Three Supports for a Higher Equity Market (Ryan Lewenza)

Monday, February 13th, 2012

TD Waterhouse’s U.S. Equity Analyst, Ryan Lewenza, has just released his team’s latest outlook for U.S. equities, titled, “Three Supports for a Higher Equity Market.”

Here are the highlights from the report. The entire contents follow in the slidedeck below (fullscreen for the better read, or download):

· The recovery in the U.S. stock market since the March 2009 lows has been driven by three key supports: 1) liquidity injections by global central banks, 2) improving economic momentum, and 3) strong corporate profits. In our opinion, we are currently hitting on 2.5 of those 3 supports, which is why we see the potential for further upside in H1/12. While the technical backdrop and high level of investor complacency lead us to believe a short-term pause/pullback is likely, we continue to recommend investors “buy on the dips.”

· The European Central Bank (ECB) initiated a lending program in December 2011 to European banks that were facing an escalating credit crunch. The program, called the Long-term Refinancing Operation (LTRO), involved issuing €489 billion in 3-year loans to European Banks to: 1) help them address their short term liquidity needs, and 2) engender European banks to purchase sovereign bonds, in an effort to help drive sovereign bond yields lower. The LTRO program is expected to be expanded later this month, with another €1 trillion expected to be issued to European banks. As history has clearly shown, when central banks are injecting liquidity into the system, risky assets tend to benefit, which is one important reason we remain constructive on equities in the coming months.

· The second support is the ongoing economic reacceleration in the U.S. and global economy. In the U.S., the data continues to come in above expectations, with the probability of a U.S. recession declining materially in recent months. Obviously, the key question is whether the positive momentum will continue, especially since we saw similar strength in the H1/11, which then reversed in the second half of year. For now the data remains supportive, and another factor behind our more constructive outlook for H1/12.

· Finally, as we have outlined at length in past reports, U.S corporate profits have never been stronger, helping provide an important support to equities.

U.S. Equity Strategy (Three Supports for a Higher Equity Market) – February 10, 2012

Tags: Backdrop, Bond Yields, Central Banks, Complacency, Corporate Profits, Credit Crunch, Dips, Economic Momentum, Equity Analyst, European Banks, Global Economy, Injecting Liquidity, Lows, Pullback, Recession, Risky Assets, Sovereign Bonds, Td Waterhouse, Term Liquidity, U S Stock Market
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Europe’s Great Deleveraging Has Only Just Begun

Friday, February 3rd, 2012

While Europe’s financial services sector equity prices have retraced almost half of their May11 to Oct11 losses as we are told incessantly not to underestimate the impact of the LTRO, Morgan Stanley points out the other side of the balance sheet will continue to sag. While short-term liquidity (at least EUR-based liquidity as USD FX Swap lines are back at record highs this week) may have seen some of its risk culled, the real tail risk of the ‘Great Deleveraging’ has only just begun. As MS notes, we may have avoided a credit crunch but European banks could delever between EUR1.5 and EUR2 Trillion over the next 18 months as the unwind is far from over. History suggests that over a longer time-frame, around five to six years – the deleveraging could reach EUR4.5 Trillion assuming zero deposit growth and the LTRO will slow but not stop the process. As we discussed last night, this deleveraging will inevitably lead to continued contraction in European lending to the real economy (no matter how much liquidity is force-fed to the banking system) which will most explicitly impact Southern and Peripheral Europe and the Emerging Markets of Central and Eastern Europe.

Deleveraging has indeed a long way to go if history is any guide.Morgan Stanley sees four broad buckets of bank deleveraging likely:

In the meantime, we assume the Central Banks of the world will do the only thing they know, print and funnel liquidity to these increasingly zombified financial institutions; and while Dicky Fisher was calming us all down this evening on our QE3 expectations (given Gold and Silver’s recent price action), it seems perhaps even the Fed is getting nervous at just how little surprise factor they have left given such a ravenously hungry deleveraging and insatiable need to maintain the market/economy’s nominally positive appearances.

