Despite all the policy machinations — from TARP capital infusions to outright asset purchases, temporary lending facilities, a near-zero fed funds rate and various guarantees on bank liabilities — loans outstanding in the commercial banking system have continued to contract. Instead, banks have preferred to accumulate securities rather than make new loans. Even those purchases have flattened in recent months as banks are back to hoarding more excess reserves.

We won’t argue with the counterfactual — without these measures, the contraction in bank loans outstanding would no doubt have been much more dramatic, as an Austrian-style simplification of balance sheets would have naturally gathered momentum following the Lehman Bros. bankruptcy. But the reality is neither the household nor business sector is eager to add to its debt, and bank loan officers are still battling rising loan loss recognition from the last private credit bulge. This is much as we anticipated — the private sector has hunkered down, is spending less money than it is earning and is paying down or liquidating existing debt loads.

Why Banks Aren’t Lending originally appeared in the Daily Reckoning. The Daily Reckoning, a FREE daily e-letter, offers a "uniquely refreshing" perspective on the global economy, investing, and today's markets.

As you can see from the chart below, it is usually only in the first year of recovery that year-over-year labor productivity growth breaks through 4%, as it just did in Q3. When combined with hourly labor compensation growth now screwed all the way down to a 0.5% pace, falling unit labor costs are the result.

Unquestionably, labor productivity gains are one key driver of long-term growth. But here is the hitch we see developing: Small businesses appear to be on the ropes. Large businesses have cut to the bone. Both GDP and S&P 500 profit results indicate companies that are achieving high labor productivity and lower unit labor costs have, so far, been able to hold onto these gains through higher profit margins. However, if U.S. firms do not step up the reinvestment of these profits into the real economy, by lifting production up enough to first end the inventory contraction and begin inventory rebuilding, and then also stepping up their reinvestment of profits in more efficient technology or new products, then the nascent U.S. recovery will sputter out…

To put it in the extreme, labor productivity gains will not get us very far if the profits generated from them do not start getting ploughed back into voluntary inventory rebuilding and reinvestment in capital equipment.

A Key to Escaping the Recession originally appeared in the Daily Reckoning. The Daily Reckoning, a FREE daily e-letter, offers a "uniquely refreshing" perspective on the global economy, investing, and today's markets.

Furthermore, by adding $262 billion to Treasury holdings, $79 billion to agency holdings and $515 billion to mortgage-backed security holdings from March through mid-October, the Fed has also suppressed the yields available to households in these segments of the fixed-income market. In effect, we believe the policy gambit has been to herd investors into equities and corporate bonds by reducing yield opportunities in other asset classes. By doing so, we believe the Fed has sought to induce wealth effects designed to cushion the blow of the past year’s financial crisis on real economic activity.

Thus we face some incompatible truths. Demographically [think baby boomers], more investors should be migrating to lower-risk portfolios and looking for asset mixes that provide some combination of high-income yield, security of principal and inflation protection… Policy-wise, central banks have responded to the economic carnage wrought by a major financial crisis by lowering short-term interest rates, which reduces yields on near-cash instruments like money market funds and Treasury bills. Through quantitative easing measures, they have been bidding down yields in a variety of longer-term fixed-income classes, like government bonds, mortgage-backed securities and, in some cases (as with the Bank of Japan), even corporate bonds.

Investors who demographically are at a stage of life when they need to earn high yields with fairly secure principal while maintaining a good hedge against inflation risks are finding central banks have clipped the menu of many opportunities. We suspect this portfolio incompatibility may not end well.

The Fed’s Real Objective in Keeping Rates Near Zero originally appeared in the Daily Reckoning. The Daily Reckoning, a FREE daily e-letter, offers a "uniquely refreshing" perspective on the global economy, investing, and today's markets.

From a mainstream economic perspective, it should be renamed Leisure Day, as unemployment is interpreted as an individual choice of leisure over paid labor effort. Of course, only a tenured professor could be expected to come up with such a conclusion. As it stands, it is currently estimated there is one job opening for every six people looking for work.

Since employment is a lagging indicator of economic activity, we learned over the years to dig deeper than the headline figure to get a read on where labor market conditions may be going. One of the more useful, but often ignored, parts of the employment report tells us about the percent of private industries that are net offering jobs. Even when payrolls are shrinking in total, some industries are still net hiring – and, indeed, this is part of how markets facilitate the reallocation of productive resources during a recession, which, as the Austrian approach reminds us, is crucial to long term-growth prospects.

This measure is called a diffusion index, and we prefer to look at the average in this series over the past three months to avoid too many miscues. As it stands, the breadth of private industries net hiring, though still at a lower level than the last recession, has consistently climbed from the March lows. The pace of broadening is even a bit stronger than what we observed in the last exit from a recession, which, as you may recall, was followed by a jobless recovery. If the slower pace of layoffs is all a sugar high from extreme policy measures, or if a double dip is about to open up before investor eyes, this is one of the places it should show up first. So far, this diffusion index is more consistent with an unemployment rate that peaks near year-end around 10% and begins to show some improvement in Q1 2010. We would also note while survey results still report perceptions of a very difficult job market, these measures have stabilized in recent months.

