Wages, Salaries, Retail Sales & Inventories

Forecasts looking for inventory restocking to boost growth in the second half had best look elsewhere. I noted this for manufacturers the other day and today's personal income report presages retail sales data that will prove out that retailers still have too many goods on hand.

Wage and salary disbursements totaled $5,031 billion in July, up marginally from $5,025 billion in June but $30 billion less than April and $380 billion below year ago levels -- a 7.4% year-over-year decline. This never-before-seen-since-the-Depression loss in purchasing power happens when payrolls lose 5.7 million jobs in 12 months and there is no inflation. As employment losses slow so too will the loss in income and whenever firms start hiring again wage disbursements will rise as well. But there is a long way to go before all this lost income is regained and in the meantime the accumulated loss in wealth keeps getting bigger. Mix the debt burden into all of this and consumers will be leading the economy but only to less profligate ways.

It is no wonder that control retail sales (sales less autos, building supplies and gasoline) collapsed with incomes (see chart), but the extent of the collapse evidently shocked retailers -- as evidenced by the big jump in the retail inventory/sales ratio (not including motor vehicle and parts dealers). The ratio has fallen from its recent peak but it is still far enough above pre-recession levels to suggest that retailers will keep selling from their shelves. Inventory spending is a long way off.

Nine Trillion Over Ten Years -- Not So Bad

Nine trillion in borrowing over the next ten years sounds like a lot of money, and it is, but the reaction reminds me of David Stockman and his $250 billion deficits as far as the eye could see. Where does that $250 billion stack up today relative to GDP? In 1983 that kind of deficit was about 6.5% of GDP. Today, 6.5% of GDP is about $930 billion -- or $9 trillion divided by ten. So we are back to Reagan-era deficit spending. Of course we never got $250 billion as far as the eye could see, if fact after Gramm-Rudman in 1986 the deficit began to shrink in absolute and relative terms until 2001, when the era of disinflationary monetary and fiscal policies ended. During, I might add, Republican rule of the White House, the Fed, the Congress and the Supreme Court.

The chart below plots out the unemployment rate, the amount of Federal borrowing and the dollar amount equal to 6% of GDP. I chose 6% because that was effectively the peak of the Reagan era. Note that borrowing doesn't start to fall until the unemployment rate decline. Considering the extent of the current recession in terms of its damage to household and business spending, odds of a quick decline in unemployment is small -- and so too are the odds of drop in Federal borrowing. You can also add to this a major difference between the 1980s and 90s versus now -- the buildup in the Social Security trust fund that financed a good part of the Federal budget is finished. Over the next 10 years dissaving by the trust fund means more borrowing irrespective of base Federal spending and revenues.

As for those worrying about the takeover of the Federal sector, remind yourself that at present there is no net new private sector borrowing to speak of and without Federal spending the economy would be in much worse condition. There is always a cyclical ebb and flow to borrowing by the Federal government, nonfinancial businesses, households, and state & local governments (see pie chart below). As for crowding out, below is a scatter plot of Federal borrowing against household and business borrowing. It is quite clear that the volatility on the private side occurs even though Federal borrowing stays is a relatively narrow range.

In sum, deficit forecasts are notoriously poor and the present collection will turn out no better. The amount sounds large, but it is not sufficiently different from the Reagan error. Instead of lowering high marginal tax rates and starving government, the current plan is for government to spend instead. Considering the sharp difference in the condition of the economy then and now, it might prove to be a pretty good idea -- the overburdened household balance sheet means someone has to spend in order to keep the economy growing.

Durable Goods Orders -- Inventory Restocking A Premature Expectation

Growth forecasts for the second half of the year are built, in part, on manufacturers restocking inventories. The forecasts will need a better base than that. Judging from the ratio of inventories to shipments and the year-over-year growth for new orders and inventories, manufacturers of nondefense capital goods excluding aircraft are not likely to be growing inventories anytime soon (see chart below).

Coming out of the previous recession, inventory growth didn't turn positive until very late in 2004 and the ratio of inventories to shipments was well below the low of the previous cycle. Of course the economy was well into recovery by then, led by consumers and their new found mania for home buying -- an unlikely occurrence for this cycle.

Lest one think I am painting too broad of an industrial stroke, after all different industries lead and lag in each cycle, the same chart is produced for manufacturers of information technology -- the expected lead industry for a post-industrial world. Unfortunately, the chart paints a similar picture. Less negative growth in inventories is likely, positive growth isn't.

In sum, forecasting a positive second half on the basis of manufacturing to rebuild inventories seems more like wishful thinking than not.

