June 30, 2005
RESEARCH ROOM UPDATE
BP's 2005 Statistical Review of World Energy was published in June. CS highlights a few of the ugly details in the Research Room.
INTEREST RATE RISK? WHAT INTEREST RATE RISK?
Interest rates are the "greatest risk" facing the stock market, according to a freshly minted survey of money managers. "The managers rate interest rates above geopolitical events, inflation worries and increasing energy costs as their major source of concern," according to Frank Russell Company's June 2005 Investment Manager Outlook. "But they believe higher rates will have a stronger impact on bonds, U.S. Treasuries and real-estate securities—on which they are uniformly bearish—than on stocks."
This is a curious take on the risks that may or may not harass the bond market in the months and years ahead. But whatever you think of the Frank Russell survey, the bond market to date has little respect for the sentiments espoused in the polling report.
Indeed, the bond market wears its hubris on its collective sleeve these days. With the Federal Reserve scheduled to announce its latest thinking on the price of money (an FOMC interest rate announcement is due this afternoon, Washington time), the yield on the benchmark 10-year Treasury remains under 4%. To say "under 4%" is to reference a rate that's rarely been that low in the past generation.
But with the Fed once again poised to raise Fed funds by 25 basis points, which would bring the rate to 3.25%, hubris on the part of the fixed-income set becomes that much more of a burden. It doesn't help the bond bulls to learn that this morning's latest weekly update on initial jobless claims supports the view that the economy isn't quietly slipping toward recession any time soon.
Americans workers filing for first-time unemployment benefits dropped again last week to 310,000, the Labor Department reported. That's the lowest since April 15. Although today's release surprised economists, who collectively had expected a slightly higher number, the trend of falling jobless claims is par for the course, according to a four-week moving average of the statistic of late, courtesy of Briefing.com.
If the Fed raises rates again today, as many expect, the next hurdle for the bond market is weighing the odds of how long the game could roll on. For perspective, more than a few observers of the economic scene have recently been predicting that the current trend of interest rate hikes has come to an end. But as the economic data rolling in continues to suggest continued strength, tightening the monetary strings may still have some momentum yet.
Indeed, at least one dismal scientist today is warning that the momentum could extend into 2006. "We expect the Fed to continue to raise interest rates steadily into next year to contain inflation," Richard DeKaser, chief economist at National City Corp. in Cleveland, tells BusinessWeek.
In search of clues to suggest otherwise is job one for the fixed income set. For the moment, the challenge is proving a bit tougher than it was earlier this week. Even the oil market's not giving aid and cover to the bond bulls at the moment: a barrel of oil changed hands briefly this morning in early trading for less than $57, the lowest since mid-June, and down sharply from the $60-plus posted just a few days earlier.
Oil, goes the thinking, can derail economic growth if its price is high enough. Fifty dollars a barrel didn't do it, and it's unclear if the recent high of $60 can deliver sufficient drag. No doubt that many leveraged bond bulls are praying for $70 a barrel, and a Fed that's willing to sit on its hands after a year of rate hikes.
Hope springs eternal, nowhere more so than in the trading pits of the world's fixed-income palaces.
June 29, 2005
DOES THE DOLLAR RALLY HAVE LEGS?
Few expected it, but the dollar rallied just the same. In the wake of the currency's volte-face arises the question, Is this a dead-cat bounce?
The answer will be revealed in due time, layered with the usual mystery that accompanies such turning points in the pricing of assets. Nonetheless, forex traders must pay their rent like the rest of us, forcing them to ponder if the greenback's 2005 rally still has legs. It's a bit easier to conclude in the affirmative at the moment, given that the U.S. Dollar Index is up over 11% year to date. Momentum, in sum, is stifling the voices of the bears. What's more, the index, at around 89, is bumping up against a technically significant level of 90, which represents a hurdle that, if overcome on the upside, will signal to more than a few traders that the bull market in the buck will roll on.
Among the clear and present rationales for buying greenbacks is the rising rate of interest paid on dollar-denominated debt. If recent history holds, yet another incremental yield enhancement is coming, courtesy of the crew at the Federal Open Market Committee, which assembles tomorrow and, by most accounts, will again elevate Fed funds by 25 basis points.
That would bring Fed funds to 3.25%. By comparison, the European Central Bank's main refinancing rate resides at just 2.0%, a rate that's doing the euro no favors in its competition with the greenback. Indeed, similarly wide disparities exist between the 10-year Treasury Note's 3.9% current yield and its equivalent in France and Germany, where a 10-year government bond offers only 3.1% in current yield.
"We're not expecting a pause [in rate hikes] anytime soon by the Fed so this means the interest rate is more and more attractive in the U.S. and the dollar can keep doing well,'' Sven Friebe, a currency strategist at Credit Suisse Group in Zurich, told Bloomberg News today.
If there are obvious charms supporting the dollar's ascent of late, buying today requires minimizing the challenges that threaten to harass the American economy, and by extension its currency in the longer term. Indeed, the trade deficit is no less a shade of red today than it was last year, or the year before. If anything, the chasm between imports over exports continues to widen over time. The monthly updates of trade deficit routinely top -$50 billion a month of late, and in February the -$60 billion mark was breached for the first time.
By contrast, the federal budget deficit has shown tentative signs of improvement, thanks to a recent rise in tax receipts, as reported by the Treasury. June 15 stands out as the day of note on this score in that the government collected $61 billion in tax receipts in one 24-hour period—an all-time record and, the optimists conclude, a sign that the government's red ink will shrink in coming months.
"The recent surge in tax revenues is not just a one-day event," wrote Michael Darda, chief economist and director of research for MKM Partners, in National Review on Monday. "Fiscal year to date, total government receipts are up 15.5 percent, the fastest rate of increase on a comparable FYTD basis since 1981. The difference between the growth rate of tax revenues and the growth rate of government spending has widened to 8.4-percentage points, the largest since late 2000 when the budget was in surplus."
If the recent optimism on the dollar's fortunes extends beyond merely a technical bounce in an otherwise bearish cycle, confirmation must be forthcoming in upcoming economic reports. If today's final revision in first-quarter GDP is a sign, there is hope that the dollar rally will last beyond tomorrow's lunch break. Indeed, the economy rose by a real 3.8% in the first three months of this year, up slightly from the previous estimate of 3.7%, the Bureau of Economic Analysis reported today. That's the second time running that the final GDP number was substantially higher than the preliminary estimate.
It's also worth noting that the first quarter's 3.8% advance exactly matches the rise in the fourth quarter, suggesting that the economy's holding its ground. Still, skeptics abound, starting with the bond market. The yield on the 10-year Treasury seems inclined to stay below 4%, which effectively dismisses the notion that second-quarter GDP will offer a continuation of the first-quarter strength. It was only in late March that the 10-year traded above 4.6%. What's changed? Not GDP, which continues to chug along.
Will the chug turn into something less? The first big-picture clue comes on July 28, when the advance estimate of second-quarter GDP is released. Till then, the market will have to make due with lesser signs of things to come, such as tomorrow's personal income and spending numbers for May, the Institute for Supply Management's June survey of manufacturing scheduled for release this Friday, and the various updates on this month's state of employment affairs to be dispensed on July 8.
Waiting may be the hardest part, but the dollar bulls are impatient.
June 28, 2005
BACK & FORTH, TO & FRO
The frontline in the debate over pricing bonds can be found in the analysis of two opinionated pundits. In the bulls' camp is David Malpass, chief economist at Bear Stearns, who argues in an op-ed in today's Wall Street Journal (subscription required) that the "U.S. expansion has been strong and steady despite the warnings of fragility, the repeated claims of a slowdown, and the fear of China (as intense as the Japan fears of the 1980s)." Taking the opposing view is Bill Gross, chief investment officer of Pimco, the giant bond shop in Newport Beach, Calif. "This recovery is different," Gross writes in a newly published essay, "because it was spawned and subsequently nurtured on the back of asset appreciation alone."
Finding corroboration, or dissent, depends on which market you're reviewing. Gold, for example, seems inclined to favor the Malpass view of the world. Despite fears of an economic slowdown, the price of the precious metal has remained buoyant in recent weeks. Although gold's price slipped yesterday, it's up more than 5% since the end of May. This despite crude oil's climb of more than 16% to new record highs month-to-date through June 27. Crude's bull run, we're told by some, will take a toll on the economy, thereby cooling the fans of inflation. Gold bugs, it would appear, have yet to buy into that argument.
Ditto for Malpass, who observes "U.S. growth has averaged a fast 3.9% pace since the initial 7.4% tax-cut-related growth celebration in the third quarter of 2003. Thanks in large part to smaller businesses, U.S. unemployment has fallen to 5.1%, with wage and salary income growing at a 10% annual rate in the revised fourth-quarter data." Nonetheless, cries of a looming slowdown are on the march, he laments, as are increasing calls for the Fed to call off its ongoing campaign of rate hikes, which presumably will resume on Thursday when the Federal Open Market Committee meets again. "The recent decline in bond yields is being presented as a likely economic slowdown and a justification for the Fed to stop hiking rates," he notes. But history suggests something else, he concludes: yield declines in the past two years have led to growth.
Malpass expects more of the same this time around. But one man's ceiling is another man's floor. Pimco's Gross counsels readers to be suspicious of the current recovery, very suspicious. The reasoning is tied to the source of the economy's current strength, namely, decisions made in the aftermath of 9.11, when policy makers opted to engineer asset appreciation by way of injecting liquidity into the economy by way of fiscal and monetary means. This government-induced pump priming "would be the vehicle of choice to engineer a recovery until domestic investment and concomitant job growth kicked in," Gross writes. He goes on to note,
Greenspan and company have high hopes that investment and then employment will ultimately kick in and work their self-sustaining magic one more time, but jobs and investment these days go to Asia at the margin, and domestic animal spirits have been squelched by the looming inevitability of reduced returns on risk capital in a low interest rate world.
As a result, Gross reasons, "This recovery is on fragile legs because it is asset-appreciation-based and that future asset appreciation is vulnerable based on the weakening stimulative power of interest rates.
Judging by the yield on the benchmark 10-year Treasury bond, the fixed-income set tends to agree with Gross. Indeed, the 10-year's yield is below 4%, a neighborhood that's been occupied this month for the first time with gusto since March 2004. If the economy's poised to hold its own, if not accelerate its growth rate, there are few takers of that theory in the bond pits.
Good thing, suggests David Gitlitz, chief economist at TrendMacrolytics. Buying into the weak-economy theory by way of rising oil prices is something less than foolproof, he argues in a missive to clients yesterday. "We find arguments supporting the notion that higher oil prices justify the Fed at this week's meeting tilting toward a less assertive posture barren of substance," he writes, charging that worries over rising oil prices as a threat to the expansion "has been significantly overdone."
