Light Dawns on Marble Head

A friend of ours was fond of using the expression, "light dawns on marble head" as he slowly perceived what he believed to be obvious and right there before him had he only been more attentive.  So it may be with all of us, from time to time.  Sometimes things are not at all obvious, though, and we're simply being modest, as was the case with our friend. Sometimes it's simply a matter of jotting things down that can be viewed in plain sight.

Plotted below is the yield on the 30-year UST at roughly its high and low marks for the year, for each of the past four years (2010-2013).  The cyclical high yield in each year has come in the rather narrow period of late March – early April.  In fact, the high yield has printed in a period spanning no more than 26 days!  US Treasury bonds, particularly at the long end of the yield curve show their greatest price reaction to economic strength or weakness, signs that their greatest foe, inflation, might be creeping in or receding.  Hence, when the economy appears to be at its strongest, the 30-year trades its weakest and prints its high yield for the cycle.

The cyclical low in yield for the 30-year has occurred in a somewhat wider range over the past three years, from late July – early Sept (too early to tell for 2013).  While this is a wider period than its high yield mark, this data still indicates a span of less than 45 days.  Now, perhaps this is purely coincidental that the 30-year would signal its greatest price strength and weakness at precisely the same time each of the past four years.  Or perhaps, there's some pattern worth discerning.

Why this pattern might occur requires some speculation, but as another friend of ours was fond of saying, "numbers don't lie".  We believe the reason for this trend is the economic false-starts we’ve seen for Q1 for the each of the past three years and, we suspect, carrying over into Q1 2013.  As discussed in  a previous post on this blog, the data from BLS and Commerce have been favorable in each winter period for the past four years, causing bond prices to weaken, only to fall off in spring and summer (causing bond prices to rally).  

We believe that this pattern is not coincidental, but rather relates to the seasonal adjustment models that the two departments use to account for what they believe to be normal seasonal patterns. If true, these factors are distorting the picture of growth in the winter months, causing the UST long bond to weaken substantially (in price) only to recover strongly as that growth fails to carry forward into the warmer months. 

The best description of the seasonal adjustment factors we've seen was in a blog post to the Washington Post:  http://www.washingtonpost.com/blogs/wonkblog/wp/2012/08/05/wait-the-u-s-economy-actually-lost-1-2-million-jobs-in-july/

Too Much Eggnog Over at Commerce?

"US Retail Sales Beat in February, Topping Consensus Forecasts".  "Retailers got an Unexpected Valentine from Shoppers: Strong February Sales". "US Retail Sales Rose in February by the Most in Five Years".  "Retail Sales Surprise to the Upside in February". 

So what do those four headlines have in common?  Hint: they are not varying reports of the February 2013 US retail sales number.  Rather, they are reports of February retail sales for 2010, 2011, 2012 and 2013, respectively.  Similarly, the employment data for February 2011, 2012 and 2013 surprised to the upside.  In each case, however, for both retail sales and employment, the numbers softened by mid-Spring into Summer, disheartening investors who were convinced that the long awaited green shoots of economic recovery were finally taking root.

Now we can ask, what is it about the US economy that causes the data to be so strong in January and February only to slip back into weakness a few months later?  Or, we can ask, what is it about the seasonal adjustment models used by BLS and Commerce that cause consistently false positive readings on the economy during the winter months?

There have been numerous articles written on this topic, but a recent article on ZeroHedge confirmed our suspicions that the seasonality models might be in need of some, well, adjustment.  What they found was that the surprisingly strong February 2013 retail sales number of 1.1% (vs expectations of 0.5%) before seasonal adjustments "actually posted the first sequential decline since 2010, as retail sales declined from $382.4 billion to $381.0 billion: this was the first sequential decline in retail sales in the month of February in three years (http://www.zerohedge.com/news/2013-03-13/adjusted-february-retail-sales-rise-more-expected-actual-retail-sales-post-first-dec).

Maybe it's time for Commerce and BLS to examine whether the consistent sputtering of the economy throughout the first half that we've seen in each of the past three years might be more their form, than the economy's substance.

The Abenomics of Japan

The market reaction to the new Japanese Prime Minister has been nothing short of eye opening.  With bold claims to battle deflation and revitalize the Japanese economy through competitive devaluation of the yen, markets around the world have been put on notice.  This is one determined dude.  Without any program of intervention actually underway, and merely a claim to begin fighting the yen sometime next year, the currency immediately entered a spirited decline, dropping from its high of 77.11 back in September to its current low of 96.12.

The Nikkei has rallied in support, reaching a new multi-year high of 12,239 on the promise of new BOJ leadership supportive of Abe's plan.  All that's left now, is for commentators to draw historical parallels to prior "currency wars" and for Christine Lagard of the IMF to declare this a currency issue, but certainly not a war.  China, always eager to jump on the bandwagon of Japan bashing, accused Japan of what the US has accused China of and for which the US is, of course, leading the parade.

As the world is increasingly convinced that all economic difficulties can be solved through currency debasement, we sit here thinking the world has really gone quite mad.  We know the argument.  Weak currencies foster competitive industry in a global marketplace, while stoking inflation as the the local consumer pays more for everything they import.  We get it.  But it's dumb.  At least for developed economies.

For many years, growth in the developing world has been built around this principle. Employ cheap surplus labor to build products that can be sold to rich people in the West.  Local manufacturers cannot compete on price, as to the labor component, and if you can turbo charge it all with a weak currency, so much the better.

But Japan today is quite different.  It is a mature, highly educated and wealthy society, with an enviable standard of living.  It's problems are demographic in an aging and declining population, economic in a heavy government sector debt burden (236% of GDP) and social, in a high standard of living for what was once an export dependent economy.  For the first time in memory, Japan is posting a trade deficit, reversing seemingly endless periods of surplus.

The strong yen was derived in part from a view that despite the country's large budget deficits and high debt burden, a high resident savings rate allowed Japan to largely self-fund its deficits.  No need to rely upon the trade surpluses of other nations to pick up the slack, the way the Chinese and Japanese have so graciously done for the US.

All these historic trade surpluses, however, have put Japan in an enviable position, at least compared to the US.  According to a recent article by Bloomberg News, Japan surpassed China as the largest holder of US securities in 2012, at $1.84 trillion and the second largest holder of US Treasury bonds (behind China) at $1.12 trillion.  In many ways, this makes the Japanese problem less insoluble than that of the US.

Japan should enter a course 180 degrees away from that charted by Abe.  They should begin selling their holdings of US dollar denominated assets and using the proceeds to reduce their own debt.  This "reverse" intervention would cause the yen to appreciate in value, not only through the currency transactions directly but through a perceived strengthening of the currency on the basis of the stabilization of the country's fiscal imbalances.

A stronger yen would hurt their export sector, perhaps, but Japan's real problem with exports (as with the US) is excessive labor unit costs by global standards.  Quite simply put, if Japan wants to compete in the markets for manufactured products that the world perceives to be commodities, without technological or qualitative distinction, it has to lower its standard of living, not its currency.  This, again, is equally true of the US.

A stronger yen, however, will lower the cost of imports for Japanese consumers.  It will stretch their dollar further, so to speak, at home as well.  And it just might break, rather than contribute to the deflationary spiral by stimulating consumption.  Ask yourself: if a Japanese businesswoman needs to fill her car with gas on the way to work and finds that it costs her the equivalent of $70 rather than $110, is she going to delay filling up, hoping that prices are lower next week?  Of course not.

If she saved $40 on gas, is she more or less likely to pick up a nice bottle of French wine with dinner at the market?  Particularly, if it cost the equivalent of $25 rather than $65. And would these lower prices and greater spending power make her feel poorer?  Unlikely.  And if interest rates were raised so she and her family could see their savings rise, this might not hurt their wealth effect either.

A stronger yen would boost final demand rather than weaken it.  And for a modern Japan that can no longer produce the best quality at the cheapest price, internal demand may be far more important to the country's economic future than the old model of currency debasement and export dependence that Abe is preaching.