Babcock faces off adversarial investors

Babcock Capital Should Consider Winding Up, Says Pendvest

By Stuart Kelly

Nov. 29 (Bloomberg) -- Babcock & Brown Capital Ltd., a fund managed by Australia's second-largest investment bank, has performed so poorly on the stock exchange it should consider winding up, a U.K hedge fund said.

Pendvest LLP, the fund's second-biggest investor with a 5.2 percent stake, demanded a special meeting to vote on returning half the company to shareholders and consider options including winding up completely, according to a letter sent to Babcock yesterday, a copy of which was obtained by Bloomberg News. Pendvest said Babcock's assets are worth more than its share price.

``Babcock & Brown Capital is an inefficient vehicle where the underlying value of the investments may never be truly reflected in the stock price,'' London-based Pendvest said in the letter. Babcock Capital declined to comment on the allegations and agreed to hold a meeting on the matter.

Babcock capital's shares jumped 7.2 percent to A$4.77 on the Australian Stock Exchange at 10:56 a.m. in Sydney. The Sydney- based fund had advanced 0.5 percent this year as of yesterday's close, lagging behind the 12 percent gain in the S&P/ASX 200 Index. The fund posted a full-year net loss of A$132 million ($117 million) in August after earlier forecasting a profit of as much as A$30 million.

Babcock & Brown Capital said it will call a meeting within 21 days to consider the proposals, according to a statement to the stock exchange. Erica Borgelt, a spokeswoman for Babcock & Brown Capital, declined to comment further on the matter.

Pendvest wants Babcock to return A$425 million, or A$2.13 a share, to investors. The asset manager valued Babcock shares at between A$7.80 and A$10 each.

Irish Investments

Pendvest also said Babcock should consider selling its investments in Eircom Ltd., an Irish telephone business, and Golden Pages, which runs Israel's largest print and internet phone directories.

Babcock, which last year bought 57 percent of Ireland's largest phone company, said in August cutting 900 Eircom employees may cost as much as 175 million euros ($260 million), paring as much as A$165 million from earnings. It initially forecast an impact of as much as A$5 million.

Pendvest also demanded the company address A$122.6 million in fees paid to parent Babcock & Brown Ltd., saying some of the fees should be returned to shareholders. Babcock owns 7 percent of the fund.

Paul Samuelson on the central banks' roles

Balancing market freedoms

Paul Samuelson

(IHT) All through the years of the Great Depression, Wall Street publicists and President Herbert Hoover would repeatedly declare: "Recovery is just around the corner."

They were wrong. And history repeats itself.

Today, Federal Reserve Chairman Ben Bernanke admits that nobody, including him, is able to guess how near to bankruptcy the biggest banks in New York, London, Frankfort and Tokyo might be as a result of the real estate crisis.

As one of the economists who helped create today's newfangled securities, I must plead guilty: These new mechanisms both mask transparency and tempt to rash over-leveraging.

Why should non-economist readers care about these technicalities?

Because the policy tools that served so well for Alan Greenspan's Federal Reserve and for the Bank of England now have to be changed.

It used to be enough for a central bank to "lean against the wind." That means lower interest rates when unemployment is too high and when deflation threatens. And when business growth is too brisk, central banks are supposed to raise their interest rates to dampen growth and to forestall price-level inflation that threatens to exceed 2 percent per year.

Today, central bankers and U.S. Treasury cabinet officers cannot know whether current interest rates are too high or too low. This is surprising, but true. The safest bond interest rates are indeed low. But financial panic engendered by the burst bubble of unsound U.S. and foreign mortgage lending means that even a mammoth corporation like General Electric would find it expensive now to finance a loan needed to build a new and efficient factory.

The situation is not hopeless. New, rational regulations that discourage predatory lending and rash borrowing could help a lot. Also, as we learned during the Great Depression, the government's treasury and its central bank must be both the lenders of last resort and the spenders of last resort. Speculative markets will not stabilize themselves.

The best policy is actually the middle way: not too much freedom for market forces, and definitely not too little freedom.

Global markets have moved into a new epoch. China, India and even Russia and Ireland are currently growing at almost twice the pace of the United States and the core countries of the European Union. Gone are the days when an American president could command ocean tides to come in and go out.

The U.S. population is 5 percent of the global total, yet it enjoys per person about 20 percent of total global output. That's the picture now. Will this last?

When I come to write a newspaper article like this 10 years from now, I believe America may still be leading the pack in per-capita affluence. But in all probability, the China that has already displaced Japan as the economy with the second biggest total gross domestic product will likely have a total GDP equal to America's.

When that happens, a typical Chinese family will still be a lot poorer than a family in the United States or even Ireland. Remember, China's population is several times that of America or any European country. Don't even ask me what the U.S. dollar in 2017 will be worth.

President George W. Bush and Vice President Dick Cheney will have long retired on their respective ranches, but their rash 2000-2007 tax-cut-and-spend policies will by then have harvested the follies that they sowed.

Since we live ever in the short run, global leaders must make their best guesses about what to be doing in 2008. Here are my tentative suggestions:

Watch developments closely. If America's Christmas retail sales fail badly - as they could when high energy prices and high mortgage costs pinch consumers' pocket books - then be prepared to accelerate credit infusions by central banks on the three main continents.

Keep in mind threats of excessive inflation. But be aware that the skies will not fall if the price-level indices blip up from 1.9 to 2.6 percent per annum. What worsens the public's expectations about price instability are excessive spikes in the cost of living.

Finally, to reduce the burden of mass foreclosures of over-expensive mortgages, we should explore new quasi-public agencies, as we did with the Depression-era Reconstruction Finance Corp., that specialize in supplementing for-profit ordinary lenders. This suggests expanding in a controlled way the lending powers of quasi-public agencies such as Fannie May and Freddie Mac. Better that they should lose a bit when they help homeowners of modest means fend off foreclosures on their onerous mortgages.

Maybe such innovations will turn out not to be needed. But keeping in mind worst-case scenarios of the freezing-up of banks and other lending agencies, exploratory planning is worthwhile insurance.

What the world does not need now is tolerance for any persistent weakness in global Main Street growth. It is better when physicians worry too much about a patient's health than when they worry too little.

Richard Bookstaber on derivatives-driven contagion

Blowing up the Lab on Wall Street
Thursday, Aug. 16, 2007
By RICHARD BOOKSTABER

(Time Magazine) Looks like Wall Street's mad scientists have blown up the lab again. The subprime mess that is cutting so wide a swath through financial markets can be traced to the alchemy of creating collateralized debt obligations (CDOs) compounded by the enormous amount of leverage applied by big hedge funds. CDOs are derivatives — synthetic financial instruments derived from another asset.