Sixty-dollar-a-barrel oil is nearly one-third lower than the early-1980s price of crude in real (inflation-adjusted) terms, Gitlitz continues. "Moreover, with efficiency improvements and fuel substitution in the intervening years, the economy is more than 25% less oil-intensive than it was then." He'll have to rethink those assumptions at some point if oil keeps rising, but for the moment the economy's staying the course of growth.
Indeed, demand for oil shows no signs of letting up, at least on the trading floor of the New York Mercantile Exchange. If and when the demand for oil begins to recede, all bets are off, Gitlitz concedes. On that score, keeping a close eye on China's economic growth will do wonders for deciding the future path of oil in the foreseeable future. If the Middle Kindgom's economy cools sufficiently any time soon, the reversal of fortune threatens to take more than a little air out of crude's pricing support in the near term.
But even those who worry about a stumble in China's economy aren't of one mind when it comes to inflation, i.e., that it's doomed to fade. Consider Joachim Fels, Morgan Stanley's fixed-income economist in London, who today notes that Chinese authorities are "trying to clamp down on the property bubble," which could lead to slower global growth. High oil prices may do no less as well, he adds. Nonetheless, an unexpected jump in inflation, particularly in the U.S., "worries" Fels. The main reason: "I think markets are wholly unprepared for such an outcome. While real bond yields are already very low, suggesting that bond investors anticipate slow growth, the recent decline in market-based inflation expectations implies that a pick-up in inflation would genuinely surprise markets."
What might cause an uptick in inflation? Higher oil prices combined with a slowdown in productivity growth, the latter being brought on by rising unit labor costs, Fels argues. True, globalization is keeping a lid on such a rise, he acknowledges. "However, domestically produced services account for a much larger chunk of the consumer basket than manufactured goods, and that’s where the productivity slowdown should lead to rising inflation pressures."
For all the back and forth, Mr. Market is forced to grapple with the immediate question: deciding what side of the debate will move the Fed when it convenes on Thursday? The recent rise in gold prices suggest that the Fed should continue to err on the side of caution and keep raising Fed funds. The bond market could hardly disagree more. Clarity is coming. In what form and when is the mystery.
June 27, 2005
WE'RE ALL SWISS NOW
Forget the Fed. America's saviour awaits in another Paris Air Show.
It was in gay Paree that the appetite for aeronautics snatched the U.S. durable goods orders report for May from the jaws of defeat. As the Big Picture's Barry Ritholtz observed, durable goods exploded upward by 5.5% last month, although Boeing's sales of civilian aircraft orders drove "virtually all" of the increase. Indeed, after you take out transportation orders, durable goods for May posted a –0.2% loss.
Boeing sales aside, economic weakness promises to be a topical subject this week. Translated: worries about inflation are out, and bidding up bond prices is in (as if they were ever really out). International Strategy & Investment Group's Nancy Lazar helped set the tone in an interview in the new Barron's (subscription required) when she opined that the global economy's growth is slowing. "But I think the slowdown in the economy is good news because there were some inflationary pressures starting to build up in the system." Does this suggest a recession? No, she offers. "I don't think we have the ingredients for a recession. There was an inflation scare that is fading pretty quickly -- not disappearing but fading pretty quickly. The slowdown in the economy further increases the odds that inflation probably slows a little bit."
A similarly upbeat view of inflation's reportedly receding momentum comes in the newly published Annual Report from the Bank for International Settlements:
The relative stability of inflation rates in 2004 is particularly striking when set against past periods of rising oil prices. While the increase in oil prices itself was small compared with the past two episodes, that in commodity prices as a whole is roughly equivalent. Despite the sharp depreciation of the dollar, which should have added to upward pressures, import price inflation in the United States has remained surprisingly contained. The effect on consumer prices is almost negligible. Negligible, BIS continues, because of several factors that have kept inflation low and stable:
· One is increased efficiency among developed economies, which manifests itself as lower oil imports relative to GDP. "Oil accounts for a smaller portion of imports than two decades ago as energy consumption per unit of GDP has declined," the report notes.
· Deregulation and technological advances have heightened competition and made raising prices tougher. "The steadily growing import penetration from emerging market countries such as China illustrates this effect."
· Wage pressures have remained muted, thanks to globalization. "Many observers believe that the widespread relocation of production, the outsourcing of some services and the increased mobility of labor across borders have curtailed the bargaining power of workers and trade unions in many industrial countries."
· The evolution of inflation expectations. Thanks to two decades or so of falling/stable inflation rates in the U.S. and elsewhere, central banks enjoy a high level of credibility with the capital markets. As such, any uptick in prices is expected to be short lived.
Against this backdrop, the Federal Reserve is scheduled to meet on Thursday on the ever-popular subject of setting interest rates. The Fed funds rate currently sits at 3.0%, up from 1.0% a year ago, and Mr. Market is looking for yet another 25-basis-point hike later this week. That may be the last, say some pundits. A few even predict cutting rates will return to the Fed later this year.
The sentiment can be found over on the long-end of the interest-rate curve. The benchmark yield on the 10-year Treasury Note, roughly 3.9% at the moment, is again testing lows not seen in over a year, i.e., before the Fed embarked on its round of monetary tightening.
As the U.S. yield curve continues to flatten, and bond yields around the world soften in sympathy, the market is pricing in an economic slowdown, or worse, into debt from New York to Zurich. The central bank in the U.S. has spared no effort in pumping up the money supply in recent years. But the jury's still out on whether that liquidity will deliver any more in the way of inflationary damage. The operative question is fast becoming: has the inflation momentum of the last few years run its course?
Indeed, the 10-year Swiss government bond is yielding under 2%--more than 100 basis points the short-term Fed fund rates! Any surprises of economic growth could take the air out of the global bull market in bonds quickly, but for the moment the U.S. and other markets seem intent on following Zurich's lead. And who can argue on a Monday when oil prices rose to another all-time high above $60 a barrel? The world economy is energy efficient, relative to the past, but there are limits. If $60-plus holds, the near-term pressure on GDP will endure, and then some.
When it comes to pricing bonds, we're all Swiss now.
June 24, 2005
ALL THE WORLD'S A STAGE FOR OIL ACQUISITIONS
Treasury Secretary John Snow and others in Washington have been eager to boost American exports, but the proposed sale of the El Segundo, Calif.-based oil firm Unocal Corp. to China's state-owned CNOOC Ltd. isn't quite what they had in mind.
No matter if Unocal ends up going to a Chinese oil company or ChevronTexaco, which is also trying to buy the California oil company, the scramble to acquire oil and natural gas reserves has arrived on America's shores in earnest.
In a world where finding new, previously unknown oil supplies appears to be an effort destined for diminishing results, the next best game in town is buying what others have already discovered. "It basically indicates desperation for oil on the part of the Chinese that they'd be willing to countenance congressional disapprobation," Stephen Leeb, president of Leeb Capital Management and author of The Oil Factor, tells Forbes. "They know that it will not be viewed favorably by many in our government, yet they are willing to make a bid."
Buying off the shelf is hardly new to the oil game. Indeed, that's why the Seven Sisters of yore have been reduced to four or five, depending on how you define Big Oil. BP's $6.75 billion purchase of a 50% stake in Russian oil firm TNK in 2003 is a recent example. There are of course many others, including the 1998 merger of Exxon with Mobil, BP's acquisition of Amoco in 1999, and Chevron's marriage with Texaco in 2000. Are you starting to see a trend?
Ironically, pundits poring over the earlier deals reasoned that the low price of oil was driving Big Oil into one another's arms. And who could argue at the time? Oil in late 1998, for instance, dipped below $11 a barrel at one point in New York futures trading. Economies of scale helped take the sting out of selling the low-priced commodity. But so did the other, and at the time, less-appreciated factor: the rising cost of exploration and production, which is just oil-speak for fading opportunities for discovering the next big find.
Fast forward to 2005 and the prospect of China, India and others competing for scarcer oil reserves has created more than a little incentive to secure existing supplies, by far the easier, and arguably less pricey pickings compared to searching barren tundras and the bottom of sea beds for formerly hidden supplies of crude.
Indeed, China and India's ascent on the global economic stage, combined with the vanishing odds of a big find promise to be the central issue in energy markets for decades to come. "The emergence of China and India as principal players on the global energy scene represents the most important change in the global energy economy in 30 years," wrote Philip Verleger Jr., a senior fellow at the Institute for International Economics, earlier this year in Energy: A Gathering Storm? "In 1990, consumption in these two countries amounted to no more than 3.5 million barrels per day, approximately 5% of global petroleum use. In 2003, 13 years later, use in the two countries has more than doubled and now accounts for more than 10% of global oil consumption."
Securing existing supplies will take many forms, with the CNNOC bid for Unocal being just one. For those countries with ample supplies above and beyond domestic needs there's no trivial temptation by governments to take a stronger hand. That was true a generation ago when Saudi Arabia and other oil-laden countries in the Middle East nationalized the oil business within their borders. A similar, if less overt strategy is being pursued in Russia, where the Kremlin's defacto takeover of the giant oil company Yukos serves as a reminder that governments still view crude as something more than a commodity to be left to the whims of the marketplace.
In the wake of CNOOC's bid for Unocal, the U.S. is now faced with the question of what to do, if anything, about growing foreign demand for existing energy supplies, including supplies that reside under Corporate America's ownership. The CNOOC-Unocal deal, if completed, would have "disastrous" consequences for the U.S. economy and homeland security, charges U.S. Rep. Richard Pombo, chairman of the House Resources Committee, reports the Houston Chronicle. "This should be a wake-up call for America to get as serious about energy as China appears to be."
The ball for the moment seems to be in Treasury Secretary John Snow's court. In his other role as chair of the Committee on Foreign Investment in the U.S. he's required to review the CNOOC deal for loopholes and, in theory, could reject it on the grounds of national security. For the moment, he's remaining diplomatically neutral, explaining yesterday that the deal remains "hypothetical at this point ... because we don't have a transaction," according to Marketwatch.com.
But theory is quickly giving way to events on the ground. The stakes are high, and so is the price of oil. The final stage in the oil industry's evolution has begun, and the winners will be those with the highest bids and/or a government willing and able to extend a heavy hand.
June 23, 2005
A DIP BELOW 4%
The bond market has its story and it's sticking with it, namely, an economic slowdown is coming. That, at least, seems to be the message in yesterday's dip below 4% for the yield on the 10-year Treasury Note. That's the first slip below that mark since June 9.
