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					     the ambiguous economy!
      Thinking Outside of the
             Cubicle




Mary Ann Hurley, D.A. Davidson, May 9, 2006
            The Son of the Pitch*
                           Economy!




*Son of A pitch…New York Post headline skewing Randy
Johnson for suing ex-girlfriend for return of $71,000 paid for
day care for his daughter.
Fortune 500 2006 (revenues)
1. Exxon Mobil
2. Wal-Mart Stores
3. General Motors
4. Chevron
5. Ford Motor




  Oil companies, and struggling elephants (GM, Ford)
                    in the top five
     First timers on the Fortune 500 – Yahoo (#414),
                Goggle(#353), eBay(#498)
Web sites coming out of nowhere
  (it seems like it anyway)…and
      becoming massive online
   phenomenon's, top 10 traffic
sites…like MySpace…New kid on
      the block…Facebook an
 interactive, image-laden site for
college students, there is talk this
        will sell for $2 billion.
Edward R. Murrow, Walter
 Cronkite…Perky Katie
      Couric???

    “And that's the way it is.”
    Walter Cronkite
The good, bad, and ugly:
                                      Globalization,
                                      Low Inflation,
                                      Productivity,
                                       Innovation,
                                Robust Economic Growth,
                           High and Higher Corporate Earnings,
                                   High Energy Prices,
                                  Commodities go wild,
                                    Geopolitical risks,
                                         Bird flu,
                                 Consumer indebtedness,
                                     Housing Froth,
                                   Muted wage growth,
                                   Strong job growth,
                                 Current Account Deficit,
                                      Budget Deficit
Flat/inverted yield curve (like a pancake or the
 state of Kansas), yesterday…gone “sort of”
                     today


Every economic slowdown has been preceded
          by a flat/inverted curve.
     “Although macroeconomic forecasting is fraught
     with hazards, I would not interpret the currently
     very flat yield curve as indicating a significant
     economic slowdown to come…”


Ben Bernanke, Reflections on the Yield Curve and Monetary
Policy, March 20, 2006
What conclusion should we draw? Clearly, bond prices, like other asset prices,
incorporate a great deal of information that is potentially very relevant to
policymakers. However, the information is not always easy to extract and--as
in the current situation--the bottom line for policy appears ambiguous. In
particular, to the extent that the recent behavior of long-term rates reflects a
declining term premium, the policy rate associated with a given degree of
financial stimulus will be higher than usual. But to the extent that long-term
rates have been influenced by macroeconomic conditions, including such
factors as trends in global saving and investment, the required policy rate will
be lower. Given this reality, policymakers are well advised to follow two
principles familiar to navigators throughout the ages: First, determine your
position frequently. Second, use as many guides or landmarks as are
available.
In the context of monetary policy, these principles suggest that policymakers
should monitor bond yields carefully in judging the current state of the
economy--but only in tandem with the signals from other important financial
variables; direct readings on spending, production, and prices; and a goodly
helping of qualitative information. Ultimately, a robust approach to
policymaking requires the use of multiple sources of information and multiple
methods of analysis, combined with frequent reality checks. By not tying policy
to a small set of forecast indicators, we may sacrifice some degree of
simplicity, but we are less likely to be misled when a favored variable behaves
in an unusual manner… Ben Bernanke, Reflections on the Yield Curve and
Monetary Policy, March 20, 2006
   “Yet, under the placid surface, there are disturbing
trends: huge imbalances, disequilibria, risks – call them
  what you will. Altogether the circumstances seem to
 me dangerous and intractable as any I can remember,
  and I can remember quite a lot. What really concerns
   me is that there seems to be so little willingness or
              capacity to do much about it.”


Paul A. Volcker, Former Federal Reserve Chairman
1979-1987, April 10, 2005 Washington Post (adapted
from a speech given at an economic summit sponsored
by the Stanford Institute for Economic Policy Research)
       Every Fed tightening has been
       associated with a financial crisis
1970        Penn Central
1974        Franklin National
1980        First Penn/Latin America
1984        Continental Illinois
1987        Black Monday
1990        S&L Crisis
1994        Mexico
1997        Pacific Rim/Russia/LTCM
2000        Tech bubble bursts
2006        ????
the ambiguous economy!
  THINKING OUTSIDE OF
  THE CUBICLE
I. Today’s Reality Show – the
   ambiguous economy?
II. Son of a Pitch – does reality
    bite?
III.Fed – extra innings?
IV.Closer – thinking outside of the
   cubicle
                                                  GDP



