“The Trade” Puts Economy at Risk
February 8, 2010
Despite the fact that corporate earnings “exceeded” false expectations and economic reports have been more positive than negative, the stock market has stumbled and rates have fallen. There are two primary reasons for this. First, the stock market was already priced to perfection. Second, the global deleveraging trade showed some early signs of becoming unglued. In last month’s Longer-term Commentary, and other early commentaries as well, I’ve discussed the big wild card risk for 2010 was dollar strength that would disrupt the big speculative global leveraged trade. A little explanation of what happened last week is in order because this could hold the key to entire year.
The Trade
The first hint of trouble in the sovereign debt market was a few weeks ago with Dubai. That crisis was quickly dispensed with, but confidence of investors/traders took a hit. That caused them to look at the problems in Europe. The first focus was Greece, which faces a huge challenge to avoid default. Calming words from various European Central Bank officials and a questionable Green budget resolution helped to quiet the immediate clamor. But all this really accomplished was to give traders and investors time to expand their lists of worries. Last week that list included Spain and Portugal. Ireland and Italy are not far down on the worry list.
The problem is not that default in any of these nations is imminent; it is that the possibility of default has been introduced. This has led to the pummeling of the market values of those bonds. You might recall that our mortgage related liquidity crisis occurred long before any of the suspect securities took a single nickel of loss. It began because confidence in the securities evaporated and market values tumbled.
If investors owned these debt securities outright, this wouldn’t be a huge problem. But, the problem mirrors the mortgage backed securities problem. These bonds are owned through leverage. As short-term borrowing rates plunged, hedge funds and others borrowed near zero to buy the higher yielding sovereign securities. This is a global trade. Those speculators sought the cheapest countries in which to borrow. Those countries would be the U.S. and Japan. As an example, a big euro fund would borrow from a U.S. bank. The fund would then sell the borrowed dollars to buy euros for purchase of the Greek bonds for instance. What happens is that the fall in the value of the bonds triggers margin calls from the U.S. bank. Now the hedge fund is in the position of liquidating the bonds in an illiquid market or selling other more liquid assets.
As those sales are made, the fund then must sell the euro proceeds to buy dollars to meet the margin call. This has the impact of driving the dollar higher, which in turn hurts all of those global leveraged trades that relied on borrowed dollars. Even if the investments were in assets not in question, the rising value of the dollar pressures investors because they are losing money as they calculate selling the foreign currency to buy back dollars. As long as the dollar was falling, this was a win-win for foreign investors. They won as the riskier assets were rising in price and they won as the foreign currency they invested with was rising in value vs. the dollar. Now the worm has turned. The dollar’s rally is triggering currency losses, and the loss of confidence in many riskier foreign assets is triggering market value declines.
Although the focus right now is on sovereign debt, there are various riskier assets around the globe that have benefited from the global play. We have the world’s generous central banks and governments to thank for this. It’s one thing to keep rates too low for too long, but it’s another thing to have failed to put in place risk controls to prevent a reflating of asset bubbles.
Perhaps this too will pass. But last week’s market activity could also be the tip of the iceberg. Think one more step with me. Right now investors are the ones taking losses. But at some point in time their losses could become the lender’s losses. Financial meltdown Part II? Hopefully not, but we need to be aware of the risks that are surfacing. A very disturbing omen emerged out of the G-7 meeting over the past weekend. Numerous G-7 officials emerged to assure the markets that there was no real debt crisis and that any concerns were contained to a small part of the market. Let’s see. When and where have we heard that one before? Bernanke and Paulson talking about subprime mortgages in 2007 perhaps?
While the economic news has turned more favorable, another banking crisis would put the economy back on its heels. Nascent growth in confidence on the part of businesses and consumers stopped dead cold. Putting this risk aside for the time being, a few points on the economy are worth noting.
A Little Better Than Just Less Bad
From April of 2009 on, economic reports were cheered as less bad. Payrolls fell by an average of 750,000 for the first three months of 2009. By the time we got to May, the awful 347,000 job loss for that month was less bad enough to generate great optimism. The following months were also in the mode of being just less bad but not good. In the latest jobs report there was more to like than not like. The news was not all just less bad.
Under no circumstances can you call any month in which jobs were lost good, but there were elements that were. Temporary workers rose again, as did hours worked. Historically this has presaged Nonfarm Payroll growth. Caveat, this did happen back in September as well and didn’t result in expanding payrolls. But this was a good sign.
