Give The People What They Want

The Fed announced that it is easing 25 basis points (Fed Funds and Discount rate). The Fed expressed concern over inflation and stated that it believes that stimulus it has already injected into the economy will promote modest growth. However, the financial markets latched on to this:

"Recent information indicates that economic activity remains weak. Household and business spending has been subdued and labor markets have softened further. Financial markets remain under considerable stress, and tight credit conditions and the deepening housing contraction are likely to weigh on economic growth over the next few quarters.

Although readings on core inflation have improved somewhat, energy and other commodity prices have increased, and some indicators of inflation expectations have risen in recent months. The Committee expects inflation to moderate in coming quarters, reflecting a projected leveling-out of energy and other commodity prices and an easing of pressures on resource utilization."

It ignored the fact that the Fed left out the "downside risks remain" from the previous statement. Although the Fed may not be stating that it is pausing, it is hinting that it is getting near the end of its easing cycle.

To be fair to the market, the Fed's statement has me concerned as well. When it stated:

"Although readings on core inflation have improved somewhat, energy and other commodity prices have increased, and some indicators of inflation expectations have risen in recent months. The Committee expects inflation to moderate in coming quarters, reflecting a projected leveling-out of energy and other commodity prices and an easing of pressures on resource utilization."

it made me think the Fed doesn't understand why some commodity prices (food and oil) are higher (speculation and the weak dollar, not increased demand). However, a wave of sanity came over me and I realized, the Fed knows what is going on.

If it knows the true reasons why food and energy prices are higher, why is it playing dumb? The answer is the dollar. The Fed does not determine dollar policy. That is the domain of the treasury and, by extension, the President. Besides, the Fed knows that the majority of the increased demand comes not from the U.S., but from overseas.

Does this mean that the Fed is on the correct course? I hope so, but an increasing number of economists are joining my camp that the Fed should pause now. With American families having difficulty managing monthly budgets, rationing of various food stuffs and the Canadian government paying farmers to kill hogs rather than feed them to free up food crops, the current situation cannot exist forever. Look for oil below $100, a Fed pause and the long bind at 4.75 by the end of the third quarter. The interim period will be most interesting, however.

Join Together With The Band

An increasing number of experts and pundits are expressing the opinion that there is a dollar-fueled bubble in food and energy (and to a lesser extent, U.S. treasuries). The question is: what will the Fed do about it?

Judging by the street consensus, as measured by Fed Funds futures and various Wall Street polls, the Fed will probably cut 25 basis points and then pause. If only this were true (or better yet, the Fed pauses on April 30th). Unfortunately, I am not optimistic that "Helicopter Ben" will shed his moniker.

This does not mean that I am changing my opinion that shorting oil and long treasuries and going long bank and finance (equity and fixed income). Eventually the Fed must pause and then tighten. Since timing an absolute bottom is difficult and correctly doing so requires luck much more than skill, I have no desire to leave my fate to the agents of fortune. I am already long bank and finance and short long treasuries and oil. My God have mercy on my portfolio.

When The Truth Is Found...

The Personal section of today's Wall Street Journal discusses how to invest to beat inflation, other than buying very rich TIPs. One suggestion offered by the Journal are Corporate inflation adjusted notes (IPIs). The Journal does a fairly good job of explaining IPIs. Noted are IPI's illiquidity and credit risk. However, the Journal could have been clearer in explaing the inflation adjustment feature.

The Journal states that IPIs adjust using the year-over-year change of CPI as a benchmark. This is not exactly true. IT is not CPI, but the CPI Urban Consumer Index Non-Seasonably Adjusted or CPURNSA as a benchmark. This may sound nit-picky as they are similar inflation measures, but similar is not exact.

Here is the formula to derive the inflation component of an IPI's coupon.

It is the current month CPURNSA (usually a three month look back, so the bond is always lagging current data) minus a year ago CPURNSA divided by a year ago CPURNSA. This can be expressed as CPI1 - CPI13 / CPI13.

If one thinks about this for a minute one comes to a possibly troubling conclusion. That is, it is possible for inflation to be positive and have the coupon decline. This is possible if the year-over-year change, though positive, is less than the previous coupon. If the inflation rate was unchanged, ones coupon would consist only of the spread above CPURNSA. If we have deflation, the coupon can be as low as 0.00%. This, plus the fact that IPIs are small illiquid issues make them very poor bid for in the corporate bond market. It is not uncommon for a bond purchased at par one day to be bid at 92 the very next day. IPIs are buy and hold securities.

IPIs should be used as a part of a well-constructed fixed income portfolio as a hedge versus inflation and not as a way to make a quick buck. This may be especially true since we may be at the top of the inflation cycle.

A Little Bit of History Repeating

Investors never seem to notice bubbles until their portfolios are in shambles (and then they usually blame someone else). The tech bubble caught Main Street (and many on Wall Street) by surprise, in spite of the fact that the vast majority of so-called "dot-coms" never once approached profitability. The "new elite" claimed that all of us who who were concerned with what appeared to be flawed business models (with poor business plans) were considered to be Luddites who did not understand the "new economy." These avant garde investors soon learned that the new economy was still subject to old math. Of course it was President Bush's fault because he was in office when the economy officially fell into recession or it was Alan Greenspan's fault for changing Fed policy. It was never that most "dot-com" investments were garbage from the beginning.

