Background to China's Cut in Banks' Reserve Ratios

(This commentary was written for the Shocks & Surprises Global Weekly Summary before the announcement of Monday's cut in reserve ratios. It has not been altered, because it gives what I believe is useful background to that decision.)

If Chinese monetary policy is to be continued consistently in the practice of the last few years, an early policy relaxation achieved by cutting banks’ reserve requirement ratio is to be expected, with each 1 percentage point cut gifting banks approximately Rmb 1.25tr in deposits available for lending, but probably also draining money from government bond markets in similar amounts.
Just as reserve ratios were raised to limit the monetary consequences of the huge inflow of capital during the last eight years, so now as capital exits China (despite a frenzied stockmarket boom), banks’ liquidity needs boosting.

The week’s economic data leaves no room for doubt that the economy continues to weaken: early in the week it was revealed that March’s exports fell 15% yoy, cutting the month’s trade surplus to just US$3.1bn.  Later came the news that M1 growth had slowed to 2.9% yoy and M2 growth to 11.6% in March, and that aggregate new financing was weaker than expected at Rmb1.18tr. Still later, there were disappointments for industrial production (up just 5.6% yoy), for retail sales (up just 10.2% yoy) and for urban investment (up just 13.5% yoy ytd).  Taken together they reveal that the underlying loss of momentum intensified, perhaps dangerously, in the industrial sector, in domestic demand, and in monetary conditions.

The fact that 1Q GDP growth was reported to have slowed only very modestly, to 7% yoy, was undercut by the fact that nominal GDP growth had slowed to just 5.8% yoy. Worse, when one excludes the positive impact of a 1Q trade surplus equivalent to 5.4% of GDP, the resulting nominal domestic demand growth slumped to just  0.9% yoy (or 5.3% on a 12ma).

Consequently, policy-loosening is needed, and soon. What form should it take? When in early February PBOC cut reserve ratios, it it claimed the cut was to offset capital outflow, rather than open the gate for monetary easing. As the chart shows, this was China’s consistently applied policy between 2007 and the middle of 2013: as China’s reserve rose from US$1.1tr in January 2007 to US$3.55tr by July 2013, so the reserve ratios required of banks rose from 9.5% of deposits to 20% of deposits. During periods when the reserves build-up slowed or faltered in 2H2008 and again in 2011-2012, PBOC responded by cutting RRRs.

So far, however, it has not responded significantly to the far sharper falls in reserves seen during the last six months. In 3Q14 reserves fell by US$106bn, in 4Q14 they fell by a further US$45bn, and in the first three months of 2015 they fell by a further US$113bn.  1Q’s fall is the most worrying, since it indicates a heavy flow of capital out of the country. During 1Q, we know that China recorded a trade surplus of US$123.8bn, and that it attracted US$38.4bn in FDI whilst overseas direct investment out of China came to US$25.8bn - these flows add up to a net inflow of US$136.4bn. However, we know that foreign reserves fell by US$113bn, which means that the combination of the balance of services and net capital movements produced a deficit of US$249.4bn.  This is an extraordinary development, given the background of surging domestic stockmarkets, which one would normally expect to attract capital into China.

One explanation has it that the capital has merely migrated to Hong Kong in order to capture the profits from arbitraging between the different stockmarket prices of A-shares in China and Hong Kong. No-one doubts that this arbitrage has been enthusiastically pursued, but since Hong Kong’s foreign reserves rose only US$3.7bn during 1Q, such investment cannot be more than a footnote in the larger story of capital flight from China.

Now let us look at the impact these capital outflows have made on the cashflows of China’s banking system, counted as the change in deposits minus the change in loans. In this analysis, we also have to include one other policy initiative - the widening of the definition of deposits made in January 2015 which added approximately Rmb8.3tr to January’s deposit total. For the purposes of the chart below, these are excluded.

