Bridgewater Associates: Central Banks Coordinated Response To The Global Crisis - December 2011

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Bridgewater Associates: Collection of Writings (1999-2012)

Bridgewater Associates: Collection of Writings (1999-2012)

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  • 1. Bridgewater ® Daily Observations is protected by copyright. No part of the Bridgewater ® Daily Observations may be duplicated or redistributed without prior consent from Bridgewater Associates. Copying or redistribution of The Bridgewater ® Daily Observations is in violation of the US Federal copyright law (T 17, US code). 1 Bridgewater ® Daily Observations 12/01/2011 Bridgewater® Daily Observations December 1, 2011 ©2011 Bridgewater Associates (203) 226-3030 Ray Dalio Greg Jensen Larry Cofsky Jason Rotenberg Melissa Ristoff Central Banks’ Coordinated Response to the Global Banking Crisis As you are aware, the European banking liquidity and capital problem has been allowed to progress to potentially catastrophic levels for the global banking system. Yesterday’s coordinated dollar- liquidity- adding moves by major developed central banks conveyed a message that the liquidity tap is open. How exactly liquidity will be directed (beyond that which has been stated) is not clear. But presumably the message is that it will be made liberally available. At this stage we have more questions than answers about what can be done by whom given the deteriorated value of collateral. Though it is not yet clear what which central banks will do what, what is clear is that they are now easing to try to offset the deleveraging forces. For example, China's PBOC contributed to the easing by lowering its reserve requirements 50bps. Looked at more broadly in the context of a number of central back actions over the past few months— the Fed's twist; the new BoE round of QE; the ECB's rate cut, additional liquidity offering, and renewed bond purchases; and Australia, Brazil, and Indonesia's rate cuts— yesterday's announcements are further examples of a clear trend toward renewed easing across the globe in response to deteriorating conditions. Here are the monetary policy reactions globally since the economic and financial weakness became clear this summer: Tightening Easing Turkey: Tightening through increase in ON lending rate, though easing reserve requirements on FX deposits Russia: growth and inflation outlooks have turned down along continued uncertainty around global events Peru: indicators of global activity show signs of weakness and increased uncertainty Developed central banks cut rates on USD swap lines 50bps China: Eased reserve requirements 50bps India: continued tightening, hiking 50bps over last two meetings Iceland hiked 25bps at each of last two CB meetings Korea: uncertainty around growth intensified due to external risk factors Sweden: slowdown expected to be more pronounced than was forecasted in July Philippines: inflationary pressures expected to ease with the slowdown in dev world Chile: concerns about fiscal and financial risks have intensified England: BoE announced £75bln quantitative easing purchases Europe: ECB announced more covered bond purchases and other liquidity measures Hungary: tightened 50bps to fight forint declines Norway: high uncertainty about future outlook Malaysia: increased uncertainties surrounding global and domestic growth prospects Europe: ECB eased 25 bps United States: Fed started $400bln "twist" operation Poland: a possible economic slowdown in Poland coming primarily from abroad Indonesia cut 75bps Singapore: reduced upward slope of currency band Brazil: cut 100bps in past two meetings Thailand: eased 25bps Australia: eased policy rate 25bps Switzerland: pegged the Franc Most Recent Central Bank Actions From Tightening to On-Hold
  • 2. 2 Bridgewater ® Daily Observations 12/01/2011 Early in 2011, roughly half the world was tightening. That fraction has come down rapidly over the past few months as global conditions have weakened. Percentage of Countries Tightening in Last 3mos 0% 10% 20% 30% 40% 50% 60% 70% 80 85 90 95 00 05 10 Regarding the Decision to Lower the Cost of the Temporary Swap Lines We think two elements of the decision are notable: First is the fact that the decision was a coordinated effort, and, as evidenced by the statements coming from the various central banks, this coordination was noticeably public. While we would be careful to not read too much into this action, the coordination and the desire of US policy makers to publicly push through support for Europe despite the potential political downside may suggest a shift and be the first of a few global steps that may buy Europe some time (i.e., IMF/ELA coordination). But, this move by itself doesn't do much if it is not followed up with other steps. Second, we think it's hard not to see yesterday’s announcement as a clear indication of the acceptability of tapping these lines, even an invitation to the world's banks to do so. If the banks decide to the take the money, that could amount to a major injection of dollar liquidity. So far the banks have avoided the dollar swap lines despite the tightness in dollar markets. We are watching them closely. To note one sign of the possible impact of the announcement on funding conditions, a key indicator of dollar funding stress for Europe, the Euro/USD basis swap, retraced about a quarter of its sharp deterioration since the summer. This measure of financial stress had recently reached levels that suggested funding pressures as bad as those during the height of the 2008 crisis. When the swap lines were reopened back in September (with much less public fanfare) the basis swap saw little change. Yesterday’s move left it at what are still crisis levels, but the improvement is a positive initial sign for bank funding conditions in Europe.
