Category: zerohedge

“The Fed’s real dilemma is that its policy is creating a financial market bubble that is large relative to the pickup in the economy that it is producing,” Bridgewater notes as the relationship between US equity markets and the Fed’s balance sheet (here and here for example) and “disconcerting disconnects” (here and here) indicate how the Fed is “trapped.” However, as the incoming Yellen faces up to her ‘tough’ decisions to taper or not, Ray Dalio’s team is concerned about something else – “we’re not worried about whether the Fed is going to hit or release the gas pedal, we’re worried about whether there’s much gas left in the tank and what will happen if there isn’t.”

 

Via Bridgewater,

In the old days central banks moved interest rates to run monetary policy. By watching the flows, we could see how lowering interest rates stimulated the economy by 1) reducing debt service burdens which improved cash flows and spending, 2) making it easier to buy items marked on credit because the monthly payments declined, which raised demand (initially for interest rate sensitive items like durable goods and housing) and 3) producing a positive wealth effect because the lower interest rate would raise the present value of most investment assets (and we saw how raising interest rates has had the opposite effect).

All that changed when interest rates hit 0%; “printing money” (QE) replaced interest-rate changes. Because central banks can only buy financial assets, quantitative easing drove up the prices of financial assets and did not have as broad of an effect on the economy. The Fed’s ability to stimulate the economy became increasingly reliant on those who experience the increased wealth trickling it down to spending and incomes, which happened in decreasing degrees (for logical reasons, given who owned the assets and their decreasing marginal propensities to consume).

As shown in the charts below, the marginal effects of wealth increases on economic activity have been declining significantly. The Fed’s dilemma is that its policy is creating a financial market bubble that is large relative to the pickup in the economy that it is producing. If it were targeting asset prices, it would tighten monetary policy to curtail the emerging bubble, whereas if it were targeting economic conditions, it would have a slight easing bias. In other words, 1) the Fed is faced with a difficult choice, and 2) it is losing its effectiveness.

We expect this limit to worsen. As the Fed pushes asset prices higher and prospective asset returns lower, and cash yields can’t decline, the spread between the prospective returns of risky assets and those of safe assets (i.e. risk premia) will shrink at the same time as the riskiness of risky assets will not decline, changing the reward-to-risk ratio in a way that will make it more difficult to push asset prices higher and create a wealth effect.

Said differently, at higher prices and lower expected returns the compensation for taking risk will be too small to get investors to bid prices up and drive prospective returns down further. If that were to happen, it would become difficult for the Fed to produce much more of a wealth effect. If that were the case at the same time as the trickling down of the wealth effect to spending continues to diminish, which seems likely, the Fed’s power to affect the economy would be greatly reduced.

…

…we think that US monetary policy is nearing a new test that will require wisdom and creativity along the lines of that which was required to deal with those problems. 

The basic issue is that quantitative easing is a much less effective tool when asset prices are high and thus have low expected returns than it is for managing financial crises.  That’s because QE stimulates the economy by (1) offsetting a panic by providing cash to the financial system when there’s a need for cash, and (2) by raising asset prices, and driving money from the assets they buy into demand and investment, creating a higher level of future economic activity.  So, the policy was particularly wise and most effective (in the sense of impact per dollar) at the height of the financial crisis when there was both a desperate need for cash and when extremely depressed asset prices were heavily weighing on demand and investment. 

Now, there is a flood of liquidity and asset prices are high relative to underlying fundamentals.  So the impact of additional asset price increases on demand is much less (as high asset prices and low future returns make assets more interchangeable with cash). 

Quantitative easing today is driving asset prices to unsustainable levels, without stimulating much additional activity.  That leaves a much clearer tradeoff between driving up asset prices today and lowering future returns (the price of which will be paid in the future).  During the crisis period, that was much less the case, because pulling forward returns from the future (i.e.,  raising prices) was then also creating future earnings growth (by helping to normalize the economy). 