The chart shows how successful this flexible movement of reserve ratios has been in muting the financial repercussions of China’s foreign exchange build-up - typically during the heavy inflow years it halved banks’ net cash inflow, whilst in 2011 it engineered a genuine liquidity tightening.  However, it also shows that the huge capital outflows from China during the last year has completely changed banks’ cashflow situation: before changes in reserve ratios, the picture changed from a net cash inflow of Rmb2.02tr in the 12m to March 2014, to a net outflow of Rmb3.52bn in the 12m to March 2015. 

With PBOC having cut RRRs so far by only 50bps, the situation is hardly improved: the net cashflow moves from a Rmb214bn shortfall in the 12m to March 2014, to a Rmb4.395bn shortfall in the 12m to March 2015. Still, at this point, every percentage point cut in RRRs would free up approximately Rmb 1.25tr, potentially available for lending. 

It is in this context that the widening of the definition of deposits, which resulted in a book entry inflow of an estimated Rmb8.3bn deposits in January, and a positive cashflow for that month of Rmb 6.53bn, becomes so crucial. Looked at in the light of the pressure capital outflow is putting on China’s bank liquidity, this re-definition looks like a useful holding tactic of a central bank hoping to avoid significant cuts in RRRs (perhaps because of the negative impact cuts would make on government bond markets?).  If capital outflows continue to pressure banks’ cashflows - and it's difficult to believe it won’t, given the deterioration in China’s economic data - more and deeper cuts to reserve requirements will be expected and needed.

China 1Q GDP: The Cost of Financial Efficiency

China’s 1Q GDP growth of 7% is exactly as predicted/stipulated, and by itself tells us nothing interesting, except that it provides no cover for a much-needed relaxation of current policies.

More interesting is what happened to nominal GDP growth, which slowed to just 5.8% yoy. Although we do not have a quarterly breakdown by expenditure, I estimate that in nominal terms, China’s capital stock was growing by around 13.3% yoy in 2014 (based on depreciating gross fixed capital investment over 10yrs). If so, nominal growth of 5.8% means asset turns, and therefore returns on capital, must certainly be plummeting far faster than that 7% ‘real GDP’ suggests. 

But there is a second calculation to be made. Nominal growth slowed to 5.8% yoy even though the 1Q trade surplus of US$123.8bn is a multiple of the US$16.6bn surplus recorded in 1Q14. The trade surplus was equivalent to 5.4% of GDP in 1Q15 rather than the 0.8% of 1Q14, and that must make a major contribution to the overall nominal GDP growth. When one subtracts the trade balance from nominal GDP to estimate nominal domestic demand one finds China’s domestic economy already at a standstill - it rose only 0.9% yoy in 1Q15.

(Incidentally, I am  not straining for this result - I do these calculations every time).

We can also use the nominal GDP data to explore how money and finance are affecting China's economy. The relationship between money and the economy, and the Chinese population and money, has not yet stabilized, but neither is it deteriorating any more rapidly than usual. Monetary velocity (GDP/M2) continues to deteriorate, although given how badly asset turns must be falling, the deterioration is actually surprisingly modest.   Liquidity preference also continued to fall to new lows, but as with monetary velocity, the continuing fall is no worse than one would expect, extrapolating from historic seasonal trends. 

And finally, I am interested in the efficiency of Chinese finance, expressed as how much additional GDP growth is associated with an extra yuan of finance.  Recovering this efficiency of finance is, after all, an indispensable aim of any reform which hopes to rebalance the economy. For bank lending, over the last 12 months an extra 1 yuan of lending has been associated with only 0.44 yuan of extra GDP. This has not quite stabilized the fall seen between 2011 and 2014, but the rate of decline has clearly moderated.  What’s more, the last year (and in particular the last two quarters) have been marked by the government’s successful attempt to shut down several ‘shadow banking’ lines of finance and squeeze that financing back into straightforward ‘bank lending’.  In the year to March 2015, bank lending accounted for 67.5% of aggregate new financing, up from 54.6% in the same period last year.  Naturally, this shift in the form of financing will tend to produce a decline in the measured efficiency of bank finance. 