Here's the recipe for a CDO: you package a bunch of low-rated debt like subprime mortgages and then break the package into pieces, called tranches. Then, you pay to play. Some of the pieces are the first in line to get hit by any defaults, so they offer relatively high yields; others are last to get hit, with correspondingly lower yields. The alchemy begins when rating agencies such as Standard & Poor's and Fitch Ratings wave their magic wand over these top tranches and declare them to be a golden AAA rated. Top shelf. If you want to own AAA debt, CDOs have been about the only place to go; hardly any corporation can muster the credit worthiness to garner an AAA rating anymore. Here's where the potion gets its poison potential. Some individual parts of CDOs are about as base as bonds can be — some are not even investment grade. The assumption has been that even if the toxic waste bonds really stink, the quality tranches can keep the CDO above water. And life goes on.

The problem is that CDOs were untested; there was not much history to suggest CDOs would behave the same way as AAA corporate bonds. After all, the last few stress-free years have not exactly provided much of a testing ground for what can go wrong — until, that is, subprime mortgages started their death march. Suddenly, investors realized things can actually head south in a big way, even stuff completely unrelated to CDOs. Like your stocks.

It's not the first time this has happened, yet Wall Street still isn't getting the message. One August day nine years ago, Russian bonds defaulted. A surprising result of this default was the spectacular failure of Long-Term Capital Management (LTCM), a hedge fund in Greenwich, Conn. Surprising because LTCM had nary a penny in Russian bonds. They nearly took the global financial structure with them.

Today we're seeing another improbable linkage. A number of hedge funds are failing; others are seeing returns plunge. Among these is Goldman Sachs's flagship Global Alpha Fund, which burned a quarter of its $10 billion value over the last few weeks. And just as LTCM was free of the Russian debt that precipitated its collapse, Global Alpha was not a player in subprime junk. Indeed, Global Alpha's problems have not come from mortgages at all, but from a portfolio of stocks.

Why does this happen? Why is a hedge fund like Global Alpha affected by events in markets far removed from its bread-and-butter exposure? The root of the problem is high leverage. For example, when this debacle hit, one of Goldman's funds was leveraged 6 to 1, so every dollar of investor capital claimed six dollars of positions. This is the dry kindling for a market firestorm. When things go bad for a highly leveraged hedge fund, it gets a margin call and has to sell assets to reduce its exposure. Naturally, as it sells, prices drop. The falling prices mean a further decline in the fund's collateral, forcing yet more selling. And so goes the downward cycle. Hedge funds that hold the toxic CDOs can easily undermine those that don't. It can be difficult to sell the stuff that's causing the problem; those markets are beyond redemption. So if you can't sell what you want to sell, you sell what you can sell. The fund looks at its other holdings, focusing on the more liquid positions and reduces its exposure there. This causes pressure on these markets, markets that have nothing to do with the original problem, other than the fact that they happened to be held by the fund that got in trouble. Now that these markets are feeling the heat, other highly leveraged funds with similar exposure will have to sell. This leads to another cycle of selling, but in what was up to that point a healthy market unrelated to the initial turmoil.

As the subprime crisis propagates, it doesn't matter that some instruments are fundamentally strong and others are weak. What matters is who owns what, who is under pressure and what else they own. Hedge funds are constantly shifting their exposure, so it is difficult to predict the course a crisis will take. But if you are a highly leveraged fund precariously perched as these dominos fall — as Goldman's are today and as LTCM was in 1998 — you become part of the game. And if you are both highly leveraged and big, the problem that started in one insignificant little segment will now become your problem, and a much bigger one. Again, it's all about leverage. This is the case for crises in the past and will be the case for crises in the future. A world in which highly leveraged hedge funds share similar strategies makes it inevitable that what we are seeing now will occur again. And the more complex the strategies, the more surprising the linkages that will emerge.

Yet, incredibly, despite the risk this poses, no one keeps watch over leverage. No regulator knows how much leverage the hedge funds have or how that leverage is changing.

The lesson this time around with Global Alpha is the same as it was with LTCM. But we seem to be slow on the uptake. These funds hired the best and the brightest, yet they became embroiled in crises largely of their own making. If it could happen to them, it will happen again. And we'll all share in the consequences. Again.

Japanese stock markets take a toll despite strengthening yen

Japan's Topix Falls 20% From 2007 High, Signaling Bear Market

By Elizabeth Stanton

Nov. 22 (Bloomberg) -- Japan became the first of the world's 10 biggest stock markets to enter a bear market when the Topix index declined 20 percent from its 2007 peak.

The 39-year-old Topix, the broadest gauge of equity prices in the world's second-largest economy, fell 2.1 percent yesterday to 1,438.72, the lowest since October 2005 and down 20.8 percent from its 2007 high of 1,816.97 on Feb. 26.

Japanese companies are struggling with slowing economic growth in the U.S., their largest market for exports, the yen's appreciation and record crude oil prices. The Topix decline from a 15-year high in February signals the government's efforts to revive the economy from more than a decade of inconsistent growth, have hit a snag, investors said.

``Performance potential is limited by a deteriorating economic outlook, both foreign and domestic,'' said Florence Barjou, Paris-based strategist at Lyxor Asset Management, which oversees $100 billion.

The Nikkei-225 Stock Average, created in 1949, is just short of bear market territory. It fell 2.5 percent yesterday to 14,837.66, the lowest since July 2006 and down 18.8 percent from a six-year high of 18,261.98, also on Feb. 26.

The Nikkei is a price-weighted average of 225 Japanese companies including Toyota Motor Corp, Mitsubishi UFJ Financial Group and NTT Docomo Inc. with a median market value of 748.9 billion yen ($6.89 billion). The Topix is a capitalization- weighted index of 1,719 companies with a median market value of 469.8 trillion yen.

Less Than Stellar

The Topix decline ``would be an official bear market so to speak, but Japan hasn't been an area of stellar growth for 10 years,'' said Paul Hickey, managing partner at Bespoke Investment Group LLC in Harrison, New York.

Most stock markets have fallen this month, with the U.S. Standard & Poor's 500 Index down 8.6 percent, on pace for its worst month since September 2002. The declines reflect expectations that investment losses created by the biggest slump in housing since 1991 are curbing growth in the world's largest economy.

The MSCI World Index of developed-country shares is down 7.9 percent from a record on Oct. 31, and the MSCI Emerging Markets Index has fallen 11 percent from its high on Oct. 29.

