Today's Tidbits

September 25, 2007 TIDBITS

Steve Roach Sees Weakening Dollar as Sign of Rising U.S. Economic Problems
From The New York Times: “Currencies are first and foremost relative prices — in essence, they are measures of the intrinsic value of one economy versus another. On that basis, the world has had no compunction in writing down the value of the United States over the past several years… Sadly, none of this is surprising. Because Americans haven’t been saving in sufficient amounts, the United States must import surplus savings from abroad in order to grow. And it has to run record balance of payments and trade deficits in order to attract that foreign capital. The United States current account deficit — the broadest gauge of America’s imbalance in relation to the rest of the world — hit a record 6.2 percent of gross domestic product in 2006 before receding slightly this year. America must still attract some $3 billion of foreign capital each business day in order to keep its economy growing. Economic science is very clear on the implications of such huge imbalances: foreign lenders need to be compensated for sending scarce capital to any country with a deficit. The bigger the deficit, the greater the compensation. The currency of the deficit nation usually bears the brunt of that compensation. As long as the United States fails to address its saving problem, its large balance of payments deficit will persist and the dollar will keep dropping… the American consumer is now at risk. Consumption expenditures currently account for a record 72 percent of the gross domestic product — a number unmatched in the annals of modern history for any nation.
This buying binge has been increasingly supported by housing and lending bubbles. Yet home prices are now headed lower — probably for years — and the fallout from the subprime crisis has seriously crimped home mortgage refinancing. With weaker employment growth also putting pressure on income, the days of open-ended American consumption are likely to finally come to an end. That will make it hard to avoid a recession. Fearful of that possibility, foreign investors are becoming increasingly skittish over buying dollar-based assets… Foreign appetite for United States financial instruments is likely to be sharply reduced for years to come. That would choke off an important avenue of capital inflows, putting more downward pressure on the dollar… the more the Fed under Ben Bernanke follows the easy-money Alan Greenspan script, the greater the risk to the dollar. Why worry about a weaker dollar? The United States imported $2.2 trillion of goods and services in 2006. A sharp drop in the dollar makes those items considerably more expensive — the functional equivalent of a tax hike on consumers. It could also stoke fears of inflation — driving up long-term interest rates and putting more pressure on financial markets and the economy, exacerbating recession risks. Optimists may draw comfort from the vision of an export-led renewal arising from a more competitive dollar. Yet history is clear: no nation has ever devalued its way into prosperity.”

Slowing Sales at Target Hint at Consumer Spending Slowdown For Holidays
From The Wall Street Journal: “Two retailers that have been strong performers in recent years said late yesterday that they are facing softer-than-expected sales, raising concerns about whether once-exuberant consumers are finally starting to snap their wallets shut. Target Corp. yesterday evening cut its forecast for September sales at stores
open more than a year to an increase of just 1.5% to 2.5%, down from its previous forecast of 4% to 6%.... said customer traffic was weaker than expected, and that sales in the Northeast were particularly slow…At the same time however, retailers are predicting one of the slowest Christmas selling seasons in years, as the slump in the housing market worsens. Consumers also are being pressured by higher food and gasoline prices. These new suggestions that consumer spending is slowing are likely to add to worries that the combination of a worsening housing market, credit-market turmoil and a weakening job market (if last month's disappointing hiring is repeated) could push the U.S. close to or into recession -- despite the Federal Reserve's recent interest-rate cut. Consumer spending accounts for more than two-thirds of total output in the U.S. Higher energy and food prices have been pinching sales of some other retailers recently. Separately, home-improvement retailer Lowe's Cos. …said sales are trending below previous expectations because of drought in the mid-Atlantic, Southeastern and Western regions of the U.S. The drought hurt sales of outdoor-related merchandise such as plants… the retailer has been consistently overly optimistic about the housing market's problems, which has led it to lower earnings forecasts for three of the past four quarters.”

