Trade Deficit Larger Than Expected Due to Rising Oil Prices

Higher oil prices ballooned the monthly trade deficit to the widest figure in over a year.  The deficit for November was -$63.1 B (consensus -$59.5B, prior -$57.8B). 

 

The gap between imports and exports widened by 9.3% MoM, the largest increase in two years as imports grew faster than exports, though exports did rise to a record new high.  A weaker dollar continues to support demand for US goods and services, pushing export growth to record highs for the past nine months in a row. 

 

Exports grew +0.4% MoM in November, while imports rose 3%, mainly due to higher oil prices.  Excluding energy, the trade gap widened by $1.5B MoM as non-petroleum imports rose 1% (1/3rd of monthly increase, energy accounted for 2/3rds of monthly increase in imports).

 

By category, the US is a small net exporter of services ($9.6B), and a huge net importer of goods (-$72B).  Aircraft exports plunged -19% MoM in November, followed by declines in telecom equipment of -6.3% and capital goods at -2.3%.  Automotive exports grew by +4.5% MoM. Oil imports grew by +17.3% MoM, and are up 58% YoY.  Industrial supplies rose +8.5% MoM, and food prices continue to increase, growing +2.5% MoM and 10.2% YoY.

 

In total dollar terms, exports totaled $205.4B in November while exports were fewer at $142.3B, hence the trade gap.  When looking only at trade volumes, and not prices, the trade deficit still increased in November.  This indicates that volumes rose, as well as prices, to push the deficit wider.

 

The trade deficit with China eased back to $24B from almost $26B the prior month.

Import Inflation Remains at Record Levels

After surging higher last month, import prices paused in December.  On a monthly basis, prices were unchanged in December, but that is from a higher level as November's increase was increased to +3.3% MoM from the original report of a +2.7% monthly gain.  The gain in November was the largest monthly increase in 17 years (1990). 

The annual price increase was also bumped up last month to an even more lofty rise of +12.1% YoY from the previously reported gain of 11.4%.  December's annual increase fell back to 10.9% YoY, but is higher than the consensus call of +10.5%.  The annual price increases seen in recent months are the largest since 1987.

Higher oil prices and a weakening dollar are the primary causes for the imported inflation pressures.  These two factors spur inflation and erode consumer's purchasing power, while also increasing raw materials costs for manufacturers.  The dollar declined around 9% in 2007.  Despite the weakness in the economy, the Fed will remain concerned about the impacts of rising inflation.  This is the reason the term "stagflation" is beginning to be discussed recently.

Export prices have also been rising, especially for agricultural products.  Agricultural prices rose +23.5% YoY in 2007, a record increase in the data going back to 1985.  Export prices rose +.4% MoM in December, and are up 6% YoY.  On an annual basis, import prices have risen almost twice as fast as export prices.

January 10, 2008    TIDBITS

Comments on Bernanke’s Testimony

From Bloomberg:  “Federal Reserve Board Chairman Ben S. Bernanke said ``additional policy easing may well be necessary'' to offset ``downside risks'' to growth… ``We stand ready to take substantive additional action as needed to support growth and to provide adequate insurance against downside risks.''  Bernanke's comments suggest the Federal Open Market Committee will cut interest rates further this month to reduce the risk of a recession…``Incoming information has suggested that the baseline outlook for real activity in 2008 has worsened and the downside risks to growth have become more pronounced,'' Bernanke said … ``A number of factors, including higher oil prices, lower equity prices, and softening home values, seem likely to weigh on consumer spending as we move into 2008.''…In December, Fed officials didn't explicitly recognize downside risks to growth, saying increased ``uncertainty'' surrounded the outlook for growth and inflation.”

From FTN:  [Bernanke said] “Financial and economic conditions can change quickly. Consequently, the Committee must remain exceptionally alert and flexible, prepared to act in a decisive and timely manner and, in particular, to counter any adverse dynamics that might threaten economic or financial stability.”

From Goldman:  “Bernanke's speech today is very supportive of additional Fed cuts over the first half of 2008.  Significantly, he notes the possibility of more action to support growth, but makes only passing reference to inflation.  His commitment to "act in a decisive and timely" manner is consistent with our expectations of a 50bp cut at the January 30/31 FOMC meeting…Much of the speech contains a cogent discussion of the housing downturn, and how it has spilled over -- and will likely continue to spill over -- into a broader economic downturn.  Specifically, he discusses the spread of weakness from falling housing prices into rising delinquencies which then feed into falling values for assets built on them.  This cycle continues with reduced capital bases for financial intermediaries which hold the assets, causing them to cut back on their lending which pushes down asset prices further.  Bernanke also notes the potential for adverse dynamics to take hold in the labor market following the very weak December employment report.  Left unsaid, but clearly lurking below the surface, is the potential a multiplier interaction between weaker consumer spending and further labor market weakening.”

From Reuters:  “Analysts welcomed Bernanke's forthright acknowledgment of the dangers faced by the economy, which many fear could fall into recession.  "I think he's come to terms with the fact that while inflation may be a concern down the road, he has to take care of the train that's coming at him right now, which is the fear of a recession,"… U.S. stock markets surged after Bernanke's comments, while the dollar remained weaker against a basket of currencies as investors concluded that the Fed would aggressively lower interest rates at its end-of-month policy-setting meeting.  The Fed's policy-setting Federal Open Market Committee holds a two-day meeting January 29-30. Bernanke's comments reinforced market expectations that it will cut interest rates a half percentage point.”

From HSBC:  “Given Bernanke's speech today, we stick with our 3% Fed funds year-end call, but are now looking for a 50bp cut on Jan 30 instead of our earlier call of 25bp… After a 50bp cut in Jan, we look for 25bp eases in March, June and September.”

From CITI:  “50 bps cut no later than the January meeting.  There is a slight chance (10%) that they can go inter-meeting if things get significantly worse.  Fed Funds Futures have an 84% cut built into that date, increased from 65% yesterday.

From Deutsche Bank:  “Mr. Bernanke's comments on the economic outlook were dovish; he highlighted the downside risks to growth from fragile financial markets and did not sound overly concerned about inflation, although he did repeat the Fed's familiar refrain that inflation expectations must remain stable.  Should inflation expectations become "unmoored" the Fed would lose credibility as well as the flexibility to respond to adverse economic shocks.  We thought the most important part of the speech was at the end; it sounds to us that a 50 bp rate cut is on the table and that the Fed is going to adopt an explicit easing bias…we are staying with 25 bps and an easing bias.”

From Morgan Stanley:  “we now look for the FOMC to cut the funds rate target by 50 bp at the January 30 meeting… In the Q&A, Bernanke indicated that the Fed is not currently forecasting a recession but sees slow growth with downside risks. When asked about the possibility of fiscal stimulus, the Fed Chairman indicated that he can’t comment until he sees some specifics and that his current focus is on monetary policy because that is an immediate tool that can be used to influence the economy.  We suspect that the Fed is not headed toward an intermeeting move largely because we don’t really see a potential trigger on the economic calendar. Some sort of significant market event would probably be required to bring the Fed in before their meeting at the end of the month.  Finally, Bernanke noted that the TAF operations “have had some positive effects” but that tight financial conditions continue to “pose downside risks to growth.” This is because the impact of the TAF operations on term funding markets cannot address broad credit concerns and balance sheet constraints. Still, officials indicate that the TAF will continue as long as there are bids and may well become a permanent addition to the Fed’s toolkit.”

From Credit Suisse:  “We now expect a 50 basis point cut in the funds rate at the January FOMC meeting, to 3.75%, and a further 75 basis points in 2008.”

From Deutsche Bank:  “Fed's Hoenig (non-voter) says inflation pressures rising, economy has been under considerable stress but not as pessimistic as some about outlook.”

