Third quarter final GDP growth held at 4.9% annualized, as expected.This is the fastest quarterly growth pace in four years. The fourthquarter is expected to show a dramatic deceleration, to around 1%annualized growth. Consumer spending rose to 2.8% from 2.7%, asexpected.
The bad news today was in the inflation indicators, which unexpectedlyrose. For the third quarter, the GDP price index rose to 1% from theoriginal estimate of +.9%. Core PCE rose to 2% QoQ from the original1.8% growth expectation. Tomorrow the November PCE inflation numberswill be reported.
Corporate profit revisions showed companies made less than previouslyreported, but personal incomes were revised up to a 6% annualizedgrowth rate from 5.8% previously.
Thursday, December 20, 2007
Unemployment Claims Edging Higher
Initial jobless claims rose 12k last week, to 346k (consensus 335k),the largest increase in a month. The four week moving average climbedto 343k, the highest level since October. YTD initial claims haveaveraged 320k, so the trend is slowly rising. Continuing claims roseto a one month high of 2.646M. The six month average for continuingclaims is much lower, at 2.564M.
Wednesday, December 19, 2007
Today's Tidbits
TAF Results
From Morgan Stanley: “The Fed just released the results of the first TAF auction…the key stats are the stop-out rate and the bid-to-cover. The stop-out rate was 4.65% -- right on expectations. The bid-to-cover ratio was 3.1. The results are consistent with the notion that banks have a strong demand for funding at the right price. If the stop-out rate had been above the discount rate (4.75%), it would have conveyed a hint of desperation. Alternatively, a lower bid-to-cover would have signaled a lack of interest in the new program. The results indicated that 93 institutions submitted bids. So, the mean bid per institution was $660 million. This suggests that the bidders probably included a mix of large and small institutions (since the maximum bid amount was $2 billion).”
Declining Homeownership Will Especially Depress Single-Family Demand
From Goldman Sachs: “Although housing starts have already fallen sharply from 2.2 million to less than 1.2 million, we expect a further drop to around 750,000 before a bottom is reached. The declines will likely remain concentrated in the single-family sector, where a declining homeownership rate is weighing heavily on demand and is likely to keep excess supply measures stubbornly high. The fundamental backdrop for multi-family building is better because falling homeownership should ultimately result in rising construction of rental units…Housing activity has plummeted over the past two years. In the single-family sector, housing starts are down 54% over the past two years, the largest decline on record except for the deep recession of the early 1980s. With single-family starts of 829,000 (annualized), roughly 400,000 below the average of the past two decades, one might think that we should now be close to the bottom of the cycle. After all, the homeowner vacancy rate currently stands at 2.7%, roughly 1 percentage point above the average of the past two decades. Since this is equivalent to about 800,000 homes, one could argue that a stabilization at the current level of housing activity would eliminate the supply overhang over a 2-year period. But this logic fails to take account of changes in the homeownership rate. In a falling homeownership environment, single-family housing starts need to fall further below their long-term trend to unwind the excess supply. For example, a trend decline in homeownership of ½ percentage point per year lowers the demand for owner-occupied homes by over 500,000 per year…Thus, we estimate that single-family starts still have substantially further to fall and will bottom around 500,000 (annualized), probably in late 2008. One implication of our analysis is that measures of excess supply such as the homeowner vacancy rate and home inventories are likely to stay elevated over the next few quarters, despite the seemingly depressed levels of housing activity. In particular, the homeowner vacancy rate—our favorite measure of excess supply—is unlikely to fall sharply from its current near-record level of 2.7% until later in 2008. Ultimately, declining homeownership should lead to the construction of more multi-family rental units as a rising percentage of the population rents their accommodation. Nevertheless, we expect some near-term declines in the multi-family sector as well, for three reasons. First, more than half of all multi-family units are built for sale, and this sector is likely to see similar pressures as the single-family market (think Miami condo buildings). Second, the rental vacancy rate currently stands at 9.8%, more than 2 percentage points above the long-term average. This implies a period during which rising demand for rental accommodation may well be accommodated by falling vacancies, without much need for new construction. Third, banks are tightening their standards for commercial real estate loans (which include multifamily construction loans). In the most recent Senior Loan Officers’ survey, a net 50% of all banks reported such a tightening, the largest proportion since 1990. Because of these headwinds for multifamily construction, we expect a sizable decline in this sector as well, from 358,000 (annualized) in November 2007 to around 250,000 in late 2008.”
Falling House Prices Imply Higher Savings Rates
From Merrill Lynch: “…weak demographic fundamentals point to years of sluggish real estate activity, particularly in terms of the "price". The looming dominance of the "move down" buyer suggests that home values will continue to soften long after the building industry mops up the current excess supply. In fact, real estate pricing in general can be expected to be in the doldrums through 2012. The need to save for retirement will have to increasingly come "organically" in the form of setting aside an extra nickel or dime from every dollar earned in after-tax wages and salaries as opposed to what we as a society have been doing for the better part of the past decade, in essence, blurring the distinction between real estate as a "consumption good" (place to live) and real estate as part of the "portfolio" (investment) that was going to experience sustained double-digit appreciation and emerge as a fountain of cash-flow in the future.”
Implications of a “Worse Case” House Crash Scenario on Economy and Banking
From Barclays: “…The banking sector’s exposure to real estate collateral is at an all-time high, while real estate valuations in a large number of economies are similarly at – or just below – all-time highs… real estate loans are 40% of US bank credit, an increase of 10% over the past decade… In the US, the nascent housing futures markets imply a further 15-19% fall in property prices in the 20 main cities through to 2010. These projected losses match or exceed the worst property price declines seen over the past half century… in the US, the largest historical drop in the Case-Shiller price index was in the 1989-91 period, when prices dipped just 4%. Since the peak in 2006, this index has already dropped 6%, with the futures market implying substantial further declines, for a total fall of 21% in house prices. Property futures markets are unequivocally discounting a savage bear market for real estate, anticipating a broad-based decline in prices of 15-30% in the UK and US markets… Overall, the derivative markets are effectively forecasting the worst real estate bear market of the post-war period. Meanwhile, the banking system’s exposure to real estate lending is the highest of the post-war period. It is difficult to construe the coincidental combination of these two factors as positive for banks. Substantial declines in the value of the collateral underpinning the banking system’s largest loan exposures will raise the risk inherent in the sector. More to the point, delinquencies, defaults and write-offs are bound to rise from current levels, if the forward real estate prices prove to be an accurate forecast… Assuming a modest drift up in the unemployment rate to 5% and the 21% decline in house prices forecast in the derivatives market, the regression suggests that the delinquency rate for all residential real estate loans will climb above the previous 1991 peak to a new high of 4%... Overall, if the forward market prices for real estate are an accurate forecast of actual price trends, an accumulation of bad property loans is likely to be a drag on bank profits throughout the next two years. Such an outcome is not priced into banking sector equity prices. As noted earlier, the consensus among analysts is for a deep V-shaped trajectory for bank profits, a sharp recovery beginning as early as next quarter. Indeed, when the bank sector’s 2 year forward PE ratios are considered, it is clear that the stock market has not downgraded the medium-term outlook for bank profitability. In contrast to both the 1989-91 and 1998 credit crunches, US 2 year forward bank PE ratios are just above 70% of the market average. During both previous episodes, bank PE ratios fell to less than half the market average. Falling real estate prices have an implication for economic growth, as well as bank profits. Clearly, a sustained increase in write-offs and losses will persuade banks to be less than eager to extend fresh credit. Exactly such a process is under way at present. However, the general expectation that the present credit drought will be short-lived is contradicted by the implications of forward property prices. If these derivative markets are correct in their gloomy assessment of real estate trends, the credit drought will not ease much when liquidity returns to the money markets but will, in fact, persist to some degree for the next two years. Certainly, if real estate prices decline in the manner foretold by the futures markets, the primary banking system is not going to be in a fit enough condition to fully replace the asset-backed market and associated entities as a source of fresh credit. To a great extent, the secondary banking system that comprised of CDOs, SIVs, Conduits, hedge funds and asset-backed securities has shut down. This sector had been responsible for the majority of lending over the past five years. The collapse of the secondary banking system and the diminution of the originate-and-distribute bank model have left a gap in the process of credit provision. Primary banks, if they are labouring under a burden of real estate bad loans, are unlikely to be willing or able to fill this gap. A drop in real estate prices of the dimensions envisaged by the futures markets also has clear connotations for household wealth and hence for consumption. To quantify this possible effect, we regressed the US household savings rate against the wealth-to-income ratios for household equity holdings and real estate holdings. The resulting equation gives us a rough framework for estimating the possible impact of a shift in wealth on the savings rate. The exercise suggests that if house prices do indeed fall 21% as discounted by the futures market and if equity markets are flat over the same period, there is a 2.25% upward risk for the personal savings rate. Since real personal consumption has averaged a 2.9% growth rate over the last two quarters, if such a rise in the savings rate occurred, a recession would seem to be inevitable. Simply put, house price futures are foretelling a real estate bear market of recession-inducing magnitude. The extent of the property bear market forecast by derivatives is much larger than implicitly assumed in other asset valuations. Neither banking sector equity prices nor indeed equity prices in general appear to be anticipating a 15-30% slide in property prices. Equally, consensus economic forecasts – which cluster round a short-lived US slowdown – are clearly not incorporating a savage 2-to-3 year real estate bear market. This is presumably because the price declines anticipated by the property derivative markets are much larger than the more modest losses foretold by econometric modelling of house price trends. Were economists to adopt the property derivatives forecast of property price trends, the net result would be much weaker and more recessionary expectations for growth. Clearly, the accuracy of derivative market forecasts is far from perfect. Currently, the property derivative markets are dominated by attempts to hedge property exposure and the technicals have been very strongly bearish. However, to some degree, the implicit forecasts may be self-fulfilling, in the sense that lenders might take their cue on real estate credit availability and pricing from the derivative markets… with a global resource scarcity keeping headline inflation rates high, central banks are not in a position to be able to ease aggressively in support of real estate prices. To the extent that rate cuts have obviated past real estate bear markets, this particular comfort blanket is looking distinctly threadbare. The broad point, however, is that property derivative markets – and indeed the price-to-book ratios of property companies – are painting a much more negative picture of the economic and financial future than are other asset markets. An investment theme of selling financial and retail sector equities versus the bombed out property sector or bombed out property derivatives market would appear to make some sense. More generally, the pricing of the property forward market provides us with a strong admonition to be cautious regarding the absence of recessionary pricing in any other asset markets. The combination of extensive real estate price declines and monetary policy circumscribed by high inflation is a particularly toxic mix.”
From Bank of Montreal: “… the Boston Fed’s superb report on subprimes. Among its many statistics: Historically, 20% of homes purchased with subprime mortgages end in foreclosure; in 2006-07, this rose to 30%. During a 20% drop in housing prices, subprime borrowers are fourteen times more likely to default than borrowers in rising markets.”