  • 3. 3 Bridgewater ® Daily Observations 12/01/2011 -0.2% 0.0% 0.2% 0.4% 0.6% 0.8% 1.0% 1.2% 1.4% Jul-07 Jan-08 Jul-08 Jan-09 Jul-09 Jan-10 Jul-10 Jan-11 Jul-11 Jan-12 1-Year Euro / USD Basis Sw ap Europe's Other Central Banks We are watching them closely. As you know, based on how we add up the numbers, we believe that the European banking crisis dwarfs the European sovereign debt crisis (which is enormous) so that, if the sovereigns were in great shape, they would still have ruinous liabilities from trying to save "their" banks. So, both bank and sovereign deleveragings are underway. In this great deleveraging, as in all great deleveragings, there is a squabble over who will pay for what. Of course, in this case, the squabble is especially challenging because there are 17 countries (with opposing factions in each) with radically different vested interests pretending to act in their "common interest". In the old days -- when each country was a country, had its own central bank that printed its own currency and had its own fiscal organizations -- it was pretty easy to anticipate what their monetary and fiscal policies would be in light of their circumstances. However, now that the policy tools and the hands on them are not so neatly aligned with the vested interests, the policy moves are not as obvious. In all great deleveragings, governments have always tried the austerity path first, found that it doesn't work (because of the negative feedback loop) and shifted to have their central banks print money and devalue. Of course, when the great depressions are broad-based (as in the Great Depression and now), they all want to do this, so the devaluations are against gold and other assets that benefit from this reflation. In the Great Depression of the 1930s, the printing/devaluations took place in a sequence in which one country devalued (in moves called "beggar thy neighbor" policies), which shifted the relative tightenings to those that didn't print/devalue, which caused them pain, which prompted them to print/devalue. Now, Europe is going down this path. Since the appetite of those who have wealth to transfer it to help the debtors is limited and since it is increasingly apparent that austerity is ineffective, the great myths that "all we need to do is create faith and investors will come" and "austerity and our EFSF/ESM supports will create faith" are being shattered. While there is an emerging realization that restructuring these countries’ debts will have to occur, it is also understood that the rates at which these restructurings can occur without having a collapse are limited. So all eyes are now on the European Central Bank. However, this "European" central bank represents 17 countries with very different vested interests. While some people think that the ECB "money" can be funneled to the debtor countries without it costing anyone anything, policy makers with common sense know that's not true. Naturally, the representatives of the countries who need the support think that the ECB buying their bonds is the sensible thing to do while the others don't.
  • 4. 4 Bridgewater ® Daily Observations 12/01/2011 Given these circumstances, now is the logical time for the individual European central banks to reemerge and use the powers that they have (independent of the ECB) to aid their banks and their sovereigns. There is increasing speculation that their facilities may also be used as part of the funding for some sort of IMF bailout mechanism. As they act to support the European financial system, the debt/liquidity that they create will end up as someone's obligation, so we all need to consider whether what they are doing is printing or building up greater liabilities for European governments. In an environment in which the sovereigns and the banks are essentially broke, the national central banks are the last line of defense against growing bank runs. The national central banks are not obliged to report their operations in a timely and transparent manner, so there is some mystery about how much lending they have actually done. What is clear is that their support to European banks has surged over the past year -- from basically nothing to over 100 billion -- and has likely risen more than what has been reported. These facilities have been key in helping to offset the pain of domestic bank runs, particularly in Ireland and Greece. National Central Bank Support (€bn) 2007 2008 2009 2010 2011 25B 50B 75B 100B So far, the only national central banks largely known to have active Emergency Liquidity Assistance (ELA) facilities are in Greece, Ireland and Belgium, though it would not at all be surprising to us if the list is longer and not yet known. However, over the past several months, Italian and French banks have been dramatically ramping up their borrowing from the ECB, suggesting that those systems as well are beginning to suffer from a loss of private-sector funding to the point where they are forced to seek support from the ECB. The question now is how much more pressure they can take before they have used up all of the collateral acceptable to the ECB, which would require France and Italy to embark on ELAs of their own.
