Why Market Moves Have Been Misguided

Thursday, July 19th, 2012

by GCGodfrey, The Investment Insight

As U.S. stocks and the European equity index ended last week in positive territory, against a backdrop of disappointing data, market moves seems misplaced. Instead, Central Bank action is cosmetic not medicinal, a tool for reassurance not economic change. Developments from the recent EU Summit are either temporary or limited and capital remains restricted. However, economic deterioration heats up the pressure for action. Therefore, Central Banks are damned if they act and damned if they don’t. For sentiment to turn, we need to see signs of stability, as well as support.

Watch this being hotly debated on CNBC, with an entertaining edge…

Central Bank Action is Cosmetic Not Medicinal

Central bank action is being met with scepticism, and initial market rallies used as selling opportunities for profit taking. This is because moves are cosmetic and not medicinal, as in the short term they may reassure markets that measures are being taken, but they are of limited effectiveness at significantly boosting growth. Even Draghi himself, the President of the European Central Bank, argued “price signals (have) relatively limited immediate effect”. They won’t stimulate demand and, by potentially hurting bank profitability, could reduce the incentive to lend – the opposite of the target outcome.

Nevertheless, for the first time, we have seen the ECB cut the benchmark interest rate below 1%. In the same week, the Bank of England announced it will be increasing asset purchases by £50m. With weak US data and Bernanke already cautious, the pressure will be on to turn ‘Operation Twist’ into a more traditional waltz. Investors will be hoping the Fed will pump more liquidity into the system instead of ‘twisting’ or neutralising purchases by selling elsewhere along the yield curve.

Summit Moves Are Limited

The outcome of extensive talks at the EU Summit likewise fuelled a ‘false rally’. Spanish government bonds have since returned to hover around the unsustainable 7% level again despite developments. Instead, the 3 key ‘achievements’ are temporary or limited, as explained below…

1.     Senior not guaranteed: Investors have been moved higher up the pecking order and will now be repaid for loans made to Spanish banks before the bailout fund. Being the ‘first’ in line to get money back is indeed an improvement but crucially the risk of loss is still there and may continue to worry the markets.

2.     Wishful thinking? The government has been removed from the equation with bailout funds now able to offer loans to struggling Spanish banks directly. Removing government involvement in bank bailouts to protects sovereign bond yields ignores the possibility investors will continue to view the health of the banks as a driver of economic health.

3.     Bond buying boost limited: Bailout funds may now buy debt directly from “solvent countries” (read: Italy). However, this is a limited source of demand and again short-sighted.

Capital Remains Restricted

The size of the problem remains a key concern and a crucial measure missing from the Summit was a substantial strengthening of the ‘firewalls’. At €500bn, the rescue fund is only 20% of the €2.4tn combined debt burden of Spain and Italy. The risk that a lack of funding will leave European leaders unable to stop the crisis spreading remains.

Economic Deterioration Heats up the Pressure for Action

With a backdrop of a deteriorating economic environment, Europe is far from able to ‘grow out of the problem’. German manufacturing deteriorated for 4^th consecutive month. Relied upon as a rare source of growth, the outlook is dimming. European unemployment has reached its highest level since the creation euro. This is unlikely to spur spending and instead put the pressure back on Central Banks to do something to kick-start economic growth.

Therefore, Central Banks are damned if they act and damned if they don’t. For sentiment to turn, we need to see signs of stability, as well as support.

Note some of this article has been published by the Financial Times

Copyright © The Investment Insight

Tags: Asset Purchases, Bank Of England, Bank Profitability, Benchmark Interest Rate, Central Banks, Cnbc, ECB, Economic Change, Economic Deterioration, Edge Central, Equity Index, European Equity, Governmen, Initial Market, Investment Insight, Market Moves, Price Signals, Scepticism, Target Outcome, Yield Curve
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The Economy and Bond Market Radar (July 16, 2012)

Saturday, July 14th, 2012

The Economy and Bond Market Radar (July 16, 2012)

Treasury yields headed lower again this week but not dramatically so. The minutes from the June Federal Open Market Committee meeting were released this week and indicate that Fed members remain divided on an additional round of quantitative easing (QE). In the past few years bonds have tended to rally into the QE announcement and sell off when announced as expectations are for the easing to boost the economy and financial assets. There was little in the way of real market moving economic data released this week in the U.S. but China released second quarter GDP results showing a deceleration to 7.6 percent on a year-over-year basis. This was the slowest growth since the financial crisis but is far from the “hard landing” that many were expecting. Treasury yields moved higher on Friday and the stock market rallied, in what was likely a “relief” rally for stocks.

Strengths

• We did get some inflation data this week with import prices and the producer price index; both continue to show a benign inflation environment.
• Brazil and South Korea cut interest rates this week, following the coordinated actions last week from the ECB, Bank of England and the Bank of China.
• Consumer credit hit a five-month high in May as the consumer appears to be more comfortable and banks are lending.

Weaknesses

• Chinese imports slowed dramatically in June to 6.3 percent, well below estimates. This raises concerns about the depth of the slowdown in China.
• Japanese core machinery orders plummeted 14.8 percent in May, dramatically below estimates.
• Quarterly earnings reports will pick up sharply next week but we had many companies warn this week that the economy is weakening. This was particularly true in technology and industrials.

Opportunity

• The Fed reaffirmed its commitment to an ultra low interest rate policy through 2014 and additional monetary easing is possible in the near future.

Threat

• Europe remains a wildcard with the markets shifting focus on a weekly basis.

