August 31, 2005
THE NEW NEW ENERGY BULL MARKET
There were no surprises in today’s update on second-quarter GDP, but the aftermath of Hurricane Katrina has kept everyone guessing on the energy front.
The Gulf of Mexico is home to the processing and distribution of about one-quarter of America’s energy, and that house is reeling. Katrina delivered a potent punch to the energy business, and the immediate impact is soaring gasoline prices. As of Tuesday, roughly 95 percent of the Gulf's oil production and 88 percent of its natural gas production is off-line, the Houston Chronicle reports. Maybe now the political momentum to clear the way for the development of new gasoline refineries will find traction.
Meanwhile, number crunching the nationwide fallout from the Katrina-induced energy crunch is job one in the dismal science. Accordingly, the formerly arcane statistics of motoring habits have become fertile ground for intelligence gathering as economists scramble to figure out what lies ahead. In a sign of the times, a Wall Street Journal article today considered the finer points of American refueling habits. Car owners typically keep their tanks one-quarter full, the Journal (subscription required) reports. But that was before. Today, and tomorrow, with fears of shortages coursing through the nation, there’s a possibility that drivers will prefer to keep tanks full. If so, that could lead to even higher prices for gasoline.
"What you don't have in the system is the ability to run every car full of gas,” Dan Pickering, president of Houston-based Pickering Energy Partners, tells the Journal. “If you get a hoarding mentality among the consumers, then it tightens the system even further. Fear of shortage begets the shortage. It becomes a vicious circle."
The first step has already arrived with the rationing of fuel supplies at the supplier level. Thanks to Katrina’s legacy of refinery shutdowns along the Gulf Coast, energy wholesalers say they are being forced to limit sales of fuel, according to Bloomberg News. Meanwhile, the White House sought to calm markets by announcing it would release oil from the Strategic Petroleum Reserve. That helped send oil futures lower in New York trading today.
Considering the pullback in oil in the wake of Katrina one pundit wondered if the price of crude was now headed down for the foreseeable future. "If the devastation of New Orleans and the closing of oil refineries across the Gulf of Mexico wasn't enough to spur crude oil prices much past $70 a barrel, you have to wonder what else could be," opines MarketWatch.com's David Callaway today.
Perhaps, although gasoline prices continued rising today. Coming after yesterday's huge gains, it's clear that the bulls aren't giving ground in trading pits for gasoline. As such, Joe Sixpack and his friends are about to learn a valuable, albeit painful lesson in the business of energy refining. Lesson one: crude oil and gasoline are related, but they also have the capacity to move independently of one another. Such a moment of independence has arrived. The reason is simple: gasoline is a manufactured product; oil is a naturally occurring commodity. With refinery capacity taking a hit, the only rationale response is to bid prices up.
It’s any one’s guess what the impact all of this will have on the U.S. economy, but it doesn’t take a genius to realize that the implications are less than encouraging. Gasoline, dare we say, is a strategic commodity in America--more so than even crude oil. Exactly how much pain soaring gasoline prices will shave from GDP won’t be known for some time. Indeed, it's a long way till the release of the first estimate of third-quarter GDP. Maybe the waiting list for a Prius isn't so long after all.
August 30, 2005
A PAUSE THAT REFRESHES, OR BITES?
The news was something less than a surprise. In fact, factory orders for July dropped less than the consensus predicted, according to TheStreet.com. No matter, the stock market wasn't much in the mood to celebrate. The S&P 500 closed down modestly today. The bond market, meanwhile, took the other side of the sentiment trade by bidding up the price of the 10-year Treasury. The yield on the benchmark bond fell sharply by the end of Tuesday's session, settling at 4.1%, the lowest since July 11.
Some saw it coming. Last week's news that durable goods orders crashed by 4.9% in July sent an advance warning of today's factor-orders report.
The bigger issue before the court of fear and greed is whether the manufacturing speed bump that the economy hit last month is the start of something bearish, or just one more pause.
One reason for skepticism that something dark is about to descend is today's other news: consumer confidence this month rebounded after July's fall. “Consumers appear to be weathering the steady rise in gas prices quite," says Lynn Franco, director of the Conference Board’s Consumer Research Center.
Ah, but there's a glitch (as there always is): the survey was taken no later than August 23. Since then, crude oil prices rose by nearly 8% as of today's intraday close and Hurricane Katrina yesterday dropped a costly path of devastation in New Orleans and surrounding areas. That includes the closure of oil platforms, refineries and pipelines along the Gulf Coast, reports CBS/AP.
"This is an extremely serious situation," says Tom Kloza of Oil Price Information Service of the problems in the Gulf's energy infrastructure. A shutdown of gasoline production of this magnitude comes at the "worst possible time," given that the high season for driving is underway as we write. Traders in gasoline futures were quick to agree, and so bid up the prices for September futures by nearly 20% today—yes, 20% in one day!
Will the energy shock convince consumers to rethink the shop-till-you-drop mindset that's kept the economy from the jaws of recession in past years? Only time will tell, but meanwhile there are clues to decipher. "It is important to look at what consumers are doing, not what they are saying," Mark Vitner, senior economist at Wachovia Securities, tells AP via BusinessWeek. "And consumers are already starting to cut back on discretionary purchases."
Ours is a moment of testing the economy, probing its resilience, and weighing Joe Sixpack's capacity for spending. If he can survive the latest threat to sentiment and optimism, there's no telling how much debt he can rack up on top of his already copious pile of liabilities. But for the moment, "if" is the operative word.
August 29, 2005
EYE OF THE STORM
Seventy-dollar-a-barrel oil briefly gave the bond market fresh hope. Hope here is defined as a rationale for buying debt securities on the expectation that soaring energy costs will cripple the economy and create new momentum for a decline in the price of money. Will this twisted version of fixed-income hope prevail?
To be sure, the immediate, albeit temporary trigger in today's oil-price spike had little to do with economics per se. Rather, the culprit was weather: Hurricane Katrina wreaked havoc in the Gulf of Mexico, which is a critical region in the domestic production of oil in the U.S. To be sure, the clean-up tag for Katrina promises to be substantial, which ultimately will be an economic issue. But for today, at least, oil traders were more interested in meteorology than gross domestic product.
But no matter the catalyst, all energy roads ultimately cross the path of the dismal science proper, and not necessarily for the good. "We can expect two months of lost [oil] production, and coming in the peak demand period this is the worst possible news," David Thurtell, strategist at the Commonwealth Bank of Australia, told Reuters today. In other words, even higher prices could be coming.
Oil traders predicted as much and bid up the near-term futures contract for crude to nearly $71 a barrel at one point on Monday before the price fell back to around $67. Things were just as volatile and uncertain in the natural gas markets. The New York Mercantile Exchange went so far as to declare force majeure on deliveries tied to the August futures contract. Translated: producers could avoid penalties even though they don't deliver the underlying commodity to buyers.
Surprisingly, the stock market didn't seem to mind any of this. The S&P 500 rose by 0.6% on the day. The bond market was less enthused but the yield on the 10-year Treasury managed to slip a bit on the day, falling to 4.17%, near the lowest in about a month.
The bigger question that Katrina triggered anew is whether oil's climb will come back to bite the primary engine in the economy, namely, the consumer. Barry Ritholtz, market strategist at Maxim Group, thinks it will, in part because Joe Sixpack's spending spree was already looking a bit long in the tooth. Writing today on his blog, The Big Picture, he laid out what he thinks awaits: "While it is premature to declare the American consumer shopped out,' I suspect it is now quite late in the cycle. Barring a significant improvement in economic fortunes, including robust job creation and increased personal income levels, that exhaustion now looks all but inevitable."
If so, the bull market in energy threatens to become a straw, if not the straw that helps breaks the economy's back. If so, what's a central bank to do? The Federal Reserve has in fact been raising the price of money in an attempt to slow the speculative forces in the real estate market and also nip any burgeoning inflationary forces, born of the easy money policy that ran rampant in past years, in the bud. But if an energy-induced crunch is coming, the Fed's current policy of raising interest rates could turn out to be the 20th century heir to the misguided policy of tightening in the early 1930s, as an economic slowdown gathered steam.
But there are no easy central bank answers, and by extension nothing that resembles an obvious trade in the fixed-income world. Indeed, we're also told that the ascent in the price of fuel has largely been a byproduct of a bubbling global economy.
Which view of the universe will sway the Fed? Perhaps Greenspan, in his waning days as Fed Chairman, will split the difference and hold pat on future rate increases while keeping the previous 10 hikes intact. Much will depend on fresh economic data, which starts with tomorrow's factory orders for August, followed by a fresh update on second-quarter GDP scheduled for release on Wednesday.
There are already a fair number of economic signals both in support of monetary tightening and for the opposite. Ours is a moment in time that looks to be a tipping point. One sign is the rising volatility in the stock market this month, as depicted by the VIX Index. Figuring out if the tip comes, and what will trigger it, and the degree of the kickback is the trick.
August 26, 2005
THE TROUBLE WITH CAPS
Let's get one thing straight (again): price caps won't help, and almost surely will make things worse. Sure, we understand the motivation behind putting a government-sanctioned ceiling on what someone can charge for widgets, apples, or (to pick a commodity at random) gasoline.
