The meager 1.6% GDP growth in 2013 is partially self-inflicted

More evidence is emerging that the US economic activity has slowed recently. In addition to the manufacturing output decline (see Twitter chart) and slower home sales (chart), the latest private payrolls number from ADP now shows a decline in job creation.

Source: ADP

The US is now on track to reach only 1.6% real GDP growth for 2013 - in spite of the extraordinary amount of central bank stimulus. The sad part about this weakness is that to some extent it has been self-inflicted. Policy uncertainty, including "taper"-related fears and the recent dysfunction in Washington have continued to impede growth in the United States.

The chart below shows the Conference Board's consumer confidence index. Consumer expectations, which tend to influence larger expenditures and investment, have been particularly vulnerable to "internally generated" shocks. Corporate spending and hiring is not far behind the consumer.

Source: Barclays Research

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From our sponsor:

First fall in US manufacturing output since 2009 as the Eurozone pulls ahead

The US government's dysfunction that created tremendous uncertainty recently is now filtering through the economy. The impact on manufacturing is already visible, as the output of US factories takes a dive in October.

Chris Williamson (Chief Economist)/Markit: - The flash PMI provides the first insight into how business fared against the backdrop of the government shutdown in October, and suggests that the disruptions and uncertainty caused by the crisis hit companies hard. The survey showed the first fall in manufacturing output since the height of the global financial crisis back in September 2009.

Aside from the numbers, this means loss of well-paying manufacturing jobs and further economic weakness. Congratulations go to the elected officials in Washington who helped create this mess.

Just to put this into perspective, here is the equivalent indicator for the Eurozone - a group of nations that has been struggling with recession until quite recently. Note that a measure above 50 indicates growth in output, showing that the Eurozone manufacturing output growth is now stronger than it is in the US.

Source: Markit

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From our sponsor:

Has the Great Recession created behavioral changes in the labor markets?

The US civilian unemployment rate, which clocked at 7.2% last month, has been declining at the fastest rate in nearly two decades. The focus however has been on other labor market indicators. One of those is the employment-population ratio, the proportion of the US working-age population that is employed (discussed here). With declines in the unemployment rate one would expect an increasing fraction of working-age population getting back to work. The ratio however has remained nearly constant since the recession.

The dispersion between the two measures is quite clear if one plots them on a year-over-year basis.

Source: FRED (h/t Robert Mellman/JPM)

Most would interpret this divergence as an indicator of Americans leaving the workforce in large numbers, particularly as their unemployment benefits run out. But that's not the full story. The question is whether the Great Recession had created "behavioral changes" in the labor markets. Here are a few points worth addressing with respect to the flows in and out of the workforce (based on recent work by Robert Mellman/JPM):

1. Are people more likely to get discouraged and leave the workforce after the Great Recession than in the past? The answer is quite surprising. The "dropout rate" is actually similar to historical trends.

JPMorgan: - Despite the background of high unemployment, drop-out rates of the unemployed are surprisingly similar to prior expansions. 

2. Then why have so many people left the workforce? The answer is simple. Taking roughly the same "dropout rate" as before but applying it to a much larger number of unemployed people than in the past will create a large total "drop-out" pool.

3. But are those who exited the workforce more reluctant to reenter the job market than has been the case historically? Once again it turns out that the "reentry willingness rate" is not materially different from history.

JPMorgan: - ... there has been no increased reluctance of those out of the labor market to enter the labor market in any given month (whether into employment or unemployment). An average of 7.6% of those out of the labor market entered every month in the prior expansion, and the figure is 7.5% for the current expansion.

4. Why has the employment-population ratio not budged since the recession? One of the persistent problems with the US labor markets is the current pool of unemployed people taking far longer to find work than in the past. This would suggest that the key for those without work is to enter the workforce as quickly as possible - even if it means part-time, temp, consulting, etc. The barriers to re-entry are much higher these days than any time in recent decades.

JPMorgan: - The labor flow data show that the chance of an unemployed worker finding a job in a given month fell dramatically during the last recession and has remained near its lows since.

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Comparison to an earlier period of accommodative monetary policy

Here is an observation. The last couple of years show some interesting similarities to the period ending in early 2005. The reason for such a comparison is that then, just as now the Fed began to gradually exit its highly accommodative policy.

Both periods show similar trends in the unemployment rate, although the absolute levels are quite different. That, at least in theory, is usually the rationale to consider exiting stimulus.

Similarly housing prices show an upward momentum during both periods. Obviously the speculative fervor of the pre-recession housing market is (supposedly) not present in the current environment.

