From The Wall Street Journal: “U.S. house prices "likely would have to fall considerably" to return to a normal relationship with rents, says a study by one former and two current Federal Reserve economists. The study, which doesn't necessarily reflect the views of Fed policy makers, suggests prices would have to fall 15% over five years, assuming rents rose 4% a year. House prices would have to fall further if the adjustment took place more quickly. The study tracks rents and home prices back to 1960 and found annual rents fluctuated at around 5% to 5.25% of home prices until 1995. At the end of that year, the average monthly rent was about $553 (or about $6,600 a year) and the average home price was about $134,000. But starting in 1996, home prices started to grow much more rapidly than rents. By the end of 2006, they had more than doubled to an average of $282,000, while the average rent had risen 48% to $818. That drove the annual rent/price ratio down to 3.48%. That means the rent/price ratio is about a third below its long-term average. To return to normal would require some combination of falling prices and rising rents. The paper suggests house prices would need to fall about 3% a year, if rents grew in line with their 4% average annual growth this decade. Of course, the link between house prices and rents can remain out of whack for years… lower long-term interest rates can explain only a small part of the drop in the ratio. "To justify current price levels, you need rapid growth in rents." But it's hard to imagine the scenario that would justify such rapid growth in rents, he added. Indeed, it's possible rents will grow more slowly than 4%, reflecting the overhang of unsold homes that might be rented out… the authors postulated a five-year horizon for the rent/price ratio to return to normal by looking at previous downturns. "When a downturn begins, it will last for a while."”
Alt-A Market Had a Bad Year in 2007
From Merrill Lynch: “Not only has the subprime mortgage market that fuelled the last leg of the bull run in housing in 2005-06 been completely shut down, but look at what has happened to the Alt-A market: Volume lending in this space plunged by 64% in 3Q to $39.3 bln from the 2Q record high of $109.5 bln just before the credit crunch intensified …The delinquency rate here may not be the near-20% it is in subprime, but for the 2006 vintage is up to 4.71% from comparable loans made in 2005 (1.97%) and those in 2004 (1.07%) – making this the worst year for Alt-A credit quality on record.”
Delinquent Consumer Loan Payments Rise to Highest Level Since Last Recession
From Reuters: “Americans are falling further behind on consumer loans, with late payments rising to the highest level since the nation's last recession in 2001, data released Thursday show. In its quarterly study of consumer borrowing, the American Bankers Association said the percentage of loans at least 30 days past due rose to 2.44 percent in the July-to-September period from 2.27 percent in the previous quarter. The delinquency rate, which covers eight loan categories, was the highest since a 2.51 percent rate in the second quarter of 2001. Late payments on some types of loans rose to levels not seen since the 1990s… In the July-to-September period, the delinquency rate on home equity loans rose to a two-year high of 2.28 percent from 1.99 percent in the prior quarter, the ABA said. The rate of late payments on home equity lines of credit rose to 0.84 percent, the highest since the fourth quarter of 1997. Meanwhile, late payments on "indirect" auto loans, which are made through dealerships, totaled 2.86 percent in the third quarter, a 16-year high. Credit-card delinquencies fell to 4.18 percent from 4.39 percent in the second quarter.”
From Dow Jones: “Consumer bankruptcy filings climbed 40% in 2007, as the ongoing turmoil in the housing market and growing debt levels held by consumers led more individuals to seek protection from creditors. The American Bankruptcy Institute, using data from the National Bankruptcy Research Center, said that total consumer filings were 801,840 for 2007… The large annual increase came despite a decline in consumers filing for bankruptcy protection between December and November. There were 66,389 consumer filings in the last month of the year, compared to 71,799 filings in November.”
