Angela Merkel and Nicolas Sarkozy today issued a clear statement in favor of providing emergency funding to debt-stricken Greece. Just a few days ago it appeared that German and French officials were contradicting each other on whether or not investors should be forced to suffer losses. The latest move however, sends a clear signal to the markets that the Eurozone’s two largest economies do not intend to see investors taking a loss.
Source: BBC News
It may be too much for most people to fully comprehend the size of the government’s $14.3 trillion debt, so let’s put this in terms each of us can understand – yesterday the United States maxed out all its credit cards.
By law, the government is restricted to a debt ceiling of $14.294 trillion. This limit came into play on Monday and means the government is effectively prevented from selling bonds and taking on any further debt. The Treasury Department released a somber statement noting that by raiding the nation’s pension funds it could manage to meet the nation’s debt obligations until mid-summer, but unless new funds are available by then, the Treasury would have no choice but to default on some of the country’s debt obligations.
Mandatory Spending vrs. Discretionary
The U.S. debt has become a ferocious beast with an insatiable appetite. In 2010, mandatory spending grew nearly 15 percent over the previous year and totaled $2.17 trillion. At the top of the list was Social Security at a shade under $700 billion with Medicare / Medicaid following at $453 billion and $290 billion respectively. It is also noteworthy that interest on the national debt – also a mandatory expenditure – cost American taxpayers $164 billion for the year.
Discretionary spending for 2010 was also up significantly gaining almost 14 percent over the previous year to $1.38 trillion. Defense spending as you might imagine, was the number one expenditure on the discretionary side accounting for $663.7 billion. By comparison, the remaining discretionary totals are minuscule with the number two category – the Department of Energy – accounting for “only” $26.3 billion.
Here is the problem facing lawmakers. Mandatory spending is just that – mandatory. In other words, the government has few options to find savings in these areas. With respect to discretionary spending, other than the big-ticket defense spending, the remaining expenditures are – relatively speaking – insignificant. Locating a spare trillion or so in this category will require significant cutbacks across many different departments and would take months to complete; the government has at best, a few weeks.
So why not simply raise the lending limit? Well, this would be the obvious solution but the typical back-room shenanigans are in full-bloom in Washington right now and it is unclear when this approval may come. Both sides are using the debate to positions themselves as the better steward of the nation’s finances and should this partisan back-and-forth continue past the Treasury’s warning date, some form of default is unavoidable. Treasury officials are already quietly considering the worst case scenario and are identifying areas where a default would create the least damage.
If it comes to that extreme, it seems unlikely that the government would risk sacrificing its credit rating by defaulting on its interest payments. The resulting collapse in investor confidence would force yields much higher on subsequent bond offerings and this would have grave consequences on America’s ability to raise funds in the future. After all, the U.S. will be forced to rely on deficit financing for the foreseeable future so this option is a non-starter.
It is also hard to imagine that the government will take the route of slashing healthcare or dismantling other social programs. This would be a tough sell with the 2012 election campaign about to kick-off in earnest but the political posturing does serve to set up the debate between the two camps – the Democrats who favor minimal spending cuts with increased taxes, and the Republicans who demand dramatic spending cuts as the cost for garnering their support for raising the credit limit.
So far, it appears that both sides are more concerned with scoring political points at each other’s expense rather than tackling what could quickly become a crisis issue. Despite the looming election, both sides would be well-advised to ease up on the politics until the financing question is settled for the short term at least.
A good start would be to remove the specter of a default by approving an increase in the borrowing limits ASAP. Once markets are reassured that a default is not going to happen, then lawmakers can address the larger question of spending and taxes.
Oh, and here is something else to keep in mind – just because the limit has been increased on your credit card, it doesn’t mean to have to spend it.