The Fed's stimulus of course came in different forms for the two periods. In the pre-recession era, the Fed used the overnight rate to provide accommodation, which dipped down to 1% at the peak of the stimulus. In the current environment - with the overnight rates effectively at zero - the stimulus is in the form of longer-term rates which are adjusted via securities purchases. The chart below shows the stimulus (blue) and the start of the exit for both periods. The trends in the "risky" assets are quite similar during those periods.

What does this say about the current environment? The accommodative period that started with the burst of the tech bubble and ended in 2005 may have been overdone, igniting the housing bubble through artificially low rates (see post from 2009). The exit did not end well, as rising rates sent shock waves through the overleveraged housing market. The current stimulus cycle is of course quite different. Nevertheless the lesson here is that the longer the accommodation period the more dangerous the exit (as we already saw with the emerging markets rout).

Update: Here is an excellent comment on the topic from Joseph Longino of Sandler O'Neill -

The fact that the 16-day partial closure of the federal government has prolonged quantitative easing reveals how far the Fed has moved beyond crisis management to the quotidian calibration of the post-crisis economy. The core job description of a central bank in a capitalist economy, including the Fed, is not to fine-tune the economy or financial system but to help secure the broader stability that inspires in private participants the confidence necessary to make plans for tomorrow rather than to be fixated on today or, worse, yesterday.

Five years ago, in the depths of the crisis, the Fed and U.S. Treasury distinguished themselves among their international peers by masterfully intervening to avoid global collapse. However, yesterday is not today, and every time the Fed magnifies the putative importance of quantitative easing in the public consciousness by further delaying tapering, it administers a reverse placebo effect to the recovering patient, increasing anxiety that the crisis hasn’t passed at all but lies in wait for the unwary, and risking a systemic shock when measured tapering is no longer practicable or possible.

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From our sponsor:

Reasons behind the sell-off in crude oil

WTI crude oil has undergone a substantial correction in the last few days. What's going on?

Source: Barchart

A few reasons for this price adjustment come to mind:

1. Iran seems to be getting ready to enter the market as it prepares for sanctions to be lifted.

Reuters: - Iran is reaching out to its old oil buyers and is ready to cut prices if Western sanctions against it are eased, promising a battle for market share in a world less hungry for oil than when sanctions were imposed.

New Iranian President Hassam Rouhani's "charm offensive" at the United Nations last month, coupled with a historic phone call with U.S. President Barak Obama, revived market hopes that Iranian barrels could return with a vengeance if the diplomatic mood music translates into a breakthrough in the stand-off over Tehran's disputed nuclear programme.

The Islamic republic's crude exports more than halved after the European Union and United States, which accuse Tehran of seeking nuclear weapons, tightened sanctions in mid-2012, cutting its budget revenues by at least $35 billion a year.

"The Iranians are calling around already saying let's talk ... You have to be careful, of course, but there is no law against talking," said a high-level oil trader, whose company is among many that stopped buying Iran's oil because of sanctions.

2. Yesterday's employment report points to weak economic growth, tapering demand expectations for crude. In particular, private payrolls growth came in way below expectations.

Source: Econoday

3. Related to the slower growth expectations for the US as well as to the recent government shutdown is the buildup of crude oil inventories.

ABC: - The U.S. Energy Department will release crude stockpile figures for last week later Wednesday and a 3 million barrel increase is expected.

The supply report for the week ended Oct. 11 was released Monday after being delayed five days due to the government shutdown. It showed crude supplies up by 4 million barrels.

That expectation of 3 million barrels increase was too low. The actual number this morning was 5.2 million, as inventories continue to build.

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From our sponsor:

A couple of facts about small bank failures in the US

There are still a number of misconceptions with regard to the volume and the causes of most commercial bank failures in the US after the financial crisis. Here are a couple of facts that some may find helpful:

1. Although 2008 saw some spectacular bank failures such as Citi, WaMu, and Wachovia (note that Bear, Lehman, Merrill, and AIG were not banks), the actual number was dwarfed by the Savings and Loan Crisis in the late 80s. Nevertheless there were nearly 500 small and regional banks that failed over the last 5 years.

Number of US bank failures per year

2. Contrary to popular belief, the biggest reason for bank failures was not the losses associated with bad small business loans, derivatives, or even residential mortgages. Just like during the Savings and Loan Crisis, it was the overexposure to commercial real estate loans that brought many banks down. And it was the commercial real estate loans that saw the worst default rates. The chart below shows the delinquency rates by major loan type for smaller and regional banks (ex top 100).

Source: FRB

Some argue that smaller banks did more relationship-driven lending than their larger cousins. True, but that type of lending was exactly what often ended up in an FDIC takeover. Bankers' cozy relationships with local developers were prevalent and often ignored by the regulators.

