Sunday, September 30, 2007

This Weekend's Contemplation - The Intangible Wealth of Nations

A recent study by the World Bank indicates that it is intangibles like the rule of law, property rights, the school system that really account for the differences between nations. These are very interesting ideas with some analytical basis for a change. Our understanding of the differences between nationts is beginning to move from opinion to some basis in analysis. Even if the analysis has problems it is start that will eventually evolve into better analysis. From the WSJ:

A Mexican migrant to the U.S. is five times more productive than one who stays home. Why is that?

The answer is not the obvious one: This country has more machinery or tools or natural resources. Instead, according to some remarkable but largely ignored research -- by the World Bank, of all places -- it is because the average American has access to over $418,000 in intangible wealth, while the stay-at-home Mexican's intangible wealth is just $34,000.


But what is intangible wealth, and how on earth is it measured? And what does it mean for the world's people -- poor and rich? That's where the story gets even more interesting.


Two years ago the World Bank's environmental economics department set out to assess the relative contributions of various kinds of capital to economic development. Its study, "Where is the Wealth of Nations?: Measuring Capital for the 21st Century," began by defining natural capital as the sum of nonrenewable resources (including oil, natural gas, coal and mineral resources), cropland, pasture land, forested areas and protected areas. Produced, or built, capital is what many of us think of when we think of capital: the sum of machinery, equipment, and structures (including infrastructure) and urban land.

But once the value of all these are added up, the economists found something big was still missing: the vast majority of world's wealth! If one simply adds up the current value of a country's natural resources and produced, or built, capital, there's no way that can account for that country's level of income.

The rest is the result of "intangible" factors -- such as the trust among people in a society, an efficient judicial system, clear property rights and effective government. All this intangible capital also boosts the productivity of labor and results in higher total wealth. In fact, the World Bank finds, "Human capital and the value of institutions (as measured by rule of law) constitute the largest share of wealth in virtually all countries." (my emphasis)

Once one takes into account all of the world's natural resources and produced capital, 80% of the wealth of rich countries and 60% of the wealth of poor countries is of this intangible type. The bottom line: "Rich countries are largely rich because of the skills of their populations and the quality of the institutions supporting economic activity."

What the World Bank economists have brilliantly done is quantify the intangible value of education and social institutions. According to their regression analyses, for example, the rule of law explains 57% of countries' intangible capital. Education accounts for 36%.

The rule-of-law index was devised using several hundred individual variables measuring perceptions of governance, drawn from 25 separate data sources constructed by 18 different organizations. The latter include civil society groups (Freedom House), political and business risk-rating agencies (Economist Intelligence Unit) and think tanks (International Budget Project Open Budget Index).

Switzerland scores 99.5 out of 100 on the rule-of-law index and the U.S. hits 91.8. By contrast, Nigeria's score is a pitiful 5.8; Burundi's 4.3; and Ethiopia's 16.4. The members of the Organization for Economic Cooperation and Development -- 30 wealthy developed countries -- have an average score of 90, while sub-Saharan Africa's is a dismal 28.

The natural wealth in rich countries like the U.S. is a tiny proportion of their overall wealth -- typically 1% to 3% -- yet they derive more value from what they have. Cropland, pastures and forests are more valuable in rich countries because they can be combined with other capital like machinery and strong property rights to produce more value. Machinery, buildings, roads and so forth account for 17% of the rich countries' total wealth.

Overall, the average per capita wealth in the rich Organization for Economic Cooperation Development (OECD) countries is $440,000, consisting of $10,000 in natural capital, $76,000 in produced capital, and a whopping $354,000 in intangible capital. (Switzerland has the highest per capita wealth, at $648,000. The U.S. is fourth at $513,000.)

By comparison, the World Bank study finds that total wealth for the low income countries averages $7,216 per person. That consists of $2,075 in natural capital, $1,150 in produced capital and $3,991 in intangible capital. The countries with the lowest per capita wealth are Ethiopia ($1,965), Nigeria ($2,748), and Burundi ($2,859).

In fact, some countries are so badly run, that they actually have negative intangible capital. Through rampant corruption and failing school systems, Nigeria and the Democratic Republic of the Congo are destroying their intangible capital and ensuring that their people will be poorer in the future.

In the U.S., according to the World Bank study, natural capital is $15,000 per person, produced capital is $80,000 and intangible capital is $418,000. And thus, considering common measure used to compare countries, its annual purchasing power parity GDP per capita is $43,800. By contrast, oil-rich Mexico's total natural capital per person is $8,500 ($6,000 due to oil), produced capital is $19,000 and intangible capita is $34,500 -- a total of $62,000 per person. Yet its GDP per capita is $10,700. When a Mexican, or for that matter, a South Asian or African, walks across our border, they gain immediate access to intangible capital worth $418,000 per person. Who wouldn't walk across the border in such circumstances?

The World Bank study bolsters the deep insights of the late development economist Peter Bauer. In his brilliant 1972 book "Dissent on Development," Bauer wrote: "If all conditions for development other than capital are present, capital will soon be generated locally or will be available . . . from abroad. . . . If, however, the conditions for development are not present, then aid . . . will be necessarily unproductive and therefore ineffective. Thus, if the mainsprings of development are present, material progress will occur even without foreign aid. If they are absent, it will not occur even with aid."

The World Bank's pathbreaking "Where is the Wealth of Nations?" convincingly demonstrates that the "mainsprings of development" are the rule of law and a good school system. The big question that its researchers don't answer is: How can the people of the developing world rid themselves of the kleptocrats who loot their countries and keep them poor?


Finally A Forecaster That Is Being Honest - He Does Not Know What Will Happen.

In an article from Yahoo, Nick Bloom at Stanford University has done some research that indicates that the US economy is potentially in for a "second moment shock" resulting from the credit crunch in August. However, based on historical analysis it is difficult to forecast what the effect will be, other than the level of uncertainty in the economy will be higher.

These comments are interesting becasue finally there is a forecaster that knows that things could get potentially worse, but he is not exactly sure what will happen. Maybe the correct forecast is that the level of uncertainty is going to increase. As a result people can stop wasting there time predicting what will happen (prophecy) and start stating that in their scenario analysis the level of uncertainty is going to increase and adjust their risk, growth, loss, etc. criteria appropriately.

Forecasters are busy churning out new and gloomier economic predictions because of a global credit crunch whose outcome nobody can be sure of until financial conditions normalize and uncertainty subsides.

Investment bank Goldman Sachs joined the swelling ranks of gloom converts this week, slashing its forecasts for growth in the United States, Japan and Europe.

"Much has changed since mid-July, when we wrote that 'the global economy continues to enjoy one of the strongest sustained expansions in modern history'," chief economist Jim O'Neill said in a note announcing hefty forecast cuts.

"The key question, which will take time to answer, is the extent to which the credit crunch will affect the real economy." (my emphasis)

The IMF is working on new and probably lower forecasts after raising its predictions for much of the planet's growth outlook on July 25, a couple of weeks before central banks were forced to take action to try to head off a full-scale credit crunch.

What none of the old forecasts or the new predictions that are coming out now do is factor in the impact of a crisis that has yet to run its course.


Nick Bloom, an economist at Stanford University, has taken a stab at one major facet of the problem, the indirect toll which crises have on business investment, hiring and output because of a sudden rise in uncertainty.

Essentially, this "second moment shock" as he calls it, will have a potentially far greater impact than the crunch itself in the first three to six months of the affair. (my emphasis)

He constructed a model using stock market volatility during more than 40 years since the Cuban missile crisis of late 1962 as a proxy for uncertainty to help identify the impact that the events have on corporate behavior.
"These shocks appear to have real, large effects, with the uncertainty component alone generating a one percent drop and rebound in employment and output over the following six months, with a milder long-run overshoot," Bloom says.


The impact of the underlying shock which in the first place triggered the uncertainty at corporate level -- be it war, oil price spikes, stock market crashes or the currency credit crunch -- can have an impact for a more prolonged period.

"While the second moment effect has its biggest drop by month 3 and has rebounded by about month 6, persistent first moment shocks generate falls in activity lasting several quarters," Bloom says in a research paper.

"There's a short sharp burst of uncertainty. It's a sort of double-whammy," Bloom added in a telephone call with Reuters. (my emphasis)

Central banks can cut interest rates to ease the pain of the current credit squeeze, but monetary policy has a limited impact until anything between nine and 18 months later, he added.

That means the uncertainty shock, something central banks are very wary of but have difficulty quantifying, will hurt hardest between now and the year-end.

"It's kind of half of a recession. The credit crunch gives you the other half, so you basically get a short recession," Bloom said.

