The Economy

Easy Lending on Main Street and Wall Street

I have written here extensively about the issue of how wide the effect of the subprime mortgage mess might become. This past week S&P (the debt rating entity) somehow had a revelation that it maybe, possibly should reconsider the manner in which it rates debt. In one sense that is the story itself. Why is a debt rating agency waiting until well-after-the-fact to do this?

The concern at present stems from the losses being suffered in the subprime or B-paper mortgage market. Someone sent me am e-mail message this week suggesting that I clarify what "A-paper" and "B-paper" actually mean. I would pose a simple definition: A-paper is any mortgage which gets an approval by the FNMA Desktop Underwriting System. If it does not then it is something other than A-paper. The classifications get murky but the point is that once you get past A-paper the risk increases. The de facto problem is that Wall Street firms attempted to redefine subprime and wound up screwing things up. The irony is that it is wealthy folks with investments in hedge funds that are getting hosed.

The question begging for answer is this: How badly will this effect hurt the banking system. On Wednesday a Fed Reserve Governor and a Treasury Department official tried to assure the House Financial Services Committee that the problem was not systemic. Fed Governor Walsh: "Our overall view is that there are certainly losses, that we might not be at the bottom of this tumult, but they don't appear to be raising, to this point, systemic risk issues." Treasury Undersecretary Steele: "does not seem to be a systemic issue. ''The market "is going through an adjustment process,'' he added. "It seems to be happening in an orderly way.''

To which I say "I hope so." To some extent the Fed mitigates concern by assuring folks that the sky is not falling because in absence of that reassurance investors tend to make bad decisions.

Credit Suisse Group reported this week that so far investors have lost as much as $52 billion in selling off their portfolios of subprime mortgages.

The concerns are that much of this debt may be held by relatively unregulated hedge funds and that those folks are leveraged and will lose not only their money but also the money of the banks whom they borrowed from. If that happens then there could be risk to the banking system.

This is having some strange consequences. Banks are getting skeptical about lending money to LBO (leveraged buy out) firms. Bloomberg reported this week that "more than a dozen companies were forced to postpone or restructure debt sales in the past three weeks." LBOs are still strong but they may be having to accept stronger conditions form lenders. This is good as it makes for a healthier banking system.

The problem (I think) is that behind all of this is an industry of credit default swaps which spreads the risk out. The present situation might be compared to the impact of a hurricane on the insurance industry. Until the losses are known it gets harder to properly price credit defaults going forward and things such as LBOs may take a vacation.

It should be noted that the LBO industry established a parallel to B-paper called "covenant lite loans." Most commercial debt has conditions. For example the lender might demand that a certain cash flow be generated by the borrower to maintain the debt or at least the rate. This would be like having a 30 year mortgage on which the rate got adjusted upwards because your income fell.

The reality is that too much money was out there to lend and a lot of bad loans have been made both to home owners and to big corporations.

For us folks in the mortgage and real estate business the questions are: How will all of this affect rates and with the B-paper debacle coming at the end of an extended housing boom (increases in supply) just how much will that affect housing prices. One of the problems here is that real estate sales people do not like to discuss this. The blab about prices when they are rising but for some strange reason are in some locales rather quiet on the topic at present.

The concern about home sales and construction slowing down is that this will have a wider effect on the economy. Less stuff will get purchased by the folks not buying those homes and less building material will be purchased by the developers not building those homes and fewer craftsmen will be employed to not build those homes.

---

Dick Lepre

Deflation? Maybe not but Something to Think About.

I, in absolutely no way, believe that this week's inflation data points to deflation. What is impressive to me is that this is not even discussed. In 2003 deflation as a topic was au courant at present it is not. This merely shows that topics about the economy become news or not news. This week global warming is still news, OJ is again news, deflation is not news. One might be objective and say that deflation is not news because it is not happening but then again it was happening to an even smaller extent in 2003 when it was news.

In short the folks who create stories for newspapers and magazines were not ready for this so did not bring it up. So even though this is not happening and will not happen I want to create a scoop and report on the topic of deflation - something which is not happening and not going to happen. The point to be made here is that while we may see this large drop in overall CPI as something inherently good there is a truely dangerous thing about continued price drops. Deflation would be a monster problem for economies. Read on.

First: Disinflation

Disinflation is a decrease in the rate of inflation. The rate of inflation decreases but its actual value is still positive. If we use CPI to measure inflation, then we have been in a disinflationary environment since the early 80's.

The attention to disinflation is directed to the fact that as the increase in CPI continues to fall it might hit and pass through zero and we would then have deflation.

The Asian Currency Crisis resulted, in part, from an unwise and too large infusion of capital into plants to make more stuff. There was plenty of fault to spread around. Companies, Asian governments, banks and investors all had a hand. When Asia was unable to consume these goods, there was excess capacity. That glut may have been exported to the U.S. resulting in disinflation and, if the problem is not confinable, deflation.

Our focus for so long has been on preventing inflation that, even though outright deflation is a somewhat far-fetched scenario it should still be understood because the fact is that it an extremely serious danger which folks are simply not aware of. It can cause decade long economic stagnation.

What Happens in Deflation?

