GDP was revised sharply lower, but not as much as the street had feared. I can't say that it is good news that GDP was revised lower from 2.4% to 1.6%, but it at least shows that the U.S. economy is not in free fall. Personal consumption was better than anticipated, but the primary driver were higher natural gas and electricity purchases during the early stages of the heat wave which began affecting the eastern half of the country in June. Long dated treasuries are selling off as weaker data had been baked into treasury levels. The price of the 10-year treasury note is down 17/32s to yield 2.54% and the price of the 30-year government bond is down 26/32s to yield 3.56%. Such a selloff is expected given today's data versus expectations. Yesterday's seven-year auction was very well bid for and priced at an all-time low yield for the seven-year auction. All eyes and ears will now turn to Fed Chairman Ben Bernanke when he speaks later today at the Fed conference in Jackson Hole Wyoming.
I have long been an advocate of paying close attention to not only what the Fed does, but also to what it says. However, I believe the market is expecting the Fed to be a miracle worker rather than a central bank. An increasing number of people have been calling on the Fed to find new ways to increase consumer demand and economic growth. The truth is that the Fed cannot create demand. It can only bring demand forward by enticing consumers to borrow at low rates and spend. As an increasing number of articles in the financial press have been stating the Fed is nearly out of ammunition. The Fed has very little ability to bring more demand forward.
Let me explain bringing demand forward. Be providing incentives to spend and borrow, many consumers make purchases that they would have normally made at a later date. At some point that artificial demand has to wane. However, for the past 25 years, every time that correction was set to take place (and the economic began to slow), the Fed would ease and bring more demand forward. Wall Street augmented the phenomenon by making it possible for more consumers to borrow and spend, but with rates as low as they can go (without becoming Japan) and investors now knowledgeable about what kinds of loans make up the securities necessary to facilitate such lending, demand cannot be brought forward further. Now consumers will have to pay off debts and deleverage to the point they can spend responsibly. Unfortunately that probably means growth rates far below to what we have become accustomed. It also means job creation will be poor for a number of years. It probably does not mean a double-dip recession unless consumers become more depressed and hold back spending. This morning's University of Michigan confidence reports indicates that consumers are becoming less optimistic. The danger of a self-fulfilling prophecy continues to loom. Thanks to Fed policy, Wall Street securitization and irrational exuberance by consumers (sorry Mr. Greenspan.) the country has become accustomed to growth rates usually seen in developing countries even though the U.S. economy is quite developed.
A paradigm shift is likely to occur where the U.S. consumer begins to live more within his or her means (don't worry, Americans will still borrow, just not as much). The result will be several years of sub-par growth and high unemployment until natural demand takes over as consumers need to replace durable goods which wear out and a growing population and gradually improving consumer finances eat thorough the housing surplus. Relying on housing to drive the economy in the manner it has during the past two decades is unreasonable and probably unfeasible. Patience is a virtue and will likely be rewarded.
The markets’ response to Mr. Bernanke’s speech at the Fed conference in Jackson Hole, Wyoming was reminiscent of Monty Python: The life of Brian. In the film, Brian desires to join the Peoples’ Front of Judea. He is asked by the group’s leader, Reg: “How much do you hate the Romans?” To which Brian’s response is: “A lot.” Reg tells Brian: “Alright you’re in.”
This is not much different than what happened in Jackson Hole. The markets have been asking Mr. Bernanke: “What are you going to do to stimulate the economy?” Last Friday Mr. Bernanke answered: “A lot.” The market said: “Alright, busy stocks and sell bonds.” In my opinion the stock markets rally and the bond market’s fall was a so-called dead cat bounce, or at least it should be. The Fed is mostly out of ammo. The guns have been fired. Now the economy must advance under its own power. The advance will be slow and there may be some set backs, but it will advance, unless of course, the leadership in Washington, insists on poor strategy.
Fear of the forthcoming policy and tax changes, along with an undeniable trend toward consumer deleveraging will slow the economic recovery. This is to be expected. As a country we spent like drunken sailors and we now have to become more responsible. The question is: Without bubble-like conditions can unemployment fall below 7.00%? I am not a trained economist, but I find it hard to imagine unemployment that low. Our best hope is for entrepreneurs looking to maintain or better their lifestyles to drive the economy forward and thus create jobs. Unfortunately, many of those in power are not pro-business, not even pro-small-business. They believe that to be pro-business is to be anti-worker. Shortsightedness will be the death of this nation.
Buy high-quality bank bonds 7-10 (15 years if a step up), callable agencies and (if one is an equity buyer) high-quality dividend-paying stocks. Many investors have been buying junk bonds even though they may be outside of their risk tolerances. Investors are better off taking duration risk to pick up yield rather than going down in credit quality. The problem is that the ability of lower-rated companies to issue debt may merely be putting off eventual defaults.
Sunday, August 29, 2010
Thursday, August 26, 2010
The Gorge of Eternal Peril
Jobless came in better (or not as bad) as expected. Make no mistake, 473,000 new claims is troubling and the prior week's upward revision is also not good news, but the street was fearing worse. Continuing claims fell to 4,456,000, but the prior number rose to 4,518,000. Not accounted for in the continuing claims number are displaced workers receiving extended benefits. The number of displaced workers receiving extended benefits rose by 302,000 for a total of 5.84 million more people receiving unemployment benefits than indicated by the continuing claims data. Do the math. That would be over 10 million people receiving some kind of unemployment benefits. It is going to be a long time before we see unemployment drop below 9.00% never mind the sub 8.00% rate predicted by government economic officials last year. The Fed has viewed full employment as being between 5.00% and 6.00%. Good luck seeing that any time soon. Most economists see unemployment above 9.00% through 2011.
Relatively good news from the mortgage sector. Foreclosures and delinquencies fell on a percentage basis. However, the trend with in the quarter indicates that new delinquencies and foreclosures were beginning to rise. Mortgages more than one month overdue increased. This indicates renewed distress among home owners. Experts believe that such an increase suggests than a slowing economy may push foreclosures higher as borrowers lose their jobs. One street economist told Bloomberg News:
"As we work through the bucket of troubled loans, we’re seeing an increase in a new crop of troubled loans." "It’s primarily driven by the jobs market. It still takes a paycheck to make a mortgage payment."
It will be a long way back, but we will come back, as long as consumers to no become too discouraged and businesses are incentivized to create jobs. When you figure out the last part, let me know.
Durable Goods data missed expectations by a wide margin, so wide that the upward revisions of the priors month's data hardly matter. Durable Goods less the volatile transportation sector came in at a -3.8%. That is a horrendous number.
There were some disturbing signs within the durable goods data. For instance, there were gains in the purchase of business equipment, but the equipment is being used to replace less efficient equipment rather than for expansion purposes. By most accounts there is excess capacity in the economy and there is little reason to add more. Manufacturing continues to be the strongest sector, but there are signs it too is beginning to slow. Manufacturing makes up such a relatively small portion of the economy that reliance on it for growth is not a prudent strategy.
New home sales, like existing homes sales, were terrible. The month-over-month change was -12.4%. The prior month's data was also revised lower. A lack of home buyer incentives and a poor jobs market are hindering homes sales. In fact, foreclosures continue to rise as walking away from homes in which one is underwater is now considered to be a prudent financial decision. REITs are doing the same with commercial properties and are being applauded for doing so by traders and strategists. Values? We don't need no stinking values.\
Folks, we may be caught in a negative feedback loop. This is where economic data misses expectations causing consumers and businesses to retrench a bit. That causes the next round of numbers to be worsen and consumers and businesses retrench some more. This is the opposite of the optimism-driven recoveries we to which we have become accustomed. Usually consumer spending breaks the trend, but the consumer is strapped. Productivity only helps to keep consumer prices in check. If consumers have little with which to spend, productivity's benefits are muted.
Some readers have asked me if it is time to sell long-dated assets to realize gains. It is hard to time this. I have been cautiously optimistic on the economy at best. What scares me here is the potential for a negative feedback loop. If you asked me last month if we would see 10-year at 2.45% I would have said: "no way" as such a yield would be pricing in a double-dip recession but the data do not bear that out. Now the data are falling in line, but it is a chicken and egg situation. Are the data driving consumer and business sentiment or is sentiment driving the data?
I think it is more of the latter. Fundamentals were indicating a slow recovery. Consumers and investors were counting on a robust recovery (without knowing where the growth was going to come from). When that did not materialize negativity set in. I can't see rates going much lower short of another severe recession or worse and would be inclined to sell the long and now, but as long as we are caught in this loop, it may not be a bad idea to ride it for a while longer. Our only hope may be a repeal of Obama-care and an extension of the Bush tax cuts. The fears of businesses and consumers must be alleviated. The last thing they need is less money in their pockets.
I was once told by a wise person: "never ignore what the market is telling you.” Please keep that in mind when considering letting ideology affect your investment strategy
Tomorrow we have GDP. We shall watch and pray.
Relatively good news from the mortgage sector. Foreclosures and delinquencies fell on a percentage basis. However, the trend with in the quarter indicates that new delinquencies and foreclosures were beginning to rise. Mortgages more than one month overdue increased. This indicates renewed distress among home owners. Experts believe that such an increase suggests than a slowing economy may push foreclosures higher as borrowers lose their jobs. One street economist told Bloomberg News:
"As we work through the bucket of troubled loans, we’re seeing an increase in a new crop of troubled loans." "It’s primarily driven by the jobs market. It still takes a paycheck to make a mortgage payment."
It will be a long way back, but we will come back, as long as consumers to no become too discouraged and businesses are incentivized to create jobs. When you figure out the last part, let me know.
Durable Goods data missed expectations by a wide margin, so wide that the upward revisions of the priors month's data hardly matter. Durable Goods less the volatile transportation sector came in at a -3.8%. That is a horrendous number.
There were some disturbing signs within the durable goods data. For instance, there were gains in the purchase of business equipment, but the equipment is being used to replace less efficient equipment rather than for expansion purposes. By most accounts there is excess capacity in the economy and there is little reason to add more. Manufacturing continues to be the strongest sector, but there are signs it too is beginning to slow. Manufacturing makes up such a relatively small portion of the economy that reliance on it for growth is not a prudent strategy.
New home sales, like existing homes sales, were terrible. The month-over-month change was -12.4%. The prior month's data was also revised lower. A lack of home buyer incentives and a poor jobs market are hindering homes sales. In fact, foreclosures continue to rise as walking away from homes in which one is underwater is now considered to be a prudent financial decision. REITs are doing the same with commercial properties and are being applauded for doing so by traders and strategists. Values? We don't need no stinking values.\
Folks, we may be caught in a negative feedback loop. This is where economic data misses expectations causing consumers and businesses to retrench a bit. That causes the next round of numbers to be worsen and consumers and businesses retrench some more. This is the opposite of the optimism-driven recoveries we to which we have become accustomed. Usually consumer spending breaks the trend, but the consumer is strapped. Productivity only helps to keep consumer prices in check. If consumers have little with which to spend, productivity's benefits are muted.
Some readers have asked me if it is time to sell long-dated assets to realize gains. It is hard to time this. I have been cautiously optimistic on the economy at best. What scares me here is the potential for a negative feedback loop. If you asked me last month if we would see 10-year at 2.45% I would have said: "no way" as such a yield would be pricing in a double-dip recession but the data do not bear that out. Now the data are falling in line, but it is a chicken and egg situation. Are the data driving consumer and business sentiment or is sentiment driving the data?
I think it is more of the latter. Fundamentals were indicating a slow recovery. Consumers and investors were counting on a robust recovery (without knowing where the growth was going to come from). When that did not materialize negativity set in. I can't see rates going much lower short of another severe recession or worse and would be inclined to sell the long and now, but as long as we are caught in this loop, it may not be a bad idea to ride it for a while longer. Our only hope may be a repeal of Obama-care and an extension of the Bush tax cuts. The fears of businesses and consumers must be alleviated. The last thing they need is less money in their pockets.
I was once told by a wise person: "never ignore what the market is telling you.” Please keep that in mind when considering letting ideology affect your investment strategy
Tomorrow we have GDP. We shall watch and pray.
Tuesday, August 24, 2010
No Denying It
Today's existing home data was ugly. It was coyote ugly. It was so bad that forecasters would probably be willing to chew off a foot to be able to get out from under their predictions. Today's data indicated that the pace of existing home sales, a seasonally adjusted annual rate of 3.83 million. Many expected the pace of home sales to decline now that the home buyer stimulus programs have expired, but the decline reported today indicates the real estate market is severely impaired. A glut of homes, more restrictive lending standards and a poor job market are conspiring to keep the housing market in an impaired state. The following appeared in the Wall Street Journal:
"I'm in no rush," said Steve Hamilton, who sold his Carlsbad, Calif., home two years ago and has been on the sidelines since. He said he was happy to continue renting a home that costs half of what the monthly mortgage payments were just a few years ago. "The tide is still going out," said the 41-year-old commercial-real-estate investor. "When I see a steady increase in local jobs, that's when we'll step back into the market."
This is another blow to those who say that consumers are not needed to lead us back. The problem is that the economy has become overly reliant on an ever stronger housing market. While increased productivity helped keep prices down, it also helped keep wage growth down. Consumers became more dependent on using home equity to fuel spending. That unsustainable part has ended. The recovery has basically stalled. I am still not in the double dip camp, but there is no denying the fact that a v-shaped recovery is not in the card. We may be lucky to see 2.00% growth and that is not enough to be of much help to the job market.
Inflation should not be a problem, but treasury yields may be over done, unless a second deep recession does occur. Some people are of the opinion that we could see stagflation and higher rates as confidence in the dollar wanes. Although that is possible, there is another piece of the equation which must be considered.
There has to be a destination for the displaced investment capital. Where is the capital going to go? To Europe? Not likely as its problems may be worse than those of the U.S. China? See what happens when you want to move the renminbi out of China. Nope, capital will stay in the dollar for now and slowly we will move forward, but a double dip is a distinct possibility.
"I'm in no rush," said Steve Hamilton, who sold his Carlsbad, Calif., home two years ago and has been on the sidelines since. He said he was happy to continue renting a home that costs half of what the monthly mortgage payments were just a few years ago. "The tide is still going out," said the 41-year-old commercial-real-estate investor. "When I see a steady increase in local jobs, that's when we'll step back into the market."
This is another blow to those who say that consumers are not needed to lead us back. The problem is that the economy has become overly reliant on an ever stronger housing market. While increased productivity helped keep prices down, it also helped keep wage growth down. Consumers became more dependent on using home equity to fuel spending. That unsustainable part has ended. The recovery has basically stalled. I am still not in the double dip camp, but there is no denying the fact that a v-shaped recovery is not in the card. We may be lucky to see 2.00% growth and that is not enough to be of much help to the job market.
Inflation should not be a problem, but treasury yields may be over done, unless a second deep recession does occur. Some people are of the opinion that we could see stagflation and higher rates as confidence in the dollar wanes. Although that is possible, there is another piece of the equation which must be considered.
There has to be a destination for the displaced investment capital. Where is the capital going to go? To Europe? Not likely as its problems may be worse than those of the U.S. China? See what happens when you want to move the renminbi out of China. Nope, capital will stay in the dollar for now and slowly we will move forward, but a double dip is a distinct possibility.
Wednesday, August 18, 2010
Why Witches Burn
In Today's Wall Street Journal, Wharton professor, Jeremy Siegel and Wisdom Tree director of research, Jeremy Schwartz express concerns that there may be a bubble in treasury prices. They make the argument that the economy is stronger than many, including the Fed, believe and that rates cannot stay down today's level forever. They advocate dividend paying stocks over bonds and de-emphasize the importance of the consumer in terms of economic growth. I find myself agreeing with them on some points, but disagreeing on others. Let's do a little dissecting of their thesis.'
Mr. Schwartz and Mr. Siegel do not see headwinds stemming from consumer deleveraging. They state:
"Today the purveyors of pessimism speak of the fierce headwinds against any economic recovery, particularly the slow deleveraging of the household sector. But the leveraging data they use is the face value of the debt, particularly the mortgage debt, while the market has already devalued much of that debt to pennies on the dollar."
I know it may seem out of place for me to challenge a Wharton professor, but I don't know where they are getting their evidence? The banks themselves report a lack of demand for credit because consumers are overleveraged and are in the process of deleveraging. There is also evidence that banks HAVE NOT marked down loans to pennies on the dollar because loans were never subject to mark-to-market accounting, mortgage bonds were subject, but not actual mortgages held on balance sheets.Another article in today's Journal mentions that many banks are reluctant to alter the terms of mortgages by forgiving principal because it would force them to realize losses on loans that have not yet been marked down. There is one hole in their theory
Another hole comes as the result of their belief that it is productivity and not the consumer which drives economic growth. They state:
"Furthermore, economists generally agree that the most important determinant for long-term economic growth is productivity, not consumer demand. Despite the subpar productivity growth reported for the last quarter, the latest year-over-year productivity growth of 3.9% is almost twice the long-term average. For the first two quarters of this year productivity growth, at over 6%, was the highest since the 1960s."
Viewing productivity as the determinant rather than a means to a consumer spending end is, in my opinion, incorrect. Productivity has indeed helped drive growth, but it has done so by freeing up capital which was used to fund production of a product to be used for expansion, research and development of new products, etc. It also worked to make products more affordable thereby increasing consumer spending. Approximately two-thirds of U.S. economic activity is generated by consumers. Discount them at your own risk. Again, I am not an economist, nor did I attend Wharton, but the productivity gains we have seen have not translated into robust economic growth. It has translated into stronger balance sheets as margins have widened even as retail sales have been lackluster. Also too much productivity leads to poor job creation or even job destruction. That cannot not good for growth. Saying that productivity is independently responsible for growth and not a contributing factor to overall consumption is something out of Monty Python. It has the same logic as trying to determine if someone is a witch.
