An Economist's Corner

Announcement

2010-10-24T21:35:00.000-04:00

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 (akarydak@stern.nyu.edu) 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!

Anthony

A Key Issue Regarding GDP Growth in Q3

2010-10-18T17:21:00.000-04:00

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

Friday's September Employment Report

2010-10-05T20:17:00.000-04:00

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
weeks.

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

2010-10-05T20:00:00.000-04:00

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

http://www.newyorkfed.org/newsevents/speeches/2010/sac101004.html

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

Marching Toward More QE

2010-09-28T20:19:00.000-04:00

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

Nominal Treasuries and TIPS: A Diverging Inflation Outlook?

2010-09-23T15:43:00.021-04:00

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 (http://economistscorner.blogspot.com/2010/09/fomc-statement-litle-closer-but-not.html). 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

The FOMC Statement: A Litle Closer But Not There Yet

2010-09-21T16:18:00.012-04:00

The FOMC statement this afternoon (http://www.federalreserve.gov/newsevents/press/monetary/20100921a.htm) 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

Next Week's Busy Economic Calendar

2010-09-09T09:55:00.019-04:00

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

The Employment Picture Brightens Up, Suddenly

2010-09-03T08:53:00.019-04:00

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

A Few Thoughts On The Current Treasury Yield Levels

2010-08-31T11:36:00.021-04:00

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

Bernanke At Jackson Hole

2010-08-27T10:54:00.013-04:00

Here's some thoughts on Mr. Bernnake's much-anticipated speech at Jackson Hole this morning (http://www.federalreserve.gov/newsevents/speech/bernanke20100827a.htm).

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

The Opening Rift Within the Fed

2010-08-24T16:28:00.013-04:00

Today's front page article in The Wall Street Journal (http://online.wsj.com/article/SB10001424052748703589804575446262796725120.html?KEYWORDS=Fed)
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 (http://economistscorner.blogspot.com/2010_07_15_archive.html) 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

Next Week's Treasury Supply

2010-08-20T11:17:00.010-04:00

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

Tracking the Recovery: Not All News Is Bad

2010-08-18T09:19:00.020-04:00

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

Uneventful CPI and Retail Sales Data for July

2010-08-13T09:05:00.017-04:00

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

Five Points On The Fed Announcement

2010-08-11T09:23:00.020-04:00

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

The Dark Side of Productivity

2010-08-10T09:17:00.014-04:00

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 (http://www.bloomberg.com/news/2010-08-06/nber-s-hall-says-faltering-jobs-data-don-t-imply-another-u-s-recession.html) 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

Employment Picture: Frustrating But Not Totally Dismal

2010-08-06T08:45:00.027-04:00

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 (http://economistscorner.blogspot.com/2010/08/dispelling-misconception-about-payroll.html). 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

Dispelling a Misconception About Payroll Growth

2010-08-05T09:39:00.029-04:00

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

The Message From the July ISM

2010-08-02T10:12:00.007-04:00

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

Three Key Points About the GDP Data

2010-07-30T09:03:00.017-04:00

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

A Practical Guide to this Week's Economic Releases

2010-07-26T09:02:00.025-04:00

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.

Source: http://seekingalpha.com/article/212409-conference-board-consumer-confidence-index-evaluating-historical-performance

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

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

2010-07-22T09:41:00.027-04:00

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 (http://economistscorner.blogspot.com/2010/07/fed-is-not-omnipotent.html).

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".
(http://www.reuters.com/article/idUSTRE66K5AJ20100721)

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. (http://www.actioneconomics.com). 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

Some Silver Lining in the Housing Starts Data

2010-07-20T09:05:00.017-04:00

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

The Fed Is Not Omnipotent

2010-07-15T11:14:00.022-04:00

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 (http://online.wsj.com/article/SB10001424052748703834604575365052129874156.html?KEYWORDS=The+Fed+Sees+Slower+Growth)
as well as in the release of the minutes of the June 22-23 FOMC meeting (http://www.federalreserve.gov/monetarypolicy/fomcminutes20100623.htm).

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

Retail Sales+Trade Deficit=Lower Q2 GDP

2010-07-14T09:11:00.013-04:00

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

The Questionable Premise of the TIPS Market

2010-07-12T09:21:00.029-04:00

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, http://economistscorner.blogspot.com/2009/09/do-double-dip-recessions-really-happen_09.html)

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

The IMF's More Sanguine Take on Global Growth

2010-07-08T09:31:00.032-04:00

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.

http://www.imf.org/external/pubs/ft/survey/so/2010/RES070710A.htm

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

The Multiple Faces of the "Exit Strategy"

2010-07-07T09:32:00.040-04:00

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 http://www.federalreserve.gov/monetarypolicy/fomcminutes20100428.htm).

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 (http://www.bestgrowthstock.com/stock-market-news/2010/07/06/lacker-fed-should-sell-mbs-buy-treasuries-mnsi/), 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

Employment Growth Still in Search of Momentum

2010-07-02T08:53:00.022-04:00

The June employment report held no major surprises.

The unwinding of 225,000 census jobs last month caused a 125,000 drop in overall payrolls, leaving private sector job gains at an unimpressive 83,000. Although private employment has increased by a total of 593,000 jobs since the beginning of the year (corresponding essentially to a gain of 100,000 a month), it remains below its December 2007 level by 7.9 million.

The health care sector continues to lead, in relative terms, job creation, turning out a 17,000 increase last month, while manufacturing (a key area of strength so far) showed a somewhat moderate by recent standards gain of 9,000. Retail trade -7,000, financial industry -15,000. Temp-help services up 21,000, following increases of 31,000 and 23,000 in the prior to months.

Although it is a component with an admittedly choppy month-to-month behavior, the 0.1% decline in the average workweek to 34.1 put an end to an encouraging uptrend that had been emerging since early spring.

On the face of it, and although it is a headline-grabbing number for the broader public, the somewhat unexpected sharp drop in the unemployment rate to 9.5% is a bit of a question mark as to its true significance. The decline was not part of any underlying strength in employment (as captured in the household survey) as that part declined by 301,000 (also affected by the laid-off census workers, but not by the exact number as in the establishment survey). Instead, there was a very sizable, but not unprecedented, contraction in the civilian labor force last month by 652,000, that accounts for the decline in the unemployment rate. Still, on a trend basis, there is no question that the unemployment rate has decidedly turned the corner from its 10.1% cycle-peak reached last fall.

Unemployment Rate

Source: BLS

All things taken into account, the employment data validate the impression that labor market conditions continue to improve but remain on a somewhat lower trajectory than needed to provide fresh impetus to the economic recovery imminently. The process of reaching a solid pace of job creation that would correspond to 200,000-250,000 monthly private payroll gains is proving to be a slower one that we had anticipated. A lingering resistance on the part of the private sector to more aggressive hiring reflects ongoing underlying uneasiness over the momentum of the recovery. This caution creates an inevitable self-fulfilling prophecy, in that it impedes the very momentum that economic activity needs to acquire to convince private companies to hire more quickly.

None of this puts the future of the economic recovery at risk but the latter appears increasingly likely to remain mired in a 3 to 3 1/4% growth range in the second half of the year.

Anthony Karydakis

Mortgage Rates: The Back-Up That Wasn't

2010-06-30T09:41:00.015-04:00

At the beginning of the year, one of the frequently expressed concerns was the presumed adverse impact that the end of the Fed's massive MBS purchase program was likely to have on mortgage rates. This was a pretty straightforward argument based on the premise that supply is a major driver of mortgage rates and, in fact, yields more broadly.

Although, in classic market modus operandi, the sheer anticipation of that outcome was enough to cause a modest back up in yields prior to the expiration of the Fed's program at the end of March, the reality is that mortgage rates have declined appreciably since the beginning of the year, with the 30-year fixed rate mortgage dipping to 4.67% last week, according to this morning's data released by the Mortgage Business Association (http://www.mortgagebankers.org/NewsandMedia/PressCenter/73294.htm).

Source: Federal reserve Bank of St. Louis, MBA

The fiscal turmoil in the eurozone since the beginning of the year, an ongoing downward drift of domestic inflation, and a modest loss of momentum in the economic reports recently have all conspired to fuel a powerful rally in the bond market, driving mortgage yields lower as well. This dynamic has trampled any demand/supply-related considerations stemming from the Fed's withdrawal from the mortgage market in the second quarter.

As we have argued before, supply is a temptingly convenient factor to use in any rationale attempting to forecast the direction of long-term yields. In reality, though, it has a particularly poor track record to justify such attention. The most dramatic perhaps demonstration of the exaggerated importance that markets often attribute to supply is the fact that Treasury yields have been able to absorb a massive onslaught of supply in the last 18 months, without any signs of indigestion and remain near historically record-low levels, despite an economic recovery that has been taking hold for nearly a year now.

The advocates of supply as a key determinant of market yields always offer the caveat of "all other things being equal". The problem is that, outside the universe of academic research and computer models, those "other things" are almost never equal. In fact, changes in supply conditions typically contain the very seeds of a powerful counter-effect that neutralizes its impact. For example, the massive Treasury fiscal deficits were the direct result of a sever financial crisis and deep recession, both of which were potent forces pushing yields lower.

A similar explanation accounts for the impressive resilience of mortgage rates following the end of the Fed's purchase program; that is, the broader conditions in both the domestic economy and global market environment were a far more dominant driving force of such yields than the end of the Fed's purchase program.

Anthony Karydakis

A Cautionary Note On the Data Ahead

2010-06-28T08:53:00.021-04:00

With the economic recovery steadily approaching a key juncture, the overall tone of the various economic releases may also change as a result, projecting an overall softer undertone that may help support the latest downward drift of bond market yields.

In the three most recent quarters, since the recovery got under way, economic growth has benefited heavily from the classic inventory cycle, which contributed 0.7, 3.8, and 1.9 percentage points respectively to GDP growth since Q3 2009; in some cases, like in Q4 2009, a faster rate of inventory accumulation accounted for 2/3 of the entire GDP growth. With the inventory dynamic slowly- but predictably- losing its fizzle, and the the boost from last year's fiscal stimulus waning by year end, a perceptible risk exists that, economic growth may be downshifting in the second half of the year, unless another sector of the economy makes up for that.

The implication of this is that pressure is building on employment growth to pick up materially in the coming months to support stronger income growth and consumer spending. The labor market statistics have been quite mixed recently, with private payrolls stalling, following a solid turnaround in the first quarter, and initial claims essentially treading water since the beginning of the year.

The relatively unimpressive picture of labor market conditions does not represent a direct threat to the viability of the recovery per se, as the latter has already entered credibly the phase of a self-sustaining expansionary dynamic. However, it does hold the key to the pace of economic growth over the next 3 to 4 quarters.

Against such a background, the importance of the ever-pivotal employment report on Friday may be greater than usual.

With a potentially sizable number of temporary census workers laid off in June, the focus, once again, should be on private payrolls, which have averaged a fairly respectable 139,000 in the last three months. Even if the nominal payroll print for the month is only marginally positive, or even a small negative, a gain in the 150,000 to 200,000 range for private payrolls would be encouraging and consistent with economic growth plowing ahead at a solid clip. However, a private payroll gain in June comparable to the disappointing 41,000 reported for May may require a reassessment of the working assumption that the recovery can sustain a growth rate in the 3 1/2% to 4% range into early 2011.

Time is running out for the employment picture to show its hand.

Anthony Karydakis

The FOMC Statement: The Day After

2010-06-24T09:18:00.010-04:00

The FOMC's unambiguously bond market-friendly statement yesterday provided a strong boost to Treasuries, triggering a rally that has brought the 10-year yield within striking distance of the 3% mark.

In surveying the landscape today, a few comments are in order:

1) The subtle, but unmistakable, caution reflected in the Committee's assessment of the growth prospects, pushes the possible timing of the first tightening move well into 2011 (with a more specific handle on such timing being hard to assess at this distance). This is strongly reinforced by the acknowledgement in the Committee's statement that, in addition to financial market conditions that are not "supportive" of growth", inflation is also trending lower. It is critical to stress here that an outright Fed tightening move does not necessarily have to coincide with the beginning of any asset sales from the Fed's portfolio, as the latter might come first- although it has now also been pushed further out. (We will have a special article on the various pieces of the Fed's exit strategy in the coming days).

2) While fed funds futures moved quickly to remove the bulk of any risk for a Fed move this year (with only a "natural" residual of risk left in the pricing of the December contract due to ever-present, background concern about year-end distortions in the funds market), Eurodollar futures continue to reflect a moderate, steady uptrend in the 3-month LIBOR rate- the direct effect of ongoing concerns about bank liquidity. Such concerns are also fueled by the prospect of the release of the bank stress-test results in Europe at some point next month.

3) With the Treasury yield curve on course to maintain its core steepness for quite some time now, plain, old-fashioned carry trades remain very much in vogue. Viewed from a slightly different angle, this implies that any curve flattening trades, which may still have some appeal in the midst of a potential stretch of strong economic reports, should be managed with caution and viewed as purely tactical and with limited objectives.

Anthony Karydakis

Europe's Fiscal Crisis May Help the Euro's Survival

2010-06-23T09:18:00.012-04:00

The recent fiscal turmoil and associated existential doubts about the fate of the eurozone's common currency may have actually been a particularly constructive development for the latter's future, as they have brought to the forefront the long-simmering underlying tensions with an unmistakable sense of urgency to address them head-on.

This dynamic has led to a barrage of meaningful proposals about a new, tighter framework that would allow for a better harmonization of underlying fiscal policies among the bloc's various countries and also a mechanism for closer supervision to ensure compliance with stated targets. The ECB President put forward such a plan earlier in the week (http://wallstreetpit.com/32435-ecbs-trichet-eu-governments-in-breach-of-fiscal-rules-could-lose-voting-rights), which has the tacit support of the powers-that-be within the EU. The exposition of the fault lines within the eurozone's member countries has left virtually no room for ignoring that ticking bomb that had always been identified, since the inception of the euro, as a potential threat to its long-term survival.

In the near-term, the wave of fiscal austerity measures sweeping the european countries- including, most notably, the U.K (a non-eurozone mmeber)- is meant to help defuse the immediate global financial market anxiety vis-a-vis the european countries' sovereign debt. At the same time, the longer-term plans laid out by the EU to prevent such a turmoil in the future can go a long way toward redressing the massive productivity gaps and sense of fiscal discipline in the future among the various member countries, which would strengthen the common currency's prospects.

The institutional response by the EU to the recent crisis may not be succeed in putting the recent financial market uneasiness to rest any time soon, as markets are famously demanding of hard evidence establishing the effectiveness of such measures in correcting the underlying problem. In fact, a risk does exist that, over the next couple of years, some marginal reconfiguration of the euro countries may take place, as Greece's longer-term ability to participate hangs in the balance. However, in a little noticed development last week, Estonia (with a total public debt of only a minuscule 7.2% of GDP) also announced it will be joining the euro club as of January 2011, increasing the number of participating countries to 17 (http://www.nytimes.com/2010/06/18/business/global/18euro.html).

The key point is that while a possible reshuffling of countries using the euro in the future remains a distinct risk, an outright break-up of the common currency is, by the same token, a particularly low probability outcome over the medium-term. In fact, the recent- and, mostly, ongoing- unsettling fiscal situation in the eurozone may have increased the prospects of the euro's survival down the road.

Anthony Karydakis

The Yuan Announcement and Market Reactions

2010-06-21T09:37:00.028-04:00

This morning's dominant piece of news for financial markets is China's announcement over the weekend that it would adopt a "more flexible" exchange rate policy with the yuan. As a result, commodities and equities are rallying, on the rationale, that the likely appreciation of the yuan will lead to stronger economic growth in the U.S. (and, therefore, stronger corporate profits and demand for commodities), while the bond market is, predictably, taking a hit.

As an initial, broad, assessment of the significance of the move on the yuan, the front page article in today's WSJ ("China Eases Currency peg) is a reasonably adequate one. However, in evaluating the financial markets' reaction to the news, and the sustainability of this morning's price dynamic, some perspective is desperately required.

Despite this morning's fairly substantial rise, by nearly 0.5%, of the yuan against the dollar, the pace of further appreciation is likely to proceed very slowly, with the likely total amount of such appreciation by year end probably limited to the 4% to 5% range. Such a tightly controlled pace of the yuan's rise over the next six months or so is likely to be mostly due to two factors: a) The strong influence of the export lobby in China that will strenuously resist a more substantial pace of appreciation, particularly in an environment where their main export markets are growing at a very unimpressive pace, and b) The fact that the yuan is going to be managed against a basket of currencies, with the euro being one of its key components; if the euro's recent weakness persists, then the rise of the yuan against the dollar will have to be very limited to offset its potential further rise against the euro within the basket.

Against that backdrop, it is hard to imagine the prospect of a more flexible yuan policy ahead, which will probably lead to a further moderate appreciation next year, becoming a game-changer for the outlook of the U.S. economy over the next 12 to 18 months. Actually, the manufacturing sector, which is presumably the sector of the U.S. economy likely to benefit the most by a stronger yuan, has been doing particularly well in the last 9 months, having already become a key driving force of the economic recovery.

But the problem is not the manufacturing sector. The key challenges for the U.S. recovery over the medium-term include a still cautious pace of job creation, tight bank lending standards, any ripple effect from the fiscal turmoil in the eurozone, and the lingering drag from the housing market meltdown. Potentially stronger exports to China over that time frame are not likely to materially alter the outlook for economic growth in the U.S.

As a result, it is questionable whether the stock market's enthusiasm generated by the yuan announcement over the weekend will have long enough legs- that is, beyond a matter of a few days- to sustain a powerful rally in equity prices. It will not be before long when both equities and Treasuries refocus on the underlying realities permeating the current economic environment.

The prospect of only a cautiously optimistic FOMC statement on Wednesday -a reminder that the economic environment is still confronting a number of headwinds-, uneven economic data (with the emphasis on this week's struggling initial claims series and the magnitude of the likely decline in May's durable goods orders) may help put a brake on the stock market rally and the slide in Treasuries by the end of the week.

Anthony Karydakis

Picture-Perfect May CPI But Initial Claims Raise Some Eyebrows

2010-06-17T09:02:00.007-04:00

The May CPI report is near-perfect in that it confirms the picture of uneventful price trends, putting to rest any lingering concern about either inflationary, or deflationary, impulses in the current environment.

The 0.2% decline in the overall index last month was the result of a 2.9% fall in the energy component- the latter largely due to a 5.2% drop in gasoline prices. The core CPI's increase of 0.1% for the month, follows a flat reading in April, and represents only the second gain in the series since the beginning of the year. In fact, in the last 6 months to May, the core CPI has been up 0.8%, while in the last three months, it has risen by only 0.4%. Year-on-year, core inflation is up 0.9%.

Source: Bureau of Labor Statistics

In the last three months, the key housing component (which represents 40% of the overall CPI) has been flat (with a 9% drop in fuel oil prices helping offset a 15.8% spike in the "lodging away from home" category), while apparel prices have declined by 4.2% and, even medical costs have risen by a relatively moderate -by the standards of that component- 2.9%.

The impressively benign price picture is hardly surprising, given the abundant amount of slack in the economy and its slow absorption rate in in the midst of a moderate economic recovery, with these factors likely to continue taming price trends over the next 12 months or so.

Inasmuch as the favorable price dynamic should appropriately be viewed as providing the Fed with ample space to delay the onset of the tightening process, it is important to recognize that the monthly inflation data are not likely to be the primary reason that will determine the timing of the Fed's exit strategy. Instead, that is more likely to be shaped by a combination of the Fed's assessment of three factors: a) the economic recovery's prospects -particularly, in the wake of the fiscal turmoil in Europe- b) the ability of the global financial system to withstand the stress that a turnaround in the U.S. interest rate cycle would entail, and c) the degree of restlessness on the ground (i.e financial markets) about the need to see that the Fed remains vigilant vis-a-vis the longer-term inflation risks posed by the liquidity currently in the system.

The 12,000 rise in initial unemployment claims in the week of June 12 to 472,000 would not disconcerting per se, given the inherent volatility of the series, but it does validate a disappointing pattern of an essentially stalled downtrend in claims since the beginning of the year. The 4-week moving average of the series is now at 464,000, not much different compared to five months ag0.

The puzzle with the behavior of claims in recent months is that it stands in sharp contrast with the significant overall turnaround we have seen in the monthly payroll data and most other labor market measures. Although, we should not expect claims and payrolls to go hand-in-hand over the short-term, one would have thought that a nearly six-month period is long enough to have allowed the two series to send a more consistent message.

One explanation for the disconnect is that the payroll data may ultimately be revised downward for the first part of the year during the annual benchmark revisions of the series next spring. Another possible, but not fully satisfactory, explanation is that the last recession has caused profound dislocations among the various sectors in the economy, where some industries continue to shed off jobs at a strong pace (therefore accounting for the still elevated level of lay-offs), while other industries are turning around in a more robust fashion, accounting for the bulk of the hiring reflected in the improved payroll data.

Today's initial claims data were for the survey week of the June employment report and there is usually an attempt to use claims as a hint for what the monthly employment report may look like. The correlation between initial claims during the employment survey week and payrolls for that month is non-existent, but, at times, some loose relationship may exist between new filings and the unemployment rate. Still, there is no meaningful hint that can be derived from today's data, as the 472,000 claims number today was nearly identical to the 474,000 claims number for the survey week in May.

The rise by 88,000 to 4.571 million in the continuing claims for the week of June 5th is also consistent with the broader theme of lack of progress on the front of both initial filings and claims recipients.

