This is a key distressed market to follow since Las Vegas has seen the largest price decline of any of the Case-Shiller composite 20 cities. Prices, as of the November report, were off 61.6% from the peak according to Case-Shiller, and off 9.2% over the last year. Prices just keep falling. Sales in 2011 were at record levels, more than during the bubble, and it looks like 2012 will be an even stronger year.

From the LVGAR: GLVAR January 2012 Housing StatisticsGLVAR reported that 48,186 local properties were sold in 2011, including 38,153 single-family homes and 10,033 condominiums and townhomes. That broke GLVAR’s all-time sales record set in 2009, when it reported 46,879 total sales. In 2010, GLVAR reported 43,877 total sales.

“At the rate we’re going, 2012 has the potential to be another record sales year,” she said.

According to GLVAR, the total number of local homes, condominiums and townhomes sold in the traditionally slow sales month of January was 3,591. That’s down from 4,250 in December 2011, but up from 3,214 total sales in January 2011.
...
The total number of homes listed for sale on GLVAR’s Multiple Listing Service decreased from December to January, with a total of 19,160 single-family homes listed for sale at the end of the month. That’s down 0.4 percent from 19,230 single-family homes listed for sale at the end of December and down 12.9 percent from one year ago. GLVAR reported a total of 4,133 condos and townhomes listed for sale on its MLS at the end of January. That’s up 1.8 percent from 4,061 condos and townhomes listed in December, but down 25.6 percent from one year ago.
...
In January, GLVAR reported that 52.5 percent of all existing homes sold in Southern Nevada were purchased with cash. That’s up from 50.8 percent in December. Meanwhile, 28.1 percent of all existing local homes sold during January were short sales ... Bank-owned homes accounted for 45.5 percent of all existing home sales in January, down from 46.0 percent in December 2011.So 73.6% of the sales were distressed, and over half were purchased with cash.

One of the keys is the decline in inventory. Note that the GLVAR reports both total inventory, and inventory excluding "contingent" listings (usually short sales). Total single family inventory was down 12.9% from a year ago, and excluding contingent listings, inventory was down 35.8%!

Yesterday Goldman Goldman Sachs economist Sven Jari Stehn argued that the labor force participation rate would remain "broadly flat at 63.7% through the end of 2013". He argued there would be a cyclical boost to the participation rate this year from the recovering economy, but a structural decline in the participation rate due to demographics. (Note: some decline in the participation rate has been expected over the next couple of decades).

The updated population controls from the 2010 Census showed a higher percentage of younger and older workers compared to the prime working age group (25 to 54), and also more women (participation rate is lower for women) than originally estimated - so the aggregate participation rate is now at 63.7%. Stehn argues that structural factors alone could push the aggregate participation rate down further to 63.1% by the end of 2012, but that this will probably be offset by more people returning to the labor force as the economy recovers.

The participation rate plays a key role in calculating to unemployment rate. First a few definitions from the BLS Glossary:

• Civilian noninstitutional population: Included are persons 16 years of age and older residing in the 50 States and the District of Columbia who are not inmates of institutions (for example, penal and mental facilities, homes for the aged), and who are not on active duty in the Armed Forces.

• Labor force: The labor force includes all persons classified as employed or unemployed in accordance with the definitions contained in this glossary.

• Labor force participation rate: The labor force as a percent of the civilian noninstitutional population.

• Unemployment rate: The unemployment rate represents the number unemployed as a percent of the labor force.

So a lower participation rate - with the same level of employment - would mean a lower unemployment rate.

Below is a table showing the sensitivity of the unemployment rate to three levels of the participation rate (centered around Goldman's forecast) and three rates of job creation for 2012. (note: this is mixing two different surveys - the household survey for the participation rate and unemployment rate, and the establishment survey for payroll jobs. Over time these two surveys move together, but there can be significant variability in the short run). December 2012 Unemployment Rate based on Jobs added and Participation Rate Participation Rate63.4%63.7%64.0%Jobs added per month (000s)1507.6%8.0%8.5%2007.2%7.7%8.1%2506.9%7.3%7.8%
If the January pace of payroll employment growth continues (around 250 thousand jobs per month), and the participation rate stays at 63.7%, then the unemployment rate could fall to 7.3% in December 2012. But even at a slower pace of payroll growth, the unemployment rate could be at or below 8% by the end of the year - unless the participation rate rises or the economy slows sharply.

The recent FOMC projections (see below) are for the unemployment rate to be in the 8.2% to 8.5% range by Q4 2012, and perhaps the FOMC was expecting the participation rate to increase this year.

If the participation rate doesn't increase, and payroll growth continues (even at 150 thousand per month), then the FOMC projections are too high. But even if the FOMC revises down their unemployment rate forecast, they will still view a 7.5% to 8% unemployment rate at the end of 2012 as unacceptably high.

Unemployment projections of Federal Reserve Governors and Reserve Bank presidents Unemployment Rate1201220132014 January 2012 Projections8.2 to 8.57.4 to 8.16.7 to 7.61 Projections for the unemployment rate are for the average civilian unemployment rate in the fourth quarter of the year indicated.

Friday’s employment data was the latest of a series of data showing marked improvement in the U.S. economy. ISI counted 18 straight weeks of stronger U.S. data including better vehicle sales, same store sales, homebuilding and manufacturing.

Also, U.S. money supply is growing at a robust 10 percent year-over-year, greasing the wheels for America’s economic engine, which showed 3.7 percent growth in nominal GDP in the fourth quarter.

What was the spark that lit the bottle rocket and sent the fireball into the sky for the economy?

The Wall Street Journal recently reported U.S. corporate tax receipts as a share of profits were at the lowest level in 40 years. Corporations paid a tax rate of 12 percent on profits during the fiscal year that ended September 30, 2011, less than half the average rate companies paid from 1987 to 2008. They employed a tax incentive known as “bonus depreciation” allowing businesses to deduct the capital that they invest back into their businesses.

At the same time, capital expenditures for American companies reached $1.5 trillion in 2011, up 10 percent from 2010. This is the third year in a row of increased capex spending.

There appears to be a multiplier effect here: As corporations pay fewer taxes, they can deploy additional capital by expanding their businesses and purchasing new fleet vehicles, machinery and data systems, which then creates and maintains thousands of jobs for American citizens.

