February 27, 2010

Market Insights - 27 February 2010

Dear Friends & Fellow Investors

Here is the latest issue of Market Insights. As always, please email any questions to: info@fxistrategies.com

In This Week's Issue
• Weekly Snapshot
• Chart Of The Week
• Weekly Barometers 
• Long Period Of Low Interest Rates
• Inflation vs. Deflation - The Ongoing Debate
• FDIC List 702 Problem Banks
• Some Notes on Diversification
• Email From A Colleague
• Week-end Reading 

Weekly Snapshot
• Real GDP in the US rose at an annual rate of 5.9% in the fourth quarter of 2009 (ESA)
• US existing home sales fell 7.2% to a seasonally adjusted annual rate of 5.05 million (AP)
• SEC voted 3-2 to curb short selling for securities that drop 10% in a single day (NY Times)
• A report on pay at Wall Street firms found that bonuses rose by 17% last year, to $20.3 billion (Economist)
• US Initial unemployment claims jumped to 496,000, the highest level since November (Bloomberg)
• US durable goods increased 3.0% from December '09 but excl. transportation they decreased 0.6% (ESA)
• Industrial new orders up by 0.8% in euro area (Eurostat)
• US new home sales in January-10 fell 11.2% from December-09 and were 6.1% below January-09 (ESA)
• Fed Chairman Bernanke told Congress that low interest rates are still needed to support the economy (AP)
• German GDP remained unchanged Q4 of '09 from previous when it expanded by 0.7% (Economy.com)
• 702 banks are on the FDIC list of  “Problem Banks”, an increase of 450 since 2008 (FDIC)
• US consumer confidence declined sharply from 56.5 in January to 46.0 in February (Conference Board)

Chart Of The Week
You may have heard that Wall Street bonuses paid to New York City securities industry employees rose by 17 percent to $20.3 billion in 2009.  In light of these numbers, public anger is understandable. 

WB_Bonus

At the same time, I have just read Warren Buffet’s Annual Letter to Shareholders which is full of insightful information and highly recommended!  With his usual sobering clarity, Mr. Buffett has these things to say about Wall Street’s CEOs and the largest financial institutions:

In my view a board of directors of a huge financial institution is derelict if it does not insist that its CEO bear full responsibility for risk control. If he’s incapable of handling that job, he should look for other employment. And if he fails at it – with the government thereupon required to step in with funds or guarantees – the  financial consequences for him and his board should be severe.

It has not been shareholders who have botched the operations of some of our country’s largest financial institutions. Yet they have borne the burden, with 90% or more of the value of their holdings wiped out in most cases of failure. Collectively, they have lost more than $500 billion in just the four largest financial fiascos of the last two years. To say these owners have been “bailed-out” is to make a mockery of the term.

The CEOs and directors of the failed companies, however, have largely gone unscathed. Their fortunes may have been diminished by the disasters they oversaw, but they still live in grand style. It is the behavior of these CEOs and directors that needs to be changed: If their institutions and the country are harmed by their recklessness, they should pay a heavy price – one not reimbursable by the companies they’ve damaged nor by insurance. CEOs and, in many cases, directors have long benefitted from oversized financial carrots; some meaningful sticks now need to be part of their employment picture as well.

Weekly Barometers  (click on chart for larger image)

Stock2010-0226   FX2010-0226

Long Period Of Low Interest Rates  
In his opening statement of the Semiannual Monetary Policy Report to the Congress, Fed Chairman Ben Bernanke emphasized that he did not plan to begin raising interest rates anytime soon given that the economic recovery would likely slow down later this year when government stimulus is withdrawn as expected in the coming months. 

Inflation is expected to remain subdued, with consumer prices rising at rates between 1 and 2 percent in 2010 through 2012. In the longer term, inflation is expected to be between 1-3/4 and 2 percent, the range that most FOMC participants judge to be consistent with the Federal Reserve's dual mandate of price stability and maximum employment.

The possibility of a deflationary threat has increased as indicated by the core inflation rate which fell by 0.1% in January, dropping for the first time in 28 years.  Assuming that economic growth remains subdued in the face of a challenging labor market and considering the possibility of further deleveraging in private and commercial real estate,  deflation could be a serious threat. 

Using an analogy by Paddy Hirsch, senior editor of Marketplace, the Fed stimulus in terms of interest rates looks like someone driving a car with the accelerator pedal almost pushed to the floor.  It does not appear that the Fed's ultra-low rate policy had much of an effect on the real economy so far and there is not much more the Fed can do to accelerate.  Is this Japan all over again?  Is this country prepared for a possibility that the S&P500 might be at or below 1,000 in 2010?

Bernanke

Click on image to view Mr. Bernanke’s opening statement.

Inflation vs. Deflation, The Ongoing Debate 
The heated debate over inflation/deflation continues. Depending on time frame and data points, the pendulum appears to be swinging back and forth between the two opposing camps which stand firm and passionately support their views.

The supporters of inflation point to the massive stimulus efforts by the Fed and other central banks which lowered interest rates to historically unseen levels and they used an array of easy money measures including quantitative easing to spur economic activity and growth. Such easy money policies should, in theory, lead to inflation somewhere down the road, so their argument.

The deflationist camp however argues that further deleveraging is necessary. Stubbornly high unemployment would lead to a demand crunch and a longer than expected housing slump would make any return to higher price levels unlikely. Some evidence of that was presented in the recent core CPI data showing the first, albeit miniscule, -0.1% drop since 1982. Mr. Bernanke, in his recent remarks before Congress, re-emphasized that extremely low interest rates would remain for an extended period of time given a potential slow-down of economic recovery later this year.

Let me try to put both camps in some disarray...

In terms of the inflationist view, one has to concede that ultra-low interest rates and easy money are typical text-book moves in spurring economic activity and the typically unavoidable inflation that comes with it. This time might be different however. Money and credit given to the banks has not found its way into the economy because it made more sense (and still does) for banks to park that cash taking advantage of the instant money making give-away i.e. borrowing at near 0% and buying Treasuries – easy returns for the banks at no risk. Given these hand-outs, why bother with much riskier consumer or commercial loans, particularly given the chance of further declines in asset prices. Looking at it from the supply side, so what if interest rates are at historic lows? On paper, one might get a 30 year fixed mortgage for 5% but banks aren’t lending, so strike that argument.  From the demand perspective, businesses and consumers are scared and they would much rather reduce their leverage and save in view of a difficult economic recovery or worse, a possible a double-dip recession.

Best evidence in terms of credit (=money) finding its way into the economy is seen in what economists call the (Money) Multiplier Effect.  The chart below indicates that despite the well publicized efforts by the Fed, the monetary base has fallen below 1.0 which means it has a negative multiplier effect i.e. it is contracting, quite the opposite of the results central bankers were hoping to achieve.

MULT-2010-02-B

To the deflationists, I would point towards the increasing cost of healthcare, education and other necessities that put the prospects of lower prices into question. For instance, California health insurance giant Anthem Blue Cross scheduled rate hikes of up to 39% as reported by the LA Times. If you have children in schools or college, you know for a fact that there is no deflation whatsoever to be found in the cost of education. For many other countries unthinkable, US students can easily pay $40,000-$50,000 per year for the cost of a college education. In terms of deflationary trends in financing, have you read the fine print on your credit card agreements recently? Financing rates of 20% or higher are not exactly indicative of deflationary trends. Other price indicators like oil don’t appear to be heading back to below $40 a barrel prices anytime soon either.

