For Job Growth to Return, More Hiring Not Necessary

Initial unemployment claims continue to drift lower, declining by 12,000 in the latest week to 502,000- their lowest level since January. Although weekly claims are a notoriously noisy indicator, the "smoother" 4-week average version of the series leaves no doubt about a solid downtrend being underway, which helps cast the underlying dynamic of labor market conditions under a more positive light than the recent headlines that focused on the cycle-high unemployment rate of 10.2%.

The steady downtrend in the claims data since a peak of about 670,000 in the first quarter to around 500,000 currently simply reflects a very significant cooling in layoffs. While the ongoing declines in the monthly nonfarm payroll data are somewhat disappointing, there is a key element that is often not properly recognized in the interpretation of the various labor market indicators as offered in the press.

Source: Bloomberg, Haver Analytics

The emphasis seems to remain recently on the reported reluctance of employers to step up their hiring plans in the near future. As a result, the superficial conclusion that is drawn is that, as long as that pattern persists, we are unlikely to see actual job growth in the monthly payroll figures, This represents a misconception of what the payroll numbers are about, which is essentially the net of the total number of people hired in the course of the month minus the total number of people laid off. Even if, for the argument's sake, the total number of people hired does not increase for a while, if the number of people laid off continues to decline (which is what the initial unemployment claims data are reflecting), then the payroll numbers can still become positive- showing, on the face of it, job growth again. In other words, all we need is for layoffs not to exceed hiring.

With the downtrend in claims seemingly intact, and the monthly payroll declines recently averaging only about 25% of the magnitude of those declines in the first quarter, then we are steadily approaching the point where actual jobs growth will manifest itself in the monthly data- without the need for employers to actually increase their hiring.

Given the recent broader trends in both claims and payrolls, we are probably on track to start seeing positive numbers for the latter series in the first quarter of 2010.

Anthony Karydakis

The Challenge With the Fed's Balance Sheet

The bloated size of the Fed's balance sheet in the post-Lehman period has become the subject of concerns of varying intensity, as it represents a potential inflation flashpoint when the economic recovery starts gaining traction. The dramatic increase in the Fed's balance sheet is, of course, the direct result of the unprecedented amount of liquidity that needed to be injected into the banking system in order to prevent a complete meltdown of the financial structure since September 2008.

The injection of that liquidity has been delivered via a combination of a number of special lending facilities and outright purchases of different kinds of securities. While in the early phase of such liquidity injections, the vehicle of choice was mostly the array of special lending facilities established by the Fed late last year and early 2009, in the last seven months or so, the mix has shifted heavily away from such programs and in favor of outright purchases of securities. As of November 4, 2009, approximately 75% of the Fed's total balance sheet consisted of securities held outright (vs. about 1/3 in March), while the remaining 25% consisted of the various special liquidity facilities.







The downtrend in the size of the Fed's special liquidity facilities reflects the easing of the most acute phase of the seizing up of credit market conditions late last year, and, therefore, the quiet winding down of programs like the TAF (Term Auction Facility), the Primary Dealer Credit Facility, the Commercial Paper Funding Facility, etc. However, this trend has been fully offset by the Fed;s stepping up of two key programs of purchasing securities outright: $300 billion of Treasuries (the program was just completed at the end of October), and the still ongoing massive program to purchase a total of $1.25 trillion of agency mortgage-backed securities and $175 billion of agency debt (both of which are expected to be completed by the end of the first quarter of 2010). The net result of that shift among the Fed's various programs has had no discernible effect on the total size of the central bank's balance sheet, which actually remains in the vicinity of $2.2 trillion- essentially close to its peak reached since the fourth quarter of 2008.

The gradual winding down of the special liquidity facilities can, on the face of it, be viewed as a positive development, reflecting the relative restoration of normalcy in credit market conditions. However, this is the easier part of the Fed's challenge ahead to ultimately withdraw the massive amount of liquidity injected into the financial system during the peak of the crisis. The tougher part of the Fed's job is still ahead, which remains the eventual unwinding of a portfolio of holdings consisting, to a very considerable degree, of mortgage-backed and other non-Treasury securities.

With the mortgage-backed securities market still scarred by its near-apocalyptic experience of the last two years, the Fed's hands are tied in terms of its ability to resell those securities back into the market any time soon. So, the stage is set for the Fed to remain the proud owner of well over a trillion of low-quality securities over an extended period, mostly counting on the slow runoff of these holdings over a multi-year horizon.

As a result, when the time comes for the Fed to move decisively to start draining the excess liquidity, actively dumping its bloated portfolio of outright holding is unlikely to be a viable component of its exit strategy. Instead, in implementing the latter, the emphasis will need to be more on both conventional (reverse Repurchase Agreements) and more recently introduced tools (interest paid on bank reserves).

Anthony Karydakis

And Now, the Dollar Carry Trade

The popularity of the yen carry trade since the mid-90s has waxed and waned and has defied several times premature proclamations of its demise. It has been linked to the development of market bubbles around the world, including the Asian financial crisis in 1997 and the global stock market rally in the late 90s.

For a good part of the last 15 years, the trade has been the darling of the hedge fund community, allowing investors and speculators to borrow in yen at the practically zero Japanese short-terms rates and then convert such borrowing into investments in other countries that were offering an appreciably higher rate of return. By doing so, they were, naturally, exposed to the risk associated with the country they were invested in as well as to the risk that the yen would appreciate sharply by the time they had to repay back the original loan. Still, the yen carry trade was offering lucrative rewards that were vastly overshadowing its implied risks, and this helps explain its remarkable longevity as the financing tool of choice for both speculation and more legitimate investment around the globe.

Predictably enough, there was a massive unwinding of such yen carry trades in response to the financial crisis set off by the Lehman affair last year, as emerging market economies were viewed as particularly vulnerable to the unusual intensity of the turmoil sweeping global finance. In recent months though, as emerging markets have largely defied those dire expectations and are increasingly coming out of the crisis, if anything, in better shape than most industrialized economies, the lessening of the earlier anxiety over their resilience has led to an impressive revival of the carry trade. The only difference is that the yen has now been joined by a very powerful partner that threatens to take the lead in that game: the U.S. dollar.

The dollar's joining of the global carry trade is the direct, and natural, result of the near-zero short-term rates in the U.S. since December 2008; in a way, it was almost an inevitable outcome. After some initial hesitation to assess the likely duration of the Fed's zero interest rate policy, global financial market participants have, in recent months, felt increasingly confident that the record low short-term rates in the U.S. are not likely to be reversed any time soon- an expectation that the Fed continues to nurture in its public pronouncements.

