Today's Tidbits

Disadvantages of a Weak Dollar
From Merrill Lynch: “Who would have thought that the Fed would lower rates by more than investors expected with the dollar within a breath of an all-time low against all the major currencies? They did, and inflation expectations are accordingly rising. The 10-Year T-Note yield has now backed up 25+ basis points in the last 2 weeks, and TIPs spreads have jumped as well…A quick reiteration of our views on the global imbalances seems appropriate. Simply put, the US trade imbalances are so huge and the export base so small that the only way to solve the global imbalances is to constrain domestic US consumption. We have argued that there are basically three ways to do that: 1) raise taxes, 2) raise interest rates (or keep monetary policies tighter than they normally would be), and/or 3) depreciate the dollar so that goods produced outside the US become unaffordable to Americans. If #1 or #2 were not going to be implemented, then the markets would take care of #3. Depreciating the currency is generally a politically acceptable route, and one often chosen by developing nations with current account imbalances (after all, what politician wants to tell voters they can't buy things?). However, it is also the route that is the least controllable. It now seems quite clear that Washington as a whole (i.e., both fiscal and monetary authorities) has chosen #3. So, whereas American markets have been focusing on assets that seek to merely maintain wealth (dollar-denominated commodities and gold, for example), the remainder of the world is investing to build productive assets and wealth.”
From The Telegraph: “Saudi Arabia has refused to cut interest rates in lockstep with the US Federal Reserve for the first time, signalling that the oil-rich Gulf kingdom is preparing to break the dollar currency peg in a move that risks setting off a stampede out of the dollar across the Middle East… "Saudi Arabia has $800bn (GBP400bn) in their future generation fund, and the entire region has $3,500bn under management. They face an inflationary threat and do not want to import an interest rate policy set for the recessionary conditions in the United States,"… As a close ally of the US, Riyadh has so far tried to stick to the peg, but the link is now destabilising its own economy… There is now a growing danger that global investors will start to shun the US bond markets. The latest US government data on foreign holdings released this week show a collapse in purchases of US bonds from $97bn to just $19bn in July, with outright net sales of US Treasuries. The danger is that this could now accelerate as the yield gap between the United States and the rest of the world narrows rapidly, leaving America starved of foreign capital flows needed to cover its current account deficit – expected to reach $850bn this year, or 6.5pc of GDP. Mr Redeker said foreign investors have been gradually pulling out of the long-term US debt markets, leaving the dollar dependent on short-term funding. Foreigners have funded 25pc to 30pc of America's credit and short-term paper markets over the last two years… "This is nothing like the situation in 1998 when the crisis was in Asia, but the US was booming. This time the US itself is the problem," he said…the biggest danger for the dollar is that falling US rates will at some point trigger a reversal yen "carry trade", causing massive flows from the US back to Japan. Jim Rogers, the commodity king and former partner of George Soros, said the Federal Reserve was playing with fire by cutting rates so aggressively at a time when the dollar was already under pressure. The risk is that flight from US bonds could push up the long-term yields that form the base price of credit for most mortgages, the driving the property market into even deeper crisis. If Ben Bernanke starts running those printing presses even faster than he's already doing, we are going to have a serious recession. The dollar's going to collapse, the bond market's going to collapse. There's going to be a lot of problems," he said. The Federal Reserve, however, clearly calculates the risk of a sudden downturn is now so great that the it outweighs dangers of a dollar slide. Former Fed chief Alan Greenspan said this week that house prices may fall by "double digits" as the subprime crisis bites harder, prompting households to cut back sharply on spending. For Saudi Arabia, the dollar peg has clearly become a liability. Inflation has risen to 4pc and the M3 broad money supply is surging at 22pc. The pressures are even worse in other parts of the Gulf. The United Arab Emirates now faces inflation of 9.3pc, a 20-year high. In Qatar it has reached 13pc. Kuwait became the first of the oil sheikhdoms to break its dollar peg in May, a move that has begun to rein in rampant money supply growth.”
From Bloomberg: “The dollar sank to a record low against the euro …``One thing that should be clear is that this is not a dollar-friendly Fed,'' said Jim McCormick, the London-based global head of currency research at Lehman Brothers International. ``The biggest focus going forward is going to be the monetary policy expectations.''
From Lehman: “Then, wow! 50-bps? No warning. No steering the markets towards his decision. Just 50bps in the fact of $80 oil, a weak $, and inflation which, while perhaps waning, certainly not gone…the market has tossed away its dollars, its long bonds, and just about anything else that the market believed was good to own with a cool and credible Fed. I don't blame them.”

