Global Financial Conditions Monitor, Week ending March 21st 2008

Global equities seesawed across last week as investors grew jittery after the buyout of the troubled Bear Stearns at a fire-sale price by J.P.Morgan but garnered some confidence on the back of a string of positive moves by major Central Banks. The financial sector led most of the rallies throughout the week as investors hailed the Fed’s 75 bps cut in its key interest rate along with a host of broad based liquidity injection measures as a potential building block in the long term solution to the credit crisis. Stronger than expected first quarter results of investment banking giants Goldman, Lehman and Morgan Stanley also helped shore up global equities. The Dow gained 3.25% across the week while the FTSE gained 1.49%.

Citing a weakening economic outlook as well as an elevated inflation, the US Federal Reserve delivered another shot in the arm to the slowing economy as it cut the Federal funds rate as well as the discount rate by 75 bps each, thereby bringing them down to 2.25% and 2.5% respectively. Earlier in the week, Bear Stearns's sudden meltdown had forced the Fed to take the extraordinary measure of allowing securities firms to borrow from the central bank under terms normally reserved for regulated banks.

In an effort to bolster the ailing housing market, the OFHEO reduced the capital surplus that GSEs Fannie Mae and Freddie Mac must hold to 20% from 30% previously. The move is expected to provide a much-needed respite to the two hobbled GSEs as it provides up to USD 200 bn in immediate liquidity to the troubled MBS market. The Fed’s latest measures to unfreeze the credit markets appears to be working in the MBS market where yields have come off their recent highs. The difference on the yield on 30-year MBS compared with U.S. Treasurys fell to 2.74 percentage points, from a high of 3.7 on March 6th. However, upward risks remain abound as another collapse may trigger massive develeraging as investors, banks and others try to reduce their own exposure to risky markets. In what has become one of the most pervasive credit crisis, the issue no longer remains whether it will yield a recession, which seems certain, but whether the Fed’s novel efforts would help to cut the tail risk of a deeper and prolonged recession scenario.

Funding pressures unlikely to abate soon:

The Fed’s new direct lending program aimed at primary dealers coupled with a substantial 75 bps cut in its key interest rate eased funding pressures in the short term money markets over the last week. The size of the total borrowing from the Fed’s primary credit lending facility suggested broader interest amongst the securities dealers. The program drew an average of USD 13.4 bn in daily borrowing in the week ending March 19th ’08 with firms having USD 28.8 bn in loans outstanding.

The 3M USD LIBOR edged up 2.7 bps across the week to 2.606% while the 6M USD LIBOR rose 17 bps to close 2.53%. The ABCP market deteriorated for the third consecutive week with its outstanding value having dropped by USD 4.3 bn last week compared to a USD 5.7 bn dip previously.

A few spoonfuls of potent medicine by the Federal Reserve

In its bid to overcome growing recession and liquidity fears, the Fed had earlier announced that it would add further liquidity to money markets by raising the size of the Term Auction Facility (TAF) auctions to be held on March 10th and 24th to USD 50 bn each, an increase of USD 20 bn from the amounts that were announced on Feb 29. Fed officials also announced that it would initiate a series of 28-day term repurchase transactions that are expected "to cumulate to USD 100 bn" and increase the auction sizes further in future if conditions warrant. Yesterday, the Fed in coordination with four other Central Banks (BoE, SNB, BoC and ECB) stepped up its efforts to assuage the growing strains in global credit markets by significantly extending dollar loans to banks in their respective nations. The Fed supplemented its previous TAF and repo initiative with the Term Security Lending Facility (TSLF) thereby expanding its low securities lending program to enable bond dealers to borrow up to USD 200 bn of Treasury securities, collateralized by other securities, including Fannie and Freddie Mac backed bonds, Fannie and Freddie Mac backed MBS and other AAA rated MBS. Furthermore, the Fed also raised the size of its "swap" agreements with the European Central Bank (ECB) to USD 30 bn from USD 10 bn previously, and with the Swiss National Bank (SNB) to USD 6 bn from USD 2 bn previously. With many banks in the EU facing huge dollar loan obligations while being exposed to risk of US mortgage loans, the swap agreements would enable the respective Central Banks to borrow dollars from the Fed and lend the same to their own banks, thereby alleviating the funding pressures in these markets.

March 10th TAF Auction suggests increased demand for funds:

The result of the March 10th TAF auction suggests that funding pressures continue to exist amongst US banks despite substantial liquidity injection by the Fed through previous TAF auctions in addition to the discount window borrowing as well as open market operations. Until January, it seemed that the Fed had done considerably well in managing market liquidity and eased liquidity concerns in the short term money markets. This is evident from the table above, which depicts a significant drop in bid/cover ratio ( 1.25 in Jan 28th from 3.08 in December 17th) as well as total propositions submitted (USD 37.45 bn from USD 61.553 bn in December 17). However, credit conditions deteriorated markedly over the past two months as the contagion spread beyond the realms of subprime mortgage onto much safer Alt A and even prime mortgages to some extent, thereby hitting major banks, bond insurers, mortgage insurers, hedge funds among others. The latest TAF auction reflected heightened demand for funds with the number of bidders increasing to 82 from 72 previously while total propositions rose to USD 92.595 bn from USD 50 bn previously.

How is TAF different from TSLF?

The Fed has established the Term Auction Facility (TAF) program in order to auctions funds to depository institutions of approximately one-month maturity. The TAF is essentially a collateralized credit facility that allows all those depository institutions that are eligible under the Discount Window Facility, to bid for an advance from its local Federal Reserve Bank at a rate that is Auction determined. The collateral that is eligible to be pledged remains the same as under the Discount Window facility, which includes U.S. Treasury securities, State and local government securities, Collateralized mortgage obligations (AAA rated), and Investment-grade certificates of deposit.Under the Term Securities Lending Facility (TSLF) the Fed auctions U.S. Treasury securities, which includes Treasury bills, note and inflation indexed securities against AAA/Aaa-rated Residential Mortgage backed securities not on review for downgrade along with bonds and MBS which are backed by Fannie and Freddie Mac. The TSLF essentially extends the Fed's low-profile Securities Open Market Account (SOMA) lending program enabling banks to pledge a wider range of collaterals for a longer period of up to 28 days at a time rather than overnight, as was the case with SOMA.

