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March 02, 2004

Super Helpful Interim Transmissions?

Super Helpful Interim Transmissions...We were extremely pleased to see that Greenspan appeared to be in good health at his semiannual Monetary Policy Report to Congress in mid-February. Quite frankly, we expected his arm to still be in a sling post the incredible job he did patting himself and the broader Fed on the back in early January during a speech where he described how deftly and insightfully the Fed has dealt with the post stock market bubble economy and financial environment stateside. This was the same soliloquy where he essentially told the crowd point blank that any future problems to befall the US economy surely would not be a result of any current or past Fed actions. We don't know about you, but these interim FOMC meeting communication opportunities are super helpful. Quite simply, we've come to characterize most Greenspan public communiqués these days as Super Helpful Interim Transmissions of information.

In all sincerity, Greenspan's testimony mid-February was one of the more bullish presentations of his entire Fed tenure. After his incredibly self-congratulatory commentary in early January, we were wondering if Greenspan was warming up for his chairmanship swan song. To be honest, his testimony a few weeks back has us wondering the same thing. Is Greenspan planning to go out on a self appointed high note? Not allowing history to judge his legacy, but rather attempting to chisel in marble his own Fed tenure epitaph? The Fed saved the day, all is well, in fact better than well. They're currently keeping the party rocking. And any negative events in the road ahead surely have absolutely nothing to do with what have been the good deeds and best intentions of the Fed. Very quickly, we just can't help ourselves from taking a brief look at various Greenspan statements in speeches over the last few weeks relative to real world data that help characterize and put into perspective his commentary. We've always thought it a shame that in his public communiqués Greenspan never uses visual aids. We plan to correct that right here and right now. Sure, we're taking individual comments out of context, but in no way are we twisting his words or attempting to distort his message.

"The gross domestic product expanded vigorously over the second half of 2003 while productivity surged, prices remained stable, and financial conditions improved further. Over all, the economy has made impressive gains in output and real incomes; however, progress in creating jobs has been limited."

For now, some of the data points mentioned above are only available through the 3Q period end of last year. We'll use data that covers the YTD period of 2003 through the third quarter end. None of the data is annualized. It is literally point to point calculations.

Although the headline nominal GDP number grew in more than an acceptable manner YTD through the third quarter, largely due to the incredible stimulus injected into the system during 3Q, is a YTD 0.8% increase in the industrial production index really an "impressive gain in output"? The nominal numbers appear to tell us that productivity increased in line with GDP growth, as opposed to surging out ahead of it as seems the common perception these days. Industrial input prices as measured by the CRB and PPI close to kept pace with GDP expansion through 3Q. (Just as an FYI, these two measures surged in 4Q.) They were stable relative to GDP during the period measured, but certainly not on an absolute rate of increase basis. In this first three quarters of last year, total credit market debt surged at a rate slightly over 4x's the expansion in nominal GDP, and this includes the phenomenal 3Q GDP quarter. If this is an improvement in total "financial conditions", then what is deterioration? Lastly, is a 0.2% three quarter advance in real wages and salaries an "impressive gain"? Of course, Greenspan was spot on in his characterization of jobs as per the above quote. In what has to be one of the most incredible attempts at reflation in modern central banking history, the virtual complete and utter lack of domestic wage and salary inflation stands out like a sore thumb. For ourselves, it is nothing short of one of the key indicators of the moment. If you stuck us on a desert island for the next year and only allowed us to have access to one economic indicator, this would be the one. Why? Simple, consumer spending accounts for 70% of current domestic GDP.

Because it's so important, one last quantitative perspective on personal income in the current post recessionary environment. The following table documents the point to point change in personal income 26 months after the official end of each of the last six recessions covering over four decades in this country.

Any questions?

"The household sector's financial condition is stronger, and the business sector has made substantial strides in bolstering balance sheets. Even though the ratio of overall household debt to income continued to increase, as it has for more than a half-century, the rise in home and equity prices enabled the ratio of household net worth to disposable income to recover to a little above its long term average. The low level of interest rates and large volume of mortgage refinancing activity helped reduce household's debt-service and financial-obligation ratios a bit."

"Both the debt service and financial obligations ratio 'rose modestly' over the 1990's. During the past two years, however, both ratios have been essentially flat. The debt service ratio has remained 'a touch' above 13 percent, whereas the financial obligations ratio has hovered 'a bit' above 18 percent."

So this is the recovery in the household financial picture?

Of course we are near record highs in these generic debt service ratios while simultaneously finding ourselves in a record low interest rate environment.

