All Things in Moderation

Markets are lower after the ECB increased the size of its emergency liquidity program to Greece. Bonds and MBS are up.

No economic data today

We are getting to crunch time with Greece. Euro-area leaders are meeting Monday to try and hammer out some sort of gameplan. The ECB’s emergency liquidity package expires on June 30, which is also the day a big payment is due to the IMF. It is looking more and more likely that Greece is going to exit the Euro. While most Greek debt is owned by the Greek banking system, some is owned by the big European banks as well. Some could see a hit to their capital. This will probably be dollar (and Treasury) bullish.

Chinese stocks have been selling off, and have entered correction territory (defined as down 10%). The Chinese stock market has been in bubble territory for a while, and it looks like it is finally bursting. This market is being fueled by a toxic cocktail of margin debt and dumb money. Current margin debt is $368 billion. The market increased over 150% in one year (or about $6 trillion). While the index was higher in 2009, the Shanghai Composite P/E is currently about 95x earnings, versus 68x at the height of the 2009 market.

The bursting of the Chinese stock and real estate bubbles is going to complicate the Fed’s job of trying to normalize interest rates by causing a flight to quality in US Treasuries. The biggest headache for the Fed will be when China begins to export deflation. Inflation is still too low as far as the Fed is concerned. The biggest fear? Interest rates are already at the zero bound throughout the world, and central banks are largely out of ammunition.

Stocks are flattish this morning ahead of the FOMC decision. Bonds and MBS are down small.

The FOMC rate decision is scheduled for 2:00 pm EST today, so beware of volatility around that time. We will be getting a new set of economic projections and a new dot graph. Yellen will also hold a press conference afterward. What will investors focus on? the dot graph.

Mortgage Applications fell 5.5% last week. Purchases fell 4.2% while refis fell 6.9%.

It is looking like there might not be a deal with Greece, as Tsipras said Greece was willing to live with the consequences of saying “no” to their creditors. Bloomberg provides this helpful graph of where we are in the tug-of-war between creditors and Greece: The ouzo is definitely running out of the glass at this point

Barclay’s is exiting the US MBS market, following Royal Bank of Scotland’s lead. They will still trade risk sharing bonds and might still trade agency paper, but they are out of the market making business in pre-crisis paper.

Markets are lower this morning as the rhetoric between Greece and the EU gets heated. Bonds and MBS are up.

Housing starts dropped 11.1% in May to 1.036 million. April was revised higher from 1.135 to 1.165 million. Building permits rose 12% however to 1.275 million. Housing starts have been very volatile, so it makes more sense to look at the trend, which is generally up. You can see that April’s reading was exceptionally good, so a pullback in May is not all that surprising. The good building permits number (highest in 8 years) provides some basis for confidence in the housing recovery. Permits went way up in the Northeast.

Is the private label market coming back, at long last? Issuance of mortgage backed securities have increased to $32 billion this year from $18 billion last year. Much of this new paper is tied to rentals or distressed mortgages from the bubble years. To put the $32 billion into perspective, the private label market was $1 trillion before the crash. As far as new origination goes, pretty much only high quality jumbos are getting securitized, and even that is difficult as the banks prefer to portfolio these loans. We are still a long way from having any sort of robust non-conforming securitization market, but we are headed that way.

The FOMC meeting starts today, and tomorrow we will get the statement, along with the updated projections and a press conference from Janet Yellen. The Street is still thinking the first hike comes in September.

Homebuilders Standard Pacific and Ryland announced a merger of equals yesterday, which will create the 4th largest homebuilder in the US behind D.R. Horton, Lennar, and Pulte. Standard Pacific and Ryland have been discussing the deal for years and they think the timing is right for a push out to the East Coast. Part of the rationale for the deal was to diversify Standard Pacific’s footprint from the red-hot California market, which is showing signs of overheating.

Stocks are lower after talks between Greece and its creditors broke down over the weekend. Bonds and MBS are up.

