The Capital Wire

SIGNIFICANT CLUES

Rising Treasury yields in spite of last week’s benign CPI and higher jobless claims numbers and this week on a lower ISM number, gave us important clues to a possible shifting construct in the bond market. We’re now witnessing bond selling in spite of soft economic numbers – an important clue. On a purely technical perspective, bond price action has changed markedly over the last few weeks. Bouts of retail buying in the morning are now met with selling throughout the day as opposed to vice versa.

The possible reasons for this shift in perception are plentiful. Was it tough talk from Korea? Or perhaps the recognition that finally, foreign central bank dollar diversification rhetoric is fast becoming dollar-diversification reality? How about the recognition that the Fed is more hawkish than previously thought? Have the bond vigilantes finally woken up – soured by a paltry yield that didn't justify growing market risk? Or am I just making too much out of recent price action, as the recent surge in yields is just another technical bounce?

Whatever the reason, price is king, as it is the final arbitrator. Price validates our views and confirms our suspicions. Unlike the surge in Treasury yields in Jun 02 and Mar 03 – a surge built on the prospect of solid economic growth – a potential surge today would be built on more ominous reasons. While it is too early to tell, could further bond price deterioration in spite of soft economic numbers confirm the start of the unwinding of, say, FCB held U.S paper, and with it the unwinding of the highly-leveraged U.S consumer?

Watch for more divergence Friday, as more bond selling (rising yields) after a soft Friday employment number could be very problematic.

FRONT PAGE NEWS

The nearly flawless Bill Miller of Legg Mason is optimistic about 2005 – namely by not flinching over the sustainability of the “unsustainable” current account deficit.

Counter this with an ambitious (forecasted is always a tremendous task) and more pessimistic paper by Roubini and Setser, where they try to pinpoint the upper-limits to the C/A deficit and the Bretton Woods II system as a whole.

The subject of global imbalances is front page news. As Donald Coxe’s (Global Portfolio Strategist of BMO Financial Group) “Rule of Page Sixteen” states, "You don't make or lose serious money from a story on Page One: you make or lose serious money from a story on Page Sixteen which is on its way to Page One." What lies on page sixteen? How about the severe underfunding of Defined Benefit Pension Plans - definitely a neglected subject but something that could soon possibly be making headlines. For more on this, visit Ryan Labs Asset Management which puts out an excellent monthly asset/liability tally.

On a side note: Google recently decided to allow existing Gmail account holders to distribute an additional 50 accounts (of which I have 20 left). If anyone needs an account (1GB free space), feel free to email me.

TWO COMPETING VIEWS OF THE BOND MARKET

The yield curve continued to flatten yesterday as the 10-yr note broke 4.00% for the first time since October of last year, although gains were forfeited today with the spread between the Fed funds and the 10-yr note now at 1.57%. This yield contraction is indeed odd considering we are well into a Fed tightening cycle and core inflation is creeping higher, albeit slowly.

There are two ways of viewing the current bond market: 1) a market manipulated through government intervention/policies, or 2) a market simply fulfilling its role as a discounting mechanism.

1) FCB/US Treasury Manipulation View:

We all know of the relentless foreign central bank buying of dollars and thus US Treasuries – initiated either because of structural commitments (maintaining a dollar peg) or a dependency on export-led growth. We also know of Treasury’s debt management policies of increasing the stock of short-term treasuries while decreasing the stock of longer-term treasuries – shortening the average maturity of outstanding government debt – while ultimately squeezing the supply of the 10-yr note. These factors have contributed greatly to the underlying strength in the bond market in spite of bearish economic undertones.

FCB intervention will continue to provide lift for the bond market until they change current FX policy or when export-led growth is supplanted by domestic led growth in their countries. Due to recent underlying strength in the bond market, previous speculation of foreign central bank diversification out of dollar assets was probably a bit premature (although we won’t know for sure until BIS and IMF data are released).

Treasury’s policy of shortening the average maturity of outstanding debt, although still prevalent, is less appealing today than it was when the yield curve was steep. After all, the rationale behind the idea was to take advantage of low interest payments at the short-end of the curve when the Fed held rates low.

Nevertheless, these two factors have produced a “dishonest” yield curve, in that the current yields do not convey true market expectations.

2) Market Discounting View:

The market can also be viewed for what it has always been: a forward-looking, discounting mechanism. If we ditch the FCB / US Treasury manipulation analysis, and take up the pure market discounting view, we’re headed for a ditch - at least according to the bond market:

The bond market is discounting something short of deflation (the economic ditch). Today long-term yields are at the same levels as they were before the Fed dropped its deflationary bias. So, if the Fed is confident enough to raise rates 150 bps on the assumption that economic growth is sustainable, what’s freaking out the bond market?

