Is Gold an Inflation Hedge?

There was an interesting Q&A last Wednesday on Minyanville between Professor Scott Reamer and a fellow Minyan. Professor Reamer fielded this question on gold's role as an inflation hedge.

Prof. Reamer,
I always have a problem understanding what makes gold go up. Is it mainly the inverse relationship between gold and the dollar? If that's the case then if it is also an inflation hedge, that would mean rates would have to be raised and the dollar would rise. Help me out on this one.
Thanks,
MJ

Professor Reamer's Reply

The correlation between gold and the US dollar index (DXY) (the average of six major currencies vs. the USD) is minus 0.42 over the last two years, minus 0.44 over the last nine years and minus 0.28 over the last 17 years. A +1 correlation means perfect correlation (gold goes up, dollar goes up), a -1 correlation means perfectly anti-correlated (dollar goes up, gold goes down), and a 0 correlation means no correlation whatsoever. What the above tells you is that the widely held belief that gold goes up when the dollar goes down is not supported by the statistics: a -0.28 correlation is a weak correlation at best and is certainly within the normal volatility that these two date series exhibit.

So, in the US, M3 has gone up by something like 207% over the last 20 years while gold has gone up in USD terms by 58%. So has gold been a hedge against inflation over this time frame? Of course not - stocks have been a better hedge against inflation than gold, and property even more of a hedge than that.

But that is not to say that gold doesn't have its uses: gold will likely be a fantastic wealth preservation vehicle once the fiat currency regime (the post Bretton Woods system with the US as global economic hegemon) comes to a grinding and ignominious end (a certainty approaching 1 on the probability scale - timing less certain). I would encourage you to read the book The Golden Constant by Roy W Jastram - it makes the unintuitive case (with a look over the historical data from 1560-1976) that gold performs better (in appreciation terms) under deflationary regimes rather than inflationary ones, thus throwing a significant wrench into the idea that gold protects under inflationary regimes (dollar down, gold up).

As for the 'reason' why gold acts as it does, I would only point you to the ideas presented by Amos Tversky and Dan Kahneman whose research on behavioral finance tells us that economic agents make persistently irrational decisions - my hypothesis is that they are using their limbic systems rather than their cortexes and thus are driven by emotion and not a utility-maximizing function. This has massive implications for understanding WHY markets behave as they do. I couldn't encourage you more to investigate this idea further.

Scott

Thanks Scott. It is great to see you posting more frequently on Minyanville. The book to which you refer "The Golden Constant" is out of print. There is however, some discussion on Mises: Jastram's Classic Study of Gold's Purchasing Power.

This seminal work rigorously analyzes the purchasing power of gold in England and the United States from 1560 to 1976, employing a meticulous methodology that:

• constructs unified series of the price of gold since 1560;
• constructs unified series representing the level of wholesale commodity prices in every year since 1560
• determines the statistical relationship between these two series in such a way as to measure the purchasing power of gold since 1560;
• analyzes the behavior of that purchasing power in periods of inflation and deflation; and
• assesses the extent to which gold served as a hedge during inflationary periods and a conservator of purchasing power during deflationary periods.
  

The Golden Constant demonstrates conclusively that gold holds its purchasing power remarkably well over time. It concludes that gold prices do not chase after commodities, but rather that commodity prices return to the index level of gold, over and over, and that gold provides an effective refuge in times of upheaval.

There is a link in the Mises article to a PDF version of the book, but unfortunately the target is not found.

A Dissenting Dissection

An even better discussion of how gold acts in inflation and deflation was presented in the article Gold and Deflation: A Dissenting Dissection by Bob Landis.

Landis takes apart the thesis that gold is a hedge against inflation, relying on the work of Jastram to do so. Let's Dig In.