                                                           GDP POWER
                                                            GAME!!!
    7.5
                                                                         4.8% 1Q 2006
    6.5

    5.5                                                 2 Q moving average
    4.5

    3.5

    2.5

    1.5

    .5
              03                             04                 05                 06

Source: Commerce Dept., BEA, Credit Suisse
                                                Non-Farm Productivity
                                               Year/year percent change



                                                  Maintaining its historically
                                                   high level? Allows high
                                                  growth/profits/low inflation




                                                                          2.9% 2005, 4Q -.5% from 4.2%
                                                                            3Q, expect a jump 1Q 2006



Source: Bureau of Labor Statistics – U. S. Department of Labor, Yardeni
                                       Consumer Spending
                                  Quarter/quarter percentage change

                                              CONSUMER ON STERIODS???
       7                                     57 quarters (and counting) jolting           7
                                             consumer spending streak breaks
       6                                       Joe DiMaggio 56 game hitting               6
                  Not shown                               streak?
       5          061Q 5.5%                                                               5

       4                                                                                  4

       3                                                                                  3

       2                                                                                  2

       1                                                                                  1

       0                                                                                  0
                                               054Q .9%
       -1                                                                                 -1
               92     93     94     95    96     97   98   99 00   01   02 03   04   05

Source: Bureau of Economic Analysis, Merrill Lynch
                                                    Retail Sales
                                              Year/year percent change


                                         Consumer basic instinct…SPEND!
                                          Retail sales account for 50% of
                                                consumer spending
                                                                            7.9% March




Source: Bureau of Census – U. S. Department of Commerce, Yardeni
Manufacturing is
  flying high?
                               ISM Composite Index


                       Built Long Term Tough? Vehicle
                         production is scheduled to
                           decline in May and June
                                                        57.3 April, 5 month
                                                               high




Source: ISM, Yardeni
                                           Industrial Production
                                         Year/year percent change



                                   .6% month/month rise in
                                   March…3.6% year/year is
                                      good not stellar?


                                                                    3.6% March




Source: Federal Reserve, Yardeni
                                     Business Inventories-to-Sales Ratios

                                Blame productivity?
                         Does just-in-time means we will not
                         see a build up in inventories in real
                                        time?



                                                                   The inventory/sales ratio in
                                                                    Feb. rose fractionally to
                                                                    1.26 vs. a record low 1.25
                                                                       the previous month.




Source: Bureau of Census – U. S. Department of Commerce, Yardeni
  Housing
  A nail gun
 headache for
the economy?
House prices, which have increased rapidly during the past several
years, appear to be in the process of decelerating, which will imply
slower additions to household wealth and, thereby, less impetus to
     consumer spending. At this point, the available data on the
     housing market, together with ongoing support for housing
   demand from factors such as strong job creation and still-low
mortgage rates, suggest that this sector will most likely experience
     a gradual cooling rather than a sharp slowdown. However,
  significant uncertainty attends the outlook for housing, and the
  risk exists that a slowdown more pronounced than we currently
    expect could prove a drag on growth this year and next. The
Federal Reserve will continue to monitor housing markets closely.

Fed Chairman Ben S. Bernanke, Testimony (fourth paragraph,
more than a little concern?) before the Joint Economic Committee
of the U.S. Congress, 4/27/06
                                                    Existing Home Sales
                                                           Millions
 A little panic selling/buying? Sales unexpectedly
     rise…but inventories rocket. Single-family
   inventories are now up 32.5% year/year, and
condos/coops up a whopping 86.5% over last year.
Home appreciation fell from double digits gains to
       7.4% year/year, first time in over a year.

                                                                           March rose
                                                                          .3% to 6.920
                                                                             million
                                                                             units
                                                                           annualized




Source: National Association of Realtors, Yardeni
                                                 New Home Sales
                                                     Millions
                    Do I have nails in my head…how can
                     the biggest increase in a decade be
                           negative? Prices fell 2.2%
                   year/year. This is the first decline since
                    December ’03. Are builders reducing
                   prices to move inventories? Throw in a
        Mary Ann??? little panic buying, and also keep in
                       mind that new home sales only
                         represent 15% of total sales?


                                                                     March rose
                                                                   13.8% to 1.213
                                                                     million units
                                                                   annualized, the
                                                                   biggest jump in
                                                                      a decade.