I’ve previously pointed to the growing importance of the short-end compared to the long-end of the curve. Basically, as pointed out above, the Treasury has shortened the maturity of all outstanding government debt (creating a higher supply of short-term debt). Couple this with an old Bill Gross concern (refer to my 1/13 post) where corporations swap long-term debt into short-term floating rate paper to reap the benefits of lower interest payments, and you have a situation where the US economy is all the more dependant on rates staying low at short-end of the curve – especially the Fed funds rate. With exposure being greater on the short-end during this tightening cycle compared to previous cycles, the effects of each 25 bps move by the Fed are being magnified. Aside from the impending profit sqeeze, reduction in economic growth, and increasing pressure on equity prices - all brought about by a higher discount rate - this speaks directed to the myriad of current asset bubbles – the ultimate concern for the bond market. I’m concerned most with bubbles originating from non-consumer debt as mortgage debt payments are still low and not as sensitive to moves in short-term rates. Those more exposed and vulnerable at the short-end include major players in the bubbling private equity market – hedge funds, venture capital funds, LBO firms; a concern held by Mark Anson, investment chief at CalPERS (California Public Employees’ Retirement System), the biggest pension fund and largest investor in venture capital funds in the country.

There it is – two competing views of the current bond market. Pick your poison.

WHIFFS OF PROTECTIONISM?

It’s one thing for US officials to verbally display discontent toward Chinese foreign exchange policy; it’s quite another to actually give them an ultimatum by introducing a bill threatening to slap tariffs on any incoming goods from China if current Chinese FX policy is not reconsidered. According to reports, at least a dozen US Senators have agreed to co-sponsor a bill that would give China a 180-day time window to revalue their currency or face a 27.5% tariff on all incoming Chinese goods.

This bill, if ratified, would elicit a new wave of protectionism – something that has long worried Morgan’s Steve Roach. It would also compromise the delicate relationship where China subsidizes the US consumer through capital inflows (and thus through bond purchases) while US consumers purchase cheap Chinese goods.

The “leverage” factor also comes into play. China has the leverage – through the boatloads of Treasuries it holds – to soothe protectionism fears by dumping/limiting purchases of US bonds (thereby shutting up US policymakers fearful of a Chinese-induced US recession), or to possibly expedite certain geopolitical or militaristic agendas if aggravated. The use of large dollar holdings to push a political agenda or express displeasure over US policy is not without precedent.

AEI’s Desmond Lachman:

Beyond the economic considerations that might motivate central bank dollar sales, one would think that the US Administration would be equally concerned about the potential for politically motivated such sales. As Barry Eichengreen, the noted economic historian, reminds us, it is not so long ago that General Charles De Gaulle used France’s large dollar holdings in the early 1970s to express displeasure about the US handling of the Vietnam War. By unloading France’s dollar holdings, he pulled the plug on the erstwhile Bretton Woods fixed exchange rate system, whose collapse shook global financial markets.

The question that now needs to be addressed is whether the foreign central banks’ massive dollar reserve holdings might not place the US in an untenably vulnerable economic position. Might for instance China not be tempted some day to unload its vast dollar holdings to express its displeasure over US policy concerning the Straits of Taiwan?

THE FUTURE RETURN ON EQUITIES DEBATE

As an extension to the debate over Social Security privatization, the debate over future equity returns is heating up here and here. It is framed around the 6.5% average annual rate of return that equities have yielded over the past 100 years and whether this same yield is attainable for the next 75 years. Proponents of privatization proclaim that nothing has changed to expect anything less than the historical average, while opponents cite such things as current rich valuations as a hindrance to such expectations. This 6.5% assumption over the next 75 years is the soul of the privatization proposal, as anything much less than that number compromises the proposal’s merit. 

I’ll leave it to the pundits to slug it out over the specifics of future dividend yield/growth, GDP growth, P/E multiples and whatever else is baked into the prices of equities. But here are some qualitative points to keep in mind:

- Those that assume that the 6.5% return of yesterday signals a 6.5% return for tomorrow ultimately fail to appreciate the common disclaimer that past performance does not ensure future results. Just ask any ex-trader who’s been bludgeoned by the market for carrying such a nonsensical mindset.

- Stocks have historically been a superior investment relative to other classes such as bonds, but only when priced right in the beginning. It could be that valuations were cheap in 1900 whereas today they are expensive (21x peak earnings), or that dividends were high relative to today’s low yields. A starting dividend yield of 4.2% goes a long way toward explaining the 6.5% total equity return. Today, dividend yields are nowhere near 4.2%.

- Higher prices paid today generally leads to lower expected returns tomorrow.  Because valuations are historically high, expected future returns on stocks are lower than they have been in the past. Meaning that by buying stocks today, the margin that stocks yield over bonds would be much slimmer than what has historically been the case. Now the question becomes how much slimmer, and is the added yield (equity risk premium) enough to compensate investors for added risk – after all stocks are inherently riskier than bonds as they are upon liquidation a subordinated claim on assets.

I’m of course leaving out much more, but it’s a start. For those that need a refresher on this subject, refer to the heavyweights: work by Rob Arnott and Peter Bernstein (monographs available here), Dimson, Marsh, & Staunton, and Ibbotson Associates (all predict lower future equity returns) – and as a counterweight, Jeremy Siegel and Glassman/Hassett, who hold more optimistic views.

ANTICIPATING THE MUCH AWAITED BOND SELL-OFF

Chinese economist Fan Gang’s comments on China’s loss of faith in the U.S dollar was a rhetorical warning shot, probably in retribution to the gory budget numbers and to the Bush administration’s seemingly blasé position on the deficit.

