- Links for 07-02-15
- Fed Watch: Ahead of the Employment Report
- 'Path to Grexit Tragedy Paved by Political Incompetence'
- Did Dodd-Frank Fix Too Big To Fail?
Posted: 02 Jul 2015 12:06 AM PDT
Posted: 01 Jul 2015 11:59 AM PDT
Ahead of the Employment Report, by Tim Duy: A rare Thursday release of the employment report is on tap for tomorrow, and all eyes will be watching to see if it falls in line with the other, more optimistic US data of late. Indeed, it increasingly looks like this year's growth scare was driven by temporary factors, not a fundamental downturn in the US economy. Consequently, anything reasonably close to expectations would bolster the case of those FOMC members looking for a first rate hike later this year, as early as September.
The ISM report for June was in-line with expectations, with fairly good internal components. Note in particular the bounce-back in the employment component:
Other employment data also indicates the underlying trends in the labor market are holding. Initial unemployment claims - a leading indicator - give no cause for worry:
And the ADP employment report came in slightly ahead of expectations at a private sector job gain of 237k for June. All of this suggests that the consensus for tomorrow's headline number of 230k is reasonable, although I am inclined to bet that the actual number will beat consensus.
The usual headline numbers, however, may not be the stars of the show. Attention will rightly be on the wage numbers. Further evidence that wage growth is accelerating would indicate that the labor market is finally closing in a full employment. Such data would point to a rate hike sooner than later as it would raise the Fed's confidence that inflation will be trending toward target. See Federal Reserve Governor Stanley Fischer today:
Regarding inflation, an important factor working to increase confidence in the inflation outlook will be continued improvement in the labor market. Theoretical and empirical evidence suggests that inflation will eventually begin to rise as resource utilization tightens. And while the link between wages and inflation can be tenuous, it is encouraging that we are seeing tentative indications of an acceleration in labor compensation.
Tantalizing evidence on wage growth comes from the Atlanta Federal Reserve Bank:
With fairly low inflation, this suggests that real wages growth is indeed accelerating, which helps account for the relatively solid consumer confidence numbers we are seeing. Demand for new cars and trucks also remains strong, although I sense that we are not likely to see higher numbers going forward.
Also from the Atlanta Fed is their GDP tracker, which continues to head back to consensus range:
This is in-line with Fischer's assessment of the economy:
The U.S. economy slowed sharply in the first quarter of this year, with the most recent estimate being that real GDP declined 0.2 percent at an annual rate. Household spending slowed, while both business investment and net exports declined. Much of this slowdown seemed to reflect transitory factors, including harsh winter weather, labor disputes at West Coast ports, and probably statistical noise. Confirming that view, the latest monthly data on real consumption provide welcome evidence that consumer demand is rebounding, and that economic activity likely expanded at an annual rate of about 2.5 percent in the second quarter.
What about Greece? St. Louis Federal Reserve President James Bullard dismissed Greece as a reason for concern. Michael Derby at the Wall Street Journal reports:
What's happening in Europe "would not change the timing of any rate hike. I would say September is still very much in play" for raising rates, Mr. Bullard told reporters after a speech in St. Louis. More broadly, he said "every meeting is in play depending on the data," which he said had been "stronger" recently. He also described recent inflation data as being "more lively" and set to rise further over time.
I doubt other Federal Reserve officials are quite as confident, but they have plenty of time between now and September to assess the situation. As I said Monday, they will be looking for evidence of credit market spillovers. If they don't see it, the economic data will rule the day. Bullard also argued the case of a faster pace of rate hikes:
"The Fed should hedge against the possibility of a third major macroeconomic bubble in coming years by shading interest rates somewhat higher than otherwise" would be the case based on historical norms, Mr. Bullard said. "The benefit would be a longer, more stable economic expansion."Mr. Bullard warned "my view is that low interest rates tend to feed the bubble process." He did not point to any major imbalances right now even as he flagged high stock market levels as something to watch, acknowledging the role of technology could be changing how the economy interacts with financial markets.