Having the currencies of the two major economies in the world (a somewhat qualified statement, as Japan is likely to be surpassed by China as the #2 economy by early 2010) becoming the vehicles for a global carry trade has some very potent implications. A record amount of foreign capital has been coming into emerging market economies in the last couple of quarters, fueling not only major stock market and commodity rallies but also classic speculative bubbles in real estate markets and other assets. (http://online.wsj.com/article/SB125729703390626817.html)

In a somewhat ironic twist of events, it is precisely the very fact that the financial system in the major industrial countries suffered major damage in the midst of the crisis in the last eighteen months, that set the stage (via the zero short-term rates that it created in the U.S.) for the latest round of speculative bubbles already springing up around the world now. This dynamic, if it gathers more steam in the coming months (and, given that it involves a number of the Pacific Rim countries), may soon resemble the period leading up to the Asian financial crisis in 1997, which ended famously not so well.

Few emerging market countries have the luxury of taking measures to actually restrict such massive capital inflows, as they rely heavily on such flows to resume the faster growth rates they desperately need to continue lifting the living standards of large parts of their population. That is why it is an impressive testament to Brazil's solid position as an increasingly emerging economic global powerhouse that, last month, it imposed a 2% tax on capital inflows. This was a first, measured, act to stem the unfettered streaming of "hot-money" in to the country, that could plant the seeds of destabilization of one of the most successful economies in the world today.

The emergence of the dollar carry trade, which has clearly played its role in the weakening of the dollar since the first quarter of the year, and its already observable implications in a number of countries, creates another source from which the next pop in global financial markets may come. The risk for the latter will become more palpable when the time comes for the Fed to start reversing its near zero short-term rate policy.

Anthony Karydakis

October Employment Data: Disappointing But Not Uniformly Bad

Although the spike in the unemployment rate to 10.2% is attracting most of the attention because of its presumed psychological implication, the rest of the employment data for October paints a somewhat more complex picture of the labor market.

As we have emphasized repeatedly in this space, despite its high visibility as a barometer of labor market conditions, the unemployment rate is a lagging indicator and typically tends to drift higher in the early stage of an economic recovery (and, as such, it is not a useful gauge for detecting relatively changes in labor market conditions around turning points in the cycle). The reason for that seeming paradox is that the rate tends to move higher due to an expansion of the civilian labor force as a result of previously discouraged workers that return to it when the economic environment starts improving. Still, in October, the spike in the unemployment rate was not caused by an increase in the size of the labor force but by a huge decline (-589,000) in household employment. (This is a survey completely separate from the establishment survey that produces the nonfarm payroll data).

What is becoming an increasingly curious pattern here is that there is a very big gap that has opened up between the household employment data and the payroll data, as the former have declined by a total of 1.77 million in the last three months alone versus a total decline of "only" 563,000 in payroll employment during the same period. Such gaps between the two surveys are not totally unheard of over a number of a few months but, ultimately, that gap will need to narrow moving forward. Given that the improving trend in payrolls has been well established by now and is unlikely to be reversed suddenly (despite the fact that they are still turning out monthly declines), the most likely outcome is that the gap will diminish with household employment improving somewhat and the unemployment rate dipping in the next couple of months.

In fact, the payroll trend continues to improve, as the 190,000 decline in October was accompanied by a 91,000 net upward revision to the previous two months. This brings the average decline in payrolls in the most recent 3-month period to 188,000 versus 357,000 in the prior three months and 690,000 in the first quarter of the year. In other words, things are getting steadily, and appreciably, better on the labor market front, but not fast enough to project a confident turnaround of the employment picture.

One element that was relatively disappointing in today's data was that the average workweek remained at its cycle-low of 33.0 hours. Normally, an upward drift in the workweek (despite its heavily choppy pattern on a month-to-month basis) is supposed to precede a pick up in hiring patterns, as companies tend to utilize their existing labor force more intensely first (when the economic environment starts improving) before they hire more workers.

All in all, despite the eye-catching pop in the unemployment rate, the employment report did little to challenge the premise that an economic recovery is slowly getting underway but it did reinforce the view that this recovery will be of the moderate variety for some time.

Anthony Karydakis

Three Fed Officials to Watch

As the economic recovery slowly starts gaining some credibility, the financial markets' favorite guessing game is poised to become the timing of when the Fed will start tightening policy. Although some dialing down of a number of the emergency liquidity programs has already been occurring quietly in the last few months, the prospect of a rate hike and aggressive draining of reserves from the banking system would understandably represent a more decisive stage of the tightening process, and, as such, raise a higher level of anxiety among market participants. It was in that context that the New York Fed felt compelled to issue an unusual clarification last month to the effect that although they are already examining closely the mechanics of how the draining of liquidity will be achieved when the time comes, this should not be interpreted as suggesting that any decision has been made as to when this might happen.

Against that backdrop, statements made by various Fed officials in the next couple of months will be scrutinized closely for any hints of an upcoming change in monetary policy. Given the financial markets' notorious propensity for overreaction to just about anything, it is quite possible that some of these statements, while expressing, in many cases, simply the personal views of the FOMC member, will be misconstrued as a hidden message to the markets and can cause an undeserving degree of noise.

It is fair to argue though that, inasmuch as all voting FOMC members are technically equal, some members are more equal than others and their views carry a significant amount of weight in terms of providing hints about the likely inflection point in interest rate policy. Other members' views are immensely less important in that regard, as they often express personal biases that may not be shared by the majority within the Committee.

At the top of the list of Fed officials whose views really matter is obviously Ben Bernanke himself. His comments, as always, deserve a close degree of scrutiny in the period ahead, as he is certainly in a position to steer a number of other FOMC members that may have less strong conviction on the issue to his camp of thinking. He also has more high profile opportunities than any other Fed official to express any subtle changes in his thinking regarding the assessment of the economic recovery and the need (or, lack of thereof) to maintain the near-zero interest rate policy of the last 11 months.

The other two Fed officials that should be presumed as expressing the mainstream Fed view on policy are Vice Chairman Don Kohn and New York Fed President Bill Dudley. Don Kohn is an old hand at the Fed, a true product of the system and his views tend to adhere very closely to the "official" view at the institution (which should be taken as including Ben Bernanke's as well). Given his role as a semi-official statesman within the Federal Reserve System, he often feels subconsciously restrained to avoid veering far from the Chairman's official thinking. Although, prior to his appointment as Vice Chairman at the Fed, he had expressed views strongly skeptical of the concept of inflation targeting (which Bernanke was openly advocating), there have been no instances in the last three years or so where he has deviated from the Fed "party line".

Given the special role that the New York Fed occupies within the Federal Reserve System, its President has historically been viewed as always closely aligned with the Chairman of the Fed and Bill Dudley is no exception. He has loyally preserved that tradition since his appointment in that position in January of this year and in his public speeches, he always offers an eloquent and unapologetic defense of official Fed policy, using arguments that are often identical to those that Bernanke is making in his own appearances.

In the search for early hints that things in the Fed's thinking are starting to change, markets would be well served if they focused more on comments made by those three key Fed officials only and view the true significance of any comments made by other regional Fed Reserve Bank Presidents with extreme caution. In recent years, the latter have caused, all too often, a lot of commotion for their purported significance regarding Fed policy, while in the end they have turned out to mean not much at all. Regional Fed Presidents are independent thinkers and are obviously entitled to expressing their own views in their public appearances. But when the time for a vote at an FOMC meeting comes, there is usually only token dissent (1 or 2 votes), as they tend to fall in line with the majority represented by the Chairman, and always, the President of the New York Fed.

