Saturday, July 29, 2006

The Fed is Done!

For now, it seems obvious to me that the fed is done with it's rate raising campaign. With the GDP number showing a rapid slowdown in the economy, there is not the political will to continue raising rates. The fed, I believe, is operating under the premise that a slowdown in the economy, by itself, will be enough to decrease inflationary pressures. Whether or not this is correct remains to be seen. With the drop in long term yields lately, it is apparent that bond investors believe that the fed will in fact be lowering rates in the near future. I think that this belief has also permeated itself into the stock market with the pop last week after GDP numbers came out. However, the canary in the coal mine wil be the value of the dollar itself. If interest rate differentials become less attractive to foreign buyers, then dollar denomenated assets may be dumped, or at least purchased in much lesser quantities. The fed is walking a tightrope. They want to keep the dollar stable because of the dependance on foreign funding of our defecits, they want to keep inflationary expectations in check to keep long term rates down, they want to produce a soft landing in the housing market without a major systemic shock. Can they do it? I have my doubts. Previous credit binges have never ended well. And the fed, no matter how well intentioned, cannot protect us from our own follies forever.

Monday, July 17, 2006

The U.S. is going broke.

Published in Federal Reserve Bank of ST. Louis July/August 2006 by Laurence J. Kotlikoff.


There are 77 million baby boomers now rang-
ing from age 41 to age 59. All are hoping to collect
tens of thousands of dollars in pension and health-
care benefits from the next generation. These
claimants aren’t going away. In three years, the
oldest boomers will be eligible for early Social
Security benefits. In six years, the boomer van-
guard will start collecting Medicare. Our nation
has done nothing to prepare for this onslaught of
obligation. Instead, it has continued to focus on
a completely meaningless fiscal metric—“the”
federal deficit—censored and studiously ignored
long-term fiscal analyses that are scientifically
coherent, and dramatically expanded the benefit
levels being explicitly or implicitly promised to
the baby boomers.
Countries can and do go bankrupt. The United
States, with its $65.9 trillion fiscal gap, seems
clearly headed down that path. The country needs
to stop shooting itself in the foot. It needs to adopt
generational accounting as its standard method
of budgeting and fiscal analysis, and it needs to
adopt fundamental tax, Social Security, and
healthcare reforms that will redeem our children’s

US Going Broke

Saturday, July 15, 2006

Odds of recession increasing? (WSJ)

Warning Signs
Consumer Caution, Oil Prices
Increase Risk of a Recession
Economy Is Still Expanding,
but Middle East Fighting
Shakes Market Confidence
A Slowdown in Retail Sales
July 14, 2006 11:38 p.m.; Page A1
With oil prices surging, financial markets gyrating and consumers turning cautious, the risks of recession are rising.

For now, the U.S. economy is still expanding, unemployment is a low 4.6% and most forecasters predict higher energy prices and interest rates will slow the economy -- not shrink it.

But this past week's fighting in the Middle East is shaking Wall Street's confidence. The Dow Jones Industrial Average fell 106.94 points Friday and was down 3.2% for the week, wiping out most of 2006's gains. (Read more.) Stocks of retailers and home builders, susceptible to rising interest rates and tight-fisted consumers, sagged. Yields on long-term Treasury bonds fell below short-term yields, a phenomenon often seen as a harbinger of recession.

A big worry is surging oil prices, which have contributed to several past recessions. Amid the Middle East turmoil and militant attacks in Nigeria, crude oil for August delivery rose 33 cents to close at $77.03 a barrel on the New York Mercantile Exchange on Friday, a new nominal record.

In all, oil prices were up 4% for the week, hitting stocks of auto makers, airlines and other oil-dependent industries. They also increased the chances that the retail price for a gallon of regular gasoline -- which averaged $2.96 on Thursday, according to the American Automobile Association -- could breach $3.

"Given that the U.S. economy is already under the weather, the [Middle East] conflict does carry the potential of bringing the economy into a recession," said Carlos Asilis, a Miami-based portfolio manager for hedge fund Vega Plus Capital Partners.

In another sign of a slowdown, the Commerce Department said Friday that retail sales in June slipped by a seasonally adjusted 0.1% to $363.80 billion, led by a 1.4% fall in sales of autos and parts. Excluding sales of autos -- and price-driven increases in gas-station sales -- retail sales were up just 0.1%, far short of the inflation rate. Total retail sales are up 5.9% over the past year.

A recession-warning gauge devised by Federal Reserve economist Jonathan Wright -- based on yields on the three-month Treasury bill and 10-year Treasury note and the Fed's current target for short-term rates -- calculates the odds of recession in the next year are now at 36%, up from 14% six months ago. (See Mr. Wright's paper.)

Merrill Lynch economist David Rosenberg put them even higher, at 40%, noting that a slowing economy could pose problems for business and consumer borrowers and deepen the slowdown. And Ian Shepherdson, chief U.S. economist at High Frequency Economics, a Valhalla, N.Y., consultant, sees a 50% chance of recession. "Hopefully, the Fed will recognize that risk and not be crazy enough to raise rates again next month," he said.

As the economy has perked up and the threat of deflation has faded, the Fed has taken short-term interest rates to 5.25% from an extraordinarily low 1% over the past two years. But with growth slowing at the same time that inflation is accelerating, the Fed faces a tough call at its Aug. 8 meeting.

As markets fell and oil prices rose Friday, futures markets were putting at 52% the odds of another Fed increase. That was down from 59% on Thursday. Markets hope for more clues to the Fed's thinking when Fed Chairman Ben Bernanke testifies before Congress Wednesday and Thursday.

Even those who don't foresee recession expect a significant slowdown. "I'm not bold enough to forecast a recession at this point," said Paul Kasriel of Northern Trust Co., Chicago. "But I do think that the economy has entered a very soft patch here."

Complaining About Gas Prices

Signs of that can be seen at Dunham's Department Store, in Wellsboro, Pa, where some shoppers are complaining about energy costs. John Dunham, the store's president, quoted one customer as saying: "You wouldn't believe -- it cost me $90 to fill up my tank the other day."

In June, sales at the 42-employee store fell 5% from a year earlier; revenue for the year is expected to be flat. "Everyone feels a little bit pinched" by high energy prices, Mr. Dunham said.

"Consumers are ... no longer simply willing to spend everything they have to sustain their lifestyles," said Joel Naroff, of Naroff Economic Advisers. They're more cautious and are now beginning to cut back on spending. That's what's beginning to show."

It's not only low-income consumers who are pulling back. Makers of boats and recreational vehicles say demand is softening. Fleetwood Enterprises, a maker of recreational vehicles, posted lower-than-expected earnings this past week.

Brunswick Corp., the world's largest maker of recreational boats, cited "significant declines in retail demand" -- unit sales were off 10% in the second quarter -- and pared profit predictions and production plans. The company said demand was weakest for boats costing between $100,000 and $250,000. "We believe the marine business is not alone in experiencing weakness," Chief Executive Dusty McCoy said in a conference call Wednesday.

The University of Michigan's midmonth report on consumer sentiment fell to a reading of 83 in July from 84.9 in June, according to those who saw the report Friday. Consumers' assessment of present conditions fell sharply. Consumers expect consumer prices to rise 3.1% in the next year, down from 3.3% last month, a development likely to please the Fed.

Anxiety about the housing market intensified as well, particularly after a profit warning from D.R. Horton Inc., which had been dubbed the Teflon builder because of the way it stood out for sticking with its guidance for the year. The Fort Worth, Texas, company, which had been expecting to close on 58,000 houses this year, said Thursday night that it now expects to close on only 50,000.

The company's bleaker earnings guidance raises questions about whether the housing market slowdown will prove more painful than many had predicted. Some analysts expect similar bad news from other builders in the coming weeks.

Of course, recessions are notoriously hard to predict, and early-warning gauges can be misleading. "You have to monitor movements among so many indicators," said Victor Zarnowitz, a longtime business-cycle watcher now at the Conference Board, a business-research organization in New York. "It's complex to find a consensus in economic activity."

The U.S. has shaken off a surprising number of shocks in the past few years. "We have found that the U.S. economy has been surprisingly resilient, surprisingly able to manage the increase in prices that we have already seen," Energy Secretary Sam Bodman said at a Friday news conference with Canadian government officials. "I am hopeful that it will continue to do so."

Lakshman Achuthan of the Economic Cycle Research Institute in New York, which tries to predict the turns in the economy, expects just that. "In terms of recession risk, we don't see that yet," he said. "Our leading indicators of growth, while they're down, are not in recessionary territory."

Welcome signs of life in the Japanese and European economies and continued vigor in China, moreover, suggest they might help sustain world economic growth as the U.S. slows.

But in a sign of concern over the economy, investors have been shifting money toward long-term Treasurys, as they often do during times of trouble. That has driven the yield on 10-year Treasury notes, which began the month at 5.15%, down to 5.07%.

That puts the 10-year yield below the Fed's 5.25% target for the federal funds rates, which banks lend to each other overnight, and below the 5.1% yield on two-year Treasury notes. Because investors usually demand higher returns for locking up money for longer periods, it's unusual for long-term interest rates to fall below short-term rates. When that happens, it's often a sign that investors believe the economy is about to slow, forcing the Fed to cut short-term rates.

