Get It Right

Yesterday's New Home Sales report was just awful. Some experts tried to spin to portray the numbers as not being all that bad. Spin all you want, if it looks like a duck, walks like a duck and quacks like a duck, one can be certain that it is not a golden goose. Miller Tabak's Dan Greenhaus called yesterday's New Home Sales report "horrible.


With substantial government stimulus being pumped into the housing markets, why did new home sales fall? The answer is that rising foreclosures are creating bargains in the secondary market. Why buy new for $450,000 when you can buy slightly used for $250,000. The supply if homes continues to be greater than demand. This will keep home prices down and the demand for new homes soft.

Today did not bring with it encouraging economic data. Headline Durable Goods looked, but when one backs out volatile and seldom repeatable aircraft sales, Durable Goods actually fell. Most components other than aircraft came in either negative or below forecast. One possibility for the pull back in Durable Goods is that manufacturers are pulling back while they gauge demand. Judging by recent reports, especially Consumer Confidence, demand is going to soft in the near future.

Some bulls pointed to the increase of 11,000 factory jobs registered in today's Durable Goods report. However, manufacturing only makes up approximately five percent (durable goods manufacturing accounts for seven percent of the U.S. economy) of the U.S. economy. Also, there have been announcements of significant service sector job cuts in recent days. For example: Finance company Ford Motor Credit announced it will eliminate 1,000 jobs. The manufacturing sector is not immune as evidence by Ford cutting 900 jobs at a plant producing Mustangs and the possibility of 3,000 jobs losses should GM close its Hummer brand as is now expected. Folks, until there is significant job growth there will be no v-shaped recovery in the broader economy. In fact, we may have seen the peak of corporate earnings for some time.

What about exports? The remainder of the world is slowing with us. Former IMF economist Ken Rogoff warns that Chinese growth could fall to the 2.00% area as that country's debt-fueled bubble deflates. As I have said before: "decoupling is a myth." In fact, the world is more linked than ever. This is evidenced by the behavior of asset prices.

Early in yesterday's trading session (before Bernanke's testimony began to hit the tape), a reader asked my why equities were rallying in in the wake of poor economic data. I explained that it was due to dollar weakness. The equity market recovery is a result of both a weaker dollar and mega government stimulus (extremely low rates). As long as rates stay low (as Fed Chairman Bernanke says they will) and the dollar remains weak the equity markets could perform well. However, if the data is so poor that it appears that consumers ability to spend will remain constrained we could see a selloff in the equity markets. That should strengthen the dollar. That is what is happening today following poor jobless claims data.




Today's Jobless Claims data was troubling to say the least. It demonstrates that U.S. job growth is nearly non existent. We appear to be treading water at best. Remember, it takes job growth for about 100,000 per month to keep pace with new workers entering the workforce.

Finally, if the markets are a dollar story how does one take advantage of dollar volatility. I am a believer in that the U.S. dollar will be one of the stronger currencies in the near future. When I say this many readers whine about our massive debt issuance, large deficits and inflation being fueled by cheap credit. These critics must understand that the U.S. does not exists in a vacuum. Smaller countries can have debt an currency crises which have little effect on the rest of the world. The U.S. is not Argentina. We sneeze and the world catches cold. This is evidenced by the problems elsewhere around the globe.

In my opinion we have seen a crisis (autumn 2008) and rebound (2009). Now we will move forward based on fundamental growth. This means demand from replacement, efficiencies and population growth. These will increase demand for housing, products and services. That may not lower the unemployment rated back down to 5.00%, but it should, at some point, lower unemployment below 9.00%. What is full employment? That is a moving target, but it is probably higher than what we have seen during the two previous bubbles when experts attempted to convince us that prevailing economic conditions were fundamentally sustainable (while consumer debt rose to record levels).

Trade ideas. GE Cap and BAC 10-year notes. BAC subordinate notes are particularly attractive. I would go long the dollar (or short oil). Look for the curve to remain steep for now, but the next major move will be a bear flattener.

Banks, You're On Your Own

The Fed threw the markets a curve ball this afternoon by raising the Discount rate 50 basis points to 0.75%. The financial media is all a-buzz with stories discussing how the Fed is going to tighten sooner and more rapidly than expected. Let's put things into perspective.

Raising the discount rate affects no one and nothing except for banks needing funding from the Fed window. If anything this was a shot across the bows of the banks. The statement the Fed is trying to get across is that banks have been given enough help. It is now time for banks to fly under their own power. This will have little or no effect on the strongest banks. Banks which still have impaired balance sheets and which could have difficulty getting interbank financing at the Fed Funds or LIBOR rate should take the move as an incentive to fix whatever remains broken.


The knee-jerk reaction in the corporate bond market could be to broadly widen credit spreads on all bank and finance bonds. If that happens to bonds issued by J.P. Morgan, Goldman Sachs, Morgan Stanley US Bancorp, PNC, etc. should be viewed as a buying opportunity. Even BAC should be a good buy. Beware the regionals and banks which remain government owned.

