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April 29, 2005

JUNK SALE

If the high-yield bond market is the fixed-income equivalent of the fat lady singing, the diva appears to be yodeling. Just what she's saying, and what it means for the markets is debatable, but there's no doubt that there's a whole lot of singing going on.

The yield on the KDP High Yield Daily Index has risen sharply over the last month. As of yesterday, this measure of yield for low-grade bonds touched 7.67%, the highest since June 2004. It was only in early March that the index was yielding around 6.5%--more or less the lowest in a generation.

A lot can change in a month, as suggested by the longest sustained rise in junk yields in nearly a year. Is this so-called early warning sign a reliable indicator of things to come in the price of money? Or is the lady singing for reasons that have little to do with the wider world beyond junk?

One reason for pausing before answering comes from the signals in the far-more influential 10-year Treasury Note, which is showing no comparable signs of stress of late. The benchmark government bond yields around 4.2%, and has been falling for much of the past month after reaching roughly 4.65% in late March.

In the wake of yesterday's weaker-than-expected report on economic growth, it's hardly a shock to learn that traders of government debt are in no rush to dump the securities. The slowdown implied by the first quarter GDP rise of 3.1%, down from 3.8% in the fourth quarter, is giving new life to the notion that Treasuries are again worth buying. The rationale is that interest rates will cease rising, if not start falling again, in the face of a slowing economy. Of course, that assumes that the Fed will ignore the growing inflation signals. But we digress.

In any case, who's about to argue against the idea that the economy's set to further slow? Certainly not the oil market, at least not today. A barrel of crude closed below $50 in New York today for the first time since February. The implication: marginal demand growth for energy is cooling, and that is easily reversed engineered to conclude that the economy's slowing.

If that's the accepted wisdom, is the junk market in agreement? Hard to say, although this is clear: junk yields are rising on a relative as well as absolute basis. The spread in high-yield debt over the 10-year Treasury is nearly 360 basis points, the highest since May 2004.

Is the divergence significant, or just an anomaly? Only time will tell, but in the meantime some pundits are reminding of the lessons imparted by history when it comes to junk yields. "Historically, the debt market, especially the high-yield market, has frequently served as an early warning signal for broader weakness in the capital markets," Dun Yin, an analyst with high-yield-oriented broker/dealer CRT Capital Group, tells AP via BusinessWeek.

But hold on a minute. We learned today from the government that Joe Sixpack spent more in March than economists expected. What's more, Joe earned more than the dismal science predicted. Certainly that takes off a bit of the gloom imparted in yesterday's GDP report. What's more, the personal spending and earnings news helped light a small fire on Wall Street, pushing the S&P 500 up by more than a percent.

So where does junk fit into all this? Maybe nowhere. It's possible that the high yield market's adjusting to ills of its own making. One economist who follows junk says the recent back-up in yields reflects trends specific to the market. "The recent corporate spread widening was precipitated by a handful of company-specific problems,'' Dana Saporta, an economist at Stone & McCarthy Research, recently wrote in a report, according to Bloomberg News.

Indeed, some news stories circulating note that the presumed ongoing decline in the credit status of GM (it's currently just one notch above junk) and other companies will soon dump an excess supply of low-grade debt on the market. That threat, runs the logic, is pushing down prices (and yields up) in anticipation of the future supply rush. "Profit warnings from the world's top two auto groups, General Motors and Ford, have cast a pall over the high-yield credit markets," says Jeremy Field of Credit Suisse in London, according to a recent story in the International Herald Tribune. "Both companies are teetering on the edge of investment grade, and investors are justifiably concerned about the impact of over $200 billion in debt entering the high-yield market. A blow-up in the auto sector will not just affect dollar bonds; it will reverberate across every credit market and currency."

Junk bond investors are already feeling the reverberations, whatever the ultimate source. High-yield bond funds have reported net outflows of nearly $1 billion in the two weeks through April 27, reports AMG Data Services. That follows $4.3 billion of outflows from the sector in March.

But one veteran junk-bond watcher, Martin Fridson, who publishes Leverage World, dismisses this notion that this is all about anxieties over a coming supply wave. "Investors are overstating the potential impact of a GM downgrade," he advised in a recent newsletter, AP reports. "Fears of the high-yield market being crushed by new supply of fallen-angel debt are not justified."

Perhaps, but we'll still be keeping a close eye on GM and Ford in the weeks ahead for any clues about which way the wind's blowing, and which song the fat lady's singing.

Posted by jp at 9:27 PM | Comments (0)

April 28, 2005

THE SCIENCE WAS A BIT MORE DISMAL TODAY

The economy expanded at its slowest pace in two years in the first quarter, the government reported today, handing pessimists one more piece of ammunition for claiming that a slowdown is upon us.

Economists were generally expecting a real annualized rise in first-quarter gross domestic product (GDP) of around 3.5%. Instead, the number came in at 3.1%, the Bureau of Economic Analysis advised. That's a long way from the 3.8% logged in the fourth quarter.

For those intent on seeing the glass still half full rather than half empty there was this tidbit: the all-important personal consumption expenditures (PCE) fared slightly better, rising 3.5%. That's down from 4.2% in the fourth quarter, but the fact that PCE's still advancing above GDP’s pace keeps hope alive that Joe Sixpack hasn't written off trips to Wal-Mart and Home Depot just yet.

Meanwhile, the oil market extracted the obvious conclusion from the GDP number early on in today’s trading session. For a time, a barrel of crude changed hands for under $50. Oil prices rebounded later on, but the message remained clear: the threat of decelerating economic growth in the world’s leading consumer of oil has the potential to take the wind out of the energy’s market sails.

But like radiation treatment for cancer and carpet bombing, a slowdown is a blunt instrument for cooling off the high-flying oil market. Blunt maybe, but effective nonetheless. And who says the patient has to die in the process? Not Eric Green, a money manager with Penn Capital Management who spoke with Bloomberg News. “We were bound to slow down, but the outlook for the market looks good,” he reasons. Perhaps, but the stock market seems to think otherwise, considering the S&P 500’s sharp fall today in the wake of the GDP report. Yet Green dismisses today’s market action as “overreaction,” explaining that an economy that’s still growing above 3% gives the bulls incentive to keep buying.

In a perfect world, a slowing economy will bring down the price of oil and yet keep enough momentum going for corporate earnings increases. But is such a sweet spot a reasonable expectation?

Maybe, but it’s going to take more than a day or two to muster confidence on that question. For the moment, the market needs to digest a few additional economics reports to figure out which way the economics winds are blowing. Indeed, the first-quarter GDP casts doubt over the investment outlook. Fresh data in coming weeks will either provide support for the first-quarter snapshot or sow reason for thinking it was less than representative of the morrow.

Hope, in short, doesn’t die quite so easily given the strength of earnings reports in recent quarters. The possibility of one more leg up in stock prices keeps more than a few pundits looking for another rally, or so suggests one analyst looking at the U.S. from an outsider’s perspective in Canada. “You have better than expected earnings, there's a lot of concern about the economy and the Fed is raising rates, albeit slowly so when you look at the price action in the broad market, it seems to want to move higher but it can't,” John Johnston, chief strategist at The Harbor Group at RBC Dominion Securities, tells
CBC News.

Can’t or won’t? It’s worth noting that today’s GDP report also reveals that business spending slowed sharply to 4.7% in the first quarter from a blistering 14.5% rate in last year’s fourth quarter. And then there’s the price deflator gauge, a measure of inflation, which accelerated to 3.2% from 2.3%.

Hmmm, slowing business spending, a consumer showing signs of a bit more shopping fatigue, oil prices that remain defiantly over $50 a barrel, and one more indication that inflation’s continuing to inch higher add up to a mix that broadcasts something less than confidence on Wall Street. Looks like the stagflation scare, real or imagined, still has legs.

With that cue, all eyes now turn the Federal Reserve’s interest-rate decision next week. Take it away, Alan.

Posted by jp at 10:44 PM | Comments (1)

April 27, 2005

DURABILITY TEST

One freshly published number in the dismal science can mean a lot these days when it comes moving investor sentiment. The case du jour comes to us from The U.S. Census Bureau, which reported this morning that durable goods orders posted an unexpected March decline—and a sharp decline at that.

New orders for manufactured durable items, which are defined as pricey goods that are made to last several years or more, dropped 2.8% last month. That's the steepest slump since September 2002. Transportation equipment was the big loser. In fact, transportation-related orders have been descended now for four months in a row.

Transportation equipment orders are an economically sensitive group, and volatile too, and so economists like to remove them from the mix to assess trend. Alas, even after this adjustment there was still a fair amount of red ink left on the table. In fact, durable goods-ex transport fell by 1.0% in March, the most since last October.

Does this mean the economy's slowing? The bond market was only too quick to make that conclusion. The yield on the 10-year Treasury Note slipped today, falling to 4.23%.

But the stock market wasn't quite so sure. The S&P 500 rose a bit today, effectively shrugging off the news in durable goods. Or was the modest equity rally more of a sigh of relief in seeing oil prices fall?

In any case, as troubling as today's durable goods number appears to be, it's actually worse if you consider that last week's major piece of economic news came in the form of rising consumers prices. Indeed, the CPI index revealed itself to be increasing at an accelerating pace in March: up 0.6%, the fastest since October.

Assume for a minute that today's durable goods order is the definitive sign that economy's slowing. Next, take that assumption and mix it vigorously with last week's inflationary CPI report. What do you get?

Stagflation. Paul Krugman made that argument last week in his New York Times column. And while more than a few pundits took issue with Krugman's analysis, he's found one more reason in today's economic news to stand by his column.

Nonetheless, inflation is not yet of the "runaway" variety nor is the economy anywhere near failing on all cylinders. "To get into a stagflation regime you would have to have inflation expectations unhinged, and we definitely don’t have that,” Sheryl King, senior economist at Merrill Lynch, tells MSNBC.

But if it's too early to say definitively if stagflation's a legitimate threat, neither is it premature to draw up a list of trends that could provide aid and comfort to stagflation's forces. That includes higher energy prices and rising import prices, courtesy of a falling dollar. For a nation with a growing appetite for things foreign, that's not an encouraging sign. Indeed, import prices jumped by 7% for the year through March, or more than double the rate of increase in the government's consumer price index.

Tomorrow's first estimate on the first-quarter GDP from the Commerce Department will play into investors fears, or optimism, depending on what the numbers show. The consensus outlook is for an economy that advanced by 3.5% during January through March, according to TheStreet.com.

GDP reports, on the other hand, are hopelessly lagging indicators. For better or worse, the first-quarter GDP release will be the last major piece of statistical evidence published before the Federal Reserve convenes next Tuesday and debates whether to raise or not to raise the price of money.

