Relevant and even prescient commentary on news, politics and the economy.

A Diverging Eurozone

I am sick today and had to cancel plans with a friend tonight. I decided to look at Eurozone unemployment rates to pass the miserable time.

According to the Friday Eurostat press release,

The euro area1 (EA16) seasonally-adjusted unemployment rate was 10.1% in November 2010, unchanged compared with October4. It was 9.9% in November 2009. The EU271 unemployment rate was 9.6% in November 2010, unchanged compared with October4. It was 9.4% in November 2009.

The Eurozone started growing again in Q3 2009. But since then, the regional labor forces show a sharp divergence in resource utilization, as measured by the unemployment rates: the weak (Periphery) from the strong (core).

Here’s how it looked in 2007 before the Eurozone entered recession.

The 2007 unemployment rates were quite similar in levels, where the differences in unemployment rates across the Eurozone are defined primarily by structural, rather than cyclical, factors.

Here’s how it looks now, where the weakness in resource utilization due to cyclical factors is hitting the Periphery hard compared to the core countries, especially Germany.

The chart above illustrates the change in the unemployment rate over the last two years using the September-November 3-month average for comparison. The countries are ranked from largest to smallest percentage increase in the unemployment rate over the two periods.

All of the PIGS (Portugal, Ireland, Greece, and Spain) have seen their unemployment rates rise by 57% (Spain) or more (+82% for Ireland). To the right of the Euro Area average, you have Germany and Luxembourg seeing their unemployment rates decline over the same period.

The divergence in labor force deterioration across the Eurozone since 2007 is quite striking.

Rebecca Wilder

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Central banks underpin euro and diversify toward "other currencies"

The IMF released its Q3 2010 Currency Composition of Official Foreign Exchange Reserves (COFER) report. The COFER database provides the breakdown of official central bank portfolio holdings by currency across advanced and emerging/developing market economies.

The picture is roughly half complete, as 44% of the global reserve positions go unallocated. But the trend in reported FX holdings indicates that central banks are supporting the euro, giving it a lower bound. Furthermore, there has been a shift in portfolio holdings toward “other currencies” in advanced and emerging market central bank portfolios.

According to the report, Q3 2010 total central bank reserve holdings increased to $9.0 trillion, up by $564.4 billion over the quarter. $317.7 billion of the increased asset holdings are not “allocated” a currency denomination (“unallocated reserves” in the charts below), but the rest, $247 billion new portfolio holdings, were denominated in the following currencies:

  • $107.7 billion in new assets denominated in US dollars
  • $3.4 billion in new British pound assets
  • $24.2 billion in new Japanese yen assets
  • $0.3 billion in new Swiss franc assets
  • $87.5 billion in new Eurozone euro assets
  • $23.6 billion in new “other currency” assets

Of note, the quarterly increase in euro assets is the largest since Q2 2009. Central banks saw the weak eurodollar as a buying opportunity, down to 1.2238 on 6/30/2010. Central bank demand at low prices will likely be an important buffer to eurodollar weakness going into 2011.

Central bank portfolio assets denominated in US dollars plummeted in late 2008 and early 2009, as global central banks faced sharp capital account outflows. Since then, US dollar-denominated assets have recovered, and so have those that are “unallocated”(those reserve portfolio holdings that go unreported), which surged $881 billion since Q1 2009.

Another important point, is that the share of allocated reserves for “other currencies” has increased from 1.8% in Q4 2007 to 4% in Q3 2010. This trend will likely hold into 2011, as global central banks diversify reserve assets. Candidates for “other currency assets” likely include those denominated in commodity currencies, Australian dollar or Canadian dollar, and those of strong Asian economies, perhaps Singapore dollar. The breakdown is unavailable.

A look at the Advanced reserve assets is interesting, since just 12.3% of total portfolio holdings go unallocated.