The true inflation is probably best examined in terms of the “felt-inflation” which is of course a lot harder to measure because it’s different for everyone. One has to look at various scenarios and a possible scenario for a US person might look like this:

You have a secure (government) job, full benefits (i.e. benign healthcare costs), recently bought a house taking advantage of the low interest rates and the depressed housing prices, and you live in a nice neighborhood with a public school district still intact, then yes; recent and possibly near-to-medium-term outlook would indeed be deflationary.

However, if your income has been stagnant for the past 5 years (that is if you are lucky to still have a job), you bought your house 5 years ago with an adjustable rate mortgage, you do not have an employer sponsored healthcare plan and you send your children to a private school while paying for some essentials with credit cards, then deflation must feel as an unreachable as Nirvana.

Defining and measuring inflation is one thing. One could argue whether the baskets of goods measuring consumer and producer prices are adequate and whether one can trust the data and metrics. However, a more realistic measure, albeit more difficult to implement, would be a scenario based personal inflation barometer similar to the Cost of Living Index and using that as a determining factor for policy and investment decisions.

FDIC List 702 Problem Banks
Along the lines of why banks aren’t lending, the FDIC released the Quarterly Banking Profile for the 4th quarter of 2009 today. 702 banks are on the list of  “Problem Banks”, an increase of 450 since 2008.  Equally disturbing is the increase of failed institutions.  140 institutions failed in 2009 up from only 25 in 2008.
FDIC-ProblemBanks
Should we be worried?  Elizabeth Warren, Chair of the Congressional Oversight Panel, believes so as she introduces the COP's February Report "Commercial Real Estate Losses and the Risk to Financial Stability."  She addresses a larger problem that may not be apparent from the FDIC report.  The risk to financial stability from the exposure of some 2900 banks with a “high concentration of commercial real estate loans”.  All banks on that list are smaller community banks which is a rather worrying development. If a large number of community banks were to fail, the impact on the small business community, the real back-bone of our economy, could be devastating.

The full report is available online at: http://cop.senate.gov/documents/cop-021110-report.pdf

Please consider this excellent video.

Some Notes on Diversification
In prior commentaries, we have discussed the concept of Correlation as an important element of the asset allocation process.  In simple terms, one should try to invest in asset classes which are showing a lesser degree of correlation in order to balance risk.  That said, correlation of assets changes over time and, as we saw during the financial crisis, different asset classes can achieve a high degree of correlation resulting in extreme difficulties to balance risk (see chart below as a reminder).

diversification-failure

Since we discussed inflation earlier, reviewing the correlation of asset classes can help to determine if an inflation hedge is actually working.  For instance, when the US Dollar came under pressure in 2009, a good way to hedge against the possible dilution in value of the Dollar (i.e. an implied inflation) was to buy Stocks.  The US Dollar and the S&P500 moved almost as mirror images.

USD-SPX-2010-0226 

From a US perspective, other possible inflation hedges included Gold and so-called commodity currencies such as Australian or New Zealand Dollars.  To understand why the Australian Dollar is called a commodity currency, please review the chart below.  For a large part of 2009, Aussie Dollar and Gold moved in the same direction and charts is showing near parallel movements upward.

FXA-Gold-2010-0226

It is therefore important to assess current and future correlation of two asset classes so as to make sure one doesn’t necessarily “load up” too heavy on one side.  For instance, buying Gold and Australian Dollar at the same time might give an added return during times of high correlation.  But it also increases the risk by the same amount.  One needs to carefully balance these factors when establishing a portfolio and assess whether one is comfortable with the potential risk.  If you have a specific question about the correlation of two or more asset classes, please send us an email.

Email From A Colleague  
While discussing economic trends, a colleague sent me this neat check list in terms of assessing the prospects for a balanced budget. Referring to the ballooning US deficit, Eric Van Wetering noted:

From a strategic point of view the deficit is even more worrying because of the fact that it weakens the strength of the US position in the world. In the past the US has 'veered back' again (if that is correct English) but now there is more doubt about that ability (certainly long term).

• Obama has to help to reverse the economic trend in the US (need money).
• Has to bring people back to work (need money).
• Still has, apart from terrorism, 1 1/2 war on his mind (need money).
• Must make an effort to improve the health care system in the US (need money).
• Must make an effort to improve education in the US (need money).
• And has to bend back the strong deficit trend (will have much less money available).

Reminds me of FDR and the New Deal. The Great Depression ended for the US in real terms in about 1941-1942 when they were already boosted by massive European defense orders and started the massive ramp-up after Pearl Harbor. I sincerely hope we don 't 'need' a major war to get out of this one.

Week-end Reading
A bit lengthy but invigoratingly cynical, please consider this nice round-up of this seemingly never-ending story:  Wall Street's Bailout Hustle by MATT TAIBBI.
RS-Image

Have a wonderful week-end!

Disclaimer
Neither the information nor any opinion contained in this communication constitutes a solicitation or offer by us to buy or to sell any securities, futures, options or other financial instruments or to provide any investment advice or service. Each decision by you to do any investment transactions and each decision whether a particular investment is appropriate or proper for you is an independent decision to be taken by you. In no event should the content of this communication be construed as an express or an implied promise, guarantee or implication by or from us that you will profit or that losses can or will be limited in any manner whatsoever. Past results are no indication of future performance.

February 26, 2010

Inflation Versus Deflation, The Ongoing Debate

The heated debate over inflation/deflation continues. Depending on time frame and data points, the pendulum appears to be swinging back and forth between the two opposing camps which stand firm and passionately support their views.

The supporters of inflation point to the massive stimulus efforts by the Fed and other central banks which lowered interest rates to historically unseen levels and they used an array of easy money measures including quantitative easing to spur economic activity and growth. Such easy money policies should, in theory, lead to inflation somewhere down the road, so their argument.

The deflationist camp however argues that further deleveraging is necessary. Stubbornly high unemployment would lead to a demand crunch and a longer than expected housing slump would make any return to higher price levels unlikely. Some evidence of that was presented in the recent core CPI data showing the first, albeit miniscule, -0.1% drop since 1982. Mr. Bernanke, in his recent remarks before Congress, re-emphasized that extremely low interest rates would remain for an extended period of time given a potential slow-down of economic recovery later this year.

Let me try to put both camps in some disarray...

In terms of the inflationist view, one has to concede that ultra-low interest rates and easy money are typical text-book moves in spurring economic activity and the typically unavoidable inflation that comes with it. This time might be different however. Money and credit given to the banks has not found its way into the economy because it made more sense (and still does) for banks to park that cash taking advantage of the instant money making give-away i.e. borrowing at near 0% and buying Treasuries – easy returns for the banks at no risk. Given these hand-outs, why bother with much riskier consumer or commercial loans, particularly given the chance of further declines in asset prices. Looking at it from the supply side, so what if interest rates are at historic lows? On paper, one might get a 30 year fixed mortgage for 5% but banks aren’t lending, so strike that argument. From the demand perspective, businesses and consumers are scared and they would much rather reduce their leverage and save in view of a difficult economic recovery or worse, a possible a double-dip recession.