When firms start shedding labor more aggressively than their production activity is contracting, labor productivity (output produced per hour of work) tends to reaccelerate as the pressure on the remaining work force intensifies. In fact, productivity growth has begun to rebound, and we believe it has a good shot at pushing through 4% year-over-year growth by year-end, from the current 2% pace in the nonfarm sector. At the same time, businesses struggling to stay alive have pressured labor compensation growth. Hourly compensation (wages and benefits) growth has been on a disinflation (that is, decelerating inflation) path through the entire recession. We suspect it will be flirting with deflation near year-end, which is something we have not seen since Q4 in 1949.

If we put these two developments together – labor compensation growth approaching deflation, while labor productivity growth reaccelerates – we get deflation in unit labor costs. Companies that can hold the line on pricing while unit labor costs are falling will tend to experience rising profit margins, and rising profit margins are generally a signal to expand production. Improving cost conditions are one benefit of recessions, and if final demand can stabilize or improve from sources other than the household sector – say, fiscal policy or an improvement in the trade balance or the onset of some replacement capital spending – then this can be a route back to economic recovery. We will have more to say about this in the next monthly letter, but for the moment, it does look like firms are successfully compressing cost conditions.

This matters because with the release of Q3 S&P 500 earnings in October, we suspect strong operating leverage will become apparent to equity investors. Earnings improvement through Q2 has been all cost cutting related in a flat or falling revenue environment for most companies. If Q3 begins to show top-line revenue improvement, as we suspect it will, then earnings will be fed by both revenue and profit margin gains. After the seasonal September jitters, the exposure of the operating leverage available to firms that have cut to the bone could very well capture the imagination of investors, leading to the next leg in the advance of US equity indexes since early March.

According to supply managers in the manufacturing sector, goods sector production has been on the rise since June, and new orders are through the roof. By way of reference, the new orders index was scraping a new historical low back in December, rivaled only by the 1980 lows following Fed credit controls. Never before in the six decades of Institute for Supply Management (ISM) records have new orders surged so dramatically in any eight-month span. Never before has the ISM new order and production indexes recorded these levels without marking an escape from recession. No doubt the “cash for clunkers” sugar high has something to do with this, but we doubt it explains away all of the dramatic reversal in supply manager perceptions, as the export indicator in this report has also improved remarkably since the December 2008 lows.

These ISM results are usually good for a three-four month lead time on government reports for industrial production, shipments and new orders. We can anticipate the rebound depicted above will now reverberate in the monthly reports from here to year-end, at a minimum. In particular, the ISM production index has provided a reasonably good guide to year-over-year momentum in manufacturing production.

The sharpest monthly contractions in industrial production began in September of last year as the credit markets went into cardiac arrest, and all parts of the economy went into a cash grab/cash conservation mode so that prior cash commitments could be met. This included dramatically reducing production and liquidating existing inventory stocks. In other words, the comparisons against year ago are about to get ridiculously easy, and a healthy 5% year-over-year manufacturing production growth rate is certainly within reach by year-end 2009.

As summer slips away into the flaming leaf show of fall, we conclude the labor market is still a mess, but we can find some broadening of hiring activity even though total payrolls are still contracting. That means the necessary reallocation of productive resources, which is part of the function of recessions, is under way. More importantly, unit labor costs are falling as the pace of layoffs has overshot the contraction in output, and labor productivity is improving as a consequence, which is a second growth encouraging outcome of recessions.

The question remains what lies ahead after the massive quantitative easing operations of the Federal Reserve have lapsed and the bulk of the fiscal stimulus is behind us. In the very near term, we can surely expect auto sales to wilt following the end of the cash for clunkers program, but we remain impressed by what supply managers in the most cyclical part of the economy, namely manufacturing, have to say about new orders, production and export conditions. Policymakers panicked and adopted a “whatever it takes” stance, one that has proven to be the most radical outside of major wartime conditions. Looks like something took – and not surprisingly, gold is taking out the $1,000 per ounce mark at the same time.

Regards,

Rob Parenteau
for The Daily Reckoning

Unlabor Day originally appeared in the Daily Reckoning. The Daily Reckoning, a FREE daily e-letter, offers a "uniquely refreshing" perspective on the global economy, investing, and today's markets.

Analysis by anecdote has its dangers. One instance may not be representative, for example, of what is going on in the larger picture. However, we do recall back in the ’80s, there was one brokerage firm in the South that kept a running count of the number of dead chickens on the road to use as a proxy for GDP. The idea was the stronger the economy, the more trucks stacked with crates of chickens would be heading to the slaughterhouse, and hence the more crates would be falling off the back of trucks. Estimating GDP by road kill volumes struck us as a bit of a reach, but if memory serves us correctly, this anecdotal measure did a lot better than some of the Wall Street economists we followed at the time.

