There are no big themes dominating the news today. So it is a perfect time to hit a couple of themes with an economic and market theme approach. Let’s talk banks, Japanese trade, the currency wars and deflation.
Banks. First, on the banking sector, one theme I have seen a lot regarding the lack of credit growth has to do with the increasingly onerous regulatory environment we live in being incompatible with prodigious credit growth.
We heard Jamie Dimon complaining about this yesterday, commenting on Fannie and Freddie putbacks driving tighter lending standards at banks. Honestly, I think there is some truth to Dimon’s view, meaning that the documentation hurdles to getting a mortgage are higher now because banks are afraid that if they don’t document everything, they will be make themselves vulnerable to Fannie and Freddie being able to stick the banks with loans packaged into GSE paper if those mortgages go sour.
My view here is that we want good regulation. And we didn’t have it leading up to the crisis. On the flip side, while higher documentation is necessary, as usual, the response has been overkill, because it is driven by fear. At the margin, this has retarded mortgage credit growth in a bad way. But better documentation is necessary to prevent shoddy underwriting in a originate to distribute mortgage environment in which originators have fewer incentives to maintain good underwriting standards. Let’s also remember that Fannie and Freddie are going after so-called strategic defaulters for deficiency judgments as well. Their regulator, the FHFA has mandated they do so in order to recoup the bailout costs shouldered by US taxpayers. So, a lot of what we see now in the US mortgage market is driven by the changed regulatory environment for Fannie and Freddie. And that IS having a negative impact on credit.
Now, Calculated Risk did a brief analysis on whether mortgage lending was too tight and came down saying lending probably is too tight, whereas it is easier in other arenas. This is a classic case of fighting last year’s war when the excess is somewhere else: leveraged loans, subprime auto, etc. Some regulatory relief is coming, with regulators promising not to make strict 20% down payment requirements but this prevents a further tightening. It does nothing about today’s lending environment.
Bank capital. At the same time, the need for more bank capital is going to make banks more reluctant to make loans. This is true on both sides of the Atlantic. Here’s what’s happening in the US:
The biggest banks in the US might have to issue at least US$260bn of senior unsecured debt over and above what they need to run their businesses in coming years, to comply with anticipated stricter loss-absorbing capital rules and extra equity buffers to be announced by the Federal Reserve after November.
The estimate, from one of the US’s biggest banks, is a conservative one that is based on the maximum 20% level of total loss-absorbing capital to risk-weighted assets that the Financial Stability Board is expected to propose at the G-20 summit in November, in addition to a raft of additional equity buffers.
The FSB’s proposals, outlining the amount, type and location of loss absorbing capacity for global systemically important banks (G-SIBs) will be reviewed and subject to change before being finalized in 2015.
Fed governor Daniel Tarullo has hinted that the Fed’s version of the FSB rules, expected to be released at the end of this year or early 2015, might be tougher.
The credit crisis proved to us that poor regulation and undercapitalized banks don’t mix. As difficult as the increased capital requirements may seem, they may be necessary if we are to prevent another crisis. Is the negative consequence of this lower credit growth? Yes, probably we will see lower credit growth as a result of these measures. But, credit growth should not be the driving factor behind economic growth. We need to see productivity gains and wage gains too. I would prefer to see lower credit growth and larger wage gains as a mix that maintains growth without relying on credit. At least the first half of the puzzle is rectified. The wage growth is what is now missing.
In Europe, we also have learned that at least 11 banks will probably fail the stress tests. The talk is of three banks in Greece, three in Italy two in Austria, one in Portugal, one in Belgium and one in Cyprus. I am not enamoured with stress tests as a failsafe for bank health. But to the degree we are moving to a higher capital environment, this will reduce fragility in Europe’s financial system and weaken the bank – sovereign nexus at the core of the sovereign debt crisis there. As with the US, the need to raise more capital will at the margins, reduce willingness to lend. But this is not necessarily a bad thing.
Europe is relying on monetary policy and credit growth to do the heavy lifting to get it out of a depression. This approach will not work, especially with fiscal policy tight. I expect European growth to be weak for years to come.
Japan. We got Japanese trade figures today. The numbers support my contention that competitive currency devaluation is a poor way to reflate the economy. Behind the Argentine peso, which lost purchasing power because of rampant inflation and a sovereign default, the yen is predicted to end 2015 as the biggest loser among major currencies. Kyle Bass of Hayman Capital was on CNBC earlier today touting his short Yen trade. Yet when we look at the figures, Japan is seeing no benefit.
Japan posted a record deficit of ¥5.427 trillion in goods trade in the first half of fiscal 2014, against a backdrop of rising energy imports caused by the prolonged halt in nuclear power generation, the government said Wednesday.
The deficit expanded 8.6 percent from a year earlier to reach the highest amount for the April-September period since data became available in 1979.
And here’s the problem as the BBC put it today:
The weak yen has helped bring down the cost of Japanese goods sold abroad.
The finance ministry data showed that exports to Asia were strong, with sales to China up 15% for the month.
However, a consequence of the weaker yen has been to raise the cost of importing fuel, raw materials and components, hurting the manufacturing sector in particular.
The euro is expected to remain weak. And so Europe is obviously doing its part in the currency wars to gain an edge by exporting its deflation abroad. But will it work? I say no, especially since the periphery’s major trading partners are within the eurozone.
So what I expect is continued downward pressure on prices as consumption demand growth remains weak. Japan will be the test case for monetary policy’s ability to manufacture inflation. I am dubious about this and had a good exchange with David Beckworth on Twitter regarding the possibilities. I said I’m not convinced a central bank can hit an inflation target reliably. Japan will be a good test.
The BoE is now missing the target pretty horribly with inflation almost 1% below target. Soon it may need to send a letter to Chancellor explaining why. If you check the Bank of England’s website, you will see they sent letters to the Chancellor showing their lack of inflation target performance every year from 2007 to 2012. That’s a poor showing.
My expectation is that Japan will miss the 2% target as oil prices remain low and the consumption tax bites.
I will leave it there for today. I had intended to write about Apple’s earnings but I will save that for another day.