Sunday, December 19, 2010

The Causes of High Bond Yields

The Causes of High Bond Yields

Carlos M. Pelaez

© Carlos M. Pelaez, 2010

This post analyzes the various likely causes of the recent sharp increase in Treasury yields in relation to monetary policy and the world economy. The contents are as follows:

I Causes of High Treasury Yields

II Failure and Risks of Quantitative Easing

III European Sovereign Risks

IV Economic Indicators

V Interest Rates

VI Conclusions

References

I Causes of High Treasury Yields. Chairman Bernanke provided an explanation of the need and objectives of the monetary policy of the Fed known as quantitative easing in an interview with CBS’s “60 Minutes” (http://blogs.wsj.com/economics/2010/12/05/bernanke-on-cbss-60-minutes/ http://www.cbsnews.com/video/watch/?id=7117930n&tag=cbsnewsMainColumnArea.6 http://www.cbsnews.com/video/watch/?id=7120553n&tag=cbsnewsMainColumnArea.6). This section considers the possible causes of the rise in yields since the announcement by the Fed on Nov 3 of the decision to purchase an additional $650 billion of Treasury securities (http://www.federalreserve.gov/newsevents/press/monetary/20101103a.htm) while the following section (II) considers the possible failure and risks of quantitative easing. According to Chairman Bernanke, in the CBS interview, there are two major factors of the need for further monetary stimulus by the Fed: (1) the economy is growing slowly, which is a major reason why lending is at low levels; unemployment is high, posing the risk of further slowdown of the economy; and the economy is barely growing at 2.5 percent, close to the level where growth may not be self-sustaining; (2) inflation is at a very low level, approximating the point where prices could fall or what would be an adverse situation of deflation. The action by the Fed consists of quantitative easing, or the purchase of $650 billion of Treasury securities to lower their yields with the objective of lowering interest rates to the private sector that could cause faster economic growth. Why are Treasury yields increasing?

Table 1 provides the yields and prices of the 10-year Treasury note at peaks, troughs and selected dates in the past decade with emphasis after the credit/dollar crisis and global recession. The yield of 2.481 per cent on Nov 4, 2010, a day after the announcement by the Fed of another widely anticipated round of quantitative easing, rose to 3.517 percent at the close of market on Dec 15 and climbed to 3.338 percent on Dec 17. The declines in prices relative to Nov 4 were 8.6 percent for the yield of 3.517 percent on Dec 15 and 7.2 percent for the yield of 3.338 percent on Dec 17. The 10-year Treasury yield has risen by about 100 basis points since Nov 4 in opposite direction of the intended policy of the Fed.

Table 1, Yield, Price and Percentage Change to November 4, 2010 of Ten-Year Treasury Note

DateYieldPrice∆% 11/04/10
05/01/015.51078.0582-22.9
06/10/033.11295.8452-5.3
06/12/075.29779.4747-21.5
12/19/082.213104.49813.2
12/31/082.240103.42952.1
03/19/092.605100.1748-1.1
06/09/093.86289.8257-11.3
10/07/093.18295.2643-5.9
11/27/093.19795.1403-6.0
12/31/093.83590.0347-11.1
02/09/103.64691.5239-9.6
03/04/103.60591.8384-9.3
04/05/103.98688.8726-12.2
08/31/102.473101.33380.08
10/07/102.385102.12240.8
10/28/102.65899.7119-1.5
11/04/102.481101.2573-
11/15/102.96497.0867-4.1
11/26/102.86997.8932-3.3
12/03/103.00796.7241-4.5
12/10/103.32494.0982-7.1
12/15/103.51792.5427-8.6
12/17/103.33893.9842-7.2

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

Source:

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

There are at least five interrelated causes of the rise in Treasury yields but it is quite difficult to separate their effects to measure their relative merit:

1. Economic Recovery. Market participants and economists argue that short-term economic indicators are showing improvement in economic conditions. The effect of this view is that investors would fear that economic improvement would force the Fed to increase the fed funds rate. The unbiased expectations theory of the term structure of interest rates would predict an increase in long-term interest rates. A possible objection to this view is that there are still about 27 million people in job stress, some15 million unemployed and another 12 million working part-time because they cannot find full-time employment. Marginal improvements in job stress do not suggest sufficiently strong economic conditions for the Fed to abandon the program of adding bank reserves to induce economic growth that would reduce unemployment and underemployment. Economic indicators do not still suggest growth of the economy at the pace of recoveries from deep recessions in the 1980s, 1970s and 1950s.

