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

Tuesday, September 21, 2010

The FOMC Statement: A Litle Closer But Not There Yet

The FOMC statement this afternoon ( contained a little bit for everyone. To those who have been increasingly agitating for another meaningful round of quantitative easing, the statement offered the seemingly reassuring language that the Committee" will continue to monitor the economic outlook and financial developments and is prepared to provide additional accommodation if needed". At the same time, there was not even an attempt to present the contours of the criteria that will be used to make that determination, an omission that reveals traces of ambivalence, or unpreparedness, within the FOMC about such action.

The Fed's hesitation to be more specific, or assertive in its intention to implement additional quantitative easing is probably the result of both its natural reluctance to promise, or commit to, a specific outcome but also the product of its continuing soul-searching as to where that route makes fully sense on a risk-reward basis. For an additional round of material quantitative easing, an increase in the size of the Fed's portfolio by a number in the vicinity of $1 trillion is probably what the Fed is looking at, with no guarantee that such an injection will actually be pivotal in jump starting the anemic recovery. At the same time, by taking that route, the Fed will be dramatically increasing the magnitude of its own headaches in handling successfully the exit strategy when the time ultimately comes (because, at some point, it will!). The issue of whether creating that substantial additional risk that will be left lurking around the corner is a worthwhile endeavor for the Fed is arguably unsettled in the policymakers' own mind at this point.

A reasonable conclusion, based on the above, would be that additional quantitative easing of some significance is not yet a done deal, particularly in view of some publicly expressed resistance to such measures by some Fed officials. However, the Treasury market's nearly euphoric reaction to the announcement strongly suggests that the consensus interpretation is that it is only a matter of time until the Fed proceeds with such action- it is as if the "when" is the only issue to be settled and no longer the "if".

This is a risky proposition. By adopting that interpretation, the market is exposing itself to the prospect that the tone of the various economic reports stabilizes in the coming weeks (signs of which have actually appeared recently) and this provides the Fed with more breathing space to wait longer before any decision about more quantitative easing is put in place. The odds that such action will in the end be taken have risen somewhat in the wake of the FOMC's statement today, but they are not nearly as close to a foregone conclusion as today's price action in the Treasury market implies.

Anthony Karydakis

Thursday, September 9, 2010

Next Week's Busy Economic Calendar

Due to a vacation overseas, there will be no new articles posted until the week of September 20th.

The moderate back up in Treasury yields caused by the more resilient-than-expected labor market report last Friday has essentially put the market in an "on hold" mode, awaiting further cues as to which way to go next. The particularly light economic calendar this week also left Treasuries more sensitive to supply, with the maneuvering around the 3-, 10-, and 30-year auctions representing the main drive of price action so far. A somewhat underwhelming Beige Book on Wednesday and a 27,000 decline in initial jobless claims were not potent enough information to provide prices with any momentum in either direction

This state of relative inertia has the potential to change next week, as the economic calendar is packed with major releases, usually known for their market-moving potential. At the same time, the absence of any new coupon supply almost guarantees that the economic data will be in the driver's seat of next week's price action, with a reasonable prospect that will help the market break out of this week's stalemate.

At the top of the list of such key reports next week are August's retail sales on Tuesday, the September Empire Fed and Philly Fed manufacturing surveys on Wednesday and Thursday respectively, and CPI (August) along with the University of Michigan Consumer Sentiment (September) index on Friday.

Following some inconsistent performance in the last few months, retail sales should show a moderate gain of about 0.5%, with only a slightly smaller gain in the ex-autos component. The overall number should benefit from better-than-expected "back-to-school" sales for the month and will probably underscore the fact that, contrary to concerns expressed recently, the consumer is not quite as moribund as feared. We view personal spending as still on track to post a gain in the 2-2 1/4% range (annualized) in Q3.

The two manufacturing surveys could be pivotal in setting market tone next week, not only because of the usually considerable degree of attention they command but also due to their dramatic drop in the last three months- which is particularly true for the Philly Fed (-7.7 in August compared to 21.4 in May). Both indexes should show a rebound by about 10 points or so, providing reassurance that their sharp weakening earlier in the summer was mostly caused by auto-related and other unspecified distortions and were not the precursor of an ominous, broad-based slowing in manufacturing.

A gain of 0.1% in the core CPI for August (+0.2% overall) would leave that closely watched measure of inflation at +0.9% on a year-on-year basis for the fifth consecutive month. This, although not ground-breaking material as such, should be viewed as mildly reassuring that the disinflationary dynamic is not picking up steam and that core inflation may stand a good chance of stabilizing at a fairly safe distance from the dreaded zero mark in the context of an ongoing economic recovery.

Although, on balance, the overall tone of next week's economic reports should feel consistent with a recovery that continues to plow ahead at an admittedly unimpressive pace but is showing no signs of fizzling dangerously. However, the behavior of the Treasury market, as has often been attested to in the last year or so, is not always a linear function of the specific economic reports, as other parameters often can interfere with that relationship. For example, headlines associated with the sovereign debt situation in Europe that seem to be making their way back up to the spotlight in the last few weeks, can, depending on the degree of surprises that the data hold, have a significant role to play. So, all things considered, it is safer to argue that next week has the potential to offer more exciting (see, noisy) price action in the Treasury market but offers no promises of a decisive directional move.

Anthony Karydakis

Friday, September 3, 2010

The Employment Picture Brightens Up, Suddenly

The August employment report provides irrefutable evidence that the economic recovery is alive and well, moving forward at a reasonable enough clip to put "double dip"-related concerns to rest.

Not only did private payrolls rise by a moderate 67,000 last month but significant upward revisions to the prior two months in the overall numbers by a cumulative 123,000 jobs suddenly paint a more resilient labor market picture than previously thought.

The 54,000 decline in the headline payroll number for August is inconsequential, as it reflects the distortion caused by the layoffs in census workers for the month (-114,000).

Since last December's low, the private sector has created a total of 763,000 jobs in the first eight months of the year, meaning an average of 95,000 jobs a month. While the number is definitely short of where it ultimately should be (probably in the 200,000+ range), it is still respectable for an economic recovery the sustainability of which has often been called into question recently. The message here is that, despite the much-publicized defensive attitude by companies, the private sector is moving ahead with a pace of hiring that, while cautious, still indicates an irreversible forward momentum in economic growth.

Health care employment was up 28,000 in August, as the sector remains a steady source of job creation in private payrolls, having averaged about 20,000 a month so far in 2010. Construction employment was up 19,000 (reflecting in part the return to work of 10,000 striking workers in July), while manufacturing jobs fell 27,000 due to a sharp decline in motor vehicle production (the result of a different pattern this year for the industry's retooling process during the summer months).

The average workweek for all employees- a key predictor of future hiring- was unchanged at 34.2 hours in August, remaining at the high end of its range for the year.

Comparable gains in both the size of the civilian labor force and employment in the household survey (154,000 and 139,000 respectively) caused an uptick in the unemployment rate to 9.6%, which is right in the middle of the 9.5-9.7% range that has prevailed for the series since May. The stalled unemployment rate in the last several months reflects both the still moderate pace of private payroll growth and the unwinding of the Census workers.

By throwing cold water to the more pessimistic views of the economy expressed by some in the last few months, today's report represents a significant blow- at least for the time being- to the Treasury market's seemingly irrepressible summer rally, as it deflates expectations about additional quantitative easing by the Fed and helps tame the most intense concerns about the deflation risk. In fact, on that last front, one of the more low-key elements of the report, average hourly earnings for all employees, showed a solid gain of 0.3% in August, which translates into a 1.7% gain on a year-on-year basis. With wage increases holding up at a moderate pace, the deflation story becomes a little more difficult to rationalize.