Source: Bureau of Census – U. S. Department of Commerce, Yardeni
                                                    Housing Starts
                                                       Millions

                      I see a nail gun headache in
                       your future? Starts are the
                         first to feel the effect of
                     rising/bloated inventories and
                               slowing sales




                                                                     7.8% decline
                                                                      in March to
                                                                     1.960 million
                                                                         units




Source: Bureau of Census – U. S. Department of Commerce, Yardeni
Commodities?
The monkey on our
   back???
                                             CRB Metal Spot Index
                                                 1967 = 100


                                                                    4/25

                                  Feed Me! China
                               driving up commodity
                                      prices?




CRB metal spot index Includes copper scrap, lead scrap, steel scrap, tin and zinc.
Source: Commodity Research Bureau, Yardeni
                                     Gasoline Pump Prices – National Average
                                                 Dollars per gallon




                                        Road Rage? Will higher fuel prices             4/19
                                     translate into lower spending elsewhere?
                                       Remember every one cent increase in
                                       gasoline prices drains $1.3 billion from        4/19
                                          consumer’s disposable income.

                                                            Total




                                                                                  Ex Taxes



Source: Oil & Gas Journal, Yardeni
                                         Gold Spot Price
                                        Dollars per ounce


                                   Gold Bugs alive and well…what does
                                    it mean? Holding gold can be an
                                    alternative to holding dollars…so
                                     higher inflation, financial crisis,
                                              weaker dollar?               4/25




Source: Haver Analytics, Yardeni
                                                   Trade-Weighted Dollar
                                                         1973 = 100



                                                               Dollar has once again
                                                               started its downward
                                                            trend…good for exporters,
                                                            not for future interest rates
                                                                      (higher)?




                                                                                            4/21




Includes Euro zone, Switzerland, Japan, United Kingdom, Canada, Netherlands,
Sweden, Austria, Finland, Mexico, and Australia.
Source: Board of Governors of the Federal Reserve System, Yardeni
                                                     Employment Payroll
                                                          Millions

                     Good but not “knockout” job
                     growth… vs. other economic
                 recoveries. Not inflationary? Blame
                    globalization and productivity?




                                                                           211,000 jobs
                                                                          added in March




Source: Bureau of Labor Statistics – U. S. Department of Labor, Yardeni
                                                    Unemployment Rate
                                                      Percent change



                                                 Is the unemployment rate “artificially”
                                                low? The labor participation at 66.1% is
                                                     close to the historical lows (vs.
                                                 “modern” high of 67.3% in April 2000).




                                                                                   4.7% March




Source: Bureau of Labor Statistics – U. S. Department of Labor, Yardeni
                                       Employment Costs

  Remember the ECI includes wages and benefits. Good for inflation going
  forward…not for consumer spending? Muted wage growth? Employees
    picking up more of their health costs? ECI rose a benign .6% 1Q, 2.8%
year/year. Wages/salaries are up .7%, 2.7% year/year. Benefits are up .5% 1Q,
                                3.4% year/year.
 year/year%
    8                                                         Benefits
    7
                                                     Employment Cost
    6                                                Index (ECI)

    5

    4

    3

    2                                                            Wages and
    1
                                                                  Salaries
        86       88        92        94        96        98       00        02   04   06


Source: Bureau of Labor Statistics – U. S. Department of Labor, Credit Suisse
                                   Capacity Utilization
                                     Percent change

              Inflationary? Output cap at a cycle high and
                will be viewed problematically by the Fed
                   who remains concerned about rising
                   utilization rates…but should they be
                                 concerned?
                                                             81.3% March




Source: Federal Reserve, Yardeni
            Inflationary? Does the domestic output gap matter…in a
                 world where global manufacturers are building
               factories/plants in China, Vietnam, US (foreign auto
                            manufacturers) wherever?

                                      Is the global output gap (not domestic
                                        output gap) what spikes inflation?
                                     Stephen S. Roach, Chief Economist at
                                    Morgan Stanley cites researchers at the
                                    Bank for International Settlements* who
                                      constructed alternative versions of a
                                    global output gap…bottom line, slack in
                                    the global economy contained inflation
                                          in individual economies. BIS
                                      researchers also concluded the 2005
                                       global output gap – GDP weighted
                                    construct, showed that there was good
                                       balance between global supply and
                                           demand…tame US inflation.

*Claudio Borio and Andrew Filardo, “Globalisation and inflation: New cross-country
evidence on the global determinants of domestic inflation”
                                                               PPI
                                                    Year/year percent change

                         Where’s the commodity fire? Inflation Trending
                            lower year/year…blame globalization?
                                     PPI rose .5% in March,
                                    3.5% year/year vs. 3.7%
                                      the previous month


                                                                               Is inflation
                                                                                 falling?




