Why so positive about the economic numbers?

It seems that the optimists found good even with the economic numbers today. GDP was revised down in the first quarter by -6.4%. Much worse than the -5.5% posted before. The second quarter was down only 1% instead f the expected 1.5%. The thought is that there is momentum in GDP after a bad first quarter. However if you look a personal consumption we were down -1.2% over double what was expected. This is going to be the driver for a strong recovery. Chicago PMI was up sightly but not like some of the big moves in other countries. The NAPM Milwaukee was down below 50 to 45.

The numbers suggest that the US is in slow growth even with all of the stimulus. This is reflected in the relative performance of the US stock market against equities in other countries. US is a laggard versus emerging markets and similar to Europe for large cap stocks.

The dollar was weaker based on new risk taking. We continue to move back and forth between risk seeking and risk avoidance in currency trading.

Confidence around the world growing

The global confidence by country shows more clearly what we already know. The advanced economies are in a malaise. The only countries which are showing a flat rise in confidence are the United States, France and Germany. The only regions which are below average are the United Sates, Japan and Europe with the addition of some selected countries like Taiwan and South Korea who were affected by steep declines in exports. Most of Asia is positive and getting more optimistic.

No wonder the recovery is occurring in the developed world. This is still the place to be for longer-term currency plays.

NYMEX regulation - the CFTC should be concerned

I wrote an entry on the the CFTC yesterday questioning the comments of a CFC commissioner. Now I have to side with the regulators given the evidence that was presented on the "self-regulation" of traders by the NYMEX futures exchange. The NYMEX has the authority to set accountability levels for trading positions in the energy markets.

Accountability levels are based on reporting levels set by the exchange. These rules include hard caps on the number of contracts that can be held on the three days before expiration of a contract and accountability levels which if exceeded could lead to the exchange asking for a freeze or a reduction in positions. Given these rules, there would be the expectation that few traders would exceed the accountability standards. While not a hard cap, traders would be put on notice that the exchange was monitoring these positions closely. Monitoring is important and should be a requirement for ensuring a well functioning market. Of course, some would argue that this is an infringement on the freedom of traders but the exchange has a responsibility to see that the markets are fair and orderly and that means that no one person can have an excessive amount of the open interest in a contract. The issue is what is the number of contracts that would be excessive. NYMEX set the number of contracts at 10,000 in a single contract month.

The CFTC noted that 43 traders exceeded the limit of 10,000 contracts in a single month in the last year. The average amount that these traders exceeded the standard was substantial. This was not an issue of a few contract above the limit for a few days. What should we think of the exchange for allowing this excess over their levels and not taking any action clear action. The logic is questionable when everyone has been watching this issue closely since the spike in oil prices last year.

NYMEX argues that these were set conservatively because they were just accountability standards and that hard limits would be higher. This still begs the question of why have these accountability limits if they would not take any action to stop or review in detail the behavior of traders. Market participants clearly did not believe there would be any repercussions based on exceeding the accountability standards.

The result of lax accountability is what we are now seeing, a regulator who will now ask for control of this process. After focusing on the idea that the exchanges should be best able to regulate their activities, the exchanges blew their freedom and they should pay for the consequences.

The sad part of this saga is that the link between excesses in position sizes and price manipulation may not be able to be clearly made. Hard position limits are now being discussed at levels that would be much tighter then imagined just a few weeks ago. There is little evidence for anyone to tell what is the appropriate level of position limits and we may not be able to get to this key question in the current environment.

Richmond Fed manufacturing survey explodes on the upside

Richmond Fed manufacturing survey exploded on the upside. This move since the beginning of the year has been largest reversal since the introduction of the survey. There was nothing like it in the previous recession. At this rate, we will hit new highs in another month or two. This also beat the market expectations.

Now, this was not viewed as important as the Conference Board consumer confidence numbers which actually fell this month, but we believe this is something to watch closely. We are not looking for green shoots but there is clear evidence that businesses are getting more comfortable with the environment. The PMI surveys around the world are showing the same pattern. What is interesting about the Richmond survey is that it is a mix of shipments (33%), new orders(40%) and employment (27%).

This is not just a feel good survey. Combine this with the better Case Shiller numbers and we might say there is reason for more risk taking around the globe.

CFTC "new and better" findings

Am I going crazy or did I actually read the following comments from a CFTC commissioner?