Adding to the belief that a slump is heading this way is the chatter in Europe that an interest-rate cut is imminent. Speculation on that front helped motivate traders to sell the euro, which now trades at around $1.20, which is near its lowest level against the buck since September 2004.
"Lower interest rates cannot come quickly enough for manufacturers,” Howard Archer, chief UK economist at Global Insight, told the Financial Times today. Belgium, for instance, is "on the brink of recession," advises Expatica. Italy's already in a recession, to judge by the 0.2% drop in its real GDP in the first quarter and Germany isn't far behind with a1.1% rise in its economy in the first three months of this year. France is doing slightly better with a 1.7% rise in GDP in the first quarter, but its 10.2% unemployment rate shows no signs of falling. Ditto for Germany's 11.8% jobless rate in France.
If the pressure for a rate cut is growing, the European Central Bank so far refuses to budge. The ECB's main refinancing rate for the moment remains at 2%, where it's been for the past 24 months. But there's a different mindset in Sweden, where the Riksbank on Tuesday embarked on an aggressive easing policy by cutting its benchmark rate by 50 basis points to 1.5%. Meanwhile, the minutes of the Bank of England's monetary policy meeting earlier this month reveal that some members voted for interest rate cuts. Although BoE ultimately decided to stand pat, it's clear that momentum is on the march for lower rates in Europe.
The Treasury market in the U.S. seems caught up with similar expectations. Never mind that the Fed's still tightening. Indeed, today's jobless claims release for last week suggests the economy is still erring on the side of growth. Initial jobless claims fell to 314,000 for the week through June 18. That's down by 20,000 from the previous week, and the lowest since mid-April, according to the Labor Department.
Regardless, the market will no doubt be highly focused on the payrolls report for June, scheduled for release on July 8. The burning question hanging over that release is whether the weakness depicted in the May report was a fluke or something more omninous. Indeed, last month witnessed the slowest rise in nonfarm payrolls—just 78,0000—since August 2003, raising questions of whether the U.S. economy was headed for a slowdown of some magnitude.
The optimistic interpretation was that May was a one-time event. Economic consultancy Stone & McCarthy subscribes to that brand of confidence, arguing that a "snapback" in the June payrolls is likely. The only question is how big the snapback will be, the firm advises. Rolling out its crystal ball, S&M's best guess is a gain of 195,000 new jobs for June, a prediction supported somewhat by today's news of a fall in last week's jobless claims. The oil market offers its own prediction for a robust economy by keeping the price of crude near an all-time high in New York futures trading. No wonder the bond market this morning was already rethinking the wisdom of a 10-year yield of under 4%.
June 22, 2005
RESEARCH ROOM UPDATE
Can the euro dethrone the dollar as the world's reserve currency? The recent strength in the buck suggests otherwise, but a working paper from two professors say the unthinkable could in time become thinkable if two conditions are met. For the details, take a look at the latest addition to the CS Research Room.
June 21, 2005
WHAT'S UP WITH GOLD?
Gold is money, say the metal's fans. But that doesn't necessarily mean it has a life of its own. Or does it?
The conventional wisdom holds that gold's price moves only in reaction to the world's reserve currency. That is, when the dollar rises, gold falls; when the buck slides, gold jumps. Negative correlation, as the quants like to say.
The relationship is as one would expect in a universe dominated by the global economy's most important fiat money. To the extent that the standard bearer of faith in government paper stumbles, it's only reasonable to see the historical alternative to states' monetary systems take wing, or vice versa.
But can gold rally of its own accord? Or fall in a vacuum? Perhaps, or perhaps not. Whatever the answer, the precious metal’s rally of late smacks of something a bit out of the ordinary when you consider that the dollar’s been strong too. Is the traditional relationship on the skids? Indeed, the precious metal trades at roughly $438 an ounce as we write today. That’s a $20 climb in about two weeks
"The recent historical connection between the dollar and gold has broken down," Jeremy East, global head of precious metals at Commerzbank, told Reuters last week.
Ah, but why? And what does it mean? That may take some time to decipher, but more than a few explanations are already floating about. One theory is that gold’s historical role as a store of international value is enjoying a renaissance now that the euro’s reputation has been damaged after France and Holland snubbed the European constitution. Never mind that the liquidity of gold trading is but a fraction, and a tiny one at that, relative to the euro. “The argument for fund interest in gold as an alternative to the euro is fatally flawed because the gold market is simply too small,” Barclays Capital analyst Kamal Naqvi tells Bloomberg News. Gold’s $10 billion of daily trading is a drop in the bucket next to the $700 billion in the euro.
Still, there are those who say that gold is in play again as a safe haven for the disillusioned fleeing the euro. And to the extent traders are selling euros in search of gold, the relatively thin liquidity in gold next to the euro helps drive up the price of the precious metal.
As usual, Euro Pacific Capital’s Peter Schiff has his own view of what Mr. Market’s saying about gold. "The fact that gold's strength comes not as a result of weakness in the dollar, but of weakness in the euro, suggests that in the minds of many, the euro has already replaced the dollar as the reserve currency of choice,” he writes on his firm’s web site. “However, now that fears have emerged with regard to the euro, safe haven money is going into gold. That is why over the past several weeks, the price of gold has risen sharply in terms of all currencies. In other words, this is a legitimate gold rally, not simply a dollar decline.”
Perhaps, although gold bugs aren’t necessarily of one mind on the current rally in their favorite metal. Gold isn’t strong,” writes Julian D. W. Phillips of AuthenticMoney.com via Goldseek.com. Rather, the dollar is weak, but the euro is weaker, which only lends the illusion that that the dollar’s stronger, he opines.
Could it really be that simple?
Maybe, but it's going to take more than a little convincing, whether from the dollar's or the euro's perspective. According to Bloomberg, for instance, gold's correlation to the euro "began to diverge" after Europe sent the European Union constitution packing. "I'm not ready to throw away a five-year correlation with the currencies," Leonard Kaplan, president of Prospector Asset Management. "I don't believe that gold can rally on its own."
June 17, 2005
THE KINGDOM OF HOPE
Saudi Arabia, home to the world's greatest proven reserves of oil, claims it can double its current production. No mean feat, considering that the roughly 11 million-barrels a day (b/d) that it claims it currently pumps is just about the highest in the desert kingdom's history. History, in other words, offers no guide to the future on this matter, according to authorities who oversee those reserves. As such, elevating Saudi production to 23 million b/d in the years ahead is well within the country's capacity, according to Abdallah S. Jum'ah, president and chief executive of Saudi Aramco, the planet's biggest oil company, albeit one run by a government.
In a speech to Rice University last month, Jum'ah asked and answered the critical question, according to a transcript of the talk published by Aramco, the Saudi oil company: "Can Saudi Arabia and Saudi Aramco step up and deliver? It's a fair question, given what's at stake, and a question I can easily answer with an emphatic 'yes.'"
But a new book by Matthew Simmons questions the basis for such optimism. "This book tells a story about Saudi Arabia's oil that differs sharply from the official Saudi version," writes Simmons in Twilight in the Desert: The Coming Saudi Oil Shock and the World Economy. "Instead of the oil abundance of the official version, it argues that Saudi Arabian production is at or very near its peak sustainable volume (if it did not, in fact, peak almost 25 years ago), and is likely to go into decline in the very foreseeable future."
In fact, Simmons told CS in New York recently that the "odds are pretty high" that Saudi Arabian oil production has already peaked. Over coffee at the Sherry-Netherland Hotel in New York earlier this week, he predicted to this reporter that Saudi output, if current production rates are maintained, could "collapse" by 50% to 90% in three years.
Far-fetched? Perhaps, but very much in keeping with the pull-no-punches style of Simmons, who's chairman and CEO of the Houston energy-oriented investment bank Simmons & Co. Indeed, he's been throwing water on the Saudi's optimistic claims about future production for several years now. Dispensing speeches around the world that Saudi reserves are less than they're claimed to be, Simmons has increasingly drawn the attention of the media and the ire of the kingdom.
Indeed, the Saudis have recently felt compelled to challenge Simmons in more direct terms. But as he points out in his book, the only definitive way to clear away any questions is to let outside oil experts assess the Saudi fields. To date, that's been a non-starter for a country that regards information about its oil fields as something of a state secret.
That leaves talk, on both sides, and the available data. The latter is the basis for Simmons book, i.e., more than 200 technical papers on Saudi oil fields published over the last 30 years by the Society of Petroleum Engineers (SPE). Some of the papers are written by Saudi oil officials of yore. Although there is something less than a smoking gun in the book, Simmons makes a compelling case for at least considering that the Saudi oil miracle is past its prime.
Some of the supporting evidence stems from simply understanding the history of Saudi Arabian oil production. That includes the realization that Saudi production exploded in the 1970s after U.S. production peaked and began its irreversible decline that continues to this day. The speed at which Saudi production was increased ultimately damaged the long-term capacity of its reserves, which are centered on a handful of "super-giant" fields, Simmons explains. The question is how much were the fields damaged. Whatever the answer, "the rush to produce as much oil as the world demanded strained the physical limits of the reservoirs…."
Saudi oil officials recognized the dangers of so-called overproduction early on, Simmons reveals, citing various SPE papers. Indeed, the Saudi production cutbacks during 1982 through 1986 were motivated by the need to "provide badly needed rest and recovery for Saudi Arabia's giant oilfields after a decade or marathon output," the book claims.
One of the more intriguing points in Simmons' book is that the questions about the viability of raising Saudi's production capabilities is old news. Twilight in the Desert digs up the mostly forgotten history of the 1974 U.S. Senate hearing on the question of the Kingdom's output. Among the issues raised, as recounted in a New York Times article by Seymour Hersh in 1979, was the worry by Saudi Oil Minister Zaki Yamani in the early 1970s that oil was being produced at such a high rate that it threatened to reduce output in the long term relative to what a more responsible production pace would otherwise deliver.
Why would Aramco produce at a potentially dangerous high rate and threaten its bread and butter over time? Yes, world demand was growing and the oil was badly needed as the 1970s progressed. But as Simmons explains, citing the Hersh story, there's another issue to consider, and it relates to the fact that Aramco's senior management in the early 1970s (primarily employees of Chevron, Texaco, Mobil, and Exxon) thought the Saudis would soon nationalize the oil company. They were right, of course, and out of that fear Aramco intentionally overproduced so as to cash in before nationalization took away the money-printing machine from the Western oil firms and their shareholders.
The question of whether the Saudi oil fields were permanently damaged in the 1970s is a question that can only be answered by inspecting the wells on the ground. Ditto for the doubts raised by Simmons about whether Saudi Arabia has sufficient untapped reserves to double oil output, and thereby offset any decline from existing wells.
