Riksbank hikes rate, Fed likely to cut

Many central banks stopped tightening monetary policy after credit markets went into turmoil. Sweden's is not one of them. From the Riksbank's press release yesterday:

At its meeting on 29 October, the Executive Board of the Riksbank decided to raise the repo rate by 0.25 percentage points to 4 per cent. It is also probable that the interest rate will need to be raised slightly further in the future. During the first half of 2008 the repo rate is expected to be around 4.25 per cent. The Riksbank’s view of the future repo rate path remains largely the same as in June. The assessment is that the interest rate increases will contribute to an inflation rate in line with the 2 per cent target at the same time as production and employment develop in a balanced manner.

The Federal Reserve is expected to go in the opposite direction later today, especially after the latest economic reports. From Bloomberg yesterday:

The Conference Board's gauge of confidence declined to 95.6, the lowest since October 2005, from 99.5 in September, the New York-based group said today. Home values in 20 U.S. metropolitan areas slid 4.4 percent in the 12 months that ended in August, according to the S&P/Case-Shiller home-price index.

The figures heighten concern that consumers will put a brake on spending, which accounts for more than two-thirds of the economy. Fed policy makers will need to cut the target rate for overnight loans between banks tomorrow by a quarter point to 4.5 percent to prevent the housing recession from triggering a broader economic decline, some analysts said.

And the credit market turmoil may not even be over. From Bloomberg:

Banks shut out of the market for short-term loans are finding salvation in a government lending program set up to revive housing during the Great Depression.

Countrywide Financial Corp., Washington Mutual Inc., Hudson City Bancorp Inc. and hundreds of other lenders borrowed a record $163 billion from the 12 Federal Home Loan Banks in August and September as interest rates on asset-backed commercial paper rose as high as 5.6 percent. The government-sponsored companies were able to make loans at about 4.9 percent, saving the private banks about $1 billion in annual interest.

To meet the sudden demand, the institutions sold $143 billion of short-term debt in August and September, according to the FHLBs' Office of Finance. The sales pushed outstanding debt up 21 percent to a record $1.15 trillion, an amount that may become a burden to U.S. taxpayers because almost half comes due before 2009.

Like Fed rate cuts at the sign of any market distress, it is possible that this is only delaying the inevitable. Or maybe worse.

Yves Smith at naked capitalism comments that recourse to the FHLB means that "risk has been passed from institutions that could have been permitted to fail (or at least suffer) to one too big too fail. We'll learn all too soon whether this was a move that we will regret."

Japanese unemployment rises

This week we get a look at the employment picture in several major economies, starting with Japan's. Unfortunately, it's not a great start. Bloomberg reports:

Japan's unemployment rate unexpectedly rose for a second month, undermining the central bank's case for raising interest rates.

The jobless rate climbed to 4 percent in September from 3.8 percent last month and 3.6 percent in July, the statistics bureau said today in Tokyo...

The number of jobs available for each applicant slipped for a third month to 1.05 in September from 1.06 in the previous month, the Labor Ministry said today.

September household spending, however, surprised on the positive side.

Household spending climbed 3.2 percent from the same month a year earlier, the statistics bureau said today in Tokyo. The number benefits from being compared with a 6 percent drop in September last year, when the average income of respondents was lower. The median estimate of 32 economists surveyed by Bloomberg was for a 1.4 percent increase.

September retail sales reported yesterday by Bloomberg had also provided a positive surprise.

Japan's retail sales unexpectedly rose for a second month in September as lingering summer heat spurred demand for cold drinks and two long weekends prompted people to fill up their gas tanks and drive.

Sales climbed 0.5 percent from a year earlier, the same pace as August, the Ministry of Economy, Trade and Industry said today in Tokyo. The median estimate of 18 economists surveyed by Bloomberg News was for a 0.7 percent decline.

US stocks post solid gains, Hang Seng breaks 30,000

US stocks had a good day yesterday. MarketWatch reports:

U.S. stocks rallied Friday, and posted solid weekly gains, with technology stocks leading the charge after Microsoft Corp.'s earnings blew past analysts' estimates while raised forecasts from Countrywide Financial Corp. helped soothe concerns about bad home loans.

Investors also looked positively for the coming week, with firm expectations that the Federal Reserve will cut interest rates again...

The Dow Jones Industrial Average rallied 134 points to 13,806, to end near its highs of the session. For the week, the Dow posted a gain of 2.1%...

The S&P 500 Index gained 20 points to 1,535. For the week, the broad index advanced 2.3%.

But most of gains were seen in the tech-heavy Nasdaq Composite Index which rallied 53 points, or 1.9%, to 2,804. For the week, the Nasdaq rose 2.9%.

Tech bubble 2.0?

Stock prices rose despite the University of Michigan reporting yesterday that its consumer confidence index fell to 80.9 in October from 83.4 in September.

Germany is also seeing consumer confidence falling even as consumer prices continue to rise.

In fact, inflation could remain a concern in the euro area in general as money supply in the form of M3 grew 11.3 percent in September, near a 28-year high.

Japan, in contrast, is still waiting for inflation to re-appear. From AFP/CNA:

Japan's core consumer prices fell 0.1 percent in September from a year earlier, the government said, in line with market expectations.

But the core consumer price index (CPI) for Tokyo alone in October, which is seen as a leading indicator for national price trends, rose 0.2 percent from the previous month and was flat from a year earlier...

The government also reported that Japan's industrial output dropped by 1.4 percent in September from the previous month as automakers curbed production, matching market forecasts.

Falling consumer confidence or prices isn't a worry in China though, not with retail sales rising 17 percent, producer prices rising 2.7 percent and house prices rising 8.9 percent in September from a year earlier.

And riding on the coat-tails of China's boom, Hong Kong's stock market has surged, the Hang Seng Index closing above 30,000 for the first time yesterday after gaining 550.73 points or 1.8 percent to close at 30,405.22.

Chinese stocks plunge as economy moderates

China's economy appears to be moderating. AFP/CNA reports:

China's economy...grew by 11.5 percent in the third quarter and the first nine months of 2007, compared with the same periods a year earlier, the National Bureau of Statistics said...

