macroblog

The World According To Goldman Sachs (And Almost Everyone Else)

From my email, "A Tale of Two Tail Risks," from Goldman Sachs' Michael Vaknin:

• Sub-prime mortgage woes still hold centre-stage as housing fundamentals deteriorate further.
• A full-blown spillover from credit markets to other asset classes is unlikely as corporate sector and global macro fundamentals remain strong.
• Rather, credit market will feature less leverage, more convents, elevated volatility and gradual supply absorption.
• Upward risks to global inflation also remain high on the list of what investors worry about currently.
• On our baseline case, prudent monetary policy should limit a build-up of inflationary pressures.

Some details:

From a fundamental standpoint, there are two conflicting forces to consider. First, the ongoing deterioration in the residential housing market will continue to weigh on the mortgage market. Recent housing market data point to further inventory accumulation, while price indicators suggest the deceleration in house prices has gained more traction recently. The Case-Shiller 10- and 20-city composite indexes have declined sharply in April (7?% on annualized basis). The resulting decline in housing equity, along with the recent widening of mortgage rates and tightening of contractual mortgage conditions are all likely to keep credit investors on high alert.

On the bright side, corporate fundamentals remain fairly robust. Corporate default fundamentals are in good health, and from a macro perspective, corporate earnings are still supported by broadly favourable global demand conditions. While measures of industrial activity (including our Global Leading Indicator) have been somewhat softer than expected recently, from a level perspective the global manufacturing cycle remains comparatively strong, and a more broad-based weakness in the data is needed to shift this perception. Today's US ISM and the upcoming US payroll data are highly important in this respect.

That ISM report was, of course, a good one, although today's news on pending home sales failed to break the string of lousy housing data and factory orders for May were primarily lauded for being less bad than expected.  But put it together and the consensus seems to be that it all adds up to the Goldman Sachs story.  That's what came through in yesterday's round-up of forecasts from the Wall Street Journal, and the story that we're sticking to appeared again today in Bloomberg's coverage of the housing sales and orders reports:

Economists and the Federal Reserve predict growth will accelerate from its first quarter pace, the weakest since 2002, even as housing remains a burden. Fed Chairman Ben S. Bernanke said last month there was no sign of "major spillovers'' from the housing slide. Industry reports for June show manufacturers are raising production as businesses spend on investment.

"The second half is coming together almost perfectly according to the Fed's plan,'' said Mark Vitner, senior economist at Wachovia Corp. in Charlotte, North Carolina. "Housing is going to be a drag but if we get some strength in business spending then the economy will be able to handle it.''

Though some of the forecasters in that Wall Street Journal survey -- about 20 percent --- put inflationary risks at the top of their wish-not list, GS's Vaknin wants to ease their minds:

As global activity continues to grow at an above-trend rate and commodity prices remain elevated, a re-acceleration in consumer price inflation, particularly in the major markets, remains a clear risk to the outlook for financial asset returns. Consider that, on a year-on-year basis, headline inflation in advanced economies has accelerated from 1.7% in Q4:06 to around 2.0% currently, driven largely by higher food and energy prices. Such acceleration comes on the back of extended tightness in production capacity: According to the OECD, the output gap in this group of countries is about to move into a positive territory by year-end after hovering in negative levels since mid-2001.

Despite these seemingly worrying observations, we that think inflation, particularly in the G-7, should accelerate only moderately before stabilizing at benign levels early next year. Granted, elevated food and energy prices may keep headline inflation above core measures for a bit longer. But this should be seen in the context of two important developments: (1) US core inflation is on a genuine deceleration path, and (2) Monetary policy stance remains prudent in other major economies where upside inflation risks are clearly higher.

The "monetary policy stance" is key, and it probably explains why so many commentators are taking their predictions of a policy-rate cut off the table for the time being.

What's That Unpleasant Sound?

According to Lombard Street Research, it's a credit crunch.  From the U.K. Telegraph (hat tip, Action Economics):

The United States faces a severe credit crunch as mounting losses on risky forms of debt catch up with the banks and force them to curb lending and call in existing loans, according to a report by Lombard Street Research.

The group said the fast-moving crisis at two Bear Stearns hedge funds had exposed the underlying rot in the US sub-prime mortgage market, and the vast nexus of collateralised debt obligations known as CDOs.

"Excess liquidity in the global system will be slashed," it said. "Banks' capital is about to be decimated, which will require calling in a swathe of loans. This is going to aggravate the US hard landing."...

Lombard Street’s warning comes as fresh data from the US National Association of Realtors shows that the glut of unsold homes reached a record of 8.9 months supply in May. Sales of existing homes slid to an annual rate of 5.99m.

The median price fell for the 10th month in a row to $223,700, down almost 14pc from its peak in April 2006. This is the steepest drop since the 1930s.

The Mortgage Lender Implode-Meter that tracks the US housing markets claims that 86 major lenders have gone bankrupt or shut their doors since the crash began.

The latest are Aegis Lending, Oak Street Mortgage and The Mortgage Warehouse.

It is worth noting that those are specifically mortgage-lending corporations not commercial banks, so I am not clear on the basis of this claim:

Lombard Street said the Bear Stearns fiasco was the tip of the iceberg. The greatest risk lies in the “toxic tranches” of lower grade securities held by the banks.

Much-trumpeted claims that banks had shifted off the riskiest credit exposure on to the asset markets was “largely a fiction”, said [Charles Dumas, the group's global strategist].

In fact, the article contains more assertions than facts.  But I think it is agreed that if there is going to be a really big spillover effect from ongoing housing woes, this is where we'll find it.   

Still The Place To Run

Just when you think you have it figured out.  From Bloomberg:

Treasurys rallied Wednesday, after recent sell-offs in bond prices sent the benchmark yield to a five-year high, attracting money from investors amid speculation the economy will continue to grow at moderate levels.

The buying spree occurred despite news of a jump in May retail sales, higher- than-expected import prices and a Federal Reserve Beige Book survey of regional economies that depicted an economy with tame inflation and moderate growth.

One explanation for the sudden reversal in the Treasury-yield trend is that there is no explanation required: On a day-to-day basis asset prices rise and asset prices fall.  Unless you are one of the relatively few who makes his or her fortune vacuuming up the arbitrage pennies, it really is of no consequence.  Still, it's fun (if not particularly productive) to speculate.  One line of argument might be that the strong retail sales were really not quite as strong as they seem.  From the Wall Street Journal Online:

We do not advise looking at either the very weak April or the robust May result alone, as neither is an accurate representation of underlying consumer spending… While May saw a bounce, the two months together don’t paint a particularly ebullient picture, particularly when looked at excluding large, price-related gains in gasoline purchases. –Joshua Shapiro, MFR, Inc.

But if you don't like that one, the Bloomberg article has plenty more:

"There are lots of rumors out there" to explain the unexpected rally, said T.J. Marta, fixed income strategist at RBC Capital Markets. "Our rumor is that there was a huge purchase of 30-year notes by an Asian buyer."

After the purchase "a sheep-like mentality" set in, inspiring more buyers to return to the market, Marta said...