When this phenomenon -- known as an inverted yield curve -- occurred last year, many economists dismissed its significance because the Fed was keeping rates extraordinarily low. But that's no longer true.

Retailer Shares Take Hit

On Wall Street, shares of retailers have been hit particularly hard, as investors worry that high energy prices will cut into shoppers' ability to spend on other items. Shares of Wal-Mart Stores Inc., whose many lower-income customers are especially sensitive gasoline prices, slipped about 2.5% on Friday after the retail data was released.

Also hit hard were shares of General Motors Corp. and Ford Motor Co., hurt in part by the view that high gasoline prices are cutting into the sales of sport-utility vehicles, their most profitable products. Investors have instead been favoring utilities and other companies whose earnings have held up in past downturns.

Stewart Pillette, head of Pillette Investment Management in San Francisco, said even fund managers who typically put their money into technology stocks and other traditionally high-growth areas, are loading up on defensive stocks. "They've turned extremely cautious," he said.

Though Byron Wien, chief investment strategist at hedge fund Pequot Capital Management, said he doesn't see a recession coming, he said his firm has taken a more defensive posture amid the tensions in the Middle East, rising oil prices and slowing corporate earnings.

"Our job is to make money when we can and protect capital when we can't," he said. "Right now, we're in capital-protection mode." But every downturn has its bottom. "When people get alarmingly pessimistic," he added, "that's when it's time to buy. It looks like that day is coming."

Additionally on Friday, the Labor Department reported that import prices were up 0.1% in June after rising 1.7% in May. Excluding oil, import prices climbed 0.4% last month.

Fed's Recession Risk Paper

Friday, July 14, 2006

Is the consumer starting to crack? From minyanville.

consumer cracking?

One thing we Americans will never be accused of is self-restraint. Faced with entreaties to “eat all you can eat”, “shop til you drop” and “SuperSize It”, we are powerless to resist…and we’ve got the bloated balance sheets and physiques to prove it. After stuffing ourselves silly over the last few years, however, it appears some of us have finally had enough. The latest retail roundup reinforces what we suspected all along-- the U.S. economy is starting to get a little soft around the middle. Sure, things at the high-end are still quite firm. But our middle-class gut has definitely started to head south. As the nation’s midsection succumbs to gravity and the lower-income ranks begin to swell, mid-tier retailers and dining establishments are feeling the pinch.

After kicking and banging their household ATMs to deliver any cash still trapped inside it appears the jig is finally up. Combing through the Fed’s Commercial Bank Assets release last Friday (must reading for insomniacs) we made a most shocking discovery. Transaction deposits (aka checking accounts) at banks plunged -$30b in one week and are down -8.4% y/y, their lowest level since the last recession. Gee, might this evaporation in deposit balances foreshadow a slowdown in discretionary spending ahead? Sure looks like it…

Yep. Things are sure starting to look dicey on the consumer front. And no wonder, our promised safety net -- income growth -- is fraying before our eyes. Loath as we are to rain on the wage inflation parade, the surge in Average Hourly Earnings in last week’s Payroll Report likely owes more to mix shift than spontaneous beneficence on the part of Corporate America. The return of a handful of manufacturing jobs (which tend to be higher paid) buoyed earnings. The same thing happened in April only to reverse course in May. But this is a fairly minor quibble. The real issue is that wage growth continues to lag inflation. And that’s using the government’s inflation gauge. One shudders to imagine what the ‘real’ real wage picture looks like!

Interestingly, the last few times U.S. consumers found themselves in this infelicitous situation, housing booms were also providing an income cushion. In each case, asset inflation mooted lackluster wage growth…for a spell. Once the boom ended, however, the lack of wage growth began to matter and recession promptly ensued.

Which brings us to today. With no more equity to tap, day-laborers are struggling to finance larger mortgage payments, higher credit card minimums and $3/gallon gasoline with skimpy wage growth. And if you think they’ve got it bad, imagine how those with ZERO wage growth feel! I’m talking about the senior set. Trying to keep up with the rising cost of living (which is particularly punitive when you consume an outsized share of healthcare where inflation is most rampant) with the income generated from 40-year low interest rates has to be tough. One could forgive them for being a little crotchety. Just how strapped our fuddy-duddies have become was made clear in the MBA’s recap of 2005 mortgage activity released earlier this month. It revealed that reverse mortgage incidence mushroomed 45% in the latter half of 2005 from the first six months of the year! It is mind-boggling that this hasn’t received greater attention. I guess it’s naptime at the AARP. Zzzzzz…

No matter. The issue will take centerstage soon enough when the government finds itself forced to bail out strapped consumers in general and these retirees in particular. It was always inevitable that the baton would be passed from monetary to fiscal policy. As the fruits of Greenspan’s asset-dependent economy begin to sour, fiscal policymakers will hasten to provide alternate sustenance.
At a minimum, a slowdown in the 70% of the economy that the consumer represents will boost cyclical outlays. (I mean, having deposit balances contract -8.4% at a time when mortgage payments are up 15% is bound to take a toll). But we fear the spending won’t stop there. The housing bust may be met with more direct government assistance. After all, should homeowners find themselves owing more than their home is worth, they might decide to mail in their keys rather than their mortgage payments. This could seriously weaken the banking system. (As we’ve pointed out repeatedly, banks have record exposure to real estate via direct mortgage loans and MBS holdings). So, why take a chance? Why not just bailout those homeowners on the brink? Besides, the government surely feels some culpability since Fannie (FNM) and Freddie (FRE) helped put us in this situation. So, enjoy the budget celebration while it lasts. It won’t be long before this trend reverses…and meaningfully. The Great Housing Bubble will be followed by the Great Government Bailout and our budget deficits will go from bloated to morbidly obese.

As consumer spending slows and Washington grows, our financing needs will rotate…

The million-dollar question, of course, is: Will our foreign financiers care? Will they finance our expanding public sector liabilities with the same alacrity they did trade?? To the extent that the lion’s share of our capital flows are now coming from private sector institutions stretching for yield, the answer would seem to be ‘no’. After feasting on sophisticated asset-backed exotica and derivative delicacies it seems unlikely these folks will dull their palates with our public sector pork. Of course, when credit risk mounts its return this paper, too, will lose its allure.

Never fear, we’re assured, the return of risk will simply send our foreign financiers back to the ‘safety’ of Treasuries. After all, they’ve still got to put their forex dollars ‘to work’. Sigh. Such is the arrogant assumption made by most US-based investors. As if this were a binary decision---have dollars, must recycle. There are, in fact, two options for dollar holders: invest or spend. Increasingly our financiers are opting for the latter.
Topping the list of places to spend their dollars is oil. We’ve made the point repeatedly that a ‘cold war’ for energy resources would provide material competition for US financial assets. But perhaps now, after seeing oil stand unharmed amid the mayhem and destruction in May, the point will command more respect. So, let’s review: At the margin, dollars that used to be recycled into US assets are now being used to buy energy security. This is creating a feedback loop as, the higher oil prices go, the less compelling it is to vendor finance US consumers. (Because the marginal benefit of printing money to lend to US consumers is now being offset by the ‘tax’ associated with paying higher dollar-priced oil). In fact, we appear to be at a critical threshold. With a $10 annual increase in the price of oil sucking $300b from oil consuming nations’ pockets, it takes a $20 increase to offset the $600b global trade with the US. Over the last year, oil is up $18. Obviously, US import growth slows (as it is now), the math becomes even less compelling.

Oil isn’t the only thing our former financiers are spending their dollars on. They are also hard at work trying to create their own consumer-economies. This kind of change doesn’t happen overnight. Actually, with $900b in cash on hand (China’s forex reserves) it might! But, it clearly isn’t going to be accomplished by sending dollar reserves to the US Treasury.
At the same time our Asian financiers are starting to use their dollars to buy economic independence rather than US Treasuries, their consumers have also stirred to life. In Japan, consumer confidence is the highest in twelve years. Real wage growth is positive and bank lending just notched its largest increase since 1996. Meanwhile, in the US, confidence is generally eroding, real wage growth is negative and home equity lending is contracting year on year.
So, while the US has been the favored place to ‘put dollars to work’ over the last several years, that may be about to change. As the US housing boom turns to bust and our consumers downgrade from prosciutto to pork rinds, it seems unlikely our creditors will do the same.

End of "money for nothin"?

TOKYO - Japan's central bank raised interest rates Friday for the first time in six years, ending an era of zero percent interest and sending the clearest signal yet that the world's second-largest economy has pulled out of a decade-long slump.


The decision boosts the Bank of Japan's key overnight call rate to 0.25 percent from 0.069 percent — effectively zero.

The move was widely expected by analysts and investors, and puts Japan closer in line with monetary policy in the United States and Europe, where central banks are also tightening the reins on easy money.

It was "absolutely" the right move at the right time, said Jesper Koll, chief economist at Merrill Lynch in Tokyo.

"Zero interest rates were a necessary emergency policy," Koll said. "But Japan needs the beginning of a normalization process. Normality means money isn't free."

The zero percent interest policy did not mean Japanese consumers and businesses were able to get interest-free loans. Japanese banks still charged interest, albeit relatively low — mortgage rates were less than half of what they are in the United States — but did not have to pay interest on deposits.

