Weekend Contemplation #1 – Is the Consumer Out of Steam?

The excerpts below are from a Market Watch article that discusses whether or not the consumer is out of steam. The entire article maybe of interest to some because it addresses individual retailers.

Shoppers have already adjusted their spending to accommodate climbing energy prices and interest rates, but the housing slump and problems obtaining and affording credit are proving too tough to juggle for many, according to some of the nation's largest retailers, who are bracing for a tough second half of the year.

"Consumer spending has been moving ahead at reasonably healthy rates in the past couple of months, but this latest drop in confidence will likely take some wind out of the consumer's sails at the end of the third quarter and in the fourth quarter," Brian Bethune, Global Insight's economist, told MarketWatch on Friday.

On Friday, the widely watched index of consumers sentiment about the economy conducted by the University of Michigan and Reuters posted a sharp drop to 83.3 from 90.4 in July.

Wal-Mart Chief Executive Lee Scott, speaking on a recorded earnings call, said many of his customers are living paycheck to paycheck.

Merrill Lynch Chief Economist David Rosenberg has become so bearish that he believes that the trouble already is at hand.

"There are plenty of signs now suggesting that we may be in the early stages of a consumer-led recession for the first time in 17 years," he said in a research report this week.

Yes, he said, there's the volatility rocking the stock market, but there's also a "massive" pullback in mortgage lending, hedge fund problems, the Federal Reserve's infusion of liquidity and the "sharp retrenchment in risk appetite."

"While the turmoil on Wall Street is an understandable distraction, the future is very likely in the hands of the consumer on Main Street USA and the latest signposts are not encouraging," he added.

Not everyone is ready to write off consumers just yet. Art Hogan, Jefferies & Co.'s chief market strategist, concedes that the macro economic landscape isn't pretty, but said spending won't stop.

"History has proven out that betting against the U.S. consumer is the wrong bet," he said.
High-income shoppers appear mostly unfazed by all the events so far, although some industry observers worry that the deterioration in the stock market could take its toll on them too as they watch their wealth dwindle.

Mike Ullman, chief executive at J.C. Penney Co. isn't worried about spending as much as he is about consumer psychology. "Sentiment is the thing that cuts across multiple sectors and affects everybody's attitudes," he said.

Auto sales, Rosenberg noted, have fallen for a record seven months in a role and slipped to a nine-year low of 15.2 million units in July "and there is no sign of a pick up in the first half of August," he said. And sales of new and existing homes are also at multiyear lows.
If more spending dries up, recession fears will swell.

"I'm nervous," said Standard & Poor's Chief Economist David Wyss. "The odds of a recession have increased. The danger is that these kinds of financial panics can be self fulfilling."

Mike Niemira, chief economist for the International Council of Shopping Centers, said it's not a traditional recession that's at work right now, but a growth recession. The growth of consumer spending has slowed considerably from its 5% gains two years ago to what could be a 2.5% gain, at the high end, by the end of the year.

"We've been in slow-growth mode for a year," he said.

That that means, according to Scott Hoyt, director of consumer economics at Moody's Economy.com, is that the consumer can no longer shoulder the burden of the economy alone.

"As long as they've got jobs and their incomes are growing, there will be enough spending growth to keep the economy moving," he said. "But we're looking at investment income and foreign trade as being more the leaders of economic growth now rather than consumers."
While many argue that the slow down in consumer spending was hardly unexpected and the evidence so far -- soft sales in building materials, furniture and home furnishings -- is mostly tied to the housing market, momentum is what is critical.


GDPI has been declining for the last year and net exports are too small to significantly effect real GDP. PCE and GDPI comprise 87.5% of GDP (double click on image below to enlarge).


"All of this can feed upon itself and ultimately give us a recession," Niemira said. "That's the worry today."

But by Jefferies strategist Hogan's thinking the slow down in consumer spending isn't nearly enough to push the U.S. economy into a recession.

