May 31, 2005
RESEARCH ROOM UPDATE
Ronald McKinnon, professor of international economics, Stanford University, contests the so-called conventional wisdom on the matter of exhange rates and trade deficits in a new working paper added to the CS Research Room.
DUALISM IN EXTREMUS
France is said by some to be no friend to the United States on matters geopolitical, but when it comes to foreign exchange it's hard to imagine a more obliging partner. Granted, the current French aid to the dollar is incidental, courtesy of Gallic independence in the form of France's rejection of the European Union's constitution on Sunday. But from a trader's perspective, a rose by any other name would smell as sweet.
By the same logic, albeit in reverse, gold bugs are less than happy with the French dispensing of the constitutional referendum over the weekend. Indeed, whatever helps the greenback necessarily hurts the precious metal. And in the wake of the French vote, the euro has fallen on hard times, dropping to lows against the dollar today not seen since last October. The flip side of a weak euro is a strong dollar, which in turn translates into lower gold prices. The dollar and gold are, as the statisticians like to say, negatively correlated.
It wasn't supposed to be like this, to listen to the gold bugs. The American government has the large and growing fiscal budget deficit. The U.S. harbors the world's greatest trade deficit as well. This, the supporters of barbaric metal say, should boost the fortunes of gold.
And boost it has, until recently. Gold, after climbing more than 25% in the final six months of 2004, has subsequently suffered a crisis of confidence. This year through today's close, gold has dropped 4.5%. Until Sunday, the decline was thought to be temporary, associated with the rebound in the dollar. Hardly great news, but a rebounding dollar was surely temporary, right? The fiscal and trade deficits of American mintage would eventually take their toll. Nothing ever moves down in a straight line. Let the traders have their fun with the buck for now. The comeuppance of the greenback would soon return, the promoters of gold's attributes explained.
But then the French threw a wrench into the precious metal's machine. Traders are less concerned with the twin deficits and more with tectonic plates that support the euro. In short, selling the dollar is yesterday's excuse for fear and loathing on the forex trail. Financial justice, we're told, is in abeyance.
In its place comes euro phobia. If the French can reject Europe's constitution, what other sacred cows can be vanquished?
Perhaps the Dutch voters will provide a hint. The Netherlands votes tomorrow on the European constitution, and polls suggest that another "no" is coming. What might it bring? The Scotsman's chief political correspondent writes today that "a second repudiation within a week will be a devastating setback for the constitution, adding to the pressure on the leaders of the 25-member EU to reconsider the direction of European integration when they gather for a summit in Brussels in two weeks."
Technically, it doesn't matter how the Dutch vote, since approval of the constitution requires a consensus "yes," and the French have already seen fit to discard the document's future in its present form. Perhaps a rewrite of the constitution is coming, which will deliver another round of voting. But that's months, if not years away, if at all, and for the moment nobody can think that far in advance. As such, another resounding no from Holland threatens to raise the degree of anxiety about the euro and spawn a deeper, longer-lasting selloff than imagined just yesterday.
Gold bugs, being readers of newspapers like everyone else, are scrambling to justify staying bullish on the metal. Chief among them is Peter Schiff, president of Euro Pacific Capital. Writing today on the firm's web site, Schiff all but dismisses the dollar's latest rally as something less than enlightened. "The French 'no' vote on the European constitution, which has created political uncertainty in Europe, has produced the reflexive, and ironic 'flight to quality' into the U.S. dollar." But the associated logic is less than airtight, he charges. "As currency traders focus their attention on potential future problems for the European Union, they lose site of current and more acute problems confronting the United States. It is ironic that the currency of the world’s biggest debtor nation is still the 'safe haven' of choice when concerns arise regarding superior currencies of creditor nations."
But all hope for the gold bugs isn't lost. While traders of bullion have registered their skepticism today by selling the metal, gold-mining shares are sending a somewhat different message. The Philadelphia Stock Exchange Gold and Silver Index, a popular measure of listed gold-mining shares, is showing determination of late in moving higher. After a sharp sell-off this morning, the index clawed its way back to a petite loss on the day. Meanwhile, the Philly Gold & Silver index has jumped 10% since May 16, vs. a slight loss in bullion over that stretch. The gold market, in short, is of two minds. But which one's right?
Bifurcated messages, in fact, are all the rage these days. The bond market's rally of late, which dropped the yield on the 10-year Treasury to below 4% today for the first time since February, suggests a slowdown in the economy, as does today's news of the sharp drop in the Chicago Purchasing Managers report for May. But then there's the bullish aura connected with the S&P 500's recent rise, which coincides with today's update on consumer confidence, which the Conference Board says jumped sharply higher in May.
Anything's possible in the capital markets. And that, it seems, is part of the problem at the moment.
May 30, 2005
FRENCH FRIED REFERENDUM
For now, there are only questions. But Mr. Market will soon demand answers.
In the meantime, reflection, speculation and finger pointing are in full swing in the wake of France’s emphatic rejection of the European constitution on Sunday. A complex and flawed document, to be sure, although its raison d’être can be boiled down to this: a tool for streamlining the cumbersome decision-making that now prevails in the European Union. Of course, the streamlining, such as it is, can only take place if the various member states approve it. But for the moment, the jury’s out on the allure of enhanced bureaucratic efficiency.
At best, the “non!” vote cast by the French on the referendum strikes a temporary blow for the forces of economic integration on the Continent. Does the result have legs? Only time will tell, but it’s possible that the French vote yesterday will trigger a more problematic and perhaps fatal dose to any momentum on taking the European Union to the next level. The next clue in this soap opera comes on June 1, when Holland casts its vote. EU supporters have their fingers crossed, although according to several polls the result may very well echo the message dispensed so strongly by the French majority yesterday.
A few observers are reading the writing on the proverbial wall. "There is a risk of contagion," European Commission President Jose Manuel Durao Barroso told French LCI Television after the French voted by “no” by a 55% margin, Reuters reports.
Whatever comes, the European Union will go on as before for the foreseeable future, if not forever. But now there are questions, including, What does this mean for the euro?
There’s no immediate risk to Europe’s currency. Betting otherwise seems like a fool’s game at this point. But that won’t curb the doubts, which carry a bit more resonance in the wake of France’s resounding vote.
The dollar is sure to be a beneficiary of the doubts, at least in the short term. In fact, in early trading after the French vote the initial reaction of forex traders was to sell first and ask questions later. The euro dropped to a seven-month low against the greenback after the news hit the world’s markets. “The French result suggests people are skeptical about the EU and further enlargement,'' says Armin Mekelburg, a currency strategist at HVB Group in Munich, Bloomberg News reports. The same article also quotes Guy Stern, chief investment officer of Credit Suisse Asset Management's German business in Frankfurt: “We will have a problem with the euro. It could depreciate 5 percent to 10 percent.''
America’s trade and fiscal deficits suddenly look a bit less threatening next to the quandary that the French have imposed on the euro, not the least of which is the question: will France or some other euro country ultimately pull out of the currency? The dollar has its troubles, but at least no one’s worrying that California’s going to quit the greenback and give monetary independence a whirl.
If such a threat, however remote, hangs over the euro, what can the EU do to depose such concerns? Not much, at least not until the French vote is thoroughly digested and its impact, if any, is revealed elsewhere in Europe.
Meanwhile, there are the questions. Lots of them. As the dollar’s challenges of recent years remind, questions can mean a lot when it comes to valuing currencies.
May 28, 2005
THE CAPITAL SPECTATOR'S RESEARCH ROOM DEBUTS
Today we unveil The Capital Spectator Research Room, a modest effort to highlight some of the essays, opinions and research papers that catch our attention for one reason or another. We may or may not agree with the conclusions in these pieces, but the ideas intrigue us. As we add to the list of notable links in the Research Room, we'll update you here, with a short note. You'll also find a permanent link to the Research Room in the upper-left hand side of the Capital Spectator's main page. Happy reading!
May 27, 2005
BOTH SIDES NOW
The stock market yesterday was encouraged with the upward revision in first quarter gross domestic product. So too was the bond market. Can both markets be right?
Indeed, before the Thursday revision there was a somewhat different view of the world. In particular, the first estimate of first-quarter GDP was 3.1%, a pace that sparked worries that a "soft patch" in the American economy was approaching. But the soft-patch forecast was dealt a mild setback yesterday with the first-quarter GDP revision that recalculated the economy's growth at a higher 3.5%, according to the Bureau of Economic Analysis.
The notion that growth was a bit more robust than previously thought had the expected effect in the stock market. The S&P 500 climbed by more than one-half a percent as the Nasdaq Composite tacked on slightly more than a percent yesterday.
The stock market's glee was no great shock. A stronger economy typically translates into stronger earnings. But why did the bond market yawn at the upward revision in GDP? That is, why the slight drop in yield yesterday in the benchmark 10-year Treasury, which closed Thursday's session at roughly 4.08%, down every so slightly from 4.09% at the previous close—both of which are yields that are the lowest since February.
Perhaps the fixed-income set took inspiration from the fact that the GDP price index for the first quarter was revised down a bit to an annual 3.2% rate from 3.3% previously. In addition, there's the knowledge that the unexpected narrowing of the trade deficit in March contributed to the bullish revision in GDP for the January-March period. Indeed, the slimmer trade gap was the byproduct of lesser imports, which in theory will help trim inflation's momentum in the U.S. a bit.
On the other hand, wage and salary income advanced somewhat in the latest GDP revision. For one wing of the dismal science, that's a warning flag for inflationary pressures. The Wall Street Journal (subscription required) today quotes David Greenlaw, an economist with Morgan Stanley, as saying that the uptick in wages and salaries may portend higher inflation down the road. Greenlaw notes too that he expects the Federal Reserve to be poring over the revised GDP numbers in the days ahead to gauge whether labor cost increases are here to stay, and if that raises the inflation threat.
But maybe some in the bond market are expecting support for buying fixed-income securities anew when the Institute for Supply Management (ISM) releases on June 1 its manufacturing index update for May. Why? Paul McCulley, managing director of the giant bond shop Pimco, explains in his May Fed Focus essay, noting that "In the Greenspan era, the Fed never keeps tightening once the ISM Index drops below 50.
The ISM Index "is the single best indicator of cyclical regularity in the manufacturing sector, itself driven by cyclically regular swings in the pace of inventory accumulation, which is the primary impulse to cyclical regularity in commodity prices (and the so-called PPI pipeline)," McCulley continues. At present, the ISM Index stands at 53.3%. Readings above 50 are said to be a sign that the manufacturing sector's expanding; below 50 suggests economic contraction. Although the ISM measure was in growth territory as of April, as it's been since June 2003, the trend of late is decidedly down. Indeed, the ISM Index peaked in the current cycle at 62.8 back in January 2004, and it's been downhill ever since.
Will it dip below 50? It's all but certain in the near term, predicts McCulley. If history's a guide, a below-50 reading will coincide with an end to the Fed's rate hikes, McCulley suggests. Timing is unknown, of course. But between now and the June 30 meeting of the Federal Open Market Committee there is ample opportunity for dreaming, speculating and otherwise bidding up the price of fixed-income securities.
