Kenneth Rogoff on Sovereign Credit Risk

Professor Rogoff interviewed by Henry Blodgett and Aaron Task -

Video

Bottom line - banking crises are often followed by sovereign debt crises or inflation crises. U.S. has ability to pay its debts, but does it have the political will to do so going forward? The professor also expects California to be on the brink of default repeatedly over the next few years. (If California were an independent country, it would have had the 11th largest economy in the world in 2008.)

Sovereign Credit Risk Getting Attention

First it was Dubai , now it's Greece... Morgan Stanley thinks the risk of an actual default by Greece is minimal, but the issue of sovereign credit risk looks to be an important one going forward, with the U.S. and UK now both on "the chopping block".

Remember, much of the risk associated with the financial crisis was not removed, but rather transferred from the private to the public sector. At best, the issue of sovereign credit risk is going to be sitting there - kind of like a missed extra point early in a football game - for some time.

Manpower Survey Suggests Payrolls May Soon Turn Positive

Here's the story from Bloomberg, consistent with Friday's BLS report.

In a speech Monday Bernanke said the US economy confronts some formidable headwinds going forward (restrictive credit + weak job market). This took a bit of the bid out of the USD, and gold rallied off its lows and for a while was even up on the day. Also, NY Fed president William Dudley reiterated the "subdued expansion" forecast for 2010, and said that if correct, it would be appropriate to keep rates exceptionally low for an extended period.

Weekend Clean Up

The Yen weakened sharply versus the dollar over the past few days, but also weakened versus the Euro. The divergence between Yen strength vis a vis the Euro and the direction of the S&P never reached the extremes of July 2008 or early March 2009, but it did catch the attention of your humble pajama clad blogger. Here's the chart as of Friday's close -

In a post from late October I said I'd be watching for closing Tick readings above 1000 to indicate the October correction was over. Well, we got quite a few of those. The first one came November 3, followed by November 5, and November 9. The latest +1000 closing Tick reading was November 16.

I also mentioned that I'd be watching for a US dollar index close above its 50 dma since that had not occurred since April, and that when it did occur it could signify a regime change of sorts - either an outright return of risk aversion, or at least the end of the dollar down and everything else up. Well, on Friday the USD closed above its 50 dma.

In late October the UUP (trading vehicle for being long the USD index)began to pick up volume and on November 5 it traded a record 13.3 million units, suggesting that perhaps a turning point in the dollar was imminent. But the dollar just kept dropping, setting new lows for the move as recently as last Tuesday. So the question is whether Friday's rally is a fake out, or the beginning of a more sustained rally, one strong enough to put the fear of the market back into the dollar bears and hard asset bulls. According to Bob Hoye's December 3rd Pivotal Events , a USD close above 75.5 would conclude a TD Sequential buy pattern. The USD closed Friday at 75.78.
(To read more about the TD Sequential, click here .)

For those who prefer to eschew chart esoterica, let's just say that a sustained dollar rally would likely be predicated on the notion that the Fed will be hiking rates sometime before 2011. But just because the economy is recovering from the worst downturn in 70 years doesn't mean that rates will be headed higher. According to Jan Hatzius of Goldman , the economy will need to create 250k jobs a month to make inroads into the unemployment rate and the question is whether the recovery will be strong enough to do that. Furthermore, to a casual eye, the Fed's current zero rate policy is accomodative at least, and a hike to 1% over the next year could be seen more as a normalization than a tightening. The problem with that view is according to the Taylor rule , the zero rate is "too high", and rates should actually be negative. It also seems likely that the Fed will reduce its balance sheet before hiking rates. Baby steps...

A Bit of Cognitive Dissonance

The day of the ADP employment report, ftalphaville quoted a press release from TrimTabs estimating the November job losses at 255k - that's more than twice the Bloomberg consensus estimate and more than 23 times the BLS figure. The post I've linked to includes a chart of TrimTabs record over the prior 22 months, and it's very close to the revised numbers of the BLS. TrimTabs methodology involves analyzing daily income tax deposits at the US Treasury.

The shock value of the BLS report derives from the fact that it is inconsistent with other recent data, not just TrimTabs' estimates. The ADP report, the ISM employment sub indices (outright contraction in services, barely positive growth in manufacturing), initial jobless claims, as well the Rasmussen consumer surveys (17% of adults say their finances are getting better, 49% say they are getting worse) all suggest a still grim employment backdrop.

