Global Financial Risks and the Fed
Carlos M. Pelaez
© Carlos M. Pelaez, 2010, 2011
The objective of this post is analyzing global financial risks as revealed by the threat of stagflation, augmented by sovereign risks and having impact on valuations of risk financial assets. The contents are as follows:
I Stagflation
II Sovereign Risks
III Valuations of Risk Financial Assets
IV Economic Indicators
V Interest Rates
VI Conclusion
References
I Stagflation. There is inflation everywhere in the world economy, with slow growth and persistently high unemployment in advanced economies. Table 1, updated with every post, provides the latest yearly data for GDP, consumer price index (CPI) inflation, producer price index (PPI) inflation and unemployment (UNE) for the advanced economies, China and the highly-indebted European countries with sovereign risk issues. The table now includes the Netherlands and Finland that with Germany make up the set of northern countries in the euro zone that hold key votes in the enhancement of the mechanism for solution of the sovereign risk issues (http://www.ft.com/cms/s/0/55eaf350-4a8b-11e0-82ab-00144feab49a.html#axzz1G67TzFqs). Stagflation is still an unknown event but the risk is sufficiently high to be worthy of consideration. The analysis of stagflation also permits the identification of important policy issues in solving vulnerabilities that have high impact on global financial risks. There are four key interrelated vulnerabilities in the world economy that have been causing global financial turbulence: (1) sovereign risk issues in Europe resulting from countries in need of fiscal consolidation and enhancement of their sovereign risk ratings; (2) the tradeoff of growth and inflation in China; (3) slow growth (see http://cmpassocregulationblog.blogspot.com/2011/02/mediocre-growth-raw-materials-shock-and.html) and continuing job stress of 25 to 30 million people in the US (see http://cmpassocregulationblog.blogspot.com/2011/03/unemployment-and-undermployment.html); and (4) the timing, dose, impact and instruments of normalizing monetary and fiscal policies (see http://cmpassocregulationblog.blogspot.com/2011/02/policy-inflation-growth-unemployment.html) in advanced and emerging economies. This section considers possible effects of normalizing monetary policy. The following section II focuses on sovereign risk issues in Europe.
Table 1, GDP Growth, Inflation and Unemployment in Selected Countries, Percentage Annual Rates
| GDP | CPI | PPI | UNE | |
| US | 2.7 | 1.6 | 3.6 | 8.9 |
| Japan | 2.5 | 0.0 | 1.7 | 4.9 |
| China | 9.8 | 4.9 | 7.2 | |
| UK | 1.5 | 4.0 | 5.3* output 14.6 input 8.5** | 7.9 |
| Euro Zone | 2.0 | 2.4 | 6.1 | 9.9 |
| Germany | 4.0 | 2.1 | 5.5 | 6.5 |
| France | 1.5 | 1.8 | 5.5 | 9.6 |
| Nether-lands | 2.4 | 2.0 | 10.3 | 4.3 |
| Finland | 5.0 | 3.1 | 8.1 | 8.0 |
| Belgium | 1.8 | 2.9 | 9.0 | 8.0 |
| Portugal | 1.2 | 3.64 | 5.7 | 11.2 |
| Ireland | 1.7 | 4.0 | 13.5 | |
| Italy | 1.5 | 2.1 | 4.6 | 8.6 |
| Greece | -6.6 | 5.2 | 6.7 | 12.4 |
| Spain | 0.6 | 3.3 | 6.8 | 20.4 |
Notes: GDP: rate of growth of GDP; CPI: change in consumer price inflation; PPI: producer price inflation; UNE: rate of unemployment; all rates relative to year earlier
*Feb Office for National Statistics http://www.statistics.gov.uk/pdfdir/ppi0311.pdf
** Jan EUROSTAT http://epp.eurostat.ec.europa.eu/cache/ITY_PUBLIC/4-02032011-AP/EN/4-02032011-AP-EN.PDF
Source: EUROSTAT; country statistical sources http://www.census.gov/aboutus/stat_int.html
Wall Street Journal Professional Factiva
The DJ-UBS Commodity index has increased 31.7 percent since a low on Jul 2, 2010 (see Table 7 below in section III on Valuations of Risk Financial Assets). According to market data from the Financial Times, Brent crude oil was last priced at $113.84/barrel and has increased by 43.3 percent in the past 52 weeks; the crude oil front month futures was priced in NYMEX at $100.59/barrel, increasing 24.1 percent in the past 52 weeks; COMEX gold 1 futures chain front month was last priced at $1423/ounce, increasing by 29.2 percent in the past 52 weeks; copper high grade front month futures was last priced at CMX at 421.20 cents, increasing by 24.9 percent in the past 52 weeks; and corn front month futures was priced at 660.00 cents at CBT, increasing 85.9 percent in the past 52 weeks (http://markets.ft.com/markets/commodities.asp). Oil prices fell after the closing of refineries caused by the earthquake and tsunami in Japan. The current economic environment could have risk of repeating the stagflation of the 1970s. Table 2 provides the rate of yearly growth of GDP, CPI inflation and UNE (rate of unemployment) from 1969 to 1982. Double digit inflation rates plagued the 1970s with the economy running in “stop and go” episodes. The Fed raised the fed funds rate with the effective rate reaching 22.36 percent on Jul 22 of 1981 (http://www.federalreserve.gov/releases/h15/data/Daily/H15_FF_O.txt). The rate of unemployment rose to 9.7 percent in 1982. Several countries that had borrowed for financing balance of payments deficits declared moratoriums on their foreign debts, impairing balance sheets of money-center banks. The increase in interest rates to deal with stagflation caught the banking industry with short-dated funding and long-term fixed-rate assets. In a parallel of what could happen when the Fed abandons its near zero interest rates, 1150 US commercial banks, around 8 percent of the industry, failed, almost twice the number of banks that failed from establishment of the FDIC in 1934 until 1983 (Benston and Kaufman 1997, 139; see Pelaez and Pelaez, Regulation of Banks and Finance (2009b), 72-7). More than 900 savings and loans associations, equivalent to around 25 percent of the industry, had to be closed, merged or placed in conservatorship (Ibid). Taxpayer funds in the value of $150 billion were used in the resolution of failed savings and loans institutions. In terms of relative dimensions, $150 billion was equivalent to 2.6 percent of GDP of $5800 billion in 1990 and 3.6 percent of GDP of $4217 billion in 1985 (http://www.bea.gov/national/nipaweb/TableView.asp?SelectedTable=5&ViewSeries=NO&Java=no&Request3Place=N&3Place=N&FromView=YES&Freq=Year&FirstYear=1980&LastYear=1990&3Place=N&Update=Update&JavaBox=no). The equivalent in terms of 2.6 to 3.6 percent of US GDP in 2010 of $14,657 billion would be $381 billion to $528 billion (data from Ibid). Wide swings in interest rates resulting from aggressive monetary policy can wreck the balance sheets of families, financial institutions and companies while posing another recession risk. While it is true that the Fed can increase interest rates instantaneously, the increase from zero percent toward much higher levels to contain inflation can have devastating effects on the world economy. The Financial Times/Harris Poll finds that few respondents in the major economies of Europe and the US are not concerned of being affected by inflation (http://www.ft.com/cms/s/0/0354c278-3d0d-11e0-bbff-00144feabdc0.html#axzz1Ead9yEL8). About 40 percent of respondents in the UK, US and Germany expect strong or very strong effects from inflation and 60 percent in Spain and France.