WSJ Says Bank of America Seriously Considering Buying Countrywide

From Bloomberg:  “Countrywide Financial Corp., the biggest U.S. mortgage lender, rose the most ever after the Wall Street Journal reported the company is in ``advanced'' talks to be acquired by Bank of America Corp.  Countrywide issued a statement declining to comment after the shares rose as much as 74 percent, and Bank of America spokesman Bob Stickler declined to respond to the Journal's report, which cited people familiar with the situation.”

Moody’s Concerned Freddie Mac May Not Have Sufficient Capital

From Bloomberg:  “Freddie Mac, the U.S. mortgage-finance company that lost a record $2 billion in the third quarter, may be downgraded by Moody's Investors Service because damage from loan defaults could be worse than the ratings company expected.  Moody's threatened to lower Freddie Mac's financial strength rating from A-, the second-highest grade, which may prompt the government-chartered company to raise additional capital. McLean, Virginia-based Freddie Mac's Aaa senior long-term debt rating and Prime-1 rating for its commercial paper or short-term IOUs won't be cut, Moody's said.  Freddie Mac declined 59 percent in the past 12 months on the New York Stock Exchange and dropped another 2.9 percent today. Rising mortgage defaults forced Chief Executive Officer Richard Syron to shore up Freddie Mac's finances by selling $6 billion of preferred stock in November, slicing the dividend by 50 percent and reducing mortgage assets by 4 percent to $701.4 billion in the three months ended Nov. 30. Freddie Mac ``may experience higher credit losses than Moody's previous expectations,'' Moody's analysts led by Brian L. Harris in New York said in the report late yesterday. ``In its review, Moody's will focus on Freddie Mac's asset quality and the potential that the company may experience an elevated level of credit charges over the near to medium term.''  The New York-based rating company's financial strength rating measures the likelihood a company will need assistance from a third party, such as the government or shareholders.”

From Deutsche:  “This raises the possibility that Freddie might proactively address its

expected credit losses/provisions for Q4 before the release of its Q4 financials report. To continue to manage capital, we would expect to see further declines in the retained portfolio. The retained portfolio has declined by about $30bn since August and now stands at 701.4bn. Our expectation is that Freddie will choose to reduce the portfolio size before resorting to another dividend cut or preferred stock issuance or a BFSR downgrade. This could be positive for the senior debt in the medium-term after the headline shock subsides as long as no actual debt downgrades occur.”

Implications of a $2,500 Car on Oil Prices

From The Houston Chronicle:  “On Thursday, the Indian automaker Tata Motors is expected to unveil a car that sells for $2,500.  That's less than some Americans will spend on a big-screen high-definition television before the Super Bowl. But it's within reach for many in India's emerging middle class, where the nominal per capita income is $1,089, according to the International Monetary Fund…The car, of course, is not something most Americans would want to drive. Tata's design codifies cheap, and the sacrifices are legion, according to a description in the New York Times. Standard safety equipment for most U.S. vehicles, for example, costs more than $2,500.  The new Tata will not, by our standards, be safe or environmentally friendly, and it probably won't be fun to drive. It has a maximum horsepower of about 35, the Times reported, so it's more lawn mower than muscle car.  But that's not the point. Tata knows that most people who already own cars won't be interested in its new model, whose name hasn't been revealed.  It's targeting the hundreds of millions of people in the developing world who now ride scooters or bicycles or walk.  If it succeeds, crude prices may continue their climb of the past year. The Tata probably will consume far less gasoline than the sport utility monstrosities common on American highways, but even the addition of several hundred million lawn mowers would rattle the markets.  "This is going to really shoot demand to levels we have not seen before," said Michael Economides, an oil expert at the University of Houston and a former adviser to several state-owned oil companies. "That's going to open up segments of the population that weren't accessible."  In China, for example, demand for oil surged in recent years as more people moved to urban areas, their incomes rose, and they bought cars. Now, 1,000 new cars take to the streets of Beijing daily, Economides said.  Tata is, in essence, offering mobility to the emerging middle-class economies of India, Vietnam, Pakistan, China and much of Africa. We know, better than anyone, what a middle class does when it adopts a device that fundamentally changes lifestyles: It never lets go.  In fact, it upgrades. The people buying $2,500 Tatas today will someday be buying more expensive models with more car-ness — bigger and heavier bodies, more powerful engines and more options like air conditioning and electronics. All of which translates into even greater demand for fuel.  "The price of oil is becoming less and less dependent on what happens in the U.S.,"…”

MISC

From Bloomberg:  “European Central Bank President Jean- Claude Trichet signaled the bank won't cut interest rates and may raise them to contain inflation even as economic growth slows.  The ECB's Governing Council is ``prepared to act preemptively so that second-round effects and risks to price stability do not materialize,'' Trichet said at a press

conference in Frankfurt today after the bank kept its benchmark interest rate at 4 percent. He said policy makers will ``not tolerate'' an inflation spiral of rising prices and wages.”

From The Wall Street Journal:  “Two of the biggest names on Wall Street are going hat in hand, again, to foreign investors.  Citigroup Inc. and Merrill Lynch & Co… Now, they are in discussions to get additional infusions of capital from investors, primarily foreign governments.  Merrill is expected to get $3 billion to $4 billion, much of it from a Middle Eastern government investment fund. Citi could get as much as $10 billion, likely all from foreign governments.”

From Morgan Stanley:  “It is likely that SWFs [Sovereign Wealth Funds], in the aggregate, may outsource 20% or so of their assets to external investors. The new SWFs being established may place US$150 billion or so of funds with external managers. Going forward, as the AUM of all SWFs grow over time, another US$200 billion may be placed with external managers annually over the coming five years.”

From CITI:  “GS reports there is a 50% chance Japan will slip into recession and cut its

2008 growth estimate for Japan.”

From Bloomberg:  “Wal-Mart Stores Inc. and Costco Wholesale Corp. posted December sales that exceeded analysts' estimates as shoppers increased spending at discount chains after feeling the pinch of higher gasoline costs and lower home prices.  The results provided a glimmer of hope after the worst holiday-sales season since 2002.”

From The LA Times:  “Americans shopped hard enough during the holidays to give stores a boost in sales over last year -- with many purchases charged to credit cards.  That's not unusual. But in November, according to government data, revolving consumer debt climbed at an annual rate of 11.3%, the most in six months.  That means people will be struggling to wipe away debt even as the economy is relying on them to help it steer clear of a recession.  "It's just a matter of time before we see more pronounced weakness in consumer spending," …And as the new year gets underway, shoppers …are reining themselves in. "I found that my spending was a lot more on credit cards," … "So now I have to cut back so I can pay it off." …"The credit card debt is the hardest debt to escape from," …Many Americans will be redirecting or curtailing their spending as they worry about an expanding array of problems, including the weak housing market, tighter credit, slower job growth and an unnervingly erratic stock market.  Some who spend beyond their means can dip into savings and pull out the plastic only so long before they're left with two unpleasant options: sharply cut spending or file for bankruptcy. Or both. That's bad news either way for retailers coming off a less than cheery holiday season.”

From The Atlanta-Journal Constitution:  “…for a shot at a job at a new Wal-Mart…In just two days, and with virtually no advertising or even any signs, a staggering 7,500 people filled out applications for one of the 350 to 400 available positions.”

From Bloomberg:  “Some economists, including Blinder, also fault Greenspan for fostering the housing bubble by keeping interest rates too low for too long. The Fed cut its benchmark rate to a 45-year low of 1 percent in June 2003, held it there for a year, then raised it only gradually, in quarter-percentage-point increments…A simulation by Stanford University professor John Taylor suggested that much of the housing boom could have been avoided if the Fed hadn't cut rates so deeply and had raised them back

up more quickly…Greenspan maintained that the housing bubble was inflated not by the Fed's monetary policy but by a global savings glut that held down long-term interest rates worldwide… Greenspan also pointed out that the U.S. wasn't alone in experiencing a housing boom in the early 2000s. The IMF said in its World Economic Outlook last October that other nations, including Britain, Spain and Australia, experienced bigger house price run-ups than the U.S.”

