Today's Tidbits

Weakening Dollar Puts Fed Monetary Policy in Tough Space
From Cumberland Advisors: “…markets now completely dismiss the credibility of any Treasury Secretary who says “the strong dollar is in the national interest of the United States”. Snow was and now Paulson is fully ignored when he makes this utterance. We think that the Fed doesn’t know what to do about the dollar. They would rather not include it in their decision-making apparatus. Bernanke learned from Greenspan’s mistake 20 years ago when the new Chairman Al raised rates to defend the dollar and ended up triggering a stock market crash and a slowdown. Chairman Ben is not about to repeat that error. But what can the Fed do? If it raises rates to defend the dollar, it will exacerbate an already slowing economy and will condemn the housing adjustment to a longer and harsher outcome. If it ignores the weaker dollar, it takes a certain amount of inflation risk…In addition the Fed is watching the oil price and food prices and worrying about them spreading into the “core” concept of inflation. Some Fed folks are wondering whether or not the concept of core inflation is correct for the present times. That makes the central banking game even tougher. A weaker dollar certainly helps the growth rate of the US economy. But is it a lot of help? Some statistical estimates (BCA) indicate that “the trade-weighted dollar would have to depreciate about 18% over an 18 month period to lift real GDP growth a full percentage point.” That‘s a traded weighted decline of 1% per month. We have only seen a small fraction of that rate of decline this year. A 1% per month FX decline of the dollar would cause enormous dislocations in the financial markets of the world. Intervention by many central banks and government funds would work against its likely outcome. The sell off in US dollar denominated bonds would be severe. So we will assume that these institutions will operate in their strategic self interest. That means no dollar rout. And it means more export growth in the US and it means higher import prices. The combination will act to restrain the Fed from cutting too aggressively AS LONG AS there is no recession developing. If a US recession gets on the top of the Fed’s radar screen, the dollar FX will be ignored and the Fed will act to avoid an extended domestic slowdown as it first priority. We don’t expect a recession. If we get one, it will be very ugly. In the US stock markets, the technology sector has the greatest exposure to foreign revenue; hence. It gets the biggest earnings boost from a weaker dollar. Half of the S&P 500 Information Technology sector pre-tax income is foreign sourced.”
From UBS: “Bernanke's speech in New York last night was notable in that he presented a picture of a Fed Chairman swimming in a pool full of alligators. On one hand, he noted the weak Dollar has been pushing up prices and that the 50bp rate cut in September was done with an eye toward quickly reversing that cut if conditions warranted. On the other hand, Bernanke fretted about the ongoing drag on growth from the housing industry and how consumer spending may suffer in the months ahead. Bernanke and the FOMC appear to be in the same place as the rest of us: waiting to see if there are more dropped shoes from housing and watching the credit markets to see if they can pull themselves together after the 50bpt rate cut. Our view is this: we're not yet half-way into this housing recession and the 76% rise in Oil prices since the January 2007 lows is a real threat to push the vaunted American consumer into the abyss--and the economy with it.”

Foreigners Pulled Plug on Lending to US Banks During August Credit Turmoil
From Deutsche Bank: “Why did the TIC data plunge? The August net long-term TIC data showed a $69.3B decline, the largest drop-off ever. When short-term securities are included, the decline totals $163.0B, also a record drop. The main reason for the plunge was due to an $111.4B decline in US domiciled banks dollar denominated liabilities, in particular for non-negotiable deposits such as bank-sponsored CDs. Basically, banks were not able to issue private label paper to foreign investors, or put another way, foreign investors were unwilling to lend dollars to banks based in the US, consistent with higher Eurodollar rates. Ostensibly this was due to the shut-in in activity in the money market associated with subprime defaults and the blow out of asset backed commercial paper spreads. To be sure, as the money market returns to normal, the TIC data will recover. It should be noted that the TIC data are lagging and that they do not provide us with any fresh insight into market trends/activity. Rather, the data provide us with a clearer picture of what occurred during the summer liquidity crisis.”
From JP Morgan: [On TIC data]”…it is interesting that US investors continued to have appetite for foreign securities despite the ceasing up of financial markets. That may mean more for the continued decline in the USD than anything else in this report. That is, US investors chose to exit the US during a time of financial crisis, which suggests that they do not view USD-denominated assets as "safe havens" during troubled times.”