The central bank's rate hike will likely nudge higher the rates consumers and small businesses are charged. This was widely anticipated, causing Japanese bank lending to grow at its fastest pace in over a decade in June, fueled in part by an "act now" mentality on the part of borrowers.

Japan lowered rates to zero in 2001 in an attempt to jump-start the beleagured economy and wipe out a destructive trend of sprialing price declines, known as deflation, that eroded corporate earnings and workers' paychecks.

Raising rates underlines that deflation is quickly becoming a distant memory and that the economic recovery is gathering speed.

"Today's decision will contribute to ensuring price stability and achieving sustainable growth in the medium and to long term," the BOJ said in a statement released after the policy board's unanimous 9-0 vote to raise rates at the end of a two-day meeting.

Prime Minister Junichiro Koizumi, in Jordan for a visit, said Japan hasn't yet emerged from deflation yet, but is close. "I hope we emerge from deflation as soon as possible, but that hasn't happened yet," he said.

In a nod to concerns that higher borrowing costs could stifle Japan's nascent economic comeback, BOJ chief Toshihiko Fukui emphasized that the bank will act cautiously with further interest rate movements.

"We are not embarking on so-called consecutive interest rate hikes," Fukui said at an afternoon news conference. "We will carefully study the state of the economy and prices to gradually adjust interest rates."

The bank's move links Japan with the other major economies in terms of monetary policy. In June, the European Central Bank raised its key interest rate to 2.75 percent, while the Federal Reserve has lifted the fed funds rate 17 times straight to 5.25 percent.

Some consumers will see immediate — albeit still meager — benefits as retail banks gradually lift interest paid on savings accounts. Tokyo-Mitsubishi UFJ Bank, the world's biggest bank by assets, announced it would lift the interest on basic savings accounts to 0.1 percent, from 0.001 percent, starting Tuesday.

Fukui also said he would not resign over an investment scandal that has eroded public trust in the central bank.

Fukui acknowledged last month he had invested in a fund run by Yoshiaki Murakami, a well-known shareholder activist who was arrested on charges of insider trading recently.

The investment wasn't illegal, but it has prompted questions about conflict of interest. It also sparked public outrage that Fukui's investment had more than doubled to 22 million yen ($190,000), while most Japanese were earning virtually no interest on their savings because of the Bank of Japan's zero interest rate policy.

Fukui has repeatedly apologized while denying any wrongdoing. He also has donated the entire investment to charity.

He stood his ground again Friday, reiterating his plans to stay on.

"I caused a fuss and worried many people, but I still have a duty to fulfill," he said. "There is no change in my intention."

In the weeks leading up to Friday's decision, several ruling party officials had urged the bank to hold off, worried that the BOJ would repeat the mistake it made in August 2000, when it lifted borrowing rates prematurely — and choked a recovery.

Fukui defended Friday's hike saying the economy is on firmer footing today.

"Objectively speaking, economic fundamentals are more robust and adverse to shocks than they were in 2000," he said.

Japanese stocks fell — but some of that was attributed to worries about soaring oil prices amid rising violence in the Mideast, traders said. Tokyo's benchmark index tumbled 252.71 points, or 1.67 percent, to 14,845.24 points.

Compared to six years ago, Japan's economy is much stronger, with corporate profits up, unemployment falling to eight-year lows and prices rising. The economy has turned in five straight quarters of growth, and forecasts call for up to 3 percent growth this year.

Proponents of a rate hike say it is need to head off inflation as Japan recovers. May's consumer prices rose 0.6 percent for the seventh monthly gain.

"In this environment, maintaining the previous level of the policy interest rate may result in large swings in economic activity and prices in the future," the central bank said, adding that Japan's economy continues to expand moderately and that consumer prices are in a general upward trend.

Koll said he expects the BOJ to raise interest rates by 0.25 percent each quarter over the next year so that the key rate stands at 1 percent next summer.


With reporting by Hiroko Tabuchi in Tokyo.

Tuesday, July 11, 2006

An open letter from Stephen Roach to Ben Bernanke!

Dear Ben,

It’s time to take a deep breath. You are off to a rocky start as Chairman of the world’s most powerful central bank. Your policies are not the problem. Given the über accommodative legacy you inherited from your legendary predecessor, the three 25 bp rate hikes in each of the three policy meetings you have chaired have made good sense. The issue is more subtle —- your ability to send a consistent message to financial markets. This is a critical element of your job description. It defines your credibility as a policy maker as well as the credibility of the great institution you now lead. In the end, without credibility, a central bank is nothing.

You know this, of course. As one of the world’s leading academic apostles of inflation targeting, you have long stressed the merits of anchoring financial market expectations of monetary policy with a simple price rule. With price stability now widely accepted as the sine qua non of central banking and with core inflation rates in the US and around the world not all that far away from the hallowed ground of price stability, there is considerable merit in underscoring a determination to preserve the hard-won gains of the past 25 years. This could well be your golden opportunity.

With all due respect, Ben, you are close to squandering that opportunity. A transparent policy rule has real merit in minimizing unexpected and undesired swings in financial markets. But any such rule is as good as its disciplinarians — the central bankers who are charged with delivering the message to the public at large. It pains me to say this, but your message has been all over the place.

What I am alluding to are several reversals in your official pronouncements in the past couple of months. It all started with your 27 April testimony before the Joint Economic Committee of the US Congress, where you openly entertained the possibility of an “unjustified pause” in the Fed’s monetary tightening campaign. That was followed by your 5 June speech at an International Monetary Conference in Washington DC that sent a clear warning about your concerns over “unwelcome developments” on the inflation front. Then there was the policy statement immediately after the 28-29 June FOMC meeting, underscoring the Fed’s forecast that a “…moderation in the growth of aggregate demand should help to limit inflation pressures over time.” Nuanced or not, in this brief two-month time span, your official statements have gone from dovish to hawkish and back to dovish again. Such inconsistencies raise serious questions about your credibility as the world’s leading monetary policy maker.

Speaking of that, you and your colleagues at the Fed must be mindful of the international context and consequences of your posture. Your back-and-forth waffling comes at a critical juncture in the global monetary tightening cycle. Jean-Claude Trichet of the ECB surprised the markets with his own tough talk last week — in effect, pre-announcing another rate hike for August, a month when Europe is normally at the beach. At the same time, the Bank of Japan’s Governor Toshihiko Fukui has also been talking tough for several months, signaling the end of a seven-year zero-interest rate regime and the onset of a long-awaited normalization of Japanese monetary policy. His first step could well be imminent — most likely at the BOJ’s upcoming 14 July policy meeting.

Ben, that puts the consequences of your recent reversals in a very different context. Global investors are perfectly comfortable with the notion that the Fed, which began its tightening campaign long before other major central banks, would be the first to attain its objectives. The idea of the “policy catch-up” by foreign central banks has long been embedded in the consensus view of a cyclical dollar weakening. However, to the extent that the European and Japanese central banks stay on message while you do not, the monetary policy credibility factor could well shift away from the United States. Given America’s outsize current account deficit, a relative credibility erosion could spell sharp downward risks to the dollar — and equally sharp upside risks to real long-term US interest rates. That’s the last thing an asset-dependent, overly-indebted US consumer needs. A resumption of the greenback’s weakness in recent days suggests that you can’t take this possibility lightly.

It was always going to be difficult to wean the markets from the measured Fed tightening campaign that has unfolded without interruption over the past 24 months. When the federal funds rate was 1% in June 2004, the next move was a no-brainer. But now at 5.25%, it is obviously much trickier. The key for you is not to let your understandable sense of uncertainty over the economic and inflation outlook morph into an on-again, off-again assessment of policy risks. This was supposed to be the sweet spot in the policy cycle for inflation targeters like yourself. Lay out the metric you are targeting, provide a clear assessment of the risks, and then let the policy rule generate the unambiguous answer. Easier said than done, I guess.

I think the best thing you can do at this point is to borrow a page from the Greenspan era and make a simple statement of your policy bias. For example, as long as you perceive inflation risks to be on the upside of your tolerance zone, you and your colleagues can endorse a tightening bias. Conversely, if inflation risks tip to the downside, it may be appropriate at some point to announce an easing bias. The bias statement works best when the policy rate is near the so-called neutrality threshold. It is less appropriate when the overnight lending rate is far away from such an equilibrium. In the current context, the verdict would be clear — a tightening bias is in order until inflation risks recede. There’s nothing automatically actionable about such a bias that locks you into a move at each and every policy meeting. There is ample leeway to pass on a policy move and still maintain your concerns.

There may well be a silver lining in your unfortunate experience of the past couple of months. Central banking is as much art as it is science. In that vein, it is equally important to be mindful of one of the major pitfalls of the current financial market climate — seven years of one asset bubble after another, driven by the mother of all liquidity cycles. It is high time to bring this dangerous state of affairs to an end. These are the same bubbles that spawn wealth-dependent distortions to saving and massive global imbalances. Not only must you commit to price stability in the narrow sense of your CPI target, but you and your central banking colleagues in Europe, Japan, and China must be equally willing to commit to an orderly withdrawal of excess liquidity in order to put a seriously unbalanced world on safer footing. That underscores my recommendation to maintain a tighter policy bias at low rates of inflation than a strict price rule might otherwise imply. If that’s what it takes to break the moral hazard of the “Greenspan put,” it is a risk well worth taking.

