Bond markets are pricing in rate hikes this year by the ECB and the BoE. Both are inflation targeters, so which one should react first to a possible spike in oil prices? What’s your answer?
(1) Neither. As FX appreciation and fiscal austerity pass through to domestic prices, the core will drag down the headline. If they hike, stagflation will result.
(2) The ECB, because it is the most hawkish of all central banks, in my view. The ECB mandates a rigid targeting scheme compared to that of the BoE. Since the January 2005, the BoE has successfully targeted inflation slightly under 2% just 27% of the time, while ECB has done so 61% of the time.
(3) The UK. The January 2011 UK inflation rate was 4% Y/Y (3.2% in November on a harmonized basis) and near-double that in the Eurozone, 2.4% according to the flash estimate.
Furthermore, the UK story is not one of just energy and food. The chart below illustrates the diffusion of price inflation across the components of the harmonized HICP (data at Eurostat), and the legend lists the period average for each economy. Diffusion levels above 50 indicate that a larger share of component prices are growing at an annual rate above 2% that below 2%. The diffusion a measure of the breadth of price pressures…
…and is UK inflation broad-based! In contrast, inflation in the Eurozone is focused in the commodity and energy space. Now, I’m not suggesting that the BoE hike – in fact I would recommend the opposite, or at least stay on hold – but I’m sure that the BoE has its vision acutely focused on developments in the Middle East.
If I had to choose an economy that would be derailed by the price spikes in the commodity space, it would be the UK. But I choose (1).
Central bankers are trained not to say anything of any relevance in long speeches or interviews, and Jean-Claude Trichet is a master at this. So we were a little surprised when he told Die Zeit that governments should fine tune their fiscal policy in the fight against inflation. Here is the quote: “Individual countries must accept the monetary policy as a given and adjust their national policies accordingly…When a country experiences a boom, it needs to make its own national policies …more restrictive in order to avoid the economy overheating or speculation getting out of control.” The policy consensus has been for the last few decades that monetary policy is the instrument of choice to control inflation and inflation expectation, while fiscal policy should be oriented towards medium-term goals. Fiscal policy has a role to play in countries that overheat relative to the rest of the eurozone – like Spain before the crisis – but this is hardly applicable now. (If you consider Germany as overheating, there is not much you can do with fiscal policy to constrain the inflationary pressures, especially considering the time lags through which fiscal policy operates. We interpret Trichet’s statement as saying: monetary policy is currently constrained, so fiscal policy is all we have got. This is quite extraordinary, and makes us wonder whether the ECB is really determined to prevent an upward drift in inflation.)
(read on after the jump!) RW: This could be a very astute representation of Trichet’s comments: that fiscal policy should be the main tool to target inflation expectations to the upside if the ECB feels they are taking care of the downside! The implication is that the ECB is ‘on hold’ for much longer than markets expect. Today, for example, the Eonia forward swap curve (the Eonia rate is the Euopean equivalent of the federal funds interbank rate) has 25 bps in ECB rate hikes priced in through August 2011, 50 bps through the December. The Eurointelligence interpretation of Trichet’s comments would suggest that this is way off, that the ECB is on hold for some time.
There are several caveats to consider regarding the ECB’s policy stance: (1) As I’ve argued before, German wage pressures are bound to get a bit frothy this year, which may challenge the ECB’s resolve. If those pressures are more robust than history demonstrates – I argue that they will – a new ECB president would be less accommodative in its policy response than Trichet implies… (2) …which brings me to my next caveat: Trichet’s term as ECB President ends in October 2011. His successor – the most likely candidate at this time is Mario Draghi – will then take the monetary policy scepter. Will he/she hit the ground running? Better put: will he/she hike rates right out of the gate if German inflation and/or commodity price inflation is perking up? (3) The ECB has been known to jump the gun with regards to commodity prices. Trichet, in his February policy statement, reiterated that he expects near-term price inflation to see its fair share of time above 2%; this suggests that he may have learned his lesson in 2008 (see this post regarding the ECB’s reactionary policy).