If productivity increases and growth increases, then productivity must increases growth. However, such logic ignores the real driver of growth, that is consumption. Productivity can make consumption more affordable, by lowering the cost of goods and services, but it can also reduce wages and eliminate jobs. This is what we are currently experiencing. Where is Sir Bedevere when you need him?
This brings me to where I do agree with Mr. Siegel and Mr, Schwartz:
Low rates, increased productivity the propensity for U.S. consumers to spend, albeit at a slower pace, should keep corporate balance sheets relatively health unless consumers become so spooked that they stop spending as they had in 2008 and early 2009. If that happens a self-fulfilling double-dip prophecy could occur, but we are probably not their. Large-cap firms, utilities, etc. should be able to pay healthy dividends and will be less volatile during the next several years as the economy adapts to structural changes.
Another area in which I agree is interest rates. Unless the U.S. becomes Japan, rates should trend modestly higher during the next several years. Since U.S. consumers are unlikely to adopt Japanese consumer customs, a truly lost decade is not all that likely. Rates should back up at some point. Although rates on the long end of the curve could (probably should) move up 100 or more basis points during the next few years, their absolute levels should not be historically high. Even Mr. Schwartz and Mr. Siegel use a move to a 4.00% 10-year as an example. Not exactly runaway rates. However, 4.00% is 140 basis points higher than today's level. That translates to approximate price declines of about 10 to 12 points on bonds with a 10-year maturity. However, bonds 10-year bonds issued by BAC, MER (not explicitly backed by BAC), C, MS and even GE have room to experience credit spread tightening which could offset rising rates. Most other sectors are relatively rich. If long-term rates and inflation are modest, the Fed will not have to do much in the way of tightening. Sure, it may eventually raise the Fed Funds rate to 2.00% to 3.00%, but that is not enough to get %25-par LIBOR floaters off of their floors and would result in coupons of fixed-to-float bonds in falling even as their long-term treasury trading benchmarks rise. The result is lower bond prices.
However, there is another respected professional whose opinion is nearly diametrically opposed to those expressed by Mr. Siegel and Mr. Schwartz. Noted financial analyst, Gary Shilling is more doubtful of a robust U.S. economic recovery than even I. He believes that we could be entering a deflationary environment and that the yield of the 30-year government bond could fall to 3.50%. Dr. Shilling became famous in the 1980s for predicting a long-term rally in bonds. His prediction came to fruition in spades. Dr. Shilling believes that consumers are grossly overleveraged and will need decades to right their financial circumstances. I agree with him. We have been on a 25-year spending spree. It is now time to pay the piper and the tune is not a happy one.
Mr. Schwartz and Mr. Siegel do not see headwinds stemming from consumer deleveraging. They state:
"Today the purveyors of pessimism speak of the fierce headwinds against any economic recovery, particularly the slow deleveraging of the household sector. But the leveraging data they use is the face value of the debt, particularly the mortgage debt, while the market has already devalued much of that debt to pennies on the dollar."
I know it may seem out of place for me to challenge a Wharton professor, but I don't know where they are getting their evidence? The banks themselves report a lack of demand for credit because consumers are overleveraged and are in the process of deleveraging. There is also evidence that banks HAVE NOT marked down loans to pennies on the dollar because loans were never subject to mark-to-market accounting, mortgage bonds were subject, but not actual mortgages held on balance sheets.Another article in today's Journal mentions that many banks are reluctant to alter the terms of mortgages by forgiving principal because it would force them to realize losses on loans that have not yet been marked down. There is one hole in their theory
Another hole comes as the result of their belief that it is productivity and not the consumer which drives economic growth. They state:
"Furthermore, economists generally agree that the most important determinant for long-term economic growth is productivity, not consumer demand. Despite the subpar productivity growth reported for the last quarter, the latest year-over-year productivity growth of 3.9% is almost twice the long-term average. For the first two quarters of this year productivity growth, at over 6%, was the highest since the 1960s."
Viewing productivity as the determinant rather than a means to a consumer spending end is, in my opinion, incorrect. Productivity has indeed helped drive growth, but it has done so by freeing up capital which was used to fund production of a product to be used for expansion, research and development of new products, etc. It also worked to make products more affordable thereby increasing consumer spending. Approximately two-thirds of U.S. economic activity is generated by consumers. Discount them at your own risk. Again, I am not an economist, nor did I attend Wharton, but the productivity gains we have seen have not translated into robust economic growth. It has translated into stronger balance sheets as margins have widened even as retail sales have been lackluster. Also too much productivity leads to poor job creation or even job destruction. That cannot not good for growth. Saying that productivity is independently responsible for growth and not a contributing factor to overall consumption is something out of Monty Python. It has the same logic as trying to determine if someone is a witch.
If productivity increases and growth increases, then productivity must increases growth. However, such logic ignores the real driver of growth, that is consumption. Productivity can make consumption more affordable, by lowering the cost of goods and services, but it can also reduce wages and eliminate jobs. This is what we are currently experiencing. Where is Sir Bedevere when you need him?
This brings me to where I do agree with Mr. Siegel and Mr, Schwartz:
Low rates, increased productivity the propensity for U.S. consumers to spend, albeit at a slower pace, should keep corporate balance sheets relatively health unless consumers become so spooked that they stop spending as they had in 2008 and early 2009. If that happens a self-fulfilling double-dip prophecy could occur, but we are probably not their. Large-cap firms, utilities, etc. should be able to pay healthy dividends and will be less volatile during the next several years as the economy adapts to structural changes.
Another area in which I agree is interest rates. Unless the U.S. becomes Japan, rates should trend modestly higher during the next several years. Since U.S. consumers are unlikely to adopt Japanese consumer customs, a truly lost decade is not all that likely. Rates should back up at some point. Although rates on the long end of the curve could (probably should) move up 100 or more basis points during the next few years, their absolute levels should not be historically high. Even Mr. Schwartz and Mr. Siegel use a move to a 4.00% 10-year as an example. Not exactly runaway rates. However, 4.00% is 140 basis points higher than today's level. That translates to approximate price declines of about 10 to 12 points on bonds with a 10-year maturity. However, bonds 10-year bonds issued by BAC, MER (not explicitly backed by BAC), C, MS and even GE have room to experience credit spread tightening which could offset rising rates. Most other sectors are relatively rich. If long-term rates and inflation are modest, the Fed will not have to do much in the way of tightening. Sure, it may eventually raise the Fed Funds rate to 2.00% to 3.00%, but that is not enough to get %25-par LIBOR floaters off of their floors and would result in coupons of fixed-to-float bonds in falling even as their long-term treasury trading benchmarks rise. The result is lower bond prices.
However, there is another respected professional whose opinion is nearly diametrically opposed to those expressed by Mr. Siegel and Mr. Schwartz. Noted financial analyst, Gary Shilling is more doubtful of a robust U.S. economic recovery than even I. He believes that we could be entering a deflationary environment and that the yield of the 30-year government bond could fall to 3.50%. Dr. Shilling became famous in the 1980s for predicting a long-term rally in bonds. His prediction came to fruition in spades. Dr. Shilling believes that consumers are grossly overleveraged and will need decades to right their financial circumstances. I agree with him. We have been on a 25-year spending spree. It is now time to pay the piper and the tune is not a happy one.
Tuesday, August 17, 2010
Malaise and The GSEs
Last Week's Initial Jobless claims ticked higher to 484,000 - the highest number since February of this year. Continuing claims fell to 4.452K from a prior revised 4,570K (up from 4,537K). It is believed that many displaced workers who fell off of the continuing claims roles fell onto the roles of extended benefits rather than finding jobs. High unemployment obviously crimps consumer demand, thereby dampening the recovery. However, it also conditions people to become more frugal. Those of us who have parents or grandparents who experienced the Great Depression know that their spending habits were much more conservative than those of the generations which followed.
Import Prices came in higher than the prior month, but lower than the consensus forecast. Prices here moderated be declines in building materials, metals and machinery. These were the sectors which were expected to lead the recovery. Nomura chief economist David Resler told Bloomberg News: "With the unemployment rate still quite high, resources idle everywhere, it’s pretty clear to me that we shouldn’t have much in the way of inflation."
CPI rose for the first time since March, but prices were not up across the board. CPI was driven higher by rents, used cars, tobacco and clothing. These are not exactly signs of an economic recovery. In fact, higher rents often signal the opposite as former home owners are forced to rent living quarters thereby creating increased demand which results in higher rents. Most other sectors experienced price declines. Retail sales rose, but when auto sales and gasoline purchases are removed, consumers actually purchased fewer goods than the prior month. Although today's numbers do not paint a recessionary picture, they do appear to portend modest, but positive, growth.