Tags: Banking System, Central And Eastern Europe, Central Banks Of The World, Credit Crunch, Dicky, Eur1, European Banks, Financial Institutions, Financial Services Sector, Force Fed, Fx Swap, Gold And Silver, Insatiable Need, Market Economy, May11, Morgan Stanley, Ms Notes, Record Highs, Sector Equity, Term Liquidity
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ECB Says Credit Crunch Averted; Yet ECB Overnight Deposits Again Hit Record High; Skyrocketing ECB Balance Sheet

Friday, January 13th, 2012

Following a relatively tiny two-day rally in the Euro the ECB blows its horn with a statement Credit Crunch Averted

The euro rose, extending its first weekly gain versus the dollar in six weeks, as Italian bonds advanced and after European Central Bank President Mario Draghi said policy makers have averted a credit shortage.

The 17-nation currency climbed against all but two of its 16 major counterparts as Spanish debt also rallied as Italy prepared to sell notes today. The Dollar Index (SPX) dropped for a second day before a U.S. report forecast to show consumer confidence improved this month, reducing demand for the U.S. currency as a haven.

Draghi said the central bank’s massive injection of cash into the financial system last month is beginning to flow through into credit markets. “There are tentative signs of stabilization of economic activity,” he said in Frankfurt after the ECB’s policy meeting yesterday. Policy makers kept the benchmark rate at a record low of 1 percent after two straight quarter-point reductions.

Draghi’s Statement in Perspective

After a 5-week decline, some snapback in the Euro is to be expected. The impetus is just as likely to be the action by the ECB to hold interest rates at 1% as anything else.

Actually, given extreme bearish sentiment on the Euro, no reason at all is needed for a euro relief rally.

For a look at sentiment including charts of record-high short interest on Euro futures, please see Euro Suffers Longest Losing Streak Since 2010; Record High Speculative Short Positions; Big Specs vs. Currency Movements; Not Timing Devices written January 8.

ECB Overnight Deposits Again Hit Record High

As for the idea a “credit crunch has been averted”, please consider the Wall Street Journal report for January 13 that says ECB Overnight Deposits Again Hit Record High

Euro-zone banks’ overnight deposits with the European Central Bank hit yet another all-time high Thursday, likely reflecting continued funding pressures in the banking sector as well as the approaching end of the reserve period.

Banks deposited €489.906 billion ($627.77 billion), the central bank said Friday, up from €470.632 billion Wednesday.

The daily deposits have been extremely high since banks in December tapped the ECB for its first-ever three-year loan. ECB President Mario Draghi Thursday said the extra long-term facility has been successful at preventing a serious credit contraction in the banking sector. The ECB launched the operation to address the fact more than €200 billion in bank loans was coming due in the first quarter, Mr. Draghi added.

Some analysts attribute that the ever-increasing deposits to the fact that banks are hoarding their excess funds—a good deal of which originate from the three-year ECB loan—by channeling them back to the central bank.

However, Mr. Draghi dismissed that idea at his press conference Thursday. He said the banks drawing on the ECB’s refinancing operation are “by and large” different from those banks that have been depositing their funds with the ECB overnight.

European Banks Hoarding Cash

European banks aren’t lending now, nor will they lend any time soon as discussed in German Economy Contracts in 4th Quarter; Spain’s Industrial Output Plunges 7%; UK Trade Deficit Widens; European Banks Wisely Hoard Cash

Skyrocketing ECB Balance Sheet

The reason for debt rally is not that a credit crunch has been avoided, but rather, the ECB has become the lender of only resort, bloating its balance sheet to record levels.

Please consider Swelling ECB Balance Sheet Brings Relief, Poses Risk For Euro

The European Central Bank’s increasingly swollen balance sheet has helped calm volatile markets, but some believe it could itself become a problem and bring more volatility to the 17-nation currency bloc.

Nearly a year’s worth of anticrisis lending measures have sent the ECB’s books to a record EUR2.73 trillion, some 29% of the euro zone’s gross domestic product. This expansion, capturing both the collateral pledged by banks receiving funds from the central bank and the sovereign bonds it has purchased for its own account, has been welcomed by bond investors, who see it as a stabilizing force. But the excess liquidity bodes for a weaker euro, and has some wondering if the ECB’s own solvency could eventually be in peril.