It was a trading week with the broad dollar sell-off finding few obstacles in the calendar. The absence of hawkish innovations from the FOMC has been taken by the market as an all-clear to add to bearish USD momentum and carry trades. It seems that its only immediate savior is a renewed Euro-zone crisis. The technicals are again showing that most currency’s are in overbought territory now that many of the short term targets have been printed. Maybe it will be left up to Central Banks to protest, just like the RBNZ did by stating that their currency strength was ‘unfavorable’. Below are some of the highlights of the week:
EUROPE
Americas
ASIA
WEEK AHEAD
The Organization of Economic Co-operation and Development (OECD) said Tuesday that it expects Canada will lead all G7 countries in economic growth for the first half of 2011. According to the OECD, the Canadian economy will expand by about 5.2 percent for the first quarter ended March 31st, and suggests further growth of 3.8 percent for the second quarter.
The OECD also upgraded its forecast for Germany putting it second behind Canada with predicted growth of 3.7 percent for the first quarter, followed by France at 3.4 percent, and the United States at 3.1 percent. The OECD declined to provide a prediction for Japan given the recent events, but overall, the OECD says the G7 economies are performing better than earlier expected.
As a leading exporter of resources, Canada continues to benefit from stronger commodity prices especially crude oil prices which are at a two-year high. In January and February alone, Canada added over 84,000 new jobs and if the employment report scheduled for release this Friday comes in as expected, Canada could add another 30,000 new positions. As a result, the unemployment rate is expected to fall to 7.7 percent from 7.8 percent as of the end of February.
In addition to an improving job market outlook, the Canadian dollar is also benefitting from a growing tolerance for investment risk. The dollar – known as “the loonie” because of the waterfowl image on the reverse of the dollar coin – traded at 96.70 U.S. cents on Tuesday to match the highest price for the loonie against its American counterpart since November 2007.
The downside of the currency appreciation of course is that it makes Canadian exports more expensive for buyers who must exchange weaker currencies into Canadian dollars. The Bank of Canada – which is scheduled to announce its next interest rate announcement on April 12th – noted the “considerable challenges” exporters face from a strengthening loonie in a policy statement released on March 1st.
Most analysts believe the Bank of Canada’s April statement will leave interest rates unchanged at one percent, but there is a growing recognition that the Bank will be forced to hike rates later in the year to contain inflation.
Gold gained more than a percent today to close at an all-time high above $1,450 an ounce. Silver also rose to hit a 31-year high to $39.12 an ounce.
“Bernanke’s comment makes inflation a more real event in the United States. He at least acknowledged the fact that the Fed needs to monitor inflation very closely, and that spooked investors into gold,” said Mark Luschini, chief investment strategist at broker-dealer Janney Montgomery Scott.
A sharp increase in other commodity prices including oil, corn, and grain increased gold’s attractiveness as a hedge. Concern over growing violence in the Middle East and supply concerns helped drive commodities higher.
The US economy grew at an annualized rate of 2.6 percent in the third quarter but failed to meet expectations of 2.8 percent. Despite this, most pundits felt the overall news was positive.
“The pace of recovery in the United States is a little bit stronger than people had been expecting just a few months ago,” Tim Quinlan, an economist at Wells Fargo Securities LLC in Charlotte, North Carolina, said before the report. “What had been a sort of dreary outlook has turned into a halfway okay outlook and that’s a relative improvement.”
Source: Bloomberg
Bank of Canada Governor Mark Carney used a press conference in Toronto to once again warn of the risk posed by Canada’s rising household debt levels. Specifically, Carney warned that the cost to carry debt will increase significantly as interest rates rise over the next few years.
“Household debt in Canada is now at a record high, is now higher than it is in the United States,” Carney said. “At a minimum for us at the bank we have to think about what the implications of this are for how the economy performs if there is an adjustment to housing prices. Because then the wealth is less…and what’s the impact of that on consumption in Canada.”
Source: Reuters
Battle lines are forming ahead of a looming currency war that threatens to pit the developed nations against the emerging economies of Asia and South America. Over the coming months, we can expect a “race to the bottom” as countries maneuver themselves into an exchange rate advantage with their trading partners.