CP Market Improving
From JP Morgan: “Commercial paper outstanding fell $19.0 billion nsa in the week ending September 19… Over the last six weeks, CP outstanding has fallen a cumulative $294 bn, or 13.5%...ABCP outstanding has fallen 20.8% over the last six weeks, but the rate of decline has slowed in the past two weeks. In the past two weeks, ABCP outstanding has fallen an average of $15.1 bn per week, compared with an average of $53.6 bn in the four prior weeks. Yields for all types of CP fell after the Fed cut rates, and the spread between ABCP and other types of CP has narrowed over the last week. Nonetheless, the spread between ABCP and financial and nonfinancial CP remains much larger than usual.”

Consumers Have Shifted From Using MEW to Selling Assets to Fund Excess Spending – Risk is Corporate Buybacks End as Credit Conditions Tighten
From Morgan Stanley: “The household sector has an ostensibly solid balance sheet. In fact, the sector’s net worth hit a new all-time high in dollar terms in the June quarter, and is almost back at all-time highs relative to income. However, balance sheet metrics are typically poor indicators of financial risk, particularly when the assets are valued at market prices. At the top of a boom asset prices are almost always elevated, providing a false sense of financial solidity. For example, the non-financial corporate sector’s debt-equity ratio hit an all-time low in the US in 1999. Historically, debt, or leverage, has been a much better indicator of risk – and it hasn’t mattered what assets are on the other side of the ledger. On that measure, American households, with record leverage, are high risk. Cash-flow measures are even more worrying, in my view… the household sector’s net financial requirement, which is a net cash flow measure. As I’ve noted before, the household sector has never, prior to this cycle, run a cash-flow deficit. The deficit was 8¾% of disposable income at its low. Changes in cash-flow are very important for growth. If the cash-flow deficit is widening that is usually positive for growth, because it suggest that outlays are growing faster than cash income. Conversely, a rising cash-flow balance bodes ill for growth…Note that recessions are usually associated with the cash-flow balance rising, and it is a rising cash-flow balance that leads the GDP downturn.

The household sector’s cash-flow balance has risen gently over the past year, and that has led to GDP growth slowing to below-trend levels… there is potentially a lot more adjustment to come. What are the household sector’s options? It has two: continue to fund the deficit by either increasing debt or selling assets; or reduce the deficit by slowing the growth in outlays relative to the growth in cash-income. So far the household sector has found it relatively easy to finance the cash-flow deficit. For several years the principal financing tool was borrowing, largely funded against housing – so-called home equity withdrawal (HEW). Over the past 18 months, however, that has become more difficult. But households found an alternative financing source: selling assets, principally equities…The ‘surplus HEW’ series shows the household sector’s borrowing requirement net of HEW. In 2003-04 the sector over-funded its deficit, at the peak extracting US$394bn more in HEW than needed to cover the cash-flow deficit.
Now, however, HEW is $288bn less than the deficit – a financing hole that needs to be filled. The other series is net equity purchases. Over the four quarters to June the household sector sold just over $700 billion of equities. (This includes executives selling equity grants given as remuneration.) The household sector was able to sell equities because the corporate sector was a willing buyer… the corporate sector was a net buyer of $770bn of equities through the year. In other words, over the past three years there has been a transition from households borrowing to fund their cash-flow deficit to the corporate sector borrowing to buy back stock to fund the household sector’s cash-flow deficit. But here’s the rub: the apparent end of the boom in corporate activity will likely lead to a significant fall in net corporate buy-backs in the current half…A fall in household (equity) asset sales will come just as lending conditions have been significantly tightened, courtesy of the sub-prime problems. The risk is that the tightening in financial conditions – debt finance and the reduced scope for equity sales – may cause the household sector, either willingly or unwillingly, to accelerate the pace at which it narrows its cash-flow deficit. That would like be sufficient to tip the US into recession.”