The Case Against Bernanke

Steve Roach (economist and chairman of Morgan Stanley Asia) in a commentary just released by the FT --

Barack Obama has rendered one of his most important post-crisis verdicts: Ben Bernanke will be nominated for a second term as chairman of the Federal Reserve. This is a very shortsighted decision. While America’s head central banker deserves credit for being creative and courageous in orchestrating an unusually aggressive monetary easing programme, it is important to remember that his pre-crisis actions played an equally critical role in setting the stage for the most wrenching recession since the 1930s. It is as if a doctor guilty of malpractice is being given credit for inventing a miracle cure. Maybe the patient needs a new doctor. . . .

. . . Mr Bernanke made three critical mistakes in his pre-Lehman incarnation: First, and foremost, he was deeply wedded to the philosophical conviction that central banks should be agnostic when it comes to asset bubbles. . . .

Second, Mr Bernanke was the intellectual champion of the “global saving glut” defence that exonerated the US from its bubble-prone tendencies and pinned the blame on surplus savers in Asia. While there is no denying the demand for dollar assets by foreign creditors, it is absurd to blame overseas lenders for reckless behaviour by Americans that a US central bank should have contained. . . .

Third, Mr Bernanke is cut from the same market libertarian cloth that got the Fed into this mess. Steeped in the Greenspan credo that markets know better than regulators, Mr Bernanke was aligned with the prevailing Fed mindset that abrogated its regulatory authority in the era of excess. . . .

Roach's last point goes to the heart of what I have been writing of late -- there is no sign, none whatsoever in recent comments by Mr. Bernanke that he has re-examined his libertarian view or at least has come to terms with that view as a central banker in a world where markets are elsewhere rigged.

The Bernanke reappointment is a welcome chance for a broader debate over the conduct and role of US monetary policy. Mr Obama has made sweeping proposals that give the Fed broad new powers in managing systemic risks. I argued in the Financial Times 10 months ago that the Fed should not be granted these powers without greater accountability as required by a “financial stability mandate” – in effect, forcing the Fed to shape monetary policy with an aim towards avoiding asset bubbles and imbalances. Without a revamped policy mandate, it is conceivable that we could face another destabilising crisis.

Ultimately, these decisions boil down to the person – in this case, Mr Bernanke – who is being charged with the awesome responsibility as America’s chief economic policymaker. As a student of the Great Depression, he should have known better. Yes, he reacted strongly after the fact in taking actions to avoid the pitfalls highlighted by his own research. But he lacked the foresight and courage to resist the most reckless tendencies of the era of excess. The world needs central bankers who avoid problems, not those who specialise in post-crisis damage control. For that reason, alone, he should not be reappointed. Let the debate begin.

Unfortunately the debate is done and the Congressional fawning begins. Mr. Bernanke will do his part by railing against fiscal spending while sidestepping the fact that the economic turmoils beginning with the 1990-91 recession have come from the mismanagement of monetary policy and not too large of a Federal budget.

Mr. Roach also makes the point, rightly so, that it is premature to declare Mr. Bernanke's efforts a success. Indeed, any sense of normalcy in the markets should be tempered by the fact that the Fed is still repoing all that frozen credit on the books of the banks. If the Fed put the securities back to the banks market normalcy would disappear in a hearbeat -- and so would Bernanke's chance at reappointment.

Moving the economy forward is going to be a long tough slog and unless we have clarity on the dollar/yuan relationship the U.S. will be back in the soup soon enough but without an underleveraged Federal sector to save the day.

President Obama made a choice that made the Fed's depositors happy. That doesn't make it the right choice or an inspired one.

How toxic finance created an unstable world

This is an excellent commentary by Wolfgang Munchau in today's FT. He kicks off his commentary by offering us this --

The best description I have found of how economics and finance interacted is by Anton Brender and Florence Pisani*. The two French economists describe in great detail how money from European and Asian exporters ended up in US consumer or mortgage debt and how risk was transformed in the process. The main point is that global imbalances would not have become so extreme if global finance had not provided exotic new instruments.

The paper is an excellent history lesson, but history means nothing unless we learn from it. Anyone who has been reading my commentaries knows my view that securitisation was the market response to too much capital chasing too few investment opportunities -- asustained and growing imbalance in domestic saving and investment. Chairman Bernanke avoids mentioning all this when talking about macromanaging the future -- he just wants better tools to regulate important nonbank players. Too rapid credit creation in a low inflation environment will, I gather, again get no response from the Fed. I gather the belief is that the market will regulate itself. Haven't we had enough of that. But enough of my words.

Mr. Munchau wraps up his commentary this way --

Without securitisation, the world cannot sustain such extreme imbalances indefinitely. There is no way that Wall Street and the City of London will recreate the pre-crisis levels of securitisation, even if we make no changes to financial regulation. Rebalancing is likely to occur eventually. The US will run a large budget deficit for a few years, which partially offsets the sudden increase in US private sector savings, but it cannot do this forever. It is theoretically possible that American households will have repaired their balance sheets in a few years and will return to binge spending by then, but I doubt it.