Case-Shiller Housing Index Probably a Better Indicator Than OFHEO Index
From JP Morgan: “The largest decline ever in the 10-metro area index, which goes back to 1987, was 6.3%oya in April 1991. Many of the cities experiencing the sharpest declines—mainly along the coasts and in the Southwest—are the same cities that experienced the sharpest price increases during the housing boom. The Case-Shiller house price indices, like the OFHEO, track price changes for constant-quality existing homes and also control for regional shifts in the mix of homes sold. However, unlike the OFHEO, the Case-Shiller indices include nonconforming mortgages (mortgages over $417,000 in 2006 and 2007). In addition, subprime activity is underrepresented in the OFHEO, but likely not in Case-Shiller metrics. These differences explain greater appreciation in the national Case-Shiller index during the boom years but also more rapid deceleration subsequently. Thus, in 2Q07, the national S&P Case Shiller index was down 3.2%oya, while the OFHEO purchase-only index was up 2.6%oya. These differences probably make the Case Shiller indexes more reliable measures of house price changes at this time than the OFHEO indices.”

Home Equity Extraction Likely to Slow to 3.9% of Disposable Income This Year
From Lehman: “Homeowners have continued to extract equity from their homes, but at a slowing pace. Net equity extraction (less closing costs) fell to $494bn saar from an upwardly revised $639bn in Q1 [Based on Fed data]…Given falling home prices and tighter lending standards in the mortgage market, equity extraction is likely to continue to decline. If we assume extraction falls at roughly double the rate in Q2 over the next two quarters, extraction will total about $400bn this year. This equates to roughly 3.9% of disposable income, which is less than half the amount in 2005…”

Petro-Dollar Risks and Politics
From Lehman: “By holding onto massive dollar reserves and pricing oil in dollars, Saudi Arabia is sitting on two assets that threaten to depreciate in value. By pegging the Riyal to the dollar, the kingdom also risks importing inflation and damaging the Saudi economy. Riyadh’s predicament has increased both macroeconomic and geopolitical risks to the price of oil. The US dollar has long been a key mechanism tying together the two most important players in the global oil market – the US and Saudi Arabia. The “dollar alliance” between Riyadh and Washington dates back to the aftermath of the oil crisis of 1973, when then US Secretary of State Henry Kissinger and US Secretary of Treasury William Simon negotiated a bilateral agreement with the Saudis to assure petrodollar recycling. Since then, Riyadh has accumulated over $800 billion in dollar reserves, a large part of the $3.5 trillion in total dollar reserves thought to be held by the Gulf countries (GCC). Likely contributing to the recent pop in oil prices, speculation has increased that the dollar alliance between Washington and Riyadh is ending. With the US and Saudi business cycles appearing increasingly out of sync, it may become more difficult for Riyadh to maintain its currency peg to the dollar without causing inflation… While a Saudi currency peg may be broken as the Fed continues to ease monetary policy
in the US, we do not expect Saudi Arabia to make any rash decisions to break the dollar
alliance that has prevailed for a generation. Often referred to as the “central banker” of
the oil market, the kingdom has proven on multiple occasions that it is focused on
protecting the buoyant outlook for the global economy, as much to assure itself of a
buyer as to preserve its political alliance with the United States. That usually means ensuring enough oil is supplied to the market and holding spare capacity for use in the
event of a supply disruption. Today, however, given mushrooming dollar reserves and
the fragility of the US economy, it also means holding off on significant reserve
diversification or doing anything that would initiate an attack on the US dollar… We do not doubt that the kingdom’s increased leverage due to higher oil prices and a declining dollar will be put to use. It is difficult to imagine exactly how that leverage over Washington will manifest itself, but it may include higher technology weapons at greater discounts or greater consideration of Riyadh’s concerns in other areas, including regional security. Thus, while the world might actually never witness the Kingdom using its enhanced leverage, the fact that speculators perceive it to exist may push up the price of oil. The kingdom is also not alone in its recently improved bargaining position. Other large dollar reserve holders may also attempt to extract rents from Washington, and it is certainly possible that one or more of these countries could set off an attack on the dollar by diversifying its reserves or de-linking its currency. It is clear that after a generation on the sidelines, the dollar has re-emerged as an upside risk to oil prices.”
From Reuters: “Iran is receiving more than 70 percent of its income from crude oil exports in currencies other than the U.S. dollar…Nippon Oil and several other Japanese refiners have started paying for crude in yen at Iran’s request…”