I guess in retrospect we should have seen this coming. After all, history tells us that transitions to a new Fed Chairman invariably don’t go well. The “transition curse” saw the equity market quickly challenging Alan Greenspan with the Crash of 1987, the bond market promptly testing Paul Volcker, and a dollar crisis immediately confronting G. William Miller. The so-called risk reduction trade, which commenced in early May, could well go down in history as the Bernanke test. There’s nothing like unforgiving financial markets to find the Achilles’ heel of a new central banker.

The good news is that you have another important chance to recover your credibility — your midyear appearance in front of the US Congress slated for 19 July. The bad news is that this may be your last chance for a while. A third reversal could well spell a serious and damaging setback to Fed credibility. A serial bubble blower was bad enough — the last thing world financial markets need is a serial flip-flopper.


Stephen S. Roach

Chief Economist

Morgan Stanley

Monday, July 10, 2006

Disaster averted at Freddie and Fannie?

WASHINGTON - A potential financial disaster that could have shaken the housing market was averted because regulators discovered accounting failures at Fannie Mae and Freddie Mac, the new head of the agency that oversees the mortgage giants said Monday.
The government-sponsored organizations appear to have gotten the message that they need to reform, but it still will take years to repair their internal problems, James B. Lockhart said in an interview with The Associated Press.

"The housing market is so important to this country," said Lockhart, who has headed the Office of Federal Housing Enterprise Oversight for about two months. "And to have it built on what turned out to be a shaky foundation could have caused significant financial problems."

Problems were averted, he said, because the regulators acted to identify and order corrections at Fannie Mae and Freddie Mac, which together stand behind some 40 percent of the $8 trillion U.S. home-mortgage market.

"The good news is that it was caught in time and the remedies are starting to be in place, so that there was no major problem for the average American," Lockhart said.

Lockhart, a friend of Bush from prep school and college, became director of an agency whose previous leader had for years waged a quixotic battle against the two politically powerful companies. After serious accounting problems at Fannie Mae and Freddie Mac became known, a push by the administration to tighten the government reins on them gained ground in Congress.

Lockhart, 60, was executive director of the Pension Benefit Guaranty Corp., the federal agency that backs private defined-benefit pensions, in the administration of the first President Bush. He has worked in the private financial sector and was deputy commissioner of Social Security before taking his current job.

Like the White House and many lawmakers, he believes the mortgage holdings of Fannie Mae and Freddie Mac — totaling more than $1 trillion — should be reduced. He called legislation pending in the Senate "a very good starting point."

Fannie Mae, the second-largest U.S. financial institution after Citigroup Inc. and the second-biggest borrower after the federal government, is restating its earnings back to 2001 — a correction expected to reach at least $11 billion. The company was fined $400 million in a settlement in May with OFHEO and the Securities and Exchange Commission, one of the largest civil penalties ever in an accounting fraud case. It also agreed to make top-to-bottom changes in its corporate culture, accounting procedures and ways of managing risk.

The accounting failures and earnings manipulation at Washington-based Fannie Mae became known in September 2004 after the OFHEO regulators discovered them in a special review. No. 2 rival Freddie Mac had its own accounting crisis in mid-2003, when the company disclosed that it had misstated earnings by some $5 billion — mostly underreported — for 2000-2002 and ousted its top executives. Similarly, it was fined $125 million by OFHEO and ordered to make changes.

If either company should fail, there could be less money for consumers to borrow to get a mortgage, and interest rates on home loans could be forced higher.

Congress created Fannie Mae and Freddie Mac to inject money into the home-loan market. They buy mortgages from banks and other lenders and bundle the loans into securities for sale to investors worldwide.

"The risk has certainly been reduced by the remedial actions that the two management teams have put in place at our direction," Lockhart said. But it will take a number of years — two, three or more — for the two companies to get their financial houses fully in order, he cautioned.

In addition, he said, "There's still some arrogance in the culture. ... There are certainly people in both organizations that have retained and will retain some of that arrogance."

OFHEO's review found that current and former executives of Fannie Mae reaped hundreds of millions of dollars in bonuses in a deceptive accounting scheme from 1998 to 2004. Employees are said to have manipulated accounting to hit quarterly earnings targets so senior executives could pocket the bonus money.

Lockhart has promised that his agency will pursue some company executives to recover allegedly tainted bonus money if the Fannie Mae board fails to do so.

Pimco's Paul McCulley on Keynsian thought meeting Austrian thought!

A Kind Word for the Austrian School
By Paul McCulley

Bill Gross teases me that I'm not just a Keynesian, but a religious Keynesian. There is an element of truth to that, as evidenced by the fact that the only major piece of art that I own is a portrait of Keynes by Salisbury, the preeminent portrait artist of Keynes' time. And it hangs in my office, presumably watching over me. So, Bill does have a point.

As a practical matter, however, I also have deep appreciation for other schools of economic thought. And, yes, that includes the Austrian School. Indeed, there is much overlap between Keynesian thought and Austrian thought, even though many think they are antithetical lines of thinking.

I was reminded of this recently when reading a brilliant essay by William White, of the Bank for International Settlements - Is Price Stability Enough? Mr. White's core thesis is that low and stable inflation in goods and services prices, presumably the holy grail of central banking, is not a guarantee of steady growth in real economic activity.

To be sure, that has been the case over the last two decades, at least in the United States, a dynamic known as the Great Moderation: lower volatility in both inflation and growth. There is a rich professional literature arguing the sources of this blessed outcome, with the consensus being that it has been the consequence of greater reliance on private markets - both in the United States and 'round the world in the allocation of resources; better macroeconomic policies, and in particular better monetary policy; and old fashioned good luck.

This consensus, at least in the United States and especially in the halls of the Federal Reserve, leads to the conclusion that monetary policymakers should:
Always and everywhere target - implicitly or explicitly - low and stable inflation and perhaps even more important, low and stable inflationary expectations.

Do nothing in response to changes in asset price valuations unless those changes imply an undesirable course for aggregate demand growth relative to aggregate supply growth, implying an undesirable path for the output gap and, thus, inflation and inflationary expectations.
Taylor's Austrian Constant

This is standard Keynesian stuff, married to a Phillips Curve. Or, for those who remember the jargon from school days, it's the IS-LM model married to NAIRU. It is also the foundation of the ubiquitous Taylor Rule, with one major exception: Mr. Taylor has a "neutral" real rate as a constant in his Rule.

And the concept of a "neutral" real rate is a very Austrian notion: there exists some unobservable interest rate (called the "natural" rate by Austrians) that perfectly matches the time preference of lenders and borrowers and in the absence of fiat currencies, free markets would find this rate (as if by Adam Smith's invisible hand), bringing about just the right amount of investment and savings.

In turn, Austrians argue that if fiat currencies do exist and if policymakers peg rates below the natural rate, there will be an excess of investment relative to that level which would generate returns consistent with the natural cost of borrowing, producing an investment bubble, which will be revealed when policymakers lift rates to or above the "natural" rate, generating an investment bust.

This is where the Austrian School is in direct opposition to the Keynesian School. For Keynes, investment was not a function of savings, but rather savings was a function of investment, which drives income, from which savings flow. Yes, after the fact, savings and investment must, as an accounting matter, equal each other.

But there was no a priori reason, Keynes argued, that savings and investment would ex post equal each other at full employment. For Keynes, what mattered was ex ante investment desires, which were driven by the state of confidence in long-term return expectations, summarized as animal spirits.

Thus, for Keynes there was no magical natural - or neutral - rate of interest. Indeed, Keynes actually put more emphasis on the role of stock prices than interest rates in eliciting the ex ante desire to invest. Yes, the great James Tobin found his Q in Chapter 12 of Keynes' General Theory!

Which brings us back to the ironic crossover between the Keynesian School and the Austrian School: if investment is a function of animal spirits and if animal spirits get their mojo from asset prices, then boom and bust in investment is endemic to the capitalistic system. That doesn't mean that it's not the best system ever devised for allocating resources. It is. But it is also inherently given to cycles of euphoria followed by doom.

For the Austrians, the solution to this problem was to kill fiat money systems and in the absence of that prescription, to resist using fiat money systems to soften periods of busts. For Keynes, writing at a time when the Austrian "solution" was de facto being applied, called the Great Depression, this made no sense at all. If investment and savings were equaling each other at 25% unemployment, then it was the duty of the sovereign to incite animal spirits with monetary ease, while even more important, boosting public investment.

Could this prescription lead to ex post maldistribution of investment, as the Austrians argued? Yes, Keynes acknowledged that; indeed, his very own work - Chapter 12 again! - implied this outcome. But for him, what mattered most was to achieve full employment. And he didn't trust unfettered markets to consistently deliver that outcome, as the Austrians argued.