Table 2, US Annual Rate of Growth of GDP and CPI and Unemployment Rate 1969-1982
| ∆% GDP | ∆% CPI | UNE | |
| 1969 | 3.1 | 6.2 | |
| 1970 | 0.2 | 5.6 | |
| 1971 | 3.4 | 3.3 | |
| 1972 | 5.3 | 3.4 | |
| 1973 | 5.8 | 8.7 | |
| 1974 | -0.6 | 12.3 | |
| 1975 | -0.2 | 6.9 | |
| 1976 | 5.4 | 4.9 | 7.7 |
| 1977 | 4.6 | 4.7 | 7.1 |
| 1978 | 5.6 | 9.0 | 6.1 |
| 1979 | 3.1 | 13.3 | 5.8 |
| 1980 | -0.3 | 12.5 | 7.1 |
| 1981 | 2.5 | 8.9 | 7.6 |
| 1982 | -1.9 | 3.8 | 9.7 |
Note: GDP: Gross Domestic Product; CPI: consumer price index; UNE: rate of unemployment
Source: ftp://ftp.bls.gov/pub/special.requests/cpi/cpiai.txt
http://www.bls.gov/web/empsit/cpseea01.htm
There are diverging views by the Fed and the European Central Bank (ECB) in the analysis of the economy, inflation and financial markets, projections of growth and inflation and policy stand. This divergence is partly revealed in the forecasts of the Fed and the ECB shown in Table 3. GDP growth in 2011 and 2012 is projected to be higher in the US by the Fed than in the euro area by the ECB. The Fed emphasizes core PCE (personal consumption expenditures) inflation, which is more subdued currently and in the forecast than the inflation yardstick of the ECB, which is the harmonized consumer price index (HCPI). An important element in the Fed’s view is that the rate of unemployment will continue to be high such that the job stress in the US economy will prolong over many years. There are significant differences in the analysis of the economy and financial markets by the Fed and the ECB, which are discussed in turn.
Table 3, Forecasts of GDP and Inflation and Policy Rates of the Fed and the European Central Bank %
| 2011 | 2012 | |
| Fed | ||
| GDP | 3.4 to 4.5 | 3.5 to 4.5 |
| PCE inflation | 1.1 to 2.0 | 1.3 to 2.0 |
| Core PCE | 1.0 to 1.9 | 1.2 to 1.9 |
| Fed funds rate* | 0 to 0.25 | |
| Unemployment | 8.2 to 8.5 | 6.6 to 7.5 |
| ECB | ||
| GDP | 1.3 to 2.1 | 0.8 to 2.8 |
| HCPI inflation | 2.0 to 2.6 | 1.0 to 2.4 |
| Main refinancing* | 1.00 |
*On March 11, 2011
Note: PCE (personal consumption expenditures), HCPI: harmonized index of consumer prices; the policy rates of the Fed (fed funds rate) and ECB (main refinancing) are for Mar 11, 2011.
Source: http://www.federalreserve.gov/monetarypolicy/files/fomcminutes20100127.pdf
http://www.ecb.int/pub/pdf/mobu/mb201103en.pdf
A critical source of the view of the Governing Council of the ECB (GC-ECB) is the Editorial published after their meeting in the ECB’s Monthly Bulletin (http://www.ecb.int/pub/mb/editorials/2011/html/mb110310.en.html?CSRT=1011510846816516863). The crucial phrases in the current Editorial are: “Strong vigilance is warranted with a view to containing upside risks to price stability. Overall, the Governing Council remains prepared to act in a firm and timely manner to ensure that upside risks to price stability over the medium term do not materialize. The continued firm anchoring of inflation expectations is of the essence.” The phrase “strong vigilance” could indicate an increase in interest rates in the next meeting of the GC-ECB (http://noir.bloomberg.com/apps/news?pid=20601087&sid=auUD1rgy5E.c&pos=3). The ECB used this phrase in 2005 to 2007 to indicate rate increases in the next meeting (Atkins and Dennis 2011Mar3). The GC-ECB analyzes inflation in terms of commodity prices that could have secondary effects on overall inflation:
“With regard to price developments, euro area annual HICP inflation was 2.4% in February 2011, according to Eurostat’s flash estimate, after 2.3% in January. The increase in inflation rates in early 2011 largely reflects higher commodity prices. Pressure stemming from the sharp increases in energy and food prices is also discernible in the earlier stages of the production process. It is paramount that the rise in HICP inflation does not lead to second-round effects and thereby give rise to broad-based inflationary pressures over the medium term. Inflation expectations over the medium to longer term must remain firmly anchored in line with the Governing Council’s aim of maintaining inflation rates below, but close to, 2% over the medium term.”
The ECB (2004) finds that oil price increases eventually cause deterioration of the terms of trade of Europe, export prices divided by import prices, which has adverse effects on GDP levels and employment. ECB (2004) researched oil price increases of 270 percent in 1973-1974, 187 percent in 1978-1979 and 56 percent in 2003-2004. The analysis of the ECB (2004) is that there are various interrelated channels of effects of oil prices on inflation (see Pelaez and Pelaez, The Global Recession Risk (2007), 119-27). Petroleum derivatives have a first round impact on consumer prices through their weights measured by price indexes. Producer prices are affected because petroleum derivatives are inputs in production. The second round is characterized by inflationary expectations resulting from the increase in consumer prices. Wage pressures tend to develop by combination of increases in consumer prices and expectations of higher prices. The ECB (2004) measures that an increase in oil prices of 10 percent results in an increase in consumer prices of 1.5 percentage points spread throughout a period of six months. The HICP has an immediate increase of 0.1 to 0.2 percentage points because of the energy weight of 8 to 9 percent in the price index. There is pass-through of the increase of energy prices to production costs that subsequently raises consumer prices but by less than the direct price increases. The second round is characterized by the combination of inflation expectations and wage negotiations.
The ECB (2004) argues that monetary policy has a role in preventing secondary round effects of energy shocks on inflation. In accordance with Kydland and Prescott (1977), credibility in inflation control is critical in preventing exacerbated inflationary expectations. Thus, the emphasis of the GC-ECB is that “anchoring of inflation expectations is of the essence” (http://www.ecb.int/pub/mb/editorials/2011/html/mb110310.en.html?CSRT=1011510846816516863). The risk of not taking action is that the ECB could be anticipated as complacent with inflation if the economy is not growing at full capacity, resulting in higher inflation that can flatten the growth path of the economy when stronger action is required.
The GC-ECB also expresses concern with fiscal adjustment to prevent the use of the heavy hand of interest rate increases in inflation control (Ibid):
“Turning to fiscal policies, all governments need to fully implement their fiscal consolidation plans in 2011. Where necessary, additional corrective measures must be implemented swiftly to ensure progress in achieving fiscal sustainability. Beyond 2011 countries need to specify ambitious and concrete policy measures in their multi-year adjustment programmes, so as to underpin the credibility of their fiscal consolidation targets of ensuring a rapid correction of excessive deficits and returning to a close-to-balance or surplus position. Strengthening confidence in the sustainability of public finances is key, as this will reduce interest rate risk premia and improve the conditions for sound and sustainable growth” (see also http://www.ft.com/cms/s/0/03201c64-4bf2-11e0-9705-00144feab49a.html#axzz1G67TzFqs).
The ECB has been stressing the need for fiscal prudence as a complementary policy of central bank policy (see Pelaez and Pelaez, The Global Recession Risk (2007), 127-35).
Chairman Bernanke (2011Mar1, 4-5) summarizes the current Fed view for continuing monetary accommodation:
“The pace of recovery slowed last spring--to a rate that, if sustained, would have been insufficient to make meaningful progress against unemployment. With job creation stalling, concerns about the sustainability of the recovery increased. At the same time, inflation--already at very low levels--continued to drift downward, and market-based measures of inflation compensation moved lower as investors appeared to become more concerned about the possibility of deflation, or falling prices.”