The dilemma the Fed faces now is that the tools currently at its disposal are pretty much used up, in that interest rates are at zero and US asset prices have been driven up to levels that imply very low levels of returns relative to the risk, so there is very little ability to stimulate from here if needed.  So the Fed will either need to accept that outcome, or come up with new ideas to stimulate conditions.

We think the question around the effectiveness of continued QE (and not the tapering, which gets all the headlines) is the big deal.  Given the way the Fed has said it will act, any tapering will be in response to changes in US conditions, and any deterioration that occurs because of the Fed pulling back would just be met by a reacceleration of that stimulation.  So the degree and pace of tapering will for the most part be a reflection and not a driver of conditions, and won’t matter that much.  What will matter much more is the efficacy of Fed stimulation going forward. 

In other words, we’re not worried about whether the Fed is going to hit or release the gas pedal, we’re worried about whether there’s much gas left in the tank and what will happen if there isn’t.

via Zero Hedge http://feedproxy.google.com/~r/zerohedge/feed/~3/pyI2qcz7Feo/story01.htm Tyler Durden

“The Fed’s real dilemma is that its policy is creating a financial market bubble that is large relative to the pickup in the economy that it is producing,” Bridgewater notes as the relationship between US equity markets and the Fed’s balance sheet (here and here for example) and “disconcerting disconnects” (here and here) indicate how the Fed is “trapped.” However, as the incoming Yellen faces up to her ‘tough’ decisions to taper or not, Ray Dalio’s team is concerned about something else – “we’re not worried about whether the Fed is going to hit or release the gas pedal, we’re worried about whether there’s much gas left in the tank and what will happen if there isn’t.”

 

Via Bridgewater,

In the old days central banks moved interest rates to run monetary policy. By watching the flows, we could see how lowering interest rates stimulated the economy by 1) reducing debt service burdens which improved cash flows and spending, 2) making it easier to buy items marked on credit because the monthly payments declined, which raised demand (initially for interest rate sensitive items like durable goods and housing) and 3) producing a positive wealth effect because the lower interest rate would raise the present value of most investment assets (and we saw how raising interest rates has had the opposite effect).

All that changed when interest rates hit 0%; “printing money” (QE) replaced interest-rate changes. Because central banks can only buy financial assets, quantitative easing drove up the prices of financial assets and did not have as broad of an effect on the economy. The Fed’s ability to stimulate the economy became increasingly reliant on those who experience the increased wealth trickling it down to spending and incomes, which happened in decreasing degrees (for logical reasons, given who owned the assets and their decreasing marginal propensities to consume).

As shown in the charts below, the marginal effects of wealth increases on economic activity have been declining significantly. The Fed’s dilemma is that its policy is creating a financial market bubble that is large relative to the pickup in the economy that it is producing. If it were targeting asset prices, it would tighten monetary policy to curtail the emerging bubble, whereas if it were targeting economic conditions, it would have a slight easing bias. In other words, 1) the Fed is faced with a difficult choice, and 2) it is losing its effectiveness.

We expect this limit to worsen. As the Fed pushes asset prices higher and prospective asset returns lower, and cash yields can’t decline, the spread between the prospective returns of risky assets and those of safe assets (i.e. risk premia) will shrink at the same time as the riskiness of risky assets will not decline, changing the reward-to-risk ratio in a way that will make it more difficult to push asset prices higher and create a wealth effect.

Said differently, at higher prices and lower expected returns the compensation for taking risk will be too small to get investors to bid prices up and drive prospective returns down further. If that were to happen, it would become difficult for the Fed to produce much more of a wealth effect. If that were the case at the same time as the trickling down of the wealth effect to spending continues to diminish, which seems likely, the Fed’s power to affect the economy would be greatly reduced.

…

…we think that US monetary policy is nearing a new test that will require wisdom and creativity along the lines of that which was required to deal with those problems. 

The basic issue is that quantitative easing is a much less effective tool when asset prices are high and thus have low expected returns than it is for managing financial crises.  That’s because QE stimulates the economy by (1) offsetting a panic by providing cash to the financial system when there’s a need for cash, and (2) by raising asset prices, and driving money from the assets they buy into demand and investment, creating a higher level of future economic activity.  So, the policy was particularly wise and most effective (in the sense of impact per dollar) at the height of the financial crisis when there was both a desperate need for cash and when extremely depressed asset prices were heavily weighing on demand and investment. 

