Wednesday, November 29, 2006

Built Ford Tough?

Let's talk about some sobering realities in regards to Ford, which was downgraded by Moody's to Caa1 on Monday after borrowing a fresh $18 billion.

1) According to Moody's, since 1983, 21% of issuers rated in the Caa range are in default within one year. 43% of these issues are in default in 3 years, and 79% of Caa issuers are in default in 10-years.

2) Ford has pledged every damn asset they have, including their equity in Ford Motor Credit and Volvo, to secure the new loans. In effect, these assets have been taken away as security for Ford bond holders and given to new creditors.

3) This means that, de facto, Ford bond holders have become subordinate to creditors, and are unlikely to enjoy much recovery.

Now here is the good news. Ford has substantial amounts of free (e.g. non-pledged) cash, between $25 billion and $38 billion depending on who you ask. Fitch says they think cash burn will be around $8 billion next year. So at that rate, they should last another 3 years or so. But then again, if auto sales are weakening, the $8 billion figure may turn out to be conservative.

I talked to a corporate trader today who is heavy into trading Ford bonds. They've now hocked everything they can, he told me. If their current restructuring plan doesn't work, and work quickly, Ford is going to implode.

As Julius Caesar once said, the die is cast.

Tuesday, November 28, 2006

Bernanke Speaks

Ben Bernanke spoke today in New York before the National Italian American Foundation on his economic outlook. The speech was mainly void of any relvalations. The Fed is more concerned about inflation right now, but sees inflation as moderating over the next year as the economy slows. We've heard that same basic statement from several Fed speakers as well as the public releases.

He did speak directly on the topic of rising labor costs, which I wrote about a few weeks ago. Here is the quote.

"What implications does the pickup in labor costs have for price inflation? One possible outcome is that increases in labor costs will largely be absorbed by a narrowing of firms' profit margins and not be passed on to consumers in the form of higher prices. The fact that the average markup of prices over unit labor costs is currently high by historical standards suggests some scope for this outcome to occur. If higher labor costs are mostly absorbed by firms and not passed on, then workers will see the gains in their nominal compensation per hour of work translated into greater real compensation per hour; in the process, workers would capture a greater share of the fruits of the high rate of productivity growth seen in recent years. The more worrisome possibility is that tight product markets might allow firms to pass all or part of their higher labor costs through to prices, adding to inflation pressures. The data on costs, margins, and prices in coming months may shed some light on which of these two scenarios is likely to be the better description of events."

So it comes down to your view of pricing power. Until recently, the feeling was that firms had very little pricing power, that globalization was taking it away. But once again, the money supply rules, and now it seems the deluge of money the Fed gave us in 2002-2003 has allowed pricing power to re-emerge. We'll see how it plays out.

We're not going to pay!

Reader HFT asked me about Ecuadorean bonds, so here are my thoughts. First, some background.

Rafael Correa is now claiming victory in Ecuador's presidential election, and has threatened to default on its foreign debt. As ___ from the University of Sussex said in today's WSJ, "Correa wants to press the reset button on Ecuadorean politics..." He is also looking to rewrite the Ecuadorean constitution.

The CDS market for Ecuador is gapping, and is now over 500bps up from 250 at the beginning of the month. According to Bloomberg, that level is wider than Lebanon or Iraq. Now, I'm not an EM trader so I cannot give much insight into whether 500bps represents a buy or what. But its interesting to contrast this situation with that of a regular corporate bond default.

When a corporate bond defaults, bond holders have a legal right to the defaulted company's assets. In a simple situation where bond holders have the only claim in bankruptcy court, bond holders could choose to become the new equity holders of the company, or else could choose to liquidate the assets and take what recovery they could.

The situation with sovereigns is far more complex. There is no legal authority to force a sovereign to pay their debts. When you lend money to a nation, you are really at their government's mercy. The only incentive nations have to pay debt service is continued access to debt markets. As soon as a government hints that it might not repay its debt, the spigot from foreign investors goes dry.