Kim Rupert, fixed-income strategist at Action Economics, attributed the day's gains to "an oversold condition."

"We've come a long way in a short time," she said.

Renewed concerns about the deteriorating subprime mortgage market may have spurred some safe-haven buying. BusinessWeek online Wednesday reported that a 10-month-old Bear Stearns Companies Inc. (BSC) hedge fund is down 23% for the year largely due to subprime problems.

That last one is the one that catches my eye, as it reflects a point that seems to prove itself over and over again: When the players get nervous, it's still to the U.S. Treasury market they run.

What's Going On?

Geez, I leave the country and look what happens.  From the Financial Times:

The benign credit conditions that have helped fuel the global buyout boom came under threat on Thursday as the yield on 10-year US government bonds registered its biggest daily jump in years...

The yield on the 10-year US government note hit 5.14 per cent in New York trading, marking the biggest one-day advance in several years, before settling back to 5.10 per cent. That brought 10-year yields above those on shorter-term Treasuries, restoring a more normal – that is, “steeper” – yield curve.

If you were wondering why, the FT article provides some hints:

... yields on US, European and Japanese government bonds have been climbing for a month, fuelled by strong economic data and, in places, fear of inflation.

The inflation theme got some play this week in the Wall Street Journal (page A1 in the June 6 print edition):

For the past decade, low-priced labor from China, India and Eastern Europe has helped much of the world enjoy economic growth without the sting of inflation. Now that damper on prices is beginning to reverse -- and global inflation pressure is starting to build.

Hmm.  A few years back, the New York Fed's Jonathon McCarthy had a look at the impact of import prices on a country's inflation rate.  Here's what he found:

The response of consumer prices to an import price shock is also positive and usually statistically significant, although smaller than the PPI response (Figure 6). In absolute terms, the pass-through is largest in Sweden, quite large in the US, and small in Japan.

That sounds promising, but when Jonathon looked a little further he found this:

... despite the appreciation of the US dollar and the decline in import prices, these factors had little effect on the US disinflation once the oil price decline is taken into account.  Domestic price shocks also were a disinflationary factor in most of these countries...

Furthermore:

[we investigate] whether pass-through to domestic inflation may have changed. When discussing the influence of exchange rates and import prices on domestic inflation,some analysts point to greater global integration as a reason for a greater pass-through of these factors... They suggest that exchange rates and importprices have not assumed a bigger role in domestic consumer price inflation in recent years, and may even have had a smaller role. The conclusion that the pass-through is modest still appears to hold in this later period.

And though I only have the data through Wednesday, to my eyes the market for inflation-protected Treasury securities doesn't reveal much in the way of a jump in inflation expectations:

   

    

All this may help explain comments like this one, from the aforementioned Wall Street Journal article:

In remarks to a bankers conference in South Africa yesterday, U.S. Federal Reserve Chairman Ben Bernanke said rising Chinese domestic costs could eventually feed through to U.S. imports, but likely would only have "modest" effect.

To be sure...

Still, he reiterated that risks to moderating inflation "remain to the upside" in the U.S. because demand is high relative to capacity.

... but that is not a development that arose in the last several days.  So that leaves us to conclude that this week's run in bond yields are being "fuelled by strong economic data"?  Interesting question, but my flight back home beckons.  I'll ponder that one on my return.

Where The Risk Is

And so it appears that the moment of truth is near, when we will finally see beyond the immediate fate of the housing market and determine the magnitude of the collateral damage (no pun intended).  I think that there is a consensus that, if the worst is to come, some sort of substantial disruption to financial markets will be in the middle of it all.  Nouriel Roubini covers about every inch of territory you can on this theme, even managing to juxtapose Alan Greenspan and Ben Bernanke with foreign-policy neo-conservatives.  In somewhat more measured tones, Kash Mansori and Calculated Risk have begun to fret about the potential for spillover into the commercial banking sector.  Says Kash:

In my previous post I explained why I think that the quantity of bad mortgages in the US economy may actually be enough to significantly affect the non-performance and write-off rates for the US banking system as a whole. Yesterday, Calculated Risk followed this up with a discussion of why he thinks that the health of commercial real estate loan portfolios may soon suffer the same fate that residential loan portfolios are currently experiencing.

Some of that is not speculation, as this story from own neck of the woods so clearly shows:

The quaking U.S. market for subprime mortgage loans is rattling National City Corp. too.

The parent of National City Bank of Pennsylvania has decided it won't try to sell $1.6 billion in subprime loans after all, due to "adverse market conditions," National City said in a securities filing Thursday. The loans "are currently not saleable at what management considers an acceptable price," the bank said.

Instead, Cleveland-based National City took a write-down of $11 million in February, and sometime this month will return to its portfolio the loans it had intended to sell. "A further write-down is likely," the filing said. Spokeswoman Kristen Adams would not elaborate...

Additionally, National City expects to add "on the order of $50 million" to its reserves for possible loan losses, the filing said.

But here's how the story ends:

National City shares closed yesterday at $35.99, up 30 cents.

Hmm.  Frankly, I just don't think the traditional banking sector is where be the dragons.  Instead, I worry about the answers to three questions: 1. Will a growing perception of risk begin to choke off lending to investment projects that are otherwise economically viable?  2. Will a growing perception of risk cause businesses to forgo or defer an increasingly large quantity of investment projects?  3.  Have hedge funds, private equity funds, and specialty financial corporations become such important parts of the credit channel that there is scant relief to be found from a relatively unscathed traditional banking sector?

To question 1, we have this, from Bloomberg:

Risk premiums on investment-grade corporate bonds are at their highest level in more than three months on concern rising delinquencies by subprime borrowers will slow the U.S. economy...

"This period of volatility is likely to continue as long as there is divided opinion about the magnitude and resulting financial impact of the subprime problem,'' said Edward Marrinan, head of North American credit strategy at JPMorgan Chase & Co. in New York. "Subprime risks and accompanying fears of a spillover into the broader consumer sector are the catalysts for the heightened volatility currently exhibited by all risky asset classes,'' he said in an interview...

The 7-basis-point increase in investment-grade spreads is the index's worst three-week performance since the period ending May 20, 2005, Merrill data show. The increase means a company would pay $70,000 more in annual interest for every $100 million borrowed.

We might hold on to the belief that firms are partially insulated from rising borrowing costs (or restrictions on loan availability) due to the fact the corporate cash-flow to investment ratio remains relatively high...

   

   

... but there are two problems with seeking shelter in that picture.  First, we have data only through the third quarter of 2006, which is pretty stale information at this point.  Second, and more importantly, a high cash-flow to investment ratio may itself be a symptom of business's unwillingness to commit to fixed investment spending.

To question number 3, I have no idea what the answer is.  And I wish I did.

The Yield Curve: Still A Wild Card

Although the incoming data related to real activity in the U.S. may not prove the case against the 2007 crash-and-burn scenario, it sure is not providing much support for it.  From housing starts, to retail sales, to industrial production, you have to actually work to generate some negative spin. One should always seek perspective, of course, and there are indeed reasons to restrain your optimism.  Listen, for example, to Dean Baker:

The consensus estimate for retail sales growth in December was 0.5 percent. Naturally, people were surprised when growth was reported at 0.9 percent, as the NYT (among others) told us. Well, they really should not have been surprised, because the November numbers were revised down by 0.4 percent, which means that the December sales level was just where the consensus estimate put it.

