Momentary exuberance?

Highlights

The markets saw dramatic movements last week. US Stocks extended losses on Tuesday sending the Dow below the psychologically critical 10,000 price mark for the first time in 2010. This was after a bigger than expected slump in home sales fuelled concerns that the economy may head back into a recession. Fears accentuated after S&P cut the sovereign Ireland rating one notch down to AA- with a negative outlook on concerns that the cost of supporting its banks is rising at a fast pace. US 10y yields slid to the lowest since 2009, below 2.5% at one time after the durable goods report showed a worse than expected print. Bunds advanced even after German business confidence unexpectedly rose in August.

The dismal week turned upside down after Bernanke’s speech at Jackson Hole. The S&P reacted with a 1.6% jump on Friday closing above 10,150. The 10y Treasury yield selling off dramatically to near 2.64%. Chairman Bernanke assured the markets that the Fed intends to do “all it can” to ensure a US recovery.

Is this the “I get knocked down, but I get up again” phase or is it just a “momentary lapse of reason.”

Bear Roubini, Bull Bernanke

Nouriel Roubini, the New York University economist who predicted the global financial crisis, said U.S. growth will be “well below” 1 percent in the third quarter and put the odds of a renewed recession at 40 percent.

“With growth at a stall speed of 1 percent or below, the stock markets could sharply correct, and credit spreads and interbank spreads widen while global risk aversion sharply increases,” he said. “Thus a negative feedback loop between the real economy and the risky asset prices can easily then tip the economy into a formal double-dip,” he said, referring to two recessions in a quick succession.

Bernanke, on the other hand expressed confidence in the Fed’s ammunition to handle a double dip possibility. “The issue at this stage is not whether we have the tools to help support economic activity and guard against disinflation. We do,” Bernanke said in a speech at the Fed’s annual conference in Jackson Hole, Wyoming, detailing choices that include renewed large-scale securities purchases.

Economics

Purchases of existing homes plunged 27.2 percent to a 3.83 million annual rate, figures from the National Association of Realtors showed today in Washington. The pace compares with the median forecast of a 4.65 million rate, according to a Bloomberg News survey.

The revised forecast for Q2 GDP came in slightly better than expectations of 1.3% but plummeted to 1.6% vs. the previous estimate of 2.4%. “It’s bad…but we were prepared for worse”, was the feeling in the market.

What’s behind the home sales data?

Sales of previously-owned homes, after a good run in March and April, slid in June before crashing in July. Sales last month were down 26% from one year earlier and 27% from June.

I suspect a large portion of this drop is due to the ending of Home-buyer tax credit of $8,000 in April. Clearly, temporary tax credits succeeded in getting buyers to change their behavior. But once the tax credits disappeared, so did the buyers. There is no reason to have signed a contract in May and not in April when you could have gotten an $8,000 tax credit.

What’s less clear is whether stimulus has done anything else to change demand. While mortgage rates continue to fall every week into record territory, the expiration of tax credits shows that housing demand is not much better than it was 18 months ago, when the market was in freefall.

Sure markets were to slide for a couple of months (May and June) after tax credit were finished. But the plummet of July certainly points to lack of structural demand. How long before we say that it not ONLY the lifting of tax credit that has caused demand to fall? I guess may be a month more….max!

Double Bubble?

US Rates

St. Louis Fed President James Bullard’s speech on Friday caught much attention. Bullard furthered the dovish Fed sentiment stating that if economic developments suggested increased disinflation risk, the Fed might consider purchases of Treasury securities in excess of those required to keep the size of the balance sheet constant. He also tried to balance his outlook stating that “continued expansion is the most likely course going forward.” Bullard told reporters on a more hawkish note that while he continues to have concerns with the “extended period” language, he did not dissent as a mark of respect to the Fed’s practices.

Employment

The job environment in the US came under some threat last week as unemployment claims increased unexpectedly to 500k, the highest level since November 2009. The report printed a number higher than the maximum forecasts of 42 economists surveyed by Bloomberg, which ranged from 460k to 495k. The claims number induced a response from President Obama, who noted an urgent need for congressional action towards cutting taxes and easing credit for small businesses.