As evidence of a slight slowdown, Li of the statistics bureau pointed out that economic growth in the second quarter had been 11.9 percent, while inflation in September was 6.2 percent, down from 6.5 percent in August...

The bureau confirmed that fixed-asset investments expanded by 25.7 percent in the first nine months of 2007 from the same period a year ago.

The figure marked a wafer-sized easing from the first half of the year, when investments in fixed assets were up 25.9 percent.

Fears of further tightening from policy-makers, however, led to a plunge in the Chinese stock market yesterday. Bloomberg reports:

The CSI 300, which tracks yuan-denominated A shares listed on China's two exchanges, declined 254.22, or 4.6 percent, to 5,333.79 at the close, the biggest slide since Sept. 11. It was the biggest fluctuation among equity markets included in global benchmarks. Among the measure's 300 members, 266 fell. All 10 of the benchmark's industry groups dropped.

But there remains an undertone of optimism about the prospects for Chinese stocks. From Reuters:

Eight local analysts surveyed by Reuters this week predicted [Shanghai's main] index, which was at 5,633 points at midday on Thursday, would close this year around a median of about 6,000. All but one forecast a rise to about 8,000 by next June...

"The bull run is far from over. Rapid growth in the economy and corporate earnings offsets part of the pressure from high valuations," said Wu Haijun, an analyst at Power Pacific Corp. of Canada.

Perhaps there is still just too much liquidity flowing around. Bloomberg reports that crude oil prices are also back on the rise.

Crude oil rose to a record above $91 a barrel in New York on an unexpected drop in U.S. stockpiles and concern that supply from the Middle East may be disrupted.

Elsewhere, US stocks were little changed even as yesterday's data showed that US housing remains shaky while manufacturing's ability to offset the housing weakness remains uncertain. Reuters reports:

The Commerce Department said new single-family home sales rose 4.8 percent in September to an annual rate of 770,000 units from a downwardly revised 735,000 pace in August...

Thursday's housing data had little impact among U.S. Treasury traders who expect a modest, 25 basis point cut in a key interest rate when Federal Reserve policy-makers meet next week. Stocks, too, were little changed as the Dow Jones industrial average was down 3.33 points and the Standard & Poor's 500 index was down 1.48 points on the day. The dollar fell near an all-time low against the euro as investors debated the size of an expected Fed interest rate cut...

Durable goods orders fell 1.7 percent in September on the back of a sharp drop in transportation orders...after a 5.3 percent decline in August...

Initial claims for state unemployment insurance benefits totaled 331,000 in the week ended October 20 following the prior week's upwardly revised 339,000, which originally had been reported as 337,000...

Europe economy is also seeing increasing signs of slowing, with Germany's IFO business confidence index falling to a 20-month low of 103.9 in October from 104.2 in September and INSEE's index of French business confidence falling to 108 in October from a revised 109 in September.

US stock market resilient in face of negative news

Much of yesterday's news was bad, but the stock market held up relatively well. MarketWatch reports the US stock market action.

After shedding more than 200 points, the Dow Industrials ended 1 point lower at 13,675.3, with 15 of its 30 components lower...

The brunt of the selling pressure was seen on the tech-heavy Nasdaq Composite which settled 24.5 points down, almost 0.9%, at 2,774.76...

The S&P 500 fell 3.71 points to 1,515.88.

Already down, the major stock indexes solidified their losses after the National Association of Realtors reported sales of existing homes and condos fell 8% in September to their lowest level in eight years, with median sales prices down 4.2% in the past year. Read Economic Report.

Losses reported by Merrill along with concerns in the pipeline for Internet retail giant Amazon.com fueled worries about the extent of the damage of the recent credit-related trouble and its impact on the economy.

Hope for an imminent Fed cut was said to be a factor in limiting the loss at the end of the day, but Mark Hulbert points out that the market has recently had a lot of buying support from corporate insiders anyway.

Elsewhere, the data mostly point to further softening of the global economy.

Bloomberg reports the preliminary readings for the eurozone service and manufacturing sector indicators for October.

Growth in Europe's service industries accelerated in October as banks started to recover from higher credit costs sparked by defaults on U.S. subprime mortgages.

Royal Bank of Scotland Group Plc's services index rose to 55.6 from 54.2 in September, according to a preliminary estimate published today...

Manufacturing growth slowed for a fourth month, today's report showed. The manufacturing index dropped to 51.5 from 53.2, the lowest since August 2005. Economists expected a decline to 52.9, according to the median of 33 estimates. A composite index for services and manufacturing fell to 54.5 from 54.7, the weakest reading since September 2005...

Meanwhile in Japan, Bloomberg reports that exports slowed in September.

Japan's exports grew at the slowest pace in two years in September as shipments to the U.S. fell, a signal that the nation's economic expansion may cool because of waning demand in its largest market.

Exports rose 6.5 percent from a year earlier, the Finance Ministry said in Tokyo today, less than the 8.1 percent median estimate of 10 economists surveyed by Bloomberg News and 14.5 percent in August...

Imports fell 3.2 percent last month, the first drop since February 2004. Oil imports contributed two thirds of the decline, the ministry said. Analysts expected a 0.9 percent increase in the import bill.

US stocks and bonds gain amid mixed economic data

Fears of a repeat of 1987 appear to be fast receding, looking at yesterday's performance on Wall Street. From Bloomberg:

U.S. stocks rose the most in two weeks after better-than-expected earnings from Apple Inc. and American Express Co. eased concern the housing slump has depressed consumer spending...

The Standard & Poor's 500 Index added 13.26, or 0.9 percent, to 1,519.59. The Dow Jones Industrial Average gained 109.26, or 0.8 percent, to 13,676.23. The Nasdaq Composite Index increased 45.33, or 1.7 percent, to 2,799.26, helped by a late-session rally on Research In Motion Ltd.'s alliance with Alcatel-Lucent to distribute the BlackBerry e-mail phone in China.

The rise in equities wasn't at the expense of bonds. From Reuters:

The U.S. Treasury debt market eked out gains on Tuesday as bond bulls brushed off a recovery in equities and focused on signs of a slowing economy and prospects of the Federal Reserve cutting interest rates...

