Hard or soft landing?

What with the Xmas holiday and all I'd lost track of the state of the macroeconomy. In particular, I had not updated my answer to the question "will the US economy experience a fall in inflation in 2007 without undergoing a recession (the soft landing scenario), or will the bust in the housing market combined with high energy prices send the economy into the tank (hard landing scenario)?" All I know from the last month or so of data is what I glean from the Xmas Stocking Index (XSI): the kids' stockings had more than the usual amount of crap in 'em this year, indicating that the economy - at least at 84 Springs Ave. - is doing pretty well.

So I toodle over to the BLS website to check on employment indicators for December (released January 5. There I find that the economy produced a healthy 167,000 more jobs in December, putting us at 1.8 million for the year. That's 150,000 a month on average, at or a few tens of thousands above the level we think is needed to keep up with growth in the labor force. Good news then. Meanwhile I see the CPI inflation rate was zero in the month of November, bringing the overall inflation rate down to 2.0% for the year ending November 2006 and the core inflation rate down to 2.6%. Still a way to go, but clearly the numbers are heading in the right direction. So the soft landing scenario is looking better and better.

For the pessimist's view, one needs to go to Nouriel Roubini's blog. Roubini has been predicting a housing market - driven recession in 2007 since last summer. He notes that news from the housing market continues to be grim:

Sub-prime mortgages have been a crucial element of the real estate boom of the last few years. While in 1994 only 5% of mortgage originations were subprime, in that last two years 20% of all mortgage originations have been subprime. Note also that interest-only and payment-option ARMS – many of which are to subprime borrowers - were 2% of loan originations in 2000; while by 2006 they accounted for 40% of loan originations. So what happens in the subprime market is of great importance for developments in the housing market in 2007.

The latest news – discussed in previous blogs of mine - are that both subprime lenders and borrowers are increasingly in trouble. On the lending side at least four subprime lenders have gone under in the last couple of months. Other major subprime lenders are rumored to be on the way to bankruptcy or are on the selling block.

He then looks at an interesting little index called the ABX index. Quoting from the Financial Times:

“The ABX index represents a basket of credit default swaps on high-risk mortgages and home equity loans. On asset-backed securities such as home equity loans, CDS provide a type of insurance against the de-fault of a specific security.

The most heavily traded sub-index, representing loans rated BBB-, has fallen 5 per cent in the past month, as hedge funds have flocked to bet on the downturn and pushed up the cost of insuring against default.”

“the [sub-prime] loans are often packaged into securities and sold to investors to help lenders reduce risk. More than $500bn of such securities were issued in the US last year.The problem for investors who bought last year's crop of high-risk mortgage originations, was that as the US housing market slowed, so too did mortgage applications.To prop up sagging origination volumes, mortgage lenders relaxed their underwriting standards - lending to ever-riskier borrowers at ever more favourable terms.

In the last few weeks of 2006, the poor credit quality of the 2006 vintage subprime mortgage origination came home to roost. Delinquencies and foreclosures among high-risk borrowers increased at a dramatic rate, weakening the performance of the mortgage pools. In one security backed by subprime mortgages issued last March, foreclosure rates were already 6.09 per cent by December, while 5.52 per cent of borrowers were late on their payments by more than 30 days. Lenders also began shutting their doors, sending shock waves through the high-risk mortgage markets. Another lender, Mortgage Lenders Network, last week joined the ever-growing list of originators closing, bringing the high-risk market kicking and screaming into the new year.

Traders say the problems have kept new investor money at bay, and dramatically weakened a key derivative index tied tothe performance of 2006 high-risk mortgages, the ABX.
Alex Pritchartt, an ABX trader at UBS, said: "Investors were really shocked in the fourth quarter at the speed of deterioration. So buyers are likely waiting to see the bottom before getting back in."

He therefore continues to predict a substantial slowdown in 2007 driven by weakness in the housing market. But I can't help but think that the unusually warm winter, which has pushed oil prices down to around $50 per barrel, may have saved our bacon. Global warming may have severe longrun consequences for the economy, but it seems to have worked out all right for us in 2007. The only thing standing between us and a solid economic performance for 2007 is more instability in the Middle East. Uh oh, what's that?

President Bush's speech on Wednesday night ... paid lip service to the Iraq Study Group report, but cast aside its advice that he negotiate with Iran and Syria. Instead, he rattled sabers at Iran with some ferocity, accusing it of arming insurgents in Iraq and threatening it with international isolation. He attempted to rally his Sunni Arab allies, such as Egypt, Jordan and Saudi Arabia, in this effort. He said, "We will disrupt the attacks on our forces. We'll interrupt the flow of support from Iran and Syria. And we will seek out and destroy the networks providing advanced weaponry and training to our enemies in Iraq." He announced that he would position another aircraft-carrier battle group in the Persian Gulf and would deploy Patriot antimissile batteries.

Then Thursday came a U.S. raid on an Iranian consulate in the Iraqi Kurdish city of Irbil. By the end of the day, rumors of war with Iran had spread to normally cautious corners of the Internet. The Washington Note wondered aloud if Bush had issued an executive order to commence military action against Iran and Syria. Was the raid a deliberate provocation and the preface to war?