You might make a similar case for the industrial production index, which grew more than expected in December, but was revised down (into negative growth territory) in both November and October. And you can always blame the weather for making things look too darn good.

Nonetheless, I think a fair-minded assessment -- if I may speak fair-mindedly myself -- would be "not bad."

Then there is the yield curve where, despite some recent movement, the spread between long-term and short-term interest rates remains stubbornly south of zero.  Writing in the online version of the Cleveland Fed's Economic Trends feature, Joe Haubrich and Brent Meyer review a little history, and do a little extrapolating:

The slope of the yield curve has achieved some notoriety as a simple forecaster of economic growth. The rule of thumb is that an inverted yield curve (short rates above long rates) indicates a recession in about a year, and yield curve inversions have preceded each of the last six recessions (as defined by the NBER). Very flat yield curves preceded the previous two, and there have been two notable false positives: an inversion in late 1966 and a very flat curve in late 1998. More generally, though, a flat curve indicates weak growth, and conversely, a steep curve indicates strong growth...

While such an approach predicts when growth is above or below average, it does not do so well in predicting the actual number, especially in the case of recessions. Thus, it is sometimes preferable to focus on using the yield curve to predict a discrete event: whether or not the economy is in recession. Looking at that relationship, the expected chance of a recession in the next year is 43%.

Not everyone is convinced, of course, but right now it looks to me to be the bears' strongest suit.

The FOMC Minutes Were Hawkish... er, Dovish... er, What?

There was one slant at FX Daily...

With investors honing in on the Fed’s repeated warnings of a slowing economy, the factory report is becoming a key element in the effort to turn group dovish. When the ISM rebounded in positive territory, rate cut expectations were quickly pared back. On the other hand, a forecasted cut will not be lifted by one indicator. This was evident by the unusual rise in T-notes after a decidedly hawkish FOMC minutes.

... another at MarketWatch...

U.S. Treasurys closed higher Wednesday, sending yields lower, after two reports pointed to weaker employment in December while the minutes from the latest Federal Open Market Committee meeting showed that U.S. central bankers were caught off-guard by the extent of economic slowing.

... a yawn at FXStreet.com...

FOMC minutes do not reveal anything significant – but there have been new inflation developments since Dec 12.

... and the same in the market for options on federal funds futures:

   

   

So the consensus remains that there will be no change in monetary policy through May?  Not necessarily, as I explain at the Cleveland Fed website.

Is Monetarism Dead?

Courtesy of Mark Thoma, I am sent to the Scientific American blog, where JR Minkel ruminates on the contributions of Milton Friedman, asking the question "Is economics a science?".  Minkel offers up the question in the spirit of open debate, so fair enough.  I did, however, find this passage somewhat puzzling:

Well, Friedman's most famous prediction was a pretty good one: he foresaw the possibility that high unemployment could accompany high inflation, a phenomenon better known as stagflation. That foretelling earned him the Nobel Memorial Prize, although Friedman's monetary theory is currently out of favor.

A similar sentiment is expressed by the eminent historian Niall Ferguson, in an article titled "Friedman is dead, monetarism is dead, but what about inflation?"

It wasn't just that Friedman rehabilitated the quantity theory of money. It was his emphasis on people's expectations that was the key; for that was what translated monetary expansion into higher prices (with positive effects on employment and incomes lasting only as long as it took people to wise up)...

... it will be for monetarism — the principle that inflation could be defeated only by targeting the growth of the money supply and thereby changing expectations — that Friedman will be best remembered.

Why then has this, his most important idea, ceased to be honoured, even in the breach? Friedman outlived Keynes by half a century. But the same cannot be said for their respective theories. Keynesianism survived its inventor for at least three decades. Monetarism, by contrast, predeceased Milton Friedman by nearly two.

The claim that "Friedman's monetary theory is currently out of favor" is, I think, wildly overstated -- at best.  Pick up virtually any textbook in monetary or macroeconomics and what you will find is a presentation that it is fully steeped in Professor Friedman's justly famous "The Quantity Theory of Money: A Restatement."  In simple terms, the quantity theory says something like this:  Inflation results from an excess of money growth over the amount of money that people want (expressed in terms of money's purchasing power over goods and services). If you have taken a course in macroeconomics, or money and banking, that is probably what you learned, and it was bequeathed to you by Milton Friedman. 

So why the belief Friedman's views have fallen into disrepute?  I think it is a result of two things that, in the end, have little to do with whether Friedman's version of the quantity theory remains the dominant intellectual tradition among macroeconomists. 

First, there is the association of Friedman's oft-cited constant money growth rule with the broader quantity-theoretic logic.  Part of the rationale for the constant money growth rule had to do with specific assumptions that Friedman invoked regarding money demand -- the assumption, specifically, that changes in money demand not associated with income growth tend to be relatively slow and predictable.  Part of it had to do with his judgment that the control needed to successfully "fine tune" the economy far exceeds the capacity of mortal men and women.  These elements are not, however, essential to the quantity theory itself. Not accepting Friedman's views on these matters is very much different than rejecting the general quantity theory framework or its core implication that inflation is, in the end, a monetary phenomenon.

Second, there is the fact that monetary aggregates are themselves little used in the practical implementation of monetary policy.  An exception, of course, is the European Central Bank, which still claims fealty to the notion that growth in monetary aggregates is a legitimate guide to policy choices.  But, as William Keegan reports in the Guardian Unlimited, even that pillar of monetary policy may be "tottering":

The two elements became known as the 'two pillars' of the ECB's approach - an approach which seems to give too much influence to changes in the money supply (the 'second pillar'), which most economists now believe to be unreliable guides to the kind of short-term changes in the economy that concern central banks when they take their decisions about rates.

Sensitive to such criticisms, the ECB held a conference in Frankfurt 10 days ago, and its subject was 'The role of money: money and monetary policy in the 21st century'. Guests included a glittering array of central bankers, including Ben Bernanke, Alan Greenspan's successor as chairman of the US Federal Reserve, many distinguished academic economists, and a few journalists such as myself.

Bernanke and most of the academics gave short shrift to the importance of the 'second pillar', with varying degrees of politeness. Trichet delivered a spirited defence of the ECB's approach, as did Otmar Issing, the embodiment of the second pillar, who recently retired from being the highly influential chief economist of the ECB.

The tone of the conference was so one sided - that is, against the message of the hosts - that a conspiracy theory developed about this being the last stand of the monetarist-inclined ECB, and that they had invited hostile academics to give them an excuse to get off the hook, rather in the way that organisations employ management consultants to advise them to make changes they wish to make anyway.

