Fin/Inv

The headline GDP number was revised up to 5.9% annualized growth in Q4 (from 5.7%), however most of the improvement in the revision came from changes in private inventories. Excluding inventory changes, GDP would have been revised down to around 1.9% from 2.2%.

This table shows the changes from the "advance estimate" to the "second estimate" for several key categories:

	Advance	Second Estimate
GDP	5.7%	5.9%
PCE	2.0%	1.7%
Residential Investment	5.7%	5.0%
Structures	-15.4%	-13.9%
Equipment & Software	13.3%	18.2%

Note that PCE and Residential Investment (RI) - the two leading categories - were both revised down in Q4.

Changes in private inventories are transitory (only lasts a few quarters at the start of a recovery), and although the headline number was revised up, final demand was weaker than in the advance estimate.

by Tom Bozzo

Brad DeLong observes that the FY2011 budget features "big, very big" tightening on the revenue and spending sides (2.5% of GDP "from 2010 to 2011") for the prevailing labor market conditions. DeLong wants his "morning in America" (don't we all?), and is understandably alarmed at the pessimistic forecast of the rate of labor market improvement. Paul Krugman echoes the sentiment on "near-term" fiscal tightening.

As is always the case, the tightening question has to be "relative to what?" [1] Receipts as a fraction of GDP are expected to increase fairly substantially, for example, but that's largely a consequence of expected economic growth.

Compared to the current-policy baseline, the FY 2011 (10/2010-9/2011) budget increases the FY 2011 deficit by around 0.8 percent of GDP. In FY 2012, the budget would subtract around 0.7 percent of GDP from the current-policy deficit. Krugman is correct to attribute this to the winding-down of ARRA stimulus and of our "overseas contingency operations" better known as the wars in Iraq and Afghanistan. Go see Table S-2 here [PDF]. Additionally, current policy has some stimulus on top of current law. Allowing most of the Bush tax cuts to become permanent reduces FY 2011 receipts by around 0.9 percent of GDP. (See Table 14-2, here.)

As for the timing, the budget assumes (see Table 2-1) that real GDP in quarter 4 of calendar year 2010 will be 3 percent higher year-over-year; in Q4 of 2011 (a/k/a Q1 of FY 2012), real GDP is expected to increase another 4.3 percent. Even with the tightening, Q4 2012 real GDP would increase another 4.3 percent y/y. So the FY 2012 tightening only arrives after two years of modest growth.

If measures labeled as such are actually to be temporary economic stimulus measures, they obviously must end sometime. Ending them after the expansion ends is stupid — the tightening would reinforce the subsequent downturn — so it's going to take some steam out of the expansion one way or another. The most pressing timing concern would be not to take away the stimulus before it's clear that the recent GDP growth is sustainable; I'd argue that after two years of growth, should we get there, the case that measured GDP growth is a matter of one-time shots and/or statistical glitches will be fairly weak.

The slow assumed labor market recovery Brad DeLong notes might be seen as a mirror-image of the GDP recovery assumed in the budget baseline:



The budget's baseline economy (with the triangle marks) isn't as pessimistic as OMB is willing to imagine in public (and if you're Ken Houghton, you might see all of these as irrationally exuberant), but the 'output gap' opened by the recession is assumed to close very slowly. While higher-frequency data are not equally optimistic, there's building evidence (so far, outside of employment) for a reasonably strong recovery. And as Maynard explains at Creative Destruction, it's arguably in the administration's interest to err on the pessimistic side since people (again, even including some economists) don't understand counterfactuals and thus tend to inappropriately place blame (or credit) for surprises.


[1] Every economics professor who disparages the "jobs created or saved" concept should be immediately stripped of tenure and exposed to the current labor market for forgetting that all economic analysis is counterfactual.

Is it really Good News that changes in Real Private Inventories were 3.4% of that 5.7% Q-on-Q GDP in Q4? (h/t Alea's Twitter feed)

Most reasonable assumption: firms overproduced, relative to actual buying, in anticipation of the Xmas season.

Maybe more later.

By request, the following graph is an update to: The Investment Slump in Q2

The following graph shows the rolling 4 quarter contribution to GDP from residential investment, equipment and software, and nonresidential structures. This is important to follow because residential investment tends to lead the economy, equipment and software is generally coincident, and nonresidential structure investment trails the economy.

Click on graph for larger image in new window.

Residential Investment (RI) has made a positive contribution to GDP the last two quarters, and the rolling four quarter change is moving up.

Equipment and software investment made a small positive contribution to GDP in Q3, and a larger contribution in Q4. The four quarter average is also moving up.

As expected, nonresidential investment in structures is now declining sharply as major projects are completed. The economy will recover long before nonresidential investment in structures recovers.

And as always, residential investment is the best leading indicator for the economy.

This is an update to a graph I posted in early 2009 ...

Click on graph for larger image in new window.

This graph shows the real GDP declines from the prior peak for post WWII recessions.

The recent recession was the worst since WWII (the peak decline was 3.83% in Q2 2009).

Even after the strong GDP growth in Q4 (due to inventory changes), current GDP is still 1.9% below the prior peak in real terms. If the recovery is sluggish - as I expect - it will take several more quarters to return to the pre-recession peak in real GDP.

Any analysis of the Q4 GDP report has to start with the change in private inventories. This change contributed a majority of the increase in GDP, and annualized Q4 GDP growth would have been 2.3% without the transitory increase from inventory changes.

Unfortunately - although expected - the two leading sectors, residential investment (RI) and personal consumption expenditures (PCE), both slowed in Q4.

PCE slowed from 2.8% annualized growth in Q3 to 2.0% in Q4.

RI slowed from 18.9% in Q3 to just 5.7% in Q4.

Note: for more on leading and lagging sectors, see Business Cycle: Temporal Order and Q1 GDP Report: The Good News.

It is not a surprise that both key leading sectors are struggling. The personal saving rate increased slightly to 4.6% in Q4, and I expect the saving rate to increase over the next year or two to around 8% - as households repair their balance sheets - and that will be a constant drag on PCE.

And there is no reason to expect a sustained increase in RI until the excess housing inventory is absorbed. In fact, based on recent reports of housing starts and new home sales, there is a good chance that residential investment will be a slight drag on GDP in Q1 2010.

Click on graph for larger image in new window.

This graphs shows Residential investment (RI) as a percent of GDP since 1947.

RI had declined for 14 consecutive quarters before the increase in Q3 2009. The Q4 report puts RI as a percent of GDP at just over 2.5%, barely above the record low - since WWII - set in Q2 2009.

Notice that RI usually recovers very quickly coming out of a recession. This time RI is moving sideways - not a good sign for a robust recovery in 2010.

The second graph shows non-residential investment as a percent of GDP.

Business investment in equipment and software increased 13.3% (annualized). This is a good sign, but continued investment probably depends on increases in underlying demand.

Investment in non-residential structures was only off 15.4% (annualized) and will probably be revised down (this has happened for the last few quarters). I expect non-residential investment in structures to continue to decline sharply over the next several quarters. In previous downturns the economy recovered long before nonresidential investment in structures recovered - and that will probably be true again this time.

When the supplemental data is released, I'll post graphs of investment in retail, offices, and hotels, and a breakdown of residential investment.

The transitory boost from inventory changes is frequently a great kick start to the economy at the beginning of a recovery - as long as the leading sectors (PCE and RI) are also picking up. This report has to be viewed as concerning ... and is reminiscent of Q1 1981 and Q1 2002 ... both examples of inventory changes making large contributions to GDP, but underlying growth remained weak.

As expected, GDP growth in Q4 was driven by changes in private inventories, adding 3.39% to GDP.

From the BEA:

Real gross domestic product -- the output of goods and services produced by labor and property located in the United States -- increased at an annual rate of 5.7 percent in the fourth quarter of 2009, (that is, from the third quarter to the fourth quarter), according to the "advance" estimate released by the Bureau of Economic Analysis.
...
The increase in real GDP in the fourth quarter primarily reflected positive contributions from private inventory investment, exports, and personal consumption expenditures (PCE). Imports, which are a subtraction in the calculation of GDP, increased.

The acceleration in real GDP in the fourth quarter primarily reflected an acceleration in private inventory investment, a deceleration in imports, and an upturn in nonresidential fixed investment that were partly offset by decelerations in federal government spending and in PCE.
...
Real personal consumption expenditures increased 2.0 percent in the fourth quarter, compared with an increase of 2.8 percent in the third.
...
Real nonresidential fixed investment increased 2.9 percent in the fourth quarter, in contrast to a decrease of 5.9 percent in the third. Nonresidential structures decreased 15.4 percent, compared with a decrease of 18.4 percent. Equipment and software increased 13.3 percent, compared with an increase of 1.5 percent. Real residential fixed investment increased 5.7 percent, compared with an increase of 18.9 percent.

This is very close to my expectations and shows a fairly weak economy (real PCE increase 2.0%). The question is: what happens in 2010?

I'll have some more on GDP and investment later ...

In a research note released last night, Goldman Sachs raised their estimate of Q4 GDP from 4.0% to 5.8%. They cautioned that the "headline will be an eye-popper", but that this growth is mostly due to inventory changes: "More than two-thirds of our estimated increase comes from a sudden stabilization in inventories". They also noted "anything between 4½% and 7% is possible given the volatility of the inventory data".

The rest of the note cautions on 2010, and Goldman still sees sluggish growth of just under 2.0% with the unemployment rate peaking in early 2011.

This is what we've been discussing - GDP boosted by inventory changes in the 2nd half of 2009, followed by sluggish growth in 2010.

San Francisco Fed President described the impact of inventory changes back in September: The Outlook for Recovery in the U.S. Economy

I expect the biggest source of expansion in the second half of this year to come from a diminished pace of inventory liquidation by manufacturers, wholesalers, and retailers. Such a pattern is typical of business cycles. Inventory investment often is the catalyst for economic recoveries. True, the boost is usually fairly short-lived, but it can be quite important in getting things going. ...

But what if this doesn't "get things going"?

When was the last time we saw 5%+ GDP growth, due mostly to inventory changes, and increasing unemployment? It was in Q1 1981.

The 1980 recession ended in Q3 1980, and inventory changes boosted Q4 GDP by 3.8%, and Q1 1981 GDP by an amazing 6.4%! However underlying demand remained weak (as defined by GDP ex-inventory changes, and PCE) as shown in the following table:

	1980-IV	1981-I	1981-II	2009-III	2009-IV1
GDP	7.6%	8.6%	-3.2%	2.2%	5.8%est
GDP ex-Inventory Changes	3.8%	2.2%	0.8%	1.5%	2.0%est
PCE	3.4%	1.5%	0.0%	2.0%	1.7%est
Change in Unemployment Rate	-0.3%	0.2%	0.1%	0.3%	0.2%

Look at the blue period, and notice the boost in GDP from inventory changes in the Q4 1980, and Q1 1981. But PCE was only 1.5% in Q1 1980, and fell to 0.0% in Q2 1980. Since there was no pickup in underlying demand, the economy slid back into recession in July 1981.

Now the causes of the current recession are very different from the early '80s, but once again we are seeing a transitory boost from inventory changes and underlying demand remains weak. With the huge overhang of existing home inventory and record rental vacancies, and the ongoing repair of household balance sheets, I expect underlying demand to remain weak in 2010.

The blip in the 2nd half from inventory changes was expected, and I expect Q4 to be the best quarter for GDP for some time.

¹ Q4 2009 is estimated. GDP is from Goldman Sachs, and ex-inventory and PCE is from my own estimate.