  • 5. 5 Bridgewater ® Daily Observations 12/01/2011 ECB Support to Banks (€bn) 2008 2009 2010 2011 50B 100B 150B 200B France Italy It is worth keeping in mind that while these ELA programs have been ramping up, there is the potential that their use could escalate much further. The European banking system continues to have a high reliance on risky, short-term wholesale funding, and there is roughly 10 trillion euros of support that continuously needs to be renewed. The stability of the system is both at the mercy of the counterparty's willingness to lend and also pressured by the still-declining value of European assets used as collateral for that funding. These funding gaps will create continued pressure for European banks to de-lever in a controlled manner, either by raising more stable funding or by reducing assets. How ELAs work Each national central bank has the right to create an ELA and lend under whatever terms it desires, i.e., the length of funding, the acceptable collateral, the haircut offered on that collateral and the interest rate offered are at the discretion of the individual countries and the laws that govern their central banks. When the ECB conducts regular repo lending operations, it lends against high quality, liquid collateral (largely securities that are rated A- or better, with the exception of sovereign debt, which can be lower); it does not generally accept loans or collateral with very low ratings. The ELAs, on the other hand, are willing to accept lower-quality and less liquid collateral than the ECB. As banks run out of ECB-eligible collateral, either because other liabilities are being pulled or the value of the collateral they are posting to the ECB declines, an ELA provides the possibility of posting lower quality bonds, loans or even self issued bonds, in order to obtain funding. This collateral is likely to prove extremely difficult to liquidate in the event of a default. The ECB can act to close an ELA with a 2/3 vote of the ECB governing council if it believes the ELA interferes with its monetary policy objectives. However, we would think that given the number of countries that potentially need an ELA, obtaining a 2/3 vote against any particular ELA will be very difficult. ELAs Are Backstopped by the National Central bank, then the Sovereign In the event that domestic banks default on their ELA with their National Central Bank, the National Central Banks could suffer a loss if the collateral is insufficient to cover the loan. These losses, unlike losses from ECB repo lending, would not flow directly to the ECB. European law, specifically Article 14.4 of the statute of the European System of Central Banks, states that the national central banks are on the hook for these losses. And over the past few years, whether through law (as in the case of Belgium) or assurances (as in the Irish finance ministry’s “letters of comfort” to the Irish Central Bank), sovereigns have largely affirmed their obligation to make good any losses taken by the national central banks through the ELA facilities. If the sovereign is unable to recapitalize its national central bank, which is not unlikely for peripheral countries, then the national central bank could theoretically operate with a negative equity position and the losses still wouldn’t flow to the ECB.
  • 6. 6 Bridgewater ® Daily Observations 12/01/2011 In the event that a country with an ELA defaults and leaves the EU, then there is a likelihood, though it is not clear, that the ECB would recognize a loss. This may or may not result in a capital call by the ECB on member states. The ECB has several hundred billion euros of buffers (revaluation account, seignorage, reserves, and capital) to absorb losses, so a loss from an ELA, even if it did end up with the ECB, would not necessarily result in a capital call. Other Countries Developed Demand Remains Anemic; Evidence of a Spillover to EM Demand Remains Limited Developed world household demand remains depressed, and if this weakness persists over time it may flow through to weaker incomes, resulting in a further deterioration in conditions. Within the developed world, US demand has improved a bit and is moderate, while demand is very weak in the rest of the developed world. In the emerging world, demand has cooled a bit, but remains moderate. EM demand has slowed a lot less than production, which has been more affected so far by slower developed world spending along with the pullback in foreign capital. Typically, in the emerging world production has led incomes and spending, as much more of production is driven by external demand and policies are often linked to the developed world (so policies are not as much an independent driver as in the developed world). We would expect some emerging demand weakness going forward, with the question being one of degree. In the developed world, current conditions clearly call for further easing, while the ability to do so remains in question. Many emerging countries are in a better position to ease both fiscal and monetary policy if conditions warrant, but some may be constrained by capital flight and currency weakness. We have seen movement towards easing in the emerging world, most recently with China’s decrease in reserve requirements. However, fully replacing foreign capital flows with domestic easing may prove challenging (see the Sept. 26 Observations). Below are measures of demand for the developed world and emerging world (excluding China). Japan’s numbers are not representative of underlying growth because of distortions related to their earthquake, and we show China further below (our demand measures are around 8-10% and a bit below their historical average, though also slowing). World Household Demand Growth (BW 3m est.) -6% -4% -2% 0% 2% 4% 6% 8% 10% 12% 07 08 09 10 11 EM Ex Chn DW ex Jpn Weak Below we zoom in on demand conditions in the emerging world and then the developed world.
