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Sunday, May 18, 2008 6:45 PM

Rosenberg: Debunking Five Myths

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David A. Rosenberg, Merrill Lynch's Chief North American Economist, is Debunking five myths.

We identify and rebut the following five myths:

1. The first quarter GDP report says no recession
2. The April employment report was benign
3. The Fed is done and the next move is to hike
4. The credit crunch is over
5. Housing looks set to stabilize

1. The first quarter GDP report says no recession

In our view, the folks that are relying on the “plus” sign in front of that first quarter 0.6% GDP number as a sign that we dodged the recession bullet, we believe, are not correctly interpreting the data.

what the National Bureau of Economic Research (NBER) monitors to date the recessions are (i) employment; (ii) real personal income less transfer receipts; (iii) industrial production; and (iv), real manufacturing and trade sales. Employment peaked in December/07. Real income peaked in September/07. Production peaked in January/08. Real sales peaked in October/07. So, it is still reasonable to believe that the recession started some time between September and January.

2. The employment report was benign

Companies are cutting hours aggressively While companies did not cut as many positions as we expected, they cut the hours instead. The average work week plunged 0.3% (and, aggregate hours worked were down at an annual rate of 1% in the past three months), which, by the way, would be the equivalent of 400,000 job cuts. This is a sign that labor market conditions and domestic demand are far softer than the headline suggests. What drives consumer spending inevitably is income growth. Average weekly earnings fell 0.2% sequentially in April in what was the largest decline in two years. This dragged the year-on-year rate down to 3.1% from 3.3% in March, 3.7% in February and the nearby peak of 3.8% posted last November in what is clear disinflationary trend in wages.

3. The Fed is done and next move is to hike

The Fed expects economy to remain soft for quarters not months. While the Fed did strongly hint that it will very likely go on hold for the next few months, the notion that the central bank is anywhere close to where the Fed futures contracts are in terms of making its next move a hike – not just one, but almost four tightenings through 2009 – should be laid to rest as the overall tilt was still toward providing monetary accommodation if there is to be next move at all.

4. The credit crunch is over

Is that a fact? So why do you think the Fed has added asset-backed securities to the list of eligible collateral? To be accepting student loans less than a week after President Bush addressed the issue in his recent address speaks volumes. The real kicker is the Fed accepting credit card ABS – seemingly in response to the difficulty the banks are experiencing in terms of securitizing their card loans – and because of the nature of credit card ABS, old deals “return” to the balance sheet unless the related loans can be re-securitized. None of these banks can afford the capital hit (both balance and loan loss reserve related) of additional balance sheet loans – especially credit cards with 4%+ provisions.

So, what the Fed has managed to do in its latest intervention is to come up with a way for the banks to keep securitizing credit card loans at a time where there is no securitization market. How the markets and the media treat this as a positive is a true mystery – the Fed is basically degrading its balance sheet in these rescue operations.

We continue to hold the view that investors may be significantly underestimating the impact of a recession let alone the kind of consumer downturn that lies ahead. Even if the capital that has been secured thus far proves to be sufficient to cover for these future losses, what about the enhanced capital needs for securitization transactions and derivatives? If the regulators are going to adequately address their current “too interconnected to fail” concerns. No bank balance sheet is prepared for this; nor is it obvious that dealer banks are being valued on earnings that reflect the regulatory future will likely no longer involve the 30-to-1 leverage ratios of the present and past.

5. Housing looks set to stabilize

After all, the homebuilding stocks are up more than 10% so far this year, so something good is obviously getting priced in by someone. But as we highlighted recently in our report, The never ending story, the inventory situation in the residential real estate market is going from bad to worse. The Census Bureau’s all inclusive inventory data were released for the first quarter and showed that the total number of single-family and condominium units that are vacant and for sale rose 4.5% or at a near-20% annual rate – for the second quarter in a row – to a record 2.277 million units. The ‘frictional’ or normalized level is closer to 1.2 million, so this represents a 1.3 million deviation from what is normal. At current sales rates, it would take almost two years to absorb that excess inventory backlog. Alternatively, single-family housing starts will have to slide a further 25% from their already depressed levels and test their all-time lows of around 500,000 and stay there for a good four years. Either way, we are probably much further away from the bottom in starts and prices than is generally perceived – judging by the intractable unsold inventory backlog, the downturn could well last through to 2010.
There is plenty more to read in Rosenberg's article including a Monthly CPI forecast, an Interest rate forecast, a Forex forecast, and an economic forecast, all quarter by quarter.

Inquiring minds will be interested in many of those and I encourage everyone to take a look. Following is a close look at just one of the above, Rosenberg's interest rate forecast.

Interest Rate Forecast

click on chart for sharper image.

That's quite an interest rate compression forecast from here. Even more so when Eurodollar futures are pricing in hikes.

Eurodollar Futures Forecast

Eurodollar futures are implied forward interest rates on short term (3 month loans) bank to bank. It is one of the largest (by volume traded) as well as most liquid of all contracts.

Eurodollar Futures Table

click on chart for sharper image

To get a rough approximation of implied forward rates subtract the column "Last" from 100. For example: looking at the December 09 row, 100 - 96.28 = 3.72. The calculation is not exact because of time/value considerations but it is useful as a rough conceptual guideline. Perhaps a chart would be easier to understand.

Eurodollar December 2009 Contract

click on chart for sharper image

Note: The above Eurodollar chart and Table are as of May 15.

That is a chart of one specific Eurodollar contract, namely the December 2009 contract. As you can see, the contract followed nicely rate cuts by the Fed, peaking in mid-March. Since then over 100 basis points (97.40 vs. 96.28 ) have been taken away. From the perspective of mid-March, four additional quarter point hikes have been priced in.

Huge Difference In Opinion

Clearly there is a huge difference in opinion between Rosenberg and Eurodollar futures. Conceptually I agree with Rosenberg on interest rates as well as his debunking of 5 myths. I also think new lows in yield are coming on 10 year treasuries and the long bond. I believe most are underestimating the length and severity of this recession. I see no reason to diverge from what I said in Case for an "L" Shaped Recession.

However, one must always be aware of possible actions Bernanke might take. One of them is to start paying interest on reserves. Should Congress allow this measure now (see Fed Asks Congress for Power to Pay Interest on Reserves Sooner) It might allow Bernanke to expand the Fed's balance sheet at will while putting a floor under interest rates.

Bernanke is of course hoping to prevent a replay of what Japan went through (interest rates at 0% and no way to cut further). Should Congress grant Bernanke his wish, I am quite confident it will backfire in ways not yet seen.

Mike "Mish" Shedlock
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