Pimco´s Bill Gross Must Read Piece On CPI

The following post from Bill Gross is worth reading every single sentence. While i´m with Mish on what Inflation is ( see Inflation: What the heck is it? ) it is very telling how the US is able in depressing the symptoms of inflation. But as long as foreigners are willing to destroy money in buying US treasuries and agency paper one has to congratulate the US for their excellent PR ( no sarcasm! )........ I´m staying with gold......

Ich empfehle dringend das komplette Posting von Bill Gross zu lesen. Bekanntermaßen sehe ich die Definition von Inflation wie Mish ( siehe Inflation: What the heck is it? ). Es ist schon bemerkenswert wie die USA es schaffen die Symptome der Inflation auf äußert vielfältige Weise zu manipulieren. Der Irakfeldzug ist verglichen damit ein Lacher. Solange Sie es trotzdem schaffen genügend ausländische Investoren zu finden die Gelder besonders in Staatsanleihen und Papieren von Fannie & Freddie zu versenken kann man es den USA nicht einmal übel nehmen die kreative Berechnung jenseits von Enron & Co zu heben. Man muß hier ausdrücklich das herausragende PR loben ( das meine ich ehrlich ). Ich für meinen Teil bleibe da lieber beim Gold......

Thanks to Wall Street Follies

Hmmmmm? Gross / Pimco - What this country needs is either a good 5¢ cigar or the reincarnation of an Illinois “rail-splitter” willing to tell the American people “what up” – “what really up.” We have for so long now been willing to be entertained rather than informed, that we more or less accept majority opinion, perpetually shaped by ratings obsessed media, at face value. After 12 months of an endless primary campaign barrage, for instance, most of us believe that a candidate’s preacher – Democrat or Republican – should be a significant factor in how we vote. We care more about who’s going to be eliminated from this week’s American Idol than the deteriorating quality of our healthcare system. Alternative energy discussion takes a bleacher’s seat to the latest foibles of Lindsay Lohan or Britney Spears and then we wonder why gas is four bucks a gallon. We care as much as we always have – we just care about the wrong things: entertainment, as opposed to informed choices; trivia vs. hardcore ideological debate.

It’s Sunday afternoon at the Coliseum folks, and all good fun, but the hordes are crossing the Alps and headed for modern day Rome – better educated, harder working, and willing to sacrifice today for a better tomorrow. Can it be any wonder that an estimated 1% of America’s wealth migrates into foreign hands every year? We, as a people, are overweight, poorly educated, overindulged, and imbued with such a sense of self importance on a geopolitical scale, that our allies are dropping like flies. “Yes we can?” Well, if so, then the “we” is the critical element, not the leader that will be chosen in November. Let’s get off the couch and shape up – physically, intellectually, and institutionally – and begin to make some informed choices about our future. Lincoln didn’t say it, but might have agreed, that the worst part about being fooled is fooling yourself, and as a nation, we’ve been doing a pretty good job of that for a long time now.

I’ll tell you another area where we’ve been foolin’ ourselves and that’s the belief that inflation is under control. I laid out the case three years ago in an Investment Outlook titled, “Haute Con Job.” I wasn’t an inflationary Paul Revere or anything, but I joined others in arguing that our CPI numbers were not reflecting reality at the checkout counter. In the ensuing four years, the debate has been joined by the press and astute authors such as Kevin Phillips whose recent Bad Money is as good a summer read detailing the state of the economy and how we got here as an “informed” American could make.

Let me reacquaint you with the debate about the authenticity of U.S. inflation calculations by presenting two ten-year graphs – one showing the ups and downs of year-over-year price changes for 24 representative foreign countries, and the other, the same time period for the U.S. An observer’s immediate take is that there are glaring differences, first in terms of trend and second in the actual mean or average of the 2 calculations. These representative countries, chosen and graphed by Ed Hyman and ISI, have averaged nearly 7% inflation for the past decade, while the U.S. has measured 2.6%. The most recent 12 months produces that same 7% number for the world but a closer 4% in the U.S.

This, dear reader, looks a mite suspicious. Sure, inflation was legitimately much higher in selected hot spots such as Brazil and Vietnam in the late 90s and the U.S. productivity “miracle” may have helped reduce ours a touch compared to some of the rest, but the U.S. dollar over the same period has declined by 30% against a currency basket of its major competitors which should have had an opposite effect, everything else being equal. I ask you: does it make sense that we have a 3% – 4% lower rate of inflation than the rest of the world? Can economists really explain this with their contorted Phillips curve, output gap, multifactor productivity theorizing in an increasingly globalized “one price fits all” commodity driven global economy? I suspect not. Somebody’s been foolin’, perhaps foolin’ themselves – I don’t know. This isn’t a conspiracy blog and there are too many statisticians and analysts at the Bureau of Labor Statistics (BLS) and Treasury with rapid turnover to even think of it. I’m just concerned that some of the people are being fooled all of the time and that as an investor, an accurate measure of inflation makes a huge difference.
The U.S. seems to differ from the rest of the world in how it computes its inflation rate in three primary ways: 1) hedonic quality adjustments, 2) calculations of housing costs via owners’ equivalent rent, and 3) geometric weighting/product substitution. The changes in all three areas have favored lower U.S. inflation and have taken place over the past 25 years, the first occurring in 1983 with the BLS decision to modify the cost of housing. It was claimed that a measure based on what an owner might get for renting his house would more accurately reflect the real world – a dubious assumption belied by the experience of the past 10 years during which the average cost of homes has appreciated at 3x the annual pace of the substituted owners’ equivalent rent (OER), and which would have raised the total CPI by approximately 1% annually if the switch had not been made.

In the 1990s the U.S. CPI was subjected to three additional changes that have not been adopted to the same degree (or at all) by other countries, each of which resulted in downward adjustments to our annual inflation rate. Product substitution and geometric weighting both presumed that more expensive goods and services would be used less and substituted with their less costly alternatives: more hamburger/less filet mignon when beef prices were rising, for example. In turn, hedonic quality adjustments accelerated in the late 1990s paving the way for huge price declines in the cost of computers and other durables. As your new model MAC or PC was going up in price by a hundred bucks or so, it was actually going down according to CPI calculations because it was twice as powerful. Hmmmmm? Bet your wallet didn’t really feel as good as the BLS did.

In 2004, I claimed that these revised methodologies were understating CPI by perhaps 1% annually and therefore overstating real GDP growth by close to the same amount. Others have actually tracked the CPI that “would have been” based on the good old fashioned way of calculation. The results are not pretty, but are undisclosed here because I cannot verify them. Still, the differences in my 10-year history of global CPI charts are startling, aren’t they? This in spite of a decade of financed-based, securitized, reflationary policies in the U.S. led by the public and private sector and a declining dollar. Hmmmmm?

In addition, Fed policy has for years focused on “core” as opposed to “headline” inflation, a concept actually initiated during the Nixon Administration to offset the sudden impact of OPEC and $12 a barrel oil prices! For a few decades the logic of inflation’s mean reversion drew a fairly tight fit between the two measures, but now in a chart shared frequently with PIMCO’s Investment Committee by Mohamed El-Erian, the divergence is beginning to raise questions as to whether “headline” will ever drop below “core” for a sufficiently long period of time to rebalance the two. Global commodity depletion and a tightening of excess labor as argued in El-Erian’s recent Secular Outlook summary suggest otherwise.

The correct measure of inflation matters in a number of areas, not the least of which are social security payments and wage bargaining adjustments. There is no doubt that an artificially low number favors government and corporations as opposed to ordinary citizens. But the number is also critical in any estimation of bond yields, stock prices, and commercial real estate cap rates. If core inflation were really 3% instead of 2%, then nominal bond yields might logically be 1% higher than they are today, because bond investors would require more compensation. And although the Gordon model for the valuation of stocks and real estate would stress “real” as opposed to nominal inflation additive yields, today’s acceptance of an artificially low CPI in the calculation of nominal bond yields in effect means that real yields – including TIPS – are 1% lower than believed. If real yields move higher to compensate, with a constant equity risk premium, then U.S. P/E ratios would move lower. A readjustment of investor mentality in the valuation of all three of these investment categories – bonds, stocks, and real estate – would mean a downward adjustment of price of maybe 5% in bonds and perhaps 10% or more in U.S. stocks and commercial real estate.

