Steve Blitz Morning Notes

Quick Take on FOMC Minutes: Letting the Hawks Have Their Day, Raising Downside Risks

2011-05-19T08:32:00.000-04:00

When does the Fed first tighten? We will know the answer by September. By that time the economy will have worked through enough of the current downside risks listed in the most interesting addition to the minutes. To the extent that the recovery is still intact by the fall we could very well see the first steps towards removing monetary accommodation in the fourth quarter. The more interesting question will be whether the Chairman has the support to do something if those downside risks cause the recovery to falter, and what that something would be.

The minutes contain what is, by now, the rather standard argument between the hawks and doves on inflation risk in a high unemployment economy. To me, the more important addition to the minutes is the much broader view on the potential for downside in the economy in the second half of the year:

“While rising energy prices posed an upside risk to the inflation forecast, they also posed a downside risk to economic growth. Although most participants continued to see the risks to their outlooks for economic growth as being broadly balanced, a number now judged those risks to be tilted to the downside. These downside risks included a larger-than-expected drag on household and business spending from higher energy prices, continued fiscal strains in Europe, larger-than anticipated effects from supply disruptions in the aftermath of the disaster in Japan, continuing fiscal adjustments at all levels of government in the United States, financial disruptions that would be associated with a failure to increase the federal debt limit, and the possibility that the economic weakness in the first quarter was signaling less underlying momentum going forward.”

I believe that this view is shared by Bernanke, Dudley and Yellen.

The hawks have the upper hand right now in driving Fed policy; the Chairman, Dudley, and Yellen will have their day again if the economy falters as they fear it will. It seems to me that there is no other rational political way for the Chairman to play his hand.

The “Great Stall” In Action

2010-10-08T15:07:00.001-04:00

Looking at the 64,000 private sector jobs created in September, after accounting for the usual 24,000 in health care, the rest were either in temporary business services or at restaurants (which is kind of temporary work as well). Thankfully people who are employed still like to eat out.

Against all this, local government employment contracts -- a sure sign of federal stimulus money falling away. There was also the announcement of a 300,000 jobs takeaway from the total because of benchmark revisions that go in effect in February. This essentially removes the net add from the BLS's broken birth/death adjustment

Here we are after nine consecutive months of growth in private sector jobs and the broad U-6 unemployment rate sits at 17.0% compared with 17.3% when the year began. Total private payrolls are just shy of 108 million -- the last time payrolls were this low, prior to the current recession, was March 1999. A decade of employment gains wiped out and at the current pace it will take another decade to get back to the pre-recession peak at 115.6 million. On the good news front, the tenure of long-term unemployment has been shrinking since May.

Unknown healthcare and tax costs are having a negative impact but not nearly as much as the lack of demand growth from any important sector of the economy. The policy plan now is to boost exports through a depreciated dollar with quantitative ease offsetting any rise in interest rates related to foreign debt holders wanting a higher yield to compensate for the loss on holding dollars.

The “Great Stall” Opens Volatility Season for Stocks

2010-08-05T09:09:00.001-04:00

The “Great Recession” didn’t give way to the “Great Depression” – rather it transformed itself into the “Great Stall”. The July ISM data underscored the current circumstance with reported declines in net new orders in the manufacturing and non-manufacturing sectors. It is hard to interpret the ADP reported increase of 42k jobs in July as heralding an upswing in employment, especially when it contains a drop of 21k jobs at goods-producing firms and a decline of 6k jobs at manufacturing firms. Unemployment claims for the week of July 31st are out this morning and have again surprised to the upside. Recognition of sustained low growth, plus the rising risk of deflation inherent with a stalled economy having substantial resource slack, will hit the equity market precisely when the volatility season begins and reaches its peak in October.

Fed Officially Between "Rock" and "Hard Place"

2010-06-23T15:44:00.000-04:00

The FOMC is officially worried about growth and deflation risk and they are at the ready to act if need be. Financial conditions have become “less supportive of economic growth” but don’t believe for a minute that the reason rests on ”developments abroad” -- the economic recovery is now “proceeding” rather than “continued to strengthen” while everything aside from business spending is either weak or depressed. The shift of the phrase regarding the “moderate pace of recovery” from starting the sentence about the Fed’s anticipation of a gradual return to full employment in the context of price stability to the end of the sentence and then starting the sentence with “Nonetheless” speaks volumes – in Fedspeak. More surprising was adding that “underlying inflation has trended lower” before their standard line about substantial slack and restrained cost pressures. The Fed is telling us that deflation risk is now on the table.

To underscore their concern about deflation and lower growth, the ”monitor the outlook” phrase was broken out into a separate paragraph. As for Hoenig’s dissent, it had to stay considering that its removal would’ve signaled that the Fed lurched to one step from pressing the panic button.

The FOMC is now confronted with limits of monetary policy when rates are zero. The banking system is stuffed with cash but the liquidity is sitting in reserves at the Fed essentially against legacy assets of too many bad loans and broken securities. The cash isn’t there to lend out—banks haven’t even taken down as many Treasury securities relative to total bank credit as they normally do at this point in the cycle. Nonfinanical corporations are also sitting on a mountain of cash, but it matches a mountain of long-term debt raised to put cash in the coffers and lower the volume of short-term obligations—and net worth is still well below the pre-recession peak. At some point, the corporate cash will go into hopefully productive capital investments, but the opportunities aren’t there yet.

The Fed is officially between the “rock” and the “hard place”

Consumers Drop the Baton

2010-06-11T09:43:00.000-04:00

Retail sales are not as negative as the headline, but they were also never as positive as April’s headline. Core retail sales, sales without spending for autos, building materials and gasoline, was up 0.10% in May after falling 0.22% in April. Discretionary retail sales, purchases of items people don’t have to buy, fell 0.05% in May after falling 0.26% in April. Positive and negative volatility in several spending categories can be tied to the boom in house buying in April. Bottom line, consumers only spend when they have to and they don’t spend much -- spending is not the recreational activity it was prior to the recession. Unemployment is still at extraordinary high levels, there is no equity to take out of homes, and the stock market has proven of late to be an unsteady source of wealth to fund purchases. This economy is still a long way from consumers picking up the growth baton from manufacturers. And manufacturers are facing renewed headwinds of their own, thanks to the cheapening of European exports into Asia. Second half GDP growth is not going to surprise to the upside.

May Employment -- This Is What a Deleveraging Economy Looks Like

2010-06-04T14:04:00.002-04:00

It is time to stop searching for the right letter to describe the recovery. It isn’t a V and it won’t be a W, it is a hyphen – flat, low growth indicative of an economy in the process of deleveraging. There is no other interpretation for an add of only 41,000 private jobs plus the downward revision to the April jobs numbers. The median number of weeks out of work climbed to record 23 weeks and of those unemployed 46% have been out of work for more than 26 weeks. And the data from Labor is that much more suspect – in the worst recession since the 1930s the birth/death add in the 12 months ending in May added 427,000 jobs against a reported decline of 831,000 jobs. Without the adjustment the number of jobs lost would have been 51% bigger. The percent of firms surveyed that are hiring plus one-half of those standing still dropped to 54.1% from 66.7% last month. Judging from still elevated jobless claims, the slowdown in new job listings posted on the internet, and the fading impact of government stimulus, it is difficult to see how job growth strengthens from here in a politically acceptable time frame to the levels that cut into unemployment.

