New Credit Conumdrum Poses Risks To Economy / Barron´s ( Recommended Reading )

Tuesday, June 9, 2009

UP AND DOWN WALL STREET DAILY

New Credit Conundrum Poses Risks to Economy



By RANDALL W. FORSYTH


The bond market could kill the supposed recovery that's spooked it.

REMEMBER ALAN GREENSPAN'S FAMOUS "CONUNDRUM?" Back in 2006 and 2007, by which time the Federal Reserve had nudged up its federal-funds target to 5.25%, long-term Treasury yields stubbornly refused to follow. And so mortgage credit remained cheap and easy even as the Fed supposedly was leaning toward tight money.Now, there's a conundrum in reverse, with Treasury yields shooting up in the face of the Fed, which not only is pegging the overnight fed-funds target at near zero but also actively buying intermediate and longer Treasuries, U.S. agency obligations and mortgage-backed securities.

The market, faced with a seemingly unending stream of auctions of new Treasury securities, is demanding higher yields to absorb the new merchandise. And with the Fed actively buying Treasuries, and thereby printing money to cover the budget deficit, some observers are extrapolating this debt monetization as putting the U.S. on the road to fiscal perdition.

Friday brought the concerns over higher Treasury yields to a head, with a smaller-than-expected decline in non-farm payrolls in May sparking a huge backup in Treasury yields. "One would have thought we printed +345,000 instead of -345,000 based on that reaction," writes David Rosenberg, who now analyzes the markets and the economy from his perch at Gluskin Sheff, a Toronto money manager.

Since the May employment report's release Friday morning, the yield on the two-year note is up nearly a half percentage point, to 1.41% Monday, as the interest-rate futures market futures began to discount multiple hikes in the fed-funds rate. The benchmark 10-year note ended at 3.91%, about half the increase on the short end.

There are too many reasons to list here why the May payroll number understates the weakness in the labor market, which was captured better by the surge in the unemployment rate to 9.4%. Among those working, a record number are forced to settle for part-time jobs, which has slashed the number of hours worked, and thus, income.
Meanwhile, Americans are paying off non-mortgage debt at an unprecedented rate.

Consumer credit shrank in April by the second-biggest amount on record, $15.7 billion, which was exceeded only by March's $16.6 billion decline. According to Lombard Street Research, the decline in consumer credit is the sharpest since 1980 -- remember Jimmy Carter's credit controls? -- and the biggest since the spring of 1943, when wartime rationing left nothing for consumers to buy.

"This is not surprising," writes Lombard Street's Gabriel Stein. American households understand the need to pay down debt and rein in excess spending. One important way they've done that has been through refinancing mortgages or tapping home-equity lines and effectively taking advantage of the Fed's program to purchase Treasury, agency and mortgage securities.

But they haven't suddenly become Dave Ramsey acolytes, at least not of their own volition.
Bank analyst Meredith Whitney wrote in the Wall Street Journal in March that she expects over $2 trillion of credit lines on credit cards to be cut this year and another $2.7 trillion next year.

I am in the cross-hairs of that trend in plastic. Citigroup (ticker: C) canceled two of my credit cards without warning in the past couple of weeks, one issued on behalf of ExxonMobil (XOM) , the other for AT&T (T). The reason: I hadn't charged anything on either card in several months and had a nil balance. That's even though I have a long-standing, upper-tier account with Citibank. Why do I get the feeling that Citi's card operation has no idea about the New York bank's doings?

That won't crimp the Forsyth household's spending, but slashed credit lines could severely curtail consumption elsewhere. As for the households that were scrambling to refinance their mortgages to pay down credit cards and other consumer credit, the backup in Treasury yields will reduce their opportunities.

All of which suggests the rise in Treasury yields could be self-limiting. The refinancing process depends on the Fed's ability to cap mortgage rates, LSR's Stein writes. Otherwise, deleveraging will be more protracted, depending solely on consumers' cutting borrowing by slashing spending.

In that case, any incipient recovery in housing, consumer spending and therefore the economy as a while could aborted. Or to use the cliché of the moment, the green shoots could be nipped in the bud. That, in turn, would cap any rise in Treasury note and bond yields based on misplaced expectations of Fed tightening.

Monday's other market action could be telling: the Treasury 30-year bond actually rose slightly in price, lowering its yield; the dollar recovered from its recent swoon, while gold sold off for a second day.

Rosenberg observes there's a lot of good news priced into the stock market after its recent rally while there are a lot reflation expectations built into the Treasury market, where 10-year yields exceed current inflation by 4.5 percentage points.

But a continued rise in Treasury yields could erase the good news discounted by the stock market if it throws a spanner in the works of the mortgage market.