Best Ideas

Testing the Limits of Central Banks

As of eleven years ago, developed nations were in distress with the collapse of several major
financial institutions and a freezing of the commercial paper market. The response was the
massive intervention of central banks which not only provided liquidity, but also financial
support to the chock points of the financial markets. The biggest surprise to many economists
was the muted effects of the massive quantitative easing (QE); many had predicted a jump in
inflation and a flight from currency into gold, neither of which happened. A major and lingering
impact was actually the exact opposite, that is deflationary conditions which have been
manifested in negative interest rates throughout the EU (more on this later). The reason why
we focus on QE is that it is with us again. Despite no evidence or threat of a recession let
alone the threat of a depression, the ECB announced a reversal of its short-lived hiatus from
QE and will start shortly start creating money to purchase assets. This is a massive sea
change that has all but been ignored by the media. For those attentive investors, the message
is clear: the ECB will engage when there is but a whiff of a slowdown. Turning to the US, the
latest news is Mr. Kudlow’s announcement that the FED should cut rates. Assuming our
analysis is correct, there are numerous implications to the stance the central bankers are
taking, and we will attempt to address some of those implications (hint: there is no “free lunch”).

Bolstered Credit Quality - At a time when most citizens are obsessing about paying their
hard-earned cash into the treasury, some central banks, such as the ECB are not waiting, and
are stoking up the printing presses. Whether directly (in the case of the ECB and the BOJ) or
indirectly in the case of the FED and the BOE, fixed income (and other) assets are benefiting
via the suppression of interest rates and the incentive to go out on the risk spectrum. Hence,
both the probability of default and the loss given default levels are muted. Despite concerns
about the attenuated length of the current credit cycle, the cycle appears likely to be more
attenuated as a result of the support provided by the central banks.

Suppressed Funding Costs – the massive and continuing QE has the impact of suppressing
interest rates and bolstering weaker credits (is not that the intent?) and over time, this unnatural
state of affairs is having massive impacts. First, those who depend on a spread between assets
and liabilities are being eviscerated. The most recent example of this condition is Deutsche
Bank, which as of a decade ago was THE powerhouse bank in Europe and now is debating
whether to undertake a merger and yet ago issuing additional stock just to survive. May of the
UK banks have obtained government capital and the French banks remain challenged. Other
institutions such as pension funds have unrealistic return hurdles and have or will be forced to

Bloated Debt – as can be seen on the below graph, debt has grown [to the point that __].
Perhaps of greatest concern is the level of sovereign debt with Japan taking the lead at a debt
to GDP level of 214%: