Thursday, September 22, 2011

It's still all about Europe

The market's wild reaction to the FOMC's announcement yesterday (gold down, dollar up, euro down, T-note and T-bond yields down, equities down, commodities down) begs an attempt to diagnose what is going on. One explanation that seems to make sense is that what the market was really looking for from the FOMC was a QE3, not an Operation Twist 2. Increasing the duration of the Fed's Treasury holdings doesn't do much of anything for the economy, but deciding to no longer pay interest on excess reserves, for example, would have been a clear move to an easier policy stance, and that might have relieved some of the pressures in Europe, or at least so the thinking goes. By not announcing a true easing of monetary policy, the FOMC's announcement could thus have sparked fears that the deterioration in Europe was increasingly likely to result in some sort of economic destruction. 

So here's my guess as to mindset behind the market moves these past several days: The market's desire for Treasury bonds has gone way up because there is huge demand for a safe asset that still pays interest and is assured of having a buyer for the next 10 months. Plus, as indicated in my previous post, the mortgage market's negative convexity is adding significantly to the market's desire for duration, thus accentuating the decline in Treasury yields. The demand for euros fell because Europe is now seen to be in worse trouble—not even the Fed can help, and the dollar is the only safe-haven that is still cheap. Gold wasn't favored because if the Eurozone economy collapses, then inflation is more likely to go down than up (recall that gold fell in the second half of 2008); this message is also seen in the 30 bps drop in forward breakeven inflation spreads since last week.

Equities everywhere are down because the market fears that a Greek default is imminent and it will be contagious and that could result in a global financial crisis and/or a global economic slump similar to what followed in the wake of the Lehman collapse in 2008. Commodities are down because of the widespread fear that a global economic slump/collapse is just around the corner, and because speculators everywhere have been burned by huge volatility.

At the core of all these concerns is Eurozone sovereign debt default risk, as I noted here and here

To balance these fears, and to flesh out some of the price action, consider the following updated charts:

Since late 2009, the number of U.S. persons receiving unemployment insurance (above chart) has dropped by 5.2 million, or more than half (i.e., down 55% from a peak of 11.5 million). Over this same period, the unemployment rate has declined from 10.1% in Oct. '09 to 9.1% today.  Fewer people being supported by unemployment insurance equals more people with a greater incentive to find and accept a job. In the end, that is a good thing.

Over that same time frame, the number of new claims for unemployment insurance has been falling steadily. On an unadjusted basis (see chart above), new claims were only 350K in the week ending Sept 16th, down from 382K in the same week last year. There is no sign here of any imminent or emerging collapse in the U.S. economy or the jobs market.

On a seasonally-adjusted and smoothed basis, the trend in weekly claims appears to still be declining. Recessions are always preceded by a substantial increase in claims, but that is manifestly not the case today.

The index of Leading Indicators continues to rise, up 6.5% over the past year. Every recession for the past 50 years has been preceded by a significant decline in the growth rate of this index; that is not the case today. To be sure, this index is not always a good leading indicator, but it is not even close to signaling impending doom or even a modest recession.

The behavior of swap spreads—excellent leading indicators of systemic risk—is the clearest indicator that it is Europe that is facing the big problems. There is now a huge and unprecedented divergence between U.S. and Eurozone swap spreads. Systemic risk in the U.S. remains within a "normal" range, but eurozone swap spreads are over 100 bps, a sure sign of imminent and painful problems there.

The dollar has been the main beneficiary of the recent panic crisis, but it is still quite low from an historical perspective. It's recent strength derives mainly from the new-found weakness in the euro, not from any effective tightening on the part of the Fed. Maybe a QE3 could have helped Europe, but that is far from obvious, and in any event there are no other signs that dollars are in short supply relative to demand.

The most recent data on residential and commercial property prices (June and July, respectively) shows that prices have been roughly flat for the past two and a half years. The bursting of the commercial property price "bubble" is quite obvious here, but now that it has burst, prices are no longer declining.

The recent plunge in copper prices is typical of many commodities: very painful, but not by any means unprecedented, and prices are still quite elevated from an historical perspective. Speculators of all stripes have been burned in many ways with all the volatility sweeping the markets these days. It's not surprising that commodity prices have corrected.

Gold has suffered a nasty, $180 decline from its recent, all-time high, but from a long-term perspective it looks like a simple correction. Gold only got as high as it is because it has been pricing in lots of devastating news; this recent decline could be an indication that although the recent news has sparked a panic in bond and equity markets, it's not as bad as gold investors had expected.

To date, the drop in the S&P 500 from its recent highs has been about 15%. Prices are still almost 70% above the Mar. '09 lows. It's a panic, to be sure, but not nearly a collapse. Corporate profits have doubled from their year-end 2008 lows, the average PE ratio is only 12.3, according to my Bloomberg, and those facts provide a strong safety net for prices.

Taking everything into consideration, it's quite apparent that the source of the recent angst is the increasing likelihood of a major sovereign default (e.g., Greece), and the fear that this might prove contagious and eventually escalate to the level of a global financial and economic panic. There's no denying that Greece is almost certainly going to default, and that it will be the biggest sovereign default on record. Whether that is big enough to bring down the entire world is the question at hand. I just don't see it.


Anonymous said...
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Pragmatic Investor said...

The problem is that when you see it, everyone on the street sees it. I mean main street, not wall street. US poverty rate is at 17 year high. That's not what economic recovery is made of. The rise in leading indicator is all due to M2 increase which is caused by flight to safety. Removing M2 supply, LI is actually down 0.4% versus up 0.3% from last month. Bloomberg's earnings unfortunately is operating earnings which excludes ex-items, write downs, etc. It's a shame a financial authority like Bloomberg does not publish true earnings any more.

John said...

It's not all about Europe. There is deep pessimism about the future of the American economy going forward, as Pragmatic Investor alludes to.

Republicans want to maximize fear and loathing of the Administration's performance handling the economy while investment consultants want to boost optimism to lift markets.

The fear argument is winning.

Squire said...

It isn't ALL. The stock market wants inflation. The FED offered none yesterday. Since the U.S. economy can’t have organic growth due to many drags, it needs apparent growth (NGDP nominal GDP). The FED isn’t going to cooperate with that thus a slowdown in US growth will cause further slowdown in the world economy. The U.S. is ever more so the safe haven. Thus stocks and currencies were sold, and dollars and treasuries were bought. Gold isn’t so interesting without inflation expectations and was sold too.
The U.S. economy cannot operate, let alone prosper without increasing debt and stimulus and inflation. It needs massive radical reforms in trade, immigration, energy and tax. The industry cartels of education and health care need to be broken along with their supporting government agencies. Social engineering needs to be stopped.

Bill said...

Boy do I wish I had sold everything in April.

Benjamin Cole said...

The GOP fearmongering and obstructionism is playing havoc, as is the Fed's inability to chart a steady, clear, projected course to higher nominal GDPs. The investing public is baffled.

And Obama missed a wonderful opportunity to change the D-Party into a pro-business party just as Bush jr. missed a chance to de-militarize the GOP.

So we the anti-business D-Party, the lunatic GOP, and a dithering Fed.

Besides that, everything is great.

John said...


It's not the government's business to be "pro-business" any more than it is for business to be pro-government. The government works for the people. Businesses are not people, they are human constructs comprised of laws.

Bob said...


How is the GOP fearmongering and how are they being obstructionist? Because they don't go along with the socialist agenda of the so called progressives?

The very ideal of a democracy is to allow discent. Primarily we have, at the current time, two major opposing ideologies, capitalism and socialism, bucking horns. The socialists are in power now. It is the duty of the other side to discent.

I vigorously dislike this accusation of fearmongering and calls of obstructionism. It is anti democratic.

You are sounding like a mouthpiece for the Obama administration.


McKibbinUSA said...

Hopefully, the US Federal Reserve is not committed to any "secret" "too big to fail" deals that are linked either directly or indirectly with Greece, Spain, Portugal, or Italy -- I would add to that list California and New York, as well...

Rick said...

Don't forget the disappointing news from China yesterday.

There is a very simple explanation for the current state of the stock market. The July 27th GDP revision revealed that in real terms, the US GDP has not yet recovered to its pre-recession level. For six months, the markets acted on the prior data that claimed such a recovery.

The S&P 500 then retreated to levels printed just before the collapses of the GSE's, Lehman, AIG, Merrill Lynch and WAMU and Wachovia. Yesterday, the S&P returned to those levels in the aftermath of the Fed's comments on future risk, the downward Fed Ex guidance, and China. After hours, there were more indications that corporations are again beginning to delay or reduce cap-ex on IT spending. The political rhetoric is noise, but it does contribute to a sour mood. Plus, there is the old market adage, sell at Rosh Hashanah and buy Yom Kippur.

However, given the Fed's outlook and Geithner's comments that we are on edge of another great recession, it is logical for the stock market indices to print again its pre-Lehman numbers at this time.

Benjamin Cole said...


If you are reading, I clearly state the D-Party is anti-business. I am not a mouthpiece for anyone, except maybe my wife.

The GOP federal budget posturing nearly caused a panic, and yet they went ahead and agreed to deficits anyway--and ran huge deficits in a much better economy during the Bush years.

Ethanol? The USDA? $3,333 from every man, woman and child in the USA for a Defense-VA-Homeland Security boondoggle-arama? That's every year.

$13k from a family of four, out of the private sector and into the maw of Washington DC.

$4 trillion for two unfunded wars?

The current-day GOP deals in fearmongering and nihilism. That said, I may vote for Romney, who actually strikes me as a bright, friendly guy.