Investment News Briefs Wednesday, September 9, 2009

“The pace of economic activity appears to have slowed markedly, owing importantly to a decline in consumer expenditures,” the Fed said in a statement. “Business equipment spending and industrial production have weakened in recent months, and slowing economic activity in many foreign economies is damping the prospects for U.S. exports.

“Moreover,” the statement added, “the intensification of financial market turmoil is likely to exert additional restraint on spending, partly by further reducing the ability of households and businesses to obtain credit.”

The Fed also lowered its discount rate – the rate at which it lends directly to banks and Wall Street firms – by a half-percentage point to 1.25%.

A wave of failures among banks and financial institutions have stymied lending and roiled global credit markets. The world economy faces a significant uphill battle as a result.

The U.S. economy expanded by 2.8% in the second quarter, but that expansion was largely the product of government stimulus checks and a weak dollar. The federal government returned roughly $168 billion back to American taxpayers in the form of rebate checks earlier this year. The tax rebates, which were mailed through May, kept U.S. consumers afloat, while a weak dollar accelerated a torrent of exports out of the country.

Since then, consumer spending has been undermined by rising unemployment and the dollar has strengthened substantially.  The advance estimate for third quarter gross domestic product (GDP) is to be released today (Thursday), and most analysts anticipate the U.S. economy shrunk during the three months ended Sept. 30.

“The growing reality is that this is not just a slowdown, but a true recession,” Joel Naroff, president and chief economist of Naroff Economic Advisors said in an interview with Money Morning.

“U.S. GDP contracted significantly in the third quarter,” said Naroff, who believes the economy may have contracted by 2.5% to 3.0% in the quarter. “Such a sharp slowdown is not expected.”

Citigroup Inc. (C) analysts Geoffrey Dennis and Jason Press said last week that they now expect an entire year of contraction before the economy gets back on track in the second half of 2009.

“We are now expecting one of the sharpest recessions in the post-war period,” Dennis and Press wrote in a report to clients on Oct. 21.

The Fed statement said the rate cut “should help over time to improve credit conditions and promote a return to moderate economic growth,” but noted “downside risks to growth remain.”

This is the ninth time that the central bank has lowered rates since September 2007. The Fed has also loaned hundreds of billions of dollars to banks through a new lending program and earlier this week began loaning money directly to major businesses by purchasing commercial paper.

The Fed yesterday lowered the interest rates it will charge to buy unsecured commercial paper to 1.84%, down from 1.89% on Tuesday. It lowered the interest rate on asset-backed commercial paper to 3.84% yesterday, down from 3.89% the day prior.

The central bank created its program to buy 90-day commercial paper directly from issuers on Oct. 7, meaning it’s now three weeks old.

The Fed’s new loan programs have expanded assets on its balance sheet by 104% during the past year to $1.804 trillion, or 12.6% of GDP, Bloomberg reported.
Rate Reductions Around the World

While the Federal Reserve struggles to keep the U.S. economy from sinking into a second Great Depression, central banks in Europe and Asia are also on the defensive and could soon join the Fed in slashing rates – if they haven’t already.

The British Office for National Statistics last week said that, after a flat second quarter, the U.K. economy contracted 0.5% in the three months ended Sept. 30. It’s likely that Germany, France and Italy have already entered into a recession, as their second-quarter GDP fell 0.5%, 0.3% and 0.3%, respectively.

The International Monetary Fund (IMF) said last week that the economy of the 15-country Eurozone would grind to a virtual standstill in 2009.

The European Central Bank (ECB), which raised rates as recently as July, backtracked and cut its benchmark rate by half a point on Oct. 8, dropping it down to 3.75%. ECB President Jean-Claude Trichet said Monday that the central bank’s Governing Council could take additional steps at its next meeting, currently scheduled for Nov. 6.

“I consider it possible that the Governing Council would decrease interest rates once again at its next meeting,” ECB President Jean-Claude Trichet said yesterday. “Taking into account the recent substantial decline in commodity prices together with a substantial weakening in demand which has emerged lately, upside risks to price stability have diminished.”

Nick Parsons, head of markets strategy at nabCapital (OTC: NABZY) in London, told The Guardian that the Bank of England (BOE) could also follow the Fed’s move with a one-point cut of its own. That would leave the BOE’s rate at 4.5%

China, on the other hand, wasted no time in following the lead of the U.S. Fed. The People’s Bank of China cut its interest rates yesterday, reducing its key one-year lending rate from 6.93% down to 6.66%.  The rate cut was the central bank’s third reduction in two months.

China’s economy registered a solid GDP expansion of 9% in the third quarter – a noticeable step down from the 11.9% pace set in 2007.  Beijing is clearly worried about the effects a global recession would have on its economy and wants to ensure growth does not slow any further.