Anthony Karydakis

Tuesday, August 31, 2010

A Few Thoughts On The Current Treasury Yield Levels

With Treasury yields standing essentially at their lows for the year, having declined by over 50 basis points in the long end over the last four weeks, the obvious question that emerges now is "what happens next?".

A few thoughts on this topic.

1) Although the Treasury market rally can be extended further under a certain set of circumstances, revisiting the post-Lehman low of nearly 2% for the 10-year (reached in December 2008) should not be viewed as the odds-on bet at this point. At the time, the driving forces that caused the 10-year briefly flirt with the 2% mark were pervasive fears that another Great Depression was around the corner, with deflation and a possible meltdown of the global financial system to boot. The realization that those outcomes were not likely to materialize caused a very sharp back-up in yields in the first quarter of 2009, the point being that such extraordinary low yield levels are of questionable sustainability and can be reached only as a result of a certain alignment of special factors at work simultaneously.

The current environment is fundamentally different, inasmuch as there are still some scattered voices promoting a double-dip story and there is a fairly cool-headed debate as to how elevated the deflation risk truly is. Against that backdrop, the Treasury market rally has been largely fueled by the loss of momentum in the economic recovery over the last few months, the ensuing pullback in equity prices, and the broader perception that Treasuries remain a safe haven for global investors even in the midst of a relative calm on the European sovereign debt front recently. In other words, there are sound, legitimate reasons sustaining this rally, but the intensity of those driving forces is no match for those prevailing in the fourth quarter of 2008.

Based on the above, Treasury yields may find it hard to penetrate the 2 1/4% or so barrier (10-year) in the foreseeable future. To do so successfully, the market will need some new favorable developments, most likely of the "headline" type, to provide fresh impetus to the rally.

2) It is admittedly not a uniquely insightful statement to make that the extension of the rally from these levels can only mean one thing: a further flattening of the curve. This is so because most of the price action over the coming weeks is bound to be concentrated in the outer part of the curve, given the very limited room for improvement in the front end against a 15-20 basis point fed funds rate and no prospect of a change there as far as the eye can see. (It is also important to keep in mind here that the possible implementation of any additional quantitative easing measures by the Fed is unlikely to have any direct, material impact on the fed funds rate itself). In that context, a continuation of the rally is tantamount to a clean piercing of the current 200 basis points spread in 2s/10s, probably headed for the 185-195 bp range.

3) At these levels, the market is quite vulnerable to any upside surprises in the August payroll data on Friday (say, private payrolls +70K), or a more resilient ISM on Wednesday (holding up around 55.0), or another sharp decline in initial claims (-25K or so) on Thursday. Any such data, or combination of those reports, would start raising the prospect that the soft patch is waning and the pace of economic activity may be regaining its footing, causing a loss of momentum in the rally as the market takes a step back.

As is always the case, the employment data can cut both ways in terms of its impact on the market and, a distinctly weak report, can provide the new impetus that the Treasury market rally needs to march on. A decline of more than 25,000 in private payrolls, with a little changed unemployment rate, and moderate downward revisions to the previous two months' numbers can certainly make the 10-year set its sights on the 2 1/4% mark

Anthony Karydakis

Friday, August 27, 2010

Bernanke At Jackson Hole

Here's some thoughts on Mr. Bernnake's much-anticipated speech at Jackson Hole this morning (

1) His outlook for economic activity remains cautiously optimistic. This view is based on a combination of factors: ongoing repair of household balance sheets (as reflected in the higher savings rate), the corporate sector sitting on a lot of cash that can be gradually deployed for capital spending projects, and the continuing underpinning to growth from an exceedingly accommodative monetary policy moving forward). None of this sounds like an unreasonable premise. On the whole, we agree with his assessment that "preconditions for a pick up in growth in 2011 appear to remain in place". The term "double-dip" was conspicuously not mentioned at all, not even as a hypothetical risk that he does not envision.

2) He cast the Fed's recent decision to reinvest the proceeds of maturing MBS securities in its portfolio in coupon Treasuries as a defensive move designed to "avoid an undesirable passive tightening of policy that might have otherwise occurred". This is actually a fully accurate description of the recent Fed action, as it is essentially targeting the maintenance of the status quo in monetary policy and not the implementation of further accommodation.

3) Directly related to the above point is the realization- which seems to have flown mostly under the market's radar screen so far- that the weaker the pace of economic activity turns out to be over the coming months, the more aggressive the Fed's purchases of Treasuries are going to be, without any other change in Fed policy. This is so, because the further downward drift in rates that will result from any further weakening of economic activity will trigger a higher pace of mortgage refinancing activity and an accelerating rate of redemption in the Fed's MBS portion of its portfolio. Therefore, any further slowing in economic activity ahead will set into motion two powerful engines pushing long-term Treasury yields yields lower and causing a further flattening of the curve: the perception of a softening economy with the associated rising deflation risk plus the pick-up in the pace of Treasury purchases by the Fed.

4) Inasmuch as he discussed, in a fairly balanced fashion, the various pros and cons of some of the additional accommodative policy measures the Fed can consider in the future, he left no doubt that, if the pace of economic activity continues to degrade and the deflation risk is rising, the Fed will take additional action. At this point, he stated that there is no decision by the FOMC to activate any of the other possible such measures (increase the net size of the Fed portfolio, reducing the interest paid on bank excess reserves, or provide a specific time frame committing to a near zero rate policy in the FOMC statements).

Anthony Karydakis

Tuesday, August 24, 2010

The Opening Rift Within the Fed

Today's front page article in The Wall Street Journal (
on the divergence of opinions within the Fed regarding the recent decision to prevent the gradual shrinking of its mortgage portfolio by reinvesting such proceeds in Treasuries, highlights a key undercurrent of the debate over this issue: that is, whether there is much the central bank can do at this point to prop up the struggling economic recovery.

The skepticism that was expressed by some FOMC members as to whether the Fed should proceed with the adoption of that measure at its most recent meeting was ostensibly based on the wisdom of assuming the risks implied by such action. The risks in question were not, at this stage, related to the injection of any additional liquidity into the system, but more to the implied message of lack of confidence that the Fed was expressing in the economic recovery's prospects. A directly associated risk was the perception that the Fed might be creating that this can be the prelude toward a second wave of asset purchases if the economic recovery continues to limp in the foreseeable future.

Perhaps underlying the skepticism as to the wisdom of proceeding with the announcement of the latest measure at the FOMC meeting is the premise that, after all, such steps are unlikely to make a real difference in reinvigorating economic activity. In other words, the unspoken message here is that a number of monetary policymakers do not essentially believe that there is much that the Fed can do to influence the direction of economic activity and any additional steps at this point are fraught mostly with risk and have no likely benefit.

The above is a view that we also share and have expressed in a recent article in this space ( but is one that is extremely difficult to be acknowledged by the Fed in public. It would be a highly problematic affair for a major central bank to openly state that there is not much left that it can do to jump-start a decidedly underwhelming economic recovery. It is in that context we should see the Fed's recent decision to reinvest the proceeds of maturing MBS securities in Treasuries and any other additional measure that may be announced in the coming months. It is more a reluctance to publicly acknowledge that its arsenal has been nearly depleted and that it will require quite some time until the economy and financial market conditions have fully healed from the highly traumatic experience of the last three years.

As Mr. Bernanke remains under steadily building pressure to show responsiveness to the recent "soft patch", he cannot afford total inaction, particularly if the upcoming stream of economic data remains unmistakably soft. As a result, the possibility of additional nominal measures by the Fed cannot be dismissed. However, such a course of action will, at the same time, almost guarantee a widening schism within the Fed and the opponents of that path are likely to become increasingly vocal. A taste of that became already apparent today with comments by Dallas Fed President Fisher, where he expressed skepticism as to whether the Fed will achieve anything with the new action it announced at the August 10 meeting or is simply "pushing on a string".

