A Conversation with Tony Boeckh, author of ‘The Great Reflation’

I waited a long time for a conversation with Tony Boeckh, his newsletters are a must read for anybody looking to keep a finger on the pulse of the markets both in the USA and internationally, you can sign up for free at the homepage.

Tony’s career has spanned over 40 years and during the entire time he has focused on banking and credit, starting in the Canadian central bank, then taking over the helm at the industry stalwart publication Bank Credit Analyst. His recent book ‘The Great Reflation‘ is a culmination of thoughts on the future of finance and what trends we can expect, and perhaps more importantly, the trends that investors can profit from.

My questions are in bold.

You look at the world in a very macro sense, what indicators, given the span of your career, have you found to be the best guides? Interest rates? flow of funds?

“That’s a never ending question, I am every eclectic, and look at a number of things, liquidity and the rate of change of liquidity in particular is important and that is what drives markets, but how do you measure it? There are different ways to do that, but it is a slippery concept and the measurements are subject to difficult constraints, data can be wrong, or the financial system evolves in ways that your old harvesting methods don’t pick up”.

So what do you watch for in liquidity?

“For what are banks doing with their assets and liabilities, watching the banks gives you a much better handle on what is happening in the system because, at least years ago, banks were the main part of the financial system 70% or more but that is reducing so we have had to constantly change our approach. Corporate liquidity matters as well so we look at liquid assets to total assets, for market measures a good one is the US Treasury yield curve”.

“When it is very steep it tends to be a good indicator, flat or inverting means there is trouble coming”. He focuses on the Treasury Yield curve, or the commercial paper/corporate sector yield curve, believing that generally they tend to give a similar answer, but that any one measure on its own can be very deceptive, he used to look at the debit/loan ratio [cheques cashed against bank deposits], but that is no longer possible.

“in 1930 the debit loan ratio showed the economy was getting worse. Then the Fed stopped publishing that series which was a real pity because it took a key metric out of the market. A lot of people look at money supply and from time to time that has been a good thing to watch, but which measure do you look at? M0 (monetary base), or M2 then M3/M4? Money supply can be misleading, and often random”. For the most part he is a big fan of looking at the asset side of the bank balance sheet and looking at what they do with their money.

“Bank holdings of securities as a percentage of total bank assets is important, if they are adding to liquid assets its an indication the system is becoming liquid and is good for financial markets, on the lending side, if institutions are selling securities to expand loans it means money is getting tighter, if the Fed is lagging behind on rate movements they may not be raising rates but the system is getting tighter, and that shows up in liquidity long before it is evident anywhere else”.

Banks in Ireland are more likely to sit on bonds and make better returns than they are to extend lending at lower margins, what do you think of that?

“Sitting on paper after a recession is typical, so they [banks] buy bonds instead of extending loans, they increase the least risky assets, that is actually a bullish indication, the system is becoming more liquid, after a time lag they start lending. Liquidity is a leading indicator, some forecast by taking a view on the economy, but don’t forget: the market forecasts the economy not the other way around, that is the biggest issue that people face in trying to understand the economy”.

So is there a danger in trusting economists too much?

“Absolutely, a lot of people are pure economic forecasters, and some are very good but the good ones look at different things: talk to David Rosenberg sometime- he is brilliant (and also Canadian!) he has moved back to Canada and he’s a very good economist, but he stayed bearish during the entire recovery over the last 18 months. I think he did this because economic indicators are only one side of the market, he may yet be right, but he missed a huge rally that was staring liquidity watchers in the face”.

“The stock market, ultimately is determined by profits, which is driven by the economy but catching the cyclical swings makes you late if you watch the economy only. Don’t worry about where the stock market is, worry about where profits are, watch that and you are watching the real indicator”.

O.K. but where do you look for that?

“Bank balance sheets, household balance sheet, corporate sector balance sheets. A series of indicators relate to liquidity, sometimes the reading is good, other times it is confusing”, then he looks at other sets, valuation as an adjunct to other things, but he readily admits that it doesn’t always tell you about turning points.

“Negative changes in liquidity with market decreasing means you’ll want to pull the plug a lot faster. The fourth key thing is psychological factors, which tell you a lot about risk. At the bottom of the market in 09′ the valuation was good, the psychology was as bearish as possible and liquidity was going straight up while the technicals looked washed out… That was a screaming ‘buy’!”

Is the reflation going to be monetary? If so how is gold in a bubble at the same time?

“Nobody knows how this will play out, the great reflation is an experiment. Private debt became public debt and now we are in act 2, Greece is the canary in the coal mine, it told the world what happens when you have too much debt, there is a huge shift toward austerity and that is happening to different degrees in different countries. If we get the fiscal restraint required it will put huge downward pressure on the economy, and that impacts on monetary policy, with a ZIRP you can’t go lower so government’s can buy debt to drive down interest rates which will ultimately lead to much higher inflation. Gold bugs who have been forecasting this see it as the buy signal”, but he thinks that the risk is much further down the road, the big threat is deflation and will remain so for some time. “Gold might come through eventually, but for now its a crowded trade”.

Do you believe in locomotion? where large economies recovering will pull smaller economies with them.

“It is happening, in particular in developing countries, the balance of power is shifting and doing so rapidly, that is going to continue, there is no way around that, western countries will be at 1-1.5% growth a year. most of Asia will be at 7-8%, the Chinese are trying to diversify into real assets with their dollars, they are buying companies, mining, energy, so if the US goes the inflation route then the Chinese will ride that wave up indirectly”.