Anthony Karydakis

The Trouble With Complaining About the Budget Deficit

Let's start with an indisputable fact. The U.S. budget deficit recently reached near-stratospheric levels, representing (at $1.42 trillion in fiscal year 2009), approximately 10% of GDP. This is about 3 times higher the rate that is generally considered as acceptable, or manageable, among the industrialized economies. The natural implication of that is that there needs to be an extremely high degree of awareness about the need for the deficit to come down in the next few years. No sane person would object to any of that so far.

But, judging by opinion polls in the last few months- meant to evaluate the degree of approval that President Obama enjoys with the American public- it appears that one of the main consistent criticisms leveled at his job performance so far is that he is doing a poor job at handling the fiscal situation. That is where things seem to get dangerously off the path of both reality and rationality- no doubt due to a poor understanding by the broader public of the factors that shape the fiscal picture of the country.

To begin with, the new Administration cannot be held responsible for the fiscal 2009 deficit, as this was based on a budget that had already been set by the Bush Administration and the fiscal year was already one third underway when Obama took office in late January.

The reason for the explosion of the budget deficit in the last fiscal year was the combined result of two factors that had nothing to do with the new President: the meltdown of the financial system with its associated bank bailouts and an unusually deep and prolonged recession. The first of the two represents very simply the cost of cleaning up after the banking crisis (which had was already underway some five months before Obama even took office), while the second reflects the massive loss of tax revenue and increase in certain types of government spending that are always associated with an economic downturn and higher unemployment.

So, now we have established -and there is probably very little quarrel with that outside the Fox News Channel's "commentators"- that the Obama Administration did not at least cause the skyrocketing deficit. Let's take a closer look at the repeatedly expressed "concerns" of the American public that the Administration is not doing enough to control the deficits.

There are two types of action that the Administration can take to actively seek the reduction of the deficit: cut spending or increase taxes. Increasing taxes in the midst of a severe recession is simply a catastrophic action, as it would have weakened much further an already plunging pace of consumer spending, therefore throwing the economy into an even more pronounced downward spiral. Cutting spending on programs, like the federally-funded, multiple extensions of unemployment benefits, would not only increase immensely the economic hardship of millions of Americans but would have also, from the strictly macroeconomic standpoint, allowed income growth to suffer more severe damage (which would have contributed to a further deepening of the recession).

One finds it almost irresistible to ask those who state that one of their main concerns about the direction of the country is the administration's poor handling of the fiscal deficit, whether they would have preferred a sharp increase in their taxes and shorter unemployment benefits when they lose their job, so that the new President shows a tougher stance on tackling the deficit. Or, whether, they would have preferred less spending on the various government assistance programs designed to prop up the economy in their own state, like construction projects and the like. When confronted with these options for dealing with the deficit problem more aggressively, perhaps they might (but, then again...they might not) recognize how ill-informed and misguided their criticism of the fiscal situation and those they consider responsible for it is.

The deficit is bound to come down appreciably in the current fiscal year- perhaps close to $1 trillion- as a direct result of the improvement in economic activity and the ensuing pick up in tax revenues. Left to its own devices, it should continue to move lower in fiscal year 2011, as the economic recovery gathers momentum. This is the way things always work with regard to the part of the budget deficit that has been affected by the down phase of the business cycle ("cyclical deficit").

In fiscal 2010, in particular, there is still a moderate headwind toward any further shrinking of the deficit coming from the remainder of the fiscal stimulus package coming on line, but ultimately, the deficit will be trending lower in the next few years. Whether such a downtrend will come soon enough on its own to return it to the 3.0% range by 2013, as Obama has promised, or whether more "pro-active" steps will be needed, that remains to be seen. For the time being, though, as Tim Geithner sensibly put it in an interview today (link below)

(http://money.cnn.com/2009/11/01/news/economy/Geithner_economy.cnnw/?postversion=2009110111)

the deficit can wait, as the undiluted emphasis should remain on securing that the emerging economic recovery will acquire a self-sustaining dynamic soon.

Anthony Karydakis

Third Quarter GDP: Cautious Optimism

The third quarter real GDP report that showed an annualized rate of growth of 3.5% has been widely described so far as "stronger-than-expected" and confirming that the recession is indeed over.

The first such assessment is of relatively limited material value (as today's number was only an advance estimate which is is almost always revised, at times appreciably, in the two subsequent months), while the second simply makes something that had already become pretty evident, simply even more so.

The true importance though in the Q3 GDP data lies in their composition, which shows a number of elements coming together to provide some reason for optimism.

It is the combination of a 3.4% rebound in personal spending, a much slower pace of inventory liquidation (making inventories a net contributor to Q3 GDP by 0.9 percentage points), a modest 1.1% gain in residential construction, and a 2.3% increase in government spending that give a preview of an economic recovery with the potential to gain traction in the next couple of quarters. Sure, personal consumption was boosted by a surge in spending on durables ("cash-for-clunkers"), and the gain in government spending reflects the fiscal stimulus program still very much in the pipeline. But somewhat artificial as these two sources of vigor in Q3 may seem, those programs were originally designed precisely to ignite the first sparks of a self-sustaining expansionary dynamic- and they seem to be playing that role well for the time being. That conclusion is reinforced by the fact that the "cash-for-clunkers" program continued to drive inventory levels lower last quarter, therefore setting the stage for a pick up in auto production in the next few quarters.

Even capital spending that had posted alarmingly steep declines in the previous three quarters (-19.5% in Q4 2008, -39.2% in Q1, and -9.6% in Q2), fell by only 2.5%, suggesting that the earlier retrenchment has probably already run its course.

As we have argued before, the various components of GDP and overall pattern of growth can be somewhat muddled around the inflection point of the cycle and this is likely to be validated again in the current quarter, where the unwinding of the "cash-for-clunkers" program could cause personal spending to be flat or even negative. Some of that will be offset by an even stronger contribution to growth from inventories and a small pick up in capital spending.

At this early point, a 2.0-2.5% annualized growth rate for Q4 is not an unreasonable estimate.

Anthony Karydakis

Bubbles

The issue of whether monetary policy is an appropriate tool to try to burst asset bubbles, or prevent them from actually forming, has been the subject of an ongoing debate since the meltdown of the stock market in 2001 and the most recent nosedive of the housing sector and its well-known by now devastating implications for the financial system and the economy. In that context, Alan Greenspan's infamous "hands off" approach has been called sharply into question in the last couple of years and a steadily growing chorus of policy-makers seems to realize the need for central banks to find ways to better contain asset bubbles.

