Keeping things in perspective

The following excellent commentary is by Scott Grannis, Chief Economist at Western Asset Management.
-- David M Gordon / The Deipnosophist
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There's been no shortage of bad news recently, with subprime lending problems topping the list, followed by a housing downturn that is almost two years old and which has seen building permits plunge 35% with no end yet in sight. Subprime losses may eventual total in the hundreds of billions of dollars, and spreads have widened significantly even for the highest-rated subprime tranches. Housing prices have only just begun to fall. The level of financial stress in the system is perhaps best summed up by the 10-year swap spread, which has now reached levels that are reminiscent of the Russia/LTCM crisis in 1998.

[click on each chart to enlarge]

But not all is doom and gloom. The economy has proved fairly resilient so far, as evidenced by low and stable weekly unemployment claims and double-digit growth in federal tax revenues. Second quarter growth was almost certainly much stronger than the first quarter's anemic 0.6% pace, and stock prices continue to move broadly higher all over the world, bolstered in no small part by record-setting profits. Industrial commodity prices are making new highs across the board, European and Japanese growth has accelerated, and Asia is booming. Real interest rates are not particularly high anywhere in the world. Although energy prices are elevated, they are no higher in real terms than they were in the early 1980s, when it took twice as much oil to produce a unit of output as it does today. It's hard to see the U.S. economy going into a recession with this sort of backdrop. I'm reminded of how the 9/11 terrorist attacks coincided almost to the day to the end of the relatively mild 2001 recession. It takes a lot to bring the U.S. economy to its knees.

What's disturbing about recent developments in the bond market is that spreads of all stripes are wider. Only the most prudent of investors (e.g., those investing only in Treasuries) have escaped the subprime debacle unscathed. Does this presage a widespread contagion of subprime problems to the financial market and the economy in general? A quick check of low-quality spreads shows they too have widened, but not by much when viewed from an historical perspective. Emerging market spreads blew out to 1600 bps in the wake of the Russia/LTCM crisis, but today they are less than 200 bps. BBB-rated subprime loans are the only securities trading with four-digit spreads today.

With all the widening of spreads and the gyrating of interest rates, it's not surprising that actual and implied volatility in the bond market have shot up. But here again, from an historical perspective the current level of volatility is still generally low. Indeed, the only time that bond volatility was lower than it is today was in the months leading up to the Russia/LTCM crisis. Low volatility is a sign of complacency and conducive to leverage, which then exposes those who have levered up to unexpected risks. That's a painful lesson that some bond investors have yet to learn.

Although conditions in the financial markets are certainly stressed, it's likely the case that the damage will be relatively contained. Potential losses in subprime lending could eventually register in the hundreds of billions, but would not likely exceed 1% of the $35 trillion liquid global bond market. Moreover, those losses have already been eclipsed by the rise in equity market valuation year to date. Wider swap spreads might thus be telling us that there is a relatively small group of investors who are trying very hard to reduce their risk exposure and/or leverage. For example, CDOs that loaded up on subprime mortgage paper are facing big losses and are being forced to hedge and/or close out their positions. The market's appetite for risk has been falling all year but has really plunged in the past month or so. The subprime crisis appears to be the trigger, but things have been complicated by the sudden rise in volatility and the recent rise in interest rates, both of which fueled a lot of hedging from mortgage investors. Financial institutions around the world are scrambling, especially those with significant exposure to subprime, since no one wants to be caught with their fingers in this poisoned pie. It's a classic rush for the exits.

But already we see that 10-year Treasury yields have dropped 40 bps from their June highs, and volatility also is lower today than June highs. And while some home owners are getting squeezed by the subprime lending fiasco, small businesses have seen a huge improvement in their ability to raise funds: non-financial commercial paper has doubled since early 2004, and commercial and industrial loans are up over 40%. Similarly, nonresidential construction has picked up almost all of the slack to date that has been generated by the residential construction market. Asset markets can undergo huge repricings (e.g., the 1987 stock market collapse) without meaningful consequences for the economy.

Of course, even though subprime losses will likely be only a drop in the bucket of global liquidity, the market requires some time to digest everything. No one walks away from losses of this magnitude without putting up a fight, and we probably haven't seen all of the bankruptcies that are likely to occur.

On another front, the weak dollar is nearing levels that begin to raise warning flags. On a nominal basis it's as weak as it's ever been. On an inflation adjusted basis it's been weaker, so the sky is not yet falling. But it's worth noting that with the dollar undeniably weak and falling, Fed Chairman Bernanke's Humphrey-Hawkins testimony the other day did not contain a single mention of the word "dollar." Indeed, Bernanke has not referenced the value of the dollar in any of his speeches or testimony so far this year, and neither have the other Fed governors. The last time Bernanke referenced the value of the dollar was in a speech last December, when he noted that the dollar's weakness presented a problem to the Chinese economy that could be solved by a revaluation of its currency. That's a roundabout way of endorsing a weaker dollar. Treasury has also been conspicuous by its absence on the subject of the dollar this year. The last time Secretary Paulson mentioned the dollar (August of last year), the best he could muster was "a strong dollar is in our nation's interest," but he qualified that by noting that the dollar's value was determined by market forces. If this isn't benign neglect I don't know what it is.

The dollar is beset by some powerful negatives to be sure: Benign neglect on the part of the Fed and Treasury, an economy that is underperforming most of Europe and Asia, and a subprime lending panic that seemingly strips the Fed of any ability to raise rates in its defense. A Democratic-controlled Congress is pushing hard for a meaningful increase in taxes on income and capital gains, at a time when tax competition is resulting in lower and flatter taxes across new and old Europe. Protectionist sentiment on both sides of the aisle is steadily rising, with potentially negative consequences for the economy and world trade in general.

With the dollar falling and risk levels rising, it's not surprising that gold is rising. In real terms it's not yet at the extremes we saw as inflation spiraled up to double-digit levels in the late 1970s, but it is significantly higher today than its average of the past 30 years.

Commodities are making new highs almost every day (with the notable exception of gasoline prices which are falling), but most of the rise in the past year is due to the weakness of the dollar. For example, commodity prices are relatively unchanged since early 2006 when measured in Australian dollars, euros, or sterling. In inflation-adjusted dollar terms, spot commodities today are still less expensive than they were in 1970.



The dollar's gyrations don't mean much to the man on the street, and it's tough to find a significant statistical link between the dollar's value and the rate of U.S. inflation. But it's probably true that the dollar can't fall a whole lot more without posing some serious problems. The world's demand for dollars is weak and falling, and the Fed has not taken sufficient steps to shrink the supply of dollars. The good news is that there is no apparent shortage of dollar liquidity in the world, so that should help us get through the subprime and housing problems. But the bad news is that an excess of dollars may eventually contribute to higher U.S. inflation. Consider: if the rest of the world wants to reduce its holdings of dollar bonds and deposits, those dollars must be spent on goods, services, or other tangible assets in the U.S. economy. This would mean a rise in money velocity and that in turn could fuel a rise in the general price level.

But for all the dollar's problems, a fix is hardly elusive. With the budget deficit on track to reach zero as early as next year, Congress may find it difficult to justify higher taxes. (Corollary: even if central banks' demand for Treasuries is collapsing, so too is the supply of Treasuries.) For its part, the Fed wouldn't need to do much to increase its non-existent support of the dollar. And if housing merely declines at a slower pace, the drag on the economy will ease.