Mr. Bernanke has a very fine line indeed to walk on, between maintaining a posture of a Fed capable of still influencing the course of economic activity and causing a bigger rift within the institution that, at some point, can spill out into the open.

Anthony Karydakis

Friday, August 20, 2010

Next Week's Treasury Supply

The Fed's decision last week to start reinvesting the proceeds of its maturing MBS securities in Treasuries has triggered a significant rally in the government securities market with a sharp flattening of the yield curve- both entirely predictable developments.

In assessing today's yield levels, lower by nearly 30 basis points in the 10-year sector (and by about 35 basis points in the case of the long bond) since August 9, it is tempting to argue that the market may feel somewhat vulnerable ahead of next week's 2-, 5-, and 7-year auctions. After all, the three auctions represent a combined total of $102 billion of supply (supplemented by another $6 billion of a re-opened 30-year TIPS auction on Monday).

Still, that temptation should probably be resisted, for three reasons.

1) Supply per se has rarely been a factor that alters the direction of a trend in yields; it can cause hiccups, but not change the underlying dynamic of a potent move. The latter, in this case, is fueled by the sensible perception of a cooling momentum in the economic recovery. The economic data on next week's calendar are quite unlikely to challenge that perception, as existing/new home sales and durable goods orders are notoriously noisy and any unexpected strength in those reports is likely to be viewed cautiously and produce only a very limited reaction. Friday's University of Michigan consumer sentiment index is simply the final number for August and highly unlikely to deviate appreciably from its early-month reading of 69.6. This leaves us with initial claims, which, given their current level of 500,000, should be expected to show a decline of 15,000 to 20,000 anyway- a fairly uneventful development.

2) With the market's state of mind about a downshifting in economic growth likely to remain intact next week, the current yield levels can still be viewed as reasonably attractive, particularly for the 5- and 7-year sectors (although admittedly less so for the 2-year at 48 basis points). Despite the dramatic flattening of the curve since the day prior to the FOMC announcement, the 5- to 7-year sector remains attractive on a carry basis (roughly 120 and 180 basis points respectively over their financing costs). The cushion is substantial enough to absorb any backup of the market in the coming weeks associated with either a headline risk or a wickedly strong key economic report. Both maturities should continue to be underpinned in the coming weeks by their status at the center of the Fed's newly activated reinvestment program of its maturing MBS holdings.

3) With the plain vanilla carry trade already appealing in its own right, continuation of the recent stream of soft economic reports can keep the debate over deflation and/or a "double dip" scenario alive and cause the rally to be extended further, making the 7-year sector, in particular, well positioned (along with 10s) to capture that move.

Nervous as one always feels about a market going into heavy supply nearly at its highs, it is hard to come up with solid arguments about a meaningful back up in yields (not of the simple hiccup kind) that would make those who bought next week's auctions regret it in the next few weeks.

Anthony Karydakis

Wednesday, August 18, 2010

Tracking the Recovery: Not All News Is Bad

With the momentum of the economic recovery having slowed visibly since late spring, the spotlight has remained consistently on the overall dispiriting tone of the various economic reports. The bond market's rally, the latest leg of which was fueled by the Fed's decision to re-invest the proceeds of its maturing MBS securities in Treasuries, has been based on the premise that the cooling of economic activity can be appreciable. Inevitably, some errand, but misguided, predictions of a "double dip" scenario have emerged as well.

In that environment, with the market focused almost single-mindedly on the downshifting in the pace of economic growth, it is easy to miss some low-key positive signals suggesting that things may actually be stabilizing. Two such pieces of information have, in fact, emerged since the beginning of the week that portend constructively for the underlying trajectory of the recovery.

The first such report was the Fed's Senior Loan Officers Survey conducted in July that showed that "on net, banks had eased standards and terms over the previous three months on loans in some categories". The survey included 57 domestic banks and 23 U.S. branches and agencies of foreign banks. In a key part of its summary conclusions, the report states that "Domestic survey respondents reported having eased standards and most terms of C&I loans to firms of all sizes, a move that continues a modest unwinding of the widespread tightening that occurred over the past few years. Moreover, this is the first survey that has shown an easing of standards on C&I loans to small firms since late 2006".

This is a potentially very significant shift taking place on the bank lending standards front that may start removing one of the major roadblocks for the fledgling economic recovery. Inasmuch as the survey also found that most of that improvement is concentrated at large domestic banks, versus smaller banks or U.S. branches of foreign institutions, its importance cannot be underestimated for its likely impact on both consumer and capital spending- and, by extension, the overall economic recovery- over the coming quarters.

Granted, that actual lending activity will naturally be a function of demand for such credit in the first place, and the survey found little change on that side of the equation in the latest period- presumably a reflection of lack of confidence of the business sector in the trajectory of the economic recovery. Differently put, easing of credit standards by banks is a necessary but not sufficient condition for robust business expansion plans and household spending. However, it represents an undoubtedly crucial positive development, following an approximately 3 1/2-year period during which the tightening of bank lending standards had become an albatross around the economy's neck.

The second encouraging report this week was the sharp increase in July's industrial production (+1.0%), which included a 1.1% surge in manufacturing output. While it is true that the latter benefited greatly from a 14.5% spike in vehicle production (largely the result of the industry's decision not to proceed with the seasonal shutdowns in July for retooling), the real value of the reports lies elsewhere.

Output of business equipment, a key category in manufacturing, rose an impressive 1.8% last month, following solid gains in the prior four months. Such strength demonstrates that there is still decent momentum left in manufacturing, despite the waning inventory cycle dynamic. The implication here is that the strong comeback of capital spending in the first half of the year (17% annualized in Q2, following a 7.8% increase in Q1) appears to be pushing ahead in Q3, representing one of the key pillars of growth for the recovery in the coming quarters.

Anthony Karydakis

Friday, August 13, 2010

Uneventful CPI and Retail Sales Data for July

While neither the retail sales nor the CPI data for July produced any surprises, they offer, in a low-key kind of fashion, a somewhat reassuring overall message that can be summarized as follows: despite concerns about a retrenchment in personal spending recently, consumption is not pulling back in a particularly ominous way, while the pace of the disinflationary process may be losing some steam.

The 0.4% increase in last month's retail sales was broadly in line with expectations and was largely boosted by a 1.6% surge in auto sales and a 2.3% spike in gas station sales- both items that are not usually considered as a credible indication of underlying consumer spending trends. In the last three months, total retail sales are up a fairly respectable 5.9% over the same three-month period in 2009, a comparison that admittedly benefits from the distinctly weak state of the economy in the first half of last year.

The more meaningful measure of retail sales, and the one that enters directly the GDP calculations is total sales less autos, building materials, and gas station sales. That measure edged lower by 0.1% in July, its third decline in the last four months.

Still, unimpressive as these numbers admittedly are, they remain consistent with growth rates of about 2 1/2-2 3/4% in both personal spending and GDP for the third quarter.

The 0.3% rise in the July CPI was entirely due to a 2.6% increase in energy prices (with gasoline prices, in particular, up 4.6% for the month), the first increase of that component since January. The energy category accounted for 2/3 of the gain in the overall CPI last month. Outside food and energy, the core index rose by a trend-like 0.1%, leaving its year-over-year increase unchanged at 0.9%.

The recent string of impressive monthly gains in used cars and trucks prices continued in July, with that component rising by 0.8%, following gains of 0.9% and 0.6% in the previous two months alone. On a year-over-year basis, used cars and trucks are up a stunning 17% and remain an important reason for which the disinflationary process in both the overall and core CPI has not been even more intense in the course of the last year

In a possible sign that the disinflationary dynamic may in fact be in the process of cooling somewhat, the shelter component (accounting for 30% of the overall CPI) rose 0.1% in July, its third consecutive such increase.

