Z1

Today the quarterly Flow of Funds (aka Z1) report was released by the Federal Reserve. What is the Flow of Funds report? Imagine the USA was a company: it's income statement would be called GDP report, and it's balance sheet would be the Flow of Funds. In my opinion this is the most important economic statistics release there is.

Unfortunately for this blog and its readers, I am quite busy at the moment getting ready to commence employment at Keefe, Bruyette and Woods research department in London, and I'm likely to become more and more busy as days go by. I will thus ask my dear readers to confer to the fantastic blogs linked below in the right column of this page for analysis of  and commentary on the all-important Z1 report.

Hulbert: advisory sentiment back to dangerously high levels

Which of course is bearish (link here). Note that this type of contrarian indicator works best at a horizon of a few weeks.

Guest post: Paul Kasriel on fiscal deficits and inflation

Today I had the pleasure of exchanging a few emails with Paul Kasriel, Chief Economist of Northern Trust. Paul is in my opinion one of the greatest economic forecasters around (you can read him here). I don't think he would disagree if I said he is a great student of Friedman and Hayek, and that he knows what is money and what is inflation. Here is what I asked him and his response:

RK - Some economists argue that money and government bonds are near-perfect substitutes in an investor portfolio. Thus, they conclude, large fiscal deficits will result in higher rates of inflation, whether or not the central bank lets the money supply grow very fast or not. What is your opinion of this theory?

PK - I do not understand the argument. If the government sells the public bonds and the banking system (including the central bank) does not create the credit for the purchase of these bonds, then the public is transferring purchasing power to the government. The public cuts back on its current spending and the government increases its current spending. In contrast, if the banking system creates the credit for the public to purchase government bonds, then the public does not have to cutback on its current spending and the government can increase its current spending. This would be inflationary. In the former case, the Austrian economists refer to this as "transfer" credit inasmuch as purchasing power is transferred from one entity to another. The Austrians refer to the latter case as "created" credit in that the banking system and central bank create credit, much like a counterfeiter, enabling one entity to increase its purchasing power while not necessitating any other entity to cut back on its purchasing power. Perhaps I am missing something in the argument of these economists who believe that government debt issuance is inflationary in and of itself.

Those economists I mention (they seem actually to be a majority of economics scholars), believe that a dollar is a dollar, is a dollar. But if you issue a bond, someone has to cut its spending in order to buy it. Also, why not extend the theory and include AAA rated private bonds to government bonds? And while you're at it, just throw in all investment grade bonds.

To conclude, Japan seems to provide a pretty convincing evidence for Paul's point of view. But as he says, maybe we're missing something?

Conspiracy theorists are not going to like this one

More precisely, by conspiracy theorists I mean people who have been arguing that the Bush and Sarkozy administrations had been using their connections with media barons to influence the public opinion and thus, voters (Let's leave Berlusconi and Putin out of this...).

James Hamilton over at Econbrowser Menzie Chinn reports on a recent study by University of Chicago professors Matthew Gentzkow and Jesse Shapiro, who use standard econometric methods (which is why this subject is not too far away from the usual posts on this blog) to explain what drives a newspaper's political orientation. Two main conclusions: a paper's political orientation is very correlated to "the political orientation of people living within the paper's market", and "the politics of the paper's owner seem to matter much less". Hamilton Chinn continues:

Gentzkow and Shapiro conclude that papers to some degree are just giving their readers what the readers want so as to maximize the newspapers' profits.

The full study is here.

This rally looks technically ok - for now

Three weeks ago, I called for the end of the little correction we had experienced in the beginning of the year, and the reason was mostly technical. Today, I cannot find a technical reason to call for the end of this three week old rally: market breadth and internals are quite good (see this post to understand why these indicators should be followed). Sentiment used to be ultra-bullish, which was bearish. It is not anymore. Most of the liquidity indicators I follow have turned up. Volume is lacking, but it has been lacking since the March 09 bottom.

The fundamentals however are deteriorating. Leading economic indicators around the world look toppy, Greece is only the beginning of a multi-year (multi-decade ?) long round of sovereign credit problems, and the financial sector is likely to face renewed troubles due to fading official support and high default rates in commercial and residential real estate (why does everyone thinks that because banks are paying huge bonuses then they must be fine? This is simply flawed logic). Add to this stretched valuations and soon-to-be fading policy stimulus, and voilà! you have a recipe for some choppy waters in risk assets.

But for now, Mr. Market just doesn't seem to care, and the path of least resistance seems to be up.

Hamilton on the Treasury Supplementary Financing Program (SFP)

Warning: geekiness level more elevated than usual.

