A Long Winters Nap

Although the street will be thinly staffed for the next week, markets often go nuts this time of the year. The cause is the reduced number of market participants. While many individual investors are scurrying to make year end trades, most market makers are snug in their beds while visions of sugar plums dance in their heads. Notable exceptions are hedge funds. The Ebenezer Scrooges among them will not permit them to enjoy the season. They are all business. This can be a very dangerous time for small investors. It is true that volatility brings opportunity, but it also brings danger. This is alright fro traders who have large pools of capital with which to play and the ability to hedge bets, but such market environments can spell trouble for investors. There is a vast difference between a trader and an investors.

Market conditions prevalent during the past 25 years has turned many investors into traders. Market conditions have made trading relatively easy. One need only buy a portfolio of high-quality stocks and wait. If one waited long enough one experienced a profit of varying amounts. Why was this so? Because the preceding 25 years were terrible for the markets. Tax and economic policy changes, along with lower interest rates and (I hate this term) financial innovation, sparked the longest period of economic growth in U.S. history. What we witnessed was a prolonged recovery from a prolonged slump. The recovery matured in 2000. Efforts to rekindle growth created a bubble which could not be sustained. As with mature economies, mature markets are more stable, Growth and corrections will be more subdued. This had caused many investors to allocate assets outside their stated risk tolerance levels. Some may not realize they have done so.

Emerging markets have been an attractive destination for investor capital. Thus far the bet has been a good one, but it has coincided with the recovery in U.S. equity markets. This is merely a rebound from last years' crisis. The truth is that there is no decoupling. Economies around the globe are more intertwined than ever. Another problem facing investors in emerging markets is that they may be sowing the seeds of their own demise.

The influx of capital from the U.S. has begun to hurt export driven economies by strengthening their home currencies. Stronger currencies versus the U.S. dollar mean that goods produced cost more in terms of dollars. The results are higher prices, reduced profits or both. Countries such as Brazil are considering tax penalties to discourage foreign investment to keep the real week. Several other nations have acknowledged they are also considering similar moves. Then there is China.

China, being a command economy,. can add and remove stimulus at will thereby managing internal consumer demand. Banking on Chinese consumers to lift the global economy to new heights is a pipe dream at this time. China will only permit consumers to spend to meet its specific goals. If the government believes that the economy is overheating and inflation is becoming a problem it will engage in polices limiting consumer spending. The Chinese economy is likely to exhibit strong growth for the foreseeable future as the country is so far behind the West it will take many years of strong growth just to build the necessary infrastructure to make China a truly developed nation. Also, Chinese economic data are difficult to verify. The government controls the release of all data, including corporate earnings data. If China reports 8% growth one must take it at its word.

Domestically-focused investors have been placing bets on inflation. Their thinking is that low interest rates, the printing of dollars and record U.S. debt issuance will result in inflation pressures. The effect may be far less than many investors believe. Interest rates and debt issuance are just two factors influencing inflation pressure. One must also consider consumer demand, foreign exchange rates and corporations willing to erode profit margins to maintain their share of a smaller U.S. market. Allusions to the stagflation days of the late 1970s disregard the changes within the U.S. economy which have occurred since then. The U.S. economy is less insular and is no longer manufacturing-based. Back in the days of polyester leisure suits job growth (or losses) and inflation sprang forth from places such as Detroit, Pittsburgh, Cleveland and Bethlehem, PA. Now job production is scattered around the country in service industries such as technology, retailing, healthcare and financial serviced. The production of goods is primarily done overseas and these exporters would rather erode their significantly-wide profit margins than raise prices and lose valuable market share. This, combined with reduced spending as consumers live closer to their means, promise to keep inflation relatively low.

Subdued inflation make TIPs bad bets as trading vehicles. All are at premiums and have inflation indices over 1.00, some significantly so. Short-term TIPs (inside five years) could result in net losses for investors should inflation be tame. TIPs should be used as a hedging vehicles rather than speculations. The best TIP is the 1.375% due 7/15/18 as it is priced near par and has an inflation index near 1.00. Corporate inflation-protected notes are (how should I say this?) garbage. They adjust versus a year-over-year calculation of inflation. Even if inflation ran a steady 3.00% year after year there is now upward adjustment if the coupon as the rate was unchanged. If inflation declined from 3.00% to 2.50% coupons fall even though inflation was positive. This is a simplified but accurate explanation of how such bonds work.

I don't think there will be a double dip recession, but growth charts could more resemble a Nike "swoosh" as consumers rely more on income and less on borrowed fund. Also, much of the growth we have seen this year has been due to government stimulus plans. This was to be expected. However unlike in the recent past, such stimulus may not prime the economic pump, but rather give a temporary boost resulting in the economy settling back to a fundamental growth rate lower than to what we have all become accustomed during the past two decades. Recent home sales data illustrate the effect government stimulus is having. Existing home sales were surprisingly positive due to home buying benefits, but new home sales fell as the data reflects contracts to build new homes not closings. These home buyers would not be able to take advantage of government programs unless extended. Since it takes upwards of a year to bring a home from plans to completion, counting on government programs still being in effect when it is time to close is a risky proposition.

Less volatile markets present a problem to those investing via fee-based accounts. Growth rates and lack of volatility will make it difficult to justify paying management fees of two or three percent. Why pay annual fees to sit and watch a portfolio. This is especially true of fixed income accounts. The best plan is to construct a portfolio which meets your current needs consisting of appropriate securities and adjusting it only when your needs change or when an unforeseen event affecting an investment requires reallocating capital.

Enough of this talk of business. It is Christmas Eve, a time for those who observe the holiday to be with friends and family. Tonight as I sit by the fire with those I love, I will raise a glass of Old Fezziwig ( a great ale brewed by Samuel Adams) and wish a happy holiday season to all my readers and health and prosperity in the New Year. I shall be back the first week of January.

Slacker

I am of the opinion that the peak Fed Funds rate during the coming cycle will be somewhere around 4.00%. My thinking is that with consumers forced to live closer to their means, growth and inflation will lag recent past cycles. To make sure I wasn't being too pessimistic, I asked a very respected fixed income strategist (one who has been somewhat more optimistic than I) his opinion regarding where he thinks Fed Funds will peak before the Fed begins to ease again. Imagine my surprise when he tells me that he believes Fed Funds will peak around 3.00% during the coming cycle. This is bad news for investors determined to stay in cash or who think they can eliminate interest rate risk by purchasing LIBOR-floater longer-term bonds and preferreds.

Please understand that the Fed SHOULD remain extraordinarily accommodative for an extended period of time. I am a cruel sot. I believe in responsible borrowing and investing. Corporations and individuals should be permitted to suffer the consequences of their actions. Keeping rates too low for too long could create new bubbles. Fed policy is certainly at least partially responsible for higher gold and oil prices.

So what is a fixed income investor to do? Diversify. Ladder, barbell and use different products, CDs on the short end, agencies on the belly of the curve and bank and finance bonds seven to ten years out. Also, please understand what makes a bond tick. Features such as calls, floats and steps are structured to benefit the issuer, not the investor.

A TARP Christmas

"I'm dreaming of a TARP Christmas."

That is the Christmas carol ringing in my head. First we had Bank of America repay its TARP funds, then Citi will pay back a portion of its TARP funds. Well Fargo is the latest to announce its TARP repayment. Well will sell approximately $10.4 billion of stock and will repay all $25 billion of government aid. This is in contrast to Citi which will pay back only $20 billion of the $45 billion of aid money it received from the government. The Treasury will also sell up to $5 billion of Citi shares. That would still leave another $20 billion of aid money Citi would have to repay. It also means that the government will continue to have a major ownership stake in the most troubled large bank in the U.S. Baby steps Vikram, baby steps.



Today, JP Morgan came with a sweetheart of a preferred deal. A sweetheart deal for JPM that is. The new preferred will have an initial coupon in the 7.25% to 7.375% areas. That is a fairly low coupon for long term debt. However, it gets better for JPM. After five years the coupon will float off of three-month LIBOR. Typically these deals float 400 or more basis points over three-month LIBOR and have no floor or ceiling. However since Three-month LIBOR cannot go below 0.00%, the effective floor is the spread. Investors and financial advisers became all giddy at the prospect of rising coupons. However, if the coupon rises above where JPM can issue long-term securities, JPM will simply call it away at 25. A flat or inverted yield curve is usually required for such a situation. If the yield curve remains steep and the coupon remains below the trading yield, the preferred will trade at a discount, regardless of how high "rates" rise. Although as long as rates rise one is at least compensated with higher rates while one suffers with a $22 trading price.