Despite the incredible increase in residential real estate prices and common stock prices over 2003, as Greenspan describes, these ratios have improved "a bit". Moreover, disposable personal income growth in 2003 was the beneficiary of substantial tax cuts that will ultimately be non-recurring, despite having already occurred an anomalistic three years in a row. Just what would these characterizations of current household finances look like without once in a generation lows in interest rates and some serious asset inflation in both stock prices and real estate over the last year?

Lastly, here's a picture of a current corporate sector that has apparently "made substantial strides in bolstering balance sheets". If these are substantial strides, just what would characterize relatively inconsequential reconciliation?

"Interest rate spreads on both investment-grade and speculative-grade bond issues narrowed substantially over the year, as investors apparently became more confident about the economic expansion and saw less risk of adverse shocks from accounting and other corporate scandals."

Have interest rate spreads contracted so significantly because happy days are here again, confidence is justifiably gushing on the Street, and folks worldwide are banging down the doors in a mad rush to partake in the cornucopia of US financial assets? Or are we simply watching a mad rush for nominal yield during a period where we are experiencing once in a generation lows in the general level of nominal interest rates? We won't belabor the point, but as we have described many times, short term, safe fixed income assets are generating negative real rates of return with the Fed Funds rate anchored firmly at 1%. The Fed is essentially forcing savers and investors out on both the maturity and investment risk curves in order to capture nominal yield. Moreover, again as we have often spoken about, carry trade activities among the levered speculative and hedge community are on in full force in terms of borrowing short (maturities) and investing long (in longer dated, higher yielding, and perhaps riskier assets such as junk and emerging market debt). After all, these investment daredevils have had Greenspan's implicit guarantee that their cost of short term capital would go nowhere near term. The next "adverse shock" won't be accounting or corporate scandals, it will ultimately be the unwinding of unprecedented massive levered investment positions. Maybe at that point CNBC can stop spending half the day covering the all important Martha Stewart saga, do you think?

As you can see in the chart above, when the Fed Funds rate collapsed in the early 1980's, it was not long until interest rate spreads (as measured by the Moody's Baa yield compared to that of the 10 year Treasury) likewise contracted significantly. We're seeing the same thing today, although clearly these two periods are quite different in character. Reaching for yield in periods where safe investment vehicles are returning negative real returns is nothing new. And it's certainly no guarantee that investors are wildly confident. Remember, don't mix up a theoretical display of investment confidence with yield starvation and financial speculation. Perhaps Greenspan forgot this simple little rule in his recent testimony.

"Accordingly, the currency depreciation that we have experienced of late should eventually help contain our current account deficit as foreign producers export less to the United States. On the other side of the ledger, the current account should improve as US firms find the export market more receptive."

We're officially two years into a meaningful dollar decline relative to major foreign currencies and there has been no reconciliation in the US trade position whatsoever. The dollar volume of imports relative to exports is higher today than it was two years back.

At the end of 2003, here's the real data on the US trade balance with a few major foreign trade bloc's:

Just how is the US trade situation to improve dramatically when our largest trade deficit situation is with a country pegging its currency to the dollar? And our third largest deficit position is with a country who won't think twice about spending four to five times its trade surplus position with the US just to intervene in foreign exchange markets? In fact, over the last 13 months, Japan spent roughly $240 billion attempting to intervene in the dollar-yen cross rate. Simply incredible when looked at relative to the size of its trade surplus with the US. They'd have been better off simply giving every US citizen a voucher to be spent only on Japanese goods as opposed to throwing their money down a currency interventionist rat hole. Does this tell you how extreme Japanese currency intervention attempts have become and how wild the current global proliferation of paper just to support the worldwide economic status quo? Of course, not once did Greenspan mention the unprecedented magnitude of current foreign exchange intervention activities globally. Well, at least Greenspan did characterize the timing of the turn in the trade imbalance as "eventually". Who knows, that could be a "considerable period". No problem, we can "use patience".

The Deflector Shields Are On Full Power Capn'...

"The outlook for the federal budget deficit is another critical issue for policymakers in assessing our intermediate and long run growth prospects and the risks to those prospects. The imbalance in the federal budgetary situation, unless addressed soon, will pose serious longer-term difficulties. The longer we wait before addressing these imbalances, the more wrenching the fiscal adjustment ultimately will be".