So the wider measure - the GDP gain associated with an increase in total new aggregate financing (including bank lending) - becomes the one to watch. And the news is good: the efficiency of finance is improving, albeit only marginally. In the 12m to March 2015, one yuan of extra total financing was associated with 0.302 yuan of extra GDP, up from 0.295 yuan in the 12m Dec 14, and 0.251 yuan in the 12m to Sept 14. In fact, the 12m to March 2015 was the highest reading since 4Q2013 - although it is still less than half the 0.77  yuan achieved during pre-crisis 2006-2009. 

The problem is that these small gains have been bought at an economic cost which is too great to sustain. We have previously laid out how China’s trade data, and its monetary conditions are deteriorating too rapidly for comfort. If in addition, we accept the extraordinary possibility that 1Q nominal domestic demand slumped to only 0.9% yoy, it seems inevitable and indeed unavoidable that some rather extensive belt-loosening will be needed and accomplished in the near future. At which point, we can expect the hard-won gains in financial efficiency to be lost once again.  

Can China's Bad Monetary Data Really Be Good News?

There’s a usually-lucrative understanding that bad economic news can be good news because of the positive policy response it provokes. This works so often one can forget that the belief assumes that the news is not so bad that it is telling you events are spinning out of control, and/or that there’s nothing going on that an early policy easing won’t fix. But if these don’t hold, bad news can be just that - bad news.

And so to China’s March’s monetary and credit data. As bad news goes, this was nearer to the real thing than is comfortable.

Purely in measurement terms, China’s March M2 and M1 data was the weakest I’ve seen, (excluding obvious holiday-related anomalies). M1 growth slowed to 2.9% yoy on a monthly movements a full SD below historic seasonal trends, and the weakest since 1996 at least (with the exception of Jan 2014 - a holiday anomaly).  M2 growth was worse, slowing to 11.6% yoy on a monthly movement which was 1.4SDs below trend, and the slowest growth in more than 20 years (holiday anomalies excepted). Bank deposits growth slowed to 10.1% yoy, and again, the monthly movement was 1.5SDs below trend.

But the weakness of the monetary and credit data isn’t the only thing weighing on Chinese monetary conditions. In addition, the Rmb has tracked the dollar higher, actually rising 0.1% yoy against the dollar in March,  whilst the dollar was up 13.6% yoy against the SDR.  And with 10yr government bond yields of 3.5%% and CPI inflation of only 1.4%, the 2.1% real yield is 0.6SDs above historic seasonal trends. It is this combination of factors which means that, from an empirical point of view, the current deterioration in monetary conditions is unprecedented for China. 

As one would expect, such monetary constriction is hurting the rest of the economy (regardless of what tomorrow’s 1Q GDP result might show). 

The data suggests that monetary conditions have deteriorated beyond the point in 2008 when it was deemed necessary to rescue the economy. The wider data (particularly March’s trade data, with its collapsing exports and collapsing trade surplus) is also consistent with the worry that negative feedbacks from the real economy to the financial economy are beginning to re-inforce the monetary constriction. Whilst we are (probably) not yet in the maelstrom, I’d say it is visible from the deck. 

So the first requirement of bad news being good news is plainly present: the data of the last couple of days is surely bad enough to provoke an early and more vigorous policy response. 

The question then becomes: can the policy tools available easily fix the problem? And here I have two combined worries. The first is simply political and strategic: an effective policy response would almost certainly involve at least a partial repudiation of the reform strategy to which Xi Jingping has dedicated his presidency. Clearly, it will be he rather than the PBOC who will determine policy, but how can he square the major reliquefication the economy needs without setting back the process of improving capital allocation, upon which the necessary strategic change in China’s growth model rests? From this strategic point of view, a reprise of the 2009 credit splurge is almost unthinkable. (Isn’t it?)