2. Inflation. Another argument intimately related with the recovery of the economy is a higher rate of inflation that could pierce the 2 percent “unwritten” target of the Fed. At some point the Fed would be forced into increasing fed funds rates to prevent a higher rate of inflation than would be consistent with the dual mandate of maintaining price stability.

3. Budget Deficit and Government Debt. Investors could fear that the financing of large government deficits, perhaps at around one trillion dollars indefinitely, could saturate markets with supply of Treasury securities to finance the deficits, refinance maturing debt and finance increasingly heavy interest payments. Increasing the supply of Treasury securities causes declines in their prices or equivalently increases in their yields. Part of the concern with the fiscal situation of the US during the week originated in the Tax Relief, Unemployment Insurance Reauthorization and Job Creation Act of 2010 justified by the statement that it “does not worsen the medium- and long-term deficit. These are responsible, temporary measures to support our economy that will not add costs by the middle of the decade” (http://www.whitehouse.gov/taxcut). Without dwelling on the employment and economic claims, the fiscal situation will evidently not improve as a result of these measures. The fiscal situation is worrisome with government expenditures of 24 percent of GDP in 2010 with revenue at 15 percent of GDP and government debt rising to 90 percent in 2020 (http://online.wsj.com/public/resources/documents/WSJ-20111201-DeficitCommissionReport.pdf 8-9). It is difficult to believe that the same government that created this fiscal imbalance, which is a record since World War II, will adjust expenditures and revenues in the absence of a major political shock that results from an explosion of the budget deficit and government debt.

4. Fed Balance Sheet. In the week ended Dec 15, 2010, the line “Reserve bank credit” in the Fed balance sheet, stood at $2374.3 billion or $2.4 trillion (http://www.federalreserve.gov/releases/h41/current/h41.htm#h41tab1). The portfolio of long-term securities of the Fed reached $2105.1 billion or $2.1 trillion, composed of: $889.8 billion of long-term notes and bonds, $46.5 billion of inflation-indexed notes and bonds, $148.1 billion of federal agency securities and $1020.7 billion of mortgage-backed securities (Ibid). The item “reserve balances with Federal Reserve Banks” stood at $1053.8 billion or $1.1 trillion, consisting of reserves by depository institutions deposited at the Federal Reserve Banks. The Fed created assets in its balance sheet in the form of long-term securities by creating a liability in the form of bank reserves that are paid an interest rate of 0.25 percent per year. The first round of quantitative index was financed by increasing bank reserves 24 times from $43 billion in Nov 2007 to $1038 billion in Nov 2010 (http://www.federalreserve.gov/releases/h3/hist/h3hist1.pdf). US monetary liabilities, or base money, consisting of currency held by the public plus bank reserves deposited at the Fed, increased 137.9 percent from 2007 to 2010. It is true that the Fed can increase interest rates in “15 minutes,” in fact instantaneously, as remarked by Chairman Bernanke in the “60 Minutes” interview: the mere hint that the Fed is about to increase interest rates could cause sharp worldwide increases throughout the term structure of interest rates. It is far more difficult to believe that there is an orderly “exit strategy” from this balance sheet as the Fed was rehearsing before the change in mood toward more quantitative easing in late August. There are three factors that could cause disorderly unwinding of the Fed balance sheet:

i. Duration Trap. Positions in securities that are professionally and actively managed are leveraged 10:1 and lead market yields. If there is an expectation of a trend of backup of yields, professional money managers will dump duration, feeding the trend of increases in yields. There is a dramatic example from recent history. The worldwide crash of bond markets in 1994 began in the US in fear of inflation resulting from commodity prices that never materialized. The Fed increased the fed funds target from 3 percent in Jan to 6 percent in Dec with the yield of the 30-year Treasury jumping from 6.29 percent to 7.87 percent, causing price declines of 13 percent, and the yield of the 30-year mortgage rose from 7.07 percent to 9.20 percent (Pelaez and Pelaez, The Global Recession Risk (2007), 206-7). Assuming a 30-year Treasury with coupon of 7 percent priced at 99.999 with yield of 7 percent, the instantaneous rise in yield to 9 percent would result in price of 79.3619 for a principal loss of 20.6 percent. European bond prices crashed throughout 1994 as analysts advised of decoupling from the US experience that never materialized. The correlation of G3 (Europe, US and Japan) bond yields was only 0.18 and 0.40 for stock markets but G3 bonds collapsed. Statistical models used in stress tests, as in the episode of Long-term Capital Management in 1998, may not capture actual crash of fixed-income securities and stock markets. Policy errors such as this one raise doubts about the infallibility of monetary and fiscal policy. There are fluctuations around trends and sometimes fluctuations without trends. A problem in one asset class spreads to other assets classes as dealer capital is reduced by margin calls and financing-price haircuts that force paring positions in other classes, as it happened in 2007-2009 and in 1994. Duration is higher the lower bond yields and coupons, ceteris paribus. Lowering bond yields by quantitative easing with the Fed aiming to maintain about 30 percent of Treasury securities in circulation poses the risk of an uncontrollable upward trend of yields, magnified by market anticipations of risk of principal loss.