Rate Resets for Subprime ARMS Will Get Little Help From Lower Fed Funds Rate
From LEHC: “Numerous Wall Street firms noted this week that the recent surprise move by the FOMC to cut the funds rate by 50 bp will have very little impact on subprime mortgages facing their first rate reset over the next few months. The reason? Incredibly high margins, and rate reset caps.
From Merrill Lynch: “Over the next several months, billions of adjustable-rate mortgage loans will reset in the US. Housing economists estimate that ~ $685.5 billion adjustable-rate loans will reset between q4'07 and Dec.'08. Estimates show that ~ 68.9% of these resetting arms are SubPrime with 2-3yr prepayment penalties (painful), which are normally pegged to 6- or 12-month LIBOR plus some enormous spread - 500-600bps (painful).”
From Barclays: "Prepays for all index series continue to decline, a trend that bodes ill for future delinquency and loss performance of subprime RMBS, given the large amount of first interest rate resets rapidly approaching."

Second Largest Homebuilder Plans to Increase Discounting to Reduce Inventories
From LEHC: “Lennar Corp., the nation’s second largest home builder (by deliveries) in 2006, reported a huge loss for the quarter ended 8/31/07, mainly resulting from write-offs of land options and write-downs of property. The company also reported declining margins and increased sales incentives, but the numbers on net new home orders showed that the company had been too timid in slashing prices so far this summer. For the quarter ended 8/31/07, Lennar reported net home orders of just 5,804, down a startling 47.5% from the comparable quarter of 2006…The company’s sales cancellation rate (expressed as a % of gross orders) was 32% in the latest quarter. The company noted that its average sales price on home deliveries in the latest quarter was $296,000, down 6.3% from a year ago, and noted that most of the decline was the result of increased sales incentives (an average of $46,000 per home this quarter compared to $35,900 per home a year ago). As the company’s CEO noted today, the housing market continued to deteriorate this summer in a manner that the company didn’t anticipate, and that as a result the company will become much more aggressive in discounting home prices to reduce inventories.”

Estimating China’s Exposure to a U.S. Economic Slowdown
From Citi: “Exports already account for 36% of China’s GDP, while the US market makes up 22% of China’s total exports… a slowdown of US GDP growth by 0.8ppt could cut Chinese growth by 1.1ppt. These imply an elasticity of 1.4.1 In a recession scenario, US growth could fall by 3ppts from our 2008 forecast of 2.5%. This would directly drag down Chinese growth from the expected 11% to 6.9%. This OEF model, however, probably ignores two important mechanisms. One, the model does not automatically take into account likely policy responses by the Chinese government. During the East Asian financial crisis, China maintained 7.8% growth through expansionary policies. The authorities would probably act again to prevent significant slowing of the economy given their strong belief of 8% minimum growth. Two, the model does not effectively capture changes in capital flows. In a world with rising risks and slowing growth, capital is likely to leave emerging market economies. But China could be an exception this time around, as many investors have begun to view China as a safe haven. Plus, while world interest rates start to fall, Chinese interest rates are probably still on an uptrend. This could mean increased capital flows to China in the event of a US recession. On balance, the Chinese economy would slow, but expansionary policies and capital inflows could support its GDP growth at 8-9%. In this hypothetical scenario, the trade and current account surpluses would narrow sharply; profit margins might collapse; growth would become even more dependent on investment activities; and inflationary pressure could ease.”

Health Care Insurance Premiums Growing Three Times Faster Than Inflation Rate
From Dow Jones: “A study shows that health-care cost increases are down to their lowest level in nearly a decade, but they’re forecast to rise at a much faster rate again in 2008. The study from Hewitt Associates says total health-care costs to employees will jump by double digits next year, and that point-of-service and preferred-provider-organization coverage - which have seen growth rates in the low single digits during 2007 - will jump by a high-single-digit percentage. Those increases will be more in line with health maintenance organizations and traditional indemnity plans. Hewitt researchers say that this year’s price increase was artificially low since many employers have been socking away extra cash for health care of late. “In ‘06 and ‘05, employers were budgeting too much so they had overall surpluses in the plan…“They didn’t have to budget so much [this year].”… insurers also will be upping their price increases by a percentage point or so, to about a 9% gain - roughly triple the rate of inflation. Employers generally already have lined up their health-care plans for the coming year and are feeling the extra pinch…the average cost per employee for major companies will hit $8,676 next year, up from $7,982 this year, an 8.7 increase. Rate increases were up 5.3% this year, down from last year’s level of 7.9%. Employee contributions to health insurance will rise at a faster rate, going to $1,859 a year from $1,690, for an increase of 10%. Including out-of-pocket charges such as co-payments and deductibles, total health-care costs for employees should average $3,597 next year, up 10.1% from $3,266. During 2007, traditional indemnity plans rose 9.1% while HMOs were up 8.7%. Point-of-service and preferred-provider costs, however, rose more modestly, up 3.9% and 2.4%, respectively.”

