On QE Tapering, Volatile Markets and the Microbiome – Part 1 !

From: aditya rana
Date: Sat, Jun 22, 2013 at 2:26 PM
Subject: On QE Tapering, Volatile Markets and the Microbiome – Part 1 !


The Fed meeting on June 19, 2013 may well have marked the beginning of a slow and gradual withdrawal of the unconventional monetary easing policies enacted by the Fed in late 2008 to prevent the U.S. (and global) economy from sliding into a depression. However, the adverse (and somewhat violent) reaction of global markets to this event might have set in motion a chain of events which could derail the Fed’s exit plan, forcing them to reverse course as they had to do in previous years (i.e. 2010, 2011 and 2012). To help shed light on this critical issue facing global markets, I summarise below recent commentary from Gavyn Davies (ex-chief economist of and Chairman of Fulcrum Asset Management – Goldman http://blogs.ft.com/gavyndavies/2013/06/20/the-fed-begins-its-long-and-gradual-exit/ ) and PIMCO (http://www.pimco.com/EN/Insights/Pages/Promise-to-Be-Irresponsible.aspx) :

Gavyn Davies:

-The key point made in Fed statement was that downside risk to the economy had abated since last Autumn, presumably because the U.S. economy had weathered the negative impact of the fiscal tightening rather well and the tail risk of a European meltdown had been averted.

-Bernanke, however, emphasised that they expect the QE programme to end only in the summer of 2014 when the unemployment rate is expected to drop below 7.0%, and that short rates will remain near zero until at least June 2015 and the 6.5% unemployment threshold (and not trigger) maybe revised downwards.

-The Fed has taken a big risk in announcing the start of an exit process before a significant improvement in the labour markets, and the risk of a sharp rise in bond yields could jeopardise the slow recovery.

-The pace of improvement in the labour markets has been slow, while the monthly employment numbers are now averaging 199,000 rather than 129,000 last September, the unemployment rate has only fallen to 7.6% from 7.8% over the same period.

-Moreover, the decline in the unemployment rate has been driven mainly by people dropping out of the labour force and the critical employment/population ratio has remain unchanged. Additionally, other measures of unemployment have not shown much improvement since last September,

-The Fed, by introducing unemployment thresholds, is trying to convince markets that, while the exit process might have commenced, it is likely to be a long haul given the still unhealthy state of the labour market.

-While risk to all assets has increased, it does not (yet) signal the start of a bear market in bonds.

PIMCO (Barnet, Worah):

-The recent rise in real yields, and the fall in inflation expectations, poses a real risk to the U.S. recovery.

-The housing market is very sensitive to real interest rates (even more than to nominal rates) , and the recent 100 basis points increase in mortgage rates poses a big risk to the nascent recovery in the housing market which is key to the economic recovery. Owning a house is attractive when you expect higher inflation and rents to move up, but fears of deflation force you into cash and renting.

-Increasing Inflation expectations are important to escape a liquidity trap (i.e. rates are at zero) because they allow for continued monetary easing via negative real interest rates which support an increase in nominal GDP.

-In the aftermath of the 2008 financial crisis, the Fed implemented QE1 which raised inflation expectations from deeply negative territory to about 2% . However, since then the Fed has rushed to exit QE, at the end of the first quarter in 2010, 2011, 2012 and now 2013, on the perceptions of an improving economy and 10-year inflation expectations reaching 2.5% (see chart below).

-With seasonality in economic data, in the oil markets and in the flow of funds into inflation protection at the beginning of every year, the Fed has tended to overreact by announcing an exit which has then pushed inflation expectations down, real rates up and slowed the economy, thereby forcing the Fed to ease again.

-In order to ignite the animal spirits and push real rates down, the Fed attempted to "promise to be irresponsible" by stating that rates would remain at zero until inflation rises above 2.5% and unemployment remains above 6.5% and that it would continue it asset purchases programme without a specific end date. The market and the economy responded by showing some signs of improvement.

-However, the market did not expect the Fed to announce its exit plan with modest growth and employment improvements and core PCE inflation at a record low of 1.1%. The market will now likely challenge the Fed’s commitment to push the economy out of a liquidity trap with negative consequences. Less monetary easing is a de-facto tightening.

-With rates at the zero bound, tapering too soon and a possible reversal later, could prove to be a costly mistake and actually result in making the Fed’s balance sheet even bigger.

We are at an important juncture for global markets. While the market is likely to continue to be nervous about the Fed’s tapering programme for a while longer, the monthly purchases of $85Bn per month should provide some level of support. As noted in previously, with the fiscal deficit financing declining to about $100BN (from approximately $500 BN over the prior six months) for the balance of this year, total purchases by the Fed of $500 BN (even if adjusted downwards at the September meeting) would actually increase the net liquidity flows into markets.

