Thursday, January 29, 2009

US bond market looking beyond recession



Markets are always forward looking. They will discount future information and include it in today's price. The US bond market is starting to move beyond the recession and liquidity story to now account for the deficit and inflation story. In the Fall, the bond market was fixated on a flight to quality but now the we are seeing a meaningful reversal in some Treasury relationships to account for the trillion plus deficit and the potential that longer-term debt will be monetized.

New home sales and durable good orders fall off a cliff and the bond markets take a dive on a poor five-year action. Forget about the bad economy, it is the financing and inflation stories that is driving the market right now.

Nominal rates have stopped declining and are increasing since the beginning of the year. The yield on 2-years have increased 25 bps form the lows in mid-December. Five years are up 45 bps, 10-years up 68 bps, and 30-years up 91-bps. There is a clear reaction that as you move out the yield curve there is more emphasis on funding and inflation.

Now there is a strong literature on the fact that deficits do not matter, but that was for deficit levels much lower than current projections. The market was stable until the bad 5-year auction. The Treasury sold $78 billion in a week. The market is suffering from supply exhaustion. If the market will not buy the bonds, then the Fed will have to monetize which has the potential for longer-term inflation.

Long-rates are mostly driven by inflation expectations which are all the more telling for the longer-term trends. Break-even inflation rates are all on the rise. For example, the 30-year break-evens are up almost 100 bps since the end of November. Even the short rate break-evens for say 2-years are showing a significant change. Here, the break-even has gone from negative 6.95 to -2.79. This is is a 400 bps change in about 45 days. The Fed has made an impression that they plan to reflate the economy and produce rising prices. Five-year numbers have moved from negative to positive territory although the change has not been as great.

Friday, January 23, 2009

Currency mainpulator? The new China story

Tim Geithner made a splash at his confirmation hiring by stating that President Obama believes that China is a currency manipulator. This is a strong change in policy and will create significant tension in the in Sino-American relationships.

First, the legal definition of being classified a currency manipulation is very specific and China has not met the definition. It is unfair to characterize China with this label at this time. Second, as the biggest buyer of US Treasuries there is no reason to make the Chinese upset at the when we will be issuing over $1.2 trillion in debt over this fiscal year. Third, China needs to be further integrated in the global not pulled into a defensive view. Fourth, the currency changes do not suggest manipulation on a multilateral basis. The yuan has strengthened versus many Asian currencies. Fifth, this is the type of rhetoric that can lead to trade wars.

Now, we do know that the yuan is not a flexible exchange rate and there has been evidence that currrency is undervalued by a number of economist. China has built up a war chest of over $2 trillion in foreign exchange because of their efforts to depress the currency. More work has to be done to refine the definition of manipulation and the monitoring of currency developments by Treasury. See the recent IIE report. Neverthless, is this the time and place for a manipulation discussion? We should expect better politics from a potential Treasury secretary.

More moves to quantitative easing

We know that the Fed has moved to a quantitative easing even if it has been called by other names such as a credit easing policy. The Bank of Japan is considering the purchase of corporate bonds which would be similar to the Fed policy initiative. The Bank of England has started to take steps in the same direction with policy announcements this week.

The Bank of England is putting in place an asset purchase plan akin to some hybrid Treasury and Fed policy. The process will have the bank buy non-financial credit paper and have it funded through Treasury issuance of debt. There would be a swap of private for public debt. The program of up to 50 billion pounds will have the bank take the credit risk to reduce spreads with money raised by Treasury. This would have a process in place for the bank to ultimately buy asset and fund with new money. The Bank has been careful about stating the intentions of this policy because a weak pound will only get worse if there was a clear belief that the money supply would be turned on without any restraints. The BOE has already increased its balance sheet by a factor of three. We have seen the impact on sterling.

Monday, January 19, 2009

Measuring emerging market sovereign debt risk


Not surprising, sovereign credit risk has increased with the global economic crisis. We have seen an increase in downgrades most recently with the credit watch of a number of EU countries. The macro fundamentals that measure sovereign risk have started to move to indicate increased risks.

