Is the current correction over?

Discussion in 'Economics' started by mktreflections, Mar 25, 2007.

  1. Is the current correction over?

    The Standard & Poor's 500 index, a benchmark of corporate America's equity, dropped 75 point from 1449 Feb 27, 2007 to 1374 March 5, 2007, a 5.2% correction so far, triggered by a slide in Chinese shares and warnings by Greenspan that the U.S. economy was vulnerable to a slowdown.

    S&P closed at 1436, As of March 23, 2007, just 13 points short of its open on Feb 27, 2007, retracing 82.6% of its loss since the current correction started.

    Is the current correction over? I would probably say yes, in the sense that the bottoms may have been found on 030507 for S&P, Dow and Nasdaq, So, just about 5.2% correction this time? Probably yes.

    The indexes may test the 030507 low again, but it is very difficult for the indexes to go a lot of lower than 030507. I doubt S&P will make it to 200MA of 1354, about 20 points lower than 030507’s close. (

    The strong headwind against bears are from FA and PA, PA being political analysis.

    Let’s start with Fed.

    Fed, being US central bank, is also a political institution, a part of US government. In my “Fed and three representations”, I talked about Fed’s dual mandate instituted by Congress: employment and inflation objectives. That’s politics right there.

    For simplicity, inflation objective is more important for bond holders. As bond holders, higher than expected inflation is bad, with default being the worst. That’s why on the long-end of yield curve, inflation risk has to be priced. If the inflation turns out to be higher than expected, your bond would depreciate, other things being equal. So bond market participants like Bill Gross cares big deal about Fed’s control of inflation.

    Employment objective is more important for workers like average Joe, again for simplicity. For Joe, with a big mortgage and credit card balance outstanding, he probably doesn’t care much about inflation, and theoretically he could even benefit from it as a debtor: creditor’s loss is always debtor’s gain. But Joe needs a job, and for every Bill Gross, there have to be many Joes, ratio unknown. So, there have to be many jobs around.

    Politics is called “balance of power/interest” sometimes. I guess that’s one of the reasons, House Financial Services Committee Chair Barney Frank told Fed chief Ben bluntly early this year that he opposes a specific numerical inflation objective because it might conflict with the Fed’s employment objective as part of its dual mandate. Ben, being an “data dependent” professor and supposedly one of enthusiasts for numerical inflation objective (ECB’s present target is to keep inflation below, but close to, 2%.) , must be disappointed a little bit. But I think Ben understands the message very well, being an inventor of “Ben’s helicopter” himself.

    A government in a capitalist economy would use its power to provide certain level of employment to the working class. Marx had a gap in his capitalism theory on this issue. He thought the working class in England of his time would have to launch a revolution just to survive.

    To make accomplishing its employment objective easier, US government debased US financial system from gold standard long time ago, and has since then practically put US financial system on a “bond standard”. With Fed’s treasury operation, government can manage liquidity in the system according to its policy purpose. Why tie up yourself to a piece of metal like gold or silver? Why tie up yourself to a particular value of CPI such as 2%?

    Fed’s statement on March 21, 2007 was interpreted by market basically as a Ben Put:

    “At the very least, many take comfort that U.S. Fed Chairman Ben Bernanke appears, like his predecessor Alan Greenspan, to be ready to help with easier money if things get rough or in the event of nasty shocks, like this year's subprime mortgage jolt.” (

    As to inflation, if CPI 1-2% is presumed to be Fed’s comfort zone, why 2.7% cannot be presumed?

    Deng Xiaoping proves to be the master of politics, just like his other CCP comrades. “ A cat is a good cat as long as it can catch a mice, color of cat doesn’t really matter, black or white”.

    Bond market

    Through bond market, Fed “controls” (lack of a better word) banks and banks control economy. Average daily trading volume of Treasuries is about $500B, 7 times of that of NYSE and Nasdaq.

    The weekly average of corporate debt sales of 2007 is $24.6 billion, or $100B per month, according to data compiled by Bloomberg.

    So, it is important for bond market and Fed to understand each other, and to keep economy going, so Joe has a job and pays his bill, and Gross makes his profit. It seems they do understand each other well.

