Wednesday Before Turkey Day

The 10-yr note yield has fallen to 3.99%, below 4% for the first time since 2005, on the same day oil traded above $99 for the first time ever. West Texas Intermediate is currently trading at $98.28 on the NYMEX.

 

Governors of the Bank of England voted 7-2 to leave rates unchanged last night. What’s noteworthy is the two dissents, both in favor of a rate cut.

The Fed’s forecasts yesterday suggest the economy will stabilize very quickly. The unemployment rate has already risen from 4.4% to 4.7% in seven months, and the Fed figures it will only rise another tenth or two in the next 14 months. The language of yesterday’s minutes suggest the Fed thinks it can achieve this without further rate cuts (maybe), but Bernanke’s assessment of the economy in testimony to the JEC just a couple of weeks after the FOMC meeting suggested more significant risks to growth. As a result, the market has priced in a higher chance of rate cuts after seeing the forecast.

 

Of course, an alternative view is that investors saw the forecast, shrugged it off and priced in higher odds of rate cuts after seeing the dysfunction of the credit markets rise to a new height yesterday.  LIBOR is rising, spreads are widening, Fannie and Freddie, traditionally the biggest stabilizing influences when the mortgage market gets wobbly, have their own problems and it is increasingly obvious there is no bailout coming from Congress.

The WSJ says companies are starting to regret recent share buybacks, wishing they had the cash now as capital is depleted by losses. On top of depleting cash reserves, it also means many bought stocks high and are now forced to sell them low, and/or cut their dividends.

 

The WSJ says high-end retailer Saks is still doing well. The paper credits wealthy consumers, but a 10% increase in tourism and the weakness of the dollar is also a likely factor. Big US cities are packed with foreign Christmas shoppers this year.

 

Today, jobless claims are expected to fall from 339k to 330k. Final November U Mich sentiment is expected to stay at 75.0 and October leading indicators are expected to fall 0.3%.

Tuesday Trivia

The WSJ credit market column pretty much sums up the climate with its headline, “The Big Thing Right Now Is Panic.” Listed in the column are 1.) the Cerberus/Chrysler $4bn loan sale has been postponed again, this time until after Thanksgiving 2.) agency bond spreads widened yesterday 3.) 3-mo LIBOR is creeping back toward 5% as some banks in the average push to raise cash and 4.) the flight-to-quality rally in Treasuries, which took the 2-yr yield to 3.15% and the 10-yr to 4.07% yesterday.  

On BBG this morning, retailers brace for weak sales through the first quarter of next year, which essentially means they are betting on a weak Christmas season with no gift-card related bounce in Q1.  In the WSJ today, sovereign wealth funds are poised to buy US hard assets. The deal story of 2008, they say, may be foreign government ownership.  Also in the WSJ, Sumitomo Mitsui bank reported a 30% drop in first-half net profit due to US subprime loan exposure.  

Treasuries are a little higher in yield at 3.21% for the 2-yr and 4.08% for the 10-yr this morning as foreign investors recoiled a bit from yesterday’s extreme low. Today, housing starts are expected to fall from 1191k to 1170k, which would be the lowest level since 1993. This afternoon, the Fed will release the October FOMC meeting minutes and a long term economic forecast.   

Monday’s Minutia

China has asked banks to freeze lending through the end of the year in an effort to cool its economy. Banks have canceled loans and frozen credit lines in response. The Chinese economy is booming despite a series of rate hikes this year. Officials would normally use further rate hikes to slow growth, but with the US Fed cutting rates, rate hikes put significant upward pressure on the yuan, which would slow exports. (Which might not be a bad idea if the economy is overheating, but that’s just our opinion.) A moratorium on loans is risky, as it may prick the mainland Chinese stock-market bubble. Still, the policy underscores the differences between China’s economy, with its high saving rate, and ours. A suggestion by Jimmy Carter in 1980 that consumers refrain from using credit caused the US economy to shrink by 10% in two quarters. The effect on China is likely to be considerably smaller.

 

Moody’s says the value of commercial real estate is falling due to the credit crunch. CMBS was under pressure last week in part in reaction to a research piece that shows commercial followed residential real estate with an 18 month lag in prior real estate cycles. Moody’s research is corroboration that 18 months seems to be the lag in this cycle, too.