The risk of analysis by anecdote is that by nature, our minds tend to gravitate toward confirming our existing opinions and perspectives. “Confirmation bias” is the label the behavioral finance types have applied to this recurring tendency in our thinking. Once our minds make sense of a confusing jumble of facts, we inadvertently tend to pay attention to the information that corroborates the initial story. As any marketing professional will attest, we also tend to be persuaded more easily by compelling images or entertaining stories than by facts and figures. For investors, these built-in perceptual biases can lead to building too large a position in one investment theme or hanging onto one position for far too long.

We have been detailing growing evidence of a turn in the US economy in recent months. The bounce in existing homes sales reported last week is yet one more sign that even in the most bombed-out part of the economy, there is some activity stirring. The median home price, which has fallen 28% from the July 2006 peak, remains above its April 2009 lows. And in the Northeast, the National Association of Realtors reports existing single-family home sales have risen 44% from their January lows.

Judging by the strong gains in US equity indexes on this release, this is precisely the type of confirmation many equity investors have been seeking regarding the prospects of a V-shaped recovery. So while on vacation at a spot on the ocean south of Portland, Maine, that we have visited for better part of four decades, we decided to walk around with eyes wide open.

Our destination was an old mill town that thins out down the river-wooded areas that lead to some sweeping beaches. The beachfront is laced with light gray beach sand the consistency of powdered sugar that fills in between bold, seaweed-strewn granite outcroppings. Lobster traps bob just off the coast, and at daybreak, the lobstermen are out pulling their traps. A few miles south, the Bush family compound lies behind a gated fence, and weathered, cedar-shingled vacation homes along the picturesque seacoast stand in stark contrast to the nitty-gritty core of the town upstream. Such are the intriguing contrasts of New England: historical legacy abides by natural beauty.

Walking around, eyes wide open, we noticed more of the vacation homes had for sale signs on their front lawns than last year. Last summer, the signs were standing mostly on the lawns of the inland locals who had no doubt been taunted by the siren song of liar loans in order to make the leap from renting to owning – probably sometime right around 2006, at the peak of the market. Now the gentry, who often try to pass down their seaside vacation homes through the generations, appeared to be distressed sellers as well.

More striking, in the urban core of the town, several miles upriver from the coast, we had never seen so many for rent signs. The last of the mill jobs had just been eliminated, and much of the mill complex at the center of town had been turned into condos or stripped down to the brick walls (in a somewhat haunting see-through condition) in preparation for a risk-hungry developer to create condos out the remaining shell. Either a glut of rental properties has developed in the core of the town or families are doubling up as the unemployment rate has climbed.

We noticed the weakness in the last housing starts report did come from the multifamily or rental side, and rents as recorded in the CPI did fall in July relative to June, so this may all be symptomatic of the next stage of the real estate workout. In the college town we have lived in for nearly two decades on the West Coast, which should be brimming with student renters, we have also noticed a blossoming of for rent signs. We previously wrote that off as the inevitable result of state budget cuts leading to dramatic cuts in fall enrollment, but perhaps this initial conclusion was too sanguine.

The shack near the beach where we remember our father sneaking off to indulge in the guilty pleasures of a chocolate shake and fried clams had closed after decades of operation, as had the fish purveyors’ shop in the village near the mouth of harbor. Oddly enough, a real estate office has taken the place of the fishmonger. Off on the water, lobstermen were reportedly cutting each other’s trap lines, sinking each other’s boats and occasionally pulling guns on each other. Fuel prices were up, but the wholesalers that purchase the lobsters were offering rock-bottom prices for the catch, leaving the lobstermen in fairly desperate straits.

On the main beach itself, which curves up in a two mile long crescent before grass-covered dunes, French was spoken under every other collection of beach umbrellas. The strong Canadian dollar is getting more mileage stateside – apparently enough that the humble bungalow our family vacationed in back in the ’70s had been bulldozed by a Quebec-based steel magnate and replaced with a barn-sized trophy house, which only paled in comparison with the trophy mansion next to it, built a year or two prior, by a US pharmaceutical company CEO.

Most striking was the absence of people on the beach during the weekdays. Even in the depths of the 1973-5 recession, we cannot recall the beach seeming so sparsely populated. Maybe the soggy weather had encouraged more people to cancel their vacation plans earlier in the summer, or maybe “staycations” have come to dominate as households try to save money and find diversions closer to home.

What are we to conclude from walking around with our eyes wide open? The recent upturn in the economic data can (and we suspect will) be used to confirm the V-shaped aspirations of professional equity investors in the months ahead. Without it, driving US equity indexes higher, after a 50% move off the bottom, would surely prove problematic. It will also be used by policymakers to claim victory with their extraordinary and unconventional policy measures. Chairman Ben Bernanke needs to be able to declare some sort of victory if he wishes to be reappointed in January of next year. With the health care proposals literally on the ropes in many town meetings, the president will need to claim victory elsewhere to regain traction in the polls going into 2010, which will host midterm elections.

