Author: Bonddad

DIA +.04%, SPY +.26%, QQQQ +.53%
10-Year Treasury +6/32 yielding 4.09%
Oil +1.7%, closing at $56.58
Dollar +.2% versus Euro, down .25% versus Yen

The markets rose again today.  A .2% increase in housing starts and 330,000 unemployment claims led traders to believe the economy is on firm footing.  There were several reports stating traders are more bullish for the second half of the year, believing the economic fundamentals are solid.  Yesterday’s Federal Reserve Beige book confirms this perception – the Fed report indicated most economic sectors are indeed solidly expanding.

The 10-Year Treasury rose 6/32 to close at 4.09%.  The Philadelphia manufacturing survey came in a -2.2% compared to an estimated 10% increase.  A reading below 0 indicates a manufacturing contraction.  This negative reading combined with this weeks’ low inflation numbers led traders to believe inflation is under control.

Oil increased 1.7% to close at $56.68/bbl.  Summer is typically the heaviest driving season, which leads to increased oil prices for consumers.  As a result, traders bid up oil.  OPEC also released a report about 2005 demand that projected world oil demand 100,000 barrels/day above current OPEC production. In addition, Wednesday’s weak inventory report and near capacity production report is still concerning some traders about the overall supply and demand situation in the oil market.

The dollar was up .2% versus the Euro and down .25% versus the Yen.  The dollar’s recent gains versus the Euro are less about US growth and more about continued fears regarding the EU’s future.  Today, EU ministers met to discuss the EU budget and there were reports regarding possible disagreements.  This further increases trader’s concerns about the Euro’s future.  Technically, the dollar is very overbought relative to the Euro.  The dollar recently topped near 109 Yen/Dollar and has since fallen a touch.  However, the move is likely mere profit taking as most currency traders have focused on the Euro.  

The Republicans have used supply side economics to justify tax cuts for the rich since 1980.  Starting with Reagan, the total combined debt accumulated under 17 years of Republican economic leadership is 5.170 trillion, or a 10.61% compound annual growth rate.  

The argument used to justify the tax cuts is they will sufficiently stimulate the economy to pay for the increased debt that originally funds the tax cut.

When will the economy grow fast enough to pay down this Republican incurred debt?

DIA +.16%, SPY +.19%, QQQQ +.32%
10-Year Treasury -2/32, yielding 4.12%
Oil +47 cents to $55.57/bbl
Dollar -.8% versus Euro and -.2% versus Yen

Oil’s price spike above $56/bbl largely caused this morning’s sell-off.  However, stocks rebounded as oil fell from its daily highs.  Also encouraging the markets was the surprisingly low core CPI increase of .1%.  Overall CPI was down .1%.  However, oil has increased in price since this figure was tabulated, indicating a higher CPI number is likely next month.  The NYSE advance/decline number was 19-12 while the NASDAQ’s was 16-13.  Technically, the markets are treading water.  The NASDAQ has sold-off from its May rally, and the DOW and S&P are still trading in a fairly thin range.  This indicates traders are evenly split regarding future price direction.

The 10-Year Treasury ended down 2/32, yielding 4.12%.  Part of today’s drop was a continuation of the technical sell-off in the markets.  The 10-Year is still technically overbought, although it is in better shape than in the last month.  The market sold-off to a larger loss earlier in the day after the NY manufacturing index rebounded from last months sharp decline.  In addition, the Fed released its Beige Book, which reported the US economy is on firm footing.

Oil increased 47 cents to close at $55.57/bbl.  The Department of Energy reported oil inventories decreased 1.8 million barrels last week, although inventories are still higher than last years level.  Refineries are also operating at 96.7% capacity which gives very little room for any problems.  Finally, OPEC announced an increase in their production ceiling.  However, this increase of 500,000 largely confirmed the levels where most OPEC producers are already producing rather than a meaningful increase.

The dollar lost .8% versus the Euro and .2% versus the Yen.  The US’ structural imbalances returned to the forefront of trader’s perception today, as the Treasury announced net capital inflows were 47 billion last month.  This is the second consecutive month where foreign purchases have been too low to support the US’ trade deficit.  