McCulley's take on the future is music to the bond market's ears. So too is this morning's news from the government that the inflation-adjusted price index for personal consumption expenditures rose a modest 0.2% in April, down from 0.4% the month before despite the fact that personal income rose a robust 0.7%.
The stars arguably are aligning in the bond market's favor. As a bonus, the stock market doesn't have a problem with the data either. When everyone's bullish, there's no place for bears. That by itself suggests opportunity, or perhaps a warning, albeit one that only a contrarians can embrace.
May 26, 2005
You can see a lot just by observing, Yogi Berra famously said of the national pastime. The adage also applies to the stock market as well as to baseball. But in the process of observing equities and thereby seeing a lot, logic isn't always forthcoming.
Consider the tally of the ten sectors that comprise the S&P 500. Ranked by the change in estimated operating earnings for this year's first quarter over the actual year-earlier quarter, the materials sector is the clear winner, posting a gain of 67%, according to Standard & Poor's. In second place was the energy sector (+40%), followed by utilities (+30%).
So far, so good, although a very different message comes from Mr. Market by way of the market capitalization he assigns to each of the S&P's ten sectors. That starts with financials, the leading S&P 500 sector by market cap, topping the list with a 20% weighting in the S&P 500, as of May 25. This despite the fact that financials came in seventh in the ten-sector race for the pace of raising earnings in this year's first quarter over the comparable period in 2004 with a 7.8% advance.
It's also interesting to note that materials, even though the group posted by far the fastest rise in earnings in the first quarter from a year earlier, was dead last in terms of market cap, grabbing a measly three percent share of the S&P 500. Energy fared a bit better with an 8.2% market-cap weighting in the S&P, although utilities fared worse with a 3.2% weighting.
Perhaps Mr. Market is looking at net income as the arbiter of market cap. Alas, looking at the S&P sectors through this financial prism doesn't necessarily lend more clarity. Indeed, the energy sector claimed more than 13% of the S&P 500's net income in the first quarter, second only to the 27% for financials. By that gauge, one could argue that energy deserves second billing in the market cap ranking. In fact, energy comes in seventh in a field of ten on the market-cap scale.
On the other hand, materials holds just a 4.2% share of S&P 500 net income, and utilities weigh in at 3.8%. That seems to jibe with the low market-cap ranking for each. But this analysis satisfies only if the pace of earnings increases, for which both sectors excelled, is irrelevant.
Investors, of course, are primarily interested in returns. But even this universal metric leaves questions. Indeed, the S&P Energy ETF (Amex: XLE) still leads the pack this year with its shares rising 14% through yesterday. Given the bull market in oil, who could argue? Ok, but why has the S&P Financials ETF (Amex: XLF) shed 4% year to date? Yes, we've heard that interest rates are headed higher, the bond market's judgment notwithstanding. But financials are far and away the leading market-cap sector in the S&P 500. Why haven't they fared better as an investment? Should we conclude then that financials' market cap is too high, and thereby due for a fall? Or, perhaps energy's market cap is too low and due for a rise, in which case the constituent stocks are set to climb further?
The mystery thickens when you consider that the S&P Materials ETF (Amex: XLB) has lost the most this year compared with its sector brethren, posting a 6.3% loss in 2005 through yesterday's close. Rapid earnings increases apparently don't mean much to Wall Street in 2005.
On the other hand, the S&P Utilities ETF (Amex: XLU) has climbed 7.5% this year even though its year-over-year earnings grew by less than half as fast compared with the materials sector.
The market may be efficient, but it's not always logical.
May 25, 2005
THE OECD BEFRIENDS THE DOLLAR
The OECD became the dollar's new best friend yesterday when the Paris-based group issued a warning that the euro-based economy has stumbled and needs help regaining its footing. That's hardly news, but the OECD's Economic Outlook was compelled nonetheless to restate the obvious in yesterday's newly released edition with the advisory that "what is badly lacking is sustained momentum in the euro zone."
The OECD projects that the euro region economy will expand by a slim 1.2% this year vs. 3.6% for the United States. Even Japan's projected 1.5% real GDP growth for 2005 beats euroland's outlook according to the OECD.
More than just good economic results are at stake. If there's any hope of fending off the future fallout of the growing global economic imbalance (namely, America's consumption binge relative to Asia's penchant for saving and Europe's economic stagnation), it will come in part from progress on jolting the Continent's economy into a higher gear. Or so we're told. The "continuing divergences in domestic demand between Europe and some Asian countries on the
one hand, and the United States on the other, cannot be treated with benign neglect," the OECD asserts.
Fixing Europe is a thankless challenge, to be sure. The Continent has long been trying to promote stronger GDP growth, but with little success relative to the U.S., much less Asia ex-Japan. One only has to look at the latest reported GDP numbers for proof. France and Germany, which represent the lion's share of the euro-based economy, muddled along with real annualized GDP advances of 1.7% and 1.1%, respectively, in this year's first quarter. No one can argue the point that such growth rates pale next to the 3.6% GDP rise in the first quarter for the U.S. What's more, Europe's diminutive status is far from new. In 2004, the euro region's GDP posted a 1.8% rise, less than half of America's 4.4% ascent, according to OECD.
Once again, the debate turns on what will cure Europe's ailing economy? Reforming the labor market so that firings and hirings are easier is a perennial favorite prescription, albeit one that receives mostly lip service.
One of the OECD's recommendations in its latest report is notable in that it also calls for boosting euro GDP by way of a fresh dose of monetary stimulus, otherwise known as cutting interest rates. Or as the OECD writes: "monetary policy may have an immediate role to play by significantly cutting policy rates. In the current context of low underlying inflation and weak aggregate demand, the case for easing the monetary stance in the euro area looks indeed rather compelling."
Fast forward to the relative interest rates of the U.S. vs. Europe. The Fed funds rate is currently 3.0%, up from 1.0% in June 2004. The equivalent rate set by the European Central Bank is 2.0%, which has prevailed since mid-2003.
From mid-2001 through late last year, the euro's key rate (the so-called main refinancing operations rate) has exceeded Fed funds. That premium in the euro rate has contributed to the currency's strength against the dollar. Indeed, the euro climbed sharply from mid-2001 through the end of 2004 against the greenback, advancing more than 50% over that span.
In 2005, however, the euro weakened against the buck, slipping about 7% year to date. The flip side of that is the rally in the dollar this year (the U.S. Dollar Index is up by roughly 6% so far in 2005). It's no coincidence that the renaissance in the dollar comes in the wake of multiple hikes in the Fed funds rate.
To the extent that rising interest rates lend aid and support to the formerly beleaguered buck, forex traders are betting that more of the same is on tap at the next Federal Open Market Committee meeting, which convenes June 30. On that date, another 25-basis-point rate hike is expected. Or so one could predict based on the fact that the inflation-adjusted Fed funds rate (Fed funds at 3.0% less the 3.5% annual rise in the consumer price index through April) remains negative at around –50 basis points. By this rudimentary measure of real Fed funds, a neutral inflation-adjusted rate (i.e., 0% real) was last seen stalking the monetary landscape in 2002. If the Fed is still intent on returning monetary policy to something akin to neutrality, it follows that another rate hike is in the offing.
The president of the Federal Reserve Bank of Atlanta suggested as much today. "My personal view is that we’ve not yet reached a neutral policy stance," Jack Guynn opined today in a speech to a homebuilders association, a group more sensitive than most to the prospect of interest rate hikes. "I have strongly supported the Fed’s actions to gradually remove our policy accommodation," continued Guynn, who doesn't have a vote in the FOMC's interest-rate setting decisions. "I believe our strategy to act before the appearance of widespread price increases is sound and necessary to keep inflation and inflation expectations firmly in check."
Where, then, does continued monetary tightening in the U.S. leave the euro? In a tight spot, and all the more so if the ECB takes OECD's advice and cuts rates. In that case, the euro's key rate would be falling while the dollar's key rate is rising. It doesn't take the smartest trader in the forex community to translate that into a tactical buy signal for the buck.
Then again, with ECB's key rate already at a relatively low level, future cuts are hardly assured. More likely, say some analysts, is that ECB rate hikes will be delayed. Reuters yesterday quoted euro zone monetary sources as saying that an ECB rate rise won't come until 2006. But keeping euro rates steady amounts to a defacto rate cut in relative terms if the Fed continues to tighten. As such, if it walks like a duck, and quacks like a duck, will forex trader cry fowl?
On the American side at least, tightening remains the trend du jour. The M2 money supply's seasonally adjusted annual rate of change, for instance, has been slipping of late, according to latest Fed data. For the 12 months through April 2005, M2 advanced by 4.1%, but rose by just 3.2% for the six months through April, and by only 1.7% for the three months through April. A trend with legs?
Maybe it's time to dust off the ancient art once popular in the early 1980s of watching the latest weekly monetary reports from the Fed, scheduled for release each Thursday at 4:30 p.m., Washington time.
In the meantime, the dollar seems to have secured some breathing room, temporary though it may be. Still, that's no small feat for a currency that otherwise looked set for extended tumbling based on the jump in America's trade and fiscal deficits in recent years, not to mention the so-far moderate rise in inflation by way of the consumer price index.
But if raising interest rates is bringing support to the buck, traders with more than a 20-minute investment horizon should be asking where we go from here. Can the Fed keep tightening? It can if the economic news on balance stays strong on a relative and absolute basis. On that score, another data point that gives the dollar bulls hope is this morning's durable goods orders, which rose 1.9% in April, the biggest monthly increase since November as well as a sharp turnaround from March's 2.3% decline.
Of course, just when you thought all the stars were aligning on one side of the economic aisle, along comes a new glitch. Today's installment was nothing new in the grand scheme of trends; rather, it's a reminder of an old gremlin that goes by the name of oil. The price of a barrel of crude jumped today above $50 for the first time since May 12. The trigger: U.S. oil inventories, the Energy Department reported today, unexpectedly dropped for the week ended May 20. That's the first drop in inventories in five weeks. Coming just before the unofficial launch of the driving season (Memorial Day weekend), the news was an easy excuse for buying.
The broader point, lest any one forget, is that oil imports, on which the U.S. increasingly relies, puts downward pressure on the dollar. Maybe that's why the U.S. Dollar Index slipped a bit today despite the seemingly bullish recommendation from the OECD on lowering euro rates.
Soaking it all in, investors may want to decide which scenario is more likely to prevail over time: an interest-rate premium in the dollar relative to the euro, or rising oil imports.
Ergo, the conflict between paper assets and tangible commodities remains alive and well.
May 24, 2005
ONE METAL, TWO VISIONS
It's never been easy being a gold bug, but now it's getting complicated.
Such is life for divining financial trends in the 21st century, or so it appeared at the New York Institutional Gold Conference, which ended a two-day run today at the New York Marquis Marriott. Surveying this confab of all things gold, CS was able to discern at least two distinct shades of optimism among those who think the metal's going higher still in the years ahead. The first is what we'd call the traditional gold bug, a creature marked by an unwavering belief that inflation is on the rise, and so then is the price of gold, which closed today at roughly $418 an ounce, or about $20 below where it closed at 2004's end.
