Today's Tidbits

Economists Thoughts on the Fed Statement
From Goldman Sachs: “Statements on recent and prospective inflation are slightly more hawkish than we expected; however, the FOMC retains its focus on core inflation (as expected) and gives no hint of discomfort with policy on its current setting.”
From Lehman: “The FOMC statement acknowledges the recent improvement in core inflation - somewhat odd given the the year-over-year rate is likely to be unchanged versus the last core PCE reading prior to the 9 May FOMC statement which described inflation as "elevated." This suggests that the removal of the word had less to do with a change in the FOMC's view on the inflation outlook and more to do with removing a word that was garnering unwanted attention. The use of the phrase "convincingly demonstrated" sounds much like President Lacker's comments regarding the statistical significance of the recent movements in core inflation and reflects future uncertainty about the inflation outlook which is further highlighted by the retention of the inflation bias…This statement highlights the contrast between the reported inflation figures and the upside risks to future inflation. The trends in total and core inflation are likely to further aggravate this contrast and could lead to further surprises despite the Fed's best efforts to educate the market.”
From Deutsche Bank: “The Fed is not going to drop its inflation bias until core inflation has moved lower and/or until the unemployment rate rises noticeably.”
From FTN: “The Fed was expected to adopt a less alarmist tone in its discussion of inflation, and indeed, core inflation was no longer described as “elevated.” But the Fed is also clearly skeptical of the recent drop in core inflation, because it was accomplished without the increase in the unemployment rate that is central to the Fed staff’s improving inflation forecast. As such, the new language about inflation, which appears below, does not suggest any chance of a rate cut in the near future: “Readings on core inflation have improved modestly in recent months. However, a sustained moderation in inflation pressures has yet to be convincingly demonstrated. Moreover, the high level of resource utilization has the potential to sustain those pressures.” The refusal to allow GDP growth to return to potential despite inflation that is now in the upper end of the Fed’s target band raises the odds that inflation will fall through the lower end of the band at some point down the road. After all, monetary policy works with a considerable lag, even if Bernanke and his colleagues choose to conduct policy as if the lag is negligible. In the meantime, the Bernanke Fed’s strict adherence to the NAIRU theory, which holds that there is a trade-off between unemployment and inflation, makes it considerably less friendly toward working Americans than the Greenspan Fed was in the Nineties, something that is likely to further cool the relationship with a Congress that is already unhappy with the Fed’s lack of action on mortgage regulation in the wake of the subprime mess.”

Easy Credit Diminishing in Buyout Market
From The Boston Globe: “Investors who put their money to work in credit markets ask themselves two basic questions every day: How much risk do I want to take, and how much will I insist on being paid for it? The debt bubble, which has bent all kinds of credit markets out of shape in the last couple of years, changed the usual answers to those questions. Investors began to take on more and more risk, which wasn't a particularly good thing to begin with. Worse, they weren't getting paid any more for their trouble. The bubble put a practically unknown subprime mortgage market on the front page. It paid for an increasingly risky leveraged buy out boom. It helped boost debt offerings from emerging markets around the world. But investors who rolled over before are pushing back a bit now, and that would be a good thing. How the debt bubble ultimately unwinds, or blows up, is the single most important issue facing all stock and credit markets today… investors in all kinds of credit markets appear to be rethinking risk… That speculation has been driven by excess liquidity, huge amounts of global money looking for ways to earn more income.”
From USA Today: “Wall Street is cooling on a popular money-making strategy: borrowing gobs of cash to fund deals and other investments with the potential to deliver big gains. Leverage, the financial tool that has fueled the private-equity buyout boom and helped hedge funds amplify returns, is now being viewed more cautiously by professional investors. The rising concern stems from a belief that interest rates are on the rise, especially for riskier bonds, which would make it more costly for Wall Street titans to fund deals. Another warning flag: recent financial stress at two Bear Stearns' hedge funds that got in trouble using leverage to invest in pools of bonds tied to the faltering subprime mortgage market. "There is definitely a dark side to leverage," says Jeremy Siegel, professor of finance at the Wharton School.”
From Bloomberg: “Lenders increasingly worried about financial risks of takeover deals are demanding higher interest rates…Lenders fear that easy credit for takeovers could come back to haunt them if buyout targets get into financial trouble. In recent days, the deepening woes of the sub-prime mortgage market have reminded Wall Street of the risks of cheap credit…Carl Icahn, who has spent more than four decades on Wall Street buying and selling companies, said private equity firms have enjoyed "a walk in the park" in terms of financing deals in recent years, as yield-hungry lenders and investors have fallen over themselves to provide credit…Investors have demanded higher yields on junk bonds in recent weeks…Bond investors "have drawn a bit of a line in the sand," said Brian Arsenault, high-yield strategist at Morgan Stanley in New York. "Investors are saying 'I have my pick of quite a few high-yield offerings over the next few months, so I am going to be a little more selective.' " The deal market also has been rattled by proposals by some in Congress to change the tax structure of buyout firms and hedge funds, lifting the top tax rate from 15% to 35% on certain of their investment earnings. That could make takeover deals less lucrative. Asked about the proposed legislation, Treasury Secretary Henry M. Paulson Jr. said Wednesday that "I don't believe it makes sense to single out one industry." He warned that a tax increase could have "unintended consequences."”
From Barclays: “For all the fear and loathing currently being inspired by events in the credit markets, it is worthwhile putting developments into their historical context. Although lower rated US mortgage securities have imploded in value, the widening in corporate credit spreads has been barely significant enough to warrant the term “blip.” Spreads on BBB rated US home equity loans currently range between 1,000 and 2,200 bp for 2006 and early 2007 paper. In contrast, the prevailing spread on BBB corporate paper is all of 71 bp. Even junk bond spreads are barely above 300 bp. A 2,130 bp spread differential between two debt instruments of the same credit rating does rather call into question the utility and credibility of the ratings system itself. As far as recent trading patterns are concerned, to be sure, corporate high yield spreads are widening in a significant manner, but set against the collapse in sub-prime mortgage paper, or indeed against the broader sweep of history, recent events are no more than a minor wriggle in the corporate credit markets.”

