2009 Forecast: The U.S. Dollar

Like most markets, the Forex market has been incredibly volatile over the last year. Currency expert Kathy Lien lists possible courses for the economy and the U.S. dollar and the Euro in 2009 in her blog post below.

2008 Price Action: It has been an exceptionally active year in the foreign exchange market as currency volatilities hit record highs. In the first half of the year, everyone was worried about how much further the dollar would fall but in the second half of the year the concern became how much further the dollar would rise. More specifically, after hitting a record low against the Euro in the second quarter, the U.S. dollar surged to a 2 year high against the currency in the beginning of the fourth quarter. From trough to peak, the dollar index rose more than 23 percent in 2008.


3 Themes for 2009: The U.S. economy and the dollar’s fate in the years ahead could be determined by what happens in 2009. We are focusing on 3 big themes that will impact the U.S. dollar and each of these themes encompasses a lot.

1. U or L Shaped Recovery: The U.S. is in recession and the slowdown is expected to deepen in 2009. Before a recovery is even possible, the economy has to work through more weakness and negative surprises. Non-farm payrolls declined by 533k in November, sending the unemployment rate to a 15 year high of 6.7 percent. With many U.S. corporations forced to tighten their belts, the unemployment rate could rise as high as 8 percent. We expect this to happen because over the past 50 years on average, recessions have boosted the unemployment rate by 2.8 percent. When the current recession started in December, the unemployment rate was 5.0 percent. If you tack on 2.8 percent, that would drive the unemployment rate to at least 7.8 percent.

Therefore non-farm payrolls could double dip, just as it has in past recessions. In this case, we would expect a rebound followed by another sharp loss that rivals November’s job cuts. A rise in unemployment spreads into incomes, spending and then usually leads to more layoffs. We need to see this toxic cycle end before we can see a recovery. Consumer spending has already been very weak and the trade deficit is widening as the dollar strengthens. As the 2 primary inputs into GDP, we expect fourth quarter growth to be very weak. The strength of the U.S. dollar in Q3 and for most of Q4 will also take a big bite out of corporate earnings, leading to disappointments for the stock market. This is why we expect more weakness in the U.S. dollar and the U.S. economy in the first quarter of 2009. However towards the middle of the second quarter, we may begin to see the U.S. economy stabilize as it starts to reap the benefits of Quantitative Easing and President Barack Obama’s fiscal stimulus plan. New Administrations usually hit the ground running and as such we fully expect the rest of the TARP funds to be tapped shortly after his inauguration. The shape of the U.S. recovery will have a big impact on the price action of the U.S. dollar and the path to a stronger dollar will be through a weaker one.
The following chart illustrates the double-dip trend of non-farm payrolls during the 2001 recession.

2. Safety vs. Yield: The dollar’s rally in the second half of 2008 has been largely driven by risk aversion, deleveraging and repatriation. In other words, despite the next to nothing yield offered by dollar denominated investments, a flight safety into U.S. dollars and government bonds has kept the U.S. dollar from collapsing against currencies like the British pound, Canadian and Australian dollars. The concern for safety was so high that investors were willing to take negative yields just to park their money with the U.S. government. A bubble is brewing in the Treasury market and any improvement in risk appetite will take the market’s focus away from safety and back to return on money at which time ultra low interest rates could become a detriment for the U.S. dollar. The dollar’s performance against other currencies would be contingent upon growth in the rest of the world. For example, if the U.K. economy is in the process of recovering, demand for yield and the prospect of return could send the GBP/USD higher, but if the recession in the Eurozone deepens, then the Euro may no longer be the flavor of the month.

3. Compression in Interest Rates and Volatility: Volatility in the currency market hit a record high in 2008 but in 2009 we expect the volatility to compress as interest rates around the world converge. Much of the volatility this past year has been spurred by speculation about how much various central banks would cut interest rates. As they run out of room to ease, we may stop seeing monetary policy surprises which can eventually lead to stabilization for carry trades. Don’t expect this to happen in the first quarter however as many central banks are still expected to cut interest rates. The Fed’s rate cuts have long been a big driver of market volatility and now that risk is off the table. When the monetary and fiscal stimulus start to impact the U.S. economy, the market may actually start talking about a rate hike in the U.S. Interest rates cannot remain at zero forever, especially if inflation starts creeping higher in the second half of the year.

Growth: Although we expect the US economy to start its slow recovery in the second half of 2009, GDP growth next year will still be negative. Retail sales and non-farm payrolls will be particularly ugly in the first quarter, but we are optimistic that monetary policy and fiscal stimulus will begin to help the economy. The record decline in mortgage rates should also help to stabilize the housing market in 2009. Something between a L and U shaped recovery is likely.
Inflation: Deflation is much more of a problem for the US economy than inflation. Oil prices are more than 75 percent off their highs. As a result, we have seen either flat or negative consumer price growth every month between August and November. The December numbers have yet to be release, but there is no reason to expect CPI to be positive. Since the beginning of the year annualized consumer price growth has fallen from 2.1 percent to 1.1 percent. The U.S. economy has not officially hit deflation, but with commodity prices continuing to fall and consumer demand slumping, deflation will become a greater risk than inflation in the first half of 2009. However this may change in the second half as Quantitative Easing, fiscal stimulus and hopefully a weaker currency boosts inflation.

Monetary Policy: US interest rates have fallen 400bp from 4.25 percent to 0.25 percent in 2008. For most people, interest rates at 0.25 percent are as unattractive as zero interest rates. With U..S rates pretty much at zero, the Federal Reserve has informally adopted its own version of Quantitative Easing. Some people may even argue that the Fed has been pursuing this strategy for months now. In conjunction with the Treasury department, the Fed has doubled their balance sheet in the past 3 months to more than $2 trillion. They have done this by purchasing direct equity investments in banks, easing standards on commercial paper purchases, made efforts to relieve institutions of their toxic asset-backed securities and are now considering buying Treasury bonds and agency debt. By buying these assets, they are adding money into the financial system. Like the Yen, Quantitative Easing exposes the U.S. dollar to significant downside risks because the Federal Reserve is basically printing money and using that money to flood the market with liquidity, eroding the value of the dollar in the process. However it is a step that the central bank needs to take to stabilize the U.S. economy and to prevent a deflationary spiral. The central bank will not be worried about a weak currency and will in fact welcome one because they know that a weaker currency is like an interest rate cut in many ways because it helps to support and stimulate the economy.

Visit the GFT Site for my Technical Outlook for the U.S. Dollar

This post can also be viewed at kathylien.com.

U.S. Debt - The Biggest Bubble of All

As the federal interest rate approaches a flat zero economists are questioning the future of American Treasury bills. Tim Iacono from The Mess That Greenspan Made provides a key excerpt from recent press which highlights the possible—perhaps inevitable—bursting of the U.S. debt bubble.

In today's commentary at Bloomberg, Michael Sesit consults with the "Bond King" on what many call the biggest and baddest bubble of them all - U.S. debt.

To Bill Gross, co-chief investment officer of Newport Beach, California-based Pacific Investment Management Co., the answer is yes. “Treasuries have some bubble characteristics, certainly the Treasury bill does,” Gross said earlier this month. “A Treasury bill at zero percent is overvalued. Who could argue with that in terms of the return relative to the risk? There is no return.”

...

The bursting of a bubble in the U.S. government bond market would be a perilous event.

First, it would cause large losses for millions of investors, especially U.S. retirees who regard Treasury securities as the ultimate safe investment.

Second, it might threaten Treasuries’ status as the global “risk-free asset” and would damage the international stature of the U.S. Foreigners, who own about half of all Treasuries, might stop funding the country’s growing trade and budget deficits without an increase in U.S. interest rates.

Finally, a busted Treasury-market bubble could undermine the dollar’s global reserve-currency status, which in turn would spell higher U.S. interest rates, undercutting economic growth.

Big and bad and likely to burst someday...

This post can also be viewed on themessthatgreenspanmade.blogspot.com.

Home Sales Continue To Fall, But Sentiment Is Up

Home sales are continuing on their downward spiral, but for some reason consumer sentiment is heading up. Maybe it is the holidays inspiring optimizing, or maybe consumers just can't imagine things getting any worse. In light of all the negative news going around about the economy and real estate, it was a little exciting to hear something was heading in the positive direction. The bad news of course is that consumers have been up and down for months, and seem prone to mood swings. For now, though, consumers, possibly high on their cheap gasoline, are feeling better than they did last month. Tim Iacono from The Mess That Greenspan Made looks closer at the latest real estate reports and talks a bit about consumer sentiment in his blog post below.

