Fed Ponders Bolder Moves

Bernanke Opens Door to Buying More Securities If Economy Falters Further.ArticleVideoInteractive GraphicsComments (127)more in Economy ».EmailPrintSave This ↓ More.

By JON HILSENRATH And SUDEEP REDDY



Federal Reserve Chairman Ben Bernanke walked with Fed Gov. Donald Kohn on Fridayoutside the Jackson Lake Lodge before the opening session of the Kansas City Fed's annual symposium near Jackson Hole, Wyo.

.JACKSON HOLE, Wyo.—Federal Reserve Chairman Ben Bernanke opened the door to bolder steps by the central bank if the economy continues to falter, amid fresh signs that growth has fizzled in the past few months.



Sudeep Reddy and Neal Lipschutz break down comments today by Federal Reserve Chairman Ben Bernanke on the U.S. economy and look at what's left in the Fed's arsenal. Plus, Microsoft Co-Founder Paul Allen Sues Google and others over patents.

Speaking Friday to world monetary policymakers gathered in Wyoming, he said "policy options are available to provide additional stimulus" to the U.S. economy, should it be necessary.



The latest sign of trouble for the economy came Friday as the Commerce Department revised down its estimate for second-quarter growth in gross domestic product. The economy grew only 1.6% in the period, not the 2.4% annual rate previously estimated.



Stumbling GDP growth adds to the gloom already created by plunging home sales and other signs that consumers are shying away from spending. Technology bellwether Intel Corp. warned Friday its third-quarter revenue could fall short of estimates because of weak demand for personal computers.




Japan Warns on Intervention After Yen Rise. Access thousands of business sources not available on the free web. Learn More.All of this drives home a grim political reality for the Obama administration and for Democrats facing elections this fall: What many had hoped would be a "summer of recovery" is ending on a dismal note.



"The pace of recovery in output and employment has slowed somewhat in recent months," Mr. Bernanke said in his speech in Wyoming, an annual event hosted by the Kansas City Fed. He made the case that growth will pick up in 2011, spurred in part by consumers who have shored up their damaged finances. However, he also made clear the Fed would respond if that forecast is wrong and growth continues to falter, and expressed confidence that its efforts would work.



Mr. Bernanke sketched out four options the Fed could deploy to boost the economy. At the top of the list is the resumption of a program of long-term securities purchases by the Fed, which could help to drive already-low long-term interest rates down even more. The Fed can't use its traditional lever of pushing short-term interest rates down because it has already pushed them to near zero.




.Another option would be to lower the interest rate banks get for reserves they keep with the Fed, even though it's already quite low, Mr. Bernanke said. He also said the Fed could promise to keep short-term interest rates low for a longer period than markets currently expect. A final option, which Mr. Bernanke ruled out but which some private sector economists recommend, would be to raise the Fed's inflation target to more than 2%, from its current informal target of 1.5% to 2%, Mr. Bernanke said.



Investors were buoyed by the news. The Dow Jones Industrial Average surged 164.84 points, or 1.65%, to close at 10150.65.



Economists still put low odds on the economy falling back into recession, but they acknowledge that the likelihood has been rising. Double-dip recessions are rare in history, sometimes the result of policy mistakes—such as pulling back stimulus too quickly or aggressively, as happened in the U.S. in the 1930s and in Japan in the 1980s. The most recent case of an economic relapse in the U.S. was the 1981-82 recession, which followed the 1980 downturn.



Goldman Sachs has one of the most pessimistic outlooks for growth among Wall Street banks, but even it sees the economy growing 1.5% in the second half of this year and early 2011. Goldman economists put the likelihood of a double-dip recession at 25% to 30%, a substantial risk but still unlikely.



One of the biggest potential challenges is stagnation in hiring, or a return to declining payrolls—which would choke off momentum for the private sector to grow. "If the labor market starts to shrink again, it has effects on both workers' confidence and on their incomes and that tends to reinforce the downside," said Goldman Sachs economist Ed McKelvey.



Friday's GDP report showed a surge in imports, which grew at the fastest rate in 26 years, during the second quarter. Growth in imports far exceeded U.S. exports and wiped out more than three percentage points of U.S. growth in the quarter.



Mr. Bernanke said the deterioration in trade in the second quarter might have been due to "temporary factors" and said exports could be a source of growth in the months to come.



Journal Community

..Many companies are socking away cash, rather than investing in new projects, in part to guard against risks they see emerging. Friday's GDP report showed for the first time that a key measure of after-tax corporate profits in the second quarter remained strong, rising 25% from a year earlier. But that represented only a 2.9% increase from the previous quarter, far slower than the gain in the first quarter.



"This is what business has been trying to tell policymakers all along—that confidence isn't high, uncertainty is great and there's a reluctance to take on risk," said Ronald DeFeo, chief executive of Terex Corp., a Westport, Conn.-based heavy equipment maker.



Mr. DeFeo, just back from Brazil, hasn't shifted back into cutback mode. "All we're doing," he says, "is trying to go those markets in the world where business and opportunity are better matched than in the U.S."



Richard Mershad, chief executive of Micro Electronics Inc., a computer retailer, said U.S. consumers remain extremely cautious in their spending.



The Hilliard, Ohio, company has avoided adding workers for the past three years, instead trying to raise productivity by automating more of its distribution to drive costs down. Mr. Mershad said he's "a little bit concerned about another dip" in the economy and plans to keep the company focused on cutting overhead expenses. "We have to do more with less," he said.



A similar sense of caution is entrenched in corporate board rooms across the U.S. and poses a major challenge for policymakers like Mr. Bernanke.



Mr. Bernanke's speech signaled that the Fed's position has shifted notably in the past few months. Early this year, officials spent much of their time planning an exit from easy money crisis policies, and unwound several of their emergency lending programs. Now, if the Fed takes any action, an easing of policy looks more likely than any tightening.



Fed officials disagree on whether more action is needed and whether the steps the Fed chairman outlined would be effective. The consensus-driven Fed chief is weighing the arguments among the dozen regional Fed bank chiefs and the four other Fed board members who have a say in Fed policy as he assesses whether to do more.



"None of the (Fed's options) would move the needle significantly on either the economy or the risk of deflation," Harvard professor Martin Feldstein said after the Fed chairman's speech. Interest rates are already very low, he noted, but that has not generated much consumer or investment demand. "He's in a bad spot."



Inflation trends weigh heavily on Mr. Bernanke's mind. The threat of a Japan-like period of falling consumer prices looms. Though Fed officials don't believe deflation is likely to happen, Mr. Bernanke made clear his tolerance was running low for further declines in inflation, which is already low, at 1%, and below the Fed's informal objective of 1.5% to 2%.



Write to Jon Hilsenrath at jon.hilsenrath@wsj.com and Sudeep Reddy at

Reinhart’s Seven More Years of High Unemployment Hit Fed Today

By Vivien Lou Chen



Aug. 27 (Bloomberg) -- As a seven-year-old in Cuba, Carmen Reinhart memorized the routes of ships carrying silver from Peru and Bolivia to Spain. By 16, she had moved to Miami and got a job at a Sears Holdings Corp. store reviewing credit applications and payment records.



That fascination with history and data has propelled a career at Bear Stearns Cos., the International Monetary Fund and the University of Maryland in College Park. Now Reinhart, 54, is using a paper studying 15 economic crises since World War II to warn Federal Reserve Chairman Ben S. Bernanke and fellow policy makers that sluggish growth and high unemployment in the U.S. might persist through 2017 or longer.



“Whether one looks at advanced economies or a whole sample that includes emerging markets, the picture is one of lower growth during the decade that follows the crisis,” she said in an interview from Washington this week. “We are already three years into this post-crisis window. The clock starts ticking in the summer of 2007.”



Reinhart’s work has made her the female economist most frequently cited by other economists. Her latest paper, “After the Fall,” co-written with husband Vincent Reinhart, is being presented today at the Fed’s annual symposium in Jackson Hole, Wyoming.



An unemployment rate of 8 or 9 percent over the next seven years is not “outside of the experience that we have documented,” she said. Her studies of crises in Finland, Japan, Norway, Spain and Sweden that started between 1977 and 1992 show median per-capita economic growth declined by 1 percentage point in the decade following the shock.



Prescient Work



Reinhart’s work in the past 20 years has proved prescient, which she says is her proudest accomplishment. In 1992, as a researcher at the Washington-based IMF, she and Columbia University economist Guillermo Calvo wrote about the likelihood of abrupt reversals of capital flows into Latin America. That was before the Mexican peso collapse of late 1994. In 1996, a year before the Asian financial meltdown, she co-wrote a paper documenting the links between banking and currency crises.



“She’s done very important work and looked at things other people didn’t notice,” said Morris Goldstein, a senior fellow at the Peterson Institute for International Economics in Washington. “Very few people have been able to turn out important papers with that kind of consistency.”



In a 2008 paper, Reinhart and co-author Kenneth Rogoff, a Harvard University professor and former IMF chief economist, identified the possibility of a deep, lasting effect on asset prices, output and employment that might result from the subprime mortgage crisis in 2007.



Financial Folly



The paper helped form the foundation for a 2009 book titled “This Time Is Different: Eight Centuries of Financial Folly.” In it, Reinhart and Rogoff trace the similarities among financial crises dating back to Medieval times, including government defaults, banking panics and inflationary surges.



The 463-page book is “one of the most comprehensive treatments, in terms of time span and the effects that they looked at,” said Goldstein, who has known Reinhart for 25 years.



