The problematic nature of current bond yields

One of the features of the credit crunch era has been the falls in first world interest-rates and bond yields. The first phase saw the slashing of official short-term interest-rates and once that was seen to be inadequate, central banks directly purchased bonds to reduce yields further. It is seldom put like this but there was already an implied failure as according to the models back then the interest-rate cuts should have done the trick. Back then I was already looking ahead to when there would have to be ch-ch-changes and posted the view that central banks would delay what has become called policy normalisation.

For example back on the 24th of February 2011 I pointed out this about a speech from David Miles of the Bank of England.

 My problem with this is that when you act as they have and you have in effect used what weapons the Bank of England has virtually to the maximum by cutting interest-rates by 4.75%% and spending some £200 billion on asset purchases then you have been extraordinarily interventionist. Accordingly it is then hard for you to blame events because some of them are the consequence of your own actions……

What that illustrates is that already the truth was being manipulated and also I am glad I wrote “virtually to the maximum” as of course the amount of asset purchases has more than doubled. In addition we have seen credit easing in the UK via such policies as the Term Funding Scheme and the start of full-scale QE from the European Central Bank as well as negative interest-rates.

But the point about delaying proved to be very accurate as the Euro area is still actively pursuing QE and in net terms the UK has managed to raise interest-rates by a measly 0.25%. The opportunity in 2014/15 was meant with promises via Forward Guidance but no action.

The US

This is the one country which has taken clear action on the path to normalisation. Here is the current state of play.

In view of realized and expected labor market conditions and inflation, the Committee decided to maintain the target range for the federal funds rate at 2 to 2-1/4 percent.

That is currently working out be be around 2.2% and more rises are promised. Also there is some reversing of the QE or Qualitative Tightening.

The Committee directs the Desk to continue
rolling over at auction the amount of principal
payments from the Federal Reserve’s holdings
of Treasury securities maturing during each
calendar month that exceeds $30 billion, and to
continue reinvesting in agency mortgage-backed
securities the amount of principal
payments from the Federal Reserve’s holdings
of agency debt and agency mortgage-backed
securities received during each calendar month
that exceeds $20 billion.

That combined with forecasts of another interest-rate rise in a fortnight and at least a couple next year seemed to put pressure on bond markets. However this sentence in a speech from Federal Reserve Chair Jerome Powell shook things up on the 28th of last month and the emphasis is mine.

We therefore began to raise our policy rate gradually toward levels that are more normal in a healthy economy. Interest rates are still low by historical standards, and they remain just below the broad range of estimates of the level that would be neutral for the economy‑‑that is, neither speeding up nor slowing down growth.

You may note we seem to have travelled from “policy normalisation” to neutral. But what the neutral interest-rate represents is an attempt to figure out what interest-rate would neither stimulate or contract the economy. Or a sort of measure of what we might aim for as a new normal. When they are trying to put a pseudo scientific gloss on things economist and central bankers call it r-squared.

However the “just below” dropped the expected path for US interest-rates by 0.5%.

Bond Markets

Let me take you to the Wall Street Journal on Tuesday.

This quarter, yields on longer-dated bonds have dropped and those on two-year Treasurys are flat. The gap between two and 10-year Treasury yields is now around 0.11 percentage point, compared with around 0.55 percentage point at the beginning of the year.

This is attracting a lot of attention in the financial media but the change of 0.44% is pretty much my 0.5% suggestion above. Now let us look at the US ten-year yield which is 2.9% as I type this and we see that in basic terms it is predicting a couple more 0.25% interest-rate rises. This will come in the next year or so if true so it is not very different to the two-year yield of 2.76%.

If we look beyond Federal Reserve policy we have seen a fall in the price of oil over the past month or two. If we look at it in Brent Crude terms then just above US $86 of early October has been replaced by below US $59 this morning as oil follows equity markets lower. The exact amount of the change varies but the path for inflation now seems set to be lower as it has been rare in 2018 for the oil price to be below where it was this time last year. That is another reason for lower bond yields.

Is this a signal of a recession? Here is the St.Louis Fed from last week.

Does the recent flattening of the yield curve portend recession? Not necessarily. The flattening of the real yield curve may simply reflect the fact that real consumption growth is not expected to accelerate or decelerate from the present growth rate of about 1 percent year over year. On the other hand, a 1 percent growth rate is substantially lower than the U.S. historical average of 2 percent. Because of this, the risk that a negative shock (of comparable magnitude to past shocks) sends the economy into technical recession is increased.

That is a fascinating way of looking at it and in my experience precisely zero bond market participants will look at it like that. It is also revealing that we seem to just assume growth will now be lower. Didn’t they save us?

Comment

I wanted to look at this subject today because of the clear changes which are happening. Now it looks much less likely that US interest-rates will pass 3% and if they do not by much. So “normalisation” will be at best about two-thirds of what it might have been considered to be pre credit crunch ( 4.5%). Some of you have suggested that we can no longer afford interest-rates and yields above 3% so well done at least if we stay where we are! If Italy folds you may get a second tick in that box.

But as we look wider we see even more extraordinary developments. Let me take a look at my own country the UK which is in political disarray yet the ten-year Gilt yield is below 1.3%. So those predicting a surge in Gilt yields are slipping back into the bushes whilst I note the extraordinary absolute level and the persistence of negative real yields which bust past metrics. Germany has a ten-year yield of 0.26% and a five-year one of -0.3% as we note again more metrics which are busted.