“There is an unspoken dance between to the two nations (US and China), the US might devalue but China will hold companies and assets that benefit from that, ultimately it is political, if it wasn’t they’d (the USA) let unemployment go to 20% go back to fiscally orthodox solution, but politically they can’t do that.

Was the crisis was driven by the ex ante expectations of bailouts for ‘too big to fail’ institutions?

(This is a very economics based question which was put forward by Trinity College maestro Constantin Gurdgiev, so in plain-speak it is as follows: was the crisis partly created by a belief beforehand that investors were sure that even if things went wrong, that the government would intervene with a rescue or bailout package for financial institutions and therefore it gave them the confidence to take bigger levered risks)

“The moral hazard factor… ‘Yes’ and it has been building for 30 or 40 years, there has been a progressive pattern of governments bailing out the economy, after the Great Depression the government was perceived to have responsibility for full employment, there was even a full employment act in 1946. Since then during every recession they run in, pump money and run deficits. The deficits started in the 60’s, Penn Central, then Franklin National Bank were saved, in the seventies it was car maker Chrysler, so it was evident that the government would bail everything out, then in 87′ Greenspan pumped the markets. This trend has been building, meaning people took on more and more risk, the recessions became shallow and that made people think the system was stable so it was o.k. to take more risk, it all falls down and what do they do?… The biggest bailout in history”.

How will balance be restored in the world? My belief is that the USA will eventually rip off china via a devaluation which will drive up exports and reduce deficits, it cures all ills and has hegemony to back it – what do you think?

“Ultimately the rubber meets the pavement on China and the USA, at the moment there is a ‘balance of financial terror’, the US are saying ‘don’t like our currency? don’t hold it! The Chinese don’t want devalued Dollar but then Euro collapses, so now they think ‘should we hold yen or sterling? At the same time Russia is buying Canadian dollars for reserves, China can’t do that (they missed the boat so to speak) so they are stuck with the USA and they have all these dollars and they can’t dump them, if the dollar tanks then China tanks.

“Currently Dollar is the best looking horse in the glue factory. This is the fascinating issue; ‘how does this play out?’. The international monetary system and how governments approach them are THE story, the developed countries economies are going to be gravitating toward 1-1.5% GDP growth. With low growth and real interest rates of 2-2.5% the debt/gdp ratios are hard to control”.

“When you try inflating away the debt the average term to maturity gets shorter and shorter, at present its around 4 years, in a fiscal orthodoxy they should be issuing long term bonds, that is the sensible idea, it also gives them protection against inflation, the shorter the term and the more the perception of inflation the quicker it inflates interest rates and that is where you get the death spiral. The US government won’t go there willingly, central banks don’t inflate because they want to, they do it when it is the least bad alternative. If the US goes for orthodox policies while unemployment is going up then you have a big problem, debt monetization etc. In 2009 they started that but they will have to go back and do it again”.

How closely linked or correlated do you believe the housing cycle and business cycle to be?

“In the past they were closely correlated, but that seems to have broken down, the US one is not very different from that in Spain and Ireland, some are more extreme, it will take years to bring that out of the system, then you have demographics working against the housing market, so many people bought homes based on rising prices and now they are under water, pension funds are down, and there is nowhere to bounce from, people will start selling their home earlier in this scenario to raise money because their pensions are not worth what they expected them to be, supply will swamp demand for a long long time, we  simply overbuilt”.

If you could give three golden rules to people who wanted to delve into the kind of inisight you have what would they be?

“That’s a tricky one, I suppose in terms of early training- work at a central bank, that is the best way to learn how the financial system works”. His training at Bank of Canada was invaluable. “Be eclectic and flexible, the business of analysing and forecasting is more of an art than a science”, he has always been sceptical of people building models, he wasn’t into the quantification/quantitative systems but people tend to accept them or believe them because modelling is hart to refute, but equally it just doesn’t work in real life, hence his profound belief that its an art, not a science. “The different schools of economic thought matter, Keynesian’s, Austrians, Monetarists, but you must apply the best of each one depending on what is happening at the time, and never under estimate the stupidity of central bankers and government officials, the paradox is that these people are bright, high IQ’s, PHDs, and they can make the biggest blunders you can think of. the Federal Reserve is a great example”, he catalogues their mistakes in his book, “the only periods when it worked well was by luck”.

“Politicians also have huge capacity to do stupid things, and work out of self interest. It’s like they (the USA) have a permanent minority government, nothing ever gets done until there is a crisis”, Churchill once said ‘You can count on the yanks to do the right thing, but only after they have exhausted the other possibilities’. “Go on what they do not what they say, ignore the verbal noise, for investors you have to be the CEO of your own portfolio, don’t run with the herd”.

Do you find any economic school of thought represents the lunatic fringe?

“The core of the Austrian view is solid but the supporters can sometimes be a little out there, the problem with Keynsians or Monetarists is that they never look at the balances sheet. Supply side guys can also be crazy”. He also thinks that (especially in the US) the system is flexible, that below the surface there are hard working americans looking to correct things, get efficient, looking for new opportunities, the micro can be far better than you think, don’t ever dismiss the micro or anecdotal. “The best thing the government can do is not screw it up”.


I didn’t get to type everything Tony said, the conversation lasted about 45 minutes and was a really interesting one to be part of, getting a world view from such a well known analyst, and in particular some insight into how he thinks is a huge benefit for a practitioner and I hope that to some degree that I have shared that with our readers. His book ‘The Great Reflation’ will be reviewed here in the near future.

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