Curious then that the apparent new regime, which has an ambitious social agenda, is so willing to poison the foreign debt well. I read pieces from Citigroup and Merrill Lynch, both saying that Ecuador is in such good fiscal shape that a default would be an odd move. So maybe its all saber rattling. Maybe its Correa's way of communicating to the public just how sweeping his plans are, even if some of the elements of the plan aren't implemented. Who knows?

The question for investors is do you really want to bet on this guy? Just as Europe is starting to realize how bankrupt an idea socialism is, it seems that Latin America is renewing its fascination. Does Correa not realize how fungible capital is today? Does he not see that foreign manufacturers currently operating in Ecuador could move to India or China or Singapore in a heartbeat? Why does he want his country to look more like Cuba and less like Mexico?

For my money, the spread on Ecuadorean CDS could be 1,000bps, I'm still staying away.

Housing is bad... but not that bad (Part III)

A weak durable goods report got the bond market all juiced up this morning, pushing the 10-year below 4.50% briefly. But at 10AM, a better-than-expected Existing Home Sales figure took a bit of the wind out of the market's sail, and the 10-year is now only up 3 ticks.

Now I know this is going to be hard to believe, but existing home sales actually increased in October to 6.24 million up from a revised 6.21 million. We know that there will come a time where housing activity stabilizes. When that might be and at what levels remains to be seen. But looking at existing sales, the last 4 prints have been 6.33, 6.30, 6.21, 6.24.

Seems to me that if existing homes are moving at a consistent pace, then the market has found a clearing price. If that's right, then prices should recover as the new home inventory is worked off.

I don't think four prints from existing home sales is enough to reach the above conclusion, but by the time we actually have enough data to reach that conclusion, the market will have already moved. So I'm putting my money on a soft landing.

Monday, November 27, 2006

Stocks push bonds higher

The Dow is getting hammered today and I think that's what's keeping the bond market above water. The 10-year was down 10 ticks earlier today on reports that the weekend sales were strong, but with the Dow down 160, bond have rallied and are now +5 ticks on the day. That's a 1/2 point turnaround.

Interesting that the bond market has performed so well the last two trading days given the dollar sell off. If inflation is defined as a decline in purchasing power, then a weaker dollar is synonymous with higher inflation. This is particularly true in the U.S., where such a large percentage of consumer goods are imported. Weaker dollar means the price of imported goods goes up.

A more technical way to look at a dollar sell-off is that storing capital in U.S. dollars has become less attractive. So for example if foreign interest rates are higher than U.S. rates, then investors may choose to invest overseas and enjoy the greater carry. Of course, if this were happening, then we'd still expect the bond market to decline, which isn't happening.

One realistic possibility is that investors are pulling money out of the U.S. stock market and investing it overseas. This seems plausible given the sharp sell-off in U.S. stocks today. But if that were happening, I'd expect European stocks to ourperform the U.S. over the last few days. That's not happening either. The FTSE, the CAC, and the DAX are all underperforming the DJIA since Wednesday. The Nikkei is a little better, but it isn't the yen that's been driving this recent move, its been the euro.

Anyway, I think there will be better entry points in the near future. I'm holding any cash I have until I see 4.65% on the 10-year.

Wednesday, November 22, 2006

More on me being wrong

A post about being wrong. My wife would love it.

Several times in the last couple months I've made the case for a steepener. So far, so shitty on that bet. The curve has moved persistently more inverted since the end of September, now sitting at -18bps (2's vs. 10's), which is about the most inverted it got in February before making a big bear steepener in the spring.

Even though its painful to be wrong no matter what, at least part of my investment thesis is playing out (so far): that there was a limit to how inverted the curve could become. So having the curve go against me for ~20bps has a pretty nominal impact on relative return. I view my curve bet to be as much about the relative payoff as it is about the odds of a steeper or flatter curve. Consider the following:

1) Periods of curve inversion tend to be short, lasting less than a year. The curve has been inverted or nearly so for almost all of 2006.

