10 Year Treasury Yield Outlook -- On Target

Today's GDP data, including the revisions, widened the output gap and lowered the sites on growth in the recovery. The ten-year yield is consequently falling. The technical picture suggested as much and I wrote about it a few days back, and a few months ago as well -- an updated 60--minute chart is below. The low in yield comes about a year after the recession ends and this one should prove the same. The technicals point to lower yields and that is the trend until the technicals point in a different direction. Target yields are a break of 3.50%, a highly probable drop to 3.25% and ultimately revisiting sub-3.00% yields -- not necessarily on this run but at some point in the next 6 to 12 months.

From an investing standpoint, the short-term curves are too steep for what the Fed will most likely be doing. A 2-year Treasurys should offer an excellent total return over the coming 12-months. Remember, however, no promises implied and its your money and your decision.

GDP Growth -- Looking Forward To Capital Spending

The numbers are in and, yes, the data now reflect a downturn as bad as we thought it was but the important question is what kind of economic recovery are we building. The inflation hawks should be quieted by the data revisions further widening the margin between actual and potential GDP. The second quarter data shows the usual early signs of an economy about to leave recession -- a positive push now and in the next several quarters from government spending, a smaller trade deficit, and inventory restocking. Of most interest to me, however, the contribution to growth that is going to come from business investment in capital equipment and software.

The chart below illustrates the contribution of business spending to real GDP growth. It is striking just how much of a drag business spending was during the current downturn, considering that it was never near the contributor to growth that it was during the 1990s. The current decade has, in fact, the distinction of having capital equipment spending adding the least to real GDP growth in the post-war period.

Of greater concern is the longer lag between the end of recession and the beginning of capital spending adding to GDP growth. Pre-1990 it was either on the mark with the end of recession or one quarter after. It took four quarters post the 1990-91 recession and five quarters post the 2001 downturn.

If we are going to get the more balanced, less leveraged growth in the economy going forward then the economy needs to be led by investment spending and that is only going to happen if a cheaper dollar boosts exports and import substitution. I believe the dollar will cheapen and the economy will see lots of energy-related investments (see 1970s) and investment spending will be a key contributor to growth in the recovery to come.

To get there, expect the funds rate to not rise by 200bp in the next 18 months as implied by the Treasury curve and contradicted by NY Fed President Dudley. As for inflation, considering the gap here and the over-capacity globally, by the time it is in an issue the policymakers and bond vigilantes will be focused on something else.

Fed Funds Futures Forecast? -- Market Veering Wrong & Dudley Said So

No longer lurching from crisis to crisis, the capital markets can get back to displaying just how much they ignore facts to chase fantasy even during relatively calm markets. A current case in point is the pricing of the Federal funds futures. The Dec 2010 contract is forecasting a 1.75% funds rate and a 50/50 probability that the Fed will hike rates to 2.00% at its Dec 14 meeting.

The pricing flies in the face of two bits of evidence. First, this is going to be a long, slow, halting recovery for a number of reasons. Chief among them is that the private sector is lacking the firepower to use leverage to boost growth. Government is trying to replace the loss of private borrowing with public spending but the impact is going to be limited.

Second, the Fed is clear that it will take its time and, in all likelihood, too much time to unwind its largesse. Even if they are unwinding in 18 months, betting near certainty that the funds rate will be 175 to 200bp above current levels by year-end 2010 is the kind of wager that keeps the lights on in Las Vegas.

Take these words from Bill Dudley (President of the New York Fed) given yesterday at the Association for A Better New York Breakfast Meeting --

I’m going to suggest that the balance of risks is still tilted toward weakness in growth and employment and not toward higher inflation. I will also argue that it is premature to talk about “when” we are going to exit from this period of unusual policy accommodation. . . . .

. . . . there are a number of factors which suggest that the pace of recovery will be considerably slower than usual. In particular, I expect that consumption—which accounts for about 70 percent of gross domestic product—is likely to grow slowly for three reasons. First, real income growth will probably be weak by historical standards.

Second, households are still adjusting to the sharp drop in net worth caused by the persistent decline in home prices and last year’s fall in equity prices. This suggests that the desired saving rate will not decline sharply. That means consumer spending is unlikely to rise much faster than income. In other words, weak income growth will be an effective constraint on the pace of consumer spending. . . . .

. . . .Perhaps most important, the normal cyclical dynamic in which housing, consumer durable goods purchases and investment spending rebound in response to monetary easing is unlikely to be as powerful in this episode as during a typical economic recovery. . . .

. . . . If the recovery does, in fact, turn out to be lackluster, the unemployment rate is likely to remain elevated and capacity utilization rates unusually low for some time to come. This suggests that inflation will be quiescent. For all these reasons, concern about “when” the Fed will exit from its current accommodative monetary policy stance is, in my view, very premature.

There was more in this speech about the technicals of the Fed's alphabet soup of programs that restored liquidity to the capital markets and that the central bank now has the ability to really reign in credit by paying interest on nonborrowed reserves. The mechanics are correctly laid out, the idea that the Fed will have the foresight they haven't displayed since Volcker was Chairman is another story.