But if this one New England town is any indication, beyond the V-shaped impression that “Cash for Clunkers” pump priming and other influences will leave over the next couple of quarters, there is plenty of economic restructuring to be accomplished beyond the V impression. The legacy of the housing bust will linger long over this area. More lobsters might get ordered in Manhattan, but living large will remain out of reach for many households that cannot access credit anywhere near the fashion they once grew accustomed to, but now regret. Reinventing growth without reliance on private credit bubbles is undoubtedly the task ahead, and we suspect this will become increasingly apparent once the sugar high of policy stimulus wears off.

Best regards,

Rob Parenteau
for The Daily Reckoning

Analysis by Anecdote originally appeared in the Daily Reckoning. The Daily Reckoning, a FREE daily e-letter, offers a "uniquely refreshing" perspective on the global economy, investing, and today's markets.

To our mind, the twin head winds of private sector deleveraging and impaired financial institutions with unusually high-risk aversion are the larger issue. If the business and household sectors seek to maintain a high net saving position (that is, saving from income flows minus tangible investment expenditures), as was the case in Japan, then barring the political willingness to allow debt defaults and rapid relative price changes to rip through the economy, only a rising trade surplus plus an increasing fiscal budget deficit can deliver US economic growth. As we will show you in a moment, though, we are detecting for the first time some signs of life in business investment.

Most investors, policymakers and economists appear to be either ignoring the implications of private sector deleveraging or have implicitly assumed any such deleveraging will prove short-lived. The latter is, of course, more consistent with their experience, but as many professional risk managers at hedge funds and other institutions recently learned the hard way, the past is at best an imperfect guide to the future – especially if you do not stop to consider why the past developed the way it did.

We have expressed the challenges of private sector deleveraging in our work on US financial balances.

In simplest terms, the challenge of a balance sheet recession is this: In the face of a large drop in asset prices, the private sector reduces spending on goods and services in order to save enough money out of income flow to reduce balance sheet leverage. Unless the trade balance improves and fiscal stimulus is ramped up in a large enough fashion, private income flows will tend to fall as households and firms spend less money to try to reduce debt loads. Realizing that one man’s outlays are another man’s income, the end result of this process is much like a dog chasing its tail: Private sector income deflation arises as spending is curtailed, and falling income aggravates attempts to reduce debt burdens.

In a world where Austrian School precepts held sway, the dog would be allowed to exhaust itself and start out fresh, facing less-distorted relative price signals that eventually would lead to a more productive set of behaviors. Debts that could not be supported would be allowed to disappear in default, creditors would gain ownership of any remaining tangible productive assets and prices for products and labor would adjust until growth returned to the trend path dictated by the available supply of productive resources and the willingness of entrepreneurs to search for profitable production opportunities.

Few nations appeared prepared to take the pain of such unfettered adjustments. Instead of allowing a debt deflation to rip and eventually burn itself out, contemporary policymakers aim to reduce debt-servicing costs, socialize losses and buttress private sector money income flows. Two routes to buttress private sector money flows are available: first, by an improved trade balance (so more domestic and foreign spending is received as income by domestic producers) and, second, by an increased fiscal deficit (so more income is received by the private sector from government expenditures than is removed by taxation). At a global level, until we discover life on another planet, the first exit strategy is, of course, unavailable.

Balance sheet recessions have distinct characteristics from normal garden-variety recessions, and so it is no surprise that recoveries from balance sheet recessions will tend to have different profiles as well. Consumer durable and home sales usually, along with an abatement in the pace of inventory reductions, lead the charge in garden-variety recessions. Not so this time – or, at least, less so. We anticipate recoveries in these areas are likely to prove shallower than usual, but judging from the move in the S&P 500 consumer discretionary stocks year to date, most investors have been positioning as if we were working with a more garden-variety recession. We suspect this will prove to be a mistake, especially as more of the infrastructure-related components of the fiscal policy come into view as 2010 approaches.

For example, consumer expectations, as measured by surveys performed by the University of Michigan, have tended to offer a reasonably good guide to the year-over-year growth rate in consumer spending, adjusted for inflation. July results so far display a 9-point decline in expectations, back below the April readings, but still above the recent February lows. The latest reading on inflation-adjusted consumer spending growth is still as bad as it was during the depths of the 1973-5 recession, which we know was the deepest recession of the post-World War II period. While consumer expectations are consistent with real consumer spending growth migrating back to flat year-over-year gains, this is not the usual liftoff that is typical of garden-variety recessions.

However, Dr. Richebächer worked with a model of economic growth driven by business capital spending, not by consumer spending. This approach was consistent with much of the emphasis of the classical economists, who emphasized the importance of capital accumulation to growth. It was also consistent with Austrian School insights and the work of J.M. Keynes (although subsequently forgotten by some Keynesian followers).