I am not comforted by this scenario. Both China and Europe are likely to continue with broadly the same policies, trying to rely on exports for future growth while failing to produce sufficient domestic demand. The noises we hear from Germany in particular suggest that politicians and industry are looking forward to returning to the status quo ante.

So if all we do is stimulate the economy in the short term through monetary and fiscal policies, and tighten financial regulation, we are not really solving the problem. We can regulate to prevent another subprime crisis, but another subprime crisis is unlikely to occur even we did not regulate at all.

In the absence of another credit boom, which is improbable given the weakness of the global banking sector, imbalances will contract one way or the other. Without an increase in domestic demand from Europe and China, there is nothing to take up the slack created by the saving of the US private sector.

Once the US stimulus expires, and the budget deficit starts to narrow, global demand will settle at a new lower level. Under those circumstances, it is difficult to see how the world economy can return to the pre-crisis levels of growth, or even close to them.

This is why we should be worrying more about global economics right now than about global finance.

Couldn't of written it better myself.

When Will Fed Tighten? They Give Us The Indicator To Watch

A great way to understand what the Fed is thinking is to rummage through the Work Papers on their web site. Back in April Thomas Trimbur at the Federal Reserve Board published "Improving Real Time-Estimates of the Output Gap". Because the Fed continues to maintain that Price Index inflation is the key variable to sustain stable economic life, as opposed to credit creation, they follow the output gap concept to determine when demand is beginning to strain on the capacity to produce and so, by extension, increase inflationary pressures. Regardless that I believe this is a quaint notion in a global world, it is the Fed's view that counts and they count Capacity Utilization as the best real time indicator of the gap between actual and possible output. Here is the abstract from the paper:

This paper investigates strategies for real-time estimation of the output gap. First, I examine estimates from univariate models with stochastic cycles. This corresponds to the use of model-based band-pass filters in real-time, and I find that the turning points in real-time and final output gap series match more closely for higher order models and that the revisions properties and real-time accuracy are more favorable. Second, I investigate the use of capacity utilization as an auxiliary indicator to improve on output gap estimates in real-time. I find that this bivariate approach leads to significant gains in the accuracy of real-time estimates and in the quality of revisions.

The chart below shows Cspscity Utlization (an FRB data series) against recessionary periods. The horizontal line is the dividing line between noninflationary and inflationary growth (of course it is a more gradual and lagged process, but I am keeping it simple).

The Fed is a long way from considering s hike in the funds rate and now we know their gauge to measure just how far away they are.

Update on Oil Price Technicals -- The Corrective Run Is Coming To An End

A couple of months ago (Oil Price Technicals -- A Picture of Shifting Supply & Demand) I wrote that the oil rally was giving every indication that it was topping out but not to get too bearish yet as a run to $80 was in the offing. We are almost at $80 (based on NYMEX Crude nearby contract) and that level should bring out a lot of sellers, the Chinese among them. China revalues the Yuan to the dollar when oil gets over $80 in order to defray higher energy costs. Considering the recent reversal of economic fortune in that country keeping oil from even getting above $80 seems a likely priority. Considering the falling momentum along with some strong fundamentals, I would consider setting up some shorts now and then scaling more in as the price gets above $75. As for the downside objectives, first stop is just under $60 and if support there doesn't hold (and I don't think it will) then $45. Remember this is no guarantee and it is your money at risk -- so it is your decision and yours alone.

Bernanke In Jackson Hole Reveals How Much He Learned

Fed Chairman Ben Bernanke spoke this morning to the annual gathering of like-minded bankers and economists in Jackson Hole, Wyo. that is sponsored by the Fed Bank of Kansas City. The speech this morning contains everything that one would expect the Chairman to say -- we saw, we acted, we saved the world (italics are mine):

As severe as the economic impact has been, however, the outcome could have been decidedly worse. Unlike in the 1930s, when policy was largely passive and political divisions made international economic and financial cooperation difficult, during the past year monetary, fiscal, and financial policies around the world have been aggressive and complementary. Without these speedy and forceful actions, last October's panic would likely have continued to intensify, more major financial firms would have failed, and the entire global financial system would have been at serious risk. We cannot know for sure what the economic effects of these events would have been, but what we know about the effects of financial crises suggests that the resulting global downturn could have been extraordinarily deep and protracted.

The self-congratulation is nice, and yes he did finally figure it out after turning a big problem into a catastrophic one, but there is no reference to the Fed's complicity in all this-- allowing credit growth to accelerate unabated because CPI inflation remained low and allowing the financial system to do whatever because of Bernanke's and others strong belief in the market system to self-regulate and democratize risk. This part of the speech tells us exactly what he didn't know going in and learned and I find it particularly scary in a Fed Chairman (italics mine):

. . a panic is possible in any situation in which longer-term, illiquid assets are financed by short-term, liquid liabilities, and in which suppliers of short-term funding either lose confidence in the borrower or become worried that other short-term lenders may lose confidence. Although, in a certain sense, a panic may be collectively irrational, it may be entirely rational at the individual level, as each market participant has a strong incentive to be among the first to the exit. . . .