A skeptic would wonder whether the U.S. asset-based economy can afford an appropriate repricing or the BLS was ever willing to entertain serious argument on the validity of CPI changes that differed from the rest of the world during the heyday of market-based capitalism beginning in the early 1980s. It perhaps was better to be “entertained” with the notion of artificially low inflation than to be seriously “informed.” But just as many in the global economy are refusing to mimic the American-style fixation with superficialities in favor of hard work and legitimate disclosure, investors might suddenly awake to the notion that U.S. inflation should be and in fact is closer to worldwide levels than previously thought. Foreign holders of trillions of dollars of U.S. assets are increasingly becoming price makers not price takers and in this case the price may not be right. Hmmmmm?

What are the investment ramifications? With global headline inflation now at 7% there is a need for new global investment solutions, a role that PIMCO is more than willing (and able) to provide. In this role we would suggest: 1) Treasury bonds are obviously not to be favored because of their negative (unreal) real yields. 2) U.S. TIPS, while affording headline CPI protection, risk the delusion of an artificially low inflation number as well. 3) On the other hand, commodity-based assets as well as foreign equities whose P/Es are better grounded with local CPI and nominal bond yield comparisons should be excellent candidates. 4) These assets should in turn be denominated in currencies that demonstrate authentic real growth and inflation rates, that while high, at least are credible. 5) Developing, BRIC-like economies are obvious choices for investment dollars.

Investment success depends on an ability to anticipate the herd, ride with it for a substantial period of time, and then begin to reorient portfolios for a changing world. Today’s world, including its inflation rate, is changing. Being fooled some of the time is no sin, but being fooled all of the time is intolerable. Join me in lobbying for change in U.S. leadership, the attitude of its citizenry, and (to the point of this Outlook) the market’s assumption of low relative U.S. inflation in comparison to our global competitors.

Euroland’s Real Estate and its Importance for the Euroland Economy / Pimco

Matthieu Louanges from Pimco is doing a good job of describing the Eurozone housing market and that there are regions California & Florida would be proud of....... The biggest "froth" is for sure in the UK housing market.

Matthieu Louanges von Pimco gelingt hier wie ich finde eine gute Zusammenfassung des Immobilienmarktes in der Eurozone. Und in der Tat befinden sich einige Länder und Regionen auf Augenhöhe mit Kalifornien & Co....... Für mich der mit Abstand verrückteste Markt ist jedoch nach wie vor der UK Immobilienmarkt.

The bubbles that exist now in housing are in more than two dozen countries.” Alan Greenspan, 2 October 2007

> That´s from the man who once said it is impossible to identify bubbles and especially the US housing bubble and saw a deflation threat with credit growth easy in the double digits....... And that is the same guy that for example, just a year ago, cautiously opined that the “worst [of the housing downturn] may well be over.” Please shut up! Here is what the Case/Shiller futures are predicting for 2011 and the latest news isn´t helping either Foreclosure Filings Soar in 3rd Quarter .......

> Und das vom Mann der noch vor einigen Jahren behauptet hat das es unmöglich ist zu erkennen ob es sich um Blasen handelt. Insbesondere hat er das ganze in den USA nicht kommen sehen. Zudem hat er den Boden für dioe Immobilienkrise für den Herbst 2006 vorhergesagt. Hier ein Blick auf die Housing Futures für das Jahr 2011.Die letzten Meldungen von der Zwangsvollstreckungsfront dürften auch nicht gerade hilfreich sein .... Dafür hat er trotz einem Kreditwachstum was sich bereits im zweistelligen Bereich bewegt hat eine akute Deflationsgefahr erkannt. Das Ende der Geschichte ist bekannt. Schimanski würde wohl sagen "Halt´s Maul!".... :-)

Euroland’s Real Estate and its Importance for the Euroland Economy and ECB Policy

The crisis in the U.S. housing market will – in the view of PIMCO – dominate Fed policy over the next years, and signs for this are already evident. The real estate slowdown has impacted U.S. GDP reports via the negative contribution from the construction sector and we expect that consumption will not escape some significant correction going forward. Will Euroland’s housing market and economy face a similar fate?

Euroland Chasing U.S. Property Prices
More recently, worries about housing markets in other parts of the world have surfaced and with it the fear that the housing slowdown might become a more global phenomenon. The Financial Times of 29 September reported on its front page that “Holiday homes face price fall threat,” stressing the ongoing weakness in the Spanish housing market. As I am French, I am also well placed to report that the doubling of the property prices in France over the last eight years or so has undoubtedly supported consumers’ confidence and their ultimate consumption. I myself enjoyed the wealth effect to some extent (though I don’t own much!) and certainly feel a bit less comfortable now that prices seem to have plateaued and that some house price deflation might seem as unavoidable in my nice city of Les Sables d’Olonne on the French Atlantic coast as in some parts of the United States.

In fact, the real house price appreciation trend in Euroland over the last years has kept up with the U.S. (Chart 1).

How important is and has the real estate market been for the Euroland economy in the last years? Are there signs of weakness yet in the housing market? And, finally, what impact can we expect on consumption and the overall economy, credit growth and European Central Bank (ECB) policy? These are the questions we will address in this piece.

Residential Investment’s Limited Impact
There are different ways through which the real estate market can impact the economy. The obvious one is by looking at the contribution of the construction sector to GDP growth measured by the share of residential investment in GDP as shown in Chart 2. Spain has clearly been benefiting from the boom in the construction sector. The contribution to GDP growth from that part of the economy has been about 1% per year since 1999

In fact, the housing boom in Spain presents some similarities with the post-unification era in Germany, as well as with the most recent developments in the U.S. The share of the construction sector in the Spanish GDP is now higher than it was in Germany at the end of the post-unification real estate boom and much higher than it was at the peak of the U.S. housing cycle in 2005. The impact is less pronounced in other countries.

Looking at France, the contribution of the construction sector to GDP growth has been about 0.2% in the last years while, in Germany, it has even been negative until 2004. Since then, residential investment has stopped being a drag to German GDP growth, which in itself can be seen as a positive.

Transactions and Wealth Effect Drive Consumption
Another way of looking at the importance of the real estate market, particularly housing, is through the consumption effect, which consists of two factors: the number of transactions and the wealth effect. When people buy apartments or houses, they tend to buy more furniture, TVs, etc: This is the transactions effect. When people see the prices of their homes go up, they feel wealthier, have better credit scores and tend to consume more: This is the wealth effect.

From the late 1990s until 2004, both the number of transactions and prices – as shown in Chart 3 – accelerated, especially in France and Spain.

The wealth effect is particularly evident in Chart 4. When we look at 2003 consumption growth in a large group of countries worldwide and regress the growth rate with the level of house price appreciation, we see a strong correlation. Germany and Japan, for example, had no price appreciation and no real consumption growth. On the other hand, Spain and France had strong price appreciation and stronger consumption.

So far, we have seen in this installment of the European Perspectives that since the beginning of this century the share of residential investment has increased in Euroland, particularly in Spain, and that price appreciation in Euroland supported consumption, especially in Spain and France. What we haven’t considered yet is that the boom in housing resulted also in an acceleration of credit growth for home purchases (Chart 5).
We know the ingredients from the finance side that fueled credit growth and thus the housing markets in Europe: low interest rates in the European Monetary Union (EMU) (thanks to the convergence of the national bond curves down to the German yields), innovation in the mortgage markets (with the creation, for example, of new 50-year mortgages) and the exporting of the UK housing bubble into other European regions (through the surge in demand for holiday homes).
We would add that the real estate market tends to act on momentum with increasing prices boosting the demand for real estate as those who are planning a purchase tend to accelerate their decision and as increasing prices make a real estate investment look more attractive for the cohort of pro-cyclical minded investors. On the flip-side, housing slowdowns tend to take a long time to reverse, and this is why the current signs of weakness are particularly alarming.

First Signs of Weakness in Euroland Housing
Currently, there are at least three signs of a weakening in the Euroland housing market: Price appreciation is slowing while mortgage growth and housing permits are indicating a sharp correction in construction activity in the coming months.