Would TSLF serve its purpose?

Global financial markets have hauled the Central Bank's coordinated actions with the Dow climbing 3.5% yesterday while the S&P 500 gaining 3.71% yesterday. Conditions in the short term money markets eased considerably following Fed's initiatives to address hightenened liquidity pressures coupled with an assurance " to conduct TAF auctions for at least the next six months unless evolving market conditions clearly indicate that such auctions are no longer necessary," The 3M USD LIBOR dipped further below the current fed funds target rate to 2.8675% from 2.938 bps last week while the 6M USD LIBOR touched a low of 2.74% from 2.86% last week. The TSLF provides an important outlet for stained MBS, thereby comforting dealers who were stuck with the soured paper after being dumped by investors facing margin calls. The move would also help partially mitigate the investor nervousness over financial condition of GSEs Fannie Mae and Freddie Mac, who had posted huge fourth quarter losses amidst rising delinquencies. However, there is a high risk that TSLF may prove to be a short term analgesic as the securities lending facility is a temporary transaction with the MBS returning to bank balance sheets after maturity. Also, with the ball now in the Fed's court, the Fed's own balance sheet looks much riskier thanks to the increased share of the risky MBS instead of the safe treasuries. The Fed, which would need to cushion these risky securities with extra collateral and guarantees, seems confident that the TSLF would play an important role in promoting liquidity in the financial markets for treasury and other collateral and thus foster the functioning of financial markets more generally.

Rising foreclosures + plummeting home equity = worsening housing crisis

Credit rating agencies have put ratings of various insurers on watch for downgrades because of continued weakness in the U.S. mortgage markets, especially foreclosures on mortgages backed by subprime and limited-documentation borrowers. Bond as well as mortgage insurers are under tremendous pressure to raise billions of dollars in capital to forestall possible downgrades in their credit ratings as worries about the value of the securities they've insured persist. Failure to make higher payments on ARMs by property owners has lead to a surge in bank seizures of US homes. With property owners failing to make higher payments on adjustable rate mortgages, U.S. home foreclosures have jumped 90% YoY to 45,327 in January. Total foreclosure filings, which include default and auction notices as well as bank seizures, have increased 57% YoY in January, its highest level since August last year. According to Realty Trac, more than 1% of U.S. households were in some stage of foreclosure during 2007. The situation is expected to worsen in the months to come with an estimated USD 460 bn of adjustable mortgages scheduled to reset in 2008. Delinquency rates have already touched their highest levels since 1985 having increased by 87 bps since December 2006 to 5.82% in the last quarter. As long as house prices continue to plummet rising foreclosures would compel banks to resell the foreclosed properties (estimated to be 1 mn in 2008), adding further to the glut of inventory and forcing prices down even further. The vicious circle is expected to persist unless house prices recover. However, a housing bottom looks nowhere in sight with Mr. Bernanke expecting housing to weigh on the economy "in current quarters". The sharp fall in house prices has also created negative equity for home owners as they find it difficult to secure funds on housing stock whose net worth is depleting sharply. Share of homeowners' equity, the market value of a home minus the size of its mortgage, has plunged to 47.9% in the fourth quarter of 2007 from a high of more than 80% in 1945, a reflection of surging delinquencies and housing foreclosures. Value of housing related assets (including mortgaged assets) have fallen by USD 170 bn to USD 20.2 tn last quarter.

Over the recent past, policy markers in coordination with various financial institutions have announced multiple measures aimed at comforting homeowners squeezed by the housing mess. The U.S. Department of the Treasury and the Department of Housing and Urban Development in collaboration with the country's largest mortgage servicers convened the "Hope Now Alliance" whose objective is to try and halt the flood of foreclosures either by freezing mortgage rates, extending payment periods, counseling and postponing or eliminating scheduled rate reset increases. Further more, six major mortgage lenders, namely, Washington Mutual, Bank of America, Wells Fargo, JPMorgan, Citigroup and Countrywide Financial in coordination with the Bush administration have worked out a plan titled "Project Lifeline", wherein the lenders promise to seek contact with homeowners who are 90 or more days overdue on their mortgages. In some cases, homeowners will be given the chance to "pause" their foreclosure for 30 days while lenders try to work out a way to make the loans affordable. The New York State Insurance Department met with banks to persuade them to inject capital into the monolines - reportedly in the region of USD 5 bn in immediate capital and ultimately to commit up to USD 15 bn as concern mounted that further guarantor downgrades could force a fresh round of write-downs. In a move to boost the housing market in expensive areas, the government has raised the cap on the size of mortgages that can be bought by government-sponsored mortgage giants Fannie Mae and Freddie Mac or insured by the Federal Housing Administration (FHA). Furthermore, Fed Chairman Ben Bernanke has urged lenders to reduce the principal amount of troubled mortgages and proposed that the FHA's authority be expanded so that it can then insure the written-down loans.

Although the steps taken by the Bush administration towards rescuing homeowners on the brink of foreclosure are definitely in the right direction, the measures undertaken might prove to be just a short term palliative rather than providing a permanent solution. While lenders need to move more aggressively to reduce loan balances to current home values and make monthly payments affordable, these lenders face the risk of lawsuits from troubled investors that own the loans if they believe that borrowers have been given overly generous terms. One also wonders how many of the bigger loans Fannie Mae and Freddie Mac will be able to finance when they themselves are heavily cash strapped having recorded massive fourth quarter losses of USD 3.56 bn and USD 2.45 bn each. While Bernanke's rescue proposals have recieved a positive response from policy makers and are expected to effectively address the housing crisis if implemented succesfully. It is, though, a huge, 'if'.

