Canada as major holder of Treasuries

What attracts eyes in the recent Treasury securities buyers is Canada's emergence as one of the major holders of the Treasury securities. In fact, Canada's holdings have increased by a factor of about 15 from 8.4 billion US dollars in January 2009 to 125.2 billion dollars in October 2010. Given that the US Treasury statistics didn't mention Canada at all before 2008, "the rise of Canada" sounds very sudden.

One might see the reason as an increase in Canada's foreign reserves by the Bank of Canada's intervention into currency markets, stemming the currency's appreciation to underpin exports. But Canada's foreign reserves have gained only 14 billion dollars so far from January 2009, a meager amount compared to 117 billion dollars increase in the US Treasury securities holdings.

Then, what is the true reason? I haven't had the definite answer, but I guess it is, as is the case with the UK, thanks to custodians which hold US Treasuries on behalf of others. For example, Royal Bank of Canada, the largest bank in Canada, acquired JPMorgan Chase & Co's investment adviser servicing business, which was inherited from Bear Stearns. Canada's bank might be seen as an alternative of custody to the US counterparts, which have been grappling with the banking crisis.

China keeps buying Treasuries

A little while ago, a rumor was frequently heard around in the markets that China, the world largest holder of foreign reserves, is going to diversify its portfolio away from the US dollar assets like the Treasury securities in favor of, say, euro bonds like German Bunds. In March 2009, Zhou Xiaochuan, governor of People's Republic of China, dared to argue for a gradual move towards using IMF's Special Drawing Rights as a global reserve currency, criticizing the dollar as too much concentrated in global foreign reserves.

China's intention was to shun the dollar's decline as the Fed launched the first quantitative monetary easing in the mid March 2009, because the country accumulated a staggering amount of the Treasury securities immediately after the Lehman crisis in September 2009 crushed the US stock and MBS markets China heavily invested in. But now it looks like China isn't raising a voice against the dollar.

Why? The reason is simple: the dollar hasn't depreciated so much since then, in part due to the Greek crisis that smacked the euro down to the four-year low in 2010. This enables China to feel safe still buying the dollar assets, especially the Treasuries.

China is using UK custodians to keep its dollar assets, which is reflected in the graph above. Given a steady increase in China's foreign reserves, the UK holdings of US Treasuries would shift to China's in the next revision of statistics, hence lifting the country's holdings upward more in line with foreign reserves.

Nonetheless, China's appetite for euro assets hasn't languished at once. The country bought more than 230 billion yen of Japanese short-term bonds in January to July this year, but sold all of them for only two months of August and September. The reason is that China needed a temporal vehicle to lay aside money to flee from the Greek crisis, so it got back to the euro once the crisis stabilized.

Does China keep investing in the dollar? Nobody knows for sure. However, given the eurozone crisis, which is now involving Spain, the world's ninth largest economy, doesn't seem to subside soon, China's words for diversification would be seen as only a bluff.

Bright news on the next quarter

A bit of good news is coming from, unexpectedly, Japan, which predicts that the next quarter, namely January to March, sees a stronger growth in the world, especially Asia. Unfortunately, it isn't that Japan has finally escaped from a trap of chronicle deflation started in the early 2009, though the consumer price index released today shows that deflation is gradually moderating in the country.

The overall consumer price index rose 0.1% in November from the previous year, the second consecutive month of positive growth after twenty months of decline. The core consumer price index, which excludes volatile products like fresh foods from the overall index, decreased 0.5% from the previous year, but it is the smallest decline in nineteen months. Deflation is, albeit very slowly, on the mend.

Meanwhile, the index of industrial production rose 1.0% in November from the previous month, the first gain in six months. It is the same with a median forecast. A bit of surprise is that manufacturers expect a stronger growth of production in the months ahead according to a survey conducted by the METI. Output is forecast to increase 3.4% in December from the previous month, and 3.7% in January.