So my view is that we cannot rely on old recession metrics because another cause of all of this is that QE4 from the US Fed has got closer. I have worried all along that interest-rate rises might run into more QE and if they do we will be singing along to Coldplay.

Oh no I see
A spider web and it’s me in the middle
So I twist and turn
Here am I in my little bubble

 

 

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Central banking forward guidance ignores the rules of probability

Today we can continue our journey into the world of central bankers which is a cosy international club. It was hard as the New York Federal Reserve Bank reported in glowing terms the visit of its President John Williams to the Bronx not to recall a previous effort from his predecessor William Dudley. From Reuters in 2011.

He then stretched for a real world example. The only problem was he chose the Apple’s latest tablet computer that hit stores on Friday, which may be more popular at the New York Fed’s headquarters near Wall Street than it is on the gritty streets of Queens.

“Today you can buy an iPad 2 that costs the same as an iPad 1 that is twice as powerful,” he said.”You have to look at the prices of all things.”

This prompted guffaws and widespread murmuring from the audience, with one audience member calling the comment “tone deaf.”

“I can’t eat an iPad,” another said.

That of course echoed around the world. This event by the Tweet storm looks more controlled in terms of audience so he may have avoided questions like this.

“When was the last time, sir, that you went grocery shopping?” one audience member asked.

Equilibrium Unemployment

Last night Michael Saunders of the Bank of England gave a speech to the CBI and as early as the fourth sentence he was pontificating about the theory that just will not die and about a number he cannot possibly know.

In the last 10-15 years, these effects from population ageing have been fairly benign, reducing the equilibrium jobless rate and neutral interest rate.

Let me now take you back just over five years when David “I can see for” Miles was giving us forward guidance on the equilibrium unemployment rate.

we will not tighten monetary policy until a recovery is strong enough and sustained enough that it has made a meaningful dent in unemployment so that it at least falls to 7 per cent…….. that linking the horizon over which an exceptionally expansionary monetary policy continues to support demand to the rate of unemployment has merit.

It is easy to forget now that we were being steered away from using GDP for monetary policy and towards the unemployment rate along these lines. Poor old David must wish he had never uttered the words below.

I suspect this is largely because the weight of money is behind a view that the significant positive news on the economic outlook means that the 7% unemployment level might be reached within around eighteen months………

Actually the unemployment rate plunged such that by the New Year these words were even more embarrassing.

If that is so unemployment is likely to fall rather more
slowly than would be usual.

Putting it another way the equilibrium unemployment rate is now 4.25% according to the Bank of England via 4.5%,5%, 5.5% and 6,5%. They may have guided to 6% as well but I do not recall it and these things tend to get redacted. Imagine you went to an engineer who guided you towards 7000 revs in your car then a few years later decided it was 4250! This sort of thing can only happen because central banking is a closed shop where the establishment appoint the same old “independent” crew.

Returning to Michael Saunders and yesterday he loses the plot more here.

Over the last 25 years, the share of the 25-64 age population with tertiary level (ie university or
similar) education has risen from 19% to 43%, a bigger rise than in most advanced economies (see figure
4).ix The tertiary education share among people aged 25-40 years is now around 50%, and the rise in this
measure has slowed in recent years.

A triumph according to Michael except he ignores the fact that this accompanies a really poor period for real wages. Indeed if the workforce is indeed more qualified, then real wages are even lower on a like for like basis. Are qualifications now required for lower skilled jobs and frankly what value are they? These are the real questions central bankers ignore as they pose the question how did we get here? That of course has been driven by their policies.

The attempt to use demographics as a smokescreen clears quickly as we compare the number below with the 2.75% error.

 This shift in workforce composition away from age groups that tend to have high jobless rates has cut the equilibrium jobless rate by about 0.3 percentage point since 2007.

 

Neutral Interest-Rate

We now move on to one of the central banking obsessions of our times. The so-called neutral interest-rate is examined below.

However, the MPC judges that, in practice, population ageing currently is lifting the stock of household assets, both in the UK and globally – and hence is pushing the equilibrium level of global real interest rates lower, and will continue to do so for some time.

Interesting ( sorry). If we look at the UK real interest-rate are low because the Bank of England put them there! It then thought bond yields were too high so QE was used to help lower them. Even this was not enough so it used credit easing to reduce mortgage rates. On the other side of the coin it has had two main phases of what it calls “looking through” rises in inflation. The first in 2010/11 when both main consumer inflation measures peaked above 5% per annum and then more recently after the EU leave vote.

The fundamental issue here is something that I learnt during my days as an option trader. On the quiet days we spent many hours discussing how to measure low probability events or what we would call  far out of the money options. One company called CRT built quite a empire based on the view that low probability events were undervalued and therefore bought them and counted the profits. Those of you who have followed the collapse of the company called OptionsSellers last weekend might note that it appears ( it has been vague on the details) to have done the reverse and accordingly according to the CRT theory has lost money. In this instance all of it.

Bringing this back to central bankers lets us note that Bank Rate is presently 0.75% and the estimate of the neutral rate is say in the range 2.5% to 3%. Because that is far away and also because interest-rate changes have been so rare that is an extraordinarily low probability event. An intelligent man or woman would therefore conclude that they are likely to know little or nothing about it until there is more evidence ( like some actual interest-rate rises). By contrast central bankers regularly opine about it and attempt to present it as a fact when in fact the rest of us are singing along to Ivan Van Dahl.

Oh tell me why
Do we build castles in the sky?
Oh tell me why
Are the castles way up high?