The Fed has a dual mandate of “conducting the nation’s monetary policy by influencing the monetary and credit conditions in the economy in pursuit of maximum employment, stable prices, and moderate long-term interest rates” (http://www.federalreserve.gov/aboutthefed/mission.htm). That mandate would require monetary accommodation under current and forecast conditions in the view of the Federal Open Market Committee (FOMC). With the fed funds rate at the zero bound of 0 to ¼ percent per year since Dec 16, 2008, the Fed has engaged in additional “nonconventional” policy of purchasing long-term securities of $1.7 trillion in Dec 2008 to Mar 2009 and reinvesting interest and maturing principal in long-term Treasury securities after Aug 2010 plus purchase of an additional $600 billion after Nov 3, 2010 (http://www.federalreserve.gov/newsevents/press/monetary/20101103a.htm).
The Fed view of pass-through of commodity price increases to inflation is also analyzed by Bernanke (2011Mar1, 3-4; see also Dudley 2011NYUS, 2011NYSC):
“Although overall inflation is low, since summer we have seen significant increases in some highly visible prices, including those of gasoline and other commodities. Notably, in the past few weeks, concerns about unrest in the Middle East and North Africa and the possible effects on global oil supplies have led oil and gasoline prices to rise further. More broadly, the increases in commodity prices in recent months have largely reflected rising global demand for raw materials, particularly in some fast-growing emerging market economies, coupled with constraints on global supply in some cases. The rate of pass-through from commodity price increases to broad indexes of U.S. consumer prices has been quite low in recent decades, partly reflecting the relatively small weight of materials inputs in total production costs as well as the stability of longer-term inflation expectations. Currently, the cost pressures from higher commodity prices are also being offset by the stability in unit labor costs. Thus, the most likely outcome is that the recent rise in commodity prices will lead to, at most, a temporary and relatively modest increase in U.S. consumer price inflation--an outlook consistent with the projections of both FOMC participants and most private forecasters.”
Chairman (Bernanke 2011Mar1, 4) emphasizes that the “we will continue to monitor these developments closely and are prepared to respond as necessary to best support the ongoing recovery in a context of price stability.” Several presidents of regional Federal Reserve banks are raising concerns about the program of quantitative easing (http://noir.bloomberg.com/apps/news?pid=20601087&sid=aO3Hvikh6xAU&pos=4). The line “reserve bank credit” in the Fed balance sheet for Mar 9, 2011, is $2560 billion, or $2.6 trillion, with portfolio of long-term securities of $2333 billion, or $2.3 trillion, composed $1185 of long-term nominal notes and bonds, $56 billion of long-term indexed notes and bonds, $143 billion of federal agency debt securities, and $949 billion of mortgage-backed securities; reserve balances with federal reserve banks stood at $1379 billion, or $1.4 trillion (http://www.federalreserve.gov/releases/h41/current/h41.htm#h41tab1).
In the period 1857-1906 of rapid growth and expanding world trade, British export prices declined at the rate of 0.5 percent per year while the world economy grew rapidly (Imlah 1958, Pelaez, 1976a). In 1860-1900, Brazil’s inflation was 1.6 percent per year likely because of sustained fiscal profligacy (Pelaez and Suzigan 1978, 143; see Pelaez 1974, 1975, 1976b, 1977, 1979; Pelaez and Suzigan 1978, 1981). High inflation also coexisted with abundant slack in the economy in the second half of the 1980s (Pelaez 1986, 1987). We know much less about inflation than simple analysis that inflation only occurs and accelerates when the economy is moving to full capacity utilization.
Bloomberg has captured that participants in financial markets are searching a resemblance of a possible interest rate hike with the bond-market crash of 1994 (http://noir.bloomberg.com/apps/news?pid=20601087&sid=axVtDrKVjOMs&pos=7). The bond market crash is commonly used in stress tests by financial institutions (Pelaez and Pelaez, International Financial Architecture (2005), 114-5; Pelaez and Pelaez, The Global Recession Risk (2007), 206; Pelaez and Pelaez, Globalization and the State, Vol. I (2008a), 97, Government Intervention in Globalization (2009c), 63-4). The bond market crash of 1994 was caused by nonexistent “fear of inflation” in contrast with nonexistent “fear of deflation” in the current decade. The FOMC doubled the target of the fed funds rate from 3.00 percent in Jan 1994 to 6.00 percent in Dec. There is no technical explanation in theory or empirical measurement for this inflation hunting. Table 4 provides the yields of the 30-year Treasury bond (30Y), the 10-year Treasury note (10Y) and the 12-month consumer price inflation. The price of the 30-year Treasury bond (30P) is calculated by assuming that the coupon is equal to the yield in Jan of 6.29 percent and then calculating the price of a bond maturing in exactly 30 years. The price of the 10-year Treasury note (10P) is calculated by assuming that the coupon is equal to the yield in Jan of 5.75 percent and then calculating the price of a bond maturing in exactly 10 years. Thus, the prices of both the 30-year Treasury bond and the 10-year Treasury note are exactly 100.00 in Jan. In reality bond coupons were different and maturities not exactly 30 or 10 years. However, the exercise does provide a measure of the collapse of bond prices resulting from Fed policy. The data do coincide with the expectations hypothesis of the term structure (Ingersoll 1987, 387-92) that a shock of short-term interest rates causes increases in yields of long-term securities: the yield of the 30-year Treasury bond rose 158 basis points as fed funds rates doubled; the yield of the 10-year Treasury note rose 206 basis points; and the 30-year conforming mortgage rate jumped 214 basis points. The pain in the bond market is shown by a decline of the price of the 30-year Treasury bond (30P) by 18.1 percent and of the 10-year Treasury note (10P) by 14.1 percent from Jan to Dec 1994. The capital loss of fixed-income market valuations worldwide could have been as high as $3 trillion, or 42.3 percent of US GDP of $7085 billion in 1994 (http://www.bea.gov/national/nipaweb/TableView.asp?SelectedTable=5&ViewSeries=NO&Java=no&Request3Place=N&3Place=N&FromView=YES&Freq=Year&FirstYear=1992&LastYear=1996&3Place=N&Update=Update&JavaBox=no). The Fed courted a global recession with the doubling of the fed funds rate but had no effect on consumer prices as shown in the last column of Table 4: the 12-month rates of the US CPI remained in a tight range of 2.29 to 2.69 percent with no evidence of acceleration in 1994 and with most 12-month rates below 2.69 percent with the exception of 2.77 percent in Jul and 2.96 percent in Sep. There is a long lag in effect of monetary policy impulses on inflation (Romer and Romer 2004) such that Fed policy is not likely to have prevented inflation higher than what it would have been without this policy of inflation hunting. What the episode does show is that there is no rigorous theory or empirical knowledge justifying these aggressive monetary policy impulses that have propelled to magnified shocks in the current decade.