Hamilton thinks the increase in the SFP is rather surprising given the other "outs" the Fed could use, and it may be part of a broader, still undisclosed strategy. This strategy in my opinion would simply be the unlegislated bailout of Fannie and Freddie.

Question: Obama worries me more than Greece or anything else so far. Let me know if I should change my viewpoint on the guy...

Don't discount Greece yet. It may be a small country, but the domino effect could be severe (remember subprime? it was a tiny portion of the US mortgage market). Obama unfortunately, has no understanding of economics and has been relying on a financial intelligentsia (Bernanke, Geithner, etc.), who were instrumental in getting us into this mess, to get us out of it. The result is that the U.S. is following the footsteps of Japan and its "zombie banks" and dire fiscal situation (not to mention the fantastic moral hazard risk brought on by bailing out bank bondholders). To me the only good news since Obama took office is that Volcker seems to be getting a bigger and bigger voice in this administration. I hope this is a sustainable trend.

"Bond on bonds – disaster ahead"

... in which Barcap's Tim Bond forecasts developed market bond yields to double over the next decade. I tend to agree with that forecast, although Tim Bond and I have completely divergent reasons why.

He thinks an aging population will cause a surge in government debt/GDP ratios, which will increase risk premia. I believe that an aging population lowers potential GDP growth and thus, bond yields as well. I believe that inflation is the one main driver of bond yields in developed markets: cf. Japan, with it's government debt/GDP closing in on 200% (this is much higher than anything forecast for Europe and US in the next twenty years).

However, I am much less confident that the current handling of the financial crisis will not bring a spurt of high inflation down the road. It's not yet in the cards, but avoiding that scenario will require extreme toughness from policy makers - something I have trouble believing in.

By the way, as I have argued in many posts in the past six months, I believe in the near term the risks to bond yields are tilted to the downside: in my opinion, there is still more risk on banks balance sheets than on sovereigns balance sheets, and renewed flights to quality cannot be dismissed. For now.

Stop it with the data-mining, Mr. Rosenberg

I have a lot of respect for David Rosenberg, the chief economist over at Gluskin Sheff (previously with Merrill Lynch). However, I have a lot of trouble reading his daily commentaries because: 1) they're a tad too long, 2) they often repeat, and 3) Rosenberg much too often cherry picks data to fit and prove his preconceived opinion (opinion to which I agree for the most part - the point being I much rather like people forming an opinion out of data and logic rather than the other way around).

As an exemple, Rosenberg recently highlighted the extremely high (0.95) correlation between the S&P 500 and the Copper/Gold ratio over the past three years. Unfortunately, the reason for this is more the fact that the correlation between stocks and both the metals has been very high over that period. In econometrics, this is known as multicollinearity (a violation of regression assumptions), and is typically detected by a high correlation which carries low significance, reflecting inflated standard errors.

Let's look at the data since 1997: the correlation between stocks and the copper/gold ratio drops to 0.55, while the correlation between stocks and copper is a lower 0.37 (the one between stocks and gold is about zero). 0.37 is still statistically significant so we haven't got rid of the multicollinearity problem, but at least now we can overlook it. Conclusion: Copper/gold has a somewhat significant and relatively high correlation with equities.

Mr. Rosenberg, you see, your point was valid. Why did you have to torture the data to "prove" it?

No more accrued interest for us

I'm talking about accruedint.blogspot.com obviously.

This adds up to an already too long list of great bloggers who have stopped blogging in the past couple years or so. Somehow I feel that, although the quantity of finance blogs has been increasing exponentially in the past few years, the aggregate quality has remained constant.

Stupid headline of the day

"Dollar Soars as China Surprises Markets with Reserve Requirement Hike" (source not disclosed out of kindness).

The dollar may be "soaring" (by a full 0.81% !) today, and China may have hiked rates, but the two events are in no way related. You see, when a country has a fixed exchange rate, it has no control over monetary policy: reserve requirement hikes will induce more hot money inflows (looking for a higher return then dollar-denominated money funds, with no currency risk vs. the dollar), which means a higher money supply - since the central bank has to print the yuan needed to be sold to foreigners in exchange for foreign currency so as to keep the exchange rate constant. China has tried to sidestep this with controls on capital flows but everyone knows they are looser than the US-Mexico border. This is econ 101 and is known as the impossible trinity.

What is the relation between this and my saying the above headline is stupid? Because if China is hiking rates, it shows at least an intent, a signal if you will, of tightening monetary policy. But as I just discussed, this can only happen if China lets its exchange rate appreciate.

And that would be everything but positive for the US dollar.

Reversal?