"The U.S. dollar is no longer, in our opinion is no longer, (seen) as a stable currency and is devaluating all the time, and that's putting troubles all the time…So the real issue is how to change the regime from a U.S. dollar pegging to a more manageable reference, say euros, yen, dollars -- those kind of more diversified systems.''

When analyzing these statements one shouldn’t lose sight of the clear distinction between rhetoric and reality. Pulling the plug on America’s subsidy hurts both parties. China’s mercantilist motives of buying dollars (and thus U.S. bonds) to stroke their export base while concurrently assisting the U.S consumer who in turn buy Chinese goods is highly advantageous for Chinese growth. Limiting currency losses is simply not compelling enough to forego these benefits. I firmly believe that China would rather U.S authorities exercise fiscal restraint than to have the U.S suffer punitive damages through Chinese capital flight (or limited capital inflow).

But for those that believe the current U.S subsidy will continue indefinitely and that the bond market is therefore immune to a major sell-off – think again. Despite massive foreign capital inflow into the U.S Treasury market, we’ve had two substantial sell-offs in the past two years – one occurring in June 03 where yields rose 150 bps (the sharpest increase in yields since 1994, prompting a severe widening of credit spreads and a mini scare for those invested in GSE’s – Fannie Mae’s duration gap probs); and the other in March 04 where yields rose over 100 bps. So much for foreign central bank/private investor support given the extent of each sell-off.

Much has changed since the massive sell-off in 2003 including: higher inflationary pressures, a more restrictive monetary authority, a deteriorating budget outlook, a U.S economy even more dependent on foreign central bank intervention, etc. – all leaving the U.S bond market in a much more precarious position and thus more prone to an even larger bond market fall irrespective of FCB intervention.

Laying out the rationale for a major bond market fall is the easy part – timing it is more difficult, if not impossible. But if history is any guide, next Friday’s employment number (coupled with the Fed meeting) could provide the trigger as both sell-offs in 2003/4 commenced with a solid employment number.

--UK

UNFAVORABLE TRENDS

Tom Lasseter and Jonathan S. Landay - Knight Ridder Newspapers (thank you Brad Delong for the link):

“The unfavorable trends of the war are clear:

- U.S. military fatalities from hostile acts have risen from an average of about 17 per month just after President Bush declared an end to major combat operations on May 1, 2003, to an average of 71 per month.

- The average number of U.S. soldiers wounded by hostile acts per month has spiraled from 142 to 708 during the same period. Iraqi civilians have suffered even more deaths and injuries, although reliable statistics aren't available.

- Attacks on the U.S.-led coalition since November 2003, when statistics were first available, have risen from 735 a month to 2,400 in October. Air Force Brig. Gen. Erv Lessel, the multinational forces' deputy operations director, told Knight Ridder on Friday that attacks were currently running at 75 a day, about 2,300 a month, well below a spike in November during the assault on Fallujah, but nearly as high as October's total.

- The average number of mass-casualty bombings has grown from zero in the first four months of the American occupation to an average of 13.3 per month. - Electricity production has been below pre-war levels since October, largely because of sabotage by insurgents, with just 6.7 hours of power daily in Baghdad in early January, according to the State Department.

- Iraq is pumping about 500,000 barrels a day fewer than its pre-war peak of 2.5 million barrels per day as a result of attacks, according to the State Department.

"All the trend lines we can identify are all in the wrong direction," said Michael O'Hanlon of the Brookings Institution, a Washington policy research organization. "We are not winning, and the security trend lines could almost lead you to believe that we are losing."

These unfavorable trends are reminiscent of that earlier war nearly 40 years ago. Certain “efficiency” measures (measures of success) used by military planners during Vietnam such as the “net body count” (N. Vietnamese Army + Vietcong killed, missing or captured in action, less American forces + S. Vietnamese Army killed, MIA/CIA) and the “kill ratio” (N. Vietnamese Army + Vietcong killed, MIA/CIA divided by American forces + S. Vietnamese Army killed, MIA/CIA), deteriorated rapidly after hitting a high point in 1968, while eventually falling negative in 1971, as pointed out in Niall Ferguson’s Colossus. According to Ferguson, over the entire period of the conflict the U.S inflicted higher absolute numbers of casualties on N. Vietnamese and Vietcong than were suffered by American and S. Vietnamese forces – but as the U.S presence was scaled back and the American public’s tolerance to bear further U.S casualties diminished, the odds tipped in favor of the insurgents.

Clearly, U.S presence in Iraq has not been scaled down and remains a focal point within the administration, while public support is waning though not overwhelmingly so. What proves exceedingly worrisome is the fact that while additional resources are being poured in (w/ an additional $80 billion requested), efficiency numbers are deteriorating.

--UK

EBAY: THAT HURT

Elevated equity valuations are not necessarily a call for a defensive posture. Historically high valuations relative to fair value can persist, leaving stocks to trade at a rich premium relative to average historical valuation metrics for an extended period of time.  The substance that allows stocks to defy gravity (resist mean regressive tendencies) is the high risk propensity/tolerance of market participants. If investors are willing to bare risk in spite of high valuations, market pressure to return to historically normal valuation levels will be limited. Of course market perception is quite fickle and can change on a dime.