    Corporate bonds:

    “Corporate debt sales totaled $34.8 billion in the week ended March 9, more than double the previous week's total of $14.9 billion, when investors fled all but the safest assets” (

    “The perceived risk of owning corporate bonds has fallen from a five-month high, and an index of derivatives tied to subprime mortgage bonds has gained about 14 percent in the past three weeks. Even emerging market bonds, among the riskiest assets, are rallying.”

    The CDS (credit default swap) index I followed:
    iTraxx Crossover 10 Y was 319.33 on 032307, down from
    340.88 on 030507

    DJCDXNI is currently at 34.73, down from about 40 on 030507.

    Mortgage bonds:

    “An index of credit-default swaps on 20 mortgage securities rated BBB- and created in the second half of 2006 fell 36 percent from Jan. 18 to Feb. 27 when it reached a low of 62.25, indicating deteriorating confidence. Since then, the index has recovered, climbing 13.75 percent to 70.81, according to London- based Markit Group Ltd., which administers the ABX-HE-BBB- 07-1. The index traded as high as 97.47 on Jan. 19.”(

    Hedge Fund is never behind anybody

    “Ahead of curve” is the slogan of Citadel’s founder, billionaire trader Kenneth C. Griffin.

    Citadel bought bankrupt ResMae Mortgage Corp. two weeks ago, and took a 4.5 percent stake in Accredited (
    So, Citadel, one of my MMs, even acted long before Fed’s statement on 032107.

    Farallon Capital Management LLC, a San Francisco hedge fund that invests in companies facing cash shortfalls or bankruptcy, said this week it held talks to buy San Diego-based Accredited Home Lenders Holding Co. before agreeing to lend it $200 million.


    Subprime is a big problem without Ben Put, and a manageable problem with Ben Put. Is that the bond market and Hedge fund’s interpretation of Fed’s statement?

    They are probably right, and consequently we probably have seen lows for major stock indexes on March 05, 2007.

    Caution is always advised for traders. As one of big the volume guys in treasuries trading (031207 “What would you do if you are Citadel?” Marketref;, I suspect Citadel probably sold a lot of treasuries last Friday.

    “Selling on news” in Treasuries last Friday pushed down price across the entire yield curve, raising up 10Y and 30Y yield indexes back to the level on or before Feb 27, 2007.

    Yield curve not inverted any more

    The central piece of “IS THE CURRENT CORRECTION OVER” is the so-called Ben Put as the bond market and hedge fund perceived.

    The yield curve seemed to have confirmed this:

    “For the first time since the Fed ended a two-year run of interest-rate increases in August, the central bank 0n 032107 signaled that its next move might be either to lower or raise borrowing costs, instead of just the latter. The Federal Open Market Committee's statement omitted a previous reference to ``additional firming'' in favor of the more general ``future policy adjustments.'' (
    Also for the first time since August 2006, 10Y T yield indx exceeded 2Y T yield indx on 032207.

    I have talked much about Bill Gross’s long complaint that he can not make money with an inverted yield curve. Now, the inversion of yield curve has been reversed or flattened, indicating bond market’s current expectation that Fed will cut the Fed’s fund rate, or at least not to raise it.

    About the front end and the long end of the yield curve:

    Front-end is more sensitive to Fed’s rate policy.

    Long-term rates theoretically equal to the average of current and expected future short-term rates, which more or less reflect economic condition or growth rates, plus inflation risk premium and risk premium.

    Inflation risk remains:

    The Fed on 032107 said ``the high level of resource utilization has the potential to sustain'' inflation pressures, due to the followings:

    Capacity utilization rate

    Overall capacity utilization in February increased to 82.0 percent from 81.4 percent in January, with historical average being 81%.

    Rate of unemployment minus the rate of nominal annual wage growth: if it is not greater than 50 base points, it will be out of Fed’s “comfort gap”.

    Unemployment rate as of 022007: 4.5%

    Hourly earnings rose 0.4% in February. That is a bit stronger than expected, and puts the year-over-year increase at 4.1%.

    Productivity growth

    Productivity growth, slowed to 2.1% over 2005 and 1.4% over 2006, although possibly due to cyclical factors, while trend productivity growth is roughly 2½%.

    The productivity deceleration has contributed to acceleration in unit labour costs of 3.4% over the past year.

    Given the increased likelihood of cuts in short term rates, and may be a slightly upward movement in inflation risk, the long-end of curve may not change very much either directions, other things being equal, more likely to be lower than higher.