. . . As high haircuts make financing portfolios more difficult, some borrowers may have no option but to sell assets into illiquid markets. These forced sales drive down asset prices, increase volatility, and weaken the financial positions of all holders of similar assets, which in turn increases the risks borne by repo lenders and thus the haircuts they demand.This unstable dynamic was apparent around the time of the near-failure of Bear Stearns in March 2008, and haircuts rose particularly sharply during the worsening of the crisis in mid-September. As we saw last fall, when a vicious funding spiral of this sort is at work, falling asset prices and the collapse of lender confidence may create financial contagion, even between firms without significant counterparty relationships. In such an environment, the line between insolvency and illiquidity may be quite blurry.

. . . during the crisis runs of uninsured creditors have created severe funding problems for a number of financial firms. In some cases, runs by creditors were augmented by other types of "runs"--for example, by prime brokerage customers of investment banks concerned about the funds they held in margin accounts. Overall, the role played by panic helps to explain the remarkably sharp and sudden intensification of the financial crisis last fall, its rapid global spread, and the fact that the abrupt deterioration in financial conditions was largely unforecasted by standard market indicators.

Ben learned an awful lot about markets and financial systems. After all, if he knew all this in August 2007 he would have immediately known that lowering interest rates would not fix a collateral problem set off by a weakening housing market and ebbing inflows of foreign capital. The market indicators were there to indicate all of this, but in the "efficient market" view of the world those indicators were neither standard or accepted.

He ends the speech with this (italics mine):

We must work together to build on the gains already made to secure a sustained economic recovery, as well as to build a new financial regulatory framework that will reflect the lessons of this crisis and prevent a recurrence of the events of the past two years

And how exactly is Mr. Bernanke going to employ these new regulations given that he gives no reason to believe that he learned anything other than the plumbing that makes a financial system function. If I were in Congress and able to ask him questions at his confirmation hearing, this is what I would want to know.

Insured Unemployment Rate -- Jobless Recovery Yes, New? No

The growing noise about a jobless recovery is old news -- recoveries have been increasingly jobless, especially the last two. The important question is why. As for giving evidence of the jobless upturns, I am reproducing a table from my July 9 blog showing the steady increase in the number of months until total employment gets back to the pre-recession peak (see below). Because population grows, the table is somewhat misleading -- a rate relative to the number of people in the labor force is a better indicator. The chart below does that with the number of weeks it takes to get from the insured unemployment rate peak to the previous cycle low. Here too we see the lengthening in time.

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

As for the why, the increasing amount of off shore labor used to supply domestic demand has something to do with it. Given the increased skew in the distribution of income, low consumption at the lower end of the income scale (those workers most affected by the shift in production activity) barely impacts the overall numbers. Getting out of this box will not be quick, but if the Treasury and the Fed are determined to end the strong dollar policy and perhaps offer a tax credit to firms hiring low wage workers, the economy might begin to get that recovery led by import substitution and increased exports. We can only hope.

Stock Market 1930? -- Pattern Prognosticating Misses The Point

A number of articles, on the web and off, have recently come out trying to tie the current equity market price pattern to 1930 -- meaning that another big downturn is coming and a new low is in the offing. Technical analysis of market activity has value because price action often presages fundamental events driving valuations simply because market participants in total react to what is going on before the government can officially report on it. That being said, tying patterns across decades is poor analysis and misses the important question -- what is the performance of equities going to look like in the coming years.

The equity market is always more nervous than the economy and that is exactly what happened to the market in this cycle. The spring swoon reflected an all out view that the economy was about to tumble into the abyss. As extreme negative sentiment subsided the market improved to levels reflective of a weak economy not depression. Current levels for the S&P 500 match the late 2003 levels. To believe the market is now pricing in a V-recovery is just silly.

Evidence of the market's skittishness relative to GDP is shown in the scatter plot charts below comparing year-over-year percent change in GDP to the annual change in the S&P 500. The first chart covers annual data beginning in 1896 and the other covers quarterly data beginning in in 1947. In each time frame the range of year-over-year percent change in the S&P 500 is far wider than it is for GDP. There are even periods of positive GDP growth and a falling stock market. I like looking at a long time frame because it covers every possible market and period of market regulation and tax changes.





In terms of understanding just how the market is currently priced, knowing now that it can go askew quite a ways from economic reality, the chart below is the ratio of the S&P 500 to GDP from 1896 to present -- with the recessions shaded in. I first began using this chart in the early 1990s to prove out that the equity market was returning to its late 1950s - early 1960s valuation against GDP as the economy returned to the low unemployment low inflation environment of that period -- rather than irrational exuberance.