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ABS market is on a roll again

After a rough patch this summer (driven by "taper" fears), consumer asset backed securities (ABS) business is heating up again. The bulk of that business is represented by auto and credit card loans. The pick up in demand is visible in the ABS index credit default swap contract called ABX.

Source: Markit

As a result of this liquidity, this year's car purchaser will generally have no problem obtaining credit. This even applies to some so-called sub-prime auto borrowers with low credit scores.

Source: The ISI Group

Furthermore, some of the longer term auto financing (5 years and longer) is on the rise.

Fitch Ratings: - Auto loans with original terms of 60+ months (longer-term loans) increased in 2012-2013 auto loan ABS transactions versus 2009-2011 pools. Though Fitch Ratings believes the growth of these types of loans could be negative, as they have potential for increased loss severity, we currently view these loans as underwritten to account for this additive risk and do not expect transaction asset performance to be significantly affected.

Overall, there has been a 20% increase in longer-term loans in auto ABS transactions in 2013 since 2010. The use of extended-term loans in nonprime ABS transactions increased with loan pools containing approximately 80% longer-term loans in transactions issued in 2013, up from 67% in 2010. Similarly, in the prime sector these loans comprised 43% of pools securitized in 2013 from 36% in 2010.

In spite of popular belief that ABS securitization business is limited to major "Wall Street" banks, the large regional players love this business even more. In this regulatory environment banks' ability to build a book of auto loans and then blow out a large portion of it via securitization is particularly appealing.

Fitch Ratings: - ... Fitch sees the revival of auto ABS issuance partly as an effort by these banks to gain some regulatory relief on capital and liquidity requirements.

Aside from Huntington Bancshares, few large U.S. regional banks have been frequent issuers of auto ABS paper recently. However, Fifth Third, M&T Bank and other lenders have launched new deals. Many of these transactions have been upsized from initially proposed levels.
... 

Banks are likely viewing the openness of the market as an opportunity to swap out less liquid loans for securitizations that stay on the balance sheet but receive more favourable treatment under Basel III with respect to capital and liquidity.

In some cases, the deals have included a large share of banks' total auto-loan books. For example, collateral in M&T's recent $1.4 billion ABS transaction represented over 60% of its total auto loans. Fifth Third's recent $1.3 billion ABS transaction was collateralized by a pool of loans exceeding 10% of the bank's total auto-loan balance as of June 30.

Why do investors love this asset class? There are two key reasons:

1. Consumer ABS loans' tenor tends to be relatively short. Even a 5-year auto loan is far easier to get comfortable with than a 30-year mortgage.

2. Delinquency rates on ABS have been benign.  Prime auto loan delinquencies for example are near historical lows.

Just to put this in perspective, the following chart compares delinquency rates for consumer non-real estate loans (blue) with mortgage loans (red).

This spectacular divergence that started with the housing recession in 2007 persists through today and continues to make ABS assets attractive on a relative basis.

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From our sponsor:

The dark side of rising rental costs in the US

One factor that may continue to provide tailwinds to US housing recovery is the rental market. Rents are rising faster than inflation, widening the spread between housing costs and wages.

Bloomberg: - For households with children, rising housing costs, elevated unemployment and stagnant earnings are increasingly placing rent beyond reach. The housing slump made matters worse as former homeowners turned into renters, increasing competition for available apartments.
...
Nationally, the average hourly wage among renters is $14.32 this year compared with the $18.79 needed to afford an apartment at a fair-market rent, as defined by the U.S. Department of Housing and Urban Development, without spending more than 30 percent of income on housing, a National Low Income Housing Coalition report found in March. The $4.47 gap this year is wider than the $4.10 differential in 2012.
...
Median household income has fallen every year for the past five after adjusting for inflation, with Americans earning no more than they did in 1996, according to data from the Census Bureau. The share of people making less than $15,000 climbed to 13 percent of the population in 2012, from 10.9 percent in 2000, and the share making less than $35,000 expanded to 35.4 percent from 31.4 percent.

According to the Fed, the ratio of rental obligations to disposable income is now at post-recession high. Growing rental costs are driven by declining vacancies and lower housing inventory in the US. Of course the recent rise in interest rates has not helped matters either. Higher rates raise the break-even rent level for landlords who finance their properties.

Source: CIBC

While this development is encouraging some renters to plunge into homeownership, giving a boost to home prices, it is also displacing low income families. This trend is quite troubling.