The Inflation Hedge Thesis vs. The Golden Constant

The Golden Constant examined Anglo-American price data over a period of 416 years, establishing a statistical relationship between a price series constructed for gold, on the one hand, and a price series constructed for wholesale commodities, on the other. It concluded that [p. 175]:

• Gold is a poor hedge against major inflations.
• Gold appreciates in operational wealth in major deflations.
• Gold is an ineffective hedge against yearly commodity price increases.
• Nevertheless, gold does maintain its purchasing power over long periods of time.

The intriguing aspect of this conclusion is that it is not because gold eventually moves toward commodity prices but because commodity prices move toward gold.

The work is refreshingly free of bias: Professor Jastram approached the study without an agenda. He was neither an apologist for the fiat monetary system, nor a gold bug. Indeed, he explicitly noted that “… we are accustomed to thinking of gold, itself, as money. It is not.”

....

In relation to The Golden Constant, the inflation hedge thesis is little more than an old wives’ tale. Unfortunately, that hasn’t stopped it sprouting like a weed. Lacking dispassionate empirical support, it rests instead on other theories that at root are political rather than economic.

....

While we get no joy from his view that gold is not money, we take comfort from his empirical evidence that gold acts like money. We turn also to common sense, and note the fundamental economic difference between other commodities and gold: all other commodities are produced for consumption, whereas gold, precisely as a function of its money-like qualities, is produced for accumulation. [10] Virtually all the gold ever produced still exists somewhere, albeit not necessarily where governments claim it does. Set aside for the moment the massive empirical evidence marshaled by Professor Jastram that demonstrates how differently gold and other commodities have behaved over time. How is it even reasonable to expect such fundamentally different things to act alike?

The Silver Example

Mr. Saville suggests that silver’s record during the deflation of the 1930’s shows what gold may be expected to do under similar circumstances. The comparison, it seems to us, is inapposite. Silver is different. It has had a unique and difficult history as money, exacerbated by the negative consequences of fixed ratio bimetallism, prolonged government intervention and massive private market manipulation. [12] More important, it is a commodity with an enormous number of industrial applications. It is thus produced both for consumption, as it is used up in military and industrial processes, and for accumulation. We don’t doubt that it too will someday make a comeback as a monetary metal. We can even speculate that it may do so as gold’s nearer equal in value than has been the case historically, as a result of scarcity caused by the exhaustion of above-ground stockpiles over the years. [13] Indeed, silver is currently the basis for Mr. Salinas Price’s important monetary reform effort in Mexico. [14] However, both its history and its nature are so unique as to make it a questionable guide to gold’s behavior in a deflationary setting.

The Japanese Example

Mr. Saville suggests also that gold’s performance in yen terms during the recent Japanese deflation provides further guidance as to how gold will behave in a dollar-denominated deflation. The comparison is original and provocative, but troubling in several respects.
....
to consider in isolation the yen-gold price in the context of that still-functioning dollar-based global monetary system seems unlikely to yield analytically useful information. Gold is, and was during the period considered by Mr. Saville, priced globally in dollars. Accordingly, to show that it took fewer yen to buy gold is tantamount to showing that it took fewer yen to buy the dollars needed to buy gold; this ratio seems merely to be a more roundabout way of expressing the dollar-yen exchange rate.

Come Firewalk with Me

But our biggest problem with the inflation hedge thesis is that it takes our eye off the ball. The critical question today is not whether we face deflation or inflation, but whether and when we face monetary collapse.

What is relevant is gold’s traditional role in the context of monetary collapse. This role is not, to our knowledge, in question. Gold is what you want when they seal the borders and you need to get across; it’s what’s accepted when there’s blood in the streets and nothing else flies.

Whatever can be argued about its implications for gold's behavior in inflation, the abrogation of Bretton Woods in 1971 did not change the fact that gold is the only money when the chips are down. This was a major conclusion of Professor Jastram’s research. [22] For the continuing validity of this proposition, we cite as an authority none other than Lord Greenspan, Tsar of All the Monies, Defender of the Fiat, Best Friend of Leveraged Speculators, who testified as recently as 1999 that [23]

... gold still represents the ultimate form of payment in the world. It's interesting that Germany could buy materials during the war only with gold. In extremis fiat money is accepted by nobody and gold is always accepted and is the ultimate means of payment…

Do I think it merely possible that our fiat dollar will someday collapse? If yes, then I should own gold. How much? As much as I can comfortably rationalize, perhaps using some sort of calculation of the gravity of the harm -- i.e., financial wipeout -- discounted by my sense of the probability of its occurrence.

