Battle of the EUR/USD Bulge

It is fashionable at the moment to believe that Europe, and all financial assets associated with that famous old continent, are “hopelessly buggered” (to borrow a technical English engineering term). Greece is a catastrophe, the other PIGS not far behind, the policy response is a feckless mess, the Germans are hopelessly stubborn, and the whole ridiculous Rube Goldberg  configuration of acronyms, summits, and bureaucrats is one headline away from unzipping into uncontrolled monetary and economic chaos.  This at least is the market’s story, with the bearish chorus on Europe reaching jet engine decibel levels.

Exhibit A is the speculative EUR/USD short position from the CFTC commitment of traders report, which every Friday shows a fresh record.  Non commercial euro traders are as bearish as they have ever been, exceeding even the extremes seen in May 2010 when the Greek nightmare firs burst on the scene.  CTAs are clearly on board the Euro doom train, but evidence suggests their real money friends are right there with them.  Exhibit B might be this story, reporting that U.S. money market funds (representing almost $600B in AUM) cut their lending to French banks by a modest 97% over the course of 2011…looks like those guys are out already, I would say.

Cheesehedge is also interested in the real money custodial flow information which is compiled by State Street (most recent data summarized in the table below).  The State Street data suggests real money investors have a 93% percentile long in the dollar, against an 18% percentile long position in the euro.  Real money is very clearly underweight Eurozone risk here, even as recent flow data (the first 3 columns) are beginning to suggest a strong flow of money back into the Eurozone.

So, we’ve got more or less record CTA and real money short positions, while a number of other things are happening which aren’t going according to Europocalypse script.  For all the sturm und drang which accompanied Standard & Poor’s drive by downgrade of Europe on Friday, none of the Eurozone sovereigns are selling off except for Portugal (which is a technical victim of index related selling).  Indeed, Italian and Spanish yields are well off their highs of the year, and seem unaffected by the downgrade drama.

Now consider some other important risk correlates with the Euro downtrade of late 2011:  The EUR/USD basis swap and the EUR/USD option risk reversal.  The EUR/USD risk reversal has had a massive rally in recent weeks, with an an almost 3 vol collapse in the put skew.  The EUR/USD 1Y basis swap is lagging behind, but has also tightened considerably.  In the past, a tightening EUR/USD basis and put skew have been strongly associated with rallies in spot EUR/USD  (i.e., the white line in the graph below tends to follow the red and yellow lines higher).

Given the extreme EUR/USD bearishness out there, Cheesehedge believes the euro is setting up for a fairly imminent, and fairly epic, short squeeze.  Yes, we know Greece is a joke.  But the euro is also Germany’s money and Germany is booming (more on that later).  The Euro, and Europe, has a history of surprising its doubters, and as a long term structural euro bear, Cheesehedge has the scars to prove it.

Cheesehedge is reminded of the original Battle of the Bulge, when the Allies assumed Germany was a beaten, whipped dog on the verge of collapse.  Germany’s enemies were therefore shocked at the massive counterattack the Germans launched through the Ardennes in the winter of 1944/1945, throwing the Allies back and extending the war.  Germany ultimately lost (as it will lose this monetary war), but not before inflicting a severe round of unexpected damage on its adversaries.  The Euro was almost certainly a terrible idea from its inception, and the world would be a better place without it.  Nevertheless, Cheesehedge feels a counterattack lurking in the Ardennes.  Even the magazine cover indicator is flashing a warning:

Is this really the end? Not yet…

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Unemployment – Less Slack in the U.S. Economy than You Think

Gavyn Davies provides a useful summary today of what will become an increasingly critical issue in macroeconomics over the next few years: the decline in the U.S. labor force participation rate.   Cheesehedge is generally unimpressed with much of the analysis of this phenomenon that has appeared in the media or elsewhere in the blogsphere.  There is a tendency to discount the plain fact that the U.S. labor force participation rate is in structural decline, and has been so since 2000.  It borders  on the comical that so that so many are willing to insist that a trend which has been in place for more than a decade somehow does not exist.

