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A Framework That Provides Clarity

During periods of “low visibility,” confusion reigns: for every indication of one trend, there seems to be a countertrend. The key is to glean from the collective wisdom of reliable leading indicators a clear signal that the economy is headed for a turn.

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Mar 02 2015

End Games and End Times

There has been an extraordinary slide in interest rates across the maturity spectrum that has accelerated to the downside in recent months. For example, German seven-year yields have now dropped below zero for the first time, even with the German jobless rate dropping to a record low. Typical relationships between growth and interest rates have evidently shifted, in part because of structural issues.

With the European Central Bank (ECB) set to launch its Quantitative Easing (QE) program in March, there are growing doubts about its ability to buy €60 billion worth of debt securities each month until September 2016. As a result, the potential shortage of safe assets has become increasingly evident, driving yields lower across the board. Like the Fed before it, which “tapered” its QEternity program partly because of worries about owning large proportions of key fixed income markets, the ECB will have a difficult time not “becoming the market” like the Bank of Japan. Indeed, after some $11 trillion in global QE and counting since the 2008 Global Financial Crisis (GFC), central banks may be facing the limits of QE.

Some central banks, such as those in Switzerland and Denmark, have already moved beyond a zero interest rate policy (ZIRP) to a negative interest rate policy (NIRP). But the effect has been merely to move the zero lower bound to slightly below zero, beyond which a NIRP is likely to be unworkable, given the extent to which it may distort incentives. So this is not much of a solution, either.

In effect, after years of pulling demand forward, central banks are now playing the end game: they have essentially run out of demand to be pulled forward, cementing the inexorable decline in trend growth. As they face the limits of QE, ZIRP and NIRP, there is yield compression across the maturity spectrum, as fixed income markets run out of supplies of suitable securities. Given the hunger for yield and the paucity of consumer spending to be pulled forward, “escape velocity” is becoming more of a mirage.

The inevitable inability of policymakers to fulfill their promise to revive growth years after the GFC has had far-reaching consequences. For example, as we noted in the early months of the Arab Spring, almost four years ago, “The global recession’s harshest legacy may be the staggering level of youth unemployment in most developed economies.” Those jobless rates have stayed very high, certainly in most economies across the Middle East, and also in many Eurozone economies.

Meanwhile, even though the major central banks have painted themselves into a corner, and “neither monetary policy nor fiscal policy [is] well positioned to help the economy withstand adverse shocks,” as the latest Fed minutes put it, the Fed is getting ready to declare victory and raise rates.

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