After opening and spending most of the day in the (deep) red, most risk assets, including equities, managed to turn out a small again gain last friday. This is what technical analyst call a "key reversal day", and is short-term bullish. However, the fall of the past few weeks has done a lot of technical damage: supports and trendlines broken, oscillators and indicators rolling over, etc. As such, the technical picture is not yet supportive of a sustained advance. Stay tuned.

Once again, the Baltic Dry and gold prove to be the best early indicators

They may call it "Doctor" Copper, but the metal is, just like other industrial metals, at best a leading indicator of industrial activity, and industrial activity is preceded by changes in financial conditions. The earliest signals of the correction we are experiencing in risk assets have been given by the Baltic Dry index and gold -- peaking in end November / early December, with copper and equity markets peaking more then a month afterwards:

 

Remember this the next time you watch CNBC and hear about "Doctor" Copper.

As an aside, following this logic, equities are not yet ready to stage a sustained rebound.

More on the uncertainty surrounding 2010 GDP forecasts

This is a follow-up to the previous post, in which I discussed the fact that my GDP model produces a very large range of possible 2010 GDP growth, depending on the number of lags (past observations) of the data.

To illustrate this, I backward tested my model to estimate year-ahead GDP growth as of each January since 2003, in what is called "pseudo out of sample" forecasts. It simply means that I put my model in the situation it would have been at the time, and thus, it cannot use data not known as of that moment. For example, for the 2004 GDP growth forecast, only data published through January 2004 can be used.

I had my model produce forecasts using 8 lags (the past 8 months of data) to 38 lags. Then, I calculated the standard deviation of these yearly forecasts:

 

To summarize, what this tells is that the uncertainty surrounding the 2010 figure is about five times larger than usual.

The conclusion: either my model is misspecified (which I don't rule out, but it's been very good on a pseudo out of sample exercise), or, fading monetary and fiscal stimulus, combined with an uncertain outlook for private investment and final demand, makes it very difficult to have a strong opinion on 2010 GDP. And it could of course be both.

2009 GDP Forecast and a thought on 2010

With the first GDP estimate for Q4 released, I can now compare the actual performance of U.S. GDP with my model's forecast for 2009. A picture is worth a thousand words, so here's a chart:

This is what my model would have predicted in January of last year (well not exactly as I am using revised data. I believe if I used vintage data the prediction would have been less accurate, although in the same ball park).

Note: the green bands represent the 50%, 75% and 90% confidence bands around the central forecast.

Despite improvements in recent months, my model is still calling for (much) below-consensus growth in 2010. However, because of the extremely wild swings the underlying series have experienced, which are due to unprecedented (in the estimation sample) economic dislocations, I am afraid the model could be being stretched beyond its capabilities.

(Technical note:) What is happening precisely is that, depending on the used number of lags of the data, the forecasts can be extremely different. Lags are how many months of data I let my model use: for example, I could use the past 12 months observations of money supply. I had determined previously that 30 months of observations was a good number of lags, but in any case, if I used 12 months, 24 months or 36 months, the forecasts were not very different. This is no longer the case, and it's a big problem.

However, I believe it is also a reminder that 2010 risks being quite surprising to both bulls and bears. It was easy to forecast a recovery last year when the largest stimulus in history was kicking in. It was also easy to forecast the recession (pardon my lack of humility), when the housing bubble popped. 2010 is a much less obvious story: the contribution from stimulus is going to fade and subtract from growth pretty soon, and private demand seems to be recovering extremely slowly.

Quick market update

I am reminded that I haven't commented on the market in a little while, so there it is: market's overbought oversold short term (only about 30% of stocks on the NYSE are above their 50-day moving average), and new highs still overweight new lows, so we're likely to see some sort of rally or trading range, but who knows. Longer term risks are still to the downside due to high valuations, complacency among participants, and underestimated economic and financial risks. And the same more or less applies to most risk assets, which do include gold and the euro.

Grantham on the investment management industry

Link here (do read it. It's Grantham. And it's only quarterly.)

As total fees in the past grew by 0.5%, we agents basically reached into the clients’ balance sheets, snatched the 0.5%, and turned it into income and GDP. Magic! But in doing so, we lowered the savings and investment rate by 0.5%. So, we got a short-term GDP kick at the expense of lower long-term growth.

I guess that makes me a bloodsucker wannabe.

PIMCO: Italy, Spain, Portugal sovereign CDS spreads wider than corporate spreads

Link here. Extract:

(...) Concern about debt levels and growth prospects has pushed sovereign CDS spreads wider while corporate credit spreads have continued to narrow. The trend is similar in Spain and Portugal.