From Bloomberg:  “Greenspan said in the interview that, while the Fed's bank examiners were hard at work during the mortgage-lending boom, ``we have to be realistic about what regulators can and cannot do.''  ``It is extremely rare to uncover fraud other than through whistle-blowers,'' he said. ``You don't get at it through internal audits, you don't get it through outside audits and you certainly don't get it through bank examinations.''

From CNN:  “With the national foreclosure rate zooming and the real estate market in a two-year funk, the insurance industry fears more homeowners will see arson as a way out of their financial woes. A recent report by the industry-funded Coalition Against Insurance Fraud notes that with "untold thousands of homeowners struggling with ballooning subprime mortgage payments, fraud fighters are watching closely for a spike in arsons by desperate homeowners who can no longer afford their home payments."

History indicates such a spike is coming. "When the economy is down, we see an increase in fraud," says Dennis Schulkins, a claim consultant in State Farm's Special Investigative Unit.  It may already be happening. Allstate spokesman Mike Siemienas says his company has seen an increase nationally in arsons among homes in foreclosure. In California, the state¹s insurance division reports that the number of questionable residential fires in 2007 increased 76 percent over 2006.  National arson statistics for 2007 aren't yet available, but Federal Bureau of Investigation crime data shows there was a significant uptick - 4 percent - in suburban arson in 2006, when the real estate downturn began to take hold. The arson increase in 2006 marked a change from the prior three years when suburban arson fell 3 percent, 5 percent and 6 percent, respectively.”

From Bloomberg:  “Lennar Corp.'s November sale of 11,000 properties in eight states set a price that may mark the bottom for the U.S. housing market: 40 cents on the dollar.  That's how much Morgan Stanley Real Estate paid for an 80 percent stake in the 32 communities, 60 percent less than the price at which the properties were valued just two months earlier. That's also what some investors say they would pay for distressed land, condominiums, homes and whole developments, whether it's now or later this year… About 150 so-called real estate opportunity funds have been formed to buy distressed properties and other assets, a 21 percent increase over the number this time last year and an all- time high, according to Real Estate Alert”

From The Christian Science Monitor:  “…the plight of the real estate agent – average age, 51 – reveals the human dimension of how loose lending, raw opportunity, and self-determination produced a housing bust that has stunned the US economy… "They've tasted success and big money, and now their standard of living has been rocked and reality has set in," says John Baen, a real estate professor at the University of North Texas in Denton. "The whole [economy] has been built on real estate. When the music stops, what is left?"… Evidence is growing that agents, especially in hard-hit markets like Florida, California, and Georgia, are closing up shop in large numbers, experts say.

Here in Atlanta, the number of agents letting their licenses lapse is growing at a faster pace than the number of overall licenses held. Nationally, an average agent's income dropped from $49,300 to $47,900 between 2004 and 2006… In Cape Coral, Fla., where only 30 percent of agents sold even a single home last year, real estate agents are "dropping out" daily… The Oregon Association of Realtors reports an 11.5 percent decline statewide of licensed agents in the past year… Real estate is a line of work filled with mothers returning to the workforce, older workers squeezed out of lifetime careers, and young opportunists looking to trade sweat equity for potentially big cash-outs. Indeed, the industry norm is that only 4 percent of agents choose real estate sales as a first career.”

From BBC:  “People across South Asia are struggling to cope with a severe shortage of affordable wheat and rice…Last week Afghanistan appealed for foreign help to combat a wheat shortage while Bangladesh recently warned it faced a crisis over rice supplies. 
Global wheat prices are at record highs. Problems have been compounded by crop failures in the northern hemisphere and an increase in demand from developing countries…Initially, flour shortages pushed up the price on the open market in Pakistan to as much as 60 rupees (about $1) per kilogram in some areas. The average day labourer earns only 100 rupees a day.  The state-run Utility Stores Corporation has been selling flour at 18 rupees per kilogram, but it does not have enough outlets to serve the population of 160 million.”

From Barclays:  “US crude inventories are now 71 mb lower than at the end of June. We estimate that inventories above minimum operating requirements have fallen over that time by some 70%...The cumulative effect of the gradual marginal tightening of the oil market over the past year has been to take a significant bite out of the inventory overhang …. As a very rough proxy measure of the current situation, adding together the latest available inventory data from the US, Japan and the EU-15 results in the following picture. Crude oil inventories have fallen by 45 mb Y/Y, while oil product inventories have fallen by about 86 mb Y/Y. Regionally, there are some stark differences. In Europe the Y/Y fall is virtually all in products, in Japan it is mainly crude, and in the US it is about 50-50 crude and products. In the US, the latest weekly data takes the overall inventory situation further below the five-year average…”

From Handelsbanken:  “While everyone is focused on the housing market, rising stress in the automobile industry may prove to be the unexpected event that eventually pushes the economy over the edge. Just when it looks as if a number of auto parts manufacturers are about to exit bankruptcy protection, domestic manufacturers have scheduled a significant reduction in planned assemblies. According to recently released data, domestic assemblies are set to decrease 7.5% in the current quarter to 9.8 million units seasonally-adjusted annual rate. A drop in the automotive build rate is long overdue and reflects the excessive level of inventories on dealer lots. Dislocations in the financial markets have also made it more expensive for manufacturers to offer consumer incentives to move vehicles. Although a cut back in assemblies will add to the downward pressure on the labor market, rising delinquencies on auto loans will probably not exacerbate the problems already facing the asset-backed market. The auto ABS market is fundamentally different from the sub-prime mortgage market. Specifically, consumers did not buy autos anticipating price appreciation and auto loans are not subject to reset risk as they are fixed rate loans.”

From Goldman:  “…evidence of rising inflationary pressure has raised the spectre of ‘stagflation’. Inflationary pressures have picked up. A variety of measures of global inflation show both headline and core inflation rising in a broad range of markets. Still-tight capacity, easy policy in places and the surge in food and energy prices are largely to blame. The next couple of months may also see the most troubling combination of growth and inflation headlines. Given that the market has seen and traded weak growth news already, signs of inflation problems may present the greatest new data risk in the near term. Despite these headlines, we think the risk of a persistent inflationary threat is exaggerated. As the US and others slow more, upward pressure on core inflation should reverse later in 2008. And food and energy prices may remain high, the rate of inflation here could drop quite sharply, bringing headline inflation lower. But while we expect this more benign reality to become clearer through 2008, the current point – with growth slowing, but inflation yet to respond – means the market may well worry more about inflation constraints.”

End-of-Day Market Update

From Deutsche Bank:  “In response to Bernanke's comments markets have sharply steepened the Treasury curve - whilst the front end has rallied, 10yr Treasury yields are actually up 5bps on the day. Equities have rallied, although this seems to owe as much to news that Bank of America is in advanced talks to buy Countrywide Financial Corporation.”

From AP:  “Gold soared to a record high Thursday after Federal Reserve Chairman Ben Bernanke pledged to cut interest rates, undermining the dollar and boosting demand for metals as a safe investment.”

Three month T-Bill yield unchanged at 3.23%.

