Tuesday, September 29, 2009

The Sliding Dollar...

On two separate occasions in the last several days, the ECB President, Jean-Claude Trichet, has emphasized- with some uncharacteristically for him vigorous language- the need for a strong dollar.

(http://www.ecb.int/press/key/date/2009/html/sp09092) (http://www.bloomberg.com/apps/news?pid=20601087&sid=aSd5pt2tYX.o)

The dollar has declined by about 15% against the euro since February, while it is within striking distance from its 13-year low against the yen. On a trade-weighted basis, the U.S. currency has lost approximately 11% of its value during that period.

The dollar's erosion per se may not be particularly dramatic, as it has taken place under overall orderly foreign exchange market conditions. However, it has certainly been sizable enough to raise concerns both in the Eurozone countries and Japan about its adverse implications for their own fledgling economic recoveries, as the sharp rise of their respective currencies against the dollar is now shaping as a significant headwind for the price-competitiveness of their exports at a critical juncture of the business cycle.

The dollar's slide itself can be mostly attributed to slowly building uneasiness that it may gradually lose its longstanding status as the key reserve currency around the world as well as concerns over the strength and sustainability of the U. S economic recovery underway. In the process, as is so often the case in the emotion-driven foreign exchange markets, an overall sour mood vis-a-vis the U.S currency seems to have slowly taken hold.

So, Mr. Trichet's apparent anxiety of late over the dollar decline and his repeated comments highlighting the importance of a strong U.S. currency are understandable. The trouble is that there is not much he can do about it, other than making more comments in the same vein.

The Fed has a well-known, although unspoken, policy of not allowing considerations about the dollar drive monetary policy decisions. This approach is based two main reasons: a) The fundamental incompatibility of having both an exchange rate and interest rate target at the same time- and the Fed, over the last three decades or so, has clearly thrown its lot behind interest rate targeting. b) The fact that the external sector of the U.S. economy is still relatively small (12% to 14% of GDP) and, therefore, changes in the value of the dollar are unlikely to be the determinant factors for either the pace of economic growth (via the exports mechanism) 0r the inflation prospects.

So, it is beyond unimaginable that, in this setting, monetary policymakers would be inclined to change tack and focus on the sliding dollar by raising short-term rates to defend it. To make things even more hopeless for Mr. Trichet, the U.S. Treasury also has a longstanding policy of not intervening in the foreign exchange markets (in conjunction with the New York Fed) but only in exceptional circumstances to counter disorderly market conditions. The 8-month slide of the dollar most certainly does not meet that criterion.

The only consolation that the Fed and U.S. Treasury can offer to address Mr. Trichet's plight is, at the most, to make generic, devoid of much substance, statements to the effect that the U.S. is in favor of a strong dollar. Lip-service on this issue is an inexpensive but not terribly effective tool. Raising interest rates or engaging in massive intervention in the foreign exchange markets can be effective but they are beyond the realm of plausible outcomes for U.S. policymakers.

Given the nearly one-way path the dollar has been on since Fenruary and in view of the levels it has now reached, the more likely outcome is that a bottom will start being formed in the foreseeable future that will ultimately make this episode of dollar weakening look as just another run-of-the-mill "noisy" situation in the context of a floating exchange rate regime. There is no reason to believe that the dollar's decline will transform itself into an actual crisis.

In the last six years at the helm of the ECB, Mr. Trichet has shown himself to be is a highly competent and sophisticated central banker. Now, in view of the dollar decline so far this year, he needs to show that he can be patient too.


Friday, September 25, 2009

The Treasury Market Has It About Right

Financial markets are not exactly known for being rational entities, having a deeply ingrained penchant for overreactions that often make them swing from one extreme to the other, while bypassing the more sensible middle ground. So, it is a fairly rare situation to see a market being reasonably priced, reflecting a balanced approach toward the overall economic environment and its prospects. The Treasury market seems to be such an example in its current phase.

The long end of the Treasury market has experienced some particularly major swings in the last year or so, in the midst of what has admittedly been an unusual financial and economic environment. The 10-year yield went through its wild "deflation is coming because this is the Great Depression all over again" stage late last year, causing its yield to plunge close to the historically unprecedented 2% mark last December, to the "inflation is coming because the economy is roaring ahead and the Fed will be asleep at the wheel" phase, sending its yield up to 4% just six months later.

