Saturday, March 21, 2009

The Week In Review

As next week's news is likely to be consumed by Geithner's redesign of the TALF, it is useful to summarize the events of the prior week. An overview of the ten most notable events that have occurred, compliments of BofA:

1) Fed’s moves impact Treasury notes and the dollar

The move towards buying Treasuries outright and the sharp expansion in mortgage and agency paper support was indeed very bold action by the Fed. We would expect to soon see the narrow money numbers such as M1 and the monetary base accelerate sharply. The questions have been, and will remain, whether we will see renewed credit growth, what will happen to money velocity and whether the ratio of non-liquid assets to total assets will begin to rise in the commercial banking sector.

The only obvious impact from the Fed’s intervention is on Treasury notes since that is what the central bank is actively purchasing, and on the dollar, since the growth in the money supply can be expected to accelerate – though keep in mind that other central banks are also pursuing aggressive policies so it is unclear how long the dollar bear market will really last. But since commodities and gold are priced in dollars, and because reflation expectations can be expected to be on the front burner, basic materials should also be beneficiaries.

The real aim of the Fed here was to drag down the entire yield curve out to 10-years, in our view, and this in turn will help ease debt-service strains for households and businesses as they roll over their obligations. Mortgage rates, in particular, should come way down and we anticipate could well touch historic lows of 4-1/2%. Refinancing risks should also be alleviated somewhat for corporates, at least at the margin.

2) Fed is not buying equities and not buying real estate

But beyond Treasuries, mortgages, the dollar, commodities and gold, we do not see much in the way of lingering benefits for equities or for corporate bonds outside of, say, tertiary or secondary impacts. We believe the fact that the Fed is going this far is testament to the view that the plethora of other policies thus far have fallen short. We do not feel that the contours of the business cycle, primarily the timing of the end of the recession, are going to hinge on the Fed’s move any more than was the case in Japan.

The Fed’s actions, while helping to achieve lower interest costs and perhaps unclog the arteries in the mortgage and asset-backed market, do not address the reality of corporate earnings declining again this year to an estimated $40 (on operating EPS). The Fed is not buying equities. The actions will do little to bring the unsold new housing inventory down from its record high 13.3 months’ supply, so despite the cash-flow benefits from a refinancing standpoint, we do not see the demand side being strong enough to bring this inventory below 8 months any time soon and until that happens, we believe home prices will continue to deflate.
The Fed is not buying real estate.

It was interesting to see the tepid reaction in the corporate bond market after the Fed announcement. Then again, the Fed is not buying investment grade or highyield corporate bonds, either.

3) Not obvious that demand for borrowing will be there

While the Fed can do all it can to put the financial system into a situation where it is able to extend credit again, it is not at all obvious to us that the demand for borrowing is going to be there as households in particular continue to focus their attention on climbing out of their record debt burdens. By the time the fourth quarter had rolled around, the Fed and the Treasury had already expended plenty of resources to rekindle the credit cycle, including the central bank move to cut rates to 0% effectively – and even with that effort, households cut their liabilities by over $300 billion, or at over an 8% annual rate. This marked the second time
in the past three quarters that the household sector moved, on net, to reduce their overall indebtedness, and for the first time ever, household liabilities have contracted on a year-to-year basis. This is what happens in a deleveraging phase, and it is highly deflationary and as we saw in Japan, requires time and massive doses of fiscal and monetary stimulus to even partially offset.

4) Fed policy does not operate in a vacuum

What many pundits seem to be missing is that Fed policy does not operate in a vacuum. The Fed is responding to what we can only refer to as severe trauma on the US household balance sheet. The aggregate loss in household wealth is an eye-popping $12.9tn (and now roughly up to $20 trillion in 1Q): This constitutes a 20% decline in household wealth since the peak was put in back in mid-2007. Wealth destruction of this magnitude is unprecedented since the Great Depression. At the rate it is going, the personal savings rate could be north of 10% within a year – that is a hugely deflationary event unless personal incomes are somehow shored up at the same time (though this is much more effectively addressed via fiscal policy). Yes, indeed, the Fed’s balance sheet and the balance sheet of the federal government are both expanding at record rates. That is what makes the headlines and that is what analysts, strategists and economists will be consumed with today – the latest operation technique by the surgeons.
But the reality is that patient is still in sickbay.

