John Mauldin

2010 Forecast: The Year of Uncertainty

By John Mauldin - January 9th, 2010, 8:14AM

2010: A Year of Uncertainty
“Rocking Even Me”
Prisoners of Our Preconceptions
The Statistical Recovery
The Great Experiment
Whither the Fed?
London, Monte Carlo, Zurich, and Stocks

~~~

“Lying here, during all this time after my own small fall, it has become my conviction that things mean pretty much what we want them to mean. We’ll pluck significance from the least consequential happenstance if it suits us and happily ignore the most flagrantly obvious symmetry between separate aspects of our lives if it threatens some cherished prejudice or cosily comforting belief; we are blindest to precisely whatever might be most illuminating.”
– from Transition, by Iain M. Banks
Still a man hears what he wants to hear
And disregards the rest
– The Boxer, by Paul Simon

“They Are Rocking Even Me”

This will be my tenth annual forecast issue. Time has flown by, and I enter a new decade of writing Thoughts from the Frontline. And even as I write about the high level of uncertainty of the current times, I am optimistic that at the opening of the next decade we will look back and realize that there has been an enormous amount of progress made. None of us will want to revisit the pleasures of the past ten years in some nostalgic dream. I am so ready for a new decade. And speaking of Paul Simon (above), reading the lyrics of The Boxer, one of my favorite songs from my youth, another few words seemed to hit home:
…Now the years are rolling by me, they are rockin’ even me
…I am older than I once was, and younger than I’ll be, that’s not unusual
…No it isn’t strange, after changes upon changes, we are more or less the same
At the end of the letter I announce the dates for our annual Strategic Investment Conference, tell you about an important conference I will be attending next month for 9 days (a rather large chunk of time for me!), and drop a hint about why I am going to actually buy some stocks this decade.
For new readers (and a lot of you have joined us this last year), let me quickly tell you what it is that I really do. I basically read and think for a living. I read a lot – hundreds of newsletters, articles, papers, magazines, books, essays, emails etc., almost every week. Each Friday I sit down and write about what seems to me to be the most important ideas I have come across, often tying together concepts from multiple sources into what becomes this letter, hoping to piece together a few parts of the puzzle, to help us see the bigger picture. On Mondays I send readers Outside the Box, which is an article by some other writer that I find interesting, and I try to make sure that I disagree with more than a few of them. We need to think, and that is one way of helping us do so.
The letter started out ten years ago as a way for me to put into writing my ideas and thoughts on what I had read, and I sent it out to just 2,000 people. It has grown to where today it goes to around 1.5 million people and is posted on dozens of web sites. The letter is free. You can subscribe at www.2000wave.com simply by giving me your email address. And feel free to forward the letter to friends or put a link to it on your web site. And there are Chinese and Spanish translations of the letter each week as well.

2010: A Year of Uncertainty

I read and research more for the annual forecast issue than any other letter during the year. And having had the luxury of not writing for the last two Fridays, I’ve had even more time. It seemed to me that the volume of forecasts out this year was greater than ever. But even I was amazed when Birinyi Associates, Inc. showed a picture of annual forecasts they had come across and printed out. It was a stack almost two feet tall and comprising over 3,500 pages. They helpfully summarized the projections for the major investment banks and compared them.
Their work confirmed my own reading. The projections they cited and those I have read were all over the board and more divergent than I can ever remember. But as I read the tea leaves, there is a lot of uncertainty and caveats with these forecasts. And too many are based on assumptions that the future will turn out largely looking like the past. It has been my contention for a long time that we are in a period that looks nothing like the past, and to use backward-looking data to project the immediate future carries the risk of being very misleading.
Thus, before we get into my projections, I think we need to take a survey of where we are. That means this annual issue may turn into a two-week project (I generally try to stop writing at eight pages); but if you don’t know where you are, how can you figure out where you’re going?

This is a challenging time, and I am going to challenge a lot of people’s ideas over the next two weeks. So, as we start, let’s look at why we need to very carefully assess our belief systems. The two quotes at the start of the letter point out how difficult it is for us to accept an idea that challenges our belief system, or would have negative consequences for our lives. If we are long some investment, we look for good news that tells us our investments are going up, and gloss over the negatives.
Last month, I found out I was just a few thousand miles from becoming executive platinum on American Airlines. I have never attained that level, and there are some major benefits. So, the flight which was the least expensive and gave me the required miles was a two-hour hop to Tampa, where ironically I had been the week before. I flew back on the same plane 30 minutes later.
However, the time was put to very good use. I read a pre-publication manuscript of a book by my good friend James Montier, called The Little Book of Behavioral Investing. I was asked to write the preface. I have to say that this book will become one of those that I read at least once a year, as it just so pointedly reminds me of all the ways we make investment (and life!) mistakes because of the ways our brains are hard-wired.
One of the real problems is that we “hear what we want to hear.” Our beliefs or personal interests lead us to conclusions or actions that may or may not be helpful. Let’s take a page excerpt from James’ book:

Prisoners of Our Preconceptions

“For instance, a group of people were asked to read randomly selected studies on the deterrent efficacy of the death sentence (and criticisms of those studies). Subjects were also asked to rate the studies in terms of the impact they had had on their views on capital punishment and deterrence. Half of the people were pro-death penalty and half were anti-death penalty.
“Those who started with a pro-death sentence stance thought the studies that supported capital punishment were well argued, sound and important. They also thought that the studies that argued against the death penalty were all deeply flawed. Those who held the opposite point of view at the outset reached exactly the opposite conclusion.
“As the psychologists concluded: ‘Asked for their final attitudes relative to the experiment’s start, proponents reported they were more in favor of capital punishment, whereas opponents reported that they were less in favor of capital punishment.’ In effect each participant’s views polarized, becoming much more extreme than before the experiment.
“In another study of biased assimilation (accepting all evidence as supporting your case) participants were told a soldier at Abu Ghraib prison was charged with torturing prisoners. He wanted the right to subpoena senior administration officials. He claimed he’d been informed that the administration had suspended the Geneva Convention.
“The psychologists gave different people different amounts of evidence supporting the soldier’s claims. For some, the evidence was minimal; for others, it was overwhelming. Unfortunately the amount of evidence was essentially irrelevant in assessing people’s behavior. For 84% of the time, it was possible to predict whether people believed the evidence was sufficient to subpoena Donald Rumsfeld based on just three things:
1. The extent to which they liked Republicans
2. The extent to which they liked the US military
3. The extent to which they liked human rights groups like Amnesty International.
“Adding the evidence into the equation allowed the researchers to increase the prediction accuracy from 84% to 85%. Time and time again, psychologists have found that confidence and biased assimilation perform a strange tango. It appears the more sure people were that they have the correct view, the more they distorted new evidence to suit their existing preference, which in turns made them even more confident!”
“We’ll pluck significance from the least consequential happenstance if it suits us and happily ignore the most flagrantly obvious symmetry between separate aspects of our lives if it threatens some cherished prejudice or cozily comforting belief; we are blindest to precisely whatever might be most illuminating,” wrote Ian Banks, of the protagonist in the science fiction novel Transition I am currently reading.
(By the way, if you are a sci-fi reader and have not yet become addicted to the writing of Banks, start with his early work and move through the decades. He is one of the best hard sci-fi writers alive.)
Those who are invested in the idea of a “V”-shaped recovery became excited over the jobs report last month. Unemployment rose by only 11,000 jobs, if you did not look at the underlying numbers or ignored the household survey. And the consumer confidence surveys have begun to rise. The Index of Leading Economic Indicators has now risen for six months in a row. Productivity is up. And surveys indicate that consumer spending is up. GDP growth in the fourth quarter looks to be in the 3%-plus range.
All reasons to be bullish, if you are looking for a reason to be bullish. If you don’t examine the underlying data, you can feel good. The problem is that when we look deeper into the data than just the headlines, there are concerns.
For instance, take the contention that consumer spending is rising. I called Philippa Dunne at The Liscio Report. They survey the various states about taxes, among other things. “Sales taxes are not up and the current survey we are doing is pretty bad.” She used the word “horrified” when commenting on some of the respondees’ replies at the various state tax offices. Further, today we find that credit card lending dropped $17 billion last month, the largest drop in history. And this was during Christmas!
Savings are up. Credit is down. Where did the rise in consumer spending come from? Remember, these are mostly surveys and/or comparisons with a disastrous 2008. And they compare same-store sales for chains like Best Buy, which no longer competes with the bankrupt Circuit City, or for chains that closed stores, forcing buyers to the remaining stores. The key to watch is sales taxes. When they are rising, consumer spending is rising.
Consumer confidence is rising, but from truly awful levels. The levels are still well below any level in previous recessions and certainly do not indicate a robust economic rebound.
A challenged consumer confidence survey is not surprising, given the fact that roughly 8% of the working population is getting some form of unemployment assisance. One in eight children in this country is living on food stamps. By the way, the total number of people on unemployment is about 300,000 worse than most media accounts report. The Extended (and Emergency) unemployment claims for those out of work more than 26 weeks are not seasonally adjusted. To get the total number of people on unemployment insurance of all kinds, you have to add the non-seasonally adjusted number of continuing claims, which is currently about 300,000 higher than the seasonal adjustment. Here is a chart from Philippa, at www.theliscioreport.com.

She explained, “For the week ended 12/19, 10.42 million Americans were receiving unemployment benefits, With 5.44 million Extended claims (week ended 12/19) and 4.98 million Continuing claims.
“But NSA jobless claims show a far different story. The advance number of actual initial claims under state programs, unadjusted, totaled 645,571 in the week ending Jan. 2, an increase of 88,000 from the previous week. There were 731,958 Initial claims in the comparable week in 2009… The advance unadjusted number for persons claiming UI benefits in state programs totaled 5,479,110, an increase of 388,729 from the preceding week. A year earlier, the rate was 4.0 percent and the volume was 5,317,388.
“So the actual, the real benefits paid (Initial, Continuing, and EUC claims) hit another record of 11.268 million.” (source: The Big Picture)
Today’s employment report was just terrible. The headline said we lost 85,000 jobs. That is from the establishment survey, where they call up larger businesses and ask them about their employment. They also do a household survey, where they survey about 400,000 households. That report reveals a much worse situation.
Last month, single women who are heads of households saw their unemployment ranks rise by a massive 127,000. The number of employed men fell by 214,000. The total number of unemployed in the survey rose by an enormous 589,000. Those classified as not in the work force (due to the fact that they did not look for jobs) rose by 843,000! That now means that in 2009 3.5 million people were dropped from the potential labor force count because they were discouraged.
If you add those to the 15.3 million who are unemployed, you get a much higher unemployment number than 10%. Getting that exact number is tricky, because if you are back in school (as some of my friends are) you are not looking for a job but are going to want one soon. And if the economy does rebound and jobs start to become available, then it is likely a large number of the discouraged 3.5 million will start looking for jobs and therefore be listed in the work force. Ironically, a recovering economy could see the unemployment number rise. During the recovery, it will be important to look at the total number of employed and not just at the unemployment rate.
Sidebar: As noted above, a large number of people were dropped from the official labor force. What that means is that even though the number of employed people fell, the unemployment rate did not. It will be interesting to see if a lot of those people just decided that December was not a good time to be looking, spent time with families, or decided it was too cold to get out. How many will start looking as we get into the new year? We could see a rise in the unemployment rate next month if a large number do look for work.