Yesterday's most recent data from the Conference Board's Confidence Index recapitulates very well the Economic Inquisition purgatory that living in America has become: pain and suffering now, coupled with the promise of salvation and financial bliss at some point in the future. Of course, on a long enough timeline we are all dead, so it is only fitting that the administration, whose slogan had something to do with tangible change, is gradually encroaching on the Catholic Church's turf in an all out war for the souls of America's taxpayers as tangible becomes increasingly ephemeral and, well, intangible (save for unemployment and the wads of electronic cash deposited in Goldman Sachs' employees bank accounts - both of those are all too real). While the CBCC number came in at about the expected reading of 52.9 (from 50.6 in November), all of the "improvement" in confidence came from rosy future expectations, which rose to a two year high of 75.6 (from 70.3 previously). As for the present: current conditions plunged to another record low of 18.8. Never before has the differential between present pain and future hope been so wide.

The impact of this divergence politically is all too obvious. The voting population, which has been extremely patient, and keeps hoping that the future will finally bring something better and in line with oh so many promises, may very soon change their mood and realize that the present is here to stay, regardless of what the Fed manipulated capital markets demonstrate. When that happens watch for some interesting election fireworks on this side of the Potomac river.

Reading between the lines of the CBCC indicates that Obama and CNBC's grand plan to get consumers to spend, spend, spend again has fizzled. Autobuying intentions dropped to 3.8 from 4.5 in November, the lowest read in over a year, when the SAAR was 10.5 million. The double dip in the auto sales will soon be upon us. Furthermore, buying intentions of major household appliances held at a weak 23.7: Cash for Bidets can't come fast enough. Most troubling, however, homebuying intentions have plunged to a near-thirty year low: at 1.9, the percentage of Americans planning on buying a house is the lowest since 1982.

And just in case you thought that shellshocked US citizens will look to get the hell out of Dodge, at least temporarily, to take advantage of that strong, strong dollar and travel abroad, think again. The percentage of Americans planning a vacation in the next six months fell to 35.7, the lowest since April. The David Rosenberg-penned "frugal consumer" is here to stay, which can only mean that both the Fed and the US Government will become buyers of first, last and everything inbetween resort, as the traditional component of US GDP (sorry David Bianco, you are unabashedly wrong in your "consumer is irrelevant" propaganda). Maybe it is time to dust off all those Russian Politics 101 manuals, in our search of how to defeat Soviet Style Communist fiscal and monetary policy, which have so thoroughly penetrated the United States of America itself.

2010 will be a year of major transformations, punctuated by the following key escalating divergence: i) on one hand, the ongoing contraction of the US consumer will accelerate, because even as the stock market ramps ever higher (and on ever decreasing trade volume a 2,000 level on the S&P while completely incredulous, is attainable, but will benefit only a select few insiders who continue selling their stock at ridiculous valuations), household wealth will at best stagnate (as a reminder, an increase in interest rates "withdraws" much more household net worth, due to implied house price reduction, than any comparable boost to the S&P can offset), ii) on the other hand, China, which is faced with the ticking timebomb of continuing the status quo and hoping that US consumers can keep growing the global economy, or alternatively, looking inward at its own consumer class, and shifting away from its historical export-led model. The one unavoidable side effect of this prominent departure would be a renminbi appreciation, and a logical drop in the US currency, once the US-China peg if lifted (a theme opposed recently by SocGen's Albert Edwards, who sees the inverse as likely occurring). The main question for 2010 and beyond is whether this will be a gradual decline or a disorderly drop. And behind the scenes of all the bickering, jawboning and posturing, this is precisely what high level officials from both the US and China are currently negotiating. This will be one of the major themes that defines the next decade. Another phrase to describe this process is the gradual drift of US into a nation that is aware it is no longer the primary economic dynamo of global growth as China eagerly steps in to fill that spot.

Looking at the aftermath of the financial crisis, the two major consequences that will define US economic trends for an extended period of time, are the increasingly more frugal US consumer, whose savings rate is likely to increase gradually to the long-term low double digit average, and an ongoing outflow from equities into safer assets such as municipals, bonds and loans, as the maturing baby-boomers finds the volatility of the engineered equity market far too risky as they enter retirement age.

So with US consumption-led growth entering its twilight days, courtesy of assets that simply do not provide the kinds of returns that allowed for a savings-free lifestyle, what does this mean for Asia, and China in particular? Bank of America provides a good and succinct overview of the major historical themes that have defined Asian economics, and what the next decade will likely bring.

The essence of the Asian development strategy is to build manufacturing capacity for global demand. High savings rates allowed the needed investment in plants and infrastructure to be financed domestically. This strategy was pioneered by Japan in the 1950s and 60s, copied by the Asian “Tigers” (Hong Kong, Korea, Singapore, and Taiwan) in the 70s and 80s, and by a host of other Asian countries in the 80s and 90s. What changed the game was China’s adoption of the same strategy. Exports have increased nearly sixfold since China joined the World Trade Organization (WTO) in 2001. This had a profound impact on the global economy – but it had an even more profound impact on the China’s own economy and labor market. We estimate that 150 million Chinese workers joined the global labor force and began producing internationally traded goods. (As a contrast, the US labor force is 154 million people.)

The integration of China’s vast workforce into the global economy is what tipped the balance. The transfer of jobs and production from the US, where personal and corporate savings rates were low, to China, where savings rates were high, gave rise to huge imbalances. Within a few years after WTO entry, China’s current account surplus became the world’s largest, mirrored by an even larger US deficit.

Currency appreciation would have reduced wages, profits, and the flow of savings, but China was unwilling to allow market forces to play out. Thus, thePBoC (China’s central bank)  intervened in unprecedented amounts, and the vast flow of Chinese savings was channeled  abroad in the form of foreign exchange reserves – mostly short-duration government debt and bank deposits. Essentially, China was financing its own exports by purchasing short-term debt. The bulk ofthat found its way into US markets, keeping interest rates low and setting the stage for the housing bubble.

And herein lies the rub:

The financial crisis delivered a clear verdict, in our view, on the limits to the Asian growth model. It no longer makes sense to pursue double-digit growth by lending cheaply to the US consumer.

Yet change would require less reserve accumulation or – put another way – allowing the currency to appreciate against the US dollar, to which it is now effectively pegged. China needs to manage this “exit” carefully. Moving too fast risks a dollar crisis, with a disorderly drop in the US dollar and a spike in US bond yields. Moving too slow risks a boom-bust cycle in China, with capital inflows and strong monetary growth rates putting upward pressure on asset prices and inflation.

As noted earlier, the transitioning from the status quo, which worked for many years, but is now no longer relevant for the PBoC, will be likely even more critical than Bernanke's decision on when to finally begin raising rates. Because while the latter is mostly concerned with asset-price inflation (and stoking it every chance he gets), the Chinese decision will determine not only interest-rate policy for the US for decades to come, but will decide how soon the US should prepare to accept the consolation prize of first runner up in the global economic leader category. While on an absolute basis the US Economy is still a clear outlier, the rate of growth exhibited by China makes it a virtual guarantee that the days for US economic hegemony are numbered (even more so with GDP determination which is whatever the Central Committee says it is). The only open question is when will China decide it is finally time to shift away from the export-led growth model to one which prefers its own consumers as the source of growth. This transition will likely be of historical importance: just as the inception of the US vassal relationship with China lead to a historic and unprecedented boom in household net worth, doubling to $60 trillion in the span of a decade, so shall the unwind have a comparable impact to the downside.

It is merely this moment that Bernanke and the administration are doing all they can to prolong as much as possible. Alas it may be too late, as China seems to have finally realized that in the global prisoner's dilemma game, it has taken the constant US defections for far too long enough. And with the benefits of perpetuating the charade at this point outweighed by the detriments, 2010 could just be the year when China decides it has had enough.

For much more observations on the US-China relationship, and what lies in store for both the dollar and the renminbi, below is the most recent China FX roadmap analysis from BofA.

 

Back in October, as a preview to the Q3 GDP report, I wrote: Inventory Restocking and Q3 GDP

I noted that GDP growth in Q3 and Q4 weren't in question because of a transitory boost from changes in private inventories and from stimulus spending.

Here is a repeat of the graph showing the contributions to GDP from changes in private inventories for the last several recessions. The blue shaded area is the last two quarters of each recession, and the light area is the first four quarters of each recovery.

Click on graph for larger image in new window.

The Red line is the median of the last 5 recessions - and indicates about a 2% contribution to GDP from changes in inventories, for each of the first two quarters coming out of a recession.

The key is this boost is transitory.

Last quarter I thought a 1% to 2% contribution from changes in inventories was possible. The actual contribution was 0.69%. I suspect that changes in inventories will add more to Q4; probably closer to 2%.

I also thought Personal Consumption Expenditures (PCE) would be fairly strong in Q3, especially because of the cash-for-clunkers program. My guess was "3% PCE growth in Q3, and that would mean a contribution to GDP of about 2%." The final numbers were 2.8% and a contribution of 1.96%.

The following graph shows real Personal Consumption Expenditures (PCE) through November 2009 (in 2005 dollars). Note that the y-axis doesn't start at zero to better show the change.

The quarterly change in PCE is based on the change from the average in one quarter, compared to the average of the preceding quarter.

The colored rectangles show the quarters, and the blue bars are the real monthly PCE.

Using the "two-month method" for estimating Q4 PCE growth gives an estimate of just under 1%. However - note that PCE in August was distorted by the cash-for-clunkers program (and that impacts the two-month method). So my guess is PCE growth in Q4 will be around 1.7% or a contribution to GDP of 1.2% or so. (less than the growth in Q3).

As I've noted, residential investment has been moving sideways, although that will show up more in Q1 2010 than in Q4. So we can add in a positive contributions from net exports, some increase in residential investment (although smaller than in Q3), an increase in equipment and software investment - and subtract out investment in non-residential structures - and Q4 should look pretty healthy.

In a reserach note this week, Ed McKelvey at Goldman Sachs called the 2nd half "ho-hum":

"At a time of the year when ho-ho-ho is the catchword, the first six months of the US economic recovery look distinctly ho-hum following the latest reports. ... Although we continue to estimate a 4% growth rate for the fourth quarter, with upside risk to that figure, the composition of this growth is not strong. Almost half of it comes from a sharp slowing in the rate at which inventories are being drawn down ..."

And it is probably a good time to repeat this graph from economy.com's Mark Zandi suggesting the greatest impact from the stimulus package is now behind us.

This suggests that all of the growth in Q3 was due to the stimulus package (and then some), and the impact is now waning - only 2% in Q4, and 1.5% in Q1 2010 - and then the impact on GDP growth will be negative in the 2nd half of 2010.

As "ho-hum" as the 2nd half of 2009 was, I expect GDP growth to be more sluggish in 2010 for the following reasons:

Most of the increase from changes in private inventories will be behind us - although it could slip into Q1 2010, but without a pickup in end demand, the boost will end soon.

Because of the huge overhang of vacant housing units, I expect any increase from residential investment to be muted.

I expect the personal saving rate to increase over the next year - leading to slow PCE growth.

Non-residential investment in structures will be a drag throughout 2010.

And as I noted last quarter, on the plus side, exports might continue to provide a boost.

So I still think GDP growth will be sluggish in 2010, with downside risks.

Note: There are several upside and downside risks to this view.

