Growing probability of positive US data surprises

US economic data has disappointed significantly during the past three months. The chart below shows this with the help of the Citi US economic surprise index (in yellow). This was also one important factor driving US Treasury yields lower (in green). As a result, growth expectation for the current quarter as well as for the whole year have been scaled back. Besides overly optimistic previous expectations, key reasons are being thought to have been higher commodity prices, most notably for energy, ongoing weakness in the US housing market as well as supply disruptions related to the Japanese earthquake and nuclear disaster. However, I am convinced that a technical factor - seasonal adjustments - has played an important role but goes unnoticed (see below). Looking ahead, reduced expectations coupled with slightly lower energy prices and especially a turn in seasonal factors suggest that the US economy should start to surprise again on the positive side soon.

US data has been surprising on the downside since early spring

Source: Bloomberg

I am convinced that seasonal adjustments have played an important role in recent negative data surprises. Seasonal factors assume a significant re-acceleration of the US economy during spring following a weaker winter period. Given that the economy continues to operate with a high level of spare capacity, the seasonal swings in the economy should be less pronounced than has historically been the case (companies will fire fewer workers than usual during the winter and summer months as they have less workers anyhow and with that they will hire fewer workers during spring and autumn). Furthermore, employment in highly seasonal sectors dropped sharply during the last recession (-2mln employees in construction, -2mln in manufacturing since end 2007) whereas it grew in non-seasonal sectors (+1.4mln in education and health services). This as well should render the economy less seasonal. However, as the chart below shows, the seasonal adjustments do not reflect this.
The chart below shows the seasonal adjustments used in the US employment report to adjust the payrolls number, in blue the seasonal adjustment over the past 12 months and in red the average seasonal adjustment over the previous 10 years. Given that on average, employment was slightly higher over the past decade than now (133mln vs. 131mln), and because the economy should exhibit less seasonality, the seasonal factors should have become lower. Instead, they have even become larger!
As a result, seasonally adjusted data should be weaker than the underlying trend during the seasonally strong periods of spring and autumn and the data should be stronger than the underlying trend during the seasonally weaker months in summer and winter.

Seasonal adjustments are reversing again as summer draws closer

Source: BLS, ResearchAhead

In turn, it is probably not a co-incidence that the Citi US economic surprise index topped out at the beginning of March. This is the time when data relating to February starts being released and as the chart shows, February is the start of the period with highly positive seasonal adjustment factors. However, we are now entering the seasonally weak June-August period. Togehter with reduced expectations, the probability is becoming substantial that US economic data starts to surprise positively again!

When should Greece default?

Greece is insolvent, however a restructuring/reprofiling should be postponed.

Speculation about a Greek restructuring (or in the milder form a reprofiling) have reached a new high. Reason is that in the short term Greece needs to secure the payment of the next tranche from the EU/IMF bail-out package, otherwise it is running out of cash at the beginning of July. But looking into 2012/2013 reveals that even with the bail-out package Greece faces a funding shortfall of around EUR 60bn (see chart below, courtesy of RBC). It was assumed that by 2012 Greece would be able to access the capital markets again to secure parts of its financing needs. However, now this appears very very unlikely. In turn, Greece either needs more bail-out funds or its need to restructure its debt (at least do a maturity lengthening exercise). While I have for a long time stated that Greece is insolvent (see for example the Greek Fire series which I started in autumn 2009), I think that a restructuring now needs to be avoided and should be delayed into 2013.