Toyota, the Japanese company with the largest market value, fell 2.8 percent yesterday to a 16-month low amid concern U.S. sales will slow. Toyota is the second-biggest auto seller in the U.S. behind General Motors Corp.

Rising Yen

The yen has strengthened against all 16 major currencies since mid-year, making Japanese products more expensive in other countries. Against the dollar it has gained 9.8 percent, reaching a more than two-year high of 108.51 per dollar yesterday.

Losses in global credit-markets are fueling the yen's rise by spurring investors to sell higher-yielding assets that were purchased with yen borrowed at low interest rates and sold. The Bank of Japan's overnight call rate, the main rate at which banks lend to one another, is 0.5 percent, the lowest among the major economies.

Record crude oil prices, a problem for all manufacturing economies, are a particular disadvantage in Japan, which imports almost all of the oil it uses. Crude oil futures touched a record $99.29 a barrel in New York Mercantile Exchange trading yesterday, and are up 62 percent in the past year.

The Bank of Japan on Oct. 31 cut its growth estimate for the year ending in March to 1.8 percent from 2.1 percent. Reflecting reduced expectations for economic growth, the yield on 10-year Japanese government bonds yesterday fell to a 23-month low of 1.439 percent.

Investors in Japan's stock market have experienced worse over the past two decades than the drop from this year's peaks. In 1990, the Topix lost almost 40 percent of its value and the Nikkei lost almost 39 percent.

Market bets on lower interest rates on growth concerns

Fed Forecasts Spur Traders to Ignore Warnings on Cuts (Update1)

By Scott Lanman

Nov. 21 (Bloomberg) -- The Federal Reserve's first set of quarterly economic forecasts fueled speculation that it will cut interest rates again, contrary to warnings by policy makers in the past two weeks.

The degree of ``uncertainty'' about the growth outlook is greater than that for inflation, officials said in a supplement to minutes of their October meeting released yesterday. While officials expressed confidence price increases will ease, they viewed markets as ``still fragile and were concerned that an adverse shock'' would worsen economic risks.

The wariness about a continued credit collapse pushed odds of a rate cut next month up to 92 percent, according to federal funds futures, from as low as 70 percent. Investors differ with Chairman Ben S. Bernanke and other officials, who have said this month that the dangers of a slower expansion and faster inflation were ``roughly'' balanced.

``Risks aren't balanced,'' said Michael Feroli, a former Fed board staff member who is now an economist at JPMorgan Chase & Co. in New York. ``Recent developments in financial markets increase the likelihood that they will ease.''

Treasuries climbed today, sending yields on 10-year notes below 4 percent for the first time in two years as investors flocked to the safety of government debt.

As part of its new release on the three-year economic estimates of Fed governors and district-bank presidents, the central bank discussed risks to the outlook. ``Most participants judged that the uncertainty attending'' their growth forecasts ``was above typical levels seen in the past,'' the Fed said.

Growth Forecast

Officials predicted growth will slow to as low as 1.8 percent in 2008, according to the middle range of projections. That would be the weakest since the 2001 recession. The Fed's historical estimates indicate that the actual expansion is likely to be within 1.3 percentage points above or below the estimate.

In June, policy makers anticipated 2.5 percent to 2.75 percent growth next year. Officials left their projection for inflation, excluding food and energy costs, little changed at a 1.7 percent to 1.9 percent pace for the next two years.

``The focus in the minutes is on the downside risks to growth,'' which contrasts with an ``optimistic inflation forecast,'' said Robert Eisenbeis, the former head of research at the Federal Reserve Bank of Atlanta. ``They clearly will respond if needed.''

Rate Cuts

The Federal Open Market Committee lowered its benchmark rate by a quarter point on Oct. 31, to 4.5 percent, after reducing borrowing costs a half point in September.

Since the meeting, banks have warned of billions of dollars of losses on debt tied to subprime mortgages. Stocks have also retreated, while the number of private economists predicting a recession has risen, according to the National Association for Business Economics.

While the ``most likely'' scenario is consumer spending and business investment rise at a ``moderate'' pace, Fed officials recognized a market shock ``could further dent investor confidence and significantly increase the downside risks,'' the minutes said.

Such a disruption could come from ``a sharp deterioration in credit quality or disclosure of unusually large and unanticipated losses,'' the Fed said.

In their speeches and public remarks, policy makers have said they expect growth to accelerate by the middle of 2008 and warned that surging energy and commodity prices, and a falling dollar, may push up inflation.

`Rough Patch'

Economic reports confirming a ``rough patch'' in the economy ``would not, by themselves, suggest to me that the current stance of monetary policy is inappropriate,'' Fed Governor Randall Kroszner said Nov. 16. Further rate cuts may increase the risk inflation will accelerate, he signaled.

Federal Reserve Bank of St. Louis President William Poole said in a Nov. 15 interview with Dow Jones that ``there can only be chaos'' if the Fed follows traders' expectations in setting policy.

``When you think about the effects of monetary policy, you are going to be thinking about several quarters ahead,'' said Douglas Elmendorf, a former assistant director of the Fed's research and statistics division who is now a senior fellow at the Brookings Institution in Washington. ``The FOMC is very focused on maintaining and building their credibility on keeping inflation low.''

Yesterday's forecasts are the product of a 1 1/2-year review commissioned by Bernanke to improve how the Fed communicates its policy objectives. He said in a Nov. 14 speech that the new reports will help show ``how our policy decisions respond to incoming information and will enhance our accountability.''

Less Optimistic

Fed policy makers are less optimistic about the 2008 expansion rate than private economists. The median Fed estimate of about 2.25 percent is less than the 2.4 percent consensus prediction of the Blue Chip survey of forecasters. Four of 17 Fed governors and presidents expect growth of 1.8 percent or less.

Fed officials will have more opportunities to send investors a message before the Dec. 11 meeting. Next week, at least four regional-bank presidents speak, including Philadelphia's Charles Plosser and William Poole of St. Louis. Bernanke speaks Nov. 29 at an event in Charlotte, North Carolina.

``There is a very slow movement toward understanding the severity of financial market problems and the impact on the economy,'' said Kurt Karl, chief U.S. economist at Swiss Reinsurance Co. in New York. ``The question is, what is the Fed waiting for?''

Yen carry trades unwind

Yen Trades Near Two-Year High Versus Dollar on Growth Concerns

By David McIntyre and Kosuke Goto

Nov. 22 (Bloomberg) -- The yen traded near a two-year high against the dollar on concern widening credit-market losses will slow global economic growth, pushing investors to sell higher- yielding assets financed by borrowing in Japan.