Anthony Karydakis

Wednesday, August 11, 2010

Five Points On The Fed Announcement

There's a number of comments that need to be made regarding the Fed's announcement yesterday that it will start reinvesting principal payments from its mortgage portfolio in longer-dated Treasuries.

1) The amount of such proceeds is probably in the $250 billion range in the course of the next 12 months, but its exact size can vary appreciably from that number as it will depend on changes in the current prepayment rate of the mortgage portfolio. If the rally that was set off yesterday afternoon in the long end of the Treasury market has legs and MBS spreads over Treasuries remain tight, then the amount that the Fed will have available for reinvestment can quickly rise to $300 billion, or possibly higher.

2) There is no explicit promise by the Fed that this program will remain in effect over a full 12-month period ahead, but a reasonable assumption is that it probably will, as it allows for a gradual return of the Fed's portfolio to the normal "Treasuries only" content. However, if at any point along the way, the mortgage market shows evidence of serious strain as a result of the Fed's actions, then the program could be either slowed or suspended, as the Fed can hardly afford to destabilize a market that had only recently started healing from a highly traumatic experience in the previous couple of years. Any such mid-course correction in the Fed's plans would obviously result in a smaller total amount of Treasury purchases than the "penciled-in" $250 billion number above.

3) The reinvestment of the proceeds of maturing mortgages in coupon Treasury securities will be roughly in like with the overall lengthening of the duration of the Fed's Treasury portfolio, which currently stands at approximately 7 years from 3 1/2-years that prevailed in the pre-crisis period. However, no further extension of that duration is likely, as for that to happen the Fed would need to be buying exclusively 10-year paper- which is a highly unlikely prospect. In fact, the average duration of the Treasury portfolio may shorten very slightly, as a result, over the coming months.

4) Inasmuch as the average duration of its Treasury holdings will not be altered dramatically from its current level, the implication of those additional purchases ahead is that, when the moment down the road comes for the Fed to actually start shrinking its overall portfolio, there will be a more massive amount of selling of longer-dated coupon securities. It is reasonable to argue that this, viewed in a vacuum, would have a steepening effect on the Treasury curve. However, such sales intended to shrink the Fed's overall portfolio would by definition be taking place in an environment where the Fed is finally implementing its exit strategy, that is to say, tightening. As a result, the curve at that time would be coming under severe flattening pressure and the massive sales of the Fed's longer-dated Treasury portfolio would probably act more as a factor mitigating the degree of such curve flattening rather then cause an outright steepening per se.

5) All in all, the Fed's decision to gradually shift the composition of its overall portfolio away from MBS is arguably one of the least dramatic, or disruptive, measures that could have been adopted in response to the recent loss of momentum in the economic recovery. Its true effectiveness in helping the economy is very much an open question, once the Treasury market's initial reaction and front-running of the announcement plays out. But it allows the Fed to deflect the steadily growing pressure in recent weeks to show some responsiveness to the softer economic data on the ground, while quietly working toward restoring at least a more normal composition in its portfolio holdings.

Anthony Karydakis

Tuesday, August 10, 2010

The Dark Side of Productivity

Nonfarm business productivity declined 0.9% in Q2, following an upward revised gain of 3.9% in the first quarter; on a year-on-year basis, the series is up also 3.9%. Given that the productivity numbers are notoriously volatile on a quarterly basis, year-on-year comparisons should generally be viewed as more valuable.

Productivity usually rises sharply in the early phase of the business cycle, reflecting the sharp adjustments to the business sector's operational costs during a recession. This is a typical phenomenon that is described by the term "cyclical" productivity gains to differentiate it from the longer-term, "secular" trends of that measure.

Inasmuch as it is a much desired outcome for any economy to experience strong productivity gains of either kind (while, admittedly, the secular gains are generally considered more important), the flip side of robust productivity increases is that it represents an impediment to job growth. The concept here is that businesses can produce the same amount of output with less production resources- labor being a key such input.

So, against that backdrop, the views expressed last Friday by the head of the National Bureau of Economic Research, Robert Hall, that the slow pace of job creation may simply reflect strong productivity gains ( merits serious consideration.

The average productivity gain in the last five quarters (including the presumed last quarter of the recession in Q2 2009 and the first four quarters of the economic recovery since then) has been a stellar 4.9%, compared to gains of 3.7% in the comparable periods associated with the previous two recessions (2001 and 1990-91). One can argue that this was, to some degree, to be expected, given the severity of the last recession that may have led to somewhat stronger productivity efficiencies. Still, even if there is something to this argument, it does little to change the basic problem that the robust rise in productivity in recent quarters is an obstacle to a faster pace of job growth.

The trouble is that the above argument cannot be fully validated in real time, given that the productivity series is famously revised, often quite substantially, a long time after the quarterly data are released. The benchmark revisions of the series can sometimes alter very materially previously perceived productivity patterns. As a result, some caution would be prudent here before any unconditional adoption of this argument. However, with apparently solid productivity gains underway and private payroll growth frustratingly slow but not negligible, there is very little space open for any double-dip scenario to materialize.

Anthony Karydakis

Friday, August 6, 2010

Employment Picture: Frustrating But Not Totally Dismal

This morning's employment report was to a large extent uneventful and, as such, provided very little new insight into the underlying dynamic of the labor market.

While the unwinding of 143,000 Census workers dragged the headline payroll number down (-131,000), private payrolls rose by 71,000, which is roughly consistent with the number that the ADP survey on Wednesday would have suggested for July. One discouraging element in the data was the fairly substantial downward revision to June's private payrolls from an initially reported gain of 83,000 to an increase of only 31,000.

The implication of that downward revision is that in the first seven months of the year, private payrolls have now increased by 630,000, bringing their average monthly gain to 90,000 versus an average increase of 100,000 that was the case in the first six months of the year prior to this morning's release. Supporting the broader picture of a downshifting in the pace of economic activity in late spring is the fact that two thirds of the total increase in private payrolls so far this year took place in March and April.

Manufacturing jobs turned out a solid gain last month (+36,000) but they benefited considerably from fewer seasonal layoffs in the auto industry, the latter accounting for 21,000 of those jobs. A modest bright spot in the data was a small gain in retail jobs following sizable declines in the previous few months. However, given rising uneasiness expressed in recent days about back-to-school sales, it will be interesting to see whether a reversal in that jobs category is in order for this month.

The battered state and local governments shed a combined 48,000 jobs in July, underscoring the reality that the dismal state of their finances continues to represent a headwind for the prospect of an acceleration in both job creation and overall economic growth over the next few quarters.

A 0.1% gain the average workweek for all private employees to 34.2 hours helps maintain the series at the upper end of its range for the cycle, holding out the promise of a pick up in the pace of hiring in the coming months.

The unchanged unemployment rate at 9.5% was the result of relatively proportionate declines in both the size of the civilian labor force (-181,000) and household employment (-159,000) for the month. Given the current trajectory of job growth, and allowing for a modest improvement later in the year, the unemployment rate is on track to end the year around 9 1/4%, broadly in line with the Fed's most recently revised forecasts.

By failing to provide any surprises to the upside that would reinvigorate expectations of a significant pick up in the pace of hiring ahead, the employment report tended to solidify the perception of an economic recovery unable to build any measurable momentum, and it may have actually lost some in the late spring-early summer period. However, there is a need to maintain the sharp distinction between such an admittedly disappointing reality and the talk that has resurfaced recently about a double-dip scenario.

As we have argued before, the latter scenario remains a highly unlikely outcome, and, in our article yesterday in this space, we showed that, recent history suggests, that it takes considerably longer than just one year following the end of a recession for job growth to show any major acceleration ( Against that measure, the current pace of payroll growth is not particularly out of the ordinary for this phase of the economic recovery.

Anthony Karydakis

Thursday, August 5, 2010

Dispelling a Misconception About Payroll Growth

Here's some important historical information regarding the behavior of payroll growth in the past, against which tomorrow's employment report should be evaluated.

