Friday, February 29, 2008
Wednesday, February 27, 2008
PPI for the month of January reached 7.4% on an annualized basis. This is the highest level since 1981, 26 years ago. For many investors this is ancient history. The link between PPI and CPI has changed significantly over the last two decades, but we may be moving back to an early 1980’s relationship.
The link between CPI and PPI has been generally high. The correlation has been above .8 for the entire 25 year period. The same has not been said for CPI ex food and energy where the correlation has actually turned negative over the last four years.
PPI over the last four years has been higher than CPI and the gap is getting larger. This is at odds with what occurred during most of the 1990’s when PPI was actually lower than CPI. The sustained increase of PPI over CPI and CPI ex food and energy makes it more likely that CPI will be pulled higher. PPI is more volatile but the sustained increases in PPI make it less likely that a short-term reversal in energy or food will bring down CPI.
A simple regression analysis suggests that the behavior over the last few years is different than for the longer period. For 1980 to the present, there is a strong positive relationship between PPI and CPI ex food and energy. The beta is approximately .54 for PPI as the explanatory variable. For the time period from 2000 to the present, the Beta with PPI as the independent variable is slightly negative. The relationship between PPI and CPI is similar but the betas are higher.
The coupling of higher inflation with the increased likelihood that the Fed will continue to ease is a recipe for a falling dollar.
Friday, February 22, 2008
Root cause –
- Slowdown in the housing market in response to rising interest rates. Short rates plateau in the second half of 2006.
Reaction in financial markets –
- Credit problems with CBO market for subprime lending as a result of rising rates. The rising rates caused an increase in delinquencies and defaults which stressed deal structures. Price of CBO deals decline . No buyers for lower rated tranches.
- Buyers in SIV ABS market dry up. Funding problems for leveraged deals. SIV ABS market contracts as market moves to Treasuries. Loans placed back on bank balance sheet. Credit crunch in structured market.
- Losses reported by major financial institutions. Cleaning of executive suites. Risk premiums in LIBOR market increase. Capital infusion for some large institutions to offset losses. Funding risk for financial institutions associated with lack of transparency. Uncertainty with loses from subprime because holders of securities are unknown. Pricing is difficult because no two way markets.
- Credit standards increased by banks. Lending constrained. Bank loan syndication markets contracts. High yield risk increases as defaults increase.
- Auction rate municipal market contracts and borrowing rates increase.
- Monoline insurance provides in crisis which affects municipal market. Bail-out likely. Northern Rock, mortgage lender, is taken over by the British government.
Reaction by the government -
- Discount rate cut
- Fed Funds cut to lower the cost of borrowing
- Term Auction fund to provide credit to banks
- Some central banks cut funds rate.
- “Hope Now” program from Treasury Department
- Too little too late?
- What alternative to cutting rates?
There was no good economic statistics that came out this week in the United States. We are almost at the point that the silver lining in an economic announcement will be when the downtrend is less severe.
We started out the week with the NAHB housing market index hovering just above the all-time lows. This diffusion index shows that there is no expectation for a changing the housing market for at least the next six months. Mortgage applications were down big after a large number last month at the beginning of the year. The volatility of this series has increased which is similar to what happened the last recession. Housing starts and building permits are just above the lows from the 1991 recession level. This number has to move down to allow the high inventory to be worked off. If we are early in the recession, this number will move lower over the next few months. Building permits are still above a million units on an annual basis. This number is going to have to turn down first if you expect to see housing start fall further.
The consumer confidence numbers from ABC have continued their downturn, but it should be noted that the confidence levels are still higher than what they were a year ago. Initial jobless claims have not increased significantly but the continuing claims are starting to move higher. The Philadelphia Fed factory survey moved further negative to levels that were similar to the beginning of the last recession. Exports are not going to solve the manufacturing problem.
CPI inflation is at the 4.5 percent level which is similar to what we saw in early 2006. The core inflation rate is actually below the levels from a year ago but at 2.5% which is higher than the 2% target. Nevertheless the break-even inflation rates from the difference between nominal and TIP bonds suggest that inflation will be contained as measured for 10-year maturities. The shorter-term four year break-evens are looking at an expected inflation of 2.38 percent. Bonds have traded down since the last set of Fed cuts.
