Wednesday, December 30, 2009

2010 Forecast: How's the gas mine? Is it paying off for you?

Well, its forecast time. I'm going to do this over the course of four posts, I think. Maybe more. This first post is going to focus on what I see for general economic growth in 2010 assuming basic conditions that exist today persist into the new year. The next post will discuss what I expect the Fed to do in response and why that might cause some problems for risk assets. The third post will look at what happens if the Fed doesn't do what they are supposed to do (a real risk to be sure) and what the consequences will be of that. The fourth post will answer whatever questions I get on the first three.

First I'd like to say that the economy is recovering, but not in quite the same way we've seen in the past. I know its become cliche to talk about a moderate recovery, so here is some nuance you aren't reading every where.

First, the industrial sector is enjoying a strong recovery. The ISM manufacturing survey and Fed's industrial production figures show above-average activity.

Other series confirm the same ideas. Durable goods orders are strong. Capacity utilization has risen from 68.3% to 71.3% in just 5 months. After the 2001 recession, it took over 2 years for capacity utilization to recover 3 percentage points.

It isn't terribly hard to see why industrial production has recovered so much. Look at inventories.

Knowing that demand was as low as it was in 4Q '08 and 1Q '09, the severe drop off in inventories points to virtually no actual production. Thus production has recently increased in a big way mainly as catch-up. For 6-months every one was so scared they did nothing. All that while inventories dwindled. Now in order to sell anything producers need to produce.

This is, of course, one of the textbook reasons why there is typically a boom period after a recession. Inventory rebuilding. That part of the cycle is hardly over. I went back and looked at inventory levels from 1960 to today and divided it by the current dollar PCE index. Basically its an economy-wide inventory to sales ratio.

At first glance this looks like a persistent decline over time. This can be explained by everything you were taught in business school about improvements in inventory management over time.

But take a second look. Basically the ratio is oscillating in a range from 1960-1980. Then there is persistent decline until about 2001, when the ratio gets stuck in the 14-15% range until 2008. Below I've zoomed in to the recent period.

You worry about those fighters! I'll worry about the tower! If firms were to increase inventories from 12.8% of sales to 14.5% of sales, holding PCE constant, it would require a 13.4% increase in inventory levels. That could add considerably to GDP in 2010.

So that's what's booming. You can guess what's mediocre. Consumers. Here's personal income growth.

Somewhat below average. And certainly far below average if we took out recessionary periods. Then consumer spending.

Same story. Below average and a good bit below average for non-recessionary periods.

What does this point to? A business-lead recovery. Its not impossible. Business spending can and does occur in the absence of strong consumer demand. We know that businesses have spent very little on capital replenishment. Below is non-residential private investment courtesy of the BEA.

You can see that the drop off is much more severe this recession than in 2001 or 1991. In fact, fixed investment as a percentage of GDP (9.5%) is at its lowest point since the early 1960s (although about the same as the 1990-1991 recession.) Since 1960, the average capital spending level as percentage of GDP is 11%. In order to get capital spending up to 11%, businesses would have to increase capex by 16%! Again, this could add considerably to GDP without a serious ramp-up in consumer spending. In fact, I'm modeling that fixed investment adds something like 1.1% to GDP in 2010.

Bottom line: I think GDP grows above 4% on average in 1Q and 2Q 2010, then drops off a bit into the mid 3's for the second half.

Next, we'll look at why a second recession is highly likely (but its 2-3 years out) if the Fed does its job right. Then we'll look at what happens if the Fed doesn't do its job right. Hint: think bell bottoms and burnt sienna couches.

Tuesday, December 15, 2009

Debt Wars Episode II: Attack of the Traders

My post from last week on debt generated some conversation about leverage and the value of arbitrage-free prices. Basically I'm arguing that if leverage (a.k.a. trading debt) is exceedingly expensive, then arbitragers won't be able to perform their essential function.