No Federal Reserve started to raise rates before industrial production had risen several months in a row and the unemployment rate was falling. There is nothing going on now or likely to go on, in terms of the economy and policy, to support the high probability bet being made in the Fed funds futures market.

Ten Year Treasury Yields -- A Quick Look

The second half of the year has traditionally been a period of falling Treasury yields. Why a pronounced seasonal should exist is a mystery to me but it what it is and shorting into year-end is generally a losing trade. I am still holding to my earlier stated view that 10-year yields could drop back below 3% before the real bear market gets underway -- and there is every signal that the secular bull market in bonds dating back to 1982 is coming to an end. The 60-minute bar chart of 10 -year yields(see below) shows the market turning down in yield (obviously up in price). Getting back below 3.5% is the high odds bet but buying further out of the money calls expiring in December or January has good risk/reward characteristics. Volatility is low, the forward pricing is for higher yields so out-of-the-money spot is even further out-of-the-money against the forward -- on other words, calls are a relatively cheap play. (remember -- this is my opinion, no guarantees, and you make up your own mind with your own money).

Federal Reserve Balance Sheet -- Shrinking On Its Own

Joseph Abate at Barclay Capital does a great job following the Fed balance sheet and its implications for money market rates. This week the self-liquidation that Bernanke talked about in his testimony contracted the Fed's reserve balances by nearly $30 billion. Not a lot of money when we are talking trillions, but those billions do eventually add up.

From Mr. Abate's Weekly Federal Reserve Balance Sheet Report --

Despite the settlement of nearly $30bn in liquid assets this week, the Federal Reserve’s overall balance sheet contracted with reserve balances falling by nearly $30bn.

• The various Federal Reserve liquidity programs are rapidly disappearing – and most could be gone by the end of summer.
• Declines in the CP-FF may slow in coming weeks as the paper left in the program remains challenged.
• Detailed monthly data from the Federal Reserve indicate that borrowing from these facilities remains highll concentrated among just a handful of banks and issuers.
• The recent contraction in bank reserves has not pushed the effective funds rate higher.

The GroupThinkTank In DC - No Chance For New Ideas Or Fresh Thinking

One signature problem of organizations that fail is that everyone running the place have spent their lives on the inside talking pretty much only to themselves. Faced with a challenging economic environment some fresh thinking, unlike Bernanke's testimony, might help the Republic emerge from the current mess with better balanced growth. Instead, and not surprisingly, this article appears in the WSJ regarding deck chair shuffling amongst economists in D.C. To be fair, we would see similar people moves if Obama were Republican, only with some different institutions thrown in.

Here is the article from the WSJ Blog "Fed Staffer Heads to Brookings" by Sudeep Reddy.

The Brookings Institution sent a slew of economists into the government in recent months, from Jason Furman to the White House National Economic Council (after working for the Obama campaign) to Douglas Elmendorf at the Congressional Budget Office to White House Budget Director Peter Orszag (at Brookings before heading CBO). Now it’s getting a couple of additions from the government.

The think tank said today the new co-directors of its Economic Studies program will be Karen Dynan, a Federal Reserve staffer, and Ted Gayer, a Georgetown professor. The program’s director since 2006, Bill Gale, will continue his research at Brookings heading other programs (the Tax Policy Center and Retirement Security Project).

Dynan, who has been at the Fed since 1992, was a senior economist at the White House Council of Economic Advisers from 2003 to 2004. (She’s married to the aforementioned Elmendorf, the Brookings alum who heads CBO.) Gayer, a public policy professor at Georgetown, was Deputy Assistant Secretary for Microeconomic Analysis at the Department of the Treasury in 2007 and 2008. He also was a visiting scholar at the American Enterprise Institute.

Japan shrinks from the American embrace

A interesting article in today's FT written by David Pilling lays out the generational shift in Japanese leadership towards a group that feels no real moral ties to the U.S. and its defense umbrella. This generation feels the gravitational pull of China's economy -- the big offshore factory for many of Japan's manufacturers. Japan may not have the GDP growth but it has a sustained current account surplus and an aging population looking to invest its savings someplace -- someplace with a young and growing dynamic economy that generates an excess return on capital. East Asia has collected and controls the capital necessary to finance its growth. At the same time East Asia's growth is less and less dependent on growth from sales to Europe and the U.S.

This shift in the center of the world's economic gravity is not trivial -- and Russia is very likely looking to align itself with China, Japan, and India rather than the traditional West that answers Russia's new found capitalism with NATO membership for its former SSRs.

For U.S. economic policy the importance of no longer allowing the Asian trading nations to sustain cheap currencies is critical. Failure to let currencies hit market-determined levels will continue to transfer wealth from West to East. It is a huge mistake to allow a strong dollar policy to again underpin the U.S. recovery by sustaining foreign capital inflows. The cost of credit would stay too low for too long and fail to allow domestic saving to balance with domestic investment. The "opportunity" to address these problems in this recession will have been lost and the next downturn will be worse.

