Consumer Confidence Plunges in February

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



Source: Action Economics

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

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

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

Anthony Karydakis

CPI Inflation, Nearly Perfect

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

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

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


Source: Bureau of Labor Statistics


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

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

Anthony Karydakis

As the Eurozone Saga Continues...

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

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

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

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

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

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

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

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

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

Anthony Karydakis

Re-writing the Playbook on Monetary Policy

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

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

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

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

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

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

Anthony Karydakis

A Matter of Degree

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

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

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

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

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

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

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

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

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

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

Anthony Karydakis

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

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

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

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

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

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

Nonfarm Payrolls (monthly data; in thousands)



Source: Bureau of Labor Statistics


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

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

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

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

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

Anthony Karydakis

Productivity Surges

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

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

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

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


Nonfarm Business Productivity

Source: Bureau of Labor Statistics


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

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

Anthony Karydakis

Mr. Bernanke and the Perplexing Populism of a Naubel Laureate

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

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

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

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

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

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

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

Now, this is serious double-take material.

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

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

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

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

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

Anthony Karydakis

Fourth Quarter GDP Consistent With a Moderate Recovery

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



Source: Bloomberg, Haver Analytics


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

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

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

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

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

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

Anthony Karydakis

Federal Funds Targeting: The End of an Era?

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

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

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

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

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

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

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

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

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

Anthony Karydakis

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

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

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

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

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

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

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

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

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

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

Anthony Karydakis

That Unflagging Demand for Treasuries

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

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

So, someone out there is clearly buying Treasuries.

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


Net Foreign Purchases of Long-Term Treasuries

Source: Action Economics


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

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

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

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

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

Anthony Karydakis

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

Do Budget Deficits Drive Bond Yields?

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

AK
______________________

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

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

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

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

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

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

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

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

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

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

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

Anthony Karydakis

A Rough Patch for Treasuries: Much Ado About Nothing?

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

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

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

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

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

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

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

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

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

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

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

Anthony Karydakis

A Holiday Gift from The Treasury

By Scott Tolep

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

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

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

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

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

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

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

Taking Advantage of the Low Yields

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


10-Year Treasury Yield

Source: Bloomberg

First, some basic facts:

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

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





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

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

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

Anthony Karydakis

The Undervalued Yuan: And Then There Was Silence

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

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

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

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

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

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

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

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

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

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

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

Anthony Karydakis

A certain Senator from Connecticut

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

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

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

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

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

It is simply sad.

Anthony Karydakis

As Lending Continues to Shrink...

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

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

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

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

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

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

Anthony Karydakis

A Propos Greece's Troubles

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

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

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

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

A few thoughts.

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

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

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

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

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

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

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

Anthony Karydakis