One Step From Targeting Asset Prices

Which brings us back to the Taylor Rule, with its "neutral" real rate constant, a very Austrian concept. Recognizing that "flaw," many researchers, including at the Fed, have been empirically trying to model a time-varying "neutral" rate. I applaud that work. But once you take that step, you are only one step away from targeting asset prices, as the key variable driving fluctuations in the neutral rate are fluctuations in risk premiums, in response to changes in animal spirits. Thus, in my view, asset prices should matter for monetary policy and not just through the output gap-inflation channel.

Indeed, this is precisely the point of Mr. White's essay, as well as that of a speech I gave to the Money Marketeers Club of NYU in February: too much focus - and too much success - in stabilizing goods and services inflation on one- to two-year horizons is a prescription for boom and bust in asset prices and, from a starting point of low inflation, is actually a prescription for both increased volatility and deflation on longer horizons.

Ironically, Mr. Greenspan more or less said the same thing last September when he declared:
"In perhaps what must be the greatest irony of economic policymaking, success at stabilization carries its own risks. Monetary policy - in fact, all economic policy - to the extent that it is successful over a prolonged period, will reduce economic variability and, hence, perceived credit risk and interest rate term premiums."
This is especially the case when a central bank - such as the Fed - explicitly promises not to lean against bubbles unless they portend a negative impact on the inflation outlook for goods and services prices, while also having a clear track record of "mopping up" after bubbles burst. This asymmetric reaction function - commonly called the Greenspan Put - is a form of moral hazard, which actually makes bubbles more likely.

Mr. Greenspan rejects, of course, the notion that the Fed put a floor under asset prices during his tenure, notably the stock market, noting that if it was a floor, it was a floor in the cellar of a tall building. Narrowly, that is correct. But broadly speaking, it is an incontrovertible truth that the Fed under Greenspan ran an asymmetric reaction function, with market participants fully aware that was what the Fed was doing. By definition, such a policy should be expected to contract risk premiums and lift asset price valuations.

But, as Mr. Greenspan himself said last summer in his valedictory address at Jackson Hole, "history has not dealt kindly with the aftermath of protracted periods of low risk premiums." Thus, it is hard for me to avoid the conclusion that too much success in stabilizing goods and services inflation, while conducting an asymmetric reaction function to asset price inflation and deflation, is a dangerous strategy.

Yes, it can work for a time. But precisely because it can work for a time, it sows the seeds of its own demise. Or, as the great Hyman Minsky declared, stability is ultimately destabilizing, because of the asset price and credit excesses that stability begets. Put differently, stability can never be a destination, only a journey to instability.

Keynes knew that. The Austrians knew that. On that, they agreed. What they disagreed about was whether instability was caused by fiat money makers holding real rates away from the natural level. For Keynes there was no ex ante natural rate level, only an ex ante imperative for policy-makers to pursue full employment. And the key to that was maintaining investment - private and public. For Keynes, there was no natural rate of interest at which that would happen, because investment is inherently the product of animal spirits, which fluctuate in animal-spirited ways.

Thus, the notion that the Fed can ignore asset prices except to the extent they matter in a Taylor Rule framework is, to my way of thinking, loosing its moorings. The putative neutral real rate is indeed time varying, not a constant as Taylor assumed. Actually, I think most Fed officials agree with that proposition, including Chairman Bernanke.

What they haven't embraced, however, is that the dominant variable driving fluctuations in the neutral rate is fluctuations in risk appetites in the private sector, which have a pro-cyclical reflexive quality, fueled by moral hazard. And that is a prescription for both Austrian maldistribution of resources as well as long term deflationary risk.

To be sure, those outcomes haven't bitten either the U.S. or global economy in the bum yet. But that doesn't mean they won't. In fact, the logic of the serial-bubble game suggests that the longer it is played, the more difficult it is to play, as the number of under-levered assets declines every time the game is played.

How to get off this treadmill? First and foremost, I think, as discussed in my Money Marketeers speech, the Fed needs to set its inflation target - or comfort zone, as it is called - high enough so that the U.S. economy - and indeed the global economy - could absorb a shock to aggregate demand, perhaps from a bursting property market bubble, without generating palpable risks of deflation, triggering once again the Fed's asymmetric policy of aggressive easing. Second, I think policymakers should be more wary of excessive pre-commitments to the markets.

This is not, I want to stress, the same thing as reducing transparency. As New York Fed President Giethner articulated brilliantly in a speech last month, transparency involves candidly presenting what you know and also what you don't know. Acknowledging genuine uncertainty is not being opaque, so long as the sources and nature of the uncertainty is transparently communicated. In contrast, articulating certainty when uncertainty is reality is not transparency, but a disservice called moral hazard.

Bottom Line

Yes, I am a Keynesian. But more precisely, I'm a Keynesian wearing Minsky clothing, and doffing Austrian shoes. In the fullness of time, I expect Chairman Bernanke, a brilliant Keynesian, to rediscover that the Austrians were not all wet in their diagnosis of the potential for maldistribution of investment, even though they were soaking wet about what to do about it. The Austrians said let the asset price and credit excesses purge themselves. A much better way, I believe, is to lean against the excesses preemptively, using all available tools, including regulatory tools.

Yes, inflation targeting is fine. Myopic inflation targeting is not. Asset prices matter, and not just in the context of their influence on aggregate demand relative to aggregate supply and, thus, inflation. Asset prices matter in their own right, because wild swings in asset prices, even in the context of "stable" goods and services inflation, are a source of both volatility and maldistribution in investment.

And, in the long run, a source of deflationary, not inflationary risk.

Some more trouble for homebuilders.

More pain for home builders
KB Home, Dominion Homes issue negative views on housing
E-mail | Print | | Disable live quotes
By John Spence, MarketWatch
Last Update: 9:17 AM ET Jul 10, 2006

BOSTON (MarketWatch) -- A pair of home builders said the U.S. housing market continues to soften, reflected by weaker orders and higher cancellations, and one of them warned that the downturn could continue into next year.
Despite a healthy backlog of homes awaiting construction, KB Home (KBH :45.12, -0.64, -1.4% ) said in a Securities and Exchange Commission filing Friday that its outlook is cautious "as conditions in many of the markets we serve across the U.S. have become more challenging in recent months."
The Los Angeles company added that several of its markets "have been affected by a buildup of new and resale home inventories, higher interest rates and higher cancellation rates, particularly markets that have experienced rapid price appreciation or substantial investor activity, or both, in the past few years."
For the quarter ended May 31, KB Home, the nation's No. 5 builder by 2005 deliveries, said net orders fell 19% from the year-ago period to 9,908 homes.
Although the company is positive on the long-term outlook for housing on strong demographics and job growth, it cautioned it expects "the current negative trends in the U.S. housing market to continue for the remainder of 2006 and, possibly, into 2007."
Another builder, Dominion Homes Inc. (DHOM :8.28, -0.45, -5.2% ) , also on Friday reported deteriorating order trends.
The Dublin, Ohio, builder said that for the second quarter ended June 30, it sold 356 homes with a sales value of $66.2 million, versus 655 homes and $123.1 million in the year-earlier period.
Deliveries and backlog also fell from the year-earlier quarter, reflecting "the difficult home sales conditions in the company's markets," Dominion said. The company focuses on first-time buyers in the Midwest.
Raymond James & Associates analyst Rick Murray on Monday lowered his 2006 and 2007 profit outlooks for the company after the disappointing report. He cut his 2006 forecast to a loss of $1.50 a share, from a loss of 85 cents, and the 2007 estimate went to a loss of $1.35 a share from a loss of 35 cents.
"Dominion continues to face challenging conditions in the Columbus [Ohio] market, to which there appears to be no relief in sight for the foreseeable future," said Murray, who reiterated his underperform rating on the stock.
"The earnings outlook remains unpromising at this juncture, as we do not anticipate an increase in demand for new construction in the near term," he added.
Home-building stocks have been punished as housing cools -- the Dow Jones U.S. Home Construction Index (DJ_3728 :0.00, 0.00, 0.0% ) is off about 30% year to date.
Much of the concern has been centered on higher interest rates. For the week ended July 6, the 30-year fixed-rate mortgage averaged 6.79%, approaching its most recent peak of 6.81% set in May 2002, according to Freddie Mac (FRE :58.14, +0.54, +0.9% ) .
John Spence is a reporter for MarketWatch in Boston.

Sunday, July 09, 2006

Once More, congratulations to The Azzurri!

It was an ugly game, and probably France outplayed Italy for a majority of the game. But, the Italian defence did not crack and won the game on penalties. Fabio Cannavaro was magnificent.

Wednesday, July 05, 2006

ECB and inflation.

ECB May Toughen Tone on Inflation, Maintain Key Rate (Update1)
July 6 (Bloomberg) -- The European Central Bank will probably keep interest rates unchanged today, and policy makers may toughen their inflation-fighting rhetoric to pave the way for an increase as soon as next month.

ECB policy makers led by Jean-Claude Trichet will probably keep the benchmark rate at 2.75 percent, all but two of the 50 economists in a Bloomberg News survey said. The ECB will announce its decision at 1:45 p.m. in Frankfurt and Trichet will brief reporters at 2:30 p.m.

Investors have raised bets the ECB will step up rate increases to keep faster economic growth and surging oil costs from fueling inflation in the dozen euro nations. Policy makers lifted their key rate by a quarter point in the past three quarters. Producer prices are rising at the fastest in more than five years and unemployment is at the lowest since 2001.