Anthony Karydakis

In Defense of the ECB

2010-06-14T10:17:00.020-04:00

The ECB has received a considerable amount of criticism in recent weeks, as a result of its decision last month to start buying sovereign debt of some of the euro bloc's most vulnerable countries. The essence of the, at times, surprisingly sharp tone of such criticism is that the ECB has compromised its strongly prized sense of independence and is now succumbing to political pressures to pull out all the stops to contain the fiscal turmoil that has spread ominously across much of the eurozone. Furthermore, the critics argue, by doing so, the ECB is undercutting its much cherished anti-inflation credentials

The ECB's purchases of sovereign, euro-denominated, bonds have been fairly aggressive so far, with a total of over EUR40 billion of such purchases having settled in the first three weeks of the program. ECB watchers expect the program to reach EUR 60 to 70 billion in the foreseeable future. Although no official breakdown is available regarding the issuing countries of the bonds purchased, it is widely believed that the bulk of those purchases involve Greek debt.

The criticism of the ECB on this issue has been unfair and, by most reasonable standards, widely off-the-mark.

Despite the ECB's much publicized single mandate of keeping inflation in the eurozone "below, but close to, 2%", it is always the unspoken, but paramount, responsibility of any central bank to preserve the integrity of the financial system in the country/zone of its operation in periods of pronounced stress. That is exactly what major central banks have always done under such circumstances in recent history, with the most dramatic such episode being the 2008-09 global financial crisis.

In response to the crisis, both the Fed and the ECB took a number of unprecedented measures, some of which were going directly against the traditional concept of a central bank as the ultimate inflation fighter. It was precisely in that context that the Fed engaged in a program of purchasing $300 billion of Treasury securities, crossing a line that was nearly unthinkable in the past- namely of debt monetization; and this, before including the massive program of purchasing mortgage-backed and agency securities, totaling $1.4 trillion. During that period, the ECB conspicuously refrained from purchasing any sovereign debt of its member countries and limited itself to purchasing a total of EUR 60 billion of "eligible covered bonds" in the open market.

That the ECB is coming now under fire for moving aggressively to help extinguish the fire ignited by the fiscal turmoil that has threatened the integrity of the euro, is a serious misreading of its true mission. Meeting the inflation target "over the medium term" is certainly critical, but, first, Mr. Trichet needs to keep the eurozone in one piece to be able to conduct monetary policy with the objective of meeting his single mandate on inflation. There would be no role for the ECB to play if the eurozone collapsed. In fact, it would be negligence, bordering on serious monetary policymaking malpractice, for the ECB to refrain from taking significant special measures in the midst of the bloc's intense fiscal crisis.

As far as the potential inflation repercussions of the ECB's recent program of sovereign debt purchases, the risk appears quite limited. The HICP (Harmonized Index of Consumer prices) for the eurozone is running at 1.5% in the 12-month period to April and is expected to tick higher to 1.6% after the release of the May data tomorrow (6/16/10). Although it does represent an appreciable upturn compared to its low point six months ago and it is still comfortably below the 2% target. Besides, it would be unreasonable to believe that the projected modest pace of eurozone GDP growth in 2010-11 of about 1.5% represents a risk of generating any inflationary impulses.

Mr. Trichet's anti-inflation credentials have been impeccable in the last six and a half years at the helm of the ECB. Inflation is running close to its lowest since the inception of the euro and is lower than the rate prevailing in most legacy countries prior to the creation of the common currency. If anything, he has often been criticized in the past for being overly committed to the ECB's official inflation target, often at the expense of growth in the eurozone and with a steady bias toward keeping monetary policy a notch or two tighter than circumstances might have warranted at various points. (After all, the intense criticism he received for being in a tightening mode in early July 2008 -having raised the ECB's overnight rate by 25 basis points to 4.25% in just two months prior to the Lehman affair- is still fresh).

The ECB and Jean-Claude Trichet have built enough capital with their strong anti-inflation credentials over the years that they should not be viewed with suspicion as to whether they are compromising their commitment to price stability with their bond purchase program in response to an exceptional set of circumstances that they have been confronted with. They deserve more credit than that. Doing otherwise simply highlights the sad reality that markets have, indeed, very short memory.

Anthony Karydakis

The Real Problem With An Early Fed Tightening Move

2010-06-10T09:11:00.032-04:00

The Kansas City Fed President, Thomas Hoenig, has been an increasingly vocal proponent of the view that that the Fed should no longer offer financial markets the promise of zero short-term rates for an "extended period" of time- having dissented in each FOMC meeting since the beginning of the year over the use of such language in the official statement. In recent days, and on two separate occasions, he has upped the ante by arguing that the Fed should raise the fed funds rate to 1% by the end of summer. (http://www.reuters.com/article/idUSN0810408120100609)

Mr. Hoenig's rationale is a fairly straightforward one: short-term rates are at unustainably low levels, setting the stage for inflationary complications over the long run, and the economic recovery has already gained sufficient traction to withstand a series of modest steps that would signal the beginning of the normalization process for rates. Furthermore, according to that view, monetary policy is meant to be anticipatory and leaving rates at zero for too long would risk planting the seeds for the next bubble that could destabilize the financial system again; therefore, it needs to act soon before any such clouds appear on the radar screen.

A limited number of other Fed officials also appear to be showing signs of uneasiness recently about the possibility that the Fed may be creating some risks by delaying the beginning of the exit strategy; Philadelphia Fed President Plosser and St. Louis Fed President Bullard have made some "soft" comments along those lines in the last few weeks.

On the face of it, it is hard to disagree with Mr. Hoenig's argument on this issue. The U.S. economic recovery is moving forward in the context of a broader, albeit uneven, turnaround in the global economy and the financial system. Although the latter is still confronted with seemingly never-ending challenges (the latest one being the sovereign debt market turmoil), it has admittedly come a long way since the heady days of 18 months or so ago. Against such a backdrop, how damaging a relatively modest increase of 75 to 100 basis points in the fed funds rate- or beginning the unwinding of the Fed's massive portfolio- can be to the economy or the financial system?

This view, though, does suffer from a serious flaw in that it vastly underestimates the potentially disproportionate negative reaction that financial markets will show to concrete actions signaling that the interest rate cycle is turning. The Fed's raising of the fed funds target, as well as the interest it pays on bank reserves, by as much as 100 basis points in a series of quick moves over the next couple of months (the latest time frame proposed by the Kansas City Fed President) is likely to lead to a major selloff in the bond market, as participants, in typical fashion, will front run the prospect of further tightening by the Fed. After all, the funds rate would still be at an extremely low 1% and, by most people's standards, the concept of normalization of short-term rates would envision a road toward a funds target in the 3% to 4% range.

The bulk of such a selloff in response to the Fed's first shot across the bow would be heavily skewed toward the front end of the market, causing a severe flattening of the yield curve, which, in turn, would undercut one of the key factors that have contributed to the healing and return to relative profitability of the banking system in the last several quarters. In view of the recent doubling of the 3-month Libor rate to over 50 basis points- a direct reflection of the anxiety percolating in the European banking system due to the sovereign debt situation- an abrupt further increase in short-term rates that would be set off by any Fed tightening can prove dangerously destabilizing for the global financial system in the current setting.

Inflation in the U.S. and eurozone remains at extremely low levels and, given the unimpressive forward momentum of the economic recovery in both regions, it is unlikely to show any upturn over the next 12 months or so. With regulatory financial reform in the offing, both in the U.S. and Europe, and the threat of a default by some countries (the debt of which is largely held by European banks) lurking in the background, the global banking system is finding itself again at a key juncture.

None of this suggests that the Fed should remain sidelined out of fear of potentially disturbing the fledgling economic recovery and delicate balance of the banking system. Short-term rates are indeed unsustainably low and the gradual unwinding of the Fed's balance sheet may indeed start taking place later this year, before any other overt tightening policy action is announced.

But it is imperative to recognize that the view Mr. Hoenig has been openly advocating has a major hidden risk, as it is not about just a series of modest steps that would still leave the funds target at a historically very low level- therefore unlikely to be very consequential to the broader environment. A series of modest such rate hikes by the Fed will translate into a potentially massive back up in yields that would far exceed the actual Fed action. And for that to be absorbed relatively smoothly (that is, with only a reasonable amount of noise), without throwing everything up in the air and creating renewed sources of anxiety and turmoil, the Fed needs to be highly confident that the time is ripe for such action.

The inevitable change in the FOMC's language from the current "extended period" wording will be the first test of the markets' ability to handle stress over the next few months, on the account of a perceived risk of real tightening down the road. But, arguing that the overall economic and financial environment is ready at this point to accept the blow of actual Fed tightening over the next couple of months is a proposition somewhat disconnected from the realities on the ground as to how markets function.

Anthony Karydakis

Is Global Growth Slowing After All?

2010-06-08T09:03:00.018-04:00

The presumption that the Eurozone fiscal crisis will be a pivotal factor that will have an adverse effect on global economic growth ahead has been widely adopted by financial markets in recent weeks. While such a potential risk cannot be dismissed, we remain skeptical as to how significant its negative effect on the U.S. (or, global, for that matter) economy will ultimately be.

The OECD, for one, is not so sure. Two weeks ago, it released an upward revised estimate for economic growth in its member countries for 2010 and beyond compared to its previous forecast issued in November 2009. In its latest forecast, it now expects growth to rise by 2.7% this year versus 1.9% in its previous, "pre- Eurozone fiscal crisis" estimate, while it has also revised higher its growth estimate for 2011 to 2.8% from 2.5% previously.
(http://www.oecd.org/document/9/0,3343,en_2649_201185_45303817_1_1_1_1,00.html)

The OECD's upgraded forecast, while acknowledging the growing risks stemming from the instability in sovereign debt markets, is based on the reality of rising global trade flows. This trend is, to a considerable degree fueled by the sharp fall of the euro since late last year and the ongoing strength in growth in China and other key emerging market economies.

Even in the eurozone, which has been squarely in the eye of the fiscal storm recently, it is still not clear whether the net effect of the fiscal austerity measures sweeping its member countries will have a bigger contractionary effect on growth than the benefit to growth derived from the boost to the bloc's exports to other non-euro countries- courtesy of the weaker euro. The latter effect, is in fact, quite powerful, as the euro has not declined by over 20% since late last year against the U.S. dollar alone but also against the yuan, allowing eurozone exports to gain competitive ground globally at the expense of China.

The news coming out of Germany (the world's second biggest exporter) in the last two days highlights that ambiguity best. Factory orders surged in April by 2.8%, after an upward revised 5.1% increase in March, driven by a 5.5% spike in export orders from countries outside the euro area. Also, just this morning, Germany's industrial production numbers showed a solid gain of 0.9% in April, suggesting that the economic recovery in the biggest eurozone economy (and a global exports powerhouse) is moving forward at a good clip.

The single most important channel via which any protracted sovereign debt market instability can influence the U.S. economic recovery is the sharp pullback in equities and its possible adverse effect on consumer spending in the months ahead. Again, the uptrend in personal spending is unlikely to be derailed by a 10% or so erosion in the equity market- particularly if this proves to be a relatively short-lived affair. Moreover, a partial offset to the adverse impact of equities on household spending is provided by the recent sharp increase in mortgage refinancing activity- again, the direct result of the eurozone' fiscal crisis having led to lower market and mortgage rates lately.

Risks to the prospects for the U.S economic recovery do exist and the extend to which the sovereign debt situation deteriorates requires close monitoring in the months ahead. However, in the heat of the moment, there is at times a tendency to underestimate the resilience and complexity of the U.S. economy, and this is a risk we also need to guard against.

Anthony Karydakis

May Employment Report: Underwhelming, But Not Ominous

2010-06-04T08:58:00.020-04:00

With the emphasis traditionally placed on the headline nonfarm payroll number, today's employment report can only be described as disappointing. The census-bloated payroll increase of 431,000 in May included only a modest 41,000 gain in private payrolls compared to gains of 218,000 and 158,000 in April and March respectively. On such grounds, the Treasury market's initial reaction to the report is fully understandable, and, on some level, perhaps justified.

However, a more dispassionate look at the specifics of the data still points to an ongoing underlying improvement in labor market conditions, albeit at a pace that, overall, still falls short of expectations for this phase of the economic recovery.

Some of the silver lining, that merits attention in the May report includes:

a) A 29,000 increase in manufacturing jobs, which brings the cumulative gain in that category in the last 5 months to 126,000. This is fully consistent with the strong showing of the employment component in the ISM recently, which confirms that the sector is moving ahead at a solid clip.

b) The gain in the workweek for all employees continues to rise, edging up again to 34.2 hours, a classic precursor to more hiring ahead. The series has been showing a steady uptrend since late last year.

Source: Bureau of Labor Statistics

c) In the household survey, the number of persons employed part-time for economic reasons (the so-called involuntary workers) fell by 343,000 last month to 8.8 million. A downtrend in this series should be viewed as a direct reflection of an improving labor market landscape, as employers are increasingly more willing to employ full-time workers in the midst of a turnaround in the overall economic climate.

The drop in the unemployment rate to 9.7% last month from 9.9 in April, is of little material importance, as it essentially returns the series to its Q4 2009 level, and it was mostly the result of a somewhat counter-intuitive fall in the number of unemployed re-entrants to the labor market by 286,000 in May.

Without downplaying the disappointingly slow pace of net new hiring in the private sector, it appears that, apart from the notoriously noisy nonfarm payroll number itself, there is little reason to conclude from today's report that the recovery is in danger of stalling. Such conclusions would represent an overly hasty take on a set of data that tend to be more nuanced than the disproportionate degree of attention paid to a single number (that also enjoys a well-deserved reputation for being the subject of, at times, extreme revisions in subsequent months).

Based on the broader set of economic indicators released in recent weeks, there is little reason to scale down appreciably our earlier "penciled-in" forecast that we are likely to see average monthly private payroll gains in the vicinity of 200,000 in the third quarter.

Anthony Karydakis

A Note On The Housing Market

2010-05-26T09:03:00.021-04:00

A short Caribbean vacation will interfere with the posting of any new articles in the coming days. The next article will be posted on June 4th, discussing the employment report. - AK

________

The Mortgage Bankers Association's index of weekly new mortgage applications is often a more useful gauge of the state of the housing market than the monthly new and existing home sales reports. This point was validated again this morning with the release of both the latest weekly MBA data and the 14.8% surge in new home sales for April.

While the overall index new mortgage apps rose 11.3% in the week of May 21, this was the noisy result of a 17% spike in the refinancing component (the direct beneficiary of the rally in the Treasury market and associated fall in mortgage rates); the key purchase component of the index fell 3.3%- following sharp declines in the prior two weeks- to its lowest level in 13 years.

Source: www.calculatedriskblog.com

The behavior of the purchase component recently highlights two important issues regarding the underlying dynamic in the housing market:

a) The expiration of the home-buying incentives in April has caused a sharp drop-off in the demand for homes in May. This suggests that, taking into account both the tax incentive-related spike in mortgage applications for purchases in April and the subsequent sharp decline so far in May, "true" demand remains essentially moribund during the key spring season. The most that can be said is that some kind of a bottom is being formed but with no credible signs of a turnaround yet.

b) Contrary to the popularly held belief, demand for housing is poorly correlated with the level of mortgage rates. The average 30-year mortgage rate declined again last week to 4.80% from 4.83% in the prior week (and over 5% in April). Still, as evidenced by the string of declines in the purchase component in the last few weeks, demand for homes has been unresponsive. In fact, it is a point often missed by analysts, that the collapse of the housing market since 2006 has been accompanied by a strong downtrend in mortgage rates.

The explanation for this seeming paradox is a fairly straightforward one: Demand for homes is above all a function of levels of employment and income growth and not mortgage rates- the latter representing a largely peripheral (and, at times, irrelevant) factor. Differently put, when people are unemployed, or seriously concerned about their job security, they will not undertake the major decision to buy a house simply because mortgage rates are low. Even a 1% mortgage rate would do nothing to make it plausible for an unemployed person to buy a home.

In fact, it is somewhat ironic, but analytically sound, to argue that demand for homes will only strengthen when the economic recovery has been meaningful enough over a longer period (2-3 years), as employment levels improve, wage gains increase and mortgage rates are on the rise.

In the current environment, with unemployment levels still very high, despite the unmistakable turnaround in underlying labor market conditions, households remain reluctant, or unable, to make the leap to by a home, irrespective of the historically low mortgage rates. Combining this dynamic with a still heavy inventory of unsold homes in most regions of the country, it is unlikely that any material turnaround in the housing market is in the offing over the next 6 to 12 months.

Anthony Karydakis

The Consumer Remains Unfazed

2010-05-25T10:23:00.007-04:00

Although hardly the most important item on the markets' mind this morning, the strength in the May Consumer Confidence Index deserves some attention, at least briefly.

The surge in the index to 63.3 from 57.7 in April is a testament to the steadily improving domestic economic environment and, particularly, of the consumer sector. The expectations component turned out the biggest increase, up 7 points to 77.4, while the current conditions component rose 2 points to 30.2. The spike is even more remarkable in that it took place in the midst of a period where the stock market's performance has been dismal.

Source: Action Economics

Both of the key barometers of consumer psychology (Conference Board's Consumer Confidence Index and the Reuters/University of Michigan Consumer Sentiment Index) are highly sensitive, on a short-term basis, to stock market behavior and sharp swings in gasoline prices. Over a somewhat longer period, perceptions of the job market situation tend to be more influential in driving those measures. While it is true that job market conditions have improved markedly in recent months, they have not done so in a spectacular enough way, as evidenced by the near cycle-high unemployment rate of 9.9%, to fully justify the decidedly upbeat consumer attitudes that evidently overrun any anxiety associated with the recent stock market turmoil.

All in all, this means only one thing, that is that there has been a dramatic turnaround in the way the economic environment is perceived by households, and this fuels a sense of optimism and growing confidence in the future. It appears that consumers are less willing, at this point, to let significant short-term noise in the stock market shape their view of where the economy is headed. This speaks volumes of the credibility of the economic recovery's forward momentum- at least for as long as the global financial market anxiety does not transform itself in to a full-fledged crisis.

Looking ahead, and as the economic recovery unfolds further, the Consumer Confidence Index is bound to move much higher from its current, historically low, levels. However, the series may still suffer a modest pullback in June, particularly if the unsettled stock market environment persists. Furthermore, the University of Michigan Sentiment Index for the entire month of May (to be released Friday) may slip from its early-month reading of 73.3 to 72.0 or so, under pressure from the ongoing stock market erosion.

Anthony Karydakis

Long-term U.S. Treasury Yields: Reaching For a 2% Handle?

2010-05-21T08:46:00.037-04:00

The massive rally that has pushed long-term Treasury yields lower by over 85 basis points (as of this writing) since early April has spectacularly confirmed the unique status of that market as a safe haven in periods of anxiety and global financial turmoil. It has also set into motion a dramatically different dynamic and created a new reality on the ground.

What started as a localized fiscal crisis of a small, profligate, eurozone economy (Greece) morphed quickly into a major debt crisis engulfing a number of the bloc's economies. The turmoil that was set off in an expanded part of the sovereign debt market universe has shaken the foundation of the euro as a currency, calling into question the momentum of the economic recovery in many countries. In such a precipitously deteriorating environment, equity markets have taken a major hit around the world, making U.S. Treasuries the obvious place to be.

In an attempt to offer a perspective as to where this new dynamic may be leading the Treasury market, a number of points need to be recognized:

1) The underlying reasons that triggered the powerful Treasury market rally in the last several weeks are unlikely to disappear any time soon and an appreciable risk exists that they may actually become broader in scope and/or intensify. Although the headline risk related to the eurozone fiscal crisis as such may follow an "ebb and flow" pattern, the factors currently supporting Treasuries are multiple and intertwined, at the core of which is essentially a major repricing of global risk.

This leads to #2.

2) Even if one of those factors were to "normalize" somewhat in the coming weeks (say, a partial rebound of the euro or equities), any resulting damage to Treasuries is unlikely to be severe enough to send yields back close to their levels prior to the start of this rally. This was actually validated- on a smaller scale- on Thursday this week, where a rebound of the euro from its previously reached 4-year low against the dollar did not prevent Treasuries from pushing ahead with a strong rally for the day.

In other words, the current yield levels are slowly gaining legitimacy, as a reflection of broader concerns about the outcome of the deeply unsettled state of global financial markets, and may no longer be closely influenced by any single factor.

This paves the way for #3.

3) The key issue of whether the current financial market turmoil will end up having actually a significant adverse impact on the U.S. economic recovery (a view we do not fully subscribe to, yet:http://economistscorner.blogspot.com/2010/05/on-beleaguered-euro.html) will require time to be sorted out, one way or another. Until then, the Treasury market participants will probably find "room" to front-run the prospect of an economic slowdown, which should continue to underpin the market.

And this brings us to #4.

4) There is a clear element of asymmetry as to how the Treasury market is likely to react to the various economic releases in the period ahead. Solid economic data will probably tend to be downplayed on the grounds that they do not yet reflect the slower growth that the market is implicitly pricing in. (This is especially likely to be the case if the unsettled conditions in equities, the euro, and sovereign debt markets persist). However, unexpectedly weak economic data will be quickly be viewed as validating the underlying narrative that the pace of the recovery is cooling.

Against that backdrop, and with the 10-year yield having already in its sights the 3% mark, regaining a 2% handle for the first time since April of last year is now a reasonable probability. Further continuation of the Treasury rally should continue to be led by the long end, leading to additional curve flattening, with the 2s/10s spread compressed to the 235-240 basis points range. The front end's upside potential will continue to be restrained by the fact that, after all is said and done, the fed funds rate is already at zero and there is an exit strategy somewhere looming in the horizon.

Anthony Karydakis

April CPI: The Disinflationary Trend Remains Intact

2010-05-19T08:42:00.013-04:00

The April CPI highlights dramatically the reality that the nearly two-year old disinflationary dynamic remains very much in place. Although the 0.1% decline in the overall index can be summarily brushed aside as the direct effect of noise related to energy prices for the month (-1.4%), the impressive part of the report is the behavior of the core component, which was flat in April. A 0.1% drop in the key housing category (42% of the overall CPI) and another sizable decline in apparel prices (-0.7%) were instrumental in producing the flat reading in the core index last month.