Do I think it inevitable that our fiat dollar will suffer the fate of all paper currencies throughout history? If yes, then I am a gold bug, and it is my dollar exposure, not my gold “investment,” that I must rationalize.

Those were short excerpts from a well written and very educational piece. I highly recommend reading the complete article.

Proof

Charts speak better than words. Are professor Reamer, Bob Landis, and Jastram right or is gold some sort of inflation hedge in general? I asked Nick Laird (Sharefin) at Sharelynx Gold to shed some light on the situation. Following are a collection of charts, some of which he specifically created for this article.

US Dollar Index vs. Gold



US$ Index vs. Gold (annual rate of change)




US$ Index vs. Gold
(annual rate of change - revised scale)



Gold Vs. Inverse US$ index (annual rate of change)



Gold Vs. Inverse US$ index
(annual rate of change - revised scale)



As professor Reamer suggests, there is indeed an inverse correlation between gold and the US$ but that correlation is not especially strong. The correlation is also prone to wild extremes at times yet at other times one has to exaggerate the scales on one side of the comparison to see the relationships clearly.

Is Gold An Inflation Hedge?

Let's now turn to the question "Is gold an inflation hedge?" Of course this now begs the question "What is inflation?" To some inflation is a sustained rise in prices, to others inflation is a decline in the purchasing power in the dollar, but I am sticking with the Austrian definition that inflation is an expansion in money and credit. In that regard, I use M3 as a measure of expansion of money and credit.

Gold Vs. M3 (Annual rate of change)



Gold Vs. M3



That last chart is crystal clear. Gold is simply not an inflation hedge for periods as long as 22 years and perhaps much much longer. Those using other measures of inflation instead of M3 should see a similar thing. If you disagree, please send me a chart.



Charts for this article were custom made by Nick Laird (Sharefin) at Sharelynx Gold. The opinions expressed in this article are mine and do not necessarily reflect the thoughts of Sharefin. Nick graciously provided the charts, the interpretations are mine.

Final Thoughts

Gold in many timeframes is not much of an inflation hedge.
In terms of real price, gold is a better deflation hedge than an inflation hedge. The reasons...

1. Gold is money. Proof of that statement can be found in the market behavior of gold. The markets treat gold as if it was money (not only now but on a historical basis). On that basis gold must be considered money regardless what the central banks say.
2. Money is worth more in terms of other goods and services during periods of deflation. During periods of disinflation "cash is trash" and that helps explain why gold dropped from over 800 to 250 even though we had a positive (although falling) rate of inflation for much of that timeframe.
   
3. Gold is stateless and has no liabilities attached to it. It is the only money that won't be touched by whatever measures the authorities decide to take to combat deflation.

In addition to being a deflation hedge, gold may also play a role in a panic flight to safety scenario. For example: If the US dollar were to suddenly collapse and/or if fiat currencies were totally repudiated in general, gold would be a huge beneficiary.

Given the current underlying conditions, with increasing chances of a deflationary credit implosion related to housing, along with some chances of a collapse in the dollar, Yen, or fiat currencies in general, the incentive to store wealth in the form of gold is massive.

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

Robber Barons or Communist Central Planning

Imagine for a minute that you own a fruit stand. You sell oranges, grapefruit, lemons and limes. Perhaps in season you sell apples, peaches, and strawberries. What would you think if the government came in and forced you to sell broccoli, asparagus, and pecans? Hopefully you would be horrified. After all, wouldn't that smack of failed Soviet command economics?

Well sad to say that is exactly the proposal made by the attorney general of Mississippi, Saturday February 17, 2007. Please consider Miss. AG Seeks Legislation on State Farm.