The next hopeful sign came from the household survey that showed a big gain in jobs and a big decline in forced part-time work. The numbers suggested that part-time workers (or workers who had seen their hours cut back) were seeing their hours increased. We also saw that the manufacturing sector added jobs for the first time in over two years.
Of course there was bad news. The carnage in the construction sector rolls on with a 75,000 job loss. While residential payrolls have long ago been wound down, the commercial worker sector is continuing to fall as long-term projects are completed and no new ones emerge. A very big red flag was in the state and local government workers sector that saw a job loss of 41,000. As you know, this is a sector I’m very concerned about.
Finally, we should never forget the biggest problem at all with this report is the source of the report itself – The Bureau of Labor Statistics (BLS). If anyone still takes these reports as gospel, the BLS did its best to dispel that notion by issuing revisions that increased the jobs lost total by a huge 1.2 million over the past two years. In the report for January, the BLS reported the huge gain in household employment while at the same time added over 250,000 workers to the “discouraged workers” pool; this takes them out of the Unemployment Rate calculation. They also had a huge 700,000 upward adjustment due to “seasonal” factors. I mentioned a couple of months ago that relying on payroll data was folly, especially during the November to February time. The BLS just has too many modeling adjustments at their disposal to play with. Taken at face value, the overall report was okay.
We need better than okay. The job ahead is huge. We need monthly gains of about 300,000 per month for five years to truly get back on track. This will take growth in our economy, growth in our exports, global growth, some breakthrough industry, and stability in the budgets of state and local governments. That’s a lot to ask, but we’ve been surprised before.
Here is one eye-opening fact uncovered by David Rosenberg, former Merrill Lynch economist and now with a Canadian wealth management firm. He dug deep and discovered that the number of workers in the U.S. is now 129.5 million, exactly the same number of workers we had in 1999. Yet, demographically, we have 29 million more people eligible for the workforce than in 1999. That’s a shocker folks, and it’s a reminder that we might be further down the road to becoming Japan than we realize.
Even Better
Benjamin Disraeli, British Prime Minister and novelist in the 19th century, once said, “There are three kinds of lies: Lies, damned lies, and statistics.” Disraeli died in 1881, but he must have seen the future of the BLS and other economic data generating sources. With that caveat still in mind, there are other hopeful signs in the numbers.
Retail Sales do appear to improving, albeit slowly. Christmas and post-Christmas sales were slightly above expectations. The precipitous decline in consumer borrowing has stalled according to the very last Consumer Credit report. The National ISM manufacturing index rose sharply. These are all indicative that an increase in production to restock depleted inventories could be underway. Any sustained increase in production must be driven by a sustained increase in consumer sales, and the jury is still out on that with a weak jobs market. But on the surface, and taking the statistics at face value, positive signs have developed over the past couple of months.
Blinders On
If everyone keeps the blinders on, the road ahead isn’t paved with gold but it does appear to have fewer potholes. The problem remains that we have some serious, unaddressed faults in the global financial and investment structure. As I discussed last week, nothing has changed in the regulatory world to put in breakers to halt or even limit the damage from another financial induced crisis. I had a brief moment of optimism when President Obama presented to plan of Paul Volcker for regulatory changes. Alas, the money poured into Washington from Wall Street’s bankers, and that legislation was dead on arrival. Of course it’s not just a U.S. problem. It’s a global market and global regulatory problem. The global rally in stocks might have made everyone feel better for a while, but it also obscured the structural weaknesses that remain firmly in place. This fundamental weakness will continue to surface until it finally must to be addressed.
Conclusion
If we learned nothing else from last week, we should have learned this much. Despite the hand-wringing over our budget and the Fed’s monetary looseness, in times of crisis the U.S. dollar and U.S. treasuries is still the safe harbor. Given what I think will be a bumpy road, economic performance aside, I believe you can put worries about higher interest rates aside for the rest of this year. Certainly we’ll have some volatility from time to time, but I just don’t see a sustained rise in rates at least through 2010. Credit unions have a lot of cash to spend and a lot of assets to be replaced and repriced in 2010. This does not bode well for margins. This is one of the few times I can ever recall that we should all be hoping for a Fed tightening move.
Dwight Johnston
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