Home and Equity Valuations -- Nowhere to Go But Sideways

2010-05-25T09:20:00.000-04:00

By focusing on the monthly bounces in the housing data one risks missing the bigger point – the two main assets supporting household balance sheets and, by extension, the global economy at large, have nowhere to go but sideways. Equities and homes are priced to a level that can be appraised as fair or expensive, depending on one’s view point, but neither can realistically be called cheap.When the equity bubble popped in 2000 the economy could weather the collapse because a housing bubble could replace it. A “bubble-swap” followed by "double-burst" occurred in the late 1970s, when the culprit was a deep recession followed by soaring price inflation followed by a deeper recession. Today there is no potential for unlocking domestic equity valuations as there was in 1982. As for housing, it took 20 years before the real dollar volume of existing home sales cracked the high of the late 1970s. The potential for global growth is locked up in the Asian trade surplus. Once that spending power is unleashed on the world real economic recovery can begin. Until then, governments can only buy time by swapping leverage for leverage. Majestic Research

Retail Sales -- Less Than Meets The Eye

2010-05-14T09:45:00.000-04:00

The consumer is back but only for holidays, birthdays and anniversaries. Yes, the April data are a payback for the boost to March from the early Easter but to end the analysis there is to understate how much more careful consumers are about spending their money. Control retail sales (sales less autos, gasoline, and building materials) were down -0.25% against a 0.66% raise in March. Spending on purely discretionary items were also down -0.26% in April. With more hiring and fewer layoffs, consumption is set to grow but not drive the economy. If it does do the driving, it would mean lower savings and that ensuing romp through the mall will end up being short-lived. Recent downside volatility in the equity market should, if anything, reinforce the notion that try as consumers might to convince themselves otherwise, the outcome of this recovery and the recovery of their portfolios are not yet assured. Read more -- Majestic Research

Trade Balance Improved

2010-05-12T10:26:00.001-04:00

The headline number showed the trade balance worsening by $996 million in March and the culprit was oil prices. The balance of trade in services improved by $813 million and the balance of trade in goods net of oil improved by $296 million – a $1.1 billion improvement in the balance of trade. As far as GDP accounting is concerned, the headline number, which includes oil, is what counts. But when counting on an export driven recovery and the impact of that on the rest of world, it is the non-oil deficit that matters. All in all, strong export growth is the reason why business spending is up along with rail traffic in containers. So far so good, but there are quite a few black swans swimming around in the middle of the pond. Continued positive momentum in trade is anything but assured.

Employment Data Diffuses to Stalled Weakness

2009-11-06T10:43:00.003-05:00

The obvious truism is that turning monthly job losses into gains means getting firms to hire and the Diffusion Index shows that along those lines the number of firms adding workers has only managed to improve to levels equal to the lows of previous post-war recessions.

To Read The Whole Article Please Go To Pangea Market Advisory

Third Quarter GDP -- Does One Quarter Make A Trend?

2009-10-29T11:31:00.001-04:00

Even after accounting for government-program induced spending on cars and homes, there were enough positive signs in the data this morning to signal that a statistical end to the recession has occurred. The big jump in GDP will. . . .

To read the whole article go to Pangea Market Advisory

Durable Goods Orders - The Fed is Debating What?

2009-10-28T17:15:00.001-04:00

We are all guilty of converting data into changes, percent changes or percent changes of the percent change for the purpose of identifying early a change in trend. I thought it would be a good idea today to just look at the dollar amount of new orders for durable goods without putting the series through a series of mathematical calisthenics (see chart below). Not being able to resist some sort of contortion I show the series in real dollar terms as well. Either way, the stark collapse in orders and the meager bounce from the bottom suggests what today’s consumer survey told us – the economy has bottomed but it isn’t bouncing.

Read the whole article -- go to Pangea Market Advisory

Bernanke Calls For Balance & Asia Could Care Less

2009-10-19T15:41:00.001-04:00

Fed Chairman Ben Bernanke spoke today on "Asia and the Global Financial Crisis" at the Federal Reserve Bank of San Francisco’s Conference on Asia and the Global Financial Crisis, Santa Barbara, California. This call for balanced growth policies in Asia has been made before by Bernanke, Geithner, Summers and others. The call appears to be falling on deaf ears as far as Asian exporters are concerned. Here are some excerpts from today's Bloomberg News article "Won Crushes Yen as Dollar Substitute in Asian Rally" --

To read the whole article free of charge go to Pangea Market Advisory

Capacity Utilization, Fed Policy, Oil and China -- One Big Gordian Knot

2009-10-16T12:31:00.003-04:00

The production and capacity numbers released this morning indicate that the recession likely ended in June. But it as important, if not more so, to recognize that the reported 70.45% capacity utilization rate only just reaches the 70.93% low of the 1981-82 recession (the previous worst economic crisis since the Depression). The importance of this indicator owes to the Fed’s historic consideration of capacity utilization as the best real time indicator of economic activity (see the working paper “Improving Real-Time Estimates of the Output Gap” by Thomas Trimbur). From the official end of the past two recessions it took the Fed 38 and 32 months respectively before the first increase in the funds rate (see chart). The timing, of course, depends on how fast spare capacity is taken up. After the 2001 recession it took 32 months for capacity utilization to go from 73.53% to only 77.74%

To read whole article go to Pangea Market Advisory.

Cash for Clunkers -- It Worked!

2009-10-14T16:39:00.000-04:00

The "cash-for-clunkers" program has been the subject of more negative comments and bad puns than anything an administration has put out for a long long time. Most of the comments have focused on the program's inevitable failure to permanently raise the level of spending for autos and/or anything else. By extension, the reaction is that Obamanomics is a complete bust. Political rage absent of thought to other possibilities is not the best way to go through life, unless your goal is to get crankier as you get older. The chart below plots out auto industry inventories, sales, and the inventory/sales ratio.The cash for clunkers progam moved the auto industry out of depression and into recession at an extraordinarily rapid pace. This saved a lot of investors, public and private, a lot of money,

We can see now that the program was never really intended to be a permanent boost to sales, I think even Larry Summers and Ben Bernanke knew that. The cash for clunkers trade was meant to alleviate an extraordinary overhang of unsold cars under which an entire industry was about to collapse. Normal recession metrics for sales, inventories, and production are now in play and they will be for some time but the government accomplished what it set out to do -- saving an industry and giving it the time to do what's necessary to save itself short-term and for the long haul. It will be a while before we know whether the auto industry finally gets it right, but at least they now have the time to figure it out.

Retail Sales - A Question of Momentum

2009-10-14T12:01:00.000-04:00

Pronouncements that the “Great Recession” is over require third quarter spending to continue into the final three months of the year. While it looks like Wall Street employees will have the cash to buy holiday gifts, the country is a lot bigger and today’s retail sales give some pause to the notion that the economy has positively turned positive.

To see charts and read whole blog, please go to Pangea Market Advisory

Stocks & Bonds -- In Synch

2009-10-09T17:14:00.002-04:00

In the past several years there have been some divergent valuations between the credit and equity markets, with the equity market tending towards the more optimistic. The chart below compares the P/E ratio of the S&P500 Industrial sector to the option adjusted spread (OAS) of the Merrill Lynch BBB Coporate Index. This chart of daily data covers the period from Jan 2002 up until yesterday. The data points for the past month are in red.

