The Oser View

Housing & GDP

This morning the Census Bureau reported that new home sales fell 16.6% in January to 937,000 units on a seasonally adjusted, annualized basis, the biggest month-over-month drop since 1994.  Simultaneously, the Commerce Department announced that growth in Gross Domestic Product during last year's fourth quarter was revised downward from a strong 3.5% to a sub-par 2.2%.  Neither of  these numbers can be considered good news, but they do put the current economic picture into better perspective.  And they help to explain why yesterday's unpleasantness in the stock market was a hiccup, not a crash.

Housing, as we all know, is in a slump, but the seemingly huge drop in new home sales this January was more a statistical quirk than a portent. The actual number of new homes sold--not seasonally adjusted and not annualized--in any given month is relatively small, particularly in the winter.  Just 70,000 new houses were sold in January compared to 89,000 in January 2006.  The big change was in the number of sales in the western states: 12,000 this year compared to 26,000 last year.  Parts of California experienced unusually cold weather in January, which may have impeded house hunters, and many of the most speculative real estate markets in the last couple of years were in California, Nevada, Arizona and Utah.  A more important barometer is existing home sales, which moved up to 6.46 million units (annualized) in January, having made a fairly clear bottom at about 6.3 million units (annualized) during the second half of 2006.

The decline in GDP from the inflated initial estimate makes it clear that the economy did slow late last year, but did not stall.  After a torrid first quarter, annualized GDP growth was 2.6%, 2.0% and 2.2% in the last three quarters of 2006.  In fact, we may actually be experiencing the elusive "soft landing" in which an over-heated economy slows down without tumbling into recession.

Federal Reserve Chairman Ben Bernanke told Congress this morning, "There's a reasonable possibility that we'll see some strengthening of the economy sometime during the middle of the year."  He also noted that the financial markets "seem to be working well."  This is a clear signal that the Fed will not, and need not, rush in to bail investors out.  One never knows until long afterwards how well Fed policy worked, but we are beginning to believe that the Bernanke Fed knows what it's doing.  More importantly, the markets are beginning to think so too.   

Sources: www.census.gov & Bloomberg News

No Worries

Imagine a world where war is endemic.  Many antagonistic nations have the power to destroy life and property on a massive scale with a single weapon.  Ancient tribal, ethnic and religious hatreds breed seemingly endless cycles of attack and retaliation.  One superpower can and does invade and destabilize any other country it deems its enemy.  A few hundred million people live in luxury while billions live in poverty.

Now imagine, if you can, what the economic system of such a world must be like.  How each nation must fear and distrust every other.  How each must erect tariffs and other trade barriers to protect its own industries.  How currencies are manipulated for temporary advantages that can never be sustained.  And how nations practice every form of cheating, counterfeiting, and unscrupulous practice in a never-ending game of beggar thy neighbor.   

If the political and social landscape described above is recognizably our own, the international economic scene is utterly different.   Despite unprecedented geo-political uncertainty, premiums for credit risk are historically low.  The flow of goods and capital among nations is historically high. Capital appears to exist and travel in a peaceable, idyllic world where there are no losers, only winners. 

Here in the United States, high-yield (i.e. “junk”) bonds were by far the best performing sector in 2006, returning 11.64%, which was more than twice as much as the next best sector.  And the worse the credit-rating, the better the performance.  Last month, the index of CCC-rated bonds returned 2.49% while Treasuries lost 0.82%.  Not surprisingly, yield spreads have contracted sharply.

One reason for this is the emergence of credit default swaps as a major derivative vehicle.  These contracts are, in effect, insurance policies that protect investors against bond defaults.  The cost of insurance is supposed to be correlated to risk, but the cost of credit default swaps is at all-time lows both in Europe and the United States.  At Friday’s close a $10 million US credit default swap contract cost just $120,000, a drop of 30% since September.  Over the same period, the costs of credit protection in Western Europe has fallen even further, from €290,000 per €10 million to just €188,000.  One big reason is that credit default swaps are being securitized into collateralized debt obligations (CDOs).  CDOs are divided into classes with different risk characteristics and sold to a wide variety of investors.  Essentially, credit risk in the developed world is being granularized, expanding its market and driving down its price.      

