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

The household survey paints a clearer picture of the January employment report than does the nonfarm payroll

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.

and…

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.

Rebecca Wilder

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Egyptian CDS in line with Portuguese CDS

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:

  1. 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.
  2. 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).
  3. 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%.
  4. 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.

If you want to know more about CDS, please see a helpful 2009 publication by Deutsche Bank.

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:

Country Subject Descriptor 2011
Egypt General government net lending/borrowing -7.622
Portugal General government net lending/borrowing -5.232
Egypt General government net debt 60.993
Portugal General government net debt 82.864
Egypt General government gross debt 71.725
Portugal General government gross debt 87.086
Egypt Current account balance -1.605
Portugal Current account balance -9.171
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.

Rebecca Wilder

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The other measure of income, GDI, shows faster growth and an oversized profit contribution

There are two measures of income: the spending side (Gross Domestic Product, or GDP) and the income side (Gross Domestic Income, GDI). I’d like to see what GDI is telling us about the Y/Y recovery, since it’s a better predictor of turning points, according to FRB economist Jeremy J. Nalewaik.

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.

Rebecca Wilder

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According to the Setser Test, it’s unlikely that China reduced its Treasury holdings in November

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)

According to Brad Setser, only in the annual survey of US portfolio holdings are China’s measured holdings of US Treasuries accurate:

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.

RW: Yes.

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.

RW: The Fed’s custodial holdings increased by a sizable $39 billion. More likely than not, this was due in part to Chinese activity.

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.

Rebecca Wilder

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European policy…really?

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).

Ambrose Evans-Pritchard agrees with my interpretations of Trichet’s speech:

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)
Greece 20.2 26
Spain 26.1 27.5
Italy 27.0 28.5

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.

The EU made several recommendations in their 2010 Surveillance of Intra-Euro-Area Competitiveness and Imbalances (pg. 78):

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.

Rebecca Wilder

Appendix: Another measure of relative price competitiveness, the GDP deflator.

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Which country prints more and runs bigger government deficits: Canada or the US?

Even though Europe is on the forefront of global bond news these days, I’d like to revisit the US Treasury market. Specifically, I’ll look at the Canadian-US bond spreads, which tell an interesting tale of Fed purchases and US deficit fears.

First, the Canadian over US government bond spreads for two longer term issues, 10yr and 30yr in chart below, have been falling for some time. Today (Jan. 10, 2011), the 10-yr Canadian Treasury over the 10-yr Treasury spread is around -12 basis points (bps), i.e., the Canadian 10-yr bond is 12 bps lower than the US 10-yr. The 30-yr spread is roughly -86 bps.

The recent divergence of the ‘spread’ between these two spreads presents a bit of a conundrum, since the two have more or less moved in lockstep.


Note: in the chart above, each dotted line represents the period average for the 30 calendar day (30-c.day) moving average spread of similar color.

The conundrum is this: the 30-yr spread has deviated well below its 2002-2011 average of 8 bps, while the 10-yr spread is sitting roughly at its average, -13 bps. But this is not a conundrum if you consider recent US policy, holding all else equal.

One the one hand, the Federal Reserve is concentrating its bond purchases in the long end of the curve, primarily below the 10-yr maturity. According to the NY Fed, 23% of the $600 bn will be allocated to the 7yr-10yr part of the curve, while just 4% will support the 17yr-30yr end. Therefore, and holding all else equal, the CAN-US spread proxies somewhat the effects of Fed policy in the bond market. The Fed is supporting the 10-yr spread roughly at trend(Section II in chart above), while contemporaneously raising inflation expectations relative to that in Canada.

On the other hand, without Fed support the 30-yr spread is pricing in not only rising inflation expectations but also an increasing US sovereign risk premium relative to that in Canada. This is a similar premium that was attached to Canadian sovereign debt in the early- to mid- 1990s (Section I in the chart above).

Compare the chart below, which illustrates the annual federal deficit in the two countries as a percentage of GDP, to the chart above. Notice how when the red line, (Canadian government deficit) moves aboe the blue line (US government deficit), the average spread drops (Section III in first chart)? That premium is now feeding into the 30-yr spread at an increasing rate (Section II of first chart).

I am in no way suggesting that the US should undergo a similar fiscal austertiy program as that taken in Canada in 1995 (please see Stephen Gordon at Worthwhile Canadian Initiative). What I am demonstrating, though – and rather qualitatively, I might add – is that absent active Fed purchases in the back end of the curve, there is a risk premium emerging in the US bond market relative to that of at least one country with markedly lower government deficits, all else equal, of course.

Rebecca Wilder

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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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