Credit default swaps (CDS) are a market security used by investors to buy 5-yr protection (in this case) against default (or the like). As the spread rises the implied probability of default does too. Current market values imply a 39% probability of default by the Irish sovereign (listed in legend), 20% by that of Spain, and 14% by the Italian sovereign, etc. Cash bond spreads are blowing out again, too, where Spain now must pay a 216 bps premium over Germany on a 10-yr loan (the sovereign bond). I’d say that’s not totally irrational.
I completely understand why these negotiations are stalling. I’m Spain – it’s not clear that Spain commented against the pact based on this article, but I digress – why would I agree to a deal that forces more ‘competitive’ measures, which really just means quashing indexed wage growh, reducing the government deficit, adhering to a fiscal policy rule (which, by the way should be modeled after Germany’s debt brake), and adopting a standardized tax rate? Okay, I will if you (Germany) will. Meaning, I’ll increase my competitiveness by stripping away aggregate demand if you allow prices to rise. I’m Germany – no way. (Please see my previous post which argues that a successful transition to a more stable Eurozone depends on higher Germany inflation.)
Der Spiegel spells it out pretty succinctly in an article that is now two weeks old but still totally relevant:
Germany will only agree to additional guarantees for the euro rescue fund — as the Commission and other parties have called for — if its partners approve its competitiveness pact.
Simply put: we (Germany) will only agree to eventually bail you out if you agree to our harsh demands at that time, or you agree to our harsh demands now. You’re choice.
This political drama is far from over. (More exciting analysis below the jump)
(Dan here…Kantoos responds to Rebecca…http://kantoos.wordpress.com/2011/02/15/rebecca-wilder-on-eurozone-monetary-policy-and-german-inflation/ )
Here’s another little fact to think about: The price to buy protection against a default by the Japanese sovereign is just 77 bps, that’s only 23 bps above that for the German sovereign. This is ironic because Germany is the premiere demander of fiscal austerity, while Japan is not (to say the least) with gross debt equal to 221% of GDP (according to the IMF) – or is it?
The table below lists common characteristics usually associated with rising CDS spreads (CDS spreads are current as of 4pm today and may vary according to pricing source): the stock of debt held by foreigners (any currency denomination) and the stock of gross public debt. The final column illustrates the ability of a country to print fiat currency that is not backed by anything but government decree.
I think it’s pretty clear: Japan and the US have very elevated government debt, but low external holdings AND can print their own money to finance liabilities (which by the way are in most part denominated in their respective currencies). Clearly markets’ attach weight to this simple fact via low CDS spreads.
David Beckworth points to Scott Sumner, who points to Kantoos on the effectiveness of nominal income targeting in Germany. Kantoos’ illustration certainly suggests that the ECB has been successful in getting the dynamics of output and prices (nominal GDP) right over the last decade.
I have no contention with the historical evidence. Whether or not the historical data supports an effective nominal GDP target is trivial compared to the suggestion that the ECB will tolerate a pickup in German nominal GDP going forward. Wage pressures and lower unemployment will lead higher nominal GDP, but will likely increase German inflation as well; this will set the stage for tighter, rather than accommodative, ECB policy.
Although Kantoos did acquiesce that the ECB doesn’t officially target nominal GDP, he didn’t, in my view, give this simple fact enough face time. The ECB is the most hawkish of the G4 central banks. As you can see from the histogram of inflation over the last decade, the central tendency is very strong at 2-2.5%.
As the histogram shows, the ECB rarely institutes a policy rule that drives inflation above its stated objective: “the ECB aims at inflation rates of below, but close to, 2% over the medium term.” The ECB’s reaction-function to German price pressures will be of utmost importance, given Germany’s 26% weight in Eurozone inflation.
Kantoos and David Beckworth posit that the 2% wage growth achieved due to highly competitive German industry (see reference at end of post) is evidence that the ECB targeted nominal GDP and nominal per-capita GDP effectively. In contrast, I would argue that the ECB’s had it pretty easy, where the recession simply delayed the inevitable tightening that would have occurred in favor of the 2% inflation target.
