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Front-Running a Fed Hike

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Last week markets generally began to price in greater Fed hiking during 2010

The December 2010, 3-mo, Eurodollar futures contract sold off 25bp, from a yield of 1.12% to 1.37%. The 2yr Treasury yield rose 15bp from 0.6791% to 0.8538%. And the US dollar rallied broadly, with the DXY index rallying to its highest weekly close since the week ended Nov3. These market reactions derived from a confluence of data reports and Fedspeak.

 

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Much of the data showed unexpected strength

 

The biggest influence was the better than expected prints in both the non-farms and unemployment reports

Non-farm payrolls fell only 11K, while unemployment dropped to 0.2ppts to 10.0%. There were no obvious signs of distortions that often allow economists to discount aberrational prints. Other strong data during the weak supported the move in expectations for the Fed.

 

Regional activity indicators showed unexpected strength

Chicago PMI for Nov, which unexpectedly rose to 56.1, a high since Aug’08. The Milwaukee NAPM jumped from 50 to 57.0, near the highs since Jan’08. The Dallas Fed manufacturing survey rose 0.3% (consensus unchanged), a high since Oct’07.

 

Housing showed unexpected strength

Construction spending for Oct avoided the expected 0.5% decline, instead holding at unchanged, while pending home sales unexpectedly surged 3.7%m/m (consensus -1.0%).

 

Vehicle sales jumped even more than expected

Total vehicle sales increased from 10.45m to 10.92m (consensus 10.5m), while domestic vehicle sales surged from 7.94m to 8.36m (consensus 7.8m). Both readings remain weak (lows since the early-‘80s, but for recent months), but they do indicate that the market for vehicles is rising and not merely stagnating at the lows of 2009.

 

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Fedspeak also led markets to expect earlier hiking

 

The Beige Book boosted hopes that the US economy is recovering and that the global economic recovery will rise into a self-sustaining mode. The report’s summary noted a general improvement in economic activity and that consumer spending had picked up moderately while manufacturing activity was steady to moderately improved.

 

James Bullard, President of the St. Louis Fed, has shifted his rhetoric. This past week, he stated that the potential for a jobless recovery could increase the Fed’s willingness to hike despite high unemployment. He also suggested that the increasing destructiveness of asset market volatility suggested that the Fed should take asset prices more into consideration going forward.

 

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Reasons to not believe the markets should be pricing in Fed hikes. The Great Deleveraging continues.

 

The Beige Book was not uniformly optimistic

Despite the generalized sense of recovery, the report presented a lot of qualifications. Most districts reported house prices continued to fall, commercial real estate remained not only weak, but continued to deteriorate, and financial institutions reported declining loan demand, tightening lending standards, and deteriorating loan quality.

 

Despite regional gains in activity, the national ISMs both dropped

The manufacturing ISM dropped more than expected, from 55.7 to 53.6 (consensus 55.0), suggesting that a peak in the recovery’s momentum had been reached. The services ISM report was even more worrisome, with the print unexpectedly falling from 50.6 to 48.7 (consensus 51.5), a level consistent with those during most of not only 2008, but also the 2001 recession.

 

Employment gains likely to be significantly artificial and temporary – but unemployment will remain high

One theory regarding the better than expected prints for unemployment and non-farm payrolls was that the seasonal factors have been distorted by the hellacious and historic job shedding that occurred between Oct’08 and Jun’09. During eight months of this nine month period, job losses exceeded 380K, a level exceeded only three prior times since 1960. As the seasonals attempt to digest these aberrations, they will distort future payrolls figures. A second development that will distort the employment picture is the temporary hiring of 1.5m people to conduct the decennial census. Hiring is likely to begin in Q1’10 and boost the employment picture at least through Q1 and maybe into Q2 of 2010. However, the effect of both these factors suggests that the employment picture could worsen again around mid-year 2010.

 

Separately, policy leaders have warned repeatedly that unemployment will remain higher for longer in coming years. Note that the average length of unemployment has risen to 28.5 weeks, a record. The previous cyclical high in data back to 1948 was 21.2 weeks in July 1983. One reason for the persistence of unemployment is that the asset bubbles in real estate and financial securitization have led to massive, structural misallocation of human resources. A second reason for the persistent unemployment is that the US auto sector is dying despite (or because of) the best efforts to keep union members employed even as foreign manufacturers gain market share with cheaper labor inputs. The creation of not only new business opportunities, but also the retraining of unemployed individuals will take quarters, if not years, to develop.

 

US homeowners still in trouble

The Treasury Department has conceded that the Home Affordable Modification Program has failed, largely because of a lack of interest on the part of banks. Laurie Goodman of Amherst Securities Group found that 70% of loan modifications involving only interest rate reductions, rather than principal reductions, have failed after 12 months. At the end of Sep a record 14.4% of borrowers were either in default of foreclosures.

 

US banks still weak – and so is lending

The FDIC closed another 6 banks closed this weekend, including AmTrust with $12bn in assets. The rising closures are going to put even greater pressure on the FDIC and federal government. Commercial bank loans and leases, which had risen from below $6.7tn in Oct to almost $6.8tn by mid-November, have fallen two consecutive weeks and now stand at $6.764tn, near the level in place in Dec’07. For all the stimulus and bailouts, the blood supply, credit, is not getting to the body, or real economy.

 

Japan to sell US Treasuries?
During the week, the market was spooked by a rumor that the Japanese, who own the second highest concentration of US Treasuries ($751bn of the $3.5tn held by foreign entities), might be looking to sell US Treasuries. The rumors were eventually discarded as hogwash. However, when considering the plight of the Japanese fiscal situation, perhaps the rumors do not constitute an impossibility. The Japanese have exhausted their domestic marketplace for JGB issuance and are having to turn to the international markets at the same time as other countries. It is realistically more palatable to simply raise cash needed for fiscal stimulus by selling their “savings” (holdings) of US Treasuries rather than wade into an unfriendly market place.

 

And the threat of an international credit crunch continues to loom

Chancellor Merkel warned in her weekly radio address that German is "in a very critical situation" and needed to make plans to head off a credit crunch. Political, industrial and banking leaders met to put together an emergency plan. The IFO report revealed severely tightening lending conditions in Germany, and German leaders fear that more stringent G20 capital requirements for banks being proposed will exacerbate the issue. Private lending had fallen 0.8%y/y in October, while M3 has been declining since April.

 

And Germany is not alone, as S&P issued a report stating that European companies faced a $1.5tn funding shortfall next year as central banks withdraw liquidity at the same time that governments compete for additional private funding. The report forecast that while as many as 75 large companies could be forced into default, the crunch would prove much harsher for smaller entities.

 

Finally, Morgan Stanley warned that the UK might become the first major country to suffer a full-blown debt crisis, as early as 2010. The US investment bank warned that the UK could suffer a loss of the country's AAA status. The crisis would stem from the toxic debt owned by the banking system as well as the government's budget deficit. It could cause bond yields to jump 150bp, the currency to drop 10% and the BoE to raise rates to put a floor under the currency, risking a double dip recession.

 

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The bottom line is that both the US and global economies continue to recover only with massive, indeed historic, support from governments, including low interest rates. And the governments are approaching limits regarding market and voter willingness to accept ongoing fiscal spending programs, even though the banking system remains weighed down by non-performing loans and toxic assets. Any belief that economies are actually functioning on their own strength is delusional, and premature Fed hikes will present the US with a rerun of the 1937 hard landing.



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