More Companies Expecting a Recession
From The Financial Times: “America has entered 2008 in greater danger of recession than at any stage since the collapse of the internet bubble in 2000-01, as the world’s largest economy struggles to maintain growth in the face of the credit squeeze, a housing slide and high oil prices. Fourth-quarter growth for 2007 looks likely to come in at 1 per cent or less on an annual basis, while the current three months are unlikely to be much better and could even be worse… According to the latest NBC News/Wall Street Journal poll, more than two-thirds of Americans believe the US is either in recession now or will be in 2008. Some of the country’s most famous economists – including Alan Greenspan, the former Federal Reserve chairman, as well as Lawrence Summers, former Treasury secretary, and Martin Feldstein, president of the National Bureau of Economic Research – put the odds of recession at close to 50-50. This is striking, because economists say it is almost impossible to forecast recessions and, in the last quarter of a century, there have been only two brief and shallow periods of negative US growth...Bill Gross, chief executive of Pimco, the world’s largest bond fund manager, goes as far as to say he – like many ordinary Americans – thinks a recession has already started, in December. Ominously, the credit markets have started to price for recession, with risk spreads rising on securities that have no direct connection with the troubled housing or financial sectors…In addition, while credit markets appear to be pricing in an increasingly high likelihood of recession, equity markets and the oil market – while off their highs – are not. Wall Street is divided: Morgan Stanley is forecasting a recession, joining Merrill Lynch and Goldman Sachs, which are long-time bears, but JPMorgan and Lehman Brothers are noticeably less gloomy. Business leaders are split, too, with finance and housing executives much more pessimistic than their counterparts in other sectors… At the heart of the problems is the bursting of the housing bubble that helped to power American growth since this economic cycle started six years ago. The end of the bubble has brought a brutal slide in home construction, house price falls that threaten to undermine household wealth and consumer spending, and turmoil in the credit markets that are used to finance housing. The US has endured financial crises before with little or no effect on the real economy – for example, in 1987 and 1998. But these were autonomous financial crises with little connection to the underlying US economy. This financial crisis is different. It is defined by the bursting of twin bubbles in housing and the credit markets – bubbles that were deeply interconnected. Easy money and the collapse of discipline in the credit markets helped push house prices to unsustainable levels. But when the residential property bubble finally burst it took the credit market bubble with it – decimating the value of hundreds of billions of dollars of securities linked to subprime loans that were safe only as long as house prices kept going up. Now the credit crisis poses a direct threat of its own to the US economy. The secondary market for mortgage securities is dysfunctional, throttling the supply of many types of home finance and thereby putting further downward pressure on the housing market. Meanwhile, banks are being forced to take tens of billions of dollars in housing-related assets, once held in off-balance sheet vehicles, on to their books, while incurring massive writedowns on these and other securities.”
From The New York Times: “…while investors usually cheer an impending rate cut, the minutes only fueled anxiety that the economy would fall into a recession in the coming months.”
From Deutsche Bank: “I do not remember trading a mkt before that was so convinced of a recession even though there is virtually no evidence to support the idea. Undoubtedly, the economy is slowing, led by a moderation in consumer spending. Still, slowing is one thing, a recession is a whole different ball game. The only way Fed Funds go to the 2.5% rate that 2's currently imply is if the economy contracts. As rich as 2's are, 10yr notes are probably worse. The growth and inflation expectations implied by 10's are just plain silly. Yet, the mkt trades very well. Clearly, the set-up trade on the street the last few days of '07 was to get short. Now that 2's are 50bps richer than their auction stop, I'd imagine a lot of the shorts have been cleared out before tomorrow's number. Our economists think that a few more modest Fed eases could lead to a rebound. The street almost always underestimates the resiliency of the US economy. Does it really sound so IMPOSSIBLE that we rebound out of the housing slump? 2.8% 2yrs suggests the mkt thinks so.”
Dealer Outlooks for Economy
From JP Morgan: “For more than a year, a consistent rain cloud has hovered on the horizon as a downturn in housing, financial market stress, and rising energy prices has threatened to derail the US economic expansion. In the event, the economy chugged along solidly through 2007 even as it absorbed these significant drags. GDP growth is tracking 2.8% for the year as a whole (Q4/Q4). Payrolls have averaged a respectable 108,000 monthly gain through the first eleven months of the year and were accompanied by personal income growth of close to 6% …Our inclination is to raise 4Q07 GDP growth (currently 1.5%), while lowering growth for 1H08 (currently 1.75%). Stubbornly high energy prices and a view that some of the strength in 4Q07 demand — notably defense spending and early holiday shopping sales — is set to borrow from growth at the start of this year, warrant this revision.”
From Morgan Stanley: “The benign environment over the past few years of strong synchronous global growth, low inflation, low interest rates, and ample access to liquidity seems to be a relic of the past. The future is clouded with little consensus about how the turn in the credit cycle will play out… 2008 opens with volatility near multi-year highs across financial markets. This backdrop of instability is likely to persist, especially as expectations on central bank policy are far more diverse than this time last year…In our view, this suggests more, not less, volatility across markets going forward… After the strongest four year run in global growth seen in decades, the engine looks set to slow. While the global economy proved resilient to the initial deceleration in the US economy, our economics team looks for housing-related weakness to drag more meaningfully on the consumer. This should result in more spillover to the global economy given the broader reach of the US consumer relative to the insulated US housing market. Indeed, slower growth is already evident in Canada, the UK and, increasingly the Eurozone. China too may slow in the second half of 2008 if policymakers’ attempts at cooling the economy take hold, particularly as Olympics-related spending tapers off. The relatively slower pace of global growth in 2008 would suggest greater downside risks for commodities, weighing on currencies with greater leverage to the global growth cycle… Though it is not clear the worst is yet over for the USD, there is already a lot of bad news in the price… We kick off 2008 …stuck in risk aversion mode. With market sentiment on tenterhooks and the healing process likely to drag on, the safe haven bid should remain alive.”