To the deflationists, I would point towards the increasing cost of healthcare, education and other necessities that put the prospects of lower prices into question. For instance, California health insurance giant Anthem Blue Cross scheduled rate hikes of up to 39% as reported by the LA Times. If you have children in schools or college, you know for a fact that there is no deflation whatsoever to be found in the cost of education. For many other countries unthinkable, US students can easily pay $40,000-$50,000 per year for the cost of a college education. In terms of deflationary trends in financing, have you read the fine print on your credit card agreements recently? Financing rates of 20% or higher are not exactly indicative of deflationary trends. Other price indicators like oil don’t appear to be heading back to below $40 a barrel prices anytime soon either.

The true inflation is probably best examined in terms of the “felt-inflation” which is of course a lot harder to measure because it’s different for everyone. One has to look at various scenarios and a possible scenario for a US person might look like this:

You have a secure (government) job, full benefits (i.e. benign healthcare costs), recently bought a house taking advantage of the low interest rates and the depressed housing prices, and you live in a nice neighborhood with a public school district still intact, then yes; recent and possibly near-to-medium-term outlook would indeed be deflationary.

However, if your income has been stagnant for the past 5 years (that is if you are lucky to still have a job), you bought your house 5 years ago with an adjustable rate mortgage, you do not have an employer sponsored healthcare plan and you send your children to a private school while paying for some essentials with credit cards, then deflation must feel as an unreachable as Nirvana.

Defining and measuring inflation is one thing. One could argue whether the baskets of goods measuring consumer and producer prices are adequate and whether one can trust the data and metrics. However, a more realistic measure, albeit more difficult to implement, would be a scenario based personal inflation barometer similar to the Cost of Living Index and using that as a determining factor for policy and investment decisions.

February 24, 2010

Long Period of Low Interest Rates

In his opening statement of the Semiannual Monetary Policy Report to the Congress, Fed Chairman Ben Bernanke emphasized that he did not plan to begin raising interest rates anytime soon given that the economic recovery would likely slow down later this year when government stimulus is withdrawn as expected in the coming months. 

Inflation is expected to remain subdued, with consumer prices rising at rates between 1 and 2 percent in 2010 through 2012. In the longer term, inflation is expected to be between 1-3/4 and 2 percent, the range that most FOMC participants judge to be consistent with the Federal Reserve's dual mandate of price stability and maximum employment.

The possibility of a deflationary threat has increased as indicated by the core inflation rate which fell by 0.1% in January, dropping for the first time in 28 years.  Assuming that economic growth remains subdued in the face of a challenging labor market and considering the possibility of further deleveraging in private and commercial real estate,  deflation could be a serious threat. 

Using an analogy by Paddy Hirsch, senior editor of Marketplace, the Fed stimulus in terms of interest rates looks like someone driving a car with the accelerator pedal almost pushed to the floor.  It does not appear that the Fed's ultra-low rate policy had much of an effect on the real economy so far and there is not much more the Fed can do to accelerate.  Is this Japan all over again?  Is this country prepared for a possibility that the S&P500 might be at or below 1,000 in 2010?

Bernanke 

Click on image to view Mr. Bernanke’s opening statement.

February 23, 2010

FDIC lists 702 Problem Banks

The FDIC released the Quarterly Banking Profile for the 4th quarter of 2009 today. 702 banks are on the list of  “Problem Banks”, an increase of 450 since 2008.  Equally disturbing is the increase of failed institutions.  140 institutions failed in 2009 up from only 25 in 2008.
FDIC-ProblemBanks
Should we be worried?  Elizabeth Warren, Chair of the Congressional Oversight Panel, believes so as she introduces the COP's February Report "Commercial Real Estate Losses and the Risk to Financial Stability."  She addresses a larger problem that may not be apparent from the FDIC report.  The risk to financial stability from the exposure of some 2900 banks with a “high concentration of commercial real estate loans”.  All banks on that list are smaller community banks which is a rather worrying development. If a large number of community banks were to fail, the impact on the small business community, the real back-bone of our economy, could be devastating.
The full report is available online at: http://cop.senate.gov/documents/cop-021110-report.pdf
Please consider this excellent video.

February 20, 2010

Market Insights - 20 February 2010

Dear Friends & Fellow Investors

Here is the latest issue of Market Insights. As always, please email any questions to: info@fxistrategies.com

In This Week's Issue
• Weekly Snapshot
• Charts Of The Week
• Weekly Barometers 
• A Token For The Fed's Sugar Daddies? 
• US Mortgage Debt versus US GDP 
• The Next Move For The US Dollar 
• Something About Technical Analysis 

Weekly Snapshot
• US consumer prices rose 0.2% in January and increased 2.6% annually (BLS)
• The Fed raised the discount rate to 0.75% but insisted that this does not tighten policy (Economy.com)
• Barclays reported that pre-tax profit almost doubled in 2009, to £11.6bn (Economist)
• BNP Paribas, France’s biggest bank, saw net profit almost double last year, to €5.8bn (Economist)
• Producer Price Index in the US rose 1.4% in January, seasonally adjusted (BLS)
• US Leading Economic Index up 0.3% in January after a 1.2% gain in December (Conference Board)
• US Industrial production in January advanced 0.9% following a 0.7% jump in December (Bloomberg)
• US Housing starts in January rebounded 2.8% after dipping 0.7% in December (Bloomberg)
• US Building permits decreased 4.9% since December, but are up 16.9% from January 2009 (ESA)
• The ZEW Indicator of Economic Sentiment for Germany decreased by 2.1 points in February 2010 (ZEW)
• Japan's real GDP grew 1.1% in the fourth quarter of 2009 (Economy.com)
• U.K. annual inflation rate surging above the 3% upper end of the BoE's target range (Economy.com)
• Foreign demand for US Treasury securities falls by record amount as China reduces holdings (AP)

Chart Of The Week (click on chart for larger image)
The Fed announced a 0.25% hike in the discount rate right after US markets closed on Thursday.  In the currency markets, the US Dollar gained against all major currencies immediately after the announcement. The Euro consequently got hammered, dropping over 100 points in just 10 minutes (see 5 min chart on the left below).  And after Friday’s benign inflation data, the Euro went right back to where it started. Text-book moves like these don't happen all that often; traders live to catch one of these once in a while...

Euro-2010-02-19  Euro-2010-0220-b

Weekly Barometers  (click on chart for larger image)

Stocks-2010-0219  FX-2010-0219

A Token For The Fed's Sugar Daddies?  
Widely publicized and with plenty of market reaction, the Fed raised the discount rate to 0.75% on Thursday, but insisted that this does not tighten policy. As Reuters reported on on Friday:

The president of the New York Fed, William Dudley, said the central bank's pledge to keep benchmark borrowing costs low for an extended period of time "is still very much in place."

Well speak for yourself Mr. Dudley and Mr. Bernanke, but the market sure did not take your words all that serious.  In currency markets, the reaction was immediate as we saw in a sudden increase in the US Dollar against all major currencies (see Euro chart above).

However, the Fed’s "surprise move", maybe not be so surprising after all. In previous FOMC meetings, the end of quantitative easing had been alluded to already. But let's look at the the Fed move from another angle.  Central Bankers almost always base monetary policy on "controlling" interest rates and money supply. Looking at a Central Bank from a business perspective however, the Central Bank is in this most enviable position in that it can essentially write its own ticket, i.e. tell its creditors what rate they are prepared to pay for incurring yet more debt.  But what if government finances were so out of whack that it became increasingly difficult to service the debt at these ultra-low rates? Now the objective is no longer that of "control" but rather a question of creating incentives to find buyers for yet more debt. As Dow Jones reported:

"Treasury prices slipped a bit more Thursday, with the 30-year Treasury down by nearly a point in price, after a disappointing 30-year Treasury auction, the government's final offering of the week."