Bucking conventional wisdom, the Saudi peninsula has been widely explored, and so the odds of any great new discovery of oil remains unlikely, Simmons warns. Meanwhile, the still-copious flow of oil from the Kingdom relies on aging super-giant oilfields. "There is a genuine probability that Saudi Arabia is now overproducing some or all of its key giant oilfields, and this introduces a risk of accelerated decline," he writes. Indeed, oilfields have a finite life. For a time, output increases, then peaks, then declines. Saudi fields must ultimately live, and die, by this law of oil drilling. The fact that the main wells that make up the bulk of Saudi output were abused in the 1970s suggests that time is running out.
"Thus, I must conclude that the odds are better than even that oil output from at least several of Saudi Arabia's key oilfields is now at risk of entering an irreversible decline," Simmons concludes.
Timing, of course, is open to debate. Arguably, so is Simmons' reasoning. Aramco claims that its reserves are underestimated, according to an Energy Information Administration profile of the country. In any case, EIA accepts the promises that Saudi production will rise materially, projecting, that the kingdom's output will reach 18.2 million b/d by 2020 and 22.5 million b/d by 2025.
Simmons can only question such optimism, and provide some reasoned analysis based on the limited information he's privy to. But this much is clear: in order to prove Simmons wrong, the Saudis almost certainly will have to come up with replacements for giant oilfields that have been in production for decades. To date, there's a lot of talk about tapping new reserves, but the hard data remains to be seen. The stakes, however, are sky high. If Saudi production materially reversed, the shock waves would reverberate like an earthquake in the market, making the recent rise in oil prices look modest by comparison.
Meanwhile, the Saudis insist there's nothing to worry about. But absence the inspection of the Saudi fields and related data, it's all talk from an outsider's perspective. And as recent trends in the oil futures markets suggest, talk is still cheap, and a barrel of oil's getting pricier. Indeed, oil moved above $56 a barrel in New York yesterday for the first time since early April, just shy of the $57-plus record set that month. To judge by this book, that may prove to be a bargain in the years ahead.
June 16, 2005
DEFLATION, JOE SIXPACK, AND THE GOVERNMENT'S PRINTING PRESS
Forget about inflation, writes Ed Yardeni today in a note to clients. "The next mood swing among investors is likely to be increasing concerns about deflation," writes the chief investment strategist of Oak Associates. BCA Research made a similar point on Tuesday, advising that in 2005 "inflation will surprise on the downside." As a result, "The obvious investment implication is to buy bonds."
For those who agree, there's just one glitch: the bond market in the United States has already rallied, leaving yields at less-than-compelling levels. The 10-year Treasury currently yields around 4.12%. That's up from a quick dip under 3.9% earlier this month, but as recently as March the 10-year Note was changing hands at yields above 4.6%. Then again, if deflation will again be returning to the Public Worry Number One in the markets, there may still be life left in the old fixed-income bull.
But what of the rebound in the consumer price index of recent years? Doesn't that keep the fixed-income set awake at night? The roughly 1% to 2% range for CPI in 2002 has given way more recently to 2.5% to 3.5%. Not to worry, opines Yardeni, who predicts that the cyclical rebound in CPI is kaput. "The CPI core inflation rate is down to 2.2% from February's peak of 2.4%," he writes. "Core prices are up only 1.1% at an annual rate over the past two months. April's core PPI rates also support our disinflation outlook. Intense global competition, cheap technology, and solid productivity growth should keep inflation subdued."
The junk bond market seems to be signaling as much—again. The spread on the KDP High Yield Daily Index relative to the 10-year Treasury has fallen sharply in recent weeks. The rally in junk bonds, and the commensurate fall in the spread, is striking by coming so soon after the high-yield debt market sold off dramatically between mid-March and mid-May. But yesterday's inflation fears have become deflation expectations in some corners. Indeed, as of yesterday's close, the junk spread over the 10-year was roughly 3.2%, down from 4.0% on May 18.
If all of this sounds familiar, you're right; it is. Deflation, you may recall, was all the rage as a topic of concern and fear in 2002 and early 2003. Among the oratorical gems dispensed at the time was the November 2002 "Make Sure 'It' Doesn't Happen Here" speech by Ben Bernanke, a member of the Fed's Board of Governors.
Bernanke's talk was no small weapon in convincing Mr. Market that the central bank could squash deflation virtually at will. To reprise the principal point, we quote the operative passage: "The U.S. government has a technology, called a printing press (or, today, its electronic equivalent), that allows it to produce as many U.S. dollars as it wishes at essentially no cost," Bernanke said. "By increasing the number of U.S. dollars in circulation, or even by credibly threatening to do so, the U.S. government can also reduce the value of a dollar in terms of goods and services, which is equivalent to raising the prices in dollars of those goods and services." In case any missed the point, he pulled no punches in summing up the central message: "under a paper-money system, a determined government can always generate higher spending and hence positive inflation."
Not long after Bernanke delivered that timely reminder, the pace of increase in the consumer price index began climbing. CPI's annualized rates of increase, as low as 1.1% in 2002, in time gave way to as much as 3.5%, which was the rate as recently as this past April. But with May's drop to 2.8%, the deflationistas are becoming newly emboldened.
Before you run out and buy bonds, it's instructive to review a less widely quoted portion of Bernanke's infamous talk, in which he explained the deflation's cause is "generally the result of low and falling aggregate demand."
There was a palpable fear that consumer demand would sag in the months after 9.11, thus the deflation worry. In 2005, however, more than a few economists are worried about the opposite, namely, an over-stimulated consumer who keeps buying even in the face of mounting debts. Real estate investing in particular is said by some to be the center of gravity for the current penchant to spend now and ask questions later.
Whether it's homes or SUVs, Joe Sixpack is spending and piling up debt in the process. Indeed, a broad measure of the ratio of debt payments to disposable personal income (financial obligations ratio) published by the Fed depicts the extent of the buying spree and is flashing a warning sign in the eyes of some dismal scientists. Perhaps the ultimate risk is the spending train goes to far and snaps back. In the meantime, the race to Target and Wal-Mart is the only game in town.
Nonetheless, deflation chatter is on the rise, and some corners of the bond market are buying into it. From a short-term trading session, such advice may have merit. Indeed, the buying resumed a bit in the 10-year Note today, with the yield on the benchmark Treasury falling slightly to roughly 4.07%.But for those who're inclined to ride this train, prudence (and an understanding of recent history) suggest keeping an eye open for a new talk by some prominent Fed official on the power of the printing press.
June 15, 2005
MISSING IN ACTION
Inflation, Milton Friedman first counseled all those years ago, is a monetary phenomenon. But in the here and now, inflation suddenly seems to be something less than threatening.
Consumer prices fell 0.1% in May, the Labor Department reported today. That's the first drop in 10 months. Wholesale prices retreated by an even greater measure in May, falling 0.6%, we learned yesterday.
Putting the two price reports together has made the cries of the inflation hawks look a bit melodramatic. Indeed, it's tougher to get worked up over inflation after the two price reports. Fair enough, so then why isn't the bond market conspicuous by its lack of celebration?
Some of it may be the market living up to the old saw to buy on the rumor and sell on the news. Regardless, the yield on the benchmark 10-year Treasury Note was essentially unchanged today, closing the session at 4.11%. That's up from less than 3.9% touched earlier this month.
Rising yields and falling inflation? Sure, why not?
Then again, perhaps the fixed-income set's worried that the fall in CPI and PPI was but a temporary bump on the road to dark things, largely driven lower energy prices in May. According to the CPI report, energy slid 2% last month, the first monthly decline for the data series since January. For wholesale finished goods, energy costs decreased 3.5% in May.
Indeed, the core CPI for May (which extracts food and energy costs from the mix) rose 0.1%, as did the core PPI last month. Although that's modest, it's a notable difference from the declines posted by the broad CPI and PPI measures.
But energy prices have a notorious history of late of marching higher after any and all declines, and June is shaping up to be merely the latest chapter in that history. Oil today closed at $55.55 a barrel, which is just under the all-time high set back in April, and no trivial hazard for future inflation reports.
There are even more ominous gremlins lurking, charges Peter Schiff of Euro Pacific Capital. "Despite May's benign figures," he writes today in an essay posted on his firm's web site, "which were driven mainly by falling energy prices, so far 2005 is on pace to achieve the largest CPI increase in fifteen years." He goes on to point out that oil prices are up 18% in the last four weeks. If the dollar's new-found strength reverses, that's likely to translate into higher commodity prices, he explains. The bottom line for Schiff: "I except CPI gains in the second half of 2005 to push the year’s total increase to over 4.6%, its second largest gain in twenty-four years."
Monetarists may not care either way, invoking the world according to Friedman as a defense. On that score, the growth rate in the M2 money supply continues to downshift, according to data from the Fed. For example, looking at a four-week average of M2 reveals that the rate of change has slowed dramatically to a week-over-week increase of around one-tenth of one percent for the week ending May 30, down from six-tenths of one percent for the week of April 4. The proverbial tightening of the monetary strings, in other words, is alive and well at the moment.
The question is whether applying the monetary brakes will neutralize other forces, such as oil prices, that are thought by some to contribute to higher inflation.
Monetarism, it seems, is being put to the test. So far, it seems to be winning. Nonetheless, two questions loom. One, will the Fed's newly acquired miserly ways prevail when it comes to the money supply? Two, even assuming that money supply expansion remains relatively constrained, will that overcome what some say is advancing inflationary pressures from other corners of the economy? Inquiring minds, and trigger-happy bond investors, want to know.
June 14, 2005
TALKING TOUGH, TALKING TURKEY, AND JUST PLAIN TALKING
The sound of desperation is in the air these days regarding the matter of crude oil. Or is that merely the squealing that comes whenever reality is accepted at face value?
Against the backdrop of OPEC's latest rendezvous in Vienna, and more than a few signals that the cartel's back is up against the wall in trying to raise production, the U.K. energy minister started talking tough on oil drilling in the North Sea.
Malcolm Wicks will reportedly take a "hardline stance on mature North Sea oil fields this week, pledging to revoke exploration licenses if companies fail to develop their assets quickly enough," according to a story over the weekend in Scotland on Sunday. It seems that worries of oil sitting idle is a fear that no forward-looking energy minister in Britain can tolerate. What's next? Congress enacting legislation that forces the oil industry to drill in ANWR?
Perhaps there's a connection between Wicks' ambitious new policy and the view, as reported by the U.S. Energy Department and others, that North Sea oil production has peaked as is now fated for an illustrious decline. In any case, it's hard not to notice the heavy hand of government getting becoming ever more active in the business of drawing oil from the ground. As Scotland on Sunday explained, "In a report to be published this week by the government's North Sea task force PILOT, Wicks will reveal details of a new scheme that allows him to force oil companies to invest in fields where evidence of oil has been found."