From Bloomberg -

The U.S. Commodity Futures Trading Commission will issue a “new and better report” next month bolstering the case for regulation of swaps dealer and index investors in markets it oversees, Commissioner Bart Chilton said today.

If the CFTC has the same data, how are they going to get a better report? There is no question that index players are more significant. They did not exist before. The issue is whether their activities caused distortion in price. This would suggests that contracts where they trade were pushed out of line with contracts not traded by index players. That evidence has not been apparent.

One of the regulatory objectives of the CFTC is to ensure there is not market manipulation. So where is the market manipulation caused form these players. It is not easy to find distortions and manipulation in the markets and clearly there have been cases in the past but most have been focused on what happens in the delivery month. The index players are usually out of the delivery month contract because of index rolls so the chance of manipulation near delivery is minimized.

The August report “will be better and we will not try to spin it and say speculators had no role, like we did last year,” Chilton said in an interview today on Bloomberg Television. Chilton said he can’t prejudge what the report will say.

So is he is saying that the report last year was not truthful? Of course, speculators have a role. You cannot imagine what price volatility would be like if there were only commercial users or hedgers. What happens if everyone wants to protect their exposures and short futures without any speculators. The price would fall excessively. This could not be sustained so there would be no futures market. The question is whether speculators create distortions. The report last year was referring to whether the speculators moved the market in ways that caused inefficiencies or welfare distortions.

From Wall Street Journal -

But that analysis was based on "deeply flawed data," Bart Chilton, one of four CFTC commissioners, said in an interview Monday.

So what does it mean to say that the data is "deeply flawed"? The CFTC collects the data. If there is flawed data why have there not been proposals to right this data injustice? What new data is now available. One hopes that this new data is available for others to analyze.

From Bloomberg -

Chilton said today the agency hasn’t already decided to put position limits in place. The agency will “strike the right balance to make sure that markets operate efficiently and avoid fraud or abuse,” he said.

Chilton, who dissented from the commission’s report last year, said today that “many will have a greater degree of confidence” in the new report.

Who are these many? The ones who want more regulation? Where was the outcry from academics and statisticians on the last report?

“If we have it my way, we will not go slow” and will “have something by the end of the year,” Chilton said.

Does this sound like the comments of a man who has an open mind? If there is new evidence that draws new conclusions, I look forward to reading about it, but it is appropriate to tease the market with what may be the conclusions without providing facts. Remember that he is controlling regulation on some of the most important markets in the world.

The right balance is to conduct analysis and make careful observations about market behavior. After this analysis is completed, a careful set of alternatives have to be crafted so the identified problem can be solved without some unintended consequences. There is no question that the composition of players in the markets has changed, but that does not lead to the conclusion that they have created a market distortion.

Whole economic team gets financial lesson from China

The Obama Administration sent Geithner, Summers, Orszag and Bernanke to the Chinese talks in Washington to explain the current economic plan. The Chinese get better treatment than Congress, but then the Chinese are paying the bills. Of course, having everyone there makes sense, the creditor wants to talk with the team of the debtor.

"We sincerely hope the U.S. fiscal deficit will be reduced, year after year," Assistant Finance Minister Zhu Guangyao told reporters after the Monday talks had ended.

"The Chinese government is a responsible government and first and foremost our responsibility is the Chinese people, so of course we are concerned about the security of the Chinese assets," Zhu said, speaking through an interpreter.

Will this make a difference? The problem is the intangible. The confidence in bonds and a currency once the economic numbers are bad is determined by the belief that the debtor will change. The debtor has to swear that change will occur while convincing their voting public that there will be no costs or changes in service and benefits. Something will have to change but not today.

If you can store it, buy it - the case for base metals

Industrial metals have seen significant gains since the beginning of the year. This is in marked contrast to other commodities especially grains and softs which have shown mixed performance.

What makes this a focus of interest is the fact that metals usually closely follows the global business cycle and the talk has been about a slow recovery. The price action suggests something else.

The bottom in the copper market was in December 2008. Since that time we have been moving at a steady pace upwards. The peak came in the Spring of last year similar to the stock market. Lead, zinc, and nickel all had their lows in December. The silver market bottomed in November and has also been on an uspswing. Gold hit low in November and is just below old highs from early2008. The only exception has been aluminum which has started to move upwards but at a slower pace.