Table 4, Fed Funds Rates, Thirty and Ten Year Treasury Yields and Prices, 30-Year Mortgage Rates and 12-month CPI Inflation 1994
| 1994 | FF | 30Y | 30P | 10Y | 10P | MOR | CPI |
| Jan | 3.00 | 6.29 | 100 | 5.75 | 100 | 7.06 | 2.52 |
| Feb | 3.25 | 6.49 | 97.37 | 5.97 | 98.36 | 7.15 | 2.51 |
| Mar | 3.50 | 6.91 | 92.19 | 6.48 | 94.69 | 7.68 | 2.51 |
| Apr | 3.75 | 7.27 | 88.10 | 6.97 | 91.32 | 8.32 | 2.36 |
| May | 4.25 | 7.41 | 86.59 | 7.18 | 88.93 | 8.60 | 2.29 |
| Jun | 4.25 | 7.40 | 86.69 | 7.10 | 90.45 | 8.40 | 2.49 |
| Jul | 4.25 | 7.58 | 84.81 | 7.30 | 89.14 | 8.61 | 2.77 |
| Aug | 4.75 | 7.49 | 85.74 | 7.24 | 89.53 | 8.51 | 2.69 |
| Sep | 4.75 | 7.71 | 83.49 | 7.46 | 88.10 | 8.64 | 2.96 |
| Oct | 4.75 | 7.94 | 81.23 | 7.74 | 86.33 | 8.93 | 2.61 |
| Nov | 5.50 | 8.08 | 79.90 | 7.96 | 84.96 | 9.17 | 2.67 |
| Dec | 6.00 | 7.87 | 81.91 | 7.81 | 85.89 | 9.20 | 2.67 |
Notes: FF: fed funds rate; 30Y: yield of 30-year Treasury; 30P: price of 30-year Treasury assuming coupon equal to 6.29 percent and maturity in exactly 30 years; 10Y: yield of 10-year Treasury; 10P: price of 10-year Treasury assuming coupon equal to 5.75 percent and maturity in exactly 10 years; MOR: 30-year mortgage; CPI: percent change of CPI in 12 months
Sources: yields and mortgage rates http://www.federalreserve.gov/releases/h15/data.htm CPI ftp://ftp.bls.gov/pub/special.requests/cpi/cpiai.txt
The monetary policy shock in the US in 1994 was transferred throughout the world and from the market for Treasury securities to other classes of fixed income such as mortgage-backed securities and derivatives (Pelaez and Pelaez, The Global Recession Risk (2007), 206-7). There were significant losses in high-duration securities reinforced by dumping of duration in portfolios to compensate and avoid losses much as it happened in the financial crisis after 2007 (Brunnermeier and Pedersen 2009). Decoupling of bond prices in Europe and the US did not occur with eventual crash of European bond prices that deteriorated throughout 1994. The correlation of stock markets of the US, European Union and Japan was measured as only 0.40 and of bond yields as only 0.18. The tightening of monetary policy in the US was an important factor in the Mexican crisis of 1995 with GDP growth of 4 percent in 1994 converting into contraction of 6 percent in 1999 (Mishkin 1999, 3). Aftershocks were experienced in Argentina and Brazil.
Table 5, updated with every blog, provides in the second column the yield at the close of market of the 10-year Treasury on the date in the first column. The price in the third column is calculated with the coupon of 2.625 percent of the 10-year note current at the time of the second round of quantitative easing after Nov 3, 2010 and the final column “∆% 11/04/10” calculates the percentage change of the price on the date relative to that of 101.2573 at the close of market on Nov 4, 2010, one day after the decision on quantitative easing by the Fed on Nov 3, 2010. Prices with the new coupon of 3.63 percent in recent auctions (http://www.treasurydirect.gov/instit/annceresult/press/preanre/2011/2011.htm) are not comparable to prices in Table 5. The highest yield in the decade was 5.510 percent on May 1, 2001 that would result in a loss of principal of 22.9 percent relative to the price on Nov 4. The Fed has created a “duration trap” of bond prices. Duration is the percentage change in bond price resulting from a percentage change in yield or what economists call the yield elasticity of bond price. Duration is higher the lower the bond coupon and yield, all other things constant. This means that the price loss in a yield rise from low coupons and yields is much higher than with high coupons and yields. Intuitively, the higher coupon payments offset part of the price loss. Prices/yields of Treasury securities were affected by the combination of Fed purchases for its program of quantitative easing and also by the flight to dollar-denominated assets because of geopolitical risks in the Middle East. The yield of 3.401 percent at the close of market on Mar 11 would be equivalent to price of 93.4727 in a hypothetical bond maturing in 10 years with coupon of 2.625 percent for price loss of 7.7 percent relative to the price on Nov 4, 2010, one day after the decision on the second program of quantitative easing. If inflation accelerates, yields of Treasury securities may rise sharply. Yields are not observed without special yield-lowering effects such as the flight into dollars caused by the events in the Middle East, continuing purchases of Treasury securities by the Fed and now the tragic earthquake and tsunami affecting Japan and possibly other regions. Important causes of the rise in yields shown in Table 5 are expectations of rising inflation and US government debt estimated to reach 75 percent in 2012 (http://cmpassocregulationblog.blogspot.com/2011/02/policy-inflation-growth-unemployment.html
Table 5, Yield, Price and Percentage Change to November 4, 2010 of Ten-Year Treasury Note
| Date | Yield | Price | ∆% 11/04/10 |
| 05/01/01 | 5.510 | 78.0582 | -22.9 |
| 06/10/03 | 3.112 | 95.8452 | -5.3 |
| 06/12/07 | 5.297 | 79.4747 | -21.5 |
| 12/19/08 | 2.213 | 104.4981 | 3.2 |
| 12/31/08 | 2.240 | 103.4295 | 2.1 |
| 03/19/09 | 2.605 | 100.1748 | -1.1 |
| 06/09/09 | 3.862 | 89.8257 | -11.3 |
| 10/07/09 | 3.182 | 95.2643 | -5.9 |
| 11/27/09 | 3.197 | 95.1403 | -6.0 |
| 12/31/09 | 3.835 | 90.0347 | -11.1 |
| 02/09/10 | 3.646 | 91.5239 | -9.6 |
| 03/04/10 | 3.605 | 91.8384 | -9.3 |
| 04/05/10 | 3.986 | 88.8726 | -12.2 |
| 08/31/10 | 2.473 | 101.3338 | 0.08 |
| 10/07/10 | 2.385 | 102.1224 | 0.8 |
| 10/28/10 | 2.658 | 99.7119 | -1.5 |
| 11/04/10 | 2.481 | 101.2573 | - |
| 11/15/10 | 2.964 | 97.0867 | -4.1 |
| 11/26/10 | 2.869 | 97.8932 | -3.3 |
| 12/03/10 | 3.007 | 96.7241 | -4.5 |
| 12/10/10 | 3.324 | 94.0982 | -7.1 |
| 12/15/10 | 3.517 | 92.5427 | -8.6 |
| 12/17/10 | 3.338 | 93.9842 | -7.2 |
| 12/23/10 | 3.397 | 93.5051 | -7.7 |
| 12/31/10 | 3.228 | 94.3923 | -6.7 |
| 01/07/11 | 3.322 | 94.1146 | -7.1 |
| 01/14/11 | 3.323 | 94.1064 | -7.1 |
| 01/21/11 | 3.414 | 93.4687 | -7.7 |
| 01/28/11 | 3.323 | 94.1064 | -7.1 |
| 02/04/11 | 3.640 | 91.750 | -9.4 |
| 02/11/11 | 3.643 | 91.5319 | -9.6 |
| 02/18/11 | 3.582 | 92.0157 | -9.1 |
| 02/25/11 | 3.414 | 93.3676 | -7.8 |
| 03/04/11 | 3.494 | 92.7235 | -8.4 |
| 03/11/11 | 3.401 | 93.4727 | -7.7 |
Note: price is calculated for an artificial 10-year note paying semi-annual coupon and maturing in ten years using the actual yields traded on the dates and the coupon of 2.625% on 11/04/10
Source:
http://online.wsj.com/mdc/public/page/mdc_bonds.html?mod=mdc_topnav_2_3020
II Sovereign Risks. There are two important developments in the resolution of sovereign risk issues. First, at the meeting on Mar 11, 2011, the heads of state and government of the euro area made progress in resolving the sovereign risk issues summarized in a document of conclusions (euro area 2011Mar11) to be formally approved at a subsequent meeting on Mar 24-25. The conclusions follow the general framework of the transformation of the European Financial Stability Facility (EFSF http://www.efsf.europa.eu/about/index.htm) into the permanent European Stability Mechanism (ESM) (euro area 2010Nov). The heads of state and government reached the following conclusions (euro area 2011Mar11):
1. The total lending capacity of the ESM will be €500 billion and the combined capacity of the EFSF in transition to the ESM will not exceed this limit. In contrast to guarantees only in the earlier agreement, the lending capacity will be buttressed by “an appropriate mix between paid-in capital, callable capital and guarantees” with time allowed for subscription of paid-in capital in accordance with “national parliamentary procedures” (euro area 2011Mar11, 3). Until definitive implementation of the ESM, programmed for 2013, the lending capacity will not exceed €440 billion. In order to ensure AAA-rating, cash reserves would have to be deposited on the guaranteed bonds issued by the EFSF, restricting effective lending from €440 billion to €250 billion. The new agreement would allow full lending of the €440 billion such that the countries with highest credit rating, France and Germany, would likely increase their financial guarantees but no details are yet available and may face political hurdles in Germany, as analyzed by the Financial Times (http://www.ft.com/cms/s/0/bf3ef3c8-4c49-11e0-82df-00144feab49a.html#axzz1G67TzFqs).