The chart illustrates the annual change in central bank portfolio holdings in the Advanced economies denominated by currency. Advanced central banks increased their US dollar assets by $196 billion (64% of reported reserves) since Q3 2009, and further increased euro asset holdings by $76.9 billion. The annual euro asset accumulation is down from the $146 billion peak in Q1 2010, but still above the decade average of $43 billion. Interestingly, advanced economies are accumulating assets denominated in “other currencies”, a new $42 billion over the year and well above the $5.8 billion average.

Emerging market central banks loaded up on US dollar assets in 2010, $137.9 billion over the year in Q3 2010 and further accumulated “other currency” assets, $25.7 billion over the year. Finally, emerging market central banks increased their holdings of euro assets in Q3 2010 after reducing euro positions for two consecutive quarters previously. Again, a lower bound seems to have been set to underpin the euro.

The annual increase in unallocated reserve assets in the emerging market space is large, $498 billion in Q3 2010. If history is any guide, though, then 65% of the new positions are denominated in US dollars. It’s also likely that a sizable portion is denominated in euro, since the euro had a very good run against the dollar in Q3, up 11.4% over the quarter.

We’ll see, but this analysis suggests that global central banks will underpin the eurodollar in the 1.20-1.25 range. Furthermore, commodity currency assets are very likely becoming more of a reserve position to central banks.

Rebecca Wilder

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Drop the corporate saving rate, please…

Update: The term corporate savings below refers to excess saving, gross saving over gross domestic investment, as a percentage of GDP. This is the defined 3-sector financial balance model (referred to below).

The Federal Reserve Flow of Funds showed a third quarter shift in the financial sector balances: the corporate saving rate declined 0,25% to 2,7% of GDP; the household saving rate fell 0,13% to 3,8% of GDP; the current account fell 0,11% to 3,5% of GDP; and the government increased its saving rate 0,27% to -10,0% of GDP.

Basically, the government was able to increase saving slightly, even as foreigners increased surpluses against the US, at the cost of reduced household and firm saving.


The chart above illustrates the 3-sector financial balances approach, which is the identity that the private sector and public sector saving rates must equal that of the foreign sector (the current account). The private sector is broken into the household and corproate sectors. For a discussion of the 3-sector financial balances, see Scott Fullwiler, Rob Parenteau; and I’ve written on this as well.

(Note: I am in Deutschland, where the keyboard and number system are slightly different from that in the US – so for this post, I can write ß whenever I want to, but I won’t, and all numbers with “,” represent an American decimal point, “.”. Funny thing is, when I use the Blogger spellcheck here, everything is highlighted yellow, so I plead “in Deutschland” for any misspellings :))

Some people may see the large government deficit, still -10% of GDP, as the ‘problem child’ of the sectoral financial balances. Me, I see the government deficit as a red herring of the corporate saving rate, which remains stickily in the 2-3% range. Until the corporate saving rate falls markedly, let’s say to zero or below, the unemployment rate is to remain high, and the household deleveraging process slower than would otherwise be if wages and disposable incomes were growing more quickly.


The chart illustrates the corporate saving rate and the unemployment rate, both have an 84% correlation. Therefore, adjusting for the standard deviations, corporate saving and the unemployment rate move roughly in sync. When the corporate saving rate is negative, firms purchase new capital goods and hire labor for production faster than they accumulate financial assets, thereby reducing the unemployment rate. In contrast, when the saving rate is positive, firms are investing in financial assets (or consuming capital at a higher rate) faster than they are increasing the capital stock and labor force, thereby increasing or leveling the unemployment rate.

In a very simple linear regression model (chart below), the relationship betwen the corporate saving rate and the unemployment rate exhibits an R2 of 70%. Accordingly, reducing the corporate saving rate to zero corresponds with a near-3ppt drop in the unemployment rate to 7%, all else equal, of course.


So one way to quicken the household deleveraging process is to reduce the corporate saving rate. Reducing the corporate saving rate corresponds to a falling unemployment rate, so that workers accrue SOME pricing power (they have none at this point).

Another way is to increase the fiscal deficit, to Mark Thoma’s point in The Fiscal Times this week. The correlation between the government financial deficit and the unemployment rate is -92%.

This is where the two come together: fiscal policy needs to provide incentives to lower the corporate saving rate.