Now, there is a flood of liquidity and asset prices are high relative to underlying fundamentals.  So the impact of additional asset price increases on demand is much less (as high asset prices and low future returns make assets more interchangeable with cash). 

Quantitative easing today is driving asset prices to unsustainable levels, without stimulating much additional activity.  That leaves a much clearer tradeoff between driving up asset prices today and lowering future returns (the price of which will be paid in the future).  During the crisis period, that was much less the case, because pulling forward returns from the future (i.e.,  raising prices) was then also creating future earnings growth (by helping to normalize the economy). 

The dilemma the Fed faces now is that the tools currently at its disposal are pretty much used up, in that interest rates are at zero and US asset prices have been driven up to levels that imply very low levels of returns relative to the risk, so there is very little ability to stimulate from here if needed.  So the Fed will either need to accept that outcome, or come up with new ideas to stimulate conditions.

We think the question around the effectiveness of continued QE (and not the tapering, which gets all the headlines) is the big deal.  Given the way the Fed has said it will act, any tapering will be in response to changes in US conditions, and any deterioration that occurs because of the Fed pulling back would just be met by a reacceleration of that stimulation.  So the degree and pace of tapering will for the most part be a reflection and not a driver of conditions, and won’t matter that much.  What will matter much more is the efficacy of Fed stimulation going forward. 

In other words, we’re not worried about whether the Fed is going to hit or release the gas pedal, we’re worried about whether there’s much gas left in the tank and what will happen if there isn’t.

via Zero Hedge http://feedproxy.google.com/~r/zerohedge/feed/~3/pyI2qcz7Feo/story01.htm Tyler Durden

Submitted by Alasdair Macleod of GoldMoney.com,

This week an article in Euromoney points out that liquidity in bond markets is drying up. The blame is laid at the door of regulations designed to increase banks’ capital relative to their balance sheets. Furthermore, the article informs us, new regulations restricting the gearing on repo transactions are likely to make things worse, not only reducing bond market liquidity further, but also affecting credit markets. The reason this will be so is that in a repurchase agreement a bank supplies credit to non-banks for the period of the repo.

One could take another equally valid point of view: the reason for deteriorating liquidity in bond markets is due in part to yields being unnaturally low. If you price bonds too highly, which amounts to the same thing, few investors want to buy them without the unconditional support of the central bank as a ready buyer. This, after all, is why just the hint of tapering recently was enough to derail the markets. So here again we come up against the same choice: if the Fed insists on mispricing the market with its interventions and zero interest rate policy it must fully support the market with both QE and also twist applied to the yield curve to maintain market liquidity.

For the investment analysts and commentators that still expect tapering this must come as something of a surprise. The underlying point they have missed is that once a central bank embarks on a policy of printing money as a cure-all, it is impossible to stop, or even to just taper without risking a liquidity crisis. Increasingly illiquid markets are now telling us that QE should be increased.

The point was rammed home this week by the ECB’s decision to lower interest rates. The move was sold to the financial press as designed to stimulate inflation and reduce the risk of deflation. However, central to the deflation argument is the need to stimulate liquidity in the secondary markets, which according to the Euromoney article “are now close to breakdown”.

At least the ECB rate cut should defuse tapering expectations in US markets, making it easier for the Fed to back down from its failed experiment. The Fed now needs to plant the suggestion that QE will have to be increased, or a similar mechanism designed to boost liquidity introduced.