Sovereign risk will become increasingly important in the currency markets. The deterioration of credit risk carries over to currency markets. Increased risk lead to capital outflows and depreciation. Our own research suggests that sovereign risks increase in importance when there is a turning point in business cycles especially for the case of a downturn. The behavior of sovereign risks is non-linear or rests on thresholds which are the reason why we favor conditional forecasting. The risk will not be an issue until it hits a threshold.

This is similar to what some IMF economists have called the rules of thumb approach. See “Rules of Thumb” for Sovereign Debt Crises by Paolo Manasse and Nouriel Roubini. In this paper, Manasse and Roubini use the Binary Recursive Trees approach to help identify risk situations. The Binary approach tries to find conditional breaks or classifications in the data which suggest what are the conditions for risky sovereign debt. A set of conditions or factors are necessary at specific levels or thresholds to trigger sovereign risk situations. Finding the critical values for a set of macrovariables allows for the determination of safe versus risky sovereign debt and currency situations basedon trigger or conditional values.

Safe countries with minimal risk would be those that have a set of economic conditions which include low total external debt, low short-term debt, low public external debt and an exchange rate that is not overvalued. The risky sovereign environments can be classified as those that have debt unsustainability, illiquidity, or macroexchange rate risks. In the first case, high external debt above 50% of gdp with monetary and fiscal imbalances as well as large external financing needs make for a risky situation. Illiquidity risks are characterized by high short term debt in excess of 10 percent of reserves with political uncertainty and tight international capital markets. The macroexchange risk comes from low growth and fixed exchange rates.

Unfortunately we are having a number of emerging market countries that are falling into the illiquid and debt unsustainable conditions. Reserves are falling for a number of countries so short-term debt as a percentage of reserves is rising. External debt and total debt levels are also increasing with the growth of fiscal imbalances. The table hows that foreign exhange reserves have been falling fast for some countries. We are watching for these trigger points because there will be greater risk differentiation across countries as this crisis continues.

Friday, January 16, 2009

Explicit inflation target is the talk of the day to stop deflation

With the CPI numbers just being released, the CPI MOM was down .7% in December and the YOY was up only .1%. The decline to current YOY levels is unprecedented. There were some steep falls in the past 30 years, but inflation was at much higher levels. Both the absolute and relative declines this month were significant. Much of the headline inflation decrease is associated with the decline in commodity prices; nevertheless, the core CPI is still hovering at 1.8% and is relatively sticky. The core has fallen below 2% for the first time in five years when it was just above 1%.

Economic policy circle discussions have been focused on deflation. With a strong recession, we could see negative inflation as prices are further revised downward. Low inflation is embedded in break-even spreads between nominal and TIPS bonds. Deflation is a major negative for borrowers and will only make the economic situation worse, so one of the keys to monetary policy will be to ensure that we inflate the economy. This has led to more discussion about setting firm inflation targets for the Fed.

More Fed presidents are coming out with the idea that an explicit inflation target should be the working policy of the Federal Reserve. This will send a clear signal on the target that will manage monetary policy and manage anxiety on deflation. The easing would stop if inflation moves above the target. More importantly, the problem of a zero bound will be stopped. If rates are close to zero, then any deflation will lead to positive real yields which will have a negative impact on the economy. Because long-term rates are so driven by inflationary expectations, an explicit target will reduce nominal uncertainty and allow rates to find a fixed range. The chance of wild deflation or inflationary expectations would be stopped.

Inflation targeting has been effective during the 1990’s to control inflation. Now central bankers want it to be used to control deflation. The problem is determining how to structure these targets. Do you use core or headline inflation? How low does inflation have to go before the Fed will act to further add money to the system? What will happen if inflation starts to increase above the target yet the recovery is only beginning? What will happen to Fed communication and creditability if they do not hit the target? While there has to be new innovative targets for measuring policy during a deflation, care has to be taken in forming the structure of a new policy or the market will face greater uncertainty

The multiplier debate on tax cuts or spending increases

Joe Stiglitz does not want to squander the stimulus package with tax cuts. This is one of the key issues faced by the government. What will have the most multiplier effect. In the one corner is Greg Mankiw the former chairman of the CEA and the Christina Romer, the new chairman of the CEA versus those that believe in bricks and mortar for the stimulus plan.