One of the most constant complaints about the current economic recovery is that it has failed to generate enough job creation that would inspire greater confidence in the growth trajectory ahead. The hard numbers though question the validity of that perception head-on.

Irrespective of which month precisely the NBER will declare as representing the end of the latest recession, it is a fair expectation to have that it will most likely be the middle of last year (somewhere between June and August). This means that we are already about a year into this economic recovery. In the last six months (January through June 2010), private payroll growth has averaged 100,000 a month, a fairly reasonable pace but clearly below where we would like that number to be when the economic recovery finally reaches the point of operating on all cylinders.

In the first year of economic recovery following the previous two recession, job growth did not fair nearly as well compared to the current situation. In the second six-month period of the first year following the end of 2001 recession, private payrolls averaged approximately -9,000 (compared to the above mentioned 100,000 average monthly gain in the comparable period for the current recovery). Furthermore, if we consider the early phase of the economic recovery that followed the July 1990-March 1991 recession, private payroll growth during the second six-month period of that first year was -27,000.

Private Payroll Growth (monthly, 1982-June 2010)

Source: Bureau of Labor Statistics

Another critical part of that comparison is that, in the economic recoveries that followed both the 1990-91 and 2001 recessions, it took 3 to 4 years for the pace of private payroll growth to reach its peak pace (300,000+ a month in the first case and approximately 200,000+ in the second one) . While it is true that the experience with the labor market dynamic was quite different following the 1981-82 recession, when both the economy and private payroll growth roared ahead in 1983, no one has ever argued that the current economic recovery was meant to be compared with what is arguably one of the most impressive economic recoveries in modern history (that is, the one that followed the 1981-82 recession).

The message here is, that despite the frustration with the unimpressive pace of job creation so far, that pace is far superior to the one associated with the economic recoveries in the last two decades. It is also often missed, in the midst of such frustration, that, often, it does take a period considerably longer than a single year for the machine of job creation to get into full gear following a recession.

Differently put, by historical standards, there is nothing particularly wrong with the pace of employment growth in this recovery.

Anthony Karydakis

Monday, August 2, 2010

The Message From the July ISM

The modest decline in the July ISM for manufacturing to 55.5 from 56.2 was hardly surprising, given the somewhat erratic tone of the other three regional manufacturing surveys so far (Philly Fed. Empire State, Chicago). Still it renders itself to a few observations.

Source: Bloomberg, Haver Analytics

The index, although it has retreated in the last few months from its cycle peak of 60.2 in April, remains at historically healthy levels. In fact, the mid-50s range for the ISM is decidedly above the levels that prevailed for the series in the two-year period of 2006-07 prior to the recession.

Some pullback from the spring levels was nearly inevitable, as the inventory replenishment cycle in the manufacturing sector is winding down. It is also true that a much-publicized pick-up in auto production in the last three months may have helped cushion the ISM's retrenchment during that period, in the wake of the waning push from inventories. So, as auto production has already probably peaked, the behavior of the series in the next couple of months could be quite telling of the remaining underlying momentum in manufacturing.

On that score, our expectation is that the ISM will probably dip a little lower into the fall months to the 53.0-54.0 area, as it will receive some support from the seemingly stronger than previously anticipated growth in Europe. The key point is that ISM levels in that range should still be viewed as consistent with a healthy manufacturing sector and an economic recovery plowing ahead.

Anthony Karydakis

Friday, July 30, 2010

Three Key Points About the GDP Data

This is not meant to be an exhaustive line-by-line analysis of today's GDP report but rather intended to highlight some key pieces of useful information contained in it.

1) Today's report included revisions going back to 2007 and the new data show that the recession was deeper than previously estimated, particularly in 2008.

While overall GDP growth between Q4 2006 and Q1 2010 has now been revised down to +0.2% from +0.4% previously estimated, the contraction in 2008 -on a Q4 to Q4 basis- has now been revised to double from the original number (-2.8% now vs. a -1.9% initially).

Compounding the picture of an even deeper recession than assumed earlier, personal spending fell by twice as much (-1.2%) as the previous estimate for 2009, with a much sharper decline taking place in the first half of last year than the original number had suggested.

2) Although the Q2 2010 GDP number came in slightly on the low side (at 2.4% annual rate) of the market consensus, the sharp upward revision to the Q1 number to 3.7% from 2.7% initially reported translates into a 3.1% growth rate in the first half of the year. While far from impressive, it validates the premise that despite the distinct unevenness and at times disappointing tone of the various data, the economy is on a 3% to 3 1/4% growth path. We would not assign any particular significance with ominous overtones to the slower pace of growth in Q2, as this is the normal course of quarterly fluctuations in such data.

Source: Bloomberg. Haver Analytics

3) In fact, two specific elements in the Q2 data should be viewed as moderately constructive. a) Capital spending surged 17%, following a 7.8% increase in Q1. This shows a robust comeback of capital spending, following devastating declines in the 2007-2009 period, making that sector one of the key engines of growth in the current phase. b) Despite the intense uneasiness over the failure of labor markets to improve at a faster pace so far, personal consumption held up at an acceptable 1.6% rate of growth vs. 1.9% in Q1. While still unimpressive, it does indicate that there is still a core rate of spending (largely reflecting pent up demand from the "dark" for the economy period of 2008-09), that, despite the high unemployment rate, provides a moderate base that continues to support the recovery moving forward.

In a nutshell, there is little in today's data that can be used to fuel fears of a double-dip, a scenario we have been deeply skeptical of in this column. While it is true that the recovery remains on an unimpressive trajectory, it is still moving ahead, with a natural change in the composition of growth, as is to be expected for this phase of the cycle (less contribution to growth from inventories, but with capital spending slowly puking up the baton).

Anthony Karydakis

Monday, July 26, 2010

A Practical Guide to this Week's Economic Releases

With the much criticized, but hardly surprising, results of European bank stress tests out of the way, the U.S. Treasury market's attention has already turned to this week's three coupon auctions and a barrage of scheduled economic releases.

Among the various economic reports on this week's calendar, certain of them occupy a more prominent role, as they have the potential to provide fresh insights into the state of economic activity at the turn of the quarter.

Although generally (and appropriately so), the Consumer Confidence/Sentiment indicators are considered as "soft" data in that they reflect psychology rather than actual activity, the July reading of the Conference Board's Consumer Confidence Index (Tuesday) is a little more meaningful than usual. The series showed a particularly sharp decline of nearly 10 points to 52.9 in June and the consensus seems to be looking for an additional modest drop in July. However, given the sheer magnitude of June's decline, and given that the index had also stood at more elevated 57.7 in May, the potential exists for a moderate rebound from July's level to the mid-50s area. This is not an unreasonable expectation, in view of an overall more resilient stock market this month, one of the factors- besides perceptions of labor market conditions- that tend to influence the confidence surveys.


Durable goods orders, a key but often hopelessly volatile measure of momentum in the manufacturing sector, fell 0.6% in May but is expected to rise modestly (around 1%) in June, boosted by a rebound in the transportation component and, specifically, aircraft orders for the month. If ex-transportation orders manage to eke out a gain in June, that would be fairly significant in that this will be following a 1.6% gain in such orders in May. Given some uneasiness created by an unexpectedly lower ISM reading in June, back-to-back gains in the ex-transportation durable goods orders should help restore confidence in the underlying momentum of the manufacturing sector.

It is for the same reason that Friday's Chicago PMI should be viewed as the third key economic release of the week. The series was relatively little changed in June at 59.1 vs. 59.7 in the prior month, not retreating by nearly as much as the national ISM. The consensus seems to be that the Chicago PMI will catch up with the cooling reflected in last month's ISM and retreat by an additional 2 to 3 points to the 56-57 range in July. While the broader premise of a modest interim downshifting in manufacturing activity in the midst of a waning inventory cycle is reasonable, a decline of the magnitude expected by the consensus in July is far from assured. In fact, if the Chicago PMI holds up in the vicinity of its June level, this would trigger a nearly automatic upward revision to expectations about next Monday's July ISM (currently expected to edge lower to 55 from 56.2 in June).