Recession jitters balloon in the US as labor market sheds 63K jobs in February

Recession jitters ballooned in the US economy after its labor market shed 63K jobs in February, its fastest rate since March 2003. The February NFP numbers belied market expectations of a 25K increase. Job losses suffered in January were worse than first reported, revised to -22K from -17K previously. Two successive months of negative jobs growth does not augur well for an economy slated to be on the brink of a recession. The payroll declines hit almost every sector of the US economy, except for government jobs. However, the gains in government jobs (+38K) did little to offset the massive fall in private employment (-101K). While the goods producing sector extended its downfall, cutting an additional 89K jobs in February (-54K previously), dwindling support from the services sector (+26K from +32K previously) is a major concern for the embattled U.S economy. Substantial job losses in retail trade (-34K) and financial services (-12K) have been primarily responsible for the slowdown in services employment. Within financial activities, employment in credit intermediation (which includes mortgage lending and related activities) has fallen by an additional 5K last month. The manufacturing sector, which has been slashing jobs continually for the past 20 months now, axed 52K more jobs in February (-31K previously) while the construction sector followed suit as employment slumped by 39K from -25K previously. The construction sector has been on a downtrend since the sub prime fiasco unfolded as declining home sales and tightening mortgage lending standards have together dented builders' sentiment. The industry has lost a total of 321K jobs since its peak in September 2006. Meanwhile, the February unemployment rate edged down to 4.8% from 4.9%. This is primarily because some job seekers dropped out of the labor force. The size of the US labor force declined by an estimated 450,000 in February, thereby driving down the unemployment rate. Average hourly earnings increased 0.3%, up 3.7% on a YoY basis. The bleak job report has reinforced the widening view that the US economy is falling into a recession. Amidst the ongoing turmoil in the housing and financial markets, the report has heightened fears of a 'negative feedback loop" in which financial market strain lead to a weaker economy, which in turn leads to more financial market turbulence. The February data supports the Fed's recent aggressive response to signs of economic weakness and suggests further easing at its next FOMC meeting.

US Manufacturing slumps to a five year low as ISM slides to 48.3 in February

Manufacturing activity across the US weakened to a five year low as the US ISM manufacturing breached the 50 threshold in February falling to 48.3 from 50.7 in the previous month. The February reading, which came in slightly below consensus expectations of 49, further aggravates recessionary concerns in the US economy. A reading below 50 signals contraction, while any reading above 50 signals expansion. Digging deeper into the data, the major components new orders and production have also registered a decline with the new orders index continuing to remain in the contraction territory, dropping further to 49.1 from 49.5 in January while the production component of the index edged down, although still above the expansion threshold. (50.7 from 55.2 previously). This underlined the ongoing weakness in capital spending, previously reflected in the January durable goods orders release, which depicted a 5.3% MoM decline in new orders. Inventory liquidation continued for the 22nd consecutive month as anufacturer’s inventories contracted again in February with the Inventories index falling to 45.4 as compared to 49.1 in the previous month. Labor market conditions in the manufacturing sector continued to remain iffy as reflected by the manufacturing employment index, which fell to 46 from 47.1 in January. Meanwhile, inflation concerns remained anchored with the prices paid index still at elevated levels, despite edging down to 75.5 from 76 previously. Historically, ISM has been a reliable predictor of US recessions and the current slump in US manufacturing
has added onto concerns about an impending US hard landing. A slowdown in manufacturing may also end up decelerating trade improvement, a significant factor to support growth during such distressed times. Recent speeches by top Fed officials coupled with the dismal nature of economic and financial news over the past fortnight strongly suggests that the Fed officials are prepared to ease interest rates further in order to stave off a possible recession in the U.S.

Bernanke signals further easing amidst multiple economic risks

Key economic data released over the past fortnight revived angst about a stagflation in the U.S. economy, an unwelcome combination of slowing growth and persistent inflation. Economic jitters finally caught up with U.S. capital spending as new orders for manufactured durable goods plummeted by 5.3% MoM in January after having climbed substantially (4.4% MoM) in December 2007. The housing market continued to plummet as January new home sales declined by 2.8% (588k vs. 605k previously), thereby posting the weakest reading since February 1995. An iffy labor market has begun to weigh heavily on consumer confidence, which fell to its lowest reading since March 2003. Meanwhile, inflation qualms came to the fore, fueled by oil’s rally to records over USD 100 a barrel. US headline CPI increases 0.4% MoM in January, a pace akin to that in the previous month. Inflation of core prices (excluding volatile food and energy costs), which is closely watched by the Fed, edged up to 0.3% MoM (the fastest pace since June 2006) from a steady 0.2% in each of the preceding 9 months.
While the higher than expected CPI data release had caused some apprehension amongst market participants about the future Fed stance, the Federal Reserve Chairman Ben Bernanke’s semi annual testimony before the House Financial Services Committee effectively dispelled any doubts on this front. Although the chairman did acknowledge that inflation risks are skewed slightly to the high side, he made it clear that the growth still remains the Fed’s primary concern. Offering no indication that the struggling housing sector is approaching a bottom, Mr. Bernanke noted that housing would weigh on the economy “in current quarters” and that nonresidential construction which had held up well so far “is likely to decelerate sharply”. He acknowledged that the contagion had begun to affect other sectors of the economy like consumer and business spending, which had survived the housing turmoil for most of 2007. Noting that some small banks could yet fail because of the recent housing crunch, the Chairman reminded investors of possible risks remaining in the financial sector .He added that financial markets remained under ‘considerable stress’ and that officials will monitor financial developments ‘closely’.
Bernanke’s dovish comments reverberated Donald Kohn’s speech earlier in the week. The Vice Chairman had warned that the turmoil in credit markets and the possibility of even slower economic growth posed a ‘greater threat’ than inflation. He had also added that the housing correction had further to go, and financial market recovery was likely to be prolonged. In line with the gloomy outlook, the FOMC members lowered their growth forecasts for 2008 which were released along with the minutes of the January 30th FOMC meeting. While the minutes clearly focused on the downside risks to growth in the near term, the real GDP central tendency range was shifted down from 1.8 - 2.5 to 1.3 - 2.0 for 2008 and unemployment rate moved higher to 5.0 - 5.3. Although the minutes did revise its inflation forecast higher to 2.0-2.2% for 2008, the focus remained on inflation expectations, which are believed to be still under control.
Recent speeches by top Fed officials coupled with the dismal nature of economic and financial news over the past fortnight strongly suggest that the Fed officials are prepared to ease interest rates further in order to stave off a possible recession in the U.S. This has further reinforces another 50 bs cut in the Fed funds rate at the March 18th FOMC meeting with risks definitely skewed on the downside