The second, and more innovative school of thought among the gold bugs could hardly be more different in citing the catalysts that will elevate the price of the metal. This faction predicts that deflation is coming, courtesy of the mounting pile of debt accumulated by both governments and individuals. Yes, we've been there, done that, and listened to Bernanke's monetary threats. But what's old is new again.
In any case, wouldn't deflation hinder the price of gold? Not at all, says deflationary wing of the precious metal club.
Despite the disparate visions of the future, both sides of the aisle in the church of gold are united in a vision of higher gold prices. Timing is necessarily vague, of course, but to talk to a representative on either side is to receive rhetorical injections of supreme confidence about the path of least resistance for the precious metal. As many have noted before, it's quasi religious. But is it a sin to believe in something other than inflation from a gold bug's view of the world?
Perhaps, but in so observing the opposing factions cheering the metal, it necessarily follows that one side will be wrong. Deciding which one, of course, is the trick. We say "trick" because those predicting higher inflation have had the monetary smoking guns on their side in recent years, i.e., a money supply advancing at a rate above and beyond the obvious and immediate needs of the economy. But the tide may be turning on the monetary front, raising the question of what's the economic impact of a reversal of the monetary fortunes after erring on the opposite extreme for several years?
Deflation, of course, say some gold bugs, albeit a minority within a minority. With that in mind, we cite the recent downturn in the annual rate of increase in the money supply. Consider that M2 money supply advanced at a mere 1.7% on a seasonally adjusted annual basis for the three month through the end of last month, or down sharply from the 4.1% for the 12 months through April 2005, according to the Federal Reserve. The slowdown is even more striking in the narrower measure of money supply known as M1, which actually contracted its pace of change for the three months through April.
A new smoking gun? Or just a technical correction to be ignored?
In fact, it's not money supply that worries the gold bugs, some of whom expect deflation. Rather, it's debt. Indeed, a gold bug who warns of deflation is one Jay Taylor, who publishes the J. Taylor's Gold and Technology Stocks newsletter. Taylor believes that the rising pile of debt, and a presumed inability to pay it off, will bring on deflation. "It is remarkable to me that with only a slight slowing down of global U.S. dollar liquidity we are already seeing warning signs of illiquidity that could lead to a deflationary collapse," Taylor writes via an article dated today in HoweStreet.com. Debt is the raw material from which fiat money is manufactured. "With each new money creation episode by policy makers aimed at avoiding deflation, they plant the seeds of an even deeper recession and a more dangerous financial framework," namely, a deflationary contraction, he predicts.
The bond market seems to agree with this line of thinking, to a point. The yield on the 10-year Treasury was near to testing the year's lows on yield. The benchmark government bond yielded just five basis points over the 4.0% market, the least since early February. In high inflation's coming, you'd never know it by watching the bond market.
The belief that deflation will ultimately prevail explains the recent weakness in gold, Taylor continues. "This is true in my view because 99% of gold investment demand comes from people who think gold is a great asset to own during inflation but a terrible one to own in deflation." Being in the remaining one percent of the gold-bug population puts Taylor in the position of both believing in the prospects for gold and predicting a fall in prices generally. A re-education of gold bugs may be coming, but in the meantime there'll be a lot of head scratching: "And so in the early stages of the deflationary process, until people begin to realize gold is money, the baby is being thrown out with the bath water so to speak."
Gold, in short, is only in a temporary downturn. Among Taylor's sources for his deflationary outlook are Bob Hoye, a strategist who publishes his forecasts from the perch of Institutional Advisors. In an interview in February, Hoye explained in Taylor's newsletter that deflation would be the byproduct of rising debt that triggers an economic collapse and a Fed that for various reasons won't be able to continue to engineer rising prices. Hoye explains: "…once the contraction starts, I suggest that it overwhelms the ability of the Fed to pursue its portion of credit creation. I’m not saying that the Fed is going to suddenly tighten. No bloody way—not willingly! But the whole system is going to tighten as all the leveraged 'liquidity' disappears."
What unfolds when and if the liquidity disappears is, of course, open to debate. On that score, there's still time to consider the matter with the assumption that the end is not yet here. Using sales of existing homes as a proxy, liquidity is alive and well in some corners, according to today's news from the National Association of Realtors. An all-time record of existing home sales was reached last month, the group notes. Single-family home sales rose 4.5% to a seasonally adjusted 6.28 million. Could there be a connection with the fact that the median single-family home price was $203,800 last month, up 15% from 12 months previous?
Is this how deflation starts? Or is it a sign of inflation? Even the gold bugs can't agree.
In any case, more than a few pundits of the financial scene remind that the Fed's printing presses can produce dollars in virtually unlimited quantity. To the extent that inflation is a monetary phenomenon, inflation is always just around the central bank's corner.
But Hoye distinguishes between the money supply and real money. " It’s a misnomer to call M-1, M-2, and M-3 money. And so once the prices of the assets being speculated turn down, then the margin clerk takes over." In short, "Credit is taken on because of soaring asset prices. As the prices stop going up, you are left with the debt."
When the bubble pops, the margin calls come and investors sell whatever they can. Money, in the form of gold, will increase in value as it represents pure wealth, or so the argument goes. In a deflation, Doug Casey of Casey Research counseled a few years back, "gold would soar in serious deflation." Why? Because gold is a device for conserving capital when all else is bleeding wealth, he opines. In that context, gold's value will rise in a relative sense by protecting wealth.
Then again, one larger-than-usual bubble known as the stock market popped a few years back. The result, so far, is higher inflation; marginally so, but higher nonetheless. Gold prices have climbed during that stretch as well. In fact, a gold bug of the inflationary line of thinking recently felt that the deflationistas had to be reminded again of what makes gold price tick. Steve Saville of Speculative-investor.com via SafeHaven.com writes on April 19: "...when gold was the official form of money it was a hedge against deflation whereas under the current monetary system [which is to say fiat money] it is a hedge against inflation. We think additional inflation is by far the most likely outcome over the coming 1-5 years so it follows that we are long-term bulls on gold."
But the deflationistas aren't so easily convinced, and in fact they worry about the next big collapse. Speaking of which, the leading candidate for the next bubble bursting is arguably real estate. Would a sharp correction in housing prices be any more likely to bring on deflation? If so, what would be the implications for gold? Alas, in a sign of the times, consensus among the gold bugs has become elusive.
May 23, 2005
Is the economy slowing, or is it not? As usual, the answer depends on the data you're consuming and the economist who's got your ear.
For those inclined toward optimism, the latest guesswork from the National Association for Business Economics brings a moderate improvement in the economic outlook. "After a mild slip during the early spring, our panel expects the expansion to regain its footing,” Carl Tannenbaum, chair of NABE's outlook survey committee, said in a press release dated today.
The NABE panel, comprised of 50 professional forecasters, predicts GDP will rise only by a real (inflation adjusted) annualized 3.0% in this year's second quarter, although the rate of economic growth will increase to 3.5% in each of the third and fourth quarters, the group forecasts.
But how to square that with two recent regional manufacturing surveys from the Federal Reserve system that paint a picture of a less-than-trivial slowdown? The Philadelphia Fed's manufacturing index for May for its region dropped to its lowest level in nearly two years. Another manufacturing gauge for May released by the New York Fed for its region offers corroborating signs of a slowdown. The Empire State Manufacturing Survey for May fell to its lowest since April 2003, providing another reason for remaining cautious about the prospects for second-quarter GDP.
That is, unless you take the NABE forecast as gospel. Then again, the NABE has been less than a rock of stability on its forward economic assessments. In its February survey, the consensus expected GDP in 2005 would advance by 3.6%; now the group says 3.4%, albeit with the kicker that the second half of this year will pick up speed over the first half. The rising trade deficit, we're told, was the culprit that trimmed the 2005 GDP forecast.
Ah, but the trade deficit in its last statistical outing showed signs of narrowing. The record $60 billion of red ink in the trade balance for February slipped to just under $55 billion in March. Will the trend continue? If so, GDP's pace of expansion may yet deliver some upside surprises.
To judge by last week's action in the dollar, more than a few folks in the forex community seem to agree. The U.S. Dollar Index continued to forge higher last week, closing on Friday at nearly 87, the highest since October 2004.
Adding to the bullish atmosphere on valuing the dollar lately is the chit-chat about China and its export machine. In particular, the tough talk emanating in Washington on the matter of pushing for a floating of the Chinese currency, the yuan, has some in the forex world licking their speculative chops. One scenario thrown about runs like this: China will be persuaded to remove the dollar peg and instead let the market value its currency, which almost certainly will induce a sharp rise in that currency's value relative to the dollar. In turn, China's exports will be more expensive for dollar-based consumers in the U.S. That, the politicians tells us, will help convince Joe Sixpack scale back his buying of TVs and t-shirts manufactured in Shanghai.
The bottom line: the narrowing of the U.S. trade deficit will persist, this school of thought counsels. Indeed, China accounts for about one-quarter of the trade deficit logged in this year's first quarter, so any downturn in Chinese exports to these shores will also pare the red ink in trade.
But there's reason to wonder if forcing a sudden revaluation of the Chinese yuan will automatically deliver an easy boon to the U.S. economy in the form of lesser Chinese exports to America. In fact, letting Mr. Market value the yuan may do nothing to trim the U.S. trade deficit, or so advised Fed Chairman Alan Greenspan on Friday. Limiting Chinese exports by force or otherwise will just redirect demand for importing to other suppliers, he explained at the Economic Club of New York, according to Reuters. "So essentially what we will find is we are importing from a different area but we'll be importing the same goods," Greenspan predicted. "The effect will be a rise in domestic prices in the United States and as a consequence of that, we will have other impacts…."
It's interesting to note that while the maestro's stated subject in his Friday address to the Economic Club was energy, a Reuters writer on the scene relates that no energy questions were forthcoming after Greenspan's speech. The world of currencies, by contrast, was a topical subject at the conclave. The dollar apparently is clearly the new hot topic, even as the greenback rises and pulls back, at least for the moment, from what some thought was the forex equivalent of the abyss.
In any case, the U.S. is forging ahead with its yuan plan, or so it appears. China will be made to do the "right" thing one way or the other. On that score, U.S. Treasury Secretary John Snow yesterday named the new point man to push America's cause for a yuan revaluation. Meanwhile, criticism in the U.S. Congress aimed at China is on the advance. To cite one example, courtesy of the Courier-Mail in Australia: "There has never been any good faith on the part of the Chinese to act in a way that is fair, that honors the opportunity that we give them to grow their economy by using our markets for that growth," the Democratic Minority Leader Nancy Pelosi charged last week.
Such talk is neither uncommon in Washington these days, nor is it being ignored in Beijing. Indeed, China last week announced it was raising textile tariffs on its domestic exporters by 400% on 70 products, reports Chinadaily.com. America wants higher import prices and by golly it's going to get them.
Perhaps that's better than a trade war, although we don’t completely dismiss that possibility yet until and unless tempers in Congress cool and certain members of the Bush administration rethink their foreign currency policy. But don't hold your breath.