It is likely that this strong growth in output is based mostly in Asia's demand, which was evidenced in the last month's exports report. Japan's exports grew 9% in November over the year, the first acceleration in nine months. The biggest contributor is Asia, which claims nearly 80% of total growth, whereas North America's contribution is mere 0.3% and shares a modest 3% of total growth. The US economic recovery is still too anemic to bring a robust support for Japan.

Given a highly positive correlation between Japan's and the US output, the latter is also likely to be underpinned in the next quarter by a strong demand in Asia. The recent rise in the US interest rates would herald a robust growth in the US.

Do you believe this?

The latest result in Japan's quarterly Tankan survey, which captures business sentiment, is less bleak than anticipated, but at least not encouraging in the sense that the sentiment index for large corporations declined for the first time in seven quarters. But as was written in this blog before, gloomy sentiment among corporations has already been predicted given a negative effect of two major factors on the economy: one is a surging yen, and the other is the expiration of government subsidies to eco-friendly cars.

What's worse is that large corporations see the demand for new products will lessen more both in domestic and foreign markets in March 2011, and hence resource slack will keep on worsening. They are also concerned that production cost will rise more than selling price, thus putting a downward pressure on the performance. You see no good news at all in the coming quarter.

In the meantime, the Tankan survey allows us to estimate a forecast figure of stock markets and the economy for the coming quarter.

The graph above shows a positive relation between the business sentiment index for all industries and the Nikkei stock index since 2000. Using a forecast figure of the business sentiment index as of March 2011, the Nikkei stock index is estimated to be 12106 in March 2011, well above today's closing price of 10303.83.

The second graph illustrates another positive relation between the index of overseas supply and demand conditions for large Japanese manufacturing firms and the yoy growth rate of real US GDP since 2001. The intuition is very simple. The more the US economy grows, the more overseas demand arises for Japanese companies. Taking this relationship into account, the US GDP is forecast to grow 0.9% annually from the previous quarter in October to November 2010 and 3% in January to March 2011. A 0.9% growth of this quarter would be lower given the currently released strong figures of US economic indexes.

What's interesting is that this positive relationship weakens if extended before 2001. One of the reasons is thought to be the increasing reliance of Japan's economic growth on exports since the start of this century. Anyway, Japanese economy might not be jubilant to the end of the coming quarter according to workaholic salarymen.

A question on the US recovery

The headline looks like cheerful on the news that the index of industrial production in the US rose 0.4% in November from the previous month, a four-month high since July. Moreover, you might want to jump for joy to hear that both of overall and core consumer price index climbed 0.1% in November from the previous month, still subdued in a historical standard. Hence, Bloomberg reports:

Industrial production in the U.S. increased more than forecast in November and consumer prices slowed, indicating the recovery is gaining momentum without generating inflation.

Output at factories, mines and utilities rose 0.4 percent, the biggest gain since July, after a revised 0.2 percent drop in October, a Federal Reserve report showed today in Washington. The consumer-price index climbed 0.1 percent in November after a 0.2 percent gain the prior month, the Labor Department said.

Assembly lines are speeding up as business investment and exports grow and consumer spending accelerates, helping to buoy an expansion that Fed policy makers said yesterday isn't strong enough to reduce a jobless rate hovering near 10 percent. Price increases that are below central bankers' goal will boost the case to maintain the Fed's purchases of $600 billion in securities through June to spur growth.

"The manufacturing sector continues to heal itself," said John Herrmann, a senior fixed-income strategist at State Street Global Markets in Boston. "The outlook for business spending on equipment and software remains very positive." Fed Chairman Ben S. Bernanke "is unlikely to withdraw accommodation until he sees a clear upward turning point in core inflation and a downward turn in unemployment."

What should be noted here is, however, that the index of industrial production sank from the previous year for the fifth straight month, the first time since the late 2008 to the early 2009. It doesn't necessarily mean that the economy is falling back into recession at least for now, but the downward trend is not supposed to "indicate the recovery is gaining momentum" right away given that the US economy still remains too fragile that it's far from on the path to a full-fledged recovery.