The latter, of course, is a topical subject at the moment when it comes to the latest effort to circumvent, manipulate and otherwise ignore the forces of supply and demand. Hawaii's Public Utilities Commission on Wednesday announced price caps for gasoline in the state. The new law, which says wholesalers can charge no more than $2.16 a gallon for regular or roughly $2.74 when taxes are included, takes effect September 1. Maybe it's the isolation mindset that comes from living in the middle of the Pacific. Or, perhaps it's the fact that Hawaii suffers from the highest gas prices of any state. But whatever the reason, facts are still facts.
Indeed, the heart may agree with Hawaii's decision, but the head is apoplectic over the news. History is vague on many subjects, but when it comes to price caps--and price floors, for that matter—the evidence is pretty clear: don't try this at home.
The basics for understanding why price caps are the regulatory equivalent of a wet rag can be found in countless real-world examples. Type "price caps" into Google and see for yourself. Here's but one instance of how price caps ultimately conspired to make a bad situation worse. Remember the electricity crisis in California in the summer of 2000? A quick refresher: electricity became scarce in no small part because regulators decided to impose a price cap. As Adrian Moore and Lynne Kiesling have written, those price caps were "a recipe for blackouts and higher long-run costs."
In fact, the result is almost always the same whenever price caps rear their ugly head. There's no great mystery as to why. Price caps create a disincentive to increase supply. And since price caps are usually dispatched in times of supply shortages and (surprise, surprise) high prices, the notion of further restricting supply is up there with such brilliant ideas as the Fed's restrictive money supply policy in the early 1930s. Throwing gasoline on a fire, in other words, has the usual effect.
But hope, albeit a misguided hope, springs eternal. What, we wonder, does Hawaii expect to find at the end of the price-cap rainbow? Yes, escalating gasoline prices are taking a toll on consumers, especially those with lower incomes. But is the prospect of dramatically lower quantities of gasoline a solution?
Economics teaches that you can control price or quantity, but not both at the same time. Hawaii's regulators either don't know that, or choose to ignore it.
As for trying to figure out a better solution, that starts with looking at the facts. Fact one: the absence of price caps didn't get us into the current energy mess, and the imposition of said caps won't get us out. The real solution lies elsewhere, which includes such things as building more gasoline refineries, and enacting legislation that creates incentives, if not mandates more efficient energy use. Of course it's easier to announce price caps, and then go home and declare victory.
Meanwhile, informed minds can argue about what's the best way to proceed in what some are calling the post-oil era. This much is clear: price caps not only won't help facilitate the transition to a post-oil era, they're likely to delay the process. Prices in a free market deliver signals about how society values commodities and services and, by extension, the related alternatives to using those commodities and services. To the extent the government steps in and second guesses the market and effectively tells society that gasoline is worth less than its free-market price, that creates new but ill-advised incentives and disincentives.
Since the Nixon administration, the United States has talked a good game about reducing oil imports and becoming energy independent. But it's been mostly talk, as the millions of SUVs on the road attest while oil prices reside north of $67 a barrel. One of the reasons America's energy policy has made little, if any progress since the first oil crisis of 1973-74 is that the incentive to do something else has been missing in action. In other words, gasoline costs have remained, until recently, low in inflation-adjusted terms.
Bending over backwards to keep gasoline prices low scratches an immediate political and consumer itch, but in the long run it boils down to this: the post-oil age will only commence in earnest when the pain of doing nothing exceeds the anxiety that comes with trying something new. We're not advocating higher gasoline prices by any means (we drive too!), but supply and demand don't lie. That said, it behooves a great nation to figure out how we get from here to there, even if it's one state at a time.
August 25, 2005
WHO'LL BLINK FIRST?
Oil prices continue reaching into record-high territory, but the consumer, so far, isn't blinking. The sight of sharply rising energy costs and continued trips to Wal-Mart has surprised more than a few dismal scientists, and caused a few ripples here and there in terms of expectations for corporate earnings. But by and large, given the magnitude of oil's rise, the American economy has remained largely unaffected by any notable degree. Can this strange dance of ascending consumer spending and energy prices continue? Perhaps, but not without ramifications.
Stephen Roach, Morgan Stanley's chief economist, predicts that something's got to give if Joe Sixpack keeps spending and energy prices remain high. The way Roach figures it, Joe will either cut back on everything from vacations to buying DVDs, or else his continued his financial profligacy will sink the U.S. national savings rate below its current level of zero.
As choices go, Roach's bifurcated forecast of the economic future is more than a little disturbing—if you believe it. Clearly, some don't. The strategists at Griffin, Kubrik, Stephens & Thompson, for instance, earlier this week dismissed the threat of an energy bull market as a consumer killer. "For at least the past three years, there has been a constant drumbeat of pessimism surrounding rising energy prices," a GKST report published Monday observes. "Yet, retail sales have accelerated consistently. Retail sales, excluding gas station sales, rose just 2.8% in 2002, but were up 3.9% in 2003, 6.5% in 2004, and are up 7.6% during the year ended in Q2 2005." Oil prices, of course, have ascended into the heavens over that span. Crude averaged $26.10 a barrel in 2002, GKST reports. Yesterday, a barrel closed over $67 for the first time.
If the past is prologue, the optimism of the GKST folks is reassuring. On that note, this morning's update on weekly initial jobless claims delivered another reason to think the economy continues to chug along handsomely, thank you very much. For the week ending August 20, initial filings for unemployment slipped 4,000 to 315,000 from the previous week, the Labor Department reports. Save for a few times this year, weekly jobless claims haven't been this low since 2000.
As for Joe's willingness to spend, a fresh measure of his urge to spend comes next week, September 1, when personal income and spending for July is released. Meanwhile, there's the Roach advisory to consider, or dismiss: "If the American consumer fails to adjust in the face of an energy shock, U.S. national savings will plunge further — taking an already massive current account deficit to the flash point," he writes. "This would have profound implications for a US-centric world that is utterly lacking in support from autonomous domestic consumption."
Such fears would quickly fade if and when oil prices pull back from recent highs, Roach continues. "Unfortunately, that's a bet the financial market consensus has been making for far too long."
The advance warnings to monitor on this front in terms of market sentiment include the dollar and gold. But like so many other metrics, these two gauges offer a mixed message. The dollar is again looking weary, giving aid and comfort once again to Roach's worst fears. Indeed, the U.S. Dollar Index's rally this year seems to have topped out last month. Gold, on the other hand, has been in a holding pattern for much of this year, although the metal's been inching higher over the past few weeks. Nonetheless, if the precious metal carries a warning, it's less than compelling at the moment.
For bond investors, the incentive to buy the 10-year Treasury continues to fade as competing rates of shorter maturities move higher. A five-year certificate of deposit averages 4.11%, according to Bankrate.com, just a hair below the current yield on the 10-year Note. Meanwhile, the two-year Treasury yields 4.00%.
Why buy a 10-year Treasury at 4.16% when something comparable can be had in debt instruments of shorter maturities? Stephen Roach may have an answer. Indeed, if the consumer gives way, sending the economy into a tailspin, the 10-year's prospective capital gains could yet prove alluring. But if Joe Sixpack keeps spending himself into financial oblivion, the current account deficit may fall deeper into the red, perhaps triggering a sell off in the dollar and sending interest rates sharply higher.
The Federal Reserve might be pleased with the latter scenario. The central bank, after all, is desperately trying to convince bond traders to sell Treasuries so as to raise long-term rates. To date, no luck, although the Fed presumably will keep trying. The next FOMC meeting comes on September 20, and there are still a fair number of strategists expecting yet another 25-basis-point hike in Fed funds.
All in all, the theme of something's got to give seems like a fair assessment of the financial and economic scene of the moment. Exactly what gives and when, of course, remains the unknown, but a rising tide of pundits think energy will be a key variable one way or the other.
David Kotok, chief investment officer of Cumberland Advisors, echoes the Roach advisory. In an email to clients today, Kotok reviews history and notes that the personal savings rate was higher from the 1970s through the early 1990s relative to today's goose egg. In fact, the savings rate was around 9.5% in the 1970s, and peaked at 11.2% n 1982, vs. zero currently, he comments. Although the savings rate declined in the 1990s, it was still safely positive. "Those higher savings rates acted as a cushion to absorb the higher energy costs…" he advises. "In this energy cycle, the cushion is gone."
Perhaps the bull market in housing will step in and fill the gap this time around, although Kotok's skeptical of this savior if in fact there's a real estate bubble in the works and it's poised to pop.
The crunch time will come this winter, Kotok predicts, when the heating season is in full swing. "Many households will be squeezed and have to cut back on their spending. We think this will show up soon in lower estimates for the growth rate of the U.S. economy," he writes.
Perhaps the first sign that the Kotok outlook will come to pass if and when the Fed blinks first by ending its campaign to raise rates. The bond market, bless its one-track-minded soul, continues to bet on no less.
August 24, 2005
HOME ON THE RANGE
Watching the bond market these days is a bit like watching Rover chase his tail. There's a lot of spinning and swirling, and a vase or two gets knocked over, but Rover never finds resolution. The fixed-income set too seems to be spinning its wheels a lot lately but just can't decide if the economy will grow or contract. Depending on the week, one or the other sentiment prevails until some bit of news emerges to reverse the trend.
The current thinking among the fixed-income set is that the economy will weaken, or so suggests the 10-year bond yield's decline since August 8, when the benchmark Treasury was priced at roughly 4.4%. Today, the ten year closed out the session at about 4.17%.