Posted by jp at 9:36 PM | Comments (0)

April 26, 2005

THE BUYING GAME

There was no news yesterday at President Bush's ranch in Crawford, Texas, but there was plenty of talk when the head of the world's biggest oil-consuming country chatted with his counterpart from the world's biggest supplier.

After playing host to Prince Abdullah, the working leader of Saudi Arabia, the President explained that "a high oil price will damage markets and he knows that," according to AP via SignOnSanDiego.com. Bush also observed that "one thing is for certain: The price of crude is driving the price of gasoline. The price of crude is up because not only is our economy growing, but economies such as India and China's economies are growing."

Growth, it seems, is a challenge as much as an opportunity to the global economy. Not to worry, though; the Saudis have a plan. What is it? Well, they plan to pump more oil, at first by squeezing their ever-thinning spare capacity down to the nub. In the longer term, they'll invest billions to bring new fields online is the silver bullet. Promises, promises.

In any case, all of this has been widely discussed before the prince set foot in the Lone Star State, but "the plan" nevertheless impressed White House National Security Adviser Stephen Hadley. "Clearly, the news that came out of the meeting today ought to be good news for the markets and we would hope that and other factors would result in some positive news, in terms of the price fronts," Hadley said of the Bush-Abdullah meeting in a briefing to reporters on Monday.

But for all the optimism, there seems to be some disagreement as to whether Saudi Arabia is pumping as much as it could in the spring of 2005. "The problem in the oil markets now is a perception that there is inadequate capacity…" Hadley told said. Meanwhile, Reuters TheStreet.com reports that Prince Abdullah's Foreign Policy Adviser Adel al-Jubeir said that the oil markets are adequately supplied. Someone it seems needs a perception adjustment.

Oil traders, however, are going with the Saudi's viewpoint. Consider that when the nearby oil futures contract closed in New York last week, a barrel of crude changed hands for well over $55. By the end of today's session, the price was roughly $54.

Tomorrow, next month, next year, and beyond, however, is another matter. Indeed, while much of the world, along with Wall Street, is focused on where the price of oil is headed in the short run, strategic thinkers in the energy business are casting their votes on the long haul in the here and now.

The smoking guns can be found in recent decisions of big oil (ChevronTexaco's purchase of Unocal) as well as in the domestic refinery business, as witnessed by Monday's news that Valero Energy Corp. plans to buy oil refiner Premcor Corp.

Valero is already the nation's biggest refiner, and the deal promises to further consolidate Valero's leading presence in the industry. Consolidation and economies of scale, in other words, is the name of the game from here on out.

Indeed, the acquisition news sent the remaining refinery stocks higher on the reasoning that additional takeovers are coming. Shares of Tesoro Corp., for instance, temporarily shot up in the wake of the Valero announcement on Monday before pulling back today.

But for all the bullish anticipation about refinery stocks, there's still skepticism about Valero's decision to buy Premcor. The Street, as if you needed another reminder, still isn't sure about the notion of oil as a scarce commodity in the long haul. The Wall Street Journal (subscription required) today suggests as much by pointing out that the string of profits in recent years in running a refinery is temporary and therefore due for a correction a la the 1980s. Jay Saunders, a Deutsche Bank analyst, is quoted as saying that Valero's acquisition of Premcor represents a "significant risk." Why? Valero's paying a 19% premium for Premcor shares.

Indeed, refinery stocks are a recent arrival to the halls of optimism. As recently as 2002, shares of Valero were trading at below book value. No more: the top indy refiner now trades at two-and-a-half-times book.

Risk or not, Saunders still rates Valero a "buy," the Journal notes, suggesting that some on the Street are torn by this energy bull market. Ok, so why the "buy"? Reviewing the nation's refinery capacity of late may yield a clue. Echoing the Saudi output situation, there is little spare capacity at the moment in U.S. refineries. In January, for example, refinery capacity was running at 91.3%; for December 2004, it was 95%, the Energy Department reports.

Ninety-percent-plus capacity is nothing new in the refinery game of late, but it wasn't always so. In the early to mid-1980s, refinery capacity was around 70% for a number of years.

But the economy has since grown, and is growing. The bottom line: demand for gasoline and other refined oil products ascends too. Yet new refineries have become an extinct species, prompting the Energy Department to warn, as it did last year, that surplus U.S. refinery capacity is disappearing. No wonder that gasoline imports have been trending higher. This past January, gasoline imports were running at the equivalent of 803,000 barrels a day, up by a third from a year earlier.

Yes, there are risks to Valero's purchase of Premcor, just as there were risks when Sunoco purchased a large refinery from El Paso Corp. last year. But in a world of rising gasoline demand and dim prospects for building new refineries any time soon, buying is the only game left in town.

Indeed, buying rather than developing seems to be a theme throughout the energy business of late. A number of large oil companies have been buying existing production in addition to developing it from scratch. Why? A clue comes from a Reuters story about declining production at BP.

The dearth of new refineries in the United States is a self-imposed limitation courtesy of NIMBY (not in my backyard) while the reportedly declining opportunities to develop large, new oil fields globally is a byproduct of geological constraint. In either case, the path of least resistance leads to a common conclusion: buy up the competition. In fact, the buying game has only just begun.

But don’t confuse consolidation of refineries with increasing production output. The dwindling number of players is no short cut to increasing supply. Only God can make a tree, and only a new refinery can materially expand gasoline production.

Lower prices from refinery consolidation probably aren't imminent either. Or so Senator Ron Wyden (D-Oregon) tells The Deal today. "We know that concentration of the oil industry is already squeezing consumers at the pump, and this proposed acquisition by Valero of Premcor would create the biggest U.S. refiner and tighter concentration in a number of areas."

Wyden is an outspoken critic of mergers in the refinery business, but does he realize that the government has been instrumental in driving consolidation. As Lynne Kiesling of Knowledge Problem writes today of the Valero/Premcor deal, "I continue to think that this merger pattern is consistent with the fact that environmental regulation has broken apart the economies of scale in petroleum refining, making it more costly, and that the mergers are a way to recapture those economies of scale."

Perhaps when the refinery industry devolves into a true state of oligopoly (if it's not there already), the government will promote the development of the nation's first new, major refinery since 1976. Either that or hand out bicycles. Till then, the refinery stocks are in play.

Posted by jp at 9:26 PM | Comments (0)

April 25, 2005

TURNING OVER ROCKS IN MR. MARKET'S GARDEN

Is the market efficient? Efficiency as in prices reflect all known and relevant market information. By those terms, prices are by definition efficient, which is another way of saying that neither hidden value nor veiled excess lurk in the shadows.

If the market is efficient, then whatever Mr. Market tells us is the start and finish of any investment conversation. One of the ways that Mr. Market talks is by assigning market capitalizations to the various sectors. If the market is truly efficient, then sectors with the largest capitalizations are presumably also the ones with the brighter futures compared with those of lesser values.

But if the market's efficient, would Mr. Market's assessment of the morrow in a given sector differ radically across market-cap spectrums?

The question comes up these days when you peruse the world of large-cap stocks relative to their small-cap brethren. In particular, the S&P 500, representing large caps in one corner, and the S&P 600, a proxy for a cross-section of small companies, in the other.

In the large-cap realm of the S&P 500, the financials industry continues to command the lion's share of the market capitalization. Taking 19.8% of the total S&P 500 market cap, financials enjoy all the hope and faith that Wall Street can muster. Indeed, financials have been at or near the top of the feeding chain for some time. The likes of Citigroup, Bank of America rule the hill here. Never mind that interest rates may go up in the months and years ahead and cut into this sector's bread and butter. That's a distant fear at the moment. Instead, the financial behemoths are presumed to be winners come hell or high water, or so Mr. Market suggests.

But Mr. Market is not of one mind when it comes to financials. Indeed, there's a different perspective over in the small-cap market, where stodgy industrials comfortably lead the market-cap race. Taking an 18.3% share of the S&P 600's market cap, industrials have been the darlings within the small-cap universe. We're talking of names like Oshkosh Truck Corp. and Roper Industries, which manufactures various industrial instruments.

On the surface, the two sector leaders seem to be prudent choices. In both the large-cap financials and small-cap industrials, earnings have been advancing nicely. Yet the big-cap financials have the edge in terms of a lower projected valuation. Based on Standard & Poor's numbers, the expected price-earnings ratio for the financials in the S&P 500 will be 11.3 once 2005 earnings are reported. The comparable p/e for the small-cap industrials will be materially higher at 16.8, based on projected 2005 earnings.

The notion of higher earnings overall is no pie-in-the-sky dream. A survey released today by the National Association for Business Economics gives reason for expecting growth to remain a force for some time in the American economy. “Hiring plans continue to improve, capital spending appears healthy, and profit margins are strong by historical standards," says Jim Meil, chief economist for the Eaton Corp., via NABE's survey. Although there are signs that the pace of growth may be slowing, there are no smoking guns that suggest anything like a recession is imminent, the NABE report suggests.

Economic growth, capital spending, and the like, of course, help boost earnings. As such, it's no wonder that Wall Street expects both large-cap financials and small-cap industrials to report higher earnings by the time the final reports for 2005 go into the history books.

But growth doesn't mete out its benefits in equal doses. In support of that notion, we cite today's report from Richard Berner, a Morgan Stanley economist who's charged with keeping an eye on the United States. "Labor markets have firmed noticeably over the past two years, judging by traditional cyclical metrics such as the unemployment rate and the median duration of unemployment," he writes. "Together with rising inflation, I think tighter labor markets will soon push up nominal compensation growth in time-honored, cyclical fashion."

Meanwhile, a number of economists are saying that when April's payrolls numbers are released early next month, the month will show some progress over March's slim payroll gains of 110,000. Among the numbers being thrown about by dismal scientists is a gain of 175,000 for April. Hardly a roaring economy, if it comes to pass, but neither is it low enough to dismiss Berner's worries.

In a world where economic growth is chugging along, but so too is inflation, it doesn't take much to expect that more interest rate hikes are in the cards. If so, will financials remain the darlings along with industrials?

Already there are reasons to wonder. Although the S&P 500's financials are expected to have the lower p/e relative to the S&P 600's industrials, it is the small-cap industrials that are projected to raise earnings by 25% vs. 8% for big-cap financials. On a relative basis as well, the small-cap industrials seem to have the edge as well: the sector's 25% earnings growth rate predicted for this year is near the top among the S&P 600's sectors. The S&P 500's financials' 8% earnings advance, by contrast, is near the bottom among big-cap projected earnings growth rates.

Mr. Market, once again, will have to prove his efficiency, and dismiss quite a lot of historical baggage in the process.

Posted by jp at 9:48 PM | Comments (0)

April 22, 2005

THE NEW NEW GOLDEN AGE OF OPEC

The House of Representatives has embraced the much-debated energy bill, or as it's known formally in the hallowed halls of Congress, H.R. 6. But don't hold your breath that this creation of politicians will provide delivery into the promised land of energy independence or affordable prices for oil and its byproducts. H.R. 6 is legislation, not divine intervention, and as legislation goes, it leaves more than a few things to be desired.