This will not be difficult in the prevailing economic conditions. Even though GDP remains a positive figure, concerns over deflation abound and are preoccupying more and more analysts. These are concerns which analysts can readily accept as an immediate and greater risk than inflation.

via Zero Hedge http://feedproxy.google.com/~r/zerohedge/feed/~3/AYODrMtNJws/story01.htm Tyler Durden

Submitted by Alasdair Macleod of GoldMoney.com,

This week an article in Euromoney points out that liquidity in bond markets is drying up. The blame is laid at the door of regulations designed to increase banks’ capital relative to their balance sheets. Furthermore, the article informs us, new regulations restricting the gearing on repo transactions are likely to make things worse, not only reducing bond market liquidity further, but also affecting credit markets. The reason this will be so is that in a repurchase agreement a bank supplies credit to non-banks for the period of the repo.

One could take another equally valid point of view: the reason for deteriorating liquidity in bond markets is due in part to yields being unnaturally low. If you price bonds too highly, which amounts to the same thing, few investors want to buy them without the unconditional support of the central bank as a ready buyer. This, after all, is why just the hint of tapering recently was enough to derail the markets. So here again we come up against the same choice: if the Fed insists on mispricing the market with its interventions and zero interest rate policy it must fully support the market with both QE and also twist applied to the yield curve to maintain market liquidity.

For the investment analysts and commentators that still expect tapering this must come as something of a surprise. The underlying point they have missed is that once a central bank embarks on a policy of printing money as a cure-all, it is impossible to stop, or even to just taper without risking a liquidity crisis. Increasingly illiquid markets are now telling us that QE should be increased.

The point was rammed home this week by the ECB’s decision to lower interest rates. The move was sold to the financial press as designed to stimulate inflation and reduce the risk of deflation. However, central to the deflation argument is the need to stimulate liquidity in the secondary markets, which according to the Euromoney article “are now close to breakdown”.

At least the ECB rate cut should defuse tapering expectations in US markets, making it easier for the Fed to back down from its failed experiment. The Fed now needs to plant the suggestion that QE will have to be increased, or a similar mechanism designed to boost liquidity introduced.

This will not be difficult in the prevailing economic conditions. Even though GDP remains a positive figure, concerns over deflation abound and are preoccupying more and more analysts. These are concerns which analysts can readily accept as an immediate and greater risk than inflation.

via Zero Hedge http://feedproxy.google.com/~r/zerohedge/feed/~3/AYODrMtNJws/story01.htm Tyler Durden

As we remember the fallen this weekend…

Prussia: Oh, f##k you France.

 

(click image for huge legible version)

 

 

(h/t Jim Quinn’s Burning Platform blog)

via Zero Hedge http://feedproxy.google.com/~r/zerohedge/feed/~3/_T4j2dH3wag/story01.htm Tyler Durden

As we remember the fallen this weekend…

Prussia: Oh, f##k you France.

 

(click image for huge legible version)

 

 

(h/t Jim Quinn’s Burning Platform blog)

via Zero Hedge http://feedproxy.google.com/~r/zerohedge/feed/~3/_T4j2dH3wag/story01.htm Tyler Durden

 

One of the primary themes for this letter over the last few months has been the potential of a major market top forming. We now have what I can only call “numerous bells” ringing.

 

First and foremost, I want to alert you to a disturbing trend in stock mania. That trend pertains to money inflows to stock mutual funds.

 

One of the best means of gauging investor sentiment for individual investors pertains to how they move their money in and out of mutual funds.

 

For example, from 2007 until the end of 2012, investors pulled over $405 billion out of stock based mutual funds. Over $90 billion of this was pulled in 2012 alone: the largest withdrawal since 2008.

 

In contrast, over the same time period, investors put over $1.14 trillion into bond funds. They brought in $317 billion in 2012: again, this was the most since 2008.

 

This marks quite a reversal of asset class fund flows: before 2008, stock funds usually took in $2 for every $1 investors allocated to bond funds.

 

However, this trend reversed back to normal in 2013. The Fed finally succeeded in inducing investors to move into stocks again. And they have done so in a big way. Thus far in 2013, investors have put $277 billion into stock mutual funds.

 

This is the single largest allocation of investor capital to stock based mutual funds since 2000: at the height of the Tech bubble. That year, investors put $324 billion into stocks. We might actually match that inflow this year as we still have two months left in 2013.