Further, the Department of Treasury announced the major foreign holders of US Debt where a similar "soft surprise" occurred.  As of latest data from Dec-09, Japan outranked China again as the number one holder of US Treasuries with total holdings of $768bn.  China, now second, was holding $755bn worth of US Treasuries having scaled back their US holdings by about $45bn since last summer.  Maybe it is just a coincidence that the Fed moved ahead with a rate hike. But we cannot helping considering the pressure that has been building up for the Fed in terms of continuing to financing the growing US debt.  The prospects of further US budget deficits are daunting and it is too early in the game to derive any conclusions for the timing on further rate increases.  However, this small teaser move in higher rates may just be the right token for the Fed's sugar daddies...

Major-Foreign-Holders   MajorForeignHolder-2009-12

US Mortgage Debt versus US GDP
Speaking of deficits, the economic report of the President is out and along with it pages upon pages of data, charts and tables.  This report was written by the Chairman of the Council of Economic Advisors and you can download the entire document here

At some 450 pages I have neither the time nor the energy to read this in its entirety.  However, as I was browsing through some of the data tables, I noticed two numbers that seemed too similar to ignore.  US GDP is about the same as the total mortgage debt outstanding, roughly $14.4 trillion, give or take a few billion.  This ratio of US GDP versus mortgages hasn't always been so closely matched as the chart below indicates.  On average, total US mortgages were below 50% of the GDP until about 1977 when the ratio started to gradually increase culminating in the year 2006, the height of the US housing market when for the first time in history US mortgage debt outranked US GDP.

US-GDP-versus-MortgageDebt

I have a hard time comprehending how public and private household debt could ever get this far out of hand, but the graph essentially expresses my personal sentiment as to what is wrong with the US economy.  To get back to sustainable economic growth, something's got to give.  In this case, either US GDP vastly improves, or the more likely development occurs - US mortgages, the biggest portion of US household debt, have to continue to delever to bring back this unique ratio to a more tolerable level and in line with historic averages.

The Next Move For The US Dollar
On to the multi-million Dollar question: Where is the Dollar heading now that there is a possibility that the US rate tightening cycle has begun? Here’s my 2 cents on this question:

In 2009, practically everyone and their mother were dumping Dollars in favor of any other semi-stable currency.  Word on the street was, the US Dollar is doomed for sure, so let’s find an alternative.  Biggest gainers were the higher yielding currencies for instance Australian and New Zealand Dollars which were also the favored plays for a carry trade.  Eventually that trade got very crowded and particularly when sovereign debt concerns surfaced, most notably in Dubai and Greece, the flight to the safe haven US Dollar re-emerged.  Perception about future events is what drives the markets and at the moment, the fundamentals in the US are perceived to be stronger than in Europe or in Japan.  The Fed’s move may or may not be the beginning of a rate tightening cycle, but it gave a signal to the markets.  In terms of rates, the ball is now in Europe’s and Japan’s court but a move by either seems unlikely.  Japan has effectively not raised their rates in two decades, why should they do it now?  Europe has their share of issues dealing with potential defaults by one of more PIIGS (Portugal, Italy, Ireland, Greece and Spain) countries.  A slightly weaker Euro may play into the hands of the stronger European economies who are very dependent on exports.

The question therefore is, which of these major currency/country components is perceived to be in a stronger position going forward?  Looking merely at attitudes, the US appears to have the momentum as Americans are perceived to use more aggressive measures to fight their way out of an economic downturn.  Attack is viewed as the best defense.  Europeans and Japanese by contrast are generally more subdued and defensive in their outlook and that attitude is a component of the recent currency movements too.  Hunkering down and waiting out the crisis appears to have been the prevailing attitude in Europe as well as in Japan.

This means, in terms of a short to medium-term outlook, there is continued pressure on the Euro and, to a lesser extent, the Japanese Yen.  But the US Dollar outlook versus some other currencies may not be as one-sided.  Referring to the Weekly FX Barometer above, the currency movements of the past week are in our view indicative of a possible short to medium-term trend going forward.  It won’t be a one-way trade as it was in 2009 which means, one cannot simply buy US$ and sell every other currency.  The commodity currencies Australian and Kiwi Dollar (and to some extent, Canadian Dollar, Brazilian Real, Russian Ruble etc.) will be closely correlated with the price of Gold and other industrial commodities.  They could be an ideal inflation hedge.  And as long as the US rates remain roughly at current levels, there is still enough room for a carry trade, taking advantage of the higher deposit rates “down under”. Any further softening of inflation data however, will be a signal to get out of the carry trade, something that in view of the recent CPI figures needs to be watched closely.  

Looking at some of the Asian currencies, a different story emerges. Fundamentally, the arguments for a stronger US Dollar are not nearly as compelling.  Take China and India out of the equation, as very special cases, and you are left with some potentially interesting currencies, albeit slightly more difficult to put on as a trade.  In terms of strong fundamentals, Singapore, Taiwan and South Korea may be countries where a stronger currency could emerge simply because of their superior (to the US) government finances.

Going forward, the Greenback may have a slight edge against the Euro until the Europeans sort out their internal issues with sovereign debt.   Other currencies however, may show a fair amount of resilience against the US Dollar and despite the current momentum in favor of the US$, they are more likely to remain stable with potentially more upside against the Euro.

From a technical perspective, the US$ Index has gained back nearly half of its losses from 2009.  It is now in an interesting territory approaching the 50% Fibonacci retracement level.  It will be intriguing to see if and how fast the Dollar Index can take these next technical hurdles to consolidate the ongoing up-trend.

USD-2010-0220   

On a final note, we need to remind ourselves that the underlying economic and fiscal conditions in the US are still very precarious.  In particular, the outlook on US government’s finances, which lead many to believe that the Dollar is toast in the first place, has not changed.  As recently noted, the US budget deficit is at a record $1.56 trillion for the current fiscal year only to be followed by another deficit of $1.27 trillion for fiscal 2011.  There is no indication that the US government’s finances will improve anytime soon, which goes back to a point made earlier.  In order to continue keeping its “sugar daddies” somewhat happy, the Fed must take a hard look at finding the right balance between incentivizing for US treasury buyers and stimulating the economy.   In terms of trying to balance this via interest rates, it looks like a double-edged sword to me.  But given the choice, it would seem more likely that the Fed would let go of a strong Dollar policy for the sake of keeping the US economy alive.

Something About Technical Analysis (Warning: For Technical Traders Only)  
Last week, we featured an S&P500 chart by Serge Perreault as our chart of the week.  Here is another copy...