2) The 20-yr average for the 2-10 slope is 90bps and the median is 69bps. The maximum (using month-end values) slope is +266, the minimum is -47.

3) The curve tends to steepen after the Fed starts cutting, usually flattening ahead of Fed cuts.

So we know that the inversion is already advanced in age and the upside for slope is greater than the downside. That makes a steepener a pretty good bet just based on risk/reward. If I'm wrong, and we get to the -50bps area in slope, that's only -30bps from here. If I'm right the median figure is +90bps from here.

The third point is the kicker for me. If the Fed starts cutting, there will be an initial period of inversion, followed by a severe steepener. If the Fed doesn't cut, then the curve will at least get back to a slope of +10 to +20 or so, because the inversion that now exists assumes some number of Fed cuts.

Tuesday, November 21, 2006

EOP deals conventional wisdom a blow

Blackstone's purchase of Equity Office Properties (EOP) is getting a lot of attention from bond traders for various reasons. First, we had all assumed that REITs were relatively LBO-proof. This is because REITs are generally highly levered to begin with, so piling more leverage on top was thought to be unfeasible in most cases. It is also because most REITs live with fairly restrictive bond covenants. So if a private equity firm wants to buy up a REIT, it isn't easy to do it with debt.

However, the financiers are proving smarter than the lawyers in finding ways around the covenants. Rumors are abound on how Blackstone will handle EOP's covenant debt. They always have the option of doing make-whole calls, but the make whole will be mucho expensive. EOP's 30-year debt has a make-whole call at +30bps to the old 30yr. That would mean those bonds would cost about $1.4 on the dollar to call via a make whole.

They would more likely tender bonds. I.e., Blackstone would publicly offer to buy bonds at some price from existing bond holders. The problem with that is bond holders know that Blackstone is forced to retire debt, therefore there is an incentive for bond holders to not sell. Usually in these cases, the tendering firm (Blackstone) will attempt to have the problematic covenants simply dropped. I'm hearing that EOP's debt is governed by simple majority, which would mean that if Blackstone can convince a majority of bond holders to drop the covenant, there ceases to be a covenant issue and the outstanding bonds can remain outstanding. They don't use charisma to do this, they use cash.

Here is how it might work. Take the 30-year bonds I mentioned earlier which have a make whole call worth $140. Blackstone tells bond holders they will buy bonds at $120 if the holder also agrees to vote to drop the covenant. This creates a sort of prisoner's dilemma. If a bond holder refuses the tender, they might get $140. But if a majority of bond holders accept the tender, the bonds go back to being worth par. Actually, less than par, since the new company would be more highly levered and undoubtedly be rated below investment grade.

Another option for Blackstone would be to "ring fence" certain bonds. This would involve creating a subsidiary with exactly enough assets to meet covenant requirements and assign the most expensive make-whole call bonds to that sub.

So these bond games will be fun to watch if you are an innocent bystander. If you are a cash bond holder, its probably going to be a profitable venture. If you are a CDS holder, the situation is a bit more murky. No default event has occurred, so nominally nothing has changed for the CDS holder, but at the end of all this, what deliverable securities will remain? Let's say that 3/4 of all bonds are tendered and all covenants are dropped, but 1/4 of bonds remain outstanding because they are stuck in some structure. Now those bonds are downgraded to junk, and for CDS holders, those becomes your reference bonds. So whole cash holders win, CDS holders lose.

Another harrowing part of all this is the realization that no one is safe from a buyout. If a highly levered REIT with restrictive bond covenants can command an 8% premium in a buyout, who knows what's next?