In a report in late October, J.P. Morgan pointed out that GDP per employed worker was at a record high, and that based on this indicator's behaviour over 13 previous business cycles, payrolls could turn positive by January 2010. Are we on track for this?

Recoveries tend to be choppy and uneven, but I'm still confused.

Shocked

The BLS Employment report for November was a shocker. Payrolls shrank only 11k versus the 100k consensus forecast. The rosy number did not jive at all with the ADP report released Wednesday, which had a > 90% correlation with the BLS numbers going into today.

This was good news, right? Well, assuming it's not a one-off, it's good news for Main Street and perhaps not such good news for Wall Street. Just when the rate normalization campaign was getting pushed out further and further (Q4 2009, Q1 2010, 2H 2010, maybe 2012?...)suddenly Fed funds futures are showing a better than even chance of a rate hike by the June meeting. So far oil and equities are holding their gains through the carnage in gold and the rise in the USD and Treasury yields, but the stock indexes are well off their highs...

Internals Look Tired

The percentage of NYSE stocks above their 50 dma has been trending down for a while.

So has the advance-decline line -

Volume has been declining as well, which suggests that the market is vulnerable to any bad news -

The closing tick has been in a down channel -

On a 15 minute chart, you can see the Tick lead the way down on Thursday.

The White House said that it expects Friday's employment report to show a rise in the jobless rate. The Bloomberg consensus was for the jobless rate to remain at 10.2%. On Wednesday the Rasmussen consumer confidence index hit a 4 month low. Guess "the consumers" haven't heard all the great economic news lately.

Speaking of which, I couldn't believe how the Beige Book report was spun so positively...True some sales were robust... but they were sales of used autos. I'm not sure we're not living through a depression.

Beige Book Confirms the Obvious

No surprises from the latest Beige Book on economic conditions across the 12 Federal Reserve Districts. Some excerpts -

Reports from the twelve Federal Reserve Districts indicate that economic conditions have generally improved modestly since the last report. Eight Districts indicated some pickup in activity or improvement in conditions, while the remaining four--Philadelphia, Cleveland, Richmond, and Atlanta--reported that conditions were little changed and/or mixed.


Consumer spending was reported to have picked up moderately since the last report, for both general merchandise and vehicles; a number of Districts noted relatively robust sales of used autos.

Residential real estate conditions were somewhat improved from very low levels, on balance, led by the lower end of the market. Most Districts reported some pickup in home sales, though prices were generally said to be flat or declining modestly; residential construction was characterized as weak, but some Districts did note some pickup in activity. Commercial real estate markets and construction activity were depicted as very weak and, in many cases, deteriorating.

Financial institutions generally reported steady to weaker loan demand, continued tight credit standards, and steady or deteriorating loan quality... Labor market conditions remained weak since the last report, though there were signs of stabilization and scattered signs of improvement. While some Districts reported upward pressure on commodity prices, they saw little or no indication of upward wage pressures or of any significant increase in prices of finished goods.

For a while now, commercial real estate has been viewed as one of the biggest problems still ahead -

Commercial real estate conditions were widely characterized as weak and, in many cases, deteriorating further. Market conditions were reported to have weakened in virtually all Districts, with rising vacancy rates, downward pressure on rents, and little, if any, new development. Expectations for 2010 were also quite low. Boston characterized the commercial real estate outlook as "bleak," Dallas noted that construction was at "historically low levels," and Kansas City described the sector as "distressed." Still, some Districts noted scattered signs of encouragement: Cleveland and Chicago referenced public-works projects as a source of increased business, Richmond noted signs of increased leasing activity from the health and education sectors, Atlanta indicated a modest pickup in new development projects, Minneapolis noted some recently started hotel and retail development, and San Francisco cited slight improvement in availability of financing for new development.

Check it Out

The excellent FTalphaville blog is even more interesting than usual today with numerous posts by guest Jonathan Wilmot of Credit Suisse.

Definitely worth a visit.