This issue is now pushing to the forefront of both markets' and analysts' attention, as a number of central banks around the world are already moving to tighten monetary policy (Australia, Norway), or gearing up to do so in the foreseeable future. The motivating factor for such an approach is ostensibly a concern that asset bubbles are forming anew in some countries, fueled by the unprecedented amount of liquidity that had been previously injected into their financial systems in the context of dealing with a major financial crisis.

http://www.bloomberg.com/apps/news?pid=20601087&sid=aIYvRd5Zjf2Y

The thinking that naturally flows from that (also reinforced by the realization of how damaging inflated asset prices can be if left unchecked) is that central banks are now on the lookout for early signs of such bubbles forming and, therefore, quicker to switch to a tightening mode to avoid repeating past mistakes. This would presumably apply to the Fed as well, given that the rebound in stock prices since March has been viewed by some- unjustifiably- as excessive.

If things were only that simple...

Central banks of the major industrialized economies (U.S., Euro area, U.K.)- which have, suffered the most from the recent financial crisis- have extremely limited room for maneuver in the midst of the ruins that the events of the last two years have left behind. These economies are only now to starting to emerge from the sharpest economic contraction in many decades and with financial systems which have, to varying degrees, been deeply scarred by it.

It is unrealistic, bordering on plain naivete, to expect any of these central banks to engage in pre-emptive strikes against the potential risk of an asset bubble in their system, in the midst of a generally expected moderate and halting economic recovery, underpowered by far-from-stable banking systems. Those central banks simply do not have that luxury, as their paramount concern remains to ensure that the economic recovery gains some traction first. As a result, their hands are essentially tied by the harsh realities of a complex and unforgiving environment that shows little respect for theoretical economic models or abstract concepts of preventing bubbles. This predicament is probably more applicable in the case of the Fed and the Bank of England and, perhaps, slightly less so in the case of the ECB, which has at times shown signs of and impressive, and calculated, imerviousness to seemingly desperate needs of the Euro economy.

The central banks around the world that can afford at this stage to consider tightening policy out of fear of emerging bubbles domestically are those of countries with overall sound banking systems, and economies which (as a result of the latter) are already showing credible signs of an economic rebound that cannot be derailed by any tightening action in pursuit of bubble containment.

In the U.S, irrespective of what the stock market does in the next few months, the Fed can only limit itself to the frustrating role of a passive observer, as it cannot go after it in an attempt to implement lessons that may have been learned from the experience of the last decade (assuming that such lessons are pointing to some sort of clear and useful policy action, in the first place- but this will be the subject of another article).

In other words, the Fed may still not be in a position to do much about any bubble formation in the foreseeable future, as it operates within an environment that is decidedly not under its own control.

To recite a major political philosopher of the 19th century, "Men make their own history but not in circumstances of their own choosing".

Anthony Karydakis

U.S. and Europe: The Tale of Two Labor markets

By most measures, the recession in the Eurozone countries has been at least as devastating as in the U.S. In fact, GDP is expected to contract by at least one percentage more in the Euro area in 2009 compared to the point estimate of about -2.5% currently used for the U.S. Still, despite the more severe loss of output, the unemployment rate in the Euro countries has risen much less dramatically than in the U.S.

Since the beginning of the recession in the U.S. in December 2007, the unemployment rate has doubled from 4.9% to 9.8% last month. In the Eurozone, during that period, the unemployment rate rose from 7.3% to 9.6% last month. The explanation for that seeming paradox lies in the vastly different structure of the labor markets in those two major economic entities.

To start with, labor mobility in the Euro countries is much lower compared to the U.S., largely due to cultural differences related to the premium Europeans place on the "quality of life" concept. In other words, a Paris-born and bred employee who recently lost his job is highly unlikely to relocate to a medium-sized, provincial city simply because of a job opportunity there, although staying in Paris would prolong his period of unemployment. This obviously leads to a higher "core" in the unemployment rate in the Euro countries compared to an economy like the U.S. where a high degree of labor mobility is the norm.

More importantly, though, the famous social safety net that countries in the Eurozone provide to their citizens- which is the pride of Europe and often a source of scorn in this country- creates a very different dynamic in the functioning of the labor market there vs. here. Precisely because labor laws are structured to offer a fair degree of protection to employees during periods of hardship, it is more difficult for employers in the Euro area to lay off employees during an economic downturn, as there are significant benefits and other compensation that need to be given to those that are laid off. As a result, it is costlier for employers to fire workers compared to the more bare bone benefits provided to laid off employees in the U.S., and companies in Europe often tend to hang on longer to their under-utilized employees until an economic turnaround occurs.

The flip side of that dynamic is that those same employee-friendly labor laws that make it more difficult and expensive to lay off workers in the Eurozone make companies think long and hard before they proceed with a more aggressive pace of hiring when the economy turns around, as expanding their number of employees during the good times may imply a higher burden when the cycle turns sour again.

The implication of those differences in the structure of the labor markets is that in the down part of a business cycle, the unemployment rate in the U.S can shoot up past that in the Euro area and that is exactly the situation currently. This gap is likely to persist over the next six to twelve months, as the relatively moderate economic recovery in both the U.S. and Eurozone is unlikely to lead to a significant pick up in hiring in either economy. However, over a 2- to 4-year horizon, the unemployment rate in the U.S. will most probably decline faster than that in Europe, confirming the familiar pattern where the Euro countries experience an overall higher rate of unemployment than the U.S. during the more mature phase of the business cycle. (This was also reflected in the 4.9% unemployment rate that the U.S. had just prior to the latest recession vs. a 7.3% unemployment rate that prevailed in the Euro area ta the same time).

Still, it is questionable whether, as this economic expansion unfolds over the next few years, the unemployment rate in the U.S. can move that sharply below that of the Euro zone, as GDP growth in this country may fall behind that of previous economic expansions, therefore failing to reduce the unemployment rate as sharply as in the past. In other words, it is an open question as to whether the U.S.unemployment rate can decline again, over the medium-term, in the 4% to 5% range. If the latter were indeed not to happen again in this new cycle., then the social safety net that protects workers in the Euro zone so much better during the difficult economic times will then also be causing less harm compared to the U.S., when the good times are rolling once again.

Anthony Karydakis

Layoffs Are Still Slowing

Despite a small increase by 11,000 in the latest week's initial unemployment claims data reported this morning, the cooling trend in layoffs remains practically intact.

New filings for unemployment benefits (not to be confused with the total number of people actually receiving unemployment benefits) currently stand at 531,000, which is sharply below the peak of approximately 670,000 reached in the first quarter of the year. Given that this is a notoriously noisy series (probably an even worse offender, in that regard, than the famously volatile monthly nonfarm payrolls data), the only sensible way to interpret it is on a 4-week moving average basis. The latter measure was essentially unchanged at 532,000 in the latest week, sustaining the seven-month old downtrend of the series. Still, despite this decline, weekly initial claims still have a long way to go before they returned to the level prevailing just prior to the beginning of the recession, which was around 350,000.

Source: Bloomberg, Haver Analytics

There is practically no correlation between the weekly claims numbers for a certain month and the nonfarm payrolls data for that month, as the sources of the two series and methodologies used are vastly different. More importantly, though, initial claims provide us information regarding layoffs, while nonfarm payrolls are the net result of both layoffs and hiring. Both series have shown a significantly more encouraging trend in recent months. Ultimately, with the downtrend in claims continuing, a moderate acceleration in the pace of hiring cannot be too far behind.