Deflation might be a nightmare because we are not prepared for it. Deflation is the opposite of inflation. Prices of goods and services would fall over time. Seems good? Stuff is cheaper = good. But not so fast. Cash would increase in value. Debt, which was no big thing in times of inflation, might prove fatal to municipalities, companies and individuals. The effective interest rate would rise and defaults might result. This could lead to chaos in banking. Debt heavy companies would feel pressure to cut wages and salaries. Folks with mortgages might not have any income as their jobs disappeared. In deflation, debt is a curse. A retiree on a fixed income would find himself richer each month. One might curse the mortgage broker who got them a 6% fixed rate mortgage. Aarrgh!! My payments are fixed. I have fewer dollars of income. Each month the value of that fixed number of dollars would increase. The value of my home would decrease. Why should I make my mortgage payment? In the first four years of the Great Depression, prices fell an average of 8% per year and big chunks of the economy went down with them.

Note then that deflation would be dangerous at a time such as the present when individuals, municipalities, states and the Federal government have taken on a lot of debt. The burden would be exaggerated by deflation.

In deflation there is little incentive to invest in plants and equipment. Why invest today if the expense of doing so will be less next year?

An example of deflation killing an industry is Telecom. Large capital investments in bandwidth were made – some of it with borrowed funds – and the price of bandwidth collapsed. The telecom industry was hurt by its own competitiveness, a side effect of a free-market economy. Karl Marx snickered in his grave.

Inflation and deflation can be viewed in a historical perspective. In the book "The Death of Inflation," British economist Roger Bootle points out that inflation has been the exception throughout history, not the rule. British studies show that in 1932, prices were slightly lower than they were in 1795. And, according to Bootle, when one looks at prices dating back to the year 1264, 97 percent of all the price inflation in the last 700 years has occurred since 1940. (I am not sure what this implies but it sounds "cool". And don't ask me where he got prices of stuff in the year 1264.)

But really. It seems far-fetched that any nightmare deflation scenario could occur soon.

What I see as more likely is the following:

1) inflation is (for the time) under control.

2) Americans, unlike Japanese, are spenders. We are not going to stop spending. That is downright un-American. The Japanese are savers. They actually think about the future. Look where it has gotten them.

3) The global economy has served to temper U.S. inflation. There is not a worldwide environment of deflation which would necessitate lowering prices and wages here.

4) We now know that we can have very low unemployment (something around 4%) and yet very low inflation. The root of inflation is not what it was once thought to be. Lower than 6% unemployment used to be regarded as a necessary cause for inflation. Globalization has changed the rules.

5) Computer prices continue to drop and are now available to most anyone. The Internet promotes price competition. The cost of transactions, such as processing an online application, are decreasing. People are trading stocks at rock-bottom fees using the WWW. Again, this is a price-tempering force, not a source of deflation.

6) Deflation - the dangerous Japan-like deflation - would occur only (to repeat paragraph II) as a parallel to a lengthy period of recession. Could that happen? Yes. Is it likely? No.

Is Inflation Contained?

We can talk about what the Fed is doing and what yields are doing or going to do but when all the shouting is done it is all about inflation. The underlying reason is quite simple. The folks who buy fixed income securities: Treasury debt, corporate bonds and mortgage backed securities (or parts thereof) are people who already have a lot of money. If you are wealthy you are really not concerned about acquiring more money than you will ever be able to do anything with you are concerned about preserving the purchasing power of your present wealth.

For such a fortunate person the investment of choice is some sort of bond and the sole enemy is inflation. Thus, yield on bonds move with inflation or, more correctly, the perception of inflation.

The Measures of Inflation

Inflation is well-contained. By "inflation" we are almost always talking about CPI. But, there are other measures of inflation. Some of these are more forward looking than the backward looking, "this is what happened last month" nature of CPI.

Consumer Price Index (CPI)

CPI is a measure of the average level of  prices of a fixed "market basket" of goods and services purchased by consumers (food, clothing, utilities etc.). CPI is an indicator of inflation on the retail level.

This is calculated every month by the Bureau of Labor Statistics and available online at http://www.bls.gov/cpi/

The are 2 major CPI's:
CPI-U (U is for Urban) which represents about 80 percent of the total U.S. population. It is based on the expenditures reported by almost all urban residents, including professional employees, the self-employed, the poor, the unemployed, and retired persons as well as urban wage earners and clerical workers.

CPI-W is based on the expenditures of urban households that meet additional requirements:
More than one-half of the household's income must come from clerical or wage occupations and at least one of the household's earners must have been employed for at least 37 weeks during the previous 12 months. CPI-W represents about 37% of the population.

It is the CPI-U which everyone (including me) calls "CPI".

CPI includes:

Food and beverages (cookies, cereals, cheese, coffee, chicken, beer and ale, restaurant meals)

Housing (residential rent, homeowners' costs, fuel oil, soaps and detergents)

Apparel and its upkeep (men's shirts, women's dresses, jewelry)

Transportation (airline fares, new and used cars, gasoline, car insurance)

Medical care (prescription drugs, eye care, physicians' services, hospital rooms)

Recreation (newspapers, toys, musical instruments, admissions);

Education and communication (tuition, postage, telephone services, computers);and

Other goods and services (haircuts, cosmetics, bank fees)

CPI is seasonally adjusted to cull apart the changes that are seasonal from the underlying economic changes. Seasonal changes are fluctuations in prices that occur at the same time very year. They might be due to: automobile model changeovers, weather and holidays. For example, gasoline costs more in the summer, tomatoes cost more in the winter. An interesting issue at present -when inflation is tame - is that the question may well be: are we actually measuring inflation or are we measuring the accuracy of this months seasonal adjustments?