The yen was also close to the strongest in about two months against the Australian and New Zealand dollars, favorites of the so-called carry trade, as global stocks fell. The dollar reached an all-time low against the Swiss franc on concern the Federal Reserve will cut interest rates for a third time this year to prevent subprime mortgage losses dragging the U.S. economy into recession.

``There is yen strength to come,'' said Peter Pontikis, treasury strategist at Suncorp-Metway Ltd. in Brisbane, Australia. ``People are unwilling to take carry trade positions. You can't have the subprime sector implode without any consequences.''

The yen traded at 108.41 per dollar at 9:21 a.m. in Tokyo after touching 108.26 yesterday, the strongest since June 2005. The currency was at 161.01 per euro from 161.13 late yesterday, when it reached 160.08. Gains in the yen will accelerate should it rise above 108.20 per dollar today, Pontikis said.

The yen traded at 94.53 per Australian dollar from 94.39 yesterday in New York when it reached 93.72, the strongest since Sept. 11. It was at 81.41 against New Zealand's dollar from 81.50 yesterday when it touched 80.72, the highest since Sept. 18. The Nikkei 225 Stock Average fell 0.7 percent today,

Thanksgiving Holiday

Currency fluctuations may be exaggerated because U.S. stock and bond markets are closed today for the Thanksgiving holiday, said Kazuyuki Takami, a manager of the currency trading department at Bank of Tokyo-Mitsubishi UFJ, a unit of Japan's largest publicly traded bank by assets.

The dollar traded at $1.4855 per euro and 1.1018 against the Swiss franc. The U.S. currency dropped to a record low of $1.4870 per euro yesterday and earlier touched 1.1015 versus the franc.

The dollar has declined 11 percent this year against the euro as the Fed's two rate cuts since September to 4.5 percent reduced the allure of U.S. assets. The U.S. Dollar Index traded on ICE Futures U.S. in New York touched a record low of 74.944 yesterday, the weakest since the gauge started trading in 1973.

Fed Rate Cuts

The odds of the Fed cutting rates a quarter-percentage point to 4.25 percent on Dec. 11 were 90 percent, up from 68 percent a month ago, futures contracts traded on the Chicago Board of Trade show.

Reports yesterday showed the Reuters/University of Michigan's final consumer sentiment index for November fell to 76.1, while the New York-based Conference Board's index of leading U.S. economic indicators slid 0.5 percent in October.

The yield advantage of U.S. two-year Treasuries over similar-maturity Japanese government debt shrank to 2.26 percentage points today, the narrowest since 2004, making U.S. assets less attractive to international investors. The two-year German bund widened its yield advantage over comparable-maturity Treasuries to 65 basis points, the widest since 2004.

Gains in the yen may be limited by speculation importers will take advantage of its gains to buy foreign currencies.

`Good Opportunity'

``This level is a good opportunity for Japanese importers to buy the dollar against the yen,'' said Tokyo-Mitsubishi UFJ's Takami. ``They will take advantage of the yen's rally.''

Japan's currency may fall to 109.50 a dollar today, Takami forecast.

The yen has advanced against all 16 of the most-actively traded currencies this month as investors reduced holdings of carry trades. In that time, Australia's dollar declined 12 percent, New Zealand's currency weakened 8.6 percent while South Africa's rand lost 11 percent.

In carry trades, investors borrow money in low-yielding economies such as Japan and lend the funds in high-yielding countries to profit from the spread. The risk is that currency moves wipe out earnings. When the trade weakens, traders sell high-yielding assets and buy yen to repay borrowings.

Volatility Declines

One-month implied volatility for the yen fell to 14.75 percent today, down from 14.98 percent yesterday. Implied volatility on one-month euro-dollar options also slid to 17 percent from 18 percent yesterday.

The benchmark interest rate in Australia is 6.75 percent while New Zealand's is 8.25 percent. Japan's borrowing cost is 0.5 percent while Switzerland's is 2.75 percent.

``People are worried about a slowdown in global growth and they are running away from risky assets, giving a boost to the yen's strength,'' said Michael Malpede, a senior currency analyst in Chicago at Man Global Research, part of MF Global Ltd., the world's largest broker of exchange-traded futures and options contacts. ``The fear is that we may see a few more shoes drop.''

The cost of borrowing in dollars for three months rose to the highest in four weeks yesterday, said the British Bankers' Association. U.S., European and Asian stocks sank. The Standard & Poor's 500 Index fell 1.6 percent, erasing its gain this year.

The spread, or extra yield, investors demand to own emerging-market dollar bonds instead of Treasuries widened to 2.6 percentage points yesterday, the most since 2005, according to JPMorgan Chase & Co.'s EMBI Plus index.

Will booming emerging markets remain an oasis of growth amidst US recession?

Recession in America
America's vulnerable economy
Nov 15th 2007 From The Economist print edition
Recession in America looks increasingly likely. Can booming emerging markets save the world economy?

IN 1929, days after the stockmarket crash, the Harvard Economic Society reassured its subscribers: “A severe depression is outside the range of probability”. In a survey in March 2001, 95% of American economists said there would not be a recession, even though one had already started. Today, most economists do not forecast a recession in America, but the profession's pitiful forecasting record offers little comfort. Our latest assessment suggests that the United States may well be heading for recession.

Granted, GDP grew by a robust 3.9%, at an annual rate, in the third quarter. Granted also, revisions may well push this figure up. But that was the past. More timely signs suggest that the economy could stall in this quarter. By early next year, output and jobs could be shrinking. The main cause is the imploding housing market. Experts said that house prices could never fall nationwide. But fall they have, by 5% in the past 12 months. Residential investment has collapsed, but a glut of unsold homes means that prices have much further to drop. Americans' spending is likely to be dented much more by a fall in house prices than it was in 2001 by the stockmarket's collapse. With house prices lower and credit conditions tighter as a result of the subprime crisis, households can no longer borrow against capital gains to support their spending.

Dearer oil is set to squeeze households further (this week's drop in crude prices notwithstanding). Consumer confidence has already fallen sharply. It cannot be long before consumer spending stumbles, which in turn would hurt companies' profits and investment. The weak dollar will boost exports, but at only 12% of GDP, exports are too small to make up for a weakening of consumer spending, which accounts for 70%.

I want to break free

Will an American recession drag the rest of the world down with it? The economies of Europe and Japan rebounded strongly in the third quarter, but look likely to slow down. Although both should be able to keep chugging along, neither is likely to set any great pace. Strengthening currencies will hurt exporters in both places. Europe's own housing hotspots are cooling, and some of its banks have been sideswiped by America's subprime ills.