Bloomberg: - The number of children without a home increased by an estimated 2 percent, according to NAEH, a Washington-based non-profit focused on policy and research on the needs of homeless people.
...
The share of Americans experiencing “deep poverty,” living at less than 50 percent of the $23,492 poverty line for a family of four, climbed to 6.6 percent in 2012 from 4.5 percent in 2000, based on Census Bureau data released last month.

That may increase the pipeline of Americans heading toward homelessness. There was a 9.4 percent increase in the number of poor people “doubled up,” or living with friends or family due to economic need, between 2010 and 2011, based on the NAEH 2013 report. Crowley said 2011 is the latest year for which usable data on doubling up is available.

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Abe gets ready to start "naming and shaming"

As discussed earlier (see post), the key issue with Japan's economy these dyays is wage growth - or lack thereof. And that is holding back the so-called Abenomics. Recent increases in prices (mostly from yen's depreciation) can not be sustained unless salaries keep up. Inflation and weak wage growth can squeeze consumer spending power and stall economic growth. And Japan needs to have a sustainable period of price increases to get out of the deflationary hellhole. With a long history of wage declines however, getting Japanese firms to change their behavior has been a difficult task.

Apparently Abe has had enough. According to TV Tokyo (h/t ISI Group) Abe will begin pressuring business leaders directly to raise wages. The goal is to start with a corporate wage survey. How would a survey help? In Japan if the survey is published with the companies' names shown, the strategy of "naming and shaming" just might work. Public image is critical to most Japanese firms and this just may push them to change the way they pay their employees.

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From our sponsor:

This simple trading strategy points to rationale for currency wars

Looking for a simple way to outperform the market on your international equity index portfolio? Here is a simple algorithm from JPMorgan (warning: do not try this at home). Select two countries with the worst performing currencies (against USD) over the past 4 months and go long equity indices of those two countries. Now select the two best performing currencies and short the indices of those countries (to the extent that's possible). Repeat the exercise once a month. If you back-test this simple strategy, you get the following excess returns.

Source: JPMorgan

Hard to believe, right? Obviously there is friction in shorting equities of certain countries and the "actual returns may vary". Nevertheless this is telling us that currencies drive equity returns for many nations.

The explanation seems to be tied to exports. Exporters' shares and firms that support them, such as developers, raw materials firms, banks, etc.  perform better when a nation's currency is weak. The opposite holds true as well - strong currencies make exports more expensive, creating drag on revenue. This simple strategy therefore points to the rationale for "currency wars". Want a stronger stock market in the next few months, weaken your currency. You may end up with other problems, such as inflation, but the stock market should do well.

Take India for example. After the rupee took a massive beating this summer (see post), inflation has picked up and the economy has slowed.

Source: Econoday

Yet SENSEX, the broadly watched stock market index, is now at a 3-year high.

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From our sponsor:

"Radioactive" treasury bonds: the "least unconstitutional" path?

The Gallop sentiment index is now at the lowest level since 2011, when doubts about Italy's ability to roll its debt posed risks to EMU's stability. It took the first 3-year LTRO program to bring some calm to the markets and to consumer sentiment. Now, in a matter of days we are back to those lows again.

This is a serious blow to the US economy, with the full damage becoming visible in months to come. While there isn't much that can be done about the shutdown without some sort of a deal, academics have been desperately searching for a solution to what amounts to a constitutional crisis - the debt ceiling impasse. One such proposal came from Columbia University (Neil Buchanan and Michael Dorf).

The authors argue that the executive branch is presented with two competing directives. The Obama administration is required to spend money on programs appropriated by Congress (including paying on government debt, paying for Social Security, Medicare, etc.). At the same time the president is not allowed to issue incremental debt. Complying with both is an impossibility, forcing the president to violate the constitution one way or another. The two Columbia law professors argue that in such a situation the president should choose the "least unconstitutional" path. And that would be issuing additional debt without the approval from Congress (see paper below).

The problem with this solution is the market. Selling "unconstitutional" treasuries will encourage traders to short these bonds against older (constitutional) vintages. Inevitably someone will challenge the paper's constitutionality - potentially all the way to the Supreme Court. In the mean time yields on such paper may end up being quite high. Ultimately it will push up rates across the board as more of these bonds hit the market. Such a scenario could make the Fed's "taper" feel like child's play. The authors call these bonds "radioactive" and admit this solution could be problematic. Nevertheless they argue it is better than an outright default and could potentially pacify the markets.

It took the 3-year LTRO to calm global markets in 2011. Now we talking about "radioactive" bonds to help us do the same in 2013?