If there is undue optimism in the market it is shared by bond and equity investors. The P/E ratios travelling between 14 and 16 line up on the marginally conservative side relative to OAS levels just over 300 basis point -- but keep with the general trend of lower OAS translating into higher P/E ratios. In sum, the credit and equity markets are cautiously optimistic over future earnings and the ability to pay off debt. This isn't to say they are right, only to say that there is a reasonable consensus.

The Price of Gold Says Nothing About The Dollar

2009-10-08T18:45:00.000-04:00

The price of gold is up sharply and so is the chatter about inflation, debt, and the demise of Western Civilization. At a time when the critical global economic issue is unbalanced growth the golden chatter ignores gold’s price in real dollars versus gold’s nominal price in yen, euros, and sterling. If the U.S. is coming apart at the seams how come the real dollar price of gold is only 66% of the 1980 peak? Why does the yen today buy as much gold as the dollar does and also as much as the dollar did in 1980? Gold costs less for Europe than it does for Japan or the U.S., fair enough, but gold also costs Europe 1.5 times more than it did when gold peaked globally in 1980.

Go to Pangea Market Advisory to see the whole article.

Technical Outlook for 10-Year Treasury Yield -- Update

2009-10-07T16:22:00.001-04:00

I have been writing on the technical outlook for Treasury yields for some time and since the spring my forecast has been for a second half rally based on two factors. First, Treasuries rally in the second half of the year. I can not give anyone a good reason why that should be true, market prices really should not have any seasonal bias, but I have been around long enough to recognize a strong pattern when I see one and not let fundamentals get in the way. Second, yields and inflation bottom in the first year of economic recovery -- and we haven't turned that corner just yet. If you want to be optimistic and say the recession ended in June (a view I do not share, as my work tells me the fourth quarter will be negative for real GDP) then the bottom for yields occurs next year.

As for the current marketplace, the chart below shows that yields have dropped through some key selling pressure and the 10-year is set to at least challenge 3.00% and more likely to drop to a 2.80% yield. This is all on target with my writings in the spring and there is certainly nothing to dissuade me now.

Longer-term please understand that the market is building a base to finally break through the downward yield channel that dates back to 1986. Look for the big break to higher yields to begin in the first half of 2010.

Part and parcel with the recovery is higher real yields to temper the leveraged consumption growth that was so damaging to the structure of the economy. This is going to be a capital spending expansion, if the policy makers get it right, supported by a revalued yuan and yen. Can we stop talking about the horrors of a depreciated dollar and begin talking about ending the unfair competitive nature of Asian trade policy -- keeping their currencies unreasaonably cheap in order to keep their labor cheaper. But that is a tale for a different article.

The V Flops to an L as Duration of Unemployment Hits a New Record

2009-10-02T10:59:00.004-04:00

The September employment data and attendant revisions should put to rest any notion of a “V” shaped recovery . . . .

To read post please go to Pangea Market Advisory

New Orders Index Bodes Well For Employment, CDS Spreads Augur Caution

2009-10-01T18:42:00.001-04:00

On the eve of the September employment data, the ISM data released this morning bodes well . . .

To read the rest of this article please go to Pangea Market Advisory website.

Corporate Cash & Capital Spending

2009-09-30T16:19:00.002-04:00

Second quarter GDP data for corporate profits present a level of cash flow that has usually been prologue to. . . .

To read whole article go to Pangea Market Advisory

October Stock Market -- Most Volatile of All

2009-09-29T17:50:00.003-04:00

The calendar turns to October -- historically the most volatile month in the year (see chart). It is also telling that the average price change for the month is close to zero (see chart). In other words, there is no bias to the direction of price in the first month of the fourth quarter -- only that prices get there with a lot of noise. The biggest down October

To read complete blog go to www.econmkts.com

There's no V in Durables

2009-09-25T09:49:00.004-04:00

It is important to remember that durable goods data are notoriously volatile from month to month so patterns and trends inform more than point estimates. Looking at nondefense capital goods less aircraft the pattern of sales, shipments, unfilled orders and inventories suggests that the worst of the recession is over but we are far from recovery of any shape let alone a V.

Inventories and sales are still in deep negative territory on a year-over-year basis. For those looking to shorter measures of momentum -- new orders are down for the second consecutive month. To the extent that inventory restocking is supposed to help lift the economy past the current quarter, the ratio of inventories to new orders has peaked but the ratio is only down to the peak levels of the 2001 recession (see chart).

All told this isn't great news for the hawks squawking about V-shaped recoveries and inflation. The economy is better in that the economy has moved into a mild recession from a near economic collapse. There is still a long way to go.

Recovering Is Not Recovery And The Fed Is Still A Long Way From Tightening

2009-09-23T14:40:00.007-04:00

The Fed has moved from agnostic to true believer when it comes to economic recovery. More specifically, they see a "V" shaped return to positive growth as a better bet than a slow upturn. They signaled their upgrade of the economy's prospects by stating that economic activity has "picked up" rather than "is leveling out" (August statement) and that the FOMC now believes their policies will "support a strengthening of economic growth" rather than "contribute to a gradual resumption of sustainable economic growth".

The Fed is going to test its belief first by reducing their support of the credit market. They signal that the financial crisis is over when they state that the Fed will now only "continue to employ all available tools" rather than "employ a wide range of tools". The narrower need for policy options is underscored by the FOMC pushing out the finish line of its plan to purchase $1.25 trillion in agency mortgage-backed securities from year-end to March 2010. Buying less per week means less market support and you can be sure that should conditions warrant they will end up owning less than the targeted amount. The proof-in-the-pudding will be how credit spreads react as the Fed begins tip-toeing away from the market.

Belief, however, is not certainty and the Fed made sure to let everyone know that it sees only a "gradual return to higher levels of resource utilization" -- meaning high unemployment and low factory usage is going to be with us for quite a while longer. Capacity utilization is the Fed's real time indicator of when the punch bowl needs to leave the party and utilization rates are still below the lows of the previous recessions (see earlier blogs). "V" shaped or not, it will take a long time before we see levels that made the Fed tighten in the past. Therefore the FOMC "expects that inflation will remain subdued for some time". To underscore the greater impact of resource utilization on overall inflationary pressures, the FOMC removed any reference to energy and commodity prices.

In other words first steps first -- remove the market's liquidity underpinnings before even considering a higher Federal funds rate. And if past is prologue we will be well into 2011 at best before the funds rate is above 0.25%.

V is for Victory, Not Recoveries

2009-09-23T13:38:00.005-04:00

As we wait for the Fed to hint to us their plan for scaling back their security holdings (they are already talking with broker/dealers regarding reverse repos) there has been a rising chorus of economists, analysts, and pundits singing that not only is the recession declared to be over but that the shape of the recovery will be a V -- a sharp upturn with inflation risk is on the rise. The Treasury market doesn't appear as worried.

Considering the track record of this chorus during the past several years why would anyone would believe they've got it right now. Bernanke's assertion that the recession is over must be taken in context with his proclamations that the sub-prime housing collapse was not going to effect the broader economy. Better that the Fed Chairman is a cheerleader than a doomsayer but that is beside the point. There is no question that the current quarter will be positive, probably to the tune of a real 2.0% SAAR. This is just the math that comes off of increased auto spending and a decreased pace of inventory de-stocking. The fourth quarter is likely to be negative.