It wouldn't surprise any one to learn that the United Kingdom is interested in maximizing domestic oil production at a time when questions are swirling about global supply. (The U.K. and Norway are the main owners of North Sea oil.) Given the fact that North Sea oil has been a critical supply of non-Opec oil, Britain's reluctant to let its former energy silver bullet fade without a fight.
But even Opec's not quite the cartel it once was. Yes, the boys from Vienna are going to raise their production target, or so the media's reporting. But the fresh supply will be marginal at best, totaling roughly 500,000 barrels a day. As the Guardian newspaper observed today, the member states of Opec are already pumping oil at capacity. "A rise in output by half a million barrels a day will have little effect on high oil prices, Opec officials conceded today," the British newspaper reported a day ahead of the group's meeting in Vienna.
The head of energy research at Barclays Capital in London agrees, and then some. "Even if Opec decides to raise its output ceiling, it won't ease fears of tight supply toward the end of the year," Paul Horsnell told BusinessWeek today.
What's more, don't blame the cartel for the current state of energy markets, Opec told the United States, Europe and other oil-consuming economies that rely on Middle East imports. Rather, take a look in the mirror, and start building more refineries in the process. "The supply is here, inventories are building, there is certainly no shortage of supply -- so build, build refineries," Saudi Arabia's Oil Minister Ali al-Nuaimi counseled his nation-state clients, according to Agence France-Presse via Channel NewsAsia. "Start building refineries and you will solve maybe half of the problem," he said to reporters as he jogged in Vienna. "We have to convince the governments to build refineries in the United States and elsewhere. Everybody is late in building refineries." Indeed, neither Europe nor the U.S. has built a new refinery since the 1970s, Bruce Evers, an analyst with Investec in London, comments in the article.
But refineries, old or new, need oil. And when it comes to delivering more, the cartel has learned to talk turkey. Opec President Sheik Ahmad al-Fahd al-Sabah of Kuwait, when asked if the much-discussed plan to hike the cartel's production quota by one-half-million barrels a day is substantial or something less, responded, "Just symbolic," according to Reuters. Honesty won't necessarily bring prices down, but it's a refreshing change nonetheless.
June 13, 2005
The OECD released a new study on trends in pharmaceutical spending in the developed economies, telling us what we already knew: expenditures on drugs have taken wing.
The extent of the spending increase is striking nonetheless. From 1998 through 2003, consumer purchases of pharmaceuticals advanced by an average of 32% a year in real (inflation-adjusted) terms across the OECD countries, which includes the United States, Western Europe, Japan and generally the developed markets around the world. In fact, drug spending's rise has outpaced total health expenditures over the past five years in most OECD countries. In the U.S., for instance, spending on drugs grew more than twice as fast as total health expenditure.
The combination of demographic trends (the aging of populations in developed nations) and innovative drug research and development has converged to deliver a golden age to the business of selling drugs.
Or so one would think. A more bullish backdrop than the one painted by the OECD report could hardly be imagined for an industry. But to judge by the big-cap healthcare stocks in the S&P 500, the investment outlook appears somewhat more nuanced. Indeed, one could argue that investing in the big-cap drug names is something less than a sure bet at the moment The drug industry, simply put, has a few health problems of its own.
Some of troubles can be attributed to wonder drugs gone bad. Paying for the cleanup is proving to be expensive. Eli Lilly, for example, agreed last week to pay $690 million to settle legal claims that the company inadequately warned that taking its anti-psychotic drug Zyprexa could lead to diabetes. How big a bite is $690 million for Lilly? Roughly 38% of 2004 net income.
Lilly is far from the only big-cap drug company fending off lawsuits these day. Merck and Pfizer have their own legal battles tied to pain killers. Is it taking a toll on earnings? It sure as heck ain't helping.
Whatever the reason, something's certainly putting a drag on earnings momentum in a sector that not that long ago was touted as among the best-positioned corners of corporate America for cashing in on the aging of the Baby Boomers. But so far, the results look middling at best.
Consider that the S&P healthcare sector's operating earnings rose by 15.5% in the two years through the end of 2004, according to data from Standard & Poor's. Impressive? Depends on the benchmark. For example, the drug industry's rate of growth is far below the 47% rise in S&P 500's earnings advance over that period. In fact, on a percentage basis, healthcare's earnings advance was near the bottom among the ten sectors that comprise the S&P 500: only three other sectors (consumer staples, telecom, and utilities) posted lesser rates of earnings growth over the two years.
Looking at long-run performance of the S&P's healthcare stocks depicts more lethargy. Over the last three years through the end of last month, for example, the S&P 500 Healthcare Index's 2.5% annualized total return has trailed the S&P 500's 5.6%.
On the other hand, year-to-date comparisons paint a different picture. Indeed, the S&P Healthcare Index is up 3.9% in 2005 through June 9, crushing the S&P 500's small total-return loss over that stretch. Is health's rise this year simply a dead-cat bounce, or is something more fundamental afoot?
One ETF analyst who follows the S&P 500's sectors suggests caution when it comes to drugs. He writes recently that there are still clouds on the horizon for the big drug stocks. First-quarter numbers reveal that the fundamentals for the S&P healthcare sector "continue to deteriorate," observes Michael Krause of AltaVista Independent Research in New York. In particular, he notes that return on invested capital for pharmaceuticals fell for a fifth year in a row to 12.6% annualized, down from 18.8% in 2000.
If investors are expecting earnings to come roaring back in the big-cap healthcare stocks, the optimism isn't yet reflected in the 2005 estimates posted by Standard & Poor's for the sector. For all of 2005, healthcare's operating earnings (based on bottom-up estimates as of May 31) are expected to advance 8.4% over 2004. That's below the predicted 10.9% rise for the S&P 500 overall and far below the comparable forecasts for the more impressive double-digit gains expected in five other sectors, including the soaring 27% earnings gain envisaged for materials stocks this year.
But Mr. Market doesn't necessarily agree. In fact, he's expecting something on the order of the opposite from what the predicted operating earnings for 2005 suggest. Consider that while the price for the Materials Select Spider Trust ETF (Amex: XLB) has lost more than 6% this year through June 9, the Healthcare ETF (Amex: XLV) has climbed 3.3%. So much for clear and concise connections between earnings projections and equity performance.
The market may be more or less efficient, but the associated messages dispensed from the belly of Mr. Market's beast can still be cryptic.
June 10, 2005
Deciphering the collective mind of the bond market is one of the more challenging tasks in the 21st century, right up there with trying to cure cancer and deciding if the bull-market run in Google's stock is the Internet bubble reincarnated.
Consider this morning's release of May's U.S. Import Price Index from the Labor Department. Import prices dropped a hefty 1.3% last month, the biggest monthly decline since December 2004's 1.4% fall. The main reason for retreat in May was the slide in petroleum prices last month. Given America's voracious appetite for imported oil, any decline in crude prices necessarily pares import prices generally, as today's numbers remind.
It all looked like a confirmation of the bond market's general theory of late, i.e., that pricing pressures were less than expected by the inflation hawks. For the moment, at least, the bulls of fixed income had been redeemed with economic support.
But if you thought the import-price news would spur fresh buying in the benchmark 10-year Treasury Note, you were mistaken. Big time. The 10-year's yield jumped sharply today to around 4.04% as traders sold the associated Treasury in no uncertain terms. That's the first time the yield has settled above 4% since May 30.
Whatever the reasons for the reversal of fortunes in the bond pits, the combination of falling import prices and higher yields in long-dated bonds gave inspiration to fixed-income traders, who bid up the U.S. Dollar Index to its highest close since September 2004. But logic may be question in forex trading too, or so one could argue after considering today's trade balance news for April. The Bureau of Economic Analysis advised that the red ink on the U.S. trade ledger grew a bit, dipping to –$57 billion in April, down from a revised –$53.6 billion the month previous. One could reasonably ask: is that the kind of news that traders like to hear if they're long the greenback? Today it was. Ah, but will it hold true next time?
Don't answer that. Rather, ponder the fact that it's a different world, and what passed for prudence and judgment in the past can be easily torn asunder. The financial world is the most wired, most technologically advanced industry in the world, but it's no more predictable (or rational) than it was when telegraphs were the leading edge of high-tech communication tools. It may even be a bit less so, but that's a subject for another day.
Meanwhile, in the here and now, it's all a matter of interpretation. It always was, of course. And always will be, leading to the perennial rule of relevance: One trader's worries are another's reason to buy. Exercising that freedom, one strategist favors the sunny side of the trade-deficit interpretation and asserts that "we actually see a lot of positives'' in the trade numbers from the dollar's perspective. So says Robert Sinche, head of currency strategy at Bank of America in New York, who also tells Bloomberg News today: "We're now getting signs the trade balance is stabilizing.''
Stabilizing? Not so fast so a card-carrying dollar bear. Peter Schiff, president of Euro Pacific Capital, and a veteran skeptic on the so-called American economic miracle, was unimpressed as ever with today's trade news. In an essay posted today on the firm's web site, Schiff dismisses the happy talk with his usual growl and bite: "The fact that the fourth-worst monthly deficit ever is considered good news is startling evidence of just how far the bar has been lowered when it comes to America's deteriorating trade imbalance."
Indeed, some strategists tried to meet the Sinches and Schiffs of the world halfway by suggesting that today's dollar rally is less about an improving outlook for the buck and more about deteriorating expectations for the euro, which suffered no small amount of damage after France and the Netherlands torpedoed the European Constitution last week. And to judge by the continuing decline and fall of the euro today, that's a reasonable observation.
But just to keep things interesting, gold decided to rally, which is somewhat surprising given the dollar's strength today. Indeed, the precious metal jumped more than $3 an ounce, its highest close in nearly a month. Gold usually rallies when the dollar falls.
Let's assume at least that the gold bulls didn't take comfort from the news that the federal budget deficit is showing signs of receding a bit. May's red ink fell considerably from a year ago thanks to a jump in tax revenues, according to Treasury data via BusinessWeek. Then again, the White House yesterday pared its forecast for economic growth a touch, predicting a rise of 3.4% in 2005, slightly below the forecast of 3.5% made last December, according to The New York Times.
Does the latter offset the former? And while we're asking questions, can a trade deficit that grows worse in May vs. April be good for the dollar? Can gold rally along with the dollar? Are falling import prices bullish for bonds? Whatever the answers, rest assured they'll change on Monday.
June 9, 2005
RESEARCH ROOM UPDATE
John Hussman, manager of the Hussman Strategic Growth Fund, weighs the odds of what some say is an approaching recession. He lays out his case in a new essay published earlier this week, and now noted in the CS Research Room.