Anthony Karydakis

Nothing Wrong With the Stock Market

In a world of 24/7 cable news, the rally in the stock market over the last several months is often described by various self-proclaimed experts as suspect, unjustified, and unsustainable, given the broader economic environment we are in. Such a downbeat take, which is meant to raise alarm bells and the audience's anxiety level, certainly helps ensure some extra face time of those "analysts" in front of the cameras. The only trouble is that they are misguided and, most probably, wrong.

The seemingly dire assessment of the current state of the stock market and its medium-term prospects is based on a potent mix of a half-truth and lack of understanding of what is historically an essentially normal behavior of the stocks for this phase of the business cycle.

The half-truth in question is that those who are skeptical of the stock market's performance are focusing exclusively on the fact that prices have risen by approximately 40% (S&P 500) since March. This disguises the reality that March was actually the absolute bottom of a very sharp decline in the midst of a major recession and broader financial market turmoil, and that stock prices are still about 45% below their level of two years ago. In other words, yes, the stock market's rebound since the spring has been impressive, but from an extremely depressed level and has only recouped less than half of the losses it had suffered in the prior 18 months or so. Some perspective is always useful.

The other critical part that seems to be missing from the analysis of those who doubt the legitimacy of the stock market rally this year is that, historically, stock prices start rallying in the middle of a recession, with such a turning point preceding an economic recovery by roughly six to twelve months. This is only reasonable, as with most of the bad news associated with an economic downturn having already been discounted as the market takes a dive in the early phase of a recession, prices subsequently start looking ahead at the prospect that an improvement in the overall environment is not too far down the road; recessions do ultimately end.

With the prevailing view currently that the emerging economic recovery is likely to be of the moderate kind, there is little reason to believe that the stock market has incorporated a radically more optimistic scenario into its recent behavior. It is simply staging a rally in anticipation of an already steadily materializing end of a particularly dark period for both the economy and financial markets.

None of this suggests that stocks cannot experience temporary setbacks in the period ahead, as market perceptions about the tone of the economic recovery will inevitably oscillate. Markets, after all, do go up and down, while they may still be in the midst of a broader trend. But there is nothing to suggest that, against the realities of the current economic environment and its medium-term prospects, there is something fundamentally wrong with the behavior of stock prices so far this year.

Anthony Karydakis

The Sweet Payoff of Prudent Policies

In surveying the economic landscape around the world, three countries stand out in terms of showing credible signs of having shaken off the recent misadventures of the global financial system with minimal damage and are already well on the way toward a solid comeback: China, Australia, and Brazil.

On the face of it, the structure of those countries' economies could not have been more different: China is -for all intents and purposes- a state-controlled economy, while Australia's falls squarely in to the group of developed, free market-oriented, industrialized ones. As for Brazil, its economy is powered by a hybrid of tightly government-regulated sectors and private sector mechanisms. However, despite their sharp differences, they all had one critical element in common that allowed them to weather the financial turmoil of the last 1 1/2 year quite well and escape relatively unscathed: overall sound banking systems.

In the case of China, the explanation for that is fairly transparent. Banks are government-controlled and essentially implement "guidelines" and policies regarding lending practices and types of assets on their balance sheets issued by the economic authorities and the State Council. This structure, although it did not insulate them completely from some exposure to bad real estate loans once China's construction boom ended, prevented the banking system from getting buried under a pile of toxic assets that caused the near meltdown of the financial system in the West. The result is that, after taking a big initial hit in the immediate post-Lehman stage of the global financial crisis last year, the Chinese economy is already coming back on line and is on track to grow in excess of 9% this year and return to double-digit growth in 2010.

Although the stability of the banking system in a country where the economy remains largely centralized may sound like an unimpressive achievement at first, there was an additional reason for the quick turnaround of the Chinese economy, which deserves considerable attention: the famously "front-loaded" fiscal stimulus package of approximately 4 trillion yuan announced last November. The package was geared toward stimulating domestic consumption, and its highly efficient implementation caused a turnaround in consumer spending by the second quarter of this year, helping the overall economy make a quick comeback. One cannot, at least for a fleeting moment, avoid the sad comparison here with the highly inefficient way the $787 billion fiscal stimulus package in the U.S. has been handled so far, with nearly 2/3 of the funds not having been disbursed yet, eight full months after it was signed into law earlier this year.

Although Australia is undeniably a free-market based economy, part of the tradition in that country has always viewed the government as having the responsibility to take measures to protect its citizens against the pitfalls of the impulsive greed its own corporate sector. Against that backdrop, the banking system in that country has typically been closely supervised and banks never strayed too far from their more conventional role and had very limited exposure to toxic assets. As a result, the Australian economy skirted the global recession and is already on the rebound- so much so that earlier in the month it became the first G-20 economy to raise short-term rates (by 25 basis points to 3.25%) with another hike expected before the end of the year.
(http://online.wsj.com/article/SB125480012867566719.html)

Brazil's famously tight banking regulatory environment- that had often attracted criticism in the last decade as burdensome- became the country's savior in the midst of the recent financial crisis.
(http://www.reuters.com/article/GCA-Economy/idUSTRE58965M20090910)
Although Brazil's economy experienced a major slowdown this year (unavoidable, given that it is a major commodities exporter feeling the brunt of the global downturn), the economy itself has impressed with its resilience and GDP growth is likely to be flat this year with a widely expected return to the 4% to 5% range next year.

President Lula's steadily rising stock as a successful leader on a continent where countries (including his own) had a long history of blowing up in some fashion, received another major boost by the way Brazil handled the global financial turmoil. His sensible, moderate policies, which have consistently resisted a free-for-all brand of capitalism in order to achieve the temporary illusion of faster growth, have been nicely rewarded in the current environment and helped solidify Brazil's standing as an emerging powerhouse on the global scene.

It is hardly surprising that the countries that had a consistently prudent approach to managing their financial system and broader domestic economic policies (http://www.nytimes.com/2009/05/14/business/global/14frugal.html) are now the ones that are emerging from the crisis in the best shape. Another such case is Norway, the solid economic prospects of which are now widely expected to lead the Norges Bank (central bank of Norway) to hike short-term rates later this month. Nor is it surprising that two of the G-20 countries that have suffered the most in the last 18 months are those that had banking systems that nearly collapsed under the weight of unfettered free-market, essentially unregulated, raw version of capitalism: the U.S. and the U.K.

One can only wonder whether there is some lesson to be learned here.

Anthony Karydakis

Two Messages From September's Consumer Price Index

There are two messages to be taken away from today's release of the September CPI.

1) Core inflation continues to show no evidence that would support the concerns of those who argue that there is a considerable risk of deflation ahead. That measure of inflation actually rose a solid 0.2% last month, leaving its year-on-year increase at 1.5%. In the last six months, core inflation has been running at 1.9%, while its 3-month annual rate (by definition, given the shorter period, more prone to noise) is running at a 1.3% rate.

