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Monthly Archives: February 2011

Who’s paying taxes? v2

Another graph, very similar to my previous post ,  on who’s paying taxes in America.

(click to enlarge)


Update on Junk Bond Market

Junk bond market had given investors great return in both 2009 and 2010.  With junk yield approaching historical low, one of the greatest short opportunities starts to take shape.

The memory of the great credit bubble burst in 2007 is still fresh .  Back then, junk bond spread (with comparable treasuries) reached its lowest point in history, about 2.6%.  Now the yield spread stands in 4.5% range – looking relatively high and indeed the spread may go even lower – This is exactly the argument from junk bulls.

But a simple analysis clearly defies bulls’ logic, in favor of junk bears.

First, interest rate is at historically low.  It can only go up in the future, regardless whether it’s due to true economic recovery or because high inflation forces interest rate to rise.  When the Fed reverses its monetary policy, bond market will be hit hard.  Junk bond, with its bigger default risk and higher volatility, will be hit hardest.

Second, if the economy instead turns southward, entering a period of protracted low growth, mimicking Japan after its housing bubble burst, then the default risk will rise sharply.  By then, Bernanke co. may print more money, but it won’t matter any more.  Ask yourself: What real effect have QE1 and QE2 really had on the economy, besides popping up asset prices?!

For investors, timing again is important. Watch the Fed’s move and hear their talks- any sign of rate hike will be the trigger.

This short video from Financial Times gives you a nice  historical perspective on the junk bond market.

(click on the graph to play the video).




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Maybe “stagflation” is for real…

Yield curve is telling a very different story than the stock market.  Echoing Meltzer’s earlier piece, “Bernanke’s 70s show“, maybe stagflation is for real…reports WSJ:

Treasurys may be signaling trouble.


The market is behaving in ways that suggest investors are starting to fret over the potential for stagflation in the U.S.

Consider the Treasury “yield curve.” It refers to the difference between short-term and long-term interest rates on U.S. Treasury debt.  Typically, as the economy is expanding, this curve has an upward slope, and is usually at its steepest during the earliest stages of a recovery.

Eventually, investors anticipate the Fed will begin raising interest rates to stave off inflation. That tends to lift short-term rates, compress long-term ones, and generally flatten the curve, or even invert it if investors expect the outcome could be recession.

Lately, with the U.S. growth outlook improving, the slope of the curve hasn’t started flattening, as might be expected at this point in the recovery. Instead, it has gotten steeper.

Earlier this week, the spread between two-year and 30-year Treasury yields hit a record-wide four percentage points, notes RBS Securities. At the same time, the implied annual inflation rate over a five-to-10 year horizon, based on Treasury yields, has moved up above 3% and towards levels last seen before the Fed’s previous rate-rise cycle began in mid-2004.

Investors, in other words, don’t expect the Fed to be as aggressive as in the past in raising rates—even as they see inflation on the rise.

“I think the Fed’s credibility is in question here,” says Priya Misra, head of rates strategy at Bank of America Merrill Lynch.

Or perhaps investors simply realize the Fed has put itself between a rock and a hard place. The U.S. unemployment rate is currently 9.4%, after all. It was at 5.6% in June 2004.

In a twist, the best scenario for the U.S. now is that interest rate increases in China, Brazil and other emerging markets rein in global cost pressures, giving the Fed—and the recovery—some breathing room.

The U.S. needs strong growth more than ever, especially with limited appetite for serious fiscal overhaul, to assuage the market’s other worry: wide deficits and heavy debt.

The clock is ticking.

Catherine Mann: Fed should give up its job rate target

Interview of Cathy Mann at Brandeis University.  She noted there was inconsistency in the Fed’s monetary policy —given the current unemployment rate, the Fed can’t be fighting inflation and unemployment at the same time — Either the Fed will have to give up their target on unemployment rate (6%), or they’ll have to give up their inflation target.   And since neither QE1 or QE2 did much to job creation, it’s better to give up the target on unemployment rate, rather than letting the market form expectations that inflation is going to get out of control.

America’s new export – Inflation

It’s the replay of 1H of 2008, only with more severity.  If were not for Lehman’s collapse, the prices of commodities would have shot to the roof more than two years ago. Now the still-the-same super easy monetary policy made commodity prices, especially food prices, come back again, evident everywhere in the world.

(click to enlarge, source: BOE)
China just reported its latest CPI number of close to 5%, but food prices jumped over 10% year over year.  The food inflation forced China’s Bureau of Statistics to adjust down the weight of food in the CPI calculation.  Isn’t this ridiculous! — The government wanted to you to believe as if inflation does not exist!
At the same time, various signs show that the huge excess reserves are being gradually unleashed from banks’ balance sheets — one indicator is that the yield on junk bonds has almost reached historical lows; another sign is that banks now started to relax their lending standards to both consumers and small businesses.
What we are seeing is exactly the divergence of traditional inflation measure (CPI) and asset inflation. Let’s call it “biflation”.