The percent return for base metals since the beginning of the year:

Lead 77.70%
Copper 76.38%
Nickel 41.27%
Zinc 36.34%
Silver 23.73%

In a new era of cheap funding, it makes perfect sense to stockpile metals. Carry costs are extremely low. There also is no spoilage. Price are well below previous highs. There is no problem with management or corporate actions. You get to hold it in your warehouses if you want.

You have to assume that the price of money will decline faster then the price of these metals. So if you are China or another country with high dollar reserves it makes sense to diversify into metals for that rainy day.

Dollar and post presidential election blues

The long-run moves have not been positive since the inception of flexible exchange rates.

Hat tip to Larry Greenberg of Currencythoughts.com

"... dollar has a checkered history in years following presidential elections.

• The U.S. currency devalued in February 1973 and was severed from its fixed parities one month later after which it tumbled another 24% by early July.
• By end-October 1978, the dollar had lost 29% against the mark in the first 21 months of the Carter Presidency.
• The dollar experienced a golden age in the first Reagan term, but a change of Treasury Secretaries at the beginning of the second term was associated with plunges of 30% against the mark and 24% against the yen in the final ten months of 1985. By end-1987, the U.S. currency had lost over half its value against the mark and yen.
• After peaking on June 15, 1989. dollar/mark fell 17% by the end of the year.
• Verbal sparring over trade with Japanese officials during the first six months of the Clinton presidency caused the yen to soar nearly 25% against the dollar by July 1993."

We can actually go further with some this history. The flexible exchange rate period moved forward with the cover of a second term for Nixon. The Bush presidency was a unusual for not having a dollar run after the election, but it was fighting a recession in his first year the 9/11 events within nine months of taking office. However, the March 2002 through March 2008 period was one of the worst in dollar hitory. There was no strong dollar policy. The dollar during the fist six month of the Obama Administration has suffered after the flight to quality capital flows started to reverse. We will ahve to wait and see what will be the imapct of this dollar decline. The dollar blues have been bipartisan.

One positive surprise in the global economy - limited protectionist rhetoric

The Economist had a interesting article theme in this week's addition, the lack of protectionism in the global economy. This is after world trade has declined by 1/3 in the last year. Make no mistake there is more rhetoric associated with trade and there have been more cases before the WTO, but generally there has been less wholesale talk of raising tariffs and discussing dumping by trading partners. Conversations to restart the Doha trade talks have continued even though they have dragged on for years.

This means that we may be able to get back to more normal growth than what occurred during the Great Depression. There are reasons for the change in trade patterns over the last few decades. Trade has become more sensitive to GDP. Trade in components within a firm has also exploded. This recession has seen massive increases in inventory which are being sold off first. Trade was cut preemptively. All of this has been a good sign for the long-run. We hope it continues.

The trade tensions in Europe should rise

It does not seem like the there is a current account problem in Europe when you look at the EU in total. The current account is close to zero, but if you drill down there are significant divergences across countries. This is a potential friction that will not go away. There are a number of countries which have large current account deficits and they do not have any control over monetary policy; consequently, there is little that can be done to close the deficit. Devaluation is not possible except for the EU as a whole. They cannot control trade policy and there are restrictions on the budget deficits that can be created. If there is no global recovery, these current account deficits may only get worse if other countries will compete through competitive devaluations.

What EU countries do to better there competitive situation will be one of the more interesting policy situations facing advanced economies.

Regime changing - what should be the reaction?

Detecting regime changes may be one of the most important skills of any investor. You need to know when the world is changing to make effective investment judgments. There has been significant statistical work on measuring regime changes, but the more important issue is not when will they occur and but how will markets react to a regime change. Put differently, the skill of regime detection is knowing how markets will react to a change in regime.

Cade Massey and George Wu provides a good description on the causes of under and overreaction to regime changes in their Management Science work, "Detecting Regime Changes: The Cause of under- and Over-reaction". They develop a explanation that is called the system-neglect hypothesis. Their premise is that investors will primarily react to the signal that they observe such as information announcements and only secondarily to the environment that creates or produces the signal. We do not spend enough time thinking about the environment.

