Markets at Work

A real fun article from the NY Times about the pizza slice price war in Manhattan.

Pizza Slice Price War

Bernanke explains why the Fed is still leaning towards being more accomodative

Fed Chair Bernanke gave a talk today at a conference organized by National Association for Business Economics. His talk today was about recent improvement in Jobs growth and it revealed some interesting information about his current thinking. Bernanke noted that it was sort of puzzling that even though the job market has improved recently, GDP growth has not picked up. There is a relationship in economics called Okun’s law which relates change in the unemployment rate with GDP growth. According to Okun’s law we should have seen around a 4% GDP growth rate to see the kind of drop we have seen in the unemployment rate, whereas in reality we only got about 2% GDP growth in 2011. Bernanke thinks it could just be businesses finally undoing some of the extreme layoffs they did during the recession. To have sustainable jobs growth we will finally need better GDP growth, therefore he thinks it is important to keep a very accommodative monetary policy so that GDP can grow at a faster pace and we continue to see a reduction in the unemployment rate. Conversely one can also draw the conclusion that this improvement in the job market will be temporary if GDP just grows at last years pace. Below is a link to the talk, if you have a chance go and read it. It is very well written and informative and not too technical.

Bernanke Talk at NABE conference

The tables have turned

The markets are down today because of weak manufacturing data in China and most of Europe. In the US, jobless claims came in better than expected pointing to continued improvement in the labor market. Coming out the financial crisis, global growth was the one positive factor which allowed S&P 500 companies to have good profit growth. Now it seems we are seeing the opposite. The US is continuing to show improvement in economic conditions whereas rest of the world is starting to slow down.

Some Red Flags

Over the last few months we have had a rising stock market mainly driven by a reduction in risks of financial contagion in Europe and improving economic data in the US.

The main cause of improvement in Europe was due to the action taken by the ECB where they offered banks 3 year loans and also reduced the quality of the collateral they would take to secure the loans. The program called Long Term Refinancing Operation (LTRO) has allowed the banks to borrow around 1 trillion Euros. This has averted a liquidity crisis in Europe because banks had to roll over a lot of debt this year and they were having trouble raising money in the private credit markets. Now the banks have met their refinancing needs through the LTRO.

On the economic front the US economy is showing signs of improving. The jobs data has been coming in stronger than expected and the unemployment claims data has been hitting new lows not seen since 2008. Due to operation twist from the Fed we have also had no increase in yields which generally puts a damper on economic growth and the stock market.

Due to the reasons outlined above, risk assets like equities have done very well. This week though we have had two data points which are raising some red flags. One was that the Durable goods orders month over month came in quite worse than expected. They were down 4% for January and even ex-transportation (which is very volatile) they were down 3.2%. Expectations were for a flat reading. The main reason for the drop was that December was pretty good due to an expiry of tax credit, but still the drop was worse than expected. The other data point which was not good was the manufacturing ISM index which was released today morning and came in at 52.4, worse than the expectations of 54.6. Considering the good numbers coming from the employment front, one would have expected an acceleration in the economy but these numbers are sort of throwing water on those expectations. These numbers don’t point to a recession but they do lower expectations for a stronger recovery.

Wall Street Journal raises the same issues

The WSJ has an article today which talks about exactly the same issues I raised in my previous post about the Treasury market not behaving normally. They raised the same points about operation twist and the fed revealing its forecast for short term interest rates remaining at zero till 2014.

One very interesting statistic in the article is that since operation twist started, the Fed has bought 91% of all the supply from the US Treasury for bonds maturing in 20 to 30 years. That is clear indication that the Fed is having a big influence at the long end of the yield curve. The Fed is succeeding in providing stimulus to the economy this way as mortgage rates still remain near all time lows when they should have normally started to go up.

What’s going on in the Treasury market

Over the past few weeks we have seen mostly positive economic reports and improvement in Europe  (yields of Italy and Spain have dropped below 6%). As expected the stock market has been rising steadily and the S&P 500 is close to a yearly high (NASDAQ is already at a new yearly high and at the highest level in 11 years). In light of these circumstances one would have expected that Treasury bond yields would have risen up a reasonable amount also. But we are not seeing that. Typically treasury yields move down when their is a flight to safety or decreasing inflation. In the current scenario you have risk coming down and data to support an improving economy. Other asset classes like Stocks and commodities are behaving as expected that their prices are going up. The 10 year treasury yield as of today is around 1.95% which is near the lower end of the range for the last 6 months, whereas stocks are comfortably at new 6 month highs. If treasury yields would have not broken down their correlation with stocks, they should have probably been in the 3% range by now.