Among the various definitions of "neutral" found in the Oxford English Dictionary, one informs: "occupying a middle position with regard to two extremes."
When it comes to monetary policy, neutrality may be a state of mind, however. As for Greenspan's mind in particular, the maestro isn't saying where neutrality lies, even though he was directly asked as much today. Is he holding back? Or, if we take him at face value, is he unsure? Not to worry. Even though he can't (or won't?) put a number on neutrality at the moment, it will reveal itself eventually. To quote the master from his testimony today in Congress: "We will probably know it when we are there, because we will observe a certain degree of balance which we have not perceived before, which would suggest to us that we're somewhere very close to what that rate is."
All of which reminds us of the old quote from Justice Potter Stewart on the issue of defining pornography: Tough if not impossible in the abstract, "But I know it when I see it…."
Similarly, we're reluctant to say exactly what constitutes a neutral Fed funds rate. But taking a page from the maestro, we're reasonably sure that when we see a neutral rate, we'll know it. In fact, we'd go so far as to say that in the absence of a neutral rate, we'd know it too. And as it turns out, we don't see neutrality in the Fed's monetary policy at the moment. Neither, we suspect, does the head of the central bank, which is why Greenspan hinted that the price of money will continue to rise, albeit indirectly by noting that the economy remains on "reasonably firm footing."
CS, on the other hand, can be more direct and confide in you, dear reader, our deepest, darkest thoughts on monetary policy, whereas the chairman of the Federal Open Market Committee undoubtedly feels more constrained. As such, we can speculate wildly, and perhaps incorrectly as to where the monetary equivalent of Switzerland lies. Drum roll please…. It's somewhere above the current 3.0% Fed funds rate. Whether Greenspan and his colleagues on the FOMC agree is the operative question, and one that gets resolved incrementally, starting with the next confab on rates scheduled for June 30.
Meanwhile, Mr. Market will pay close attention to next week's releases of May price indexes for clues about what will be dispensed at the June 30 interest-rate-setting rendezvous. For the moment, April's consumer price index is the latest data installment on the official inflation rate, a measure that tells us that prices generally are rising at 3.5% a year, or exactly 50 basis points above the target Fed funds rate. (Hint, hint.)
Perhaps the bond market agrees that neutrality is above 3.0%, perhaps not. What we can say for sure is that the yield on the 10-year Treasury Note inched higher today for the second day running (a minor miracle given fixed-income trends of late). The intrepid investor considering whether to loan Uncle Sam money for a decade is looking at yield compensation of roughly 3.95%, a hair better than yesterday's offering but a world, or at least a continent away from the 4.65% that prevailed as recently as late March.
All of this in the wake of what some say was Greenspan's effort to talk tough with the bond bulls today. As MSNBC noted today after the maestro spoke: "Federal Reserve Chairman Alan Greenspan left little doubt Thursday that the central bank intends to continue pushing short-term rates higher."
Welcome to the new new age of certainty on the future path of interest rates, and the new new arrogance of the bond market to yawn in the face of certitude.
As for the stock market, renewed talk that the Fed will hike for the ninth consecutive time on June 30 triggered some modest buying. The S&P 500 climbed by half a percent on the day and the Nasdaq Composite did a bit better. What is it the equity traders like in Alan's latest sermon on the political mount? Perhaps it's the fact that the stock market believes that raising interest rates is painful but necessary to fend off rising inflationary pressures, and on balance, corporate America will benefit. The bond market disagrees, but then what else is new?
Not much, other than to wait for more data. Let's start with tomorrow's import price index for May.
On second thought, why wait when no less a source than the maestro himself suggests the path of least resistance. Indeed, Greenspan mentioned that some real estate markets were getting frothy. Or, as he put it last month, via Bloomberg News: "there is a 'good deal of speculation' in real estate markets, and 'we're also seeing it in the mortgage market.'"
Although today he blamed so-called exotic financing vehicles, namely, interest-only (IO) mortgages, even CS can connect the dots. And that connection reveals that low interest rates make IO mortgages, along with conventional ones, more attractive, which in turn promotes buying real estate. High interest rates, or, dare we suggest it, neutral rates relative to current rates, would make IOs less attractive, and in the process remove a bit of froth from the property markets.
We know the risks. Heck, we may even know the solutions. Your move, Alan.
June 8, 2005
SEWARD'S FOLLY & AMERICA'S BURDEN
In the late-1970s, Alaska's oil output was on the rise. The ascent was timely, coming in the wake of the Opec-engineered oil crisis of 1973, which announced to the world (and the U.S. in particular) that the days of counting on cheap, accessible supplies were gone, though not necessarily for geological reasons. By 1978, Alaskan crude production exceeded one million barrels per day on average for the first time, Energy Department numbers recount. That was roughly 14% of America's domestic oil production in 1978. Alaska's output eventually doubled in absolute terms, hitting slightly more than two million barrels a day in 1988.
It's been downhill ever since. In 2003, Alaska pumped an average of 974 million barrels of oil a day. More declines are coming, reports The Washington Post today. "[Alaska's] oil keeps flowing through a maze of aging wells, pumps and pipelines that poke through the snow on this desolate North Slope tundra. But this vast field is ailing: Output has fallen by nearly 75 percent from its peak in 1987 and is expected to continue dropping."
The rise of Alaska's oil output in the 1970s was no trivial factor in offsetting the growing clout of Opec. But where will the new Alaskas come from?
It's a timely question, and one that lacks a satisfying answer. Nonetheless, offsetting falling oil production from Alaska's existing fields promises to be among the leading energy challenges for America for the foreseeable future. All the more so since Alaskan crude offered the dual benefit of being ample and safe, i.e., within U.S. jurisdiction.
To understand just how valuable Alaska has been to the U.S. oil consumer, consider that in 1978, the average of 1.23 million barrels of crude pumped from the state represented 14.1% of America's total domestic output. In 2003, Alaska's production fell to 974,000 barrels a day, although that smaller absolute output represents a larger share of U.S. total domestic output (16.9%) compared to 1978.
The reason: U.S. production ex-Alaska continues to fall, a trend that's been in place since the early 1970s. Alaska's rise as an oil producing state all those years ago helped fill the gap for America's ever-rising appetite for energy. But the Alaska solution is fading.
So where will the next Alaska come from? Theoretically, the best bet is still Alaska, namely, the Arctic National Wildlife Refuge (ANWR), which is about 100 miles east of the lion's share of Alaska's current production base known as Prudhoe Bay. Average estimates put recoverable reserves in ANWR at about 10 billion barrels. Alas, the prospects of drilling for oil in ANWR are clouded by politics. Although Congress passed a budget resolution recently that procedurally enhances the possibility of drilling in ANWR, it remains to be seen if any crude ultimately flows thanks to ongoing political opposition to the project.
More troubling is the fact that 10 billion barrels doesn't go as far today as it did 30 years ago. America's daily consumption of oil is 20 million barrels a day and rising. That's up by around one-third since the mid-1980s.
Tapped or not, ANWR remains America's last big oil resource, short of some grand new discovery yet to be found. But even if ANWR development started today, "tangible benefits to consumers" are likely to be a decade away, according to a UPI article last month via MENAFN.com. In the meantime, it's a safe assumption that U.S. domestic production will continue to decline and dependence on oil imports will continue to rise.
That future is increasingly front and center among movers and shakers in Washington. The latest example comes in comments from Christopher Hill, the State Department's assistant secretary for East Asia and the Pacific. "China's energy needs are going to be enormous in the future," he said to a Senate Foreign Relations subcommittee, according to Reuters. "The question is, are they looking to develop energy or are they looking to take it off the market."
Politics and geological fate are conspiring to derail America's quest for developing significant new reserves that are at once safe and accessible. In turn, that's forcing oil companies to pursue the next best thing, or in some cases, the least worst thing. That ranges from braving the political hazards of drilling in forbidding locales to suffering national leaders who otherwise deserve something less than a warm embrace.
But times are tough in the discovery business, and tough times require tough actions that sometimes fall short of noble acts. Or so we're told. One indication of the new new world that dominates comes from a report last month that the U.S. lobbyist for Libya's Muammar Gaddafi had a seat on the Energy Department's top advisory board, Reuters relates. Libya, of course, still casts a dark image for many Americans, some of whom blame the North African nation for the terrorist act that brought down Pan Am Flight 103 over Lockerbie, Scotland in 1988.
Oil, of course, has long been the bridge that brings rogue nations into formal, and not so formal agreements with the U.S., the mother of all oil-consuming nations. No less is true today. Indeed, Spencer Abraham, the former energy secretary who appointed the Gaddafi lobbyist, was serving on the board of a large U.S. oil company (Occidental Petroleum) that's at the forefront of cutting new drilling deals in the oil-rich Libya, according to the Reuters story. Indeed, as a story published a few days back in the Los Angeles Times observes, Libya has recently awarded Occidental with a sizable, lucrative oil deal. That's one reason why the L.A. Times wonders if Occidental is now "ripe for a takeover."
None of this should come as a surprise to any one who follows the Great Game. Nonetheless, some are still shocked, shocked to find such intimacy between oil-laden regimes of questionable integrity and the United States. "Do we really want someone advising the U.S. energy secretary on energy policy who has literally signed up to put Libya's interests first?" Mary Boyle of the watchdog group Common Cause asks in the Reuters story. The answer depends on how bad we want to replace Alaska's fading oil supply.
Indeed, the low-hanging fruit may have been picked in Alaska, forcing oil companies to focus on lesser, and riskier targets in the state, including heavy oil, icWales reported last month. Much as the hungry man looks at food that the rich man ignores, America and the oil consuming nations of the world are officially in the business of turning over rocks that formerly held little or no interest.
Nonetheless, American consumers are going to miss Alaska's crude. Lest any one forget, a constant reminder is sure to arrive from time to time in the form of the occasional, if not permanent bull market in crude prices.
June 7, 2005
THE JOY OF MOMENTUM
The iShares Lehman 7-10 Year Treasury ETF (Amex: IEF) is sitting on a 10.3% total return for the 12 months through today's close. That's a healthy performance edge over the 1.9% rise in that stretch for the iShares Lehman 1-3 Year Treasury ETF (Amex: SHY). There's nothing inherently peculiar about longer-term maturities outperforming shorter terms. Sometimes it happens, sometimes it doesn't. But the fact that longer-term Treasuries are besting shorter ones is more than a little out of the ordinary after the Federal Reserve has hiked interest rates for nearly a year.
But these aren't ordinary times, and the fixed-income set isn't inclined to play its usual role when it comes to taking cues from the central bank. The pricing of debt in 2005 is something less than conventional relative to what the historical record implies.