2. A member state can request financial assistance from the ESM when that assistance is required in preserving the stability of the euro area as a whole. Approval of the request requires debt sustainability analysis in unanimous agreement by the European Commission and the International Monetary Fund (IMF), in liaison with the ECB. Strict conditionality will be required under a macroeconomic adjustment program (for IMF conditionality and programs see Pelaez and Pelaez, International Financial Architecture (2005)).
3. Loans will be in the form of financial assistance from the ESM and EFSF but intervention in the primary market of debt issuance could occur within the macroeconomic program with strict conditionality. The earlier agreement specified only loans.
4. The rates charged by the EFSF will be lowered by considering debt sustainability of the borrowing members but with a premium for risk and within the principles of lending rates of the IMF. The ESM will follow the same principles. The rate for Greece’s program will be reduced by 100 basis points and the maturity increased to 7.5 years, in accordance with IMF guidelines.
5. Member states will implement concrete measures to correct the situation of banks that reveal vulnerabilities in the stress tests to be conducted in the summer.
6. Finance ministers will complete the six legislative proposals on economic governance of the European Commission that will include debt reduction of 1/20.
7. The imposition of a tax on financial transactions will be considered by the euro area, European Union and in international levels.
Second, the European Banking Authority (EBA), replacing the Committee of European Banking Supervisors (CEBS) (http://www.eba.europa.eu/), is coordinating the stress tests of European banks to be conducted in Apr with results released in the summer. The expectation is that Tier 1 capital (common equity plus retained earnings) will be set as 5 percent of risk-weighted assets (http://www.ft.com/cms/s/0/96503040-4a8b-11e0-82ab-00144feab49a.html#axzz1G67TzFqs; see http://www.eba.europa.eu/News--Communications/Year/2011/The-EBA-completes-its-top-management-structure-and.aspx). The tests of 2010 only required 6 percent capital without taking Tier 1 capital into consideration. The requirement of Basel III is Tier 1 capital of 7 percent by 2019. There may be some differences in how diverse national authorities define capital. The number of banks to be tested is 88. The EBA plans to release test scenarios by Mar 18 (Ibid; on stress tests see Pelaez and Pelaez, International Financial Architecture (2005), 130-4, Globalization and the State, Vol. I (2009a), 95-100, Government Intervention in Globalization (2008c), 63-4, Financial Regulation after the Global Recession (2009a), 164-6).
III Valuation of Risk Financial Assets. The financial crisis and global recession were caused by interest rate and housing subsidies and affordability policies that encouraged high leverage and risks, low liquidity and unsound credit (Pelaez and Pelaez, Financial Regulation after the Global Recession (2009a), 157-66, Regulation of Banks and Finance (2009b), 217-27, International Financial Architecture (2005), 15-18, The Global Recession Risk (2007), 221-5, Globalization and the State Vol. II (2008b), 197-213, Government Intervention in Globalization (2008c), 182-4). Several past comments of this blog elaborate on these arguments, among which: http://cmpassocregulationblog.blogspot.com/2011/01/professor-mckinnons-bubble-economy.html http://cmpassocregulationblog.blogspot.com/2011/01/world-inflation-quantitative-easing.html http://cmpassocregulationblog.blogspot.com/2011/01/treasury-yields-valuation-of-risk.html http://cmpassocregulationblog.blogspot.com/2010/11/quantitative-easing-theory-evidence-and.html http://cmpassocregulationblog.blogspot.com/2010/12/is-fed-printing-money-what-are.html
Table 6 shows the phenomenal impulse to valuations of risk financial assets originating in the initial shock of near zero interest rates in 2003-2004 with the fed funds rate at 1 percent, in fear of deflation that never materialized, and quantitative easing in the form of suspension of the auction of 30-year Treasury bonds to lower mortgage rates. The ECB (2004) study of oil price shocks considers the increase of oil prices by 56 percent in 2003-2004, precisely during the incidence of the 1 percent fed funds rate in fear of deflation. The charts of risk financial assets show sharp increase in valuations leading to the financial crisis and then profound drops that are captured in Table 6 by percentage changes of peaks and troughs. World financial markets were dominated by Fed and housing policy in the US. Table 6 now has a row for the Chinese yuan (CNY) rate of exchange relative to the US dollar (USD). China pegged the exchange rate at a value that afforded significant competitive power in trade, at around 8.2798 CNY/USD, revalued it from 2005 to 2008 by 17.6 percent, pegged it again to the dollar to avoid loss of competitiveness during the global recession and then revalued it by 3.6 percent by Fri Mar 11, 2011. The first round of quantitative easing and near zero interest rates depreciated the dollar relative to the euro by 39.3 percent between 2003 and 2008, with revaluation of the dollar by 25.1 percent from 2008 to 2010 in the flight to dollar-denominated assets in fear of world financial risks and then devaluation of the dollar by 16.6 percent by Fri Mar 11, 2011. Between 2002 and 2008, the DJ UBS Commodity Index rose 165.5 percent largely because of the unconventional monetary policy of the Fed encouraging carry trade from low US interest rates to long leveraged positions in commodities, exchange rates and other risk financial assets.