Look at the chart below from my friend Greg Weldon. (It just hit my inbox.) It shows the percentage of people who are participating in the work force. (www.weldononline.com) It is sadly dropping, which means that incomes to families are dropping. The number of people I know who are looking for work or are struggling increases each week. It truly saddens me.

The Statistical Recovery

So why, if the employment picture looks so bad, are we getting positive GDP numbers? I coined the term “Statistical Recovery” last summer to describe an economy where the statistics are positive but it certainly doesn’t “feel” like a recovery. So, how is it that we see a rise in the statistics?
First, year-over-year comparisons are looking better, since 2008 was horrific. Second, inventory levels are about as low as they will go. In the way GDP is figured, a reduction in inventory reduces GDP. That was a negative figure for most of this recession. Simply because inventories not falling any more, it is easier to get a positive GDP.
Second, as I have written, there are one-time benefits for GDP from the federal stimulus. Roughly 90% of the 2.2% growth in GDP in the third quarter was attributable to the stimulus, and we will see a similar affect in the 4th-quarter numbers and at least through the first half of next year.
A reduction in imports is also a positive for GDP. Ee are buying less “stuff” from abroad, so that helps statistically.
Martin Feldstein, one of the great economists of our time, was quoted last week as saying that the recession is not over. Indeed, it you look at past recessions, it is not all that unusual (8 out of 11 times) for there to be positive GDP quarters in the midst of an ongoing recession.

The Great Experiment

So this is the backdrop as we look into the future. Unemployment is rising and is likely to remain stubbornly high (over 10%) for some time, except for the few months this coming summer when the Labor Department will hire hundreds of thousands of temporary census workers. The savings rate is rising, and consumer spending is at the very least challenged. The stimulus starts to drop sharply in the latter half of the year. States, counties, and cities are short about $260 billion and will either have to cut services (and thus jobs) or increase taxes. Housing is likely to get weaker, as there are large numbers of defaults coming because of mortgage-rate resets this year and next (more on that in a few weeks). Valuations on stocks are in the high range, and do not portend well for long-term returns.
Further – and this is the most important item to me – Congress is likely to allow the Bush tax cuts to expire and to add insult to injury with some form of large tax increase for heath care. Between the local, state, and federal tax increases, we could see a massive increase in taxes of perhaps $500 billion in a $13-trillion economy, or about 4% of GDP.
Think about that for a moment. It is likely we will begin 2011 with close to 10% unemployment, if not higher. Christina Romer’s work shows that tax cuts have a three-times benefit to GDP. Tax increases presumably have a similar negative effect. (Ms. Romer, by the way, is President Obama’s Chairwoman of the Council of Economic Advisors. This is not a partisan idea.)
This is the great experiment to which we are going to be subjected. There are those who agree with Art Laffer and company that tax cuts are a positive for the economy (that would include your humble analyst). And there are those who contend that the economy did just fine in the Clinton years before the Bush tax cuts and that we will do just as well if we take them away. And further, taxing the rich a little more is not really going to change their behavior.
My contention is that if such a tax increase is enacted all at once, the economy will at a minimum dip back into a nasty recession. If I am wrong, then I will have to abandon one of my long-cherished beliefs. I will have to stop arguing that tax cuts are as important as I think. Right now, when I read the data and studies, they confirm my tax-cutting bias. But I have to be willing to change my mind if The Great Experiment proves me wrong.
But if you think unemployment is high now, you will really not like what happens if we dip back into recession. It could go a lot higher. They are truly risking a great deal if they decide to pursue this experiment.
Thus, I am faced with a great deal of uncertainty as I look into the future with my forecasts – and we will get into the bulk of the actual forecasts next week. I almost titled this letter “The Year of Waiting,” because there are so many important developments we are waiting on. Will they actually raise taxes in such a soft economy, or will cooler heads prevail and the increases be postponed, or at least phased in over 4-5 years? What will the health-care bill look like? There are so many things that could significantly change any predictions.
As I have written for years, the stock market drops an average of over 40% during a recession. If we go into a recession in 2011, it is highly unlikely that there will be an exception to the bear market rule. But this market seemingly wants to go higher. Smart people like my partner Steve Blumenthal argue with me that the technicals say we could go a lot higher in the short term. And he may very well be (and probably is) right.
This is a trader’s market. It is not time to buy and hold large indexes or high-beta stocks and expect to be made whole over the next ten years. Hope is not a strategy. But waiting for the “shoe to drop” is frustrating, I know. However, that is the situation we find ourselves in.
We will go into this next week, but the current environment is quite different than 1982, when the last bull market started. Rates were falling; they are now likely to rise over time. Taxes were going down. Valuations were at historical lows, not high and rising. Inflation was coming down. And on and on. The current environment is not one in which bull markets are born.

Whither the Fed?

The futures market is pricing in rate hikes from the Fed beginning this fall. I highly doubt a politicized Fed will hike rates with unemployment over 10%, ahead of a November election. We are going to have a very easy monetary policy for longer than most observers think.
The Fed has painted itself into a very tough corner. Raising rates in a high-unemployment environment is risky. Bernanke knows what happened in 1937 and does not want a repeat. But by keeping rates too low for too long, they risk an asset bubble or two. And the federal fiscal deficit of over $1.5 trillion is not making their situation any easier.
The Fed has announced it is ending many of their various and sundry programs in the first quarter. They have essentially been the mortgage market. What will happen to rates? I think that is one of the reasons why Geithner has essentially lifted any limit on explicit guarantees for Fannie and Freddie. It will be seen as higher-paying government debt. It will also cost you, Mr. and Ms. Taxpayer, hundreds of billions in increased deficits, as they are telling those entities to eat the losses from large numbers of loan modifications. This is outrageous on so many levels. Congress should at least have to approve this.
It’s getting close to my eight pages, so let me end by saying that, as we face the next crisis – and we will (there is always another crisis) – we will find we have not fixed the causes of the last one. We still have banks too big to fail, we have not put the credit default swaps on an exchange, we have not reinstated Glass-Steagall, Barney Frank’s bill (which was not the one that came out of committee) now makes it exceedingly more difficult to short stocks, we keep in power the same people who missed the problems the last time, and the list of bad policies bought (typo intended) to you by bank lobbyists grows ever longer. If the current bill looks like it was written by the bank lobby, that’s because it was. But it means we will have to face the same problems all over again. But that is another story for another day. Next week we look at the dollar and other currencies, gold, commodities, bonds, emerging markets, and more.

London, Monte Carlo, Zurich, and Stocks

Tomorrow I head to Santa Barbara for the annual business planning session with my partners at Altegris Investments. Let me quickly note that our annual Strategic Investment Conference will be April 22-24 in La Jolla. The speaker lineup is powerful. Already committed are David Rosenberg, Dr. Lacy Hunt, Dr. Niall Ferguson, and George Friedman, as well as your humble analyst. We are talking with several other equally exciting speakers. This conference sells out every year, and you do not want to miss it. We will have an announcement soon.
Secondly, I am going to go to the Singularity University’s 9-day Executive Program from February 26 through March 6. As for how I feel about it, the fact that I would devote nine days to it basically says it all. They have a very powerful faculty brief a rather small group about how the future of a variety of technologies will impact all aspects of business and the economy. It is not cheap, at $15,000, but I think it will be worth my time. They have had more applications than they have slots, but they have said they will give my readers special preference (as far as possible). You can go to www.singularityu.org and click on the link to the conference to find out more. I have been told who some of my fellow attendees will be, and let me say that the list is impressive. I am really looking forward to it. Hope to see some of you there.
I will be in London January 20-23, then a few days in Monte Carlo, and then Zurich and Geneva mid-week. I do have some times open, and will be speaking in London with my European partners, Absolute Return Partners. Drop me a note if you would like to meet, and I will see what we can do.
Finally, next Monday’s Outside the Box will be very unusual. I have not bought a stock for over ten years, preferring managers and funds. But starting in the next few weeks, I am going to begin buying stocks in a particular asset class, and intend to accumulate a portfolio over the next five years. Even in the face of what I think will be a recession. If you are interested in my thinking on this, be sure and read the letter.
I am so ready for 2010 and the next decade! As I look back, every decade has been better for me, and I think this decade will keep that trend intact. As Tiffani comes back from maternity leave (kind of), we have a lot of ideas for ways to serve you better. And we are going to be looking for suggestions. We are excited.
I am going to the Cowboys game tomorrow night, and hope we can beat our post-season jinx. This is going to be a very busy year for me, but I have to admit I am having more fun than I ever had. Thank you for being a part of it all.
Your more optimistic than this letter sounds analyst,

John Mauldin
John@frontlinethoughts.comCopyright 2010 John Mauldin. All Rights Reserved

Good Debt Charts

From Zero Hedge and Rogoff

The Pragmatic Capitalist's Ultimate Guide to Predictions and Outlooks

The Pragmatic Capitalist's Ultimate Guide to Predictions and Outlooks

We’ve compiled many of the very best outlooks from various analysts, gurus, hedge funds and investors.   We hope you find the list helpful in mapping your successful 2010:

Wall Street Banks

• Goldman Sachs 2010 Investment Outlook

• Deutsche Bank 2010 Outlook

• Credit Suisse Is Cautious

• Morgan Stanley’s 2010 Outlook

• UBS 2010 Outlook

• RBC’s 2010 Outlook

• Saxo Bank’s Coming Black Swans

• 2010 Outlook From Northern Trust

• Bank Of America/Merrill Lynch Is Bullish On 2010

• Prudential’s 2010 Investment Outlook

• PIMCO’s 2010 Outlook

• PFG Best’s Look Back And Ahead

• Wall Street Is Very Bullish About 2010

Hedge Funds & Investment Gurus

• Marc Faber’s 2010 Investment Outlook

• Jim Rogers Is Still Skeptical

• Hussman: 80% Chance Of A Market Plunge

• Boeckh Investments

• Sprott Asset Management: The Rally Is Fake

• ECRI: The Recovery Will Continue In 2010

• Comstock Is Still Bearish

• Jeff Saut Debates Todd Harrison

• TCW’s 2010 Outlook

• Cumberland Advisors 2010 Outlook

• Biriyni’s 2010 Outlook

• Sam Stovall Is Cautiously Optimistic

• Steve Keen’s 2010 Investment Predictions

• Leuthold Turns More Cautious On 2010

• Robert Prechter: Stocks Will Fall In 2010

• David Tepper’s 2010 Outlook

• Richard Bernstein’s 10 for 2010

• 20 for 2010 By Doug Kass

• 2010 Outlook From ISI Group

Actionable Ideas, Alternative Assets & Potential Potholes

• RBC’s top trades for 2010

• How To Prep For An Uncertain 2010

• Goldman’s Top Trades For 2010

• Morgan Stanley’s Favorite Stocks

• JP Morgan’s Top Trades For 2010

• More Cost Cuts Could Help These 8 Firms

• 10 Stocks For 2010

• Will 2010 Be 2004 All Over Again?

• Where To Invest In 2010

• What Does History Tell Us?

• The 5 biggest risks to 2010

• 10 Themes For 2010

• The 10 Best ETF’s For 2010

• Gold Will “Super Spike” In 2010

• Gold Is In A Bubble And Could Crash

• The Housing Market Is Still In Trouble

• The Lumber Market Is Picking Up

• The U.S. Remains A Low Beta Investment

• Dividends Could Play A More Important Role In 2010

• Goldman’s 2010 Commodity Outlook

The Outlook Abroad

• JP Morgan Expects Emerging Markets To Rise 30%

• Nomura On China’s Positive Outlook

• Morgan Stanley Says Chinese Stocks Are Poised To Rally 30%

• Bank Of Canada Says Stocks Are Overvalued

• Ignore Brazil At Your Own Peril

• The 4 Reasons Emerging Markets Will Outperform

And others added at Demand Side's discretion

Richard Bernstein

Saxo Bank

Doug Noland sees a bubble year

Issues 2010:

Let’s start by setting the backdrop.  The world is operating without a stable monetary regime.  There is no gold standard.  There is no functioning Bretton Woods currency stability regime.  There is no longer even an ad hoc dollar reserve “system” that tended – at least on occasion - to discipline foreign Credit systems and restrain excesses.  Like never before, Credit systems around the world operate unrestrained.  It is my long-held view that pricing mechanisms – and Capitalism generally – function poorly in a backdrop of unrestrained (inherently mis-priced) Credit.