The truly negative outcome is for the yield curve to be steep and short-term rates to remain low. That is probably the most likely scenario for 2014. Why do I believe this? Let's look at typical Fed policy cycles. The economy slows, the Fed eases, rates fall, but short-term rates fall more significantly than long-term rates. The economy shows signs of recovery. Inflation expectations cause long-term rates to rise, thereby further steepening the curve. The economic cycle matures and to combat inflation the Fed tightens by raising the Fed Funds rate, moderating inflation pressures casing the curve to flatten. It is often the case that the Fed overshoots resulting in a flat or inverted yield curve. It usually takes a number of years to go through this cycles, often three to five years. This would be perfect timing for this JPM preferred to experience a coupon decline when it begins to float. Floaters DO NOT eliminated interest rate risk for investors. If they did issuers would be exposed to such risk. Floaters are like Las Vegas. Investors can win, but the deals are structured to favor the house (the issuer).

Happy Chanukah and Merry Christmas.

In The Year 2010

2009 is winding down, but the year will not go quietly. First their was the Dubai default. Then there were the Greece and Spain credit ratings downgrades. Even the U.S. and UK received stern warnings about their respective credit ratings coming under pressure in the near future. The grass isn't greener in the neighbors back yard. In fact even China, that vaunted engine of growth, is not is nearly as strong as its economic data and its cheerleaders would have us believe. Nearly all of its growth has been driven by huge amounts if government stimulus, which is sustainable. What the Chinese government is hoping for is that it can keep its economy expanding (and its people happy) until demand increases from (drum roll please) the U.S.!!! The good ole USA is still the world's main source of economic activity.

There is a mistaken belief that U.S. banks are the worst on the planet. Although U.S. banks (even healthy banks) remain impaired when compared to their typical condition, European banks (along with others in various parts of the world) have their fair share of impairment and foreign governments are feeling the pain of propping them up. It may be fair to say that the worst of the financial crisis is over, but it may be a long time (if ever) before we return to conditions common during the past 25 years. Why if ever? Let's answer a question with a question. Why do many people assume that the economic conditions of the past 25 years are "normal" After all, those conditions never existed prior to that time period. The truth is that there is no "normal" The economy is evolving and ever-changing. One thing is for sure. Consumers cannot spend more than they make ad infinitum. Eventually one becomes over leveraged and can no longer spend like a drunken sailor. When that happens, demand falls and prices follow. All of the government spending or shovel-ready jobs the government can conjure up can create sustainable economic expansion similar to what we saw during the days of ever-cheaper and ever-easier credit.

So what does this mean for the markets? As it becomes apparent that the U.S. remains the best of a fermenting (I won't say rotten) bunch, the dollar will strengthen. Equity markets will begin to trade sideways (possibly correcting mildly), non-industrial commodities will fall (see gold) and the dollar will strengthen. At some point the Fed tightens further strengthening the dollar. Tighter money takes away the bank carry trade and makes leverage more expensive which in turn makes borrowing to play the markets more expensive. The result will be credit spreads stop compressing and corporate bond yields begin to follow movements of treasury yields. The reason is that bank profits will moderate from levels seen in 2009. Most other sectors of the markets will see spreads remain constant or widen slightly. Junk bonds could see a significant correction in a year or two as weaker firms struggle to refinance debt at affordable levels (if at all). I think Fed Chairman Ben Bernanke has it right when he says that the economy will grow, but will face significant headwinds. Investors will have to accept that they are in fact investors and not traders because trading opportunities will be fewer and farther between than to what they have become accustomed. Ladders and barbells anyone?

Going Down

For the first time in 2009 I actually purchased something to capture a changing market environment. Having stayed on the sidelines for all of the past year ( I did not sell during the crisis and did not buy during the recovery as neither one made sense to me), I decided to act. I took a long position in TBT, an ETF which gives double short exposure to the long end of the treasury curve. It is not a perfect short play on the long end of the treasury curve. TBT corresponds to twice the daily movement of the Barclays Capital 20+ Year U.S. Treasury index. However, it is an affordable way to speculate (emphasis on speculate) on rising rates on the long end of the curve. After all, I am not a man of such eminence to be able to short U.S. treasuries.

At first glance it may appear that I have changed my tune and am now predicting a blow out of long-term rates. That is not the case. I am merely predicting that long-term rates cannot stay this low forever. I would be thrilled if by this time next year the yield of the 30-year government bond is over 5.00% and the 10-year treasury note yield is over 4.00%. In fact 100 basis points may be the extent of the rise we see in the next year or two (possibly for the entire cycle).

Why do I think that the rise of long-term rates will be limited? The economy is just not that strong and economic activity, consumer activity, will not reach levels seen during the past two decades with more traditional lending standards. In fact, I think the economy will stumble somewhat during the next two quarters. What I am saying is counterintuitive I know, but markets are not behaving logically. We have gold and stocks being used as dollar hedges fueled by cheap leverage. As soon as the Fed removes its extensive stimulus and borrowing costs rise for traders, trades will begin to unwind. As short-term rates rise the U.S. dollar will strengthen as investors begin to buy on the short end of the curve at new higher rates. As the dollar strengthens, the need for dollar hedges diminishes causing a further selloff of gold, equities and junk bonds. The strengthening dollar reduces, but not eliminates the need for foreign central banks to buy long-term treasuries to manage their currencies. That is where the mild rise in long-term rates comes from.

When discussing this strategy and theory with a colleague he asked where the money that is currently invested in stocks, junk bonds and gold going to go? The answer is back to the lenders. The great rally of 2009 is mostly due to speculating with borrowed money. The Fed hopes that the economy can catch up to the equity markets and a correction will be avoided or dampened. This is the holiday season and maybe Mr. Bernanke's wish will be granted.

Happy Thanksgiving

This Thanksgiving we have much for which to be thankful. We live in the greatest country on earth. We have the love of our family and friends to brighten our lives and we (hopefully) have our health. There is something else for which we all should be thankful, foreign central banks. Thanks to indirect bidders (which consist primarily of foreign central banks), this week's treasury auctions (2-year, 5-year and 7-year) went very well. In fact today's 7-year auction was she strongest since last July. Not surprisingly, prices of long-dated treasuries rallied following the auction. What was surprising was the selloff of long-dated treasuries just prior to the auction. Did people really think that the auction would be a flop? For the past two months, predictions of waning interest among foreign central banks have been rampant. These predictions have been base on text book theory instead of reality.

Text books tell us that when a country lowers short-term interest rates, issues large amounts of debt relative to GDP and attempts to devalue its way out of a financial crisis, inflation and higher long-term rates are the result. The text books are correct in most circumstances, but not when it pertains to the U.S., not now. The U.S. is unique in that it is the largest market place for goods produced around the globe. This means that exporting nations need to moderate the dollar's slide by purchasing dollars (in the form of U.S. treasuries) which simultaneously results in selling their home currencies. Failure to do this results in exporters either raising prices (which could result in reduced market share) or smaller profit margins. Foreign central banks must either purchase dollars or peg their home currencies to the dollar as China has done. Pegging to the dollar has its own internal inflationary consequences so it is usually command economies, such as China, which engage in this practice as they can dictate prices and supply of goods to their consumers. At some point the U.S. may not be the dominant market place, but that day is not yet on the horizon. Look for continued strong buying of U.S. treasuries until inflation pressures resulting from growth take hold.

Growth driven inflation is not yet on the horizon because bank cannot lend the way they had in the past because they cannot securitize and sell low-quality loans to unsuspecting buyers (with the help of cooperative ratings agencies). Borrowers will have to prove their creditworthiness. Consumer borrowing will return to levels which were common before 25 years of rate declines and financial engineering by quants who have no clue why historical data was what it was, only that it was.
I had an interesting conversation with a financial adviser who was shocked that Moody's may downgrade bank preferreds, She stated that she believed that the bank troubles were past and that the stock market, oil prices and gold prices were up on string growth expectations. I explained to her that radioactive assets continue to poison the balance sheets of many banks, large and small and that commodity prices and the equity markets are rallying due to the weaker dollar. She was dumbfounded by my assessment. I am no genius. Most fixed income traders, analysts and strategists know exactly why certain assets prices are rallying. the problem is that most financial advisers are equity oriented. The U.S. treasury market is the best gauge of economic and inflation out look. It is what makes that market tick. The treasury market is telling us that economic will be unspectacular for some time. This is your father's economy. Get used to it.

Happy Thanksgiving.