Upon the Fed's announcement the dollar rallied and the long end of the treasury curve sold off. The reason for the dollar rally was the speculation that by investing in dollars one will be able to ride short-term rates higher. Another reason is that if this is the start of a greater trend for higher borrowing costs for banks, they will be forced to lend and the economy will expand. This is also why long-term treasuries sold off. I think the markets are being a bit too optimistic.

Banks will not lend if they cannot securities the loans. That means that loans have to be of a very high quality and /or be agency eligible. If bank borrowing costs rise, credit will not flow any easier as it is more cost-effective not to borrow and lend than to write bad loans.

This could also be a warning sign that the newly confirmed Ben Bernanke is more Paul Volcker and less Arthur Burns. Today we had a somewhat higher PPI report. That doesn't matter that much to CPI unless businesses can pass along price increases. That is not the case at this time.Many pundits believed that Mr. Bernanke would not take any action to raise any rates as long as employment struggled. Today's jobless claims data was disappointing. So why did the Fed shock the markets at all? Because raising rates could help employment.

Stay with me here folks and let me explain. Picture yourself as a business owner or chief executive. Your costs for materials has just risen, but your sales have not. Consumers are not back in the game and may not be back for a long time (if ever) so you cannot raise prices for your goods or services. How are you going to make ends meet? You are going to pare workers. However, what if rates rose, the dollar strengthened and, due to a stronger dollar, the prices you pay stabilize or fall. Now you do not need to cut your workforce further.

Look for growth to remain modest as the dollar strengthens. A stronger dollar hurts U.S. exports (there goes manufacturing), but is helps every other area of the U.S. economy. It also attracts foreign investment into the U.S. keeping long-term rates under control.

I think long-term rates will rise some more, but low to mid 4.00% is all we get out of the 10-year treasury this time around. Fed Funds and LIBOR probably to go beyond a 4.00% handles. Owners of LIBOR floaters may get a point or two more out of their preferreds, but the time to sell is fast approaching.

Have a great weekend and buy large bank bonds on any dips.

Color By Numbers

During today's trading session the U.S. equity markets rallied after some encouraging data. The first was better-than-expected earnings by Barclays. The second was a better-than-expected Empire Manufacturing report. The third was data which indicated that foreign demand for U.S. treasuries waned in December. At first glance this looks very bullish for stocks and very bearish for bonds, but the truth is not skin deep. This was evidenced by the differing reactions by the treasury market (which counterintuitively rallied) and the equity market.


Let's begin with Barclays. Barclays reported very good numbers. The bank did report strong profits from investment banking, but most of its profit was due to the sale of Barclays Global Investors to Black Rock for $9.9 Billion. Barclays improved core earnings are not to be dismissed, but the numbers are not quite as rosy as the financial press would have us believe.

The same can be said for Empire Manufacturing. The report came in at better-than-expected 24.9, but a closer look at the data reveals that almost every component was worse than the previous month. What carried the day? Inventories. It was the inventory component which drove the number higher. New orders fell to 8.8 from 20.5. Shipments fell to 15.1 from 21.1. Prices paid fell slightly to 31.9 from 32. A gauge within the report which measure the outlook for the next six months fell to 52.8 from 56. However, the employment component rose to 5.6 from 4.0. I would consider this a mixed report.

The Net Foreign Securities Purchases data indicated that China was a net seller of U.S. treasuries, but Japan was a net buyer. All told foreign central banks were net sellers of U.S. debt. If that was the case, why did the long end of the treasury curve rally? It turns out that much of the selling came fro China liquidated treasury bill holdings. This would affect the short end and nor the long end. Yields on the long end are hanging in there as the bond market is not convinced that robust, sustainable growth is yet upon us.

I feel like I am raining on everyone's parade, but that is not my intent. I am just trying to make sense out of the data and policy. One reader suggested that I publish some trade ideas. With few exceptions I have been reluctant to do so. I don't want to be accused of hawking products or talking books, but if readers want some specific opportunities I will come up with a few. I will not be easy and in this mature, if not rich, fixed income market beauty is truly in the eye of the beholder.

For What It's Worth

As the market recovery reaches maturity any investors and market participants are asking: "What are my securities really worth?" With the equity markets up nearly 50% and corporate bond credit spreads within or approaching historic norms, this is a good question to ask.

During the past year, too big to fail policies, a VERY accommodative Fed and relaxed accounting policies (such as the easing up on mark-to-market accounting) had market participants buying until they could buy no more and investors once again believing that trees will go to the sky. However, reality is setting in. Investors are asking: "What happens when the Fed becomes less accommodative?" What happens if the toxic assets not being marked by banks are not really worth 100 cents on the dollar?" "What happens if businesses have become more productive and do not need to rehire many workers who were laid off?" These are good questions. The answers will probably not be what most investors want to hear.