This is supposedly “deal week” for Greece. They owe the IMF $1.7 billion. If they don’t pay (and they have already missed one payment), then it makes it hard for the ECB to continue providing emergency liquidity. The current program with the ECB expires at the end of the month. Rhetoric is getting more and more heated between Germany and Greece at this point. At issue are the pensions. Greece is steadfastly resisting restructuring the country’s pension system. And the Germans are getting sick of it: ‘We will not let the German workers and their families pay for the overblown election promises of a partially communist government,’’ Vice-Chancellor Sigmar Gabriel wrote in a Bild opinion column on Monday. If they can’t get a deal, then the ECB will probably stop supporting the Greek banks and the county will have to impose capital controls to keep hard assets from fleeing the country. It sounds like the Europe will consider allowing Tsipras some sort of face-saving change to the deal, but nothing really meaningful. The bond markets are getting nervous, as the Greek 10 year bond yield is up almost one full percentage point this morning at 12.723%. For us in the the US markets, any sort of Greek exit will probably cause a flight to quality, which means it would be bullish for US bonds.

Chart: Greek 10 year bond yield:

In other “bullish for US bonds” news, the manufacturing sector had a rough go of it in May. Industrial Production fell 0.2%, manufacturing production fell 0.2% and capacity utilization fell to 78.1%. Separately the New York State Empire Manufacturing Index fell to -1.98. While manufacturing is no longer the economic driver it used to be, these are still lousy numbers, and reinforces the idea that the Fed will stand pat this week.

The NAHB Homebuilder index rebounded to 59 in June, topping its post-crisis highs. Builder confidence is more or less back at “normalcy.” While homebuilder sentiment is back to normalcy, housing starts most certainly are not. The Street is forecasting housing starts to come in at 1.09 million tomorrow, which is still 27% below the normal, pre-bubble level of 1.5 million starts a year. Starts are only now approaching the recessionary lows of the past. So while builders may have positive sentiment, they aren’t putting their money where their mouth is, at least not yet.

Chart: housing starts, long term:

The FOMC meets on Tuesday and Wednesday this week. This will be the first FOMC meeting where a rate hike is in play. Given some of the weak economic data and persistent low inflation, it is unlikely the Fed will hike rates this week, however the language of the statement will certainly be important. Expect to see some volatility this week in bonds, between the FOMC and the Greek situation. LOs, be sure to tell your borrowers about the risks of floating.

If the Fed does in fact hike rates, it doesn’t necessarily follow that the 10 year bond yield (and by extension mortgage rates) will spike. When you look at the tightenings in the past, the yield curve flattened, which means the short end of the curve (overnight rates etc) moved higher, but the longer end of the curve largely ignored the increase. The 2004 tightening cycle is probably the most relevant, as we were still in the aftermath of the collapse of the stock market bubble. The Fed increased the Fed Funds target rate from 1% to 5.25% over the course of 2 years. The US 10 year basically went nowhere.

Chart: aftermath of 2004 rate hikes:

For a contrarian view on the Fed and long-term interest rates, listen to Bill Gross, who thinks the world’s central banks want higher long-term rates because they are worried about insurance companies and pension funds. These entities are not able to earn the returns they need in this low interest rate environment (the actuarial tables couldn’t care less that rates are zero), and they have been forced to take a lot of credit risk. The most painless way to avoid a crisis is to let long-term rates slowly creep up. It just goes to show how small the eye is in the needle the world’s central banks need to thread.

Elizabeth Warren and the left are not fans of share buybacks And there are legitimate questions about companies levering up to fund buybacks. And yes, buybacks are more tax efficient than dividend hikes because investors can defer taxes on capital gains by not selling. . However they are trying to conflate stock buybacks with “market manipulation,” which is fraud and illegal. I think the gameplan is twofold here: The first is to weaken the presumption that management’s first priority is to maximize shareholder value. The second is to shame companies into raising wages for workers.

Stocks are lower as both the EU and Greece dig in their heels over a rescue package. Bonds and MBS are up small.

Inflation remains muted at the wholesale level. The Producer Price Index rose 0.5% in May, however that is energy driven. Ex food and energy, it was up 0.1%, or 0.6% year-over-year. The PPI is not that critical of an inflation index – the Fed uses the PCE deflator – but it shows that inflationary pressures remain contained. IMO we won’t see any sort of inflation until we see wage gains, and we are only just starting to see that.

Higher energy prices are not denting consumer sentiment according to the University of Michigan. June Consumer sentiment rose to 94.6 from 90.7 in May.