Let's look at consumption, which claims the biggest part of GDP. Real average hourly earnings for all employees have trapped in the range of $10.38 to $10.4 for seven months. While core retail sales, retail sales excluding volatile products like motor vehicle and parts, increased 1.2% in November, a eight-month high since March, household consumption is not likely to leap dramatically in the coming months if a lackluster growth of income continues.

Furthermore, another concern is arising in bond markets, where the yield of 10-year US Treasury notes reached 3.55% yesterday, a seven-month high since May. What's important here is that the rise in the bond yield is mostly derived from the rise in the real yield, which equals to the nominal interest rate minus the expected inflation rate. The rise in the real yield is considered to worsen the load of corporate debt, hence hindering investment. Private investment hasn't contributed much to the US economy, especially compared to household consumption which has the largest share of GDP. But given that consumption is expected to grow at best modestly due to still high unemployment and devastated housing markets, a lack of help from any source would suck a vigor of, if any, economic recovery.

Growth outlook leads rate hike

Obama's tax deal with the Republicans is causing a massive sell-off in bond markets across the globe. According to a Reuters report,

Benchmark 10-year yields reached as high as 3.33 percent going into the auction, which meant a whopping 40 basis points had been added since Monday's close,

…

The benchmark 10-year U.S. Treasury note US10YT=RR was down 1-1/32, with the yield at 3.265 percent. The 2-year U.S. Treasury note US2YT=RR was down 6/32, with the yield at 0.624 percent. The 30-year U.S. Treasury bond US30YT=RR was down 1-9/32, with the yield at 4.453 percent.

There seem to be several reasons for the rate hike. First, the extension of the Bush tax cut could help boost the economic growth, especially by sustaining households still trapped in a devastating condition of housing markets. Second, some argues that the tax cut could lead to more deficit spending, hence slackening a balance between supply and demand in bond markets. Third, the Fed might end up buying fewer bonds than previously planned due to more bright prospect for the economy.

Those three factors are supposed to have had more or less combined effects on the plummet in bond markets. What's interesting is that the inflation expectation is constrained compared to the real interest rate which is rising almost in tandem with the nominal interest rate. The rise in the real interest rate could swell debt burden for private business sector, thus costing corporate investment. At least for now, fixed investment would play a minor role to drive the US economy.

In the meantime, Japan's third quarter GDP has just been revised upward, outpacing the US and Europe in the same period.

Gross domestic product grew at an annualized 4.5 percent rate in the three months ended Sept. 30, faster than the 3.9 percent reported last month, the Cabinet Office said today in Tokyo. In nominal terms, the economy grew 2.6 percent, less than the 2.9 percent earlier projected, as price declines deepened.

Private consumption, which accounts for about 60 percent of GDP, also fueled the expansion as households stepped up purchases of energy-efficient cars ahead of the expiration of a subsidy program. Japan's economy is now poised to contract this quarter because of slowing exports and an erosion in the outlook for corporate profits after the yen's surge.

The more the third quarter GDP grows, the less the fourth quarter grows given the household has already trimmed down its spending after the government subsidy to eco-friendly cars was over in September. The government has recently decided to infuse 5.1 trillion yen to the economy as an extra budget to counter a strong yen and deflation, adding up to 915 billion yen of stimulus package approved in September which was criticized as too small. Moreover, the Bank of Japan launched another monetary easing in November, supporting the government effort. But so far, the likelihood is increasing that Japan's economy falls back to a contraction this quarter after four successive quarters of growth.

At least, it looks like that underlying economic conditions verify the rise in the US interest rates.

US fails to renew tax cut

It looks like the US government is tumbling on fiscal support for the economy as has been expected from the result of the November election, boding ill for the country struggling in a fear of deflation.

Democratic measures to extend tax cuts for most Americans failed in the U.S. Senate on Saturday as Republicans -- and some Democrats -- blocked them because they did not also extend low rates for the wealthy.

President Barack Obama said he was disappointed with the vote, but indicated he was open to compromise on the tax cuts enacted under former Republican President George W. Bush, if certain conditions were met.