"There is a Chicken Little crowd as it pertains to consumer spending," he said, referring to those doomsayers who believe the sky is falling. "Once in awhile they're going to be right. I think they've correctly predicted two out of the last 25 setbacks."


My response to all these differing opinions is - that is why they invented horse racing. How much of your money do you want to bet on your opinion? If the answer is none - then your just another person with an opinion.

A Comment Today from the FOMC

A terse comment from the FOMC today suggests that not much has changed since last week.

Financial market conditions have deteriorated, and tighter credit conditions and increased uncertainty have the potential to restrain economic growth going forward. In these circumstances, although recent data suggest that the economy has continued to expand at a moderate pace, the Federal Open Market Committee judges that the downside risks to growth have increased appreciably. The Committee is monitoring the situation and is prepared to act as needed to mitigate the adverse effects on the economy arising from the disruptions in financial markets.

The Fed Cuts the Discount Rate by 0.5% - A Little Form Over Substance

The Fed cut the discount rate this morning by 0.5%. There seemed to be a lot of excitement about this, but it is mostly form over substance. The discount rate is the rate charged by the Fed for borrowing from the Fed, which is different from the Fed Funds rate. It is rarely used and going to the “discount window” is usually considered going to the lender of last resort. But if it makes the market happy, who am I to disagree. From Market Watch or read the real deal from the Fed:

In a move wildly applauded by financial markets on both sides of the Atlantic, the Federal Reserve announced Friday that it's cut the discount rate by a half percentage point to 5.75%.

The Federal Reserve Board said it was acting to "promote the restoration of orderly conditions in financial markets." The Fed also said it would allow banks to borrow unlimited funds at 5.75% for 30 days, rather than the overnight loans previously allowed at 6.25%.

By cutting the discount rate instead of the federal funds rate, the Fed signaled that it believes problems are mainly confined to the financial system, and are not yet impacting the broader economy. The cut in the discount rate provides funds to banks, but does little to change consumer and commercial interest rates, as a cut in the fed funds rate would do.

"Markets should not be calmed by this tactic," wrote Ian Shepherdson, chief U.S. economist for High Frequency Economics. "This move is not going to provide any relief to the overall economy."
In a separate statement, the policy-setting Federal Open Market Committee acknowledged the precarious state of credit markets and the economy.

The discount rate is the interest rate charged to commercial banks and other depository institutions on loans they receive from regional Federal Reserve lending facilities. It differs from the key federal funds rate, which is the rate at which private institutions lend to other depository institutions overnight.

"We can only speculate about this, but the decision to move the primary discount rate rather than the fed funds rate may indicate that the Fed anticipates some institutional failure as soon as today, probably not a bank, but rather an institution that has substantial bank liabilities that may not be able to clear," Shepherdson said.

The discount window has been rarely used; only an average of $87 million is borrowed on an average day, said Tony Crescenzi, chief bond market strategist for Miller Tabak & Co. There has been something of a stigma attached to using the discount window, Morgan Stanley's Greenlaw said.

Another “Nuts & Bolts” Description of How the FOMC Works

In case you are wondering how the FOMC actually injects cash into the market place, the article from the WSJ.com/Economics (8/16/07 post) gives an excellent description. This ties in really well with two earlier post about injecting capital into the markets and recent trends in the Fed Funds rate market.

As a side note the content of WSJ.com/Economics is very good and it provides an excellent service to the investing public. It often covers subjects that you had in school, but if you don't work with everyday they get away from you over time. If you are surfing the net on economic/business related issues this is always a good spot to land just to see what's new. This blog is a relatively new service for the WSJ. I hope they see fit to keep it up and running (and free).

Much has been made in recent days about the deviation between the actual fed funds rate charged on short-term loans and the target set by the Federal Open Market Committee, with some going so far as to call it a de facto rate cut. How does the Fed keep the actual rate near its target, and what does the recent deviation mean? Here’s a primer.