The bottom that had been forming in the chart of existing home sales over the last year, aided by a growing number of foreclosure sales, developed a rather large hole during the month of November as reported by the National Association of Realtors.
It remains to be seen whether sales return to the 4.9 million rate average of the last year, the 8.6 percent tumble from 4.91 million in October to just 4.49 million in November helping to push the inventory level back up to the high for this cycle at 11.2 months of supply.

More importantly, the median sales price dropped a whopping 13.2 percent in November on a year-over-year basis, from $208,000 to just $181,300, the lowest level since early-2004. The AP reports that this is most likely the biggest annual price decline since the Great Depression (NAR records only go back to 1968).

Sales fell most in the Northeast (down 12.0 percent), followed by the South (down 10.9 percent), the Midwest (down 7.4 percent), and the West (down 4.3 percent). Existing home sales in the West were helped by the continuing high level of distressed home sales, the realtors' trade group estimating that 45 percent of all sales nationwide are either foreclosures or short sales.

Homebuilders aren't finding it any easier to sell real estate as the Commerce Department reported(.pdf) that new home sales also tumbled, falling 2.9 percent from an annualized rate of 419,000 in October to 407,000 in November, the slowest pace since 1991.
Sales have declined 35.3 percent from year-ago levels, the worst decline since April 1980 when new home sales plunged 50.5 percent. Inventory remains at historically high levels, averaging 11 months of supply over the last year, as builders continue to offer incentives and slash prices.

The median price dropped 11.5 percent on a year-over-year basis, from $249,100 to $220,400, however, these figures continue to be deceptively high due to the many financial incentives available to buyers that do not show up in the sales price.

In one of the few pieces of good economic news this week, the mood of the consumer, as measured by the Reuters/University of Michigan Consumer Sentiment Index, improved during the month of December, rising from the 28-year low seen last month.
The index rose to 60.1 from a mid-month reading of 59.1, up from November's historic low of just 55.3 as lower gasoline prices and some stability in financial markets helped to lift spirits.

The inflation expectations associated with this report are now getting very interesting. Survey respondents put the one-year inflation rate at just 1.7 percent, down from 2.9 percent last month, while the five-year rate came in at 2.6 percent as compared to 2.9 percent in November.

More than anything else, inflation expectations are driven by the cost of gasoline since these are the easiest prices for consumers to measure but, with food prices continuing to rise, it bears watching in the period ahead how inflation as reported in the government's consumer price index matches up with consumers' expectations of the same.

This post can also be viewed on themessthatgreenspanmade.blogspot.com.

Strong Dollar: Taking Its Toll On Corporate Earnings

While savers and retirees are excited about the recent strength shown by the U.S. dollar, not everyone is happy about it. Since the dollar has strengthened, corporate earnings have taken a hit, and it is no coincidence. A stronger dollar means that U.S. goods sold overseas all of the sudden become more expensive, and as a result sales suffer. Currency expert Kathy Lien explains this phenomenon in more detail below.

I have spoke often about the consequences of a strong currency. In the case of the US, the weak dollar in the first half of the year has helped to contribute to Q2 and for some Q3 corporate earnings as well. However I strongly believe that Q4 earnings will be very bad. Partly because of the global recession and partly because of the strong US dollar.

There is an article in the Wall Street Journal today titled “Stronger Dollar Cools Sales in Overseas Hot Spots” that talk about this same theme.

But I want to show you their charts on US exports:

Source: WSJ

And now take a look at a chart of the Dollar Index:

Source: Bloomberg

Do you see the correlation?

Also, the strength of the Japanese Yen is a big reason why Toyota is forecasting their first loss in 7 DECADES!!

Source: WSJ

This post can also be viewed on kathylien.com.

A Christmas Wish For Your 401(k) Account

Most people lost a good portion of their 401(k) this year, but will next year be any better? Most people would have to say yes, if for no other reason than it would be hard to comprehend anything being worse than 2008 was. Already analysts are predicting much stronger earning next year, but then we are hearing reports about how horrible this holiday has been, and how that is going to kill some companies. So can we expect a Christmas gift this year for our 401(k) and other retirement accounts? James Picerno from The Capital Spectator offers up his insight below.

U.S. corporate earnings have been under pressure for some time, based on reported operating earnings for the S&P 500. Indeed, the bloom fell off the rose a year ago, when S&P earnings took a dive in 2007's fourth quarter from the formerly plush levels.

A lower level of earnings has prevailed ever since, as our chart above shows. But bottom-up estimates (as per Standard & Poor's as of December 16) are decidedly upbeat for 2009. If the forecast proves accurate, by this time next year S&P 500 operating earnings will return to the record levels posted in 2007. If such an earnings rebound is coming, the S&P 500 looks inexpensive based on the forward earnings multiple of 10.6, as per the full-year 2009 earnings estimate of $83.44.

Reuters reports that a key source of the expected earnings turnaround next year will come from none other than the ailing financial sector. That would be no trivial rebound, considering the current depth of earnings red ink weighing on the financial sector. But that will give way to positive earnings next year, or so we're told.

Consumer discretionary sector earnings are also thought to be poised to soar next year, rising 46% for full-year 2009 earnings, based on bottoms-up predictions. That's nearly twice the S&P 500's predicted earnings rise. In fact, only the energy, industrials and materials sectors of the S&P 500 are expected to suffer lower earnings in '09 vs. this year. The other 7 sectors for the S&P are on track for higher elevations.

It sounds like just the holiday treat we've been waiting for. Yet we must be wary of analysts bearing gifts. Indeed, bottom-up analysts as a group tend to be more optimistic relative to top-down analysts. Even so, the top-down crowd sees earnings growth for next too. The high end of forecasts among top-down calls for a rich $100 for 2009 S&P earnings, vs. $60 on the low end for this group's prediction, The Wall Street Journal recently noted.

For what it's worth, your editor is also confident that next year's earnings for the S&P will rise above this year's dismal results. But that's like saying Wall Street's bloodbath won't be so bad in 2009 vs. the last few months.

One of the few bright spots about life after the apocalypse is that a rebound of sorts is virtually guaranteed. Timing is always a question, of course, but rebounds eventually arrive. But no one should confuse a bounce off the bottom as a sign that a return to trend is imminent for corporate earnings. The economic headwind promises to be quite stiff next year, and it remains to be seen who'll have the stamina and the savvy to weather the storm.

Yes, government stimulus will be an increasingly positive force as next year unfolds. But unless you're expecting miracles, it's best to keep the celebratory champagne on ice for the foreseeable future. It took us years to get into this mess, it'll take more than a 2 or 3 quarters to get us out. That doesn't preclude a bounce, but repairing the damage this time will take more than running the printing presses at full speed.

This post can also be viewed on capitalspectator.com.

How Will Deflation Worries Affect Gold?

Gold has historically been an asset that people turned to when they are worried about inflation. Today, though, we are in a very unique situation. Governments around the world still don't have inflation under control, but there is a lot of worry right now of deflation. Because inflation is tracking down and deflation is on the horizon nuemours measures are being taken that could have dramatic impact on inflation, and the price of gold, in the future. Deflation may or may not ultimately come, but if it does what impact will it have on Gold prices? What about if deflation doesn't come, and inflation spikes, what then? Tim Iacono from The Mess That Greenspan Made looks closer at that question in his blog post below.

This morning's Ahead of the Tape column($) in the Wall Street Journal neatly summarizes conventional wisdom regarding gold, beginning with the 'ol "inflation hedge" saw.

As the quintessential hard asset, one that traditionally hedges against rising consumer prices, gold's trajectory these days should be downward. After all, prices for just about every other commodity, from oil to nickel to cotton, have plunged as inflation risks have seemingly abated and as investors increasingly fear deflation.

Yet, gold has largely traded between $750 and $850 an ounce for the last few months, and is up about 8% since the Fed cut interest rates to between 0% and 0.25% last week.