The second problem is that at this stage we simply do not really know what sort of damage is growing inside the banking system, or how the rapid diversification and elaboration of China’s financial systems will affect how the system as a whole works. But we do know there are multiple potential sources of bad loans in the system: real estate loans; local authority financing vehicle loans; commodity finance loans (both domestic and international). And, of course, on top of that there’s straightforward commercial and consumer lending that’s going bad. 

Although we can’t know the details, we can see plenty of signs that concern is mounting. At the highest strategic level, February’s decision to re-define China Development Bank as an official policy bank is at least consistent with the possibility of problems in its domestic real estate and international commodities-project loans. Similarly, the central government’s decision to allow local authorities to replace expensive financing vehicle bad debt with centrally-backed bonds is also a plain acknowledgement of their financing problems.  But on a more mundane basis, we have Dagong Rating’s warning of problems in the internet-based P2P lending market, with their report raising the prospect that losses to creditors (mostly small investors) could reach Rmb 100bn. And we have the suspension/near collapse of Hebei Financing, which is carrying approximately Rmb 50bn loan guarantees.

The third problem complicates the situation further: because China’s debt problems are no longer merely domestic, any monetary rescue package which significantly undermines the international value of the Rmb is problematic by itself. We touched on this yesterday. 

And it is in this context that we should consider China’s other piece of ‘bad news’: China is losing its fx reserves even faster than we had thought. In 4Q, we saw that despite a US$67bn current account surplus, China’s foreign exchange reserves fell US$44.7bn, implying a capital outflow of  US$112bn during the last three months of 2014. Now figures for 1Q show foreign exchange reserves falling by a further US$113bn in the first three months of 2015, despite writing a trade surplus of US$123.8bn during that period! Bear in mind that this massive net capital outflow happened at a time when China’s stockmarket was on the sort of tear which normally attracts capital inflows.  It raises the question: what level of reserves is China already devoting to maintain the value of the Rmb? 

All of this leaves us in a less comfortable position than normal. Generally speaking, my default bias in China is one of comfort verging on complacency. The system has an extraordinary level of resources, both financial and political, that it can deploy if necessary. And this has been bolstered by a belief that provided China's domestic cashflows remain strongly positive (as they have been historically), then ways can and will be found to finesse balance sheet problems, even if it takes some time for the political fix to be found. I also think that China's leading bureaucrats are exquisitely alert to the potential problems of their economy and financial system - I genuinely think there is a level of senior administrators who spend huge amounts of time and mental energy obsessing about these problems. Similarly, I have little doubt that China's banks are better run than at any time in the relevant past. But conversely, experience tells us that PBOC can be dangerously slow to recognize when its policies are inflicting real damage - remember, it was still raising rates in summer 2008!

The problem now is two-fold: PBOCs responses have already been dangerously slow, and, worse, capital outflow has, at least for now, denuded the financial system of the positive cashflow which the rest of the economy is being forced to generate, and which is needed to cover any spike in non-performing assets. So at this stage, I fear that what we're seeing is just what it seems to be: bad news.

Short Thoughts on China's March Trade Disaster

China’s March trade data looks nothing short of disastrous.  In particular, the 15% yoy fall in exports is a dreadful shock, with the US$144.57bn in exports the lowest nominal total since February 2014’;s holiday-afflicted tally. Worse, March is usually a strong month for exporters, with the history of the last five years showing an average rise of 40.1% mom: this year, exports fell 14.6% mom. In terms of standard deviations from the pattern, February;’s total was 1.6SDs above trend, but March’s was 6.7SDs below trend.

Such a collapse can’t really be described as a ‘deviation against the trend’, but rather a result which smashes the historic trend entirely - China has entered new and dangerous waters.  As such, it has implications both for China and its trading partners.

Before we consider that, however, there is another possibility - that the very smashing of normal seasonal patterns points to some sort of seasonal anomaly which we don’t yet understand and which is afflicting only exports. If so, we should ignore this monthly collapse in preference to the slightly longer-term picture.  Doing so allows one to see that during 1Q exports rose 4.6% yoy, which, although not great, is roughly in line with the 6% yoy growth recorded in calendar 2014.