A couple Fed researchers have crunched the numbers and believe that the natural rate of unemployment is about 4.3%, versus the 5.2% number the Fed currently uses. They focus on labor’s share of income, which has fallen from 72.2% in 2001 to 62.9% now. If correct, that means the Fed has room to let the economy run. The bigger question is why the number has fallen so much. Is it weak bargaining power? Is it the fact that the emerging companies in the US need less employees? (For example, GE has a market cap of $276B and has 305,000 employees. Facebook has a market cap of $228B and has only 10,000 employees). IMO, it will come down to the labor force participation rate. Are the people who have involuntarily exited the labor force coming back?

Stocks are higher this morning after retail sales came in better than expected. Bonds and MBS are up.

Retail Sales rose 1.2% in May, matching estimates. The control group, which strips out some of the more volatile components rose 0.7%, higher than the 0.5% estimate. The big gainers were building supplies, autos and gasoline. 

Import prices rose 1.3% on a month-over-month basis. Business Inventories picked up 0.4% as well.

Initial Jobless Claims came in at 279,000, a strong number. This is the 14th consecutive week below 300k.

The Bloomberg Consumer Comfort index slipped to 40.1 from 40.5. These sorts of consumer confidence / sentiment indices are really inverse gasoline price indices.

2015 could be the best year in housing since 2006, according to the NAR. Rising rates are not discouraging buyers – in fact the opposite is happening. Buyers are worried that affordability is going down and that is motivating them to buy now.

Separately, consumers are getting more bullish on housing, according to the Fannie Mae National Housing Survey. They are not getting more bullish on the economy however, even though their incomes are rising. Pessimism about the economy is at a six month high.

The left is all up in arms after Jamie Dimon said that Elizabeth Warren doesn’t understand the business of banking. I have seen stories where she confuses lending and servicing, so Jamie has a point. She has found her niche as the Ted Cruz of the Left – happy to play to the base and annoy her adversaries with overheated rhetoric. It is okay, Liz, even the really smart people don’t understand it all that well.

Stocks are flattish after Greece submitted a plan to creditors which was rejected. Bonds and MBS are down

Mortgage Applications rose 8.4% last week in spite of a massive sell-off in bonds, which took the 30 year fixed rate mortgage from 4.02% to 4.17%. Purchases were up 9.7% while refis increased 7%. Note that this bump is following the shortened Memorial Day week, so that accounts for some of the increase. The purchase index is approaching 2 year highs, although we are a long way from normalcy.

How much have the banks been fined / spent on legal for the financial crisis? About $300 billion. And the governments aren’t done yet. They still are scratching their collective heads wondering why credit is so tight, though.

For all the talk about how tough the Millennials have it, Generation X has it even worse. The financial crisis hit them during their peak earnings years. Want to know why consumer spending is down so much? The elderly boomers already bought their last TVs, while Gen-Xers are struggling with the 50% hit to their net worth they took in the bust. Millennials are just trying to find a job. I do think that the next big political schism will fall along generational lines, with the baby boomers trying to extract more resources from their broke offspring who want to means test the benefits their parents get.

Hovnanian, the New Jersey based homebuilder, fell 13% yesterday after they disappointed the Street with earnings. Margins fell as they company had to offer more incentives to move their inventory. Gross margins fell from 20% to 16%. The company characterized the housing market as “a  bit tentative.” Hovnanian operates in New Jersey, North Carolina, Pennsylvania, Virginia, Maryland, California, Texas, Tennessee, Alabama, and Mississippi. Not surprising since the Northeast / Mid Atlantic / Deep South housing markets have been lagging the red-hot West Coast markets.

More gloomy prognostications from JP Morgan: The US is entering a period of slower growth due to low productivity (which fell 3.1% last quarter). They anticipate job creation to average around 75,000 a month, unless some new productivity-enhancing technological development comes around. The last time we went through that was the 1970s, productivity stagnated and the oil shocks along with automatic wage increases in union contracts ignited a wage-price spiral. FWIW, I am not sure I buy that argument – cheap energy is not going away, and solar keeps getting cheaper and better.

Stocks are lower this morning on concern that Chinese growth is slowing. Bonds and MBS are lower.