Comment

I would like to look at something I think we can all agree with.

For most of the last 10 years, the economy has generally had significant amounts of spare capacity.

But look where it then goes.

Now, with the economy having grown above its modest potential pace for six or seven years that spare
capacity has been used up, with supply and demand in the economy broadly in balance.

Really? A more intelligent statement would be to say that the quantity measure (employment) has been strong but wage growth has been disappointingly weak. The failures around the “output gap” have led to claims wage growth is on the turn for many years from this crew. The reality is that the two main real wage falls have come when they have “looked through” inflation.

Anyway he saved the best to nearly last. If so how come we are where we are then?

BoE research suggests that this is not the case for the UK so far, and that the total impact of interest rate changes on growth and inflation is similar to the pre-crisis period.xlv The easing in mid-2016 seemed to provide the expected boost to the economy.

There are a couple of escape clauses in the second sentence such as “seemed to” and “expected” ( by who?) but we seem to be in “the operation was a success but the patient died” territory to me.

 

 

 

 

 

What is the economic impact of tighter US monetary policy?

It is time for us to look West again and see what is happening in the new world and this week has brought a curious development. Ordinarily it is central bankers telling us about wealth effects and then trying to bathe in the implications of their own policies but in the US right now there is an alternative.

Stock Market up more than 400 points yesterday. Today looks to be another good one. Companies earnings are great!

That is from the Twitter feed of @realDonaldTrump and continues a theme where this seems if numbers of tweets on the subject are any guide to be his favourite economic indicator. Indeed on Tuesday he was tweeting other people’s research on the matter.

“If the Fed backs off and starts talking a little more Dovish, I think we’re going to be right back to our 2,800 to 2,900 target range that we’ve had for the S&P 500.” Scott Wren, Wells Fargo.

There is a danger in favouring one company over another when you are US President especially with the recent record of Wells Fargo. But the Donald is clearly a fan of higher equity markets, especially on his watch, and was noticeably quiet when we saw falls earlier this month. This does link in a way with the suggestions of a trade deal with China that boosted equity markets late on yesterday, although with the People’s Bank of China hinting at more easing the picture is complex.

The US Federal Reserve

Unless Standard and Poorski is correct below then the Fed is currently out of the wealth effects game.

FEDERAL RESERVE ANNOUNCES IT WILL BEGIN PURCHASES OF APPLE IPHONES AND IWATCHES AT A PACE OF $1 BILLION PER MONTH

One cautionary note is that humour in this area has a habit of becoming reality later as someone in authority might see this as a good idea. Also even the many central banking apologists may struggle with the US Fed buying Apple shares from the Swiss National Bank.

The current reality is rather different because as we stand QE ( Quantitative Easing) has morphed into QT  where the T is for Tightening. For example yesterday’s weekly update told us that its balance sheet  has shrunk by US $299 billion dollars to  US $4.1 trillion and the reduction was mostly due to the sale of US Treasury Bonds ( US $173 billion) followed by US $101 billion of Mortgage-Backed Securities. Over the next year we will expect to see around double the rate of change if it continues at its new raised pace.

 Effective in October, the Committee directs the Desk to roll over at auction the amount of principal payments from the Federal Reserve’s holdings of Treasury securities maturing during each calendar month that exceeds $30 billion, and to reinvest in agency mortgage-backed securities the amount of principal payments from the Federal Reserve’s holdings of agency debt and agency mortgage-backed securities received during each calendar month that exceeds $20 billion. ( Federal Reserve ).

Consequences

From the Wall Street Journal on Monday.

After hovering around 2.3% for most of the spring and summer, the three-month London interbank offered rate, or Libor, has been climbing since the middle of September, settling at 2.53% on Monday, its highest level since November 2008.

I am sure most of you are thinking about the rises in US official interest-rates and the shrinking balance sheet as well as the year-end demand for US Dollars I looked at back on the 25th of September . Well your Easter Egg hunt looks likely to be much more fruitful than the one at the WSJ.

Analysts don’t fully know why the spread has moved the way it has in recent months.

If we ignore the why and move onto what happens next? Lisa Abramowich of Bloomberg is on the case.

3-month U.S. Libor rates have surged to a new post-crisis high, of 2.54%, more than double where it was last year. This is important because so much debt, including leveraged loans, are pegged to this rate. Companies will find themselves paying more interest on their debt…

As to how much debt I note Reuters have been estimating it at US $300 trillion which even if we take with a pinch of salt puts the Federal Reserve balance sheet into perspective. Oh and remember the booming leveraged loan market that had gone to about US $1.1 trillion if I recall correctly? Well Lisa has been on the case there too.

Short interest in the biggest leveraged-loan ETF has risen to a record high.

So in areas which bankers would describe as being “innovative” we see that Glenn Frey is back in fashion.

The heat is on, the heat is on, the heat is on
Oh it’s on the street, the heat is on

We can add that to the troubles we have seen in 2018 in emerging markets as the double combination of higher US interest-rates and a stronger Dollar have turned up the heat there too.

The US Dollar

Firstly we need to establish that whilst talk of challenges abounds the US Dollar remains the world’s reserve currency. So a rise impacts on other countries inflation via its role in the pricing of most commodity contracts and more helpfully may make their economies more competitive. But if we are looking for signs of trouble it hits places which have borrowed in US Dollars and that has been on the rise in recent times. I have reported before on the Bank for International Settlements or BIS data on this and here is the September update.