Second Quarter Personal Income Growth Remained Solid Nationally
From Wachovia: “Income growth moderated to a 4.9 percent pace in the second quarter, reflecting a payback from a 10.3 percent first quarter spike caused by bonus payments occurring in the first quarter. Nominal personal income grew in 49 states and the District of Columbia. New York saw the lone drop, a contraction of 0.1 percent for the quarter. Even with a slight second quarter dip, New York shows the second largest gain in income over the past year, trailing only California. Texas is the clear up-and-comer, with personal income up nearly 8 percent. The fastest growth continues to be in the Rocky Mountains, where mining activity is providing a sizable boost to income… Wages and salaries accounted for just over half the growth, while interest, dividends and rents accounted for more than a third of the rise… The industrial heartland in the Midwest posted modest income gains during the second quarter, as manufacturing activity has revived somewhat in recent months. Michigan, which has had the weakest major economy in the nation for most of this decade, saw personal income rise solidly for the second consecutive quarter. Weaker growth in earlier periods, however, has held year-to-year income gains to an anemic 3.6 percent. Surrounding states have faired slightly better, but most of the Midwest remains in the lowest or second lowest quintiles for income growth over the past year. Ohio and Michigan have both seen poor income growth mirroring their employment losses over the past year, 0.15 and 1.25 percent, respectively … Utah continued to post exceptionally strong income growth, leading the nation with an annualized growth rate of 8.2 percent in the second quarter and 9.3 percent growth over the past year. Utah also led the nation in nonfarm employment gains over the same period with growth of 4.85 percent… Texas saw the third fastest rate of personal income growth, up 7.99 percent over past year. The state’s economy has been booming, which also saw the largest gain in nonfarm jobs over the same period. Gains are evident across the board”


More Bank Loan Write-Downs Coming
From Dow Jones: “The nation’s three biggest banks are likely to suffer major third-quarter writedowns, possibly topping $1 billion apiece, to reflect the eroded value of loans to highly indebted companies. The expected hits stem in large part from loans the banks made, or committed to make, to finance the leveraged buyout boom that ground to a halt this summer. Banks traditionally farmed out the loans to an array of investors - other banks, hedge funds and vehicles called collateralized loan obligations - but risk-averse buyers are now balking. That’s forcing banks to either offer the loans at bargain prices or to hold them on their books at discounted values. Analysts and investors have been trying to forecast the fallout for banks ever since the credit crunch hit, forcing them to guess at banks’ exposures and then the level of discount. Wall Street brokerage firms made the task somewhat easier last week when they reported third-quarter results and said they had cut the value of their leveraged loan books by some 4% to 6%. Analysts expect Citigroup Inc., J.P. Morgan Chase & Co. and Bank of America Corp. to take similar haircuts when they report quarterly earnings next month, assuming the credit markets neither dramatically improve nor deteriorate before then.”