These massive reflationary efforts should be seen, in our view, as a partial antidote, not a panacea, to the deflationary effects brought on from the unprecedented contraction in the largest balance sheet on the planet: The $55 trillion US household balance sheet. Based on what house prices and equity valuation have been doing this quarter, we are likely in for a total loss of household net worth approximating $7 trillion this quarter alone, which would bring the cumulate decline in consumer wealth to $20 trillion. This wealth loss exceeds the combined expansion of the Fed’s and government balance sheet by a factor of more than five, which should put the reflation-deflation debate into perspective.

5) Overall inflation still heading lower

Overall CPI rose by a higher than expected 0.4% M/M in February led by 3.3% gain in energy prices (gas prices were the key culprit, up 8.3% M/M). Energy added 0.2 ppt to the headline. Core CPI was up 0.2% over the month with persistent increases in several core goods categories including apparel 1.3%, new cars 0.8%, tobacco 0.7% and drug prices 0.6% M/M.

Both apparel and car prices are likely to reverse in upcoming months as retailers continue aggressive discounting tactics to lure customers given the depressed state of demand. Higher tobacco prices continue to reflect higher state and local tax increases as governments attempt to capture higher revenues. Higher wholesale prices for tobacco products are also likely a factor. Elsewhere, core service prices eased (up 0.1% M/M) with a similar increase in owners equivalent rent. Higher medical care services (0.3%) and tuition (0.5%) costs were partially offset by declines in hotels (-1.8%) and airfares (-2.1%) – declines in these latter two
categories are clearly reflecting the falloff in demand and resulting easier pricing.

Relative to year-ago levels, overall CPI rose 0.2% versus a flat reading in January. We anticipate that by 2Q the headline will begin to head into negative Y/Y terrain and that by 3Q we could be looking at declines of 3.0%. Easy and significant year-ago comparisons for energy are a key driver in falling headline prices. Ore prices, up 1.8% Y/Y in February versus 1.7% in January, are also expected to ease toward sub-1% by 3Q with more competitive pricing for a broad array of consumer categories at its back.

6) Broad-based declines in output; new lows in utilization

We saw a 1.4% slide in industrial production in February, and how broadly based the declines were. The level of the index, at 99.7, is at its lowest since April 2002. Over the past six months, production has sunk at a 17.6% annual rate – underscoring how the pain has spread from the homebuilders to the consumers and now to the manufacturers. Tech production was cut 3.4% last month and has fallen now for seven months in a row, a losing streak not seen since the 2001 “wreck”. But the YoY trend has sunk to -13.8% and this took out the -12.8% low
posted in the last cycle when tech was the major culprit behind the recession, not an innocent bystander as is the case today. Note that the widening in the supplydemand gap is global and underscored by the reversal in the price of steel – which had rebounded in the aftermath of the Chinese fiscal stimulus plan to $490/ton in February from $360 in November but has since declined back to $415.

Manufacturing capacity utilization rates fell to a new all-time low of 67.3% from 67.8% in January and 69.7% in December. These are highly deflationary numbers. Much of the excess capacity is for finished product – 61.6% for machinery, 60.2% for tech, 49.1% for wood products, 68.2% for fabricated metal products, 43.6% for motor vehicles. But look at the resource sector – CAPU rates are holding up rather well: 88.2% in mining, and 88.3% in the energy patch, as examples.

7) ISM manufacturing index heading lower in March

The Philly Fed manufacturing index came in markedly better than expectations at -35.0 in March versus -41.3 in February (the market was braced for -39). Still, at this level, activity in the region contracted at a rapid pace with ongoing declines in practically every component. The leading new orders index plunged 10.4 points over the month to -40.7, suggesting that bigger declines in shipments and production lie ahead. Further supporting an ongoing recession was a record low in capex spending intentions over the next six months. And look at prices received – still flirting near record deflation lows of -32.6 (second lowest ever!) – and prices-paid at -31.3, which indeed was a record low. Together with the new lows reported in the March NY Empire survey, the national ISM index is expected to decline from the 35.8 print we saw in February.