The best hope that global growth can stay strong lies instead with emerging economies. A decade ago, the thought that so much depended on these crisis-prone places would have been terrifying. Yet thanks largely to economic reforms, their annual growth rate has surged to around 7%. This year they will contribute half of the globe's GDP growth, measured at market exchange rates, over three times as much as America. In the past, emerging economies have often needed bailing out by the rich world. This time they could be the rescuers.

Of course, a recession in America would reduce emerging economies' exports, but they are less vulnerable than they used to be. America's importance as an engine of global growth has been exaggerated. Since 2000 its share of world imports has dropped from 19% to 14%. Its vast current-account deficit has started to shrink, meaning that America is no longer pulling along the rest of the world. Yet growth in emerging economies has quickened, partly thanks to demand at home. In the first half of this year the increase in consumer spending (in actual dollar terms) in China and India added more to global GDP growth than that in America.

Most emerging economies are in healthier shape than ever. They are no longer financially dependent on the rest of the world, but have large foreign-exchange reserves—no less than three-quarters of the global total. Though there are some notable exceptions, most of them have small budget deficits (another change from the past), so they can boost spending to offset weaker exports if need be.

This does not mean emerging economies will grow fast enough to make up for the whole of a fall in America's output. Most of them will slow a bit next year: for instance, China's growth rate may dip to “only” 10%. So global growth will ease—which, after five years at an average of almost 5%, close to its fastest pace ever, it needs to do. But thanks to the vigour of the new titans, it will stay above its 30-year average of 3.5%.

A tale of two prices

The rising importance of the world's new giants will not only boost growth. It will also shift relative prices, notably those of oil and the dollar. And the consequences of this will be less comfortable for developed countries, especially America.

The oil price has risen mainly because of strong demand in emerging economies, which have accounted for as much as four-fifths of the total increase in oil consumption in the past five years. In past American recessions the oil price usually fell. This time it is likely to hold up. That will not only hurt the finances of Western consumers, but may also make the jobs of their central bankers harder, by combining inflationary pressure with economic slowdown.

The enfeebled dollar—lately in sight of $1.50 to the euro—would be weaker still without enormous purchases by central banks in emerging economies. This support is now waning. China and others are putting a smaller share of increases in reserves into the American currency. And Asian and Middle Eastern countries with currencies linked to the dollar are facing rising inflation, but falling American interest rates make it harder to tighten their own monetary policy. They may have to let their currencies rise against the sickly greenback, meaning they will need to buy fewer dollars. More important, as international investors wake up to the relative weakening of America's economic power, they will surely question why they hold the bulk of their wealth in dollars. The dollar's decline already amounts to the biggest default in history, having wiped far more off the value of foreigners' assets than any emerging market has ever done.

The vigour of emerging economies is good news for the world economy: for its growth, it has much less need of a strong America. The bad news for America is that this, in turn, may mean that the world also has less need of the dollar.

Hard landing expected

With Recession becoming inevitable the Concensus shifts towards the Hard Landing View. And the Rising Risk of a Systematic Financial Meltdown
Nouriel Roubini | Nov 16, 2007

It is increasingly clear by now that a severe U.S. recession is inevitable in next few months. Those of us who warned for the last 12 months about a combination of a worsening housing recession, a severe credit crunch and financial meltdown, high oil prices and a saving-less and debt-burdened consumers being on the ropes causing an economy-wide recession were repeatedly rebuffed the consensus view about a soft landing given the presumed resilience of the US consumer.

But the evidence is now building that an ugly recession is inevitable. Thus, the repeated statements by Fed officials that they may be done with cutting the Fed Funds rate are both hollow and utterly disingenuous. The Fed Funds rate will be down to 4% by January and below 3% by the end of 2008.

More revealing of the change in mood the financial press and some of the most prominent market analysts are coming to the realization that a recession is highly likely. The Economist has a cover story and long piece arguing that a US recession highly likely (and citing this author's work with Menegatti and our views on the inevitability of such a recession).

More importantly, on Wall Street some of the leading analysts that had been in the soft landing camp for the last year have now moved their forecast in the direction of hard landing. It is not just David Rosenberg of Merrill Lynch who has been informally in the hard landing camp and is now explicitly talking about a consumer recession. It is not just Jan Hatzius of Goldman Sachs who was always more bearish relative to the soft landing consensus and is today explicitly talking about a US recession and a credit crunch reducing lending by $2 trillion.

Even in soft landing houses such as Morgan Stanley and JP Morgan the tone is completely different now. At Morgan Stanley Steve Roach was the in-house bear while Richard Berner (a most sophisticated economist and analyst) was the in-house soft landing optimist. With Roach now gone to run Morgan Stanley Asia, the commentary by Richard Berner has become increasingly darker. And the latest Monday piece by Berner is titled “The Perfect Storm for the US Consumer” where his points on the headwind forces hitting the US consumer are completely overlapping with my analysis of such risks in my recent “The Coming US Consumption Slowdown that Will Trigger an Economy-Wide Hard Landing. Berner starts with

“Serious pressures are mounting on the US consumer on five fronts: Job growth is slowing, surging energy and food quotes are draining purchasing power, adjustable rate mortgages are resetting, lending standards are tightening, and housing wealth will likely decline. Do these dark clouds finally and ominously herald the perfect consumer storm?”

And he concludes with:

“Risks to the consumer are rising, and the risk of outright US recession is higher now than at any time in the past six years: Housing is in sharp decline, consumers are vulnerable, and companies may cut capital spending and liquidate inventories. A strong contribution from global growth is still a huge positive, but spillovers from US weakness to trading partners may hobble that lone source of strength. These pressures could last longer or be more intense than I expect. And even if the economy skirts overall recession, corporate earnings will likely decline.”

An even more persistently bullish bank was JP Morgan that kept on warning for the last year that the biggest risks to the US economy was not a growth slowdown but rather a growth pickup and the risk that inflation would surprise on the upside and force a behind-the-curve Fed to raise the Fed Funds rate above 6%. This analysis obviously proved wrong and now the very smart – but mistaken - Bruce Kasman has had to throw in the towel and accept that the downside risks to grow are sharp and that the Fed will cut the Fed Funds rate to 4%. As he put it in his latest note:

US outlook change: More drag, more ease -- Drags from energy, and credit tightening push GDP forecast to 1% on average for current and upcoming quarter -- Fed is likely to recognize growing downside risk and ease 50bp, to 4% by end of 1Q08 -- December meeting outcome remains close, but we now expect 25bp move from a proactive Fed As the US moves through the fourth quarter, incoming economic news remains consistent with our forecast of a growth “pot hole”. Powerful drags now in place — from tighter credit conditions and an intensified contraction in residential investment — are evident in the decline in output and employment in the goods producing industries and in a slowing in consumption spending…. …three developments over the past month look set to increase downward pressure on growth.