The Q2 GDP data on Friday are unlikely to be materially important to the market, as they will reflect the distinct softening in economic activity that had already become apparent in the partial data for the quarter and which has already been largely discounted. The directionless behavior of initial unemployment claims, and their distinctly choppy pattern in the last few weeks due to anomalies in the normal seasonal shutdown of auto plants, both have delegated the series to a second-row seat in terms of significance for the time being and this is unlikely to change with this week's number- almost irrespective of what the number actually is. It is hard to imagine the Q2 Employment Cost Index on Friday becoming any one's real focus, given that wage and price pressures are broadly viewed as a non-issue in the current environment. Finally, Friday's Reuters/University of Michigan Consumer Sentiment index for the entire month of July is likely to represent a simple, inconsequential, fine-tuning to its early-month reading of 66.5...

...and, of course, this morning's 24% jump in June's new home sales is not particularly telling of anything either, as it represents only a partial rebound from a disastrous 36.7% cratering of such sales in May.

All in all, the first three reports we identified above (Consumer Confidence, Durable Goods Orders, Chicago PMI) as standing out in this week's crowded calendar have the potential to paint a picture of a somewhat more resilient than generally assumed economic recovery, following a string of at times very disappointing data in the last several weeks.

Anthony Karydakis

Thursday, July 22, 2010

Mr. Bernanke In a Bind...(and a footnote on Europe)

Mr. Bernanke's testimony before the Senate Banking Committee yesterday has already received an abundant amount of coverage, both in the media and among market professionals- so, there is not much particularly insightful that can be added at this point.

Still, his comments with regard to a specific topic during his testimony merit a few special observations, as they also relate directly to the heart of an article we published in this space a few days ago (

During the Q&A, the Fed Chairman was asked by Senator Jim Bunning (R, Kentucky) whether the Fed is "out of bullets" to use in order to help strengthen the underwhelming economic recovery. His reply was "Well, I don't think so. We need to continue to evaluate those options. As I said, we are not prepared to take any specific steps in the near term, particularly since we're still also evaluating the recovery, the strength of the recovery. But I do think that there is some potential for some of those steps to be effective" (italics added for emphasis).

His triple-qualified answer can hardly be viewed as an expression of confidence in the Fed's ability to actually do much at this point. Gone are the days where he was vigorously emphasizing the Fed's nearly unlimited arsenal of policy-making tools, including the infamous metaphor about helicopters throwing money into the economy from the sky- already done, and it has not worked.

Mr. Bernanke proceeded to enumerate some of those options (paying less interest on bank reserves, bolstering the Fed's language committing to keep rates low for an extended period, not allowing maturing securities to run off of its balance sheet, or embark on more asset purchases), while adding conspicuously that "...they are not going to be conventional options, so we need to look at them carefully and make sure we are comfortable with any step that we take".

While the true effectiveness of some of these measures can be called into question outright (see the first of the above links to our recent article), all of them do include considerable risks for the Fed, which make these options even less appealing on a cost-effective basis. For example, if the Fed were to engage in another round of asset purchases- massive enough to have any perceptible effect, to the tune of 30-40 basis points on market rates- it would create enormously bigger complications for its ultimate exit strategy, as it would then require the absorption of a much bigger amount of liquidity than what is currently the case. Or, it would reflect a certain degree of disconnect from the reality on the ground to argue that the Fed's elimination of the interest rate it now pays banks on their excess reserves (25 basis points) would have an effect on bank lending standards and/or economic activity; bank lending standards are not so tight because there is not enough liquidity in the system. In fact, the banking system is already swimming in reserves.

The truth is that Mr. Bernanke has probably run out of credible options to activate in order to help the economy, and this was the subtext to his highly cautious answer to that question during his testimony yesterday. Any of the remaining options are of questionable effectiveness, fraught with more risks than any potential benefit they offer.

The Fed Chairman, understandably, could not acknowledge that in public. However, his appreciation of the bind the Fed is in makes it rather unlikely that the Fed will proceed with the implementation of any such additional "stimulative" measures. If the economic recovery remains stuck on a 3% path over the net few quarters, the pressure on the Fed will be building to show that it is taking some action to alleviate the stubbornly high unemployment rate. Our guess is that Bernanke will be inclined to resist the activation of such additional steps of mostly cosmetic value and will simply prescribe patience for the economic recovery's dynamic to pick up steam over time.

For now, one thing is almost certain: that the "extended period" language is safe over the coming months.

(A brief note on Europe)
Two key economic reports coming out of Europe this morning surprised with their vigor and raise some questions about the widely anticipated slowing in economic activity there due to the fiscal austerity situation.

Eurozone's industrial orders surged 3.8% (month-to-month) in May, following a 0.6% gain in April. In the three-month period to May, orders are up 8.5% versus an increase of 5.8% in the three-month period to April. ( To alleviate any skepticism that this report was for May, and therefore less relevant to the period immediately following the peak of the fiscal crisis in the spring, the Eurozone's July manufacturing PMI rose to 56.5 from 55.6 in June. The service sector PMI for the bloc also rose in July to 56.0 from 55.5 in June. The strength in both PMIs for July was particularly pronounced in the data for Germany.

It may admittedly be too soon for any slowing in economic activity in Europe, as a result of the fiscal austerity policies in place, to be reflected in the July data yet. However, what these reports show is that two months after the peak of the fiscal turmoil that shook the Eurozone countries, economic growth in the bloc still has respectable forward momentum that may withstand better than originally assumed by many the fiscal policy headwinds.

Anthony Karydakis

Tuesday, July 20, 2010

Some Silver Lining in the Housing Starts Data

The 5% decline in June's housing starts to 549,000, from a downward revised drop of 14.9% in the prior month, is a stark reminder of the still dismal state of the residential construction sector. By way of a quick comparison, starts were running in the vicinity of 1 million units in the first half of 2008 and over 2 million at the peak of the housing market in 2005.

Source: U.S. Census Bureau

In recent months, the 8,000 tax credit-induced pick-up in existing and new home sales had created the perception that the housing sector might be turning the corner. That impression was based on the blurring of the distinction between starts and sales, particularly since the latter was driven by an admittedly transient factor. The strengthening in the demand for purchases of homes since last fall mostly led to a decline in the previously massive inventory of both new and existing homes but not to a meaningful pick up in construction For housing starts to embark on an even moderate upswing from their depressed levels, it would require a reasonable degree of confidence by the construction industry that the stronger demand for housing is here to stay. We are not at that point yet.

In the meantime, starts remain trapped withing a 500,000 to 650,000 range, which, while plain dismal per se, at least indicates that the market is forming a bottom- which is, of course, by no means tantamount to a turnaround. The perception of the housing starts series forming a bottom also received some cautious support today from a 2.1% rise in building permits, although that was driven by a 20% spike in the noisy multi-family category.

A final note.

Inasmuch as a simple stabilization of housing starts at these historically very low levels is nothing to cheer about, it does imply a waning drag on GDP growth ahead and has been an instrumental factor allowing the current economic recovery to unfold so far.

Residential construction itself (without counting the adverse effect of a collapsing sector on traditional consumer spending on household-related items) subtracted one full percentage point from growth in both 2007 and 2008, and 0.7 percent last year on the whole (it did have a moderate contribution to growth in the second half of the year, which was no match for the big drag it represented in the prior two quarters). While it took out a modest less than 0.3% from growth in Q1 2010, it should be roughly neutral in the balance of the year, removing a key headwind to the halting economic recovery.