(Read more after the jump) Measured on a quarterly basis, annual per-capita nominal income growth in Germany averaged just 2.1% since Jan. 1999 (when the ECB took over monetary policy across the Eurozone). Germany represents 26% of the HICP (harmonized price index used by the ECB, and the weighting data is available at Eurostat table prc_hicp_inw), so upward economic pressure on German prices and output (nominal GDP), would manifest into, all else equal (i.e., not offset by deflation in other big countries), average inflation above the ECB’s comfort zone – I use the word ‘zone’ loosely; it’s 2%. The ECB is unlikely to tolerate this.
Currently, tax hikes and a rebound of economic activity and commodity prices are pressuring prices in even the ‘fiscally austere’ European economies (Spain at 2.9% annual inflation in December). So the offset to German inflation pressures on the average inflation rate are not existent at this time.
My sense is that the ECB is biding its time until German price pressures emerge before they have to tighten monetary policy across the Eurozone. For example, the ECB must have been happy that some German unions are negotiating wage hikes that are lower than the current rate of annual per capita nominal GDP growth, 4% Y/Y in Q2 and Q3 2010. (see chart above).
So how much time does the ECB have? At this time, excessive inflation is not ubiquitous in the German HICP, the ECB’s preferred measure of inflation. Currently it really is mostly a food and energy story.
I computed a diffusion index across all of the subcomponents of the HICP index for some Eurozone economies. The index is pretty simple: above 50, there are more components of the HICP that are growing at a greater than 2% annual pace, while below 50, there are more components growth below the 2% pace.
The December diffusion in Germany, 28, is lower than its average since 2004, 33. Not only has Germany historically seen prices growing broadly lower than 2%, but they still are. However, despite the low the level of diffusion, the trend is upward.
As wage contracts reset, I expect that the breadth of price increases will increase and drive overall inflation above the historical German comfort zone, 1.5% average 1995-2007 (before the recession). In the weaker economies, Portugal (not shown), Italy, and Spain, there has been a pickup in subcomponent-level 2% inflation as well – eventually pressures in these economies should fade with fiscal austerity.
However, pressures are in the pipeline. Tight capacity utilization and labor markets will inevitably drive inflation on the cost side.
According to the European Commission, the survey of German Q1 2011 capacity utilization, 84.9%, is above its decade average, 83.1%. Eventually, German firms will have to pay higher wages on the margin in order to satisfy strong(er) demand.
And German labor markets are tight. Schroeder’s labor reform has dropped the unemployment rate, 6.6% in December 2010 on a seasonally-adjusted and harmonised basis, to well below its 15-year average, 8.5%. Inflation from the cost side is certainly in the works, barring a surge in productivity, that is.
In my view, German prices should be allowed to trend upward – the German real exchange rate is too low. If Spain, Italy, Portugal, or Ireland are to have any chance at all for fiscal austerity to actually drop the fiscal deficit, German prices must rise (I’ve written about this before). In my view, though, it’s more likely that the ECB attempts to quash a discrete shift in German nominal income growth via tighter policy than accommodate it.
I don’t like to make economic forecasts. Though I do it on occasion, I generally leave that to Tim Duy — he’s much more of a data grubber than I am so he’s better at it anyway. I do try to comment on what data says when it’s released, mostly at MoneyWatch, but I don’t generally consider those to be formal forecasts of where the economy is headed.
There’s a good reason why I try to avoid forecasts. In the past, whenever I’ve tried to predict the path the economy would take, I’ve found myself reading subsequent data releases in a way that supports the forecast. I think that once you make a forecast, it affects your objectivity, and I think that applies generally, not just to me.
Perhaps that’s why I’m feeling more and more alone in talking about the current state of the economy. Though the worries began long before this, in June of 2008 I did a MarketPlace segment where I predicted that the recovery of unemployment would lag output, and I said that policy should begin addressing the problem immediately due to the long lags between the time when policy begins is first considered and the time it actually has an impact on the economy. Ever since, I’ve found myself watching to see if that forecast was correct (which is another reason why I don’t like to make forecasts — you hope you are correct, but being correct in this case means people will struggle to find jobs, so it brings on an internal contradiction — how can you hope people will struggle?).
