Sunday, October 24, 2010


My recent return to the financial industry has proved to be more taxing on my time that I had originally anticipated. As a result, the frequency and quality of the articles on this blog would have suffered, given the lack of adequate time to devote on preparing them. Under the circumstances, I have decided to suspend updates for the time being. It may become possible, at some point in the future, to re-activate this blog but I simply do not have a good sense yet as to when, or whether, this will become feasible.

We may, or may not reconnect again, but, in the meantime, if you wish to stay in touch with my work in the financial industry, drop me a line at my Stern email address ( and I may be able to add you (compliance permitting!) to my current distribution list!

It has been a wonderful ride over the last 14 months and I want to thank all of you for your interest in my thoughts.

Stay in touch!


Monday, October 18, 2010

A Key Issue Regarding GDP Growth in Q3

Based on all available information to date, Q3 GDP growth looks like a 2% proposition, with the caveat that the international trade and inventory data for September are still not available (nor would they be by the time the advance GDP report is released on October 29. This incomplete information and associated assumptions that the Commerce Department will have to make have the potential to print a number that will be materially different next week.

The composition of third quarter GDP is of special importance here, as it is likely to have a direct bearing on the current quarter's GDP growth. Last Friday's retail sales data for September, along with substantial upward revisions to the prior two months, have set personal consumption on a respectable 2-2 1/4% path in Q3, while the widening of the trade deficit in August points to net exports becoming a bigger than previously assumed drag on growth.

The key though is that there appears to have been a faster pace of inventory accumulation last quarter, which represents a potentially worrisome development. While solid contribution of inventories to economic activity is an integral part of the dynamic in the early stage of an economic recovery (as businesses scramble to replenish previously depleted inventories in the midst of the downturn), an inventory bulge at this point is problematic. In all likelihood, any inventory build-up in Q3 was of the involuntary kind due to a pullback in final demands. The implication of that is that, unless final demand picks up in the current quarter, production cutbacks may act an impediment to a stronger pace of GDP growth in Q4.

Still, the degree of the negative role that the inventory situation may play in the current quarter will depend on the magnitude of both the inventory build-up in Q3 and also whether final demands will remain subdued in the current period.

All in all, growth continues to show no evidence of a near-term upswing and is headed for continuing sub par performance into the first quarter of next year, probably remaining in the 2 to 2 1/2% range.

Anthony Karydakis

Tuesday, October 5, 2010

Friday's September Employment Report

To say that that there is a lot riding on the September employment report is
probably an understatement, as it clearly has the potential to settle the issue of
whether the Fed will proceed with another round of quantitative easing in a few

A number of things to be kept in mind for Friday.

1) In the establishment survey, the emphasis, once again, should remain on private
payrolls, as the unwinding of the Census workers will continue to distort the headline
payroll print. The "Census effect" may not disappear until December, although it should
be gradually fading in the October-November period. 

2) Private payrolls have averaged 95K a month since the beginning of the year, reflecting
the creation of a total of 763K jobs in the private sector since January. More than half of
these jobs were created in just two months in early spring (March-April), prior to the onset
of the "soft patch". In the last 4 months, the average monthly gain has slipped to 71K,
representing a total of 286K jobs created in that period. 

3) The question of what number is needed to make the Fed willing to at least temporarily
suspend the activation of new QE measures requires a high degree of oversimplification,
as the Fed will not be making that decision based on a single number in the employment
report. With that in mind, a gain of over 130-140K would probably help the debate alive
within the FOMC as to the necessity for such action. Of course, revisions to the prior two
months will also matter, as any surprising strength in the September private payroll
number could be offset by revisions in the opposite direction.