Wednesday, February 20, 2008
“The four most dangerous words in investing are ‘This time it’s different.’”-Sir John Templeton, yet a nuanced approach tells us that times are often different. The current talk about a recession may be one of those different times. Many factors are the same with identifying a recession but the causes seem to change. The credit crunch has had an impact on the real economy, but for what seems like the longest time the sectors outside the housing industry have been doing reasonable well. Consequently, some of the models that try and provide a probability of a recession have not sent clear signals of a potential recession.
The quantitative approaches are in some cases being more cautious then opinions of market analysts. The number of stories concerning a US recession has increased substantially if you look at the internet and the number of economists who are not seeing a recession in 2008 is getting fewer and fewer, yet when you look at objective measures on the probability of a recession based on the behavior of past economic data the story is mixed. The betting market in the Intrade betting exchange shows that the odds of recession are very high. This may be a better measure of public opinion than looking at the number of stories of recession.
The yield curve probability model shows much different results than what economists are thinking. Up until this summer the yield curve was flat to slightly inverted and had been calling for a greater than 20% probability of recession for almost a year. It was almost getting to the point that the yield curve model was giving a false signal. Only now are we getting the slowdown that has been expected, but the steepening of the curve now makes the probabilities start to change and move to a low chance of a recession. By this measure the Fed has reacted and has taken action which will change the course of the real economy by the end of the year.
More complex recession probability models are showing mixed results. The Jeremy Piger model of recession probability has inched up but is nowhere near levels that would suggest that we are in a recession. For more details, look at his homepage http://www.uoregon.edu/~jpiger/. Piger is a former economist at the St Louis Fed. Coincidently, the other model used to forecast recession probabilities is also by a former economist from the St Louis Fed, Michael Dueker, who is now at Russell Investments. He developed a qualitative VAR model for recession forecasts and finds a much higher probability that is above his threshold for a recession. He is calling for a two quarter recession for the first half of 2008. His work can be read in more detail on econbrowser.com;
http://www.econbrowser.com/archives/2008/02/predicting_rece.html. His approach employs a business cycle index with a vector autoregressive model to find recession probability forecasts. He uses GDP growth, core CPI inflation, the slope of the yield curve and the Fed funds rate. The fed funds rate and the slope of the yield curve are common to all of these models so the action is in the fundamental data. He notes that there is a difference with a recession recognition model which have not shown high probabilities and recession prediction models like his which are giving clear signals.
What you do find is that recession probability models can move from low or no probability to an extremely high number in a very short time. The probability of recession is also based on the data being used because there just are not that many recessions to look at. Each one may have unique features for its cause, but if you leave off some of the data from the 1970’s you will get different probabilities.
The nice thing about these types of models is that they truly give a quantitative measure of a recession chance and can be the basis for meaningful discussion on the particulars of what makes this time different. Unfortunately, the numbers are truly leaning to a recession regardless of how you cut the data.
Tuesday, February 19, 2008
There are two definitions for a recession. One is formal and set by the NBER and the other is an informal approach. The informal definition states that a recession is two consecutive quarters of negative GDP growth. The more formal approach is based on watching four economic series as well as the GDP series.
The NBER committee places particular emphasis on two monthly measures of activity across the entire economy: (1) personal income less transfer payments, in real terms and (2) employment. In addition, the committee refers to two indicators with coverage primarily of manufacturing and goods: (3) industrial production and (4) the volume of sales of the manufacturing and wholesale-retail sectors adjusted for price changes.
Personnel income peaked in September of last year without counting transfer payments. On a real basis personnel income is still above 3% assuming an inflation rate of 2.5%. Transfer payments have changed by 1.25 percent over the last year so personnel income would still be positive albeit below the long-term growth trend of 3%.
The unemployment rate has moved up from the lows of 4.5 percent at the beginning of 2007 to the current levels of 4.9 percent. This change is not near the levels for the last recession but is clearly trending up.
Industrial production is above its lows but only reaching 2% on a nominal basis.
Retail sales have hovered around 4% on a nominal basis so sales are below the long-term trend on a real basis.
Looking at either the formal or informal numbers tells us that we are still not at the point of being in a recession; however, the markets seem to focus on the probability estimates for a recession and that is telling s slightly different story. Using the probability models, the chance of a recession on a forward basis is in some cases over 50%.
There once were some bankers from Gaff
Whose products were layered with math.
With assets worth billions
Now stated in millions,
Those chaps were too clever by half!