The unadjusted data is what people actually pay. The adjusted data is what is reported in the media. CPI is a number that reflects prices with 1982-1984 averages as 100.0. The percentage changes announced month-to-month are adjusted so as to be a percent of the value of the last month's index.

CPI is based on a very large sample of goods in a very large sample of places. The one criticism that can be made is that it takes no account for what people actually buy. If, because of El Nino, tomatoes which cost $1.39 a pound in March now cost $4.59 a pound, people will diminish their purchases. Because of this, CPI is, in terms of what people actually buy, slightly overstated.

PPI

PPI is the Producer Price Index - this measures the average change over time in the selling prices received by domestic producers of goods and services. PPI's measure price change from the perspective of the seller. This varies from CPI this is a measure of price change from the buyer’s perspective. Sellers' and buyers' prices may differ due to subsidies, taxes, and the dynamics
of distribution costs. They also are affected by the "depth" of competition of the marketplace.

Implicit Price Deflator

While CPI might be the "Dow" of Inflation it is, in essence, a measure of the price that people pay for things and services. The economy, however consists of a bit more than individuals.

A broad measure of economic activity is GDP (Gross Domestic Product). The GDP Implicit Price Deflator or IPD is based on the Gross Domestic Product and therefore reflects price changes in all goods and services transactions in the United States, including the consumer, producer, investment, government and international sectors. The IPD for GDP takes into account
the price changes of the goods and services that actually happened. The IPD for the GDP is, thus, a more meaningful measure of inflation than either CPI or PPI.

IPD might, for example, be used to adjust the cost of a long term projects such as Civil Engineering projects. The EPA, for example, writes it into the bids for toxic cleanup projects. If one wanted to compare the economic impact of natural disasters from different periods, it would be appropriate to normalize the dollar losses at the time that the occurred using IPDs rather than CPIs.

ECI

ECI is the Employment Cost Index. When we were hearing about a tight labor market this might be where inflation would first show. ECI is the cost of labor on a fixed basket of occupations. This eliminates the effect of the influence of employment shifts among occupations. While the average hourly earnings data would be affected by a shift in the occupational composition of the workforce and would appear as a wage gains, ECI would not be affected. Wages & salaries account for about 72% of the ECI. The rest is benefit costs.

Data is available from BLS at:
http://stats.bls.gov/news.release/eci.t01.htm

FIG

FIG is a product of Economic Cycle Research Institute, Inc. This is a construct that is forward looking. It is a way to predict future inflation. The previously discussed indices take note of inflation that has already occurred. ECRI has a WWW site at http://www.businesscycle.com

This site is a, sort of, Bible on inflation. FIG is reputed to be able to predict inflation up to a year ahead.

 

 

---

Dick Lepre

Sticky Wages & Prices

The Fed must certainly be feeling that its long series of hikes should be starting to have some effect but this is where perception competes with reality. Even if the Fed feels that its actions are sufficient to accommodate economic reality it may still hike to quash concerns about inflation.

This heightens the fact that we are in a new economic age. World currencies used to be tied to commodity prices (e.g. gold). This was called the Bretton Woods system. Bretton Woods was a set of rules whereby each country was obligated to adopt a monetary policy that maintained the exchange rate of its currency within a fixed value—plus or minus one percent—in terms of gold.

The U.S was THE dominant world power when Bretton Woods was created but an interesting thing happened in the late 1960s' which has some striking similarities to the present. The 1960's were dominated by Viet Nam and the Great Society (OK, I left out rock and roll and drugs but let's make that another newsletter). The unwillingness of the Administration to raise taxes in the face of the added expenses of Vietnam an the social programs of the Great Society led to a very serious decline in gold reserves. In essence Bretton Woods collapsed totally in 1972 and the world went on a floating currency system. The US could no longer tolerate or guarantee the conversion of dollars into gold. (BTW, if you have time on your hands Google this topic and you will be surprised at the number of disparate zealot groups who tie all of our troubles to dropping the gold standard.)

The only vestiges remaining are the near pegging of the Chinese currency to the dollar but in essence we have one big floating exchange for world currencies.

Of course the underlying problem is that these are all fiat currencies - money printed by the central banks with less than clearly defined standards of accountability.

What we now have is a system in which not only commodity backing (gold standard) but even control over the money supply has given way to a system in which control over one thing - interest rate policy - is supposed to be able to keep not only the economy of the US but everyone else's economies functioning.

A Sticky Issue

An issue which economists like to discuss which never seems to make it to the mainstream media is the stickiness of prices and wages. The idea here is that both wages and prices are sticky. "Sticky" means that wages and prices do not instantly or even quickly adjust to changes in money supply, demand or supply. If there were a completely "free market economy" out there economists would believe that wages and prices should adjust more often than they in fact do. Except for the price of gasoline and perhaps fresh produce almost nothing adjusts rapidly.