• Russia lowers key rate, kills carry trade.  Merry Christmas, foreigners.  ("In Soviet Russia, rates lower you") [bloomberg]
• Ethanol producers sue California to prevent low-carbon fuel restrictions. (Corn shortage forces greens to start to eating their own young?) [wall street journal]
• Latvia attempts to lower pension benefits to avoid fiscal meltdown. Courts: "Denied." Latvian PM: "We will just go bankrupt if we observe all legal norms" (Sufficiently satirical comeback fails me) [baltic reports]
• Increase in pension contribution requirement for NY Teachers causes rush to lock in old rates.  (Officials shocked, shocked to find that rational actors avoid taxes)  [wall street journal]
• Retailers extend Christmas hours to boost traffic. (Losing money for every open hour, but making it up on volume) [bloomberg]
• Dubai's Burj Dubai tower about to open as world's tallest building [in foreclosure?]  (Maybe.  Obama inspired transparency in government initiative forbids exact height disclosure)  [reuters]
• FinCEN proposes sharing bank data with foreign officials.  (KGB a/k/a "Goldman Sachs (Moscow)" to reopen economic espionage desk, install Rezident in Manhattan) [reuters]
• Japan's budget includes $484 billion deficit.  200% Debt:GDP just around the corner.  (Obama: "Only $484 billion?  You fail at fiat, Hatoyama.") [reuters]
• China revises energy per GDP unit use down to 5.2% 2007-2008. (Keynes resurrected! Taxpayer funded government stimulus double counts growth, single counts energy use) [financial times]

Anyone looking at their 401(k) portfolio performance since the end of August will undoubtedly be very happy (and extremely surprised), as the market has climbed steadily higher despite i) increasingly declining trading volume and ii) consistent and material withdrawals from domestic equity mutual funds. Furthermore, if anyone was merely looking at the trading action in regular hours, one would think there was absolutely no profit made since early September. The reason for that: all the upside since September 14th has come exclusively from after hours action. The chart below demonstrates the relative performance of regular hour trading in the SPY as well as that in the extended session. The notable observations: gaps, gaps, gaps. Every single day, minimal volume pushes the futures index higher. Good news, bad news, it don't matter to the Goldman S&P and Russell 1000 futures desk: they just lift every micro offer, giving the impression that the market is unstoppable, often leapfrogging each other as the latest viagra'ed GDP or unemployment rumor is spread. Come morning, it is time for the HFT brigade to come in and scalp their trillions of pennies while leaving the market unchanged, then at 4pm handing it off again to leveraged futures manipulation and dark pools. In a nutshell, this is the secret of the past quarter's phenomenal market performance.

A longer-term chart highlights the regime changes since the March lows, when for several months in a row, regular hours would carry the broader market higher, then would flatline, and let the futures trading desks take over. Rinse. Repeat. That way both the HFTs and dark pools end up happy.

The observant among you will immediately realize what this implies: not only is there no volume breadth to the recent move in the markets, but the actual push higher likely occurs on at most tens of thousands of futures contracts on a daily/weekly basis. The fact that literally several blocks of AH trades, used persistently, can move the market higher by 6% over the past 3 months, even as regular trading accounts for absolutely no part of this move, and that the SEC finds nothing troubling about this phenomenon, should be sufficiently telling about how "efficient" US markets have become.

The reason for this focus away from regular hours trading is simple: all After Hours does is provide leverage due to the much shallower trading overnight. Zero Hedge is currently finalizing ES volume data to determine just what leverage the futures desk as JPM and Goldman uses in their interminable push to make the Dow 36,000, working title of "EV/EBITDA = Infinity (Or Better Yet, Negative)? Who Gives A Shit: The Fed Has You Covered", the bestseller it was always meant to be. 

chart h/t CreditTrader

By Marla Singer and Geoffrey Batt

Like a buzzing mosquito inside the netting over your bed, wings on the heavy Mustique air, humming a small pinhole of bright light through the dark veil of your dreams of unbridled success, we have been annoyed by the constant propensity of even learned economists to measure the performance of equity markets in nominal terms.  "Worst decade for stocks since [horrific period marker]!" is only the most egregious (not necessarily the most common) offender in this respect.  In truth, we have long failed to see the logic of measuring performance in nominal terms (our sporadic gold denominated S&P 500 posts are a good example).

In the long run, performance matters only if it increases wealth, and it makes little sense to speak of wealth unless it is relative to purchasing power.  To ignore this little point would elevate, say, Weimar fund managers circa 1923 to levels that would make Soros look like Scotsman Capital's Vince Farrell.  Let us then undertake together a brief adventure in the measuring of real, rather than nominal performance.

Today, in a preview of a much larger Zero Hedge project on all the CPI components, we offer the S&P 500 index since 1980 denominated in four individual CPI components with annotated starting and ending values:

 

 

 

 

 

Or, in layman's terms, you are fat, Vitamin C deficient1, sick2, and uneducated3, but well indoctrinated4.

We couldn't have planned this better.  Now watch some commercials and get out there and buy some consumer goods.  We have GDP numbers to revise.

1. 1. Not Seasonally Adjusted, U.S. city average, Oranges, including tangerines, Base Period:  1982-84=100
2. 2. Seasonally Adjusted, U.S. city average, Prescription drugs, Base Period: 1982-84=100
3. 3. Seasonally Adjusted, U.S. city average, College tuition and fees, Base Period:  1982-84=100
4. 4. Not Seasonally Adjusted, U.S. city average, Televisions, Base Period: 1982-84=100 - corrected to reflect correct series ending datapoint of 1095.63

We probably can't get more relevant commentary on today's absolutely massive downward GDP revision than that penned today by Goldman Sachs' Edward F. McKelvey:

This was a much larger than normal revision for the third pass on a given quarter, knocking what once was a fairly robust 3.5% bounce down to a mediocre 2.2% (from 2.8% prior to this revision). All sectors except the trade balance -- a focal point of last month's  downgrade -- saw some downward revision. Revisions were particularly deep in business investment -- to -5.9% from -4.1%, worth two tenths of the revision --  and in inventories (also worth nearly two tenths).

That would be those sectors that should, one would think, be among the easiest to count in the first place, especially on the second try.

Goldman is being very kind here.  Goldman started off the day with this from GS Breakfast Bytes:

GDP for Q3 (third estimate)... not much change, though risks lie to the downside.  GS: +2.8%; median forecast (of 73): +2.8%, ranging from +2.5% to +3.7%; last (Q3 second estimate) +2.8%.  The third cut on a given quarter does not usually produce much of a  change in the growth estimate.  In this  case, the risks against our assumption of no change lie to the downside, reflecting large downward revisions to construction spending for August and September.  Like many others, we do not  see a meaningful probability of changes in the +0.5% estimate for the GDP price  index or the +1.3% figure for the core PCE price index.  (Emphasis ours).

It is difficult to get a more direct sense for how much mind share government bailouts (and government figures) have managed to command.  That even the most pessimistic member of the "consensus" (n=73) managed to overshoot the mark by nearly 14% and the average sailed full speed into a 27% pop-up should remind us of three things:

1. The Bureau of Economic Analysis of the United States Department of Commerce has ceased to be (if it ever was) a reliable outlet for economic data.  (Be this the result of misfeasance or malfeasance depends on the reader's propensity to credit conspiracy theory).
2. That what passes for the professional prognosticator class these days is pathologically incapable of realistic appraisal.
3. That the largest single expression of a Keynesian "injection" in the history of Keynesians or injections (or the planet) struggled to create even the most anemic growth.  Net the double counting of stimulus funds it seems difficult to imagine even a remotely encouraging (or positive) "growth" figure could be tortured out of the economic realities that would be so plain if one but looked out the window to forecast them.

If it isn't clear to everyone by this time that the United States remains firmly in the grips of a massive "shadow recession," then we can only credit this ignorance with some unshakable and deeply rooted form of denial or a seriously reckless case of willful blindness.  Either way, we would like to commend the current powers that be for their tour de force performance in establishing themselves firmly both as the most masterful of bullshit artists to occupy the beltway (and that's saying something) and simply the most economically inept (and expensive) team ever to hold national office.  The risk adjusted returns on this particular ruling clique would make the pre-dollarization Zimbabwe carry trade look attractive.

If there is a silver lining to be found here it is probably that this little experiment might finally drive a splintered wooden stake through the heart of John Maynard Keynes' ghost (or at least irradiate Paul Krugman's ravings to within 50 rads of his professional life).

From the BEA:

Real gross domestic product -- the output of goods and services produced by labor and property located in the United States -- increased at an annual rate of 2.2 percent in the third quarter of 2009 ...

GDP was revised down from the advance estimated of 3.5% to the preliminary estimate of 2.8%, and now to 2.2%.

Personal consumption expenditures (PCE) were revised down to 2.8% from 2.9%.

And investment in nonresidential structures was revised down to -18.4% from -15.1% (aka falling off a cliff).

A list which contains both some quite interesting swans and turkeys:

   1. There is a glaring upside to first-quarter 2010 corporate profits (up 100% year over year) and first-quarter 2010 GDP (up 4.5%). It grows clear that, owing to continued draconian cost cuts, coupled with a series of positive economic releases and a long list of company profit guidance increases in mid to late January and early February, there is a very large upside to first-quarter GDP (up 4.5%) and, even more important, to S&P profit growth (which doubles!). The upside on both counts is in sharp contrast to more muted growth expectations. While corporate managers, economists and strategists raise earnings per share, full-year growth and S&P target estimates, surprisingly, the U.S. equity market fails to respond positively to the much better growth dynamic, and the S&P 500 remains tightly range-bound (between 1,050 and 1,150) into spring 2010.
   2. Housing and jobs fail to revive. An outsized first-quarter 2010 GDP (up 4.5.%) print is achieved despite a still moribund housing market and without any meaningful improvement in the labor market (excluding the increase in census workers) as corporations continue to cut costs and show little commitment to adding permanent employees.
   3. The U.S. dollar explodes higher. After dropping by over 40% from 2001 to 2008, the U.S. dollar continued to spiral lower in the last nine months of 2009. Our currency's recent strength will persist, however, surprising most market participants by continuing to rally into first quarter 2010. In fact, the U.S. dollar will be the strongest major world currency during the first three or four months of the new year.
   4. The price of gold topples. Gold's price plummets to $900 an ounce by the beginning of second quarter 2010. Unhedged, publicly held gold companies report large losses, and the gold sector lies at the bottom of all major sector performers. Hedge fund manager John Paulson abandons his plan to bring a new dedicated gold hedge fund to market.
   5. Central banks tighten earlier than expected. China, facing reported inflation approaching 5%, tightens monetary and fiscal policy in March, a month ahead of a Fed tightening of 50 basis points, which, with the benefit of hindsight, is a policy mistake.
   6. A Middle East peace is upended due to an attack by Israel on Iran. Israel attacks Iran's nuclear facilities before midyear. An already comatose U.S. consumer falls back on its heels, retail spending plummets, and the personal savings rate approaches 10%. The first-quarter spike in domestic growth is short-lived as GDP abruptly stalls.
   7. Stocks drop by 10% in the first half of next year. In the face of renewed geopolitical tensions and reduced worldwide growth expectations, stocks drop as the threat of an economic double-dip grows. Surprisingly, though, the drop in the major indices is contained, and the U.S. stock market retreats by less than 10% from year-end 2009 levels.
   8. Goldman Sachs goes private. Goldman Sachs (GS) stock drops back to $125 to $130 a share, within $15 of the warrant exercise price that Warren Buffett received in Berkshire Hathaway's (BRK.A) late 2008 investment in Goldman Sachs. Sick of the unrelenting compensation outcry, government jawboning and associated populist pressures, Warren Buffett teams up with Goldman Sachs to take the investment firm private. The deal is completed by year-end.
   9. Second-half 2010 GDP growth turns flat. The Goldman Sachs transaction stabilizes the markets, which are stunned by an extended Mideast conflict that continues throughout the summer and into the early fall. While a diplomatic initiative led by the U.S. serves to calm Mideast tensions, flat second-half U.S. GDP growth and a still high 9.5% to 10.0% unemployment rate caps the U.S. stock market's upside and leads to a very dull second half, during which share prices have virtually flatlined (with surprisingly limited rallies and corrections throughout the entire six-month period). For the full year, the S&P 500 exhibits a 10% decline vs. the general consensus of leading strategists for about a 10% rise in the major indices.
  10. Rate-sensitive stocks outperform; metals underperform. Utilities are the best performing sector in the U.S. stock market in 2010; gold stocks are the worst performing group, with consumer discretionary coming in as a close second.
  11. Treasury yields fall. The yield of the 10-year U.S. note drops from 4% at the end of the first quarter to under 3% by the summer and ends the year at approximately the same level (3%). Despite the current consensus that higher inflation and interest rates will weigh on the fixed-income markets, bonds surprisingly outperform stocks in 2010. A plethora of specialized domestic and non-U.S. fixed-income exchange-traded funds are introduced throughout the year, setting the stage for a vast speculative top in bond prices, but that is a late 2011 issue.
  12. Warren Buffett steps down. Warren Buffett announces that he is handing over the investment reins to a Berkshire outsider and that he plans to also announce his in-house successor as chief operating officer by Berkshire Hathaway annual meeting in 2011.
  13. Insider trading charges expand. The SEC alleges, in a broad-ranging sting, the existence of extensive exchange of information that goes well beyond Galleon's Silicon Valley executive connections. Several well-known long-only mutual funds are implicated in the sting, which reveals that they have consistently received privileged information from some of the largest public companies over the past decade.
  14. The SEC launches an assault on mutual fund expenses. The SEC restricts 12b-1 mutual fund fees. In response to the proposal, asset management stocks crater.
  15. The SEC restricts short-selling. The SEC announces major short-selling bans after stocks sag in the second quarter.
  16. More hedge fund tumult emerges. Two of the most successful hedge fund managers extant announce their retirement and fund closures. One exits based on performance problems, the other based on legal problems.
  17. Pandit is out and Cohen is in at Citigroup. Citigroup's Vikram Pandit is replaced by former Shearson Lehman Brothers Chairman Peter Cohen. Cohen replaces a number of senior Citigroup executives with Ramius Partners colleagues. Sandy Weill rejoins Citigroup as a senior consultant.
  18. A weakened Republican party is in disarray. Sarah Palin announces that she has separated from her husband, leaving the Republican party firmly in the hands of former Massachusetts Governor Mitt Romney. An improving economy in early 2010 elevates President Obama's popularity back to pre-inauguration levels, and, despite the market's second-quarter decline, the country comes together after the Middle East conflict, producing a tidal wave of populism that moves ever more dramatically in legislation and spirit. With the Democratic tsunami (part deux) revived, the party wins November midterm elections by a landslide.
  19. Tiger Woods makes a comeback. Tiger Woods and his wife reconcile in early 2010, and he returns earlier than expected to the PGA Tour. After announcing that his wife is pregnant with their third child, both the PGA Tour's and Tiger Woods' popularity rise to record levels, and the golfer signs a series of new commercial contracts that insure him a record $150 million of endorsement income in 2011.
  20. The New York Yankees are sold to a Jack Welch-led investor group. The Steinbrenner family decides, for estate purposes, to sell the New York Yankees to a group headed by former General Electric (GE) Chairman Jack Welch.

Obama emerges triumphantly from negotiations in Copenhagen having secured a 2 degree cap on world temperature.  Of course, this implies a sea level increase limit of seven to nine meters.  Having successfully commanded the tide to remain out, Obama and the United Nations have broken new ground in assuring climate status quo through international agreement.  (Oh, and several programs directed at the mass redistribution of wealth to non-democratic kleptocracies were also outlined in the lobby during intermission cocktails).

Enforcement hasn't been discussed yet, but we are confident that a "Weather Czar" will be appointed to gauge world temperature compliance and levy world GDP bonus clawbacks in the event the limit is breached by the planet.  Further, though the summit failed to fail to reach a non-binding consensus, it does provide the basis for hope that emissions targets will be re-aligned to newly developed targets for emissions targets.  John Kerry expressed confidence that new targets for targets would be realized sometime when it wasn't quite so cold outside, and pointed out that the appointment of a Czar and involvement of the EPA would eliminate the need for any legislative authorization to clawback world bonuses in any year where global temperatures exceeded the mandatory limit.  No word yet on how the clawbacks would be used, but speculation includes the Administration's new "polar bears saved or created" programs.

Unfortunately, Obama will be forced to leave the Global Warming Conference due to an imposing winter storm bearing down on the mid-atlantic and due to dump as much as twenty inches of snow in the nation's capitol, which may, in turn, delay the arrival in Washington, D.C. of the largest carbon footprinted transportation logistics infrastructure on the planet.  Obama will therefore be unable to attend the final vote on the motion that the next conference will be in the South of France in August.

Even though we presented Don Coxe's report in full earlier, we wanted to recapitulate his thoughts on gold, as we believe they deserve a post of their own. With gold having become, as we expected more than half a year ago, the most discussed and volatile asset class to accompany the latest Fed inflated bubble, Coxe's view is a welcome addition to other such notable perspectives from the likes of Jim Grant, David Rosenberg, Dylan Grice, Goldman Sachs and many others.

 

---

 

Gold

As the only major financial asset that never pays interest or dividends, gold’s performance could be the clearest, purest example of Zero-Based Investing:

With a 25% rise this year, Gold has beaten the S&P roughly 7%. As measured by the XAU, gold mining stocks’ total return is 35%.

But gold’s investment return was exceeded by the amount of publicity and debate it generated. Its late-year blow-off past $1200 briefly made it a Page One story—thereby automatically guaranteeing a sharp correction.

The media were filled with authoritative explanations:

• Hyperventilating Commentators’ Explanations:
• the collapse of the dollar;
• the repudiation of Obamanomics;
• a warning of a coming financial collapse, leading to Depression;
• a signal of the runaway inflation to come;
• China has only begun to convert its dollar holdings into bullion: the best is yet to come;
• a short squeeze on gold ETFs which are misrepresenting how much bullion they hold: beware of counterparty risk: buy bullion, not paper;
• a coming Armageddon in the Mideast.

Sophisticated Explanations

• gold is the only asset that is nobody’s liability and is therefore a haven in an increasingly uncertain world;
  capitulation by hedged gold miners, notably Barrick;
• India’s purchase of 203 tonnes from the IMF, removing the overhang in bullion markets;
• China’s announcement that its gold holdings are higher than were previously revealed;
• “Peak gold” discussions, as investors ponder the failure of gold mines to maintain—let alone increase—their production despite record bullion prices. The classic expression for getting rich quick is to find a gold mine—but it takes time, experience and capital to bring on a mine. Reported gold companies’ reserves haven’t been rising, but soaring gold prices will change that: millions of tons of low-grade “resources” that haven’t been booked as ore reserves will be reclassified if gold prices remain near or above current levels;
• recognition of the longer-term implications of central banks’ astounding levels of creation of fi at money at a time they are collectively becoming net buyers of gold—after decades of sustained selling;
• respect for gold’s future because prices have managed the remarkable feat of setting new records at a time jewelry demand—traditionally the main support for gold—is slumping sharply;
• portfolio diversification by sophisticated investors who seek a haven at a time of zero returns on Cash—with no indications that central banks are about to abandon their Zero policies.

Clients can undoubtedly add other justifications and explanations to their lists.

We were in Toronto the week gold prices were setting records daily, and were asked—on TV—to explain the dramatic run-up. Various prominent commentators were falling all over themselves to issue ever-higher targets for bullion prices.

We admitted that we couldn’t explain the sudden rush and the dramatic daily leaps. When asked for our price target, we suggested….

“As an historian, I seek some historic data to assist our predicting. When gold broke through $1,000, we began considering appropriate targets. As every English schoolboy knows, 1066 was the Norman Conquest—the first gold target. The next important date was Magna Carta—1215—and gold has now managed to attain that level. The next big date is the Provisions of Oxford 1258 [when Simon de Montfort forced important constitutional changes on Henry III].

“My one-year target for gold is 1345—the onset of the Black Death.

“Apart from that, I really can’t say how high gold could ultimately go, although longer-term it should reach 1485, when Richard III fell in the Battle of Bosworth, launching the Tudor monarchy, and giving us the enduring quote, “My Kingdom for a horse!” The interviewers laughed, and changed the topic.

Next day, Goldman issued its authoritative target price for next year: 1350.

We were called for comment, and graciously accepted that prediction because it was the end of the Black Death.

The point of these musings is that no one really has any idea of the longer term price of gold that can be justified by sober analysis.

All that we can sensibly say is that gold’s price entered a 20-year Triple Waterfall collapse in 1980, falling from $825 to $250, and has risen every year in this decade. If it can maintain its strength at a time jewelry demand
is shrinking, then investors and speculators are in charge; their motivations include momentum and malaise: Gold looks good because it keeps going up, and they’re scared about what the Fed and Obama and other central banks and governments are doing, and have no great confidence that there will be a sustained, noninflationary economic recovery, so gold is a good place to hide.

Gold has been the best-performing major commodity since the financial crisis began:

We see no big reason why that outperformance should be over. After its breathless run to $1220, it’s entitled to correct back toward $1,000—or even a bit below that chiliastic level—without ending its bull market.

Finally, gold may even be decoupling from the dollar. The sheer scale of foreign exchange reserves in China, Hong Kong, India and other countries whose currencies are pegged, directly or otherwise, to the dollar may be
opening a whole new demand for gold. Just to maintain even tiny percentage exposure to gold in forex reserves means these nations must remain on the buy side. The euro was once seen as a worthwhile alternative to the dollar in Asian forex accounts, but the unfolding problems of its Eastern European and Mediterranean members are exposing the euro’s internal contradictions as a viable alternative to the dollar.

In a world in which nearly all paper money has problems, and in which the sheer supply of paper money is expanding far faster than global GDP, gold has its best claim as a constituent of foreign exchange reserves since Bretton Woods booted it out sixty-five years ago. [emphasis ours]

Did You Make Money? Then It Was a Good Deal

By Jim Cramer
RealMoney Columnist
12/18/2009 9:30 AM EST
http://www.thestreet.com/p/rmoney/jimcramerblog/10649290.html

The Citigroup (C) deal was a good deal. It just wasn't good for the bank.

I was adamant the other day -- some would say rabid -- that you be in on the deal. I specifically did not want you to buy it ahead of the deal, although I am now being ridiculed -- thanks Huffington Post! -- for suggesting that I wanted you in at $3.70.

Look, I have no idea really how Citigroup is doing. That's because they don't know how it is doing. That's the biggest flaw of the joint, of course. But what does matter is that I think that worldwide GDP growth is going to be stronger than people think, and that will cure a lot of the errors of all banks, including Citigroup.

Sometimes, as I say in Getting Back to Even, bad merchandise turns into good merchandise at a price. The idea that so much supply could knock down Citigroup to where the stock traded is of ZERO interest to me. The dilution? It is manageable.

The main thing is the stupidity of the critics who keep calling it a bad deal. A bad deal is one that breaks print, not one that goes up after.

Make judgments only about whether you make or lose money. That's what you can try to control.
The rest is dross ginned up by people who need something to write or talk about.

At the time of publication, Cramer had no positions in the stocks mentioned.

Could the next black/green/dark gray swan be so obvious that it has avoided everyone? Well, except for the deputy governor of the Bank of China, who just gave the world a startling reminder of economics 101, when he said that it is "getting harder for governments to buy United States Treasuries because the US's shrinking current-account gap is reducing the supply of dollars overseas." Oops.

