Contemplating Key Indicators

I figure when things are relatively quiet, it is time to start thinking about the bigger picture.

Quiet? Are things quiet now? Well, sorta… we still have problems:

• We still have an oversupply of houses.
• Investment banks are still overlevered in their swap books.
• Commercial property prices are beginning to fall, and that will have negative effects on the equityholders, and those who finance them.
• Though there is no logical replacement for the US Dollar as the global reserve currency, the US is gaming the system, passing inflation through to the rest of the world. Maybe the world doesn’t need a reserve currency. In any case, there are a lot of annoyed central bankers looking to drop their peg to the US dollar at a convenient time that doesn’t hurt their home economies badly.
• We are still waiting for the junk issuance from 2004-2006 to start defaulting in size.
• Our retiree healthcare cost crisis is coming in five years, and will last for two decades.
• The pension crisis comes in the next 5-10 years, and will last for two decades.
• Most of the demographic crises will cover the developed world.

But as for now, the news flow is light, and nothing is presently cratering. Consider the short-term lending markets (click charts to enlarge):

The above graph shows the difference between yields on A2/P2 commercial paper and the 2-year Treasury. What this says is that a BBB company can borrow unsecured for a month at 2.7%. Not bad. Now look at the Treasury-Eurodollar [TED] spread:

Things have improved. The TED spread is down to 0.78%. To me, normal is 60 bp or lower. The question still remains as to what happens when the Fed begins withdrawing its new lending facilities. As it stands now, they seem to be increasing them further. (I don’t get it.)

In the midst of this, the Fed has not increased the monetary base in a loosening cycle. The last permanent injection of funds was 5/3/07, long before they started to cut rates. What growth in credit has come from a loosening of the leverage policy toward the banks.

As you can see, we have hit levels of total liabilities of the banking system versus the monetary base of the Federal reserve that we haven’t seen since the early 80s. (I need to multiply that graph by 1000 to show that the multiple is 11x. Oops.)

But, my proxy for bank profitability on new money shows that if you can borrow at 12 month US LIBOR, and lend to fund Fannie Mae 30-year mortgage passthroughs, you can make good money now.

What of Fed funds policy? The market is expecting a 25bp hike in December. I think they are dreaming, but if you are going to bet, you have to know the line.

What of inflation expectations? Above is my 5-years forward 5-year inflation graph. The expectations of inflation are low, at least as far as institutional investors are concerned, even as the measure of inflation underlying TIPS rolls ahead at 4% or so.

At least the yield curve, above, has resumed a normal shape, as noted before, that will be good for the banks in the long run.

Now, since mid-March, global long rates have bottomed. I use 10-year swap rates here because they are more comparable than government bond rates. From my viewpoint, this is due to an increase in expected nominal growth for the Gross World Product. I can’t tell whether that is coming through inflation or real growth, but I am guessing at mainly inflation.

So, after all of this, where do I stand?

• We still have problems to work through. (See top list above.)
• The short term lending markets have largely normalized. So has the yield curve.
• The economy may not be in recession. Then again, it is probably close to the line.
• Long-term implied inflation measures are quiet amid a jump in global inflation measures.
• Global long rates are rising.
• If the banks can lend, they can make decent money on new loans.
• The Fed is still trying to be “too cute,” solving problems through unorthodox means. Hey, for now it is good, but who can tell what the long term effects will be. I am still a skeptic here. Until they unwind the new lending schemes, and return to a clean balance sheet, the game is not over.

Comments

[rdial54]

Still feeling a bit uneasy about the markets, real estate, stocks. Not sure we are out of the woods yet but hope the downturn is mild.

[zb]

Nice summary of many things I have been wondering about. Surely there must be a reckoning to the end of massive consumer credit and debt. Like many investors based on logic, I am not counting on a quick recovery here.
Fascinating to see how the economy would pull off the opposite. Of course, many people are beginning to delve deeper into official statistics these days.

[deaverb]

Level headed approach to a situation that seems unduly disruptive, I think, because of our 24/7 culture. It is Saturday AM and here I am--and others. In the old days it would be the newspaper and on our way to other things. Much of this relates to the baby boomers aging, I think, and not feeling altogether good about it (I am just barely a preboomer). A black cloud lurks about that. Interestingly, they have money, at least more than previous generations, but feel they didn't get "enough"...i... general (Bill Clinton represents this; twice President, but still wanting more--to remain relevant, etc).

Brush that aside and we have a mighty even keeled financial situation. For some time now, people have buckled back down to work; haven't heard anything of late about people "scoring" on stocks or real estate; heard a lot about getting back to working hard.

This cycle is getting us refocused. Above all, the major corporations in the nonfinancial sectors are doing well: Walmart, Target, Walgreen, P & G, Kraft, GE (nonfinancial), Microsoft, google, and the list goes on and on. We may even take smaller cars, better insulation, green energy saving, more seriously this time around. And make it stick.