In fact, the core CPI has remained essentially flat in the last three months and is now up only 0.9% on a year-on-year basis. Putting it in a context, the series has now dipped below its year-on-year gain recorded in the prior distinct disinflation episode in the 2002-03 period, where it never fell below 1%.

The ongoing downtrend in core CPI in recent months is hardly surprising, given the very nature of inflation as a lagging indicator and the enormous amount of slack that has resulted from the severity of the 2007-09 recession. Despite the credible economic recovery under way, it is inconceivable to imagine any negotiating power by labor that would put any upward pressure on wages and salaries (and, by extension, the "services" part of the CPI that accounts for 60% of the index). Moreover, any increase in production costs associated with the rising commodity prices recently is quickly absorbed by manufacturers and retailers in the form of narrower profit margins.

On that score, it is telling of the near uniform absence of even a hint of upward price pressures that both the "services" and "commodities, ex. food and energy" parts of the CPI have been up by only 0.8% and 1.2% respectively from a year ago.

At the very minimum, the April CPI data continue to provide ample room for the Fed to delay the timing of implementing the process of rate hikes, until the economic recovery has picked up enough momentum and the absorption of the current slack is well under way. Despite any possible changes in the language of the FOMC statement over the next couple of meetings in relation to the "extended period" part, the working assumption should remain that any rate hike by the Fed prior to the end of the year is a very low probability outcome.

Anthony Karydakis

The Beleaguered Euro

2010-05-17T11:26:00.020-04:00

To say that the euro is experiencing its most serious existential crisis since its inception is a pretty salient statement by now, given the barrage of media coverage in the last two months in the midst of the eurozone's intensifying fiscal debt crisis.

In that environment, talk of a possible break-up of the euro bloc's common currency is gathering steam, and the resulting strong downward pressures exerted on the currency pushed it briefly today to a 4-year low against the dollar. While a euro break-up is no longer in the realm of fiction and is gaining increasing legitimacy as a possible outcome, it is always helpful to put the entire issue and its implications into some context.

Four points need to be highlighted:

1) If the eurozone member countries prove ultimately unable to regain the credibility demanded by markets that they will manage to enforce a true convergence of fiscal policies among all member-countries moving forward, then a real risk exists that the euro may disintegrate as a currency. However, the stakes for all countries involved are much too high for such an outcome to occur without all other measures to rescue the common currency have been exhausted first. Already loud voices have been raised from the powers-that-be (Germany and France) in support of a more centralized mechanism of coordinating fiscal policies for all member countries of the bloc.

In other words, any breakup of the euro is unlikely to be the result of panic and disarray within the eurozone in the midst of a crisis, but rather the product of a very deliberate and time-consuming process by the member-countries involved. The issues that need to be sorted out by each country in any decision to revert to their original national currencies are complex and multidimensional (setting new exchange rates, sorting out the payments on existing debt denominated in euros, handling of outstanding international trade transactions and contracts, and so on) and they can not be made in a rush. So, any suggestion that a euro break-up is a plausible outcome in the next few months is totally unrealistic (as Goldman Sach's Chief Global Economist, Jim O'Neil, has also pointed out; see link http://www.bloomberg.com/apps/news?pid=20601087&sid=aw._c97.VLVc&pos=4).

2) Perhaps, a more likely, but considerably less disruptive, outcome of the current crisis in the euro zone would be that, at some point, some of the weaker member-countries of the bloc are forced, via some indirect process that will need to be put in place, to abandon the euro. Still, this is not a likely solution in the midst of the current intense phase of the bloc's fiscal crisis, as it would tend to add fuel to the already raging fire. First, the bloc will need to put out the fire (that is, stabilize the dismal debt picture of many of its member countries) and, then, at a later point, deal with potentially more radical measures that might involve the expulsion of some countries.

3) Despite its precipitous decline in the last three months or so, the euro is not remotely close to its lowest level reached against the U.S. dollar since its inception. Such a level was reached in 2000-01 at approximately 0.82, while the euro today stands around 1.23 (but with an admittedly downward momentum in place). So, the current levels of the euro against the dollar are not alarming per se; it is simply the persistence and intensity of the sell off that bear close monitoring in the weeks ahead.

Source: ECB

4) Much has already been made about the likely adverse effect that the slower pace of economic growth in the eurozone ahead will have on the U.S. economy (as the direct result of more fiscal austerity measures adopted by most member countries for this year and next ). While it is true that more than $15 billion a month of U.S exports have as their destination a eurozone country and that such exports will suffer somewhat, it is important to remember the following:

a) The main driving engine of the U.S recovery in this phase remain the consumer, capital spending, and the inventory cycle. Net exports, which represent a relatively modest amount of overall GDP (about 12%) to begin with, are unlikely to constitute a major risk of derailing the U.S economic recovery. The slower pace of GDP growth in the eurozone may represent an additional moderate headwind for the U.S economy but, most probably, not a defining factor. b) Although most of the focus so far has been on the contractionary effect of fiscal austerity on growth in the eurozone countries, it is often unrecognized that a portion of that will be offset by stronger exports from the bloc- the direct benefit of a weaker currency.

Anthony Karydakis

Consumer Spending Has Good Momentum (and a note on Deutsche Bank's Payroll Forecast for May)

2010-05-14T09:19:00.012-04:00

The implications of this morning's retail sales data can be summarized as follows:

a) The o.4% increase in both overall retail sales and ex-autos, suggests a healthy momentum of personal spending entering the second quarter and broadly lays the foundation for an annualized gain of 3 1/4-3 1/2% in consumption in the current period. This points to another solid pace of GDP growth in Q2, which, at this distance, is tracking in the 3 1/2 to 4% range.

b) The revisions to the previous few months of retail sales point to an upward revision to first quarter's pace of personal consumption to 3.8% from 3.6% initially reported. This should lead to an upward revision to Q1 GDP growth to 3.5 or 3.6% from the earlier estimate of 3.2%.

c) Combining the above two points, GDP growth is on a 3 3/4% or so track in the first half of 2010, validating the premise of a recovery moving ahead at a sound clip.

d) The consumer remains unfazed in the face of still rising home foreclosures, a stubbornly high unemployment rate, and ongoing tightness in bank lending standards.

---------

Our friends at Deutsche Bank put out a research note yesterday, that has already circulated extensively, predicting a 475,000 nonfarm payroll gain for May. The forecast is based on the entirely reasonable assumption that- given the pattern of hiring observed in the 2000 Census- census workers are likely to show a spike of 250,000, and possibly, more, in May. Then, essentially, this leaves the private payroll gain at about 250,000 for the month, similar to the 231,000 increase in April.

The "warning" for the risk of a high nominal payroll print in May is fair and understandable, but, in a way, the "point" should be almost "pointless" for market participants, as every one's true focus in the last few months has been the ex-census number, which is instantaneously subtracted from the overall print at the moment the data are released. In reality, the attention that the sensible, and obvious, point made by the Deutsche Bank note yesterday, was much ado about nothing, as no one was going to take a census-bloated payroll number in May as anything other than what it is- an utterly immaterial piece of noise.

The only question that remains is whether a 225,000-250,000 private payroll gain is indeed in the cards for May and the answer to that, based on overall labor market trends lately, is a qualified yes.

Anthony Karydakis

The Budget Deficit Is Stabilizing

2010-05-12T16:03:00.020-04:00

Despite the biggest monthly budget deficit on record reported for April ($82.7 billion), the fiscal situation appears to be slowly stabilizing; in fact, an argument can be made confidently that it is already turning the corner.

A direct comparison of last month's deficit with April 2009 is somewhat disheartening, as it represents a nearly $62 billion deterioration- the combined result of a 8% decline in revenue and a 14% increase in spending. On the revenue side, the weakness in individual tax receipts (-$30billion) far exceeded a $9 billion gain in corporate receipts. On the spending side, the increase in April was, to a large extent, artificial due to the acceleration of payments certain payments to April 30th from May 1st, due to the involvement of a weekend.

In the first seven months of the current fiscal year, the deficit has totaled $799.7 billion, essentially identical to the cumulative $802 billion deficit in the first seven months of fiscal 2009. But the steadily improving pace of economic activity and the quick rebound of the corporate sector underway are all setting the stage for relatively robust June and September tax payments, which should help solidify the picture of the overall deficit having turned the corner. Adding to the broader improving fiscal dynamic is the dwindling pieces of last year's fiscal stimulus spending program.

Although it does not sound like a development worth celebrating, the budget deficit is at this point on track to total $1.3 trillion this year, versus $1.42 trillion last year. The risk, if anything is that it may turn out to be slightly below the $1.3 trillion mark. In fact, such an outcome would be fully in line with the Congressional Budget Office's most recent forecast issued in January.

As a direct result of that improvement, the recently announced reductions in the size of the Treasury's 3- and 10-year note auctions are likely to be expanded to cover other coupon maturities by the end of the third quarter. However, given the Treasury's underlying bias to increase its reliance on longer-maturity debt, its slowly declining borrowing needs in the coming months are likely to be manifested primarily in the short end of the yield curve. By the end of the calendar year, the cuts in the size of all auctions will have become more aggressive, given a deficit that is currently projected to be smaller by as much as 1/3 in 2011 compared to the current fiscal year.

Anthony Karydakis

April Employment: Solid Evidence of a Labor Market Rebound

2010-05-07T08:44:00.017-04:00

The April employment report (http://www.bls.gov/news.release/pdf/empsit.pdf) provides further strong evidence that labor market conditions are turning around in a convincing manner.

Not only did ex-census nonfarm payrolls increased by a robust 224,000 last month (overall payroll gain of 290,000, including 66,000 census workers) but both March and February were revised upward for a net cumulative gain of 121,000. The direct implication of these numbers is that in the last two months, nonfarm payrolls, excluding census workers, have averaged a gain of 203,000- which is very close to what can reasonably be expected to represent the medium-term trend in payroll growth in this expansion.

Nonfarm Payrolls (monthly seasonally adjusted, incl. census workers)

Source: BLS

Adding credibility to the picture of steadily improving labor markets, the gains in the establishment survey were broad-based among the various categories: an apparently irrepressible manufacturing sector added another 44,000 jobs (third consecutive gain), retail trade 12,000 (also third consecutive gain), leisure and hospitality 45,000, education and health services 35,000, even the troubled construction industry generated 14,000 jobs following a 26,000 gain in March.

The average workweek for all employees inched higher again to 34.1 hours, validating a steady uptrend since the beginning of the year, and pointing to the sustainability of the latest pick up in hiring in the months ahead. The index of aggregate hours worked also rose a healthy 0.4%, replicating its gain in March.

The seemingly disappointing rise in the unemployment rate to 9.9% is actually the result of a 805,000 surge in the size of the civilian labor force that overran an impressive gain of 550,000 in household employment last month and caused the rate to increase.

The expansion of the labor force in the early phase of an economic expansion is a classic phenomenon and should be viewed as evidence that perceptions about the state of labor market conditions among prospective workers are improving quickly, motivating them to start looking for employment (and, therefore, be counted as part of the labor force again). Employment, as measured by the household survey has actually soared by a total of 814,000 in the last two months, despite its spectacular inability to make the unemployment rate move in a more encouraging direction. Still, as the distortions related to the interplay between labor force growth and employment in this phase of the cycle runs its course, the unemployment rate should be on a decisive downward trend in the second half of the year.

The labor market has convincingly turned the corner, inasmuch as, given the enormous slack that has been created by the depth of the last recession, such an improvement can never come fast enough. Payroll growth though is acquiring a respectable momentum and, as the residual caution of the business sector's hiring plans slowly subsides, the potential clearly exists for payroll gains to remain on a 200,000+ path later this year.

Anthony Karydakis

Spain and Friday's Employment Report: A connection

2010-05-05T15:03:00.013-04:00

In the last several days, Spain has surpassed Portugal as the next most vulnerable country in the Eurozone, stepping into the eye of the fiscal storm that is sweeping the bloc.

This development, on the face of it, is somewhat counter-intuitive, as Spain's total debt stands at a relatively benign 55% of its GDP, making it a rarity within the Eurozone as a country that is still in compliance with the requirement that such a ratio not exceed 60% of GDP. However, that ratio is rising quickly for Spain and, given the large current and anticipated budget deficits over the next couple of years, is expected to approach 80% of its GDP by 2013.

Still, even such prospect would not be particularly ominous, if it weren't for two highly disturbing characteristics of the Spain situation. First, the reluctance of the Spanish government to implement so far aggressive fiscal austerity measures to convey a reassuring message to global financial markets. This is the direct result of the country's extremely limited room for maneuver in the midst of the current crisis, given an already exorbitantly high unemployment rate of over 20%. Imposing a credible fiscal austerity package would send the unemployment rate sharply higher, with potentially cataclysmic consequences of social unrest. Second, the dramatic spike in Spain's borrowing costs in recent days, raises the specter of the country finding itself soon unable to access capital markets at an acceptable cost and approaching the downhill path that Greece was forced to take.

Spain may be at the threshold of another downgrade by the ratings agencies, which could actually come as early as Friday, adding more fuel to the already raging fire in the Eurozone's sovereign debt crisis. It is after all the fourth biggest economy in the Eurozone, accounting for approximately 12% of its output. Spain is not Greece and the entire fiscal crisis in the Eurozone may well be entering a new phase, if Spain finds itself effectively shut out of sovereign bond market financing.

All of this brings us squarely to Friday's employment report in the U.S.

Depending on the headlines on the Spain (and, to a somewhat lesser degree, Portugal) debt front by Friday, the U.S. Treasury market's response to April's nonfarm payroll data may deviate appreciably from the more "traditional" one. This means that the typically adverse reaction to a potentially above-consensus, "ex-census", payroll number may be mitigated by any negative developments on Spain's debt status. A deteriorating situation in Spain may well keep European sovereign bond and equity markets on the defensive, providing a bid for Treasuries that can overrun, or moderate, the natural instincts of the market to sell off on a strong employment report.

If the payroll report is underwhelming, as hinted at by the ADP number today (which, itself though, needs to be viewed somewhat cautiously, given its generally poor correlation with nonfarm payrolls) and Spain continues to slide over the next 48 hours, then the U.S. Treasury market may be set up for a potent rally, breaking through the lower end of its yield range since the beginning of the year.

Anthony Karydakis

The Trouble With the Savings Rate

2010-05-03T10:54:00.021-04:00

In the flurry of economic reports released this morning, one particular piece of data received relatively attention: the decline of the personal savings rate to 2.7% in March.

Source: www.calculatedrisk.com

Although the Q1 GDP report last Friday had already shown a drop in the savings rate to 3.1% for the entire quarter- from 3.9% in the prior two quarters and a cycle-high of 5.4% in Q2 2009- this morning's drop to the lowest monthly level in 18 months is a telling development.

The decline in the savings rate in March confirms a downward trajectory in the series over the last six to nine months and validates the earlier suspicion that the spike in the rate around the middle of 2009 was largely a reflection of circumstantial factors- namely, income transfers related to the fiscal stimulus, and a more defensive approach of households in the midst of a deepening recession.

As personal consumption started coming alive in the second half of last year and reached a robust annualized rate of 3.2% in the first quarter of 2010, the savings rate has been steadily drifting lower, gravitating again toward the disappointingly low 2.0 to 2.5% range that had prevailed for the better part of the last 10 years. The downtrend in the rate dispels any hopes expressed in some quarters last year that a new paradigm of an overall higher savings rate may be emerging, which, although it might act as a headwind for the fledgling recovery, would tend to correct one of the major imbalances in the U.S. economy in the last two decades.

At the time, we had expressed reservations as to whether a deeply entrenched into the psyche of the American consumer culture of spending was about to enter a truly new, more prudent phase (http://economistscorner.blogspot.com/2009_10_07_archive.html). Inasmuch as the savings rate is a notoriously revisable series (often after many years following the originally released data) it now appears that with the increasing recognition of an improving economic environment, consumers are slowly reverting to past habits, the only redeeming value of the latter being that they are helping to solidify spending and the impetus of the recovery at this juncture.

Anthony Karydakis

The Recovery Is Moving Forward

2010-04-30T11:11:00.005-04:00

This morning's economic reports provide solid encouragement to the premise that the economic recovery is moving forward at a good clip.

Here's some key points to be highlighted:

1) Despite the seemingly underwhelming pace of GDP growth in Q1 (3.2% annualized), the most important aspect of the report was that the two pivotal engines of GDP are indeed making a credible comeback. Personal consumption rose by a robust 3.6%- following moderate gains in the prior two quarters- confirming that the consumer is plowing ahead, underpinned by a somewhat less ominous labor market picture and an impressive stock market rally.

2) After a two-year period of a "slash-and-burn" reaction of the corporate sector to the severity of the economic downturn, capital spending is back. It rose at a 4.1% annual rate in Q1, following a 5.3% pace in the prior quarter, with the all-important equipment and software category rising by a solid 13.4%.

3) With personal consumption and capital spending on the rebound and the inventory cycle still in full force (inventories contributed nearly $51 billion to last quarter's growth, after a contribution of a staggering $129 billion to the prior quarter's GDP), the recovery has adequate fuel to offset the headwinds stemming from tight lending standards and a struggling housing market and has the potential to move ahead at a 3.5-4.0% clip in the balance of the year.

4) The five-point spike in the April Chicago PMI to 63.8- its highest level in five years- suggests that the turnaround of the manufacturing sector in the last nine months or so remains intact. This, if broadly validated by the ISM report on monday, sets the stage for a solid increase in this month's industrial production and also for moderate job gains ahead in a sector where employment had been literally decimated in the prior three years.

Anthony Karydakis

The U.S Economy and the Eurozone Fiscal Crisis

2010-04-29T09:34:00.018-04:00

Now, that the race to contain the fire set off by the implosion of the Greek economy has entered the home stretch, with an announcement of the specifics of an IMF-led bailout expected this weekend, here's a brief assessment on any likely impact of this episode on the U.S. economy.

The already unambitious forecast of about 1.5% GDP growth in the Eurozone bloc this year will need to be downgraded moderately, in the wake of the fiscal crisis that has engulfed a number of its member countries. The issue is no longer economic growth in Greece per se, where a contraction in output by as much as 7% is in the cards following the austerity measures that will be mandated jointly by the EU and IMF. The real issue is that the new dynamic that the Greece situation has unleashed, is likely to trigger enhanced fiscal austerity measures in the other vulnerable Eurozone countries (Spain, Portugal, Ireland, and Italy), as they struggle to fend off the specter of becoming the next Greece. In fact, their already sharply elevated borrowing costs in the last couple of months will inevitably necessitate offsetting domestic cuts, which will slow economic activity further in those countries, and, by extension, in the entire Eurozone.

U.S. exports to the Eurozone countries are running at over $15 billion a month and the demand for such exports is bound to be curtailed in the balance of the year and into 2011. This should have a non-negligible impact on the manufacturing sector in this country, given its export-oriented profile. However, the adverse impact of an export slowdown to the Euro countries on the overall U.S. economy is likely to be more mute, perhaps costing U.S. GDP growth 0.2 to 0.3% over the next four quarters. The export sector represents, after all, a relatively small part of U.S. GDP (12-13%).

On the other side of the ledger, there is an often unrecognized, inadvertent, benefit for the U.S. as a direct result of the fiscal upheaval in several Euro countries: the prospect that long-term yields will remain lower than otherwise, as the Treasury market continues to benefit from the lingering uneasiness about the creditworthiness of some Eurozone sovereign debt.

While the "natural" cyclical forces of an unfolding economic recovery might have exerted some moderate upward pressure on Treasury yields later in the year, that dynamic may countered by the global appeal of Treasuries as a relatively safer place to be for some time. Yes, it is true that the rumored 120-140 billion euro rescue package that Greece will be receiving is, by far, the most massive bailout operation even undertaken by the IMF and its partners (by comparison, the total IMF-led bailout of a number of countries during the Asian financial countries in 1997 was $120 billion, or roughly the equivalent of 90 billion euros). But this will not settle the background risk for a possible default of Greece down the road and the anxiety over how successful Portugal/Spain/Ireland/Italy will be in putting their own house in order.

In fact, the Asian financial crisis is a pertinent reference in attempting to evaluate the impact of the current Eurozone fiscal crisis on the U.S. economy. At the time, the immediate reaction to the crisis by most analysts was that the collapse of a bloc of countries representing nearly 1/3 of our exports market was bound to be highly detrimental to U.S. growth. However, funds fleeing the turmoil in Asia quickly found shelter in the U.S. Treasury market, driving long-term yields down by approximately one percentage point, producing a moderate stimulative effect on the U.S. economy in the first half of 1998.

On the assumption that the fiscal saga in the Eurozone does not lead to an outright blow-up of additional countries, the net effect of the Greek affair on the U.S. economy will likely be marginal. If, however, the instability emanating from this episode afflicts severely the macroeconomic picture of a longer list of countries and reignites fears about the fragility of European and global banks, then things can quickly take a more ominous turn.

Anthony Karydakis

The Eurozone's Fiscal Saga: Shifting Focus?

2010-04-26T09:18:00.011-04:00

Since the Greek fiscal drama took center stage in January, the widespread expectation was that it would ultimately lead to the country's bailout, which would put out the intense flare ups of anxiety that were afflicting the sovereign debt markets. Although the moment of the all-but-inevitable bailout for Greece has arrived, it is now far from certain that the markets' apprehension toward European sovereign debt will subside any time soon.

As negotiations over the specifics of the fiscal austerity plan between the Eurozone/IMF and Greece continue, fears that the sheer magnitude of the country's total debt burden is unmanageable and will lead to a restructuring of its existing debt (over 300 billion euros), have intensified. It has also become increasingly likely that the initial amount earmarked for the bailout- a total of 45 billion by the Eurozone countries and the IMF- will prove to be insufficient and bound to increase.