Monday, November 20, 2006

An even swap

If you were focused on the rate gyrations from last week, you might have missed what was actually the most important move in investment grade fixed income. Swap spreads. For our more casual readers, swap spreads represent the difference between the Treasury rate and the rate on the fixed portion of an interest rate swap. So for example, if one wanted to enter into a 10-year interest rate swap today, where you would be paying a fixed rate over the 10-years and receive 3-month LIBOR, the fixed rate would currently be 5.10%. That is currently 50bps over the 10-year. So we would say the 10-year swap spread is 50bps. Swaps are available for pretty much any term you like. Swap spreads tend to be about the same as very strong corporate spreads. On the short end, the corporate spread might be a little tighter and on the long end the swap spread is a little tighter.

This is extremely important for determining spreads of other products, in large part because swaps are a common means of hedging a fixed rate position. So if you are a corporate trader looking to take on credit risk, but want to eliminate interest rate risk, you would use a swap to do it. And if the swap spread rises, then your desire to own the hedged credit position diminishes, causing credit spreads to widen. MBS and Agency debt is also highly swap correlated.

The 10-year swap spread moved 4.5bps tighter in the last week, which might not sound like much, but is actually quite a move. 4.5 bps is about 3/8 of a point on the 10-year. The graph below shows it a little more dramatically.

The swap rate (green) moves down suddenly right at the end. There are a couple broad reasons why swap spreads tend to move. One is the slope of the curve, because a steeper slope allows for more carry trades, which increases the demand for rate hedges. But as the second graph shows, the curve has moved a good bit flatter (more inverted) during this period.

In fact, look back to June, when swap spreads were their widest. The slope has moved consistently flatter/more inverted, but swap spreads keep tightening. So that does not explain it.

Sometimes when the Treasury market sees a big rally, the swaps market lags. From 11/10 to 11/17, the 10-year was 1bps higher in yield. So that isn't it either.

Volatility can move swap spreads, with lower vol implying tighter spreads, but vol isn't moving. The implied vol on 5x5 swaptions was virtually unchanged last week. Vol has climbed from 15.3 in June to 16.8 now. All that time, swap spreads have gotten tighter.

To me, there is only one good explanation. Cash. Cash coming from the sidelines into the market and not enough supply to take it. Think about it: we know that MBS issuance is way down this year due to housing activity and higher rates. We also know that corporate issuance has been lackluster for a couple years. Even Agency issuance has been down due to delevering on the GSE's part. Meanwhile everyone from PM's to CDO managers to foreigners have to put cash someplace.

Tuesday, November 14, 2006

On Vacation

I'm on Vacation this week, so I probably won't have much intelligent to say about the markets here. See you next week.

Friday, November 10, 2006

Inflation target dead?

I recently read a Merrill Lynch commentary that mentioned, somewhat off-handedly, that an officially sanctioned inflation target for the Fed is less likely with a Democratic congress. As I've said many times, I'm a big fan of inflation targeting for a variety of reasons. I think most people who are of the Milton Friedman school of monetarism are at least sympathetic to the idea.

Inflation targeting works for various reasons, but one of the primary reasons is wrapped up in rational expectations theory. That is, when people expect a certain level of inflation, they will act accordingly. For example, when negotiating wage contracts, or borrowing rates, the expected inflation level will influence the final figures. These actions will steer inflation toward the expected level.

If you believe in rational expectations, then expanding the money supply can't have any impact on real GDP growth. If the public knows the Fed is providing easy money, they will adjust their inflation expectations. So laborers get raises but firms raise prices all at the same rate, so no one is better off and inflation is higher.

Keynesians reject the notion that economic actors are all that rational. So let's say there is a glut of inventories in the economy at the time the Fed is expanding the money supply. Now consumers have more money but maybe firms don't raise prices right away and instead choose to reduce inventory. Had the influx of money-related demand not occurred, firms may have cut production in order to eliminate inventory, which reduces GDP. But because of the money expansion, the inventory is sold and production levels remain high.

I'm sure most people reading this are thinking both scenarios sound pretty reasonable. I'm more sympathetic to the monetarist perspective. In the second scenario, I agree you'd wind up with inventory reduction, but before too long the easy money would result in pure inflation, and that increased level of inflation would become ingrained in expectations. Now to bring inflation expectations back down, the Fed would need to conduct a painful round of tightening. So the short-term benefit of better GDP through easy money is more than offset by the need for severe tightening down the road.