Price growth has been slowing for about a year. In France and Spain, the slowdown in price appreciation is remarkable (Chart 3). In fact, the last numbers released by FNAIM (the French federation of real estate agents) indicate some deflation in the French housing market in the last months, with a decline in the prices of apartments of 1.7% over the quarter to September 2007. After multiple rate hikes by the ECB, higher mortgage rates are starting to impact borrowers. In addition, prices have reached levels that made it increasingly difficult for people earning non-investment bank salaries to purchase anything in cities like Paris or Barcelona (the average price per square meter in the centre of Paris is now exceeding 7,000 euros).

Moreover, mortgage growth, as measured by the loans made to households for property purchases, has slowed remarkably since the middle of 2006 (as shown in Chart 5) under the influence of higher mortgage rates, lower affordability and probably a less favorable outlook for housing. What is similarly remarkable – and supports our previous intuition that housing and consumption are well linked – is that consumer credit growth declined simultaneously (Chart 5). The growth rate of credit to households has been slowing overall, which might indicate some weakness to come in Euroland consumption.

This is, of course, an important consideration for the ECB. This development should make the central bank less worried about the pace of credit growth than before, even though broad-based monetary growth remains quite strong due to other factors like the attractiveness of monetary assets in the context of a flat yield curve.

> Too bad that the ECB didn´t care on the escalating way up........

> Nur dumm das die EZB auf dem Weg als die Sache jahrelang eskaliert ist tatenlos zugesehen hat.....

Housing permits in Euroland are now slumping in line with the bearish developments described above. This is particularly the case in Spain, where the number of housing permits is falling by an annualized rate of about 40% (Chart 6). But permits are also falling at the entire euro area level, as the composite shows.

In addition, anecdotal evidence suggests a decline in the number of transactions in countries like Spain and France, but unfortunately, there appears to be no hard data depicting these series (if anybody knows of such a data series, please let me know!).

When summing it up, the story sounds very much like in the U.S. at first sight: Prices are not rising anymore or are even falling, mortgage growth is declining and housing permits indicate a stronger slowdown to come in the contribution of residential investments to GDP growth. However, a Euroland-wide price depreciation does not appear to be a reasonable scenario given the differences between the countries in the euro zone.

Slowing GDP and Credit Growth
The development outlined above suggest that euro area GDP will most likely suffer from negative impacts through construction sector growth as well as deteriorating consumption outlooks in the countries that had enjoyed housing booms. Spain appears particularly at risk, with a GDP growth rate that could fall from a 3.5% pace to 2.5% if the construction sector would stabilize and everything else remained equal (which would not be the case given the negative externalities in terms of consumption as previously noted). France is also at risk but the consumption effect will dominate, based on a decline in the number of transactions, as well as stabilizing, if not falling, prices. From an average of 2.4% household consumption growth per annum, consumption in France has already dropped to a level of 1.7%. However, the countries most affected by the housing and construction slowdown only contribute about 35% to euro area GDP, thus mitigating the impact on the euro zone average. Still, even countries like Germany are experiencing a slowdown in construction, as illustrated by the decline in housing permits.

The good news for the ECB should be the decelerating growth rate in credit to households. Interestingly, in the September ECB press conference, Jean-Claude Trichet spent a long time explaining that several factors are causing broad money growth to rise. He particularly mentioned the flattening of the yield curve, which has increased the attractiveness of monetary assets relative to less liquid, longer-maturity instruments (which should not be too worrisome for the ECB) and the growth of loans to non-financial companies. The recent re-pricing of risks in the credit markets and the ongoing liquidity crisis in Euroland might make these contributions to monetary growth particularly vulnerable in the next months. This should please the ECB.

To sum it up, Euroland enjoyed strong real estate markets over the last years with some similarities to the U.S. when it comes to price appreciation or the contribution of residential investment to GDP growth in some countries. Euroland is now suffering from a significant slowdown in housing, which is most likely going to impact consumption negatively and slow down credit growth to households. In fact, some of these effects are already visible and contributed to the recent downward revisions of GDP growth forecasts for 2008 by most market participants. Ultimately, the housing market developments in Euroland support the case for an ECB on hold for now.

> In the meantime the cpi is climbing to levels we havn´t seen since the ECB is in charge and is sharply higher than their official 2% percent target.... Thank god they are vigilant..... No wonder more and more peoople are daydreamimg how the Bundesbank have handled this mess

> In der Zwischenzeit bewegt sich die Konsumentenpreisinflation auf Höhen die wir seitdem die EZB das Ruder übernommen hat nicht gesehen haben...Zum Glück wird ja täglich betont das sie sehr wachsam sind.......Es wundert mich nicht das sich immer mehr Leute fragen wie eine unabhängige Bundesbank diese Situation gehandhabt hätte.

The Coming Storm / Pimco on UK

After Ben Bernanke and the Fed have saved the US it is time to move to the UK (sarcasm off)....Myles Bradshaw from Pimco has an excellent take on the UK. He is very bullish on UK gilts. The conclusion is that he is not very optimistic on the UK economy. Key to his outlook is that the housing market has some very tough times ahead...... If you want to read about my view on the UK (including housing, commercial real estate, BOE, Northern Rock, pound etc ) click here . If Pimco is bullish on bonds i would be the super bull....... ;-)

Nachdem Bernanke und die Fed die Krise in den USA ja gestern anscheinend beendet haben ist es Zeit sich mehr denn je dem nächsten Patienten zuzuwenden.....(Sarkasmus) Myles Bradshaw von Pimco hat hier eine gute Übersicht über das momentane Bild in UK zusammengezimmert. Er ist ziemlich bullish was UK Staatsanleihen angeht. Kann nur bedeuten das er für die Wirtschaft eher pessimistisch ist. Dreh und Angelpunkt seiner Analyse ist der britische Immobilienmarkt der weltweit seinesgleichen sucht. Um meine bisherigen Meinungen zu UK (private und gewerbliche Immobilien, Northern Rock, Boe, Pfund etc) klickt bitte hier. Wenn man Pimco als Anleihebullen bezeichnet dürfte ich als der Superbulle durchgehen....... :-)

The Coming Storm / Myles Bradshaw
....Looking forward, monetary policy will tighten for consumers even if the Bank of England’s Monetary Policy Committee (MPC) leaves rates unchanged. Firstly, mortgage rates are set to rise as consumers refinance out of their 2005 2-year fixed-rate deals. Secondly, consumers will be hit by a widening in mortgage spreads as banks pass on the higher funding costs from the recent crisis in wholesale money markets. Unfortunately, this will all occur at a time when income growth is weak and debt-servicing costs are at the highest levels since the last recession.

The party is over

Mortgage Rates on the Rise
According to the Council of Mortgage Lenders (CML) data, fixed-rate mortgage lending doubled to an estimated £230 billion in the four quarters from July 2005 as households took advantage of the August 2005 rate cut to lock in low mortgage costs. At the end of 2006, fixed-rate mortgages accounted for about 45% of the £1 trillion stock of outstanding mortgages, up from 25% in 2003. This locking in of low mortgage rates has lengthened the time it takes for MPC interest-rate increases to affect the consumer. By May 2007, base rates had increased by 100bp but the effective mortgage rate had only risen by 37bp.

The next twelve months will probably see most of these fixed-rate deals mature and interest rates for a majority of households rise. CML data already shows that 2-year, 75% Loan-to-Value (LTV) mortgage rates averaged 4.67% in July 2005 compared to 6.1% in July 2007. The inverted shape of the yield curve means there is little incentive to switch into a floating-rate mortgage now; the average CML base rate tracker rate was 6.27% in July.
But fixed-mortgage rates will probably rise further still, irrespective of whether the MPC raises rates again. Fixed-rate mortgages tend to track wholesale interest rates in the bond market with a lag of two to three months. The mortgage rate presented to the consumer in July has usually been fixed in the bond market by the mortgage lender in April or May. Since April, 2-year sterling swap rates have increased by about 40bp. Households may be able to achieve lower interest rates by paying higher arrangement fees to mortgage lenders or by signing up to discount mortgages that penalize the borrower with lock-ins after the discounts expire. But the bottom line is that come October, 2-year fixed-rate deals could be some 175bp higher than they were two years ago; slightly more than the increase in base rates over that period. Monetary policy is not impotent; it is just taking longer to work.