Table 6, Volatility of Assets
| DJIA | 10/08/02-10/01/07 | 10/01/07-3/4/09 | 3/4/09- 4/6/10 | |
| ∆% | 87.8 | -51.2 | 60.3 | |
| NYSE Financial | 1/15/04- 6/13/07 | 6/13/07- 3/4/09 | 3/4/09- 4/16/07 | |
| ∆% | 42.3 | -75.9 | 121.1 | |
| Shanghai Composite | 6/10/05- 10/15/07 | 10/15/07- 10/30/08 | 10/30/08- 7/30/09 | |
| ∆% | 444.2 | -70.8 | 85.3 | |
| STOXX EUROPE 50 | 3/10/03- 7/25/07 | 7/25/07- 3/9/09 | 3/9/09- 4/21/10 | |
| ∆% | 93.5 | -57.9 | 64.3 | |
| UBS Com. | 1/23/02- 7/1/08 | 7/1/08- 2/23/09 | 2/23/09- 1/6/10 | |
| ∆% | 165.5 | -56.4 | 41.4 | |
| 10-Year Treasury | 6/10/03 | 6/12/07 | 12/31/08 | 4/5/10 |
| % | 3.112 | 5.297 | 2.247 | 3.986 |
| USD/EUR | 6/26/03 | 7/14/08 | 6/07/10 | 03/11 /11 |
| Rate | 1.1423 | 1.5914 | 1.192 | 1.390 |
| CNY/USD | 01/03 2000 | 07/21 2005 | 7/15 2008 | 03/11 2011 |
| Rate | 8.2798 | 8.2765 | 6.8211 | 6.574 |
| New House | 1963 | 1977 | 2005 | 2009 |
| Sales 1000s | 560 | 819 | 1283 | 375 |
| New House | 2000 | 2007 | 2009 | 2010 |
| Median Price $1000 | 169 | 247 | 217 | 203 |
| 2003 | 2005 | 2007 | 2010 | |
| CPI | 1.9 | 3.4 | 4.1 | 1.5 |
Sources: http://online.wsj.com/mdc/page/marketsdata.html
http://www.census.gov/const/www/newressalesindex_excel.html
http://federalreserve.gov/releases/h10/Hist/dat00_eu.htm
ftp://ftp.bls.gov/pub/special.requests/cpi/cpiai.txt
http://federalreserve.gov/releases/h10/Hist/dat00_ch.htm
http://markets.ft.com/ft/markets/currencies.asp
The trends of valuations of global risk financial assets are dominated by the carry trade from near zero interest rates in the US to take long positions in risk financial assets. Investors and financial professionals learned from losses or how to avoid them. The carry trade is now more opportunistic in quickly realizing profits to avoid losses during periods of risk aversion resulting from events such as the European risk issues, fears of the tradeoff of growth and inflation in Asia, geopolitical events such as the ongoing Middle East oil price shock and slow growth with high unemployment and underemployment in the US together with expectations of increases in taxes and interest rates. When risk aversion is subdued, the combination of near zero interest rates of fed funds and quantitative easing creates again the dream of traders of “the trend is your friend” without as strong a belief in the Bernanke-put, or floor on risk financial asset valuations set by Fed monetary policy, as in earlier periods. Table 7 captures in the fourth column “∆% to Trough” the decline of risk financial assets resulting from the European sovereign risk issues after Apr and the sharp recovery in the last column “∆% Trough to 3/ 11/11” that was not interrupted by the second round of Ireland in late Nov. The final column “∆% Trough to 3/ 11/11” shows that after Jun there is repetition of the trend of high valuations of risk financial assets with the exception of the dollar that devalued by 16.6 percent. A major risk of world capital markets is in sustained increases in oil prices that could cause another downturn of risk financial assets similar to the one that occurred in the European sovereign risk event after Apr 2010. That risk could be significant as shown by the decline of valuations of risk financial assets in column “∆% to Trough” with high double-digit losses. The column “∆% Week 3/11/11” shows fresh losses in the week of Mar 11 after recovery in the prior week ending on Mar 4 from the decline of stock market indexes by two percentage points or more in most cases in the earlier week ending on Feb 25. Risk financial assets are experiencing significant turbulence.
Table 7, Stock Indexes, Commodities, Dollar and 10-Year Treasury
| Peak | Trough | ∆% to Trough | ∆% Peak to 3/ 11/11 | ∆% Week 3/ 11/11 | ∆% Trough to 3/ 11/11 | |
| DJIA | 4/26/ 10 | 7/2/10 | -13.6 | 7.5 | -1.0 | 24.3 |
| S&P 500 | 4/23/ 10 | 7/20/ 10 | -16.0 | 7.1 | -1.3 | 27.5 |
| NYSE Finance | 4/15/ 10 | 7/2/10 | -20.3 | -2.9 | -1.1 | 21.9 |
| Dow Global | 4/15/ 10 | 7/2/10 | -18.4 | 2.4 | -2.8 | 25.6 |
| Asia Pacific | 4/15/ 10 | 7/2/10 | -12.5 | 5.5 | -2.9 | 20.5 |
| Japan Nikkei Aver. | 4/05/ 10 | 8/31/ 10 | -22.5 | -9.9 | -4.1 | 16.2 |
| China Shang. | 4/15/ 10 | 7/02 /10 | -24.7 | -7.3 | -0.3 | 23.1 |
| STOXX 50 | 4/15/10 | 7/2/10 | -15.3 | -4.3 | -2.5 | 12.9 |
| DAX | 4/26/ 10 | 5/25/ 10 | -10.5 | 10.3 | -2.7 | 23.1 |
| Dollar Euro | 11/25 2009 | 6/7 2010 | 21.2 | 8.1 | 0.6 | -16.6 |
| DJ UBS Comm. | 1/6/ 10 | 7/2/10 | -14.5 | 12.6 | -3.5 | 31.7 |
| 10-Year Tre. | 4/5/ 10 | 4/6/10 | 3.986 | 3.401 |
T: trough; Dollar: positive sign appreciation relative to euro (less dollars paid per euro), negative sign depreciation relative to euro (more dollars paid per euro)
Source: http://online.wsj.com/mdc/page/marketsdata.html.
Table 8, updated with every post, provides the percentage changes of the DJIA and the S&P 500 since Apr 26, around the European sovereign risk issues, from current to previous selected dates and relative to Apr 26. Chairman Bernanke (2010WP) first argued on Nov 4, 2010 that quantitative easing was also designed to increase the valuations of stocks with the objective of creating a wealth effect that would motivate consumption. The problem is that the Fed does not control effects over multiple asset classes including riskier financial assets such as commodities and exchange rates. The decline of major US stock indexes in the week of Feb 25 without full recovery in the week of Mar 4 and renewed weakness in the week ending on Mar 11reduced the valuations of the DJIA and S&P 500 to single digit increases since the effects of the European sovereign risk event beginning around Apr 26.
