Wednesday 25 September 2013

Primer on US budget and debt ceiling negotiations

The ongoing political wrangling in Congress is the source of bewilderment for many, with even major media outlets getting the federal budget talks confused with the debt ceiling.Bloomberg is the latest victim, failing to distinguish the difference between the two issues. In essence, budget spending must be agreed by October 1st to avoid a government shutdown, while the debt ceiling must be extended later in October so that the Treasury Department can continue to borrow and honor its sovereign debt obligations.


The 2013 budget expires at the end of this fiscal year (September 30th) and if a new bill is not agreed upon the US will face its first federal government shutdown in 17 years. The consequences involve hundreds of thousands of federal employees facing furlough (temporary unpaid leave), a possible delay in payment of military personnel and the closure of national parks and some administrative departments. Of course, members of Congress will be paid as normal.

Last week the Republican-controlled House of Representatives passed a resolution that would fund the federal government until December 15th. However, this bill would deny funding to the Affordable Care Act (Obamacare); a requirement insisted by a group of uncompromising Tea Party members. The bill is now with the Democratic-majority Senate, which will likely add in the funding for Obamacare before sending it back to the House.

However, it is not clear when the Senate will actually have its resolution ready for the House as several Republicans, and some Democrats, are pledging to use every measure possible to prevent the Senate from restoring Obamacare funding. The measures should be unsuccessful, but they will likely delay the final vote until late on Sunday (September 29th). That will leave John Boehner and his Republican House colleagues with just a day to decide if they want to anger the Tea Party by allowing Obamacare funding or appease the hardliners by forcing a government shutdown. While the economic impact of a shutdown will be relatively minimal, such a situation will do little to aid the GOP’s fractured image.

Debt Ceiling

Presuming that a budget bill is soon resolved, the focus will turn to the US Treasury’s $16.7 trillion debt ceiling. This will garner much more international attention as failure to extend the debt limit will heighten expectations of a possible sovereign default. Essentially, the Treasury issues billions of dollars in new debt each month to fund various government departments because tax revenue isn’t enough to cover spending. But without a higher limit, the Treasury will be unable to issue enough debt to meet the government’s needs.

Treasury secretary Jack Lew says that by October 17th there will only be about $30 billion to meet the nation’s commitments. This is worrying given that a $60 billion social security payment is due on November 1st. He warns that without sufficient funds the US will fail to meet all of its obligations for the first time in its history. The protracted debt ceiling negotiations in 2011 marked another first as the US debt rating was downgraded from AAA, the highest level. In addition, an agreement was only reached on the condition of spending cuts. And the political situation seems even more divisive now.

Like with the budget bill, funding for Obamacare will be the major point of contention. Boehner says that House Republicans will only vote to raise the debt ceiling if the full implementation of Obamacare is delayed for 12 months. President Obama counters that there will be no negotiations over the debt limit. Ultimately, someone will have to give-in, otherwise US credit-worthiness will be damaged and financial markets will react with gusto.

While prices on US Treasury bonds rose after the downgrade in 2011, market conditions are different today. Prices have been on a downward trend since May, with rates subsequently rising. Even though rates have fallen somewhat in the last week as markets reacted to the Federal Reserve’s tapering delay, they seem set to resume an upward trend when quantitative easing slows. Failure to increase the debt ceiling will add further impetus to rising rates as investors sell their holdings of Treasuries.

The consequence will be higher mortgages and corporate borrowing costs. Moreover, it will see a further deterioration in people’s opinion of the political system as partisan wrangling chokes the fragile economic recovery.

Sunday 15 September 2013

MacroWatcher: Fed Tapering and Weekly Notes

The Federal Reserve’s quantitative easing program, announced in November 2008, has coincided with many positive developments. Equity markets have rallied strongly, the housing market has begun to recover, unemployment figures are improving and banks have recapitalized. This week the Fed holds a two-day meeting and may subsequently declare a tapering of QE; something eagerly anticipated by markets.