Rogoff, 57, calls his collaborator “an economist’s economist,” with a “broad knowledge of global history, politics and finance that is simply extraordinary.”



She is the No. 1 ranked female economist worldwide as of July, based on criteria used to judge the popularity of her work, according to RePEc: Research Papers in Economics, an online database of economic material operated by volunteers in 71 countries. She’s also the only woman listed among the top 50 U.S. economists.



‘A Little Sensitive’



“The way she looks at the world is very different from the conventional model, which uses the standard assumption that financial markets are perfect,” said Calvo, her professor at Columbia in New York. “She was always looking for imperfections in the market.”



While “well-noticed” by colleagues in the profession, “she’s a little sensitive about being overlooked by Ivy League schools for teaching positions,” said Calvo. “It’s quite remarkable that, given all her papers, she hasn’t been approached.”



That may be so because Reinhart hasn’t written a “technical paper with tools that can be used by other economists,” he said.



For her part, Reinhart says her biggest professional disappointment is that the kind of “empirical work I do is not well-rewarded in the profession.”



Family Flees Cuba



With a childhood love of the romance and adventure behind pirate lore and tales of shipwrecks, Carmen Castellanos fled Cuba at age 10 with her parents in the first decade of Communist leader Fidel Castro’s rule. Each carried a suitcase with three changes of clothes. Her father, an accountant, found work as a carpenter in Pasadena, California, while her mother became a seamstress.



After moving to the East Coast, she attended Florida International University in Miami and later Columbia, where her thesis adviser was Robert Mundell, winner of the 1999 Nobel Prize for economics. Her professors included Maurice Obstfeld, a specialist in international economics who now teaches at the University of California, Berkeley.



It was at Columbia that she met her husband, a former monetary-affairs director at the Fed and now resident scholar at the American Enterprise Institute, a Washington-based research organization that favors limited government and free markets. She says she often sat next to Vincent Reinhart in classes because he was one of the few fellow left-handers and she wanted to avoid bumping arms with other students.



Valentine’s Day Gift



For Valentine’s Day one year, Vincent Reinhart gave his wife statistical yearbooks from the League of Nations dating to the 1920s. She says her 53-year-old husband is now the first person to hear about and read her work, offering suggestions on drafts and commenting on the final versions.



Carmen Reinhart, who once studied fashion merchandising, says her “mistrust” of financial-market exuberance dates back to the 1980s, when she began work as an economist at Bear Stearns. At the time, the U.S. was experiencing recession and rapid disinflation, while Latin America got swept into a debt crisis.



Her almost decade-long collaboration with Rogoff began after he hired her to become a deputy director at the IMF, the agency created at the end of World War II to help maintain global financial stability. Rogoff recalls thinking her study of the links between banking and currency crises “seemed like a breath of fresh air compared to the more introspective papers everyone else was writing.”



Contrast With Geithner



The pessimistic outlook in her paper presented at Jackson Hole contrasts with the view of Treasury Secretary Timothy F. Geithner, who said this month that the U.S. economy is “gradually healing.”



The nation has more than a 50 percent chance of experiencing a lost decade like Japan, when a collapse in land and stock-market prices gave way to economic stagnation and deflation starting in the 1990s, according to Reinhart. To avoid that outcome, policy makers should immediately announce a plan to increase taxes and cut spending in about a year, she said, adding her husband generally shares the same position.



“We have the pretty clear view that you want to not necessarily implement austerity right now, but you certainly want to announce it right now, with plans to deal with the deficit and debt in a realistic time frame,” she says.



‘Japan-like Scenario’



“Our recovery still leaves a great deal to be desired,” Carmen Reinhart said. “My concern is that because the U.S. is the world’s reserve currency, we can still borrow in bad times, and that a more Japan-like scenario lies in store. A lot of the forces are already in place.”



With the U.S. government’s gross debt rising to about 90 percent of gross domestic product as tax revenue declined during the recession, “we have to pay future attention to the debt.”



“You don’t want to pull the plug out completely on stimulus,” Reinhart said. Still, “you have to start thinking about what measures are required to curb the deficit, and cap or reduce the debt. You don’t have the luxury to focus on the choice of one or the other. You have to deal with both.”



To contact the reporter on this story: Vivien Lou Chen in San Francisco at vchen1@bloomberg.net

Q2 GDP-Adv. and Revised

Highlights

• Second quarter GDP increased 2.4%, which was fairly close to the Briefing.com consensus estimate that called for a 2.5% increase.
• There was a significant bias in the consensus forecast, however, and the details of the data suggest that Q2 GDP was actually stronger than originally expected.
• The BEA re-estimated all of the data from 2007 though Q1 2010 for its annual benchmark revisions. Q1 2010 GDP was revised up from 2.7% to 3.4%.  Since the consensus forecast was based upon the pre-revision data, Q2 GDP was actually substantially higher than estimated.

Key Factors

• The revisions, though, lent credence to what many people on Main Street had been thinking. The recession was deeper than originally expected and the recovery effort has been a little slower.
• From its peak in Q4 2007, GDP contracted 4.10% to its trough in Q2 2009. This was roughly 0.44 percentage points less than originally thought. The recovery effort through Q1 2010 only produced an increase in output of 2.57%, about 0.05 percentage points below the previously released data.
• The recovery did pick up a little steam in the second quarter compared to the first. Although the headline growth number of 2.4% was weaker than the revised  3.7% growth rate for the first quarter, real final sales of domestic product were up 1.3% compared to a 1.1% increase in Q1.
• Basically, second quarter GDP outperformed the first quarter with the exception of inventory growth. The individual GDP components confirm this.
• While PCE growth fell from 1.9% to 1.6% and export demand slipped from 11.4% to 10.3%, every other component showed improvement versus the first quarter.
• Nonresidential investment in structures increased 5.2% from -17.8%.
  Equipment and software purchases rose 21.9% compared to 20.4%.
  Residential investment increased 27.9% from -12.3%.
  Imports were up 28.8% from 11.2%.
  Government expenditures jumped 4.4% from -1.6%.

Big Picture

• The US has finally exited the recession, but growth prospects remain weak. As the inventory cycle continues to rev up, it expected that GDP will continue to grow throughout 2010. However, inventory growth will not result in more jobs and consumption could fall as government stimulus wanes in beginning of next year.

Category	2010 Q2	2010 Q1	2009 Q4	2009 Q3	2009 Q2
GDP	2.4%	3.7%	5.0%	1.6%	-0.7%
Inventories (change)	$75.7B	$44.1B	-$36.7B	-$128.2B	-$161.8B
Final Sales	1.3%	1.1%	2.1%	0.4%	0.2%
PCE	1.6%	1.9%	0.9%	2.0%	-1.6%
Nonresidential Inv.	16.9%	7.8%	-1.4%	-1.7%	-7.5%
Structures	5.1%	-17.76%	-29.2%	-12.4%	-20.2%
Equipment & Software	21.9%	20.5%	14.6%	4.2%	0.2%
Residential Inv.	27.8%	-12.3%	-0.8%	10.6%	-19.7%
Net Exports	-$425.9B	-$338.4B	-$330.1B	-$390.8B	-$342.0B
Export	10.4%	11.4%	24.4%	12.2%	-1.0%
Imports	28.8%	11.2%	4.9%	21.9%	-10.6%
Government	4.4%	-1.6%	-1.4%	1.6%	6.2%
GDP Price Index	1.8%	1.0%	-0.2%	0.8%	0.3%

Revised..

Category	2010 Q2	2010 Q1	2009 Q4	2009 Q3	2009 Q2
GDP	1.6%	3.7%	5.0%	1.6%	-0.7%
Inventories (change)	$63.2B	$44.1B	-$36.7B	-$128.2B	-$161.8B
Final Sales	1.0%	1.1%	2.1%	0.4%	0.2%
PCE	2.0%	1.9%	0.9%	2.0%	-1.6%
Nonresidential Inv.	17.6%	7.8%	-1.4%	-1.7%	-7.5%
Structures	0.4%	-17.76%	-29.2%	-12.4%	-20.2%
Equipment & Software	24.9%	20.5%	14.6%	4.2%	0.2%
Residential Inv.	27.1%	-12.3%	-0.8%	10.6%	-19.7%
Net Exports	-$444.9B	-$338.4B	-$330.1B	-$390.8B	-$342.0B
Export	9.2%	11.4%	24.4%	12.2%	-1.0%
Imports	32.4%	11.2%	4.9%	21.9%	-10.6%
Government	4.3%	-1.6%	-1.4%	1.6%	6.2%
GDP Price Index	1.9%	1.0%	-0.2%	0.8%	0.3%

Weak Firms Pile On Debt—and Trouble

By MIKE SPECTOR And MICHAEL ANEIRO

For America's weakest companies, today's credit markets are a miracle drug allowing them to cheat death.

Many firms with speculative-grade credit ratings are tapping a record high-yield bond market to repay existing debts. They also are refinancing their loans, pushing out maturities and nabbing lower interest rates. This "kick the can" approach has paid off for companies that investors left for dead just 18 months ago, including Rite Aid Corp., MGM Resorts International and auto supplier Tenneco Inc.

These companies' fundamentals still give cause for concern. MGM, for instance, recently posted a wider second-quarter loss of $883.5 million, compared with a $212.6 million loss a year earlier. Slowing MGM's progress: an inability to coax profits out of a new Las Vegas development.

Still, riskier debt is among the only ways to find higher yields as the Federal Reserve keeps interest rates near zero and yields on government bonds stay low.