The fed funds rate is the rate banks with excess reserves charge when they lend money to other banks overnight. It moves according to a traditional supply-demand path. When there are more institutions looking to borrow than lend, the rate goes up. When there are more lenders, it goes down. The Federal Reserve sets a target for this interest rate, and the Trading Desk at the Federal Reserve Bank of New York adds or drains funds to keep the rate near its target, which is now 5.25%.

Each morning, reserve forecasters at the New York Fed and at the Board of Governors in Washington compile data on bank reserves for the previous day and make projections of factors that could affect reserves for future days. They consult with Treasury Department officials, and then the Trading Desk officials in New York make a plan for the day. The plan is then reviewed by at least one voting FOMC member.

At this point, the Trading Desk prepares to enter the market to execute repurchase agreements (temporary purchases of securities from the dealers, who agree to repurchase them on a specified date at a specified price) or, more rarely, reverse repurchase agreements (temporary sales of securities). The recent Fed actions have all been repurchase agreements.

The Desk sends an electronic message to all of the primary dealers (21 large banks and securities brokerages that trade with the Fed), asking them to submit bids or offers within 10 to 15 minutes. The message states the term of the operation, but doesn’t specify its size. The size of the operation is announced later, after the operation is completed. The dealers’ propositions are evaluated on a competitive best-price basis. Primary dealers whose offers have been accepted, and those whose offers have been turned down, are notified of the results, usually about five minutes after the bids or offers were due.

The Desk accepts bids of varying rates and sizes, aiming to keep the average rate near the FOMC target. However, this process is filled with uncertainty — especially at times of market turmoil — and trades between institutions outside of the repurchase agreements can move the rate. The Desk may also make agree to deals with rates below the target on a given day, while still aiming to keep the rate at the Fed’s target over the longer term.

The Fed’s recent wave of repurchase agreements came as the market had driven the average actual rate above the FOMC target. The infusion of liquidity has brought the average actual rate below 5.25% in recent days, at some points approaching zero. In fact, it has been just below 5% since the Fed began pumping funds into the market last week.

This doesn’t mean the Fed wants the rate to remain below its target. One possible explanation is that the central bank is erring on the side of caution, temporarily overshooting its goal of a lower rate while the liquidity situation returns to normal.

Another possible factor keeping the rate down is transactions between dealers outside of the Fed’s repurchase agreements. Some trades have taken place at rates near 0% over the last few days. These trades don’t represent the majority of transactions, but may be dragging down the average rate.

The Fed Funds Rate and the Request for the Fed to Cut Rates

It appears that the Fed has already cut the Fed Funds rate effective last Friday. One of the tools at the disposal of the Fed is the FOMC. With the large injections of cash starting last Thursday the Fed has already effectively cut the Fed Funds rate from an average of 5.28% the last half of July (3 bps over its target rate of 5.25%) to 5.13% the first half of August. Since Monday the average Fed Funds rate is 4.76% (admittedly only 3 data points).

The constant requests by various individuals in the investment community to lower the target rate by 0.25% is a waste of time and bad policy. The Fed has tools at its disposal to move the markets on a temporary basis without making the “large” move of dropping the target rate. It is better to attempt to move the markets with a surgical strategy then to make the “large” move and drop the target rate. After all, what is Plan B if the Fed drops the target rate and the markets do not improve. (double click on image to enlarge)

Personally, the Fed gets an “A” for last week’s cash injections.

Rating Agency Problems #2 - Credibility

Yesterday’s post on the rating agencies and the part they played in the current credit market problems was fairly popular. In it the question was posed “how do the rating agencies function independently”. Today’s article in Bloomberg answers the question – they probably don’t. The rating agencies had to give up something and it should come as no surprise that it may be their credibility.

Moody's Investors Service and Standard & Poor's, the arbiters of creditworthiness, are losing their credibility in the fastest growing part of the bond market.