From Goldman Sachs: “ISM shift to contractionary territory hurts equities, rallies bonds. Oil close to $100/bbl adds to market jitters. Market has priced significant US weakness in rates, consumer stocks. But history suggests recessions see even more easing than now priced. Current expected easing cycle would be unusual as an actual outcome… …since market is pricing more than a mid-cycle episode, less than recession. We see more growth risk than the market still.”
Benefiting From the Return of Stagflation
From Barclays: “The first trading day of 2008 was marked by a blunt reaffirmation of the stagflation theme. Gold, platinum, gasoline, the CRB and crude oil all moved up sharply to new historical highs. Meanwhile, manufacturing data in the UK and the US were weak and below expectations, with Q4 Singaporean GDP surprising by a 3.2% contraction. Although Libor rates have fallen slightly, there is little evidence from either the credit or money markets that the credit crunch is easing in the new year. Indeed, the BoE bank lending survey – the latest of such surveys to be published, conducted between 19 November and 12 December – showed a pronounced tightening in credit terms and availability to both households and companies. Expectations for a quick improvement in the lending markets are wide of the mark. The core problem has been a very rapid growth in bank assets…The annual increase through to November is almost double the average increase of the prior couple of years. Since the annual increase in deposits for US and eurozone banks during 2007 was in line with past experience, the shortage of term funding or liquidity is readily explained. Although the consensus has it that the lack of term liquidity in the money markets is due to mutual fear within the banking system, the truer explanation is simple indigestion, due to involuntary bank asset growth. The process of securing the appropriate funding – presumably via “sticky” retail deposits – for these assets is likely to take some time. It is implausible to believe that the advent of a fresh year will suddenly provoke an outbreak of normality in the money markets. Overall, the economic background of a sharp credit tightening, slowing growth and rising inflation pressures remains very much extant as we enter 2008… we should expect to see Asian and Western economy growth rates diverge. The economic implications of this situation are wholly and perhaps counter-intuitively negative. The continuation of strong Asian and developing economy growth is one of the factors pushing natural resource prices higher. In turn, the effect of higher commodity prices on US and European inflation rates is to curtail central banks’ freedom of manoeuvre, limiting the degree to which they can offset the credit crunch with lower rates… Stagflation is not a positive environment for equities. As we have pointed out in the past, history shows that equities deliver their worst returns (an average annual total return of minus 1.9% in real terms or 4% in nominal terms since 1929) during economic interludes characterised by above-trend inflation and below-trend growth. Fairly obviously, the underlying cause of this weak performance is likely to be a latent fear that high inflation will inhibit monetary authorities from fully offsetting the contraction with lower interest rates, compounding the more typical concern that slower growth will bring lower profits… In the current instance, the stagflationary condition could prove more persistent than usual. For the sake of example, although US growth has decelerated very sharply, there is no evidence of a comparable deceleration in commodity demand. Indeed, even within the US, gasoline demand in December is set to record the 26th straight month of year-on-year increases, according to our commodity colleagues. Meanwhile, non-OECD oil demand growth remains robust, with non-OPEC supply continuing to surprise the market to the downside. At the risk of gross over-generalisation, the primary causes of the supply/demand imbalance in the physical resource markets are twofold. First, there has been a very significant increase in the level of demand driven by rising per capita demand in the large developing economies. Second, a combination of diminishing easily accessible supplies, a rampant inflation of sectoral labour and capital goods costs and the various influences of global warming have all conspired to dampen supply growth across a wide range of raw materials. Both of these factors are more secular than cyclical in nature and are not likely to be repealed by slower growth. A further consideration regarding the persistence of stagflation is the desychronisation of regional growth patterns, with growth in the emerging economies – who have been responsible for the bulk of the resource demand increase – remaining firm for the time being. If equity exposure should be eschewed in a stagflationary phase, the historical record is more confusing for bonds. For an entire 77-year sample of US asset returns, we have found that bond (20-year average maturity) returns are typically very weak, averaging just 1% in nominal terms during stagflationary periods. However, if we confine the sample to the past 20 years, we find that average nominal bond returns are a more respectable 6.4%. Although the latter sample is of necessity very small, these findings would seem to suggest that the bond market’s response pattern to stagflation may have undergone a shift during the 1980s. This shift was perhaps engendered by increased confidence that intervals of high inflation would always prove transitory, inflation eventually responding to slower growth under the standard output gap analytical framework… Overall, we continue to feel that the current stagflationary environment justifies the negative view we have taken on equities and the cautiously bullish views we have taken in bonds of both the real and nominal varieties, along with commodities.”