Mark Sniderman – Cleveland Federal Reserve Bank
There are more write-downs by financial institutions from the subprime area, so the credit crunch is far from over. The markets have to clear and that cannot happen if there are continued changed in the value of the holdings.
We are also seeing the continued use of Term Auction Facility (TAF) which means that banks have a need for short-term financing at inexpensive cost. The latest auction saw more bids almost 2 times the $30 billion of funds in the facility. While the economics of using the facility makes sense, the fact that the facility is still needed suggests that there is still strain in the banking system.
The NAHB index has moved up from lows in December at 18 to a current level of 20. This is the second month in a row of an increase, but any optimism should is pure speculation. This is a diffusion index so good conditions would exist with a reading above 50. We are nowhere near that mark.
In fact, the only component of the index that showed some life was the traffic of prospective buyers. People are looking but the market is not clearing. The only reason the prospects look a little higher is that brokers probably think that the increased traffic will lead to sales but that tells us nothing about the price or whether there is any increase in wealth for the seller. Brokers get paid on volume. Of course, the commission is a function of price but the turnover is what is important to them at his time.
Monday, February 18, 2008
I finished the new book by Ian Ayres, Super Crunchers: Why Thinking-by-Numbers is the New Way to be Smart. It got the recommendation from Steve Levitt the author of Freakonomics that it could change the way you think. I should like this book as someone who has been a quantitative analyst for his entire career. I have always felt comfortable with the discipline of systematic investing, yet my feelings were mixed at the end. There is the conclusion that looking at the numbers will provide better insight. Looking for long-term relationships will be able to eliminate the problems of emotions with investing. There will be less risk of being swayed by emotions or the whims of crowds.
Ayres does convincing job of making you feel like this should be the only alternative to decision making. In fact, he was thinking of calling this book, the end of intuition. He provides great examples of how quantitative investing does a better job of diagnosis than most physicians. Equations do better than many experts. Randomized trials are an excellent way of providing insight on alternative theories.
Still, in the investment area, there may be room for intuition. The room for error with investment decisions is large. Many regression equations trying to provide explanation of returns find that they can explain less that 15% of the total variation in returns. The results of many regressions are a function of underlying assumptions. The variables in many regressions are unstable. Intuition is needed to provide the right quantitative framework and power to know when to change models. My conclusion is that super crunchers need intuition in order to properly set the problem and interpret the results. There is still no substitution for experience in interpreting what models are telling the analyst. There no chance for randomized trials in the normal sense with investing. Quantitative investing without intuition is as dangerous as using the seat of your pants. There has to be a balance between the intuition that comes from experience and the power of focusing on the numbers.
Friday, February 15, 2008
The trade deficit has declined and there has been a closing of the current deficit. Some of this closing has been associated with the declining dollar. Imports are getting more expensive and exports are finding new markets because they are cheaper. We have talked about the added benefit of a decoupled global economy. A slowdown in US growth will cut imports while the fact that the rest of the world is still growing is good for US exports. This is basic trade theory at work. However a decline in oil prices will have a quick benefit.
Crude oil imports are now at $26 billion per month. While goods exports is still higher, crude oil imports have increase fivefold since 2000. Higher oil prices have not been good for the dollar. The increase in oil has matched the decline in the dollar since 2000.
A decline in oil prices, given the current relationship will lead to a strengthening dollar and further improvement in the trade balance. Of course, the sensitivity to a crude oil price decline is not high. The dollar has declined by 30% since the beginning of 2002 while oil prices increased by 300+% over the same time period. A decline in oil prices from current levels of $95 per barrel to $85 per barrel will only lead to a possible 1% increase in the dollar. The impact on the trade balance will be a decrease in imports of about $2.5 billion.
Crude oil prices will be a key driver for the dollar over the next few months.
The latest trade numbers for China have come out and they continue the same trend. China is a trade juggernaut. The total volume of trade with China is over $2 trillion dollars. The Trade surplus for the month was above $20 billion. The trade surplus with the worlds was $262 billion and the trade surplus with the US was $256 billion. China is becoming more important for US trade than Canada. It is a larger exporter of products to the US.
It is more likely that trade restrictions with China will be a major topic for Congress even with the yuan appreciating. The change in the currency does not offset the cost advantage in many manufacturing areas.
Thursday, February 14, 2008
A similar pattern of increased residuals also applies to the 5-year and 2-year Treasury note futures. In fact, the variation away from the fitted model is more pronounced.The returns for 2-year Treasuries also more closely follow the monetary cycle.