It hasn't been an entirely smooth ride. Gold sank amid panic this fall as investors crowded into the U.S. dollar. And it remains well under its $1,002 close back in March. But the metal hasn't stumbled nearly to the degree many other commodities have. Clearly, deflation worries aren't tugging at gold.

It's probably fair to say that, with what the central banks around the world have been doing over the last year or so, gold owners who are now worried about the recent downward trend in the consumer price index are few and far between.

It continues...

And while inflation isn't apparent today, stimulus packages and bailouts mean much more money in the system. That is classically inflationary. Moreover, despite efforts to sop up this liquidity later, the effects of unintended consequences might mean some portion of the trillions added to the Fed's balance sheet are likely to "stick around" to fuel inflation, says Axel Merk, who recently increased gold exposure in his Merk Hard Asset Fund and personal portfolio.

Says Malcolm Southwood, commodities analyst at Goldman Sachs JBWere in Australia, "I'm telling clients that the environment over the next five years is extremely constructive because of the inflationary risks further out."

Near-term gold could still demonstrate some weakness as the last of the panic trade peters out. And if the European Union cuts interest rates, as some expect, that could boost the dollar's value, which could undermine gold. And U.S. and European Central banks could sell gold to raise cash to pay for bailouts, which would be bearish for gold prices. But Mr. Southwood suspects Asian central bankers looking to diversify reserves would grab that supply, seeing the sales as "an alarm signal about the dollar."

And what if deflation does hit? Even that doesn't necessarily spell doom for gold, as some think. During the deflationary Great Depression, "gold preserved its value," says Matt McLennan, a lead manager at First Eagle funds, which runs a gold fund. "It preserved its purchasing power."

Yes, some of this new money is likely to "stick around" as Axel Merk says - maybe a lot of it.

This post can also be viewed on themessthatgreenspanmade.blogspot.com.

Understanding The Federal Reserve System

Are you completely confused by the whole Federal Reserve system? If so you are not alone, but you really should at least attempt to understand it. The Federal Reserve plays a huge part in how our economy runs, and every American should be concerned with that right now. While most explanations I've read about the Federal Reserve would probably be confusing for most non-economists to read, a recent one published by James Hamilton on Econbrowser does a fabulous job explaining how the Federal Reserve works.

As a bonus Hamilton also explains all the new and creative things the Fed is doing to help get us out of the financial mess we are in, as well as the present state of the Fed's balance sheet. If you are at all interested in how the Federal Reserve works, and what is going on there today, I strongly recommend that you read his article.

Click here to read the full article.

America's Ponzi Scheme Era

There has been a lot of talk lately about ponzi schemes, and of course this can be directly attributed to the recent Madoff scandal. As Paul Krugman points out in his article, though, there isn't all that much difference between Madoff's actions and the actions of the entire investment industry. After all the end result was the same, the investors lost a bunch of money while the facilitators ran off with the spoils. Mark Thoma from The Economist's View shares the Krugman article in his blog post below.

The costs of "America's Ponzi Era":

The Madoff Economy, by Paul Krugman, Commentary, NY Times: The revelation that Bernard Madoff — brilliant investor (or so almost everyone thought), philanthropist, pillar of the community — was a phony has shocked the world, and understandably so. The scale of his alleged $50 billion Ponzi scheme is hard to comprehend.

Yet surely I’m not the only person to ask the obvious question: How different, really, is Mr. Madoff’s tale from the story of the investment industry as a whole?

The financial services industry has claimed an ever-growing share of the nation’s income over the past generation, making the people who run the industry incredibly rich. Yet, at this point, it looks as if much of the industry has been destroying value, not creating it. And it’s ... had a corrupting effect on our society as a whole.

Let’s start with those paychecks. ... The incomes of the richest Americans have exploded over the past generation, even as wages of ordinary workers have stagnated; high pay on Wall Street was a major cause of that divergence.

But surely those financial superstars must have been earning their millions, right? No, not necessarily. The pay system on Wall Street lavishly rewards the appearance of profit, even if that appearance later turns out to have been an illusion.

Consider the hypothetical example of a money manager who leverages up his clients’ money..., then invests the bulked-up total in high-yielding but risky assets... For a while — say, as long as a housing bubble continues to inflate — he (it’s almost always a he) will make big profits and receive big bonuses. Then, when the bubble bursts and his investments turn into toxic waste, his investors will lose big — but he’ll keep those bonuses.

O.K., maybe my example wasn’t hypothetical after all.

So, how different is what Wall Street in general did from the Madoff affair? Well, Mr. Madoff allegedly skipped a few steps, simply stealing his clients’ money rather than collecting big fees while exposing investors to risks they didn’t understand. ... Still, the end result was the same (except for the house arrest): the money managers got rich; the investors saw their money disappear.

We’re talking about a lot of money here. In recent years the finance sector accounted for 8 percent of America’s G.D.P., up from less than 5 percent a generation earlier. If that extra 3 percent was money for nothing — and it probably was — we’re talking about $400 billion a year in waste, fraud and abuse.

But the costs of America’s Ponzi era surely went beyond the direct waste of dollars and cents.

At the crudest level, Wall Street’s ill-gotten gains corrupted and continue to corrupt politics... Meanwhile, how much has our nation’s future been damaged by the magnetic pull of quick personal wealth, which for years has drawn many of our best and brightest young people into investment banking, at the expense of science, public service and just about everything else?

Most of all, the vast riches ... undermined our sense of reality and degraded our judgment. Think of the way almost everyone important missed the warning signs of an impending crisis. How was that possible? ... The answer, I believe, is that there’s an innate tendency on the part of even the elite to idolize men who are making a lot of money, and assume that they know what they’re doing.

After all, that’s why so many people trusted Mr. Madoff.

Now, as we survey the wreckage and try to understand how things can have gone so wrong, so fast, the answer is actually quite simple: What we’re looking at now are the consequences of a world gone Madoff.

This post can also be found on economistsview.typepad.com.

U.S. Dollar Rallies, But Will It Last?

The latest jobless claim report came in better than expected, although, while the numbers were better than expected they certainly were not good. Considering everything that is going on in the financial world, though, any time numbers come in better than expected there is a certain exuberance emitted, as people hope that this might be the first sign of recovery. While recovery is not likely anytime soon, it doesn't stop people from hoping. Of the recent announcements affecting the dollar, some have been good, while others have been bad. Currency expert Kathy Lien evaluates the impact of these recent happenings on the U.S. dollar in her blog post below.

Here’s a snippet from my Daily Currency Focus on GFTforex.com

After seeing the US dollar sell off for 5 straight days against the Euro and Japanese Yen, we were not entirely surprised to see today’s recovery, especially on the heels of better than expected economic data. The market has become accustomed to disappointments so good news was a welcome change. The European Central Bank has also reduced the interest rate that it offers to banks that deposit with them in order to encourage lending. The 15 percent rally in the Euro has led many to people to believe that the ECB may reconsider their plan to hold interest rates steady in January and the deposit rate cut was seen as a step in that direction. Thin market conditions near the holidays have exacerbated the volatility in the currency market. However even though the greenback is higher today, we had both positive and negative news impacting the dollar.

The Good News: Better Data, Oil at $36, More Stimulus on the Way

The Philly Fed index and jobless claims were better than expected, but the improvements still masked underlying weakness. New orders singlehandedly drove the Philly Fed index higher as sharp deteriorations were seen in the other 8 subcomponents. Even though the number of people claiming unemployment benefits still rose by more than 500k last week, the rise was less than the previous period, which suggests that the hemorrhaging in the labor market is slowing. However that has not stopped weekly claims from hitting a new high. There was also news that Obama’s economic team is looking to push through a stimulus package worth up $775B over the next two years. This package should play a big role in helping to turn the US economy around. Oil prices have also fallen to a 4 year low of $36 a barrel, which represents a 75 percent decline from its record high. In may not be long before we see gasoline prices at $1.50 a gallon. Lower oil prices acts as a tax cut for consumers and should help to improve consumer spending.

The Bad News: GE AAA Rating at Risk, Pessimistic Comments from Fed Official

Aside from the fact that the good news masked underlying weakness, more worrisome reports have hit the corporate sector. Leading indicators fell to the lowest level in 4 years on the back of a sharp rise in jobless claims and decline in US equities. Standard & Poor’s revised General Electric’s rating outlook from stable to negative, which suggests that GE’s AAA credit rating may be at risk. A company’s credit rating is directly tied to their cost of borrowing and their overall health. GE’s problems center on their financial unit which was hit hard by the credit crisis. All Big 3 automakers have also announced that they will idle a number of their plants over the next month, reflecting the severity of their financial situation.