Derby correctly notes, however, that this places Bullard out of the Fed consensus:
Mr. Bullard's suggesting that rates may need to be lifted more aggressively in the future puts him at odds with some of his central bank colleagues. Many key Fed officials are now gravitating to the view that changes in labor market demographics and other forces may mean the Fed could keep rates at a lower level relative to historic benchmarks. Most officials now expect that the long-term fed funds rate target, now at near zero levels, will likely stand at around 3.75%.
Fischer, for example, still argues for a gradual pace of normalization and is much more sanguine on the financial market excess:
Once we begin to remove policy accommodation, the Committee's assessment is that economic conditions will likely warrant raising the federal funds rate only gradually. Thus, we expect that the target federal funds rate will remain for some time below levels viewed as normal in the longer run. But that is only a forecast, and monetary policy will, in practice, be determined by the data--primarily data on inflation and unemployment.What about financial stability? We are aware of the possibility that low interest rates maintained for a prolonged period could prompt an excessive buildup in leverage or cause underwriting standards to erode as investors take on risks they cannot measure or manage appropriately in a reach for yield. At this point, the evidence does not indicate that such vulnerabilities pose a significant threat, but we are carefully monitoring developments in this area.
Fischer is closer to the FOMC consensus than Bullard on these points.
Bottom Line: Incoming data continues to support the case that the underlying pace of activity is holding, alleviating concerns that kept the Fed on the sidelines in the first half of this year. I anticipate the employment report, or, more accurately, the sum of the next three reports, to say the same. Accelerating wage growth could very well be the trigger for a September rate hike, while Greece could push any rate hike beyond 2015. I myself, however, tend to be optimistic the Greece situation will not spiral out of control.
Posted: 01 Jul 2015 10:02 AM PDT
Path to Grexit tragedy paved by political incompetence: Since our last episode, the crisis in Greece has escalated further. Negotiations between the government and its creditors collapsed over the weekend, and restrictions on bank withdrawals will now follow.
The next step is for the government to issue the equivalent of IOUs to pay salaries and pensions. The country is seemingly on the slippery slope to exiting the euro.
Many of us doubted that it would come to this. In particular, I doubted that it would come to this.
Nearly a decade ago, I analyzed scenarios for a country leaving the eurozone. I concluded that this was exceedingly unlikely to happen. The probability of a Grexit, or any Otherexit, I confidently asserted, was vanishingly small.
My friend and UC Berkeley colleague Brad DeLong regularly reminds us of the need to "mark our views to market." So where did this prediction go wrong?
Why a euro exit didn't make sense
My analysis was based on a comparison of economic costs and benefits of a country exiting the euro. The costs, I concluded, would be severe and heavily front-loaded.
Raising the possibility, however remote, of exit from the euro would ignite a bank run in said country. The authorities would be forced to shutter the financial system. Economic activity would grind to a halt. Losing access to not just their savings but also imported petrol, medicines and foodstuffs, angry citizens would take to the streets.
Not only would any subsequent benefits, by comparison, be delayed, but they would be disappointingly small.
With the government printing money to finance its spending, inflation would accelerate, and any improvement in export competitiveness due to depreciation of the newly reintroduced national currency would prove ephemeral.
In Greece's case, moreover, there is the problem that the country's leading export, refined petroleum, is priced in dollars and relies on imported oil, which is also priced in dollars. So much for the advantages of a depreciated currency.
Agricultural exports for their part will take several harvests to ramp up. And attracting more tourists won't be easy against a drumbeat of political unrest.
What went wrong?
How did Greece end up in this pickle? Some say that the specter of a bank run was no longer a deterrent to exit once that bank run started anyway due to the deep depression into which the Greek economy had sunk.
But what is remarkable is how the so-called bank run remained a jog – it was still perfectly manageable until the Greek government called its referendum on the terms of the bail out deal offered by international creditors, negotiations broke down and exit became a real possibility.