Many States Fall Behind in Funding Retiree Benefits – Tax Hikes and Service Cuts Likely
From The New York Times: “Almost half of the states have been underfunding their retirement plans for public workers and may have to choose in the years ahead between their pension obligations and other public programs, according to a comprehensive study to be released to the public on Wednesday. All together, the 50 states have promised to pay some $2.7 trillion in pension and retiree health benefits over the next 30 years, according to the Pew Center on the States, which spent more than a year studying the issue. The amount does not include separate retirement plans run by local governments. While some states are managing their costs reasonably well, the center found that others, like New Jersey and West Virginia, have made serious mistakes and are now cutting education and health programs as they struggle with costs incurred decades ago…Unlike companies, state and local governments are not subject to federal pension laws, which set uniform standards for private industry. If a company skips its required pension contributions, it can be required to pay a big excise tax. No comparable enforcement mechanism exists for states. Even in the absence of federal oversight, some states, including Alabama, Arkansas and North Carolina, have been diligently prepaying their retirement obligations, the center found. But others have consistently let their contributions lag behind the amounts needed. The study showed that about half the states fell into each category. Among the states that have fallen behind, some, like Florida and Iowa, have been skimping only slightly. But several — including Illinois, Kansas, Oklahoma, Michigan, New Jersey, Virginia and Washington — have contributed far less than the required amount, year after year. Other states appear to have been fully funding their pension plans, only to run into trouble in the last few years, at which point they started to fall behind. States in this situation include Colorado, Kentucky, Maryland and Ohio…Even in the most extreme cases, Ms. Urahn said, the public may not be aware of any problem because there is always enough money to keep sending out pension checks, and retirees do not complain. But once the money dedicated to pensions starts being depleted faster than it is replenished, financial problems are likely. The further behind a state falls, the more cash it has to come up with each year to catch up. At some point, the ailing retirement system can start to dominate the state’s overall finances, taking cash away from other important programs…The report also noted that besides pensions, most states had promised health benefits to retired public workers and are only now starting to grapple with those costs. Retiree health plans run the gamut, from very rich to bare bones. Some states, like New York, have succeeded in maintaining well-financed pension plans, only to find themselves forced to come up with tens of billions of dollars more, because they promised retiree health care and did not set aside any money to cover that…States cannot turn to Washington for help…”
From Bloomberg: “Wall Street's three-year love affair with debt sold by U.S. states and cities is over. Municipal bonds, whose returns trounced Treasuries and corporate debt from 2004 to 2006, are headed for their worst year since 1999…securities firms reduced their holdings during the third quarter by the largest amount in at least 12 years, data compiled by the Federal Reserve show… Subprime-related losses also hit bond insurance companies that guarantee about half of all U.S. municipal debt, weakening investors' confidence in the AAA corporate ratings that are applied to the obligations and hurting prices last month. Munis returned 3.02 percent this year, compared with 3.85 percent for corporate securities and 8.42 percent for government debt, Merrill indexes show. That's the worst performance since 1999, when state and local government debt lost 6.34 percent. As investors retreated from corporate and asset-backed bonds to the safety of Treasuries, some also sold munis … Yields on 10-year municipal bonds averaged about 93 percent of what the U.S. government pays, compared with 83 percent on average in the two years before August. Investors typically accept lower rates on state and local debt because interest is exempt from taxes…The higher yields relative to Treasuries means local government borrowers pay 34 basis points, or 0.34 percentage point, more in interest than if municipal bond yields had stayed at 83 percent of Treasuries as in the two years ended in July. A 34-basis-point increase on $9.4 billion of bond sales -- the amount local government borrowers including Chicago's O'Hare International Airport have pending over the next 30 days –means about $320 million in additional interest through 2017.”
MISC
From Bloomberg: “U.S. home foreclosures rose 68 percent in November from a year earlier…There were 201,950 foreclosure filings in November, including default notices, auction letters and bank repossessions, down 10 percent from October's total, RealtyTrac reported today. California, Florida and Ohio had the most filings and Nevada had the highest foreclosure rate.”
From Dow Jones: “Morgan Stanley said it is shoring up its capital with a $5 billion investment from China’s sovereign wealth fund after a $9.4 billion write-down related to mortgages pushed the bank into a deep loss for the fourth quarter. The write-downs were primarily the result of a speculative trading bet that went bad, and their scale — more than twice the size of the $3.7 billion hit the bank forecast on Nov. 7 – was a blow to Chief Executive John Mack, who has pushed the firm to boost results by taking on more risk. Mack’s move to sell a stake of just under 10% to China Investment Corp. makes Morgan Stanley the latest damaged U.S. financial institution to seek help from cash-rich funds investing emerging-market government wealth.”
From JP Morgan: “President Trichet today made plain in today’s Parliamentary testimony how much the Council is biased against cutting its policy rate. The latest staff projections see inflation at 2-3% next year, well above the ECB’s target ceiling of 2%, with the risk to these projections "clearly on the upside". These risks include the potential for knock-on effects from high headline inflation to inflation expectations and wages, and also the possibility that food and energy prices might rise further in 2008. The staff continues to forecast growth remaining moderately above trend, although Trichet allowed that the risk to the growth forecast is to the downside. JPMorgan sees ECB policy rates remaining at 4% barring a major threat to growth, believing that against a backdrop of high resource utilization and earlier, pre credit crunch plans to hike rates beyond 4%, the ECB would like to see some slack created in the economy.”
From Bank of Montreal: “The Bank of England minutes from the December meeting showed a surprising 9-to-0 vote to cut rates 25 bps. The MPC acknowledged that there will be some short-term pressure on inflation, but decided that the downside risk to inflation and economic growth in the medium-term warranted pre-emptive action. Tightening credit conditions definitely played a role in the move. “Clear signs of slowing in secured lending to households…tightening in credit conditions faced by firms… increased risk of a more severe reduction in the availability of credit...worsening financial market turmoil, and the consequent tightening of credit conditions, had increased the downside risks to activity and inflation in the medium term.” There were also concerns that the housing market is slowing faster than expected and that consumer spending growth has downshifted in Q4.”
From Bloomberg: “The pound fell below $2 for the first time in three months on speculation the Bank of England will keep cutting interest rates to prevent the global credit crunch from curbing growth in Europe's second-largest economy. The U.K. currency has dropped 4.3 percent versus the dollar since trading at a 26-year high of $2.116 on Nov. 9. This year, it has weakened most against the Brazilian real, declining 14 percent. It's 12 percent lower against the Canadian dollar.”
From SunTrust: “News that S&P has downgraded 6 insurance companies caused a sharp reversal in Treasury prices. MBIA and AMBAC maintained AAA status, but the outlook was lowered to “negative” vs stable. ACA’s rating was cut to CCC from A.”
From Bank of Montreal: “Gold is the only financial asset that is nobody’s liability. That makes it a pure store of value when financial panics are disemboweling risky paper assets—stocks and commercial paper alike.”
From JP Morgan: “Prospects for an increase in conforming loan limits gained ground
this past week, as the Treasury showed support for the idea. At this point, there are a number of supporters of the idea in DC, but the sticking point now appears to be whether the increase can be kept as temporary. The increase will likely follow the bill announced in May, which raised conforming loan limits to the median home price by MSA, up to a maximum of $626,000. Many uncertainties remain, including whether they would be included in the TBA market, or whether there would be a FN/FH Jumbo market. However, if it were to pass, loans with balances between $417,000 and $626,000 are likely to benefit from the improved execution. Under current g-fees, execution as a conventional pass-through is 2-3 points better than as a non-agency pass-through.”
End-of-Day Market Update
From Lehman: “Liquidity seemed to hit a new low on Wednesday when, after a fairly quiet morning session, treasuries went haywire in the afternoon… A little after 1:00 NY time, the market just exploded, with ten year notes rallying 7 basis points in a half hour, and two year notes rallying about 10 bp. There were rumors of a large long end buyer driving the move, but the yield curve did not really flatten that much in the rally, and ten year note futures were strong performers. And then, as quickly as the market rallied, it turned on a dime and sold off, with tens getting within a couple of ticks of the 1:00 levels. Then at 3:00, as if on cue, the market jumped again, with tens evaporating up 10 ticks almost instantaneously. (I say evaporating because I don't think I actually saw them trade between 101-13 and 101-23 on the move.) We didn't really find a plausible explanation for today's whipsaw moves, but it is a reminder (I know, "broken record") of how painfully thin and illiquid markets have become into year end. If you have something big to do, and maybe even something not that big, it seems to cost a lot of basis points to do it… Wednesday's 3:00 yield changes, which were quite different from the 2:00 and 4:00 yield changes, were very roughly as follows:
2 years: -5.6 bp
5 years: -4.3 bp
10 years: -5.8 bp
18 years: -5.5 bp
30 years: -5.8 bp”
From RBSGC: “Volatility was undoubted a theme, as the market's sharp moves in the afternoon were driven by stocks testing some key lows and a generalized anxiety that is extending the common flight-to-quality bid. This is a trend that we do not expect to shift in any meaningful way -- particularly as the long over-due holiday vacations begin and street staffing lightens.”
From UBS: “Swaps saw very good 2-way flow in the belly, and swap spreads tightened across the board after a 6bp intraday roundtrip. Spreads narrowed by 1-2bps in the minutes immediately following the TAF results. Agencies saw buyers in the 5-7 year sector, and sellers of 10-years. The 2-year area cheapened going into the FHLB auction of $4B worth of new 2-years, but the new issue held in versus Libor after pricing at L-23.5. Mortgages saw foreign buying this morning, and were as much as 7 ticks tighter to Treasuries at one point. They have since come off their tights and are 4 tighter on the day.”
From JP Morgan: “Mortgages tightened several bp in LIBOR OAS over the past several days, bringing spreads to average levels for the past six months.”
Three month T-Bill yield fell 13.5 bp to 2.90%.
Two year T-Note yield fell 8 bp to 3.11%
Ten year T-Note yield fell 9 bp to 4.03%
Dow fell 25 to 13,207
S&P 500 fell 2 to 1453
Dollar index rose .17 to 77.59
Yen at 113.43 per dollar
Euro at 1.438
Gold unch at $802
Oil rose $1.17 to $91.25
*All prices as of 4:25pm
From Morgan Stanley: “The Fed just released the results of the first TAF auction…the key stats are the stop-out rate and the bid-to-cover. The stop-out rate was 4.65% -- right on expectations. The bid-to-cover ratio was 3.1. The results are consistent with the notion that banks have a strong demand for funding at the right price. If the stop-out rate had been above the discount rate (4.75%), it would have conveyed a hint of desperation. Alternatively, a lower bid-to-cover would have signaled a lack of interest in the new program. The results indicated that 93 institutions submitted bids. So, the mean bid per institution was $660 million. This suggests that the bidders probably included a mix of large and small institutions (since the maximum bid amount was $2 billion).”
Declining Homeownership Will Especially Depress Single-Family Demand
From Goldman Sachs: “Although housing starts have already fallen sharply from 2.2 million to less than 1.2 million, we expect a further drop to around 750,000 before a bottom is reached. The declines will likely remain concentrated in the single-family sector, where a declining homeownership rate is weighing heavily on demand and is likely to keep excess supply measures stubbornly high. The fundamental backdrop for multi-family building is better because falling homeownership should ultimately result in rising construction of rental units…Housing activity has plummeted over the past two years. In the single-family sector, housing starts are down 54% over the past two years, the largest decline on record except for the deep recession of the early 1980s. With single-family starts of 829,000 (annualized), roughly 400,000 below the average of the past two decades, one might think that we should now be close to the bottom of the cycle. After all, the homeowner vacancy rate currently stands at 2.7%, roughly 1 percentage point above the average of the past two decades. Since this is equivalent to about 800,000 homes, one could argue that a stabilization at the current level of housing activity would eliminate the supply overhang over a 2-year period. But this logic fails to take account of changes in the homeownership rate. In a falling homeownership environment, single-family housing starts need to fall further below their long-term trend to unwind the excess supply. For example, a trend decline in homeownership of ½ percentage point per year lowers the demand for owner-occupied homes by over 500,000 per year…Thus, we estimate that single-family starts still have substantially further to fall and will bottom around 500,000 (annualized), probably in late 2008. One implication of our analysis is that measures of excess supply such as the homeowner vacancy rate and home inventories are likely to stay elevated over the next few quarters, despite the seemingly depressed levels of housing activity. In particular, the homeowner vacancy rate—our favorite measure of excess supply—is unlikely to fall sharply from its current near-record level of 2.7% until later in 2008. Ultimately, declining homeownership should lead to the construction of more multi-family rental units as a rising percentage of the population rents their accommodation. Nevertheless, we expect some near-term declines in the multi-family sector as well, for three reasons. First, more than half of all multi-family units are built for sale, and this sector is likely to see similar pressures as the single-family market (think Miami condo buildings). Second, the rental vacancy rate currently stands at 9.8%, more than 2 percentage points above the long-term average. This implies a period during which rising demand for rental accommodation may well be accommodated by falling vacancies, without much need for new construction. Third, banks are tightening their standards for commercial real estate loans (which include multifamily construction loans). In the most recent Senior Loan Officers’ survey, a net 50% of all banks reported such a tightening, the largest proportion since 1990. Because of these headwinds for multifamily construction, we expect a sizable decline in this sector as well, from 358,000 (annualized) in November 2007 to around 250,000 in late 2008.”