“Mr Mankiw cites a recent study by Christina Romer and David Romer, economists at the University of California, Berkeley, who found that each dollar of tax cuts raises GDP by about $3 (€2.30). Such studies, based on past data, may have little to say about the situation the world now faces. Americans confronted with debt, shrinking retirement accounts, houses worth less than mortgages and a tough credit environment will save more of their money than in the past. That was the experience with the February 2008 tax cut, where less than half of it has been spent. It matters who gets the break – if it is lower income Americans, the fraction spent will, on average, be greater than for wealthier Americans.”

“Tax breaks for business may prove to be a sink-hole as bad as the troubled assets relief programme. Particularly worrisome are rumours that companies will be allowed to set off their losses against profits made in the past five years to get tax rebates – a big gift to those who mismanaged risk, including banks such as Citibank. Some suggest that, having exhausted the more transparent bail-out strategy, banks are seeking less transparent help through the tax code. We learnt the lesson from Tarp: we need to link handouts to changes in behaviour. We should have insisted banks commit to more lending. Now we should insist any tax breaks for business are linked to investment.”

This is a variation of the supply arguments that have gone on for the last two decades. Do we create more stimulus with putting money in the pockets of the taxpayers or would we be better off targeting the money for specific expenditures that that could add to productivity such as infrastructure.

This will be a fight of whether growing government will be better or growing net after- tax income. The data does not help in analyzing the problem. The February 2008 tax cut was not effective because much of the excess money was saved, less multiplier. Stiglitz makes a good point that if states raise taxes when the Federal government cuts them there will be no net positive gain. The historical record from the research of Romer is that the tax cut has a bigger multiplier. So who is right? The evidence is not clear if you argue from the February cut. The data in the past tells a different story.

The current proposal with a mix of both may be effective. A tax cut especially to lower income families will lead to more consumption and can be used to pay-down debt. The impact will be immediate relative to large public works projects that may take time to start. Do we have $800 billion in shovel ready projects? Watch the debate on this issue because we are seeing an interesting mix of politics and economics.

Thursday, January 15, 2009

Race to zero rates continues around the world

ECB cut rates by 50 bps to 2%. They have cut rates 225 bps since October. The Bank of Thailand also cut rates by 75 bps to bring their levels down to 2%. The Bank of England cut rates last week by 50 bps to 1.5% the lowest levels in 315 years. The old levels of 2% were during the Great Depression. Every major developed country now has rates at 2% or less. We could lump the world into a number of groups.

There is the "zero rate club" of the US, Japan, Switzerland, and Singapore. The trading target may be slightly above zero but for trading purposes the nominal rates are close to zero. The objective is stop deflation and provide stimulus for their economies.

There is the "I'm heading for zero but have not gotten there club" which includes the ECB, Canada, UK, Sweden, Norway, Slovakia, Czech Rep, and Denmark. This would be the developed countries and Europe. There will be slight differences with some of the Eastern European countries keeping a slight premium with their bank rates.

The third club would be the "my nominal rates are higher, but I have a negative real rate club" This would be most of the rest of the world. Their inflation rates have been a little sticky so the nominal rates have not yet been taken down to G7 levels.

The final club is "the outlier club" where both nominal and real rates are high relative to the rest of the world. This would include Brazil, Turkey, Hungary, and maybe Mexico. With the exception of Brazil, these are countries that have the potential for currency crises and would be on any sovereign watch lists.

No central bank is worried about negative real rates. There is little or no reason to hold government paper in this environment, yet gold is below levels of one year ago.

Wednesday, January 14, 2009

A TARP we can believe in - 90% of local funds from the Capital Purchase Program go to two banks

Treasury announced that it has provided $14.77 billion in fund to local banks. This, on the surface seems to make sense, but you read beyond the headline and there a problem. $13.388 billion went to two institutions, Bank of America and American Express. This represented 90.6% of the total. At the other extreme, we gave $1.065 million to Independence Bank in Rhode Island. We also provided $2 million to Surrey Bancorp in North Carolina. I am sure that we would be interested in the "pay for play" connection on some of these payments. Rent-seeking is king!

