27 Million Persons in Job Stress, European Sovereign Risk, the Principal Loss of Quantitative Easing and Policy Failure

 

27 Million Persons in Job Stress, European Sovereign Risk, the Principal Loss of Quantitative Easing and Policy Failures

©Carlos M. Pelaez, 2010

Carlos M. Pelaez

This post relates the continuing job stress of 27 million people in the US to policy failure and risks in the world economy and capital markets. The individual sections are as follows:

I 27 Million Persons in Job Stress

II European Sovereign Risk

III Policy Failure

IV The Principal Loss of Quantitative Easing

V Global Devaluation War

VI Economic Indicators

VII Interest Rates

VIII Conclusion

I 27 Million Persons in Job Stress. There are 26.4 million people in the US in job stress, consisting of 15.1 million unemployed (of whom 6.2 million long-term unemployed for 27 weeks and over or 41.9 percent of total unemployed), 9 million employed part-time for economic reasons (who are unable to find full-time jobs) and 2.3 million marginally attached to the labor force (who want and are willing to work and have been looking for employment sometime in the past 12 months) (http://www.bls.gov/news.release/pdf/empsit.pdf). Total nonfarm payroll employment seasonally adjusted (SA) rose by 39,000 in Nov and private payroll employment rose by 50,000. Table 1 provides the monthly change in jobs in the prior strong contraction of 1981-1982 and the recovery in 1983 and in the contraction of 2008-2009 and in the recovery in 2009-2010. The data in the recovery periods are in relief to facilitate comparison. There is significant bias in the comparison. The civilian noninsitutional population was 174.2 million in 1983 and the civilian labor force 111.6 million, growing by 2009 to a civilian noninstitutional population of 235.8 million and civilian labor force of 154.1 million, that is, increasing by 35.4 percent and 38.1 percent, respectively (http://www.bls.gov/cps/cpsaat1.pdf). What is striking about the data in Table 1 is that the numbers of monthly increases in jobs in 1983 are several times higher than in 2010 even with population higher by 35.4 percent and labor force higher by 38.1 percent in 2010 relative to 1983 nearly three decades ago. Professor Michael Boskin of Stanford, former Chairman of the CEA, provides analysis of growth in cyclical expansions in an article for the Wall Street Journal (http://professional.wsj.com/article/SB10001424052748703882304575465462926649950.html ). The critical historical perspective is that average quarterly rates of growth in the expansions after a severe recession were incomparably higher than during the current expansion: 6.2 percent in the first four quarters and 4.5 percent in the first 12 quarters after the trough in the second quarter of 1975, 7.7 percent in the first four quarters and 5.8 percent in the first 12 quarters after the trough in the first quarter in 1983 and only 3 percent in the first four quarters and 2.9 percent forecast in the first 12 quarters after the trough in the third quarter of 2009. GDP grew at the SA quarter-on-quarter yearly-equivalent rate of 1.7 percent in IIQ2010 and 2.5 percent in IIIQ2010. Growth has been mediocre in the five quarters of expansion beginning in IIIQ2009 in comparison with earlier expansions and also in terms of what is required to reduce the job stress of 26.4 million persons. Some of the job growth and contraction in 2010 is caused by the hiring and subsequent termination of temporary workers for the 2010 census.

Table 1, Monthly Change in Jobs, Number SA

Month	1981	1982	1983	2008	2009	2010	Private
Jan	95	-327	225	-10	-779	14	16
Feb	67	-6	-78	-50	-1266	39	62
Mar	104	-129	173	-33	-213	208	158
Apr	74	-281	276	-149	-528	313	241
May	10	-45	277	-231	-387	432	51
Jun	196	-243	378	-193	-515	-175	61
Jul	112	-343	418	-210	-346	-66	117
Aug	-36	-158	-308	-334	-212	-1	143
Sep	-87	-181	1144	271	-225	-24	112
Oct	-100	-277	271	-554	-224	172	160
Nov	-209	124	352	-728	64	39	50
Dec	-278	-14	356	-673	-109

Source: http://data.bls.gov/PDQ/servlet/SurveyOutputServlet

http://www.bls.gov/schedule/archives/empsit_nr.htm#2010

http://www.bls.gov/news.release/pdf/empsit.pdf

 

Important aspects of growth of payroll jobs from Oct 2009 to Oct 2010, not seasonally adjusted (NSA), are provided in Table 2. Total nonfarm employment increased by 842,000, consisting of growth of total private employment by 1,086,000 and decline by 244,000 of government employment. Manufacturing employment increased by 89,000 while private service providing grew by 1,024,000. An important feature is that jobs in temporary help services increased by 356,000. Temporary help services rose by 494,000 since the low in Sep 2009, increasing in Nov 2010 by 40,000 (http://www.bls.gov/news.release/pdf/empsit.pdf 2). This episode of jobless recovery is characterized by part-time jobs.