Tags: Bank Of China, Bank Of England, Bond Market, Chinese Imports, Deceleration, Ecb Bank, Economic Data, Federal Open Market Committee, Financial Assets, Import Prices, Inflation Data, Interest Rate Policy, Japanese Core, Machinery Orders, Market Radar, Open Market Committee, Producer Price Index, Quarter Gdp, Quarterly Earnings Reports, Treasury Yields
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Global Lack of Growth versus Central Banks

Tuesday, July 10th, 2012

It’s been just over a week since the euphoria over Euro fix 19.0 came to light, but as we awake Spanish yields are back over 7% and Italian yields are over 6% – the same levels they were at before “the breakthrough” a week ago Thursday night.  Since zombies have become so popular in our culture, one can parallel the European mess to these creatures of the night – it just cannot be killed.  That said, the market recognizes each time push comes to shove, Germany relents – the main trick is figuring out which periods the market is calmed by this, and which periods the market forgets that.  Of course each “solution” thus far has been little more than papering over the structural issues, but at some point the end game comes.

Meanwhile, the drama in Europe has distracted some from the fact global growth is slowing dramatically.  China joined the central bank cutting party last Thursday, riding shotgun with the Bank of England and the ECB – signaling to some to expect some poor economic data out of the country this week.  Overnight Chinese inflation was released at a paltry 2.2% (the lowest in about 2.5 years) – of course you can believe what you wish about the real number, [Sep 13, 2010: BW - What's China's Real Inflation Rate? (What's China's Real Anything?)] [Nov 12, 2010: Even China Accuses China of Fibbing About Inflation] but the weakness in commodities through much of 2012 signals China has slowed significantly.  ”Reported” inflation was 5.5% as recently as November 2011.  Premier Wen Jiabao was reported as saying downward pressure on the economy is still “relatively large.”  Chinese stocks continue to suffer.

Meanwhile the U.S. economic data continues to stagnate as the ECRI predictions of recessions in latter 2011 look much more probable.  Of course the difference between a statistical recession and what it feels like to the common man can be two worlds.   U.S. markets were hit Friday by a weak labor report but a late day “The Fed is coming!” story out of the WSJ helped lift indexes well off their lows.  For those of bullish conviction this was an excuse to work off a short term overbought condition, and the S&P 500 dipped exactly to its gap up open post Euro summit announcement Friday, which also happened to be very near a 38.2% retracement of the move off the June 26th lows – funny how that works.

Long story short if you were not “in” the market Thursday night ahead of a binary outcome Friday (or no announcement at all out of Europe) there were no gains to be had by the end of day Friday.  The extent of the advance that remained was only that gap up Friday morning.   Go forward pulling back not much more than the 50% retracement (134.20 on SPY) or worse case the 61.8% retracement (133.40 on SPY) of this move off June 26th would be the base cases for bulls.  The latter would fill the entire European summit gap.

After a very heavy few weeks of news, and European headlines the news flow should slow down.  China releases GDP later this week along with other news, and the FOMC speculation should be quiet until next week when Bernanke speaks to Congress.   FOMC minutes are released Wednesday so that could move markets.  Most of the U.S. economic data this week is not market moving.  That said, we now transition to earnings season.  Despite all the hubbub across the globe the past few years, U.S. corporate profits have been able to rebound smartly off their dramatic lows of 2008/early 2009.  But that story is now potentially getting long in the tooth, so the tailwind this provided in 2010 and 2011 might be coming to an end.  More on this in a later post.

Tags: Bank Of England, Central Banks, Chinese Stocks, Common Man, Creatures Of The Night, Downward Pressure, ECB, End Game, Euphoria, Global Growth, Inflation Rate, Last Thursday, Poor Economic Data, Premier Wen Jiabao, Recession, Recessions, Riding Shotgun, Two Worlds, Wen Jiabao, Zombies
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What if the Fed Throws a QE3 and Nobody Comes? (Hussman)

Monday, July 9th, 2012

The financial markets were largely unresponsive to news of further easing by the European Central Bank, the Bank of England, and the People’s Bank of China last week. Notably, Spanish bonds plunged, while German short-term government bonds now yield -0.17%, indicating growing concern about sovereign default risk in the Euro area. Every few days will undoubtedly bring word of new “agreements” and “mechanisms” – arcane enough to mask their futility – that promise to solve the European crisis. The headwinds remain very strong. The key distinction here remains liquidity versus solvency. There is little doubt that liquidity will be provided at every opportunity, though the continual degrading of collateral standards by the ECB suggests that all the good collateral has been pledged already. More importantly, with a global recession visibly unfolding, solvency risk will only increase.

The odds remain against European countries agreeing to the surrender their national sovereignty to the extent needed to create a “fiscal union” and enable massive and endless transfers of public resources from stronger to weaker European countries. Barring a catastrophe severe enough to either prompt European countries to hand fiscal control to a central administrator, or to prompt Germany to agree to unconditional bailouts, the least disruptive move would be for Germany and a handful of stronger countries to leave the Euro first, and allow the remaining members to inflate as they wish.

With regard to the economy, I noted two weeks ago that the leading evidence pointed to a further weakening in employment, with an abrupt dropoff in industrial production and new orders. Mike Shedlock reviews the litany of awful figures we’ve seen since then, focusing on the new orders component of global purchasing managers indices: U.S. manufacturing new orders and export orders plunging from expansion to contraction, Eurozone new export orders plunging (only orders from Greece fell at a faster rate than those of Germany), and an accelerating decline in new orders in both China and Japan.

Recall that the NBER often looks for “a well-defined peak or trough in real sales or industrial production” to help determine the specific peak or trough date of an expansion or recession. From that standpoint, the sharp and abrupt decline we’re seeing in new orders is a short-leading precursor of output. As the chart below of global output suggests, I continue to believe that we have reached the point that delineates an expansion from a new recession.