In the article, Mr. Pilling writes:

The centre-left Democratic party of Japan, a loose alliance of LDP defectors, technocrats and former socialists now almost certain to win power next month, has explicitly questioned some of the alliance’s sacred cows. In its 2007 manifesto, its latest word on the subject, it said it would “re-examine the role of the US military in the security of the Asia Pacific region and the significance of US bases in Japan”. The manifesto also stressed the importance of building trust with Asian neighbours, particularly China. . . . .

. . . . When push comes to shove, the DPJ is likely to walk away from many of these positions. There are already signs of realism flooding the Good Ship Rhetoric. Yukio Hatoyama, the party’s leader, recently stressed the need to preserve “continuity in diplomacy”.

Yet the DPJ’s suggestion that it wants to forge a new, more equal US alliance has unnerved Washington. Even under the alliance-friendly LDP, Japan’s US friends have struggled to keep Japan in the frame. Hillary Clinton, now secretary of state, deeply offended Tokyo when, in a 2007 article in Foreign Affairs, she stated baldly that the Sino-US relationship was the world’s single most important. The remarks evoked painful memories of her husband’s notorious “Japan passing”, symbolised by his diplomatic no-no of skipping Tokyo on his way to Beijing. Washington has also rattled Japan by allowing North Korea to tiptoe to nuclear status.. . . . .

. . . . Japan’s supporters struggle against those, sometimes called the “continentalists”, who favour a “go to China” policy on issues from global warming to North Korea. So seductive is the argument that the US should cut out the middle-man, that Mike Green, a top adviser on east Asia under President George W. Bush and a paid-up member of the Popeye Club, felt obliged to spell out the counter-argument in recent congressional testimony. “Rather than decreasing the strategic significance of Japan to the United States, China’s growing power has made the US-Japan alliance even more important,” he said. . .. .

. . . . Yet the imminent victory of the DPJ is more than a political realignment. It also marks a generational shift. For virtually the first time, Japan will be run by leaders with no strong memory of the war. They will seek to recalibrate an alliance with the US shorn of wartime guilt and postwar dependence. As hard as it will be, they will also strive to construct a security alliance that acknowledges Japan’s ties with Asia and China’s growing regional clout. As one US commentator says of the DPJ’s likely posture towards Washington: “Sit, stand, bark! They’re just not going to do that any more.”

Commercial Property Blues

Commercial real estate is growing problem and Bernanke noted it in today's testimony -- the Q&A portion. While the underwriting abuses in residential mortgages did not travel to the commercial market, easy credit did create lax lending standards and the more recent vintages of CMBS are the ones with the rapidly accelerating default rates. To give a sense of how the market is pricing all this, the chart below, courtesy of Barclay Capital, shows the spread to LIBOR for the most "protected" CMBS tranche -- AAA Super-Duper -- and the spread to LIBOR for BBB Industrials. Industrial spreads have improved, commercial mortgage spreads have not.

FHFA Reports Home Price Index Increase -- My Leading Indicators Say This Is Only The Beginning

The Federal Housing Finance Agency reported today that home prices rose. My own work, using Radar Logic prices (they are real time and don't lag like Case/Shiller and others), has been indicating higher prices for some time. I have built a set of leading indicators based for the 25-MSA Composite and for several individual MSAs that are based on price momentum, transaction activity, and mortgage spreads to Treasurys. I have also shown in this blog and my Report on Real Estate that home prices lead the economy and do not wait for employment and incomes to rise.

From today's release from the FHFA --

U.S. home prices rose 0.9 percent on a seasonally-adjusted basis from April to May, according to the Federal Housing Finance Agency’s monthly House Price Index. The previously reported 0.1 percent decline in April was revised to a 0.3 percent decline. For the 12 months ending in May, U.S. prices fell 5.6 percent. The U.S. index is 10.7 percent below its April 2007 peak.

Below is the graph of what the FHFA is reporting --



As for my leading indicators, here is the chart for the 25 MSA Composite --



While most of the MSAs I cover are indicating buy signals, LA and MIA most of all, the New York market is still soft and the Manhattan Condo market is going to get softer still.

The Macroprudential Bernanke

Today's testimony sounded a lot like the Captain of the Titanic taking credit for the rescue after driving the ship into an iceberg. He also wants to assure everyone of safe passage going forward because he is using the same navigation techniques only now the guys in the engine room are under his direct command.

We heard today a predictable collection of words to satisfy the required report to Congress -- the Fed saved the day, the Fed needs broader supervisory/regulatory powers to prevent the day from needing to be saved again, caveats regarding the tepid outlook, inflation and the budget, and then he tosses the obligatory bone to Congress regarding transparency and oversight. His op-ed piece in the WSJ calmed the market's concerns about the great unwind to come -- it is self-liquidating.

In his words --

To some extent, our policy measures will unwind automatically as the economy recovers and financial strains ease, because most of our extraordinary liquidity facilities are priced at a premium over normal interest rate spreads. Indeed, total Federal Reserve credit extended to banks and other market participants has declined from roughly $1.5 trillion at the end of 2008 to less than $600 billion, reflecting the improvement in financial conditions that has already occurred. In addition, bank reserves held at the Fed will decline as the longer-term assets that we own mature or are prepaid. Nevertheless, should economic conditions warrant a tightening of monetary policy before this process of unwinding is complete, we have a number of tools that will enable us to raise market interest rates as needed.