 

Table 2, Employees in Nonfarm Payrolls Not Seasonally Adjusted in Thousands

	Nov 2009	Nov 2010	Change
A Total Nonfarm	130,969	131,811	842
B Total Private	107,974	109,060	1,086
B1 Goods Producing	18,177	18,239	62
B1a Manufacturing	11,627	11,716	89
B2 Private service providing	89,797	90,821	1,024
B2a Temporary help services	1,966	2,322	356
C Government	22,995	22,751	-244

Note: A = B+C, B = B1 + B2

Source:

http://www.bls.gov/news.release/pdf/empsit.pdf

 

II European Sovereign Risk. The banking editor of the Financial Times, Patrick Jenkins, provides perceptive analysis of the bailout package for Ireland (http://www.ft.com/cms/s/0/f478cede-fbe9-11df-b7e9-00144feab49a,dwp_uuid=50df1d0c-9e54-11df-a5a4-00144feab49a.html#axzz16nLocuve). The volume of the package is €85 billion, or around $111.4 billion, but the key doubt is the confusing structure, consisting of €50 billion to be used in spending by the government, €10 billion for recapitalizing the banks and €25 billion of what, for want of a better word, is called “back pocket” by Patrick. The allocation of the €10 billion to individual banks is specified clearly but the explanation of the huge “back pocket” is that 300 percent more will be required to resolve the banks. There will be no interest charges of 5.83 percent on the €25 billion “back pocket” unless it is drawn out. There is no explanation for the contingency or “back pocket” that market participants must guess. Bank stress and liquidity assessment will be conducted subsequently but liquidity appears to be crucial.

The assistance to Ireland is still processed through the European Financial Stability Facility (EFSF) created by agreement of the 16 member states of the European Monetary Union (EMU) third phase or euro zone on May 9, 2010 (http://www.efsf.europa.eu/about/index.htm). The EFSF consists of a package with total funding of €750 billion with €440 billion provided by issue of bonds with AAA rating, €60 billion by the European Commission in the form of emergency loans and €250 billion by IMF loans. However, IMF loans must be approved on a case-by-case basis and the €440 billion are effectively €250 billion because of the need to deposit guarantee cash of 40 percent of the sale of bonds to maintain their AAA rating, such that the resources are limited to €310 when adding the €60 billion of emergency loans (http://professional.wsj.com/article/SB10001424052748704526504575634913516773290.html?mod=WSJ_hpp_MIDDLTopStories). The EFSF expires in 2013 when it will be replaced by a permanent facility for financing among governments, the European Stabilization Mechanism (ESM) (http://www.ft.com/cms/s/0/ef45ed34-fb08-11df-b576-00144feab49a.html#axzz16dEqzGJ6 http://www.ft.com/cms/s/0/3c4af038-fb23-11df-b576-00144feab49a,dwp_uuid=79cadde4-5c1b-11df-95f9-00144feab49a.html#axzz16i8S0PyF).

An important new feature of the ESM is providing for crisis resolution involving contribution by the private sector. Beginning in 2013 all bonds issued by sovereign members of the euro zone will incorporate collective action clauses (CAC). Three important features of CACs include: (1) collective representation of bondholders to create a representative in negotiations; (2) decision by majority vote instead of unanimous vote; and (3) sharing of resources by investors to avoid multiple litigation (see Pelaez and Pelaez, International Financial Architecture (2005), 197-202). CACs became official IMF doctrine in resolution of crises when default is a possibility. An automatic bailout mechanism will be replaced by decisions on individual cases. It will still be possible for an individual country to apply for liquidity assistance from the ESM in exchange for a credible adjustment program. In the new regime, if the IMF, the European Central Bank (ECB) and the European Commission decided that a country’s debt were unsustainable, the country would have to engage in restructuring negotiations with its creditors as condition for assistance. In the first stage, creditors will be encouraged to continue their relations with sovereign debtors but in the second stage there will be various forms of default such as extensions of maturities, standstills, reductions of interest payments and even write downs. CACs will not be a majority of public debt for six to eight years after their implementation in 2013.