Mae West, Dolly Parton and the Top Heavy Markets

I was discussing the markets with a very experienced an knowledgeable colleague about how "toppy" the equity market is. I told him it is "Mae West" toppy. It is "Dolly Parton" toppy. The tell-tale signs for us is the retail order flow into riskier vehicles and equity market participants positive spin on nearly economic report. Today, retail sales came in below the street consensus and the prior month's data was adjusted down. Empire Manufacturing came in well below economists expectations. Fed Chairman Ben Bernanke warns of headwinds ahead and the need for continued extraordinary monetary accommodation. In response the equity market rose 136 points.News reports indicate that many equity market experts were encouraged that retail sales turned positive. However, the fixed income market had a much different response.

Fixed income market participants took the weak economic data and Mr. Bernanke's comments for what they were and the result was a sharp rally of the prices of long-dated treasuries. Is it that the fixed income experts are smarter than the equity experts? Not really, it is just that the fixed income market participants are more honest. The equity geeks know that the economic fundamentals do not justify current equity market levels. They are hoping that they can force a self-fulfilling prophecy. That the weak dollar is helping to fuel the rally encourages the equity participants. They don't care why the market is up, only that it is up. That is until they want to take profits and then they are the first out the door.

Another sign that the equity (and fixed income credit markets) may be overdone are comments that certain phenomena "always" follows data which we are seeing now. Always is a long time and can the data can be selectively gathered by using time periods advantageous to one's argument. I say that "always" is a word that we should "never" use. Have we ever had current levels of household debt before? No. Have we ever had an economic malaise with interest rates already affective at zero? No. Have we ever had a global economy with a fierce battle for market share before? No.

What many "experts" decline to discuss is that current levels of unemployment were last seen in the early 1980s, before nearly three decades of ever-lower interest rates. The fact is that the robust growth and very low unemployment experienced since the 1980s are fundamentally unsustainable. They were fueled by ever lower interest rates and ever easier lending standards which resulted in ever higher home price which resulted in ever more home equity to be used to buy lifestyles unattainable by way of income alone. The problem is that such home price increases (and the resulting growth in home equity) is unsustainable. Now we have reverted to the mean, maybe a little below the mean, but current economic activity is much closer to fundamental levels than the credit-fueled spending binges of the 1990s and 2000. Bill Gross has it right, get conservative now.

USA!

As I expected, the 10-year treasury was very well received. The bid to cover ratio was a string 2.81 versus an average of 2.61 for the last 10 auctions. The indirect bidders (which includes foreign central banks) came it at 47.3% versus a prior 47.4%. The 30-year auction was a bit softer than expected, at least on the surface. The bid to cover ration for the 30-year government bond slipped to 2.26 from 2.39 average for the last 10 auctions. Foreign central bank buying remained strong.

Last week's auctions cause prices on the long end of the curve to rally, but that did not help the U.S. dollar as investors continue to invest in foreign currencies. I think that bubbles exist in foreign currencies, equities, high yield bonds and some high grade bonds. Joining me in the camp is Bill Gross of PIMCO. Bill believes that those markets are over done and U.S. treasuries are the place to be. It is difficult for me to say this as a long-time corporate bond trader, but the credit markets are overdone here. Spreads between 10-year industrials, such as Wal-Mart are well under 100 basis points. Verizon and ATT paper are in the 100 basis point area. Only in the bank and finance arena does some value exist. That is because there could still be some bad news (but not fatal news) ahead. The more retail participation the more overvalued the asset class at this time. This goes double for floating rate notes.

I have been through the floater story before. I still have financial advisors buying floaters at tight spreads and very low yields in an effort to eliminate interest rate or, in the case of CPI floaters, inflation risk. These products do no such things. If floaters eliminated these risks for investors, they would create such risks for the issuers!!! Why is it so difficult for advisers and investors to understand this? It irks me when advisers tell me they know better and that I am wrong. Please, I don't tell financial advisers how to do estate planning, don't tell me how bonds work. Bonds have been my specialty for over 20 years.

Libor-based floaters do best when the yield curve is flat and the coupon benchmark (LIBOR) and the trading benchmarks (10-year or 30-year treasuries) are similar. This is why their prices are at discounts even though long-term rates have crept up. Fixed-rated bonds and preferreds have rallied tremendously. Most LIBOR floaters are so far below their floor coupons based on calculations that it is going to take 300 or more basis points of Fed tightening before these securities can move above their floor coupons. By that time we could be into the next part of the economic cycles heading towards lower inflation and lower long-term rates and the Fed once again easing.


CPI floaters adjust off of the year-over-year change of the rate of inflation based on the CPI Urban Consumer Index (non-seasonally adjusted). If inflation, YoY, is at 3.00% for two consecutive years, your coupon FALLS to its spread over the index. If inflation declines from 3.00% to 2.00%, your coupon drops. The coupon would be spread off of a negative calculation. Anyone buying these for inflation protection should be tested for drugs. Buying floaters is to SPECULATE that the observed benchmark will perform in a certain fashion. LIBOR floaters do best when the curve flattens and CPI floaters do bets when the RATE OF INFLATION rises. TIPs are rich as well, but at least a case can be made to have a hedge versus inflation. The best strategy for rising rates or inflation is to ladder or barbell a portfolio.

Rally 'Round The Dollar

The equity markets staged another rally. In keeping with recent trends commodities prices rose and the dollar fell. The relationship between the falling dollar and rising equity prices may not always exist, but it is currently a reality. Traders know full well that it is government stimulus and the printing of money and issuing of debt that is weakening the dollar and pushing asset prices higher. However, traders in different areas of the capital markets are expressing very different opinions. Most fixed income market participants acknowledge that he run-up of asset prices, including their own securities, is due to current monetary and fiscal policies.

Many equity market participants would have us believe that the resurgent asset prices are based on strengthening fundamentals. This reminds me of 2008 when oil wonks tried to convince us that rising oil prices was due to increasing demand. Anyone with half a brain knew it was a dollar hedge. When the financial crisis ensued, investors flocked to the safety of the dollar and oil prices plummeted. Some oil traders tried to explain that away by saying that oil dropped because the economic crisis was going to slow the global economy and reduce the demand for oil. This theory is blown out of the water by the current oil market. Last week, the International Energy Agency revised downward its forecast for oil consumption. However, oil prices continue to rise. Oil, gold and equity prices area all the result of a weaker dollar. Even higher high-yield bond prices are due to government stimulus. Without the government over stimulating the economy, many of these companies would not be able to refinance their debt by selling it to euphoric investors. At some point, these new bonds along with existing bonds coming due in the next five years, will have to be refinanced. This could be problematic once government stimulus is gone.

Beware of those who point to previous economic recoveries, such as 1983. I have written extensively on why the 1980s recovery is very different than today's recovery. The Wall Street Journal correctly points out the difference, not the least being that in 1983 interest rates were still very high. All the Fed had to do was to ease to reinvigorate the economy. Also, the S&P is trading at 7 times earnings rising to 10 times. When the current rally began the S&P was already at 13 time earnings and has risen to 19 times. According to the Journal the average is 16 times. The Journal also correctly points out that tax policy was becoming more business friendly in the 1980s. There is no such trend on the horizon now. All in all, this rally is only as strong as the greed which is fueling it.

Today's three-year auction was very well received by investors, especially indirect bidders which include foreign central banks. I am expecting a strong 10-year auction, in spite of more supply coming to market and fed policy which is weakening the dollar. If one is an exporter, one must do what one can to slow or stop the dollar slide to keep one's goods competitively priced. Later this week we will discuss the shape of the yield curve.