ii. Bank Reserves at the Fed. The Fed could decide indefinitely not to sell or prevention reduction of its portfolio by compensating with additional purchases the attrition of maturing securities. The portfolio was acquired by issuing a monetary liability of the US government: bank reserves. If economic conditions improve and regulatory pressure softens, banks would find creditworthy and remunerative opportunities to lend to their clients. Banks would withdraw reserves from the Fed to lend to clients. In the exit strategy phase earlier in 2010, the Fed argued that it could raise interest rates on reserves to prevent their withdrawal. The interest rate paid on reserves is the marginal cost of bank funding, much as the same as the rate on fed funds. The increase in funding costs increases the interest rates on loans. Treasury securities maturing near the term of bank loans would experience an increase in yield, much the same as long-term debt of companies. The increase of interest rates on reserves would be transmitted along the term structure of interest rates, causing an increase in yields or equivalent decline in price. Traders of portfolios of long-term securities would dump duration. Managers of maturity transformation would require increases in rates of long-term assets, such as loans, to compensate for the estimated increase in short-term funding costs, in the effort to preserve net interest margin that remunerates the cost of capital to the bank or other financial institution.

5. Alternative Risk Assets. Professor Jeremy Siegel, of the Wharton School, and Jeremy Schwartz, of Wisdom Tree, analyzed in late Oct the risks of capital losses of positions in Treasuries with high duration in a must-read opinion article for the Wall Street Journal (http://professional.wsj.com/article/SB10001424052748704407804575425384002846058.html ). An increase in yields of 10-year Treasuries from 2.8 percent, at a much higher level at the time of their writing, to the 4 percent almost reached in Apr would cause a capital loss exceeding three times the then current yield of 10-year Treasuries (Ibid). Such an increase could occur as Siegel and Schwartz point out because of acceleration of the rate of growth of the economy. They quote data from the Investment Company Institute that from Jan 2008 to Jun 2010 the outflows from equity funds totaled $232 billion while $559 billion flowed into bond funds. There may be another but similar avenue for a rise in stocks compared to decline of bonds. Companies are holding $3 trillion in cash and may engage in attractive mergers and acquisitions (http://noir.bloomberg.com/apps/news?pid=newsarchive&sid=aFzUwxN3LKsQ ). In a recent article in the Wall Street Journal, Professor Siegel argues that improved expectations on economic growth and inflation are raising Treasury yields (http://professional.wsj.com/article/SB10001424052748703766704576009621740764118.html?mod=WSJ_Opinion_LEFTTopOpinion&mg=reno-wsj). In this view, rising yields may reflect an improved outlook on the economy.

II Failure and Risks of Quantitative Easing. If quantitative easing is an effective policy, why has the economy not recovered after the purchase by the Fed of $2.1 trillion of long-term securities, a zero interest rate of 0 to ¼ percent since Dec 18, 2008, and injection of $1 trillion of bank reserves to purchase long-term securities? An important channel of transmission of quantitative easing is that “if money is an imperfect substitute for other financial assets, then large increases in the money supply will lead investors to seek to rebalance their portfolios, raising prices and reducing yields on alternative, non-money assets. In turn, lower yields on long-term assets will stimulate economic activity” (Bernanke and Reinhart 2004, 88). The commitment of the Fed to purchasing long-term securities is designed to impress on investors that prices will increase and yields decline for asset classes that are related to long-term borrowing costs of firms, such as corporate debt and asset-backed securities collateralized with loans. Portfolio rebalancing originates in the theory of financial markets in conditions of risk. An important advance in this theory was the application of general equilibrium methods and the elimination of the assumption of perfect substitution between money and other capital assets (Tobin, 1962). Portfolio choice theory developed by Markowitz (1952), Tobin (1958), Hicks (1962), Treynor (1962), Sharpe (1964) and Lintner (1965) provided the separation theorem of Tobin, which states that the share of wealth allocated to individual risky assets is independent of the optimum share of risk assets in the total portfolio, and the theory of choice of an optimum risk-asset portfolio with borrowing or lending at the riskless or “pure” rate of interest. Equilibrium is attained by changes in the share of individual risk assets in the risk-asset portfolio that change their prices or rates of return. Tobin (1969) provided the general equilibrium model in which the Tobin q, or market value of capital relative to the reproduction cost of capital, responds positively to an injection of base money, ∂q/∂B>0, where B is base money. André et al (2004) formalized further the Tobin (1969) model and its applicability to quantitative easing. Vayanos and Vila (2009) formalize for present purposes the preferred habitat model of Culberton (1957, 1963) and Modigliani and Sutch (1966) with a rich analysis of how arbitrageurs engage in carry trade along the term structure when quantitative easing changes bond prices. Various recent contributions, such as Hamilton and Wu (2010), measure the effects of quantitative easing on Treasury yields.