This is bad news for investors in LIBOR and CPI floaters. I have seen CPI floaters' coupons drop to 0.00%. We do not need deflation for that to happen, only for the year over year inflation rate to be unchanged. The price of the benchmark 10-year note is unchanged to yield 2.72. The price of the 30-year government bond is up 10/32s to yield 3.90%. Ladder and focus on the belly of the curve. Snap up step-ups (corporate or agency) as they are among the better fixed income values in the markets.
Monday's Wall Street Journal Credit Markets column discusses the recent swing to bullish sentiment in the treasury market. The median forecast for 10-year note at year end is a yield of 2.88%. However, that is including Morgan Stanley's forecast of 3.50% (down from 5.50%). MS is also forecasting second half 2010 growth at 3.3%. This is what makes markets. Mort Zuckerman's editorial in the Journal may have been a bit pessimistic, but his description of the changed dynamics of the U.S. economy is correct. Gerald O'Driscoll's editorial explains that the Fed cannot solve the economic problems we are facing. He correctly states:
"In most cases, investment booms drive industries with sound fundamentals. When the cheap credit keeps flowing, however, fundamentals are forgotten and the process evolves into a mania (to use the old-fashioned term). What cannot be sustained will not be, so the boom ends in a crisis."
"In these scenarios, the collapse of demand is a consequence—not the cause—of the bust. Policies to address crises must get cause and effect right."
Cause and effect are often confused in this industry. One oft confused indicator is the yield curve (and its shape_. Many consider the shape of the yield curve as a predictor of future economic conditions. On the surface it is difficult to dispute this. One can see the relationship between a flat(ter) curve and economic slowdowns time and time again. However, there are a cadre of bond people (of which I am one) who believe that the yield curve reflects rather than predicts,. What it reflects is disinflationary Fed policy. The Fed raises short-term rates to quash inflation pressures, long-term rates stop rising and often fall resulting in a flat yield curve. The yield curve merely confirms what everyone should have already seen coming by watching the Fed. It goes flat after steps have been taking to moderate growth. It is a lagging to coincidental indicator of where the economy is heading. The Fed is the premier indicator of growth and inflation. Currently Fed policy and commentary is forecasting sluggish times ahead.
Freddie and Fannie have been the topic of discussion this week In Washington DC. Treasury Secretary Tim Geithner, Pimco's Bill Gross and a host of mortgage professionals, economists and academics discuss the role played by the GSEs in the financial crisis and what is to become of them. Pimco's Bill Gross believes that the GSE's should be nationalized. Pay no attention to his long positions in their bonds. Treasury Secretary Tim Geithner expressed the opinion that government should play a smaller role in the mortgage market. I am sure his comments are reverberating throughout the Democratic side of the aisle in Congress.
Many legislators, mainly Democrats, were and continue to be supporters of GSEs in their public / private forms. Congress had its cake and was eating it too. Congress directed the GSE to engage in unprofitable and often dangerous activities, such as backing and securitizing mortgages taken out by borrowers who could ill afford to repay them all in the name of social justice. However, it was the private sector (stock and bond holders) which financed the GSEs. The government is in a sticky situation.. The GSEs are engaging in business which would result in government crackdowns (if not bankruptcy) if undertaken by banks. However, with nine out of ten mortgages being GSE-backed. Not much can be done about the GSEs at this time. Bonds should be ok, but common and preferreds are likely to be worthless. The can gets kicked down the road some more.
Import Prices came in higher than the prior month, but lower than the consensus forecast. Prices here moderated be declines in building materials, metals and machinery. These were the sectors which were expected to lead the recovery. Nomura chief economist David Resler told Bloomberg News: "With the unemployment rate still quite high, resources idle everywhere, it’s pretty clear to me that we shouldn’t have much in the way of inflation."
CPI rose for the first time since March, but prices were not up across the board. CPI was driven higher by rents, used cars, tobacco and clothing. These are not exactly signs of an economic recovery. In fact, higher rents often signal the opposite as former home owners are forced to rent living quarters thereby creating increased demand which results in higher rents. Most other sectors experienced price declines. Retail sales rose, but when auto sales and gasoline purchases are removed, consumers actually purchased fewer goods than the prior month. Although today's numbers do not paint a recessionary picture, they do appear to portend modest, but positive, growth.
This is bad news for investors in LIBOR and CPI floaters. I have seen CPI floaters' coupons drop to 0.00%. We do not need deflation for that to happen, only for the year over year inflation rate to be unchanged. The price of the benchmark 10-year note is unchanged to yield 2.72. The price of the 30-year government bond is up 10/32s to yield 3.90%. Ladder and focus on the belly of the curve. Snap up step-ups (corporate or agency) as they are among the better fixed income values in the markets.
Monday's Wall Street Journal Credit Markets column discusses the recent swing to bullish sentiment in the treasury market. The median forecast for 10-year note at year end is a yield of 2.88%. However, that is including Morgan Stanley's forecast of 3.50% (down from 5.50%). MS is also forecasting second half 2010 growth at 3.3%. This is what makes markets. Mort Zuckerman's editorial in the Journal may have been a bit pessimistic, but his description of the changed dynamics of the U.S. economy is correct. Gerald O'Driscoll's editorial explains that the Fed cannot solve the economic problems we are facing. He correctly states:
"In most cases, investment booms drive industries with sound fundamentals. When the cheap credit keeps flowing, however, fundamentals are forgotten and the process evolves into a mania (to use the old-fashioned term). What cannot be sustained will not be, so the boom ends in a crisis."
"In these scenarios, the collapse of demand is a consequence—not the cause—of the bust. Policies to address crises must get cause and effect right."
Cause and effect are often confused in this industry. One oft confused indicator is the yield curve (and its shape_. Many consider the shape of the yield curve as a predictor of future economic conditions. On the surface it is difficult to dispute this. One can see the relationship between a flat(ter) curve and economic slowdowns time and time again. However, there are a cadre of bond people (of which I am one) who believe that the yield curve reflects rather than predicts,. What it reflects is disinflationary Fed policy. The Fed raises short-term rates to quash inflation pressures, long-term rates stop rising and often fall resulting in a flat yield curve. The yield curve merely confirms what everyone should have already seen coming by watching the Fed. It goes flat after steps have been taking to moderate growth. It is a lagging to coincidental indicator of where the economy is heading. The Fed is the premier indicator of growth and inflation. Currently Fed policy and commentary is forecasting sluggish times ahead.
Freddie and Fannie have been the topic of discussion this week In Washington DC. Treasury Secretary Tim Geithner, Pimco's Bill Gross and a host of mortgage professionals, economists and academics discuss the role played by the GSEs in the financial crisis and what is to become of them. Pimco's Bill Gross believes that the GSE's should be nationalized. Pay no attention to his long positions in their bonds. Treasury Secretary Tim Geithner expressed the opinion that government should play a smaller role in the mortgage market. I am sure his comments are reverberating throughout the Democratic side of the aisle in Congress.
Many legislators, mainly Democrats, were and continue to be supporters of GSEs in their public / private forms. Congress had its cake and was eating it too. Congress directed the GSE to engage in unprofitable and often dangerous activities, such as backing and securitizing mortgages taken out by borrowers who could ill afford to repay them all in the name of social justice. However, it was the private sector (stock and bond holders) which financed the GSEs. The government is in a sticky situation.. The GSEs are engaging in business which would result in government crackdowns (if not bankruptcy) if undertaken by banks. However, with nine out of ten mortgages being GSE-backed. Not much can be done about the GSEs at this time. Bonds should be ok, but common and preferreds are likely to be worthless. The can gets kicked down the road some more.
Wednesday, August 11, 2010
Land of the Lost
Trade Balance data indicates that the trade deficit widened as imports of consumer goods increased while U.S. exports decreased. According to the data, the increase of consumer imports was due more to inventory replenishment after months of inventory depletion rather than increased consumption. Also adding to the wider trade deficit was a decrease of U.S. exports of equipment and machinery as emerging economies attempt to rein in expansion. Today's data indicates that second quarter GDP will be revised lower. Moody's senior economist Aaron Smith had this to say:
"Clearly not all of these imports of consumer goods are being purchased or consumed and some of it is going into inventories. It’s consistent with slower global growth. We’re going to get less of a boost from exports in the second half versus the first half."
The Fed painted a more solemn picture of U.S. economic recovery. This has apparently caught some market participants off guard. Why? I have no idea. Anyone with any historical perspective of growth and policy and has looked around at the state of the consumer (not to mention forthcoming tax and regulatory changes) could have figured out that the economy was not poised to roar back. Businesses will only add workers if they must. Business is reactive on the employment front because technology and outsourcing has made being proactive hiring unproductive.