The Curve

I usually don't simply copy and paste articles from the Wall Street Journal (I leave that to those who run my desk at my real job), but Today's Wall Street Journal "Credit Market's" column speaks to my arguments about the yield curve. Besides, I have a mild concussion and have to do as little thinking as possible (maybe I should run for office?). The article notes how the Fed's decision to keep short-term rates low has hurt the prices of long-term bonds and helped the prices of TIPs. Be careful when buying TIPs because when the Fed does tighten, inflation pressures will abate, somewhat. The steepening yield curve is bad for LIBOR-based floaters. This would be a buying opportunity for such floaters as they should do better when the Fed does tighten and the curve flattens, eventually, but these preferreds are already too rich. Here is the article:

By MIN ZENG
Prices of Treasurys with longer maturities fell after the Federal Reserve reiterated its commitment to keep rates at record lows for an extended period, disappointing some investors and fanning worries that low rates may fuel inflation.
But prices of short-dated Treasurys, the most sensitive to official rate changes, gained, and traders pushed their expectations for the first rate increases into the summer of next year.
In the run-up to the Fed's statement, there had been expectations that policy makers might use a change in language to signal to markets that, with the economy on the mend, they were moving toward tightening policy. "The market got a bit ahead of itself pricing in possible changes in the Fed language," said Ian Lyngen, senior government bond strategist at CRT Capital Group.
The Fed's unchanged stance hurt longer-dated Treasurys as investors worried that the ultralow rates will fuel inflation. An additional concern for investors: record debt supply coming up next week, when Treasury sells a total of $81 billion in notes, up from the previous record of $75 billion.
The Treasury Department is scheduled to sell $40 billion in three-year notes, $25 billion in 10-year notes and $16 billion in 30-year bonds to cover its fourth-quarter funding needs.
On Wednesday, the benchmark 10-year note was down 20/32 point, or $6.25 per $1,000 face value, at 100 20/32. Its yield rose to 3.548% from 3.473% Tuesday, as yields move inversely to prices. The 30-year bond was down 1 22/32 points to yield 4.439%. The two-year Treasury gained 1/32 point to 100 6/32, lowering its yield to 0.905%.
Treasury inflation-protected securities outperformed plain-vanilla, or nominal, bonds as inflation expectations increased, measured by a widening yield spread between a 10-year TIPS and a 10-year nominal Treasury note. The spread widened to 2.12 percentage points. It suggests investors expect an average annualized inflation rate of 2.12% within a decade. That still is lower than the 2.50% expected before the collapse of Lehman Brothers.
Separately, the Fed scaled back one of its asset-purchasing programs. The Fed said it would buy $175 billion of agency debt -- issued by Fannie Mae and Freddie Mac -- less than the $200 billion the Fed had said it would buy. The Fed said the reduction reflected the limited availability of agency debt. Still, yield premiums on agencies -- as such debt is known -- widened over Treasurys by 0.03 to 0.05 percentage point in response to the Fed's announcement.
Debt Ceiling Seen Later; No More 20-Year TIPS
The Treasury pushed back the date it expects to hit the $12.1 trillion U.S. public debt ceiling to mid-to-late December, taking pressure off Congress to raise the limit. However, it noted "the government's cash flows are volatile and forecasting a precise date is difficult." Treasury Secretary Timothy Geithner has requested that Congress increase the ceiling. The U.S. public debt stood at $11.92 trillion Monday. Meanwhile, the Treasury announced plans to sell $81 billion in new securities next week to refund $38.5 billion in maturing issues and raise $42.5 billion.—Meena Thiruvengadam
Write to Min Zeng at min.zeng@dowjones.com

Carry On

The FOMC, as expected, announced that it will leave the Fed Funds rate unchanged and will keep them low for an extended period of time. The FOMC also said that although there are signs that the economy is improving there could be continued headwinds from high unemployment and constrained consumer spending due to the lack of income growth, reduced credit and lower housing wealth the Fed will continue to buy agency debt and MBS in an effort to keep mortgage rates low. The markets are concerned that the Fed is keeping rates too low for too long. This caused the yields of long-dated treasuries to rise. The equity prices gave up much of their earlier gains on the news.

The carry trade is becoming more lucrative for banks. They can borrow from mother (the Fed) and lend to father (the treasury) and make about 3.25% in the process. The Fed is concerned that the carry trade is helping to drive profits and the recovery in the financial sector and does not want to remove the punch bowl prematurely. A steep yield curve is bad news for libor-based preferreds and bonds as the disconnect between coupons and trading yields widens.

Here is the full FOMC statement:

Release Date: November 4, 2009
For immediate release
Information received since the Federal Open Market Committee met in September suggests that economic activity has continued to pick up. Conditions in financial markets were roughly unchanged, on balance, over the intermeeting period. Activity in the housing sector has increased over recent months. Household spending appears to be expanding but remains constrained by ongoing job losses, sluggish income growth, lower housing wealth, and tight credit. Businesses are still cutting back on fixed investment and staffing, though at a slower pace; they continue to make progress in bringing inventory stocks into better alignment with sales. Although economic activity is likely to remain weak for a time, the Committee anticipates that policy actions to stabilize financial markets and institutions, fiscal and monetary stimulus, and market forces will support a strengthening of economic growth and a gradual return to higher levels of resource utilization in a context of price stability.
With substantial resource slack likely to continue to dampen cost pressures and with longer-term inflation expectations stable, the Committee expects that inflation will remain subdued for some time.
In these circumstances, the Federal Reserve will continue to employ a wide range of tools to promote economic recovery and to preserve price stability. The Committee will maintain the target range for the federal funds rate at 0 to 1/4 percent and continues to anticipate that economic conditions, including low rates of resource utilization, subdued inflation trends, and stable inflation expectations, are likely to warrant exceptionally low levels of the federal funds rate for an extended period. To provide support to mortgage lending and housing markets and to improve overall conditions in private credit markets, the Federal Reserve will purchase a total of $1.25 trillion of agency mortgage-backed securities and about $175 billion of agency debt. The amount of agency debt purchases, while somewhat less than the previously announced maximum of $200 billion, is consistent with the recent path of purchases and reflects the limited availability of agency debt. In order to promote a smooth transition in markets, the Committee will gradually slow the pace of its purchases of both agency debt and agency mortgage-backed securities and anticipates that these transactions will be executed by the end of the first quarter of 2010. The Committee will continue to evaluate the timing and overall amounts of its purchases of securities in light of the evolving economic outlook and conditions in financial markets. The Federal Reserve is monitoring the size and composition of its balance sheet and will make adjustments to its credit and liquidity programs as warranted.
Voting for the FOMC monetary policy action were: Ben S. Bernanke, Chairman; William C. Dudley, Vice Chairman; Elizabeth A. Duke; Charles L. Evans; Donald L. Kohn; Jeffrey M. Lacker; Dennis P. Lockhart; Daniel K. Tarullo; Kevin M. Warsh; and Janet L. Yellen.

No Surprises

CIT filed for a pre-packaged Chapter 11 bankruptcy protection. This was not unexpected. It appears as though senior bond holders will get 70 cents on the dollar in new second lien secured notes (second claim on specific assets, probably receivables) and 30 cents in equity. Subordinate debt, preferred and equity holders are wiped out. This does not solve CIT's broken business model, but it may give them the breathing room to do so. The question is: What kind of revenues can CIT generate by focusing more on lending to higher-quality businesses and less to lower-quality businesses. Other firms are already courting CIT's better clients. Some have defected.

Don't feel too bad for institutional bondholders. Many will get par. How is that you say? Many bought credit default swap protection. As with the GM bankruptcy, bondholders buy default protection agree to compensation via a bankruptcy, deliver their bonds to whomever sold them protection, receive 100 cents on the dollar and leave the CDS seller to receive bankruptcy recovery. This is why bondholders would not agree to the bond exchange prior to bankruptcy. They needed a bankruptcy to receive par.


As part of its restructuring plan with the Her Majesty's Treasury, Royal Bank of Scotland agreed to suspend all dividend and coupon payments on its hybrid and preferred securities. It also agreed not to call any issues in. The time frame is two years. There are more details which can be found on HM Treasury's website, but the key here is that RBS and the British Government heeded the European Commissions wishes and suspended dividends. ING and ABN could take similar action. Their preferreds are not suitable for investors needing income.

One surprise came from the auto sector as GM and Ford unexpectedly reported profits. Now the annualized sales rate is over 10mm units nationwide. Unfortunately the Detroit makes need about a 16mm units sales U.S. sales pace to break into the black. Baby steps, I guess.

Graphic Markets

The markets were downright giddy this morning following a better-than-expected GDP report. The markets nearly became euphoric when the summary tables revealed that it was consumer spending which was largely responsible for the rise in GDP. However as the day wore on, cracks were beginning to appear in the façade of the first read of third quarter GDP.

Economists and strategists fro around the street expressed doubts that consumers will be able to keep the economy chugging along. Zach Pandl of Nomura Securities told the Wall Street Journal: "We don't think the kind of pillars are there for a strong recovery." A report published by Citi Private Bank Global Fixed Income Strategy state: “The recovery in developed countries, however, is by no means robust, nor is it likely to resemble a “V”-shaped rebound that is typically associated with downturns of this magnitude.