Economists need to know just how sticky wages and prices are to properly model interest rate policy. Stickiness increases the length of time that it takes for policy changes to have an effect. Consequently, it is important to always know how sticky prices and wages are. It is very easy to get a handle on prices. A gigantic number of electronic transactions captured by computers every second. Some where out there the retail price of beef correct to 5 decimal places and update every one minute is known.

Wages are tougher. The week to week changes in wages are simply not known. Perhaps an entity such as ADP has the data but it would be nice if the Federal Reserve had better access to the current cost of wages. Wage inflation is a significant contributor to inflation and the Fed must have better access to this data.

But Why so Sticky?

Economists seem to be struck by the fact that wages and prices are as sticky as they are. In a theoretical economy prices and wages would be changing much more quickly but the fact is that these are real things tied to real people. While it might make theoretical sense for a plant manger possessed of absolutely perfect data to have a meeting with his employees at the start of the third quarter and say, "Folks, you all need to take a 1.734% cut in wages this quarter if you all want to be working here at the start of the 4th quarter." There are considerations. He might be instantly murdered by an employee. Employees might have such resentment to his request that their productivity falls off dramatically. Employees might say, "Screw it. Keep my wages where they are because I bet that I am not one of the folks who will not be here in the 4th quarter."

Prices are also sticky. There are considerations here. A restaurant cannot print new menus just because the prices of beef changes for week-to-week. Poker game like considerations regarding market share are also important. Both wholesalers and retailers are resistant to marking up prices if it will cost them market share. The power of a mega-retailer such as Wal-Mart gives them a certain amount of insulation against price shocks. Their suppliers may well be willing to forego all of most of their profit for the ability to sell to them next year. Folks who shop at Wal-Mart do not have a lot of discretionary spending to do. Contrast that with Neiman-Marcus or Whole Foods which have clientele seeking something other than a bargain.

Maybe stickiness is a consequence of having such a low domestic savings rate. If the average family had 12 months of expenses cushioned in their checking account they might have a different attitude about the effect of less than sticky wages and prices. Stickiness might be a consequence of our profligacy.

These discussions have a purpose. Making correct decisions about monetary and fiscal policy necessitates the ability of the Fed to estimate the stickiness of wages and prices. This gets into the arcane space of economics. See, for example, Optimal Fiscal and Monetary Policy with Sticky Wages and Sticky Prices by Sanjay Chugh.

---

Dick Lepre

Inflation

Last week we spoke once again about inflation. The most important single factor which affects the yields of fixed income securities is the perception of inflation. Fixed income securities include Treasuries, corporate debt, debt backed by credit card accounts and - most importantly to those in the mortgage business - mortgage backed securities.

Understand that folks who buy fixed income securities are a different set of folks from those who invest in equities. Fixed income securities are purchased by folks who a wealthy and want a fixed return. For them the only enemy is inflation. Inflation eats away the purchasing power of their wealth and a fixed return at or above inflation guarantees that their money will but as much in the future as it does today.

The point is that inflation sets the tone for fixed income yields including mortgages. It is more accurate to say that "the perception of inflation sets the tone."

Thus, any"good" economic news tends to send yield higher. During the 1990's the big thing was the BLS Employment Situation Report. On March 8, 1996 the BLS announced that Non-farm payrolls were +705,000. The 30-year bond was off 3 4/32 points that day. The fear was that the demand for workers would increase salaries and that wage increases, unlike the ups and downs of commodity prices, tend to stick.

As it turned out the jobs boom of the late 1990's did not lead to any outsized wage increases. In fact, wages increases have barely outstripped inflation since 1960. Contained inflation necessitates contained wages.

There have been two notable features about the recent containment of wages. One is outsourcing or offshoring in simple terms the cold, hard fact that if workers here push their wages above the point where foreign competition can provide the product much less expensively the work will move elsewhere. This has been expedited by IT, inexpensive telecommunications and inexpensive shipping costs. The other fact about compensation is that the numbers are slightly misleading. In recent years real wages have been virtually dead flat. ("Real" wages are nominal wages adjusted for inflation.) Yes, employee compensation has increased because of the high year-to-year increases in employer paid medical coverage. This leads to a "no one is happy" situation. The employer is paying more but that increase is not going to the employee.

There are many measures of inflation but there are two which we suggest that you pay particular attention two. One is core-CPI. Core-CPI measures retail prices without the annoying month-to-month spikes that occur with energy and food. Of course everyone buys food and energy and is most certainly impacted by higher gasoline and food prices but these go up and down and the point is that core-CPI provides a steady measure of inflation without the chatter of energy and food prices. As far as gasoline prices go this is something which is overdone my the media. There is always more coverage about higher gasoline prices than lower gasoline prices.

The second measure of inflation is one watched closely by the Fed. It is the PCEPI - Personal Consumption Expense Price Index. While CPI and core-CPI measure just prices, PCEPI measures the prices of that which consumers actually buy. Thus, if the price of an item goes up and due to demand elasticity folks buy less of it CPI will not be affected by the action of consumers but PCEPI will be.