Sure, the bill opens the door for drilling in the Arctic National Wildlife Refuge (ANWR) in Alaska. If the Senate gives the green light to the legislation—a big "if"--America will have access to oil that was formerly off limits. But how much oil are we talking about? A middle-of-the-road estimate is around 10 billion barrels, according to the Energy Department.

Make no mistake, 10 billion barrels is nothing to sneeze at. What's more, the American economy needs it, to judge by the line of SUVs at the local gas station. Until and if we have a viable, economically reasonable source of alternative fuel arriving on the scene, the United States is looking at an oily future, like it or not.

Meanwhile, conservation warrants a role, and the country needs to do more of it. But let's be clear about the limits of conservation: as a practical matter there are limits, starting on the political and social fronts. Translated, few politicians want to push too hard to compel Joe Sixpack to turn down the thermostat and drive a smaller car. Joe, being an American, is only too happy to go along with Washington's policy of Don't Ask, Keep Driving. Jimmy Carter, you may recall, tried that, and look where it got him. No wonder there's not a lot of politicians running around in cardigan sweaters yelling, "Drive less, turn off the heat, and save America from doom." That's not a message that resonates with the American public. Of course, if and when oil reached $100 a barrel, maybe the resonance would be a bit more compelling.

In any case, saving energy isn't the same thing as producing it. Or, as House Resources Committee Chairman Richard Pombo says, via the San Francisco Chronicle, "We cannot conserve our way out of an empty tank of gas."

Fair enough, but neither can we pump our way out of the current energy challenge with ANWR. The United States is now consuming 20 million barrels a day, if not more. At that rate of consumption, ANWR would be depleted in about a year and a half. In practice, of course, ANWR's supply will take years if not decades to fully deplete because the U.S. has multiple sources of supply.

In fact, it's those multiple sources that are at once the current solution and the long-term burden. A solution because the growing share of foreign imports of oil provide energy that is otherwise lacking in domestic supply; a burden because a variety of geopolitical and geological trends threaten to complicate the business of importing oil as the years go by.

Neil McMahon, the oil analyst in residence in the London office of Sanford C. Bernstein Ltd., puts his rhetorical finger on the core challenge for the global economy in a research note yesterday by wondering where additional global supply will come from in the years ahead. The focus of late has generally been on demand, and how all the usual suspects are sparing no expense to slake their respective oily thirsts. But demand must be met with supply, or so one hopes.

No matter how you slice it, China is front and center on the subject. As it happens, the world's most populous country with an economy to match just happened to report that it's oil imports rose dramatically in March by 23%, according to ChinaView.com.

Who can satisfy a 23% rise in oil demand? The answer, increasingly, is Opec. Non-Opec oil, by contrast, threatens to suffer diminishing status in relative and absolute terms. "Ever since crude prices hit $30/bbl in 2003," writes McMahon and his team, "most have presumed that higher prices would be a sufficient market signal for producers to increase supply and act as the natural mechanism to bring prices lower. However, even now at $50/bbl pricing, all evidence suggests that, outside of OPEC and the FSU [former Soviet Union], no supply response from the oil industry heartlands has been forthcoming."

McMahon charges that the International Energy Agency and others have been "overestimating the supply response to oil prices above $40/bbl…." In fact, the IEA may be on track to overestimate to the tune of 500,000 barrels a day, or about half of the expected growth in global supply for 2005.

The problem is that bringing large quantities of new, non-Opec supply on line is difficult and expensive. It also takes time. Exactly how much and how soon, if every, any new, non-Opec supply will find its way into the economies of consuming nations is debatable. But for the moment there's full transparency in the fact that this silver bullet isn't forthcoming. Even high prices don't seem to coaxing non-Opec supply increases, Bernstein observes. Even at $50 a barrel, non-Opec supply increases (excluding the former Soviet Union) are notable by their absence. What's more, that's atypical. In the past, high prices have brought new non-Opec supply on line. This time around, nada. Based on the past dozen years of oil history, the current absence of new non-Opec supply hikes "marks a distinct departure from historic price/supply relationships."

That leaves Opec in the driver's seat, a status that's geologically preordained for the cartel. But even Opec won't be able to flip a switch and materially raise output any time soon. In support of that fact, Saudi Arabia, which claims the world's biggest oil reserves and the most spare capacity at the moment, has announced plans to double its investment in energy development in the next five years to $50 billion, according to the Wall Street Journal (subscription required).

Indeed, the game has changed for Saudi Arabia in that the kingdom has scrapped the illusion of sticking to Opec's oil production quotas. Rather, the new rule is sell every barrel of oil that you can get your hands on. The age of subtlety in oil diplomacy is over.
Let's call it the fallout from the realization that Saudi Arabia's current production ceiling, said to be around 11 million barrels a day, will be woefully insufficient in just a few years, if it isn't already.

Meanwhile, inquiring minds want to know what $50 billion of new investment will buy in the way of increased output from the kingdom. The Journal cites no less an authority than Ali Naimi, Saudi Arabia's oil minister, who projects that his country's production will rise to 12.5 million barrels a day by 2009, or about 25% higher than current levels.

But 2009 is a long way off, all the more so when you learn that China's on track to import the equivalent of an entire ANWR in 15 years at the most.

Perhaps the Chinese economy will slow, and give the world's oil producers time to catch up. Then again, perhaps not. China's GDP expanded at an unexpectedly strong 9.5% in the first quarter. To quote Agence France-Presse via Taiwan News, "China's runaway economy showed no signs of slowing in the first quarter…."

Posted by jp at 9:03 PM | Comments (0)

April 21, 2005

THE DECLINE & FALL OF JOBLESS CLAIMS

The Labor Department this morning delivered another wake-up call to the Federal Reserve regarding its still-negative real (inflation-adjusted) Fed funds rate. The buzzer sounded with the release of the weekly report on initial jobless claims, a widely followed number for gauging economic momentum, or lack thereof.

Today, it was all about momentum, however: upward and onward. The consensus forecast for initial jobless claims was 329,000, but the economy offered 296,000 instead. The magnitude of the better-than-expected news on the number of folks filling for jobless claims last week could hardly be more stark relative to recent history. Indeed, last week's 296,000 is tied with an earlier report issued in February as the lowest weekly number since late-2000.

One weekly gauge of unemployment claims doesn't say much, of course, although it speaks a little louder coming a day after the higher-than-expected rise in consumer prices for March. What's more, this morning's jobless claims number is the third consecutive weekly drop.

Ah, but there's the ever-present mitigating circumstance, which in this case is reportedly "seasonal adjustment issues" connected with the Easter holiday. Nevertheless, it's hard to spin today's jobless claims number as something other than another piece of evidence that the economy's still expanding.

"The report indicates that the economy continues to grow at a solid pace, but this is contradicted by other data," Tony Crescenzi, chief bond market strategist at Miller Tabak, explains in MarketWatch.com.

But the stock market wasn't focused on "other data" today. The S&P 500 took wing, climbing roughly 2% on the day. The bond market was apparently reading from the same script, albeit with a different though hardly unexpected result. The 10-year Treasury Note sold off sharply, elevating the 10-year's yield up above 4.3% for the first time in more than a week.

Does all of this suggest that the Federal Reserve will hike interest rates again when the Federal Open Market Committee meets again on May 3? Only if you ignore the "other data" that Crescenzi refers to, starting with the release today of the so-called leading economic indicator (LEI), which fell by 0.4% in March, according to the Conference Board.

Of the ten components in the leading indicator, which is said to be a measure of future economic activity, only two were positive contributors last month: the interest rate spread and manufacturers' new orders for consumer goods and materials.

The decline in the LEI last month represents the biggest stumble in over two years. Signs of things to come? Perhaps, suggests Jason Schenker, the economist following matters domestic for Wachovia, in a research note today. "The decline in the LEI in March resulted in the index going negative year-over-year for the first time since April 2003," he writes. "Although the index is only down -0.5 percent year-over-year, a protracted period of negative year-over-year rates has historically been associated with recession."

Nonetheless, Schenker believes the economy is still "solid" and opines that "we are merely moving from recovery into the more moderate growth phase of expansion…."

That's his story and he's sticking to it. Indeed, more than a few observers of the economic scene say as much. That growth bias may very well remain intact until the market gets its first peek at first-quarter GDP estimates, which will be released at 8:30 a.m. New York time on April 28. The consensus projection calls for 3.5%, down slightly from 3.8% logged in the fourth quarter.

Yes, Virginia, the quarterly GDP numbers are always woefully lagging snapshots, but that doesn't mean they can't be market-moving events when and if they deviate from the best guesses of the dismal scientists.

Posted by jp at 9:37 PM | Comments (0)

April 20, 2005

GREAT EXPECTATIONS

The bond market decided to err on the side of optimism again today—optimism, that is, from a bond trader's perspective. Whatever you call it, there was a fair amount of it in and around trading of the benchmark 10-year Treasury Note, which now yields 4.20%, the lowest in more than two months.

The continued decline in the 10-year's yield is particularly striking in light of today's report on consumer prices. The news on that front was less than encouraging in the battle to contain inflation. But the bond market was unimpressed and instead was in a buying mood. No mean feat in the wake of the consumer price index's rise of a stronger-than-expected 0.6% last month, the Labor Department reports. Although there have been increases of that magnitude in recent history, 0.6% is the highest in five months, representing the top end of monthly increases for some time. Indeed, you have to go back to 1999 to find a higher monthly jump in CPI.

What's more, core CPI is now surprising on the upside too. Unlike yesterday's calm in the March core wholesale price report, consumer prices for March excluding food and energy jumped by 0.4%, the highest in nearly two years.

Why is the bond market so nonchalant in the wake of bad news on inflation? Perhaps yesterday's sharp drop in housing starts has something to do with the recent incarnation of confidence among debt investors. Indeed, the government reported that housing starts hit a brick wall in March, falling 17.6% from February. That's the biggest drop since 1991.

Yes, Virginia, housing starts surged to an all-time high in February. As a result, even after the March decline, housing starts are still at a level that prior to 2004 was thought to be nosebleed terrain.

Yet the housing industry saw fit to put on the breaks. Is this the start of the much-discussed popping of the real estate bubble? If so, maybe the bond bulls aren't so crazy after all. A serious, sustained decline in the housing market has the potential to take the wind out of the economy's sails, and in the process making everyone but a bond trader miserable.

But more than a few analysts aren't ready to throw in the towel on the real estate boom just yet. "It's too early to get excited about this. You are coming off huge numbers in January and February," David Wyss, chief economist for Standard & Poor's, tells Knight-Ridder. Mark Zandi, chief economist at Economy.com, is similarly skeptical that this is the end, explaining to the Washington Post that the drop in housing starts is a "head fake. The [real estate] market isn't slowing at all."