Not all economists are counting on consumers to tow the economic line. Some experts believe that business inventory replenishment and business-to-business commerce will carry the economy to a sustained recovery. Others believe that a weak dollar, which lowers the cost of U.S.-made goods abroad, is the answer. However, a weak dollar causes problems domestically, such as higher food and energy prices. These headwinds can be disastrous for the economy. The truth is that U.S. economic growth hinge on the consumers’ ability to spend. With wage growth expected to be poor and credit availability to be based on prudent lending standards, the economy appears to be heading for peak growth in the 2.5% to 3.5% in the current economic cycle.

Attempts by the administration to reinflate the economy with credits, rebates and by forcing banks to ramp up consumer borrowing will cause serious problems down the road. The sooner the government admits that three percent growth is what is fundamentally sustainable and assets prices, including real estate, must be permitted to reset to reflect supply and demand the better off we will all be.

I have previously discussed how the equity market rally has been due in large part to the weaker dollar and the cheap short-term borrowing which is helping to cause the weaker dollar. The following is a chart which demonstrates the correlation between the weaker dollar (using the strength of the euro vs. the dollar as an example), crude oil and the Dow Jones Industrial Average:




Last year I argued that rising oil prices were not, as many commodities traders insisted, due to increased demand, but due to the weaker dollar. Oil was being used as a dollar hedge. When the financial crisis struck last September, the flight to safety had investors flocking to the dollar. Oil prices plummeted. This year, with the dollar weakening, oil prices are rising. Equity prices are also rising because of the weak dollar. As the dollar weakens it takes more of them to properly represent values of companies this causes equity prices to rise. The above chart bears this out. Therefore, if the Fed begins to tighten before the economy can fly in its own (sans stimulus), a significant correction could ensue. The problem is that the Fed will tighten by late 2010 and growth will be modest. It will be interesting to see if the market can maintain its strength in the face of tighter monetary policy.

True Colors Shining Through

The equity markets are getting a dose of reality as a series of economic reports and continued strong demand for U.S. treasuries weigh heavy on the minds of equity investors. A mediocre durable goods report combined with unexpectedly poor new home sales and consumer confidence data to push equity markets lower. Another strong treasury auction, this time the five-year note, demonstrated that not everyone is convinced the global economy is out of the woods.

In spite of the best efforts of market bulls and government officials, consumers and investors are wising up to the fact that much of the improvements observed in economic data has been due to inventory replenishment, after a long period of depletion, and government stimulus. Goldman Sachs cut its forecast for third quarter GDP to 2.7% from 3.0% due to the lackluster durable goods data. I believe Pimco’s Bill Gross had it right when today he said in an interview on CNBC: "The new normal recognizes the economy is deleveraging."

The problem is that the government is trying to leverage the economy back to health. Are government officials stupid? No, they are merely politicians. These hypocrites who criticized Wall Street for focusing on short-term profits over long-term results are guilty of the same offense. Rather than let the economy correct to fundamental growth rates and permit home prices to find levels at which those who can obtain credit (a shrinking group thanks to an over supply of homes and rising unemployment), the government is attempting to repeat past mistakes of too much leverage in an attempt to engineer another sharp, quick, but unsustainable recovery in order to keep the voters happy and themselves in office. They are sacrificing long-term prudence for the short-term goal of remaining in power.


This is what got us here! For nearly three decades, whenever the economy would falter, the Fed would bail out the economy by lowering rates. Wall Street helped by creating vehicles to package all kinds of sour loans into palatable investments. Politicians permitted (some encouraged) this to happen. All was good as long as the populace was happy and politicians remained in office.

The government is reaching way back in search of mistakes to make. The administration and its partners in Congress are pushing for wage and price controls and extension and expansion of stimulus plans such as the first time home buyer credit which may become available to existing homeowners looking to upgrade to a larger home. The government is also choosing favorites among corporations. If one lends to and for unionized businesses one can get government assistance. If one lends to small or medium-sized businesses, which are largely non-unionized, one is left to fend for oneself. Just compare GMAC to CIT.


The demand for treasuries is likely to remain strong as I (and most other fixed income experts) am expecting strong 10-year note and 30-year government bond auctions. If the Fed tightens, the lack of cheap leverage will take many equity buyers out of the market. The weaker dollar was also helping to buoy stock prices. As the dollar weakens more of them are required to represent the value of companies, hence share prices rise. Fundamentals will eventually rule, that is why we have corrections.
The true colors of the economy are about to come shining through

Making Sense

Rather than pick a topic and write extensively about it I am reverting my old form and will discuss a variety of current topics.

Let's begin with the economic recovery. An article in the Wall Street Journal ponders why investors remain jittery in spite of "clear signs" of economic recovery. The fact is that, other than equity bulls, problems remain within the economy. In actuality, much of the "recovery" has been due to cheap capital, inventory replacement and unsustainable incentives such as Cash for Clunkers and the home buyer tax incentive. Not every one sees the clear signs.


Also in the Wall Street Journal is an editorial by Christopher Wood points to the disturbing fact that the nascent recovery is heavily dependent on government stimulus. He points to the artificial demand for homes and cars bringing demand forward at best and enticing consumers to purchase for whom it is not in their best interest to do so.

This opinion was echoed by Bill Gross and Nouriel Roubini. Mr. Gross believes that growth will be below historical trends and Mr. Roubini believes that cheap leverage (for those who can get it) is creating more asset bubbles in equities and commodities. I believe that they are both correct. Consumers will not and cannot borrow as they had during most of the past 20 years. This will remove significant consumer demand from the economy. Since consumer spending is responsible for approximately 70% of U.S. economic activity, pent up demand may not be what the bulls expect.


On the auto front UAW workers at Ford continue to reject concessions to help make Ford competitive with GM and Chrysler which, after bankruptcy, have much lighter debt loads. What is going through the minds of auto workers. Apparently not much. Speaking of autos, FIAT announced that Dodge will specialize in "blue-collar muscle cars" and trucks. The more plebeian car line will consist of FIAT models, but that it will take several years to bring over the little FIATs as they do not currently meet U.S. safety and emission standards. The popular Dodge Caravan mini van will be axed. The smells a lot like AMC / Renault and we all know how well that turned out.

Morgan Stanley continues to hawk $1000-par fixed to floater LIBOR-based preferreds. The first MS argument was that when "rates" rise the value of these preferreds will rise. I have previously demonstrated that it is a flattening yield curve which results in higher prices. Contact me for mathematical and historical evidence.

Looking for another angle, MS is now marketing these preferreds by pointing to their attractive yields to call. Even though the calls are unlikely to occur for economic reasons, MS believes that they will be called as banks want to instill confidence by calling in Tier-1 securities. 1) Banks want more, not less Tier-1 capital. 2) If banks wanted to retire such securities they could buy them in the open market at discounts. There is no reason to call them at par. They are trading at discounts because the street does not believe a call to be likely. I have it from reliable sources that MS is loaded with these issues and is using retail accounts to move the inventory. Very few firms market $1000 preferreds to retail clients as they are institutional vehicles and illiquid in retail sizes. Trades of 1mm are the norm.

Never Assume

I had the pleasure to touch base with a financial adviser who was a reader of a former publication I published. We reminisced about days gone buy and he informed me that he respected my work in spite of my blowing the call with the GSE preferreds. I took a little exception to that.

It is true that I stated that I thought that a government seizure of the GSEs and a cessation of their preferred dividends was not the most likely scenario, I did warn that the government (for political reasons) could suspend GSE preferred dividends. It made no sense to do so from an economic standpoint as it only saves about $2 billion annually for each FRE and FNM. It also wiped out the non-cumulative preferred market which in turn helped to sow capitalization concerns among U.S. financial institutions. This helped to cause the runs which brought about the demise of Lehman Bros., forced Merrill Lynch into the arms of BAC and forced Goldman and Morgan Stanley to become bank holding companies (to be able to borrow from the Fed and acquire Tier-one capital via deposits). In fact, the government's plan to buy preferred stock interest in banks via TARP was the direct result of the banks in ability to issue Tier-one-qualifying preferred stock because of the treatment of the FRE and FNM preferreds. My opinion is based on logic. If asked, I will always tell what I believe makes sense, but will also warn that markets and government officials will often behave illogically.


What illogical phenomena do I see?

1) Dow 10,000: There is no fundamental reason for the rapid and significant recovery of the equity markets. Unemployment will continue to rise and once inventory replacement subsided, economic data will moderate. Lending will not become as easy as it had been because too many investors have the consequences of lax lending standards fresh in their minds. To be fair, the deep decline of the stock market was equally unjustifiable. The equity markets are the least efficient at predicting or even reflecting economic conditions, followed closely by the high yield bond market, due to the amount of fear and greed prevalent in those markets.