Rating Agencies To Defend Practices Before Congress Tomorrow
From CNN: “Since the subprime crisis erupted, plenty of blame has been pinned on the big credit rating agencies. Just what went wrong at these firms - and what can be done to stave off another disaster - will be the topic of hearings on Capitol Hill this week. Lawmakers are expected to grill executives from Moody's and Standard & Poor's, two of the biggest agencies, before the Senate Banking Committee on Wednesday. Securities and Exchange Chairman Christopher Cox is also scheduled to testify. The House Financial Services Committee will follow with a hearing on Thursday… many say there is little Congress can do to overhaul the rating system, and in turn, restore confidence in the complex debt products that have exploded on Wall Street in recent years… The rating agencies have responded to the criticism by contending that they only issue opinions about creditworthiness - and investors can choose to ignore their ratings. "Ratings are not recommendations to buy, sell or hold a particular security. They simply provide a tool for investors to assess risk and differentiate credit quality,"… There is recognition that the conflicts of interest in the rating industry are problematic, but reform won't come easily,… Under legislation passed last year, the SEC has the authority to inspect credit rating agencies…doubtful there will be a significant increase in regulatory oversight, largely due to the heavy costs that would incur. "The SEC and other regulators aren't prepared to come in and police the opinions issued by rating firms,"…”

MISC

From Morgan Stanley: “Commodities continued their outperformance and posted the highest weekly, month-to date and year-to-date returns of 3.6%, 10% and 18% respectively. The market witnessed reversal of risk appetite after the Fed cut the target rate by 50bps. Equities rallied 2.8% during the week and posted second highest returns of 3.5% and 7.6% on a month-to-date and year-to-date basis respectively.”

From Lehman: “The stabilization in money markets persisted through Monday. The Fed reported that rates on asset-backed commercial paper (ABCP) continued to retreat, though spreads remain historically wide to the funds rate. The weighted average maturity of new issues continued to climb as investors become willing to purchase longer maturity paper. LIBOR rates, though lower over the course of the past week, remain elevated to Treasuries and the funds rate. Finally, volatility of the funds rate itself has fallen to normal levels: in the last four days the effective funds rate has varied no more than 2bp from target.”

From Morgan Stanley: “…preemptive actions do not come without a cost, and in our view the Fed is swapping systematic / liquidity risk, for longer term inflation risk. As a result we think the curve will continue to steepen and volatility will continue to rise…”

From JP Morgan: “In the current environment, characterized by tight bank balance sheets, it appears highly likely that any near term lending that spans year-end will be priced at a premium. The 1999-2000 experience, when the year-end turn premium skyrocketed to levels never seen before or after, provides some (albeit wide) bounds and some guidance…the current turn premium is well below Y2K levels…the Y2K pattern appears likely to repeat itself - i.e., the implied turn premium will drift wider from current levels for another week or two.”

From Citi: “…we've seen the expectations of future Fed cuts actually decline. We've gone from pretty much fully pricing an eventual move to 4.0% to now pricing in only a move to 4.25% in both Fed Fund Futures as well as Eurodollar's.”

From RBSGC: “What the data can not tell us is how many of those for sale signs represent motivated sellers who will deal at any price (foreclosed properties, speculators who waited far too long to get out, etc.) vs. those homeowners who were just hoping to sell closer to the highs in prices.”

From Wachovia: “With closings across the country delayed or even canceled by financing trouble, the credit crunch showed up in full force in August's home sales data.”

From Macroeconomic Advisors: “Q3-2007 Current Quarter GDP Tracking 2.5 percent…”

From Credit Suisse: “The mild slowdown we project for global economic growth (from a 5.2% rate estimated this year to 5% next year) should keep a lid on inflation pressures, by increasing economic slack. And that’s despite the sharp rises seen in commodity prices (oil, metals, softs). To be sure, the inflation outlook remains largely unchanged for developed countries, while that for Non-Japan Asia looks less favorable, especially for China. That said, the contagion effect from the worsening Chinese inflation outlook should be limited: Rising inflation in China is largely driven by soaring food prices…”

From Deutsche Bank: “Today's economic data are a prime example of why we expect the Fed to make a 25bps insurance-cut at the October FOMC meeting-souring housing market conditions will take a toll on consumer attitudes, and hence spending, in the coming months and quarters. Given the paltry 2% year-over-year rate of growth in the economy and tame core inflation, we think the Fed will be forced to further lower rates in order to fend off a recession.”

From Citi: “While sales indications, including autos, are far from falling off a cliff
(beware of potential new strike distortions), the third quarter appears to be ending on a soft note. The earliest signs from fundamental data suggest the Fed's policy stance prior to September 18 was relatively tight for a decelerating economy, already carrying a heavy burden from contracting housing. This should be kept in mind by those speculating on inflationary impact.”

