Equity Market Rally: A Major Unrecognized Factor

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

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

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



Source: moneycentral.msn.com

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

Anthony Karydakis

The FOMC Statement And Its Key Wording

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

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

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

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

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

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

Anthony Karydakis

Retail Sales Confirm the Consumer Comeback

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

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



Source: Bloomberg, Haver Analytics

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

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

Anthony Karydakis

The EU's Ideas to Deal With Another Greece

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

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

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

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

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

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

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

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

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

Anthony Karydakis

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

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

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

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

Source: Bureau of Labor Statistics

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

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

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

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

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

Anthony Karydakis

More Weakness in the Economic Reports Ahead

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

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

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

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

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

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

Anthony Karydakis

The Mixed Tone of the Economic Data

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

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

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

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

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

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

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

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

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

Anthony karydakis

Consumer Confidence Plunges in February

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