2) The shunning of 10-year corporate bonds. Investors do not understand the difference between credit products and interest rate products. Corporate bonds ARE NOT interest rate products

3) The love affair investors have with floating rate bonds. Floaters are designed to NOT BENEFIT investors merely because rates rise. Most floaters have coupons which reset versus LIBOR, but trade off of long-term treasury benchmarks. This means that even if rates across the yield curve moved higher by 500 basis points in unison such bonds will trade at deep discounts because the coupon will be significantly lower than the trading benchmarks. A flat curve is needed for price appreciation. CPI floaters measure the change of the rate of inflation, not merely positive inflation. Hence the low or zero coupons we now see on such bonds.

4) The recovery has to be as robust as "always": What is always? The last two cycles is not "always", but that is what many investors and pundits use as their historical examples. With lending standards becoming more responsible, look for PIMCO's forecast of 3% - 4% peak growth to come to fruition.



I'll leave you with the reminder of the warning given back in 2004 that GM could file for bankruptcy and was not too important for the economy to not be permitted to file.

Dow 10,000 - So What

Media types are screaming from their electronic bully pulpits are telling us how Dow 10,000 is an indication that the economy is on its way back and the markets are back to normal. All Dow 10,000 means is that the DJIA has reached 10,000 for the third time (1999 and 2003 as well). The investing public has been guiled into believing that the markets are efficient. This is always true. The least efficient are the equity markets. Due to the diverse group of investors (coming in all stripes), the equity markets are more influenced by fear and greed than any other markets. This is why they exhibit the biggest booms and the biggest busts. They also attempt to be forward looking. When things look bleak, the equity markets try to get ahead of the curve and often slump severely. When conditions show even modest improvement, equity investors will pour money into equity markets. Today was a good example.

JPM reports better-than-expected earnings and the market loves it. Pay no attention to deteriorating asset quality and the probability of reduced trading revenue this quarter. Keep in mind that JPM is probably the best of the banks. What about economic data? Retail sales rose a modest 0.5%. However, because it beat the street consensus of 0.3%. Never mind that the prior report indicated a rise of 1.1%. How about import prices? The data wasn't so bad thanks to a year-over-year decline of oil prices, but oil is creeping higher and the weakening dollar can be inflationary among imported goods.

Forthcoming economic conditions may justify Dow 10,000. After all, it is not such a lofty number. The DJIA first reached that level 10 years ago! Still, no equity bull can answer my question: How will consumers spend without a job and without easy access to credit? They don't have an answer, at least one they want to give. Jobs improve AFTER consumers who can spend, do spend. The problem is that there are so many people out of work and running out of unemployment benefits and credit, they cannot spend enough to generate enough business to warrant rehiring of displaces workers. Also, the days of easy credit are over. Investors will no longer buy vehicles backed by liar or ninja loans (No Income, No Job or Assets), no matter what their credit ratings. The days of using one's home as a piggy bank which is refilled with equity every few years is over. The days of no money down unconventional loans are over. Thank goodness!

The truth is that the reduced borrowing and increased spending is good for the country in the long run. We have been on one big 25-year economic speed trip. Now we are going through withdrawal to come clean. It is painful, but necessary. If permitted to sober up, the U.S. economy will be more fundamentally sound in a few years, but the days of families earning $75,000 per year driving $50,000 vehicles and living in $500,000 homes are over.

Current conditions have fixed income investors reaching for yield. They see opportunities where none may exist. Beware high yield bonds. Yes, they have had quite a run, but now may be the time to sell before reality sets in rather than buy. I have also seen investors buy low-coupon preferreds at discounts thinking that they will reap a windfall WHEN they are called at $25. Here is a tip. An issuer needs to save between 75 and 100 basis points to make a par call economically feasible. This means that preferreds with coupons below 7.00% have a great chance of being traded by my grandchildren. Investors buying GSprB or ATT at yields dipping below 6.00% are borderline stupid.

Enjoy tomorrow's earnings releases. GS and C report.

It's Not That Bad - It;s Not That Good.

Don't read too much in to the poorer-than-expected 30-year auction today. Yesterday's 10-year note auction was a blow out. This week's auctions were re-openings of existing treasuries. Both trade at premiums (30-year over 107). This precludes some institutions from purchasing. Next month we have truly new treasuries. That will be a better gauge of interest. Even with the large premium investors bot $12 billion 30-years at 4.00% versus an expected 3.99%. 4.00% does not indicate a desertion of long-dated treasuries by any means.


Why am I not enamored with the recovery? It comes down to jobs, wages and spending. During the past 20 years, spending in the U.S. grew far more than did wages. This was due to easy access to ever cheaper leverage. Those days are gone. at least for now. They never should have arrived in the first place. Without consumer spending, job growth will be tepid. Without job growth, wage growth will be lackluster and spending will suffer. The U.S. economy has improved and will continue to do so, but going forward the economy will look more like the 1950s than the 1990s or 2000s.

In and Out and In and Out

I will be posting here sporadically during the next month. I have school work to which I must attend. I should be back in full force by mid November. In the mean time, pay close attention to the words of Stiglitz, Laffer and E-Erian

Stocks, Bonds and Automobiles.

This was a rough week for economic optimists and stock market cheerleaders. The stock market took its biggest beating in months. Long-dated treasuries reached their lowest yields in months. Auto sales dropped sharply in September without the benefit of "Cash for Clunkers." Let's discuss.

GM reported a sales decline of 45% and Chrysler a drop of 42%. The government and it's UAW supporters have their work cut out. Both companies are losing markets share and are directionless in terms of product. GM, Chrysler and Ford need annual U.S. market auto sales of approximately 15mm to 16mm. The current sales pace is just over 9mm. With traditional lending standards back in use (one actually has to prove their ability to make payments) it is unlikely that auto sales will reach necessary levels, even when the economy rebounds. How critical is it for the Detroit Three to sell to subprime borrowers? Prior to its bankruptcy filing, GM's management asked the government to assist GMAC in lending to subprime borrowers. GM and Chrysler are done in their current forms and as long as they have to depend on UAW labor.

Speaking of recovery, nearly every economic indicator is pointing to another moderation as inventory replacement peters out. Lenders report that foreclosures continue to be problematic and credit card defaults and delinquencies continue to rise. Asset-backed experts continue to warn of significant, permanent impairments to loans, especially those issued from 2005 onward.

The financial media continues to report that, in spite of encouraging economic signs, companies are reluctant to hire (actually, they continue to shed jobs). Either these journalists are trying to help jawbone the economy and especially) the markets higher or the are clueless as to how the economy works. It is the consumer which drives business, not the other way around.

The financial markets are telling a divergent story. The equity markets are (or were) indicating that the economy was poised to make a sharp, V-shaped recovery. The reason given is so lame. "It has to recover sharply because of the government stimulus" is not a valid argument when one considers why the economy fell into the deepest recession since the great depression. There is no leveraging our way out of this. The stock market is wrong. However, it was wrong when it sunk to its cyclical low in March.

The equity market may be considered the market of hope and fear, but one could argue that the bond market is the market of reality. This is not to say it has never been wrong in its ability to predict the economic future, but it is less influenced by wild springs generate by speculative greed and fear. The treasury market in particular is an institutional market with much foreign central bank involvement. Until the U.S. economy exhibits structural and not credit-driven or inventory replacement growth will foreign central banks reduce their purchases of U.S. treasuries.

The fear that foreign central banks will abandon the dollars are unfounded, at least for now. Remember, foreign exporters to the U.S. are paid in dollars and not their home currencies. They have a vested interest in keeping their exchanges rates versus the U.S. dollar favorable. One way to do that is to buy U.S. treasuries. This as the added benefit of helping to keep U.S. consumer interest rates low making it even more affordable for U.S. consumes to spend. This is not to say that long-term rates will never rise. It is not a far fetched scenario to see the 10-year treasury note approaching 4.50% or 5.00% in 2011, but that could be the cyclical high. I think we see the 10-year hit 2.75% before we see it hit 3.75%.

Investors and consumers had better change their outlook. We will be back to the days when buying a television required looking at the family budget and buying a new car was the talk of the neighborhood. In may opinion, this is not a bad thing, unless you work for the UAW and the Detroit Three.

The Fed's Ponzi Scheme

The stock market is up approximately 57% since its March lows. One would forgiven if they assumed that investors were pouring money into equity mutual funds. Actually it is bond funds which have garnered investors's attention. Morningstar reports that bond funds have received net deposits totalling $209.1 billion while stock funds attracted $15,2 billion in deposits. Why have many investors shunned equities, especially with its sharp rise, and have flocked to bonds?