It is unlikely the U.S. government would have achieved the same return on investment and multiplier effect on the economy.

All opinions expressed and data provided are subject to change without notice. Some of these opinions may not be appropriate to every investor.

I noted in a recent post that much of Northern Europe currently represents a good value for long-term investors.

Not only are these countries especially cheap right now, but they generally have better growth prospects than other developed markets and based on current credit default swap spreads, they are perceived as less risky than their southern neighbors.

Now, a new BlackRock Investment Institute paper offers further evidence in support of the case for the Northern Europe. The paper, “BlackRock Sovereign Risk Index: Eurozone Revisited & Notable Movers,” contains the Institute’s latest quarterly update of its Sovereign Risk Index scores, which measure countries’ sovereign risk.

According to the latest ranking, “fiscally squeaky clean and economically robust” Northern European countries are at the low-risk end of the spectrum, while slower-growing Southern European countries plagued with debt problems dominate the higher-risk side of the index data.

It’s also worth pointing out that the Southern European countries tend to rank lower than most emerging markets, supporting my view that many emerging markets actually appear to be pictures of fiscal rectitude compared with much of the developed world.

In fact, a number of emerging markets moved up in the new quarterly ranking. As shown above, for instance, China and Peru both jumped up three notches due to new economic data showing better fiscal situations.

 

Source: The BlackRock Investment Institute

While hardly new to anyone who actually has been reading between the lines, and/or Zero Hedge, in the past few months, the Greek endspiel is here, and as a note by Goldman’s Themistoklis Fiotakis overnight, the Greek timeline, or what little is left of it, “allows little room for error.” Furthermore, “Due to the low NPV of the restructuring offer it is likely that part of this investor segment may be tempted to hold out (particularly owners of front-end bonds). How the holdouts are treated will be key. Paying them out in full would probably send a bullish signal to markets, yet it would be contradictory to prior policy statements about the desirability of high participation both in practical terms as well as in terms of signalling. On the other hand, forcing holdouts into the Greek PSI in an involuntary way would likely cause broad market volatility in the near term, but could be digested in the long run as long as it happens in a non-disruptive way (as we have written in the past, avoiding triggering CDS or giving the ECB’s holdings preferential treatment following an involuntary credit event could cause much deeper and longer-lived market damage).” Once again – nothing new, and merely proof that despite headlines from the IIF, the true news will come in 2-3 weeks when the exchange offer is formally closed, only for the world to find that 20-40% of bondholders have declined the deal and killed the transaction! But of course, by then the idiot market, which apparently has never opened a Restructuring 101 textbook will take the EURUSD to 1.5000, only for it to plunge to sub-parity after. More importantly, with Greek bonds set to define a 15 cent real cash recovery, one can see why absent the ECB’s buying, Portugese bonds would be trading in their 30s: “Portugal will be crucial in determining the market’s view on the probability of default outside Greece… Given the significance of such a decision, markets will likely reflect concerns about the relevant risks ahead of time.” Don’t for a second assume Europe is fixed. The fun is only just beginning…

From Goldman Sachs – Market Uncertainty Ahead from Euro Area Sources

Overview

News reports over potential progress in Greece’s PSI talks and the possible involvement of the ECB/EFSF in the restructuring deal have once again boosted the performance of risky assets, with S&P futures trading stronger and the dollar weaker. Peripheral Euro area bonds are trading flat-ish. Today is a quiet day in terms of data releases and markets are likely to start focusing on tomorrow’s ECB and BOE meetings…. In today’s note we discuss the reasons for managing our recommendations more cautiously, linked to Euro area sovereign uncertainties and the likely balance of risks around the ECB’s policy stance vs. market expectations.

A Tight Timeline For Greece Allows Little Room For Error

Greece remains an important source of risk to watch. As we have argued in the past, markets have interpreted the case of the Greek Private Sector Involvement as a precedent for restructuring within the Euro area. Over the last eight months of PSI discussions and preparations, the deterioration in Greek debt dynamics has been accompanied by a gradual deterioration in the terms of the deal for the existing bondholders (in an effort to achieve debt sustainability). In the end, the revealed preference of policymakers in the Greek case has been to pass a significant part of the cost of restructuring Greek debt to the private sector. Fundamentals in Greece may be much worse than in other countries, but the market has extrapolated the policymakers’ reaction function to the other peripheral countries with better fundamentals, thus pushing risk premia higher.

The next few weeks will be no exception. There are important issues to be resolved and further important precedents to be set thereby. To better grasp the complications at hand it is important to discuss the timeline of events ahead. The agreement between the Greek government and the creditors represented by the IIF is likely to be reached in parallel with an agreement between the IMF and the Greek government on the new austerity measures. Then the new austerity measures (including reductions in minimum wages and further reductions in pensions), which are likely to prove unpopular domestically, will need to be approved by the Greek parliament. All this needs to take place about 3-4 weeks ahead of the March 20th bond redemption, so that there is enough time for the IMF to sign off on the new loan package, for the offer to be extended across bondholders and for maximum participation to be pursued.

As we have discussed in previous pieces on the subject, outside official lenders, Greek bond holders and Euro-area banks, there are about EUR70bn of bonds scattered across different institutions. Due to the low NPV of the restructuring offer it is likely that part of this investor segment may be tempted to hold out (particularly owners of front-end bonds). How the holdouts are treated will be key. Paying them out in full would probably send a bullish signal to markets, yet it would be contradictory to prior policy statements about the desirability of high participation both in practical terms as well as in terms of signalling. On the other hand, forcing holdouts into the Greek PSI in an involuntary way would likely cause broad market volatility in the near term, but could be digested in the long run as long as it happens in a non-disruptive way (as we have written in the past, avoiding triggering CDS or giving the ECB’s holdings preferential treatment following an involuntary credit event could cause much deeper and longer-lived market damage). One way of staging such an involuntary restructuring operation for the holdouts would be the retroactive imposition of collective action clauses and their invocation following the conclusion of the voluntary restructuring operation. The introduction of such clauses would likely happen before the PSI exchange offer goes live – in order to further discourage investors from holding out.

The good news is that after a successful restructuring operation, Greece’s systemic importance as a source of risk declines meaningfully due to the limited refinancing needs, the meaningful reduction in debt servicing costs and the low levels of residual market exposure to Greek bonds post PSI.