 

Indeed, investors are reaching a type of mania for stocks. They put $45.5 billion into stock based mutual funds in the first five weeks of October. If they maintain even half of that pace ($22.75 billion) for November and December, we’ll virtually tie the all-time record for stock fund inflows in a single year.

 

That record, again, occurred in 2000. At that time the NASDAQ had just staged a massive bubble rally.

 

 

What followed was one of the worst market collapses of all time:

 

 

 

Be forewarned.

 

For a FREE Special Report outlining how to protect your portfolio a market collapse, swing by: http://phoenixcapitalmarketing.com/special-reports.html

 

Best Regards,

 

Phoenix Capital Research

 

 

 

 

 

 

 

 

via Zero Hedge http://feedproxy.google.com/~r/zerohedge/feed/~3/AcsHxETW5Og/story01.htm Phoenix Capital Research

For almost two years (most recently this week), we have been vociferously explaining the dismal fact that "quantity" of jobs in this recovery is no match for dreadful "quality" of jobs as the "born-again jobs scam" contonues to roll on. Bloomberg's Matthew Klein has decided that nine pictures are better than a thousand words as he explains (in short sentences and simple charts) what the jobs report really means…

 

Via Bloomberg's Matthew Klein (interactive graphic here),

 

 

And (as we noted previously)…

…So Bernanke promises to keep the money market and repo rates—-that is, the poker chips for the casino—-at zero until  “well after” the unemployment rate drops below 6.5 percent.  But it will never get there because the jobs market and Main Street economy are structurally broken.  Indeed, measured on a consistent basis, the unemployment rate is still over 11 percent based in the labor force participation rate of late 2008 and is over 13 percent based on the labor force participation rate at the turn of the century.

 

And no, that can’t be explained away by the baby boomers going on Social Security.  During January 2000 there were 75 million Americans over age 16 that did not hold a job. Today there are 102 million in that category—about 27 million more. Yet the number of participants in OASI (old age social security) is up by just 6 million during the same period.  Moreover, there is no doubt about what happened the other 21 million citizens:  they are on disability, food stamps, welfare or have moved in with friends and relatives or landed on the streets in destitution.

 

In short, the US economy is failing and the welfare state safety net is exploding. And that means that the true headwind in front of the allegedly “cheap” stock market is an insuperable fiscal crisis that will bring steadily higher taxes, lower spending and a gale-force of permanent anti-Keynesian austerity in the GDP accounts. And for that reason, the Fed’s strategy of printing money until the jobs market has returned to effective “full employment” is completely lunatic.

via Zero Hedge http://feedproxy.google.com/~r/zerohedge/feed/~3/7lGD59ulch4/story01.htm Tyler Durden

For almost two years (most recently this week), we have been vociferously explaining the dismal fact that "quantity" of jobs in this recovery is no match for dreadful "quality" of jobs as the "born-again jobs scam" contonues to roll on. Bloomberg's Matthew Klein has decided that nine pictures are better than a thousand words as he explains (in short sentences and simple charts) what the jobs report really means…

 

Via Bloomberg's Matthew Klein (interactive graphic here),

 

 

And (as we noted previously)…

…So Bernanke promises to keep the money market and repo rates—-that is, the poker chips for the casino—-at zero until  “well after” the unemployment rate drops below 6.5 percent.  But it will never get there because the jobs market and Main Street economy are structurally broken.  Indeed, measured on a consistent basis, the unemployment rate is still over 11 percent based in the labor force participation rate of late 2008 and is over 13 percent based on the labor force participation rate at the turn of the century.

 

And no, that can’t be explained away by the baby boomers going on Social Security.  During January 2000 there were 75 million Americans over age 16 that did not hold a job. Today there are 102 million in that category—about 27 million more. Yet the number of participants in OASI (old age social security) is up by just 6 million during the same period.  Moreover, there is no doubt about what happened the other 21 million citizens:  they are on disability, food stamps, welfare or have moved in with friends and relatives or landed on the streets in destitution.