In April 2005, foreigners purchased a net total of 47.4 billion dollars of long-term US Securities.  This data is best viewed in comparison to the US trade deficit, which was 58 billion dollars last month, and 57 billion in April.  Put another way, the US came up 9.6 billion dollars short in funding its trade deficit in April.
More importantly, it appears some Asian central banks are slowly halting their total amounts held of US Debt.  In June 2004, Japan held 666.6 billion in US debt compared to 685 billion in April 2005.  That comes out to a net annual increase of 18.4 billion.  Over the same period, China increased its holdings of US debt from 194 to 230 billion for a net increase of 36 billion.  Korea increased its holdings from 44.5 to 55.9 for a net increase of 11.4 billion.  The combined annual increase for these three countries is 65.8 billion, which would finance roughly 1 ¼ months of the US trade deficit.

Most of these countries are most likely purchasing treasuries in transactions called duration swaps rather than accumulating an increasing position of US securities.  A duration swap is a method of managing a fixed-income portfolio in a manner that attempts to neutralize interest rate risk.  This is s hunch based on personal experience and has no basis in fact.

Earlier this year, the Asian banks announced the formation of the Bellagio Group, a group that comprises most of the US’s large Asian creditors.  The group was publicly called a “study group”, but many analysts believe a desire to diversify Asian central bank assets away from the dollar was the real reason for this group’s formation.  Since this announcement, several countries have increased their currency swap arrangements, indicating they may be increasing preparedness in case of a currency crunch.  The increasing amount of central bank currency swaps adds further strength to the analyst’s opinion about the real underlying reason for this group.

As this is the second month of decreasing foreign purchases (last month was 40.6 billion total) it is now increasingly likely that foreign banks are growing tired of their role as financiers of the US’ spending habits.

DIA +.22%, SPY +.23%, QQQQ -.40%
10-Year Treasury -1/4 yielding 4.12%
Oil – 35 cents closing at $55.42/bbl
Dollar +.65% versus Euro; unchanged versus Yen

The markets were mixed today, largely driven by event-specific news.  Retail sales dropped .5% last month, while producer prices dropped .6%, although core PPI inched up .1%.  a drop in energy prices was largely responsible for the PPI drop.  Considering energy prices have rebounded over the last month, this number could be an aberration.  GM announced it is making progress regarding its health costs.  This was a primary reason for the Dow’s upward move.  

The 10-Year bond lost ¼, yielding 4.12%.  Today was partially a continuation of the last 5 days’ technical sell-off.  The 10-year is still overbought, meaning the yields are simply unattractive to investors.  The markets are also more of the opinion the Fed will continue interest rate hikes for more than a few months.  

Oil dropped 35 cents to close at $55.42/bbl.  Today’s drop was partly technical, considering the recent run-up in prices.  In addition, traders are positioning for tomorrow’s weekly inventory report.  OPEC announced it will raise its production ceiling by 500,000 barrels/day.  However, this is a somewhat hollow promise as most oil producers are already producing at or above their proscribed ceilings.   Technically, the oil market is neutral, indicating that an extreme report in either direction could send the markets into a major move.

The dollar rose .65% versus the Euro and was near unchanged versus the Yen.  Fallout regarding the EU vote continues to hurt the Euro.  While there is some speculation the Euro is nearing fair value, traders continue to sell Euros.  More importantly, traders continue to liquidate long Euro positions.  This indicates that bullish sentiment regarding the Euro is slipping.  The dollar is heavily overbought versus the Euro.  Regarding the Yen, the lower economic numbers coming from the US stalled the dollar’s recent upswing versus the Yen.  However, the dollar is still benefiting from a change in perception regarding the Euro.  This implies the market thinks the Euro is not as strong a competitor for reserve currency of choice among market participants.  This change is benefiting the dollar.