Global Financial Conditions Monitor - Week ending February 29, 2008

Global equity markets remained depressed last week amid a succession of downbeat corporate news, and weak economic data. Earlier in the week, investors had grown hopeful that the worst might be over for firms saddled with soared mortgage-related bets following positive developments in the monoline industry. However, that optimism quickly evaporated following a string of negative headlines as the week progressed. AIG’s fourth quarter results coupled with UBS estimates that losses from the global credit crisis will top USD 600 bn reawakened investor’s financial fears, after the insurance major reported a USD 5.29 bn loss, the deepest in its history, and took a USD 11.2 bn write down related to the estimated market value of credit derivatives. The Dow ended down 2.42% over the week, while the FTSE slipped 1.92%.

Shaken by the credit market malaise, Government sponsored mortgage lenders, Fannie Mae and Freddie Mac, recorded massive fourth quarter losses of USD 3.56 bn and USD 2.45 bn each amid a sharp rise in delinquencies. With Standard Chartered having abandoned a plan to bail out Whistlejacket Capital, the SIV booked losses of USD 300 mn and became the first bank-sponsored SIV to default. In an odd silver lining, the monoline industry got a temporary breather last week as Moody’s became the second ratings agency to reaffirm MBIA’s AAA rating after S&P on Monday. Both rating agencies have moved MBIA to negative outlook from ‘on review from downgrade’, thereby reducing the possibility of imminent ratings cut.

The embattled municipal bond market received a major setback last Friday after hedge funds were forced to unwind complicated bets and in the process dump billions of dollars of the securities. The hedge funds fire sales sent yields on debt from munis to historic high levels, with the average AAA-rated, 30-year muni bond yielding 5.14% on Friday as compared to 4.42% on a U.S. Treasury 30-year bond. The future looks gloomy for the munis with two short-term municipal markets, for auction rate and variable demand note obligations, having frozen in recent weeks because investors are apprehensive about the credit worthiness of bond insurers as a result of their bad bets on subprime mortgage investments.

Short term money markets beginning to feel the pressure:

The Federal Reserve's sixth auction through its Term Auction Facility (TAF) lent USD 30 bn of 28-day credits at 3.080 pct, above the 3.0 pct Fed funds target rate and well below the 3.5 pct discount window rate. The auction reflected increased demand for funds with the number of bidders (72 from 66), and the spread between the stop-out rate and the minimum bid rate (27bp from 15bp) going up.
The 3M USD LIBOR dipped marginally to 3.0575% while the 6M USD LIBOR edged down 1.25 bps over the previous week to close 2.93%. The total weekly borrowing from the discount window fell to USD 0.845 bn from USD 1.1 bn previously.

The Asset backed commercial paper (ABCP) market showed some improvement after deteriorating for 4 consecutive weeks after its outstanding value rose by 7.6 bn as compared to a USD 11.6 bn dip in the previous week

Global Financial Conditions - Week ending February 22, 2008

Economic jitters weighed heavily on global equity markets over the past week. Investors primary fear of an incipient recession was further aggravated by the February Philly Fed index of factory output which shrank the most in seven years. Concommitantly, inflation qualms came to the fore, fueled by oil’s rally to records over USD 100 a barrel. An unexpected USD 2.5 bn ABS related writedown by Credit Suisse thanks to alleged ``mismarkings'' by a group of traders kept the lid on gains in the European markets with the FTSE slipping 1.0% across the week. Following a 1.15% plunge on Thursday, the Dow ended the week up 0.8% as markets spun around, sparked by hopes for a USD 3 bn bailout of bond insurer Ambac Financial Group. A rescue would enable the monoline to retain its AAA rating and help banks avoid losses on securities gauranteed by Ambac.
The beleaguered bond guarantors remain a focus of market attention. On Wednesday, several sources reported that the struggling bond guarantor, FGIC Corp, had notified the New York State Department about its intention to split the business into two companies, one insuring safe municipal bonds while the other keeping responsibility of riskier debt securities. While the move would help protect investors of safe municipal bonds, it threatens to roil banks that are large holders of MBS.
Meanwhile in an important development on the other side of the Atlantic, the U.K. Treasury acquired all of Northern Rock PLC’s shares, as a formal process to nationalize the distressed mortgage lender, in its bid to mitigate potential risks to the wider financial system if Northern Rock was to collapse.
The surge in iTraxx Europe Crossover index as well as the North America CDX index since the beginning of the year provides stark evidence that the contagion is spreading to investments linked to the corporate debt market. The annual cost of five years of insurance against default on USD 10 mn in bonds on the CDX index has risen to USD152,000 from USD 80,970 at the start of the year.

Conditions in the Money Market generally worsen...
Mounting strains in the credit market are beginning to take a toll on the short-term money markets with 3M USD LIBOR edging up by 1 bp over the last week to 3.08%. Over week ending February 20th 2008, the net liquidity borrowings through the repo and discount window stood at USD 18.1 bn. The total weekly borrowing from the discount window rose to USD 1.1 bn from USD 0.28 bn previously.
The Asset backed commercial paper (ABCP) market, which had shown notable improvement until the beginning of 2008, deteriorated for the 4th consecutive week after its outstanding value dropped by USD 11.7 bn as compared to a USD 6.2 bn dip in the previous week. As a part of its ongoing effort to alleviate liquidity concerns the Fed conducts its sixth TAF auction today, offering 28 day credit of USD 30 bn.

Inflation refuses to ebb, US headline CPI increases 0.4% MoM in January

The US headline CPI increased 0.4% MoM in January, a pace akin to that in the previous month. Inflation of core prices (excluding volatile food and energy costs), which is closely watched by the Fed, edged up to 0.3% MoM (the fastest pace since June 2006) from a steady 0.2% in each of the preceding 9 months. On a YoY basis the situation looks much more alarming, as headline inflation jumped 4.3% from an already elevated level of 4.1% in the previous month while core inflation grew 2.5%, its highest annual rate since March 2007. At the current levels, the core CPI is substantially above 1% - 2% zone targeted by the Fed for core PCE, a worrisome sign for the Federal reserve officials who are already grappling with serious growth concerns. Core inflation has risen at an annual rate of 3.1% over the past three months.