Rebecca Wilder

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Transmission Channels for the Fed’s QE2

What are the channels for QE2? In a recent post, David Beckworth outlines his frustration:

It has been frustrating to watch Fed officials explain QE2. The standard Fed story centers around the QE2 driving down long-term interest rates and stimulating more borrowing.

On the tip of my tongue, I can think of three direct channels: (1) the interest rate channel, which is the source of his frustration, (2) the wealth effect channel, and (3) the weak-dollar channel.

  1. The interest rate channel: the Fed lowers current and expected real borrowing costs to firms and households, thereby stimulating domestic demand via increased consumption and investment. Clearly, this is the most clogged channel, as it requires increased bank lending and leverage build.

  2. The wealth effect channel: the Fed drives up the price of riskless assets (bonds), forcing substitution toward risky assets (equities, corporate bonds, etc.), which raises household wealth (via asset price appreciation) and current consumption demand. This channel was highlighted publicly in October by Brian Sack at the 2010 CFA Fixed Income Management Conference:”Nevertheless, balance sheet policy can still lower longer-term borrowing costs for many households and businesses, and it adds to household wealth by keeping asset prices higher than they otherwise would be.” In my view (see chart below), this has been the strongest channel through which Fed policy has worked.
  3. The weak-dollar channel: the Fed prints money, thereby debasing the currency relative to global trading partners. The technicalities of a weak dollar policy prevent the Fed’s actions as directly being a weak-dollar policy; however, the short-term effect on the dollar was quite strong. In the end, though, we see that the Fed’s policy has had no accumulated impact on the dollar to date (see chart below). This policy still has some time to work through, since the Fed only recently initiated its quantitative easing program again. Furthermore, it’s unclear to me how the dollar will play out in 2011 (perhaps another post), since it’s really a relative game: Fed QE versus the European debt crisis, EM inflation expectations rising, or the like.

The chart below proxies the three channels using the 5y-5yr forward TIPS rate (1), the S&P 500 equity index (2), and the dollar spot index (3). The value of each channel is indexed to the September FOMC meeting for comparability.

The interest rate channel has been negative, as expected real yields increased 35% since the FOMC meeting, driving up expected borrowing costs. The wealth channel has been strong and positive. The S&P 500 gained 9% since the September FOMC meeting date, but the gains really started earlier, as speculators front-ran the Fed decision. Finally, the dollar channel fizzled out, as the dollar index (against major trading partners) is pretty much flat over the period.

I’d like to hear your input regarding other potential channels for Fed policy. But the data has, objectively, been surprising to the upside. Thus the growth outlook has improved. The chart below illustrates the Citigroup economic news surprise index (compared to Bloomberg consensus), which turned to the positive at the outset of November.

Many moving parts.

Rebecca Wilder

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Japanese Q3 2010 GDP growth hit it out of the ballpark but set to fall flat next quarter

The Japanese economy grew 3.9% at a seasonally-adjusted annualized rate in Q3 2010 and over 2X the pace in Q2 2010 (data here). According to Bloomberg, the headwinds to Q4 growth are household consumption and the yen:

Consumption, accounting for about 60 percent of GDP, led the gain as households stepped up purchases of fuel-efficient cars ahead of the expiration of a subsidy program and as smokers stocked up before an Oct. 1 tobacco-tax rise. The yen’s climb to a 15-year high will probably damp growth this quarter as companies from Sharp Corp. to Nikon Corp. cut profit forecasts.

To be sure, the surge in real GDP growth is unlikely sustainable; but it’s not because of the yen’s strength, per se. True, consumption growth is more likely to print on the lefthand, rather than the righthand, side of the 0-Axis. However, the yen on a trade-weighted basis and in real terms hovers at its historical average; hence, the currency poses less of a risk to growth.

The chart illustrates the contributions to non-annualized quarterly growth (not annualized, GDP grew near 1% in Q3) from each of the GDP components: private consumption (C), investment (I), inventory build (Inv), government consumption (G), and net exports (NX).