I wanted to illustrate this in a bit more detail by giving a admittedly stylized example. As you are reading this, bear in mind that I'm merely explaining why some degree of leverage is needed to produce efficient markets. This shouldn't be taken as an endorsement of any particular level of leverage, simply as an argument that Wall Street leverage is basically good.

Let's pretend we live in a world where there is a discrete amount of "real" money that is investable in the short-run. That is to say that all long-term investors have fully allocated their investments and any change in their demand for investments only occurs in the long-run. We can imagine this sort of like a world of dollar cost averagers who put some set amount of money aside for investment at the end of each year. However during the course of the year, the level of investable capital is constant.

Now let's assume we're at equilibrium and the market is perfectly efficient. Suddenly a new bond issue comes to market. Who is going to buy it? Given that investors don't have any uninvested assets, the only way an investor could buy this new asset is if they sell other assets. This can't work, of course, because if one investor sells another investor has to buy. There isn't any available net capital in the system.

Now many readers are thinking to themselves that this is a dumb example, since obviously my initial assumption doesn't hold. We see capital flowing back and forth all the time. Investable assets obviously aren't fixed.

Or are they? Consider who makes up real money investors. Individuals? They might have some assets sitting in their checking account which could in theory be invested, but its clearly limited. They have bills to pay with their liquid money. Corporations? Similar to individuals. Mutual funds? On any given day, they only have what they have.

Maybe we can't say that investable assets are literally fixed, but I argue that in the short run its damn close.

Furthermore, real money isn't going to react to relatively small arbitrage opportunities. Let's assume the yield curve is dead flat at 5%. Let's further assume that ABC Corp has bonds outstanding due in 2018 currently trading with a 6% yield. Now ABC wants to sell new bonds which will have a maturity in 2019. What should the yield be? With a flat yield curve, the yield should be extremely close to the 2018 bonds.

But if real money has limited excess capital, there will be a supply/demand imbalance here. Real money will have to be enticed to bring in new capital, and therefore the absolute yield will have to be large enough to do the enticing. Relative yield doesn't apply.

Put yourself in this situation. You wake up one morning comfortable with your investments when some poor bond salesman calls you up and asks about these new ABC Corp bonds. You admit that you have some money in your checking account, but are you going to tie up your liquidity for a 6% yield? Or 6.5%? Or 7%? Depends on your own situation. Might have to be 9% or 10%.

Now let's introduce the possibility of fast money. They also have limited capital, but we'll assume they also have access to leverage.

So back to ABC Corp. They look to sell new bonds. Real money is strapped and wouldn't be enticed unless the yield is 8%. But fast money can afford to go long new bonds vs. a short of the 2018 bonds with a yield differential that is much smaller. If fast money can get 10/1 leverage, a 1% differential earns them a 10% IRR. Or even better, fast money can speculate that once ABC Corp has sold their large bond issue, the supply/demand picture will improve. That is to say, if ABC Corp wants to sell $1 billion in bonds, real money can't take it down. But once the deal clears, fast money can sell the $1 billion bonds in smaller chunks at a tighter spread. Maybe fast money would therefore take the bonds at 6.25% and try to sell them off at 6%. That would be about a 2% price gain. At 10/1 leverage, that's a 20% IRR.

Why do we care about ABC Corp's cost of funding? Because the markets are supposed to be an arbiter of capital. If the cost of capital is distorted by technicals, the market can't function in this manner.

This problem is most glaring when the market is in panic mode. Last fall, real money almost universally wanted to sell at the same time that fast money had no access to capital. Efficient markets completely broke down.

Again, it isn't that unlimited leverage is a good thing. But without leverage, markets can't work.

Thursday, December 10, 2009

Debt: How am I to know the good side from the bad?

I was listening to Megan McArdle on the EconTalk podcast the other day. (By the way, I recommend the EconTalk series for any real economics wonk. The subject matter is often not particularly investment related and it usually runs about an hour, but its my clear favorite podcast.) The subject of the podcast was Megan's Atlantic article titled "Lead us not into Debt" and the subject of consumer debt generally. At one point in the conversation the question is raised, is debt inherently bad?