Most importantly, there is today no common understanding that stable international finance is wholly dependent upon individual Credit systems being operated with discipline and restraint.  Quite the contrary, as the universal policymaking view these days is that aggressive stimulus and monetary looseness are essential for supporting financial and economic recoveries.  The world is devoid of a monetary anchor and operating in a unique monetary environment that foments speculation, financial excess, imbalances, economic maladjustment, and potent bubble dynamics.  As we begin 2010, inflationism is still seen as the solution instead of the problem.

The year 2008 marked the collapse of the Wall Street/mortgage finance Bubble.  It specifically did not mark the end of the Chinese Bubble, the global Credit Bubble, or even the greater U.S. Credit Bubble.  Last year saw the emergence of the Global Government Finance Bubble – quite possibly a monumental development.  Accordingly, 2010 should be viewed as a Bubble Year.  This implies a bipolar perspective when contemplating probable outcomes:  On one end, the Bubble expands and makes it through the year.   Or, on the other, the Bubble bursts and financial systems and economies sink right back into crisis.  As a long-time analyst of Bubbles, I caution against predicting the timing of their demise.  

Last year saw intense speculation reemerge in U.S. and global financial markets.  It is the nature of speculation to intensify as long as it is accommodated by loose financial conditions.  Similarly, it is the nature of Bubbles to expand and become more robust unless inflation dynamics are quashed through some type of monetary tightening.   Excess begets excess… And the more protracted – hence powerful – the Bubble the greater the degree of tightening necessary to eventually rein it in.  The more robust and expansive the Bubble the greater the dislocation associated with its bursting.  I see no appetite anywhere in the world this year to aggressively suppress Bubbles. 

The unfolding Bubble in China is historic, and their policymakers appear poised to tinker.  Tinkering doesn’t quell Bubbles – certainly not seasoned ones.  I have espoused the view that the Chinese Credit Bubble has entered the dangerous “Terminal Phase” of excess.  How this dynamic and the course of policymaking play out is a Major Issue 2010.  I expect Chinese authorities to work diligently in an effort to ration the amount of Credit available for real estate speculation.  At the same time, the stated goal of stimulating domestic consumption implies huge growth in Chinese household debt. 

I am generally skeptical in the efficacy of Credit rationing.  This was a focal point of a great debate in the U.S. back in the late-twenties.  One (dovish) camp believed that the focus should be on limiting the flow of Credit financing stock market speculation, while at the same time working to maintain ample Credit to fuel the booming economy.  The problem is that years of expanding Credit create a (financial and economic) system with both a huge Credit appetite and a potent propensity for inflating the quantity of new Credit.  Attempts to limit speculative Credit – or even lending to certain sectors – is generally ineffective in itself and fails to address the major issue of runaway total system Credit growth.  Indeed, after Bubble dynamics have taken firm hold, attempts to restrict Credit by the nature of its use will tend to distract policymakers and delay efforts to contain systemic excesses.  From my point of view, determined, decisive and independent monetary management provides the only hope for reining in “terminal phase” Credit Bubble excess.  Such an approach seems in very short supply these days, and I’ll be surprised if much of it emerges in China in 2010.

Here at home, Chairman Bernanke apparently doesn’t discern Bubble risk.  Incredibly, in his Sunday morning speech he even argued that Fed rate policy was about right during the 2002-2006 period – and that a low Fed funds rate wasn’t the cause of the U.S. housing Bubble.  And we can also assume the he believes his speeches (including his November 2002 - “Helicopter Ben” - “Deflation: Making Sure ‘It’ Doesn’t Happen Here”) did not create a major moral hazard issue. 

The markets have no fear that the Fed will tighten in response to financial speculation.  I believe the Fed examines today’s real estate markets and fears “deflation.”  I would imagine they see a stock market still 25% below all-time highs and worry of “disinflation.”  They see stagnant (at best) household debt growth, declining bank Credit, and still impaired securitization markets and see no credible inflation threat.  Looking in the rear-view mirror, they just don’t see problematic financial leveraging and lending excesses.  They would surely view the reemergence of asset inflation as confirmation of their adept policymaking.

The Fed’s overriding focus is stimulating sustainable recovery.  They will err on the side of caution when it comes to removing crisis-period liquidity measures.  I will assume that they will not be raising rates meaningfully until they are confident that the markets and economy have first adjusted well to ending quantitative easing operations.  Meaningful financial tightening is nowhere in sight.  The Bernanke Fed still believes that monetary policy is a “blunt tool” and, as such, is inappropriate for dealing with Bubbles.  They prefer stronger “regulation.” So, who is responsible for regulating Washington Credit excesses? 

The Fed’s analytical framework and rear-view approach will not serve them well.  Today’s domestic Credit excesses are concentrated in the Treasury and agency markets.  In a replay of Mortgage Finance Bubble dynamics, Federal Reserve policies today accommodate the Government Finance Bubble.  Dr. Bernanke’s talk of helicopter money and the government printing press was fundamental to creating an environment where the markets operated confidently knowing the Fed was there to provide a market liquidity backstop.  The Fed’s fingerprints were all over the historic mispricing and over-extension of mortgage Credit.  Today, “quantitative ease” and the perception of potentially unlimited Federal Reserve monetization (balance sheet growth) have greatly distorted the pricing mechanisms for government borrowings and debt instruments generally.   

Because of the Fed’s words and deeds, the marketplace is dysfunctional when it comes to pricing risk.  These days, the price of government Credit has no relationship to the interaction of its supply and demand.  If Washington seeks to borrow a couple hundred billion - or a few Trillion - it really has little impact on yields.  In an ominous replay of the Mortgage Finance Bubble, government intervention has severely distorted the capacity of the marketplace to properly price risk, allocate resources, and discipline market participants (borrowers and speculators). 

The Fed should have “leaned in the wind” in response to double-digit mortgage Credit growth in years 2002, 2003, 2004, 2005, and 2006.  Instead, the Fed did the exact opposite, believing at least for awhile that the expansion of mortgage Credit was a mechanism to ameliorate deflationary pressures.  Furthermore, it had convinced the marketplace that it was there to protect against any potential Credit bust.  And then once the housing/mortgage Bubble really gained a foothold the Fed was unwilling to rein in the monster it had unleashed.  The marketplace had become so dysfunctional that the best “trade” to profit from the inevitable bust was to load up (and feed the mortgage Bubble) on GSE obligations.

Similar dynamics now promote the Government Finance Bubble.  In a more orthodox financial world, our central bank would be expected to “lean against the wind” as our federal government sets course on destroying its (our) creditworthiness.  Not these days, as the Fed holds short-term rates steadfastly at near zero, balloons its balance sheet with GSE MBS, and again convinces the marketplace that its balance sheet will always be there as a liquidity backstop. 

Despite the prospect of the Fed ending its MBS purchase program in March, GSE MBS spreads to Treasuries ended today near 17-year lows.  The marketplace must expect that Fannie and Freddie are to resume their balance sheet growth (and market liquidity-backstop function!), that the Fed will keep its opens open to support the MBS market, or a combination of both.  The MBS marketplace is rife with government intervention and price distortions.  It has succumbed to dangerous Bubble dynamics and how it functions through the year is a major Issue 2010.

As I mentioned again last week, combined Treasury and GSE MBS debt expanded $2.8 TN in the 15 months ended September 30, 2009.  The emergence of the Global Government Finance Bubble was crucial for the stabilization of the U.S. and global economy.  U.S. recovery is dependent upon the continuation of this Bubble, and this Bubble is dependent upon massive government fiscal and monetary stimulus.  Optimism is now running high, and the U.S. economy could make the bulls look smart in 2010.  Butthat is very unlikely change the very bearish secular thesis.

The nature of the unfolding economic recovery is an Issue 2010.  Will private-sector Credit creation begin to expand sufficiently and, in the process, allocate ample Credit for sound investment and meaningful job growth?  Will a self-reinforcing Credit cycle commence, or is the system now trapped in government debt Bubble dynamics?

A respectable December for the retailers has optimism for consumer rejuvenation running high.  The S&P Homebuilding index was up 14.6% this week, as the marketplace positions for a traditional economic rebound.  But major questions for 2010 remain:  How vulnerable is the housing market to higher mortgage yields?  How long will the marketplace finance massive deficit spending and GSE debt issuance without demanding significantly higher yields?

My thesis that the unfolding reflation will be altogether different than past reflations may be tested in 2010.  So far, massive government stimulus has stabilized both asset markets and national incomes.  And some pent up demand throughout the economy is expected.  At the same time, savers are receiving about nothing on their savings, while energy and many other prices continue their ascent.  Surging financial asset prices have boosted household confidence and Net Worth.  Yet a meaningful rise in market yields could easily pressure bond, stock and home prices.  To what extent mortgage Credit growth can recover and foster a self-reinforcing housing recovery is a key financial and economic Issue 2010.

Unprecedented market interventions by the government played a decisive role in stabilizing mortgage finance, housing markets, and household spending.  It played a similar role in stabilizing the municipal debt market.  That cash-strapped state and local government regained access to inexpensive borrowings was instrumental to financial and economic stabilization.  If a traditional recovery ensues, perhaps state and local governments can grow out of their debt problems.  A more reasonable bet is that municipal finance faces serious and festering structural debt issues.  California is an absolute fiscal mess.  Do loose financial conditions continue to accommodate what will be enormous 2010 state and local borrowing requirements?

Today, the markets are infatuated with risk assets.  From the perspective of Bubble analysis, this is not all too difficult to explain.  The first week of the year saw about $45 billion of corporate debt issues.  Despite enormous new supply, investment grade debt spreads are at pre-Lehman crisis levels.  The same can be said for junk bond and emerging debt spreads.  Credit conditions are loose for most creditworthy borrowers, which feeds market demand for these debt instruments - which translates to even greater Credit Availability.  In such an environment, even commercial real estate doesn’t look so bad.  But is such an accommodating financial landscape sustainable?

It is always impossible to know what developments will surface to upset the applecart:  there are any number of festering financial, economic, political, and geopolitical issues that might impede the unfolding Bubble.  At the same time, it is not unreasonable to suspect that policymakers might tend to delay dealing with tough issues.  The federal deficit is out of control, and monetary policy is outrageously loose.  There is an “exit strategy” with assorted doors.  There is the looming issue of Fannie and Freddie.  The FHA and Ginnie need to be reigned in. 

Looking back, policymakers of all stripes missed their opportunities to make tough but necessary decisions in 2009.  And now 2010 just doesn’t have the feel of a year that will witness a lot of decisive policymaking.  In Washington, the focus will turn to the 2010 elections.  The Fed will worry about its reputation and independence.  Fearing for their jobs and fearful of mistakes, timid will win over bold.  Bubbles treasure timid.

Until proven otherwise, I’ll project 2010 as a year of escalating Monetary Disorder – disorder globally across a broad spectrum of markets.  A global Bubble would seem to ensure unsettled currency markets.  Dollar optimism runs surprisingly high to begin the New Year.  Yet the scenario of a dollar problem leading to a jump in U.S. borrowing costs still doesn’t seem all that nutty to me.  Another spike in energy and commodities wouldn’t surprise me, but the best bet is numbing volatility.  The emerging markets are poised for a wild year.  And, of course, all eyes on interest rates.

As I mentioned above, a Bubble Year suggests the likelihood of bipolar outcomes.  I’ll conclude by admitting that I get that uneasy feeling that our central bank is quite determined to avoid learning lessons.

David Kotok

David R. Kotok co-founded Cumberland Advisors in 1973 and has been its Chief Investment Officer since inception. He holds a B.S. in Economics from The Wharton School of the University of Pennsylvania, an M.S. in Organizational Dynamics from The School of Arts and Sciences at the University of Pennsylvania, and a Masters in Philosophy from the University of Pennsylvania. Mr. Kotok is also a member of the National Business Economics Issues Council (NBEIC), the National Association for Business Economics (NABE), the Philadelphia Council for Business Economics (PCBE), and the Philadelphia Financial Economists Group (PFEG).