(click to enlarge, source: BOE)

Ronald McKinnon, an expert of exchange rate and US dollar at Stanford University, labels inflation as America’s latest export:

What do the years 1971, 2003 and 2010 have in common? In each year, low U.S. interest rates and the expectation of dollar depreciation led to massive “hot” money outflows from the U.S. and world-wide inflation. And in all three cases, foreign central banks intervened heavily to buy dollars to prevent their currencies from appreciating.

When central banks issue base money to buy dollars, domestic interest rates are forced down and domestic inflationary pressure is generated. Primary commodity prices go up quickly because speculators can easily bid for long positions in organized commodity futures markets when interest rates are low.

The world saw a surge in the dollar prices of primary commodity prices in 1971-73 following the Nixon shock of 1971 when the U.S. abandoned the gold standard. There was also a commodity price surge during the Greenspan-Bernanke shock of 2003-04, when the federal-funds rate was reduced to an unprecedented low of 1% followed by a falling dollar.

Now we have what one might call the Bernanke shock. The Fed has set U.S. short-term interest rates at essentially zero since September 2008, followed in 2010 by quantitative easing to drive down long-term rates. Predictably, primary commodity prices in 2009-10 surged. In 2010 alone, all items in the Economist’s dollar commodity price index rose 33.5%, while the industrial raw materials component soared a remarkable 37.4.%.

The longer-term inflationary and economic consequences over the next decade of this most recent U.S. loose money shock remain to be seen. But we can glean useful hints by looking at the aftermaths of the two earlier shocks. In the 1970s, “stagflation” (inflation combined with cyclical bouts of unemployment and wide swings in exchange rates) seemed intractable. Productivity growth in mature industrial countries fell sharply.

The Greenspan-Bernanke interest rate shock of 2003-04, followed by a weakening dollar into the first half of 2008, created the bubble economy. Primary commodity prices began rising significantly in 2003-04, then flattened out before spiking in 2007 into the first half of 2008.

But the biggest bubble was in real estate, both commercial and residential. With low mortgage rates and no restraining regulation on mortgage quality, average U.S. home prices rose more than 50% from the beginning of 2003 to the middle of 2006. This led to an unsustainable building boom—with echoes around the world in countries such as the U.K, Spain and Ireland. The bubbles in primary commodity prices collapsed mainly in the second half of 2008. But the residue of bad debts, particularly ongoing mortgage defaults, led to the banking crisis and global downturn of 2008-09.

So what lessons can we draw from these episodes of U.S. easy money and a weak dollar for the stability of the American economy itself?

First, sharp general price increases in auction-market goods such as primary commodities or foreign exchange (i.e., a weakening dollar) is an early warning sign that the Fed is being too easy—a warning that the Fed is again ignoring as we enter 2011.

Second, beyond the rise in primary commodity prices, general price inflation in the U.S. only comes with long and variable lags. After the U.S. monetary shock, hot money flows into countries on the dollar standard’s periphery cause a loss of monetary control and general inflation to show up there more quickly than in the U.S.

In 2010, consumer price indexes shot up more than 5% in major emerging markets such as China, Brazil and Indonesia, while the consumer price index in the U.S. itself rose only 1.2%. Similarly, after the Nixon shock of 1971, there was much more explosive inflation in Japan in 1972-73 than in the U.S. But by December 1979, inflation in America’s producer and consumer price indexes was more than 13%.

Overconfident Ben Bernanke

In the following video, Ben Bernanke answers questions from Paul Ryan (R-WI). Paul asked some really sensible questions. Bernanke remains largely too confident. This is generally not a good sign.

Allan Meltzer, a historian specialized in the Federal Reserve system, in the following WSJ piece, shares his historical view on the Fed and inflation outlook. He thinks Bernanke Fed will put us on another “70s show”.

In the 1970s, despite rising inflation, members of the Federal Reserve’s policy committee repeatedly chose to lower interest rates to reduce unemployment. Their Phillips Curve models, which charted an inverse relationship between unemployment and inflation, told them that inflation could wait and be addressed at a more opportune time. They were flummoxed when inflation and unemployment rose together throughout the decade.

In 1979, shortly after becoming Fed chairman, Paul Volcker told a Sunday talk-show audience that reducing inflation was the best way to reduce unemployment. He abandoned the faulty Phillips Curve thinking that unemployment was the enemy of inflation. And he told the Fed’s staff that while he thought highly of their work, he did not find their inflation forecasts useful. Instead of focusing on near-term output and employment, he changed the Fed’s policy to put more emphasis on the longer-term reduction of inflation. That required a persistent policy that President Reagan supported even in the severe 1982 recession.

We know the result: Inflation came down and stayed down. The Volcker disinflation ushered in two decades of low inflation and relatively steady growth, punctuated by a few short, mild recessions. And as Mr. Volcker predicted, the unemployment rate fell after the inflation rate fell. The dollar strengthened.