While it is true that the overall CPI is down 1.4% from a year ago (a significantly smaller decline compared to a couple of months ago, when its year-on-year reading was -2.1%), that much less meaningful measure of inflation has still risen at an annual rate of 2.9% in the last six months and 2.5% in the last three months. The reason for the attention-getting discrepancy between the year-on-year reading of the headline CPI and its most recent annualized rates is that the former reflects the dramatic collapse in energy and commodity prices in the second half of 2008, as the global recession was settling in. Those negative year-on-year readings for the headline inflation are likely to evaporate by early 2010. In any event, it is always of course core inflation that matters, and this is, predictably, softening- but not nearly at a pace that could raise the anxiety level over the possibility of deflation.

2) The medical care component of the CPI (representing approximately 6.5% of the total index) rose by a robust 0.4% in September, bringing its year-on-year increase to 3.6%. In the last six months- in the midst of the recession that has generated an overall unmistakably disinflationary dynamic- medical care has risen by 3.6%, with the "hospital and related services" sub-category rising by 6.6%.

This should put to rest any lingering doubt that heath care costs are defying gravity and are disconnected from the broader economic environment and overall price trends in this country, screaming to be brought under control. Credible press reports that (during the unfolding open-enrollment period when employees are selecting their health plan for next year) the cost of coverage is up by double-digit numbers compared to last year, are rounding out the bleak state of spiraling health care costs in this country. Congress has already done a frustratingly inadequate job at addressing the cost containment aspect of health care reform legislation in the various bills thus far in the process. One would only be justified to feel dispirited by the prospect of ultimate success on that front in any final legislation , now that the free-for-all among a myriad of special interest groups has been unleashed to influence the ultimate outcome over the coming weeks.


Anthony Karydakis

Reviewing the Latest Evidence

Based on the available data so far, annualized GDP growth is likely to come in close to 3.0% in the third quarter (release scheduled for October 29th). As we have argued before, the GDP numbers do not always tell an accurate story and can, at times, even be misleading, as they are largely a mechanical exercise that can be subject to various distortions. But it is fair to say that a quarterly annualized growth rate of close to 3% is a much more encouraging outcome than, say, a 1 % contraction.

The available information upon which such a GDP estimate for Q3 is currently based is incomplete, as key pieces of data (consumption, residential investment, international trade, and inventory data for September) have not been released yet. On that score, this week's retail sales numbers for September (and any accompanying revisions to the August sales data) will go a long way toward shaping the key personal consumption component for the quarter. Consumption is slated to rebound at a rate of about 3% in Q3, supported, to a considerable extent, by the "cash-for-clunkers" program. A much slower pace of inventory liquidation last quarter is likely to be the other major contributor to growth for that period, helping offset a modest decline in capital spending.

But moving away from the intricate details of the various categories in GDP, the most encouraging aspect of the various economic reports recently is their relative consistency in pointing to a steady improvement in the broader economic environment. The manufacturing sector is staging a comeback (with the ISM having returned solidly to pre-recession levels despite shrinking auto output), consumer spending is perking up (beyond the recent auto incentives program) and initial unemployment claims continue to drift lower on a trend basis. In addition, the economic climate is turning up globally, with the Euro-zone, Japan, and China all showing credible signs of rebounding from their respective troughs.

Skeptics of the legitimacy of the unfolding economic recovery continue to point to the still considerable monthly net losses in nonfarm payrolls (albeit dramatically smaller compared to the early part of the year) and the still tight bank lending conditions as evidence that the sustainability of the recent improvement should be viewed as suspect.

While both of these factors are undeniable characteristics of the current economic landscape, it is important to recognize two things: a) It is a well-established fact that the economic data often tend to send mixed signals at major inflection points of the business cycle, as achieving an unimpeachable consistency in such data is something that takes quite some time to emerge after the trough of the cycle. The mixed tone of the various employment statistics may not dissipate until the first quarter of next year, when monthly payrolls start growing again. b) The bank lending situation is far more likely to have a moderating effect on the forward momentum of the recovery rather than impeding the recovery from taking hold altogether in the first place.

Without underestimating the challenges ahead, quietly, but steadily, an economic recovery is already taking hold.

Anthony Karydakis

Cudos to the Nobel Peace Prize Committee

As the subtitle of this space above suggests, commentary in these pages will be focusing on the "economy, markets, and more". It is in that context that I am presenting the following thoughts, in the wake of the announcement that President Obama has been awarded the Nobel Peace Prize for 2009. (Fair warning: this post is not for everyone).

AK

______________________________________________________________________

As the high-decibel media pundit machine is already going on overdrive over the surprise announcement that President Obama has won the Nobel Peace Prize, and the vitriolic attacks against that decision are already piling up quickly, and predictably, by a segment of the political spectrum, it is important to realize a simple fact that often goes painfully unrecognized in this country.

The decision reflects the, at times, vastly different view that people outside this country have of the U.S. than many Americans do.

It is a brave decision that, on the face of it, goes against the conventional wisdom that the Nobel Peace Prize is awarded to someone as recognition of that person's achievement in bringing about peace in a troubled part of the world. By that criterion, Obama was not eligible for that honor. But his being awarded the Prize reflects an incredibly intense appreciation by the Nobel Committee and a large part of the international community, that the U.S. is now turning the page on its recent history of war-mongering around the globe and unconditional bullying and intimidation of other countries that happen to have a different perspective on a certain issue.

It is a decision that expresses the thirst that the rest of the world has to see the U.S. play a constructive and inspiring role in helping resolve the numerous, complex, and often menacing, issues around the globe. It is a decision that shows a deep appreciation for an emerging process of deliberate and rational decision-making on critical global problems, as opposed to impulsive, ill-informed and ideologically-driven decisions by leaders who had shown in recent years a scary and embarrassing inability to grasp- let alone articulate any thinking about anything.

Yes, it is a decision about rewarding hope- the hope the Obama's still young presidency is projecting to many around the globe that the U.S. has a new face and is ushering in a new way of engaging the world.

Rewarding and nurturing that hope, in such a high profile manner, is at least as important, and perhaps more so, than rewarding someone who has already made a tangible contribution toward a peace agreement in a troubled spot of the world. That was the spirit of the Nobel Peace Prize Committee's decision and no one can personify it more than President Obama in these unsettled times.

Anthony Karydakis

PIMCO's Bet

When PIMCO's super-star CIO, Bill Gross, speaks, the bond market always pays attention. This is so, not only because of the stunning track record he has built over many years managing the firm's flagship Total Return fund but also because of the impressive muscle that the sheer size of PIMCO's funds under management allows him to flex in the fixed income markets.

So, Mr. Gross' latest offering (link below) is that he is buying Treasuries as protection against deflation.