But my opinion isn't the one that matters. If the people in congress, and the people advising them (like Paul Krugman) think more along the Keynesian line, then they will more often advocate monetary policy based on various economic figures, like capacity utilization and business inventories, not just core PCE. Ben Bernanke would then be in a political fight to get his inflation target, which not only would jeopardize his job should the Democrats take the White House, but could even impact the Fed's independence.

Bernanke can run a de facto inflation targeting Fed anyway. He makes a public announcement that he wants core PCE to be between 1.5% and 2.5%, and promises to do everything in his power to keep it there. Pretty much an inflation target eh? Why risk the political fight?

Thursday, November 09, 2006

Another non-bond post

In thinking about the Democratic sweep on Tuesday, I continue to struggle with what they are actually going to do with their new-found power. The consensus is they'll try to increase the minimum wage, but I think most serious economists will agree that this will have minimal impact on the economy as a whole. Its also widely reported that the Dems are interested in curbing executive pay.

This gets me thinking about the issue of income disparity. The fairness element of this issue is a debate for another forum. My question is, what are the economic consequences of a widening income disparity?

First, it seems there is no single measure for income disparity. What is the correct way to measure this? Is it the top 10% vs. the bottom 10% in income? Or 1%, or 20%? Is the relevant question how do the richest Americans compare with the poorest, or how the poorest compare with the median, or how the median compare with the richest? Sometimes the "poverty line" is used in calculating income disparity, but this tends to be a moving target.

In my mind, we cannot define how to measure the issue without defining what economic problems might arise. The classic argument is that too much income disparity leads to social unrest. So let's think about that for a moment. If the gap between the wealthiest 10% and the poorest 10% is widening because the rich are getting richer but the poor are about the same, then there is no reason to expect social unrest.

History tells us that social unrest tends to grow out of hopelessness more so that simple disparity. The French and Russian peasants lived with the feudal system for centuries and rose up not because they suddenly resented the rich, but because they were starving. I'm sure they resented their feudal lords all along, but it was only once their situation got worse that actual social unrest occurred.

Now, it sounds like I'm being incredibly callous about poverty in America. This argument is not to say that there aren't people really struggling nor that there is nothing we should do about poverty as a society. Again, fairness is another issue for another blog. What I'm saying is that the issue of income disparity, as it exists in America, is not a macroeconomic growth problem. It is a political issue. A moral issue.

So as January rolls around and the Democrats start making the case for a higher minimum wage and for curbs on executive pay, there will undoubtedly be arguments that there are economic problems with large income disparity. Whatever your position is on these issues from a fairness/moral perspective, income disparity as an economic problem is dubious.

No signals today

Mixed bag of economic data today. Import prices were low, inventories high, and consumer confidence low. That bolsters the bond bull's position. But jobless claims and the trade deficit were both low, which bolsters the bond bear's position. None of these are numbers I'm all that interested in. We really have to wait until Tuesday of next week to get anything real meaningful with PPI and retail sales. I'm focused on generalized inflation figures and consumer spending, and to a lesser extent, housing inventories.

Wednesday, November 08, 2006

Don't blame the Dems

The bond market has been grinding higher the last 3 sessions after last Friday's blood bath. Today I keep seeing headlines saying Treasuries are advancing on the Democratic sweep of the legislative branch. I don't think so. I think you had fast money move the market lower on Friday, but so-called real money accounts pushing it higher the last three days.

I'm basing this on three things. First, I'm hearing from a lot of small dealers that anything in inventory not nailed down is getting lifted. If someone like Morgan Keegan or First Tennessee is seeing their 500 bond Freddie Mac positions lifted left and right, that's banks and smaller money managers, not big hedge funds.