And there is a second lifeline to this less-pessimistic approach: although March’s imports fell 12.9% yoy, the monthly move (a 30.3% mom rise) conformed almost exactly to historic seasonal patterns, after 1SD+ falls in both January and February. Although with the exception of petroleum and refined products, there is no sign of a recovery in China’s appetite for industrial commodities,  volumes of commodity imports have generally stabilised.

Hang onto that hope, because, having acknowledged those qualifications, March’s collapse of exports, and the consequent collapse of the trade surplus (to just US$3.1bn in March from Eu60.62bn in February), are the last thing China needs. There are two interlinked problems. First, China needs a hefty trade surplus to counter enormous underlying cash outflows which are undermining the liquidity of its financial system. Let’s do the maths: during 4Q14 China had a current account surplus of US$67.021bn, but its foreign exchange reserves fell by US$44.68bn - so somehow there was a net capital outflow of US$111.7bn in 4Q alone.  Second, this capital outflow put pressure on the banking system’s net cashflow: the private sector generated a net savings surplus of Rmb1.925tr in 4Q, equivalent to 8.9% of GDP. These surplus savings should have piled into the banking system as a build-up of net deposits: in fact, what happened during 4Q14 was that banks gave out Rmb 900bn more loans than they received in deposits.

That is the background to January’s expansion of the definition of ‘deposits’ counting towards regulatory loan/deposit ratios, the cuts in banks’ deposit reserve requirements announced in February, and, of course, the cuts in interest rates.

But there is a third problem: if the collapse in March’s export earnings and trade surplus are taken at face value, they also suggest that the loss of competitiveness may put the Rmb under pressure.  That is something I expect PBOC will be reluctant to entertain, simply because of the level of international debt China is now carrying. How much debt?  Last week fx regulator SAFE said those debt were ‘broadly under control’ at US$895.5bn at end-2014, of which US$621.1bn was short-term debt, and US$274.4bn was medium and long-term debt.  But it could be much more: according to BIS, at end-September 2014 (latest data available), their banks had extended US$1.3tr in debts to China, and in 4Q, BIS also reported private international debt securities outstanding to China to total US$91bn. If you are carrying that sort of debt-load, there’s plenty to lose from a currency devaluation. 

This is where things begin to matter, a lot, for China’s trading partners. Right now, most of Asia is living in a world in which although liquidity flows from the West to the East have lessened as the dollar has strengthened, thus discouraging growth-by-leverage, most companies have found compensation in a rise in the terms of trade.  So although in March, export prices were down 11.6% yoy in dollar terms for Japan, down 10.2% for S Korea and down 7.7% for Taiwan, in each case, import prices were down much further, so terms of trade were up 12.2% yoy for Japan, 9.7% yoy for S Korea and 9.6% yoy for Taiwan. The upshot is that the deflationary impact of a sharply rising dollar on profits and margins have been more than offset by falling import prices. 

Such a reasonably satisfactory outcome  for the rest of Asia would probably not survive a trading environment in which China was compelled to devalue sharply to recover export market share gains. 

Heresy About US Jobs Data

To start with the obvious: Friday’s headline news that the addition to non-farm payrolls slumped to only 126k in March was one of the larger shocks of the last few months, down 138k from the revised 264k added in February. This was the weakest number since December 2013, and was bad enough to cut 10yr treasury yields from 1.91% to 1.8% instantly, before settling at around 1.83%.

The key features were a collapse in hiring in the construction sector (the sector shed 1k jobs in March, having hired 29k in February),  a slump in hiring in the leisure & hospitality sector (13k hired in March vs 70k in February), and slowing hiring in education & health (38k in March vs 57k in February).  In addition, the mining sector continues to shed jobs, with 11k lost in both March and February. These details suggest at least some of the weakness can be attributed to the sectoral slump in the oil industry, and unusually poor weather conditions. In fact, the number of people unable to work owing to bad weather came to 182k (nsa) in March, which is 41k more than usual for March.

