The Trouble With the Savings Rate

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


Source: www.calculatedrisk.com

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

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

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

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

Anthony Karydakis

The Recovery Is Moving Forward

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

Here's some key points to be highlighted:

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

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

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

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

Anthony Karydakis

The U.S Economy and the Eurozone Fiscal Crisis

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

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

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

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

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

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

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

Anthony Karydakis

The Eurozone's Fiscal Saga: Shifting Focus?

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

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

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

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

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

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

Anthony Karydakis

Treasury Yields: The New Equation

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

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

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

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

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

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

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

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

Anthony Karydakis

The Goldman Issue and Financial Markets

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

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

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

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

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

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

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

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

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

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

Anthony Karydakis

This Week's Data: Confirming the Pattern

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

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

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

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

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

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

Anthony Karydakis

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

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

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

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

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

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

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

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

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

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



Anthony Karydakis

The Long Shadow of Greece's Woes

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

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

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

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

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

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

Anthony Karydakis

The Employment Data and the Fed

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

The answer is, probably not.

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

1) The strength of the real sector economic data.

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

2) The price outlook.

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

3) The state of the banking system.

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

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

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

Anthony Karydakis

Job Growth Is Back

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

Source: Bureau of Labor Statistics

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

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

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

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

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

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

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

Anthony Karydakis

On Long-term Treasury Yields

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

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

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

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

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

Anthony Karydakis

A Note on Friday's Employment Report

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

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

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

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

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

Anthony Karydakis

New Home Sales and the Big Misconception

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


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

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




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

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

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

Anthony Karydakis

The Weak Euro...Really?

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

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

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


The Euro vs. U.S. Dollar



Source: ECB


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

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

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

Anthony Karydakis

Equity Market Rally: A Major Unrecognized Factor

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