 

Swiss Re took a mark to market charge of about $1bn against a subprime investment in October, resulting in a loss in the quarter of $876 million. In a related story, Saturday’s WSJ reported that several bond funds can be added to the casualties list after bottom-fishing bond purchases in September turned sour in October.

 

The WSJ says the influence of the dollar on inflation has diminished as foreign producers tend to eat price changes caused by currency losses. The paper cites a series of studies by economists that show only ¼ to 1/10 of changes in the currency are passed on to consumers, which helps explain all those European Christmas shoppers in Manhattan this year. Shoppers with euros can find some spectacular values compared to what they would pay at home.

 

A National Association of Business Economists survey shows 9 of 50 economists surveyed in October put the odds of recession in 2008 over 50%, almost twice as many as a month ago.

 

Today, the November NAHB home builders sentiment index is expected to slip to 17 from an all-time low reading of 18 in October. Housing starts will be released tomorrow along with the October FOMC minutes, which will be accompanied by an FOMC forecast update.

Tuesday’s Trivia

A flurry of earnings warnings from financial services companies suggests the bad news is by no means behind us. The WSJ calls HSBC’s warning about further losses significant because HSBC was a bellwether of third quarter problems. E*Trade warned it would have to mark down securities on its books, causing a 59% drop in shares yesterday.

 

Bankers worked out a simplified M-LEC arrangement over the weekend, with bigger fees and fewer barriers to entry. The entity is expected to be up and running, buying assets from SIVs, in January.

 

The WSJ says several money funds are scrambling to “shore up” funds with SIV exposure to avoid breaking the buck. Several have contacted the SEC for guidance on how to handle SIV holdings. Funds are expected to start scrambling to address SIV exposure as the ratings agencies have warned they cannot maintain the highest ratings on funds with exposure to troubled SIVs.

 

Fitch downgraded $37.2bn in CDOS, with $14bn falling from AAA to junk status, a move that could put further pressures on the ABCP market.

 

China raised rates another 50bp, and is expected to continue to tighten in the months ahead. Chinese inflation accelerated to 6.5%, with a 55% rise in pork prices leading the way. In an emerging economy like China’s, food prices often lead other inflation, because a rising standard of living for the poorest means a surge in food consumption. Food inflation is a significant concern for the government, as food inflation can quickly lead to social unrest.

 

This afternoon, September pending home sales are expected to have fallen 2% after falling 6.5% in August. Pending sales lead existing home sales by a month or two.

Friday’s Fish Wrap

Junk bond spreads have pushed through their summer wides and asset-backed commercial paper outstanding fell by $29.5bn as the mood in the credit markets turned decidedly gloomier this week. We think it has a lot to do with the new Fed conundrum Bernanke outlined yesterday: the Fed feels it is exacerbating the inflationary threat from dollar weakness and rising commodity prices if it cuts rates, while risking significant economic weakness (i.e., recession) if it doesn’t. As much as we feel for the poor guy – did anyone else notice the return of the nervous quaver in his voice yesterday? – we can’t help but wonder if Alan Greenspan would not have spun a way out of this mess. For instance, can’t you see Greenspan telling Congress that rate cuts are good for the dollar if they stabilize foreign investor confidence in dollar assets?

 

Bernanke warmed up – and relaxed – by time he reached the Q&A, in part because the mood in the financial markets is ugly enough that the typical partisan sniping was almost entirely absent from the hearing yesterday. Lawmakers appeared genuinely concerned and appealed to Bernanke for advice. Joint Economic Committee Chairman Schumer even urged Bernanke to work behind the scenes if he wasn’t comfortable saying things in the open. It was in the Q&A that Bernanke suggested allowing Fannie and Freddie to purchase jumbo mortgages with a Federal Government guarantee to relieve pressures in that part of the market. He suggested a few caveats that would take some of the risk off the guarantor and lawmakers were downright enthusiastic. Schumer called it a really good idea, promising to get right to work on a bill.

 

In the meantime, off the Hill, OFHEO Chief Charles Lockhart fired a letter back at NY AG Andrew Cuomo questioning his judgment, understanding and jurisdiction in subpoenaing the GSEs on Wednesday. He requested a meeting with Cuomo, something the AG agreed to. But at the same time, Cuomo’s office said it will not back down.  