Bond trading has finally started to become profitable. The slowdown in US growth has forced down interest rates which have been great of those hold long bond exposures. Volatility has increased so there are starting to be some trading opportunities. This is the first time in years that we have had a sustained period of bond price gains.
One of the interesting facts about long-term interest rate has been how range-bound they have been since the last recession. As a result of this range-bound behavior, there has been a marked deterioration in trend trading in this asset class. Forecasting models have also deteriorated because there variation in rates has been much lower than some of the economic variables although both inflation and growth have been fairly stable over the last five years. The cumulative price return from holding long 10-year note futures has been zero for the last five years. The 5-year and 2-year note futures have performed only slightly better as the curve steepened. The 10-year futures has seen an increase in volatility but has not moved in a single. The tug between slower growth and inflation seems to be real on the long-end of the curve.
The chart highlights the fact that not much has been going on in fixed income for years and may explain the complacency that we have seen in these markets. Without variation in interest rates, investors reached out for higher yields. With limited volatility, there was a strong desire for buy and hold investing in yield products. We are now seeing the impact of that yield reaching.
“Nothing is so destabilizing as stability,” Hyman Minsky.
“By trying to take risk out of the markets, we made this downturn inevitable,” James Grant “Paying the Price for the Fed’s Success” editorial New York Times.
With the Fed lowering interest rates but credit tight in housing, the monetary policy impact will be felt in other market sectors. There is strong evidence that lowering rates does not help in a credit crunch if banks are unwilling to lend in a sector. The dollar decline or devaluation and the current account deficit story, however, is more complex.
A decline in the dollar does not mean that the terms of trade have changed. There are clear example of periods in trade history where there has been a change in the value of currencies but not the expected impact on trade. The US-Japan trade story is a perfect example. (Steve Hanke makes this point in a recent Forbes point of view column.)
More importantly, the current account deficit that is the worry of many is not solved solely by changes in exports. Imports are also important and the improvement in the trade balance has to do with the fact that the economy is slowing so imports are slowing. It may not show as clearly because of the high cost of energy imports but the improvement story has as much to do with a slowing economy in the US and stronger growth abroad as the decline in the dollar.
Do not forget that the dollar has been in a slight since 2001 over which time the deficit actually got bigger. There may be a tipping point for exports to increase but the driver is more likely decoupling of growth. The current account deficit also will not change by just changes in trade. The financial flows are larger and more important.
The current account deficit is also an accounting identity equal to the the sum of excess private investment over savings and the government deficit. The current account deficit will close when savings increase or the government deficits decrease. Since the government deficit is expected to grow, the closing of the current account deficit will have to be driven by higher private savings. The higher savings is most likely to come from a decrease in consumption relative to income. If consumers believe there has been a change in their wealth from say a decline in the value of their homes, there will be a retrenchment of spending. Consumption will decline and we will see an increase in savings. This is currently happening even with the strong retail number reported yesterday.
Trade balances will change but not because of a policy that allows the dollar to decline. The more likely channel of transmission will be through changes in growth and savings around the world which will change the aggregate demand for goods and services.
Friday, February 8, 2008
The ECB held rates firm this week, yet the dollar rallied. The dollar euro exchange rate is now below the levels at the beginning of the year. The current interest differential story states that the dollar should not rally. Rates are more attractive in Europe. Even if the ECB action of no change was expected, it does not suggest there should be a rally unless there is new information in the market.
The story is not in the numbers but the words and expectations. ECB President Trichet admitted that Euroland growth is slowing and action may be necessary. This is a softening of the ECB inflation stand even without a rate decline. The market view is that there is no decoupling story and rates will have to come down in Europe because it will be affected by a US recession. Interestingly, we know that the decoupling story does not apply between the US and Japan, yet we have seen yen strengthening since the beginning of the year. The growth slowdown link is still in place, so the idea of a strengthening euro has been placed on hold. So much for a simple story in FX land.
Of course, the currency is the relative price between two countries so if the ECB and Fed both reduce rates the same rate differential will be in place. If the rate gap remains at current levels, the dollar should be range-bound or lower. However, an alternative is found in the Dec 2008 interest rate futures. The Eurodollar futures is pricing in another 50 bps in Fed cuts while Euribor futures are expecting 90 bps of cuts. The interest gap will actually decline and be more favorable for the US, albeit US rates will still be lower. The currency markets now think the ECB is behind the business cycle curve and does not believe that they will be solely an inflation fighter. That may have been confirmed by Trichet comments.