Something to Watch

There seems to be a bit of a divergence forming in the direction of the S&P 500 and the relative strength of the Euro versus the Yen. The chart shows the S&P 500 steadily working its way higher over the past 4 months, while the Euro has moved sideways to down versus the Yen. So far, no big deal, but when the two diverge markedly, as they did back in the spring and early summer of 2008, and again in late February 2009, it's been wise to pay attention. Strong divergence between the two has tended not to last.

Did Somebody Say 2012?

Are we talking about the end of the world? Not unless you think the End will coincide with or result from the Fed beginning to hike rates. I'd heard 2011 suggested as the year interest rates start to get back to normal, but this was the first time I ran across 2012 as the predicted start of the Fed's rate normalization campaign. The yield on the 2 year Treasury closed Monday at .67%, very close to its December 2008 low of .6. This is some recovery we're having, eh?

Meanwhile the consensus opinion embedded in Fed funds futures is that the rate hikes will start sometime next year, as you can see from this chart from Trendmacro.com

When Down is Up, Japan Style

Just as the relentless weakness in the US dollar has come as a bit of a surprise to your humble pajama clad blogger (believe me - I get the reasons for USD weakness, I've just been surprised at how so crowded a trade could keep on working with nary a bump along the way), so too has the relentless rise of the Yen. I started wondering about Japanese intervention in currency markets back in March when it took about 95 yen to buy a dollar. As I write this, 86.43 yen buy a buck.

A phrase caught my attention in this article from FT on Japan's moves to break a deflationary spiral -

But deflation in so-called core-core consumer prices, which exclude energy, rose to 1.1 per cent from 1 per cent in September.

In Japan, deflation is once more on the rise.

Frugal Fatigue and Other Things

The other day I dropped into my local Whole Foods to pick up a few last minute Thanksgiving odds and ends. The bill was less than 15 bucks, an outlier for a Whole Foods visit. The clerk handed me a card which entitled me to a free pizza next time my grocery bill came to more than $25. I've seen similar promotions in other markets involving free light bulbs or deeply discounted bath tissue or paper towels for those who spend more than $25 or so. Retailers in general are doing what they can to combat the consumer propensity for downsizing their spending, a trend still in evidence on "Black Friday" .

According to a recent report from Credit Suisse, the increase in household balance sheet volatility alone makes people feel less wealthy. Even if you've done great this year, you may not feel as confident about spending because of the wrenching experiences of the past couple of years. Damage has been done to people's psyches if not their balance sheets. So even though the top 20% of earners account for 40% of consumer spending, the top quintile may well stay cautious going forward. Still, for those who have the luxury of rebelling against a self-imposed frugality, there is "frugal fatigue", a neat little catchphrase for those worried well (in the financial sense) who want to rationalize their more whimsical or impulsive purchases during what are for many some very hard times .

Optimists can take heart from another observation in the CS report - that consumer spending tends to trough before payrolls trough with a lead time of 0-22 months over the past 7 recessions. In other words, it would be incorrect to assume that payroll employment must begin to rise before spending picks up.

But then this past recession has been unlike the previous 7 in both duration and intensity, and none of the prior 7 involved a housing bubble collapse. Below is a chart from economagic which plots both the yoy% change in personal consumption and the yoy% change in non-farm payrolls. If the current trend continues, then once again spending will have led payrolls.

As I write this, Asia is up, US stock futures are up, and the US dollar is getting whacked. Most likely it's all due to this.

Good times...

Who's Headed for Subprime?

With the Dubai default on everyone's mind, it's worth noting the NY Times story earlier this week about how the White House expects the US goverment's interest expense on its debt to rise from $202 billion in 2009 to $700 billion in 2019. The article states "an additional $500 billion a year in interest expense would total more than the combined federal budgets this year for education, energy, homeland security and the wars in Iraq and Afghanistan."

Below is a chart from Carmen Reinhart depicting external debt default/restructuring cycles over the past 200 years

Are we about to embark on an up cycle in sovereign debt defaults? As a November 20th WSJ article about a leap in the cost of sovereign credit default swaps put it "risk has not gone away, but has been transferred to the public sector".

You know, as in "there's no free lunch".

Hello to All That Again?

On Wednesday afternoon I noticed that the VIX had closed below its 10 day moving average for 15 consecutive trading days. I decided to take a look at how often this had occurred during the current decade, and if it had any predictive value for stock market direction 7, 14, and 21 trading days later.