But in addition, March’s weak non-farm payrolls data echoes other signals of domestic demand weakness  recently: in February retail sales fell 0.6% mom and wholesales sales fell 3.1% mom and orders for durable goods fell 1.4% (as did orders for capital goods non-def ex-air). In addition,  housing starts fell by 17% mom in February, to the lowest since Jan 2014.  This weaknesses are also linked (both cause and effect) to the mini inventory-cycle which the industrial sector is currently working through.  Finally, one should acknowledge the possibility that the inadvertent tightening of monetary conditions imposed by the strength of the dollar, may also be having a depressing influence on domestic demand.

Having established that the non-farm payrolls number was genuinely weak, and that, although unexpected, it is not totally out of sync with the rest of the economic data,  it is worth exploring an alternative possibility - that the apparent weakness may actually reflect changing labour market behaviour linked to an improvement in labour market morale. Admittedly, such an interpretation seems bizarre, and totally at odds with bond market reaction to the data. 

The case for such an interpretation starts with some of the rest of the data contained in March’s labour market surveys.  First, average hourly wages rose 0.3% mom in March, beating expectations for the second time in the last three months, even though a modest retreat in the average number of hours worked meant that  average weekly earnings actually fell 0.1% mom.  In other words, even though conditions are relatively slack, there is no sign of weakening wage pressure. 

Second,  although the weakness of the Establishment Survey’s count of non-farm payrolls was echoed in the Household Survey’s count of employment - up just 34k - the Household Survey contained strands of information which run counter to a simple ‘bearish’ interpretation. First, although the survey showed those ‘employed’ up only 34k, it also showed those in work up 346k, whilst those unemployed fell by 130k. The difference in the totals is explained by two factors: first, the number self-employed rose by 299k on the month, and the number not in the workforce rose by 227k. Those 227k who fell out of the labour force cut March’s labour participation ratio to 62.7% - a retreat back to the lows seen in Sept 2014 and again in Dec 2014. 

Looking at that 227k rise in the number 'not in the workforce', it turns out that the number wanting a job fell by 169k.

Both these factors, if believed (and the volatility of the Households Survey means there must be a question-mark over its findings), are difficult to reconcile with the straightforward ‘times are tough, so hiring is down’ reading of the data.  That bearish reading is also difficult to reconcile with two other factors: first, the record job openings data, and secondly, the currently very strong consumer confidence readings, which specifically include sharply-improved perceptions of labour market conditions.

Traditionally, such improved perceptions would suggest that wages would need to rise in order to attract new entrants into the market, or to fill the record-high number of openings currently unfilled.  In the absence of such wage-rises one would expect to see labour participation rates not rising in line with the economic cycle, whilst rising self-employment coexisted with falling unemployment. Put bluntly, if people consider that the economy is strengthening and that the likelihood of finding a job if needed has improved, then employers may find themselves needing to raise wages more than they had expected in order to attract new employees. 

Ever since the Great Recession, there have been numerous attempts to guess at what level the US might be fully-employed, in the sense of the cycle provoking accelerating wage rises. As time has gone on, the estimated unemployment rate at which full employment is reached has been revised down and down.  It is consistent with the totality of March’s employment surveys  that that rate is now being reached at just the point at which exogenous factors (oil prices, weather, West Coast port problems) have engendered a sub-cycle of inventory and capex related economic weakness.   

It is perhaps deep heresy, and maybe just plain stupidity to suggest it, but the data overall is consistent not simply with the subcyclical weakness, but also with the underlying improvement and strength of the US jobs market. In which case, the immediate bond-market reaction may turn out to be . . . . wrong. 