Table 8, Percentage Changes of DJIA and S&P 500 in Selected Dates
| 2010 | ∆% DJIA from earlier date | ∆% DJIA from Apr 26 | ∆% S&P 500 from earlier date | ∆% S&P 500 from Apr 26 |
| Apr 26 | ||||
| May 6 | -6.1 | -6.1 | -6.9 | -6.9 |
| May 26 | -5.2 | -10.9 | -5.4 | -11.9 |
| Jun 8 | -1.2 | -11.3 | 2.1 | -12.4 |
| Jul 2 | -2.6 | -13.6 | -3.8 | -15.7 |
| Aug 9 | 10.5 | -4.3 | 10.3 | -7.0 |
| Aug 31 | -6.4 | -10.6 | -6.9 | -13.4 |
| Nov 5 | 14.2 | 2.1 | 16.8 | 1.0 |
| Nov 30 | -3.8 | -3.8 | -3.7 | -2.6 |
| Dec 17 | 4.4 | 2.5 | 5.3 | 2.6 |
| Dec 23 | 0.7 | 3.3 | 1.0 | 3.7 |
| Dec 31 | 0.03 | 3.3 | 0.07 | 3.8 |
| Jan 7 | 0.8 | 4.2 | 1.1 | 4.9 |
| Jan 14 | 0.9 | 5.2 | 1.7 | 6.7 |
| Jan 21 | 0.7 | 5.9 | -0.8 | 5.9 |
| Jan 28 | -0.4 | 5.5 | -0.5 | 5.3 |
| Feb 4 | 2.3 | 7.9 | 2.7 | 8.1 |
| Feb 11 | 1.5 | 9.5 | 1.4 | 9.7 |
| Feb 18 | 0.9 | 10.6 | 1.0 | 10.8 |
| Feb 25 | -2.1 | 8.3 | -1.7 | 8.9 |
| Mar 4 | 0.3 | 8.6 | 0.1 | 9.0 |
| Mar 11 | -1.0 | 7.5 | -1.3 | 7.6 |
Source: http://online.wsj.com/mdc/public/page/mdc_us_stocks.html?mod=mdc_topnav_2_3004
The issue of capital controls is actually an issue of exchange rate policy. Table 9, which is updated with every post, shows in the last three rows the Chinese yuan (CNY) to US dollar (USD) exchange rate or number of CNY required to buy one USD. China fixed the rate at around 8.2765 CNY/USD for a long period until Aug 2005. That rate afforded a competitive edge to Chinese products in world markets and in competition of internally-produced goods with foreign-produced imports. China then strengthened the yuan by 17.6 percent until Jul 2008 when it fixed it to the dollar in an effort to prevent the erosion of its competitiveness in world markets and at home to protect the economy from the global recession. China resumed the revaluation of the yuan in 2010, with revaluation by 3.6 percent by Mar 4, 2011. Table 9 shows the sharp appreciation relative to the dollar of most currencies in the world, which is far higher than the Fed’s objective of attaining by quantitative easing “a moderate change in the foreign exchange value of the dollar that provides support to net exports,” as revealed for the first time by Yellen (2011AS, 6). Bernanke (2002FD) states:
“Although a policy of intervening to affect the exchange value of the dollar is nowhere on the horizon today, it's worth noting that there have been times when exchange rate policy has been an effective weapon against deflation. A striking example from U.S. history is Franklin Roosevelt's 40 percent devaluation of the dollar against gold in 1933-34, enforced by a program of gold purchases and domestic money creation. The devaluation and the rapid increase in money supply it permitted ended the U.S. deflation remarkably quickly. Indeed, consumer price inflation in the United States, year on year, went from -10.3 percent in 1932 to -5.1 percent in 1933 to 3.4 percent in 1934. The economy grew strongly, and by the way, 1934 was one of the best years of the century for the stock market. If nothing else, the episode illustrates that monetary actions can have powerful effects on the economy, even when the nominal interest rate is at or near zero, as was the case at the time of Roosevelt's devaluation.”
Many countries have complained that Fed “nonconventional policy” of near zero interest rates and quantitative easing is designed to cause, or at least results in, competitive devaluation of the dollar that would export US unemployment to other countries. A widening differential between interest rates in the euro area and the US could further devalue the dollar, inducing carry trade from near zero interest rates in the US to risk financial assets.
Table 9, Exchange Rates
| Peak | Trough | ∆% P/T | Mar 11 2011 | ∆% T Mar 11 2011 | ∆% P Mar 11 2011 | |
| EUR USD | 7/15 2008 | 6/7 2010 | 3/11/ 2011 | |||
| Rate | 1.59 | 1.192 | 1.390 | |||
| ∆% | -33.4 | 14.2 | -14.4 | |||
| JPY USD | 8/18 2008 | 9/15 2010 | 3/11 2011 | |||
| Rate | 110.19 | 83.07 | 81.84 | |||
| ∆% | 24.6 | 1.5 | 25.7 | |||
| CHF USD | 11/21 2008 | 12/8 2009 | 3/11 2011 | |||
| Rate | 1.225 | 1.025 | 0.928 | |||
| ∆% | 16.3 | 9.5 | 24.2 | |||
| USD GBP | 7/15 2008 | 1/2/ 2009 | 3/11 2011 | |||
| Rate | 2.006 | 1.388 | 1.608 | |||
| ∆% | -44.5 | 13.7 | -24.7 | |||
| USD AUD | 7/15 2008 | 10/27 2008 | 3/11 2011 | |||
| Rate | 1.0215 | 1.6639 | 1.015 | |||
| ∆% | -62.9 | 40.8 | 3.5 | |||
| ZAR USD | 10/22 2008 | 8/15 2010 | 3/11 2011 | |||
| Rate | 11.578 | 7.238 | 6.87 | |||
| ∆% | 37.5 | 5.1 | 40.7 | |||
| SGD USD | 3/3 2009 | 8/9 2010 | 3/11 2011 | |||
| Rate | 1.553 | 1.348 | 1.267 | |||
| ∆% | 13.2 | 6.0 | 18.4 | |||
| HKD USD | 8/15 2008 | 12/14 2009 | 3/11 2011 | |||
| Rate | 7.813 | 7.752 | 7.788 | |||
| ∆% | 0.8 | -0.4 | 0.3 | |||
| BRL USD | 12/5 2008 | 4/30 2010 | 3/11 2011 | |||
| Rate | 2.43 | 1.737 | 1.666 | |||
| ∆% | 28.5 | 4.1 | 31.4 | |||
| CZK USD | 2/13 2009 | 8/6 2010 | 3/11/ 2011 | |||
| Rate | 22.19 | 18.693 | 17.449 | |||
| ∆% | 15.7 | 6.7 | 21.4 | |||
| SEK USD | 3/4 2009 | 8/9 2010 | 3/11 2011 | |||
| Rate | 9.313 | 7.108 | 6.328 | |||
| ∆% | 23.7 | 10.9 | 31.9 | |||
| CNY USD | 7/20 2005 | 7/15 2008 | 3/11/ 2011 | |||
| Rate | 8.2765 | 6.8211 | 6.574 | |||
| ∆% | 17.6 | 3.6 | 20.6 |
Symbols: USD: US dollar; EUR: euro; JPY: Japanese yen; CHF: Swiss franc; GBP: UK pound; AUD: Australian dollar; ZAR: South African rand; SGD: Singapore dollar; HKD: Hong Kong dollar; BRL: Brazil real; CZK: Czech koruna; SEK: Swedish krona; CNY: Chinese yuan; P: peak; T: trough
Note: percentages calculated with currencies expressed in units of domestic currency per dollar; negative sign means devaluation and no sign appreciation
Source: http://online.wsj.com/mdc/public/page/mdc_currencies.html?mod=mdc_topnav_2_3000
http://federalreserve.gov/releases/h10/Hist/dat00_ch.htm
http://markets.ft.com/ft/markets/currencies.asp
IV Economic Indicators. International trade is growing rapidly with US exporters benefitting. Nominal dollar data for various types of sales data, not adjusted for price change, are growing at double-digit yearly levels, suggesting inflation through the production and distribution chain. The job market continues to be weak because economic growth is mediocre in comparison with earlier expansions from sharp cyclical contractions. The private sector of households and business continues deleveraging while the government sector at the federal, state and local levels is leveraging.
The US trade deficit worsened from $40.3 billion in Dec to $46.3 billion in Jan. Exports seasonally adjusted rose 2.7 percent in Jan, after rising 2.0 percent in Dec but imports increased 5.2 percent in Jan after rising 2.6 percent in Dec (http://www.census.gov/foreign-trade/Press-Release/current_press_release/ft900.pdf). The trade deficit with China widened to $23.3 billion in Jan, which was higher than $20.7 billion in Dec, followed in magnitude by a deficit of $9.9 billion with OPEC in Jan that was higher than $8.3 billion in Dec. Table 10 provides the trade balance, exports and imports not seasonally adjusted. The US has been experiencing rapid growth of both nominal exports and imports of goods and services. Exports grew at the rate of 22.9 percent in the 12 months ending in Jan 2011 and imports 22.2 percent. It is difficult to isolate the growth of exports originating in dollar devaluation.