Weaker companies are enjoying the spoils. "Junk-bond" deals this summer have yielded around 8.6%, according to Barclays Capital. That is lower than a year ago, when these yields were around 10%, and a far cry from the more than 20% that investors demanded during the financial panic in late 2008.
Only 5.5% of companies around the world with junk credit ratings have defaulted in the past year, according to Moody's Investors Service. As of November, 13.5% of these companies had defaulted during the previous 12 months.
But even as investors throw cash at these firms, a number of them could have trouble generating enough cash flow to service the debt in coming years, say analysts and restructuring advisers.
"For the 'maturity wall' to not be a problem and things to get better, you need real economic improvement, and that's not happening," said Kingman Penniman, head of credit research firm KDP Investment Advisors.

Associated Press

Rite Aid has been mired in red ink for the better part of three years. But the drugstore chain has managed to survive by cutting costs and just raised $650 million in secured bonds at an interest rate of 8%.

Some $800 billion in debt on risky companies' books matures over the next four years, according to Moody's. Lenders' decreased risk appetite, a double-dip recession or a prolonged period of mediocre economic growth all pose threats to the market's ability to absorb companies' refinancing needs, Moody's says.
"The interest rates don't seem to be following some of the fundamental risk profiles of the companies," said Kevin Cassidy, a Moody's senior credit officer.
About two-thirds of the new funds have been used to repay existing debt, rather than for deals or other capital expenditures. Companies rated B- or lower have issued $31.2 billion in debt so far this year, according to Diana Vazza, head of Standard & Poor's Global Fixed Income Research.
"When the dam breaks, it will be unbelievable," said Barry Ridings, the vice chairman of U.S. investment banking at Lazard Freres & Co. who advises companies restructuring their debts. Low-margin, consumer-dependent companies are "all going to be in trouble at some point if they have too much debt."
Many companies are getting new life both from junk-bond investors and banks. MGM, the big Las Vegas casino operator, nearly collapsed in 2009 amid more than $14 billion in debt and huge downturns in consumer spending and real-estate values. But MGM muddled through. In March, it extended maturities on more than $4 billion of a credit line to 2014 from 2011. It also sold $845 million in senior secured notes to repay some of that bank debt.
Moody's upgraded MGM's credit rating in March, but the casino operator remains in risky territory. It still has over $13 billion in long-term debt. "We believe that we have sufficient liquidity to address our upcoming debt maturities," said MGM's finance chief, Dan D'Arrigo.

View Full Image

MGM Resorts recently posted a wider second-quarter loss, but it has still been able to refinance debt at lower interest rates. Above, a monorail runs between hotels at MGM's CityCenter in Las Vegas.

Rite Aid has been mired in red ink for the better part of three years. But the drugstore chain has managed to survive by cutting costs and just raised $650 million in secured bonds at an interest rate of 8%. The use of the proceeds: repaying a $648 million bank loan due 2015. Rite Aid also pushed out the maturity of a credit line to 2015 from 2012 and got better pricing.

The company's stock trades under $1 and maintains a weak credit rating that suggests it is at high risk for defaulting. The company didn't respond to requests for comment.

Risks aside, Investors are only too happy to do these deals, as they search for higher returns amid low yields on safer paper.

"All these companies don't have the cash flow to pay off all their debt, but they were never expected to," said Russ Morrison, a bank-loan fund manager at mutual fund Babson Capital. "They were expected to gradually pay it down and delever. Those things are just standard in this market."

Blockbuster Inc. shows how overconfident investors could be left holding the bag. Last fall, the movie-rental chain tapped the booming high-yield market to raise $675 million in new senior bonds. Investors enticed by the debt's 11.75% yield helped Blockbuster raise about twice the funds originally sought. The company used the money to eliminate its bank debt.

But Blockbuster continues to lose money amid intense competition from movie-kiosks operated by Coinstar Inc.'s Redbox and Netflix Inc., which mails DVDs and streams movies online. Today, its senior bonds have lost more than half of their value, and the company is warning it may have to file for Chapter 11 bankruptcy protection, or in the worst case, liquidate. Blockbuster declined to comment.

Other firms have defied the odds. In 2006, private-equity firms saddled hospital operator HCA Inc. with huge debt in a $31 billion leveraged buyout. In March, HCA pushed out the maturity on $2 billion of its bank debt to 2017 from 2013 and sold $1.4 billion in bonds to eliminate other bank obligations. Today, HCA is mulling a public offering of its shares.

Many companies, including Harrah's Entertainment Inc. and Unisys Corp., have avoided bankruptcy with distressed-debt exchanges. In these deals, companies often ask investors to retire current debt for new debt that matures later with sweetened terms, equity, or a combination of both. These deals can also feature debt buybacks.

Energy Future Holdings Corp., the former TXU acquired in a record $45 billion 2007 buyout by private-equity firms KKR and TPG Inc., recently said it would exchange $3.6 billion in notes for $2.18 billion of new notes and $500 million in cash. Despite that and other recent deals to chip away at debt, Fitch Ratings downgraded Energy Future two notches, noting it has $22 billion in debt due in 2014. Energy Future declined to comment.

Write to Mike Spector at mike.spector@wsj.com and Michael Aneiro at michael.aneiro@dowjones.com

July Durable Orders

Highlights

• The advanced durable goods report would suggest that manufacturing activity is headed for a slowdown in the coming months as durable goods orders increased only 0.3% in July.
• The Briefing.com consensus expected orders to increase 3.0%.
• Orders excluding transportation fell 3.8%, well below the consensus forecast of 0.5% growth.

Key Factors

• Volatility in aircraft orders over the past several months has made movements in durable goods orders difficult to track, and July proved no different. After declining 25.3% in June, aircraft orders increased 75.9% in July. The jump in demand for aircraft kept the headline orders growth level in the black.
• Excluding transportation, the growth pattern in production has been much more stable since October 2009. Since then, manufacturing orders have fallen in the first month of the quarter before rebounding during the next two months.
• This pattern held in July.
• The only difference this month from the previous quarterly trends was the size of the drop. Orders fell at the fastest rate since January 2009 and it would take a much more sizable increase in orders over the next two months to pull it back into positive territory for the quarter.
• Business investment has also followed this trend since October.  In July nondefense capital goods orders excluding aircraft fell 8.0%. We expect orders to rebound next month.
• Shipments of nondefense capital goods excluding aircraft were revised up from 0.5% to 1.0% in June. This should give a slight positive bump to the second quarter GDP revisions.

Big Picture

• Durable goods order trends have been extremely postive since late 2009. That reflected a revival in consumer demand and lofty expectations for continued consumption growth. While bank credit remains tight, large firms have been able to take advantage of low yields by issuing their own debt for capital purchases.

Category	JUL	JUN	MAY	APR	MAR
Total Durable Orders	0.3%	-0.1%	-0.7%	2.9%	0.1%
Less Defense	0.3%	0.2%	-0.6%	3.4%	0.0%
Less Transport	-3.8%	0.2%	1.4%	-0.9%	4.9%
Transportation	13.1%	-1.1%	-6.6%	15.4%	-13.2%
Capital Goods	-2.7%	0.2%	-0.8%	6.3%	-5.7%
Nondefense	-2.8%	1.2%	-0.4%	8.1%	-6.7%
Nondefense/nonaircraft (core cap gds)	-8.0%	3.6%	4.7%	-2.8%	6.7%
Defense Cap Goods	-2.2%	-5.6%	-3.4%	-3.1%	0.0%

S&P 500 Index Dividend Yield vs 10y Bond Yield, PE vs Interest Rate

Not Bull, Not Bear: Meet the Wolf Market

By KRISTINA PETERSON

'A wolf is clearly a smaller animal than a bull or a bear,' said phrase coiner Michael Purves, 'but it's very quick and decisive.' Here, a tame wolf in the village of Nadbiarezha, north of Minsk, Belarus

NEW YORK—Out of the quest to accurately describe hybrid concepts came the spork, brunch, pluot and mule. One investor's struggle to characterize the U.S. stock market's recent twists and turns led to new market terminology.

Welcome to the "wolf" market.

The wolf market is characterized by a tight trading range, increased volatility, high stock correlations and quick reversals, said its coiner, Michael Purves, chief global strategist and head of derivatives research at BGC Financial. Choppy trading makes it hard to pick stocks based on fundamental qualities, leaving shorter-term options and technical analysis better tools for navigating its bounces, he said.

"I was walking around the block one night and thought, you know, we need another animal," Mr. Purves said. "A wolf is clearly a smaller animal than a bull or a bear, but it's very quick and decisive."

Mr. Purves dates the start of the wolf market to late April although its origins reach further back, he said. In the rally from the March 2008 lows, investors priced in expectations of a faster recovery than has yet materialized. The market has struggled to find direction, balancing the drag from the late spring European sovereign-debt crisis and the recent slew of lackluster economic data with the more encouraging second-quarter earnings. That has left trading trapped in a tight range, subject to sharp ups and downs.

On the bearish side, Mr. Purves doubts the Standard & Poor's 500 index will be able to break above its April high of 1225 by the end of the year. But bulls can point to strong second-quarter earnings and demand from growing economies such as China, keeping a floor around 1010 in the S&P 500, he predicted. Meanwhile, the CBOE Market Volatility index, known as the market's fear gauge is likely to stay elevated between 25 and 35 for longer than normal. The VIX closed Friday at 25.49.

Of course, low volume during August trading has exacerbated market swings. Monday's trading volume was the lowest of the year and isn't likely to substantially increase until September.