Many investors are concerned that a default in the Hellenic republic could ricochet across the 17-nation currency bloc. That could renew an assault on other euro-zone bond markets that are already distressed.

More worrisome are relaxed collateral rules. When the ECB introduced a three-year tender last month at generous 1% interest rates, more than 500 banks gorged themselves on a record EUR489 billion of the central bank’s cash. Some commentators worry that a worsening of peripheral bond markets could endanger securities pledged by the banks, posing a considerable solvency threat to the central bank.

“The quality of the balance sheet deteriorates as it expands, which is doubly problematic,” said Michael Woolfolk, senior currency strategist at BNY Mellon in New York.

European banks are dumping sovereign debt at record levels on the ECB. Germany and France are on the hook. 10-year Italian bonds are down substantially, but the rate is still 6.5% with the ECB the buyer of only resort.

Good luck with that policy as Europe heads into a massive recession.

Mike “Mish” Shedlock
http://globaleconomicanalysis.blogspot.com

Tags: Bank President, Bearish Sentiment, Benchmark Rate, Consumer Confidence, Credit Crunch, Credit Markets, Currency Movements, Dollar Index, Economic Activity, Euro Zone, Losing Streak, Mario Draghi, Massive Injection, Point Reductions, Quarter Point, Short Interest, Snapback, Spx, Timing Devices, Wall Street Journal
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Massive Demand for LTRO, as 523 Banks Request a Total of 489B Euros ($641B)

Thursday, December 22nd, 2011

Risk markets first blush reaction to the LTRO is quite positive as their was huge demand to borrow from the ECB at 1%. Even NASDAQ is back to positive after being in the red, post Oracle blow up. Reuters expectation was 310B euros, so this figure came in at >150% over that level. Of course we do not know what this money will be used for, but as outlined last night the expectation is a good portion will be for a form of ‘backdoor QE/TARP-lite’ as an end around the treaty for the ban on ECB’s direct purchase of sovereign debt. (Did I put enough acronym’s in 1 sentence for you?) But as a speculator what the banks eventually use the money for is less important today, than the PERCEPTION of what the banks will use the money for. The meme is it’s for a massive carry trade and to stuff themselves with ever more debt (debt on top of debt solves everything after all!), at least of the short term variety. As long time readers now “perception is reality”…. until it no longer is. Frankly it seems perverse we are celebrating banks running to the ECB to borrow more….

Via Reuters:

• A total of 523 banks borrowed money at the tender with demand way above the 310 billion euros expected by traders polled by Reuters in the run-up to the operation. The banks’ lunge for funding pushed the euro to a one-week high versus the dollar and sparked a rally in stocks.
• The three-year loans are the ECB’s latest bold attempt to ease the euro zone’s troubles. It is the most the bank has ever pumped into the financial system, topping the near 450 billion it injected with its first one-year loans back in 2009.
• Its hope is that the ultra-cheap and ultra-long funding will have a range of beneficial effects, including bolstering trust in banks, easing the threat of a credit crunch and tempting banks to buy Italian and Spanish bonds, thereby calming markets and easing the currency bloc’s sovereign debt crisis.
• “The take-up was massive … much higher than the expected 300 billion euros. Liquidity on the banking system has now increased considerably.” said Annalisa Piazza at Newedge Strategy, adding that the take-up probably came largely from banks in the euro zone’s debt-laden states.
• While an interbank lending crunch may have been avoided, it is much less certain banks will use the money to buy Italian and Spanish government debt, as French President Nicolas Sarkozy has urged, given the competing pressures on them to cut risk, rebuild capital and lend to business.
• “While this might help to address recent signs of renewed tensions in credit markets and support bank lending, we remain skeptical of the idea that the operation will ease the sovereign debt crisis too as banks use the funds to purchase large volumes of peripheral government bonds,” said Jonathan Loynes, Chief European Economist at Capital Economics.
• Rather than a simple flat rate, the 3-year funds were offered at an interest rate which will be the average of ECB’s main interest rate over the next three years. That benchmark rate is, after a rate cut earlier this month, at a record low of 1.0 percent.