Anthony Karydakis

Thursday, July 15, 2010

The Fed Is Not Omnipotent

The softening tone of the economic data in recent weeks has turned the spotlight to the issue of what additional action the Fed may need to take to provide new fuel to the underwhelming economic recovery. This emerging debate was also highlighted in yesterday's front page Wall Street Journal article (
as well as in the release of the minutes of the June 22-23 FOMC meeting (

Although the Fed's conclusion at the late June meeting was that no additional measures were deemed necessary at that point, the ongoing weakness in the economic data- showcased again in this morning's disappointing Philly Fed and Empire Fed manufacturing surveys for July- is likely to keep the debate alive and probably intensify it.

A discussion as to what further action the Fed can take to reinvigorate the recovery is understandable but based on the premise that monetary policy-making does indeed have the power, or leeway, to achieve that goal in the current environment. With the federal funds rate close to zero and an enormous amount of liquidity slashing around in the the financial system, this is not so obvious.

The Fed has seemingly exhausted the array of the most potent tools it possesses to promote economic growth, that is short-term rates and quantitative easing. In fact the entire structure of interest rates remains extremely growth-friendly, with not only Treasury yields near record-lows but also with credit spreads at historically tight levels. The economic recovery's inability to inspire great confidence, nearly a year after its onset, is not the result of market yields that are not low enough or the financial system having inadequate liquidity. It is mostly the result of a lengthy healing process following a devastating financial crisis and recession that is preventing the low interest rates and abundant liquidity from having a more textbook-like stimulative effect on economic activity.

It would simply not be credible to argue that the Fed's facilitating of another 7 to 10 basis points decline in the federal funds rate form its recent 17 to 20 basis point average would have any effect on the economy at this point. Similarly, injecting more liquidity via the resurrection of some of the special temporary liquidity facilities that were put in place after the Lehman affair and were winded down by the beginning of this year would do nothing to promote economic activity, as those facilities were largely meant to stabilize a financial system on the brink of collapse and offset a disastrous liquidity squeeze in the aftermath of Lehman. The financial system is currently swimming in liquidity and it is far from clear that the doubling of the LIBOR rate since the beginning of the year is an issue that can be addressed with more liquidity injection by the Fed via such temporary facilities.

Against this backdrop the only possible remaining course of action for the Fed would be the resumption of the Fed's program of asset purchases, which ended in March. The objective would presumably be to help bring market yields lower, both in the Treasury and MBS markets, which would help provide a boost to the economic recovery. Appealing as this avenue may appear at first, a less impulsive, facts-based, examination of its implications raises some caution flags.

The Fed's staff has reportedly conducted some studies showing that the central bank's asset purchase program- which has led to an increase in its balance sheet by $1.5 trillion today compared to before the financial crisis- may have lowered market yield by as much as 50 basis points. The precision of those studies usually leaving a lot to be desired, and given that a 50 basis point estimate was presented as an upper limit, it is probably more realistic to assume that the effect of the Fed's asset purchases on long term yields has been somewhat smaller.

Both long-term Treasury yields and mortgage rates are lower today compared to the prevailing ones at the time when Treasury purchases and MBS purchases by the Fed ended (in October 2009 and March 2010 respectively). In the meantime, the momentum of the economic recovery has slowed. Arguing that the Fed's possible resumption of an asset purchases program could engineer another 20 to 30 basis point decline in yields that would prove to be materially helpful to economic activity is a highly questionable proposition. Besides, the idea of the Fed embarking on another massive program of asset purchases that would increase its portfolio by another $500 to $800 billion suffers from a cost-effectiveness problem. Such an additional increase in the Fed's balance sheet would complicate enormously further the Fed's ultimate exit strategy, given the bigger amount of liquidity to be absorbed at that time.

If the pace of the economic recovery slows to a disconcerting degree ahead, the Fed may be under extreme pressure to show that it is responding by taking some action and perhaps resume some asset purchases. In reality, though, the economic recovery is not suffering from interest rates that are not low enough or from a banking system that is not liquid enough and this calls into question the true effectiveness of any such action. Inasmuch as the Fed is often perceived as powerful enough to manipulate economic growth at will, the effectiveness of monetary policy is seriously compromised in the midst of circumstances like the current ones. Japan has already found that out.

Anthony Karydakis

Wednesday, July 14, 2010

Retail Sales+Trade Deficit=Lower Q2 GDP

The widening of the May trade deficit by $2.0 billion to $42.3 billion yesterday (both in nominal and real terms- the latter being the key to GDP calculations) and the somewhat disappointing retail sales for June this morning, both point to an appreciably lower Q2 GDP than previously expected.

As a result of the May trade deficit number, net exports are now expected to be a bigger drag on Q2 growth than previously thought, probably to the tune of $50 billion, subtracting more than 1 1/2 percentage point from GDP. This would be almost double the 0.83 percent net exports had subtracted from Q1 GDP growth.

In terms of the June retail sales, overall sales fell 0.5%, largely due to a 2.3% decline in vehicle sales. Excluding autos, sales were off by a more modest 0.1%. The part of the retail sales report that is most directly relevant to GDP calculations- that is, total sales less autos/gas station/building materials- was up 0.2% for the month, following a 0.1% decline in May.
These numbers are consistent with personal consumption in the 2 1/4-2 1/2% range in the second quarter, below the first quarter's 3.0% annual rate.

The net-net of these two reports is that Q2 GDP growth now looks more like a 2.5% proposition, with the pace of inventory accumulation remaining the wild card, given the limited inventory data available to date. Such a pace of growth would follow a twice-downward revised 2.7% Q1 GDP, confirming the disappointing failure of the recovery to pick up any momentum in the spring months from an already unimpressive first quarter.

Still, moving forward, a gradual- albeit, frustratingly slow- acceleration in employment growth should help sustain an improvement in income growth and consumption in the second half of the year, that would lead to a rebalancing of the growth trajectory to the 3.0-3.5% range. In fact, the seeds of this likely trend were evident in the May trade deficit data, as well in the ongoing deterioration of the international trade picture in recent months, as imports rose by a healthy 2.9%, reflecting the unfolding strengthening in consumer spending.

Anthony Karydakis

Monday, July 12, 2010

The Questionable Premise of the TIPS Market

Since the height of the sovereign debt turmoil that rocked Europe in mid-May, inflation-indexed Treasury securities (TIPS) have underperformed nominal Treasuries by a wide margin. As a result, the yield spread between the latter and TIPS for 10-year maturities (breakeven) has narrowed by about 50 basis points from its average (and close to its normal trend) of 230 basis points in the first four months of the year.

Source: Federal Reserve Board

The reason for the significant concession that the TIPS market has offered in the last eight weeks is a fairly straightforward one. The fiscal crunch that is affecting many European countries (including the non-eurozone U.K) has been widely perceived as a major headwind that is likely to affect adversely the growth prospects in the U.S. over the medium-term. As a result, the already unimpressive growth trajectory of the economic recovery is being downgraded, as is the already tame inflation outlook.

With core CPI already below 1.0% (0.9% year-on-year) and overall inflation steadily drifting lower (currently at 2.0% year-on-year), the expectation is that the renewed weakness in the economic outlook is likely to cause a further downward drift in both inflation measures ahead- with the behavior of the overall CPI being the relevant index for the pricing of TIPS. The term "disinflation" has increased in popular use recently, while, talk of a double-dip recession and an outright deflation has resurfaced more pointedly. Against that background, the primary appeal of TIPS (that is, to offer protection against inflation over the maturity of the security) naturally dissipates, which accounts for the narrowing of the breakevens.