Enjoy!
Columbia Law Review

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From our sponsor:

Market distortions in the short end of the curve

In recent years the 1-month treasury bill has been quite sensitive to policy risks. While in the past the bill mostly responded to changes in the Fed's overnight target rate, in the current zero rate environment other events cause bill pricing to fluctuate. Changes in the 1m yield have not always corresponded to moves in longer term rates. For example, "taper" fears caused a spike in the 10-year rates while pushing the 1m bill down into the 0-2bp range.

On the other hand, bank CD ("certificate of deposit" or "term deposit") rates just kept moving lower. Flush with deposits (see post), most banks have little use for additional short-term financing. As a result, the 1-m treasury bill now yields more than an average 1-month CD - which is a distortion that would normally never exist.

Source: Bankrate.com

An even more bizarre market distortion is that the one-month LIBOR (which is somewhat tied to CD rates these days) is also lower that the corresponding treasury bills. The spread between the two has become negative for the first time in history.

A naive interpretation of this effect would be that the US government credit is worse than bank credit. A better way to think about this however is that the one-month bill is priced to be longer than one month. Let's hope that all of this will be just a bad dream tomorrow, with the Senate apparently beginning to make some progress.

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Goldman: LTRO-III is only a matter of time

Over the past year, the ECB's (Eurosystem's) consolidated balance sheet declined roughly three quarters of a trillion euros. As discussed earlier (see post) most of this decline is due to the repayment of a portion of the MRO/LTRO loans that the ECB extended to the area's banks in 2011 and 2012.

ECB's (Eurosystem) balance sheet (source: ECB)

Some economists  - particularly those looking at the Fed and the BOJ - view this reduction as a form of tightening in the area's monetary conditions. The ongoing need to roll a number of maturing periphery governments' and banks' bonds, risks flaring up the debt crisis. Many believe the ECB should flood the banking system with liquidity once again in order to blunt any roll issues as well as to halt the declines in credit growth (see post).

A number of economists think that "LTRO-III", a third major long-term lending program to the euro area's banks, will help the situation. According to them it is only a matter of time before the ECB decides to proceed with another round of liquidity injections.

Goldman: - We no longer expect the ECB to offer a longer-maturity LTRO by the end of the year, following the latest statements from a number of Governing Council members to the effect that such a move was not being considered at this point. However, we maintain our view that such a measure would address several potential problems affecting the banking sector and the wider economy. A longer-maturity LTRO would, for example, buy insurance against the risk that maturing short-term government and bank debt would lead to renewed tensions in the Euro area financial system. We therefore continue to believe the ECB will eventually counter the decline in excess liquidity by offering another longer-maturity LTRO.

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Yield curve inversion moves beyond one month as fiscal negotiations progress remains elusive

It took a while for the public to begin to care about the debt ceiling fiasco, but the realization is sinking in that this is not just "fun and games".  Google search frequency for the term "government default" has moved way past the spike in 2011 to hit a new record.

Google search frequency for the term "government default"

Equity investors have pinned their hopes on a potential breakthrough in negotiations, with Paul Ryan suddenly stepping into a leadership role (see post). VIX dropped some 24% (relative move) in a couple of days in response and indices rose sharply.

VIX implied volatility index (source: Barchart)

Expectations have risen that the Republican leadership will attempt to find a face-saving solution that will reduce the ongoing bleeding of popular support for the GOP. The party is in trouble and is facing potential losses of seats in the House. What's even more concerning for some is the prospect of a Democrat in the White House for another 8 years. If anything, this should be enough of an impetus to find a speedy resolution.

Bond investors however are not taking any chances. The yield curve inversion has now moved beyond 1-month bills, with maturities out to three months are feeling the impact. Rumors persist that institutions are continuing to move out of treasury money market accounts in fear of having their funds frozen.

Today much of the action has moved to the Senate, with hopes that something positive could happen this weekend. The news so far is not encouraging.

POLITICO: - It’s now the Harry and Mitch show.

After Senate Democratic leaders rejected a proposal Saturday by Sen. Susan Collins (R-Maine) to end the budget impasse, the burden to find a solution now falls squarely on Majority Leader Harry Reid and Minority Leader Mitch McConnell — two shrewd tacticians who have a long, complicated and contentious personal and political history with each other.

Republican senators, eager for a way out of a shutdown fight that has roiled their party’s brand, reacted to the leadership discussions positively, believing that the two crafty dealmakers could concoct a proposal to reopen the government and avert the nation’s first-ever default as soon as next week.

Reid, however, was notably more dour.

When asked if he is confident he could reach a deal with McConnell, Reid told POLITICO: “No.”