If there's a logic to any of this it seems to be that transitions take time, and cause more than a little anxiety along the way for those desperate for clear signs of what lies ahead. Indeed, the great secular decline in the 10-year's yield has been in a holding pattern for two years, bouncing within a range of roughly 3.1% (which was briefly touched back in June 2003) to 4.9% in June 2004. The range has since tightened up, but the bouncing continues unabated.
It used to be different. From 1981 through the first half of 2003, a persistent, if at times sidetracked secular bull market in bonds kept the 10-year's yield on a fairly stable path of decline. (It's easy to say that with the benefit of hindsight, of course, but we're saying it just the same.). But in the wake of the sideways trend of the last two years, strategic investors are wondering how long the range-bound meandering can last, and whether the new world order will deploy further yield declines or exactly the opposite.
It's an old question, and one that CS has struggled with for some time. But what's old is new. Alas, we don't have any more insight into the future today than we did yesterday, but we still have eyes in our head.
On that note, this morning's news on July's durable goods orders has added fresh excuses to continue buying Treasuries, which reduces yields. New orders for manufactured durable goods dropped 4.9% last month, the Census Bureau reports. That's the first monthly decline since March, and the steepest fall since January 2004. Economists generally were predicting a fall of just 1.5%.
Yes, the durable goods report is a volatile beast, bouncing around in any given month. But the magnitude of the drop, along with the far-deeper fall than the consensus outlook called for, has caught the attention of the market. "When it misses by this amount, you have to accept the volatility and still be concerned," Barry Hyman, equity market strategist at Ehrenkrantz King Nussbaum tells MarketWatch.com.
At the very least, capital spending has taken a breather. Does that mean it's time to run for the exits and sell stocks and buy bonds? There was, in fact, a bit of just that today. Not only were traders chasing Treasuries, they were selling stocks, to the tune of a 0.6% drop in the S&P 500.
But if there's signs of trouble brewing when it comes to capital spending, optimists prefer to look at today's report on new home sales for July to perk up investing spirits. Sales of single-family homes rose by a sizzling 6.5% over the revised June number, the government advised today. As we've come to expect, the latest measure of the demand for housing was another new all-time high.
The economic news today was clearly one of a mixed message, but in what may be a sign of the times, traders decided to focus on the negative. Does the pessimism have legs?
August 23, 2005
VARIATION ON A THEME
Judging by the rise of U.S. inventories of crude oil, all's well at the moment in the land of energy. Commercial stocks of crude (excluding the Strategic Petroleum Reserve) are far above where they were 12 months previous. So why is the price of crude dispatching a decidedly different, if not ominous message?
The combination of ascending crude inventories and rising prices runs contrary to the laws of common sense and Economics 101. Rising supplies, from lumber to pork bellies, are usually associated with falling prices. But the term "usually" leaves the potential for the occasional variation on a theme, and the here and now just so happens to be one of those variations.
For the week ended August 12, U.S. commercial crude oil inventories totaled 321.1 million barrels, excluding the SPR. That's up about 15% from a year ago, according to data from the Energy Department. In fact, crude inventories at current levels are well above the average range that's prevailed since December 2003.
If rising oil inventories are destined to have a moderating impact on prices, destiny's taken a holiday. No word yet on when, or if the vacation ends, and the mystery keeps the market bubbling. Indeed, it's hard not to notice that while oil inventories in the U.S. advanced 15% over the last year, oil prices have climbed by roughly 45% over that span.
Clearly, inventory trends aren't moving markets these days. Arguably, the far more relevant variable is the world's spare production capacity, or the lack thereof. Global spare capacity in the oil industry has fallen to its lowest level in 30 years, advises the Energy Department.
The future path of that spare capacity promises to cast a long shadow on oil prices for the foreseeable future, and perhaps for eternity. That leads to the topic of what drives spare capacity? Supply and demand, of course. More specifically, Mr. Market is focused on the global oil industry's ability to keep new production capacity growing at one step ahead of demand. Alas, the news on this front invariably flows slowly, if not imperceptibly in the short term.
But this much is clear: Barring some extraordinary discovery of new oil wealth, much of the spare capacity relative to demand growth turns on the usual suspect in the matter of oil: Saudi Arabia. The debate increasingly is one of whether the Saudis have the goods. They say they do, but skepticism is growing, as evidenced in part by the rising price of oil.
No one really knows if the House of Saud can materially increase production in the years ahead. Even the Saudis, we suspect, aren't quite sure. Managing the massive oil supplies that grace the Saudi peninsula is a far more complicated, and slippery (no pun intended) task than most people appreciate.
Regardless, the challenge of delivering more and more crude going forward will require nothing less than extraordinarily successful results in discovery and production, along with maximizing output of existing oil fields. How extraordinary? As a step toward an answer, we'll close by quoting Sadad al-Husseini, the recently retired head of Saudi Aramco's exploration and production division, courtesy of the current issue of the New York Times Magazine, where he discusses the trend of ever-rising global oil demand and the problem of quenching that thirst on a global scale:
"The problem is that you go from [average worldwide oil consumption of] 79 million barrels a day in 2002 to 82.5 in 2003 to 84.5 in 2004. You're leaping by two million to three million a year, and if you have to cover declines, that's another four to five million.'' In other words, if demand and depletion patterns continue, every year the world will need to open enough fields or wells to pump an additional six to eight million barrels a day--at least two million new barrels a day to meet the rising demand and at least four million to compensate for the declining production of existing fields. ''That's like a whole new Saudi Arabia every couple of years,'' Husseini said. ''It can't be done indefinitely. It's not sustainable.''
August 22, 2005
Pity the goldbugs. Inflation, depending on your point of view, is climbing higher, or topping out. The price of gold of late arguably reflects a little of each. After a four-year rally that carried the precious metal to over $450 an ounce last December, gold has moved sideways in 2005, reflecting the back and forth that has become the inflation debate.
The metal now changes hands at roughly $438. That's up a tidy 58% from 2001's close. Thus far in 2005, however, gold's unchanged from last year's final trade. And to judge by the action in the year-over-year change in the monthly consumer price index this year, the lack of movement in the metal looks eminently reasonable. For July, the CPI advanced 3.2% relative to 12 months previous, a middling performance based on recent history.
Price trends for wholesale prices, otherwise known as producer prices by way of government reports, reveal a similar trend of no particular bias. July's producer price index is up 4.6% over the year-earlier figure, or slightly below the 5% posted in March.
It's easy to dismiss the inflation fear, to judge by pricing trends in 2005, and the gold market has effectively done just that. But before we toss away the inflation story completely, it's instructive to step back and consider the historical perspective. Reviewing year-over-year monthly data for the CPI and PPI from 1970 suggests that pricing trends remain caught in a range that's held for much of the past 10 years. In fact, the 12-month changes in CPI and PPI of late reside in the high end of their respective range.
The momentum that previously carried CPI and PPI 12-month changes to the current atmosphere was born in 1999 and 2000, a moment in time when an equity bull market in general, and tech stocks in particular, raged. The arrival of the bear inevitably took its toll, exacerbated by the extraordinary effects thrown off by September 11, 2001. Disinflation, in other words, quickly took center stage in 2001 and 2002, pulling out the rug out from the upward pressure on prices that was formerly evident in 1998-2000.
But while the mounting pricing pressure was derailed, it wasn't killed. With the rate of 12-month increase in the CPI and PPI now revisiting the former high ground occupied in 2000 and early 2001, the question necessarily becomes: What next? Will the range currently occupied prove to be a ceiling once more? If so, what reasons can a thinking investor cite to expect such an outcome?
The natural forces of deflation sweeping the global economy are the obvious citations. The Federal Reserve, argues one school of thought, has tried, and so far successfully kept the forces born of the workforces in China, India and all the rest from exporting outright deflation into the American economy. As a result, the inflationary efforts of the central bank are meeting with the deflationary forces of the global economy. The outcome has been a compromise in the form of modest inflation, as recently witnessed in the CPI and PPI.
But these two opposing forces are not immune to change, either economic or political. As such, one can rightly wonder what might vary going forward that would produce a different result from the recent past. Here's where it gets tricky since the variables that can trigger a breakout in inflation's recent range, or keep the beast contained in familiar terrain, are numerous and more than a little slippery.
What, for instance, is the path of least resistance in the rate of growth in the economy? The answer will depend in no small degree on the where the price of oil's headed. Who among is prepared to say with any confidence what crude's value on the near-term futures contract will be, say, six months from now? We don't need specifics—a mere "higher" or "lower" relative to today will suffice.
Alas, that's tougher that it sounds. Indeed, gold bugs and bond investors aren't natural allies, and as history suggests they typically see the future quite differently. Inflation is good news for gold bugs while the opposite is true for owners of debt securities. But by the standards of year-to-date total returns in two representative ETFs, that historical distinction is less than obvious in the waning days of summer.
The StreetTracks Gold Trust (Amex: GLD), which tracks the price of bullion, has slipped by around one-half of one percent through August 19. The iShares Lehman 7-10 Year Treasury Bond ETF (Amex: IEF) fares better, with a total return of 2.3% through August 19. But if gold and bonds are designed to be something less than fully correlated asset classes, the similarities in year-to-date performance far outweigh any differences.
We have no doubt that events will conspire, and perhaps quite soon, that will re-emphasize the distinctions between gold and bond returns.