On the employment front, Friday’s disappointing report of 80,000 jobs created in June may be looked on longingly within a few months, as we continue to expect the employment figures to turn negative shortly. That said, it remains important to focus on the joint action of numerous data points, rather than choosing a single figure as an acid test. I noted last week in Enter, the Blindside Recession, GDP and employment figures are subject to substantial revision. Lakshman Achuthan at ECRI has observed the first real-time negative GDP print is often seen two quarters after a recession starts. Earlier data is often subsequently revised negative. As for the June employment figures, the internals provided by the household survey were more dismal than the headline number. The net source of job growth was the 16-19 year-old cohort (even after seasonal adjustment that corrects for normal summer hiring). Employment among workers over 20 years of age actually fell, with a 136,000 plunge in the 25-54 year-old cohort offset by gains in the number of workers over the age of 55. Among those counted as employed, 277,000 workers shifted to the classification “Part-time for economic reasons: slack work or business conditions.”

What if the Fed throws a QE3 and nobody comes?

To date, the stock market has largely shrugged off the evidence of oncoming recession, in the confidence that the Federal Reserve will easily prevent that outcome and defend the market from any material losses. On that point, it is helpful to remember that the real economic effects of Fed actions in recent years have been limited to short-lived bursts of pent-up demand over a quarter or two. Not surprisingly, as interest rates are already low, and risk-premiums on more aggressive assets are already remarkably thin, the impact of quantitative easing around the globe continues to show evidence of diminishing returns.

With the help of some preliminary work from Nautilus Capital, the following charts present the market gains, in percent, that followed versions of quantitative easing by the Federal Reserve, the European Central Bank, and the Bank of England on their respective stock markets (measured by the S&P 500, the Dow Jones EuroStoxx Index, and the FTSE Composite, respectively). In order to give QE the greatest benefit of the doubt and account for any “announcement effects,” the advances in each chart are based on the 3-month, 6-month, 1-year and 2-year gains in each index following the initiation of the intervention, plus any amount of gain enjoyed by the market from its lowest point in the 2 months preceding the actual intervention. The effects of most interventions would look weaker without that boost.

Remember that quantitative easing “works” through central bank hoarding of long-duration government bonds, paid for by flooding the financial markets with currency and reserves that essentially bear no interest. As a result, investors in aggregate have more zero-interest cash, and feel forced to reach for yield and speculative gains in more aggressive assets. Of course, in equilibrium, somebody has to hold the cash until it is actually retired (in aggregate, “sideline” cash can’t and doesn’t “go” anywhere). Increasing the quantity simply forces yield discomfort on more and more individuals. The process of bidding up speculative assets ends when holders of zero-interest cash are indifferent between continuing to hold that cash versus holding some other security. In short, the objective of QE is to force risky assets to be priced so richly that they closely compete with zero-interest cash.

Understanding this dynamic, it follows that QE will have its greatest impact on financial markets when interest rates and risk-premiums have spiked higher. If interest rates are low already, and risky assets are already priced to achieve weak long-term returns (we estimate that the S&P 500 is likely to achieve total returns of less than 4.8% over the coming decade), there is not nearly as much room for QE to produce a speculative run. Leave aside the question of why this is considered an appropriate policy objective in the first place, given the extraordinarily weak sensitivity of GDP growth to market fluctuations. The key point is this – QE is effective in supporting stock prices and driving risk-premiums down, but only once they are already elevated. As a result, when we look around the globe, we find that the impact of QE is rarely much greater than the market decline that preceded it.

To illustrate, each of the Fed, ECB and BOE quantitative easing interventions since 2008 are presented below as a timeline. The shaded area shows the amount of market gain that would be required to recover the peak-to-trough drawdown experienced by the corresponding stock index (S&P for Fed interventions, EuroStoxx for ECB interventions, FTSE for BOE interventions) in the 6-month period preceding the quantitative easing operation. The lines plot the 3-month, 6-month, 1-year and 2-year market gain following each intervention, adding any gain from the low of the preceding 2 months, to account for any “announcement effects.” Technically, the lines should not be connected, since they represent the gains following distinct actions of different central banks, but connecting the points shows the clear trend toward less and less effective interventions, with the most recent interventions being flops. Notice also that central banks have typically initiated QE interventions only when the market had somewhere in the area of 18% or more of ground to make up.

Of all the experiments with QE, the round of QE2 from late-2010 to mid-2011 was most effective, in that stocks recovered their prior 6-month peak, and even some additional ground. Yet even with QE2, the Twist and its recent extension, as well as liquidity operations such as dollar swaps and so forth, the S&P 500 is again below its April 2011 peak, and was within 5% of its April 2010 peak just a month ago (April 2010 is a particularly important reference for us, since that is that last point that the ensemble methods we presently use would have had a significantly constructive market exposure). The largely sideways churn since April 2010 reflects repeated interventions to pull a fundamentally fragile economy from the brink of recession, and recessionary pressures are stronger today than they were in either 2010 or 2011. Investors seem to be putting an enormous amount of faith in a policy that does little but help stocks recover the losses of the prior 6 month period, with scant evidence of any durable effects on the real economy.

In short, the effect of quantitative easing has diminished substantially since 2009, when risk-premiums were elevated and amenable to being pressed significantly lower. At present, risk-premiums are thin, and the S&P 500 has retreated very little from its April 2012 peak. My impression is that QE3 would (will) be unable to pluck the U.S. out of an unfolding global recession, and that even the ability to provoke a speculative advance in risky assets will be dependent on those assets first declining substantially in value.