``The ECB will express satisfaction at the outlook for growth but also underscore the risk of inflation and, to a degree, lay the groundwork for the next increase,'' said Kornelius Purps, an economist at HVB Group in Munich. ``I expect Trichet to intensify his hints to make the case for a rate increase.''

Economists at JP Morgan Chase & Co, ABN Amro and Barclays Capital last week said they expected the bank to move faster than they'd anticipated. JP Morgan Chief Economist David Mackie expects the bank to raise its rate to 4 percent by early 2007.

`Upside' Risk

Borrowing costs are rising globally as central banks seek to rein in inflation. In the U.S., the Federal Reserve on June 29 raised its main lending rate for a 17th meeting to 5.25 percent from 5 percent and said further increases depend on future information on growth and inflation. Economists expect the Bank of Japan to raise interest rates next week after keeping them near zero since March 2001 to end deflation in the world's second-largest economy.

Stronger growth is giving the ECB room for further rate increases. The European Commission said June 30 that the euro- region economy is expanding faster than it forecast in the previous month, with risks to the 2.1 percent growth estimate ``tilted to the upside.'' The ECB expects about the same pace this year after a 1.3 percent expansion in 2005.

European manufacturing expanded in June by the most since August 2000 and services grew at the fastest pace in six years. Euro-region unemployment declined in May to the lowest since October 2001, pushing the jobless rate to 7.9 percent.

`Higher Adjustment'

ECB council members have said they're concerned accelerating growth leading to more entrenched inflation as companies pass on higher costs and workers seek more pay.

``I would not rule out a higher adjustment to rates than 25 basis points,'' nor quickening the pace of increases from once every quarter, ECB council member Nicholas Garganas said in an interview on June 26. In another interview the same day, fellow council member Yves Mersch said the bank ``won't hesitate to act'' when needed and that rates are still ``historically low.''

``They have sent a clear message that they want to step up the pace and we will discover the word `vigilant' thrown about with abandon,'' said Charles Diebel, head of European rates strategy at Nomura Holdings Inc. in London. ``The market would take that as a sign they will move at the start of August.''

Trichet last used the word ``vigilant'' to prepare markets for the rate increase on June 8.

Rising Prices

Euro-region inflation held at 2.5 percent in May and credit growth grew at the fastest pace since the bank took charge in 1999. The ECB aims to keep inflation just below 2 percent.

Crude oil prices have increased 26 percent since early December when the ECB raised rates for the first time in 2 1/2 years. Crude touched a record of $75.40 a barrel in New York yesterday and was trading at $74.99 at 8:15 a.m. in Singapore.

Producer-price inflation in the euro region accelerated to the fastest pace in more than five years in May. Excluding energy, prices rose 2.6 percent from a year earlier, up from 2.2 percent in the previous month.

``ECB hawks can credibly claim that growth above trend, inflation above target and a run-away surge in credit justify a faster pace of policy firming,'' said Holger Schmieding, chief economist at Bank of America in London. ``The key risk to our baseline scenario of one 25 basis point rate hike each quarter remains that the ECB may accelerate the pace.''

Investors have increased bets the ECB will raise rates more rapidly. At 3.64 percent on July 5, the yield on the three-month futures contract for December shows investors have now almost fully priced in a further 75 basis points of tightening by the ECB this year, compared with 50 basis points on June 12.

The contracts settle to the three-month inter-bank offered rate for the euro, which has averaged 15 basis points more than the ECB's key rate since the currency's debut in 1999.

Interview with Ken Heebner from WSJ!


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Surviving a Real-Estate Slowdown
A 'Loud Pop' Is Coming,
But Mr. Heebner Sees Harm
Limited to Inflated Regions
July 5, 2006; Page R1
The real-estate market shows signs of slowing. Is there deeper weakness ahead? Fewer questions are more important to mutual-fund investors. Many own funds with real-estate-related shares -- not to mention homes and vacation properties. And many economists believe a slowdown of the housing market could hurt the overall economy.

To get a lay of the land, we tracked down Kenneth Heebner, who since 1994 has managed the $1.2 billion CGM Realty Fund. It has the best 10-year record of all real-estate-focused mutual funds, according to fund tracker Lipper Inc., up an average of nearly 22% a year during the past decade, well more than double the broader market. The fund also has one of the best one-year records, up 32% through June 30.


See fund performance by sector, plus the complete Mutual Funds Quarterly Review.
Mr. Heebner, 65 years old, is better positioned than many real-estate fund managers to speak about prospects for the housing sector. His fund has viewed its mission more broadly than most rivals, so he isn't shy about ditching real-estate stocks. Among big holdings for CGM Realty during the past year: coal-company stocks, a hot category that qualifies in Mr. Heebner's view because coal companies own a lot of land. He also runs three other mutual funds, including CGM Focus Fund, so he spends a lot of time looking beyond houses and hotels to other parts of the economy. These three funds have among the best five-year records in their categories.

Here is our conversation:

WSJ: How is the housing market?

Mr. Heebner: A significant decline in prices is coming. A huge buildup of inventories is taking place, and then we're going to see a major [retrenchment] in hot markets in California, Arizona, Florida and up the East Coast. These markets could fall 50% from their peaks.


Journal reporter Gregory Zuckerman discusses how concerns about a housing slowdown have investors shifting their money to hotel and apartment REITs.

PODCAST: Mr. Zuckerman interviews Ken Heebner of CGM Realty Fund to discuss investing in the real-estate market. Listen now or subscribe, plus see all the Journal's podcasts.
WSJ: What has you so concerned?

Mr. Heebner: I'm worried that more people will default on their mortgages. Risky mortgages such as interest-only and pay-option adjustable-rate mortgages require no principal amortization and in some cases payment of only a fraction of the interest due, have been widely used in the last two years. Some people got 100% financing for their homes. It made the tech bubble look like a picnic. When housing is going up rapidly and you can buy far more than your income can support, some people are eager to make big profits by extending themselves financially.

As housing prices fall more people will be under water, and these people are just going to walk away from their homes. They are going to say, 'I'm outta here.' You're going to see increasing foreclosures over the next several years. As [home] prices come down, it will create a difficult environment for home builders.

WSJ: What data have you most worried?

Mr. Heebner: We're seeing a huge increase in inventories of unsold homes. The role of incentives in selling a home is increasing so the weakness doesn't show up immediately in list prices. Large price declines will follow in inflated markets.

WSJ: More than 25% of homeowners don't have a home mortgage because they own their property outright. Won't this keep problems in check?

Mr. Heebner: Most people won't have problems and much of the country will be fine. I don't think anything will go wrong in places like Texas, Iowa City or Minneapolis. ... But prices are being set by a minority of participants in the market, [those who have borrowed the most and used the most aggressive types of mortgages]. There will be a loud pop in inflated markets. It's where prices were artificially inflated by people buying houses with risky mortgages that we'll see problems. ... The person who feels the pinch is the person who used an aggressive mortgage and is struggling to meet the mortgage payments.

WSJ: Given the big size of some of the markets that you see as inflated, won't the regional 'pops' reverberate throughout the economy?

Mr. Heebner: The pops will reduce the growth rate of the economy, but they won't precipitate a downturn. The economy only turns down when the Federal Reserve takes aggressive action to cause a downturn. I think the current pattern of higher interest rates reflects a decision to normalize rates after taking them to abnormally low levels to stave off potential deflation. When the extent of the housing slowdown becomes apparent, I think the Fed will pause, rather than take rates to a level that threatens an economic downturn. The only real threat to the economy is an overly aggressive Fed, and not a downturn in the housing market, which won't by itself push the economy down. In fact, it provides an insurance policy against the Fed becoming overly aggressive.

WSJ: Do you agree with economists who have described the individual consumer as a linchpin of the economy during the past few years, using refinancings to fuel the expansion?

Mr. Heebner: Borrowing against home equity has been overrated as a source of economic stimulus. While it has been a factor in the economic expansion, I don't think it's been the most important factor.

WSJ: How are you allocating investments in your real-estate fund?

Mr. Heebner: We define real estate broadly; it includes mining companies, because of the land they use. Today we have about 25% of the fund in mining stocks. The stocks are attractive, but I also see significant opportunity in real-estate investment trusts, which comprise 69% of the portfolio. We also have 6% in commercial real-estate brokers.

WSJ: What areas of real estate are you most excited about?

Mr. Heebner: We're investing in office and apartment REITs, like Archstone-Smith Trust, Essex Property Trust Inc., SL Green Realty Corp. and AvalonBay Communities Inc. Apartment rents are going higher [as rising interest rates makes homes less affordable for many consumers, and a strong economy encourages rent increases].

In many parts of the country, like Texas, when demand goes up, companies can do more building of rental apartments. But the greatest supply constraints are in parts of the Northeast and California. And that's where the apartment REITs we own are focused.

In the office sector we like Vornado Realty Trust as well as SL Green, which have great management and are in Manhattan, one of the most supply-constrained areas in the country.

WSJ: Many apartment-REIT stocks already have climbed. Aren't rent increases baked into the stock price?