In this regard, the collapse of US business investment spending as a share of GDP over the last two quarters is most striking, and no doubt this is in part testimony to the “lockdown” mentality that spread among corporate CFOs after the Lehman Bros. debacle and the subsequent freeze in credit markets. CFOs went into cash conservation mode and, of course, not just inventories and payrolls got the axe, but capital spending plans were put on ice.

In a smoothly growing economy, households do not consume all that they produce. They save out of income flows, and businesses mobilize the associated unconsumed output as working capital or in the production of new plant and equipment. With the sharp revival in the personal saving rate in the wake of plummeting asset prices and extremely weak job prospects, it is no wonder that US nominal GDP has tracked a deflationary path in recent quarters. Higher household saving, with no mobilization of that saving into reinvestment in plant and equipment, is bound to short-circuit any economy.

We believe the extremely sharp retrenchment in business capital spending is important because the gross spending flows are nearly down to estimated levels of depreciation. That is to say net investment is fast approaching zero. If this is correct, replacement demand for capital equipment is likely to arise in some industries, and therefore could play a larger role in any economic recovery than usual.

We cannot ignore that some industries will be shrinking their available capital stock as the economy adjusts to a reduced private debt growth path. Autos are an obvious case in point. Nor are we ignorant of the extremely low reading on capacity utilization in the manufacturing sector. But we suspect investors and economists may be missing the fact that gross capital spending has dropped so dramatically that replacement demand for capital equipment is likely to kick in sooner than usual. Indeed, perhaps this recognition of the onset of replacement demand is part of the relative performance in tech stocks year to date, as the tech capital stock tends to depreciate quicker than other forms of capital equipment.

We have previously noted the Institute for Supply Management (ISM) new orders series has been signaling a revival in order flows, and with the usual three-four month lag, Commerce Department orders are, in fact, confirming the ISM improvements. Dollar levels of manufacturing orders are starting to make the turn, and capital goods orders are already showing improvement off levels that marked the end of the last recession. By composition, the order improvement is reported in the industrial machinery, materials handling machinery and nondefense aircraft and parts segments. Recent Boeing announcements call the improvement in the last category into question, but the key point here is that even at historically low rates of capacity utilization in the manufacturing sector, there are signs of life in new orders for capital goods. The initiation of replacement demand for some types of capital equipment may have begun given the sharp plunge in gross business investment to levels close to estimated depreciation.

We are quite certain Dr. Richebächer would have recognized this is no garden-variety recession, and so we believe he would agree that positioning investment portfolios as if it were, green shoots in the consumer area and all, is unlikely to prove very satisfying. We are also quite certain Dr. Richebächer would have argued any sound and sustainable recovery requires an improvement in business investment. Business investment is the route to lower cost production and product innovation, as well. In the absence of any such improvement, higher household saving rates will simply tend to show up as shortfalls in the revenues of consumer-oriented firms and a weak, if not falling, nominal GDP. What we wish to share with you is that we are finding evidence that business capital spending has been cut so sharply over the prior three quarters that it is reasonable to expect some replacement demand to begin showing up – and indeed, for the first time in months, we can find evidence of higher new orders for capital goods. While fears of a relapse are still building, that is one green shoot we believe Dr. Richebächer would deem worth applauding.

Best regards,

Rob Parenteau
for The Daily Reckoning

A Green Shoot Worth Applauding originally appeared in the Daily Reckoning. The Daily Reckoning, a FREE daily e-letter, offers a "uniquely refreshing" perspective on the global economy, investing, and today's markets.

Maybe we lack sufficient imagination, but this approach does not strike us as a plausible exit strategy from the broken global growth model. It is a stopgap measure at best, designed to buy time, with fingers crossed that global demand gathers enough speed by year-end. We thought Asia faced some serious macro challenges at the beginning of this year, and we see no reason to change our mind yet.

China, undoubtedly, has extraordinary potential, and we would not for a moment disregard the desire of Chinese leaders to achieve the status of the next global hegemon. The fact of the matter is that until China is prepared to accept currency appreciation, and thus prepared to reorient its growth strategy away from export-led development without simply putting up redundant capacity or building up speculative inventory stocks, its goal is likely to remain elusive…

Asia’s production structure needs to recalibrate for a slower Western consumer growth profile, and that inevitably must involve steps that scrap excess capacity and allow new domestic demand sources to flourish. When we see it, we will be happy to flag it. In the meantime, using bank credit to keep production going and stuffing inventories in warehouses looks like a precarious gambit, at least from the vantage point that Dr. Richebacher cultivated over his career.

The Chinese Commodity Conundrum originally appeared in the Daily Reckoning. The Daily Reckoning, a FREE daily e-letter, offers a "uniquely refreshing" perspective on the global economy, investing, and today's markets.

As we have documented in recent weeks, the list of US macro series showing stable nominal levels over the past 3-4 months continues to increase. These include

1. Retail sales
2. New orders for durable goods
3. Imports of materials and finished goods.

That is not what usually happens in a debt-deflation dynamic, which cumulatively builds on itself.