If some of these small institutions are in trouble and need funds, shouldn't regulators be pushing for mergers? How much work is involved to monitor the 41 banks that represent less than 10% of the program. 95% of the banks get less than 10% of the funds. If we have major mortgage foreclosures, should the money be spent this way on small institutions. The loss on one home in California may be greater than the capital given to some of these banks. Was this the intent of the program? I thought we wanted to use the power of the Treasury to have a big impact on liquidity.

Bernanke Stamp Lecture tells all

Chairman Bernanke provided an insightful lecture on current Fed policy at the Stamp Lecture in London yesterday. This is good reading on the distinction between credit easing and quantitative easing. The subtle differences are important because the impact of each policy is not the same.

Comments in the FT Alphaville provide a useful summary.

Credit Easing versus Quantitative Easing
The Federal Reserve’s approach to supporting credit markets is conceptually distinct from quantitative easing (QE), the policy approach used by the Bank of Japan from 2001 to 2006. Our approach–which could be described as “credit easing”–resembles quantitative easing in one respect: It involves an expansion of the central bank’s balance sheet. However, in a pure QE regime, the focus of policy is the quantity of bank reserves, which are liabilities of the central bank; the composition of loans and securities on the asset side of the central bank’s balance sheet is incidental. Indeed, although the Bank of Japan’s policy approach during the QE period was quite multifaceted, the overall stance of its policy was gauged primarily in terms of its target for bank reserves. In contrast, the Federal Reserve’s credit easing approach focuses on the mix of loans and securities that it holds and on how this composition of assets affects credit conditions for households and businesses. This difference does not reflect any doctrinal disagreement with the Japanese approach, but rather the differences in financial and economic conditions between the two episodes. In particular, credit spreads are much wider and credit markets more dysfunctional in the United States today than was the case during the Japanese experiment with quantitative easing. To stimulate aggregate demand in the current environment, the Federal Reserve must focus its policies on reducing those spreads and improving the functioning of private credit markets more generally.

The Chairman does a good job of providing a summary of the Fed objectives and should make anyone who reads this feel more comfortable that the Fed is on the right track. Bernanke talks about the toolkit available for the Fed and gives a good explanation of how and why certain tools are being used. He actually starts with a discussion on communication as an important tool. He continues to send the clear signal that short rates are going to stay down for some time and this is the key to bringing down long-rates which is the ultimate objective of their policies. Bernanke makes it clear that he understands the communication challenge associated with running these complex policies. He also began talking about the exit strategy which has been an overhand in the market.

This speech which will generally go unread should provide global market confidence that the Fed is following a clear and well-thought path.

Tuesday, January 13, 2009

Stock market drives yen behavior

The US stock market has been a bell-weather for yen behavior during this economic crisis. This is at odds with the historical behavior between the SPX and yen which had shown negative correlation and a regression beta which was close to zero for the period prior to the crisis. Surprisingly, there is not a strong relationship between the VIX index and the yen even though the talk has been that the volatility measure is the key to measuring risk aversion. The SPX is proxying for US as well as global growth. Given the important relationship between Japanese exports and US growth it may not surprise many that there is a relationship; however, there is then the problem with explaining the lack of relationship during the early part of the 2000's. Of course, the size of the recent stock move could dominate the regression results.


This relationship between the SPX and yen is actually much stronger than what has been the case between yen and the NKY index. Given the high percentage of market capitalization in the NKY with exporters, it would seem logical that a fall-off in exports which drives down stock prices would show up in yen appreciation. The line of causality would not make sense. A fall in Japanese stocks would not cause a flow into Japan so it would not be expected that the relationship would be strong.

We like the SPX global risk proxy story right now, but the bias from the large move may suggest that there will be a decoupling between the two. Trading yen against short-term stock moves will be risky.

Trade Balance improves - Nothing good in the numbers

We should be excited with an unexpected improvement in the trade balance but a close inspection will provide only limited bright spots. Yes, it did improve and oil imports continue to decline, but the rest of the report show that global growth is declining. Call it the incredible shrinking global economy. Exports have declined jut over 15% and import showed significant slowing at down 20%. Hong Kong, Singapore and Malaysia all showed import declines of over 20% YOY. Exports to places like Taiwan have fallen by over 30% YOY.