Despite high valuations, current investor propensity to bare risk is still high as seen through rising equity prices (2005 market action notwithstanding), tight credit spreads, a blistering housing market, etc. The risk propensity/valuation interplay is something that John Hussman regularly point out in his weekly market comment. According to Hussman:

“Though the recent selloff in the major indices is certainly what one might have expected from an overvalued, overbullish, overbought market, it does not follow that stock prices are inherently poised to fall apart. Again, valuation has everything to do with long-term returns, but precious little to do with short-term ones. As long as investors have a robust willingness to accept risk, there can be very little pressure on the market to decline toward more historically normal valuations. So in addition to valuations, we have to consider the quality of market action. The greatest plunges in market history have always emerged from overvalued markets in which investors have recently become skittish toward risk, as evidenced by market action.”

Overall, market internals have not deteriorated enough to warrant complete risk aversion. Although, when mega-stalwarts like EBAY forfeit nearly $20 after missing consensus earnings estimates, you start to worry. Ebay’s drop clearly signals first, that investors are beginning to display at least some semblance of risk aversion, and second, that the market is currently priced for perfection. Ebay’s dramatic decline delivered a clear warning shot. Rarely do markets exert upside pressure when market leaders or high relative strength issues buckle. Be careful out there – the market has coughed up a valuable informational nugget – and it’s not good.

--UK

FOCUS ON THE SHORT END...

While the largely impervious longer-dated 10-yr note has remained essentially unchanged during the past year despite raising inflationary pressures, the shortest end of the curve, the Fed funds rate, has seen its yield increase 125 basis points. Of course this class is controlled by the Federal Reserve, by which we view its yield (Fed funds rate) as an indicator of where the widely watched bond Northstar – the 10-yr note – is headed. Unfortunately, foreign central bank intervention has produced a massive structural skew, leaving the relationship between the Fed funds/10-yr note a highly dubious one. So, if the short-end/long-end relationship is lost due to a FCB-dominated 10-yr note, and FCB’s are essentially buying securities throughout the yield curve, then the Fed funds rate is the last standing “honest” guide along the interest rate spectrum. It’s crucial to go further and add that the short-end of the curve is gaining, and should possibly be given more, importance than the longer dated 10-yr note. I point to two important pieces that give this idea some merit – one by Nouriel Roubini and the other by PIMCO's Bill Gross.

According to Roubini, in a superb piece on liquidity/rollover risk on U.S assets, in recent years the U.S has substantially decreased the average maturity of government debt:

“We also know, from official Treasury data that the average maturity of US government bonds has sharply fallen in the last few years. In the late 1990s, when our budget deficits were turning into surpluses, the average maturity of issuance of Treasuries (i.e. the marginal maturity of newly issued debt) went up from about 50 months in 1994 to almost 90 months in 1999; and the average maturity of the total stock of debt thus increased from about 60 months in 1994 to about 70 months in 2000. But since 2000, things have radically changed: the average maturity of issuance fell from 90 months in 1999 to about 25 months by the end of 2002 to then recover only very modestly to 34.2 by September 2004 (a much lower figure than its value in the 1970s, 1980s and 1990s) while the average maturity of the total debt has fallen from about 70 months in 2000 to only 55.1 in September 2004.

How to explain such a sharp fall in the average maturity of the US government debt? Of course, with the sharp fall in short-term rates relative to long-term rates in 2001-2003, Treasury found it cheaper to finance itself short term rather than long term. But of course, if the expectations hypothesis holds, there is no free lunch here as long rates reflect expectations of future movements in short rates. More seriously, Treasury has tried to limit the short run fiscal costs of the growing budget deficit by reducing the maturity, and thus the interest bill, of government debt. But, as the experience of Mexico in 1994 suggest, this is a dangerous debt management strategy: issuing lots of cheap short-term debt may seem a bargain but if a rollover crisis then does occur serious trouble can ensue.

Also, it is clear that one of the main reasons for the shortening of the US debt maturity is given by the identity and preference of the holders of this debt: since foreign central banks prefer to hold short-dated maturities in part because short term debt can be disposed of more quickly when necessity or preferences so require, the US Treasury has had to oblige and provide the assets, short dated T-bills, most preferred by foreign investors. Note also that (based on Treasury data), by now 51% of all US government debt is held by foreigners and at least 29% of all US foreign debt is held by foreign central banks. These figures are very large and historical highs for the US.”

In an April 2002 Investment Outlook (unfortunetly taken off the archives), fresh off a tiff with General Electric regarding their Aaa debt rating, Gross dwells into the corporate practice of using interest rate swaps to term out long-term debt while paying interest payments at commercial paper rates – something GE’s chief Immelt admitted was a practice used at GE following Gross’ comments on GE debt.