In all these models, an exogenous shock such as quantitative easing disrupts portfolio equilibrium of investors. The disruption of portfolio equilibrium as analyzed in the theory of portfolio choice triggers changes in the proportionate shares of assets held until the optimum point in the efficient frontier is attained. With the fed funds rate pegged at 0 to ¼ percent and most short-term rates with little or no risk around this level, the arbitrageur has an incentive to borrow at the short-term rate to invest in risk assets. The choice of risk assets is highly diversified: commodities, currencies, junk bonds, asset-backed securities, stocks, emerging market securities and so on. The carry trade that is relevant to explain portfolio rebalancing is from borrowing at near zero interest rates of fed funds to take long positions in risk assets. This carry trade encourages: (1) financing of everything at near zero interest rates; (2) taking excessive risks with high leverage to magnify what appear opportunities with low risk because of the commitment of the Fed to keep rates near zero indefinitely; (3) ignoring sound credit practices because increases in asset prices given as collateral, such as housing, can provide repayment of debt; and (4) minimizing liquidity because of its high opportunity cost of near zero short-term interest rates. These four practices of financial markets were induced by the Fed’s interest rates near zero and eventually resulted in a financial crisis that provoked a global recession when the Fed increased the interest rate from 1 percent in 2003-2004 to 5.25 percent in 2006 while consumer price inflation jumped from 1.9 percent in 2003 to 4.1 percent in 2007 (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)). Table 2 shows the inflation of financial assets caused by the zero interest rate until 2007 and the subsequent collapse when underlying mortgages soured under pressure of the rise in interest rates. A similar event could be in the making when the Fed attempts to control inflation rising above its target of 2 percent.

Table 2, Volatility of Assets

DJIA10/08/02-10/01/0710/01/07-3/4/093/4/09- 4/6/10

∆%

87.8-51.260.3
NYSE Financial1/15/04- 6/13/076/13/07- 3/4/093/4/09- 4/16/07

∆%

42.3-75.9121.1
Shanghai Composite6/10/05- 10/15/0710/15/07- 10/30/0810/30/08- 7/30/09

∆%

444.2-70.885.3
STOXX EUROPE 503/10/03- 7/25/077/25/07- 3/9/093/9/09- 4/21/10

∆%

93.5-57.964.3
UBS Com.1/23/02- 7/1/087/1/08- 2/23/092/23/09- 1/6/10

∆%

165.5-56.441.4
10-Year Treasury6/10/036/12/0712/31/084/5/10
%3.1125.2972.2473.986
USD/EUR7/14/086/03/108/13/10
Rate1.591.2161.323
New House1963197720052009
Sales 1000s5608191283375
New House2000200720092010
Median Price $1000169247217203

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

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

The intention of quantitative easing by the Fed is to channel funds originating in buying bonds with injection of bank reserves into financing capital goods for investment by firms and durable goods for consumption by families. Higher investment and consumption are equivalent to higher aggregate demand that translates into accelerating economic growth and hiring. The mechanism is to lower long-term rates of financing the private sector by withdrawing supply of long-term Treasury notes, in the five to seven year segment, that results in increasing their prices or equivalently lowering their yields. Lower yields of long-term Treasury securities result in lower yields of long-term corporate debt and also lower rates on long-term bank loans that can be securitized in bonds that are floated at lower yields.