Our read always has been that the wave of debt-deflation dynamics building last year would provoke a massive policy response. While home price deflation is still ripping, and headline consumer price indexes are showing mild deflation, it appears the debt-deflation risk is being contained by extreme fiscal and monetary measures.

Stability is better than free fall, but it is not the same as expansion, and we believe equity investors have shoved valuations high enough over the past three months that they now require signs of economic growth, not just stability, to carry equity indexes higher. We think the odds of them getting that could improve after we get past the auto production and dealer downshift later in the summer, but the rise in Treasury yields is becoming alarming.

While there were no failed auctions this week, longer-dated Treasury bond yields continue to back up not just on supply issues, but also as private portfolio preferences have moved toward riskier assets and, in some cases, into inflation hedges on the bet the Fed will be forced to monetize the growing fiscal deficit.

Our view has been unless the commercial banks start putting some of their $1 trillion in cash holdings into Treasuries (thereby picking up net interest income to rebuild profitability and balance sheets), the Fed will be forced into taking steps that imply a ceiling in Treasury yields is in place. The only other way out we can see is if the US macro news flow relapses and private portfolio preferences shift back to less risky assets, which puts equity indexes at risk of a sell-off.

So from a strategic point of view, we believe equity investors want and need to see stronger economic and earnings results to drive indexes higher, while bond investors need just the opposite to calm Treasury yields down. In addition, through near-zero interest rate policy (ZIRP) and quantitative easing (QE) approaches, the Fed has been trying to push private investors into riskier asset classes while the Treasury’s debt issuance calendar implies they need private investors to prefer owning Treasury bonds, which are generally not the asset of choice in an economic recovery scenario.

In other words, we have contradictory crosscurrents here. If the Fed doesn’t intervene to slow or halt the Treasury yield backup, there is a chance the stabilization in unit home sales will wither away. If the Fed does step up QE operations to halt the Treasury yield rise, professional investors taking the “green toilet paper” view will continue to sell dollars and buy commodities. Down the line that implies higher energy prices for consumers and higher input prices for manufacturers, neither of which we would consider growth supportive developments.

Our concern is the green toilet paper contingent has the Fed in a corner for the moment with a trade that initially could look self-fulfilling, along the lines of the infamous Soros 1992 trade against the British pound and the Bank of England. At the moment, we honestly cannot see an easy resolution unless some Goldilocks growth path (not too hot, not too cold) develops, but we would we need to monitor this one very closely.

To wit, we can envision the following scenario feeding on itself.

You cannot have

· A central bank pursuing near ZIRP and QE, which, after all, are designed to trash cash and force private investors out the risk spectrum into equities, corporate bonds, mortgage bonds, lower rated debt, etc…

· And have the Treasury issuing loads of public debt at the same time from a massive fiscal ease designed to reaccelerate the economy without expecting Treasury yields to increase…

unless the central bank and commercial banks are willing to soak up Treasury issuance with money creation, or unless the Treasury can get away with “underfunding” – that is, direct monetization of the deficit. There is a policy incompatibility problem, in other words, or at least really incoherent expectations management.

And that puts the Fed on the spot. Do they choose to cap Treasury yields by explicitly stepping up QE operations and buying more Treasury bonds in the open market (or possibly more mortgage-backed securities, to thereby decouple mortgage rates from rising Treasury yields)? Or do they just let Treasuries find their own equilibrium, accepting the risk the economy may relapse again as 10-year US Treasury yields sail through 4%?

Let’s say Helicopter Ben Bernanke decides he does not want to take the tail risk of setting off the next Great Depression. He doesn’t want to go there because he has already exhausted his bag of unconventional monetary policy tricks and he knows he will have to come up with even crazier policy moves, like buying equities outright or making direct loans to companies, if he faces a relapse in economic activity. That means if he flinches, some investors will take that as a sign to increase their short dollar/long commodity trades…

which feeds inflation fears…

encouraging more investors to sell existing Treasury holdings to the Fed…

which creates more “monetization” of public debt…

and more short dollar/long commodity trades…

eventually begetting more intervention by foreign central banks trying to defend the dollar and thereby prevent their own currencies from kiting higher by creating their own money to buy dollars…

which transmits inflation fears out of the United States into a wider range of countries…

creating a fantastic, self-fulfilling feedback loop.

Stepping back, one could see this as a doomsday machine for fiat currencies…Shades of Soros 1992, when he took on the Bank of England and broke the pound, except this one is larger scale, with much more at stake.

We intentionally avoid sensationalizing our analysis – the world is a wild enough place without all the hype. But we feel it important to flag this one for you, because we can see how this dynamic could feed on itself… and we know professional investors have been trained over the serial asset bubble years to flock toward such trades… and we can see how policymakers may be checkmated by professional investors.

Regards,

Rob Parenteau
for The Daily Reckoning

The Fiat Currency Doomsday Machine originally appeared in the Daily Reckoning. The Daily Reckoning, a FREE daily e-letter, offers a "uniquely refreshing" perspective on the global economy, investing, and today's markets.