The specter of a Greek default later this year will continue lurking in the background and become a source of variable anxiety for the Eurozone bond, as well as equity, markets. While a period of relative "calmness", in terms of headlines, may succeed the announcement of the Eurozone/IMF agreement with Greece in the coming days, attention is likely to quickly turn to the other two Eurozone countries that seem the most vulnerable after Greece: Portugal and Ireland.

Until now, the overwhelming urgency of Greece's predicament had essentially shielded those two countries from becoming the target of the global bond markets' wrath, although their borrowing costs have risen sharply since the beginning of the year. In relative terms, Ireland may be in a somewhat better position, given an aggressive fiscal austerity program it announced pre-emptively late last year and has been given the benefit of the doubt in terms of the country's commitment to implementing it so far. Portugal is in a more vulnerable state as its economy suffers from a structural lack of competitiveness- just like Greece's- and a debt burden that is almost 10% of GDP. To make matters worse, a set of measures to address these challenges that were announced a couple of months ago were viewed as of dubious effectiveness and the country's prospects for economic growth this year are particularly poor.

And all of this, without even considering complications with the fiscal picture in Spain and, conceivably, Italy at some point.

With the risk of a Greek default not disappearing convincingly any time soon and two other members of the PIIGS slowly coming under increasing scrutiny, the situation in the Eurozone is not likely to return to normal in the foreseeable future. What can also contribute to the tension surrounding the increased attention that some of these countries will now be receiving is the likely growing resistance by Germany and France -in that order- toward the prospect of engineering a series of additional Greek-style bailouts. Voices that have already been raised in Germany about ultimately forcing some of the weaker countries to leave the euro bloc may gain traction, and this is not exactly a dynamic that would make any questions about the future of the euro itself go away easily.

Anthony Karydakis

Treasury Yields: The New Equation

2010-04-22T11:16:00.024-04:00

Recently, in this space, we criticized the view expressed by Morgan Stanley, that 10-year Treasury yields are headed for 5 1/2% this year, as too simplistic because it was relying heavily on the argument that the government's massive borrowing needs will inevitably push yields sharply higher. The behavior of Treasury yields in recent days warrants revisiting briefly this topic.

After briefly piercing the 4% mark earlier this month, the 10-year Treasury yield has returned again comfortably to the middle of its 3.60% to 4% range that has prevailed since the beginning of the year. On the face of it, such a resilient performance runs contrary to the general perception that strengthening economic activity and an unprecedented (and relentless) onslaught of new supply can become key drivers for Treasury yields. Those factors, although analytically intriguing, have a very mixed track record in terms of validating what is expected of them- and this is so even in relatively "normal" times.

But the current environment is all but normal. It is dominated by a set of complex factors, originating from multiple sources, which, hard as they are to incorporate into any model with the well-intended ambition to forecast interest rates, do nonetheless play a pivotal role in affecting Treasury yields.

A low-grade anxiety over the Greece fiscal saga that continues to reverberate within global financial markets and its implications for the Eurozone, compounded by the headlines related to the Goldman affair have again reasserted the prominent role of Treasuries as the place to be in periods of uncertainty. As a result, they have decidedly trumped any uneasiness over the increasing credibility of the economic recovery and record issuance of government debt. So much so, that a string of solid economic data in the last couple weeks and the Treasury's announcement today that it plans to sell a record of $129 billion of Treasury securities (including $11 billion TIPS) next week, have failed to disturb the solid underpinning of the Treasury market in this environment.

All in all, even the broader, more classic, fundamentals are not that hostile to Treasuries either. Strengthening economic data are not inherently negative for the Treasury market but only to the extent they are viewed as a proxy for future inflationary pressures. However, with core inflation continuing to drift lower- the direct result of both the great inertia of price trends and the huge amount of slack to be absorbed from the last recession- and the Fed squarely reassured by such a benign inflation dynamic, the steadily firming economic data are non-threatening to the Treasury market.

Long-term Treasury yields will ultimately break-out of their 40-basis point range so far this year; this is, after all, an unsustainably narrow range over a longer period. However, the risk is about even that such a breakout in yields will occur on either side of the range. Intensification of the uneasiness over the Eurozone fiscal situation, or a technical correction in the stock market, can cause a breakout to the downside, while the opposite is likely if things are uneventful on those two fronts and the monthly payroll data pick up steam unexpectedly reigniting more visceral fears among Treasury market participants.

For the time being, until something significant changes in the configuration of the current environment, the 4 to 4 1/4% zone for the 10-year Treasury yield needs to be approached as a buying opportunity.

One would like to think that, setting aside the short-term noise, fundamentals will ultimately reassert themselves as the main driving force for long-term yields. This brings up the need though to expand the menu of fundamentals to be considered in an environment where there are multi-layered forces influencing Treasury yields. Supply and economic data alone are just not enough any more.

Anthony Karydakis

The Goldman Issue and Financial Markets

2010-04-18T15:08:00.029-04:00

A legitimate prospect exists that the SEC's lawsuit against Goldman Sachs will turn out to have a number of implications that considerably exceed the initial noise associated with the announcement itself.

With the extent of the alleged Goldman violations still uncertain due to ongoing investigations, there is some inescapable questions as to how serious the end result of all of this will be for the future of the storied Wall Street firm; that is, whether this will turn out to be a run-of-the-mill financial scandal that will ultimately be settled out-of-court in the true tradition of most such incidents or it will fundamentally shake up the firm with potentially unpredictable consequences.

However, there is more to this affair than the consequences for Goldman Sachs itself.

The contours of the implications for the financial markets of the SEC's lawsuit though are already starting to take shape.

To begin with, the lawsuit is re-injecting a perceptible element of risk into the financial system, given the palpable uneasiness over how systemic such practices, as those alleged in the Goldman case, will turn out to have been among other major (investment) banking institutions. Just at a time when the financial system was viewed as having made significant progress toward healing from the 2008-2009 crisis, old wounds may be re-opened in the form of potential discovery of many more questionable, or downright illegal, practices by financial firms. What makes this prospect more plausible is the current environment where regulators are under growing pressure to reassert themselves as true watchdogs of a financial industry, the perceived abuses of which have attracted an enormous degree of criticism from many corners in the last year and a half.

Lingering anxiety over the outcome of such investigations, now also conducted by both German and U.K. regulatory authorities (http://www.bloomberg.com/apps/news?pid=20601087&sid=aDp6aZ3vXDOg&pos=1), should create an environment conducive to an elevated headline risk, for some time. This will represent a major hurdle not only for bank stocks but for the broader stock market as well, disrupting its irrepressible 13-month rally. Some widening of mortgage-backed and other derivatives products' spreads is likely as well, as those instruments are coming under renewed intense scrutiny.

With the stock market going into a more defensive mode and spread products becoming the target of steadily louder voices of both criticism and suspicion, the Treasury market, by virtue of its safe haven status, is likely to be the clear beneficiary of that dynamic. As a result, this should help mitigate the Treasury market's sensitivity to occasionally strong economic reports in the coming weeks.

Against the backdrop outlined above, any traces of anxiety over an earlier-than-generally assumed implementation of the Fed's exit strategy should be put to rest. The Fed is extremely sensitive to the degree of stability of the financial system and in a period where uneasiness over its integrity and with potentially multiple legal actions against the industry percolating, the Fed's strong preference would be to keep a low profile and avoid any action that could destabilize a system already under intense scrutiny.

For the Goldman affair to have the potential to impact materially the trajectory of the economic recovery, it would require a much broader fallout than the one envisioned at this early stage. Depending on the degree of pressure major banking institutions feel that they may be coming under, extending the period during which their infamous tightening of credit standards of the last two years remain in effect is a plausible outcome. This, alone, though, may not be enough to seriously impact the momentum of the recovery, as the forces propelling the economy forward are by and large self-sustaining and not easily derailed at this point.

Still, on that score, how far the newly found determination of financial regulators is prepared to go to make up for their previously embarrassing lethargy will be a pivotal factor that needs to be watched closely in the foreseeable future.

Anthony Karydakis

This Week's Data: Confirming the Pattern

2010-04-15T11:37:00.022-04:00

This week's plethora of economic reports so far confirmed a pattern that has become the hallmark of this economic recovery: a healthy rebound in consumption, with a manufacturing sector almost on fire, and still potent disinflationary forces at work.

Both the deterioration in the international trade deficit to -39.7 billion in February (largely the result of a sharp increase in imports) and the spike in retail sales last month (+1.6% overall, with ex-autos up +0.6% and solid gains in most key categories) reflect the somewhat counterintuitve pick-up in consumer spending in Q1, despite the stubbornly high unemployment rates. Retail sales are now up a dazzling 7.6% from a year ago, although the comparison is admittedly skewed to the upside due to the fact that the economy was still sliding around this time last year. The most potent driving forces of this renewed vigor in spending are pent-up demand from the recent recession and a surging stock market. At this point, personal spending is estimated to have grown at an annual rate of over 3% in the first quarter.

The solid pace of economic growth in a number of our key trading partners has helped fuel an impressive comeback of the manufacturing sector since the second half of 2009, which has already been consistently reflected in the monthly ISM numbers. The momentum of the sector was validated again this week by the strong gains in both the Empire State (31.9 from 22.9 in March) and Philly Fed (20.2 from 18.9 in March) surveys for April. Today's industrial production gain of only 0.1% for March disguises a robust increase of 0.9% in the key manufacturing component of the report and is largely the result of a plunge in utilities output by 6.4%. Inasmuch as the 0.9% rise in manufacturing output may, in part, reflect a payback for the possible adverse effect of weather patterns in February, the series has still averaged a very healthy gain of 0.6% in the last two months.

Fully supporting Bernanke's reiteration this week of the "extended period" expression in regards to Fed policy, the March CPI confirmed the prevalence of persistent disinflationary forces in the U.S. economy. The flat core CPI for the month has now left the 6-month annualized rate of that measure at only +0.6%, with the 3-month version of the series at an attention-getting -0.2%. With an abundant amount of slack in the economy remaining to be absorbed, the risk is that, if anything, core inflation may dip lower still in the months ahead from its current 1.1% year-on-year. This should be kept firmly in mind, as the bond market enters a period where the monthly payroll gains gather some steam.

As for the rise in the initial claims data, the report was probably, by the BLS's own tacit admission, too distorted by the Easter holiday, to be meaningful.

The recovery is moving along at a respectable, albeit, somewhat uneven pace. The net of it all is that growth is on a 3.5% to 4% path that should put to rest any lingering doubts as to the self-sustainability of the recovery, and, at the same time, the inflation outlook should help contain any bouts of market anxiety over the risk of Fed tightening this year.

Anthony Karydakis

Morgan Stanley, Goldman Sachs, Treasury Supply, and Bond Yields

2010-04-12T09:26:00.020-04:00

A Wall Street Journal article over the weekend showcased the starkly different views of two major financial institutions (Morgan Stanley and Goldman Sachs) as to where bond yields are headed later this year.

http://online.wsj.com/article/SB10001424052702304703104575174322462884524.html?KEYWORDS=Yield+Views+Couldn%27t+Differ+More

The Morgan Stanley view is that 10-year Treasury yields are likely to spike, largely due to pressure stemming from heavy Treasury issuance, hitting 5.5% by year end. On the other extreme of the spectrum, Goldman's chief economist thinks that long-term yields are likely headed toward 3.25% in the midst of low inflation, and considerable slack in the economy that will keep overall credit demands in check. To add an extra twist to the sharply diverging views about the direction of bond yields, those two firms had, according to the WSJ, the best "economic forecasting" record in the last two years. So, what is going on here?

Far from attempting to simply add another view to the mix of what is often a thankless, or even hopeless, exercise of forecasting interest rates, the purpose of this note is to highlight some basic facts on this topic.

Treasury supply, tempting as it often is to enlist as an argument rationalizing a certain interest rate outlook, has historically shown a very weak correlation with the direction of yields on a trend basis.

In the '80s, when the Reagan tax cuts caused the U.S. budget deficit to more than quadruple by the middle of the decade, bond yields declined dramatically during that period, driven by the rapidly falling inflation and the the unwinding of the previously unprecedented Fed tightening. In the late '90s, when the fiscal situation improved dramatically, switching from fairly substantial deficits to sizable surpluses, long-term bond yields fell moderately in late 1998, they rebounded quickly in 1999-2000 under pressure from a robust economy and Fed tightening despite the growing budget surpluses and Treasury paydowns. Moreover, the most recent episode where yields have fallen since 2007- despite the explosion of Treasury supply with no imminent relief in sight, calls further into question, and spectacularly so, the weakness of the relationship between deficits and bond yields.

And, of course, there is also Japan. The most indebted industrialized economy, that has been running massive budget deficits since the '90s, has consistently experienced low bond yields (in the 1% to 2% range) throughout the last 15 years- the result of a stagnating economy and persistent deflationary pressures.

Abrupt changes in the fiscal outlook can, at times, lead to an emotional "front running" of it by markets, with yields moving initially in one direction or another, at times significantly so. However, the "supply" trade usually has somewhat limited shelf life and ultimately more powerful fundamentals determine the trend in yields. In a globally interconnected financial market environment, demand for Treasuries can also increase in a manner that offsets the onslaught of supply. Countries other than China, are stepping in to fill any gap left by that country's possibly more cautious approach toward Treasury purchases. To demonstrate the point, the Chinese were net sellers of Treasuries in late 2009 and around the turn of this year, but Treasury yields did not move appreciably, as Japan and other key emerging market economies with growing official reserves (Brazil, Russia and others) are making up for the difference.

Back to the divergence between Morgan Stanley's and Goldman's view on rates for 2010: Long-term yields can come under pressure at some point (with the sustainability of any such back-up still subject to questioning), as the recovery takes hold and the market goes through bouts of uneasiness over the timing of the Fed's exit strategy. But a back-up in the 10-year yield to 5.5% because of heavy Treasury supply, as Morgan Stanley predicts, feels like reducing a pretty complex financial and economic environment to something disturbingly simplistic.

Anthony Karydakis

The Long Shadow of Greece's Woes

2010-04-08T09:11:00.012-04:00

As it is becoming increasingly evident this week, the fiscal crisis in Greece can have repercussions that far exceed the confines of that country or the so-called bloc of PIIGS within the Eurozone. The renewed blow-out of Greece's borrowing spreads highlights how difficult the road to a relative containment of that country's fiscal troubles will be and it appears that the entire affair is steadily marching toward a major, IMF-led, bailout to the tune of 30 to 40 billion euros.

In the meantime, the spike of the Greek spreads are already taking a toll on Eurozone stock markets, as shares of European banks are taking a particularly hard hit. Protracted anxiety over the outcome of the Greek debt problem can cause a more substantive setback to the prospects of an already fragile economic recovery in the Eurozone countries via weaker stock prices and household wealth formation and also by exposing more fault lines in the banking system on the continent; in regards to the latter, it is, after all, German and French banks that are holding the lion's share of the repeatedly downgraded Greek sovereign debt.

U.S. equities, despite their impressive rally in the last year or so (buoyed by the reality of an economic recovery gaining traction) may not remain totally immune to any significant downturn of European equity markets under a scenario where Greece remains on the brink for an extended period. Such an outcome may take some of the tailwind out of the sails of the U.S economic recovery, as, given the still high level of unemployment, consumer spending would need to rely more on the net wealth effect from equities in the months ahead.

The Greek affair is also complicating the ECB's exit strategy, as any outright tightening that the famously hawkish ECB might be contemplating for later in the year could become a highly destabilizing factor for the entire Eurozone recovery. The ECB has already been forced, as a direct gesture to the Greek debt crisis, to announce that it will continue accepting less than top-rated collateral for its open-market operations beyond the end of the year, reversing a previous decision to end that special liquidity program by December.

The flare-up of anxiety created by the blow-out of Greek spreads this week has also been a key factor -along with the unmistakably reassuring comments by Bernanke yesterday- contributing to two healthy auctions so far this week and the quick retreat of Treasury yields, following the initial sell off that followed last Friday's employment report. Yields across the maturity spectrum have now pulled back by as much as 15 basis points, returning essentially to pre-employment report levels.

All in all, the long shadow that the Greek saga is casting should be viewed as a reminder that global financial markets are indeed far more interconnected than often realized. The message for the U.S. treasury market, in particular, perhaps can be simply summarized as follows: It is no longer just about nonfarm payrolls, or economic data...

Anthony Karydakis

The Employment Data and the Fed

2010-04-05T11:17:00.029-04:00

With the March employment report representing a clear turning point in underlying labor market trends, the question quickly becomes whether the time frame for Fed tightening ahead have changed in a material way.

The answer is, probably not.

The moderate back-up in Treasury yields since Friday is understandable, but a less emotional look at the configuration of the current environment continues to point to the fourth quarter of the year as the earliest plausible timing for the Fed to start tightening. In a nutshell, there are three key parameters that will determine when the Fed will feel confident enough to initiate that process:

1) The strength of the real sector economic data.

On that score, things are looking up recently, with the manufacturing sector leading the way and increasing evidence that consumer spending is turning up as well. The labor market statistics (not simply payrolls, but jobless claims as well) are also improving steadily but at a still unimpressive pace. Inasmuch as it is encouraging to see a 100,000+ plus private payroll gain for March and initial claims resuming recently their previously stalled downtrend, both series continue to reflect a profound slack in labor market conditions. (The 9.7% unemployment rate can vividly corroborate that picture). It would be both an analytically dubious- and, politically, simply untenable- decision by the Fed to start tightening within the first six months or so of the first credible signs of a discernible, but slow, turnaround of the still poor employment picture.

2) The price outlook.

Core inflation continues to drift lower, with both the core CPI and PCE deflator currently at 1.3% on a year-on-year basis. While it is true that inflation tends to be a lagging indicator, the reality is that they key price data should continue to inch lower in the balance of the year, therefore providing a very favorable backdrop against which the Fed will be contemplating its next step. In fact, by the Fed's own forecasts just six weeks ago (http://www.federalreserve.gov/monetarypolicy/mpr_20100224_part4.htm ), core inflation could move closer to 1% by year end. Nobody questions the premise that monetary policy has to be anticipatory and not wait for inflation to accelerate in order to apply the brakes. But with a very considerable slack in the economy to be absorbed over time and inflation drifting lower, it is exceedingly hard for the Fed to rationalize a more restrictive policy during that period.

3) The state of the banking system.

Although the healing process of the banking system has come a long way from the scary days of the fourth quarter of 2008, the industry's lingering vulnerability is pointedly reflected in the ongoing reluctance of banks to engage in more historically "normal" lending practices. The latest Fed loan officers' survey showed, for the first time in more than two years, lending standards not being tightened further (http://www.federalreserve.gov/boarddocs/snloansurvey/201002/default.htm), but this still leaves them at disconcertingly tight levels. This not only continues to represent an impediment to the pace of the economic recovery gearing up significantly in the foreseeable future but it also minimizes the risk of any inflationary impulses resulting from the excess liquidity in the system (not much lending, no inflation)- hence, it buys time for the Fed to allow the recovery to roll unimpeded for a while.

The decision as to when the Fed will move to the more substantive face of its exit strategy (the first phase, which consisted of shutting down the various liquidity facilities has already been largely completed, after all) will hinge on a set of factors that are far more complex than the relative improvement in the employment data.

True, the March employment report raises the Treasury market's anxiety level a couple of notches but it has not moved up materially the time when the Fed will take action validating that anxiety.

Anthony Karydakis

Job Growth Is Back

2010-04-02T09:20:00.020-04:00

The March employment report confirms a meaningful improvement in underlying labor market conditions and convincingly points to a resumption of job growth in the U.S. economy.

Source: Bureau of Labor Statistics

What makes today's employment report a true "game changer" for the state of labor markets is not only the 162,000 increase in nonfarm payrolls for March but also a good number of other key elements that offer good reason for optimism in regards to the unfolding dynamic of the employment situation.

To start with, the smaller-than-expected rise in census workers (48,000) last month, leaves the key measure of private payrolls (which excludes all government employees, not just census workers) with a solid gain of 123,000- the biggest monthly increase for that series in approximately three years. Moreover, the manufacturing sector continued to generate net gains in employment (17,000), following a total gain of 28,000 in the prior two months. Even construction, clearly the most beleaguered sector of the economy in the last recession, which had been losing an average of 72,000 a month in the last year, turned out a modest gain of 15,000 in March.

To solidify the picture of a labor market that has turned the corner in a credible way, both January's and February's payrolls were revised higher for a net cumulative gain of 62,000. All told, payrolls have now averaged a modest gain of a little more than 40,000 a month (ex-census workers) since the beginning of the year. The 3-month average is also significant here in that it neutralizes the role that the more favorable weather in March vs. February may have played in boosting somewhat the payroll number last month (as this would simply represent a payback for the comparably adverse impact of the snowstorms on the February number).

All three measures of the workweek (for all employees, for production and non supervisory employees, and for those working in the manufacturing sector) showed gains of 0.1 to 0.2 hour (s) last month. The moderate improvement in the workweek in the last few months points to a further pick up in the pace of hiring in the period ahead.

The fact that the unemployment rate held steady at 9.7% for the third consecutive month, despite a 740,000 expansion of the labor force since the beginning of the year, strongly supports the view that we have already seen the peak in the unemployment rate for the cycle at the 10% level reached late last year. Reflecting the cyclical re-entry of previously discouraged workers into the labor force, the participation rate edged higher again to 64.9% last month, following another modest gain in February.

The employment data are notoriously choppy on a monthly basis and revisions and other inherent noise may briefly challenge the premise of a consistent improvement on the labor market front in the next few months. But the evidence is now nearly impeachable that the employment situation is finally starting to respond, in a historically "appropriate" manner, to the reality that a respectable economic recovery is taking hold.