In the meantime, the lazy days of summer prevail. Sit back, have a drink, and imagine what life might be like in the autumn. Just don’t fall asleep. The times will be a changin'.
August 18, 2005
KEEP ON TRUCKIN'?
Did the price of crude oil peak last Friday, when futures traders in New York pushed up the near-term contract to an intraday high of $67.10, which stands as an all-time high?
Recent history suggests that keeping a healthy dose of skepticism is in order when it comes to predicting the imminent death of the energy bull market. The ascent of crude prices wasn't history during the buying spree of late-June and early July, when prices pushed above $60 a barrel in New York for the first time in history. Nor was the bull market kaput in late February when prices crossed north of $50 a barrel for the first time. And it sure as heck wasn't over when the $40 mark was breached for the first time in May 2004.
So why should we think it's over now? What's changed? Not all that much in the grand scheme of energy dynamics. Still, one reason for thinking that the oil train is due for at least a temporary rest is tied in to the odds that an economic slowdown is coming, in no small part due to oil's rise. It's no surprise to learn that bull markets in oil in the past have been associated with dramatic economic slowdowns. The obvious examples are also the most dramatic ones, starting with the oil crisis of 1973-74, when gross domestic product contracted sharply from late-1973 through early 1975.
It doesn't take a Ph.D. in economics to realize that slower growth requires lesser quantities of additional oil at the margins. But higher oil prices may not lead to a recession this time, some pundits advise. The difference in this energy bull market is that demand is pushing prices higher. In contrast, past episodes of energy-induced recessions were the result of energy supply shocks of one sort or another. "When oil prices are pushed higher by demand rather than a supply shortfall, people have time to adjust," David Wyss, chief economist at Standard & Poor's in New York, tells AP today via The Shreveport Times. "We just keep on trucking."
Based on recent economic news, who can argue? "A lot people are surprised with how resilient the economy has been with these oil prices," observes Tom Bentz, an oil broker at BNP Paribas Commodity Futures in an article from SmartMoney.com published earlier this week. "Certainly, at $50 a barrel, a lot of people thought that would put a damper on things."
But there was no damper in site at $50, or even $60. The question is, would $60 oil have a bigger negative impact on the economy after 12 months vs. the two months that crude's been at that altitude? The answer is probably "yes," assuming, of course, $60-plus holds. Indeed, the longer oil prices remain high, the greater the economic damage. Whether that damage is enough to push the economy over the edge to recession remains a debatable point, but an increasingly topical one.
For what it's worth, one economist who watches oil goes so far as to cite the words that have come back to bite so many in the predicting business: It's different this time. "For the past year," University of California economics professor James Hamilton writes on his blog, "I've been telling people that this time it's going to be different--the economy could weather the rising price of oil without a downturn." He goes on to explain, "the reason that the oil price increases of the last two years have not caused a recession yet is that they have built up gradually, and resulted not from a drop in supply but instead from strong global demand. Faced with a gradual price increase and rising incomes, most people have been able to adapt to the higher prices and make adjustments in an orderly way that does not cause serious economic dislocations."
But in what may be a significant sign of the times, Hamilton's optimism has receded a bit, giving way to a touch more anxiety: "Just within the last couple of weeks, I've been hearing a lot more expressions of anxiety and concern--the sort of psychological factors that produce abrupt spending changes."
As Hamilton and others remind, the surge in gasoline prices in particular has attracted Joe Sixpack's attention. As the price of filling up his SUV has continued to rise, our consuming hero Joe has been forced to consider the financial toll and wonder what such a trend would do to his leisure spending over time. To date, there's no smoking gun in the form of a material slowdown in consumer purchases. What's more, there's been no similar fallout in the real estate market. But with the Fed continuing to raise short term rates, and gasoline and energy still in a bull market, until we see otherwise, one has to wonder if the economy is headed for rougher times.
Of course, things still look rosy if you're focused on this morning's business outlook for the Philadelphia region. The Philadelphia Fed this morning reports that manufacturing in the area "continued to expand," based on the August survey. In fact, the Philly Fed index rose sharply higher for the second month running.
But you don't have to look far for a conflicting data, if you're so inclined. On that front, the news in this morning's leading indicator for July from the Conference Board offers another excuse to wonder about the future. Although the index rose by 0.1% last month, that paled in comparison to June's 1.2% advance. Is the sharp slowdown in the leading indicator, which is designed to predict future economic activity, a sign of things to come? Perhaps, although it's too early to tell, particularly with a volatile index such as this.
As we await for confirmation, or rejection, of the apparent trend suggested by the leading indicator, Ken Goldstein, economist at the Conference Board, which publishes the index, observes: "The leading economic indicators suggest moderate growth into the fall. "The spike in energy prices is one factor in this outlook, which mirrors the economic situation in much of the rest of the industrialized world. Of more concern is the level of business executive and consumer confidence. Both investment and hiring intentions reflect a level of caution over both pricing and profit strategies."
If you prefer answers quickly, with hard edges and distinct conclusions, take a look at the molecular biology or plumbing. Economics, on the hand, will drive you crazy. Welcome to the asylum.
August 17, 2005
DEAD, OR JUST DORMANT?
Maybe it's not so benign after all. Producer prices rose 1.0% in July, the Bureau of Labor Statistics reports. As with yesterday's news on consumer prices, removing food and energy from the equation lessens the pricing momentum, bringing the PPI pace of advance down to 0.4% last month. But 0.4% ain't hay.
In fact, 0.4% is the highest monthly rise in the so-called core producer price index since January's 0.7%. As a result, core PPI now running at 2.8% over the past 12 months—the highest since 1995. Yes, Virginia, that's 1995.
Inflation, if you haven't yet caught the drift, isn't quite dead. That fact promises threatens to be front and center when the Fed convenes its next Federal Open Market Committee meeting on September 20. Indeed, today's PPI report all but insures that another 25-basis-point hike in Fed funds is coming. The news on wholesale prices "raises the probability that the Fed will not pause [in its raising of interest rates] this year," Anthony Chan, senior economist at J.P. Morgan Asset Management tells Reuters today.
This all comes after last week's FOMC statement that core inflation "has been relatively low in recent months…." Perhaps it's time for the Fed to rethink.
At the same time, the PPI-driven inflation news is a double-edged sword for the bond market, and the economy overall. The 1.0% increase in the top-line PPI number for July was clearly driven by energy prices. Ditto for yesterday's CPI report. If nothing else, investors are being reminded that higher energy prices are more than casually connected to inflation.
The dilemma is deciding whether higher energy prices will, in addition to sparking higher inflation, also derail the economy. But which peril takes priority? Inflation or recession? The fixed-income set was pondering just that today. The day's conclusion: inflation was the bigger threat. Traders sold the 10-year in today's session to the point that the yield retraced most of what it lost in the rally on Tuesday. As such, the benchmark Treasury sits at roughly 4.3% vs. 4.2% from the day before.
If there's a case to be made for recession, the stock market wasn't buying into the fear, at least not today. The S&P 500 inched higher by 0.2% on the day. The leading names in the index moving higher were Hewlett-Packard, General Electric and Microsoft—companies that rely in no small part on a growing economy.
Equity investors also took heart from the news that the big losers in the S&P 500 today were oil stocks, including ExxonMobil, ConocoPhillips, and Chevron. No surprise here, considering that oil prices dropped sharply today—down nearly $3 a barrel in New York futures trading, the biggest daily drop in recent memory.
One day a trend does not make, as they say. Oil's still high and bond yields are still relatively low. As such, there are several questions that loom over the markets, including: Is today's oil-price decline the start of a longer correction? Gaining some insight on that topic will help convince investors, one way or another, if an economic slowdown, if not recession, awaits.
Meanwhile, it's business as usual on Wall Street, which is to say that short-term trading retains the allure of the moment over buy and hold. Indeed, the VIX index, a measure of the equity market's price volatility, is on the rise this month. We're all day trader's now.
August 16, 2005
Inflation jumped in July. But then that should come as no surprise for anyone watching the energy markets. The price of crude oil, for instance, rose more than 7% last month, based on the near-term futures contract traded in New York. The bull market in oil flowed through to consumer prices, with the CPI advancing 0.5% last month, reports the Bureau of Labor Statistics. That's slightly higher than what the consensus estimate called for, and far above the unchanged consumer prices that prevailed in June.
But once you strip out food and energy prices, CPI continues to look like a toothless beast. So-called core CPI rose just 0.1% in July, less than the 0.2% that economists were generally predicting. In fact, July's core CPI rise was the third straight month that the index advanced by a spare 0.1%.
The bond market prefers to ignore the energy component when it comes to inflation. To the extent that energy's the source of the inflationary pressures haunting the CPI, that's not a threat for the fixed-income set. And not without reason, say some traders of debt. High oil prices may stoke inflation fears, but the same elevated prices in crude also raise the specter of an economic slowdown. Which side has the upper hand at the moment? Once again, the recession-is-coming crowd does. Indeed, the bond bulls were again out in force in today's trading, chasing the government's paper anew. The yield on the 10-year Treasury Note fell today for the fourth time in the last six sessions. The 10-year's current yield of roughly 4.2% is now the lowest since July 28's close.
