Is This The Real Life?

The debate over inflation rages on. Some believe that inflation will continue to spiral out of control. Others believe that higher food and energy prices will keep overall inflation low by reducing consumer demand and it will all work out with little overall pain for U.S. consumers. Although I agree that higher food and energy prices will help hold down prices in other areas of the economy. Consumers will be squeezed if food and energy prices decouple from the rest of the economy.

In the past, price moves in nearly every sector of the economy were the result of increased or decreased domestic demand. The oil supply shocks of 1973 and 1979 are notable exceptions. During these periods, energy prices began to rise an inordinate amount versus prices in other sectors. However, at that time, companies had sufficient pricing power to raise prices to compensate and labor had enough leverage to win wage increase. This led to high broad inflation and high interest rates which led to stagflation.


Now, companies do not have the pricing power to easily increase prices and labor has little leverage to win wage increases. So is all well? Not hardly. During the past 25 years, the U.S. economy has thrived on leverage (borrowed funds) to thrive. Prices have outstripped wages by large margins, but cheap financing has enabled consumers to borrow to embark on a spending binge. Cheap financing has also caused real estate values to rise sharply enabling homeowners to use their homes as piggy banks. These days are now at an end.

The result is that not only are consumers not making discretionary purchases, many are having difficulty feeding their families in the manner in which they are accustomed. I see serious trouble ahead for U.S. consumers as they have little influence on energy prices and are unlikely to experience rising incomes.

Unless energy prices can be brought down, the U.S. economy will be stuck in a kind of twilight zone, not quite in recession and not quite in expansion. The easiest and most expediant course of action is to tap our domestic energy resources, but environmentalist are blocking this course of action. I am an environmentalist, but I am also a pragmatist and U.S. citizens come first.

What about oil speculators? Since oil prices have risen more than demand during the past year, there is likely to be a correction at some point. However, if oil falls beyond the mid $90 area ant any time in the future (unless more supply can be brought on line) I would be shocked.

What about interest rates? Look for long term interest rates to continue their recent rise. I would not be surprised to see the 10-year treasury note at 4.50% and the 30-year government bond at 5.00% by July 4, 2008.

What about short-term rates? They promise to stay historically low, but a bit higher than present levels. The Fed controls the short end of the yield curve and is not in a position to raise rates dramatically. Look for small increases by either late 2008 or early 2009.

What about a repeat of Paul Volcker's rapid rate increases to quash inflation? The Fed will have a difficult time doing this. Raising rates will not cause Americans to consume less food and energy, unless they become so destitute that they can't afford to subsist.

What about higher rates strengthening the dollar? That is likely to happen if and when interest rates on the intermediate portion of the yield cure reflect true inflation pressures. As this will probably happen, look for the dollar to strengthen modestly and for energy prices to stabilize or fall slightly, eventually. To help food prices, using ethanol as a fuel or fuel additive needs to be reconsidered.

What's Your Price For Flight?

There has been much discussion and anticipation regarding when higher food and energy prices would begin to filter through to so-called core sectors of the economy. The day of reckoning may be upon us.

Late this afternoon, Dow Chemicals announced that it will raise prices as much as 20%. This could put pressure on some of its customers (PG, Unilever, etc.) to do the same. This was reported by both the Wall Street Journal and Bloomberg News. Bloomberg News also reported that Hershey Foods was considering price increases.

The yield of the 30-year government bond topped 4.70% on inflation fears. It had been rallying when oil prices rose due to flights to safety. This correlation in no more. Inflation will not rise unabated unless the Fed permits it to do so (unlikely) Also, higher energy prices should result in reduced consumption (to some extent), increased incentive to tap other energy sources and reduced consumption of products and services whose prices are pushed higher which should limit inflation. In the meanwhile, look for the long bond to top 5.00% by Mid-July and a 4.50% 10-year note.

Financial stocks will take it on the chin, but rebound in 2009 as more writedowns and major shake-ups lie ahead. This is a golden opportunity for investors who can look outside the box and deal with some volatility.

Someone answer this question for me. Why aren't more investors buying extremely cheap municpals? They are trading with gross yields which are higher than corresponding treasuries.

Don't Let Me Be Misunderstood

Today the equity markets sold off, allegedly because of heightened inflation fears due to PPI numbers. These frightened investors were said to purchase U.S. treasuries, including long-dated U.S. treasuries. So we had the unusual phenomenon of long term yields falling due to inflation fears. This truly indicates that investor fear is driving the markets, at least in part.

It was fear and T. Boone Pickens which drove oil prices. Mr. Pickens predicted oil at $150 per barrel by next year. It was just three months ago that he predicted oil at $85. My how his book has changed.

I did a conference call with a branch office of a major investment firm. Again, the question came up asking when CDO prices recover, will firms take writeups. Many people mistakenly believe that CDOs are simply backed by subprime mortgages which will recover when the economy recovers. Not true.

Many (most) CDOs are backed, not just by mortgages, but by credit cards, auto loans, LBO loans, other CDOs and just about any piece of garbage that could have been squeezed into them. Some were "synthetic" CDOs backed by credit default swaps. These vehicles may eventually trade at better levels (some are not trading at all), but I have a better chance of becoming Queen of England than many CDOs have of trading at par or paying off to make investors whole.

Oppenheimer's Meredith Whitney predicted further writedowns and more pain for the financial sector. She will be proven correct. Not only will financial firms take more asset writedowns, but they will take charges making allegedly sophisticated investors whole for hedge fund investments which went sour. Too much bailing out and not enough accountability for my tastes. However, this is America in an election year. Everyone is a victim and no one gets hurt.

