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Unwinding The World’s Biggest Economic Experiment

http://www.ft.com/cm…l#ixzz2X2Dkv6m2 By Gavyn Davies When the Fed does change direction, tightening often comes in a rapid series of interest rate rises ©Bloomberg On Wednesday, the chairman of the Federal Reserve announced that the greatest experiment in the history of central banking might be nearing its end. Ben Bernanke’s announcement included many caveats, but the financial markets did not miss the message. Since 2009, the central bank has been buying financial assets – US Treasury bonds and some types of corporate debt – paid for by an expansion of the monetary base (so-called “printing money”). This kept interest rates low, which damaged savers but helped indebted businesses and households. It has also been the major prop for financial markets. Within about a year, if the Fed’s plans come to fruition, the US government deficit will need to be financed from private sector savings – not by the central bank. Asset markets will be left to fend for themselves as the biggest buyer withdraws from the arena. That is why some hedge funds sold off bonds this week, causing a big drop in their prices – the flipside of which is a rise in borrowing costs (or “yields”). Mr Bernanke has expressed consternation that adjustments to the path for the Fed’s balance sheet, such as the one he announced this week, can have such a profound effect on the bond market. But investors are making logical inferences from central bank behaviour. The Fed does not change direction often. When it does, tightening often comes in a rapid series of interest rate rises that are not fully anticipated by investors. Furthermore, when the Fed was supporting markets, investors had to seek out new sources of income to replace declining interest receipts on their government bond holdings. In this so-called “reach for yield”, some of them leveraged themselves up to buy into emerging markets and bond funds – positions they are now dropping sharply. It is impossible to be sure where deleveraging will end. The last big unwind – a much smaller one – started almost exactly a decade ago. On June 25, 2003 the Federal Open Market Committee met amid expectations of a cut in the interest rate from 1.25 per cent to 0.75 per cent. Vincent Reinhart, the committee secretary, opened the meeting with some gallows humour. “On Friday”, he said “I was in line with my 11-year-old son to purchase Harry Potter and the Order of the Phoenix . . . It is somewhat longer than the briefing papers the committee has received. But it, too, considers an alternative world filled with uncertainty and great perils”. Alan Greenspan was chief wizard at the Fed that day. Mr Bernanke, more radical than he is now, was there, but mostly stayed silent. The committee was fully aware of the dangers ahead when it decided to cut the federal funds rate by only 0.25 percentage points. The market concluded that the Fed was preparing to tighten policy sooner than expected, and sharply adjusted expectations for where it thought rates would be in the years ahead. The same thing happened this week. The previous big Fed exit, announced on February 4, 1994, was even more dramatic. It was a day that triggered such turbulence that it is etched in the memory of all bond traders. Working as a Goldman Sachs economist, I was on the bond trading floor when the Fed released an innocuous-sounding statement. The FOMC had decided “to increase slightly the degree of pressure on reserve positions . . . which is expected to be associated with a small increase in short-term money- market interest rates”. Pardon? After a few moments, there was an explosion of noise as realisation set in. The market was unprepared for the Fed change, Investors were over-leveraged and knee-deep in Mexican debt and mortgages. Equities emerged relatively unscathed. But before the bloodbath ended that November, the survival of the US investment banks was at stake. Mr Bernanke wants this time to be different. His main weapon will be transparency and forward guidance. He says the Fed will end its asset purchases only if unemployment falls below 7 per cent, reducing the risk of tightening before the economy can take it. Short-term interest rates will stay close to zero for a long time after that and eventual rises will be gradual. He wants bond prices to fall slowly, leaving time for the financial system to adjust. There are two risks with the Fed’s exit plan. The first, raised by Paul Krugman and other Keynesian economists, is that it sends a premature signal to the world economy that the central banks will tighten before the private sector recovery has achieved escape velocity. This has happened before: the Fed made this error in 1937-8 and the Bank of Japan in 2006. Macro-economists such as Michael Woodford argue that the main economic effect of the Fed’s asset purchases is that they signal to households and business that the central bank is serious about keeping short rates lower for longer than normal. These stimulatory effects could now be reversed. If so, the US recovery might peter out, taking the global economy down with it. The second danger, in sharp contrast, is that the Fed has left it too late to bring market exposures under control, in which case the unwinding might take bond yields and credit spreads much higher than economic fundamentals seem to justify. In the famous phrase of Warren Buffett, the legendary investor, we only discover who is swimming naked when the tide goes out. Higher bond yields would spell danger for the financial system – and would mean rising mortgage rates at a time when the US housing market is only just starting to recover. The exit from quantitative easing was always going to be long and arduous. There is no historical playbook for the central banks to follow. Like a fighter pilot who has experienced combat only in a flight simulator, the real thing might be very different. The central bankers are confident that they have the technical tools to finish the job but, as Mr Bernanke admits, it will be like landing that plane on an aircraft carrier, and possibly in stormy seas. The writer is chairman of Fulcrum Asset Management and writes a blog on macroeconomics on FT.com Continue reading

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China In Carbon Trading Experiment

18 June 2013 China in carbon trading experiment China will pilot its scheme in seven places; Shenzhen, Beijing, Shanghai, Tianjin, Chongqing and the provinces of Hubei and Guangdong China, the world’s biggest carbon emitter, is to launch its first carbon trading scheme as a pilot project in Shenzhen. The test scheme, which will be rolled out to seven areas by 2014, could be spread across the country after 2015. Beijing is aiming to reduce the amount of carbon dioxide emitted per unit of gross domestic product by 40-45% from 2005 levels by 2020. The government has previously faced pressure to reduce pollution in cities. Expensive habit? Carbon emissions trading schemes are meant to encourage companies to reduce their carbon dioxide emissions by setting a limit, called a cap, on the level of carbon dioxide that can be emitted in a region. Companies are given credits, each equal to one tonne of carbon, which they can then buy and sell according to individual needs. Watch: China is launching a new carbon trading scheme in the country’s southern city of Shenzhen. The bigger polluters have to bear the added cost of buying more carbon credits, while the less polluting companies can make money by selling their credits. The Shenzhen Carbon Exchange is set to launch on Tuesday. It will cover 635 industrial and construction companies. A previous statement from the exchange said it expected to add transport firms as well as all major companies that consume oil, gas, coal and power. Shenzhen is the smallest of the test regions in terms of overall carbon emissions. China will pilot its scheme in six other places; Beijing, Shanghai, Tianjin, Chongqing and the provinces of Hubei and Guangdong. Price swings Carbon trading schemes have encountered problems elsewhere in the world. Recently the biggest carbon-trading scheme in the world, run by the European Union, nearly collapsed. Launched in 2008, the system began successfully with the price for carbon emission credits rising to $40 (£25.50) a tonne, encouraging some companies to switch to using cleaner fuels. However, as Europe entered its prolonged economic crisis, industrial activity fell dramatically, reducing the need for companies to buy emissions credits. Along with other factors, this caused a gradual fall in the price of carbon credits and in recent weeks the price has fallen below $4 a tonne. “In Europe there was definitely a lot of speculation around the credits – it was one of the most volatile commodities,” said Winnie Tang, a director at Kind Resources an investment and deal advisory firm. “A lot of traders were speculating that the price will keep going up and up, but then all of a sudden the financial crisis hit and the prices dropped.” Continue reading

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