 

In short, the US economy is failing and the welfare state safety net is exploding. And that means that the true headwind in front of the allegedly “cheap” stock market is an insuperable fiscal crisis that will bring steadily higher taxes, lower spending and a gale-force of permanent anti-Keynesian austerity in the GDP accounts. And for that reason, the Fed’s strategy of printing money until the jobs market has returned to effective “full employment” is completely lunatic.

via Zero Hedge http://feedproxy.google.com/~r/zerohedge/feed/~3/7lGD59ulch4/story01.htm Tyler Durden

1.  The monthly establishment survey of the US employment report was stronger than expected and sufficient to lift the 3-month private sector average (190k) above the 6-month average (175k).  Yet it is little different from the 12-month average (196k), which suggests that despite some volatility, the trend is little changed.  The household survey, apparently more prone to being skewed by the government closure continues to under-perform.  Over the past three months, it has recorded an average loss of 239k jobs.  

 

This coupled with other measures of the labor market, such as hours worked and average earnings do not show a marked improvement in the US labor market. Similarly, the preliminary estimate of Q3 GDP, which is subject to statistically significant revisions, was flattered by inventory accumulation, which will either be revised away or act as a drag on Q4 GDP.  The underlying trend in final demand has remains unchanged.  

 

2.  With the core PCE deflator not moving toward the Fed’s target and fiscal uncertainties looming, the increased speculation of tapering at the December meeting remains premature. On one hand, there are some in the blogsphere who do not think the Fed can ever taper (“QE-infinity”) and while many bank economists continue to err on the side of seeing a greater urgency to taper than appears to be the case.  We continue to see a more compelling case for tapering in March 2014.  

 

3.  Janet Yellen’s confirmation hearings begin on Thursday.  Appearing before the Senate Banking Committee, which has seen her a few other times in her illustrative career, Yellen is unlikely to be controversial.  She is neither dove nor hawk, but an independent thinker, responding to her remarkably prescient understanding of the economy, and this will likely be borne out in her testimony.   Yellen is a gradualist.   The risk is that she appears more centrist than dovish.  

 

The Senate Banking Committee is not where Yellen will meet her stiffest opposition.  That will be on the Senate floor itself, where 60 votes are needed for procedural issues, though a simple majority is needed for approval.  This creates some space for obstructionist tactics.  Nevertheless, Yellen’s confirmation hearings this week may provide the news wires with headlines, but not offer investors much real news or insight into Fed policy under her leadership.  

 

4.  The European Central Bank surprised last week with a 25 bp cut in the repo rate and extended the period of full allotment of its regular refi operation for another year.   It appears to have a controversial decision as news wires report that nearly a quarter of the Governing Council had preferred to wait at least another month.  The ECB persists with the easing bias, as in rates will this low or lower for an extended period.   Yet its measures are unlikely to prove effective in the triple threat of deflation, weak money supply growth and lending, and the decline in excess liquidity that may soon pressure money market rates.  The key EONIA trades closer to the deposit rate (zero) than the repo rate (now 25 bp).  In effect, lowering the ceiling is not really material in the current environment.  The ineffectiveness of the ECB’s measures means that additional steps will have to be forthcoming.  There are no good options (that are also politically realistic).  A new LTRO, while mentioned by Draghi, will unlikely be taken up by the strong banks, ahead of the Asset Quality Review and stress tests, which means there will be a stigma of its use and suggest a low take down.  

 

Draghi also mentioned the possibility of additional rate cuts.  Another cut in the repo rate (to zero) may improve financial conditions temporarily, but not address the underlying deflationary pressures or the causes of the year and a half contraction in lending to businesses and households.  Since the deposit rate was cut to zero, banks have reduced their use of that facility.  Pushing the deposit rate below zero could distort money markets and have other unintended and unforeseen consequences, as no other major central bank have offered negative deposit rates.    If that is the downside, the upside is even less clear. Lower rates by themselves are unlikely to arrest the deflation and contraction in lending.  