4) Speaking of revisions: Along with the September employment report the BLS will also
be releasing its benchmark revision to the level of nonfarm payrolls in March 2010. This is
the BLS's first estimate, with the final number to be released along with the January 2011
employment report next February. There is no way of predicting whether the level of
payrolls for this past March will be revised up or down, but there seems to be growing
chatter in recent days that the number will be revised downward- by a potentially
appreciable amount. (What counts as "appreciable" with regard to the benchmark revision
is probably something to the tune of 300-400K or more). This is based on the impression
that the BLS has a bias toward overestimating job creation in periods of weak economic
activity. Also, another factor contributing to the talk of a substantial downward revision to
the March payroll level is the significant discrepancy between the ADP survey and the
BLS data over the last year - with the former showing a much slower pace of job growth.
With that taken into account, it needs to be emphasized that we have no hard information
pointing safely toward a sizable downward revision to the benchmark March number.
(For the record, the biggest downward revision in recent memory was the one announced
last fall for March 2009, which was by more than 820K).

5) There seems to be an unusually strong consensus that the unemployment rate will be
up in September to 9.7% from 9.6% in August. There are two main reasons behind that
expectation: 1) the civilian labor force showed a sharp contraction in the June-July period,
shrinking by a cumulative 833K. It is fairly uncharacteristic to see a contraction of the
civilian labor force in a phase of the cycle where, on balance, the economic
environment is improving compared to a year ago. Although the civilian labor force
bounced back by 550K in August, there is still a deficit of 285K jobs over the last three
months, which most analysts expect to be rectified in September in the form of a jump in
the size of the civilian labor force. 2) The unemployment rate in August was actually
9.64%, which, in conjunction with the above point about the labor force, makes it a natural
to inch to the 9.7% mark. 

While the unemployment rate is largely a lagging indicator and unlikely to change
materially anyone's perception of the broader economic environment, from the Treasury
market's standpoint a potential spike above the widely anticipated 9.7% (and with a little
help from an "s advertised" private payroll number) would be viewed as a license to
continue its seemingly irrepressible rally.

Anthony Karydakis

About the Fed's Purchases of Treasuries

The Head of the NY Fed's Open-Market Trading Desk, Brian Sack, gave a
thoughtful speech yesterday at the CFA Annual Conference, where he
discussed the Fed's decision on August 10th to reinvest the principal
payments of maturing agency and MBS debt. He also discussed at some
length the various issues associated with the prospect of any further
expansion of the Fed's balance sheet. The full text of his talk can be
found at

It is worth keeping in mind that the Fed is already committed (before
they consider any additional such measures in the coming weeks) to
purchasing a very sizable amount of Treasuries over the medium-term, as
a result of the August 10th decision. At the time, they estimated that
the amount of agency and MBS debt that would be running off by the end
of 2011 was likely to be around $400 billion. In his speech yesterday,
Brian Sack stated that this estimate now is already"somewhat higher"
compared to what was considered on August 10th. This is the direct
result of the strong rally in the Treasury market in the interim, with
10-year yields declining by approximately 35 basis points since August
9th. (The Treasury rally and the ongoing tightness of mortgage spreads
increases the pace of MBS prepayments in the Fed's portfolio).

If long-term Treasury yields were to decline moderately further in the
near future, the Fed's "automatic" purchases of Treasuries would
increase even more. Of course, the exact additional amount of Treasuries
that would need to be purchased over the next 15 months (over that
initial $400 billion the FOMC mentioned on August 10) would also be
partly contingent upon the length of period that rates remain close to
their lows over that time frame. However, with the economic recovery now
expected to remain on a very moderate growth path, yields are likely to
remain low well into 2011.

All in all, the Fed may already be on track to purchase $500 to $600 billion of
Treasuries by the end of next year, WITHOUT explicitly announcing any additional
QE next month. Now, if the Fed does announce a stand-alone, "active" program of
additional Treasury purchases in November- and that adds significant
further momentum to the Treasury rally, then the combined effect of the
two programs of such purchases will be magnified due to an even faster
prepayment rate of mortgages as yields continue to decline. The end
result here is that the Fed may end up buying an appreciably higher
amount of Treasuries over the next 12 to 15 months than officially
stated; depending on the trajectory of economic activity over that
horizon, such a number could easily exceed the $1.5 trillion mark.