Nonperforming loans — ones that are in default or close to it — were already rising, to be sure, but the banks still had all the liquidity they needed. The European Central Bank supported the Greek banking system with emergency liquidity assistance (ELA) right up to the very end of June. Only when Greece stopped negotiating did the Central Bank stop increasing ELA. And only then did a full-fledged bank run break out.
So I stand by the economic argument. Where I need to mark my views to market, however, is for underestimating the role of politics. In particular, I underestimated the extent of political incompetence – not just of the Greek government but even more so of its creditors.
In January Syriza had run on a platform of no more spending cuts or tax increases but also of keeping the euro. It should have anticipated that some compromise would be needed to square this circle. In the event, that realization was strangely late in coming.
And Prime Minister Alexis Tsipras and his government should have had the courage of its convictions. If it was unwilling to accept the creditors' final offer, then it should have stated its refusal, pure and simple. If it preferred to continue negotiating, then it should have continued negotiating. The decision to call a referendum in midstream only heightened uncertainty. It was a transparent effort to evade responsibility. It was the action of leaders more interested in retaining office than in minimizing the cost to the country of the crisis.
A hard lesson learned
Still, this incompetence pales in comparison with that of the European Commission, the ECB and the IMF.
The three institutions opposed debt restructuring in 2010 when the crisis still could have been resolved at low cost. They continued to resist it in 2015, when a debt write-down was the obvious concession to Mr Tsipras & Company. The cost would have been small. Pretending instead that Greece's debts could be repaid hardly enhanced their credibility.
Instead, the creditors first calculated the size of the primary budget surpluses that Greece would have to run in order to hypothetically repay its debt. They then required the government to raise taxes and cut spending sufficiently to produce those surpluses.
They ignored the fact that, in so doing, they consigned the country to an even deeper depression. By privileging their own balance sheets, they got the Greek government and the outcome they deserved.
The implication is clear. Never underestimate the ability of politicians to do the wrong thing. I will try to remember next time.
Posted: 01 Jul 2015 09:36 AM PDT
Gara Afonso and João Santos at the NY Fed's Liberty Street Economics blog:
What Do Bond Markets Think about "Too-Big-to-Fail" Since Dodd-Frank?: In our previous post, we concluded that, in rating agencies' views, there is no clear consensus on whether the Dodd-Frank Act has eliminated "too-big-to-fail" in the United States. Today, we discuss whether bond market participants share these views.
As we discussed in our post on Monday, the Dodd-Frank Act includes provisions to address whether banks remain "too big to fail." Title II of the Act creates an orderly liquidation mechanism for the Federal Deposit Insurance Corporation (FDIC) to resolve failed systemically important financial institutions (SIFIs). ...
Since the Dodd-Frank Act makes it easier to intervene at the holding company level, we predict that, relative to the pre-Dodd-Frank era, investors' perceptions of the risk of holding bonds of a parent company would have increased relative to the risk of holding bonds of its subsidiary bank. To test this hypothesis, we compared how bond spreads evolved for a matched pair of bonds—one issued by the parent company and one by its subsidiary bank. This approach lets us isolate any differential effect of the new resolution procedure on the parent company relative to its subsidiary. A downside, though, is that there are only a few cases where both the parent and the subsidiary have the same bonds traded in financial markets.
Contrary to our hypothesis, the difference in option-adjusted spreads to Treasuries of the parent companies and their subsidiary banks ... has not widened since the Dodd-Frank Act was enacted. ...
Our previous post demonstrated that rating agencies do not have a unanimous view of the current level of government support of U.S. commercial banks and their holding companies. The results here indicate that market participants' perceptions of the relative risk have not increased as one would have expected given the new resolution framework introduced by the Dodd-Frank Act. ...
Together the evidence suggests that rating agencies and market participants may have some doubts about the ability, so far, of the Dodd-Frank Act to deal with "too big to fail." However, some observers have argued that once all provisions of the Dodd-Frank Act are implemented, any remaining expectations of government support will disappear. Time will tell.
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