CDO Woes Highlight Pricing Concerns – Mark-to-Model Risks
From The Financial Times: “…collateralised debt obligations (CDOs), are designed to yield juicy returns while also carrying high credit ratings. They have proved popular with hedge funds as well as with longer-term investors such as pension funds and insurance companies, many of which have bought billions of dollars of such securities in recent years - thus providing the liquidity that was then channelled into mortgage loans. But heavy losses incurred at the two Bear Stearns hedge funds as a result of such financial haute couture have prompted fears that the CDO emperor may turn out to have no clothes. Such a revelation could threaten the value of investor portfolios around the globe - not just in the mortgage sector but in the way many sorts of company fund themselves…CDOs are rarely traded…many of these new-fangled instruments have never been priced through market trading. Instead, products such as CDOs, which are designed to be held until they mature, have often been valued in investor portfolios or on the books of investment banks according to complex mathematical models and other non-market techniques. In addition, fund managers and bankers often have broad discretion as to what kind of model they use - and thus what value is attached to their assets. So when Wall Street creditors last week threatened fire sales of CDOs seized from the stricken Bear Stearns funds, thus creating a market price for them for the first time, they also threatened to create a wider shock for the system. Fire sales rarely realise anything close to the previously expected value of assets. But if these deals went ahead, they would provide a legitimate trading level that would challenge current portfolio valuations…the crisis at Bear's funds has left investors, brokers and regulators asking an uncomfortable question: can the pricing models that have provided the foundations for this new financial edifice really be trusted? Or will valuations turn out to be over-optimistic and result in further investor losses…To an extent, the valuation problem for CDOs reflects the fact that the frenetic pace of innovation seen in the financial industry this decade has outpaced the development of its infrastructure. It has often been the case that when new instruments emerge in the banking world, the market is initially quite illiquid, meaning that the level of trading is low. But the murky nature of new products has rarely had broad systemic implications, because they have typically occupied a small niche. What makes the CDO sector unusual is that it has exploded at such a breakneck pace with bankers packaging bonds, loans and other debts into ever more complex structures. Last year alone, about $1,000bn in cash and derivatives CDOs was issued in Europe and the US, according to data from the Bank for International Settlements. More than one-third was composed of asset-backed securities, often including low-grade mortgages…However, many other such products are created by bankers directly with their clients and then simply left to sit on the books of an investor. Since such instruments typically last three to five years - and the CDO boom is so recent - many have not come to the end of their life. Nor have they been traded…"The lack of a publicly quoted market for CDOs and like assets is exacerbating the liquidity problems for these assets beyond the underlying economics, for example, in subprime real estate." To compensate, investment institutions and banks use a variety of techniques to assign a value to these instruments in their accounts. In some areas, third-party data groups exist that can offer price estimates. However, the pace of innovation is so intense that it is hard for these providers to keep up with all corners of the market. So in many cases, investors are turning to alternative techniques to create prices. One tactic used by hedge funds entails asking several brokers for price quotes and taking an average. Results vary - not least because dealer banks may hold positions in these instruments themselves. "It is very easy for hedge funds to shop around to find valuations that suit them best and then book their assets at that," says one banker who advises hedge funds. "Going back to the bank that sold you a CDO and asking for a price is rarely likely to produce an accurate picture." Another approach is to estimate valuations based on the ratings the instruments receive from credit rating agencies. Yet this does not offer a fail-safe valuation method either. The rating agencies have been downgrading bonds backed by subprime mortgages in recent weeks but critics say they have been slow to act and face difficulties in analysing the market. Christian Stracke, analyst at CreditSights, a research company, says: "With so little truly relevant historical data on the behaviour of subprime mortgages, and with such massive structural changes having occurred in the mortgage landscape in recent years, any time-series analysis approach is little more than a not-so-educated guess." Moreover, while ratings attempt guidance on the chance of default, they offer no indication of how market prices could behave - as the rating agencies stress. As the BIS noted in its annual report this week, ratings reflect expected credit losses rather than the "unusually high probability" of events that "could have large effects on market values". That means that on the rare occasions that instruments are traded, a large gap can suddenly emerge between the market price and its book value. This week Queen's Walk Fund, a London hedge fund, admitted it had been forced to write down the value of its US subprime securities by almost 50 per cent in just a few months. That was because when it was forced to sell them, the price achieved was far lower than the value created with the models the fund had previously used - which had been supplemented with brokers' quotes. But unless circumstances arise that force a market trade, valuations often remain at the investment managers' discretion. While managers say they strive to assign honest values, these are often difficult for an outside accountant to verify, since the techniques used are invariably highly complex. Moreover, incentives do not always encourage fair valuations: hedge fund managers, for example, are typically paid a percentage of the profits they book, giving them a vested interest in reporting a high asset valuation. At best, this means that the valuations of CDOs, for example, may often lag behind any swings in broader asset classes; at worst, this ambiguity may enable hedge fund managers or investment bankers to keep posting profits - even when markets fall…history also shows that large-scale structural dislocations - such as a serious mispricing of assets - are rarely corrected in an orderly manner. Thus the big risk now is that if thousands of banks and investment groups suddenly have to slash the value of the securities they hold, the wave of accounting losses might at best leave investors wary of purchasing all manner of complex financial instruments. At worst, it could trigger more distressed sales and a broader repricing of financial assets, not just in the subprime sector but in other illiquid markets too.”