    The “worst” had been priced in by stock market

    Earnings growth for S&P500

    Most recent Q1 2007 Q2 2007 Q3 2007 Q4 2007
    --S&P 5.3% 6.3% 3.5% 15.6%
    --First Call 4.3% 4.4% 6.6%
    --One Month Ago (1) 6% 7% 7% 16%
    --Two Months Ago (2) 8.2% 8.5% 5.2% 16.2%
    (1) Combination of First Call and S&P estimates. (2) First Call forecasts.

    IQ and EQ by bond and stock market since Feb 27, 2007

    IQ is information (mostly macro) query, more for bonds, and E for earnings or “emotions”, more for stocks.

    Most of the macro and earnings data have been already “chewed” by market prior to Feb 27, 2007.

    IQ and EQ on and after Feb 27, 2007:

    Jolted by subprime, the market was seeing future economic scenario as worst and as far as possible, particularly on March 05, 2007, with all bad information and fears priced.
    One measure of intensity of EQ is VIX. “ VIX, a measure of the market's expectation of 30-day volatility in the S&P500 index, jumped by the most in its 17-year history late in February” (

    One important piece of all bad information “IQ” and “EQ”ed by market priced in prior to 032107 is market’s anticipation that Fed may not change its bias on 032107.

    Considering all these, and noting particularly the extreme point EQ has reached, I think, stock indexes may have seen the bottom of the current correction on 03052007.

    Fed’s fourth representation: USD

    I agree with many market participants that Fed has an USD objective, which I think is to maintain some kind of order of USD movement in either direction and within certain range, numerical values unknown, just like Fed’s employment and inflation objectives.

    Considering that the entire US yield curve is probably going to be lower, and with front-end lower than long end, there would be some downward pressure on USD, if Europe and Japan’s yield curves are going to stay where they are.

    USD Indx: after touching a all YTD of 82.75 low on 032107, it is now back to 83.25, still close to all time low since April 2005, after falling below 81 in Jan 2005. USD since then has gone as high as above 92 near the end of 2006 and has been trending down after that.

    CCP Put

    I think, somehow, CCP has a strong interest in supporting an orderly USD, cooperating to some degree with Fed on its USD objective, kind of playing Japan’s similar role in the past.
    Here are some data (

    1. China’s accumulation of USD

    China is currently running 100 billion dollars a year trade surplus;
    About 50 billion dollars of foreign capital flow into China per year to build factories to manufacture goods to be exported to US, to sell into Chinese consumer markets, or just to construct buildings
    There is also about 50 billion dollars a year of so called hot money flowing into China in anticipation of the upward revaluation of yuan against dollar.

    All together, there are about 200 billion dollars a year to be sold for yuans, about 10 % of China's GDP.
    Chinese government must buy up the majority of 200 billion dollars to prevent the plunge of dollar against yuan, and to maintain yuan's undervalued status vs. US dollar.
    By assuming that 100 billion dollar worth of yuans become excess yuans that Chinese government cannot mop up through its monetary operations, the total lending by the repeated lending of banks balloons to 10 times of the original seed money of 100 billion dollar equivalent yuans, almost 50% of the total GDP of China.

    In that sense we may say that China's economic expansion is rooted on its export business and the foreign capital inflow, and it is in China’s interest that the trade surplus with US and foreign capital inflow continue.

    2. Recycling of China’s USD back into US

    As for the 200 billion dollars that Chinese government buys up in a year, Chinese government has no choice but to recycle them back into US financial market since US dollar is the legal tender only within US. Chinese government, using the 200 billion dollars at hand, buys US treasury instruments, mortgage backed securities and probably even commercial papers.

    Of course, the total US trade deficit is over 600 billion dollars a year, so the other 400 plus billion dollars are also recycled back into US financial market just like the 200 billion dollars from China; the other 400 plus billion dollars is coming from Japan, Taiwan, South Korea, Hong Kong, oil producing nations and so on that run hefty current account surpluses. The 600 plus billion dollars will eventually flow into the hands of lenders in US to be lent out repeatedly just as in the case of China. Assuming 10 fold increase of the total lending from the seed money of 600 plus billion dollars originated from US trade deficits, the total lending in US will balloon to 6 trillion dollars. In the case of US the lending goes into the hands of businesses and paid out as wages and salaries, and become consumer loans.