Two-thirds of economist respondents to a Wall Street Journal poll expect some form of tapering to be announced Wednesday, but that number is surprisingly small. Markets appear to have priced in a taper, with bond yields rising sharply since Fed Chairman Ben Bernanke first hinted at the possibility back in May. The recent improvement in the unemployment rate, falling to 7.3% from 8.1% last year, has further bolstered expectations of a reduction in the Fed’s asset purchases. If the Fed were to postpone a tapering decision this week there could be a swift reaction. Market volatility would increase and the Fed’s ability to communicate effectively to markets will be cast into doubt.

The central bank will be keen to avoid a jolt in markets and will likely reveal some form of QE reduction. Currently, the program involves $85 billion of monthly bond-buying and this number will likely be decreased to $70 billion, probably involving a reduction in both mortgage and treasury purchases.

Economic fundamentals may prevent the Fed from tapering by a larger number. While the unemployment rate has declined, labor force participation has also fallen markedly, dampening the significance of a lower jobless figure. Moreover, monthly nonfarm payrolls were disappointing in July and August. Therefore, a relatively small $15 billion tapering will not significantly upset the impact of QE while also allowing the Fed time to analyze future economic data before committing to further reductions. This number should be enough to satisfy markets that already have tapering priced-in, while also setting in motion the Fed’s efforts to normalize monetary policy.

To assuage any economic concerns, Bernanke will likely emphasize that the reduction in QE is not indicative of future tightening by saying that monetary policy will remain accommodative. The Fed has said that a 6.5% unemployment rate and 2.5% inflation are targets for monetary tightening, but given the decline in labor force participation it may be communicated that a realization of these figures will not result in immediate changes in policy.

Of course, the Fed could announce a larger or smaller taper than the widely expected $15 billion. A larger reduction seems unlikely given the mixed US data of late, while a smaller number could see some volatility in bond markets. Markets will also be watching the Fed’s revisions of its GDP, unemployment and inflation projections from 2013 to 2015 and also its new forecasts for 2016. An interesting dichotomy will emerge if the Fed announces tapering while also revising GDP lower. However, such an outcome is unlikely given that the Fed has overestimated GDP in recent forecasts.

Dangers of Single Data Point

The validity of the US initial weekly jobless claims was cast into doubt last week. On Thursday the Bureau of Labor Statistics reported that the previous week’s claims were 292,000; the lowest level since April 2006 and 38,000 below economists’ consensus expectations. The number was surprising, but was devoid of any credibility when the Bureau revealed that most of the decline was due to two states retooling their computer networks, resulting in faulty reporting. The incident highlights the dangers of allowing one stream of data to influence an economic perspective.

Japan’s Tax

Good news came from Japan last week as prime minister Shenzo Abe will risk his domestic political popularity to implement an increase in sales tax next April. Although not yet officially announced, the decision to raise value-added consumption tax from 5% to 8% will help address the nation’s growing public debt burden [expected to be 230% of GDP by 2014].

There were some concerns that Abe may renege on the locally unpopular tax. But such a development would cast doubt on whether the government was committed to addressing its finances while simultaneously increasing the likelihood of future ratings downgrades and Japanese sovereign bond sell-offs. Abe is expected to pacify concerns about the economic impact of the tax hike with additional stimulus spending of up to Y5 trillion [$50 billion].

Week Ahead

While markets will be focusing on the Fed’s meeting, there is also the release of US industrial production data on Monday, consumer price index inflation figures on Tuesday and the Leading Economic Indicators report on Thursday. In Europe, the key release is the German ZEW economic sentiment survey on Tuesday, while the nation will go to the polls at the weekend as Angela Merkel is expected to retain her position as Chancellor with the makeup of the ruling coalition still unclear.