So what is really happening. Here are a few reasons why I think this divergence is happening and I will order them based on what I think is the most probable cause

1. I think the main reason for this behavior in bond yields is the Fed. The Fed is suppressing yields in two ways. First, through Operation Twist the Fed is selling shorter term bonds and buying longer term maturities to push those rates down. The Fed is soaking up some of the supply of these bonds so they have artificially suppressed the yields for these long term maturities. Second, just recently the Fed openly revealed that their current view is to keep short term interest rates near Zero till 2014. By declaring this they have seduced bond traders into thinking that they don’t face much interest rate risk in the medium term.
2. The other possibility, although I don’t strongly believe in it, is that the bond market traders are thinking differently than stock market traders. It is possible that the bond market does not believe in the current economic strength and feels we will head back into economic weakness pretty soon and we might again face possibility of deflation.

I think a lot of traders feel that the fed has committed to keeping interest rates near zero till 2014, but in reality this is just their current viewpoint. The Fed can easily change its view with new data, so traders shouldn’t read too much into this 2014 forecast.

Across the board good data

I am back after a 2 month hiatus. I was in India for a 4 week vacation and just busy with starting my business. I am hoping to update the blog on a much more regular basis going forward.

Today we had two economic releases which were across the board good.

• The jobs report came in a about 100K better than expected and most of the internal components of the data like average work week(increased by 0.1hrs), average hourly earnings(increased by 0.2%) were all good. The job growth was also pretty broad based across all sectors
• The other big surprise of the day was the Non-Manufacturing ISM survey which came in quite good at 56.8 vs expectation of 53.3. The most encouraging were the internal components, both new orders and employment had strong jumps from previous months.

The stock market as expected is reacting very positively to this data. Looking at most data points it does appear the US economy is starting to accelerate. In fact the US seems to be doing one of the best among developed nations. We also have some improvements in the European credit markets. The improvement has mainly been driven by the strong actions taken by the ECB in December where they announced a 3 year loan program for European banks. They have also approved their permanent bailout fund the ESM whose size will be 500 billion Euros.

The main red flags now we have are coming form Asia. There are good indications that the Chinese real estate market has slowed down dramatically. Indian growth has also slowed and that was my observation when I was visiting there. The European problem is far from resolved also, it is a slow work in progress.

Central banker in training

We are having a pullback in the market after the new ECB head Mario Draghi quashed some hopes of ECB being involved in solving the Euro crisis by lending to the IMF. Last Thursday in a speech, Draghi had mentioned the words “other steps might follow” if the European nations agree on stringent fiscal rules. Those words were taken by the markets and the financial media as hint to a stronger ECB involvement in dealing with the Euro crisis.

There has been talk about a program of the ECB lending to the IMF which will in turn lend to European countries. The reason you have take this circular route is because by law the ECB cannot lend directly to sovereign countries.  So this is a technicality to get around that law because the ECB is allowed to lend to the IMF, although in spirit it is going against the law. Today Draghi strongly suggested that he wants to stick to the spirit of the the European treaty and he expressed surprise at how his words were interpreted. Draghi is new on the job and I think it is a lesson for him that whenever he gives speeches he has to be pretty specific, unless he wants to achieve a policy end by being vague.

Some positive developments in Europe

We are seeing some positive developments in Europe which could lead to a more sustainable solution to the European crisis.

The first positive indication came from the new ECB chief Mario Draghi last Thursday where he indicated that if there is a wide agreement on some stringent fiscal requirements among the EU nations, then the ECB could play a larger role in dealing with the European crisis.

The other positive development came today. It appears France and Germany the two most influential member of the EU are finally converging on how they want to handle the European crisis. Looks like they are calling for modifying the European treaty to include more stringent fiscal requirements which will limit the level of fiscal deficits a country is allowed to have. Till now France and Germany were on a different page with France calling for more ECB intervention without much constraints. It appears France is finally moving more towards the German position and setting up a system which closely resembles the one that Draghi wants in place for the ECB to play a larger role.

In response to these developments, you are seeing a strong pullback in most European bond yields, especially in those of Italy and Spain. The level of pullback is pretty large, which tells me the market is also thinking something more sustainable could happen. Also another positive development is that the new Italian government led by Mario Monti passed tough austerity measures.

The EU leaders have a summit on Dec 9th and we will find out more on how the proposal by Merkel and Sarkozy is received by everyone else.

The key thing now for the world equity markets over the next 6 months to a year is if this solution is too late. It appears Europe is heading into a recession, so are we going back into a negative feedback cycle where lower tax receipts make the fiscal situation worse.

Stress in the banking system

In general over the last few weeks US economic data has been coming in better than expected. Unemployment claims for this week came in at 388K, which is one of the lowest reading this year. Leading indicators today came in at 0.9% vs expectations of 0.6%.

Although the US economy is doing better than expected, we are seeing tighter credit conditions in the global banking system. One measure of stress in the banking system is the LIBOR rate. LIBOR is what big banks charge each other for money. Even though central banks haven’t tightened monetary conditions you are seeing increase in LIBOR rates. That means banks are being more cautious and charging more to lend to each other as they worry about the solvency of their counter party.  Here is a link to the chart of 3 month LIBOR and you can see that it has been steadily rising over the last few months.

3 month LIBOR