The funny thing about natural (and economic) systems: they can only be pushed so far before they snap back to default state. With the entire world embarking on an unprecedented spree of domestic bubble blowing to mask the collapse in global GDP, everyone forgot to trade. Zero Hedge has long emphasized that the drop in world trade can only sustain for so long before it brings the current destabilized system back to some form of equilibrium. Because with every country intent on merely printing more of its own currency, whether it is to build bridges or to make the stock of electronic book fads trade at 100x earnings, said countries ran out of non-domestic cash. Alas, this is most critical for the United States, now that Treasury monetization is over, as the US needs to constantly find foreign buyers of its debt to fund unsustainable deficits. Foreign buyers who have US dollars. And according to Shanghai Daily, this could be a big, big problem.

Here is what the BOC's Zhu Min said earlier:

"The United States cannot force foreign governments to increase their holdings of Treasuries," Zhu said, according to an audio recording of his remarks. "Double the holdings? It is definitely impossible."

"The US current account deficit is falling as residents' savings increase, so its trade turnover is falling, which means the US is supplying fewer dollars to the rest of the world," he added. "The world does not have so much money to buy more US Treasuries."

In a nutshell, in printing trillions of assorted securities, the Treasury has soaked up the world's dollars, which due to US banks not lending, is sitting and collecting dust in the form of bank excess reserves. These excess reserves can not be used to buy Treasuries and MBS as that would be literal monetization (as opposed to the figurative one which is what QE has been). And the world is running out of dollars with which to buy Treasuries.

Does this mean that the "world" will be forced to buy dollars, and thus spike the value of the greenback? Not necessarily:

In a discussion on the global role of the dollar, Zhu told an academic audience that it was inevitable that the dollar would continue to fall in value because Washington continued to issue more Treasuries to finance its deficit spending.

 

Submitted by JM

Happy Holidays and God bless.   If the season brings you peace, congrats.  If the year has been painful on the job or financial front, accept my sincere wishes that the coming one brings better times.

It’s the holiday season:  whoop-dee-doo and conspiratorially enjoying KOSHER wine, not getting up early to watch Bloomberg (sorry Scarlet), and in general dispelling gloom.  I can’t offer anyone gloom-dispelling economic data, because I don’t see much but government socialism coming out of Pandora’s Box.  I do offer data that moderates fears of a specific kind of apocalypse:  a currency crisis.

The apocalyptic flavor of the month is dollar crisis. One should take the possibility seriously.  The data does offer reasonable assurance that it won’t happen anytime soon.  Yes, even in spite of massive (but not unprecedented) fiscal and monetary craziness, a socialist president, a populist legislature, and seething people just itching for the whole outhouse to go up in flames.  Why doesn’t it make sense that the dollar should be out on its rear while gold or oil and their devotees dance in the street?

Because those distinctly American circumstances don’t incorporate a wide enough range of vision.  The issue isn’t about the United States in a vacuum.  It is about the United States as a reserve currency country whose debt acts as the world financial system’s risk-free collateral.  Before any imminent implosion of the dollar, there is a whole zoo of more flawed economies like Dubai and Greece and dozens of others that would fall.  As old as history itself is the truth that the last ones standing claim the spoils of victory.  The United States has the 61st highest public debt ratio in the world. 

I built a model to understand currency crisis events better using data from fourteen financial crises occurring in the last 25 years.  The data used admits no examples of total military demolition or war, although such crises naturally accompany conquest. 

The model specifies two mechanisms that drive tectonic currency shifts and a big residual.  This means that the quantifiable probability of a currency crisis hinges on:  1) deposits to GDP and 2) public sector debt to GDP and 3) the Unquantified.  

The Cast

It isn’t just a rouges gallery of prodigal sons under consideration (UK and USA excluded, because their stories aren’t over by a long shot).  It’s an eclectic mix of times, places, Swedes, and Thais.  And yes, everyone’s favorite sad sack—Argentina—shows up four freaking times.  In broad brushstrokes, the case studies present three crisis profiles, although there is no doubt that a lot of intermixture is present in nearly all countries.

• Bank credit booms are common factors in 6 of the financial crises (Argentina ’95, Finland ’91, Japan ’97, Korea ’97, Philippines ’97, Sweden ’91)
• Bank insolvency and system-wide bank runs were the common factor in (Argentina ’81, Indonesia ’97,  Korea ’97, Ukraine ’98) 
• Unsustainable fiscal imbalances and current account problems were the cause of four very nasty currency (and sovereign debt) crises (Argentina ’89, Argentina ’02, Russia ’98, Thailand ‘97).

Bank credit booms end in bank credit busts that typically require serious debt repudiation and nationalization (maybe not in name) of the banking system.  Bank insolvencies not remedied through capital injections or bank balance sheet repair end in a run on the country’s financial system.  Repairing the balance sheets is not easy, and often associated with the residue of prior government direction of credit.  The nastiest of all financial crises are the result of government failure to show fiscal restraint.  More information can be found here and here.

The Goods

The whole idea of a currency crisis is a study in extremities:  pure tail risk explanation.  I explored these extremes using the database of Luc Laeven.  Yes, I know predictive models are not a perfect fit for reality… the logistic model I used is just an objective way to organize available information free of emotional and a chunk of cognitive bias.  I didn’t use all available data, as some of it is ill-conditioned; some is too complicated; and with some it just didn’t seem worthy of violating simplicity.

The story the data tells. 

• “Creditor’s rights” from 1 to 4 (4 = best) is just subjective garbage and it shows.    (Pr  > χ²= .6882 sucks in every way)
• Current account doesn’t matter much in the model precisely because there are actually three distinct channels through which currency crisis are born.  Korea, Japan, and others had no balance of payments problems but still had financial crises.  (Pr  >  χ² = .9174… even this sucks)
• Depositor insurance really has no value in this model at all.  This is probably the result of mixed effects—simultaneously positive because depositor insurance fosters confidence in the financial system, negative moral hazard problems because the buyer doesn’t beware when she should. (Pr  >  χ² = .9449… totally sucks…)
• Now we are getting somewhere:  public sector debt/GDP.  It is a clear signal of a government financial health, i.e., living within its means.                                     (Pr  >  χ²= .1563… not utterly lousy)
• Deposits to GDP is quite interesting.  As the ratio goes up, the probability of a currency crisis goes down.  Governments (elected or autocratic) have strong incentive to protect the saved capital of its citizens, meaning its currency.  The more deposits stored in the financial system, the stronger the state protection of the currency.  (Pr  > χ² = .1322… not horrible for a logistic regression)

Hard Core Data Porn

The model fit wasn’t great.  Even the most significant parameters indicate only a weak contribution to implied probability.  Some combination of the variables and more sophisticated calibration could very well result in greater significance, but model risk and over-fitting are things to avoid.  You can see the parameter results in Table 1.

The results can be visualized in Chart 1, which graphs the deposits-to-GDP-ratio to the estimated probability of a currency crisis.  Countries with low deposit to GDP ratios uniformly show higher default probability.  There is a clear logic in this:  your elected and appointed officials don’t like, respect, or even give a shit about you.  But they do fear for their jobs.  Seems governments of all composition are somewhat careful to stop screwing around before you get real pissed.  Ninety-nine percent of respondents are against raising the debt ceiling?  Fed audits?  Glass-Steagall coming back?  We’ll see what the mid-terms heave up. 

Stop Worrying and Love the Dollar: The Risks

With a deposit to GDP ratio in the United States 80% and rising, the probability of a currency crisis by government tinkering with the financial system has a likelihood fading like Lindsay Lohan’s career.

A more realistic channel is through explicit government failure to correct an unsustainable fiscal position, and as a result goes crash and burn like Russia, Thailand, Argentina (’89), and Argentina (’02).  To me, this is a question of the central bank balance sheet, as they have been sustaining the current fiscal hubris. 

The “balance sheet” risk of a dollar crisis reduces down Federal Reserve solvency.  The chart below shows a theorized Fed balance sheet with insolvency condition at the bottom (hat tip:  Willem Buiter).  That steaming pile of MBS isn’t the Fed’s only risk.

So long as seignorage income exceeds the cost of business plus payments to the Treasury all is well.  The problems are:

• Seignorage is limited when the central bank must repay TIPS, because they are CPI linked.  If TIPS issuance becomes too large, recapitalization by the Treasury is the only way out of insolvency.  The Fed becomes Citi, and the dollar gets really scared.
• Defaults on the (non-performing?) MBS the Fed acquired through direct purchases and unsecured lending to the private sector is the other concern.  Problems arise when seignorage can’t generate sufficient income to cover the losses.  Money printing does not always get a free ride. 

These are non-trivial risks.  But given that the Fed has been able to borrow billions of dollars at essentially 0%, and the MBS securities probably are generating at least some yield, I’m not losing any sleep yet.  The greatest benefit of having the reserve currency of the world is that the United States issues exclusively dollar-denominated debt.  Don’t screw it up by issuing a lot of TIPS, idiots.

The risk I most concerned with is that nature of the universe is unforgiving of mistakes.  It is an unquantifiable risk:  a powerful take-away of the model is its insufficiency.  Quantitative exercises may be free of emotional bias, but they are not free of assumptions.  And the big assumption spoken here is linearity.

Here’s hoping Benny, the squid, and Santa’s ‘lil hermaphrodite (Timmy Geithner) don’t base their lives on linearity just because it is tractable and easy.  The diagram below shows why.  The dashed blue line represents assumed linearity:  the implication is that Fed can manipulate the dollar exchange rate however it wants by applying appropriate incremental interventions.  If they screw it up, they’ll just intervene differently until the situation is reversed.  However, if the world reacts to interventions in a non-linear way, then applying incremental interventions can result in sudden and irreversible shifts from reserve currency status to toilet paper (the red arrow).  The world almost surely lies somewhere between these two regimes.  But nobody knows the exact functional form of the world, so hedge accordingly.

AAA Super-Senior Nihilism?  Come On, Guys…

It is a strange human perversity that bad times make some welcome complete annihilation as a transformative event.  Perhaps it’s just a desire to escape mediocrity—a reset switch that puts everyone back to ground state.  I guess such a reset seems so much easier than the pain-staking process of wealth-building and just plain dealing with the Latvian gambit front and center.  It is not. 

Are there risks in a long dollar position?  Sure.  But there are risks in eating smoked herring and choking to death.  The real issue is the characterization of that risk, and the expected cost incurred if the event is realized.

But as far as the data suggests, we are not at the culmination of the Kali Age when the earth is wanting in tranquility, strong in anger, rising in power, and soon falling.  It could have happened already.  It’s not like the twentieth century wasn’t thoroughly awful what with concentration camps and gulags and the Cultural Revolution… I’m stopping now. 
Cosmic carnage as a fine diversion!  Pity that mundane reality sours the fantasia. 

Courtesy of David Rosenberg of Gluskin-Sheff

It’s that time of the year when ‘sell-side’ research departments publish their Year-Ahead Reports (as I once did in the not-too-distant past); as do all the financial magazines.

I realized after countless emails and phone conversations (in that order) that there is a very high expectation that I publish one too. I honestly have no intention of publishing a specific set of forecasts in my current role as the Chief Economist and Strategist for Gluskin Sheff for public consumption — the granularity of my recommendations is reserved for our Investment team and our client base. Be that as it may, I am more than happy to comment on what I see as an emerging consensus and my general view on the direction of the economy and the markets in the coming year without getting into too much detail or numerical forecasts, which are the domain of the ‘sell-side’ macro teams globally.