Serge-Perreault-100212

A good friend pointed out a discrepancy in that chart from the data he was gathering.   An interesting discussion then ensued and we noticed that Serge Perreault’s chart was drawn using a semi-logarithmic scale whereas my friend was using an arithmetic scale to draw the chart.  The differences in terms of drawing trend-lines can be significant, potentially giving wrong entry/exit point signals for major trends.  See both versions of the scales for the same S&P500 chart:

Semi-Log Scale Arithmetic Scale
SPX-Log Chart SPX-NoLog

Which one of the two settings is used by the majority of traders?  I posed this question to numerous colleagues and traders and interestingly, the jury isn’t out yet.  Doug Short from www.dshort.com wrote me and said:

A log scale on the y axis (correctly speaking, a "semi-log" chart) makes a lot of sense for longer time frames and even on shorter ones when the range on the y-axis is large. See this article at the StockCharts website for more detail, especially the section on scale settings:

http://stockcharts.com/school/doku.php?id=chart_school:chart_analysis:trend_lines

I have also received plenty of feedback, particularly from Forex traders, who felt that arithmetic charts which are typically the default settings for many trading platforms, were the right ones to use.  Another dear friend, who is a Quant, was very skeptical about using log or semi-log charts for Forex.  He noted that log-charts for Forex appear are not ideal because each currency trade consists of 2 moving components making up the price of the currency pair.  Unlike trading stocks, one is never just long or short of a currency.  In reality, one is always long one currency while simultaneously shorting the other.  As a result, the movements in currencies have sort of a natural filter or break and the kind of large scale movements one might see in stocks are less likely in Forex.  Rest assured that the mathematical concepts of proving such a statement are beyond my capabilities but I can second that assessment from personal trading experience. 

In closing, I would recommend that you test very thoroughly what works for you before you base any trading decision on any given technical indicator. 

Good luck and good trading!

Disclaimer
Neither the information nor any opinion contained in this communication constitutes a solicitation or offer by us to buy or to sell any securities, futures, options or other financial instruments or to provide any investment advice or service. Each decision by you to do any investment transactions and each decision whether a particular investment is appropriate or proper for you is an independent decision to be taken by you. In no event should the content of this communication be construed as an express or an implied promise, guarantee or implication by or from us that you will profit or that losses can or will be limited in any manner whatsoever. Past results are no indication of future performance.

February 19, 2010

A token for the Fed's sugar daddies?

Widely publicized and with plenty of market reaction, the Fed raised the discount rate to 0.75% on Thursday, but insisted that this does not tighten policy. As Reuters reported on on Friday:

The president of the New York Fed, William Dudley, said the central bank's pledge to keep benchmark borrowing costs low for an extended period of time "is still very much in place."

Well speak for yourself Mr. Dudley and Mr. Bernanke, but the market sure did not take your words all that serious.  In currency markets, the reaction was immediate as we saw in an immediate increase in the US Dollar against all major currencies.

The Fed "surprise move", maybe not be so surprising after all. In previous FOMC meetings, the end of quantitative easing had been alluded to already. But let's look at the the Fed move from another angle.  Central Bankers almost always base monetary policy on "controlling" interest rates and money supply. Looking at a Central Bank from a business perspective however, the Central Bank is in this most enviable position in that it can essentially write their own ticket, i.e. tell its creditors what rate they are prepared to pay for incurring yet more debt.  What if government finances were so out of whack that it became increasingly difficult to service the debt at these ultra-low rates? Now the objective is no longer that of "control" but rather a question of creating incentives to find buyers for yet more debt.

As Dow Jones reported:
"Treasury prices slipped a bit more Thursday, with the 30-year Treasury down by nearly a point in price, after a disappointing 30-year Treasury auction, the government's final offering of the week."

Further, the Department of Treasury announced the major foreign holders of US Debt where a similar "soft surprise" occurred.  As of latest data from Dec-09, Japan outranked China once more as the number one holder of US Treasuries with total holdings of $768bn.  China, now second, was holding $755bn worth of US Treasuries having scaled back their US holdings by about $45bn since last summer.  Maybe it is just a coincidence that the Fed moved ahead with a rate hike. But we cannot helping considering the pressure that has been building up for the Fed to continue financing their debt.  The prospects of further US budget deficits are daunting and it is too early in the game to derive any conclusions for the timing on further rate increases.  However, this small teaser move in higher rates may just be the right token for the Fed's sugar daddies...

Major-Foreign-Holders

February 13, 2010

Market Insights - 13 February 2010

Dear Friends & Fellow Investors

Here is the latest issue of Market Insights. As always, please email any questions to: info@fxistrategies.com

To our Chinese Readers: Kung Hei Fat Choi – Happy Chinese New Year!

In This Week's Issue
• Weekly Snapshot
• Charts Of The Week
• Weekly Barometers 
• Euro 2.0 
• Recommended Video 
• More On ETFs 
• How The Big Banks Make The Big Bucks 

Weekly Snapshot
• US retail sales in January increased 0.5% from December, to $355.8 billion (ESA)
• China said for the second time in a month it would force banks to increase their reserve levels (Reuters)
• Germany's GDP flat and Italy went into reverse in the final quarter of 2009 (Reuters)
• Industrial production down by 1.7% in Euro area (Eurostat)
• Eurozone GDP grew by only 0.1% in the last three months of 2009 (AP)
• European leaders have reached a deal to provide aid to Greece (Reuters)
• One in five US mortgages are underwater (Zillow/Reuters)
• Chinese exports in January rose 21% from the previous year (FT)
• China's imports jumped a record 85.5% in January from the year before (FT)
• US Trade Deficit increases to $40.2 Billion in December (Bloomberg)
• Traders and hedge funds have bet more than 40,000 contracts ($7.6bn) against the Euro (FT)
• CDS spreads on PIIGS sovereign bonds continue to rise during the week (Eurointelligence)

Charts Of The Week (click on chart for larger image
On the left below, please consider this nice chart from Serge Perreault, courtesy of Dshort.com.  We have added a version of the same viewpoint and included the Fibonacci retracement levels (blue horizontal lines).  For technicians, please note the upside momentum still needed to break above the more important green downtrend resistance. The Fibonacci levels indicate a level of 965 for the S&P as a first initial stop.

Serge-Perreault-100212  SPX-2010-0213

Weekly Barometers  (click on chart for larger image)

Stocks-2010-0212   FX-2010-0212

Euro 2.0  
As reported by various news channels, European leaders have reached a deal to provide aid to Greece in order to help overcome its debt crisis.  The pledge of support by European leaders though has been vague and no detailed plans are yet available.  Further, as reported by Reuters in Greek Debt Profile:

Total borrowing need in 2010 is 53.2 billion Euros or 21.8 percent of GDP. This is down by 13 billion from 2009 and includes 12.95 billion in interest payments, a primary deficit of 10 billion Euros and redemptions of 30.23 billion.

"Peanuts" compared to the financing needs of some US States one would think... Then why is Greece so important and such a fear factor for the Europeans, and what are the prospects that the Eurozone will return to a path towards recovery?

This is an oversimplification of things but hopefully it illustrates one of the core issues within the Eurozone: 

The EU sort of “put the cart before the horse” by embarking on a common currency prior to common fiscal and legal environment among the member states.  It is particularly evident in the current PIIGS (Portugal, Italy, Ireland, Greece & Spain) crisis that the common currency has taken away a natural escape valve, i.e. individual country currency which, unlike monetary and fiscal policy, can be a faster and more effective escape valve adjusting economic imbalances through market forces.  In the absence of a domestic Greek currency (previously the Greek Drachma), the Euro is the adjusting mechanism and the result is a weaker Euro.