The Q3 pace of growth is almost certainly not sustainable and has a decent chance of turning negative in Q4 2010 for the following reasons. (See charts below text for illustration)

* The biggest contribution to Q3 growth came from consumer spending, +0.66%. Investment contributed positively, 0.11%, but has been trending downward. Key data points are inauspicious for consumer spending: the unemployment rate hovers stickily around 5% and October auto sales saw a 27% annual decline, as green auto subsidies expired.

* Although the JPY/USD has appreciated 14% since the middle of 2010, the real effective exchange rate, the economic driver of a country’s trade balance, has been stable over the same period (see final chart below) and in line with its longer-term average. So while I don’t expect net exports to turn negative, per se, any additional impetus to growth is unlikely to come from trade.

* Therefore, the key to growth is final domestic demand, and more specifically consumer spending. That’s a stretch.

Rebecca Wilder

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Eurozone rebalancing depends on German inflation

The Federal Statistics Office reported that German consumer prices increased 0.2% on a seasonally-adjusted basis in October, translating into a 1.3% annual gain on a harmonized basis. German prices are very sticky, since the domestic economy doesn’t see the boom and bust cyclical behavior like that in other developed economies. However, inflation may headed north, especially if the trend in industrial prices (PPI), a +3.8% annual clip, is any leading indicator. (Click on chart to enlarge.)

Will German policymakers see the inflation for what it is? It’s a shift in relative prices to drive real German appreciation in order to rebalance current accounts across the region amid a fixed currency regime.

The Eurozone region is now characterized by current account imbalances, imbalances that are now being addressed through fiscal austerity measures. According to the IMF October 2010 World Economic Outlook, Germany will run the second largest current account surplus in the Eurozone as a percentage of GDP this year (second to Luxembourg), 6.1%, while Greece and Portugal will run the largest deficits, -10.8% and -10%, respectively. Among the bigger economies, Spain’s 2010 current account deficit sticks out at -5.2% of GDP. In fact, just 6 of the 16 Eurozone economies are expected to run current account surpluses in 2010.

If these fiscal austerity measures are to succeed in Europe, the hardest hit economies – Spain, Portugal, Ireland, Greece – must generate income externally via export growth. In order to gain export growth, competitiveness must be drawn upon in one of three ways (or a combination): (1) the nominal exchange rate depreciates in the debtor countries (CA deficit countries); (2) final goods prices fall in the debtor countries relative to the creditor countries; or (3) unit labor costs fall in the debtor countries relative to the creditor countries. Any combination of the three will shift the real exchange rate in favor of the debtor countries and drive export growth.

Since (1), depreciation of the nominal exchange rate, is clearly not an option in the single-currency Eurozone, it’s up to (2) and (3). I’ve talked about wage-cutting; and most of the fiscal austerity packages include some degree of public sector wage cuts, so I won’t address that here. And point (2) has been addressed mostly via fiscal austerity dragging price pressures domestically, and leading to increased competitiveness. But point (2) can be seen from another light…

…it’s all about relative prices, and inflation in Germany realtive to the debtor countries can establish competitiveness in debtor countries.

German inflation is important for two reasons.

First, it’s all about relative prices (point 2 above), so competitiveness in Spain, for example, could similarly be generated if German inflation rises relative to that in Spain, holding Spanish inflation constant – even more so if Spain’s inflation rate is falling . In fact, a rather stark increase in German inflation is likely needed to generate a rebalancing effect when nominal depreciation is out of the question (as is the case for the Eurozone).

On to the second reason why German inflation is important: the ECB average inflation target.

The table to the left illustrates the compounded annual rate of inflation (CAGR) for each of the current member Eurozone economies since 2000. Germany has, on average, seen prices rise at a 1.7% annual rate, while Spain has seen prices rise at a 2.9% annual rate.

Amid fiscal austerity, German inflation is needed is to keep the ECB’s target average inflation rate– the average inflation rate is the weighted HICP across all of the Eurozone economies – around 2% while the much of the Eurozone experiences disinflation (or deflation).