Just how uncertain things are for economic forecasters was highlighted recently when the International Monetary Fund raised its forecasts for global economic growth on July 25 to 5.2 from 4.9 percent.

Some two weeks later, the European Central Bank began a wave of emergency lending to prevent money markets form seizing up and the IMF, along with many others, could do little more than say it would soon try to revise the forecasts again.

Saturday, September 29, 2007

What is a Recession, Soft Landing, Hard Landing, and Stagflation?

With all the talk about recessions and a whole host of other terms like soft landing, hard landing, and stagflation, I thought it would be useful to define a few terms to make sure everyone is on the same page.

Although everyone talks about recessions there is no official agreed-upon definition. According to the National Bureau of Economic Research (NBER) :

The financial press often states the definition of a recession as two consecutive quarters of decline in real GDP. Our procedure differs from the two-quarter rule in a number of ways. First, we consider the depth as well as the duration of the decline in economic activity. Recall that our definition includes the phrase, "a significant decline in economic activity." Second, we use a broader array of indicators than just real GDP. One reason for this is that the GDP data are subject to considerable revision. Third, we use monthly indicators to arrive at a monthly chronology.

The NBER is the organization that officially defines a recession in the US. Although it does not use an exact definition a recession is generally defined as:

. . . . a recession-the way we (NBER) use the word-is a period of diminishing (economic) activity . . . .. We identify a month when the economy reached a peak of activity and a later month when the economy reached a trough. The time in between is a recession, a period when the economy is contracting.

. . . Most of the recessions identified by our procedures do consist of two or more quarters of declining real GDP, but not all of them. . .

In addition:

The NBER considers real GDP to be the single measure that comes closest to capturing what it means by "aggregate economic activity." The committee therefore places considerable weight on real GDP and other output measures. Following the precedents established in many decades of maintaining its business cycle chronology, however, the committee considers a wide range of indicators of economic activity. There is no fixed rule for how the different indicators are weighted.

According to InvestorWords.com:

Stagflation is a period of high inflation and high unemployment (stagnation) occurring simultaneously.

Soft Landing is the avoidance of both inflation and high interest rates as well as a recession as an economy slows its growth rate. opposite of hard landing.

Hard Landing is when the economy goes directly from a period of expansion to a recession. This might happen if a government or monetary authority is more restrictive in its fiscal or monetary policy than what is appropriate for the economy. opposite of soft landing.

A Lot of Talk About A Recession, But There Are Also A Lot of Conflicting Signals

In the last month or two there has been a lot more talk about a potential recession, but there are also a lot of mixed signals. With all that said the consumer spending number for Q3 will be out at the end of month and hopefully this will give a better indication of where the economy is headed. One major problem is that consumer spending is very difficult to predict, so as a result economist have a notoriously poor track record of predicting recessions. But, before getting all involved in whether or not a recession will occur, what if the US economy were to slide into a slow growth phase where real GDP only grows 1% per quarter for two quarters? This is not a recession, but the effects will be almost the same as if the economy had a growth rate of -1% for two quarters. From Reuters:

Recession talk is heating up as the slumping housing market threatens to shackle free-spending consumers, yet stocks remain near record highs, indicating that many investors see little cause for alarm.

Identifying recessions as they happen is notoriously difficult, but if the Wall Street bulls have it wrong, history suggests they are in for a decidedly unpleasant surprise.

The last time a U.S. recession hit as the Dow Jones industrial average hovered this close to an all-time high was July 1990, and the index promptly dropped 22 percent. As for the most recent economic downturn in 2001, the Dow peaked more than a year before the recession began.

This economic cycle is proving particularly perplexing because a key measure of economic health, the job market, has been resilient despite plummeting housing activity.

The traditional arbiter of recessions, the National Bureau of Economic Research, identified the beginning of the 2001 slump eight months after it started, far too slow to be of much use to quick-trading Wall Street.

That leaves economists relying on an unusual assortment of timely gauges in hopes of calling the downturn. The trouble is, they're giving conflicting signals.

Wall Street should be a good indicator because it reflects the state of corporate profits, although the current gains may say more about investors' faith in the Federal Reserve to keep cutting interest rates to stave off recession.

At the same time, retailers . . . . are warning of disappointing sales, painting a gloomier picture of Main Street.

A long-time favorite, the yield curve, or spread between interest rates on the 10-year Treasury note and the three-month bill, has a reputation for forecasting recessions as much as 18 months ahead.

That measure had been signaling a downturn for many months, but a surprisingly deep cut in official U.S. interest rates on September 18 stoked inflation fears and drove up rates on the 10-year note, erasing the curve's recession forecast.


Among the more obscure measures, analysts at research firm Liscio are looking at "bibliometrics," or the number of times a word is mentioned in newspaper articles. A rise in the frequency of the use of the word recession "has an excellent history of calling downturns in near real-time," they say, and there has been a dramatic spike in September.

J.P. Morgan economist Haseeb Ahmed tracks consumer confidence data measuring whether people think jobs are hard or easy to get, and notes that the difference between those two groups has narrowed considerably over the past two months. "A drop this large over a two-month period ... is unprecedented except during or in the immediate aftermath of recessions," he said.

A growing chorus of analysts argue that as goes housing, so goes the economy.

Rising real estate values left homeowners feeling flush in recent years and more confident about paying for their retirement, and many economists say that wealth effect gave a lift to consumer spending.

With new home prices for August posting their biggest year-over-year drop since December 1970 and consumer confidence on the downswing, spending is showing signs of slowing.

That doesn't bode well, considering that consumer spending accounts for more than two-thirds of the economy.

John Makin, an economist at the American Enterprise Institute in Washington, thinks a recession is likely, and points out that an initial cut in interest rates by the Fed, such as the one earlier this month, "usually coincides with the onset of a recession."

Makin also cited a recently published paper by Edward Leamer, an economist at the University of California at Los Angeles, detailing how downturns in housing and consumer durables demand have preceded eight of the last 10 recessions.

However, Leamer does not think a recession is imminent because one of his preferred indicators, manufacturing sector employment, remains positive.

"There's going to be sluggish spending on the consumer side, but that's a recipe for slow growth, not recession," Leamer said. "A recession is not sluggish growth. A recession is unwanted idleness of labor and capital. The key component of that is the labor market."

"I'm thinking more along the lines of two quarters of negative growth, because I think the Fed is on the job here," he said. "The thing that might make it last longer is the fact that there's so much spending and borrowing that has been contingent on rising house prices, so if they persist in falling it could be longer."

Friday, September 28, 2007

The Fed is More Frank About the Situation the Housing and Capital Markets

The following comments from Dennis Lockhart, President of the Atlanta Federal Reserve Bank, are more frank about the condition of the housing and capital markets. Also his comments included some of the justification for the rate cut. From Market Watch:

The bottom of the housing market may not be reached until the second half of 2008 or later, according to Dennis Lockhart, the new president of the Atlanta Federal Reserve Bank.


"I believe the bottom of the housing downturn could be a ways off -- potentially the second half of 2008 or later," Lockhart said Friday in a speech at Middle Tennessee State University.

The persistence of the housing downturn seems likely to cause some drag on consumer spending, Lockhart said. He added that the balance of risks has shifted from higher inflation toward slower growth.

"I believed, and still do, that the factor weighing most heavily on this change in the outlook has been the potential negative ramifications of the financial turmoil," Lockhart commented. (my emphasis)

He believes that the Fed could steer the economy into a soft landing, comparing monetary policy to flying an airplane: "I believe the current Fed policy abets a flight path of lower but still positive growth with moderate inflation." *

But Lockhart quickly said that "more turbulence may be ahead."


Conditions in the financial markets have improved to some degree since August, he reported. In the past two weeks, stress in the market for asset-backed commercial paper has shown signs of subsiding, he elaborated.

While inflation remains at the upper bounds of his comfort zone, Lockhart said that the Fed has made progress against it. "That's why I believe the recent moderation of inflation readings allowed a tactical move to reduce risks to the general economy with a federal funds rate cut."

Lockhart dismissed suggestions that the Fed rate move increased moral hazard. "I didn't see the logic of subordinating the general welfare of our nation's economy to the possibility that some participants in financial markets might draw tainted conclusions about the future landscape of risk."

*By the way, a soft landing is defined as The avoidance of both inflation and high interest rates as well as a recession as an economy slows its growth rate. opposite of hard landing. A hard landing is defined as When the economy goes directly from a period of expansion to a recession. This might happen if a government or monetary authority is more restrictive in its fiscal or monetary policy than what is appropriate for the economy. Both terms come from InvestorWords.com, which is a quick dictionary of investing/finance/economic terms.