Two year T-Note yield fell 3bp to 2.68%

Ten year T-Note yield rose 5.5 bp to 3.88%

2/10 Treasury curve steepened to  120bp

Dow rose 118 to 12,853 

S&P 500 rose 11 to 1420

Dollar index fell .54 to 75.88

Gold rose $14 to $893 (New all-time record high)

Oil fell $1.50 to $94.13

*All prices as of  4:30pm

Today's Tidbits

Goldman Sachs Says Economy Falling Into a Recession
From Goldman Sachs: “The recent data suggest that the US economy is falling into recession. We expect economic activity to contract modestly through late 2008, followed by a gradual recovery in the course of 2009. Fed officials are likely to respond by cutting the funds rate target to 2½% by late 2008…The recession is likely to last 2-3 quarters and should be relatively mild by historical standards, with a cumulative decline in real GDP of only about ½% (not annualized). There are three reasons to anticipate a relatively mild downturn. First, we expect Fed officials to set aside their residual inflation concerns and cut the fed funds rate aggressively to 2½% by late 2008, with a 50-basis-point cut at the January 29-30 FOMC meeting. Likewise, 10-year Treasury note yields are likely to decline a bit further to 3½% by late summer. Second, with influential economists on both side of the aisle calling for fiscal stimulus, there is a decent chance that Congress and the Bush administration will agree on a temporary tax cut to take effect later this year, especially if the economic data remain weak. Third, although global growth is slowing somewhat, the weak dollar and the shrinking trade deficit are likely to continue to support activity in export-oriented sectors…In terms of sectors, consumer spending is likely to post a (small) outright decline -- unlike in the 2001 recession -- as the housing downturn spills over via a negative wealth effect and consumers find it harder to obtain credit. The downturn in capital spending should be more moderate than in 2001, largely because the starting point is much less elevated. The decline in economic activity is likely to push up the unemployment rate to about 6¼% by late 2008 and will likely result in a significant setback in corporate profits, by about 7½% on an after-tax basis (GDP definition). With our switch to an outright recession call, we have also deepened our forecast for the cumulative decline in nominal house prices, to a 20%-25% peak-to-trough decline from a 15% drop previously.”

Bloomberg Survey of Economists Predicts U.S. Won’t Go Into Recession
From Bloomberg: “The U.S. will skirt recession as consumer spending slows without collapsing, a survey of economists showed. Economic growth will average 1.5 percent in the first six months of 2008, matching the fourth quarter's pace, according to the median estimate of 62 economists surveyed by Bloomberg News from Jan. 3 to Jan. 8. The rate of expansion would be the weakest since the last nine months of 2001…The Federal Reserve will cut interest rates more than previously anticipated, economists said, triggering a reacceleration in growth by the third quarter that will keep the economy from stalling. Economists put the odds of a recession developing within the next year at 40 percent…Nine of the 47 economists responding to the question put the odds at about even and five said the economy would contract…Growth forecasts were lowered for every quarter of the year, even as the estimate for the last three months of 2007 was boosted. The world's largest economy will expand 2.1 percent in 2008, down from 2.3 percent forecast last month and the weakest since 2002…The Fed will reduce borrowing costs in both the first and second quarters, bringing the benchmark interest rate down to 3.5 percent by mid-year. Last month, economists forecast the Fed would reduce the rate just once more and hold it at 4 percent through 2008.”

St. Louis Fed President Poole’s List of Mortgage Market Mistakes
From MarketWatch: “Investment professionals' "shortsightedness" led them to make fundamental errors that led to the mortgage crisis and credit meltdown, St. Louis Federal Reserve President William Poole said Wednesday…The bulk of Poole's speech was devoted to the need for better financial education -- not only for borrowers but also for investment professionals. Poole said five key mistakes were made, and professionals made four of them. "I can understand the mistakes many financially naïve borrowers made but have a hard time understanding how so many investment professionals could have been so wrong," he said in the prepared text. "Many observers point to greed, but I prefer a different explanation. Shortsightedness rather than greed explains actions that led to losses of tens of billions of dollars and the failure of many financial firms." Poole's list of five key mistakes: Borrowers took on mortgages they could not afford. Mortgage brokers put too many people in unsuitable mortgages. They knew, for instance, that adjustable-rate mortgages probably wouldn't be right for many borrowers if interest rates rose as the market expected. Investment banks jeopardized their reputations by securitizing mortgages without doing due diligence on the underlying assets, many of which were based on "inadequate or spurious information." Rating agencies put their stamp of approval on securitized mortgages without considering whether AAA ratings could be maintained if house prices fell. Investors scooped up those securities without doing adequate analysis first. "Investors too readily accepted the AAA ratings at face value," Poole said. "A reach for yield with inadequate attention to risk in another basic lesson that apparently cannot be relearned often enough. "There are no new lessons here," he said. "The mistakes that brought us to this point have been made before."”

Why High Oil Prices Aren’t Increasing Supply
From Reuters: “Oil at $100 a barrel should give exporters every incentive to pump more, but their difficulty in doing so shows the world is struggling to sustain production. A growing number of leading industry figures -- the CEOs of Total…and ConocoPhillips …among them -- now question mainstream forecasts for supply, suggesting the era of "plateau oil" is nearer than many in the business have admitted. While global oil demand is projected to grow to more than 100 million barrels per day later this century, some argue it may not be possible to boost flows beyond the current rate of some 86 million bpd. Supply still falls short even after so-called unconventional oils extracted from tar sands and converted from natural gas are taken into account, said Sadad al-Husseini, a former top official at state oil giant Saudi Aramco. "Today's oil prices are high because there are limited new supplies," Husseini, who ran exploration and production at the Saudi state oil company from 1986-2002, told Reuters. "There's a history now. We're several years into level production." In 1980, when crude first hit an inflation-adjusted high of $100, the pace of drilling by producing countries and major oil companies became fast and furious, leading to rising output and a price collapse in 1986… Conventional supply from outside OPEC has missed forecasts in recent years and appears for now to have hit an "effective plateau", according to the International Energy Agency (IEA), adviser to industrialized countries. Non-OPEC countries pump about 60 percent of the world's oil and the 13 members of OPEC make up the balance. OPEC sets output limits for 12 of its 13 members. Many countries within the Organization of the Petroleum Exporting Countries -- whether for reasons of war or sanctions, lack of investment or falling supply at ageing fields --- are unable to raise output. "OPEC can do little," Shokri Ghanem, the top oil official for OPEC member Libya, told Reuters. "Most OPEC countries are producing at capacity." Many analysts expect prices to rise further unless demand crumbles as a result of a recession…”

U.S. Overinvested in Housing
From Robert Samuelson: “In Sweden, Britain and Italy, new homes average under 1,000 square feet. By 2005, the average newly built U.S. home measured 2,434 square feet…"We're not selling shelter," says the president of Toll Brothers, a builder of upscale homes. "We're selling extreme-ego, look-at-me types of homes." In 2000, Toll Brothers' most popular home was 3,200 square feet; by 2005, it had grown 50 percent, to 4,800 square feet… "Buying a bigger house isn't an investment," warned Wall Street Journal columnist Jonathan Clements. It's "a lifestyle choice -- and it comes with a brutally large price tag." Not only are mortgage payments higher; so are costs for utilities, furniture and repairs. Worse, government subsidizes these supersize homes along with suburban sprawl and, just incidentally, global warming. In 2008, the tax deduction for mortgage interest payments will cost the federal government $89 billion. The savings go heavily to the upper-middle class and the wealthy -- the least needy people -- and encourage ever-larger homes. Even with energy-saving appliances, those homes are likely to generate more greenhouse gases than their smaller predecessors. As individuals and a society, we've overinvested in housing; we'd be better off if more of our savings went into productive investments elsewhere.”

Roach Recommends Government Not Interfere in Housing Price Correction
From Stephen Roach of Morgan Stanley: “America’s current account deficit is due more to bubbles in asset prices than to a misaligned dollar. A resolution will require more of a correction in asset prices than a further depreciation of the dollar. At the core of the problem is one of the most insidious characteristics of an asset-dependent economy – a chronic shortfall in domestic saving. With America’s net national saving averaging a mere 1.4 per cent of national income over the past five years, the US has had to import surplus saving from abroad to keep growing. That means it must run massive current account and trade deficits to attract the foreign capital… A sharp decline in asset prices is necessary to rebalance the US economy. It is the only realistic hope to shift the mix of saving away from asset appreciation back to that supported by income generation. That could entail as much as a 20-30 per cent decline in overall US housing prices and a related deflating of the bubble of cheap and easy credit… As home prices move into a protracted period of decline, consumers will finally recognise the perils of bubble-distorted saving strategies. Financially battered households will respond by rebuilding income-based saving balances. That means the consumption share of gross domestic product will fall and the US economy will most likely tumble into recession… Washington policymakers and politicians need to stand back and let this adjustment play out. Yet the US body politic is panicking in response – underwriting massive liquidity injections that produce another asset bubble and proposing fiscal pump-priming that would depress domestic saving even further. Such actions can only compound the problems that got America into this mess in the first place… It is going to be a very painful process to break the addiction to asset-led behaviour. No one wants recessions, asset deflation and rising unemployment. But this has always been the potential endgame of a bubble-prone US economy. The longer America puts off this reckoning, the steeper the ultimate price of adjustment. Tough as it is, the only sensible way out is to let markets lead the way. That is what the long overdue bursting of America’s asset and credit bubbles is all about.”