~~~

“It Was Only a Paper Moon”
January 7, 2010

The rarity of a New Years Eve blue moon has now morphed to a waning gibbous form as the moon leads reveling partygoers back to an early January reality. We will summarize some of the investment strategy themes for the start of this century’s second decade. The bullets follow.

1. 2010 will be the year of very large sovereign debt issuance. Governments in mature economies in Europe (including the UK), Asia (Japan), and North America (the US) will be borrowing huge amounts, while private-sector borrowings remain low and still shrinking in some areas. Government debt is substituting for private debt. The market will confront continuing credit-watch notices and credit downgrades for sovereign states. This will be disconcerting, since the downgrades will occur on the 50 US states and the 27 EU states. In our view this creates terrific opportunity for bond investors who are able to sort through the credits and who understand the nature of debt. Taxable (Build America) and tax-free municipal bonds in the US are an example of an area where investors can act opportunistically. This is less true for most corporate debt and federal agency debt, where spreads have narrowed. The debt of financial enterprises is an exception. Cumberland’s managed bond accounts have favored this strategy for over a year and have extremely underweighted Treasury debt in 2009. We expect that strategy to continue as spreads in Muni land sequentially narrow in 2010. For some details see Peter Demirali and John Mousseau commentaries on our website, www.cumber.com.

2. Stocks still have room to go higher before this bull market is over. This may be in spite of a corrective selloff during 2010. Various estimates of S&P 500 earnings for 2010 range from about $70 to $80. At a 15 multiple that would put a fair-value range on the S&P Index of 1050 to 1200. A 15 multiple against a 10-year Treasury bond yield of 3.8% suggests an equity risk premium of about 3 points, which is in line with fair valuation. The surprise in 2010 may come on the upside, since labor costs are held down by the high rate of unemployment. That means productivity and profits will be unusually high coming out of this post-crisis recession. We expect the US stock market to close the “Lehman gap.” That could bring stocks to the pre-Lehman-failure level of over 1250 on the S&P 500 Index. Cumberland’s ETF accounts have been nearly fully invested throughout most of 2009 and continue that way as we enter 2010.

3. The Fed is likely to keep the short-term interest rate very low for an “extended period” while it gradually withdraws the special facilities put in effect under “emergent and exigent” circumstances. These two terms are important for investors to understand. “Exigent and emergent” mean the Fed has to officially find that the emergency conditions exist in order to maintain these special facilities. This is a black and white test for the Board of Governors. They have to vote that the conditions either do or don’t exist. If it isn’t clear, then the likely answer is that they still do exist. We believe “extended period” means about 3 or 4 FOMC meetings before a change in rates will be initiated. That is about a half a year and enough time for the Fed to determine that the emergency is over. The clues for this change are likely to be revealed in speeches by FOMC members, in the quarterly economic forecasts of the FOMC members and in the statements that the FOMC makes and releases after each of its meetings. Bob Eisenbeis has comments about using the forecasts as clues; find it on our website at www.cumber.com. Markets will react to any change that suggests the “extended period” is approaching an end. The FOMC does not know the extent of that forthcoming market reaction. It can only guess at it which is why it will do as much as possible to prepare the markets for this change. The FOMC also knows that the greatest risk to the fragile and nascent economic recovery comes from the FOMC moving too soon. Double-dip recessions and “W” economic outcomes have occurred in the past only when the Fed moved too soon and triggered the second down leg. 1937-38 and 1980-81 are two examples of this type of policy error. Bernanke has said he will not repeat this mistake. We take him at his word.