Japan Households' Sceptical Vision

Bank of Japan's 1Q Tankan confirmed what we already knew from looking at the way the private sector is managing its balance sheet - that corporate Japan is watching the sky, holding fire on investment spending until they become absolutely convinced that nominal sales growth can be relied upon to sustain asset turns.  But what of the household sector?  Has PM Abe done a better job of shifting their expectations than he has done with corporates?

The short answer is: not much. A glacial improvement in perceptions of the economy since 2009 was first boosted by the promise of Abenomics but then knocked back by last year's tax rises - and now once again the glacial improvement has resumed. Much of that has to do with improved household incomes. However, to the (small) extent that this has been accompanied by increased spending, households seem increasingly to be developing buyers' remorse.  Finally, whilst Bank of Japan has persuaded people that prices are currently going up, there has been no flicker at all in longer-term inflationary expectations.

Since 2006 the central bank conducts a quarterly survey of households, tracking opinions on economic conditions, household income and spending, and views on inflation. As one would expect, it paints Japan's householders as grim and generally pessimistic survivors of decades of deflation. Nevertheless, virtually every indicator shows an underlying long-term upward trajectory interrupted by last year's tax rises, but in partial remission by 1Q15.

The evidence is presented in diffusion indexes - ie, the proportion of people saying positive things minus the proportion of people saying negative things.  For example, in the chart below, in which the red line tracks views on the current situation relative to the previous 12 months, seven percent think things have got better, whilst 31.6% say things have got worse, so the DI reading is minus 24.6. The chart shows, PM Abe's election was greeted with a sharp and unprecedented outbreak of optimism about prospects, and a positive reassessment of current conditions. The optimistic expectations were sustained for two months before draining away, whilst the improvement in current conditions was maintained until . . . the tax rises.  However, 1Q has seen a partial recovery in household opinion on current conditions and the coming  year.

Over the long term, households'  economic views are determined mainly by changes in their income, with some input also from what's happening to businesses they are employed in/involved with, and also by the level of street bustle.  For 1Q, however, the improvement was driven by business performance, and to a lesser extent income. This is perhaps surprising, because the DI for what's happened to income over the last 12 months rose 3.5pts to minus 28.1, which is the best in the series' history.  In addition, income outlook rose 7.1pts to minus 27.8,  which was only enough to restore it to pre tax-rise levels.

But improved income prospects are probably not going to translate into increased spending. The DI for current household spending fell 4.9pts, and the outlook for spending also fell 0.6pts.  In the case of the outlook for spending, the DI has now retreated back to pre-Abe levels.  It's also worth paraphrasing what these two DIs are saying: 'Right now I'm spending more than I used to, but next year I'm quite determined to cut back'.  That's a fairly solid rebuff to those who anticipate that a change in inflationary expectations will release a rush of domestic demand.

There's a second with that view - it assumes that Bank of Japan's quantitative easing program not only can generate modestly positive inflation, but that by doing so it can raise household's inflation expectations.  The survey directly asks householders for their views on how fast prices are rising currently, how fast they will rise in the coming year, and how fast over the next five years. What it reveals is that Bank of Japan has managed to raise perceptions of current inflation from an average of 2.8% in 2012 to 5.6% now, and that this perception is still rising.   It has also managed to shift the dial slightly on 12m inflation expectations, with a rise from an average of 4% during 2011-2012, to a steady 4.8% now.  However, there has been absolutely no movement at all in 5yr inflationary expectations: in 1Q that expectation was at 4%, which is exactly the average sustained since 2010.

US Bond Yields and the Rediscovery of Normality

What chance of a bond market collapse as the Fed starts to lift rates?

The final stage in the US Fed's long edging-back to 'normality' will be the first interest rate rise - still generally expected in June. This provokes two  major worries. First, there is the generally unacknowledged problem that for the foreseeable future Fed interest rate decisions are much more exposed to policy error than before the Great Recession.  The reason for this is that the Fed (and its market watchers) can no longer deploy the Taylor Rule (of thumb) to judge what should be done, and what is likely to be done, because there is no robust technical consensus over what US potential output might be. For the foreseeable future, we are more likely to discover the limit to potential US output by tripping over it than by calculation.  