Countrywide’s Woes Deepen
From Bloomberg: “[Countrywide’s] Foreclosures doubled to 1.44 percent of unpaid principal in December from 0.7 percent a year earlier at the company's unit that handles billing and processing, Countrywide said in a statement today. Overdue loans increased to 7.2 percent from 4.6 percent. Countrywide tumbled another 15 percent today after losing more than a quarter of its market value yesterday, when the company denied speculations it will file for bankruptcy… Washington Mutual Inc., the biggest U.S. savings and loan, and IndyMac Bancorp Inc., the second-biggest independent mortgage company, lost as much as 16 percent… Credit-default swaps on Countrywide moved deeper into distressed levels for a second day. Sellers were demanding 30 percent upfront and 5 percent a year for contracts protecting Countrywide bondholders from default for five years… Countrywide made $6 million in subprime loans in December, down from $3.7 billion a year earlier, reflecting its tighter standards for lending and the inability to sell the loans to investors in the secondary market. While the change ``has reduced balance sheet risk caused by its non-conforming originations, the dramatic decline in Countrywide's earnings power this transition has caused has kept CFC's creditors nervous about the company's liquidity,''…”

Relative Asset Class Performance in 2007
From Merrill Lynch: “Bonds outperformed Stocks in 2007. This is the fifth annual outperformance for Treasury Bonds so far this decade. Treasury Bonds have not led in five or more years of a decade since the 1930s. Gold outperformed all three major asset classes for the 3rd consecutive year. This has not happened since the late 1970's.
Larger stocks took the performance lead in 2007. The two largest quintiles of the S&P 500 outperfomed the index, whereas the remaining quintiles underperformed. The performance spread between the largest and smallest quintiles of the S&P 500 was nearly 19 percentage points. Investors became increasingly risk-averse as the year progressed. Low beta outperformed high beta by 258 basis points for the full year, overcoming an 800 basis point lag at mid-year. Only two sectors, Financials and Consumer Discretionary, underperformed the S&P 500 in 2007. Annual sector outperformance has not been this broad since 1993. However, only 45% percent of the stocks in the S&P 500 outperformed the index this year, well below the 56% annual average in the prior five years.”

China Adds New Price Freezes to Energy Prices as Inflation Rises
From Bloomberg: “China will freeze price increases of oil products, natural gas and electricity in the ``near term,'' Premier Wen Jiabao said, as the government tries to curb inflation at an 11-year high. The government will cap costs of daily goods when necessary.. Inflation in the world's fastest-growing major economy surged to 6.9 percent in November, the fastest since 1996, and was named by policy makers as one of the two major economic risks for 2008, along with overheating. The central bank pledged a ``tight'' monetary policy this year after six interest-rate increases in 2007 failed to rein in price surges. ``China is facing greater risks of import-induced inflation in 2008 even after factors attributed to last year's price rise, such as pork and grain shortages, dissipate,'' said Zhu Baoliang, chief economist at the State Information Center in Beijing…The Chinese government controls the prices of fuel, public transportation and staple foods that make up most of the basket of goods used to track inflation. Since July, the National Development and Reform Commission, the top planning agency, has asked local governments to refrain from raising prices. Still, the government unexpectedly increased fuel prices as much as 10 percent in November to help refiners cover costs after crude oil rose to a record. It also raised natural gas prices for industrial users by a third. ``The government can't put off energy price increases forever,'' said Zhu, whose center is an affiliate of the NDRC. The freezes ``may create more price distortions between domestic and international markets and harm domestic companies' earnings.''”

MISC

From UBS: “FOMC member Poole today said that it was too early to tell if the housing situation would lead to recession. He said that although economic fundamentals are strong, the Fed is monitoring both inflation and recession risks.”

From BMO: “The final Redbook report for December showed that sales fell 0.7% from the prior month, and were up just 1.3% y/y …[Consumer] Credit is now up 5.2% y/y, a bit below the 5.8% y/y rise in disposable personal income, but hardly marking a major retrenchment.”

From The Wall Street Journal: “Since 2005, developers in the U.S. have produced more retail space than office space, rental apartments, warehouse space or any other commercial real estate category.”

From Natixis: “5y into 5y forward breakeven inflation (from inflation swaps, which abstracts from the financing and seasonal issues embedded in the TIPS BEI curve) fell to the lowest level since 2006 and appears ready to challenge multi-year lows around 2.50%.”

From Merrill Lynch: “Overall, the S&P homebuilders index took another beating yesterday, falling 6.5% — for this year, the group is already down an eye-popping 18%, on top of a 60% decline in 2007 and 21% drop in 2006.”

From Morgan Stanley: “Dec 2007 saw the lowest US default rate in 26 years at 0.9%.”

From BMO: “We now have five trading days behind us, and the Dow is now down 5.1%, the S&P 500 is off 5.3% and the Nasdaq has shed 8% to start the year. Both the Dow and S&P are off to their worst start ever for a year, both probed through to their lowest closes since last spring and both have seen the 50-day moving average drop below the 200-day MA…the 10-year Treasury of 3.78% yesterday was the lowest close in nearly four years (i.e. back when the Fed funds rate was still 1%).” [Note – Bloomberg TV said this was the worst annual start for equities since 1930 this morning.]

From The Washington Post: “With hurricane fears and the soaring costs of housing and storm insurance, many here have begun to fret that Florida, long a mecca for tourists and snowbirds, has lost its allure. "The word has gotten out about Florida. It is not the paradise that many people once thought it was,"…According to the Census Bureau, the number of people moving from other states to Florida has declined from 268,000 in 2005 to 35,000 last year -- by far the most precipitous drop since such records started being kept in 1990…And recently released state figures from the moving company United Van Lines suggest that in stark contrast to years past, as many people are moving out of Florida as are moving in. Four years ago, for example, the company's statistics showed about 60 percent of its Florida shipments were inbound and 40 percent outbound; in the past two years, the number of inbound and outbound shipments has been almost evenly split.”

From Business Week: “KB Home specializes in moderately priced homes, often for first-time home buyers. An increase in KB Home's cancellation rate from 50% to 58% may be a sign these buyers are having a tougher time getting loans, noted UBS analyst David Goldberg. Deutsche Bank's Hooper says the future direction of home prices may be determined by whether subprime homeowners—those with riskier credit histories and mortgage payments that are resetting to higher levels —can avoid foreclosure. Under a worst-case scenario, 40% of subprime mortgages could foreclose, and house prices could drop 15% to 20% over the next two years. If foreclosures are confined to 20% of subprime borrowers, prices could fall 5% to 10%. In any case, "home prices could decline for the next couple years or more," putting a drag on consumer spending that "could be with us for some time to come," he wrote.”

From The Street.com: “Gold gained after heavy buying on the debut of [gold] futures contracts in Shanghai…”

From Goldman: “Clear signs are emerging of a deterioration in [Japanese] corporate sentiment. A wide-ranging deterioration in sentiment was reflected in the December BOJ Tankan survey. Since the economic recovery began in 2002, business sentiment had been steadily improving in the nonmanufacturing sector on the back of a recovery in domestic demand, but sentiment has now begun deteriorating for the first time in five years. Deterioration is also being seen in many other sentiment indicators apart from the Tankan survey. A particularly notable deterioration is being seen among smaller businesses in the nonmanufacturing sector, where prices of raw materials are increasing as the economy emerges from deflation, which is placing an especially heavy burden on companies with little pricing power. The deterioration in business sentiment reflects weak momentum in corporate earnings.”