But credit default swaps and CDOs are only two links in a long chain.  Risk appetite is the balance between what we fear to lose and what we need to earn with the funds we have.  The fear of loss is certainly, and with reason, declining.  According to Standard & Poor’s, the default rate for US corporate bonds is near an all-time low of 0.44%.  The perceived safety of corporate bonds is helping to compress spreads, which in turn makes it more difficult for bond investors to achieve sufficient earnings.  The extremely low level of corporate defaults is a consequence of skyrocketing corporate profits, which are up over 65% since 2003.  Higher profits also play role in keeping Treasury bond yields low because along with growing profits comes increased tax revenue.  As a result, Treasury debt issuance is actually falling, despite the added costs of the Iraq war.   Thus the basic law of supply and demand comes into play.  There is less supply of Treasury debt in a period of growing demand for investment vehicles.  The whole system is working in an unintended partnership to keep spreads tight and yields low.

We can now follow the chain to its global implications.  In the previous paragraph, I wrote of “the funds we have.” That “we” is not just US investors, but investors from all over the world who have huge amounts of funds to invest.  The story is well-known.  Japan, China, the OPEC nations, and to a lesser extent other developing nations have huge productivity engines but limited internal consumption.  They sell their surplus to the US and finance those purchases by buying US financial assets in the “goods for bonds” trade.  As of November 2006, foreign investors hold $2.2 trillion of US Treasury debt or more than 50% of the outstanding total.  They own 60% of the Treasuries issued in the last 12 months as well as 29% of all US corporate bonds.  Including financial assets and the trade deficit, the US owes China alone $1 trillion. 

So far, the profitability of the “goods for bonds” trade has trumped two other macro factors.  The first is the battle between capital and labor, which has swung decisively towards capital.  The full benefit of US corporate profitability and the productivity explosion in the developing world have left most ordinary workers behind.  As the chart opposite shows, corporate profits as a share of US national income stands at 12.4%, a 50-year high, while labor’s share has dropped to 56.3%, the lowest since 1965.  US workers can’t produce goods anywhere near as cheaply as foreign producers (or US companies that outsource production overseas).  That’s why domestic manufacturing employment has fallen to just 10% of non-farm employment and the US has become a service economy.  This would be a recipe for disaster, were it not for cheap credit, facilitated in good part by foreign demand for US financial assets. 

The second macro factor brings us back to our starting point.  Global liquidity is stronger than terrorism, war and social inequality.  Money isn’t a Maoist or a Moslem, an Israeli or an Iranian.  It doesn’t need a passport or a security check.  It flows unimpeded and in greater amounts across every border every day.  Ultimately, why this should be is a mystery.  There is no real answer to the question of why sometimes—like now—greed overcomes fear while at other times, fear overcomes greed. 

What is pretty certain though, is that, to paraphrase JP Morgan, the risk equation will fluctuate. Right now, the supply/demand equation of global liquidity is working in our favor; it will turn against us when decreased demand collides with increased need for supply.  The end of the current phase will most likely come from the confluence of two emerging trends.  The first is reduced foreign appetite for our debt, as productive capacity and consumer demand become more balanced in the developing world.  The second is the growing debt load necessary to finance entitlement programs like Social Security and Medicare.   

From our present vantage point in history, the turn is a question of "when" not "if."  It's an outcome that is still years in the future, but when it arrives, the best we can expect is a sharp rise in interest rates.  The worst case would a forced and drastic reordering of our economy and lifestyles.  But there is no vantage point on the future not shrouded in fog and shadow.  So for now, why worry?

Top photo: William Hogarth. Gin Lane (detail), 1822
Chart: From the Bureau of Economic Analysis, Morgan Stanley Research   

CPI--More Smoke than Fire

The Bureau of Labor Statistics announced this morning that the Consumer Price Index for All Urban Consumers (CPI-U) rose 0.2% in January and 0.3% excluding food and energy.  Year-over-year increases are 2.1% and 2.7%, respectively.  The increases were slightly higher than expected and have halted, at least temporarily, the rally in bond prices that began in late January.  But a close look at the numbers gives us more reason for comfort than worry about inflation prospects. 