Greek funding needs and financing shortfall

Source: RBC

I see two main reasons why a restructuring now is not advisable. First, contagion for the other weak peripheral countries as well as for the Eurozone banking sector would be truly devastating. Moody's already announced that in the case of a Greek reprofiling it would have significant adverse consequences for peripheral debt ratings. Furthermore, the market will most likely also punish peripheral sovereign issuers and lead interest rates significantly higher, rendering it even more difficult for these economies to grow and for the budget deficits to be reduced according to plan. Additionally, for the already weak Eurozone banks, such a course of events would significantly damage its capital base and risks shutting them out of the money markets, rendering their dependence on ECB funding even larger. However, if reprofiling/restructuring is postponed into 2012/2013, this risk of contagion should become lower. For other sovereigns the risk of contagion should decrease if in they use this time period to improve their fundamentals while for the weak banks it means they need to improve their capital base and reduce their holdings of peripheral debts. The latter can be done easily as maturing bonds - and a significant amount of peirpheral bonds will mature over the next two years - are not being replaced anymore.
The second key reason for a delayed restructuring is that the high sovereign debt of Greece is not the cause of the problem but only a symptom. Greece has very weak sovereign institutions/weak governance. As a result of that the Greek state has a substantial revenue problem (much more so than an expenditure problem). The chart below shows estimates for the shadow economy (in % of GDP) vs. the ranking in the Ease of Doing Business index constructed by the World Bank. Tax compliance in Greece is very low and Greece's shadow economy is estimated to be around 25% of GDP, by far the highest in the Eurozone. Furthermore, Greece ranks only #109 for ease of doing business. Additionally, Greece ranks also lowest for a Eurozone country in the Corruption Perception Index by Transparency International (#78).

Weak institutions in Greece: Ease of doing business vs. shadow economy

Source: World Bank, IAW

These structural shortcomings have burdened Greece for a long time and are the root cause for the high debt burden. If Greece reduces its debt via default, then the Greek sovereign will still face this revenue problem and the Greek economy its structural shortfalls. In turn, it would only be a matter of time before Greece indebtedness starts soaring again and a new debt-cycle commences.
As a result, first Greece needs to strenghten its governance and improve its economic structure before it should restructure. If it restructures now, this will ease the pain and hence reduce the pressure for such measures.

Germany is going strong

Barring short-term ups and downs, the multi-year outlook for the German economy remains very bright. One of my major topics has been the extremely favourable short as well as long term outlook for the German economy (see for example the publication German Wirtschaftswunder 2.0 from May last year as well as Don’t underestimate the German consumer dated Jan25). Germany has embarked on a multi-year virtuous circle with high real growth due to structural reasons (high competitiveness of the German economy, relatively healthy fiscal situation, end of the decade-long high real rates period) as well as cyclical reasons (extremely accommodative monetary policy environment which via higher inflation and an improvement in credit availability becomes even more accommodative). I am convinced that even though consensus growth expectations have been raised somewhat, just how positive and long-lasting this growth environment will be remains vastly underappreciated. Last week’s much better than anticipated Q1 growth numbers (+1.5% qoq vs. +0.9% expected and remember that these numbers are not annualised) once again support this notion. As the German statistics office stated: “In a quarter-on-quarter comparison (adjusted for price, seasonal and calendar variations), a positive contribution was made mainly by the domestic economy. Both capital formation in machinery and equipment and in construction and final consumption expenditure increased in part markedly. The growth of exports and imports continued, too. However, the balance of exports and imports had a smaller share in the strong GDP growth than domestic uses.”
Hence, as I expected, it is not only the export industry which drives this cyclical upswing but the domestic economy is increasingly contributing to growth. As unemployment is dropping and real wage growth should pick up, the longer-term outlook for domestic consumption remains bright. I think there are two more important factors which will cause the domestic economy to do increasingly well:During the first decade of the Euro, Germany has suffered from a tight monetary environment (weak credit growth and much too high real yields). This depressed domestic investment by the corporate sector and led the savings ratio higher (an increase in the savings ratio was also a rational response to increased economic insecurity amid the high number of reforms in social security and labour markets earlier last decade). Now, the monetary environment is becoming increasingly accommodative (historically very low nominal yields coupled with above-trend inflation means that real yields are extremely low; additionally given the strong economy credit availability is improving). In combination with the healthy economy and a high level of competitiveness, the corporate sector should increase its domestic investments. Additionally, given higher job security (amid the low level of unemployment), the savings ratio of private households should drop markedly. Finally, weak consumption by German households during the past decade suggests that there should be a lot of pent-up demand, especially for durable goods and housing.