                                                                                3.5%
                                                                                March


Source: Bureau of Labor Statistics – U. S. Department of Labor, Yardeni
                                         Core PPI (excluding food and energy)
                                               Year/year percent change




                                   Core PPI was only up .1% in March, 1.7%
                                    year/year. Companies unable to pass
                                 through high commodities costs to the final
                                                   buyer?




                                                                          Inflation trending lower?




                                                                                       1.7% March


Source: Bureau of Labor Statistics – U. S. Department of Labor, Yardeni
                                                               CPI
                                                     Year/year percent change




                                     CPI was up .4% in March, 3.4%
                                 year/year vs. 3.6% the previous month.
                                  CPI no doubt will be energized next
                                                  month.




                                                                                3.4%
                                                                                March


Source: Bureau of Labor Statistics – U. S. Department of Labor, Yardeni
                                          Core CPI (excluding food and energy)
                                                Year/year percent change


                                   Core CPI was up .3% in March, 2.1% year/year,
                                      unchanged from previous month. But it is
                                  interesting to note 70% of the increase resulted
                                   from apparel, shelter (housing excluding utility
                                 and furniture costs)…no evidence of pass through
                                 of commodity costs. Also it should be noted only
                                    something like 10% of the final product is the
                                   commodity cost…70% labor costs (contained).



                                                                                  2.1%
                                                                                  March




Source: Bureau of Labor Statistics – U. S. Department of Labor, Yardeni
So what do we have?

      Goldilocks economy?
             Sweet Spot?
               Oil slick?
           Housing froth?
   A globalization revolution?
    An ambiguous economy?
Does it bite?
the ambiguous economy!
  THINKING OUTSIDE OF
  THE CUBICLE
I. Today’s Reality Show – the
   ambiguous economy?
II. Son of a Pitch – does reality
    bite?
III.Fed – extra innings?
IV.Closer – thinking outside of the
   cubicle
The Son of the Pitch
     Economy!
 “Son, what kind of pitch
 would you like to miss.”
Dizzy Dean
Ambiguous risks???
Ambiguous math???
 Everybody’s favorite theory (it seems anyway)…slowing
consumer spending (if it happens) due to slowing housing
 and higher energy costs will be augmented by wage/job
   growth, business Capex will pick up the slack, heck
business is sitting on a tub of money, and we need to cool
down a bit anyway…and the rest of the world is heating up,
          wanting to chow down on our exports.


   What about that pesky current account deficit? “Don’t
worry be happy” argument…foreigners love our assets, and
 there’s that global saving glut thing, and the world will re-
     balance over time without any major disruptions.


  And remember our economy has shown resiliency and
     flexibility in face of many economic challenges.



                      BUT…
   “Yet, under the placid surface, there are disturbing
trends: huge imbalances, disequilibria, risks – call them
  what you will. Altogether the circumstances seem to
 me dangerous and intractable as any I can remember,
  and I can remember quite a lot. What really concerns
   me is that there seems to be so little willingness or
              capacity to do much about it.”


Paul A. Volcker, Former Federal Reserve Chairman
1979-1987, April 10, 2005 Washington Post (adapted
from a speech given at an economic summit sponsored
by the Stanford Institute for Economic Policy Research)
     No simplistic
     solutions???
Let’s take a closer look
  at the risks and the
          math.
Will we see a slowing in
 consumer spending?
“As you know, we Americans
       do love debt!”
Fed President Richard Fisher
                                        Household Debt-to-Income Ratio

               Record high debt! The amazing
               race to acquire debt …the consumer
               has done something that has never been
              done…increased their debt 30 percentage
             points in a five year period span 2000-2005.                            2005Q3 = 129%
            Percent
            130
                                                                            2000 = 100%
            110
                                                              1986 = 75%
            90
                        1956 = 50%
            70

            50

            30
                   52       56      60         64   68   72   76   80   84 88   92    96   00   04

Source: Federal Reserve Board, Merrill Lynch
Will higher interest rates
and a slowing housing
market kaput consumer
        spending?
                                               Income Growth

                          Year/year percentage change since 2001 4Q

           35
           30                                           Does money grow on trees…that
           25                                            make homes…it sure the heck
           20                                           does not come from wages and
           15                                                      salaries.
           10
           5
           0
           -5
           -10
           -15


                                                                   Wages and
                 Cash outs                       Dividend
                                                                    Salaries
                      Home Equity Lines of
                                                            Proprieties   Interest
                            Credit                                                   Rental
                                                             income       Income
                                                                                     Income
Source: Freddie Mac, Bureau of Economic analysis, Merrill Lynch
                 Home Equity extraction (billions) – consumer’s ATM machine?