In the Ripple Effect of the Housing Slump, Here Comes Another Ripple – Lower Corporate Profits

The effects of the housing market are slow to unwind, but they are unwinding none the less. Everyone knew that the housing slump would eventually bite into corporate profits. Well according to Bloomberg it looks like that ripple is on its way.

I seldom make statements about investing because this purpose of this blog is to discuss macroeconomic issues. But, the third quarter profit reporting season might be a good time to be standing on the sidelines with your hands in your pockets (unless of course you really know what you are doing). No wonder many in the investment business are clamoring from a rate cut in October. But let me repeat myself from a previous blog. When the Fed cuts the Fed Funds rate by 50 bps one month and may cut it again 6 weeks later, this is not a good thing. It means that the economy has growth issues.

Profit in the U.S. may grow at the slowest rate in more than five years this quarter as the housing slump hurts results at companies from IndyMac Bancorp Inc. to Target Corp.

Earnings of Standard & Poor's 500 Index members may rise an average of 3.2 percent from a year earlier, breaking a 20- quarter streak of gains exceeding 10 percent, according to data compiled by Bloomberg.

Since Aug. 20, at least 52 financial and consumer discretionary companies in the Standard & Poor's 500 Index have issued third- quarter forecasts that met or fell short of analysts' estimates, compared with 10 that said earnings would be higher than forecast.

``The consumer is feeling the impact of lower housing prices,'' said Timothy Ghriskey, who manages $1 billion as chief investment officer at Solaris Asset Management in Bedford Hills, New York. ``Any consumer discretionary industry is affected, whether it's restaurants, cruise ships, automobile sales.''

Consumer confidence dropped to the lowest level in almost two years in September after home sales weakened in August, the Conference Board said on Sept. 25. The housing slump is the biggest in the U.S. in at least 16 years.

U.S. companies that cited housing as they trimmed forecasts in recent weeks include Pool Corp., the biggest U.S. distributor of swimming-pool equipment; Masco Corp., the maker of Behr paint and Delta faucets; Knight Transportation, a short- haul trucking company; FedEx Corp., the second-largest U.S. package delivery company; and CarMax Inc., the biggest U.S. car dealer.

Pasadena, California-based IndyMac Bancorp, the second- biggest U.S. mortgage company, said on Sept. 7 it may post a loss for the first time in at least eight years. Loan origination probably will fall 20 percent in the third quarter from the second, the company said.

Target, the second-largest U.S. discount chain, slashed its projection for this month's sales on Sept. 24. Wal-Mart Stores Inc., the world's largest retailer, last month reported profit below analysts' estimates and cut its third-quarter forecast.

The International Council of Shopping Centers Inc. lowered its estimate for U.S. retail sales growth in September after sales fell 1 percent last week.

Lowe's, the second-biggest home-improvement retailer after Home Depot Inc., said on Sept. 25 that profit this year may be at the low end or slightly below an Aug. 20 forecast.

Merrill Lynch & Co., the third biggest U.S. securities firm, may post losses of as much as $4 billion on writedowns of mortgages, corporate loans and collateralized debt obligations, resulting in the lowest quarterly earnings in almost six years, Goldman Sachs Group Inc. analyst William Tanona said on Sept. 26. He cut his full-year profit estimate by 25 percent
.

Thursday, September 27, 2007

New Home Sales Continues Its Decline

The beat goes on with new home sales. From Market Watch:

Sales of new homes dropped 8.3% in August to a seasonally adjusted annual rate of 795,000, the slowest sales pace since June 2000, the Commerce Department estimated Thursday.


Sales are now down 21.2% in the past year, with no sign of a bottom in the crippled housing market. "This is just hideous," wrote Ian Shepherdson, chief U.S. economist for High Frequency Economics.

"This is more evidence that it's going to be a long and -- for a lot of people -- a painful process," said Mike Schenk, economist for the Credit Union National Association. "The soft housing market will be with us for a long time, at least 18 months."

The median sales price fell 7.5% to $225,700 compared with a year earlier, the largest year-over-year decline in 37 years. The median price can be affected by the mix of homes sold between and within regions, and the price does not include nonmonetary incentives, such as upgrades, free vacations and new cars.

The inventory of unsold homes fell by 1.5% to 529,000, the fifth straight decline as builders struggle to bring their inventories down. The inventory represents an 8.2-month supply at the August sales pace, the highest since March.

On Tuesday, the National Association of Realtors said sales of existing homes fell to a five-year low in August, while inventories jumped to an 18-year high.

Total home sales -- existing and new -- fell 5% in August to a seasonally adjusted annual rate of 6.30 million, the lowest in six years.


The government cautions that its housing data are subject to large sampling and other statistical errors. Large revisions are common. The standard error of 12.4% is so high, in fact, that the government cannot be sure in most months whether sales rose or fell. (my emphasis)

Sales rose 42.3% in the Northeast to 74,000 annualized and rose 20.5% in the Midwest to 135,000. Sales fell 20.8% in the West to 179,000 and fell 14.7% in the South to 407,000, the lowest in five years.

A Good Summary of How the US Dollar Has Fared Since the Drop in the Fed Funds Rate

Excerpts below from an article in Bloomberg, gives a good summary of how the dollar has fared since the Fed cut rates. As anticipated in a number of previous posts at this site, a drop in the Fed Funds rate would weaken the dollar over time. If the Fed finds it necessary to continue to drop rates to keep the US economy from sliding into a recession (the likely case) we will continue to see a decline in the dollar. This will do a number of things to the US: 1) US exports will become cheaper, 2) Imports into the US will become more expensive in the US dollars, this includes oil, 3) things in the US will become cheaper, so expect more investment in the US by foreign firms such as the 20% stake in NASDAQ that will be purchased by Middle Eastern interests, 4) the interest in holding US dollars as a reserve currency will decline, 5) interest in buying US Treasury securities (i.e. financing the US debt) outside the US could decline without an interest rate increase, etc. There are probably additional issues that have been missed, but this gives an idea of some of the issues at stake.


The dollar fell to an all-time low against the euro on speculation a government report will show a drop in U.S. home sales, bolstering the Federal Reserve's case for cutting interest rates.

The currency is headed for its biggest quarterly slump versus the yen since December 2004 as the yield advantage for two-year Treasuries over similar-maturity Japanese debt narrowed to the least in almost three weeks. The dollar has weakened against 14 of the 16 most-active currencies since June 30, falling 4.4 percent versus the euro.

``We are most likely to see further downside for the dollar,'' said Adam Cole, head of global currency at Royal Bank of Canada in London. ``If you look at the economic fundamentals of the U.S., there's little to stand in the way of further dollar weakness against other major currencies.''

Against the euro, the dollar fell to $1.4148 at 10:54 a.m. in London, after reaching $1.4166, the lowest since the European currency's January 1999 debut. It traded at $1.4128 in New York yesterday. The U.S. currency was little changed against the yen at 115.62.

The dollar has touched a record against the euro for six straight trading days. Deutsche Bank AG, the world's biggest currency trader, this week forecast the dollar will decline to $1.45 per euro by year-end. (my emphasis)

The euro pared gains against the dollar and yen after the European Central Bank loaned the most to banks today since October 2004, renewing concern about credit-market squeeze. The central bank loaned 3.9 billion euros at its emergency rate. (my emphasis, looks like the credit crunch is not over yet)

The European single currency then recouped some losses on ECB figures showing M3 money supply, which policy makers use to gauge future inflation, held near to a 28-year high in August, adding to the case for higher interest rates.

Futures contracts today showed 86 percent odds the Fed will lower its target overnight lending rate between banks by a quarter-percentage point to 4.50 percent at its next meeting Oct. 31, compared with 80 percent a week ago. The European Central Bank's key rate is 4 percent and the Bank of Japan's is 0.5 percent, the lowest among industrialized countries. (my emphasis, please realize that this value can change very rapidly)

Europe's single currency may strengthen to $1.4500 by year- end, Lee Wai Tuck, strategist at Forecast Singapore Ltd. forecast, citing the prospects of a further shift in interest- rate differentials between the U.S. and the 13-nation region in favor of the euro.

Wednesday, September 26, 2007

The Foreign Currency Markets Have Grown Significantly in the Last Few Years - The BIS

Excerpts below from the WSJ states that according to the Bank of International Settlements (BIS), the foreign exchange markets have grown significantly since 2004. The ties in well with an earlier post discussing the changing role of the US economy amongst the world economies. Let's face for those brought up in a period where the US economically dominated the world, it looks like "we" are going to have to change our thinking and make some room on the bench for other players.

. . . . a report by the Bank for International Settlements in Basel, Switzerland, adds some hard numbers to that picture. Global markets are exploding in size, scope and complexity.

The BIS, which offers services to central banks, provides a reality check on financial globalization by tracking the size of foreign-exchange markets.

In April, daily turnover in currency markets rose to $3.2 trillion, the bank said yesterday. That's more in value than the annual economic output of Germany or China, changing hands in currency markets every day around the world. It's also up 71% from the BIS's last survey in 2004, the largest jump in volume since the institution began conducting its benchmark survey in 1989.

The currency market is "the world's biggest fruit and vegetable stall," says Jim O'Neill, global head of economic research at Goldman Sachs Group Inc. "There are so many participants in it, and it adjusts very quickly to new information."

The study touches on many types of financial transactions, from hedge funds making complex financial bets, to companies transacting money to source parts in China, to Americans loading up on yen or euros before a trip abroad.

The BIS figure tracks garden-variety currency interactions: on-the-spot transactions to convert two currencies, forward contracts purchased by individuals or institutions to buy currencies at a future date, and swaps that involve the exchange of two currencies at two points in time.

Economists have long hailed the benefits of globalization. When two countries trade, it allows each to focus on producing what it is most efficient at doing. Financial globalization helps banks and investors spread out their risks and absorb unexpected shocks.

The downside of the increasing financial globalization was apparent in the turmoil that gripped world markets in July and August. The crisis demonstrated how financial risk -- once concentrated in lending by banks -- can appear far away in expected ways, possibly leading to contagions. That's a big challenge for central banks and regulators as they attempt to monitor the health of the global financial system.

The BIS said technology played a key role in fostering the explosion of currency trading, with automated trading models allowing investors to continually chase small moves in currencies. "A significant expansion in the activity of investor groups including hedge funds" as well as individual investors also contributed to the increase, it said.

The report showed that players in the currency market are increasingly relying on complex instruments to make bets or reduce their exposure to risk. Trading in financial derivatives linked to currencies soared to $2.1 trillion a day, the report said, a rise of more than 70% since 2004. Large companies are also taking a more active and sophisticated approach to managing currency exposure.

The most dramatic rise came in cross-currency swaps, in which two parties agree to exchange streams of interest payments in different currencies for a certain period. Those daily volumes grew by 281% between 2004 and 2007, possibly because investors were seeking to hedge rising investments in foreign currency bonds.

Emerging-market currencies were involved in almost 20% of all transactions in April. The share of the Chinese yuan in the total currency turnover increased, although it remains very small. The currency is isolated by Chinese government capital controls. It remained behind currencies like the Korean won and the Polish zloty.

Contrary to some expectations, the dollar didn't fall much out of favor as the world's pre-eminent currency. The dollar was on one side of more than four-fifths of all daily currency transactions, a slight decrease from 2004, though up from 1995. That was mostly due to the currency's depreciation in the past three years.

The share of the Japanese yen in total turnover also decreased. Currencies that are playing a larger role on the global stage include the Australian dollar and the New Zealand dollar, according to the report, thanks to a rush of investors seeking out the high interest rates in those countries.

The survey, carried out once every three years, polled 54 central banks and monetary authorities. Industry insiders said the figure for daily turnover of $3.2 trillion, while bigger than many had expected, could underestimate the true size of the industry.

Hedge funds, for example, can now trade directly with each other, and this kind of flow isn't captured by the survey.

The report's conclusions echo the experience of players in the currency markets, who say they've seen a growing interest on the part of companies and investors in trading currencies.


The BIS report said that the United Kingdom and the U.S. remain by far the largest currency-trading centers, together accounting for just over half of the total. Switzerland, meanwhile, overtook Japan as the third-largest trading center.


A Summary of the Recent News on the Housing Market

The excerpts below from an article in the WSJ shows that in the housing market the beat goes on.

Most forecasts don’t see the market turning around until 2009 or 2010, mostly that is about as far out as they can see with any level of confidence. If you look at previous downturns (bursting bubbles) in previous housing markets, commodity markets , even stock markets history demonstrates that the return to the peak prices seen in 2005 or 2006 could take 8 to 10 years. The housing decline of the early 1990s took just over 8 years for the prices to go from peak in 1989 back to that peak price in the late 1990s. This process takes so long because first the selling public and homebuilders must come to the realization that the market is severely depressed. Second, prices must drop to work-off the excess inventory (currently a problem with existing home sellers), and third consumers need to return to the market to buy (also a problem now because many consumers understand that the bottom as not been reached). It appears that we are still in the middle of this process and make no mistake this is a process that is not only financial, but psychological as well.

If you disagree with this thinking look at the NASDAQ in 2000 (March 10, 2000 a daily high close of 5048 was reached) and looked at it today. Since March 2000 to yesterday’s close the NASDAQ is still down over 46%.

(Double click on graph to enlarge)










The housing market is going into a deeper chill, and consumers are starting to shiver. Sales of existing homes in August fell sharply, and home inventories by one measure soared to an 18-year high, according to data released yesterday. . . . . The housing market is worrying consumers, raising fresh concerns about economic growth. Consumer confidence fell this month to its lowest level in almost two years, a new survey showed. . . . . . "The combination of all this is indicative of an economy that has lost quite a bit of momentum," said Joshua Shapiro, chief U.S. economist at the consulting firm MFR Inc., an economic forecasting firm that advises investors.

. . . . Overall, sales of existing homes tumbled 4.3% in August to an annual pace of 5.5 million, the slowest in five years, the National Association of Realtors said yesterday. More worrisome: The number of homes for sale is enough to satisfy 10 months of demand at the current pace. Two years ago the figure was below five months. Analysts cite excess supply in forecasting that an upturn in sales and prices may not come until 2009.

Home prices in July fell 3.9% from a year earlier, according to the S&P/Case-Shiller home-price index. The index, which tracks prices in 20 U.S. metropolitan areas, hadn't measured that big of a decline since just after the 1990-91 recession.

The bottom is "not yet in sight" for housing, said Mr. Shapiro, the economist. He said the growing number of unsold homes "argues for accelerating declines of prices."

The Conference Board said yesterday that its index of consumer confidence dropped to 99.8 in September from 105.6 in August, putting it at the lowest point since November 2005. The survey ended on Sept. 18, the day the Fed lowered interest rates by half a percentage point. The share of consumers reporting jobs as "hard to get" rose to 22.1% from 19.7%.

Individual home owners have been slower than builders to bring down their prices to match demand, but that may be changing as the housing slump worsens. (my emphasis)

The National Association of Realtors reported yesterday that the median national home price was $224,500 in August, up 0.2% from $224,000 in August 2006. Those numbers can be skewed by the mix of homes sold in a particular month. Economists say the Case-Shiller index is less vulnerable to that distortion because it tracks the sales of individual homes over time.


Tuesday, September 25, 2007

What is a Credit Score and How Does It Work?

Below are excerpts from a WSJ article that discusses how the basic FICO or credit score works. Having built credit scores a decade ago and worked with credit scores much of career as I designed underwriting systems, I found this article to be a good basic description of the subject. Based in the questions I have received from family and friends over the years, I would have to say that the subject of credit scores is more poorly understood than anything else.

. . . . Most consumers don't know their numbers until they apply for loans. Scores typically range from 300 points to 850 points.
Fair Isaac Corp. developed the FICO credit score, used by more than 90% of the largest lenders. About 40% of the population has a FICO score of 750 or higher; 18% has a 700-749 score; 27% has a score between 600 and 699, and 15% has a score below 600.

The score doesn't include a person's savings history or income. It varies depending on whether it comes from Fair Isaac or from one of the three largest credit reporting bureaus -- Equifax, Experian and TransUnion. . . . . The scores vary because not every credit reporting bureau has exactly the same information. This occurs becasue credit bureaus tend to be concentrated in certain geographic locations so the bureaus vary accordingly. (my comment)

. . . . However, about 35% of the score comes from payment history. That includes whether a person pays on time, and the presence of adverse records like a lien or bankruptcy, says Craig Watts, a Fair Isaac spokesman.

An additional 30% of the score is based on the amount owed, says Mr. Watts. Someone who has borrowed the maximum on a credit card will get a lower score than someone carrying a debt of less than half of what is available on the card. In the business this is called utilization. (my comment) A further 15% comes from a person's credit history. In the business this is called depth of file. (my comment) The older the accounts, the better. An additional 10% is based on the type of credit on record, and the final 10% comes from the number of recently opened accounts and credit inquiries. More inquiries is worse than less (my comment).

Missing even a single payment could cost 100 points. Consumers can raise their scores by paying bills on time, not borrowing to the limit on credit cards, and paying off debt.

Until this summer's subprime crisis, a score of 720 or higher earned you some of the best interest rates, says John Ventura, director of the Texas Consumer Complaint Center at the University of Houston Law School. Borrowers now need a score in the high 700s to get the same benefits, he says.

Getting the best rates could save thousands of dollars. A report released in July by the Consumer Federation of America and Washington Mutual Inc. found that if consumers with an average score increased their score by only 30 points, they would save $76 a year in finance charges. If all consumers raised their scores by 30 points, there would be $20 billion in savings.

The benefits are dramatic for mortgages. Raising a score from a range of 580-619 to 660-699 could save someone with a 30-year, $300,000 fixed mortgage $5,148 in one year, according to Fair Isaac's Web site (
www.myfico.com).

Consumers shouldn't cancel old cards that they don't use, because "closing an account eliminates a positive reference," says Steven Katz, a spokesman for TransUnion.

If you plan to apply for credit in the near future, experts advise, don't use a credit card to pay for groceries and other purchases. Credit-rating companies see only the balance on the day they check.

Consumer groups recommend getting your score and a credit report at least once a year, more often if there is any possibility that you have been a victim of identity theft.

The reports are available free once a year from each of the three major reporting agencies and for a fee more often. Consumers must use the Web site
www.annualcreditreport.com rather than the individual Web sites to get the free reports.

ARM Resets are Almost Over

The excerpts below from an article in the WSJ states the number of subprime ARM resets is coming to a close within by year-end. At least this part of pain in the housing market is ending, but there is still plenty to go. For example, some percentage of the resets will turn into foreclosures within a year. Furthermore, the resets are going to increase the inventory of unsold homes, which already stands at 10 months (according to the NAR), higher over the next 12 months.

. . . . . one dismal milestone may soon move into the housing market's rearview mirror, potentially giving rise to hopes for a rebound soon. Homeowners owing $31.8 billion in subprime adjustable-rate mortgages began paying higher interest rates this month, according to Moody's Economy.com.

That is the highest amount of subprime ARMs due to reset over a one-month period in this housing cycle. By December, resetting subprime ARMs are forecast to drop to $25.2 billion. By the end of 2008, they will have fallen to $3.6 billion, because lenders have largely stopped making such loans to borrowers with spotty credit histories.

The tsunami of interest-rate resets has been a big factor in the jump in defaults roiling credit markets this year. In August, foreclosure filings rose 36% from the previous month and were up 115% from last year, according to RealtyTrac. As ARM resets reach a peak, more homeowners will have trouble meeting payments.

More Bad News About Housing – The Beat Goes On

According to an article from CCMoney.com the National Association of Realtors (NAR) reports that the sale of existing homes is down again in August.


Housing markets continued to slump across the nation in August as the number of existing homes sold dropped for the 13th straight month, according to the latest report from the National Association of Realtors.

Sales fell 4.3 percent from July to a seasonally adjusted annualized rate of 5.50 million. Sales have fallen 12.8 percent since last August's pace of 6.31 million homes. . . . .

. . . . . The slump pushed up the inventory glut to 4.58 million existing homes, the highest level in 16 years. There is now a 10-month supply of homes on the market at the present rate of sales. (my emphasis)

In another article from CNNMoney.com, Moody’s Economy.com is predicting a further decline in single family homes in most major metropolitan areas. The article is worth a read and includes a table of major cities and their forecasted decline in housing prices.

Over the next few years, more than three-quarters of the nation's housing markets will suffer some decline in home prices. Many will experience double-digit hits in a forecast that has worsened considerably in recent months.

According to an analysis conducted by Moody's Economy.com, declines will exceed 10 percent in 86 of the 379 largest housing markets. And 290 of the cities will experience price drops of 1 percent or more.

Nationally, Moody's is projecting an average price decline of 7.7 percent. That's a jump from the 6.6 percent total price drop that the company was forecasting in June and more than twice that of last October's forecast of a 3.6 percent price decrease.


Many of the worst hit cities are in Sun Belt areas that experienced outsized home-price growth during the real estate bubble, according to Arnold Slesers, an associate economist at Moody's.

Monday, September 24, 2007

How Are The Retailers Doing – The Market Is Not Excited

With all the excitement about the cut in the Fed Funds Rate and the positive response in the stock market one may wonder how the market was valuing the retailer market. After all, if the stock market was up but the retail component is lagging the market clearly does not think the retail sector will do that well in the near term. If the retail sector is a surrogate for consumer spending, maybe the market is not really that confident about the strong economic growth in the near term. Just maybe all recent increases in stock prices are caused by the euphoria of a rate cut and have nothing to do underlying fundamental strength of the economy.

To test this idea I created a simple index, using June 1, 2007 as a base, so the S&P 500 index could be compared to the S&P Retail Index.

The first graph below clearly shows that although the S&P 500 has had its ups and downs since May, the index is only slightly off the highs sustained through May, June and July. The S&P Retail Index is, however, a different story. The Retail Index also had its ups and downs in May, June, and most of July, but beginning in late July the index began to decline from the base period. More importantly, although the index has recovered from its lows in mid-August it has not recovered as much as the S&P 500 index over the same period. As a matter of fact if the difference between the two indices is calculated it clearly indicates that the S&P 500 is recovering much more quickly than the Retail Index (graph two).
















What does all this mean? As stated above if the larger market is up but the retail component is lagging the market clearly does not think the retail sector will do that well in the near term. With consumer spending accounting for 70% of real GDP it appears that the market ultimately is saying that economic growth will be weak in the near term. Does this mean we will have a recession within the next 6 to 9 months. It is difficult to say, but clearly things are lining up that way.


Sunday, September 23, 2007

Changes Ahead for the US Economy Relative to the World’s Other Economies

The excerpts below from a WSJ article indicate that years of excessive importing by the US may be coming to an end for a variety of reasons. Maybe in the future when the US sneezes the rest of the world will wonder who is catching cold.

For years, economists have warned that the U.S. can't run up endless charges on the national credit card to cover its huge appetite for imported cars, oil, electronics and other goods. Someday, they said, the bill will come due.

After 16 years during which the U.S. mainly borrowed and bought while much of the rest of the world lent and sold, the global economy appears to be undergoing a fundamental shift. American exporters are finding eager overseas markets for their products. U.S. consumers are beginning to temper their free-spending ways as the housing boom turns to bust. China, the Middle East, central Europe and Africa are absorbing more of the world's imports. The result: Instead of depending as heavily on the U.S. for demand, the world economy could become more evenly balanced. . . . . The massive U.S. trade imbalance is the product of a tangle of causes and effects. It springs largely from foreign-exchange rates, the attractiveness of U.S. financial markets, the profligacy of U.S. consumers versus the thrift of consumers elsewhere and persistent differences in economic growth rates among countries.

Between 1999 and 2006, the U.S. economy grew an average of 2.9% per year, while Germany and Japan each limped along at 1.4% growth rates, according to the IMF. Faster growth means more imports. The richer Americans felt, the more they spent on Chinese toys, German motorcycles, Mauritian shirts or Japanese cars. The housing boom gave consumers a sense of well-being that led them to spend more freely than ever.

At the same time, the growth differential served as a lure for foreign investors. Generally speaking, it's easier to make money investing in stocks in a steadily growing economy than a more languid one. The temptation is especially strong when the financial markets are as deep and liquid as those in the U.S are.

The U.S. government compounded the effect by overspending its budget and issuing Treasury securities to cover its debts. The central banks of China and Japan, among others, have bought trillions of dollars in U.S. notes.

More foreign currency chasing fewer dollars made each dollar more valuable. The stronger dollar, in turn, reverberated through the economy again, making imports relatively cheaper and U.S. exports relatively pricier. The strengthening dollar made U.S. stocks, bonds and other investments even more attractive to foreigners because they were more valuable in euros, yen, pounds or other currencies when the investors cashed out.

For many years, the combination of those forces led the U.S. to buy far more from overseas than it sold abroad. In the second quarter of this year, the current-account deficit measured $191 billion, or more than $760 billion on an annualized basis. To pay for those imports, the U.S. has to attract $2.1 billion in foreign investments every day.

Conditions, however, have changed dramatically. These days, U.S. growth lags behind that of many of its overseas trading partners. The IMF is projecting 2% growth for the U.S. in 2007, and 2.6% growth for Germany and Japan. The 13 countries that share the euro are expected to grow 2.5% this year, according to Bank of America.

American consumers' endless confidence and insatiable appetite at the mall appear to have been jolted by falling house prices and, more recently, tight credit conditions. "The forces that had been supportive to excess consumption for a decade are now headed the other way, and the U.S. consumer just can't keep driving...America's current-account deficit to higher highs," says Stephen Roach, chairman of Morgan Stanley Asia in Hong Kong. Mr. Roach calls that "one of the key conditions...that could be critical in triggering a long-overdue rebalancing of the global economy."

Indeed, the slowing domestic economy already appears to be stifling growth in American demand for foreign goods. The U.S. share of global imports has fallen to 14.3%; the lowest since the recession of 1991-92, according to IMF data. In 2000, the U.S. soaked up 18.8% of world imports. By contrast, Brazil, South Africa, India and other developing countries now account for 40.1% of global imports, up from 28.4% in 1991. "We're not the sole market of last resort," says Mr. Quinlan, the Bank of America strategist. (my emphasis)

The slowing economy and uncertainty about U.S. financial markets are feeding back into the currency markets. "I expect to see more and more weakening of the dollar in the coming months and years," predicts Princeton economist Alan Blinder, a former vice chairman of the Federal Reserve Board. Currency trends are notoriously hard to predict, though. Mr. Blinder confesses that he thought the dollar was embarking on the long march downwards in 2002, only to see it pick up again in 2004. The Japanese yen has not gained much ground on the dollar compared to 10 years ago.

. . . . There are still obstacles to a smooth rebalancing of global trade flows, and China is one of the biggest. Beijing has been reluctant to allow its currency, the yuan, to rise much against the dollar, despite fierce pressure from U.S. lawmakers and business executives who say that the artificially weak currency gives Chinese companies an unfair edge over American firms. The yuan has appreciated about 10% against the dollar since Beijing first allowed it to move in July 2005, but U.S. manufacturers -- backed by Treasury Secretary Henry Paulson -- say that's not far enough or fast enough to allow even-handed competition.

While China and India are bigger markets for U.S. companies than they used to be, "there are nearly one billion workers in Asia who earn less than $2 per day," says Bank of America's Mr. Quinlan. "They can afford a Coke, but until they can afford a car and computer, global rebalancing will proceed slowly."

Weekend’s Contemplation – The Shrinking Middle Class in America

I heard on NPR a few days ago that the NY Times will stop charging for the online version of the newspaper. Apparently the NT Times has determined that they can make more money from internet advertising then they can for charging for the subscription. I am not sure when this will happen or if it has already happened, but in any case this allows access to a columnist that I like to read because he makes me think - Paul Krugman. Below is a column in the NY Times that he wrote recently (9-18-07) that is worth a read, especially if you are older and can remember the last five decades as a current event and not history.

“I was born in 1953. Like the rest of my generation, I took the America I grew up in for granted – in fact, like many in my generation I railed against the very real injustices of our society, marched against the bombing of Cambodia, went door to door for liberal candidates. It’s only in retrospect that the political and economic environment of my youth stands revealed as a paradise lost, an exceptional episode in our nation’s history.”

That’s the opening paragraph of my new book, The Conscience of a Liberal. It’s a book about what has happened to the America I grew up in and why, a story that I argue revolves around the politics and economics of inequality.

I’ve given this New York Times blog the same name, because the politics and economics of inequality will, I expect, be central to many of the blog posts – although I also expect to be posting on a lot of other issues, from health care to high-speed Internet access, from productivity to poll analysis. Many of the posts will be supplements to my regular columns; I’ll be using this space to present the kind of information I can’t provide on the printed page – especially charts and tables, which are crucial to the way I think about most of the issues I write about.

In fact, let me start this blog off with a chart that’s central to how I think about the big picture, the underlying story of what’s really going on in this country. The chart shows the share of the richest 10 percent of the American population in total income – an indicator that closely tracks many other measures of economic inequality – over the past 90 years, as estimated by the economists Thomas Piketty and Emmanuel Saez. I’ve added labels indicating four key periods. (double click on graph to enlarge)

These are:

The Long Gilded Age: Historians generally say that the Gilded Age gave way to the Progressive Era around 1900. In many important ways, though, the Gilded Age continued right through to the New Deal. As far as we can tell, income remained about as unequally distributed as it had been the late 19th century – or as it is today. Public policy did little to limit extremes of wealth and poverty, mainly because the political dominance of the elite remained intact; the politics of the era, in which working Americans were divided by racial, religious, and cultural issues, have recognizable parallels with modern politics.


The Great Compression: The middle-class society I grew up in didn’t evolve gradually or automatically. It was created, in a remarkably short period of time, by FDR and the New Deal. As the chart shows, income inequality declined drastically from the late 1930s to the mid 1940s, with the rich losing ground while working Americans saw unprecedented gains. Economic historians call what happened the Great Compression, and it’s a seminal episode in American history.

Middle class America: That’s the country I grew up in. It was a society without extremes of wealth or poverty, a society of broadly shared prosperity, partly because strong unions, a high minimum wage, and a progressive tax system helped limit inequality. It was also a society in which political bipartisanship meant something: in spite of all the turmoil of Vietnam and the civil rights movement, in spite of the sinister machinations of Nixon and his henchmen, it was an era in which Democrats and Republicans agreed on basic values and could cooperate across party lines.

The great divergence: Since the late 1970s the America I knew has unraveled. We’re no longer a middle-class society, in which the benefits of economic growth are widely shared: between 1979 and 2005 the real income of the median household rose only 13 percent, but the income of the richest 0.1% of Americans rose 296 percent.

Most people assume that this rise in inequality was the result of impersonal forces, like technological change and globalization. But the great reduction of inequality that created middle-class America between 1935 and 1945 was driven by political change; I believe that politics has also played an important role in rising inequality since the 1970s. It’s important to know that no other advanced economy has seen a comparable surge in inequality – even the rising inequality of Thatcherite Britain was a faint echo of trends here.

On the political side, you might have expected rising inequality to produce a populist backlash. Instead, however, the era of rising inequality has also been the era of “movement conservatism,” the term both supporters and opponents use for the highly cohesive set of interlocking institutions that brought Ronald Reagan and Newt Gingrich to power, and reached its culmination, taking control of all three branches of the federal government, under George W. Bush. (Yes, Virginia, there is a vast right-wing conspiracy.) - I usually do not express political opinions, however Paul Krugman does. Inclusion of his opinions in a post is done for completeness and may or may not represent my views on the subject.

Because of movement conservative political dominance, taxes on the rich have fallen, and the holes in the safety net have gotten bigger, even as inequality has soared. And the rise of movement conservatism is also at the heart of the bitter partisanship that characterizes politics today.

Why did this happen? Well, that’s a long story – in fact, I’ve written a whole book about it, and also about why I believe America is ready for a big change in direction.

For now, though, the important thing is to realize that the story of modern America is, in large part, the story of the fall and rise of inequality.


Friday, September 21, 2007

Fed States That Housing Boom in US Caused by World Wide Low Long-Term Interest Rates

The excerpts below from an article in the WSJ, gives the Fed’s arguments as to why the housing boom in the US was caused by low long term rates earlier this decade. It is difficult to know the correct answer to this problem because we do not have the Fed’s perch. However, it should be apparent to everyone that the world capital markets are becoming more integrated and other countries are playing a larger part then during previous decades. This entire boom/bust issue will give academics something to debate for a long time.

Federal Reserve Chairman Ben Bernanke, responding to critics who contend the Federal Reserve's low interest rates earlier this decade helped create a housing boom and bust, said global factors that held down long-term interest rates world-wide were a more important factor.

Mr. Bernanke told lawmakers at a House hearing on the nation's housing slump that while Fed policy does work in part by influencing asset prices, "I think the primary factor leading to increases in house prices -- not only in the U.S., but in many countries around the world -- was the generally low level of [inflation-adjusted] long-term interest rates in global capital markets." . . . .

. . . . Between early 2001 and June 2003, the Fed reduced short-term interest rates to 1% from 6.5%. In a series of moves beginning in June 2004, it started raising rates, reaching 5.25% in June 2006. From early 2002 to mid-2005, the 10-year Treasury yield, the primary determinant of long-term mortgage rates, generally fluctuated around 4%. Mr. Bernanke said that as the Fed "lowered interest rates to 1% and raised them gradually, mortgage rates did not respond very much." (my emphasis)

Mr. Bernanke's remarks echo those of his predecessor Alan Greenspan in Mr. Greenspan's recently released memoir and related interviews. "I find this issue that the Federal Reserve created the housing bubble just utterly devoid of any awareness of who created all the other bubbles," Mr. Greenspan said in an interview last week with The Wall Street Journal. Many countries have seen home prices rise more than in the U.S., in particular Britain and Australia, whose central banks didn't lower rates as far as the Fed did.

Mr. Bernanke was a Fed governor from August 2002 to June 2005. Over that period, he not only backed Mr. Greenspan's low-rate policy, he also provided theoretical and empirical justification for it in speeches and research.

Some economists say Mr. Bernanke and Mr. Greenspan are minimizing the Fed's contribution to the housing boom. Thomas Lawler, a housing-finance consultant in Vienna, Va., says the Fed's low rates helped both subprime and adjustable-rate mortgages gain market share from fixed-rate mortgages. ARMs, he said, grew from just 10% of mortgage originations in 2001 to almost a third in 2004.

Brian Sack, who worked with Mr. Bernanke at the Fed and is now at forecasting firm Macroeconomic Advisers, points out that expectations of short-term rates help determine long-term rates. The 10-year Treasury yield was about a percentage point lower with the Fed's easy policy than if the federal-funds rate, its main target for short-term interest rates, had remained around 4.5% to 4.75%, he said. He said that the Fed intended to boost housing at the time, because the rest of the economy was so weak.

Both men say it is harder to attribute the continued increase in home prices in 2005 and early 2006 to the Fed. (my emphasis) A new study by economists Jonathan Wright of the Fed and David Backus of New York University attributes the continuance of low long-term rates during that period to lenders' willingness to accept a lower premium for lending over long, rather than short, periods due to "some combination of diminished macroeconomic and financial-market volatility, more predictable monetary policy, and the state of the business cycle."

Thursday, September 20, 2007

More Oil Price Details

The following from the WSJ gives additional perspective on the price of oil:

The weakening dollar is putting upward pressure on oil prices as other forces are already sending it up.

In addition to the main drivers of rising prices -- voracious demand by China and India and concern over supplies -- the interest-rate cut by the Federal Reserve this week could push the dollar lower and further lift oil.

A weaker greenback gives oil producers an extra incentive to drive prices higher: Oil is denominated in dollars on the global market, so producers are being paid for their output in less-valuable currency.

The further that crude pushes into new territory, the greater the risk that a price shock might damage the global economy. Oil costs can affect everything from transportation costs to consumer spending and retail sales.

Oil prices that rise too far could trigger a consumption decline either as a short-term correction or, some vocal bears warn, a more ominous repeat of the sharp rise in the late 1970s and steep subsequent fall that contributed to economic woes that reached into the early 1980s. Not likely, those price increases were significant on the order of two or three times the previous price. These increases will not be that dramatic in the short term unless there is a geopolitical problem.

While long-term oil forecasts are all over the map -- from $45 a barrel up to $100 -- a potent combination of conditions has laid the groundwork for the oil markets to now test what that new upper threshold may be. The only way for the price to drop to $45 is for OPEC to open up production and they do not have that much excess production. The other way is for the world to slide into a recession severe enough to decrease the price of oil.

Not only oil is affected. Most commodities are denominated in dollars, and commodity producers are often paid for in dollars, so commodities prices in general have risen as the dollar becomes less valuable.

Goldman Sachs Group Inc. commodity analysts now forecast year-end crude prices of $85, "with a high risk of a spike above $90" a barrel because of "anemic oil-supply growth."

The recent credit crunch also might imperil future supplies. Smaller oil and gas exploration companies are starting to report difficulty getting funding, says Subash Chandra, an analyst at Jefferies & Co.

Soaring prices aren't yet curbing global demand as much as might be expected -- at least not yet -- partly because the price is up considerably less when denominated in relatively stronger currencies. While oil prices have risen more than 160% in dollar terms since 2003, oil is up 97.5% in euros and 118% in Indian rupees, for example.

The Organization of Petroleum Exporting Countries has been recently lamenting the weaker dollar, which gives its members an incentive to keep a lid on production in hopes of raising prices. Earlier this year, Mohamed Bin Dhaen Al Hamli, OPEC's president, called the dollar's impact on its members' buying power "significant."

"I suspect that the dollar's depreciation is certainly an agent that is pushing oil prices up," says George Magnus, a senior economic adviser at UBS AG in London, while noting that supply-and-demand fundamentals guide long-term trends.

Crude's continuing climb leads some economists to fret about a vicious cycle in which expensive crude indirectly undermines the dollar further. Their argument: A portion of the dollars pouring into Persian Gulf countries are being converted into other, stronger currencies such as the euro as those countries gradually reduce their dollar holdings in foreign reserves.

"There's a desire not only to limit production but also to diversify away from dollars," says Richard Berner, an economist at Morgan Stanley.

Some Details on the Price of Oil #1

Just a few comments on the price oil and what drives the market, from Market Watch:

Crude-oil futures closed above $83 a barrel Thursday, sending the expiring benchmark contract further into uncharted territory on news that oil facilities in the Gulf of Mexico shut down 28% of production ahead of what's expected to become the tenth named storm of the Atlantic hurricane season.

An area of low pressure has entered the Gulf of Mexico and could become a tropical depression in the next 12 to 24 hours, Accuweather.com reported Thursday afternoon. The system could become Tropical Storm Jerry on Friday, it said.

MMS estimates that about 27.5% of oil production in the Gulf has been shut in, or roughly 360,169 barrels of oil per day. It points out that estimate oil output from the Gulf as of April 2007 was 1.3 million barrels of oil per day.

At the same time, crude supplies fell by 3.8 million barrels, motor gasoline inventories climbed by 400,000 barrels and distillate supplies rose by 1.5 million last week, the report said.

"As long as inventories of crude keep dropping, I think we can expect the price to keep rising," said Charles Perry, chairman of energy-consulting firm Perry Management.

But he said the Organization of the Petroleum Exporting Countries is concerned about the price climb. The group of key oil producers would "really like to see the price fall, and [that] may cause them to increase production," said Perry.

"What OPEC fears is conservation and alternate fuels, both of which are encouraged by higher prices," he said.
(my emphasis)

Treasuries and the Dollar Down, Oil and Gold Up – All From a Cut in the Fed Funds Rate?

As anticipated the effect on long term interest rates, oil, gold, and the dollar has been a decrease in the value of Treasuries (increase in interest rate) and an increase in the price of oil and gold, adding up to a decline in the value of the dollar. No need to worry about it at this time, we will not know for weeks or even months to come whether or not this was the right action for the Fed. However, with the increase in the price of oil you can expect higher prices for food and gas within a few months. From Market Watch:

Treasurys were lower Thursday, pushing yields higher, as the dollar's drop against most major currencies and recently high oil prices kept alive investors' worries about inflation in the wake of the U.S. Federal Reserve's interest rate cuts on Tuesday.


The euro broke through the $1.40 level for the first time on Thursday into uncharted territory, and the trade-weighted dollar index fell to a new 15-year low.

The fact that Saudi Arabia's central bank held rates steady overnight, failing to respond to a Fed cut for the first time ever, was taken by some investors as a possible signal that it could be mulling the end of pegging its currency to the dollar. That in turn raised concern that the world's largest oil exporter would reduce investment of its massive foreign reserves in dollar-denominated assets such as Treasurys.


"Fears that the Saudis will abandon the dollar peg has pressured bonds lower overnight," said Tom diGaloma, head of Treasury trading at Jefferies & Co.

The two-year note was down 5/32 at 99 27/32 with a yield of 4.083%, up from 3.982%.
"The 10-year yield topped 4.60%, even as foreign investors are getting cold feet on the dollar," noted analysts at Action Economics.

The drop in longer-dated bonds indicates the market fears that lower interest rates will lead to inflation over the long term, which would erode the value of fixed-income assets. Bond prices and yields move inversely to one another.

The dollar has fallen significantly against most major currencies since the Fed made its larger-than-expected half-point cut in both its federal funds target as well as the discount rate on Tuesday.
(my emphasis) Lower rates erode the returns on dollar-denominated assets.

The Fed said its move was made to prevent the fallout from credit woes following the subprime mortgage meltdown from dragging down the broader economy.

But on Thursday, most investors were focused on gauging external risks rather than domestic ones.

The lack of Saudi interest rate action "raises questions about the loss of the ostensible peg. We tend to be rather more narrowly focused on the economic risks in the U.S. and so less sensitive to the dollar -- perhaps analytical myopia on our part," wrote David Ader, U.S. government bond strategist at RBS Greenwich Capital.

He noted that the weaker dollar does potentially inhibit the actions of central banks such as the European Central Bank and the Bank of Japan. Foreign banks hold massive foreign currency reserves that they need to invest. Moreover, he said, the mass of dollars held by oil producers is surely rising with oil prices recently rising to new highs.

"The latter does get invested eventually and the charts...show some strong correlation between oil prices, oil producers foreign exchange reserves," and capital inflow data, he said.

Crude-oil futures closed above $83 a barrel Thursday, sending the expiring benchmark contract further into uncharted territory.

The dollar's plunge sent gold futures sharply higher, with the lead-month contract at one point hitting a 27-year high of $746.30 an ounce.

Wednesday, September 19, 2007

T Boone Pickens on the Price of Oil

It is time to turn away of interest rates for a while and talk about energy. T Boone Pickens about the price of oil from Yahoo.

Oil will continue to trend higher after hitting fresh highs over $82 a barrel but is unlikely to puncture the $100 level this year, Texas oilman and investor T. Boone Pickens said on Wednesday.

"You'll hit $100 -- I don't think you'll hit $100 this year unless you have some kind of geopolitical event that causes that to happen, but you're going to get to $100 at some point," Pickens told Reuters in New York.

Concerns that supplies will struggle to keep up with demand as the Northern Hemisphere gears up for winter pushed U.S. crude oil futures to a record $82.51 a barrel on Wednesday, prompting forecasts it could rise to $100.

"The trend is up, and if your supplies are 85 million barrels per day (bpd) globally, and you look at what demand is predicted to be for the fourth quarter, it is 88 million bpd," Pickens said.
"It means probably demand is greater than supply and the price goes up further."


Pickens said that while oil will eventually reach triple digit levels, it was unlikely to spike to $100 this year unless an unforeseen event upsets fundamentals.

Pickens, who heads the heads the BP Capital hedge fund, which was valued at $4 billion earlier this year, said prices could be pressured if demand shows signs of wavering.

"We haven't been at this level, so I don't have a feel for when we start killing demand with price," he said, adding oil could fall back to $78 a barrel before rising further.

In April when prices were around $65 a barrel, the legendary oilman forecast oil prices could tip $80 in late 2007 due to supply constraints.

What the Fed Funds Cut Means for the Future

Everyone was all excited about yesterday’s cut in the Fed Funds rate by 50 bps. Everyone acted as if good times were back again and here to stay. What concerned me most is what the Fed said and did not say about the rate cut. From the WSJ:

Federal Reserve Chairman Ben Bernanke moved aggressively to stop the spreading credit crunch from sinking the nation's economy with a surprising half-percentage-point cut in interest rates, casting aside for now worries about appearing to bail out investors.

The cut, which exceeded the quarter-point reduction most economists had expected, signals that Mr. Bernanke, fearing broad damage from the market turmoil that erupted a month ago, preferred to risk doing too much rather than too little. The move came amid a sizable drop in home sales, construction and prices that could send mortgage defaults higher and damp consumer spending.

In a break from the past, the Fed did not say whether higher inflation or weaker growth was its greatest worry or whether those worries were equal; it thus gave no hint about what its next move would be. "Some inflation risks remain," it said. But "developments in financial markets...have increased the uncertainty surrounding the economic outlook." (my emphasis) Markets put high odds on a quarter-point cut at the Fed's next meeting, on Oct. 30. . . .

. . . . "Economic growth was moderate during the first half of the year, but the tightening of credit conditions has the potential to intensify the housing correction and to restrain economic growth more generally," the Fed said in a statement accompanying yesterday's decision. "Today's action is intended to help forestall some of the adverse effects on the broader economy that might otherwise arise from the disruptions in financial markets." Sounds to me like someone is worried about the the effect of the credit markets on the overall economy. Not good news.


Tuesday, September 18, 2007

What the Fed Funds Rate Cut Could Really Mean?

The short article below was in this morning’s WSJ. These are my sentiments exactly:
No matter what the Federal Reserve does, somebody is in for a surprise.

The Fed is expected to cut the target rate it sets for overnight loans between banks today, but by how much is an open question. Although most firms are looking for a quarter-point cut to 5%, a significant minority, including
Goldman Sachs and Merrill Lynch, are looking for a half point. Futures that price off of interest-rate expectations suggest that investors are evenly divided between a quarter-point and a half-point reduction.

That means that if the central bank follows the base case, cutting by a quarter point, there will be plenty of investors who think it is behind the curve. If it cuts by a half-point, some Wall Streeters may worry that things are worse than they look. A half-point cut also would raise hackles among those who think the Fed shouldn't bail out speculators who took on too much risk and lost. (my emphasis)

If the Fed cuts its overnight federal-funds target rate by a quarter point, it could cut the rate that it charges banks to borrow money at its discount window by more as a signal to market participants that it stands ready to prevent credit markets from seizing up. Many market participants expect a large discount-rate cut, but there is a caveat that the Fed might find too large to ignore: If such a cut leads to a substantial increase in borrowing at the discount window, the influx of cash onto banks' reserve balances could push the federal-funds rate well below its target.

Perhaps investors would be better off today by not overthinking about the Fed and instead ask the bigger question: Is the economy on the cusp of recession? If it is, there will be many more Fed cuts, and profit disappointments, to come. If it isn't, then it might be a fine time to buy. (my emphasis)

What the Cut in the Fed Funds Rate by 0.5% Will Mean to the Consumer

The following from Market Watch gives you an idea of what the drop in the Fed Funds rate means to the consumers. For starters, just as stated in previous posts, oil is up to $81.45 per barrel, gold is at $724, and the value of the dollar against the euro is down. All-in-all not much.

For debt-weary consumers, the Federal Reserve's decision to shave interest rates on Tuesday is welcome news for their stock holdings but won't do much for their mortgage payments or savings accounts.


Responding to fears that a credit crunch -- exacerbated by a sagging job market, a housing-market pullback and the related crisis among subprime mortgage holders -- is squelching economic growth, the Federal Reserve took 0.50 percentage point off the target Fed funds rate, marking the first cut in that benchmark since 2003, and 0.50 percentage point off the discount rate.
For those on the brink of foreclosure, that's not the life preserver they need to keep them from falling in. And for those who also are subprime mortgage borrowers -- there's an estimated 1.5 million to 2 million out there -- the Fed move is of little consequence.

"It will help those who need it the least," said Richard Hastings, an analyst at Bernard Sands LLC. "But for those who need the most help, this does nothing for them. The Fed cannot help them at all."


Many borrowers who now face painful adjustments in their mortgage rates are stuck because lenders have quit making loans in those riskier markets altogether, making it much harder to refinance out of a burdensome loan regardless of interest rates. The homeowners must either come up with the money for the higher monthly payments, work with their lender to modify their loan terms or sink into default and foreclosure.

The Fed move will, however, lend a hand to those with home-equity lines of credit, whose rates are tied directly to the prime rate, the rate banks charge their most creditworthy customers. Banks generally mirror any Fed rate moves in their prime rate.

"This is going to be the beginning of some relief although it's not going to make a big difference right away," said Ellen Bitton, chief executive of Park Avenue Mortgage in New York.

A half-point cut "will not save the day," said Moody's Economy.com analyst Ryan Sweet. "Further action is going to be needed." He says consumers should watch for next month's Fed meeting on interest rates, set for Oct. 31, as well as the December meeting.

Lower rates could even hurt those whose incomes are tied to short-term interest rates on money markets and savings.

"That's the downside for those households that have financial assets tied to the interest rates and are generating cash off of that," said Carl Steidtmann, chief economist with Deloitte Services.

The decision did, however, catch the markets attention. After the Fed reduced the rates, the Dow Industrials Average rallied more than 260 points to an intraday high of 13,671.02.


Here's what consumers can expect:

If a consumer is paying 8.25% interest on a $100,000 loan that is based on the prime rate -- such as a home-equity line -- a rate reset to 7.75% is likely. That's the difference of about $500 a year, or roughly $41.66 a month in interest charges.

Resets on some adjustable-rate mortgages will be slightly better. Many ARM interest rates are based on an average of Treasury note yields coupled with a fixed margin, now at about 2.75 percentage points. At Tuesday's 10-year yield of 4.49%, the rate is 7.24%. In July, it was at 7.77%. That makes the monthly payment on a $200,000 mortgage $1,363, about $73 less than it was in July. But Treasurys could head even lower following the Fed action.

Rates on credit cards, which have taken on a bigger role in consumer financing in recent months, are likely to dip a bit too, lowering minimum monthly payments.

Savings-deposit rates will go down, meaning that your bank balances won't appreciate at the same rates you've seen all year.

Ditto on money market rates, hurting those on fixed incomes -- generally the elderly -- who rely on cash generated from such safe investments.

Interest rates on new loans for cars will fall, though it won't have any effect on loans already in place. But Brian Bethune, the U.S. economist with Global Insight, urges consumers to wait until contract negotiations between autoworkers and their bosses are done this month. "They could pull out all the stops," he said about automakers' desire to unload inventory. And if the Fed lowers rates again next month, all the better.

Not surprisingly, there's a caveat to all this: The Fed's cut in interest rates comes at a time when prices on energy and commodities are rising. The cut also could stimulate inflation, sending prices on everything higher.