Wholesale Inventories increased 0.4% in April, while wholesale sales rose 1.6%. The inventory to sales ratio was 1.29x, which is on the high side. This means that unless sales increase markedly, manufacturers will have to slow down production to work down the excess inventory. This would dampen GDP growth going forward.

Job openings hit 5.4 million in April, the highest number since the survey began in late 2000. The “quits rate,” which is an important data point for the Fed is inching up to 1.9% from 1.7% a year ago.

The NFIB Small Business Optimism index rose to 98.3 in May, finally approaching “normalcy.” Money quote regarding the labor market: “Owners report that the labor market is, from an historical perspective, getting very tight. Owner complaints about “finding qualified workers” are rising, job openings are near 42 year record high levels, and job creation plans remain solid. Over 80 percent of those hiring or trying to hire in May reported few nor no qualified applicants. This is inconsistent with current Fed policy, which has no impact on the supply of qualified workers.” In terms of biggest concerns for small business, quality of labor (not cost) remains the #3 biggest concern, behind taxes and government regulation. Quality of labor has now displaced “poor sales” on the top 3 list.

The Chinese stock market bubble continues to inflate despite a weakening economy. The Chinese government is basically endorsing the rally, and is changing the rules regarding margin selling to ease the problem of forced selling. China is undoubtedly having an episode similar to the US in the 20s and Japan in the 80s. It may (and probably will) go on for a lot longer than people think it will. But with each passing day, the “investments” get more marginal and more speculative, and the whole edifice is built on borrowed funds, which always seems to end badly when the music stops.

Completed foreclosures fell to 40,000 in April, down from 50,000 a year ago, according to CoreLogic. The seriously delinquent rate fell to 3.6%, the lowest since Feb 2008. About 521,000 homes are in some stage of foreclosure, down from 694,000 a year ago. Foreclosure inventory remains the highest in the judicial states of New Jersey and New York. Note, New York is going to do something about zombie foreclosures: vacant homes which are taking their time to get through the process. Lest anyone think they are doing this to give investors a chance to limit their losses, the real reason is so they can sue if they are unhappy with the way the property is being maintained.

Stocks are lower after Greece officially missed its payment to the IMF. Bonds and MBS are up small.

The week after the jobs report is usually data-light and this week is no exception. The only data that should matter is retail sales on Thursday. While the labor market seems to be improving, consumer spending is still lagging. Part of that is demographic, where you have a bunch of old rich people who probably bought their last TVs, toasters, etc and a bunch of young broke people.

Bonds got rocked on Friday after the stronger than expected jobs report. 280,000 jobs were created in May, and the two prior months were revised upward from “dismal” to “not hideous.” Average hourly earnings rose to $24.96, up 2.3% from last year. The unemployment rate ticked up to 5.5% as the labor force participation rate improved to 62.9%. It is looking like the first quarter weakness was indeed transitory, and weather-driven. It probably doesn’t mean the Fed is moving in June, but September is definitely in play.

The big question the Fed is grappling with is the ceiling on the labor force participation rate. If it is high, say 66% – 67%, then returning workers will keep a lid on wages, and the Fed will be able to let the economy run a bit longer. It also means the overall growth potential for the economy is higher. If the ceiling is low, say 64% – 65%, it means wage inflation will force the Fed’s hand earlier, which means the “speed limit” of the economy is lower. Of course demographics explain some of the long term changes in the labor force participation rate, however many of the long-term unemployed want to (and need to) have a full-time job. Whether they can get meaningful jobs after being on the sidelines for multiple years is an open question.

In spite of the huge sell-off in bonds over the past two months, the street is forecasting  a 2.5% 10 year yield for 2015. The Fed has been consistently over-optimistic on the economy in general, and the simple fact that the Fed funds rate is increasing does not necessarily mean long term rates are going to go up big. Take a look at the chart below: it is the 10 year bond yield minus the Fed Funds target rate. In the last tightening cycle (early 2004 to early 2006), the Fed Funds rate increased from 1% to 5.25% over the course of two years. During that same period, the 10 year bond yield increased from about 4.8% to 5.2%. The yield curve actually inverted towards the end of the cycle (which more or less broke the real estate bubble). In other words, the Fed could start hiking rates this year and we could see the 10 year go basically nowhere.