Second, spreads are moving tighter in MBS and corporates. If hedge funds were pushing the market around, they'd be doing it in derivatives, which would leave spreads at best unchanged. Probably wider.

Finally, hedge funds and prop traders (i.e., fast money) like to trade the number. In other words, they are the ones who tend to move the market whenever big economic releases cause a large move, like last Friday. Real money tends to form a generalized economic opinion that doesn't change from day to day, regardless of that day's economic number. So when you I see several days of small moves all in the same direction, its indicative of long-term buyers entering the market.

So what's that telling you? There are two possibilities. Either more money managers are becoming convinced by the bearish economic forecasts, or its simple portfolio squaring. I think the later. The most recent piece of major economic data was positive, so I don't think PM's were convinced of the bearish thesis by anything that's happened in the last two weeks. However, regardless of my position, I'm always looking to square my portfolios. By that I mean, get cash that's accrued to work. If a PM is already bullish on rates, he wouldn't wait around much with cash, jumping in with bids anytime there is a sell-off.

To me that sounds a lot like the last three days.

Crowding out effect

Every other blog in the world is spending today pontificating about the change in control of the U.S. House (and probably the Senate). Talking about how it will impact the markets beyond the next week or so is speculative at best. I say this because the Democrats ran primarily on a anti-Iraq/Bush platform, not really on any sort of economic policy. At one time, the Democrats were the tax and spend party, promoting transfer programs and heavy regulation. But the last really successful Democratic politician, Bill Clinton, spent his years lowering the deficit, reforming welfare, and getting NAFTA past. So A) I think the focus will remain on Iraq, possibly creating neglect on other issues, and B) We don't know what direction the Democrats are going to head since they never told us.

On this blog, however, we talk about the bond market. Since the budget deficit was an issue that caused at least some typical Republican voters to switch sides in 2006, I thought today's entry could focus on the so-called crowding-out effect.

The crowding-out effect is when government borrowing causes higher interest rates, increasing the cost of private investment activity. With the increased cost, some amount of private investment is forgone, hence deficit spending by the government results in "crowding-out" of private activity. Some argue that deficit spending is therefore economically harmful. They either argue that government spending is inherently inferior to private spending, or that any stimulus from the deficit spending would be offset by the crowding out effect.

We know that, all else being equal, if the government borrows more, interest rates will rise. Its simple supply and demand, the government demands more money (or supplies more bonds) and therefore the price of money (interest rates) must rise. So it would seem as though the crowding out effect is pretty obvious.

However, academics looking for an actual impact on the economy from the crowding out effect struggle to find one. I think this is for a couple reasons. One is, many factors influence interest rates, so trying to isolate just one is very tough. Second, the government has changed their borrowing strategy at various times in history, so at one period they may borrow more long-term and another more short-term, which would have different impacts on interest rates.

I think the biggest reason why the crowding out effect is hard to observe is that the national debt as a percentage of GDP isn't that volatile. Here is a graph of same.

The figure increased a bit during the 1991 recession/Gulf War, decreased during the capital gains tax boom of 1999-2000, and increased again during the Iraqi War. But overall, not that volatile. In addition, government spending does encourage some degree of private investment, e.g., the government awards a defense contract to Boeing, so Boeing expands its production capacity. So combine the relative stability of Federal debt, and the mitigating impact of encouraging some degree of private investment, and it turns out the crowding-out effect doesn't have much effect on interest rates in any given year. I'd say more likely that the crowding out effect has a fair-sized impact, its just fairly constant from year-to-year.

That being said, I think there is merit to the idea that private investment is better for the long-term prospects of the economy than government spending. The reason why savings/investment is important for an economy is to replenish our capital stock (i.e., keep factories in working order), and to expand productive capacity (i.e., build more factories). If we have no investment, then our ability to produce more goods to keep up with population growth is hampered. That would cause per-capita income to decline.