Central banks these days do tend to conduct monetary policy with reference to interest rates rather than monetary growth.  But choosing a target for an overnight bank lending rate -- like the federal funds rate -- is implicitly about choosing a path for money growth.  Once an interest path is chosen, money growth follows automatically, and is in that sense invisible (or, mathematically, redundant).  That does not, however, mean that the insights of the quantity theory are obsolete.  That central bank practice has evolved toward a focus on a price (the short-term interest rate) rather than a quantity (money growth) says more about our confidence in the measurement of money than it does about our confidence in the theory that inflation has its roots in money growth (a theme that is expanded on, at length, in an essay in Federal Reserve Bank of Cleveland's 2001 annual report.)

It is true that recent influential ideas about inflation and central banking have incorporated the existence of "cashless" economies, which would indeed move us outside of the reach of the quantity theory.  But those ideas contemplate the control of inflation in a hypothetical world (asking, for example, whether rules that work well in a monetary economy might work equally well in a non-monetary economy).  That alone does not invalidate quantity-theoretic reasoning.  What is more, justifying some aspects of central bank behavior -- the desire to avoid sharp movements in interest rates, for example -- seems to require the existence of money, and in an entirely conventional way.  Which is to say, in more or less the fashion handed down by Milton Friedman. 

Up to the very end -- hat tip, again, to Mark Thoma -- Professor Friedman was explaining why money matters.  How appropriate.  Although many these days would be less enthusisatic than he about emphasizing a particular measure of money, his ideas about money are as vital to the core of monetary policy reasoning as they ever were. 

The king is dead. Long live his kingdom.      

Yuan Wildcard

Today, from MarketWatch:

Long-term mortgage rates have dropped in eight of the last nine weeks to hit their lowest level since March.

Aha.  A clear signal its time to review the latest evidence that, just maybe, change is a'comin on the dollar/RMB exchange rate.  William Polley was all over the story last week, opining that it "certainly does seem reasonable for China to start widening the band" in which the RMB is allowed to trade.  Sure enough, on Sunday this was the report from the Financial Times:

China is allowing the market to play an increasing role in setting the exchange rate value of the renminbi, while weakening the influence of a reference basket of currencies, according to Zhou Xiaochuan, central bank governor...

The role of the currency basket was “gradually diminishing” in favour of market supply and demand, Mr Zhou told Caijing, according to advance copies of the magazine’s reports seen by news agencies.

Beijing has not previously given any details of how the exchange rate regime works, but analysts say the currency basket’s influence has always appeared to be minimal and that in practice authorities retain full control over the renminbi’s value. But Mr Zhou’s remarks will be seen as a signal that the central bank remains keen to allow greater moves in exchange rates and to allow the renminbi to climb further against the dollar.

You, of course, have heard this before...

Mr Zhou said Beijing was committed to moving gradually towards a more flexible exchange rate mechanism.

... but Brad Setser informs us that it ain't getting any easier:

China is (once again) tightening up its controls on capital inflows, and loosening its controls on capital outflows.  Forbes:

“The regulator has for several months been tightening up its supervision of short-term capital inflows and loosening up capital account controls on outflows as it fights off a wave of speculative funds betting on yuan appreciation.”

Those capital controls have certainly allowed the Chinese government to pursue their slow and easy approach to "a more flexible exchange rate mechanism" with great success.  The burden of proof is probably on those who might suggest that they cannot continue on.  But should it, by design or circumstance, prove otherwise, how long can those low US interest rates last?

Have Interest Rates Peaked? Part 2

From Bloomberg:

The Federal Reserve will probably lower its benchmark interest rate in the first quarter of 2007 as slowing economic growth diminishes inflation pressures, according to economists at Citigroup Inc.

The biggest U.S. bank by assets previously forecast the Fed would keep its target rate for overnight loans between banks at 5.25 percent through June. The bank now predicts a quarter-point reduction by March, with the Fed holding the rate at 5 percent through September...

Citigroup also lowered its forecast for benchmark 10-year Treasury yields to an average of 4.6 percent in the first quarter, from 4.9 percent.

The motivation for this change of heart is no mystery:

"There's softer growth, and with oil prices down and lower inflation, the Fed in a sense can follow the market's lead,'' Michael Saunders, chief Western European economist at Citigroup in London, said in an interview today. "A modest ease in rates should cushion the economy.''...

"The U.S. economy currently is in the most intense phase of its downdraft, due to plunging housing construction,'' Citigroup Global Markets analysts, including Todd Elmer in New York, wrote in a report to clients yesterday. "The cooling in demand should reduce inflation risks sufficiently to open a window for a token easing early next year.''

Also at Bloomberg, Caroline Baum says things in the housing market are even worse than you think:

For months, builder sentiment looked out of sync with the actual housing statistics. When one considers that the worst news on new home sales may not be reflected in the government data, it's easier to understand why they're so glum.

Simply put, cancellations are rising, and they aren't being captured in the aggregate statistics because of the way the survey is designed. Hence, sales are being overstated and inventories understated.

"Once a sales contract is signed, there's no way of recording the cancellation or putting the home back in inventory,'' says Dave Seiders, chief economist at the National Association of Homebuilders in Washington. "Builders keep track of gross and net sales; we don't have a net sales number from Commerce.'' ...

The effect of higher cancellations is "to overstate the overall level of sales and understate the level of inventories,'' [Joe Carson, director of global economic research at AllianceBernstein] says. The opposite is true at the bottom of the economic cycle, when sales pick up and the resold homes aren't registered as a sale or removed from the "for sale'' pile.

How bad is it?

We know from big builders that cancellation rates are rising. Seiders says the rate "has roughly doubled over the last year'' and is ``more serious at the big companies.''

Just this week, Lennar Corp., the No. 3 U.S. homebuilder, said its cancellation rate was running at more than 30 percent. Net new orders fell 5 percent in the quarter ended Aug. 31.

Cancellation rates rose to 29 percent in the April-June quarter at D.R. Horton Inc., the second-largest homebuilder, and deteriorated further in July, according to the company. That compares with an historical average rate of 16-20 percent.

And earlier this month, KB Home said net orders (an order is considered a sale) plummeted 43 percent in the three months ended Aug. 31, a rate that includes cancellations.

I'm still not sure about the macroeconomic consequences of comparisons like this...

What makes the current situation so worrisome is the "unprecedented inventory overhang, encompassing new and existing markets and many of the largest metropolitan areas,'' Carson says. "Its sheer size raises the odds that prices will fall more and longer nationwide than they did in the 1990s.''

... as I am convinced that overall conditions in financial markets are very much different today.  But I won't object to "worrisome." 

UPDATE: Dean Baker weighs in on cancellations as well:

The [new home] sales figures are also somewhat exaggerated, since there are many more cancellations now than in the past. (Cancellations are never subtracted from sales.)

Have Interest Rates Peaked?

Edward Hugh thinks so.  Though Edward notes that commentary from the ECB suggests otherwise -- an observation made about the Federal Reserve by Tim Duy -- the belief that interest rates will fall before they rise is being driven by a sense that economic growth in developed countries is slow and getting slower.  Slower economic growth means less demand for borrowing by consumers and businesses, and hence lower real (or inflation-adjusted) interest rates. And, so the story goes, as with the U.S. and Europe, so with the world.