The New York-based ratings firms last month gave a new breed of credit derivatives triple-A ratings, indicating they were as safe as U.S. Treasuries. Now, investors are being offered as little as 70 cents on the dollar for the constant proportion debt obligations, securities that use credit-default swaps to speculate that companies with investment-grade ratings will be able to repay their debt.

``The rating doesn't tell me anything,'' said Bas Kragten, who helps manage the equivalent of about $380 billion as head of asset-backed securities at ING Investment Management in The Hague. ``The chance that a CPDO won't be triple-A tomorrow is a lot greater than it is for the government of Germany.''

Ratings are ``a measure of risk on a buy-and-hold basis and say nothing about the pricing volatility of an investment,'' said Gareth Levington, a senior analyst at Moody's in London. ``The market level isn't hugely relevant for the rating.''

Derivatives are financial instruments derived from stocks, bonds, loans, currencies and commodities, or linked to specific events like changes in the weather or interest rates.

The rating firms help borrowers structure debt securities in a way that will get the highest possible credit rankings while allowing managers of the securities the most profit, according to Charles Calomiris, the Henry Kaufman professor of financial institutions at New York's Columbia University.
Moody's earned $884 million last year, or 43 percent of total revenue, from rating so-called structured notes, according to Neil Godsey, an equity analyst at Friedman, Billings, Ramsey Group Inc. in Arlington, Virginia. That's more than triple the $274 million generated in 2001.

Ratings firms ``used to be seen as good, objective folks dressed in white, who you could count on to give reliable opinions,'' said Christopher Whalen, an analyst at Institutional Risk Analytics, a research firm in Hawthorne, California, that writes software for auditors to determine if banks are accurately valuing their assets. ``But when they got involved in structuring and pricing these deals, I think they crossed the line. They have lost a lot of credibility.''

CPDOs were first created last year by banks ranging from Amsterdam-based ABN Amro Holding NV, the largest Dutch lender, to New York-based Lehman Brothers Holdings Inc. HSBC Holdings Plc in London and Dresdner Kleinwort in Frankfurt also sold CPDOs.

CPDOs sell credit-default swaps, contracts that would pay a buyer face value for bonds if the company that issued the debt can't meet interest payments or otherwise defaults. CPDOs provide insurance on a basket of 250 companies, borrowing up to 15 times their initial capital, boosting their investments to as much as $60 billion.

ABN Amro's Surf CPDOs fell to as little as 70.2 cents from almost 104 cents on June 6, and were quoted at 76.73 cents yesterday, prices on Bloomberg show. An equivalent price decline on government notes would push the yield as high as 11.7 percent.

The increase in credit-default swap indexes means investors can expect to earn a higher premium for providing debt insurance as soon as new indexes are created in September. To make up for losses, CPDOs would typically increase their borrowing.

European Banks Still Nervous About the Markets

Excerpts below from an article in the WSJ indicates that the European banks are still nervous about lending to one another. Although the ECB and the BOJ started pulling some of their money out on Tuesday the European banks interbank lending rates remain relatively high. Note that the ECB and BOJ have not pulled that much money out and the Fed and the Bank of Canada injected cash on Tuesday. As stated in earlier posts this problem has not been resolved.

As Europe's money markets calm down and central banks cut off the extra cash they have been providing to avoid a global credit meltdown, several indicators show commercial banks remain unusually hungry for cash and nervous to lend to each other over longer periods.

After four days of flooding money markets with funds, the European Central Bank and Bank of Japan effectively drained a little liquidity from the markets yesterday, in a sign of confidence that the global financial system is returning to normal.

The Federal Reserve Bank of New York canceled a $7 billion overnight injection of funds it had set for 9:30 a.m. yesterday, blaming technical problems, and then implemented it at 10:30 a.m. The snafu rattled the markets briefly.

The Fed had alerted the market to its intentions early in the day. To suggest the maneuver was more ordinary than a response to the continuing strains in credit markets, it said the intervention would be needed "to accommodate heightened reserve needs typical" on a day when the Treasury is raising money in the bond market.