Portugal’s Significance to Rise Post-Greece

Greece has created a market concern to do with low recovery rates in the event of a restructuring episode in the Euro area, which has been reflected across sovereign risk premia in peripheral Euro area bond markets. However, Portugal will be crucial in determining the market’s view on the probability of default outside Greece. This is because Euro area policymakers have gone out of their way to signal that Greece is a unique case, addressed with a one-off operation. Therefore it will be important that this commitment is maintained.

As Silvia Ardagna and Andrew Benito discussed in a recent Viewpoint, it is likely that Portugal may need an increase in assistance funds. The progress that Portugal has made in its adjustment programme and the reasonably limited resources that need to be put to work make it likely that a “top-up” of official funds to fully cover Portugal’s needs may ultimately be the preferred policy option.

But given the significance of such a decision, markets will likely reflect concerns about the relevant risks ahead of time.

From Peter Tchir of TF Market Advisors

The ECB’s Scary Carry Trade

According to the WSJ, the “ECB is willing to forego profits on their Greek bonds”.

That statement strikes me as one of the scariest things that a central banker could say (and there is some tough competition for that one).

Forego profits?   Here is the chart of a typical Greek bond over the past 2 years.  The ECB started buying Greek bonds in May 2010, and stopped sometime in 2011.

How do they possibly have “profits” to give up?

They have “profits” because they live in an accrual accounting world.  They buy bonds, don’t mark them, and accrue the interest.  The accrued interest counts as “profit”.  That is the carry trade.  That is what everyone is so excited about for the banks.  Banks can buy bonds, not mark them, and book the interest accrual (and payments) as profit.

The problem with accrual accounting is when a sale is forced.  Whatever the reason for the sale (in this case, a restructuring/default by Greece), the accrual accounting game is over and you have real profit or loss.  The “profit” is the total proceeds received for the sale, versus total purchase price, plus any coupon payments received, minus costs of carrying the position.

Some entity is taking the real world loss.  These bonds were bought at prices far above their current value.  Since most Greek bonds only pay interest annually, there may be a lot of accrued, but unpaid interest that will also be lost.

It strikes me as very scary that the central bankers seem more comfortable in an accrual accounting world.  It is also scary that all future policies seem to be based on an attempt to show that all prior policies worked whether or not they did in reality.  It also explains why they are so comfortable with plans out to 2020 when Greece just missed their projections for January by €1 billion.

Can’t wait to see the details of this plan, but can’t imagine that we won’t be discussing a second round of restructuring or default before long.

PIMCO’s Mohamed El-Erian visited with CNBC this morning, and offered his usually interesting thoughts on the macro economy and investment themes. Interestingly, he touted precious metals in this interview (relative to equities) which is the first time I’ve really heard him tout them.

8 minute video – email readers will need to come to site to view:

• This year’s market gains will need more than an improving economic picture and investor willingness to shrug off the European debt crisis, Pimco’s Mohamed El-Erian said. “It’s too early to declare victory,” the co-CEO for the world’s largest bond fund told CNBC in an interview Tuesday.
• He outlined three issues that must be addressed if the 2012 rally is to continue:

1) Geopolitical risk that remains both in Europe and the Middle East.

2) A “handoff to more sustainable policies” beyond the monetary easing from the world’s central banks.

3) Getting “long-term investors” off the sidelines and putting their money to work in riskier assets than bonds.

• As those headwinds remain, El-Erian advises investors to dedicate a smaller portion of their portfolios to stocks and a larger allocation toward precious metals. On bonds, he advocates shorter duration, with a target of seven years or less, which is where the Federal Reserve has focused its debt-buying efforts.
• “They’re both willing and able,” El-Erian said of the Fed and other central banks and aggressive monetary policies. “The issue is the effectiveness. Even the central bankers are beginning to announce that it is not just about the benefits, it’s also about the costs and risks.”
• “The central banks are absolutely committed, but we must not extrapolate that they will remain highly effective,” he continued. “They need help. They are a bridge and they have to be a bridge to somewhere. So far the other government agencies are on the sidelines.”
• “There’s more to do,” El-Erian said. “It’s critical that nothing be done to interrupt this wonderful cyclical bounce. We want the cyclical bounce to translate into a secular bounce, because that’s what the markets need to sustain the wonderful returns so far this year.”
• El-Erian contrasted the situation in Europe from the Lehman Brothers collapse in 2008, and said that while central banks “have become much more proactive” with refinancing operations, the current economy may not be as prepared for economic shock. Regarding the “Lehman moment,” El-Erian said, “If you define it as the economy being able to take the shock, that’s in fact a higher risk because we are in a worse place than we were in ’08.”

Disclosure Notice

Any securities mentioned on this page are not held by the author in his personal portfolio. Securities mentioned may or may not be held by the author in the mutual fund he manages, the Paladin Long Short Fund (PALFX). For a list of the aforementioned fund’s holdings at the end of the prior quarter, visit the Paladin Funds website at http://www.paladinfunds.com/holdings/blog

Standard Chartered Securities’ Rahul Singh, Nipun Mehta, HDFC’s VK Sharma, and O(x)us Securities Chairman, Surjit Bhalla, weigh in on India’s powerful market rally, and its sustainability, followed up with a discussion on the India GDP growth estimate for 2011-2012 due at the end of the February 7 trading session.

Source Videos:

Rahul Singh, Head of Equity Research, Standard Chartered Securities
http://profit.ndtv.com/video/Experts-on-GDP-growth-estimates-and-stock-market…

Nipun Mehta, Market Expert, and Private Banker
http://www.ndtv.com/video/player/top-tips/market-rally-might-not-sustain-on-p…

VK Sharma, Business Head, HDFC Securities
http://profit.ndtv.com/video/Market-uncertainty-over-buy-power-stocks-on-dips…

Surjit Bhalla
http://profit.ndtv.com/video/Experts-on-GDP-growth-estimates-and-stock-market…

From the MBA: Refinance Activity Increases as Rates Hit Survey Lows
The Refinance Index increased 9.4 percent from the previous week. The seasonally adjusted Purchase Index increased 0.1 percent from one week earlier.

The average contract interest rate for 30-year fixed-rate mortgages with conforming loan balances ($417,500 or less) decreased to 4.05 percent, the lowest rate in the history of the survey, from 4.09 percent ...