If the past is a bit less than prologue on Wall Street of late, investors must fend for themselves when interpreting the usual suspects of quantitative signposts. No easy task. Indeed, the Fed keeps trying to engineer an outcome in long-term yields that has so far proven elusive. Frustrated with the lack of traction in adjusting the price of money in long rates, the high priest of the central bank has taken to sermonizing with enhanced transparency, which is no mean feat for a man long recognized for reaching the creative pinnacle in oratorical obfuscation. Yes, dear readers, it has come to this: Greenspan has decided to talk turkey.
Why, the Maestro asks, are long-term yields falling while the Fed is explicitly trying to coax the opposite? Whatever the reason for this "conundrum", as he's previously labeled the situation, the mismatch between long and short rates is "clearly without precedent," Greenspan said yesterday, by way of satellite, at an International Monetary Conference in Beijing.
One theory is that the economy is slowing, he offered. History suggests that when the spread between long and short rates narrows, economic lethargy or worse threatens. As an explanation, that's a "credible notion," Greenspan admitted. But the maestro wasn't necessarily convinced. "Periodic signs of buoyancy in some areas of the global economy have not arrested the fall in rates," he countered.
In fact, he speculated, any future arrival of an inverted yield curve (short rates above long rates) seemed likely to break with history and signal something other than recession. "I'm not sure what such a configuration, should it occur, would mean," he said, referring to an inverted yield curve, in response to a question, Reuters reports via MSN Money. "I'm reasonably certain we would not automatically assume that it would mean what it meant in the past."
In any case, we may find out soon what an inverted yield curve means, or doesn't mean. A mere 35 basis points separates the currency yields between the two-year Treasury and its ten-year counterpart—the lowest spread since January 2001.
Greenspan's relatively unambiguous predictions also included hedge funds. The chairman warned that the portfolios were playing with fire if they thought the long-running decline of bond yields would produce continued success in the realm of fixed-income trading. The "low-hanging fruit" of profits has been picked, he said. "Continuing efforts to seek above-average returns could create risks for which compensation is inadequate. Significant numbers of trading strategies are already destined to prove disappointing…." Adjusted for Greenspan-speak, that sounds like the Maestro just issued a sell signal for portfolios that are long bonds.
Who knows, the sell signal may prove accurate in the not-too-distant future if Greenspan comes to the conclusion that one reason for the low long rates is related to the ongoing negative real (inflation-adjusted) Fed funds rate. In that case, the FOMC may be prone to hike Fed funds after all at the next meeting set for June 30. If so, may the topic of conversation among Fed board members will focus on the fact that the last time the real Fed funds was positive (above the year-over-year change in the consumer price index) was late 2002.
But if yesterday's lecture from Alan was designed to put a modicum of fear into the hearts of bond traders, there's scant sign of success a day later. The yield on the 10-year Treasury Note slipped once more today, albeit by just five basis points. But at 3.9%, the 10-year's rarely been much lower. And neither, it appears, is the Fed's power to persuade and cajole.
June 6, 2005
WAITING FOR A SIGN
The value-stock train has had quite a run, but the momentum has to end sometime. As always, the question is when?
We don't have a clue, but we do have eyes in our head and so we can watch the numbers. And those numbers have started catching the attention of more than a few pundits of late. Consider that the Russell 1000 Growth Index (a measure of large-cap "growth" stocks in the U.S.) has started showing signs of relative lethargy compared to its value counterpart (Russell 1000 Value). Year-to-date, for example, Russell 1000 Growth (R1000G) is down 0.1% through June 2, according to Frank Russell Company's returns calculator. Meanwhile, the Russell 1000 Value Index (R1000V) is up 1.7% through June 2.
It's any one's guess if growth is making a comeback relative to value. If it is, it's been a long time coming. Growth has taken a back seat to value for the most part since the great collapse of stock prices after the Internet-stock bubble. Consider that for the five years through June 2, R1000V is up an annualized 5% on a total return basis vs. a –9.8% per year for R1000G.
The implication behind value's long-running outperformance over growth is that it's better to err on the side of caution. Value stocks are thought to be safer by association with undervaluation. Growth stocks, on the other hand, live up to their name, which is why they were the relative favorite in the late-1990s: R1000G posted a five-year annualized return of 32.4% through December 31, 1999 vs. 23.1% for R1000V. Today, either record looks alluring, but in the Go-Go 1990s, trailing by an annualized 1,000 basis points was unforgivable.
So-called style indexes (value and growth) usually run through cycles, with one besting the other for a time until the trend turns. It's hard to know exactly when the trend turns except in hindsight. Nevertheless, Russell notes in a press release last week that "growth stocks outpaced their value counterparts in May at every capitalization tier." That's the first month that value beat growth since December and only the second time in the past calendar year.
Adding to the growth-is-making-a-comeback mentality is the fact that tech stocks led the rally in May. Within the big-cap Russell 1000, technology was the clear sector winner last month, rising 8.5%.
But is this how an extended rally in growth relative to value begins? Mr. Market arguably isn't yet convinced. As CNN Money columnist Michael Sivy today advises, "Growth stocks are trading below their historical valuations, while value stocks are above their norms. Investors either expect a slump or feel the odds are scary enough to require defensive stockpicking."
Trends change one tick at a time, although one could be forgiven for expecting that a return to growth's dominance would be accompanied by corroborating evidence in the economy. Do we have that in the "slow, steady growth and stable inflation and interest rates…." that now prevails, according to Sivy? Indeed, that's fertile ground for growth stocks, and the fact that there's a fair amount of "undervaluation" only sweetens the deal, he notes.
But didn't the fixed-income set last week send a message that economic growth is slowing, and therefore the Federal Reserve will soon stop raising interest rates? Indeed, the bond market today stands by its prediction by keeping the yield on the benchmark Treasury Note under 4%. That's the fifth consecutive day of closing the session on the 10 year below 4%, a signpost that hasn't occurred in more than a year.
It's no surprise to find that the stock market, in this case growth stocks, disagree with bonds. Nonetheless, the current dispute in outlook is particularly inopportune for investors trying to discern if growth stocks are set for relative, if not absolute, outperformance after a long stretch in the performance desert.
It didn't help that there were few distinctions today within the various corners of the stock market. Stocks were virtually higher across the board by capitalization and style. Nor to the reasons for the buying lend much insight: catalysts included a dip in crude oil prices and speculation that Fed Chairman Alan Greenspan will lend support in testimony to Congress on Thursday.
If you're having trouble trying to where financial enlightenment lies, and which prediction rings hollow, you're not alone. Last week, Stephen Roach, chief economist at Morgan Stanley and long-running bear on fixed-income securities, confided in a research note that he was "rethinking" his outlook on bonds. "I have long been torn between bearish and bullish forces on the bond market outlook." As such, he "suspects" that bond yields will remain low for some time. Perhaps they'll even drift lower. There are risks to his forecast, but that's his story for the moment and he's sticking to it.
But while the yield on the 10-year threatens lower realms, the Fed has been hiking short-term rates (until recently, anyway). But confusion and indifference reign supreme on the short end of the yield curve nevertheless. Despite a sharp rise in money market yields over the past year, investors are less than enthused. "U.S. money market funds are struggling to attract investor dollars despite rising yields, in part because of investors' high-risk appetite for long-dated bonds, analysts and fund managers said on Monday," Reuters reports today.
Even the Fed's power to move assets to money markets is in question these days. By that measure, is it any wonder that investors generally are bewildered? In any case, be nice. If you see someone wandering aimlessly down Wall Street, be a pal and direct him to a coffee shop (or a good psychotherapist).
June 3, 2005
ANOTHER BRICK IN THE WALL OF WORRY
The bond market may be wrong, as so many have charged this week regarding the 10-year Treasury Note's dip to its lowest in more than a year. But this morning's jobs report for May isn't making it any easier for skeptics of the recent rally in debt to deliver a knock-out punch to the forces of fixed-income optimism.
Nonfarm employment, a widely watched measure of national labor trends, rose a meager 78,000 last Month, the Department of Labor reported. If President Bush was still facing a re-election, cries would be heard near and far from his political opponents that the economy wasn't producing sufficient jobs and that a Democrat was needed in the White House. But the election is long gone and so dissecting the latest monthly employment report is again left for dismal scientists and investors to pore over the numbers.
On that score there's not much to chew on. May's 78,000 rise in nonfarm workers is both a sharp drop from April's 274,000 addition and the lowest gain since August 2003. End of story. Yes, any one month can be volatile, and so we shouldn't take any single number too seriously. But waiting for context will take another month for the next jobs report and the bulls and bears are chomping at the bit today.
As you might expect, the bond market took immediate comfort from the sluggish jobs report for May. After the news was released at 8:30 a.m., New York time, traders aggressively bought the 10-year Treasury Note, sending its yield down to just above the 3.8% mark for a time.
Regardless of the debate over where the "right" yield for the 10 year lies, it's clear that the chatter over the weekend will accelerate on the issue of whether the Fed's interest-rate hikes are history. Finger-pointing or celebrating, depending on whether you favor bonds or stocks, for the moment lies with today's labor report. In fact, the employment trend in recent months has been less than stellar, opines Barry Ritholtz, market strategist at Maxim Group. "I have to disagree with the assessment of job growth as 'steady,'" he writes today on his blog, The Big Picture. "Its not -- its been erratic, weak and disappointing. [Non-farm payrolls] rose by a mere 78,000 in May (April's outlier 274,000 was unrevised ). March was revised down by 44,000 to 122,000. Weakness in May was across the board, but notable was the poor service sector growth (+64,000 versus an imaginary +232,000 in April)." Simply put, "Despite the spinning you heard on TV, there's no way to avoid reality: This Nonfarm payrolls report stunk the joint up."
If so, why hasn't the economic stench worked its way over to the stock market? The S&P 500 climbed 6% through yesterday since bottoming out on April 20. The Nasdaq Composite is up nearly 10% over that stretch. What's more, the price of oil in recent weeks is up to its old tricks and has returned in the mid-$50 range. Is this how a recession begins? Or is something rotten in bond land?
Indeed, the Treasury yield curve is nearly flat, with short rates close to matching long rates. Indeed, a spread of less than 40 basis points separates the yield on 10-year Treasury (~3.85%) from its two-year counterpart (~3.5%). That's the smallest spread since early 2001.
As a result, it's not too early to wonder if the yield curve will soon invert, with short yields exceeding long yields. Historically, that's been a sign that a recession is just around the corner. The bond market expects no less. The stock market, for the moment, begs to differ. Who'll blink first?
DIVORCE ITALIAN STYLE?