Despite the recent rate cut, Fed officials remain very pessimistic about the outlook for the US economy. Fed President Fisher expects the US economy to continue to contract in 2009, driving the unemployment rate past 8%. Having leaned towards hawkishness in the past, Fisher’s dovish comments are particularly alarming. However Greenspan expects the economy to rebound in 6 to 12 months, but of course he is no longer involved in US monetary policy.

This post can also be viewed at kathylien.com.

So Just How Bad Is It In California?

California's budget problems have gone from bad to worse. Democrats and Republicans are at a standstill on how to fix the problems, and while they fight nothing is getting done to address the problem. At the current pace California will run out of money in a couple months, which would be an absolute disaster. California has the largest state economy in the country and their pain will surely be felt in all of the U.S. Tim Iacono from The Mess That Greenspan Made looks closer at the latest developments in his blog post below.

News from Sacramento this morning has the Democrats attempting an end-run around their Republican rivals in the latest effort by the California legislature to stem the flow of red ink.

The Sacramento Bee reports that a vote is planned today on an $18 billion package of tax increases and budget cuts, crafted in such a way as to not require a single Republican vote.

By adroitly stitching together proposals that lower some taxes and raise others, Democratic legislators contend the package is "revenue-neutral" and thus could be passed by a simple majority rather than the constitutionally required two-thirds vote for tax increases.

The plan would raise taxes on gasoline, personal income and sales; cut state spending on schools, state universities and programs for the needy; and lower the state's payroll by $657 million.

Whether the attempt is moot will be decided by Gov. Arnold Schwarzenegger, who could veto the plan.

The first comment on this item neatly summarizes the view of many in the state.

They spent like drunken sailors when the State was flush with money. As a former drunken sailor, I would like to point out that at least drunken sailors stop spending when they run out of money.

Yesterday, state officials cut off funding for some $3.8 billion in infrastructure projects in order to conserve cash that may be needed in the months ahead.

Bloomberg provides the details in this report:

The California Pooled Money Investment Board, made up of the controller, the treasurer and the governor’s finance director, took the step to save money a day after the Legislature failed to approve tax increases for a second time. The impasse may hamper the state’s ability to raise funds by selling bonds, and the officials said it may cost tens of thousands of jobs in a state already reeling from the housing market’s collapse.

“California’s fiscal house is burning down,” Treasurer Bill Lockyer said in a statement. “The people still wait for their elected leaders to pull them out of the fire, stop the blaze and rebuild the house on a solid, lasting foundation. Until that happens, the infrastructure work so vital to getting our economy back on track will lie crippled.”

California, the most-populous U.S. state, will run out of money as soon as February unless lawmakers end an impasse over how to replace revenue lost amid the recession. Governor Arnold Schwarzenegger’s administration has said it may begin paying bills with IOUs should the state run out of cash, a measure used only once since the Great Depression.

The Wall Street Journal reports that things are not much better at the local level.

California may soon have more bankrupt towns on its hands.

The city of Vallejo, Calif., gained national attention earlier this year by filing for Chapter 9 bankruptcy protection. Now, two neighbors are fighting to avoid the same fate, as the state's economic crisis spreads.

Isleton and Rio Vista, small towns roughly 50 miles northeast of San Francisco, say they have begun consulting with bankruptcy lawyers as they draw up plans to deal with their mounting budget crises. The towns' leaders say they hope to avoid bankruptcy, but concede the move may eventually be their only option.

"We're strapped for cash and by the end of March or early April we may not have enough money to pay for payroll," says Hector De La Rosa, Rio Vista's city manager.

Even the state's public retirement system is causing problems lately.

Without its two top executives for the last six months, Calpers (California Public Employees' Retirement System), once admired for their shrewd asset management and stellar investment returns, has nearly run aground as their bad real estate bets get even worse.

The fund is now one of the biggest owners of undeveloped residential land in the country, after placing leveraged bets that, in some cases, have lost over 100 percent of their value. Since July, the giant pension fund has lost nearly 25 percent of its assets with the situation likely to get worse before it gets better.

The fallout is being felt all over the state, particularly in the town of Pacific Grove, as discussed in this story also from the Wall Street Journal.

Pacific Grove, a coastal town south of San Francisco, already faces a budget crisis. Now losses by California's giant pension fund could make the pain worse.

"Calpers could bankrupt us faster than anything else," says Mayor Dan Cort. City officials say other towns face financial stress unless the California Public Employees' Retirement System is able to quickly recover from its investment losses. Says Dan Davis, a former city councilman who has crunched the numbers for Pacific Grove: Other municipalities "are trying to live in denial."

In recent years, Pacific Grove has seen its annual pension costs soar, largely because of increased contributions to make up for losses caused by the last market downturn. Last month, residents voted to consider ditching Calpers as the town's pension provider and look into possible alternatives. But the window of opportunity may have shut. With the market's plunge this fall, the city would have to spend $10 million or more to pay off its widening obligations to vested retirees were it to pull out of Calpers.

The commenter at the Sacramento Bee had it right - worse than drunken sailors.

This post can also be viewed on themessthatgreenspanmade.blogspot.com.

Looking Ahead To The Bubble Of Tomorrow

As we deal with the consequences of the current asset bubbles popping around us, it is hard to give any thought to future bubbles. However, considering all the recent moves that the government has made, we really do need to pay attention to what their ramifications will be. The things that the government has done are unprecedented, and we should expect the next round of bubbles to be the same. James Picerno from The Capital Spectator talks more in depth about this in his blog post below.

Governments are now working overtime in dispensing monetary and fiscal medicines intended to renew, restore and revive battered economies. In time the aid will quicken the economic heartbeat, although exactly when and to what degree is unknown. The patient has for years gorged on any number of goodies, ranging from the sweet treats of leverage and the candied delights of easy money to roller-coaster thrills of irrational investing.

The party, of course, is over, and the cleanup may go on for some time—probably longer than we expect. In a somewhat haphazard and increasingly desperate effort to ease the current and future pain, governments are dishing out unprecedented rounds of stimulus pills. For obvious reasons, everyone's watching each new step in what promises to be a long run of conventional and unconventional programs intent on propping up economies from east to west, north and south and everywhere in between.

But while the lion's share of attention is on the medicines, what might follow once the patient is no longer in imminent danger of cardiac arrest? In a speculative exercise of considering the possibilities, we offer the following thoughts for the post-crisis world order, which one day will arrive, amazing as it seems at the moment.

* Inflation
Yes, inflation. Strange as it sounds to talk about inflation at a time when deflation seems to be stalking the U.S. economy, it's never too early to think about the natural state of economic affairs. One day (don't ask us when), all this stimulus and its baggage will be yours. Pulling back on the sea of money washing ashore will eventually require the mother of all mopping-up campaigns. Assuming, of course, the Fed and central banks around the world have the stomach for the task.

Make no mistake: pulling back will be tough, very tough. Imagine the scenario a year from now. Let's make a big assumption and say that the economy's showing signs of life and GDP manages to post a modest 1% rise in Q4 2009, with more of the same expected for 2010. Higher interest rates would certainly be warranted, relative to the near-zero levels of the moment. Perhaps much higher rates will be required. But will Bernanke and the boys be willing and able?

The political pressure to keep the stimulus going will probably be immense. Meanwhile, warnings of higher inflation at some point are likely to fall on deaf ears for an extended period. Higher inflation, after all, is just what the Fed wanted by lowering rates so low and so arguments for containing the revival in prices will initially dismissed.

Yes, the inflation beast will work his way back into the director's chair. He always does, and he has a thousand tricks up his sleeve. His task will be all the easier if the deflation mindset takes root, which looks increasingly possible.

Nonetheless, some corners of finance are worried about the longer-term risks. That includes the dollar sellers and the gold buyers. Yes, deflation is a risk, but in the long run history tells us that inflation always comes out on top eventually.

What's more, a sudden change in the weather is hardly beyond the pale. Recall that inflation worries were all the rage earlier this year. Yet that fear quickly gave way to deflation. Expecting smooth and gradual changes on the pricing front may be asking for too much in the 21st century.