Mississippi Attorney General Jim Hood said Friday he will seek legislation aimed at blocking State Farm Insurance Cos. from refusing to write new homeowners and commercial policies in the hurricane-battered state.

Hood's plan would require any company that writes automobile insurance in Mississippi and also writes homeowners policies in other states to offer homeowners and commercial properties throughout Mississippi.

Hood said his plan is modeled after actions taken by Florida. Florida's legislation primarily deals with preventing policy cancelations and non-renewals, but Hood said a model could be crafted to force companies to write new policies.

"We're looking at a robber baron in the face that is trying to make an example of Mississippi," Hood said of State Farm.

State Farm, Mississippi's largest homeowner insurer, said Wednesday it has had enough of the "untenable" legal and political climate in the state and is suspending writing new homeowners and commercial policies. The company said the suspension would begin Friday and continue until the business climate in the state is more palatable.

In a statement Friday, U.S. Rep. Bennie Thompson, D-Miss., said he was "deeply disturbed" by the decision and said Congress would hold hearings on the insurer's conduct.

State Farm spokesman Phil Supple said Friday that Hood's rhetoric, including his comparison of State Farm to a "robber baron," is a "remarkable response to what was purely a business decision."

Hood's plan prompted criticism from other Mississippi officials, who say the Florida legislation it's based on is driving insurers out of that state. "Florida did something similar and we're seeing companies leave Florida daily," said Lee Harrell, Mississippi's deputy insurance commissioner.

Robert Hartwig, vice president and chief economist for the Insurance Information Institute in New York, an industry-funded group, said Hood's proposal isn't likely to succeed in compelling State Farm to continue writing new homeowner policies.

Automobile insurance isn't profitable enough to offset losses in the sale of homeowner insurance in a hurricane-vulnerable region so the company may be inclined to stop selling auto policies if they also must sell homeowner policies there, Hartwig said. "The only losers in this situation are consumers facing fewer options for automobile insurance," Hartwig said.

Should Mississippi be stupid enough to pass legislation forcing "the farm" to sell asparagus when "the farm" only wants to sell grapefruit and oranges, what will happen should be obvious: The price of grapefruit, oranges, and asparagus will all rise when "the farm" rightfully tells Mississippi to shove it and takes its produce stand elsewhere.

The government has no business telling "farms" of any sort what kind of fruits and vegetables they can sell, nor does the government have any business setting prices for "produce". Wasn't Soviet command style economics discredited long ago?

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

Every Picture Tells a Story

In the past few months we have seen repeated bottom calls by David Lereah at the NAR. We have also heard Robert Toll proclaim to be "dancing above the bottom", and just this past week Greenspan himself said "The housing slump was all but over."

Following is a a graphical presentation to see if we can determine just how likely those statements are to be true. The pictures speak for themselves.

Hew Home Inventory



Is the Bottom In?

California Default Notices
(click on chart for a much better view)



Is the bottom in?

San Diego Defaults



Is the Bottom In?

Subprime Market Share



With credit standards tightening.....
where is the pool of new buyers going to come from?

Piggyback Loans



With credit standards tightening.....
where is the pool of new buyers going to come from?
Just a reminder, take a look at that first chart again of inventory.

Housing Starts 1965-2007
(click on chart for a much better view)



Is the bottom in?
In time or price or starts?

XHB - Hombuilders ETF
(click on chart for a much better view)



Is the top of this retrace in?

Thanks to....
Economagic, Calculated Risk, Professor Piggington, Immobilienblasen, B.C. Anonymous, Foreclosure Forum, and Inside Mortgage Finance for the images used in this post.

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

Ford North America Report Card

Detroit News is reporting Ford fix-it plan off track.

Report: Sales goals missed, morale low
Ford Motor Co. is failing to meet key goals in its turnaround plan and employees are losing confidence in the company's ability to save itself, according to an internal report released to employees and obtained by The Detroit News on Thursday.