The news doesn't surprise us. Or does it? In any case, a government official from Italy has suggested the formerly unthinkable in the wake of the French and Dutch rejection of the European constitution, namely: leaving the euro.
Italian Welfare Minister Roberto Maroni said his country should consider leaving the euro and return to the lira, Reuters reports today. Originally speaking to the newspaper La Repubblica, and later Reuters, Maroni said that the euro "has proved inadequate in the face of the economic slowdown, the loss of competitiveness and the job crisis." The solution? "Give control over the exchange rate back to the government."
Maroni, of course, is just one man and with limited influence. But Italy's in a recession, and doubts are spreading on the Continent about the benefits of economic integration. It's a safe assumption that others in Europe think like Maroni. It remains to be seen how many euro skeptics will go public. But rest assured, where there's smoke, fire usually follows. Whether it burns down the euro house completely, or merely scorches it, is the question.
June 2, 2005
Game on, says Bob Walters, chief economist for Quicken Loans, in reaction to the latest decline in mortgage rates and the related rise in loan inquiries, reports Bankrate.com. Real estate may be a bubble, as many pundits have charged, but if so then it's also true that ours is a bubble-friendly climate.
Among the direct catalysts for the current state of affais is the benchmark 30-year fixed-rate mortgage, the cornerstone gauge of what Joe Sixpack will pay to buy a home. The going rate now sits at 5.65%, the lowest since February and well below the 6.34% from 12 months previous, Bankrate.com advised today. That's no surprise to any one following the bond market, which saw fit to pare the yield on the 10-year Treasury Note to under 3.9% yesterday for the first time since March 2004.
The minor milestone in bond market yields confounds more than a few observers of the financial scene. And for good reason, since falling long rates happen to coincide of late with rising short rates. An odd coupling to be sure, and one that's not long for this world.
In the short term, by contrast, there's no arguing with Mr. Market. The all-important short rate known as the Fed funds, which currently resides at 3%, has climbed from 1% a year ago. Long rates could care less, and have registered their snub in no uncertain terms. The divergent trend in short rates relative to long ones stirred Fed Chairman Alan Greenspan recently to label the sight a "conundrum." But whatever you call it, the ongoing drop in long yields is inspiring capital flows in more than trivial ways, and perhaps for reasons that are less than the textbook definition of prudent.
Consider the real estate investment trust (REIT) market, which has returned to form in recent weeks by pushing up to new highs. That's nothing new in REIT land, which is one of those rare corners of the equity markets relatively unaffected by the grand bear market that otherwise afflicted stocks in the opening years of the 21st century. The Morgan Stanley REIT index touched a new high on May 23, and currently remains just below that apex. The traditionally yield-rich REIT market retains more than passing interest for investors who're watching current payouts on fixed-income securities continue to sink. This despite the fact that the Morgan Stanley REIT index now yields less than 5%. That looks a bit thin by historical standards, although that isn't stopping investors from snapping up real estate securities.
Alas, beggars can't be choosy in the new world order of declining yields. That raises the issue of whether the Federal Reserve is doing enough to slow what some say is a speculative frenzy in real estate, ranging from keeping the momentum going in the nearly six-year-old bull market in REITs to stoking the public's desire for taking out new mortgages for buying bigger abodes if not second and third homes.
Of course, the bond market's view could prove prescient, namely: the Fed's monetary tightening is over, and if that didn't suffice, well, too bad. If true, that's sure to dash any hopes of taming the bullish aura that continues to permeate all things property related. Still, there's grumbling in some circles that the fall in long yields is merely a function of the Fed not raising short rates fast enough. If the central banks really wanted the 10-year Treasury yield to rise, the monetary levers are available, if only the Fed would muster the discipline to exercise those levers, say critics.
But while some dream of 50-basis-point rate hikes, the bond market presumes that zero will now become the operative number in future press releases from the FOMC.
Yet, one might wonder if today's robust upward revision in first-quarter labor costs to 3.3% spells trouble for the blazing confidence that now characterizes the fixed-income set. Maybe, although relatively few bond traders are paying attention. There was virtually no sign today of reversing yesterday's sharp drop in the 10-year Treasury yield, which remained essentially unchanged at just under 4.9% by the close of today's trading.
Clearly, the bond market's in no mood to worry, although some in the dismal science feel compelled to point out what others choose to dismiss. That includes today's release of employment data, courtesy of the Labor Department. To cut to the chase, revisions in first-quarter data now show that unit labor costs advanced at a faster rate (3.3%) in the first three months of this year compared to productivity's revised increase (2.9%).
The trend raises the inflation specter, or so we're told. "Some will see this faster labor cost growth as a warning sign of an imminent acceleration in price inflation…." wrote David Resler, chief economist at Nomura Securities in New York, in a research note today for clients.
Yes, productivity (output per hour worked in the nonfarm sector) was also revised up in the first quarter to 2.9% from 2.6% in the initial estimate. "Ordinarily that would have translated into slower growth in unit labor costs," observed Resler. But the ordinary takes a back seat to the irregular in this case, thanks to the higher revised growth rate in unit labor costs, which are now advancing at a four-year high of 4.3% over the past four quarters, he reports.
Jan Hatzius, a Goldman Sachs economist, passed along a similar warning via Reuters today, explaining, "Historically, such a gap [in labor cost increases over productivity] has typically resulted in a significant acceleration in [the Fed's preferred core inflation measure] over the following year. Presumably, this relationship has not gone unnoticed among Fed officials."
Presumptions, however, can be a dangerous indulgence these days, in central banking and elsewhere. But there's still hope, and more than a little money tied to the notion that the unit labor costs revision won't add up to much. As Resler noted, "growing international competitive pressures have weakened that wage-price linkage." How much has it been weakened? Good question, and one without a good answer short of waiting for future labor and productivity data to roll in.
In the meantime, there's a booming trade in believing that the deflationary winds from overseas economies continue to blow over the American labor market and help turn today's long positions in bonds into yet another profit tomorrow. Game on!
June 1, 2005
THE NEW NEW BULL MARKET IN BONDS
The yield on the benchmark 10-year Treasury Note turned more than a few heads today by dipping to under 3.9%-- the lowest since March 2004. The not-so-subtle message: the economy's cooling, and so it's safe for any and all bond bulls to come out of the closet.
By some accounts, the bond market is now pricing debt in anticipation of an outright recession. Anything less may incur a painful rebuke for buyers of Treasuries, particularly those investors who've jumped on the bandwagon at today's slim yields. David Gitlitz, chief economist at TrendMacrolytics, is among those who smell trouble ahead for the bond bulls. Bonds, he writes today in a letter to clients, "appear badly mispriced" for an economy that he thinks will grow by 3% to 3.5%, the latter being the first quarter's rate of GDP expansion.
The bond market begs to differ, of course. But are we really about to go from a 3.5% GDP growth rate to a recession or thereabout any time soon? Anything's possible, but is it probable?
Then again, bond traders can point to some supporting evidence for the sport of chasing yield. That includes today's comments from the Dallas Fed president, Richard Fisher, who advanced the central bank's penchant for transparency a notch by announcing that "we're clearly in the eighth inning of a tightening cycle," Marketwatch.com reported. ""We have the ninth inning coming up at the end of June...."
There were other goodies to chew on in fixed-income circles today. Indeed, today's release of the Institute for Supply Management (ISM) manufacturing index for May revealed that the measure dropped to 51.4 last month, the sixth monthly decline. As trends go, this one seems to have legs.
The ISM report is all the sweeter for bond bulls considering that the digital ink is still wet on last month's missive from Pimco's Paul McCulley, who wrote that "In the Greenspan era the Fed never keeps tightening once the ISM Index drops below 50." What's more, he provided the historical track record to support the observation.
A reading above 50 in the ISM gauge is said to indicate growth in the manufacturing sector; below-50 readings reflect contraction. What are we to conclude from the latest data point? Arguably, it's too close to call at this point, although finely balanced indices don't deter the bond market from jumping to conclusions these days. Nonetheless, the ISM gauge is still above 50, albeit barely. Nonetheless, growth still has the edge quantitatively speaking. On the other hand, the 51.4 reading on the ISM comes the closest to dipping below 50 since June 2003, when the metric closed at 50.4. There may be two ways to interpret this numerical see-saw, but Mr. Market today was only interested in one.
Adding to the giddiness of the fixed-income set was news that the ISM prices paid index for May declined to a 20-month low. Translated: inflation as a fear on Wall Street is as dead as Dickens' Marley. In any case, ISM reports that 16% of manufacturers said they paid lower prices in May, up from 10% in April and 5% in March. Meanwhile, a falling share of manufacturers indicated they paid higher prices: 32% in May, down from 52% in April.
Corroboration for the bond market's thesis that the Fed's rate hikes are history was also found in today's stock market action. The S&P 500 seemed to breath a sigh of relief in the wake of the ISM report by posting a healthy gain of nearly 1% today. Never mind that a slowing economy may soon come back to bite stocks; today, it was all about buying.
"The Fed has told us they will continue to raise rates at a measured pace, but each decision will be made on the basis of existing or current conditions," Hugh Johnson, chief investment officer of Johnson Illington Advisors, explained to BusinessWeek today. "And current conditions tell me that it's not a sure bet the Fed will raise rates at their June 30 meeting."
Then again, neither is it a sure bet that the Fed won't raise rates one more time. That is, unless you're measuring sentiment by watching only the bond market. For everyone else, there's the realization that getting from here to the next FOMC meeting on June 30 exposes investors to the risks of fresh economic news. Among the potential gremlins that could crash the current party unfolding in the bond market: the import price index, scheduled for release on June 10; and the producer price index, which will be updated anew on the 14th of this month. And as recent history shows, these measures have shown a tendency to rise. Will history repeat itself? For the moment, though, such releases, and the risks they may or may not represent, are a world away.
Nonetheless, the enlightened investor should keep in mind that these are strange times. Exhibit A is the suspicion that money is probably flowing out of the euro and into the dollar in heavy doses in recent days for reasons that have less to do with finance and more with politics. In the wake of France's rejection of the European constitution on Sunday (and Holland's "no" vote today), it's suddenly chic to sell Europe and buy America again, and that may be no small driver in today's Treasury rally. The dollar certainly continues to exploit the euro's new ills. The U.S. Dollar Index closed above 88 today for the first time since last October. It's hard to know where the new migration into the dollar is ending up, but it's a safe bet that some, if not most is being parked (temporarily?) in Treasuries until the euro bashing subsides a bit.
Yes, perhaps the shift into the greenback marks a turning point of some import that will prove enduring. Or perhaps not. But politics and finance can make for strange and volatile bedfellows, which is why the ancient gods of finance preached diversification in both bull and bear markets.