• Oil on the boil. Global crude oil prices rose more than $10 dollars during October, and has held at an elevated level this month. If current levels are maintained, it would represent a drag on annualized household income of approximately one percentage point between now and the end of the first quarter. This drag, which has yet to have been felt, adds to the forces weighing on consumer spending.

• Temporary lifts to fade. Although an upward revision to 3Q07 growth to close to 5% now looks likely, this outcome is partly borrowing from growth in the quarters ahead. Defense spending, which has grown at a 9% annualized pace in the past two quarters, is almost certainly due for a pause. And a significant upward revisions to inventory building in 3Q07, points to an adjustment ahead. Indeed, the latest rise in ISM customer inventory index, combined with auto production schedules pointing to cutbacks through year end, suggests that stockbuilding is likely to subtract from growth this quarter and next.

• Credit tightening broadens. Results of the Fed’s latest Senior Loan Officers Survey indicates that credit conditions are tightening broadly and that demand for credit is slowing. Most recently, credit conditions have tightened significantly for commercial construction projects with CMBS securitizations plunging over the past couple of months. While the quantitative effects of this tightening is hard to measure, credit conditions look set to remain tight for a longer period than anticipated in our current forecast.

Taken together, these developments warrant a downward revision to an already sluggish growth forecast for the coming quarters. The trajectory of GDP growth is being lowered by one half percentage point per quarter through the middle of 2008, with the path of consumption, stockbuilding, and nonresidential construction activity shouldering much of the burden. During this quarter and next, GDP growth is expected to be particularly soft, averaging a meager 1% percent. The underlying resiliency of the US corporate sector will be severely tested through a period in which profits are expected to contract. While we continue to believe that firms are unlikely to retrench in a manner that produces a recession, the risks of a recession remain uncomfortably high. We currently place the risk of a recession taking hold in the coming two quarters at 35%. The Federal Reserve has made it clear that it is willing to act preemptively in the face of elevated recession risks. Having moved 75bp in two meetings, its October statement signalled that it viewed the risks to growth and inflation as balanced — a message that the bar for further easing was high. Against this backdrop, the Fed will need to shift materially its perceptions of risks about the outlook in the direction of our forecast change to produce ease. We now believe such a shift will take place and produce 50bp of additional ease by the end of the 1Q08.

When the most prominent and respected and sophisticated “soft-landing” analysts on Wall Street turn this bearish and start talking about high probability of a recession and downside risks to growth and of a consumer recession you know that these are code words for admitting implicitly – short of an official and explicit endorsement of such view that very few analysts of Wall Street can afford to have because of sell-side research constraints - that they believe that a recession is highly likely.

So at this point the debate is less and less on whether we are going to have a recession that looks inevitable; but it is rather moving towards a debate on how deep, protracted and severe such a recession will be. But the financial and real risks are much more severe than those of a mild recession.

I now see the risk of a severe and worsening liquidity and credit crunch leading to a generalized meltdown of the financial system of a severity and magnitude like we have never observed before. In this extreme scenario whose likelihood is increasing we could see a generalized run on some banks; and runs on a couple of weaker (non-bank) broker dealers that may go bankrupt with severe and systemic ripple effects on a mass of highly leveraged derivative instruments that will lead to a seizure of the derivatives markets (think of LTCM to the power of three); a collapse of the ABCP market and a disorderly collapse of the SIVs and conduits; massive losses on money market funds with a run on both those sponsored by banks and those not sponsored by banks (with the latter at even more severe risk as the recent effective bailout of the formers’ losses by theirs sponsoring banks is not available to those not being backed by banks); ever growing defaults and losses ($500 billion plus) in subprime, near prime and prime mortgages with severe known-on effect on the RMBS and CDOs market; massive losses in consumer credit (auto loans, credit cards); severe problems and losses in commercial real estate and related CMBS; the drying up of liquidity and credit in a variety of asset backed securities putting the entire model of securitization at risk; runs on hedge funds and other financial institutions that do not have access to the Fed’s lender of last resort support; a sharp increase in corporate defaults and credit spreads; and a massive process of re-intermediation into the banking system of activities that were until now altogether securitized.

When a year ago this author warned of the risk of a systemic banking and financial crisis – a combination of global liquidity and solvency/credit problems - like we had not seen in decades, these views were considered as far fetched. They are not that extreme any more today as Goldman Sachs is writing today on the risk o a contraction of credit of the staggering order of $2 trillion dollars in the next few years causing a severe credit crunch and a serious recession. As I will flesh out in a forthcoming note the risks of such a generalized systemic financial meltdown are now rising. Hopefully by now some folks at the New York Fed and at the Fed Board are starting to think about this most dangerous systemic financial crisis that could emerge in the next year and what to do to prepare for it.

JP Morgan bullish on Chinese stocks

Focus on earnings not valuations, says JPMorgan

By Yi Tin Chak | 19 November 2007

The US bank remains bullish on Asian equities for 2008, projecting a fifth straight year of gains for regional markets.

Having correctly projected in September that the Hang Seng Index would reach 29,000 thanks to strong liquidity inflows, JPMorgan is now sticking its neck out suggesting there is still room for Asian equity valuations to rise. The investment bank’s current 2008 year-end target for the HSI is 35,000 points, indicating more than a 20% upside from current levels.

The bank’s other forecasts for next year include a 22,000-point call for the H-share index, indicating a 24% upside; and a 22,500-point target for the Mumbai Sensex index which is 18% above where it is trading at the moment.

Given that the Asia-Pacific ex-Japan indices are up 40% year-to-date and the 12-month forward price-to-earnings multiple of the MSCI Emerging Markets Free index has increased to 14.5 times from 8.2 times in the past five years – leaving it 2.7 standard deviations above the five-year average - one could argue that this is a pretty bold statement.

Most Asian equity markets have also seen very rapid gains since their August lows, which has caused concerns in some camps that a broader correction is due. Indeed, in a 2008 equity outlook report published last week, JPMorgan itself highlights that the risks for emerging markets is shifting from fundamental volatility to valuations.

“No one feels comfortable with the valuations today, because they are back to where they were in the very early-1990s,” remarks Adrian Mowat, chief Asian and emerging markets equity strategist at JPMorgan.