Does anybody remember the old EF Hutton financial services commercials?  The commercial stated: “When EF Hutton talks, people listen.”  As a fan of good advertising, I loved these commercials.  Fed governors are the banking equivalent of EF Hutton; when they talk, people listen.  Today, Fed Governor Bies made a speech about the real estate market, and we should listen.
“The recent growth in HELOCs has been remarkable; at the end of 2004, outstanding drawn HELOCs at all insured commercial banks totaled $398 billion, a 40 percent increase over 2003. Meanwhile, the agencies have observed some easing of underwriting standards, with lenders competing to attract home equity lending business. Lenders are sometimes offering interest-only loans and are sometimes requiring very small down payments and limited documentation of a borrower’s assets and income. They are also relying more on automated-valuation models and entering into more transactions with loan brokers and other third parties. Given this easing of standards, there is concern that portions of banks’ home equity loan portfolios may be vulnerable to a rise in interest rates and a decline in home values. In other words, there is concern that not all banks fully recognize the embedded risks in some of their portfolios. But supervisors believe that, like most other lending activity, home equity lending can be conducted in a safe and sound manner with appropriate risk-management systems.”

From a banking perspective, tighter credit standards increase the price of loans.  For example, a more in-depth financial analysis for a perspective borrower increases the bank’s costs in preparing the loan.  In addition, from a consumer perspective, banks are nearly identical – there is little difference between bank 1 and bank 2.  Therefore, a bank’s best sales pitch is price.  Also note the huge increase (40%) in home equity lending over the last year.  This increase indicates home equity loans are cash centers for the financial industry.  And the banks – being for profit institutions – want to milk this cow for all it’s worth.

Finally, a slipping of credit standards is a sign that the real estate market may be topping.  An increase in the level of risk market participants are willing to take is usually a sign they are stretching their abilities to make as much money from an economic cycle as possible.

There has been a great deal of talk about interest only loans, but no one has really explained what these new methods of financing are.  Well, by the time you read all the way through this article, you should know what an interest only loan is an why they can be very dangerous.  And the best part is you get to participate!
First, get a piece of paper and a pencil.  Now, draw a rectangle.  Now draw a straight line from the upper-left hand corner of the rectangle to the lower-right hand corner of the rectangle.  You now have a rectangle divided into two triangles.  Along the bottom of the rectangle write the label “time” and along the vertical side write “amount of money”.

Congratulations!  You have now successfully diagrammed a standard mortgage cash flow!  Pat yourself on the back on a job well done.  Now, let’s explain the components of this thing by comparing it to a standard bond payment.

Here is a good place to explain the difference between a mortgage and a traditional bond payment.  When someone gets a loan in the form of a bond, they make interest payments on a regular basis and repay the amount of the loan (the principal) at the end of the loan term.  For example, suppose you sell a $1000 face amount bond at 10% interest for 10 years.  The $1000 is the face amount of the loan, or the actual amount of money you are borrowing.  This is also called the principal amount.  The interest is the cost of the loan, or the price you pay to the lender for using the lender’s money.  Over the 10-year life of the bond you will make annual interest payments in the amount of $100.  But, when you make these interest payments, you don’t repay any of the principal or the amount of the loan. Instead you repay the lender the cost of the loan and save repaying the principal for the last payment.

To compare the above bond payments to a mortgage, we’ll return to our rectangle diagram.  The lower triangle represents the interest component of the cash flow and the upper triangle represents in principal component of the cast flow.  Now, remember the horizontal line represents time.  So every time you make a mortgage payment, you pay a particular amount of interest and a particular amount of principal. At the beginning of the loan, you pay mostly interest and a little principal.  At the end of the loan, you pay mostly principal and a little interest.  This process is called amortization, or the process of dividing a particular stream of payments into interest and principal components over a particular period of time.

Now, notice with the standard mortgage diagram, you are paying a combination of interest and principal.  Every time you make a payment, you are whittling down the face amount of the loan.  So in year 10 of a 30-year mortgage, you should theoretically have a smaller face amount due to the lender.

With an interest only mortgage, you are only paying interest for the first part of the loan. While you are paying only interest, the principal amount remains unchanged.