Falling House Prices Imply Higher Savings Rates
From Merrill Lynch: “…weak demographic fundamentals point to years of sluggish real estate activity, particularly in terms of the "price". The looming dominance of the "move down" buyer suggests that home values will continue to soften long after the building industry mops up the current excess supply. In fact, real estate pricing in general can be expected to be in the doldrums through 2012. The need to save for retirement will have to increasingly come "organically" in the form of setting aside an extra nickel or dime from every dollar earned in after-tax wages and salaries as opposed to what we as a society have been doing for the better part of the past decade, in essence, blurring the distinction between real estate as a "consumption good" (place to live) and real estate as part of the "portfolio" (investment) that was going to experience sustained double-digit appreciation and emerge as a fountain of cash-flow in the future.”
Implications of a “Worse Case” House Crash Scenario on Economy and Banking
From Barclays: “…The banking sector’s exposure to real estate collateral is at an all-time high, while real estate valuations in a large number of economies are similarly at – or just below – all-time highs… real estate loans are 40% of US bank credit, an increase of 10% over the past decade… In the US, the nascent housing futures markets imply a further 15-19% fall in property prices in the 20 main cities through to 2010. These projected losses match or exceed the worst property price declines seen over the past half century… in the US, the largest historical drop in the Case-Shiller price index was in the 1989-91 period, when prices dipped just 4%. Since the peak in 2006, this index has already dropped 6%, with the futures market implying substantial further declines, for a total fall of 21% in house prices. Property futures markets are unequivocally discounting a savage bear market for real estate, anticipating a broad-based decline in prices of 15-30% in the UK and US markets… Overall, the derivative markets are effectively forecasting the worst real estate bear market of the post-war period. Meanwhile, the banking system’s exposure to real estate lending is the highest of the post-war period. It is difficult to construe the coincidental combination of these two factors as positive for banks. Substantial declines in the value of the collateral underpinning the banking system’s largest loan exposures will raise the risk inherent in the sector. More to the point, delinquencies, defaults and write-offs are bound to rise from current levels, if the forward real estate prices prove to be an accurate forecast… Assuming a modest drift up in the unemployment rate to 5% and the 21% decline in house prices forecast in the derivatives market, the regression suggests that the delinquency rate for all residential real estate loans will climb above the previous 1991 peak to a new high of 4%... Overall, if the forward market prices for real estate are an accurate forecast of actual price trends, an accumulation of bad property loans is likely to be a drag on bank profits throughout the next two years. Such an outcome is not priced into banking sector equity prices. As noted earlier, the consensus among analysts is for a deep V-shaped trajectory for bank profits, a sharp recovery beginning as early as next quarter. Indeed, when the bank sector’s 2 year forward PE ratios are considered, it is clear that the stock market has not downgraded the medium-term outlook for bank profitability. In contrast to both the 1989-91 and 1998 credit crunches, US 2 year forward bank PE ratios are just above 70% of the market average. During both previous episodes, bank PE ratios fell to less than half the market average. Falling real estate prices have an implication for economic growth, as well as bank profits. Clearly, a sustained increase in write-offs and losses will persuade banks to be less than eager to extend fresh credit. Exactly such a process is under way at present. However, the general expectation that the present credit drought will be short-lived is contradicted by the implications of forward property prices. If these derivative markets are correct in their gloomy assessment of real estate trends, the credit drought will not ease much when liquidity returns to the money markets but will, in fact, persist to some degree for the next two years. Certainly, if real estate prices decline in the manner foretold by the futures markets, the primary banking system is not going to be in a fit enough condition to fully replace the asset-backed market and associated entities as a source of fresh credit. To a great extent, the secondary banking system that comprised of CDOs, SIVs, Conduits, hedge funds and asset-backed securities has shut down. This sector had been responsible for the majority of lending over the past five years. The collapse of the secondary banking system and the diminution of the originate-and-distribute bank model have left a gap in the process of credit provision. Primary banks, if they are labouring under a burden of real estate bad loans, are unlikely to be willing or able to fill this gap. A drop in real estate prices of the dimensions envisaged by the futures markets also has clear connotations for household wealth and hence for consumption. To quantify this possible effect, we regressed the US household savings rate against the wealth-to-income ratios for household equity holdings and real estate holdings. The resulting equation gives us a rough framework for estimating the possible impact of a shift in wealth on the savings rate. The exercise suggests that if house prices do indeed fall 21% as discounted by the futures market and if equity markets are flat over the same period, there is a 2.25% upward risk for the personal savings rate. Since real personal consumption has averaged a 2.9% growth rate over the last two quarters, if such a rise in the savings rate occurred, a recession would seem to be inevitable. Simply put, house price futures are foretelling a real estate bear market of recession-inducing magnitude. The extent of the property bear market forecast by derivatives is much larger than implicitly assumed in other asset valuations. Neither banking sector equity prices nor indeed equity prices in general appear to be anticipating a 15-30% slide in property prices. Equally, consensus economic forecasts – which cluster round a short-lived US slowdown – are clearly not incorporating a savage 2-to-3 year real estate bear market. This is presumably because the price declines anticipated by the property derivative markets are much larger than the more modest losses foretold by econometric modelling of house price trends. Were economists to adopt the property derivatives forecast of property price trends, the net result would be much weaker and more recessionary expectations for growth. Clearly, the accuracy of derivative market forecasts is far from perfect. Currently, the property derivative markets are dominated by attempts to hedge property exposure and the technicals have been very strongly bearish. However, to some degree, the implicit forecasts may be self-fulfilling, in the sense that lenders might take their cue on real estate credit availability and pricing from the derivative markets… with a global resource scarcity keeping headline inflation rates high, central banks are not in a position to be able to ease aggressively in support of real estate prices. To the extent that rate cuts have obviated past real estate bear markets, this particular comfort blanket is looking distinctly threadbare. The broad point, however, is that property derivative markets – and indeed the price-to-book ratios of property companies – are painting a much more negative picture of the economic and financial future than are other asset markets. An investment theme of selling financial and retail sector equities versus the bombed out property sector or bombed out property derivatives market would appear to make some sense. More generally, the pricing of the property forward market provides us with a strong admonition to be cautious regarding the absence of recessionary pricing in any other asset markets. The combination of extensive real estate price declines and monetary policy circumscribed by high inflation is a particularly toxic mix.”
From Bank of Montreal: “… the Boston Fed’s superb report on subprimes. Among its many statistics: Historically, 20% of homes purchased with subprime mortgages end in foreclosure; in 2006-07, this rose to 30%. During a 20% drop in housing prices, subprime borrowers are fourteen times more likely to default than borrowers in rising markets.”
Many States Fall Behind in Funding Retiree Benefits – Tax Hikes and Service Cuts Likely
From The New York Times: “Almost half of the states have been underfunding their retirement plans for public workers and may have to choose in the years ahead between their pension obligations and other public programs, according to a comprehensive study to be released to the public on Wednesday. All together, the 50 states have promised to pay some $2.7 trillion in pension and retiree health benefits over the next 30 years, according to the Pew Center on the States, which spent more than a year studying the issue. The amount does not include separate retirement plans run by local governments. While some states are managing their costs reasonably well, the center found that others, like New Jersey and West Virginia, have made serious mistakes and are now cutting education and health programs as they struggle with costs incurred decades ago…Unlike companies, state and local governments are not subject to federal pension laws, which set uniform standards for private industry. If a company skips its required pension contributions, it can be required to pay a big excise tax. No comparable enforcement mechanism exists for states. Even in the absence of federal oversight, some states, including Alabama, Arkansas and North Carolina, have been diligently prepaying their retirement obligations, the center found. But others have consistently let their contributions lag behind the amounts needed. The study showed that about half the states fell into each category. Among the states that have fallen behind, some, like Florida and Iowa, have been skimping only slightly. But several — including Illinois, Kansas, Oklahoma, Michigan, New Jersey, Virginia and Washington — have contributed far less than the required amount, year after year. Other states appear to have been fully funding their pension plans, only to run into trouble in the last few years, at which point they started to fall behind. States in this situation include Colorado, Kentucky, Maryland and Ohio…Even in the most extreme cases, Ms. Urahn said, the public may not be aware of any problem because there is always enough money to keep sending out pension checks, and retirees do not complain. But once the money dedicated to pensions starts being depleted faster than it is replenished, financial problems are likely. The further behind a state falls, the more cash it has to come up with each year to catch up. At some point, the ailing retirement system can start to dominate the state’s overall finances, taking cash away from other important programs…The report also noted that besides pensions, most states had promised health benefits to retired public workers and are only now starting to grapple with those costs. Retiree health plans run the gamut, from very rich to bare bones. Some states, like New York, have succeeded in maintaining well-financed pension plans, only to find themselves forced to come up with tens of billions of dollars more, because they promised retiree health care and did not set aside any money to cover that…States cannot turn to Washington for help…”
From Bloomberg: “Wall Street's three-year love affair with debt sold by U.S. states and cities is over. Municipal bonds, whose returns trounced Treasuries and corporate debt from 2004 to 2006, are headed for their worst year since 1999…securities firms reduced their holdings during the third quarter by the largest amount in at least 12 years, data compiled by the Federal Reserve show… Subprime-related losses also hit bond insurance companies that guarantee about half of all U.S. municipal debt, weakening investors' confidence in the AAA corporate ratings that are applied to the obligations and hurting prices last month. Munis returned 3.02 percent this year, compared with 3.85 percent for corporate securities and 8.42 percent for government debt, Merrill indexes show. That's the worst performance since 1999, when state and local government debt lost 6.34 percent. As investors retreated from corporate and asset-backed bonds to the safety of Treasuries, some also sold munis … Yields on 10-year municipal bonds averaged about 93 percent of what the U.S. government pays, compared with 83 percent on average in the two years before August. Investors typically accept lower rates on state and local debt because interest is exempt from taxes…The higher yields relative to Treasuries means local government borrowers pay 34 basis points, or 0.34 percentage point, more in interest than if municipal bond yields had stayed at 83 percent of Treasuries as in the two years ended in July. A 34-basis-point increase on $9.4 billion of bond sales -- the amount local government borrowers including Chicago's O'Hare International Airport have pending over the next 30 days –means about $320 million in additional interest through 2017.”
MISC
From Bloomberg: “U.S. home foreclosures rose 68 percent in November from a year earlier…There were 201,950 foreclosure filings in November, including default notices, auction letters and bank repossessions, down 10 percent from October's total, RealtyTrac reported today. California, Florida and Ohio had the most filings and Nevada had the highest foreclosure rate.”
From Dow Jones: “Morgan Stanley said it is shoring up its capital with a $5 billion investment from China’s sovereign wealth fund after a $9.4 billion write-down related to mortgages pushed the bank into a deep loss for the fourth quarter. The write-downs were primarily the result of a speculative trading bet that went bad, and their scale — more than twice the size of the $3.7 billion hit the bank forecast on Nov. 7 – was a blow to Chief Executive John Mack, who has pushed the firm to boost results by taking on more risk. Mack’s move to sell a stake of just under 10% to China Investment Corp. makes Morgan Stanley the latest damaged U.S. financial institution to seek help from cash-rich funds investing emerging-market government wealth.”