Titled "Report Card: Ford North America," the report paints a grim picture of a company unable to stop its downward spiral.

Ford missed its retail sales goal in the United States for January by 10,600 vehicles -- or nearly 1 percentage point of market share -- and now expects to miss its retail market share goals for February and March, the report shows.

The company hit its material cost reduction target for January, but will miss its targets for February and March by a wide margin, according to the current forecast.

Ford's problems are not lost on employees, only 47 percent of whom say they have confidence in Ford's long-term success. And less than 45 percent believe the automaker's "Way Forward" plan is working, according to the results of an employee survey included in the report.

The failure to meet the plan goals is the first sign of real trouble for CEO Alan Mulally's new regime. While Ford lost more money in 2006 than ever before -- $12.7 billion -- most of that damage was done before the former Boeing Co. executive was tapped to lead Ford last fall.

Since then, Mulally has stressed the need for unblushing honesty and rigorous accountability, urging his executives to set realistic goals for 2007. However, Ford's Americas team failed to meet these supposedly more realistic targets.

That is bound to put more pressure on Ford Americas President Mark Fields and his team. Wall Street is likely to be more indulgent with Mulally, according to Bradley Rubin, who follows Ford for BNP Paribas. "He's already done the hard thing, which is raising the capital and getting enough cash in there to fix Ford's problems," Rubin said. "It's not about how much they lose in '07. Earnings have taken a back seat to whether or not they have enough cash and financial flexibility."

In December, Ford put up all of its U.S. assets to secure more than $23 billion in financing to fund the turnaround plan.

Fields went over the report with employees Wednesday as part of his regular weekly Webcast, but acknowledged that he is having a hard time convincing them to keep the faith.

According to a quarterly survey of employee morale, results of which were included in the report, most employees have a dim view of Ford's future. Just more than 50 percent were optimistic about the future a year ago, and Ford set a goal of increasing that number to 60 percent this year. But it has already fallen to below 50 percent.

Product -- or the lack thereof -- is a major cause for this pessimism. Only 38 percent of workers surveyed said they believe Ford has "the right products to move the company forward."

According to the report released to employees this week, the shortfall in retail sales was "due to greater-than-expected segment shift out of pickups, unfavorable share performance related to SUVs and lower-than-planned availability of (Ford's) new products."

Ford is well on its way to meeting its goal of cutting some 44,000 jobs in the United States by 2008. The company also plans to idle 16 factories by 2012.

Product -- or the lack thereof -- is a major cause for this pessimism. Only 38 percent of workers surveyed said they believe Ford has "the right products to move the company forward."

Wow. I guess that says it all. 62% of the work force does not believe in the company. In the just wondering department: After Ford gets rid of 44,000 employees and shuts down 16 plants, exactly how much of Ford's US operations will be left?

Ford Monthly Chart
Click on chart for a better view.



In December, Ford put up all of its U.S. assets to secure more than $23 billion in financing to fund the turnaround plan. Near term that staved off bankruptcy, at least for a while. The questions now are: How fast will Ford burn through that cash? What is going to happen to car and truck sales heading into a consumer led recession? I suspect the burn rate will be a lot higher than anyone thinks once this recession gets going.

Technically Ford is challenging a brutal monthly down trend line that has capped every rally since 1999. It is also sitting modestly above a long term support line dating all the way back to 1993. If that support breaks, Ford will be following the airlines and auto parts manufacturers into bankruptcy.

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

The "R" Word

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

Economic Reports

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

Industrial Output
Industrial output falls sharply in January

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

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

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

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

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

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

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

Capital Flows
December sees $11 billion net capital outflow

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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



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

Factory ISM
Factory gauges point different directions

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

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

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

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

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

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

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

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



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

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



Daily Chart



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

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

Bernanke's Box

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

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

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

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

Largest Home Price Drop on Record

Housing is Local (Except when it's National).
The NAR is reporting a record slump in home prices.