Changed Conditions for Mortgage Lenders
But this is only half the story. Over the past few years, competition in the mortgage market has driven down the spread between consumer mortgage rates and wholesale interest rates – which indicate mortgage lenders’ funding costs – to unsustainable levels. Chart 2 shows how fixed-rate mortgages tend to track wholesale rates, and how mortgage spreads have narrowed sharply over the past two years. These spreads are now set to widen.
Firstly, the sharp rise in LIBOR rates that occurred in August will increase mortgage lenders’ funding costs. The recent change in credit investors’ risk appetite in the current market turbulence means that banks’ balance sheets have been saddled with large amounts of loans from private equity leveraged buy-outs and lines of contingent credit that have been called. The recent stress in global money market rates – where overnight Sterling rates rose by as much as 70bp to a high of 6.5% – reflects banks’ increased need for cash to finance these unexpected new loans. Overnight rates have now settled down, partly due to large liquidity injections by the U.S. Fed and the European Central Bank (ECB), but one- to six-month money market rates have not. Three-month Sterling LIBOR rates rose over 60bp in August, despite the fact that interest rate expectations fell. While LIBOR rates may fall over the coming weeks, they are unlikely to quickly return to July levels unless central banks cut rates. The net result is that monetary policy has been effectively tightened over August despite the MPC leaving rates unchanged. Secondly, the growth of the residential mortgage-backed securitisation (RMBS) market has enabled many mortgage lenders to sell repackaged mortgages to investors. This has reduced lenders’ exposure to borrowers’ credit risk and encouraged business models that focus on high volumes and low margins. But investors’ appetite for asset-backed securities like RMBS has been dampened by the recent turmoil in credit markets. More importantly, the cost of securitising these assets has increased (see Chart 3). The spreads over LIBOR on U.K. residential mortgage-backed securities have gone back to early 2004 levels, when fixed-rate mortgage spreads were about 0.3% higher. Many mortgage lenders will come under pressure to raise margins and reduce volumes. This does not bode well for the consumer.
Higher Income Share for Debt Servicing
But it is not just the spread on mortgage rates that has fallen over the past few years. Lending standards have also declined due to the easing in credit availability. As a result, homebuyers have been able to borrow more money relative to their income while debt-servicing costs are now taking a larger share of consumers’ income. The CML data show that average Loan-to-Income ratios have increased to 3.16x in June, up from 2.4x in 2000. Higher deposits have kept LTV ratios pretty stable at around 80%, so mortgage lenders should be protected if house prices weaken. But increased debt levels have now driven debt-servicing costs as a share of income markedly higher. According to the CML, mortgage interest payments accounted for 17.7% of the average borrower’s income in June, up from 15.4% twelve months ago. This is the highest level since 1992, in spite of the fact that interest rates are about 40% lower than in 1992. Factor in repayment of principal, and debt-servicing costs are within spitting distance of the 1990 high. Chart 4 shows Citigroup’s estimate of total (rather than just mortgages) household debt service relative to disposable income. ...

Lower Retail Sales Looming
On top of this, leading indicators of the housing market have already started to roll over, despite the modest rises in effective mortgage rates to date. The recent Royal Institute of Chartered Surveyors (RICS) survey showed that surveyors’ price expectations fell sharply to the lowest level since summer 2005. Housing activity has been highly correlated with consumption.....The RICS measure of new home buying enquiries has been a great leading indicator of housing activity. It tends to lead mortgage approvals by about three months, which, in turn, lead retail sales by about five months. The RICS measure has fallen sharply since the middle of last year and is only just above the lows of 2005, which preceded a collapse in retail sales growth and led to a surprise interest rate cut in August 2005.

The effects of the rate hikes will start to show over the coming months. Consumers will see higher interest rates as fixed-rate mortgages roll off and as mortgage spreads widen. Tepid income growth and debt-servicing costs near record highs mean consumers have little to cushion them against higher interest rates. Facing this storm, the U.K. economy is likely to slow down and grow below trend.

U.S. Credit Perspectives / PIMCO

It is always good to hear what one of the biggest players is doing in such critical times. And i have to admit that since i followed the reports they have a really good track record. So i find it interesting to hear that PIMCO is now warming up to the secondary bank loan market ( probably like this one )and that they are still largely avoiding bonds from financials. Click on the headline to read the entire report.

Es kann nicht schaden wenn man zu hören bekommt was einer der größten Spieler im Kredit und Anleihemarkt zu sagen hat. Das gilt besonders dann wenn man wie Pimco in den letzten Jahren ziemlich ein extrem guten Track Record vorweisen kann. Besonders hervorzuheben ist hier das PIMCO wohl sein Engagement im sog. " Secondary Bank Loan Market" ausbauen will ( dieses hier könnte ein gutes Beipsiel sein ) und das Bonds von Finanzunternehmen noch immer extreme Risiken bergen. Klickt bitte auf die Überschrift um den kompletten report zu lesen.



To summarize, our firm’s view was that rising global liquidity was stimulating an aggressive search for yield which, when combined with rapid innovation in the structured credit markets, was leading to excesses that dislodged the fundamental link between the prices of assets and their underlying values in the corporate bond market. We noticed another discouraging trend as a growing number of private equity deals and aggressive corporate managers were piling more debt on balance sheets through leveraged buyouts (LBOs) and increasing shareholder-friendly initiatives such as share buybacks. Finally, the lack of covenant protection and the tight level of credit spreads (Chart 1) relative to history led us to under-weight investment-grade credit risk, and favor other asset classes where we felt returns would be higher and risks lower.

....The second bottom-up opportunity where PIMCO has benefited thanks to significant credit analysis from both our corporate and mortgage team has been our belief that the U.S. housing market would surprise on the downside. We have written extensively on our housing views and our positioning across PIMCO portfolios remains under-weight housing, sub-prime and cyclical credit risks. Rising inventories, tightening lending standards, and significant sub-prime and prime adjustable-rate mortgage (ARM) resets were an early warning sign that prompted us to reduce housing and sub-prime mortgage exposure. Not surprisingly, the relationship between home prices and mortgage rates has changed amid falling prices and tightening credit conditions. The real mortgage rate (Chart 4), or the difference between the current 30-year mortgage rate and the year-over-year change in housing prices, has been rising sharply. Investors who moved into these asset classes without thoroughly analyzing risks are now clearly wishing they had done more bottom-up credit work. Fortunately, PIMCO’s bottom-up investment process prompted us to pro-actively steer our clients away from these risks.

Knowing when to avoid risk and play it conservatively, as in golf, is just as important as knowing when to take risk. At PIMCO, we saw opportunity in the energy sector and risk in the housing and homebuilder sector that markets were not priced to reflect. Fortunately for our clients with credit exposure, these bottom-up decisions have paid off as energy sharply outperformed homebuilders (Chart 5). In golf terms, our corporate bond, mortgage and credit teams have just hit a 3-wood 250 yards right on the green
Our current strategy will be to move a portion of our high-quality investments into more credit risk as opportunities present themselves. One opportunity may be in the bank loan market, which has re-priced significantly, and specifically in the credit default swap market which references bank loans. The loan credit default swap index (LCDX), which references a diversified basket of bank loan credit default swaps (LCDS), has gone from initial spreads of LIBOR+120 to over LIBOR+350 in roughly two months. This has caused the relationship of the spread on the high yield credit default swap index (HY CDX), which references a diversified portfolio of high yield CDS, and LCDX to change dramatically (Chart 6).

Banks hedging bridge loan commitments have likely influenced the move wider in LCDX and its recent underperformance versus HY CDX. Given the significant forward calendar of new issuance lined up to come to market, it is not surprising recent covenant-lite bonds and loans have come under pressure. Despite these near-term negative technical factors, our initial analysis of the putting green suggests bank loans, and specifically LCDX, have cheapened considerably.