Misc Housing Market Info
From OFHEO: “…the current conforming loan limit will not be reduced for 2008. If the index used to calculate the maximum loan level should increase, the amount of the increase in 2008 would be reduced by the decline calculated in 2006 of 0.16%. Under no circumstance, however, would the maximum loan level for 2008 drop below the 2006 and 2007 limit of $417,000.”
From Merrill Lynch: “The National Association of Home Builders sentiment index fell to its lowest level on record in October, falling to 18 from 20 in September. The underlying details were weak as well, with all of the components now at all-time lows. Present sales fell to 18 from 20 (previous record low was 19 in January 1991), future sales were unchanged at 26 (a record low), and prospective buyer traffic slipped to 15 from 17 (taking out the previous record low of 16, which was set in December 1990 and just recently matched this August, and means more bad news for home sales). So clearly the situation is dire for US homebuilders. We believe the pain is likely to continue until the inventory overhang begins to unwind - which is only likely to occur via massive price capitulation. As an aside, today we had the second largest US homebuilder say that it expects "the housing environment to remain challenging" - so the outlook continues to look grim as well…The regional components in the NAHB report also looked weak. The Northeast and South fell a modest one point, to 26 and 21 respectively. The West, where the housing bubble was more prevalent, really took it on the chin, tumbling to just 14 from 18 last month. The Midwest region was the only bright spot in the entire report, ticking up to 15 from 13 - albeit still at a very low level.”
From Bloomberg: “D.R. Horton Inc., the second-largest U.S. homebuilder, said orders in the fiscal fourth quarter plunged to the lowest in almost six years as customer cancellations soared and banks restricted lending. Orders…declined for a sixth straight quarter, falling 39 percent … from a year earlier. The value of houses ordered in the period ended Sept. 30 slid 48 percent to $1.3 billion. The cancellation rate was 48 percent, up from 38 percent in the previous quarter…Fourth quarter orders fell 48 percent in the Northeast, 52 percent in the Midwest and 27 percent in both the Southeast and South Central regions, the company said. The South Central area includes Texas. Orders in California fell 58 percent and 39 percent in the Southwest, which includes Arizona. They slid 54 percent in the company's western region, which includes Nevada and Oregon.”
From Dow Jones: “U.S. Treasury Secretary Henry Paulson offered a sobering view of the pressure the housing market was having across the country, saying the decline stood “as the most significant current risk to our economy.” Paulson even acknowledged that problems in credit, mortgage, and housing markets were much more severe than anticipated. “The ongoing housing correction is not ending as quickly as it might have appeared late last year,” he said in a speech to Georgetown University Law Center, according to prepared remarks. “And it now looks like it will continue to adversely impact our economy, our capital markets, and many homeowners for some time yet.””

