Today is a bit of a potpourri because I have three different unrelated topics to discuss and one review item. But I’ll make it (relatively) short. I have the most to say about Germany.
Bullish on the US economy
Let me start off with my ‘bullish’ economic commentary. For the past several months, I have been saying that there are basically no signs that near-term recession is a realistic probability. And by that I mean that I haven’t seen any data that would suggest the US economy is growing slow enough and the downside risks are large enough to tip us into a recession in the next six months or so. I consider the period beyond six months to be the medium term.
And anything after that timeframe is pure speculation. For example, my call last year that the base case for 2020 was a recession was purely speculative – and based on the trajectory of US growth down plus a prediction that policy error would compound that downward momentum. I said so at the time. But, the Fed has been especially attuned to not killing the recovery. And their present policy stance is accommodative enough that the risks may be to the upside rather than the downside, especially in terms of support for risk assets.
So, as 2020 has begun, I have seen data that has pointed to a bottoming in the manufacturing sector in the midst of a continued (and normal) slowdown in mid-to-late cycle job growth. The key shock to the US and global economies is the coronavirus outbreak. JPMorgan is talking about its taking 5.3% off Chinese Q1 growth. And since China is the second largest economy in the world, that’s big. But, to the degree the virus impact ends soon enough, we have some pent up demand in Q2 and Q3 that JPMorgan also notes in its forecast.
So, on the whole, in a benign coronavirus scenario, we have a demand timing issue and a marginal dip in global GDP growth. Since global GDP growth was already slowing, that is a bit worrying, especially for the eurozone, where economies are more fragile. For the US, given it remains above stall speed, the hit would not be problematic. It’s a protracted and escalating coronavirus situation that is the wild card. Let’s just deal with the uncertainty of that without making numerical predictions.
So, my view is that the US looks good – better than other developed economies. But global growth has slowed and continues to slow. The coronavirus presents significant downside risk there. But, for now, the tightening of financial conditions has receded. And as a result, the potential for policy error has diminished as well. verall, the situation is mostly positive for risk assets, especially bonds.
Fed Governor Quarles
As the year began, though, the big policy error question was about the Fed and its balance sheet. That’s because people were concerned the Fed would make the Y2K mistake with its repo-induced balance sheet expansion. If you recall, in 1999, everyone was concerned about computers breaking down because they were hard-coded for just two digits to reflect a year. People feared the year 2000 would look like the year 1900 to computers and everything would go haywire. The Fed injected liquidity into the system in 1999 just in case it was needed. But, after these Y2K bug worries turned out to be unfounded, they withdrew that liquidity, shrinking their balance sheet. And some people look at this as the trigger for the popping of the tech bubble.
Obviously, the worry is that the Fed would do the same thing in 2020 after the repo mess quieted down. But those fears have proved unfounded. There’s been no wind down in the balance sheet. Enter Fed Governor Randal Quarles. Here’s the key part of a speech he made on the 6th regarding future Fed policy:
Although I fully support the FOMC’s current plan to purchase Treasury bills and increase the size of the balance sheet in the very short term, over the longer-term, I believe that the viability of balance sheet policies is enhanced if we can show that we can meaningfully shrink the size of the balance sheet relative to gross domestic product following a recession-induced balance sheet expansion. In effect, I believe that balance sheet policies are more credible if we can show that there is not a persistent ratcheting-up effect in the size of the Fed’s asset holdings.
What he’s saying is this: I am fine with the recent repo operation, even though it has expanded the Fed’s balance sheet when we had been working to shrink it until recently. But, this re-expansion is temporary. Over the longer term, we at the Fed have to find a way to keep the balance sheet from growing more than GDP growth.
Now, while he isn’t saying the Fed is going to re-commit the Y2K error, he is saying that he is uncomfortable with the size of the Fed’s balance sheet – ostensibly because future quantitative easing is more potent if it’s a temporary expansion of the Fed’s balance sheet and not a permanent one. I haven’t fully digested what this means and whether it makes sense. But I do want to flag it because the repo mess showed us that shrinking the Fed’s balance sheet was more complicated than the Fed originally thought. And so, the potential for another policy error is clearly heightened if the Fed tries to shrink the balance sheet again, whether now or, as Quarles indicates, later.
The Repo Mess
As for Repo, I have been looking at the various explanations of what’s happening. And I think George Selgin gives a good overview of the baseline macro view here and in an interview on Real Vision with Raoul Pal. I have also heard what Zoltan Pozsar and Perry Mehrling have been saying about repo and liquidity issues. And I feel like I have a better understanding of the issues as a result. Here are two broad conclusions I would draw:
- The repo market is more important now because regulators are forcing financial institutions to prefer it for overnight liquidity since it is a funding market backed by collateral. That narrows the venues institutions feel comfortable using for overnight liquidity. And in worst case scenarios this means you could have a narrow exit during a liquidity crisis that causes damage to the financial system.
- US institutions have better access to dollar liquidity than foreign ones do. There are two different inter-connected US dollar money market systems, one that is onshore and the other offshore. Not all dollars are created equal as a result. And so, in a liquidity crisis, we should expect the offshore funding market dollars to be ‘worth less’ than the onshore dollars = again, a sign of narrowed exits. And because the lion’s share of increased global borrowing has been done in US dollars by offshore debtors, there’s a higher likelihood that offshore funding is going to be where the next crisis occurs.