Let’s use some numbers to illustrate this point.  I’m going to use simple numbers that don’t represent actual amounts in order to make the illustration easier to understand.

Suppose you take out a $100,000 30-year mortgage at 10%.   With a standard mortgage by year 10 you have repaid say 1/3 of the principal, or $33,000.  However, by year 10 of an interest only loan you still have $100,000 outstanding on the loan.  This is where the problem comes in with interest only loans.  At some time in the future, the debtor may get hit with a massively escalating financing payment that will not go down.  

This is an overly simplified version of the real thing, but the core principles are the same.  Interest only loans make a traditional mortgage borrower more like a corporate borrower and making him more subject to the same problems as a corporate borrower.  

For those of you unfamiliar with his work, Steven Roach of Morgan Stanley Dean Witter is one of the foremost economic commentators on Wall Street.  His current article is titled “The Big Squeeze” and its focus is the lack of income growth in the current US recovery: “America’s income-short, consumer-led recovery is the aberration — not the norm — in this Brave New World. It is all about ever-declining personal saving rates, ever-widening current account deficits, mounting debt burdens, and increasingly wealth-dependent consumers.”
“…even in the US, growth in hourly worker pay averaged only 3.3% over the past four years. [But] With consumer inflation averaging 2.1% over the 2001-04 period, real compensation per hour in the US business sector expanded at a 1.2% rate over this four-year interval.

“…real compensation per hour in the US business sector expanded at a 1.2% rate over this four-year interval [this is the inflation adjusted figure].  But that needs to be put in the context of America’s productivity performance — average gains of 3% during 2001-04.  Economics teaches us that trends in worker rewards and productivity go hand in hand over time.  That most assuredly has not been the case in the United States in the early 2000s, with growth in real compensation per hour averaging only about one-third the pace of underlying productivity growth.”

Let me stop right here and decode Mr. Roach’s ecotalk.  Inflation is just a fancy way of saying how much less a dollar is worth on an annual basis.  For example Mr. Roach notes the US’ average inflation number of 2.1% for the last four years.  So $1 in 2000 would be worth $97.9 in 2001 and so on.  

Productivity is simply a measure of how much more of product X a person, company or economy can make in a specific time frame.  It stands to reason that if an entity can make more of X in the same amount of time it will make more money.  Suppose a company originally make 5 units per hour and improves productivity to 10 units per hour.  The company has effectively doubled its profit per hour of production.  As a result, the company should reward its employees with higher wages to compensate them for their performance.

This is where the rub with the current situation comes in.  Although the US is more productive, it’s employees are not being compensated for their improved performance.  

This helps to explain the pathetically low-savings rates and record high debt levels of the US consumer.  The US worker sees more of X being made, but he is not receiving his fair share of the increase in productivity.  As a result, he participates in the expansion by going into debt.

However, it is important to explain why the US worker is not receiving his share of increased productivity.  As Mr. Roach explains:

“My vote for the explanation continues to go for the “global labor arbitrage” — a critical outgrowth of globalization and the concomitant integration of cross-border labor markets.  The pace of cross-border integration has now reached hyper speed.  Global trade surged to a record 28% of world GDP in 2004 — up dramatically from a 19% share as recently as 1991; over the 1987 to 2004 interval, our estimates reveal that the expansion of global trade accounted for fully 35% of the cumulative increase in world GDP growth — essentially double the 17% share over the 1974-86 period.”

Let me decode all this ecotalk.  “Cross-border integration” simply means that geographic borders don’t mean much to business.  A company can move money to a new location at the click of a button and set-up a manufacturing facility.  As a result, the company does not have to increase US worker’s pay at US rates, but at the rates of other countries.  In effect, the US worker is competing against all a companies employees – national an international.  This puts the US worker at a competitive disadvantage when negotiating wages.

