

MKS said...

There is one problem with this argument - in a global economy, attempts to devalue your currency result in a global "race to the bottom".....rememeber that if USD or EUR weaken, then Yen, AUD and other developing currencies strenthen - so they in turn intervene to cool off. I agree that a huge one-time stimulus would have been better, but now, doing one QE after another will add fuel to the fire.
By the way, your target for the "Domed house" top keeps moving all over the place!!!

ARJ said...

Thank for your great insight! For trading, as long as FED keeps pumping money and nobody would have problem with that, then we have to go with the fresh new money out of the printing machine.

But if you would continue, what would you forecast after next year or so? After FED/CB's build up even bigger balance sheet, and gov's put up a hugh deficit, how the picture would be for the future?

Don't you believe the latest boom bust cycle too spectacular, and to do with FED's bad policy, or is FED's step to save us via printing money not to bring us a bigger problem in the end?

ARJ said...

Have to say, really appreciated your market view as always. Just not sure what FED has been doing is actually good in longer term.

If good, wonderful, we have an easy solution, if bad, then, this damn FED better not to dig a even big hole for us, and ultimately destroy the economy and more...