But why tie up your money for ten years when you can get virtually the same yield on a two-year Treasury? A slim 20 basis points is all that separates the two-year Treasury from its 10-year counterpart. If you buy the two-year Treasury in the here and now, you can lock in a yield of around 4.0%. The 4.0% on the two year is all the sweeter when you learn that the iShares Lehman 1-3 Year Treasury Bond ETF (Amex: SHY) yields a trailing 2.7%.
Logic may not be bursting the buttons in bond land, but there's plenty of relative value to pass around.
August 15, 2005
It's nothing new, but the endurance of the trend doesn't dim the spectacle of the bond market resuming its preference for sending the yield on the benchmark 10-year Treasury Note lower. The decline is all the more striking coming in the wake of the Fed's latest hike in interest rates on August 9. Since that day, the 10-year's yield has slipped to roughly 4.25% on Friday from 4.40% when the central bank elevated the Fed funds rate rose by 25-basis-points to 3.50%.
What does it mean when the bond market is intent on taking issue with the Fed's monetary policy and rendering Greenspan & company something less than influential? The answer: to be determined.Clarity oozes ever so slowly from the market in the dog days of August.
Among the questions one should ask in trying to deconstruct the current "conundrum" is whether the persistence of low long rates in the face of rising short rates reflects a belief in the approach of a slowing economy or, alternatively, the continued rise of excess savings that are flowing into bonds and thereby keeping yields lower than economic fundamentals suggest?
Tackling the economic slowdown theory first, one can look to the recent statistical releases to question the logic of this view that things will get worse before they get better. This morning's release of the New York Fed manufacturing index is the latest reason for a central banker to see the economic glass as still half full rather than half empty. The August Empire Manufacturing index, a survey of manufacturers in New York state, rose more than expected, and has advanced for three months in a row.
Growth is easily found on a national basis as well. Indeed, the Federal Reserve has no doubt noticed that the nominal year-over-year rise in GDP in the second quarter was 6.1%, or more than a bit higher than the current 3.5% Fed funds rate. Liquidity, one could argue, still has the upper hand, or so these crude metrics convey, which suggests that additional tightening in the money supply is warranted.
That seems to be lending support to the view that buying Treasuries the world over still makes sense despite the various macroeconomic challenges facing America. Indeed, investors near and far bought a $71.2 billion Treasury notes, along with corporate bonds and other securities in June, the government reports today. That's the highest since February's $79.6 billion, and is also up sharply from a revised $55.8 billion in May. Foreigners may yet decide that U.S. debt's allure is fading, but signs of such a shift in market sentiment have yet to arrive in any material way.
Investors are still gobbling up American debt instruments, and that appetite has proven influential of late in overcoming news that the U.S. economy remains robust. But the fixed-income set is showing signs of anxiety nonetheless. And with just 20 basis points or so separating the yield on the two-year and 10-year Treasuries, who can argue against keeping one eye open and another on the sell button?
Still, there's enough give and take to see any financial future you desire. Depending on the day, or the hour, bulls or bears prevail, with the trend of going nowhere fast winning the day. The demand for Treasuries makes the dollar relatively more attractive, which in turn helps keep the 10-year yield lower than it might otherwise be. But a strong economy implies more Fed rate hikes, which in theory inspires the bond market to run for cover. Back and forth, round and round. Resolution is coming...one day.
August 12, 2005
DOLLAR BLUES ANEW
Is the dollar's rally in 2005 history? It's more than a little easy to suspect as much in August. After rallying 10.5% this year through the end of July, the U.S. Dollar Index has reversed course thus far in August, falling 2.7% through this morning's trading. The recent fall from grace raises new questions about the greenback, which previously suffered a three-year bear market through the end of 2004. But the bulls were heartened by the dollar's rebound this year, recently bolstered by recent economic news that showed the American economic expansion alive and well. What happened?
For starters, the forex market was reminded this morning that the U.S. continues to suck in imports at a faster rate than it spits out exports. Or, in the vernacular of international economics, America's trade deficit continues to widen. The trade balance for June slipped to -$58.8 billion, a 6.3% deterioration from May's -$55.3 billion, the Bureau of Economic Analysis reports today. That's not quite as bad as the -$60.1 billion logged in February, but it wouldn't take much to set a new record in the months ahead, and who in the dismal science really expects that a new all-time low in the trade deficit isn't just around the corner?
It's more than a little troubling to note that while imports in June grew by $3.4 billion to $165.6 billlion, exports of goods and services were "virtually unchanged," according to BEA. And it gets worse: goods exports actually decreased, mainly in foods, feeds, beverage, consumers goods and industrial supplies and materials.
Forex traders seem to have anticipated the obvious, selling the buck ahead of the news in recent weeks. Perhaps the realization that the American economy continues to chug along sent a signal of some contrarian aura to those who ply the currency markets for a living. Recall that some have warned in recent years that a global economic imbalance stalks the international scene, namely, an America that consumes like there's no tomorrow while Asia is more inclined to save. In Europe, meanwhile, the economies on the Continent are sufficiently weak relative to America so as to cast doubt on the prospects of materially expanding U.S. exports to the likes of France and Germany. “The U.S. economy is simply stronger than that of most of our trading partners and modest currency movements have proven insufficient to remedy the balance,” Stephen Stanley, chief economist at RBS Greenwich Capital, tells MSNBC.
Nonetheless, the events of recent vintage have extended a cozy relationship that's served Joe Sixpack well. Joe, of course, has a taste for any number of consumer goods and gadgets. He likes a wide selection, and he likes his gadgets cheap. That's where Asian suppliers, including China, have stepped up to the plate, supplying Joe with what he wants, and then some, and at prices he just can't refuse. The result has been a rising flow of dollars into foreign economies in exchange for an ascending mix of goods arriving in droves at such locales as the Port of Long Beach in California. As you might expect for this crucial point of entry for Asian imports into the U.S., business has been good, and exploding truck traffic in and out of the port is among the smoking guns. So too is the fact that inbound container traffic at the port is up 18.5% year to date through the end of June. What's more, inbound container flows outnumber outbound by nearly three to one.
But let's be clear about the trade deficit: the pressing problem for the American economy on this front is less about Joe buying a new Chinese-manufactured television set on the cheap. The far bigger issue to grapple with is the fact that America's oil imports continue to rise, and with the price of oil doing no less, the combination weighs heavily on the balance of trade. The dollar value of crude imports jumped to a record $14.6 billion in June, up from $13.7 billion in May. The volume of crude imports also grew in June, rising to 328.3 million barrels from 318.6 million barrels the month before. Considering that the price of crude, as of yesterday's close, was up 16% from the end of June all but insures that oil will continue to be a thorn in America's trade deficit for some time.
No wonder, then, that forex traders are selling. "Given the dollar's current negative disposition, this disappointing [trade deficit] number highlights once again the dollar's structural liabilities and should facilitate further dollar selling," opines Alex Beuzelin, foreign exchange analyst at Ruesch International, in a Reuters story today. "I would expect this to translate into fresh lows for the U.S. currency."
Look out below….
August 11, 2005
GREED & FEAR, GASOLINE & OIL
Crude oil futures reached yet another record high of $65 a barrel yesterday, and in early trading this morning the bull kept on rolling. Skeptics who thought oil couldn't climb this far, this fast have been understandably quiet of late. But for all the talk of a secular rise in energy prices, one could wonder why the current rally hasn't corrected. Indeed, we may very well be in the middle of a secular bull market for energy, but the ebb and flow of trading hasn't yet been relegated to the dust bin of history.
Let's start with yesterday's weekly petroleum report from the Energy Information Administration, a release that showed that U.S. commercial inventories of crude (excluding the Strategic Petroleum Reserve) continue to move higher. For the week through August 5, crude oil stocks advanced 0.9%, and over the past year through that date they're up 9.7%. At 320.8 million barrels, EIA observes, "U.S. crude inventories are well above the upper end of the average range for this time of year."
If oil inventories continue to increase, why hasn't the price of oil pulled back? One reason, as the Centre for Global Energy Studies has recently noted, is that rising inventories are at odds with a lack of spare oil production capacity in the world. Most of the globe's spare production capacity resides within Opec, and within the cartel much of that spare capacity is found in Saudi Arabia. But the kingdom's ability to ramp up production from current levels is constrained, at least in the short term, giving rise to bull market in oil's price. "Stocks have built rapidly in the first half of 2005, despite $60 oil," according to a new report from the International Energy Agency reports the London Times, "but clearly, the market verdict remains that more inventories are needed until investment responses catch up and demand patterns are clearer."
Bumping up against a wall is also the story when it comes to manufacturing gasoline in America, where new refinery development has remained the stuff of dreams for two decades. In the U.S., refineries operated at 95% capacity last week, the EIA reports. Meanwhile, gasoline demand keeps rising, the agency notes. For the week ending August 5, gasoline demand was 9.483 million barrels per day, up slightly from 9.472 million barrels a day a year earlier.
It's also true that gasoline inventories fell last week for the sixth week in a row. That lends momentum to the fact that this is the peak season for gasoline demand, courtesy of summer driving, a fact that hasn't been lost on traders. In fact, gasoline, measured by the near-term futures contract traded on the New York Mercantile Exchange, has run up more than oil. Gasoline prices climbed more than 60% this year through yesterday vs. 53% for oil.
The incentives for elevating oil inventories further, in short, remain high. But that's where oil and gasoline part company. Crude oil is an unrefined product that's pumped from the ground; gasoline is manufactured and therefore subject to the constraints of refinery capacity, of which a thin 5% spare capacity exists in the U.S.