The Fed indicated that it will keep the Fed Funds rate low for an (even more) extended period of time. It will also use proceeds from its maturing mortgage-backed securities to purchase treasuries with maturities ranging from 2-years to 10-years. The market is rallying on such news. One dissenter was Kansas City Fed President Thomas Hoeing. Mr. Hoenig believes such accommodation does more harm than good. He opined that such extreme accommodation does little to boost economic activity in this environment, but it could create inflation problems down the road should the economy change /recover structurally (there is that word again). I tend to agree with Mr. Hoenig and Pimco's Bill Gross. This is not cyclical economic issue, but a structural issue.
The economy is not structurally able to maintain levels of activity to which we have become accustomed.without continued stimulus. However, the Fed cannot entice consumers to borrow when they are already over-leveraged and are upside-down in their homes. The Fed cannot force banks to lend when it does not make sense to do so other than with top-flight borrowers. They have difficulty securitizing Alt-A and subprime loans and they do not whish to carry such risk on balance sheets. Not only would that be a poor business decision in this environment, but could incur the wrath of government regulators for taking too much risk, not to mention being accused of "forcing" loans upon those who can not afford them.
Look folks, floaters are not attractive at this time. Short-term rates are not rising and in spite of the rally on the long end of the curve, the slope of the yield curve will remain very much positively sloped. Step-ups remain a more attractive option, although they are rallying for obvious reasons. What is rallying counterintuitively are 10-year TIPS (and TIPS ETFs). Apparently retail investors feel more comfortable buying 10-year tips because they are less fearful of higher interest farther rout on the curve. They are shooting themselves in the foot. 10-year TIPS tend to do WELL when long-term rates rise as this usually means inflation pressures are materializing. Treasuries and TIPS are supposed to move in opposite directions. One is supposed to hedge the other. Clients just don't get it.
Laddering is still the best strategy and the belly of the curve (5 to 7 years) is the best place to overweight if one was inclined to overweight a spot on the curve. Currently it makes little sense to extend past 10-years unless clients are very desperate for every last basis point of income. One can get nearly 75% of the slope of the entire yield curve without extending past 10 years.
10-year treasuries extended their rally following a very good auction. Here are the results:
Yield came in at 2.730% vs. 3.119% in July.
Indirect bids 45.82% vs. 34.98% Avg 12 auctions
Bid-cover 3.04x vs. 2.98x Avg 12
The percentage of indirect bids is most impressive to me. Recent auction data has indicated that indirect purchases (which includes foreign central banks) softened a bit, but auctions were bolstered by strong domestic demand. Today's results indicated that foreign investors are very much back in the game. They were undoubtedly discouraged by the Fed's assessment of the recovery and were encouraged to by treasuries following the Fed's commitment to do the same.
U.S. treasury yields are at levels which are pricing in a double this recession. This however may be due to a flight to quality, account rebalancing and traders rejiggering hedges. However, if fear of a double dip recession strengthens a self fulfilling prophecy could result.
Don't expect the Fed to spark a strong expansion. The U.S. economy is not structured for such a rebound at this time and forthcoming regulation, tax policy and health care rules will cause significant head winds for business expansion and hiring. Unless there is a sea change in DC we could be in for a lost decade.
"Clearly not all of these imports of consumer goods are being purchased or consumed and some of it is going into inventories. It’s consistent with slower global growth. We’re going to get less of a boost from exports in the second half versus the first half."
The Fed painted a more solemn picture of U.S. economic recovery. This has apparently caught some market participants off guard. Why? I have no idea. Anyone with any historical perspective of growth and policy and has looked around at the state of the consumer (not to mention forthcoming tax and regulatory changes) could have figured out that the economy was not poised to roar back. Businesses will only add workers if they must. Business is reactive on the employment front because technology and outsourcing has made being proactive hiring unproductive.
The Fed indicated that it will keep the Fed Funds rate low for an (even more) extended period of time. It will also use proceeds from its maturing mortgage-backed securities to purchase treasuries with maturities ranging from 2-years to 10-years. The market is rallying on such news. One dissenter was Kansas City Fed President Thomas Hoeing. Mr. Hoenig believes such accommodation does more harm than good. He opined that such extreme accommodation does little to boost economic activity in this environment, but it could create inflation problems down the road should the economy change /recover structurally (there is that word again). I tend to agree with Mr. Hoenig and Pimco's Bill Gross. This is not cyclical economic issue, but a structural issue.
The economy is not structurally able to maintain levels of activity to which we have become accustomed.without continued stimulus. However, the Fed cannot entice consumers to borrow when they are already over-leveraged and are upside-down in their homes. The Fed cannot force banks to lend when it does not make sense to do so other than with top-flight borrowers. They have difficulty securitizing Alt-A and subprime loans and they do not whish to carry such risk on balance sheets. Not only would that be a poor business decision in this environment, but could incur the wrath of government regulators for taking too much risk, not to mention being accused of "forcing" loans upon those who can not afford them.
Look folks, floaters are not attractive at this time. Short-term rates are not rising and in spite of the rally on the long end of the curve, the slope of the yield curve will remain very much positively sloped. Step-ups remain a more attractive option, although they are rallying for obvious reasons. What is rallying counterintuitively are 10-year TIPS (and TIPS ETFs). Apparently retail investors feel more comfortable buying 10-year tips because they are less fearful of higher interest farther rout on the curve. They are shooting themselves in the foot. 10-year TIPS tend to do WELL when long-term rates rise as this usually means inflation pressures are materializing. Treasuries and TIPS are supposed to move in opposite directions. One is supposed to hedge the other. Clients just don't get it.
Laddering is still the best strategy and the belly of the curve (5 to 7 years) is the best place to overweight if one was inclined to overweight a spot on the curve. Currently it makes little sense to extend past 10-years unless clients are very desperate for every last basis point of income. One can get nearly 75% of the slope of the entire yield curve without extending past 10 years.
10-year treasuries extended their rally following a very good auction. Here are the results:
Yield came in at 2.730% vs. 3.119% in July.
Indirect bids 45.82% vs. 34.98% Avg 12 auctions
Bid-cover 3.04x vs. 2.98x Avg 12
The percentage of indirect bids is most impressive to me. Recent auction data has indicated that indirect purchases (which includes foreign central banks) softened a bit, but auctions were bolstered by strong domestic demand. Today's results indicated that foreign investors are very much back in the game. They were undoubtedly discouraged by the Fed's assessment of the recovery and were encouraged to by treasuries following the Fed's commitment to do the same.
U.S. treasury yields are at levels which are pricing in a double this recession. This however may be due to a flight to quality, account rebalancing and traders rejiggering hedges. However, if fear of a double dip recession strengthens a self fulfilling prophecy could result.
Don't expect the Fed to spark a strong expansion. The U.S. economy is not structured for such a rebound at this time and forthcoming regulation, tax policy and health care rules will cause significant head winds for business expansion and hiring. Unless there is a sea change in DC we could be in for a lost decade.
Tuesday, August 10, 2010
The (String) Pusher
The FOMC announced its rate decision. Anyone who was surprised by the Fed's decision to leave the Fed Funds rate effectively at 0.00% (actually 0.00% to .25%) is either delusional or living under a rock. The Fed did give us a mild surprise by decided to reinvest the proceeds of its maturing mortgage-backed securities into U.S. treasuries (especially longer-dated treasuries). Aside from helping to keep long-term rates in check, the impact on improving economic growth is negligible. Here is the Fed's statement
"Information received since the Federal Open Market Committee met in June indicates that the pace of recovery in output and employment has slowed in recent months. Household spending is increasing gradually, but remains constrained by high unemployment, modest income growth, lower housing wealth, and tight credit. Business spending on equipment and software is rising; however, investment in nonresidential structures continues to be weak and employers remain reluctant to add to payrolls. Housing starts remain at a depressed level. Bank lending has continued to contract. Nonetheless, the Committee anticipates a gradual return to higher levels of resource utilization in a context of price stability, although the pace of economic recovery is likely to be more modest in the near term than had been anticipated.
Measures of underlying inflation have trended lower in recent quarters and, with substantial resource slack continuing to restrain cost pressures and longer-term inflation expectations stable, inflation is likely to be subdued for some time.
The Committee will maintain the target range for the federal funds rate at 0 to 1/4 percent and continues to anticipate that economic conditions, including low rates of resource utilization, subdued inflation trends, and stable inflation expectations, are likely to warrant exceptionally low levels of the federal funds rate for an extended period.
To help support the economic recovery in a context of price stability, the Committee will keep constant the Federal Reserve's holdings of securities at their current level by reinvesting principal payments from agency debt and agency mortgage-backed securities in longer-term Treasury securities.1The Committee will continue to roll over the Federal Reserve's holdings of Treasury securities as they mature.
The Committee will continue to monitor the economic outlook and financial developments and will employ its policy tools as necessary to promote economic recovery and price stability.