The obstacle to the transmission mechanism of quantitative easing is that even if long-term costs of borrowing and consuming by the private sector were effectively lowered, the uncertainty of legislative restructuring of business models and draconian regulation restrains investment and consumption. Quantitative easing is processed through the financial sector that is being constrained by the Dodd-Frank financial regulation bill. A few examples illustrate the barrier to investment and consumption created by the restructurings and regulation. The Basel Committee on Banking Supervision (BCBS) has released the Results of the Comprehensive Quantitative Impact Study (QIS) to assess the effects of proposed global capital regulation rules (http://www.bis.org/publ/bcbs186.pdf). A key issue is the impact on banks of the common equity tier 1 capital (CET1). The QIS finds that “the capital shortfall for Group 1 banks in the QIS sample is estimated to be between €165 billion for the CET1 minimum requirement of 4.5% and €577 billion for a CET1 target level of 7.0% had the Basel III requirements been in place at the end of 2009. As a point of reference, the sum of profits after tax prior to distributions across the sample of Group 1 banks in 2009 was €209 billion” (Ibid, 2). The Fed is considering a rule to implement Dodd-Frank provisions that would reduce the fees received currently by banks from merchants on transactions using debit cards from 44 cents per transaction to 7 to 12 cents per transaction or a reduction of bank revenues from 84.1 percent to 72.7 percent. A major bank provisioned a loss of $10 billion in the third quarter for the reduction in value of its cards business with an annual drop of $2.3 billion (Ibid). This is equivalent to profit controls by regulation, with resulting decline in volume of financing and increases in interest rates while frustrating innovation that is the driver of economic growth and progress. The Credit Card Accountability, Responsibility and Disclosure Act of 2009 (CARD) (http://www.whitehouse.gov/the_press_office/Fact-Sheet-Reforms-to-Protect-American-Credit-Card-Holders ) was signed into law on May 22, 2009, and entered into effect on February 22, 2010. CARD harmed the credit card industry and its users who are nearly everybody. Credit card issuers reduced the credit limits of their clients to protect their business, resulting in lower credit scores that are based on utilization. As a result many homeowners who would have qualified for the 4.17 percent refinancing rates in Nov were disqualified by their inadequate credit scores caused by CARD (http://professional.wsj.com/article/SB10001424052748704681804576017923196489558.html?mod=WSJPRO_hpp_sections_personalfinance). In an article in the Financial Times, Henry Kaufman finds that Dodd-Frank increases uncertainty regarding growth, creating obstacles to competition in finance and restricting the independence of financial institutions (http://www.ft.com/cms/s/0/0d05c9c0-0955-11e0-ada6-00144feabdc0.html#axzz18O5dM5fG

). There are 2400 pages in Dodd-Frank and numerous rules for its implementation without hard knowledge on what are the effects of individual provisions and major uncertainty on their combined impact on the financial system and the overall economy. Kaufman concludes that the US should begin again its regulation of finance.

Table 3, updated in every post, provides the recent behavior of risk financial assets. There was sharp decline in values of financial assets caused by the uncertainties of sovereign risk in Europe and growth of the economy of China. The final column provides the potential effects of quantitative easing since its widespread insinuation by members of the Federal Open Market Committee in Aug: sharp increases in value of all financial assets and depreciation of the dollar. Zero interest rates and quantitative easing merely induce arbitrage of risk financial assets or otherwise the economy of the US would have grown rapidly out of the recession and not by mediocre rates compared with past expansions after deep contractions. The distortions of risk financial assets pose the risk of another financial event with unpredictable consequences on the overall economy instead of the intended growth stimulus.

Table 3, Stock Indexes, Commodities, Dollar and 10-Year Treasury

PeakTrough∆% to Trough∆% Peak to 12/17∆% Week 12/17∆% T to 12/17
DJIA4/26/107/2/10-13.62.60.718.6
S&P 5004/23/107/20/10-16.02.20.321.6
NYSE Finance4/15/107/2/10-20.3-9.3-1.513.9
Dow Global4/15/107/2/10-18.4-1.50.120.7
Asia Pacific4/15/107/2/10-12.54.60.619.5
Japan Nikkei Average4/05/108/31/10-22.5-9.60.916.8
China Shanghai4/15/107/02/10-24.7-8.61.921.4
STOXX 504/15/107/2/10-15.3-3.9-0.213.4
DAX 4/26/105/25/10-10.510.2-0.323.1
Dollar
Euro		11/25 20096/7
2010		21.212.80.2-10.6
DJ UBS Comm.1/6/107/2/10-14.57.01.125.2
10-Year Tre. 4/5/104/6/103.9863.338

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

The evolution of the Dow Jones Industrial Average (DJIA) and the S&P 500 since the first quarter of 2010 is shown for selected dates in Table 4. The road has been bumpy. There is similar behavior in the other financial assets in Table 3 that is covered in this blog. Different combinations of sovereign risk events in Europe, fears of growth deceleration in China and regulatory shocks in the US combine to increase worldwide volatility of financial asset values. There is no apparent evidence in this behavior that growth is becoming more robust in the US such that equity prices have increased in anticipation of higher sales and profits. More robust growth is a forecast of future economic conditions. Unfortunately, the forecasts of economists are second only to those of astrologers. Equity prices were predicting expansion of the economy beyond 2007 just before a global recession and it is difficult to separate accurate anticipations of future corporate performance in a booming economy from arbitrage opportunities in current equity prices.

