The "R" Word

A series of economic reports came out on February 15th that can best be described as "dismal". Recession is now knocking on the door. In the weeks and months to come expect to hear the "R" word much more frequently. Let's take a look at some of the reports.

Economic Reports

• Industrial Output
• Capital Flows
• Weekly Jobless Claims
• Factory Sector ISM

Industrial Output
Industrial output falls sharply in January

U.S. industrial production fell in January by the largest amount since Hurricane Katrina devastated the Gulf Coast in September 2005, the Federal Reserve reported Thursday.

Industrial output of the nation's factories, mines and utilities fell 0.5% in January, the fourth decline in the past five months. Automakers and other producers are slashing production to bring down their inventories of unsold goods.

The decline in factory output was even steeper, with production down 0.7%. Production of motor vehicles and parts fell 6%. Vehicle assemblies fell to their lowest level in nearly a decade. The decline in factory output was broad based. Factory output excluding vehicles fell 0.4%.

The report was "dismal," wrote Stephen Stanley, chief economist for RBS Greenwich Capital, although he judged that the January downturn was a "temporary weather-related bump in the road," not a fundamental shift in the economy.

"The sector is in recession," wrote Ian Shepherdson, chief U.S. economist for High Frequency Economics, noting that output fell 1.7% annualized in the fourth quarter and is heading for a decline in this quarter as well.

Capacity utilization fell to 81.2% in January from 81.8% in December. This is the lowest level since last February. The Fed had been worrying about high rates of capacity utilization feeding into inflation.

"The sector is in recession," wrote Ian Shepherdson, chief U.S. economist for High Frequency Economics. Indeed it is. That is in addition to the housing sector which is also clearly in recession. It should not be long before the word "sector" is replaced by the words "United States".

Capital Flows
December sees $11 billion net capital outflow

U.S. monthly capital flows reversed in December to an outflow for the first time since June 2005, the Treasury Department reported Thursday. The U.S. recorded an outflow of $11 billion in December, compared with an inflow of $70.5 billion in November, the Treasury said.

The U.S. economy has required big inflows of capital of about $70 billion every month to fund its large current account deficit, which totaled $225.6 billion in the third quarter -- about 6.8% of gross domestic product. The large inflows of foreign capital have kept U.S. interest rates lower than they would otherwise be, boosting the real-estate sector and other asset markets with cheap money.

The dollar fell against yen and the euro following the report, which, according to Action Economics, "didn't sit too well" with the markets after Tuesday's report on the nation's growing trade gap and a Wall Street Journal report that China is considering shifting some of its $1 trillion in foreign reserves into riskier assets, such as corporate bonds, stocks and even commodities.

Net long-term capital inflows, meanwhile, fell to $15.6 billion in December from $84.9 billion in November. This marked the lowest inflow since January 2002.

Foreign private investors sold stocks in December, and they bought fewer Treasury bonds and corporate bonds. Foreign central banks bought a record amount of government agency bonds to close out 2006.

Overall, foreign private investors bought $39 billion in long-term securities in December, compared with $115.7 billion in November. They purchased only $4.5 billion in Treasury bonds and notes in December, compared with $33.1 in the previous month, according to the data.

A senior Treasury official noted that the monthly data are volatile and should be viewed over longer terms.

The article reported "A Wall Street Journal report that China is considering shifting some of its $1 trillion in foreign reserves into riskier assets, such as corporate bonds, stocks and even commodities." Just what are they thinking? Sorry, that's the wrong question. Here's the right question: Are they thinking at all? There's nothing quite like a rush into riskier assets such as corporate bonds and stocks headed smack into a recession when those asset classes have not seen any kind of significant decline for four years. Didn't Japan try that once or twice too? The Bank of England sold gold after it fell from 800 to 250. This is simply what central banks do all the time, whether they are thinking about anything or not.

Weekly Claims
Jobless claims jump 44,000 to 357,000

The unemployment lines grew longer last week, in part because of bad weather in the Midwest and Northeast, the government reported Thursday. The number of people collecting unemployment benefits rose to the highest level in a year.

Seasonally adjusted initial jobless claims increased by 44,000 to 357,000 in the week ending Feb. 10, the Labor Department said. It's the highest level since late November. And it's the largest weekly increase since September 2005, just after Hurricane Katrina devastated New Orleans.

The four-week average of new claims - which smoothes out one-time events such as holidays or weather - rose by 17,500 to 326,250, the highest since December.
Meanwhile, the number of people collecting unemployment benefits in the week ending Feb. 3 rose by 71,000 to 2.56 million, the most in 13 months. The four-week average of continuing claims rose by 18,000 to 2.52 million, the most in 12 months.

Long-term unemployment has been stubbornly high during this expansion, despite the decrease in the unemployment rate to 4.5%. In January, about 30% of the 7 million official unemployed people had been out of work longer than 15 weeks, while 16%, or 1.1 million, had been out of work longer than 27 weeks.