From Deutsche Bank: “…the Euro-zone’s share of world imports (28%) is now twice that of the US (14%), and the US share has fallen 5 % points since 2000 despite strong US consumption growth for much of this period. Meanwhile, 21% of world imports are now attributed to EM Asia, up from just 9% back in 1980. These numbers suggest an important “rebalancing” development in final demand growth…Annual US imports stand around $2.2 trillion, 58% of which now come from EM [emerging market] countries… private consumption levels in the BRICs [Brazil, Russia, India and China] have been rising rapidly…at the end of 2006, personal consumption (in USD terms) in the BRICs was almost one-third that of the US…”

From Market News: “China's passenger vehicle retail sales rose 10.8 pct year-on-year… Ford Motor said its retail sales in China rose 30 pct in 2007 to 216,324 units, led by strong sales of the Ford Focus. German automaker Audi said it sold a record 102,000 cars in China last year.”

From Deutsche Bank: “The Fed’s announcement of the Term Auction Facility (TAF) program and the passage of year-end has not only narrowed the spread between 1-Mo ABCP and LIBOR by about 95 bp but it has also lowered 1-Mo LIBOR by about 75 bp. Some of the spread narrowing also reflects the improvement in the quality of ABCP… has reduced the spread of 3-Mo LIBOR relative to expected Fed Funds by about 30 bp…”

End-of-Day Market Update

From UBS: “Treasuries rallied today on renewed mortgage-related concerns that pummelled the mortgage lender stocks, once again. The 2s30s curve steepened 4bps on the day as of 3pm… Treasury volume was a fairly heavy 144% of the 30-day average… Spreads widened across the board… Agencies…lagged Libor 0.5-1bp, continuing their week-long streak of underperformance. Fannie priced $4B of its new 2-year at L-19, and $4B of a 5-year at L-15.5…Mortgages saw some decent servicer and originator activity, trading in line to Treasuries and 1-2 ticks better to swaps.”

From Bloomberg: “U.S. stocks gained the most in two weeks after Warren Buffett's Berkshire Hathaway Inc. said it may invest in municipal bond insurers and Hewlett-Packard Co. predicted earnings will withstand an economic slowdown. Bear Stearns Cos., Merrill Lynch & Co. and Morgan Stanley helped financial shares rebound from a four-year low…The Standard & Poor's 500 Index added 18.94, or 1.4 percent, to 1,409.13, rallying from a 10-month low. The Dow average climbed 146.24, or 1.2 percent, to 12,735.31, erasing an 87-point drop. The Nasdaq Composite Index added 34.04, or 1.4 percent, to 2,474.55. ``Warren is viewed, rightly or wrongly, as the smartest investor perhaps in the world,'' … ``People took notice of the sector. Financials led the rally.''”

From Deutsche Bank: “…last hour of trading reverses all of yesterdays post 3:00 rally and then some… as the 'world' seemed to decide that any 'possibility' of an equity investment in the monolines is enough to raise the 'all clear' flag… market tracked a narrow range for most of the day with little activity.”

Three month T-Bill yield rose 2 bp to 3.23%.
Two year T-Note yield rose 5 bp to 2.73%
Ten year T-Note yield rose 4 bp to 3.83%
Dow rose 146 to 12,735
S&P 500 rose 19 to 1409
Dollar index rose .31 to 76.42
Yen at 109.82 per dollar
Euro at 1.466
Gold unchanged at $878
Oil fell $.66 to $95.69
*All prices as of 4:35pm

January 9, 2008    TIDBITS

Goldman Sachs Says Economy Falling Into a Recession

From Goldman Sachs:  “The recent data suggest that the US economy is falling into recession. We expect economic activity to contract modestly through late 2008, followed by a gradual recovery in the course of 2009. Fed officials are likely to respond by cutting the funds rate target to 2½% by late 2008…The recession is likely to last 2-3 quarters and should be relatively mild by historical standards, with a cumulative decline in real GDP of only about ½% (not annualized). There are three reasons to anticipate a relatively mild downturn. First, we expect Fed officials to set aside their residual inflation concerns and cut the fed funds rate aggressively to 2½% by late 2008, with a 50-basis-point cut at the January 29-30 FOMC meeting. Likewise, 10-year Treasury note yields are likely to decline a bit further to 3½% by late summer. Second, with influential economists on both side of the aisle calling for fiscal stimulus, there is a decent chance that Congress and the Bush administration will agree on a temporary tax cut to take effect later this year, especially if the economic data remain weak. Third, although global growth is slowing somewhat, the weak dollar and the shrinking trade deficit are likely to continue to support activity in export-oriented sectors…In terms of sectors, consumer spending is likely to post a (small) outright decline -- unlike in the 2001 recession -- as the housing downturn spills over via a negative wealth effect and consumers find it harder to obtain credit. The downturn in capital spending should be more moderate than in 2001, largely because the starting point is much less elevated. The decline in economic activity is likely to push up the unemployment rate to about 6¼% by late 2008 and will likely result in a significant setback in corporate profits, by about 7½% on an after-tax basis (GDP definition). With our switch to an outright recession call, we have also deepened our forecast for the cumulative decline in nominal house prices, to a 20%-25% peak-to-trough decline from a 15% drop previously.”

Bloomberg Survey of Economists Predicts U.S. Won’t Go Into Recession

From Bloomberg:  “The U.S. will skirt recession as consumer spending slows without collapsing, a survey of economists showed.  Economic growth will average 1.5 percent in the first six months of 2008, matching the fourth quarter's pace, according to the median estimate of 62 economists surveyed by Bloomberg News from Jan. 3 to Jan. 8. The rate of expansion would be the weakest since the last nine months of 2001…The Federal Reserve will cut interest rates more than previously anticipated, economists said, triggering a reacceleration in growth by the third quarter that will keep the economy from stalling.  Economists put the odds of a recession developing within the next year at 40 percent…Nine of the 47 economists responding to the question put the odds at about even and five said the economy would contract…Growth forecasts were lowered for every quarter of the year, even as the estimate for the last three months of 2007 was boosted. The world's largest economy will expand 2.1 percent in 2008, down from 2.3 percent forecast last month and the weakest since 2002…The Fed will reduce borrowing costs in both the first and second quarters, bringing the benchmark interest rate down to 3.5  percent by mid-year. Last month, economists forecast the Fed would reduce the rate just once more and hold it at 4 percent through 2008.”

St. Louis Fed President Poole’s List of Mortgage Market Mistakes

From MarketWatch:  “Investment professionals' "shortsightedness" led them to make fundamental errors that led to the mortgage crisis and credit meltdown, St. Louis Federal Reserve President William Poole said Wednesday…The bulk of Poole's speech was devoted to the need for better financial education -- not only for borrowers but also for investment professionals.  Poole said five key mistakes were made, and professionals made four of them.  "I can understand the mistakes many financially naïve borrowers made but have a hard time understanding how so many investment professionals could have been so wrong," he said in the prepared text.  "Many observers point to greed, but I prefer a different explanation. Shortsightedness rather than greed explains actions that led to losses of tens of billions of dollars and the failure of many financial firms."  Poole's list of five key mistakes: Borrowers took on mortgages they could not afford.  Mortgage brokers put too many people in unsuitable mortgages. They knew, for instance, that adjustable-rate mortgages probably wouldn't be right for many borrowers if interest rates rose as the market expected.  Investment banks jeopardized their reputations by securitizing mortgages without doing due diligence on the underlying assets, many of which were based on "inadequate or spurious information."  Rating agencies put their stamp of approval on securitized mortgages without considering whether AAA ratings could be maintained if house prices fell. Investors scooped up those securities without doing adequate analysis first. "Investors too readily accepted the AAA ratings at face value," Poole said. "A reach for yield with inadequate attention to risk in another basic lesson that apparently cannot be relearned often enough.  "There are no new lessons here," he said. "The mistakes that brought us to this point have been made before."”