The ECB announced three decisions at the meeting of its council on Dec 2: (1) unchanged refinancing facility rate of 1 percent; (2) indefinite extension of liquidity assistance to banks until conditions change; and (3) continuance of the program of buying sovereign bonds of euro zone members (http://professional.wsj.com/article/SB10001424052748703377504575650422043652404.html?mod=WSJ_hpp_LEFTTopStories http://noir.bloomberg.com/apps/news?pid=20601087&sid=axMiSXTNCqD4&pos=2). The bond purchase of the ECB is different from quantitative easing not only in much smaller dimensions, likely now at €60 billion compared with €1.5 trillion ($2 trillion) for the US, but also in strategy of calming episodes of risk-spread volatility in specific market segments of selected sovereigns (http://www.ft.com/cms/s/0/8f63e8b2-fe46-11df-abac-00144feab49a.html#axzz16z6JMPCX). At the same time, the president of the ECB, Jean-Claude Trichet, suggested that governments must increase the size of their aid to countries experiencing difficulties in their bond markets (http://www.ft.com/cms/s/0/ce0ee7c4-fec8-11df-ae87-00144feab49a.html http://professional.wsj.com/article/SB10001424052748703989004575652153695672646.html?mod=wsjproe_hps_LEFTWhatsNews).

After a week of the package for Ireland and the disclosure of the ESM, sovereign debt markets continue to be in turmoil with fluctuations of yield spreads of multiple countries and credit sensitivity measures (http://www.ft.com/cms/s/0/56376e4a-ff15-11df-956b-00144feab49a.html#axzz17BY0E2ss). The number of countries experiencing difficulties with their sovereign debts is increasing. The joint GDP of the initial countries is only $733 billion or 6.1 percent of the euro zone’s GDP: $305 billion Greece, $204 billion Ireland and $224 billion Portugal (see Table 3). The total including other countries is of significant dimension of $4506 billion, or 37.3 percent of the euro zone’s GDP, when adding $1275 billion for Spain, $461 billion for Belgium and $2037 billion for Italy. The “too-big-to-fail” criterion may collide against the “too-big-to bail out.”

 

Table 3, GDP, Debt/GDP and Current Account/GDP for Selected Countries

	GDP $ Billions	Debt/GDP 2010 %	Debt/GDP 2015 %	Current Account % GDP 2010	Current Account % GDP 2015
Euro Area	12,067	53.4	67.4	73.8	0.2
Germany	3,652	58.7	61.8	6.1	3.9
France	2,865	74.5	78.7	-1.8	-1.8
Portugal	224	79.9	93.6	-9.9	-8.4
Ireland	204	55.2	71.4	-2.7	-1.2
Italy	2,037	98.9	99.5	-2.9	-2.4
Greece	305	109.5	112.6	-10.8	-4.0
Spain	1,275	54.1	72.6	-5.2	-4.3
Belgium	461	91.4	100.1	0.5	4.1
USA	14,624	65.8	84.7	-3.2	-3.4
UK	2,259	68.8	76.0	-2.2	-1.1
Japan	6,517	120.7	153.4	3.1	1.9
China	5,745	19.1	13.9	4.7	7.8

Source: http://www.imf.org/external/pubs/ft/weo/2010/02/weodata/index.aspx

 

Professor John H. Cochrane of the University of the Chicago Booth School of Business provides illuminating analysis in an article for the Wall Street Journal (http://professional.wsj.com/article/SB10001424052748704594804575648692103838612.html). The bailout of Ireland and the ESM are justified by the need to prevent “contagion” from countries in current difficulties to other countries that have not experienced major stress. Contagion, as argued by Cochrane, is inflicted by a country on itself through excessive budget deficits and resulting debt, much the same as it is occurring in the US and multiple states. A major problem is the reliance on short-term debt, actually by countries and everybody else, because it is relatively cheaper. Short maturities are dominating US debt with significant portion refinanced yearly. An important consequence of quantitative easing is to concentrate debt in short maturities. This may have been the original sin of the financial crisis.