That was not unprecedented. The Phillips Curve often fails to forecast correctly. Spanish inflation has increased in the last year while the unemployment rate rose above 20%. Britain also has rising inflation and rising unemployment. Brazil lowered inflation and unemployment together. There are many other examples if only the Fed would look at them.

Throughout its modern history, the Fed has made several of the same policy mistakes repeatedly. Two are prominent now. It concentrates on near-term events over which it has little influence, and neglects the longer-term consequences of its operations. And it interprets its dual mandate as requiring it to direct all of its efforts to reducing unemployment when the unemployment rate rises. It does not have a credible long-term plan to reduce both current unemployment and future inflation, so it works on one at a time. This is an inefficient way to achieve a dual mandate. It failed totally during the Great Inflation of the 1970s. I believe it will fail again this time.

Commodity and some materials prices have increased dramatically in the past year. Countries everywhere face higher inflation. Despite the many problems in the euro area, the dollar has depreciated against the euro, a weak currency with many problems, suggesting that holders expect additional dollar weakness. Imports will cost more.

I believe it is foolhardy to expect businesses to absorb all the cost increases by holding prices unchanged. And loan demand has started to pick up, increasing the amount of money in circulation. It is a big mistake to expect that the U.S. will escape the inflation that is now rising throughout the world.

Because the Fed focuses on the near term, it tends to ignore changes in money-supply growth. This, too, is a mistake. Sustained inflation always follows increases in money-supply growth. Sustaining negative real interest rates (i.e., adjusted for inflation), as we have now, will cause this.

The Fed should make three changes. First, it should increase the short-term interest rate it controls to 1%, which would show that it is aware of the inflation risk and will act promptly to counteract it. Current low interest rates are an opportunity for the Fed to start reducing excess reserves.

China steps up its global currency move

There has been a stream of news on Chinese government's new move to make Yuan global. First, Bank of China recently allowed customers in NYC to open Yuan account; then China is set to allow its firms to trade currency swaps to hedge currency risk starting from March 1st; then foreign firms operated in China, such as McDonald, now will be allowed to issue Yuan-denominated bonds in Hong Kong. According to NYT,

Richard Lavin, a group president at Caterpillar, said his company’s $150 million Hong Kong offering last November was less expensive than taking out a loan in China or raising the money in dollars and then converting those dollars into renminbi. The bonds were issued to help finance Caterpillar’s equipment leasing business in China.

Meanwhile, in Russia, Vietnam and Thailand, some cross-border trades with China can now be settled in renminbi, so that trading partners do not have to convert in and out of dollars. One pilot program lets Russian companies like Sportmaster, a retail chain based in Moscow, buy or sell goods using Chinese currency.

And in New York, the Chinese government has permitted an overseas branch of Bank of China to accept deposits in renminbi. That enables depositors outside China to bet on a currency that is widely expected to appreciate against the dollar over the next few years.

Robert A. Mundell, a Nobel laureate economist whose research is credited with helping develop the euro, says the renminbi’s rise is all but inevitable.

“The RMB is likely to become a reserve currency in the future, even if the government of China does nothing about it,” Professor Mundell said in an e-mail response to questions. He noted that the renminbi was already a regional currency in Southeast Asia, where China had become the dominant trading partner of many countries.

If China does eventually open its capital market by eliminating currency exchange controls, he said, “the progress of the RMB as an international currency will be assured.”

As an influence on global financial markets, the renminbi is “still a distant, distant, distant fourth,” said Albert Keidel, a China specialist at the Public Policy Institute at Georgetown University in Washington. “People are going to start holding more renminbi, but it will be at least a decade or two for it to become a leading world reserve currency.”

I expect that, in an optimistic scenario, Yuan will become fully convertible in five to ten years.

Is US manufacturing really declining?

A lot of misconceptions, a lot of wrong facts – you don't find "Made in USA" in consumer goods, but US manufacturing is everwhere in durable and capital goods.  According to Jeff Jacoby of Boston Globe:

Americans make more “stuff’’ than any other nation on earth, and by a wide margin. According to the United Nations’ comprehensive database of international economic data, America’s manufacturing output in 2009 (expressed in constant 2005 dollars) was $2.15 trillion. That surpassed China’s output of $1.48 trillion by nearly 46 percent. China’s industries may be booming, but the United States still accounted for 20 percent of the world’s manufacturing output in 2009 — only a hair below its 1990 share of 21 percent.

A vast amount of “stuff’’ is still made in the USA, albeit not the inexpensive consumer goods that fill the shelves in Target or Walgreens. American factories make fighter jets and air conditioners, automobiles and pharmaceuticals, industrial lathes and semiconductors. Not the sort of things on your weekly shopping list? Maybe not. But that doesn’t change economic reality. They may have “clos[ed] down the textile mill across the railroad tracks.’’ But America’s manufacturing glory is far from a thing of the past.

read more here