Anthony Karydakis

Tuesday, September 28, 2010

Marching Toward More QE

What started as a hint in Bernanke's Jackson Hole speech a few weeks ago and was seconded by a more overt hint to that effect in the latest FOMC statement, seems to have taken the form, in the Treasury market's mind, of an almost unstoppable march toward more quantitative easing by the Fed. Today's front page article in The Wall Street Journal, along with the sharp decline in the Conference Board's consumer confidence index for September, seemed to have added an air of a near inevitability to the prospect of additional purchases of Treasuries by the Fed in the foreseeable future.

The obvious question that this dynamic generates is whether there is anything, at this point, that can derail this outcome.

With the various economic reports in recent days having failed to provide any glimmer of hope that economic activity is gearing up, the possible "cicrcuit-breakers" are dwindling fast. With Friday's ISM likely to show, if anything, a modest retreat from its 56.7 level in August, the only potential piece of economic data that would allow the Fed to take a step back and wait a little longer, appears to be the September employment report. While putting forward hard and fast rules here as to what nonfarm payroll number would be required to put the Fed's apparent plans on hold is a tricky task, it is not unreasonable to argue that a gain in private payrolls by more than 125K in September (to be released on October 8) might give the Fed some room to take a small step back. (Such a reference number is not outlandish, as just in July- in the midst of the current soft patch- private payrolls turned out a gain of 107K). Then, the behavior of the September core CPI could take an unexpectedly pivotal role in the final decision. With the core index currently running at 0.9% year-on-year, a gain of 0.2% in the series for the month could help expand the Fed's breathing space- at least for a while.

Anthony Karydakis

Thursday, September 23, 2010

Nominal Treasuries and TIPS: A Diverging Inflation Outlook?

As of next week, I will be returning to the financial industry, while maintaining some of my teaching responsibilities at Stern. Every effort will be made to maintain a pace of approximately two new postings each week, although, on rare occasions, that standard may not be fully met.- AK

One of the most intriguing market reactions to the FOMC's signal last week that additional purchases of Treasuries may be in store is the strong rally in TIPS, which has fully kept up with that in nominal long-term Treasuries. This has helped sustain the strength that TIPS have demonstrated since the beginning of the month, and which has led to a rebound of the break-evens in the 10-year sector by about 30 basis points.

That nominal Treasuries have rallied in the aftermath of the Fed's announcement is hardly surprising, although we felt that it contained a bit of a "jumping the gun" element ( Still, the enhanced prospect of potentially sizable purchases that would likely remain concentrated in the long end of the market, can explain the resumption of the rally that had suffered a modest setback earlier in the month.

The impressive vigor of the rally in the TIPS market (which would almost certainly be excluded from any Fed asset purchase program) can only be attributed to the part in the FOMC statement that expresses the policymakers' discomfort with the rate of core inflation running below the Fed's medium-term objective, of presumably closer to 2%. Another way of putting it is that TIPS became suddenly more attractive because the Fed signaled that they may provide more liquidity to the system via quantitative easing to fend off any deflation risk- and possibly reflate the economy.

Something though does not quite sit right with the above interpretation of the strength of the TIPS market. If TIPS are rallying because the Fed's anticipated second round of quantitative easing will cause more inflation (therefore making TIPS appealing), why don't nominal Treasuries see that perceived threat of higher inflation, and have, instead, rallied as well by a roughly comparative amount?

The only plausible explanation here is that Treasuries have evidently made the assessment that the extra demand for long-term securities by the Fed will squarely outweigh the setback that such maturities would otherwise be suffering as a result of any heightened inflation fears. This is, in our opinion, a somewhat heroic proposition, as patterns of market behavior over the medium-term have almost invariably shown that concerns about inflation tend to be a more reliable and potent driver of nominal long-term yields than supply-related considerations.

The above analysis does not imply that the widening of the TIPS break-evens since the beginning of September will be reversed. In fact, that push may continue, albeit in a somewhat choppy manner. However, such a move would more likely be fueled by a slow retreat of the most intense deflation concerns that would allow TIPS to maintain a firm underlying bid consistent with the tacit view of 1.75-2.0% inflation over the long-term. At the same time, Treasuries may remain close to a standstill, pulled in opposite directions by that same inflation prospect and positive- although, still not guaranteed to materialize- supply considerations.

Anthony Karydakis