"This is a market that's trying to feel its way and it's feeling its way during an extremely slow period in which many folks are out on vacation," said Robert Pavlik, chief market strategist at Banyan Partners. "We've obviously exited the recession, but people are still nervous about the conditions."

With stocks trading closely together as macroeconomic issues dominate the market, investors are relying more heavily on technical analysis, Mr. Purves said. In part, the rise of algorithmic trading already has made the market's moves more closely tied to technical triggers. Also, an environment where interest rates are close to zero makes cash-flow analysis of companies difficult.

"In the absence of something else, technicals loom larger," Mr. Purves said. He also advocates turning to options to make shorter-term bets in a murky market.

The wolf market may be here to stay, at least until the economic recovery accelerates or another catalyst prompts the market to find footing. Mr. Purves believes the wolf market will last into 2011.

"It's going to take a long time to reverse to a classic economic cycle," he said.

Write to Kristina Peterson at kristina.peterson@dowjones.com

Credit-Card Rates Climb

Levels Hit Nine-Year High as New Rules Limiting Penalty Fees Help Fuel Rise

By RUTH SIMON

Interest rates continue to tumble for the U.S. Treasury, companies and home buyers alike. But for a large portion of 381 million U.S. credit-card accounts, borrowing rates have been moving only one way: up.

New credit-card rules that took effect Sunday limit banks' ability to charge penalty fees. They come on top of rule changes earlier this year restricting issuers' ability to adjust rates on the fly. Issuers responded by pushing card rates to their highest level in nine years.

In the second quarter, the average interest rate on existing cards reached 14.7%, up from 13.1% a year earlier, according to research firm Synovate, a unit of Aegis Group PLC. That was the highest level since 2001.

Those figures look especially stark when measuring the gap between the prime rate—the benchmark against which card rates are set—and average credit-card rates. The current difference of 11.45 percentage points is the largest in at least 22 years, Synovate estimates.

By comparison, the spread between 10-year Treasurys and a standard 30-year fixed-rate mortgage is just 1.93 percentage points, near historical averages, according to mortgage-data provider HSH Associates.

The moves are driven by a combination of forces. The Credit Card Accountability Responsibility and Disclosure Act of 2009 has given card issuers less flexibility to raise interest rates as they wish. At the same time, issuers are still dealing with credit-card delinquencies that remain above historical levels.
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Editors' Deep Dive: Credit-Card Firms Move Beyond New Rules

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"The rules have changed and the goalposts of risk have changed," says Paul Galant, chief executive of Citigroup Inc.'s Citi Cards unit.

Banks used to boost rates in a hurry on borrowers who fell behind on payments or otherwise turned out to be surprisingly risky. However, under the Card Act, financial institutions must warn customers at least 45 days before making substantial changes to rates or fees. People can avoid future rate increases and pay off existing balances over time.

As a result, most changes affect only new credit-card purchases. New rules that took effect Sunday limit what banks can collect in penalty fees, too.

Now bank executives say they need to be smarter when setting the initial interest rates on credit cards. In many cases, that means starting off with a higher rate. "We can't come up with penalty pricing or if we can, quite frankly, it's too late to do much good," says Stephanie Keire, head of consumer credit-card risk management at Wells Fargo & Co.

The sponsor of the Card Act, Rep. Carolyn Maloney (D-NY), said that despite the rising rates, the law benefits consumers because it eliminates unwelcome surprises and provides them with a clear picture of the costs they will face. "Better that consumers should know up-front what the interest rate is, even if it's higher, than to be soaked on the back-end by tricks and hidden fees."

At Discover Financial Services, a diminished ability to boost rates is causing the Riverwoods, Ill., company to offer fewer interest-free balance transfers for new customers, says Discover President Roger Hochschild. Balance transfers have declined 60% from last year. A typical offer might include 0% interest on the transferred amount for a year, with customers paying a balance transfer fee.

More increases are looming as card issuers respond to the new penalty-fee limits, says Ken Paterson, vice president of research at Mercator Advisory Group.

Many banks rushed to boost rates before limits on increases for existing customers took hold in February. Some lenders have recently raised rates for new borrowers. For example, Capital One Financial Corp. in June increased the rate on its Classic Platinum for Young Adults card by 2.9 percentage points from the previous 16.9%, and increased the rate on its No-Hassle Cash Rewards card by 1.9 percentage points.

In May, Wells Fargo & Co. increased the interest rate on new Cash Back Home Rebate, Platinum and College cards by one percentage point. Citigroup boosted the minimum rate on its Platinum elect card by two percentage points in July. The higher rates apply to new accounts.

Besides raising, rates, increasingly stingy lenders are revamping some of their underwriting techniques. Banks are relying more heavily on what is known as trend analysis to determine which borrowers are showing signs of improvement or weakness in their financial condition, says Steven Wagner, president of Experian PLC's Consumer Information Services unit.

A credit-card applicant might be considered too risky if he used much of his existing credit in recent months. That could increase the chances that the borrower might be denied a new card or charged a higher rate.

Some issuers want to better use their data on existing customers. Bank of America Corp. says its move in March to merge its deposit-gathering and credit-card units was aimed partly at weighing existing relationships with the Charlotte, N.C., company more heavily in credit decisions.

Bank of America now is more likely to offer customers with large deposits at the bank a lower rate, higher credit limit or better rewards than similar borrowers it knows less about.

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Getty Images

New credit-card rules that took effect Sunday limit banks' ability to charge penalty fees. Above, a woman uses a credit card to pay for fuel.
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Meanwhile, lenders are quicker to reduce credit lines at the first signs of financial stress, including late payments on other bills, a pay cut and unemployment. Several large U.S. banks have begun parsing employment and income data for changes that could affect the riskiness of existing customers, says John Cullerton, vice president at Equifax Inc. He declined to name the lenders.

In an effort to better manage risk, card issuers are handing out less credit, too. The credit limit on new bank cards averaged $3,923 in May, the latest month for which data are available, according to Equifax. That is down 11% from an average of $4,422 a year earlier.
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* Earlier: The New Credit-Card Tricks

Rising interest rates on many credit cards won't necessarily lead to more profits for issuers. "The interest-rate increases are designed to improve and protect profitability," says John Grund, a partner with First Annapolis Consulting Inc., but stubbornly high delinquencies and Card Act curbs will eat into those gains, at least in the short term.

Most cards now carry variable rates, meaning any increase in the prime rate is likely to be quickly passed along to borrowers. "Consumers will end up getting squeezed" when the Federal Reserve begins to raise rates as the economy recovers, says Ben Woolsey, director of marketing and consumer research at CreditCards.com.

Still, some bank executives say the interest-rate trend is likely to reverse as the U.S. economy recovers. "This is a very competitive industry," says Kenneth Clayton, senior vice president at the American Bankers Association, a trade group. "Somebody will take advantage of lower defaults to drive prices down."

Write to Ruth Simon at ruth.simon@wsj.com

Preparing for the Next 'Black Swan'

After a decade-long bear market and two years of turmoil that saw the stock market plunge by 57%, investors are betting on still more financial pain in the months ahead.

Bond yields are near record lows. Gold continues to soar. And stocks are whipsawing as traders try to predict the direction of an economy that remains, in the words of Federal Reserve Chairman Ben Bernanke, "unusually uncertain."

But not every investor is trembling with anxiety over the next financial blowup. Some are embracing the market's volatility—and constructing portfolios to profit from it.

A growing number of money managers and financial firms are rolling out investment products designed to exploit big declines known as "black swan" events. Most of the products are geared toward institutional investors such as pension funds, endowments and high-net-worth families—but black-swan strategies are trickling down to Main Street as well.

The term black swan was popularized in a 2007 best-selling book by author and investor Nassim Nicholas Taleb. It derives from the ancient belief, once widespread in the West, that all swans are white—a notion that was proven false when European explorers discovered black swans in Australia.

The gist: Anything is possible. In fact, big surprises are more common than people think.

In financial terms, a black swan usually results in drastic moves in the market—events such as the 1990 Iraqi invasion of Kuwait, the Sept. 11, 2001, terrorist attacks and the recent financial crisis. Statisticians call these events "fat tails" (because they occur on the fringes, or tails, of a bell curve), while professional investors try to manage their "tail risk."

The basic idea behind Mr. Taleb's black-swan strategy is to keep most of your money ultrasafe, and to bet a small portion—say 10%—on options contracts or other speculative bets whose prices will soar during a market panic.

The collapse of Lehman was a boon to black-swan investing. Funds run by Universa Investments LP, a Santa Monica, Calif., hedge fund managed by Mr. Taleb's longtime collaborator Mark Spitznagel, gained more than 100% in 2008. Mr. Taleb has been an adviser to Universa since it launched in 2007; its assets have swelled during that time to about $6 billion from $300 million.

Today, there are as many as 20 hedge funds specializing in tail-risk strategies, most of which have formed in the past 18 months, according to Hedge Fund Research Inc. Capula Investment Management LLP of London and Pine River Capital Management LP of Minnetonka, Minn., are among the firms that have started tail-risk hedge funds this year.

Some of these specialized funds aim to profit when markets tank. Others are designed to protect against a market plunge but still profit when markets rise. Investors don't typically put all of their money into these funds—but they are putting in more these days.

Retail investors are getting more access to black-swan-oriented strategies, too. Bond-fund giant Pacific Investment Management Co., or Pimco, has recently begun using tail-risk strategies in its Pimco Global Multi-Asset Fund, which launched in October 2008; in its RealRetirement target-date funds; and in its new equity funds launched this year. The firm also has filed a registration statement with regulators to offer exclusive "private placement" investments to well-heeled investors using tail-risk hedging strategies.