Here is the reality.  The U.S. reached a key demographic tipping point in 2008-2010, a structural change in the economy which just happened to coincide with the huge cyclical shock of the Great Recession.  While nobody has been watching,  the leading edge of the Baby Boom generation has started to age out of the work force.  Because the size of the Baby Boom generation is much larger than the generations, notably  Generations X & Y, which followed it into the labor force, the impending retirement of the Boomers will apply downward pressure on the aggregate size of the U.S. labor force  for years to come.

This is not a controversial argument.  It is simply demography and arithmetic.  Consider the following chart, taken directly from U.S. census projections of the U.S. population through 2050.  The chart shows the number 60-69 year olds in the U.S. minus the number of 16-24 year olds.  This is an important quantity to consider because the 16-24 cohort has a high transitional probability of labor force entry, while the 60-69 cohort has a high transitional probability of labor force exit.  By considering the relative quantity of eager young job seekers versus imminent retirees, you can get an intuitive sense of demographic pressures on the U.S. labor force.

Until 2000, there was a rising supply of young people likely to enter the work force relative to older people on the cusp of exit.  This relative quantity peaked in 2000, and began to decline precipitously right around 2008.  The number of 60-69 year olds will exceed the number of 16-24 year olds beginning in 2016, and will continue to do so in every year through 2034.  The next chart shows the structure of labor force participation across age cohorts in the U.S. as of 2011:

This chart illustrates the point that most labor force entry occurs by age 24, and is almost entirely complete by age 29.  Labor force exit really starts around age 55,  and dramatically accelerates as workers hit 60.  Although participation rates for workers older than 70 have been rising somewhat in recent years, labor force participation beyond the age of 70 is de minimis and likely to remain so.  Putting the age structure of labor force participation together with the shape of the U.S. population pyramid, one can easily arrive at a straightforward forecast of the U.S. labor force and labor force participation rates.  The chart below shows Cheesehedge’s own forecast, which simply shifts the population pyramid forward in time assuming participation rates for each age cohort stay constant at 2011 levels:

Wow. Doing this, the observed decline in the U.S. labor force participation rate since 2000 is  no mystery at all.  It is as simple as people getting older and dropping out.  What is more interesting is the inflection point on the red line above (which occurs right around 2010).  Not only is the decline in the participation rate set to continue for the forseeable future, its pace is likely to accelerate over the next decade.  In terms of absolute number of workers, the U.S. labor force is likely to be flat over the next several years, before beginning to shrink in absolute terms beginning sometime around 2018.  Now, the wildcards in the above forecast are net immigration to the U.S. and the possibility of materially higher participation rates for very old workers.  Notably, however, neither the immigration story nor rising elderly employment story have been able to offset the empirical fact of a steady structural decline in labor force participation over the past 12 years.  Granny working at Walmart is a story…demography is a fact.  Even if we were to observe in the future implausibly large rises in international migration or elderly labor force participation, these developments will at best simply counteract the downward demographic pressures on the labor force.  It is very clear that the U.S. has no chance of seeing anything like the huge labor force growth that was the rule in the 1970s, 1980s, and 1990s over the next 20 years.

Why is this important?  Common perceptions of the level of job growth necessary to bring the unemployment rate down are largely based on expectations of constant growth in the U.S. labor force.  You will frequently hear statements in the press like “The U.S. economy needs to generate 250-300,000 jobs per month to lower the unemployment rate.”  In an environment of stagnant labor force growth, this statement, is manifestly, patently false. If the labor force doesn’t grow, averaging 150,000 payroll additions per month over the course of a year  will lower the unemployment rate by 1.2% by the end of the year.  From an idle resources standpoint, a 0.1% drop in the labor force participation rate has the same economic significance as creating 240,000 new jobs.