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From our sponsor:

The Fed now holds more securities than all US banks combined

As discussed previously (see post), US commercial banks have been scaling back on their loan portfolio growth. Banks have been even more aggressive however in reducing growth of their securities holdings. The year-over-year growth is at the lowest level since the financial crisis. The reasons vary. In some cases it was simply about trimming treasuries and MBS holdings as rates rose sharply this summer. In other cases, such as with corporate bonds, it is due to the various regulatory pressures, e.g. the Volcker Rule.

And while banks are cutting their securities inventory, the Fed keeps buying. Recently the Fed' holdings of securities (mostly treasuries and MBS) materially exceeded that of all US banks combined. Prior to the financial crisis banks owned 2.5 times the amount of securities held by the Fed. The chart below puts it in perspective. Before the securities buying program is over however, the differential is expected to widen even further.

Securities held by US commercial banks; Securities held by the Fed

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From our sponsor:

GOP leadership faces the harsh realities of the polls

The Republican party has a problem. The government shutdown seems to be helping the president in the polls.

Simultaneously Republicans' image is getting hammered, as an increasingly growing proportion of US voters blame them for the shutdown.

Associated Press: - The Associated Press-GfK survey affirms expectations by many in Washington - Republicans among them - that the GOP may end up taking the biggest hit in public opinion from the shutdown, as happened when much of the government closed 17 years ago. But the situation is fluid nine days into the shutdown and there's plenty of disdain to go around.

Overall, 62 percent mainly blamed Republicans for the shutdown. About half said Obama or the Democrats in Congress bear much responsibility.

This is not about who is right or wrong - these are simply the facts. And the GOP needs to pay attention, particularly as the mid-term election year approaches. Apparently they have been. With the White House having the upper hand in the polls, it seems that Rep. Paul Ryan has been tagged to get the GOP out of this mess. A senior Republican congressional staff member has told Sober Look that Ryan was asked to help "end the shit show". Looking beyond the typical rhetoric on both sides, he seems to be making some progress.

CNN: - Paul Ryan steps into budget fight.

"And at that point, both Democrats and Republicans say, the tone of the meeting changed," King said. "The president said, "'Listen, I'm not going to negotiate with you until you reopen the government, but go to your members, find out what you need to do to get that part done and let's try to make some progress.'"

CNN's reporting on the meeting is based on accounts from multiple sources who attended. The meeting appeared to help begin to break the logjam that has kept parts of the government shut down for 11 days, leaving hundreds of thousands of federal employees without work and causing countless ripple effects, from lost tourist revenue around national parks to a threat to the Alaskan crab fishing season.

Let's hope it works. The debt ceiling alarm clock will wake up the nation in exactly one week.

SoberLook.com

From our sponsor:

Spike in bill rates rippling through repo, other money markets

Yields on treasury bills with near-term maturities have spiked to multi-year highs as the debt ceiling deadline approaches. While market participants are generally expecting to see a resolution (albeit a temporary one), some are not taking any chances.

USA Today (AP): — Fidelity Investments, the nation's largest money market mutual fund manager, has sold all of its short-term U.S. government debt — the latest sign that investors are increasingly nervous about the possibility of a government default.

Source: US Treasury

Institutional investors have rolled a chunk of their holdings into cash during September but in the last week or so started pulling out of government money market funds - moving funds into bank deposits instead.

Source: ICI (unit=$1MM)

Investors fear that their accounts will be frozen, as money fund managers who don't receive timely payments on bills are unable to meet redemptions. Many money market funds also use repo (collateralized loans) with treasuries or agency MBS as collateral. These short-term loans usually yield slightly more than treasury bills, giving money markets a few extra basis points. But with bills under pressure and investors getting out, repo rates have suddenly risen as well (after a period of declines - see post).

Bloomberg: - “We’ve seen some rise in repo rates in sympathy with the broad move higher in money-market yields, most dramatically in the near-term Treasury bills, given concerns over the debt-ceiling,” said Andrew Hollenhorst, fixed-income strategist at Citigroup Inc. in New York. “October futures contracts have had a sharp yield rise, signaling expectations for significant moves higher ahead, consistent with the sharp spike we saw in 2011 before the August debt-limit deadline.”

Source: DTCC

Some continue to believe that a technical default by the US government would impact treasury securities only. But as we see from the repo example, that assumption is quite naive. An adjustment to bill rates is already rippling through a number of other money market instruments. If we don't have a resolution on the debt ceiling soon, the shock will ripple across broader markets as well.