While only recent, this phenomenon should spark intense debate among market participants. One camp might argue that it is difficult to justify sovereign credit spreads that are wide relative to domestic companies, as the sovereign will always exercise its right to levy taxes and fees to correct its balance sheet at the expense of the private sector. The other camp might suggest that many corporate balance sheets are pristine, and for particularly strong companies with a global footprint, the risk of default is indeed lower than the sovereign as they can only be taxed where they earn revenue and, in an extreme case, could change their domicile.

I am not an expert on credit or on Italy but I would personally be surprised if this situation persisted in the long run.

A few words from veteran analyst Richard Russell

I want to remind subscribers that (in my opinion) we are now dealing with a bear market rally that is in the process of topping out. The actual bull market topped out back in 2007. Therefore we are now dealing with a rally in a bear market that appears to be topping, and there is a world of difference. A bear rally that is topping out will not give off the same warning signals that a dying bull market will. Thus, many analysts who are still bullish are looking at the wrong thing. They don't see the usual signs of a bull market topping out because that is not what is happening. And this is keeping them bullish. What we're looking at is a rally in a bear market that is in the process of topping out.

Top or not, I don't see the point in having much, if any, exposure to equities at these levels of valuation (see most of my previous posts... this little correction we've had should come as no surprise to regular readers, and it wouldn't be much surprising either if it develops into a full fledged down leg. Upside potential is very limited for the broad U.S. stock indices).

"Emerging Markets Appear Fully Priced"

From BCA Research: Emerging Markets Appear Fully Priced

Contrary to Nouriel Roubini or The Economist, I don't believe there are "asset bubbles everywhere". There are a few little bubbles here and there (some high end housing markets in fast-developing Chinese cities come to mind). "Fully priced" is more appropriate, and this means upside potential is very limited in most equity and bond markets, as well as some commodities (unless a full-fledged bubble develops, which is unlikely before the banking system starts lending again). It also means downside potential is very important, and we've had a taste of that last week in developed equity markets.

Fed Watch: "It's not about interest rates yet"

From Tim Duy:

St. Louis Fed President James Bullard is delivering a pretty clear message. In his view, policy for the foreseeable future is about altering the rate of asset purchases, not interest rates. This will be a challenging new ocean for Fed Watchers to navigate. Will the Fed scale up asset purchase by $25 billion? $50 billion? Hold steady? Sell $25 billion back into the markets? Fun, fun, fun.

What I find interesting is that, initially, when the Fed entered quantitative easing (or qualitative easing if you prefer to call it that way - I personally believe it's not what the Fed buys but how much of anything it buys), they decided to start paying interest on excess reserves. The goal was to be able to eventually raise rates without having to scale back the Fed's balance sheet.

Look where we are today: banks are criticized for not lending out their excess reserves and the Fed is talking about managing policy using its long term assets before acting on short term rates.

"Sentiment very bullish... which should be bearish"

From David Rosenberg:

With the equity market 70% off its lows, we have a mere 23% bearish sentiment reading on the AAII survey (American Association of Individual Investors), a level not seen since four-years ago. Imagine that at the March lows, bearish sentiment on this survey was running at 70%. Now it is 23%.
Looking at the Investor Intelligence poll, the bearish sentiment is all the way down to 16% (the lowest since April 1987). At the March lows in the market, 47% of the investment newsletter editors were bearish. And for the traders, we see that Market Vane bullish sentiment is now at 57%, which is the highest since November 2007; at the March lows, the reading was 35%.

I'm reading the headlines today and I see that, despite bellweathers JP Morgan and Intel beating analyst forecasts, the indices are down almost one percent. This is not good action.
Meanwhile, Mark Hulbert reports that the sentiment picture is improving.

Most popular

Following are links to the most popular posts on this blog (reverse chronological order):

• The long-term costs of bailouts and nationalization of mortgage debt on inflation and external debt
• Stock market technicals
• U.S. stock market valuation 
• Gold: is this a bubble - yet ?
• Tax incentives-based measures to tackle the financial sector overgrowth and the Too Big To Fail problems
• Bubbles and China
• Reconciliation of residual income and free cash-flow models
• "Never sell America short"

Option-ARM payment shock

Via Calculated Risk, a report by Amherst Securities which reaches more or less the same conclusions Credit Suisse did (and reported in March here and again in June here by yours truly).

The conclusions, more or less, are that while the first wave of mortgage defaults in the "Subprime" category has subsidized subsided in recent months, a second wave is about to hit the shores in the Option-ARM category as the payments on these mortgages are recast higher (in the 100% to 150% range).