Currency devaluation as a policy weapon is nothing new. Exporting nations in particular have relied on it for years and one need only look to China to find a textbook example of how manipulating currencies can give exporters a decided advantage. In the matter of just a few decades, China has transitioned itself from a backwards, feudal-based system to the world’s third largest economy, and if you believe the hype, our best hope for leading the global recovery.
Of course, there are two sides to every story, and while China’s story is one of incredible success, there is no question that much of this success has come on the backs of its trading partners, and the United States in particular.
This is because China continues to follow a policy that “pegs” the yuan closely to the US dollar. It does this by maintaining complete control over the exchange rate it pays for US dollars earned through the sale of exports, and exporters are required to convert all foreign currencies to the yuan. This is also how China has amassed considerable US holdings within its $2.5 trillion total foreign reserves.
By pegging the yuan in this manner, the Bank of China can prevent the yuan from appreciating against the dollar and this is an important consideration as the US accounts for nearly 20 percent of China’s global sales. In 2009, China’s exports to the US were just under $300 billion and if the yuan were allowed to appreciate significantly against the dollar, exports would increase in cost and China would lose much of its competitive edge.
China’s artificial exchange rate presents a daunting challenge for American manufacturers competing for the consumer dollar. President Obama obliquely referred to the trade deficit with China in last January’s State of the Union address when he suggested that reducing the deficit by half would result in new jobs for Americans.
Of course, the trade gap will not decline by 50% on its own. The only way this goal can be reached within the four-year time frame set out by the President, is for the US dollar to depreciate against the currencies of the major exporting nations. Given the existence of the yuan peg however, and the fact that China represents such a large part of the trade gap, it seems that simply devaluing the dollar will not achieve the intended result. But Congress has a plan.
This plan includes a recently approved a bill that if passed into law, will enable US legislators to levy tariffs on goods imported from countries found to be engaging in unfair trade practices. The premise is simple – if we can’t compete on an exchange rate basis, then we’ll price them out of the market. This is no doubt aimed directly at China and is just the latest skirmish in what could easily become a much wider battle.
Oil prices continued a two-day slide dropping 60 cents to $81.61 a barrel while the dollar rose by 0.3 percent against a basket of currencies. The market is also awaiting the minutes of the FOMC meeting on September 21 for indications on the likely extent of a widely awaited second round of quantitative easing in the United States, commonly referred to as “QE2″.
Source: Reuters
There are two main threats currently facing the Chinese economy, and to the chagrin of the country’s policymakers, the yuan is caught squarely in the middle.
China’s central bankers have long been accused of pursuing a policy deliberately aimed at weakening the yuan to help ensure the competitiveness of China’s exports in the global marketplace. Indeed, it was China’s ability to manufacture and market goods at cheaper rates than most other exporting nations that helped make China the world’s leading exporter.
One unintended side effect of this growth however, has been a rapid increase in domestic consumerism. This is the result of a new wave of wealthy entrepreneurs, together with the rise of a working class armed with an increasing disposable income and a growing desire for consumer goods. It is this conflict – the clash between the needs of the exporters balanced with the need to address the threat of domestic inflation – that is forcing Bank of China officials to reconsider its yuan valuation policy.
China’s main export market in the United States has started to rebound in the past few months. Today’s Non-Farm Payroll report determined that unemployment fell to 9.7 percent from 10.0 percent in January, but it is still far too early to declare things are back to normal. Meanwhile, Europe – China’s second-most important market – is still suffering an on-going debt crisis in several Euro Zone nations, that continues to drag down the value of the euro.
Things are also touchy on the home front however, as a rapid increase in domestic spending has officials warning of the potential for inflation. Much of this spending has been in the form real estate and has propelled property values dramatically in recent months. Prices rose at an annualized rate of 7.8 percent in December on top of a 5.7 percent increase in November, marking the fastest rate of growth in nearly two years.
The dilemma facing policymakers is clear – keep the yuan weak to boost exports or increase rates and buy up excess liquidity in a bid to head off inflation.
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