Voting for the FOMC monetary policy action were: Ben S. Bernanke, Chairman; William C. Dudley, Vice Chairman; James Bullard; Elizabeth A. Duke; Donald L. Kohn; Sandra Pianalto; Eric S. Rosengren; Daniel K. Tarullo; and Kevin M. Warsh.
Voting against the policy was Thomas M. Hoenig, who judges that the economy is recovering modestly, as projected. Accordingly, he believed that continuing to express the expectation of exceptionally low levels of the federal funds rate for an extended period was no longer warranted and limits the Committee's ability to adjust policy when needed. In addition, given economic and financial conditions, Mr. Hoenig did not believe that keeping constant the size of the Federal Reserve's holdings of longer-term securities at their current level was required to support a return to the Committee's policy objectives."
None of what the Fed published in its statement is novel. Recent economic data indicated everything the Fed stated. Businesses have little need to add to staffing. Whenever possible, businesses will choose to spend on productivity rather than workers. Bank lending is contracting, due in good part to a reduced demand for credit as stimulus plans have ended and overleveraged consumers cannot and will not add to already high debt levels. Some investors where hoping that the Fed would see a silver lining inside the economic cloud. All it found was rain, not a recessionary torrent mind you, but a growth dampening drizzle.
Interestingly, one voting member dissented. That person was Kansas City Fed president, Thomas Hoenig. Mr. Hoenig is of the opinion that the Fed buying long-dated treasuries and stating that it will keep the Fed Funds rate low for an extended period of time will help speed the economic recovery. Some have interpreted his opinion to mean that the economy is in fact on the path to robust growth.
Although I disagree with the optimistic interpretation of Mr. Hoenig's dissent, I do agree with his opinion. The Fed has already done everything it can do to foster an economic recovery. In fact, the Fed may have set itself and the country up for future inflationary or stagflationary problems, unless Mr. Bernanke or his eventual successor takes a page out of Paul Volcker's book (Note: Although possible, I do not believe that neither inflation nor stagflation are a near-term possibility as we are not the only large economy facing a recovery with head winds - see Europe.
No, I believe Mr. Hoenig sees the situation for what it is. The U.S. economy was over-stimulated for over two decades which led to rates of consumption and increases in asset values, such as home prices, to rise to levels which were beyond their structurally possible potential. Now we all have to come back to earth. 2.00% to 3.00% GDP may be all we get.
We are not entitled to a new SUV every few years or a 4,000 square foot McMansion. An economy predicated on ever stronger sales of SUVs and continued home building is fundamentally unsound. The amount of cars which can be sold and the amount of homes which can be built is finite. There is only so much land and, unless we see large waves of immigrants, population growth may be slowing. Much like trying to fight the last war, trying to recreate the economy of the past 20 years may be an exercise in futility, much like pushing on a string.
Stay away from LIBOR and CPI floaters, buy TIPS which trade near or below par and have inflation indexes as close to 1.0 as possible (if not below) and then only has a hedge. A better hedge would be a step-up note and please; ladder, ladder, ladder.
Tip of the day: Bond features such as calls floating rates and step coupons tend to favor the issuer in most scenarios, not the investor.
"Information received since the Federal Open Market Committee met in June indicates that the pace of recovery in output and employment has slowed in recent months. Household spending is increasing gradually, but remains constrained by high unemployment, modest income growth, lower housing wealth, and tight credit. Business spending on equipment and software is rising; however, investment in nonresidential structures continues to be weak and employers remain reluctant to add to payrolls. Housing starts remain at a depressed level. Bank lending has continued to contract. Nonetheless, the Committee anticipates a gradual return to higher levels of resource utilization in a context of price stability, although the pace of economic recovery is likely to be more modest in the near term than had been anticipated.
Measures of underlying inflation have trended lower in recent quarters and, with substantial resource slack continuing to restrain cost pressures and longer-term inflation expectations stable, inflation is likely to be subdued for some time.
The Committee will maintain the target range for the federal funds rate at 0 to 1/4 percent and continues to anticipate that economic conditions, including low rates of resource utilization, subdued inflation trends, and stable inflation expectations, are likely to warrant exceptionally low levels of the federal funds rate for an extended period.
To help support the economic recovery in a context of price stability, the Committee will keep constant the Federal Reserve's holdings of securities at their current level by reinvesting principal payments from agency debt and agency mortgage-backed securities in longer-term Treasury securities.1The Committee will continue to roll over the Federal Reserve's holdings of Treasury securities as they mature.
The Committee will continue to monitor the economic outlook and financial developments and will employ its policy tools as necessary to promote economic recovery and price stability.
Voting for the FOMC monetary policy action were: Ben S. Bernanke, Chairman; William C. Dudley, Vice Chairman; James Bullard; Elizabeth A. Duke; Donald L. Kohn; Sandra Pianalto; Eric S. Rosengren; Daniel K. Tarullo; and Kevin M. Warsh.
Voting against the policy was Thomas M. Hoenig, who judges that the economy is recovering modestly, as projected. Accordingly, he believed that continuing to express the expectation of exceptionally low levels of the federal funds rate for an extended period was no longer warranted and limits the Committee's ability to adjust policy when needed. In addition, given economic and financial conditions, Mr. Hoenig did not believe that keeping constant the size of the Federal Reserve's holdings of longer-term securities at their current level was required to support a return to the Committee's policy objectives."
None of what the Fed published in its statement is novel. Recent economic data indicated everything the Fed stated. Businesses have little need to add to staffing. Whenever possible, businesses will choose to spend on productivity rather than workers. Bank lending is contracting, due in good part to a reduced demand for credit as stimulus plans have ended and overleveraged consumers cannot and will not add to already high debt levels. Some investors where hoping that the Fed would see a silver lining inside the economic cloud. All it found was rain, not a recessionary torrent mind you, but a growth dampening drizzle.
Interestingly, one voting member dissented. That person was Kansas City Fed president, Thomas Hoenig. Mr. Hoenig is of the opinion that the Fed buying long-dated treasuries and stating that it will keep the Fed Funds rate low for an extended period of time will help speed the economic recovery. Some have interpreted his opinion to mean that the economy is in fact on the path to robust growth.
Although I disagree with the optimistic interpretation of Mr. Hoenig's dissent, I do agree with his opinion. The Fed has already done everything it can do to foster an economic recovery. In fact, the Fed may have set itself and the country up for future inflationary or stagflationary problems, unless Mr. Bernanke or his eventual successor takes a page out of Paul Volcker's book (Note: Although possible, I do not believe that neither inflation nor stagflation are a near-term possibility as we are not the only large economy facing a recovery with head winds - see Europe.
No, I believe Mr. Hoenig sees the situation for what it is. The U.S. economy was over-stimulated for over two decades which led to rates of consumption and increases in asset values, such as home prices, to rise to levels which were beyond their structurally possible potential. Now we all have to come back to earth. 2.00% to 3.00% GDP may be all we get.
We are not entitled to a new SUV every few years or a 4,000 square foot McMansion. An economy predicated on ever stronger sales of SUVs and continued home building is fundamentally unsound. The amount of cars which can be sold and the amount of homes which can be built is finite. There is only so much land and, unless we see large waves of immigrants, population growth may be slowing. Much like trying to fight the last war, trying to recreate the economy of the past 20 years may be an exercise in futility, much like pushing on a string.
Stay away from LIBOR and CPI floaters, buy TIPS which trade near or below par and have inflation indexes as close to 1.0 as possible (if not below) and then only has a hedge. A better hedge would be a step-up note and please; ladder, ladder, ladder.
Tip of the day: Bond features such as calls floating rates and step coupons tend to favor the issuer in most scenarios, not the investor.
Sunday, August 8, 2010
Tick-Tock Broken Clock
Nonfarm Payrolls came in much worse than expected, but much of that was due to government job cuts, including census workers. The revision was even uglier and only half of the downward revision was government workers. The remainder came from the private sector. The Unemployment rate remained at 9.5%, but that was because over 100,000 discouraged unemployed workers answered the survey by stating they were not seeking employment at this time. The real unemployment rate is believed to be much higher.
I have a theory that the best private sector jobs data will be reflected in today's report and the report due out on September 3rd. My reasoning is that employment data is a lagging indicator and today's data reflects hiring during the height of the recovery and inventory replacement. The increase in manufacturing payrolls bears this out.
What is troubling for me are the increase of discouraged workers (over 389,000 additional displaced workers who have become discouraged and have ceased seeking employment since last ) year and the reliance on manufacturing data for private sector job growth. Not only is manufacturing a small part of the U.S. economy, but most of the manufacturing jobs were in the automotive sector. The was due to government assistance to automakers and increases demand from the "Cash for Clunkers" program. This is not the way to drive the economy forward.
