Echo

Rebecca's taking an indefinite break from blogging

Tuesday, November 23, 2010

I started a new job in August 2010. It's a challenging, exciting, and thoroughly satisfying position, however, I am left with little to no time for my family. I have made the decision to cease commentary on News N Economics at this time.

I see this as an indefinite pause. Perhaps, though, at one point I may be able to dedicate time to my career and blogging simultaneously once again.

Thank you all for reading and providing feedback. It is the dedicated readership that keeps a blogger going.

Best regards, Rebecca

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

Monday, November 15, 2010

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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Ireland: the battle against "markets"

Friday, November 12, 2010

Is it the sheer size of its contingent liabilities that is driving Irish spreads? Finance Minister Brian Lenihan thinks so via the Irish Independent:

"There is no doubt in my mind that while the announcement on the banking sector in September was not disbelieved by the markets, it wasn't fully believed either because there is a wait and see policy of seeing whether it is an accurate account of exposures in the banking system," the minister said.
Or is it German Chancellor Angela Merkel's recent rhetoric? According to the Irish Times, since her most recent statement on private haircuts, "All stakeholders must participate in the gains and losses of any particular situation", officials are readying the EFSF for possible tapping by the Irish government:
The Irish Times has established, however, that informal contacts are under way between Brussels, Berlin and other capitals to assess their readiness to activate the €750 billion rescue fund in the event of an application from Dublin.
The EU quashes this rumor.

Or is it that "markets" just don't buy the Irish fiscal austerity reduces the Irish budget deficit story? According to the Irish Independent, this is the opinion of Nobel laureate Joseph Stiglitz (mine, too, by the way):
“The austerity measures are weakening the economy, their approach to bank
resolution is disappointing,” Stiglitz, a Columbia University economics professor, said in an interview in Hong Kong today. “The prospect of success is very, very bleak” for the government’s plan to resolve the problem, he said.
What's driving spreads? (They've come off a bit today, but they're still just under 600 basis points over German bunds (as of 6am this morning).) Furthermore, the EU came out with a statement that reiterates the exclusion of outstanding debt on any new restructuring mechanisms:
..does not apply to any outstanding debt and any programme under current instruments. Any new mechanism would only come into effect after mid-2013 with no impact whatsoever on the current arrangements.
The answer is, it's probably a mix of the three above. Markets are starting to price in an insolvent government balance sheet, which will ultimately lead to default - some call Ireland's sovereign balance sheet insolvent but still liquid .

I side with Stiglitz, that ultimately its deficit reduction plan will reveal the axiom that is the three-sector financial balance: if you don't have a surge of external income, then the private sector and the public sector cannot simultaneously increase saving.

Exhibit A. The year of austerity - and even harsher and more front loaded austerity is on the way - has proven to squash growth prospects for the Irish economy compared to the average, which is the Euro area.

The chart illustratest the index of quarterly GDP, as reported by Eurostat. The Euro area data is current through Q3 2010 (only on a "flash" basis), while the Irish GDP figures are available through Q2 2010. These numbers are not annualized; but as of Q2 the Irish economy is running 11% below its Q1 2008 level of GDP, while in Q3 the Euro area as a whole is producing just 2.7% short of its Q1 2008 level.

But the Irish government is sticking to its plan. Recently the Central Bank of Ireland published its quarterly report, where it simultaneously downgraded the growth forecast AND announced that further action will be taken to bring the government deficit to 3% of GDP by 2014. Since then, the government announced deficit cuts that exceeded those originally planned by a factor of two. Seems fishy to me.

Rebecca Wilder

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Eurozone rebalancing depends on German inflation

Tuesday, November 9, 2010

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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German industrial production fell in September

Monday, November 8, 2010

Today German industrial production surprised to the downside in September, falling 0.8% over the month on a seasonally-adjusted basis. The contraction brought the annual pace of growth to 7.9% over the year, down from a 10.7% clip in August.

It looks like my data mining is proving to be rather useful. The ratio of the Ifo expectations/current index, which tends to lead German IP growth by about 6 months, turned down in February 2010 - now so has the pace of annual industrial production growth. The implication is that the Q4 2010 rate of domestic activity is likely to be quite weak.
The chart illustrates the 6-month lead of the trend in Ifo expectations index minus the trend in Ifo current index and the annual growth rate of industrial production.

By my count (you'll have to trust me here), German data has surprised 9 times to the upside and 10 times to the downside this month (October through current). We'll see; but the scales are tipping to the downside.

Rebecca Wilder

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According to bond markets, Ireland is not yet Greece

Friday, November 5, 2010

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

This article is crossposted with Angry Bear blog.

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G4 GDP, reaction ECB

Tuesday, November 2, 2010

It's complicated. The ECB is currently juggling two objectives: perpetually assuaging bond investors in the face of a shaky financial system, and managing policy for an economy with a single currency and sovereign government issuers.

But is it really so complicated?

The chart above illustrates the peak (deemed 2008 Q1 here) to trough and recovery of GDP across the G4 (Eurozone, UK, US, and Japan). None of the G4 have returned to 2008 Q1 levels of production (pre-2008). Ironically, as the US Fed readies itself for QE2, the American economy has returned the farthest back up the "production path".

The German recession was deeper, but the rebound has been quick. Annual GDP growth in Q2 2010 was well above potential, 3.7% over the year, and the labor market continues to see gains. But German growth has not been sufficient-enough to bring neither its nor the Eurozone's level of GDP back to pre-2008 levels (as of Q2 2010).

To be sure, 2H 2010 GDP remains to be factored into the recovery in Germany and the Eurozone. Perhaps when all is said and done, Germany will recover smartly in 2H 2010 to generate the final 2.7% bump in GDP to return to pre-2008 levels before the 2011 fiscal austerity measures start to crimp export income. Thus, is the ECB holding pattern correct?

That remains to be seen. If the ECB continues to set policy as it has done so in the past, however, it'll take an economic slap in the face before the ECB reacts to real economic growth and eases further.


The chart illustrates the refi rate (ECB policy rate) at a 2-quarter lead to the annual pace of GDP growth. The relationship is strong and positive, with a correlation is 82%.

The relationship suggests that the ECB's reaction function actually follows economic growth trajectories, but at a two-quarter lag (roughly). For example, the ECB was raising rates into the third quarter of 2008 only to see GDP fall 2.1% at an annual clip in the fourth. It dropped the refi rate by 1.75% in Q4 2010.

The ECB targets inflation, not GDP growth; but the reaction function is roughly 2-quarters lagged to the disinflationary pressures that stem from recession (from my simple exercise, of course). In conclusion, if the ECB is going to react to GDP-induced disinflation signals (i.e., negative growth), then it could get a lot worse in the Eurozone before policy eases further: 1H 2011 is my bet.

Rebecca Wilder

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

Monday, November 1, 2010

This commentary is crossposted with Angry Bear blog.


This 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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