Some individual investors even are considering setting up black-swan portfolios of their own. "The 2008 downturn got me thinking that black swans can happen and will happen," says Justin McCurry of Raleigh, N.C. The 30-year-old transportation engineer says he is thinking of putting a small portion of his portfolio into options as a way to "limit downside or to pick up some extra money if things went crazy."
Black Swan (blak-'swan)


An unforeseen event that can wreak havoc on the financial markets.
-21%

1987 Stock-Market Crash

(10/16/87 – 12/4/87)
-16%

Iraqi Invasion of Kuwait

(8/2/90 – 2/28/91)
-12%

Sept. 11 Attacks

(9/10/01 – 9/21/01)
-19%

Implosion of Long-Term Capital Management

(7/17/98 – 8/31/98)
-46%

Collapse of Lehman Bros.

(9/12/08 – 3/9/09)
Spreading Your Bets

The old cure for extreme events was simple diversification: spreading your bets among a broad array of asset classes. But the financial crisis showed that asset allocation isn't always reliable when markets tumble in unison.

Diversification "works most of the time, but when it doesn't work, those times really kill you," says John Liu, who heads up Citi Portfolio Solutions, a newly formed unit at Citigroup Inc. dedicated to developing and managing tail-risk hedging strategies for institutional investors.

But black-swan investing has its risks, too. The biggest: When markets are behaving normally, the strategy can miss out on a rising stock market—even as costs add up.

That is because the strategy typically involves buying lots of out-of-the-money "put" options on everything from stock indexes and interest rates to currencies. Put options confer the right to sell the underlying instrument if the price falls to a certain level. Because they offer protection, their values soar during market panics, producing big profits for the holders. But if the market doesn't plunge, the options expire worthless, and the investor must buy new options to replace the old ones.

If markets hold steady or rise for long periods, those costs can add up. During the stretch from late 1990 to early 2000 there wasn't a single bear market, commonly defined as a 20% or greater fall from the peak. An investor using a pure black-swan strategy would have missed out on one of the greatest bull markets in history.

Another risk: Because black-swan events are so unpredictable, the markets' reactions to them can be equally unpredictable. Just because an approach worked last time doesn't mean it will work in the future. Some of the new products launched in the past two years might not perform well under duress.

And Wall Street is always happy to cater to investors' bullish or bearish whims, so long as it can charge fees. "Whenever an investment company tells you that they've come up with a product that can protect you from black swans, you should hold onto your wallet," says William Bernstein of Efficient Frontier Advisors.

Despite the risks, a growing number of professional investors are diving in, whether to protect against a plunging market or to profit from one. Brett Barth, a partner of BBR Partners LLC, a multifamily office in New York, in June started investing client money in Pine River Capital's Nisswa Tail Hedge Fund. "For what we expect to lose on the premium we're spending, we expect to get a big payoff in a tail-risk event," Mr. Barth says.

Similarly, Brinton Eaton, a wealth-management firm in Madison, N.J., earlier this year began using a structured product from Deutsche Bank AG called "Emerald" to reduce its black-swan risk. The instrument, which uses derivatives tied to an index such as the Standard & Poor's 500-stock index, typically does better in periods of higher volatility. It is designed to post small returns in most markets, says Jerry Miccolis, Brinton's principal and chief investment officer. "But in very dramatic times, that bet gets amplified."

Ordinary investors are seeking out black-swan investing opportunities as well. Pimco's Global Multi-Asset Fund, launched in 2008, has attracted $2.3 billion in assets so far despite its hefty fees for retail investors, including a 1.91% levy for its Class A shares.

Kent Smetters, a risk-management professor at the University of Pennsylvania's Wharton School and president of Veritat Advisors, a Philadelphia-based online financial-planning firm, is working with financial advisers to bring tail-risk strategies to retail investors in a lower-cost mutual-fund vehicle by early next year. "Turbulent markets also provide lots of opportunities," Mr. Smetters says.

Investors wary of paying fees to mutual-fund managers can implement their own tail-risk strategies. In "The Black Swan," Mr. Taleb recommends a "barbell" strategy in which investors put 85% to 90% of their portfolios in extremely safe instruments, like Treasury bills, and the remaining 10% to 15% in highly speculative bets such as options.

That strategy is designed to lose a little bit during most years and to profit handsomely when markets tank. The key to the barbell strategy is knowing what your maximum loss is and being comfortable with it, says Mr. Spitznagel, who has been managing tail risks for more than a decade. Before founding Universa, Mr. Spitznagel and Mr. Taleb ran another black-swan hedge fund, Empirica Capital, from 1999 to 2004.
Participating in Rallies

To some investors, Mr. Taleb's model might seem extreme. One alternative is to use a hedging technique designed to allow investors to participate in rallies while staying protected during black-swan crashes. "When you eliminate your upside, you really get hammered over time," Mr. Smetters says.

His strategy aims to limit losses to 10% in a market crash but also allow for significant upside potential. To do that, he builds a type of "zero-sum collar" that uses a combination of put options to limit losses and call options to take advantage of the upside. (Whereas puts give investors the right to sell a particular security at a predetermined price, calls give investors the right to buy.) As the market rises, Mr. Smetters says, he cashes in the small gains from the call options and purchases new ones.
[Blackswanjump]

A similar hedging approach involves buying protective puts on stocks you already own in your portfolio. Say you own shares of International Business Machines Corp., which are trading at about $127. For about $7.60 you could buy a put that allows you to sell the stock if the price falls to $125 at any point in the next five months. That put would likely soar in value during a market rout.

Citigroup's Mr. Liu says investors who want to hedge for a black-swan event can usually keep their existing asset allocations in place as long as they are willing to spend 0.5% to 1% of their portfolio's expected return on the protection.

The Pimco Global Multi-Asset Fund, meanwhile, aims to limit potential losses in any one year to 15% while still participating in market rallies. Co-manager Vineer Bhansali says he tries to keep hedging costs between 0.50% and 0.75% of assets.

The portfolio itself seems fairly conventional. At the end of June, it held 45% in equities, 29% in developed-markets cash and bonds, 13% in emerging-markets bonds and 13% in real assets like commodities and gold, says Kevin McDevitt, mutual-fund analyst at Morningstar Inc.

Pimco doesn't spend a lot of time forecasting what the black swans might be, Mr. Bhansali says. Instead, it looks at "pressure points" in asset classes that have "gotten substantially out of whack," and buys the cheapest protection possible, from puts and calls on stock indices to options on interest rates and currencies.

Of course, it takes a lot of diligence for ordinary investors to trade puts and calls on a regular basis. Those trades can be especially tough to swallow when markets are going up and options are expxiring worthless.

"It's very difficult for traders to engage in a strategy that does very little in the vast majority of markets," Mr. Spitznagel says.

Unlike most investors, he says, "We are prepared to wait a very long time to get a black swan." He adds: "I do happen to believe that more panic is looming."

Write to Jane J. Kim at jane.kim@wsj.com

July Leading Indicators

Highlights

• The Conference Board's Leading Indicators Index rebounded back into positive territory in July after a one-month contraction in June.
• The index increased 0.1% in July after falling 0.3% in June. The Briefing.com consensus called for the index to increase 0.2%, though.

Key Factors

• Since seven out of the 10 index components are known prior to the release, the slight downward surprise will probably not result in any market reaction.
• Of the three estimated components, orders of nondefense capital goods excluding aircraft (+0.01%) was the only component to post a positive contribution to the index. Consumer goods orders had no effect on the index while M2 declined 0.08%.
• The index would have been much stronger if not for a strong drop in July's consumer confidence reading. The rebound in the preliminary reading in August will drive the Leading Indicators Index higher next month.

Big Picture

• The leading indicator index does not provide much information on where the economy is headed. It is composed of 7 key economic variables that are known prior to the release and 3 estimated components. Therefore, the only differences between the actual indicator and the consensus is due to the estimation techiniques for money supply, new orders of nondefense captial goods, and new orders for consumer goods. Usually the differences between the leading indicator estimates and consensus estimates for these variables are minor and do not effect the overall index.

Category	JUL	JUN	MAY	APR	MAR
Total Index	0.1%	-0.3%	0.5%	0.0%	1.4%
Manufacturing Workweek	0.07%	-0.33%	0.20%	0.13%	0.33%
Initial Claims	0.05%	-0.05%	-0.01%	-0.08%	0.14%
Cons. Gds Orders	0.00%	0.01%	-0.09%	-0.02%	0.21%
Vendor Performance	0.07%	-0.26%	-0.02%	-0.26%	0.27%
Nondef. Cap Gds Orders	0.01%	-0.04%	-0.01%	0.15%	-0.13%
Building Permits	-0.08%	0.04%	-0.16%	-0.30%	0.14%
Stock Prices	-0.01%	-0.14%	-0.23%	0.14%	0.21%
Real M2	-0.08%	0.16%	0.34%	-0.11%	-0.13%
Interest Rate Spread	0.30%	0.32%	0.34%	0.39%	0.38%
Consumer Expectations	-0.22%	0.03%	0.07%	-0.04%	-0.01%

Release Details

Leading Indicators

• Importance (A-F): This release merits a C-.
• Source: The Conference Board.
• Release Time: 10:00 ET around the third week of the month for the month prior.
• Raw Data Available At: http://www.tcb-indicators.org/.