Meaning all is well until he deems it isn't. Since he missed that mark by a wide margin the last time, what are the guideposts this time? Considering that he is still beating the "CPI is inflation" drum, he will make the same mistake again.

. . maintaining the confidence of the public and financial markets requires that policymakers begin planning now for the restoration of fiscal balance. Prompt attention to questions of fiscal sustainability is particularly critical because of the coming budgetary and economic challenges associated with the retirement of the baby-boom generation and continued increases in the costs of Medicare and Medicaid. Addressing the country's fiscal problems will require difficult choices, but postponing those choices will only make them more difficult.

If the budget is fixed it would be better. Remember, however, that the trade deficit as a percentage of GDP expanded in the 1990s because of corporate borrowing --the budget deficit was moving towards surplus. In the current decade it was households borrowing to buy houses. In both cases, the management of monetary policy supported the unsustainable growth in leverage. Slippage in market confidence came from the financial sector's meltdown made possible by the gross mismanagement of monetary policy and the Fed's failure of regulatory oversight.

The Federal Reserve has taken and will continue to take important steps to strengthen supervision, improve the resiliency of the financial system, and to increase the macroprudential orientation of our oversight. For example, we are expanding our use of horizontal reviews of financial firms to provide a more comprehensive understanding of practices and risks in the financial system.

"Macroprudential." "Horizontal reviews." This reads as if it was written by some management consultant from McKinsey or Bain or someplace like that. And like most consultant-speak it is meant to sound as if the speaker is smarter with more insight than the consultee. It would be better if we heard directly what precepts will be guiding Chairman Bernanke's oversight through the next cycle assuming his faith in the marketplace and its democratization of risk has been shaken -- or perhaps it hasn't.

The Congress, however, purposefully--and for good reason--excluded from the scope of potential GAO reviews some highly sensitive areas, notably monetary policy deliberations and operations, including open market and discount window operations. In doing so, the Congress carefully balanced the need for public accountability with the strong public policy benefits that flow from maintaining an appropriate degree of independence for the central bank in the making and execution of monetary policy.

And what exactly were the benefits of having an independently omnipotent FOMC focused on CPI inflation while ignoring the explosion in credit creation and then underestimating what would happen once credit began to implode.

A perceived loss of monetary policy independence could raise fears about future inflation, leading to higher long-term interest rates and reduced economic and financial stability.

Letting Congress run monetary policy is not a good idea, but the Fed has not brought us a stable, balanced economy. Quite the contrary. And the banality of Bernanke's testimony belies any sense that there has been a seismic change in how monetary policy should be executed.

DeWitt Clinton’s Remarkable Alumni

A brief moment to be proud of my high school, class of '72. Read the article, the book referenced was co-authored by one of my history teachers. A quote in the article struck me as a refreshing reminder of when public education was a priority of society to be fulfilled by local government --

More than 2,000 people crowded through the marbled halls to the auditorium of DeWitt Clinton High School on Mosholu Parkway to hear Mayor James J. Walker inaugurate the ambitious all-boys institution, which cost the city $3.5 million. Mayor Walker remarked, “This temple of education will well repay us even after we are gone, by training future generations to be good citizens.” Indeed, Clinton’s impact would not only give back to New York, but repay American society in significant ways.

Let economists of the Chicago school argue vouchers all day long -- like they argued markets are efficient and sent government policy off a cliff -- and let any of them show me a private high school with as vast a list of alumni who added to American society in so many different walks of life.

As fellow alum Stan Lee always wrote --

'nuff said.

Yield Curve -- From Last Humphrey Hawkins To Now

From Chairman Bernanke's last Humphrey-Hawkins testimony to today the Treasury yield curve has steepened and quite a bit -- yields have risen on 3 year maturities out to 30 (see chart). The long Treasury is up 100 basis points in yield and the 10-year nearly that. All in all, the steeper curve is a good outcome. Pricing in higher yields for notes longer than 2 years in maturity suggests a market anticipating growth and the Fed reacting to it.

Inflation worriers need not worry just yet -- the first thing the Fed and Treasury needed to do was restore confidence that there will be an economy. Credit spreads and the curve suggest that policy has gone a long way in that direction, but market participants are still not fully sold on the growth scenario lifting all lenders and borrowers. It will be interesting to hear how Bernanke tells the unwind tale to keep inflation expectations moored once economic growth begins to recover.

Financial Credit Spreads Improving But . . . .

The chart below tracks 5-year CDS for JPM and GS from year-end 2006 to date. Both have started improving yet again but are still 80bps or more off their traded lows in early 2007, back when there was full faith in their credits. Through the period GS fared much worse, perhaps a sign that markets value a banking franchise more than the air out of which an investment bank's balance sheet is made.

Still, optimism in the darkest hour paid off and is paying off still. A return to pre-recession spreads is a ways off considering the over-indebtedness problems and the continued need for the Fed to back-stop everything but Treasury debt. Recent indicators of returning economic growth, however tepid the turnaround turns out to be, and the penchant for the market to be as overly pessimistic in bad times as it is too optimistic when good times are rolling, suggest that taking in 117bp/year in premium against a GS default in the next five years is not a bad bet -- apparently the market is not quite as convinced of GS invincibility as Mr. Krugman.