From JP Morgan: “President Trichet today made plain in today’s Parliamentary testimony how much the Council is biased against cutting its policy rate. The latest staff projections see inflation at 2-3% next year, well above the ECB’s target ceiling of 2%, with the risk to these projections "clearly on the upside". These risks include the potential for knock-on effects from high headline inflation to inflation expectations and wages, and also the possibility that food and energy prices might rise further in 2008. The staff continues to forecast growth remaining moderately above trend, although Trichet allowed that the risk to the growth forecast is to the downside. JPMorgan sees ECB policy rates remaining at 4% barring a major threat to growth, believing that against a backdrop of high resource utilization and earlier, pre credit crunch plans to hike rates beyond 4%, the ECB would like to see some slack created in the economy.”
From Bank of Montreal: “The Bank of England minutes from the December meeting showed a surprising 9-to-0 vote to cut rates 25 bps. The MPC acknowledged that there will be some short-term pressure on inflation, but decided that the downside risk to inflation and economic growth in the medium-term warranted pre-emptive action. Tightening credit conditions definitely played a role in the move. “Clear signs of slowing in secured lending to households…tightening in credit conditions faced by firms… increased risk of a more severe reduction in the availability of credit...worsening financial market turmoil, and the consequent tightening of credit conditions, had increased the downside risks to activity and inflation in the medium term.” There were also concerns that the housing market is slowing faster than expected and that consumer spending growth has downshifted in Q4.”
From Bloomberg: “The pound fell below $2 for the first time in three months on speculation the Bank of England will keep cutting interest rates to prevent the global credit crunch from curbing growth in Europe's second-largest economy. The U.K. currency has dropped 4.3 percent versus the dollar since trading at a 26-year high of $2.116 on Nov. 9. This year, it has weakened most against the Brazilian real, declining 14 percent. It's 12 percent lower against the Canadian dollar.”
From SunTrust: “News that S&P has downgraded 6 insurance companies caused a sharp reversal in Treasury prices. MBIA and AMBAC maintained AAA status, but the outlook was lowered to “negative” vs stable. ACA’s rating was cut to CCC from A.”
From Bank of Montreal: “Gold is the only financial asset that is nobody’s liability. That makes it a pure store of value when financial panics are disemboweling risky paper assets—stocks and commercial paper alike.”
From JP Morgan: “Prospects for an increase in conforming loan limits gained ground
this past week, as the Treasury showed support for the idea. At this point, there are a number of supporters of the idea in DC, but the sticking point now appears to be whether the increase can be kept as temporary. The increase will likely follow the bill announced in May, which raised conforming loan limits to the median home price by MSA, up to a maximum of $626,000. Many uncertainties remain, including whether they would be included in the TBA market, or whether there would be a FN/FH Jumbo market. However, if it were to pass, loans with balances between $417,000 and $626,000 are likely to benefit from the improved execution. Under current g-fees, execution as a conventional pass-through is 2-3 points better than as a non-agency pass-through.”
End-of-Day Market Update
From Lehman: “Liquidity seemed to hit a new low on Wednesday when, after a fairly quiet morning session, treasuries went haywire in the afternoon… A little after 1:00 NY time, the market just exploded, with ten year notes rallying 7 basis points in a half hour, and two year notes rallying about 10 bp. There were rumors of a large long end buyer driving the move, but the yield curve did not really flatten that much in the rally, and ten year note futures were strong performers. And then, as quickly as the market rallied, it turned on a dime and sold off, with tens getting within a couple of ticks of the 1:00 levels. Then at 3:00, as if on cue, the market jumped again, with tens evaporating up 10 ticks almost instantaneously. (I say evaporating because I don't think I actually saw them trade between 101-13 and 101-23 on the move.) We didn't really find a plausible explanation for today's whipsaw moves, but it is a reminder (I know, "broken record") of how painfully thin and illiquid markets have become into year end. If you have something big to do, and maybe even something not that big, it seems to cost a lot of basis points to do it… Wednesday's 3:00 yield changes, which were quite different from the 2:00 and 4:00 yield changes, were very roughly as follows:
2 years: -5.6 bp
5 years: -4.3 bp
10 years: -5.8 bp
18 years: -5.5 bp
30 years: -5.8 bp”
From RBSGC: “Volatility was undoubted a theme, as the market's sharp moves in the afternoon were driven by stocks testing some key lows and a generalized anxiety that is extending the common flight-to-quality bid. This is a trend that we do not expect to shift in any meaningful way -- particularly as the long over-due holiday vacations begin and street staffing lightens.”
From UBS: “Swaps saw very good 2-way flow in the belly, and swap spreads tightened across the board after a 6bp intraday roundtrip. Spreads narrowed by 1-2bps in the minutes immediately following the TAF results. Agencies saw buyers in the 5-7 year sector, and sellers of 10-years. The 2-year area cheapened going into the FHLB auction of $4B worth of new 2-years, but the new issue held in versus Libor after pricing at L-23.5. Mortgages saw foreign buying this morning, and were as much as 7 ticks tighter to Treasuries at one point. They have since come off their tights and are 4 tighter on the day.”
From JP Morgan: “Mortgages tightened several bp in LIBOR OAS over the past several days, bringing spreads to average levels for the past six months.”
Three month T-Bill yield fell 13.5 bp to 2.90%.
Two year T-Note yield fell 8 bp to 3.11%
Ten year T-Note yield fell 9 bp to 4.03%
Dow fell 25 to 13,207
S&P 500 fell 2 to 1453
Dollar index rose .17 to 77.59
Yen at 113.43 per dollar
Euro at 1.438
Gold unch at $802
Oil rose $1.17 to $91.25
*All prices as of 4:25pm
Tuesday, December 18, 2007
Today's Tidbits
Fed’s New Mortgage Rules
From Dow Jones: “The Federal Reserve proposed new rules for subprime mortgages, including a ban on low- documentation loans and limits on penalties for borrowers who prepay their debts. The plans, the Fed's biggest regulatory initiative since Chairman Ben S. Bernanke took office in February 2006, are aimed at curbing lending practices that contributed to record foreclosures. Board members unanimously voted in a hearing today to make lenders responsible for determining whether borrowers can afford their mortgages even after low starter rates expire… The proposed new rules ``were carefully crafted'' to deter ``improper lending'' without ``unduly restricting mortgage credit availability,'' he said. Bernanke is aiming to preserve the Fed's consumer-protection role after Democratic lawmakers blamed it for lax oversight and introduced legislation to set rules for mortgage lenders. Today's proposals received mixed responses from legislators, consumer advocates and finance-industry officials… Today's package covers all high-cost mortgages, which are defined as loans with rates at least 3 percentage points above a comparable Treasury security for first mortgages and 5 percentage points for second loans, or home-equity loans… The proposal also went beyond its initial scope of consideration, and recommended new disclosure rules aimed at mortgage brokers, appraisers and solicitors. The rules apply to both prime and subprime loans. Fed governors approved prohibiting lenders from paying brokers fees in excess of what the borrower initially agreed. The proposal bars coercion of appraisers, and defines seven advertising practices as misleading or deceptive.”
Interesting Discussion on Equity Market Cycles – Are we in a Bull or Bear Market?
From Merrill Lynch: “The past five years — was it a bull market or a bear market? Well, if you look strictly at “price”, it has been a classic cyclical bull market – the S&P 500 has obviously risen more than 80% from the late 2002 lows. But every inch of the way, it was earnings growth that led the bull run – though we now know looking at all the write-downs that a certain volume of this growth in the “E” was nonrecurring. The benefit of hindsight. But the P/E multiple has actually been in a bear market through the entire piece – going from 27x at the market bottom to just over 18x right now. Imagine what this cyclical bull market would have done if the multiple had expanded! But this is a key point Two-thirds of the great bull run that started in 1982 and ended in 2000 was pure multiple expansion – going from the trough of 8x to the peak of over 30x in that 18-year interval. During that time, of course, we saw the spreading technology breakthroughs, more responsible monetary policy, smaller government, deregulation, the breakdown of global trade barriers and the crumbling of Communism lead to ever-declining rates of inflation and inflation expectations and much lower bond yields and much higher “fair-value” P/E multiples. But only one-third of that great bull market was due to profit growth – the majority of the gains were in the price that investors were willing to pay for that earnings stream. But in this current cycle — it’s all been about earnings That is a good thing and a bad thing – a bad thing because we are about to go through an earnings recession with no cushion from the multiple which remains above historical norms (and no, this is not justified by “low” interest rates, which in real terms are actually right in line with long-term averages in the private sector). The P/E multiple did something it has never done before in the context of a bear market and bottomed at 27x at the late-2002 lows in the S&P 500. On average, the multiple troughs at 12x at the bear market bottom, but not in this latest cycle, and the reason for that is because the Fed had cut rates so aggressively back then that it actually took, for the first time ever, the level of the 3-month Eurodollar deposit rate below the level of the S&P 500 dividend yield. This was unheard of. Not only that, but the Fed ensured that this spread remained negative for two years (the fall of 2002 to the fall of 2004) and during that early time frame, the stock market bull run was well entrenched, with the S&P 500 appreciating 40% and breaking many key technical barriers along the way. Not until this bull market was into its third year was the level of money market rates pushed above the dividend yield – though these metrics have switched course because these 3-month eurodollar deposits now command a 310 basis point premium over the 1.9% dividend yield even with the Fed’s moves to cut the funds rate and discount rate in recent months. But the major conclusion is this - Even with the rally that was induced by negative real short-term rates by the Fed and subsequently nurtured by the strongest earnings cycle on record (some would argue financially-engineered), the P/E multiple has remained in a bear market. And if history is any guide, the fundamental low in the multiple will be closer to 12x than the current level of 18x. So the multiple has, over time, been gravitating lower and the question must be asked as to whether the Fed’s aggressive easing in 2002-03 merely delayed the inevitable compression to the traditional lows of 12x that defined so many bear market lows in the past. We had an earnings recession back in 2001-02 coupled with P/E compression and that delivered a severe bear market. Then we had a huge cyclical snapback in earnings from 2003 to 2006 that more than offset the effects of a sustained narrowing in the multiple and gave us a powerful bull market. But now we are on the precipice of an earnings recession What if we are correct at $83 on operating earnings next year and the multiple finds its way to the 12x level that would have been consistent with prior secular bull market starting points (aka real buying opportunities) – a level we may well have seen in late 2002 or early 2003 if the Fed had not so dramatically altered the relationship between the dividend/earnings yield with cash rates. That then would mean a snick below 1,000 on the S&P 500 (the “glass is half full” shows that this would still be one-third above the 2002 low and double the level prevailing in 1995). We want to stress that this is not, repeat not, a target by any stretch of the imagination. It is about generating a discussion and sparking a debate. Maybe – just maybe – we never did complete that entire bear market from 2000 to 2003 and the earnings recovery masked what was and still is a mean-reverting downward trend in the P/E multiple. But the fact that we have both cash and bonds outperforming equities with two weeks to go in the year, despite a 150 basis point cut in the discount rate, is indeed an ominous signpost. Then again, whenever the Fed has been forced to cut the discount rate this much in the past, it has generally been because the economy was heading for a hard landing, with the accompanying decline in corporate earnings, stock prices and Treasury yields.”
World Bank Revises Down Size of Economies in China and India
From Barclays: “China and India’s economies are 40% smaller than previously estimated. That is one of the major findings from yesterday’s release of the 2005 International Comparison Program (ICP), an initiative led by the World Bank over 2003-2007 to estimate Purchasing Power Parities (PPPs) of 146 economies. It marks the first time China participated in the ICP, and the first time since 1985 that India has. Compared with earlier estimates, which were based on old and very limited data, China and India’s shares in global GDP have been downwardly revised from 14% and 6%, to 9% and 4% respectively. A natural implication for the global economy is that growth, both retrospectively and forward-looking, will now also have to be revised lower, given that contributions from the emerging economies of China and India would now be weighed by smaller shares. But what does this mean for commodity demand? Clearly, while the way of measuring China and India’s GDP has changed, historical levels of Chinese and Indian commodity demand have not. If anything, we see this downsize in their economic clout as presenting a positive risk to future demand growth…suggesting that growth in both economies have in fact been much more energy/metal intensive than initially thought. Re-looking at the same numbers in per capita terms, trimming Chinese GDP numbers by 40% does make sense for its energy/metal demand for a given level of income… the same level of GDP per capita is now associated with higher copper demand per head, bringing Chinese demand more in line with the path that other Asian economies have taken in their earlier years of industrialisation. The picture for oil demand depicts a very similar story. The second implication relates to the growth potential in both China and India’s economies now that they are starting from a lower base. After the revision, China’s PPP per capita is approximately 14% that of Japan and 19% that of Korea, while the same set of numbers for India are 7% and 9% respectively… China and India are only in an early phase of their industrialisation process. This, coupled with their massive economic size and potential, point to continued strong demand growth in commodities for many more years to come.”