At Present

Inflation is always a fear to those concerned about mortgage rates. I would offer the observation that the only areas is which we see inflation are energy prices and health care. We have talked about both of these topics extensively if previous newsletters.

Energy prices get a lot of media coverage because it has become somewhat of a tradition. The sharp spike we have seen in crude prices will abate next year because a lot of new supply will come on line. More supply and the same demand equals lower prices. I have said this before: The chance of the price of a barrel of crude being $40 in mid-2007 is greater than it being $100.

In the meantime there is lingering concern about the higher cost of energy bleeding over into the price of just about everything. For now it is just a concern. I do not see inflation getting out of hand in the near future. We may see inflation (core-CPI) get as high as 4% year-over-year which, admittedly, is a lot higher than the Fed's goal of 2% but is not what I would term"out of hand." In the short run, if we see core-CPI above +0.2% for several months the Fed will continue tightening. If it falls back to or below +0.2% for a couple of months we will likely see the Fed stop hiking.

-- Dick Lepre

The I-Monster

The Appropriateness and Inappropriateness of the Political Process

There has certainly been much discussion lately about what to do about illegal immigration. I will offer her no suggestions. For me there are many obvious solutions but what I want to discuss is that this is an example of a process which is best solved by the traditional political process. Senators and Congressmen can gather ideas, discuss and debate the issues. The dynamics of the political process leaves things to chance. The best solutions may not be adopted unless the more powerful and influential members of Congress get behind than. Also, this is an issue which is, to some extent regional. Illegal immigration impacts California, Texas and Arizona to a greater extent than it impacts other states.

My point here is that the solution to this problem should be amenable to the traditional political process.

To this I contrast the issue which was raised in Rate Watch #499 We Need a New fiscal Authority. The issue there was that it was not possible for Congress and the administration to solve fiscal issues (mainly tax rates) with the traditional political process.

When I published that newsletter (co-authored by Jurgen Brauer) I hoped that it would generate more feedback and some productive discussion. Please read that in the blog and add some comments. It may be found at We need a New Fiscal Authority

The I-Monster.

I am going to treat the issue of inflation over the next few weeks. The most important factor which moves interest rates is not really inflation but rather the perception of inflation.

I want to start with something which I wrote exactly 10 years ago. This was RateWatch #24 - The True Story of the I-Monster. This started a series of newsletters over the years in which I dealt with the I-monster - inflation

From: April 14, 1996

This is a story about mortgage rates. Once upon a time (January 1996) mortgage rates were getting very low (around 7.125% with no points). Everyone in the land of homeowners was happy because they were going to pay less interest to the big, bad banks. Yippee, they shouted. We can save money on interest and buy a second car or pay off those credit cards with the evil rates. Or maybe just buy candy and get fat. Then it happened. The Inflation-Monster who had not been seen in a couple of years was said to be coming to the land. The I-Monster was an evil creature who ate citizens money. Well, he didn't actually eat it he just made it act funny so that it didn't buy so much stuff.

The Bureau of Labor Statistics said (3/8/96), "Good news, citizens. 705,000 more of you are working. Isn't that neat?". The citizens said: "Aargh! No. That means the I-Monster is coming. Help. Help. Sell our bonds. And they sold their bonds, and sold their bonds, and sold their bonds. And interest rates went up and up and up. People scratched their heads and cursed at the loan brokers who hadn't locked their rates.

On April 5 the Bureau of Labor Statistics said: "More good news citizens. 140,000 more of you are working now. And by the way, there weren't quite 705,000 more of you working last month. Oh, and by the way the percentage of you who aren't working increased". People were a little confused about the numbers but still they said: "Aargh! The I-monster is coming, the I-monster is coming. Sell our bonds. Sell our bonds. And interest rates went up and up.

People got concerned and started to look for I-Monster footprints. The I-monster's footprints (he has 2 feet) were called CPI and PPI. The footprint experts looked and looked and said, "Humm, we see only little footprints. We aren't sure that the I-monster has been here. He leaves much bigger footprints".

On April 12 people stopped worrying a bit about the I-Monster and bought back their bonds. And interest rates started going down. The only problem was that when they went home for the weekend they realize that it was almost April 15. This is the date each year when the Internal Revenue Monster really does come and eat their money.

The moral of the story is that one way or another someone eats your money.

Dick Lepre

The Trade Deficit

Flash: the tade deficit is big. The following is a copy of comments regarding this which I posted on a blog today: The trade deficit is a most interesting topic. Folks should understand that dismissing the trade deficit is hardly a fabrication of this administration. It goes back to Adam Smith who said in 1776, "Nothing is more absurd than this doctrine of the balance of trade." Now let's grant that the economy of Adam Smith was not exactly the economy of today but untimately the question is something like this: "so what?" By that I mean are international borders what is important or economic activity and well-being? The trade deficit, as expounded here is illusory. Trade deficits exist between cities and states and between nations. Put it this way: if the trade deficit between Japan and the US is truly a problem (like floods and earthquakes are problems) then if Japan became the 51st state would it still be a problem? The trade deficit is a problem only to the extent that one regards this as an "us" vs. "them" situation. Economic activity exists (in a capitalistic system) because welath holders invest their savings in things which produce economic activity. That economic activity cares not what the eventual source of that wealth was. Are American workers who work at Toyota plants worse off than those who work for Ford?