The return to business-as-usual at the ECB was encouraged by falling short-term lending rates on overnight markets, where the rate at which banks lend to each other hovered yesterday around 4%, the target set by the ECB, which governs monetary policy for the 13 nations that share the euro currency. That rate was far below the highs near 4.7% last Thursday that prompted the ECB to step in.

Central banks manage economic growth and prices by setting a target for the rate on overnight loans between big banks. Then, they use open-market operations to increase or decrease the supply of funds in order to keep the market rate near the target. When the rate moves far above the bank's target rate, it signals that liquidity in the market is tight and banks are unwilling to lend to each other.

But a potential reason the ECB didn't intervene yesterday, analysts say, is that it had flooded euro-zone markets with its weekly infusion Tuesday. During its regular weekly money-market operation, the ECB injected €73.5 billion ($99.5 billion) more than it had budgeted. As opposed to the unscheduled cash injections, which were short-term, banks can hang onto these funds for a week.

"This huge weekly injection has relieved the pressure for the ECB to be undertaking massive daily injections," said Julian Callow, chief euro-zone economist with Barclays Capital in London, in a research note. "It means also that there is now a large cash surplus in euro-area money markets, which has pushed the overnight rate down."

At the same time, longer-term money-market interest rates are rising -- an indicator banks are becoming more nervous about lending to each other for longer periods of time.

The three-month euro money-market rate rose to 4.5% yesterday from 4.4% last Thursday, according to the European Banking Federation. Analysts say the rise reflects banks' fears that some victims of the U.S. subprime fallout have yet to emerge.

"Banks are still afraid of lending to each other for longer periods," said Antonio Villarroya, an interest-rate strategist at Merrill Lynch in London. "They fear the counterparty risk, and they fear that they might need the money themselves."

The CPI is Up 0.1% in July

The CPI was up 0.1% in July. When you look at the 3 month average versus the YOY numbers it appears that energy moderated considerably in the last few months. However, food is still up 4.3% from a year ago. Details of the article can be found at Market Watch and the original government press release can be found at BLS.

With gasoline prices falling, U.S. consumer prices increased 0.1% in July, the slowest inflation rate in eight months, the Labor Department reported Wednesday.

The core consumer price index, which excludes volatile food and energy prices, increased 0.2% for the second straight month.

Falling energy prices, a moderate rise in housing costs and flat auto prices held the CPI in check for July, partially offsetting higher prices for apparel and medical care.

The CPI is up 2.4% in the past year, the lowest year-over-year increase since February, while the core CPI is up 2.2%, close to the upper end of Federal Reserve's target zone.

Fed officials have noted that inflation has slowed since last year, but they've also said they are not persuaded that "a sustained moderation" has been "convincingly demonstrated."

The three-month annualized change in core inflation has picked up for three months in a row and is now up at a 2.5% annual pace. "The pattern gives backbone to the Fed's continued insistence that a 'sustained moderation' in the inflationary environment may not yet have taken hold," wrote Kenneth Beauchemin, an economist for Global Insight.

Officially, the Fed has said it's more worried about higher inflation than slower growth, but financial markets have a different view, betting that the Fed will lower its overnight interest-rate target as early as next month to ensure that the weakness in the housing and credit markets doesn't create too much of a drag on the broader economy.

Aftermath of the Capital Injections by the World’s Central Banks

The central banks are in the process of cleaning up all the capital that injected into the markets last week. Some central banks are in the process of getting their money back, while the Fed and the Bank of Canada were injecting small amounts (small is a relative number, I would be happy with 0.1% of what the Fed injected). Once again the conditions that caused the capital to be injected have not gone away, so injections in the future are a definite possibility. By the way, the anticipated rate cut by the Fed of 25 bps by October will not save the market. Continuing their policy of injecting cash as needed will help the market more than than a rate cut. From Yahoo:

Central banks in Europe and Japan on Wednesday mopped up cash poured into money markets to quell a global credit storm, but in Canada and the United States there were more measures to shore up liquidity.