Typically, unemployment benefits run out after 26 weeks for those who are eligible. Those who exhaust their unemployment benefits are still counted as unemployed if they are looking for work.

Are they really attempting to blame this on the weather? Of course. Was there any mention that construction jobs were way up in November and December because of unseasonably warm weather? Of course not.



Jobs are where the rubber meets the road in this expansion. It remains to be seen if this weekly claims number is an outlier, but in conjunction with the other economic reports I find that unlikely. As an aside, it is now taking enormous increases in M3 just to stand still. In 1980 it took $1 of new debt to create $1 of GDP; in 2000 it took $4 and today it takes $7. We seem to be pushing on a string and the expected revisions to the 4th quarter GDP shows it.

Factory ISM
Factory gauges point different directions

The New York Fed's Empire State index jumped to a healthy 22.4 in February after two soft months, but the Philly Fed index fell to 0.6, pointing to a barely growing manufacturing sector in the Philadelphia region.

The two gauges are of interest primarily because they are seen as clues to the national Institute for Supply Management survey for February due out in two weeks. In January, the ISM index fell unexpectedly below 50% for the second time in three months. In the ISM, readings under 50% indicate the factory sector is contracting.

The Philly Fed new orders index fell to negative 0.5, while the shipments index dropped by more than 22 points to 1.7. The unfilled orders index improved to negative 10.5, indicating that manufacturers are working off their backlogs. The prices-paid and prices-received indexes showed little change. The employment indexes contracted.

In Empire State report, the headline index rose to 24.4 from 9.1, confounding expectations of a drop to 8.7. New orders and shipments increased and unfilled orders moved out of negative territory. The employment indexes improved. The Empire State new orders index rose to 18.9 from 10.3. Shipments rose to 27.1 in February from 16.1. The inventory index improved to negative 7.5 from negative 19.2.

If one is looking for outliers, the Empire State report is likely it. Still, In January, the ISM index fell unexpectedly below 50% for the second time in three months. In the ISM, readings under 50% indicate the factory sector is contracting. The Fed has never in history hiked with a negative ISM reading.

Rate Cuts Coming?
Odds of first-half '07 rate cut more than double after data

The odds of an interest rate cut through the first half of 2007 more than doubled, after weaker-than-expected industrials production data, lower-than-anticipated import price growth and a sharp rise in weekly jobless claims offset a surprise rise in manufacturing activity in the New York region. July fed funds futures were last up 0.02 at 94.785, which implies a 14% chance that the Federal Reserve will lower its target on overnight rates to 5% from 5.25% by its policy setting meeting in late June. At the intraday high of 94.79, the highest price seen since Jan. 22, the odds of a cut stood at 16%. Late Wednesday, the odds of a cut were at 6%.

At the time of this writing the odds were not yet reflected on the Fed Funds Rate Predictions Chart. Here is a chart showing the June FOMC meeting expected outcome as of February 13.



Click on the above link to refresh the chart. Within a day or two the chart should show some significant differences. Right now the chart shows that odds of a June hike are greater than the odds of a cut. That will change.

$TNX
Treasury Bears (and they seem to be damn near everywhere) have been salivating over the latest uptick in yields. Let's step back and look at the big picture. Following is a monthly chart.



Daily Chart



From a seasonality standpoint, treasuries are generally bearish from the beginning of the year through tax season (April-May) timeframe, and if that upper trendline on the monthly chart is going to break, now would be the time. In light of economic data, I doubt we see that happen although there could potentially be one last blast higher in a bond revolt when the Fed is forced to start cutting.

The pent up domestic demand for treasuries is in my estimation enormous. Nearly every hedge fund, mutual fund, and investor has been chasing stocks for a long time. Treasuries are generally despised except by foreign central banks. But when the US equity markets finally die of speculative exhaustion, I expect to see a massive repricing of risk with junk yields moving substantially higher and US treasuries yields, substantially lower, in a flight to safety construct.

Bernanke's Box

Bernanke has to be suffocating in that box he is in. Interest rates are no longer accommodating for the real economy and the rising bankruptcy and foreclosure data in conjunction with a sinking jobs picture and anemic GDP proves it. On the other hand the FF rate is not high enough to kill financial speculation. Proof of the latter is collapsing yield spreads on junk and foreign bonds, rising NYSE margin levels, what seems to be insatiable demand for credit swaps, and a stock market where all news (good or bad) is generally cheered.

There is also the carry trade fuel to consider. The carry trade is attractive as long as money borrowed in Yen finds sufficient returns elsewhere and/or the Yen itself continues to sink. The greater the interest rate differential between the US and Japan the more attractive the carry trade is. Could it be a collapse in treasury yields in the US as opposed to a rise in interest rates in Japan that sinks the carry trade boat?

Regardless of what the triggers are, a recession and a repricing of risk are both baked in the cake.

Mike Shedlock / Mish
http://globaleconomicanalysis.blogspot.com/