The answer is two-fold:

1) Baby Boomers are aging. They will focus less on stocks and more on bonds. An aging population means more focus on bonds.

2) Not everyone buys into the recovery story. In fact, it is mostly equity oriented money and fund managers who talk the V-shaped recovery story.


It is true that the bond guys have fund managers talking their books and the markets higher. PIMCO's Bill Gross is one. However, not everyone on the bond size of the business is talk a book. Art Laffer, Alan Greenspan and even Ben Bernanke, to name a few, are warning of sluggish growth once government stimulus ceases. The plain truth is that there can be no sustained strong growth or core inflation pressures (at least not at first) without job growth and either wage growth (which has been sluggish during the past two decades) or easy access to increased amounts of leverage. The Fed decided to focus on cheap leverage to stimulate the economy, cycle after cycle.

The problem with using ever cheaper leverage to reinvigorate the economy is that it is a finite proposition. After all, interest rates cannot be lowered ad infinitum. At some point rates will approach zero and the ability to stimulate the economy ceases. Another factor in the economic growth experienced during the past two decades is securitization. Securitization enables lenders other than traditional banks and finance companies to write loans to risky borrowers, securitize the loans, sell them off and loan the proceeds to new borrowers. Again, leverage is not forever. eventually these borrowers have to make payments on these loans. Paying debts would strain family budgets. The Fed's answer was to lower rates again. Wall Street would find new ways to lend to who really should be unlendable. Home prices would rise due to low interest rates and easy loan terms attracting more buyers. Now the existing borrower could refinance their mortgages and spend either the new budget surplus or spend the increased home equity resulting from Fed policy.

We have hit bottom. No longer can the Fed lower rates from here. No longer can loans requirements be lowered to the point where the unemployed were receiving credit. Wages have little chance of growing as companies keep a tight hold on expenses. The consumer is out of the game. The treasury market is right. The economy will be sluggish once again. Today's poor ADP Employment report and Chicago Purchasing Managers' report is only the beginning. I am looking for more poor data during the next several quarters.

Here's A Little Song I Wrote

I have received many questions regarding the credit markets. Let's discuss:



1) Allianz has decided to delist its AZM preferred. This has nothing to do with the health of Allianz, but rather the burdensome reporting requirements required to list a security on a U.S. exchange. Allianz has decided that being listed on the NYSE is not worth the time, effort and money required to list AZM.

2) Will RBS or ING suspend preferred dividends? From an economic perspective, both of these firms are unable to pay preferred dividends. Payments are being made using government aid money. Thus far, the British and Dutch governments have permitted such payments. If the political winds shift the dividends could be suspended. Only own RBS, ABN AMRO or ING if you have faith in national governments. Freddie and Fannie preferreds have taught me not to touch governments.

3) What preferreds to I like? Most preferreds are no longer cheap. The two which I think may offer the best values are National City NCCprC (PNC) and Countrywide CFCprA (BAC).

Do not be lulled into a false sense of security (don't panic unduly either). My fear is that investors are increasingly densistize to risk. This happened between 2003 and 2oo6. Invetsors, reaching for yield, would invest in securities inconsistent with their risk tolerances to pick up yield. That could be a dangerous proposition this time around (but bot yet).

Long-term treasuries yields will remain low (for now), but when it pops it could be ugly. Remember, a 10 year noncallable bond will experience of about 3 to 5 points of price decline for a 50 basis point rise of its YTM. Although I agree that PIMCO is mostly right in stating that low long-term interest rates will probably be with us for awhile. Please e-mail or post questions.

And It Makes Me Wonder

Today's 7-year treasury auction went very well. The new 7-year U.S. treasury note drew a yield of 3.005 versus an expected 3.047. The financial media was eager to explain the strength of the auction away. For instance, Bloomberg News credited (blamed) weaker-than-expected existing home sales data for the flight to U.S. treasuries. If one merely looks at the surface, that explanation would appear to be accurate. However, we do not stop at the surface around here.

A dead give away that existing home sales were not the driving force behind the strong 7-year auction is the indirect bid data. Indirect bidders, which includes foreign central banks, purchased 61.7% of the new issue. According to U.S. treasury data, indirect bidders purchases an average of 46.2% of the past seven 7-year auctions. Although some smaller investors may have been motivated to participate in today's auction because of today's existing home sales data. Foreign central banks take a big picture approach to treasury purchases and it is very likely that the majority of today's indirect participation was decided upon days in advance (if not longer) of today's auction.

What do foreign central banks know which would encourage them to continue to purchase large quantities of U.S. treasuries at historically low yields in the face of a strong stock market. The answer is that indirect bidders may buy treasuries, but they do not buy the V-shaped recovery argument.

Foreign central bankers know that U.S. economic growth will be hindered by poor consumer activity over the next several years. They know that problem is not a lack of bank lending, but a rediscovery of prudent lending standard. The U.S. economy (and global economy) has enjoyed ever-cheaper credit and ever-lax lending standards. The party is over folks. Look at all the charts you want, the past IS NOT an indication of the future (man, I sound like a mutual fund). Seriously, one cannot look at past cycles, isolate a repeated trend and automatically assume it has to happen again and again. One must also consider the extenuating circumstances. The Fed is not perfect, but I believe it to be accurate when it states that growth will be modest in the near future.

It is the possibility, if not probability, of muted growth that is keeping long-term yields low, for now. This leaves fixed income investors in a quandary. Overweight the long end and you are caught with your pants down when long-term yields finally move higher. Overweight the short end of the curve and your income stream is so low it is almost impossible to catch up even if one extends out on the curve at a later date at higher yields. We would need Carteresque economic conditions to make market timing rewarding in the treasury markets.

Also, investors should understand the difference between fixed income investments which are interest rate products and those which are credit products. U.S. treasuries are interest rate products as they have no credit risk. Short-term securities, such as T-bills and short-term notes, trade at yield levels which reflect Fed policy. Longer-term yields, such as those found with 10-year notes and 30-year government bonds reflect inflation expectations. If bond investors believe that inflation pressures are going to be mild, they are willing to invest on the long end of the curve at modest yield levels as they do not believe inflation will be present which will erode the value of their fixed cashflows.

Credit products, such as corporate bonds, trade at yields which reflect interest rate projections AND the perceived creditworthiness of the issuer. It is possible for corporate bond yields to behave quite differently than treasury yields. We have had two good examples during the past year. Last year as the banking system was pushed to the brink of collapse, credit spreads for financial companies widened out. This caused corporate bond yields to rise. At the same time, treasury yields fell as the Fed lowered short-term rates and investors bought treasuries across the yield curve in a flight to safety from corporate debt to government debt. Corporate bond yields moved in the opposite direction of treasury yields. This makes some portfolio stress tests useless as they tend to stress a fixed income portfolio for specific moves in interest rates,. Most stress tests cannot account for the behavior of credit yields. Many do not account for the changing shape of the yield curve due to Fed policy and inflation expectations. Long-term and short-term yields more often than not do not move in lock step with each other. In fact, they may not even move in the same direction. Always contact a fixed income professional before venturing into the fixed income markets.


So which market is correct in its forecast for the U.S. economy? Don't bet against the bond market.

Another Tricky Day

Today, the Fed left the Fed Funds rate at 0.00% - 0.25%. This was expected. What was not expected by the markets, especially the equity markets, was the Fed's lack of color on how and when it will remove stimulus. Yes, the Fed said it would scale back the purchasing of agency debt and agency MBS and be finished with the program by the end of the first quarter 2010. The FOMC also stated that the economy was exhibiting some strength. On the release of the FOMC statement the equity markets sold off and the bond market rallied. Why the counterintuitive response from the markets?