Since late June though, long-term rates have settled down considerably, with the 10-year yield staying essentially between 3 1/4% and 3 3/4% , and, in fact, spending most of its time closer to the middle of that already relatively narrow bracket. That range reflects a reasonable assessment of the medium-term outlook for both the economy and Fed policy, as it implicitly incorporates the assumption of a moderate economic recovery (the initial momentum of which may be subsequently tempered by a number of much-analyzed headwinds), an alert but supportive monetary policy, and a backdrop of subdued inflation pressures.

Unless there is a fundamental re-examination of the entire outlook ahead, presumably caused by a radical change in the tone of the various economic releases or unexpected headline events, the 3 1/4 to 3 3/4% range should hold for the foreseeable future, always allowing for fairly short "excursions" to neighbouring yield levels. In the meantime, plain, old-fashioned, carry trades should continue to hold their appeal.


Wednesday, September 23, 2009

Disentangling Two Key Concepts About Fed Policy Ahead

In the context of the debate as to when the Fed may start reversing the extraordinarily accommodating monetary policy of the last two years, a critical distinction is often overlooked: a gradual unwinding of the array of special liquidity programs and actually raising short-term rates are two very different things.

Those two types of actions are not, in fact, likely to be closely correlated, although the former action should legitimately be viewed as a precursor of the latter. Still, the time gap between those two phases can be quite significant.

The Fed is under tacit pressure from the ever inflation-sensitive bond market to demonstrate vigilance with regard to the gradual withdrawal of the massive liquidity injected into the system in the last two years or so. The Fed is very mindful of such market expectations, as well as of the undeniably real risks that all of these liquidity injections imply if not offset at the appropriate time, and is likely to start moving in that direction once evidence that the economic recovery is embarking on a solid track emerges. In fact, this week's reports about the Fed consulting with primary dealers about the logistical aspects of reverse-RPs and the slower pace of purchases of mortgage-backed and agency securities announced by the FOMC on Wednesday should be viewed as signs that such a process is already underway in a low-key manner. Other such steps should be expected to follow as part of a carefully calibrated process through the turn of the year, increasing the number of special programs that the Fed is already dialing down without much fanfare in the last few months.

Still, initiating steps that are meant to address the scope of the various liquidity programs is not tantamount to approaching the point of an actual tightening of monetary policy in a more conventional sense (i.e, raising rates); the standard that needs to be met for the latter to occur is a much higher one.

It is extremely difficult (or, should we say, inconceivable?) for the Fed to start raising the funds rate in an environment where bank lending remains tight- therefore, sustaining a degree of anxiety about the amount of traction the recovery will ultimately gain- and the unemployment rate is on the rise. The upward trajectory of the unemployment rate could persist well in to 2010, representing a major impediment to any prospect of a rate hike, at least through next summer.

In other words, one should take on face value the FOMC's diligently repeated assertion in its recent statements that the federal funds rate is likely to remain at exceptionally low levels for an "extended period". Even after the front end's rally in response to the FOMC statement on Wednesday, fed funds futures are still pricing nearly a full 25 basis point tightening move by next April, which, while not outlandish, should be viewed as a low probability outcome.


Monday, September 21, 2009

The End of the Recession and the NBER

Steadily growing evidence suggests that the recession probably ended in the third quarter of 2009 but don't expect to hear such news from the official arbiter of business cycles, the National Bureau of Economic Research (NBER), any time soon. Typically, it takes anywhere from 6 to 18 months from the actual end of a recession until the NBER makes an official pronouncement to that effect, and this pattern will almost certainly hold in this cycle as well. As a result, it will likely be well in to next year when the NBER provides us with the precise time when the most recent cycle reached its trough.

As it is fairly well known by now, the NBER does not use quarterly real GDP data as the key criterion to determine the beginning and end of a recession, but, instead, a set of monthly gauges of economic activity (mostly, employment, real income, production, and sales) with a varying degree of emphasis on each- per business cycle. In determining that December 2007 was the start of this recession, the NBER clearly placed greater emphasis on the employment data, as that month was the last before an unbroken string of monthly (20 to date, and counting) declines in payroll employment. It is precisely because of its focus on a mix of key monthly measures of economic activity that the NBER is able to pinpoint a specific month within a quarter that represents the start and end of a recession.

