ricardian ambivalence

Markets sure are unusual at the moment. The price action is testing all sorts of assumptions – and has busted one of my longstanding views. (Partially) based on the observation of JGBs over the years, I had concluded that nominal bond yields could not remain negative for a sustained period of time.

Facts have made a fool of me  … what I had dismissed as a technical anomaly a month ago (the top dashed line is a month back) has now become a ‘feature’ of the CHF Bond market.

The Jan’14 Bond is now -30bps, the Nov’14 is -25bps, the Mar’16 is -8bps, and the Oct’16 is -3bps .. the question is why?

I suspect that foreign money is pouring out of Europe and into CHF capital markets.

Out of EUR because folks do not want the uncertain currency position – they are not sure if there will be a EUR in a few years time, however they have confidence in the Swiss Franc.

You can see that EURCHF has been sitting at the SNB’s 1.20 floor for a few weeks now – I wonder who is buying all that EUR?

SNB data for the week to 25 May show ~17bn CHF increase in sight deposits (around EUR14.2bn at EURCHF 1.20). My guess is that this number will have significantly increased in the most recent week.

I also suspect that SNB’s swelling EUR portfolio is one of the major reasons that 6m German bills offer a handsome -3bps return (not to mention 10yrs at 1.27%).

Why into bonds – and not bank deposits? Perhaps these investors do not trust that banks will remain solvent if the worst happens, so they prefer the security of a Government that is very unlikely to go broke over a zero interest bank deposit.

Why not cash? After all that is a zero yield claim on the swiss government – well, where are you going to put that many Francs?

MOnetary policy is bond buying, and the world needs easier monetary policy just now – so i have every expectation that yields will keep falling.

Finally, I want to take a pot shot at the “yields drive FX” view of the world. Currency and Bonds are both liabilities of the National Treasury – the primary factor to consider when valuing both is the expected future surpluses process 9parenthetically, that means that we already have a form of Euro-bond, but that’s another story!).

In the current market, this ‘credit view’ is driving capital flows. This is why yields are falling and currencies are staying up in markets where the sovereign’s credit is strong. That is what’s happening in Australia just now.

The ongoing move to gas as a source of cheap energy is a great hope for the US over the medium term. The WSJ reports that even truck fleets are making the switch (ht Jim Hamilton).

It is a great thing to have cheap energy, and i suspect that fracking will supply first the US, and later the world, with abundant cheap (and clean) gas.

It is difficult to export gas (which is why the Australian gas investments are mega-projects) so at this point US gas prices have collapsed, while Asian Gas prices (our customers) remain higher. Because gas is difficult to export, the immediate threat is not to Australian Gas exports and investment projects – it is to our coal exports / investments.

The collapse in US gas prices has led to substitution away from oil and coal – both of which are much easier to export. Displaced US coal is being exported, and this is lowering global coal prices. My expectation is that displaced US coal will continue to depress global coal prices, and that the lower price will diminish the incentive to invest in additional Australian coal production.

We get an update from the ABS on investment intentions today – I suspect the period where capex surprises with strength is now over. My guess is that plans will be revised down, and that some of the so-called ‘baked in’ projects will never make it ‘into the oven’.

Without a mining boom, we never would have raised rates – like almost everyone else – so the investment unwind ought to mean a return to 5% mortgage rates.

How low does the RBA’s overnight cash rate have to go to get mortgage rates down ~5%? That depends on funding markets. Right now my guess is that you would need a 1% cash rate.

The sell-side /blogger reaction to Fed Dudley’s recent speech suggested that the Fed had made an unexpectedly hawkish move.

Tim Duy, for example, concluded from it that:

the baseline scenario should be that QE3 is not on the table

This was a surprise to me, as the data since the April Fed meeting has been a bit softer, and Bernanke had explicitly gone out of his way to say that QE remained on the table at the April presser.