Two-year Treasury notes...were up 2/32 higher in price for a 3.84 percent yield, down from 3.86 percent late on Monday.

Benchmark 10-year notes...were flat in price for a 4.41 percent yield, down 1 basis point from late Monday.

The Richmond Fed's manufacturing survey for October gave both equity and bond bulls reason for hope. While the manufacturing index for October fell to -5 from 14 in September, the index of expected shipments jumped eighteen points to 36 and the new orders indicator added sixteen points to 35.

In the euro area, industrial orders saw a rise of 0.3 percent in August after falling a revised 2.6 percent in July. However, Edward Hugh looks at the eurozone industrial orders data in greater detail and notes that "Western Europe is slowing visibly".

Slowing is more apparent in the UK after the Confederation of British Industry said yesterday its monthly manufacturing order books balance fell to -6 in October from +6 in September while a quarterly survey showed manufacturers were at their most pessimistic since the beginning of last year.

Not-so-black Monday

So much for fears of another Black Monday yesterday. While Asian and European stocks fell, mainly in reaction to Friday's falls on Wall Street, stocks in the US actually rose yesterday.

Bloomberg reports:

About nine stocks gained for every five that fell on the New York Stock Exchange as U.S. markets overcame a 115-point decline in the Dow Jones Industrial Average and losses in Europe and Asia. The Standard & Poor's 500 Index added 5.7, or 0.4 percent, to 1,506.33... The Dow average climbed 44.95, or 0.3 percent, to 13,566.97. The Nasdaq Composite Index increased 28.77, or 1.1 percent, to 2,753.93...

The Russell 2000 Index, a benchmark for companies with a median market value of $646 million, gained 1.4 percent to 810.08. The Dow Jones Wilshire 5000 Index, the broadest measure of U.S. shares, rose 0.5 percent to 15,247.75. Based on its advance, the value of stocks increased by $91.6 billion.

Looks like comparisons with 1987 are premature.

An accident waiting to happen

This is what Alan Greenspan says of the recent market turmoil, according to Reuters.

An unusually high degree of risk-taking across asset classes made recent financial market turmoil all but inevitable, former Federal Reserve Chairman Alan Greenspan said on Sunday.

"The financial crisis that erupted on August 9th was an accident waiting to happen," Greenspan said in a speech on the sidelines of the International Monetary Fund and World Bank meetings. "Credit spreads across all global asset classes had become suppressed to clearly unsustainable levels."

"Something had to give."

But didn't Greenspan himself contribute to the credit bubble during him time as Fed chairman?

Greenspan himself has drawn some criticism for cutting U.S. benchmark interest rates to 1 percent in 2003 and holding them there for a prolonged stretch, which some say helped inflate the U.S. housing bubble. But the former Fed chief said it was low long-term interest rates set in financial markets that pushed down mortgage costs and encouraged home buying.

"Central banks around the world have essentially lost control over the markets beyond maybe three or four or five years out. In other words, there is no evidence that we at the Fed had the capability of affecting mortgage interest rates," he said, noting that even when the U.S. central bank began raising rates in 2004, mortgage rates remained low.

Perhaps Greenspan hadn't read this paper from Marek Jarociński and Frank Smets presented at a St Louis Federal Reserve Bank conference last week. From the conclusion:

There is...evidence that monetary policy has significant effects on residential investment and house prices and that easy monetary policy designed to stave off perceived risks of deflation in 2002 to 2004 has contributed to the boom in the housing market in 2004 and 2005.

However, Greenspan almost certainly would have been aware of the analysis from John Taylor presented at the Jackson Hole symposium where the latter concluded that a higher federal funds rate path from 2002 onwards "would have avoided much of the housing boom" and the "reversal of the boom and thereby the resulting market turmoil would not have been as sharp".

Even the low long-term interest rates that Greenspan claimed was beyond the control of central banks was partly attributed by Taylor to monetary policy. He said that "the 2003-2005 period show a large downward shift in the responsiveness of the federal funds rate to inflation" and "this could have led investors to believe that there was a longer run change in policy which would have reduced the response of long term interest rates".

And this is not even taking into consideration the roles of other central banks like the ECB and the BoJ in contributing to easy monetary conditions during much of the period concerned.

For more explicit finger-pointing, see the Economist article "Fast and loose: How the Fed made the subprime bust worse".

Yen gains on rise in risk aversion

You can always tell when markets are nervous when the yen rises, as it did yesterday. Bloomberg reports:

The yen rose the most in six weeks against the euro as a decline in global stocks prompted investors to sell higher-yielding assets funded by loans in Japan.

Japan's currency gained for a fifth day versus the dollar, the longest winning streak in almost a year, and posted its best week against the euro in two months, as the risk of holding corporate debt increased...

"Risk aversion is the name of the game and people are cutting back risks," said Robert Fullem, vice president of U.S. corporate currency sales at Bank of Tokyo-Mitsubishi UFJ Ltd. in New York...

Against the dollar, the Japanese currency advanced to 114.51, from 115.63 yesterday. It also gained against all 16 most-actively traded currencies...

The Dow Jones Industrial Average lost 367 points and closed at the lowest since the Federal Reserve cut its benchmark lending rate Sept. 18. Citigroup Inc., Bank of America Corp. and JPMorgan Chase & Co. led financial shares to their worst week since 2002 after Wachovia Corp. said loan defaults lowered profit. Energy producers dropped the most in two years...

In a sign of growing credit market risk, the CDX North America Investment Grade Index has climbed 10 basis points this week, according to Deutsche Bank AG in New York, the biggest weekly increase since July 27. It rose 1.75 basis points today to 56 basis points...

Interest-rate futures traded on the Chicago Board of Trade show a 92 percent chance the Fed will cut the target rate for overnight loans a second time this year to 4.5 percent on Oct. 31. The odds were 32 percent a week ago.

It wasn't exactly Black Friday, but will it be Black Monday? We'll know in a few days' time.

