The euro kicks sand in the dollar's face

There's hope for the greenback yet! Sure, by reaching 1.42 against the euro, the dollar sure looks like a 90 pound weakling at Muscle Beach. But take a look at this 30 year graph (before 1999, the ECU --the euro's shadow predecessor--is used):



It looks like 1.4 dollars per euro (approximately) is a pretty hard ceiling!

Just kidding. It's most likely coincidence, unless some strange technical analyst voodoo is taking place.

But there's a real pattern here: dollar lows coincide with U.S. recessions AND oil price surges (in 2001 the first condition is met, but not the second). Correlation is not causation, but this certainly seems to support the dollar-oil price link many have been talking about lately.

I forgot to mention that.....

If the 23% fall in house prices in the 10 largest metro areas that housing futures are indicating comes to pass, that spells recession.

Wondering how low house prices will fall?

Some interesting results are coming out. Moody's expects prices to fall, peak to trough, 7.7% nationally (hat tip: Calculated Risk).

According to Moody's, the bulk of the adjustment will be over by late 2008. This does not square with previous housing downturns, which played out over many years (check this post).

Sounds nasty? Moody's seems positively euphoric compared to the prices quoted in the CME's recently introduced housing price futures, based on the Case-Shiller indices (hat tip: Housing Wire). The 10 city average (includes the largest urban areas) will accumulate a drop of 23% over the next four years.

Scary stuff indeed.

Robert Lucas doesn't get it

Via Mark Thoma, we learn that Robert Lucas, Nobel laureate, wrote a rather incoherent opinion piece on the WSJ. This paragraph left me dumbstruck:

It ... is all too easy for easy money advocates to see a recession coming and rationalize low interest rates. ... [But] I am skeptical about the argument that the subprime mortgage problem will contaminate the whole mortgage market, that housing construction will come to a halt, and that the economy will slip into a recession. Every step in this chain is questionable and none has been quantified. If we have learned anything from the past 20 years it is that there is a lot of stability built into the real economy.

Where to begin? Sure, housing construction won't drop to zero, but housing starts have fallen from 2 million in 2005 to just 1.3 million (annual rate) this August, dragging down the economy. And then there's the slight detail of falling house prices and negative payroll growth.

It's amazing how many people are still in denial about the severity of the housing-led threat.

Cutting rates on 'potential' economic slump? The horror!

Sarcasm is hard to avoid after reading a Bloomberg article titled "Bernanke Cuts on Slum 'Potential', Adopting Greenspan Approach"

After all, isn't avoiding 'slumps' the main job of central banks? Or do they have to wait until a full-blown recession to start cutting rates?

The problem, as always, is semantics. As George Orwell noted long ago, sloppy language leads to sloppy thinking. This is very much in evidence in this article, as in most financial journalism. Concretely, one has to determine what is understood by 'potential slump'

I'm pretty sure that the author meant was that Bernanke sought a rate cut to insulate the economy from the turbulence in financial markets, much as Alan Greenspan did by cutting rates after the Russian debt/LTCM debacle in 1998.

But that analogy is incorrect. In 1998, the U.S. economy was cruising along, growing at an annual rate well over 3% in the first half of that year. Thus, the rate cuts were purely preventive in the sense that market turmoil might have led to a downturn if no action had been taken.

The situation is very different this year. A sharp slowdown, though not a recession, in the economy was pretty evident well before turmoil hit the markets. In fact, while the credit crunch will certainly aggravate the recession in the housing sector, this downturn mostly reflects an imbalance in housing supply and demand that, while obviously related to financial factors, is not determined solely by them.

Thus, the rate cut is not 'preventive': the threat of a housing-led recession is very real and growing, with the current market turmoil clearly contributing to it.

With all due respect, the persons that question the rate reduction on moral hazard (bailout) grounds are nuts, as they're asking the Fed to not do its job. The other set of critics, who state that the Fed is underestimating the risk of inflation, are on firmer ground, but not much. After all, core PCE inflation is below 2%, within the Fed's informal range, and the economy is growing below potential.

Ben's Soothing Tonic

It seems Dr. Ben decided that the patient was best served by having the patient down his medicine in big gulps rather than sips.