In theory, gasoline demand will remain high through the Labor Day weekend, the unofficial end of summer and the driving season. But if history's a guide, demand will soften from September through March, as EIA data show to be the case in recent years. It's worth noting too that gasoline prices, while generally climbing since late-2001, have for the past two years suffered a sharp downturn in late summer (August 2003) and early fall (October 2004). Oil too has shown a tendency to pull back around the same time, declining in late-August and early September in both 2003 and 2004.
As Mark Twain long ago advised, history doesn't repeat itself, but sometimes it rhymes. Exactly when and where those rhymes come is anyone's guess. But with gasoline and oil prices running higher in virtually unbroken lines, it may be time to reconsider the omnipresent concepts of greed and fear from a tactical perspective.
August 10, 2005
The Federal Reserve yesterday repeated its intention to continue raising interest rates, and some investors actually believe it, which in turn inspires selling. But such running for cover isn't universally embraced, at least not yet. The bond market, to name the conspicuous example, isn't quite sure if it wants to take the Fed warning to heart.
The warning, such as it is, comes by way of Fed-speak in yesterday's FOMC statement: "…the Committee believes that policy accommodation can be removed at a pace that is likely to be measured."
Expecting no less, yield-sensitive equities pre-emptively reacted. The Morgan Stanley Reit Index has suffered a sharp correction in recent days, although it rebounded a bit today. The Dow Jones Utilities Average too has been falling of late, albeit less sharply than REITs. Is this a sign that the rising short-term rates are set to lure assets away from yield-oriented equities in the weeks and months ahead?
Perhaps, although the bond market's not yet convinced that rising short rates are a real and present danger for longer-dated maturities in the debt realm. Despite the 25-basis-point rise of Fed funds to 3.5% on Tuesday, the yield on the 10-year Treasury remained essentially unchanged today relative to yesterday's close, and currently hovers at just under the 4.4% mark.
One theory making its way around the bond market is that the Fed, by raising short rates, will keep any inflationary pressures bubbling in check. One analyst goes so far as to note that with yesterday's 25-basis-point hike behind us, there's a relief rally underway in Treasuries. "With the Fed out of the way, there's a little relief that they weren't as hawkish as might have been inferred from recent data," Gerald Lucas tells Bloomberg News..
The old advice not to fight the Fed is s-o-o-o yesterday. And not without reason, since fighting the Fed has been less-than-savvy advice for much of the last 14 months. When the central bank began raising Fed funds back in June 2004, a 10-year Treasury yielded nearly 4.6%. Despite Fed funds ascending to 3.5% yesterday from1% in June 2004, the 10-year Treasury yield has fallen slightly. Fighting the Fed, in sum, has been a profitable game—to date.
Still, Fed rate hikes were once considered bad news for the bond market. Today, rate hikes are said by some to be a sign that the Fed's intent on keeping a lid on inflation. We can only guess what it will all mean tomorrow.
August 9, 2005
INVERTED CURVES AND TORTURED MARKETS
The current pace of economic growth has "been worse than average," the Center on Budget Policy Priorities laments today, although that didn't stop the Federal Reserve from raising interest rates again today. In fact, the tax cuts of 2001 and 2003 were dispatched in vain, the think tank's paper suggests, advising that "the economy’s overall performance does not make up for the adverse fiscal effects of the recent tax cuts or the unusually uneven distribution of the economic gains from this recovery."
The numbers lend support for this view, CBPP reports. The average annual growth rate in gross domestic product after economic troughs in the post-World War Two era is 4.7%. The current recovery, thus far, measures only 3.3%, although that happens to be a bit higher than the 3.2% average posted for the 1990s.
Meanwhile, the current recovery rolls on, which is to say that the final chapter on the GDP-expansion experience in the 21st century has yet to be written. To judge by some of the more optimistic predictions, there's still hope among some dismal scientists for acceleration in economic growth. Ethan Harris, chief U.S. economist at Lehman Brothers, tells clients in a research note that he expects America's GDP in this third quarter will rise by 4.5%, up from his previous guess of 3.5%, Reuters reports today. And for the fourth quarter, he thinks the economy will advance by 4% vs. an earlier estimate of 3.5%. The catalyst for the fresh dose of bullish thinking? The "out-sized inventory destocking in the second quarter," he explains.
Harris' perspective is sanguine next to the 3.4% reported for the second-quarter rate of GDP expansion. But the bears are hardly an extinct species on the matter. Consider the latest Merrill Lynch downgrade for economic growth. The U.S. economy will expand by just 2.7% next year, down from a previous forecast of 3.2%. "Our revised outlook for 2006 is being premised on changes we are making to three key assumptions," Merrill economists David Rosenberg and Sheryl King wrote in a report published Friday, notes The Globe and Mail. "Our oil price assumption, which we have taken higher to $50 from $40 (U.S.) a barrel, our dollar assumption has gone from a 4% decline to flat, and of course we bumped up our Fed funds forecast to 4% for the end of this year from 3.5% and the peak effect of that will show through in 2006." The same article quotes Pimco's Bill Gross has predicting recession "at some point in 2006/2007," as he declared on CNBC last week.
So why is the Fed raising rates? Today's 25-basis-point hike brings the Fed funds to 3.5%, the highest since the ill-fated month of September 2001. Nonetheless, by the central bank's reckoning, 3.5% remains "accommodative and, coupled with robust underlying growth in productivity, is providing ongoing support to economic activity," or so the Fed told us in a statement accompanying the rate hike. "Aggregate spending, despite high energy prices, appears to have strengthened since late winter, and labor market conditions continue to improve gradually."
But if Greenspan and company expect the bond market to be impressed with the ongoing elevation in the price of money, today was something of a disappointment. The yield on the 10-year Treasury Note slipped a bit on the day, dipping ever so slightly to 4.4% in the wake of the Fed funds rise. As a result, the yield curve (to use the argot of the bond world) moved a step closer to inverting. That is, short rates moved nearer to long rates, with less than 30 basis points separating the current yields on a 10-year Treasury and its 2-year counterpart—that's down from 180 basis points as recently as 12 months previous. If and when the two-year yield moves above the 10-year, the inversion of the yield curve will have arrived in all its ignominious glory.
Ignominious because an inverted yield curve has often signaled the approach of recession. But the warning's not perfect, relates Richard Bernstein, chief U.S. strategist for Merrill Lynch. When it comes to corporate profits, however, the historical record's clearer. "Although inverted yield curves do not uniformly forecast economic recessions, every inverted yield curve of the last 40 years has been followed by a profits recession," he explained on July 25 by way of Reuters. Sometimes the profits decline occurred in as little as six months after the arrival of an inverted yield curve, although in one case it took as long as two years. The average lead time was 14 months.
No wonder that Larry Kudlow, host of CNBC's Kudlow & Company, is calling for the Fed to cease and desist with its current strategy of monetary tightening. "The central bank has succeeded in removing most, if not all, of the excess liquidity they created following 9/11 and the vicious deflation that preceded the terrorist attacks," Kudlow writes today in the National Review. "In my view, the Fed should declare victory and stop their auto-pilot restraining actions before they completely flatten or invert the yield curve."
But such cries are falling on deaf central banking ears. The next opportunity for something different comes on September 20, the date for the Fed's next regularly scheduled FOMC meeting.
August 8, 2005
BULLS & BEARS, FEAR & LOATHING
It's only a coincidence that President Bush signed energy legislation into law today as the price of crude oil nearly touched the heretofore unthinkable $64-a-barrel mark at one point during futures trading in New York. Perhaps that's why the president announced what everyone already knew as he put pen to paper. "This bill is not going to solve our energy challenges overnight," he warned in Albuquerque, New Mexico just before signing the bill.
If not overnight, most Americans would settle for a solution sometime in the foreseeable future, preferably in what a middle-aged adult might term "within my lifetime." But even that may be asking too much. It was Richard Nixon, after all, who announced all those years ago that the United States was on a mission to rid itself of the petroleum problem, namely, the dependence on foreign imported oil. America's been on a mission ever since, and with little to show for it in terms of lowering the degree to which the country relies on offshore shipments of crude.
Today's bull market in oil is nothing new, of course, nor is today's rise in a barrel of crude a reaction to the new energy law. In fact, the oil market seems to be saying in no uncertain terms that no matter what the President signs, or doesn't sign, matters not when it comes to putting a price on the world's most valuable commodity.
In fact, the factors behind the latest ascent in crude are a mix of technical and geopolitical: various shutdowns of refinery capacities and renewed fears of terrorism in Saudi Arabia, according to Bloomberg News.
After last week's economic news, there's no immediate hope that the economy will provide a reason to reprice oil downward based on fears of a slowdown, much less recession. That's not to say that oil won't suffer a price correction, but the catalyst will have to come from elsewhere.
Is it the perfect storm for oil? It's easy to think so, given all the smoking guns of the moment. The flip side of this view is that it's the perfect selloff for the bond market. The yield on the benchmark 10-year Treasury Note continued rising today, closing above 4.4% for the first time since early April. True, inflation seems well contained at the moment, or so the government tells us. But that's not likely to stop the Federal Reserve from raising Fed funds by another 25 basis points tomorrow, when the Federal Open Market Committee convenes for its regularly scheduled meeting.