Some government spending programs are for infrastructure, which are important long-term investments. But much of government spending has no positive long-term impact on productive capacity of the economy. For example, when the government buys more tanks, the goal is to defend our borders not to expand productive capacity. Defense is an attempt to maintain the status-quo, and while obviously important, the economy would be better off in the long-run if we didn't have to spend as much. We spend on defense because we have to, not because we want to. Similarly, transfer payments (e.g., social security, medicare), don't expand our productive capacity at all. Mind you, this isn't a political judgment about the merits of transfer payments, rather a statement of fact about the nature of these payments.

So generally its up to private investors to build new factories, invent new products, etc. Its clear that federal deficit spending has some impact on interest rates and therefore crowds out some level of private investment. Plus, you ultimately cannot keep spending more than you're bringing in, the compounding of interest will eat you alive. So on the balance I'm for lowering the deficit. But the deficit problem does get way too much play as an economic issue among both politicians and the media.

Monday, November 06, 2006

Housing and golf

I was playing golf with a client about 2 years ago, and as I was lining up a putt, I declared that it was impossible for the housing market to get so expensive that people couldn't afford houses. Home prices are governed by supply and demand like any other market, I reasoned. If the price is too high, demand would fall. Since demand (at the time) was in fact, rising, obviously prices aren't so high that homes were generally unaffordable. Obviously it could become unaffordable for a given consumer, but not for consumers generally.

What I ignored was the possibility of widespread investment in residential real estate. According to the National Association of Realtors, 27.7% of homes bought in 2005 were for investment. Investors have to outbid consumers for properties. It may be that a portion of homes bought by investors wouldn't have sold to a consumer, e.g., a home in such bad condition that its unlivable. In the majority of cases, though, investor demand has shifted the demand curve for homes outward.

So far, housing starts have fallen about 500,000 from their peak in January. Investor demand in 2005 represented about 2.3 million homes, so the lost demand from investors out-weighs the decrease in new supply.

As FRB of Dallas president Richard Fisher said the other day, the Fed really created this housing bubble by holding rates so low for so long. I am increasingly of the belief that investors speculating in the housing market really created the bubble.

Investors will not hold on to houses at a loss. They will either rent them out or sell them at a loss and walk away. The good news for the housing market is that if economic fundamentals continue to be strong, then it should only take 1-2 years to wring out the speculative investors. After that, I'd think the housing market will get back to a more normal pace of appreciation.

Friday, November 03, 2006


On the back of yesterday’s fairly high ULC figure, today’s low unemployment figure has the Treasury market running for cover. The 10-year is down a full point and the 30-year is down 1 and a half.

I can see why this is causing consternation for the bond bulls. With inflation figures still high and unemployment falling, what's the argument for Fed cuts again?

Not that simple

Commenter Richard suggested that my "simple math" from yesterday really isn't that simple. He's right for a variety of reasons. Most obvious is that the ULC calculation might not perfectly reflect total consumer income, such as wealth gains from sale of securities or real estate. Another important point which Richard brought up is the problem of imports. If consumers have 5% more income but use it entirely to buy foreign goods, the impact on U.S. inflation may be minimal.

I spoke with John Burger of Loyola College in Maryland's economics department last night about ULC. He supposed the negative serial correlation issue I mentioned yesterday is probably due to poor measurement on the part of the BLS. Be that flawed methodology or that the data is just hard to get a handle on, either way I'm suspicious of the downward trend in ULC.

Thursday, November 02, 2006

Fisher on the tape

FRB of Dallas president Richard Fisher spoke in New York today, speaking mostly about data quality and the need to look at activity beyond U.S. borders when making decisions about domestic monetary policy.

This speech sounds a little less hawkish than other's he's given recently. His (and my) favorite inflation gauge -- trimmed mean PCE -- printed a little lower last month, falling to 1.7% from 2.7% the previous month. The YoY number is still 2.6%, which everyone would agree is too high. Anyway, Fisher characterized the inflation picture thusly:

"It is possible that the trend in overall consumer inflation has peaked and is finally heading lower. Next, the not-so-good news: The overall inflation trend remains at a level above my comfort zone. I am encouraged by the change in direction of trend inflation, and I hope that in the future my CEO and CFO contacts will be telling me that the competitive forces of globalization have kept their pricing power limited or nonexistent."