Reduced Chinese FX Sterilization Raises Inflation and Other Risks
From Barclays: “Textbook economics suggests that rapid foreign exchange reserve accumulation, if not fully sterilised, breeds inflation. The underlying logic is simply that the conversion of current account receipts into local currency will increase the money supply - and therefore increase inflation – unless it is mopped up by sales of government bonds and bills. To judge from developments in Asia, the textbook is correct. The region – non-Japan Asia – is displaying all the hallmarks of a classic inflationary boom, with unrestrained foreign exchange reserve growth the culprit. In essence, currency intervention to limit or control foreign exchange appreciation is breeding a very rapid increase in FX reserves that is not being fully sterilised. The resulting increase in money supply is driving both consumer and asset prices sharply higher…it is important to recognise that the end result will be a level of inflation that eventually forces a sharp tightening in overall monetary conditions. The endpoint is therefore a popped asset bubble, with all the various attendant negative implications for growth. While the inflationary boom is underway, growth is seemingly unstoppable and the cycle invulnerable…However, once the inflation in consumer and asset prices becomes intolerable, the expansion is doomed…The longer it takes authorities to tighten monetary conditions – both internal and external - the greater the negative impact…In an ideal world, Asian currencies would be allowed to float freely. Currency appreciation would therefore limit growth in the regional current account surplus, while there would be no cause for FX reserves to increase. Hence, there would be no dangers of an inflationary splillover into the domestic economy. In a less ideal world in which currencies are not free to float, the risks of an inflationary boom stemming from rapid FX reserve growth can at least be offset by sterilisation. If the central bank sells new bonds and bills to the same magnitude as the increase in reserves, additions to the money supply will be mopped up by the debt sales and will therefore not be able to influence domestic prices. Unfortunately, even this less-than-ideal solution has not been implemented by the monetary authorities in the regional giant, China. In fact, according to our Chinese analysts, the sterilisation ratio (balance of payments surplus minus government bond and bill sales) has fallen steeply over the past 12 months to stand at just 34% (ie, only 34% of the surplus/reserve growth is being sterilised). It is certainly no coincidence that the decline in the sterilisation ratio has coincided with a sharp rise in signs of economic overheating. For the sake of example, in August last year, when the sterilisation ratio was running at 80-90%, the Chinese equity market traded at a trailing PE ratio of 16-17. This was high, but not unjustifiably high given the underlying growth rate. Now, the trailing PE ratio is 46, with some sectors such as technology or health valued at truly demented ratios between 100 and 150… the greater the inflation of the asset bubble, the greater will be the eventual baleful impact on the economy when the bubble pops. In China’s case, the usual negative wealth effect on households may be the least of the post-bubble problems. More worrying, in our view, is the evidence of sizeable cross-shareholdings among the corporate sector, a phenomenon that is very reminiscent of Zaitech Japan in the late 1980’s. Extensive equity price falls will reduce corporate cashflow sharply, thereby raising solvency issues. In turn, this scenario threatens the broader global economy via an interruption of Chinese import demand as Chinese companies are temporarily bereft of liquidity. Clearly China has sufficient resources, in the shape of gigantic foreign exchange reserves and a very low government debt/GDP ratio, to be able to bail out a business sector unduly damaged by equity market losses. However, the interim between equity market collapse and government bailout is likely to be very scary indeed for the rest of the global economy, particularly those bits of it – emerging markets, commodity and energy producers – that have benefited directly from China’s growth acceleration. Certainly a growth hiatus, under which the pace of global growth falls very sharply for a couple of quarters, would be a plausible outcome from a popped Asian equity bubble.”

Details Behind Fed’s 50bp Discount Rate Cut
From JP Morgan: “Minutes to discount rate meetings between August 16 and September 18 solidified perceptions that SF Fed's Yellen and Philly Fed's Plosser stand on opposite ends of the FOMC's spectrum. On August 23, less than a week after the Fed's emergency inter-meeting cut of the discount rate, the SF Fed's Board of Directors voted for an additional 25 bp inter-meeting cut in the discount rate. (Traditionally, regional reserve bank boards vote for the action proposed by the banks president.) Just as interesting, going into the September 18 FOMC meeting, Plosser's Philadelphia Fed had requested no change in the discount rate. Much like the FOMC minutes, the discount rate minutes provide little guidance on the differing rationales for a 25bp vs. 50bp cut in the discount rate. Both groups of directors were concerned about downside risks to economic activity. One difference that was noted was that among the directors voting for a 50bp cut, "some noted that a weak employment report for August was perhaps an early sign of a slowdown." The NY Fed made up its mind for a 50bp cut on September 7, the day of the August employment report; the other banks voting for a 50bp cut waited until the middle of the following week, Sept. 12-13, but several days before the September 18 meeting.”
From Bloomberg: “Five of the 12 regional Federal Reserve Bank boards opposed the central bank's decision to lower the charge for direct loans to banks by half a percentage point last month. Four district banks voted to cut the discount lending rate by only a quarter point in early September, while the Philadelphia Fed wanted no change at all, minutes released in Washington today said. The records show greater divisions among officials than indicated by last week's minutes of the Sept. 18 Federal Open Market Committee meeting. That report said ``all members'' judged a half-point reduction in the benchmark rate was ``most prudent.'' Presidents of at least three banks had expressed skepticism about a cut before the Sept. 18 meeting. ``There has to be more policy debate that is going on than what is reflected in the minutes'' of the FOMC meeting, said Brian Sack, senior economist at Macroeconomic Advisers LLC in Washington and a former Fed Board section chief. ``It is somewhat mysterious that we don't see a description of that discussion.''”