The opinion that a nontrivial slowdown may be in full bloom is not hard to find, but in case you are looking you can start in Europe -- at Alpha.Sources-CV (here and here), at Bonobo Land, and at The Skeptical Speculator.   And don't forget the UK. 

As for the US, I could just say Nouriel Roubini and leave it at that, but if you are particularly interested in the global connections you can soak in Martin Wolf's take from Economist's View.  On the interest rate part of the scenario, here's the view from The Capital Spectator:

Let's start with the bond market, where the benchmark 10-year Treasury yield has dipped below 4.6% for the first time since February. In fact, the 10-year yield has been on a slippery slope for since July, when a 5.2% current yield prevailed early in the month. The catalyst for the decline is, of course, the ongoing stream of economic reports that show the economy is slowing. (The latest is this morning's update on new orders for durable goods, which tumbled for the second straight month in August--the first back-to-back tumble in more than two years.)

I'll tell you the truth -- that durable goods report was not to my liking, as the weakness appears to be fairly broad-based:

   

 

   

I hear you: Don't get carried away with one report.  I'm with you, but I will note that one of the keys to the whole soft-landing scenario is that capital spending will stay robust even as residential investment and, to a lesser degree, consumer spending fade.  If that doesn't happen, the arithmetic starts to get tricky, and those bets on lower interest rates may start to look pretty good.

A Hat Tip, Nothing More

I really can't add much to Jim Hamilton's wonderfully clear exposition of the yield curve, the expectations hypothesis of the term structure, and what it all might mean in the current economic environment beyond advising you to go read it.  Extra cool points are awarded for the link to the "recession predictor" at Political Calculations, an interactive program based on research by the Federal Reserve Board's Jonathon Wright that allows you to plug in relevant information about the Treasury yield curve and receive, free-of-charge, an estimate of the probability of recession arriving within in a year.  It's been around for awhile, so I somehow missed it the first time around.  To atone, you will henceforth find the path to the recession predictor in the "Useful Links" list of this weblog.

The May Inflation Report: The Buzz On OER

Several contributors to the Wall Street Journal's always interesting round-up of expert opinion took special note of the continuing contribution of owners' equivalent rent (OER) to the recent string of less-than-delightful CPI inflation reports.  High Frequency Economics' Ian Shephardson gives as nice an explanation about what it's all about since -- well, since the Cleveland Fed discussed it in this month's Economic Trends.  Explains Mr. Shephardson:

OER is being pushed up by a combination of falling rental vacancy rates and increased demand for rentals as rising short rates price people out of the home buying market. OER is also probably being pushed up by a technical quirk; it rises relative to primary rents when utility costs slow -- they have fallen for four straight months.

And why do we care?

The core was driven higher by a huge 0.6% jump in owners' equivalent rent, the biggest increase in 16 years... --Ian Shepherdson, High Frequency Economics...

Much of the recent acceleration in core inflation has been due to rapidly rising owners' equivalent rent, which in turn has been boosted by the slowing housing market … --Steven A. Wood, Insight Economics...

The rising rent dynamic that we have discussed for a while has now pushed core CPI prices up by 0.3% for two consecutive months and could continue to do so for a few more months. The core inflation numbers, therefore, are unlikely to look favorable for some time given the sticky nature of this dynamic...--Bears Stearns U.S. Economics

Some clearly view this as much ado about -- I guess something about which there should be less ado.  Again from Mr. Shephardson...

Ex-OER, core CPI rose only 0.1%. The story is one of a relative increase in rents; monetary policy is the wrong tool to deal with this.

... and from BNP Paribus Market Economics:

Excluding shelter costs, however, core CPI is scant sign of the acceleration that the Fed is finding "unwelcome." The Fed's silence on its attitude to the role that rental inflation is playing in generating this year's pick is both baffling and increasingly embarrassing ...

But our friend Barry Ritholtz warns...

While we can all agree that OER has understated inflation for about a decade, it is way premature to suggest that it is now overstating it. At worst, it is merely catching up with where it should be.

... and, in my opinion, Stephen Stanley, of RBS Greenwhich Capital, nails it...

Increases in OER can not be easily dismissed. In any case, it is pretty silly to exclude nearly 40% of the core. And even if we do, the 3-month annualized change for the core excluding rent and OER was still 2.9%, a clear acceleration from prior trends …

... with an assist from Morgan Stanley Fixed Economics:

The core PCE data released over the next couple of months might not show quite as much acceleration [as CPI numbers] -- because shelter has a much smaller weight -- but it is still likely to display some upward drift.

As, indeed, it already has.  I'm looking at the data, and, positive spin is hard to come by.

UPDATE: Steve Cecchetti adds this:

... I firmly believe  that some measure of the cost of owner-occupied housing belongs in the price index used for monetary policy purposes.  We should not just get rid of it.  Furthermore, looking at these data, there are two choices: Either the OER distorts the CPI, or it doesn't.  If it does, then along with claiming that measured inflation is currently too high, you have to accept that measured inflation from 2001 to 2004 was too low.  That is, there was never a deflation scare.  Instead, policy was much too loose following the end of the 2001 recession.  That's what I think, but I doubt that Chairman Bernanke does.

Do You Hear What I Hear?

Says John Berry to -- let me think -- nearly everyone, that would be a big no, at least when it comes to parsing what all the recent Fedspeak really means.  From his Bloomberg column today:

Every time a Federal Reserve official says that U.S. inflation in recent months is outside the "comfort zone,'' investors sell assets on the grounds rates are headed higher, perhaps much higher.

The investors ignore the fact that the officials also say pointedly that they expect economic growth to slow and inflation to subside later this year. None of the officials, from Fed Chairman Ben S. Bernanke on down, have indicated they believe a new inflationary spiral has begun.

To the contrary, many of them have explicitly said the opposite.

Need an example?  No problem.

For example, on June 12, Sandra Pianalto, president of the Cleveland Federal Reserve Bank, said in a speech in Orlando, Florida, that core consumer prices have increased ``at an annualized rate of more than 3 percent during the past three months. This inflation picture, if sustained, exceeds my comfort level.''

That part of Pianalto's remarks was one reason cited for a sharp drop in stock prices that day.

Few paid much attention to other parts of her speech that suggested strongly that she expects inflation to ease without much more action by the Fed. The current Fed target of 5 percent for the overnight lending rate is ``near a point that is consistent with a gradual improvement in the inflation outlook,'' Pianalto said.

"I expect a flattening out of energy prices, a cooling housing market, continued strong productivity growth, and a moderation in the overall pace of economic activity,'' she added.

And Berry demonstrates he is down with the blog-hood:

Economist J. Bradford DeLong of the University of California at Berkeley posted a video commentary about inflation on his Web site June 12. In it he noted that it is the Fed's job "to worry about inflation, and to say it stands ready to boost interest rates substantially should any inflationary spiral appear to start taking hold.''

With wage increases so subdued, DeLong said, the odds are "that there will be no significant uptick in inflation and no significant increases in interest rates from now forward to the end of the business cycle.''