Item: Energy costs fell 1.5% in January including a 3.1% decline in petroleum-based energy.  Fuel oil costs dropped 5.6% and natural gas prices were 3% lower than in December.  Gasoline prices also fell 3% and are 2.7% lower than in January 2006. 

Item: Owners' equivalent rent, the proxy for housing costs and the largest single component of the CPI, rose 0.2%, following increases of 0.3% in December and 0.4% in November.  This means that the pace of increase in rents is slowing as more vacant condos, bought as speculative investments in hot markets, are being rented rather than sold for quick profits. 

Item: The biggest increase in January was in tobacco and smoking products, where prices jumped 3.1%.  Cigarettes are a special case whose prices are driven far more by taxes than by market forces. 

Today's data won't make the Fed change course, but it shouldn't add fuel to inflation fears either.

Source: www.bls.gov/cpi/

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Adapted from Charlene Li's blogger code of ethics.

No Exit

On December 27, 2005, the difference in yield between the ten-year and the two-year US Treasury Note slipped into negative territory.  From that day to this, the spread has averaged -0.2% and has not been greater than 0% since August 11. On July 17, 2006, the yield spread between the 10-year Treasury note and the three-month Treasury bill also turned negative.  Since then it has averaged -0.3%.  These below-zero spreads are like below-zero temperatures.  They make for cold, hard days in the banking world, where most of the profit is still made the old-fashioned way: borrowing money short-term from depositors and lending it long-term to borrowers.   

In this month’s commentary, we will have a look at how we got to such an unpleasant pass and whether there is any way out.  Our story begins early in 2000 when the air was just starting to leak from the dotcom bubble.  The Fed, preoccupied as usual with inflation, missed the initial hissing noise.  Even as the NASDAQ index dropped from its peak of 5,048 on March 1, the Fed kept raising the fed funds rate: to 6.00% on March 21 and 6.50% on May 16.  The Treasury yield curve—that is, an imaginary line connecting the yields of Treasury securities of increasing maturity—began the year with a nice upward slope and a spread of 1.2% between ten-year and three-month maturities.  But faced with the Fed’s inability to hear, or failure to comprehend, the stock market’s message, the curve quickly turned negative. 

The Treasury curve was saying, “By keeping short-term interest rates high, the Fed is going to drive the economy into recession.  It’s safe to own long-term bonds because soon the Fed will be forced to change course.”  And that’s just what happened.  An investor who bought the ten-year Treasury note at its then-current yield of 5.50% in December 2000 was making a very smart decision, even though fed funds were at 6.50%.  Soon enough, the economy faltered and the Fed began to cut short term interest rates.  By the end of 2001, the fed funds rate was down to 1.75%.  Our ten-year T-Note investor had a very tidy profit that would only grow larger in the years ahead.  The Fed held the funds rate at 1.75% for most of 2002, before easing to 1.25% near year-end.  Finally, on June 25, 2003, the Fed dropped the cost of overnight loans between banks to 1.00% where it remained for a year.
 
Several Fed officials have admitted recently that keeping the fed funds target so low for so long was a mistake, but the Treasury market did not wait to draw its own conclusion, which was that the Fed had lost its collective mind.  Treasuries began selling off the day after the last Fed ease.  Between June 25 and Labor Day 2003, the ten-year Treasury note yield rose from 3.4% to 4.6%.  Because bond yields and prices move in opposite directions, the change represented a 10% decline in value.  The Treasury yield curve had now become historically steep.  As a natural consequence, the carry trade flourished as never before.  Borrowing at 1.00% and investing in instruments without credit risk at 4.00% or even 5.00% was too profitable an opportunity to pass up.  Extending maturities to five or even 10 years seemed well worth the risk.  It had taken a long time for the fed funds rate to fall, and a quick rise seemed ever more unlikely the longer the Fed stood pat.         