  • 7. 7 Bridgewater ® Daily Observations 12/01/2011 Emerging World Demand Has Moderated but Remains Healthy Emerging market demand has cooled over the last six to nine months, but not nearly to the same degree as the developed world. The broadest measures of demand are actually the softest, with both second quarter and third quarter PCE growth rates looking modest. However, retail sales growth is still healthy at around 7% through October, and confidence measures remain near secular highs, suggesting that EM demand is still healthy and not weakening further. The chart on the left shows PCE growth versus retail sales growth and on the right PCE growth versus confidence levels (since confidence levels have a stronger relationship than changes with demand growth). The confidence measures are normalized by their volatility, so that a reading of zero would correspond to average levels. We exclude China so as not to completely distort the measures for the rest of the emerging world (China’s demand remains healthy but it has slowed since last year). -5% -3% -1% 1% 3% 5% 7% 9% 11% 03 04 05 06 07 08 09 10 11 -15% -10% -5% 0% 5% 10% 15% 20% EM ex CHN Real PCEQoQ EM ex CHN Real Retail Sales Some moderation, but still healthy -6% -4% -2% 0% 2% 4% 6% 8% 10% 03 05 07 09 11 -3 -2 -1 0 1 2 EM ex CHN Real PCE QoQ EM ex CHN Consumer Conf., z Slow dow n not evident in conf measure In the beginning of the year, emerging production and demand growth were falling together while more recently demand growth has stabilized while production growth continues to weaken. However, it may just be a matter of time before the lack of production growth flows through to demand. Unlike in the developed world, production has tended to lead in the emerging world as changes in external demand flow through to lower production, then incomes, and then finally domestic spending. While domestic policies also drive conditions, they have tended to be more linked to the developed world, and developed world demand makes up a greater share of EM production. -5% -3% -1% 1% 3% 5% 7% 9% 11% 13% 00 01 02 03 04 05 06 07 08 09 10 11 EM Ex-China Production Grow th EM Ex-China Demand Grow th Slow dow n in EM grow th has been mostly in production. Domestic demand has stabilized.
  • 8. 8 Bridgewater ® Daily Observations 12/01/2011 Developed World Demand Remains Weak Despite some improvement in retail sales in the last month or two, developed world demand measures remain weak. In particular confidence measures remain secularly weak despite the uptick in November. Real PCE (the broader but staler measure) was nearly zero in the second quarter and looks to be mediocre in the third. Overall, the generally low levels of demand and confidence reflect the realities of a deleveraging, depressed asset prices, and weak prospects for income and employment. As we show further below, there is also a sharp divergence between healthier US demand measures and weaker demand measures elsewhere. -6% -4% -2% 0% 2% 4% 6% 8% 95 97 99 01 03 05 07 09 11 -12% -7% -2% 3% 8% 13% DW PCE Grow th (Ex-Jpn, QoQ Ann.) DW Real Retail Sales Grow th (Ex JPN, QoQ) Mediocre PCE. Pop in retail sales driven by US. -6% -4% -2% 0% 2% 4% 6% 8% 95 97 99 01 03 05 07 09 11 -3 -2 -1 0 1 2 DW PCEGrow th (Ex-Jpn, QoQ Ann.) DW Consumer Confidence (Ex-JPN,z) Confidence dow n in recent months, and secularly w eak Developed world demand has gone from contracting to roughly flat, which is of course still very weak. But even this small improvement has mostly been driven by a pop in US demand while the rest of the developed world demand continues to contract. Europe in particular continues to weaken as Germany and France deteriorate. As we have discussed in previous Observations, this increase in spending in the US has been financed by a decline in the savings rate. With unemployment at elevated levels, anemic wage growth, and constrained borrowing, this increase in spending is likely unsustainable. Therefore it is likely that this source of strength will fade in coming months and more stimulation will be necessary to support developed world demand. Household Demand Growth (BW 3m est.) -8% -6% -4% -2% 0% 2% 4% 6% 8% 00 01 02 03 04 05 06 07 08 09 10 11 Dev World (ex-JPN, ex-USA) USA Recent uptick in dev w orld demand driven mostly by the United States Looking at this picture at a more granular level, growth rates are similar in most emerging regions at around 4-5%, but these growth rates are below the historical average for the emerging world. There is however a fair amount of difference between countries, with Singapore being very weak (although their demand growth rates are also very volatile). China’s demand growth is particularly strong (though
