US Economy Has Its Legs But Heads Up For The Piano - The Week Ahead

Economic forecasters have been busy. We’ve got several key releases next week, among these Feb Personal Income on Monday, the Mar Chicago Purchasing Managers Index and Feb Factory Orders on Thursday, then Mar Vehicle Sales, Feb Construction Spending and the key Mar Employment report on Friday.

And what are we to make of this release stream? Just this: At the end of the week we will see that the labor market continues to improve, that factory activity is strong, that vehicle sales are robust.

Clients should prepare for that result.



Also next week we can expect the Japanese to make further progress in sculpting a rescue package. Production stoppage exists but is priced in. We can’t comment on renewed nuclear concerns aside from the caution to discount the headlines - for those in search of the truth, the media make poor bed mates.

Japan’s Nikkei average dropped 10% the week of Mar/13. On Mar/14 there was pure panic, world financial markets. On that day we provided an anchor, telling clients to look for resolve, resilience, a quick rescue package, this as the herd went off the cliff. We noted that economic contagion would be limited. The only real potential danger to US interests, we noted, was repatriation. So we advised clients to expect a quick turnaround. Sure enough, Asian stocks last week just showed the largest gain since November. Thank you very much.



So far, so good. In the most general sense then, clients can expect a continued firming in US equity prices and higher interest rates.

Unless:

The Mid East will continue as the principle potential retardant to US vigor.

All sorts of “rules-of-thumb” exist on the Street - $10 higher in crude triggers such and such % reduction in US GDP. We don’t use “rules-of-thumb” around this shop. We know that conditions for price discovery rarely repeat. Let the kids resort to gimmicks.

It’s enough to know that course-of-least resistance for crude will remain higher over the intermediate term. Witness unrest in even Jordan for goodness sake. Still doubt contagion?

We printed 106.69 on May WTI, Thursday, closing Friday at 105.52. Prices in this range will discourage spending. A Saudi / Iranian conflict would print our 120 high-side target in a jiffy. An Israeli strike would do the same. This is dangerous stuff here folks. It is not as Bernanke implied, a blip. Take it seriously.

Robert Craven

Review

One’s track record is key. It is in fact all you own in this business.

If we cherry pick, slide away from past predictions we then become simply one of the crowd, holding hands, shouting out together in the dark. One of these was the economist Paul Samuelson who said that, “.. to be published is to be found out.” We’re not interested in joining that club.

Most of what we predicted Q4 for the US economy is now reality, much of it priced in. However, it is useful to visit those sectors where we could have done better. One of these is manufacturing. That sector has flattened estimates. Our job is to detect major flaws in consensus but we missed that one. Next, although the consumer cooperated Q4, he slowed his pace a tad, so far Q1. But we predicted an acceleration for Q1.

Aside from these we are fairly pleased with results, which includes of course jobs. Private sector growth is expected to increase 200M for Feb, that release tomorrow morning. If so that will fit our anchor quite nicely. But even if tomorrow’s report is for some reason weaker than expected, we can look for much stronger reads ahead. That will be the trend for this key sector.

Finally, to the Mid East: The pursuit there of consensual gov’t will only increase by the way of breadth and intensity. That movement will be adorned with major upheaval and no doubt more violence along the way. Thus the clear risk of higher crude prices remains. So for example an abrupt and peaceful ending to the crisis in Libya would cheer markets, tanking crude. We would then advise our clients to take advantage of this price movement because there is more to the Mid East than Libya. This week’s arrest of a Saudi cleric for calling for democratic reform and a constitutional monarchy simply reinforces this view.



Robert Craven

Middle East

We have followed the Mid Eastern situation rather closely past years. Investors world wide are at this writing trying to guess the extent of contagion in that region. We can help them. It will be all enveloping.

A fissure has been detected and it will be exploited. To repeat from an earlier sketch - this movement will not be limited to Egypt and Libya. We are now at launch time.

The degree of violence accompanying this adjustment is an unknown to us. However, the course of least resistance for crude prices over the intermediate term is higher. A 30% increase in crude (for ex., 125 on W Texas inter.) is the high side risk as we take this path. And that would deliver a significant retardant to US growth, especially crimping consumer activity, shaving at least 1 ½ % from GDP if maintained for very long.

Corporate planners and investors are to account for this risk.



From Mark LeVine, a prof at UC Irvine, and sr visiting researcher at the Centre for Middle Eastern Studies at Lund Univ in Sweden: “The youth of the Arab world, until yesterday considered a ‘demographic bomb’ waiting to explode in religious militancy and Islamo-fascism, is suddenly revealed to be a demographic gift, providing precisely the vigour and imagination that for generations the people of the region have been told they lacked. They have wired - or more precisely today, unwired - themselves for democracy, creating virtual and real public spheres were people from across the political, economic and social spectrum are coming together in common purpose.”

And so it is. Even now we witness the unthinkable - protest in the quiet backwater of Oman, before a sedate and tranquil country. Two people have been killed. Suddenly the Sultan has promised to create 50M jobs, plus an allowance equivalence of $390 for job seekers.

The Sultan does not understand that he and his kind cannot provide a solution; they are the problem.

Naturally, an evolution to consensual gov’t in this region is a plus for the US. It is a guarantee as we said before of long-term energy security (another is enlightened US energy policy, material for another sketch).

We have witnessed the birth of a new era in the Mid East, one which can only enhance the interests of the West in years to come.

Robert Craven

Central Planners at the Fed

It never works. A planned economy that is. As most of the world has given it up - China and India the largest and most recent examples - first Obama, and now Bernanke have embraced it.

With 2012 in mind Obama pretends he’s learned his lesson. Bernanke makes no such overtures.

The Fed’s mandate was price stability; full employment is now included. An individual or individuals may see to the first, the later is far out of scope for any would-be social architect.

When the Fed sticks close to home - supplying or extracting short term funds, letting the rest of the term structure see to its own, it does pretty well. When the Fed tries to manipulate longer term interest rates - rates then no longer driven by the old fashioned myriad of mkt pressures, but by planners at the FOMC - we are in for some trouble (See our Feb/9 sketch).

