US Savers Turned the Screw in 1Q

• US Cyclical Factors including ROC and Real Labour Productivity Remain Sharply Positive
• But Deleveraging Accelerated Again in 1Q, Pushing Up Private Sector Savings Surplus , and and Pushing Down Loan / Deposit Ratios
• Renewed deleveraging is anomalous, and is not reflected in asset prices or straightforward risk measurements
• Renewed deleveraging is anomalous at a time of exceptionally bad bond-market value
• So the Growth Risk for the Rest of the Year Remains on the Upside

We now have quarterly GDP numbers for the world's major economies, so it's time to start tracking movements in the fundamental ratios which structure the world's business cycles, starting with the US.

Our view based on these ratios for 4Q11 were (in this piece)as follows: “. . . by our estimate returns on capital are around their highest since 2000 and are still rising, which will continue to foster investment spending; labour productivity continues to grow (adjusted for changes in capital stock), which will underpin the slowly- accelerating addition of jobs; and, most importantly, we believe that the net develeraging of the economy which started in 2008 is now complete. We do not expect significant re-leveraging to take place this year, but the mere fact that deleveraging is no longer the key dynamic will shift the economy out of its modest 2.4% annualized growth trend which it has sustained since the end of the recession in 2009 and towards a 3%+ rate.”

How much of that is still right? The good news is that returns on both capital and labour continue to rise, at an accelerating pace – the best underlying news for a sustained business cycle upswing.

ROC is still climbing, and this continues to fire major capital investment spending: in nominal terms, total fixed capital investment jumped at an annualized pace of 20.8% during 1Q. In real terms, private capital spending rose only a miserable 1.4% annualized - but there seems to be an unaccounted seasonal factor at work depressing the 1Q investment numbers, since this was the best 1Q reading since 2006. Overall, nominal capital stock is probably growing around 1.2% a year – still less than half the c4% yoy nominal GDP growth, so we should expect ROCs to continue to rise along with asset turns.

Real output per worker, adjusted for capital stock per worker, also accelerated mildly to 3% during 1Q, an inflection from from 2.8% in 4Q10 which should be enough to sustain improvements in the labour market. 

As far as margins are concerned, the US international terms of trade have held steady since they bottomed out in December 2011: since then export prices have risen 2%, whilst import prices have risen just 1%.

All of this suggests the US cycle should be in buoyant good health. But it doesn't seem to be: the 2.2% annualized GDP growth recorded in 1Q was lower than I expected, and a retreat from the 3% of 4Q11. And there's probably more on the way, since the GDP data disappointed even before the 'soft patch' began to show up in the data for April and May's economy.

I have previously explained the origins of that 'soft patch' in the industrial sector, using changes in momentum of output, domestic demand, inventory and export demand. I think that analysis is both correct and useful . . . . but also incomplete.

For the big disappointment of 1Q is that deleveraging had not stopped, as I expected. Rather, it re-started and re-intensified – and it is that which so far is the decisive factor in the US recovery. One can capture this by two counts. First, the private sector savings surplus jumped to 8% of GDP in 1Q from 5.2% in 4Q11. There are strong seasonal factors at work, but nevertheless, that jump was sufficient to push up the 12m ratio to 4.7% of GDP, from 3.8% during calendar 2011. This is the only quarter since 2009 that the PSSS has risen significantly. 

Second, the same story is written in the banking system's balance sheet: during 4Q11 banks' loan to deposit ratio stood at 81.8%, and was rising gently, having seemingly bottomed out in 3Q11. But by early May 2011, the ratio had fallen again, to 80.8%, with deposits rising US$153bn since the beginning of the year, compared to a rise of only US$70bn for loans. 

Awaiting Eurogeddon, it may seem obvious that caution must reassert itself. But, of course, the timing doesn't fit. More, reawakened caution was not obviously reflected – and frankly, still is not obviously reflected – in US financial asset prices. During 1Q, most measurements of risk were in retreat: 5y bank CDS rates declined to average 201bps in 1Q12 from 252bps in 4Q11, whilst the capital risk premium on 10yr Treasuries (spread between 10yrs and 10yr TIPs) widened modestly in a way which usually signals improving risk tolerance.