The average contract interest rate for 30-year fixed-rate mortgages with jumbo loan balances (greater than $417,500)decreased to 4.29 percent, the lowest rate in the history of the survey, from 4.33 percent ...The purchase index is still moving sideways at a very low level, but I expect the changes to HARP to lead to a surge in refinance activity in March.

From the WSJ: Concession Smooths Way Toward a Greek Debt Deal
The European Central Bank has made key concessions over its holdings of Greek government bonds ... The ECB has agreed to exchange the government bonds it purchased in the secondary market last year at a price below face value ...

The idea is for the ECB, in effect, to exchange its Greek bonds for bonds of the European Financial Stability Facility ... The EFSF ... will return the bonds to Greece, and Greece will then agree to repay the EFSF for the price at which the fund bought the bonds from the ECB ... officials said the ECB's concessions could contribute a maximum €11 billion to fill a gap estimated at some €15 billionThe ECB would break even, or might even make a small profit on the transaction. A similar plan would probably help Portugal and Ireland too.

From the Financial Times: Greece misses bail-out deadline
Greece missed another deadline ... on Tuesday night ... [Prime Minister] Lucas Papademos ... would hold the talks on Wednesday morning and expected a deal to be presented for approval at a meeting of eurozone finance ministers later in the week.
excerpt with permissionI still think a deal is likely.

From MarketWatch: New York AG cancels bank settlement statementNew York Attorney General Eric Schneiderman late Tuesday postponed a much anticipated conference call with reporters that was set up to announce whether the state would participate in broad a settlement with five big banks over foreclosure practices.Uh, never mind.

From Diana Olick at CNBC (video at 4:30 PM): New York state Attorney General Eric Schneiderman will make a statement at 6 PM ET.

Olick speculates that if Schneiderman announces New York is joining the settlement that that might mean he has to drop the suit against MERS that was recently filed.

Update: From Bloomberg: States With Highest Foreclosure Rates Among Bank Deal HoldoutsCalifornia, New York, Nevada, Florida and Massachusetts are among the handful of states that haven’t signed a deal with banks over foreclosure abuses ... California Attorney General Kamala Harris and New York Attorney General Eric Schneiderman, who have been some of the most outspoken in pushing for changes to the deal, were among those who hadn’t joined as of yesterday’s deadline.
...
Bank of America Corp., JPMorgan Chase & Co. and Wells Fargo & Co. made a last-minute demand that New York drop claims filed against them Feb. 3 as a condition of the foreclosure settlement ... The push by the three banks raised an obstacle in getting Schneiderman’s support for the deal, said the person.

In a research note released last night, Goldman Sachs economist Sven Jari Stehn looked at the population revisions from the 2010 Census and argued that there is "No Labor Force Participation Rebound in Sight".

This is a key point. Some of the recent decline in the participation rate was expected due to demographics (mostly aging of the population), but most analysts expected some rebound in the participation rate this year as the economy (hopefully) improves. Goldman is now expecting the participation rate to stay flat through 2013.

From Stehn:
The demographic structure of the population matters because participation follows a distinct life cycle: it rises with age as teens enter the labor force, reaches a plateau between ages 25 and 55, and falls sharply thereafter due to retirement. Moreover, participation is higher for prime-age men than women, mostly due to child bearing. This life-cycle pattern can be seen by splitting the working-age population into four groups: young individuals (aged 16-24 years), prime-age men (25-54), prime-age women (25-54), and older individuals (55+). Specifically, in 2011 prime-aged individuals had much higher participation rates (89% for men, 75% for women) than young (at 55%) or older individuals (at 40%). The updated population controls from the 2010 Census revealed an increase in young and older workers relative to prime-age ones, pushing down the estimate for the aggregate participation rate.
...
[O]ur model suggests that the participation rate will remain broadly flat at 63.7% through the end of 2013This is very important. Although I expect the participation rate to decline over the next couple of decades as the population ages, I thought the participation rate would rise a little in 2012. If the participation rate stays steady at 63.7%, then the unemployment rate would fall quicker than I had expected (and possibly quicker than the Fed expected too). I'll add some calculations later.

This is a reminder that we can't just look at the participation rate and the overall employment-population ratio (the ratio of employed to over 16 population).

Click on graph for larger image.

During this period of a significant shift in demographics, it helps to look at the employment-population ratio for the prime working age group (25 to 54 years old). This leaves out most changes in demographics, although there are more women than originally thought, so that impacts this ratio too.

For this key demographic, it appears the employment situation for men is improving a little, but the employment situation for women is still lagging behind.

My worldwide pursuit of good investing bargains takes me to some magnificent countries. In my view, Brazil is certainly among the most beautiful and economically vibrant in the western hemisphere. Its Portuguese-speaking multiracial population of almost 200 million1 represents a growing and upwardly mobile consumer market. Brazil is the fifth most populated country in the [...]

From the BLS: Job Openings and Labor Turnover Summary
There were 3.4 million job openings on the last business day of December, up from 3.1 million in November, the U.S. Bureau of Labor Statistics reported today.
...
Although the number of job openings remained below the 4.4 million openings when the recession began in December 2007, the number of job openings has increased 39 percent since the end of the recession in June 2009.
The following graph shows job openings (yellow line), hires (dark blue), Layoff, Discharges and other (red column), and Quits (light blue column) from the JOLTS.

This is a new series and only started in December 2000.

Note: The difference between JOLTS hires and separations is similar to the CES (payroll survey) net jobs headline numbers. This report is for December, the most recent employment report was for January.

Click on graph for larger image.

Notice that hires (dark blue) and total separations (red and light blue columns stacked) are pretty close each month. When the blue line is above the two stacked columns, the economy is adding net jobs - when it is below the columns, the economy is losing jobs.

Jobs openings increased in December, and the number of job openings (yellow) has generally been trending up, and are up about 15% year-over-year compared to December 2010.