The recovery will come but only grow slowly. The economy is still sitting with capacity utilization below the lows of the past two recessions, job losses are continuing, and remember that the recovery of the past decade, one of the more anemic ones on record, was built around getting overleveraged to buy a house. Where exactly is this V coming from?

As to the fourth quarter, this is the headline in today's WSJ -- "Holiday Jobs Look Scarce as Pessimism Grips Retail"

Nearly half the nation's 25 biggest retail chains expect to hire fewer holiday workers this season than they did last year, another sign that retailers aren't counting on recession-strained shoppers to relax the tight grip on their pocketbooks this year.

About 40% of stores surveyed across a broad swath of retailing, including consumer-electronic chain Best Buy Inc., teen-retailer American Eagle Outfitters Inc., and luxury-goods seller Saks Inc., told the Hay Group, a human resources consulting firm, that they expect to hire between 5% and 25% fewer temporary workers this year than last, when the recession forced many retailers to trim staff in response to falling sales.

That's a grimmer outlook than the Hay survey found a year ago, when 29% of retailers said they would be slashing their holiday workforce. . . .

. . . . A third of retailers in the survey said they expect sales during Christmas to decline 5% to 25% this year. Another third expect sales to remain the same as last year. Researcher Retail Forward estimates last year was the worst selling season in 42 years with sales declining 4.5% in the fourth quarter. It also issued a forecast predicting sales will be flat with last year's weak numbers.

"Retailers are not planning inventory or staffing for any sales growth this holiday," said Craig Rowley, vice president of the global retail sector for Hay Group.

Fewer holiday jobs will only make retail sales worse, said Mr. Katz, the Harvard labor economist. "It is what we call the multiplier effect -- consumers are pessimistic about the jobs market, so they are not shopping as robustly, and as firms continue to not hire or lay off workers, consumers get more pessimistic," he said.

Bit since this is a banking day, the accompanying chart points up why the banks aren't going to be opening their pocketbooks to lend. In every cycle banks repair by boosting securities holdings relative to loans and leases. The current one is no different and it has only really begun. Further, so much of the loan growth has been centered in real estate, commercial and residential. Who are they going to lend to next to rebuild their books?

Housing Starts/Completions Signals Bottom Not Growth

2009-09-17T10:42:00.005-04:00

The single-family home implosion kicked-off the "Great Recession" and it appears that the collapse is over based on the ratio of starts to completions (see chart). This will be another factor helping GDP turn in a positive growth number in the current quarter. Unfortunately the boost is unlikely to carry through into the final three months of the year.

Behind the implosion was an extraordinary excess of building driven by demand levels pulled from the future and pushed by too-cheap credit. It couldn't last forever and it didn't and builders went over the cliff. Housing cycles by nature are inventory driven. Down cycles consequently see starts below completions and the end is signaled when starts and completions move back to balance. As the chart below indicates, this is where we are and it also has generally coincided with a recession's end.

But this housing cycle is different. In the past, housing demand fell off because of weak income and falling employment. The recession consequently built pent-up demand for homes that was unleashed when the economy turned. This time around future demand was satisfied before its time and those that lost their homes because they bought too early in their life-cycle are unlikely to be getting a mortgage in the near future. The consequence is that the current downturn isn't building unsatisfied demand for new homes -- it is only getting the demographic supply/demand equation back into some normal cyclical balance. Starts will, of course, stay low enough long enough for pent-up demand to build and eventually push the housing cycle forward. The key is knowing when pent-up demand is exceeding available inventory by enough to kick-off a new cycle in building.

Given that the housing industry appears to have finally gotten starts in line with demand, it will still be a while before pent-up demand builds. At least the first part of the housing correction is now completed. For real GDP growth this means an add to the 3rd quarter but the boost from housing is unlikely to carry forward and help 4th quarter GDP turn in a positive number.

Capacity Utilization, Fed Funds, & The Hi-Tech Economy

2009-09-16T10:28:00.006-04:00

Production and capacity data released this morning and Bernanke's comments yesterday have market participants stirring that the recession is over and figuring out how to best price-in the possibility it is true. Capacity utilization data are important because they are, by the Fed's own research, the best real time indicators of when to begin taking away the punch bowl. While the market is premature in pricing in a tightening given the historic relationship with factory utilization, the coming cycle may see the Fed stay on hold for an even longer period. Data are proving out that hi-tech is an increasingly pro-cyclical industry and so the Fed now has a new industry to consider before raising the cost of borrowing.

In response to this morning's data the Jan 2011 Fed funds contract is down near 10bp in price -- an implied yield of 1.5%, an expectation of a more than 130bp increase in the funds rate between now and then. While this is more realistic than last August when the Jan 2011 contract was priced to a 2.25% Fed funds rate, 1.5% is still out of line with historic experience. The Fed waits for utilization rates to recover quite a bit before acting, as illustrated below and as I wrote a few weeks back ("Before the Minutes -- Capacity Utilization Says At Least 35 Months Before First Rate Hike". Those 35 months are still there at a minimum considering that utilization rates today are still far below the lows of the past three recessions. You can still bet against Fed tightenings.

Further supporting the case that it is going to be a while before the Fed begins to take away stimulus is to compare factory utilization rates for hi-tech with the auto industry. Automobile manufacturing may be the industry of what was but it is still big enough to impact the overall stats for manufacturing activity. So before dismissing the poor state of factory activity in the U.S. as an automobile-induced event, it is worth seeing how some other industries are faring. Oil and gas extraction, for example, remain at full capacity. Hi-tech is a key industry to watch because it offers, with its virtual highway, the road map for U.S. industrial growth. The chart below illustrates that since the 2000-02 dot com bust the sector appears to be much more pro-cyclical. In fact, utilization rates in this decade never topped the late 90s levels let alone the Y2K-induced peak in 2000-01. There is a reason why Bernanke noted the fragility of the upturn. He is going to wait a long time before making industry pay more for the credit off of which the economy expands.

Discretionary Retail Sales Turn Positive ... But

2009-09-15T09:26:00.004-04:00

This morning's release of August retail sales signaled good things for the economy most specifically because discretionary buying was positive. The overall number was not too much of a surprise given auto sales and the run-up in gasoline prices. But general merchandise store sales were up 1.6%, clothing store sales were +2.4% and sporting goods, hobby, book & music stores saw sales increase 2.3%. As the chart below indicates, this is the first solid monthly gain for all three categories since the recession began. There are always some quirky seasonals and weather issues that can front load, at this time of year, back-to-school sales. Because incomes continue to be squeezed and jobs are still being lost, one should be cautious about putting too much optimism into one number. Nevertheless, a plus is better than a minus and underscores that, at the very least, the world isn't still coming to an end. The greater economic challenge, if all this is going to work out in a sustainable manner, is for domestic production to feed domestic demand. To this end, the tire tariff is only the opening shot to protracted negotiations to create more balanced trade.

U.S. Dollar Depreciation Reflects Portfolio Shifts Not Shifting Terms of Trade

2009-09-11T08:34:00.006-04:00

The hand-wringing over the depreciating dollar has begun anew and again it is focused on the wrong metrics. Currencies are supposed to change in value in order to re-balance the terms of trade. Take a look at the chart below of the 90-day percent change in the Fed's Trade-Weighted Dollar Index against the Major Currencies (Euro, Sterling, Yen, etc) where the U.S. trade deficit isn't and against the OITP (Other Important Trading Partners -- Brazil, Russia, India, China) where the U.S. trade deficit is. In the last 90-days, the dollar has depreciated near 8% against the major trading currencies and only -1.5% against the OITP.