And what if inflation doesn't stay contained? Morgan Stanley's Stephen Jen, who heads up the firm's currency research in the London office, considered the unthinkable in a new essay. He opines that the market is "likely to seriously contemplate" a U.S. economy that "will likely grow strongly in 3Q (i.e., 5.0%), as inventories drawn down in 2Q are rebuilt." Jen goes on to predict that with "U.S. economic growth likely to exceed the potential rate of 3.25 to 3.50% for the foreseeable future, exerting pressure on capacity, I feel risks to inflation could tilt to the upside, compelling the Fed to contemplate going beyond ‘neutral,'" which is to say rising faster and further than generally anticipated by the folks in bond land at the moment.
That's just what the fixed-income set doesn't want to hear. But it was just a few months back that Bill Gross, chief investment officer of Pimco, the giant fixed-income manager, predicted a range of 3% to 4.5% for the 10-year Treasury for the next three to five years. That may yet prove accurate, but at the moment the top-end of that range looks set to be give way as yields climbs higher.
The question then is whether the recent bond selloff is sustainable? And for the answer, one must necessarily look to Joe Sixpack and assess his spending habits. Dr. Ed Yardeni, chief investment strategist at Oak Associates, says Joe hasn't yet lost his penchant for pulling credit cards from his wallet and handing them over to the nice clerk behind the cash register in exchange for TVs, cellphones and other assorted goodies. So, is the consumer able and willing to keep spending? "We think so, replies Yardeni in a missive to clients today:
The latest employment report shows that the jobs are there to keep consumers shopping. So far this year, jobs are up 191,000 per month, on average, and should at least match if not exceed last year's 2.2 million total net gain. Wage inflation remains subdued at 2.7% year-over-year and almost one percentage point higher than core consumer price inflation. This suggests that productivity is still growing at a solid pace.
One factor that may yet slow the economy is a widespread belief that the real estate boom is in fact ending, if not collapsing. If Joe no longer believes that his three-bedroom ranch will rise in value at 20% a year perhaps he'd be inclined to give the credit cards a rest.
Yes, the economy would indeed slow if the real estate bull market corrected, opines the economics team at Wachovia Securities. "Sooner or later, and w think sooner, home price momentum will slow," the firm counseled in an August 1 report. "When this happens we believe the economy will lose an important engine of growth." Just don't expect a housing bust, Wachovia adds, delivering something of a soft landing for the economy.
There's always the possibility that consumers will eventually be frightened by rising oil prices, although to date that continues to be a paper tiger as far as our hero Joe's concerned. No doubt there's may be something on the horizon to revive fears of economic turmoil. Just not today, although the pessimists keep turning over rocks.
August 5, 2005
207,000 AND COUNTING
The economy, to draw on the vernacular, is cookin' with gas. That's the message embedded in this morning's jobs report for July, a month that witnessed a 207,000 rise in nonfarm payrolls. That's well above the 180,000 consensus forecast and the revised 146,000 gain for June, according to Briefing.com. But wait, there's more: average hourly earnings jumped 0.4% last month, the fastest monthly pace since an identical rise a year earlier.
Although the unemployment rate remains unchanged for July compared with the previous month, standing pat at 5.0%, it's hard to interpret the latest batch of data as anything other than bullish for an economy that seems intent on chugging along, if not picking up a bit of speed.
Employment growth was particularly strong in the retail group, where new jobs rose by 50,000 last month. That's in contrast to virtually change in retail employment in June. In July, the Labor Department reports, "retail employment gains were widespread, including growth in clothing stores (13,000), motor vehicle and parts dealers (10,000), and building material and garden supply stores (7,000)."
Today's jobs report will undoubtedly promote a fresh round of rethinking the appropriate level of money's price. The Federal Reserve, as it turns out, meets next Tuesday, August 9, to consider just that conundrum, or increasingly, the lack thereof by way of Greenspan's recent definition of the word. From today's vantage, raising rates another 25 basis points looks set to be one of the more anticipated financial events in the coming week.
David Resler, chief economist at Nomura Securities, wrote to clients today of July's jobs news, "Overall it is a consistently, solid report. Labor markets remain healthy and with the economy on the mend from the spring inventory correction, further [non-farm payroll] gains above 200,000 should become the norm."
Such a norm isn't exactly what the bond market had in mind a month ago, but, hey, things change on Wall Street. Indeed, the 10-year Treasury sold off sharply at the outset of today's trading in the wake of this morning's jobs data, thereby immediately pushing the yield on the benchmark bond up to nearly 4.4%, the highest in about four months.
But the growing realization that the U.S. economy isn't giving up its growth bias without a fight has more than one implication. Indeed, sustained growth suggests that demand for energy will remain robust. In fact, buyers were keeping prices near all-time highs in early trading today. The bulls are also aided by worries that the latest installment of refinery problems will keep buyers at the fore. "With refinery problems at the moment and demand increasing in the fourth quarter, there is a chance prices could rise further,'' Sam Tilley, an analyst with Sucden U.K. Ltd., a London broker, tells Bloomberg News. "The world seems to be getting used to $60 a barrel."
The question is whether investors generally are also getting used to the idea of an economy that seems to finding its second wind.
August 4, 2005
REVIVED, REFRESHED, AND AVAILABLE FOR PURCHASE (AGAIN)
The government giveth, and taketh.
Taketh was front and center in October 2001, when the Treasury pulled the long bond from active duty. Yesterday, the 30-year Treasury was called back into active duty, with the first issue up for auction on August 8 at 1:00 pm New York time, according to yesterday's statement from the Treasury. (Step right up, and no pushing—everyone will have a chance to lend money to Uncle Sam.)
The revival of the 30-year evokes a few thoughts, a bit of reflection, and some unanswered questions about whether buying the latest new-old innovation in debt is a wise move at this juncture.
It's hard not to notice that the government cancelled the 30-year when interest rates were falling—correction: rates were virtually collapsing, courtesy of the folks at the central bank. Recall, dear reader, that the Fed funds rate exited 2000 at 6.5%; a year hence, at the close of 2001, Fed funds were a much-diminished 1.75%, eventually on their way to 1.0% by the middle of 2003.
The Federal Reserve was fighting deflation, real or imagined, back then. One of Treasury's actions during the war was taking the 30-year bond out of circulation, thereby removing a security that was at the top of the capital-gains-manufacturing chain among Treasury debt issuance at the time.
Fast forward to August 2005 and interest rates are again on the rise, with Fed funds currently at 3.25%, and by many accounts set to rise again by 25 basis points to 3.5% when the Federal Open Market Committee meets again next week, on August 9.
It was only in the spring that the Treasury also decided to stop selling savings bonds with variable rates, which in the current climate translates into rising rates. Now we have a government willing to sell bonds with a fixed rate of three-decade maturities in an era that arguably will witness rising rates for the foreseeable future. All of which moves us to respond with a soberminded "Hmmm…"
But let's not be cagey. The government's relaunching the 30-year for reasons that have less to do with serving the public interest and more with financial necessity. The Federal government is an institution that's broke? Or so one could assume by noting the pile of debt that constitutes the bottom line for the government's books of late. The Federal budget deficit last year was -$412 billion, according to the Congressional Budget Office. And while CBO advises that the red ink's projected to recede in coming years, deficits are nonetheless expected through 2011.
But negative cash flow needn't cramp a government's style, courtesy of having the usual advantages that come with the job of overseeing the people's business and holding the purse strings along the way. Thus, a government's budgetary stumbles can be "solved," at least in the short term, with the ancient art of printing more money to keep the lights on and the rent paid. One means of printing money is selling bonds, and by favoring longer-term maturities the latest Treasury strategy also serves the useful function of deferring the return of capital further out in time. To which a prospective buyer must spend more time wondering what the rate of inflation will be in coming decades. Care to take a shot at guessing what inflation will be from here on out through, say, February 2036?
None of this will necessarily dampen enthusiasm for 30-year bonds. "There is a lot of demand for long-term assets out there," David Wyss, chief economist at Standard & Poor's tells the Chicago Tribune today. "It provides a safe, long-term guaranteed rate of return. The other point is that they are not as enamored with the stock market as they once were."
Whether there's demand or not for the "safe" long bond doesn't change the swirl of financial and economic events that conspired to bring the 30-year back to life. In the same Tribune story Ed Peters, chief investment officer of PanAgora Asset Management in Boston, observes of the long bond's restoration, and what the act says of the related decision making at the Treasury: "It is mostly a capitulation that deficits are going to be around for a while."
August 3, 2005
SAFE AT ANY PRICE?
In the new world order du jour, oil's comfortably north of $60 a barrel, inflation's running at a modest annualized 2.5%, the 10-year Treasury Note yields roughly 4.3%, and the economy's advancing by an inflation-adjusted 3.4% a year at last count. To jump to the punch line: the much-feared fallout from a bull market in oil is a no-show.
Is this rosy scenario sustainable? Is oil no longer a threat at any price. To the extent the consumer votes with his wallet, there's reason to be optimistic. Indeed, Joe Sixpack wasn't intimidated by oil's price ascent, at least not in June, when personal spending rose 0.8%, one of the stronger increases of late.
But if oil's price keeps rising, is it time to rethink the so-far minimal fallout from escalating energy prices?
Much has been made of oil's lesser role as an input in growing the economy. Compared with 20 years ago, that's certainly the case. But it's unclear at what point oil's price rise offsets its diminished function as a component of GDP expansion and unleashes more astringent effects on the world of paper assets and economic growth.