III Policy Failure. The objective of the combined monetary and fiscal stimulus is to turn around the economy, creating the conditions for the private sector to grow and create jobs. The calculation of the government stimulus by Mark Pittman and Bob Ivry at Bloomberg declined from $12.8 trillion committed and $4.2 trillion used by March 2009 to $11.6 trillion committed and $3.0 trillion used by September 2009 (http://www.bloomberg.com/apps/news?pid=newsarchive&sid=ahys015DzWXc# see Pelaez and Pelaez, Regulation of Banks and Finance (2009b) 224-7, Financial Regulation after the Global Recession (2009a), 157-70). The Federal Reserve total commitment by September 2009 was $5.9 trillion, or 50.8 percent of the total, and the use was $1.6 trillion, or 53 percent of the total. Even the most optimistic are beginning to realize that the combined stimulus did not work as intended.

Boskin analyzes why the spending stimulus failed in an article for the Wall Street Journal (http://professional.wsj.com/article/SB10001424052748704679204575646994256446822.html). This analysis is important because of proposals of another round of short-term fiscal stimulus, consolidation of government finance in the medium and long term and reform of entitlements and taxes in the long term. The Fed echoes this effort because short-term fiscal stimulus could compensate for the ineffectiveness of monetary policy at very low interest rates (http://professional.wsj.com/article/SB10001424052748704594804575648561513994200.html?mod=wsjproe_hps_LEFTWhatsNews). The argument in support of these policies is that the package of $814 billion was insufficient to increase aggregate demand and stimulate the economy. Additional spending stimulus may not be advisable currently. The report of the National Commission on Fiscal Responsibility and Reform summarizes the situation of the US as (http://online.wsj.com/public/resources/documents/WSJ-20111201-DeficitCommissionReport.pdf 8-9):

“Our nation is on an unsustainable fiscal path. In 2010, federal spending was nearly 24 percent of GDP, the value of all goods and services produced in the economy. Only during World War II was federal spending a larger part of the economy. Tax revenues stood at 15 percent of GDP this year, the lowest level since 1950. The gap between spending and revenue—the budget deficit—was just under nine percent of GDP. Since the last time our budget was balanced in 2001, the federal debt has increased dramatically from 33 percent of GDP to 62 percent of GDP in 2010. The Congressional Budget Office projects if we continue on our current course, deficits will remain high throughout the rest of this decade and beyond, and debt will spiral even higher, reaching 90 percent of GDP in 2020.”

An important theoretical development is the application of the theory of the liquidity trap by Krugman (1998), which is part of the foundation for quantitative easing. The definition of the liquidity trap by Krugman (1998, 141) is “a situation in which conventional monetary policies have become impotent, because nominal interest rates are at or near zero: injecting monetary base into the economy has not effect, because base and bonds are viewed by the private sector as perfect substitutes.” The liquidity trap reflects an economy experiencing deflation that cannot be contained by increasing base money, which is the sum of currency held by the public plus reserves deposited at the Fed by depository institutions or mostly banks. Deflation results in a painful real rate of interest. Krugman (1998) emphasizes the role of expectations. Central banks have been concerned over decades with controlling inflation such that expectations of the public may be rigid in the sense that policies of increasing base money to reflate the economy may not be expected to last after inflation returns. The policy of the Fed in conditions of deflation must consist of a credible promise “to be irresponsible,” that is, that it will maintain the policy as long as required to drive the economy out of the liquidity trap (Krugman 1998, 161).

There has been active debate between Krugman (2007a, 2007b) and Schwartz (2008) and Nelson and Schwartz (2007, 2008) on the proper analysis of monetary economics. These debates are infrequently solved by appeal to data because of samples that reflect multiple probable causes, which cannot be separated in measuring their relative contribution to effects. Schwartz (2009) identifies the key issue of recent monetary policy that in pursuit of vigorous economic recovery and emphasis on avoiding deflation manifests in distorted values of financial assets that augment the depth of recession when values collapse.

Quantitative easing transmits to the real economy by lowering long-term yields of Treasury securities caused by rebalancing of portfolios in expectation of higher returns resulting from purchases of securities by the Fed that increase prices or equivalently lower yields. Portfolio rebalancing can occur by appeal to the models of Markowitz (1952), Tobin (1958), Hicks (1962), Sharpe (1964) and Lintner (1965). Borrowing at short-term riskless interest rates and going long on a portfolio of long-term securities is the essence of this portfolio adjustment, coinciding with the current rate of 0 to ¼ percent on fed funds and the current yield of the 10-year Treasury of 3.007 percent. The first step of transmission is to encourage investors and arbitrageurs to acquire positions in the target 5 to 7 year maturities of Treasury securities. The general equilibrium model of Tobin (1969) as formalized by Andrés et al (2004) provides the portfolio adjustment mechanism under the critical assumption of less than perfect substitution between money and income-yielding securities, also considered by Brunner and Meltzer (1973). The preferred-habitat model of Vayanos and Vila (2009) provides analysis of how arbitrageurs’ carry trade of borrowing at very low short-term interest rates and going long in long-term securities can lower long-term yields.