Tightening credit conditions have also raised significant uncertainty about whether or not announced LBOs will get funded. Higher financing costs, due to tighter credit conditions and widening credit spreads, should reduce the momentum of future deals. The institutional forward loan calendar has grown significantly (Chart 7) and, as a result, the stock market could face increasing headwinds, with less aggressive private equity support and higher financing costs on future deals. In the bond market, tighter credit conditions, more robust covenant protection, and wider credit spreads are leading to opportunities for our clients. A recent bank loan deal with a spread of LIBOR+400 priced recently at a significant discount. This type of pricing is now giving us the opportunity to potentially earn significant returns on senior secured bank loans over the next several years.
PIMCO will seek to capitalize on selective opportunities in the new issue and secondary bank loan market now that terms are becoming more favorable for bondholders. Bank loans historically recover around 75% in the event of default due to senior positioning in the capital structure. Credit fundamentals remain healthy for a lot of companies, and bank loans are currently experiencing less than 1% default rates (Chart 8). What’s the big picture? At current spreads of roughly LIBOR+400, a diversified portfolio of bank loans would have to default at near 16%, assuming a 75% recovery rate, for an investor to break-even versus LIBOR. While bank loan defaults rose to 8% in 2000, a rise from the current level below 1% to anything remotely approaching 16% is highly unlikely. Clearly, technicals, not fundamentals, are driving spreads in the bank loan market.
Within the credit markets, another area of potential opportunity is in financials, which have sharply underperformed recently, with both banks and broker spreads (Chart 9) moving to levels not seen in over five years. Uncertainty surrounding sub-prime, housing and bridge loan exposure has changed the outlook for the financial sector.

While widening spreads in bank debt, bank capital securities and brokerage paper could represent opportunities, we are being highly selective in our bottom-up credit process to ensure we avoid unnecessary risks.

Enough is Enough / PIMCO´s Bill Gross

On top of his monthly comment is here a link via Marketwatch Bond guru sees possible 5%-10% drop in stocks. Click on the headline to read the entire piece with some thoughts on the "rich getting richer".

Zusätzlich zu dem monatlichen Kommentar von Gross hier noch ein weiterer Link via Marketwatch Bond guru sees possible 5%-10% drop in stocks. Klickt bitte auf die Überschrift um zusätzlich noch die Meinung zu den Reichen die immer reicher werden.

Several hundred billion dollars of bank loans and high yield debt wait in the wings to take out the private equity and leveraged buyout deals that have helped propel stocks to Dow 14,000. And lenders…mmmmm, how do we say this…don’t seem to have much of an appetite anymore. Six weeks ago the high yield debt market was humming the Campbell’s soup theme and now, it’s begging for a truckload of Rolaids. Yields have risen by 100 to 150 basis points in response as shown in the Chart

Some wonder what squelched the hunger of potential lenders so abruptly, while in the same breath suggesting that the subprime crisis is "isolated" and not contagious to other markets or even the overall economy. Not so, and the sudden liquidity crisis in the high yield debt market is just the latest sign that there is a connection, a chain that links all markets and ultimately their prices and yields to the fate of the U.S. economy. The fact is that several weeks ago, Moody’s and Standard & Poor’s finally got it into gear, downgrading hundreds of subprime issues and threatening more to come. "Isolationists" would wonder what that has to do with the corporate debt market. Housing is faring badly but corporate profits are in their prime and at record levels as a percentage of GDP. Lenders to corporations should not be affected by defaults in subprime housing space, they claim. Unfortunately that does not appear to be the case.

Thanks to Minyanville

As Tim Bond of Barclays Capital put it so well a few weeks ago, "it is the excess leverage of the lenders not the borrowers which is the source of systemic problems." Low policy rates in many countries and narrow credit spreads have encouraged levered structures bought in the hundreds of millions by lenders, in an effort to maximize returns with what they thought were relatively riskless loans. Those were the ABS CDOs, CLOs, and levered CDO structures that the rating services assigned investment grade ratings to, which then were sold with enticing LIBOR + 100, 200, 300 or more types of yields. The bloom came off the rose and the worm started to turn, however, when institutional investors – many of them foreign – began to see the ratings downgrades in ABS subprime space. Could the same thing happen to levered structures with pure corporate credit backing? To be blunt, they seem to be thinking that if Moody’s and Standard & Poor’s have done such a lousy job of rating subprime structures, how can the market have confidence that they’re not repeating the same structural, formulaic, mistake with CLOs and CDOs? That growing lack of confidence – more so than the defaults of two Bear Stearns hedge funds and the threat of more to come – has frozen future lending and backed up the market for high yield new issues such that it resembles a constipated owl: absolutely nothing is moving.

.... Covenant-lite deals and low yields were accepted by money managers as if they were prisoners in an isolation ward looking forward to their daily gruel passed unemotionally three times a day through the cellblock window. "Here, take this" their investment banker jailers seemed to say, "and be glad that you’ve got at least something to eat!"

Well the caloric content of the gruel in recent years has been barely life supporting and unhealthy to boot – sprinkled with calls and PIKS and options that allowed borrowers to lever and transfer assets at will. As for the calories, high yield spreads dropped to the point of Treasuries + 250 basis points or LIBOR + 200. Readers can sense the severity of the diet relative to risk by simply researching historical annual high yield default rates (5%), multiplying that by loss of principal in bankruptcy (60%), and coming up with an expected loss of 3% over the life of future loans. At LIBOR + 250 in other words, high yield lenders were giving away money!

>Looks like Homer has also entered the bond and credit market.... :-)

>Sieht ganz so aus als wenn Homer auch den Anleihe und Krdeitmarkt geentert hat... :-)

Over the past few weeks much of that has changed. The mistrust of rating service ratings, the constipation of the new issue market and the liquidity to hedge the obvious in CDX markets has led to current high yield CDX spreads of 400 basis points or more and bank loan spreads of nearly 300. The market in the U.S. seems to be looking towards this week’s large and significant placing/pricing of the Chrysler Finance and Chrysler auto deals to determine what the new level for debt should be. In the U.K., a similarly large deal for BOOTS promises to be the bell cow for European buyers. But the tide appears to be going out for levered equity financiers and in for the passive owl money managers of the debt market. And because it has been a Nova Scotia tide, rising in increments of ten in a matter of hours, it promises to have severe ramifications for those caught in its wake. No longer will double-digit LBO returns be supported by cheap financing and shameless covenants. No longer therefore will stocks be supported so effortlessly by the double-barreled impact of LBOs and company buybacks. The U.S. economy in turn will not benefit from this tidal shift and increasing cost of financing. The Fed tightens credit by raising short-term rates but rarely, if ever, have they raised yields by 150 basis points in a month and a half’s time as has occurred in the high yield market. ...

something smells fishy / Pimco on the employment data

nothing new to readers of the blogging world. it is very telling when one of the most important statistics is almost useless....remember this when you hear the "experts" yelling on cnbc etc after the number from friday......one can expect a mega revision downward in august......if you want more on this topc surf the labels with lots of frustrating details on how flawed the data is......

dürfte für leser der blogs nichts neues sein. es ist aber bezeichnend wenn eine der wichtigsten erhebungen komplett nutzlos ist....immer wieder lustig wenn man mit diesem wissen die "experten" auf allen kanälen zu sehen bekommt....erneut an diesem freitag zu bewundern..... es ist jetzt schon klar das die nächste revision eine echte hausnummer gen süden sein wird ..wenn ihr mehr details zur erhebung wissen möchtet bitte unter den labels stöbern..

Here at PIMCO, we continue to expect the unemployment rate to go up. Thus, we are still (painfully, since December) long of duration, concentrated in the front end of the yield curve. And why are we still bearish on employment growth?

First and foremost, unemployment is a lagging variable, notably of momentum in discretionary aggregate demand. And discretionary aggregate demand has been unambiguously decelerating in recent quarters, and not just in residential construction, as displayed in the chart below.

The Great Puzzle

So why hasn’t the unemployment rate already risen? It’s the great puzzle, in the words of San Francisco Fed President Janet Yellen. The short answer to the puzzle is that the labor force participation rate has fallen, accounting fully for the drop from 4.7% to 4.5% for the unemployment rate over the last year. But this doesn’t make sense when you look at nonfarm payroll growth, which, again in the words of Ms. Yellen, has been gangbusters.

The labor force participation rate is decidedly pro-cyclical, meaning that it goes up as tight labor markets induce new entrants into the labor market; and it goes down when soggy labor markets lead the discouraged unemployed to drop out of the labor force. So, the short answer to the puzzle is the right answer only if nonfarm payroll growth really ain’t gangbusters.