Disclosure Notice

Any securities mentioned on this page are not held by the author in his personal portfolio. Securities mentioned may or may not be held by the author in the mutual fund he manages, the Paladin Long Short Fund (PALFX). For a list of the aforementioned fund’s holdings at the end of the prior quarter, visit the Paladin Funds website at http://www.paladinfunds.com/holdings/blog

Tags: Backdoor, Beneficial Effects, Blow Up, Blush, Bold Attempt, Carry Trade, Credit Crunch, Debt Crisis, ECB, Euro Zone, Lunge, Massive Demand, Nasdaq, Qe, Reuters, Risk Markets, Sovereign Debt, Speculator, Tarp, Time Readers
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Goldman On Deleveraging And The Sovereign-Financial Feedback Loop

Thursday, December 8th, 2011

It is no surprise that there is both an implicit and explicit link between financial entity risk and that of their local sovereign overlord. The multitude of transmission channels is large and the causalities, not merely correlations, run both ways, providing for both virtuous (2009 perhaps) and vicious (2010-Present) circles. Goldman Sachs, in its 2012 investment grade credit outlook takes on the topic of the feedback loop which is engulfing financials and sovereigns currently – noting that despite the ‘optical’ cheapness of financial spreads to non-financials (and equities) that it is unlikely to compress significantly without a ‘solution’ to the sovereign crisis being well behind us. The key takeaway is that pre-crisis sovereign credit premia were, in hindsight, uneconomically tight (unrealistic) and expectations of a return to those levels is incorrect as they see the current repricing of sovereign risk as a paradigm shift as opposed to temporary repricing due to market stress. “Sovereign spreads will likely emerge from the crisis both more elevated and more dispersed”, meaning floors on bank spreads will be elevated and deleveraging pressures to be maintained raising the real risk, outside of spam-and-guns Euro-zone crashes, of a potential credit crunch. This is already evident in European loan spreads, which as we have discussed many times is the primary source of funds (as opposed to public debt markets as in the US).

Goldman Sachs: The Feedback Loop Between Sovereigns And Financials

The spread differential between financials and non-financials is at all-time highs. Even so, we do not expect this relative spread premium to compress until the risk from the European sovereign crisis is safely behind us. Financials remain disproportionately exposed to the interaction of downside macro risk and the enormous pressure under which European sovereigns and banks are laboring. Exhibit 15 shows that US and European bank spreads have been highly correlated with European sovereign spreads in 2011—a trend we expect to persist in the next few months. It is therefore hard for us to see how financial spreads can outperform as the crisis worsens (which in our view is still the most likely scenario from here).

It now seems clear that European policy efforts will not try to stabilize sovereign credit spreads at pre-crisis sovereign spread levels. In hindsight, the credit premium built into sovereign spreads were unrealistic. Looking forward, the ECB (backed by the Germans) has publicly resisted the notion that it either can or should push back against the market’s recent repricing of this risk. Instead, policy makers want to see peripheral sovereigns make the adjustments to domestic demand necessary to accommodate this sharp increase in sovereign borrowing costs.

There will be even greater pressure on sovereign spreads in the near term since the core countries and ECB clearly need to keep the external pressure elevated to assure the continued adaption of austerity measures. The “benefits” of austerity will not likely be visible for at least a year (on the contrary, the front-loaded portions of these austerity measures will most likely prove counter-productive). And demands for austerity are more likely to grow as it becomes evident that the repricing of sovereign risk has a large permanent component, reflecting a paradigm shift in the pricing of sovereign risk as opposed to a temporary repricing of market stress. Sovereign spreads will likely emerge from the crisis both more elevated and more dispersed.

For banks, this means credit spreads are almost surely going to embed a persistent premium for sovereign risk. This logic implies there is much less upside room for spread tightening in periphery banks than a simple naïve benchmarking to pre-crisis levels would suggest.

We also expect deleveraging pressures on banks to remain high. The magnitude of announced deleveraging plans of European banks already totals hundreds of billions. We expect the deleveraging trend to continue in 2012. This raises the risk of a potential credit crunch that would further weaken growth, which in return negatively impact banking activity, impair bank assets, and thus amplify the banking crisis.