We now have a 7% unemployment rate threshold to monitor for a final ending of the QE programme, and based on the Fed’s prior record of being overly optimistic on the economy, it is unlikely that QE will end in the summer of 2014. More likely, it is a QE programme with changing amounts (up and down) depending on the pace of economic recovery well into 2014. Also, watch closely the statements by the Fed governor’s Yellen, Williams and Dudley (the "Troika") as they have accurately indicated upcoming changes in Fed policy in recent years. Lastly, with the annual Jackson Hole central bank summit in late August and the Fed meeting in mid-September (not to mention the German elections!), we can expect another volatile summer ahead of us!.

In addition to the Fed, actions by the ECB and the PBOC to reverse their (misguided!) tightening policies will be important to monitor. To put it in context (via The Wall Street Examiner), the ECB has reduced its balance sheet by about Euro 500 BN since late last year through the repayments on its LTRO progamme. The correlation between its balance sheet size and the U.S. Treasury market is uncanny as the chart below depicts-due to European banks parking their excess funds in U.S. Treasury bonds for the carry (on a FX hedged basis). On the issue of the PBOC tightening (according to Reuters) the PBOC has drained 198 billion yuan ($30 BN) so far this year after injecting 1.438 trillion yuan ( $218 BN) in 2012. 1.4 trillion may sound like a lot, but it was on a base of over 29 trillion, so it was an increase of “only” 5%, which pales in comparison to the 35% the Fed is adding to its asset base this year. To a large extent, the ECB and the EM world have piggy-backed off the Fed’s aggressive monetary easing policies implemented late last year- and now it’s their turn to engage in the heavy lifting or risk a meltdown in their financial markets.

So the time has come to watch the parameters outlined above closely – as the famous financial philosopher L. Berra wisely said, “You can observe a lot by watching.”

On the Microbiome-Part 1:

The cutting edge of current medical research is to look into how the vast amounts of microbes in our bodies influence our health – as long as we are able to maintain the diversity and balance of this "ecosystem" we remain healthy and if it gets out of whack, we fall prey to a host of illnesses. In this regard, I came across a fascinating article on the subject by a Berkeley professor, Michael Pollan. Some key points (it’s a long article and will cover it over a few newsletters):

-Our bodies have about 10 trillion human cells, but play host to about 100 trillion microbial species (mainly bacteria) called the microbiota – which comprise largely commensals (i.e. free loaders), mutualists (live for mutual benefit) and a small number of pathogens.

-99% of the genetic information we pass on to our progeny is microbial, and this "second genome" (i.e. the "microbiome") may influence our health even more than the genes we inherit from our parents which tend to be fixed, while the second genome can be reshaped and cultivated.

-Disorders in our "ecosystem" – a loss of diversity or a proliferation of the wrong type of microbe may expose us to a whole host of chronic diseases and infections. Human health should now "be thought of as a collective property of the human-associated microbiota" as per a recent landmark research note on the subject.

-Our resident microbes also appear to lay a critical role in training and modulating our immune system, to help it distinguish between friend and foe, and the alarming increase in auto immune diseases in the West could be related to a disruption in the interaction between our bodies and their microbes.

-The multi-fronted attack on bacteria over the last century, and the western diet which is detrimental to the well being of the microbiota, has led to an impoverished "Westernized microbiome".

-The environment plays a significant role in shaping a person’s microbiome, with a family sharing a house have a similar microbial community.

-The development of a baby’s gut commences during and shortly after birth, when a distinctive infant community of microbes assembles in the gut. With the intake of solid food, and then weaning, the types of microbes gradually shift until age 3, when they finally resemble an adult community similar to their parents.

-The study of a baby’s gut community has yielded important insights into why they matter so much to our health – and one of the first clues was the issue with human breast milk.

-Human breast milk has a certain complex carbohydrate which the human infant lacks the enzyme to digest – contradicting evolutionary theory which argues that it should have value to the infant or would have been discarded long ago as a waste of precious resources.

-However, it is now clear that the particular carbohydrate nourishes a specific bacterium which has a unique ability to break down and make use of it. And the growth of this bacteria in the baby’s gut crowds out the pathogens and protects the lining of the intestines which plays a critical role in preventing infection and inflammation.

-Human milk is a "prebiotic" – a food for microbes – as well as a "probiotic" – i.e. carries a population of beneficial microbes introduced into the body, so the guts of bottle fed babies are not optimally colonized.

-Most of a baby’s gut community are acquired during birth – a microbially rich and messy process that exposes the baby to a variety of maternal microbes. Babies born by Caesarean, being born under a relatively sterile procedure, do not acquire the mother’s vaginal and intestinal microbes at birth.

To be continued.

I will be travelling next weekendsto the next newsletter will be sent out on July 6!. Here’s to navigating volatile markets over the summer and being friendly to those friendly microbes!




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