The US dollar has become even more dominant as the prime foreign currency for international borrowing. Dollar credit to the non-bank sector outside the US rose from 9.5% of global GDP at end-2007 to 14% in Q1 2018…….The growth in dollar borrowing by EMEs or  emerging market economies  has been especially strong, but dollar exposures vary substantially both across countries and in terms of sectoral composition.

An example of this has been Argentina which is caught in a trap of its own making as for example a devaluation would make its US Dollar debts more expensive. Or if we look at India it seems its shadow banks have caught something of a cold in this area.

India Is Said to Expect Shadow Banking Default Amid Cash Squeeze- Bloomberg Non-bank financiers and mortgage lenders have 2.7 trillion rupees ($37 billion) of debt maturing in the next five months, immediately ( @SunChartist )

 

Comment

So far we have mostly looked at the international impact of US monetary policy so let us now look more internally. If we look at interest-rates then the 30 year fixed rate mortgage has risen to 4.83% having started the year at 4% and which takes it back to early 2011. This reflects rising Treasury Bond yields which will have to be paid on ever more debt with official suggestions saying US $1.34 trillion will need to be issued in the next year.

Against that the economy continues to be in a boom. We will find out more later as for example will wages growth reach 3%? But economic growth has been above that as the last 6 months suggests around 3.8% in annual terms assuming it continues. So for now it looks fine but then it always does at times like this as for example a slow down and rising bond yields could in my opinion switch things from QT to QE4 quite quickly. After all worries about US stock market falls  started with it still quite near to what are all time highs.

Also if you want some more numbers bingo the BIS provided some more for Halloween.

The notional value of outstanding OTC derivatives increased from $532 trillion at end-2017 to $595 trillion at end-June 2018. This increase in activity was driven largely by US dollar interest rate contracts, especially short-term contracts.

 

 

 

 

What next for the War on Cash?

Yesterday we took a look at a country which seems to be happy heading for a post cash era. Sweden has seen nearly a halving of cash use in the past decade and the size of the change would be even larger if we factored in inflation and did the calculation in real terms. This is particularly significant as we remind ourselves that Sweden already has negative interest-rates, and as I pointed out yesterday there are roads ahead where it would cut them further from the current -0.5%. The reason why cash is an issue for negative interest-rates is that it offers 0%, and so there must be a “tipping point” where interest-rates go so negative that bank deposits switch to cash in enough size to create a bank run. Such a prospect has created terror in central banking halls and boardrooms and has been the main barrier to interest-rates being cut even lower than they have. In my own country the Bank of England was so terrified of the impact of lower interest-rates on the “precious” that it claimed 0.5% was a “lower bound”, even when other countries were below it. That had a different reason ( their creaking antiquated IT systems could not cope with 0%) but told us of their primary response function.

Cash in the USA

The Financial Times has taken a look at this and seems upset at the result.

Americans can’t quit cash

If we switch to the actual research which was undertaken by  the Federal Reserve Banks of Atlanta, Boston, Richmond, and San Francisco we see the following.

In October 2017, U.S. consumers each made on average 41.0 payments for the month . Thus, on average, an adult consumer made 1.3 payments per day. Notably, an average
of 40.2 percent of consumers per day reported making zero payments. Also in October 2017, U.S. consumers each made on average $3,418 worth of payments for
the month.

So after finding out how much as well as how often? We get to see via what method.

In October 2017, consumers paid mostly with cash (30.3 percent of payments), debit cards (26.2 percent), and credit cards (21.0 percent). These instruments accounted for three-quarters of the number of payments, but only about 40 percent of the total value of payments, because they tend to be used more for smaller-value payments. In contrast,
electronic payments accounted for 30.3 percent of the value of total payments but only 8.9 percent of the number
of payments. Checks, at 17.7 percent, continued to account for a relatively high percentage of the value of
payments.

As you can see cash remains king (queen) in volume terms but has faded in value terms. The bit that sticks out to me is the amount still accounted for by Checks ( cheques) as I am struggling to think of the last time that I used one. Also the comments section provides a reason as to why cash remains in use for small payments on such a large-scale in the US.

Americans carry cash for smaller transactions partly because their unstinting devotion to the $1 bill means it is much lighter.  I can carry round a bunch of 1s and 5s for coffee in the day at a fraction of the weight of the euros or pounds that would do the similar job in Europe. ( Saughton)

For those unaware UK coins are fairly heavy and the £1 and £2 coins get more use than you might expect as the Bank of England has had its struggles with getting £5 notes into general circulation. So suit and trouser pockets can take a bit of a pasting. If we continue in the same vein even the convenience of digital payments faces an apparent challenge.

Those of us still paying cash are standing in lines behind phonsters fumbling with their payment app. When it looks faster and easier I’ll switch. ( Proclone )

That may be because it does not work well.

The other main reason the US lags on electronic purchases is because the cashless infrastructure is atrocious. ( Saughton)

Also that it may be businesses rather than consumers which prefer cash.

Mom and pop stores and restaurants may require cash for any transaction, and almost all do for purchases under $10. Cheques for larger payments are also due to vendor requirement. That dynamic would be worth comparing to other markets instead of implying consumer preference. ( Pharmacy )

What about the Euro area?

I noted that the replies pointed out the way that cash remains prevalent in Germany (historical), Belgium ( tax-avoidance) and Austria ( see Germany) so let us take a look. From the European Central Bank or ECB.