Meanwhile, we'll leave it to the dismal scientists to revamp their econometric models and tell us whether the political events of the moment will narrow the trade deficit in coming months and thereby boost GDP.
May 19, 2005
CRUDE RHETORIC AND SLIPPERY PRICES
The price for a barrel of crude dipped below $47 today in New York futures trading, the lowest since early February. Among the proximate catalysts for the latest bout of bearishness for the commodity, which extends a sell off that began in early April, is news that U.S. inventories of crude continued to rise last week, according to the latest weekly petroleum report from the Energy Information Administration.
Supporting the inventory news is the ongoing efforts by Saudi Arabia to talk down prices. Mr. Market has for some time ignored the kingdom's repeated attempts to cool the market with promises that dramatic increases in production were coming in the years ahead. But those promises no longer seem to be falling on deaf ears.
And the promises keep coming. Abdallah S. Jum'ah, president and CEO of the Saudi oil company Aramco, said on Monday at Rice University that his firm, the world's largest oil company, stands willing, ready and able to double its current production in the coming years, reports Arab News.
Similarly rosy pledges of production hikes came afresh on Tuesday from Saudi Arabia's minister of petroleum and mineral resources. "I want to assure you here today that Saudi Arabia's reserves are plentiful and we stand ready to increase output as the market dictates," assured Ali Al-Naimi at an energy conference sponsored by the Center for Strategic and International Studies in Washington, D.C.
The market's heard it all before, of course, and then some. But the Saudi's message carries a bit more resonance these days. The effective transfer of enhanced influence to move trader perceptions to the kingdom is a double-edged sword, of course, but it's the new reality of the moment.
Meanwhile, in an another move to reassure the marketplace that all's well with supply chains, the office of U.S. Energy Secretary, Sam Bodman, announced on Wednesday that a visit to by a representative of the world's biggest oil consumer to the world's primary supplier is scheduled for later this year, reports Reuters via CNNMoney. This after a visit last month by Saudi Crown Prince Abdullah to President Bush's ranch in Texas.
Despite all the efforts in oil diplomacy these days, and its limited success of late, it's worth remembering that Mr. Market is notoriously short sighted and skittish. As evidence, consider that oil prices have risen from around $40 last December to the upper-$50 range in this year's early spring, but have since been heading back down—all without a material change in the known variables of supply and demand. Is Saudi Arabia saying something different today than it was in previous weeks and months? No, not really. All of which suggests that something less than absolute market efficiency prevails in the oil-trading pits.
If guesswork and speculation necessarily dominant the pricing of oil in the short term, a bit more clarity, though not necessarily comfort is found when surveying the long haul. On the latter subject, even the Saudi PR machine throws the market a bone of substance every now and again for those who're inclined to read the full transcripts and dig below the headlines. Consider, for instance, the admission by Saudi's oil minister at the CSIS conference earlier this week: "The previous era of overcapacity has ended," Ali Al-Naimi said.
Indeed, spare oil production capacity in the world is estimated to be just above one million barrels a day in 2005, the Energy Information Administration reports. That slim margin of excess is forecast to slip again next year. As a measure of how thin one million barrels a day is within the global economy, consider that as recently as 2002 excess capacity in the world was well over five million barrels a day--from five to one in just three years!
One million barrels of spare capacity represents around 1% of global oil consumption, based on 2003 data. Given the rise in energy demand since 2003, the excess capacity margin is probably much lower today, perhaps one-half of one percent. The point being: the world economy's oil production buffer has rarely been thinner in recent memory. As a result, the potential for serious supply disruptions looms large.
As troubling as that is, the problem is compounded by the fact that demand growth forges higher no matter the constraints and bottlenecks of elevating supply. EIA projects that world oil demand will grow 2.7% this year over 2004, and 2.5% in 2006.
Where will the extra supply come from? Saudi Arabia, of course. That is, there seems to be no one else in OPEC who can step up to the supply plate any time soon. According to April EIA numbers, all of
OPEC's 900,000-to-1.4-million spare capacity resides in Saudi Arabia.
All of which suggests that the future price of oil will turn heavily on Saudi Arabia's ability to ramp up production at a pace that keeps up with the rise in global demand growth. In past decades, that's not been a problem since much of the quick and easy reserves on hand in the kingdom were sitting idle. Any increased demand could be met by drawing on the country's ample excess supply that was available for tapping. But with that excess supply virtually exhausted, new oilfield/infrastructure development is necessary to satisfy demand growth.
Yes, in theory adding new production capacity isn't a problem. But in practice it's complicated for more than a few reasons, starting with the substantial investment dollars needed to complete the task. Given the size and scope of dramatically increasing oil output, it's a task that's inevitably a hot-button political issue of no small relevance in a country where the oil wealth is less than evenly distributed. Meanwhile, there's the sneaking suspicion among some in Aramco and the Saudi government that the current bull market in oil won't last, which translates into a reluctance to engage in expensive new production projects. Thus the emphasis on talk.
All that aside, a back-of-the-envelope calculation implies that the kingdom's failure to meet global demand growth will result in a rise in oil prices. How to avoid that untoward future? The kingdom must come up with an additional two-million-plus barrels of oil a day each and every year, assuming a 2.5% rise in world oil consumption growth and no production increase outside Saudi Arabia, That amounts to raising production by one-fifth of current production every 12 months.
Of course, any production increases elsewhere in Opec and in non-Opec nations will lessen Saudi Arabia's burden. The leading source for hope on that front beyond Saudi fields lies with Iraq, the world's third-largest source of oil reserves. But getting more oil out of the country beyond current production of around two million barrels a day won't be easy, warns Neil McMahon, oil analyst at Sanford C. Bernstein in London. The immediate problem is terrorism, which Bernstein and others say is rising this year in terms of the number attacks on pipelines and deaths in the country from insurgent activity. Meanwhile, rebuilding Iraq's antiquated oil infrastructure will take time, oil-industry resources that are already in high demand around the globe, and lots of money.
Silver bullets, in other words, are in short supply. That leaves Saudi Arabia in the driver's seat for the foreseeable future. How does Mr. Market digest that reality? To judge by the recent decline in oil prices, optimism is the new new thing in the pricing of oil. How long it lasts is quite another matter.
May 18, 2005
Food and energy are the offending variables, this morning's inflation report for April informed. And what does Mr. Market do with offensive data? Dismiss it, of course.
The top-line consumer price index advanced 0.5% last month, but extracting food and energy from the mix shows consumer prices as unchanged in April, the Labor Department reported. Whether or not such an extraction is enlightened is a topic for another day on Wall Street. In the here and now, there are far more potent issues at hand to celebrate, such as the fact that oil prices remain in retreat again today, a trend that adds weight to the inflation-is-a-tootheless-beast implication suggested by this morning's core-CPI number.
The bond market was quick to draw that inference. Traders bid up the price of the 10-year Treasury Note due in May 2015, which in turn reduced the yield considerably to is closing of around 4.09% today, the lowest since the middle of February.
Adding to the bullish aura on bonds today was a prediction by fixed-income guru Bill Gross, chief investment officer of Pimco, that the 10-year Treasury yield could fall to as low as 3% over the next three to five years. The reason: scant evidence of mounting inflation pressures.
"If 3% inflation is all we can get from the past 5-years’ asset inflation, it’s hard to believe that we get more from what’s left," Gross wrote in his latest monthly investment outlook. "The potential to reflate via interest rates is nearly over." He explains that the combination of globalized free trade and a surplus of cheap labor in Asian markets means that "it will be difficult to generate U.S. inflation higher than our current 3% even if interest rates fall further."
It's hard to argue otherwise in light of this morning's CPI report. "This is telling us that much feared inflationary pressures are moderating," Anthony Chan, senior economist at JP Morgan Asset Management, tells AP via The Washington Post. "This is very, very encouraging."
The view that inflation's threat is receding harks back to the state of mind that prevailed at the Federal Reserve in 2002 and 2003, when deflation was Public Enemy Number One and injecting liquidity into the monetary system was the first, last, and best vaccine against a downward spiral in prices. The strategy of juicing up pricing pressure worked, or at least it seemed to work. Inflation, measured by CPI, moved up convincingly in 2004 and as of last month was advancing at a 3.5% year-over-year rate, which is tied with November's pace as the fastest since 2001.
Now we're told that, a la Bill Gross and others, that the engineered inflation of the recent past has run its course. The Fed, in its infinite wisdom, will simply turn a few switches back at the shop and inflation's moment in the last few years will evaporate on command. What's more, this great monetary feat may be unfolding as we write. Indeed, the 3.5% advance in the CPI falls to 2.2% after subtracting food and energy from the calculation. What's more, even that 2.2% is middling based on the last several years.
But before we retire inflation from our list of fears it's instructive to take a deeper look at April's CPI report. Note, for example, that while core CPI (ex food and energy) was nonexistent last month, a number of component groups showed lesser signs of repairing just yet to the sleepy world of absolute price stability.
Consider, for example, that food and beverages advanced 0.6% in April, housing was up 0.3%, and medical care rose by 0.2%. Apparel was the sole victim of deflation, falling by 0.6% last month, a trend that's prevailed often in recent months. But there's no question that prices generally are rising, or so the details of the CPI report counsel. Whether they're rising enough to warrant inflation anxiety is open to debate, but prices are rising nonetheless. In fact, Bill Gross himself, along with others, have warned that the government may be underestimating the reported inflation figures.
Meanwhile, Peter Schiff of Euro Pacific Capital, an inflation hawk's inflation hawk, wasted no time in challenging the veracity' of today's unchanged core CPI rate. In a commentary posted on his company's web site, he argued in his usual stinging tones that inflation is something more than indicated by the core CPI rate lets on, which Schiff labels "pro-forma CPI," a reference to the discredited methodology for calculating corporate earnings translated into a pricing-metric equivalent. He goes on to throw down the rhetorical gauntlet, predicting that "bond investors foolish enough to believe the 'core CPI' propaganda will likely be just as disappointed as stock investors who fell victim to the same scam with pro-forma earnings."
Nonetheless, the preference for seeing as inflation as yesterday's worry suddenly finds new popularity. It must be stated too that this optimism is built in no small degree on the house of energy and the expectation that the price rally in oil is now behind us.
But just how wise is it to ignore energy when considering current and future inflation? Indeed, investors have been burned more than a few times in history in expecting oil prices to remain cheap and/or drop sharply. Has something changed to make such optimism any more appetizing for the thinking investor?
In any case, one school of thought advises that we've seen oil prices throw their worst at the economy and the damage has been limited. As Ed Yardeni, chief investment strategist of Oak Associates, wrote in a note to clients today, first-quarter S&P 500 earnings rose by 13.1%--the 12th consecutive quarter of double-digit earnings increases for the venerable benchmark.
Still, declaring the energy threat as dead and buried may be premature. As Yardeni acknowledges, oil demand continues to "soar" among emerging economies, including China and India. Five years from now, it's a safe bet that global demand will be materially higher than it is today. From that assumption follows the perennial, though currently marginalized question, Will supply be able to keep pace?