Our economic problems run far deeper than what can be healed by more reckless bubble-blowing by the Federal Reserve. At the center of global economic turmoil is a mountain of bad debt that was extended on easy terms by weakly regulated lenders with a government safety net. Global leaders have done all they can to protect the lenders at the expense of the public – to make good on the bond contracts of mismanaged financial institutions by breaking the social contracts with their own citizens. The limit of this unprincipled madness is being reached.

The way out is to restructure bad debt instead of rescuing it. Particularly in Europe, this will require numerous financial institutions to go into receivership, where stock will be wiped out, unsecured bonds will experience losses, senior bondholders will get a haircut on the value of their obligations, and loan balances will be written down. Bank depositors, meanwhile, will not lose a dime, except in countries where the sovereign is also at risk of default. Even there, depositors will probably not lose any more than they would if they held sovereign debt directly. In the U.S., the pressing need continues to be mortgage restructuring, and an emerging recession is likely to bring that issue back to the forefront, as roughly one-third of U.S. mortgages exceed the value of the home itself.

Liquidity does not produce solvency. Bailouts from one insolvent entity to another insolvent entity do not produce solvency. Efforts to stimulate growth will not produce solvency if a large fraction of the economy is overburdened with debt obligations that cannot be repaid. What will produce solvency is debt restructuring. The best hope is that global leaders will recognize the necessity and move ahead with debt restructuring in an orderly way, particularly in the European banking system. The worst nightmare is that global leaders will deny the necessity and belatedly discover that they have squandered the last opportunity to avoid a disorderly finale.

Market Climate

A quick note on performance – as we’ve noted since the inception of Strategic Growth Fund in 2000, our investment horizon is specifically focused on the complete bull-bear market cycle, measured from bull-market peak to bull-market peak, or bear-market trough to bear-market trough. My view that stocks have entered a new bear market makes it reasonable to examine the most recent cycle, measured from the bull market peak of October 9, 2007 (on the basis of total-return) to the recent peak on April 2, 2012.

During the 2000-2007 peak-to-peak cycle, Strategic Growth outperformed the S&P 500 by a cumulative margin of 119.79% vs. 20.70% (11.46% vs. 2.62% on an annual basis). During the 2002-2009 trough-to-trough cycle, Strategic Growth outperformed the S&P 500 by a cumulative margin of 37.95% to -1.25% (5.10% vs. -0.19% on an annual basis). As I observed in numerous annual reports, that full-cycle performance margin was “as intended” – neither extraordinary nor disappointing from the standpoint of our long-term expectations.

In contrast, the most recent peak-to-peak cycle from 2007 to 2012 was challenging. For most investors, everything went wrong in the downturn and then everything went right in the recovery. For us, everything went reasonably as expected during the downturn, but my insistence on making our methods robust even to Depression-era data led to a significant “miss” of the market’s recovery in 2009 and early 2010 that will not be repeated in future cycles even under identical conditions and evidence. Largely as a result of that miss, Strategic Growth lagged the S&P 500 during the most recent cycle, by a cumulative margin of -12.91% vs. 0.08% (-3.01% vs. 0.02% on an annual basis). The Funds page includes full historical performance data on all of the Funds, as well as annual reports and other information.

In every cycle, Strategic Growth has experienced just a fraction of the downside experienced by the S&P 500 (-6.98 vs. -47.41% for the S&P 500 in the 2000-2007 cycle; -21.45% vs. -55.25% for the S&P 500 in the 2002-2009 cycle). I recognize that nobody can feed a family with reduced downside. It does, however, make it far easier to recover from difficult periods. The most recent market cycle was an outlier on nearly every basis that investors can imagine. It was – and I am confident it will remain – an outlier from the standpoint of our own full-cycle performance as well.

As a side note, from the presumptive bull market peak on April 2, 2012 through Friday of last week, the S&P 500 is down -3.95%, while Strategic Growth is down -0.78%. Needless to say, if the recent bull market establishes a new high, some of the above calculations will change. The essential point remains that our “two data sets” challenge in 2009 through early 2010 more than accounts for the cumulative performance shortfall of less than 13% between Strategic Growth and the S&P 500 in this cycle, and the methods we brought to bear on that problem leave us well prepared for a very wide range of market outcomes in the cycles ahead. We’ll go forward from here.

As of last week, our estimates of prospective market return/risk in stocks remained in the most negative 0.5% of historical observations. We’ve examined a range of possible outcomes that could produce a shift in our investment stance. While a further advance would moderately take the “edge” off of our present defensive stance, we also estimate that a fairly small advance would also re-establish an overvalued, overbought, overbullish condition that would weigh on any material risk-taking. So the greatest amount of latitude to accept market risk would be from substantially lower levels. Of course, that’s the most likely point at which another round of QE would be initiated as well. As usual, our willingness to expand our exposure to market risk will remain focused on observable measures, not on some untestable faith-factor. For now, we remain tightly defensive. Strategic Growth remains fully hedged, with a staggered strike hedge (just over 1.5% of assets being committed to raising our put option strikes), Strategic International remains fully hedged, Strategic Dividend Value is hedged close to 50% of its stock holdings (its most defensive stance), and Strategic Total Return has a duration of about one year, just over 10% of assets in precious metals shares, and a few percent of assets in utilities and foreign currencies.