The Democratic plans -- to renew low tax rates for individuals with income up to $200,000 and for those making up to $1 million -- failed in procedural votes, as Republicans said low tax rates for the wealthiest should also be extended.

No Republicans backed the Democratic proposals, and a few Democrats voted against them.

Saturday's rare Senate votes were the latest skirmish in the battle over the tax cuts, which expire at the end of the year.

Obama and other Democratic leaders want to extend only the cuts for low- and middle-income Americans, contending the tax breaks for the wealthy would add too much to the yawning U.S. budget deficit.

Republicans, who dismissed Saturday's vote as a political stunt because the measures had been expected to fail, argue that raising taxes for the rich is a mistake that would cost jobs because wealthy Americans provide employment.

"Those provisions should have passed," Obama told reporters. "I continue to believe that it makes no sense to hold tax cuts for the middle class hostage to permanent tax cuts for the wealthiest 2 percent of Americans -- especially when those high-income tax cuts would cost an additional $700 billion that we don't have and would add to our deficit."

He said negotiators needed to "redouble" their efforts to ensure middle-class Americans did not face higher taxes on Jan. 1.

A White House official said Obama told Democratic congressional leaders on Saturday he was open to compromise but would oppose even a temporary extension if it did not include an extension of benefits for the unemployed and extension of other tax cuts that benefit middle-class families.

Nowhere near end

European debt crisis has gone from Greece to Ireland, Spain, and even Belgium. Where is this going? How does this end?

 It looks like the budget austerity curtails the yield spread over Germany's Bunds, Europe's benchmark bond. What's interesting in the graph above is that most crisis countries are located below the trend line.

It's not clear whether or not this signals the next countries for market anxiety.

Japan decouples from Asia

"Decoupling" usually refers to a talk on Asia's or emerging countries' economic expansion with little dependence on the West. But it looks like that decoupling is starting to take on another round in Asia: decoupling inside Asia.

A sign of stagnation is gradually looming in Japan, which has still been mired in a persistent deflation. The unemployment rate in October rose unexpectedly to 5.1% from 5.0% in September. The average estimate was 5.0%. The index of industrial production in October fell 1.8% from the previous month, a consecutive decline over 5 months for the first time since October 2008 to February 2009. The result may look like better than the average forecast of a 3.2% fall, but the fifth straight month of decline sounds more stark than the actual number.

The sagging global demand may also help drag the third largest economy down to the bottom. Nevertheless, a considerable damage on the economy is coming from the factors peculiar to Japan: the expiration of government subsidies to cars and electronic products, and the 15-year high yen which is sending a downward pressure on exports. Household consumption is no hope to underpin the economy amid sticking deflation.

Japan has so far enjoyed the four consecutive quarter of positive growth, but it now risks a contraction in this quarter. It was more or less anticipated, but it's awful nonetheless.

Miyako Suda, a member of the BoJ policy board, admits the possible downfall in this quarter.

Prolonged economic weakness may keep Japan in deflation longer than the Bank of Japan's current forecast, a member of its policy board said on Wednesday, offering the bleakest view to date by a central bank policymaker.

Board member Miyako Suda said there was a strong chance Japan's economy will contract in the final quarter of this year after strong growth in July-September, which was due mostly to expiring government stimulus steps offering incentives to buy low-emission cars.

…

"Considering the impact from recent yen rises and the worsening of sentiment among companies and consumers, the risk of prolonged weakness in the economy remains high."

Meanwhile, the other two Asian giants, China and India, are showing rather a sign of overheat in the economy, putting a pressure on the authorities to raise the interest rates before inflation accelerates. China is first.

China's manufacturing grew at a faster pace for a fourth straight month in November, indicating the economy can withstand higher interest rates as price pressures escalate.

The Purchasing Managers' Index rose to 55.2 from 54.7 in October, China's logistics federation said on its website today. That was more than the 54.8 median estimate of 14 economists surveyed by Bloomberg News. A PMI released by HSBC Holdings Plc also jumped.

Today's reports showed input prices surging, reinforcing the case for the central bank to boost borrowing costs again after it lagged behind counterparts from Malaysia to South Korea. Concern that monetary tightening will hamper corporate profit growth spurred an 8 percent sell-off in China's benchmark stock index in the past month.