In Brief

The Leading Indicators report is, for the most part, a compendium of previously announced economic indicators: new orders, jobless claims, money supply, average workweek, building permits, and stock prices. Therefore, the report is extremely predictable and of very little interest to the market. Though this series does have some predictive qualities, it is a common criticism that it has predicted "nine of the last six" recessions.
The Commerce Department previously published the leading indicators series. The collection and publishing of these data is now done by the non-profit Conference Board, which also produces the Consumer Confidence index.

In Depth

Purpose
The purpose of the leading index is straightforward: It is designed to signal turning points in the business cycle.
Composition
The index of leading indicators includes the ten economic statistics listed below.

1. The interest rate spread between 10-year Treasury notes and the federal funds rate.
2. The inflation-adjusted, M2 measure of the money supply.
3. The average manufacturing workweek.
4. Manufacturers' new orders for consumer goods and materials.
5. The S&P 500 measure of stock prices.
6. The vendor performance component of the NAPM index.
7. The average level of weekly initial claims for unemployment insurance.
8. Building permits.
9. The University of Michigan index of consumer expectations.
10. Manufacturers' new orders for nondefense capital goods.

The Conference Board, the organization that produces the leading index, standardizes these variables according to their individual weights in order to construct a composite leading index. Note that we have listed the components in order of importance. The difference between 10-year Treasuries and the fed funds rate carries the most weight; historically, this approximation of the slope of the yield curve has proven relatively more successful than other components at predicting future economic activity. Along those same lines, orders for nondefense capital goods carry the smallest weight because they have typically proven relatively poorer at pointing to changes in the direction of economic growth at large.
Performance
The leading index receives plenty of criticism. Indeed, skeptics often joke that it has correctly signalled nine of the last six recessions. Meanwhile, in its literature, The Conference Board cites the lead times with which the leading index has correctly predicted economic downturns. It is thus fair to ask whether the leading index is useless or priceless.
The answer lies somewhere in between. The charge that the index predicts recessions that do not come to fruition--and fails to warn of those that do--is hardly a fair criticism. No forecaster, even armed with an arsenal of economic statistics, has a perfect track record when it comes to predicting recessions. It is therefore unreasonable to assume that a ten-component index can do any better. That said, the index does have some reliability problems. For example, it failed to turn down prior to the 1990-91 recession, and in 1995 it signalled a downturn that never came to pass.
Usefulness
The leading index is more useful now that The Conference Board has taken control of it (the Department of Commerce stopped producing it at the end of 1996). Conference Board researchers quickly scrapped two of the old components--the change in sensitive materials prices and unfilled orders for durable goods--and added the interest-rate spread that appears in our list above. The index now lacks a wholesale price term, which some see as critical to determining future demand and inflation trends, but on net the new index emits less pronounced false signals and does a better job than it used to.
Briefing finds the leading index most helpful when we can make a statement like this: The leading index has decreased only once during the past year. Of course, even a strong trend like that does not guarantee that a recession will not form over the coming six to nine months. But we can get additional help from looking at the leading index with the coincident index, which is also published by The Conference Board, and alongside a couple of other leading indices published by Columbia University. Indeed, there exists much research that deals with the criteria for determining recession warnings (i.e., the leading index must fall during four of seven months and the

The Great American Bond Bubble

If 10-year interest rates, which are now 2.8%, rise to 4% as they did last spring, bondholders will suffer a capital loss more than three times the current yield.

By JEREMY SIEGEL AND JEREMY SCHWARTZ
Ten years ago we experienced the biggest bubble in U.S. stock market history—the Internet and technology mania that saw high-flying tech stocks selling at an excess of 100 times earnings. The aftermath was predictable: Most of these highfliers declined 80% or more, and the Nasdaq today sells at less than half the peak it reached a decade ago.

A similar bubble is expanding today that may have far more serious consequences for investors. It is in bonds, particularly U.S. Treasury bonds. Investors, disenchanted with the stock market, have been pouring money into bond funds, and Treasury bonds have been among their favorites. The Investment Company Institute reports that from January 2008 through June 2010, outflows from equity funds totaled $232 billion while bond funds have seen a massive $559 billion of inflows.

We believe what is happening today is the flip side of what happened in 2000. Just as investors were too enthusiastic then about the growth prospects in the economy, many investors today are far too pessimistic.

The rush into bonds has been so strong that last week the yield on 10-year Treasury Inflation-Protected Securities (TIPS) fell below 1%, where it remains today. This means that this bond, like its tech counterparts a decade ago, is currently selling at more than 100 times its projected payout.

Shorter-term Treasury bonds are yielding even less. The interest rate on standard noninflation-adjusted Treasury bonds due in four years has fallen to 1%, or 100 times its payout. Inflation-adjusted bonds for the next four years have a negative real yield. This means that the purchasing power of this investment will fall, even if all coupons paid on the bond are reinvested. To boot, investors must pay taxes at the highest marginal tax rate every year on the inflationary increase in the principal on inflation-protected bonds—even though that increase is not received as cash and will not be paid until the bond reaches maturity.
Today the purveyors of pessimism speak of the fierce headwinds against any economic recovery, particularly the slow deleveraging of the household sector. But the leveraging data they use is the face value of the debt, particularly the mortgage debt, while the market has already devalued much of that debt to pennies on the dollar.

This suggests that if the household sector owes what the market believes that debt is worth, then effective debt ratios are much lower. On the other hand, if households do repay most of that debt, then the financial sector will be able to write-up hundreds of billions of dollars in loans and mortgages that were marked down, resulting in extraordinary returns. In either scenario, we believe U.S. economic growth is likely to accelerate.

Furthermore, economists generally agree that the most important determinant for long-term economic growth is productivity, not consumer demand. Despite the subpar productivity growth reported for the last quarter, the latest year-over-year productivity growth of 3.9% is almost twice the long-term average. For the first two quarters of this year productivity growth, at over 6%, was the highest since the 1960s.

From our perspective, the safest bet for investors looking for income and inflation protection may not be bonds. Rather, stocks, particularly stocks paying high dividends, may offer investors a more attractive income and inflation protection than bonds over the coming decade.

Yes, we can hear the catcalls now. Stock returns calculated off the broad-based indexes have been horrendous over the last decade. In 2009, the percentage decline in aggregate dividends was the largest since the Great Depression. But remember the last decade began at the peak of the technology bubble.

Those who bought "value" stocks during the tech bubble—stocks with good dividend yields and low price-to-earnings ratios—have done much better. From December 1999 through July 2010, the Russell 3000 Value Index returned 35% cumulatively while the Russell 3000 Index of all stocks still showed a loss.

Today, the 10 largest dividend payers in the U.S. are AT&T, Exxon Mobil, Chevron, Procter & Gamble, Johnson & Johnson, Verizon Communications, Phillip Morris International, Pfizer, General Electric and Merck. They sport an average dividend yield of 4%, approximately three percentage points above the current yield on 10-year TIPS and over one percentage point ahead of the yield on standard 10-year Treasury bonds. Their average price-earnings ratio, based on 2010 estimated earnings, is 11.7, versus 13 for the S&P 500 Index. Furthermore, their earnings this year (a year that hardly could be considered booming economically) are projected to cover their dividend by more than 2 to 1.

Due to economic growth the dividends from stocks, in contrast with coupons from bonds, historically have increased more than the rate of inflation. The average dividend income from a portfolio of S&P 500 Index stocks grew at a rate of 5% per year since the index's inception in 1957, fully one percentage point ahead of inflation over the period. That growth rate includes the disastrous dividend reductions that occurred in 2009, the worst year for dividend cuts by far since the Great Depression.

Those who are now crowding into bonds and bond funds are courting disaster. The last time interest rates on Treasury bonds were as low as they are today was in 1955. The subsequent 10-year annual return to bonds was 1.9%, or just slightly above inflation, and the 30-year annual return was 4.6% per year, less than the rate of inflation.

Furthermore, the possibility of substantial capital losses on bonds looms large. If over the next year, 10-year interest rates, which are now 2.8%, rise to 3.15%, bondholders will suffer a capital loss equal to the current yield. If rates rise to 4% as they did last spring, the capital loss will be more than three times the current yield. Is there any doubt that interest rates will rise over the next two decades as the baby boomers retire and the enormous government entitlement programs kick into gear?

With future government finances so precarious, private asset accumulation and dividend income must become the major sources of retirement funding. At current interest rates, government bonds will not be the answer. One hundred times earnings was the tipping point for the tech market a decade ago. We believe that the same is now true for government bonds.

Mr. Siegel is a professor of finance at the University of Pennsylvania's Wharton School and a senior adviser to WisdomTree Inc. Mr.Schwartz is the director of research at WisdomTree Inc.

Beijing Opens Up On Bonds

By AARON BACK and JOY C. SHAW

BEIJING—China's central bank said it will widen overseas access to its domestic bond market as part of a program to promote the use of its yuan currency in international trade.

China has been promoting the use of yuan to settle trade transactions, while also trying to avoid rapid liberalization.



The trial program, announced Tuesday, will allow some yuan held offshore to be invested in China's interbank bond market, where most government and corporate debt trades and which is now largely off-limits to foreign investors. Opening up more channels for overseas investors is a key step in the internationalization of the yuan, a new priority for the Chinese government.


China has been promoting the use of yuan to settle trade transactions, while also trying to avoid rapid liberalization that could disrupt its carefully nurtured domestic financial stability. One of the hurdles it has faced is that the strict controls on funds moving in and out of China give companies outside China who are receiving yuan in payment few places to hold the currency. The new program would allow such funds to flow back into the local bond market.