(http://www.bloomberg.com/apps/news?pid=20601087&sid=afmg9Fh9v_zs)

His view, and, by extension, that of PIMCO's, has been recently that the economy is likely to experience a below-trend rate of growth over the next few years- in the vicinity of 1% to 2%-, as a result of a new paradigm that he believes is emerging, which will lead to a historically elevated saving rate at the expense of consumption. Under that scenario, the persistent moderation in the pace of GDP growth over the medium-term will sustain a slack built-up, which may convert the year-long disinflationary trend into a full-fledged deflation story.

This is not a perspective uniquely promoted by Bill Gross, as others have also argued that the rise in the savings rate and consumer de-leveraging since the onset of the current recession will prevent the economic recovery from acquiring a strong forward momentum over the next year or two. It is not, on the face of it, a totally irrational argument either.

The trouble though is the "higher savings rate" argument is not nearly as "clean" as those who promote it seem to assume.

To begin with, history is heavily against it, as the Chart below shows. In nearly all of the past recessions depicted, the savings rate has risen, as a natural defense of consumers in the face of an anxiety-filled economic environment. The trouble is that it has almost invariably tended to resume its secular downtrend (at least since the '70s) once the recession is over, households regain their deeply entrenched spending habits under the advertising blitz of an irrepressibly consumerist society, and everything returns to its old, merry ways. Assuming that, somehow, things will be different this time and consumers will adopt more prudent spending patterns on a sustainable basis once the recession is over, requires a leap of of faith- and not a small one at that.





The other problem with the concept of a savings rate as a gauge of recent, current, or soon-to-be-adopted spending habits is that it is an atrociously revisable series, to the point that such revisions can alter in a major way past impressions and end up portraying, in retrospect, an entirely different picture. For example, the savings rate for 1981, after a series of revisions over the years, today shows as approximately 11% but it was originally reported as slightly over 5% at the time; and this is only one tiny example in a long history of consistently upward revisions that the personal savings rate series has undergone in the last 20 years or so. Against that backdrop, one wonders whether the recent rise in the savings rate (to a still unimpressive 3% to 4% range) is credible, or sustainable, enough to build a longer-term scenario around the premise that there is indeed a new paradigm emerging here.

The final grounds upon which PIMCO's bet can be called into question is whether one can expect the disinflationary trend in the U.S. to continue relentlessly in the face of nearly 2% GDP growth (the upper limit of Bill Gross's anticipated range) and a likely upturn in global commodity prices. The latter would be a reflection of the vigorous comeback of the economies in China, the rest of Asia, and parts of Latin America (most notably, Brazil) as well as a moderate rebound in the Euro-zone. That dynamic does have the inherent potential to stem the slowing core rate of inflation in the U.S. moving forward and cause a reversal of the circumstantial decline in the overall CPI in the last 12 months.

Bill Gross has certainly earned his stripes in a notoriously brutal business over a long number of years and his views, at times against conventional wisdom, always deserve a fair hearing. He has also shown a remarkable ability in the past to keep an open mind and recognize his own "off" calls early enough and change tack before disaster hits- a quality that should earn him even greater respect. It is that latter quality that may ultimately come in handy with regard to his latest bet.

Anthony Karydakis

The 1970s Inflation Experience: An Unlikely Comeback

By Scott Tolep

There is considerable concern in some quarters that, over the medium-term, the US faces a sharp rise in inflation similar to the 1970s.

(http://www.cnbc.com/id/33114243 , http://www.usatoday.com/money/books/2009-01-18-book-review-great-inflation-aftermath_N.htm).

This view is based primarily on the fact that the Fed will be unable to remove the massive amount of liquidity from the system before higher inflation becomes entrenched in the economy and inflation expectations adjust upward. This process will undoubtedly require precise technical judgment on the part of the Fed, given the lag between the increase in the money supply and its effects on the economy and the overall price level. However, to suggest that the US will experience 1970s-like inflation may be overlooking the following key distinctions between now and then:

1) The experience in the late 1970s was preceded by nearly a decade of rising inflation stemming from the Fed’s willingness to trade higher inflation for less unemployment. By the time the Fed was given a mandate (in 1979) to control inflation at all costs, the public’s inflation expectations were firmly anchored at a very high level. This led to the vicious cycle of monetary restraint and ease where rates fluctuated within a range of 1,000 basis points between March-1980 and July-1981. In contrast, inflation over the past decade has been in the 2-3% range, longer-term inflation expectations are currently stable, and the Fed’s mandate to maintain price stability is now a well-established policy that has been around for 30 years.

2) The unprecedented shock in oil prices between 1973 and 1980 reinforced the already well-anchored, high inflation expectations. This adversely impacted the Fed’s ability to use monetary policy as a tool in resetting inflation expectations. No one knows exactly where oil prices are headed, but it seems reasonable to assume that when the Fed starts raising rates, it will not follow a 7-year period in which oil prices had increased by 500%.

3) The fundamental outlook on unemployment is different now than it was in the 1970s. Compared to the 1973-1975 recession, there is now a much higher probability for a “jobless recovery”. Capacity utilization rates today are lower, the banking sector is in appreciably worse condition, and households are more likely to save and de-leverage. There seems to be a growing acceptance that going forward, the baseline level of structural unemployment in the US may be in excess of the 5-6% range it has been accustomed to over the past 15 years. After the 1973-1975 recession, unemployment was gradually reduced to pre-recessionary levels. A drive by monetary policy to achieve a similar objective this time around does not appear to be a realistic prospect, which should alleviate some of the political opposition the Fed may face in its decision to withdraw liquidity from the system.

Once the economic recovery is well underway, it is reasonable to assume that inflation will, at least initially, drift above the 2-3% implied target. But predicting a return to the days of 10%+ inflation does not take into account some fundamental differences in the economy and the role of the Fed today as compared to the 1970s.

Mr. Greenspan's "Prediction" and The Media

In an interview Alan Greenspan gave on one of the Sunday morning TV shows, he made the comment that he "suspects" that the unemployment rate will rise above 10% and stay there for a while before it subsequently starts coming down.

(http://www.nytimes.com/2009/10/05/business/economy/05greenspan.html)

This was actually a comment devoid of any insightful content. Mr. Greenspan simply stated something that is widely acknowledged as an extremely high probability outcome (bordering on self-evident) at this point, that is, that the unemployment rate- already at 9.8%- is poised to cross the 10% mark in the foreseeable future.

The unemployment rate is a lagging indicator and the past pattern of its behavior shows a strong tendency of it peaking, by a varying lag, after the end of a recession. The reason for that is that with the first signs of improvement that emerge toward the beginning of an economic recovery, previously discouraged workers that had dropped out of the labor force are coming back, therefore swelling the size of the labor force faster than the pace at which the economy can absorb them.

For example, in the 2001 recession, the rate did not peak until 19 months after its official end, while in the 1990-91 recession, it peaked 15 months after it ended. The 1981-82 recession was somewhat of an exception, as there was a synchronized peak of the unemployment rate with the trough of the business cycle in November 1982. In the highly peculiar recession of 1980, the peak in the rate also coincided with the low point of that unusual cycle. The 1973-75 recession led to a peak in the unemployment rate just a couple of months after its end.