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From our sponsor:

Jobless claims back to reality

As discussed before (see post), "something is rotten" in the the world of unemployment claims statistics. The data has simply been wrong - though it wasn't clear where it went wrong. As many pointed out, the issue has likely been at the state level, particularly in California, where computer system changes created a backlog of claims to be reported. So California chose to send in numbers that didn't include all the claims. And the US Department of Labor chose to publish them - knowing they were wrong. At the same time economists just accepted these numbers as real, some pointing to amazing improvements in US labor markets. And now as California caught up with its "booking" of claims into their "upgraded" system, the claims spiked.

Econoday: - A giant spike in weekly jobless is mostly tied to continued counting problems in California and is only partially the result of the government shutdown. About 1/2 of a gigantic 66,000 increase in initial claims in the October 5 week reflects backlog issues in California from a computer changeover last month, while about 15,000 of the increase reflects claims from non-Federal workers including contractors who have been hit by the government shutdown. Federal employees are not included in headline claims with the latest data for this category available only for the September 21 week which was of course before the shutdown hit.

The spike is not real and neither was the earlier decline. We just got back to the original trend - plus some laid-off federal government contractors.

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From our sponsor:

First signs of federal government mess impacting consumer spending

While data is difficult to come by, there are signs that the sharp drop in consumer confidence since the federal goverment shutdown (see post) is translating into weaker consumer spending. For example the ICSC-Goldman same store sales index has unexpectedly declined.

Source: Econoday

Econoday: - In the first indication on the economic effect of the ongoing standoff in Washington, ICSC-Goldman's same-store sales index slipped 0.1 percent with the year-on-year rate slipping to plus 1.8 percent from 2.1 percent. The report cites weakness across most segments.

The Johnson Redbook same store sales index has weakened recently as well.

Source: Econoday

Moreover, the ISI Restaurants Sales Survey has been quite sluggish, though it's too early to tell if this is related to poor consumer confidence.

Source: The ISI Group

Typically we have a lag between a major shift in consumer sentiment and its full impact on spending. Perhaps a more timely indicator of consumer behavior is the stock market. And the stock market is telling us there is a real risk of slower spending growth ahead. The chart below compares the Consumer Discretionary Select Sector (XLY) with the overall market (SPY). The underperformance of consumer discretionary shares just in the last 3 days is quite clear. The government shutdown and the upcoming debt ceiling uncertainty is expected to negatively impact US consumer spending.

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3 days to cure

Credit Suisse recently pointed out an important fact about US sovereign credit default swap (CDS) mechanics. US CDS is based on treasuries (linked to a specific security - the co-called "reference obligation"), which according to the official offering document (see offering circular here), do not have a "grace period". Under such circumstances sovereign CDS documents dictate that the grace period is three days before an event of default is declared. That means if the US Treasury fails to make a principal or interest payment on any treasury security, an ISDA credit event will be triggered after three days. Markets move much faster than politicians.

Credit Suisse: - For US CDS, one of the important points is that there is no stated "grace period" in the Uniform Offering Circular for Treasury securities. Therefore CDS documents state that a failure to pay principal or coupon can be cured in three days before an ISDA credit event is declared. Although a single Treasury security is the "reference obligation," any Treasury security that is pari passu to this obligation could cause a credit event – as long as it was not cured in three days.

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Wishing for US debt ceiling train wreck

How long will it take for the US Treasury to run out of funds if the October 17th deadline comes and goes without an increase in the debt ceiling? The answer is - less than a couple of weeks.

Source: Barclays Research

Fitch Ratings: - A formal review of the rating with potentially negative implications would be triggered if the US government has not raised the federal debt ceiling in a timely manner prior to when the Treasury will have exhausted extraordinary measures and cash reserves. According to official comments by the US Treasury secretary, extraordinary measures could be exhausted by 17 October.

In such a scenario, the Treasury would be forced to dramatically cut back on current spending with adverse implications for the economic recovery. Even if it were to prioritise debt service - something the Treasury has repeatedly stated it has neither the legal authority nor logistical capability to do - it would likely incur arrears on a range of payment obligations and thus continue to incur debt, but in a disorderly and disruptive manner.

Amazingly, there seem to be countless Americans who are rooting for this to happen. Emails are pouring in arguing that a US default in fact is a good thing. They really believe this will magically solve the US fiscal deficit problem and/or somehow "punish" the Obama administration. They don't seem to realize that this is akin to wishing for another 2008, while US government deficit would only worsen as a result (with tax revenue collapsing while entitlement liabilities growing just as fast). Alternatively these people just don't seem to value their jobs, homes, pensions, and bank accounts - all of which will be at risk should the US government fail on its obligations.

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Market's overnight rate expectations are more dovish than the Fed's own forecasts

Market expectations of the first rate hike have once again been pushed out to May of 2015.