The answer may not have much to do with identifying the path of least resistance for bonds and stocks in the coming days and weeks, but it has everything to do with devising an informed investment strategy for the years ahead.
May 17, 2005
THE SPREAD SHALL SET YOU FREE
The Treasury market may be indifferent to current events in the economy, but the high-yield segment of debt securities, otherwise known as junk bonds, is focused like a laser beam these days.
The spread, or yield premium, in junk over the 10-year Treasury Note has been moving unambiguously higher since March, and the trend shows no sign of slowing. At the close of trading today, the KDP High Yield Daily Index carried a premium of 376 basis points over the 10-year Treasury Note. The last time the spread was that rich was November 2003.
Detailing the mechanics of spread ascension is every bit as remarkable as the fact that it's risen to such heights in the first place. The recap of this peregrination in yield starts with the fact that the KDP High Yield Daily Index closed today at a 7.90% yield, the highest since June 2004, which coincidentally happens to be the month that the Federal Reserve began elevating the price of money for the first time in the 21st century.
The 10-year Treasury yield, by comparison, is a slothful gauge of money's price. By the close of trading today, the benchmark bond's yield settled virtually unchanged from yesterday at roughly 4.12%. In fact, while the KDP yield has been on the march upward since March, the 10-year Treasury has been generally moving in the opposite direction.
Deconstructing how we've arrived at this contrapuntal state of yield trends is one thing. Deciphering what it means is something else. Indeed, there are two distinct and ultimately hostile outlooks embedded in the menu of outlook served up by these two corners of fixed-income finance. On one side of the table is the Treasury market, where yields are more or less stable, if not falling. Then there's contradictory and unappetizing message of rising yields from junk bonds.
Each is saying something materially different from the other, or so one can argue. The Treasury market, if we may be so bold as to assume prescience, tells us that the economy will err on the side of slower growth in coming quarters. Or so the 10-year's stable/falling yield implies. Entwined in that forecast is the assumption that inflation won't amount to much after all. Even today's producer price index, which rose by a higher-than-expected 0.6% in April, is of little consequence, traders of Treasury appeared to be advising the rest of us today.
But the junk-bond market would have you believe that inflation is something to lose sleep over and economic growth may be materially better than anticipated. The complication, of course, is that high-yield bonds aren't a full-fledged card-carrying member of the bond guild. Given their low credit-rating status, junk is viewed by Mr. Market as a love child born with the genetic makeup of both equity and debt. All of which suggests that the sell-off in junk bonds may be less about the future path of yield and more about the concerns of the underlying health of the corporate issuers. In fact, if one views the recent history of high-yield bonds by price, which moves inversely to yield, the junk chart looks more like the stock market, ergo, a market that's been falling.
If worries about the future health of corporations is really what's bugging the high-yield market, then the stable/falling yield in the 10-year Treasury doesn't look all that out of step after all.
Neither then does the April 26 launch of the Access Flex Bear High-Yield Fund, which effectively offers short exposure to junk bonds. Unsurprisingly, this mutual fund with an inherently pessimistic posture has jumped 1.4% during its short life thus far.
It's getting easier to find short exposure to the high-yield market, and thereby benefit from the rising yields. But deciding if the prediction will prove profitable as a long-term proposition is as tough as ever.
May 16, 2005
THE EMPIRE STUMBLES
The first question in looking at the grim trend of decay that screams out from today's update of the Empire State Manufacturing Survey is whether the news should be taken seriously. Pairing this numerical incarnation of negativity with competing measures of the national economy raise a conflict, effectively pitting optimism against its ancient rival of despair.
But should we really take one state's apparent decline and fall as a sign of the times? Although minds differ on the answer, there's no debating the sharp drop in April for this measure of New York state manufacturing activity. "The general business conditions index dropped fairly sharply for the second month in a row, to a level of -11.1—its lowest reading since April 2003," the report advises. What's more, measures of both new and unfilled orders also fell into negative terrain; the shipments gauge remained near zero; and the index of employee totals dropped to its lowest mark in over two-and-a-half years. To quote the technical term that describes this pile of economic data: Ouch!
Or so one would think. But optimists aren't so easily swayed. That includes David Resler, chief economist with Nomura Securities in New York. In a research note distributed today, he effectively dismissed the Empire State Index's warning as something less than compelling. In fact, he all but labeled it misleading. Yes, the yardstick fell sharply to –11 from 2, but that's not necessarily a reason to worry, Resler wrote:
"If its results had not been so discredited last month when it fell to 3 (now revised) from 20, the implied slowdown, and its rapidity would be significant. However, there was no validation of this index's decline in April, in other regional surveys, the ISM index or the Federal Reserve's beige book and we assume the same lack of correlation with be evident in those same releases for May. Similarly the macro-data, from retail sales, to employment and initial claims, provide no validation of the Empire Index either."
Overall, the Empire Index's drop is "more perplexing than it is worrisome," Resler concluded. Chalk it up as an anomaly as opposed to a warning for the national economic scene.
Indeed, a report released earlier this month from the Federal Reserve Bank of Philadelphia backs up Resler's optimism. Coincident indexes measuring the first quarter of 2005 of economic activity for each of the 50 states shows growth is by far the dominant state of affairs around the country. The indexes increased in 46 states and declined in only four, a press release dated May 5 announced.
Although first-quarter surveys are dated material compared with the Empire Index's update on April activity, Mr. Market seems inclined to take the bullish side of the story today. The S&P 500 rose 1% today, hardly giving the Empire Index a passing glance. The benchmark 10-year Treasury Note yield yawned, remaining essentially unchanged at roughly 4.15%. Not even the formerly shaky dollar finds reason to turn tail and assume the worst today. Rather, the U.S. Dollar Index for a time tested new highs this year as the bias for expecting growth will overwhelm any counter trends, anomalous or otherwise, before pulling back to settle slightly up on the day.
But some take a darker perspective nonetheless. "This is awful," Ian Shepherdson, chief economist at High Frequency Economics LLC in Valhalla, New York, says of today's Empire Index news in an interview with Bloomberg News. "The survey is much weaker than we expected, and it supports our view that the soft patch is not over."
Shepherdson seemed to be in the minority today, but there's still reason to sleep with one eye open. The Treasury today reported that investors the world over in March consumed U.S. assets at the slowest rate in more than 18 months. Net foreign purchases of U.S. securities totaled $45.7 billion in March, down by 45% from February. Is this a sign that the red ink in the federal budget and trade deficits, which have been rising in recent years, are starting to give foreigners pause about holding more American paper assets?
Well, we've seen warning signs of this ilk come and go before with nary a burp. Why should this time be any different?
American economic growth, or lack thereof, will ultimately bring the answer. As always, that answer comes in individually wrapped dosages. And no dosage is likely to have greater weight on investor sentiment, domestic or foreign, these days than the numbers emanating from real estate, which is arguably the last, great remaining prop of consumer optimism.
On that front, tomorrow brings news of April's housing starts and building permits, reports that will help us answer the pressing question: Is Joe Sixpack and his extended family still intent on taking out a new loan to buy another investment condo in Florida? The retort will be dispatched tomorrow, to a degree. With any luck, it'll go a long way in helping investors decide whether dismissing such metrics as the Empire Index is truly enlightened or deserving of a less-forgiving epithet.
May 13, 2005
CALLING ALL CONTRARIANS
The consumer seems to have picked a timely moment last month to cut back on buying imports, an act which helped pare the trade deficit in April. Indeed, import prices rose by 0.8% last month, the Bureau of Labor Statistics reported today. That was twice as high as consensus prediction from the dismal scientists.
On first glance, the 0.8% jump in the prices of foreign goods arriving on America's shores looks like progress since that number's down from the revised 2.0% jump posted in March. But taken outside of that context, there's little to cheer about with an 0.8% rise.
Import prices on a year-over-year basis are now running at 8.1% through April—a pace that's a world above the 3.1% pace for domestic price increases, measured by the March consumer price index.
To the extent that Joe Sixpack continues shunning foreign-made goods, however, today's news on the import-price front will have a limited impact on inflationary pressures in these United States. But Joe, even after his latest bout of forswearing offshore-manufactured trinkets, has a long way to go in proving that he's about to favor domestic.
The challenge starts with the structural reality that is the American economy in 2005, which is to say an economy that's increasingly relying on Asia, among other regions, for satisfying Joe Sixpack's consumptional predilections. Even assuming our middle-class hero's mustered the discipline necessary to help slim the trade deficit going forward, self-control only goes so far short of riding bicycles and dining by candlelight for the foreseeable future.
Indeed, petroleum imports were a leading cause of the last month's rise in import prices. Petroleum import prices surged 3.1% in April, while non-petroleum imports advanced a relatively meager 0.4%.
But therein lies the seed of hope. Indeed, for those seeing the glass half full, there's reason think that better days lie ahead with import prices since oil prices continued falling today. Traders of crude futures in New York saw fit to drop a barrel of oil at one point on Friday to its lowest price since late February. Selling, it seems, has become the path of least resistance in the world's most important commodity.
It's anyone's guess how far oil prices will drop from here on out, assuming they do in fact drop further. But the stakes are crystal clear. For the sake of keeping a lid on inflation, the bond market should start praying that oil prices do in fact stay below $49, as they did today at the close.
In fact, the fixed-income set seems to be expecting no less. The yield on the 10-year Treasury Note slipped again today, effectively dismissing the import price news. The benchmark Treasury's yield settled at around 4.13%, the lowest in nearly three months.
"Excluding petroleum [import prices were] only up 4 tenths [of a percentage point], so really it's the same old-same old story," Patrick Fearon, senior economist at A.G. Edwards, tells Reuters.
Combined with weak oil prices, it's suddenly easy if not fashionable to dismiss inflationary news. Indeed, forex trades were dismissing any and all threats as they bid up the dollar again today to its highest level since last October, based on the U.S. Dollar Index.
The embedded assumption in the bond and forex markets is that oil's down, will stay down, and is probably headed lower still. No one was willing to argue with that presumption as Friday trading drew to a close. Well, almost no one.
The weak link in all of this is that the stock market's looking increasingly ill. Although the S&P 500 was down less than a percent today, the index's rally that began back in early 2003 is looking tired. The S&P is off nearly 5% this year. Is the slippage merely a bit of healthy profit taking after two calendar years of gains, or is something more ominous brewing that as yet is only hinted at in falling equity prices?
Whatever the answer, Wall Street analysts remain bullish, or so the consensus earnings estimate for the S&P suggests. Operating earnings estimates for the S&P 500 for full-year 2005 call for an advance of 11.6%, according to bottom-up numbers posted by Standard & Poor's. Sure, that's below the 23.7% earnings rise logged by the index in 2004. But even 11.6% is nothing to sneeze at, assuming it comes to pass, when measured next to the economy's nominal annualized rise of 6.2% posted in this year's first quarter.
Why then the gathering despair in equity prices? Does the stock market smell an economic stumble afoot? We know the bond market does, or so the falling yield suggests. The question then becomes: who's willing to bet against both the conventional wisdom in stocks and bonds?