* Oil
Just as inflation worries have been banished in recent months, so too are the headline-grabbing predictions of $200 oil. These days, that's a forecast with one too many zeroes.

But let's be clear: the recession-inducing fears that are pushing oil lower these days will eventually abate. That doesn't mean oil will suddenly resume its skyward run at the first sign of economic stability. But marginal growth in oil demand isn't dead; it's merely hibernating.

China, India, and, yes, the United States will one day be in need of more oil. Yes, green technology will slow future demand for fossil fuels. But unless you're expecting miracles, the world economy will almost certainly be consuming more oil in 3 to 5 years compared with today. The crowd, however, will be focused on demand trends over the next year or two and thereby conclude that high oil prices are forever gone. Oil companies will be pressured into agreeing, resulting in a sharp decline in searching for and developing new oil fields. Those are the seeds that will push prices higher once more, perhaps to new all-time heights, although probably not for several years.

* The Bubble of 2013?
No one knows where all the stimulus will wind up, but there are pretty good odds (and a fair amount of historical precedent) suggesting that exuberance will eventually reanimate itself with all its immoderate excess intact. Some say that Treasuries are now a bubble waiting to burst, courtesy of interest rates that can only go higher from here. Perhaps, although it's a safe bet that one day, perhaps sooner than we expect, bubble sightings will return.

Bubbles, writes John Kemp of Reuters, are no accident. "It is the direct consequence of the Fed's asymmetric response to shifts in asset prices." Much will depend on whether the reflation policy is, at the appropriate time, wound up and put in the closet. In theory, it's a no-brainer. In practice, there are complications.

Finally, we bring all this up mainly as a reminder that it's always difficult to maintain strategic perspective. Two years ago, when all the major asset classes were rising, few could imagine the current pain of the moment. Similarly, looking at where we're headed several years from now looks about as relevant as studying the moons of Saturn. But the future keeps coming, even if we're not looking. It's tempting to make all our investment decisions based on what happened yesterday, but we're all probably better off keeping our strategic-investing focus on what's likely to unfold several years from now. No easy task, to be sure. Par for the course if you're intent on winning the investment game.

This post can also be viewed on capitalspectator.com.

New York Proposes New Taxes To Combat Budgetary Shortfalls

Thanks to drastically decreasing tax revenues, states must create new ways to meet their budget obligations. Many states have been able to make ends meet simply by cutting expenses, but this won’t be enough for others. Some states—such as California—have begged the federal government for help, while others—such as New York—are taking matters into their own hands. The governor of New York, David Patterson, is proposing a slew of new taxes that he hopes will help bring the budget in balance.

Considering the state of the economy, most economists would say that the last thing you want to do is raise taxes on consumer goods, but Patterson says he is left with little choice. "This is where we are," Paterson told reporters, according to Alley Insider. "Maybe we should have thought about this when we were depending on what we thought was inexhaustive collections of taxes from Wall Street - and now those taxes have fallen off a cliff."

In total the proposal is for 88 new taxes and fees, including what is being dubbed the “iPod tax,” which is essentially a tax on downloaded entertainment from the internet according to Alley Insider. The goal is to close a budget gap of $15.4 billion.

While these taxes are for the state of New York only, depending on how this proposal works out there could be many states ready to follow in their footsteps. A majority of states are facing budget problems, and with the economy showing little signs of recovering, they need to do something quick. Do they start cutting essential services, or will they raise taxes? That is the question that these states will need to ask themselves.

Flurry Of Fed Moves Could Lead To Hyper Inflation

In what was a surprising move yesterday, the Fed dropped the Fed funds rate basically to zero, surpassing market expectations. Everyone fears deflation, and the Fed is willing to do whatever it takes to avoid it. But as Toni Straka from The Prudent Investor points out, these drastic moves could soon lead us to hyper inflation.

Share and bond markets rallied on Tuesday after the Federal Reserve announced that it will give away new money for almost free, lowering the Fed Funds target range to a historical low of 0% to 0.25%. The Fed had cut the Fed Funds rate in late October by 50 basis points. The new record low rate is a reaction to to the de facto status quo in treasury securities where short maturities of up to 6 months trade at yields below the upper end of the target range.

In a most unusual move the Fed provided publishable background on its decision, writes the WSJ blog, detailing it all here. The Fed has not held press briefings until now.

While markets welcomed the bold move, gold, the canary in the mine of inflation, advanced as well, piercing the important resistance at $850. Investors are obviously pricing in that all Treasuries yield less than the inflation rate of currently 3.7% YOY.

But the move to a zero interest rate policy will come at the cost of higher inflation in 2009 and 2010, it can be safely predicted. Chairman Ben Bernanke and his fellow Federal Open Market Committee (FOMC) members pulled out all stops in order to jumpstart the economy and assured market participants that the Fed would continue to engage in the dubious game of printing fresh money for collateral it does not want to talk about.

Once more proving their image of inflationistas par excellence the FOMC said the Fed can be expected to hold on to its free money policy for quite some time and use all tools to promote a return to growth.

The Federal Reserve will employ all available tools to promote the resumption of sustainable economic growth and to preserve price stability. In particular, the Committee anticipates that weak economic conditions are likely to warrant exceptionally low levels of the federal funds rate for some time.

But money for nothing alone will not help, the Fed reasoned, preparing markets for more growth in the Fed's balance sheet after it has exploded from $800 billion to $2.2 trillion since last summer. Expect the Fed to continue to buy more worthless MBS (mortgage backed securities) while substituting the banking sector in the commercial paper market.

The focus of the Committee's policy going forward will be to support the functioning of financial markets and stimulate the economy through open market operations and other measures that sustain the size of the Federal Reserve's balance sheet at a high level. As previously announced, over the next few quarters the Federal Reserve will purchase large quantities of agency debt and mortgage-backed securities to provide support to the mortgage and housing markets, and it stands ready to expand its purchases of agency debt and mortgage-backed securities as conditions warrant. The Committee is also evaluating the potential benefits of purchasing longer-term Treasury securities. Early next year, the Federal Reserve will also implement the Term Asset-Backed Securities Loan Facility to facilitate the extension of credit to households and small businesses. The Federal Reserve will continue to consider ways of using its balance sheet to further support credit markets and economic activity.

I translate this into "we will throw (fiat) money (that costs us next to nothing) on every problem as we did in the past 2 decades." See more worthless money created that will be exchanged for more MBS that are valued on a theoretical basis, i.e. not the market price which may be only a tiny fraction of the initial face value.

The announcement that the Fed is looking into buying longer term US Tresuries raises immediate fears that the Fed will be monetizing the federal debt again after a portfolio shift towards MBS in the recent past. Any talk about deflation misses the point of unprecedented monetary inflation that will show up in the real economy 2009/10.

Eric de Carbonnel argues at DollarDaze that monetary inflation does not even have to pump up money supply - my favorite theory - but that it is a loss of confidence that increases the velocity of money, resulting in the dange of hyper inflation.

The record low official Fed Funds rate may be elusive though. Jake at EconomPicData sees a disconnect between municipal bonds and Treasuries, reflecting the horrendous outlook for cash strapped communities which had invested heavily in property debt. Now they are broke.

GRAPH: The yield spread between Munis and 5-year Treasuries soared to a record high of 325 basis points. Graph courtesy of EconomPicData.

DollarDaze draws a historical comparison that shows deflation can be a hazy illusion.

As an example of deflation leading to hyperinflation, consider the case of the Weimar Republic. In 1920, Germany experienced a deflationary collapse, with the average citizen finding it harder and harder to get enough money for necessities. Banks, short of money, could not honor checks, and businesses were strapped for cash to buy materials and meet payroll. Fearing a collapse that would throw millions of workers out on the street, the German government desperately printed money in an attempt to re-inflate the economy. During this period, despite the government's money printing, the mark actually gained in value against foreign currencies, so that prices of imported goods fell by some 50%.

Eventually, as a result of the money supply's rapid expansion, the nation's massive foreign debt, and the shrinking economy, German citizens lost all confidence in their currency, and the Weimar Republic experienced one of the worst cases of hyperinflation in modern economic history.

Check out the time series of the Weimar hyper inflation - with the interim "correction" before it went parabolic - here.