Would that the markets could accept that quite reasonable forecast.

Whatever forecast markets are accepting, it seems to be having the desired effect.  From Monday's Wall Street Journal (page A2 of the print edition):

Inflation expectations have become increasingly important to monetary policy in recent years. When people anticipate a rising inflation rate, the prevailing theory goes, they are likely to behave in ways that will bring about higher prices. If workers anticipate a robust inflation rate in a year's time, they will be more likely to push for higher wages now. If businesses expect higher inflation, they will be more likely to increase prices sooner.

Preventing this kind of inflationary spiral is what Fed Chairman Ben Bernanke had in mind last week when he said the central bank will be "vigilant" in combating the recent upward trend in prices.

I added the emphasis.  The article continues:

Another measure of expectations comes from the minute-to-minute trading in the bond market, where investors can choose between ordinary Treasury securities, which pay a fixed interest rate, and Treasury Inflation-Protected Securities, which guarantee a return above the prevailing inflation rate. Comparing the yields on the two securities gives one measure of how much investors think prices are expected to climb. The wider the spread, the higher the expected inflation rate...

In a development that surely pleased Mr. Bernanke and his colleagues, the tough talk had the desired effect. The spread between standard and inflation-indexed Treasury bonds retreated to below 2.5 percentage points last week, a victory, perhaps only temporary, in the Fed's battle to "anchor" inflation expectations

There are, of course, two key questions raised by this observation.  First, are those improvements a result of John Berry's and Brad DeLong's "reasonable forecast" or a result of, and contingent upon, the belief that more rate hikes are a'coming.  Second, will those improvements survive this week's inflation statistics.

UPDATE: Mark Thoma suggests expectations themselves work against a pause, even if their heart of hearts policymakers would prefer a pause.  Stumbling and Mumbling questions whether this is a sensible way to run monetary policy.

We'll know the answer to that second question real soon. 

Poole (And Haubrich) On The Yield Curve

Federal Reserve Bank of St. Louis president William Poole weighed in today on whether we should care about the spread between long-term and short-term interest rates and, if so, why?  If you are new to the topic it is a nice enough introduction, but there is also plenty there for people who have thinking about the topic for awhile.  What I found interesting was his take on why the yield curve -- yield curve "inversions" in particular -- may have been more informative back in the day:

Many of the inversions of the yield curve starting in the 1960s occurred under the old deposit interest rate ceilings established under Regulation Q. The ceiling on the deposit rate led to “disintermediation” from the banking system when monetary policy tightened and increased the responsiveness of the quantity of money inside the banking system to Federal Reserve policy actions. However, there was no inversion associated with the recessions of 1957-58 and 1960-61. Before the mid 1960s, the Fed adjusted Regulation Q interest ceilings in a fashion timely enough to prevent significant disintermediation.

In an environment of slow adjustment of Reg Q ceilings, when the Fed stepped on the monetary brakes, bank credit became tight and the real short-term interest rate quickly rose well above its equilibrium level. Because the market anticipated that the monetary brakes would be loosened within a relatively short time frame, long-term interest rates rose by a much smaller amount, and the yield curve inverted temporarily. It was during this era that yield-curve inversions came to carry negative business-cycle connotations. All too often, the clampdown on credit was severe enough to be associated with a recession but not steadfast enough to bring about lasting disinflation.

In a recent Cleveland Fed Economic Commentary, my colleague Joe Haubrich offered a different, though perhaps complementary, explanation for why the predictive power of the yield curve may have faded over time:

... a more credible regime means less persistent inflation: The Fed stops inflation quickly once it starts, and so inflation is only temporarily high. In a less credible regime, once high inflation begins, it stays around, and the monetary authority does little or nothing to stop it.

In the case of the less credible regime, inflation shocks will tend to shift up both short- and long-term interest rates, as inflation feeds through to both. Thus, with persistent inflation, nominal shocks don’t shift the yield curve’s slope very much—both long and short rates move together. Now suppose that these inflationary expectations aren’t the part of the yield curve that predicts real activity. That is, the real part of the yield curve, interest rates adjusted for inflation, is what predicts real activity. Then, under a less credible regime, nominal shocks don’t distort the curvature of the yield spread, and inversions can signal recessions.

Under a credible regime, with low persistence of inflation, it is a different matter. In this case, an inflation shock will increase short rates, but not long rates, because long-term expectations of inflation don’t change. Thus a nominal shock twists the yield curve, distorting the message of the underlying real curve. This pattern seems to hold—at least for the United States; times of high inflation persistence are also times when the yield curve predicts well. In times of low persistence (like in the present, credible regime), the yield curve does less well.

Poole concludes that any present concerns about the short-term/long-term spread are much ado about not much:

I must say that I’ve been a bit puzzled by the inversion/recession talk that began last fall. As already noted, the spread between the 10-year bond and the fed funds never became negative last fall and still isn’t. Yet, inversions associated with recessions have been quite large... looking back at 1980-82 experience makes clear that simply counting presumed patterns in the data, without guidance from economic theory, is not a wise strategy. The early 1980s were so different from today’s conditions in so many respects that the experience of twin recessions in a high inflation era has little bearing on understanding the term structure today.

Joe, I would guess, doesn't disagree all that much, but does suggest we not entirely discount the yield curve's history:

Using the yield curve remains an exercise in judgment that requires balancing the long, successful history of the yield curve’s predictive power with some recent evidence of its fading foresight. It also requires judgment because predictions of real activity represent only one facet of the problem facing the FOMC: Inflation is the other. Still, as the Committee becomes more familiar with the risk-management approach to policymaking, it seems that the signal from the yield curve deserves some weight.

Mr. Greenspan And The IMF Find Common Ground?

Mark Thoma reports...

Greenspan warns on global asset price fall, Financial Times/Reuters: Former Federal Reserve Chairman Alan Greenspan warned on Wednesday a global glut in liquidity would result in a fall in asset prices.

... while Kash has this at Angry Bear:

WASHINGTON (MarketWatch) -- After several years of low interest rates and ample liquidity, storm clouds are developing over global financial markets, according to a new report from the International Monetary Fund.

Well, by definition higher interest rates mean lower bond prices, and I guess the idea is that, because an equity price is something like the discounted flow of future dividends, higher interest rates mean lower equity prices too.

Is this bad?  Before you answer that question, the first thing to recognize is that interest rates are prices, and prices don't just magically change -- they rise or fall because demand and/or supply change.  If interest rates are rising because global economic growth is strengthening and investment opportunities expanding, I'll have to put that in the good, or at least benign, category. (And note that higher interest rates do not mean that equity prices fall -- while higher interest rates mean a larger discount is applied to dividend or earnings flows, it is also the case that faster growth means those flows themselves increase.)

On the other hand, interest rates may rise, particularly in the United States, because global savers lose confidence in the dollar, or financial fragilities cause global production opportunities to contract.  I'll put those types of rate increases in the bad, or at least not-so-good, category.