More concerns for US economy

The US dollar continued its fall yesterday on heightened expectations of a rate cut after the day brought more worrying data on the US economy. From Reuters:

A report by the Philadelphia Federal Reserve Bank showed manufacturing in the Mid-Atlantic region grew more weakly than economists predicted in October. Its business activity index dipped to 6.8 in October from 10.9 in September...

However, the report's inflation gauge shot higher...

The Labor Department said new claims for unemployment aid climbed by 28,000 last week, much more than anticipated and the biggest increase for any week since February.

But it wasn't all bad.

A separate report from the Conference Board in New York showed its Index of Leading Economic Indicators rose a modest 0.3 percent in September after declining 0.8 percent in August, offering some reassurance about future prospects.

On the other hand, Asha Bangalore at Northern Trust thinks that the rebound in the leading index will be temporary as initial jobless claims and consumer expectations are predicted to turn negative in October.

Growth concerns dominate

In the US, growth concerns have been centred on housing and yesterday's reports only reinforced those concerns. Reuters reports:

Housing starts tumbled 10.2 percent to a 1.191 million unit annual rate, the slowest since March 1993, the Commerce Department said on Wednesday. Economists had expected starts to slip, but the sharpness of the downturn took them by surprise...

Indeed, the Commerce Department said permits for future building fell 7.3 percent last month, the sharpest drop since January 1995, to an annual rate of 1.226 million, the lowest level since July 1993.

The Beige Book was not particularly optimistic either.

A survey of business contacts conducted by regional Federal Reserve banks to help prepare for the Oct. 31 interest-rate meeting found U.S. economic growth has slowed since August, with consumers pulling back a bit and housing falling further.

And inflation failed to moderate further in September.

The Labor Department said the Consumer Price Index, the most broadly used gauge of inflation, rose 0.3 percent last month, the biggest gain in four months. However, the core rate, which excludes energy and food, moved up a modest 0.2 percent...

In addition, oil prices hit a record $89 a barrel on Wednesday, increasing worries that inflation will move higher and hinder economic growth.

Weak US economic growth is having an impact on the IMF's assessment of global growth. From Bloomberg:

The IMF lowered its projection for the global expansion next year to 4.8 percent in its semiannual World Economic Outlook, from an estimate of 5.2 percent in July. A weaker outlook for the U.S. was mostly to blame, as the fund reduced its forecast to 1.9 percent, from 2.8 percent.

"I would emphasize that there are serious risks ahead," Simon Johnson, the IMF's chief economist, said at a press conference in Washington. "The smoke has not yet cleared" from the financial-market turmoil, he said.

"Robust" growth in China, India and Russia, which accounted for half the global expansion over the past year, will compensate for the American slowdown, the fund said in its report. The IMF's new prediction is still half a point faster than the average pace so far this decade.

But it is not just the US economy facing problems. Japan's economy appears to be slowing too, with its leading economic indicator falling to 27.3 in August from 72.7 in the previous month.

BoC holds, inflation accelerates in euro area, growth concerns in the US

The Bank of Canada left its main interest rate unchanged yesterday, but meanwhile we still can't rule out another rate hike from the European Central Bank, not after September's inflation numbers in the euro area hit 2.1 percent, the highest since August 2006 and up from 1.7 percent in the prior month.

The Bank of England, though, may start considering cutting interest rates after inflation in the UK held steady in September at 1.8 percent.

US CPI inflation data come out later today and the core rate will be the main focus. However, Alan Greenspan is now suggesting that monetary policy-makers may need to give greater weight to the rising costs of energy and food. From Reuters:

"The notion of looking at a core price requires that energy and food have no long-term trend and that their fluctuations are essentially random. That is now becoming an increasingly questioned premise," Greenspan said.

Greenspan also thinks that the credit crunch will continue to weigh on the US economy.

"Even though the credit crunch is easing, it is residual," he said in an interview on CNBC television.

The impact tighter credit has had on borrowing costs "is going to slow this economy down to a certain extent," he said. The effects of that slowing are likely to last into the first quarter of 2008, Greenspan said.

Treasury Secretary Henry Paulson probably agrees, saying yesterday that the US housing crunch is likely to continue to impact the economy and capital markets "for some time yet".

And data out yesterday indicates that the pessimism on housing is justified. From MarketWatch:

The seasonally adjusted housing market index fell to a record low of 18 in October from 20 in September, the National Association of Home Builders reported Tuesday. It's the lowest reading in the index since its inception in 1985. Read more at the NAHB website.

The rest of the economy has done better, but there are signs of slowing there nevertheless. Again from MarketWatch:

Output of the nation's factories, mines and utilities increased by 0.1% in September, softened by a drop in production of motor vehicles, the Fed said. Output was flat in August.

Credit market turmoil and monetary policy

I had not much bothered to link to the many articles that have analysed the causes of the credit market turmoil partly because in my opinion, most of these analyses, especially those from the mainstream media, failed to put emphasis on the root of the problem. Wolfgang Munchau's article at the FT is one of the exceptions.

Two months after the beginning of the credit crisis, the monetary policy establishment has reached a consensus on its causes: the complexity of some of the instruments, shortcomings in the mathematical models, weakness in risk management and, of course, the role of the ratings agencies...

I concede that each one of these factors contributed to this crisis. But...I believe that the explosive growth in credit derivatives and collateralised debt obligations between 2004 and 2006 was caused by global monetary policy between 2002 and 2004.

In parts of 2002-04, both the US and Europe experienced negative real interest rates...

... It means that those who have access to credit at that rate – in this case commercial banks – have an interest in borrowing an infinite amount... In a world of perfect credit markets, one would expect negative real interest rates over a long period to cause a credit bubble...

[I]t is time to learn the main lesson of this crisis, which is that credit matters for monetary policy, a fact over which many central bankers are still in denial.

One shortcoming in the article though is that while it specifically points fingers at the Fed and the ECB, it fails to mention the roles that the BoJ and the PBC played as well.