The chart below shows the development of 10y German real yields (defined as 10y nominal Bund yields minus German yoy headline inflation). As can be seen, the monetary environment has become significantly easier over the past two years given that first nominal bond yields have become much lower and inflation has recently moved higher again. Furthermore, current German real yields are the lowest since the start of the Euro!

10y German real yields (10y nominal Bund yield - German inflation rate) at record lows

Source: Bloomberg; Research Ahead

Immigration trends are shifting. Earlier this week the German statistics office published the latest immigration data for 2010. It showed that on a net basis some 128.000 people have moved into Germany. This is a significant shift from earlier years and marks the highest net immigration since 2003. It is down to both, more foreigners moving to Germany and less German residents moving abroad. I am convinced that immigration will increase further. A key factor for immigration are relative economic prospects. Given that the German economy is doing so well and hence creates a lot of jobs whereas a host of other European countries are doing poorly with high unemployment rates, suggest that the attractiveness of Germany has increased significantly. Significant positive migration would positively affect trend growth (as it provides more labour to the economy and increases private sector demand) and help to ease the demographic problems Germany is facing in its social security system.

Source: German Statistics Office

Finally, I remain convinced that a key factor for the market share of German corporates in the global export markets remains determined by the level of the Euro vs. the key competitors of the German industry. Here, Japan seems to be very important, not only for the auto sector but also for machinery and chemicals. As the chart below shows, the EURJPY cross rate has moved sharply lower since the start of the financial crisis (from around 170 to currently 115, i.e. c.p. Japan lost 30% in relative price competiveness vs. Germany) and remains close to 10-year lows. Coupled with production losses following the catastrophes in Japan, Germany should be able to take away market share from Japanese manufacturers.

Trade-weighted Euro and even more so EURJPY provide significant stimulus for Germany

Source: Bloomberg

Heaven Knows I'm Miserable Now

The misery index was used in the 1970s to show the stagflationary nightmare. It is constructed by summing up the inflation rate and the unemployment rate. The higher this index, the worse the economic situation for a country. The misery indexes I show below are constructed slightly differently. While I take the unemployment rate as is, I dont use the inflation rate directly but rather the deviation of inflation from 1.5% (thereby assuming that 1.5% is somehow a superior inflation rate, but it could equally be a different low but positive number). Reason is that a very low/negative inflation rate has also negative economic and social consequences. Additionally, I add the budget deficit to the inflation rate and unemployment rate. A high budget deficit has also negative economic costs and reduces current as well as future fiscal flexibility.

US adjusted misery index

Source: ResearchAhead

The above chart shows the history of this misery index for the US (black: unemployment + adjsuted inflation, blue: +budget deficit). As can be seen, including the budget deficit, this misery index is back to the level prevailing during the stagflationary 70s. While at that time, unemployment and inflation were the problem whereas budget deficits were fairly low, this time unemployment and the deficit are high, whereas inflation has so far remained low.

Only Germany is on the bright side

Source: ResearchAhead

The chart above shows the adjusted misery index including the budget deficit for various economies. The UK shows a similar behaviour as the US. The Eurozone overall has as well seen a sharp rise in its misery index. However, the index is still at levels which were prevailing during the mid-90s. Finally, the German misery index has already dropped back to the levels which were prevailing at the height of the dot-com boom.

A country can lower unemployment if it reverts to more fiscal spending but at the expense of a higher budget deficit. Alternatively, a looser monetary policy could also be used to lower unemployment with the risk of fuelling inflation further down the road. As a result, there is a trade-off between these three variables which limits cyclical macro-economic policy. I am convinced that a lot of the economic problems (=surge in the misery index) are of a structural nature for the over-indebted/over-spending/over-leveraged US/UK and peripheral Eurozone countries. What is needed to significantly and sustainably lower the misery index again is time, structural reforms and improved corporate competitiveness.