Mr. Heebner: Yes, people assume rents are going up, but the question is the magnitude of the increases. Consensus appears to assume 5% increases in the next year but I think the increases will be a lot more than that. Demand will grow, but supply of apartments won't because construction costs are increasing significantly and supply constraints will limit new developments in California and parts of the Northeast.

WSJ: What's your take on home-builder stocks?

Mr. Heebner: At the end of 2001 we bought home builders. These stocks were trading at six times earnings, and people were worried that the stocks would be hurt by an economic downturn. I became positive when I saw the growth potential created by rising demand and market share gain by the public builders. But if 20% of purchases are for investment purposes and so many borrowers are subprime, that says to me trouble is coming. We started cutting back on home-builder shares at the end of the fourth quarter of 2004 and eliminated them during the first six months of 2005.

WSJ: Why are you buying hotel REITs?

Mr. Heebner: After the 9/11 attacks, hotel construction fell, and it has only slightly recovered. But demand is growing, as the global economy strengthens and leisure travel is strong, as is business travel. You'll see more tourism with the dollar weaker. During the next several years, there will be an inadequate supply of hotels and that makes for a healthy environment for REITs. We like Host Hotels & Resorts, LaSalle Hotel Properties and FelCor Lodging Trust.

WSJ: What sectors are you favoring in your other funds?

Mr. Heebner: Energy and steel. I believe that the global supply and demand imbalance for crude oil remains in place. Robust global demand for steel is outrunning the ability of steel producers to meet demand.

WSJ: Your 10-year record includes a tough period. In 1998, the real-estate fund lost 21%, worse than the REIT index and much worse that the big gains of the broader market that year. What did that period teach you?

Mr. Heebner: In 1998 I had an aggressive position in hotel REITs. ... I anticipated that more companies would use a REIT structure to shield their earnings from taxes. But Congress changed the law, and I didn't see it coming. The market was smarter than I was. The lesson is that, if I see legislative activity that could be negative, I should pay more attention.

WSJ: How much should ordinary individual investors have in real-estate stocks and funds, given they probably own their homes?

Mr. Heebner: Commercial real estate has a totally different outlook than residential housing, [so commercial REITs] represent diversification. ... I own all the funds I manage and I own the condo I live in.

Write to Gregory Zuckerman at

Ugly win for the French.

July 6 (Bloomberg) -- France will face three-time champion Italy in the July 9 World Cup final after Zinedine Zidane, playing in his last soccer tournament, scored from a penalty kick to give his team a 1-0 victory.

The 34-year-old Zidane, who got two goals in the team's 1998 final win over Brazil, slotted his kick past Ricardo in the 33rd minute at Munich's World Cup stadium yesterday to give France a shot at a second world title.

The French, who exited the 2002 World Cup without scoring, advanced to a rematch of the 2000 European Championship final, which they won 2-1. The final will be held at Berlin's Olympic stadium.

``Zidane affords the French public real dreams,'' France coach Raymond Domenech told reporters. ``That's always been the case with him for 10 years now.''

Zidane, who is quitting after the World Cup, knocked Portugal out of a tournament for the second time with a penalty kick after his sudden-death winning goal in the Euro 2000 quarterfinals.

The player nicknamed ``Zizou'' took two steps before drilling his shot past goalkeeper Ricardo, who got his fingertips to the ball without changing its course.

Ricardo Carvalho was adjudged to have tripped Thierry Henry for the penalty, a ruling the Portuguese disputed. Portugal coach Luiz Felipe Scolari remonstrated when the referee turned down a penalty appeal as Cristiano Ronaldo, jeered by fans with his every touch, fell in the area with France defender Willy Sagnol's arms raised next to him.

`Ugly Duckling'

``We were the ugly duckling of the final four,'' Scolari told SporTV.

Italy defeated Germany 2-0 yesterday with goals in the last two minutes of extra time in Dortmund. It's aiming for a European record fourth World Cup victory. Brazil has the most wins with five.

Portugal came closest to tying the score when goalkeeper Fabien Barthez scooped a dipping 35-yard free kick from Ronaldo into the air like in volleyball and Luis Figo headed the ball over the bar with 13 minutes left.

The French defense, shielded by midfielders Claude Makelele and Patrick Vieira, had mostly contained Portugal's attack as it secured a fifth shutout at the tournament.

Portugal had the better of the early play, with Deco forcing Barthez into a diving save and Maniche shooting just over the bar. Barthez also saved from Figo before France began to respond midway through the first half.


Henry cut inside right-back Miguel and shot straight at Ricardo then minutes later turned Carvalho in the penalty area, catching the defender and falling to the ground with outstretched arms to win the penalty.

Scolari, fuming about the decision, protested again as Ronaldo fell in the area under Sagnol's challenge. Ronaldo was criticized by England players for urging the referee to dismiss Wayne Rooney in the previous round.

As the second half began, Ricardo scrambled to save a shot by Henry that crept under his body, deflected off his hand and span out of play. The Portugal goalkeeper then blocked a shot by Ribery with one hand.

Portugal striker Pauleta turned in the penalty box and fired into the side of the net in the 53rd minute, before former world player of the year Figo missed the best chance after Barthez's unorthodox save from Ronaldo.

`Party Continues'

France won its second World Cup semifinal in five attempts and ended Scolari's unbeaten run at the World Cup at 12 games after the coach led Brazil to the world title four years ago.

Scolari played seven minutes without a striker after taking Pauleta off in the 68th minute and only putting Helder Postiga on in the 75th. Maradona said: ``He paid for it.''

France's substitute striker Louis Saha will miss the final after receiving a second yellow card. In World Cup play, France and Italy are tied at two wins each.

``We hope the party continues,'' France defender Lilian Thuram told reporters. ``At the beginning of the World Cup we had a fixed objective. Now we want this to end with a good finish.''

The Portuguese were taking part in their first World Cup semifinal since 1966, when they lost to England. They will face host Germany in Stuttgart on July 8 in the third-place playoff.

Portugal had allowed only one goal in Germany before today and was unbeaten in 17 matches at major tournaments. France also beat Portugal in the semifinals of the 1984 and 2000 European Championships.

Tuesday, July 04, 2006

Congratulations to The Azzurri!

Italy Beats Germany 2-0 on Late Goals, Reaches World Cup Final
July 5 (Bloomberg) -- Italy scored twice in the last two minutes of extra time to beat host nation Germany 2-0 and advance to the soccer World Cup final against Portugal or France, who play tomorrow.

Fabio Grosso curled in a left-foot shot from 15 yards in the 118th minute to send the entire Italian squad charging onto the field in celebration. With the final play of the game, Alessandro del Piero hit the ball past Jens Lehmann from 10 yards to hand Germany its only defeat in Dortmund in 15 matches.

``To beat the Germans in their own backyard is incredible,'' coach Marcello Lippi told reporters. ``Our team played such a good match in this atmosphere. The team was composed.''

Lippi's team moved within one victory of a European best fourth title and will play in its sixth final, one short of the record held by Germany and Brazil. The team shrugged off a match- fixing scandal back home to reach the final for the first time since losing to Brazil in 1994. Italy has never lost to Germany in a major tournament.

``It was an unforgettable game,'' former Argentina captain Diego Maradona told Spain's Cuatro TV station. ``Lippi played the game of his life. Italy deserved to win.''

It's the first time the Italians have won in extra time of a World Cup since they defeated Germany in the 1970 semifinal. They hit the frame of the goal twice in extra time yesterday and were indebted to a fingertip save by Gianluigi Buffon to keep them in the game. The Azzurri exited the past four competitions after taking the game beyond the regulation 90 minutes.

Fast Pace

In a match of high tempo in front of a sellout crowd of 65,000, each team mounted several attacks and created the clearer chances at the end of regulation play. After managing just three shots in the first half, Germany had 13 efforts in total in the match, two fewer than Italy.

Italy, which has reached the final every 12 years since 1970, twice came close to winning the game in the first period of extra time as Alberto Gilardino struck the post with a scuffed left-foot shot, and Gianluca Zambrotta hit the bar a minute later.

Germany's Lukas Podolski headed yards wide when he was unchallenged at the end of the first period, and later forced Buffon to tip his drive over the bar.


``We both had our opportunities to settle it before the final whistle,'' Germany's Miroslav Klose, the tournament's top scorer with five goals, told broadcaster ZDF. ``My compliments go to Italy. They got the better of us and scored great goals in the end.''

Italy had 57 percent of possession and Andrea Pirlo, who forced Lehmann into a late diving save when the score was tied, was named man of the match.

Francesco Totti had the game's first shot on target after four minutes, testing Lehmann from a 30-yard freekick. The goalkeeper easily collected the ball, which deflected off Germany's defensive wall.

Germany's best effort in the first half came as Bernd Schneider fired over from 15 yards after receiving a pass from Klose on the edge of the area. He has scored only once in his previous 69 international matches.

Klose ran at goal near the start of the second half, accelerating past Gennaro Gattuso and Cannavaro, but failed to control the ball and Buffon came off his line to smother the attack. Lehmann cleared as Simone Perrotta raced in on goal in the 85th minute, felling him in the process, and the game went to extra time.


After only 38 seconds of extra time, Gilardino cut inside Michael Ballack and hit a close range effort against the post, before Zambrotta rattled the bar from 20 yards. Podolski headed wide from a David Odonkor cross and clutched his head in horror.