If true, that implies that the Fed will continue tightening the monetary screws. Or so the futures markets for Fed funds predicts. The June '05 contract for Fed funds is priced for a 3.0% rate. That, of course, is speculation. Truth at the moment is 2.75%, although that rate will be officially reassessed when the Federal Open Market Committee gathers for its next regularly scheduled meeting on May 3.

If gold prices and the U.S. Dollar Index have any influence on May 3 confab, another rate hike is coming. The precious metal inched up in Wednesday trading, holding fast to the 1.6% gain logged yesterday. Meanwhile, the U.S. Dollar Index slipped to its lowest in nearly a month.

Getting the buck back into an ascending mode will take some convincing from the Fed, and 25 basis points may not be enough to do the trick. John Rothfield, a currency strategist at Bank of America, sees pressure building for another rate hike of some degree. "Market expectations for the pace of Fed tightening are still down fairly aggressively over the past month,'' he tells Bloomberg News. "We expect the dollar to keep drifting lower.''

Rothfield's not alone. Whether that has any impact on the Fed remains to be seen. But as we go into the next FOMC with a CPI report that's raising warning flags, it's only a question of time before the bond market catches on that the risk in fixed-income may be higher than suggested in the 10-year's yield trend of late.

Posted by jp at 9:33 PM | Comments (0)

April 19, 2005

TWO NUMBERS, ONE FATE

Gauging inflation is always a tricky business, but rarely more so than in the spring of 2005. Today's report on producer prices from the Labor Department is merely the latest clue suggesting as much.

To wit, wholesale prices rose 0.7% last month. That's the fastest in four months and a pace that's also tied for second with several recent reports for the second-fastest monthly rise since early 2003. Inflation, in short, appears intent on pushing higher.

But before you run out and sell bonds, take a look at the producer price index (PPI) less food and energy. By that adjusted measure of wholesale inflation, things look decidedly less bubbly on the matter of pricing pressures. Indeed, PPI less corn muffins and sweet light crude rose a sleepy 0.1% in March. Inflation, where is thy sting?

What we're left with is two takes on wholesale pricing trends, with two materially different views. One says beware, the other suggests it's nap time when it comes to worrying. The question for investors, Which measure tells the truth?

In search of an answer, or at least a lesser mystery, we start by deciphering the reason for the divergence in the two numbers. Fortunately, that's no great task. The disparity can be explained in a word: energy. Prices for oil, gasoline and such jumped 3.3% in March alone.

All of which brings us back to square one, namely, which PPI index tells the real story? If you tell us where oil prices are headed, we can deliver a definitive answer. Short of that prescience, there is only guesswork.

But the prospect of guesswork never kept Wall Street sitting on the benches. In that spirit, the conjecture for today is assuming that oil prices will remain steady if not decline. If PPI ex-food and energy represents no threat, then the opportunity for hope is wide open, goes the reasoning. Ergo, there are new financial fish to fry, opines Brian Williamson, vice president at The Boston Co. "The focus is on earnings now this economic number [PPI] is out of the way. The market looks to be doing OK off the get-go here," he tells CNN/Money today.

Indeed, the S&P 500 rose 0.6% today, providing some relief to the selling of late. A number of encouraging earnings reports helped turn the tide during the session, including a 25% rise for earnings at the computer chip maker Intel. After the market closed, there was more good news with Yahoo's report that profit doubled from a year ago at the Internet-based media company.

But if the Street's eager to dismiss the energy variable, oil traders aren't quite ready to climb on board that wagon. The price of a barrel of crude jumped sharply today, rising by nearly $2 a barrel. Renewed worries that gasoline inventories may turn out to be less than anticipated sent the energy bulls back into overdrive. "Gasoline inventories are in decent shape, but it wouldn't take long for the excess to disappear as we go into peak demand this summer,'' Tom Bentz, an oil broker at BNP Paribas Commodity Futures, tells Bloomberg News.

And while we're speaking of commodities, gold posted a tidy little rally today in the wake of the PPI report. Presumably, with the precious metal now trading at its highest in about a month (nearly $434 an ounce), the gold market believes that the broad-line PPI rise of 0.7% is the real McCoy.

But fret not as there's more opportunity to separate the inflationary wheat from the chaff on Wednesday. Indeed, tomorrow brings the March report on consumer prices. And just to keep things lively, the government will offer fresh updates on oil inventories from the Energy Department. Affirmation or rejection of one's investment bias awaits. Either way, count on the renewed bull market in volatility, courtesy of the VIX, a measure of volatility on the S&P 500.

Posted by jp at 10:07 PM | Comments (0)

April 18, 2005

TO FIGHT OR NOT TO FIGHT?

Should equity investors fight the Fed?

Absolutely, writes Ed Yardeni last week in a report to clients. The chief investment strategist at Oak Associates is bullish and he isn't going to let any central bank threat of higher interest rates stand in the way of optimism. "I continue to place my bets on the bull," he asserts. And just to make sure no one misunderstands, he clarifies his view of the morrow in no uncertain terms: "There is no foreseeable reflation, stagflation, deflation, or recession in my outlook." Take that, pessimists and nattering naybobs of negativism.

Lest any one think Yardeni has no respect for the Fed's power in matters financial, think again. He explains that while he's reluctant to dismiss the time-honored counsel to avoiding sparring with the central bank, i.e., buying stocks when rates are set to rise, the time is ripe for doing just that. Or, to be precise, the adage needs a 21st century makeover, he argues: “Don’t fight the Fed if the Fed is fighting a serious inflation problem.”

And there's the rub: the current battle with inflation, such as it is, isn't serious, Yardeni concludes. That is, it's not serious enough to derail his bullish outlook on stocks. The monetary tightening won't bring a recession, and so the rise in earnings can roll on, giving equities the fuel they need to climb higher, he tells us.

The consensus outlook for earnings on the S&P 500, by our own back-of-the-envelope calculations, is in fact higher by around 22% vs. the current reported earnings. If the estimates come through as predicted, the price-earnings ratio on the S&P 500, now around 19, would fall to 16, assuming the S&P remains unchanged at today's close of 1145.98. By the standards of the last decade or so, 16 looks fairly attractive.

But the question on every investor's lips suddenly is whether those rosy earnings estimates will come true after all. Indeed, after last week's pummeling of the equity market, it's getting harder to think like Yardeni. Sure, the market posted a small gain today, though that's hardly indicative of much after so many declines. The S&P has given back the entire rally since early November, sending out technically bearish signals for the folks who follow the charts.

What can change the negative sentiment? Earnings, of course. Once again, they are the only game left in town, and all eyes will be focused like a laser beam on companies reporting this week. And a busy week it is. The convergence of first-quarter earnings reports hitting the Street and a fresh dose of skepticism and a weak stock market means it's put-up or shut-up time.

"When the markets struggled for a technical bounce in the morning, that was investors sending a message that we're either heading toward an economic recession or toward a profits recession," Hugh Johnson, head of equity trading at First Albany, tells CNN/Money today. "Earnings reports may be positive now, but investors will be very sensitive to any indications that they might not rise in future quarters."

Perhaps, although there was reason to breath a sigh of relief, for the moment at least. Despite last week's disappointing earnings news from IBM, not all's dismal in earnings land. As Reuters today reports, more than half of the 66 S&P 500 companies that reported first-quarter earnings as of Friday beat the estimates, while around 23% fell short, and 20% matched the Streets consensus outlooks.

3M Company's latest is, by one account, representative of what's coming, which is to say, hope, the Reuters story also notes. The Street was expecting $1.01 in per-share earnings today for the diversified manufacturer and instead was treated to a small premium when 3M announced actual results of $1.03. "3M's earnings should relieve investors because it has a broadly diversified exposure to the American economy and that is a bellwether for the market generally," says Mike Lenhoff, chief strategist at Brewin Dolphin Securities Ltd. in London.

But good earnings alone (assuming that's what the first quarter will on balance reflect once all the numbers are released) are only one thing weighing on Mr. Market. Inflation, Mr. Yardeni's comments notwithstanding, is still an issue, and an unresolved one at that.

A bit more resolution comes tomorrow, when the producer price index is released. More than a few dismal scientists are worried that the pace of wholesale inflation could be advancing at a rate that will surprise Wall Street.

Indeed, even the bond market seemed to be hedging its bets…sort of. The yield on the 10-year Treasury Note inched higher today for the first time since last Wednesday. That's hardly a reversal of fortunes, but perhaps it's a whiff of things to come. The fixed-income set was apparently spooked by comments from Fed Governor Susan Bies, who said today, "I believe that, while underlying inflation is expected to continue to be low, the Federal Reserve must be more alert to incoming data, and continue to remove policy accommodation at a measured pace, consistent with the incoming data and its commitment to maintain price stability."

Of course, Bies, in true Fed style, also made another comment that gave aid and comfort to the Yardeni view of the world: "I expect that the economy will continue to expand at a solid pace this year," she said, via MarketWatch.com. "Though inflation pressures have risen somewhat in recent months, longer-term inflation expectations appear to have remained well contained."

But no matter which Bies comment seems more influential, that part of the bond market that's least tolerant of elevating signs of risk continues to build defenses for a coming storm, real or imagined. Consider that the yield on junk bonds, measured by the KDP High Yield Daily Index, continues to march higher at a rapid clip. While traders have generally bought up government bonds for much of April, investors in lesser-quality debt have been quietly but earnestly selling junk bonds this month. As a result, the yield on the KDP benchmark is now above 7.5%, the highest since last August.

One corner of the bond market's not inclined to fight the Fed, while the other side is. We're not sure if this is the last battle of the post-bubble wake, or the first scuffle of the new investing era. But whatever it is, the outcome promises to be influential.

Posted by jp at 9:43 PM | Comments (0)

April 15, 2005

DON'T WORRY, BUY BONDS

The catalyst for today's red ink on Wall Street is widely explained as IBM and its disappointing earnings report. Big Blue earnings per share in fact did surprise on the downside with 85 cents a share for this year's first quarter, well below the roughly 90 cents that analysts were generally expecting.

But there's more to the sharp fall in the major stock market indexes today, which shaved about 1.7% off the S&P 500 and nearly two percent from the Nasdaq.

How to explain the S&P, now at its lowest since last November? Perhaps part of the answer resides offshore. In the search for clues behind the sell-off, the continuing rise in import prices could be a suspect. Today's report from the Labor Department reveals that import prices for March rose 1.8%, the highest monthly increase in over two years and more than double February's advance. On a year-over-year basis, import prices are advancing at a 7.1% pace. As recently as February 2004, the comparable year-over-year number was under 1%.