More ECB rate hikes needed

I have long been of the opinion that the ECB will start to raise rates early (see A higher ECB repo rate by June dated Feb 2) but leave liquidity ample and that this would not constitute a policy mistake (see No ECB policy mistake dated April 5) as the North-Eastern countries need higher rates whereas the ECB repo rate has lost in importance for the fiscally challenged and economically underperforming peripheral countries.
The latest economic data - be it real activity, inflation or monetary data - all support the case for further significant rate hikes to 2-2.25% by year end (which means the ECB will likely take a 50bp step, probably in Q4). Today's 2.8% estimate for yoy CPI in April marks the highest inflation rate in the ECB's history, barring the end 2007-end 2008 period when, however, the repo rate stood at 4% (and was raised to 4.25% in the summer 2008) and just before the deflationary impact of the Great Recession depressed inflation rates again. Now the repo rate stands at only 1.25% and given the surging inflation rates has increasingly accommodative effects on the already strongly growing North-Eastern countries, most notably Germany. And to reiterate: For the economically weak peripheral countries the level of the repo rate has lost in importance as bond yields have become much more dependent on credit developments (Spain, Italy, Belgium) or are a matter of negotiations with the EU/IMF (for Greece, Ireland, Portugal). Additionally, for the banking sectors in these countries it remains more important to secure funding than the price they pay for this funding and here the ECB still provides ample liquidity.
Furthermore, today's M3 data - where yoy growth came in at 2.3% - only look low at first sight. I have long been of the opinion that looking at M3 does not provide an accurate picture about the state of the economy/future inflation risks. Given that M1 constitutes roughly half of M3, and M1 is extremely influenced by the ECB's balance sheet developments, M3 is very dependent on the ECB's measures as well. When the ECB significantly lengthened its balance sheet in 2008 to support the financial system, it also helped to stabilise M3. However, the related growth in M3 was not a precursor of inflation. Now that the ECB stopped growing its balance sheet, M3 growth is being depressed. In turn, M3 growth remains distorted and does not provide accurate signals about future inflation pressures.

ECB Balance Sheet (in €mln)

Source: Bloomberg

I think that a much better indicator of inflation pressures than M3 growth is growth in M3-M1. M3-M1 is not distorted by the ECB's balance sheets actions and much better reflects supply and demand for funds in the banking sector and the real economy. The chart below shows yoy growth in M3-M1 compared to growth in M3. It highlights that in 2008 inflationary dangers were unprecedented (whereas according to M3 they were similar to late 2001), in 2009 deflationary pressures were larger than M3 data indicated and that by now inflationary pressures are similar to late 2005. Yoy growth in M3 of 2.3% is still the lowest in the history of the Euro, barring the period since the Great Recession. In turn, M3 data would suggest that inflationary pressures remain very low, whereas M3-M1 data shows that inflationary pressures have risen significantly.

M3-M1 does not track M3 all the time

Source: ECB, ResearchAhead

Finally, growth in M3-M1 fits well with headline inflation and has a good fit with the ECB repo rate (in fact a much better fit than M3 data). The chart below compares yoy growth in M3-M1 with the ECB repo rate as well as with yoy headline CPI. As can be seen, growth in M3-M1 tracks the ECB repo rate well, especially since around 2002. It explains why the ECB waited so long in 2005 to hike rates (whereas growth in M3 would have suggested a much earlier rate hike) and again why it chose to hike rates at the start of this month despite low M3 growth data.

Growth in M3-M1 tracks the ECB repo rate well

Source: ECB, Bloomberg, ResearchAhead

Overall, activity, inflation as well as monetary data all suggest the need for a significantly higher ECB repo rate. If history is any guide, the current environment would be compatible with a repo rate of at least 2%! I expect the ECB to take us there by year-end (and to hike further in 2012).