At the outset, let it be known that when I read everyone else’s year-ahead prognostications, all I can think of is, “where do I store this stuff for a year so I can look back and say ‘That was so wrong!’.” It’s not that the reports are always bullish every year; it is that they seem so contrived. And, as I mentioned in the December 10th edition of Breakfast with Dave, this year, probably like most years, there seems to be a remarkable level of agreement. Based on my reading, here is what I conclude the consensus views are as we head into 2010:

• Muted recovery, but positive growth, for sure! No risk of a ‘double dip’.
• Equity markets up!
• A barbell strategy of domestic multinational blue chips and emerging market equities.
  The U.S. dollar is…neutral, but we did locate more bulls than bears (so much for the ‘carry trade’ thesis).
• Positive on commodities for the most part.
• Concerned about government balance sheets, and therefore…
• …Bearish on long term government bonds because they are the ‘competition’ and, after all, who would tie their money up for 10 years at 3.5% when you can lose 22% in stocks? And, therefore…
• …Bullish on spread product (as long as it’s not long-term). And, therefore…
• …Really comfortable with high yield (just for the coupon and the view that default rates will come down).
• Certain that volatility will not be an impediment.
• The Fed will begin to raise rates in the second half of the year, but that this will have no impact since they will still be low.

So here we are with a glorious opportunity to reintroduce Bob Farrell’s Rule 8: “When all forecasts and experts agree, something else is going to happen.”

That being said, these economists and strategists, many of whom I know, are smart guys (and gals) and they are human. To ‘talk your book’ is human; to have the courage to ‘buck the consensus’ is divine. I too am human; I also like to feel that I have courage of my convictions; and I too have a “book” (of sorts — it’s called reputation). But I have decided to take the opportunity of the “Year-Ahead Moment” to transition from sell-side to buy-side and more importantly, to reflect on the past year and really try to prognosticate from the gut. You would be surprised how a blend of intuition and experience can make a difference in a cycle like the one we are in that has absolutely nothing in common with the other recessions of the post-WWII era.

Forecasting is a humbling profession even in the best of times and I have learned a lot in the past year, especially from my partners here at Gluskin Sheff who realizes all too well that:

1. It is what is embedded in asset prices benchmarked against the forecast that is of utmost importance for investors;
2. The focus of any forecast must take into account the reality that minimizing portfolio risks is at least as critical as maximizing the returns, and;
3. Every forecast has an error term and the range around any projection in a post-bubble credit collapse can be extremely wide.

I do not view the economic events of the last two years as a classic recession/recovery phase. They only exist in the context of a secular credit expansions and contractions. We are in a post-credit bubble credit collapse that is ongoing, à la Bob Farrell’s Rule 4: “Exponential rapidly rising or falling markets usually go further than you think, but they do not correct by going sideways.”

Mainstream economists called this downturn “The Great Recession”. This is truly a gentle way of saying “Depression”. When we can have the courage to come to grips with the fact that we did in fact experience a depression of sorts, which is by definition a credit event, then and only then can we draw a conclusion that a sustainable recovery will not get underway until the ratio of household credit to personal disposable income reverts to the mean (and goes to an excess in the opposite direction). I know it sounds harsh, but we shall endure — believe it. Transition is rarely without pain.

The ratio of household debt to disposable income is up from a 30% ratio back in the 1950s to 125% today (though down from 139% at the peak in 2007). Mean reverting to a ratio closer to 60% means that the deleveraging process will be a multi-year event and by the time it is over, more than $7 trillion in additional household credit will have to be extinguished. For more on this see the unbelievably grotesque article on the front page of last Thursday’s (December 10) Wall Street Journal — The New American Dream.

Perhaps inflation is a consensus forecast but deflation is the present day reality and often lingers for years following a busted asset and credit bubble of the magnitude we have endured over the past two years. The fact that China’s voracious appetite for basic materials will continue to exert upward pressure on commodity prices does not detract from this view, especially given the widespread excess capacity in the manufacturing sector and the new frugality that has gripped, and in many cases, been embraced by the retail sector. Higher raw material prices, owing to developments in Asia as opposed to demand pressures here at home, will prove to be a sustained source of profit margin compression for many sectors and companies linked to finished consumer goods and services.

So, much of what I have read in various Year-Ahead Reports predict corporate earnings, GDP growth here and abroad, interest rates and relative values of currencies. As I mentioned earlier, the error term is bound to be very wide in this new paradigm (since WWII) of a secular credit collapse. GDP growth in 1934 was 10%, but the Depression wasn’t over until 1940.

Since 1989, the Japanese stock market has had no fewer than four 50%-plus rallies and there still has been no period of growth that can be called a sustained expansion. Today, we have our own special set of conditions and it is bound to be tricky as is typical during a post-bubble credit collapse, no matter how intense the government reaction. Prematurely committing to the ‘risk’ trade is probably going to be the most lamentable action over the next few years.

Suffice it to say, we believe that the dominant focus will be on capital preservation and income orientation, whether that be in bonds, hybrids, hedge fund strategies, and a consistent focus on reliable dividend growth and dividend yield would seem to be in order. To reiterate, I see the range of outcomes in the financial markets and the economy to be extremely wide at the current time. But one conclusion I think we can agree on is the need to maintain defensive strategies and minimize volatility and downside risks as well as to focus on where the secular fundamentals are positive such, as in fixed-income and in equity sectors that lever off the commodity sector.

This, in turn, underscores my primary focus of favouring Canadian dollar based investments over the U.S. because at no time in my professional life have the downside risks — economic, fiscal, financial and political — been so low on a relative basis and the upside potential so high as is the case today. The near-2,000 basis point gap this year between the TSX and the S&P 500 — the former leading — should be taken in the context of being just past the halfway point of a secular (ie, 16-18 year) period of outperformance. Northern exposure never felt this hot.

More bad news for a troubled Greece. And all this happening even as finance minister George Papaconstantinou says that Greece "is not banking and not operating under the assumption" that the Hellenic country will be bailed out by its Eurozone neighbors.

The minister has certainly read the Dick Fuld script: in an interview with the FT, he said "we're operating on the firm belief that we need ourselves to do whatever it takes to bring down the deficit," he said, and noted that Greece has a "very clear determination" to deal with its budget deficit, which is worth about 12.7% of gross domestic product, and a debt of over 109% of GDP.

click on image for full interview

Remember all that pooh-poohing when the gulf states were talking about their own currency?  About how silly that would be?  That it would never happen?  Yeah well, sort of looks like it might.  True, there is a deep and very comfortable denial in the United States such that the country can spend anything it wants, pump debt to any level it likes, play whatever games it wishes with the way it counts spending, and still enjoy the benefits of a reserve currency indefinitely.  That denial may be just about ready to hit reality:

“The Gulf monetary union pact has come into effect,” said Kuwait’s finance minister, Mustafa al-Shamali, speaking at a Gulf Co-operation Council (GCC) summit in Kuwait.

 

The move will give the hyper-rich club of oil exporters a petro-currency of their own, greatly increasing their influence in the global exchange and capital markets and potentially displacing the US dollar as the pricing currency for oil contracts. Between them they amount to regional superpower with a GDP of $1.2 trillion (£739bn), some 40pc of the world’s proven oil reserves, and financial clout equal to that of China. Saudi Arabia, Kuwait, Bahrain, and Qatar are to launch the first phase next year, creating a Gulf Monetary Council that will evolve quickly into a full-fledged central bank.

 

The Emirates are staying out for now – irked that the bank will be located in Riyadh at the insistence of Saudi King Abdullah rather than in Abu Dhabi. They are expected join later, along with Oman.

 

The Gulf states remain divided over the wisdom of anchoring their economies to the US dollar. The Gulf currency – dubbed “Gulfo” – is likely to track a global exchange basket and may ultimately float as a regional reserve currency in its own right. “The US dollar has failed. We need to delink,” said Nahed Taher, chief executive of Bahrain’s Gulf One Investment Bank.

Well, Ben is certainly Man of the Year for proponents of a Gulf currency.

While Bernanke is preparing to hit the TV circuit (after hiring Obama's exhausted teleprompter team) to cash in on his Time Warner accolade, even as he is set to do nothing at all about the liquidity bubble forming in every aspect of the economy, the much more logical and efficient country of Norway is doing the right thing, and in making sure its economy does not overheat, has raised interest rates by 0.25% to 1.75%. The target rate: 1.25%-2.25%. In other news: Goldman Sachs is not moving to Oslo.

Full Norges Bank statement:

Meeting 16 December 2009

Economic developments

The Executive Board has placed emphasis on the following new information that has emerged since the previous monetary policy meeting on 28 October:

• In the third quarter, activity increased in the US, Asia, the euro area and Sweden, while it continued to fall in the UK. At the same time, unemployment is high with substantial spare production capacity. The OECD projects a fall in GDP for OECD economies of 3.5 per cent in 2009 and a rise of 1.9 per cent in 2010, thus revising up its June growth projections by 0.6 percentage point in 2009 and 1.2 percentage points in 2010.
• Inflation among Norway’s trading partners is close to zero. In the euro area and China, prices are now higher than a year ago, while the level of prices continues to fall in Japan. In many countries, different indicators of underlying inflation are still in the interval 1¼ - 2 per cent.
• Market rates indicate that market participants expect central bank key rates in the US, euro area and the UK to remain unchanged in the period to summer. Key rate expectations 12 months ahead have fallen in the US and the euro area by about 25 basis points, while they remain unchanged in the UK. Australia’s central bank has raised its key rate in three steps, the first time on 6 October, by a total of 0.75 percentage point to 3.75 per cent.
• Long-term government bond yields have fallen in many countries. In the UK, Greece and Ireland, government bond yields have edged up and prices for insurance against government debt default in countries such as Greece and Ireland have risen. 
• In Norway, three-month money market rates remain approximately unchanged. Three-month money market premiums have fallen by 0.1 percentage point and have so far in the fourth quarter been somewhat lower than assumed in the October Monetary Policy Report. The interest rate differential against trading partners remains approximately unchanged at 1.5 percentage points. 
• According to Norsk familieøkonomi, mortgage lending rates have been increased by 12 of 20 banks (1) . Weighted residential mortgage lending rates have increased by 0.12 percentage point. According to Statistics Norway, average bank lending rates to households were 0.18 percentage point lower in 2009 Q3 than in Q2.  Average corporate lending rates were 0.26 percentage point lower in 2009 Q3 than in Q2.
• The import-weighted krone exchange rate index (I-44) has depreciated by 1.0 per cent. So far in the fourth quarter, the krone exchange rate has been 0.4 per cent stronger than projected in the October Monetary Policy Report. 
• The main stock indices have advanced. The Oslo Børs benchmark index has gained about 12 per cent. The turmoil sparked by the company Dubai World’s debt problems resulted in a temporary decline in international equity markets and long-term government yields. The price of credit default swaps for Dubai and for finance companies in Europe and the US showed a marked increase.
• The spot price of Brent Blend oil has decreased somewhat. In the past five trading days, the spot price has averaged USD 72 per barrel. Futures prices for 2010 have been USD 77 per barrel over the past five trading days. 
• The Economist commodity-price index has increased by 6 per cent in XDR (2) terms. In the same period, dry cargo freight rates increased by 23 per cent. 
• The year-on-year rise in the consumer price index (CPI) was 1.5 per cent in November. Adjusted for tax changes and excluding temporary changes in energy prices (CPIXE) consumer prices rose by 2.3 per cent. Adjusted for tax changes and excluding energy products (CPI-ATE), the rate of increase was 2.4 per cent. Other indicators of underlying inflation ranged between 2.5 and 2.7 per cent. Underlying inflation has been broadly as projected in the October Monetary Policy Report. 
• According to Perduco’s expectations survey for 2009 Q4, inflation expectations one year ahead have edged up. Long-term inflation expectations have fallen. 
• Seasonally adjusted registered unemployment was 2.9 per cent in November, unchanged on October and approximately as projected in the October Monetary Policy Report. According to Statistics Norway’s labour force survey (LFS), both unemployment and the labour force contracted by 2000 from August to September, after falling by 13 000 and 12 000 respectively in the previous month. The contraction in employment from July to September was somewhat more pronounced than expected in the October Monetary Policy Report.
• Preliminary seasonally adjusted figures from the quarterly national accounts show that mainland GDP grew by 0.5 per cent from 2009 Q2 to Q3, as projected in the October Report. Growth was solid in private consumption, traditional merchandise exports and public sector demand, but gross private sector investment showed a marked decline. 
• In November, the enterprises in Norges Bank’s regional network reported moderate output growth. They expect growth to continue at the same moderate pace ahead. Employment is stable and is expected to be unchanged ahead. Operating margins had declined somewhat, although to a lesser extent than in the previous rounds.
• According to preliminary seasonally adjusted figures from the quarterly national accounts, household consumption increased by 1.1 per cent from 2009 Q2 to Q3. Spending on goods showed the strongest rise. The index for household spending on goods rose by a seasonally adjusted 2.7 per cent from September to October. This is somewhat higher than assumed in the October Report. The number of new car registrations increased by 45.5 per cent in the year to November 2009. TNS Gallup’s trend indicator, which measures consumers’ perceptions of and expectations concerning their own financial situation and the country’s economy, rose from 11.6 points to 16.4 points from 2009 Q3 to Q4.
• According to seasonally adjusted preliminary figures from household income accounts, the household saving ratio excluding dividend income rose from 5.7 per cent in 2009 Q2 to 6.5 per cent in Q3. Over the past ten years, the household saving ratio excluding dividend income has averaged 0.6 per cent.
• Gross domestic debt (C2) in the private and municipal sector increased by 5.1 per cent in the 12 months to October this year. The corresponding figure for September was 5.5 per cent. Growth in credit to non-financial enterprises is still decelerating, while household credit growth picked up in October. Non-financial enterprises’ holdings of liquid assets (M2) increased by 2.5 per cent in the year to October 2009.
• According to house price statistics from the real estate industry, house prices rose by a seasonally adjusted 1.2 per cent in November. House prices have increased by 15.1 per cent since the trough in November 2008. Since the peak in June 2007, house prices have risen by 3.7 per cent. 
• According to building statistics, the number of housing starts fell by 9.6 per cent in the 12 months to October 2009. Measured by utility floor space, housing starts remained approximately unchanged. Seasonally adjusted, the number of housing starts was 1622 in October, down from 1629 in September but up from 1586 in August. The number of other building starts has risen for three consecutive months. According to order statistics for the building and construction industry, the value of new orders remained unchanged from 2009 Q2 to Q3. Seasonally adjusted, the value of new orders increased by about 9 per cent. 
• Manufacturing production fell by a seasonally adjusted 1.5 per cent from September to October after a rise of 2.1 per cent in the previous month. Manufacturing production was a seasonally adjusted 1.5 per cent higher than in 2009 Q3 than in Q2. The industrial confidence indicator in Statistics Norway’s business tendency survey rose from -7 to -5. Managers expect output and employment to fall in 2009 Q4 and new orders are expected to level off.
• According to order statistics for manufacturing, the value of new orders increased by 3 per cent from 2009 Q2 to Q3. Export orders rose, while orders in the domestic market fell. The value of order stocks decreased by 7.0 per cent in the same period. 
• According to Statistics Norway’s investment intentions survey for manufacturing, mining and electricity, estimated manufacturing investment in 2009 is 30 per cent lower than the estimates for 2008 published at the same time last year. Estimated manufacturing investment for 2010 is 22 per cent lower than in the 2009 survey. For most manufacturing sectors, estimated investment is considerably lower than in this year’s survey.
• According to the Q4 investment intentions survey for oil and gas production, investment in petroleum activities in 2009 is estimated at NOK 141.2 billion, i.e. value growth of 11 per cent compared with the estimate for 2008 published at the same time last year. Investment for 2010 is estimated at NOK 138.5 billion, which is 5 per cent lower than the estimate for 2009 published at the same time last year.

 

Assessment

Growth has revived in the global economy and activity is now also picking up in the US and in most European countries. Prices for oil and other commodities remain high and financial markets are functioning more efficiently. Even though growth has picked up, there are no prospects of a strong recovery.  Economic developments ahead are still uncertain, particularly in countries with large government deficits. We expect only moderate growth ahead in the US and Europe. In a number of countries, key rate expectations are still low and have edged down since the previous monetary policy meeting.

Monetary policy is oriented towards consumer price inflation of close to 2.5 per cent over time. Consumer price inflation has been as expected. Underlying inflation is close to 2.5 per cent, but will probably fall in the period to summer, partly as a result of the krone appreciation earlier this year. The krone exchange rate has now stabilised, broadly in line with projections in the October Monetary Policy Report. As a result of low productivity, higher costs in the corporate sector, growth in household demand and higher capacity utilisation, consumer price inflation will gradually move up again.

Activity in the Norwegian economy has rebounded approximately as expected. Capacity utilisation is lower than normal, but it appears that the downturn will be fairly mild. Growth in private consumption is strong and house prices are rising sharply. Export growth is picking up somewhat more rapidly than expected. Unemployment remains at a relatively low level.  On the other hand, recent investment intentions surveys indicate that corporate and petroleum investment may be somewhat lower than estimated. The enterprises in Norges Bank’s regional network expect moderate growth in output ahead.

The Executive Board’s strategy is that the key policy rate should be in the interval 1¼ - 2¼ per cent in the period to the publication of the next Monetary Policy Report on 24 March 2010 unless the Norwegian economy is exposed to new major shocks. The analyses in Monetary Policy Report 3/09 indicate that the key policy rate should thereafter be raised gradually. Higher capacity utilisation or a weaker krone may, on the one hand, result in higher-than-projected inflation. On the other hand, inflation may be lower than expected if the krone remains strong or productivity picks up rapidly. Should the krone appreciate considerably more than projected, the interest rate may be increased to a lesser extent or later than currently envisaged. 
 
Economic developments have been broadly in line with projections. The Executive Board considered the alternative of keeping the key policy rate unchanged, but interest rates are low and the October increase in the key policy rate has had a limited impact on bank lending rates. At the same time, the upturn abroad and in Norway has, as expected, gained a firmer foothold and the outlook for next year seems less uncertain. On the basis of an overall assessment, the Executive Board decided to increase the key policy rate at this monetary policy meeting.

Decision

The key policy rate is raised by 0.25 percentage point to 1.75 per cent with effect from 17 December 2009.

 

Footnotes

1)   New variable-rate residential mortgages of NOK 1 million, within 60% of purchase price

2)   Special drawing rights, IMF. As of 14 December XDR 1 = NOK 9.17

One of the things that spooked the market yesterday was not so much any concerns of tightening language in today's FOMC statement, as much as a rumor that the Fed was planning on bumping up the discount rate. Krishna Guha, in a blog post, wondered, "might the Fed raise the discount rate at this week’s policy meeting? I think this is a possibility and should be considered as a risk factor. But I would not include a discount rate increase in my base case forecast for the meeting." The key reason for this would be the increasing desire of the Fed to "draw an increasingly sharp distinction between liquidity policy and monetary (interest rate) policy in the spirit of the ECB’s separation principle at this meeting and in subsequent communications." Yet the question remaind: is the Fed about to hike the Discount Rate?

Goldman provided some additional thoughts:

The logic for increasing the discount rate rests on “normalization” (Guha’s word) of the unconventional component of the Fed’s policy mix and not on normalization of short-term interest rates, which in Guha’s view is “still some way off.”  Thus, if the Board chose to do this the emphasis would be on increasing the spread between the discount rate, which currently stands at 50 basis points (bp), and the federal funds rate, currently targeted between zero and 25bp, as just another step in a sequence of moves that have already been taken to wind down the facilities by making them less attractive to banks.  Since late June, the Fed has periodically reduced both the amounts on offer in its auction facilities – the Term Auction Facility (TAF) and the Term Securities Lending Facility (TSLF) – and the terms on these and other facilities, including discount window loans (to be available for up to 28 days instead of the current 90 days as of January 14, 2010).  As a result of these changes as well as the general improvement in financial conditions, the combined outstanding balances in liquidity and commercial paper facilities has dwindled from $1.2 trillion (trn) as of late June, when the first of these changes occurred, to $135bn last Wednesday.  Given this progress and the normalization in the financial markets at large, why would it not make sense to start raising the discount rate?
 
Our answer – and we believe the FOMC’s answer as well – is that a discount rate increase would risk a lot more than it would achieve.  Even if advertised loudly as something other than a hike in short-term interest rates, the financial markets would inevitably treat it as the precursor of such a move.  Note in this regard the selloff that developed in fixed-income markets as this story circulated yesterday.  Meanwhile, the benefit in terms of shrinking either the Fed’s balance sheet or the volume of excess reserves would be trivial.  As of Wednesday, the outstanding balance at the discount window was just $19bn – less than 1% of total Federal Reserve assets ($2.2trn) and less than 2% of excess reserves ($1.1trn).  By comparison, outstanding TAF balances were nearly $86bn.  Moreover, some of these loans (at either facility) may be to banks that need short-term liquidity but still perceive a stigma to revealing this need to other banks at a time when most of them are swimming in excess reserves.  Thus, while Fed officials may wish at some point to restore a wider spread between the discount rate and federal funds target rate -- we’re not even sure of that given the difficulty they encountered in getting banks to use the discount window early in the crisis, when the spread was 100bp – they are apt to leave the spread alone until rate hikes of a more conventional variety are closer at hand if not already underway.

While the Fed has now heard loud and clear what the real policymaker, Goldman Sachs, feels about any less than accommodative monetary policies, the money printing institution does have to be concerned about the ever increasing desires out of all legislative bodies to curb its drunken sailor ways. And a discount rate increase may just be that middle ground that placates many of the popular concerns vis-a-vis eventual tightening, as well as reminding that Bernanke's policies are not solely geared to perpetuating the taxpayer subsidized zero cost of capital bank piggy bank.

So with most eyes glued to every word of the Fed Statement, here is, once again, what Fed HoldCo Goldman Sachs believes will come out of the Fed at ~ 2 pm today, in a sentence by sentence read of the expected release:

While there have been upside and downside surprises over that period, on balance these surprises have prompted upgrades to growth estimates for the fourth quarter.  Consequently, we see a number of spots in the first paragraph, which is devoted to a summary of recent growth developments, where the FOMC could upgrade its assessment.  Taking the November 4 version of that paragraph sentence by sentence:
 
“Information received since the Federal Open Market Committee met in September suggests that economic activity has continued to pick up…This remains true, with GDP tracking into the fourth quarter at a stronger pace than now posted for the third.  However, the acceleration is due mainly to faster progress in reducing the pace of inventory liquidation; for example, we estimate that real final sales are currently rising at a 2.3% annual rate, about the same as the 1.9% rate posted for the third quarter.
 
…Conditions in financial markets were roughly unchanged, on balance, over the intermeeting period…Fed officials could justify a more upbeat tone here.  Our Goldman Sachs Financial Conditions Index (GSFCISM) has eased by about 30bp since early November, mostly due to an increase in stock prices.  Dollar weakness has also contributed modestly, though some would not see this as an improvement; in any case, Fed officials would not be specific about the sources of better financial conditions.
 