Table 4, 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 8-1.2-11.32.1-12.4
Jul 2-2.6-13.6-3.8-15.7
Aug 910.5-4.310.3-7.0
Aug 31-6.4-10.6-6.9-13.4
Nov 514.22.116.81.0
Nov 30-3.8-3.8-3.7-2.6
Dec 174.42.55.32.6

Source: http://online.wsj.com/mdc/public/page/mdc_us_stocks.html?mod=mdc_topnav_2_3004

Table 5, updated with every post, provides another consequence of quantitative easing that many foreign economic officials characterize as a global exchange war. With interruptions by events in European sovereign risk and Chinese economic growth, quantitative easing depreciates the dollar against most currencies in the world.

Table 5, Exchange Rates

PeakTrough∆% P/TDec 17 2010∆% T Dec 17∆% P Dec 17
EUR USD7/15
2008		6/7 201012/17 2010
Rate1.591.1921.319
∆%-33.49.9-20.5
JPY USD8/18
2008		9/15
2010		12/17 2010
Rate110.1983.0783.96
∆%24.6-1.123.8
CHF USD11/21 200812/8 200912/17 2010
Rate1.2251.0250.962
∆%16.36.121.5
USD GBP7/15
2008		1/2/ 200912/17 2010
Rate2.0061.3881.553
∆%-44.510.6-29.2
USD AUD7/15 200810/27 200812/17 2010
Rate0.9790.6010.985
∆%-62.939.20.9
ZAR USD10/22 20088/15
2010		12/17
2010
Rate 11.5787.2386.870
∆%37.55.140.7
SGD USD3/3
2009		8/9
2010		12/17
2010
Rate1.5531.3481.314
∆%13.22.515.4
HKD USD8/15 200812/14 200912/10
2010
Rate7.8137.7527.777
∆%0.80.30.5
BRL USD12/5 20084/30 201012/17
2010
Rate2.431.7371.712
∆%28.51.429.5
CZK USD2/13 20098/6 201012/10 2010
Rate22.1918.69319.091
∆%15.7-2.113.9
SEK USD3/4 20098/9 201012/17
2010
Rate9.3137.1086.840
∆%23.73.826.6

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; 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

III European Sovereign Risks. Leaders of the European Union approved on Dec 16 an amendment to the treaties creating a permanent vehicle for rescue of highly indebted countries (http://www.ft.com/cms/s/0/14b22126-0948-11e0-ada6-00144feabdc0,dwp_uuid=79cadde4-5c1b-11df-95f9-00144feab49a.html#axzz18VrzZs7B). Article 135 of the Treaty will be amended to read: “the Member States whose currency is the euro may establish a stability mechanism to be activated if indispensable to safeguard the stability of the euro area as a whole. The granting of any required financial assistance under the mechanism will be made subject to strict conditionality” (http://www.consilium.europa.eu/uedocs/cms_data/docs/pressdata/en/ec/118572.pdf 1). Opinions of the European Parliament, European Commission and European Central Bank will result in a full decision of the draft document by Mar 11. Every member state will have to approve the amendment. The European Stability Mechanism will follow IMF and standard international practice, with decisions on a case-by-case basis without private sector involvement before support of countries in liquidity constraints (Ibid, 2). The 27 members of the European Union agreed even if only 16 are members of the euro zone. The conclusion is that the members “have a joint strategy to make our economies crisis proof and to enhance structural economic growth in Europe” (Ibid, 2). There were not increases in the bailout funds but the meeting created the strongest impression that European Union leaders were willing to support large countries such as Spain and Italy should they face financial strains (http://www.ft.com/cms/s/0/cf1454f4-09e7-11e0-8b29-00144feabdc0,dwp_uuid=79cadde4-5c1b-11df-95f9-00144feab49a.html#axzz18Vtjte3i). Table 6 shows that the combined GDP of Portugal, Ireland, Italy, Greece and Spain amounts to $4045 billion or 33 percent of the GDP of the euro zone of $12,067 billion. The BIS Quarterly Review informs that “as of the end of the second quarter of 2010, the total consolidated foreign exposures of BIS reporting banks to Greece, Ireland, Portugal and Spain stood at $2281 billion” (http://www.bis.org/publ/qtrpdf/r_qt1012b.pdf). Communication through banks and bond markets could transmit the sovereign risk difficulties among various countries. In an article in the Financial Times, Komal Sri-Kumar, Chief Global Strategist of TCW, draws on his rich experience of the debt crises in Latin America to conclude that a permanent solution of the European sovereign risk issues will eventually require debt reduction that could be followed by real economic growth (http://www.ft.com/cms/s/0/38ec7ed2-06c4-11e0-86d6-00144feabdc0.html#axzz18W1yI2Uu). In another essay for the Financial Times, Lorenzo Bini Smaghi of the Executive Board of ECB argues that debt default in European countries would reduce the financial wealth of families and business in such a way that it could have harmful effects in the social fabric of many countries (http://www.ft.com/cms/s/0/0c5511d4-0955-11e0-ada6-00144feabdc0,dwp_uuid=79cadde4-5c1b-11df-95f9-00144feab49a.html#axzz18W3P0t4C). This would be the reason in this view why countries are adopting austerity measures instead of some forms of default. The choices are becoming difficult for sovereigns facing financial strains.