Sure they’ve got all the statistics at their disposal, sure they’re all experts, these Fed types, sure they’ve got the power to pull almost any trigger. But that’s no different from any planners of the past - all of whom have failed. Heck, even modern day Communists and socialists have begun to repudiate this approach. Communist China, a phony, knows best. As they replaced planning with more reliance on markets their growth rate spiked.

Thomas Sowell reminds us that, “Elites may have more brilliance, but those who make decisions for society as a whole cannot possibly have as much experience as the millions of people whose decisions they preempt. The education and intellects of the elites may lead them to have more sweeping presumptions, but that just makes them more dangerous to the freedom, as well as to the well-being, of the people as a whole.”


Robert Craven

Conspiratorial? Certainly Not!

We’ll see quite a little data this week folks. Some carries no mkt-moving potential. Some does, beginning with Jan Retail Sales tomorrow, then on to the Jan PPI, Housing Starts and Ind Production data, all on Wed., then finally to Jan CPI and the Phil Fed’s Regional Manuf’s Outlook survey on Thur.

By Friday we will have seen that core price pressures remain contained (because that which in not “contained” is ex’d out). We will see that consumer activity continues to grow, that manuf is booming. If longer-term interest rates where only impacted by this data, in isolation then they would be just a tad higher at the end of the week, and only a tad as the mkt crowd is told there is no inflation; they take that home with them.

We can peer offshore for just a moment however to see what would happen to US rates if the mkt view grew for inflationary pressures. The UK Gilt (10 yr UK obligation) is now 50 or so basis points (each “basis point” is .01 of 1%) higher that beginning year levels, last at 3.85%. The US 10 yr is only 30 bps higher for the same time period, last 3.66%. Measured inflation in the UK is almost double that in the US and the Fed-fueled spike in global commodity prices has had a heck of a lot to do with it (along with a weak currency). But Bk of Eng gov King won’t budge, won’t brake with a hike, parroting Benanke that inflation is near zero if one ex’s food and energy.

Well folks, we are not of a conspiratorial bent. However, if we were we might say that the Fed is going to extremes, looking for any excuse to keep rates in the cellar, because of its incestuous relationship with major St firms - the two are linked at the waist. We know from personal experience this to be a fact. Unusually and unnaturally low rates make a ton of $ for St firms; they can finance practically any inventory at a profit. There is a good part of your answer why the Fed, and maybe even the Bank of England are looking the other way.

Oh, but then we’re not conspiratorial. Forgot that.

Robert Craven

Thouhts on the Fed chair before the House.

Chairman Bernanke defended his expansionary policy today. Our view is that it’s misguided.

But whatever it is, it is a stealth operation. Bernanke points to Core CPI (not the broader #) as cover for QE2, noting that Core CPI is now as low as it's been in many years. Well naturally Ben. It’s “EX” everything that’s on its way to the moon - food & energy. This is convenient for the Fed, just as it was when Art Burns decided to take food & energy out so he could fuel Nixon’s reelection. It stuck. His rationale? The Fed has no control over wheat or oil prices; these are mostly driven by weather and other acts of God.

Now of course the spike in world commodity prices is driven, not just by natural phenomena but by the Fed’s dollar-creation machine. It hits first the 40-odd countries who peg or closely peg to the $. As we noted in an earlier sketch, they either import inflation (print their local currency to buy $’s to keep the $ expensive) or they allow their currency to strengthen and tank their exports. Either way, it comes back to hit us, or a portion of it does.

Too bad for offshore folk but not to worry here in the US says Bernanke because he can exit gracefully when things become overheated. Maybe so but we don’t see how. Recall that under QE1 & 2 the Fed buys longer-term treasuries and mortgage paper through so-called recognized dealers. It pays for these bonds by crediting the banks’ account at the Fed. (If the bank wants paper $, the Mint takes care of that, and delivers the things in trucks.)

So how will Bernanke reverse? He will sell securities to this group, reversing the process by taking the money out of circulation. If he sells short-term T-bills, short term rates will move higher. If he sells longer-dated stock, longer term rates will come under pressure. They don’t own as many t-bills so we guess they’ll hammer the longer end - 2 - 10 yrs perhaps that impact all of us.

He figures he can fine tune the act but over the years we have never known the Fed to have much of a handle on anything but their traditional targets - O/N money and reserves. They are far out of their league when they try to figure the direction of longer rates.

Every prospective home buyer, corporate planner, trading operation and saver has a stake in just how they pull this off, if at all.

Robert Craven

Thalidomide and the Fed

Until their plan to buy everything-under-the-sun the Fed provided (or extracted) liquidity mainly through an O/N market by the way of so-called “repos” or “reverse repos,” these with so-called registered dealers. The Fed fine-tuned with “Fed Funds” as the speedometer. FF’s is the rate prime banks charge each other for O/N money on which to make their required reserves good with their regulator. Some are flush, some aren’t. The hungrier banks are to make loans the more pressure on FF’s. If the Fed wants to slow things then they won’t meet the demand in that mkt; short term rates will spike, and in theory, economic activity will slow. If the Fed wants to be accommodative they supply more money to that market; banks take it as reserves and (Econ 101) the multiplier effect takes over.

Key here folks is that nothing was forced on the market, on the general interest rate environment; takers could come to or stay away from the trough, given demand or lack of in the economy. Longer-term rates ( 2 - 30 yrs) which impact all of us, were left to find their own level.

This worked fine until Q4 ‘08. Policy makers were desperate. Nothing in the medical cabinet would impact this new pathogen. Thus massive Fed intervention - no longer just short term operations, but buying long treasuries and mortgage paper, QE 1 (12/08 - 3/10) - was meant to 1) prevent a world meltdown and then 2) fire a recovery with lower rates. The meltdown was prevented. No one knew the side effects of this kind of medicine however.

Now there is no crisis but they’re at it again. We all know that Bernanke decided on the second major dose - QE 2, Nov ‘10 and plans to continue that medication to Q3 ‘11. Bernanke is now out of his league; if there is a Oath of Hippocrates for central bankers he hasn’t taken it.

