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Farrell: What to Worry About

Ready, set, go. 2010 has begun. This Friday, January 8, we will get the Bureau of Labor Statistics monthly jobs report. Two months ago (October) 111,000 jobs were lost. November saw a decline of 11,000. The consensus is for a flat report but I have seen as big a loss estimate of -100,000. Last week initial unemployment claims took a surprise dip, and the four-week moving average also fell for the seventeenth week in a row. That sparked optimism that this week could actually see a job gain. Well over 100,000 temporary jobs have been created the last two months and that is often a telling indicator.

To put that into a context, last January, which is a time we would all like to forget, 90,000 temp jobs were lost. The creation of over 100,000 temp jobs is significant. In a recovery, as we have said before, productivity comes first, then temp jobs, then permanent jobs. If the jobs report is strong, look for bond yields to move up. The good news would be job creation, the bad news would be higher bond yields. The ten-year bond finished last week at about a 3.8% yield (actually a bit higher, but close enough.) The average 30-year mortgage was at a 5.14% yield at weeks' end, the Journal reported. At a 3.8% ten-year, the mortgage rate should be about 3.8 +1.6, or 5.4%. Even without the ten-year moving up, mortgage rates will rise and soon, if not already, cutting off all refinancing activity. So the first thing I am worried about is mortgage rates.

The second thing I worry about is mortgage rates. The Federal Reserve will soon exit the market for buying mortgage-backed securities after having swept up (by the time they are done) $1.25 trillion worth. That has kept the secondary market alive and interest rates lower than they otherwise would have been. The Treasury Department pulled a clever one last week by saying they will guarantee Fannie and Freddie for three years. That will allow them to keep mortgage paper on their books if no natural buyer emerges when the Fed walks away. But there are plenty of natural buyers — it depends on the price. So rates will have to be allowed to go up or the Treasury (which is you and me via our tax dollars) will soon be stuffed with potential liabilities.

Because we are in a worry mode, let's add sovereign credit to our list. Argentina, the Baltic States, Iceland, Portugal, Italy, Ireland, Greece, Spain and Dubai come to mind. Abu Dhabi will probably paper over the Dubai situation and the European Union will muscle Greece to some level of cooperation. But then I think about Japan where government debt is over 200% of GDP and they can't seem to break out of the malaise. Scott Nixon, writing in last Saturday's Wall Street Journal, says the "UK's fiscal position is the worst in the industrialized world, with no implicit guarantee." But forget all of those. California, which would be the seventh largest economy in the world if stand-alone, is appealing to the Feds for billions in aid. But the Federal Government is working on trillion-dollar deficits for the next few years. There has to be a worldwide belt tightening. We simply can't afford all we would like, and that has implications for stock markets and interest rates.

2010 and 2011 will see a bunch of adjustable mortgage resets, and while probably not new to anyone, we will have continued foreclosures. It is good news that the Case-Shiller home price index has risen five months in a row sequentially, but with continued foreclosures and the existence of a large "shadow inventory" of homes waiting to come on the market, home prices are probably flat at best for a while.

The biggest challenge facing the markets this year will be the Fed trying to, as my pal Jason Trennert of Strategas says, "stick the landing" when they implement an exit strategy for all the stimulus money pushed into the system. Mark Gilbert of Business Week says, "The risks of getting the timing wrong are considerable. If the Fed abandons its zero interest rate stance too soon, it could ruin a recovery that is already undershooting economic forecasts. Wait too long, though, and cheap money might inflate new asset bubbles of the kind that led to the credit crisis in the first place." My guess is that Bernanke, being a scholar of the Depression, will remember the ill-timed interest rate hike of 1937 that toppled the fragile economy back into recession. He will drain liquidity via the unconventional means the Fed has set up, but keep the Fed Funds rate low to have a steep yield curve for the banks to earn their way out of trouble.

And maybe the banks don't deserve the help. Graham Bowlen of the NY Times estimates that banks have withdrawn $3 trillion in credit from the market the last 15 months. Small businesses are the primary creators of jobs and the stories of how difficult is for them to get credit are becoming legend. Credit has to be available for the system to function.

Admittedly, all of the above is known. It is probably priced into the market to some extent. What might give us real trouble would be the unknown that rises up to surprise us. The most thoughtful "surprise" I have heard comes from my great friend, Doug Kass. He worries there is "A tidal wave of populism (that) could affect the economy and the market more than many people assume. There is an angry subtext—the average American resents some of our largest institutions (especially of a financial kind), our politicians (Republicans and Democrats alike), and the wealthy. When the policies of populism (higher taxes and more costly regulation) are mixed with a number of other nontraditional headwinds (municipal disarray, a still-wounded lending mechanism, etc.), the trajectory of economic growth will almost certainly be stunted. I believe these influences and policies will be reflected, contrary to consensus, in a weakening economy by the second half of 2010." Doug is one smart, thoughtful guy. If he is worried, then I am, too.

But—good markets are built on the wall of worry. I stand by my reasonably optimistic thoughts expressed in the last few letters. I was thinking about my beloved NY Giants and football playoffs and got all upset, so I had to vent. I should have remembered instead what Casey Stengel said when he was asked if having sex the night before a game hindered his players performance. Casey answered "It isn't sex the night before a game that is the problem. It is staying up all night looking for it."

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