The most important reason for which it takes at times an exceedingly long period for the NBER to determine a start and end date of a recession is that "the Committee waits long enough so that the existence of a recession is not at all in doubt" (http://www.nber.org/cycles/recessions_faq.html). In the current complex environment, where some doubts linger about the sustainability of the emerging economic recovery and concerns are expressed over the risk of a W-shaped recovery, the NBER's wait is likely to be on the longer end of its 6- to 18- month historical range, unless the forward momentum in economic activity that will develop in the second half of 2009 turns out to be surprisingly robust that puts any remaining doubts convincingly to bed. When the end of a recession is officially declared, it is rarely revised subsequently, as the last such incident was in 1975 and has never happened since 1978.

Given the likely timeline involved, by the time the NBER declares the recession as over, it will be largely an issue of pure semantics as the attention of market participants will have long shifted away to other more pressing issues.


Thursday, September 17, 2009

The Fading Deflation Story

In the immediate aftermath of the Lehman episode last September, two dire predictions quickly entered the mainstream of market psychology: 1) A severe recession was almost inevitable (it had not been officially declared by the NBER at the time, nor was there broad agreement that the economy was already in one), and 2) There was a clear and imminent danger of deflation ahead.

While the first of the above predictions materialized in a manner that became part of the history books, the latter has not come to pass yet, nor is there any persuasive evidence to suggest that it will ultimately do so. In fact, if anything, it is intriguing that the core rate of inflation has shown only a moderate, orderly downward drift by about one percentage point during that period, to 1.4% in the last 12 months leading to August 2009. To be sure, overall CPI has declined by 1.5% from a year ago, but this is almost entirely the result of a 23% collapse in energy prices (highlighting the very limited relevance of that index as a gauge of price trends). Not much going on outside of that, despite a broad-based, massive unwinding of commodity prices in the course of the last year.

Even after the inflation data are put under the microscope, there is no detectable quickening in the last several months of the moderate disinflation trend that has been underway for about a year now. The core rate of CPI inflation has been running at 1.4% in the last three months, while it has been running at a somewhat faster pace in the last six months (1.9%).

Of course, inflation is a lagging indicator, implying that the downtrend may have not run its course yet. Still, in the next 2 to 3 quarters, the disinflationary trend will be confronted by two important headwinds: 1) A significantly improving economic environment compared to the previous 12 months or so, which will act as a natural brake toward any further slowing in the rate of price increases, and, 2) An upturn in import prices, stemming from the roughly 8% depreciation of the dollar since the beginning of 2009. The 6.5% decline in non-petroleum import prices over the last 12 months has appreciably contributed to the slower rate of core inflation during that period but is unlikely to continue moving forward.

The bottom line is that core inflation may still drift closer to 1% over the next 6 to 9 months, but that is still, after all, a long way from zero. For the record, it is worth recalling that the concerns about deflation in this cycle are not that different from those expressed in the early phase of the recovery following the 2001 recession, which had prompted the then Fed Vice Chairman Ben Bernanke to make the infamous by now comments that earned him (unfairly) the nickname "helicopter Ben". Also, for the record, core inflation in the 2002-03 period bottomed out around 1%.

Deflation always makes for a good, scary story. The trouble is that it is much harder to come about.


Wednesday, September 16, 2009

Employment Trends: Trading Employees

Michael Swanson
Senior Analyst, Sterling Infosystems

For the past few months, the size of the loss in nonfarm payrolls has been shrinking. Although the economy is still shedding jobs, the fact that the loss has been getting smaller is an encouraging sign that the recession is coming to an end. But questions remain about when will payrolls finally stabilize and what will be the pace of their future growth. To offer insight, in this piece I will examine the two subcomponents that affect employment: hires and separations. After all, the change in employment is just the difference between hires and separations.

The Bureau of Labor Statistics publishes a survey called the Job Openings and Labor Turnover Survey (JOLTS). It publishes nonfarm hires and separations on a monthly basis, lagging the total nonfarm payrolls by one month. Although mixing BLS surveys can be dangerous, recent improvements to the JOLTS methodology has made it comparable to nonfarm employment.

