Not Quite

It was only a few short weeks ago that pundits were all over the airwaves warning us about mega-inflation, rapidly-rising interest rates and a mass exodus of foreign investors from the U.S. dollar.



Since then we have had a 10-year treasury note auction with record buying by foreign investors, including central banks.. We also saw take consumer prices, softer-than- retail sales, a leveling off of jobless claims after some improvement, lower capacity utilization and lower interest rates.



Many market participants expected the Fed to begin hinting that it is ready to change course. However, Fed Chairman Ben Bernanke defended his policies during a G20 meeting this morning.



In his speech he implored China to increase the value of the yuan. Mr. Bernanke stated that commodity prices have risen “significantly” due to increased demand from emerging economies. He went on to say that countries which freely float their currencies “have seen their competitiveness erode relative to countries that have intervened more aggressively in foreign exchange markets.”



This is precisely why China closely manages its currency. China’s policy makers know full well that if the yuan appreciates too much, either China’s export prices would have to rise or their profit margins could be squeezed. Neither option is particularly desirable for China’s policy makers. Smaller profit margins could squeeze businesses. Higher prices could mean lost market share as other emerging economies would likely become price competitive.



There is another method to Mr. Bernanke’s madness. The Fed has been much criticized for helping to push commodities prices higher by keeping rates low, thereby weakening the dollar. There is more than one way to lower commodity prices. Yes, the Fed could begin to tighten, but that could put added downward pressure on real estate prices as higher rates make homes less affordable. It could also nip the recovery in the auto sector in the bud. Another possible result of Fed tightening could be higher borrowing costs for corporations. Such a scenario could severelynegatively impact corporate borrowers, especially those on the lower end of the credit quality scale.



Another alternative for would be for China to permit the value of the yuan to rise to what the market will bear, thereby slowing China’s economy and reducing the demand for commodities. China’s demand for U.S. treasuries (U.S. dollars) would probably shrink and U.S. long-term rates could rise and the yield curve steepen. However, higher long-term yields could entice other investors thereby limiting further dollar weakness. Round and round we go. The bottom line is that China’s “management” of its currency is making life difficult for central bankers around the globe. It does not appear as though drastic changes to China’s currency policies are imminent.



To consumers, inflation is an price increase which affects their daily lives. To the Fed, inflation are price increases of goods and services which have inelastic demand curves which can impair economic activity. Currently the Fed is dealing with inflation among commodities, but stagnation in the price of services and wages. In fact, some areas of the service economy are cutting prices to increase business. Housing continues to be a problem. Sure, the Fed can raise rates, strengthen the dollar and help bring down food and energy inflation, but what would that do to housing of the manufacturing-led recovery? The result would probably be the economy grinding to a halt.



We all must realize that the economy many of us had come to view as normal was not sustainable. Home prices cannot be expected to double every few years. Equity markets cannot be expected to rise 20% each and every year. Not everyone can own a McMansion and a $40,000 SUV. The sooner this is acknowledge, the sooner the country can move forward.


Please read Andy Kessler's op / ed in Wednesday's WSJ.

Housing Bubble Explained.

Not great, but cute explanation of the housing bubble:

http://www.xtranormal.com/watch/11131655

Buy Mortimer

What don't these people understand? Foreign central banks need to buy dollars. They need to support the dollar in order to keep their currencies from rising in value, too much. They need to maintain favorable exchange ratios.

What about inflation? Why would they buy the 10-year of inflation may be on the rise? They bought the 10-year as a way to combat inflation. Say what?

That's right. Most inflation has been in commodities and energy. These are denominated in dollars. By purchasing treasuries, the dollar is strengthened and that to have a deflationary effect on commodity prices. Mark my words, the 10-year note will need at least all of 2011 to get to 4.00% and it may take more than one year for both Fed Funds and three-month LIBOR to get past 2.50%. Rates are not poised to explode higher.

Groundhog Day!

Today is Groundhog Day and once again the ADP data exceeded the street consensus estimate. This time by 47,000 jobs. However, the prior data were revised lower buy 50,000 jobs. What does this mean for Friday’s payrolls data? Possibly nothing. Last month, stronger-than-expected ADP numbers did not portend stronger private payrolls data. Friday is going to be interesting.



The street is forecasting 140,000 new private jobs for January (the same as the street’s ADP forecast) and for 143,000 new jobs, all in. If this comes to fruition, this is below the pace believed to be necessary to keep up with the number of new workers entering the workforce or to lower the unemployment rate.



However, the unemployment rate could fall, even with sub-par job growth. Due to the method in which the household survey is conducted, respondents answering that they are not working, but are not actively seeking employment are not counted as being unemployed. An increasing number of discouraged displaced workers can actually make the unemployment rate fall. Conversely, if these displaced workers become more optimistic and answer that they are looking for work, the unemployment rate could rise, even though the job picture is becoming brighter. The devil is in the details.



Today’s Wall Street Journal “Credit Markets” columns discusses floating rate notes and that issuers feel comfortable coming to market with such structures because many investors believe that inflation pressures are building and the Fed will have to raise rates, thereby flattening the yield curve. The article also notes that for the past year, floaters may not have been a good place to be (something alluded to in Making Sense).



The article quotes a fixed income market participant who states:



"People have had the view for the last year, or year and a half, that short-term rates aren't going higher any time soon, and that is not an environment where you think you can make money on floating-rate debt.”





As we published last week, we may be getting closer to the time when the Fed has to take action by raising short-term rates, but that could still be a long way off. Remember, issuers come to market with structures which they believe are good sources of financing for them. Investors can influence the terms of bond structures by voting yea or nay with their investment dollars. Floaters can be valuable hedges versus various outcomes, depending on the structure. However, they are not (as is often explained in basic financial publications of financial adviser training) a way to eliminate interest rate risk. No issuer would ever come to market with such structures for obvious reasons.