Quits declined slightly in December, but have mostly been trending up - quits are now up about 5% year-over-year. These are voluntary separations and more quits might indicate some improvement in the labor market. (see light blue columns at bottom of graph for trend for "quits").
All current employment graphs

One of the salient questions asked of Bernanke by Congress relates to a Kevin Warsh oped in the WSJ, in which he said the following: “Private investors are crowded out of the market when the Fed shows up as a large and powerful bidder. As a result, the administration and Congress make tax and spending decisions—with huge implications for our standard of living—with heightened risks around future funding costs.” This is arguably the question that dominates Fed policy making under the Operation Twist doctrine, in which the Fed buys up long-dated paper and sells Short dated (under 3 years), the second leg of which however is completely irrelevant, as the Fed has already guaranteed ZIRP until 2014, in essence confirming that Twist was nothing but a stealth QE3 as we have claimed all along, as the Fed’s ZIRP4EVA policy effectively offsets any and all short-dated sales. Needless to say Bernanke’s response was irrelevant. However, here is the most jarring statistic. As Barclays showed a few days back, under Twist, the Fed has monetized virtually all, and specifically 91% of all gross issuance in the 20-30 year maturity bucket. In other words, Warsh is absolutely spot on, and once again we are left with an artificial market in which it is only the Fed that defines the UST curve shape by molding the long end. What happens when Twist ends? Will the 30 Year collapse? What happens when there is no explicit back stop to the long end? Is this the reason why Bill Gross yesterday said that he fully expects much more check writing by the Fed for the next ’12, 24, 36 months.” And how can it not: we don’t have a market of rational players any more – the entire market is merely one irrational player, whose biggest counterparty incidentally, the ECB, is beyond broke. Finally, what happens to the Fed’s balance sheet when interest rates start rising? Holding a portfolio with a duration greater than it has ever been, the DV01 is currently well over $2 billion (i.e. a $2 billion loss on every basis point increase in rates). And rising.

h/t John Lohman

In all the excitement over the December 21 LTRO, Europe forgot one small thing: since it is the functional equivalent of banks using the Discount Window (and at 3 years at that, not overnight), it implies that a recipient bank is in a near-death condition. As such, the incentive for good banks to dump on bad ones is huge, which means that everyone must agree to be stigmatized equally, or else a split occurs whereby the market praises the “good banks” and punishes the “bad ones” (think Lehman). As a reminder, this is what Hank Paulson did back in 2008 when he forced all recently converted Bank Holding Companies to accept bail outs, whether they needed them or not, something that Jamie Dimon takes every opportunity to remind us of nowadays saying he never needed the money but that it was shoved down his throat. Be that as it may, the reason why there has been no borrowings on the Fed’s discount window in years, in addition to the $1.6 trillion in excess fungible reserves floating in the system, is that banks know that even the faintest hint they are resorting to Fed largesse is equivalent to signing one’s death sentence, and in many ways is the reason why the Fed keeps pumping cash into the system via QE instead of overnight borrowings. Yet what happened in Europe, when a few hundred banks borrowed just shy of €500 billion is in no way different than a mass bailout via a discount window. Still, over the past month, Europe which was on the edge equally and ratably, and in which every bank was known to be insolvent, has managed to stage a modest recovery, and now we are back to that most precarious of states – where there is explicit stigma associated with bailout fund usage. And unfortunately, it could not have come at a worse time for the struggling continent: with a new “firewall” LTRO on deck in three weeks, one which may be trillions of euros in size, ostensibly merely to shore up bank capital ahead of a Greek default, suddenly the question of who is solvent and who is insolvent is back with a vengeance, as the precarious Nash equilibrium of the past month collapses, and suddenly a two-tier banking system forms – the banks which the market will not short, and those which it will go after with a vengeance.

The WSJ has more on this very subtle but so very critical shift in the European bailout game theory equilibrium:

A group of top European banks is disclosing that they didn’t borrow money under the European Central Bank’s bank-lending program, fearful of being perceived as bailout recipients.

The broad participation in the program, known as the Long-Term Refinancing Operation, fueled a sense of euphoria among many bank executives and investors that the worst of the Continent’s two-year banking crisis was over. In a second batch of loans in late February, analysts expect the ECB to distribute as much as €1 trillion in additional funds, partly because the central bank is making it easier for banks to borrow.

But some bankers and observers are starting to warn about unexpected fallout from the ECB’s loan program. A top concern among banks is that the receipt of central-bank lifelines could subject them to potential political or regulatory interference and sully their ability to declare themselves free of any outside help. That sentiment has the potential to damp demand for future ECB loans, at least among the Continent’s strongest banks.

In other words, the market is finally waking up that the LTRO, more than merely carrying the upside of a mechanism preserving the status quo for a brief period of time, also has the downside of implicit stigma associated with any and every bank that is found to use it. And the punchline here is that the second a European “Jamie Dimon” emerges and starts touting their lack of need to use LTRO cash, the whole plan collapses. It appears that Deutsche Bank, the bank whose assets are 80% of German GDP, is just that equilibrium collapse factor.

It isn’t yet clear how many banks declined to borrow but the list includes Deutsche Bank AG and Barclays PLC. While the ECB doesn’t divulge which banks borrowed, most companies are expected to disclose the information as they release annual results this month.

“The fact that we have never taken any money from the government has made us, from a reputation point of view, so attractive with so many clients in the world that we would be very reluctant to give that up,” said Josef Ackermann, Deutsche Bank’s chief executive, explaining to analysts last week why the German lender didn’t borrow from the ECB.

Mr. Ackermann said Deutsche Bank still is scarred from its experience borrowing from the Federal Reserve in the first phase of the financial crisis in 2008. U.S. regulators encouraged banks to borrow under the cloak of promised confidentiality, but when the banks’ identities were subsequently disclosed by the Fed, the recipients were dubbed bailout recipients. “We learned a lesson,” Mr. Ackermann said.

Other bank executives privately have voiced similar opinions. Some of that sentiment is likely to surface publicly in coming weeks as banks report annual results and executives face questions from investors about whether they borrowed from the ECB.

English banks are also suddenly scrambling to portray themselves as healthy:

In the U.K., the Financial Services Authority informally encouraged the banks to tap the ECB loan program, although the regulator also made clear that the decision was up to the individual banks, according to executives with several British banks. The goal of the FSA, shared by other European regulators, was to promote broad use of the facility and reduce any stigma associated with borrowing, said people familiar with the matter.

A number of top British banks, including Barclays, Standard Chartered PLC and Lloyds Banking Group PLC, opted not to borrow from the ECB, according to people familiar with the matter.

Beyond the implicit, there are explicit risks associated with being bailed out:

“Those heavily reliant on ECB funding run risks of interference as a price for continued support. This may come to be seen as a form of nationalization,” said Simon Samuels, a European banking analyst at Barclays Capital. He said bank executives are likely to worry that regulators will view their dependence on ECB funds as a sign of a broken business model and will pressure them to restructure operations.