Not much changed during the housing bubble. Almost anyone who could fog a mirror got a mortgage or mortgages to purchase over valued homes they could not afford. Of course it was the Fed's fault for keeping rates too low for too long (which it did), but the Fed did not twist borrowers' arms and force them to purchase unaffordable properties with poor borrowing vehicles. The Fed did not force lenders to write mortgages with little or now down payments or documentation. Truthfully, arrogant financial institutions thought that only a certain portion of borrowers would default and that they could securitize these dangerous loans in ways that appeared attractive to investors, and besides, they would be off bank balance sheets.

Now we have a bubble in U.S. treasury prices because the Fed has taken the Fed Funds rate too low and there is mass panic among investors. There are bubbles in TIPs and oil because of the weak dollar. A weak dollar which will miraculously strengthen once the Fed stops easing and eventually tighten.. Don't be surprise of your TIPs investment is down 10% (it could happen) and you get a negative return after, inflation, at maturity. Oil at over $119 per barrel practically screams bubble. As a fellow blogger friend of mine stated, if the real price of oil was this high, Wyoming Oil shale would be all the rage. In other words; if $119 was market-driven, instead of speculation-driven, capital would be spent to get oil out of shale in Wyoming (one of the world's largest oil deposits, but expensive to obtain).

In recent editions of the Wall Street Journal, many experts (one of which I am not) debate whether or not the slowing economy will result in lower fuel prices. It's the dollar folks. Strengthen the dollar, fuel prices will fall, all-in inflation will decrease, core inflation will rise, the Fed will tighten, long-term treasury yields will rise and credit spreads in the financial sector will fall.


In the interest of full disclosure I am making it known that I am short the long end of the treasury curve and am going long bank and finance fixed income.

I Have Become Comfortably Numb

It is official. I have become desensitized to the plight of troubled homeowners, distressed investors and beleaguered financial advisers. Basically, I have no sympathy for those who did not do their homework and got burned as a result. Here are three truths.

1) Adjustable rates mortgages can and do adjust higher.

2) Perpetual securities and securities with long maturities are just that. They are long-term investors. Call dates, auctions and other optional features should not be counted on.

3) Higher returns ALWAYS involve more risk (of some kind).

I also have no sympathy for commercial banks and investment banks who are being burned by subprime mortgages.

Banks deserve what they get for not doing their due diligence. Low documentation or no doc. loans (a la Rescap) are trouble. Who doesn't know that?

Investment banks who believed they could create safe vehicles backed by garbage collateral or other vehicles backed by garbage deserve their writedowns.

I have no sympathy for firms who, after being blown up by very brilliant quant mathematicians who have no financial markets experience. Using brilliant, but inexperienced math grads in the capital markets is like putting a rookie with a 100 mph fastball, but with no game experience, on the mound against the NY Yankees.

To make matters worse, Wall Street firms are still looking to hire the same people. A quick search on Bloomberg and EFinancial careers indicates that all firms want are new quants with better models. Management doesn't get it. Markets cannot be reduced to a formula.

Markets involve humans beings with human emotions such as fear and greed. Models and the computers on which they are run are logical. Market participants are not. I would rather have one trader with 20 years of experience than a team of rookie quants.

Why doesn't management get it? Because they are part of the Ivy League club.

Want to be successful in the fixed income markets? Be diverse. Don't jump in on every fad investment and know what you own.

Currently, CDs, government agencies, high grade corporates and preferreds (on the long end) are at home in most portfolios.

To some of my readers who are scared and confused: FNMA and FHLMC are AAA-rated, will remain AAA-rated and will not lose their implied government backing.

Get Over It

"I turn on the tube and what do I see a whole lotta people cryin' don't blame me. They point their crooked little fingers at everybody else. Spend all their time feelin' sorry for themselves. Victim of this, victim of that. Your mommas too thin; your daddys too fat." The Eagles - Get Over It".

Today's Wall Street Journal featured an excellent article, an interview with Alan Greenspan, in which he attempts to defend himself against acusations that he caused the housing bubble and financial system crisis. Although I am among those who believe he kept inetrest rates too low for too long, Mr. Greenspan did not react the way he did for no reason.

Lets go back to 2001. The U.S. was in or coming out of a mild recession caused by the burtsing of the tech bubble. We had the attacks of 9/11. Individuals and businesses went into panic mode. Pundits predicted more attacks and economic turmoil would be the result. Companies laid off workers, liquidity dried up and the Fed had to take the rare step of cutting Fed Funds and Discount rates in between FOMC meetings. Were things really that bad? No, not really, but many people were acting illogically.