The carry trade from near zero fed funds rate may encourage investment in financial risk assets other than long-term Treasury securities such as commodities, currencies, emerging stocks, junk bonds and so on. Table 4 shows that when sovereign-risk doubts calm temporarily as during the past week the carry trade of shorting the dollar while going long on risk financial assets dominates volume and price appreciation in risk markets. Since the trough after the first wave of sovereign-risk doubts around Jul 2, the dollar has devalued by 12.5 percent while all other risk financial assets have appreciated by high double-digit percentages.

 

Table 4, Stock Indexes, Commodities, Dollar and 10-Year Treasury

	Peak	Trough	∆% to Trough	∆% to 12/03	∆% Week 12/03	∆% T to 12/03
DJIA	4/26/10	7/2/10	-13.6	1.6	2.6	17.5
S&P 500	4/23/10	7/20/10	-16.0	2.9	2.9	19.8
NYSE Finance	4/15/10	7/2/10	-20.3	-9.9	4.2	13.1
Dow Global	4/15/10	7/2/10	-18.4	-2.3	3.1	19.7
Asia Pacific	4/15/10	7/2/10	-12.5	4.3	3.5	19.2
Japan Nikkei Average	4/05/10	8/31/10	-22.5	-10.6	1.4	15.3
China Shanghai	4/15/10	7/02/10	-24.7	-10.2	-1.0	19.2
STOXX 50	4/15/10	7/2/10	-15.3	-5.8	1.1	11.2
DAX	4/26/10	5/25/10	-10.5	9.7	1.4	22.5
Dollar Euro	11/25 2009	6/7 2010	21.2	11.3	3.2	-12.5
DJ UBS Comm.	1/6/10	7/2/10	-14.5	6.0	4.7	20.7
10-Year Tre.	4/5/10	4/6/10	3.986	3.007

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

 

There is a precedent to the current stimulus to positions in risk financial assets by near zero fed funds rates. Monetary policy in 2003-2004 induced high leverage, excessive risks, low liquidity, short-term financing and unsound credit decisions that were the primary cause of the credit/dollar crisis and global recession (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).

The consequences of the global hunt for yields induced by monetary and housing policy are shown in Table 5. The second column shows a dramatic rise of 87.8 percent in the Dow Jones Industrial Average (DJIA) from 2002 to 2007, a more modest increase in the NYSE financial index of 42.3 percent in 2004-2007, an increase in the Shanghai Composite index of 444.2 percent in 2005-2007, jump in the Nikkei Average by 131.2 percent between 2003 and 2007, rise in the STOXX Europe 50 index of 93.5 percent in 2003-2007, and increase in the UBS commodity index by 165.5 percent in 2002-2008. Zero or near zero interest rates induced significant volatility by the carry trade from low yielding currencies into fixed income, commodities, currencies, emerging stocks and debt securities, junk bonds and any type of speculative position such as the price of oil rising to $149/barrel in 2008 during a global contraction (Pelaez and Pelaez, Globalization and the State, Vol. II (2009b), 203-4, Government Intervention in Globalization (2009c), 70-4). The 10-year Treasury traded at 3.112 percent on Jun 16, 2003, rising to 5.297 percent on Jun 12, 2007, collapsing to 2.247 percent on Dec 31, 2008, and rising to 3.986 percent on Apr 5, 2010. New house sales peaked historically at 1,283,000 in 2005, declining to 375,000 in 2009 while the median price jumped from $169,000 in 2000 to $247,000 in 2007 to fall to $203,000 in Jul 2010. The other two columns show the decline of risk financial assets during the credit crisis and the incomplete current recovery. Central bank policy induced the financing of nearly everything with short-dated funding at very low interest rates. When year-end consumer price inflation rose from 1.9 percent in 2003 to 3.3 percent in 2004, 3.4 percent in 2005, 2.5 percent in 2006 and 4.1 percent in 2007 (ftp://ftp.bls.gov/pub/special.requests/cpi/cpiai.txt), the FOMC increased the target on the fed funds rate by 17 consecutive rounds of 25 basis points in meetings from Jun 2004 to Jun 2006, raising the rate from 1 percent to 5.25 percent. The combination of short-term zero interest rates, similar effects to quantitative easing by suspending the auction of 30-year Treasuries and housing subsidy caused a worldwide hunt for yields that ended in a world financial crash, global recession and serious distortions in risk/return calculations.