But wait—this just in! High oil prices are the leading cause behind the price hike. Prices for non-petroleum imports rose just 0.3% in March while prices for petroleum imports skyrocketed by 10.6%. A barrel of crude now changes hands in the nearby futures contract in New York for just over $50, down from as much $58 on April 4. More than a few hopeful souls are looking at the trend and concluding that it's the start of a correction that will bring energy prices back down to something approaching fair value.

Promoting no less, Opec today released a report that emphasizes that oil production in the cartel will grow by 1.6 million barrels to 32.7 million this year courtesy of new capacity coming on line in several member countries. "Even with the high expected demand for OPEC crude," the cartel's web site counsels today, "Member Country production should be more than adequate to meet projected requirements, according to the OPEC Monthly Oil Market Report for April."

Bucking the trend of late, traders are actually taking the cartel at its word. As a result, the crowd believes that selling oil is preferable to buying at the moment. The turn in sentiment, as oil analyst Neil McMahon of Sanford C. Bernstein in London wrote yesterday in a note to clients, is quite reasonable. Opec, he explains, is "ensuring the market remains supplied well above current demand levels, as demonstrated by the continuing ascent of total oil inventories in the U.S., while this month's International Energy Agency report casts doubts on the ability of China to sustain double-digit demand growth."

Bottom line: McMahon predicts oil prices are headed for a $40-to-$50 range in the second quarter. With today closing just 49 cents above that upper limit, who can argue?

If the trend in falling oil prices has legs, today's inflationary news with import prices doesn't mean much. If fact, it's downright irrelevant, if you buy into this line of thought. The bond market is certainly buying that notion, along with every Treasury security in sight. Adding to the fresh joy in bond land is the suggestion by way of IBM that earnings may increasingly face headwinds. "We've had bad news for stocks and bad news for the economy and that's been very supportive for the bond market,'' Orlando Green, a fixed-income strategist in London at Calyon, tells Bloomberg News today.

Whatever the reason, the fixed-income set today ignored the jump in import prices and instead aggressively bought the benchmark 10-year Treasury Note. The yield on the 10 year fell again on Friday, and sharply so, falling to roughly 4.24%, the lowest since mid-February. But there was no confirmation of the bond rally in the dollar, which slipped today, based on the U.S. Dollar Index.

In fact, time isn't necessarily on the bond market's side, and for more than a few reasons. We'll just consider one, and let Bernstein's McMahon do the talking, again quoting his research note from yesterday:

We are growing in confidence that the market should become much tighter towards the fourth quarter and into 2006. We believe the IEA remains overly optimistic in their outlook for levels of spare capacity, and production growth in Russia. Moreover, an analysis of IEA revisions to non-OPEC supply forecasts reveals that, contrary to recent history, an incremental supply response to $50/bbl is failing to materialize.

No less a voice on energy matters than the U.S. Energy Secretary said as much today, warning that Americans should expect high prices for gasoline in the years to come. "A simple explanation of this very complex problem is that we're using energy faster than we're producing it," Secretary Bodman explains via Reuters.

And that brings us back to imports, namely, rising oil imports. But today, at least, that's nothing to worry about, or so the bond market suggests.

Posted by jp at 3:53 PM | Comments (0)

April 14, 2005

HEY, JOE, WHERE YOU GOIN' WITH THAT CREDIT CARD IN YOUR HAND?

Has the day of reckoning for the consumer begun? No, not quite. But the economic observers who're warning that Joe Sixpack's debts are set to cast disorder far and wide in the economy have another statistical release to dangle in the face of the optimists.

Retail sales in March advanced by a less-than-expected 0.3%, the Census Bureau reported yesterday. While the number disappointed most economists, and is middling at best, the more disturbing trend was documented in the retail sales report that excludes auto sales. Indeed, retail sales less motor vehicles inched up by a thin 0.1% last month, the lowest since April 2004, when sales ex-autos declined.

For those inclined to see the economic glass half full, the positive spin on all of this is that the sales report took it on the chin only because of higher energy costs. The rising price of gasoline and other fuels presumably convinced our hero Joe to stay home and read a book instead of venturing out to swipe his credit card one more time. "You are beginning to feel the pinch from higher interest rates and higher oil prices," Louis Crandall, chief economist at Wrightson ICAP, tells Bloomberg New via the Chicago Tribune. "Spending growth isn't going to fall dramatically, but it's likely to slow."

Assuming as much, the question then becomes: Does it matter if spending slows because of variable X vs. variable Y? Given the current state of affairs, the answer heavily depends on where you think energy costs are headed in the next six to 12 months.

In turn, that's a cue for the optimists to argue that things may be looking up. Oil prices today briefly dipped below $50 a barrel for the first time since February. Yes, oil rallied afterwards, closing above $51 a barrel. But the writing's on the wall, we're told: the bull market in crude's peaked and all will soon be well again in the retail business.

Perhaps, but if you believe some economists, the predicted slowdown in consumer spending has less to do with energy prices and more to do with self-inflicted debts. The dismal scientists at the Levy Economics Institute are front and center with such thinking. That's not making them popular on Main Street, but it certainly makes for dramatic reading. In a recent report they warn: "A jump in personal bankruptcies and a sharp drop in consumer spending will be inevitable."

Pessimism springs eternal in predicting Joe's decline and fall. But no one's ever gotten rich warning that he's about to stumble. Then again, even Joe has limits. Where exactly those limits lie is debatable, although they may be closer than you think.

If Joe's penchant for spending is headed for a fall, one can wonder how the Federal Reserve will react. Indeed, cheap money has been a staple in recent years in keeping the consumer machine rolling. Would the central bank be any less inclined to keep the Fed funds rate in negative real (inflation-adjusted) territory if the consumer shows signs of reluctance in buying another TV or SUV?

To judge by trading in the dollar and the benchmark 10-year Treasury Note today, we're way off base for even asking if inflation risks could rise. The U.S. Dollar Index jumped to its highest since early February. If there are any fears that the Fed will sacrifice the greenback on the alter of boosting consumer spending, there were precious few traders in the forex pits today willing to put their money where their anxieties are.

But maybe there's another explanation. A quick survey of the news wires, as always, provides an alternative perception, namely, the dollar's rising for fundamental reasons as opposed to blind hope. Reports that the euro region's economic growth looks as blasé as ever helped prop up the buck. "The growth story in the U.S. is alive and well,'' Lara Rhame, a currency strategist at Credit Suisse First Boston tells Bloomberg News. "The dollar will be going stronger.''

But why stop there? Perhaps there's a logic to a stronger dollar even if inflation were to accelerate. The fear of higher inflation and a Fed that reacts by tightening the monetary strings makes the greenback more attractive, say some analysts. But this notion assumes the Fed's committed to fighting inflation at the expense of letting Joe's shopping sprees of late fade into history. But the assumption could be over baked, which is to say that the old dual mandate of protecting the currency and maximizing national employment at the same time may come back to haunt the central bank once again.

Peter Schiff of Euro Pacific Capital is about as pessimistic as one can get on the speculation as to how the Fed will decide which is the bigger priority. The central bank, he opines, "can not bring down the inflation tree, without simultaneously bringing down the entire U.S. economy, which at present is comfortably resting in its extended branches." Once forex traders see the light, he reckons, "bad news on inflation will once again be reacted to as being bad news for the dollar."

Until and if that day of enlightenment arrives, it's business as usual. The dollar's up and the ten year's yield is down. Hope springs eternal, but so does fear.

Posted by jp at 4:00 PM | Comments (0)

April 13, 2005

CONSUMPTION ECONOMICS

In the good old days of energy shocks, consumers cut back when prices jumped. But cutting back is no longer popular sport in the current bull market for oil.

Long gone are the days in the 1970s, when higher oil prices eventually convinced Joe Sixpack to drive less, buy cars with more fuel-efficient engines, turn down the heat, and otherwise curtail the more-egregious energy-sapping activities. A chart in the oil chapter in new World Economic Outlook from the IMF (Figure 4.2) shows the collective result of that mindset of yesteryear: global oil demand fell sharply in the wake of the rise in the real (inflation-adjusted) rise in oil prices in the era when incumbent presidents went by the name of Nixon, Ford and Carter.

In the Bush II era, the rising price of energy has yet to materially lower global demand. Or, as Rodrigo de Rato, managing director of IMF explained in speech earlier this month, "So far, the effects of higher oil prices on global growth and inflation have been manageable…."

Meanwhile, the demand train rolls on. World oil consumption was recently averaging 82.2 million barrels a day, the International Energy Agency says. That's up from less than 80 million barrels a day in 2003. Overall, demand growth is advancing at the fastest pace in 24 years, IEA advises via BBC News. The cause? Bubbling economies in China, India along and the U.S. (the world's largest oil consumer), to name the primary suspects.

Economic growth, to restate the obvious, is a beast that's still largely fed by oil. Yet the global economy appears to be less sensitive to oil's price. Indeed, crude oil has been in a bull market since the end of 1998, but the trend's having little effect on the consumer mindset. Is this because of a cultural shift that minimizes, if not dismisses the notion of sacrifice and conservation in favor of consumption at all costs? Or perhaps the explanation is that oil prices are still well below their real (inflation-adjusted) peaks that harassed the decade of the seventies. Maybe it's because real interest rates have been artificially low. Then there's the point about how economies are much less energy intensive these days: raising gross domestic product takes fewer barrels of oil today compared with 30 years previous.

Whatever the answer, it seems clear that oil demand will only drop materially with the arrival of recession in the U.S. and/or other leading economies. Indeed, a world that's inured to high prices is necessarily a world that can afford to pay up.

Even better is the prospect of slower demand growth without recession. If that's a sweet spot, the markets got a taste of it with yesterday's news from the IEA that China's thirst for oil slowed in the first two months of this year. That's helped take some of the froth out of crude oil's price.

Adding to the selling momentum of late in the oil futures trading pits is news from the Energy Information Administration that U.S. inventories of crude are rising fast, having reached their highest in several years in recent weeks. America's oil stocks totaled 317.1 million barrels as of April 1, up nearly 5% since early March and almost 9% higher relative to mid-January. More of the same was on view today when the EIA released its weekly storage numbers and reported that crude inventories rose again for the week through April 8. The news triggered a wave of selling in oil futures, bringing prices below $51 a barrel intraday for the first time since March 1.

While the U.S. continues to stockpile oil at a rapid clip, Saudi Arabia forges ahead with pumping, and not necessarily with the blessing of Opec. Adam Sieminski, global oil strategist with Deutsche Bank in London, opines today in a report that the Saudis have recently started encouraging the buildup of oil stocks as a means of bringing prices down. "While OPEC debates the pros and cons of $50+ oil ahead of their June 15 meeting," Sieminski and his team write, "the Saudis are already raising production and encouraging contango [higher prices in longer dated futures contracts] in the markets to allow stocks to build. Higher inventories will eventually lower prices at the front end of the curve to where the Saudis want oil to sell in 2005—perhaps closer to $40 than 50/bbl."