 

The Lockhart letter is here: http://www.ofheo.gov/newsroom.aspx?ID=395&q1=1&q2=None

Links to the letters sent to Fannie and Freddie are here: http://www.oag.state.ny.us/press/2007/nov/nov7a_07.html

 

The exchange is almost comical, but the effect on the market is real and destabilizing. This summer, conforming mortgages were an island of stability in a sea of chaos, but that is beginning to change now that this legal threat is on the table. Hopefully it will be diffused quickly, but Cuomo is not known for backing down.

 

Today, the September trade deficit is expected to grow from $57.6bn to $58.5bn thanks to higher oil prices. Also, the U Mich consumer sentiment index is expected to fall from 80.9 to 80.0.

Thursday Trivia

The markets are trading as if Ben Bernanke had nothing new to say this morning, which is almost true. But there was one important difference between his testimony and the Fed’s October statement. The statement characterized the risks to growth and inflation as roughly balanced. In the testimony, we learned that there are significant risks to growth balanced by significant risks to inflation. The fed is clearly nervous about both, but is concerned that anything done to fix one set of problems will only make the other set of problems worse.

Bernanke seems to think his hands are tied. As a result, the Fed relinquished its preemptive role in October. The Fed will continue to adjust rates in the future, but it will do so behind the curve, not ahead of it. Ultimately, that means a higher risk of recession and eventually, a lower fed funds rate.

Wednesday’s Wash

Productivity grew 4.9% in the third quarter, enough to lift the year-on-year rate of growth from 0.7% to 2.4%. We have reservations about the accuracy of the official productivity statistics – they are so often at odds with the evidence in corporate profits data – but the Fed puts a great deal of weight on these stats in its decision making, so the strong rise is significant from a policy standpoint.

The productivity boost came from a 4.3% rise in output on a 0.5% reduction in worker hours. The combination also resulted in a 0.2% drop in unit labor costs, despite a 4.7% rise in compensation per hour.

Bottom line: This report suggests one more big reason not to worry about wage inflation. (The rising unemployment rate is another.) The Fed should be thrilled with this report. Some of the strength is no doubt spurious, but as it wipes out what was no doubt spurious weakness in the last couple of quarters, there should be no problem there.

Crude is trading above $98 this morning and gold is over $840 as the dollar slides to a new low. The dollar fell after Cheng Siwei, vice chairman of China’s National People’s Congress said China must diversify its foreign exchange reserves, “favoring strong currencies over weak ones.” The dollar, he said, is “losing its status as the world currency.” Cheng has no authority over China’s currency policy, and has often urged change without affecting it. Nonetheless, his comments echo a sentiment increasingly popular among senior party officials, including those at the People’s Bank.

The WSJ says Wall Street bonuses will be smaller this year, but not everyone will be affected evenly. Bloomberg notes that Goldman’s bonus pool is big enough to buy Bear Stearns. Oddly enough, investment bankers are expected to take home more than last year despite huge third quarter losses, thanks to big first half gains.

GM is about to report it’s biggest ever loss on a write down of tax credits it would have used if it were profitable. Ford is also expected to swing back into the red on weak sales.

French bank Societe Generale took a hit from US subprime exposure in earnings announced last night. IndyMac halved its dividend after reporting a loss that was more than five times bigger than expected. The company once specialized in Alt-A loans and took a big hit from delinquencies despite changing strategies some time ago to emphasize conforming mortgages. The loss was compounded by a sharp drop in loan demand. The company expects a year to year-and-a-half before recovering and warned it may cut its dividend again.

Today, third quarter productivity is expected to have rebounded to 3.2%, reflecting the decent rise in Q3 GDP on a minimal rise in payrolls. Consumer credit is expected to rise $9bn in September after a $12bn rise in September.

Tuesday’s Trivia

The Fed’s October senior loan officers’ survey made clear how dramatic the tightening of credit was over the summer. Banks were most aggressive about tightening standards on residential mortgage loans. A significant tightening of subprime loan standards that began in the first quarter was joined by a significant tightening of Alt-A and prime standards in the third quarter. Banks also tightened standards on commercial real-estate loans and raised the spread on commercial and industrial loans. It’s also noteworthy that despite Fed rate cuts, banks are not cutting deposit rates, mostly because a handful of banks with significant problems in their mortgage portfolios have been cut off from the bond market and are using high deposit rates to lure deposits from other banks.