Imports are a function of income so as the US retrenches, the import will decline. Exports will be related to income in the foreign country, so improvement in trade may be related to faster declines in US growth relative to the rest of the world.

Sunday, January 11, 2009

How do we get the jobs? Moving to four million

His new target to save or create 4m jobs, announced on Saturday, marked the second time in three weeks that Mr Obama had raised the goal. He originally said the stimulus would generate 2.5m jobs before upping it to 3m last month.

From the FT... new comments from the President-elect

Everyone wants the President elect to succeed. We would like a leader who will provide confidence and clear direction. In fact, we long for such a leader. This is something that we have been missing since the economic crisis began. Being positive is not enough. we need truth combined with action. There is no question that we will need a significant counter-cyclical fiscal package, but we do not think it is helpful to revise the job numbers repeatedly while not changing the economic package. these have to go hand-in-hand. It does not help to win market confidence if there is a new job number which is higher every time there is a new unemployment number. There needs to be better clarity on how the fiscal plan will work or the negative market reaction will be swift.

Bund auction failure - a new sign of the times

The talk of the week was about the poor unemployment numbers from the US and the poor confidence numbers in Europe. It is a coin toss about which economy will be worse so there is no clear direction in the dollar/euro trading.

What has not been given as much attention has been the failure of the 6 billion euro bund auction which was not able to raise the expected amount of money. What does this mean when the German government is not able to raise the money it wants with euro rates still relatively high versus the US? Germany has not planned the same type of aggressive fiscal plan so this should not have been a problem. If Germany cannot raise money what will this say about Italy or some of the other lower quality euroland countries? What does this tell us about the US and its ability to raise over $1.2 trillion in this fiscal year. We may be in for some surprises with investors less willing to fund at these low levels in the size that the governments would like.

This is the real story for the first week of the year.

Flow of funds tell a different story than bank loans

We have commented on the Fed H8 report which shows that bank lending has increased over the last year, bu the Fed flow of funds data tells a different story. In this case, there has been a significant retrenchment of both consumers and non-financial businesses. We usually expect to see a decline in business debt as they retrench but this has usually not been the case for consumers. The fall is unprecedented. The only way to reconcile some of these numbers is through the fact that credit is not available through non-bank forms. It is the shadow banking system that has contracted. We agree that there has been significant changes in the credit markets but it is not clear how the credit transmissions have changed. This transmission story has to be more closely analyzed.

The second chart shows the amount of debt outstanding which is finally declining. It is interesting to note that the debt outstanding was stable for most of the 1970's when economic growth was slow and equity prices were flat. The charts are provided by the Levy institute of Bard College.

What kind of fiscal package?

There has been significant talk about the Obama fiscal package but there has been very little discussion on the economics of the package other than it has to be be big, very big. Some of have stated that the tax cuts associated with the package are necessary to have the Republicans follow along on passage but no one has asked the important question on what will have the biggest bang for the buck. We know that the temporary tax cut of second quarter of 2008 did not have much of an impact but that could because of its temporary nature.

N Greg Mankiw provides an interesting perspective on the package in the NYT which should cause food for thought. http://www.nytimes.com/2009/01/11/business/economy/11view.html?_r=1&ref=business. He presents the evidence that the multiplier effect of a tax cut may be much greater than what would occur from just increasing government expenditures. In fact, the positive effect of tax cuts is something that can occur immediately while any increase in fiscal spending will take some time and may be subject to waste. So there is a choice. We could provide tax relief to individuals and businesses which will have an immediate effect and allow the taxpayer to make the decision on how best to spend the money or we could have the government spend the money on what it thinks the country needs.

The use of fiscal spending is an important tool and this is a rare chance to change the mix of spending to enhance infrastructure, but a tax cut is not a bone thrown to Republicans but an effective means of getting a strong multiplier effect. The CEA appointee Christina Romer has shown the important impact of tax cuts, so we only hope that President-elect Obama and Romer can carry the day with the economic evidence.

What credit crisis? - Look at bank credit expansion

We have a credit crisis! No one can get credit! We have to solve the credit crisis and get money to those who need it!

How many times have we heard these words in the last few months? We have heard this from experts and we have heard it on the street. We have heard it in editorials and this is one key reason why we need to have the fed explode its balance sheet and we need significant fiscal stimulus.