James Williams of WTRG Economics today writes of the Saudis' new-found penchant for pumping, explaining, "The Saudis appear to be looking down the road toward the possibility of a supply shortage next winter if inventories are not higher than normal going into the 4th quarter."

In the short run, the Saudi-supported rise in oil inventories is convincing traders to sell. The decision to forgo the Jimmy Carter tactic of cardigan sweaters in place of turning up the thermostat has, for the moment, been bailed out by the recent tumble in oil prices. But reconciling the short term with the long term is a perennial challenge, and that starts with the best guess on what the future will bring. By the IEA's estimate, the global economy will require 60% more energy in 2030 relative to 2002. The future, as always, starts now.

Posted by jp at 4:19 PM | Comments (0)

April 12, 2005

FOLLOW THE LEADER

The U.S. balance of trade slipped to another all-time deficit in February--$61 billion vs. $59 billion in January, reports the U.S. Census Bureau. If you thought the news would take a hefty bite out of the dollar, you were mistaken. By the close of Wall Street trading today, the dollar gained ground against the euro and yen.

If that counters forex logic, think again, say the buck's bulls. The catalyst for that corner of optimism stems from trade between U.S. and China, goes one school of thought. Although America's trade deficit with China remains firmly negative, February's level of red ink with the Middle Kingdom actually slipped in February from January, reports CBC.

In another instance of China's sway over the markets, the International Energy Agency advised that demand growth for oil recently took a breather in the world's most-populous nation. "Chinese demand growth slowed to 5.4% in the first two months of 2005, well below the 20.8% growth seen a year ago," IEA reports. The news helped slash the price of a barrel of crude in New York today by almost $2.

The prospect of lower crude prices in turn gave inspiration to the dollar bulls, which in turn comforted the bond market. The yield on the benchmark 10-year Treasury yield fell sharply today, dropping to roughly 4.36%, the lowest since early March. The adjustment in the price of money is in part connected to the optimism that lower oil prices will reduce the U.S. trade deficit.

But while China's the catalyst du jour for deciphering trends in asset prices, there's just one problem: Mr. Market's extrapolating short-term trends for short-term speculation and ignoring the big picture. In the long run, does anyone really think that China's oil consumption is headed lower? Similarly, is there an economist in the house who's predicting that Chinese exports to the United States will continue falling in the coming months and years?

Traders in New York are concerned only with the morrow. But elsewhere, the strategists are making plans for the next decade. That includes China's petroleum strategists. As the Globe and Mail reports today, "China made its first tiny foray into Canada's oil sands industry Tuesday as CNOOC Ltd. bought a small stake in privately held MEG Energy Corp. for $150-million." Speaking of the deal, CNOOC's chief financial officer tells Canada's National Post, "I am excited with our low cost entry into oilsands, gaining a footstep in this potential area."

Posted by jp at 4:24 PM | Comments (0)

April 11, 2005

BY ANY MEANS NECESSARY

Not everyone's worrying that rising crude oil prices will impair economic growth, but you can count the bond market in as one more pessimist.

We say that based on the observation that the yield on the 10-year Treasury Note has come down off its late-winter/early spring spike. After jumping to roughly 4.65% in late March (the highest since June 2004), the tide has since turned. The rate on the 10-year closed at roughly 4.4% in today's session, and the way traders are feeling lately it wouldn't take much to imagine that a test of the 4.0% level is coming.

In the standard scramble among journalists to "explain" why rates are falling and the bond ghouls are becoming giddy once again, Reuters ventured a guess by reporting that a profit warning from Ford last week spooked the market. One bond trader observed: "There's a huge camp out there that believes the economy is slowing down, and the Ford thing urges them on."

Perhaps. If so, Tuesday's retail sales report from the U.S. Census Bureau provides an opportunity to support or reject the renewed confidence of the bond bulls by parsing the March tally. For the moment, it's anyone's guess as to the outcome, says one economist on the eve before the release. "Retail sales is a real big uncertainty--we will find out how higher gasoline prices have impacted consumer spending," Richard Yamarone, director of economic research at Argus Research, says via ObviousNews.com. "There are a number of questions that are lingering, and as always the number-one question for bond holders is 'what is the inflation outlook?'"

But the strategists at BCA Research aren't waiting. On Friday last, the respected advisory shop in Montreal, Canada dramatically reduced its global equity weighting for April to 66% from 91% in March. "This month’s reduction is across the board: weights were reduced in both Europe and Japan," BCA writes. "The model maintains a zero weight in U.S. equities." Where's the money going? "Capital has been re-allocated to bonds, the bulk of which is in the U.S. market, following the backup in yields in the past two months." (Yields, of course, may be turning down again, but let's not quibble just yet.)

To the extent money managers need or want equity exposure, what's a prudent investor to do? For one thing, start thinking like a bond investor and then translate that into equity management. BCA offers some tips, starting with a review of who's vulnerable to high oil prices and who's less vulnerable. "The impact of rising oil prices on equity markets is a function of the oil intensity of economic activity and the composition of stock market capitalization," BCA counsels.

By that reckoning, the Japanese market is the "biggest direct loser" of a gusher in oil prices by virtue of the county's 1.3% total market cap in oil producers vs. 38.5% in oil consumers. A bearish ratio, to say the least. On the opposite extreme is Canada, whose equity market cap is comprised of 21.6% percent vs. 10.5% in oil consumers. (For U.S. perspective, the scales tip in favor of oil consumers: 14.3% over oil producers' 8.2%.)

The outlook that oil prices will stay relatively high, if not continue to ascend, favors oil-heavy stock markets such as Canada's, the BCA report suggests. In other words, if you want to stay bullish as an equity investor, start thinking like a bond trader.

On the other hand, higher-than-expected inflation may trip up paper assets of any and all varieties. For the moment, hope springs eternal that only good news will prevail, in part nurtured by the Fed's long-running comments using such buzzwords as "contained" on matters of future overall price trends. But then why is Philadelphia Fed President Anthony Santomero, who's also a voting member of the Federal Open Market Committee, making noises to the contrary? Then again, is he making noises to the contrary?

"We have to be vigilant about inflation…" Santomero told Reuters yesterday. "We are looking at an economy that, to the extent that it continues to move in the direction at the speed we think and most forecasters believe is the case, we can continue to move as we have." Translated: the 25-basis-point rate hikes that have prevailed since last June will continue. "But we are prepared to do what is necessary either way to respond to incoming data."

Posted by jp at 9:46 PM | Comments (0)

April 8, 2005

WHAT GIVES?

It's clear that the dollar's been falling, but what does it mean, Horatio? What does it mean? Different things to different people, comes the reply from the financial gods on high.

Indeed, weighing the implications of the decline and fall of the world's reserve currency has perplexed more than a few in the dismal science. Among the topical questions of late: why hasn't a chastened buck reduced imports and increased exports from these United States?

Whatever the answer, there's no debating the fact that the trade deficit has grown larger as the dollar's fallen further, the Census Bureau informs. Invoking the age-old phrase of frustration and inquiry we respectfully wonder, What gives?

Kathleen Cooper, under secretary for economic affairs at the Commerce Department, took a stab at an answer in today's New York Times. "The current surge in imports is strongly related to our rising industrial output," she explains. "Goods that are assembled in this country have an awful lot of imported components that used to be made in this country."

So the economy's strength receives the blame--or should we say praise?--for the bull market in imports. But even taking the optimistic view, as some do when it comes to America's expanding trade deficit, there's the sticky issue of the dollar. Let's assume for a moment that the rising appetite for imports in the U.S. is a function of the country's economic growth. Clearly, that's the case—recession economies tend to import less, or so one could assume. But no if whether higher levels of imports are good or bad, imports in excess of exports put pressure on the currency, in this case the dollar. Sometimes a currency can weather the storm, sometimes it can't. The U.S. is clearly in the latter category at the moment.

And that state of affairs raises a question: If increased exports are a good thing, as some claim, must the definition of continued economic improvement imply that the dollar will get weaker? If so, can the U.S. economy grow if its currency runs the other way?

Complicating the analysis is the fact that a rising share of goods imported into the U.S. comes in the form of crude oil. Consider that in January 2005, oil's value as a percentage of the total value of goods imported (separate from services) was 8.5%, up from 7.9% a year earlier, based on crunching numbers published by the Bureau of Economic Analysis. In other words, an increasing portion of "our rising industrial output," to borrow the phrase from Commerce Department's Cooper, is imported oil.

Conceptually, which is to say in a world of truly free oil markets and a lack of geopolitical friction, that's not a reason for worry. Rising energy inputs, after all, jibe with a growing economy. The former is essential for maintaining and even stoking the latter. But there's a glitch with that model in the real world as it applies to the U.S., namely: the value of oil imports is rising faster than the physical quantity of oil imports. Indeed, the number of oil barrels imported into the U.S. rose by 4.3% in January 2005 over the year-earlier month—that translates into a fraction of the 29% pace of increase in the dollar value of those oil imports.

That's a convoluted way of saying that oil prices are rising. Or that the value of the dollar is falling. Or both.

For the American economic machine, some observers are taking it all in stride at the moment. Higher oil prices have yet to bite the U.S. economy by any material degree that's obvious, at least to the lay eye. And with oil prices down again on Friday for the fifth day running, hope that more of the same will prevail is in the air.

But the oil gremlin isn't dead, he's only geographically challenged, or so it seems. News of weak retail sales in Europe last month, in the wake of the sharp rise in oil prices, has turned a few heads. "Oil prices are surely having a damping impact on sentiment and diminishing purchasing power," Juergen Michels, an economist at Citigroup Global Markets in London, tells Bloomberg News. French retail sales, for example, declined the most in over a year last year. Aie! All of which convinced one bond manager in Geneva to declare to Bloomberg: "Oil is a threat to economic growth."

The World Bank yesterday seemed to jump on that horse with the prediction that global growth is at a "turning point," and that rising oil prices were partly to blame, the Boston Globe reports. ''Global growth momentum has peaked," the bank announced.

But even if you think that rising oil prices will take a toll, there's still plenty of opportunity to debate in terms of outcome. The traditionalist thinks that rising oil prices will resurrect inflation. But such thinking is so yesterday among pessimists. Rather, oil spikes deliver deflation, or so goes the progressive wing of the gloomsters.

Escalating energy prices will lead to a slowdown, Adolf Rosenstock, senior economist at Nomura International, explains via
Reuters. But there the traditional analysis ends: "Once a slowdown kicks in, you are back to the old deflationary scenario," he adds.

Make that the new old deflationary scenario. Back to the future. That's your cue Mr. Bernanke.

Posted by jp at 9:51 PM | Comments (0)

April 7, 2005

RHETORICALLY BESMIRCHING?