I have to read that as Fisher would start to feel more amiable to cuts if trimmed PCE continued to print below 2%, particularly if the YoY number would fall to that level.

A labor of love... and money

Unit Labor Costs, one of the stats I view as critical in the analysis of inflation, came in higher than expected this morning: +3.8% vs. survey of 3.4%. Productivity was also below expectations: 0.0% vs. 1.0% surveyed. ULC for 2Q was also revised higher from 4.9% to 5.4%.

The bond market is mildly lower: down about 1/8. I'm surprised its not down more. My suspicion is that the bond bulls are focusing on the trend for ULC more so than the number itself. Witness the graph! The green line is the stat and the yellow is a four quarter moving average.

So while the 3Q ULC rise is well above the 15-year average of 1.74%, it has also decelerated two quarters in a row. Visually, it doesn't look like this is a figure that goes through short-term trends. In other words, it seems to accelerate one quarter then decelerate the other. In fact, only 26% of periods did the change in ULC show the same sign two quarters in a row.

The moving average is more telling. Note that the ULC is calculated on a quarterly basis and then annualized, so a four quarter moving average gives us a good full-year picture. The MA shows more apparent trends. During the deflation scare of 2001-2002, we did indeed see weak ULC figures. Today, we are obviously on an upswing. In fact, the MA is currently 5.30%, matched in this time series only by 5.35% in 3Q 2000.

If the dollars paid to laborers are rising at a 5.3% clip, the marginal propensity to consume is about 100% (i.e. consumers spend every additional dollar they earn), and output of consumer goods is growing below 5.3%, then consumer prices must increase. Even a monetarist such as myself can agree to this more Keynesian approach, because its simple math.

If you hold goods available for sale constant, but increase the dollars consumers have to spend, then the price of those goods must rise. It follows that if you increase the dollars consumers have to spend at a faster pace than output increases, then prices must rise.

Monetarists believe that inflation is always and everywhere a monetary phenomenon. But in real life, its tough to tell what the relevant money supply is. For example, if the Fed puts more money into circulation, but some foreign central bank decides to put an equal amount of dollars into a vault to maintain a currency peg, money available to the economy hasn't really changed at all. So we're forced to look at indicators of increasing money supply, such as rising labor costs.

In real life, my simple Keynesian math example gets a little complicated, because you have to consider availability of imports, which are fluid. But in my mind, as long as ULC is growing faster than 3% or so, core PCE will stay above the Fed's comfort zone. I can’t see the Fed cutting in this environment.

Wednesday, November 01, 2006

CME to list CDS

The Chicago Mercantile Exchange plans to list futures on credit defaults. It sounds to me as though the process will be similar to a credit-default swap, but will be exchange traded, which should improve liquidity.

A credit-default swap is where one party agrees to pay a fixed payment and in exchange, the other party agrees to buy a reference obligation at par in the event of a default. So let's say you owned some Clear Channel Communications bonds and you wanted to eliminate the credit risk, but for whatever reason, you didn't want to sell the bonds. You sell a credit default swap, and if Clear Channel defaults, you simply sell your bonds to the other party at par. You pay for the protection in the form of a fee, which in practice is similar to the LIBOR spread of a floating-rate bond of the same issuer.

CDS have come to dominate corporate bond trading, because its a cleaner way of achieving credit exposure. Rather than try to find a specific bond, which may or may not be available, you simply short the CDS, which pays you the spread you wanted anyway. CDS can also be more liquid than specific bond issues, which makes it a good place for hedge funds to speculate on movements in the credit market.

If the CME goes through with their program, it would make derivatives trading all the more attractive over cash corporates for large institutional investors. Will anyone actually trade bonds anymore??