4. Inflation will not be a threat in 2010. Much of the market player’s hand wringing about a big inflation coming is misplaced. Velocity measures are at their lowest in the last decade in the US, euro –zone, and Japan. As an outcome of monetary policy, inflation needs to have two operative elements: an expanding private sector credit multiplier and a rising labor cost. In most mature OECD country economies, both credit and labor are pressured as we enter 2010. That is certainly true in the United States. If anything, we see inflation flat-to-declining in 2010 and into 2011. That means upward pressure on bond yields that arises from inflation risk premia is likely to be muted. Markets seem to expect otherwise, which is why they may be pleasantly surprised. If bond yields rise, it will be due to credit concerns or a fall in the global supply of savings. Note that foreign official holdings of US government securities approach $3 trillion as we enter 2010; this number was well under $1 trillion at the millennium anniversary. We expect it to rise over the next decade as the US continues to run large current account deficits.

5. Worries about an end to emerging market growth are premature. We expect the emerging market growth story to continue for a long time. Corrections in these markets are buying opportunities. Investors should not confuse high volatility in both directions with an end to the long-term growth story. High “Vol” in emerging markets will continue, as it should, since these economies have more cyclical risk attached to them than the mature ones. The mature ones are more predictable, although they are experiencing much slower growth rates and rapidly rising debt ratios. We continue to overweight emerging markets in our Global Multi Asset Class approach to ETF investing. Bill Witherell has a piece on Global asset allocation posted on our website, for those who are interested in this detail. See www.cumber.com.

We look forward to a fascinating year as markets continue to heal from the policy-failure-induced vicious destruction of 2008 and early 2009. That traumatic period has given way to the stimulative-policy-induced recoveries of 2009 and 2010. We view these recoveries of the world’s economies as tentative and fraught with higher than normal risk. Policy making is extraordinarily unusual in this cycle. The Fed is in unchartered waters with its new tools. The federal deficit is enormous. America’s tax policy is very uncertain and likely to lead to much higher rates of taxation in the United States once the economic recovery gets into a more sustainable mode.

We believe the US should be viewed as a new entrant into the group of social-democratic states that pursue “industrial polices” where government is a large intervener into private affairs and private enterprise. That means comparisons need to be thought about differently. Government debt-to-GDP will be over 100% in the US, UK and euro–zone by the end of this new decade. It is approaching 200% in Japan. Social burdens and aging populations will play enormous roles in their respective economics. 90% of the world’s debt is denominated in these four currencies: yen, pound, dollar, and euro. We discuss these issues in some detail in our forthcoming book “Invest in Europe Now!” The book is an effort I co-authored with Italian financial journalist Vincenzo Sciarretta. Wiley will release it in April.

Regrettably, we will not leave on Friday for the GIC meetings in Shanghai and Hong Kong; meeting details are found at www.interdependence.org. A wrenched back, some meds and doctors keep us from catching up with Asian, African and North American friends who are planning to attend. For those nearby and capable of last minute travel, the event that we helped organize and now must experience vicariously features conversations with policy makers, investors, bankers, and economists; all are scheduled during the week.

By the time the GIC delegation returns in mid-January the blue moon of New Years Eve will have waned through gibbous and crescent to the first new moon of the new decade. Is this a paper moon? A prescient moon? Will we need moonshine to tolerate the craters ahead? Or will moonbeams illuminate a path for investors in the coming decade?

David R. Kotok, Chairman and Chief Investment Officer, email: david.kotok@cumber.com

Fed's Hoenig warns against moon creatures and inflation

The 2010 Outlook and the Path Back to Stability, by Thomas M. Hoenig, President, Federal Reserve Bank of Kansas City: ...Policy Challenges Ahead As I have indicated, a key contributor to the economic recovery is the extraordinary fiscal and monetary stimulus provided by governments and central banks around the world. In the U.S., we have seen the largest fiscal stimulus in history...

While these policy actions have been instrumental in helping to stabilize the economy and financial system, they must be unwound in a deliberate fashion as conditions improve. Otherwise, we risk undermining the very economic performance we hope to achieve. In the case of fiscal policy, the ballooning federal deficit must be controlled and reduced. ...

As the private sector recovers, increasing demand to finance both public and private debt will likely place upward pressure on interest rates. Eventually, there will be pressure put on the Federal Reserve to keep interest rates artificially low as a means of providing the financing. The dire consequences of such action are well documented in history: In its worst cases, it is a recipe for hyperinflation.

Addressing the deficit will be made all the more complicated by the fact that many of the stimulus programs are scheduled to wind down in 2011 at the very time the Bush administration tax cuts are also scheduled to expire. It will be an extremely abrupt shift in fiscal policy from stimulus to restraint that will cause the economy to weaken. Addressing the deficit under these types of circumstances will be controversial and desperately unpopular. ...

In the case of monetary policy, the challenges are no less daunting. The Federal Reserve must curtail its emergency credit and financial market support programs, raise the federal funds rate target from zero back to a more normal level, probably between 3.5 and 4.5 percent, and restore its balance sheet to pre-crisis size and configuration. ... However, normalizing monetary policy and the Federal Reserve’s balance sheet will be a ... contentious undertaking, and there are differing views regarding when this process should begin, how fast it should proceed, and what form it should take.

One view is that the Federal Reserve should delay interest rate normalization until there is more certainty that the economy and financial markets have completely recovered from this crisis. At that time, the accommodation can begin to be removed. Those who hold this view believe that high unemployment and low inflationary pressures due to excess capacity create considerable economic downside risks if the Federal Reserve removes stimulus. Their biggest fear is of the “double-dip” recession. In their minds, these immediate risks continue to outweigh concerns about long-term economic performance.

This is an appealing argument. The recovery is in its early stage, and weak data continue to emerge in some reports. State and local governments remain under severe fiscal pressures despite considerable federal assistance. Business investment spending for nonresidential construction and equipment remains weak. Additionally, those parts of the country heavily exposed to the subprime lending bust and to the auto industry remain depressed. Also, there is no denying the fact that despite improvements, labor markets and parts of our financial system remain under stress. Thus, while the economic and financial recovery is gaining traction, risks and uncertainty remain major deterrents to removing the stimulus.

Unfortunately, mixed data are a part of all recoveries. And, while there is considerable uncertainty about the outlook, the balance of evidence suggests that the recovery is gaining momentum. In these circumstances, I believe the process of returning policy to a more balanced weighing of short-run and longer-run economic and financial goals should occur sooner rather than later. ...

As I have already said today, experience has shown that, despite good intentions, maintaining excessively low interest rates for a lengthy period runs the risk of creating new kinds of asset misallocations, more volatile and higher long-run inflation, and more unemployment — not today, perhaps, but in the medium- and longer-run. ...

Low rates also interfere with the economy’s ability to allocate resources and distort longer-term saving and investment decisions. Artificially low rates discourage saving and subsidize borrowers at the expense of savers. Over the past decade, we channeled too many resources into residential construction and financial activities. During this period, real interest rates—nominal rates adjusted for inflation—remained at negative levels for approximately 40 percent of the time. The last time this occurred was during the 1970s, preceding a time of turbulence. Low interest rates contributed to excesses. It would be a serious mistake to attempt to grow our way out of the current crisis by sowing the seeds for the next crisis. ...

FOMC Minutes: Expect Slow Economic Recovery

FOMC Minutes: Expect Slow Economic Recovery

from Calculated Risk by CalculatedRisk

1 person liked this

Here are the December FOMC minutes. Economic outlook:

In their discussion of the economic situation and outlook, meeting participants agreed that the incoming data and information received from business contacts suggested that economic growth was strengthening in the fourth quarter, that firms were reducing payrolls at a less rapid pace, and that downside risks to the outlook for economic growth had diminished a bit further. Although some of the recent data had been better than anticipated, most participants saw the incoming information as broadly in line with the projections for moderate growth and subdued inflation in 2010 that they had submitted just before the Committee's November 3-4 meeting; accordingly, their views on the economic outlook had not changed appreciably. Participants expected the economic recovery to continue, but, consistent with experience following previous financial crises, most anticipated that the pickup in output and employment growth would be rather slow relative to past recoveries from deep recessions. A moderate pace of expansion would imply slow improvement in the labor market next year, with unemployment declining only gradually. Participants agreed that underlying inflation currently was subdued and was likely to remain so for some time. Some noted the risk that, over the next couple of years, inflation could edge further below the rates they judged most consistent with the Federal Reserve's dual mandate for maximum employment and price stability; others saw inflation risks as tilted toward the upside in the medium term.