                                                                    2000 2001 2002 2003 2004 2005
          Total home equity extraction
          Greenspan/ Kennedy *                                        106 175 326 376 490
          % of disposable income                                      1.5% 2.3% 4.2% 4.6% 5.7%

          Home equity extraction parts
          Cash-outs from refis                                           26      83   111   147 142   204
          (Freddie Mac data)

          Total home-equity loans (HEL)                                  90      25    66 102   203 155**
          (Flow of Funds)

          * From “Estimates of Home Mortgage Originations, Repayments, and Debt on One-to-Four
          Family Residences,” by Alan Greenspan and James Kennedy, September 2005
          ** Through 3Q, annual rate


Source: Federal Reserve Board, , Freddie Mac, Bureau of Economic Analysis, UBS
   The   BIG     picture…and were not talking about that
  plasma HD television you got in 2005 from your cash out.


Based on Fed’s Flow of Funds (released 3/09/06)

2005 Mortgage Equity Withdrawal (MEW)
                   Annualized
1Q $556 billion
2Q $772 billion
3Q $883 billion
4Q $780 billion
                                        3Q was almost 10% of
                                         disposable personal
                                              income!!!
Alan Greenspan estimated that 50% of MEW is
 spent…ISI Group pointed out that for every
  $100 billion decline in MEW implies a $50
 billion in spending …that is approximately a
       .5% decline in consumer spending.
                 Residential Real Estate as a share of household assets

   Percent                                                                   Percent
     40                                                                         40
                    Residential Real Estate                          38.7%
                     includes second home, time
                   shares, one to four family rental
                  properties, not comparable before
      35                     1995 survey                                        35

                              Primary
                           Residence only
      30                                                                        30




      25                                                                        25
                                    ALL TIME HIGH??? Frothy or what (keep in
                                    mind this is 2004, Fed’s latest data…2006
                                                up, up and away?)
      20                                                                        20
               1989           1992             1995    1998   2001    2004

Source: Federal Reserve Board, Goldman Sachs
   Other signs of froth…crazy numbers or what???
   (source: Bloomberg’s Caroline Baum and Andy
                      Laperriere)
•42% of mortgage loans in 2005 were interest only and negative
amortization ARMS vs. 32.6% in 2004 vs. 1.9% in 2001 according
to LoanPerformance’s asset- and mortgage-backed database,
does not include Fannie Mae and Freddie Mac securities.
LoanPerformance is a unit of First American Corp, that
maintains the two largest databases of mortgage information in
the country.
• According to a study by First American Corp., 22% of the
borrowers who borrowed at initial rates of 2.5% or less during
the past two years have negative equity in their homes, and 40%
have less than 10% equity. Also a third of people who took out
adjustable rate mortgages in 2005 have negative equity and 52%
have less than 10% equity.
•43% of first time buyers put 0% down
           More froth and frothy thoughts?
•Foreclosed properties are up 63% from a year ago. Realty Trac.
•Delinquency rates are up to 5.7% in the 4Q 2005 vs. 4.4% in the
3Q 2005. Mortgage Bankers Association (MBA)
•Sub prime delinquency rates rose to 3% in February 2006 vs.
2.84% a year ago. LoanPerformance
•$330 billion Arms will reset this year and $1 trillion next year.
Mortgage Bankers Association (MBA)
•25% of jobs created since 2001 are related to housing
•Remember the Japanese real estate crash in 1991, it has only
been recently that the Japanese real estate market has shown
signs of recovery…15 years.
Re-visiting our “ favorite theory” again
    Everybody’s favorite theory (it seems anyway)…slowing consumer
 spending (if it happens) due to slowing housing and higher energy costs
  will be augmented by wage/job growth, business Capex will pick up the
  slack, heck business is sitting on a tub of money, and we need to cool
down just a bit anyway…and the rest of the world is heating up, wanting to
                        chow down on our exports.