How Much Liquidity is the Fed Really Adding?
From Hussman Econometrics Advisors: “Case in point is the ridiculously over-hyped "term auction facility" announced last week. According to that announcement, the Fed plans to auction about $40 billion of "liquidity" this week: $20 billion on Monday December 17th, which will be a 28-day repo, and another $20 billion on December 20th.
… there are currently $53 billion of repos outstanding (as of Friday), fully $39 billion that mature this week. And wouldn't you know it, the Fed is going to be "injecting" $40 billion this week too. So here's a little acid-test of whether the Fed will actually be providing new "liquidity," or whether it's just trying to brew up a tempest with what's already in that little teapot. Watch the NY Fed's listings of open market operations:
http://www.ny.frb.org/markets/omo/dmm/temp.cfm?SHOWMORE=TRUE
If the Fed is actually adding liquidity, you'll see not only the two $20 billion repos on the 17th and 20th, but additional repos to replace the $39 billion that are coming due this week ($5 billion mature on Tuesday the 18th, and fully $34 billion are set to mature on Thursday the 20th). If the Fed does nothing but those two $20 billion longer-dated repos, all it will have done is to change the maturity of its outstanding repos, without changing the amount. Now, that's not to say I believe that even if the Fed does temporarily buy $40 billion of government securities for 28 days, before selling them back out, it will do much for the solvency of the $12.7 trillion U.S. banking system, much less exotic CDOs and mortgage-backed securities. As I've emphasized in recent weeks, if you track all those daily and weekly rollovers and figure out the total quantity of Fed repos outstanding at any given time, you'll find that the Fed has only injected $18 billion in "liquidity" since March. If investors think the Fed buying up a few billion of Treasury and agency debt means a hill of beans, they might do well to remember that the U.S. government is running up annual deficits in the hundreds of billions. In fact, the U.S. Treasury will float tens of billions of new debt in December alone (most of which will be sopped up by foreigners, who have increased their holdings of Treasuries by well over $200 billion in the past year). This will be mixed in with refinancings. Last week, for example, the Treasury auctioned $21 billion in 3-month bills and $20 billion in 6-month bills. In doing so, the Treasury offset every bit of the Federal Reserve's actions this week, even if it turns out that the $40 billion "term auction facility" represents new liquidity and not just rollovers. Why aren't investors just as interested in that? When the Fed does open market operations, all it's doing is buying up (temporarily or permanently) a tiny fraction of U.S. Treasury debt and replacing it with currency and bank reserves. But every time the Federal government issues more debt to finance its deficits, the new issuance cancels out any beneficial increase in liquidity the Fed could possibly provide. So it's difficult to understand why investors would get all excited about the Fed temporarily buying up a few billion in government securities, when we've got a Federal government that's simultaneously and permanently issuing and then constantly rolling over many, many times that amount. It's an escape into dreamland to believe that Fed actions have any chance at all of providing more "liquidity" when the Federal government's deficits suck up in a matter of weeks every bit of liquidity that the Fed has provided in a year. These Fed actions are nothing but marginal tinkering around the edges of the global financial system, and investors are starting to catch on. Still, it's fun to watch when you understand what's going on. In fact, there will be all kinds of interesting things we'll get to watch this week. For instance, the Fed does its first $20 billion auction on Monday, but there's a timing disparity - only about $5 billion of expiring repos come on Tuesday, and the other $34 billion come due on Thursday. So between Monday and Thursday, we'll observe at least a temporary jump of $15-20 billion in Fed repos outstanding. There's a good chance that during that 3-day overlap, the actual Fed Funds rate will creep below the current target of 4.25% (watch the chart here: http://www.ny.frb.org/markets/openmarket.html). If that happens, you can bet that some analysts will incorrectly conclude that the Fed is doing some sort of "stealth easing." But it will be nothing more than a 3-day timing overlap between maturing and new repos.
More interesting is to watch what happens on Thursday. That's when we get $34 billion of repos coming due. If the Fed does little more than $20 billion through its "term auction facility," that will put the total for the week at $40 billion, versus $39 billion expiring, and it will be clear that this whole maneuver is simply a way for the Fed to temporarily refinance its expiring repos using a slightly longer 28-day maturity, rather than any effort to actually increase the amount of reserves. In any event, banking conditions aren't likely to change even if $40 billion in additional 28-day repos actually materialize. Indeed, a Bloomberg report noted "A Fed official told reporters that the U.S. central bank's efforts won't add net liquidity to the banking system. The plans are aimed at buttressing so-called term funding markets, such as for one-month loans, rather than overnight cash." Should be interesting. Finally, it's worth repeating that the total amount of outstanding repos has increased by only $18 billion since March, nearly all of which has been drawn out as currency in circulation. Most likely, the Fed will enter a "permanent" open market operation on the order of $10-20 billion at some point in the coming weeks to formalize that increase in outstanding currency. That move will probably be met by ridiculously over-hyped reporting as well. But it's entirely predictable. In short, Wall Street analysts aren't paying attention to the data if they believe that the Fed is "pumping" hundreds of billions into the economy to provide some kind of "safety net" for the banking system or the mortgage market. Is it really too much to ask that they make some attempt to understand the subject about which they opine incessantly? As for the Fed itself, it's a great gift to offer people hope, but a great disservice to offer people false hope, and I think that's what the Fed is doing. What's going on in the mortgage market is not a crisis of confidence that we can talk ourselves out of - it's a problem of structural insolvency, where many borrowers literally don't have the means to service their debt over the long-term, because many of them were counting on rising home prices over the short-term. By acting as if a few billion in repos will substantially change this equation, the Fed is raising hopes, and setting the markets and the economy up for disappointment that will be far worse as a result. Bernanke would be better off admitting that the Fed has no chance of providing meaningful "liquidity" when the Federal government is issuing Treasuries at ten times the rate the Fed can absorb them. At that point, Americans would see better that the resources we need to invest, compete and become a financially sound nation are being hoarded by the Federal government and sent up in flames.”
MISC
From Bloomberg: “Money market rates tumbled after the European Central Bank injected an unprecedented $500 billion into the banking system as part of a global effort to ease gridlock in the credit market. The amount banks charge each other for two-week loans in euros dropped a record 50 basis points to 4.45 percent, after climbing 83 basis points in the past two weeks, the European Banking Federation said today. The decline is the first sign attempts by policy makers to revive interbank lending are succeeding.”
From CNN: “Gasoline demand has fallen for the first time in years as drivers appear to recoil from near-record prices, throwing doubt on America's seemingly insatiable thirst for fuel. Growth in gasoline demand has been slowing all year. In five of the last seven weeks, the amount of gas that Americans consume has actually fallen compared to the same time last year…In some weeks demand has fallen by as much as 3 percent…Gasoline is one of those items that some economists consider "inelastic," that is, people will buy it no matter what the cost. But the recent drop in demand puts that into question, and suggest people will cut out unnecessary trips if they are too expensive.”
From Bank of Montreal: “For only the second time since the bad old days of the early 1980s, headline U.S. CPI inflation is now higher than the 10-year Treasury yield (4.3% versus just over 4.1%). The other time was when CPI temporarily spiked after Hurricane Katrina…Not good. The last time this occurred for a prolonged period was in two episodes in the 1970s --- both of which were followed by an economic downturn.”
From Morgan Stanley: “The current account deficit fell to $178.5 billion in Q3 from $188.9 billion in Q2. As a share of GDP this represented a decline to 5.1% from 5.5%, low since 2004Q1 and down from the peak of 6.6% in 2006Q3. The goods and services trade balance improved to -$173.2B from -$178.4B, as previously reported in the monthly trade figures, while the income balance jumped to $20.5B from $12.7B, a record high, on significant increases in interest and dividend payments on U.S. owned foreign assets and a sizable rise in receipts on direct investments abroad.”
From Barclays: “Disappointment about the super-SIV plan, the Paulson rate freeze plan, and the TAF should all drive home the point that policy measures can only do so much in solving both the liquidity issues and the subprime problem. The possibility of more write-downs by banks and brokers, as well as year-end funding issues, should also help the curve to bull steepen into year-end.”
From Deutsche Bank: “Clearly, the housing figures have been abysmal this year, however we think we may be seeing early signs of a bottom-after all, housing activity can only fall so far, and the construction figures are already the lowest since the housing recession in the early 1990s. Case in point, homebuilders' sentiment appears to have hit bottom, it has held steady at an index level of 19 for the last three months. Residential investment is likely to subtract about 1% from GDP both in the current quarter and Q1 of 2008. However, by Q2 of next year we project the residential investment share of GDP will fall to a record low, which means its negative effect on growth should trail off. However, significant negative second-order effects on the economy are likely to remain as a result of elevated inventories and potential further declines in house prices.”
From Merrill Lynch: “The Dow closed down 172 points, which was the first time we have seen back-to-back triple-digit losses since the onset of the credit crunch in mid-August (before the Fed began to ease). There were 5 decliners for every gainer on the Big Board – talk about bad breadth. And all ten S&P 500 sectors were down, but leading the decliners this time were not the usual culprits (financials, consumer discretionary) but rather 2%+ slides in the seemingly impenetrable ‘decoupling’ groups such as materials, tech and energy…It could just be that the market is starting to price in the earnings recession that began in earnest a quarter ago.”
From RBSGC: “…intriguing story in the WSJ where Greg Ip writes about a discussion within the FOMC that about the balance of risk assessment. He interviews Plosser (a hawk) who said the assessment may convey too much confidence about the direction of rates -- and offered that inflation pressure is spreading beyond energy. This is one man's opinion, and a leading hawk's at that, but still sheds some light on the internal debate within the Fed and suggests that their own struggle/confusion over the balance of risks mirrors the markets.”
From Dow Jones: “Fitch Ratings said it would set a ceiling for ratings on certain structured investments, while also implementing stricter requirements. The move comes as issuance and trading in these markets have ground to a halt with spooked investors retreating to the sidelines amid the ongoing credit crunch - forcing rating companies to reassess their methodology and also take into consideration the ease with which these securities trade. “Credit ratings really aren’t designed to measure liquidity. They measure credit performance as defined by the probability of default and ratings migration,”…”
From Merrill Lynch: “The Baltic Dry index continues its march downward, falling 0.3% on Friday to a level of 9918, which is the lowest since October 7. For the week, the index is down 1.5% and, since hitting an all-time peak back in mid November, the measure of global dry bulk commodity shipping rates has fallen by 10.1%. Could this be fore-shadowing a moderation in the commodity complex? The CRB index hit its peak on November 6, and since then, the index is down 2.4%.”
From Morgan Stanley: “Congressional wrangling over the Alternative Minimum Tax (AMT) appears likely to lead to an unprecedented delay to the start of the tax filing season. This could have a significant impact on the volume of tax refunds that will be pumped into the economy in early 2008 and represents yet another potentially important headwind for the US consumer…The IRS cannot process tax returns until all of its systems conform to current tax law. Normally, all tax legislation is completed by early-November and the IRS is ready to start processing returns by mid-January or so. At present, the IRS estimates that it will take seven weeks after the bill is signed before they can start processing returns. So, even under a best case scenario, the IRS probably will not be able to begin mailing refund checks until mid-February…it seems likely that the refund delay could -- at least temporarily -- take a significant chunk out of discretionary spending in early 2008, adding to the near term downside risks confronting the US economy.”