And new research by both Ray Stone4 of Stone and McCarthy and Sheryl King5 of Merrill Lynch suggest this is indeed the case. Please refer directly to their research for the exhaustive details, but the bottom line is simple. Detailed data in the Bureau of Labor Statistics (BLS) Business Employment Dynamics (BED) release, which comes out with a two-quarter lag, show employment growth of only 19 thousand in 2006Q3, while the nonfarm payroll tally for that quarter was over 450 thousand. More recently, the BLS’s more timely Job Opening and Labor Turnover Survey (JOLTS) for April – last month! – showed job openings rose only 24 thousand, with this series essentially flat since last August. The JOLTS report also showed that new hires in March (this data subset is released with a one month lag) fell 29 thousand.

Something smells more than fishy here. Not that I’m accusing the BLS of any skullduggery. None! Rather, it is a historical fact that nonfarm payrolls – before annual benchmark revisions, which continue for six years! – understate employment early in recoveries (leading to the inevitable contemporaneous label of "jobless recovery"), while they overstate employment late in expansions.

And a key reason is that the BLS, while very good at counting heads at existing firms, must make an assumption, in real time, about the birth-death rate for firms, so as to estimate the net gain/loss in jobs as firms open and close, a never-ending feature of a capitalist economy. In the early years of expansions, the birth assumption systematically is too low and the death assumption is systematically too high, which results in "jobless recoveries," which turn out to be not-so-jobless recoveries upon revision. The exact opposite holds in the late years of expansions and particularly in recessions. Such is the case, it would appear, at present.

Thus, in contrast to last August, when the job tally for the year ending March 2006 was revised up some 800 thousand, a stunningly large revision, the opposite is likely to unfold in this August’s benchmark revision for the year ending March 2007. Not to suggest, I hasten to add, that a downward revision equal to last year’s upward revision is in the cards. The honest answer is that we don’t know how big it will be. But available data, notably the BED and JOLTS data, point squarely to a downward revision.

So what, you say. Economists always bellyache about the quality of the data when they go against their forecasts. This is true. It is also true, however, that poor data can make for poor policy making, if and when the data is taken to be religiously true. This is particularly the case if the data is known to be lagging data of the business cycle, as is the case with the unemployment rate. Acting on the data, or refusing to act because of it, is the stuff of policy mistakes, sometimes known as recessions

as i´ve said before they should hire the "statz crew"..... :-)

PIMCO-Gross "How We Learned to Stop Worrying (so much) and Love “Da Bomb”

good and long ( this is already a summary) piece from pimco. please keep in mind that when you read this "bullish" (except for us asssts....) piece from gross that he is a bond guy. we will see how the outlook will be when we will see "events" like (hedge funds, derivatives, failed lbo´s , popping bubbles in almost every credit market etc) .... we havn´t seen a real stresstest yet.....

guter und langer beitrag von gross. bedenkt bitte bei der lektüre das er die sicht eines anleihemanagers hat. zudem könnte einige der annahmen einem ernsten test unterzogen werden wenn wir wohl nicht zu verhindernde "ereignisse" im kreditmarkt (hedge fonds, derivate, unternehmenspleiten etc) gegenüber stehen. ..den wirklichen stresstest haben wir bisher noch nicht gesehen.....

...For the purpose of this Outlook, “da bomb” is globalization and all of its wondrous benefits – high growth, low inflation, accelerating profits, and benign interest rates. For that matter, you can compile a short list of critical factors that have aided and abetted globalization’s surge during the past decade or so: the information technology revolution, favorable government policies including inflation targeting and lower taxes, a shift to freer low cost markets in China and India, as well as moves towards deregulation and lower trade barriers worldwide. ......


These have been PIMCO secular themes for years now, but somehow after correctly analyzing the evolution of “da bomb” we never stopped worrying about it and how it might end; like Slim Pickens headed for his mushroom cloud destination 20,000 feet below, we were giddy, but subconsciously pretty darn worried. We foresaw rising global growth, but said it would be “moderate” due to a lack of aggregate demand. We spoke to a “stable disequilibrium” which referred to good times now, but maybe bad times on the horizon, and emphasized not the stability but the potential downside arising from trade deficit imbalances, U.S. debt buildup, and resultant financial flows. Those worries were enough to tilt portfolio constructions towards a more U.S. centric housing led slowdown which we hit right on the money, but they steered us away from a more global orientation where the rest of the world continued to experience 5%+ growth rates and to dominate financial market trends. ........

Secular Review
Globalization. Technology. Freer markets/financial innovation. Favorable public policy. These are “da bomb’s” critical components and we could spend paragraphs expounding on the influence of each. ....... accelerating global growth; disinflation; increasing returns on equity capital; and low real interest rates

......Interestingly, each of these trends has a common thread, as do the components of “da bomb”: The ascendance and dominance of capital vs. labor. Add a billion or so potential workers to the global labor force, blend in a technology S curve acceleration, combine these with deregulation, lower taxes, and free trade, and you have a recipe for accelerating returns to capital and diminishing returns to labor. Higher stock prices, lower inflation, declining interest rates and importantly a rather low volatility environment for both economic growth and asset prices have resulted. It’s known as the “great moderation” in economic circles, assisted not insignificantly by what has been called Bretton Woods II, a recirculation of surplus reserves into consuming nations that has promoted growth and lower interest rates – no mean feat in historical context.


What’s New?
Does this virtuous circle favoring capital at the expense of labor continue? We see nothing to stop it absent a global financial bubble popping of sorts, an accelerated decline of U.S. housing in the short run, or a U.S.-led trade policy reversal that could precipitate counter-attacks from Asian exporters. These three are not “black swans” as they say. Asset bubbles are a near inevitable result of attractively financed leverage in search of a limited array of financial assets – and the exuberance that inevitably accompanies them. In turn, if U.S. housing declines soon morph into the consumer sector, the belief in a U.S.-centric global economy will reemerge, and a cyclical argument for slower global growth will accompany it. Anti-trade legislation may or may not become a reality.....


A bigger threat to asset markets however, comes not from slower economic growth in the short-term, but inflationary pressures towards the end of our secular timeframe. Note first of all the increasing influence of non-core food and energy prices in G-7 nations over the past few years as illustrated in Chart 5 for the United States. Since 1967, average differences in headline vs. core inflation have essentially been zero, despite distinct periods of cyclical variation. Now, however, with globalization so dominant and Chinese/Asian appetites for oil, soybeans, and iron ore amongst other commodities so voracious, it’s hard to envision an extended period of lower headline U.S. increases.

thanks to http://www.wallstreetfollies.com/

This may bias more central banks to begin considering headline numbers in their policy decisions like Japan and the ECB do already.

There are other global threats to the disinflationary character of “da bomb.” Chart 6 outlines an increasing trend of import prices from mainland China through Hong Kong and then outward. Admittedly, the appreciation of the Yuan has played a part, but that, I suppose, is the point. As the Yuan inexorably revalues, China’s ability to export deflationary impulses to the rest of the world becomes questionable, especially as it itself experiences internal inflation. China may still be exporting deflation to Asia and Euroland, but it clearly is beginning to export mild inflation to Japan and the U.S. ....


All of this will make interesting discussion points at Central Bank policy meetings for years to come. Over 20 CBs (Central Banks) are officially on the “inflation-targeting” bandwagon with the U.S. a de facto member since the appointment of Ben Bernanke. Yet even if the magic 2% inflation target is agreed on by nearly all G-7 policymakers, and a 3-4% target by many developing nations, once-reliable short-term rate targeting levers may not work as effectively. The abundant liquidity of today’s financial marketplace may be another way of describing the ability of private agents – be they hedge funds, private equity, or simply old-fashioned banks – to create credit on their own given satisfactory reserve levels which are now more than ample.
Unwillingness to employ increased margin requirements by the Fed during the NASDAQ bubble, and near 0% margin downpayments accepted by mortgage bankers during the housing bubble, give evidence to the diminishing influence of CBs and the growing influence of private agents in the credit creation process. ...


Financial Markets
These portents of higher inflation and still strong global growth may seem negative for global bond markets and indeed they are, but cyclical countertrends as evidenced currently in the U.S., Japan, and elsewhere suggest caution in overreaching just yet into bearish secular territory. ..... Following the flows (if you can) has been key in determining G-7 yield trends both short and long-term. Government intermediate and longer curves have been pushed down, and to counter the stimulative effect, short policy rates have been set higher than might otherwise be the case. To illustrate, “10-year real rates” throughout most G-7 curves have been lower in the past few years than they have been over the prior two decades as shown in Chart 7, part of a study done by PIMCO’s Ramin Toloui.