The Bank of Canada stepped in after a day on the sidelines of the money market, and the Federal Reserve added $7 billion in temporary reserves as losses in the U.S. subprime mortgage market sent Wall Street stocks slumping again.

For the first time since it began pumping extra cash into Europe's money markets on Thursday, the European Central Bank gave no extra short-term money to keep the financial system operating smoothly. Central banks in Japan and Switzerland actively drained cash from their local markets after injections of liquidity in the past week.

However, emerging market Asian central banks took steps to smooth trade in the region's currency markets as ongoing credit fears hit stocks and sent the yen to a 4-1/2-month high, as investors unwound carry trades involving borrowing in yen to invest in higher yielding securities elsewhere.

Analysts warned that the credit squeeze and liquidity problems were spreading.
"The turmoil in financial markets continues with a greater contagion in Asia, emerging markets and investment grade credit," Tullett Prebon G7 economist Lena Komileva said.

Signs of credit bottlenecks have led investors to scale back expectations for interest-rate increases or, in the case of the Fed, have raised expectations for an ease.

The Fed's action was modest compared with the $38 billion it poured into markets on Friday, the largest amount injected since just after the September 11, 2001, attacks. But dealers said it was a reminder the Fed remained alert to market needs.

The Bank of Canada injected C$350 million ($330 million) of repurchase funds and left the market flush with cash at the end of the day. It left a C$500 million balance in the Large Value Transfer System, which allows easy balance settlements by banks, up from the normal C$25 million. It said it plans to do the same on Thursday.

But ECB President Jean-Claude Trichet said on Tuesday money market conditions had progressively returned to normal, although the central bank would continue to watch developments closely.

Central banks in Malaysia, Indonesia and the Philippines were suspected of intervening once again on Wednesday though, selling U.S. dollars to slow the declines in their currencies.

The Home Builders Index is Down Again in August

The NAHB/Wells Fargo housing market index is down again in August according to Market Watch. Most of the component indices are at or near the lows most of which were set in 1991, the last severe housing decline. With these values being set so late in the house buying cycle of the year, I fully expect most of these indices will set new lows later this year.

Battered by daily headlines about severe problems in the credit markets, U.S. home builders grew even more pessimistic in August, driving a monthly sentiment gauge to the lowest levels since January 1991, the National Association of Home Builders reported Wednesday.

The NAHB/Wells Fargo housing market index fell two points in August to 22, which means about a fifth of builders nationwide think the market is "good." A year ago, the index was at 33. Two years ago it was at 67.

Numbers over 50 would indicate more builders think conditions are good than think they are bad.
Over time, the home builders' index has been correlated with single-family housing starts, which are down 37% from their peak.

All three components of the home builders' index fell to cyclical lows in August, with two of them matching the lowest readings in the 22-year history of the index. Confidence fell in three of four regions and was unchanged in the South.

"There is no question that problems in the subprime mortgage sector have spilled over to other components of housing finance, including the Alt-A and jumbo markets, delaying a revival of the single-family housing market," said NAHB chief economist David Seiders in a statement.

The index measuring current sales of single-family homes dropped by one point to 23, the lowest since the record-low 19 in January 1991. The index measuring expected sales in the next six months dropped by two points to 32, matching the record low. The index measuring traffic of prospective buyers through developments fell by three points to 16, also matching the record low.
"Builders realize that issues related to mortgage credit cost and availability have become more acute, filtering some prospective buyers out of the market and prompting others to delay their decision to purchase a new home," said NAHB President Brian Catalde, a home builder from El Segundo, Calif.

"Builders are responding by trimming prices and stepping up non-price incentives to bolster sales and limit cancellations, although we're dealing in a difficult market environment," Catalde said. Regionally, the index was unchanged at 25 in the South, fell one point to 23 in the West, fell five points to 14 in the Midwest, and fell two points to 30 in the Northeast.