Fourth-quarter report from National Association of Realtors shows largest price drop on record as markets with price declines now outpace those with gains.

Prices slumped 2.7 percent in the fourth quarter compared to the fourth quarter a year earlier, according to the report from the National Association of Realtors (NAR). That's the biggest year-over-year drop on record and follows a 1.0 percent year-over-year decline in the third quarter.

In addition, 73 metropolitan areas reported a decline in the fourth quarter, compared to a year earlier. That outpaced the 71 that saw a gain. It was both a record number and percentage of markets showing a decline in the group's quarterly report. Five markets saw prices unchanged.

The most recent median prices are down even more: 3.4 percent since hitting record highs in the second quarter. Almost three-quarters of the markets, reported on by the group, saw declines in median prices over the past six months, with eight reporting double-digit declines.

But the weakness in prices wasn't restricted to those kinds of markets. Springfield, Illinois, reported a 16.2 percent drop in the fourth quarter compared to the third quarter, the biggest decline during that time frame, along with a 10.4 percent decline compared to a year earlier.

Still, the trade group statement said it believed that the worst was over for the drop in prices.

"Examination of data within the quarter shows home prices stabilizing toward the end," said a statement from David Lereah, the NAR's chief economist. "When we get the figures for this spring, I expect to see a discernable improvement in both sales and prices."

Here is a chart of nationwide prices.



Click here for the latest home prices in 149 markets tracked for the fourth quarter of 2006.

"Examination of data within the quarter shows home prices stabilizing toward the end," said a statement from David Lereah, the NAR's chief economist. "When we get the figures for this spring, I expect to see a discernable improvement in both sales and prices."

David Lereah is a paid cheerleader. On that basis I expect to see David Lereah cheerleading regardless of what the facts are. As for me, I will take the other side of the bet: I expect to see an economy heading into recession, with increasing foreclosures, more distress auctions, more bankruptcies, and weakening prices. One of us will be right and one of us wrong. I will say in advance that at some point there will be a fake rally of sorts, from what level I do not know but my inclinations are that such a rally will occur after a deeper slump than this one. The foreclosure party has really just started.

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

US GDP Flunks Smell Test

Flashback January 31, 2007 - Bloomberg reported: U.S. Economy: Growth Quickens, Propelled by Spending.

The U.S. economy grew at the fastest pace in a year last quarter as declining energy costs helped power consumer spending and contain inflation, enhancing Federal Reserve Chairman Ben S. Bernanke's stature at the start of his second year.

Gross domestic product increased at an annual pace of 3.5 percent, the Commerce Department said in Washington today. That was more than forecast and up from a 2 percent pace in the prior three months. Other figures today showed manufacturing and construction still struggling to shake off a slowdown.

Stocks rose after the Fed, which left its benchmark interest rate at 5.25 percent today, said inflation has "improved" at the same time data have shown "somewhat firmer economic growth."

Central bankers, in a statement accompanying the rate decision, said that "readings on core inflation have improved modestly in recent months'' and that price pressures would likely "moderate over time."

Higher Stock Prices

The Dow Jones Industrial Average increased 106 points, or 0.8 percent, at 2:40 p.m. in New York. The Standard & Poor's 500 Index rose 9.4 points, or 0.7 percent.

In less than two weeks the 4th quarter US GDP was revised lower from +3.5% or so to something closer to +2.0 to +2.5%. I remember all the fanfare from everywhere touting US 4th quarter growth. The odd thing is, today I am scrambling to find much of anything on the revised lower estimates. This is the best mainstream media report I can find. It happens to be from Australia.

The Sydney Morning Herald is reporting US trade gap drags down GDP.

An unexpectedly wide December trade gap and pared down business inventories are certain to slice a big chunk off the government's gauge of fourth-quarter economic growth, showing the year ended on a subdued note.

In fresh data on a key piece of the economic pie, the government on Tuesday reported that the US trade deficit widened 5.3 per cent to $US61.2 billion ($A79.43 billion) in December, pushing the full year's shortfall to a record $US763.6 billion ($A991.11 billion).