Sunday 8 September 2013

Macro Weekly Overview

Last Friday was a good example of the incongruity that often exists between economic indicators and financial markets. The US Labor Department announced that 169,000 new jobs were added in August, falling short of economists’ forecasts of 175,000 to 180,000. The Department also announced that the number for July was revised lower from 162,000 to 104,000. Yet stock markets subsequently jumped higher despite figures indicating employment sector weakness.

The phenomenon of stocks rising on bad economic news has been a common occurrence recently as investors feel a weak labor market may spur the Federal Reserve to maintain its monetary stimulus policies and delay tapering plans. However, it does raise the question of how weak economic data needs to get before stocks would fall?

On a broader scale, the disconnect between stocks and the economy has also been driven by companies’ cost-cutting, which has resulted in profit margins rising to all-time highs and boosted the attractiveness of stocks. Of course, neither the Fed’s stimulus nor companies’ cost-cutting are sustainable measures over the long-term and soon markets will cease their positive reaction to negative news.

Unemployment Rate

Adding to the feeling of disconnect, Friday’s releases showed that the US unemployment rate fell to 7.3% in August, even though consensus expectations were for a 7.4% rate and fewer jobs were added than forecast. The decline in the unemployment rate was actually a case of good news being bad news. The drop was due to a shrinking labor force, meaning that fewer people are seeking employment. The smaller labor force can be caused by people becoming discouraged from seeking work, staying in college longer and changing age demographics. But its decline is masking weakness in the employment sector. Interestingly, data using the trendline average labor force participation rate [compiled by Zerohedge] shows that the unemployment rate actually rose from 11.2% to 11.4%.

M&A Activity

While US economic data has been inconsistent lately, some optimism can be taken from a rise in M&A activity. Last week Verizon announced a deal to take full control of its wireless unit from Vodafone while Microsoft said it will buy Nokia’s mobile phone business, pushing this year’s global M&A volume to $1.56 trillion [data from Thomson Reuters]. Total M&A was $2.6 trillion in 2012. Cash-rich companies seeking cheaper assets is a sign they are optimistic about growth and indicates a re-leveraging in the economy.


While Italy verges on further political turmoil as prime minister Enrico Letta stands firm in support of removing Silvio Berlusconi from parliament, there are some signs of stabilization in other periphery economies. Last week it was announced that Spain’s manufacturing sector grew for the first time since April 2011 according to an unexpectedly strong PMI reading of 51.1 (greater than 50 indicates expansion). Spain has also succeeded in lowering unit labor costs, thus boosting competitiveness and aiding its export market. While unemployment remains a major concern, at least it fell slightly in August to 26.3%, marking a decline for a sixth consecutive month.

Unemployment is even worse in Greece at 27.6%, but the rate of the economy’s contraction in the second quarter was revised lower last week to 3.8% from an initially estimated 4.6%. It was the best reading for Greece in three years and while there is no reason for cheer, it is some evidence of stabilization.


Market activity was heavily influenced by developments surrounding Syria last week and that is likely to continue in the near-term. President Obama will be seeking support from Congress for his military strike plans but it’s not clear what route he will take if there is a vote not to intervene. If a strike does go ahead, the reaction of Syrian allies will be crucial. Iran's deputy foreign minister is scheduled to visit Moscow next week to discuss Syria with Russian officials. Russia has already sent naval ships to the Syrian coast and anxiety looks set to escalate in the coming weeks.

Week Ahead

Upcoming US economic data will not bring much clarity to the Fed’s tapering date as the only releases are producer price inflation and consumer sentiment indices on Friday. However, political wrangling is set to begin as Congress returns from its summer break and gets set to tackle Syria and negotiate the federal debt ceiling. Elsewhere, China will release keenly-watched industrial production data on Tuesday and Europe will follow suit with its number on Thursday.

With such a variety of market-moving factors looming, volatility looks set to escalate and the nervousness of investors is evidenced through data that shows a $15.3 billion withdrawal from stock funds in the past three weeks and $7.7 billion in redemptions from Pimco’s flagship bond fund in August.