A number of factors were expected to support near-term expansion in economic activity. Consumer spending appeared to be on a moderately rising trend, reflecting gains in after-tax income and wealth this year. Recent upward revisions to official estimates of the level of household income in recent quarters gave participants somewhat greater confidence that consumer spending would continue to expand. The housing sector showed continuing signs of improvement, though housing starts had leveled out after increasing earlier in the year and activity remained quite low. Businesses seemed to be reducing the pace of inventory reductions. The outlook for growth abroad had improved since earlier in the year, auguring well for U.S. exports. In addition, financial market conditions generally had become more supportive of economic growth. While these developments were positive, participants noted several factors that likely would continue to restrain the expansion in economic activity. Business contacts again emphasized they would be cautious in adding to payrolls and capital spending, even as demand for their products increases. Conditions in the commercial real estate (CRE) sector were still deteriorating. Bank credit had contracted further, and with many banks facing continuing loan losses, tight bank credit could continue to weigh on the spending of some households and businesses. Some participants remained concerned about the economy's ability to generate a self-sustaining recovery without government support. In particular, they noted the risk that improvements in the housing sector might be undercut next year as the Federal Reserve's purchases of MBS wind down, the homebuyer tax credits expire, and foreclosures and distress sales continue. Though the near-term outlook remains uncertain, participants generally thought the most likely outcome was that economic growth would gradually strengthen over the next two years as financial conditions improved further, leading to more-substantial increases in resource utilization.
emphasis added

And on real estate:

CRE activity continued to fall markedly in most parts of the country as a result of deteriorating fundamentals, including declining occupancy and rental rates, and very tight credit conditions. Prospects for nonresidential construction remained weak.

In the residential real estate sector, home sales and construction had risen relative to the very low levels reported in the spring; moreover, house prices appeared to be stabilizing and in some areas had reportedly moved higher. Generally, the outlook was for gains in housing activity to continue. However, some participants still viewed the improved outlook as quite tentative and again pointed to potential sources of softness, including the termination next year of the temporary tax credits for homebuyers and the downward pressure that further increases in foreclosures could put on house prices. Moreover, mortgage markets could come under pressure as the Federal Reserve's agency MBS purchases wind down.

That last paragraph is important. It appears residential investment will disappoint in Q1, and prices might already be falling again - and that is before the massive government support programs will be wound down over the next 6 months. Of course CRE is getting crushed, but residential investment is usually a key to a recovery - and residential investment will remain sluggish.

Byron Wien for 2007 and 2008

Byron Wien: Ten Surprises for 2007 and 2008

from Credit Writedowns - Finance, Economics, and Markets by Edward Harrison

 

Given the fact that I have just finished writing two articles on Wien’s predictions for 2010, I thought it relevant to look back at the last three years of Wien’s surprises to just before the housing crisis.  I posted the 2009 predictions last year. The post is here.  Wien calls these events that he gives even odds where the consensus sees only a one-in-three chance. He’s been doing it since 1986. Below are his lists for 2007 and 2008.

Wien certainly didn’t say anything about the housing crisis in 2007.  Overall, you have to say he has a bullish bias. For example, he predicted the S&P 500 would hit 1600, cruising through the March 2000 highs.  And t did eclipse March 2000 highs – although just barely. He was also bullish on oil, commodities, precious metals, China, Japan and Barack Obama in 2007.  Overall his picks were pretty good.  Here they are.

1. The S&P 500 exceeds 1600 surprising even optimistic strategists and investors. The combination of strong earnings, reasonable valuations and excess liquidity throughout the world drives the U.S. market higher. Market volatility increases substantially with the VIX index rising to 20.
2. Secretary of the Treasury Paulson’s trips together with the forthcoming Olympics move China to a more accommodative attitude toward the United States and the West. China revalues the yuan by 10% and eases terms for Western partnerships with Chinese companies.
3. Despite a world-wide economic slowdown, crude oil remains in short supply because of Asian demand and the price per barrel returns to $80. Development of alternative sources of energy and sales of hybrid cars remain disappointing. There is a movement in Congress to encourage the construction of nuclear powered electric utility plants and local resistance seems to be softening as the “green wave” starts to take hold.
4. As the standard of living rises around the world, agricultural commodity prices continue to soar. Corn goes to $5.00 a bushel, wheat to $7.00, soybeans to $9.00 and cotton to $.80 a pound. The volatility of cattle prices also attracts investor attention.
5. S&P 500 earnings grow by more than 10% for another year, exceeding analysts’ estimates. Profit margins hold their own as productivity continues to improve.
6. The Federal Reserve does not lower rates in the spring. The 10-year U.S. Treasury yield goes to 5.5% as higher wages cause inflationary pressures to increase and the yield curve turns positive. Real growth in the U.S. approaches 3% once again as housing begins to recover. Credit spreads widen as defaults increase in a service oriented, competitive economy that is brutal to manufacturing companies.
7. The price of gold goes to $800 and silver approaches $18. The dollar is stable against the euro because of renewed economic growth in the U.S. and higher interest rates.
8. Economic conditions in Japan continue to improve. After being one of the worst equity markets in a developed country during 2006, the Nikkei 225 rises 15%. In this market large capitalization stocks do outperform their smaller brethren.
9. The emerging markets of Asia take a rest. Attention shifts heavily to Latin America and Brazil stands out. It is a country with vast natural resources and reasonable labor costs. The country moves closer to an investment grade rating and the Bovespa rises to 55,000.
10. Neither of the current frontrunners for the 2008 presidential election in the U.S. proves to have staying power. Rudy Giuliani pulls ahead for the Republicans as fears of terrorism heat up again and Barack Obama gains momentum as he demonstrates that inexperience isn’t a terminal liability.

The market turmoil in 2007 (see the credit crisis timeline) meant caution to anyone watching events, so I see his 2008 calls as much more telling regarding his biases. The interesting bit is his confidence in Obama’s political fortunes, which obviously goes back to at least 2006 since he wrote the 2007 list at the beginning of 2007.  Someone more plugged in can give me the scoop, but it sounds a lot like Obama had his Wall Street connections up and running pretty early.
As for his economic forecasting, he accurately predicted a recession, a drop in the stock market, and commodities-driven inflation. He was right to be bullish on gold and commodities. But he was wrong to be bullish on the Dollar as it got creamed in the first half of the year.  All in all, this is as good as it’s going to get for someone who missed the housing bubble and its fallout.

1. In spite of Federal Reserve easing, and other policy measures, the United States economy suffers its first recession since 2001 as housing starts stay soft and banks are reluctant to lend to anyone where a whiff of risk is apparent. Federal funds drop below 3%. The unemployment rate moves definitively above 5% and consumer spending is lackluster.
2. Standard and Poor’s 500 earnings decline year-over-year and the index drops another 10%. Energy and materials stocks hold up relatively well in what is viewed as a correction rather than a bear market. Market conditions start to improve during the summer.
3. The dollar strengthens in the first half reaching US$1.35 against the euro and weakens in the second exceeding US$1.50. The European Central Bank begins an accommodative monetary policy. Foreign investors flock in to buy cheap assets in the US early in the year but the dollar declines later as several countries holding large reserves diversify into other assets.
4. Inflation rises above 5% on the Consumer Price Index as higher commodity prices and oil finally begin to have an impact in spite of modest wage increases. The 10-year US Treasury yield rises to 5%. Stagflation becomes a frequent presidential campaign and Op-Ed discussion topic.
5. The price of oil goes down early in the year and up later, sinking to US$80 a barrel in the first half as western economies slow and inventories are drawn down, and rising to US$115 in the second. Established wells continue to decline in production while China, India and the Middle East increase their consumption.
6. Agricultural commodities remain strong. Corn rises to US$6 a bushel and cotton to US$0.85 a pound. Gold reaches US$1 000 an ounce as disillusionment with paper currencies spreads across Asia.
7. The recession in the United States slows the Chinese economy modestly but its stock market declines sharply. Investors recognize that paying biotechnology stock multiples for highly cyclical companies doesn’t make sense. The Chinese revalue the renminbi by another 10% to control inflation and as a gesture to foreign governments participating in the Olympic Games who complain that Chinese terms of trade are unfair. Several long distance runners refuse to compete in certain Olympic events because of continuing air pollution problems.
8. The new Russian President Dmitry Medvedev, under the tutelage of Vladimir Putin, becomes more assertive in world affairs. He insists that Russian oil and gas be paid for in rubles and demands a Russian seat at major world conferences. Russia and Brazil stock markets lead the BRICs. The Gulf Cooperation Council markets begin to attract interest among emerging market investors.
9. Infrastructure improvement becomes an important election theme for both parties and construction and engineering stocks rally in anticipation of huge programs beginning after the new President’s inauguration. Water becomes a critical problem world-wide and desalination stocks soar.
10. Barack Obama becomes the 44th President in a landslide victory over Mitt Romney. With conditions in Iraq improving, the weak economy becomes the determining issue in voters’ minds. They want to make sure that gridlock ends and Congress gets something done for a change. The Democrats end up with 60 Senate seats and a clear majority in the House of Representatives.