Enter Mr. Logical, A.K.A Alan Greenspan. Mr. Greenspan knew he had to provide stimulus to get the economy over this illogical and irrational hump. His actions did help, but people were still acting illogically. No matter what stimulus Mr. Greenspan provided, job growth languished and politicos who relish a poor U.S. economy to forward their socialist agendas took full advantage of the situation (all this was caused by capitalism and Mr. Bush. The irrational and illogical behavior of the tech bubbles was, supposedly, irrelevant).

As the economy was unresponsive (or so it appeared), Mr. Greenspan lowered the Fed Funds rate to 1.00% in June 2003 and kept it there for one year (which we now know was too low too long). However, it was only too low too long because individuals, lenders and Wall Street all acted irresponsibly and, in the world of Alan Greenspan, illogically.

Never in Mr. Greenspan's logical mind did he think that consumers would be stupid enough to buy homes they could not afford (on a large scale). He could not imagine lenders writing mortgages for people who could not afford to pay them (or, even worse, did not ask borrowers to document their financial situation to prove that they could afford it). He never imagined that the rocket scientists on Wall Street would package portfolios of glow-in-the-dark loans into AAA-rated securities and that supposedly intelligent investors (including municipal finance officers, many who thus far, have been derelict in their duties in ensuring prudent investments for their constituents) would buy these things without knowing how they were constructed and what was contained within.

It is true that Mr. Greenspan's policies encouraged borrowing, but they were not responsible for bad behavior on the part of borrowers, lenders and investors. They are responsible for their own actions. They should suffer the consequences whenever it does not lead to another depression.

May The Schwartz Be With You

My heart bleeds for Bear Stearns CEO Alan Schwartz. Until today we had not considered Bear Stearns a victim. However, Mr. Schwartz points out that if the Fed had instituted aggressive liquidity facilities earlier, Bear could have been saved or at least have been sold for a more realistic price. Shame on you Ben Bernanke. It is all your fault for not saving Bear sooner.

I suppose it was Mr. Bernanke's fault that Bear was over thirty-times leveraged? I suppose it is Mr. Bernanke's fault that risk management and oversight was non-existent and that Bear management fiddled while Rome burned. Bear's counterparties became wary of Bear's ability to fulfill its obligations and walked away. How is this the Fed's fault? It isn't.

The bottom line is that Bear should never have been in this situation to begin with. Management and only management should be held responsible. Management is responsible for a firm's viability, not the Federal Reserve Bank!

Bear management is not alone. We are seeing problems at UBS, CIT, AIG and two large financial firms which report "earnings" this month. Management was derelict in their duties in all the aforementioned examples. If not for the ramification for the U.S. economy, the Fed should step back and let management work their ways out of this mess. Wait until CDS counterparty risk becomes a problem.

Mr. Schwartz, you are the problem. You had better thank heaven that The Fed and Jamie Dimon bailed your ass out as well as the have. Maybe Congress should investigate you and the intrepid Mr. Cayne.

Dr. Jimmy and Mr. Jim

UBS announced a $19 billion writedown. Deutsche Bank wrote down over $3 billion and investors reverse their flight-to-safety. Does this seem counterintuitive to you too? It was at me at first until I realized what was happening. The market was testing a bottom.

Notice I said testing a bottom, not that it had reached bottom. With more writedowns yet to come and two Wall Street giants set to report earnings, more volatility could be on the way, but there were some very positive signs.

First, Private Equity firm Blackstone Group announced that it will raise $10.9 billion to purchase real estate. This could signify that prices have fallen to the point that speculative money is entering the market.

Secondly, corporations are raising money in the capital markets and their deals are being well-received by investors. Several deals, including the much-maligned (buy short sellers) Lehman convertible deal, was oversubscribed.

Lastly, investors sold the heck out of way overpriced U.S. treasuries and moved into other areas of the market.

All this probably would have happened sooner if the housing market was permitted to find a bottom, but better late than never. A recovery right now would be a major disappointment to the nanny state crowd, but I digress.

Not all investors are on the right track. Today, I still fielded calls from brokers looking to buy TIPs or T-bills for their clients. This makes me wonder what on planet some brokers reside. T-bill yields are so low that one would need 1970s-style interest rates to make up the difference for buying T-bills at today's yields.

TIPs are even worse. Breakevens are so out of whack with cash treasuries, one would need Weimar-like inflation to make buying TIPs in this environment worthwhile. To make matters worse, TIPs are so rich that a possible bout of deflation down the road could result in losing money on TIPs, even if held to maturity.

What shoudl fixed income investors do? Ladder or barbell. Mix it up. Don't just use treasuries. Include agencies (not going away) corporates and preferreds. Start by weighting things on the short end. As short-term bonds mature, investors may be able to rebalance their ladder or barbell by investing at higher long-term rates. If rates do not rise, maintain the short-term overweigtht and be thankful that you locked in at higher rates (and wider credit spreads) farther out on the curve.

Credit spreads are another touchy subject with me. I still answer the same question over and over again: "Why did corporate bond and preferred yields rise when treasury yields fell?" Maybe if Wall Street firms actually educated their brokers in the way of product and market knowledge instead of "client care" clients would be better cared for?