All things considered however, a weaker Euro may not be such a bad outcome after all.  It will enable the more export-driven economic powerhouses in Europe to tackle an ongoing and Europe-wide recession (technically not a recession anymore but a measly 0.1% growth rate for Europe in 2009 which still feels like a recession). 

As we noted last week, the default of any of the PIIGS countries would have a devastating effect on Europe’s economy and on the Euro. But Greece’s potential default may be the easiest one to absorb within the European Union.  Some other countries, notably Spain and Portugal, pose a much bigger threat to the stability of the European economy and its monetary union.  I'm afraid, until individual countries get their internal finances in order, prospects for the Euro will be much murkier than one might have expected in previous years.  And until such time, a common fiscal policy, one of the long-term objectives of the EU, may be increasingly difficult to implement.

In terms of possible scenarios going forward, I can think of a two-tiered approach towards common policies among all member states similar to the approach applied to the creation of Monetary Union within the European Union. Several EU member states, most notably the UK, have opted not to join the monetary union and chose not to adopt the Euro.  They did so for the very reasons that are currently making life more difficult for the member states and equally so for the European Central Bank in terms of steering through the crisis.

A two-tiered approach might give birth to Euro 2.0 a new and higher-rated core currency similar to an A-share of a company's stock.  The core countries would have a fast-track route towards a common fiscal and economic policy as well as a uniform legal framework. The B-share might then include countries with less rigid economic policies and obviously much higher interest rates and financing costs and a longer route towards entering overall common laws and policies. Incidentally, the core countries appear to be located in the center of Europe whereas the B-share Eurozone countries are located among its geographic outliers. The EU and the Eurozone countries are certainly facing an interesting dilemma which is not swept away by the quasi bail-out of Greece.  There are many other problems lurking beneath the surface.

Why should US investors worry? To quote a passage from John Mauldin’s most recent newsletter:

Whether it is Japan or Portugal or the US or (pick a country), the body of evidence clearly shows that there is a limit to the amount of debt a sovereign country can handle without a crisis developing. That limit is different for each country, but there is a limit that the bond market will impose. And there are many countries in the developed world that are approaching that limit.

For those of us who have a vested interest in the future and longevity of the EU and the Euro, let us hope that the rigidity and the constraints imposed by the overall EU framework will not be its downfall.  Instead, the constraints might be the catalyst for an innovative approach; as often when faced with a sheer insurmountable problem, a visionary and innovator will look at this problem as an opportunity.  How about asking Steve Jobs to come up with the framework for Euro 2.0?

Recommended Video
Please consider this enlightening video: http://2010.therussiaforum.com/news/session-video3/

At one hour, the panel discussion is a bit lengthy but very well worth your time. This rather illustrious and intelligent group of market participants and hedge fund managers expressed their various viewpoints with much gusto and conviction.  Kudos to Hugh Hendry for an outstanding and very passionate debate, giving me at least a few sleepless nights in terms of re-assessing portfolio strategies.  But I'm also taking away two very simple and fundamentally important reminders:

  • Although not a realistic representation of the entire universe of market participants, this group gives an indication of the many different opinions people have on various subjects and how they express those opinions with their wallet.  More importantly, one can see even in this small group that there is almost always a buyer for every seller and vice versa...the only real debatable metric is the price.*
  • Fascinating discussion about risk.  We could argue about the notion of risk and relationship towards risk as well as debating what is considered a risky or riskier asset class.  One could further debate whether the developed world of today was a more risky asset class/region than the developing world.  But I prefer to remind myself that widely held believe in asset allocation and diversification, the supreme mantras of modern finance (until 2008), did not achieve truly diversified portfolios and did not entirely balance risk and reward.  Even the most sophisticated models turned out to have the erroneous assumption that all risk could be diversified away.  As we are all painfully aware by now, diversification doesn't always work and when it doesn't, the effects can be devastating. (see charts below).

diversification-success  diversification-failure

* Ed. Note: In terms of the Greek crisis, something fundamentally important also seems out of balance i.e. the price and conversely the yield on those Greek sovereign bonds.  Considering the amount of negative coverage and the very real possibility of a default, why aren’t the yields on these Bonds in the double digits?  Let us assume that you had those $100M that Marc Faber so generously dished out to his panel members, would you invest in Greek Bonds yielding just about 3% above German Bonds?  Otherwise stated, assuming that a price is a true reflection of all information available to all market participants, then perhaps the Greek crisis isn’t nearly that much of a tragedy.

More On ETFs 
In our ongoing quest to shed some light on Exchange Traded Funds (ETFs), here is some useful information on an a currency ETF, CurrencyShares Australian Dollar Trust, ticker symbol: FXA

But before we delve into a more detailed discussions, we want to refer to our disclaimer at the end of this newsletter.  As always, you should read the full prospectus if you are considering any trades or investments in this ETF or any other ETF or Mutual Fund for that matter.  You can download their prospectus here.   If you don’t fully understand all the risks in an investment you should consult your financial advisor. 

The Australian Dollar was one of the winners of 2009, outpacing most other major currencies with a 28% gain against the US$.  After the market turnaround in March ‘09, the Aussie Dollar showed a high degree of correlation to commodities, in particular to Gold.

FXA-versus-Gold

And similar to Gold, it can be a very volatile trade, hence one should keep in mind that additional considerations towards risk are in place.  Having said that, this currency was the ideal carry-trade component for financing in US$ or Japanese Yen while taking advantage of the more than 3% interest rate differential in favor of the Aussie Dollar.  That worked beautifully until the end of 2009 when the major players started getting out of risk currencies and commodities and returning to the illusive safe havens, the US Dollar and Japanese Yen and turning their profits into government debt.  In recent weeks, there was another immensely profitable currency trade i.e. buy the Australian dollar versus the Euro.  But that also goes into the realm of Spot currency trading, which is not for everyone.  Email me however, if you wish to have some info on cross currency trades such as this one.

In terms of taking advantage of the interest rate differential between the US and the Australian deposit rates, and short of opening a savings account “down under”, the FXA represents an easy to establish currency position.  Unlike trading Spot currencies or Futures which is really the realm of day-traders, trading the currency via an ETF makes more sense for the medium to long-term investor, depending on your outlook and risk tolerance.  Because of the interest rate differential and the way this ETF is structured, an investor can expect a small distribution which reflects that rate differential between the Aussie$ and US$.

Date

Amount

FXA Price

Annualized Return

12/31/2009

$0.22

90.07

2.94%

11/30/2009

$0.20

91.77

2.61%

10/30/2009

$0.17

90.2

2.32%

09/30/2009

$0.15

88.38

2.02%

08/31/2009

$0.15

84.69

2.09%

07/31/2009

$0.14

83.82

2.03%

06/30/2009

$0.14

80.74

2.10%

05/29/2009

$0.14

80.23

2.07%

04/30/2009

$0.12

72.84

2.03%

03/31/2009

$0.13

69.68

2.17%

02/27/2009

$0.13

64.08

2.34%

01/30/2009

$0.18

63.78

3.42%

In 2009, total distributions were $2.09 per share at an average return of about 2.4%.  Not much, but better than most deposits currently available in US$ terms.  And it is a bit of a teaser with regard to the ETF’s expense ratio of 0.4% (below most Mutual Funds but still higher than the traditional Index Trackers) which is one of the major downsides to owning some of the more complex ETFs.