As I said above, I don’t think I’m alone in reading data in a way that supports previous forecasts, and others are much more bullish about the latest data releases than I have been. Part of my point has been that the data can be read another way. When people say, for example, that there’s nothing in the latest employment report to change the relatively optimistic forecasts they’ve made recently, I try to say that there’s nothing in the data to reject the alternative forecast either, i.e. that we are still headed for a very slow recovery of employment. Whatever your null hypothesis or prior beliefs were, the latest data did little to change that outlook.
My reason for noting that the data can be read another way goes beyond trying to show that I was right and others were wrong about how long it would take for employment to recover. I am very worried that we are, for all intents and purposes, about to abandon the millions who are still unemployed. Once we conclude that a robust recovery is underway, we will turn our attention to other things. All of the social services that we need to provide for the unemployed, simple and important things like making it possible for their kids to get dental care to name just one example, will be ignored. We devote little if any effort to job creation. We will simply turn our backs and move on.
I fully understand the desire to have a perfect landing, to get policy just right. But just right when the costs of unemployment are so much higher than the costs of inflation means that we should bias policy toward the unemployment problem. If we are going to make a mistake, it should be too much unemployment, and the inflation that comes with it, rather than too little. However, with the inflation hawks writing almost daily in the WSJ and elsewhere that we need to raise interest rates immediately to avoid inflation, and with all of the pressure to address the budget deficit, if anything the bias in policy seems to be in the other direction. Thus, while I acknowledge the fact that I am probably reading the data in a way that is favorable to previous statements, there was a good reason to worry back in 2008 that this would be a problem, and I believe there’s still good reason for worrying about it today. If I have read the data more pessimistically than others, the reason for it is simple — to push against the chance that we will forget about all the households that continue to struggle. If Ben Bernanke’s right, even with current policy we are looking at years until employment gets back to normal and we must do all that we can to help people find jobs or, failing that, provide the social services they need to get by until the employment picture improves.
Until I am sure that the economy is on firmer footing than it’s on now, and that employment prospects have improved substantially, I will continue to be the one who pushes back against optimistic reading of the data. And I will make no apologies for it beyond what I’ve said here.
(More comments after the jump) RW: Just today I was reading an Economist article from last week’s publication, Et in Arcadia ego (even in Arcadia I exist), about the homeless population that is building in the hardest hit parts of the economy (generally related to the manufacturing and housing decline). Tent cities, surging homeless rate, and poverty are becoming more of the ‘norm’; it’s really rather heart wrenching if you think about it.
And then I see a chart like this (h/t Ken Houghton at AB) on inflation expectations and asset prices. Yes, propping up asset prices – that’s what the Fed’s done here is inflate asset prices – will have the intended effect of dropping the saving rate and increasing current consumption; but to what end? Wall Street’s doing just fine, in fact. I’m a macroeconomic analyst and portfolio manager in the global fixed income space and have seen a nice shuffling around in the labor force. I wouldn’t say that jobs are plentiful, but popping up, nevertheless.
On forecasting, I find it very interesting that when Wall Street economists model their outlook for the unemployment rate – according to Bloomberg, the consensus expects the unemployment rate to drop to 8.5% in 2012 – they assume that the 2.8 million workers that are marginally attached to the labor force (of which discouraged workers is a subset) will not re-enter. Mathematically, that drops the unemployment rate: compared to a year ago, January 2010, the number of marginally attached workers has increased from 1.07% of the working-aged noninstitutional population to 1.17%, while the U3 unemployment rate dropped 9.7% to 9.0%. (the alternative measures of unemployment are listed in Table A-15 here.)
I think that run75441 says it well (in the comment section of this post):
If NILF [not in the labor force] keeps going up, it does not matter what U3 does which is a joke. Parity for U3 is reached when Participation Rate equals the Participation Rate of 2001. The numeric is to nervous and today’s measurement of U3 has no meaning.
Mark, thank you for your voice. It takes a lot of courage to push back against those that see just the tip of the economic iceberg, i.e. the parts of the economy that are trucking along just fine right now.
I’ll forward you to Spencer’s post on the January Employment report. As always, he sifts through this massive report and eloquently describes the state of the labor market. But I thought that I’d add a bit on the disparity between the household survey and the establishment survey.