Table 10, US Trade Balance, Exports and Imports $ B Not Seasonally Adjusted
| Balance | Exports | ∆% | Imports | ∆% | |
| Jan-Dec 2010 | -647.1 | 1288.7 | 20.6 | 1935.7 | 22.9 |
| Jan-Dec 2009 | -506.9 | 1068.5 | 1575.4 | ||
| Jan 2011 | -57.1 | 111.4 | 18.9 | 168.5 | 22.2 |
| Jan 2010 | -44.3 | 93.7 | 137.9 |
Source: http://www.census.gov/foreign-trade/Press-Release/current_press_release/ft900.pdf
Table 11 summarizes monthly and 12-months rates of increase of sales without price adjustment that with the exception of retail are growing at double-digit 12-months rates. Inflation is being channeled through the production and distribution chain. Sales of merchant wholesalers, except manufacturers’ sales branches and offices, seasonally adjusted but without adjustment for price changes, rose 3.4 percent in Jan from Dec and 15.4 percent from Jan 2010; sales of durable goods rose 2.3 percent in Jan and 14.5 percent from a year earlier; sales of motor vehicles and motor vehicle parts and supplies rose 7.8 percent; sales of electrical and electronic goods rose 3.4 percent; sales of nondurable goods rose 4.4 percent and 16.2 percent from a year earlier; sales of petroleum and petroleum products rose 10.6 percent in Jan and sales of farm product raw material 5.7 percent; inventories of merchant wholesalers rose 1.1 percent in Jan and 11.9 percent from a year earlier; and the inventories/sales ratio was 1.13, which was below the Jan 2010 ratio of 1.16 (http://www2.census.gov/wholesale/pdf/mwts/currentwhl.pdf). These data are all in nominal dollar values without adjustment for price changes, showing how inflation is moving through the entire production and distribution chain. The advance estimate for US retail and food services sales for Feb, adjusted for seasonal factors but not for price changes, rose 1.0 percent from Jan and 8.9 percent relative to Feb 2010; total sales for Dec 2010 through Feb 2011 rose 8.2 percent relative to the same period a year earlier; retail trade sales rose 0.9 percent in Jan 2011 and 9.5 percent over last year; auto and other sales by motor vehicle dealers jumped 25.9 percent from Feb 2010; and gasoline station sales rose 12.9 percent (http://www.census.gov/retail/marts/www/marts_current.pdf). The combined value of distributive trade sales and manufacturers’ shipments, adjusted for seasonal factors but not for price changes, rose 2.0 percent in Jan from Dec 2010 and 10.8 percent from Jan 2010; inventories rose 0.9 percent from Dec 2010 and 9.1 percent from Jan 2010; and the business inventories to sales ratio was 1.23 in Jan compared with 1.25 a year earlier (http://www.census.gov/mtis/www/data/pdf/mtis_current.pdf).
Table 11, Sales Monthly and 12 Months Rates of Increase %
| Jan 2011 | 12 Months | |
| Wholesale | 3.4 | 15.4 |
| Durables | 2.3 | 14.5 |
| Nondurables | 4.4 | 16.2 |
| Petroleum | 10.6 | 34.1 |
| Retail* | 1.0 | 8.9 |
| Gasoline | 1.4 | 12.9 |
| Trade Sales | 2.0 | 10.8 |
*Feb
Sources: http://www.census.gov/retail/marts/www/marts_current.pdf
http://www2.census.gov/wholesale/pdf/mwts/currentwhl.pdf
http://www.census.gov/mtis/www/data/pdf/mtis_current.pdf
Table 12 shows the rates of growth, seasonally annualized in year equivalents, of US domestic nonfinancial debt from the Flow of Funds report by the Fed (http://www.federalreserve.gov/releases/z1/Current/z1r-1.pdf). Much is being said about deleveraging after the financial crisis and global recession. The rates in Table 11 show that deleveraging in the US economy is being processed by households and business, or the private sector. Government, at the state and local levels, is engaging in further relative leveraging. Production and employment originate in the private sector such that future productivity and job creation may suffer from these diverging patterns of changes in nonfinancial debt.
Table 12, Percentage Quarterly Seasonally-Adjusted Annual Rates of Growth of Domestic Nonfinancial Debt
| IQ10 | IIQ10 | IIIQ10 | IVQ10 | |
| Total | 4.3 | 4.6 | 4.2 | 5.1 |
| House- holds | -2.0 | -2.5 | -2.0 | -0.6 |
| Business | 0.3 | -0.1 | 2.2 | 3.6 |
| State and Local Gov | 5.7 | -1.4 | 5.4 | 7.9 |
| Federal | 20.5 | 24.4 | 16.0 | 14.6 |
Source: http://www.federalreserve.gov/releases/z1/Current/z1r-1.pdf
The Energy Information Administration (EIA) reports that crude oil inventories of the US rose to 348.9 million barrels in the week of Mar 4 compared with 346.4 million barrels in the week of Feb 25 (http://www.eia.doe.gov/dnav/pet/hist/LeafHandler.ashx?n=PET&s=WCESTUS1&f=W). US initial claims for unemployment insurance seasonally adjusted rose by 26,000 in the week of Mar 5, reaching 397,000 compared with 371,000 a week earlier; initial claims without seasonal adjustment rose 52,147 in the week of Mar 5, reaching 406,096 compared with 353,949 a week earlier but significantly below 459,523 a year earlier (http://www.dol.gov/opa/media/press/eta/ui/current.htm).
V Interest Rates. The US 10-year Treasury note traded at 3.40 percent on Mar 11, lower than 3.49 percent in the earlier week and 3.65 percent in the prior month; the 30-year Treasury bond traded at 4.55 percent on Mar 11, down from 4.60 percent a week earlier and 4.71 percent a month earlier. Risk aversion is moving funds to dollar-denominated assets. The same flight to quality is observed in the decline of the 10-year yield of the German government bond to 3.22 percent for negative spread to the comparable Treasury security of 18 basis points (see the data in http://markets.ft.com/markets/bonds.asp?ftauth=1300017872839). The 10-year Treasury note with coupon of 3.63 percent and maturity in 02/21 traded at 101.88 or equivalent yield of 3.40 percent on March 11, but that price is not comparable to that in Table 5, which is for coupon of 2.625 percent and maturity in exactly ten years for purposes of comparison with earlier prices.
VI Conclusion. Inflation is accelerating worldwide with slow growth and persistent unemployment in advanced economies. Nominal short-term indicators of the US economy, unadjusted for price changes, discussed in section IV Economic Indicators, are jumping by around double-digit percentages relative to last year as shown in Table 11. Part of this growth is due to prices instead of volumes. The insistence by the Fed on the combination of the 0 to ¼ percent per year fed funds rate with a portfolio of long-term securities of $2.3 trillion is sanctioning the worldwide explosion in prices of commodities and raw materials. If risk aversion declines again with calmer sovereign risk issues, geopolitical events, natural disasters and the growth/inflation tradeoff in China, the widening interest rate differential caused by US monetary policy will devalue the dollar and stimulate the carry trade from zero interest rates to leveraged positions in risk financial assets. Market participants are drawing comparisons with the 1994 bond crash. If the fed falls behind in inflation control, there is risk of aggressive rate hikes in the effort to regain credibility in an event that could be worse than the 1994 bond crash because there is real inflation currently instead of merely fears and the Fed is the polar opposite of timidity and prudence in doses and instruments of monetary policy. Such a current bond crash would extend to multiple asset classes and regions. The dismantling of carry-trade induced financial risk positions could provoke another financial crisis as it happened after 2007 (Go to http://cmpassocregulationblog.blogspot.com/ http://sites.google.com/site/economicregulation/carlos-m-pelaez)
http://www.amazon.com/Carlos-Manuel-Pel%C3%A1ez/e/B001HCUT10 )
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