The answer is because the markets, especially the equity markets, believed that the Fed would announce that it would, at worst, announce that it would end its purchases of agency debt and MBS by this October as originally planned or, at best, announce that the economy was recovering sufficiently for the Fed to begin selling its portfolio of agency debt and MBS in the near future. As is typical, the equity markets were overly optimistic (they are also often overly pessimistic) and as a result, the equity markets trended lower. Of course the media published headlines that the Fed said the economy strengthened. Here is the actual FOMC statement:

For immediate release. September 23, 2009.Information received since the Federal Open Market Committee met in August suggests that economic activity has picked up following its severe downturn. Conditions in financial markets have improved further, and activity in the housing sector has increased. Household spending seems to be stabilizing, but remains constrained by ongoing job losses, sluggish income growth, lower housing wealth, and tight credit. Businesses are still cutting back on fixed investment and staffing, though at a slower pace; they continue to make progress in bringing inventory stocks into better alignment with sales. Although economic activity is likely to remain weak for a time, the Committee anticipates that policy actions to stabilize financial markets and institutions, fiscal and monetary stimulus, and market forces will support a strengthening of economic growth and a gradual return to higher levels of resource utilization in a context of price stability.With substantial resource slack likely to continue to dampen cost pressures and with longer-term inflation expectations stable, the Committee expects that inflation will remain subdued for some time.In these circumstances, the Federal Reserve will continue to employ a wide range of tools to promote economic recovery and to preserve price stability. The Committee will maintain the target range for the federal funds rate at 0 to 1/4 percent and continues to anticipate that economic conditions are likely to warrant exceptionally low levels of the federal funds rate for an extended period. To provide support to mortgage lending and housing markets and to improve overall conditions in private credit markets, the Federal Reserve will purchase a total of $1.25 trillion of agency mortgage-backed securities and up to $200 billion of agency debt. The Committee will gradually slow the pace of these purchases in order to promote a smooth transition in markets and anticipates that they will be executed by the end of the first quarter of 2010. As previously announced, the Federal Reserve's purchases of $300 billion of Treasury securities will be completed by the end of October 2009. The Committee will continue to evaluate the timing and overall amounts of its purchases of securities in light of the evolving economic outlook and conditions in financial markets. The Federal Reserve is monitoring the size and composition of its balance sheet and will make adjustments to its credit and liquidity programs as warranted.Voting for the FOMC monetary policy action were: Ben S. Bernanke, Chairman; William C. Dudley, Vice Chairman; Elizabeth A. Duke; Charles L. Evans; Donald L. Kohn; Jeffrey M. Lacker; Dennis P. Lockhart; Daniel K. Tarullo; Kevin M. Warsh; and Janet L. Yellen.

The real keys to the FOMC statement was that conditions are likely to remain week for sometime and that resource slack continues. The Fed has NO plans in the foreseeable future to raise the Fed Funds rate. It knows what I know. It knows that the consumer is not rescuing the economy this time. It knows that if the Fed stimulus was withdrawn now, the housing market would collapse.

I am not alone in this opinion. CBRE President, Ethan Penner has concerns that real estate problems are not over. In his most recent report he explains how securitization made traditional portfolio lending obsolete and how now that securitization has failed, the global financial system was doomed. He sums up the real estate situation with the following bullet points:

"We are in a process of correcting from historical high valuation - losses cannot be avoided"

"Recent lending standards stunk and most loans originated since '05 are horrible"

" Legacy CMBS market is fragile. PPIP will delay the inevitable."

"Legacy Loans are worth a fraction of face value; less than 80% even for performing loans."

"Unprecedented defaults and loss severity numbers are a certainty."

"TALF is the new repo facility for the bond market and will inspire financing activity once the market clearing begins."

"Cap rates are mostly 8.5% or higher."

"Today because of the shortage of lender equity and the system's need to equitize the lending business, leveraged first mortgage investing provides superior risk-adjusted returns to an equity stratgey."

"The bond market, through CMBS, will not have the day for RE as it didi in the early 90s."

I don't pretend to be as knowledgeable as Mr. Penner (I had the privilege of speaking with him about two years ago and I can attest he is very bright). However, I have long been of the opinion that there is no way to avoid losses due to fundamentals. If a property is only worth "X" in an environment of prudent lending standards then it is worth "X" and there is no way to make it worth more other than repeating the mistakes of the past. We are unlikely to see a repeat performance, at least not this soon after the crisis as investors are wise to just what kind of assests are used in the securitizion process and understand the risks.

The bottom line is that the consumer will be under pressure from declining and lower home values and a VERY poor jobs market. Banks will take more losses as loan valuations will be lowered. This will hold down broad-based inflation. This should keep long-term interest rates from rising too far too fast. Most inflation will be in commodities such as metals and oil as well as food. Price increases of food and energy will crimp growth by acting as a regressive tax on consumption. Those who believe business will pull us out of this economic much are dreaming. Business is reactive to consumers, not proactive.

The recession may have ended, technically, based on GDP, but modest growth due to depleted inventory replacement fueled by record economic stimulus is nothing to write home about. This is why long-term rates remain low and large treasury buyers, especially large foreign investors, continue to buy long-dated U.S. treasuries.

Stay liquid and DO NOT extend far out on the curve as long-term rates will eventually pop. Low-coupon preferreds are especially vulnerable. CDs on the short end, agency bonds 3 - 5 years out and high grade corporate bonds 6 - 10 years out are the best values in the bond market.

Train Kept A-rollin'

There is a belief among many investors that the markets always accurately represent the fair value of asset. We know that to be untrue. If stock and bond prices were always correctly valued there would very little market volatility. There would be no bubbles or corrections. We would have never has a tech bubble and severe correction. There would have been no real estate bubble and catastrophic retrenchment. There are times market prices are based on value. However, we are in markets driven by momentum traders.

There is an old saying among traders which states: "The trend is your friend". In other words, one may not agree that market prices are based on fundamental values, but if the trend is moving in a particular direction (up or down), one has to trade accordingly. Remember, there is a difference between a trader and an investor.

An investor looks for long-term value or income. He or she will seek vehicles which address particular financial needs and tweak their portfolio as necessary. Risk, yield and fair value are very important. A trader does not care whether or not an assets should be priced at a particular level. A trader only cares which direction the price of said asset. A trader may view a stock priced at $50 as being over valued, but if the momentum appears ready to push the stock to $60, the trader climbs aboard. If momentum is poised to push the stock lower, a trader may flatten his position or even go short. No matter how much momentum may be present during an asset's or market's most frenetic period, calmer heads will eventually prevail and say enough is enough.

When the value of an asset or market rises or falls well beyond what fundamentals indicate to be fair value, the prices moves (corrects) to reflect fundamental valuations I.E. tech bubble and housing bubble. Given the economic data we have seen in recent months, the severe bear market which troughed in March 2008 may have overshot to the downside (hindsight is 20/20), but the data doesn't bear out further increases in equity prices or tightening of corporate bond and preferred security spreads. Fixed income market participants and experts have been very vocal about their tempered forecasts for economic growth.

The other day, Fed Chairman, Ben Bernanke warned that although the recession may be technically over, growth will be tepid during the next several years and inflation pressures will be subdued. Today, former Fed Chairman and current presidential economic adviser, Paul Volcker gave his less-than-thrilling assessment of forthcoming U.S. economic growth. At a financial conference held in Beverly Hills, California, Mr. Volcker had this to say:

There is “long way to go” before economic growth returns to normal (whatever that is going forward).

“It will be a long slog -- a matter of years -- with the risk of some relapses along the way.”

Mr. Volcker also warned that it will be along time before it is business as usual and he favors trading and risk restriction on banks deemed to big and important to fail. You go Paul!

Bank of America Chief Economist, Ethan Harris told Bloomberg News:

"We have a deep hole to dig our way out of." He believes the U.S. labor market is "in a severe bleeding mode." He predicted that unemployment would peak at 10.2% in the first quarter 2010 before moderating very slowly.


Let's be clear, the economy's recovery prospects are limited unless jobs come back and these jobs pay well enough to promote discretionary spending. I think this is highly unlikely. Why? First; business do not hire proactively. They hire reactively. This is why the Fed has, for nearly three decades, to spark spending by lowering rates during recessions. The thinking is that those who have cash or (especially) access to credit spend, generating demand and jobs. Those days are gone. Rates are near their historic levels. There is not much spendable income available among U.S. consumers and those who have access to credit has fallen as lenders require more than a foggy mirror to obtain a loan or credit cards.

No, this economy is mired in an economic swamp, one which will require much time from which to emerge. Asset prices among corporate credit prices are (by and large) fairly priced or rich versus fundamental. Corporate bond and preferred investors should be looking toward the treasury market and not the equity market for guidance on where the economy is going.

Inflation should remain subdued, making most TIPs unattractive. Some believe that printing of money and issuance of debt will cause inflation. Although government actions such as these could put upward pressure on prices, but wage stagnation (or worse) and a poor labor market will keep many consumers on the sidelines. This makes the 10-year area of the corporate credit curve attractive, but mainly in the acquired subsidiaries of larger banks).

Instead of a V-shaped recovery, we could have an O-shaped recovery. Round and round she goes.