Now, however, a growing number of investors are trying to “be like Yale or Harvard” by moving toward more diversified asset allocations, and that includes the holders of over 50% of outstanding U.S. Treasuries, Chinese and Petrodollar central authorities among them. A day after our Forum’s conclusion, for example, China eased investment restrictions in order to allow its commercial banks to buy stocks abroad. Even without a buyers’ strike or a dramatic reversal of the U.S. current account deficit though, Treasury yields (and other widely held G-7 government issues) will lose some of their caché over the next few years and real yields may rise somewhat. .....

As an additional statement of fact, although without firm conclusion, it is striking that real global growth as shown in Chart 8 is advancing at a 5% potential rate while G-7 countries are mired at levels just above 2%. Low policy and term real rates reflective of this 2% growth are in effect financing global growth at 5% – an unprecedented spread for at least the last several decades. Investment managers and economists are fond of speaking of the Yen carry trade – borrow near 0%, invest much higher – as being the dominant liquidity lever in today’s marketplace. Chart 8 speaks to a broader more significant carry trade which admittedly cannot be efficiently employed due to capital controls and relatively immature capital markets (China, India, etc.). Still McCulley’s demand thesis can only stand in awe at the G-7 real yield/global growth rate gap, where G-7 yields in effect stabilize their own economies but serve to encourage attractive arbitrage opportunities into investments in the BRICs and other developing economies. One wonders if there may be some move towards closure in future years, a move that in turn would increase real yields, lower global growth or both.

Still Renting / PIMCO / Hall of Fame

once more excellent stuff from pimco. mark kiesel was right in the past and it his current outlook seems aslo be spot on.

einmal mehr eine tolly analyse von pimco. mark kiesel war einer der wenigen die in der vergangenheit richtig lagen und ich denke auch seine aktuelle beschreibung trifft ziemlich genau zu.


One question my friends and colleagues have asked me repeatedly over the past six months is: Are you still renting? Yes! I sold my house over a year ago and continue to rent.

Back in late 2005, I became anxious about my investment in the “American Dream,” after spending a considerable amount of time and effort researching several factors that I felt would influence housing prices. At the time, I was nervous about housing and ended up selling my house in early 2006 after owning for eight years, and then, upon closing, published For Sale, our U.S. Credit Perspectives, June 2006 publication. A year ago, I suspected housing prices were set to take a sharp turn for the worse and more “For Sale” signs were coming.

Based on the current outlook for housing, I will likely be renting for one to two more years. While many factors that influence housing prices have turned negative, I suspect we have not yet hit bottom. In fact, housing prices should head lower throughout the rest of this year and next year as well. Why? Housing inventories remain high, delinquencies and foreclosures are set to rise as homes purchased over the past few years by speculators and individuals with teaser-rate and adjustable-rate mortgages come back on to the market, affordability is low, and sentiment and risk appetite has shifted negatively. Most importantly, the availability of credit is set to take a turn for the worse as lenders tighten credit standards.

This is all great news for renters and buyers who are patient. Over time, housing prices and interest rates should decline, resulting in improved affordability. This adjustment, however, will take time and occur over a period of years, not months. Housing is illiquid and prices are sticky. As a result, potential buyers should exercise patience and not jump back into the housing market too early. A year ago, I described the state of the U.S. housing market as “the next NASDAQ bubble.” The NASDAQ took over 2 ½ years to go from peak to trough. I suspect that housing prices could display a similar pattern, and we are still over a year away from the bottom. Given these risks, I prefer renting versus owning, and an investment strategy which favors defense versus offense.

Unwinding the Housing Bubble
Housing was an asset bubble influenced by bullish sentiment, robust risk appetite and speculation, lack of fundamental analysis, cheap money, inflated appraisals and easy lending standards. These factors helped to drive housing prices up to new levels and the unwinding of these conditions is expected to drive housing prices down. Never before have we witnessed so many people lever-up real estate with so little money down or “skin in the game.” This growth in mortgage debt and risk appetite helped fuel consumer spending and corporate profits. As such, the unwinding of this bubble will have broad consequences for the overall economy.

As the housing bubble unwinds, what are the implications for the overall economy and credit spreads? The U.S. economy will likely experience sub-par economic growth for the next year as declining housing prices lead to weaker consumer spending, slower corporate profit growth, a decline in business investment and less job creation. This environment favors reducing credit risk, especially to cyclical industries and lower-quality sectors of the market. As lending standards tighten and risk appetite turns more conservative, housing prices are likely to face a further leg down.

What’s the big picture? Declining housing prices will lead to a pullback in job creation and a sharp slowdown in corporate profit growth, causing the Fed to lower short-term interest rates by the end of this year. Despite lower short-term rates, mortgage rates may not follow downward, because more cautious lenders will charge higher spreads relative to Treasuries. In addition, credit spreads should widen as consumers rein in their risk appetite for housing and investors turn more cautious on the outlook for the U.S. economy. We will now turn to an analysis of the supply and demand factors influencing housing. These factors should help to illuminate the future path of housing prices over the next year.

Inventory
On the supply side, the inventory of new and existing homes available for sale remains near all-time highs (Chart 1). The homebuilder industry helped contribute to today’s record inventories through its bullish sentiment and aggressive land purchases over the past several years. Unfortunately, homebuilders have little incentive to stop building once they have purchased land for development. In hindsight, homebuilders bought too many lots over the past few years, expecting that the run-up in land prices would continue for several more years. Given that undeveloped land is less valuable than developed land, homebuilders went through the process of getting zoning approvals on their land and started the build-out process in order to monetize their investments.

Even when prices appeared to have peaked over a year ago, homebuilders continued to commit to new developments and communities. Meanwhile, even in the face of large discounts and concessions, housing order rates have fallen more precipitously than most expected, resulting in inventories remaining stubbornly high. Undeveloped land cannot be monetized without a completed home. The cost of carry, including completion guarantees, provides strong incentives for builders to keep building. Unfortunately, housing is like a supertanker, which takes time to slow down. In addition, homebuilders have little incentive to stop building when a home is incomplete, even if economic conditions soften. All of these factors help to ensure that once projects are started, they are completed, and also help to explain why homebuilders’ inventories have remained elevated despite aggressive incentives such as –10% to –15% price discounts.

The housing market faces potential new supply from other sources as well. First, a large portion of incremental housing demand over the past several years has come from speculators and investors. With housing prices now falling in most of the markets where speculative activity was strongest, yesterday’s marginal buyer is becoming today’s marginal seller. Not surprisingly, the inventories in highly speculative regions such as Florida, California, Phoenix and Las Vegas, have risen sharply. In some of these over-heated markets, supply represents several years of demand. Not surprisingly, homeowner vacancies are soaring (Chart 2). This trend may even accelerate as recent speculators with low initial equity, and negative future equity, choose to walk away from paying monthly mortgage payments on a losing investment, especially factoring in the cost of 4-5% real estate commissions.

Another source of new supply will likely come from rising delinquencies which will eventually turn into more foreclosures. A growing segment of recent homebuyers have bought homes using teaser-rate, adjustable-rate, and no-money-down or low-money-down mortgages. As adjustable-rate mortgages reset upward, the housing market will likely see increased foreclosures involving individuals who can’t afford the new reset rate on their mortgage. The total inventory of homes in foreclosure has risen to 437,041 homes, a +39% increase over the past year.1 The problem is not only in the subprime category, as delinquencies for both prime and subprime loans are rising (Chart 3).

