Thursday, March 10, 2011

Today's links

1--U.S. Economic Optimism Declines in February, Gallup

Excerpt: Gallup's Economic Confidence Index worsened to -24 in February from -21 the prior month as Americans' optimism about the U.S. economy receded from a three-year high reached in January.

Monthly Results Understate the Decline in Confidence

Gallup's weekly economic confidence data show that consumer optimism hit a new weekly high in mid-February but fell sharply during the second two weeks of the month. As a result, the decline in optimism reported for the month is an average bolstered by relatively high confidence early in February.

Recent events are not encouraging as far as the economy is concerned. Soaring gas prices, budget battles in Washington, D.C., as well as in many states, and recent declines on Wall Street suggest that Gallup's most recent weekly measure of -29 for the week ending March 6 may more accurately reflect current consumer confidence than February's monthly average.

2--Koo: The "Strange World" of a Balance Sheet Recession, Economist's View

Must watch video with economist Richard Koo

3--Student loan debt inches to $900 billion, My Budget 360

Excerpt: The cost of college has outpaced virtually every category including medical care costs and more important household income. In order to pursue a college education many have found it necessary to go into student loan debt. The stories of people working at a dime store and paying for their education become harder and harder when public schools cost $20,000 per year and private schools are inching closer to $60,000 per year in tuition...

We have crossed a troubling threshold where student loan debt has passed up total credit card debt. This is a dramatic shift only in the last decade.

“In 2000 total student loan debt stood at roughly $200 billion while credit card debt was at $625 billion. Today credit card debt is at $790 billion while student loan debt is now closer to $900 billion. In one decade we added $700 billion in student loan debt. This is money that needs to be paid back by new working professionals and will be a drag for years to come.”...

As we have seen recently, the stock market is no guarantee of solid returns so now people are supposed to put their savings into Wall Street so they can then borrow money from the government that is doled out by banks so people can go to college? Student loan debt is even more troublesome than mortgage debt because there is absolutely no walking away from it. Plus, you have for profit colleges that in many cases are equivalent to paper mills and prey on lower income Americans. Does that sound familiar (i.e., subprime)?

4--Quantitative Easing and the Iron Law of Equilibrium, John P. Hussman, Ph.D, Hussman funds

Excerpt: As I noted last week, an understanding of equilibrium is particularly important when it comes to the Federal Reserve's program of Quantitative Easing (QE), so some further discussion may be helpful.

Essentially, QE has added to what will soon be $2.4 trillion of non-interest bearing cash and bank reserves, which someone will have to hold. The first effect of QE is therefore to immediately drive the interest rate on near-substitutes of cash (such as 1-month and 3-month T-bills) to nearly zero. This happens because any significant positive interest rate would induce people to try to shift their holdings from non-interest bearing cash to T-bills, and they bid up T-bills to the point where they are indifferent between the two. In the end, all the T-bills that have been issued are held, and all the cash is held (if interest rates could not be pressed lower, the competition between interest-bearing stores of wealth and zero-interest cash would make cash a "hot potato," causing it to rapidly lose value relative to goods, services, and everything else, which is what we call inflation).

Technically, the Fed is buying Treasury securities and creating currency and bank reserves to pay for them. This would simply be an asset swap were it not for the fact that the U.S. is running a budget deficit of about 10% of GDP, so the Fed's purchases don't even absorb the amount of newly issued Treasury debt. The government budget constraint is simple: spending = taxes, plus the change in Treasury securities held by the public, plus the change in Treasury securities held by the Fed (base money creation). So the overall effect of QE is to reduce the amount of debt that the public would otherwise have to buy, and to instead create money and bank reserves to indirectly finance government spending.

The main effect of QE on the financial markets has little to do with stimulating spending, and everything to do with the fact that the currency and bank reserves bear zero interest, and yet have to be held by someone. In equilibrium, QE requires that the interest rates on near-cash securities must also be nearly zero.

Of course, a similar process happens for riskier and longer-term assets, but the resulting returns are less exact. For stocks, we've seen investors drive prices up to the point where probable 10-year returns are only about 3.2%. But of course, you can get a 3.2% 10-year return by having zero returns for 1-year, and returns averaging about 3.6% for the next 9 years. So depending on the overall profile of returns expected by investors, it's quite possible that near term stock returns have already been driven to zero on a risk and maturity-adjusted basis. The key point, in any event, is that the primary function of QE is to distort market equilibrium by raising the price and depressing the future prospective returns on nearly every asset class.

If you look at the commodity markets, the same factors are at play. Regardless of whether one expects modest or significant inflation, it's clear that the inflation expectations of the market are generally positive. So people expect that a year or two from now, goods and services will be more expensive. But if they are holding cash or money market securities, it is clear that interest earnings will not make up for those higher prices. So what do people predictably do? They hoard commodities now. When does it stop? At the point where commodities are priced high enough that they are expected to have the same negative return, relative to a broad basket of consumer goods, as cash is expected to have....