The way to drive the economy moving forward is to create a friendly environment for small business. Forthcoming economic and tax polices do the exact opposite. Critics of small businesses have pointed to lower wages and fewer benefits than union jobs found at larger companies. However, those higher wages and greater benefits have made many large firms uncompetitive and many (unless you are a Detroit automaker) have closed their doors. Asset values and, in some instances, wages became inflated. America needs to be repriced. However, the administration and and Congress are trying to prevent a price correction. In fact, what they are proposing in the way of higher taxes and health care would cause prices to rise.... if consumers could afford to spend.
What is the DC solution? Demonize the banks for not lending. Think about it. They are bashing the banks for focusing on risk management after bashing them for poor risk management. What would be the reaction from Capitol Hill and the White House if banks gave loans to those who were higher risks and these people went delinquent or defaulted. The first reaction would be to call ban CEOs before Congress to lambaste them for creating systemic risks. A few months later, after the delinquencies and defaults piled up, the same CEOs would be hauled in front of Congress and be harshly criticized for predatory lending, forcing loans upon people who could not afford them. Please tell me again why banks should lend?
Although it is true that bank lending is somewhat tight and lending standards are high, they are closer to historical norms than what we have seen during the past 20-years. This gives us some insight to what the economy may be like during the next several years. Higher taxes, government mandates and stricter regulations, combined with less-than-free-flowing credit will keep growth, employment and inflation low.
Inflation has been a hot topic in the investor community. The equity arena and the small investor world (the two are closely related) are concerned with higher inflation and runaway interest rates. They theory is that because the U.S. is printing large amounts of money and issuing large quantities of debt, inflation and higher rates must result. Such opinions are only looking at one side of the problem.
For years, investors and financial professionals were taught to look at debt issuance as resulting in a weaker currency. A weaker currency would result in inflation as a dollar loses purchasing power. It would also result in higher long-term interest rates as investors desire higher rates of return to assume greater downside currency risk. These fears would be valid if the economy in question was unique in its difficulties and the economy was not global in nature. This is what happened in the 1970s, but the dynamics are much different today. The economy is global, other large economies are in trouble (Europe) and even booming economies are having brakes applied (China). In the current environment, deflation may be the bigger concern.
Deflation is a growing concern in the bond market. Fixed income traders and strategists are of the opinion that there is no escaping the economic down turn. The most robust economies in Asia and other emerging markets exist under the control of some of the most restrictive governments. Try to buy Chinese bonds and one would find it difficult. Try to deliver these bonds outside of Asia and one could find it impossible. What to own the renminbi? One might find it easier to acquire a unicorn. Therefore the U.S. dollar will remain the world's reserve currency. The currency which could have posed the biggest threat to the dollar, the euro, exists in an economy which is in worse shape than the U.S. economy. The EU also does not have a unified economic policy. This is evidenced by the PIIGS being able to thumb their noses at EU deficit limits.
Currently the U.S. treasury market is pricing in a flat-lining U.S. economy, if not worse. That in my view may be a little extreme, but it has a greater possibility of occurrence than a booming v-shaped recover. Pimco's Bill Gross hit the nail on the head when he stated in his investor letter that the problems facing the U.S. economy are structural and not cyclical. Until recently I was of the opinion that the Fed would begin its gradual tightening early in the third quarter of 2011. I am not of the opinion that the earliest we will see Fed tightening is the second half of 2011 if not 2012.
The treasury market has historically been among the better predictors of future economic conditions (more so than the equity market). However, this is being lost on many financial advisers. They continue to plow investors into LIBOR and inflation floating rate notes in anticipation of higher rates and inflation. Their thinking is that at sometime we will have higher rates and inflation and then they will be prepared. However, besides not understanding how said floaters work (LIBOR floaters work when the yield curve flattens, not when rates rise and CPI floaters work best when the RATE of inflation increases not just because inflation is high or even positive. Their coupons can actually fall if inflation was positive and high, but that rate falls from say 5% to 4%) they fail to correctly assess the opportunity cost of waiting at very low rates for extended period of time versus investing in higher fixed-coupon instruments.
This reminds me of 2003 when famous fixed income strategist forecast a 6.00% 10-year treasury within a year. By 2005 he was saying that his prediction was not incorrect, but his timing was off. If one took his advice they are still waiting for the 6.00% 10-year. A broken clock is correct twice a day, but one would be ill advised not to repair it. Buying LIBOR and CPI floaters is a broken clock strategy. They will be right at some point, but they are not worth the wait.
Until next time: Duck and cover!
I have a theory that the best private sector jobs data will be reflected in today's report and the report due out on September 3rd. My reasoning is that employment data is a lagging indicator and today's data reflects hiring during the height of the recovery and inventory replacement. The increase in manufacturing payrolls bears this out.
What is troubling for me are the increase of discouraged workers (over 389,000 additional displaced workers who have become discouraged and have ceased seeking employment since last ) year and the reliance on manufacturing data for private sector job growth. Not only is manufacturing a small part of the U.S. economy, but most of the manufacturing jobs were in the automotive sector. The was due to government assistance to automakers and increases demand from the "Cash for Clunkers" program. This is not the way to drive the economy forward.
The way to drive the economy moving forward is to create a friendly environment for small business. Forthcoming economic and tax polices do the exact opposite. Critics of small businesses have pointed to lower wages and fewer benefits than union jobs found at larger companies. However, those higher wages and greater benefits have made many large firms uncompetitive and many (unless you are a Detroit automaker) have closed their doors. Asset values and, in some instances, wages became inflated. America needs to be repriced. However, the administration and and Congress are trying to prevent a price correction. In fact, what they are proposing in the way of higher taxes and health care would cause prices to rise.... if consumers could afford to spend.
What is the DC solution? Demonize the banks for not lending. Think about it. They are bashing the banks for focusing on risk management after bashing them for poor risk management. What would be the reaction from Capitol Hill and the White House if banks gave loans to those who were higher risks and these people went delinquent or defaulted. The first reaction would be to call ban CEOs before Congress to lambaste them for creating systemic risks. A few months later, after the delinquencies and defaults piled up, the same CEOs would be hauled in front of Congress and be harshly criticized for predatory lending, forcing loans upon people who could not afford them. Please tell me again why banks should lend?
Although it is true that bank lending is somewhat tight and lending standards are high, they are closer to historical norms than what we have seen during the past 20-years. This gives us some insight to what the economy may be like during the next several years. Higher taxes, government mandates and stricter regulations, combined with less-than-free-flowing credit will keep growth, employment and inflation low.
Inflation has been a hot topic in the investor community. The equity arena and the small investor world (the two are closely related) are concerned with higher inflation and runaway interest rates. They theory is that because the U.S. is printing large amounts of money and issuing large quantities of debt, inflation and higher rates must result. Such opinions are only looking at one side of the problem.
For years, investors and financial professionals were taught to look at debt issuance as resulting in a weaker currency. A weaker currency would result in inflation as a dollar loses purchasing power. It would also result in higher long-term interest rates as investors desire higher rates of return to assume greater downside currency risk. These fears would be valid if the economy in question was unique in its difficulties and the economy was not global in nature. This is what happened in the 1970s, but the dynamics are much different today. The economy is global, other large economies are in trouble (Europe) and even booming economies are having brakes applied (China). In the current environment, deflation may be the bigger concern.
Deflation is a growing concern in the bond market. Fixed income traders and strategists are of the opinion that there is no escaping the economic down turn. The most robust economies in Asia and other emerging markets exist under the control of some of the most restrictive governments. Try to buy Chinese bonds and one would find it difficult. Try to deliver these bonds outside of Asia and one could find it impossible. What to own the renminbi? One might find it easier to acquire a unicorn. Therefore the U.S. dollar will remain the world's reserve currency. The currency which could have posed the biggest threat to the dollar, the euro, exists in an economy which is in worse shape than the U.S. economy. The EU also does not have a unified economic policy. This is evidenced by the PIIGS being able to thumb their noses at EU deficit limits.
Currently the U.S. treasury market is pricing in a flat-lining U.S. economy, if not worse. That in my view may be a little extreme, but it has a greater possibility of occurrence than a booming v-shaped recover. Pimco's Bill Gross hit the nail on the head when he stated in his investor letter that the problems facing the U.S. economy are structural and not cyclical. Until recently I was of the opinion that the Fed would begin its gradual tightening early in the third quarter of 2011. I am not of the opinion that the earliest we will see Fed tightening is the second half of 2011 if not 2012.
The treasury market has historically been among the better predictors of future economic conditions (more so than the equity market). However, this is being lost on many financial advisers. They continue to plow investors into LIBOR and inflation floating rate notes in anticipation of higher rates and inflation. Their thinking is that at sometime we will have higher rates and inflation and then they will be prepared. However, besides not understanding how said floaters work (LIBOR floaters work when the yield curve flattens, not when rates rise and CPI floaters work best when the RATE of inflation increases not just because inflation is high or even positive. Their coupons can actually fall if inflation was positive and high, but that rate falls from say 5% to 4%) they fail to correctly assess the opportunity cost of waiting at very low rates for extended period of time versus investing in higher fixed-coupon instruments.