We should look for payroll gains (excluding census hiring) to average 100,000 to 150,000 a month in the second quarter and for the unemployment rate to inch closer to 9.5% over that time frame.

Anthony Karydakis

On Long-term Treasury Yields

2010-04-01T09:24:00.005-04:00

The moderate back-up in long-term Treasury yields since early March has been increasingly coming under the microscope in recent days as to whether it represents the beginning of a cyclical uptrend in yields against the backdrop of an economic recovery taking hold.

At first glance, the rise of the 10-year Treasury yield by about 30 basis points to 3.90% or so earlier in the week can be attributed to a number of factors: positioning for the end of the Fed's massive mortgage-backed securities purchase program (that ended yesterday), growing evidence that economic activity remains on a credible 3.5-4.0% growth path, the relative lessening of the anxiety surrounding the fiscal situation in some eurozone countries compared to February, and the ever-present onslaught of Treasury supply.

While all of the above factors are legitimate, they do not actually amount to a dramatically different landscape for Treasuries- at least, not yet. The Fed is likely to stay on hold for an "extended period" and the inflation data remain consistently benign in the midst of a large amount of slack that has been created by the memorable severity of the last recession. Besides, the current yield levels have not broken any new ground, as they had also been visited briefly in early January as well as last August (only to retreat appreciably afterward).

As we have argued before, at some point later in the year, a potentially more meaningful rise in long-term Treasury yields should not be ruled out, in the context of a major repositioning of the entire yield curve ahead as the Fed's exit strategy is drawing nearer. Even then, it is far from certain that such a reconfiguration of yields across the entire maturity spectrum will lead to a sustainable and significant rise in long-term yields, as the bulk of such an adjustment will most likely be absorbed by a drastic flattening of the curve.

In other words, breaching the 4% mark on the 10-year- a level that is tantalizingly close and also attracts some attention due to its status as "a big, round number"- should not necessarily be viewed as a prelude to a march toward the 4 1/2-5% range. Something material in the texture of the broader economic and financial environment will need to change for the latter to become the case- and we are not there yet.

Anthony Karydakis

A Note on Friday's Employment Report

2010-03-29T12:10:00.013-04:00

Going into this Friday's March employment report, the market consensus is looking for an increase of about 200,000 in nonfarm payrolls, which, on the face of it, would represent a dramatic improvement by the standards of the last two years. In fact, if such a gain were to materialize it would be the biggest monthly one in three years and only the second increase since the onset of the recession in December 2008 (the other one being a 64,000 gain last November).

The main reason though for a potentially robust increase in the March payroll data though is likely to be the estimated hiring of about 125,000 census workers during the month. (The Labor Department is likely to provide an estimate of the number of census workers for the month).

This immediately suggests that the key number in this month's report will be the "private payrolls" one, which should still show a moderate gain- anywhere from 25,000 to 125,000. Inasmuch as an increase within the latter range would still be considered as fairly unimpressive (obviously a 100,000 plus gain would be appreciably more meaningful than a 20,000 one!), it should still be viewed as consistent with the ongoing underlying improvement in labor market conditions in recent months.

Initial unemployment claims have resumed their previously stalled downtrend in the last few weeks and the employment sub-component in the ISM is turning out some healthy readings lately- the latter reflecting a broad-based improvement in manufacturing activity. Irrespective of the specific reading (that is, initial print, before the inevitable subsequent revisions) in Friday's payrolls, there is a nearly inescapable expectation that the series is poised to embark on a sustained path of moderate job creation in the coming months.

Given that the Census hiring should continue distorting the headline payrolls number through the summer months, the focus should remain solely on private payrolls in the period ahead. At this point, it is not unreasonable to look for a monthly average gain of about 100,000 in the second quarter- excluding census workers- with further gains in the workweek from its most recent 33.1 hours.

Anthony Karydakis

New Home Sales and the Big Misconception

2010-03-26T09:08:00.016-04:00

The 2.2% decline in February's new home sales to a record low of 308,000 units this week is disconcerting in that it shows that, despite some signs of tentative stabilization in existing home sales in recent months, the nearly five-year long slump of the housing market has yet to hit a reliable bottom.

Source: http://www.calculatedriskblog.com/

On the face of it, the ongoing erosion in new home sales is somewhat perplexing. After all, mortgage rates remain at historically very low levels and the first time home owners tax credit is still in effect until the end of April 2010. In reality though, the failure of new home sales to show any signs of responding to those two seemingly favorable factors makes perfect sense.

One of the greatest misconceptions about the housing market in general is that it is directly responsive to the level of mortgage rates. The reality though is that this is not actually the case, as mortgage rates represent only one of the "second-tier" factors that influence the demand for housing, the primary ones being employment levels and associated income growth as well bank lending practices in any given period. It is a plainly absurd hypothesis to argue that much would change for home sales if the 30-year fixed rate mortgage were to dip to, say, 3%, in the midst of a broader economic environment characterized by high unemployment, slow income growth and famously tight credit standards by lenders.

It is key to remember that at the peak of the housing boom in the middle of the last decade, the 30-year fixed rate mortgage was hovering around 6.5% to 7% versus 5% these days. While it is true the impressively strong demand for housing at the time was supplemented in good part by a larger share of ARM loans than today, the overriding difference between the two periods was a booming economic activity and high levels of employment and income growth as well as notoriously- and disastrously- lax lending practices at the time.

To further put the generally tenuous relationship between mortgage rates and demand for housing in a more realistic context, it is a pretty reasonable expectation to have that, over the next three-year or so horizon, the latter will be considerably stronger despite the inevitably higher mortgage rates that are likely to accompany a broadening economic expansion and aggressive underlying Fed tightening. Higher mortgage rates will become nearly inconsequential in a context where lower unemployment and stronger personal income growth will provide households with enough confidence to proceed with the purchase of the ultimate big-ticket item.

Anthony Karydakis

The Weak Euro...Really?

2010-03-23T10:04:00.032-04:00

That the much publicized fiscal troubles in some of the Eurozone countries recently have caused the euro to lose ground in the foreign exchange markets is obviously not in question. However, arguing that a fairly moderate decline in the value of the currency from a historically very high level of about four months ago is a dramatic development that is likely to reshape the landscape of the global competitiveness of certain eurozone countries' exports (and more specifically, Germany's) is a bit of an exaggeration and reflects a disregard for the history of the currency since its inception.

http://online.wsj.com/article/SB10001424052748704534904575131980473107158.html?KEYWORDS=Villain+German+competitiveness

In January 1999, the euro was introduced at a rate of 1.16 against the U.S. dollar and suffered a significant erosion in its value, trading mostly within a 0.80 to 1.0 range against the U.S. currency in the following three years. Since then, it has been on a broad uptrend, reaching a high of 1.60 against the dollar in the summer of 2008, just prior to the financial crisis triggered by the Lehman affair. The most recent stage of its pullback, in the wake of the acute fiscal problems in the southern European countries, has still left the euro at historically high levels- about 10% higher than a year ago (Chart below).

The Euro vs. U.S. Dollar

Source: ECB

The euro remains at the upper end of the range that has prevailed against the dollar since its inception and it can be reasonably argued that its latest slide represents a relatively limited correction from unsustainably high levels it had reached last fall (and, which, Jean-Claude Trichet had repeatedly denounced at the time as not consistent with the underlying fundamentals in the eurozone but rather the result of excessive speculative activity that had pushed it to unjustifiably high levels).

It is, understandably, a welcome development for certain heavily export-oriented countries in the eurozone that the currency has retreated moderately in recent months. But, casting it as a a critical factor making countries like Germany a major export powerhouse is a misrepresentation of basic facts.

Germany had been steadily establishing itself globally as a major export-oriented economy (running the biggest trade surpluses in the world for years until it was recently surpassed by China) even during the period when the euro had been steadily rising earlier in the last decade. It is primarily through the competitive cost advantages related to the containment of real wages and increased productivity that the German economy has achieved this status and not because of any benefit related to a "weak currency".

Anthony Karydakis

Equity Market Rally: A Major Unrecognized Factor

2010-03-17T16:18:00.016-04:00

With the still weak state of the labor market and associated moderate pace of income growth often identified as key headwinds facing the economic recovery, one key factor seems to have received fairly limited recognition for its potential to offset some of those headwinds and help sustain the household sector's spending ability in the balance of the year: equities.

As equity prices are hitting 17-month highs in recent days, a non-negligible wealth-effect is steadily brewing, which should supplement the somewhat underwhelming wage and personal income growth in the coming quarters. This can become a pivotal factor that can set into motion a self-reinforcing dynamic that will lead to an acceleration of economic activity in the second half of the year. The timing of this process would be particularly fortuitous, as it will be taking the baton from the inventory cycle that will slowly be running out of steam by the end of 2010.

It is helpful to keep in mind the critical contribution that an irrepressible equity market rally in the second half of the '90s made to the impressive, above-trend, pace of GDP growth during that period. The scale of the equity market rally now is still smaller than the one during the heady days of the infamous "irrational exuberance" of the late '90s. However, stock prices have rebounded by a spectacular 65% since their low in January 2009, which represents a very powerful move in terms of contribution to household net wealth.

Source: moneycentral.msn.com

Moreover, and despite some occasional expressions of disbelief that have been voiced about the sustainability of the current levels, it should be reminded that- the rally of the last 15 months notwithstanding, equity prices are still some 30% below their level in the summer of 2007 ("pre-subprime mortgage crisis"). This helps put things in perspective and highlight the reality that, in the midst of an economic recovery that is gaining solid traction, there is nothing truly unsustainable about the current valuations of equities.

Anthony Karydakis

The FOMC Statement And Its Key Wording

2010-03-16T14:28:00.006-04:00

Despite growing reservations expressed recently by a number of FOMC members about the use of the expression that the "exceptionally low" interest rates will remain in effect for "an extended period" (http://www.bloomberg.com/apps/news?pid=20601068&sid=aFU6r1vdqIb8), the Committee preserved once again that key language in its statement today.

http://www.federalreserve.gov/newsevents/press/monetary/20100316a.htm

However, the clear acknowledgment in today's statement that "economic activity has continued to strengthen and that the labor market is stabilizing" raises the odds that a modification of the "extended period" expression may be in the cards for the April 27-28 meeting. By that time, the Fed will have in its possession the vast majority of the economic data for March and a firmer sense as to the forward momentum of the recovery going into the second quarter. If the balance of such evidence continues to show that economic activity is gathering steam, then the expression that has been at the hallmark of each FOMC statement since March 2009 is likely to be replaced by something like "for a while" or "for some time", a view that has been openly advocated by Kansas City Fed President Thomas Hoenig recently (and who dissented again on precisely such grounds at today's meeting).

The debate over the use of the expression "for an extended period" is actually mostly a matter of semantics and tactics, rather than substance.

In other words, the adoption of a milder language in that regard should not be viewed as meaning that the timing of the Fed tightening process will have been moved up. It will rather be a gesture giving the Fed somewhat more flexibility to make that call depending on the way the various economic data behave in the second half of the year, without feeling constrained by the unspoken promise that the current language provides. Although the Fed has never attempted to be more specific as to how long that "extended period" is actually meant to be, the assumption is that it corresponds to at least a 6- to 8-month horizon. Replacing "extended period" with "some time" does nothing by itself to precipitate the beginning of the tightening process, but it gives the Fed leeway to do so in the event that the pace of economic activity suprises with its strength by late summer, without the trepidation of breaking an "unwritten contract" with the markets.

Still, all in all, in view of the ongoing downward drift of inflation, a respectable but not exactly explosive economic recovery, and the tight credit conditions, the earliest conceivable timing of the first tightening move remains the fourth quarter of the year.

Anthony Karydakis

Retail Sales Confirm the Consumer Comeback

2010-03-12T09:46:00.009-05:00

The stronger-than-anticipated retail sales data for February represent a further encouraging sign that the consumer is making a credible comeback.

Not only did overall sales rise 0.3% last month (versus a consensus call for a modest decline) but the ex-autos part of the report was also up a robust 0.8%. (Auto sales themselves fell 2%, reflecting, in part, the Toyota-related issue, which was not immediately offset by a quick pick-up in sales of other brands). One of the most surprising elements in the report was perhaps the strong gain in department store sales (+0.9%), dispelling all earlier fears about last month's snow storms having been a significant adverse factor in that category.

Source: Bloomberg, Haver Analytics

For purposes of calculating personal consumption in the GDP data, the most relevant version of retail sales is the one that excludes autos, gas station sales, and building materials; that version of the report rose a very healthy 0.9%, following a thoroughly respectable increase of 0.6% in January. Based on the available data so far, consumption is probably running at a 3.5% annual rate in Q1, which should help support GDP growth in the 3% area for the period.

Of course, retail sales are one of the most "revisable" economic releases of the month and, in today's report, we had a taste of that again, as both January's and December's data were revised in opposite directions; the result of those revisions was a net small downward effect for the combined two-month period. Still, the monthly noise of the data notwithstanding, it is impossible to ignore the underlying uptrend in consumer spending, which, after all is said and one, constitutes the backbone of the forward momentum that the economy recovery is gathering.

Anthony Karydakis

The EU's Ideas to Deal With Another Greece

2010-03-09T11:14:00.034-05:00

In the wake of the headline-making story involving Greece's debt situation in the last couple of months, the European Union seems to be setting its eyes on two possible remedies from preventing such crises in the future.

The first one is the project pushed by German Chancellor Angela Merkel to ban the use of CDS on sovereign debt of the eurozone countries. The idea is that this will help curb the speculative fever against the debt of countries with the heaviest bond issuance (namely Greece, Portugal, Spain, and to some extent, Italy and Ireland) and prevent the replay of Greece-style crises in the future. The idea appears to be gathering support among the powers-that-be within the EU and stands a reasonable chance of being converted into tangible regulation in the coming months.

Although such a ban would probably be helpful in that it will remove a relatively inexpensive tool for bet-making, it is far from certain that, it alone, can tame the speculative impulses of markets vis-a-vis countries that have a clear credibility problem in terms of their fiscal policies.

The reality remains that as long as selling a sovereign bond short remains a permitted activity, there is nothing that prevents hedge fund and other speculators from simply retooling their tactics and shifting the emphasis of their arsenal toward more good old-fashioned short selling. A variation on the theme of an outright ban on CDS contracts is a proposal that would ban the use of CDS by those who do not actually own the underlying bonds (that is, it would prohibit, naked short selling). A sensible proposal for sure, but, still, far from a panacea. On that score, it is useful to remind ourselves that the absence of a CDS market did not prevent George Soros from famously breaking the Bank of England in 1992.

The second major proposal that is also promoted by the Ministry of Finance in Germany is the creation of a European Monetary Fund, modeled after the IMF, for purposes of addressing future crises in eurozone countries. The idea seems to have gained traction quickly in the last few days and is even reported that it may become operational by June.

The creation of such a safety net has some downsides and also some powerful detractors. The Bundesbank President, Axel Weber, is already on record describing the idea of the "institutionalization of emergency help" as problematic, as it would detract from the main focus, which should be to force member countries to demonstrate fiscal discipline consistently. The clear risk with the creation of a European Monetary Fund mechanism, is that the existence of a permanent safety net within the eurozone bloc may lead individual countries to feel more confident that they will be rescued internally in the future and, therefore, they can afford to be lax in enforcing fiscal discipline domestically.

http://www.ft.com/cms/s/0/ac780622-2b83-11df-9d96-00144feabdc0.html

Somehow, the focus has not remained sharp enough on the most glaring fault-line that the Greece affair has exposed, which is the lack of any enforcement mechanism to credibly implement the 3% and 60% requirements for all eurozone countries in regards to the size of their deficit as a percent of GDP and total debt respectively. The irony here is that, as recent reports have brought to the surface, nearly all eurozone countries have blasted repeatedly through those ceilings in the last ten years and resorted more than once to obscure derivatives-based transactions to disguise those violations. Therefore, they do not seem to be very eager now to put themselves in a straight-jacket by seriously beefing up enforcement mechanisms and strict monitoring.

In other words, no country has completely clean hands here.

Anthony Karydakis

February Employment Report: Once Again, Not Much New, But...

2010-03-05T09:07:00.030-05:00

Despite the moderate decline in nonfarm payrolls by 36,000, the employment report for February should be viewed as broadly consistent with the premise that labor markets are turning the corner- albeit slowly.

Last month's drop in payrolls is mitigated by two factors: a) The severe snow storms that impacted part of the East Coast during the survey week were likely a factor adversely impacting the number to some degree- an acknowledgment also made by the BLS itself (although it refrained from attempting to quantify the extent of that adverse impact and also warned that the storms may have also caused an increase in employment in certain types of jobs like cleanup and repair services), and b) A net cumulative upward revision to the numbers for the December-January period by 36,000 casts the February decline in a somewhat less downbeat light in terms of recent trend.

The snow storms may have also played a role in causing a drop in both the average workweek (by 0.1 to 33.8 hours now) and overtime hours (by 0.2). The 64,000 decrease in construction jobs, although one would be tempted to see the hand of the storms again here given the nature of the industry) is mostly in line with the employment trend in that sector in the last six months.

Source: Bureau of Labor Statistics

An encouraging element in the establishment survey was the (admittedly tiny) gain in manufacturing jobs (+1,000) following a healthy 20,000 increase in January, suggesting that the sector is plowing ahead, consistent with the solid readings of the various manufacturing indicators in the last few months. Also, the absence of a payback in the retail trade jobs category from its robust 42,000 gain in January (they were flat in February) does reflect an improving sense of confidence among retailers that consumer spending is making a sustainable comeback.

Signs of persistent cautiousness in terms of hiring plans were also evident in the establishment survey, as temporary jobs rose by another 48,000, bringing the total number of such jobs created since last September to 284,000, and reflecting a lingering hesitation by employers to add regular full-time jobs.

The actual distortion to the data from the ongoing hiring of census workers was much smaller than anticipated, as that number was only 15,000 in February. Census-related hiring still has the potential to disrupt some monthly payroll numbers in the period ahead- hence, a quick comparison of the total nonfarm payroll numbers with the private sector ones remains useful in the coming months' reports.

The absence of a partial rebound in the unemployment rate in February from its sharp 0.3% drop to 9.7% in January is the result of proportionate increases in the size of the civilian labor force (+342,000) and household employment for the month (+308,000). The steady unemployment rate raises the level of confidence in the prospect that the series may have already seen its high for the cycle at the 10% level reached in December.

All in all, the data offered little new insights into the underlying dynamic of labor markets but they leave the prospect of moderate job growth (to the tune of 50,000 to 75,000 a month) in the second quarter, intact. The turnaround of labor markets, following the devastation caused by the sheer size of losses suffered since the onset of the recession (8.4 million), is a circuitous and cautious process but there should be little doubt that it is already taking hold.

Anthony Karydakis

More Weakness in the Economic Reports Ahead

2010-03-03T12:57:00.013-05:00

Inasmuch as the pattern of the overall economic indicators has been decidedly mixed recently, things are going to become even more complicated in the coming weeks as the February data are reported. The reason for this is the series of massive snow storms that hit the East Coast last month, and which are likely to have affected a fairly wide array of indicators.

To start with, February's nonfarm payrolls are likely to show a fairly substantial decline (potentially by as much as 100,000, or more) which, on the face of it, would seem to represent a setback to the profile of steadily diminishing monthly job losses in recent months. The severe snow storm that hit Washington DC, Delaware, New Jersey, and Pennsylvania particularly hard around the time of the BLS survey week in February is likely to have suppressed payroll data in the region with adverse consequences for the overall number. The workweek in Friday's employment report may also show a dip by 0.1 or 0.2 to 33.8 or 33.7, as a result of the snow storm-related disruptions.

(For the record, the February payroll data will also be subject to another distortion, which will be pulling the series in the opposite direction, therefore partially offsetting the drag from the storms: as many as 60,000 workers were probably hired by the federal government to conduct this year's census - a process that is likely to continue skewing the total payroll numbers to the upside for several more months).

But the adverse impact of the multiple snow storms that affected the East Coast last month will also extend well beyond the employment report. The severe weather is almost certain to have suppressed a number of other indicators for February, namely auto sales as well as broader retail sales (not exactly shopping-friendly weather conditions), in addition to housing starts and new home sales.

The essence of all of this is that the key economic releases later in the month are likely to continue projecting an aura of softening economic activity, following a set of other reports since the beginning of the year that seem to suggest a cooling in economic activity. As we argued in another piece earlier this week, the mostly mixed, or plain underwhelming, economic data recently should be viewed as the normal by-product of a historically sub-par economic recovery that fails to generate consistently healthy data. As such, it should not be viewed with particular concern, as they are unlikely to reflect any derailment of the economic recovery.

What the unusually harsh weather patterns experienced in February imply is that it will be a while before we are able to discern more accurately what exactly the underlying forward momentum of the recovery is in the first half of 2010. At this point, a reasonably good bet remains that the weather-induced weakness in a number of economic reports for February will be offset by a quick snap back in the March data and any doubts about the viability of the economic recovery will safely be put to rest then.

Anthony Karydakis

The Mixed Tone of the Economic Data

2010-02-27T16:40:00.020-05:00

The various economic reports in the last few weeks have been mostly on the disappointing side, raising some uneasiness over the prospects for the economic recovery. While it was well understood that the inventory-driven pace of GDP growth in the fourth quarter was not sustainable in the early part of 2010, the latest data, taken on face value, suggest that the economy's momentum may fizzling in a disconcerting fashion.

The housing sector indicators have been particularly disheartening. Sharp declines of 11.2% and 7.2% in both new home and existing home sales respectively, with spikes in the inventory of unsold homes in both reports, highlight the still precarious state of the housing market, contrary to some tentative evidence of stabilization that had emerged previously.

The significance of a 3.0% gain in durable goods orders last month was undercut by the fact that it was entirely driven by a 15.6% surge in the famously noisy transportation category, excluding which orders were down 0.6%.