The new policy to lend money to banks for free shows that the Fed is obviously willing to monetize all debt problems that come along. With its seven new financing tools introduced since the beginning of the crisis in August 2007 the Fed is already intervening in MBS markets and tries to keep the commercial paper market afloat.

But after all these attempts are nothing more than new fiat money with a different ribbon. The road to hyper inflation is clearly visible as were most problems already more than 3 years ago.
Time will show whether the Fed has been correct in its view of current conditions. Taking it from the past 15 months the Fed has been behind the curve despite its fast moves. It is to be doubted that the increasing readiness to prop up all markets with new money will mitigate the crisis. It will rather delay it but the point of no return comes closer with every day. Central banks have a bad record of containing inflation once they set the process into motion willingly.

But these facilities have not brought the liquefying effect the Fed had hoped for. So far all attempts to revive credit markets have failed, observes not only Bloomberg, which has all the details on Tuesday's rate decision.

This post can also be viewed on prudentinvestor.blogspot.com.

So Why Do We Want To Bail Out This Homeowner Again?

I was reading through some blog posts this morning and came across one on housingdoom.com that just reaffirms my anti-bailout position. The blog post is simply a rental listing that was posted on Craigslist in Tampa, and while a rental listing in itself is nothing to rant about, you really need to read this particular one.

Here it is:

I HAVE A 3 BEDROOM HOUSE THAT I AM LETTING GO, IT SHOULD BE ATLEAST ANOTHER YEAR BEFORE THE COURT WANTS THE KEYS, SO I AM RENTING OUT THIS HOUSE WITH NO CREDIT CHECK AND ON A MONTH TO MONTH TERM, SO NO ONE IS LOCKED IN, IT IS A CHEAP WAY FOR YOU TO SAVE MONEY. THE HOUSE HAS NO APPLIANCES BUT YOU CAN GO TO CRAIGS LIST AND GET FREE ONES UNDER THE FREE STUFF. CHECK OUT THE LINKS BELOW. IF YOU ARE INTRESTED PLEASE E-MAIL ME. ALSO THERE IS NO SECURITY DEPOSIT AND THE HOUSE IS ON A 1/4 ARCE. YOU CAN E-MAIL ME DIRECTLY AT JOEYCARLO@******** FIRST COME FIRST SERVE.

THANKS JOE

The actual listing can be found here: http://tampa.craigslist.org/hil/apa/958697241.html

This guy Joe is asking $499 a month for this house, which is ridiculously low, so I’m sure that he won’t have a problem finding a tenant to take him up on his offer. Obviously he has no intention of using the rental proceeds to pay his mortgage, and is planning to take full advantage of the system for as long as he can.

This is one of the reasons why I am so adamant that a foreclosure moratorium is a bad idea. Sure a lot of homeowners really want to stay in their homes. However, many have no intention of staying in a house that is thousands underwater, and a majority of those homeowners who do want to stay in their homes probably can’t afford it, so they would just be delaying the inevitable. Then you have guys like this, who plan to milk the system for every dime they can get. He already stole the appliances, and now he plans to take advantage of the lenders some more. Since taxpayers are basically on the hook for many of these lenders, he is also taking advantage of taxpayers.

If we can figure out a way to limit the bailout to only those homeowners who actually want to stay in their homes and who can afford to do so, I might be more inclined to support it. But any bailout, or other measure, that supports guys like this, will never get my backing. This guy may be an extreme example of the potential problems at hand, but I can’t help thinking that there are tens of thousands of people out there doing this exact same thing. They probably just aren’t disclosing the situation outright like Joe here. Just reading this listing makes me angry. If Joe isn’t going to live in the house or at least try to make the payment, then he needs to return the keys to the lender. Anything short of that should be illegal, especially when taxpayers are ultimately on the hook for the bill.

Fed Drops Fed Funds Rate To Zero

Well, it looks like the Fed wasn't going to take any chances, they played all their interest rate cards as they dropped the target federal funds rate down to the 0 to 0.25 percent range. They obviously were trying to send a powerful message since most investors and economists only predicted a 0.5 percent reduction. It will be interesting to see how this plays out, but the U.S. has officially won the race to zero. Economics professor Mark Thoma from The Economist's View looks closer at this new development, and brings in some additional outside thoughts and opinions, in his blog post below.

The Fed announced it will move the target federal funds rate into the zero to .25% range, an that it plans to keep it there for some time.

Here's the Fed's statement:

Press Release: The Federal Open Market Committee decided today to establish a target range for the federal funds rate of 0 to 1/4 percent.

Since the Committee's last meeting, labor market conditions have deteriorated, and the available data indicate that consumer spending, business investment, and industrial production have declined. Financial markets remain quite strained and credit conditions tight. Overall, the outlook for economic activity has weakened further.

Meanwhile, inflationary pressures have diminished appreciably. In light of the declines in the prices of energy and other commodities and the weaker prospects for economic activity, the Committee expects inflation to moderate further in coming quarters.

The Federal Reserve will employ all available tools to promote the resumption of sustainable economic growth and to preserve price stability. In particular, the Committee anticipates that weak economic conditions are likely to warrant exceptionally low levels of the federal funds rate for some time.

The focus of the Committee's policy going forward will be to support the functioning of financial markets and stimulate the economy through open market operations and other measures that sustain the size of the Federal Reserve's balance sheet at a high level. As previously announced, over the next few quarters the Federal Reserve will purchase large quantities of agency debt and mortgage-backed securities to provide support to the mortgage and housing markets, and it stands ready to expand its purchases of agency debt and mortgage-backed securities as conditions warrant. The Committee is also evaluating the potential benefits of purchasing longer-term Treasury securities. Early next year, the Federal Reserve will also implement the Term Asset-Backed Securities Loan Facility to facilitate the extension of credit to households and small businesses. The Federal Reserve will continue to consider ways of using its balance sheet to further support credit markets and economic activity.

Voting for the FOMC monetary policy action were: Ben S. Bernanke, Chairman; Christine M. Cumming; Elizabeth A. Duke; Richard W. Fisher; Donald L. Kohn; Randall S. Kroszner; Sandra Pianalto; Charles I. Plosser; Gary H. Stern; and Kevin M. Warsh.

In a related action, the Board of Governors unanimously approved a 75-basis-point decrease in the discount rate to 1/2 percent. In taking this action, the Board approved the requests submitted by the Boards of Directors of the Federal Reserve Banks of New York, Cleveland, Richmond, Atlanta, Minneapolis, and San Francisco. The Board also established interest rates on required and excess reserve balances of 1/4 percent.

Well, that's it, we're at zero now. Any further monetary policy action will have to come through other means, e.g. quantitative easing and the purchase of financial assets.

Brad DeLong adds:

Hale "Bonddad" Stewart Is Scared: The Federal Reserve reacts to the fact that the economy train has arrived in Depression City.

Stewart writes:

Hale "Bonddad" Stewart: The Fed's Kitchen Sink Interest Rate Policy: The Fed announced their policy of establishing "a target range for the federal funds rate of 0 to 1/4 percent." This brings two points to mind:

1. The Fed has no interest rate moves left. This is it.
2. The Fed is terrified about the economy. And they have good reason:

Since the Committee's last meeting, labor market conditions have deteriorated, and the available data indicate that consumer spending, business investment, and industrial production have declined. Financial markets remain quite strained and credit conditions tight. Overall, the outlook for economic activity has weakened further....

The Fed will step up their other activities...

To the point: the Fed is scared right now. I mean really scared. And they will do anything even remotely possible right now.

Paul Krugman:

ZIRP!: That’s zero interest rate policy. And it has arrived. America has turned Japanese.

This is the thing I’ve been afraid of ever since I realized that Japan really was in the dreaded, possibly mythical liquidity trap. You can read my 1998 Brookings Paper on the issue here.

Incidentally, there were a bunch of us at Princeton worrying about the Japan problem in the early years of this decade. I was one; Lars Svensson, currently at Sweden’s Riksbank, was another; a third was a guy named Ben Bernanke. I wonder whatever happened to him?

Seriously, we are in very deep trouble. Getting out of this will require a lot of Show allcreativity, and maybe some luck too.

This post can also be viewed on economistsview.typepad.com.