As of July, the JOLTS survey reported a increase in hires and a slight decrease in separations, hence a narrowing loss in employment. But some interesting things are going on within separations. As expected, for the last 12 months layoffs have been high. Layoffs peaked at 2,568k seasonally adjusted in January. This is the largest amount of layoffs since the JOLTS began in 2001. Furthermore, as of July, layoffs have only decreased by 9.4%. It appears layoffs are still a problem.

But what is less obvious, yet intuitive when you think about it, is the significant reduction in quits. People are hanging on to their jobs during tough times. In July quits hit a low point for the JOLTS at 1,730k seasonally adjusted. This is a 45.4% decrease as compared to a peak in quits in December 2006.

Adding this all together, despite the large number of layoffs, the significant reduction in quits has kept the overall number of separations very low. In fact, during a recession when people think of lost jobs, as of July the amount of separations reached its lowest point since the JOLTS began.

Looking forward, as employers finish correcting their staffing levels, the number of layoffs will go down. Assuming quits remain constant, this will reduce separations and help stabilize nonfarm payrolls.

But will quits remain constant? Quits are at a very low level. With the worst of the downturn behind us, is it possible that people who have clung to their jobs will start looking for their next career move? Will quits increase? Furthermore, as employers slowly increase their appetites for new hires, perhaps they will start by hiring the currently employed, not the unemployed. However, hiring the currently employed will result in no change in total employment – for every hire there is a corresponding quit. For actual payroll growth, the unemployed need to be hired.

Therefore, for nonfarm payrolls to stabilize and grow, more hiring is not the complete answer. The willingness of employers to hire beyond the number of quits will be the driver of payroll growth. The speed in which employers choose to ramp up hiring to compensate for an increasing number of quits will be important. However, employers may be apprehensive. They may choose instead to increase hiring gradually. And with the shock of the recession still felt, employers engaging in cautious hiring may be able to satisfy their short-term growth initiatives by simply trading the currently employed.

Tuesday, September 15, 2009

Retail Sales Suggest Recovery Prospects On Track

The real importance of today's retail sales for August lies not as much in the sheer magnitude of the 2.7% surge for the month, as this is a notoriously volatile series and, after all, more than half of that increase was due to the now expired "cash-for-clunkers" program.

It is primarily the breadth of healthy gains in many key categories (apparel, general merchandise store, electronics &appliances sales) that provides the report with legitimacy. Excluding autos, the 1.1% gain for the month was still quite respectable, as was the version of the data that attracts the most attention by economists (which excludes autos, building materials and gasoline) that also showed a solid increase.

Despite the special factors that boosted retail sales for the month and their inevitable unwinding that sets the stage for a decline in the series for September, it is clear that consumer spending is perking up on an underlying trend basis. In the last three months, non-auto retail sales have risen by 0.8% compared to the prior three-month period; a fairly respectable gain.

If an upturn in consumer spending is confirmed by the data over the coming months, this can become a potent drive for a pick up in hiring toward the end of the year and into the first part of 2009. The prevailing view so far seems to be that, as long as job losses continue, the economic recovery cannot gain traction. This , however, seriously underestimates the reverse dynamic. Job growth may not necessarily be the starting point of a sustained pick up in spending and economic recovery- but an upturn in consumer spending (fueled by pent-up demand) may actually be the key to job growth.


Monday, September 14, 2009

Can China Benefit if the U.S. Consumes Less?

By Scott Tolep

Without question, the U.S. and Chinese economies are interdependent and each nation has a vested economic interest in the other. The U.S. and China have one of the most significant trading partnerships in the world, with over $400 billion of trade in 2008. They are each other's largest or second largest trading partners, and China owns more U.S. Treasury debt (about $800 billion) than any other country.

The global economic recession has forced U.S. households to reduce debt and consumption levels. After 15 years in which Americans have saved less than 5% of their disposable income (at times, appreciably less so), the U.S. is finally beginning to save more. This trend may continue even after the U.S. economy resumes GDP growth, if unemployment remains above, and income growth remains below, historical levels- a realistic scenario by many economists' accounts.

So, with exports to the U.S. accounting for 10% of China's economy, is it possible that a prolonged increase in U.S. savings could actually benefit China? It is possible if it triggers the economic reforms necessary to unlock the potential of its huge domestic consumer market. China's current consumption rate is 35% of GDP, which is the lowest rate of any major economy in the world, despite China being the world's third largest economy. China's economic growth rate, the highest among G-20 nations, cannot be sustained given the current lack of domestic consumption.