The rise in headline CPI was largely driven by higher food (+ 0.7% MoM in January vs. +0.1% in December) and energy prices (+ 0.7% MoM in January vs. +1.7% in December) while Owners Equivalent Rent (+ 0.3% MoM in January vs. +0.3% in December) and apparel (+ 0.4% MoM in January vs. +0.1% in December) prices pushed up the core. Food prices (13.8% weight in headline CPI) have depicted the highest MoM increase since April 2005. Owner's equivalent rent, which accounts for 24% of the headline CPI and is a major component of overall housing, has been increasing at a steady pace of 0.3% MoM for the past three consecutive months. Housing, which accounts for 42% of the CPI Index, rose 0.2% MoM, a modest increase from +0.3% and + 0.4% in the previous two month. Although core inflation has been the Fed's preferred measure of inflation, the underlying price trends in energy, particularly crude oil prices, which have already touched the three-digit level and expected to remain elevated in the near term, is an area of grave concern. Mirroring the secondary effects of higher energy prices, transportation prices have increased 0.5% MoM (+1.0% previously) while airline prices have jumped 0.8% MoM. Gasoline prices, which account for about two-thirds of the overall transportation increase, rose 1.2%MoM in January (2.8% previously).

Although recent speeches by Bernanke have suggested that his focus has shifted, presumably temporarily, to inflationary expectation rather than actual inflation data; he cannot possibly ignore the steady rise in core inflation since the past three months (+3.1% YoY over last quarter). Going forward one sees ample risks to core as well as headline inflation in the form of surging crude oil and import prices. Non-fuel import prices rose 0.7% MoM in January and have risen at a 5.2% annual rate over the last quarter. Import prices in January have increased across countries with European Union (+1.1% MoM), Latin America (+2.8% MoM) and China (0.8% MoM) being the major contributors. While in the current scenario downside risks to growth are much severe than the upside risks to inflation, accelerating consumer prices will certainly carry a significant weight in future FOMC deliberations.

Global Financial Conditions Monitor - Week ending February 15th 2008

Global equities stumbled at the start line of a raucous week, amid concerns raised by G7 officials about the ‘uncertain’ financial outlook with potential subprime losses estimated to touch USD 400 bn. However, Warren Buffet’s offer to take over USD 800 bn of municipal bonds served as a short term palliative but shares of bond insurance majors soon slumped once the proposed plan was out as the Berkshire Hathway stayed away from taking over the non munis, especially the murky mortgage backed securities. However the offer coupled with a strong retail sales data had done well to boost global equities as they gained considerably over the next two days. But the buoyant mood quickly disappeared as investors digested several unwelcome bits of news about global financial behemoths including the USD 11.3 bn Q4 loss by UBS as well as Moody’s downgrade of bond insurer FGIC’s AAA rating. The Dow, which had swung more than 175 points in each of the previous two sessions, fell 1.63% over the last two days while the FTSE ended down 1.57%. Markets gasped across the finish line, clinging to a modest gain, with the Dow up 0.88% over the week.
Meanwhile, mounting losses and the threat of credit-rating downgrades continued to hit the embattled bond and mortgage insurance industry. The country’s largest mortgage insurer, MGIC Investment Corp, posted a USD1.47 bn loss in the fourth quarter, while Moody’s downgraded bond insurer FGIC Corp’s AAA rating to A3 after the company’s capital base weakened considerably owing to its exposure to the US residential mortgage market. With FGIC having lost its top rating from all three major rating agencies, it can prompt money-fund managers to unload their FGIC insured holdings, further aggravating the ongoing credit crisis.
The Fed Chairman Ben Bernanke sounded a gloomy note about the economy in his congressional testimony. Leaving the door open for a sizable rate cut next month, he cautioned that intensifying credit and financial-market pressures are likely to restrain economic growth. Voicing concerns over the adverse impact of the roiling bond insurance industry, Bernanke noted that market worries about mortgage defaults and the ripple effects of bond insurers' woes are contributing to tighter lending standards.

Bernanke’s testimony, a harbinger of further easing in March

Key economic data released over the last fortnight remained rather mixed. On an upbeat note, advanced estimates of US retail sales for January beat consensus estimates to increase by 0.3% MoM (-0.4% in December). Headline sales were primarily driven by elevated levels of gasoline prices and high demand for motor vehicles. Ex-auto growth was also positive, as sales climbed 0.3% MoM (-0.3% decline previously). Building upon the retail sales surprise, weekly jobless claims data showed a drop in claims of 9K to 348K in the week ending Feb 9. With soaring exports partially offsetting a big jump in oil imports, the US trade deficit declined to USD 711.6 bn in 2007 after widening successively for five straight years. On the downside, US ISM Non Manufacturing index for January plummeted to 41.9 (54.4 in December), its largest monthly decline on record and much larger than the market expectations of a drop to 53. Components of the index were as bad if not worse. While new orders contracted for the first time since October 2001, employment contracted for the first time since February 2002. The New York Federal Reserve reported that its general business conditions index tumbled to -11.72 in Feb (9.03 in January), falling below zero for the first time since 2005.