This said, there are some market forces which should push this matter back into a more balanced state and assuage the concerns of those who have headaches consequent to the trade deficit. The most obvious is a floating Chines currency. The point here is that some of this trade deficit exists because of the unnatural ("unnatural" here means that typical market forces are not allowed to act) market forces keeping Chinese currency pegged.

What we are seeing is the activity of a world economy. It can be confusing and dizzying but the most important thjng is that all of this is lifting a gigantic number of folks in other countries out of poverty. And that ain't such a bad thing.

Technical Trading

Last week we spoke about "business cycles." One of the results of the existence of business cycles is technical trading. We have spoken at length on our web site in the past about technicals and in particular the stochastic.

If you listen to radio or TV reports of what the market is doing they sometimes say things like "technical selling caused the Dow to drop 50 points". We sometimes make similar comments about the bond market. If you want to understand fully why interest rates have some of those strange days, it would help to read this discussion of technical trading and keep it in the back or your mind. (Way in the back of your mind.) If you stay informed about the technical picture of the 30-year bond you can know when technical trading is likely to have an effect of the market and mortgage rates and also become assessed of longer (month-to-month) trends.

Macroeconomics

Shortly after the Great Depression of 1929 people sought answers to the questions "why" and "how can we avoid this in the future". This human tragedy was blamed on lack of understanding of the economy.

John Maynard Keynes published in 1936 The General Theory of Employment, Interest and Money. The General Theory, as it is known, started modern macroeconomics Keynes was to economics what Freud was to psychology. You could agree or disagree with him but he "wrote the book".

Keynes described "business cycles" and we still talk in those terms. Keynes' thinking was that economic fluctuations were caused by changes in savings and investments. Savings and Investments getting "out of whack" are where the troubles begin. While the GT is a great attempt to explain the movement of the economy I think that the foremost reality about economics is that it involves the quasi-rational decisions of large numbers of people. While it does not always "make sense", there is a method to its madness.

People's decisions in regard to buying and selling commodities (such as wheat or bonds) are based not only on external circumstances, such as weather or strikes but also on the "poker game" interplay of greed and the desire to anticipate the actions of the other players. The timing of many investment decisions is therefore based not on educated guesses as to what the economy is going to do but on guessing what other people are going to guess the economy is going to do. This last statement is to be taken literally not figuratively. The collapse of LTCM was, in part, the result of educated but inaccurate guesses about what other investors were going to do.

The movement of commodity prices is the result of the collective decisions of a large number of people. Some working together and some at odds. The movement of prices resembles the "random walk" of a drunk. When you first look at a drunk walking you might conclude that he is not walking toward any particular goal. If you follow him for a bit you will conclude that he is headed is some general direction, say, home, you can actually draw some conclusion about how many steps the drunk will take in any one direction on the way home. Our statistical conclusions about the "path" of the drunk maybe seriously affected by external circumstances. He may run into some friends and head to a new bar. He may be stopped by the police and have his path very seriously altered. But when he is moving there is a measurable pattern to his unpredictable steps.

Bond prices and thus, interest rates, move in a similar manner. They have (usually) a particular long-term goal but get there by a circuitous part, Instead of running into other drunken friends they run into hard economic data and press releases. Instead of getting picked up by the police they get deterred by the Federal Reserve.

The variations in the prices of commodities thus resemble statistical processes. Various mathematical models have been
developed to predict the price of commodities such as treasury bonds.

One of the reasons that Treasury bonds are, in a technical sense, more predictable than other commodities is the sheer "thickness" of the market. The Hunt brothers could never have done to the Treasury market what they did to the silver market.

Technical Trading

It is these mathematical models that constitute the basis of "technical trading". Technical trading is based on the analysis of certain data and the commitment to making decisions to buy or sell based on what the data is doing rather than listening to what analysts are saying.

The "old school" Keynesian concept of the cyclic nature of markets coupled with late 20th century computer technology providing "real-time" decision making tools make technical trading popular.

I think that it is interesting that technical trading is self-actualizing. Even if is not inherently correct, the fact that people believe in it and practice it is inclined to make it so. It is a psychosomatic economic dynamic.

Technical traders make their decisions on one or a combination of several technical indicators. The technical indicators are derived from a constant charting of certain data, if one looks at the data as graphs, the technical indicators say things like "sell when this line cross that line".

We use a technical analysis of 30-year Treasury bond futures as a forecast as our primary tool in forecasting cash Treasury prices and thus mortgage rates. We are implicitly assuming that 1) the cash price moves in harmony with the future and 2) that the 10-year moves in harmony with the 30-year. The first assumption is more or less always accurate. The second assumption is only true as long as the yield curve keeps its shape.