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Tags: Bank Of China, Bank Of England, Central Administrator, Default Risk, ECB, European Countries, Export Orders, Fiscal Control, Global Recession, Government Bonds, Growing Concern, Headwinds, Hussman, Litany, Mike Shedlock, National Sovereignty, Public Resources, Purchasing Managers, Qe3, Solvency
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No Country for Old Bulls

Sunday, July 8th, 2012

  
With global PMI rolling over again, dimming unemployment growth, and slowing EM Asia impacting global production, it is no wonder than BofAML’s economics team sees a dearth of ‘feelgood’ factors in the market. In fact, as they note, further rate cuts in the euro area and China along with around $500bn of NEW QE in this quarter are priced into the market with any hope for risk assets to rally more consistently, investors will need to see not just willing-and-able central bankers but an abatement of the sovereign crisis in Europe and improvement in global data – neither of which they expect anytime soon. Easier monetary policy can only cushion the blow from higher uncertainty in the US and Europe. Effective policy breakthroughs would thus have to come from compromises in the European Council or in US cross-party politics. Investors have yet to zero in on the real impacts of rising economic uncertainty in the US. As Ethan Harris and Michael Hanson have argued, it is unlikely that the cliff is fully priced into the markets and US political dysfunction will share the spotlight with the European crisis over the next few months. And as last time, the joint act will likely undercut investor confidence.

and the prize for best research title also goes to BAML…

BofAML: No Country For Old Bulls

Review: policy to the rescue

Global central banks continued to ease monetary policy in response to a deteriorating global backdrop. Both the ECB and China’s PBoC cut interest rates this week, while the Bank of England kicked off another round of its quantitative easing program. As we expected, the ECB lowered interest rates by 25bp and brought deposit rates down to zero. In the UK, the BoE announced it aims to add £50bn to its balance sheet over the next four months. Meanwhile in Asia, the Chinese central bank surprisingly cut interest rates less than one month after it last lowered borrowing costs.

Most importantly, policymakers’ continued focus on downside risks backs expectations of further policy support. The ECB sounded more concerned about area-wide demand conditions and, although ECB President Mario Draghi discouraged hopes of further non-standard measures such as new LTROs, we think the Governing Council will lower interest rates once again before the end of the quarter. Likewise in China, we look for follow-ups to this week’s rate cut. Reserve requirement ratios will probably be lowered within the next few days, and we expect the PBoC to cut interest rates twice more before the end of the year. This week’s policy action was accompanied by mostly downbeat economic data.

Global confidence stumbled again, with the global PMI dropping to 49.6 in June from 50.1 in the previous month (Chart 1). In the US, nonfarm payrolls expanded by a below-consensus 80k in June, while the unemployment rate remained at 8.2%. This brings the 2Q average to 75k, well below the 226k per month seen during the first quarter. The unemployment outflow rate – a statistic tracked by Federal Reserve staff – remained close to historically low levels (Chart 2).

Hot topic: a dearth of ‘feelgood’ factors

Besides further interest rate cuts in the euro area and China, we also expect the Federal Reserve to underwrite $500bn worth of QE this quarter. If we are right, systemic central banks will have largely fulfilled recent market expectations of significant policy rescue. But for risk assets to rally more consistently, investors need to see more than willing-and-able central banks, in our view. On top of expanding liquidity, a meaningful market rally needs: (i) an abating sovereign crisis in Europe; and (ii) improvement in the global data. Are these conditions likely to materialize?

We think the crisis in the euro area will remain an open sore. The outcome of last week’s summit indeed revealed steps in the right direction. But it was no game changer. As German officials have been keen to highlight, the principle of no mutualization of national liabilities without sovereignty transfers looks intact. Moreover, the painstaking debate on what both shared banking supervision and ESM direct help to banks entail is only beginning. As Laurence Boone explains, the effectiveness of a banking union lies in the details.

The Eurogroup will meet next week, when we hope to learn more about the conditions underpinning the Spanish banking bailout. By the end of the month the Troika should unveil the magnitude of funding gaps in Greece. With policymakers still balking at prospects of another debt relief round (that is, official sector involvement), pressure on the new Greek government is likely to mount. We have seen this before: if the Troika pushes for significant adjustment over a short period of time the weakest link of Greek political stability will likely break. The well-known Greek dilemmas should resurface soon.

Better EM data to be cold comfort

As recessions in euro area countries deepen and doubts about both the crisis fighting strategy and the future institutional contours of the monetary union linger, we see no meaningful respite from the sovereign crisis. But could market perceptions brighten up once global activity data start to improve? In other words, could rebounding EM economies lighten up the mood in the marketplace and help investors tolerate foot-dragging in Europe?

Our real-time global activity gauge does suggest business conditions became less negative in June. Although activity appears to have softened further in the US, conditions seem to have improved in GEMs. This pushed the global aggregate higher. That said, the GLOBALcycle still indicates that global GDP growth likely dropped to 2.1% qoq (saar) in 2Q from 3.1% in the previous quarter. Looking ahead, wobbling global business confidence argues against a meaningful follow-up from June’s improvement. But mounting policy support in countries such as China and Brazil plus substantial recent drops in EM industrial production (Chart 3) point to a 3Q rebound in local activity. Its global reach, however, will likely be limited. As the US economy weakens ahead of the oncoming fiscal cliff and the euro area remains in recession, we expect global GDP growth to remain close to the 3% level. That is down from the average 4% seen between 2010 and 2011.

The looming fiscal fog

All in all, therefore, market respite opportunities are likely to be few and far between. On the plus side, global monetary conditions should continue to ease. Next week, whereas we now expect the BoJ to stay put, we look for the Brazilian central bank to cut interest rates by 50bp. Likewise, India’s RBI will probably reduce rates by the end of the month. However, as we illustrated last week, easier monetary policy can only cushion the blow from higher uncertainty in the US and Europe. Effective policy breakthroughs would thus have to come from compromises in the European Council or in US cross-party politics.