Citing the article, Yves Smith at naked capitalism reaches the following conclusion:

And these observations lead to some interesting corollaries: it means that central bankers cannot blindly follow inflation targets, since they can lead them precisely into this negative real interest rate territory. And it also means that central bankers do need to watch for and prick asset bubbles if they are the result of overly expansive monetary policy. Note that this recommendation is at odds with the current orthodoxy which holds that central bankers can't possibly second guess the markets and call a bubble for what it is, and even if they see one, it's not their job to intervene.

Indeed, if Alan Greenspan is right about higher future US inflation and interest rates go up to 10 percent to fight it, imagine what that would do to financial markets.

Ultimately, though, the problem may be that central banks rely too much on benchmark interest rate target-setting. If you use one tool to control one variable -- more or less what the ECB is doing -- you risk other variables fluctuating wildly. If you use one tool to control two variables -- more or less what the Fed is doing -- you risk falling between two stools.

Inverted global yield curve: What does it mean?

Menzie Chinn at Econbrowser notes that based on data from the Economist, 18 out of 33 economies listed in the print edition have 10 year interest rates lower than the 3 month rate. In particular, the US 10 year/3 month spread is now positive but the euro area spread is now negative.

Citing findings from some papers (ECB working paper and Kozicki (1997)), he thinks that there may be reason to worry about the global economy, particularly in places like the euro area, Australia and the UK.

Meanwhile, William Hester at Hussman Funds thinks that an inverted yield curve could mean slower global earnings growth ahead.

Changes in World EPS have tracked the shape of the global yield curve closely, usually with about a two-year lag. The global yield curve was inverted from 1979 until 1982. The smoothed World EPS eventually declined by 10 percent. The global yield curve inverted again in 1990, and World EPS declined by a similar amount. In 2001 when the smoothed yield curve flattened, but didn't invert, World EPS again declined by more than 10 percent. The 12-month moving average of the yield curve spread hit zero in July. It has since ticked up a fraction, as short rates have fallen in response to the world-wide credit crisis.

Hester notes that year-over-year changes in World EPS have very little correlation with the short-term returns of the MSCI World price index. Nevertheless:

...there have been three meaningful declines in smoothed World earnings, bottoming in 1982, 1991, and 2001. Using monthly data, the smoothed Global Yield Curve bottomed in November 1981, May 1990, and April 2001. The corresponding declines in the MSCI World price index from those points were -17.3 percent, -19.4 percent, -35.0 percent, respectively (the peak-to-trough market losses were even worse).

China raises reserve requirement

From Xinhua:

China will raise the reserve requirement ratio by half a percentage point to 13 percent for commercial banks from October 25, the People's Bank of China (PBOC) announced on Saturday...

The move came after the central bank's announcement on Friday that the country's foreign exchange reserve has exceeded 1.43 trillion U.S. dollars by the end of September, up 45.1 percent from the same period last year...

By the end of September, the M2 -- a broad measure of money supply, which indicates the monetary demand of the whole country, grew by 18.45 percent from a year ago to 39.31 trillion yuan.

US retail sales hold up despite falling consumer sentiment

Consumer sentiment is still falling in the US. MarketWatch reports:

Consumer sentiment fell in October, continuing its slide since a peak in July, according to a monthly survey released Friday by Reuters and the University of Michigan.

The October consumer sentiment index was 82.0 -- the lowest since August 2006 -- below 83.4 in September. The consensus forecast of Wall Street economists had expected sentiment to hit 84.5.

But retail sales have held up relatively well, at least in September.

U.S. retail sales increased more than expected in September, rising 0.6% on strong sales of gasoline, automobiles and food, the Commerce Department reported Friday...

Much of the gain in retail sales can also be traced back to higher energy prices, with gasoline sales rising 2%. A surprising 1.2% gain in motor vehicle sales provided most of the remainder of the lift in sales. Excluding gas and cars, sales rose just 0.2%, the government said. Read the full government report.

Further good news is that there is little wholesale price inflation if you ignore food and energy.

U.S. producer prices rose a larger-than-expected 1.1% in September, but core inflation increased a tame 0.1%, the Labor Department reported Friday...

Energy prices alone rose 4.1% last month, the most since November...

Food prices rose 1.5%, the most since March.

Over in Japan, a little more inflation would be seen as a good thing. Instead, it got a little less at the wholesale level in September. Bloomberg reports:

Japan's wholesale inflation slowed for a third month in September as financial-market turmoil triggered by a U.S. housing slump damped commodity prices and strengthened the yen, making imported materials cheaper.

The producer price index climbed 1.7 percent from a year earlier, extending 3 1/2 years of gains and following a revised 2 percent advance in August, the Bank of Japan said in Tokyo today. The median forecast of 34 economists surveyed by Bloomberg News was for a 1.9 percent increase...

From a month earlier, Japan's producer prices fell 0.1 percent, the central bank said.

At least consumer confidence in Japan did not fall in September.

Japanese household sentiment barely rose from a three-year low in September, a signal that consumer spending is unlikely to accelerate.

An index that measures confidence among households with two or more people edged up to 44.1 points last month from 44 in August, halting a four-month slide, the Cabinet Office said in Tokyo today.

US trade deficit narrows as imports fall

Yesterday's report on the US trade deficit was reported by MarketWatch:

Boosted by a weaker dollar, the U.S. trade deficit narrowed to $57.6 billion in August from $59 billion in July, the Commerce Department reported Thursday.

Exports rose 0.4% to a record $138.3 billion, while imports fell 0.4% to $195.9 billion...

"For the first time in all my years sifting through these data (going back to 1994), a weak dollar is making a major difference for trade flows," wrote Stephen Stanley, chief economist for RBS Greenwich Capital.

But there is more to it than just the weaker US dollar.

The report showed the two sides of the economy: Weaker domestic demand coupled with strong global growth.

"While the shrinking of the trade deficit (and current account) is good news, if the shrinking is driven by weaker business activity, it won't be worth the cheering," wrote Steven Wieting, economist for Citigroup Global Markets.

"The notable part of the report is that the 0.4% decline in imports (biggest in six months) took place despite a 7% increase in petroleum imports (biggest in five months), thereby reflecting a prolonged decline in demand and the overall slowdown in the U.S. economy," wrote Ashraf Laidi, chief currency analyst for CMC Markets.