Supreme Court Reversal May Cause Some Retail Prices to Rise
From AP: “The Supreme Court on Thursday abandoned a 96-year-old ban on manufacturers and retailers setting price floors for products. In a 5-4 decision, the court said that agreements on minimum prices are legal if they promote competition. The ruling means that accusations of minimum pricing pacts will be evaluated case by case. The Supreme Court declared in 1911 that minimum pricing agreements violate federal antitrust law. Supporters said that allowing minimum price floors would hurt upstart discounters and Internet resellers seeking to offer new, cheaper ways to distribute products…“The only safe predictions to make about today’s decision are that it will likely raise the price of goods at retail,” Justice Stephen Breyer wrote in dissent.”

Globalization, and Willingness to Take Risks, Helps Wealthy Get Richer
From The Financial Times: “Last year, the assets of those with more than $30m (£15m) to invest - the so-called ultra-high net worth individuals - expanded by 16.8 per cent. By comparison, people with assets of $1m-$5m saw their wealth grow by 6.4 per cent. The number of ultra-high net worth individuals also swelled by more than 10 per cent - more than the growth in the total pool of wealthy individuals. The number of people with $1m or more to invest grew by 8 per cent to 9.5m last year, and the wealth they control expanded to $37,200bn. About 35 per cent is in the hands of just 95,000 people with assets of more than $30m. The study, prepared by Merrill Lynch and Capgemini, highlights a growing gap between the super-rich and those who would normally consider themselves wealthy. The gap has been exacerbated by rising markets and the forces of globalisation, which have allowed a relatively small number of people to accumulate vast fortunes…the difference reflected a willingness by the very rich to take greater risks. "Ultra-high net worth individuals are very aggressive investors," he said. "If things are good, they will do better than the high net worth individuals, who are more cautious." The study found wealthy investors reduced their investments in hedge funds and private equity last year, increasing their exposure to real estate and equities. The developed world continues to dominate the ranks of the world's rich: 64 per cent of high net worth individuals live in the United States, Japan, Germany, France or the UK. But in Singapore, India, Indonesia and Russia the number of high net worth individuals grew by more than15 per cent last year.”

MISC
From Bank of America: “Revisions to the core PCE deflator increase the probability that tomorrow's year-over-year (yoy) core PCE deflator will remain at 2.0% in May [rather than fall to] 1.9% yoy [as previously expected].

From Merrill Lynch: “Utilities have proven that they remain extremely sensitive to changes in long-term interest rates, despite many Wall Street assertions to the contrary… Utilities performed quite well as fixed-income volatility fell. However, they quickly began to retrace their advance when volatility began to increase.”

From MarketWatch: “…in the past 10 quarters the net issuance of stocks has also been declining. "At the same time, we've seen money flowing powerfully into the foreign equity markets," …As a result, he believes that U.S. stocks have surged in the past 12 months "more from a lack of supply than an increase in demand." “

From Citi: “Over the past year, capital spending did not contribute to growth or blunt the drag from housing.”

Market Recap
Interest rates increased, with 2y Treasuries gaining 5bp in yield to 4.94%, while the 30y bond saw yields rise less than a basis point to 5.20%, causing the curve to flatten by 4bp. Shorter maturity Treasuries are more sensitive to changing Fed rate expectations, and the continued focus on inflation concerns extended the time of the next anticipated Fed easing further into the future.

Equities are closing near unchanged, after trading higher most of the day.

The dollar index is unchanged on the day, but gold rallied $5.75.

Oil is unchanged, after trading 50 cents higher during the day.