The commodity markets have gone wheat crazy. Every wheat futures market has been up the daily limit. The CME has increased the limits to get the market to match buyers and sellers. Wheat is the best performing commodity market for the year. Adverse weather is cutting supply expectations worldwide and the inventories will be down from last year. 1975 was the last time we saw these kinds of gains in a week. Of course, corn and soybeans have also risen based on the same set of weather variables, but they cannot serve as a substitute for wheat. The wheat surplus is down 6.8 percent from the previous month.
The market is reacting around the world. China is raising its minimum purchase price to get farmers to increase production. Exports have increased as many buyers try to lock-in supply before there are any shortages. Brazil is lifting wheat tariffs from countries outside of the Mercosur trade bloc in an effort to stop price increases. The distribution of wheat is in flux.
Is this a bubble? While trading and price increase are frenzied, there will be a very low inventory of world wheat after years of strong surplus. The downside risk is high and buyers are reacting. Supply cannot keep pace in the short-run. The likelihood of sustained prices at current levels may not be high, but if you need wheat for consumption or processing, you cannot take the risk of not having what is necessary.
Thursday, February 7, 2008
The current 10-year yields are actually lower than the when we were in the last recession. Bond yield bottomed actually in June 2003, but all the buyers at that time are underwater and inflation is higher. There is little reason to hold US bonds when there are a number of countries that have higher current yields and have central banks which are still worried about inflation. The US economy is weak and the Fed is likely to do more cutting which may lead to further inflation pressure. We have moved from a bond market that was focused on growth and declining yields to one that is now focused on inflation.
"Euros Accepted" signs pop up in New York CityReuters story states that NYC is so flooded with Europeans that Euros are accepted. This may help cut the trade deficit, but it is a another sign that the dollar as a reserve currency is having problems.
Bank of England cut interest rates by 25 bps in response to the slowing of the UK economy to 5.25 percent. This is still high relative to the US even though Great Britain has been matching US behavior. The ECB, on the other hand, has continued to stay focused on its inflation target goal and kept interest rates unchanged at 4 percent. Inflation is currently above target in Euroland and is at a 14 year high.
An important theme to watch is how inflation target central banks behave in 2008. The Fed has a dual target of maintaining price stability as well as continued growth in the economy. A number of central banks do not have this dual objective but a single inflation goal. The market for Euribor seems to be suggesting that the ECB will cave on their inflation goal. It is showing rates at 3.49 for the December. If the inflation target banks do not change their behavior we will see growing divergences in interest rates which should lead to greater divergences in growth and bigger adjustments in currency markets.
Wednesday, February 6, 2008
Tuesday, February 5, 2008
The world is changing and for the first time a person who is not American or European will be chief economist of the World Bank. Justin Lin from Peking University was trained at the University of Chicago. He has specialized in development research work on China. He was the founding director of the China enter for Economic Research at Peking University. Most of his development work has focused on agriculture in China but from what I have seen he seems to be a careful and even-handed researcher. He is certainly not a part of the Washington consensus and has argued that the transition of China was based on a gradual or evolutionary approach.
Some of the chief economists for the World Bank have included, Anne Kruger, Lawrence Summers and Josephs Stiglitz. This is both a prestigious and important position in global financial markets and development; albeit the World Bank has more recently had a mixed role on the world stage. With the strong growth in emerging market countries, the mission of the World Bank has been less clear.
Lin as chief economics may have a significant impact on the direction of the World Bank, yet the impact will not be clear. Even Nobel Prize winners have not been able to truly influence the direction of the Bank. The frustrations of Joe Stiglitz are a testimony to the entrenched bureaucracy.
Friday, February 1, 2008
Home sales were below expectations on Monday, down about 4.7%. The Case Shiller index was down 7.7 percent yoy. Mortgage applications were also lower than the previous week after an end of the year boost. Construction was down 1%. Hosing is not responding to the lower interest rates. There is no relief in the housing area. Durable goods orders were actually up big which was a surprise, but consumer confidence is continuing to slide. GDP is coming in at below 1% based on fourth quarter numbers and consumption is moving at about 2%. The core PCE price index is still high at 2.7%
Overall, we have seeing a slow economy with relatively high prices -the stagflation-lite scenario.