The host, Russ Roberts, made the point that recently many in the media have suggested that consumers need access to debt in order to finance current spending, lest we suffer some sort of economic disaster. Its clear that the Fed agrees with this sentiment given how they've pushed the TALF for consumer asset-backed securities. Roberts questions whether this is really true, whether debt isn't, at least, more bad than good.

I'm a bond trader. Debt is my life. Granted, I'm more of a lender than a borrower professionally, but long-time readers will remember my defense of both the TALF and the bank bailouts as beneficial to main street primarily because I saw a functioning debt market as a necessary condition for a modern economy to function.

Roberts isn't the only one asking this question. Based on the comments and the e-mails I receive, I think many readers are sympathetic to this view. And its a great question, especially in light of the fact that our collective debts are what caused the financial crisis. Even further, the fact that our public debt is now growing at an alarming pace, potentially setting the grounds for another crisis. Isn't all this debt just bad?

After having mulled this over for three days, here is where I come out. First let's tackle debt for consumption. Specifically I'm thinking of any consumer product cheaper than a car. I'm also thinking in terms of pure positive economics, that is I'm not layering on my own judgement, merely what I think the laws of economics have to say.

First, I think there is a presumption among some that if consumer credit were tighter, there would be less aggregate demand. I don't think there is good economic evidence for this view. If a consumer buys some product, say a television, on credit, what's really happening? They are pulling forward demand. That same consumer later has to save to repay that debt. In the absence of credit, the consumer would have to save to buy the TV. I don't see what the difference is between saving to buy the TV in the first place vs. saving to repay the debt.

Let's put some numbers to this. Say its a $500 TV that the consumer puts on a credit card at 15%. Say that debt is repaid when the consumer gets a year-end bonus in exactly 6-months. Net of interest paid, the TV cost the consumer $537.50. If credit weren't available, the consumer simply waits until the year-end bonus hits and then buys the TV. As far as I can tell, aggregate demand is the same over time. In fact, since the consumer pays interest on the debt it would seem that the consumer's budget restraint results in lower demand over time the more debt is utilized.

I think some would argue that there is a multiplier effect, where more transactions are good economically. The spending turns into someone else's income which turns into someone else's spending which turns into someone else's income. Perhaps, but its still necessary for the debt to be serviced. I have to think any multiplier benefit is offset by the negative effect future savings (or more specifically debt re-payment) has on transactions.

Let's take this multiplier theory further. If we assume a transaction today has a certain multiplier impact, call it x. So the TV purchase wasn't just worth $500 to the economy but $500 times x. If that's true, then wouldn't it be that the $37.50 in interest spent would have a negative multiplier effect of $37.50/x? If the consumer just saved and bought the TV at a later date, then the $500x multiplier would hold, just at a later date, without the debt service drag.

On the flip side, there are clear examples where debt is good. I think where consumers borrow to fund asset purchases that's basically good debt. Obviously it can go too far, as we've seen recently. But its safe to say that without debt, there really couldn't be a housing market. People just wouldn't be able to lay out the kind of cash needed to purchase a home, and in most cases home's are a reasonable store of value.

I also think a lot of business debt is good. Businesses need debt to finance capital spending. Unlike the purchases of a television, corporations investing in new plant and equipment creates value for the economy. If their ability to create value is in excess of the interest cost of the debt, then I think the economy is better off.

Unlike consumer debt, business debt should tend to generate future cash flow rather, as opposed to simply pull forward demand for consumption. Thus there really is a multiplier effect to corporate leverage. Obviously too much leverage can be bad, but not enough leverage could be bad as well.

Now this next part isn't going to be popular but I'm going to say it anyway. Another area where we really need debt is on Wall Street. Here is the reality: without leverage, arbitrage-free prices won't hold. The market couldn't serve its function of properly allocating capital through the pricing mechanism. Don't believe me? What happens if two bonds deviate from their theoretical value. Maybe its two Ford Motor bonds with similar maturities trading at wildly different yields. If dealer firms have access to short-term financing, they step in an arbitrage the differential away. If they don't, then the mis-pricing remains. Again, obviously leverage can become too great, so I'm not arguing that unlimited debt is good, but I am arguing that at the core, trading debt is good.