CDS is a tricky market fraught with margin calls if you are selling default insurance. You can still profit from an improving credit the old fashioned way -- buying GS debt, such as the GS 5.5% due 11/15/2014 trading 185bp above the generic 5-year Treasury. These recommendations come with the usual caveats about it being your money and your responsibility.

World’s next top brands set to rise in the east

This article from today's FT points up, underscores, and otherwise supports my contention that it is well past the time to end U.S. economic policy based on importing the world's savings to leverage domestic spending and thus allow U.S. consumers to be the buyer of last resort for the world's overproduction. It has been to the U.S. advantage, political and economic, for developing countries to grow and prosper. But the cold war is long over. We are all capitalists now. Time to recognize that a policy bankrupting the U.S. by redirecting wealth from West to East has past its usefulness. The coming recovery should be about rebalancing U.S. and, in turn, global growth.

In today's article, Jenny Wiggins writes (bold face type is mine):

The world’s next Coca-Cola or Starbucks is more likely to emerge from Asia, the Middle East or South America than the US or Europe as global economic wealth shifts.

In research prepared for the Financial Times, Wolff Olins, the consultants behind the London 2012 Olympics logo and the Product Red campaign, has tipped five food and drink brands from emerging markets to become global brands.

They comprise Juan Valdez Café, a Colombian coffee chain; Almarai, a Saudi dairy and fruit-juice company based in Riyadh; Patchi, a Lebanese boutique chocolate chain; ChangYu, China’s biggest wine producer; and United Spirits, India’s largest liquor group, which owns Scotch whisky Whyte & Mackay.

“It used to be possible to be a global brand by dominating the US market,” said Melanie McShane, a strategist at Wolff Olins. “That’s changing rapidly. Now you have to be number one in Asia.......

. . . . . The findings echo research by US business consultancy Bain & Co, which estimated that one-third of the FT Global 500’s companies could come from emerging markets by 2015 thanks to what it calls a “seismic shift” away from developed markets.

Satish Shankar, a Singapore-based partner with Bain & Co, said that established western consumer goods brands were being forced to “battle it out” with emerging market brands as they moved eastwards to take advantage of rising demand for branded products. Some are acquiring local brands, with PepsiCo paying $1.4bn last year for Lebedyansky, Russia’s largest juice group, and Unilever buying Inmarko, the country’s biggest ice cream brand.

Coca-Cola’s attempts to acquire Huiyuan, China’s biggest juice group, for $2.4bn this year were less successful – Chinese regulators blocked the deal.

'nuff said.

Leading / Lagging Indicators -- The Bottom Is In, What's Next?

The ratio of leading to lagging indicators is a time-honored way of determining whether a recession is at hand or ending. The June data released this morning (see chart) offers strong evidence that the recession is done with. Saying that does not mean a dynamic upturn is at hand or that the labor market is going to improve at the get go. I wrote in a recent post that the time frame for private employment to return to its pre-recession peak has unfortunately extended dramatically beginning with the 1990-91 recession.

The coming recovery will be interesting as public debt & guarantees replaced and backstopped a lot of private capital while the private sector, households in particular, is still too leveraged A recovery that rebalances domestic investment with domestic saving is, however, bad politics because it means low growth (read high unemployment) for an extended period. If the Fed, Treasury, et al, stay with the strong dollar policy in place since Reagan in order to fund the Federal government's turn at running up growth with borrowed money (firms did it with tech spending in the 90s and consumers with home buying in 00's) then we get a faster upturn but it won't last and the downturn to follow will be even uglier.

Housing Starts and Pending Sales

The housing starts data released this morning was a welcome sign that, at the very least, the level of housing starts is bottoming. Starts follow transactions and while no boom is in the offing the National Association of Realtors Pending Home Sales Index points to more starts to come (see chart below). Home prices are also bottoming and beginning to rise, however modestly, based on my work with Radar Logic house price and transaction data.

The chart illustrates monthly single-family housing starts and the pending sales index lagged four months. Judging from the upturn in pending sales and the high likelihood that even more sales were put into the docket in June, the improvement in housing starts reflect an upturn in the trend rather than a blip in the data.

China's Growth -- America's Problem

Reports today of China's strong 2nd quarter growth and how it got there, assuming the reported data are accurate, means that the U.S. is facing commodity price pressures in the short-run and a political problem longer-term for addressing China's mercantilist policies that, along with the Fed's blind eye, created the credit bubble now burst. This from today's Financial Times Lex column --

Beijing has pressed every button at its disposal – which in a state-controlled economy is basically all of them – to plug the shortfall caused by falling exports. The economic model has shifted, but mainly into government hands.

Yes living in a fascist country has its upside -- China's second quarter 7.9% growth rate was aided and abetted by the government forcing the state controlled banks to make loans.

But what China has done is a sign of weakness not strength. The recent ethnic riots are suggestive enough that that the underlying social fabric requires jobs for all those young Chinese men heading into the cities and those already there. At the same time China is stuck with lots of dollar debt, the result of their own misguided policies and they can ill afford a 20% currency markdown on their holdings, and their reserves are again growing apace.