While the sums involved are likely to be modest, the move shows how China's ambitions to make its currency more widely used internationally can also require it to dismantle some of the more stringent controls over its own financial system.

Ben Simpfendorfer, China strategist at Royal Bank of Scotland in Hong Kong, said the PBOC's latest move is a "small but important step" to internationalize the yuan.

"The amount of the yuan available abroad is in part determined by this yuan trading-settlement program. There's not a large pool of yuan liquidity [offshore] now, but that could change," Mr. Simpfendorfer said. "What they are doing is they are building a very strong foundation and the internationalization of the yuan could be a lot faster than we expected."

Foreign financial institutions that participate in the yuan-settlement program will be able to reinvest their yuan proceeds in the interbank bond market, giving them a channel to invest and maintain the value of their yuan holdings, the People's Bank of China said in a statement.

Economists have long anticipated that China would widen access to its domestic capital markets in order to accommodate the increasing size of the yuan-trade settlement program. According to figures from the central bank, the volume of trade settled in yuan under the program hit 48.66 billion yuan ($7.15 billion) in the second quarter, more than double the figure in the first quarter of the year.

China said in June it would expand its yuan settlement trial to most of the country, a total of 20 provinces. The program started in 2009, allowing companies in Shanghai and the southern province of Guangdong to use yuan when trading with companies based in Hong Kong, Macau and a handful of foreign countries.

Tuesday, Mark McCombe, chief executive of HSBC Hong Kong, a unit of HSBC Holdings PLC, predicted the moves would mean increased momentum for the liberalization of the yuan.

"Allowing relevant overseas institutions to invest in the interbank bond market can offer certain channels to maintain value of the yuan funds," the PBOC said in its statement on Tuesday.

The bond-market program is open to Hong Kong-based, Macau-based and foreign banks that participate in yuan settlement, as well as overseas central banks, the PBOC said.

The Hong Kong Monetary Authority welcomed the program, saying in a statement, "This will further promote the development of [renminbi] trade settlement in Hong Kong, and enhance the attractiveness of [renminbi] offshore business in Hong Kong."
—Liu Li and Andrew Batson in Beijing and Alison Tudor in Hong Kong contributed to this article.

Write to Aaron Back at aaron.back@dowjones.com and Joy C. Shaw at joy.shaw@dowjones.com

Bears Watching

THE TROUBLE WITH REALITY IS that it lacks heart and soul. It hasn't a flicker of interest in empathy, compassion, hope or any of the precious filigree of feeling that separates us from the brutes. To the exclusion of everything else, it embodies that old Dragnet mantra of "Just the facts, ma'am." Which more often than not makes it as popular on Wall Street as ants at a picnic.

And last week reality reared its uncompromising head and scared the daylights out of the stock market, choking off a promising rally and sending stocks plummeting. Reality's unwitting (only the incurably cruel would say witless) agent in this instance was Bernanke & Co.

For what issued from Tuesday's regularly scheduled rendezvous of the Federal Reserve's Open Market Committee was a somewhat grudging admission of the obvious: that the recovery was laboring and its pace "likely to be more modest in the near term than had been anticipated." And just to demonstrate that it was on the case, that august body announced it would fool around a bit with its swollen balance sheet by using the cash thrown off by existing holdings to buy long-term Treasury bonds

Investors were underwhelmed by the remedial action proposed by the Fed and thoroughly shaken by its admission that the recovery wasn't as advertised. On both scores, their reaction was eminently sensible.

The rejiggering by the Fed of its bloated portfolio mainly demonstrates, with interest rates at ground zero, how few and feeble are the options left to it to provide a jolt to the economy. And the acknowledgment, however weaselly the phrasing, that the recovery is losing traction, stoked immediate fears that, in truth, things are worse, maybe much worse, than the Fed perceives (to be kind) or is willing to admit (to be, well, realistic).

More telling than either the sotto voce concession that the economy isn't as buoyant as anticipated or the latest mostly-for-show effort to keep it shuffling along was a recent Reuters dispatch that a woman robbed a McDonald's in Oklahoma using a pair of men's underwear held in place by paper clips to hide her face. When a hard-working bandit can't scrape up a couple of bucks to buy a decent mask, you don't need Mr. Bernanke to inform you times are tough. The story neglected to say, incidentally, whose underwear it was and how the perp came into possession of it.

What's more, in just the past week or so, we've had a downpour of depressing news that even the most unobservant citizen of this fair land couldn't help being made aware of. For openers, there was the doleful July jobs report, followed by the unexpected rise in new weekly claims for unemployment insurance—to 484,000, the most since February.

And then, to make a sore point even sorer, the Bureau of Labor Statistics' Job Openings and Labor Turnover Survey (Jolts, to the cognoscenti) showed fewer company job offerings in June for the second month in a row. That's a discouraging portent that the current ratio of one job opening for every five people currently out of work isn't about to suddenly change for the better.

Retail sales in July, except for autos and gasoline—the former sparked by a bevy of promotional lures, the latter fueled by higher prices—were nothing to write home about. They were up 0.4%, but excluding autos and gas, they were down 0.1%. With employment still punk and housing still mired in foreclosures, which, according to the authoritative RealtyTrac, were up nearly 4% in July over the previous month, prospects for a serious rebound are not, to put it mildly, promising.

Unexpected and unsettling, too, was the Commerce Department's revelation that the trade deficit in June widened by a formidable $7.9 billion, to $49.9 billion, the biggest monthly jump since 1992, when the official numbers crunchers started keeping tabs, and the largest gap between exports (which declined) and imports (which gained heartily) since October 2008.

That was a downer on several scores. One was that exports had been one of the few bright spots in the recovery. And given the lackluster pace of sales, the rise in imports suggested a palpable portion of them were destined to wind up in already-hefty inventories.

No sooner did the less-than-inspiring trade data come out than estimates for second-quarter gross domestic product fell like dry leaves in autumn. The preliminary seasonally adjusted annual growth rate of 2.4% was shaved by pencil-wielding Street savants to as low as 1.3%. And the redoubtable John Williams, chief cook and bottle washer at Shadow Government Statistics, reckons there's fair chance that GDP in the current quarter could be negative.

Now, most of those richly paid economists (John and a handful of others are exceptions) are no better than Mr. Bernanke at divining the future. But that scramble to lower their estimates for GDP, both for the second quarter and for the second half of this year as a whole, suggests they, like the Fed chairman, felt an urgent need for a reality check.

No list of causes for investor fear and loathing would be sufficient without taking note that, Germany apart, reports of a brisk European recovery and with it the vanishing of the threat of sovereign-debt default appear to have been more than a little exaggerated.

On this score, even a permabull like MKM Partners' Michael Darda, who has been pretty much on the money in calling the stock market since it hit bottom in March '09, warns in his latest epistle that while short-term funding markets in Europe have shown some stability of late, "sovereign-debt spreads in the periphery have begun to widen again, a potentially threatening sign."

A tally by the World Bank dug up by our crack researcher Teresa Vozzo showed that in 2009, the U.S. chipped in $14.3 trillion and Europe $12.5 trillion of the $58.1 trillion of the global GDP (the only other significant chunks were accounted for by China's $4.9 trillion and Japan's $5.1 trillion). So investors quite properly have been worried by indications that all's still not quite well on the Continent.

And to contend that the so-called developing nations can blissfully "decouple" for any length of time from economic drag in the world's two biggest markets strikes us as the ultimate in wishful thinking, and all the more so with China's growth slackening, and Japan being Japan.

We don't think Armageddon is right around the corner (if we're wrong who'll be left to complain?). We do think it's imperative that every now and then, investors, by nature an upbeat group, step back and take a hard look at the way things—which emphatically includes the economy—really are. This is definitely one of those times.

SPEAKING OF DECOUPLING LEADS US to the heart-rending story of Mark Hurd and Jodie Fisher. In so many ways an intriguing tale that ended, as our quip-meister colleague, Randy Forsyth, put it, with Hurd on the street.

Mark Hurd, as you doubtless know thanks to expansive public notice and comment, is the recently defrocked CEO of Hewlett-Packard. We regret not having met Mr. Hurd, but we've been an admirer for the great job he did at HP after taking the reins from Carly Fiorina, who didn't quite wreck the company, but it wasn't for lack of trying.

Ms. Fiorina, we would be derelict in failing to note, is following a well-trod path of execs who were unstintingly rewarded for leaving the company still standing and decided to seek public office. She wants to be a U.S. senator, a reasonable desire considering, as the vast majority of that body illustrates, there are no qualifications necessary to become a member, although money helps.

But we digress. Ms. Fisher worked for Mr. Hurd as a corporate consultant (a title that covers a lot of sin). Aside from wearing a perpetual smile and looking pretty, it's hard to know exactly what her chores were, except apparently to be a gracious hostess at corporate parties for clients. Her qualifications include a resume as an actress, which, according to one film buff (or perhaps he's a connoisseur of films whose characters tend to run around in the buff) is "soft core adult" stuff, bearing (or is it baring) titles like "Body of Influence II" and "Intimate Obsession."

In any case, Mr. Hurd and Ms. Fisher seemingly worked amiably together, and Mr. Hurd, for reasons not articulated so far as we know, compensated her generously— even, it emerges, fudging his expense account to do so. And then one day, Ms. Fisher sued Mr. Hurd for sexual harassment.

And here the tale turns mysterious. For both Ms. Fisher and Mr. Hurd deny there was any sexual element in their relationship. Crude minds like ours naturally find sexual harassment without sex difficult to fathom.