Since productivity growth is used to estimate unit labor cost growth, costs also must be understated for the service sector as well, which further implies service sector profits are overstated. This should all come out in the wash in future revisions, but for the meantime, it is very likely that the GDP, consumer spending and profit realities are worse than currently reported.

Transfer payments have reached a higher share of personal income than interest and dividend income. Together, that means over 30% of the U.S. personal income flows are now being earned for no increase in work devoted to production of goods and services (although we do recognize loans earning interest may, in fact, finance increased production, rather than financial market speculation). The more people get paid without directly producing goods and services, the higher the inflationary bias likely to arise in an economy. Purchasing power without production is another, perhaps more accurate, way of depicting the old saw about “too much money chasing too few goods.”

Money doesn’t chase anything. People spending money who did not produce anything to get the money – now, that’s a recipe for inflation (or less disinflation/less deflation, than otherwise would be the case from favorable cost and supply conditions, to put the point more generally). In this regard, the major rise in transfer payments from 1966-76 may have played a role in the original onset of the stagflationary ’70s, while the surge in interest income from 1978-82 may have contributed to the second wave of stagflation. Higher money incomes without increased production tends to lead to higher prices, unless, of course, saving rates among money income recipients rise sufficiently. Treasury Inflation-Protected Securities have been one way to hedge for an eventual inflation result, although they are no longer as cheap – but then again, neither are most inflation hedges, which have, for the most, part been bid up year to date.

We have been investigating which sectors have been accumulating Treasuries lately, as we believe placing new Treasury bond issuance may become more challenging not just because of the huge supply forthcoming, but because the quantitative easing measures adopted by the Fed and other central banks are designed in part to force investors out of the risk spectrum and away from cash and default-free Treasury holdings. Results from the Fed show broker-dealers, foreign investors and money market mutual funds have been the largest buyers of Treasuries of late. We are especially concerned the large buildup of long Treasury positions at primary dealers is unlikely to be sustained and there may be a rout in the Treasury market reminiscent of 1994, when Goldman Sachs had to borrow from the Japanese in order to stay afloat after getting caught the wrong way round in yield curve carry trades.

With 10-year Treasuries hitting 3.36% and passing through their 200-day moving average this week, our concern is looking less and less theoretical. We asked seasoned bond veteran Lou Crandall at Wrightson Associates about the unusual buildup in dealer position in Treasuries, and this was his assessment, which we have corroborated elsewhere:

“The large structural short positions that dealers developed in the middle part of this decade were a function of their market-making and hedging strategies. As a general matter, dealers would hold inventories of less-liquid spread products such as mortgages, ABSs and corporates on the long side, and then hedge them by shorting Treasuries of comparable duration.

“Once the liquidity crisis hit in the summer of 2007, a couple of things happened. First, the basis risk on those trades exploded, because spreads became highly volatile. Treasuries were no longer as efficient a hedge for private instruments as they had been. After Bear Stearns, you also started to see a rapid contraction in dealer balance sheets – even if Treasuries had still been an effective hedge for private-sector instruments, dealers were trying to lighten their inventories of those private obligations.

“In 2009, a couple of additional factors have come into play. Dealers wanted to front-run the Fed’s purchases of Treasuries, which probably led to a modest amount of speculative long positions in Treasuries. More importantly, the Treasury market in May has adopted new delivery protocols that impose a 300-basis point penalty on anyone who fails to delivery a Treasury on time. The prospect of that fee created a lot of uncertainty in the market in April, and led some dealers to conclude that it would be safer to conduct their market-making activity from the long side, rather than the short side, of the market in the near term. (Just about everyone came to that conclusion about the bill sector, but some applied the same logic to coupons.)

“The increase in outright long dealer positions in Treasuries is close to having run its course. We could continue to see increases for a few more weeks as dealers complete the transition. However, we are seeing a restructuring of dealers’ market-making business model, rather than an increase in outright long-term holdings in Treasuries driven by an investment view on the part of the dealers.”

Essentially, dealers covered their spread trades by purchasing Treasuries and selling agency mortgage-backed securities and corporate bond positions. Some of them reconfigured themselves as banks, where procedures for the risk weighting of capital favors holding Treasuries. These, along with some procedural changes, are essentially one-off transitions. We, therefore, do not believe broker-dealers are likely to be big buyers in future Treasury auctions. Unless U.S. macro data start to get more alarming soon – and auto production cuts could dampen the Institute for Supply Managements’ numbers, while the minor consumer bounce in Q1 was really mostly over in January and could cool further in Q2 – Treasury yields are likely to surge higher. So far, the backup in Treasury yields has not taken 30-year fixed mortgage rates higher, but this is the type of challenging set-up in the Treasury market that could squash attempts to stabilize the U.S. housing market. If you were planning on refinancing your mortgage this year, you may wish to consider acting sooner rather than later.

Best regards,

Rob Parenteau
for The Daily Reckoning

GDP and Consumer Spending Inconsistencies originally appeared in the Daily Reckoning. The Daily Reckoning, a FREE daily e-letter, offers a "uniquely refreshing" perspective on the global economy, investing, and today's markets.