From Bloomberg: “The light bulbs in almost every U.S. home and the gasoline in many cars will be altered by energy legislation that the U.S. House of Representatives passed today…The measure, approved 314-100, slashes U.S. energy use 8 percent by 2030, environmentalists say. It contains the first new vehicle fuel economy law in 32 years and mandates a fourfold increase in the use of biofuels. The bill, already approved by the Senate, phases out incandescent light bulbs, which have been in use for a century, and places the first limits on the amount of water used in new washing machines and dishwashers…``Literally, the amount of energy that's being saved by the light-bulb standard alone is more than has been achieved since 1986 for all appliances combined.''”
From Dow Jones: “President George W. Bush will sign mortgage-tax relief legislation
later this week if it passes the House as expected. White House spokeswoman Dana Perino lauded the measure, which would let homeowners avoid income tax on mortgage debt forgiven through refinancing. “This will protect homeowners from having to pay extra taxes when they refinance their mortgages on the difference,” Perino said. Bush “believes it is good policy.””
From Bloomberg: “Bill Gross, manager of the world's biggest bond fund, said the U.S. is headed for a ``mild'' recession in 2008 amid the worst housing slump in 16 years.”
Bank of America: “Corporate tax receipts at the Treasury recovered from their weakness in September. Comparing tax receipts on the day of the deadline, December receipts fell -3% year-over-year (yoy) versus a -13% decline in September.”
From Dow Jones: “Prices for most types of property and casualty insurance are expected to decline in 2008 for the first time since World War II, as a weakening economy and heightened competition hold prices down everywhere except along coastal areas that are exposed to hurricanes.”
End-of-Day Market Update
From UBS: “Treasuries rallied right out of the gate, rising almost non-stop until noon, after which they gave back a portion of their gains…swap spreads to narrow across the board. Agencies had light flows, with the front end underperforming versus Libor. Mortgages had a quiet day, with higher coupons lagging lower coupons. MBS ended 7 ticks tighter to Treasuries and 2+ to swaps.”
From Dow Jones: “U.S. Treasurys were higher Tuesday morning on the heels of an aggressive overnight move by the European Central Bank to ease liquidity pressures, which reawakened investors’ year-end liquidity concerns. The ECB Tuesday saw robust demand from banks for its offer of unlimited two-week funds at a fixed rate, lending around $500 billion in such funds to help ease strained money markets and boost liquidity into year-end. The add dwarfed the size of the Federal Reserve’s $20 billion sale Monday, the first offering in its Term Auction Facility program also designed to ensure liquidity through year-end, and raised worries that the Fed offering may not be enough…The dollar rose a bit against the yen Tuesday as a modest rise in US stocks swayed investors to take on more risk by selling the low-yielding yen and buying higher-yielders. But ranges remained tight and the greenback showed little reaction to yet another weak US housing report as markets downshift gears as the year winds down. Wednesday could be another dull session, with no important data slated for release…The market seemed unable to make up its mind Tuesday, as stocks dipped early in the afternoon and then moved back to positive territory.”
Three month T-Bill yield fell 1 bp to 3.03%.
Two year T-Note yield rose 1.5 bp to 3.19%
Ten year T-Note yield fell 2 bp to 4.12%
Dow rose 65 to 13,232
S&P 500 rose 9 to 1455
Dollar index rose .03 to 77.43
Gold rose $10 to $803
Oil fell $.14 to $90.5
*All prices as of 4:35pm
From Dow Jones: “The Federal Reserve proposed new rules for subprime mortgages, including a ban on low- documentation loans and limits on penalties for borrowers who prepay their debts. The plans, the Fed's biggest regulatory initiative since Chairman Ben S. Bernanke took office in February 2006, are aimed at curbing lending practices that contributed to record foreclosures. Board members unanimously voted in a hearing today to make lenders responsible for determining whether borrowers can afford their mortgages even after low starter rates expire… The proposed new rules ``were carefully crafted'' to deter ``improper lending'' without ``unduly restricting mortgage credit availability,'' he said. Bernanke is aiming to preserve the Fed's consumer-protection role after Democratic lawmakers blamed it for lax oversight and introduced legislation to set rules for mortgage lenders. Today's proposals received mixed responses from legislators, consumer advocates and finance-industry officials… Today's package covers all high-cost mortgages, which are defined as loans with rates at least 3 percentage points above a comparable Treasury security for first mortgages and 5 percentage points for second loans, or home-equity loans… The proposal also went beyond its initial scope of consideration, and recommended new disclosure rules aimed at mortgage brokers, appraisers and solicitors. The rules apply to both prime and subprime loans. Fed governors approved prohibiting lenders from paying brokers fees in excess of what the borrower initially agreed. The proposal bars coercion of appraisers, and defines seven advertising practices as misleading or deceptive.”
Interesting Discussion on Equity Market Cycles – Are we in a Bull or Bear Market?
From Merrill Lynch: “The past five years — was it a bull market or a bear market? Well, if you look strictly at “price”, it has been a classic cyclical bull market – the S&P 500 has obviously risen more than 80% from the late 2002 lows. But every inch of the way, it was earnings growth that led the bull run – though we now know looking at all the write-downs that a certain volume of this growth in the “E” was nonrecurring. The benefit of hindsight. But the P/E multiple has actually been in a bear market through the entire piece – going from 27x at the market bottom to just over 18x right now. Imagine what this cyclical bull market would have done if the multiple had expanded! But this is a key point Two-thirds of the great bull run that started in 1982 and ended in 2000 was pure multiple expansion – going from the trough of 8x to the peak of over 30x in that 18-year interval. During that time, of course, we saw the spreading technology breakthroughs, more responsible monetary policy, smaller government, deregulation, the breakdown of global trade barriers and the crumbling of Communism lead to ever-declining rates of inflation and inflation expectations and much lower bond yields and much higher “fair-value” P/E multiples. But only one-third of that great bull market was due to profit growth – the majority of the gains were in the price that investors were willing to pay for that earnings stream. But in this current cycle — it’s all been about earnings That is a good thing and a bad thing – a bad thing because we are about to go through an earnings recession with no cushion from the multiple which remains above historical norms (and no, this is not justified by “low” interest rates, which in real terms are actually right in line with long-term averages in the private sector). The P/E multiple did something it has never done before in the context of a bear market and bottomed at 27x at the late-2002 lows in the S&P 500. On average, the multiple troughs at 12x at the bear market bottom, but not in this latest cycle, and the reason for that is because the Fed had cut rates so aggressively back then that it actually took, for the first time ever, the level of the 3-month Eurodollar deposit rate below the level of the S&P 500 dividend yield. This was unheard of. Not only that, but the Fed ensured that this spread remained negative for two years (the fall of 2002 to the fall of 2004) and during that early time frame, the stock market bull run was well entrenched, with the S&P 500 appreciating 40% and breaking many key technical barriers along the way. Not until this bull market was into its third year was the level of money market rates pushed above the dividend yield – though these metrics have switched course because these 3-month eurodollar deposits now command a 310 basis point premium over the 1.9% dividend yield even with the Fed’s moves to cut the funds rate and discount rate in recent months. But the major conclusion is this - Even with the rally that was induced by negative real short-term rates by the Fed and subsequently nurtured by the strongest earnings cycle on record (some would argue financially-engineered), the P/E multiple has remained in a bear market. And if history is any guide, the fundamental low in the multiple will be closer to 12x than the current level of 18x. So the multiple has, over time, been gravitating lower and the question must be asked as to whether the Fed’s aggressive easing in 2002-03 merely delayed the inevitable compression to the traditional lows of 12x that defined so many bear market lows in the past. We had an earnings recession back in 2001-02 coupled with P/E compression and that delivered a severe bear market. Then we had a huge cyclical snapback in earnings from 2003 to 2006 that more than offset the effects of a sustained narrowing in the multiple and gave us a powerful bull market. But now we are on the precipice of an earnings recession What if we are correct at $83 on operating earnings next year and the multiple finds its way to the 12x level that would have been consistent with prior secular bull market starting points (aka real buying opportunities) – a level we may well have seen in late 2002 or early 2003 if the Fed had not so dramatically altered the relationship between the dividend/earnings yield with cash rates. That then would mean a snick below 1,000 on the S&P 500 (the “glass is half full” shows that this would still be one-third above the 2002 low and double the level prevailing in 1995). We want to stress that this is not, repeat not, a target by any stretch of the imagination. It is about generating a discussion and sparking a debate. Maybe – just maybe – we never did complete that entire bear market from 2000 to 2003 and the earnings recovery masked what was and still is a mean-reverting downward trend in the P/E multiple. But the fact that we have both cash and bonds outperforming equities with two weeks to go in the year, despite a 150 basis point cut in the discount rate, is indeed an ominous signpost. Then again, whenever the Fed has been forced to cut the discount rate this much in the past, it has generally been because the economy was heading for a hard landing, with the accompanying decline in corporate earnings, stock prices and Treasury yields.”
World Bank Revises Down Size of Economies in China and India
From Barclays: “China and India’s economies are 40% smaller than previously estimated. That is one of the major findings from yesterday’s release of the 2005 International Comparison Program (ICP), an initiative led by the World Bank over 2003-2007 to estimate Purchasing Power Parities (PPPs) of 146 economies. It marks the first time China participated in the ICP, and the first time since 1985 that India has. Compared with earlier estimates, which were based on old and very limited data, China and India’s shares in global GDP have been downwardly revised from 14% and 6%, to 9% and 4% respectively. A natural implication for the global economy is that growth, both retrospectively and forward-looking, will now also have to be revised lower, given that contributions from the emerging economies of China and India would now be weighed by smaller shares. But what does this mean for commodity demand? Clearly, while the way of measuring China and India’s GDP has changed, historical levels of Chinese and Indian commodity demand have not. If anything, we see this downsize in their economic clout as presenting a positive risk to future demand growth…suggesting that growth in both economies have in fact been much more energy/metal intensive than initially thought. Re-looking at the same numbers in per capita terms, trimming Chinese GDP numbers by 40% does make sense for its energy/metal demand for a given level of income… the same level of GDP per capita is now associated with higher copper demand per head, bringing Chinese demand more in line with the path that other Asian economies have taken in their earlier years of industrialisation. The picture for oil demand depicts a very similar story. The second implication relates to the growth potential in both China and India’s economies now that they are starting from a lower base. After the revision, China’s PPP per capita is approximately 14% that of Japan and 19% that of Korea, while the same set of numbers for India are 7% and 9% respectively… China and India are only in an early phase of their industrialisation process. This, coupled with their massive economic size and potential, point to continued strong demand growth in commodities for many more years to come.”
How Much Liquidity is the Fed Really Adding?
From Hussman Econometrics Advisors: “Case in point is the ridiculously over-hyped "term auction facility" announced last week. According to that announcement, the Fed plans to auction about $40 billion of "liquidity" this week: $20 billion on Monday December 17th, which will be a 28-day repo, and another $20 billion on December 20th.