What can the US do?  The answer is simple.  The US needs to develop jobs and skills that cannot be outsourced to other countries.  Let me explain this by way of contrast with a current example.  In January, the US lowered textile quotas on Chinese textiles.  Within several months, Chinese textiles flooded the US market.  US textile workers were up in arms for very legitimate reasons.  But they have very little real power to deal with the situation.  If they work for a multi-national company, the company can simply close the US plant and move it to a country where labor costs are cheaper.  If the company only has domestic operations, a pay increase is less likely because of the increased competition in the textile industry.  In short (and regrettably) the textile workers will in all likelihood have to simply take it if they want to keep their jobs.

Now, suppose the workers made a product that had a unique skill set – one that could not be easily outsourced.  This would give the workers a stronger negotiating position for wage increase.  This situation would also imply the workers were making higher wages because of the rarer nature of their product.  <

This is where the real long-term answer to the US’ low wage growth lies.  Building a job base that requires skills not available in other parts of the world.

This is what the Democrats have to push as their economic platform.

DIA +.05%, SPY -.09%, QQQQ +.51%
10 Year Treasury, +1/4 yielding 4.16%

Today’s big news was the Fed’s ¼ point increase of the discount rate, which they announced at 2:15 ET.  However, they left a sentence out of the statement that said, “Longer-term inflation expectations remain well- contained”.  The Fed caused some confusion when they announced the addition of the sentence after they issued their policy statement.  As a result, the market zig-zagged after their policy release.  The Fed maintained their position they would use a measured approach to interest rates, indicating further hikes are possible for the rest of the year.  Market internals indicate confusion among traders.  The advance decline ratio was even on the NYSE, and slightly negative on the NASDAQ with decliners leading advancers 15-14.  However, 52% of NYSE volume was negative compared with 37% on the NASDAQ.

The 10-year Treasury rose ¼ to yield 4.16%.  After the Fed made its original announcement, he market originally sold-off to a yield of 4.21%.  However, the addition of the sentence “”Longer-term inflation expectations remain well- contained” eased bond-trader’s inflation concerns and led to a market rally.  Several commentators mentioned even with the new statement, the Fed’s possible actions are still wide-open, although others noted the new language lowers the possibility of large rate increases.  

Oil fell 3%, closing below $50/bbl at $49.50.  The oil market is predicting the Department of Energy will report tomorrow that oil inventories in the US increased again.  In addition, the Saudis announced they are pumping near capacity and other OPEC members are trying to ramp up production to allow the US to purchase oil ahead of the summer driving months and winter heating oil months.

The dollar was virtually unchanged versus both the Yen and the Euro.  The Fed’s sentence omission left currency traders perplexed.  In the original statement, traders noticed the language had not changed, but also keyed into the fact the Fed did not mention anything about inflation.  This led traders to conclude the Fed could possibly raise rates aggressively.  The dollar rallied versus both currencies on the original statement.  However, the Fed’s correction led too a dollar sell-off, as traders assumed it meant the Fed would not aggressively raise rates.  In short, traders will probably spend most of the evening trying to get a true read on what the Fed actually means.

DIA +.69%, SPY +.56%, QQQQ +.40%
10-Year Treasury +3/32, yielding 4.20%

Oil was again a driving force in the equity markets.  Stocks rallied after oil dropped below $50/bbb.  When oil rallied, stocks maintained their upward momentum.  AIG group — which has been under selling pressure from an accounting issue — announced its restatement of earnings would not be as severe as previously thought.  A strong construction report outweighed a weak manufacturing report.  Finally, the market was simply oversold, encouraging “bargain hunters” to step into the market.

The 10-year Treasury gained 3/32 to yield 4.20%.  Tomorrow the Fed will announce its policy decision, which many believe will be another increase of 25 basis points.  The Treasury market is usually inactive before a Fed meeting, and today was no different.

Oil closed up 2.4% at $50.92/bbl. Reports give conflicting reasons for the upswing.  Some analysts felt technical buying was the primary reason for the increase.  Others commented that weekend violence in Iraq once again reminded traders of the “terror premium” in the market.  Finally, the ALgerian oil minister commented that demand remains strong and OPEC is already producing at capacity.

The dollar was essentially flat versus the Euro and the Yen.  Forex traders, like bond traders, are waiting for the Fed’s interest rate decision to make further moves in the market.