While most folks do not ever trade Treasury futures many of you are familiar with stock option trading and the mathematics which go with option trading. For example, I use Charles Schwab. I can pull up my trading window, enter a stock such as Google and select an option. Looking at the $600 January 2007 call (ZPXAT) I see a last trade of $13.30. In Schwab's tool I can right click on the option and pull down "hypothetical pricing for ZPXAT." This is where you can see the technicals for this option. The numbers of interest are volatility (the more volative a stock is the greater is the chance of a large enough movement so that the option finishes "in the money") and "delta." Delta is the amount that the option price should change with a $1 change in the price of the equity. The other number of interest is "theta" which is the daily decay that the option should be experiencing as time is running out.

While these same techs pertain to Treasuries I have found over the years the best technical analysis of Treasuries to be the stochastic. In part this is becuase of the details provided by Jim Garuer who comments on this each day at http://www.stomaster.com/stopdfdc.pdf. The StoMaster site looks at two numbers %K and %D (defined below). %K tells where the price closed relative to the high and low for the day. %D is a moving average of %K. The stochastic is based on reading the implications of the time graph of the %K line crossing the %D line.

Following are some of the technical data that people watch regarding Treasuries.

Stochastic

When the price of a commodity is rising, its closing price is close to the top of the range for the day. When the price is falling it is close to the bottom of the range for the day. A quantification of this is called the Stochastic Process.

The calculated stochastic variable is called %K

%K = 100[(C-L)/(H-L)] where,

C= Close, H = High, L = Low for the period in question

%K may vary from 0 to 100%, measuring the closing price as a percentage of the total range. Depending on the time frame desired, %K may represent this relationship for a Selected number of minutes, hours, days, weeks, months, years, or any other interval.

One on-line technical Treasury bond analyzer StoMaster presents this data as cycles of 60 minutes, 100 minutes, daily, weekly and monthly.

The Stochastic variable %D is simply a moving average of %K and will, therefore, describe the movements of %K on a smooth lagged basis. A buy/sell Stochastic indicator occurs when the graph of %K crosses the graph of %D Moving Average.

The moving average is the average of the previous n-days closing price. For example, a 10-day simple moving average is the average of the closing prices for the last 10 days. The effect of a moving average is to slow down the price movement so that the longer term trend becomes smoother and therefore more obvious. The longer the period of the moving average, the smoother the price movement.

The technical indicator derived from moving average is Price Cross. When a line tracking prices crosses the line of the
Moving Average a "cross" occurs and there is an indication to buy or sell.

Momentum

Momentum is simply the difference in closing price over a period of time. Momentum is defined as the current closing price minus the closing price of n days ago. Momentum describes how fast the market has been moving. (If you studied Physics you might prefer the term "velocity" but someone got this one wrong.) Momentum is plotted above and below a "zero line" and a technical indication occurs when it crosses the axis.

Directional Indicators

The +DI is the difference between the high of today and the highest high of the past n-days. The -DI is the difference between the low of today and the lowest low of the past n-days. ADX is the directional movement divided by the range over the period.

The +DI attempts to define the strength of an issue's positive price movement while the -DI, or Minus Directional Index tries to determine the strength of the issue's downward movement. I think of it as indication "just how bullish are the bulls"? vs. "just how bearish are the bears"? Generally, if the +DI is greater than -DI and ADX is equal to or greater than 25, then the trend is considered bullish. Conversely, if the +DI is less than -DI and ADX is equal to or greater than 25, then the trend is considered bearish.

Relative Strength Index

The Relative Strength Index (RSI) is a popular overbought/oversold indicator. RSI is an internal strength index that is adjusted on a daily basis by the amount by which the market rose or fell. A high RSI occurs when the market has been rallying sharply and a low RSI occurs when the market has been selling off sharply. The RSI is expressed as a percentage, and ranges from zero to 100%.

One characteristic of the RSI is that it moves slower when it as the extremes of very overbought or oversold. RSI treats price
as if it were a rubber band. It can be stretched so far and then it snaps back very quickly when the market reverses and returns to a "neutral level" relatively quickly and starts a new trend. It "freshens" quickly.

An RSI of about 75 indicates "sell" an RSI of about 25 indicates "buy".

CPI - Core and Overall

Let's understand how CPI is calculated. There are several CPI numbers. There is a number for urban consumers and a number for everyone. There is a number for people who are working and a number for everyone. The number which we use here and which is referred to in the media is called CPI-U. CPI-U is the traditional Consumer Price Index for All Urban Consumers. More accurately, what we use is seasonally adjusted Consumer Price Index for All Urban Consumers.

How is this number calculated? This is from the BLS web site: "Each month, BLS data collectors called economic assistants visit or call thousands of retail stores, service establishments, rental units, and doctors' offices, all over the United States to obtain information on the prices of the thousands of items used to track and measure price changes in the CPI. These economic assistants record the prices of about 80,000 items each month representing a scientifically selected sample of the prices paid by consumers for the goods and services purchased." CPI also includes sales and excise taxes.

The prices of many items (such as fresh fruits) suffer seasonal variations so BLS uses seasonal adjustments to factor out such variations. The variations for seasonal adjustments are at least as large as the month-to-month changes in CPI so, in looking at the month-to-month data one has to have confidence in the adjustments. Looking at the data from year-to-year has no such problems - the seasonal adjustment to the price of fruit is the same from one December to the next. Just to scare you a bit, here is the data for November 2005 to December 2005: overall CPI-U not seasonally adjusted was -0.4%. Overall CPI-U adjusted was -0.1%. Core-CPI was -0.1% not seasonally adjusted and +0.2% seasonally adjusted. Looking at the month-to-month data, one has to have a lot of confidence in the adjustments. In short, you have to believe that the seasonal increase in the price of things is the same percentage from year to year.