For me, this is very much interrelated with what Quarles is saying because the Fed’s balance sheet operations have knock-on effects in these markets. All of this is very in the weeds, of course. And I am no expert here. But, it does concern me that the Fed continues to believe it must shrink it balance sheet despite not having figured out whether it has fully dealt with the repo market problem.
CDU Head Annegret Kramp-Karrenbauer resigns
Another issue I want to flag is in Germany, where Chancellor Merkel’s heir apparent has said she will resign her position as leader of Merkel’s Christian Democratic Union and also said she will not seek the Chancellorship. What’s more, in doing so, Annegret Kramp-Karrenbauer (commonly known by her initials AKK) said that having a party leader who is not Chancellor doesn’t work. So, we have a really big problem in finding a successor for Merkel, who’s been in seat for 15 years now.
The proximate cause of her resignation is the debacle in Thuringia, where the mooted FDP-CDU coalition was created via a boost from the AfD, considered a far right party. I wrote you last week what was happening there. The salient points are that the AfD party is radioactive among mainstream political actors and that it is the largest party on the right in much of the former East Germany. The CDU has said they won’t work with the AfD…EVER. And it’s the fact that the Thuringia state CDU leaders apparently defied AKK in creating their government with the support of the AfD that led to AKK’s resignation.
Here’s the one thing I want you to focus on though. In “Der Spiegel”, when they wrote up the events, they had this paragraph near the top of the article as explanation (the original German and translation follow):
Hintergrund ist das Debakel bei der Ministerpräsidentenwahl im Landtag von Thüringen: Dort war am Mittwoch der FDP-Politiker Thomas Kemmerich mit den Stimmen seiner Partei, von CDU und AfD zum Regierungschef gewählt worden. Die gemeinsame Wahl mit den Rechtspopulisten sorgte bundesweit für Empörung und wurde auch unter Liberalen und in der Union als Tabubruch verstanden.
Die CDU-Chefin sagte Teilnehmern zufolge in der Sitzung, es gebe in der CDU ein ungeklärtes Verhältnis von Teilen der CDU mit AfD und Linken. Sie sei strikt gegen eine Zusammenarbeit mit AfD und Linkspartei.
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The debacle in the election of the prime minister in the state parliament of Thuringia is the backstory here. On Wednesday there, FDP politician Thomas Kemmerich was elected head of government with the votes of his party, the CDU and the AfD. The election with the support of the right-wing populists caused outrage nationwide. And it was also understood by the Liberals and in the CDU as a violation of a taboo.
According to participants [of a Monday morning CDU crisis meeting], the CDU leader said at the meeting that the [Thuringia] CDU had an ambiguous relationship between parts of the CDU and the AfD and the Left Party.She was strictly against cooperation with the AfD and the Left Party.
Notice that AKK mentions both the Left Party and the AfD. As I told you last week, the Left Party is a successor of the SED, which ruled East Germany during the Cold War. And in the past, they had been considered in some ways as taboo as the AfD is now.
Normalization of the Left (and the AfD?)
But, it was when German Chancellor Schroeder ran on the neoliberal reform platform in the 2005 election that he lost to Merkel when this began to shift. Here’s the story. Back then, Schroesder’s policy received condemnation from the progressive branch of his party. Party veteran Oskar Lafontaine, a sort of German Bernie Sanders, led the outrage within the party. Lafontaine was a major political figure who had been Minister of Finance from 1998 to 1999, Minister President of the state of Saarland from 1985 to 1998, and Chairman of the Social Democratic Party, Schroeder’s Party from 1995 to 1999.
Lafontaine, who comes from the blue collar coal mining district of Germany, was so outraged by Schroeder’s ‘sellout’ to neoliberalism, that he left the party and joined the newly created Labour and Social Justice – The Electoral Alternative (WASG). This splintering of the SPD caused Schroeder to lose to Merkel, who has been Chancellor ever since. In 2007, WASG then merged with the Party of Democratic Socialism (PDS), which was the new name of East Germany’s SED ruling party – to form the Left Party.
The Left Party eventually rose to power in Thuringia in the 2014 election, heading a governing coalition with the state’s SPD and Green Party, the same parties that had formed the coalition under Schroeder, which Lafontaine claimed had sold out. Now, in Thuringia, they were junior coalition partners though.
The point: Spiegel is quoting AKK’s diktat as if Spiegel equates or the CDU equates the AfD on the right with the Left Party on the Left. But the Left Party was the governing party of Thuringia for 5 years. They have effectively been normalized. And if AKK is treating them like pariahs, that won’t be lost on their voters, who will look at her and her party with contempt. The same is true for AfD – or potential – AfD voters. The AfD is the largest party on the right in Thuringia. And an AfD adherent might think the mainstream parties are trying to exclude it because they ‘just aren’t good enough’. Think of it as Trumpists initially being shunned by mainstream Republicans in the US.
Will the CDU eat crow about the Left Party and try and form a coalition with the SPD, Greens and Left Party? Or will they accede to a new election? If they do, the FDP Minister President Thomas Kemmerich’s party could fall below the 5% hurdle and be wiped out of parliament altogether. And the AfD could get more votes and have a larger number of seats than they did last time in October.
So not only is Germany stuck with Merkel because there is no successor with AKK and Ursula von der Leyen both out of the running, but German politics is total chaos in the east. I think this is bad news for stability in Germany and in Europe