Instead of a central banker he has become a government planner. QE2 is fraught with danger. His intervention is a useless as Obama’s attempt at gov’t planning, that which delayed the recovery. Bernanke is providing money which is not needed or wanted, except by the gov’t, banana republic style (The fed owns more Treasuries now than the Bank of China.) The US economy in not in need of liquidity.

The Fed’s program is meant to 1) feed the gov’t and to 2) feed the home market, a repeat mistake. It only penalizes the prudent - savers who would otherwise put their savings to more productive uses. This provides a distortion as these lower rates are purely artificial, driven by money created out of thin air. The Fed’s buying spree could create the very bubbles which brought us here in the first place. At the very least it is creating malformations on the US economic body.


Robert Craven

Update

First, to spending. Last week we saw that consumer spending for Q4 ‘10 gained 4.4% (the most since Q1 ‘06 ) following a 2.4% increase Q3. We did not know at the beginning of Q4 that spending would print 4.4%, only that it would flatten St estimates. This was the result.

Look for any surprises over the near term to be to the side of more, not less vigor than forecast. This is the course-of-least-resistance for the US economy and it is especially true for discretionary spending. Thus planners in those businesses linked to such activity are to embrace the reality of more demand for their product, H2, not less.

Background: Most analysts missed recent vigor because they 1) did not fold results of Nov/2 and traction obtained into their models, 2) gave imbalances in housing and the mess in states’ finances too much weight and 3) took consumer confidence reports to heart.



Of course, there are always wild cards - those cataclysmic events which carry the hrsp to retard US growth. A closure of the Suez Canal is one. This brings to mind the current crisis.

We followed the Mid Eastern situation (including the Brotherhood from ‘06) in a separate blog. http://bobcraven.blogspot.com/

Better, see the recent article by Vic Hansen for a primer http://pajamasmedia.com/victordavishanson/whats-the-matter-with-egypt/.

After that exercise readers will understand the failure of Mid Eastern society, and, the West as the appointed scapegoat. Along comes the internet and anyone under 40 got jealous. Dictators stand in the way. Here is the cause of recent violence. The trigger however was food prices.

Some Western observers have blamed the Fed for the recent chaos and even deaths; they argue the US is an exporter of inflation expressed in the very commodity prices which triggered this deal. Let’s see what this is all about.

Sure enough, inflation in milk and flour prices triggered protests in Algeria that left 3 people dead. Then a food vendor in Tunisia set himself alight. Now Egypt is ablaze. Egyptians suffer for example because cereal grains are up 39% in the last year, oils and fat, up 55%. Going after the nearest bad-guy target - Mubarak - is understandable.

But is Bernanke also one of the bad guys? In the sense that he conducts US monetary policy without the interests of the developing world folded in, he is. But it takes two to tango and the complainer, the developing country must make the decision to import inflation to get things going!

Higher commodity prices are not just a monetary phenomena of course - witness the worst drought in Russia and the Black Sea region for 130 years, late rains in Canada, Nina disruptions in Argentina, and a series of acreage downgrades in the US. But what about money?

We know the Fed is flooding the world with $’s; the more of them the less they’re worth. And we know that an Egypt, or a China, or an Algeria or any other developing country must buy their food in $’s. But these guys are mostly exporters. What happens if the $ cheapens relative to their currency? Right, this dampens their exports (one $ buys less), their life blood. So what do their central banks do? They print their currency out of thin air and buy dollars. Why? To keep dollars expensive to the local currency. Thus, just like China is doing these countries make a choice or decision to import inflation. That is the core to their problem. At the expense of their own savers they flood their own mkt with their own currency. That’s about all there is to it.

An Egypt or China which may want to insulate itself from this food inflation has to appreciate its currency significantly. But then its exports would tank. No way they’ll do that. Or, they have to subsidize food prices - price controls. These measures always fail. Absent these two drastic measures, countries have to live with the implication of US monetary policy.

Robert Craven

Update

Let’s take a look at the balance of the week.

We’ll see the Fed’s Beige Book tomorrow (1/12). This will reflect Bernanke’s recent commentary that improvement is noted here and there.

Thur (1/13) we’ll see the PPI for Dec, then CPI on Fri (1/14). Both of these numbers have acquired market-moving potential because of the Fed’s aggressive expansion of the money supply. If either or both are to print numbers say double expectations, the world mkt will assume the Fed’s got itself in a tight spot and yields will spike. The odds for such a print are low, but this does accurately reflect the tension in the marketplace.

Also Fri (1/14) we will have Dec Retail Sales. Estimates have been shaved a tad due to extreme weather, the end of the reporting period. Still, past few months we have predicted that consumer activity would surprise to the side of vigor. This has been the result, especially for discretionary purchases. We look for more of the same, ongoing.

Finally, the media is saturated with news of distress, EU credits. What’s this mean for the US? Not much.

There will be a nick in US exports given the recent weakness of the Euro to the $(a Euro buys fewer $’s). But major contagion? No. Our banks have very little exposure to the EU periphery credits. The real wild card as we noted earlier is a collapse of the currency. That’s something else.

Background: Nothing good can come from paranoia. But that is just what birthed the EU - the dread of US competitiveness. Sovereignty was ditched throughout Europe. There was a great leveling. Terrified, all rushed together, the weak and the strong, to row one boat. Weaker members inevitably slack on the oars. The ship is now off course and perhaps, bound to run aground.

Solutions to the current crisis were being delivered piecemeal, without recognition for example that Greece, Ireland and Portugal are insolvent. The stubborn ECB had refused to do much. But today Japan eclipsed the ECB and offered to buy a good hunk of the bonds being readied to support EU periphery credits. That helped. So did China’s promise to buy Spanish debt. And so did rumors today of increased ECB purchases of Portugese debt.

The lesser credits of Europe the poor devils got themselves in a trap - borrowing heavily, pre-crisis, in hopes of a continuum. US Democrats, always made out to be darlings in the European press were trusted by this bunch - those same Democrats who sowed the seeds to tank the world markets. Now we’re alright, or getting there, but these credits never recovered. Investors are selling their bonds as they can’t seem to pay their bills. And as investors do that, these credits’ debt bills soar even more as interest rates climb.