China must gradually allow the yuan to float against the dollar. This would not only boost households' real spending power and lift private consumption demand, but it would also allow China to conduct independent monetary policy, making it less susceptible to asset-price bubbles. It would also strengthen China's relations with the western world by warding off protectionist voices in the U.S. and other countries.

In 2007, the IMF pointed out that household incomes fell steadily in China between 1992-2004, and this caused a steady decrease in consumption. During this period, state-run banks and enterprises gained a disproportionate share of China's income and wealth. For consumers to spend more, this has to change. China must create a stronger social safety net for its citizens, and provide them with a more open financial system, one that provides them with greater investment opportunity.

China's reluctance to pursue aggressively economic reform may be linked to underlying political motivations. The centralized government may simply be seeking to delay potentially destabilizing changes. Making the necessary adjustments today may cause short-term disruptions in China, but waiting for the inevitable day of reckoning will almost certainly render the long-term consequences immeasurably worse. Fortunately for China, it may not have to wait too much longer...as long as U.S. consumers keep their wallets sealed.

Friday, September 11, 2009

The Importance of Rising Consumer Sentiment

Normally, the various Consumer Sentiment/Confidence indicators are viewed as "soft" barometers of economic activity, as they involve largely perceptions and are heavy on psychology as opposed to "hard" evidence regarding the performance of a particular segment of the economy. As such, their true significance, and despite the prominence that sometimes the media give them, is relatively limited. As sometimes the joke goes "one cannot spend confidence".

Today's sharp rebound in the University of Michigan Consumer Sentiment index for early September to 70.2 from 65.7 in August deserves a little more attention for two reasons:

a) It fits nicely in to a pattern of steadily better looking economic data in the last couple of months, suggesting that a broad number of pieces are slowly coming together to suggest that an upturn in economic activity is in the offing. To be sure, the Consumer Sentiment series is quite volatile and the early September number simply recouped some ground that the series lost in July and August, after it had reached 70.8 in June. But it does confirm that this measure of consumer attitudes has rebounded convincingly from its 55 to 60 range late last year and early 2009.

b) While it is true that one cannot spend confidence (income growth is needed for that), one can certainly spend savings. If consumers start feeling steadily more upbeat (as the solid increase in both the current conditions and expectations components of the index showed today), they may become more inclined to let the recently elevated savings rate drift lower in the next few quarters, therefore leading to a moderate pick up in spending.


The dollar, Treasuries, and a Reassessment of Risk Tolerance

Over the past week or so, many stories have focused on the falling dollar. Some of the stories are legitimate threats to the dollar, such as China beginning to assert itself by issuing yuan-denominated debt to Hong Kong (http://www.bloomberg.com/apps/news?pid=20601087&sid=a8dRCe61kx6w), and others merely make headlines, like the UN declaring the need for a new reserve currency (http://www.bloomberg.com/apps/news?pid=20601087&sid=aSp9VoPeHqul).

Both stories are the type of news that would normally cause traders to react by sounding the alarms of a dollar crisis, and the dollar has indeed made new lows for the year. However, there is no evidence of any kind yet that the dollar weakness is causing foreign investors to become apprehensive toward the U.S Treasury market. The Treasury held three successful auctions for 3- and 10-year notes as well as 30-year bonds, all of which produced strong bid-to-cover ratios and showed evidence of solid foreign participation. The question of whether or not bond investors have a great fear of oversupply (due to tge deficit) or inflation, seems to have been answered- at least for now. The current environment is one within which investors of various degrees of risk tolerance feel increasingly confident seeking opportunities.

Does this mean that U.S. bonds are decoupling from the declining dollar? Maybe not, completely, but it does demonstrate a conviction that there is no significant risk of interest rate increases in the foreseeable future. Ben Bernanke has been adamant about deflation prevention since the onset of the crisis and his words have assured markets that the Fed remains committed to facilitating a sustainable economic recovery. As a result, the prevailing view seems to be that the fed funds rate will remain trapped against the zero lower bound for some time, therefore helping prevent any major back-up in Treasury yields. As such, the strong bonds bids this week do not reflect a flight to safety, but a legitimate investment opportunity sprung out of the strong appeal of such securities on a carry basis.