Such concerns are peripheral for banks that potentially were going to have trouble refinancing maturing debt at nonpunitive prices. Virtually every major French, Spanish and Italian bank borrowed billions of euros from the ECB, according to bank disclosures and people familiar with the matter. Among those was Banco Bilbao Vizcaya Argentaria SA, Spain’s second-largest lender by assets, which borrowed €11 billion, the bank’s president told analysts last week.

Some healthy banks also pounced on the opportunity for inexpensive three-year funding. HSBC Holdings PLC was among those that borrowed even though it didn’t need the money, according to people familiar with the matter. Any profits the British bank reaps from investing the borrowed funds will be segregated from HSBC’s bonus pool, one person said.

Yet all these considerations pale before the reality that any banks that borrows even €1 on February 29 will suddenly be perceived as a lower-tier performer, when faced with banks that parade with their “fortress balance sheet.” And as everyone knows, bail outs only work when everyone agrees to be bailed out. Otherwise, it is a shortcut to collapse. Because the last thing Intesa and UniCredit and STD and a whole lot of not so healthy banks will want on March 1 and onward is to be put in the “bailout recipient” category when so many others clearly no longer need the cash…

It appears that European banks, in their vain attempts for short-term capital gains, may have just sealed the fate of the entire financial sector.

The Transparent Fed

February 2, 2012

by Rob Williams
Director of Income Planning, Schwab Center for Financial Research

and Kathy A. Jones
Vice President, Fixed Income Strategist, Schwab Center for Financial Research

Last week, the Fed unveiled a new communications strategy. They provided forecasts for growth, inflation and interest rates for the next several years. The negative bias in the rate forecasts surprised bond markets. They point to the likelihood, given current information, that the Fed will keep short-term interest rates at zero until the end of 2014 due to expectations of slow growth and subdued inflation. One view on these forecasts is that it’s too difficult to forecast so far into the future and that the Fed might be wrong and be forced to reverse course. Another view (ours, for the record) is that increased transparency is good, a positive in an open market.

• The Fed’s move is consistent with the trend toward openness. From appearances on “60 Minutes” to press conferences after the meetings of the Federal Open Market Committee (FOMC), Chairman Bernanke has transitioned the Fed from opaqueness under Alan Greenspan to more transparency. These steps bring the U.S. in line with other central banks that have provided long-term rate forecasts, such as Sweden and the U.K. By providing more information, the argument goes, the Fed can help businesses and individuals plan more clearly for the long-run and dampen market volatility. The transparency of forecasts gives them a tool to change their views more flexibly and reduce the number of “surprise” policy changes.
• The Fed also announced an explicit 2% inflation target for the first time in its history. This explicit inflation target also helps reduce uncertainty about policy long-term. The Fed will use the 2% annual target, based on changes in personal consumption expenditures (PCE) as their measure. The current year-over-year increase in PCE is 1.8% in the latest numbers. So they’re still a touch below those targets. Bernanke was asked in the press conference following the meetings, “why PCE and not the consumer price index?”  One reason is that in CPI, housing has a far greater weight.  It appears to have understated inflation during the housing bubble and may overstate it now that renting is more popular than buying. The PCE is also adjusted more flexibly to changing consumption patterns. Fed critics might also argue that annual increases in PCE also tend to be lower than changes in the CPI.

Multiple Measures of Inflation Still Below Target

Note: The Consumer Price Index (CPI) measures changes in the price level of consumer goods and services purchased by households. The CPI in the United States is defined by the Bureau of Labor Statistics as “a measure of the average change over time in the prices paid by urban consumers for a market basket of consumer goods and services.”  Core inflation (Core CPI) is a measure of inflation which excludes certain items that face volatile price movements, notably food and energy. The preferred measure by the Federal Reserve of core inflation in the United States is the Core Personal Consumption Expenditures Price Index (PCE), which is put out by the Bureau of Economic Analysis of the Department of Commerce.

Source: Bloomberg, using monthly data as of December 2011.

• Notably, the Fed did not announce a policy target for the second part of their dual mandate—employment. They explained this by saying that a host of other factors, including productivity, demographics and public policy, might change the level of maximum employment over time. Today unemployment is 8.5%, undeniably above the level of structural unemployment considered optimal now. The improving trend in unemployment may seem inconsistent with the Fed’s indication that policy will remain “extremely accommodative”—meaning, they’ll use every tool possible to keep rates low. But they do have a long-run estimate (not a target) for full employment at a rate closer to 5.5%. We think this leaves the door open to more quantitative easing in the second or third quarters of this year.
• The Fed’s growth forecasts were below consensus expectations. In the past, the Fed has released economic projections based on individual forecasts from the 5 Fed Governors including Bernanke and 12 Federal Reserve District Bank presidents. They present the central tendency, or average, of 17 participants. Despite a run of good economic data over the last few months, the central tendency (i.e. average) of the forecasts lowered the estimate for 2012 GDP growth to a range of 2.2% to 2.7% from the previous estimate of 2.5% to 2.9%. They also lowered their expectations for 2013 to between 2.8% and 3.2%, from 3.0% and 3.5% in November, and increased them slightly for 2014.
• Transparency should decrease uncertainty over what the Fed is watching and why. One side of the debate says to “keep it to yourselves.” We don’t want to know, in particular that your range of forecasts varies so widely. Another perspective is that it allows us to see what the Fed is watching most closely. And they can change their policy and consensus more flexibly. A critical point that the projections make clear: There is no single projection, and there are different views that can change over time on the committee depending on the data. We believe that the voting members of the Fed will gladly change their positions, if economic conditions (in their view) warrant it.

 

Earn Your Coupon

Corporate bonds have surged out of the gates in the first month of the year, benefiting from the post-holiday rush of confidence in U.S. equity markets, stronger appetite for risk and Fed statements that they’ll keep their policies accommodative. In fact, the riskier sectors of the corporate market, including much-maligned U.S. bank debt, have outperformed their “safe-sector” government counterparts. What’s our view of the prospects from here?