When the environment is unstable or going through changes, there will be a under-reaction to the information being transmitted. The focus is on the precise signals and not on the potential for change. Similarly, when there is a very stable environment, there will be a over-reaction to signals even when they represent noise.

Processing information is a combination of obtaining signals and determining the environment for this signal. If we think we know the environment to be very stable, we will place too much emphasis on the signal. When the environment is in a state of flux, we will under-respond to the ques we are given.

Why is there not a large market for toxic assets?

One of the continuing problems in the banking sector is that the toxic assets on their balance sheets have not moved. Sub-prime and CBO securities continue to sit on the balance sheets of financial institutions. Of course, there has been trading, but there has not been a clearing of these assets out of the banking sector and into the hands of those who want to hold these risky assets. If these problems cannot be solved, there will be little success in having a public private partnership to purchase these assets. There are a number of reasons for this lack of trading.We will discuss three reasons. Two of them may be well known and the third is suggested by recent behavioral research.

Primarily, there is an asymmetric information problem between buyer and seller. For mortgage pools, the value is determined by the composition of the pool. The initial buyers usually have better information than those purchasers in the secondary market. Without good information on the defaults, delinquencies and composition of the mortgages, there is difficulty in valuing the securities. Ratings do not provide any benchmark information. Providing good information has always been a problem in this sector. Without clear data, trade is not possible.

The change in FASB rules which allow for book value accounting for banks will reduce the desire for banks to sell assets and realize the loss. The assets may be kept on their balance sheet at a higher value which may reflect the value to maturity. Why sell an asset today at current market expectations when there is the chance they may actually improve over time?

The third reason has to do with a potential uncertainty effect which has first been discussed by Uri Gneezy, John List and George Wu in their Quarterly Journal of Economics paper "The Uncertainty Effect: When a risky prospect is valued less than its worst possible outcome." The authors find that there are certain situations when the the value of project may not exist between the highest and lowest potential outcome. Investors may actually value something worse than the lowest possible realization because of high uncertainty.

Think about the implications of this type of outcome. The potential buyers of a sub-prime mortgage pool will view the asset as worse than the worst possible outcome given they cannot properly price the alternatives. How can this happen? Without going through all of the possible scenarios, think of the uncertainty that can occur if there are no clear ideas what the environment may look like in the coming years. The high uncertainty creates unusual response to potential outcomes which place a value that is outside of the norm.

What would be the type of uncertainty which could create these types of outcomes? What id the regulatory environment is not known? What if the tax environment not known? what if the bail-out plan for home owners is unknown? All will create an large uncertainty effect. The idea that the government may control the level of uncertainty that is faced by investors is very important. There is an important responsibility for regulators to minimize uncertainty.

Europe improving confidence still has a long way to go

The IFO confidence survey in German is starting to swing upwards, but it has a long way to go to get back to anything close to normal. Still we have good evidence that once confidence starts to move upward the pick-up is strong. The exception was the 2001 recession. This information is euro positive and dollar negative. We are back in risk seeking mode for global markets.

The stock markets are reacting to all of this positive economic and earnings news by starting a strong rally. Commentators are saying that the economy is back to pre-Lehman levels. Well, that is an interesting question. If we have reversed the Lehman curse are we in a good spot with the global economy. The answer is no. We are still in worse shape than last summer, so do not break out the party hats just yet.

Bank fo Canada - the recession may be over?

The BOC dropped their target range starting in June and has talked about QE although nothing was implemented. The Loonie dropped 5% in a matter of six weeks. The BOC has stated that they plan to keep rates at 25 bps until the end of the second quarter 2010.This is the small open economy effect with monetary easing. However we can also see the impact when growth starts to turn with a complete reverse in a matter of days. Talk about a reversal of fortune.

The BOC now thinks that the Great Recession is over with the Bank Governor Mark Carney believing that the economy will expand at a rate of 1.3 percent for the third quarter. and 3% in the fourth quarter. He also stated that "an extreme outcome" scenario is no longer a risk. This is after the Bank forecasted in April that the economy would drop 1% in the same period. This would mean that the Canadian recession was only nine months long.

The comments from the Governor also have some interesting twists. Carney states that a CAD gain will "an important brake" on growth and fats growth will not occur without inflation. The BOC expects inflation at 2% in 2011:2. Faster growth will lead to CAD appreciation and inflation which may be a concern but the worst is over.