Asset-Backed Commercial Paper Market Shows Signs of Improving in New Year
From Bank of America: “Asset-backed commercial paper outstanding rose last week for the first time since mid-August.”
From Citi: “Yesterday saw a sharp move down in the asset-backed CP spread (167bp from 283bp) which suggests that a significant part of the recent rise was related to year-end funding concerns and was not of a more structural nature.”
From Barclays: “Yields on 30-day ABCP have fallen close to 40bp over the week and the spread over fed funds has come down considerably (to 50bp) after widening close to 200bp in mid-December. The asset-backed CP market had been deteriorating on continued tensions in money markets spurred by concerns abut year-end funding and mortgage-related collateral, which backs a notable portion of ABCP. Today's data hints at some improvement in this area of the market now that year-end funding pressures have faded, but we would have to see the improvement be sustained in coming weeks to draw any firm conclusions.”
Another Bull Year for Commodities?
From Citi: “What happened in commodities yesterday has happened before. In both 2004 and 2005, the GSCI rose sharply at the very start of the new year…In 2004, it rose 3.7% on the second trade date of the year and in 2005 it rose 1.5% on the second trade date of the year. In both cases it turned out to be an absolutely phenomenal year for commodities as the GSCI index was up over 42% to the high in 2004 and over 56% to the high in 2005. Both years saw peaks in late summer and, here is the important part, both rallies were due to massive asset in-flows into commodity space. We rose over 3% yesterday and my opinion is that we are again seeing massive asset flows into commodity space. Implications if I'm right: 1) Hard not to be a rip snorting bull in commodities as a little bit of money can go a long way in that space 2) We would see $4 gasoline at the pump and that would not be good for the U.S. economy. 3) Can $1000 gold and a 3 handle on 10's co-exist? I don't think so, for long. 4) Not necessarily bearish for dollar or stocks. 2004 saw dollar rise and energy and materials are 15% of S&P compared to 18% for financials.”
From Merrill Lynch: “…the Baltic Dry Index (measures global shipping rates) has slid sharply and at 8,891 today it is almost 20% below the mid-November peak and down to a four-month low.”
From Barclays: “…we wanted to highlight the strength of the ongoing upside trend in gold. The yellow metal is rallying against the major currencies and has been outperforming the Dow Jones Industrial Average since 2000. We are looking for the market to test 1000 in 2008. Over the last few years, gold has rallied 32% and 24%, respectively. The average annual gain over the past seven years has been approximately +16%. Since the market is currently approximately 16% below 1000, our 2008 target actually implies an average year of gains for Gold.”
Questioning Value of Credit Rating Agencies
From The Street.com: “Here's a New Year's resolution for Wall Street: Stop letting credit ratings agencies get paid by debt issuers for grades that can make or break their products. In the mortgage debacle that plunged U.S. financial markets into crisis last year, there's no shortage of culprits. Snake oil-selling lenders, naive borrowers, delusional investment bankers and snoozing regulators all fit the bill, but the major credit rating agencies stand out as the chief enablers. Blessed by government regulators with their unique and exclusive authority, the ratings firms institutionalized the notion that securities backed by subprime loans were basically risk-free. In other words, rather than fulfilling their proper role in the market by warning investors about the obvious risks involved in these securities, they instead opened the floodgates to all those bad actors and created a systemic problem. Why did the credit rating agencies fail so spectacularly? There's one simple reason: They were paid handsomely for their stamp of approval by the very financiers who were packaging up the bad loans and selling them around the world. "It's as if movie studios hired film critics to review their movies, and paid them only if the reviews were positive enough to get lots of people to see a movie," former Labor Secretary Robert Reich wrote on his blog. "The whole thing rested on a conflict of interest analogous to that of stock analysts who, before the dotcom bubble burst, advised clients to buy stocks their own investment banks were issuing."
