And the Fed kept on printing...

Dear readers,

Recent USD weakness has brought more nervousness in the market. Apart from the EUR and AUD the currency is losing rapidly its value against gold. How is this compatible with our deflationary view? Last week we got further confirmation the deleveraging process is still far from over. US consumer credit contracted more than expected (- $12 billion), and it isn’t showing any sign what so ever of slowing down. Headlines like Barclays wanting to spin off a £ 4 billion structured credit portfolio should be considered as part of the deleveraging process the global economy is going through as well. This should keep consumer prices contained.

Then the Federal Reserve is doing its outmost best to inject some inflation into the system. This is certainly the case for some asset classes such as equities and commodities. Last weeks rhetoric from Fed members Tarullo and Fisher, who is famous for being a hawk, already indicated the Fed will stay on hold for “an extended period” of time. Also the Fed’s 5year-5year forward breakeven inflation rate has been dropping consistently since its spike back at the beginning of August. So no signs of inflation there either. But still gold is touching new historic highs against the USD.

The explanation behind all this might very well be a distrust from foreign investors in how the US Government will succeed in managing this Mount Everest of debt they are building up. There are reasons to believe central banks are already distancing themselves from the USD.

Recent US Treasury auctions showed however good appetite for USD debt paper. The bid-cover ratio has been well above 2%. And foreign central banks subscribed well above $ 250 bln. But the question is whether this is reflecting what is really going on behind the scenes. The Treasury International Capital Flows (TIC) data shows that foreign demand for USD paper is falling off a cliff.

Figure 1: Foreign Assets in the US: Net, Capital Inflow



Source: US Department of Commerce – Bureau of Economic Analysis

This has a direct impact on the value of the USD, as foreigners are net sellers of US assets. The US spending spree financed by foreigners during this decade is also very well illustrated in Figure 1. From 2001 onwards until the breakout of the Great Credit Crisis in 2007 foreigners bought massively US assets. It was part of the build up of a current account and trade balance deficit. The US was the consumer of last resort and the oil-exporting and Asian economies re-invested these revenues back into the US. This US asset buying stopped abruptly from the moment the US consumer couldn’t use his house as an ATM machine.

It does not take a rocket scientist to figure out what would happen to the USD if this structural foreign buying flow dries up. And it is certainly an issue for a country like the US which mounting debt depends on 50% of foreigners.

According to the TIC report, foreign central banks only bought roughly $ 75.7 bln (from Jan 09 till Aug 09). At first one can argue this is highly contradictive against data from the US Treasury auction, which is over $ 250 billion. Fortunately there is no paradox here.

First of all what you need to know is that the Federal Reserve acts as a custodian bank for foreign central banks that buy US Treasuries or Agency paper. In other words the Fed holds these bonds “in custody” for these foreign banks. The TIC data is only showing the amount of capital that is entering or leaving the US, but what happens on these custodian accounts at the Fed is not told.

A first look at these custodian accounts doesn’t raise any suspicion either. The amounts on these accounts have been growing over the years. But when we have a closer look one notices something odd. Central banks have not only been buying US Treasuries, but also US Agency bonds. This is paper issued by for example Freddie Mac and does not have the same guarantee like US Treasuries. Over the years foreign central banks were buyers of US Agencies. At the beginning of October 2008 a peak was reached at around $ 970.4 bio. Over the last 10-12 months this amount has dropped by $ 207.6 billion. US Treasuries on the other hand have risen by more than $ 600 billion.

Remember the TIC data, which is pointing at $ 75.7 of new money entering the US (from foreign central banks). So how does this explain the success of the US Treasury auctions?

Chris Martenson noticed the following phenomenon already back in June.

Foreign central banks are fully supporting the new issuances, but indirectly via their huge amounts of US Agency debt that they swap with the Federal Reserve. This avoids a situation where the Federal Reserve has to start buying its own paper. Imagine which kind of panic this would cause in the bond market.

So basically out of the sale of their US Agency paper, foreign central banks keep on supporting the Fed in buying new US Treasury bonds. But in some way or another, it is ultimately the Fed that is buying its own paper.

However, as we learn from the TIC data, compared to the total of USD 600 billion that has been issued, only USD 75.7 of new money is coming from foreign central banks. In the meantime $ 552.6 billion of private money has been repatriated back abroad. This shows that there is a negative flow leaving the US and explains why the USD is has come under so much pressure recently.

US (Un)-Employment

Dear readers,

In last weeks’ Givanomics we explained the New Normal. In summary the New Normal stands for much lower economic growth, higher public debts and unemployment rates compared to the levels we were used to before the Great Credit Crisis 2007-2009.

This week we will have a closer look at some data of the US labour market in specific. The data we use is obtained by the Bureau of Labour Statistics, the Federal Reserve and research company Millennium Wave Investments run by John Mauldin.

Last month US unemployment hit 9.7%, getting close at the levels of the 1980-1983 economic recession. In real numbers, based upon a total labour force of 154,577,000 people available for the labour market, almost 15 million are out of a job right now. Over the last two years the US economy lost around 8 million of jobs.

This number is actually even worse if one takes into account the number of people who lost their full time job and have to accept a lower level part-time job. When this group is taken into account the unemployment number would be around 16.8% (this is also known as U-6 unemployment). Then we are not taking into account those who still would like to work but are not available anymore to the job market. Bear in mind in order to be part of the US labour market one needs to be registered. Those who lost all hope because of disappointment fall out of this database. Despite the fact that this is percentagewise a very small group, it would bring the unemployment number closer to 20%.

Reverting to the old normal would mean that 8 million people would need to be put back at work. On top of that one needs to take into account that the US labour market needs on average between 125,000 and 150,000 new jobs every month to accomodate newcomers to the job market. This comes from migration, people who graduate and/or women who are still entering the labour force.

Like there is subordination in a debt structure there will be a hierarchy in the job market to put all these people back to work. This will work out as follows:

The first signs of recovery in the labour market will be seen in the numbers of hours worked on a weekly basis. The first thing an employer usually does when demand is dropping, is to slow down the production process. Job lay offs are the last drastic measure to rationalise the business. From the moment that economic activity is picking up again the average hours worked in a week will start rising again. This fell from 34 hours a week to a record low of 33 hours last June.

Before there will be a substantial recruitment wave in the unemployed labour force, employers will ask part-time workers to work a bit longer, driving up the weekly hours worked. So these will be the first who will turn back to full employment. Then, if we get back to pre-recession levels of 33.8 – 34 hours worked a week, companies will hire back out of the available labour pool of fully unemployed people. The newcomers on the job market however will be the group who will find it most difficult to find a decent job.

When we extrapolate this group for the next 5 years this means that the US job market will need to add 150,000 or 125,000 * 12 * 5 or 7.5 and 9 million jobs. This comes on top of the 8 million people that lost their jobs during the current crisis.

This is the challenge the US economy will face: creating between 15.5 and 17 million jobs over the next 5 years. If we use the lowest number this still would mean that the US job market should grow on a monthly basis by 258,000, and this every month for the next 5 years.

This is a performance that the US economy not even matched during the “Old Normal”. During the booming years this average was around 230,000. If this is averaged out over the last 10 years the average was only 50,000. This was of course with a recession incorporated, but during the prosperous times of the Clinton years the US economy created only 150,000 on average every month.

We can almost guarantee you this will not happen in the absence of a Shadow Banking system that was the driving engine of cheap credit and overconsumption. As far as unemployment is concerned this is the New Normal. The US economy will have to adjust to a new environment of much higher unemployment rates which will have, in turn, a severe impact on spending.