The old saw about the dollar was -- our currency your problem. Well the Chinese economy is now like that for us. China's domestic political/social needs require an economic policy that ends up raising global commodity prices and holds the dollar hostage from the market forces that would revalue the Yuan against the dollar and help create more balanced growth for the U.S. A policy bind if I ever saw one.

TIPs - Short-term Expectations of Long-term Inflation

If you are concerned that cheaper dollars, higher energy & commodity prices, huge budget deficits, and the potential for the Fed to mishandle the unwind (their track record for shifting policy early to adjust for the economy is far from exceptional) will yield an average inflation over the next 10 years of more than 2.5% thens TIPs are extraordinarily cheap.

The TIPs market isn't as clever or as forward looking as it is purported to be. The chart below maps out the breakeven inflation rate for 10-year TIPs during this decade. Today, inflation expectations are rising, in effect normalizing towards the 2.5% average that existed between the last recession and this one. Breakeven inflation has, however, drooped of late, along with the green shoots of last spring. Going back to last fall -- average deflation during the next 10 years ? The TIPs market priced it that way. Pricing techincals created some of this, relating to potential loss in the accumulated inflation adjustment. Still, fear is fear and short-sighted panic, justified as it might have been, dramatically altered the market's expectation for inflation in the coming 10 years.

The volatility of the breakevens in the past year shows just how much the market's pricing of 10-year inflation is simply an extension of current economic conditions and not an assessment of long-term inflation risk. Market participants are notably late in recognizing a shift in the inflation environment (see rising inflation in the 1970s and disinflation in the 1980s). For those longer-thinking investors concerned about inflation, and concerned with reason, the TIPs market offers an extraordinary opportunity.

Retail Sales Start To Bottom

Looking at Control Retail Sales - sales less building materials, motor vehicles & parts, gasoline stations -- it appears that the downside momentum has slowed. The year-over-year comparisons should certainly start to look better since June 08 was last year's peak in sales because of the Bush rebates. (see chart). Current level of activity is nothing to write home about but there are enough other indicators of slight upticks in business activity to suggest that upside momentum in retail sales is more likely than not in the second half of this year.

Taxes and Wages -- What Does The Fed Think?

Looks like the Fed's staff has given Bernanke, and by extension the White House, an economic policy go signal to raise taxes on the upper end of the income spectrum. Rummaging through the Fed's working papers is a great way to get a read on the Fed's thinking -- especially so since Bernanke became Chairman. In a paper posted in June "Does Tax Policy Affect Executive Compensation? Evidence from Postwar Tax Reforms" by Carola Frydman and Raven S. Molloy. the authors find . . . . well the abstract speaks for itself:

Evidence since the 1980s suggests that the level and structure of executive compensation in U.S. public corporations are largely unresponsive to tax incentives. However, the relative tax advantage of different forms of pay has been relatively small during this period. Using a sample of top executives in large firms from 1946 to 2005, we find little response of salaries, qualified stock options, long-term incentive pay, or bonuses paid after retirement to changes in tax rates on labor income--even though tax rates were significantly higher and more heterogeneous across individuals in the first several decades following WWII. To explain this lack of response, we find suggestive evidence that concerns about within-firm equality may have limited firms' ability to differentiate top executives' compensation packages based on their marginal income tax rates.

Lunch with Larry Summers In FT -- Plan for Weaker Dollar vs Asia

The interview with Larry Summers in Saturday's FT was quite extraordinary in his revelation of what kind of economy is going to emerge from the current recession and what that has to mean for the dollar. He starts his argument by noting:

The American problem this time has more in common, at least qualitatively, with the Japanese post-bubble problem, where the issue was not reassuring foreigners but maintaining sufficient domestic demand forward to push the economy.

Generating sufficient economic demand is somewhat problematic if the U.S. is going to be a less leveraged economy, even though Bernanke has said that he would like to see people get back to spending by using the take-out from refinanced mortgages -- and current low interest rates should help that along. Isn't this how the whole mess got started? If the personal saving rate goes back to zero once job growth returns then policy has saved the day but not the economy.

Say what you want about Summers, and many have, but he is not stupid and so he goes on to outline the economy to emerge -

This new American economy, Summers hopes, will be “more export-oriented” and “less consumption-oriented”; “more environmentally oriented” and “less energy-production-oriented”; “more bio- and software- and civil-engineering-oriented and less financial-engineering-oriented”; and, finally, “more middle-class-oriented” and “less oriented to income growth that is disproportionate towards a very small share of the population”. Unlike many other economists, Summers does not believe that lower growth is the inevitable price of this economic paradigm shift.

How do you suppose all this is going to happen? Summers then says so --

As Summers puts it, “The global imbalances have to add up to zero and so, if the US is going to be less the consumer importer of last resort, then other countries are going to need to be in different positions as well.” On this possibility, Summers is bullish. “The very great enthusiasm for accumulating reserves that one saw globally is likely to be a smaller factor over the next decade than it has been in recent years,” he predicts.