But perhaps the single most unnerving message from the various economic indicators since the beginning of the year comes from the stalling of the previously solid downtrend in initial jobless claims.
After a nearly relentless decline since the spring of 2009, the series has drifted modestly higher since early January. Although noise in the weekly claims data around the turn of the year is hardly surprising, a resumption of the earlier downtrend in the coming weeks becomes an almost pressing issue to provide reassurance that the improvement in underlying labor market conditions (as reflected in the monthly payroll data) has not been disrupted meaningfully.

Despite the above, the data have not been uniformly weak recently.

The manufacturing statistics remain overall healthy, despite today's moderate drop in the February ISM to a still healthy 56.5 from 58.4. (Important to remember that this is a diffusion index, meaning that, as long as it remains above 50.0, the sector is still growing, albeit at a somewhat slower pace than in January). Besides, industrial production rose by a robust 0.9% in January, with the key manufacturing component up a solid 1%.

Also, retail sales for January posted a reasonable (although unimpressive gain) of 0.5%, with the key ex-autos category rising by 0.6%, indicating that personal consumption is still holding up.

What is then one to make of the inconsistent tone of the various reports recently?

The decidedly mixed, and often soft, tone of the data should not be viewed as downright worrisome bur rather as a reflection of the reality that this is only a 3.25-3.5% GDP growth type of economic recovery, as opposed to a more typical 5.0% to 6.0% kind of recovery in past cycles. With so much damage inflicted across the economy by the most recent economic downturn, the moderate pace of economic growth that is unfolding is not strong enough to make the data look, and feel, consistently healthy. Setbacks and pauses should be viewed as almost the norm in that setting and it will probably take several more quarters before the economic recovery engages all of its cylinders on its way to a full-fledged economic expansion.

Anthony karydakis

Consumer Confidence Plunges in February

2010-02-23T11:40:00.009-05:00

The shockingly sharp decline in the Conference Board's consumer confidence index by more than 10 points to 46.0 in February is a stark reminder of the bumpy road that the economic recovery is facing.

Source: Action Economics

Although the drop in the index can be viewed as a payback for solid, back-to-back gains in December and January, the reality is that the magnitude of the drop is attention-catching. This is so, not only because it has left the series at its lowest level in 10 months but also because of the unnerving drop in the "current conditions" component to 19.4, which is the lowest in nearly 28 years. To add to the downbeat message of the February report, the "expectations" component nearly cratered this month, falling to 63.8 from 77.3 in January.

Anxiety over the job market's prospects remains at the core of consumers' seemingly bleak assessment of both current conditions and the 6-month outlook for the economy. On the face of it, such renewed concerns over job prospects in February run contrary to other evidence in the last few months suggesting that the pace of erosion in labor market conditions is slowing. A plausible, although still wanting, explanation here might be that the cumulative anxiety and frustration over the lack of any readily visible improvement in job growth and the lingering high unemployment rate are taking a toll on household psychology.

Still, the consumer confidence/sentiment measures are "soft" indicators and contain more than their fair share of noise. It is also true that, ultimately, psychology alone will not be the defining factor of what households will do in terms of spending, as this will be shaped by whether labor markets and associated income growth continue to improve. However, the report today is a vivid example of how the decidedly sub-par (by historical standards) pace of this economic recovery to date has failed to project a convincing message to all that an economic recovery is actually taking place at all.

Anthony Karydakis

CPI Inflation, Nearly Perfect

2010-02-19T09:26:00.022-05:00

The CPI report for January, showing a gain of 0.2% in the overall index and a 0.1% decline in the core measure, helps bring to focus some key elements of the broader inflation picture in the current environment.

In terms of the January report itself, the discrepancy between the overall CPI and core was almost entirely due to a sharp rise in energy prices (+2.8%) and, particularly, gasoline (+4.4%). The unusual drop in the core last month (its first decline since 1982) was largely the result of an uncharacteristic pullback in the shelter component (-0.5%) which accounts for 33% of the overall CPI; in turn, the decline in the shelter component was driven by a sizable drop of 2.1% in hotel prices ("lodging away from home").

Moving beyond the specifics of the January report, the overall CPI is now up 2.6% from a year ago, while the core index has risen 1.6%- versus a 1.8% year-on-year gain to December 2009. (In reality, both measures would have been even lower on a year-on-year basis, if it were not for a 30% surge in tobacco prices that have added approximately 0.3 percentage during that period).

Source: Bureau of Labor Statistics

Despite pronounced -and exaggerated- anxiety in the wake of the financial crisis and deepening recession in the second half of 2008, that the economy might be facing the specter of deflation, the behavior of the CPI in recent months has safely put such fears to rest. Despite a severe weakening in labor market conditions and ensuing wage trends, as well as a sharp reversal of oil and other commodity prices in late 2008 and early 2009, core inflation has remained comfortably within a 1.5 to 2% range. While some further modest downward drift in the months ahead even as the economic recovery gains traction is still possible (inflation is appropriately considered as a lagging indicator), it is likely to bottom out in the 1 1/4% to 1 1/2% range later in the year.

This leaves the inflation picture at an almost ideal spot. The severity of the recession has predictably enough pushed the core CPI lower by one percentage point (from about 2.5-2.6% in the summer of 2008 to 1.6% today) but any further disnflationary forces are steadily diminishing in the context of an economic recovery taking hold. The substantial, but reasonable, moderation of inflation provides the Fed with some breathing room in its upcoming campaign to normalize the structure of short term rates over the next 12 to 18 months. At some point, over that time frame, inflation will probably show an upturn and, given its inherent inertia, this may not be fully successfully contained by the Fed at first. But with the cushion that the recent retreat of core inflation provides, a moderate bounce back of inflation next year is not likely to trigger any widespread anxiety over the risk of a disturbing comeback.

Anthony Karydakis

As the Eurozone Saga Continues...

2010-02-16T16:52:00.020-05:00

With mounting resistance by the German public to the prospect of a Greece bailout, that solution appears a tad less likely now than as recently as the end of last week. Positions by the powers-that-be within the EU are stiffening, with tougher demands now imposed on Greece to bolster the credibility of its already announced measures by taking additional action.

The euro remains under pressure and that is unlikely to be alleviated unless specific reassurances, tantamount to a bailout, are announced in the coming days. With Germany and France (the countries that are de facto on the hook for any action to rescue Greece) have pointedly refrained from attaching any specifics to their initial, generic, promises that Greece "will not be left alone". As the gap between words and specifics persists, relatively unconventional ideas as to how to handle the crisis with Greece's debt are being proposed and receiving some attention.

One such suggestion is the one proposed by Martin Feldstein in an article in the Financial Times, which would imply allowing Greece to bring back the drachma as its currency for certain types of transaction, while maintaining the euro for others (link below).

http://www.ft.com/cms/s/0/72214942-1b30-11df-953f-00144feab49a.html

Another suggestion that was, at first, viewed as nearly unthinkable, but no longer so, is to simply expel Greece from the eurozone and that could serve as the wake-up call for the other fiscally challenged countries (Portugal, Spain, Ireland, and, to a somewhat lesser degree, Italy) to put their house in order quickly. The EU, without openly saying so, appears quietly intrigued by the idea that cutting out of the Eurozone its weakest member may be one of the plausible outcomes and may not necessaily mean the disintegration of the euro system.

For the time being, global financial markets continue to punish the most fiscally irresponsible countries by driving their sovereign borrowing costs through the roof and the cost of credit default swaps on their debt near record-highs. After a period of lull for most of January, the Dubai debt affair is coming to the forefront again, with credit default swaps on Dubai World's debt rising sharply in recent days.

Against that backdrop, and despite the re-insertion of a distinct risk component into certain instruments, global financial markets are keeping, on balance, their cool. After suffering a setback stemming from Greece's troubles in the second half of January, stock markets both in the U.S. and Eurozone are making a partial comeback, speaking volumes of the long distance that the world of global finance has covered in the last 18 months or so.

The Eurozone's fiscal woes are often being cast as the inevitable hangover from the combined effect of a global economic downturn and financial crisis that exposed the weakest links among European countries. Moreover, the affair surrounding Greece's troubles may hold more unpleasant developments, as a possible default on that country's debt will have serious reverberations across banks in Europe that are holding mountains of such debt.

All of this may be so, but eliminating all pockets of potential blow-ups in the financial system around the world is not a realistic expectation to have, as the damage that the financial crisis has left behind will take a considerably longer period to heal. A far more sensible yardstick of where the global financial system stands today is whether it has regained its ability to absorb such disturbances, within an acceptable framework of noise-or, even turmoil- that is always inherent in financial markets even in the most normal of times. Based on that standard, the answer to that question is, so far, encouraging.

Anthony Karydakis

Re-writing the Playbook on Monetary Policy

2010-02-11T12:41:00.013-05:00

Mr. Bernnake's Congressional testimony on the specifics of the Fed's planned "exit strategy" yesterday was quite thorough but held no surprises, as nearly all of the measures he outlined had already been mentioned, in a somewhat piecemeal fashion, as being under consideration in the last few months.

http://www.federalreserve.gov/newsevents/testimony/bernanke20100210a.htm

Those measures include, raising the interest rate that the Fed currently pays banks on both their required and excess reserves, offering banks term deposits, and conducting Reverse Repurchase Agreements to drain liquidity directly.

This last point included actually a twist, as the Fed Chairman confirmed that the Fed will be looking to conduct "triparty" Reverse RPs, meaning that, for the first time, the Fed will use counterparties in such open-market operations other than primary dealers. Traditionally, the argument has been that the Fed conducts such sensitive operations only with especially vetted securities firms that have received its "seal of approval". However, this rule will need to be broken now, as this "innovation" is mandated by the staggering amount of reserves -in the vicinity of $1 trillion- that the Fed will need to absorb in due course, while the primary dealer community is thought to be able to handle transactions totaling only $100 billion or so. As such additional counterparties, the Fed is considering the money market mutual fund industry, which has a much greater ability to handle transactions of the required magnitude (link below).

http://www.bloomberg.com/apps/news?pid=20601068&sid=aSn2_iDKbl1g

Mr. Bernanke reiterated the obvious- that is, that the federal funds rate is likely to remain at "exceptionally low" levels for an "extended period" and it is indeed unrealistic to expect the Fed to move into a tightening mode over the next six to eight months. However, no one can accuse the Fed of not making meticulous preparations to return the financial system to more normal liquidity conditions when the appropriate time comes. And, just as injecting that massive liquidity at the start required an extraordinary amount of creativity and history-making measures, draining all of that liquidity on the back end will require a comparable degree of innovative tools and tactics, as the Fed continues to re-write the monetary policy-making playbook in this country.

Anthony Karydakis

A Matter of Degree

2010-02-08T11:02:00.026-05:00

The acute trouble Greece's economy is in and its implications for the Eurozone have already received extensive coverage in the last few weeks- some of which in reasonably articulate and comprehensive articles (like the ones below).

http://online.wsj.com/article/SB10001424052748703357104575045760288932720.html

http://www.nytimes.com/2010/02/07/business/global/07greece.html?scp=1&sq=Is%20Debt%20Trashing%20the%20euro&st=cse

The current predicament that the entire Eurozone entity and the euro as a currency are facing extends beyond Greece, as Portugal, Ireland and Spain are also confronting severe budgetary shortfalls and have shown widely varying degrees of willingness to tackle them effectively.

All in all, Ireland's measures announced late last year have received some cautious praise by the EU but, others, like Spain, are showing overt resistance to the idea of improsing draconian measures to bring their fiscal mess under control. Greece has now been cast in the spotlight due not only to the magnitude of the surprise that the country sprang on the EU last November by announcing "revised" data showing a deficit nearly triple of the previous "estimate" but also due to the country's sad history of avoiding to tackle some of the endemic problems that plague its economy.

How the whole crisis plays out in the next couple of months may have some implications for the dynamic of the U.S. economic recovery as well.

While the most likely outcome remains that, Greece (and, if need be, Portugal as well) will ultimately be rescued in some fashion, either by the EU or the IMF, a prolonged anxiety over the outcome and brinkmanship involved in the process can have wider repercussions for financial markets and the U.S. economy.

If the uncertainty over the fiscal crisis in those four Eurozone countries, which account for approximately 1/5 of the Eurozone GDP, is not convincingly contained soon, a further weakening of the euro can become an additional moderate headwind for the U.S. recovery, as the implied strengthening of the dollar will adversely impact the export-oriented manufacturing sector. This is a sector that has made a surprising comeback in recent months, with the ISM (the most comprehensive barometer of activity in that sector) currently standing at its highest level since 2004. But with more than 20% of U.S. exports going to EU countries, a further drop of the euro (used by only 16 of the 27 EU countries, but also tracked by a number of other currencies that aspire to join it) is bound to have more than just a negligible negative effect on the sector.

The other channel via which an extended period of doubts over the ability of any of the four Eurozone countries currently in the headlines to service their external debt without interruption is the equity markets. Equities have already suffered a setback in most European countries since the beginning of the year, in response to the dismal fiscal situation of some member countries, which has re-introduced a distinct element of risk aversion into the picture. The U.S. equity market has suffered in sympathy, as, one thing that has been learned all too well in the midst of the financial crisis in the last 18 months, is that markets are indeed global. As a result, any additional erosion in U.S. and global equities can impair the ability of households in this country to step up their spending in an environment of high unemployment and a recently elevated savings rate.

Greece is a small country with a pretty inconsequential GDP size within the Eurozone and, in different times, the gross mismanagement of its economy would not have attracted much attention outside its borders. But these are not exactly normal times, as such ripples come at a time when the global financial system is in its early phase of healing from a deeply traumatic experience and nerves can become frail more easily than in the past. Still, as the Dubai episode late last year demonstrated, financial markets have recovered enough to handle isolated glitches, but their ability to do so has its limits. Everything is a matter of degree and that is why the risk of possible contagion across other Eurozone countries bears close monitoring in the coming weeks.

Anthony Karydakis

January Employment Data: A Mixed Picture, But No Real News

2010-02-05T09:43:00.026-05:00

Last month's employment report is consistent with the broader picture of slowly improving labor market conditions, but not much beyond that.

Still, a cautionary note should be issued, as today's numbers are somewhat hard to interpret.

A key factor complicating any attempt to form a straightforward impression of the report is the benchmark revisions to the establishment survey (which produces the nonfarm payroll series) that have now shown a more disturbing trend in payrolls since April 2008. Based on the revised data, the economy had shed about 930,000 more jobs in the twelve-month period leading up to March 2009 than previously estimated. In terms of the most recent months, the revised data show that 553,000 more jobs were lost in the period from April to December 2009 than previously estimated.

All in all, according to the BLS, a total of 8.4 million jobs have now been lost since the beginning of the recession in December 2007.

In January, payrolls fell 20,000, following a sharp downward revision to December's decline from -85,000 to -150,000. Construction employment continued to erode (-75,000), while retail trade, manufacturing, and health care, all showed gains (42,000, 11,000, and 17,000 respectively). In an unmistakable sign that businesses remain cautious about stepping up appreciably their pace of adding permanently to their labor force, temporary jobs turned out another solid increase for the month (52,000), after gains of 59,000 and 95,000 in the two prior months.

Nonfarm Payrolls (monthly data; in thousands)

Source: Bureau of Labor Statistics

It is hardly surprising that, given the fiscal woes of most states around the country, 41,000 of state and local government jobs were cut last month, although this was mostly offset by an outsized increase of 33,000 in federal government jobs (in part related to hiring for the 2010 census).

The headline-grabbing 0.3% drop in the unemployment rate to 9.7% last month should be approached cautiously, as it is the result of an essentially stagnant size of the labor force in January and a curious (but perfectly within the margin of routine noise for the series) 541,000 surge in employment, as measured by the household survey. The latter represents essentially a reversal of a 589,000 decline in employment- in the household data- in December. It is much too soon to view January's drop in the unemployment rate as the beginning of a trend and, in fact, it is quite likely that the rate will move higher again in February as a payback for the counter-intuitively sharp decline last month.

A small uptick in the workweek to 33.3 hours does little to create a sense of an emerging trend, as the series gas been bouncing around that level for several months now.

In what is perhaps the single most encouraging- and meaningful- detail in the overall data, the number of persons working part-time for economic reasons (also called "involuntary part-time workers", because either their hours had been cut by their employers or they were unable to find a full-time job) dropped sharply in January to 8.3 million from 9.2 million in December. This can indeed be a sign that more full-time jobs are starting to become available.

The message from the January data is that labor markets continue to show credible evidence that they are turning the corner, but the turnaround process is proceeding at a much-to-be desired pace. Still, the odds remain squarely in favor of a moderate payroll growth trend emerging again in the coming months, with gains perhaps averaging 50,000, or more, in the spring. Such numbers are almost certain to benefit from the pick-up in hiring by the government for the 2010 census, which suggests that the emphasis in the coming months should shift toward private payrolls and not the overall number.

Anthony Karydakis

Productivity Surges

2010-02-04T09:23:00.010-05:00

Nonfarm productivity surged 6.2% in the fourth quarter of last year, following a downward revised- but still impressive- gain of 7.2% in the prior quarter. (In fact, the Q3 gain was the biggest quarterly increase in the series since Q3 of 2003). In the second quarter of 2009, the series had also surged 6.9%. As a result, on a year-on-year basis, productivity is now up a stellar 5.1%.

However, the spectacular gains in productivity in the last few quarters are hardly unexpected.

From the analytical standpoint, productivity consists of a cyclical and structural component. It is typical for the series to show outsized increases in the early phase of an economic expansion, as businesses tend to use their existing, underutilized, labor force more intensively for a while before they are convinced that an economic recovery is taking hold and start hiring more workers. Once that process runs its inevitable course and hiring picks up, productivity gains are bound to moderate precipitously again.

So, it is hardly surprising that, with economic activity bottoming out around mid-2009, productivity gains have spiked. The obvious message here is that they should not be celebrated as representing any improvement in long-term productivity trends in the U.S. economy but simply as a reflection of the economic juncture. It would take several years of a perceptible uptrend in the series to reach the conclusion that something more fundamental is happening. In fact, as the chart below shows, the current productivity surge is nothing exceptional by the standards of the behavior of the series in the early phase of the two previous economic recoveries during 1992-93 and 2002-03.

Nonfarm Business Productivity

Source: Bureau of Labor Statistics

Unit labor costs, which are essentially the mirror-image of productivity have been trending lower in recent quarters.; they fell 4.4% in Q4, following a 1.5% drop in Q3, and are now down 2.8% from a year ago. Once again, it confirms the weak state of labor markets and absence of wage pressures- not exactly surprising against the backdrop of labor slack and a 10% unemployment rate.

The spike in productivity in recent quarters helps explain how GDP growth has been taking off (averaging nearly 4% in the second half of 2009), while the erosion of jobs continues (albeit at a much slower pace). This is indeed plausible for some time but cannot remain the case moving forward, as ultimately a pick up in employment would be needed to support income growth and consumption. So, the mirage of economic growth co-existing with the absence of job creation is essentially on short leash.

Anthony Karydakis

Mr. Bernanke and the Perplexing Populism of a Naubel Laureate

2010-01-31T16:35:00.033-05:00

Now that Ben Bernanke has been confirmed by the Senate for a second four-year term as Fed Chairman, averting a potentially major financial market turmoil and the embarrassment of this country in the eyes of the world, it is high time to focus on two memorable quotes by two high-profile public figures during the heady week recently when opposition to Mr. Bernanke's confirmation seemed to be gathering steam.

It was hardly surprising to hear Senator Barbara Boxer (D-Calif) declare on January 22 that, despite her professed regard for the Fed Chairman, she would vote against Bernanke's confirmation because "...it is time for Main Street to have a champion at the Fed"- whatever Main Street's champion at the Fed exactly entails. Such a decision and rationale could have easily been brushed aside as standard populist rhetoric by a professional politician up for re-election this year and fighting for her political life.

http://www.economicpolicyjournal.com/2010/01/barbara-boxers-statement-on-bernanke.html

But it was an entirely different, and somewhat disturbing, matter, to read the following in Paul Krugman's op-ed column in The New York Times, on January 26, where he was explaining why the most he could muster to offer to his former colleague at Princeton was a very tepid endorsement.

"And then there's unemployment. The economy may not have collapsed, but it's in terrible shape, with job-seekers outnumbering job openings six to one. Nor does Mr. Bernanke expect any quick improvement: last month, while predicting that unemployment will fall, he conceded that the rate of decline will be "slower than he would like". So what does he propose doing to create jobs?

Nothing. Mr. Bernanke has offered no hint that he feels the need to adopt policies that might bring unemployment down faster."

http://dealbook.blogs.nytimes.com/2010/01/26/krugman-the-bernanke-conundrum/?scp=1&sq=Bernanke%20Conundrum&st=cse

Now, this is serious double-take material.

What kind of policies should the Fed have adopted to "bring unemployment down faster"? Bring short-term rates down to zero and keep them there for 14 months now, while still promising to keep them at that level "for an extended period"? Already done. Set in place an unprecedented array of programs to inject an enormous amount of liquidity, providing the "raw material" that banks- once they are past their critical survival phase- will have available to extend more lending? Done, too.

The most disturbing part though is this: Doesn't Mr. Krugman realize that measures specifically designed to create jobs and bring the unemployment rate down are the exclusive domain of fiscal policy and that the Fed is not part of either the Executive or Legislative branches of the government that shape such policies ? Doesn't he realize that the Fed has no legal power, whatsoever, to mandate banks to increase lending against their will? Doesn't he realize that Mr. Bernanke's view that the rate of decline in the unemployment rate "would be slower than he would like" is not a reflection of indifference on his part toward the social impact of a 10% rate but simply a realistic assessment of the economic trajectory ahead and the Fed's own ironclad limitations in regards to affecting that outcome?