To be clear, we think losses to senior bond holders of pillar banks in Europe are highly unlikely. Banks have significantly increased their liquidity positions, and we think the ECB can probably do enough to trim the tail risk of a Lehman-style shock. Nonetheless, the number of distressed banks that are now on the ECB “life-support” has increased as the sovereign crisis intensifies. The health of these banks is likely to deteriorate over time, making the final cost more expensive the longer the ECB has to provide this support.

This suggests the Senior-Sub decompression trade is warranted (as we have been saying for a while – pre-downgrades) and picking the carry on financials-non-financials seems like nothing but a beta play to us. Up-in-quality via Main ex-Financials may be lower carry but stands to benefit both ways and XOver looks set to suffer more if deleveraging forces a credit crunch.

Tags: All Time Highs, Correlations, Credit Crunch, Credit Outlook, Debt Markets, Euro Zone, European Sovereigns, Explicit Link, Feedback Loop, Financial Entity, Financial Spreads, Goldman Sachs, Hindsight, Public Debt, Repricing, Source Of Funds, Sovereign Risk, Spr, Takeaway, Transmission Channels
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Conditions Remain Fragile, But Continue to Improve

Tuesday, November 15th, 2011

Conditions Remain Fragile, But Continue to Improve

by Bob Doll, Chief Equity Strategist, Fundamental Equities, Blackrock

November 14, 2011

Eurozone Crisis Evolves With Political Changes

Markets continue to be dominated by the eurozone sovereign debt crisis, with Italy replacing Greece at the center of the crisis. How this crisis plays out is not predictable, and the upcoming days and weeks continue to be important to the outcome. Leadership changes in Greece and Italy have focused investors’ concern on whether political leadership is splintering. In our view, the crisis is moving to a point that will force leaders to make hard decisions, or the markets will simply drive Europe into recession. Notwithstanding this backdrop, risk assets were mostly up in a volatile week. The Dow Jones Industrial Average added 1.4% to close the week at 12,154, the S&P 500 Index rose 0.9% to 1,264 and the Nasdaq Composite slid 0.3% to 2,679.

To US investors, the main issue has been, and continues to be, the issue of contagion. Although US banks have been steadily rebuilding their balance sheets since 2008, the European crisis poses a threat in terms of liquidity and counterparty risk. As always, the biggest concerns are the unknowns.

US Earnings and GDP Growth Continue

Recent economic data suggests gross domestic product (GDP) growth will remain at a trend-like pace in the fourth quarter. Meanwhile, S&P 500 earnings are up more than 15% over last year and have surpassed their 2007 peak, while price-to-earnings multiples remain fairly low. In addition, money and loan growth are strengthening in the United States, and there is no sign of a renewed credit crunch. That is a big change from the worries of the summer debt ceiling debacle and tightening in financial conditions. On the other hand, while it appears job growth has also improved enough to sustain the recovery, it has not been strong enough to reduce the unemployment rate significantly.

A big unknown for US investors is the outcome of deliberations by the Congressional Joint Select Committee on Deficit Reduction, the so-called “super committee.” The group is charged with slashing the federal debt by $1.2 trillion over the next 10 years, though any resulting spending cuts or tax increases related to long-term debt reduction will not be implemented until 2013. The consensus is that this committee will achieve approximately half of the deficit reduction goal, meaning a renewed sequestration process will begin January 2013 for the remaining $600 or so billion.

The Eurozone Crisis Is Difficult, but Solvable

Returning to Europe, the real cause of the debt crisis there stems from a long period of fiscal profligacy, low productivity and excessive government spending, allowing the population to live beyond its means. These events are not all that dissimilar from those that have occurred in the United States. A financial crisis such as the eurozone debt debacle is a tough way to enforce fiscal discipline and restore some sort of equilibrium because the outcome of such a crisis is that living standards fall. Returning to equilibrium can be achieved by a sustained fall in wages and prices or by inflation and currency depreciation, which of course cuts into the real spending power of the countries and regions that are struck by the crisis.

Tags: Balance Sheets, Bob Doll, Contagion, Credit Crunch, Debacle, Debt Ceiling, Debt Crisis, Dow Jones, Dow Jones Industrial, Dow Jones Industrial Average, Economic Data, GDP Growth, Gross Domestic Product, Leadership Changes, Loan Growth, Nasdaq Composite, Political Changes, Political Leadership, Sovereign Debt, Unemployment Rate
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From Quantitative Easing To Stagflation?