Economics

The Philadelphia Fed’s General Business Conditions Index plummeted to negative 7.7, decisively worse than expectations of positive 7 and in the contraction mode. The latest reading is the worst since July 2009 and down from 5.1 last month, pointing towards a possible trend of sluggish growth, if not worse.

Bond bubble?

Over the last few weeks, there has been intense debate on whether we are witnessing a bond bubble as yields have reached within striking distance in all the sectors of the curve, having crossed lowest levels in some tenors.

I don’t think there is a bond bubble. Just because yields are at all time lows is not reason enough. I can’t find the reason for yields to be higher. Treasury auctions have performed well as suggested by all bid to cover ratios. Japan reported highest ever holding of foreign debt. Economic numbers have come out weaker than expected, inflation has been docile, and the Fed has left the “extended period” language unchanged while sending dovish signals all over. The stock markets too have continued to perform poorly.

More on the bubble babble

http://www.cnbc.com/id/38785166

Double Dip?

That’s the big question!

On the one hand we’ve had Goldman Sachs saying that the possibilities of a double-dip recession “is unusually high- between 25 to 30%- but we do not see double dip as the base case.”

On the other hand the US bond market disagrees. The economy has never contracted with the difference between short-term and long-term yields as wide as it is now. Though, the yields have also have never been lower than now! According to the Federal Reserve Bank of Cleveland, the 2y10y slope (now 211 basis points) signals a 15.5% chance of a recession in the next year.

Remember Quantitative Easing?

US Rates

Rates saw a dramatic rally last week primarily on the back of some significant policy announcements by the Fed. The US Central Bank suggested that it would re-invest the proceeds of more than $150bn from their investment in mortgage-backed securities into US Treasury notes and bonds. This is a clear change in policy stance from a few months ago, when the Fed was aiming towards a natural shrinking of its balance sheet. The Fed announced purchases of $18bn of Treasury bonds over the next month, much less than the average $50bn monthly purchases conducted last year as a part of the $300bn quantitative easing program. The purchases are expected to be in the 2 to 10y sector of the yield curve. Given that the Fed is reluctant to hold more than 35% of the market share in any one maturity, the pressure is mostly in the 5y to 7y intermediate sectors of the yield curve. The Fed also downgraded its economic forecast further accentuating the flight to quality move into Treasuries.

Yields on government bonds are now within striking distance of the all time lows seen in March 2009. The two year rate is already at an all time low near 0.6%.

Employment

This is after the prior week saw nonfarm payrolls for July decline by 131k vs. expectations of an increment of 100k. The only respite in the report was that most (if not all) of the job losses were from temporary jobs at the US Census. The employment rate, measured by the Household Survey held steady at 9.5%.

Currencies

In the obvious response, the US dollar faired quite well compared to other G10 currencies as investors moved to the shelter of US Treasuries. The Euro fell towards a three-month low in the 1.27 region. This move was also supported by the Q2 GDP report in the Euro area region which saw a robust growth of 2.2% in Germany on one hand while Greece was proven to be deep in recession with a negative growth of 1.5%. The market is set to re focus on the woes of the Euro area region.

What Lies Ahead?

One thing is certain; the next six to nine months are going to feel similar to the period from March to December 2009. The Fed is essentially elongating QE - at a smaller scale of course only because the economy is not in crisis mode. With an intent to buy $150bn of Treasury and an average of $18bn per month equates to 9 more months of wait and watch period. Whether the US goes into recession or not is difficult to say. Growth is going to be close to 0%! Be it is from the left hand side of the number scale or the right hand side. Well it’s not really surprising, what were the chances that the Fed would be able to pull-off an absolute smooth recovery in the first place. These obstructions were always on the cards.

With employment way above 9%, QE-like actions on the way, recession possibilities I don’t see the Fed hiking rates before this time next year, or perhaps even December 2011.