…Activity in the housing sector has increased over recent months…This is true with respect to sales of existing homes, so the sentence will probably stay.  However, starts have suffered a setback in the past couple of months, which might prompt a qualification of some sort.
 
…Household spending appears to be expanding but remains constrained by ongoing job losses, sluggish income growth, lower housing wealth, and tight credit…This is still broadly true.  However, the latest labor market report was much better than expected, in contrast to the one released just after the last FOMC meeting.  So we could see a modest upgrade here if Fed officials choose to give more weight to recent data.
 
…Businesses are still cutting back on fixed investment and staffing, though at a slower pace; they continue to make progress in bringing inventory stocks into better alignment with sales…The staffing part of this might disappear in recognition of the reduced pace of layoffs, but the rest still appears to be true, especially insofar as inventories are concerned.
 
…Although economic activity is likely to remain weak for a time, the Committee anticipates that policy actions to stabilize financial markets and institutions, fiscal and monetary stimulus, and market forces will support a strengthening of economic growth and a gradual return to higher levels of resource utilization in a context of price stability.”  With private-sector (and undoubtedly Fed staff) economists marking up forecasts for the fourth quarter, the introductory phrase will probably be tweaked.  The committee may also point out that they are starting to make progress in increasing capacity utilization.  However, we doubt that the overall thrust of the sentence will change.
 
The one-line second paragraph on inflation – “With substantial resource slack likely to continue to dampen cost pressures and with longer-term inflation expectations stable, the Committee expects that inflation will remain subdued for some time.” – is broadly still true despite an uptick in core retail inflation.  Tomorrow’s report on the CPI will provide a fresh reading on this.  (We expect a 0.17% increase in the CPI core; the consensus looks for a 0.1% increase.)  While retail gasoline prices have edged up at a time of the year when they normally fall, crude oil prices have fallen since early November and indexes of commodity prices have been mixed.  Meanwhile, the jobless rate has risen on balance from the 9.8% for September that the FOMC was looking at in early November, capacity utilization is in the low 70s, and large overhangs prevail in real estate markets.  Long-term price expectations as measured in the Reuters/Michigan consumer sentiment survey fell substantially in early December, while the implied 5-year inflation rate five years forward is about where it closed on November 4.
 
In the final, policy-oriented paragraph, the sentence announcing the reduction of the targeted amount of agency purchases to $175bn from $200bn will clearly go, but otherwise we do not anticipate any changes.  In particular, for the reasons just cited for the inflation outlook, the key policy sentence for interest rates
 
“…The Committee will maintain the target range for the federal funds rate at 0 to 1/4 percent and continues to anticipate that economic conditions, including low rates of resource utilization, subdued inflation trends, and stable inflation expectations, are likely to warrant exceptionally low levels of the federal funds rate for an extended period…
 
is unlikely to change, nor is the outline of credit easing that follows:
 
…To provide support to mortgage lending and housing markets and to improve overall conditions in private credit markets, the Federal Reserve will purchase a total of $1.25 trillion of agency mortgage-backed securities and about $175 billion of agency debt.  In order to promote a smooth transition in markets, the Committee will gradually slow the pace of its purchases of both agency debt and agency mortgage-backed securities and anticipates that these transactions will be executed by the end of the first quarter of 2010.”
 
Other parts of this paragraph are relatively uncontroversial – promising “to employ a wide range of tools to promote economic recovery and to preserve price stability .… [to] continue to evaluate the timing and overall amounts of [the FOMC’s] purchases of securities in light of the evolving economic outlook and conditions in financial markets …. [and to monitor] the size and composition of its balance sheet and [to] make adjustments to its credit and liquidity programs as warranted.” – and therefore likely to stay as written.

So while overall there is little room for surprise out of the FOMC, the possible Discount Rate increase could cause quite a stir if Guha is indeed right. And indeed, the credit markets are certainly much more skeptical of the continuing status quo than equities, which are blindly continuing in the only direction that the volumeless and computer-driven "rally" will allow them to go.

 

• Asian stocks rise, led by Japanese financial companies; Dollar strengthens.
• Australia's Q3 GDP grew 0.2%- showing growth momentum isn't yet self sustaining.
• FDIC in 2010 plans to add more than 1,600 staffers, mostly to handle bank failures.
• India to levy antidumping duties of as high as more than 3x the value on some Chinese telecommunication equipments.
• Senate rejects plan to import low-cost drugs.
• Sugar jumps to highest price since 1981 in New York on deficit concerns.
• US Industrial output rises 0.8% - most in three months as recovery gains speed.
• US producer prices rose 1.8% - more than f'cast in November on fuel costs.
• AAR Corp.'s Q2 net rises 28% to $13.3M on absence of charges. Revs fell 7% to $328.7M.
• Accor SA to split company - one focusing on hotels, other on vouchers.
• Adobe swung to Q4 loss of $32M on restructuring charges. Revs dipped 17% to $757.3M.
• American Airlines has proposed making JAL its exclusive Asian partner.
• AmEx 30-day managed delinquencies: 3.9% in Nov vs. 4.1% in Oct.
• Best Buy posted Q3 earnings of $227M helped by lower taxes and 4.6% rise in sales.
• British Airways and union leaders will meet for emergency talks.
• Citigroup says Abu Dhabi wants out of $7.5B share purchase agreement.
• Credit Suisse to pay $536M penalty as part of US investigation into how major Western banks illegally handled funds for Iran.
• Deutsche Bank sees a "significant" drop in its overall loan loss provision for 2010.
• EU overturned a decision ordering EDF to repay $1.3B in unpaid taxes.
• General Growth Properties will seek approval later today of an amended bankruptcy plan.
• Genworth Financial may return to operating profit in the middle of 2011.
• GM plans to repay $6.7B it borrowed from the U.S. govt by June or even sooner: CEO.
• Pitney Bowes plans to cut up to 10% of its work force; to save $200M annually from 2012.
• Stanford University has pulled $5B of private-partnership interests from the auction block.
• Wells Fargo priced 426M common shares at $25 each, raising $10.65B to repay TARP funds.
• Weyerhaeuser announces intent to elect REIT status; timing under consideration.

Economic Calendar: Data on Building Permits, Housing Starts, Crude Inventories,

FOMC Rate Decision to be released.

RECENT RATING ACTIONS
PEP BOYS-MANNY MOE & JACK (PBY)
BEST BUY CO INC (BBY)
NASH FINCH CO (NAFC)
MASCO CORP (MAS)
METROPCS COMMUNICATIONS INC (PCS)
WEYERHAEUSER CO (WY)
STARWOOD HOTELS & RESORTS (HOT)
CONSECO INC (CNO)
GENERAL MARITIME CORP (GMR)
TEEKAY CORP (TK)
TITAN INTERNATIONAL INC (TWI)
TERADYNE INC (TER)
BRITISH AMERICAN TOBACCO (BATS LN)

Data provided by Egan-Jones Ratings And Analytics

A frequent theme on Zero Hedge is the structural limitation imposed on corporate revenue and profitability absent an overall increase in the currency in circulation, or said otherwise, in the "velocity" of money. If banks do not lend out the money, and the money does not somehow find its way to companies' top lines, there is logically less revenue thus lower EPS (especially with the key layoff rounds already having taken place). We were gratified to see Rosenberg pick up on this theme in his latest "Latkes with Dave" piece. As Rosenberg points out, the banks continuing unwillingness to lend money out will end up transforming not only the political landscape in D.C., but could very easily be the end of the seemingly endless bear market rally.

Chart 1 maps out the S&P 500 with money velocity (GDP/M1 ratio). There is a 90% correlation between the two. It is one thing to have the Fed pump liquidity into the system but it is quite another for the liquidity to be re-leveraged into credit and recycled into the economy.

The Fed’s easing program is over two years old and the rampant Fed balance sheet expansion 15 months old, and still to this day, what the commercial banks have done (to Obama’s wrath) with all that liquidity is to keep it as cash on their balance sheet to the tune of $1.2 trillion. We’re not sure why Obama is as rankled as he is because the banks are in fact lending out a good chunk of that Fed-induced liquidity — right back to Uncle Sam (the banks now own a record $1.3 trillion of government securities).

Back to the chart — there is obviously a close connection between money turnover and the stock market. But we can get periodic divergences as we did in the first leg of the rally in 2003. But the carry-through from 2004 to 2007 hinged critically on that multi-year acceleration in money velocity. If we don’t see the banks begin to extend credit in 2010, it is hard to see the 2009 bounce from oversold lows as being sustained in the coming year.

On the other hand, money velocity is closely tied to general availability of credit. So the long-term chart could be simply falsely correlating two indirect derivatives of a broader systemic issue over the past 20 years: Greenspan's ever cheaper and abundantly available credit. In other words, if banks do not loosen up their "stingy" ways (which of course was the very reason why we are in this place to begin with), before the Fed tightening begins sometime in 2010/2011, then one can kiss the idea of money velocity increasing goodbye.

 

Cash for Clunkers is long forgotten, and it is now time for another manufacturing stimulus: from 34.6 in September to 24.5 in October to a mere 2.55 most recently. Diffusion data suggested further contraction in margins, evaporation of optimism and an ongoing decline in inventories: the whole 5% of Q4 GDP is becoming a Liesmanian myth.

The Empire State Manufacturing Survey indicates that conditions for New York manufacturers leveled off in December, following four months of improvement. The general business conditions index fell 21 points, to 2.6. The indexes for new orders and shipments posted somewhat more moderate declines but also moved close to zero. Input prices picked up a bit, as the prices paid index rebounded to roughly its November level; however, the prices received index moved further into negative territory, suggesting that price increases are not being passed along. Current employment indexes slipped back into negative territory. Future indexes remained well above zero but signaled somewhat less widespread optimism than in recent months. Indexes for expected prices paid and received declined moderately but remained well above zero.

Take home here - Stimulus:More Optimism::No Stimulus:Less optimism.

Survey results on general conditions:

The general business conditions index fell from 23.5 to just 2.6, suggesting a leveling off in conditions after four straight months of improvement. Roughly 24 percent of those surveyed in December said that conditions had improved, while 22 percent reported that conditions had deteriorated. Most of the other specific activity measures fell a bit less sharply: the new orders index slipped more than 14 points to 2.2, and the shipments measure declined by just under 7 points to 6.3. The unfilled orders index fell by more than 18 points to -21.1, its lowest level in nine months. In contrast, the index for delivery times held steady at -2.6, and the inventories index, at -18.4, was little changed for the third straight month.

On Margins:

Manufacturers See Margins Squeezed Survey respondents faced somewhat higher input prices in December, while their selling prices declined. The prices paid index rose 9 points to 19.7, reversing a drop of similar magnitude in November and suggesting some renewed price pressures. At the same time, the prices received index slipped 6.6 points to -9.2, its lowest level since August. Employment indexes declined for the second straight month, falling below zero for the first time in a few months: the index for number of employees slipped 7 points to -5.3, and the average workweek index fell 11 points to -5.3.

Optimism is now gone:

Manufacturers remained generally optimistic about the outlook for general business conditions and activity, although a bit less so than in recent months. After rising to its highest level in more than a year, the index for expected general business conditions retreated 14 points to 43.0—still a high level but the lowest since July. The forward-looking indexes for both new orders and shipments fell by almost as much but remained in the upper 30s, while the future unfilled orders index declined by a more moderate 5 points to 12.0. The index for expected delivery times edged up to zero, its highest level in more than a year, and the measure for future inventories was unchanged at 7.9.

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