 

Table 5, 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	7/14/08	6/03/10	8/13/10
Rate	1.59	1.216	1.323
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

Sources: http://online.wsj.com/mdc/page/marketsdata.html

http://www.census.gov/const/www/newressalesindex_excel.html

 

IV The Principal Risk of Quantitative Easing. In revealing analysis of liquidity preference, Tobin (1958) derives a discontinuous step function for an individual in which holdings of cash are zero for relatively high rates, in a vertical segment on the vertical axis above a critical rate, and collapse to zero in another vertical segment at rates below the critical rate (see also Pelaez and Suzigan 1978, 33-5, which contains the econometric research of a larger project on Brazil’s monetary history in Pelaez and Suzigan 1981, Pelaez 1974, 1975, 1976a,b, 1977, 1979). The aggregate demand for the market would have the inverse relation of liquidity preference and the interest rate as in Hicks’ interpretation of Keynes (1937, 151). A potential problem facing quantitative easing is that yields may be so low already that the only conceivable direction is an increase in yields, which is equivalent to a decline in prices. There is significant principal risk in quantitative easing that may lock the Fed and the economy in a duration trap. Duration, or the interest elasticity of security prices, is higher, all other things equal, the lower the yield and coupon. On Dec 1, credit by the Fed stood at $2.3 trillion with holdings of long-term securities of $2.06 trillion, consisting of $893 billion of notes and bonds (including inflation indexed), $148 billion of federal agency debt securities and $1022 billion of mortgage-backed securities (http://www.federalreserve.gov/releases/h41/current/h41.htm#h41tab1). There may not be a painless exist from lowering yields and acquiring $2.6 trillion of Treasury securities by the Fed equivalent to 30 percent of $8.5 trillion of Treasury securities held by the public.

Table 6 provides actual yields of the 10-year Treasury at the close of market. Price is calculated for the same coupon of 2.625 percent and maturity in exactly 10 years from Dec 3, except for the actual price for the 10-year Treasury with coupon of 2.625 percent and maturity on Nov 15, 2020. The last column calculates the gain or loss in principal that would occur if the bond were purchased at the price on Nov 4 and sold at the price in the third column calculated by the yield in the second column. The highest yield over ten years of 5.510 percent was traded on Apr 1, 2001 and the lowest of 2.123 percent on Dec 19, 2008. If yields were to back up to 5.51 percent, the principal loss would be 22.9 percent, which for the dealer means $229,000 per $1 million of position, entirely wiping out the dealer’s margin or own capital of $100,000 and still owing the financing counterparty $129,000 plus carry cost. The best return would occur at the low of 2.123 percent on Dec 19, 2008, for a principal gain of $32,000 per $1 million of position or gain of 32 percent for the dealer on margin or own capital less cost of carry. Naturally, professional portfolios are actively managed and losses of this magnitude would be avoided by offsetting the position in a declining market while gains could result in additional positions in upwardly trending markets. Small investors in dedicated bond funds may also avoid catastrophes as professional managers of portfolios switch into cash during adverse market movements but fund income may inadequately reward savings. Pension fund managers and institutions managing asset/liability maturity transformation may face more difficult adjustment. Table 6 also shows that the yield of the 10-year Treasury has increased from 2.481 percent when the Fed announced it would purchase an extra $600 billion of bonds to 3.077 percent at the close on Dec 3 for a principal loss of 4.5 percent that would have caused a loss of $45,000 on dealer’s own capital or 45 percent in a position with leverage of 10:1.

 

Table 6, 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

Note: price is calculated for an artificial 10-year note paying semi-annual coupon and maturing on 12/02/2020 using the actual yields traded on the dates

Source:

http://online.wsj.com/mdc/public/page/mdc_bonds.html?mod=mdc_topnav_2_3020

 