The reason for which, in some cases, the rate has peaked almost simultaneously with the trough in economic activity is that the economy came roaring back at very robust rates of GDP growth (5%, 6% or higher, in the first year of the recovery), allowing it to absorb fully the workers re-entering the labor force. It has already been established that, given the array of headwinds at work, this recovery is not likely to be of sufficient vigor to generate enough jobs early on to prevent the rate from rising.

Mr. Greenspan certainly understands all of that extremely well, as he has always been a diligent student of economic history. In fairness to him, he most likely, did not even think he was making a particularly novel prediction by saying that the unemployment rate will rise above 10%. (True, he used a particularly cautious tone "My own suspicion is that we're going to penetrate the 10% barrier and stay there for a while...", but this can be chalked up to his many years of having perfected a unique brand of impressively careful and convoluted statements, which he evidently has a hard time shedding now).

The somewhat amusing thing is not as much that Mr. Greenspan offered that bland observation about the direction of the unemployment rate, but that his comment has received quite a bit of play in the media in the last 24 hours, financial and otherwise, with headlines of the kind "Alan Greenspan predicts that the unemployment rate will rise to 10%" etc. One simply has to assume that, given the transparent banality of Mr. Greenspan's so-called "forecast", the media either did not recognize that as such or it has been a particularly slow news cycle this weekend that sent them to a desperate search for a "headline".

Anthony Karydakis

September Employment Report: A Few Thoughts

The disappointing employment report- with its 263K decline in September, the small net downward revision to the prior two months' declines, the drop in the labor force participation rate to 65.2% and the dip of the workweek to its cycle-low of 33.0 hours- highlights starkly the obstacles that the fledgling recovery is facing. An uncharacteristically big decline in government jobs last month (-53K versus a long-term trend of an average monthly gain of 10K to 20K) can only serve as a partial explanation for the magnitude of the drop in total payrolls. It was, after all, the sizable declines in manufacturing, construction and service jobs together that accounted for the lion's share of the overall drop.

Since the start of the recession in December, payroll employment has eroded by 7.2 million and, given the current trajectory of hiring, it is quite possible that it will reach the 8 million mark by the time the monthly numbers start turning positive. Still, that seemingly bleak prospect should not be allowed to disguise the key reality that the employment picture has improved markedly in recent months, taking the form of a much slower pace of job erosion. In the third quarter, the average monthly payroll decline was "only" 256K compared to 426K in Q2 and 691K in Q1.

Despite the generally dispiriting tone of today's employment data, it is important not to lose sight of the critical distinction between payroll growth and GDP growth in the next few quarters; the former is not a prerequisite for the latter to occur- at least not for a while. The cyclical rise in productivity that occurs in the early stage of an economic recovery (the result of employers utilizing their existing labor force more intensively at first before they resume hiring more confidently) should be adequate to generate positive GDP growth in the second half of the year and into early 2010. This, provided that hiring will catch up with, and possibly exceed by early 2010, layoffs (therefore, generating positive payroll numbers), should allow for the economic recovery to make a smooth transition into a respectable economic expansion.

There is also an additional factor that allows for that at least temporary disconnect between employment growth and GDP growth to exist. GDP numbers are, after all, a bean-counting exercise; the arithmetic of the whole thing can often play unexpected games. The massive pace of inventory depletion in the first half of the year subtracted an average of nearly two percentage points from real GDP growth in the first two quarters of the year. With inventories having now been much better aligned with sales, they are likely to be an essentially neutral factor for GDP purposes in the second half of the year and early 2010, therefore removing a potent drag on the numerical aspect of economic growth.

Ultimately, a credible economic recovery cannot take hold without payroll employment picking up. But the latter condition is not a necessity for the time being.

AK

UK Inflation Expectations: Overstated

By: Christopher Hodge

Analyst, Pharo Management

Recently, UK Prime Minister Gordon Brown, and Business Secretary Peter Mandelson announced the extension of the British version of the "cash-for-clunkers" program (http://online.wsj.com/article/SB125413637283046045.html), raising the government expenditures associated with this program to £400 million. While this may win the Labour Party some votes in the upcoming election, the increased fiscal obligations resulting from spending of that kind have certainly caught the attention of those concerned with the inflation outlook in the UK.

Inflation expectations have greatly increased with the rampant spending by the British government, and while such massive spending has almost certainly prevented an even more disastrous collapse of the UK economy, the spending is taking its toll on some aspects of the economic fundamentals.

In April, the Treasury projected that in the current fiscal year (ending in March 2010) the deficit will be at a post-war record of 12.4% of GDP, and now even that estimate looks modest. The rise in debt from 2009 to 2010 is the sharpest increase among G-7 nations, and the increase is projected over the medium term as well. In its April budget, the government said that debt will rise to 76.2% of gross domestic product in the fiscal year ending March 2014 from just 36.5% of GDP in the fiscal year ended March 2008 (http://www.dowjones.de/site/2009/09/boe-government-debt-worries-may-have-weakened-sterling-.html).

There are signs the UK economy is improving, and the IMF announced this week that it expects GDP growth in the UK to be about 1% next year. However, the economy, though poised to show positive growth in Q3, remains fragile and further government spending may be necessary - particularly, in view of an upcoming parliamentary election next spring. While it's highly unlikely that the UK defaults on its debt, investors are concerned that the government may be tempted to decrease the debt burden via inflation.

Evidence of the growing inflation can be found in the bond market, where break-even rates have almost doubled for 10-year bonds since March of this year. (see chart below)

Break-even rates are the spreads between conventional government debt and inflation-protected debt. Higher spreads reflect investors' increased concerns for future inflation. The market is currently pricing the UK inflation-protected bonds at a higher premium than any other G-7 country (see chart below).

Although the recent increases in spending are troublesome, the inflation uneasiness seems overstated by the market. The markets' current pricing of break-even rates, while high, are not unheard of in the UK. The mid-to-late 1990s saw an even greater threat of inflation. Since being granted independence in 1997, however, the Bank of England's Monetary Policy Committee has been quite vigilant in its fight against inflation. In fact, current BoE governor Mervyn King has been criticized for failing to ease monetary policy quickly enough at the onset of the current crisis. Now the market seems to believe that the BoE will miss expectations on the upside. The BoE has had a good track record of being fairly cautious with regards to signs of future inflation and should be trusted as well this time to do the same. To be sure, a watchful eye should be kept on UK deficit spending, but current break-even rates are probably far fetched.

The Sliding Dollar...

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

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

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

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

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

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

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

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

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

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

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

AK

The Treasury Market Has It About Right

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

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

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

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

AK

Disentangling Two Key Concepts About Fed Policy Ahead

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

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

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

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

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

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

AK

The End of the Recession and the NBER

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

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

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

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

AK

The Fading Deflation Story

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

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

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

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

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

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

AK

Employment Trends: Trading Employees

Michael Swanson

Senior Analyst, Sterling Infosystems

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

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

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

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

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

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

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

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

Retail Sales Suggest Recovery Prospects On Track

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

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

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

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

AK