The survey results show that in 2016 cash was the dominant payment instrument at POS. In terms of number, 79% of all transactions were carried out using cash,
amounting to 54% of the total value of all payments. Cards were the second most frequently used payment instrument at POS; 19% of all transactions were settled using a payment card. In terms of value, this amounts to 39% of the total value paid at POS. ( POS = Point Of Sale )

I doubt using geography as a method of analysis will surprise you much.

In terms of number of transactions, cash was most used in the southern euro area countries, as well as in Germany, Austria and Slovenia, where 80% or more of POS transactions were conducted with cash……… In
terms of value, the share of cash was highest in Greece, Cyprus and Malta (above 70%), while it was lowest in the Benelux countries, Estonia, France and Finland (at,
or below, 33%).

The ECB thinks it tells us this.

This seems to challenge the perception that
cash is rapidly being replaced by cashless means of payment.

It then goes further.

The study confirms that cash is not only used as a means of payment, but also as a store of value, with almost a quarter of consumers keeping some cash at home as a
precautionary reserve. It also shows that more people than often thought use high denomination banknotes; almost 20% of respondents reported having a €200 or
€500 banknote in their possession in the year before the survey was carried out.

This means that the ECB will find itself in opposition to more than a few of its population soon.

 It has decided to permanently stop producing the €500 banknote and to exclude it from the Europa series, taking into account concerns that this banknote could facilitate illicit activities. The issuance of the €500 will be stopped around the end of 2018, when the €100 and €200 banknotes of the Europa series are planned to be introduced,

 

Comment

Let us consider the relationship between the use of cash and financial crime. You may note that the ECB statement uses the word “could”. That as I pointed out back on the 5th of May 2016 is because the German Bundesbank thinks this.

There is scant concrete information on the extent to which cash is being used to facilitate illicit activity……… the volume of notes devoted to such transactions is unknown and would be extremely difficult, if not impossible, to estimate.

So the ECB seems to be basing its policy on the rhetoric of Kenneth Rogoff who in a not entirely unrelated coincidence thinks that central banks will have to go even further into negative interest-rates next time around. Our Ken has been rather quite recently on the subject of cash equals crime. This may be because if we look above we see that Estonia has moved away from cash both relatively and absolutely and yet you will have had to have spent 2018 under a stone to have missed this.

Danske Bank Estonia has been revealed as the hub of a $234bn money laundering scheme involving Russian and Eastern European customers. ( Frances Coppola)

Perhaps the authorities were too busy checking on the 500 Euro notes and missed a crime that would have taken four of out five of the total Euro area circulation. Priorities eh?

There are levels I think where this will be come more urgent. I have suggested before that I think that around -2% would be the level where people might move away from banks on a larger scale. So far in terms of headline official rates the lowest is the -0.75% of Switzerland. Of course another problem area would be created if we saw bank bailins on any scale which may be a reason why so many bank share prices have struggled.

Me on Core Finance TV

 

 

 

Higher bond yields and higher inflation mean higher national debt costs

The last week or so has brought a theme of this blog back to life and reminds me of the many years I spent working in bond markets. They have spent much of the credit crunch era being an economic version of the dog that did not bark. Much of that has been due to the enormous scale of the QE ( Quantitative Easing) sovereign bond buying policies of many of the major central banks. The politicians who came up with the idea of making central banks independent and then staffing them with people who were anything but should be warmly toasted by their successors. The successors would never have got away with a policy which has benefited them enormously in terms of ability to spend because of lower debt costs.

Italy

However the times are now a-changing and this morning has brought more bad news on this front from Italy. The BTP bond future for December has fallen to 120 which means it has lost a bit over 7 points over the last ten or eleven days. Putting that into yield terms it means that the ten-year yield has reached 3.5% which has a degree of symbolism. A factor in this is described by the Financial Times.

The commission issued its warning to the Five Star and League governing coalition after Rome deviated from the EU’s fiscal rules by proposing a budget deficit equivalent to 2.4 per cent of gross domestic product instead of the 1.6 per cent previously mooted by the finance minister Giovanni Tria. Although the new plans keep Italy under the EU’s 3 per cent deficit threshold, the country’s high debt levels — the highest in the eurozone after Greece — means Rome is required to cut spending to bring debt levels gradually lower.

However the chart below tells us that in fact you can look at it from another point of view entirely.

Actually I think that the situation is more pronounced than that as the ECB has bought 356 billion Euros worth. But you get the idea. It is hard not to think that a major factor in the recent falls is the halving of ECB QE purchases since the beginning of this month and to worry about their end in the New Year. In case you were wondering why the share prices of Italian banks have been tumbling again recently? The fact they have been buying in size in 2018 when one of the trades of 2018 has been to sell Italian bonds gives quite a clue.

If we switch to the consequences for debt costs then a rough rule of thumb is to multiply the 3.5% by the national debt to GDP ratio of 1.33 which gives us 4.65%. In practice this takes time as there is a large stock of debt and the impact from new debt takes time. For example Italy issued 2 billion Euros of its ten-year on the 28th of last month at 2.9%. So a fair bit less than now although much more expensive that it had got used too. This below from the Italian Treasury forecasts gives an idea of how the higher yields impact over time.

The redemptions in 2018 are approximately €184 billion (excluding BOTs) including approximately
€3 billion in relation to the international programme……..the average life of the stock of
government securities, which was 6.9 years at the end of 2017.

Oh and the tipping point below has been reached. From the Wall Street Journal.