Of course, lowering rates will also help keep the Chinese currency, the yuan, from appreciating against the dollar and the euro as central banks in the West pull out all the stops in dealing with the credit crisis.

“This cut was driven by the slowdown in the third quarter and the likelihood that the U.S. and other central banks will cut rates,” Xing Ziqiang, an economist at China International Capital Corp. in Beijing, told Bloomberg.

GDP growth in China has slowed for the past five quarters but so long as the nation keeps inflation in check it should be able to maintain a “reasonable” economic expansion of at least 8% next year, said Liu Erh-fei, managing director and chairman for China at Merrill Lynch & Co. Inc. (MER).

Whether Chinese banks were “wise, lucky, or better regulated,” they avoided exposure to the risky subprime mortgages and derivative products that caused the current financial firestorm,” said Liu. “There is no systemic risk in China’s banks that could spill over into a full blown financial crisis.”

China has more than enough economic weapons at its disposal to ensure strong growth going forward, including a world-leading $1.9 trillion in foreign currency reserves. China also has a budget surplus of 2% of GDP, according to Stephen Green, of Standard Chartered PLC. And public sector debt is just 16% of GDP.

Earlier this year, Beijing shifted the focus of its policy to growth rather than inflation – a choice analysts say is now paying dividends.

Inflation in China, and worldwide, is beginning to ease alongside commodities prices. Inflation in China receded to 4.9% in the year to August, from 8.7% in February. And Goldman Sachs Group Inc. (GS) forecasts that it will fall as low as 1.5% in 2009.

Source: Federal Reserve, Bank of China Cut Interest Rates as Financial Crisis Deepens

The next meeting of the Federal Open Market Committee is scheduled for tomorrow Wednesday Oct. 29. There is no doubt that growth will be the central issue of the committee’s discussion, as fears of a global recession are intensifying alongside deteriorating economic data.

The British Office for National Statistics’ said Friday that, after a flat second quarter, U.K. gross domestic product (GDP) contracted 0.5% in the three months ended Sept. 30. There’s little doubt that other European nations have already succumbed to recession, and the near bankruptcy of Iceland has highlighted the interdependency of the world’s financial system.

It’s likely that Germany, France and Italy have already entered into a recession, as their second-quarter GDP fell 0.5%, 0.3% and 0.3%, respectively. Japan – the world’s second largest economy – is also dangerously close to recession, with its economy having contracted 2.4% in the three months ended June 30.

The International Monetary Fund (IMF) said last week that the economy of the 15-country Eurozone would grind to a virtual standstill in 2009. And the prognostications for the United States are equally bad, if not worse.

The U.S. economy expanded by 2.8% in the second quarter, but that expansion was largely the product of government stimulus checks and a weak dollar. The federal government returned roughly $168 billion back to American taxpayers in the form of rebate checks earlier this year.  The tax rebates, which were mailed through May, kept U.S. consumers afloat, while a weak dollar accelerated a torrent of exports out of the country.

Since then, consumer spending has been undermined by rising unemployment and the dollar has strengthened substantially.

The unemployment rate hit a five-year high of 6.1% in September and jobless claims have continued to mount this month, with a seasonally adjusted 478,000 Americans filing for first-time unemployment benefits in the week ended Oct. 18. Initial jobless claims have soared 47% in the past year and continuing claims are up 44%.

Meanwhile the greenback has posted a strong rebound over the past month, making U.S. goods more expensive to foreign nations, and thereby weakening exports.

The dollar climbed 5.9% against the euro last week and yesterday (Monday) surged to a two year high of $1.2462 versus the European currency.

The economy has nothing left to lean on at this point, and that fact has most economists projecting a debilitating recession for the United States.

“We are now expecting one of the sharpest recessions in the post-war period,” Citigroup Inc. (C) analysts Geoffrey Dennis and Jason Press wrote in a report to clients on Oct. 21. Citi sees an entire year of contraction before the economy gets back on track in the second half of 2009. Dennis and Press predict U.S. unemployment could climb as high as 8.5% next year.

“The growing reality is that this is not just a slowdown, but a true recession,” Joel Naroff, president and chief economist of Naroff Economic Advisors said in an interview with Money Morning.

“U.S. GDP contracted significantly in the third quarter,” said Naroff, who believes GDP may have contracted as much as 2.5% – 3.0% in the quarter. “Such a sharp slowdown is not expected.”

So far, Federal Reserve Chairman Ben S. Bernanke has turned to his ever-expanding arsenal of liquidity measures in an attempt to thwart what now seems to be an unavoidable recession. However, he may eventually be forced to cut interest rates all the way to zero like the Bank of Japan did in 1999.

But first the Fed will reduce its benchmark Federal Funds target rate tomorrow by 25-50 basis points.

“The cut is already in the market,” John Ryding, economist at RDQ Economics told AFP.
“The question is whether it’s 25 or 50 basis points.”