Monday, November 1st, 2010

By Dian L. Chu, Economic Forecasts & Opinions

The United States economy grew at a sluggish annual rate of 2 percent in the third quarter, the Commerce Department reported last Friday. On the bright side, the economy is growing faster than the 1.7 percent growth in the second quarter and has registered the fifth straight quarter of expansion.

But here comes the dark side – the growth rate is far from sufficient to impact jobs. And the most disturbing piece of information is that the U.S. economy is still smaller than it was when the recession began–more than a year after the recession officially ended, which makes even a “jobless recovery” seem uncertain.

QE – The Silver Bullet?

Doubts about the scale and effectiveness of an expected Federal Reserve second quantitative easing (QE2) has roiled financial markets of late. So, the latest dismal GDP data probably will cement an official kick-off of Fed’s buying long-term U.S. Treasury debt when they meet on Nov. 3.

However, will the long awaited QE2 be the silver bullet as the market expects?

90% Debt-to-GDP Threshold

As of October 10, 2010, the total public debt outstanding reached 94 percent of the annual GDP, and will be larger than U.S. GDP, around $14.2 trillion a year, in 2012, according to the International Monetary Fund (IMF).

Obviously, the U.S. debt level has already crossed the ominous 90% GDP threshold–part of the findings of a recent study published by C.M. Reinhart and Kenneth Rogoff. The two economists’ study on the relationship between debt and growth finds that when public debt exceeds the 90% threshold, a country’s growth is significantly less–4% on average–than its lower debt counterparts.

That suggests the debt level of the United States seems to have reached a saturation point where more monetary easing would have very limited effect, and could even retard growth.

QE Unlikely to Cure Credit Crunch

Asset purchases by the central bank theoretically would push down real long-term interest rates and spur more lending, boost stock prices, and business confidence thus fueling growth.

However, we have learned from the first round of QE – record-low interest rates, and $2.05 trillion in securities holdings on Fed’s balance sheet, while benefiting the biggest U.S. companies, aren’t trickling down to the smaller business—i.e. no spending, no hiring.

In the 12 months through August, banks pared commercial and industrial lending—loans typically used by companies without access to the bond market—by 11.3 percent. It is still under debate whether the decline is driven by the supply issue–the balance sheet constraints of lenders, or from the demand side–simply the lack of it.

Regardless, I believe the private lending decline seems mostly a manifestation–from both the supply and demand side–of business confidence lost, and the uncertainty over new regulatory rules, which QE2 along is unlikely to rectify, and thus would have limited positive impacts on the economy.

Where’s The Inflation?

There’s also a distinct risk of inflation associated with back-to-back QE’s on a global scale. I think the prevailing deflation fear is quite misguided, and the Fed could be caught ill-prepared when inflation erupts.

As the liquidity works through the system, the time lag between the increase in the money supply and inflation rate is generally 12 to 18 months. Typically, the following are two instances where more money printing would not turn into rampant consumer inflation

• When the liquidity goes into creating asset bubble(s) (e.g. the Dot Com bubble, and the current U.S. bond bubble)
• Able to buy cheap imported goods to essentially export inflation

In addition, as describe in the previous “credit crunch” section, there’s a lot of the cash being held at banks to shore up their balance sheet, and corporations are also hoarding cash as ‘safety net” due to the gloomy and uncertain business climate.

So, these are some of the reasons that the U.S. has not seen much inflation spilling over to the consumer side yet, to the point that the policy makers are even having high anxiety over deflation.

Ripe for Stagflation

Well, heads up, Mr. Bernanke.

With wages rising in almost all low-cost exporting countries, it will become more difficult for the U.S. to contain inflation via cheap imports. Then, as more quantitative easing could further dilute the value of the dollar, pushing up the commodity prices, the system could be pushed beyond its limit into a possible “Demand-pull stagflation” scenario.