If I had to guess, I would put Mr. Greenspan closer to the good-to-benign story.  From the (UK) Times Online:

Mr Greenspan said that the situation would end when the amount of excess capital dropped. “I don’t know when the liquidity is going to decline, but I am reasonably confident that what we have is an abnormal situation,” he said. His comments echoed his famous 1996 warning over “irrational exuberance” in markets. However, asked yesterday whether the same diagnosis applied to present conditions, he said: “I would hesitate to use it in today’s context. Irrational exuberance, I think, would be a stretch at this point.”

Comparing that savings-gluttish take with the "storm clouds" rhetoric of the IMF, I'm not quite sure Mr. G and the good folks at the IMF see quite the same picture just yet.

UPDATE: Kash suggests, in the here and now (as the 10-year Treasury yield finally breaches the 5 percent threshold), the "rise in rates reflects a belief that the economy will continue to remain strong through the rest of the year."

How The Funds Rate Works

Caroline Baum has a nice explanation:

The relevance of the funds rate, at which banks borrow from one another for last-minute funding needs or to satisfy their reserve requirements, has nothing to do with the volume of transactions at that rate. Its importance lies in what it says about the thrust of monetary policy or, to put it another way, about the impetus for the central bank to create money.         

When the funds rate is significantly below the long-term rate, the Fed has to create excess money to keep it there. Otherwise, it would rise in response to the same forces -- supply and demand -- pushing up long rates.         

Alternatively, when the short rate is above the long rate, the central bank has to withdraw liquidity from the banking system to keep the funds rate from following long rates down.         

That's as succinct an exposition as you are likely to find about why some of us worry about flat yield curves.  The rest of the column is a little more confusing, as Ms. Baum takes issue with this:

The notion that the funds rate is inconsequential always gains popular appeal at a time when the Fed is embarked on a series of interest-rate changes, the results of which have yet to manifest themselves. The leading purveyors of that idea are the keepers of the flame.         

Fed Chairman Bernanke pretty much summed up the official party line in a March 30, 2005, speech, when he was one of seven governors on the board. The Fed has "no direct control over the key interest rates and asset prices that jointly determine the extent of financial stimulus,'' Bernanke said. Instead, policy makers are stuck setting "an otherwise obscure short-term interest rate, the federal funds rate.''         

If, as Bernanke said, "Monetary policy is effective only to the extent that Federal Reserve actions can affect a wide range of interest rates and asset prices,'' why choose such a lowly instrument for the policy rate? Why not choose the rate that matters?       

I think it incorrect to read the Chairman's remarks as suggesting "the funds rate is inconsequential."  The point is that monetary policy operates through an indirect channel that can involve short-run changes in real economic activity, longer-run effects on the rate of inflation, and movements in expectations about both.  It is indeed long-term interest rates that matter most, but they have a complicated life, influenced by every conceivable change in the economic environment.   Monetary policy is but one piece of the puzzle.  Just ask Jim Hamilton.

Odds And Ends

Another quarter begins at the University of Chicago Graduate School of Business, and I have once again cleverly fallen behind on my reading, giving me the excuse to introduce some of my favorite weblogs to new students, via this review of things I should have talked about last week.

First things first, the week ended with economic news that was mixed, at best. Kash at Angry Bear reads the durable goods reports and concludes (fairly, I think) that business investment spending is still short of spectacular.  On the other hand, at The Nattering Naybob Chronicles, Mr. Naybob is able to look on the bright side: "Both [the durable goods and house sales] reports eased inflation fears and bond yield dropped."

With respect to the real estate news, Calculated Risk, a consistently fine go-to source on the housing market, has the latest on home mortgage applications (down slightly), existing home sales (up, but perhaps not the best indicator),  and new home sales (a better indicator, and coming in "very weak".) CR also has a handy chart, mapping the pattern of home sales in recessions.  At the Big Picture, Barry Ritholtz opines: "The [Real Estate] market has dropped from white hot to red hot to mid-plateau."  Calculated Risk says   "The sky may not be falling, but... housing sales are clearly trending down."  Captain Capitalism, however, is not cheered by that prognosis, and Michael Shedlock pores over the Calculated Risk pictures, to find that his disposition is soured as well.  ElectEcon finds a prediction that things are going to get ugly fast. 

For those who simply must have more housing indicators to watch, Daniel Gross bears good news, from Standard & Poor's.  For those who just can't get enough detail on economic data period, Mark Thoma has more at Economist's View.

Speaking of data, a nice summary of U.S. wealth as reported in the Federal Reserve's Flow of Funds can be found at Angry Bear. (Although I don't necessarily endorse the conclusions, you might also enjoy the pictures provided at Economic Dreams - Economic Nightmares.)

Last week I (sort of) came to the rescue of the Consumer Price Index.  Barry Ritholtz (again) counter punches, with a Wall Street Journal survey of readers indicating the vast majority don't think very highly of the Consumer Price Index, but Russell Roberts effectively (in my view) defends the beleaguered index, at Cafe Hayek.

Also in the inflation vein, Mark Thoma follows up my post on the relationship between the CPI and the PPI with some work of his own -- broadly illustrating the point of the research I was citing.

Mark also relays the crux of Federal Reserve Chairman Ben Bernanke's speech on the yield curve.  Meanwhile, the inverted yield curve watch continues, at The Capital Spectator.

Shifting to the fiscal side of the government house, Kash breaks down the sources of federal spending growth in the United States over the past five years.  The guys at Angry Bear have had several useful, even if a bit partisan, posts on the subject in the recent past -- here, here, here, here, and here.  Gary Becker and Richard Posner provide some much needed perspective on how to think about the build-up in defense spending. 

In other legislative news, Andrew Chamberlain at Tax Policy Blog indicates that tax reform may not be dead just yet (good), and at Vox Baby, Andrew Samwick reports on the progress of pension reform (decidedly not good).

David Weman at A Few Euros More gives us the heads up on an item (from the Guardian Unlimited (U.K.) blog) bemoaning the rising tide of protectionism (among countries, including the U.S., that really ought to know better).  The Skeptical Speculator concurs that "protectionism looms." Asia Pundit reminds us that, in the United States, the impulse is bipartisan (and Sun Bin channels Stephen Roach's comments on the subject). William Polley deems it "Nothing if not predictable." Mark Thoma provides an extended commentary from the Financial Times on the dangers of "Dobbism" (as in Lou).  Daniel Drezner, however, has better news. Brad DeLong takes notice of a Alan Blinder's sometimes less charitable view of trade and globalization, to which Arnold Kling replies -- here and here.

Steve Antler (of EconoPundit) makes the connection from trade protectionism to immigration reform.   Russell Roberts is even less tolerant of the anti-immigration argument.  So is Arnold Kling (at EconLog).  EurActiv reports on how the EU is attempting to deal with its own immigration questions. The New Economist provides a glimpse of research suggesting that outsourcing explains about 28 percent of the growth in the wage gap between high- and low-skilled labor between 1980 and 1999.