This reminds me of 2003 when famous fixed income strategist forecast a 6.00% 10-year treasury within a year. By 2005 he was saying that his prediction was not incorrect, but his timing was off. If one took his advice they are still waiting for the 6.00% 10-year. A broken clock is correct twice a day, but one would be ill advised not to repair it. Buying LIBOR and CPI floaters is a broken clock strategy. They will be right at some point, but they are not worth the wait.
Until next time: Duck and cover!
Thursday, August 5, 2010
Peaking Too Early
Jobless Claims numbers were ugly yet again. However, tomorrow's Nonfarm payrolls number may be fairly good (considering where we have been), adding about 90,000 private sector jobs. That however may be as good as it gets for a while. Why is this so? For months equity market bulls have talked down the jobs data because it they are lagging indicators and do not yet reflect the strength of the economic reovery.
The fact that they are lagging indicators is why tomorrow's data may be a near-term peak. Tomorrow's private sector data reflects conditions during the height of the economic rebound. Most recent leading and coincidental indicators have been disappointing. If jobs data dutifully lags as is typical, the employment picture may be gloomy for the balance of 2010. The bond market appears to be factoring this in.
The fact is that the Fed is out of ammunition and cannot create the fundamentally unsustainable growth to which American's have become accustomed during the past two decades. We are going back to the future (I just hope Ford doesn't bring back the Edsel).
I can't wait until tomorrow.
The fact that they are lagging indicators is why tomorrow's data may be a near-term peak. Tomorrow's private sector data reflects conditions during the height of the economic rebound. Most recent leading and coincidental indicators have been disappointing. If jobs data dutifully lags as is typical, the employment picture may be gloomy for the balance of 2010. The bond market appears to be factoring this in.
The fact is that the Fed is out of ammunition and cannot create the fundamentally unsustainable growth to which American's have become accustomed during the past two decades. We are going back to the future (I just hope Ford doesn't bring back the Edsel).
I can't wait until tomorrow.
Sunday, August 1, 2010
Take a Good look Around You
Friday's GDP and revisions indicate that the economy was deeper than originally believed and the recovery more modest than originally expected. Why anyone was surprised be this is beyond me. Employment data has been consistent with a lackluster recover. Yes it is true that employment is a lagging indicator, but knowing where you have been helps you determine where you are going. It appears as though we have been through a deeper recession than anyone (anyone other than Americans actually suffering through the poor economic conditions believed.
I have been active in Scouting since 1978. Several Scout camps I have had the pleasure of visiting has a "weather rock". A weather rock is an impressive weather analysis tool. It works like this:
If rock is wet, it is raining.
If rock is white, it is snowing.
If rock is shaking, there is an earthquake.
If rock is dry, the weather is fair.
If rock is swinging, it's windy.
If rock is warm, the sun is out.
If rock is not visible, it's dark outside.
If rock is under water, there is a flood.
If rock is gone, there is a tornado (Run!!)
There are times I wish economists, analysts, strategists and market participants would include weather rock principles in their analysis. Most of the aforementioned professionals do not live in areas which were hard hit by the deep recession. Yes, many of them and their friends and neighbors have seen the values of their homes and investments drop, but few of them are concerned about putting food on their tables, paying their mortgages or finding jobs. However, many Americans are experiencing such hardships.
What appears to be escaping those predicting a sharp V-shaped recovery is that the economy immediately preceding the recession was way over stimulated. This wasn't a case where a fundamentally strong economy became a little overheated. This was a modestly hot economy that was fueled into a conflagration by very low rates and very easy borrowing terms. Consumers became overextended beyond any measure of common sense. The Fed and Wall Street reaped the wind with low rates, creative securitization and easy lending standards. Now they are reaping the whirlwind.
I agree with the majority opinion that the U.S. economy is not likely to fall into a double-dip recession, but I believe that that U.S. consumption is closer to sustainable levels than most would like to admit or believe. Experts continue to be perplexed why strong profits are not resulting in job growth (which is needed to push the economy higher). The answer is that there is no advantage in adding any workers which are not absolutely needed. It is much easier to spend on productivity increases, such as new equipment and software. This was born out in last week's durable goods numbers and by the Fed's Beige Book report.
This has put the government in a tight spot. New tax policies and heath care laws make it disadvantageous to hire workers. The Fed can only do what it can do and is already pushing on a string. Banks are more than happy to lend if it is to borrowers with solid credit scores, preferably via GSE-qualifying mortgages which can be easily securitized.
Face it folks, this is the recovery. Truthfully it has been a kind of V. The problem is that the left side of the V was 10 feet tall, but the right side is 5 feet tall. How do we get the right side to 10 feet? I don't believe we can, at least not any time soon and certainly not based on fundamentals.
This brings to interest rates. There has been renewed interest among investors into floating rate and interest rate adjustable bonds. Not as hedges mind you, but as ways to score big when interest rates and inflation explode higher. I have one question to ask: What in God's name are you thinking? I agree that rates cannot stay down here or trend much lower, but a move higher is likely to be limited. The cost of insuring against inflation and as measured by the low current rates of return versus similar fixed rate securities is prohibitively high. It is like insuring your house against flood damage when living on a tall hill. Sure flood waters may reach you after a bad storm, but the odds of that happening it makes little sense to purchase flood insurance (assuming you could qualify in the first place).
Bank of America announced that it dropped its CD rates in response to lower interest rates across the board. Other banks are likely to follow suit. The carry trade (borrowing on the short end of the yield curve and lending (in this case to the government by purchasing treasuries) on the long end of the curve) has been among the most profitable activities for banks. The bond market and the Fed have been warning us for some time that the economy is in for a slow recovery. Ignore them at your own peril.
I have been active in Scouting since 1978. Several Scout camps I have had the pleasure of visiting has a "weather rock". A weather rock is an impressive weather analysis tool. It works like this:
If rock is wet, it is raining.
If rock is white, it is snowing.
If rock is shaking, there is an earthquake.
If rock is dry, the weather is fair.
If rock is swinging, it's windy.
If rock is warm, the sun is out.
If rock is not visible, it's dark outside.
If rock is under water, there is a flood.
If rock is gone, there is a tornado (Run!!)
There are times I wish economists, analysts, strategists and market participants would include weather rock principles in their analysis. Most of the aforementioned professionals do not live in areas which were hard hit by the deep recession. Yes, many of them and their friends and neighbors have seen the values of their homes and investments drop, but few of them are concerned about putting food on their tables, paying their mortgages or finding jobs. However, many Americans are experiencing such hardships.
What appears to be escaping those predicting a sharp V-shaped recovery is that the economy immediately preceding the recession was way over stimulated. This wasn't a case where a fundamentally strong economy became a little overheated. This was a modestly hot economy that was fueled into a conflagration by very low rates and very easy borrowing terms. Consumers became overextended beyond any measure of common sense. The Fed and Wall Street reaped the wind with low rates, creative securitization and easy lending standards. Now they are reaping the whirlwind.
I agree with the majority opinion that the U.S. economy is not likely to fall into a double-dip recession, but I believe that that U.S. consumption is closer to sustainable levels than most would like to admit or believe. Experts continue to be perplexed why strong profits are not resulting in job growth (which is needed to push the economy higher). The answer is that there is no advantage in adding any workers which are not absolutely needed. It is much easier to spend on productivity increases, such as new equipment and software. This was born out in last week's durable goods numbers and by the Fed's Beige Book report.
This has put the government in a tight spot. New tax policies and heath care laws make it disadvantageous to hire workers. The Fed can only do what it can do and is already pushing on a string. Banks are more than happy to lend if it is to borrowers with solid credit scores, preferably via GSE-qualifying mortgages which can be easily securitized.
Face it folks, this is the recovery. Truthfully it has been a kind of V. The problem is that the left side of the V was 10 feet tall, but the right side is 5 feet tall. How do we get the right side to 10 feet? I don't believe we can, at least not any time soon and certainly not based on fundamentals.
This brings to interest rates. There has been renewed interest among investors into floating rate and interest rate adjustable bonds. Not as hedges mind you, but as ways to score big when interest rates and inflation explode higher. I have one question to ask: What in God's name are you thinking? I agree that rates cannot stay down here or trend much lower, but a move higher is likely to be limited. The cost of insuring against inflation and as measured by the low current rates of return versus similar fixed rate securities is prohibitively high. It is like insuring your house against flood damage when living on a tall hill. Sure flood waters may reach you after a bad storm, but the odds of that happening it makes little sense to purchase flood insurance (assuming you could qualify in the first place).
Bank of America announced that it dropped its CD rates in response to lower interest rates across the board. Other banks are likely to follow suit. The carry trade (borrowing on the short end of the yield curve and lending (in this case to the government by purchasing treasuries) on the long end of the curve) has been among the most profitable activities for banks. The bond market and the Fed have been warning us for some time that the economy is in for a slow recovery. Ignore them at your own peril.
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