 

5.    European finance ministers have a two-day meeting starting Thursday.  Although the review of Greek, Portuguese and Irish programs are anticipated, the real interest will be in progress toward the banking union.  An agreement between Germany’s CDU and SPD over the weekend strengthens Schaeuble’s negotiating position.  Essentially, Germany will insist that the European finance ministers will decide when to close failing banks, not the European Commission, and that the European Stabilization Mechanism, (ESM) will not be used to wind down troubled institutions.  Until the Single Resolution Mechanism is sufficiently financed by financial institutions, national authorities.  If national authorities lack resources, Spain’s ESM program looks to be the model that Germany wants to follow.   While Germany has some allies, most countries seem to prefer greater access to ESM funds to wind down individual problem banks.

 

6.   The UK will report the latest inflation and employment data prior to the Bank of England’s Quarterly Inflation Report.  While disinflation or deflationary pressures are evident among most of the high income countries, the UK is  notable exception.  That said, base effects suggest modest easing here in Q4.  The core rate is also likely to ease at at 2%, which is the consensus forecast would be match its lowest reading in four years.  The claimant count is expected to fall again and this is consistent with a further decline in the unemployment rate to 7.6%.  This is the backdrop of the BOE’s inflation report.  

 

The pessimistic outlook BOE Governor Carney offered when he took office in July is likely to be substantially revised.  The central bank’s growth forecast is likely to be revised higher and a faster decline in unemployment is likely to be anticipated.  Even if the medium term inflation forecast is lowered, the market appears to be discounting the likelihood a rate hike late next year or arguably early 2015.  The implied yield of the December 2014 short-sterling futures contract is currently 80 bp compared with the current base rate of 50 bp.   Whereas former Governor King’s desire to provide more stimulus was repeatedly out-voted by the MPC, Carney’s assessment and forward guidance has been given little credibility by investors.   Carney, rather than the market, is likely to change its stance.  

 

7.   Standard and Poor’s cut France’s sovereign rating to AA from AA+ last week and changed the outlook to stable from negative.   The euro was under pressure from the ECB’s surprise rate cut and the US jobs data, but the reaction in both the bond and the credit default swap supports our general view that the rating agencies views of major industrialized economies, reliant as they are, completely on publicly accessible and available information, are of marginal significance.  There appears nothing in S&P decision that has not appeared in numerous economic analysis.  There is little confidence among economists (and apparently many officials in Brussels) that the French government has put the economy on a sustainable path.  We have argued that fall of the Berlin Wall eventually forced a restructuring of the German economy and the crisis is forcing the periphery to reform (especially the pubic sector). France has had the  privilege of neither spurs of reform.

 

S&P projects French government spending to be 56% in 2015, which is the second highest among developed countries after Denmark.   The EU’s Economics Commission Rehn warned earlier last week, prior to the  S&P action, that contrary to pledges by Hollande, French unemployment would rise until 2015.   At the same time, French officials see the low interest rates (benchmark 10-year yield below 2.25%) as investors’ vote of confidence in the government’s course.  The 5-year credit default swap actually slipped slightly before the weekend, and although the 10-year bond yield rose, it increased less than Germany, allowing the premium to narrow by a couple of basis points.   The New York Times headline that said that “S.&P. Downgrade Downgrade Deals a Blow to the French Government” must refer more to appearances than substance.  

 

8.  The Abe government is struggling to implement its so-called third arrow of structural reforms.  The first two arrows, which consisted of fiscal and monetary stimulus were relative easy to enact.  In many ways it is the traditional LDP salve, though on steroids, as the quantitative easing is nearly as large as the Federal Reserve’s for an economy less than half the size.   The foreign exchange market had discounted Abenomics by taking the dollar-yen exchange rate from about JPY75 to a little over JPY100 in roughly the six months through May.  The economy itself appears to have peaked in Q2.   The economy appears to have slowed significantly in Q3.   Indeed when the GDP figures are reported this week, they will likely show the expansion at less than half of the Q2, or around a 1.3%-1.6% at an annualized pace. 