So we have been very accommodative, and we remain prepared to do more as needed to make sure that this recovery continues and that inflation stays close to target … So those tools remain very much on the table, and we will not hesitate to use them should the economy require additional support

The street appears to have over-interpreted the following sentence in Dudley’s speech:

As long as the U.S. economy continues to grow sufficiently fast to cut into the nation’s unused economic resources at a meaningful pace, I think the benefits from further action are unlikely to exceed the costs.

But read in context, it is not hawkish. Dudley sees an immediate case for more action, based on the unsatisfactory outlook, but is worried about the possible costs of further easing.

Given our forecast of stable prices and a still slow path back to full employment, there is an argument for easing further. But, unfortunately, our tools have costs associated with them as well as benefits. Thus, we must weigh these costs against the benefits of further action.

As long as the U.S. economy continues to grow sufficiently fast to cut into the nation’s unused economic resources at a meaningful pace, I think the benefits from further action are unlikely to exceed the costs. But if the economy were to slow so that we were no longer making material progress toward full employment, the downside risks to growth were to increase sharply, or if deflation risks were to climb materially, then the benefits of further accommodation would increase in my estimation and this could tilt the balance toward additional easing.

The US data has been soft of late, and global conditions have been weakening, so the events are doubtless moving Dudley toward a vote for further policy easing.

Amidst all this QE3 hunting, folks missed a very interesting talk about the montary transmission mechanism and the fed’s risk management approach to policy.

The most interesting part was Dudley’s judgement that the neutral real rate for the US economy had fallen – he cites work by SF Fed Williams and FRB Laubach that suggests it may be 0.3%.

This is around 170bps lower than ‘standard’ Taylor type rules suggest. Making such an adjustment means a Taylor 1999 rule suggests a first hike in 2015 – see the below chart.

My best guess is that there will be more balance sheet expansion this year, and that the first hike will be 2015 or later. The literature on the ZLB is clear that you should wait to lift rates until deflation risk has completely faded, so the Fed is going to be at the very least extremely slow to hike.

A rule of thumb that captures this is: if the optimal rate is below 1% go to zero (which in the Fed’s present case is 0-25bps). Looking at Dudley’s adjusted Taylor-99 chart, the trajectory suggests the optimal rate will not be greater than 1% until mid 2016.

Inflation pressures are easing, and seem likely to decline further. Headline pressures are easing as commodity prices decline, and sub-trend global growth and a decent supply response seem likely to keep it this way. High unemployment and low headline pressures are likely to keep core measures tame.

The FRBNY has made the same judgement — their underlying inflation gauge is falling fast.

If I am right about the inflation outlook, we seem likely to see further balance sheet action from the Fed before the end of this year.

It is reassuring that members of the Labor party have rediscovered the notion of innocent until proven guilty. I await their support to change many of those Acts in which they have reversed that traditional onus of proof.

Take for example, the Queensland Vegetation Management Act 1999, which basically stops farmers from clearing trees that they own. Section 66B(2):

(2) A statement of any of the following matters in the certificate or report is evidence of the matters stated in the absence of evidence to the contrary—

… (f) whether vegetation in a stated area has been cleared;

(g) whether a stated area is or is likely to be an area of remnant vegetation or regulated regrowth vegetation.

And section 67A(1):

The clearing of vegetation on land in contravention of a
vegetation clearing provision is taken to have been done by an
occupier of the land in the absence of evidence to the contrary.

Perhaps a similar provision could be added to the government’s attempts to improve the regulation of trade unions. Something like the procuring prostitutes using a union credit card is taken to have been done by the owner of that card in the absence of evidence to the contrary.

The Canberra consensus says that prior to the Hawke-Keating era, Australia’s economic policy was a wasteland of protective tariffs, over-regulation and bloated public sector monopolies. There is some truth in this but it is a simplification.