The Fed is simultaneously attempting to lower long-term yields while increasing inflation from 0.9 percent as measured by the price index of personal consumption expenditures excluding food and energy (http://www.bea.gov/newsreleases/national/pi/pinewsrelease.htm) to a “little below” 2 percent. The earlier policy of 1 percent fed funds rate ended when CPI inflation rose from 1.9 percent in 2003 to 4.1 percent in 2007 with the fed funds rate rising from 1 percent in Jun 2004 to 5.25 percent in Jun 2006. Inflation is already a policy issue in emerging Asia with 2.8 percent in Australia, 3.5 percent in Singapore, 4.1 percent in South Korea, 4.4 percent in China, 5.8 percent in Indonesia and 8.6 percent in India (http://professional.wsj.com/article/SB10001424052748703785704575642630727213078.html?mod=wsjproe_hps_LEFTWhatsNews). Inflation in the euro zone is 1.9 percent, just below the target of the ECB of 2 percent. China has shifted its official monetary policy to tightening (http://professional.wsj.com/article/SB10001424052748703989004575652040187353212.html?mod=wsjproe_hps_LEFTWhatsNews). Brazil is taking strong measures to prevent accelerating inflation that reached 5.5 percent in the12 months ending in Oct to meet a year-end target of 4.5 percent (http://professional.wsj.com/article/SB10001424052748703350104575652620822381284.html). The rise in commodity prices, affecting energy and food, is becoming a regressive silent tax on the US middle class experiencing tight budget constraints.

V Global Devaluation War. Another consequence of quantitative easing is provided by Krugman (1998, 162): “in the traditional open economy IS-LM model developed by Robert Mundell and Marcus Fleming, and also in large-scale econometric models, monetary expansion unambiguously leads to currency depreciation.” The suggestion by Chairman Bernanke to the Bank of Japan (BOJ) is very relevant to current events and the contentious issue of ongoing devaluation wars (http://www.iie.com/publications/chapters_preview/319/7iie289X.pdf, 161):

“Because the BOJ has a legal mandate to pursue price stability, it certainly could make a good argument that, with interest rates at zero, depreciation of the yen is the best available tool for achieving its mandated objective. The economic validity of the beggar-thy-neighbor thesis is doubtful, as depreciation creates trade—by raising home country income—as well as diverting it. Perhaps not all those who cite the beggar-thy-neighbor thesis are aware that it had its origins in the Great Depression, when it was used as an argument against the very devaluations that ultimately proved crucial to world economic recovery. A yen trading at 100 to the dollar is in no one’s interest.”

Bernanke finds dollar devaluation against gold to have been important in preventing further deflation in the 1930s (http://www.federalreserve.gov/boarddocs/speeches/2002/20021121/default.htm):

“There have been times when exchange rate policy has been an effective weapon against deflation. A striking example from US 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 US 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.”

Devaluation, intentionally or as a side consequence, is an important part of increasing inflation and promoting growth and employment by means of quantitative easing. Table 7 shows an almost unilateral devaluation of the dollar against currencies of advanced and emerging countries, which is widely believed to be a consequence of quantitative easing.

 

Table 7, Exchange Rates

	Peak	Trough	∆% P/T	Dec 3 2010	∆% T Dec 3	∆% P Dec 3
EUR USD	7/15 2008	6/7 2010		12/03 2010
Rate	1.59	1.192		1.341
∆%			-33.4		11.1	-18.6
JPY USD	8/18 2008	9/15 2010		12/03 2010
Rate	110.19	83.07		82.50
∆%			24.6		0.7	25.2
CHF USD	11/21 2008	12/8 2009		12/03 2010
Rate	1.225	1.025		0.976
∆%			16.3		4.8	20.3
USD GBP	7/15 2008	1/2/ 2009		12/03 2010
Rate	2.006	1.388		1.577
∆%			-44.5		11.9	-27.2
USD AUD	7/15 2008	10/27 2008		11/26 2010
Rate	0.979	0.601		0.993
∆%			-62.9		39.5	-1.4
ZAR USD	10/22 2008	8/15 2010		12/03 2010
Rate	11.578	7.238		6.85
∆%			37.5		5.4	40.8
SGD USD	3/3 2009	8/9 2010		12/03 2010
Rate	1.553	1.348		1.301
∆%			13.2		3.5	16.2
HKD USD	8/15 2008	12/14 2009		12/03 2010
Rate	7.813	7.752		7.762
∆%			0.8		-0.2	0.6
BRL USD	12/5 2008	4/30 2010		12/03  2010
Rate	2.43	1.737		1.70
∆%			28.5		2.1	30.0
CZK USD	2/13 2009	8/6 2010		12/03 2010
Rate	22.19	18.693		18.616
∆%			15.7		0.4	16.1
SEK USD	3/4 2009	8/9 2010		12/03 2010
Rate	9.313	7.108		6.794
∆%			23.7		4.4	27.0