The challenge is the enormous increase in productivity with e filing from top to bottom, IRS, to online banking, online shopping, online research, email v. phone v. travel, home offices v. corporate (24% now work from home and it is growing). In the northeast we have EZ pass payments of tolls; no one even talks about them anymore. People "know" the govt needs money; driving down the highway and paying isn't so bad AS LONG as you don't get hassled. In Texas you can blast by at 70, to keep jobs in the northeast you have to slow down for union employment--but it is still pretty cool. So efficiency is impacting jobs. No question about it. But that isn't stagflation.

[jlounsbury59]

As long as the TAF keeps accepting CDOs and derivatives of questionable value, rather than treasuries, for loan collateral, the future is shaky. David, you speculate this could go on for a long time.

The dollar is a fiat curency with no hard asset backing. The dollar is backed by the "full faith and credit" of the U.S. government. The maintenance of the value of the dollar is assigned by the government to the Federal Reserve bank. Securities held by the Fed to secure loans to banks (now including investment banks) is (by several different accounts at different times over the past 6 weeks) between 15% and 30% CDOs and derivatives of questionable value, as you (David) have pointed out. This means the value of the dollar is now 15% to 30% backed by possible junk and only 70% to 85% backed by treasuries (the "full faith and credit" of the U.S. government).

David, one might say the dollar is backed by "70% to 85% of the full faith and credit" of the U.S. government. Your implication that this could go on for some time, and possibly even increase the percentage of junk accepted by the Fed, is truly scary.

[User 191836]

the reason you don`t see the monetary base increase is because the government is buying up the stock market to perform that function,

[jlounsbury59]

191836 - What do you mean "the government is buying up the stock market"?

[gordon]

As pointed out by David Fry, and I have surmised, the I-bank broker dealers are using this almost free TAF money to BUY STOCK INDEXES, Fry says watch their earnings "TRADING PROFITS" coming up, this is where they have made most of their money over the last 6 years, now it's SUBSIDIZED. Are they using this to stimulate loans for the economy? In your dreams. Are they planning on accepting foreign junk bonds in other currencies to make disgruntled foreign central banks WHOLE on the garbage they unloaded on them? Kohn says this open checkbook may be permanent. Is this a democracy?

[gordon]

Here's proof, looking at TAF loans to broker-dealers around options expiration days, there has been MASSIVE LOANS to trade the SPY/DIA futures to PROP THE MARKET, at crucial times of breakdown in the charts. Last week was end of month window-dressing, again, facilitated by 2.25% money from the Fed. Look at the timing of the massive jump in broker borrowing.
tinyurl.com/6rlvjg

[jlounsbury59]

Gordon - - -

Thanks for your observations. I appreciate you sharing your research. So not only do I have to worry about the further collapse of the dollar due to the Fed accepting possible junk as collateral, but now I have to worry about the leveraged effects on stocks when the Fed raises rates and/or stops accepting junk.

No wonder I have become more of a trader than an investor!

[Richard Wendling]

This article talks a great deal about the market places possiblities and stablilites long term. However, it doesn't include the most destabilizing factor known to the market place and that is the specialist system that runs the DJIA. These people have the ability to totally control the market place and move it as they desire to maximize their profits. If you are interested in learning how they are now manipulating the broader market place for a major decline click on to my website. Then click on free stock reports tab at the top of the home page and then click on the latest report on the DJIA issues yesterday.

It costs you nothing except the amount of time necessary to read the report and any other information you find interesting on the site.

Thank you for your time,

Richard

[adan]

besides agreeing w/gordon above re what our monies via the fed are being used for, gotta agree with your ending stmt:

"I am still a skeptic here. Until they unwind the new lending schemes, and return to a clean balance sheet, the game is not over."

what's truly sad here is the trust that's being destroyed - more and more regular people are gonna wanna opt to stay in money markets or treasuries

imagine if actual u.s. treasuries were required to be available in all 401k's....

[adan]

besides agreeing w/gordon above re what our monies via the fed are being used for, gotta agree with your ending stmt:

"I am still a skeptic here. Until they unwind the new lending schemes, and return to a clean balance sheet, the game is not over."

what's truly sad here is the trust that's being destroyed - more and more regular people are gonna wanna opt to stay in money markets or treasuries

imagine if actual u.s. treasuries were required to be available in all 401k's....

[seekfar]

"We are still waiting for the junk issuance from 2004-2006 to start defaulting in size."

David, do you have any insightful assessment of the scale and impact of those poor quality issuance?

thx

[vaduz]

all i have learned about economics - not so much financial - leads me to think, that it will be shown that we are in a correction of a longer bear market. maybe we have to wait until the reporting season 2 qua.

[Gaucho]

WE ARE IN A RECESSION web site shadow statistics has inflation at 8%. Back that out of growth and you have negative growth rates. Volker has ststed that he thinks the inflation rates are already above 10%. Bush and his buddies are lying AGAIN. Don't drink that koolaid or you portfolio will die after the election