… there are currently $53 billion of repos outstanding (as of Friday), fully $39 billion that mature this week. And wouldn't you know it, the Fed is going to be "injecting" $40 billion this week too. So here's a little acid-test of whether the Fed will actually be providing new "liquidity," or whether it's just trying to brew up a tempest with what's already in that little teapot. Watch the NY Fed's listings of open market operations:
http://www.ny.frb.org/markets/omo/dmm/temp.cfm?SHOWMORE=TRUE
If the Fed is actually adding liquidity, you'll see not only the two $20 billion repos on the 17th and 20th, but additional repos to replace the $39 billion that are coming due this week ($5 billion mature on Tuesday the 18th, and fully $34 billion are set to mature on Thursday the 20th). If the Fed does nothing but those two $20 billion longer-dated repos, all it will have done is to change the maturity of its outstanding repos, without changing the amount. Now, that's not to say I believe that even if the Fed does temporarily buy $40 billion of government securities for 28 days, before selling them back out, it will do much for the solvency of the $12.7 trillion U.S. banking system, much less exotic CDOs and mortgage-backed securities. As I've emphasized in recent weeks, if you track all those daily and weekly rollovers and figure out the total quantity of Fed repos outstanding at any given time, you'll find that the Fed has only injected $18 billion in "liquidity" since March. If investors think the Fed buying up a few billion of Treasury and agency debt means a hill of beans, they might do well to remember that the U.S. government is running up annual deficits in the hundreds of billions. In fact, the U.S. Treasury will float tens of billions of new debt in December alone (most of which will be sopped up by foreigners, who have increased their holdings of Treasuries by well over $200 billion in the past year). This will be mixed in with refinancings. Last week, for example, the Treasury auctioned $21 billion in 3-month bills and $20 billion in 6-month bills. In doing so, the Treasury offset every bit of the Federal Reserve's actions this week, even if it turns out that the $40 billion "term auction facility" represents new liquidity and not just rollovers. Why aren't investors just as interested in that? When the Fed does open market operations, all it's doing is buying up (temporarily or permanently) a tiny fraction of U.S. Treasury debt and replacing it with currency and bank reserves. But every time the Federal government issues more debt to finance its deficits, the new issuance cancels out any beneficial increase in liquidity the Fed could possibly provide. So it's difficult to understand why investors would get all excited about the Fed temporarily buying up a few billion in government securities, when we've got a Federal government that's simultaneously and permanently issuing and then constantly rolling over many, many times that amount. It's an escape into dreamland to believe that Fed actions have any chance at all of providing more "liquidity" when the Federal government's deficits suck up in a matter of weeks every bit of liquidity that the Fed has provided in a year. These Fed actions are nothing but marginal tinkering around the edges of the global financial system, and investors are starting to catch on. Still, it's fun to watch when you understand what's going on. In fact, there will be all kinds of interesting things we'll get to watch this week. For instance, the Fed does its first $20 billion auction on Monday, but there's a timing disparity - only about $5 billion of expiring repos come on Tuesday, and the other $34 billion come due on Thursday. So between Monday and Thursday, we'll observe at least a temporary jump of $15-20 billion in Fed repos outstanding. There's a good chance that during that 3-day overlap, the actual Fed Funds rate will creep below the current target of 4.25% (watch the chart here: http://www.ny.frb.org/markets/openmarket.html). If that happens, you can bet that some analysts will incorrectly conclude that the Fed is doing some sort of "stealth easing." But it will be nothing more than a 3-day timing overlap between maturing and new repos.
More interesting is to watch what happens on Thursday. That's when we get $34 billion of repos coming due. If the Fed does little more than $20 billion through its "term auction facility," that will put the total for the week at $40 billion, versus $39 billion expiring, and it will be clear that this whole maneuver is simply a way for the Fed to temporarily refinance its expiring repos using a slightly longer 28-day maturity, rather than any effort to actually increase the amount of reserves. In any event, banking conditions aren't likely to change even if $40 billion in additional 28-day repos actually materialize. Indeed, a Bloomberg report noted "A Fed official told reporters that the U.S. central bank's efforts won't add net liquidity to the banking system. The plans are aimed at buttressing so-called term funding markets, such as for one-month loans, rather than overnight cash." Should be interesting. Finally, it's worth repeating that the total amount of outstanding repos has increased by only $18 billion since March, nearly all of which has been drawn out as currency in circulation. Most likely, the Fed will enter a "permanent" open market operation on the order of $10-20 billion at some point in the coming weeks to formalize that increase in outstanding currency. That move will probably be met by ridiculously over-hyped reporting as well. But it's entirely predictable. In short, Wall Street analysts aren't paying attention to the data if they believe that the Fed is "pumping" hundreds of billions into the economy to provide some kind of "safety net" for the banking system or the mortgage market. Is it really too much to ask that they make some attempt to understand the subject about which they opine incessantly? As for the Fed itself, it's a great gift to offer people hope, but a great disservice to offer people false hope, and I think that's what the Fed is doing. What's going on in the mortgage market is not a crisis of confidence that we can talk ourselves out of - it's a problem of structural insolvency, where many borrowers literally don't have the means to service their debt over the long-term, because many of them were counting on rising home prices over the short-term. By acting as if a few billion in repos will substantially change this equation, the Fed is raising hopes, and setting the markets and the economy up for disappointment that will be far worse as a result. Bernanke would be better off admitting that the Fed has no chance of providing meaningful "liquidity" when the Federal government is issuing Treasuries at ten times the rate the Fed can absorb them. At that point, Americans would see better that the resources we need to invest, compete and become a financially sound nation are being hoarded by the Federal government and sent up in flames.”
MISC
From Bloomberg: “Money market rates tumbled after the European Central Bank injected an unprecedented $500 billion into the banking system as part of a global effort to ease gridlock in the credit market. The amount banks charge each other for two-week loans in euros dropped a record 50 basis points to 4.45 percent, after climbing 83 basis points in the past two weeks, the European Banking Federation said today. The decline is the first sign attempts by policy makers to revive interbank lending are succeeding.”
From CNN: “Gasoline demand has fallen for the first time in years as drivers appear to recoil from near-record prices, throwing doubt on America's seemingly insatiable thirst for fuel. Growth in gasoline demand has been slowing all year. In five of the last seven weeks, the amount of gas that Americans consume has actually fallen compared to the same time last year…In some weeks demand has fallen by as much as 3 percent…Gasoline is one of those items that some economists consider "inelastic," that is, people will buy it no matter what the cost. But the recent drop in demand puts that into question, and suggest people will cut out unnecessary trips if they are too expensive.”
From Bank of Montreal: “For only the second time since the bad old days of the early 1980s, headline U.S. CPI inflation is now higher than the 10-year Treasury yield (4.3% versus just over 4.1%). The other time was when CPI temporarily spiked after Hurricane Katrina…Not good. The last time this occurred for a prolonged period was in two episodes in the 1970s --- both of which were followed by an economic downturn.”
From Morgan Stanley: “The current account deficit fell to $178.5 billion in Q3 from $188.9 billion in Q2. As a share of GDP this represented a decline to 5.1% from 5.5%, low since 2004Q1 and down from the peak of 6.6% in 2006Q3. The goods and services trade balance improved to -$173.2B from -$178.4B, as previously reported in the monthly trade figures, while the income balance jumped to $20.5B from $12.7B, a record high, on significant increases in interest and dividend payments on U.S. owned foreign assets and a sizable rise in receipts on direct investments abroad.”
From Barclays: “Disappointment about the super-SIV plan, the Paulson rate freeze plan, and the TAF should all drive home the point that policy measures can only do so much in solving both the liquidity issues and the subprime problem. The possibility of more write-downs by banks and brokers, as well as year-end funding issues, should also help the curve to bull steepen into year-end.”
From Deutsche Bank: “Clearly, the housing figures have been abysmal this year, however we think we may be seeing early signs of a bottom-after all, housing activity can only fall so far, and the construction figures are already the lowest since the housing recession in the early 1990s. Case in point, homebuilders' sentiment appears to have hit bottom, it has held steady at an index level of 19 for the last three months. Residential investment is likely to subtract about 1% from GDP both in the current quarter and Q1 of 2008. However, by Q2 of next year we project the residential investment share of GDP will fall to a record low, which means its negative effect on growth should trail off. However, significant negative second-order effects on the economy are likely to remain as a result of elevated inventories and potential further declines in house prices.”
From Merrill Lynch: “The Dow closed down 172 points, which was the first time we have seen back-to-back triple-digit losses since the onset of the credit crunch in mid-August (before the Fed began to ease). There were 5 decliners for every gainer on the Big Board – talk about bad breadth. And all ten S&P 500 sectors were down, but leading the decliners this time were not the usual culprits (financials, consumer discretionary) but rather 2%+ slides in the seemingly impenetrable ‘decoupling’ groups such as materials, tech and energy…It could just be that the market is starting to price in the earnings recession that began in earnest a quarter ago.”
From RBSGC: “…intriguing story in the WSJ where Greg Ip writes about a discussion within the FOMC that about the balance of risk assessment. He interviews Plosser (a hawk) who said the assessment may convey too much confidence about the direction of rates -- and offered that inflation pressure is spreading beyond energy. This is one man's opinion, and a leading hawk's at that, but still sheds some light on the internal debate within the Fed and suggests that their own struggle/confusion over the balance of risks mirrors the markets.”
From Dow Jones: “Fitch Ratings said it would set a ceiling for ratings on certain structured investments, while also implementing stricter requirements. The move comes as issuance and trading in these markets have ground to a halt with spooked investors retreating to the sidelines amid the ongoing credit crunch - forcing rating companies to reassess their methodology and also take into consideration the ease with which these securities trade. “Credit ratings really aren’t designed to measure liquidity. They measure credit performance as defined by the probability of default and ratings migration,”…”
From Merrill Lynch: “The Baltic Dry index continues its march downward, falling 0.3% on Friday to a level of 9918, which is the lowest since October 7. For the week, the index is down 1.5% and, since hitting an all-time peak back in mid November, the measure of global dry bulk commodity shipping rates has fallen by 10.1%. Could this be fore-shadowing a moderation in the commodity complex? The CRB index hit its peak on November 6, and since then, the index is down 2.4%.”
From Morgan Stanley: “Congressional wrangling over the Alternative Minimum Tax (AMT) appears likely to lead to an unprecedented delay to the start of the tax filing season. This could have a significant impact on the volume of tax refunds that will be pumped into the economy in early 2008 and represents yet another potentially important headwind for the US consumer…The IRS cannot process tax returns until all of its systems conform to current tax law. Normally, all tax legislation is completed by early-November and the IRS is ready to start processing returns by mid-January or so. At present, the IRS estimates that it will take seven weeks after the bill is signed before they can start processing returns. So, even under a best case scenario, the IRS probably will not be able to begin mailing refund checks until mid-February…it seems likely that the refund delay could -- at least temporarily -- take a significant chunk out of discretionary spending in early 2008, adding to the near term downside risks confronting the US economy.”
From Bloomberg: “The light bulbs in almost every U.S. home and the gasoline in many cars will be altered by energy legislation that the U.S. House of Representatives passed today…The measure, approved 314-100, slashes U.S. energy use 8 percent by 2030, environmentalists say. It contains the first new vehicle fuel economy law in 32 years and mandates a fourfold increase in the use of biofuels. The bill, already approved by the Senate, phases out incandescent light bulbs, which have been in use for a century, and places the first limits on the amount of water used in new washing machines and dishwashers…``Literally, the amount of energy that's being saved by the light-bulb standard alone is more than has been achieved since 1986 for all appliances combined.''”
From Dow Jones: “President George W. Bush will sign mortgage-tax relief legislation
later this week if it passes the House as expected. White House spokeswoman Dana Perino lauded the measure, which would let homeowners avoid income tax on mortgage debt forgiven through refinancing. “This will protect homeowners from having to pay extra taxes when they refinance their mortgages on the difference,” Perino said. Bush “believes it is good policy.””
From Bloomberg: “Bill Gross, manager of the world's biggest bond fund, said the U.S. is headed for a ``mild'' recession in 2008 amid the worst housing slump in 16 years.”
Bank of America: “Corporate tax receipts at the Treasury recovered from their weakness in September. Comparing tax receipts on the day of the deadline, December receipts fell -3% year-over-year (yoy) versus a -13% decline in September.”
From Dow Jones: “Prices for most types of property and casualty insurance are expected to decline in 2008 for the first time since World War II, as a weakening economy and heightened competition hold prices down everywhere except along coastal areas that are exposed to hurricanes.”
End-of-Day Market Update
From UBS: “Treasuries rallied right out of the gate, rising almost non-stop until noon, after which they gave back a portion of their gains…swap spreads to narrow across the board. Agencies had light flows, with the front end underperforming versus Libor. Mortgages had a quiet day, with higher coupons lagging lower coupons. MBS ended 7 ticks tighter to Treasuries and 2+ to swaps.”