In fact, the market’s primary focus on subprime ignores a major issue, which is that Alt-A and prime borrowers will also face “sticker shock” when adjustable-rate mortgages reset upward. Lehman Brothers estimates $421 billion of ARMs will reset in 2007 ($308 billion subprime and $113 billion prime) and $542 billion of ARMs will reset in 2008 ($349 billion subprime and $193 billion prime).2 Clearly, this is not just a subprime issue, but rather an ARM reset issue as both subprime and prime borrowers potentially are forced to put homes back on the market with almost $1 trillion of ARMs resetting over the next two years. What impact will this have on housing? According to a study published last month by First American CoreLogic, a total of 1.1 million foreclosures with losses of about $112 billion will occur over a period of six years or more with roughly 500,000 homes going into foreclosure over the next two years.3

größer/bigger http://www.smugmug.com/photos/136440158-O.png

Rising foreclosures will result in homes coming back on the market not only at a time when current inventories are near record levels, but also when pent-up demand for housing is low. Easy lending standards and innovations in the mortgage market over the past several years brought forward future housing demand. People who would have qualified for a mortgage in the future were given a mortgage today. Why? Lenders, hungry for yield, relaxed their underwriting standards and provided cheap money. Naturally, consumers took the bait, and levered-up with record low down payments. In fact, 46% of homes purchased in the U.S. last year had less than a 5% down payment.4 Over time, homeowners with little capital at risk and negative home equity will likely walk away from homes under water. For all these reasons, housing inventories are likely to remain high over the next few years.

Affordability and Risk Appetite
On the demand side, housing affordability remains near 20-year lows due to a sharp run-up in housing prices (Chart 4). While mortgage rates have come down slightly over the past few quarters, housing remains unaffordable for a large group of new potential buyers. This buyers’ strike will continue until prices fall and/or mortgage rates decline. Given that homebuilders can’t control the absolute level of mortgage rates, we should expect buying incentives to remain elevated over the next several quarters. Given the strong incentives for buying a new home, owners of existing homes who are forced to sell will likely be forced to lower their asking prices.

We know from the NASDAQ bubble that once risk appetite changes, prices can shift violently in the other direction. Housing is different from equities because it is much less liquid; therefore price adjustments take more time. In a down housing market, the gap between buyers and sellers widens, and volumes fall. Buyers pull back and sellers take time to realize their listing prices are too high. Eventually, housing prices in entire neighborhoods will get reset downward by the weakest hand. Just as prices went up and everyone in the neighborhood applauded the newest neighbor who bought at the top, prices will likely start to fall as financially-stretched home owners and speculators sell, and are forced out of the market. As this process unfolds, risk appetite for housing should take a sharp turn for the worse. This year’s weak start to the traditionally strong spring selling season suggests we have indeed entered the “buyer’s strike” phase of the cycle.

Credit Availability, Lending Standards and Appraisals
A major headwind for housing in the near future will be more restrictive credit availability. Lenders are already increasingly asking for income verification and higher down payments. Countrywide changed their no down-payment lending policy last month, and is now requiring homeowners to have at least a 5% stake in their homes.5 Other lenders are following Countrywide’s lead, which will result in a smaller pool of potential homebuyers. The threat of increased government regulation and restrictive legislation is likely to cause lenders to reduce offerings of no-documentation loans, and to ensure that adjustable-rate borrowers can qualify at the higher reset rate. This trend will tighten credit availability for potential homebuyers.

As delinquencies and foreclosures rise, lenders will also suffer losses. This should reduce their willingness to take risk and cause credit spreads to widen, particularly for riskier borrowers. As lending standards tighten, less credit will be granted. And, credit that is granted will likely be offered at higher interest rates. In the long run, this will be a positive for the housing market, as only buyers who can afford to buy a house will buy one. However, in the short run, tighter lending standards will cause a reduction in demand for housing, and could cause the home ownership rate to fall. Given the significant increase in projected foreclosures mentioned above, an extended period of credit tightening could materialize.

As we discussed in Credit Innovation and Opportunity, our December 2006 U.S. Credit Perspectives, the mortgage industry’s ability to develop new products that kept initial monthly payments low enabled consumers to buy homes they could not otherwise afford, and was a major factor in driving the home ownership rate up 5% in the last 10 years to today’s level of 69%. With rising delinquencies and foreclosures, the downside of credit innovation will surface and may be met face-to-face with increased regulation. Innovation in the mortgage market, which has provided a huge lift to consumers and housing prices through growth in non-traditional products (Chart 5), is clearly at risk. Consumers will likely shift away from exotic mortgages, resulting in less overall stimulus for the housing market, particularly given the lack of pent-up demand for housing.

Lenders are not the only players in the real estate market who are turning more cautious. Real estate appraisers will also become more conservative in their evaluations of property. Some appraisers, who in hindsight probably inflated appraisals over the past several years, helped contribute to the housing bubble on the way up by helping to get marginal buyers and mortgages approved in order to “make the deal work.” Given heightened regulatory oversight, appraisers will turn more realistic. As lending standards tighten (Chart 6) and appraisals become more conservative, the pool of potential homebuyers will shrink. Why? A major problem in today’s housing market is not only sales to new home owners. The “move up” market, or existing owners who want to sell their current house to buy another house, is basically frozen. Outside of speculators exiting the market, this is a major reason why cancellation rates have risen. It isn’t only the speculators and investors backing away. Potential new homebuyers can’t sell their existing home to another buyer. As a result, they cannot move up. Changing buyer sentiment, more restrictive credit and less aggressive appraisals are all helping to restrict marginal buyers.

Where’s The ATM ?
Over the past several years, consumers leveraged rising housing prices and easy credit availability using their home as an ATM. Mortgage equity withdrawal (MEW) soared, allowing consumer spending to grow faster than income growth over the past several years. This process was facilitated by rising home prices and loose lending standards. As long as housing prices were rising, lenders were willing to lend, and consumers were willing to spend, as rising housing prices gave them the confidence to draw down on savings. Today, mortgage equity withdrawal appears tapped. Consumers have been accessing their homes as bank accounts, but housing prices are now falling in many areas, and credit is becoming more difficult to obtain. The slowdown in MEW has been remarkably swift. Over the past year, consumers tapped over $400 billion less equity out of their homes than the previous year. And, in looking at the four-quarter moving average of MEW divided by nominal GDP, the change in MEW as a percent of nominal GDP is now –1.8% (Chart 7). Slower housing price appreciation is causing mortgage equity withdrawal to fall sharply, and is set to detract from U.S. economic growth.

To understand why corporate profits may be at risk as a result of the slowdown in MEW, let’s turn our attention to consumer spending. Companies make money when consumers spend. And, consumers have been spending in part due to rising housing prices, which have allowed consumers to grow debt faster than nominal GDP. Why are corporate profits as a percent of nominal GDP at new highs? Some would argue the reasons are: (a) healthy productivity gains, (b) cost cutting, (c) strong global growth, and (d) low long-term interest rates due to robust global savings. Instead, I suggest turning the focus back to the consumer and housing. Thanks to rising housing prices, consumers have been able to grow spending significantly faster than income growth, through unprecedented increases in mortgage equity withdrawal. In fact, the growth in mortgage debt parallels the growth in corporate profits (Chart 8). As a result, corporate profits, and thus economic growth, are highly dependent on housing prices. As housing prices turn negative, corporate profit growth will eventually follow.

Housing Is Today’s Leading Indictor
Housing is today’s leading economic indicator. To quote our forecast from one year ago in For Sale, “with a softening housing market, we should expect tighter lending standards, a moderation in the willingness to take risk, a slowdown in the pace of asset price appreciation, less liquid markets, and rising volatility in financial markets.” On the economic front, I believe declining housing prices and tighter credit are set to unleash a sharp downturn in housing turnover and job creation. As housing prices fall, corporate profits are expected to be at risk as consumers pull back their spending.

Housing is a momentum market. Turnover rises when real housing prices, as defined as housing price appreciation (HPA) minus mortgage rates, are rising. Turnover slows when real housing prices are falling (Chart 9). Today, the growth in real housing prices is falling. We believe real housing prices will turn further negative in 2007, causing new and existing home sales to decline towards 5 million units per year, down from a peak of over 7.5 million units per year in 2005.

Housing starts and permits tend to be a good leading indicator of job growth. Through February 2007, housing starts are down –28% year-over-year. This type of decline in housing starts typically leads to a sharp slowdown in job growth, within roughly one year (Chart 10). As a result, I believe that job creation is set to slow, possibly materially. The U.S. economy created approximately 200,000 new construction jobs last year. It would not surprise me if we lost 400,000 construction jobs this year, as homebuilders complete their existing projects and then lay off workers. As corporate profit growth deteriorates with a slowdown in housing, business investment and consumer spending, layoff announcements across all sectors of the labor mar