It is widely believed that the rise in commodity prices reflects the effects of China, India and other developing countries, but this long-term growth story certainly didn't prevent commodities from collapsing in 2008. It's a well-known result in resource economics that even when a resource is exhaustible and in significant demand, the price does not rise at a spectacular rate. Rather, except when there are new shocks that were previously unanticipated, the price of an exhaustible resource will tend to increase at roughly the rate of interest (Hotelling's rule).

Certainly, concerns in Libya and elsewhere are creating some additional short-term pressures, but it should be clear that the primary force behind the rise in commodity prices is that QE has suppressed real interest rates to negative levels. If anything, QE is one of the primary forces driving up food and energy prices globally, contributing to extreme difficulty among the impoverished of the world, and adding to social tensions and resulting violence.

5--Why The Street’s Euphoric Birthday Has Almost Nothing to Do with a Buoyant Economy, Robert Reich's blog

Excerpt: What a difference two years makes. On March 9, 2009 the Dow Jones Industrial Average hit the bottom — closing at a 12-year low of 6,547. Today the Dow is soaring well over 12,000.

From its peak in October, 2007 until its trough two years ago, the stock market lost almost $8 trillion in value. That value hasn’t been completely restored but the Street is well on the way.

Some say the Street’s buoyant revival should pull the rest of the economy with it. But this is hardly a buoyant recovery.

In theory, at least, the extraordinary bull market should be making Americans feel far wealthier than they felt two years ago. So they should be spending far more, and that spending should be fueling far more job growth than it is.

Why hasn’t it happened? In reality, the vast majority of Americans don’t feel wealthier because they hold few if any shares of stock. In fact most feel poorer because their major asset is their homes – now worth 20 to 40 percent less than they were worth in 2007 (and there’s no sign of a rebound in housing).

The Street’s bull market over the last two years has seriously enriched only the wealthiest 5 percent of Americans who hold the lion’s share of stock. While their earned income starts at $210,000, their unearned income – dividends and capital gains — now puts them considerably above that.

Shouldn’t the shopping of the top 5 percent spur lots of new jobs? Not really. While the top 5 percent are spending more, they’re not spending all that much as a proportion of their earnings. The rich sock away a bigger share of their income than everyone else. After all, being rich means you already have most of what you want.

Moody’s Analytics estimates that the shopping of America’s richest 5 percent now accounts for 35.5 percent of all U.S. consumer spending. Just think how much more spending would be going on — and jobs thereby created — if more Americans shared in Wall Street’s gains.

The remaining 95 percent of Americans are still holding back from the malls because they’re worried about their jobs, their falling wages, their higher health-care deductibles, and their dropping home values. And as long as they continue to hold back, this recovery will be painfully slow.

6--BofA Segregates Almost Half of its Mortgages Into ‘Bad Bank’, Bloomberg

Excerpt: Bank of America Corp. (BAC), the biggest U.S. lender by assets, is segregating almost half its 13.9 million mortgages into a “bad” bank comprised of its riskiest and worst-performing “legacy” loans, said Terry Laughlin, who is running the new unit.

“We are creating a classic good bank, bad bank structure,” Laughlin told investors at a meeting in New York today. He was promoted last month to manage the costs of resolving disputes stemming from the company’s 2008 purchase of Countrywide Financial Corp. “We’re going to get after this, we’re going to do it the right way and we’re going to put it to bed in the next 36 months,” he said.

The legacy portfolio will hold 6.7 million loans with outstanding principal balance of about $1 trillion, according to a presentation to investors today. The split leaves home loan President Barbara Desoer with about half her previous portfolio, as well as new lending going forward.

Laughlin’s portfolio will include loans that are currently 60 or more days delinquent as well as riskier types of loans the bank no longer originates, such as subprime, Alt-A, interest- only and option adjustable-rate mortgages, he said. He said the portfolios will be completely split by March 31 and that his will be liquidated over time. Of the 13.9 million loans Bank of America services, about 3.5 million are held by the company on its balance sheet. The rest are owned by other investors.

7--Government Shutdown Opposed by Americans in Poll Faulting Republican Cuts, Bloomberg

Excerpt: Americans are sending a message to congressional Republicans: Don’t shut down the federal government or slash spending on popular programs.

Almost 8 in 10 people say Republicans and Democrats should reach a compromise on a plan to reduce the federal budget deficit to keep the government running, a Bloomberg National Poll shows. At the same time, lopsided margins oppose cuts to Medicare, education, environmental protection, medical research and community-renewal programs.

While Americans say it’s important to improve the government’s fiscal situation, among the few deficit-reducing moves they back are cutting foreign aid, pulling U.S. troops out of Afghanistan and Iraq, and repealing the Bush-era tax cuts for households earning more than $250,000 a year.

The results of the March 4-7 poll underscore the hazards confronting Republicans, as well as President Barack Obama and Democrats, as they face a showdown over funding the government and seek a broader deficit-reduction plan.

8-- The End of QE2, The Big Picture

Excerpt: In March 2009, the S&P was down 55%, sentiment panic levels were at extremes, Valuations were fairly reasonable. Into this environment, the Fed launched a massive liquidity program designed to reliquify the frozen credit markets and recapitalize the financial sector.