“The fresh idea (although it’s been lying in the grass for years now) was that if lots of corporations were doing the same thing, then the short-term Fed Funds rate is driving the economy. Now that of course is no brilliant observation, it has been thus for eight decades or so with a temporary disconnect in the 1940s for wartime finance. But when a creation of the last 10 years – the interest rate swap – makes it possible for Corporate America to term out their debt and still pay near commercial paper rates, then that’s a revelation – or better yet, a revolution. It means that short-term rates are even more critical to the profitability of Corporate America – to the level of the stock market - to the growth rate of the American economy than ever before. It means that Alan Greenspan dare not raise interest rates too much or risk sinking the stock market and the economy once again; it means that because his ability to raise short rates is limited, that ultimately inflation may be higher than it otherwise would be in a still near deflationary world; it means that bond investors should do certain things and not do others.”

At the time of this piece (April 2002), worldwide swaps outstanding totaled $43 trillion. According to ISDA estimates, at mid-year 2004, interest rate derivatives which include interest rate swaps and options and cross-currency interest rate swaps totaled $164.49, leaving the possibility of many more corporations having swapped long-term debt back into short-term floating rate paper.

Gross goes on to add: “The dampening influence which permits corporate interest expense as a percentage of cash flow to appear so benign in Chart 2 has got to have come from lower short, not long rates, which in turn have resulted from large amounts of commercial paper/bank debt/ or – which is the hidden link - long-term debt “swapped” back into floating. Corporate interest expense truly does appear to be “de minimus” and probably because of swapped liabilities into the front-end of the yield curve.”

Bottom line: the Fed funds rate is the last “honest” rate along the yield curve and should thus be given all the more importance. Secondly, because of this and the various other reason pointed out above, one should question the saliency of today’s 10-yr note and the influence it has on the balance sheet of both the U.S government and Corporate America compared to its shorter-dated counterparts – especially on a liability basis. The Fed has started the deleveraging cycle, with or without the 10-yr note. This could present a big surprise to those that view the low rate on the 10-yr note as a temporary reprieve for a highly-levered U.S economy.

--UK

FED MINUTES

The release of the December 14 Fed minutes gave us some important clues as to what the Fed thinks of the current run-up in house prices: 

“The steep run-up in housing prices, recent increases in equity prices, and anticipated gains in payrolls were viewed as likely to boost the growth of consumption spending next year to a pace somewhat above that recorded this year...

Some participants believed that the prolonged period of policy accommodation had generated a significant degree of liquidity that might be contributing to signs of potentially excessive risk-taking in financial markets evidenced by quite narrow credit spreads, a pickup in initial public offerings, an upturn in mergers and acquisition activity, and anecdotal reports that speculative demands were becoming apparent in the markets for single-family homes and condominiums.”

Forgive me for getting hung up on adjectives, but these are important. Certain committee members have, for the first time, referenced reports suggesting the possibility that “speculative demand” is contributing to home price appreciation – implying that the Fed is cognizant of the massive run-up in home prices due in part to over-accommodative policy. Although the Fed probably views the housing market as short of being an outright bubble, it is aware of the problems such elevated prices present. As a major surrogate to income from wage growth, home prices and income from home price appreciation are far too important to be shocked into remission. The Fed realizes this and would prefer that remission be governed by the Fed than that of the market.

The Fed is starting to take a more proactive approach on the state of the housing market – and not a moment too soon. Better to douse a hot market with cold water while prices are still manageable. Market participants should realize the importance in the Fed’s statement regarding “speculative demand.” The Fed is subtly sowing the seeds for a policy induced slowdown in the housing market.

--UK

ZEROING IN ON VOLATILITY

The CBOE Volatility Index ($VIX), which measures the near-term volatility of $SPX options, fell to a near 10 year low closing at 11.23. Current low volatility figures are indeed puzzling given a tenuous macro and financial backdrop which include: a weak dollar, record current account imbalances, fiscal deficits/record high consumer debt levels, soaring energy prices, a leverage-happy financial community, unfavorable valuations, etc. Of course, the counter-weight that justifies low volatility readings is that the domestic/global economy is awash in liquidity, creating for a cash-rich Corporate America w/ strong balance sheets that in effect provides a cushion against an internal or exogenous shock. While liquidity is abundant and corporate balance sheets have indeed strengthened, I believe that such low volatility numbers do not correctly represent the true acute financial fragility of the global landscape.

Because volatility (premium) has been beaten down in such an orderly fashion for the last 1½ yrs, one has to wonder whether complacency is the only factor that explains these low numbers.

In Sept 2003, the CBOE announced changes to the computation of the $VIX, basing the calculation on all available $SPX options, as opposed to the old method of just eight out-of-the-money $OEX options ($VXO). The new index does not use traditional formulas such as the Black-Scholes model, but rather creates the volatility index directly from the options prices themselves. In comparing the $VIX (new method) and $VXO (old method), the price differential is quite subtle and therefore does not offer much insight toward explaining these decade low numbers.

In addition to these computational changes, volatility futures (ticker: VX) began trading on the CBOE Futures Exchange earlier this year. This is a development I believe is more important toward explaining the steady volatility compression of the past 1½ years. VX contracts have made the strategy of volatility trading much more accessible – where previously, one would have to employ tedious delta-neutral options spreads to buy or sell premium (volatility). The ease of trading futures contracts has provided for a deeper market, with more market participants employing directional bets on volatility – essentially taking the volatility out of volatility as well as providing for a more established trend.