The ratio is too low to believe the market is optimistic on future growth and hence overvalued to the extent that a 1930 decline is in the offing. More important is that this ratio is unlikely to rise anytime soon -- meaning that profit expectations are going to lag the economy. The mix of an expansive monetary and fiscal policy is the culprit. This is not to say the current policy mix is poor policy at the present, it isn't. The problem is that I don't see an unwind when the economy begins to recover and the equity market lags the economy when monetary and fiscal policy is expansive (World War I, World War II, 1966 to 1979). We have been in an expansive environment since the beginning of 2001 and the market has underperformed.

The stock market is now going to cycle about in the current range for some time to come, at least until there are better and more broad indicators of resurgent growth. When the economy bell rings market indexes will rise but the policy mix effectively guarantees that equities as a whole will underperform the economy.

Fed Survey on Lending Standards: Lean To Recovery Especially Housing

The Fed just released its July survey of Senior Loan Officers (charts below) and, to no real surprise, fewer banks report tightening standards and the number of banks reporting a drop in loan demand is slowing. Of course just because banks are set with their current tight lending standards doesn't mean loans are being made. This is especially true for commercial real estate, where demand continues to shrink. The best news is in housing, where I have been forecasting a rise in home prices into year-end. At the end of last year almost 80% of banks were tightening lending standards for prime mortgages and now that level is down to 20%. Borrowers have responded -- 20% of banks report an increase in demand for prime residential mortgage loans. Small but needed steps to recovery.

Surge In Private Capital Inflows Reduces Credit Spreads & Raises Longer-term Questions

Today's release of Treasury's International Capital data for June points up a surge in net private purchases of U.S. domestic securities (Treasury, Agency, corporate and equity) of $105.2 billion compared with $31.3 billion in May. The U.S. debt markets need net foreign private capital inflows to sustain pricing at non-distressed levels. The chart below tracks these flows against the two-year U.S. swap spread -- an excellent indicator of market sentiment regarding bank credit and corporate credit overall.

Sustained foreign inflows in this decade kept swap spreads from rising even though the Fed was raising interest rates and the yield curve was flattening. Historically, swap and credit spreads widened when the Fed tightened and narrowed when they eased. Looking forward, the return of foreign appetite for U.S. domestic securities alleviates the near term pain but does nothing to solve or even address the longer run problem of U.S. capital market dependency on foreign inflows. If the Fed and Treasury fail to address this issue directly, it is easy to see how a reversal of foreign market sentiment creates immediate dislocations in market pricing and, by extension, liquidity.

Retail Sales & Ten Year Yields

The poor figures for retail sales should underscore for everyone the point the FOMC was making with the insertion of "low income growth" as a constraint on household spending. The accumulated loss of wealth will do nothing but pressure prices lower if retailers want a reasonable quantity of goods flowing through their stores. Absent absolute deflation, remember that wage and salary disbursements are lower this year than last, the pace of sales will eventually grow but quite slow;y. The Fed was right to let everyone know that concern about the upturn is premature to the point of being silly.

The past few months I have given a positive technical picture of the 10-year note, targeting a return to a 3.0% yield. I also noted that, for some odd reason, the seasonals favor falling yields in the second half of the year. I can't explain why that should be so, but it is.

Picking up on the downgrade in growth potential is falling yields -- fundamentals usually catch up with the technicals. Below is an updated chart of the 10-year with 60 minute bars.

FOMC Statement --- Adding Income Growth To Household Woes

Today's FOMC statement added "sluggish income growth" to the factors constraining household spending. This factor comes right after ongoing job losses and pushes "lower housing wealth" to third place (tight credit is last). A few blogs ago (Wages & Employment -- The Problem With Low Inflation & A Strong Dollar) I noted that with actual year-over-year declines in wage and salary disbursements it appears that consumer spending is going to drag down overall growth for some time to come. The Fed has known this for a while, it is far from a state secret, so why mention it now?

I suspect they felt the need to more forcefully tell the inflation-scare crowd and the Fed funds traders looking for near 2% funds by year-end 2010 to calm down -- there is going to be plenty of time before any of these concerns come to bear. Ever since the 1987 stock market crash the Fed has consistently stayed too low for too long. Considering the much more dire economic troubles at present and that the "normalized" credit markets are only so because the Fed is still holding it together, I think it is fair to say that the Fed is going to stick with zero for a lot longer than markets think.

The Shape Of Bank Lending To Come -- Into Treasurys

I read a number of comments this morning regarding how bank lending is going to lead us out of recession. Credit growth is absolutely important for an economy to expand but the idea that banks will be rushing out to lend runs counter to recent post-recession experience. As I noted in my previous blog, real estate is where commercial banks lend the most and therein lies the problem. Real estate, either for construction or mortgages or home equity loans, is not exactly the credit a loan officer wants to now load up on. As for commercial and industrial lending, the corporate sector long ago pushed banks into marginal suppliers of short-term capital once direct borrowing from the credit markets became available. Additionally, firms usually fund out of cash at the beginning of a recovery so a big uptick in corporate borrowing is unlikely -- except for lowering average interest costs.