Investors have yet to zero in on the real impacts of rising economic uncertainty in the US. As Ethan Harris and Michael Hanson have argued, it is unlikely that the cliff is fully priced into the markets. The issue may only start to visibly influence the consensus once lumpy economic decisions – such as business investment and durable goods consumption – start being postponed in the run-up to the cliff. In all likelihood – and much like last summer – US political dysfunction will share the spotlight with the European crisis over the next few months. And as last time, the joint act will likely undercut investor confidence.

Tags: Abatement, Bank Of England, Central Banks, Chinese Central Bank, Dearth, Downside Risks, ECB, Economic Uncertainty, Economics Team, Ethan Harris, Feelgood Factors, Global Backdrop, Global Data, Global Production, Investor Confidence, Michael Hanson, Monetary Policy, Party Politics, Policy Breakthroughs, Qe
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The Economy and Bond Market Radar (July 9, 2012)

Sunday, July 8th, 2012

The Economy and Bond Market Radar (July 9, 2012)

Treasury yields headed lower this week on disappointing economic reports and global central bank easing. Two key economic data points bookended the week, with a very weak reading from the ISM Manufacturing Index on Monday, followed by a subpar employment report on Friday. On Thursday we had what appeared to be coordinated global central bank policy easing with the ECB and the Bank of China cutting interest rates by 25 basis points, along with the Bank of England adding ?50 billion to their quantitative easing program. As can be seen in the chart below, the yield on the 10-year treasury fell to the lowest level in more than a month.

Strengths

• Economic data is weak globally, forcing central banks to act which is sparking a bond rally and pushing down yields.
• Domestic auto sales remain a bright spot for the economy with GM, Ford and Chrysler all posting strong sales growth in June.
• Factory orders for May rose 0.7 percent, beating expectations.

Weaknesses

• June nonfarm payrolls were weaker than expected, rising by a meager 80,000, little changed over the past few months.

• The ISM Manufacturing Index fell to the lowest level since July 2009 and indicated contracting manufacturing in June.

• European bond yields remain elevated even after central bank intervention and the EU summit the week before.

Opportunity

• The Federal Reserve reaffirmed its commitment to an ultra-low interest rate policy through 2014 and additional monetary easing is possible in the near future.

Threat

• Europe remains a wildcard with the markets shifting focus on a weekly basis.
• China has obviously become more concerned about the economy and has eased twice in the past month.

Tags: 10 Year Treasury, Bank Of China, Bank Of England, Basis Points, Bond Market, Bond Yields, Central Bank Intervention, Central Banks, Domestic Auto, Economic Data, Economic Reports, Employment Report, Gm Ford, Interest Rate Policy, Ism Manufacturing Index, Market Radar, Nonfarm Payrolls, Shifting Focus, Strong Sales, Treasury Yields
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China Joins Global Easing Party By Cutting The Lending And Deposit Rates By 25 bps

Thursday, June 7th, 2012

Update: 9:00 am has come and gone… and no global bailout unlike November 30, 2011. Not a good sign for those expect a central-bank D-Day.

While minutes ago the Bank of England followed in the ECB’s footsteps, it was the China central bank that stole England’s thunder, announcing an unexpected rate cut moments before 7 am, and thus finally joining the global easing party: this was the first Chinese interest rate cut since 2008. As a reminder, hours before the global central bank intervention on November 30, China announced its first (50 bps) reserve requirement cut since 2008. Is today’s PBOC move, which is the first cut of deposit and 1 year lending rates also since 2008, a harbinger of something much bigger to come any second now?

From the PBOC:

The People’s Bank of China decided to cut financial institutions RMB benchmark deposit and lending interest rates since June 8, 2012. One-year benchmark deposit rate cut of 0.25 percentage points, year benchmark lending interest rate cut by 0.25 percentage points; other deposit and lending interest rates and individual housing provident fund deposit and lending rates be adjusted accordingly.

 

Since the same day: (1) the upper limit of the floating range of interest rates on deposits of financial institutions was adjusted to 1.1 times the benchmark interest rate; (2) loans from financial institutions interest rate floating range of the lower limit was adjusted to 0.8 times the benchmark interest rate.

And from Bloomberg:

China Cuts Interest Rates for First Time Since 2008

China cut interest rates for the first time since 2008, stepping up efforts to combat a deepening economic slowdown as Europe’s worsening debt crisis threatens global growth.

The benchmark one-year lending rate will drop to 6.31 percent from 6.56 percent effective tomorrow, the People’s Bank of China said on its website today. The one-year deposit rate will fall to 3.25 percent from 3.5 percent. Banks can also offer a 20 percent discount to the benchmark lending rate, the PBOC said, widening from a previous 10 percent.

European stocks and U.S. index futures extended gains as China’s move fanned optimism that policy makers around the world will do more to bolster growth. The announcement, two days before China is due to report inflation, investment and output figures, may signal that the economy is weaker than the government expected.

“This will be the beginning of a rate cut cycle and there will be at least one more reduction this year,” said Shen Jianguang, a Hong Kong-based economist with Mizuho Securities Asia Ltd. “The data to be released over the weekend must be very weak and inflation must have eased sharply.”

The MSCI All-Country World Index added 0.8 percent at 7:30 a.m. in New York. The Stoxx Europe 600 Index jumped 1.2 percent, extending yesterday’s biggest rally in six months, while the Standard & Poor’s 500 Index futures advanced 0.7 percent.

Slower Growth

The central bank last reduced benchmark interest rates in late 2008, when the government unveiled a 4 trillion yuan ($586 billion at the time) stimulus package to counter the effects of the global financial crisis. Interest rates have been unchanged since an increase in July 2011.

