I Do Not Understand the View from the Financial Markets…

I want to say that people like Global Head of Credit Products Strategy at Citigroup Matt King are simply not thinking clearly. The macroeconomic regularities that seem obvious to me simply are not there to him. What he ought to be saying is:

1. Mammoth safe asset shortage–in large part because since 2007 nobody trusts any of his peers’ issuing departments to create a AAA asset.
2. Hence destructively low yields.
3. Hence those that can need to bend every policy nerve toward creating large amounts of safe assets–which means borrow-and-spend on the part of governments: expansionary fiscal policy.

But that is rarely what he or his peers are saying. Thus I hesitate. Could they possibly be misreading the situation in such an obvious way? What are they seeing and thinking about that I am missing?

Thus I never know what to do with pieces like this:

Alexandra Scaggs: There’s No Yield, and Citi Isn’t Going to Take It Anymore:

Citi’s Matt King has some harsh words for central bankers… echoes a group of fund managers who say central banks’ stimulus efforts are distorting the way global markets function…. With negative yields on $13 trillion of safe assets, investment managers are crowding into the shrinking group of investments with yield–or into securities they may be able to sell to central banks. This has been frustrating for those fund managers, to say the least…. Here are some of the reasons he thinks markets are broken:

(1) A greater share of global equity-market variance is explained by macro factors…. (2) Credit spreads aren’t responding to climbing leverage and defaults…. (3) Normal market relationships are breaking down…. (4) Cross-asset correlations are high, even though volatility is low….

It’s clear that global central banks have had a big effect on markets. A bigger challenge is answering the following question: so what? Lower borrowing costs should be a benefit of central bank stimulus, you’d think. But King says corporate borrowing isn’t helping the economy as much as policy makers would like, and raises the risk that the leverage will make any economic downturn worse. He continues:

Most doctors–and even patients–know that when a course of drugs seems not to be working, you don’t simply keep on doubling the dosage. This applies particularly when the patient, if no longer as sprightly as they used to be, is nevertheless doing more or less fine. The side effects of such a course are more likely to kill than to cure. Yet this is what central banks now seem intent on doing. They have too much invested in their models to consider changing them in our view…

I look at graphs like this:

And I think:

• If the Fed had followed policies to put short-term safe nominal interest rates at 3%/year right now, then you add on the impact of that on inflation–pushing inflation down from just below 2%/year to just negative–and you have a real value of the dollar in all likelihood 30% more than it is today. Would exports be as high in such a world?

• If the Fed had followed policies to put short-term safe nominal interest rates at 3%/year right now, then you add on the impact of that on inflation–pushing inflation down from just below 2%/year to just negative–and you have real hurdle rates on business investment on the order of 5%-points/year higher than they are now. Would business investment–which is, in spite of the weak overall economy and sluggish growth, normal– be as high in such a world?

• If the Fed had followed policies to put short-term safe nominal interest rates at 3%/year right now, then you add on the impact of that on inflation–pushing inflation down from just below 2%/year to just negative–and you have potential homebuyers facing greatly accelerated amortization burdens. Would residential investment–pathetic as it is–be as high in such a world?

If King has a magic wand that can boost government purchases massively, then yes–higher interest rates might well be appropriate. But he doesn’t. So what is the magic wand that would boost what component of spending to offset downward pressure on exports, business investment, residential investment, and consumer durables spending that would come from higher interest rates and lower inflation right now? Or what is the magic wand that would make buyers of exports, planners of business investment, and buyers of new houses from reacting to the signals prices are sending them?

I just do not get it. King seems to envision a world in which interest rates are higher and he is happier because he can clip coupons on his portfolio, and all without anybody changing any of their spending decisions. I do not see how that world can possibly be.

Indeed, I don’t think even King would like the world he says he wants to see: business corporation and real estate equity cushions are ample on average, but in the anti-Panglossian world of bond finance that your counterparties have ample equity cushions on average isn’t worth very much in terms of guaranteeing the quality of the assets you are long, is it?