Is the budget deficit a problem? Sure it is, but without sounding melodramatic, the above comment is completely disingenuous. Sure, the budget deficit is in part exploding due to the financial drain that is the Iraqi situation. But, Greenspan must be forgetting that the government is also acting to address the economic fallout in the post financial bubble real world environment of the moment. An environment for which the Fed absolutely has some, if not a large amount of responsibility for having helped to engender. In hindsight, it is crystal clear that Greenspan and the Fed "waited too long before addressing the imbalances" in the financial markets during the late 1990's. In fact, the Fed directly fostered the late 1999/early 2000 equity market blow-off with excessive pre-Y2K liquidity expansion. So now Greenspan is chastising the Administration for not addressing the fiscal budget problem that in part is a result of Greenspan's own inaction in response to financial market speculation and panic reaction to pre-Y2K fears five-plus years ago? C'mon. Again, it's not too hard to see that Greenspan is already attempting to point the finger of potential future blame in any direction except that of the Fed. He is setting the deflector shields for potential future blame on full power.

In fact, in his late February economic outlook address to the Committee on the Budget, Greenspan used virtually the entire forum as a tirade against the evils of deficit spending while the US faces quickly rising intergenerational transfer payments for Social Security and Medicare benefits directly ahead as the baby boom generation pushes ever faster toward retirement. This was the address where Greenspan suggested looking at cutting back on future SSI benefits. Implicit in his relatively dramatic warning about the potential negative consequences of the significant Federal deficit is the message that responsibility for any future problems or bumps in the night in the US economy or financial markets lies squarely on the shoulders of current fiscal mismanagement. Look nowhere else, right?

The Blind Leading The Blind Or The Fox In The Hen House?...

"All told, our accommodative monetary policy stance to date does not seem to have generated excessive volumes of liquidity or credit."

(As a very quick note, GDP above is through 4Q of 2003, but credit market debt is only available through 3Q of last year at this time.)

If almost $5 dollars of new debt for every new dollar of GDP generated since the current monetary easing cycle began isn't an "excessive volume of liquidity or credit", then what is? Ten times? Twenty times? As you know, the current level of credit market debt relative to GDP has no precedent in US history.

"American consumers might benefit if lenders provided greater mortgage product alternatives to the traditional fixed-rate mortgage. To the degree that households are driven by fears of payment shocks but are willing to manage their own interest rate risks, the traditional fixed-rate mortgage may be an expensive method of financing a home."

Al, where've ya been? There are a ton of existing alternatives to fixed rate mortgages. In fact, more than ever before. Unless Greenspan is betting on a deflationary collapse that drags interest rates to new all time lows, how could he have made a comment such as above? He's implicitly advising mom and pop Americans to take on adjustable rate mortgage loans at what are near record low rates on fixed mortgage loans. As you know, this is like suggesting that the US government stop issuing 30 year debt at fifty year interest rate lows and load debt issuance into the short end of the Treasury curve. Who would be crazy enough to do something like this? Well, on second thought, maybe that's a bad analogy. Oh well, consider the source of the suggestion to go adjustable. No problem Al, we're way ahead of you, as the following chart aptly describes. But thanks anyway for throwing a bit of gasoline on an already open fire. By the way, the numbers in the following chart are directly from the Federal Housing Finance Board. We're certain mom and pop Americans will be more than willing and certainly knowledgeable enough to "manage their own interest rate risks" ahead. When the rate cycle gets tough we're sure mom and pop mortgage holders will simply enter into an interest rate swap agreement with their favorite mega bank derivatives department or their neighborhood hedge fund, maybe they'll short Treasuries or an ETF like the Lehman 20 year bond index (TLT), or perhaps they'll begin managing their interest rate risk by shorting Treasury futures and rolling the contracts at each expiration. You know, interest rate risk management for Dummies.

In all sincerity, we sure hope that this discussion has been something a bit more than just Super Helpful Interim Transmissions.

Market Observations
ContraryInvestor.com

Contrary Investor is written, edited and published by a very small group of "real world" institutional buy-side portfolio managers and analysts with, at minimum, 20 years of individual Street experience. Our credentials include CFA, CPA and CFP, as well as the obligatory MBAs in Finance. We are all either partners or employees of institutions with at least $1 billion under management.

Contrary Investor is our vehicle for providing what we believe is institutional quality financial market research, analysis and commentary that is characterized by honesty, integrity and credibility. We live the business and hope to bring what we learn from our daily experiences to our work at Contrary Investor. Having checked our egos at the door many moons ago, we hope to allow our work to stand on its own and speak for itself, without the personal promotion of any one individual getting in the way. No investment guru's here. Just lifelong students of and participants in an ever-changing financial marketplace.

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