More, US Treasuries became ever more expensive relative to the fair value you would expect in an economy growing 2.2%, CPI inflation of 2.82% and a Fed Funds target of 25bps. Historically, as the chart below shows, when Treasuries represent such astoundingly bad value, one expects Private Sector Savings Surpluses to start to dwindle. But rather, the opposite happened.

In conclusion, we really do not know what has provoked re-invigorated deleveraging in the US during 1Q12 - for the time being it remains anomalous. Unless or until a workable explanation is found, we should expect precisely that it will be an anomaly, which is likely to be corrected in the coming quarters. If so, the upside risks to US growth during the rest of 2012 continue to look greater than the downside risks.  

Fed Policy, Bond Yield and the Investment Cycle

There's a soundbite doing the rounds which sees the build-up of undistributed corporate profits in the US as being a function of the Fed's policy of keeping rates close to zero, and of artificially depressing bond yields. The argument is that the Fed's policy, and its public advocacy by Mr Bernanke, sends businesses the unequivocal message that there's no growth to be expected, so why bother investing. As a result, the US is seeing only a shallow capex upturn characterised only by investment by marginal companies which will evaporate like morning mists as bond yields rise to reasonable levels.

Though I'm no fan of Mr Bernanke's public mugging of Taylor rule earlier this year to allow a phony theoretical justification for any decision the Fed may wish to take, it's worth taking the few minutes needed to nail this argument. First, companies clearly are stockpiling cash, but they are also investing: last year, the annualized growth in private nonresidential investment averaged 8.3%, roughly five times the annualized rate of GDP growth. Second, private nonresidential investment in 2012 accounted for 10.8% of GDP, which is precisely the average contribution since 2000. The numbers simply don't bear out the characterization of a shallow capex upturn.

Moreover, when business leaders are surveyed, they do not seem to echo Mr Bernanke's pessimism. Among large corporations, by February and March the CEO Confidence index had recovered to early 2011 levels, with nearly 73.5% of those surveyed expecting revenue growth this year, and 52% expecting to raise capex budgets. For small businesses, the story of recovered confidence is very similar, with the NFIB Small Business Optimism Index recovering to the highest levels since 2007. True, in historic terms, that's still not very optimistic, but the improving trajectory seems undeniable.

Surveys and opinions can change. What needs challenging is the notion that the Fed's work to keep bond yields artificially low can be expected to actually scare away investment. On the face of it, it seems a silly argument. And when we look at the history, it seems even sillier.

In an earlier post, I constructed a 'fair value model' for US treasury yields normalized for growth, inflation and policy rates, and looked at the deviation of actual yields from those 'fair value yields'. When yields were lower than 'fair value' they represented bad value as investments, when they were higher than 'fair value' they represented good value as investments. I then showed that artificially low bond yields have seemed to have a predictable impact on savings levels and savings surpluses: when bonds represented significantly bad value, savings did indeed dwindle, and when bond yields represented good value, they rose in response.  

Using the model, we can look at how bond yields being lower or higher than 'fair value' has been associated with changes in investment behaviour. The argument being made is that artificially low bond yields will depress investment because of the signal being given out about likely future growth. The alternative possibility is that artificially low bond yields will stimulate investment. So which is it to be?

The graph tracks both deviations from 'fair value' for US 10yr treasuries and deviations from long-term trends for private non-residential investment spending. There's really no doubt about the result:  historically when bond yields have fallen below fair value investment has tended to recover to above-trend, and conversely, when bonds are yielding more than their fair value, investment spending has tended to be choked off. Do not be worried that the relationship is being manufactured by a clever manipulation of axes – there's a negative correlation between movements of the two which is significant at the 1% level.

In short, Mr Bernanke's policy is innocent of this charge, at least. And, oh yes, we should expect the current capex recovery to continue to gather pace this year.   

