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.