Putting 2 and 2 together he is saying that China, Japan, and the like will not run their export machines by flooding the world with their currencies in order to keep the dollar up so American consumers will buy their productive overcapacity. That game is over. Obama likely told that to the Chinese in his private meeting with the premier in London earlier this year and now he is telling us. The dollar will weaken against our trade deficit partners to the betterment of creating a more balance growth path in the U.S. This isn't about national pride in the currency, this is about leveling the playing field -- at last.

Ten Year Treasury Yields -- Update

I originally posted this on June 26, which was an update of a forecast from March. In sum -- 10 year Treasury yields bottom in the year after a recession ends. This round will be no different. Herd thinking that yields are heading higher because of inflation risk etc have spent too much time thinking and not enough investigating and understanding markets. The 10-year will likely test 3% before the year is out and drop to 2.75% or thereabouts would not be a surprise. Will yields move higher over the long-term? Yes. But not soon and certainly not now.


Which way next for the 10-year Treasury yield? Lots of opinions and the yield curve implies that rates are going to drift higher. The forwards imply a 3.61% yield on the 10-year in three months, 3.75% in six months, 3.92% in a year, 4.20% in two years and 4.5% in five years. Anyone who has ever traded or invested knows that making money means betting against the curve. The current curve is easy to bet against, which way is another story. If there is one thing to be certain about is that the 10-yield will not quietly drift higher through the next five years.

From a fundamental business cycle standpoint the chart below shows that the 10-year yield bottoms some time after the recession is over -- and consistently so. Unless you think the end date for this downturn is in, needing only the NBER to confirm, then lower not higher yields are in store.

The next chart illustrates the long downward trend channel that the 10-year yield has been traveling in since Summer 1986. Unless and until yields break from this range, claims that a long-term bear market has begun do not hold technically or fundamentally (timing of low vs recession's end). This isn't to say it won't happen it just isn't happening now.

Some posts back I wrote that the market at 4.0% was topping and it would not surprise me to see yields break back below 3.0%. Current price action supports my view for lower yields (see daily chart below). A critical test of market support will be around 3.27%. If buying continues through those yields, and the odds are in favor of continued buying, 10-year Treasury yields would drop to around 2.80%.

Interesting pattern in government bond trading is that the market retests the low price (high yield) but the high price (low yield) need only be touched once. As I wrote above, the long bear market in Treasury yields has not yet begun -- but if my read of the current rally is correct it will start in earnest later this year or early next.

Market Pricing & Labor Pains (Birth, Growth & Death) – Recoveries Are Increasingly Jobless and This One Will Be Worse.

Those trading, investing, making policy and otherwise betting on an upturn based off of employment data are betting on the wrong horse. Although buoyed by the initial claims data this morning, this group was obviously disappointed by the June jobs data and reacted by issuing policy mea culpas, widening credit spreads, dumping equities and buying Treasurys ( see post "Ten-Year Treasury Yields – What's Coming Next" ).

Although the NBER's standards for setting a trough mean no job growth no recovery, employment data do not offer an early indication of an upturn. First off, month to month job changes are essentially random and so there are no steady monthly progressions during up or down cycles. And then there are the sizable revisions (May was revised up and upside revisions are usually signals of economic growth).

One big source of revision comes when the BLS re-benchmarks the survey and fixes what the birth/death adjustment estimates. Inexplicably, for the 12 month period ending in June the BLS added 831,000 jobs from net new enterprises against 5.8 million jobs lost. In May the 12 month add was 811,000 and in March it was 717,000. Yes, during the worst recession since at least the 1980-82 period if not the post-war the BLS job birth/death job add is increasing.

Beyond the month-to-month data, using labor data to gauge the upturn is less reliable because upturns don't need as much labor as they used and they don't need new workers for a increasingly long period of time. As the table below illustrates, after the post-war recessions up to and including the 1981-82 event it took a median 14 months until the jobs total matched the peak prior to that recession's start.

After the 1990-91 recession it took 27 months for jobs to fully recover. After the 2001 downturn, it took 43 months. And that is just the absolute number of jobs – I am not adjusting for the increase in working age population which would lengthen the job recovery period. As for why it is now taking longer for a recovery to boost jobs my view is, first, that the economy is more service oriented and its firing/rehiring patterns are much less dynamic than manufacturing. Second, increased consumer demand flows to jobs overseas as so much more consumer product is satisfied by imports.

All of which is to say the coming recovery will be even worse when it comes to hiring people. This is much more a jobs recession in the service industry and financial services in particular. In addition, imports are an even greater percentage of consumer items than in the previous two recessions. Lastly, housing construction often leads the economy out of recession and that will not be the case this time around. Perhaps most important in delaying job growth is the structural shift from the highly leveraged economy that boosted household and business spending and dropped unemployment to 4.4%. The coming upturn will offer nothing of the sort, nor should policy aim the economy in that direction if there is going to be balanced sustainable growth.

There are early signs of recovery and they are in indicators of business activity. But recovery isn't coming from labor data and, as an aside, low future jobs growth and high unemployment rates means those inflation worriers should find something else to fill their time. More on early signs of recovery in the next post.