Indeed, the report on import prices also released yesterday suggests that the weaker US dollar is not translating into higher import prices outside of energy. Again from MarketWatch:

Prices of goods imported into the U.S. rose by 1% in September, rising on a big jump in prices of imported petroleum, the Labor Department reported Thursday.

The rise in the September import price index follows a drop of 0.3% in August...

Taking out petroleum prices, however, import prices fell 0.2% in September. Excluding all fuels, import prices fell 0.1% in September.

But export prices are rising.

The prices of most U.S. exports rose in September according to the report...

Year over year, export prices are up 4.5%.

While the US trade deficit has been narrowing, China's trade surplus has stayed persistently high. Bloomberg reports China's September trade data.

China's trade surplus rose 56 percent in September to $23.9 billion, adding pressure for higher borrowing costs and a stronger yuan to prevent inflows of export cash from stoking inflation.

The gap widened from $15.3 billion a year earlier, the customs bureau said on its Web site, after gaining 33 percent in August...

Exports rose 22.8 percent in September from a year earlier and imports climbed 16.1 percent, the smallest gain in three months.

BoJ keeps interest rates unchanged

As expected, the Bank of Japan left interest rates unchanged today. Bloomberg reports:

The Bank of Japan kept interest rates unchanged today because it needs more time to gauge the effect of the U.S. subprime-mortgage crisis on the global economy, Governor Toshihiko Fukui said.

Policy makers kept the benchmark overnight lending rate at 0.5 percent, the central bank said in a statement today in Tokyo. The decision was by an 8-1 vote, with Atsushi Mizuno the sole advocate for an increase for a fourth consecutive meeting.

Fukui said the central bank had "seen some improvement in global financial markets, yet some uncertainties remain"...

The central bank will stick to its stance of raising rates gradually even if it has to revise its forecasts for economic growth and inflation, Fukui said...

The central bank said the economy is "expanding moderately," leaving its monthly assessment unchanged today.

Gradual rate increases indeed. More than a year into its tightening cycle, Japan's interest rate has gone all the way up to 0.5 percent.

But I guess you can't blame the BoJ for being cautious. Economic data throughout the period had been mixed. And it continued to be mixed today. Again from Bloomberg:

Japan's machinery orders fell in August after climbing at the fastest pace in almost four years in July.

Orders declined a seasonally adjusted 7.7 percent to 1.04 trillion yen ($8.9 billion) from the previous month, the Cabinet Office said in Tokyo today...

Export growth quickened to 14 percent in August from a year earlier, helping the current account surplus widen by 42 percent, the Finance Ministry said. Bank lending accelerated for a second month in September, a central bank report showed...

Moody's Investors Service today raised Japan's debt rating to A1, the fifth-highest investment grade, citing confidence the government will pursue measures to reduce the world's largest public debt...

Elsewhere, South Korea also left interest rates unchanged at 5 percent today.

Singapore dollar as funding currency: On second thought...

I wrote about the Singapore dollar as a possible funding currency for carry trades about three months ago.

From the Monetary Authority of Singapore today:

The Singapore economy has expanded at a rapid pace in 2007, underpinned by robust growth in non-IT manufacturing and asset market-related activities in the first half of the year. Going forward, while the economy is expected to moderate to a more sustainable pace, inflationary pressures stemming from external sources, as well as domestic conditions including a tight labour market and rising rental costs, will persist.

Against this backdrop, MAS will continue with the policy of a modest and gradual appreciation of the S$NEER policy band in the period ahead. However, we will increase slightly the slope of the S$NEER policy band. There will be no re-centring of the policy band, or any change in its width. In our assessment, this policy stance will remain supportive of economic growth while capping inflationary pressures and ensuring price stability over the medium term.

This announcement came on the back of an announcement from the Ministry of Trade and Industry today that the Singapore economy grew at a 6.4 percent rate in the third quarter.

Andy Mukherjee, who had written about the Singapore dollar as a funding currency back in July, has more recently highlighted the inflationary pressures facing the economy and the "good chance of a stronger Singapore dollar".

US employment data still point to rate cuts

The United States economy is looking a little better now than it did a month ago, thanks to the latest employment report from the Labor Department. Nevertheless, the report still points to slow growth and the possibility of interest rate cuts by the Federal Reserve in the near future, if not in October.

On Friday, the Labor Department reported that nonfarm payroll employment in the US rose by 110,000 in September. In addition, the economy added 89,000 jobs in August, reversing the decline of 4,000 that had initially been reported early last month.

The report, together with signs of stability returning to financial markets, reduced expectations of a rate cut by the Federal Reserve later this month. The rate of increase in employment now appears fully consistent with a slow-growing economy and not with one in recession.

It also corroborates the reports from the Institute for Supply Management earlier in the week. These reports had shown that the ISM's manufacturing PMI dipped to 52.0 in September from 52.9 in August while the non-manufacturing business activity index fell to 54.8 in September from 55.8 in August. Both indices show slowing growth but no recession, at least not at the moment.

Economists cited by the mainstream media also generally took the employment data relatively positively.

"It certainly doesn't look like an economy that's losing momentum," John Ryding, chief US economist at Bear Stearns, was quoted in a Bloomberg article as saying. The same article quoted Michael Feroli, an economist at JPMorgan Chase, as saying: "The labor market is bending, but not breaking."

Not everyone is sanguine though. "We may be headed for trouble as it is," Robert Dederick, president of RGD Economics, was quoted in the article as saying. "Remember, economists are saying there's a 35 percent chance of a recession, which is about as far as they ever go until we're actually in the recession."

And the Labor Department's employment report for September did provide a reason for concern. According to the report, the unemployment rate ticked up to 4.7 percent in September, moving back towards levels last seen around the middle of last year. On a chart, the upturn in the unemployment trend is now clearly discernible.

History shows that when the unemployment rate turns up, it often continues to surge, leading to a recession. As James Hamilton, Professor of Economics at the University of California, San Diego, said at his Econbrowser blog over the weekend, "the dynamics that produce this tend to kick in fairly quickly once they set in". So what looks like merely slow growth now could quickly turn into a recession.