Harvinder Sian, a bond strategist at Citigroup, thinks a 10-year yield of 3.5%-4% is now the tipping point, after which yields jump toward the 7% reached at the height of the last euro crisis

Personally I am not so sure about tipping point as the “gentlemen of the spread” ( with apologies to female bond traders) have been selling it at quite a rate anyway.

 

The United States

Here bond yields have been rising recently and let us take the advice of President Trump and look at what has happened during his term of office. Whilst back then Newsweek was busy congratulating Madame President Hilary Clinton my attention was elsewhere.

There has been a clear market adjustment to this which is that the 30 year ( long bond) yield has risen by 0.12% to 2.75%.

We see that it has risen in the Trump era to 3.4% although maybe not by as much as might have been expected. However if we look to shorter maturities we see a much stronger impact.For example the two-year now yields some 2.9% and the five-year some 3.07%. So if you read about flat yield curves this is what is meant although it is not (yet) literally true as there is a 0.5% difference. Thus the US now faces a yield of circa 3% or so looking ahead. This does have an impact as the New York Times has pointed out.

The federal government could soon pay more in interest on its debt than it spends on the military, Medicaid or children’s programs.

In terms of numbers this is what they think.

Within a decade, more than $900 billion in interest payments will be due annually, easily outpacing spending on myriad other programs. Already the fastest-growing major government expense, the cost of interest is on track to hit $390 billion next year, nearly 50 percent more than in 2017, according to the Congressional Budget Office.

If we switch to the Congressional Budget Office it breaks down some of the influences at play here.From its September report.

Outlays for net interest on the public debt increased by $62 billion (or 20 percent), partly because of a higher rate of inflation.

The CBO points out a factor the New York Times missed which is that countries with index-linked debt are also hit by higher inflation. As the US has some US $1.38 trillion of these it is a considerable factor.

Also the US is borrowing more.

The federal budget deficit was $782 billion in fiscal year 2018, the Congressional Budget Office estimates,
$116 billion more than the shortfall recorded in fiscal year 2017………The 2018 deficit equaled an estimated 3.9 percent of gross domestic product (GDP), up from 3.5 percent in
2017. (If not for the timing shifts, the 2018 deficit would have equaled 4.1 percent of GDP.)

Higher bond yields combined with higher fiscal deficits mean more worries about this factor.

At 78 percent of gross domestic product (GDP), federal
debt held by the public is now at its highest level since
shortly after World War II. If current laws generally
remained unchanged, the Congressional Budget Office
projects, growing budget deficits would boost that
debt sharply over the next 30 years; it would approach
100 percent of GDP by the end of the next decade and
152 percent by 2048 . That amount would
be the highest in the nation’s history by far.

I counsel a lot of caution with this as 2048 will have all sorts of things we cannot think of right now. But the debt is heading higher in the period we can reasonably project and I note the CBO is omitting the debt held by the US Federal Reserve so that QE would make the figures look better but the current QT makes it look worse.

Comment

Debt costs and the associated concept of the mythical bond vigilantes have been in a QE driven hibernation but they seem to be showing signs of waking up. If we look at today’s two examples we see different roads to the destination. If we look at the road to Rome we see that the longer-term factor has been the lost decades involving a lack of economic growth. This has made it vulnerable to rising bond yields and which means that the straw currently breaking the camel’s back has been what is a very small fiscal shift. It is also a case of bad timing as it has taken place as the ECB departs the bond purchases scene.

The US is different in that it has a much better economic growth trajectory but has a President who has also primed the fiscal pumps. Should it grow strongly then the Donald will win “bigly” as he will no doubt let us know. However should economic growth weaken or the long overdue recession appear then the debt metrics will slip away quite quickly. That is a road to QE4.

Returning back home I note that UK Gilt yields are higher with the ten-year passing 1.7% last week for the first time for a few years.So the collar is a little tighter.The main impact on the UK came from the rise in inflation in 2017 leading to higher index-linked debt costs. This was the main factor in our annual debt costs rising by around £10 billion between 2015/16 and 2017/18.

 

 

 

 

Will real wage growth ever go back to “normal”?

A constant theme of the credit crunch era is the unwillingness of the establishment to accept that past economic theories need to be put as a minimum on the back burner. Two examples of that are the concepts of full employment and the related one of the output gap. If we start with the former that does not mean that everyone is employed as the “man from Mars” from Blondie’s song rapture might think. It involves allowing for what is not entirely pleasantly called frictional unemployment, for example of individuals temporarily between jobs. There is an obvious problem with measuring that but as we discover so often the Ivory Towers are seldom troubled by issues like that.

The output gap was something of a simple concept around comparing actual output with potential. However supporters were invariably in the group who argued there was a large amount of lost output from the credit crunch and this end gamed themselves as we are still well below that and may always be. The Bank of England Ivory Tower dropped that and instead kept telling us we had an output gap of circa 1.25% of GDP. In the end they decided to drop as it was always 1.25% or so and switched to employment as a measure. Why? Well in the UK like more than a few other places it boomed so they could shoehorn their theory into a different version of reality. Sadly for them they have made fools of themselves as their estimates began at 7% unemployment went very quickly to 6,5% and are now at 4.25%. Or if you prefer silly,sillier and so far at least silliest.

Reality

The problem for all of the above has been shown in Nihon or the land of the rising sun. There the unemployment rate has fallen as low as 2.2% this year and in August was 2.4% How can it be half the natural/full rate? Please address that question to Threadneedle Street. Whilst there are suspicions about the accuracy of unemployment rates there are also other signals of what in the past would have been called an overheating jobs market. From the Japan Times last week.