No ECB policy mistake

Readers of my blog know that I have been expecting the ECB to start hiking rates for quite some time (see for example A higher ECB repo rate by June dated Feb 2). At its last press conference ECB president Trichet strongly hinted at a rate hike for the upcoming meeting this Thursday which caused bank economists' to change their expectations and consensus is now indeed looking for a rate hike this week. However, it frequently is being stated that such a step would be a policy mistake as it would aggravate the economic problems in the periphery and thereby worsens the sovereign debt crisis. For example in the Bloomberg article Trichet risks burying ailing nations with interest-rate rise it stated that "the normalization of rates from a record low of 1 percent will disproportionately hurt Spain, Greece, Portugal and Ireland, while failing to nip inflation threats in Germany." Additionally, a bank economist was quoted with "Greece, where government debt is set to rise to 156 percent of GDP by 2014, will face an additional debt-service charge of 1.6 percent of GDP if market borrowing costs gain 1 percent on the back of the ECB raising rates, Paolini estimates."
Now to be sure, I fully agree that the economic environment varies greatly between the north-eastern Eurozone area and the periphery (and will continue to do so for some years) with the periphery needing lower rates than the north-east. However, I am also convinced that given the Eurozone debt crisis, the repo rate has lost in importance for the fiscally weak peripheral countries (or to put it differently: the monetary transmission mechanism in the periphery is impaired). The relationship between the repo rate and peripheral bond yields has weakened dramatically ever since the Eurozone sovereign debt crisis started. The effect of a higher repo rate does therefore not need to translate into higher funding costs which add to cyclical economic weakness. The chart below shows the rolling regression coefficient of changes in 10y bond yields ono changes in the 6x9m EONIA forward rate (over 120 business days). There is a relatively stable relationship between changes in the EONIA forward rate and changes in the 10y Bund yield (with changes in the EONIA forward rate being mirrored almost 1:1 by 10y Bund yields). The R2 value is around 75% (i.e. around 75% of the changes in 10y Bund yields are explained by changes in the EONIA forward rate).

Reduced repo rate iimportance: regression of 10y yields on 6x9m Eonia forward

Source: Bloomberg, Research Ahead

For peripheral bond yields, this is not the case. Since the outbreak of the Greek crisis in spring 2010, the correlation between changes in the EONIA forward rate and 10y Portuguese, Spanish and Italian yields moved into negative territory (i.e. higher peripheral yields went hand in hand with a lower EONIA rate and vice versa). However, regression coefficients have statistically not been different from zero and R2 values have been below 1%. Hence, statistically, peripheral bond yields are currently not dependent on changes in the EONIA forward rate (and with that on ECB rate action). This assessment is being confirmed by the developments over the past weeks. While 10y Bund yields rose by approx. 20bp since the last ECB meeting at the beginning of March (when the ECB prepared the market for a rate hike), 10y BTP and 10y Bono yields are slightly lower by around 5bp. On the other side, Portuguese yields rose sharply amid the political crisis and expectations that Portugal will have to apply for a bail-out soon. Hence, fundamental credit developments seem to be the main driver of peripheral bond yields and not the ECB repo rate!
With respect to the Irish and Greek sovereign, the ECB repo rate is even of much less importance. The bond market currently remains shut for these two countries (with Greece only performing some bill issuance) and they fund themselves via the IMF/EU/EFSF at pre-defined interest rates. Changes in the ECB repo rate have no meaningful effect on the interest expense of these countries. In fact, Greece could recently negotiate a reduction in the interest rate it gets charged on the bail-out loans and Ireland tries to achieve the same. For these two countries, the interest rate they have to pay are therefore a function of politics and not of the ECB repo rate.
For Eurozone banks, a repo rate rise will mean a higher funding cost. While the strong banks can easily withstand a higher funding cost, for the weak Eurozone banks the most important issue is to get access to enough liquidity with the price being is of secondary importance. And here the ECB seems willing to keep liquidity provision ample. As long as this remains the case, the effects on the banks should be low.
For households, credit on new loans will become more expensive but that is wanted for households in the north-east. For households in the periphery, the volume of new loans has been low anyhow and as a result the slowing effect via this channel should prove fairly limited. The larger problem might be that a significant amount of outstanding mortgage loans in Ireland, Spain and Portugal are variable rate loans (linked to Euribor). Given the rise in Euribor rates, this will at the margin negatively affect consumption.