The U.S. may be blind to such concerns, but elsewhere in the world there's a more acute sense that oil's continued rise is something more than a curious trend. In South Korea, for example, the sight of oil prices rising to new highs once more has raised anxieties about the future. "High oil prices shake up industries," reads a headline from today's Korea Herald. "In an economy plagued by a slow pace of recovery because of cooling exports and continual weak domestic consumption, high oil prices mean more challenges and strife for industries, particularly for the manufacturing sector that demand a lot of energy. Higher raw material costs will cut into profits."
So far, there's scant evidence that a similar set of worries afflicts the U.S. economy, which is currently enjoying a fresh bout of optimism as to its performance prospects. Indeed, on Monday we learned that the ISM Manufacturing index, a measure of industrial activity, jumped in June for its second straight month, confounding the pessimists and suggesting that the American economy is in no danger of slowing any time soon.
But that was then, and this is now. And now is dominated by the fact that oil's upward price momentum is persistent. Few may care, but facts are still facts. At $62-plus a barrel this morning, the question of how high is too high for the economy is a topic with precious little discussion. The stock market, for the moment, could care less about such diversions. The S&P 500 is pushing higher, and looks poised to make another four-year high. Yet the < a href="http://www2.standardandpoors.com/servlet/Satellite?pagename=sp/Page/IndicesIndexPg&r=1&l=EN&b=4&f=1&s=6&ig=48&i=56&fd=&dt=02-AUG-2005&xcd=500&so=3">energy sector weighting in the S&P 500 ranks seventh in a field of ten, and measured by market cap remains a distant shadow to the leader, financials.
Energy, in short, still gets little, if any respect on Wall Street, even though oil prices have been moving higher now for four years running. One can only wonder what mix of events may conspire to alter that perception.
August 2, 2005
SLEEPLESS IN RIYADH
Oil reached a new record high yesterday in New York--$62.30 a barrel—on news that Saudi Arabia's King Fahd died. The news wasn't exactly a surprise (the king had been ailing for 10 years), nor did it set off a power struggle (Crown Prince Abdullah, who has been the kingdom's defacto ruler for a decade following the king's debilitating stroke in 1995, assumed control). But today's stability masks the potential for unrest in the not-too-distant future.
"This is the largest royal family in the world and there will be a struggle as princes compete for positions of power,'' Mai Yamani, who watches the Middle East from her post at the London-based research center Chatham House, tells Bloomberg News.
The Saudi kingdom, home to a quarter of the world's known oil reserves, is a powder keg waiting to explode. When it explodes, and by how much is the question. To be sure, the heavy hand of the royals has kept the would-be revolutionaries from lighting the fuse. How long can they keep it up? Indefinitely? Perhaps. Nothing less has been promoted by the cozy relationship that Fahd engineered in the early part of his 23-year reign, and that more or less continued under Abdullah for the past decade.
But Abdullah, who's in his early 80s, and his named successor, half brother Prince Sultan, who's currently defense minister, is 77. Amid this backdrop, the winds of change, for both good and ill, are blowing. Calls for both more democracy in some quarters, and a return to more conservative tones of Islam in others are swirling about on the Saudi peninsula. Both represent a threat to the established order.
On the conservative front vying for future power is Prince Nayef, the kingdoms' interior minister who has a history of trying to undermine Abdullah's reform efforts in the past. By some account, Nayef is now in the running for the third position of deputy prime minister in the Saudi royal hierarchy, in which case he would become next in line to become king after Sultan.
"The jockeying for the number three slot," the Washington Post reports today, "hinges on one question of particular significance for the United States: whether Prince Nayef , a younger full brother of Sultan and Saudi Arabia's often outspoken and controversial interior minister, will try to get in line for the throne. Believed by Western analysts to be about 72, Nayef has controlled the kingdom's police and internal security forces for three decades, building a powerful political empire now largely managed by his son, Mohammed bin Nayef."
This much, at least, is clear: the stakes are nothing short of huge for the West, and Washington in particular. As such, watching the courtiers jockey for power in the months and years ahead promises to be something more than a parlor game.
"Saudi Arabia is a real thorny problem for Washington and other Western governments," Rosemary Hollis, head of the Middle East Programme at the Royal Institute for International Affairs (Chatham House) in London, tells BBC News. "Since the attacks by al-Qaeda within Saudi Arabia, Western governments have given serious consideration to the trends in the country. They want more reforms, in the school curriculum and in the concentration on the conservative Wahabi form of Islam, for example, but if reform is the answer, how far can you go before it turns into instability?"
More than a few minds are now focused on just that question in the wake of Fahd's demise. Energy Intelligence analyst Jane Collin observes via BusinessWeek: "The question is who will follow them as next in line to become absolute monarch of the world's biggest oil producer. As in Kuwait, where both the ruler and his heir are in their late 70s, there is no established system for handing over to a younger generation." As a result, "the potential for bitter infighting is already triggering concern about future stability in the oil-rich region."
For the moment, there's not much for the markets to do other than to bid up the price of oil as a hedge against the risk of future Saudi political instability. But the current spike to a record may be excessive if the buying is based solely on news about the Saudi royals. "The new Saudi king will most likely carry straight on with the foreign and oil policies he conducted in the last decade as de facto monarch," the risk intelligence firm Debka counsels. "Abdullah starts his reign with major assets, bonanza revenues from high oil prices and the understandings on oil and Middle East policies he established with US president George W. Bush at Crawford, Texas, in the spring of 2005."
For the moment, that's enough to pass for stability in the House of Saud.
August 1, 2005
TEN MINUS TWO EQUALS…???
Wall Street likes to keep an eye on the spread between the 10-year Treasury Note and its two-year counterpart. This particular view of the money curve has been delivering more than a little bit of drama lately, but whether that translates into clarity about the future is another matter entirely.
In normal times, a 10-year Treasury yields more than a two-year for the obvious logic that lending your money, even to a top-rated borrower such as Uncle Sam, for longer stretches requires additional compensation. But these aren't normal times, or so the spread between the two- and 10-year Treasuries imply.
The 10-year Note at the close on Friday offered less than 30 basis points more than a two-year Note. That represents a sharp fall from around two years ago, when the spread was above 250 basis points. Friday's was the lowest yield premium in the 10-year over the two-year Treasury since early 2001, a period when the economy was struggling and declines in quarterly GDP reports were very much a sign of the times. In fact, the spread has made a habit over the years of falling as an economic stumble approached.
But in the wake of the latest update on the economy's pace, released on Friday, the argument that recession lurks just around the corner seems more than a bit far-fetched. Or, might we suggest, the burden of proof lies with the recessionistas.
The economy, in fact, is bubbling along quite nicely, thank you very much. The Bureau of Economic Analysis advised last week that the gross domestic product advanced by 3.4% in the second quarter. Although the economy's pace of growth has clearly been slowing over the past year, it's not slowing fast enough, or in any compelling way to warrant yields that are within kissing distance of one another on the two- and 10-year Treasury fronts.
''We're seeing very strong growth momentum," Nariman Behravesh, chief economist at Global Insight, told the Boston Globe over the weekend. ''This recovery has staying power."
Support for that brand of optimism came anew this morning, with the release of the ISM Manufacturing Index, which reveals another jump in manufacturing activity for July. "An improved rate of growth in new orders and production continues to drive improvement in the sector," the accompanying press release announced. "It appears that the sector hit a low point in May, and has rebounded nicely in June and July."
Yet when it comes to pricing bonds, there's still less than consensus opinion prevailing in the world at large. Someone clearly believes the 10-year is a debt instrument worth owning even though its premium over the two-year is wax-paper thin. If and when the 10-year's yield slips below the two-year, which could be at any moment, the yield curve will be officially inverted. What then? Would recession drop out of the sky like some unannounced bird of prey swooping down on a napping rodent?
Barring some unforeseen event, it's tough to imagine an inverted yield curve in the here and now accompanying economic activity other than what's been standard fare of late. In fact, some dismal scientists feel compelled to forecast a pickup in GDP's pace in this year's second half. "I think there's a good chance [the rate of real quarterly annualized increase in GDP] go could above 4 percent in the third and fourth quarters," William Mulvihill, economist at Claymore Securities in Chicago, predicts by way of Saturday's Chicago Tribune.
And then there's today's Wall Street Journal (subscription required), which carried the front-page story on analysts "who're lifting projections for U.S. economic growth in the second half on expectations that the nation's retailers and manufacturers will be restocking inventories and ramping up production to keep up with demand." The article relates that the slowdown in second-quarter GDP was a byproduct of companies slashing inventories in anticipation a recession—a recession that's yet to rear its ugly head. Rebuilding those inventories, in the face of continuing strong consumer demand and robust industrial production, suggests that that the third- and fourth-quarter GDP reports will reflect more economic humming.
The economic cycle, to be sure, is not dead, but neither is it about to elbow investors in the ribs next Thursday. Squaring that with a yield curve that potentially could invert on the next trade raises more than a few questions, and for the moment a paucity of answers, or at least persuasive ones from the perspective of your editor. There are, to be sure, many theories, and more than a little speculation fueling the atmosphere in the bond-trading pit. Some are good, some less so. Meanwhile, it's a good time to be a trader. But the jury is decidedly still out when it comes to dispensing the same advice to investors in the fixed-income market.