The percentage of working-age women with jobs in Japan reached a record high of 70 percent in August, government data showed Friday………The figure for women in work between ages 15 and 64 is at the highest level since comparable data became available in 1968 and compares with 83.9 percent for working-age men,

Other measures such as the job offers to applicant ratio going comfortably above 2 signal a very strong labour market and yet this morning we have seen this. From Reuters.

 Japanese workers’ inflation-adjusted real wages fell in August for the first time in four months……..The 0.6 percent decline in real wages in August from a year earlier followed a revised 0.5 percent annual increase in July, labor ministry data showed on Friday.

This is a rather awkward reality for those who have trumpeted a change in Japan in line with the two economic theories described above, and I note a lack of mentions on social media. If we look into the detail we see this.

Nominal cash earnings rose 0.9 percent year-on-year in August, slower than a revised 1.6 percent annual increase in July.

The average level of monthly earnings is 276,266 Yen or a bit under £1900. The highest paid industry was the utility sector at 438,025 Yen and the worst-paid was the hotel and restaurant sector at 123,405 Yen. The fall can be looked at  from two perspectives of which the first is a fall in bonuses of 7.4% and the next is that the numbers were pulled down by falls in the care sector (3.8%) and education (3.6%).

As to the surge ( real wages rose at an annual rate of 2.5% in June) it was as we believed.

Major Japanese firms typically pay bonuses twice a year, once during the summer and once near year’s end…….Summer bonuses boosted real wages in June.

This morning has also brought a confirmation of why this is good.

Japanese households increased their spending at the fastest rate in three years in August as consumers made more costly purchases, government data showed Friday.

Spending by households with two or more people rose 2.8 percent from a year earlier, after adjusting for inflation, to ¥292,481, the largest increase since August 2015, the Internal Affairs and Communications Ministry said. ( Japan Times)

But that will now rend to fade away after the welcome bonuses are spent. Sadly the output gap style theories are unlikely to fade away as reality is always “Tis but a scratch” along the lines of the Black Knight in Monty Python.

The UK

In the UK we keep being told that wage growth is just around the corner. From the REC this morning.

Starting salaries for people placed into permanent
jobs increased at the quickest pace since April 2015
during September. Hourly rates of pay for temp staff
also rose at a faster pace than in the preceding
month.

The strongest area was this.

IT & Computing remained the most in-demand
category for permanent staff in September.

Perhaps it is the banks finally waking up to the all the online outages and problems. But the problem is that a sustained rise keeps being just around the corner. In its desperation to justify its theories the Bank of England switched to private-sector regular pay in its attempt to find any reality fitting the work of its Ivory Tower. But if you pick a sub-section it has to eventually fire up the overall numbers to be significant and the picture there is that total wage growth has surged from 2.8% in January to 2.6% in July. Oh hang on…..

Or real wage growth is somewhere around 0% on the official inflation measures or negative on the “discredited” RPI which gives a higher reading.

The US

Today brings the labour market data for September but until then we are left with this.

In August, average hourly earnings for all employees on private nonfarm payrolls rose by 10 cents to $27.16. Over the year, average hourly earnings have increased by 77
cents, or 2.9 percent.

August was a good month but if we switch to the annual rate but we see that even in an economy that according to the GDP nowcasts is keeping up its 4% per annum growth rate wages are struggling to break 3%. The US economy has recovered better than most and is doing well now and yet wage growth has not followed much. Real wage growth is as you can see minimal.

Over the last 12 months, the all items
index rose 2.7 percent before seasonal adjustment.

According to the Financial Post it is a case of O Canada as well.

Over the three years he’s been in power, real wages have averaged annual gains of just 0.3 per cent, versus 1 per cent the previous decade.

Comment

A feature of the credit crunch era continues to be the attempt to ignore the more uncomfortable aspects of reality. There is welcome news in the way that employment levels recovered but the price of that seems to have been weak wage growth and especially real wage growth. This afternoon that number from the US Bureau of Labor Statistics will be poured over again for that reason. The big picture though comes from David Bowie.

Ch-ch-ch-ch-changes
Turn and face the strange
Ch-ch-changes
Where’s your shame?
You’ve left us up to our necks in it

 

We have a serious problem with real wages

One of the features of the early days of this website was the fact that there were regular replies/comments suggesting that wages and earnings would continue to be a problem for some time. I doff my cap to those who first suggested it as it has become a theme of the credit crunch era. This means that your unofficial Forward Guidance was vastly more accurate and useful than those paid to do it. Here is an example from back then (Summer 2010) from the grandly named Office for Budget Responsibility or OBR.

Wages and salaries growth rises gradually throughout the forecast, reaching 5½ percent in 2014.

That to borrow from Star Wars seems like something from “A long time ago in a galaxy far, far away….”. It is even worse if we look at the situation in terms of real wages as the OBR forecast that it would be on target, so we see that real wage growth would be 3% per annum. Happy days indeed! But it was just an illusion.

The scale of that illusion was illustrated by this from Geoff Tily of the Trade Union Congress or TUC earlier this week.

So in the decade before the first TUC meeting in 1868, real wages had fallen by 0.1%. Since then, only the decade to 2018 has seen a worse performance, with real wages down by a whopping 4.4%.