A few caveats: The distributions should not be the main consideration for this trade as possible fluctuations in currency prices could easily exceed those distributions. In volatile market sessions, this could happen within one day - Know your risk!  In terms of the taxation of these distributions, they are not considered qualified dividends and therefore do not have the favorable tax treatments for US investors – Consult your CPA. 

Nevertheless, if one has any concern about the long-term viability of the US$, despite the recent consensus for a flight to safety, this is one way to diversify and it can be done as easy as trading shares. 

How The Big Banks Make The Big Bucks
In view of the upcoming Valentine’s Day, Marketplace’s Senior Editor Paddy Hirsch puts some family values into money making.  Enjoy this wonderful illustration of how the big guns make money.

Disclaimer
Neither the information nor any opinion contained in this communication constitutes a solicitation or offer by us to buy or to sell any securities, futures, options or other financial instruments or to provide any investment advice or service. Each decision by you to do any investment transactions and each decision whether a particular investment is appropriate or proper for you is an independent decision to be taken by you. In no event should the content of this communication be construed as an express or an implied promise, guarantee or implication by or from us that you will profit or that losses can or will be limited in any manner whatsoever. Past results are no indication of future performance.

February 12, 2010

What are the preferred chart settings for Technical Traders?

In terms of scale settings for technical charts, many charting packages allow you to set the scale to either arithmetic or log/semi-log charts.  The differences in terms of drawing trend-lines can be significant, potentially giving wrong entry/exit point signals for major trends.
A good example is illustrated below:
S&P 500 weekly chart analysis by Serge Perreault courtesy of http://www.dshort.com/
Serge-Perreault-100212
Alternatively, a basic trend-line drawn on a different charting package eSignal, using a standard scale.
SPX-Esignal
Which one of the two settings is used by the majority of traders?
You can cast your vote here:  http://polls.linkedin.com/p/77694/bzfqm

February 06, 2010

Market Insights - 06 February 2010

Dear Friends & Fellow Investors

Here is the latest issue of Market Insights. As always, please email any questions to: info@fxistrategies.com

In This Week's Issue
• Weekly Snapshot
• Chart Of The Week
• Weekly Barometers 
• Flight To Safety Yet Again? 
• Beneath The Icing Of The Cake
• US Budget 
• More Government Spending 

Weekly Snapshot
• US unemployment rate fell from 10.0% to 9.7% in January (BLS)
• US Payrolls unexpectedly fell by 20,000 in January (Reuters)
• Euro fell to 1.3585 against US$ on continued concerns about Sovereign Debt (eSignal)
• European Central Bank holds interest rates at 1.0% (MarketWatch)
• The Spanish government is proposing is to raise the retirement age from 65 to 67 (Le Monde)
• The ISM's manufacturing index jumped more than 3 points to 58.4 (Bloomberg)
• US Personal income in December 2009 increased 0.4% from November (ESA)
• The Bank of England decided to halt its program of quantitative easing (Economist)
• Australian central bank (RBA) left rates unchanged at 3.75% - Aussie Dollar retraces (Reuters)
• Euro area unemployment rate at 10.0% (Eurostat)
• Obama asked Congress to approve a record $708 billion in defense spending for fiscal 2011 (Reuters)
• Obama's 2010 budget deficit soars to record $1.56 trillion (Reuters)

Chart Of The Week  
A fascinating chart courtesy of Calculated Risk.  It speaks for itself...

PercentJobLossesJan2010

Weekly Barometers  (click on chart for larger image).

stocks2010-5   fx2010-5

Flight To Safety Yet Again?  
Despite a late rally in the US, equity markets remained bearish throughout the week and across the globe.  The trend towards the illusive safe haven of the US Dollar continued.  Perhaps, the majority of investors felt that the rosy projections underlying the recently released US Budget (more on that later on) gave enough reason to believe that the US markets are still a good long-term buy, all things considered.  Maybe so...

With ample negative news from Greece and concerns about possible defaults in Sovereign Debt from the PIIGS countries (Portugal, Italy, Ireland, Greece & Spain) it felt like ditching everything for US Dollars once again. 

The trashing of Euros continued and along with it, a risk adverse attitude remained in many markets evident in the ongoing drop in Gold, Silver, Oil and other commodity prices.  Particularly the Euro fell to a level nearing an important technical area.  The currency is currently approaching the 61.8% Fibonacci retracement level (green line @ 0.618 below), an important technical resistance area that may determine the fate of the Euro in the coming weeks.

EUR2010-0205

A weaker Euro may actually be one of the desired outcomes enabling the more export-driven economic powerhouses in Europe to tackle an ongoing recession.  For instance, Germany’s GDP dropped 5% in 2009 and in view of the PIIGS debt concerns, a weaker Euro may give some room for  the center of Europe (France and Germany) to grow exports enough so as to better absorb some of the fall-out from sovereign debt concerns. 

To put things into perspective however, one has to note that Greece may not be the last and certainly not the biggest concern in terms of Sovereign Debt.  A potential default by any of the PIIGS countries would have a devastating effect on Europe’s economy and on the Euro. But Greece’s potential default may the easiest one to absorb within the European Union.  There are yet more countries with much higher perceived risk of default. Please consider the chart below, showing the cost of Credit Default Swaps for some of the most problematic countries.  To illustrate:  If a country's CDS spread is 500 bps, your cost for insuring against that risk is 5% of the amount (e.g. you can insure $10 million of debt for $500,000).

CDS2010

As we concluded last week, this perceived risk will continue to weigh on the Euro and other currencies.  In the interim, the pressure on some of the affected currencies remains and calls into question the otherwise tempting carry trade i.e. financing in US Dollars and depositing in a higher yielding currency.  At the same time, this may be a good entry point for a typical contrarian strategy (i.e. selling Dollars when everyone else is buying).

Beneath The Icing Of The Cake
Friday’s US employment report saw unemployment drop from 10% to 9.7% - hooray! 
But let us examine the numbers in more detail; and to shed some more light on these numbers, please consider the following posts from Calculated Risk: 

Unemployed over 26 Weeks and Seasonal Adjustment
Employment Report: 20K Jobs Lost, 9.7% Unemployment Rate

A few points to take away from here: 
• The current employment recession is the worst since WWII (see chart of the week above)
• Long-term unemployed is a record 4.1% of civilian workforce (see chart below)

UnemployedOver26WeeksJan2010 

In addition, the discrepancy between the drop in unemployment rate and payroll numbers raises questions as to how realistic these employment reports really are. 

Aside from that, we need to remind ourselves that despite a slow down of the job deterioration, on a net basis, the US is still losing jobs and less people are at work.  It has been highlighted a few times before that the US needs to create at least 100,000 new jobs each month, just to keep up with the demographics.  In view of that, the January employment report cannot be viewed as an improvement of the labor market.  This brings us to a more complex issue altogether.

US Budget
Feel like glutton for punishment?  You can view the complete US Budget for Fiscal 2011 here.

The Budget comes in at stunning record deficit of $1.56 trillion for the current fiscal year to be followed by another deficit of $1.27 trillion for fiscal 2011.  If that doesn’t sound scary, take a look at the chart below.

US_Budget_Forecast

At nearly 200 pages, the US Budget report may be bliss for forensic accountants and analysts but in view of the busy Superbowl week-end, let's simplify things and just examine some of the economic assumptions underlying the budget.