The combination of the Fed maintaining its unprecedented monetary easing program at the September meeting as well as the assumption that Janet Yellen will be taking over for Bernanke would suggest that the central bank is farther from any rate adjustment than was expected earlier this year. In fact the market now considers the Fed to be more dovish than the Fed's own rate forecasts would suggest.

Barclays Research: - Despite stronger than expected data, the market has pushed out hike expectations. ... the market is now pricing in the Fed to hike to 0.75% by the end of 2015 vs the Fed’s [own] forecast of 1% and 1.8% by the end of 2016 vs Fed’s forecast of 2%.

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The impact of a US technical default on long-term treasuries

We know how the short end of the US treasury curve is expected to react to a US technical default (see post). But what about the long end of the curve? A survey from JPMorgan suggests that investors are divided.

This of course would be an unprecedented event and nobody really knows how fixed income markets will react.

Those who argue that longer term rates will fall believe that the economy and the equity markets (as well as other risk assets) will take such a hit, a severe deflation will ensue. Under such a scenario treasuries will become similar to JGBs, with nominal yields collapsing even as real yields stay positive.

The other group however believes that such an event will shake investor confidence in treasuries so much - by delaying payments indefinitely - that investors, particularly foreigners, will dump the paper in unprecedented amounts. The dollar will take a tremendous hit and longer term rates would spike.

Neither scenario is particularly appealing.  Politicians who think this will help balance the budget will soon realize that the collapse of tax revenue from either of these outcomes will far outweigh any supposed improvements in fiscal discipline. Sadly, by the time the realization sinks in however, it will be too late.

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US loan-to-deposit ratio the lowest in 30 years and falling

The chart below shows US total loan balances relative to bank deposits over the past couple of years. The total loan growth rate continues to deteriorate while deposits grow.

Source: FRED (5/4/2011=100)

In fact the ratio of these two measures, the so-called loan-to-deposit ratio is now at the lowest level in some 30 years.

Note that the jump in early 2010 is not real - it's an accounting adjustment

This creates material headwinds for economic growth. Unfortunately there is no evidence that the current monetary policy will reverse the trend of weakening loan growth. And as we all know, the US fiscal policy (if one could call it that) is not going to help much either...

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Washington playing with fire

Relative to 2011, the public is still not paying sufficient attention to the looming US debt ceiling deadline. Many don't even believe the deadline itself is real, arguing that the recent government shutdown would magically balance the budget. Sadly, even some educated people still think that not raising the debt ceiling will somehow help get rid of Obamacare.

Google search frequency for the phrase "debt ceiling" (click to enlarge)

Electoral calculus remains the primary driver for decision making in Washington. Politicians are willing to take the nation to the brink as they attempt to score points with their highly polarized constituency. Sadly it will be the voters who will ultimately get hurt - many of them remaining blissfully ignorant about what's about to unfold.

Just to put things into perspective, equity investors seemed more concerned about the Fed slowing securities purchases than the possibility and the impact of the US government not being able to borrow.

VIX (US stock market implied volatility index)

Some have argued that the president can override the debt limit stalemate via the 14th amendment - one of the post-Civil War Reconstruction Amendments. That would certainly explain some of the apathy. But according to the White House, that is not an option.

The Guardian: - Some Democrats argue that powers granted under the 14th amendment to the constitution, which was introduced to control southern states after the civil war, would allow the president to unilaterally borrow money if there was such a threat to the credit-worthiness of the US.

"Using the 14th would show the Republicans he means business," one former aide to Bill Clinton told the Guardian last week.

But the White House ruled out the option on Thursday, ending days of Washington debate about whether this obscure legal authority might provide a way out for Obama – at least from one half of Republicans' fiscal pincer movement. "The administration does not believe the 14th amendment gives power to the president to ignore the debt ceiling," said spokesman Jay Carney.

Without this option and given the ongoing intransigence in Washington, there is a real possibility the debt ceiling clock will run out without a deal. Some investors are not taking any chances - particularly foreigners.  The US sovereign CDS spread is grinding higher.

Source: DB

Treasury bill investors are also increasingly concerned about not being able to get their money back on time (see post) - which is causing the one-month bill rate to rise as it did in 2011.

The short-end of the US treasury curve is now inverted as a result.

There is anecdotal evidence that a few investors are taking funds out of treasury money market accounts. Even though nobody is doubting that investors in such funds will ultimately get their money back, the concern is legitimate. A technical default by the US government may result in these funds becoming frozen for some period of time. There will simply be no liquidity to fund large redemption requests. What these investors fail to realize however is that in such a scenario, treasury money market funds will be the least of their problems.

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