From Dow Jones: “U.S. Treasurys were higher Tuesday morning on the heels of an aggressive overnight move by the European Central Bank to ease liquidity pressures, which reawakened investors’ year-end liquidity concerns. The ECB Tuesday saw robust demand from banks for its offer of unlimited two-week funds at a fixed rate, lending around $500 billion in such funds to help ease strained money markets and boost liquidity into year-end. The add dwarfed the size of the Federal Reserve’s $20 billion sale Monday, the first offering in its Term Auction Facility program also designed to ensure liquidity through year-end, and raised worries that the Fed offering may not be enough…The dollar rose a bit against the yen Tuesday as a modest rise in US stocks swayed investors to take on more risk by selling the low-yielding yen and buying higher-yielders. But ranges remained tight and the greenback showed little reaction to yet another weak US housing report as markets downshift gears as the year winds down. Wednesday could be another dull session, with no important data slated for release…The market seemed unable to make up its mind Tuesday, as stocks dipped early in the afternoon and then moved back to positive territory.”
Three month T-Bill yield fell 1 bp to 3.03%.
Two year T-Note yield rose 1.5 bp to 3.19%
Ten year T-Note yield fell 2 bp to 4.12%
Dow rose 65 to 13,232
S&P 500 rose 9 to 1455
Dollar index rose .03 to 77.43
Gold rose $10 to $803
Oil fell $.14 to $90.5
*All prices as of 4:35pm
Housing Starts Fall 3.7% MoM in November
Housing remains under pressure as new permits fell -1.5% MoM, to a new14-year low, and actual starts fell 3.7% MoM, to annual rate of 1.187million new homes a year. A reduction in new home supply will helppare down current bloated inventories. Housing starts peaked inJanuary 2006, and are now running at half the pace they were then.
Single-family home starts continue to experience the brunt of thedecline, falling 5.4% MoM, to the slowest pace since 1991.Multi-family construction, which includes townhouses, condos andapartments, rose +.6% MoM, for the second consecutive monthlyincrease. Over the past year, single-family starts have fallen -34.9%YoY while multi-family starts have risen +22.6% YoY.
The South was the only region to see an increase in starts, up 0.3%MoM. The Northeast saw the biggest drop at -16% MoM, followed by theWest at -6.9% MoM and then the Midwest at -1.5% MoM. Year-over-year,the West and South have shown the largest declines in new home starts at around 27% each. In contrast, the Midwest and Northeast are closerto an average 14% annual decline.
Housing completed fell -4.1% MoM and is down -28.7% YoY, evenlydistributed between single and multi-family construction. Housingcurrently under construction fell -0.9% MoM, and is down -13.6% YoY.Single-family houses under construction has fallen -22.6% YoY whilemulti-family structures currently under construction has risen 2.9%YoY.
See attached graph of housing starts going back to 1990.
Single-family home starts continue to experience the brunt of thedecline, falling 5.4% MoM, to the slowest pace since 1991.Multi-family construction, which includes townhouses, condos andapartments, rose +.6% MoM, for the second consecutive monthlyincrease. Over the past year, single-family starts have fallen -34.9%YoY while multi-family starts have risen +22.6% YoY.
The South was the only region to see an increase in starts, up 0.3%MoM. The Northeast saw the biggest drop at -16% MoM, followed by theWest at -6.9% MoM and then the Midwest at -1.5% MoM. Year-over-year,the West and South have shown the largest declines in new home starts at around 27% each. In contrast, the Midwest and Northeast are closerto an average 14% annual decline.
Housing completed fell -4.1% MoM and is down -28.7% YoY, evenlydistributed between single and multi-family construction. Housingcurrently under construction fell -0.9% MoM, and is down -13.6% YoY.Single-family houses under construction has fallen -22.6% YoY whilemulti-family structures currently under construction has risen 2.9%YoY.
See attached graph of housing starts going back to 1990.
Monday, December 17, 2007
Empire Manufacturing Stumbles in December
NY Empire Manufacturing unexpectedly tumbled from 27.4 in November to10.3 in December (consensus 20). This was the weakest pace in sixmonths. Orders slowed as companies reduced inventories. Any readingabove zero indicates growth, so today's number indicates economicgrowth is slowing as the credit crunch reduces demand. The NYindicator has been the strongest of the regional indexes in recentmonths, and is the first to provide December data. Thirty-fivepercent of the survey group felt that conditions improved over thepast month, while 24% felt they had deteriorated.
New orders dropped from 24.5 to 14.3, shipments fell to 21.1 from32.2, and inventories fell to -10. Future unfilled orders fell tozero. On the plus side, the outlook for the next six months rose to32.4 from 30.5 last month. Both the capital expenditures index andthe technology spending index rose last month.
The Empire product range tends to be more high tech, and also to bemore sensitive to export demand than some of the other regionalsurvey's products. Exports rose to a record high last month. Anotherpositive on the inflation front is that prices paid fell from a oneyear high of 42.9 in November to 35 in December. Oil prices fellabout $8 a barrel between the survey dates in November and December.In addition, prices received rose to 12.5 from 11.9 the prior month,but it appears that companies are still unable to pass on all of theirincrease in costs, which will continue to erode their profit margins.
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The current account deficit improved more than expected to -$178.5Bfor the third quarter. This is an improvement on the -$183.5Bconsensus estimate, and an improvement from the -$188.9B deficit inthe second quarter and -$217B deficit in the third quarter of 2006.
New orders dropped from 24.5 to 14.3, shipments fell to 21.1 from32.2, and inventories fell to -10. Future unfilled orders fell tozero. On the plus side, the outlook for the next six months rose to32.4 from 30.5 last month. Both the capital expenditures index andthe technology spending index rose last month.
The Empire product range tends to be more high tech, and also to bemore sensitive to export demand than some of the other regionalsurvey's products. Exports rose to a record high last month. Anotherpositive on the inflation front is that prices paid fell from a oneyear high of 42.9 in November to 35 in December. Oil prices fellabout $8 a barrel between the survey dates in November and December.In addition, prices received rose to 12.5 from 11.9 the prior month,but it appears that companies are still unable to pass on all of theirincrease in costs, which will continue to erode their profit margins.
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The current account deficit improved more than expected to -$178.5Bfor the third quarter. This is an improvement on the -$183.5Bconsensus estimate, and an improvement from the -$188.9B deficit inthe second quarter and -$217B deficit in the third quarter of 2006.
Much Better Than Expected Foreign Demand for U.S. Financial Assets in October
Foreign demand for U.S. securities rebounded in October, rising to$97.8B for the month. This compares with a consensus estimate of netforeign demand for total TIC flows of $30B, and follows a revisedlower net sell of -$32.8B the prior month. The improvement brings insufficient dollars to more than cover the US current account deficitin October. Unfortunately the trend in foreign demand has beendeclining, as the U.S. dollar has weakened, with the two year monthlymoving average of net foreign demand for U.S. securities at $61.5B,and the one year moving average decelerating to $49B.
When just the assets with maturities of over one year are examined,total demand rose to $114B in October, and increase of $99B over theprior month. Net long-term TIC flows are watched closely because theyare believed to indicate real investment, versus just short-term "hotmoney" flows. This was the third highest monthly net internationalbuying of long-term U.S. assets ever, only exceeded by the net $132Bpurchase in May of this year, and the $125B net purchase in August2006. But it follows the record selling of over $70B in August.
Demand for U.S. equities rose to a five month high of $30B in October,as the U.S. equity markets rallied to record highs. Demand for U.S.Treasuries essentially doubled from the prior month, rising to $49.8Bfrom $26.3B. Treasury yields fell, and prices rose, on the flight toquality buying as credit concerns pushed government yields lowerversus other credit instruments. Agency debt holdings grew moremodestly, increasing from $11.5B the prior month to $14.9B in October. Corporate bonds also experienced greater demand, rising to $23.1Bfrom $16.1B in September. Overall, improved demand was broad-based,but better quality credit instruments saw more benefit.
The Chinese continue to reduce their holdings of U.S. Treasuries.Chinese holdings fell -$8.6B in October, but other regions increasedtheir investments. Japan's Treasury position grew $9.8B, the U.K.position grew $30.5B, the Caribbean holdings rose $6.5B, and oilexporters added $4.6B in October.
When looking at only long-term securities, private investors increasedtheir purchases of U.S assets four and a half times faster thanofficial institutions. Central banks bought a total of $21.8B insecurities in October, while private investors added $96.2B. Forofficial purchasers, the largest accumulation was in government agencydebt and MBS at $10B for the month. Private investors loaded up on$45.9B of Treasuries followed by $29.9B of equities and $15.7B ofagency issuance.
Looking at U.S. investor demand for foreign securities, a weakening isapparent. U.S. investors sold $5B of foreign equities in Octoberafter purchasing over $21B in September. The demand for foreign bondsfell to $9B from almost $20B the prior month.
This morning's data indicates that the monthly average currentlyaccount deficit in the third quarter of this year was $59.5B,indicating a persistent $10B monthly deficit between U.S demand forforeign goods and foreign net demand for U.S. assets. The gap betweenthese two figures is watched to see how easily the U.S. can fund itsexternal obligations, which continue to grow.
When just the assets with maturities of over one year are examined,total demand rose to $114B in October, and increase of $99B over theprior month. Net long-term TIC flows are watched closely because theyare believed to indicate real investment, versus just short-term "hotmoney" flows. This was the third highest monthly net internationalbuying of long-term U.S. assets ever, only exceeded by the net $132Bpurchase in May of this year, and the $125B net purchase in August2006. But it follows the record selling of over $70B in August.
Demand for U.S. equities rose to a five month high of $30B in October,as the U.S. equity markets rallied to record highs. Demand for U.S.Treasuries essentially doubled from the prior month, rising to $49.8Bfrom $26.3B. Treasury yields fell, and prices rose, on the flight toquality buying as credit concerns pushed government yields lowerversus other credit instruments. Agency debt holdings grew moremodestly, increasing from $11.5B the prior month to $14.9B in October. Corporate bonds also experienced greater demand, rising to $23.1Bfrom $16.1B in September. Overall, improved demand was broad-based,but better quality credit instruments saw more benefit.
The Chinese continue to reduce their holdings of U.S. Treasuries.Chinese holdings fell -$8.6B in October, but other regions increasedtheir investments. Japan's Treasury position grew $9.8B, the U.K.position grew $30.5B, the Caribbean holdings rose $6.5B, and oilexporters added $4.6B in October.
When looking at only long-term securities, private investors increasedtheir purchases of U.S assets four and a half times faster thanofficial institutions. Central banks bought a total of $21.8B insecurities in October, while private investors added $96.2B. Forofficial purchasers, the largest accumulation was in government agencydebt and MBS at $10B for the month. Private investors loaded up on$45.9B of Treasuries followed by $29.9B of equities and $15.7B ofagency issuance.
Looking at U.S. investor demand for foreign securities, a weakening isapparent. U.S. investors sold $5B of foreign equities in Octoberafter purchasing over $21B in September. The demand for foreign bondsfell to $9B from almost $20B the prior month.
This morning's data indicates that the monthly average currentlyaccount deficit in the third quarter of this year was $59.5B,indicating a persistent $10B monthly deficit between U.S demand forforeign goods and foreign net demand for U.S. assets. The gap betweenthese two figures is watched to see how easily the U.S. can fund itsexternal obligations, which continue to grow.
Home Builders Survey Remains at Record Low
The confidence of homebuilders held steady at 19 in December, for thethird month in a row, at an all-time record low. An improvement inperceptions of current sales (+1 to 19) and future sales (+2 to 26)was offset by fewer potential buyers visiting model homes (-3 to a newrecord low 14). Sentiment improved in the South and Midwest, but fellin the Northeast. The West held constant at 18.
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