While the effect of the super-low fed funds rate on the Treasury market might have been predicted, the impact on housing was something new under the sun.  Low short-term interest rates were the spark for a revolution in so-called “sub-prime” home-ownership.   I use the word “revolution” very deliberately and in distinction to the simultaneous housing boom.  The boom represented the confluence of low long-term, fixed rate mortgage rates and increasingly affluent Baby-Boomers widening the market for upscale housing, whether as primary residences, vacation homes or investment property.  The revolution required teaser ARM rates of 1.00% to 2.00% and similar innovations made possible by cheap short-term borrowing costs.  According to a report by the Center for Responsible Lending, sub-prime mortgage loan originations grew 20-fold from $35 billion in 1994 to $665 billion in 2005 and 2006.  Adjustable-rate mortgages predominate in this market.

Meanwhile, starting in June 2004, the Fed began raising the fed funds rate at “a pace that was likely to be measured.”  In fact, it was measured in 17 consecutive 25-basis point increases stretching over two years.  The last increase, on June 29, 2006, brought the fed funds rate to its present level of 5.25%, but Treasuries maintained a contrarian stance.  The difference between the fed funds target at Labor Day 2003 and today is 4.25%.  The difference between the ten-year T-Note yields on those two dates is a mere 0.2%. Virtually all of the increase in interest rates has been at the short end of the curve, progressively diminishing with lengthening maturities.  The carry trade is dead, and with it, a significant source of bank profitability.  By the third quarter of 2006, net interest margins across the banking industry were at their lowest since 1989, not coincidentally a period when the yield curve was also inverted.   

We saw how in 2000, the falling stock market preceded an inverted Treasury yield curve, which in turn preceded, and some would say, predicted, a weakening economy and a period of Fed easing.  The prime candidate for derailing the expansion this time has been the housing slowdown.  Many economists have predicted that weakness in housing will spill over into the broader economy lowering employment in affiliated industries, curbing inflation fears and ultimately convincing the Fed to reduce short-term interest rates.  But the evidence is growing that the real pain will be limited to those sub-prime borrowers, particularly those unable to refinance into conventional fixed-rate mortgages.*   In the wider housing market, sales of both new and existing homes have stabilized in the last few months.  Housing starts surprisingly increased in November and the Housing Affordability Index has been trending up since August.  Construction employment, which had dipped sharply in October and November, leveled off in December.  In contrast, the most recent mortgage delinquency statistics show a sharp increase in problem sub-prime loans.  More than 12.5% of sub-prime mortgages were 60 or more days delinquent in the third quarter, up from a low of 10.3% in the second quarter of 2005.  The delinquency rate for sub-prime adjustable rate mortgages was even worse at 13.2%. 
 
If serious problems in housing do not spread beyond the sub-prime sector, then the economy as a whole won’t slow down.  The Fed, whose focus remains steadfastly on the threat of inflation, may not ease at all in 2007, which means the yield curve may stay inverted.  The prospect of a static, directionless bond market hovering indefinitely at today’s levels is a considerably less than delightful prospect for banks.  In order to maintain spreads, banks have been forced to keep the lid on consumer deposit rates, a strategy not without risk.  As The Wall Street Journal recently reported, total bank deposits have dipped to their lowest level since the FDIC was created in 1933.  To support loan demand, banks of all sizes have turned to the wholesale money markets, once the preserve of only the largest institutions.  Since wholesale money is much more expensive than retail money, this trend has only contributed to the net interest margin squeeze. 

No exit to this dilemma is apparent, but if history tells us anything, it’s that markets always change and usually in some unexpected manner.  Here’s hoping the change comes soon.

*And, of course, the usual last-in speculators who always end up holding the bag.

Retail Sales

"Never bet against the American consumer" may be a cliché, but it's still good advice.  Retail sales for December 2006 rose a stronger-than-expected 0.9% to $369.9 billion.  Sales rose across the board, except for building materials where the ongoing slump in home sales is reflected in fewer of the improvement projects that often follow the purchase of a new home.  Sales of electronic equipments--HD TVs, iPods and X-Boxes--were up a very strong 3%, following a 5.8% surge in November.  Clothing sales rebounded from a weak November and furniture sales were also robust.

Overall, retail sales are making a big comeback after showing significant weakness from August through October when gas prices spiked.  Fed funds futures now reflect the market's expectation of no change in Federal Reserve policy until at least the third quarter.