Bond Yields and Saving Behaviour in the US

What relationship, if any, consistently holds between interest rates and private savings behaviour? Do savings really go up when interest rates go up? And can excessively high savings ratios be brought down by keeping interest rates low? If so, what rates, and how low? And if savings rates stay high regardless does that mean we're in some sort of liquidity trap?

I should probably have had this down decades ago when I first encountered an ISLM graph, but the truth is that I've never met anyone in the market who actually uses ISLM analysis. Or mentions it.

Instead I have focussed on private cashflows and savings behaviour, usually looking at private sector savings surpluses and tracking their impact on bond yields. For emerging markets, this is often crucial: the most powerful financial dynamic bar none in emerging markets is what happens to government bond yields when a private sector savings deficit flips over into a surplus, or vice versa. In these cases, the cashflows are easy to trace: if an economy develops a savings surplus, then on a net basis, the private sector is dumping cash into a financial sector which, by definition, can use it to buy only government bonds or foreign assets. Hence bond prices rise and yields fall. Easy money.

Even in the massively-open and highly disintermediated financial system of the US, traces of the relationship remain.

Interesting though this is, it's hardly a complete theory linking bond yields with savings behaviour. Nor would one expect it to be: if private sector savings surpluses and deficits were the only determinant of bond yields, the world wouldn't have so many fixed income economists (and professional Fed watchers). And the financial world would never had heard of 'fair value models' for bond yields.

So let's look at those models. In my experience these fair value models regress and regularly recalibrate from three factors:

• policy rates
• inflation rates
• growth rates

A movement, or an expected/forecast movement in any one of these will change what the model signals to be the 'fair value' of a bond.

Anything that regresses and recalibrates enough will end up looking like it has useful explanatory power. Here's how my simple fair-value model of US bond yields compares with what actually happened over the last 21 years. It's not a superb fit, and even if it was, that would be testament simply to the power of serial recalibration rather than the theory it allegedly sets out to test.

Nonetheless, the conclusions which we can draw from this model are remarkably similar to those wrested from doubtless far more sophisticated models produced by our august Wall Street friends. And so are the conclusions are drawn by comparing actual bond yields with 'fair value' yields. What screams out in retrospect is that during 2004-2008 bond yields were far lower than 'fair value'. And from there it is but a step to conclude that the chief reason for that was that policy rates were set too low for too long, and, moreover, were expected to be kept too low for longer still. The graph serves as the charge-sheet against Alan Greenspan. And as it looks as if the same thing is happening again now (bond yields far lower than 'justified' by likely economic growth and inflation), we might eventually find it thrown into evidence against Ben Bernanke at some later date.

What the chart is saying right now is simple: bond yields are simply too low, making bonds an unattractive investment. Let's put it even more bluntly: who in their right minds would save to invest in bonds right now? At which point, we get to ask (and answer) an important question – regardless of the absolute nominal bond yield, does sufficiently 'bad value' in bond yields usually dissuade saving, and do sufficiently 'generous' bond yields usually encourage saving?

And I think we can answer than question empirically with a simple 'Yes'.

Consider the relationship between the deviation of bond yields from fair-value, and movements in the private sector savings surplus. The chart below illustrates it well, and that's not just because I've fiddled the axes. More importantly, the correlation between sequential movements in these two during the last 87 observations passes the 1% significance level quite easily.

For those of us interested in recent US economic history, and in global savings/investment imbalances, this chart is pretty irresistible, as it links the descent into major private sector savings deficit during 1997-2000 and again in 2005-2007 with bond yields being somehow maintained at levels which actively discouraged saving. When yields rose (relative to 'fair value') savings deficits were trimmed and reversed.

And now? Bonds represent absolutely rotten value, and as long as this is the case, the US private sector savings surplus will continue to decline, boosting US consumer demand at a pace slightly exceeding those of private sector income growth (widely defined).

One more thing: there is absolutely no sign of a Keynesian 'liquidity trap' anywhere on this chart.