• We continue to see investment-grade corporate bonds as a place to look for yield. We’ve been one voice advocating this, and maintain that view. The overall fundamentals, in our view, such as reduced corporate leverage, improved profit margins and declining financial market volatility are positives. You can see thoughts from Kathy Jones on bank bonds in the “A Second Look at Bank Bonds” article in November. However, given the magnitude of the rally in recent weeks and ongoing risks emanating from Europe, we suggest near-term caution.
• Long-term, we expect 2012 to be the year of “earning the coupon” as compared to 2011, when much of the return in bonds came from price appreciation. Even with the extremely accommodative policy stance by the Fed, we believe that the potential for further price appreciation in bonds is limited. We’d suggest adding new positions during the pockets of time where pricing is more attractive.
• Higher risk sectors, such as financials, have rebounded the most. U.S. banks in particular have benefited from the relative calm injected into the European banking sector by the European Central Bank’s (ECB’s) move to increase liquidity in the financial system through their recently launched Long Term Refinancing Operation (LTRO). This program provides very low-cost loans to European banks, with very permissive guidelines on the collateral required to back those loans, for up to three years. This has lessened the pressure on European banks and helped increase demand for yield in U.S. bank bonds.
• Higher risk sectors are still vulnerable to negative shocks. Even with increased liquidity in the European banking system and improved U.S. investor sentiment, more aggressive, higher yielding sectors are still the most vulnerable to negative surprises from the European debt crisis and domestic economy. With growth in the developed world still fragile, in our view, bank and finance bonds are likely to remain the most volatile. We think utilities, consumer staples and other less cyclical sectors are likely to be relatively more stable.

Prices Rise for Corporate and Bank Bonds

Source: Bloomberg, using monthly data as of December 2011.

State Revenue Watch

The Rockefeller Institute of Government publishes widely referenced quarterly reports on state revenue trends, including their latest this week. In Q3 2011 and preliminary Q4 2011, state tax revenues increased significantly “while the overall economy has been growing at a relatively slow pace.” The revenue trend is encouraging. But “such a disparity” between revenue collections and the real economy “is not sustainable over time,” in their view. This may be just fine, in our view, assuming state legislatures stay on the broad course of budget discipline. In contrast, the full impact of the Great Recession on local government tax revenue—2/3 of which, on average, come from property taxes—for many issuers will continue to lag.

• State revenues grew for the seventh consecutive quarter. Total tax revenues were up 6.1%, according to the Rockefeller data, in Q3 2011 from the prior year. However, the decline starting in late 2008 was severe, so there’s been a lot of ground to make up. Nationwide, collections are still 5.3% lower than three years ago in real terms (i.e. adjusted for inflation.) The pace of revenue recovery has been dramatic, off the extreme lows of Q3 2009. But the pace has slowed, leveling out below prior peaks as expenditures rise.
• Local government revenues have faired less well. Local governments rely more heavily on property taxes, which account for more than 2/3 of total revenue for local governments, compared to the heavier reliance on sales and income taxes for state governments. As we’ve mentioned in previous updates, the impact on property taxes, particularly after a crisis so heavily driven by real estate, is generally slower. Nationwide, real (inflation-adjusted) tax revenues for local governments fell 2.0% over the last four quarters ending in Q3 2011, compared to 0.2% growth from Q3 2009 to Q3 2010, according to the Rockefeller report.
• Austerity and tight budget management remain the themes for now. While state revenue trends are strengthening, a parallel report from the Center on Budget and Policy Priorities points to continued expenditure pressures, focusing on U.S. States. Twenty-nine states project budget gaps in 2013, and health care, education and entitlement costs are ongoing challenges. The expiration of 2009 Recovery Act stimulus spending adds to these pressures. State and local governments are required by statute or their constitutions to deliver balanced budgets. But that doesn’t make cuts any less painful, politically. For the most part, however, states are making adjustments to keep budgets balanced.
• Multiple-notch downgrades. The notion of multiple-notch downgrades for some municipal issuers has gained modest media attention lately. As we wrote in the January 20th edition, rating downgrades outpaced upgrades in the last half of 2011. Moody’s also reported late last year that the number of “multi-notch” downgrades has also increased, though they remain a relatively small proportion of the number of rating actions. Often the cause is issuer-specific, related to lack of pro-active budget cuts leading to a sharp decline in financial reserves and cash balances. We expect that we’ll see more of these downgrades, especially for smaller, local governments and issuers who haven’t acted as aggressively to raise revenues or cuts costs. This is an issue for investors who hold these bonds, of course, but not, in our view, the broader market. We continue to believe that diversification by issuer or professional management using funds or managed accounts can help investors with these challenges.
• Current valuation. Investors have been clamoring for new muni bonds in the first part of the year. Supply of new issue munis has remained tight, however, pushing yields down to a touch above historic lows. The ratio of municipal to treasury yields has also fallen to under 100% for AAA-rated maturities under 10 years. Generally, we still like munis for core portfolio positions for the combination of credit quality and tax-exempt yield. But in the same vein as the comments about corporates above, we’d also suggest adding positions during pockets of weakness for buy-and-hold investors with favorable long-term views. Consider looking for yield in the middle of the curve or in credits a step down (but not too far down) the ladder from AAA, such as the high end of the “A” range in credit, minimum, or higher quality issuers with maturities from 7-15 years in laddered portfolios.

Muni Prices Peaking

Source: Barclays Capital, daily data as of January 30, 2012.

What About CDs?

Many savers are being forced to accept the painful reality that returns on cash in checking and savings accounts may remain quite low for some time. Some investors had grown accustomed to alternatives such as Certificates of Deposit (CDs) for slightly higher yields. Like other fixed income investments, the CD market has grown in complexity. Finding the right CD investment can be challenging. We think it’s worth highlighting the major questions we hear with thoughts on how to help investors through this market.