World creditors now demand 7% to loan the Portugese 10 year money (actually 7.24% at one point yesterday, triggering ECB purchases which put the rate back down closer to 7%), vs the already high 5.5% that Greece and Ireland are paying the EU emergency fund, vs 3.51% for the UK Gilt 10yr and 3.35% for the US. And if Portugal goes, and she may as she’s not growing fast enough to service her debt, then Spain is right behind, or such is the perception. Makes sense - Spanish banks are one of the largest holders of Portugese debt.

These folks should have listened to Thatcher.

Robert Craven

Too Big For Its Britches?

The Federal Reserve system was created under Wilson in 1913. Originally tasked with protecting the value of the currency its mandate was expanded in the 70's when the Federal Reserve Act was amended to promote the goals of, “maximum employment, stable prices, and moderate long-term interest rates,” (Section 2A).

“Stable prices,” means protecting the value of the $. The Fed is armed to do this by expanding or contracting the supply of $’s available - too many and they are worth less, too few and they are worth too much.

“Moderate long-term interest rates,” are not something the Fed controls very well, if at all. “Maximum employment,” are the two words however that can get the Fed in a lot of trouble.

At the moment critics claim that through the pursuit of this “maximum employment” mandate the Fed has been reduced to an extension of the administration, that is, Bernanke more the politician than the central banker.

We’ve all heard of QE2. This means that the Fed is buying practically everything under the sun in an attempt to quick start a recovery. The idea is to get medium-to-longer term rates lower, the dollar just a tad weaker in order to spur exports, all of this with employment in mind. This is not equivalent to addressing a crisis, to preventing a melt down. (Without the Fed’s emergency action Q4 ‘08, we’d all be paupers.) No, it is a completely discretionary, non rule-based activity and a mistake, one which first will have little to no impact on the pace of recovery and two, is corrosive to Fed independence, a necessary item, the heart of monetary control.

It is this trend at the Fed toward discretionary actions that is alarming to so many and who see this, correctly we believe, as just an attempt to bail out BO’s failed fiscal policy.

A group of 23 economists, money managers and former government officials issued an open letter to Bernanke on Nov. 15 saying the central bank’s planned bond purchases “risk currency debasement and inflation” and won’t boost employment.

Another critic is Fed governor Kevin Warsh, who noted recently that, "The Federal Reserve is not a repair shop for broken fiscal, trade, or regulatory policies.”

Apparently, Bernanke is not listening. We need only recall Hayek’s “Fatal Conceit” to know that a few individuals, no matter how gifted cannot replace in their judgement the complexities of a free functioning market. This applies to the FOMC as well as to Obama’s wanna-be planners.

We have followed the Fed closely for 20 years; never has it come so close to shedding its independence. Let us hope the new Congress re-writes the Fed’s mandate to confine its activities only to those of price stability.

Robert Craven

Lame Ducks Up To No Good

Just after the Nov election we highlighted a caveat to our otherwise constructive view. We might have listed this very same item as a wild card. That would be the odds that lame duck “progressives,” still welded to their twisted ideology despite, to borrow a phrase from Irving Kristol, having been “mugged by reality” will do significant harm to their Country, and simply out of spite.

We are referring of course to the left’s insistence that the rich pay up. Why the jealousy, who knows, but it can be nothing else but envy as all but the most economically illiterate now understand that tax cuts fire growth. They are in everyone’s best interest. So what if a guy making $500M gets to keep a little more. All the more likely he will plant a new garden, or maybe buy a vacation home and in so doing enrich others (nurserymen, realtors to name two of these).

From Paul Bedard of US News, “Failure by Congress to extend the Bush tax cuts, especially locking in the 15 percent capital gains tax rate, will spark a stock market sell off starting December 15 as investors move to lock in gains at a lower rate than the 20 percent it would jump to next year, warn analysts. . . .While it is unclear how bad the sell off could be, it could wipe out the year's gains......”

Not really. There will be no Dec/15 massacre as the market’s take on the odds of the lame duck tax event are already being priced in.

But there’s still no excuse for the Dem’s sordid behavior.

Pelosi and fellow partisans (not retards as they know exactly what they are up to) continue to pimp two falsehoods, the first that gov’t spending counts for something aside from union payoffs, and the second that tax cuts “must be paid for.” They’re not fools. They’re traitors.

From Michael Boskin, econ prof at Stanford, “My colleagues John Cogan and John Taylor, with Volker Wieland and Tobias Cwik, demonstrate that government purchases have a GDP impact far smaller in New Keynesian than Old Keynesian models and quickly crowd out the private sector. They estimate the effect of the February 2009 stimulus at a puny 0.2% of GDP by now. By contrast, the last two major tax cuts—President Reagan's in 1981-83 and President George W. Bush's in 2003—boosted growth. They lowered marginal tax rates and were longer lasting, both keys to success. In a survey of fiscal policy changes in the OECD over the past four decades, Harvard's Albert Alesina and Silvia Ardagna conclude that tax cuts have been far more likely to increase growth than has more spending.”

Robert Craven

Learning Experience?

We have the key employment report on Friday, this for the month of August. The near term value of every 401K or small business hangs in the balance. We better take a look at this thing.

Formally known as the Non-Farm Payroll report, the BLS gives us a monthly read for payroll in all categories except farm, domestic help, general gov’t employees and some non-profit employees. Why BLS types are afraid of cows or maids, we’re without a clue.

Past years, the market-moving potential of this release was huge. We know. We used to trade each release. With the general dampening of bond-price change, past decade, interest rates are not so vulnerable. Stock prices have replaced bond prices in that regard.

First, the likely result. Let’s take a layman’s look at the components: 1) Overall Payroll is expected to have dropped by 100M, due primarily to census bureau layoffs. Private sector employment is expected to have increased by some 40M. 2) The Average Workweek and Total Hours Worked are expected to be unchanged. 3) Unemployment is expected to hit 9.6%. 4) Hourly Earnings rose a tad, maybe 0.1%.