The Walrus Was Paul

Here’s Another Clue For You All. The Walrus Was Paul (Looking Through A Glass Onion)


Former Fed Chairman Paul Volcker (AKA the inflation slayer) expressed his concerns regarding the Fed’s independence, the amount and kinds of collateral the Fed has accepted as part of its liquidity programs and the Fed possibly being seen as a backstop for poor financial decisions.


Although he expresses concerns over the Fed’s role in rescuing the financial system and engineering a buyout of Bear Stearns, Mr. Volcker concedes that the Fed may have had little choice but to step in. He states: “I can understand why they felt they had to act. I can imagine they were faced with a problem and a very short time frame and worried about the contagion and loss of Bear Stearns."

Mr. Volcker comes down heavily on banking regulators. He asks the question: "Why were [the banks] permitted to set up those off-balance-sheet entities that may or may not have had some formal relationship with the bank? They were not regulated and [banks] didn't hold an adequate amount of capital against them. Why did that happen after the experience of Enron?"

The answer to that question is an easy one. When times are good, financial institutions make money. These off balance sheet vehicles generated large quantities of cash for institutions doing the securitization. Many of these SIVs had assets which were rated AAA. How dangerous could they be? Everyone believed the quantitative models. After all, the modelers in question were, literally, geniuses. Unfortunately, high degrees of intelligence were mistaken for infallibility. History is littered with the wreckage of such fallacies. Wall Street still has faith in the Quants. A search off Wall Street Job sites indicates that Quants are in the highest demand. We just need better models for “next time”.


It’s Getting Better All The Time

Today’s Wall Street Journal “Credit Markets” column discusses the recent spate of new bond issuance in the credit markets. Some companies have been taking advantage of a better credit market environment to issue debt for shareholder friendly activities such as share buybacks. There has been some investor interest in the high yield market, especially in the energy sector. Investors and banks are still shying away from LBO debt.


Investors who have been focusing on the financial sector may not realize that credit spreads in non-financial sectors are not nearly as wide as those in the financial sector. It is not uncommon to find a BBB-rated industrial trading with tighter spreads than A-rated financials.

Stop All The Dancing

Day in and day out we here pundits defend the price of oil being a function of supply and demand. We are told that speculation has little, if anything, to do with oil. However, when one looks at the price appreciation of other in-demand commodities, oil prices are far more inflated.

Let's look at the long end of the treasury curve. Tell me there isn't some speculating going on there. The long bond sells off due to a modestly positive (not that positive when one looks at the table and comments by Wal-Mart) advance retail sales report. Then it sells off, ostensibly because two Fed Presidents (Fisher of Dallas and Hoenig of KC) express inflation concerns. Gee, there was no unwinding of bets for a potentially poor Advance Retail Sales report and positioning for a potentially bad CPI report. CPI comes in tamer-than-expected, but only because of a change to the seasonal adjustment of energy and the inability of companies to pass prices increases on to consumers.

Finally, to all those "experts" who criticized Bernanke for engineering the Bear bailout. If he did not engineer the deal with JPM, there would have been a systemic failure. Lehman could have been the next failure and the entire street would have been negatively affected as one firm after another would have been unable to fulfill obligations to their counterparties. Anyone who has been involved in the Repo market knows what can happen when one firm fails to deliver. The entire street can fail to deliver the bond in question.

The futures market is now pricing in a 50% chance that begins tightening in October. Although that may be too soon. Look for the Fed to officially pause in June. Look for oil below $100 and the 30-year government bond over 4.75% by year-end.

Maybe I'm Amazed

In my 22 years on Wall Street, 20 years in fixed income. I am continually amazed that the repeated mistakes made by investors, traders and strategists alike. I am not referring to the repeating of mistakes of the distant past, but of the recent (if not immediate) past. Let us go back to the thrilling days of yesteryear, or at least 1999.

The setting is a retail fixed income trading desk in early 1999. I am having a conversation with our very knowledgeable and intelligent head U.S. treasury trader. We are discussing the tech boom (soon to be called a bubble). Investors are purchasing shares of tech companies which have no business plan and little hope of turning a profit. My government trader colleague tells me that people believe in the new economy. Unfortunately for these investors, the new economy was still subject to old math. Investors learned that profit matters and asset prices do not move eternally higher.

As if the tech bubble never happened, U.S. consumers, investors, traders and strategists came to believe that home prices would move eternally higher and interest rates would always remain low. Sorry, that is not true either.

Now we have the usual suspects telling us that commodities, especially food and oil will keep rising, even if the dollar strengthens (which won't happen according to these voices). Welcome to the new bubble. Once the Fed tightens as it should, the dollar will strengthen, oil will fall and investors will panic, accentuating he price decline of commodities. This will happen. The only unknown is the timing.

Another case of not knowing the past involves BAC and CFC. Last Friday, BAC stated that it may not explicitly guarantee CFC debt. This sent investors into a tizzy and caused an embarrassed S&P (which stated that it believed that BAC was going to take CFC debt onto its balance sheet) to spitefully downgrade CFC dent (Moody's left CFC unchanged on a positive watch.

It is de riguer for subsidiaries and parents to guarantee only their own debt. This is true of banks, utilities, and telecom. JPM and Bear are different as Bear is not going to live on as a subsidiary, but be absorbed into JPM.

This is not bad news for CFC bondholders. CFC will be upgraded if and when the deal is closed (BAC announced that the deal is a go). It will probably warrant a single A rating once BAC infuses cash and restructures CFC's business. Single A should be good enough for any CFC bondholder.