Spanning 2000-2009, the Spanish economy contributed roughly 0.4% to the Euro area’s average 2.1% annual inflation (based on the HICP country weight, which is 12.6% – see the Eurostat publication for links to the data). Greece contributed roughly 0.1%, on average, to overall inflation. Going forward, there will be a lot of inflation slack to be picked up as these economies contract further.

It’s gotta be Germany!

But will German policymakers and its massive export sector tolerate higher average annual inflation? Let’s say at roughly 3%, and for some time? I’m skeptical – so the outlook for the Eurozone, in my view, has just worsened.

Rebecca Wilder

By the way, I just told my German husband, Herr Wilder, about this article. You know what his response was? “Oh…Germans don’t like inflation.” Enough said.

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According to bond markets, Ireland is not yet Greece

A few articles regarding the bond crisis in Ireland:

The Irish Mess (IV)
ECB buying of Irish bonds ‘vital’ support
The world backs away from Ireland, Spain, Portugal
In keeping with Halloween, here’s a scary one
EU leaders trigger another bond market crisis
Ireland fifth best place to live (a separate issue, of course)

Yves Smith’s article (first link) is good, providing a network of associated links including one to Ambrose Evans-Pritchard. He states the following:

Yes, Ireland is fully-funded until April – and has another €12bn in pension reserves that could be tapped in extremis – but that is less reassuring than it looks. The spreads over German Bunds are mimicking the action seen in Greece in the final hours before the dam broke.

Ambrose Evans-Pritchard’s article is well worth a read; but I’d like to talk about bond markets for just a bit. Yes, the probability of Irish default is increasingly being priced into bond markets; however, Irish bond market conditions have not yet reached those of Greece in May 2010 (the bailout announcement), nor are they really close…yet.

The Irish yield curve (proxied by the 10-year government bond yield minus the 3-year government bond yield, now the 3-10) is still positively sloped. (I choose the 3-10 because of the ESFS that is in place through 2013.)

This is important. See, when there is a binary outcome being priced into a sovereign bond market, default or no default, investors go straight to the long end of the term structure, and the yield curve inverts (negative slope). In a default situation, the longer end of the curve offers a higher expected return where the potential yield compression is much larger. That’s what happened in Greece in May 2010, as the 10-yr bond yield reached 12.4% on May 7.

The two yield curves look “similar”; but Greece’s yield curve turned negative, or near -500 basis points (bps) inverted – a basis point is the % * 100 – preceding the bailout. At the time, Irish spreads (chart above) dropped to 120 bps; but now the yield curve is even steeper, 170 bps as of 6am this morning.

The 3-yr Irish spread over German bunds is certainly coming under pressure, 492 bps (as of 6am today). But the front-end sell-off is nothing compared to that in Greece: spanning the period April 1 to May 1, 2010 (i.e. excluding the surge to 1700 bps), the 3-yr Greek spread over German bunds averaged 711 bps.

Further, the Irish debt profile is longer, on average, than that in Greece. The weighted average maturity on existing Irish debt is 6.1 years (starting in 2011), where that in Greece is a shorter 4.5 years.

The chart above illustrates the share of Irish and Greek debt by maturity date. 36% of Ireland’s sovereign debt expires through 2015, just half the share of Greek sovereign debt maturing by the same year, 70%. Note, too, that according to Bloomberg, Greece has 3 times the debt outstanding of Ireland – a completely different game (for now).

Irish bonds are certainly under pressure. But Ireland being funded until the middle of next year is important, making the timing of its return to market critical.

In my view, though, the quintissential issue is the government’s ability to finance its debt via domestic growth. Here’s a great paragraph from an op-ed in the Irish Independent last week:

While interest rates charged to Ireland have been rising sharply, many large countries can borrow at very low rates, as little as three per cent. Many economists have been arguing recently that these countries should consider a further fiscal stimulus package. Instead most of them are committed to deficit reduction. This debate is one that we cannot join, unfortunately. These countries have a choice since it appears that they could borrow more if they chose to do so.