At the moment, though, it is still too early to say conclusively that this will happen.

As for interest rates, if there is a perception of a recession threat, the Federal Reserve is likely to cut them. This is especially if inflation is not a threat at the same time.

And indeed, inflation is at a level that would probably not pose a big concern to Federal Reserve officials at the moment. The common measures of inflation in the US mostly show that consumer prices are rising at a rate that is within the Fed's comfort zone of 1-2 percent.

In August, the consumer price index rose at a year-on-year rate of 2.0 percent while the consumer price index excluding food and energy rose at a rate of 2.1 percent. The personal consumption expenditures price index, more closely followed by the Federal Reserve, rose at a rate of 1.8 percent with and without food and energy.

While these are not levels of inflation at which Federal Reserve officials would want to cut interest rates under conditions of normal growth, in their minds, they are also not impediments to rate cuts if a real threat of recession is perceived.

Having said all that, the Labor Department's employment report did provide a hint of inflation. Average hourly earnings grew 0.4 percent in September, up from 0.3 percent in August. The latest rise takes the year-on-year increase up to 4.1 percent.

However, if the pickup in unemployment is sustained, an acceleration in inflation is unlikely to take hold. In fact, rising unemployment is likely to lead to a decline in inflation.

In any case, history certainly shows that in periods when the unemployment rate is rising, the federal funds rate has usually fallen.

So on balance, the latest employment data makes a rate cut by the Federal Reserve this month no longer a high probability event, but they nevertheless also show that the Fed is still likely to lean towards further cuts in the coming months.

US economy still adding jobs

Yesterday's payroll data should ease US recession fears for the time being. MarketWach reports:

The U.S. unemployment rate rose to 4.7% in September, the Labor Department reported Friday, but government data showed job growth was stronger than expected over the past three months, putting further interest-rate cuts by the Federal Reserve in jeopardy.

Nonfarm payrolls rose by 110,000 last month -- including 73,000 in the private sector -- very close to expectations of a 113,000 gain in total payrolls...

As measured by a survey of businesses, payroll growth in July and August was revised higher by 118,000, the government said. Instead of falling by 4,000 in August, payrolls rose 89,000 after revisions. The big decline in public-school employment previously reported was revised away. Read the full report...

Average hourly earnings rose 0.4% in September, putting the year-over-year growth in wages at 4.1% -- an alarm bell for those worried about rising inflation.

The average workweek was steady at 33.8 hours and total hours worked in the economy increased by 0.1%.

Job and income growth aren't the only things that are fuelling consumer spending. So is credit growth, which at least continued in August, reports MarketWatch.

Outstanding U.S. consumer debt rose at an annual rate of 5.9% in August, pushed higher mostly by a hefty gain in credit-card debt, the Federal Reserve reported Friday.

Globally, though, August data mostly indicate slower growth ahead. For example, from the OECD composite leading indicators for August:

The latest composite leading indicators (CLIs) suggest that a moderation in economic expansion lies ahead in the OECD area. August 2007 data show weakening performance in the CLI's six month rate of change in all the major seven economies. The latest data for major OECD non-member economies point to moderating expansion in China, India and Brazil, but an improved outlook for Russia.

And Japan's Cabinet Office reported yesterday that its leading index dropped to 30 in August from 72.7 in July.

ECB and BoE leave rates unchanged

Both the European Central Bank and the Bank of England left interest rates unchanged yesterday.

In his introductory statement to the press conference, ECB president Jean-Claude Trichet said that "the outlook for price stability over the medium term is subject to upside risks". He sees "sustained growth during the second half of 2007" and "real GDP growing at around trend potential" in 2008, but "risks to the outlook for growth are judged to lie on the downside" partly because of the "ongoing reappraisal of risk in financial markets". Because of the "heightened level of uncertainty, additional information is needed before further conclusions for monetary policy can be drawn" but the ECB will act to ensure that "medium and long-term inflation expectations remain firmly anchored in line with price stability".

The BoE provided no details on its deliberations yesterday, but its decision was made in the wake of a report that UK house prices fell 0.6 percent in September according to an HBOS survey.

Meanwhile, in the US, notwithstanding data yesterday showing that factory orders fell 3.3 percent in August and initial claims for unemployment benefits increased by 16,000 to 317,000 last week, expectations for another rate cut by the Federal Reserve have actually declined, according to a Bloomberg report yesterday.

The chance of policy makers cutting their benchmark rate twice more this year, to 4.25 percent, fell to 48 percent today, the lowest since the Fed cut borrowing costs on Sept. 18, futures prices show. The December contracts last week reflected a 74 percent likelihood of two quarter-point reductions.

Sentiment shifted as St. Louis Fed Bank President William Poole, Philadelphia Fed chief Charles Plosser, Atlanta's Dennis Lockhart and Richard Fisher of Dallas in the past 10 days highlighted signs the turmoil in credit markets is easing. Economic and financial reports have complemented their remarks, as commercial paper halted a seven-week slump and surveys showed continued expansion of manufacturing and services industries.

Service sectors slowing

The US economy continues to grow but at a slower pace. Reuters reports the latest economic data.

ISM said its index on service activities slipped to 54.8 in September, its lowest since March, from August's 55.8...

The employment component in the ISM non-manufacturing report rose to 52.7 in September from 47.9 in August...

Private employers added 58,000 jobs last month, in line with forecast, according to the ADP National Employment Report. It also lowered its August reading to a 27,000 increase from the initial 38,000...

Planned corporate layoffs fell almost 10 percent in September from August, led by job cuts tied to housing, said job consulting firm Challenger, Gray & Christmas. Last month's announced layoffs were 28.5 percent less than a year ago.

Europe is also seeing a slowdown, with the UK services PMI falling to 56.7 in September from 57.6 in August and the eurozone services PMI falling to 54.2 in September from 58.0 in August. Retail sales in the euro zone had also slowed in August, growing 0.1 percent compared to 0.4 percent in July.

The declines in the services indices left the JP Morgan Global All-Industry Output index at 54.7 in September, down from 56.2 in August and its lowest level since March.