It does not take a Nobel Laureate in Economics to understand those simple facts and Mr. Krugman is certainly more than qualified to recognize them fully. Then, what one is to make of the promotion of such populist, and misleading, arguments against Bernanke on a high-profile forum like The New York Times?

As we have argued before, Bernanke carries a very major responsibility for the Fed's lax supervision of the banking system while the imbalances that led to the financial crisis were brewing, and he has repeatedly acknowledged that himself. But attacking him on the grounds that, as a central banker, with the record of the measures he has taken in the last 18 months or so, he is not doing enough to bring the unemployment rate down is dsiturbingly off-base.

Populism has its role in the public discourse in any democracy but it is always disheartening to see it popping up in the most unexpected of places.

Anthony Karydakis

Fourth Quarter GDP Consistent With a Moderate Recovery

2010-01-29T09:36:00.019-05:00

The press headlines so far uniformly highlight that the 5.7% annualized growth rate for Q4 GDP is the highest in six years, which is factually true. But this morning's report is also a textbook-like case of the hard reality that, after all is said and done, GDP numbers are a "bean counting exercise". This means that GDP consists of a number of components, each one of which is subject to a high degree of noise from one period to the next, and, at times, those multiple sources of noise can present a distorted picture of what is actually going on.

Source: Bloomberg, Haver Analytics

The primary reason for the seemingly impressive growth rate last quarter was a dramatically slower pace of inventory liquidation, which added 3.4 percentage points to the overall GDP number, following a far more moderate contribution of 0.7 percentage points to the previous quarter's growth. Outside of inventories, real final sales (that is, overall GDP minus inventories) grew at a relatively subdued 2.2% rate.

Personal consumption rose 2% (following a 2.8% pace in Q3) contributing 1.4 percentage points to growth, while capital spending was up 2.9% (its first increase since Q2 2008), indicating an end to its free-fall in the prior five quarters. Net exports also contributed 1/2 a percent to growth, as imports declined sharply for the quarter.

http://www.bea.gov/newsreleases/national/gdp/2010/pdf/gdp4q09_adv.pdf

Despite its impressive fourth quarter number, GDP contracted by 2.4% in 2009 compared to the previous year.

Now, inventory replenishment is a natural part of the turnaround in economic activity in any business cycle, as it represents the legitimate adjustment of businesses to the reality of stirrings in final demands following a recession. In that context, this is precisely what has been happening again in this cycle. In fact, this inventory adjustment process goes hand-in-hand with a pick up in underlying production, which is one of the key dynamics that set into motion an economic recovery. So, nothing wrong with that, per se. Still, it does deflect some attention from the reality that today's report shows most of the other GDP components recovering at an appreciably slower pace and remains consistent with the prospect of an overall moderate economic recovery ahead.

As the inventory rebuilding process is unlikely to be sustained in the coming quarters at the pace of the most recent period, GDP is likely to cool to 3.5% or so in the first half of the year, which would be roughly in line with the average growth in the second half of 2009 (3.9%). Although inventories should remain a net contributor to GDP in the quarters ahead, all eyes are now turning to personal consumption- and, to a lesser extent, capital spending- which will ultimately determine the kind of recovery that is in store for 2010.

Anthony Karydakis

Federal Funds Targeting: The End of an Era?

2010-01-26T13:57:00.022-05:00

For over two decades now, the federal funds rate has been the key operating target of monetary policy in the U.S., as the Fed manipulated the availability of reserves in the banking system, via open-market operations, to achieve a particular level of that overnight interbank rate. Since December 2008, courtesy of the financial crisis, that rate has stood close to o% (or, as the Fed officially defines its target "within a range of 0% to 0.25%).

With a massive amount of quantitative easing put in place since the onset of the most acute phase of the crisis in September 2008, and with the Fed already actively exploring various tools that can be used in the balance of the year to drain over $1.2 trillion of extra liquidity still slashing around in the banking system, it is increasingly likely that fed funds targeting will be taking back seat in that process, if it has any seat at all.

The massive amount of liquidity that will need to be taken out of the system when the time comes is simply not on a scale that routine, even if aggressive, open-market operations (Reverse Repurchase Agreements) can handle. In fact, a distinct risk exists that attempting to adhere to procedures that have been used in the past to address "run-of-the-mill" needs to drain reserves from the banking system in order to handle such a monumental and complex task ahead would cause the Fed to lose control of the federal funds rate and deliver a major blow to its own credibility.

The need to be creative and invent new techniques to accomplish that task has been increasingly at the forefront of the Fed's preparedness efforts in the last few months. For example, just last month, the Fed Chairman proposed that the Fed offer term deposits to banks in addition to the current regime where the Fed pays interest on banks' excess reserves and reserve requirements. The idea remains the same: the Fed needs to implement effective ways to tie up progressively large amount of bank reserves and prevent them from being actively used for excessive loan creation that could fan inflation pressures when the economic recovery is on solid footing and the banking system has regained a greater sense of stability. Open-market operations were well suited in the past to handle tasks that were far more moderate in scope, when the only easing that the Fed might have put in place was of the qualitative kind. Things are very different now and the inadequacy of such tools is a fairly transparent issue.

It is precisely that problem that Richmond Fed President Jeffrey Lacker was addressing in some remarks he made earlier this month, when he raised the issue that the Fed is considering the adoption of the interest rate they now pay on bank reserves as the new benchmark rate, replacing the concept of a fed funds target used until now (see link below).

http://www.bloomberg.com/apps/news?pid=20601087&sid=akYMsCezpjlk&pos=3

The premise here is that the Fed feels more confident that they can achieve better control over the amount of bank excess reserves and lending by manipulating the interest rate they pay banks on their reserves compared to any attempt to control the fed funds rate by targeting non-borrowed reserves via open-market operations (which had been essentially the mechanism until a year and a half ago).

The whole project of managing to drain that huge amount of extra liquidity with reasonable efficiency, accuracy, and in an orderly fashion, is likely to be a pretty complex one and will inevitably include some glitches along the way, given the complete lack of precedent. But it looks increasingly likely that we may be at the doorstep of a major overhaul in the Fed's longstanding operating procedures in the conduct of monetary policy.

If the Fed does indeed usher in a new period where they express monetary policy actions in terms of the level of interest rate paid on bank reserves rather than a federal funds target, a significant prospect exists that the latter may slowly fade into oblivion- another casualty of the financial crisis.

Anthony Karydakis

First Thoughts on Obama's Bank Reform Plan and the Comeback of a Legend

2010-01-22T09:35:00.021-05:00

A more cynical view would be tempted to argue that the aggressive roll-out of the Administration's bank reform proposal yesterday was meant to quickly divert the public's attention from the Massachusetts election and ensuing unraveling of the health care reform plan. However true this may actually be, it should not detract from the merits of the proposed legislation that is widely, and accurately, reported to be the brainchild of Paul Volcker's efforts to address the fundamental causes that led to the recent financial crisis.

The three key elements of the proposed plan (1. limiting the size of banks, 2. prohibiting proprietary trading activities, and 3. prohibiting banks from investing in private equity firms or and hedge funds) are all appropriately far-reaching measures that go tot he heart of the reasons that caused the near- meltdown of the financial system in the last 18 months.

In the midst of the initial sense of gratification that one would feel to see that serious, drastic measures to address the root cause of what was wrong with the banking industry are now being put on the table, it is also imperative to view everything in a more realistic context and not uncork the proverbial champagne yet.

To begin with, as the messy process involving the proposed health care legislation demonstrated all too well recently, a proposal is not tantamount to actual legislation. In fact, despite the populist undertones that a plan to tightly regulate the financial industry inevitably contains, it is far from certain that there will be adequate bipartisan support in Congress to implement such aggressive measures that would take on the powerful industry's critical interests in a major way. In other words, the banking industry does not spend over $1 billion a year on lobbying expenses (an amount likely to skyrocket now) for nothing.

But the other major aspect of the proposed plan that may undercut its significance is the extent to which other countries would be willing to go along with comparable measures. Early response in Europe has been overall positive (that is, outside the stock markets), with warm endorsement of the plan by the major political parties in the U.K. (where it is also fully consistent with the views of the Bank of England Governor, Mervyn King) and generally supportive, but somewhat more guarded, comments coming from officials in continental Europe.

http://news.bbc.co.uk/2/hi/business/8475217.stm
http://online.wsj.com/article/SB10001424052748704509704575018622712047044.html?mod=WSJ-Markets-LEFTTopNews

The degree of support that Obama's proposals will receive from other governments with developed financial market structures will be key to the ability of those measures to achieve their intended objective, even of they were to be converted into law fully in this country. In a global financial market universe, prohibiting banks from engaging in certain types of risk activities in some countries only would quickly lead to the emergence of other "locales" as the new financial centers for such activity that would escape those restrictions; the net result of that would be to re-inject systemic risk into the picture that could destabilize the global financial system again.

On an entirely separate aspect of yesterday's unveiling of the proposal, the unqualified deference that Obama showed toward Paul Volcker by referring to the plan as "the Volcker rule" and the sheer fact that the legendary former Fed Chairman was standing right next to the President of the United States brought some unmistakable echoes from the past. Thirty years after Volcker shook the world by launching his monumental, and utterly successful, fight to drive inflation out of the system, there he was again, at the twilight of his career and life, deservedly basking in the spotlight, offering again his trademark, courageous, no-nonsence, solutions to the biggest financial crisis since the Great Depression.

For someone like myself, who has always admired the man's extraordinary integrity, competence, and selfless committment to public service, it was gratifying to see Paul Volcker on center stage again. He still stands as tall as ever.

Anthony Karydakis

That Unflagging Demand for Treasuries

2010-01-20T19:44:00.013-05:00

When the Fed's program to purchase a total of $300 billion of Treasury securities ended in October, concerns were raised that the removal of a major buyer supporting the market in the previous six months or so would tend to cause a setback for long-term yields. Those concerns were actually compounded by growing signs of an economic recovery taking hold- a dynamic that would have also been expected to push yields higher.

In fact, the Treasury market did come under pressure in the period from mid- November to late December, with long-term yields rising by more than 50 basis points. But the back-up in yields was most certainly of the moderate kind (not of the-end-of-the-world-as-we-knew-it kind), indicating that there was a potent underlying force that was offsetting the adverse dynamic of an economic recovery, large Treasury issuance, and the end of the Fed's program of Treasury purchases. Since then, yields have actually come off by about 20-25 basis points, with the 10-year note trading at around 3 5/8% again.

So, someone out there is clearly buying Treasuries.

The TIC (Treasury International Capital System) data for November 2009, released earlier this week, provide very useful insight regarding that question, as they showed a record $118.0 billion of net purchases of long-term Treasuries by foreigners during that month. This overshadows the previous record of slightly over $100 billion reported for June of last year.

Net Foreign Purchases of Long-Term Treasuries

Source: Action Economics

Contrary to the often popular perception that buying by foreign central banks is the primary factor supporting the U.S. Treasury market, such purchases represented actually a relatively small share of the overall amount in November. Foreign official institutions accounted for approximately $31 billion of those purchases, with the remaining $87 billion coming from private foreign investors, which demonstrates a broad-based interest in the Treasury market by foreigners.

http://www.treas.gov/tic/snetus.txt

The seemingly ferocious demand for long-term Treasuries is also intriguing for an additional reason. Despite the massive influx of funds into emerging markets in the second half of 2009, this does not appear to have come at the expense of the demand for Treasuries by foreign investors. The explanation here is presumably that the reduction in the perception of global market risk in the second half of 2009 has triggered such an enormous exodus of funds previously parked in cash instruments that has allowed both U.S. Treasuries and emerging markets to become beneficiaries of such money being put to work again.

The TIC data are indeed very volatile on a month-to-month basis and are typically revised- often, appreciably. In that context, it would not be surprising to see a strong payback in December for the impresive strength in November's numbers regarding net purchases of Treasuries. But the key point remains undiluted: foreigners maintain a strong appetite for Treasury securities and do not seem prepared to shun that market despite the relative restoration of calm in global financial market conditions.

In other words, the Treasury market is not simply a safe haven.

Anthony Karydakis

(In a future posting, we will look in to the role of China in the overall purchases of Treasuries by foreigners).

Do Budget Deficits Drive Bond Yields?

2010-01-03T15:17:00.036-05:00

(Due to a long-planned vacation out of the country, there will be no articles posted during that period, starting Monday, January 4th. New posts will resume after January 19h).

AK
______________________

The notion that large budget deficits tend to lead to higher yields has generally been accepted over the years without much questioning among market participants. The basic idea is a fairly straightforward one: the large supply of securities associated with those deficits can cause an over saturation in the credit markets, creating a mismatch between supply and demand and, therefore, leading to lower prices (i.e higher yields).

The academic literature in the field of economics reaches essentially the same conclusion, by highlighting the so-called "crowding out" dynamic- which means that the intense competition for funds between the government and private sector in a period of large government issuance will squeeze out private borrowers while causing rates to rise.

The prospect of massive Treasury supply ahead has, in fact, been invariably mentioned as one of the main reasons for which long-term yields have backed up moderately in the last five weeks and are viewed as likely to drift higher in 2010 in good part due to that factor. It is, however, curious that, despite the very mixed, at best, evidence that Treasury supply has any lasting effect on Treasury yields, that notion continues to hold sway among fixed income market participants.

A classic, and fairly dramatic, example where that purported relationship was actually turned on its head in this country was in the '80s. Between 1981 and 1986, the budget deficit tripled in size (to a new record by the then historical standards), while the benchmark 30-year Treasury bond yield collapsed from approximately 15% to 7.5%. The main driving force of yields at the time was the aggressive easing by the Fed, reversing the spectacular tightening that had been put in place at the beginning of the decade to fight runaway inflation. With the Fed easing at a breathtaking pace and inflation falling rapidly, bond yields did not seem to care about the mushrooming budget deficit.

In the late '90s again, when the budget situation switched from a $107 billion deficit in fiscal 1996 to a $236 billion surplus in 2000, the presumed scarcity of Treasury securities did not appear to have any measurable effect on long-term yields, which remained essentially in the vicinity of 6-6.5%.

There is probably no more spectacular case where the purported connection between supply of government securities and bond yields has been challenged "head-on" than Japan. The country has been running enormous budget deficits for more than a decade now, with its cumulative government debt running above 200% of GDP currently (approximately 3 times higher than that of the U.S.). Still, 10-year JGB yields have remained almost consistently within a 1% to 2% range during most of that period.

http://online.wsj.com/article/SB10001424052748704876804574628183234964014.html

In the case of Japan, the answer to the seeming paradox lies in two very important factors: a) the availability of a large domestic pool of savings that sustains a strong demand for government-issued debt, and b) a broadly deflationary environment for most of that period, suggesting that as long as real returns on 10-year JGBs remain within a 1.5% to 2.5% range, domestic investors will remain attracted to such paper at still very low nominal yields.

It is certainly true that differences do exist between Japan and the U.S. in regards to the fiscal dynamics. Although the first of the above two factors related to Japan's case is not applicable in the case of the U.S, the latter factor is a universal principle driving fixed income investment decisions and is likely to be a pivotal one in shaping the direction of Treasury yields over the next couple of years. If the Fed's handling of the exit strategy and the actual behavior of inflation convey a reassuring message in terms of the overall price outlook as the economic recovery gathers momentum, the back-up in yields should be relatively moderate- almost irrespective of the amount of new supply; the unique qualities of liquidity and depth that the U.S. Treasury market possesses should remain attractive in the eyes of foreign investors

To be sure, significant changes in the supply situation can very well influence appreciably market psychology for some time and add to a potential setback that yields could suffer in the midst of an economic recovery that is still likely to show more life than had been generally assumed until a couple of months ago. But supply alone is unlikely to become the defining driving force for any sustainable period of time, if a number of other key elements of the underlying fundamentals continue to make Treasury securities an appealing place to be.

None of the above is meant to imply that large budget deficits do not matter at all, as they continue to increase the reliance of this country on foreign sources of financing, with all of the associated potential (at least, in theory) unpredictability; it furthermore continues to add to the national debt, which, at least on common sense grounds, does represent a disconcerting imbalance. But, supply, per se, has been wildly overestimated as a factor that can determine the direction of Treasury yields for any sustained period of time.

Anthony Karydakis

A Rough Patch for Treasuries: Much Ado About Nothing?

2009-12-29T09:15:00.022-05:00

The moderate rise of long-term Treasury yields since late November seems to have already triggered a flurry of stories in the financial press as to its underlying reasons as well as to whether it represents the first stage of a sustained, cyclical, uptrend in such yields.

As attempts at explaining this development have been pouring in, the most commonly offered explanations offered in recent days for the back-up in 10-year Treasury yields by about 60 basis points to the 3.80-3.90% range during that period are mostly zeroing in on the following factors: 1) The prospect that the economic recovery underway may ignite inflationary pressures down the road, 2) The massive budget deficits projected over the next couple of years, in conjunction with the Treasury's expressly stated plan to shift its new issuance toward longer maturities may ultimately cause the market to choke on supply, 3) The easing of the previous anxiety in global financial markets has led to a an increasing gravitation of foreign investors toward emerging markets, therefore abandoning U.S. Treasuries, which in the midst of the financial storm of the last 1 1/2 year had largely played the traditional role of a safe-haven.

Viewed separately, none of the above factors offer a credible explanation as to the timing of the latest sell off in the Treasury market.

First, on the count of inflation fears creeping back into the Treasury market. Hard to believe that such fears are indeed real. The latest round of inflation numbers have been, if anything, reassuring regarding the price picture. Core CPI was flat in November, having averaged 0.1% in the last two months, wage pressures remain non-existent, the labor market slack is at its highest and, by most indications, inflation (given that it is a famously lagging economic indicator) is widely expected to drift somewhat lower over the next 12 to 18 months, even as the economic recovery is taking hold. Moreover, the Fed is already openly, and methodically, positioning itself to start addressing the anxiety-generating issue of its "exit strategy", adopting a posture that can only be assumed to have a soothing effect on the market. To argue that, somehow, against this decidedly benign price backdrop, the Treasury market was abruptly invaded by intense inflation concerns, defies basic facts and stretches any sense of logic.

Second, in regards to the the presumed supply concerns and dismal budget deficit prospects. Sure, but this is nothing new that was suddenly revealed to market participants at the end of November. Forecasts of massive fiscal deficits have been around for nearly a year now and have not become particularly gloomier of late. Moreover, the end of the Fed's program to purchase $300 billion of Treasury securities (which was clearly viewed as a factor supporting the market) had already ended at the end of September (so, nothing new really) and the Treasury had already announced on November 4th its intention to increase its issuance of long-term debt without any immediate adverse reaction visible at the time. In other words, it does not appear that anything new broke on the supply front around the turn of the month that would justify a fairly substantial back-up in long-tern yields.

Third, the story about a steady increase in global investors' risk appetite-resulting into a massive influx of capital in emerging market economies is hardly a new one; it has been a dominant theme for several months now, with only a" manageable", and rather transient, adverse effect on Treasury yields previously.

Perhaps a better framework for interpreting the latest back-up in yields would require a more practical, down-to-earth, approach that takes into account some simple realities as to how markets function, and which often get brushed aside to make room for more rational-sounding "explanations".

To start with, the latest rise in long-term yields, both in terms of the magnitude of the increase and also the absolute levels reached, was nothing particularly unusual to justify the emergence of any new anxiety about the direction of rates. In fact, 10-year yields touched 4% in June- having risen by 150 basis points since early spring- only to drop again to below 3 1/4% by October. The transparent, and understandable, reason for the much sharper back-up earlier in the year was the realization that the economy was about to emerge from the recession and previous assumptions about the potential deflation risk were quickly downgraded. The subsequent realization that the economic recovery was likely to be of the moderate kind, by historical standards, allowed to a pullback in yields by fall.

What is often missing from attempts to explain the Treasury market's every twist and turn is the very realization that markets are notoriously emotional entities. As such, they often have mood swings that can be triggered by any set of factors, which may have been lurking in the background fairly innocuously for a while suddenly come to the forefront, becoming every one's favorite "reason" for a certain price action. While none of the three "explanations" discussed above in this article make sense in isolation, all put together form the semblance of a rational backdrop against which the latest rise in yields can be viewed. It is also crucial to recognize that the latest sell off took place in the midst of mostly thin, holiday trading, undermining its true significance further.

To be sure, with the economy switching into a solid growth pattern ahead and the Fed on standby to start reversing the exceptionally easy monetary policy at some point over the next six to twelve months, Treasury yields are likely to move on balance somewhat higher in 2010. This would be hardly a ground-breaking development worth endless stories with purported "in-depth" explanations as to its underlying reasons. After all, that is what almost always yields do when the business cycle turns. That rise may be quite a circuitous affair. In fact, when the timing of Fed tightening is viewed as within reach, markets, in true form, are likely to overreact and yields may initially rise violently in the context of a flattening yield curve, while such an overreaction may be subsequently tempered by the realization that inflation is likely to remain firmly under control with the Fed in a highly vigilant posture.

But over-analyzing a fairly "run-of-the-mill" rise in Treasury yields over the last several weeks is probably a case of much ado about nothing...

Anthony Karydakis

A Holiday Gift from The Treasury

2009-12-28T17:58:00.037-05:00

By Scott Tolep

On Christmas Eve, the US Treasury announced that it would provide unlimited capital over the next three years, if necessary, to cover losses suffered by mortgage agencies Fannie Mae and Freddie Mac (previously the limit was set at $200 billion each). The obvious initial reaction here is that the Treasury is issuing a “blank check” to the mortgage agencies and is jeopardizing the future direction and size of the ever-growing public debt. However, there are four compelling reasons to believe that the Treasury’s decision will not increase the public debt and will support the continued stabilization of the housing market and economy:

(1) After December 31, 2009, The Treasury will discontinue its purchases of MBS, which have totaled around $200 billion since the onset of the housing crisis and have kept mortgage rates at historical lows (The Fed has a separate MBS purchase program, set to expire at the end of first quarter 2010, and is expected to reach $1.25 trillion). The Treasury’s and Fed’s purchases have undoubtedly played key roles in keeping mortgage rates low and dramatically improving the housing market. As of October, unsold inventory of both new and existing homes were at their lowest levels in 3 years or more. It appears that the worst of the housing crisis is over, so it is likely that the agencies have already received the bulk of Treasury capital infusions they'll need (~$110 billion).