Why High Oil Prices Aren’t Increasing Supply

From Reuters:  “Oil at $100 a barrel should give exporters every incentive to pump more, but their difficulty in doing so shows the world is struggling to sustain production.  A growing number of leading industry figures -- the CEOs of Total…and ConocoPhillips …among them -- now question mainstream forecasts for supply, suggesting the era of "plateau oil" is nearer than many in the business have admitted.  While global oil demand is projected to grow to more than 100 million barrels per day later this century, some argue it may not be possible to boost flows beyond the current rate of some 86 million bpd.  Supply still falls short even after so-called unconventional oils extracted from tar sands and converted from natural gas are taken into account, said Sadad al-Husseini, a former top official at state oil giant Saudi Aramco.  "Today's oil prices are high because there are limited new supplies," Husseini, who ran exploration and production at the Saudi state oil company from 1986-2002, told Reuters. "There's a history now. We're several years into level production."  In 1980, when crude first hit an inflation-adjusted high of $100, the pace of drilling by producing countries and major oil companies became fast and furious, leading to rising output and a price collapse in  1986… Conventional supply from outside OPEC has missed forecasts in recent years and appears for now to have hit an "effective plateau", according to the International Energy Agency (IEA), adviser to industrialized countries.  Non-OPEC countries pump about 60 percent of the world's oil and the 13 members of OPEC make up the balance. OPEC sets output limits for 12 of its 13 members.  Many countries within the Organization of the Petroleum Exporting Countries -- whether for reasons of war or sanctions, lack of investment or falling supply at ageing fields --- are unable to raise output.  "OPEC can do little," Shokri Ghanem, the top oil official for OPEC member Libya, told Reuters. "Most OPEC countries are producing at capacity."  Many analysts expect prices to rise further unless demand crumbles as a result of a recession…”

U.S. Overinvested in Housing

From Robert Samuelson:  “In Sweden, Britain and Italy, new homes average under 1,000 square feet. By 2005, the average newly built U.S. home measured 2,434 square feet…"We're not selling shelter," says the president of Toll Brothers, a builder of upscale homes. "We're selling extreme-ego, look-at-me types of homes." In 2000, Toll Brothers' most popular home was 3,200 square feet; by 2005, it had grown 50 percent, to 4,800 square feet… "Buying a bigger house isn't an investment," warned Wall Street Journal columnist Jonathan Clements. It's "a lifestyle choice -- and it comes with a brutally large price tag." Not only are mortgage payments higher; so are costs for utilities, furniture and repairs.  Worse, government subsidizes these supersize homes along with suburban sprawl and, just incidentally, global warming. In 2008, the tax deduction for mortgage interest payments will cost the federal government $89 billion. The savings go heavily to the upper-middle class and the wealthy -- the least needy people -- and encourage ever-larger homes. Even with energy-saving appliances, those homes are likely to generate more greenhouse gases than their smaller predecessors. As individuals and a society, we've overinvested in housing; we'd be better off if more of our savings went into productive investments elsewhere.”

Roach Recommends Government Not Interfere in Housing Price Correction

From Stephen Roach of Morgan Stanley:  “America’s current account deficit is due more to bubbles in asset prices than to a misaligned dollar. A resolution will require more of a correction in asset prices than a further depreciation of the dollar. At the core of the problem is one of the most insidious characteristics of an asset-dependent economy – a chronic shortfall in domestic saving. With America’s net national saving averaging a mere 1.4 per cent of national income over the past five years, the US has had to import surplus saving from abroad to keep growing. That means it must run massive current account and trade deficits to attract the foreign capital… A sharp decline in asset prices is necessary to rebalance the US economy. It is the only realistic hope to shift the mix of saving away from asset appreciation back to that supported by income generation. That could entail as much as a 20-30 per cent decline in overall US housing prices and a related deflating of the bubble of cheap and easy credit… As home prices move into a protracted period of decline, consumers will finally recognise the perils of bubble-distorted saving strategies. Financially battered households will respond by rebuilding income-based saving balances. That means the consumption share of gross domestic product will fall and the US economy will most likely tumble into recession… Washington policymakers and politicians need to stand back and let this adjustment play out. Yet the US body politic is panicking in response – underwriting massive liquidity injections that produce another asset bubble and proposing fiscal pump-priming that would depress domestic saving even further. Such actions can only compound the

problems that got America into this mess in the first place… It is going to be a very painful process to break the addiction to asset-led behaviour. No one wants recessions,

asset deflation and rising unemployment. But this has always been the potential endgame of a bubble-prone US economy. The longer America puts off this reckoning, the steeper the ultimate price of adjustment. Tough as it is, the only sensible way out is to let markets

lead the way. That is what the long overdue bursting of America’s asset and credit bubbles is all about.”

Countrywide’s Woes Deepen

From Bloomberg:  “[Countrywide’s] Foreclosures doubled to 1.44 percent of unpaid principal in December from 0.7 percent a year earlier at the company's unit that handles billing and processing, Countrywide said in a statement today. Overdue loans increased to 7.2 percent from 4.6 percent.  Countrywide tumbled another 15 percent today after losing more than a quarter of its market value yesterday, when the company denied speculations it will file for bankruptcy… Washington Mutual Inc., the biggest U.S.

savings and loan, and IndyMac Bancorp Inc., the second-biggest independent mortgage company, lost as much as 16 percent… Credit-default swaps on Countrywide moved deeper into distressed levels for a second day. Sellers were demanding 30 percent upfront and 5 percent a year for contracts protecting Countrywide bondholders from default for five years… Countrywide made $6 million in subprime loans in December, down from $3.7 billion a year earlier, reflecting its tighter standards for lending and the inability to sell the loans to investors in the secondary market.  While the change ``has reduced balance sheet risk caused by its non-conforming originations, the dramatic decline in

Countrywide's earnings power this transition has caused has kept CFC's creditors nervous about the company's liquidity,''…”

Relative Asset Class Performance in 2007

From Merrill Lynch:  “Bonds outperformed Stocks in 2007. This is the fifth annual outperformance for Treasury Bonds so far this decade. Treasury Bonds have not led in five or more years of a decade since the 1930s.  Gold outperformed all three major asset classes for the 3rd consecutive year.  This has not happened since the late 1970's.  

Larger stocks took the performance lead in 2007.  The two largest quintiles of the S&P 500 outperfomed the index, whereas the remaining quintiles underperformed.  The performance spread between the largest and smallest quintiles of the S&P 500 was nearly 19 percentage points.  Investors became increasingly risk-averse as the year progressed.  Low beta outperformed high beta by 258 basis points for the full year, overcoming an 800 basis point lag at mid-year.  Only two sectors, Financials and Consumer Discretionary, underperformed the S&P 500 in 2007.  Annual sector outperformance has not been this broad since 1993.  However, only 45% percent of the stocks in the S&P 500 outperformed the index this year, well below the 56% annual average in the prior five years.”

China Adds New Price Freezes to Energy Prices as Inflation Rises

From Bloomberg:  “China will freeze price increases of oil products, natural gas and electricity in the ``near term,'' Premier Wen Jiabao said, as the government tries to curb inflation at an 11-year high.  The government will cap costs of daily goods when necessary.. Inflation in the world's fastest-growing major economy surged to 6.9 percent in November, the fastest since 1996, and was named by policy makers as one of the two major economic risks for 2008, along with overheating. The central bank pledged a ``tight'' monetary policy this year after six interest-rate increases in 2007 failed to rein in price surges.  ``China is facing greater risks of import-induced inflation in 2008 even after factors attributed to last year's price rise, such as pork and grain shortages, dissipate,'' said Zhu Baoliang, chief economist at the State Information Center in Beijing…The Chinese government controls the prices of fuel, public transportation and staple foods that make up most of the basket of goods used to track inflation. Since July, the National Development and Reform Commission, the top planning agency, has asked local governments to refrain from raising prices.  Still, the government unexpectedly increased fuel prices as much as 10 percent in November to help refiners cover costs after crude oil rose to a record. It also raised natural gas prices for industrial users by a third.  ``The government can't put off energy price increases forever,'' said Zhu, whose center is an affiliate of the NDRC. The freezes ``may create more price distortions between domestic and international markets and harm domestic companies' earnings.''”