The latest trade numbers, which reflected surges in oil imports and goods from China, showed US consumers were buying more goods from overseas, which acts as a drag on US producers and ultimately economic growth.

The government reported two weeks ago that gross domestic product, the broadest measure of overall economic activity within US borders, expanded at a 3.5 per cent annual rate during the October-through-December quarter.

Now economists are expecting a revision in the GDP data due on February 28 to show a leaner reading for the quarter, after the bigger trade deficit and data showing wholesalers pared their inventories at the end of the year. When businesses meet demand by unloading stockpiles it detracts from growth because there is less need to ramp up production.

"Q4 GDP will be revised down; it didn't really pass the smell test in the first place," said Keith Hembre, chief economist at FAF Advisors in Minneapolis.

It is much easier to find decent news reporting outside the US mainstream media, especially when it comes to the US economy.

In the US, Nouriel Roubini was on top of this story with his blog entry US Q4 GDP Growth Likely to be Revised Down to 2.0-2.2% from Initial 3.5% Estimate.

It now looks like the alleged growth rebound in Q4, from the 2.0% of Q3 to the 3.5% of Q4 was an illusion based on incomplete data. Based on recent data on inventories for December (much lower than initially predicted by BEA) and today’s December trade balance figures (much worse than initially forecasted by BEA) the initial estimate for Q4 growth will be revised downward to 2.0% or at best 2.2%. Indeed 2.2% is today’s revised estimate by JP Morgan, one of the most bullish – on US growth - investment houses. In a research note today they said: “A wider than expected December trade deficit leaves fourth quarter GDP growth tracking 2.2%, down from the advance estimate of 3.5%.”.

So, the alleged growth rebound in Q4 actually did not occur. Indeed, as BEA had estimated strong consumption in Q4 and in December, it was odd that one would expect an improved trade balance in December: all those plasma and LCD TVs and consumer electronics - that were at the center of the holiday consumption binge - are imported. And indeed the December trade figures today showed the obvious: a large chunk of the consumption boom during the holidays went into imports.

One of the more interesting things I suppose is the fact that stocks rose on the report of a higher GDP and stocks rose on a revised lower GDP. Does any one care about anything or is there simply a mad panic to get into stocks before it's too late? I recall a similar panic to get into housing in the summer of 2005 "before it's too late". Here's a free tip: When everyone is rushing to get in to something "before it's too late", it is already way too late.

For a very timely (in advance) article on that concept I refer you to this short article: It's Too Late. Mish readers may wish to check the date on that article.

Let's now return to the GDP. I consider +2% to be the stall rate. I say that because the first 2% of the GDP is total nonsense (hedonics and imputations) that simply do not reflect any real economic activity. I have reported on this before but imputations include the concept of "paying oneself rent" and the GDP value of "free checking accounts".

If there was value delivered in "free checking accounts" banks would be charging for those services. In essence they already are. When you deposit money into your checking account, a "sweep" process takes that money and on a nightly basis "sweeps it from your account" into a general lending pool so that banks can lend that money out. In the meantime banks pay you 0% interest while lending it out for profitable returns. To top that off some bureaucrat comes along and decides that GDP should be higher because of the "value" you receive for that "free" checking account.

Believe it or not, there is similar nonsense in the GDP that says that if you do not own your own home, then you would be renting it from someone else. In those cases the GDP is revised upwards as if you rented your house from yourself. Given that close to 69% of the US owns their own home, the concept of paying oneself rent adds a decent chuck to the GDP. Unfortunately there are delays of close to two years on reporting of these distortions. I hope to have the next report on this, with actual figures, sometime in April.

So what does this mean? It means that a recession that seemed very unlikely a mere two weeks ago is now very much in the limelight. I am waiting to see the revision to the revision of the revision but if the next revision comes in at or below +2.5% then the first sub +2.0% will likely have me declaring the start of an "unofficial recession".

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