No recovery yet for commercial paper

Despite a tentative rebound in the latter part of 2009, all three broad categories of commercial paper outstanding - financial, non-financial, and asset-backed - are still hovering near multi-year lows. This is clearly not a sign of a recovery in this sensitive market.

Source: Federal Reserve

Not much U.S. macro news today...

... much like every single Monday. Tella Opeyemi and I argued in a 2009 paper this might be a reason for the so-called Monday effect, which is a tendency for stocks to exhibit poor performance on average on Mondays.

Our hypothesis is supported by the fact that this effect is statistically significant for stocks but also for other risky asset classes and risk-free Treasury bonds. "Investors seem to decrease their exposure to all asset classes on average on Monday, and increase their cash holdings, maybe awaiting economic and financial reports released later in the week."

Links 7/1/10

There have just been too many interesting pieces in the last few days for me to quote them all on this blog, so for once my dear readers, you are going to have to read it all (trust me it's worth it):

• Bill Gross: Let's Get Fisical, also: Time's interview
  
• Tim Duy: Fed Watch: Out of the gate with a bang
  
• a sell signal from Mark Hulbert: Bullishness now at dangerous levels
• From The Pragmatic Capitalist: The ultimate guide to 2010 investment predictions and outlooks

What's up with the baltic dry?

The baltic dry index has shed about 35% from its autumn peak, and is still about 70% off its all time peak of 2008. Compare this with copper, which, amid stories of speculative hoarding by private chinese "investors", is within a few percents of reaching records!

Considering the long-time love story between the two, a long baltic dry/short copper trade seems like an interesting bet at a six months horizon:

The long-term costs of bailouts and nationalization of mortgage debt on inflation and external debt

After years of reading his weekly commentary, I have finally managed to detect a small mistake (actually two) in John Hussman's otherwise implacable logic. Let's see that paragraph, which is about the consequences of the current and future enormous issuance of Treasury debt:

It may not appear to be costly at present, since risk-averse individuals conscious of credit risks, and foreign countries running massive trade surpluses, are still willing to accumulate the Treasury securities being issued, with no apparent impact. But ultimately, those securities will either stand as claims on our future national production, or they will be inflated away. Either the Treasury securities will retain value, so that holders such as China get to use them to acquire our productive assets in the future, while we ultimately tax ourselves in order to pay off that debt, or we must dilute the ability of those Treasuries to claim real goods and services, which is another way of saying we inflate away the debt.

There are two mistakes here, a tiny one and a more important one. First, it is wrong to say that foreigners will in the future acquire more U.S. productive assets: they already, today, by buying these newly issued securities, receive a higher share of U.S. national income through interest. Interest comes from taxes, which are paid thanks to productive assets. In other words, whether foreigners swap their Treasuries for U.S. equities or stick with their Treasuries, they still claim larger share of U.S. assets.

The second, bigger mistake is to believe that the U.S. can choose to swap an international redistribution of wealth problem (the 'either' part of Hussman's argument) for a national redistribution of wealth through inflation. There is no free lunch. 'Inflating away' the national debt is not a good expression as the debt doesn't really go 'away': it is just swapped for other securities, while the same amount is owed to foreigners.

To be specific, inflation will not resolve anything because it will result in a deterioration in the trade balance (higher pricing power to foreign producers), which itself will result in a deterioration in next external assets (claims on foreign assets minus domestic assets owned by foreigners). When all is said and done, the U.S. NIIP (Net international investment position) would have been the same with or without inflating the debt away, or maybe even worse due to the fact that some foreign producers are better positioned for a high inflation environment (think commodity exporters), and because a collapsing dollar will allow foreign investors to buy U.S. assets on the cheap.

Inflation does redistribute wealth from savers to borrowers inside a country. It does not allow a nation to escape from transferring its wealth abroad. There is only one way to do that: default.

Hamilton on the Term Deposit Facility

Excerpts (full post here):

We sometimes describe fiscal policy as determining the overall level of the public debt, while monetary policy determines the composition of that debt between money and interest-bearing federal obligations. By that definition, the Fed has clearly now entered the realm of implementing fiscal policy, by issuing debt directly in the form of interest-bearing reserves, reverse repos, and now term deposits.
The Fed would no doubt argue that it is doing so wisely, and that the decision to absorb Fannie and Freddie's debt and mortgage guarantees into the fiscal liabilities of the U.S. government has already been made by Congress and the President. The Fed is simply taking that reality as given and trying to minimize collateral damage.
Or one might see it this way: political pressures had been the cause of the quasi-nationalization and then de facto nationalization of mortgage debt in the first place, and the Fed found itself inextricably drawn into the mess. There is now political pressure to inflate the debt away, from which pressure the Fed nevertheless sees itself as immune.