RBA leaves interest rate unchanged, Fed cut sends emerging markets surging

The Reserve Bank of Australia left its interest rate unchanged today.

The Federal Reserve, of course, cut rates last month, and yesterday provided more justification for the move. From MarketWatch:

The pending home sales index fell 6.5% in August after dropping a revised 10.7% in July, the National Association of Realtors reported Tuesday. The index is at its lowest level since its inception in 2001.

Recent history shows that every time the Fed cuts interest rates, it sets off an asset market boom somewhere. This time appears to be no exception. Mike Dolan and Sujata Rao looks at the impact of the latest rate cuts on emerging markets at Reuters.

The bursting of U.S. housing and mortgage market bubbles has suddenly been replaced by emerging markets inflating, and world equities have got pumped up into the bargain.

With the herd mentality of global investors ever sharper, the Federal Reserve's decision two weeks ago to combat a U.S. credit market seizure with lower interest rate has stampeded investors to Asia, Latin America and elsewhere in the developing world.

Investment flows to emerging equity funds hit a 85-week high of $5.53 billion last week, with redemptions from developed market funds providing most of this cash, according to EPFR Global, which tracks funds with $10 trillion in assets globally.

Non-Japan Asia received 53 percent of the total.

And the price action echoes that. MSCI's index of emerging market equities has accelerated more than 13 percent to record highs since the Fed cut on September 18 and has clocked up a whopping 36 percent gain so far in 2007. China's main bourse has more than doubled this year. Brazil is up some 60 percent.

John Authers covers similar ground at the FT but also provides a wider perspective of the equity rally.

Hang Seng jumps 1,000 points

Hong Kong's retail sales rose 15 percent in August from a year earlier, the most in more than three years. But I doubt that that was what caught most investors' eyes in Hong Kong today.

Rather more likely was the 1,000 point move in the Hang Seng Index. Bloomberg reports the fluctuation in the Hong Kong stock market:

Hong Kong's Hang Seng Index closed above 28,000 for the first time, on speculation China's $200 billion investment fund will target Chinese shares listed in the city. China Mobile Ltd. paced the gain...

The Hang Seng added 1,057.28, or 3.9 percent, to close at 28,199.75 in Hong Kong, the biggest fluctuation among equity markets included in global benchmarks. The measure has jumped 38 percent since the start of trading on Aug. 20, when China said it will allow some citizens to invest directly in Hong Kong's stocks. The value of the city's equities surged $685 billion in that time, about the same as the gross domestic product of the Netherlands.

The Hang Seng China Enterprises Index, which measures 43 so- called H shares of Chinese companies, jumped 5.6 percent to 17,973.87. October futures on the main Hang Seng benchmark climbed 3.8 percent to 28,215.

Dow hits record amid manufacturing slowdown

The continuation of the global bull market in equities was confirmed yesterday with the Dow hitting a new all-time high. Bloomberg reports:

U.S. stocks rallied, sending the Dow Jones Industrial Average to a record, as investors speculated the worst may be over for banks and construction companies hurt by subprime mortgage losses...

The Dow's record caps a six-week recovery from a slump that helped wipe out almost $2 trillion in U.S. market value. The 30- stock gauge added 191.92, or 1.4 percent, to 14,087.55, above its previous closing high of 14,000.41 set on July 19. The Standard & Poor's 500 Index increased 20.29, or 1.3 percent, to 1,547.04, 0.4 percent shy of a record. The Nasdaq Composite Index gained 39.49, or 1.5 percent, to 2,740.99, the highest in six years.

Investors shrugged off a deceleration in global manufacturing reported yesterday. Clearly, investors are not worried of a slowdown as long as it bring on rate cuts.

Reuters reports the manufacturing slowdown.

The U.S. Institute for Supply Management said its index of national factory activity fell to 52.0 from 52.9 in August, below economists' median forecast for a dip to 52.6...

Overall, global manufacturing growth fell in September to its lowest level in just over two years, according to a global indicator produced by J.P. Morgan with research and supply management organizations. The index dropped to 52.3 in September from 53.1 in August...

The final RBS/NTC Eurozone Manufacturing Purchasing Managers Index (PMI) was confirmed at a 22-month low of 53.2, unchanged from the flash estimate and matching economists' expectations...

In Britain the CIPS/NTC factory PMI slipped to 55.1 in September from 56.1.

Last week, Japan had reported that its NTC Research/Nomura/JMMA Purchasing Managers Index edged up to 49.8 in September from 49.6 in August.

Yesterday's big report from Japan though was the Tankan, which showed that business confidence held steady close to a two-year high in September, with the sentiment index for large manufacturers unchanged at 23.

Meanwhile, manufacturing could still be accelerating in China, with the Purchasing Managers' Index rising to 56.1 in September from 54 in August, according to the China Federation of Logistics and Purchasing and the National Bureau of Statistics.

Will India do a China?

Andy Mukherjee asks whether India has the same disinflationary potential that China had.

Goldman Sachs Group Inc. economist Jim O'Neill wrote a paper last year, titled "Globalization and Disinflation: Can Anyone Else 'Do a China'?"

The full weight of that question is becoming evident now.

In their report, O'Neill and his team argued that China's rapid urbanization, industrialization and rising openness to trade and capital flows had all contributed to keeping inflation in the developed world lower than expected for a decade.

The Goldman analysts said China would continue offering an "inflation discount" to the world with a nascent pickup in Chinese consumer prices and wages stabilizing in 2007.

"If we're wrong and Chinese inflation continues to rise, the consequences for the rest of the world may be profound," the economists wrote. "The search, in terms of disinflationary forces, would be on to discover 'another China.'"

That's where India comes in.

To avoid a surge in consumer prices, [Federal Reserve chairman Ben] Bernanke may end up needing India to produce the disinflation that China is no longer willing or able to export...

"With the possible exception of India, it appears that none of the countries can 'do a China' on their own," Goldman's report said.

With its high birth rate and persistent trade deficit, I wouldn't expect too much from India as a disinflationary force though. Any improvement in productivity would mostly be soaked up by its own consumption and investment needs.