Incredibly, but not surprisingly, the negative rate of change for the OITP shows improvement -- this is the group of currencies, notably the Yuan, where the dollar mispricing is most grievous (see chart below) considering the trade gap that was and is growing again. What the currency movements most likely reflect is a global portfolio shift out of dollar assets into UK, Euro, Japanese, Aussie and Canadian assets. But the price movement that can begin to help address trade gap with the Pacific Rim has yet to occur in earnest.

Treasury Yield Curve -- The Ratio To Recovery

2009-09-10T15:27:00.003-04:00

Negative yield curves presage every recession and steeply positive ones are necessary to pull the economy out of a downturn. Positive curves work because they rebuild bank balance sheets and punish investors for holding cash. An interesting facet of post-industrial America (the U.S. economy since the 1980-82 recession) is that each recession has needed successively steeper yield curves to move the economy forward. Rather than look at the spread of 10-year Treasury yields to 2-year or 1-year yields I charted the ratio. I did it this way because the sharp decline in the yield environment means that a basis point of spread is worth more today. The steepening necessary for this recession, to the surprise of no one, is staggering.

There any number of reasons why steeper and steeper yield curves have been needed but my favorite is that the financial sector has effectively become the economy's core and the positive curve is a government bailout -- so why not take bigger risk the next time around. It would be nice to say that the current episode is the end of a trend but with re-regulation fading and too-big-to-fail banks getting bigger and a huge Federal deficit requiring the real yields to attract foreign capital, my guess is the end isn't here.

U.S. Trade Deficit -- Pacific Rim, Yet Again

2009-09-10T12:07:00.003-04:00

If the U.S. economy is going to recover with the balanced growth that policy makers are touting the trade relationship with the Pacific Rim (meaning China and Japan) has to change and it has to change first with currency revaluation. The trade data released today are a mixed bag that indicate a stabilizing economy but also the same trade patterns now deeply entrenched. The deficit grew most where it is centered -- in the Pacific Rim. Policy seems to be tilted for the most expedient route out of recession and waiting to address the balanced growth issue at a later date.

But the issues can not be treated sequentially, growth requires addressing the trade balance now. During the previous expansion it took some time before growth in spending on capital equipment took hold. It was generally viewed that to meet domestic demand the incentive was for domestic firms to invest overseas in plant and equipment and labor. There is no reason for firms to act differently this time, especially given the excess in global productive capacity. There is also plenty of excess capacity here and prices for labor and capital and structures could fully adjust downward accordingly but the order of the day is to avoid deflation and that is an order worth following.

Consumer Credit -- More Contraction To Come

2009-09-09T11:54:00.004-04:00

Yesterday's report that consumer credit contracted $21.6 billion in July marks about one year of diminished household borrowing and the outstanding amount is now firmly in negative territory when it comes to year-over-year comparisons. There was a bit of hand-wringing yesterday about what to do given that no borrowing means no consumer spending and without spending. . . There really isn't much that can be done as a quick fix given falling wages and depressed asset values.

The accompanying chart illustrates the ratio of consumer credit to wage and salary disbursements. As you would expect, the ratio has been rising steadily but without asset values growing there is a natural ceiling to how much current income is going to support debt. Home and equity prices are steadying but job losses continue and wages disbursements are below year-ago levels, so there is every reason to believe debt/income ratios are still well above desired levels and that outstanding debt levels have only begun to fall.

The Poor Market for Labor Confirmed by Manpower Employment Outlook Survey

2009-09-08T11:21:00.004-04:00

Last Friday I wrote that the August Employment data were better but not good and that there is still a long way to go before hiring turns positive and the Fed thinks about heading for the exits. Today's Employment Outlook Survey by Manpower only underscores my view and suggests that the shorter end of the Treasury curve should be flatter still.

The survey reveals that the employers expect a net decrease in the rate of hiring, quite weaker than the survey results from last quarter and compared with one year ago. In fact, the -3% reported is the lowest level since the survey began in 1962. Every region of the country will be hiring less, the worst being the Northeast and the South, registering 0%, is the best. The table below shows the breakdown by industry -- all are dropping save for education and health services.

Employment -- Better But A Long Way To Go

2009-09-04T12:34:00.004-04:00

Losing jobs at a slower pace only says that the “deep recession” is over and a milder downturn is underway. Talk of data turning positive and central bank exit strategies is putting several carts in front of the horse. It is true that the pace of layoffs is tailing off, but the average duration of unemployment remains at 25 weeks, a third of the unemployed have been so for 15 weeks or longer and the broad underemployment rate jumped up to a cyclical high of 16.8%.

The BLS birth/death adjustment also continues its upward trend, making the payroll numbers somewhat suspect. On a 12-month basis the b/d adjustment added 864,000 workers to the payroll compared with 838,000 for the 12-months ending in July. If not for the adjustment, the total number of jobs lost in the year ending in August would be 15% larger. When the revisions to the data are made much of the b/d adjustment will be wiped out and, perhaps, even turn negative.

Employment is a lagging indicator but to the optimism that an end is near I compare the diffusion index of employment change (the percentage of firms surveyed that are adding workers plus half of those holding jobs steady) to the change in payrolls (see chart below). The diffusion index of employment change has been rising the past several months and it increased in August to 35.2% from 29.9% in July. Jobs aren't added in earnest until the diffusion index is over 50 and the index is still well below the lows of the past three recessions.

The poor prospect for employment growth lies in the continuing accumulation of loss in wealth and income resulting from lower employment levels, the extended period of unemployment, and the increased number of marginal and part-time jobs taken when work can be found. There is a cyclical component to these figures but also a structural one. In other words, the prospect of consumers driving the economy is a long ways off.

An interesting side note to the August data is the loss in government jobs. While the Federal government is trying to do its part it is being more than offset by job losses in the Post Office and in state & local governments.

After The Minutes -- Reaffirmation of a Troubled Economy

2009-09-02T15:07:00.003-04:00

The minutes of the August FOMC meeting have been released and it reveals policymakers still very much concerned about the economy's health. Earlier today I wrote that it would be 2012 before the Fed starts tightening. In today's minutes (italics mine):

". . . given their forecasts for only a gradual upturn in economic activity and subdued inflation, members thought it most likely that the federal funds rate would need to be maintained at an exceptionally low level for an extended period."

As for the tenuous underpinnings of recovery, the Committee cites (italics mine):

"Conditions in the labor market remained poor, and business contacts generally indicated that firms would be quite cautious in hiring when demand for their products picks up. Moreover, declines in employment and weakness in growth of labor compensation meant that income growth was sluggish. Also, households likely would continue to face unusually tight credit conditions. These factors, along with past declines in wealth that had been only partly offset by recent increases in equity prices, would weigh on consumer spending. . . . very substantial excess capacity in many sectors; this excess capacity, along with the tight credit conditions facing many firms, likely would mean further weakness in business fixed investment for a time."

As for the upside, the FOMC offers (italics mine):

". . . less-aggressive inventory cutting and continuing monetary and fiscal policy stimulus could be expected to support growth in production during the second half of 2009 and into 2010. In addition, the outlook for foreign economies had improved somewhat, auguring well for U.S. exports. Participants expected the pace of recovery to pick up in 2010, but they expressed a range of views, and considerable uncertainty, about the likely strength of the upturn--particularly about the pace of projected gains in consumer spending and the extent to which credit conditions would normalize."