The annual population revisions and weather distortions have confused some. The issue at hand is, that the BLS’ two surveys, CPS (Current Population Survey, from which the unemployment rate is derived and called the household survey) and CES (Current Employment Statistics, from which the nonfarm payroll is estimated and called the establishment survey), offer conflicting views on the strength of the headline report (i.e., just the statistics about the unemployment rate and the nonfarm payroll): the unemployment rate dropped 0.4% to 9.0%, while the nonfarm payroll increased a meager 36,000 when 146,00 was expected (by Bloomberg consensus).
The report is not conflicting, in my view – it’s just weather related stuff that impacts the CES, and to a much lesser extent the CPS. The drop in the unemployment rate, although usually the statistically less popular data point, is probably the best descriptor of the monthly shift in the labor market: strong. (A 9% unemployment rate cannot be described as strong by any measure out there; I digress.)
All of this information is stated in the BLS release, which you can find here. Below I describe (1) the revisions to the CPS and (2) the weather-related distortions that discount the establishment number.
Why the drop in the unemployment rate is credible. The summary statistics show the labor force falling by 504,000. The annual revisions dropped the labor force by 504,000, so the unrevised numbers show the labor force unchanged over the month.
The summary statistics show the number of employed increasing by 117,000 The annual revisions dropped the employed by 472,000, so the unrevised number of employed increased by 589k in the release. This is a big gain.
In fact, the revisions do not materially alter the 2010 unemployment rate nor its trend in any way. By my calculations – please correct me if I’m wrong – the unemployment rate would have been 9% with or without the CPS survey revisions.
For many reasons, the change in those ’employed’ in the household survey (+589k) does not match up to the change in the nonfarm payroll in the establishment survey (+36k); but the direction of the changes across both surveys are often similar. However, +589k is sizeable by any historical standard.
So why +36k in the establishment survey versus the +589k in the household survey? Weather.Nomura economists David Resler, Zach Pandl, and Aichi Amemiya did some research on weather-related months(no link available since this is proprietary paid research and bolded by me):
In one of the largest first reported declines on record, the BLS in its February 7, 1996 report calculated that non-farm payrolls FELL by 201,000 from the previous month. The outsized decline hit both manufacturing (-72,000) and services (141,000) but the construction industry registered a net job gain of 13,000. At the time, the BLS blamed the big winter storm for skewing the job loss and a month later reported that payrolls surged by 705,000 in February after a revised drop of 188,000 in January. Since then, subsequent benchmark and seasonal factor revisions have resulted in a history showing a drop of 19,000 in January 1996 followed by a 434,000 increase in February.
These observations suggest January’s severe winter storm could skew the measurement and estimation of payrolls this year as well. From those prior episodes, we calculate that the winter storms led to a .0007 to .0015 deviation from “normal” seasonal job change in those months. A similar deviation of employment from normal seasonal patterns implies that the change in non-farm payrolls would be likely to fall in a range of -50,000 to +56,000.
Ex post, they were right – they published this research before the January employment report was released – not only about the expected weather distortions, but also regarding the level (-50k to +56k). Accordingly, it’s very likely that next month we’ll see outsized gains, given the history of this type of distortion.
Therefore, until I see a weak February number (one month from now), I’m going to assume that the headline figures were strong and consistent with the unemployment rate dropping 0.4% to 9.0%.
Of course, there’s a slew of workers that are not in the labor force that may re-enter, which would undoubtedly drive the unemployment rate up (it probably will). And let’s remember this when talking about a “strong” employment report: 9% doesn’t represent the severity of the unemployment problem – the employment to population ratio does.
It occurred to me that some Angry Bear readers may be interested in a short analysis of the Egyptian bond market. Professionally, I’m a macroeconomic analyst and portfolio manager on a global fixed income team. Since we do trade emerging market debt, of which Egyptian debt is categorized, I’ll be happy to comment.
The gist of the article is this: markets are pricing the probability of default in Portugal and Egypt similarly – I’d sell protection on the Egyptian debt. At this point, I should state the following disclaimer: this is not a trade recommendation, nor does this represent my firm’s views on Egypt or Portugal.