However if you want to keep running as winners, he said at a media briefing last week, “don’t use valuations to trigger a sell. Use concerns about earnings”.

Instead of getting stuck on valuations, Mowat prefers to focus on the issue of why Asia became so expensive in the first place. “Conditions that caused markets to become more expensive also generated more earnings growth. Have these conditions changed? I think the answer is that they haven’t changed and they have got even stronger.”

Accordingly, as the drivers of the re-rating over the past 12 months are still in place, Asian P/E multiples could rise further, he argues.

Global drivers of the re-rating include: a broadening of the investor base, notably through the Qualified Domestic Institutional Investor (QDII) scheme which is allowing Chinese institutional investors to buy overseas stocks; a convergence in risk free rates; and an expanding economic growth premium between emerging markets and the countries within the Organisation for Economic Co-operation and Development (OECD).

At a country level there are also other drivers such as low real interest rates, currency appreciation which discourages capital outflow, reform of the long-term savings industry and the improving historical performance of local equities.

According to Mowat, the average emerging markets company is expected to generate 16% earnings per share growth over the next 12 month, which is still pretty high.

“Our advice is to continue to pay up for growth. It is premium growth that attracts investors to emerging markets. This trend is increasing as local savers increase their exposure to equities,” the report states.

By the same token, companies that are growing at less than 10% may continue to underperform even if they trade at cheaper valuations, and companies that fail to deliver on growth are likely to de-rate quickly.

Mowat remains bullish on China, which is now one of the most expensive markets in the region. Against a forecast that China’s nominal gross domestic product will reach 14.1% next year, the strategist feels comfortable to say Chinese equities could attain an earnings growth of 20%. The ongoing strengthening of the Chinese currency should also help attract investors to Chinese stocks in Hong Kong as their earnings will be worth more when converted into Hong Kong dollars.

“When we look at H-shares and red chips, (many of them) are denominated in Hong Kong dollars. And 5% renminbi appreciation seems reasonable,” he says.

Mowat argues that productivity in China is under-reported. A couple of years ago when the renminbi first started to appreciate, margins came under pressure, which resulted in bottom line growth of the country’s top 5,000 companies generally lagging top line growth. Chinese corporations are of huge scale and traditionally very labour intensive. However, by making use of low borrowing costs to and hiring machines instead of labour, the improved productivity could drive profit growth in excess of nominal GDP growth.

Other forces driving up the H-share market, according to JPMorgan, include the potential for a convergence in valuations of H-shares and redchips on the one hand and A-shares on the other, through the expanding QDII programme. As the Chinese authorities encourage more domestic listings, Mowat notes there is a lack of H-share supply in the market.

Overall, the bank is overweight Hong Kong, Malaysia and Thailand in the region and has upgraded India to neutral. As Taiwan and Korea are more exposed to consumer demand in the OECD countries, which is expected to soften, the bank has downgraded these countries to underweight.

The party is over, says Roach

Roach attacks global inequality

By Dan Slater | 19 November 2007

Morgan Stanley’s Stephen Roach says disproportionate profit allocation could spell the end of globalisation.

As the chairman of Morgan Stanley Asia, Stephen Roach, wrapped up his early morning talk at the Asian Private Equity and Venture Forum in Hong Kong on Friday, he put up a dramatic diagram. The slide showed two lines, one angling sharply upwards, the other angling sharply downwards. The upward sloping line was the share of corporate profits as a share of the national income of the G7 countries. The downward sloping line was the share of employee compensation as a share of national income. According to the graphs, the former accounted for just under 60% and the latter around 10%. The significance of the graph is clear: the benefits of globalisation have accrued in a highly disproportionate manner to “the wealthy and the owners of capital”, as Roach put it.

"That is unsustainable," says Roach, “and provides a challenge to the future of globalisation.” On the topic of globalisation, Roach asserts that Asia has been a major beneficiary – most easily seen through the inexorable rise of exports as a proportion of GDP. But that growth model, based on open markets, could be threatened if social imbalances are not rectified.

“Politicians are not happy with those income figures. They want their voters to get more,” says Roach. Disgruntlement in the countries most affected by globalisation could lead not only to the traditional problem of trade protectionism, but also to financial protectionism. Financial protectionism is a new term referring to the US government not selling its treasury instruments to buyers it considers potentially unfriendly.

Other imbalances could also hurt globalisation. Roach makes the now well-known point that the US consumer binge of the past years was fuelled by rising asset prices being converted into cash by home and stock owners. Incomes have been relatively stagnant. “Consumption accounts for 72% of GDP, the highest levels seen any time in history.”

As the debt that was fuelling the asset bubble unwinds, people's incomes will inevitably be pinched, Roach concludes. “We are seeing the bursting of the world’s biggest bubble – US property," he says. The result is that “the US consumer is toast”, and will be unable to generate further economic momentum.

Roach says that current problems should have been foreseen, and that the dotcom crash of 2001 should have acted as the "canary in the coal mine". Despite only accounting for 6% of US equity market cap, the S&P500 had lost 49% two years later. Roach says that the downturn then was far more serious than anybody initially expected.

“There were similar arguments in August, with some commentators suggesting that since securitised mortgages only represent 14% of outstanding mortgages, there was little to worry about,” he says, predicting that the credit fall out would continue to worsen.

Consequently, Roach also sees a recession in the US next year as being "more likely than not”.

A crash now could be far worse than in the early-2000s, since business capital spent by the dotcoms accounted for 14% of GDP at the time. But the current personal consumption bubble is many times as large, since consumption represents 72% of GDP.

Nor will Asian consumption fill the gap left by the US consumer. “China accounts for around $1 trillion in personal consumption and $650 billion in India. The US accounts for $9.5 trillion of personal consumption.”

The impact on Asia of a US slowdown will be inevitable. “Asia is not an oasis from the US problems,” Roach says, given the steady rise of emerging Asia exports, from an average of 17% to 45% of GDP currently. Contrary to what many analysts say, Roach says consumption in emerging Asia has been trending down, while exports have been trending up. China has an export-to-GDP ratio of 37%, of which 21% goes to the US. Taiwan has a ratio of exports-to-GDP of 59%, of which 14.4% goes to the US. ASEAN has a corresponding figure of 72% of which 13.6% goes to the US. Japan registers a figure of exports-to-GDP of 22%, of which 13% goes to the US.

“Equity capital markets in Asia are frothy, because investors are assuming no impact on Asia. I suspect they are wrong,” he says.