Continuing with the international theme, Brad Setser thinks both sides are at fault in the ongoing tensions over Chinese exchange rate policies.  He also has terrific coverage of Larry Summers' must-read views on the current state of global financial markets and capital flows.  Mark Thoma notes an article on the relationship between exchange rate policies and trade gaps and a summary of research on foreign direct investment. Steve Antler suggests an explanation for "why the dollar still reigns".  Barry Ritholtz is pretty sure the answer is not Dark Matter.  Menzie Chinn, writing at Econbrowser, is even less convinced.  (He follows up that post with a very nice discussion of "purchasing power parity."  Don't worry if you don't know what that means -- Menzie will fill you in.)

Speaking of China, Daniel Gross carries a story from the New York Times on the development race between China and India, the latter a country that I think gets far less attention than it deserves.  (Lest there is any confusion, I mean positive attention.)  Interestingly, Toni Straka at The Prudent Investor -- who  unfailingly does not ignore India -- reports that India is about to float its currency and remove foreign exchange controls.

About Economics has a macro-relevant post on the, increasingly quaint, problem of the so-called zero nominal interest rate bound.  Digging even further into the history of monetary theory, Jane Galt ruminates on "free money." In the some-think-it-matters-I-don't category, The Capital Spectator comments on the retirement of M3.  So does Tim Iacono. That makes the graphs at Economist's View on M3 velocity -- explained here -- somewhat obsolete, but don't worry -- there is still M1 and M2 to absorb your attention.

UPDATE: Oh yeah -- Tyler Cowen has a new gig at the New York Times.

SPECIAL BRAIN-LOCK UPDATE:  Above I hat-tipped A Fistful of Euro's David Weman for a Guardian article  "bemoaning  the rising tide of protectionism" (my words).  Unfortunately, the Guardian article that does the bemoaning is not the one David cites.  I had in mind an earlier article by James Surowiecki.  David was pointing to another article, by Daniel Davies, arguing that capital controls do not count as protectionism.  Double hat-tip to David for keeping me on the straight and narrow.  (Oh, and by the way -- I'm with Surowiecki.)

An End To The Conundrum?

The trend in long-term Treasury yields looks to be decidedly upward -- from daily lows under 4.4 percent in late December and January, ten-year yields closed yesterday at just over 4.7 percent -- and the buzz that there is more, maybe much more, to come is in the air.

The first response to this should probably be caution. Ten-year yields were peaking near 6-1/2 4-1/2 percent about this time last year -- by June they were under 4 percent.  In June 2004 the yield had reached 4.8 -- by September that year they were back to 4.  So there is plenty of precedent for another reversal. (Kash has the picture.)

But suppose, just for the sake of argument, that we are seeing a return to interest rates comparable to the levels of, say, the latter half of the 1990s (1995-2000), when the 10-year yield averaged just a bit over 6 percent.  A couple of hypotheses as to why the time has come:

-- The global economic outlook for most of the industrialized world has turned at least baby bullish.  Japan looks to have finally turned the corner, the view from the EU is optimistic, and, if you are the optimistic sort, most of the news since the beginning of the year has suggested that the weak performance of the U.S. economy in the fourth quarter of 2005 was more of an aberration than the beginning of a trend.  (Take this week's manufacturing, inventories, and orders report for January. If you are an optimist, you can point out that things were not as bad as expected, and that orders outside of the volatile transportation sector continued to grow.)

To be sure, there are those that suggest consuming the positive with a grain of salt, and those that are downright skeptics.  But that is not really the point here.  If a broad-based acceleration of economic activity is in motion, then we would expect to see upward pressure on long-term rates, and we would expect those higher rates to finally stick.

-- There is another possibility: Monetary policy in the US (and maybe elsewhere) has finally turned restrictive, and that is beginning to show through to long-term rates.  The most basic story of the term structure is the so-called expectations theory of the yield curve.  The idea is simple: Long-term rates reflect the average of the sequence of short-term rates expected to prevail over the period until a given long long-term security matures.   Back when the federal funds rate was 1 percent, nobody expected that they would stay there forever. Indeed, when the rate hikes commenced in June 2004, members of the Federal Open Market Committee were forthright in expressing the opinion  that there would be many more to come.   

Up until recently, then, you might argue that increases in the funds rate were merely validating expectations.  But now that the market anticipates a funds rate up to (at least) the top end of what was often offered as the neutral range -- a belief reinforced in no small measure by indications from the Committee that slightly restrictive may be preferable to strictly neutral -- the new view is simply being priced into long-term bonds.

--- There is a lot of commentary about the unwinding of the so-called carry trade, but these bond market tales always strike me as a bit of the tail wagging the dog.  I have no doubt that it describes what motivates traders -- but unless the fundamentals back the play, there are baths to be had.  In the end, I'd guess the carry trade explanation is consistent with either of the above stories.

As for me, I'm not sure which of these explanations to go with at the moment (and that includes the one that proposes it's all a temporary blip). But I'm still of the opinion that the Bernanke global savings-glut/investment-dearth story was right on target. The basic conditions Mr. Bernanke was alluding to have not, in my estimation, gone away.  And that ought to at least put a ceiling on how high rates will go.

UPDATE: Professor Hamilton shares his thoughts, and links to posts at William Polley and at Economist's View that I should have.

And The Bankers Say...

The Federal Reserve's most recent Survey of Senior Loan Officers hit the street yesterday, and the  responses were generally consistent with some slight softening in the pace of economic activity.  Nothing too scary, though. There was confirmation that, yes just maybe, the housing boom is no longer so booming, and that consumer spending may be following the same track:

Significant net fractions of domestic banks reported that, since the last survey, demand for mortgages to purchase homes was weaker as was demand for consumer loans...

Demand for consumer loans reportedly had weakened further over the past three months: About 30 percent of domestic banks, on net, saw weaker demand for such loans, up from about one-fifth in the October survey.

At the same time, there was not much ado about the recent changes in bankruptcy law...

Among banks that experienced an increase in credit card charge-offs in the fourth quarter of 2005 as a result of the introduction of the new bankruptcy law, about three-quarters indicated that less than 40 percent of fourth-quarter charge-offs were attributable to this increase. In addition, banks accounting for more than one-half of credit card loans on respondents' books at the end of the third quarter reported that between 60 percent and 100 percent of the increase in the fourth-quarter charge-offs that reflected the introduction of the new law was attributable to households or individuals who would have filed for bankruptcy anyway later in 2005 or during 2006.

... and, perhaps not surprisingly, lenders do not seem too worried about the financial health of their borrowers:

A final set of special questions asked banks about their expectations for the behavior of delinquencies and charge-offs on loans to businesses and households in 2006 under the assumption that economic activity progresses in line with consensus forecasts. On balance, the responses suggest that banks expect some modest deterioration in loan quality this year from recent very high levels.

Emphasis added.

One Reason To Actually Worry About A Flat Yield Curve

From the Wall Street Journal (page C1 of the print edition):

For almost a year, the flat Treasury yield curve loomed on the horizon.

Bankers could see it coming. They had time to plan, knowing that the narrowing spread between short- and long-term interest rates squeezes their profits.

But the flattening yield curve has stymied even some of the most sophisticated and well-equipped banks in the U.S.

The nation's three biggest banks-- Citigroup Inc., Bank of America Corp. and