Meanwhile, dislocations in the financial markets intensified as mounting losses and the threat of credit-rating downgrades roiled the bond insurance industry. While raising concerns about the ‘uncertain’ financial outlook G7 officials estimated potential subprime losses estimated to touch USD 400 bn. With regulators nervous about lax lending standards, the wave of risk aversion is spreading across the spectrum of US banking industry with small lenders beginning to feel the squeeze of credit crunch. The Federal Reserve’s survey of senior bank loan officer’s survey for January offered the hardest evidence that the credit crunch may be spreading beyond real estate loans. The survey found that about 55% of banks have tightened liquidity standards for mortgages while 60% have done so on home equity lines. The survey showed a marginal tightening in credit card lending standards (32.1% from 26% previously).
Federal Reserve Chairman Ben Bernanke, in his testimony to the Senate Banking Committee assured the house that the FOMC would "act in a timely manner as needed to support growth and to provide adequate insurance against downside risks". Raising concerns about the adverse impact of tight lending standards on economic growth, Bernanke noted that more-expensive and less-available credit seems likely to continue to be a source of restraint on economic growth. Bernanke once again admitted that the outlook for the economy has worsened in recent months. He said that the economy is expected to see a "period of sluggish growth" followed by a "somewhat stronger" pace starting later this year as the effects of the monetary and fiscal policy start to be felt. In a positive move, US President Mr. Bush has signed the USD 168 bn fiscal stimulus package, approved by the Senate, thereby complementing the Fed’s endeavor to stave off a recession. Bernanke’s testimony has further cemented my view of an aggresive ( biased towards a 50 bps) rate cut at the next FOMC meeting while continued liquidity injections would continue to keep conditions in the money market stable. At this juncture, with the next FOMC meeting still a month away, the Fed’s rate decision hinges on two important factors, the nature of key economic data points released till March 18th and developments in the financial markets. Going forward, its would be interesting to take a close look at the minutes of the January 29th FOMC meeting as well as US CPI and housing starts released this week for further cues on the Fed’s next move.

Global financial conditions monitor - Week ending February 8th 2008

The week started off on a somber note as analysts’ downgrades of several major banks and credit card issuers, including Wachovia and American Express, to a sell rating pushed global equity markets lower. The S&P fell 1.9% while the Dow and FTSE declined 0.9% and 0.05% respectively. However, the worse was yet to come as a bleak reading of the US service sector followed by cautionary rhetoric by the Federal Reserve fuelled recessionary fears as the S&P plunged 3.2%, while other global indices followed suit. The bearish sentiment continued across the week as financial stocks languished with the Dow dropping 4.4% from the earlier week,
its biggest weekly decline since March 2003.

With regulators nervous about lax lending standards, the wave of risk aversion is spreading across the spectrum of US banking industry with small lenders beginning to feel the squeeze of credit crunch. The Federal Reserve’s survey of senior bank loan officer’s survey for January offered the hardest evidence that the credit crunch may be spreading beyond real estate loans. The survey found that 80% of U.S. banks tightened terms on commercial real estate loans during the period, up from 50% in the previous month. On the consumer side, about 55% of banks have tightened liquidity standards for mortgages while 60% have done so on home equity
lines. The survey showed a marginal tightening in credit card lending standards (32.1% from 26% previously).

On the brighter side, the US Congress finally approved a USD 168 bn fiscal stimulus bill thereby
complementing the Fed’s endeavor to stave off a recession. The bill is expected to benefit around 130 mn U.S. households, including Social Security and military veterans, who would be receiving tax rebates this spring. Meanwhile, there remains the odd silver lining as liquidity conditions in the short-term money market continued to improve with the Fed having announces two more TAF auctions, scheduled Feb 11th and 25th.

US Congress finally approves a USD 168 bn fiscal package to jumpstart the ailing economy

The US Congress has finally approved the Fiscal stimulus bill intended to complement the Fed's endeavor to stave off a recession in the ailing US economy, albeit with a few addendums as suggested by the Senate. Earlier, the proposed fiscal stimulus plan had received a major setback after most Republicans stuck together to oppose a bid by the Democrats to add USD 44 bn in help for the elderly, disabled veterans, the unemployed and businesses to the House-passed economic aid package. However, valuing the urgency of the situation, especially in an election year, the two parties quickly settled matters, with the Democrats dropping their demand for extra spending and tax breaks. With the Senate having given its final approval(81-16 vote) to a USD 168 bn fiscal stimulus package ,revised up from USD 150 bn passed by the House earlier, the House quickly adopted the proposed changes to set the ball rolling as soon as possible (380-34 vote). The bill is expected to benefit around 130 mn U.S. households who would be receiving tax rebates this spring. Its now just a matter of time before the Bill gets a a sign off from the U.S. President as he has already made clear he intends to sign the legislation, calling it "an example of bipartisan cooperation at a time when the American people most expect it."

While sticking to the proposals of the earlier bill passed by the House, the Senate generated an additional provision intended to benefit Social Security veterans and military veterans, as well as their surviving spouses . The final bill extends the smaller rebates of USD 300 (for individuals) or USD 600 (for married couples) to this group apart from those who don't pay income taxes but have incomes of at least USD 3,000 . This adds more than 20 mn social security recipients and disable veterans to the rebate program. The Senate also succeeded in dropping two other proposals, namely, the renewable energy tax incentives along with a provision that would have allowed companies such as home builders to get tax refunds from past years when they were profitable.



Highlights of the final package are as follows:

Tax rebates and incentives to stimulate consumption spending

• Most income tax payers to receive USD 600; working couples USD 1,200
• Workers who earn at least USD 3,000 but don't pay taxes, to receive checks of USD 300-600.This group would include Social Security recipients and military veterans receiving disability payments, as well as their surviving spouses -- a provision generated by the Senate.
• People under both categories to get an extra USD 300 per child
• Rebates would be phased out for those families earning more than USD150,000
• No rebates for those earning more than USD 174,000, unless they have children
  

Housing Related

• Dollar limit on mortgages that can be bought by Fannie Mae and Freddie Mac to be raised above USD 600,000 and perhaps as high as USD 730,000, from the current limit of USD 417,000
  

Business tax write-offs

• Additional 50% write-off on capital-equipment investments made this year
• Small businesses to be able to write off USD 250,000 from their taxes, up from USD 125,000

US Manufacturing activity rebounds as ISM increases to 50.7 in January

Manufacturing activity across the US rebounded in January as the ISM manufacturing index jumped above the pivotal 50 levels to register 50.7 with the December index being revised upward to 48.4 from 47.7 previously. A reading below 50 signals contraction, while any reading above 50 signals expansion. The stronger than expected January reading (expectations stood at 47.2) brings US manufacturing activity back into the expansion zone after having contracted for the first time last month after 10 consecutive months of expansion. A strong ISM seen in context of a 5.2% MoM surge in December durable goods orders hints at business investments holding up despite the ongoing troubles in the US economy.