Tags: Asset Purchases, China, Commerce Department, Commodities, Credit Crunch, Debt Level, Dian, Economic Forecasts, ETF, ETFs, Gdp Data, International Monetary Fund, International Monetary Fund Imf, Jobless Recovery, oil, Public Debt, Qe, Qe2, Reinhart, Saturation Point, Silver, Silver Bullet, stagflation, Straight Quarter, U S Treasury, United States Economy
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UBS: Deflation-Inflation Knife Edge

Thursday, August 26th, 2010

The debate is ongoing

August 23, 2010

�—� Two years after the peak of the crisis, the debate between deflationists and inflationists carries on.

�—� We expect the debate to play itself out differently from country to country and to evolve over time.

�—� It is important to note that as the first signs of real recovery materialize, changes in public perception can also be expected, shifting from deflationary to inflationary expectations.

�—� We have analyzed the impact of inflation and deflation on different asset classes and present our conclusions here.

In the aftermath of the financial crisis, the fate of paper money – legal tender not backed by a physical commodity like gold – has come under intense scrutiny. Opinion seems to have settled into two polarized camps, but the reality is likely to be much less clear-cut. In fact, we expect the debate to play itself out differently from country to country and to evolve over time.

The first camp points to the major credit crunch induced by stressed financial intermediaries, and the increased slack in the economy due to rising unemployment and unused capacity. In this view, these conditions could lead to deflationary pressure and a self-reinforcing debt-deflation cycle. The counterview stresses surging government debt and overheated money printing presses. In 2009, for example, central bank money supply more than doubled in the US alone. From this perspective, the increase in both debt and liquidity would inevitably lead to a surge in inflation.

Two years after the peak of the crisis, the debate between deflationists and inflationists carries on, although we think that sentiment has shifted towards the deflationist camp for the time being…

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Tags: Asset Classes, Central Bank Money, Credit Crunch, deflationary pressure, Ffffff, Financial Intermediaries, First Signs, Gold, Government Debt, Inflation And Deflation, Inflationary Expectations, Intense Scrutiny, Knife Edge, Legal Tender, Money Printing, Money Supply, Paper Money, Physical Commodity, Printing Presses, Public Perception, Target
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Deflation and Credit Crunch – Possible Themes for Chairman Bernanke’s Testimony

Monday, July 19th, 2010

by Asha Bangalore, Northern Trust

Chairman Bernanke is scheduled for the semi-annual testimony about the economy at the Senate Banking Committee on Wednesday, July 21.  The U.S. economy is in the throes of an economic recovery but the risk of deflation has entered the picture.  The deflationary threat seemed to have been defeated the last time he presented an update of the economy to Congress.  On a year-to-year basis, the Consumer Price Index (CPI) and the personal consumption expenditure price index, the Fed’s preferred measure are both holding above zero (see charts 1 and 2).  However, on a month-to-month basis, the CPI posted the third monthly drop.  The personal consumption expenditure price index declined in May and the estimates for June will be published on August 3.

In 2002, Chairman Bernanke delivered a speech about deflation (Deflation: Making Sure “It” Doesn’t Happen Here ) where in he noted “when inflation is already low and the fundamentals of the economy suddenly deteriorate, the central bank should act more preemptively and more aggressively than usual in cutting rates.”  Chairman Bernanke could use the upcoming testimony as an opportunity to present more details about this issue.  The Fed has the option to lower the interest rate paid on excess reserves to induce banks to lend or renew some of the expired special programs to purchase private sector debt.  An elaboration of the Fed’s options is possibility at this testimony.  Speaking about bank lending, the broken credit machine is the challenge of the year.  Bank lending has declined for six straight quarters (see chart 3). The financial accommodation from the Fed is parked as excess reserves of the banking system and is not being converted to loans.  The Chairman’s thoughts about the severe credit contraction should be most important topic of the testimony in addition to deflation.

Housing Market Update:  Home Builders Survey Continues to Send a Distress Signal

The Housing Market Index (HMI) of the National Association of Home Builders dropped to 14 in July from 16 in the prior month (see chart 4).  The HMI has dropped in June and July following the expiry of the first-time home buyer tax credit program.  Indexes tracking traffic of prospective buyers and sales six months ahead also fell in June and July (see chart 5). The basic message is home builders do not have the confidence to resume construction of homes, as yet.  The housing starts report will be published on July 20.