If there is a credit crisis, then it should be easy to look at the data and see a contraction of credit in the banking sector. There have also been comments that banks in the TARP program have not been lending the money to customers. Again, this should be easy to prove. The Fed data as measured in their H8 reports should show a credit contraction. This credit contraction should certainly be negative if GDP has turned negative. http://www.federalreserve.gov/releases/h8/Current/

There is actually a surprising lack of evidence to support these arguments. Look at the latest H8 report and compare the amount of credit extended in December 2007 and the level that exists in December 2008. This data would include the crunch period since September. The numbers do not show a contraction of credit. It actually shows an expansion. Bank credit increased by 8% in the last year. Consumer credit has expanded by over 8%. C&I loans increased by over 10%. Where is the crisis? Who is suffering from this crisis? The credit market is different from other markets in that the allocation is not often rationed only on price but on the quantity side. This is what makes for the crunch, yet the evidence is telling us something different. If you just showed a graph of GDP growth in the last year versus credit expansion, you would argue that the money is flowing to companies and consumers.

Now this may not mean that there is no credit crisis, but we have to be more careful on how we define the extent of the crisis or what we mean by crisis. The amount of credit extended, in some cases, has slowed, but even a slowing of credit expansion does not mean the same as a delevering of credit. Credit is less available for poor quality borrowers which one would expect in a recession. The fear is driving this market even in the face of counter-evidence.

It could just mean that the way that the data is collected is not showing a crisis. If that is the case, and the data concerning credit expansion is wrong then what is the Fed going to about the poor data problem? Who is reporting on these numbers?

A thought provoking piece was done by Minneapolis Fed economists called , “Facts and Myths about the Financial Crisis of 2008”. http://www.minneapolisfed.org/publications_papers/pub_display.cfm?id=4062.

They focus on three myths in this crisis which have continued since their paper was written in October 2008. In fact, the myths they discuss have not only continued but are more pronounced. They are:
1. Bank lending to non-financial firms has declined sharply
2. Interbank lending is nonexistent
3. Commercial paper lending has declined sharply and rates have risen to unprecedented levels

In reality, bank lending has increased in the last year. Inter-bank lending is still occurring although it is down over the last year. Commercial paper rates have fallen and are below last year for all categories. The spreads have fallen but are still wide by historical standards, but the absolute levels of rates are lower. CFO’s are paying less on their funds. Non-financial CP outstanding is higher than last year. Financial CP has increased and matches levels from mid-2007. Asset-backed Cp has fallen significantly and this is where we have seen large deleveraging and shrinking of credit. What has not been shown by the government is the link between ABS CP and other credit lines and how this has affected many companies.



The Fed has done a good job of helping with the credit problems and they may be the reason for the expansion, but the problem is more complex than what many have suggested and clearer information and data is needed to make new policies.

Thursday, January 8, 2009

Size of deficit is staggering

The size of the fiscal deficit will be huge for the next few years. The Congressional Budget Office produced their projections of the deficit which is usually more accurate than OMB. We are looking at over $1 trilli0n in fiscal 2009, but this does not include the new administration agenda which is supposed to be anywhere from $775 to $1 trillion plus over the next two to three years. Let's assume that the money is allocated as $400 billion in 2009, $400 billion in 2010 and $200 billion in 2011. This will mean that we will look at two years of over $1 trillion deficits and a 2011 number of approximately $750 billion. If the CBO is off by 10% and the recession lasts longer we could easily see the deficit being over or close to a trillion dollars every year of the Obama Administration.

So now the question is where is the financing going to come especially if foreign governments like the China will be borrowing or investing to help their own economies. Look at the size of the auctions that will have to take place. Quarter debt raising will have to exceed $250 billlion, more than the size of the annual deficit just two years ago. There will have to be longer-term debt issued but it will be at very low rates. This is unlike the 1980's when debt was issued at high coupons and provided a good opportunity for investors. The only way that this an be solved is through inflated the economy with the Fed buying more Treasury paper.

Tuesday, January 6, 2009

A new Taylor rule with asset inflation as a guide?