• What drives CD rates? Primarily, short-term rates and changing supply in the CD market. CD rates, like other fixed income products, will often depend on how many banks are in need of capital and what they’re willing to pay compared to the alternatives. In other words, more competition for the same assets could mean higher rates offered to investors, and vice versa. Moreover, interest rates on CDs and other cash investments are driven by the yields on short-term Treasuries and the Fed Funds rate. Treasury yields are low and effectively zero in short-term maturities. So are the rates offered on CDs with shorter maturities.
• We don’t expect that rates on CDs will move much higher in 2012, given the Fed’s low rate policies. Fed Chairman Bernanke has noted whenever asked that the Fed acknowledges the difficulties for savers. His response: the Fed’s mandate is employment and inflation. If those remain consistent with economic strength, then savers, in their view, will benefit. This isn’t particularly encouraging. But it’s the reality short-term savers may continue to face for some time.
• What are brokered CDs? CDs are bank products, not investments. That is, they’re the obligation of a bank, similar to cash. But methods of distribution of individual CDs may vary. “Bank” CDs are usually sold directly to a customer from a local branch. “Brokered” CDs are sold in the “brokered” market with wider distribution.
• One primary difference between bank and brokered CDs… is how a CD buyer might sell them in the event they wanted their money back before maturity. Although not required by law, most bank CDs can be redeemed early, usually after paying an early redemption fee. There are no formal guidelines governing the penalty amounts. Brokered CDs are generally traded on the secondary market. While there is generally no early-redemption fee, the price a seller might receive is dependent on the price a buyer is willing to pay.
• What about CDs from foreign banks? Some foreign banks with US branches offer CDs to U.S. savers. For all practical purposes, there isn’t much difference compared to a CD from a U.S. bank. The key feature, we believe, is FDIC protection. If a foreign bank fails, the FDIC promises to make the investor whole, up to coverage limits. In our view, foreign bank CDs with this feature can be compared on equal terms (all other terms being equal) to CDs offered by domestic banks with FDIC coverage.
• Other features may matter as much as yield. For most investors, yield and maturity are generally the most important issues. How much will you be repaid, and when? Other features, such as calls, a variable interest rate or estate features may also be valuable. Given the wide range of possibilities, purchasers, in our view, should look carefully at the other characteristics, if they want them, and how they may serve their needs.
• What role should CDs play in the cash investment and fixed income portion of an investor’s portfolio? Unfortunately, CDs and other cash investments have recently been less effective income producers in most investors’ portfolios than they have been historically. Yields are low and may not rise soon. Purchasers may be able to find slightly higher yields in CDs with longer maturities. Like a bond, the investor commits to the lower rate should rates rise, potentially with lower liquidity. Also keep in mind that CDs can be subject to interest rate risk and even issuer credit risk if you’re already over the FDIC protection limits. But for some, CDs with an above average rate may help support the more secure portions a fixed income portfolio. For more insight, see SCFR’s “What about Cash” and “Choosing CDs and Other Cash Investments” articles at schwab.com/marketinsight under Investing > Cash.

Please visit www.schwab.com/onbonds for more fixed income perspective from the Schwab Center for Financial Research. If you have questions or concerns about the issues raised in this publication, please speak to your Schwab representative.

Important Disclosures

Fixed income securities are subject to increased loss of principal during periods of rising interest rates. Fixed income investments are subject to various other risks including changes in credit quality, market valuations, liquidity, prepayments, early redemption, corporate events, tax ramifications and other factors. Income from municipal bonds may be subject to the Alternative Minimum Tax (AMT), and capital appreciation from discounted bonds may be subject to state or local taxes. Capital gains are not exempt from federal income tax.This report is for informational purposes only and is not an offer, solicitation or recommendation that any particular investor should purchase or sell any particular security or pursue a particular investment strategy. The types of securities mentioned herein may not be suitable for everyone. Each investor needs to review a security transaction for his or her own particular situation.All expressions of opinion are subject to change without notice in reaction to shifting market conditions. We believe the information obtained from third-party sources to be reliable, but neither Schwab nor its affiliates guarantee its accuracy, timeliness, or completeness.International investments are subject to additional risks such as currency fluctuations, political instability and the potential for illiquid markets. Investing in emerging markets can accentuate these risks.Past performance is no guarantee of future results.Diversification strategies do not assure a profit and do not protect against losses in declining markets.Funds deposited at an FDIC insured institution are insured, in aggregate, up to $250,000 per depositor, per insured institution based upon account type by the Federal Deposit Insurance Corporation (FDIC). The FDIC considers any other deposits you may have with an issuing bank. CDs you purchase from a particular bank are aggregated with any other deposits you may have with the issuing bank for determining FDIC insurance coverage (e.g., if you already have deposits of $250,000 with a bank, don’t purchase CDs from the same bank in the same ownership category).Barclays Capital Municipal Bond Index consists of a broad selection of investment-grade general obligation and revenue bonds of maturities ranging from one to 30 years. It’s an unmanaged index representative of the tax-exempt bond market.Barclays Capital U.S. Corporate High-Yield Bond Index covers the USD-denominated, non-investment grade, fixed-rate, taxable corporate bond market. Securities are classified as high-yield if the middle rating of Moody’s, Fitch, and S&P isBarclays Capital U.S. Corporate Bond Index covers the USD-denominated, investment grade, fixed-rate, taxable corporate and non-corporate bond markets. Securities are included if rated investment-grade (Baa3/BBB-/BBB-) or higher using the middle rating of Moody’s, S&P, and Fitch.Indexes are unmanaged, do not incur management fees, costs and expenses and cannot be invested in directly.The Schwab Center for Financial Research is a division of Charles Schwab & Co., Inc.

In the Barron’s Streetwise column this weekend, Michael Santoli featured a list that we provided of the ten least volatile S&P 500 stocks over the last decade.  Below is a table that expands the list to the forty least volatile S&P 500 names.  These are current S&P 500 stocks that have the smallest difference between their high price and low price over the last decade.

As shown, Wal-Mart (WMT) has been the least volatile stock over the last ten years with a 10-year hi/lo spread of just 54.07%.  Its 10-year high is $63.94, while its 10-year low is $41.50.  Just six other S&P 500 stocks have a 10-year hi/lo spread that is less than 100% — KMB, PGN, JNJ, SCG, KO and ED.  Other notables on the list of least volatile stocks include Microsoft (MSFT), UPS, Verizon (VZ), 3M (MMM), Procter & Gamble (PG), and Berkshire Hathaway (BRK/B).

February 6, 2012

Below we highlight the current sovereign debt credit default swap (CDS) prices for 39 countries around the world, as well as their year to date changes.

As shown, every country except one (Portugal) has seen its default risk decline in 2012.  European countries have mostly seen the biggest drops in default risk, with Belgium leading the way with a drop of 31.6%.  Greece – while it still has by far the highest default risk – has seen its default risk fall the third most in 2012 with a decline of 25.5%.  (France ranks second at -25.7%.)  The US currently has the lowest default risk out of all the countries shown by a wide margin.