It's not every day that a president raises questions about the bonds issued by his country. Thanks to competition, a government tends to give the other guy's debt a hard time in one way or another.

But, hey, this is the progressive age and anything's possible. Yesteryear's prudence is today's obstacle gumming up the works in politics. Or so it appeared when President Bush seemed to be impugning, in ever so subtle terms, the integrity of government bonds when he visited the U.S. Bureau of Public Debt in Parkersburg, West Virginia on Wednesday.

The location was the latest stop on his tour of promoting the idea of adding private accounts to the Social Security system. In full marketing mode, the President announced to the small office of workers and attending press, "There is no trust fund," referring to the portfolio of assets used to pay Social Security benefits. Looking at a file cabinet loaded with paperwork that represents the trust fund, such as it is, Bush declared that the portfolio was in fact "just IOUs."

Technically correct, in that Treasury securities are nothing more, or less, than IOUs. By that title, they're only worth something to the extent the investing public thinks they're worth something. Trust, in short, is the operative word when it comes to lending and borrowing, even for the United States. That may sound a radical notion, but some also know the phenomenon as the bond market.

For a country as dependent as America on lending, the President's choice of focus was questionable, to say the least. An editorial in the Seattle Post-Intelligencer, from which the above quotes are drawn, lamented this particular outing of the nation's chief executive, reminding, "Just an IOU? The same could be said about stock certificates, the U.S. dollar or even private investment accounts."

The comparison with the dollar is quite apt. Treasuries and the greenback, after all, are joined at the hip in the global economy from a foreigner's perspective. Attacking one is effectively attacking the other. But that's a no-no, to invoke a technical term, given America's necessity for borrowing on the global stage. Or, at least, it should.

With any number of foreign central banks stuffed to the rafters with Treasuries, it seems a tad counterproductive to suggest, however indirectly, that the integrity of U.S. government debt is something less than it's cracked up to be. Might we say that the strategy might not be the wisest use of rhetoric at this particular juncture? To be sure, we're not saying there's nothing to criticize when it comes to America's various outputs of government-sanctioned paper. But maybe, just maybe, the President should be a little more circumspect than the rest of us on such matters of shaping public perception. After all, his words are broadcast around the world and interpreted (and misinterpreted) to a degree that only rock stars and indicted corporate executives will recognize.

Of course, Treasuries may not need any defense. They aren't going away, no matter what Bush says, and in fact are likely to grow in population, as are the dollars that service them. Foreigner and U.S. citizen alike need never worry when it comes to receiving coupon payments and their original principal after buying Treasuries. The Fed is burning the midnight oil so that there will never be a dollar shortage when government bonds come due.

As to how much, or how little those dollars will buy tomorrow, next year, or a decade from now? Hmmm, maybe the President was trying to tell us something. Then again, he needn't have cast aspersions on the government's IOUs and, by extension, its fiat money. The maestro, after all, doesn't need any help.

Posted by jp at 9:55 PM | Comments (0)

April 6, 2005

DANGEROUS LIAISON

If you thought the subject of oil was a bit far afield for the steward of the nation's money supply, think again. As Alan Greenspan rides into the sunset of his final months as head of the central bank he told the National Petrochemical and Refiners Association conference in San Antonio, Texas yesterday that market forces should be allowed to prevail when it comes to the price of oil.

"We must remember that the same price signals that are so critical for balancing energy supply and demand in the short run also signal profit opportunities for long-term supply expansion," Greenspan said, according to FinFacts.com There's also the issue of incentives with alternative energy sources and how that's affected by oil's going rate. Simply put, higher oil prices create stronger incentives to new options. Perhaps that's obvious, but Alan reminded us anyway: "For years, long-term prospects for oil and gas prices appeared benign," he explained. "The recent shift in expectations, however, has been substantial enough and persistent enough to bias business investment decisions in favor of energy cost reduction."

And who could argue? Certainly no one who's read and embraced the free-market principles laid out by Adam Smith in the 18th century. Indeed, oil prices are inextricably connected to supply and demand, and supply and demand dances the dance of a feed-back loop. If supply runs short and demand holds steady or rises, prices will rise; if prices rise far enough and fast enough, they curtail demand, which creates spare capacity. Rising spare capacity, in theory, will eventually lower prices. Round and round it goes. That, as they say, is what makes markets.

And since we're praising the market, why don't we check in with the oil traders. In the wake of the maestro's energy comments, the price of crude in New York futures trading has closed lower for two days running. The impact of Greenspan's rhetoric is apparently alive and well in his waning months as central banker in chief. But even as powerful and persuasive a voice as his has limits. Indeed, there's only so much a Fed chairman can do when it comes to oil prices. In fact, the point where a central bank's punch is most potent in the energy realm is found within the arcane art of monetary policy, and on that score there are some who find reason to fault Greenspan.

There is, after all, a closely entangled relationship between the price of a barrel of crude and the dollar. Oil is a global commodity that's priced globally in dollars. That means that even a purchaser of oil who holds euros, yen or some other form of government paper is bound by the prevailing dollar exchange rate. As for dollar-based buyers of oil, forex may seem an irrelevancy, since oil's priced in greenbacks, but that's an erroneous assumption of no insignificant magnitude.

Consider the price changes in a barrel of crude (measured by the spot price on the New York Mercantile Exchange) in dollar terms vs. euro terms. Assuming a current price of $55 a barrel in the here and now, oil's up more than 200% from December 2002, James Williams of WTRG Economics tells CS. Now the kicker: in euro terms, oil's up 59% over that stretch.

That price differential is another way of saying that the dollar's weakened relative to the euro. Indeed, the U.S. Dollar Index, which is based on the average exchange rates of six leading currencies in the world, has shed about 17% from the end of 2002 through today. Clearly, forex is an essential factor in the price of oil, a fact that raises more than a few questions about what the Fed is doing to maintain the integrity of the greenback. "The weakness of the dollar over the past couple of years has definitely been one of the significant component in crude prices," WTRG's Williams explains. In fact, he notes that the differential in oil pricing is growing wider over time in euros vs. dollars.

Mr. Greenspan can speak all he wants of supply and demand and the wisdom of markets. But at the end of the day, the most powerful tool at his disposal in the war to help the United States manage energy costs to the benefit of the American consumer is to do as much as possible to preserve the value of the buck. Of course, he should be doing no less even if oil was $10 a barrel. But to judge by recent trends in the formerly mighty buck, the maestro's stumbled. Or has he? True, some if not most of the pressures on the dollar are beyond his control. The government's fiscal deficit, to cite an obvious example, is a byproduct of Congress and the White House.

All the more reason for the Fed to do what it can to succeed within its relatively narrow purview of protecting the dollar. Even under the best of circumstances, the pressure on the dollar is immense courtesy of America's large and growing appetite for imported oil. "We're buying 10 million barrels a day," notes Williams. "Every two days, $1 billion goes out of the U.S. to Mexico, Canada, Venezuela, Saudi Arabia, and others. A billion here and a billion there, and it adds up."

The Fed can, of course, print an unlimited supply of dollars to fund its oil purchases, the fiscal and trade deficits, and any number of other tasks that can be solved with a few more George Washingtons. But while there's no theoretical limit to running the government's printing press, there's a practical limit. We're nowhere near that practical limit. Indeed, it's unclear exactly where the boundary lies. But rest assured, we're a lot closer than we were when oil was $30 a barrel.

Posted by jp at 9:56 PM | Comments (0)

April 5, 2005

A SIGN OF THE TIMES?

The bond market hardly needed another smoking gun, but it got one just the same today when news hit the streets that the government was taking away the floating interest rate on EE Savings Bonds.

No longer would the Treasury pay owners of EE Savings Bonds 90% of the average yields on five-year Treasury Notes. The forumula was fine when the price of money was falling, and so a variable interest-rate payout worked to the government's advantage (and to the disadvantage of owners of savings bonds). But things have changed, don't you know? Interest rates are moving higher. That is, unless you buy EE Savings Bonds as of May 1, a fixed-income security that promises investors that time will stand still when it comes to interest rates.

"The Treasury Department announced today that Series EE Savings Bonds issued on and after May 1, 2005, will earn fixed rates of interest," reads the press release. "The new fixed rate will apply for the 30-year life of each bond…."

In a world where interest rates are rising, and arguably will continue rising, the government has decided that investors in savings bonds should have a fixed payout. Paying 90% of the five-year's yield threatens to be a loosing proposition for the Treasury. Of course, considering that ours is a government suffering no shortage of red ink perhaps it's unsurprising to learn that penny-pinching has become the policy bias of choice. "This is a huge change," says Daniel Pederson, author of Savings Bonds: When to Hold, When to Fold and Everything In-Between. Speaking to AP via BusinessWeek, he explained that a "return to fixed rates would appear to be… a way for the government to save money and as an investor, if the government saves, that means you are getting less."

Perhaps bond investors of all stripes should start getting used to getting less in terms of total returns. The benchmark 10-year Treasury Note's yield has climbed sharply since early February, which means that capital losses are on the march as well. Presumably, the rising red ink on the fiscal and trade-balance fronts, along with the weak dollar and the fallout of several years of a negative real Fed funds rate, are starting to convince the fixed-income set that even tougher times may be coming to bondland.

The U.S. Treasury, to name one institution, is convinced of nothing less.

Posted by jp at 10:04 PM | Comments (0)

April 4, 2005

ONE STEP CLOSER TO HEAVEN?

Fed Governor Ben Bernanke, a Princeton University economist, champion of inflation targeting, and defender of the central bank's recent war to fight an alleged deflation, has been nominated by President Bush to chair the Council of Economic Advisers. In light of the news, does Bernanke now jump onto the fast track for succeeding Fed Chairman Alan Greenspan, who by law must step down from that role on January 31, 2006.

"If he goes there and proves to be effective in the political arena, I think it could enhance his prospects for succeeding Greenspan," said John Shoven, director of the Stanford Institute for Economic Policy Research, tells Reuters.

Political experience is not to be dismissed when it comes to building a resume that aids in the race to receive a nod from the President to succeed Greenspan. On that score, Bernanke's odds for becoming the new maestro of monetary policy have moved up a notch. Whether that ultimately gives him a leg up on the competition is an open question, of course. Indeed, Bernanke's White House experience, whatever its worth, will be slim, measured in months, perhaps only weeks, before Bush decides on a name.

"You start squeezing the time when [Bernanke] could develop that loyalty, familiarity with the Bush crowd," Alan Blinder, a former Fed vice-chairman and current University economics professor, says via the Daily Princetonian. "How that works out remains to be seen. What's changed since February is that there are two months less during the time when [he] can develop that relationship."