Digging deeper into the data, we find that the increase in the headline index was primarily driven by higher exports, new orders and production. Exports index climbed to 58.5 in January from 52.5 previously, indicating sustained overseas demand despite domestic demand being hit by the ongoing housing market deterioration. New orders index still remains in the contractionary territory but rose to 49.5 from 46.9 previously while the production component of the index jumped to 55.2 from 48.6. Inventory liquidation continued for the 21st consecutive month as manufacturer’s inventories contracted again albeit at a slower pace in January. In line with the disappointing January NFP report the ISM also revealed a softening labor market as reflected by the manufacturing employment index, which declined to 47.1 from 48.7 in December. The ISM Price Index, a measure of prices paid by manufacturers, rose to 76 from 68 in December. This is not surprising, given the elevated levels of energy and food prices over the past two months.

Major industries which registered growth in January were Apparel, Leather and Allied products, Petroleum and Coal, Food, and Electrical equipment. Although the January ISM does provide some comfort it would do little to nudge the Fed’s dovish stance. Overall economic news has not been very encouraging thanks to the iffy labor market, worsening housing conditions and the ongoing dislocations in the financial markets. According to manufacturers questioned during the ISM survey, “The softness in residential construction has begun to manifest itself in commercial construction”.

Fed cuts rates aggressively as “financial markets remain distressed”

Seeking to thwart an incipient recession the US Federal Reserve slashed interest rates by 125 bps over the last fortnight through two successive cuts within a span of 9 days. On the heels of a global stock sell off on January 22nd, which was triggered by the Fitch downgrade of No.2 bond insurer Ambac Financial Group and further aggravated by the French bank Société Générale’s liquidation of equity positions taken by its rogue trader, the Fed made a surprise intermeeting cut of 75 bps in the federal funds target rate. However, heightened concerns regarding the onset of a potential US recession, thanks to the “stress in financial markets” and “weakening of the economic outlook”, forced the Fed’s hand for the second time, as it slashed the Fed rate and discount rate by another 50 bps to 3% and 3.5% at the January 30th FOMC meeting. Jittery
credit market conditions further reinforced the Fed’s decision as mounting losses on securities guaranteed by major bond insurer’s added onto the market’s concerns of further write downs by major financial institutions. In an effort to complement the Fed’s monetary policy endeavor, the White House and the Congressional leaders quickly hammered out a fiscal stimulus plan with nearly USD 150 bn of tax relief aimed to bolster the ailing U.S. economy. Tax credits amounting to USD 100 bn form the key part of the proposal. We believe that the bill, which now awaits the senate’s nod, is unlikely to do away with the need for further easing by the Fed since it should be effective only by mid 2008 even in the most optimistic scenario.

Economic data released over the last fortnight was skewed on the downside despite a few bright spots. Recessionary fears gripped the US economy as the pace of economic growth faltered in the 4th quarter of 2007 with the US GDP edging up 0.6% QoQ annualized, much below consensus estimates of +1.2%, compared to a solid 4.9% growth posted in the third quarter of 2007. The beleaguered US housing market is showing no signs of bottoming as new home sales in December 2007 plummeted 40.7% YoY to 604k, its lowest level since 559k in February 1995. The labor market, deemed to be the last leg of the crippling US economy, shed 17K jobs in January belying consensus estimates (+65k) that were upbeat after the robust January ADP employment data release. This is its first decline since August 2003 (-42K) when the labor
market hadn’t fully recovered from the 2001 recession. The surge in durable goods orders and the rebound in ISM were the two bright spots amidst the gloomy scenario. December durable goods orders surged 5.2% MoM (0.5% previously) while ISM rebounded above the pivotal 50 level to 50.7 in January (48.4 previously) thereby hinting that business investments are still holding up despite the ongoing troubles in the US economy.

On the brighter side, money market conditions continued to improve over the fortnight, on the back of constant liquidity injection by the Federal Reserve and Sovereign Wealth Funds. The results of the January 14th and 28th TAF auctions confirmed that the Fed has done considerably well in managing market liquidity since the earlier auctions as fewer banks turned to the Fed to shore up their liquidity position. Despite a comfortable liquidity scenario, financial markets remain fragile with S&P threatening to downgrade more than 8000 mortgage investments, the largest during the past few months. With the Fed having left the door open
for further cuts in future, the fed rate is likely to be slashed further to 2.5% by the end of Q1-08. Not to mention that the risks remain skewed to the downside...

US Labor market begins to succumb, January NFP declines by 17K

It wasn’t a happy new year for the US wage earner as the labor market, deemed to be the last leg of the crippling US economy, shed 18K jobs in January belying consensus estimates (+70k) that were upbeat after the robust January ADP employment data release. This is its first decline since August 2003 (-42K) when the labor market hadn’t fully recovered from the 2001 recession. While the January NFP does ring alarm bells it is essential to look beyond the initial estimates to gauge the real picture since they are subject to constant modification. Revisions to previous NFP data were mixed. While November job growth was revised down by almost half, to 60k. December payrolls were revised up by 64k to show an 82k gain. Nevertheless, the year 2007 has been one of the worst for the US labor market in recent years with average monthly addition of just 95K jobs as compared to solid 175K in 2006.
Gains in services like health care, retail and leisure did little to offset declines in sectors such as manufacturing, construction, financial services and government. While government shed 18k positions private employers provided little support by adding just1k jobs. The construction industry cut 27k jobs in January with most of the decline concentrated in housing. The meltdown in housing has taken a toll on construction with the industry losing a total of 284k jobs since its peak in September 2006. Thanks to plummeting house prices, the value of residential construction put in place in 2007 plunged 18.3% YoY. The axe also fell on factory workers with 28K jobs eliminated last month. Commercial banking lost 4k jobs last month. Support from the services sector seems to be dwindling as it added only 34k jobs last month as compared to 143k in December.