8) Weather could be factor in housing starts jump

Builders broke ground on 583,000 homes in February, above consensus and Banc of America Securities-Merrill Lynch expectations. We do not see this as a positive factor for the housing market given the massive 6 million unoccupied homes for sale or rent that still need to be absorbed by the market. Weather may have played a role in boosting homebuilding activity. Rainfall was significantly lower than normal in February and national temperatures were a bit warmer as well, although only 1/2 a standard deviation above normal. It was multi-family
units that were the main driver of the upside surprise, posting 226,000 units started in February, up by more than 100,000 from January’s activity. Single family starts were a more moderate 357,000, about even with January’s pace. Building permits also rose in February to 547,000 (3.0% m/m), with multi-family up by 6.6% and single down by 11.0%.

Homes completed rose to 785,000 in February, a 2.3% rise from January. Single family
completions were 505,000, an 8.2% drop from January. Still, this is about 200,000 above the current pace of sales; therefore, we expect months’ supply to remain near a multi-decade high of 13.3 months in February.

9) Current account narrows for second straight quarter

The current account deficit narrowed from $181.3 billion (revised from $174.1 billion) in the third quarter to $132.8 billion in the fourth quarter. The actual current account deficit came in below the median of analysts’ projections of $137.1 billion. The BAS-ML estimate was for a deficit of $130 billion. Between the third and fourth quarters, the current account deficit improved a record $48.5 billion dollars. Versus the third quarter current account deficit to GDP share of 5.03%, the fourth quarter deficit was 3.74% of GDP. Looking ahead, we anticipate the current account is likely to continue its sharp narrowing path as the slowdown in exports exceeds the decline in imports. After posting a current account deficit of $673 billion in 2008 (4.7% of GDP), we expect the deficit to narrow to about $250 billion (or 1.8% of GDP) in 2009.
The deficit on goods and services fell $40.5 billion, to $140.4 billion in the fourth quarter. The deficit on goods decreased $42.2 billion, to $174.1 billion while the surplus on services fell $1.7 billion, to $33.7 billion. The surplus on income increased from $29.6 billion in the third quarter to $36.5 billion in the fourth quarter. Income receipts on US-owned assets abroad fell $25.7 billion, to $165.9 billion as direct investment receipts and other private receipts (dividends and
interest payments) fell. Income payments on foreign-owned assets in the US declined $32.6 billion, to $130.2 billion as direct investment payments and other private payments fell. Net transfers to foreigners were $28.9 billion in the fourth quarter, down from $30 billion in the third quarter.

10) We remain bullish on gold

We were bullish on gold before the Fed’s latest balance sheet maneuver, and we remain bullish thereafter: Bullion is a traditional hedge against uncertainty – financial, economic, and geopolitical. See below for more evidence of such uncertainty:

“Mexico Issues Tariff List In U.S. Trucking Dispute” (WSJ, March 19th, 2009).
“Australian Panel Rejects $529.5 Million Coal Merger (WSJ, March 19th, 2009).
“Beijing Rejects Coke’s Juice Deal” (WSJ, March 19th, 2009).
“Europe Warned to Unite Or Risk Being Last to Exit Recession” (FT, March 19th, 2009).
“Export Fall Hits China Growth Forecast” (FT, March 19th, 2009).
“Increases in Cash Hoards Prompt Fears of Stifling Economy” (FT, March 19th, 2009).
“Downturn Heightens China-India Tension on Trade” (WSJ, March 20th, 2009)

If gold is positively correlated with fear, we don’t expect this bull market in bullion
to subside anytime soon. Sphere: Related Content
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Anonymous said...

Gold is related to inflation. Did you see what happened to the rest of the commodity complex when they made this move?

RPB said...

What if the growth of credit has a geometric relationship with the growth of the monetary base? What type of inflation does that set up? Have we not already seen this sort of relationship over the last 10 years? The relationship must be re-examined before we start growing M1 so dramatically.