With an eye-popping record spending for defense in light of Mr. Obama’s proposed three year spending freeze, one must question how on earth this administration was proposing that any half-way conscious person would take these measures seriously.  As the Economist magazine wrote this week:

“The cuts the president has proposed are comically insufficient.”

This of course leaves us to conclude that at least some of the economic assumptions for the 10 year budget forecast are doubtful.  Since we still believe that a sustainable recovery in the US can only come on the back of a healthy and functioning labor market, let us examine the Administration’s assumptions on employment.

As Reuters reported this week: “The US economy has lost 8.4 million jobs since the start of the recession in December 2007.” 

Further, it is widely accepted that the US economy needs to create at least 100,000 jobs each month just to keep up with demographic trends.  Over a 10 year period, this would mean 12 Million jobs need to be added just to remain at the same miserable employment level of today.  Give or take a few hundred thousand, about 20 Million jobs would need to be created by 2020 to go back to the unemployment rate of December 2007 which was just under 5%.  Creating 12 Million new jobs is already tall order and it would just ensure the status quo. But adding 20 Million new jobs in this decade is closer to an economic miracle.  Yet, the Administration seems confident that an unemployment rate of 5.2%, nearly the level of 2007, can be reached by 2018. 

ObamaUnemploymentForecast

Thus 20 Million new jobs will be created in the next 10 years and, as per forecast, the US economy will grow from about $14 trillion to about $24 trillion by 2020, an average rate of almost 5% per year.

US-GDP-Forecast-2020

But here’s the real icing on the cake:  All of that is supposed to happen with essentially no inflation.

US-GDP-Inflation-2020 

I'm not an economist but I don't see such an economic miracle happening.  If the economy grows almost 5% a year on average, and about two Million new jobs are created each year, inflation is unlikely to stay at a benign 2%.  Something has got to give...

More Government Spending
US President Obama proposed a series of initiatives to tackle unemployment and create more jobs.  Among the proposed initiates, two high profile proposals were highlighted in the media:

• $30 bn of TARP funds for community banks to spur loans to small- and medium-sized businesses. 
• $100 bn in tax credits for small business owners, e.g. breaks for hiring new workers or raised wages.

To the latter:  A $5000 tax credit for hiring new employees is simply not going to make a difference in a company's hiring decision.  A business owner will not hire a new person unless there is a business reason for it.  The net overhead increase for any new employee is still going to be upwards of 90% of the total payroll expense and it won't help cash-strapped businesses now.  A similar argument can be made for the question of wage increases - it simply won't happen unless some economic fundamentals change.

In terms of the $30bn from TARP funds that is supposed to spur loans to small businesses: Well hello, did the US administration sleep through 2008/2009?  Hundreds of billions were loaned to the big banks in the hope to stimulate consumer lending.  But as we stated before, the US is not a command economy and instead of writing risky businesses loans or even more risky consumer loans, the bankers did what any reasonable banker would do: risk management.  Why take a risk when you can borrow at 0% and buy treasuries with a three point spread? Since we learned that the big banks wouldn't take any more unnecessary risks what makes the administration think that smaller community banks would do such a thing? 

Businesses that are cash strapped and need the credit are simply too high a risk for the small banks to take on.  To give an insight into what has been happening in the real economy, please consider a story from Mike Shedlock's Blog: California Banker On "Business Loan Margin Calls"

This is simply too good to summarize, here is the story verbatim:

"California Banker" Writes:

Hey Mish

There’s an interesting type of Margin Call that I think we’re about to see take place in great numbers within the banking industry, specifically within the business lending units. When a bank makes a business line of credit it files a UCC-1 filing against all business assets including accounts receivable.

When a business becomes over leveraged and sales fall they begin to look like that are not going to make it financially. If a business owner fails to demonstrate how and when they can rectify the situation, usually with capital injections, the bank’s primary tool to recoup their loan outstanding is to perfect their interest in those business assets.

They will notify the accounts (clients) of that business they are perfecting their interest in those accounts and they are to pay the bank directly. The bank will also notify them, that failure to do so or paying the borrower does not relieve them of their liability to pay that account to the bank and could end up paying it twice.

At the same time, the bank will notify the borrower in this case that if he receives payment from his account receivables he’s to forward that to the bank, and to not do so is an act of fraud.

This is the business owner’s “Margin Call”. I don’t think business owners understand the recourse a bank has, why and when they will use it, and how important it is for a business to keep their business lender happy and work with the bank as much as possible. They also don’t realize that when a bank notifies their clients it raises such a stink as to their solvency; their clients might just choose to do business elsewhere and the notification itself can put a business out of business.

PS If you want you can change the word perfect to secure, as in secure their interest and securing their interest, it might read easier.

"California Banker" gives an example:

Hi Mish

To follow up on my previous email.

I have a client who has what's called an asset based or account receivables line of credit. It's a formula driven line of credit, and as accounts receivables go higher, their availability to borrow goes up. Likewise, as receivables go down, so does their availability under the line of credit.

If the availability falls below the outstanding of the line of credit then they are required to pay down the line usually from recently collected or paid accounts.

One client had $200,000 in accounts at the end of November 2009, and by the end of December 2009 that had fallen down to $100,000. The formula then reflected they could borrow roughly $50,000 and their line of credit outstanding was roughly $100,000.

In one month they had become significantly out of compliance and required to pay the line down by $50,000. The borrower could not pay down his line of credit.

When I asked "What happened to the $100,000 you collected from the pay down in accounts?" he said he used the money to pay off personal credit card debts.

In essence, he spent the banks collateral. This is a serious red flag in the world of bank. He reflects a negative financial picture and poor character as a business owner. In our discussion, he said he was "paying off consumer debts because the credit card companies had cut his credit limits well below what he owed and they were demanding to be paid off."

What he failed to realize is that the consumer lenders had no ability to go after his business assets directly and therefore could not put him out of business. On the other hand, we as the business bank can perfect our interest in his business assets and put him out of business by doing so.

He failed to realize if he wants to stay in business it's imperative to work with his business bank and stay within compliance of the loan terms, and if you're having issues come to the bank early and discuss them.

He also failed in that he's planning on filing personal bankruptcy anyway. That would have wiped out those credit card balances and he could have used the money instead to keep a healthy relationship with his bank and maybe kept his business alive.

Today, we are preparing letters to notify his clients they must pay us directly. It's sad, but just like a real estate foreclosure, at some point you have to pull the plug and invoke the "Margin Call".

We should not for a second believe that smaller banks have much extra capacity to handle high risk loans nor that they would selflessly support small businesses.  The risk appetite across the globe has been severely dampened in the past couple of years.  Still, it appears that every solution to the ongoing economic problems is centered around more debt?  Shouldn't a sensible business owner, as well as a sensible consumer reduce debt and therefore reduce leverage?

On a final note and to put things into perspective, the US Budget will add another $5.8 trillion of deficits over the next five years.  That’s on top of the $12 trillion public debt at the moment.  Assuming that the projections are right and the government can indeed achieve financing somewhere close to the rates currently forecasted, let’s say on average 4%, the cost of servicing $5.8 trillion of debt would be $233 billion per year.  By contrast, the estimated budget for the US department of education is $56 billion in 2010.  If the government could spend half of those interest payments on furthering education, especially basic arithmetic and personal finance, a better financially educated public may no longer tolerate decades of fiscal mismanagement by elected officials and the financial future of this country would look a lot brighter.

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