That’s the guts of the thing. Anything a lot worse and your 401K will tank. Any discretionary spending that might have been coming your way will vanish.

Now let’s think with our pocketbooks. We know that employers are scared to death of Obama. We know this because they’ve told us so. Witness Paul Otelinni, head of Intel, two weeks ago at the Technology Policy Institute’s Aspen Forum. From the IBD, “The Intel chief was harsh on the massive spending by the White House and Congress — and on the failure to extend the Bush tax cuts, the takeover of the health care industry, and the threat of new taxes on businesses to remove carbon from the atmosphere. ‘I think this group does not understand what it takes to create jobs,’ he said. ‘And I think they're flummoxed by their experiment in Keynesian economics not working.’”

OK, that is established, and, it is key to the prolonged slowdown.

And so this reading carries double the horsepower. Not only is it a reading on an economy in isolation, but a reading of an economy, for the first time in our lifetime, hanging on the whim of hamstrung employers (who by the way are cash rich).

So here is what you do, all our lefty-small-business-owner pals out there. If this release blows through estimates to the upside, you can celebrate. Buy a new Volvo or tie-dyed shirt. It means more discretionary spending in the future; folks will buy your flowers and spend for new breasts once again. If the release is below or at expectations, then be prepared to vote Republican in November. You don’t have to tell a soul, not even your spouse. But if you care about the bottom line, it’s a good move.

Face it lefties. You screwed up big time. Before you were insulated - ok for everyone else but you. It felt good to talk up the typical abstract notions. Now the hens have come home to roost because for the first time in recent memory, you guys actually gained traction by the way of BO.

How’s it feel now, making the personal sacrifice?

Try making it a learning experience while you’re at it.

Robert Craven

Wisdom From A Rocker

Ted Nugent’s an icon out there; what he can do with the Gibson most only dream of. His 6000th concert was in 2008; 30MM records and he’s still going strong. There’s many who claim these music types are a hopeless lot, that they’ll never learn, a burden of the rest of us. Certainly PP&M lend credence to that theory, but then again Baez gained an anchor and in spite of the company she kept. Nugent never had that problem - he had a grip from the get go.

Ted writes in today’s Washington Times. He demonstrates a keen grasp of the US financial situation, showing evidence of scholarship that perhaps only those of us who have taken the effort really appreciate. He reminds us at the beginning that when you’re in a hole, stop digging. Nugent notes that we are in hock to the tune of $14 trl (maybe $100trl if Medicare, Medicaid and S Sec are included). “This gigantic level of borrowing and spending is unsustainable by any measure, by any means,” Nugent explains. “The only real reason Fedzilla would do such a thing would be that those currently in charge want to destroy America and turn us into a Third World nation.”

Well, not sure we can agree that the average Democrat actually understands that by their vote they are destroying America; most are blissfully ignorant of the policy implications. The hard core - Obama and his type, yes, they are out to destroy a way of life, certainly that is so.

Nugent continues, “America is in a deep financial hole. Obama’s solution to this hole: Keep borrowing and spending. Dig, baby, dig. We shouldn't expect anything different from a president and administration who don't have a clue about how private industry works or how Fedzilla's policies stifle growth. At least from my research, I still can't find anyone on the president's closest team who has actually started a successful business. I can however find Che Guevara and Mao Zedong fans. Phenomenal.” Indeed.

Nugent may not be the world’s best writer but he does have the bull by the horns - accurate and direct. For support he quotes Erskine Bowles who heads BO’s debt commission, who told the National Gov’s Assoc the other day that, “This debt is like a cancer. It is truly going to destroy the country from within.”

Nugent’s solution: “The very first thing we need to do is elect a fiscally conservative House and Senate this fall to serve as a dam against the Fedzilla tsunami of spending. Then we need to hold them accountable. We need tax relief across the board, from businesses to individuals. Nothing will get the economy moving faster than keeping money in the hands of American businesses and people who earned it. America should have the most pro-business tax structure on the planet. We do not. My home state of Texas has the best economy in America. Interestingly, Texas has no corporate income tax, capital-gains tax or personal income tax. Don't tell me that reducing taxes across the board will not put people back to work.”

Well put Ted.

Robert Craven

Fear of Free Markets

Certainly the shanghaiing of health care was center stage in Washington. Yet there is something more we can extract, something even profound, something freighted with more gravity than this mere perfidy - that would be the chilling instinct of so many to fly to government for security, for protection from the workings of free enterprise. Why?

Gary Becker and Milton Friedman founded the Chicago School of Economics. Both are Nobel laureates. We lost the great Friedman but Becker at 79 is still very active. The WSJ carried an interview with Becker at Stanford’s Hoover Institution.

When asked about the health deal, "It's a bad bill," Becker replied. "Health care in the United States is pretty good, but it does have a number of weaknesses. This bill doesn't address them. It adds taxation and regulation. It's going to increase health costs—not contain them." Thank you.

But on pondering our key consideration - why for example capitalism has produced the highest standard of living in history and yet its beneficiaries sometimes forget that and look to government for protection, from higher health care premiums for example - Mr. Becker explains: "People tend to impute good motives to government. And if you assume that government officials are well meaning, then you also tend to assume that government officials always act on behalf of the greater good. People understand that entrepreneurs and investors by contrast just try to make money, not act on behalf of the greater good. And they have trouble seeing how this pursuit of profits can lift the general standard of living. The idea is too counterintuitive. So we're always up against a kind of in-built suspicion of markets. There's always a temptation to believe that markets succeed by looting the unfortunate."

Many of the left tend to feed exclusively on the bottom; like catfish or carp they feel secure down there. And they want the rest down there with them. But the notion that free enterprise is bad, that it spawns inequality of opportunity, is a myth. The easy way out, that chorus that the rich exploit the poor, or, to update, that insurance companies exploit consumers is utterly false IF government’s role is limited to preserving the rule of law. High health insurance premiums are no secret for goodness sake. But when a free market is permitted to operate then it is in everyone’s best interest, and, in all arenas including health.