MISC

From Bloomberg: “Not since Russia defaulted on its debt and the collapse of hedge fund Long Term Capital Management in 1998 have the credit markets suffered so many dislocations. The world's largest financial institutions have written down more than $21 billion of mortgages, securities and corporate loans whose value plummeted during the third quarter.”

From CITI: “I'm back to wondering what to make of oil which has exploded to new highs. Certainly it's got to have some economic impact if sustained at these levels ... inflationary? tax on consumer? ... as well as continuing to boost oil producers' reserves and sovereign wealth funds that are getting a lot more attention of late.”

From Goldman Sachs: “Has the unplanned expansion of bank balance sheets via hung bridge loans and the tapping of liquidity lines by CP borrowers crimped lending to other borrowers? In the past three months, C&I debt on bank balance sheets has grown at a 38% annualized pace, the fastest pace in over 30 years. We don’t know to what extent this expansion is squeezing out other borrowers because we don’t have any up-to-date information on bank lending standards. But it clearly poses a risk that lending standards will be tightened, in my view.”

From Lehman: “With GDP per capita at about only US$1,000, nearly 60% of its workforce still in the countryside and half of its population under the age of 25, India has enormous growth potential yet to be unlocked.”

From Dow Jones: “Barclays plans to list eight new ETNs tracking agriculture, copper, energy, grains, industrial metals, livestock, natural gas and nickel. The investments are slated for listing on the NYSE Arca electronic trading platform on Oct. 24…”

End-of-Day Market Update

From RBSGC: “[AM Update]…late yesterday S & P lowered its ratings on 402 classes ($4.6 bn) of U.S. RMBS backed by first-lien subprime mortgage issued during the first three quarters of 2005. As a result, the market is rallying this morning as credit concerns from a slowing housing market continues to dominate headlines- fuelling the flight to quality trade. The curve is steeper by 5 bp with the 2-yr currently lower by 7 bp (4.13%) and the 10-year at 4.65%. Not surprisingly, vols are sharply higher (2.5 bp) and shorter dated swap spreads are about 1.0 bp wider. MBS are loosing 2 ticks to 10-year UST with higher coupons doing a touch better in the bull steepener.”

From Dow Jones: “Treasury prices were higher and the yield curve steeper… The dollar was range-bound against the euro Tuesday afternoon in New York, both currencies stricken by a bout of risk aversion as equities decline. The yen subsequently managed
to maintain a lead… Wall Street shares declined again… Crude oil futures hit a new intraday record of $88.20 a barrel Tuesday, spurred higher by concerns that any Turkish incursion into northern Iraq could crimp crude supplies and by forecasts for a fourth quarter supply deficit. Prices have risen for the past five sessions…”

From RBSGC: “The market extended the overnight steepening bid -- and in an impressive manner at that. The curve steepened out as far as 53 bps, before ending the session north of 52 bps. 2-year yields got as low as 4.11%...”

2y UST -10bp to 4.12%, 10y UST -3bp to 4.64%
Dollar index +.17 to 78.25, yen -.7 to 116.7, euro -.004 to 1.416, gold +.2 to $759.6
Dow -72 to 13,913, S&P -10 to 1538.5, Nasdaq -16 to 2764
Oil +$1.48 to $87.61