``I have to pay a huge compliment to my team for the way they played,'' Germany coach Juergen Klinsmann said. ``This whole World Cup was really fantastic.''

Germany becomes the seventh host nation out of eight to miss out on the final since Argentina won the title in 1978. The Germans last lost a semifinal that year and had won their past four straight before yesterday. They have never defeated Italy in five attempts at the World Cup.

Italy is unbeaten in 24 matches.

``The guys were great,'' Lippi said. ``They managed to roll the enthusiasm and love for football onto the pitch -- simply a fantastic performance.''

Monday, July 03, 2006

BOJ may raise rates.

Bank of Japan May Raise Interest Rates Next Week, First Time in Six Years
July 4 (Bloomberg) -- The Bank of Japan will probably raise interest rates for the first time in almost six years next week after a report indicated companies plan to increase spending at the fastest pace in 16 years, a survey showed.

Governor Toshihiko Fukui and his policy-board colleagues are likely to increase the benchmark overnight call rate from near zero at the end of a two-day meeting on July 14, according to nine of 15 economists surveyed by Bloomberg News.

Fukui said last month his board will raise rates ``without delay'' should investment become excessive. Ending the zero-rate policy will give the bank tools to manage the pace of growth in an economy that is headed for its longest postwar expansion.

``The Tankan survey confirms the strength of the economy and backs up the case for a July rate increase,'' said Taro Saito, a senior economist at NLI Research Institute in Tokyo. ``The report is evidence that capital spending could start to become excessive.''

Japan's largest companies plan to increase spending 11.6 percent this year, the most since the year ended March 1991, when companies boosted investment 18.4 percent, the Bank of Japan's quarterly Tankan survey showed yesterday. The benchmark 10-year bond yield rose to 1.965 yesterday, the highest since yields touched 2 percent on May 16.

The Bank of Japan would join the U.S. Federal Reserve and the European Central Bank in raising rates as faster global economic growth and near-record oil prices stoke inflation. The Fed raised its benchmark rate a 17th straight time to 5.25 percent on June 29. The ECB may signal further increases in its key rate, now at 2.75 percent, when policy makers meet on July 6.

Government Opposition

Government opposition may prove to be an obstacle to a July increase, said Yasunari Ueno, chief market economist at Mizuho Securities Co. Prime Minister Junichiro Koizumi yesterday said the central bank should carefully assess the economy and help overcome deflation before raising borrowing costs. Chief Cabinet Secretary Shinzo Abe urged the bank to keep rates near zero to support the economy.

``We want the Bank of Japan to continue its zero-rate policy for some time,'' Abe told reporters in Tokyo yesterday.

The government asked the central bank to delay its decision in August 2000 to raise rates, allowing it to blame the bank when the economy slipped into recession three months later.

``It's natural to expect the government to exercise its right to object,'' said Ueno. ``The Bank of Japan will want to avoid a repeat of the nightmare of 2000, which would make it difficult to raise rates in July.''

Murakami Investment

Officials from the Ministry of Finance and Cabinet Office attend monetary policy meetings to express their views, without having the right to vote. Expectations for higher rates have pushed up yields in the world's largest sovereign bond market, forcing the government to pay more to fund its 749 trillion yen of debt.

The government's bargaining power was strengthened after Fukui's acknowledgment last month that he invested in a fund created by Yoshiaki Murakami, who was indicted for insider trading on June 23. Koizumi and other key policy makers said Fukui shouldn't resign over the investment, which he made in 1999 when he worked for a private research institute.

Fukui is scheduled to speak to central bank managers on July 6 in Tokyo, which will be his first formal opportunity to discuss the Tankan data.

Rising profits are prompting companies including Toyota Motor Corp. to increase spending and raise wages, ending seven years of deflation. A report last week showed that core consumer prices, which exclude fresh food and are the bank's preferred measure of inflation, rose at the fastest pace in eight years.

Reports on machinery orders -- a key indicator of future capital spending -- bank lending and producer prices are also due before the bank meets.

``A delay to the end of the zero-rate policy could be perceived as the bank caving into political pressure and would reflect unfavorably on the bank,'' said Hiroaki Muto, senior economist at Sumitomo Mitsui Asset Management in Tokyo.

Andie Xie of Morgan Stanley on Commodity Prices and Liquidity.

Andy Xie (Hong Kong)

*High commodity prices are causing demand destruction. A significant downturn in Chinese demand for hard commodities suggests that demand is reacting to unsustainably high prices. As the property cycle turns down globally, demand for hard commodities should weaken further.

*Commodity prices reflect liquidity rather than demand. Commodity prices react sharply to the policy outlook for major central banks, indicating that liquidity rather than demand drives commodity prices. Hence, demand weakness is insufficient to bring down prices in the short term.

*Oil prices should lag demand even more. Oil exporters have become enormously rich from high oil prices in the past three years and are in a strong position to cut production to sustain high prices. It may take a global recession to bring down oil prices.

*Property downturn may exacerbate inflation. The global property boom has increased the share of corporate earnings in GDP, which has allowed businesses to hold price increases despite rising costs. As the property cycle turns down, businesses may have to raise prices more.

*High commodity prices force central banks to tighten. Global inflation is reaching ten-year highs and is likely to move higher in the coming months. Commodity prices are a major factor. As weak demand is insufficient to bring down commodity prices, central banks have to tighten aggressively to contain inflation even as the global economy cools. Financial speculation makes it difficult for central banks to achieve a soft landing for the global economy.

Global inflation is close to a ten-year high and is likely to rise further into 2007. The culprit is the unsustainably high level of liquidity, whose inflationary effect has been held back by deflation shocks (e.g., the emerging market crises, China’s SoE reform and Japan’s banking reform) in the past. As deflation shocks have ended, the current level of money supply is not consistent with price stability, in my view.

Commodity inflation is a major channel for excess liquidity to turn into inflation. Even though high prices are destroying demand, prices remain very high despite the recent decline and tend to surge whenever the expectation for rate hikes by central banks diminishes. This suggests that central banks have to tighten more than what the real economy requires in order to contain inflation.

Central bank signaling has been driving financial markets lately. Their ambivalence towards inflation only incites more financial speculation and, hence, more inflation, which makes a soft-landing more difficult to achieve, in my view. In the end, the reality of high and rising inflation will catch up with central banks, and I believe that the more dovish they are now, the more they will have to raise their interest rates later.

High commodity prices are destroying demand

Evidence is mounting that high commodity prices are destroying demand. The IEA estimates that global crude demand is rising at 1.24 mb/d, much lower than its forecast of 1.5 mb/d at the beginning of the year. Further, OECD crude stock is at a 20-year high or 54 days of demand coverage. These data suggest that crude demand has cooled and supply is more plentiful compared to 2005 or 2004. Nevertheless, Brent crude still averaged US$65.2/bbl in the first half of 2006, up 34% and 94%, respectively, from the same period in 2005 and 2004.

Demand destruction is even more apparent in base metals. China’s imports of base metals have declined sharply this year. Despite the recent correction, metal prices remain extremely high: compared to average prices in 2005, copper is currently 92% higher, aluminum 29%, nickel 45% and zinc 119%. While the commodity bulls usually cite strong demand and tight supply as reasons for the high prices, it is obvious to me that financial investment has driven up these prices.

Dovish central banks encourage speculation

The reaction to the Fed’s statement last week is a good example that commodity prices are far more sensitive to liquidity indicators than real demand. As the Fed sounded more dovish than the market expected, commodity prices rebounded sharply from the recent decline.

The commodity bubble is a knife hanging over the heads of dovish central bankers, in my view, because it encourages more speculation, which in turn causes more inflation, and I believe that the reality will catch up with the central banks that sound dovish today. The commodity bubble is one manifestation of the inflationary pressure from the very high monetary stock in the global economy. The inflationary effect of the abundant money supply was suppressed by global deflation shocks. Instead, the liquidity caused asset inflation. As deflation shocks end, asset inflation is causing consumer price inflation.

Central banks have tightened substantially already, and this is now causing the global property cycle to turn down. Central banks are worried about the effect of this downturn on demand and do not want to tighten much more to risk a recession. However, the current level of tightening is not sufficient to stop commodity speculation, in my view. This essentially puts central bankers in a box — if they focus on achieving a soft landing, they run the risk of letting inflation get out of control.

The risk of a global hard landing rises

Central bankers may not be focusing enough on the big picture, but instead could be becoming too ‘data dependent’. The big picture is that they have pumped too much money into the global economy. As deflation shocks suppressed the inflationary effect of this, money supply stimulated demand growth through asset inflation. Global conditions seemed ideal — too much money but no inflation — over the past few years.

However, the inflationary pressure was simply warehoused in asset markets; as deflation shocks end, their inflationary effect pours into the real economy. The right policy for price stability is to target asset prices, in particular commodity prices, in my view. If central banks react to consumer prices, they merely delay containing the inflationary pressure from asset inflation and make inflation more intractable. Inflation would peak out much higher than in a forward-looking policy approach. When upward inflationary pressure is delayed, central banks could well overreact and cause a global hard landing.

Must Read OECD report on Global Housing Prices!