To be sure, the larger theme we believe will dominate the consumer sector is the need to reduce leverage, which will require a higher gross saving rate than households previously achieved. In a recent issue, we introduced a base case estimate that $1.2 trillion of household debt would need to be paid down over the next three years to return the household debt-to-income ratio to the pre-housing bubble trend. French banking group Societe Generale, however, estimated that a return to the trend of the past five decades would require nearly twice that level of pay down we expected. The key point here is that the consumer contribution to any future recovery is likely to be muted by these debt head winds, regardless of the degree of fiscal and monetary stimulus applied. Equity investors using the regular playbook and running into consumer discretionary stocks should make sure their long-run earning growth expectations reflect this likelihood.

For example, this is shaping up much more as a U-shaped housing recession than the typical V-shaped one, as the inventory overhang this time around has proven difficult to manage. The National Association of Home Builders reports slightly improved home traffic, reflecting mortgage rates’ drop below 5% again as the Fed has ploughed deeper into Treasuries. Nonresidential construction, however, is just turning into a head wind for U.S. GDP growth, with commercial construction leading the way down. This is typically a late-cycle development, and nonresidential construction tends to remain a head wind well in to the next recovery.

One-third of manufacturing capacity utilization has been idled in this recession – something the U.S. economy has never seen in the post-World War II period. Capital equipment production is particularly hard hit, although the most recent monthly figures show the first sign of a turn in the momentum for both this sector and consumer goods production. Consistent with that is the pickup over the past two months of the percent of production sectors showing gains, as the one-month diffusion index has turned up and the three-month is beginning to make the turn.

Small business is arguably the most entrepreneurial segment of the economy, and there is as yet no sign of any stabilization to be found here. Plans to net hire are the lowest ever recorded, and capital spending plans are as punk as they were in the deep recession of 1973-5. We suspect the credit crunch is hitting this sector especially hard, as banks tend to ration credit to their largest customers during such periods. While we believe the policy emphasis on renewing lending to the private sector is misplaced – private sector debt loads, especially household debt, need to be paid down – if there is a sector where this policy thrust is relevant, it is the small business sector.

“Deflation” remains the watchword for 2009, with headline inflation having dipped into deflation for the first time since the 1950s and the PPI crude material series still deep in deflation, though beginning to stabilize on a six-month rate of change basis, even ex energy. As the Fed trashes cash and drags down mortgage-backed securities and U.S. Treasury yields by expanding its balance sheet, it is at the same time pushing professional investors into riskier asset classes and inflation hedges. The more we think about it, the more we wonder whether the Fed has painted itself into a corner with its quantitative easing initiative.

Despite the current deflation, the ballooning of the central bank’s balance sheet is encouraging many professional investors to increase exposures in tangible assets like precious metals, industrial metals, energy products and agricultural land. That means the cost of inputs to production will rise before the prices of final products rise. In addition, higher energy and food prices are likely to reduce the discretionary income of households already facing wealth destruction, credit constraints and job losses. We are perplexed. How does the Fed expect these impacts of higher prices for inflation hedges on either supply or demand to be supportive of economic growth? Put plainly, quantitative easing may have a built-in contradiction: The inflation expectations it is most likely to generate are in commodities that are either inputs to production or in consumer necessities. How either of these effects increases profit expectations, and hence induces a revival in production in output and employment, still escapes us.

The complexion of the U.S. macro results, while still severely recessionary, is generally better than what is coming out of Asia and Europe. Still, there are a few straws in the wind, like Japanese machine tool orders, which are showing several months of stabilization, along with Japanese consumer sentiment. These are surprising green shoots in what otherwise looks like scorched earth. We’ve proceeded on the assumption that the darker the macro news flow gets, the larger and more dramatic the policy push will be. A fiscal package on the order of 2-3% of GDP is under discussion in Japan, which will contain the damage, but we expect yen depreciation will need to be pursued, along with an escalating quantitative easing program to stabilize the Japanese income.

We’ve expected some retrenchment in equities, given technically overbought conditions and our view that the second derivative trade would give way under the Q1 earnings deluge. That concern is looking premature, although we are not yet in the thick of the earnings releases. Corporate bond spreads have not moved in synch with the equity rally, which is an anomaly we felt confirmed our decision not to chase the rally. So if we are wrong and the equity rally continues or is only briefly interrupted (say, because institutional investors that did not get on the bus early decide they need to get on quick or face career risk), the better way to hedge our view may be through a long position in corporate bonds. Alternatively, there are segments of the financial sector that have large long positions in corporates, like nonlife insurers, that could be played as well.

Best regards,

Rob Parenteau
for The Daily Reckoning

Bounce to Nowhere? originally appeared in the Daily Reckoning. The Daily Reckoning, a FREE daily e-letter, offers a "uniquely refreshing" perspective on the global economy, investing, and today's markets.