This matters a lot when markets, many economists, and apparent majority of the FOMC have capitulated to the idea of a massive output gap in the U.S. that will not be fully closed for many, many years.  With interest rates priced for the expectation of a 0% Funds rate through 2014 and perhaps beyond, Cheesehedge believes both the Fed and fixed income investors are setting themselves up for some uncomfortable moments when the unemployment rate drops much faster than both anticipate.  Indeed this is already happening.  Cheesehedge notes that the Fed’s current forecast for the year end 2012 unemployment rate (just released in November) is 8.5%-8.7%.  Hmmm, the unemployment rate just printed 8.5% in December 2011, meaning the economy is already a year ahead of the Fed’s most optimistic forecast for unemployment.  If the economy can keep adding 200k payrolls a month (as it did in December) over the next year, and the labor force participation rate drops a mere 0.3% (as it did during 2011), Cheesehedge reckons the headline unemployment rate will end 2012 at 7.1% (a full 1.5% better than what the Fed currently believes).  Are the folks buying 10 year Treasuries today at 1.84% in expectation of ZIRP and QE forever quite ready for that?

More fundamentally, a slow growing and eventually shrinking U.S. labor force has significant implications for estimates of U.S. potential GDP growth and the appropriateness of current Fed policy.  Slower growth in the U.S. labor force, all other things equal, necessarily implies that potential GDP growth in the U.S. will be lower.  So far, the Fed (and specifically its most dovish members like Janet Yellen) has resolutely refused to lower its estimates of trend GDP growth in the U.S., betraying a view that the mid  2000s growth rates fueled by the housing bubble and a consumer credit binge are somehow sustainable on a permanent basis.  They are not.

While Cheesehedge believes there currently is a large amount of slack in the U.S. economy and that Fed policy is for the moment appropriate, he is troubled by recent calls from the Evans/ Yellen/ Williams wing of the Fed for yet more stimulus even as the U.S. labor market appears to be taking a solid and sustainable turn for the better.  It seems likely that the available slack will disappear faster than many believe.  Furthermore, it is disturbing that the Fed seems willing to ignore its own research on demographic trends and the labor force participation rate.  Specifically, Cheesehedge points to this fascinating paper by the Federal Reserve Board’s own research staff from 2006, which exhaustively investigates the declining participation rate between 2000 and 2006 and concludes that the phenomenon is primarily structural, not cyclical.  Interestingly, this paper proposes a model for the participation rate (in 2006!) that forecast the participation rate would drop, due to purely structural factors , to 64% by 2012.  Remarkably for an econometric model, this forecast was spot on,  with the actual labor force participation rate reported for December 2011 at 64.0%.  In Cheesehedge’s view, this paper deserves special attention and deference because its forecast was issued in 2006, well before the recession and financial crisis and the subsequent perceptions of a cyclical output gap which would “explain ” a falling labor force participation rate.  The question of whether there is a large output gap, or whether U.S. potential GDP growth is slowing, is very politically charged in the current high unemployment environment.  That this model was created during a relative boom period when no one even anticiapted a huge recession adds enormously to its credibility.

As this recent note from the New York Fed indicates, the Fed is reluctantly grappling with the fact the the labor force participation rate is dropping, and that this decline may well continue.  The Fed seems  less willing to concede that this fact has a policy implication, and that a decline in the unemployment rate is a decline in the unemployment rate, whether it is due to robust job growth or a shrinking labor force.  Cheesehedge fears that the Fed will conclude that a rapidly declining unemployment rate due in part to shrinking labor force participation somehow “doesn’t count”, and will persist in ultra easy monetary policy even as the real slack in the economy begins to disappear.   The risk is that the Bernanke Fed slides into the error of the Arthur Burns era Fed, which persistently overestimated the size of an apparent output gap in the 1970s and refused to believe that resource constraints could exist when the unemployment was above its estimate of NAIRU.  Athanasios Orphanides (last seen wisely encouraging Europe to drop the whole idea of a Greek debt default) documents the long, sad history of central bank attempts to estimate output gaps in real time here.

Let us hope that 2012 sees a long string of positive employment surprises for the U.S.  And let us hope further that Fed’s own deeply entrenched view of a huge output gap does not blind it to the good news, preventing it from responding in a timely manner to the tightening of U.S. labor markets some time in 2013.

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