Test of QE plan - Conservative approach appropriate

Bank of England MPC agreed 9-0 to keep interest rates on hold and not extend the QE purchase program. Their view is that there is diminished downside risk in the economy. A larger purchase program is not necessary at this time. This will be an interesting test case for monetary policy in the new age of low interest rates. We will not know whether they have made the right decision for some time but now the fiscal deficit will have receive support form the monetary authority. The economy will have to grow to increase revenues and relieve deficits pressures.

The economy is doing better, but still not growing anything like what one would expect for a strong recovery. PMI manufacturing has bounce off the lows but and done better that survey expectations, but it is still below 50. PMI services is just above 51. Industrial production has started to turn although still -10 percent YOY. Consumer confidence is rising and higher than the end of last year. CPI is just below 2% so deflation concerns are diminished. Jobless claims are coming in lower then expected and average earning's are growing above 2% after hitting negative levels. Even retail sales have jumped to positive territory.

This all suggests that UK may be staggering to a modest recovery. A more conservative monetary policy is appropriate.

Mortgage applications do not tell us much

The mortgage application index was 2.8 percent but it really is not telling us much at this point. Housing still has a long way to go to recovery and the there are other more important drivers in the economy such as trade growth and consumer balance sheet adjustments which provide more information on the overall direction of the economy.

The mortgage world has changed. Look at what was going on 7-10 years ago when the boom really hit. Application growth was crazy. It slowed as we topped in the housing cycle. There was a large increase when rates fell and many of the government programs started to kick-in but now a low mortgage or tax rebates are small gains relative to whether you will have a job or there will be in an increase in taxes.

Fed's will not mechanics is the issue

Good op-ed piece by Ben Bernanke on the Fed's exit strategy. The piece does a good job about describing what would be the mechanics to decrease the balance sheet. What it does not do is tell us that the Fed has the will to use the power to exit and under what conditions the Fed will start to exit the credit markets and reduce its balance sheet.

The whole issue of rising interest rates and inflation fear is not about mechanics but about creditability. This is the same issue that was at the heart of the Volcker era. We know how to cut money to stop inflation. We also know that there will be a real economic cost from cutting the money supply. The issue during the inflation period was whether the Fed was creditable at being able to tame inflation. The creditability gap took years to solve. The slow decent of interest rates even with inflation at lower levels was a direct result of creditability problems at the Fed.

You can talk all you want about the Fed and how action will be taken to reverse the growth of the balance sheet, but the real issue is whether Bernanke or any new Fed chairman will have the courage to reverse monetary ease when a strong recovery begins. Will Bernanke under any conditions exit the monetary stimulus before a reappointment? I think not. Would a new appointee be willing to show independence? I think not.

We are a long time away from any Fed action, but the crux is the creditability of Fed independence. All of the other issues of mechanics is noise.

Eyes on consumer balance sheets

The depth and breath of the recession will be tied closely to the behavior of the US consumer. Their actions in the next few months will determine whether we will see the positive growth that was expected at the end of the year. Stimulus is important but what the consumer does with the stimulus is more important. Their actions determine the multiplier effect. If we look at the data, the course is clear. We will not get the multiplier effect from consumers. Consumers are cutting up their credit card. The growth of consumer credit is negative. This what we have seen in other business cycle and we should expect this to continue. There is no change in their behavior on this count.

What is also happening is that consumers are saving more. The savings rate is shooting up like a rocket. The savings rate is still less than what we saw a decade ago and still below the long-term average. Still consumers are placing their money in mattresses whether it is coming from earnings or from government tax cuts. Consumers want to replenish wealth especially if they are closing in on retirement.

The question is whether the government dissavings is just offsetting the decline in consumer debt activity or whether it will cause a change in consumer behavior to actually spend more. The government is sending a mixed message. No savings for the government which is the Keynesian policy story and the correct policy for the Paradox of Thrift. But there is an added burden in this whole process of recovery. Consumers are supposed to change life styles to become healthy energy conservers who eat less and behave better and not spend money. How is all of this going to happen and still create above trend growth?

Inflation -deflation debate - the near-term non-problem

The key fixed income story for 2009 is the inflation deflation debate. Of course, when is fixed income not a inflation story? There is a big gulf in reality and market expectations, but getting this question right will determine gains for the year in both fixed income and currencies.