Some bond market developments of late:
Egypt holds a BBB- rating on its local currency debt by Fitch and S&P (BB+ on its foreign currency debt). The local currency debt in Egypt is at the lowest of the investment-grade ratings, while on January 20, 2011, Fitch put Egypt on credit-watch negative.
The Egyptian pound is heavily managed. Over the last week, the USD gained just 0.9% against the pound. Maintaining a stronger nominal currency is common in developing economies to temper the effects of import prices (in this case, food).
The 5.75% 10-yr Egyptian international bond, which is denominated in USD, sold off 7% over the last week. According to JP Morgan, Egypt is well underperforming the index (Egpyt is roughly 0.5% of the index): the year to date total return on the Egyptian international bonds is -10%, while that of the JP Morgan Emerging Market Bond Index Global (EMBIG) is -0.7%.
Credit default swap spreads jumped 50% over the last week to 454 basis points (bps), according to one Bloomberg source (no link, subscription required). CDS are bilateral contracts between two parties, so pricing varies somewhat – but the trend is the same among all sources: up. This means that it’s becoming increasingly expensive to buy protection against Egyptian sovereign default.
And this is where it gets interesting: it currently costs the same to buy 5-yr protection on Egyptian bonds (454 bps) as on Portuguese bonds (456 bps). And Portugal is rated A- (negative outlook).
(more after the jump) The chart above illustrates a panel of CDS data for countries with similar market risk, where S&P’s local currency rating is listed in the legend. The CDS quoted above are priced in USD, rather than the local currency; but the spreads do quantify the market’s assigned probability of default : 29.3% for Egypt vs. 29% for Portugal (with a 30% recovery rate on both).
Generally the decision to default comes in two flavors: the ‘willingness’ and ‘ability’ to pay. Also, default can take many forms, like missed coupon payments, terming out debt liabilities, or bankruptcy (corporate).
Willingess. A quick analysis of ‘governance’ indicators at the World Bank says that on the face of it, Portugal is probably more willing to pay its debts. The governance measures are corruption, government effectiveness, political stability, regulatory quality, rule of law, and voice and accountability. Read about the methodology of the governance indicators here and get the data here.
In sum, Portugal ranks much higher on the total of the World Bank governance indicators, 6.4, compared to -2.6 for Egypt (I use a strict sum of the 6 components).
Ability. According to the IMF’s most recent World Economic Outlook (October 2010 database), Egypt is expected to grow an average 13.9% per year in nominal terms over the next three years (2010-2013). In contrast, Portugal is expected to grow just 1.7% on average for the next three years.
According to Bloomberg, on January 27, 2011, the yield on a Portuguese 1-year local bond is 3.42%, while that for a local Egyptian bond is 10.99%. I’ll take odds of payment on the one with nominal growth that exceeds the payment – Egypt.
A quick look at the WEI shows the following statistics for 2011:
General government net lending/borrowing
General government net lending/borrowing
General government net debt
General government net debt
General government gross debt
General government gross debt
Current account balance
Current account balance
International Monetary Fund, World Economic Outlook Database, October 2010
The 2011 outlook demonstrates the following: government deficits are similar in Portugal and Egypt; government debt is higher in Portugal, a country that has no monetary sovereignty; Portugal has relatively fewer reserves (comparing gross debt to net debt); and the current account deficit in Portugal dwarfs that of Egypt.
If I was an investment bank, I’d rather sell protection on Egypt than Portugal at these prices.
The chart illustrates the contribution to Y/Y GDI growth coming from each of the main income components. (Click to enlarge.)The series is deflated using the GDP deflator, since the BEA only releases the nominal numbers. All references to GDP and GDI below refer to the real series.
Observations I note:
1. The Y/Y growth rate of GDI surpassed that of GDP in Q2 2010, continuing into Q3 2010. In Q3 2010, GDI grew at a 3.6% annual clip, while GDP marked a lesser 3.2% rate. Don’t know what this means, exactly; but it could imply that the economy is expanding more rapidly than the GDP measure would suggest.