This brings us to public debt. I'm tempted to say its always and everywhere bad because I'd really love to live in a world of zero public debt. But truth is if the Federal government basically operated like state and local governments, I would probably label public debt as good. For the most part, local governments have to have balanced budgets. Despite some tricks governments pull (especially New Jersey and California, but that's another post), that's generally true. Where local governments issue debt its for capital projects, like school construction. Rather than raise taxes substantially every time they need to build a new school only to lower taxes after its complete, the government sells bonds to finance the construction. Where the government is acquiring a long-term asset, like a school, debt seems like a reasonable funding mechanism. Lord knows state and local government fund a variety of dumb spending. But compared to what the Feds finance? The states look like a bastion of responsibility.

Bottom line. Debt isn't bad. In fact, I still think keeping the debt markets generally open is a reasonable goal of government during a panic. However, the idea that debt-financed consumption is something that should be encouraged is highly questionable.

Tuesday, December 08, 2009

Bernanke: She lied to us! Terminate her immediately!

Ben Bernanke told us yesterday that inflation "could move lower from here," obviously suggesting that any Fed tightening is a long way off. These comments got the market's attention, particularly after Friday's surprisingly benign jobs number.

However, I think Bernanke is essentially telling us that the Rebel base is on Dantooine. He doesn't really think inflation is likely to fall from here. Consider his actual words: "Inflation is affected by a number of crosscurrents. High rates of resource slack are contributing to a slowing in underlying wage and price trends..." What is he saying? Currently, we have too much excess capacity to produce. Should aggregate demand expand, firms will soak up some of the slack, but its a long way from being inflationary. Its a little Keynesian, but its probably correct given the extreme amount of slack we currently have.

But that line of thinking only holds if Friday's improvement in unemployment is a one-off. And it might be. But what if it isn't? Its fair to say that this number was hardly out of the blue if you consider the previous trend. The Non-Farm Payroll statistic has been steadily improving for several moneths. Additionally, consider all the data we've seen in the last three months or so. Almost universally its been pointing to a muted recovery, but a recovery none-the-less.

The Fed won't be able to justify zero interest rates if unemployment starts falling.

There are already plenty of hawks on the FOMC. So far they haven't actually dissented but I think that merely reflects a willingness to acquiesce for now given how fragile conditions are. Read the recent speeches from hawks like Plosser or Fisher. You'll hear a consistent theme. Yes, I think extreme measures are warranted... for now.

If we see resource utilization (including labor) improving, the hawks will no longer be willing to give in "for now." Because the "now" will be something totally different. I've said it several times. There is plenty of room between zero fed funds and tight money. 0.5% would still be accommodative. 1% would still be accommodative. Hell my Taylor Rule estimate says 2% is right, so even 1.75% would be somewhat accommodative!

Now consider the position in which Bernanke finds himself. We have to remember that the man can hardly just go out there and speak his mind. When he saw the actual jobs number, (whether or not that was before the rest of us) I'm sure he was as surprised as we were. I'm sure it occurred to him that this could be a game changer. But can he come out and say that? Of course not. What if it really is just a one-off and actual job improvement is a long way off? Publicly, Bernanke has to wait until he's much more certain before saying anything too definitive.

So he goes out and tells the world that inflation could fall further, implying that monetary policy will remain as is for an extended period. I just don't buy it. If Non-Farm Payrolls turn positive in the next 2-3 months, we'll get a fed funds hike by June.

Friday, December 04, 2009

Don't get technical with me! 12/4/2009

Well! -11,000? I didn't see that coming. And I think its a game changer. There is no way the Fed can keep rates at zero while unemployment is falling. I just can't see it. I'm also willing to go out on a limb and say that one jobs start turning positive, they will stay positive. This doesn't leave me expecting blow-out GDP or anything like that. Its still a tepid recovery. But I think 4% 10s are on our target screens now.