The Taylor rule has been a good model to describe the past behavior of the Fed and is also a good model for potentially setting the Fed funds rate to meet the dual goals of controlling inflation and maintain growth. Unfortunately, this rule is going to have to be adjusted under the new environment of zero interest rates. There can be some allowances for the new environment but a bigger concern is the fact that the Fed was unable to see or act on the bubble in financial markets.

There is a strong argument to be made that it is extremely difficult to see a bubble while it is occurring although the evidence is mounting that we had all of the information needed to tell us that the housing market was out of control. What some would argue is that we could have an adjusted Taylor rule which accounts for asset price inflation which could help with the targeting of interest rates. The argument for looking at financial asset prices is twofold. First, the wealth effect is significant. The changes in wealth are very important to a developed economy that is less reliant on industrial production and more levered. Second, is the fact that assets price increases could represent a form of inflation not captured in the CPI. There is asset inflation as well as goods inflation. To look at only one part does not make a lot of sense. We could have low price inflation while seeing “inflated” asset prices.

A direct examination of financial prices is very relevant for central bankers. In this case, the spread on corporate bond may be one measure of asset price inflation. Tight spreads would tell central bankers that the market is forcing down premia or inflating the price of risky assets. The fed could target the TED or corporate spreads as ameasure of loose or tight policies now that the Fed funds rate is near zero.

Another alternative would be a direct measure of equity prices. Of course, this has inherent difficulties. A growing economy could see rising equity prices that are unrelated to inflation, yet it may be the time to have further discussion on how to measure financial tightness in a systematic fashion and use this for controlling policy. Most of the risks that have been faced in the last two years have been associated with dislocations in the asset or credit markets and not with direct goods inflation so a measure that look at these risks may better serve the Fed.

When Treasuries are taken to zero, corporates look good

What would you rather hold? A 5-year Treasury which is priced at a break-even inflation rate of under 20 bps versus TIPS or a corporate bond that may be propped up by the government. This should be a no brainer trade especially given the wide spreads which place us at the worst corporate debt risk since the Depression. Trade inflation risk for credit risk when we are seeing further deterioration in the economy would seem like a silly thing to do except if the spread is hefty enough and the absolute level of Treasuries is low enough. We may have those conditions. While there will be significant defaults and low recoveries, there is the flip side that the government has a large stimulus package to take effect in the Spring and there has been aggression action in the the money market to providing liquidity for commercial paper. Now we are seeing the Fed of New York actually buying mortgage paper.

Corporate spreads usually do not tighten until the employment level has peaked but the spread widening in corporate has been associated with a liquidity crunch which has extended beyond the probability of default and recovery. There is also a liquidity risk which was not present before in these markets, so investors are getting paid for more than just default risk.

While nothing a no-brainer, there have been periods when fixed incom outperforms stocks and the corporate bond market especially for investment grade may be a better bet than the equity alternative.

Paulson taking the long view with the global imbalance story – but how will it end


Treasury secretary Paulson commented that the root cause of the credit crisis was the global imbalance around the world. This is a story which has been discussed in international finance circles for years. The flow of funds into the US created the bubble as the risk premium for asset was pushed lower from the large flow of funds. The flow imbalance showed up in the current account deficit.

The international finance argument is that the imbalances between saver and debtor countries led to the large current account dislocations. If these dislocations get too large, there is greater likelihood of a sudden stop in the currency market in order to correct the imbalance. The large current account deficit countries like the US will have to see a dollar decline in order to help bring the deficit imbalance back to equilibrium. Once the current account reaches, and extreme there will be a sudden stop as the global financial markets realize the unsustained nature of the deficit.

This global imbalance story is a theme that will continue to drive thinking for the next few years regardless of what happens with the world economic slowdown. It is good to review this story within the context of the two major imbalance paradigms. The traditional view or global threat story focuses on the imbalance as a monetary and fiscal dislocation which can become a significant dollar and rate funding problem because the current account deficit is unsustainable. The new paradigm of global imbalances states that it is a consequence of economic and fundamental globalization. It will not lead to a sudden stop in the dollar to current the current account deficit because the imbalance is structural and will not go away easily. The answer to this imbalance problem and how we choose to deal with it will be a key to how the global growth problem is solved.