It turns out the VIX had closed below its 10 dma for 15 consecutive trading days or more 14 previous times since January 2000. Two of those occasions followed climactic sell-offs - the fall of 2002 and the spring of 2003 - so I excluded those. Of the remaining 12 instances, the S&P 500 was lower 7 trading days after the condition was met 8 times, was lower 14 trading days later 9 times, and 21 trading days later 7 times. The average decline was largest after 21 trading days - -1.9%.

So I decided that buying some December puts might be a good idea. (This is Wednesday afternoon, mind you.) Then later Wednesday evening I read the Dubai news ... Ugh, well it looks like puts won't be on sale Friday, though some closed end emerging market bond funds may well be. Sovereign credit risk has become a salient issue this year in light of all the measures taken to combat the financial crisis and economic downturn and the need to finance them. The question now is whether Dubai is just a one-off event (Dubai's excesses seem singular), or a watershed.

All I know is that your humble pajama clad blogger won't be having a 4 day weekend.

Phrase of the Week

For years Doug Noland's weekly commentary at Prudent Bear has been a high priority read. From the November 20th edition, titled "Reflation Issues Heat Up" (emphasis is mine)-

It is my thesis that there is no alternative than a major transformation of the underlying structure of the U.S. economy. In simplest terms, we must produce much more, consume much less and do it with a lot less Credit creation. The objective of current policymaking, however, is to quickly rejuvenate housing and asset prices with the intention of sustaining the legacy economic structure. Zero interest-rate policy is key to this strategy. The objective is to push savers out to the risk asset markets, as well as to transfer returns on savings from the savers to be used instead to recapitalize the banking/financial system.

"Legacy economic structure", yes that is exactly what the current policy makers are committed to. What got us into this mess? At the risk of oversimplifying, too much credit. What do we need now? Why, to get credit flowing again! One of the problems with this line of thinking is that it ignores the waning of credit demand. According to the November issue of NFIB's Small Business Economic Trends, only 4% of NFIB's member firms cited "financing" as their most important problem. At 33%, "poor sales" ranked number 1. NFIB member inventories are at record lows, yet more owners in their survey planned to reduce inventories further than planned to add to them.

As for those policymakers, I recall how the solution of many of the elected "policymakers" back when home prices were rising so much faster than incomes was not for home prices to fall, or for incomes to rise, but for credit standards to be less restrictive. I remember how Fannie and Freddie were enjoined by Congress to "do more" so more people could "buy" homes, and F&F did just that, right up till when they were taken into receivership...

It's hard to believe but just a couple of months ago there seemed to be something of a consensus building that the FOMC might soon have to start hiking rates. Market participants have since concluded that whether they have to or not, they won't. I've been astounded by the persistent weakness of the US dollar given the crowdedness of the trade and the near universal bearishness towards the greenback. Sure, the dollar bounced this week, but I've been looking for something stronger and sustained, and so far that hasn't happened. Currency traders have concluded that the FOMC is on hold for well past the forseeable future. The yield on the 2 year note dropped this week to .67%, its lowest since December, so I guess the Treasury market agrees.

A Few Charts

Last Friday there was some disappointment regarding consumer spending, but the real story in the current environment is income, and the income picture is not pretty. The chart below shows the yoy% change in nominal personal income -



Clearly for there to be sustained growth there will need to be an upturn in income over the coming months, and about half of personal income is labor income (ie, wage and salary disbursements). The good news is that one can make the argument that things are on track for this to happen. This week's Barron's mentioned that based on yearly percent changes in the ratio of GDP per employed worker over the previous 13 post war job cycles, net hiring should begin within the next 4 months.

The chart below shows how the rise in personal income tends to slightly lag the upturn in industrial production -



But income does not lag industrial production as much as the unemployment rate (shown on inverted scale)lags -



The key question in my mind is whether this is a sustainable, half-way normal recovery in the US, or not. Have we been zombified? I mean if a 1% Fed funds rate could derail the current recovery, then what kind of a recovery is it, anyway? (There is much handwringing over how the FOMC statement will be altered this Wednesday to suggest that maybe someday the Fed might, just might, have to raise rates.) And if a 1% FF rate wouldn't derail the recovery, but the Fed is too cowed by Congress and Wall Street to signal the beginning of a normalization of rates, then the probability of a very bad outcome to this whole exercise (more asset bubbles, hyperinflation) would seem to be quite high.