Overall, given that Ireland and Greece currently do not fund themselves in the bond markets and credit fundamentals are more important for the bond yields of the other peripheral countries than the level of the repo rate whereas for the weak banks it is more important that they continue to have access to enough liquidity than the price they pay for this liquidity, the effects of a higher repo rate on the economically weak peripheral countries should be very limited. Only households relying on variable rate mortgages will see a drop in their real spending power. For the north-eastern Eurozone countries the effects of a higher ECB repo rate should have more direct consequences (albeit the level of rates remains very accommodative) given that here the monetary transmission mechanism is working much better. Overall, I previously stated that fundamentally a higher repo rate is warranted (amid the level of real growth, inflation but also given improving monetary developments) and I do not see strong reasons why it should constitute a policy mistake.

The Bad and the Ugly

Finally, the EU managed to find a decision on the ESM (as well as an overhauled stability pact and increased economic monitoring and surveillance measures). Coupled with the already agreed enlargement of the effective lending capacity of the temporary EFSF (as well as a broadening of its mandate), this is a significant step forward for the Euro project. I would have preferred if the EFSF would have been allowed to be buying government debt in the secondary market but overall, the measures are going in the right direction and show that the political support for the Euro remains strong. I am convinced that these steps reduce the risk of a systemic breakdown of the Eurozone (i.e. a break-up). Additionally, it seems that markets are starting to perceive a similar picture as correlations between peripheral government bond spreads to Bunds have been falling since early this month.
The chart below shows that Portuguese and Irish spreads continued to widen. This should not come as a big surprise given all the negative news out of Portugal (collapse of the government, significant rating downgrades) which renders a bail-out very likely and the ongoing problems in the Irish banking sector, a lack of agreement about a potential cut in the interest rate of the bail-out loans and the absence of the ECB in the secondary market. On the other side, spreads of Italian and Spanish bonds have tightened considerably.

The bad and the ugly: Italy/Spain diverge from Portugal/Ireland

Source: Bloomberg

This is probably down to an improved growth outlook for the Spanish as swell as Italian economies (it has also been mirrored in equity markets where the Spanish IBEX and the Italian MIB index show the largest year-to-date gains besides Greece). Also in the case of Spain, it seems that the austerity measures taken by the government over the past two years as well as the steps to bail-out the banking sector are starting to help restore confidence. Moreover, it suggests that contagion from a likely Portugal bail-out should prove minimal. This is not only a great development for Spain - which has been frequently cited as a likely bail-out candidate following Portugal - but for the entire Eurozone. Additionally, given the size of the Spanish bond market, a self-reinforcing widening cycle (and a likely bail-out) would have caused tremendous losses on the already weak European banking sector.
Finally, these developments are support my notion that for peripheral bond yields it is much more important what the EFSF does/how the liquidity situation evolves, than whether the ECB hikes its repo rate. 10y Spanish government bond yields have fallen by some 50bp since mid January. To be sure a 5% 10y rate is still restrictive for the Spanish economy, however, it is less restrictive and as such will help the economy to stabilise and the sovereign to reduce the budget on the margin. Furthermore, as spread volatility drops, more buyers might be enticed back into investing in Spanish bonds, with the potential of establishing a positive feedback loop (lower yields=better for the deficit and the economy=improving fundamentals=lower credit risk=more bond buyers=lower yields). At the short end, the situation is similar and 2y yields fell 60bp over the past two months.
As a sidenote, these developments support the case for an early ECB rate hike. Furthermore, I expect Spanish and Italian bonds to perform further vs. Bunds over the medium term. Therefore, my expectations for the development of monetary policy remain the same as they have been since early this year:

Policy tool	Direction	Expected stance
Repo rate (ECB)	Higher	Less accommodative
Liquidity provision (ECB)	Unchanged	Ample liquidity
Peripheral bond yields (EFSF)	Lower	Less restrictive