The new paradigm states that the current account deficit may get larger without any adverse impact because of the long-term economic imbalances that are unrelated to short-term economic issues. For example, one view of the imbalance issue is that there is a less of savings problem to begin with. The savings rate as measured by the difference between income and consumption is low which would suggest that investment has to be funded from abroad, but saving in the US is not measured properly in the first place. The US does not account for savings in the form of durable goods purchased, education, R&D, and wealth effects unrelated to current income. Currently, we are seeing an increased in measured savings but in reality it is a change in the composition of savings as durable goods purchases decrease and dollar savings increase. Our actual savings rate is closer to 19% well above the number thrown out as less than 5% of income. Hence, the current account deficit could be related to other issues not the fact that the savings rate is low.

The savings argument as a long-term issue can be extended by the fact that the difference in savings rates across countries is related to demographic. As a country’s population ages, there is greater savings relative to countries that are younger. The increased savings in Japan, China, and Europe are matched by rapidly aging population which means that they will have excess savings versus, say the US, which has a younger population. The excess savings in an open global market will seek that place where it can be easily invested which means the US. Under this case, the current account deficit should be looked at through a lens of benign neglect. This capital movement is a natural part of the flow of capital between those places that have excess savings because of demographics. This is a process that cannot be changed and should not be altered through some policies to adjust the dollar at this time. This does not mean the problem should be ignored, but higher current account deficits could be sustained in the US because of the longer-term aging imbalance problem.

The new paradigm has also offered what some have called the Bretton Woods II story as another alternative which can explain a long and sustained imbalance. This story states that exchange rates have been kept low by many developed countries to foster exports. These exports were financed by the producer countries through investing profits back to the consumer countries. Emerging market money flowed back to the US to finance the trade deficit form the goods produced in those countries.

In this scenario, each group got what it wanted, yet this may be the dangerous story for 2009. At this point there is less desire to continue this process by both parties but it will not be easy for any one group to decide to get off this wild ride. Exporters have to worry about lay-offs in their countries so there is little incentive to allow exchange rates to appreciate to offset the long-term imbalances. The consuming countries have been delevering but the pain of pulling back consumption is real. However, if the consumer countries try to change the mix of goods sold from imports to domestic consumption, there could be a spiral of actions which harm all parties. One way for the change in consumption mix to occur is through tariffs on imports which could lead to the savings-export countries to cut back their investments in the US. This breakdown of the new order could be the envisioned sudden stop; however, we will have some signs of this type of direction before there is a crisis.

The third story for the sustainability of the current account deficit is the exorbitant privilege argument which states that the high return on foreign assets the US receives offsets the cost of the financing as measured by the interest income on the liabilities of the US assets bought by foreigners. The US finance at low rates while receiving higher long-term foreign equity returns. This process has allowed the current account deficit to grow and stay in equilibrium because the returns have been higher than normal. The US as a reserve currency has been able to finance at a lower rate than what has been the case for other countries. This may continue given the lower rate in the US for the short-run, but there may be a growing awareness of the investment shortfall from holding Treasuries. Additionally, many of the foreign investments by the US which have been more in equities have fallen sharply from the global decline. If these declines are sustained, then the privilege gained by the US will be diminished.

The capital flow argument is that the US is able to sustain the current account deficits because it has the most liquid markets in the world as well as the best legal and regulatory environment for investors. Given these liquid deep markets with strong investor protections, there will be a natural movement to the US as the rest of the world gains excess savings. Foreign countries do not have the deep liquid markets to allow for the protection of savings. Unfortunately, this will be put to the test in the next year. Changing the rules of investors so they are less protected will have negative impact on the perceived value for the holding US assets.

While we are believers in the new paradigm arguments, these arguments will be put to the test in the next year which could mean mounting pressure on the dollar as the delevering story ends. Key issues to watch for: (1) a change in the market environment which makes the US less investor friendly; (2) growing discussion of tariffs which will cut imports and cause a capital retaliation; (3) increased comments of currency manipulation about some countries which have been net exports; (4) sustained poor equity markets which reduces the gains from foreign investments by the US. None of these issues are new, but there will be renewed focus on these key policy issues which will feedback on the current account deficit issue.