   For the sake of argument, let say we have we have slowing consumer
 spending (don’t bet against the consumer?) due to a sharp slowdown in
 the housing market and the heavy debt incurred by the consumer… now
   look at the math, can good but not “knockout” job growth and muted
   wage growth (due to globalization?) make up the lost income from the
consumer’s ATM machine-housing? No. And will business spend without
  consumer demand? You ask…what about demand from the rest of the
   world, we will take a closer look at the dysfunctional world economy a
                                   little later.



                         Bottom line…
Re-visit Ben Bernanke testimony

House prices, which have increased rapidly during the past several
years, appear to be in the process of decelerating, which will imply
slower additions to household wealth and, thereby, less impetus to
     consumer spending. At this point, the available data on the
     housing market, together with ongoing support for housing
   demand from factors such as strong job creation and still-low
mortgage rates, suggest that this sector will most likely experience
     a gradual cooling rather than a sharp slowdown. However,
  significant uncertainty attends the outlook for housing, and the
  risk exists that a slowdown more pronounced than we currently
    expect could prove a drag on growth this year and next. The
Federal Reserve will continue to monitor housing markets closely.

Fed Chairman Ben S. Bernanke, Testimony (fourth paragraph,
more than a little concern?) before the Joint Economic Committee
of the U.S. Congress, 4/27/06
         IMPORTANT
gradual cooling vs. sharp slowdown
 As the consumer goes, so
     goes the economy
   …consumer spending
accounts for 70% of the GDP
And as the US consumer goes,
     so goes the global
         economy???
                                      2005 Personal consumption (estimated)



                                     Dysfunctional global economy…US consumer is the
                                      main driver of global growth…please note the data
                                    below is not per captia, it is total consumption. What a
                                    doozy of a problem? How do we wean the world off the
         US $billion                US …and vice versa. And if the global economy slows
        10000                                    who will feed on our exports?
        9000
        8000
        7000
        6000
        5000
        4000
        3000
        2000
        1000
        0
                           U.S.            Europe        Japan         China          India
                          295 million      726 million   127 million   1.3 billion    1 billion
                          population       population    population    population    population


Source: National sources, Morgan Stanley
Look at the math…US consumption totaled $8.7 trillion in
2005 - 25% greater than European consumption, 3.3 times
 the level of Japanese consumption, 8-9 times the size of
  Chinese consumption and 20 times India consumption
    (Morgan Stanley). Can a shortfall in US consumer
spending be compensated elsewhere in the world in one
  quarter, or even in a year…two years… especially since
    Europe, Japan, China and India have export driven
                         economics?

Bottom line, if the US consumer slows, the
 global economy slows…and no feeding
          frenzy for our exports.
           Looking at
 What about that pesky current
account deficit? “Don’t worry be
 happy” argument…foreigners
love our assets, and there’s that
global saving glut thing, and the
 world will re-balance over time
 without any major disruptions.
                                                                  US Trade Balance
                                                               12 month sum, billion dollars

                                                          Global quagmire? Our exports are
                                                         only two-thirds as much as imports,
                                                        and we would need to increase at two
                                                         times the rate of our imports just to
                                                               keep the deficit stable.


                                                                                DEFICIT
                            Imports


                                                 Balance


                             Exports                  Feb.“tombstone”
                                                       deficit of 65.742
                                                            billion

                                                                            -$739.568 billion February



Source: Bureau of Census – U. S. Department of Commerce, Yardeni
      UNCHARTED
      WATERS???




    The U.S. current-account deficit (the broadest measure of U.S.
    international trade in goods and services) increased to $804.9
billion (preliminary) in 2005 from $668.1 billion in 2004. As a share of
 GDP, the deficit increased to 6.4% in 2005 from 5.7% in 2004. It is
estimated we are now running a current-account deficit of 7% (twice
                        that of the mid-Eighties).
  Everybody says this current account deficit (90% trade
deficit) can’t be sustained long term, but Ben Bernanke said
                he is not worried about it…why?
•Global saving glut (not in the US) coined by Ben Bernanke,
the argument goes like this, most of the rest of the world is
running a current account surplus, and in his March 10, 2005
speech, Big Ben had a table showing the world running a
surplus of $137.2 in 2003 vs. $41.3 billion in 1996…where
does that money go…voila, the US.
•Central Bank buying as in the case of China to “stabilize”
the yuan