Economic policy between WWII and Whitlam was generally sensible and delivered strong and stable economic growth. Sure the Menzies government committed sins of omission, they largely left in place the Deakin doctrine of high tariffs, high wages and a white Australia, but then, thanks to the 1949 election, they also avoided the insanity of large-scale nationalisation which swept Europe and, thanks to the horror budget of 1951, they delivered prudent fiscal policy and low inflation.

The era’s greatest achievement was the massive growth in Australia’s population mostly through large scale migration. As Labor MP, Andrew Leigh, summed up in his excellent speech on Australia’s economic history:

At its peak, in 1949, Australia accepted 185,000 migrants into a population of 7.9 million. On today’s population, that would be equivalent to a migrant inflow of more than half a million people.

This was an extraordinary program. Relative to population, Australia’s post-war migration program was the largest sustained migration in the world – bigger than the US peak immigration era at the turn of the twentieth century. Many were sent to work on the Snowy Mountains scheme, which employed 10,000 men at its peak.

Indeed, according to the Australian government, 70,000 of the 100,000 men who worked on the Snowy came from overseas. As far as I know, this mass migration had bipartisan support (although Arthur Calwell preferred migrants of Baltic stock). What a great achievement and legacy.

But today, 1,700 migrants, to work on a $7 billion iron ore project, is an outrage, and perhaps the basis for a Cabinet crisis. (The Snowy cost about $8 billion in today’s dollars.)

Let’s not fool ourselves that we are better or nobler than our ancestors.

I understand that the Labor party and the unions have a close relationship but who exactly is the “we” in this statement form Paul Howes:

“I thought we were actually attacking these guys at the moment,” Mr Howes said.

“Whose side are we on? This is a big win for Gina Rinehart, it’s a big win for Clive Palmer and it’s a big win for Twiggy Forrest.”

It would be much healthier for our democracy, and for the Labor party, if there were more distance between organised labour and the ALP. Trade unions have their place but they are a vested interest. As such, they should at arms-length from government decisions and strategy.

The government should represent all Australians not the 18-odd per cent in a union.

The weakness of the Chinese and European (flash May) PMIs tells an interesting Macro story. With a bit of imagination, it is possible to see hints that the European recession is showing up in China. From there, the next step is for it to show up as lower demand for Australian Exports – and hence lower (or slower) investment demand, and therefore slower Australian GDP growth.

In May, the headline Chinese Manu PMI declined a modest 0.6pts to 48.7pts, making the seventh consecutive month below the break-even level of 50. The detail was poor, with supplier delivery times shortening (typically a sign that there are fewer other customers who are ordering products), stocks of finished goods rising, and new orders declining.

My conjecture is that at least some of the weakness on the new orders side is due to weak final demand due to the recession in Europe. The concurrent weakness of new export orders is a key part of this judgement. 

It makes sense that Chinese export orders would be slow. Europe is China’s largest trading partner, and business is slow in Europe (and has been slowing for some time). Consistent with this, employment prospects have been weak – and weakening – in Europe.

This is exactly the sort of environment in which one would expect to see an increase in household saving – and my conjecture (it will be a few months before we have the trade data) is that declining final demand in Europe is also playing a part in the slow-down in new export orders for the Chinese manufacturing sector.

I judge that it is this slow-down that will feed through to Australia, via lower investment plans: we have started to see this, but I expect that there will be more high-profile cancellations (Olympic Dam, for example, seems unlikely to go ahead).

If sustained, the EUR Composite PMI is consistent with European GDP contracting by ~0.75%q/q in Q2. With no resolution in sight, and monetary policy already maxed out, it’s easy to see a 2% contraction in 2012.

German PMIs are consistent with only a modest pace of contraction, however the PMIs suggest a much more severe contraction in the rest of Europe.

Note, this is no longer just the periphery – pretty much all of Europe, except Germany, looks very weak.

Most surprising to me is the recently terrible performance of France. The PMI suggests a pace of contraction of ~0.75%q/q …

If this is the case, France will soon be downgraded once again (S&P cut them to AA+ with a negative outlook in Jan’12, and Moody’s has them AAA / negative).