Calling all contrarians—this is your softball pitch.
May 12, 2005
FROM PRUDENCE TO PROFLIGACY IN 30 DAYS
If you're not confused when it comes to figuring out which way the economic winds are blowing, today's retail sales report for April threatens to advance the cause of puzzlement.
For those who haven't been following the soap opera otherwise known as the American economy, a quick recap is in order. When we last left the dismal science, hope was in the air after the news that the trade deficit unexpectedly narrowed in March. Although exports rose in March, the decline in imports was no less important in paring the gap. Alas, that paring was largely due to a pullback in consumer spending, which of course raises the issue of whether the "solution" to the trade deficit is worse than the disease.
But while consumers pulled back on time spent in malls and the lots of car dealers, their prudence in March gave way to profligacy in April, according to today's retail sales estimates for last month. Advance retail sales jumped 1.4% last month, up from a sluggish 0.3% rise in March, the Census Bureau reports. That's twice the rate of increase that economists were predicting, and is the fastest monthly increase since last September's 1.8% rise. Comparing last month vs. a year earlier, retail sales were up 8.6%, or more than twice as fast the economy's pace of expansion in recent quarters.
Perhaps the April bounce-back can be explained by oil prices. Recall that in March, a barrel of crude was climbing on its way to a new all-time high. The momentum in energy prices that month arguably took a toll in consumer sentiment. But as April unfolded, oil prices began slipping in rapid fashion for a time, and presumably giving Joe Sixpack a fresh injection of consumption fever, and giving our hero an excuse for reverting to form.
No matter the analysis, the fact that retail sales climbed sharply in April raises fears anew that the Federal Reserve will continue raising interest rates when it meets again on such matters on June 30. "The issue for the market is that it shows the economy remains quite vibrant and it raises the specter of further rate increases by the Fed," Frank Husic, chief investment officer of Husic Capital Management in San Francisco, tells Bloomberg News.
Fair enough. But then why did the yield on the 10-year Treasury Note slip today? If the bond bulls are worried about the Fed, they showed no fear in today's trading session. The 10-year yield slipped to its lowest since May 5 by the session's close.
While you're deconstructing the minds of bond traders, take note too that the stock market tumbled today despite the bright news on retail sales. Among the catalysts for the selling in equities: Wal-Mart Stores Inc. disappointed the Street ever so slightly by reporting first-quarter earnings per share of 55 cents vs. the consensus estimate of 56 cents. No matter that 55 cents was up 10% on the year-earlier report—not bad for one of the largest companies in the world that's still growing twice as fast as reported first-quarter GDP. But Mr. Market has no patience these days for even the smallest of frustrations, and so traders sold Wal-Mart first and asked questions later.
What's more, the price of a barrel of crude continued tumbling today, dropping more than 3% to close under $49 a barrel in New York futures trading. Lower energy prices, in theory, should boost equity traders' spirits and worry the fixed-income set in that lower fuel costs fosters economic activity, the monster that the bond market fears most. Instead, the opposite unfolded: oil dropped and so did yields. So much for applying economic logic to the pricing of securities.
Tomorrow brings news of import prices for April, thereby delivering another opportunity to misinterpret the numbers, in this case a measure of inflationary pressures, or the lack thereof blowing into the U.S. economy from abroad.
PARSING THE TRADE REPORT
The U.S. Dollar Index has been marching higher in the wake of yesterday's better-than-expected trade-deficit news. This index of the greenback in fact reached its highest mark since last November. Has the turnaround in the trade deficit that so many have hoped for finally arrived? If so, should investors celebrate or reserve judgment about the implications?
Before we go off the deep end on speculating about the morrow, we should stop and consider that it's a sign of the times that the "good news" comes in a package that just a few short years would be considered by some to be apocalyptic. Indeed, for the January-through-March period, 2005's red ink on the U.S. trade front retains its first-place status as the deepest on record. Running at -$174 billion for the first three months of this year, that deficit is materially larger than $138.8 billion from the year-earlier three-month period. In fact, the trade deficit for this year's first quarter is larger than the total red ink for all of 1997, although such comparisons look far less dramatic on a percentage-of-GDP basis.
But for the moment, optimism reigns supreme, and that optimism seems likely to carry the dollar higher for the foreseeable future. In the meantime, it's unclear if March's trade report constitutes such a true turning point, although such a trend would represent no small gift to the American economy. Slow but steady progress on reducing the red ink of trade is the preferable method for adjusting international flows. Indeed, forex traders seem approving of the prospect of closing the trade deficit in $5 billion increments.
Nonetheless, there is just one trade report of the supposed new era to review, impressive though it is. March's trade deficit was $55 billion, the Commerce Department reported. That was the smallest trade gap in six months and more than slightly below the -$60 billion-plus that the market was expecting.
Among the immediate implications: first-quarter GDP revision, due for release on May 26, will be elevated somewhat by the improving trade picture. (Larger trade deficits, in the accounting system of compiling GDP, subtract from economic growth; lesser deficits, relatively speaking, add to growth.) Michael Englund of Action Economics expects a revision of first-quarter GDP to 3.8% from the initially reported 3.1%, he writes in BusinessWeek.
Materially raising GDP in the first quarter may convince the bond market that a 4.2% yield on the 10-year Treasury Note is in need of revision too. Or maybe not. The 10-year's yield has barely moved since yesterday's trade news hit the Street. Then again, one could reasonably ask if the deepening trade deficit that has long been a part of the American economic scene is truly reversing. The bond market seems to be asking no less.
Only time will tell, of course, but that doesn't stop any one for poring over the data for clues. With editorial pick and shovel in hand, we did just that, turning over numerical rocks for signs of what may or may not come. Although we found no drama that's otherwise unreported, there were a few tidbits on which we'll be chewing until the April trade report sees the light of day on June 10.
Among the intriguing facts embedded in the trade numbers, based on seasonally adjusted data:
· Although March's 1.5% rise in exports was above the 0.8% average logged since March 2004, the rate of increase wasn't exceptional based on recent history. In December 2004, for instance, exports advanced by 3.2%.
· The rise of U.S. goods exports (up 1.6% in March) was driven by agricultural products. In seasonally adjusted dollar terms, soybeans exports were by far the leading source of higher exports, followed by corn, animal feeds, rice, nuts and dairy products. Is any future renaissance in paring the U.S. trade deficit really going to be a function of shipping more walnuts to China?
· Although so-called services exports rose in March by 1.5%, the dollar value of those exports traditionally pales next to those for goods. In March, for instance, services exports totaled $30.1 billion vs. $72.1 billion for goods. That said, on a percentage basis the rise in services exports was concentrated in "Other Transportation," which jumped 4.1%, followed by "passenger fares" with 3.9%.
· The lion's share of the fall in imports in March was in goods, led by a falloff in consumer goods. The immediate questions that the trend poses: Does Joe Sixpack's sudden caution on buying reflect a broader trend for the future? If so, what does Joe's behavior imply for 2Q GDP?
May 10, 2005
KEEPING THE FAITH
For the last three decades of the 20th century, oil and bond yields shared a stable, if hostile relationship. When the price of crude went up, so too did government bond yields. When oil prices fell, Treasury yields declined as well.
This has been no accidental relationship, writes economist David Wheelock, assistant vice president at the Federal Reserve Bank of St. Louis, in a new piece that asks the timely question: "Has the bond market forgotten Oil?"
In 2005, at least, the answer seems to be a reluctant "yes." Crude, based on the nearby futures contract traded in New York, has climbed 20% this year through today's closing price of $52.07. The yield on the benchmark 10-year Treasury Note is essentially unchanged over that span. Over the longer haul, the disparity between the two is even more dramatic. During the three years through last month, oil's climbed more than 80%, while the yield on the 10-year has fallen by around 87 basis points.
It's hard to argue that the bond market's obsessed with oil these days, yet once upon a time the fixed-income set was impressed, if not obsessed with the vicissitudes of crude. The reason was inflation, Wheelock explains. "In the 1970s, a rising price of oil often presaged a sustained increase in the rate of inflation; bond investors responded by demanding higher nominal yields to protect their real returns. Similarly, in the 1980s and 1990s, when oil prices and inflation generally fell, bond yields also fell."
No more. In the 21st century, the bond market gets worked up over precious little, least of all rising oil prices. It's fair to say that the former rapport between oil and bonds has been torn asunder. Wheelock advances several theories for the breakdown in the linkage. One is that the recent rise in oil's price coincided with the U.S. economy climbing out of the doldrums that prevailed in 2001 and 2002. During the revival of economic momentum, inflation was low and the rebound in the labor force was below par. "Few analysts viewed inflation as a threat and, as employment continued to lag, a few warned that deflation was possible," Wheelock writes. "In this environment, government security yields remained low."
Ah, but how does a thinking investor square that plausible analysis of the past with the here and now? Indeed, inflation is starting to bubble higher again, albeit on a low level thus far. Meanwhile, oil prices show no signs of retreating much below $50 a barrel. Is the yield/oil relation of yore doomed to make an untimely return?
Indeed, the labor market continues to gain momentum on the upside, as last week's surprisingly strong jobs report for April reminds, and the Fed has been signaling its determination to tighten the monetary strings for the foreseeable future. The year 2005 is shaping up to be a lot less friendly regarding the fostering of conditions that presumably led to the breakdown in the yield/oil association of a few years earlier
No matter, as the bond market seems in no particular rush to do much of anything at the moment. Despite a roller coaster of economic news in recent weeks, the 10-year's yield hasn't changed much in the last month. In fact, in today's trading session, the 10-year's yield fell, signaling that the bulls of fixed income aren't about to go away quietly.
Then again, maybe the explanation for the new relationship between oil and yields lies elsewhere. Wheelock also ponders the notion that the low bond yields have prevailed because the country sports a greater energy efficiency compared with years past. What's more, some think that the price of crude will soon fall sharply.
Wheelock also opines that the market's trust in the Federal Reserve's commitment to successfully beating inflation into submission is a factor. "The importance of maintaining a stable price level is much more widely recognized today than in the 1970s, and the bond market has considerable faith that the Fed will not allow inflation to rise (or fall) significantly from its present level," he explains. "As long as such faith persists, the price of oil can rise and fall without causing large movements in bond yields."
Spoken like a true member of the central banking establishment. And who can argue? Although the pace of inflation, measured by the year-over-year change in the monthly consumer price index, has risen in recent years, it's no higher than it was a decade ago. Advancing at 3.1% in March, CPI is increasing at a rate that prevailed during the first half of the 1990s.
But faith, like hot restaurants and the latest rate of change in inflation, can be a slippery fish. All the more so when it comes to central banking, which may be under different management in the very near future in light of the approaching forced retirement of Alan Greenspan on January 31, 2006 from the board of the Federal Open Market Committee.
In the meantime, faith springs eternal in the bond market. Looking through a rear-view mirror gives one confidence that the optimism is well founded. But does the analysis hold up when looking through the windshield at the road ahead?