While a high level of complacency is probably the overriding theme toward explaining this steady volatility compression, the effects of new volatility products should be considered in making in assessment on the significance of such low volatility numbers.

--UK

INFLATION AND THE CHINESE PEASANT

Yesterday brought us another benign inflation number. If price relief is not coming from input prices (witness rising commodity prices, oil), or the relative price level (falling dollar), it must come from wages, due in part to the Chinese labor force and the deflationary wage pressure that it entails. But, are we on the verge of a shift?

GaveKal Research:
“In all of our meetings with clients, the most common shared belief is that wage costs in the US, or elsewhere, can not rise because of the fact that ‘200 million Chinese peasants are ready to move to Chinese cities and work for nothing. Or maybe even less’. We are also frequently told that this ‘army of unemployed Chinese workers’ will prevent inflation from rearing its ugly head and consequently justifies the low yields on US Treasuries.

Interestingly, the fact that wage growth in the US is accelerating...and is likely to continue rising in the face of a weak US $ and higher import prices, does not seem to phase our clients who claim that wages costs can only fall. And neither does the fact that wages across China are rising rapidly, or that industrialists are complaining about labor shortages. In recent months, all over the Pearl River Delta, and Yangtze River Delta, a number of factories have had to deal with striking workers, asking for increases in pay from the usual RMB600- 700/month to the slightly less inhumane RMB 1000/month (see China Misconceptions); and the workers have usually won out! And this for a simple reason: most regions suffer from a severe shortage of labor (the Guangdong government, the region behind HK, places its shortage of migrant workers at 2m souls). So the myth of China's ever-deflationary pool of labor, and of the 200 million unemployed peasants (which are only unemployed when the harvest is bad, i.e.: not this year) is melting before our very eyes.”

--UK

WHICH WAY DO WE GO?

The Treasury Department released October data showing a sizable decline in net foreign purchases of U.S assets at $48.1 billion, down from $67.5 billion in September, in effect slamming the dollar. “People were expecting it to be worse than last month, but nobody was expecting it to be below 50,'' said Simon Derrick, head of currency strategy in London at Bank of New York. Surely the mere thought of dwindling foreign demand for U.S assets, let alone actual data, would place pressure on bonds. Not so. The CBOE 10-yr Treasury Yield Index shed 0.56, breaking short-term support and prompting a possible revisit of the 4.00% level.

Reasons for a bond slide mount, yet nothing has materialized. Let’s line them up: Rising inflationary pressures (as measured by the PPI/CPI and discounted by gold bugs), a depreciating dollar, a tightening monetary authority, waning foreign demand for U.S Treasuries, and ominous technical patterns ($TNX, TLT), all favor bond weakness. For traders (at least for those that incorporate the macro equation in their trading methodology), money is not made by correctly mapping out the macro landscape, but rather by correctly timing your macro bets. Timing a potential bond sell-off has proved to be a daunting task. Variant perception has prevailed for most of the year, as those that ran counter to the extreme bearish sentiment earlier this year were rewarded by massive short covering that pushed yields nearly 90 bps lower from their May highs.

Are we close to a major bond reversal (sell-off)? I’m not willing to place a bet either way. Although, for those brave souls out there, tomorrow’s C/A data and the CPI number out Friday could represent an inflection point that should go a long ways toward providing conviction and handsome future returns for one side of the trade.

--UK

FED DOLLAR POLICY

Morgan Stanley’s Global Economics Team carries an excellent debate on the dollar. I’d like to single out a comment by Morgan’s Joachim Fels on the dollar in relation to Fed policy:

"...I have the sneaking suspicion that the Fed's policy of talking the dollar down is part of their game plan to create higher inflation in the US. Core inflation (as measured by the personal consumption deflator) at 1.5% simply doesn't give you enough of a safety margin against deflation if and when the next recession hits. And, in highly indebted economies such as the US, a little more inflation helps to grease the wheels. That's why I think that stagflation will be the name of the game in America in the next few years."

Fels’ comments relate directly to Chairman Greenspan’s June 2003 analogy of creating a “wider firebreak” when speaking of containing deflationary forces. Specifically, because we know so little about deflation in terms of how it functions, its consequences, and how to properly address it, we need a wider inflation buffer than would normally be the case to shield us from an unexpected drop in aggregate demand. A core inflation rate of 1.5% is, in the Fed’s mind, not high enough – especially for a highly leveraged economy that is naturally more sensitive to economic mishaps. A depreciating dollar lends the Fed a helping hand by widening the inflation buffer.

Bottom line: don’t expect the Fed to place a rhetorical floor under the dollar anytime soon, and secondly, expect the Fed to keeping raising rates further than the bond market is currently pricing in.

--UK

BUBBLE LOGIC

Kevin Drum points to a UCLA Anderson School release calling the U.S housing market a bubble while forecasting a slide in the housing market next year.