  • 9. 9 Bridgewater ® Daily Observations 12/01/2011 slowing) which is why we excluded them from the previous charts. Within the developed world, our demand measures are below average everywhere except for the US (which as we discussed before is likely unsustainable). Japanese demand has been choppy recently, but the current weakness is reflective of their slow rebound from the earthquake. We show this picture below, with growth rates by country in the first chart and then growth rates relative to their historical average in the second chart. Household Demand Growth (BW 3m est.) -9% -4% 1% 6% 11% CHN ARG IDR PLD MAL PHP IND RUS BRZ COL PER Aus TAI TLD TUR Usa MEX KOR Can CZK HUN Eur Gbr JPN SGP EMEurope LatAm EMAsiaexChn DWexJpn World Household Demand Growth vs Average (z-score) -2.0 -1.5 -1.0 -0.5 0.0 0.5 1.0 1.5 2.0 Grow th is below average everyw here Of course, aside from the differences in growth rates between the emerging and the developed worlds, these countries are operating at very different levels of activity and demand. As the chart below shows, for many emerging economies, the financial crisis produced only a modest pause in household spending, with real spending levels today 10-20% higher than they were pre-crisis (using PCE as a proxy). In China’s case, spending levels are up almost 30%. In contrast, real spending in the developed world has only just surpassed pre-crisis levels. Three consecutive years of no real growth in household spending for the developed world has not happened in the last 50 years, so it is an indication of considerable weakness. And of course with demand growth very weak, developed economies are stagnating at these levels.
  • 10. 10 Bridgewater ® Daily Observations 12/01/2011 Real PCEvs 2008 Levels -15% -10% -5% 0% 5% 10% 15% 20% 25% 30% 35% Demand remains depressed in the developed w orld. Crisis only a temporary pause in the EM w orld. Stepping back, conditions in the developed world clearly call for stimulation given the weakness in demand growth and short-term measures (confidence surveys) that suggest some further deterioration outside of the US. In contrast, the slowdown in much of the emerging world, particularly in domestic demand, is not problematic yet because it took place from much higher levels and growth rates are still healthy in most cases. However, we still expect to see a greater flow-through from both slowing external demand (through production) and weaker capital inflows. If and when this happens, emerging economies have a greater ability to ease than developed economies. We would also expect that fully replacing foreign capital flows with domestic easing may not be trivial. Bridgewater Daily Observations is prepared by and is the property of Bridgewater Associates, LP and is circulated for informational and educational purposes only. There is no consideration given to the specific investment needs, objectives or tolerances of any of the recipients. Additionally, Bridgewater's actual investment positions may, and often will, vary from its conclusions discussed herein based on any number of factors, such as client investment restrictions, portfolio rebalancing and transactions costs, among others. Recipients should consult their own advisors, including tax advisors, before making any investment decision. This report is not an offer to sell or the solicitation of an offer to buy the securities or other instruments mentioned. Bridgewater research utilizes data and information from public, private and internal sources. External sources include International Energy Agency, International Monetary Fund, National Bureau of Economic Research, Organization for Economic Co-operation and Development, United Nations, US Department of Commerce, World Bureau of Metal Statistics as well as information companies such as BBA Libor Limited, Bloomberg Finance L.P., CEIC Data Company Ltd., Consensus Economics Inc., Consumer Metrics Institute, Credit Market Analysis Ltd., Ecoanalitica, Emerging Portfolio Fund Research, Inc., Global Financial Data, Inc., Global Trade Information Services, Inc., Hewitt Associates, LLC, Intex Solutions, Inc., Markit Economics Limited, Mergent, Inc., Moody’s Analytics, Inc., MSCI, RealtyTrac, Inc., RP Data Ltd., Standard and Poor’s, Thomson Reuters, TrimTabs Investment Research, Inc. and Wood Mackenzie Limited. While we consider information from external sources to be reliable, we do not assume responsibility for its accuracy. The views expressed herein are solely those of Bridgewater as of the date of this report and are subject to change without notice. Bridgewater may have a significant financial interest in one or more of the positions and/or securities or derivatives discussed. Those responsible for preparing this report receive compensation based upon various factors, including, among other things, the quality of their work and firm revenues.