May 9, 2005
WE'RE FROM THE GOVERNMENT AND WE'RE HERE TO HELP YOU...REVALUE YOUR CURRENCY
Some in the United States believe that letting the Chinese yuan find its true value in the foreign exchange market will deliver a quick boon to America’s economy. Perhaps. But there’s reason for doubt.
Embedded in the optimists’ notion is the presumption that the yuan is undervalued by way of Beijing’s “manipulations,” otherwise known as a peg of one dollar to 8.28 yuan that’s prevailed since 1995. Opening up this corner of forex to the light of free trade will satisfy certain members of Congress and more than a few industries that have previously taken it on the chin in competing with the Middle Kingdom. We’re all for free trade and fair prices, to the extent forex can actually deliver on such promises, but one should always go into such constructs with eyes wide open.
That starts with recognizing that there may be a few downsides looming in a sudden upward revaluation of the yuan, at least from the perspective of the U.S. Consider the possibility that if this currency strategy comes to fruition, a result may be that one of the main sources of U.S. imports these days will effectively raise its prices by strengthening its currency. Given the Federal Reserve’s growing concern with inflation, one might reasonably wonder if revaluing the yuan upward, under pressure from the U.S. government, and thereby adding that much more pressure to already rising import prices passes the smell test as enlightened economic policy at this juncture.
Enlightened or not, the powers that be in Washington want a stronger yuan. Reuters reports that the U.S. Treasury seems to be moving China’s central bank forward in terms of favorably reviewing a revaluation scheme. A meeting between Chinese officials and the representatives from Treasury is the catalyst for such thinking in the latest news cycle. "[The Chinese] have made continuous, steady progress on the necessary reforms to introduce flexibility," Treasury spokesman Tony Fratto said today. "They've made continued progress on their ability to do that. Along that continuum they've made sufficient progress to introduce flexibility now. And yes, this meeting furthered that."
Treasury Secretary John Snow weighed in on the subject as well, advising, “I don't have a timetable for it, but I'm encouraged that the Chinese have made enormous strides to put in place improvements to their financial system that will'' pave the way for the yuan to become more flexible, Snow said, according to Bloomberg News.
Sounds like they’re reading from a talking points memo. But whether the comments are inspired or not, the philosophical assumptions for thinking that a floating yuan is a short-cut to curing America’s various macroeconomic ills is misguided. Or so asserts Steven Hanke, a professor at Johns Hopkins University and a longtime observer of forex, in an op-ed piece in today’s Wall Street Journal. Similar currency schemes were tried with the Japanese yen in the 1980s, and with little to show for it, Hanke advises along with his co-author Michael Connolly, a professor at the University of Miami.
“The clamor for a yuan revaluation is loud. At one time or another, everyone from President Bush to the G-7 has had a hand in the noisemaking,” Hanke and Connolly write. “But the yuan quick fix might just be neat, plausible and wrong.” What’s more, killing the peg probably wouldn’t shrink the U.S. trade deficit, they warn, the true motivation for trying to get China to revalue. “After a yuan revaluation, the U.S. demand for foreign goods would simply be shifted from China to other countries.”
Free markets, in short, can be a double-edged sword. Perhaps someone should tell the folks in Treasury, and the U.S. Congress.
May 6, 2005
SEEING IS BELIEVING
The bond market's been reluctant to see the world through Fed-colored glasses of late, which is to say glasses that see monetary tightening as salvation from encroaching inflation. But after today's jobs report for April, the fixed-income set is starting to focus on the world as seen by the central bank.
A dramatically stronger-than-expected rise in nonfarm payrolls has the power to move otherwise immovable perceptions. The dismal scientists were calling for something on the order of a gain of 175,000 in nonfarm employment for April; the actual number rolled in materially higher at 274,000, reports the Labor Department. That's in the upper range for monthly gains in recent years.
There's more than just a strong number here. The payroll gain for April raises fresh questions about whether the weaker-than-expected first-quarter GDP report was a fluke. Indeed, the bond market took no small measure of confidence last month from the news that the economy rose at 3.1% during January through March of this year as opposed to the 3.8% logged in the previous quarter. The bond ghouls, of course, live for weak economies since that drives up the prices of bonds, which in turns drives yields down. That, in short, is nirvana in fixed-income land.
But nirvana for fixed-income traders has been put on hold. How long is anyone's guess, but optimism took a breather today. Accordingly, the yield on the benchmark 10-year Treasury shot higher, closing out the session at roughly 4.26%, the highest since April 26. Some discouraged bond investors even started mumbling that 1Q GDP revision scheduled for release on May 26 may be headed back up close to 4%.
Meanwhile, another observer captured the spirit of the day in an interview with Reuters, suggesting in so many words that yesterday's assumptions once again are destined for the circular file. "So much for soft spots, unless you think it is possible to create 700,000 jobs in the past three months and not have a solid economy," economist Joel Naroff of Naroff Economic Advisors said.
But with employment momentum rolling along, the question of what that means for inflation, and the Fed's next FOMC meeting on June 30, is back to center stage. The bond market understands that—once again, as does Kurt Brunner, a money manager with the Swarthmore Group in West Chester, Pa. "We like to see job growth, but now questions about inflation are going to be more front and center,'' he told Bloomberg News today. The Fed will "continue to tighten a little bit so that may mean it's still kind of a difficult road for stocks."
Perhaps, although by the standard of today's action in stocks Mr. Market's not quite sure what to make of the muscular employment picture in April. Indeed, the S&P 500 slipped ever so slightly today while the Nasdaq Composite inched higher.
But move on to where? Junk bonds, perhaps, which were clearly unimpressed with today's jobs report. The yield on the KDP High Yield Index rose by the smallest of margins on Friday, adding one basis point to 7.63%. The 337-basis-point spread over the 10-year, as a result, remains largely unchanged, albeit after rising sharply over the last two months from around 200 basis points in mid-March.
Indeed, the widening spread was the byproduct of the elevation in the KDP yield and the decline in the 10-year Treasury's yield. Did junk know something that Treasury traders didn't? If so, does today's calm reaction in the high-yield market signal that the storm in government bonds is over?
Definitive answers remain elusive in the here and now, but fresh clues for making slightly more educated guesses are just around the corner. That includes next week's trade balance report for March, one of the searing numbers of late among economic releases. When we last visited with this variable, the U.S. was in the red on international trade to the tune of -$61.036 billion for February—an all-time monthly low.
The dollar, it seems, is expecting something more favorable when the trade balance report hits the streets on Monday. Indeed, the U.S. Dollar Index jumped sharply today, putting the gauge within shouting distance of its 2005's highs. Of course, the dollar's strength of late is also a reaction to rising interest rates generally, including the fact that Fed funds at 3% represents a sizable premium in recent history relative to the equivalent 2% rate for the European Central Bank. And then there's today's impressive jobs report for April, which no doubt inspired more than a few dollar bulls too.
The dollar's strength, in short, is now being fueled by rising interest rates and a strong jobs reports. How long can such trends last? Good question, although an even more pressing one might unfold as follows: What are the investment implications if that combo does in fact persist? Jay Suskind, head trader at Ryan Beck & Co., was thinking along those lines when he bared his financial soul today to AP via BusinessWeek:
"Today's report comes in, it surprises to the upside, and now the thought isn't about an economic soft patch. Now, we're thinking about interest rates, and that puts the Federal Reserve back in play. We've got oil higher, and we're fearful of the Fed dampening the party. So you got good news today, but it comes with drawbacks."
May 5, 2005
RETHINKING THE 10,950-DAY MATURITY FOR TREASURIES
Last month, the U.S. Treasury announced that Savings Bonds would no longer pay a variable rate. Now we hear that the defunct 30-year Treasury Bond (which was scratched several years ago when the everyone thought the government would run a budget surplus) may be making a timely (or should we say untimely?) return.
Maybe we're a bit sensitive, but this seems like one more signal to sell bonds. Indeed, the Treasury doesn't make such decisions without a reason. The only question: what's the reason?
In weighing the potential contenders we keep coming back to the subject of inflation. Indeed, why would the government suddenly want to sell you longer-term maturities debt instruments? Or take away the variable-rate option on savings bonds, for that matter? Because it thinks that inflation and interest rates are going down? If you believe that, you're on the short list to buy swampland in Arizona.
Then again, that's the Capital Spectator's take on the credit markets in the here and now, and that's a take that doesn't necessarily reflect the bond market proper. In fact, ours seems to be a view that's in direct contrast with fixed-income traders, to judge by today's action in the benchmark 10-year Treasury Note.
If you thought that today's news that 30-year Treasuries may be making a comeback would frighten the bond market into selling, you thought wrong. The yield on the 10-year slipped a bit today, which is to say that traders were buying the 10-year. With a current yield of roughly 4.15%, a 10-year Treasury, while not exactly priced for perfection, is still very much trading on the expectation that the future holds favorable news on the inflation front. Namely, inflation will remain "contained," to quote the Federal Reserve, and so fixed Treasury payouts will more or less hold their value in coming years.
Further isolating ourselves from the herd, we duly note that junk bond yields slipped a bit today as well, settling at 7.62% on the day, according to the KDP High Yield Daily Index.
No doubt the optimism on the fixed-income horizon was boosted a bit by today's nonfarm productivity release, which revealed that U.S. output per hour in the nonfarm business sector rose by 2.6% in the first quarter, up from 2.1% previously, according to the Labor Department. That's still a long way from the extraordinary 8.7% logged in the third quarter of 2003, although the rise in productivity generally gives aid and comfort to the notion that labor trends won't stoke the fires of inflation.
Or so goes this view of productivity, which is tied to the belief that greater output per worker helps keep a lid on inflation. Why? If Acme Widget can increase output without hiring another employee, that lessens inflationary pressures, at least if you subscribe to the once-dominant school of thought that falling unemployment boosts pricing power.
All which works back to the delight of bond investors because higher productivity at this juncture suggests slower growth in employment, which implies the economy's slowing and so interest rates won't rise as fast, if at all. In fact, unit labor costs inched higher in the first quarter over the fourth quarter, which arguably inspires companies to pull back on hiring. That's just what may be unfolding if one takes today's initial jobless claims report to heart: new fillings for jobless benefits rose last week to their highest in four weeks.
But one long-time pessimist on the U.S. economy and inflation isn't inclined to change his views based on today's numbers. Indeed, Peter Schiff of Euro Pacific Capital remains as bearish as ever when it comes to prospect for paper assets issued by the government. What's more, today's news on 30-year bonds only strengthens his distrust of the Treasury's motives, ulterior or otherwise.
"While it makes perfect sense for the government to borrow for 30 years," Schiff writes today on Euro Pacific's web site, "I would question the intelligence of any one foolish enough to lend," i.e., buy Treasuries.
By that assumption, there are more than a few fools around. No matter, Schiff is sticking to his analysis. "With short term rates now at 3%," he continues,
and the yield on 30 year bonds at about 4.5%, the savings between borrowing short and borrowing long are not nearly as great as when short rates were only 1%. As a result, the Treasury apparently realizes that it no longer makes sense to keep the maturity of its debts so short.