In addition to U.S. debt, and further along the risk spectrum, many other asset classes, including gold, SPX, most currencies vs. USD, and global equities have risen, indicating a reflation of sorts. This makes sense, given the cautiously optimistic economic numbers overseas, particularly among emerging markets. It has been made apparent that the U.S. will not lead out of this downturn and, as such, it makes limited sense to pile cash in money markets when more attractive returns are available in most asset classes across the board. Some of the most rich investment opportunities are to be found in the places that have already begun traveling the road to recovery, or better yet, don't have much recovering to do, and recent price action indicates that the markets seem to be recognizing that fact.

Chris Hodge
Analyst, Pharo Management

Wednesday, September 9, 2009

Do Double-Dip Recessions Really Happen?

As mounting evidence is pointing to a respectable pace of GDP growth in the second half of the year (probably around 3%), voices of disbelief that this is indeed the beginning of a much-awaited sustainable economic recovery also seem to be growing louder.

The argument those doubters are making is that the next couple of quarters will prove to be a fake recovery and the economy is at a considerable risk of slipping back into recession shortly afterward. A closer look at the pattern of past recessions and ensuing recoveries shows very little support for the concept of a so-called double-dip recession, as such an episode has never actually happened in, at least, the last 75 years or so (i.e since the Great Depression).

The implicit reasoning of the double-dip camp seems to be that this recession has definitely been not of the "run-of-the-mill" variety- in terms of contributing factors, severity, and duration. This suggests that one has to be open to the possibility that a more unconventional pattern lies ahead, which may deviate from historical precedent. Granted, this is a seemingly legitimate point. Still, the odds that the slowly unfolding economic recovery will prove to be a simple interlude on the way to another significant leg-down in the economy are extremely slim.

Let's consider the following.

The average duration of the last 13 economic expansions- going back to the mid-1930s) has been approximately 60 months, with an extremely wide range of 12 to 120 months (http://www.nber.org/cycles/cyclesmain.html).

The closest approximation to a double-dip recession that one can find in that period is the 1980-82 episode, in the sense that, within a year after the end of the shortest-lived recession on record in July 1980, the U.S. economy slipped into another recession in July 1981, the latter lasting until November 1982. Reasonable people have attempted to make (cautiously) the point that this was essentially one long, "two-stage" recession, from January 1980 to November 1982, with a fake-out recovery in-between.

Intellectually intriguing as this argument may seem, it does suffer from a major flaw, which undercuts its historical legitimacy when it is attempted to be superimposed on the current economic environment. The 1980-81 initial recovery and subsequent second recession were not a case of a feeble recovery in the second half of 1980 that never quite took hold and ultimately fizzled by mid-1981. It was quite the opposite. This was in fact a case of an extremely robust recovery in the second half of 1980, that stoked fears that the Fed's titanic struggle against inflation would be jeopardized. As a result, then Fed Chairman Paul Volcker tightened aggressively again sending short-term rates to above 20% by the spring of 1981 and, predictably enough, throwing the economy into a second tailspin.

In other words, the 1981-82 recession did not happen simply because the economic recovery in the second half of 1980 just fizzled. Instead, it was the result of a very determined campaign by the Fed to finish off the project of rolling back inflation at the calculated cost of causing a second recession.

Beyond the clinical review of basic historical facts, there is a more solid explanation as to why double-dip recessions are extremely rare, if possible at all.

The reality is that once an economic recovery gets underway, it is not easily derailed, as a classic expansionary dynamic takes hold that ultimately propels economic activity forward. The expansionary dynamic in question consists of a combination of pent-up consumer demand, in conjunction with a need to replenish badly depleted inventories, both of which lead to a pick up in production. In the current environment, the upturn in growth already underway in Asia and, to a more moderate degree, the Eurozone, adds another source likely to provide impetus to the fledgling economic recovery in the U.S. Moreover, the bulk of the fiscal stimulus spending approved earlier in the year still lies ahead and stands a good chance of becoming the cohesive element that will pull everything together to create an expansionary dynamic.

One can question how strong the forward momentum of the economy will be once we get past the second half of this year, as there are indeed considerable headwinds (see, reluctance of banks to lend) to deal with. But, sounding the alarm of a "double-dip" recession ahead is just going a little too far...