I noted in previous posts how inventories are a weak reed on which to rest a growth forecast. We also know that export growth is a key to the recovery (watch for continued pressure to weaken the dollar against Asia), as to the impact of policy stimulus the FOMC offers this assessment --

"The improvement in financial markets was due, in part, to support from various government programs, and market functioning might deteriorate as those programs wind down. . . . All categories of bank lending had continued to decline. . . .

. . . fiscal policy helped support the stabilization in economic activity, in part by buoying household incomes and by preventing even larger cuts in state and local government spending. Participants generally anticipated that fiscal stimulus already in train would contribute to growth in economic activity during the second half of 2009 and into 2010 . ."

There are also a few throw-aways in the Minutes regarding inflation risk -- after all the Fed needs to keep that group from steepening the curve too much. Disinflation is, as was noted in the Minutes, the greater risk.

In all, a sober assessment of what lies ahead. Thus far policy has only succeeded in slowing the decline. Without foreign growth and a weaker dollar there is no obvious demand driver to sustain economic expansion. It is going to be a long haul before the economy is up and growing, and that is what the Fed has let us know.

Before The Minutes -- Capacity Utilization Says At Least 35 Months Before First Rate Hike

2009-09-02T11:25:00.005-04:00

If the slight uptick in capacity utilization in July (68.5 vs 68.1) marks the recession's end then we can figure at least 35 months before the Fed's tightening cycle begins. We know now the Fed uses capacity utilization as the real time indicator of economic activity (see "When Will Fed Tighten?. . .") that gauges when to begin taking away monetary stimulus. As the chart below indicates, capacity utilization bottoms with recession's end and the Fed's policy response has always lagged. Back when inflation was more of a problem the lag was shorter (see table below). After the past two recessions the Fed waited for capacity utilization to be near 6% above its low before tightening -- and that took 35 months on average.

Current events conspire to give us a much longer period before the Fed acts for many reasons, among them are the severity of the downturn and the damage to consumer balance sheets. Waiting for a 6% increase in utilization rates means taking away monetary stimulus when usage is still below the lows of the previous recessions. With inflation far from a problem and export growth a priority, the Fed is going to want more than a 6% increase in usage before the tightening cycle begins anew.

The January 2011 Fed funds contract is trading at 98.56 implying an average effective funds rate of 1.44% or about 120 basis points above current levels. You can look at the forward rates implied in the Treasury yield curve and find similar expectations of Fed tightening. Seems to me the market is way off base. It will be 2012 before the tightening cycle begins.

Capacity Utilization & When The Tightening Cycle Begins

	Recession's End Month
	Nov-70	Mar-75	Nov-82	Mar-91	Nov-01	Jul-09
Capacity Utilization	77.85	74.46	71.47	78.73	73.63	68.07
Fed funds Rate	5.6%	5.5%	9.2%	6.1%	2.1%	0.2%

Months To First Rate Hike	16	24	7	38	32	??
Capacity Utilization	83.69	83.77	74.06	83.39	77.74	72.15

Capital Utilization %Ch	7.5%	12.5%	3.6%	5.9%	5.6%	6.0%

September Stock Swoon -- Some Details

2009-09-01T19:18:00.005-04:00

It is absolutely true that September is the unkindest month as far as stock prices are concerned. While August and October are the most volatile months (see "Stocks in August -- A Volatile Month"), September is the only month with a negative average return -- based on the S&P 500 from 1896 to 2009 (see chart). Lest one think that the September average is skewed by a few big down months -- t'ain't true. Of the 113 Septembers from 1896 to 2008 only 49 registered positive returns and in the past ten years Septembers have been much more negative than not. Why this should be true is not clear to me but judging from the above average positive returns in July and August perhaps it's because the adults have returned from summer vacation.

No Inventory Growth In Goods Or Labor

2009-09-01T12:04:00.004-04:00

This morning's ISM reported that we are finally seeing outright expansion in manufacturing rather than contraction at a slower rate. Welcome news but be careful in broadening out the impact of this data too far. The sharp upturn in ISM New Orders does not mean positive growth in inventories and labor anytime soon. Overall labor and inventory rebuilding are much less impacted by new orders than they used to be. True, the cycle upturn in employment and inventory restocking duly follow new orders but the turn will be to less negative numbers not positive ones. This is the stuff of a milder recession not economic recovery.

The chart below plots inventories and new orders and clearly illustrates how inventory swings relative to new orders are much smaller than they used to be. The histograms plotted on the axis show that the average inventory number shows continual contraction while the new orders index average of just less than 60 is strongly expansionary. Firms on the whole have continued to shed inventory as part of the "just-in-time" process. The sharp drop in demand in this cycle proved out that manufacturers and retailers still had too much stock on their shelves. Looking forward, manufacturers are going to be extremely cautious in rebuilding inventories and the ISM Inventory Index is unlikely to move over 50 for a long to come. In the 1990s, in fact, it never did. I reiterate what was written in my past several blogs -- economic models basing 2nd half growth on inventory restocking will be overestimating the upturn.

I also have a chart comparing new orders to employment. Here we see that the upturn in manufacturing orders has meant less new jobs with each cycle. The smaller number of manufacturing employees has a lot to with the lessened impact of new orders on the overall jobs total. But there is also the point that, as with inventories, the sudden drop in demand left firms much more surplus labor than they thought -- and they will be cautious before adding back employees. Look for the pace of job shedding to abate and it will be several months more before the employment data indicate economic expansion.

Wages, Salaries, Retail Sales & Inventories

2009-08-28T14:47:00.003-04:00

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

2009-08-27T12:47:00.005-04:00

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

2009-08-26T11:15:00.006-04:00

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

2009-08-25T11:11:00.003-04:00

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

2009-08-24T09:08:00.002-04:00

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

2009-08-22T12:28:00.003-04:00

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

2009-08-21T12:02:00.003-04:00

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

2009-08-21T10:45:00.007-04:00

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

2009-08-20T16:39:00.004-04:00

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

2009-08-20T10:25:00.009-04:00

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

2009-08-17T15:42:00.006-04:00

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

2009-08-17T11:54:00.006-04:00

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

2009-08-13T14:12:00.004-04:00

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

2009-08-12T14:32:00.003-04:00

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

2009-08-12T12:26:00.006-04:00

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

2009-08-11T17:11:00.008-04:00

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

2009-08-11T15:44:00.003-04:00

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?

2009-08-09T19:03:00.004-04:00

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

2009-08-07T12:39:00.003-04:00

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

2009-08-06T16:49:00.004-04:00

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

2009-08-05T15:25:00.003-04:00

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

2009-08-05T07:00:00.004-04:00

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

2009-08-04T12:36:00.004-04:00

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

2009-08-03T12:25:00.006-04:00

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

2009-08-03T11:21:00.004-04:00

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.