If Bernanke, who co-authored last year's book The Inflation-Targeting Debate, ultimately makes the grade, it's all but certain that he'd push for adopting such a rule at the Fed. "As you may know, I have advocated for stronger measures [at the Fed] such as adopting an inflation target or more explicit objectives," Bernanke recently said at a student symposium at the University of Dayton, reports Reuters.

Inflation targeting, on the surface at least, seems a timely policy that's ripe for embrace. With Greenspan's tenure winding down, the question of who can fill his shoes is increasingly a topical and challenging subject in Washington and Wall Street. Whether you love or hate the current Fed chairman, it's clear that replacing his influence and broad respect in the markets is going to be tough, if not impossible, at least initially. Minds differ over whether that's good or bad for the U.S. economy and the stock and bond markets, but no one has any illusion that a new Greenspan is poised to take over.

Does that mean that a mechanical inflation targeting system is a policy whose time has come? With inflationary pressures mounting, the stakes are clearly rising. As such, inflation targeting's time has come, say the policy's supporters. Replacing Greenspan's brand of recondite means of managing interest rates with a more transparent policy would represent progress, goes this line of thinking.

The empirical evidence speaks for itself, say inflation targeting's promoters, who argue that such a rule would give the bond market greater confidence by taking much of the guesswork out of central banking, and in turn, that would persuade investors to accept lower yields.

The empirical record that inflation targeting works starts with the European Central Bank, which uses a target and boasts of a lower inflation rate compared with the United States. The two, we're told, are no accident. Indeed, the consumer price index in America is advancing at a 3.0% annualized rate, as of February. The comparable figure a 1.6% rate of inflation each for France and Germany, the two largest euro economies.

Critics respond that inflation has generally been coming down in America and elsewhere for 20 years (until recently, that is), and without the aid of an inflation target. What's more, the U.S. economy is growing at a faster clip, rising by 3.9% at a real (inflation-adjusted) annualized pace, based on last year's fourth quarter GDP report. France compares with a 2.3% rise in GDP, based on 2004's fourth quarter, and Germany's barely growing at all with a 0.6% rate of increase.

Critics of inflation targeting wonder too if handing over some or all of the Fed's current freedom to act as it sees fit in the business of setting interest rates is short-sighted. Financial emergencies, such as the fallout from Long Term Capital Management or the 1987 stock market crash, need a Fed that's flexible enough to step in an flood the system with liquidity that would otherwise be imprudent. And that, goes the argument, requires wet-ware in the form of a living, breathing Fed chairman, albeit one who has the talent for enlightened and timely decisions.

In fact, stepping in to deliver financial balm in the wake of Wall Street's greatest crash is just what Greenspan did in 1987, just a few months after he became chairman. As E. Gerald Corrigan, president of the New York Fed, told Greenspan on October 19, 1987, a day when the Dow Jones Industrials shed 22.6% in a single trading session, "Goddammit, it's up to you. This whole thing is on your shoulders."

But while the maestro opened up the monetary spigots that day, there are questions if something comparable is possible if the central bank is being run by something akin to auto pilot, otherwise known as inflation targeting. Not to worry, say advocates of a mechanical inflation-targeting rule. In fact, one member of the Shadow Open Market Committee tells CS that it's all a matter of design. There's no reason, he explains, that an inflation target can't be flexible in the short term to address any and all financial emergencies. How so? For instance, an inflation target could be measured by average results over, say, two or three years. That way, in the short run, the Fed would be free to do what it feels is necessary and still have time to pick up the slack to meet the long-run target.

Of course, no one really knows how a targeting regime would work in the U.S. for the simple reason that it hasn't yet been tried. Well, that's not completely true. Perhaps there's something to be learned from the gold standard? Tying the money supply to gold was in fact a form of inflation targeting. What's more, it worked. Maybe it worked too good. The problem with a gold standard is that its inherent inflation-containing rules eventually create pressures to do the "right" thing, monetary wise—pressures that become unbearable in political terms. That's why President Franklin Roosevelt and other pols through history have felt compelled to quit the gold standard.

Would an inflation target suffer any less pressure at some point to sacrifice longer-term integrity of the dollar for shorter-term political gain? Indeed, the Fed's twin mandate of protecting the dollar and maximizing employment hint at the Faustian financial bargain that inevitably awaits.

Perhaps there's a kernel of insight on the subject from Bernanke himself. In a speech on March 30, he explained that among the Fed's primary tools for successful monetary management is influencing long-term interest rates, which are set by the market. Indirectly, the central bank moves long-term rates by controlling short term rates via money supply. But in the end, talk is second to none when it comes to moving long rates, Bernanke concluded, reminding, "The most direct method is through talk." He went on to note,

The FOMC's post-meeting statement, the minutes released three weeks after the meeting, and speeches and congressional testimony by the Chairman and other Federal Reserve officials all provide information to the markets and the public about the near-term economic outlook, the risks to that outlook, and the appropriate course for monetary policy. With the aid of this information, financial market participants make estimates of the likely future path of short-term interest rates, which in turn helps them to price longer-term bonds. FOMC talk probably has the greatest influence on expectations of short-term rates a year or so into the future, as beyond that point the FOMC has very little, if any, advantage over market participants in forecasting the economy or even its own policy actions.

But would the influence of rhetoric be minimized, if not dispensed altogether, under an inflation-targeting regime? Bernanke, presumably, wants to know, being no amateur when it comes to deploying Fed talk with the goal of moving markets and changing investor perceptions. It was, after all, Fed Governor Bernanke who, in a widely quoted 2002 speech on the subject of fighting deflation, made a cheeky reference to the fact that the central had a printing press and was willing to use it in adjusting the money supply. Inflation, in other words, could be created at will, Bernanke reminded, and the sky, in theory, was the limit. Tough talk, and well advised, he reasoned, since deflation was considered Public Monetary Enemy No. 1 at the time.
Would such talk be banished under a Bernanke regime? Would it matter? Inquiring bond investors would like to know.

Posted by jp at 10:06 PM | Comments (0)

April 1, 2005

RED CHINA & BLACK GOLD

"The price of gasoline and oil is a reflection of problems that have been decades in the making," U.S. Energy Secretary Samuel Bodman said earlier in the week after a demonstration of hydrogen-powered car, according to Dow Jones via Rigzone.com.

The prospect of automobiles for the masses running on the first element in the periodic tables remains a concept for the future, but the bull market in gasoline and oil is very much a creature of the here and now. No such luck for a comprehensive solution to America's energy needs. Bodman went on to say that the answer will be slow in coming and that no silver bullets are imminent. A mix of alternatives is the ticket, and that includes hydrogen cars.

"We want to offer consumers [hydrogen] cars and trucks that perform just like today's cars and trucks and don't cost anymore than today's vehicles," Bodman continued. "Oil trading at over $50 means hydrogen makes more sense than ever before."

Perhaps, but for the moment the energy bulls are unimpressed. Crude oil briefly touched a new all-time high in New York futures trading today, and gasoline followed suit and then some.

The Energy Secretary can talk of auto prototypes until he's red in the face, but it doesn't mean much when it comes to calming the energy market. After yesterdays' provocative prediction from a Goldman Sachs' analysts that a "super spike" in oil's price could soon raise crude to over $100 a barrel, everyone's wondering if they'll be riding hydrogen cars or bicycles to work sometime in the near future.

Calmer voices are nonetheless trying to bring back some reason to the marketplace. Marshall Steeves, an oil analyst with Refco Group, told AP today via BusinessWeek, that the bull market in crude's run ahead of itself. "I don't think the sky's the limit," he argued. "At some point there'll be some impact on demand [from the high prices]." If so, that would help lower prices, or the optimists say. "But where that price is, is hard to determine," Steeves concedes.

There's no law against guessing, of course, and that arguably starts with China. Or so the "super spike" theorist Arjun Murti, of Goldman Sachs, writes in his infamous piece from Wednesday. The "key risk" to his bullish call, he confesses, would be a "sharp slowdown in economic growth in China and other emerging Asian economies."

China, of course, has been at the fore of the global economy's rising demand for oil, and therein lies a fair chunk of the motivation for running prices up. As such, let's take a look at China's prospects for economic growth in the near term. The first number that comes up is 9.5%, which is the real (inflation-adjusted) annualized rate of increase for China's economy as of last year's fourth quarter. How fast is 9.5%? More than twice as fast GDP's pace in the U.S.

But is 9.5% sustainable, a prelude to even faster growth, or a stepping-stone to something lower? The latter isn't hard to fathom for an economy as large as China's, and one that's posted rapid growth in recent years. For the same reason that General Electric can't grow as fast as Claude's Plumbing Supply Inc., China's rate of growth must eventually slow. The fly in that ointment is that no one's really sure when "when" is. Today, tomorrow, 20 years from now?

No matter. China's government may do what economic fate can't, at least in the short term. The rapid growth in the country threatens to raise the inflation rate, some economists warn. The risk of letting inflationary pressures grow unchecked is no trivial threat in the world's most populous nation, which is intent on keeping a lid on political dissent, calls for democracy, and so on in part by creating jobs and elevating living standards. On those twin scores Beijing has racked up an impressive, if still imperfect record. Letting inflation chip away, perhaps materially, at the progress is considered unlikely.

"China has to further resolve various existing problems in the national economy," writes China Economic Net today. Number one on that list is calming the "great pressures from the overheating fixed assets investment rebound in China." Number two is upward momentum in prices. Keeping a lid on runaway investment and any associated rise inflation, in short, are said to be crucial, the article counsels. "Controlling the scale of the overheating fixed assets investment is still the core task of the macro-economic control in 2005, and an important aspect to change the continuous high investment rate and low consumption rate."

Meanwhile, there are other bumps that lie waiting in the economic road. The U.S. Department of Agriculture recently predicted that China's "extraordinarily high GDP growth….may be dampened by several obstacles." Among those: an undervalued currency, nonperforming bank loans, inefficient state-owned enterprises, and rising income disparities.

In fact, China's central bank expects that the economy slowed to 8.9% in the first quarter. "Strong external demand is still a key driving force for economic growth and private investors remain confident, although rapid investment growth has been contained," the research bureau of the People's Bank of China said in a report issued Wednesday, according to China View. Another government research shop, the State Information Center, predicts that 1st quarter growth in China will slip to 8.8%. For 2006-2010, an annual 8.0% is the number floating around, according to Reuters via The Economic Times.

The kicker, the China View article adds, is that inflationary pressures have yet to dramatically ease. Is Beijing destined to put on the brakes that much harder? Or is the fate of slower growth in the hand of investors?

"A sharp decline in contribution from investment will be the most important factor for slowing GDP growth in the first quarter,'' China's State Information Center said via the China Securities Journal on Tuesday, reports Reuters via The Standard.

It looks like parsing China's GDP reports is the new hot read for oil traders, as well as Secretary Bodman.

Posted by jp at 10:08 PM | Comments (0)