US CPI came out this week with the usual mixed news message. CPI YOY was down -1.4 while the core CPI ex food and energy was stable at 1.7%. So what do we believe? If you look at headline CPI, the real rate of interest is significantly positive. 5-year Treasuries are at 4% so there could be an easy argument that we should see a rally. If you focus on the core we are slightly positive at .75%. Now we could argue that real rates should be negative in general at this point in the business and credit cycle if we want to see a recovery, but under the core inflation story we are approximately fair value.

The Fed scorecard could be considered mixed. If the objective of policy is to move rates to zero and get inflationary expectations positive to force real rates to be negative, they have failed. With the inflation rate negative, we still have positive short-term real rates.

The big difference in the two inflation indices was caused by the commodity price shock last year. Note that we have now reversed the big increase in CPI from last year, bu we over-all core inflation is not negative. (We are assuming that the inflation rate is measured properly.)

The graph of the difference in inflation indics shows that we can go for long periods of the the core CPI and headline being different. Headline as expected is more volatile. The correlation between the two rates has actually fallen over the last ten years. We are now seeing an increase but this c0movement is still low. Looking at these number suggests that deflation may not be a problem.

Reviewing the macro information suggests that inflation is not a problem in the short-run. There is a large output gap and a significant decline in capacity utilization. There is little change that we will have a tightness in the real economy. Money has increased as measured by the Fed balance sheet but most of this is in the form of excess reserves so the money multiplier and velocity have been falling. There is excess of money in the system. Hence there is no reason to believe that inflation will go up in the next two to three years.

There may be an inflation problem but it will not be present anytime soon. There may be a deflation problem but it is not present in the data once we account for the commodity price shock of last year.

BOE independent thinking ... can we expect more?

Adam Posen, the new addition to the Bank of England Monetary Policy Committee, had many strong comments on policy in the UK. He clearly believes that the UK fiscal policy of continued deficits is not credible. For more on Posen, see the questionnaire in advance of Treasury Commitee hearing.

One of the most interesting issues is how he would exit QE. This is important given the fact that the BOE did not extend the Treasury purchase program which suggests that an exit is possible in the near future.

I will begin research on the three-dimensional exit strategy that all central banks and governments in the OECD, including critically the UK, must undertake from their emergency policy measures when the crisis is past. I say “three-dimensional” because exit will require the removal of monetary ease and liquidity, the reversal of fiscal stimulus and deficits, and the withdrawal of guarantees for, and some public ownership of, the financial sector. The timing of each on its own terms, with what practical indicators policymakers should watch, is of vital importance, as is the sequencing of the exit in each of the three areas when they will interact.

This is a thoughtful and useful way of thinking about the problem.

The interesting issue is how this would apply to the US:

• reduce the Fed balance sheet - the balance sheet seems to have stabilized
• reversal fiscal stimulus - we have not even maxed this
• withdrawal of guarantee programs - this is a real unknown but TARP pay-back is an indirect start.

No surprises in Japan, so why the yen sell-off this month?

Japanese industrial production is up again this month but the YOY change in still down 29.5% , like last month. Consumer confidence is up from last month but below expectations. Nevertheless, money is still flowing back to Japan as evidenced by the stronger yen. This money is not going into the stock market which has been in a nose-dive since the beginning of the month. If money has been flowing back to dollar as a safe haven, the flight to quality effect is even stronger in Japan especially relative to the commodity currencies. With a staggering economy. the flows to yen seem out of touch with rest of the world.

Treasury market survives the four auction week

Supply may be an issue, but economics always dominate the market. This is one of the reasons why it has always been hard to model supply with interest rate changes. With the stock market declining for four weeks and economic data showing a weak recovery, Treasury debt will be the place to put cash. The Treasury was more than happy to provide the supply, a total of over $160 billion in one week.

4-week bills $34 billion
13-week bills $32 billion
26-week bills $31 billion
3-year notes $35 billion
10-year bonds $19 billion
30-year bonds $11 billion

The bill auctions are for the most part rolling over existing debt and is demanded by many who still are holding large cash balances since the credit crisis accelerated last Fall. The longer-end raised new money.