Table 6, 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 Area12,06753.467.473.80.2
Germany3,65258.761.86.13.9
France2,86574.578.7-1.8-1.8
Portugal22479.993.6-9.9-8.4
Ireland20455.271.4-2.7-1.2
Italy2,03798.999.5-2.9-2.4
Greece305109.5112.6-10.8-4.0
Spain1,27554.172.6-5.2-4.3
Belgium46191.4100.10.54.1
USA14,62465.884.7-3.2-3.4
UK2,25968.876.0-2.2-1.1
Japan6,517120.7153.43.11.9
China5,74519.113.94.77.8

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

IV Economic Indicators. Economic indicators continue to show improvement but with depressed levels in real estate and significant job stress. The first sentence of the statement of the Federal Open Market Committee (FOMC) on Dec 14, 2010 states: “information received since the Federal Open Market Committee met in Nov confirms that the economic recovery is continuing, though at a rate that has been insufficient to bring down unemployment” (http://www.federalreserve.gov/newsevents/press/monetary/20101214a.htm). A possible interpretation is that the Fed considers economic conditions to be even weaker than in the first sentence of the Nov 3 statement: “information received since the Federal Open Market Committee met in September confirms that the pace of recovery in output and employment continues to be slow” (http://www.federalreserve.gov/newsevents/press/monetary/20101103a.htm). US industrial production grew 0.4 percent from Oct to Nov after declining by 0.2 percent from Sep to Oct. Industrial production in Nov was at 93.9 percent of its level in 2007 and 5.4 percent above the level in 2009. Capacity utilization in Nov rose to 75.2 percent, which is 5.4 percentage points below the average from 1972 to 2009 (http://www.federalreserve.gov/releases/g17/Current/default.htm). The Philadelphia Fed Business Outlook Survey reports strong improvement from 22.5 in Nov to 24.3 in Dec for a third consecutive month of expansion. The important index of new orders rose 4 points in Dec for a third consecutive month of increases (http://www.philadelphiafed.org/research-and-data/regional-economy/business-outlook-survey/2010/bos1210.pdf). Seasonally-adjusted after-tax profits of US manufacturing corporations were $122.7 billion in the third quarter of 2010, increasing by $5 billion relative to the second quarter of 2010 and $94.5 billion higher than in the third quarter of 2009 (http://www2.census.gov/econ/qfr/current/qfr_mg.pdf). Retail and food services sales seasonally adjusted rose 0.8 percent in Nov and 7.7 relative to Nov 2009; retail trade sales rose 0.9 percent in Nov and 8.1 percent from 2009; and auto and other motor vehicle dealers sales rose 12.8 percent from 2009 (http://www.census.gov/retail/marts/www/marts_current.pdf). Distributive trade sales and manufacturers’ shipments, seasonally adjusted, grew 1.4 percent in Oct relative to Sep and 9.3 percent relative to Oct 2009; manufacturers’ and trade inventories, seasonally adjusted, grew 0.7 percent in Oct relative to Sep and 6.9 percent relative to Oct 2009 (http://www.census.gov/mtis/www/data/pdf/mtis_current.pdf). Private-sector housing starts, seasonally adjusted, rose 3.9 percent in Nov but stood 5.8 percent below the level in Nov 2009; housing starts were 4.0 lower in Nov relative to Oct and 14.7 below the level in Nov 2009. Housing starts in Jan-Nov of 2010 were 553,400, higher by 6.9 percent relative to 517,400 in Jan-Nov 2009 (http://www.census.gov/const/newresconst.pdf Table 3, 4) but 71.3 percent lower than 1,928,300 in Jan-Nov 2005 (http://www.census.gov/const/newresconst_200511.pdf Table 3, 4). The US producer price index, seasonally adjusted, rose 0.8 percent in Nov after increasing 0.4 percent in both Oct and Sep; the unadjusted index rose 3.5 percent in the 12 months ending in Nov (http://www.bls.gov/news.release/pdf/ppi.pdf). The consumer price index, seasonally adjusted, rose 0.1 percent in Nov and the unadjusted index rose 1.1 percent in the 12 months ending in Nov; the seasonally adjusted index excluding food and energy rose 0.1 percent in Nov and the unadjusted index excluding food and energy rose 0.8 percent in the 12 months ending in Nov (http://www.bls.gov/news.release/pdf/cpi.pdf). Seasonally adjusted initial claims for unemployment insurance fell to 420,000 in the week ending on Dec 11, or 3,000 less than in the prior week (http://www.dol.gov/opa/media/press/eta/ui/current.htm). There appears to be a lower average around 425,000 claims from the fluctuation around 450,000 during most of 2010. Industrial production in the euro area rose 0.7 percent in Oct 2010 relative to Sep 2010 and 6.9 percent relative to Oct 2009 (http://epp.eurostat.ec.europa.eu/cache/ITY_PUBLIC/4-14122010-AP/EN/4-14122010-AP-EN.PDF). Exports of the euro area in Jan-Oct 2010 grew 19 percent relative to Jan-Oct 2009 and imports 21 percent (http://epp.eurostat.ec.europa.eu/cache/ITY_PUBLIC/6-17122010-AP/EN/6-17122010-AP-EN.PDF). Annual inflation in the euro area was 1.9 percent in Nov 2010 compared with the annual rate of 0.5 percent in Nov 2009 (http://epp.eurostat.ec.europa.eu/cache/ITY_PUBLIC/2-16122010-BP/EN/2-16122010-BP-EN.PDF). Inflation may still surprise deflationist forecasts in the US. The quarterly report of the Bank of Japan, Tankan, finds that business confidence of large manufacturing enterprises fell from a reading of 8 in the Sep survey to 5 in Dec; confidence in medium size enterprises fell from 4 in Sep to 1 in Dec; confidence of small enterprises improved from -14 in Sep to -12 in Dec; and fixed investment for all industries grew 0.4 in percent in 2010 after declining 18.2 percent in 2009 (http://www.boj.or.jp/en/type/stat/boj_stat/tk/gaiyo/tka1012.pdf).