The second worry is this: we may have to rediscover how how bond yields are determined if they are not simply wrangled by the Fed. The whole point of zero interest rate policies and, in extremis, central bank quantitative easing, is precisely to over-ride market mechanisms in order to command the longer-end of the yield curve.  Under such a regime, what matters for bond markets is disproportionately what the central bank decides to do.  

That's what's coming to an end, and already in the expected absence of such security, there are plenty of scary scenarios about what happens next.  This piece is an attempt to offer some prompts. 

The starting point is 'fair value yield' models, which essentially attempt to locate where bond yields 'should be' by accounting for three sets of information: 

• expected movements in the central banks' core short-term interest rate; 
• expected movements in inflation;
• expected movements in GDP growth 

In practice, these models worked tolerably well when central banks were not intervening so aggressively in the long end of the market. The chart below shows the history, and casts forward using Bloomberg consensus forecasts for interest rates, inflation and growth. 

At present, the prevailing 1Q 10yr treasury yield of just under 2% compares with a fair value yield of around 3.1%.   Further, it suggests that if GDP growth steadies to around 2.8% in 1H16, inflation rises to around 2.1% and Fed Funds rates rise to 1.45% by 2Q16, fair value yields would rise to around 4.2%.

That suggests plenty of room for yields to rise in the short to medium term. But historically speaking, does this suggest that current yields are still carrying an unusual discount inherited from the Fed's years of bond-buying?  If we look at the history of deviations from fair value, it turns out that the current 1.2% discount to 'fair value' is not historically unprecedented even in the absence of central bank activism.  Valuations are also not stretched so dramatically from 'fair value' as they were prior to the 'Taper Tantrum' of mid-2013.

In the short term, then, whilst one should anticipate yields rising, the case for a major bond crash is not compelling. In the medium term, of course, the fate of yields will be largely determined by how the economy (and the Fed) performs - which is, of course, the point about 'normality'. 

We need not leave it there: it would be nice to be able to offer some explanation of why bond yields deviate from 'fair value' in the way they have over time - acknowledging that 'fair value models' do not provide complete explanations.  The most obvious explanation is the uncertainty and error which must accompany any set of forecasts or expectations. But in addition, one tool I suggest is movements in the private sector savings surplus (measured as the current account balance minus the quarterly change in federal debt in public hands).  There is a very good reason why one would expect movements in the PSSS to have some impact on government bond yields. What the PSSS measures is, after all, the cashflow passing between the private sector and the financial system. In the simplest of institutional set-ups, if the private sector has a savings surplus (ie, it spends and invests less than it earns during a period), it deposits that surplus in the bank. The bank, by definition, can invest that cash only in either foreign assets or government bonds. 

But this is unlikely to be a simple one-way relationship, since, conversely, one might expect significant movements in bond yields to make an impact on private sector saving/spending decisions. 

Such a feedback relationship means one can't be dogmatic about causation. Nevertheless, it strengthens the expectation that major movements in the private sector savings surplus to be reflected in bond yields (and vice versa). 

Now compare the deviation of bond yields from 'fair value' with movements in the PSSS during the last 25 years. 

What it suggests is that the current gentle movement downwards in the PSSS offers some support for the current structure of bond yields.

And this is where this week's 4Q current account balance information matters: 4Q's current account deficit was estimated at $113.5bn, which suggests the deficit was running around 2.3% of GDP during 2014, essentially unchanged from 2013, and relatively stable.  In addition, it suggested that the PSSS for 2014 came in around 1.5% of GDP, and, like the current account balance, appears to have been almost stable during the last two, after drifting down gently since 2009.  In the context of the threat of bond-yield volatility during the re-discovery of normality, that stability in the core cashflow measure of the US economy is genuinely comforting.