Don't Hold Your Breath!

By Chris Puplava, March 14, 2007

Economic growth over time can be compared to breathing, with periods of inhaling (growth), and exhaling (contraction). The process of inhaling brings oxygen into the lungs which is then carried throughout the body to cells for use in generating energy (ATP) through metabolic processes. Exhaling is the expelling of carbon dioxide, a waste product that is harmful to the body unless expelled. The agent bringing oxygen to the cells and removing carbon dioxide is hemoglobin.

Likewise, liquidity is the oxygen that helps bring energy to the economy by stimulating growth, and the carrier of liquidity to and from the economy is predominantly the Federal Reserve through its control of short-term interest rates, through its open market actions, and its control of bank reserves.

Just as we reach a point where we can not inhale any more oxygen and instead need to exhale carbon dioxide, there also comes a point where the economy becomes overheated and needs to release the speculative froth and reign in inflationary pressures.

Figure 1. Economic Cycle

The process of exhaling (contraction) in the economy typically leads to a recession, with very few examples of a soft landing (mid-cycle slowdown), where the economy doesn't fully exhale but takes another breath and continues expanding. The question then is whether or not we will enter into a recession as liquidity dries up from the economic punchbowl (credit), or whether we will inhale (reflate) once more and undergo a mid-cycle slowdown.

As stated before, the Fed is a major determinant of liquidity and whether the punchbowl (credit) is removed from the economic system or refilled. Looking at the current situation points to an acceleration of a removal of liquidity from the economy as evidenced by bank lending standards tightening, the liquidity of the U.S. consumer (their balance sheets) worsening, and further weakness in the overall economy.

Credit Contraction and Delinquency Rates

With the risk of loan defaults rising, banks have tightened mortgage lending standards to levels not seen since the last housing recession. Tighter lending standards are making it more difficult for those with adjustable rate mortgages (ARMs) to refinance at rates lower than their reset rates. This is leading to higher defaults on mortgages at a time when homeowners' financial obligations ratio is at an all-time high.

Figure 2

Figure 3

Source: Moody's Dismal Scientist

Figure 4

Source: Moody's Economy.com

Many in the financial press are repeating the mantra that the problem in subprime mortgages is not spreading and that everything is fine. This is simply not the case as Alt-A mortgage losses are accelerating as well, threatening some mortgage-backed securities (MBS) that brokerage houses sell (any wonder the major brokerage stocks have plunged recently?). Alt-A mortgages are a step up from subprime borrower quality and below prime. Weakening of Alt-A mortgages indicates that the credit crunch of the lowest quality of a mortgage borrower, subprime, is spreading into higher quality borrowers.

A study by David Liu, head of mortgage credit research at UBS, reported in a MarketWatch article that Alt-A adjustable-rate mortgage interest-only (IO) loans have seen a four-fold increase in delinquencies of at least 60 days compared to levels in 2003 and 2004.

Liu warned that the deterioration in Alt-A mortgages could spread into the BBB-rated part of MBS and that investors have not yet priced un these risks. Excerpts from the article are provided below.

Losses "could potentially wipe out most of the credit support on BBB- rated bonds backed by Alt-A hybrids," Liu wrote. "And yet we have not seen any spread movements that suggest investors are taking this into consideration."

Liu's study, which used LoanPerformance data from the end of January, is based on the housing market remaining relatively flat over the next few years.

"If house prices fall over the next few years, everything in this scenario will be much worse," he said in an interview.

"There is a 34% probability that the entire BBB- tranche might get wiped out," he wrote. "Similarly, there is a 17% probability that cumulative losses reach 300 basis points, which could make BBB bonds appear on the endangered species list."

Credit quality erosion is showing up in consumer loan delinquency rates as well, resulting from a slowing in employment growth and higher interest rates. This is then translating into weaker retail sales that are contributing to the deceleration in GDP.

Figure 5

Figure 6

Source: Moody's Economy.com

The trend in delinquency rates is likely to continue as there is a delayed effect of rising interest rates and the translation into consumer loan delinquency rates by roughly a year and a half. The figure below indicates that if the Fed begins to lower interest rates right here and now, consumer loan delinquency rates will continue to rise until the middle of next year due to the year-and-a-half lag. The continued erosion in consumer liquidity will continue to weigh on retail sales and thus GDP for at least the next four quarters.

Figure 7

Source: Moody's Economy.com

A Contracting Economy

The February 28th Observation showed that transportation data pointed towards continued economic weakness ahead. Presented below is the cause of the transportation weakness as seen by a contracting economy. Both the retailer and manufacturer inventory-to-sales (I/S) ratio has been trending higher, with a sharp spike in the manufacturing I/S ratio to levels higher than the 2001 recession and the 95-95 mid-cycle slowdown.

Figure 8

Source: Moody's Economy.com

The rise in the I/S ratio for the total U.S. economy has also risen lately, and looking at the individual components of the ratio indicates the cause for the increase. Total business sales lead the trend in inventories as businesses adjust inventories to meet weaker or stronger consumption. Current business sales have contracted significantly and at a sharper rate than inventories, leading to an increasing I/S ratio. Sales have not plunged to recessionary levels but are fast approaching a negative YOY rate of change with inventory deceleration following suit.