Other Sovereigns, such as Belgium (AA / negative) and the netherlands (AAA / negative) are also likely to be downgraded.

Further downgrades to France and other ‘better quality’ European Sovereigns will reduce the operational capability of the various ‘firewall’ mechanisms. To a greater or lessor extent, these mechanisms depend on the ability to issue bonds to raise ‘firewall’ capital. Without an AAA rating, the bozooka is going to be short a bit of ammo.

In my view, European credit’s achilles is now the growth problem. Without growth, they have unstable debt dynamics, because they have primary deficits (for the most part) and must pay high interest rates. The Austerity required to retain their credit ratings, and hence market access, is reducing growth – as the uncertainty surrounding the EUR’s future is making firms too nervous to take risk and fill the space left by the contracting public (and finance and property) sectors.

The high level of yields, and the recessionary growth outlook, means that Italian and Spanish debt dynamics may be already unstable.

The best we can hope for now is that Greece defaults (again) but does not leave the EUR – so that we merely get a severe credit crunch. In that case, we merely have a nasty European recession, rather than a financial crisis – but at these yields, Spanish and Italian debt dynamics are probably already on an unstable path, even if there is no crisis.

The monthly DEEWR benefits data lags the unemployment rate, and is highly seasonal.

Mark the graph does a good job dissecting the data here.

The series reliably lags the ABS unemployment data – it takes time to file for benefits, etc. – however its value is that it confirms that the labour market did indeed soften in H2’11.

The ongoing weakness in this data ought to be the finish of the the argument that the unemployment rate never really rose, and that the labour market was never weak.

The bundesbank’s report on the German situation contains an enlightening statement on the situation in Greece (ht alphaville).

Current developments in Greece are extremely worrying. Greece is threatening not to implement the reform and consolidation measures that were agreed in return for the large-scale aid programmes.

This jeopardises the continued provision of assistance. Greece would have to bear the consequences of such a scenario.

When the Eurosystem provided Greece with large amounts of liquidity, it trusted that the programmes would be implemented and thereby ultimately assumed considerable risks. In the light of the current situation, it should not significantly increase these risks. Instead, the parliaments and governments of the member states should decide on the manner in which any further financial assistance is provided and therefore whether the associated risks should be assumed.

Greece needs to find ~12bn of savings by the end of June – doesn’t sound like the Germans have a sense of humour about their ‘issues’.

Just one of the problems with having a comptroller with a pain based sense of humour.

The minutes from the BoE’s 9-10 May meeting show that they were close to doing more QE.

for several members, the decision not to expand the asset purchase programme at this meeting was finely balanced

Given the softening of the outlook, I expect that they will deliver at least 25bn and possibly 50bn of more QE at their next meeting (from the present 325bn)

With the level of output ~4% below the prior peak, and not expected to reach that level until 2014, the mystery of elevated inflation continued to tax the MPC. Their deliberations on the issue of weak productivity growth are interesting, because this is a global problem:

The Committee discussed two possible broad explanations for this that were not mutually exclusive. Both suggested that the supply capacity of the economy had weakened alongside the weakness of demand. First of all it was possible that the weakness in productivity and demand had a common cause, such as the widespread fear of a disorderly resolution of the euro-area crisis. Symptoms would include elevated risk premia that raised bank funding costs and the cost of capital to companies, whether they were reliant on the banking system for finance or not, and weakened physical investment and innovation. The second explanation was that the weakness in productivity had itself been caused by weakness in demand, perhaps because of mothballing of capital or reduced scope for learning on the job.

Myself, i favour the demand answer – weak demand conditions may have lowererd measured productivity. Most capital is tuned to run with a given scale, and use of this vintage of capital at lower rates of production (less staffing, and lower units of output) ought to mean lower productivity.

Picking up the mothballing is hard, so this appears as an MFP shock – as you have overstated the capital services flow. This is basically what we are seeing in many economies just now.