10 Year Treasury Yield Outlook -- On Target

2009-07-31T11:40:00.004-04:00

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

2009-07-31T09:43:00.004-04:00

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

2009-07-30T09:20:00.003-04:00

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

2009-07-28T16:22:00.003-04:00

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

2009-07-24T15:23:00.003-04:00

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

2009-07-24T14:53:00.003-04:00

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

2009-07-23T11:19:00.002-04:00

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

2009-07-22T17:54:00.003-04:00

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

2009-07-22T12:07:00.005-04:00

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

2009-07-21T18:01:00.001-04:00

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

2009-07-21T15:47:00.002-04:00

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

2009-07-20T17:46:00.003-04:00

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 . . . .

2009-07-20T17:14:00.003-04:00

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

2009-07-20T15:36:00.002-04:00

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?

2009-07-20T13:08:00.003-04:00

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

2009-07-17T11:24:00.003-04:00

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

2009-07-16T07:57:00.004-04:00

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

2009-07-14T12:14:00.004-04:00

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

2009-07-14T09:44:00.003-04:00

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?

2009-07-13T10:31:00.002-04:00

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

2009-07-12T12:26:00.007-04:00

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

2009-07-10T11:46:00.000-04:00

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.

2009-07-09T11:16:00.003-04:00

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

2009-07-08T18:43:00.005-04:00

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

2009-07-08T13:09:00.002-04:00

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.

Home Prices & Recessions – Prices Turn Up First

2009-06-30T11:33:00.005-04:00

There seems to be a growing sense that home prices are not going to recover, on a national scale, before the economy shows signs that the recession is ending. To confuse this notion with some facts, the chart below shows the year-over-year percent change in the median price for existing homes over the course of the business cycle (shaded areas are recessions). Recession definitely impacts home prices, some more than others for many different reasons – affordability, real interest rate levels, unemployment rate, etc. But in each cycle, home prices recover before the economy does -- at least as far as NBER dating is concerned. Because the perception of recovery lags reality, this means that home prices begin to recover long before consumers believe the recession has ended and certainly before the unemployment rate starts to turn down. All of which is to say that in the coming months we will see home prices begin to recover even though the recession is not officially over. My forecast is for home prices to begin move higher in the third quarter (www.econmkts.com) and to finish 2009 with prices about 11% below year-end 2008 levels.

FOMC Unwind Steepens Fed Fund Futures & Signals Growth

2009-06-25T13:45:00.005-04:00

My post yesterday parsing the FOMC Statement noted that the Fed was ready to unwind and today Fed fund futures have caught on (see chart below). The Fed believes that that there is no need to rush the process because there is plenty of slack in the economy to provide inflation cover against rising energy and commodity prices. The S&P Goldman Sachs Commodity Index has risen from a low of 305.585 on February 19 to the current level of 458.3169 -- a 50% increase but still well below the high of 893.859 hit almost one year ago to the day.

The rise in commodity prices reflects recovery from depression fears not inflation and so too is the steepening Fed funds futures curve. Against May 29 and March 31 levels, there hasn't been much price change in contracts expiring between now and early 2010. Thereafter the expectation for higher rates grows. Compared with May 29 expectations, the market has raised its funds forecast for Spring 2011 by 50bps to 2.25%. Not inflation, a return of optimism.

FOMC Statement -- Fed Begins Focus On Unwind & Inflation to Come

2009-06-24T14:36:00.003-04:00

The FOMC statement today reflects a committee that believes the credit crunch is past, the economy is close to stabilizing, and believes the economy's slack buys it some time on inflation as it starts focusing on the unwind.

In the April statement, the Fed wrote:

Information received since the Federal Open Market Committee met in March indicates that the economy has continued to contract

This month --

Information received since the Federal Open Market Committee met in April suggests that the pace of economic contraction is slowing.

A tepid upbeat statement, upbeat nevertheless and here is a key component that colors the verbiage later in the statement:

Businesses are cutting back on fixed investment and staffing but appear to be making progress in bringing inventory stocks into better alignment with sales.

In April --

Weak sales prospects and difficulties in obtaining credit have led businesses to cut back on inventories, fixed investment, and staffing.

The Fed didn't drop the difficulties in obtaining credit as an oversight. While consumers remain under the same pressures, businesses are doing the normal recessionary rebalancing but can now do it without being frozen out of credit. Big progress. Progress enough, in fact, for the Fed to drop this into the statement:

The prices of energy and other commodities have risen of late. However, substantial resource slack is likely to dampen cost pressures, and the Committee expects that inflation will remain subdued for some time

In other words, we see the inflation risk on the horizon but the economy has some time. Time is necessary because the unwind of the balance sheet will not take a week or two -- and unwinding the short-term paper facilities comes first.

In April the statement had this line that is not in the current June statement --

The Federal Reserve is facilitating the extension of credit to households and businesses and supporting the functioning of financial markets through a range of liquidity programs.

The April statement ended with this line --

The Committee will continue to carefully monitor the size and composition of the Federal Reserve's balance sheet in light of financial and economic developments.

The June statement ends this way --

The Federal Reserve is monitoring the size and composition of its balance sheet and will make adjustments to its credit and liquidity programs as warranted.

The shift in language may seem small but the implication is big -- the Fed is telling us that if conditions warrant it they are ready to start pulling back.

Bernanke Set to Defend Record Amid Debate on New Term

2009-06-23T10:49:00.002-04:00

The article is on Bloomberg this morning and the opening paragraph says a lot about the problem with the debate. Bernanke sounds like the guy who lets his partygoers get drunk, drive home, and then wants credit for the rescue effort after the inevitable pileup --

Federal Reserve Chairman Ben S. Bernanke will defend his unprecedented actions to prevent a financial collapse as debate on whether he should be reappointed begins.

We did have a financial collapse and we got there because of his two major failings --

1. Bernanke's focus on inflation targetting instead of credit growth (still is, by the way)-- even though domestic inflation in a rising trade deficit economy with a strong currency propped up by the trade surplus country means little. Capital inflows impacting interest rates mean more. Too much money chasing too few investment opportunities creates the inflation in assets rather than goods & services. Bernanke could only opine that the Fed can't do anything to prevent an asset bubble.

2. When the subprime crisis started (just as capital inflows began to slow, by the way) Bernanke displayed his astonishing ignorance of the capital and foreign exchange markets by insisting this was just a subprime/housing problem and lowering interest rates (thereby boosting growth in China and we saw what happened to oil as a result -- our easy policy ignited global inflation) He should of known this was a collateral problem best solved through the open market desk and by the government buying up surplus homes rather than insolvent financial institutions.

Bernanke proved academics make a lousy Fed Chairman -- he had to bring the economy closer to his academic strengths, depression, before getting it right. In addition, he failed (as did Greenspan) to recognize the theory of second best, meaning, in this instance, you don't run policy as if we have free floating capital and foreign exchange markets when we don't.

This is not to say Summers or Yellen would be any better. The very fact that Summers is in the mix makes this very political choice an underscore to the regulatory changes in the financial sector. Once the economy is on the upturn the government wants the say on how the inflows of capital are to be allocated. After all, the deficit in national saving will be owed to the government not the private sector.

Oil Price Technicals -- A Picture of Shifting Supply & Demand

2009-06-22T17:49:00.006-04:00

Oil is a key indicator for the turn in the economy and, as my last post illustrated, for when the yuan is going to resume revaluing to the dollar. Technical analysis of price action isn't mystical -- price patterns reflect shifts in the balance of supply and demand -- how people are voting their money rather than their opinions.