Also other considerations:
The US dollar as the dominant reserve currency, it is vital to
keep the global economy stable.
Here is where it gets a little muddy (ambiguous?),
  approximately 50% (up from less than 35% in
   2002) of our debt is held by foreigners, one
 reason foreigners have invested in our debt, is
because it is stable, rock solid, and gives a good
 return,…what happens if it is perceived that we
    are not rock solid (Federal budget deficit?
Geopolitical factors?), and our returns are not as
   attractive, Bank of Japan and the European
Central Bank will be hiking rates, and the Fed will
       be done after one or two more hikes.
Also what happens if a country or countries want
  to hold our feet to the fire such as China (the
second largest holder of our debt…$265.2 billon
Feb.) for protectionism or countries in the Middle
 East who is thought to be buying our debt with
                  their oil profits.
                                      Biggest foreign holders of treasuries


                                                           Feb./2006       Feb./2005
   Japan                                                   673.1           681.0
   Mainland China                                          265.2           225.0
   United Kingdom*                                         250.8           111.0
   Caribbean Banking Centers**                             94.1            107.0
   OPEC                                                    84.9            67.7

                                                                    $140 billion jump in one
                   Hedge funds
                                                                   year? The “new” Da Vinci
                                                                   Code? Oil money? Hedge
                                                                             Funds?


   *United Kingdom includes Channel Islands and Isle of Man.
   **Caribbean Banking Centers include Bahamas, Bermuda, Cayman Islands,
   Netherlands Antilles and Panama.
Source: Department of the Treasury/Federal Reserve Board
                 Fantasy Talk


   The fear is that our debt will become less
attractive to foreigners because they can get a
 better return elsewhere…but maybe another
    concern is whether a party/parties could
    “manipulate” the market. The argument
 always used against such an outcome is the
 market is simply too large…just fantasy talk,
                      right.
                                Composition of Foreign Held Assets in the US




                                                            12% Direct
                                               14% other   Investment




                                                                      26%
                                                                   Treasuries
                                     48% Corp Bonds
                                       and Stocks




Source: Bureau of Economic Analysis, Merrill Lynch
 Finally, What can be more
          American?
Hot dogs, apple pie, and the
  Federal Deficit…except
 were not talking peanuts.
                                                                 Federal Budget
                                                                  Billion dollars
                                                Deficit


                                                                                    Deficit
                                                      Q4    Federal Budget as a % of
                                                           GDP…2.7% in 2005 vs. 3.5%
                                                           in 2004 and projected to be
                                   Surplus
                                                                  3.0% in 2006

                                                                                        Q4




                          Looks like we are seeing an            Surplus
                           improvement…but what
                           happens if the economy
                                    slows?



Source: U. S. Department of Treasury, Yardeni
the ambiguous economy!
  THINKING OUTSIDE OF
  THE CUBICLE
I. Today’s Reality Show – the
   ambiguous economy?
II. Son of a Pitch – does reality
    bite?
III.Fed – extra innings?
IV.Closer – thinking outside of the
   cubicle
The markets were thrown a screwball on June 2,
 2005 when Richard Fisher, the new president of
the Federal Reserve Bank of Dallas said that the
     Fed is in the “eighth inning” of monetary
   tightening and that the next FOMC meeting
(June 29-30, 2005) would be the “ninth inning” in
   the central bank’s contest against inflation.
  We are now in the




15 th   inning
                                                                    Benjamin Bernanke,
                                         Fed Governors:                  Chairman
   Fed Governors
    7 governors
    and the New
   York President
    always has a
        vote
                              Randall S. Kroszner Donald L Kohn      Susan Schmidt    Mark W. Olson       Kevin M. Warsh
                                                                         Bies
   Fed Presidents                           Voting Fed Presidents:
        11 Fed
      Presidents
     rotate every
   year where just
   4 of the 11 vote
                                  Timothy F.          Sandra          Jeffery M.        Jack Guynn,      Janet L. Yellen,
                                 Geithner New        Pianalto,         Lacker,            Atlanta        San Francisco
                                  York, Vice         Cleveland        Richmond
                                  Chairman
Hawks - generally tend to be “old economy believers” more inclined to raise interest when the economy is growing
strongly, and not lower rates when the economy is slowing.
Doves – generally tend to be “new economy believers”, would rather wait before raising rates, believing that the economy
can grow strongly with high productivity without igniting inflation, and lower rates when the economy is slowing.
Eclectic???
                                                   Alan Greenspan years

                                         % Change from 8/11/87 to 1/31/06


                                   A rock star for the
   500                                   ages!

   400

   300

   200

   100

   0

   -100         S&P          Dow           Treasuries Bank Home                              CPI   CRB   Gold   US
                500                                   Credit Prices                                             Dollar




Source: Total Return Indices, OFHEO Home Price Index, Trade Weighted Dollar, Merrill Lynch
   What changes do we expect to see in the Ben Bernanke tenure?