Tags: Asha, Bangalore, Banking System, Bernanke, Consumer Price Index, Contraction, Credit Crunch, Deflation, Economic Recovery, Elaboration, Excess Reserves, Housing Market, Index Cpi, inflation, Northern Trust, Personal Consumption Expenditure, Preferred Measure, Senate Banking Committee, Straight Quarters, Throes
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The Shipping Index has Fallen 50% – What Does it Mean?

Tuesday, July 6th, 2010

This article is a guest contribution by John Stepek, MoneyWeek.com.

Stock markets have had a rough week or so. But that’s nothing compared to what’s been happening in a slightly more obscure market.

Yesterday, the Baltic Dry Index saw its 27th consecutive day of losses. That’s the longest continuous slump for five years.

The Baltic Dry measures the cost of shipping dry bulk goods – commodities such as iron ore and coal, for example. The index fell off a cliff during the credit crunch in 2008, as credit to finance global trade froze.

So what is the current sell-off telling us about the state of the global economy?

Should you worry about the shipping index sell off?

The Baltic Dry Index (BDI) has fallen almost in half since the end of May – as you can see on the chart below:

Wow. That looks nasty.

But let’s put it in perspective. This is nothing compared to the 95% drop the index saw before and during the financial crisis of 2008, as you can see below:

And by and large, analysts are saying that we don’t need to get too worried about this sell off either. Why not?

The BDI measures the cost of shipping raw materials from one place to another. If the price of moving raw materials falls, then you’d assume that people are moving less stuff around the world. Presumably, that’s because demand for finished goods is also slowing down. Therefore, a drop in the BDI suggests that the global economy must be slowing down.

That’s all very logical. But it misses one point – the supply side. Because it measures the cost of shipping, the BDI might also be saying that there are simply too many ships. The BDI hit a record high in 2008, as demand for shipping rose far ahead of the supply of ships available.

So, as you’d expect, that meant that more ships were built. And fleets are still growing now, even although demand has fallen to more normal levels. More ships and static demand means shipping rates are falling.

As dry bulk researcher Derek Langston of Simpson Spence and Young told the Financial Times last month: “We still anticipate this year we will see a record year in terms of annual growth of trade. However, this is also accompanied by record growth in fleet supply.”

So everything’s just fine then? Well, we wouldn’t go that far. Melissa Kidd at Lombard Street Research is rather less sanguine about the fall in the index. Sure, “the quality of the BDI as a leading indicator has been disrupted by an oversupply of shipping.” But “the message of weaker global activity is supported by a range of other indicators.”

Chinese growth is slowing

One big factor in the fall has been a drop off in Chinese steel mill demand for iron ore. Iron ore shipments fell year-on-year in both April and May, according to Bloomberg. Iron ore is of course, a key ingredient in steel manufacturing.

But domestic steel prices in China have been falling for the past ten weeks. This is partly down to tighter monetary conditions. The construction industry is the major driver of steel demand. China’s attempts to curb the property market have hit steel consumption and therefore prices.

With iron ore prices remaining high, that’s pushed steel makers into losses. As Andreas Vergottis at Tufton Oceanic tells Bloomberg, “Profitability of Chinese steel mills is zero now, we think.”

The trouble, says Kidd, is that “China has been the world’s engine of growth for… commodities over the last 12-18 months. A cooling off in Chinese demand growth – prompted by ongoing monetary tightening – will impact heavily on global price developments” in the commodities market.

And China’s not the only one slowing down. “The JP Morgan Global Manufacturing PMI has fallen from a high of 60.9 in April to 57.0 in June.” The reading for new orders was particularly hard hit, falling from 60.3 to 55.5 over the same time. “While a PMI of over 50 points to economic expansion rather than contraction, the drop in the index components points to a slowing down in the pace of recovery.”

A turning point for the global recovery

What all this boils down to, says Kidd, is that “the global recovery has reached a turning point as the momentum provided by the inventory cycle wears off.” In other words, company restocking is now ending, and we’re waiting to see what sort of ‘real’ demand remains to pick up the slack once government stimulus is removed.

Just how bad things get remains to be seen. But even a slowing of demand doesn’t bode well for hard commodity prices in the second half of the year.

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