Recovering Lost Private Employment
NBER Recessions			Months To Return To Prior Peak*
Peak	Trough		(Dated From Trough)
Nov-48	Oct-49				10
Jul-53	May-54				15
Aug-57	Apr-58				17
Apr-60	Feb-61				15
Dec-69	Nov-70				13
Nov-73	Mar-75				15
Jan-80	Jul-80				5
Jul-81	Nov-82				11
Jul-90	Mar-91				27
Mar-01	Nov-01				43
Dec-07	--				--
		*Median from 1948 to 1982 was 14 months

Yen / Dollar -- Option Opportunity

On April 24 I wrote a post on the technical outlook for the Yen/Dollar exchange rate.

The $/Yen chart and momentum indicators suggest that the dollar bounce against the yen is ending if not over -- no guarantees as you know and any bets you make are your own responsibility. The dollar should broach the lows set in the mid 1990s but the ultimate downside is as yet indeterminate. Because the forwards are pretty flat relative to spot, thanks to effective zero interest rates in both the U.S. and Japan the spot and the forward are pretty close making it less expensive to bet on a dollar decline than it used to be. To see Yen rally past 80 by September might be a fundamental shock to some (not me) but not a technical one.

Nothing's changed except that the breakdown is beginning. More important than a point forecast is that similar low interest rates here and there puts the forwards where spot is rather than where one would expect it to be. The chart below, courtesy of Bloomberg, shows the forward curve today and the change in the past month. Right now spot Yen is 92.71 and one year forward is 92.32. A month ago the one year forward was 96.56.

At-the-money options are priced to the forward so a one year yen call versus the dollar struck well out of the money will be relatively cheap relative to expectations -- even though high implied volatility has likely given some of the bargain back to the option seller. Nevertheless, betting on 85 in one year's time has a good risk/reward ratio, in my opinion. Of course, no guarantees, you are on your own, and this trade is not suitable for everyone -- only you can figure that one out.

War on Capitalism? Taking Aaron to Task and Policy Too

Aaron Task writes for thestreet.com and has a post today in Yahoo finance declaring Government stimulus as "War on Capitalism". Normally I let this nonsense pass unnoticed but its sheer repetition has too many believing it is true. First off, Obama and Bush II were saving capitalism not declaring war on it. If they wanted to declare war they would have let WB, MER, C, and BAC follow Lehman into bankruptcy, not done anything to unfreeze capital markets, and let the consumer and business spending implosion set off a debt/deflation cycle as debt underlying income and profit expectations turns onerous and assets subsequently need to be sold to raise cash. When Roosevelt was President his response to increased carping by bankers and the like was that "they sound like a man saved from drowning and then complains that his hat wasn't saved as well". More things change ……

The kick-off for the Task post is the possibility that another round of massive stimulus is coming – and the doubt that it even works. Fact is, stimulus worked well enough in the 1930s for the economy to exit recession in March 1933 and the country to fall back into recession in May 1938 when the stimulus was reduced. Looking back, the stimulus wasn't big enough until World War II solved that problem. As for the Japan example, it doesn't hold as a comparison because they took way too long to allow failed banks to recognize losses and merge into healthier ones, the necessary step to revive lending. Remember when Japan was going to rule the world and everyone was concerned about whether they would buy U.S. debt, etc? Turns out that they might yet as this nation in a 20-year malaise more and more supplants Western banking as the source of capital to finance the Asian economy.

As for the current run of U.S. macro policy, when the economy was collapsing last Autumn it became evident that a two-prong attack was necessary. Any stimulus package designed to replace imploding consumer and business spending with government consumption would fail if the capital markets remained closed. As for the quality of the packages, monetary and fiscal alike, they are a hodge-podge. For the spending package there was no choice if there was going to be increased spending now rather than later. Without Republican support Obama needed Democrats and no self-respecting politician was going to let $787 billion get spent without a favored project tossed in. Another package? Given the back loaded spending and signs of an abating recession, I doubt it will be necessary.

The crux of the issue for Mr. Task and like minded people is the massive amount of government debt to be financed and the overwhelming amount of outstanding Treasury debt on the books. The numbers are the numbers but none of it is particularly scary -- if the spending gets the country growing in terms of real growth. It is high real growth and low inflation that reduces the debt not inflation (see the 1990s).

Herein lies the issue, how does real growth revive? A decade long run of government infrastructure spending helps but it can't be the whole thing because bridges roads and tunnels are less important to growth than the Web and cell phones – see India and China. In addition, I am not exactly sure what the sum total of the government's plan is attempting to do other than avoid economic disaster today. An obviously worthy goal but how do we recognize when enough is enough. A better balanced economy is a less leveraged economy. This means policy cannot look to get back to 4.4% unemployment, 5.5% is a more sane target.

For the U.S. to have balanced growth our major trade deficit partners (China and Japan among them, Europe not) must allow their currencies to appreciate to market levels. They have kept their currencies too cheap and manufacturing costs cheaper in order to keep their export machines growing by buying more and more dollars. How do you think they ended up with too many Treasurys and the U.S. ended up with too much capital chasing too few investment opportunities. We do not have a free trade world with free floating currencies and acting as if we do is how the Fed helped create the mess the economy is in.