 

Japan’s leading economic index fell to zero in September for the first time in a decade, signaling the economy may be in trouble again.

 

Fitch raised China’s long-term foreign currency debt rating from A to A+, the same as South Korea and Taiwan. The ratings outlook was also changed from stable to positive. China’s local-currency rating was also boosted, from A+ to AA-. The country’s huge trade surplus, abundance of foreign currency holdings and positive economic outlook were all cited as factors in the decision. Moody’s and S&P both raised China’s rating in July.

 

American Home Mortgage Company sued Triad, a mortgage insurance company, yesterday for non payment on several delinquent mortgages. Mortgage insurers as a group are under tremendous pressure as the number of foreclosures mounts. A system that was designed to protect borrowers in case of unemployment is being sorely tested by the systemic problems in the wake of the bubble bursting in housing. It’s another significant element in the ongoing test of the system of housing finance. American Home’s lawsuit is one minor salvo in this ongoing story, but an important reminder that mortgage lenders will keep the pressure on insurers to keep mortgages current whenever possible.

 

There’s no US data today. Bernanke speaks, but he is not expected to comment on the economy or Fed policy. His topic is microfinance and community development. If he does stray into any of the big topics du jour it is likely to be the availability of subprime mortgages.   

 

Bloomberg says the latest round of big bank losses may force the Fed to cut rates again. The market is certainly betting that way. In a related commentary this morning, Bloomberg commentator Jonathan Weil writes that Citi’s claim that $8bn – $11bn in losses in its subprime portfolio occurred after the end of the third quarter is reminiscent of the scene from Beverly Hills Cop where Eddie Murphy’s character Axel Foley pulls into the Beverly Hills Country Club in his beat up Chevy Nova and tells the valet “Can you put this in a good spot? `Cause all of this $#@& happened the last time I parked here.”

Thursday’s Update

Yesterday’s FOMC announcement was clear: the Fed does not intend to cut rates any further for now. Concluding that “the upside risks to inflation roughly balance the downside risks to growth,” the Committee feels that yesterday’s cut “combined with the policy action taken in September, should help forestall some of the adverse effects on the broader economy.” Until about a week ago, when expectations started drifting down to 4.25%, the futures market did not show a cut in December. Fed funds were expected to be 4.5% at year end. Yesterday, the markets again showed 98% betting on no cut. But in the first quarter, the market is still pricing in one more move downward.

 

Corporate profits are the economy’s Achilles heel. Profits have been slowing since the fourth quarter of 2004 and are negative year-on-year as of the third quarter. Take out the obvious weak sectors — housing related and financials — and earnings are up only about 4%. If weak earnings persist, it should translate into reduced capital spending, slower hiring and reduced income growth. So, we are on the lookout for slower equipment spending, slower commercial construction and slower hiring. All three of these have slowed already to some extent, but not alarmingly. They must deteriorate further if the Fed is to be spurred into action again.

 

Last night, the dollar was fractionally stronger as an anticipated rate cut was offset by an unanticipated resolve not to ease again. Oil topped $96 on the news that US refineries had allowed inventories of crude to run off last week rather than buying at $90+. And, US equity futures are down as the Fed’s announcement sinks in. Credit Suisse was the last big Wall Street player to report earnings last night and was right on top of expectations, with a relatively small write down of about $1.5bn in trading and investment banking losses. This morning, the WSJ attacked Bear Stearns CEO James Cayne on the front page, saying he was too busy playing golf and playing bridge to steer the firm through this summer’s crisis.

 

The IRS is investigating hedge funds and private equity funds for systemic non-payment of taxes. The investigation is focused on stock swaps and loans structured to avoid tax withholding. The IRS says many hedge fund partners can’t even be bothered to file a return.

 

RealtyTrac reported yesterday that the foreclosure rate doubled from a year ago in the third quarter with a 30% increase from the second quarter. Foreclosures are more widespread than in Q2, with the concentration in California and Florida still high, but lower than last quarter.

 

Today, September income rose 0.4% and consumption rose 0.3%, the core PCE deflator was unchanged at 1.8% yr/yr. Later, the ISM index is expected to fall from 52.0 to 51.5. Yesterday’s drop in the Chicago PMI suggests a reading below 50 in the national index today.