From FTN: “There are already close to a hundred thousand newly unemployed mortgage company employees looking for work on top of several hundred thousand unemployed residential construction workers.”

From JP Morgan: “…the deterioration in the labor market differential (jobs – plentiful less jobs-hard-to-get) in today’s confidence report…we have only seen a two-month drop this large (7.8 points) during or in the immediate aftermath of recessions…Sept, Oct, and Nov 2001 were the last time we saw 2-month cumulative declines, and prior to that only in Oct and Nov 1991 was the drop greater than 7.9 since 1990.”
From GaveKal Research: “Since 1970, most cuts by the Fed (1970, 1974, 1985, 1989, 2001) were followed for at least two years by massive declines in the inflation rate. There were, however, exceptions: 1980 (which was quickly taken back by Mr Volcker) and 1998 (which was also quickly taken back). Which leaves us with the following question: Will the recent Fed cut prove to be right? Or will it be, like 1980 and 1998, a mistake quickly taken back?... In recent years, the Fed has been more broadly right than wrong (five out of seven). Better yet, when it has been wrong, it was quick to change its course and adjust to the underlying realities… there are three things that a central bank can control: the growth rate of its money supply, its interest rate, or the value of its currency. Unfortunately, as the Chinese central bankers are now discovering, it cannot control all three at the same time.”
From Dow Jones: “Freddie Mac increased its retained portfolio 1.6% from July to August to a record $732.2 billion. This is the largest monthly increase since the company
agreed to limit its portfolio growth in mid-2006.”

From Natixis: “…there are some investors who are anxious to believe the incredible argument that equities are “looking past the valley” and that it is the right time to invest, even though I can’t recall them ever “looking past the peak.””

End-of-Day Market Update

From RBSGC: “Prices firmed up over the course of Tuesday with the curve quite a bit steeper, and with most of those gains lost into the close… volume over the course of the day came off from what started as a pretty active session to one that was merely average.”

From SunTrust: “Considering how active the overnight session was, today's trade has been a complete fizzle. Prices bubbled up, reached their highs just before the economic releases, only to spend the rest of the day heading south. The news on the economy was weak…It is hard to say what caused the sell-off, other than the news was already discounted. Equities recovered their losses, which took a bit of steam out of bonds too. The short end of the market held most of its gains, but the long bond is now in the red on the day. Dollar weakness is hurting there.”

From UBS: “The 2y-10y yield curve steepened by nearly 5bp in treasuries today--continuing its run to new steeps for the move. Much of the steepening came late day as 10yrs backed up and 2's stayed right around 3.99%... TIPS had better overall selling in the long end as 20y Breakevens cheapened by 1.5bp on the day. Agencies saw another day where short Agencies richened to Swaps and cheapened to treasuries as 2yr spreads have gone 6.5 wider in the past 2 days. We had early extension flows in Agencies…there was very little outright rate activity in swaps today.”

From Bloomberg: “The dollar fell to a record low against the euro as declines in consumer confidence and home resales increased expectations that the Federal Reserve will cut borrowing costs for a second time this year. The U.S. currency weakened to a 15-year low against a basket of six major peers on speculation another decrease in lending rates will make U.S. assets less attractive to international investors…The dollar … touched $1.4154, the weakest since the euro's debut in January 1999. The U.S. currency decreased 0.27 percent to 114.56 per yen…The New York Board of Trade's dollar index that measures its value against six major currencies touched 78.213, the lowest since September 1992. The Fed's trade-weighted dollar index against major currencies fell on Sept. 20 to the weakest since its inception in 1971. U.S. Treasuries rallied on the consumer and housing data, pushing the two-year note's yield down to 3.97 percent. The comparable-maturity German bund yielded 4.01 percent, increasing its advantage over the Treasury note to 0.04 percentage point, near the widest since September 2004.”

From UBS: “Equity markets were mixed, with the S&P500 about unchanged but the Nasdaq up 0.6%. 10-year Treasury yields were steady at 4.63%; 2-year yields fell 5bp to 4.00%. Oil prices fell $1.27 to $81.38.”