Arguably, the expected renaissance of the 30-year Treasury Bond must pass muster with the foreigners, a group that's been more than accommodating in buyer lesser-maturity instruments in recent years and thereby financing America's trade and fiscal deficits. Whether you agree or disagree with Schiff's pessimism on America's capacity to dig itself out of its red-ink hole, he makes a warning flag about the kindness of foreign investors, or the lack thereof, going forward:
In the end, not only will the federal government be confronted with far bigger budget deficits, but it will also need to finance them at considerably higher interest rates. The Treasury had better hope that Asian savers are willing to step up to the plate, for if they balk, default or hyper-inflation will be the only alternatives. Holders of U.S. Treasuries, or any U.S. dollar-denominated assets, be warned.
May 3, 2005
THREE PERCENT AND COUNTING
The Federal Reserve raised interest rates again today. The Fed funds rate inched higher by 25 basis points to 3.0%, only just below inflation's pace, measured by the consumer price index, which advanced by 3.1% for the year through March. Twelve months previous, CPI was rising by 1.7% and the Fed funds rate was 1.0%. In short, the real (inflation-adjusted) Fed funds rate is close to being neutral, as opposed to negative, for the first time since 2002.
The catalyst for this hawkish monetary bias? Inflation is on the rise. We know because the Fed tells us so. "Pressures on inflation have picked up in recent months and pricing power is more evident," the Federal Open Market Committee announced today after raising the price of money.
Whether that inflation will be "contained," as the Fed expects, is at the center of the great debate. In particular, have Greenspan and company nipped the beast in the bud? Or is the creeping threat still creeping?
The bond market isn't quite sure how to answer if today's any indication. The yield on the benchmark 10-year Treasury closed virtually unchanged on the day, ending the session at around 4.20%. What happened to the supreme self-confidence of the fixed-income set?
The stock market, by contrast, was downright giddy, at least for a time. The S&P 500 at one point soon after the Fed announcement jumped three-quarters of a percentage point in the space of about 20 minutes. Alas, it was all light and heat. By the end of trading in New York, the S&P ended virtually unchanged, slipping by less than one-tenth of a percent.
Indecision may actually be a prudent stance for the moment. Although the Fed is showing determination when it comes to fighting current and future inflationary threats, maintaining that stance promises to get tougher to rationalize if momentum slows in the economy. With Greenspan's tenure set to end in January, the maestro is surely asking himself how he wants to go out? There are two basic choices. He can go out as the man who kept waging a war to contain inflation. Alternatively, he can keep the economy bubbling. Ah, but can he do both? Or does one fatally compromise progress on the other?
We may soon find out. Slowing momentum is just what the first quarter GDP report suggests by way of a real annualized advance of 3.1% during January through March vs. 3.9% in the previous quarter. Therein lies Greenspan's dilemma, namely, should he adjust interest rates going forward to address the first-quarter slowdown or instead stay focused on the uptick in consumer prices? For the moment, he seems to be choosing the latter.
That may prove to be the superior choice if one considers today's release of new orders for manufactured goods in March. Indeed, economists were forecasting a drop of 1.2% in factory orders, according to the Street.com. Instead, the orders advanced by 0.1%. Does that imply that first-quarter slowdown will be temporary?
Not necessarily. Although new orders generally inched higher, new orders for durable goods industries dropped sharply by 2.3% in March. If durable goods are indeed a bellwether for measuring the vigor of the economy, it's hard to dismiss the fact that this data series has been showing weakness for several months running.
The weakness in durables goods raises questions about second quarter GDP, says the chief economist for MFR Inc. via AFX. "This suggests that capital spending growth in the second quarter will be soft, lending support to the belief that second quarter real GDP growth is going to be on the weak side," opines Joshua Shapiro.
But there are many ways to slice the data ham. Optimists are inclined to note that new manufacturing orders excluding the transportation sector jumped 1.3% in March, the biggest monthly increase in a year.
No matter which bias you prefer, there's one statistic in today's factory orders numbers that sticks out like an oil derrick on Wall Street. In a sign of the times, orders for petroleum and coal products exploded skyward in March by 18%, which translates into a $5.6 billion rise—the largest on record, Bloomberg News reports.
May 2, 2005
TOUGH GUYS, TOUGH TALK & TOUGH CHOICES
Robert Portman, the newly minted U.S. trade representative, promises to get tough with China. Red ink is the reason.
"Part of [the U.S. trade] deficit is because the Chinese do not always play by the rules,'' he told the Senate Finance Committee via Bloomberg News a week before he received confirmation for ascension to the trade post from his former life as a Republican congressman from Ohio.
The presumption is that by getting tough with China, which includes forcing the Middle Kingdom to float its currency, the U.S. trade deficit will fade, if not disappear. That, in turn, will remove pressure from the beleaguered buck and lessen the momentum for raising interest rates to maintain the dollar's competitive allure in foreign exchange markets.
Indeed, the dollar's been rising this year in part because interest rates in the United States have been increasing on a relative and an absolute basis. Fed funds today stand at 2.75%, and presumably will move to 3.0% tomorrow once the Federal Open Market Committee all but confirms the much-anticipated 25-basis-point rate hike planned for Tuesday.
Oh, how things have changed. A year ago, Fed funds were 1%, while the equivalent European Central Bank rate was 2.0%. The ECB rate remains at 2%, which is to say America now leads Europe in the category of yield premium for short-term rates. That explains some, if not most of the zing in the 4.5% rise in the U.S. Dollar Index this year, and in the process reverses the euro's former aura of destiny in marching over the greenback.
But better living through higher interest rates has its limits. The Fed can't raise rates too far, too fast without risking a recession. And in light of last week's lower-than-expected GDP report, recession is suddenly a topic of renewed focus in circles economic.
On the other hand, there are many tools at the government's disposal beyond the monetary levers, and pressure is building on Portman and others in the administration to use a few of them. One school of thought seems to be that if China's growing imports are the problem, the answer must be to float the Chinese yuan and thereby nip the problem in the bud.
Clearly, artificial intervention by China has kept its currency weaker than it otherwise would be relative to the dollar. That's no great surprise, considering that the Chinese economy was growing some three times as fast vs. the U.S. economy.
There's a method to China's madness, namely, engineering a weak currency keeps imports flowing to the U.S., and keeps them flowing at prices lower than they'd be if the yuan was allowed to seek the higher level that it almost surely would aspire to in a free market.
That higher level in fact is the immediate goal for the Coalition for a Sound Dollar, which represents more than 100 American manufacturing and agricultural trade groups. The industries represented by those trade groups are invariably being squeezed by imports generally, and Chinese imports into the U.S. in particular. Or so one assumes based on comments issued by the Coalition—like this one from April 22:
The Coalition for a Sound Dollar today commended President George Bush and Treasury Secretary John Snow for their statements this week asserting that China must act now on currency reform. “We view this as a very significant change in remarks by the Administration,” said Patricia Mears, spokesperson for the Coalition. “This is a shift from ‘China should do it sometime” to ‘They should do it now.’
Mears said the next step is for the Treasury Department, in its report to Congress due later this month, to cite China publicly for manipulating its currency and immediately proceed to initiate negotiations on an expedited basis, as required by statute, to press them to eliminate the undervaluation of their currency that burdens their trading partners' economies as well as their own.
The China Currency Coalition is another group similarly disposed. “The undervalued yuan continues to push the bilateral deficit to record heights, depressing employment in the manufacturing sector and threatening the global financial system” David A. Hartquist, spokesperson for the coalition, recently stated. "Global markets cannot sustain the accelerating imbalances that result, in large part, from China’s undervalued exchange rate."
Perhaps, but one could reasonably ask if the United States economy sustain a revaluation of the yuan to market rates?
Revaluing the yuan upwards would almost certainly reprice Chinese goods upward as from a dollar-based perspective. And higher prices, presumably, would shift more demand to U.S. companies at the expense of Chinese companies.
But there are no free lunches in the global economy, least of all from a free-floating yuan. For starters, it's not clear that reduced Chinese imports to the U.S. will result in an automatic increase in sales for domestic firms. As Kristen J. Forbes, a former member of the President's Council of Economic Advisers, said in testimony to Congress last month via The Washington Post: Increased imports from China "largely reflect decreased imports of the same goods from other countries. In fact, much of China's recent increase in U.S. import share has come largely at the expense of Japan." What's more, employment in the United States has risen as imports from China have increased.
But that's not necessarily going to sway the Bush administration. U.S. Under Secretary John Taylor seems eager to have China float its currency. "We have very much stressed that they can begin to have a flexible exchange rate right now," he says courtesy of Reuters. That's diplomatic speak for suggesting that Beijing float sooner rather than later.
Perhaps the biggest risk for the United States from a free-floating yuan is the creation of new incentives, or should we say disincentives, for China when it comes to buying dollar-based assets above and beyond what prudent economic thinking dictates. China, you may have heard, is the second-largest foreign holder of Treasuries after Japan. This despite the falling greenback, which eats into the value of China's Treasury portfolio.
So, you may ask, why would China engage in self-imposed losses? That is, why would China continue to buy and hold Treasuries when such holdings have shown a clear and distinct pattern of losing money in recent years? Because holding those Treasuries keeps the yuan's value from rising in dollar terms, which promotes Chinese exports, which in turn more than offsets any losses from dollar holdings.
China, in other words, wants to sell us goods at below-market rates by financing the country's budget and trade deficits through Treasury purchases. Some in the United States are upset with that arrangement and would prefer to pay more for those goods as a short-cut to shifting production back to U.S. companies. Even assuming that outcome is likely, the "solution" risks becoming a Pyrrhic victory if China rethinks its seemingly irrational Treasury purchases.
Ergo, America depends heavily on the willingness of foreigners to finance a large chunk of its economic momentum, such as maintaining the all-important consumer spending machine by way of keeping interest rates lower than they'd otherwise be. Perhaps it's time to ask, If not China, who? Maybe Japan could pick up the slack and buy more Treasuries. Indeed, the Land of the Rising Sun already harbors some $700 billion of the Treasuries paper. How soon could Tokyo assume another $200 or so billion that now reside in China?
Arguably, some in Congress haven't asked that question, or perhaps they've already dismissed it, based on the recent introduction of the Chinese Currency Act of 2005, legislation designed to make "China accountable for the serious adverse impact that its exchange-rate manipulation and resultant currency undervaluation have on imports into the United States from China."
Paul Kasriel, director of economic research at Northern Trust, has thought long and hard about just these issues and written more than a few times on the implications. But that doesn't mean he's not perplexed by the legislation intended to force the yuan to float. "It's amazing that our Congress putting pressure on Chinese to do this," Kasriel tells CS.
No matter, Kasriel and others think the dollar's going to fall regardless over time. But if some in Congress and the administration have their way, it may fall faster and deeper than they expect.
The yuan is surely destined to be a free-floating currency. Exactly when is anybody's guess. But as China becomes increasingly dependent on capitalism, a fixed currency won't, can't last forever. But forcing Beijing's hand in the here and now may not be the smartest trick in the book at this juncture. It's probably not even likely for the time being. No matter, a government "rescue" may be coming one day, like it or not.