Although the dip in unemployment to 4.9% from 5% comes as a welcome relief, it still remains at elevated levels and may touch the dreaded 5% mark again if the jobs growth fails to recover soon. With employers tightening their belts amidst the economic slowdown wage earners are also likely to feel the heat of a slowdown in wage growth (+0.2% vs. 0.4% previously) as inflation continues to edge up. With the subprime mess having festered, a weak labor market is bound to put even greater stress on the US consumer.
The January data leaves little doubt that the US economy is beginning to falter under a trifecta of intense headwinds; a severe housing contraction, credit market turmoil and surging commodity prices.

Global financial conditions monitor - Week ending February 1, 2008

Citing ‘stressed financial market conditions’ and a ‘deepening of the housing market contraction’, last week, the Fed delivered another shot in the arm of the ailing US economy by slashing the Fed funds and discount rate by 50 bps, bringing them down to 3.0% and 3.5% respectively. Global investors welcomed the half point cut with the Dow going up almost 201 points . However the euphoria was short lived as investors sold stocks on concerns of a troubled bond insurance industry with the Dow closing the day 37.4 points down. While being bearish on the broadbased weakness in the US economy, hopes that a big merger between Microsoft and Yahoo may revive the later meant that global equities ended the week on a mixed note.

Monoline insurers continued to create havoc as further downgrades and write downs added fuel to the jittery credit market conditions. While Financial Guaranty Insurance Co became the third major insurer whose AAA rating was axed by Fitch, MBIA posted its second consecutive net loss of USD 2.3 bn as write-downs in its credit derivatives portfolio rose to USD 3.5 bn. The credit market, which is already shell shocked by write downs of about USD 100 bn at big financial firms and declines in housing values, received another blow with S&P threatening to downgrade more than 8000 mortgage investments, the largest during the past few months. While the fate of these insurers remains crucial in the unfolding financial turmoil, losses on subprime securities continued to eat into the profits of major banks across the globe. European major, UBS AG, was the biggest casualty last week as it posted a net loss of USD 11.4 bn thanks to USD 14 bn writedowns on subprime infected assets

The odd silver lining continues to be the comfortable liquidity conditions in the short tem money markets as the 6M USD LIBOR eased below 3.25%. Fiscal proposals to jumpstart the US economy got a major boost last week with the House approving the stimulus plan. While it now awaits the senates nod, it remains to be seen how well the double barreled stimulus (fiscal + monetary) helps stave off a much dreaded recession in the US economy.

Fiscal stimulus – complement not substitute to Fed easing

Plagued by an iffy labor market, contracting manufacturing activity and plummeting house prices, neither the Democrats nor the Republicans would have wanted to face the wrath of voters by standing in the way of expansionary fiscal policy measures, when the monetary authorities have gone aggressive with a 75 bps inter-meeting cut. Bearing in mind the high cost of inaction, the White House and the Congressional leaders quickly hammered out a fiscal stimulus plan with nearly USD 150 bn of tax relief aimed to bolster the ailing U.S. economy. The package valued at "about 1% of GDP", as expressed by President Bush, now awaits final approval from the Senate and sign off from the President before being implemented.

The House plans to vote the bill in early February and send it to President Bush by February 15. As of now, I do not envisage much problem on this front. The speed with which negotiations have been concluded between the two parties, underscores the urgency of the situation. Moreover, the bill is largely along expected lines and is unlikely to lead to heated debates.

Tax credits amounting to USD 100 bn form the key part of the proposal. Around 117 mn U.S. households are expected to receive tax rebates of up to USD 1,200 with checks to low-income and middle-class workers, including those who pay payroll taxes but not income taxes. Thus only the retirees, around 27 mn in number, would be receiving no tax rebates.

Highlights of the proposed package are as follows:

Tax rebates and incentives to stimulate consumption spending

• Most income tax payers to receive USD 600; working couples USD 1,200
• Workers who earn at least USD 3,000 but don’t pay taxes, to receive checks of USD 300-600
• People under both categories to get an extra USD 300 per child
• Rebates would be phased out for those families earning more than USD150,000
• No rebates for those earning more than USD 174,000, unless they have children
  

Housing Related

• Dollar limit on mortgages that can be bought by Fannie Mae and Freddie Mac to be raised above USD 600,000 and perhaps as high as USD 730,000, from the current limit of USD 417,000
  

Business tax write-offs

• Additional 50% write-off on capital-equipment investments made this year
• Small businesses to be able to write off USD 250,000 from their taxes, up from USD 125,000
  

In formulating the bill, both the parties were forced to cede ground. The stimulus bill excluded two stimulus measures proposed by the Democrats, namely, expanding food stamps or lengthening benefits for unemployed workers. The bill also does not extend the 2001 and 2003 tax cuts beyond their scheduled expiration in 2011, a proposal strongly supported by the Republicans.

The proposed fiscal plan reverberates the one laid out during the last U.S. recession that trailed the 2001 dotcom bubble. The 2001 stimulus plan was largely regarded as being well timed and effective in keeping the recession mild. Reacting to the impact of the 2001 fiscal package, the chairman had earlier said, "My judgment, and I think the judgment of most of the empirical analyses that have been done, was that the rebates in 2001 did have some impact on spending and that was of some assistance in keeping the 2001 recession relatively moderate." The then government had mailed a total of USD 38 bn (comprising of USD 300 and USD 600 of one time rebate checks) to one third of US households. Although these rebate checks did prop up consumer spending to a certain extent, according to studies by the U.S. Labor Department, its role in reviving the US economy, especially in stimulating business investments has been seen to be limited. According to some Republicans, similar tax breaks to businesses had added around 100,000 more jobs to the economy in 2003. However, in the current scenario, when demand continues to remain subdued, direct subsidies to business investments are unlikely to have the desired impact on investments unless sales get a boost from higher consumer spending.

The question that now arises is whether the fiscal package would do away with the need for aggressive rate cuts. While this is an interesting possibility, I would like to indicate that even in the most optimistic scenario, the package is unlikely to be effective before mid 2008; as the first tax rebate checks are expected to reach the US households only between May and July of this year. With the US economy on the brink of a recession, it is unlikely that Bernanke will be able to hold out for that long. Hence, I would stick on to my expectations of another 100 bps cut from the Fed by the end of Q1-08, which would bring the Fed rate to 2.50%.