Bond markets tell a different story

Bond Market to Bernanke: Recession Threat Means More Rate Cuts

By Daniel Kruger

Nov. 19 (Bloomberg) -- The headline in the financial futures market these days says Federal Reserve Chairman Ben S. Bernanke is withholding some vital information: The economy is so bad the central bank will have to lower interest rates at least three- quarters of a percentage point to avoid a recession.

Bernanke's two rate cuts since September failed to reassure the bond market, where volatility has risen four of the past five weeks, according to Merrill Lynch & Co.'s MOVE Index. Yields on Treasury bills, the haven for bond investors in times of turmoil, are near their lows of August, when losses on securities backed by subprime mortages froze credit markets.

While the record low dollar and the fastest inflation in 14 months give policy makers reasons to keep the target rate for overnight loans between banks at 4.5 percent, traders expect 3.75 percent early in 2008. Interest-rate futures on the Chicago Board of Trade show the Fed will cut borrowing costs in December and again in the first quarter, as the worst housing slump since 1991 deepens and retailers including J.C. Penney Co. and Macy's Inc. forecast slumping sales.

Investors are sending the message to Bernanke that ``you're wrong and we're going to lead you to the next ease,'' said Thomas Tucci, head of U.S. government bond trading in New York at RBC Capital Markets. The firm is the investment-banking arm of Canada's biggest bank.

Fed fund futures show traders see a 90 percent chance the central bank will reduce its target a quarter-percentage point to 4.25 percent at its Dec. 11 meeting, 67 percent odds of another 25-basis-point cut in January, and a 43 percent likelihood the rate falls to 3.75 percent in March. Policy makers already lowered the target from 5.25 percent in August.

Worse than LTCM

The Fed hasn't cut that much since 2001, when the economy shrank and policy makers lowered rates 11 times. Even when Russia defaulted and Long-Term Capital Management LP collapsed in 1998, policy makers only had to reduce rates 75 basis points.

The yield on the benchmark two-year note, the security most sensitive to rate expectations, fell 8.5 basis points last week to 3.34 percent, according to bond broker Cantor Fitzgerald LP. The price of the 3 5/8 percent Treasury due in October 2009 rose 4/32, or $1.25 per $1,000 face amount, to 100 17/32. The benchmark 10-year note yield declined 5 basis points, or 0.05 percentage point, to 4.17 percent.

Bernanke suggested the central bank is reluctant to lower rates again when he told Congress on Nov. 8 that the economy will likely ``slow noticeably'' this quarter while also citing ``upside risks'' to inflation. Fed Governor Randall Kroszner was more pointed, saying in a New York speech on Nov. 16 that ``the current stance of monetary policy should help the economy get through the rough patch during the next year.''

Stiglitz `Pessimistic'

Financial markets aren't buying it. Wells Fargo & Co. Chief Executive Officer John Stumpf said at a Merrill Lynch conference in New York on Nov. 15 that the housing market slump is the worst since the Great Depression.

Joseph Stiglitz, the Columbia University professor and Nobel-prize winning economist, said there is a 50 percent chance of a recession in the U.S. as a worldwide increase in credit costs following the collapse of the subprime mortgage market chokes off financing. ``I'm very pessimistic,'' Stiglitz said in an interview in London Nov. 16.

Financial companies may lose as much as $400 billion because of home foreclosures, based on a ``back-of-the-envelope'' calculation, Jan Hatzius, chief U.S. economist at Goldman Sachs Group Inc. in New York, wrote in a report last week. That will force banks, brokerages and hedge funds to cut lending by $2 trillion, he estimated.

Bill Yields

Merrill's MOVE index reached 112.08 on Nov. 9, the highest since Sept. 20, and was at 99.14 on Nov. 16. The gap between yields on three-month bills and the Fed's target rate widened to 1.25 percentage points, the biggest gap since Sept. 14. Bill yields fell as low as 3.16 percent on Nov. 15, near this year's low of 3.09 percent on Aug. 20.

For the first time since 2001, yields on Treasuries maturing from three months to 10 years are below the federal funds rate. Five of the past six times that has happened, the economy entered a recession, data compiled by Bloomberg show.

Most analysts don't expect a recession. After annual growth of 3.9 percent from July to September, the economy will cool to a 1.5 percent pace this quarter and expand 2 percent in the first three months of 2008, according to the median estimate of 72 economists surveyed by Bloomberg from Nov. 1 to Nov. 8. The Fed will cut its target to 4.25 percent next quarter and leave it there through 2008, a separate survey shows.

Faster Inflation

Faster inflation is making Bernanke's job tougher. Consumer prices rose at a 3.5 percent annual rate in October, the most in 14 months, the Commerce Department said Nov. 15. Crude oil soared 56 percent this year, reaching a record $98.62 a barrel. The dollar sank to a record low of $1.4752 per euro on Nov. 9 and import prices rose 1.8 percent in October, the most in 17 months, the Labor Department said.

``It seems like there's an awful lot of price pressures,'' said Jamie Jackson, who oversees government debt trading at RiverSource Investments, a Minneapolis firm that manages $100 billion of bonds. ``It's harder to be a credible inflation fighter if you ease into accelerating inflation.''

The Fed is done cutting rates and 10-year yields may reach 4.75 percent next quarter, Jackson said.

Futures traders are betting the slump in housing and losses in credit markets will reduce consumer confidence and trump the threat of inflation, which erodes Treasuries' fixed payments.

`Saving the Economy'

``The Fed will not only need to save the financial markets, in very short order they're going to have to start saving the economy,'' said Tom di Galoma, head of Treasury trading in New York at Jefferies & Co., a brokerage for institutional investors. The 10-year yield will fall below 4 percent by the end of June and two-year yields to 3 percent, he said.

Homebuilding declined 20 percent last quarter, the seventh straight drop, subtracting a percentage point from economic growth, government data show. The National Association of Home Builders/Wells Fargo may say today that its index of builder sentiment fell to 17 this month from an all-time low of 18 in October, according to the median forecast in a Bloomberg News survey. The index averaged 42 last year.

Plano, Texas-based J.C. Penney, the third biggest U.S. department-store company, cut its fourth-quarter profit prediction by as much as a third last week. Macy's, based in Cincinnati, lowered its fourth-quarter sales guidance.

``The Fed tends to be backward looking,'' said Lacy Hunt, chief economist at Austin, Texas-based Hoisington Investment Management Co., which is buying zero-coupon and 30-year Treasuries, the most bullish bets that inflation will cool. ``They're always looking at the way the world was, not the way it will be. Market rates reflect the buying and selling decisions of millions and millions of decision-makers.''

Hunt predicts the Fed may lower its target to 2 percent in the next few years.