The housing market has been a resilient beast, much to the discontent of shorts and pessimists alike. Many have argued that homebuyers have entered a state of full-on dementia, where cheap money has lent to a forfeit of logic and risk awareness. Be that as it may, the market continues to move. Here in Palo Alto, CA, a market that has definitely seen its share of price movement, prices are downright intimidating. To me, a dilapidated 2 bedroom Eichler (no garage) at the corner of a busy intersection doesn’t exactly fit the mold of typical million dollar living. Going through our weekly paper, The Palo Alto Weekly, the lowest priced home I could find would run you a mere $750,000 - not exactly cheap for a city of 65,000+ residents.

For those of you that have read a fair share of doomsday housing bubble speak like I have, here’s a forthcoming Fed study by Jonathan McCarthy and Richard W. Peach critiquing the validity of two widely used measures to support the notion of a housing bubble – the rising price-to-income ratio and the declining rent-to-price ratio (the first of which BCA Research reports hit an all-time high). Definitely worth a read.

--UK

NO NEED TO WORRY?

John Tamny of TCS tells us not to worry about our trade deficit:

"...If I own a car company and sell a car to a German, the sale is booked as an export.  On the other hand, if I sell shares in that same car company to another German, or for that matter an investor in Canada or Japan, the sale is booked as foreign investment, and will not factor into the trade deficit/surplus calculation that has so many so worried.

Given that foreign investment is not counted in the import/export equation, is it any surprise that the Unites States runs a trade deficit?  Realistically, it would be extremely scary if we did not.  Once again, all trade must balance, and the ability of the United States to consume so much of what the world produces has to do with the world showing enormous investment interest in U.S. based assets.

Because of this, and because of the mostly impressive economic growth of the United States since its founding, the U.S. has almost continuously had a trade deficit.  Thank goodness it has, in that the flipside of excessive U.S. consumption of foreign goods is heavy foreign investment in U.S. assets.  This is nothing to be ashamed of, or worried about for that matter."

The import/export mismatch that makes up our trade/current account deficit must be financed by exporting financial assets (importing foreign savings) to make up the difference. As the C/A deficit expands, more assets must be exported in place of tangible goods. Everything must balance.  As a financed-based economy, the U.S has issued paper at a healthy rate, while foreign investors have snapped it up. Tamny asserts that this demand for U.S assets is a byproduct of the attractiveness of U.S assets. "...and the ability of the United States to consume so much of what the world produces has to do with the world showing enormous investment interest in U.S. based assets." This statement is clearly misleading, if not totally partisan.

Through this simplistic assertion, Tamny shields himself from delving into the specifics of the capital inflow – namely, the composition of foreign buyers of U.S assets and the motivations that spur this investment interest. According to the chart above provided by the EPI, private foreign inflows have fallen in the last three years, while foreign central banks purchases of U.S Treasuries have increased markedly. It doesn’t end with Treasuries. Foreign central banks have also increased  purchases in MBS/asset-backed securities, corporate bonds, etc., to increase yield. Central bank purchases could be even higher than existing figures state as purchases may have been made through various intermediaries, as Brad Setser astutely points out. The noticeable absence of private inflows hardly typifies an environment where investors clamor for U.S assets based on investment merit. Foreign central bank purchases were made with the intention of stroking their export base through currency intervention and not on the basis of investment merit. FCB’s have already incurred capital losses and run the risk of added currency and bond-price risk.

Purchases of U.S assets by foreign central banks on the basis of political necessity, and not by private hands on the basis of investment merit should worry us.

--UK

THE POSITIVES OF THE POOR EMPLOYMENT NUMBER

Friday’s weak employment number gave us more of the same – a weak number following a positive blip in the prior month. Weak employment data is contributing to the fragility of this current recovery, while continuing to support stocks - as it should in the intermediate-term. During this nearly 2-year recovery, corporate America has opted to exploit operating leverage and squeeze every drop from the productive capacity of its workers, instead of increasing existing headcount. This in turn has provided for meaty margins and corporate profits at a multi-decade high as a share of GDP. This reluctance to hire fresh workers has placed a solid bid under the Treasury market as expectations of aggressive Fed rate increases have been largely muted. On Friday, the 10-yr note fell 13 basis points recouping most of the losses suffered during the prior 6 consecutive sections (roughly 20 basis points). These lower bond yields have resulted in a lower cost of capital, higher valuations, and tempered debt service for corporations with high debt issuance – all positive for equities.

American consumers have offset the paltry gains in income growth with income generated from assets (extracting home equity, capital gains from stocks), tax cuts, and debt – all of which have kept end demand strong. But sooner or later, as home prices peak, stock returns contract, and tax stimulus runs out, consumers will have to look to income from employment rather than income from assets to buoy their existing appetite for “stuff”. If current trends in employment continue, consumption-hungry consumers will be out of luck. Eventually, lower end demand resulting from persistently weak employment gains will squeeze corporate profits and outweigh the benefits of lower rates, thus putting pressure on equities.

Any sign of this impended outcome? With major stock averages recently hitting 52-wk highs and personal spending increasing 0.7%, the obvious answer is, not yet. Look to the upcoming increasingly important holiday sales numbers for any signs of wear.