Back from the Brink?

The selling on Wednesday felt a bit different from the usual. For one thing, some closed end non-US dollar fixed income funds got hit hard on high volume as the dollar rallied -






Then there was the fact that a lot of stocks dropped through their 50 day moving averages and kept going. As of Tuesday's close, about 57% of NYSE stocks were trading above their 50 dma. By Wednesday that had fallen to less than 35%, the lowest since early July. As of Wednesday's close, the 5 dma of advancers minus decliners on the NYSE was at its lowest level since March, as was the 3 dma of the closing Tick. So Thursday was set up to be a pivotal day where either the reflation bets would be reinstated or further unwound. For now at least, the benefit of the doubt goes to the bulls.

Two technical things to watch for -

A closing Tick over 1000. That last occurred on September 9. It served as an "all clear" sign after the March lows and then again after the lows in July. Should it fail to materialize in the next couple of days I'll keep my party hat in the closet.

A close above the 50 dma in the US dollar index. The USD peaked above this level for a few days in April, but hasn't closed above it since. Since we have been in a reflationary regime of "US dollar down, everything else up", technical strength by the USD would suggest that something has changed.

Tired and Vulnerable

The BKX most recently peaked relative to the S&P 500 in late August and has turned down.



Small caps peaked relative to the S&P in mid-September, and have since been rolling over.



On Wednesday, the VXX, a trading vehicle which debuted in January of this year which mimicks a long position in the first and second month VIX futures, traded about 50% more units than its previous record volume.



And the volume in UUP, a trading vehicle for the US dollar index, has been particularly beefy over the past 10 trading days or so, perhaps suggesting a turning point is at hand in the despised US dollar. I mean, everybody knows that the dollar can only go down.



Supposedly Wednesday's reversal was triggered by a downgrade of Wells Fargo by analyst Richard Bove. If true, then the markets would seem to be very vulnerable to anything like bad news, as the reflation bets came off in a hurry shortly after 3 PM.
A one-off 45 minute micro-panic, otherwise "no worries, mate"? Or a sign that a crowded and vulnerable reflation trade is just begging to be unwound a bit?

Yeah, we'll see.

Weekend Mishmash

Below is a monthly chart of the Wilshire 5000 index. You can see that over the past 15 years the 20 month moving average has been a good demarcation line between bull and bear markets.



From January 1995 through September 2000 there was but one monthly close below the 20 month moving average. Then from October 2000 through April of 2003 there were no monthly closes above that level. From May 2003 through December 2007, the Wilshire index closed each month above its 20 month moving average. From January 2008 through August 2009, it closed each month below the 20 mma. Then in September, it closed above...

Should the stock market enter a period of chop, then the 20 mma will be crossed back and forth willy-nilly and will no longer have any significance. It's value as an indicator has derived from the fact that the equity market has undergone 2 sustained bull and 2 sustained bear moves over the past 15 years, leaving the Wilshire about where it was in the middle of 1998. Still, it's an indicator I'll be checking on for a technical sense of whether pullbacks are "corrections" or something more.

Will Businesses Start Spending?

The government has done its part (for good or bad), and noone seems to have much hope for "the consumer" just yet, but what about businesses? Noting that capital spending as a percentage of GDP is at a 40 year low, BCA Research expects an upturn.

Is the Stock Market OK with a Jobless Recovery?

Friday's employment report was weaker than expected, and bad on pretty much all counts, but the stock market's reaction was muted. The last recession officially ended in November of 2001. The unemployment rate didn't peak until June of 2003. While most stocks had bottomed during October 2002, it's probably accurate to say the bull market didn't begin until March 2003. So, what if the unemployment rate doesn't peak until mid 2010? Can the equity market keep chugging higher?

Employment Factoid
During and subsequent to the last recession, the year over year percentage change in payrolls was less than 1.3% AND the 3 month annualized percentage change was less than 1% for 34 consecutive months - from February 2001 - November 2003. The streak for the current recession (which is most likely over) is 27 months, and counting.