And so we see that absent the left’s hijacking of the health sector, the fix would have been easy. As Becker explains, "Health savings accounts could have been expanded. Consumers could have been permitted to purchase insurance across state lines, which would have increased competition among insurers. The tax deductibility of health-care spending could have been extended from employers to individuals, giving the same tax treatment to all consumers. And incentives could have been put in place to prompt consumers to pay a larger portion of their health-care costs out of their own pockets."

Instead, BO artfully exploited the groundless fears of capitalism and the instinct of many to look to government for a fix. He understands the indolent nature of a good portion of our population, those whose library is stuffed with past issues of People, Newsweek and Cosmo but never an Adam Smith, John Stuart Mill, Buchanan, Stigler, Hayek or Friedman.

Robert Craven

Interest Rates IV

This final sketch - a tad delayed given Santa was in town.

Let’s try to make interest rates work for us. One of the first places to look - one’s portfolio.

The last 10 years have been good to bond holders. Fine. But recalling what we learned earlier, if we still hold bonds then perhaps an adjustment is in order, especially if maturities are far down the road. It’s not likely we want to keep it all there if interest rates are header higher.

Or perhaps we own fixed income mutual funds; perhaps some of those holding are offshore, perhaps sovereign debt (Ger., UK, Finland, Spanish, etc.). Maybe a few of us even own this debt outright. Here too, an adjustment may be in order. With very recent downgrades of Greek and Spanish debt, sovereign risk is assuming center stage. This is something quite new, at least for advanced economies, forcing many of them to pay more for their borrowing regardless one's outlook for the inflation component.

Finally, let’s look at the dollar. The dollar's rise from all-time lows is at least partially due to the expectation that the Fed will begin raising interest rates sooner than previously expected. Higher interest rates, coming off a base of zero, can hardly be considered a threat to economic activity, although as we know now, they are a threat to fixed income prices. But there’s another aspect to consider. Higher interest rates might in fact benefit a good many of us, those who have significantly more floating-rate assets (e.g., bank CDs and money market funds) than floating-rate debt (e.g., adjustable rate mortgages). Just a thought.

Take a look at the yield curve from time to time:(http://www.bloomberg.com/markets/rates/index.html.

We’ve got some tools; add to them, then go for it.

Robert Craven

Interest Rates III

Interest rates, continued.

The Term Funds market is the largest slush fund in the world. This is where US banks come to take care of business. Some banks are flush, some banks are short; they work things out. All banks have reserve requirements to meet and other short-term needs. Here is where they come to fund these liabilities. Maturities are from o/n to two weeks, some even longer. Banks lend/borrow to/from one another, without collateral. This is the heart of bank liquidity. Early Q4, 2008 this market seized up; it locked in place. As a result we were only weeks away from a free fall, one which would have made the Great Depression look like a party. Only thanks to the G-20's quick maneuvering were we spared.

In Q4, trust vanished. No single world institution trusted any other (notwithstanding decades worth of relationship). No one knew just how poisoned collateralized mortgage paper really was, or, who owned how much of it. The banks lied to each other, and, to regulators. Thus, even though funds extended in the term funds market are of a very short maturity, no one was sure if they’d get anything back.

We all remember that time. To most of us, there was an uneasy feeling, but of exactly what we weren’t sure. Major world financial institutions on the other hand, being players, feared they might not see another sunrise. They knew the implications. In what is called a "flight to quality" they sought shelter in short term US obligations - Treasury bills. These offered the least specific credit risk (visited earlier) of anywhere else in the world and no inflation risk. Recalling our anchor, prices erupted, and yields plummeted, so that the 90 Tbill yielded a tick or two away from 0%!

Next, the Fed came to life, pumping money into the system. To do this they target Fed Funds, the O/N rate in the term funds market, as a gauge of tension. The rate had been 2% end of Q3; the Fed cut it to 0.25%, effectively 0%. This means one thing - all the money you guys need is there for the taking. But, it did not help. It was, like the old saying goes - pushing on a string.

Finally, G-20 central banks guaranteed inter-bank transactions. Slowly, normalcy returned to the world’s liquidity situation. Since that time, the Fed has expanded its balance sheet, buying practically anything under the sun - they can buy a herd of longhorn steers if they want The Fed is using its balance sheet to support the housing market and economy generally (a process effective over the near term but fraught with danger).

This brings us conveniently to the Yield Curve - the pattern of US interest rates from O/N to 30 years. This is a very handy tool. We should all keep an eye on it. In Jan/08, FF’s were 3.5%, 90 day LIBOR (another short-term measure) was 3.31%, the 2 yr Treasury 2.19%, the 10yr 3.56% and the 30 yr 4.27%. At this writing, FF’s at 0.14%, 90 day LIBOR is 0.25%, the 2 yr, 0.85%, the 10 yr 3.55% and the 30 yr, 4.48%. Whoa! Quite a story this gives up. Observe how short rates out to 2 yrs are in the cellar compared to the period just ahead of sub-prime concerns, yet observe how the 10 and 30 yr yields are near the same levels. Given what we learned earlier what does this tell us? Easy. Everyone in the world wants to own short paper as is obvious by the exceptionally high prices, thus negligible yields. We know why. No one is investing, no one is hiring. Most are content to sit on it. Keep it short and safe. What about the long end, 363 basis points (a b.p. =’s one hundredth of 1%) over the 2 yr vs only 208 in Jan/08? That tells us that because short term rates are so cheap, the world’s markets are beginning to price in inflation, that is, an expansion of that component in the summary yield. This is the message of a steeper yield curve. This is not reality necessarily but consensus anticipation of reality, right now. The 30 year is cheaper (lower price, higher yield) than it was almost two years ago, but the economy is weaker. This should be the other way around should it not? If this situation continues, it will be a read flag to the Fed; for the moment however, the recovery is too fragile for the Fed to begin to reverse its past actions.

In the next and final sketch of this series we’ll look at more practical considerations, a tad closer to home.

Robert Craven

Interest Rates II

We continue with interest rates.