--UK

THE STARBUCKS BAROMETER

Yesterday, Starbucks reported sales of $486 million for the four weeks ended Nov. 28 – a 13% figure for sales at Starbucks outlets open more than a year that is roughly double what Starbucks said can be expected in future months. Sales were dubbed as “extraordinary” by Chairman Howard Schultz.

Starbucks is not only a purveyor of fine coffee, but also a cultural force. And with that selection of premium blends, coupled with that premium Starbucks label, comes a premium price. A tall latte costs $2.51, whereas as Frappuccino is $4.75 - not exactly cheap, especially if it’s part of your daily regimen.

My point isn’t about the expensiveness of a cup of coffee, but about the resiliency of the American consumer. Some would argue that Starbucks’ strong sales have more to do with preference, preference again, or maybe addiction, and less to do with one’s willingness to spend. Maybe. I view it more as an example of the continued willingness of the American consumer to spend, and spend more on premium goods, which keeps our economy going thereby providing sustenance for our trading partners. The U.S-centric world that we’ve witnessed since the 90’s, where the U.S consumer represented the single-source of global growth, remains intact. American consumerism chugs along, irrespective of record high public/private debt, a record low 0.4% after-tax savings rate, and a meager 1.4% gain in real after-tax personal income (the first two being supported by cheap money/lower interest rates and tempered debt service).

The incessant demand for Starbucks coffee (in spite of a 4% hike in prices) is yet another example of frugality taking a backseat to the hegemonic, voracious appetite of the American consumer, where those bland, watered-down cups of Folgers no longer suffice. When speaking of the resiliency of the American consumer, I’m reminded of Steven Roach’s own account of being chastised by then Fed Chairman Arthur Burns for doubting the resiliency of the U.S consumer:

“He argued that I didn’t appreciate the unflinching cyclical resilience of the US consumer -- a resilience that, ironically, was about to give way to America’s first consumer-led recession.  A lot has changed in the ensuing 30 years.  But for very different reasons, I now believe that another exception is in the offing.  The American consumer is an accident waiting to happen.  The sooner the world comes to grips with this problem, the better the chances of a successful rebalancing.”

--UK

Every now and then, China’s gradual transformation from a state-based to market-based economy hits a bump – as was the case when the government reshuffled the bosses of three big state-owned, publicly traded, telecom companies which include: China Telecom, China Mobile and China Unicom.

China’s growing prominence as a global economic heavyweight has, to a degree, masked the reality that its economy still functions under the umbrella of state control.

--UK

WHAT EXACTLY ARE THEY DISCOUNTING?

The U.S Treasury market continues to puzzle many. In spite of a feverish equity market, data and rhetoric indicating that foreign central bank purchases are diminishing, recent firm inflation numbers (CPI and PPI), and a strong employment number (although unsubstantiated), the bond market (most notably the long-bond) continues to catch a bid.

Brad Delong:
"I don't, however, understand the bond market. Do they expect the wage share to stay this low forever, and corporate profits are retained earnings to be abundant? Do they expect the capital inflow to continue forever? Do they expect the Bush administration to get serious about balancing the budget? None of these seem plausible as expectations, as modal scenarios, as central cases. But then why isn't the long bond market already pricing the supply-and-demand for loanable funds imbalance that seems inevitable in medium-run equilibrium? It's a mystery.

Perhaps it's as simple as this: in the 23 years since 1981, Ten-Year Treasury positions have yielded capital gains in 17 out of the 23 years averaging more than six percent per year. Those who are by nature likely to be short the long bond have presumably lost heavily over the past quarter century, and are no longer a significant part of the market. We may have selected for a group of long-bond traders and speculators who are powerfully overoptimistic, because optimism has been powerfully rewarded over the past quarter century. "

My own inadequately informed view sees the bond market discounting the possibility of deflation. Sound unreasonable? It was as recent as the fall of 2002 that the Fed cited deflation as a quantifiable possibility. In response, the liquidity spigot opened in the form of cheaper money that lent to epic credit extension to reflate the deflatables. With the underlying hope that this reflation campaign would encourage real price inflation, it instead inadvertently fostered bubbly asset price appreciation by persuading market participants to exhibit an unrelenting preference to take on risk and to leverage their bets accordingly. Just look at the S&P 500 which trades at 21x earnings, real estate/GSE portfolio growth, and the commodity binge to get an idea of the bubbly proportions.

Historically expensive asset markets coupled with heavy public/private debt feed into deflationary pathologies in the event of an exogenous shock (hedge fund default, currency run, higher oil prices, geopolitical crisis, etc.) – or in the simple event that a major market player decides to unwind a large position. A crescendo effect takes hold. This is something I believe many portfolio analytics teams are factoring in as a growing influence on their risk assessment.

Of course I could be proven wrong as the bond market starts to price in inflation, future growth, dollar depreciation, etc. by pushing prices lower and yields higher. But doesn’t this lend to the deflationary theme as well? After all, a high interest burden is murder to an overly-levered economy. After a while, a certain inevitability starts to set in.

--UK