(more after the jump)
2. The Q3 2010 corporate profit contribution to annual income growth, 2.2%, is overwhelming that from wages and salary accruals (labor income), 0.73%. This oversized contribution is rather remarkable, given that domestic corporate profits are just 8% of GDI, while that of wages and salaries is 55%. This will probably even out, though, as history shows a more balanced contribution between profits and wages.
3. The chart illustrates the ‘stickiness’ of labor income. The corporate profit contribution turned negative in Q4 2006, while that of wages and accruals turned negative in Q3 2008. That’s a near 2-yr lag from profits to wages. Wages are recovering now; but there will be further quarters of weak wage growth relative to profits, as claims remain elevated above the 350k mark.
4. The contribution to GDI growth from net interest payments is in negative territory. Low rates are dragging this component.
5. Supplements to wages and salaries – government transfer payments like unemployment insurance, for example – contributed 0.3% to annual GDI growth in Q3 2010. Interesting thing about this, is that the average contribution spanning the 2000-2004 period, 0.5%, outweighs that during the 2005-2010 period, 0.14%. I say interesting because the labor decline was far deeper in this cycle compared to the previous cycle. (See Calculated Risk chart from 12.3.2010)
Overall, the GDI report implies that the economy may be improving more quickly than the GDP report suggests. There’s plenty of room for improvement in this picture, however, as the labor wages remain stuck in the mud with corporate profits strong.
Tomorrow we’ll see the Q4 2010 GDP report – consensus forecast is for 3.5% Q/Q SAAR.
According to the Treasury International Capital System (TIC) release, foreigners were net buyers of US securities in November, +$39 billion over the month. Of the $61.7 billion in long-term Treasuries net purchased (notes and bonds), private investors claimed $50.6, while official investors (central banks, sovereign wealth funds, etc.) accrued a smaller $11.1 billion. Over the last twelve months, foreign investors amassed $571 billion of the high-quality US securities: Treasury notes and bonds, agencies, and stocks, which includes the -$12 billion net sale of corporate bonds. Overall, it was a reasonably positive report, indicating that long-term asset sales are roughly in line with the current account deficit (chart to the upper left).
But the pundits follow the table on major foreign holders of US Treasuries. They note that the number 1 holder, China, reduced its holdings of Treasuries in November from just over $900 billion to just under. For some reason, investors and critics of the deficit alike are worried that when China is no longer named the US’ biggest stockpiler of Treasury securities, Treasury rates will skyrocket. Oh, the bond vigilantes.
And this is when I really miss Brad Setser’s commentary (he is now at the National Economic Council). He noted time and time again, that the monthly TIC data tend to under-report the Chinese holdings, especially when they are shifting their portfolio holdings of US Treasuries up the curve. Well, that’s what the Chinese did in November: holdings of US Tbills dropped $21 billion, while longer-term note holdings increased a net $9.9 billion. (more after the jump)
This is actually a well established pattern. The past five surveys of foreign portfolio investment in the US have all revised China’s long-term Treasury holdings up (in some cases quite significantly) even as they revised the UK’s holdings down. The following graph shows the gap between Chinese long-term Treasury purchases in the TIC data and China’s actual purchases of long-term Treasuries– as revealed in the survey.
Brad Setser’s quote was from 2009, but the story hasn’t changed since. In the 2010 report for 2009 foreign holdings, the level of Chinese Treasury holdings was revised up from the TIC-implied level by near $140 billion, while that of the UK was revised down (by over 100 billion, I might add). Clockwork.
So let’s apply Brad’s test, I’ll call it the Setser Test, to see if China actually reduced US Treasury holdings in November, as the November TIC release suggests. (I highlighted Brad’s test in bold italics, RW is me). The test is listed in the middle of this post.
Brad: First, the TIC data should show a fall in China’s holdings, i.e. net sales of Treasuries.
Second, the TIC data should also show limited purchases of Treasuries through the UK.
RW: No. The UK bought near $25 billion in Treasury notes and bonds, which more than offset the drop in Chinese Treasury buying. In fact, if the TIC data is accurate, the UK is amassing a rather large stockpile of US Treasuries. This would be in sharp contrast with the average $48 billion balance of Treasury holdings since 2006 (Table 4 or 5 depending on the year)!