With short-term Treasury rates near 4.2% at the end of last week, the markets were pricing a full percentage point cut in the Fed's reference rate over the next few months. So today's decision was merely a question of how quickly the Fed would deliver. Apparently, it is alarmed enough (not surprisingly given the run on Northern Rock in the U.K.) to prescribe a large, 50 basis point dose, even if that means losing some face.

The statement offered little insight. More surprising was the massive reaction in stock prices (the S&P 500 ended 2.9% higher). I think there are two possible explanations for this reaction:

1) Lowering the cost of credit will ease losses and restore liquidity to the markets. Everything will be sunny and it'll be like the two past months never happened.

2) The economy is in danger due to the woes in the housing sector. It's good that the Fed recognizes the magnitude of the threat and is beginning to act accordingly.

Obviously, numero 1 is mucho more likely than 2, as far as investor opinion is concerned. Needless to say, I'm in the #2 camp.

Actually, make that #3: the economy is in much worse shape than generally assumed and things will get a lot worse before Ben's Magic Tonic begins to take effect in a few months. Today's reaction in stock prices was not warranted.

Before calling me Dr. Tangible Gloom, chew on this: everyone has massively, consistently underestimated the problems in the real and financial sides of the housing market, as well as their impact, over the last couple of years. I don't see that changing, yet.

The logic of bank runs

As it turns out, there is anarchy in the U.K.! The run on Northern Rock has intensified and threatens to expand to other financial institutions. As a result, the British government has had to step in and guarantee the value of all deposits in Northern Rock. The full story is here.

This is not a surprise. I predicted that the Bank of England's credit lifeline wouldn't stop the crisis. This is not the result of special insight, but of having lived through the 1995 Mexican financial crisis, when the whole system went belly up. A key lesson was that once confidence was lost in a bank, the government has to step in massively and decisively, taking over the institution or lining up an emergency buyer.

Why? Well, if everyone knows the bank is insolvent, there will be a run. And runs, even in fairly small banks, tend to undermine confidence in the whole system, specially in unsettled times like these. Without confidence, a bank is worthless.

The question is why did the government/regulators wait so long to take action? There is nothing so dangerous as a bank in desperate trouble. Facing bankruptcy, executives and directors only have one course of action: double down the bets to gamble for salvation (or, as happened in Mexico, looting the bank mercilessly). Of course, this usually fails, but not before hugely increasing the losses.

Thus, either they were inexcusively asleep at the wheel or, as usually happens, forgot the lessons of past banking crises.

Could it happen elsewhere?

As a consequence of the housing/mortgage crisis in the U.S., suspicious glances are being cast to other countries that have seen big rises in housing prices over the past few years. Will it prove contagious?

As I've argued before, the fundamental problem in the U.S. was a disequilibrium in housing supply and demand. Too few houses were build in 2002-2003 when demand boomed due to rock-bottom rates, leading to huge price rises. In 2005/2006, too many houses were built given underlying demand. Normally, temporary excess supply or demand is no big deal. The problem turned nasty due to subprime mortgage financing, which artificially boosted demand, made prices jump higher than they would've and now are corroding the markets.

Subprime financing is, as far as I can tell, mostly limited to the U.S.. But that doesn't mean that other countries will be exempt from falling prices due to overbuilding and excess demand. This week, The Economist summarizes a Morgan Stanley study which concludes that many countries have seen house appreciation far in excess of what fundamental factors justify, including the U.K., Spain and Sweden.

Let's compare the U.K. to the U.S.. Now, this is tricky because they have very different demographic profiles, circumstances and tastes. Nonetheless, I believe we can get some idea of housing trends comparing the number of housing unit completions to the estimated increase in the population (people have to live somewhere).


This graph shows that since 2004, more housing units have been built in the U.K. than the increase in population. While it can be argued that foreigners may be buying second homes in London, this situation obviously cannot last. The last time this happened house prices tumbled.

In the U.S. there's a clear, secular downwards trend in housing units per change in population (probably reflecting smaller families and more immigrants, who tend to be single upon arrival). Nonetheless, excess housing demand has obviously contributed to this ratio's fall over the last few years.

I don't know about the other countries, but things look bad for both the U.S. and U.K. Yet, maybe the fallout in Britain will prove less damaging due to less use of "creative financing". We'll see.

Anarchy in the U.K.!