The auctions went well but the process still depends on dealers taking down debt and distributing it. What happens when the economics are not favorable for the next set of auction. The dealers get hit by a freight train and there is a deep sell-off. The Fed has added two new primary dealers but the amount of capital that is used to distribute Treasury debt is limited. Models may be of limited help given the size of the auctions that the market will face. This will be an ongoing problem.

Bank of England QE changes?

There is no question that quantitative easing is the only policy option when rates get close to zero. The whole idea is to provide liquidity as the lender of last resort and to inflate the economy. Pore money into the economy to add liquidity and increase inflationary expectations. Higher expectations will push down real rates and decrease the desire to hold money. So what does the Bank of England do? It does not extend it current 125 billion sterling purchase program.

In a brief official statement, the Bank said: “The committee expects that the announced programme will take another month to complete. The committee will review the scale of the programme again at its August meeting, alongside its latest inflation projections.”

So is this an exit of the program? Hard to say but the first law of central banking is to minimize market uncertainty and the BOE has broken the law. The reaction was swift with a gilt sell-off and a jump in sterling that now looks to be reversed. How should we view this? It could be that the Bank o England believes that the program may not be necessary, but even if that was the case there could have been a better way of announcing the change.

The economic numbers are not that good that exit strategy is necessary. PMI manufacturing is still below 50 although PMI services is slightly above 50. Industrial production is still down 11.9% YOY. Consumer confidence is off the laws but still only at levels for last summer. I need help to explain this policy statement.

Unity and diversity coin from Medvedev

For Russian President Dmitry Medvedev, the monetary future is now. At his closing press conference, Medvedev held up a golden coin bearing the words “united future world currency,” which he said was minted in Belgium and handed to G-8 attendees.

“Even the mints” are thinking about a post-dollar world, Medvedev said. The test coin “means they’re getting ready.”

The Russians keep at the global currency argument even though the development of an international currency was not a topic for G8 discussion. Of course, Russia does not have the same risks as the huge central bank holdings of China so they can push this issue further. Russia also has the payment problem of oil being priced in dollars but most of Russian trade in euros. Dollar declines hurt their terms of trade.

This reserve issue will not go away. If the dollar weakens there will be more negative talk. Unfortunately, even the US government really does not want a strong dollar. The Treasury does not have a dollar policy other than it would not like to see any significant decline. However, this is not the same as saying the US has a strong dollar policy. We have to accept that this dollar reserve noise will continue.

More mixed economic news

There will not be a big change in asset prices as long as we continue with the mixed economic news.

The Economic Watchers survey in Japan came out better than expected for both current condition and the outlook even as bankruptcies in Japan increase. Mixed news albeit bankruptcies occur from past business failure.

Bank of France business sentiment is higher and within expectations. It has moved higher each month since the beginning of the year. We also have on the negative Sweden and Turkey industrial production lower, but orders are up MOM. German industrial production is up big, almost explosive, MOM. Euro-zone GDP showed a contraction in the first quarter of -4.9%.

Green shoots are a problem if there is limited follow-through. The markets also seem to be overly focused on the US, so that risk averse behavior based on US data is the global driver.

Consumer credit declines

Consumer credit declined at a slower pace this month. We expect that consumer credit should continue to decline for three reasons. One, credit has been reduced from the supply side by banks. Credit is still more restrictive than a year ago. Two, consumers pay-down debt as they try and restore their balance sheets. Three, if less consumer purchases are made, the overall demand for credit will decline. While some would like to see consumer credit increase to improve the economy, there still needs to be a clean-up of consumer balance sheets.

Tyson says we need more stimulus

Laura Tyson, an advisor to President Obama's Recovery Board stated that more stimulus may be necessary for the US economy. Looking at the economics, the stimulus plan has not worked as expected. The unemployment rate is much higher than expected, but the real issue is the multiplier or how much of the stimulus is spent versus saved. To get money immediately in the hands of consumers, you have to provide benefits or tax cuts. The shovel ready projects take time.

The issue with sending checks out is that you do not know how much will actually be consumed. We are finding that consumers are paying down debt and not making new purchases which reduces the stimulative effect. In the extreme, the government borrows money against future taxes which is then given to consumers who turn around and buy Treasuries or reduce their private debt under anticipation that taxes will be higher.

If you believe the multiplier is weaker than expected and the economy was worse than expected (although the administration stated at times that this recession was as bad as the Great Depression), then the logic suggests more is needed. However, this is the same logic that has not been working only with bigger size.