I would say he has a good feel for the economy and for politics with a slightly bullish bias. It is this bias which blindsided him when it came to the housing bubble.
Source

Icap Futures Options 2010 Newsletter

  Icap Futures Options 2010 Newsletter

Blackstone's Byron Wien's 10 surprises for 2010

Byron Wien: Ten Surprises for 2010

The Surprises of 2010

1. The United States economy grows at a stronger than expected 5% real rate during the year and the unemployment level drops below 9%. Exports, inventory building and technology spending lead the way. Standard and Poor’s 500 operating earnings come in above $80
2. The Federal Reserve decides the economy is strong enough for them to move away from zero interest rate policy. In a series of successive hikes beginning in the second quarter the Federal funds rate reaches 2% by year-end
3. Heavy borrowing by the U.S. Treasury and some reluctance by foreign central banks to keep buying notes and bonds drives the yield on the 10-year Treasury above 5.5%. Banks loan more to corporations and individuals and pull away from the carry trade, thereby reducing demand for Treasuries. Obama says, “The suits are finally listening”
4. In a roller coaster year the Standard and Poor’s 500 rallies to 1300 in the first half and then runs out of steam and declines to 1000, ending where it started at 1115.10. Even though the economy is strong and earnings exceed expectations, rising interest rates and full valuations present a problem. Concern about longer term growth and obligations to reduce leverage at both the public and private level unsettle investors
5. Because it is significantly undervalued on a purchasing power parity basis, the dollar rallies against the yen and the euro. It exceeds 100 on the yen and the euro drops below $1.30 as the long slide of the greenback is interrupted. Longer term prospects remain uncertain
6. Japan stands out as the best performing major industrialized market in the world as its currency weakens and its exports improve. Investors focus on the attractive valuations of dozens of medium sized companies in a market selling at one quarter of its 1989 high. The Nikkei 225 rises above 12,000
7. Believing he must be a leader in climate control initiatives, President Obama endorses legislation favorable for nuclear power development. Arguing that going nuclear is essential for the environment, will create jobs and reduce costs, Congress passes bills providing loans and subsidies for new plants, the first since 1979. Coal accounts for about 50% of electrical power generation, and Obama wants to reduce that to 25% by 2020
8. The improvement in the U.S. economy energizes the Obama administration. The White House undergoes some reorganization and regains its momentum. In the November Congressional election the Democrats only lose 20 seats, much less than expected
9. When it finally passes, financial service legislation, like the health care bill, proves to be softer on the industry than originally feared. There is greater consumer protection, more transparency, tighter restriction of leverage and increased scrutiny of derivatives, but the regulatory changes for investment bankers and hedge funds are not onerous. Trading volume and merger activity increases; financial service stocks become exceptional performers in the U.S. market
10. Civil unrest in Iran reaches a crescendo. Ayatollah Khameini pushes out Mahmoud Ahmadinejad in favor of a more public relations adept leader. Economic improvement becomes the key issue and anti-Israel rhetoric subsides. Talks with the U.S. and Europe begin but the country remains a nuclear threat. Pakistan becomes the hotspot in the region because of the weak government there, anti-American sentiment, active terrorist groups and concerns about the security of the country’s nuclear arsenal

Source
Blackstone Group’s Byron Wien Announces Top Ten Surprises for 2010 – Business Wire

More on Byron Wien's 10 surprises

More on Byron Wien’s Ten Surprises for 2010

from Credit Writedowns - Finance, Economics, and Markets by Edward Harrison

Byron Wien was amazingly accurate last year in his economic predictions even though his annual list is an attempt to build a non-consensus list of likely outlier events.  So, I was eager to see his 2010 list, which was unveiled earlier today. Please read his list in the post here as background.

Reviewing 2009 predictions

When Wien made his 2009 calls, the big difference between his view and mine was his move to see a second-half recovery, something I wasn’t prepared to call until April. For example, Wien saw the S&P at 1200, Gold at $1200 and oil at $80 by year’s end – forecasts which turned out to be uncannily accurate.
However, in my view, the second-half recovery is a tenuous one which depends heavily on fiscal and monetary stimulus and huge bailouts for the financial sector. Without these extraordinary steps, the year would have been much different. Without them in 2010, the recovery will not be as robust.
Let’s review:

1. The Standard and Poor’s 500 rises to 1200.  It made it to 1115.  Close enough for me as it was up over 20% on the year. Given the index bottomed at 666 in March, this rally is clearly related to the stimulus.
   
2. Gold rises to $1,200 per ounce.  It did make that magic number. Again, I see this as a stimulus-related call as there has been a rush into commodities due to worries about dollar weakness on the back of the flood of money from the Fed.
3. The price of oil returns to $80 per barrel. Another accurate prediction.  The call he makes here is a more bullish version of my view of a structural supply constraint at present prices. This supply constraint creates price whiplash and forces oil up even in a weak economic environment.
4. The yen goes to 75 and the euro to 1.65. Too dollar bearish. Wien underestimated the weakness of Japan and the Eurozone.
5. The ten-year U.S. Treasury yield climbs to 4%. This too is accurate as the 10-year made it to 3.93% in June. Obviously, this call was predicated on recovery, which we now have. You should note that Treasuries have really been clobbered since November when the Ten-Year yield reached a low of 3.20%.
6. China’s growth exceeds 7% and its stock market revives. Accurate.  Growth was even higher actually.  This is prediction which depended on economic recovery.
7. Falling tax revenues from the financial sector cause New York State to threaten bankruptcy and other states and municipalities follow.  This is head-scratchingly bearish given his other views. New York took its lumps but the real damage was in California (especially given the market-induced tax implications of Wall Street bonuses for New York).  This story is not over though.
8. Housing starts reach bottom ahead of schedule in the fall, and house prices stabilize after dropping 15% from year-end 2008 levels. The Obama stimulus program proves effective and a slow growth recovery begins before year-end. Third and fourth quarter real gross domestic product numbers are positive. This is what happened.
9. The savings rate in the United States fails to improve beyond 3%, as most economists expect. The concept of thrift seems to have vanished from American culture. Peak job insecurity and negative growth drive increased savings early in the year, but spending resumes as the economic growth turns positive in the second half, making Christmas 2009 the best ever. Exactly.
10. Barack Obama …meaningfully increases U.S. military presence… In a hawkish speech he states that the threat of terrorism forces the United States to maintain a strong military force in this strategic area. Pretty much on the money.

This is as close to 100% as you are going to see.

2010 list predicated on recovery

The first thing to note about his predictions is that they are predicated on a very strong economic recovery.  He is clearly bullish. His first prediction is that the U.S. will grow 5% this year. That is a V-shaped recovery, folks.  I see the following elements as very much dependent on a strong US economic recovery.

• The Fed starts hiking rates a la 1994.
• 10-year hits 5.5%.
• S&P goes even higher to 1300, basically doubling from March 2009 lows.
• Japan has a recovery pushing the Nikkei to 12,000.
• The Democrats only lose 20 house seats in the mid-term elections.

The other elements are not predicated on a V-shaped recovery and are pretty idiosyncratic.  I can’t say I disagree with anything at this point since I also see a (U-shaped) recovery. Even, the non-recovery based predictions seem plausible. I agree most with his calls about how industry-friendly financial services regulation and healthcare reform is likely to be.

In general, as last year, it is the bias bullish that I disagree with. I see a lot more downside risk than Wien does. And my predictions would reflect this.  Even though past performance is not necessarily indicative of future results, his accuracy in 2009 certainly makes pay attention to what he says for 2010.

Goldman Sachs Ten Questions annotated

from the Demand Side Blog and Podcast 010510
Goldman's Ten Questions For 2010
and an introduction by Tyler Durden from zero hedge

One of the great paradoxes of life is that the smarter one is, the better one realizes just how little one knows. The same thing is  true with forecasts: one can hypothesize and conjecture, but if one is unlucky, one is screwed: no matter how thought out, error-proof or logical the narrative - it is the unpredictable events that ultimately shape events, not the "priced in" obvious factors. The Heisenberg Uncertainty Principle applies in a perverse fashion not only to the wave-particle duality in the quantum realm, but to the very underpinning of economics: by predicting the future we implicitly change it. The futility of forecasts is well known to all those, who with the exception of a several few, whose very existence is an economy of scale "strange attractor" (think Warren Buffett and Goldman Sachs), have tried to repeat a winning performance, be it based on fundamentals, technicals, or kangaroo entrails.

It is also sufficiently useless to the point where we will spare you a Zero Hedge set of observations of what to expect: if you have been reading this blog, you know what we believe is relevant as we enter 2010. How it will all pan out, however, is a totally different story. It is therefore not too ironic, and somewhat fitting, that Goldman Sachs' chief economists do not leave 2009 with a dogmatic set of forecasts, which, just like every other year would have the success rate of a coin toss, but with 10 key questions addressed exactly one year into the future. Here are Goldman's 10 Questions for December 31, 2010.

To which we interject a great big Demand Side, BULL.  This expression of confusion may reflect the obsession with the stock market or financial markets in general, but recent events have proven only that wild-eyed optimists and bubble chasers were wrong.  Yes, nothing is known with certainty.  No, that does not mean it is a random draw.  The great group think of markets is not an example of changing the future, but of forming the future.  One should listen to Soros, not Heisenberg.  In predicting the future, one ought to be describing the present.  Of course the data points can change, but the outline of demand, investment, and the other fundamentals does not change.

But let's get to the Goldman Sachs predictions.  Likely authored by Jan Hatzius

---

Our forecast for 2010 features sluggish GDP growth, employment gains that are too slow to prevent a further modest increase in the unemployment rate, low (and probably falling) core inflation, and a Federal Reserve that “exits” from some unconventional monetary policies but keeps the funds rate at its current near-zero level. 

Unquote

This is the more of the same data forecast.  Not much information in terms of dynamics.
In terms of the Fed's exit.  How they are going to sell out the trillion dollars in MBS's and not take a bath is the real question.  More likely, they will do what Goldman tells them to do, and that means no funds rate increase. 

1. Have house prices bottomed?

Probably not yet, but we are quite uncertain.  Although US homes are no longer significantly overvalued, we believe that much of the increase in prices over the past six months has been due to three temporary factors: a) the homebuyer tax credit, which has been extended into 2010 but is likely to be less powerful in boosting demand than it was when first introduced in 2009; b) the Fed’s purchases of mortgage-backed securities, which have pushed down mortgage rates but are slated to end in early 2010; and c) the temporary mortgage modifications through the Obama administration’s Home Affordable Mortgage Program (HAMP), only a relatively small portion of which seem to be turning into permanent modifications.  These factors suggest that home prices are at risk of declining anew, and our working assumption is a renewed 5%-10% cumulative drop in the national Case-Shiller index through 2010.