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; 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

 

VI Economic Indicators. The perception of market participants is an improvement in the economy at the margin but with housing and employment markets still showing weakness. The Beige Book of the Fed summarizes current economic conditions as: “reports from the twelve Federal Reserve Districts indicate that the economy continued to improve, on balance, during the reporting period from early/mid-October to November” (http://www.federalreserve.gov/fomc/beigebook/2010/20101201/fullreport20101201.pdf).The Wall Street Journal provides extremely useful information of the purchasing manager index (PMI) for major economies on a monthly basis (http://professional.wsj.com/article/SB10001424052748704594804575648322057855504.html?mod=wsjproe_hps_MIDDLEFifthNews). The PMIs for Nov indicate faster expansion in China and the euro zone, especially in France and Germany. The PMI of the Institute for Supply Management of the US fell slightly by 0.3 points from 56.9 in Oct to 56.6 in Nov while new orders fell 2.3 points and production declined 7.7 points (http://www.ism.ws/ISMReport/MfgROB.cfm). The ISM’s nonmanufacturing index (NMI) rose 0.7 points from 54.3 in Oct to 55.0 in Nov with new orders rising 1 point and employment up by 1.8 points (http://www.ism.ws/ISMReport/NonMfgROB.cfm). Manufacturing goods new orders fell 0.9 percent in Oct after three months of increases, including 3.0 percent in Sep. New orders for all manufacturing industries rose 12.5 percent in the first ten months of 2010 relative to the same period in 2009 (http://www.census.gov/manufacturing/m3/prel/pdf/s-i-o.pdf). Sales of light vehicles by GM rose 12 percent in Nov and those of Ford 20 percent, in continuing improvement (http://professional.wsj.com/article/SB10001424052748704594804575648663461987900.html?mod=wsjproe_hps_LEFTWhatsNews). In the first ten months of 2010, construction spending was $684.7 billion, which is 11.2 percent lower than $770.6 billion in the same period in 2009 (http://www.census.gov/const/C30/release.pdf). Construction spending peaked in 2005 and then has fallen to very low levels without recovering an upward trend (http://www.census.gov/briefrm/esbr/www/esbr050.html). The S&P’s Case-Shiller National Home Price Index fell 2.0 percent in IIIQ10 after an increase of 4.7 percent in IIQ10. At the national level, home prices are 1.5 percent lower than in 2009. The end of tax incentives and continuing foreclosure activity seem to affect home prices (http://www.standardandpoors.com/indices/sp-case-shiller-home-price-indices/en/us/?indexId=spusa-cashpidff--p-us----). The good news in housing was the increase by 10.4 percent of the index of pending home sales of the National Association of Realtors on the basis of contracts signed in Oct. Data are for contracts instead of actual closings that occur with a two-month lag but are viewed as a forward-looking indicator (http://www.realtor.org/press_room/news_releases/2010/12/strong_phs). Initial claims for unemployment insurance seasonally adjusted were 436,000 in the week ending on Nov 27 for an increase of 26,000 relative to 410,000 a week earlier (http://www.dol.gov/opa/media/press/eta/ui/current.htm). There appears to be a decline below claims of 450,000 around which the data have fluctuated in 2010 after interrupting the significant improvement in late 2009.

VII Interest Rates. The US Treasury yield curve continues to shift upward and to the left with sharp slope in the segment after two years. The 10-year Treasury traded at 3.01 percent on Dec 3, which is higher than 2.87 percent a week earlier and 2.54 percent a month earlier. The 10-year German government bond traded at 2.85 percent on Dec 3 for a negative spread relative to the comparable Treasury of only 15 basis points (http://markets.ft.com/markets/bonds.asp).

VIII Conclusion. Unemployment or underemployment cause significant job stress to 26.4 million persons in the US. Combined fiscal and monetary stimulus of trillions of dollars could perhaps work but would be frustrated by simultaneous profound transformation of the economy with legislative restructurings and regulation altering business models, preventing capital budgeting, hiring and consumption decisions. Quantitative easing and zero interest rates inflate risk financial assets without transmitting into increases in investment and consumption or aggregate demand. There is a duration trap of quantitative easing that may tilt down the curve of the expansion phase because of expectations of rapidly rising interest rates combining with tax increases to arrest the uncontrolled fiscal budget and government debt. A radical monetary and fiscal policy shift instead of another round of short-term stimulus is required. (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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©Carlos M. Pelaez, 2010