Why, for heavens sake, didn't she sue for nonmarital, nonsexual harassment? Was she teed off at Mr. Hurd because he told her in a post-mortem discussion of one of those corporate hootenannies that she didn't smile enough? Moreover, Mr. Hurd settled the suit on terms all parties refuse to reveal. And Mr. Hurd agreed to pay HP back the $20,000 he had fudged to fatten Ms. Fisher's paycheck. And Ms. Fisher says she's sorry he was forced to resign because of little ol' her.

Since sex is out, just what did they do in the many evenings they spent together after work? Watch some of her old flicks? Or play chess, maybe?

中国允许境外金融机构投资银行间债券市场

国央行周二表示，为配合跨境贸易人民币结算试点，将允许部分境外金融机构投资中国的银行间债券市场。
拓宽海外投资者人民币资产的投资渠道是人民币国际化的重要步骤。中国一直在推进人民币在国际贸易结算中的应用，但如果海外投资者不能将所持人民币资产投资于中国多数市场，他们可能就不愿使用人民币，而是倾向于采用美元等主要国际性货币进行贸易结算。

Agence France-Presse/Getty Images
中国一直在推广使用人民币进行贸易结算，同时尽力避免快速实现人民币自由兑换。
经济学家此前预计，中国将拓宽国内资本市场的投资渠道，以适应规模不断扩大的人民币贸易结算项目。

中国央行发布公告称，允许参加跨境贸易人民币结算的境外金融机构投资银行间债券市场，可为境外机构依法获得的人民币资金提供一定的保值渠道。

汇丰(HSBC)在6月份的一份报告中写道，开发离岸人民币产品并拓宽海外投资者和企业的人民币投资渠道至关重要。否则，海外投资者和企业持有人民币及采用人民币进行贸易结算的意愿将减弱，在贸易额较高的情况下就更是如此。


中国央行的公告称，香港、澳门地区人民币业务清算行、跨境贸易人民币结算境外参加银行和境外中央银行或货币当局均可申请进入银行间债券市场进行投资。

公告显示，目前在国内银行间债券市场上交易流通的债券包括国债、政策性银行债券等十多个品种。

中国6月份表示，将把人民币跨境结算试点范围扩展至中国大部分地区，覆盖20个省、市和自治区。跨境贸易人民币结算试点工作在2009年展开，允许上海市和广东省在与香港、澳门和多个海外国家的公司进行贸易结算时使用人民币。

根据中国央行公布的数据，第二季度以人民币结算的贸易额为人民币486.6亿元（合71.6亿美元），较第一季度增加一倍多。

Treasury Premium Triples for U.S.’s Newest Bonds (Update3) March 2009

By Daniel Kruger and Dakin Campbell

March 16 (Bloomberg) -- Even in the world’s safest debt market, investors are paying triple the average premium for the easiest-to-sell securities as the 19-month credit-market freeze shows few signs of ending.

Buyers requiring only the newest, most-traded 10-year Treasuries are giving up about 0.4 percentage point of yield compared with older debt of similar maturity, according to Barclays Capital Inc., one of 16 primary dealers required to bid at government debt sales. Before the subprime mortgage crisis began in August 2007, the gap was about 0.13 percentage point.


Treasuries already lost 2.85 percent this year, according to Merrill Lynch & Co. index data, as the government accelerated bond sales to finance a federal budget deficit that President Barack Obama’s administration forecasts may expand to $1.75 trillion. Sacrificing returns for so-called benchmark bonds shows how skittish investors remain as financial markets deteriorate in the worst crisis since the Great Depression.

“It’s a pretty telling sign that things are not back to normal,” said Wan-Chong Kung, who helps manage $76 billion in fixed income at FAF Advisors in Minneapolis, the asset-management arm of U.S. Bancorp.

For investors who don’t need benchmark Treasuries, the older off-the-run securities, as they’re known to traders, are bargains, according to Kung.

‘Let Them Work’

The 8.875 percent 30-year bond that the government sold in February 1989 yields 0.4 percentage point, or 40 basis points, more than the current 10-year 2.75 percent note, which is the most comparable security and yields 2.89 percent, according to data compiled by Bloomberg. That amounts to about $40,000 a year in interest on a $10 million investment.

“I don’t expect instant gratification,” said Kung. “I set these high coupon guys on the side and let them work over time.”

Since July 2006, the yield gap, or spread, between benchmark and off-the-run 10-year securities has averaged 23 basis points, according to data compiled by the unit of London-based Barclays Plc. The average since September, when the seizure in credit markets intensified following the bankruptcy of Lehman Brothers Holdings Inc., is 46 basis points.

“It definitely represents value,” said Steve Rodosky, the head of Treasury and derivatives trading at Newport Beach, California-based Pacific Investment Management Co., which runs the world’s largest bond fund. “What you’re surrendering and what it’s a reflection of is market liquidity.”

Offers Refused

Once a new benchmark security is issued, older securities tend to trade less often, as seen in the difference between what traders are willing to pay for the bonds and the price at which holders will sell. The so-called bid-ask spread for the current 10-year note ended last week at 31.25 cents per $1,000 face amount, compared with 62.5 cents for the 8.875 percent bond, according to BGCantor Market Data.

Fifth Third Asset Management Chief Investment Officer Mitchell Stapley ran into a lack of buyers in December when he tried to sell off-the-run Treasuries that were trading in the 120s, or about $200 above their $1,000 face amount.

Dealers “just didn’t want to commit capital,” he said. “They were making me an offer I could easily refuse. We shouldn’t have to work this hard to sell an off-the-run Treasury. That should always remain one of those liquid portions of the market.”

JPMorgan Chase & Co. recommends buying off-the-run securities, betting that the difference in yields will narrow. Older securities “have remained persistently cheap,” JPMorgan strategists Srini Ramaswamy and Kimberly Harano in New York said in a March 9 research report.

Switching Focus

While the premium for benchmarks has increased from before the credit markets seized up, it’s down from 63 basis points in December, when investors drove U.S. government debt yields to record lows amid mounting losses in equity and credit markets.

Since the start of the year, investors have focused on the rise in Treasury sales as the Obama administration raises funds to pay for the $11.7 trillion bailout of the banking system, as estimated by Bloomberg calculations, and the $787 billion economic rescue package. The economy may contract 1.8 percent this year, after expanding 1.1 percent in 2008, according to a Bloomberg survey of 65 economists.

New York-based Goldman Sachs Group Inc., another primary dealer, estimates the U.S. will almost triple sales this year to a record $2.5 trillion.

Increasing Demand

Demand for the most liquid Treasuries is increasing as the plunge in financial markets worsens. While the Federal Reserve is pouring money into the banking system, the Standard & Poor’s 500 Index has lost 16 percent this year and corporate bonds are down 2.31 percent, Merrill indexes show.

At the same time, central bankers and Treasury haven’t been able to meet Fed Chairman Ben S. Bernanke’s goal of reducing consumer interest rates along with the borrowing costs paid by banks. The difference between rates on 30-year fixed mortgages and 10-year Treasuries was 2.15 percentage points on March 13, according to data compiled by Bloomberg. That’s up from an average of 1.75 percentage points in the decade before the subprime mortgage market collapsed.

“We still have an economy that’s deteriorating,” said David Coard, head of fixed-income trading in New York at Williams Capital Group, a brokerage for institutional investors.

Short-term borrowing costs are rising for financial institutions as they hoard cash following $1.24 trillion of writedowns and losses since the start of 2007.

High Rates

The London interbank offered rate, or Libor, that banks say they charge each other for three-month loans, crept to 1.33 percent last week from this year’s low of 1.08 percent on Jan. 14, the British Bankers’ Association in London said. The premium they charge each other for short-term loans as measured by the so-called Libor-OIS spread has remained above 1 percentage point since Feb. 19 after holding below that threshold in the prior five weeks.

The economy’s contraction has led to a reduction in the number of companies awarded the safest credit ratings. General Electric Co., based in Stamford, Connecticut, and Warren Buffett’s Berkshire Hathaway Inc. in Omaha, Nebraska, lost AAA grades last week. Five non-financial U.S. companies, including Microsoft Corp. of Redmond, Washington, now hold S&P’s AAA grade, down from more than 60 in 1982, the ratings firm said.

The extra yield investors demand to own below-investment grade debt as measured by Merrill is rising at the fastest pace since November on concern the longest recession since at least 1982 will push defaults to a record. Moody’s Investors Service expects the nonpayment rate to rise to 14.8 percent by year-end.

‘Little Wary’

“We’ve regressed a little bit here this month,” said Robert Millikan, who manages $5 billion as director of fixed income at BB&T Asset Management Inc. in Raleigh, North Carolina. “You’re still a little wary of everything.”

Primary dealers have reduced holdings of non-Treasury debt securities to $218.2 billion, within $7 billion of the lowest amount since March 2005, according to Fed data. At the same time, the amount of long-term Treasuries the firms held increased to $4.4 billion, approaching the record $15.7 billion in 1998.

All that means that investors will continue to pay premium for the securities they can sell whenever they need cash, said Thomas Sowanick, who manages $20 billion as chief investment officer of Princeton, New Jersey-based Clearbrook Financial LLC.

“Part of it is deleveraging and part is that Wall Street is still wounded,” he said.

To contact the reporters on this story: Daniel Kruger in New York at dkkruger1@bloomberg.net; Dakin Campbell in New York at dcampbell27@bloomberg.net.