    It is already quite a stretch or a “gap up” from Ben Put to CCP Put, let stretch a little bit further:

    Domestically, US manages its “bond-standard” based economy via Fed and bond market. Internationally, US dominates and manages a “dollar standard” based international economic and political order with CCP, an increasingly important co-stakeholder and co-manager in such an order.

    The first order of business in such a system is for Fed’s four representations and CCP’s three representation to be taken care of, some times at cost of others such as Iran, and again, that is politics.

    Speaking of Iran, I think CCP must have mixed feelings in joining US playing tough cards against it.

    Iran is a nation like China, with one of those four earliest world civilizations, which had made important contributions to the mankind, such as Arab’s numerical system and Chinese’s paper and printing. Without that, the world economy may still be on barter-trade and metal standard.

    Regardless of its glorious history and current national agenda, whatever it might be, Iran presently seems at odds with the status quo of international economic and political order, and it has to be deal with, one way or another.
  3. Are people sure that the yield curve isn't still inverted?
  4. 5Y T yield index: 44.78
    10Y T yield index: 45.87
  5. Benranke to Gross: Sorry about “Uncertainty”, but you have to deal with it.

    Uncertainty is the central point in Ben’s testimony today:
    ``Our policy is still oriented towards control of inflation, which we consider to be at this time to be the greater risk,'' he told the Joint Economic Committee of Congress in Washington today. Still, ``uncertainties have risen, and therefore a little more flexibility might be desirable.''

    Uncertainty is a trader’s friend. I made much more than yesterday.

    Market as a whole hates uncertainty, because uncertainty and the emotion derived from uncertainty cannot be arbitraged away.

    Uncertainty or emotion by definition cannot be quantified and priced, how do you arbitrage something without a price?

    A trader can trade uncertainty or emotion, a market cannot. A trader can take a bullet and sell it to somebody else; a market has to eat the bullet itself.

    “Uncertainty” is the bullet market has to take from Fed: sorry, you just have to eat it.

    Having to balance among “four representations” (employment, inflation, bond market, USD), and possibly with a stagnation foe at least as a ghost hanging around, Fed is having a hard time. “Wait for more data” may be the only consoling word these Milton educated monetarist central bankers can tell themselves for now.

    Central banks can wait, not market participants. Bonds, stocks, all have to be priced and traded, even with uncertainty in the head, and perhaps fear in the chest.

    As of 1:30ET, Bond market still got a upward sloping yield curve in its mouse to chew, inflation risk and term risk not alleviated at all compared to yesterday, with more money coming in for “safe haven”.

    Stock market: Bears got their revenge done, pushing down bulls completely off “that vertical line” (see my previous post, “Atop of vertical line”) intra day.

    “CAF”, the shanghai index “red star” is still shining, and Asian market is actually hanging on pretty well, just like their economies. Now being pushed down from “that vertical line”, bulls may not be able to see the “red star” anymore.

    Short-term, momentum is with bears now, who definitely want to take bulls to revisit the “bottom” of the trough, which was first visited on March 5, 2007.
  6. moo


    This is exactly the headline we need to see before a second leg down can begin. Just wish this would have appeared in some mainstream news media.
  7. My goodness, I can't believe I got through that. That's alot of typing, don't you wish speach recognition was better, lol

    Anyway, simply put, everyone is confused because the data points are coming out in both directions. The Fed is afraid to loosen and potentially ignite an economy that maybe just fine. They are afraid to tighten in fear of crashing the economy. Even in it's curent stated neitral stance, they are afraid of stagflation or even worse a rapidly declining economy (no sees or knows a recession is present until after the fact).

    Considering the bond market has been all over the place this year, I don't think their is a sole out there that really knows what's going on, so "Uncertainty" is the word of the day for possibly sometime. If that's the case, the market will have a hard time going higher.

    I'm trying to figure out what the market is looking for in tomorrow's economic #'s, and I have no clue because based on recent market behavior, I can make a major bearish case for all outcomes. Meanng bear points outnumber bull points in all cases.
  8. The party is over soon; liquidity is drying up; every countries around the world is hiking its rate. The inflation is everywhere; China has bigger problem with skyrocketing labour costs.