"The risk of a sharp growth deceleration has abated, but all signs are suggesting that inflation may surprise on the upside," said Tao Dong, a Credit Suisse AG economist in Hong Kong. He called input-price data "alarming."

The logistics federation's PMI showed the strongest reading in seven months, while the measure released by HSBC and Markit Economics was at an eight-month high of 55.3.

Turning to India, the November data indicates that India's manufacturing has also grown faster than before.

India's manufacturing sector expanded at its fastest pace in six months in November on the back of robust new business and a sharp rise in export orders, a survey showed on Wednesday.

The HSBC Markit Purchasing Managers' Index, based on a survey of 500 companies, rose to 58.4 from 57.2 in October. It was the strongest level since May, when it was 59.

The November reading marked the 20th consecutive month that the key index of manufacturing in Asia's third-largest economy has been above the reading of 50, which divides growth from contraction.

"The momentum in manufacturing picked up further in November. Output accelerated and growing order books point to a continued strong momentum in the months ahead," said Leif Eskesen, chief economist for India & ASEAN at HSBC.

According to another report, manufacturing is gathering steam in South Korea and Taiwan, both of which are less sanguine than the two giants though.

In South Korea, the HSBC PMI jumped to 50.23 from October's 20-month low of 46.75, ending six months of contraction.

Taiwanese manufacturing expanded for the first time in four months, with the HSBC PMI rising to 51.7 from 48.6.

At least, Japan's weakness clearly stands out compared to neighboring countries. The cabinet is preparing for another round of fiscal stimulus, but the effect is likely to be no less pallid. Taking an incompetent monetary policy into account, a gloomy moment is waiting for the country with few tools to overcome it.

Doubts on Germany's consumption-led growth

Germany is booming. The IMF predicts that Europe's largest economy will grow 3.3% this year, the highest among major advanced economies. The latest Ifo Business Climate Index, a closely watched indicator of Germany's economy, marked 109.3, the highest since unification. Some might think of bouncing consumption as the principal driver of the country's recovery, which wouldn't be enough to save the world but at least could help ailing allies in Europe amid intense pressure, mainly from the US, to expand domestic demand to dissolve global imbalances.

Is a country which has been renowned for its gigantic exports transforming itself from an export-dependent to a consumption-led economy? The details of Germany's third quarter GDP would illustrate a somber picture, as opposed to some claims, of a country which still has to rely on external demand to bolster its development while on the way to a service economy.

Regarding to the Ifo Business Climate Index, Germany's Economy Minister Rainer Bruederle is boasting that "Germany's economic recovery is self-sustaining," and "Germany is on a fast track towards the goal of full employment."

Unfortunately, to sustain the economy, Germany is still badly in need of the world demand. Exports' share rose above 51% in GDP, the highest in two years, whereas domestic consumption's share fell to the two-year low. External balance, exports minus imports, has gradually claimed an increasing share among GDP after plummeting in 2009. Household consumption contributed to more than one third of GDP growth in the third quarter, but it's quite uncertain about the durability of domestic demand without exports.

The other important important aspect of Germany's economy is that the increase in employment is almost coming from a service industry, not manufacturing. In fact, 40% of the increase in the third quarter employment derives from finance, and 30% from other services, while manufacturing has only 16%.

The rise of service industry has changed a compensation structure. Finance and other services compensation have already reached above the pre-Lehman crisis level, whereas manufacturing is still 3% lower.

Moreover, in terms of gross value added, other services has grown 4%, and finance 1% since the Lehman crisis, but manufacturing has lost 9%.

What do these numbers tell us about Germany's economy? Severe price competition coupled with rising costs could cap revenue, hence compensation and employment in the coming months. On the other hand, the economy is mutating into a service-base society for more profits and opportunities, but would stagnate given a lackluster domestic demand. Germany would have to make sure that its domestic recovery is enduring enough to sustain the economy, hence able to absorb exports from other countries.