Indeed, there are some early signs that home prices are starting to fall again.  In particular, the Loan Performance home price index fell more than ½% in both September and October.  The S&P/Case-Shiller index, which is based on three-month moving averages, remained positive in these months but the gains were smaller—averaging just over ¼% versus more than ¾% in the preceding three months—suggesting that spot observations are turning negative.

No, house prices have not bottomed.  Here Goldman is describing the scene on the ground, not anything in the future.  Forecasting should be so easy.  Look out the window.  It's raining.  "I predict rain."

2. Will banks become more willing to lend?

Probably yes, but at a pace that is only consistent with subdued spending growth.  In thinking about banks’ willingness to lend, it is important to distinguish between levels and rates of change.  Conceptually, it is the change in lending standards that should affect the change in consumption, capital spending, or GDP.

The concern in the current recovery is that the very sharp tightening of lending standards during the recession is giving way only very gradually to an easing during the recovery.  As of the fourth quarter of 2009, standards for both consumer and business loans are still being tightened modestly.

The combination of sharp tightening followed by gradual normalization puts the current cycle in a category of its own.  ... yada yada yada

Big banks will not increase lending, since there is no recovery and no prospect of increased demand and thus prospect of profit.  Smaller banks will get the big squeeze from the commercial real estate meltdown of 2010.  It would really be good if the Fed raised interest rates as a way of squeezing bank margins and making them active in the credit markets again.

3. Will small business activity pick up?

It should, but so far we are not seeing it.  We have been quite concerned about the implications of the weakness in the small business sector.  Since small firms aren’t as well captured in the economic statistics as larger firms, their weak performance may mean that standard economic indicators currently overestimate growth in economic activity.

and there is more


Small businesses are the engine of growth, it is repeated ad nauseum.  So, help small business and things will get better.  Demand is the engine of growth.  Help household spending by writing down debt, not financial sector balance sheets so they can hoard capital.  Begin big new public goods investment and stabilize the states and localities.  Otherwise.  Why would small business want to invest?  "How's business" does not mean how much of a subsidy are you getting.  It means how many customers. 

4. Will hiring revive?

Yes, but we expect the rate of job creation to reach only about 100,000 per month by the second quarter, not enough to push the unemployment rate down in a meaningful way.

Some analysts argue that US businesses cut jobs more aggressively during the recession than was warranted by the decline in output out of fear that the downturn would be even more severe.  If this were true, it might suggest that employment would rebound more sharply than suggested by the cumulative growth of real GDP from the business cycle trough.

But the evidence for the “excess layoffs” hypothesis is weak.  ... and so on

It is difficult to tell whether Goldman is being intentionally coy or what.  Surely they as major financiers realize business as overleveraged had to cut as fast as possible to keep up debt payments and to put the rosiest gloss on a bad apple.  Huge job cuts mean huge demand cuts.  The result is not a bounce, it is a hole.



5. Does the saving rate have further to rise?

Yes, we think so.  The current saving rate of just over 4% remains below the 6%-10% range that we estimate is needed to stabilize the ratio of household net worth to disposable income in a “normal” environment for capital gains on existing assets.  This is admittedly a very long-term perspective.  But in addition, the current level of household net worth also seems to imply an increase in the saving rate on simple short-term “wealth effect” grounds.  Hence, we project a gradual increase to around 6% by the end of 2011.

The main reason why we see only a very slow increase is the weakness in household income growth.  Household debt is already contracting sharply, so an increase in saving would need to reflect a pickup in gross saving—i.e. purchases of financial and physical assets—from its current, depressed level.  This will be difficult for households to accomplish if income growth remains anemic.

Goldman's "sharp contraction in household debt" means levels are back a couple of quarters.  The huge mountain of debt has not been significantly reduced.  The "savings rate" -- as we've said before -- is the difference between income and spending.  Not a build-up of financial assets, a pay-down of debt.

In standard economic analysis it is realized that an increase in income creates an increase in the savings rate.  This used to be the rationale for favoring the rich.  They save more.  They are more virtuous.  A savings rate increasing from falling incomes is bad for demand and reflects only insecurity and debt burdens, not health. It also reflect the illusion that homeowners had that their homes were a secure form of wealth.  They thought they were being prudent.  Turns out, they were just gullible marks for the financial sector.

6. Will inflation fall further?

This is really a question?  Well, it has an answer.

Very likely yes, at least as far as the “core” indexes are concerned.  As we demonstrated in a comprehensive study recently, “slack” is the best predictor of inflation both at the aggregate level and in individual sectors of the economy.   Moreover, Exhibit 6 shows that slack is pervasive throughout the economy, not just in the well known data on unemployment and industrial capacity utilization.

One particular area in which slack could put significant further downward pressure on inflation is actual and imputed rents.  There is a clear inverse relationship between the rental vacancy rate and the pace of rent inflation.  With rental vacancies at a record, we expect further significant declines in year-on-year rent inflation into negative territory.

The Demand Side view is that the price level is being supported by bubble markets in commodities, or it would be down further.  Asset price deflation, except again in financial assets where the bubble is operating, continues apace.  Rental reductions are a function of the bubble in housing collapsing, not some out of the woods vacancy rate.

7. Does the dollar pose an inflation risk?

Only to a very limited degree.  For one thing, the dollar just isn’t that weak—and that was even true prior to the most recent round of risk reduction.  It has certainly depreciated substantially over the past nine months, but we view this as the flip side of the normalization that has taken place in global financial markets.  Indeed, according to the Fed’s broad trade-weighted index, the dollar currently is slightly stronger than the average of the past two years.

Moreover, the currency is less important to inflation in the United States than elsewhere given the relatively small size of the trade sector.  Thus, while Fed officials certainly take account of its impact on financial conditions, the impact of currency changes on inflation, in particular, is quite minor.  A common rule of thumb is that a 10% depreciation in the trade-weighted dollar raises the level of the CPI by just ¼%.  So it would take a very large depreciation indeed to start ringing alarm bells about imported inflation.

Well, Demand Side would say that tradable goods have collapsed as a source of inflation risk, particularly when the Chinese peg their currency to the dollar.  The thing about the dollar is its changes are inverse to the price of oil.  Oil prices are a major inflation instigator.

8. Will Congress pass more fiscal stimulus?

Yes.  Beyond the extension of the homebuyer tax credit (and other tax relief measures) enacted in early November, the Congress has passed and the president has signed a two-month extension of unemployment benefits.  More is coming as the House has passed a much larger bill providing additional unemployment insurance (four more months) as well as more aid to states, and more infrastructure spending.  The Senate is likely to follow suit early next year, and the ultimate legislation may well include provisions such as a hiring tax credit and/or extended bonus depreciation for companies.

The president will do what Goldman tells them.  So expect this stimulus.

But even with these likely measures, the boost from fiscal policy to real GDP growth is likely to decline in the first half and vanish (or even reverse) in the second half of 2010.  This is because it is the change in spending and taxes that governs the impact of fiscal policy on real GDP growth.  Even with the latest round of packages—worth about $200bn altogether—the change will not be nearly as positive as it was in the wake of the $787bn package enacted almost a year ago.  ... the longer-term perspective is one of gradual fiscal restraint, though this is mostly an issue for 2011 and beyond.

Uh-oh.  Fiscal restraint will be sad for Goldman and the rest of the financial sector.  Deficits are supporting the cash flow that is the source of their profits.

9. How will the Fed “sequence the exit”?

In theory, Fed officials have four choices for “exiting” from their current, highly accommodative stance: (1) terminating the current program of asset purchases, (2) draining excess bank reserves via reverse repos and/or term deposit facilities, (3) hiking short-term rates via parallel increases in the federal funds rate and the interest rate on reserves (IOR), and (4) selling assets outright.

In 2010, the main form of “exit” is likely to be an end to asset purchases.  In addition, Fed officials will probably drain some excess reserves, mainly in order to prove to market participants that they are capable of doing so.   In contrast, we expect neither a hike in the funds rate nor outright sales of assets on the Fed’s balance sheet in 2010 (or for that matter in 2011).

Very short and sweet for the trillions of dollars of Fed action in question.  Exiting apparently means not getting in any further.  Too bad it got in so far.  Hard to see how it is ever going to get out of this mudhole.  Draining bank reserves is a shadow play meaning nothing.  The reserves are no source of inflation risk, even postulating a true recovery and some impetus for investment, when it won't matter if there are zero reserves, financing will be found.  Again Goldman is telling the Fed not to mess with its zero percent financing for games.  Outright sales would mean recognizing huge losses for the Fed.  Not going to happen.

10. Will the end to the asset purchases tighten financial conditions?

Possibly, although the degree is highly uncertain.  Over the past 12 months, the Fed has bought a net $1.3 trillion in Treasury coupon debt, agency debt, and agency mortgage-backed securities, about three-quarters of the total amount of net issuance in these markets.  These purchases are already diminishing and will likely stop by the end of the first quarter, while net issuance is likely to remain at levels similar to the recent pace through 2010.  This means that non-Fed buyers will need to absorb a far greater amount of “flow supply” of securities.

This could put upward pressure on long-term interest rates.  But two points are worth noting.  First, our bond strategists’ models do not find any misvaluation of US Treasury yields at present.  If this means that the asset purchases didn’t have a dramatic impact on the level of yields, it would suggest that end of the purchases might also not have a significant effect. Second, and presumably related to this, the policy shift away from asset purchases has been very well flagged and there are plenty of market participants who have a much darker view of the outlook for federal solvency than we do.  For this reason, a sizable short base in the rates markets has been established in anticipation of the end to the Fed’s purchases.  This means that much of the impact may already be discounted in the current level of interest rates.


Phooey.  Goldman does not ask, "How can we expect the Feds to continue to throw money at us?"  They instead say, "We've consolidated our position, and we're ready to ride it out.  Thanks Ben.  Good luck suckers."