Third, the Fed’s custodial holdings should not be rising at a strong clip — as, given China’s size, it is hard to see how China doesn’t make up a large fraction of all custodial holdings.
So according to the Setser Test, it’s very unlikely that China reduced its Treasury holdings in November. In fact they probably increased their Treasury holdings, given the magnitude of the Fed’s custodial balance.
This week Trichet laid down the ECB’s hand, (effectively) announcing his intention to maintain inflation at the ECB’s target rather than allow it to overshoot. For all intents and purposes, 2% inflation stabilizes the real exchange rate rather than furthering real depreciation in the Periphery and real appreciation in Germany (or the Core).
Mr Trichet’s fire-breathing rhetoric can be taken as a signal that the ECB will continue to run monetary policy for German needs and tastes, refusing to accommodate a little slippage on inflation to let Club Med regain lost competitiveness without having to endure the agony of debt-deflation. Indeed, the ECB seems to have picked up some of the worst habits of its mentor.
Only the rebalancing of inter-euro current accounts will bring stable fiscal finances for debtor and creditor countries alike, something made more difficult with 2% average inflation! Trichet, in an interview with German newspaper, Bild.de, doesn’t acknowledge this fact (bolded by RW):
Let me be very clear: this is not a crisis of the euro. Rather, what we have is a crisis related to the public finances of a number of euro area countries. All governments have to put their finances in order, and above all those governments and countries which have lived well beyond their means in the past.
Really? On the aggregate, Euro zone economies ‘living well beyond their means’ are now doing so in two respects: the current account deficit and public deficits. They’re not the same. Don’t even start with the ‘twin deficit’ story – Rob Parenteau refuted that some time ago. It’s not about government dissaving, per se. For countries like Spain, or any other Euro area economy with years of accumulated private sector leverage, the only way for the public sector to simultaneously reduce fiscal and private deficits is for Germany foreigners to dissave (foreigners run large CA deficits). (See a previous post of the 3-sector financial balances model here.)
Given the close trade ties in the Euro zone, growing income from abroad effectively means a transfer of saving from the Eurozone Core to the Periphery via the current. This requires real appreciation in Germany, for example, and real depreciation in Spain.
First, real appreciation/depreciation could have been given a fighting chance with a lapse of the inflation target. Trichet made it quite clear where the ECB stands on this front: NEIN.
Portugal, Greece, and Spain have essentially no chance if left to their own accord.
Spain along with other Periphery economies are relatively “closed” compared to the German export powerhouse; that needs to change.
The chart above illustrates the degree of openness across the Eurozone, as measured by (exports + imports) divided by GDP. Spain, Greece, Italy, and France (expected to run budget deficits the size of Spain this year) are the most ‘closed’ of the Euro area (16, not including Estonia). In Greece, Spain, and Italy, the GDP share of export income has decreased over the last decade; furthermore, it’s imports, rather than exports, that make the larger contribution to economic openness.
Export share (Q3 2010)
Import share (Q3 2010)
Even if Spain was more ‘open’, real appreciation is ingrained in the economy, as represented by unit labor costs. Structural reform is required on many fronts, private and public.
Since 2001, Spanish unit labor nearly doubled, +46%, while those in Germany grew just 17%. Recently, unit labor costs in Spain have stabilized. This is due to the contraction of the construction sector, which dragged productivity in recent years. Going forward, more is needed.
Enhancing productivity in a more sustainable way would involve further investment in and enhancing the efficiency of expenditure in research, development and innovation, as well as improving the efficiency of R&D expenditure are crucial for achieving productivity advances. Further improvements of the education and life-long learning systems and investment in human capital should also be envisaged. This may be achieved inter alia, by ensuring the effective, implementation of widespread education reforms in addition to upgrading the skills and increasing mobility of the labour force to promote a swift transition into employment, and reducing segmentation in the labour market.
Nowhere does the report say that competitiveness should be achieved by getting public finances ‘in order’. In fact, I’d deduce from these comments that more, rather than less, government spending is needed.
Without > 2% inflation, these countries don’t stand a chance.
Appendix: Another measure of relative price competitiveness, the GDP deflator.