Consumer Prices Show Record Fall: Fight Against Deflation Heats Up

Consumer prices are continuing to fall, even setting new records. This is of course heating up discussion about deflation, which is a horror no one wishes to see. Bernanke and the Fed are going to do everything they can to prevent deflation from coming, but with this crazy economy who knows if they will have the wherewithal to do so. James Picerno from The Capital Spectator dives deeper into the issue in his blog post below.

For the second month running, consumer prices fell. And by more than a little, invoking the specter of deflation once again.

CPI slumped by a hefty 1.7% in November on a seasonally adjusted basis, the government reports today. That follows October's 1.0% fall. More dramatically, last month's tumble is the deepest monthly decline in CPI since the Labor Department began keeping records on this series in 1947. Meanwhile, MarketWatch.com reports that the 1.9% non-seasonally adjusted fall in CPI is the steepest monthly rate since January 1932—the height of the Great Depression.

Meanwhile, core CPI (which strips out food and energy) is unchanged, following a slight decline in October. As this is the Fed's preferred measure of inflation, even a central banker can't deny that inflationary pressures have evaporated, at least for the time being.

Looking at the more familiar year-over-year calculation of headline CPI, consumer inflation is still positive, running at 1.0% for the 12 months through November. Even so, that's down sharply from October's annual rate of 3.7%. At this rate, CPI will soon be falling on an annual basis too.

As striking as the news is, a decline of some magnitude in CPI was expected, partly based on the earlier report of the ongoing decline in producers prices. Nonetheless, the sight of broad price indices sinking month after month in both the consumer and wholesale markets raises the question of whether this is merely a temporary state or something with more endurance?

We've been writing about rising deflation risk for some months now, and it's clear that the beast is here. It's still unclear how long it lasts, and so for the moment one can be optimistic that an unhealthy downward spiral in prices isn't fate.

Keep in mind that the massive monetary stimulus engineered by the Fed has only partly filtered into the economy. Monetary policy has a fair amount of lag time, perhaps a year or more. With each passing month, the aggressive liquidity injections will work deeper into the consumer and business sectors. Few expect a sudden rebound in spending and lending, but at this point simply keeping prices steady would be no small accomplishment.

Another reason to think that prices may soon stabilize comes from the fact that heavy drops in energy prices are currently leading CPI's descent. The energy component of consumer price inflation has lost ground for four months straight, with November's whopping 17% fall the biggest so far. But energy prices can't keep falling off a cliff month after month. Yes, the world economy is headed for tough times, which is paring demand for oil, gasoline and other fuels. But the lion's share of the price cutting relative to the highs of last summer is behind us.

There may yet be more declines in energy coming. In fact, we expect as much. But the magnitude of future declines, if any, will almost surely be smaller. Nor is it unreasonable to expect that energy prices generally will soon tread water, albeit at substantially lower levels compared with recent history.

As for the other components of CPI, well, that's another story. The transportation slice of consumer prices retreated by nearly 10% last month—the fourth month in a row of red ink. Housing prices are weakened last month, although just barely. But not every is posting price discounts. Prices for food, apparel, education/communication and medical care all managed to rise last month. Deflation hasn't yet infected everything, and therein lies more reason for hope.

Still, no one will wonder why Fed funds futures are pricing in a 50-basis-point cut at the Fed's FOMC meeting later today. If accurate, that would bring the target Fed funds down to 0.5%. As extraordinary as a 0.5% will be in historical terms, at this point it's something of a formality to reflect reality since the effective Fed funds (which is based on actual banking activity) is already at a scant 0.14%.

In sum, the war to head off inflation is in full swing. The Fed can't afford to fail in this battle. Allowing deflation to build a head of steam at this point is tantamount to economic suicide. It must be stopped, even at the risk of letting inflation out of the bag down the road. Controlling inflation, after all, is well understood, even if the political will isn't always there. Fighting deflation, by contrast, is far tougher and so preemptive medicine is preferred.

The challenge before us is defeating deflation with unconventional monetary policies, supported by aggressive fiscal stimulus. Since there's not a lot of precedent for the former, one might reason that the fiscal side of the ledger will have to do the heavy lifting, which necessarily depends on the political process. 'Nuff said.

Yet the task is not insurmountable. Indeed, monetary and fiscal policies will be that much more effective if consumer prices merely stabilize in the coming months, or at least stop dropping so rapidly. But that, as they say, is a big "if." Stay tuned.

The full post can also be viewed on capitalspectator.com.

Subprime Defaults Are Just The Beginning

If you thought we were almost done with the collapse of the mortgage market, you are sadly mistaken. Last night 60 minutes did a piece about the looming wave of mortgage defaults, Alt-A and option ARMs. While, as Scott Wilson outlines below in his guest post on Your Mortgage or Your Life, 60 minutes did not do a fabulous job on this story, they did reveal some very interesting facts and figures. One that was especially scary occurs 3 minutes and 40 seconds into the video. This shows how most of the subprime mortgages have already reset, but what is looming over the next few years is a huge number of Alt-A and option ARMs due to reset. The graphic will definitely make you change your tune if you think this carnage is almost finished.

by guest author and good friend Scott J. Wilson

I know that I am just smart enough to get by, and I know am not a genius by any stretch of the imagination. I have just been in the mortgage industry - working everything from mortgage sales to secondary markets - for more than fifteen years.

I happen to be watching CBS’s 60 Minutes tonight (12-14-08) and they had a piece called Mortgage Meltdown: Where’s the Bottom? with Scott Pelley, who did the story, and not a very good job of it. Either he or his writers need to better research their topic before they to such a report.

Mr. Pelley failed to note that POA’s qualified borrowers with “teaser” interest rates, and not the actual “payment” interest rates. But that is not what I am griping about. My complaint lay in Pelley’s false assumption that no one but a few sage individuals could see these consequences of poor lending standards coming.

All of my experience is in the explosive Orlando, Florida area, so I know a thing or two about exotic mortgage products like the soon to be infamous Pay Option ARM (POA), ticking time-bomb of the mortgage world, and the subprime’s little brother ALT A.

During the bubble from in 2004-2006, I worked for one of the biggest lenders in the nation (one of the survivors thus far) and I doing a truckload of Condo-conversions. I sold a hell of a lot POA’s to borrowers during that period, and most will all be recasting over the next two years.

I tried to always do one thing when I did sell a POA, I tried to explain to the borrowers exactly what these loans were intended for - people with season variances in income like construction and tourist trades, or for those whose income is mostly delivered from quarterly bonuses like sales people.

I did my best to point out to the borrower advantages and traps in POA’s. That being said, I am no “expert” by 60 Minutes standards, let alone “one of (only) six experts in the nation who saw this (tsunami of foreclosures) coming,” as 60 Minutes called Mr. Eagan in tonight’s story.

I knew way back when in the bubble, as did most of the loan officers that I worked with, that these were potentially bad products if they were sold to the wrong borrowers, and that most would probably fail if they allowed more than 80% loan to value (LTV), or made them available to speculators and subprime borrowers.

I also know that most of these loan officers were not geniuses either. Could we have been the only ones to know? I doubt it. So to say that the banks that offered them had no idea that POA’s had a high risk of potentially failing is just completely incorrect.

The bank’s own greed got the best of them; all they saw was the dollar signs in their eyes, as fees and points that filled their coffers.

The borrowers were really no less greedy- like I said, I did my best to explain, even tried to talk some borrowers out of using a POA to buy the property that they were interested in. But most times, it was to no avail. They either didn’t care about the risks or worse yet, their Realtor “over talked” me and told them that I did not know what I was talking about, and that the POA was their best choice:

Real estate always goes up, remember? It’s different here! No need to worry about that negative amortization loan if you stick with the only payment you can really afford, the one with the 1% teaser, your house will be worth double what you paid for it in a year or two!

But, unfortunately, the problem as the banks saw it wasn’t that these loans were going to fail in droves, nope.

The problem the banks saw was that the people were using these loans as short-term real estate investment loans with a really low initial payment, giving the investors time to remodel the property in order to “flip” the house and then move on to the next investment without having to sink so much capital into principle and interest with a higher interest commercial loan payment.

The banks were not making enough money, so they started tacking on prepayment penalties, which investors took as a cost of doing business and the banks thought of as a new revenue stream.

So the big banks and mortgage lenders had to have done some sort of analysis of these POA loans (I know Anthony did when he worked for them, whether the executives ever really read them I don’t know).