The latter would mean reducing the key rate from where it currently stands at 1.5% to just 1%. Cutting below 1% could be seen as a sign of panic, according to some analysts.

Earlier this month, the Fed conducted a joint rate cut with a number of its global partners, and other central banks around the world could again join the United States in reducing rates.

The European Central Bank (ECB) could cut its rates as soon as next week at the next meeting of the central bank’s Governing Council scheduled for Nov. 6.

“I consider it possible that the Governing Council would decrease interest rates once again at its next meeting,” ECB President Jean-Claude Trichet said yesterday. “Taking into account the recent substantial decline in commodity prices together with a substantial weakening in demand which has emerged lately, upside risks to price stability have diminished.”

Nick Parsons, head of markets strategy at nabCapital (OTC: NABZY) in London, told The Guardian, that the Bank of England (BOE) could also follow the Fed’s move with a one-point cut of its own. That would leave the BOE’s rate at 4.5%

The ECB, which raised rates as recently as July, cut its benchmark by half a point on Oct. 8 to 3.75%.

The Fed’s Broadening Balance Sheet

Cutting rates would certainly fit into Chairman Bernanke’s tactic of flooding the market with liquidity – a tactic that began last August and has broadened over the past year to include more and more tools at the Fed’s disposal. As a result, the role of the U.S. Federal Reserve as an institution has completely changed.

After previous rate cuts and cash injections failed to unfreeze credit markets, Bernanke got the green light to start buying up troubled assets and taking equity stakes in financial institutions.

Up until a year ago, the vast majority of the Federal Reserve’s holdings were in Treasury securities. However, over the past several months, Bernanke has expanded the role of the Fed to include the programs ranging from the Fannie Mae (FNM) and Freddie Mac (FRE) bailout, to becoming a buyer of last resort for undesirable assets.

In fact, the Fed set the interest rates it will charge for its purchases of commercial paper from banks and companies. The Fed said it would charge 1.88% for unsecured commercial paper and 3.88% for asset-backed commercial paper, Reuters reported.

The Fed created its program to buy 90-day commercial paper directly from issuers three weeks ago, on Oct. 7.

“The net effect of these facilities has been a truly staggering pace of growth in the Fed’s balance sheet,” said Jan Hatzius, chief U.S. economist for Goldman Sachs Group Inc. (GS).

The Federal Reserves balance sheet has more than doubled as a result, and it’s showing no signs of abating. As of Oct. 15, the Fed’s balance sheet had ballooned to $1.754 trillion from around $850 billion last year, according to The Wall Street Journal.

“In coming months, further rapid growth in the Fed’s balance sheet is likely,” said Hatzius. Hatzius also pointed out that during the Japanese credit crisis of the 1990s, the Bank of Japan’s balance sheet hit 30% of GDP, compared to the United States where the Fed’s balance sheet is currently at about 12% of GDP.

“To be sure, part of this increase occurred in an environment of outright quantitative easing by the Bank of Japan, which is not our current forecast for the Federal Reserve,” he said. “Nevertheless, the Japanese experience illustrates that central balance sheets can grow to very large numbers when the monetary authority is called upon to take over short-term financing for a large part of the economy.”

Japan suffered a decade of stagnation in the 1990s after its property and stock market bubbles burst. Money Morning Executive Editor Bill Patalon has written extensively about the eerie similarities between that collapse and the potential lost decade that could be faced in the United States.

The H.4.1 report – the Federal Reserve’s weekly report on changes to its balance sheet, set for release Thursday – will reveal how much capital was withdrawn from the Fed’s new commercial paper facility in the first three days of this week.

Source: Fed to Cut Rates at Next FOMC Meeting as U.S. Recession Appears Likely

But we’re not living in normal times, says Dan Denning in The Daily Reckoning Australia. What we’re experiencing is a financial quagmire caused by the loud popping of an unprecedented credit bubble.

The collapse of IndyMac (IMB) has been overshadowed by the threat of insolvency at Fannie Mae (FNM) and Freddie Mac (FRE). The rescue plan for the twin mortgage giants is nothing more than backdoor nationalization, says Dan. Expect runaway inflation as a result of the government’s meddling…

First, let’s report what Paulson said, in case you missed it. Paulson denied last week any support for a shareholder bailout of the two companies. But it’s not the shareholders he’s worried about. It’s the bondholders. You can tell that from how Paulson began his statement.

He pointed out the importance of the GSEs to keeping the American housing market going. This, of course, is true. While non-bank lenders collapse and other banks tighten up, Congress expanded GSE lending powers earlier this year to keep the mortgage market from going into deep freeze. The result is that GSEs wrote 80% of the loans originated in the first half of this year. If they cease operating, the American mortgage market ceases to function. Imagine what that would do for house prices?