 

With shrinking population and excess capacity in a number of key industries, it is little wonder that Japanese business are reluctant to increase investment at home.  At the same time, they are not sharing with the workers the windfall created by the weaker yen.   In September regular wages, which exclude overtime and bonuses, fell 0.3% on a year-over-year basis, the 16th consecutive month of declines.  While winter and summer bonuses did help spur consumption, the rise in inflation (a five-year high was reached in August at 0.8% before slipping to 0.7% in September) is eroding purchasing power and the real return on savings.  In anticipation of the hike in the retail sales tax on April 1 from 5% to 8% may  boost the demand for household durable goods, but unless incomes rise, the economy may falter again.  Abe’s honeymoon is over. Businesses are balking.  And just when new efforts are needed for his economic agenda, Abe may be spending his diminishing political capital on a controversial visit to the war shrine, which will do mend fences with its neighbors, not just China.  

 

9. China has reported a slew of data that generally confirm the stabilization of the economy, as officials have directed.  The purchasing manager surveys had already indicated the stabilization the October industrial production, investment and retail sales reports confirmed it.  Industrial output and retail sales ticked from September, though fixed asset investment eased slightly.  

 

The news that more likely will capture the market’s attention is that more than doubling of the October trade surplus to $31.1 bln form $15.2 bln in September.  Imports increased slightly to 7.6% (year-over-year) from 7.4%, but the larger surprise was in exports, which jumped to 5.6% from -0.3%.  Some feared that the 2.3% rise in the yuan this year would curb exports, but as we have argued, the limited valued-added work done in China (largely assembly) means that exports are unlikely to be very sensitive to small changes in foreign exchange prices.  The strength of foreign demand also appears to be more important than the controlled currency changes.  

 

Meanwhile, Chinese inflation did edge higher in October to a 3.2% year-over-year rate, an eight month high.  Consumer inflation stood at 3.1% in September.  The Reuters polls put the consensus estimate at 3.3%.  Food prices remain the main culprit.  They were up 6.5% in October from 6.1% in September.  Chinese measured inflation appears to be more a case of relative price changes rather than a general price increase.  It is the increase in house prices that seems to be of greater concern (~20% in the large urban centers) than consumer inflation.  At the same time, producer prices continue to fall.  October’s 1.5% decline is the 20th consecutive negative print.  It follows a 1.3% decline in September.  This divergence between falls in producer prices and increases in consumer prices suggests a source of profit-margins.   Taken as a whole and at face value, the latest data is unlikely to spur a change in PBOC policy.    

 

10.  The much-heralded Third Plenary Session of the Communist Party in China has begun.  Direct news has, as expected, been very light.  It is widely acknowledged by officials that reform of its growth model is needed.  There are three areas in which reform is likely to be concentrated:  the government, as in reducing bureaucracy, the market, to provide greater competition and flexibility, and state-owned enterprises, which still dominate key sectors of the economy.  The latest reports have tended to focus on the state-owned enterprises.    In the financial sector, the new Chinese government has announced a number of reforms that give market forces greater sway, including abolishing the floor for lending rates and developing a market-based prime rate.   Continued gradual movement in this direction is expected.  

 

Even after the plenary session ends, it may take observers some time to understand the results. There are two main obstacles to dramatic change in the Chinese model.  First, President Xi Jingping continues to consolidate his power, but has been frustrated by continued influence of past presidents Jiang Zemin and Hu Jintao.    Second, it is not clear that Xi or Prime Minister Li are as interested in political reform as they are economic reform.   Henry Ford once quipped that a customer can have any color Model T as long as it was black.  Despite the factions within the Communist Party, Chinese officials seem to agree the government stays Red.   That is to say, challenges to the rule of the Communist Party will not be tolerated.  In a country of contrasts, economic reform can go hand-in-hand with a crack down on human rights and civil society activists.   This includes the Zhi Xian Party (which means Constitution is the Supreme Authority) formed last week by the supporters of Bo Xilai.  The contradiction between the modernizing and flexible economy on one hand, and the archaic and rigid political system on the other, is unlikely to be resolved, but rather intensify in the period ahead.  

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