MISC

From UBS:  “FOMC member Poole today said that it was too early to tell if the housing situation would lead to recession. He said that although economic fundamentals are strong, the Fed is monitoring both inflation and recession risks.”

From BMO:  “The final Redbook report for December showed that sales fell 0.7% from the prior month, and were up just 1.3% y/y …[Consumer] Credit is now up 5.2% y/y, a bit below the 5.8% y/y rise in disposable personal income, but hardly marking a major retrenchment.”

From The Wall Street Journal:  “Since 2005, developers in the U.S. have produced more retail space than office space, rental apartments, warehouse space or any other commercial real estate category.”

From Natixis:  “5y into 5y forward breakeven inflation (from inflation swaps, which abstracts from the financing and seasonal issues embedded in the TIPS BEI curve) fell to the lowest level since 2006 and appears ready to challenge multi-year lows around 2.50%.”

From Merrill Lynch:  “Overall, the S&P homebuilders index took another beating yesterday, falling 6.5% — for this year, the group is already down an eye-popping 18%, on top of a 60% decline in 2007 and 21% drop in 2006.”

From Morgan Stanley:  “Dec 2007 saw the lowest US default rate in 26 years at 0.9%.”

From BMO:  “We now have five trading days behind us, and the Dow is now down 5.1%, the S&P 500 is off 5.3% and the Nasdaq has shed 8% to start the year. Both the Dow and S&P are off to their worst start ever for a year, both probed through to their lowest closes since last spring and both have seen the 50-day moving average drop below the 200-day MA…the 10-year Treasury of 3.78% yesterday was the lowest close in nearly four years (i.e. back when the Fed funds rate was still 1%).” [Note – Bloomberg TV said this was the worst annual start for equities since 1930 this morning.]

From The Washington Post:  “With hurricane fears and the soaring costs of housing and storm insurance, many here have begun to fret that Florida, long a mecca for tourists and snowbirds, has lost its allure.  "The word has gotten out about Florida. It is not the paradise that many people once thought it was,"…According to the Census Bureau, the number of people moving from other states to Florida has declined from 268,000 in 2005 to 35,000 last year -- by far the most precipitous drop since such records started being kept in 1990…And recently released state figures from the moving company United Van Lines suggest that in stark contrast to years past, as many people are moving out of Florida as are moving in. Four years ago, for example, the company's statistics showed about 60 percent of its Florida shipments were inbound and 40 percent outbound; in the past two years, the number of inbound and outbound shipments has been almost evenly split.”

From Business Week:  “KB Home specializes in moderately priced homes, often for first-time home buyers. An increase in KB Home's cancellation rate from 50% to 58% may be a sign these buyers are having a tougher time getting loans, noted UBS analyst David Goldberg.  Deutsche Bank's Hooper says the future direction of home prices may be determined by whether subprime homeowners—those with riskier credit histories and mortgage payments that are resetting to higher levels —can avoid foreclosure. Under a worst-case scenario, 40% of subprime mortgages could foreclose, and house prices could drop 15% to 20% over the next two years. If foreclosures are confined to 20% of subprime borrowers, prices could fall 5% to 10%.  In any case, "home prices could decline for the next couple years or more," putting a drag on consumer spending that "could be with us for some time to come," he wrote.”

From The Street.com:  “Gold gained after heavy buying on the debut of [gold] futures contracts in Shanghai…”

From Goldman:  “Clear signs are emerging of a deterioration in [Japanese] corporate sentiment. A wide-ranging deterioration in sentiment was reflected in the December BOJ Tankan survey. Since the economic recovery began in 2002, business sentiment had been steadily improving in the nonmanufacturing sector on the back of a recovery in domestic demand, but sentiment has now begun deteriorating for the first time in five years. Deterioration is also being seen in many other sentiment indicators apart from the Tankan survey. A particularly notable deterioration is being seen among smaller businesses in the nonmanufacturing sector, where prices of raw materials are increasing as the economy emerges from deflation, which is placing an especially heavy burden on companies with little pricing power. The deterioration in business sentiment reflects weak momentum in corporate earnings.”

From Deutsche Bank:  “…the Euro-zone’s share of world imports (28%) is now twice that of the US (14%), and the US share has fallen 5 % points since 2000 despite strong US consumption growth for much of this period.  Meanwhile, 21% of world imports are now attributed to EM Asia, up from just 9% back in 1980.  These numbers suggest an important “rebalancing” development in final demand growth…Annual US imports stand around $2.2 trillion, 58% of which now come from EM [emerging market] countries… private consumption levels in the BRICs [Brazil, Russia, India and China] have been rising rapidly…at the end of 2006, personal consumption (in USD terms) in the BRICs was almost one-third that of the US…”

From Market News:  “China's passenger vehicle retail sales rose 10.8 pct year-on-year… Ford Motor said its retail sales in China rose 30 pct in 2007 to 216,324 units, led by strong sales of the Ford Focus. German automaker Audi said it sold a record 102,000 cars in China last year.”

From Deutsche Bank:  “The Fed’s announcement of the Term Auction Facility (TAF) program and the passage of year-end has not only narrowed the spread between 1-Mo ABCP and LIBOR by about 95 bp but it has also lowered 1-Mo LIBOR by about 75 bp.  Some of the spread narrowing also reflects the improvement in the quality of ABCP… has reduced the spread of 3-Mo LIBOR relative to expected Fed Funds by about 30 bp…”

End-of-Day Market Update

From UBS:  “Treasuries rallied today on renewed mortgage-related concerns that pummelled the mortgage lender stocks, once again. The 2s30s curve steepened 4bps on the day as of 3pm… Treasury volume was a fairly heavy 144% of the 30-day average… Spreads widened across the board… Agencies…lagged Libor 0.5-1bp, continuing their week-long streak of underperformance. Fannie priced $4B of its new 2-year at L-19, and $4B of a 5-year at L-15.5…Mortgages saw some decent servicer and originator activity, trading in line to Treasuries and 1-2 ticks better to swaps.”

From Bloomberg:  “U.S. stocks gained the most in two weeks after Warren Buffett's Berkshire Hathaway Inc. said it may invest in municipal bond insurers and Hewlett-Packard Co. predicted earnings will withstand an economic slowdown.  Bear Stearns Cos., Merrill Lynch & Co. and Morgan Stanley helped financial shares rebound from a four-year low…The Standard & Poor's 500 Index added 18.94, or 1.4 percent, to 1,409.13, rallying from a 10-month low. The Dow average climbed 146.24, or 1.2 percent, to 12,735.31, erasing an 87-point drop. The Nasdaq Composite Index added 34.04, or 1.4 percent, to 2,474.55.  ``Warren is viewed, rightly or wrongly, as the smartest investor perhaps in the world,'' … ``People took notice of the sector. Financials led the rally.''”

From Deutsche Bank:  “…last hour of trading reverses all of yesterdays post 3:00 rally and then some… as the 'world' seemed to decide that any 'possibility' of an equity investment in the monolines is enough to raise the 'all clear' flag… market tracked a narrow range for most of the day with little activity.”

Three month T-Bill yield rose 2 bp to 3.23%.

Two year T-Note yield rose 5 bp to 2.73%

Ten year T-Note yield rose 4 bp to 3.83%

Dow rose 146 to 12,735

S&P 500 rose 19 to 1409

Dollar index rose .31 to 76.42

Yen at 109.82 per dollar

Euro at 1.466

Gold unchanged at $878

Oil fell $.66 to $95.69

*All prices as of 4:35pm