Did they not anticipate that the loans would be bad? That if someone who was taking this completely unaffordable loan out for a long period of time they would get burned, especially if the borrower had a two or three year pre-pay penalty on it and the market took a quick downturn, leaving them unable to refinance - just like it did.

Come on though, everyone can’t be so smart that we all saw this coming, but the leadership at Corporate of these mega-institutions did not - especially when they were offering No Income/No Asset options as well - now commonly know as “Liar-Loans” for their lack of any documentation in exchange for a higher interest rate.

Again, profit driven.

At one point, I told people that it was not a matter of if you can qualify or not for an Option ARM or not, if you had below-average or sub-prime credit, you would qualify , with no problems. All I had to do, was run their credit and if they had a 620 credit score (below average credit at the time), then I told them that they were approved with out even having an underwriter look at it.

Underwriters could approve even lower scores with the advent of “risk-based” and “exception” pricing add-ons, basically charging more for the additional risk posed by a riskier borrower, hence the birth of the ALT A loan, among other expanded approval products meant to sell more loans to more people.

So to have Mr. Pelley and 60 Minutes do this completely un-researched and absolutely baseless story that has little or no semblance to the truth is a more than a shame - lots of people knew this crisis was headed our way.

Hell, I wouldn’t be surprised if close to a million people knew that these loans were problems and a lot of them were going to fail. Do you think that any of them just might have worked in upper management of a these now failing banks?

Or are we really all just geniuses after all?

Well in that case then, I’d say my superior intellect makes me really doubt it.

This article has been reposted from Your Mortgage or Your Life The full post can also be viewed on yourmortgageoryourlife.wordpress.com.

Seriously…Madoff Investors Want A Bailout?

Bailout seems to be the word in 2008: Everyone is getting one, or is giving their case for why they need one. In the latest bailout request, the Alternative Investment Management Association (AIMA) is asking for aid for the investors burned in the $50 Madoff investment scam according to Reuters. On the news we have heard heartfelt stories of retirees who lost everything, but then again these were supposed to be sophisticated investors. What should we do?

For those who are unfamiliar with the Madoff investment scandal, Madoff Securities is a hedge fund which set up a big ponzi scheme and scammed investors out of approximately $50 billion. To invest in hedge funds, investors are required to be accredited, which means they have at least a net worth of $1 million or make at least $200,000 a year ($300,000 if married). These types of investments require accreditation because they are considered riskier and more complicated and they are not bound by the same SEC regulations as common investments are.

The fact that these accredited investors would even ask to be bailed out by American taxpayers is preposterous. Considering that millions of people are out of work and millions of retirees already have nothing to live on aside from their social security checks, how can these wealthy people possibly want hardworking Americans to cover their losses? The government didn’t bailout investors in traditional stocks that went bankrupt. They didn’t bailout the workers in Enron who had their entire retirement account invested in Enron stock and lost everything. Sure, it sucks that these people were scammed, but it is hard to feel sorry for them when they have a lot to begin with and they knew that their investment was inherently risky.

Compounding that, I was blown away to learn that some of these people invested every penny of their wealth in these funds. If someone has $2 million and plans to retire on that money, how can one possibly think that it is okay to invest it all in the same fund? That is just ridiculous. I wouldn’t even invest all my money in U.S. treasuries, let alone some hedge fund. This should be especially true for people nearing retirement: The closer you get to retirement, the less risk you should be taking with your money. This means that diversification is absolutely vital, and very, very little of your portfolio should be invested in things like hedge funds. I do feel for these scammed investors, but, firstly, they should have known better, and secondly, they are now in a situation similar to that of millions of other retirees, except that these investors probably have other assets of value and are still better off than most.

If we aren’t willing to spend $15 Billion to bailout the auto industry, then we can’t spend billions to bailout wealthy hedge fund investors who got burned. The AIMA had to know that there was no way they would get it. This action will only cause a PR problem for hedge funds and might lead to increased regulation in the industry. This is could be a good thing or a bad thing depending on your perspective, but it is safe to say that most hedge funds would rather not deal with more regulation or scrutiny. At the end of the day, though, if so-called “sophisticated investors” are making stupid mistakes like this, then I would have to question the criteria being used.

The Next Big Bubble To Burst: U.S. Treasuries

Everyone in the world knows that the U.S. has a huge debt, and that the U.S. economy is performing poorly. Yet, people are flocking to U.S. treasuries like never before driving yields down to record lows. The U.S. has no plans of stopping the debt train, though, so who knows how high it will go. We are on uncharted ground right now, and all it would take to push this train off the tracks is one major debt holder to start selling. Lots of other bubbles have burst recently, so why not possibly the biggest one of all? Needless to say if this happens there will be serious ramifications for the U.S. and the rest of the world, which is probably why it hasn't happened already. Toni Straka from The Prudent Investor looks closer at this looming problem in his blog post below.

Having seen most of the bubbles bursting I had listed in this post from 2005 the world may soon be in for the mother of all bubbles. With a size of $10 trillion the US government debt market has remained the world's #1, now that MBS have shed the better part of their initial values.

US treasuries have long been hailed as a safe haven for money fleeing from other overheated markets. Massive losses in more or less all other asset classes in the past 15 months have shown that investors followed Pavlov's reflexes, driving the 10-year yield to a record low of 2.55% last week.

CHART: The yield for 10-year US Treasury debt fell to a record low of 2.55% last week. This chart may see a sudden reversal based on the fundamentals.

It may be questioned whether this trust into the Federal Reserve's ability to contain long term inflation is justified, given the fact that chairman Ben Bernanke will enter history as the fastest money printer of all times.

While the Fed has reduced its federal debt holdings by $290 billion to $484 billion (buying doubtful MBS instead) in the last 12 months it was foreign investors TIC data and Treasury statistics show.

This has driven yields across the curve to record lows, leaving investors with a negative real yield when discounting inflation. US Inflation was 3.7% YOY as of October.

Institutional investors have been allocating more money into US treasuries recently, citing the safe haven status of American government bonds. But this era may be coming to an end as so many things do nowadays.

There appears to be a split of opinion. While European and American investors follow the old rule of buying US debt with a questionnable AAA rating their Asian counterparts see themselves trapped with US debt holdings they cannot sell in order to avoid a panicky stampede out of the biggest market of all.

The deficit outlook justifies a skeptical approach. Barack Obama will have to finance a budget deficit of an estimated $1 trillion in 2009, the biggest in American history. If Mr. Obama will not manage a U-turn in foreign policy which was mainly based on ignorance and arrogance under Bush, he could run into financing problems. China has urged other countries to replace Federal Reserve Notes with their own currencies in bilateral trade and voiced its concern about US fiscal policy repeatedly.

The global downturn may bring a different borrowing climate too. Losses in all asset classes across the board and record low yields will result in lower reinvestment amounts overall, it can be safely projected.
The borrowing needs will skyrocket as both the federal government and bankrupt local communities will scramble for funds to replace sudden drops in tax revenues.

Bets On A US Default Become More Expensive
While still being a mainstay for investors from all around the world, not everybody is confident about the future of a USA in the grip from the biggest financial crisis ever. Some wary souls are increasingly buying insurance against a default of the US government. According to a Reuters report from November 26, credit default swaps involving Treasuries reached a record high.

Ten-year U.S. Treasury CDS widened to 54.7 basis points from Tuesday's close of 50.0 basis points, credit data company CMA DataVision said.
Five-year Treasury CDS jumped to a record 52.0 basis points from Tuesday's close of 47.50 basis points, it said.

In plain language this means investors were willing to pay $54,700 to insure a portfolio of $10 million 10-year debt paper.

Summarizing the fundamentals such as no end to new debts, tax shortfalls, higher social and military expenditures, a central bank willing to monetize the debt and flooding the world with fresh Federal Reserve Notes, it can be safely bet that this bubble will end like all bubbles: In a gigantic burst that will unsettle everything we have learned about investing in the past.

A hat tip to Econbrowser who undug this paper by Stanford economics professor John Taylor on the failures of the Fed in the current crisis and why it all became worse this autumn.

I stand by my opinion that monetary inflation is in the early stages worldwide and will have seeped through into the real economy in 2009/10.

This article has been reposted from The Prudent Investor. The full post can also be viewed on The Prudent Investor.