MISC
From Merrill Lynch: “…the ADP data has had this tendency to overestimate private payrolls over the past 3 and 6 months. This is because the ADP does not include many large financial institutions, which do their own payroll and this sector right now is at the epicenter of the job cuts (along with housing).”
From Bank of America: “Our outlook for 2008 for credit finds the solution to the subprime mortgage crisis in a classic recipe: inflate your way out of it. Either by accident or intention, global central bank liquidity infusion to forestall the slowing impact from the credit crunch likely results in increased inflation.”
From CITI: “The aggressive liquidity injections from central banks have been part of a strategy to expand their own balance sheets in order to facilitate an orderly contraction of private sector balance sheets. It is still relatively early in the adjustment process and the central banks are likely to have to continue providing liquidity for at least the next quarter while withdrawing it at a gradual pace. Looking ahead to the rest of 2008, it is possible that greater regulation of financial market participants could be one of the direct outcomes of the credit crunch.”
From Dow Jones: “Bond guru Bill Gross, the founder and chief investment officer of PIMCO, said he expects the U.S. Federal Reserve to keep cutting rates in 2008, “perhaps as low as 3% and maybe more depending on the housing situation.” The Fed’s current current fed funds rate target is 4.25%. Gross, in an interview with CNBC, said inflation concerns and the weak dollar are “third and fourth order” considerations for the Fed, and it will focus on a “substantially” slowing U.S. economy for monetary policy. Gross told CNBC that the U.S. credit contraction problems will continue as part of a two-to-three-year housing cycle.”
From The Associated Press: “In a sign of how the once mighty U.S. dollar has fallen, India's tourism minister said Thursday that U.S. dollars will no longer be accepted at the country's heritage tourist sites, like the famed Taj Mahal.”
From Bloomberg: “Foreign investors exploited the declining U.S. dollar during the past three months to snap up American companies, taking the biggest share of U.S. deals in at least a decade. Buyers from Dubai to the Netherlands accounted for 46 percent of the $230.5 billion of U.S. mergers and acquisitions announced in the fourth quarter, the largest portion since 1998 when Bloomberg started compiling the data. The total excludes $17.9 billion of so-called passive investments by state-run funds in Asia and the Middle East in U.S. banks, including New York-based Citigroup Inc. The influx of overseas buyers cushioned a drop in domestic deals, as tighter credit markets ended the leveraged buyout boom that spurred record-setting takeovers in the first half 2007. Foreign acquirers, who stepped in as the dollar fell 10 percent against the euro last year, show no sign of losing interest, according to bankers and lawyers.”
From Dow Jones: “The yen is on a tear versus its currency rivals in the first days of 2008… It hit a five-week high against the dollar this week…[But] The simple argument against the yen this year is the same one that was used last year, the year before that and the one before that: interest rate differentials. The Bank of Japan’s key interest rate stands at a tiny 0.50%, while the central banks in the U.S., the U.K. and the euro zone have lending rates that range between 4% and 5.5%. Investors who buy the yen and sit on it are earning significantly less interest than they would with currencies from those other regions. With such small returns offered on the yen, Reid believes that investors will continue to use Japan’s currency as a funding currency for the carry trade, in which they take out loans denominated in yen to buy higher-yielding currencies.”
From Merrill Lynch: “We have motor vehicle sales tracking near 16.2 mln units, above street expectations of 16.0 mln units.”
From SunTrust: “Since Christmas, the 2 yr note has fallen 51 bp. The 2/10 spread is +107 bp, the widest in 3 years. The Treasury market is heading into the December payroll report very near recent highs and almost exactly at identical levels just prior to the last jobs number.”
End-of-Day Market Update
From RBSGC: “The main 'play' on Thursday was the steeper curve with 2s improving on the day while the balance of the curve merely tread water.”
Three month T-Bill yield fell 2 bp to 3.23%.
Two year T-Note yield fell 6.5 bp to 2.81% ( A new 3yr low)
Ten year T-Note yield fell 1 bp to 3.90% (3y low is 3.84%)
Dow rose 13 to 13,057
S&P 500 unch at 1447
Dollar index fell .1 to 75.87
Yen at 109.3 yen per dollar
Euro at 1.475 dollars per euro
Gold rose $5.6 to $863 – A new record high of $869 traded today!
Oil fell .49 to $99.13 – A new record high of $100.09 traded today!
*All prices as of 4:20pm
Two Year Yield Treasury
Gold
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