We cannot do that, nor can we devalue our exchange rate, since we do not have one. It is perfectly reasonable to ask how we got into this mess, to allocate blame and to demand retribution. But no amount of ranting can expand the limited range of choices available to the Government.

Ireland needs revenues to finance their debt. We’ll see if the persistent fiscal austerity leads to growth – I’m totally skeptical.

Rebecca Wilder

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Comparing the Fed, the ECB, and the BoE before policies diverge

The coming week is G4 central bank week. The Federal Reserve Bank (Fed) announces its policy decision on November 3; the European Central Bank (ECB) and the Bank of England (BoE) will make policy announcements on November 4; and the Bank of Japan pushed forward its November 15-16 meeting to be held now on November 4-5.

At this juncture, G4 ex Japan monetary policy is likely to diverge sharply: the Fed is expected to announce an extension of its asset purchase program, while the ECB and BoE are not expected to increase theirs. In fact, the policy wedge between the three central banks is already wide. Despite the ECB’s enacting its covered bond purchase program, the amount is small, roughly 1.4% of Eurozone GDP (see chart below), and the central bank is sterilizing the flow – sterilizing the operation means that the ECB performs equal and opposite monetary operations to reduce bank reserves by the amount of the bond purchase program.

The chart above illustrates the size of the bond purchase programs (assets sitting on the central bank balance sheet) as a share of 2010 GDP (IMF forecast). Ostensibly, and from a bank-lending point of view, Eurozone financial conditions appear to be “healthier” than those in the UK or US.

The chart above illustrates total bank lending in the Eurozone, UK, and the US; but this may change as austerity measures in some European countries infect the stronger economies via a tightly integrated trade relationship.

Policy is already much tighter in the ECB compared to its US and UK counterparts. This discrepancy is expected to diverge, as the Fed moves into QE2 mode this week.

Rebecca Wilder

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Eurozone unemployment rate up in September

Yesterday Eurostat released the September unemployment rate figures for the European Union and the Eurozone. From the release:

The euro area1 (EA16) seasonally-adjusted2 unemployment rate3 was 10.1% in September 2010, compared with [downward revised] 10.0% in August4. It was 9.8% in September 2009. The EU27 unemployment rate was 9.6% in September 2010, unchanged compared with August4. It was 9.3% in September 2009.

The Eurozone unemployment rate has been above the EU (27) unemployment rate by an average 0.45% since the outset of 2007.

Across the Eurozone 16 countries, just 5 have seen their unemployment rates fall since October 2009 (I use the teilm020 table at Eurostat, which limits the time series to this time frame). Note that the unemployment rate in Italy rose over the month (8.1% to 8.3%), so unemployment rate is now unchanged since last year.

In the third quarter (the 3-month average ending in September 2010), the unemployment rate fell across 57% of the sample listed below (a highlight of the EU (27) countries plus Japan and the US) compared to the previous quarter. This is good, but the improvement is sluggish.

Rebecca Wilder

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A little perspective on the impact that a weaker USD will have on overall economic activity

The Japanese yen, the Eurozone euro, and the British pound have appreciated 16%, 14%, and 9%, against the USD, respectively, since their 2010 lows. Some say that the “US wins” since the Fed’s quantitative easing (QE2) will drive export growth via a weaker dollar. (Note that the Fed has not actually announced QE2, this is all just speculation.)

I’m not suggesting that the stated Fed policy will be to drive down the dollar. What I do know, however, is that the United States production model is not structurally positioned to enjoy the economic panacea that is a persistent debasement of the dollar, neither in the near- nor medium- term.

The bottom chart illustrates the export share in overall economic GDP, as forecasted by the European Commission (you can download this data at the Eurostat website). Notice that the US share of exports, expected to be just 12.3% in 2010, is minuscule compared to the export markets in Europe. So what I gather from a chart like this is that the weak dollar will hurt Europe much more than it will “help” the United States.

We need domestic policy to support full employment and the expansion of our export sector that will eventually arise. See Marshall Auerback’s post this week at Credit Writedowns for a discussion on austerity, currency wars, and exchange rates.

Rebecca Wilder

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