Scary as this, it is not even the biggest concern. Here is what Paulson said early in his statement: “GSE debt is held by financial institutions around the world. Its continued strength is important to maintaining confidence and stability in our financial system and our financial markets.”

There is some US$7 trillion in GSE debt sloshing around the world’s financial system. Non-American investors own about US$1.5 trillion of it. The Treasury Department desperately wants to assure investors that Fannie and Freddie will not default on that debt. But it does not want to explicitly “guarantee” the debt. Instead, it has taken three steps, with the Fed taking a fourth.

First, the Treasury Department will increase the line of credit the GSEs have with it. Currently, that line of credit is a pretty miniscule US$2.5 billion. If the financial markets know the Treasury is willing to loan billions more to the GSEs, it might calm things down a bit. Or not.

Second, the Treasury Department will ask the U.S. Congress for permission to purchase equity in the GSEs. You can be sure it will not be common stock, but some kind of preferred shares that give the Treasury and the U.S. Taxpayer some special benefits. Both this and the first measure are designed to be temporary and not last more than 18 months.

Third, the Treasury will ask the Congress to craft legislation that gives, “the Federal Reserve a consultative role in the new GSE regulator’s process for setting capital requirements and other prudential standards.”

The Federal Reserve’s Board of Governors also met this weekend and agreed to give the New York Fed “temporary authority” to lend to the GSE’s “should any such lending prove necessary.”

That’s the policy response crafted to comfort markets ahead of a week of trading. Now, shall we translate it for you?

The Treasury gives the GSEs a new line of credit. But will it matter? Freddie Mac is set to auction a relatively modest US$3 billion in bonds this week. It’s short-term debt, 3-6 months. If yields blow out at the auction, we’ll know the market is treating the GSEs like lepers.

And besides, the GSEs may have credit with the Treasury, but the real question now is how much longer the Treasury has credit with the rest of the world. Watch gold and oil. They will tell you exactly what the market thinks.

As for the equity stake, this is pretty intriguing. It’s going to be nearly impossible for the GSEs to raise capital in the private sector. And don’t count on a Sovereign Wealth Fund to save the day. These companies have massive liabilities. The U.S. government doesn’t want to explicitly guarantee GSE obligations, though.

Instead, what we see is a back-door capital raising through a rights issue. That is, the Feds hope that talking is enough to stabilise things. But if it doesn’t turn out that way, we see the GSEs taking on the Feds as preferred shareholders and then doing a rights issue, offering the American taxpayer a large stake in the companies in exchange for billions in capital to shore up the balance sheet.

Call it what you’d like, but it’s a backdoor nationalisation. If it’s done cleverly, the Feds hope it will prevent a run on the dollar and run away oil and gold prices. If it’s done clumsily, it will still result in run-away inflation without solving the solvency problem for the GSEs.

Source: Aussie Banks Lift Rates

China is already the world’s top steel consumer and producer, churning out one-third of the global supply. This newly formed company, Guangdong Iron & Steel Group Corp., will boost Baosteel’s capacity by 33% to 40 million tons.

Specifically, it will help supply steel-hungry Toyota Motor Corp. (ADR: TM) and Honda Motor Co. (ADR: HMC), both of which have plants in the city of Guangzhou.

Baosteel also wants to build a new 10 million ton-capacity mill in Zhanjiang, Reuters reported.

Baosteel is making a fervent effort to squash local competitors and streamline operations – now more than ever – because it’s facing skyrocketing costs of iron ore, the key ingredient used in steel production.

The day it announced the merger, it also agreed to pay Australia-based Rio Tinto PLC (ADR: RTP) an average of 85% more for iron ore this year, Australia’s The Age reported. The price increase is a result of fierce demand for iron ore, but also because Rio Tinto and Aussie rival BHP Billiton Ltd. (ADR: BHP) have significantly lower shipping costs than Brazil-based rival, Vale (RIO), the world’s largest iron ore exporter, which allows them to charge a premium.

According to Bloomberg data, shipping iron ore from Australia costs about $55 a metric ton less than from Brazil. But China doesn’t have much of a choice, as its economy is growing at a 10% annual clip.

And that extra coin Rio Tinto and BHP have pocketed is dually driving up global prices and testing China’s patience.

It’s also playing a huge role in Australia’s commodity-exporting industry, which may earn 12% more than forecast for March and a record $203 billion for the year, Bloomberg reported.

“The consistent story here is that producers haven’t been able to match the ever-growing demand from China,” Gerard Burg, an energy and minerals economist with National Australia Bank Ltd. (OTC ADR: NABZY), told Bloomberg. “China’s demand is still going and still very strong.”

Source: Faced with Skyrocketing Iron Ore Costs, China’s Baosteel Rolls Two Rivals into a Joint Venture