•A more democratic Fed rather than the benevolent dictatorship of Alan
Greenspan.
•More transparency…but maybe that won’t be the case as displayed in
his “ambiguous” first speech…but maybe that is as transparent as one
can get as the economic is facing many “ambiguous” risks. But he was
surprisingly candid and forthcoming in his testimony before the Joint
Economic Committee of the U.S. Congress on 4/27/06.
•Big Ben has also been a fan of inflation targets…but again maybe he
has now determined an “ambiguous” economy needs “ambiguous”
targets.


Any concerns?
Too much of an academic…what will he do in a crisis situation.
New blood…along with Alan Greenspan, the Fed will no longer have the
experience/leadership of Fed governors Roger W. Ferguson Jr. and
Edward M. Gramlich.
What NOW???
“The Fed is very close to where we need to be”…
  Fed rate is currently at the “upper end” of the
 neutral range. “And now we're in that range, it's
 more difficult. And that's what we mean when we
            say we're data dependent."

Thomas Hoenig, the Kansas City Fed president
“Even if in the committee's judgment the risks
 to its objectives are not entirely balanced, at
  some point in the future the committee may
    decide to take no action at one or more
 meetings in the interest of allowing more time
to receive information relevant to the outlook.”
Fed Chairman Ben S. Bernanke, Testimony
before the Joint Economic Committee of the
U.S. Congress, 4/27/06
“Data dependent” Fed
  Is the Fed thinking
outside of the cubicle?
Retail sales slowed
 coincidently with
    the housing
slowdown in the UK
   and with one
   quarter lag in
      Australia
  according to the ISI Group
    Double
  Whammy???
 Is the economy
 facing a double
 drag…housing
and higher energy
prices ($3 plus at
   the pump)?
   Will productivity and
    globalization keep
inflation in check despite
 energy and commodity
prices going through the
           roof?
Go back to Ben Bernanke’s March 20 speech (an earlier slide):




 “Ultimately, a robust approach to policymaking
      requires the use of multiple sources of
  information and multiple methods of analysis,
  combined with frequent reality checks. By not
tying policy to a small set of forecast indicators,
 we may sacrifice some degree of simplicity, but
  we are less likely to be misled when a favored
     variable behaves in an unusual manner.”
Thinking outside the cubicle?
  Reality checks? Multiple
          sources?
 How will the Fed massage
    the economy to get
   moderate sustainable
  growth…soft landing for
housing and the consumer?
  Avoid the “son of pitch?”
16th inning and done???
One more rate hike…and
 a reality check pause
   (which maybe will
     become a halt)
           WHY?
  Lag time…Lag time…Lag
   time. There is always a
     lagged impact to Fed
tightening, and it is “smart”
 to pause, and collect more
 economic data…especially
         on housing.
the ambiguous economy!
  THINKING OUTSIDE OF
  THE CUBICLE
I. Today’s Reality Show – the
   ambiguous economy?
II. Son of a Pitch – does reality
    bite?
III.Fed – extra innings?
IV.Closer – thinking outside of the
   cubicle
           Three Sure Things
•Expect the unexpected…this is part of the
Fed’s risk management approach to monetary
policy in the United States.

•Expect ambiguity
•The U.S. economy is strong but not
without problems
                         What I expect/watch?
U.S. economy will grow but struggle in the second half of the year…and the
               odds have increased for a financial crisis.

What type of recovery will we get?
GDP
2006 2.5% - 3.0%
2007 2.5% - 3.0%
Why the lower growth? Higher energy prices and slowing housing…as the
consumer goes, so goes the economy.

What economic data/events is the Fed watching and will determine
when the Fed pauses?
“policymaking requires the use of multiple sources of information and
multiple methods of analysis, combined with frequent reality check”-Ben
Bernanke With that said, focus on the following:
Housing data
Inflation data - Unit labor costs, and evidence of pass-through of
commodity/energy costs
Productivity
Global stress points - dysfunctional global economy-current account deficit
Year end targets
Inflation        2.0% - 2. 5%
Fed funds rate 4.5%
2 year note      4.375% – 4.5%
10 year note     4.5% – 4.625%
Yes, I am calling for a Fed rate cut in the second half of this year.

The odds here have also increased for an interest rate spike…runaway
inflation?, dollar freefall (current account deficit)?

				
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