The asset that grows the fastest on bank balance sheets in the first year or so after a recession ends is Government Securities. The charts below illustrate that fact quite clearly. They show credit growth coming out of the past three recession by basing the outstanding loans to each sector at 100 at the end of the recession.

The only surprise here is the continued expression by many that bank credit is going to start flowing and lift the economy. There will certainly be enough credit to support general activity, as opposed to what occurred at the end of last year. What finally gets the private sector going is an acceptable balance sheet and the expectation of higher future income. It is going to take some time to get there, especially for households. Only after that point do banks jump in to finance expanding private sector optimism. It will be interesting to see what type of bank lending is going to grow the fastest. In the meantime, the accumulation of Government securities is raising the credit quality of overall bank assets.

Don't Look For Banks To Lend Anytime Soon, Except to the Government

As the FOMC meets and decides that things are better but not good there will also be, I imagine, some chatter regarding getting the banks to lend. Fair enough considering the bailout money. Banks, however, come out of recessions building up relative holdings in Treasurys before lending grows apace. Treasury holdings generally peak as a percent total bank assets a year or two after the recession is officially over (see chart).

Banks to are not going to let credit flow except to the Treasury because their liquidity hasn't materially improved -- certainly not with over 30% of bank assets tied up in real estate. The Fed can repo as much of these securities and loans as it wants, but the underlying collateral is still sitting on bank balance sheets. Banks have spent the past 25 years increasing their real estate assets to the point where the asset distribution looks like a mutual savings bank's.

Banks got that way, in part, because nonfinancial corporations don't need them like they used to. Firms borrow directly from the capital markets and use all sorts of financial engineering to get the average maturity and cost of funds that they want. The bump in C&I lending early in this recession occurred because credit markets were frozen and firms wanted to husband cash before their banks closed the credit line.

Looking at current ratios banks haven't even begun to reliquefy and there is every reason to believe the normal cyclical pattern will be followed -- banks will spend the next several years building up holdings of Treasurys relative to other assets. And making a good profit along the way given that their cost-of-funds is close to zero. The whole reliquefication process is going to take time and a lot of Treasurys. If you assume a repeat of the post 1990-91 recession experience with bank behavior and asset growth of 8% (average since 1973) then the weekly reporting banks will increase their Treasury holdings $1.7 trillion -- a 128% increase over 3 years. My view is that it is going to take a lot longer and banks will end up with a higher percentage of their assets in Treasurys. So if you were wondering who is going to bidding for all those Treasurys, the banks are.

Ten Year Bond Yields -- Technical Update

I know that most readers are not exactly enamored of using technical analysis as a guide to where prices are going. After all, the original drive behind the efficient market theory was to discredit technical analysis. That history is expertly recalleded in Justin Fox's wonderful new book "Myth of the Rational Market." From a personal standpoint, watching the ebb and flow of how people are spending their money instead of their opinions has more often given a true picture of where prices were going than, say, a reading the fundamental data.

My own technical view has been bullish on the 10-year, at least back to 3.0%, and after yields ran up to the top of their current channel (see chart of 60-minute bars) they are turning down, the short-term cycle is turning down and the RSI has broken below 50. None of this is a guarantee and unforeseen shocks (are there any others?) can turn market sentiment around in a hurry. But as of now, there are more buyers than sellers.

Corporate Credit Spreads -- Too Much Too Soon?

Count me among those that believe the downturn is ending -- not done but ending. But you can also count me among those that believe the coming upturn will look nothing like the upturns in evidence since 1982. Debt burdens will weigh on household spending and the lack of consumer demand will keep corporate spending and hiring in check. It is also important to remember that the markets are returning to some "normalcy" because the Fed is still holding this thing together with its alphabet soup of programs to backstop the capital markets. The need for these programs is abating but nevertheless still needed.

All this is preamble to a chart that Jeffrey Rosenberg at Bank of America/Merrill Lynch Research made showing where investment grade corporate spreads are relative to their cyclical narrows in May 2007 -- broken down by industry sector. The chart is reproduced below, for the whole article you need to contact Mr. Rosenberg or your BAC/MER salesperson. I think market participants are pricing some of these sectors a bit too expensive -- their optimism is bound for disappointment.

Employment -- Good News With Long-term Problems

Today’s headline news on employment was better than expected and delivers some optimism that the economy is turning the corner but a deeper look adds to my view that the accumulated loss in earnings power continues to grow and will be a significant drag on consumer spending for some time to come.