(2) Psychology plays an important factor in all markets, and the housing market is no exception. Yes, housing and the economy are stabilizing, but this painful cycle is still fresh in the minds (and bank accounts) of investors and lenders. The US will continue to experience periodic setbacks on the heels of this housing-led recession. With the Treasury discontinuing its MBS purchases, market participants are more likely to overreact to these setbacks, with the potential for destabilizing the housing market and economy and sending them back into a tailspin. The Treasury's decision to provide unlimited capital guarantees to the agencies over the next 3 years mitigates this risk.

(3) The Treasury has gained significant credibility after recovering a large percentage of the TARP funds it had injected into the banking system. It was announced earlier this month that $185 of the $245 billion that TARP invested in banks (75% of total) is scheduled to be returned to taxpayers with a profit.

http://news.yahoo.com/s/nm/20091215/bs_nm/us_usa_bailout_treasury.

(4) The Treasury’s decision should not lead to a loss of market discipline or create a “too-big-to-fail” attitude within the Agencies, as they are both currently under government control and underwriting standards are much tougher than they were in the 2005-2007 era.

Of all the US bailout investments, Freddie and Fannie may be the two most important because housing is what drove this recession and it also makes up roughly 30% of the average household net worth. The Treasury’s Christmas Eve announcement was a welcoming holiday gift not only for Fannie and Freddie, but also for the entire US economy.

Taking Advantage of the Low Yields

2009-12-22T17:26:00.045-05:00

The Treasury announced last month that, moving forward, it intends to rely more heavily on the issuance of long-term coupon securities to finance its large budget deficits that are projected over the medium-term. While the Treasury's rationale for that shift was ostensibly to gradually lengthen the average maturity of its debt to levels more consistent with past trends, the unmistakable undercurrent of that decision was that the Treasury is also interested in taking advantage of the historically low levels of long-term yields for purposes of reducing its borrowing costs.

10-Year Treasury Yield

Source: Bloomberg

First, some basic facts:

The Treasury issued $1.7 trillion of securities on a net basis (meaning that total issuance exceeded the amount of securities maturing by that amount) in fiscal year 2009 and expects to borrow a net of $1.5 to $2.0 trillion in the current fiscal year, as the cumulative amount of budget deficits over the next three fiscal years is estimated to be in the area of $3.5 trillion. By all standards, these are staggering numbers.

Since the beginning of the decade, the average maturity of the Treasury's outstanding debt has dropped from about 70 months to approximately 50 months recently, as a result of appreciably heavier reliance on short-term debt issuance over medium- and longer-term maturities for most of that period. The most recent such level represents the lowest since the early '80s.

In announcing that decision, in the context of the quarterly press conference unveiling its broader financing plans, the Treasury went at great lengths to emphasize that the project of lengthening the average maturity of its debt would be implemented very gradually to avoid disrupting market expectations and breaking abruptly with past patterns. Still, a target of reaching an average of 60 months in fiscal 2010 was stated, with an eye on extending it to 84 months over the medium-term, which would represent a historical high.

The Treasury's decision to extend the average maturity of its debt is a sound one, not only on the grounds of prudent borrowing management by spreading out its debt burden over a longer horizon but also on the count of reducing its borrowing costs over time. The latter rationale has generally been a sensitive issue for the Treasury over the years, as it has always maintained that it is not in the business of attempting to "time the market" by adopting views on the future direction of interest rates- an overall sensible approach for a government.

Still, taking advantage, in a measured way, of the unusually low levels of long-term yields (courtesy of a severe financial crisis and associated economic recession) to implement a solid debt management principle of better balancing the ratio of short- to long-term outstanding debt makes perfect sense. Inasmuch as the Treasury wants, understandably, to stay clear of the hazardous enterprise of predicting interest rates, ignoring completely a historical opportunity that would allow it to materially reduce its interest costs on a mushrooming debt over the medium-term would be almost tantamount to malpractice.

Anthony Karydakis

The Undervalued Yuan: And Then There Was Silence

2009-12-17T16:47:00.015-05:00

In the early part of the decade, it was a routine occurrence for both U.S. administration officials and politicians in Congress to criticize China's longstanding practice of keeping its currency undervalued by way of pegging it to the dollar. In July 2005, China officially de-linked the yuan from the dollar and let it appreciate by about 20% in the next three years to about 6.83 from approximately 8.3 previously. Still, since July 2008, the yuan has, for all intents and purposes, been tied to the dollar again and remained steady around 6.83. As the dollar has lost approximately 10% of its value on a trade-weighted basis since early March of this year, the yuan has also loyally followed the dollar in its slide.

Still, these days, no loud voices are raised among U.S. officials about the overt manipulation of the currency of a country that continues to run a massive trade surplus. In fact, Congress seems to have decidedly backtracked from its drive of a few years ago to put pressure on the Administration to brand China as a currency manipulator. Instead, it appears that it is increasingly the Europeans that are now taking the lead in putting pressure on China to let the yuan appreciate in accordance with its strong underlying fundamentals.

In a trip to Beijing earlier this month, a group of senior EU officials, which included the ECB President, made strongly the case to the Chinese leadership that it is beneficial for both China and the rest of the global economy to let the yuan strengthen. That was the second time in the last two years that EU officials have tried, publicly- and, presumably, in private as well- to exert pressure on China's top leadership to allow for a more realistic realignment of the yuan vis-a-vis other major currencies.

http://online.wsj.com/article/SB125927149669965449.html#printMode

The euro area's concern over the strengthening of its own currency against the U.S. dollar this year has been frequently, and unmistakably, communicated by the ECB President in the last couple of months, as it has been identified as a headwind for the region's fledgling economic recovery. The fact that the euro is at the same time strengthening by a proportionate amount against the yuan as well, obviously compounds those concerns.

The issue for the euro zone's uneasiness over the undervalued yuan in this phase of the cycle is probably less driven by the more narrow issue of the loss of price competitiveness of its exports to China itself, as its trade volume with that country represents only a modest percentage of the region's total exports. Moreover, the euro area's combined export sector is only about 15% of the total GDP of the 16 countries involved, which suggests that, inasmuch as it would certainly be beneficial for the euro area's tenuous recovery to get the most contribution from every possible component of its GDP, exports will probably not be the defining force for the prospects of that recovery.

The true reasons for Europe's anxiety over the strengthening of the euro against both the dollar and the yuan are related to concerns that a) a period of prolonged strength of the first may undermine the long-term competitiveness of the euro-zone's export-oriented manufacturing sector, which represents close to 20% of its total output, and, b) it may hurt somewhat disproportionately the prospects of Germany's economic recovery in particular, given that country's heavy reliance on exports (accounting for close to half of its GDP, including exports to other euro-zone countries). Germany is of course the pivotal economy for the entire euro area.

In comparing the silence of the U.S. recently toward the artificially undervalued yuan, one cannot avoid thinking that the growing dependence on the Chinese as a major investor in U.S. Treasury securities in an environment of skyrocketing budget deficits has been a factor in taming such voices of protest. This willingness to cultivate a close relationship with a reliable creditor-nation was evident earlier in the year when China's leaders requested assurances from the U.S. President that the country's debt will not be downgraded in view of the massive new issuance of securities; not too long afterwards, Obama did oblige, offering such reassurances in public.

While it is true that the sheer size of China's foreign official reserves also leave that country with few good alternatives to the U.S. Treasury market (which offers a unique degree of liquidity and depth that are of critical importance to any major investor on such scale), it is also true that it would be a particularly destabilizing development that could roil global investors and the U.S. Treasury securities market specifically, to see the two countries relations becoming strained in public over any overt criticism of China's currency manipulation practices.

It is undoubtedly that same need to sustain a seemingly cooperative and fairly harmonious relationship with China on the economic front that has also led the U.S. in recent years scale back dramatically, to the point of non-existence, its previous repeated criticism of that country's human rights record. Not much is heard these days about that either and it is not because of any signficant improvement of that record in the last few years..

At the same time, the Europeans, that are not particularly prone to grandstanding on human rights rhetoric around the world (preferring, instead, to adopt more pragmatic positions and solutions) and are also free of any dependence on China's debt financing prowess, now seem to be the only ones with room to continue pressuring the Chinese on the thorny issue of the undervalued yuan.

Anthony Karydakis

A certain Senator from Connecticut

2009-12-15T19:51:00.024-05:00

It is hard to turn on the TV or pick up a somewhat legitimate newspaper in the last 48 hours without coming face-to-face with the vaguely sinister grin of a certain Senator from Connecticut, who is at the epicenter of the entire health care reform bill under debate in Congress. The grin is of the "I know I hold all the cards and with a snap of my fingers I can decide whether the whole health care agenda lives or dies" kind.

This Senator is an unsuccessful Vice Presidential candidate in 2000, a miserably failed presidential candidate in 2004, and a defeated candidate in the primary contest of the Democratic party for re-election in the Senate in 2006. An experienced psychologist would be inclined to meticulously trace the origins of that grin to a massive pent-up resentment from all of these three races over the last nine years.

That grin, and its associated hard-nosed obstructionist and uncompromising attitude, is also linked to the fact that he also happens to be the second largest recipient of insurance industry contributions, having received more than 1 million dollars since 1998, according to today's New York Times. Resentment plus the serious need to earn his pay from the "all-too-kind" to him insurance lobby make for a potent motivation to drive a mean, "I now take my revenge on everyone who has repudiated me over the years" type of bargain with the Democratic majority in the Senate.

But, this particular Senator does actually have the whole world at his feet right now and he relishes that immensely. He holds even the current version of a watered-down, meek health care reform project, hostage to his whims.

It is not a classic reflection of the sad state of politics in this country.

It is simply sad.

Anthony Karydakis

As Lending Continues to Shrink...

2009-12-13T20:43:00.024-05:00

Bank lending continued to decline in the most recent period for which data are available, that is the July to September quarter. Loan balances were off by 3%, which represents the biggest quarterly decline since such data started being reported in 1984. Large banks, which have been the primary recipients of the bailout funds, accounted for 75% of that decline.

http://online.wsj.com/article/SB125907631604662501.html#printMode

This is hardly surprising, in view of extensive anecdotal evidence and repeated qualitative assessments of credit conditions by the FOMC in its most recent statements as "tight". Still, there are a couple of intriguing points that spring out of this continuing trend.

1) Until earlier in the year, with the economy marred in a debilitating recession and with both household as well as capital spending in a major retreat, it was hard to disentangle the degree to which the distinctly weak lending patterns reflected the dire state of the banking system from the naturally weak demand for lending during such a period. But with personal spending rising by healthy 2.9% annual rate in Q3 and private fixed investment turning modestly positive (capital spending itself was off again- albeit by the smallest amount since Q2 2008), it is now clear that the significant turnaround of economic conditions in Q3 was not associated with an increased willingness of banks to lend more. In other words, the reluctance of banks to lend remains deeply entrenched even in the face of a presumed improvement in the demand for credit.

2) The above suggests that the sharp pick-up in consumer spending is being financed either by the increased in household wealth resulting from the stock market rally or by a decrease in the savings rate. Although the latter was not evident yet in the October data (the rate was off only by an inconsequential 0.2% to 4.4% in that month, which represents the most recently reported figure for that series), a strong likelihood exists that the improvement in personal consumption will be increasingly relying on a decline in the saving rate.

This would shatter the expectations in some quarters that the traumatic experience of the latest recession may be leading to a new paradigm in the U.S. economy, where consumers save a higher percentage of their current income. With bank lending activity unlikely to return to normal levels for some time, employment and income growth on track for only a gradual pace improvement ahead, and pent-up household demand waiting to be fullfilled, a downtrend in the saving rate over the next 9 to 12 months remains a distinct probability.

Anthony Karydakis

A Propos Greece's Troubles

2009-12-10T17:00:00.033-05:00

The precarious shape a number of euro-zone economies have found themselves in recently has dominated financial market headlines in the last few days. Ireland, Spain, and Greece seem to have joined other "second-tier" European countries, like Latvia and Hungary, in experiencing widespread loss of confidence in the quality of their sovereign debt. The draconian measures to address the budget gap that the Irish government announced yesterday have received an initially positive response but uneasiness over their effectiveness remains high.

http://online.wsj.com/article/SB126039835690184387.html

http://online.wsj.com/article/SB10001424052748704825504574586410597112166.html

At the core of the attention-getting developments of the last few days is the massive budget deficits and total amount of debt that these countries have accumulated, mostly, but not exclusively, due to the financial crisis and global economic downturn of the last two years. Although, it is actually unlikely that a euro-zone country, like Greece (which is facing the most serious problems) will be allowed by the EU to default on its debt- with Angela Merkel reminding investors as much earlier today-credit default swaps have soared.

A few thoughts.

a) The reassurance offered by the powers-that-be in the euro-system about offering help to its members currently in trouble is obviously a positive development, but it may not be enough to resolve the issue. Greece is already resisting EU pressure to implement any major belt-tightening measures of its own as politically untenable and offers only promises of bringing its budget deficit from 12.7% of GDP this year to about 10% next year. That is likely to be viewed as a frustratingly slow pace to many. Against such obstinacy, it may not be too far down the line, where massive bets against the country's ability to contain its debt burden start being placed by global macro hedge funds- not totally unlike those that were already pushing Iceland (a non-euro zone country) against the wall as the financial crisis was erupting in 2008. (In fact the second of the above links describes exactly those emerging strategies by some). This would represent a major complication for any bail-out efforts by the EU.

2) Directly linked to the above point, the problems that Greece and Spain are facing- and, possibly, Ireland, Italy, and Portugal to various degrees- are not solely the result of the size of their budget deficits per se but more of the lack of credibility that those countries have in the eyes of global investors in terms of their determination to bring them under control. For example, Germany's budget deficit is surpassing 6% of GDP this year but Germany's sovereign debt still carries some of the lowest rates in the euro area and credit default swaps on such debt have not budged. Nobody questions Germany's commitment to reining in the deficit as economic growth picks up into next year. Of course, another key differentiating factor is the total amount of debt of the various countries involved, with Greece's exceeding 125% of its GDP, while other healthier euro-zone economies are only moderately exceeding the 60% cap mandated by the "growth and stability" pact.

3) In a way, the current predicament of the three main countries in trouble currently represents the moment of reckoning for reckless and short-sighted policies earlier in the decade, mostly driven by a goal of creating an aura of unusual prosperity largely built on sand (Ireland, Greece). The financial crisis and associated economic downturn simply helped expose the underlying fault lines of such growth.

4) Finally, it is tempting to highlight that there has been a reversal of past patterns and prevailing stereotypes as to the resiliency that different economies around the world demonstrate in the face of global financial market events of extreme stress. While emerging market economies used to be considered "high-risk" in such situations- and there is admittedly a long history of defaults on their debt to support that perception- it has been exactly those economies that have weathered best the financial turmoil of the last two years. Even Argentina, a serial offender in terms of defaulting on its debt in the last 30 years, is taking positive steps opening up its access to international capital markets again, by announcing today a decision to swap out of $20 billion of defaulted debt.

http://www.bloomberg.com/apps/news?pid=20670001&sid=awfZbkXg6Kvo

It is now, countries in the heart of Europe that are facing a particularly bleak predicament that represents a significant challenge for the cohesiveness of the euro system and testing the limits of patience of global investors.

All in all, another strong reminder, following Dubai's recent problems, that, although the global financial crisis has been by and large successfully contained, pockets of extreme fragility have been left behind and are not likely to disappear any time soon.

Anthony Karydakis

No Deflation Ahead

2009-12-08T17:01:00.021-05:00

A number of influential, and legitimate, voices- including the Fed Chairman and PIMCO- have been raised recently to the effect that they expect the pace of the U.S. economic recovery to be a very moderate one. Although, the term "moderate" is a qualitative one and is probably used by Bernanke and PIMCO having different numbers attached to it, most of those who subscribe to that view are also calling for inflation to continue drifting lower over the next year or two, with some actually raising the specter of deflation as a result (see also a previous post titled "PIMCO's Bet").

Given that inflation is a lagging indicator and there is a considerable amount of inertia associated with its behavior, anticipating a further downward drift in the pace of price increases over the next year (particularly in regards to core inflation) is reasonable; promoting the view though that deflation is a plausible risk in the context of an unfolding expansionary period begs some further explanation.

Irrespective of such diverse views on the price outlook however, a down-to-the-earth look at some key measures of inflation expectations reveals an entirely different view.

After collapsing in the fall of 2008, overwhelmed by pervasive fears of a banking system disaster and a major, depression-like, economic downturn, TIPS break-evens (the spread between nominal Treasury yields and the yield on Treasury inflation-protection securities, which implies the expected rate of inflation over the investment period) have been widening steadily since the beginning of the year. This reflects underlying expectations that the overall CPI is likely to be returning to its recent historical averages of about 2%-2.5%, in the years ahead. In fact, both the 5- and 10-year break-evens currently stand very close to their levels prior to the Lehman episode in September 2008 (see below).

5-year TIPS Break-evens

Source: Bloomberg

10-year TIPS Break-evens

Source: Bloomberg

Simply put, the restoration of these spreads to pre-crisis levels, reflects the belief that the worst of the banking crisis is behind us and that the economy is recovering at a sufficient pace (irrespective of what specific number, or additional qualitative adjective, is attached to it) to ensure the gradual return of inflation to trend. As one would have expected the implied rate of inflation expectations over the 5-year horizon is somewhat lower than the one over the 10-year horizon, as the weight of 2010 (when inflation should remain especially weak) is obviously greater in a 5-year period as opposed to a 10-year one.

Another, fairly closely watched but admittedly "soft", gauge of inflation expectations is the "5- to 10-year inflation expectations" component of the University of Michigan Consumer Sentiment Survey, which continues to hover around the 3% mark in recent months. This is somewhat higher than the anticipated rate of inflation reflected in the TIPS break-evens, which is to be expected, as consumers' perception of inflation is typically associated with a higher number than the one officially measured by the CPI. On that score, it is worth recognizing that even the "short-tern inflation expectations" component of the University of Michigan survey (representing a 1-year horizon) is also anchored just below 3%.

Somewhat unscientific as these consumer inflation expectations measures may be, they still corroborate the financial market's fairly more rigorous perceptions of the price outlook and they certainly betray no uneasiness over any prospect of deflation, which, at the margin, could make the latter a self-fulfilling prophecy of sorts.

Deflation, as a trend and not as a short-lived quirk of year-on-year comparison in the various price statistics, is a phenomenon very hard to come by and Japan is the only major industrialized country to have experienced it in recent history- largely as a result of a double meltdown in its stock markets and banking system in the 90s and a notoriously slow policy response to address it. But both of these two potentially extremely destabilizing dynamics seem to have been contained in the U.S. at the present and, as a result, have convincingly pushed the risk of deflation to the sidelines.

Further disinflation is a plausible outcome in the foreseeable future, but much to the likely disappointment of the merchants of doom, deflation is not.

Anthony Karydakis

The Employment Picture Brightens Up Suddenly, In a Major Way

2009-12-04T10:21:00.010-05:00

Labor market conditions continue to improve at a fast clip and the November employment report provided strong confirmation of that trend. This conclusion is not based on the decline in the unemployment rate to 10.0% from 10.2% (a nearly inevitable correction from a curiously sharp jump of the rate in October) but on a consistent message from just about every major aspect of the data.

It is not only that November's decline in payrolls was a mere 11,000 but, even perhaps even more importantly, there was a massive net cumulative upward revision of 159,000 in the payroll data for the prior two months. The result is a dramatically different profile of recent payroll trends, showing a faster improvement than previously thought. Payroll declines in the last 3 months have averaged 87,000 a month versus average declines of 307,000 in the preceding 3-month period and -491,000 in the 3-month period prior to that.

Source: Bureau of Labor Statistics

Adding impetus to the impressive strength of the report- compared to the relatively recent past- the average workweek rose to 33.2 hours from its cycle-low of 33.0 hours. Any moderate sustained rise in the workweek is usually viewed as a precursor of more hiring down the line, as there are limits as to how intensively employers can utilize their existing labor force before adding to it. The manufacturing workweek also jumped by 0.3 hours to 40.4, supporting evidence of a significant turnaround in that sector, as manifested by the ISM and other manufacturing surveys in recent months.

Both construction and manufacturing employment fell last month, by 27,000 and 41,000 respectively, but these are two sectors unlikely to become significant sources of job creation in the foreseeable future, as construction is likely to remain in deep freeze for some time and the bulk of increased output in manufacturing recently comes from a rise in productivity. It is also a sign of the ongoing caution that employers are still exercising in terms of hiring that temporary jobs rose by 57,000 in November and have increased by a total 117,000 since July.

However, all of the still present pockets of weakness in the payroll data need to be understood in the context of the dynamic that prevails around turning points of the cycle- meaning that not all sectors will be showing the same measure of improvement simultaneously and this is likely to be particularly true this time in view of the severity of the last recession and the major dislocations it has caused.

With the pace of layoffs slowing precipitously in the last several weeks, as measured by a strong downtrend in initial unemployment claims, monthly payroll data are poised to start turning positive in the coming months. In fact, the most reasonable expectation at this point is that by early next year, we will start seeing modest to moderate monthly gains, while the unemployment rate may continue to linger around its cycle-highs. But today's report, along with the totality of the other pieces of economic data recently, suggests that the impetus that this economic recovery is having may have been seriously underestimated.

Anthony Karydakis