So rather than the sunlit uplands suggested by the OBR we have seen a much more grim reality. As an aside this brings us back to the problem of “experts”. In my opinion you deserve that label if you get things right, for example aircraft designers as air travel is very safe. Whereas official economics bodies are regularly wrong and therefore in spite of the lauding they get from the media do not deserve such a label. I also note that those who debate that issue with me and claim that it does not matter the forecasts are wrong (!) are often from the group that have hopes of gaining employment in this area.

Discovering Japan

This morning has brought more news on wage growth in Japan but before we get to it we need to set the scene. This is because the land of the rising sun has been anything but in terms of wage growth. Or as Japan Macro Advisers put it.

Wages in Japan has been steadily falling in Japan since 1998. Between 1997 and 2012, wages have declined by 12.5%, or by 0.9% per year on average.

Japan has been the leader of the pack in a race nobody wants to win. It also provided a warning which has come in two guises. Firstly the concept of real wages falling in a first world industrialised country and secondly the very long period for which this has been sustained. This is one of the major players in the concept of the lost decade for Japan which in this regard has now lasted for two of them.

This was a driver between the original claims for Abenomics where ending the deflationary mindset was supposed involve higher wage growth. In reality the performance is shown by the official real wage index which was set at 100 in 2015 and was 100.5 last year. So very little growth and in fact a reduction on the 101 of 2014. But hope springs eternal and we know that May and especially June were much better so here is Reuters on this morning’s release of the July data.

Separate data showed Japanese workers’ inflation-adjusted real wages rose 0.4 percent in July from a year earlier, marking a third consecutive month of gains.

What this tells us is that as the bonus season is passing the better phase was for bonuses and nor regular wages or salaries. So whilst the news is welcome it is not the new dawn that some have tried to present it as. Indeed tucked away in the Reuters report is a major issue in this area.

 firms remain wary of raising wages, despite reaping record profits.

The link between companies doing well and wages rising in response has been broken for a while now. Earlier this week Japan Press Weekly was on the case.

Finance Ministry statistics released on September 3 show that in 2017, large corporations with more than one billion yen in capital increased their internal reserves by 22.4 trillion yen to a record 425.8 trillion yen.

Compared with the previous year, big businesses’ current profit was inflated by 4.8 trillion yen to 57.6 trillion yen, 2.3 times larger than that in 2012 when Prime Minister Abe made his comeback. The remuneration for each board member was 19.3 million yen a year, up 600,000 yen from a year earlier. Meanwhile, workers’ annual income stood at 5.75 million yen on average, down 54,000 yen from the previous year.

The section about the rise in profits for big businesses under Abenomics resonates because the critique of his first term was exactly that. He benefited Japan Inc and big business.

The United States

Later today we get the non farm payrolls release from the US telling us more about wage growth. But as we stand in spite of the fact the US economy has had a good 2018 so far the state of play is a familiar one.

Real average hourly earnings decreased 0.2 percent, seasonally adjusted, from July 2017 to July 2018.
Combining the change in real average hourly earnings with the 0.3-percent increase in the average
workweek resulted in a 0.1-percent increase in real average weekly earnings over this period.

Indeed if we look back as Pew Research has done we see that real wage growth has been absent for some time.

A similar measure – the “usual weekly earnings” of employed, full-time wage and salary workers – tells much the same story, albeit over a shorter time period. In seasonally adjusted current dollars, median usual weekly earnings rose from $232 in the first quarter of 1979 (when the data series began) to $879 in the second quarter of this year, which might sound like a lot. But in real, inflation-adjusted terms, the median has barely budged over that period: That $232 in 1979 had the same purchasing power as $840 in today’s dollars.

There have been gains in benefits but not wages over these times.

The Euro area

The Czech National Bank has looked at this and we see an ever more familiar drumbeat.

 In the euro area, nominal wage growth was 1.7% in 2017 Q4, while real wages were broadly flat.

This comes with factors you might expect ( Italy) but also I note Spain which is doing well.

In Italy, by contrast, hourly wages dropped both in nominal terms and in real terms (i.e. adjusted for consumer price inflation). Spain and Austria also recorded wage decreases in real terms.

Also they are not particularly optimistic looking forwards.

However, the wage growth outlooks available for the euro area and especially for Germany do not see wages accelerating significantly any time soon.

We could apply that much wider.

Comment

The message today was explained by Bob Dylan many years ago.

There’s a battle outside
And it is ragin’
It’ll soon shake your windows
And rattle your walls
For the times they are a-changin’

The truth is that the economics profession has been slow to realise that not only would the credit crunch reduce wage growth, but that it was already troubled. Only last night in a reply to a comment I referred to Deputy Governor Wilkins of the Bank of Canada spinning the same old song.

Yet, wages were rising less quickly than we would expect in an economy that is near capacity.

The same old “output gap” mantra when in fact the reality is of inflation at 3% and wages growth at 2.5%.

To be fair some places do seem to be adjusting as the Czech National Bank faces up to an issue that the UK economics establishment continually assures us is not true.

Migration from Eastern Europe, Italy and Spain,3 which has increased mainly because of the financial and debt crisis, is playing a major role. Workers from these countries are increasing the labour supply and perhaps exerting less upward pressure on wages than incumbents. ( They are referring to German wage growth).

Some however seem to inhabit an entirely different universe as this op-ed from November last year in The Japan Times shows.

Thinning labor puts upward pressure on wages, increasing living standards……

 

Let me leave you with an optimistic thought. As I watched the AI documentaries on BBC Four this week I wondered if rather than fearing it we should have hopes for it. Maybe the rise of the machines will be fairer than our current overlords.