For what its worth, here's where Fed Funds futures are. Pricing about 50% chance of hike in June. I've got to admit that you have to apply some odds to a hike in April. Suddenly my Taylor Rule post doesn't seem so crazy!

Alright on to the technical picture. Last week we bounced pretty hard off the 3.20% area which now looks like a triple bottom.

I also threw 3.48% on the chart (red line). Can't really say its a top since we broke it several times recently, but notice there's been a lot of work done right around that area. So I really wouldn't be surprised if we need to consolidate around this 3.48% area before we can push much higher in yields. Notice below that we're closing in on an over-sold area as well. (Note I'm using price of the old 10-year for this chart).

Once that happens I think its 3.71% then the recent high of 3.95%.

Meanwhile, back at Echo Base, check out the curve slope. This should be the real story when thinking about potential rate hikes. Strangely we're only 1bps flatter today. The 2-year should getting hit much harder than it is. Anyway here is a quick slope chart. Some people poo poo using resistance points with spreads but think about what the slope is. Its how much extra someone gets paid to go out the curve. Here it looks like when the spread hits about 265, investors start pushing out the curve...

Long-term I think the target might be +50 or zero, so this could be a huge play. How to play a flattener? You usually do something like short 10's and go long 2's and 30's in a certain proportion. Its a trade that often requires significant leverage and/or access to options on rate futures to really pull off. Our regular Joe readers ought to consider shorting mortgage REITs like Annaly Mortgage. They live for a steep curve.

Thursday, December 03, 2009

I told you it would work!

I've said it before and gotten all sorts of criticism, but the simple fact is that the Supervisory Capital Assessment Program, a.k.a. the bank stress tests, worked. Period. Bank of America's plan to repay the TARP is just more evidence proving this point.

You have to judge any endeavour on its own merit. That is, judge it on whether it achieved its goals. For example, its unfair to judge the Clone Wars cartoon series for what a moronic character Asoka is or for how Anakin doesn't seem to be a consistent character with the movies. Hell, I was watching with my 5-year old and at one point Yoda seems to imply that the clone troopers might be Force sensitive. Seriously? But its all OK, because my 5-year old loves it, and that's for whom the show is targeted.

Similarly, the SCAP was never meant to cure all that ailed the banking system. The purpose was to make it possible for banks to raise private capital. Before the SCAP, no one knew how much capital the big banks needed. Not just because of potential losses on balance sheet (which the SCAP did nothing to address), but because no one knew how regulators were going to react to those losses. No one had any idea that Fannie and Freddie were about to be nationalized and suddenly preferred and common shareholders were wiped out. Rhetoric was coming from all corners that banks needed to be nationalized as well, including from a certain Nobel-prize winning economist who many thought could be influential with the in-coming president.

Plus remember that the big banks were forced to take TARP money regardless of their financial conditions. What was stopping the government from simply declaring that it didn't like a certain bank's balance sheet and forcing it to take even more dilutive government investment? How could anyone invest in new bank common equity with such a high degree of uncertainty?

The only way to re-open access to private capital was to tell the market exactly how much capital the government thought a given bank needed. You knew that if the government said it was comfortable with a capital ratio of x, then investors didn't need to fear sudden nationalization if the capital ratio were actually x + 1. Sure, a bank could start out at x and then the situation deteriorates to x - 1 but that's the kind of thing analysts are comfortable with calculating. The whims of government? That's something else.

What happened after the SCAP? Investors knew that if bank losses were in the range of those projected by the tests, they didn't need to worry about dilution. Only about profitability. And with bank book values so low and the yield curve so steep, investors were willing to make that bet. Even with sketchy banks like Regions and Fifth Third.

Now is everything bright and bi-sun shiny in banking? Obviously not. I've written several times that I still think banks are quite vulnerable. But as a tax payer, I'm pretty happy to be getting out of banks. The alternative was much worse.