You may be noticing a pattern: The Fed throws a lot of firepower at a problem, often when sentiment is at an extreme. What starts out as an extraordinary emergency situation morphs into ordinary policy. This is consistent with many Central Bank interventions over time. Not only are the bankers susceptible to the emotions of the crowd, they seem to ignore, surprisingly, Behavioral Economics.

Central Bankers appear to be ruled more by fear than logic.

Hence, our present situation. Following the implementation of ZIRP, QE1, and now QE2, it appears the political will for further intervention is fading. Opponents of the policy are no longer lone voices. QE2 is very likely to end without a QE3 right behind it.

The first impact of the end of QE/ZIRP will be a rise in the US Dollar versus a basket of currencies. Some people have pointed out that the Yen never suffered during Japan’s multi-decade ZIRP policy. But Japan is a major exporter, and buyers of Japanese good must buy Yen to purchase Japanese goods. Perhaps their trade surplus helps explain why the Yen has not been pressured as the dollar was.

The Fed liquidity bid under the market will disappear. That does not mean markets will head straight down; to the contrary, other factors — earnings, contrary sentiment, short squeezes, mutual fund inflows — have the potential to keep markets afloat longer than most everyone expects.

While many people are looking for an equity collapse post QE, I wabt to suggest we widen our focus, and consider the action in Bonds and Commodities post-QE:

• Bonds: The Fed has already bought $400B of their $600B in Bonds. When that bid goes away — or if the Fed begins to reduce their balance sheet and unload these holdings, what will that do to bond prices? We should expect to see a gradual rise in interest rates, with the 30 year climbing over 5% and the 10 year breaking out over 4.25%.

• Gold: Having little industrial value — its worth is what someone else is willing to pay for it — Gold may be the most vulnerable of commodities to the end of QE.Consider that the current secular bull market for gold began under Greenspan’s rate cutting regime back in 2001. His inflationary 1% Fed rates started the entire super cycle of commodities.

• Agricultural Commodities: Its not just the weak dollar. AG has currently run up on poor crops due to drought/floods, burgeoning Asian demand, and some speculation as well.

• Oil: The Middle East is the wild card, and it makes it difficult to assess what price action could occur if the Dollar strengthens. One thing is certain: The easy speculative money has already been made. Things become much more challenging for Oil traders.

While I do not discount the probability of a significant market correction — I figure 25% peak to trough when this bull has run its course — once the Fed’s liquidity begins to drain, other asset classes will be juts as affected as equities — if not more.

9--Synthetic junk, FT Alphaville

Excerpt: Here’s an interesting Wednesday story from the Financial Times’ Aline van Duyn.

It concerns growing demand for a synthetic product — this time linked to junk, or high-yield, bonds. The market size of the product (which is tranched and linked to Markit’s CDX index) is still relatively small. But demand for actual junk bonds has been strong recently — with average junk prices even hitting par value during 2010.

So why the need for a synthetic product? Here’s the FT:

The move into junk bond derivatives also reflects the plunge in yields on actual bonds to record lows. “With the Federal Reserve providing liquidity, default rates low and yields falling, the synthetic market is a way to increase returns,” said a derivatives trader at another US bank. “Investors are looking to take credit risk.”

A search for yield, leading to financial innovation. Sound familiar?

We’re gonna call it irrational exuberance, the sequel....

10--Slowing China, Barry Eichengreen, Project Syndicate

Excerpt: China has been able to grow so rapidly by shifting large numbers of underemployed workers from agriculture to manufacturing. It has an extraordinarily high investment rate, on the order of 45% of GDP. And it has stimulated export demand by maintaining what is, by any measure, an undervalued currency.

But, in response to foreign and domestic pressure, China will have to rebalance its economy, placing less weight on manufacturing and exports and more on services and domestic spending. At some point Chinese workers will start demanding higher wages and shorter workweeks. More consumption will mean less investment. All of this implies slower growth....

There is no iron law of slowdowns, of course. Not all fast-growing countries slow when they reach the same per capita income levels. And slowdowns come sooner in countries with a high ratio of elderly people to active labor-force participants, which is increasingly the case in China, owing to increased life expectancy and the one-child policy implemented in the 1970’s.

Slowdowns are also more likely in countries where the manufacturing sector’s share of employment exceeds 20%, since it then becomes necessary to shift workers into services, where productivity growth is slower. This, too, is now China’s situation, reflecting past success in expanding its manufacturing base.

Most strikingly, slowdowns come earlier in economies with undervalued currencies. One reason is that countries relying on undervalued exchange rates are more vulnerable to external shocks. Moreover, while currency undervaluation may work well as a mechanism for boosting growth in the early stages of development, when a country relies on shifting its labor force from agriculture to assembly-based manufacturing, it may work less well later, when growth becomes more innovation-intensive.

Finally, maintenance of an undervalued currency may cause imbalances and excesses in export-oriented manufacturing to build up, as happened in Korea in the 1990’s, and through that channel make a growth deceleration more likely.

For all these reasons, a significant slowdown in Chinese growth is imminent. The question is whether the world is ready, and whether other countries following in China’s footsteps will step up and provide the world with the economic dynamism for which we have come to depend on the People’s Republic.

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