Figure 9

Source: Moody's Economy.com

Weakness in the economy has yet to show up in the unemployment rate, which is not surprising as the unemployment rate is a lagging indicator of economic growth. One indicator that often leads the unemployment rate is the YOY rate of change in the 10-year UST. As investors discount the future, a belief of economic weakness ahead translates into lower interest rates as investors buy bonds when they feel the economy will slow, leading to a disinflationary environment. The chart below shows the YOY rate of change in the 10-year UST inverted for directional similarity to the unemployment rate. The YOY rate of change on the 10-year UST often drops sharply (rises in chart) prior to increases in the unemployment rate, with the unemployment rate peaking at the tail-end of a recession or even after it. The recent plunge in the 10-year UST indicates investors are forecasting economic weakness ahead, and there is the possibility of the unemployment rate to move higher.

Figure 10

Source: Moody's Economy.com

Don't hold your breath

Even if the Fed lowers interest rates and pumps money into the system, the damage may already have been done. We have only escaped a recession once when there was a housing recession (1966-1967), and the likelihood of doing so again is slim. Residential fixed investment has now declined more than 10% on a YOY basis, with a recession resulting EVERY TIME this level has been reached. Looking at residential fixed investment as a percentage of GDP and housing permits indicates that the housing downturn has a ways to go. Not an encouraging thought with all the current subprime blowups weighing on investor sentiment and the credit crunch beginning to show up in Alt-A mortgages. Notice the repeating pattern in the three charts below of recessionary periods (grey bars) appearing after sharp contractions in the various measures? Worrisome, is it not?

Figure 11

Figure 12

Figure 13

Source: Moody's Economy.com

Further support of economic weakness ahead is the yield curve and its relationship with retail sales. Despite many commentaries of �this time is different� where an inverted yield curve has lost its meaning, take a look at the figure below which shows the directional similarity of the trend in retail sales and the yield curve. The yield curve leads retail sales and has inverted steeply since peaking in 2004. As seen by the figure below, has a recession (grey bar) ever not occurred when the yield curve inverted? Nope, not even once! Moreover, a recession has even resulted (90-91) when the yield curve was close to inverting.

Figure 14

Source: Moody's Economy.com

The lag in the yield curve and retail sales is roughly two years. Even if the Fed moved right now to slash interest rates and normalize the yield curve, the figure below indicates that retail sales will not accelerate until the middle of 2009!

Figure 15

Source: Moody's Economy.com

At the same time overall retail sales are falling, non-cyclical retail sales as a percentage of total retail sales are climbing as they did prior to the 2001 recession. There is a decent negative correlation between relative non-cyclical retail sales and the S&P 500. Relative non-cyclical retail sales bottomed (peaked in chart) in the first few months of 2000, roughly 9 months prior to the S&P 500 peak as consumer's discretionary incomes contracted, and spending on essential items (non-cyclical) increased as a percentage of total retail sales. Relative non-cyclical retail sales also bottomed at roughly the same time the S&P 500 did, indicating greater flexibility in consumer discretionary incomes.

Figure 16

Source: Moody's Economy.com

Non-cyclical retail sales bottomed in the middle of last year before spiking sharply, roughly nine months prior to the sell off that began at the end of February, a similarity that occurred prior to the last bear market. Continued relative strength in non-cyclical retail sales does not present a bright picture for the markets ahead and could be sending an omen of more pain ahead as it did in 2000. Thus, don't hold your breath that the economy will experience a soft landing as more exhaling (economic deceleration) is likely ahead as Figure 7 shows delinquency rates likely to rise for another twelve months, and Figure 16 indicates decelerating retail sales until early 2009.

The Markets

The markets continued the theme of volatility as they were down in early morning trading before staging a rally into the late afternoon, with the Dow Jones Industrial Average briefly dipping below 12,000 for the first time since October of last year. The Dow, S&P 500, and NASDAQ all managed to finish on a positive note with the Dow posting a gain of 57.44 points to close at 12133.40, the S&P 500 gained 9.22 points to close at 1387.17, and the NASDAQ rose 21.17 points to close at 2371.74. Investors sold Treasuries today with the 10-year note yield rising to 4.522%, rising 6 basis points. The dollar index was down on the day, falling 0.07 points to close at 83.64. Advancing issues represented 58% and 52% for the NYSE and NASDAQ respectively, with up volume representing 67% and 73% of total volume on the NYSE and NASDAQ.

Energy prices recovered today based on the bullish inventory data with WTIC oil rising 0.40%, and spot Henry Hub up 1.14%. Precious metals were up with gold rising $0.70/oz to $644.50/oz (+0.11%) and silver finishing up $0.06/oz to close at $12.835/oz (+0.47%). Base metals were mostly up as London Metals Exchange (LME) inventories were mostly down, with copper showing the greatest strength on the day (+2.06%) while tin displayed the weakest performance (-0.49%).

Overseas markets were mostly down with Latin markets up the most, recovering from their decline yesterday, with Brazil's Bovespa (+1.26%) and Mexico's Bolsa (+0.49%) putting in the strongest overseas performances. Japan's Nikkei index (-2.92%) and European markets put in the weakest performances, with German�s Dax (-2.66%), London's FTSE 100 (-2.61%), and France's CAC 40 index (-2.52%) all down more than 2% on the day.

The positive move today was broad based as all ten S&P sectors were up, with energy putting in the strongest performance on the day (+1.40%) and the consumer discretionary sector (+0.05%) being the biggest laggard.

Chris Puplava

Contact Information

Christopher M. Puplava
PFS Group
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