Although there is little doubt that the recovery has experienced a modest loss of momentum in the last couple of months, the risks ahead have been somewhat exaggerated. The fiscal situation in Europe is already being addressed with reasonably credible measures, and, in any event, any moderation in growth there (still not a foregone conclusion, given the latest data coming out of Germany that suggest that growth is the biggest eurozone economy is still moving forward) is offset by a solid rebound in the emerging market economies. Furthermore, economic recoveries- particularly of the relatively halting kind, like the one in the U.S currently- are known for hitting an occasional soft patch, which is not in and of itself alarming. Lastly, the notion that an economic recovery will just roll over and fizzle, triggering a double-dip, has been generally not supported by history (see,

On some level, the premise upon which TIPS have underperformed Treasuries recently is almost undesrtandable, but, nonetheless, likely flawed. Although the narrowing of the bearkevens may, in view of an upcoming 30-year TIPS auction next month and the possibility of more softness in the economic data over the near-term, persist for a while longer, it remains particularly vulnerable to evidence that, all things considered, the U.S. economic recovery remains largely on track. Therefore, a trading bet on the restoration of more normal breakeven levels in the 10-year sector over the next few months merits consideration.

Anthony Karydakis

Thursday, July 8, 2010

The IMF's More Sanguine Take on Global Growth

Despite widespread uneasiness recently about the prospects for economic activity in the U.S. and Europe, the IMF's latest forecast that was released this morning paints a noticeably more sanguine picture for global growth, both in 2010 and 2011.

The IMF has now revised its 2010 growth estimate for the group of the so-called "advanced economies" (which does not include China or India) to 2.6%- up 0.3% from its previous estimate in April. Next year's growth forecast for those countries has been left unchanged at 2.4%.

Within the group of the "advanced economies", U.S. GDP growth has now been revised higher to 3.3% for this year (from 3.1% previously) and 2.9% in 2011 (from 2.6% before). The Japanese economy is now expected to grow by 2.4% this year (versus an earlier estimate of 1.9%), while a modestly slower pace expected in 2011 (1.8% now, compared to 2.0% before). As a whole, the growth forecast for the eurozone bloc has remained unchanged at 1.0% for this year but has been downgraded by 0.2% to 1.3% for 2011.

The basic tenor of the revised forecasts consists of a small upward revision to this year's global growth, and little overall change to next year's expected growth. However, the detailed country-by-country estimates now show a marginal softening in economic activity in most of the "advanced economies" in 2011, which is offset by a moderate upward revision to the growth estimate for the U.S. next year.

The GDP growth forecast for Asian has now been revised upward to 7 1/2% this year from 7% previously, as a result of the inventory cycles and "continued buoyancy in exports and private domestic demand", while there is no change to next year's previously published forecast for a more moderate and sustainable growth rate of about 6%.

Taken literally, the IMF's upward revisions to this year's growth forecasts, and the fairly minimal downward revisions for most countries in 2011, are counter-intuitive. They seem to run contrary to the recent perception of considerably elevated risks to global growth due to the fiscal turmoil in Europe and an ensuing wave of fiscal austerity.

There are two key elements here that can help reconcile this apparent inconsistency. a) The IMF explicitly acknowledges in its report the "markedly" escalated risks to growth ahead, stemming from the financial stress associated with the sovereign debt situation and the policy response to it. At the same time, it appears that, in formulating the revised forecasts, the IMF's operating assumption is that those challenges can still be contained reasonably well without chocking growth. In other words, it views those headwinds to growth as remaining still in the sphere of a "risk" rather than having already taken a central role in driving growth ahead or having over-run the natural growth dynamics already in place. b) Economic forecasts are, to a considerable extent, a "dry" (and highly imperfect at that) exercise, where assumptions are used as inputs and "results" are automatically generated in the form of point estimates. Revisions to the tune of 0.2%, 0.3%, or even 0.5% practically represent something less than a rounding error- therefore, their true reliability needs to be viewed with a grain of salt.

Perhaps, the key message from the IMF's revised forecasts is that, headline-grabbing as they have been lately- the sovereign market situation and fiscal policy developments should be monitored closely but not considered yet as a defining factor already shaping the growth trajectory ahead.

Anthony Karydakis

Wednesday, July 7, 2010

The Multiple Faces of the "Exit Strategy"

The term "exit strategy" has become one of the most popular in the financial lexicon over the last year or so, following the unprecedented amount of liquidity injected into the system by the Fed in the midst of the financial crisis in 2008-09. It has widely come to be viewed as referring to the process that the Fed will need to engage in at some point to start normalizing financial market conditions. In one of its most linear interpretations, the term is considered as synonymous to the beginning of the Fed's raising short-term rates. Underlying such an interpretation is the frequent misconception that the absorption of excessive liquidity is tantamount to tightening policy.

In reality though, "exit strategy" is a significantly more multi-layered enterprise than that.

The process of starting to normalize liquidity levels in the financial system is not necessarily linked to a higher federal funds rate and, in fact, the timing of the former is not likely to coincide with that of the latter, but it will most probably precede it.

In the last few months, a number of Fed officials have, in nearly explicit terms, drawn the distinction between the project of asset sales from the Fed's bloated $2.3 trillion portfolio and the prospect of rate hikes. In the most recent FOMC minutes available (April 27-28 meeting) there was a fairly extensive discussion, including a number of specific steps to be considered, regarding the gradual winding down of the Fed's portfolio in the future, while there was unwavering commitment to the "extensive period" language concerning the near-zero fed funds rate

Moreover, several FOMC members have been on record in recent weeks (including richmond Fed President Lacker, St. Louis Fed President Bullard, and others) offering their own take, and -in some cases- specific ideas, on the future of the Fed's asset sales, while, with the well-publicized exception of Kansas City Fed President Hoenig, there is essentially no questioning of the premise that the fed funds rate will remain near zero beyond the end of the year.

The reason for the dichotomy in terms of how these two tracks are treated by the Fed is that any gradual lightening up of the Fed's portfolio is highly unlikely to have any impact on the fed funds rate, the latter legitimately considered as the true barometer of the degree of tightness of monetary policy. Such transactions would mostly take the form of a steady, modest stream of outright sales out of the nearly $1.2 trillion MBS portion of the Fed's portfolio, or, (to a lesser degree over the next year or so, given the long maturities involved) simply allowing for some of those holdings to run-off slowly. In any event, such a process will not affect the fed funds rate, as the latter will require a very different, direct, set of actions by the Fed (namely, raising the interest rate paid on bank reserves from its current 0.25%, as well as an aggressive program of reverse RPs).

For simple operational as well as tactical reasons, the Fed will almost certainly activate the process of a carefully controlled downshifting of the size of its portfolio ahead of any short-term rate hikes. A slow reduction in its portfolio over a number of months will achieve the dual objective of 1) leaving a lesser, more manageable, amount of liquidity to be mopped up later by reverse RPs and higher rates offered on bank reserves when the time for "real tightening" comes, and 2) avoiding to unsettle financial markets prematurely by moving ahead with a highly emotional overt rate hike, as the winding down of its portfolio is a far more discrete- almost, behind-the-scenes process.

The various modalities that the implementation of the "exit strategy" ahead can take were highlighted in some interesting comments that Richmond Fed President Lacker made earlier this week (, where he argued that the Fed should sell MBS out of its current portfolio and buy Treasuries. Such an operation would leave the total amount of liquidity in the system intact but would start restoring the Fed's portfolio to its more traditional, pre-crisis, composition of holding mostly Treasury securities. In a way, this would be a useful preliminary move toward an eventual normalization of financial market conditions over the next couple of years.

The minutes of the June 22-23 FOMC meeting that will be released next week (July 14) may offer more of an insight into the discussion among policymakers about the issue of the Fed's portfolio ahead. Although the activation of a mechanism to alter the configuration and size of that portfolio is still some months ahead, it is important to recognize that it will likely precede- quite possibly by an appreciable margin- the timing of any actual rate hike. In other words, the "exit strategy" is not a monolithic project but more like a multi-faceted affair, not all of which need to have an overt effect on rates.

Anthony Karydakis