Industrial output in China, the world’s biggest producer of steel and cement, probably rose 9.8 percent last month from a year earlier, close to the slowest pace in three years, according to the median estimate in a Bloomberg News survey of 27 economists ahead of a National Bureau of Statistics report due June 9.

Inflation may have moderated to 3.2 percent in May from a year earlier after a 3.4 percent rate in April, a separate survey showed, the fourth month consumer prices have risen by less than the government’s 2012 target of 4 percent.

Today’s move signals policy makers are concerned that the cost of borrowing is crimping companies’ spending and holding back expansion in the world’s second-biggest economy. Three bank officials told Bloomberg News last month that the nation’s biggest banks may fall short of loan targets for the first time in at least seven years as demand for credit wanes.
Slowdown Worsening

The PBOC cut banks’ reserve requirements in November for the first time in three years, and again in February and May, to spur lending.

China’s manufacturing expanded at the slowest pace in six months in May, a government report showed on June 1, adding to signs the nation’s slowdown is worsening. A separate purchasing managers’ index from HSBC Holdings Plc and Markit Economics pointed to a seventh straight contraction, the longest stretch since the global financial crisis.

Premier Wen Jiabao and the State Council, or Cabinet, pledged last month to place greater emphasis on stabilizing growth after data showed April industrial production, new loans and exports all increased less than economists forecast. The data prompted banks including Goldman Sachs Group Inc., Morgan Stanley and Bank of America Corp. to cut their economic-growth estimates.

Slowdown Worsening

The PBOC cut banks’ reserve requirements in November for the first time in three years, and again in February and May, to spur lending.

China’s manufacturing expanded at the slowest pace in six months in May, a government report showed on June 1, adding to signs the nation’s slowdown is worsening. A separate purchasing managers’ index from HSBC Holdings Plc and Markit Economics pointed to a seventh straight contraction, the longest stretch since the global financial crisis.

Premier Wen Jiabao and the State Council, or Cabinet, pledged last month to place greater emphasis on stabilizing growth after data showed April industrial production, new loans and exports all increased less than economists forecast. The data prompted banks including Goldman Sachs Group Inc., Morgan Stanley and Bank of America Corp. to cut their economic-growth estimates.

Tags: Bailout, Bank Of China, Bank Of England, Benchmark Interest Rate, Bps, Central Bank Intervention, China, China Cuts, D Day, Debt Crisis, ECB, Economic Slowdown, Financial Institutions, Footsteps, Global Growth, Gold, Harbinger, interest rates, Pboc, Percentage Points, Provident Fund, Reminder
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The Economy and Bond Market (May 21, 2012)

Saturday, May 19th, 2012

The Economy and Bond Market (May 21, 2012)

Treasuries rallied this week, sending long-term yields sharply lower. With headlines touting bank runs in Greece and Spain, the risk-off trade was in full swing this week as both gold and the U.S. dollar rallied along with Treasuries. Ten-year Treasury yields hit the lowest level in 60 years this week and German 10-year bonds hit new record lows as part of the risk-off/fear trade.

Strengths

• The consumer price index for April was unchanged and the trend in inflation data is lower.
• Housing starts rose 2.6 percent in April as the housing market remains a bright spot.
• Central banks remain supportive as the Fed minutes released from the April Federal Open Market Committee (FOMC) meeting hinted at more monetary easing if the economy slows. The Bank of England echoed similar thoughts and the market sees higher chances of additional quantitative easing.

Weaknesses

• The Conference Board Leading Economic Index fell 0.1 percent in April.
• Chinese power production rose a modest 0.7 percent, the smallest gain since May 2009.
• Eurozone industrial production fell 0.3 percent in April; expectations were for a gain of 0.4 percent.

Opportunity

• Bonds continue to grind higher and appear to be forecasting benign inflation and slow growth.
• The Federal Reserve appears willing to increase monetary accommodation if necessary, which would be a boost to the bond market.

Threat

• China’s economy is slowing faster than expected and government policy makers appear comfortable with this dynamic.
• Europe remains a wildcard with austerity programs under pressure, creating significant uncertainty.

Tags: 10 Year Treasury, Austerity Programs, Bank Of England, Bond Market, Central Banks, Chinese Power, Consumer Price Index, Economic Index, Eurozone, Federal Open Market Committee, Full Swing, Government Policy Makers, Housing Market, Housing Starts, Inflation Data, Open Market Committee, Record Lows, Term Yields, Treasuries, Treasury Yields
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Gold Standard for All, From Nuts to Paul Krugman (Guest Post)

Friday, May 4th, 2012

Via Amity Shlaes’ Bloomberg News Column,

Nut cases. That’s what they are. And if you take an interest in them, you are a nut case, too.

That’s the consensus among credentialed economists who describe advocates of a return to the monetary regime known as the gold standard. In fact, the economic pack will marginalize you as a weirdo faster than you can say “Jacques Rueff,” if you even raise the topic of monetary policy in relation to gold.

An example of such marginalizing appears in a recent issue of the Atlantic magazine. Author Adam Ozimek lists four rules upon which economists overwhelmingly agree. Right away, that puts readers on guard; they don’t want to be the only one to disagree with eminences.

The first rule Ozimek offers is that free trade benefits economies. So obvious. That makes the penalty for disagreement higher. Then you read down to the final principle: “The gold standard is a terrible idea.” By putting the proposition in such strong terms, the author raises the penalty for disagreeing. If you don’t subscribe to this view, you risk both being classed as the kind of genuine nut case who believes in protectionism, and enduring the disdain of other economists — “all economists,” as the Atlantic headline writer summarized it.