All of us encounter interest rates, either as borrowers or as creditors (investors) or both. And for a lot of us, casualty is a big mystery. What forces move these things? Greenspan for example and other "experts" make them out to be nothing if not bewildering. But in fact the basics are not bewildering at all. We can fetch all the tools we need to make our lives more comfortable around and about interest rates.

Before we can translate economic activity into interest rates we need to know the fundamentals; we’re not launching a satellite here folks, just developing an anchor. After we have done that, we can take a look at a real life petri dish, the breakdown of Q4, 2008, and the follow through. We hope to acquire some tools in the process.

What is interest? It is in fact an aggregate composed of three elements. First, the pure or base rate, second, the inflationary premium (or lack of) and finally, the credit risk, that is, risk of default specific to the debtor. Assume you own the debt (bonds) of a corporation. The maturity is 10 years and the coupon is 6%. Of that 6%, perhaps 3% is the base, or fair rate at which, all else equal, you will lend money to a near riskless credit, and that borrower will pay for the privilege. That leaves 3%. One and one half percent assume is due to inflationary expectations, that is, the expected corrosion in value due to a weakening currency that you will demand over 10 years. Finally, the remaining 1 ½ % is credit risk, that risk the market has assigned to the probability that the borrower which owes you money, will fail. This all adds up to 6%. The calculation, the process is usually more complex; we don’t care. For our purpose, this is enough.

Next, we must understand how the movement in interest rates impacts debt prices. Very simple - interest up, price down / interest down, price up. Back to our example - bonds at 6%. Assume you are the owner of one bond (usually in denominations of $1000). The coupon of 6% pays $60 annually. You decide to sell, not waiting for maturity. But assume a recession has interceded so that interest rates are now 3% for similar credits. Only a fool would give the buyer $60 a year or 6% when the market rate is 3%. You adjust the bond price and demand $2000. The $60 coupon now yields 3%. That’s all there is to if folks. This is the core or heart of the process.

Institutional markets trade interest rate-bearing instruments regularly, in billions of dollars equivalent every day. These trades, no matter how complex, always adhere to the two rules above. It is instructive to look at a few of these. For example, speculators may sell short US treasuries if they believe interest rates are headed higher (interest up, price down) with the intent to buy back the bonds cheaper at a profit. Easy. Here they are targeting the inflation component noted earlier. Or, major world banks may trade interest bearing instruments relative to one another, so-called spread trades. For example, if Morgan believes that the recovery in the UK will significantly lag that in the US, Morgan will buy UK Gilts (gov’t bonds) and sell US Treasuries. The bank (speculator) does not know where UK or US interest rates are going outright and doesn’t need to. All it needs to make a profit is for US rates to move higher, quicker than those counterparts in the UK (in this case, presumably because the US recovery will pressure rates higher, faster - the bet). This trade then focuses on relative inflation. US debt prices will fall faster than UK debt prices so the bank will make more on the US side than it loses on the UK side. Easy. Finally, a speculator may expect Germany to be downgraded as a result of the recent financial turmoil. He will buy US debt and sell Euro debt, with no particular view to relative growth at all, but specifically to creditworthiness, expecting Euro debt prices to fall relative to US as soon as the downgrade becomes reality. Here the target is the credit risk, the other of our three components.

So it’s not so tough after all, understanding interest rates and price movement. We’re getting there, that is, closer to acquiring the tools we need to make our own decisions about interest rates and our investments.

In the next sketch we will look at the near meltdown in the world debt/interest rate markets, Q4, ‘08. That process will further assist our own ends, which reside much closer to home.

Robert Craven

Interest Rates

We thought it very timely to comment on interest rates. This sketch is the first of a series. The topic is sure to put a bunch of folks quickly to sleep; the irony of course is that we’re all impacted one way or the other by these pesky little things. They’re key stuff. The better grasp we have as to causality and direction, the better shape our personal balance sheets.

OK. Where to start? How about the near meltdown of Q4, 2008? We all remember that. The guy down the road with three cars up on blocks in his front yard, falls behind in his mortgage payments, and the economy of Iceland implodes. Whoa now! I'm missing a few pieces of this puzzle myself, but hey, that about wraps it up.

A lot of lousy mortgages were handed out to this guy and his drinking buddies. P.J. O’Rourke, always the tutor, takes it from there: "Wall Street looked at the worthless paper and thought, ‘How can we make a buck off this?’ The answer was to wrap it in a bow. Take a wide enough variety of lousy mortgages--some from the East, some from the West, some from the cities, some from the suburbs, some from shacks, some from McMansions–bundle them together and put pressure on the bond rating agencies to do fancy risk management math, and you get a ‘collateralized debt obligation’ with a triple-A rating. Good as cash. Until it wasn't."

So that was a shock of the first order. Indeed, come mid-Dec/08 we find Fed Funds at 0.25%, the 2yr Treasury at 0.92%, the 10 year at 2.10% and the 30 yr at 2.60%; these were collapsed levels. Why? And, we find the dollar in the cellar, one Euro buying $1.4446. But so what? What’s all this mean? What’s "Fed Funds" and what’s the two year? Why should we care? And the Fed was up to something then too. What was it?

Change was compressed into a very brief time frame during this period. This provides a useful lab for us to fetch a notion of the dynamics impacting interest rates, our single purpose in this exercise. Once we do that we can develop a view for the direction of interest rates, the course of least resistance over the near term. Better than a stick in the eye any day.

Robert Craven

Update

We noted earlier that this recovery will not resemble that of past recessions. We also highlighted the reasons why. Let’s freshen up and see where we are now.

Some core sectors are beginning to show signs of life. Last week a well-monitored survey of the manufacturing sector (Institute of Supply Management Index) indicated a recovery in manufacturing. This is a big deal folks. Activity increased in August for the first time in 18 months, and by the largest increment in 2 years. Activity in this key sector is not robust certainly, it is subdued, but it is with the living again. Most observers now believe the recession in manufacturing is over.

Great!. Are we off and running? No. Something is missing. The recovery from the 60's recession was brief, that out of the early 80's recession, rocket-like - only 6 months. What is the problem now? Jobs. Some call this a "jobless recovery".Without jobs there is no personal income, without personal income there is no spending. We’re all hit - a depressant despite vigor in other sectors. So if manufacturers are experiencing higher new orders (which they are) and better export orders (which they are) and expanded order backlogs and lower inventories (which they are) why continue to displace workers?