Well, ok, not quite. But in the case of Northern Rock, a British mortgage lender, a liquidity shortfall has led to and ol'fashioned bank run, complete with people queuing in the street to withdraw their money. The Bank of England is stepping in with an emergency loan. This is probably a waste of time and money, as it will not likely stop the panic; only a full-blown rescue/buy out will.

A humorous aside from The Economist:

Customers queuing up in its home town of Newcastle reportedly burst out laughing when bank staff asked if anyone wanted to deposit money

Oil at $80 is no surprise

Oil at a (nominal) record of $80 a barrel? Shocking! So say many OPEC members and ExxonMobil chairman Rex Tillerson, who are most puzzled that prices stay so high given that the market is well supplied with crude. Must be those pesky financial speculators!

This, of course, is nonsense (and predictable self-interested nonsense at that). While it's possible that investors may affect the price of oil in the short-run, prices have been high for many years, which surely means that the fundamentals are really in command.

And speaking of those fundamentals, let's see what the International Energy Agency expected for all 2007 back in January. Basically, demand was forecast at 85.77 millon barrels per day, while non-OPEC supply was expected to be 50.6 million barrels per day. In the most recent forecast, demand is now set at 85.9 mbpd, while non-OPEC supply is estimated at 50 mbpd.

In other words, demand has been higher than forecast, while supply has come up short (OPEC output has been broadly flat). That sounds like an Econ 101 recipe for higher prices to me.

I don't believe

That the payroll numbers released today, bad enough as they were, bear any resemblance to reality. It's simply not possible. To see why, let's just review some numbers related to construction and real estate activities.

First, a quick review of the most recent housing and residential construction data:

Housing starts: -20.9% (July 2007/2006)
Housing units under construction: -16% (July 2007/2006)
Housing units completed: -22.2% (July 07/06)
New residential sales: -10.2% (July 07/06)
Existing home sales: -9% (July 07/06)

And yet, the Bureau of Labor Statistics (BLS)wants us to believe that employment in real estate services rose in August (600 new positions) and is up 1.5% versus year-ago levels?
Am I expected to think that residential construction employment has only fallen 3.5% in this period?

It gets worse. BLS data shows that employment in the offices of real estate brokers and agents has kept on rising, growing 3% in July over the year-ago level.

My head feels like exploding.

But even if we take these figures at face value, it's clear that eventually payrolls will catch up to activity levels, meaning that over the next few months and quarters the employment numbers will look very, very grim. And if analysts were surprised now, I can't imagine how they'll react then.

Bubble dilema for central banks

Morgan Stanley's Richard Berner reports on the ongoing debates in the Fed's annual Jackson Hole powwow. My heat-impaired self hasn't gotten around to reading all the speeches, but Berner does touch a very important point: should central banks preemptively try to prevent bubbles from appearing?

Historically, the Federal Reserve has taken the hands-off approach, just standing by to clean up the mess once bubbles burst. Fed governor Frederic Mishkin has been an outspoken defender of this asymmetric intervention policy.

Yet, as the current and previous episodes illustrate, "cleaning up" is easier said than done. One mistake and you're into "Japanese lost decade" territory. Hence, some European central bankers have come around to the intervene-early camp.

There are no easy answers, but this is a crucial debate. Let us hope it doesn't fade away as it did after the last bubble was cleaned up (sowing the seeds of the current one).

Subprime mess good for stocks?

So argues Jeremy Siegel. Key paragraph:

I think the Fed made the right moves at the right time. But the fallout from this crisis will be with us for a long time. Stocks are thought to be riskier than bonds and much riskier than mortgage bonds. Those that believed they could automatically make junk bonds safe by "backing" them with assets, be they homes or railroad cars, have been proven wrong. It turns out that the best credits are general obligation bonds based on all the firm's income and assets, not debts backed by dubious assets.

In the long run, all this is a good development for the stock market. In the last decade, more than one trillion dollars has migrated to hedge funds and untold billions to complicated debt and derivative securities. Who will buy those assets in the future? I believe quite a few investors will return to stocks and general obligation bonds - assets that they can buy and sell at any time they want.

Wall Street has rediscovered liquidity and transparency. Stocks and old-fashioned bonds have them; new-fangled collateralized debt obligations and hedge funds do not. A return to basics will be good for both the economy and the financial markets.

While he's obviously exagerating a bit, the point is taken.