On the good news front, there were reported job increases in autos and the Federal government and a sharp decline in layoffs by temporary help services. Some of these changes reflect quirky seasonals but the diffusion index (percent of firms adding employees plus one-half of those neither hiring or firing) was at 30.1 in July – up from a low of 19.6 in March and the best number since 33 in October (see chart). But consumers still aren’t expected to spend so the retail industry continues to lose jobs at an accelerated pace, in particular general merchandise stores.

First fired, however, are not first hired. The average duration of unemployment has now extended to 25 weeks -- a 5 week lengthening over the past four months. The percent of unemployed that have been out of work for more than 27 weeks rose to 33% in July from 27% in June and 19.3% one year ago. The unemployed for more than 15 weeks is now 5.1% of the total labor force. As the accompanying chart illustrates, this is far and away the highest number of the post-war meaning since the Depression. As the economy makes its shift to a lower-leveraged version, re-employment will be slow. Combining these figures with the absolute year-over-year decline in wage and salary disbursements one gets an accumulation of lost earnings that will drag down consumption for a long time to come.

The Stock Market & The Insured Unemployment Rate -- Not A Pretty Forecast

The patterned relationship between the insured unemployment rate and the stock market (S&P 500) reveals that the "jobless" recovery means it is going to be a long time before the market gets back to its pre-recession high of 1560. Short-term cyclical relationship aside, the longer run picture for the insured unemployment rate suggests that the equity markets are going to be trading sideways in a range for a long time to come.

Elaborating the secular point, the accompanying chart shows the expected inverse relationship between the insured unemployment rate and the S&P 500. The market has been very good over the years of moving higher before the peak rate and reaching its cycle high just months before the rate hits its cyclical low.

Closer inspection of the chart reveals that ever since the 1982 recession the lows for the insured unemployment rate had been trending lower and the stock market cycled to new highs. During the current cycle we saw the insured unemployment rate bottom at 1.8% -- above the 1.6% low hit in 2000. At the same time, the S&P 500 was only able to eke out a top 2.8% above its previous cycle high -- 1527 in March 2000.

The equity market's stellar overall performance during those 20-odd years ending in 2000 was a catch up in value from the "lost decade" that preceded the 1980-82 recessions (a PE expansion thanks to disinflation). Disinflation and high real rates of growth kept pushing the insured unemployment rate lower. All of this was chiefly made possible by the strong dollar policy financing an inflow of foreign goods and capital that grew to unprecedented levels.

If, as Summers and others suggest, the recovery will be more balanced that means a competitively priced dollar, higher real interest rates, and less foreign inflows of capital to leverage up growth beyond the nation's ability to invest it in productive resources. Less leverage means slower growth and that means it will be quite some time before the insured unemployment rate drops to its coming cycle low. In addition, that low will be above the 1.8% low reached in 2006. What this means for the equity market is a long period of wandering in a trading range with little likelihood that the overall market will make new highs in the coming economic upturn.

Stocks In August -- A Volatile Month

One might think of August as a quiet month for the markets given that everyone is on vacation, think again. As illustrated by the chart below, August is the second most volatile month for stock prices, beat out only by October -- and not by much. From 1896 to 2009 the standard deviation of August stock prices (DJIA) has averaged 2.03% of its mean for the month. In October the volatility registers 2.22%. The August to October period is the most volatile while the least volatility occurs from December to February.

August is a month in which many of the world's major political and economic events first hit the news. A random sampling -- Britain declares war on Germany (1914), Nazi/Soviet Pact signed, the Battle of Britain began, U.S. dropped the Atomic Bomb on Japan, Gulf of Tonkin Resolution authorizes U.S. troops in Vietnam, 1971 90-day wage/price freeze, Nixon resigned, 1990 Persian Gulf War began, Hurricane Katrina and the current global credit crisis begins as far as the equity markets are concerned (2007).

The moral of this story for August vacations -- keep your family close and your Blackberry closer.

Treasury's Debt Plan: More Sales of TIPS

If you need any indicator that inflation will be the least of the problems policy makers are going to face in the near future it is --

The Treasury Department, seeking new ways to help fund its budget deficit, is likely to announce on Wednesday a plan to ramp up sales of inflation-protected bonds, according to people familiar with the matter.

China, the largest holder of U.S. government debt, is among investors that have indicated to the Treasury that they want to buy more of the securities, which offer protection against rising inflation, the people said.

China is obviously the main motivation for the Treasury to issue TIPs, and hopefully Treasury won't have to return to Carter bonds (U.S. debt denominated in another currency). Later in the article the WSJ moves into analysis and gets it a bit wrong --

Boosting issuance of TIPS would be one tool the Treasury could use as part of its broader debt-sales program. The government will have issued a record $1.8 trillion of debt in the 12 months through September, most of which was debt that pays a fixed interest rate, unlike TIPS, which pay out more as inflation accelerates. . . .