Philly Fed Rises Sharply
From Deutsche Bank: “The September manufacturing index from the Philly Fed showed a pick up in activity in that region. The headline of this series rose to 10.9 from 0.0 previously. Two key details of the report corroborated the headline strength: new orders (15.1 vs. 7.1) and shipments (16.9 vs. 12.4) both gained. Prices paid also rose (23.1 vs. 15.4), but remained in the bottom end of the range for this series over the past two quarters; this was likely driven by oil prices. Of the components which declined, the drop in the employment component (7.5 vs. 21.2) was the most noteworthy to us, given our (and likely the Fed's) heightened concern regarding the labor market. The 6-month outlook for business conditions edged slightly lower (35.7 vs. 36.2), and in a special question 65% of respondents indicated that they saw no impact on their business from recent market turmoil.”

MISC
From Credit Suisse: “…many such borrowers are delinquent not because they're in economic distress (although clearly some are) but rather because many of these borrowers choose to be delinquent (e.g., housing market correction and lack of downpayment results in voluntarily handing in the keys) or unexpected expenses (especially for the large percentage of firsttime home buyers) or overstated income (e.g., for stated income loans). Obviously, borrowers may fall in one or all of these categories. The point is that the borrowers' source of financial duress is housing centric." They conclude that for many of these borrowers it is likely preferable to lose the house that they have zero or negative equity in than to lose their car and/or credit cards.”

From UBS: “UBS Economists have updated their estimates of contraction in the direct
housing sector to -17% in Q4 07, -11.5% Q1 08, -7.0% in Q2 08 before starting to grow modestly by Q3 next year. Their estimate has housing starts bottoming out at a 1.2mm annual pace next year – a pace not much lower than yesterday’s reading. Although the housing related component of GDP has shrunk to 5% from 6%, a sketchy estimate of direct and indirect housing-related component of GDP is likely above 10%. Though not our official call, what if 10% of the economy shrinks 25%? That would be a significant headwind.”

From Deutsche Bank: “…continue to see a reduction in the growth rate of mortgage borrowing and a flattening in consumer credit growth.”

From Lehman: “Natural gas storage …inventories for the United States have shifted back into a deficit to 2006…The United States as a whole has averaged warmer than normal every week for nearly two straight months. After a relatively cool month of July, August and September have been exceptionally warm on a population-weighted basis, and now make it very likely that the 2007 summer season will be one of the hottest on record…The very small storage builds in recent weeks have been caused in part by unusually hot weather in the Midwest and East, but also in part by declining LNG imports relative to levels recorded earlier in the summer. There have yet to be any significant storm-related supply disruptions in the Gulf of Mexico.”

From JP Morgan: “Continuing claims fell sharply in the week ending September 8, from 2.597 million to 2.544 million, and the insured unemployment rate dropped to 1.9% from 2.0%. There has been a sustained rise in continuing claims since late June, but this week’s decline reversed about half that. Nonetheless, continuing claims are still elevated and should be watched carefully.”


End-of-Day Market Update
From Morgan Stanley: “Today's rates market sell-off is looking like the disaster scenario for mortgages.”

From Bloomberg: “The difference between two- and 10- year Treasury note yields increased to the widest since May 2005 on speculation the tumbling dollar and the Federal Reserve's cut in borrowing costs will fuel inflation. Yields on 10-year notes, more sensitive to inflation expectations than shorter-term securities, rose faster than those on two-year notes, steepening the so-called yield curve… ``Investors are losing onfidence in the Fed's inflation-fighting credibility,'' said Michael Pond, an interest-rate strategist in New York at primary dealer Barclays Capital Inc. ``At the same time, we're seeing a run-up in commodities and a weakening dollar.'' The yield between 10- and two-year notes widened a third day, reaching 57 basis points… The three-month Treasury bill yield fell for the third straight day, decreasing 10 basis points to 3.80 percent, the lowest since Aug. 30.”

From Bloomberg: “Crude oil rose to a record $83.90 a barrel in New York after the U.S. said that production in the Gulf of Mexico was shut because of a storm threat. More than … 28 percent, of daily oil production was idled… Prices were already higher on signs that U.S. interest-rate cuts and a falling dollar will bolster demand.”

As of 3:40
Two year Treasury rates are 12bp higher at 4.11%, ten year Treasuries up 16bp to 4.70%
Swap spreads averaging 3bp wider on day.
The Dow is down 46.
The dollar index is down .72 to a new 15 year low of 78.58 (1992 low was 78.19).
Spot gold trading $14 higher at $735.7, after hitting new record high of $738.60 earlier.
Oil currently at 83.32, up $1.39.