Let's parse CPI. Core-CPI for December was +0.2% - at expectation. Overall CPI (less important because is include the volatile food and energy components) was -0.2%. For calendar 2005 core-CPI was +2.2%. Overall CPI for 2005 was +3.4% showing the increase in energy prices. The CBS network radio news headlined the story on Wednesday (1/17/2006) with "Inflation was the worst in 5 years" - clearly seeing a glass half-empty. The point is that Treasury markets pay attention only to core-CPI. Perhaps CBS knows more about CSI than it does about CPI.

Why is it the case that we are more concerned about core-CPI? One picture is supposed to be worth 1,000 words.

 

In short, the line for overall CPI is bouncy. The gray bars (for core) show the slow steady rise. Think of it like this: it is warmer during the day than it is at night. That does not mean that global warming has stopped because night fell or because it is winter. The media is partly responsible for this. Core-CPI is a boring story. The "gee whiz" of overall is a lot more exciting.

The following is a graph of overall CPI going back about 50 years:

But, you say, everyone buys energy and food. They certainly do; increases affect them but not so dramatically as the media would allow. Here we are attentive to the macroeconomics affecting mortgage rates and overall CPI means little. Core is everything. Increases in food and energy prices come and go. Increases in the prices of other things persist.

The following is a graph of core CPI going back 50 years:

If you do not like graphs, try this:

Using the average of 1982-1984 as a base (=100) core CPI on 12/1/2005 was 202.8.
Using the average of 1982-1984 as a base (=100) overall CPI on 12/1/2005 was 197.7. Over the past 25 years core has smoothed out the bumps in overall CPI and, in fact, slightly overestimated overall inflation. Assuming that energy prices are outstripping core at present the two may well fall on top of each other by the end of 2006.

The point simply is this: pay attention only to core-CPI. Overall CPI is too bouncy from month-to-month to get a clear reading on inflation. Core-CPI over the long run is almost exactly equal to core-CPI and does not underestimate overall CPI.

A Couple of Points

When one reads comments about inflation there are often two issues addressed regarding things which are expensive and qusetioning whether the methodology of addressing them is accurate. One is health care. This is of concern because it is so darn expensive. The criticism is that CPI does not account for increases in the cost of health care insurance. CPI instead looks at medical expenses - the actual cost of health care. Unless I am seriously confused, the correlation between health care expense and medical insurance cost is extremely strong. Using health care expense innovated of health care premiums creates no distortion in CPI.

The second issue is housing. CPI does not account for changes in the cost of home ownership. Instead it tracks rents and uses an "owner equivalent of rent" as a surrogate for the cost of home ownership. This is, in my opinion where there is potential for a temporary disconnect between CPI and reality. This methodology assumes that rents and ownership costs are always related by the same factor. Clearly this is not the case lately when increases in housing prices outstrip rents. Additionally, for folks who already own a home and have a fixed rate mortgage - changes in rents, housing prices or interest rates do not affect them. Most of the stuff which we spend money on: food, energy, and health care is gone shortly after we buy it. Housing is a different matter. Even though there may be disconnects between rent and the cost of ownership lasting for a couple of years, using rent as a surrogate for housing makes sense in the long run. Nonetheless, BLS should seek a more comprehensive model for estimating the variation in the cost of home ownership apart from using rent as a proxy.

CPI assumes that folks do not react to price increases (price elasticity of demand) by choosing not to buy items which they perceive as being too expensive. A ready example is produce. Weather-related supply abatements may cause the price of citrus fruit to increase well above its seasonally adjusted price. Folks may choose not to buy oranges. CPI still takes oranges into account as if folks were still buying as many at the higher price. CPI is about what they could have bought. By taking no account for the price elasticity of demand CPI always overestimates inflation on what folks actually do buy.

Aarrgh! Please slap BLS.

The BLS Employment Situation report issued today shows, more than anything, the necessity of revising the way the BLS and media report the data. Let's elaborate. The headline number shows 108,000 more jobs - well below the expectation of 200,000+ but that is only after revising November up by 95,000. In other words this report shows that there are 203,000 more people working than the last report counted. What we are saying is this: one should look only at the differential in the total number of folks working in this report and the total number of folks working in the last report and not worry about whether they started working in November or December.

The manner of media reporting the data is inane. In theory BLS could conclude that there were no more people working in December than there were in November but that there were 200,000 more people working. The "headline" number could always be zero but 200,000 jobs could (in theory) be added each month.

If this were science I would offer that what is being reported is not jobs but the error in the BLS's ability to identify the month in which folks started working. The error (95,000)is roughly the same size as the data (108,000). The mistake is started by BLS when it begins the report with "Total non-farm payroll employment increased by 108,000 in December." Sorry, guys, that is incorrect. Total non-farm payroll increased by 203,000. You just got the data wrong as to when folks started working.