Let’s take a closer look at jobs. The unemployment rate for Aug jumped to 9.7% (approaching the figure Reagan inherited). Interestingly, there are two surveys - one for major business, and one for households (LLC, S-corp type, etc). The biggest hit was in the smaller survey where 392,000 jobs were lost. This was the source of the rate jump. The establishment survey on the other hand showed the lowest level of job loss in over a year, as larger firms’ earlier drastic measures of cost cutting and inventory reduction pay off. This is what manufacturers are up to. The little guy (household survey) remains in the muck and continues to shed jobs at only a slightly decreased pace while the big guy about has his ship in order. Thus, we have stabilized a tad in the rate of job loss as noted in the last post. But that’s only half the picture.

Again, so why continue to fire? Why not hire if you sense demand? Because employers are scared to death, not of the economy (which they know when left to its own devices, always recovers nicely) but of the government. They know the little details that media types, and most of the masses don’t, and, they know what not to do. They know for example that payroll taxes are not only scheduled to rise, but already have risen. And they know that government-mandated unemployment compensation is funded by employers through an unemployment-compensation payroll tax. As a result, they’re not taking on any full time help. Better to grow more efficient instead. Makes sense. Then there are the tax and regulatory threats related to health care and energy reform. Potential employers would be even crazier to hire given this nonsense.

Thus, unless employers get the sense that Obama’s plans at nationalization are bound for failure, they’ll sit tight. They can make it with fewer employees - a good excuse to grow lean and mean. With this piece of the pie missing, look for the recovery to remain painfully slow.


Robert Craven

A Tragedy

Our aim is to simplify, then close the pattern ahead, affording a leg up for our readers. In Feb we labeled the American Recovery and Reinvestment Act, the administration’s trillion $ (w/ interest) "stimulus" package as not only superfluous and a complete waste of taxpayers’ money, but an act of deceit by Washington lawmakers as well. Harvard economist Robert Barro, candidate for the 03 Nobel, calls the legislation "probably the worst bill that has been put forward since the 1930s." "I mean it's wasting a tremendous amount of money," he said in an interview with the Atlantic. "I don't think it will expand the economy. . . . I think it's garbage."

The taxpayer has a growing, uneasy sense that we were right, that they’ve been taken. This is not that tough to understand. All of us have the tools at hand to judge this situation for ourselves, drawing from both history and experience. We know for example that the US economy has righted itself after each crisis, to which we will add - in spite of government intervention. Witness the Great Depression. The economy was beginning to recover before Roosevelt took office. From Lee Ohanian, director of macroeconomic research at UCLA, "Industrial production rose more than 60% from its July 1932 low until the National Industrial Recovery Act was passed in June 1933, and the industrial recovery stalled once the NIRA took effect." The problem was Washington. "The government did a lot during the Depression under the auspices of the New Deal," notes Ohanian, "and recent research is showing that some of those programs such as the National Industrial Recovery Act--which fostered cartels and raised wages far above their normal levels--substantially delayed recovery and kept employment much lower than it otherwise would have been."

So "stimulus" didn’t work in the 30's. Won’t take our word for it, doubt Prof Ohanian? Henry Morgenthau, FDR’s Sect of the Treasury testifying before the House Ways and Means Committee in May 1939: "We are spending more money than we have ever spent before and it does not work. I want to see this country prosperous. I want to see people get a job. We have never made good on our promises. I say after eight years of this administration we have just as much unemployment as when we started and an enormous debt to boot."

There is no evidence that $1 spent by the government has any net, multiplier effect for goodness sake vs the private sector. After all, where does that dollar come from? It can come from taxes or inflation or borrowing. Taxes translate to less spending for the private sector. If the Fed inflates, it means less buying power for the private sector. If the government borrows, the private sector is crowded out.

Next, even if government spending did work, providing a kick start, the last CBO study shows that through late May only about $37 billion of the $787 billion package has been spent.. For example, the Departments of Education, Transportation and Energy all have spent 2% or less of their allocations.

Finally, we know that there is ample evidence that the economy has stabilized. And a flood of freshly printed money makes a rebound all but inevitable. The Fed has cut rates to zero. M2 money supply is rising at close to a 10% rate now. Going back to WWII, a 10% rate of money growth has always led to economic growth.

A signature of the Democratic party is to erect layer upon layer of government, in which they believe all wisdom resides. Thus, the severe problems of our economy last year presented the opportunity of a lifetime for Democratic lawmakers. When Emanuel laid out his Rule Number One - "Never let a crisis go to waste," he was being nothing if not candid, exposing his and his boss’s agenda in crystal clear fashion. This is a dream come true for this bunch. Obama and Pelosi, along with their supporters are the types to see this crisis as a "great opportunity" as the president labeled it recently. They are the types, after a long period out of power, to attempt to use that "great opportunity" to push through far-reaching changes in national policy that have only a tangential connection, if at all, to the crisis but effect a weld or lock on US society that can not be undone for several generations.

What has transpired then my friends is in fact the greatest political heist ever witnessed. The bottom line is that the ARRA will leave us with a legacy of substantially rising debt without any commensurate benefit. The CBO notes that federal debt, which was about 40% of GDP at the end of 2008, is expected to rise to more than 80% of GDP in 10 years. And with no change in policy, debt could rise to nearly 100% of GDP before then. Add in the burden of unfunded government liabilities, including social security and government pensions, and the debt burden becomes truly staggering.

We expect a taxpayer revolt. As the IBD editorialized the other day regarding the ARRA, "It's as big a fraud as any perpetrated in recent years, cynically passed to take advantage of Americans during a time of economic panic and fear. Worse, it was falsely sold as stimulus when in fact it was a permanent expansion in government spending. The stimulus hasn't worked, and it won't. It should be killed off. Just throw it in the garbage, and apply the remaining $700 billion or so to cutting the expected $1.8 trillion deficit this year."

Robert Craven