No V recovery but economics turning

We know employment is usually a lagging indicator. We should be more interested in survey data because if that turns positive employers will start to hire workers. The ISM non-manufacturing survey came out at 47. Still negative but clear improvement since the beginning of the year.

The IMEF manufacturing and non-manufacturing indices in Mexico also showed gains and both have been rising since the beginning of the year. Consumer confidence in Mexico is also off the lows. New Zealand business confidence is also up.

You have to focus on these "animal spirits" because these surveys are some of the best indicators of gains in the global economy.

The dollar reserve currency risk premium ongoing story

We have written about the dollar reserve currency risk premium over the last few months. More talk has occurred about the role of the dollar as a reserve currency in the last six months than in years. This talk continued with a Bloomberg story that the yuan is deposing the dollar on China's border. More transactions will be allowed to be settled in yuan. This is a policy objective of the PBOC. The PBOC has also provided over $95 billion in swap lines to countries like Argentina, Belarus, Hon Kong, Indonesia, Malaysia and South Korea in 2009.

This growing importance of the yuan makes perfect sense. There is little reason to have settlement in a third currency for close cross-border trade. Given the size of the Chinese economy and its growing role in global finance, it should also be expected that these events will continue to occur and the PBOC will ask for more policy input with the IMF. The dollar will have to suffer. This may have nothing to do with the value of the dollar as much as it has to do with ascent of China; nevertheless, current policies by the US do not help to strengthen the dollar.

Follow the business cycle performance curve grid

A very good graphic was in the NYT "Turning the Corner?" story. The live graphic looks at the business cycle through a two dimensional grid. On the vertical is growth compared with trend and on the horizontal, change in growth over the last six months. When growth is above trend and the change is positive, the economy is in expansion. When the change is negative but still above, trend the economy is in slowdown. When growth is below trend and negative, the economy is in downturn. Finally, if growth is below trend but there has been positive change in the last six month, the economy is in recovery.

We are clearly in a downturn that has not abated. The recovery will take time because of the distance that has to be covered to get some positive growth.

Why has trade fallen so hard during this recession?

Trade has fallen off a cliff for many economies around the global. In fact, trade declines have been multiples larger than the decline in GDP. This has been surprising but a recent study by Caroline Freund in voxeu.org starts to explore this issue. See "Demystifying the collapse in trade". Freund first shows that the sensitivity of trade to changes in GDP has increased dramatically in the last few decades. The impact of every 1% decline in GDP is now almost 3.5 times greater. The issue is why is there an increased sensitivity to trade. 

Freund offers some possibilities which make sense but have to be explored in detail. These include greater drawdown in inventories which hurt production, greater protectionist policies in recessions, sourcing more form home countries in a downturn, and the use of foreign sources for marginal increases in trade.

The result is greater vulnerability for countries that have large export business; however, it also means that a turn around may also have the biggest impact for these exporting countries. At issue will be how importing countries behave. Protectionist policies will be harder to reverse so there needs to be care with restrictions on trade. The global impact of protectionist policies will change the elasticities of trade to changes in growth. 

Where is the stimulus? unemployment up

This is an unfair question with government passing the legislation less than six months ago, but then the hype about creating jobs immediately for a back-loaded program was also hype. 

The non-farm payroll numbers came out worse than expected and any tonic that we are on a better path has been eliminated. We have had 18 months of job losses and a doubling of the unemployment rate in the same amount of time. The only positive is a stabilization of initial jobless claims and continuing claims albeit the levels are extremely high. The slight increase in factory orders was positive but there was an equal decline in the revisions from last month. There are no green shoots here. 

The long history in the short shows a deep decline in employment and the consistent behavior over the last few recessions of slow recovery. The natural forces have been for declines and muted recovery. The stimulus may help quicken the recovery but the size is deeper. Unfortunately, the current unemployment rate is higher than what was predicted by the administration both with and without stimulus. It is the economy, stupid, yet the focus seems to be in many other areas.

We are seeing scared consumers that understand the economy is weak. They have been taking whatever benefit from tax cuts and saving most of it to pay-down debt. The multiplier is much weaker than expected. The wealth effect can work in both directions. Increased housing wealth that was liquefied for consumption is now being reversed. There may be little that can be done with changing consumer behavior in the short-run.