Friday 6 September 2013

Italy To Bring Anxiety Back to Eurozone

For the first time in five years the eurozone has had a relatively quiet summer. With German elections looming it was unlikely there would be any significant developments in Europe and positive economic data has added to the recent calm. But with summer ending it’s possible that political turmoil in Italy could be the catalyst for eurozone anxiety.

The coalition government has been tenuously held in place by prime minister Enrico Letta over the last four months, but it is now in grave danger of splitting. Once again Silvio Berlusconi is at the heart of unrest. Political upheaval is a recurring theme in Italy and Berlusconi’s presence is preventing the establishment of reforms to help rejuvenate a contracting economy.

Despite being convicted of tax fraud, the 76-year-old still plays a role in government through his People of Liberty party. To-date the coalition has survived by Letta avoiding key decisions and agreeing to the demands of Berlusconi’s party on issues of government personnel and tax. Last week Letta agreed to cancel a property tax even though the European Commission, OECD and IMF advised that the tax remain in place to help tackle the country’s 2 trillion euro public debt. The government has not yet announced how the lost revenue from the property tax will be recouped. Such assuaging to Berlusconi led former prime minister Mario Monti to label the government “gutless and spineless”.

Letta has thus far done everything to maintain a stable government, aware that financial markets would not take kindly to disorder. Indeed, the mere preservation of the coalition following the property tax negotiations helped Italy auction off its target of 6 billion euro worth of bonds last week.

While Letta has seemingly bowed to Berlusconi on many issues, he is standing firm in his support of a law that should remove the former prime minister from parliament - and that may be the coalition’s undoing. Berlusconi’s tax conviction has been held up by Italy’s highest court of appeal and on September 9 a Senate committee meets to begin deciding his fate. A full Senate vote on the issue is expected in October.

Letta’s support for the process has predictably drawn ire from Berlusconi’s camp. On Thursday, People of Liberty member Daniela Santanche claimed that Berlusconi has made a video that could announce his decision to withdraw support for Letta, effectively bringing down the coalition government. Berlusconi also plans an appeal to Italy's constitutional court against the tax fraud verdict and his party says the Senate should wait for that ruling before passing judgment on him. It is obviously a delaying tactic and if the constitutional court agrees to hear his case it could take years before a decision is made. Such an outcome would keep Berlusconi on the scene and dim the prospects of significant economic reform.

There is little evidence of a recovery in Italy. The economy has contracted for eight consecutive quarters with the manufacturing sector experiencing a striking decline as output has fallen more than 25% from its peak in 2007. The nation’s unemployment rate is 12%, but this would be higher if not for a government policy introduced in the 1970s which aids struggling factories by paying “unused” workers 80% of the salaries while their employer attempts to solve its problems.

Earlier this week there were headlines trumpeting a rise in eurozone manufacturing aided by a surge from Italy. Export sales drove output in August but the same manufacturing survey also showed that employment in the factory sector fell for the 25th month running, and at a slightly faster rate than in July. On Wednesday it was announced that Italy’s services sector contracted by more than economists’ consensus, highlighting weak domestic demand. Overall, the manufacturing and servicing reports illustrated that while the wider global economic recovery is gathering steam, Italy remains stagnant.

In the stock market Italian bank shares are strongly outperforming those of other European nations this year. Much of this performance is due to the relatively sound nature of Italian banks as their conservative philosophy saw most of the major institutions avoid excessive leveraging and emerge from the financial crisis intact. Yet continuing economic sluggishness will soon deteriorate balance sheets and limit profitability.

The spread, or extra yield investors require to hold Italian 10-year bonds instead of German counterparts has risen in recent weeks to about 2.5% after touching a year-to-date low of 2.27% on August 19. Current levels are still significantly lower than this year’s high of 3.61% reached in March and nowhere near the 5.75% record set in November 2011. That record was spurred by the tumult surrounding Berlusconi’s prime ministerial resignation and it looks like he’ll have a role to play in spreads widening again.