. . . . Demand for the securities is likely to increase as the economy improves and heavy federal spending on priorities such as health care push prices higher. It also would leave taxpayers on the hook for elevated interest payments if inflation remains high.

That isn't exactly true unless the Federal budget has moved to accrual accounting. TIPs carry very small coupons, smaller than the coupons on regular issues of similar maturity because the coupon on TIPs is effectively the "real" interest rate while the coupon on regular debt pays the real rate plus an inflation premium demanded by the market.

TIPs produce a stable real return for its holders because the prinicpal adjusts with the rate of inflation as measured by CPI - not seasonally adjusted. The fixed TIPs coupon pays interest on the inflated principal and the inflated principal is due at maturity. If inflation is higher then the government pays out the same real dollars in coupon payments. The principal is now being adjusted downward because of CPI deflation (food and energy are included). If there is inflation new regular debt will come with a higher nominal coupon -- so the Treasury pays more that way as well.

As for the inflated principal owed at maturity (between now and then buyers and sellers pay each other the accrued inflation premium when trading) the Treasury will issue more debt to pay off the TIPs at that time -- issuing the same real amount they are issuing today. So, in fact, TIPs are at best a cheaper source of financing for Treasury than regular bonds and at worst TIPs cost Treasury about the same.

The article goes on --

After the tepid response to auctions of fixed-rate bonds last week, Treasury officials asked some primary dealers whether they would be amenable to a new issue of 30-year TIPS -- which haven't been sold since October 2001 -- instead of five-year or 20-year TIPS, according to people familiar with the matter.

Demand for TIPS auctions this year has been robust, with last week's $6 billion reopening of 20-year TIPS garnering the highest demand in two years. The TIPS didn't entice only traditional Treasurys investors, but also those investing in stocks and commodities.

Everyone usually isn't right and the events of the past several years have proven that markets aren't particularly efficient or rational. If there is one constant, however, it is that market participants have been consistently awful at pricing future inflation. But if the Treasury can tap a cheaper source of funding, whom am I to argue.

Wages & Employment -- The Problem With Low Inflation & A Strong Dollar

Wage and salary disbursements are 6.5% below year ago levels compared with -6.0% last month and -1.2% in December. Wages never before declined during post-war recessions -- wage growth just slowed as layoffs grew (see chart). But now, as a byproduct of disinflation purchased with a strong dollar policy, wage levels are falling even though the decline in employment is smaller relative to total employment than it was in the 1973-74 recession. The implication for future consumer spending is not good.

The pace of wage declines will surely abate as layoffs slow and employment eventually increases. A slowdown in the decline does not necessarily mean positive growth in wages and by the time year-over-year changes in wages are positive the accumulated loss in buying power will be even greater than it is now. With wages falling and balance sheets overleveraged it is difficult to see consumers leading the economy out of recession.

All this underscores the importance of government spending -- and yes, spending is stimulus. As for the size of government borrowing, no one else is so it isn't a problem right now. As for all the future projections and warnings of "crowding-out", we should just recall that a few years back people, including Greenspan, were concerned about a shortage of Treasurys. In fact, that is why foreign central banks were encouraged to buy Agency debt beginning in the 1990s.

Lastly, it is time to put inflation concerns on hold.

Home Sales By Select MSA -- More Want To Than Have To

The recent spate of positive house price data have come with various caveats regarding the pricing from motivated sales (forced sales) versus non-motivated sales since a shift in the relative number of transactions in each impacts the average selling price. As a sign of the recovering home sales market, the ratio of sales of choice relative to forced sales has been on the upswing but really picked up at the beginning of May, particularly in Miami, Los Angeles and Phoenix. New York has been on the upswing since mid March while Las Vegas continues to struggle under the weight of too many speculative units (transaction data include condos). In absolute terms, the number of non-motivated transactions have been growing since the middle of January for most markets (see chart below, data from Radar Logic). Non-motivated sales in Las Vegas began to pick up in May.

The upshot is that a recovery in the housing market has begun, albeit at a very slow pace. My own leading indicators (www.econmkts.com/pangea_radar.php) have been pointing to rising home prices in most markets for some time.

July ISM -- Another Set Of Indicators Indicating Growth

The July report on manufacturing activity reflects an economy turning the corner from recession to recovery (see ISM's table below). The critical components are, from my perspective, the Backlog of Orders growing from 47.5 (contracting) to 50.0 (neutral) while Customer’s Inventories contracted from 43.5 to 42.5 and new orders jumped from contracting in June (49.2) to expanding (55.3). The turn is something that I have been pointing to these past several months in my various blogs examining leading indicators. Do not get thrown off by general commentary that one industry or another is still in the doldrums. The different sectors of the economy grow at different rates, some even contracting while others expand, and not all turn when the overall economy turns – either into recession or into recovery. The upturn I have forecast is going to be a slow process and it will be quite a while until employment is growing faster than the labor force.