V Interest Rates. Treasury yields are rising: 3.34 percent for the 10 year relative to 2.88 percent a month ago; 4.44 percent for the 30 year relative to 4.25 percent a month ago; and 1.96 percent for the 5 year relative to 1.52 percent a month ago. The 10-year government bond yield of Germany backed up to 3.02 percent with wider negative spread relative to the US Treasury of 31 basis points (http://markets.ft.com/markets/bonds.asp?ftauth=1292759504233). Bloomberg quotes on Dec 17 the 10-year bond with 2.625 percent coupon, maturing on Nov 15, 2020, at yield of 3.33 percent or equivalent price of 94 3.5/32 (http://noir.bloomberg.com/markets/rates/index.html). The price in the last row of Table 1, 93.9842 or yield of 3.338 percent, is for a non-existing bond that would mature in exactly 20 years from Dec 17 instead of the actual bond maturing on Nov 15, 2020, to maintain uniformity with the other prices in the table.

VI Conclusion.

Treasury yields have surged from 2.481 percent for the 10-year note on Nov 4, a day after the Fed announced an additional quantitative easing of $650 billion, to 3.517 percent on Dec 15 and 3.338 percent on Dec 17, or by about 100 basis points, for decline in price between 7.2 and 8.6 percent (see Table 1). There are arguments that quantitative easing was successful in increasing expectations of economic growth with evidence in the increase in the prices of equities that would explain the surge in yields. A competing explanation is that quantitative easing has merely created arbitrage opportunities in the carry trade from zero interest rates in the US to long positions in risk financial assets such as commodities, currencies, emerging stocks and so on. Inflated risk financial assets may collapse during a market event provoked by sovereign risk deterioration, pains of legislation/regulation in the US or deceleration of growth in China with the risk of affecting the overall world economy. Incentives for corporations to invest their excess cash, by freeing legislative/regulatory restrictions on business models, instead of lowering yields by quantitative easing appear more appropriate to promote rapid economic growth and hiring (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

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