The chart below is the daily spot dollar price for Brent crude (this is an index so divide by 10 to see the actual price). The move from the low set year end has a decided counter-trend price pattern and has barely retraced more than 23.6% of the decline that began in July. The current run also looks a bit exhausted as prices broke through their channel ceiling and have since pulled back to the top of the channel. The daily slow stochastic is giving a sell signal as it breaks down through 80.

So the daily chart gives every indication that the six-month oil market run has topped out but I wouldn't put the big bear hat on just yet. The price is still above some important moving averages that now look like support and commodities typically retrace 50% of a trend move before the trend resumes. In addition, commodity prices almost always have that counter trend look to them when coming off a bottom -- as opposed to stocks and bonds. Lastly, the weekly chart (see below) is still signaling higher prices.

In sum, oil prices are taking a brief breather before the uptrend resumes. The 50% retracement level is $80, also a level where some believe China will resume yuan revaluation to the dollar. Look for oil to hit $80 before any serious down move could resume -- if it does resume.

The Yuan, The Dollar & Oil

2009-06-19T16:19:00.004-04:00

China manages the Yuan to its self interest and its interest is making sure it remains the world's low cost producer -- regardless of the global imbalances created. In the past decade China kept the Yuan fixed to the dollar despite a growing trade surplus (how do you think they ended up with all those dollar assets). China finally agreed to open its currency to a managed float in mid-2005. Why then? It appears that oil above $55 per barrel did the trick. And when oil prices began rising at an accelerating pace in 2007 the Yuan's revaluation to the dollar did the same. What then going forward? Hard to say what price oil must rally through to get the Yuan again appreciating against the dollar, but current trading levels aren't it. My guess is $80 oil will do it.

Bernanke's Trail of Talk

2009-06-19T11:50:00.003-04:00

Thanks go to Austrian Filter for putting these quotes together. The site has many more and includes some of Paulson's bon mots as well. I just culled out some of the Bernanke quotes from when it all began. You can go to the site to get all the whole sorry trail of talk.

March 28th, 2007 – Ben Bernanke: "At this juncture . . . the impact on the broader economy and financial markets of the problems in the subprime markets seems likely to be contained,"

May 17th, 2007 – Bernanke: “While rising delinquencies and foreclosures will continue to weigh heavily on the housing market this year, it will not cripple the U.S.”
June 20th, 2007 – Bernanke: (the subprime fallout) ``will not affect the economy overall.''

October 15th, 2007 – Bernanke: "It is not the responsibility of the Federal Reserve - nor would it be appropriate - to protect lenders and investors from the consequences of their financial decisions."

February 29th, 2008 – Bernanke: "I expect there will be some failures. I don't anticipate any serious problems of that sort among the large internationally active banks that make up a very substantial part of our banking system."

Bernanke had no sense of the extent to which subprime mortgages were a creature of the securitization market. No sense of the impact of falling prices on these securities on the banking system just as the inflow of foreign capital began to ebb because the U.S. trade deficit began to shrink. Even if one forgives the lack of foresight on the part of the Chairman of the Federal Reserve, he and Paulson decided to attack the problem by supporting security prices rather than the price of the underlying asset -- homes. During the real Depression, the Government came in, bought wheat, and plowed it under to support prices. What a different world in which we live today.

Bank CDS Spreads React To Financial Regulation

2009-06-19T10:08:00.008-04:00

The point of the new financial regulations is to turn banks with somewhat sketchy portfolios into pillars of strength by having to put up lots of capital under the watchful eye of the Fed -- and keep them from ever again making bad decisions with over-leveraged capital. The market read the plan and decided instead that banks are now more at risk.

In the past week, C CDS has widened 91.2bp, BAC 45.91, WFC 41.78. GS widened to 160bp from 125bp last Friday and JPM went from 87bp to 108bp in the same period. That is quite a percentage leap for firms that are out from under the TARP.

In fairness to the banks, credit spreads have widened throughout in the past week. Reregulation may only be one reason and the Fed/Tsy will surely let us know what the other reasons are.

Still Wide Credit Spreads And A Tightening Fed -- Market View for Summer 2010

2009-06-18T17:29:00.004-04:00

As everyone has now figured out (if they didn't know before) markets aren't rational only efficient at averaging out everyone's expectations for the moment. The graph below charts out the yield on the Jun 2010 Eurodollar contract against the average Fed funds rate expected for summer 2010. Remember that the Euro contract is the yield on a three-month deposit made the day the contract goes to delivery, so the rate necessarily includes an expectation of where the funds rate will be plus a credit spread.

The market, in its infinite wisdom, is pricing in the Fed raising the funds rate several times between now and summer 2010. By August 10, the rate will be 1.5%. Considering all the depression talk that is quite a run to be discounting especially with no easing in credit spreads. At present that forward spread for summer 2010 is 47 basis points and has generally averaged around 42 basis points since May 10 -- when the winter scare was finally priced out of the market.

It is not quite clear to me how the Fed will be actively raising the base lending rate while banking spreads are still at recession-like wides. Looking at the level of the Eurodollar rate against the spread to expected Fed funds, someone is going to be wrong. The Fed will not be tightening, not for a long time and there is a very good chance that Bernanke will not even be running the Fed when summer 2010 rolls around. Reads to me like an arbitrage opportunity (at your own risk, etc.)

Reich Takes Aim At Financial Market Reform And Misses

2009-06-18T15:46:00.005-04:00

In his blog, Robert Reich gives his opinion on the financial reforms formally announced yesterday. Thankfully he summed his views up nicely in the first paragraph --

"The plan doesn't stop stop bankers from making huge, risky bets with other peoples’ money. It does increase capital requirements and oversight, but it doesn't require bankers to take their pay in long-term stock options or warrants, and it doesn't even hint that banks should go back to being partnerships instead of publicly-held corporations."

Obviously Reich missed that class in Money & Banking 101. If he showed up he would know that dynamic capital requirements act like reserve requirements to limit bank leverage. As for the nature of the bets, well I would like to think that there are quite a few traders, bankers, and risk managers on the look out for black swans.

If Reich really wants to make money trading less profitable he should want less of it floating around with no place to go. The solution is letting the East Asian currencies revalue to free market levels against the dollar. Import substitution and export sector growth will result. Smaller trade deficit, greater profit potential in the nonfinancial sector -- and the financial games will slow by necessity. But if the Fed/Tsy insist on quickly returning to high real interest rates and a strong dollar policy we will again have too many dollars chasing too few capital investment opportunities and then this recession will have been for naught.

Payrolls Boosted Big By Birth/Death Adjustment

2009-06-05T09:16:00.004-04:00

The May payroll number was a good sign but before getting too far ahead of today's data remember that these numbers are subject to huge revisions and include fudge factors. Because the BLS can't know to survey a firm that didn't exist a month ago BLS fudges the not seasonally adjusted payroll numbers with a birth/death adjustment. This May, on a nonseasonal basis, payroll employment was +319,000 of which 220,000 was added because of this adjustment. Interesting to note that of the 129,000 nsa increase in construction workers this month about 43,000 came from birth/death. I find it difficult to believe that so many new construction firms have come on stream in the current environment. During the annual benchmark revisions I suspect a good part of this will go away.

The chart below illustrates the running 12 month change in total employment and the change without the birth/death adjustment. For the 12 month period ending in May, Labor reports a loss of 5.4 million jobs -- which includes an add of 811,000 jobs from the birth/death adjustment. Draw your own conclusion.