But “all economists” is not the same as “all economies.” The record of gold’s performance in all economies over the past century is not all “terrible.” Especially not in relation to areas that concern us today: growth, inflation or the frequency of bank crises. The problem here may lie not with the gold bugs but with those who work so hard to isolate them.

Gold’s Real Record

Conveniently enough, the gold record happens to have been assembled recently by a highly credentialed team at the Bank of England. In a December 2011 bank report, the authors Oliver Bush, Katie Farrant and Michelle Wright review three eras: the period of a traditional gold standard (1870-1913); the period of a gold-standard variant, the Bretton Woods gold-exchange standard (1948 to 1972); and a period of flexible exchange rates (1972-2008).

The report then looks at annual real growth per capita worldwide, over many nations. Such growth, they find, was stronger in the recent non-gold-standard modern period, averaging an annual increase of 1.8 percent per capita, than in the classical gold-standard period before 1913, when real per- capita gross domestic product increased 1.3 percent annually. Give a point to the gold disdainers.

But the authors also find that in the gold exchange standard years of 1948 to 1972 the world averaged annual per- capita growth of 2.8 percent, higher than the recent gold-free era. The gold exchange standard is a variant of the gold standard. That outcome doesn’t tell you we must go back to the gold exchange standard yesterday. But it does suggest that figuring out how the standard worked might prove a worthy, or at least not a ridiculous, endeavor.

Gold shone in other ways. In a gold-standard regime, money is backed by gold, so it’s impossible, or at least more difficult, for governments to inflate. Naturally the gold standard and Bretton Woods years therefore enjoyed lower rates of inflation compared with the most recent era. The gold standard endures a reputation for causing more banking crises than other monetary regimes. The Bank of England paper suggests gold stabilizes banks: The incidence of banking crises in the non-gold-standard period is higher than the incidence in the two gold periods.

“Overall the gold standard appeared to perform reasonably well against its financial stability and allocative efficiency objectives,” wrote Bush, Farrant and Wright.

Stable Markets

Markets and countries enjoyed relative stability in gold- standard years, and capital in those years flowed to worthy growth-generating projects. The main sacrifice in gold regimes that the authors identify is that governments lose authority to micromanage domestic economies. But given governments’ records, that may not be such a bad thing, either.

It all suggests that contempt for old gold hands such as Congressman Ron Paul of Texas might not be warranted. And that it might be interesting to peruse the numerous gold-related currency plans outside the door of the academic salon. Plenty of people, many former bankers, think it is time to pass laws returning the U.S. to some version, strong or weak, of the gold standard.

Lewis Lehrman, financier and founder of the Gilder-Lehrman Institute, which focuses on history, recently published a plan to take the world back to gold, “The True Gold Standard.” Charles Kadlec, another former Wall Streeter, co-wrote his own proposal, “The 21st Century Gold Standard,” with Ralph Benko. The case for gold as a mandatory metric for the Federal Reserve in setting interest rates is made in new legislation offered by Congressman Kevin Brady, another Republican from Texas. Dozens of state legislatures are introducing their own gold- or silver-related currency legislation.

One reason people slap the nut-case label on others with impunity is that for the past 30 or 40 years most economic education has systematically excluded the gold standard and its exponents from the classroom. It’s easy to call something your professors never respected the work of a nut case. But it’s also worthwhile to ask why the professors white out the gold standard from the books. Perhaps it is because the systems they raved about in their dissertations, systems of flexible exchange rates, subsequently underperformed.

This inconsistency in their own modeling is of course hard to acknowledge. Recently Bloomberg Television drew enormous attention when co-anchor Trish Regan moderated a debate between Ron Paul and Paul Krugman, the Nobel prize-winning New York Times columnist.

Krugman’s Nostalgia

Krugman sought to hold the middle ground, noting that all he sought, through his recommendation that federal debt rise to 130 percent of gross domestic product, was a return to the kind of America in which his parents lived. The professor treated the congressman’s remarks as unscholarly; in a blog post afterward, Krugman wrote “everything Paul said about growth after World War II was wrong.”

But Krugman too has some sorting through to do. The years when his parents lived were gold years, the Bretton Woods gold exchange standard, a time when the federal government, except in world war, would never had considered raising debt to 130 percent of the economy, as Krugman suggested in the debate.

If we are going to speak of consensus, let’s not forget one that is truly universal: Our economic system stands a good chance of breakdown in coming years. The only way to limit damage from such a breakdown is to ready ourselves to choose other models by learning about them now.

Not to do so would be nuts.

Tags: Amity Shlaes, Bank Of England, Bloomberg News, Disdain, Eras, Gold Bugs, Gold Record, Gold Standard, Headline Writer, Jacques Rueff, Magazine Author, Michelle Wright, Monetary Regime, Nut Case, Nut Cases, Ozimek, Paul Krugman, Protectionism, Traditional Gold, Weirdo
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PIMCO’s Bill Gross – No QE3 Right Away, but a Few Weak Employment Reports Brings It

Monday, April 30th, 2012

PIMCO’s Bill Gross has a wide ranging interview on Bloomberg discussing all sorts of topics from more QE, the Fed following the Bank of England’s plan to ignore any inflation as ‘temporary’ so they can continue ultra easy policies, the dysfunction in Europe, the potential for recession, among other topics.

9 minute video – email readers will need to come to site to view

Tags: All Sorts, Bank Of England, Bill Gross, Bloomberg, Employment Reports, Europe, inflation, PIMCO, Qe, Qe3, Recession, Video Email
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