The opening period of 2011 has remained a good period for world stock markets as they continue the strong rally seen in December of 2010. The UK FTSE 100 has reached 6055 this morning and the Japanese Nikkei 225 equity index rallied 149 points to set an eight month high at 10,529. The American Standard and Poors 500 equity index closed at 1277 a level not seen since early September 2008. Unfortunately probably due to fears over economic overheating and inflation China is lagging such moves with the Shanghai Composite falling 0.5% to 2824. Also there was a story in the Chinese press that her currency the Yuan (also called the renminbi) will be allowed to appreciate by 5% in 2011 and such press reports are sometimes the way the Chinese regime communicates its plans. Another influence on events was the news we received yesterday on US employment.
The ADP National Employment Report
This reported the following yesterday and the emphasis is mine.
Private-sector employment increased by 297,000 from November to December on a seasonally adjusted basis……This month’s ADP National Employment Report suggests nonfarm private employment grew very strongly in December, at a pace well above what is usually associated with a declining unemployment rate. After a mid-year pause, employment seems to have accelerated as indicated by September’s employment gain of 29,000, October’s gain of 79,000, November’s gain of 92,000 and December’s gain of 297,000. Strength was also evident within all major industries and every size business tracked in the ADP Report.According to the ADP Report, employment in the service-providing sector rose by 270,000 in December, the eleventh consecutive monthly gain and the largest monthly increase in the history of the report. Employment in the goods-producing sector rose 27,000, the second consecutive monthly gain and the largest since February 2006. Manufacturing employment rose 23,000, also the second consecutive monthly gain.
As you can imagine this had quite an impact on markets and helped lead to further equity market rallies and also impacted on bond markets in the opposite direction which I shall discuss later. In essence this report hit straight on what has become a fault line in the US economic recovery which is the employment and indeed the unemployment situation. In spite of the fact that the US economy recorded growth in 2010 the employment and unemployment figures had responded very little and indeed at the end of the year the headline unemployment figure had risen. The widest measure of US unemployment the U-6 measure which includes short and part-time working had improved very little over the recovery from just over 17% to the high 16s. The US central bank the Federal Reserve had in response to this problem instituted a new programme of asset purchases called QE2 to try to help the situation and the US government added to its fiscal stimulus efforts with the tax cut/stimulus programme it announce in December that will have an impact of around US $900 billion.
So you can see that a report which indicates that US employment is improving would be something of a bombshell and the size of the improvement indicates something which would definitely help reduce unemployment if sustained for any period of time.
Market Reaction: US Treasuries (government bonds) and the US dollar exchange rate
If we start with the reaction of the US government bond market then the impact of this report was that prices fell and yields rose. Let me give you the yields for the main benchmarks with last nights close followed by the change on the previous day: five-year 2.16% (+0.14%); ten-year 3.48% (+0.13%) and the thirty-year 4.55% (+0.11%). So bond holders took a fair bit of punishment in short order and we are back to the recent yield highs on these with several consequences.
One consequence is on the US central bank the Federal Reserve which is a very large and growing holder of such securities and must have accumulated some fairly sizeable losses on a mark to market basis yesterday. This hits on a fundamental problem with the whole Quantitative Easing experiment which I have written about regularly. It goes as follows, if QE works then it always was likely that such a scenario would involve a situation where government bond yields rose and the programme accumulating on these bonds possibly large ones. For example should the Fed. be more successful than it wants to be in raising US inflation then US government bond yields would plainly rise in response and prices would fall. US taxpayers should genuinely be concerned about the dangers to their central bank in such a scenario and I have seen little discussion of this danger.
Does Quantitative Easing raise bond yields above a certain amount?
A side effect of this has created something of a possible anomaly which goes as follows. If you look at the US long bond yield of 4.55% and then look at the corresponding UK government bond or gilt yield of 4.39% I hope you get my point. There may be fears for future inflation in the US but surely such fears should be higher in the UK as we already have signs of it. It also raises a concern about QE I have had for some time which is that for longer-term yields does a point come that more of it raises rather than reduces yields? After all if it was a free lunch why bother issuing your debt to investors at all? With the UK having stopped its programme but the US having increased its then it is interesting to see longer-term US yields go above ours and of course it is the reverse of the intended effect.
The US dollar exchange rate
After a period where it had been weak the US dollar staged quite a turn-around after these figures. For example it was at 1.34 versus the Euro and is now at 1.312. The Bank of Japan will be relieved to see the Yen back at 83 which is where it intervened in September. The US dollar index which is trade weighted has risen to 80.3 and was supported by two factors which were improved US yields and improve hopes for the US economy. In another irony a rally in the US dollar is again the reverse of the intended effect of the QE2 programme.
Comment on these figures
These figures were unexpected in terms of the scale of the indicated improvement although the recent weekly figures from the Bureau of Labor Statistics had themselves indicated some improvement. One immediate impact will be that this afternoons and indeed tomorrows figures from the BLS will be eagerly awaited!
However care is needed with these figures on several counts. Firstly there are issues with the seasonal adjustment of this report as it was for December and US companies have a habit of changing payroll numbers at the end of the calender year and surprises have happened before due to this. If you compare past numbers from this report they do not always correlate with the official statistics from the Bureau of Labor Statistics and we saw an example of this only last month when a good ADP report was followed by poor official numbers. One curiosity in the numbers was the wide discrepancy between the increase in jobs in the service-sector to the increase in manufacturing where the ratio was ten to one which looks odd.
Just to muddy the waters further there was a report from ISM yesterday which covers the service industry. This report indicated expansion in the services sector as the reading went from 55% in November to 57.1% in December on a scale where a number above 50 indicates expansion. So again we are seeing signs of strength in the US economy which correlates with the report above you might reasonably think. But then came something to make me think, the employment index decreased by 2.2% to 50.5%. Yes this is a report on the same service sector which according to ADP created 270,000 jobs in December! This reminds me of the US TV programme called Soap which had the strap line “Confused you will be……” Also this report had this tucked away in it.
The Prices Index increased 6.8 percentage points to 70 percent, indicating that prices increased significantly in December.
An odd occurence in the Euro zone affects both Ireland and Greece
Yesterday the European Union raised some 5 billion Euros to help pay for the Irish bailout. What happened indicated the one of the flaws at the heart of their plan. They offered an annual coupon of 2.5% and ended up paying just under 2.6%. Yet the average interest-rate that Ireland (and Greece) have to pay on their borrowings from EU funds is more like 6%. Tucked in that difference is why the plans will fail. Imagine the difference to their prospects if the money was offered at just over 3% which is the official IMF interest-rate.
For those interested in the technicalities this money was raised under the EFSM or European Financial Stability Mechanism and is contributed too by the whole of the European Union including the UK. The Euro Zone mechanism the EFSF will be along shortly. And even at the interest-rates charged by the EFSM/EFSF we may see Portugal along soon as she is having to pay 6.8% on her ten-year bonds and had to pay 3.69% on some 6 month borrowing only yesterday.