This is not all bad. Homes were not really worth the prices at which they sold during the height of the bubble. It could be many years before population growth creates sufficient demand for homes to push prices back up to their lofty levels of a few years ago. Corporate credit spreads probably will level off in the near future and, in the case of sectors and companies which have tightened the most. The crises in Greece is not in itself a catastrophe, but it will cause investors to asses risk based on true credit quality and not on "too big to fail" (news out of Europe this weekend is that many European leaders are balking at a bailout for Greece).

Investors should also understand how their bonds and preferreds work. Understand what makes them rise, fall or be called. One may cannot know where rates and spreads will be a few years ahead, but if one knows where rates and spreads must be, one can make an educated and reasonable decision about which securities are right for the, and which securities are not. Of course, I am always available for consultation.

From 2/11

This is a post which should have been made on 2/11/10:


The EU announced a German-led rescue plan (well kind of) of the Greece. Although European leaders stated that Greece would not be permitted to fail, how this would be accomplished. The statement said that EU countries "will take determined and coordinated action, if needed, to safeguard financial stability in the euro area as a whole." What will the EU do? A lot! The EU has a dilemma. It cannot let Greece fail yet the EU has to be careful not to anger citizens of other EU countries for using their tax money to rescue nations such as Greece which have ignored EU rules concerning sovereign debt and deficits for years. The EU did not detail rescue plans, but it is believed some kind of loan package is in the works. Past French calls for a more centralized European economic government may be renewed.

News that Europe will do something to help Greece (and, by extension, the other PIGS countries) sent the prices of U.S. treasuries lower (and equity prices higher due to a weaker dollar as investors became more comfortable with riskier non-dollar assets). Also negatively impacting treasury prices was a relatively weak 30-year government bond auction. Although indirect bidders (which include foreign central banks) were present, direct bidder interest was wanting. Mysteriously, an unnamed direct bidder appeared and purchased 24% of the deal. This is unusual and the street is suspicious of whom the bidder might be.

In spite of what some media sources reported, U.S. treasuries did not trade lower due to the belief that the global economy is improving more strongly than anticipated. It was all about the Greece rescue and fear that the U.S. could experience credit quality issues from its large debt issuance and deficits. The difference with the U.S. is that we are the world's market place and the dollar is the world's reserve currency. This is not something any other country enjoys.

This weekend is Presidents Day. I hope to have a new post out on Monday

Fish or Cut Bait

Fed Chairman Ben Bernanke outlined his plan to remove the massive stimulus the Fed has infused into the U.S. economy. In a prepared statement (his live address was canceled due to the blizzard many of us are experiencing on the east coast). Mr. Bernanke suggested that the Fed could begin raising the discount rate (the rate at which financial institutions can borrow from the Fed window overnight). In 2008, the Fed lowered the discount rate to match the Fed Funds rate to help rescue the financial system. Typically, the discount rate had been 100 basis points above the Fed Funds rate. Typically, banks would not borrow from the Fed window for fear of being labeled a troubled institution. My how things have changed.

Making in more expensive for banks to borrow short-term funds should, in theory, force banks to stop the "government carry trade" in which banks borrow from the Fed and lend to the treasury (by purchasing treasuries) and write more loans. Logic says that if it cost more for banks to borrow they must earn a higher return on the borrowed capital. However, banks do have an alternative. They could simply borrow less and lend less. That is not what the administration would like to see. Mr. President, behold the independence of the Fed!

Such actions would cut into bank profits, but it would probably not leas to failures among large banks. Credit ratings downgrades and wider credit spreads yes, defaults no. This of course would lead to higher borrowing costs and wider credit spreads throughout the markets. I expect modest spread widening to continue.

The equity markets did not like what Mr. Bernanke had to say. For all the bullish bluster emanating from the equity markets participants know that, thus far, the recovery is almost completely stimulus driven and that corporate profits are not yet sustainable at current levels without significant stimulus. The markets mostly recovered late in the day, but that was probably more due to traders leaving early due to the storm and flattening their positions rather than any belated confidence in the economy.

I believe that 2010 will be a long hard slog. Upward, but slow. I don't believe that the foreign debt crisis is over either. Look for export-driven economies to look for ways to devalue their currencies to export their way to success. Beware the PIGS. Germany's proposed rescue of Greece is, at this time, a loan. Loans have to be repaid, unless one is a U.S. homeowner. :o

Brothers In Arms

Through the fields of destruction
Baptisms of fire
I've watched all your suffering
As the battles raged higher
And though they did not hurt me so bad
In the fear and alarm
You did not desert me
my brothers in arms - Mark Knoplfer / Dire Straits

www.mksense.blogspot.com


The second have last week was certainly a blood bath. Friday bordered on an apocalypse until word spread throughout the markets that the EU may announce a rescue plan for Greece over the weekend. Some pundits questioned why the potential economic collapse of a small (approximately 11 million people) would rattle markets around the globe. The reason is that there are other economies is similarly dire straits and a run on Greece could easily spill over to the remaining PIGS and beyond. Let's be clear. Europe is not an economic expansion powerhouse. Job creation is almost non-existent. Corporations experience significant interference from government and unions. They are not for profit engines of growth as to what we in the U.S are accustomed.

It has baffled me for many years why investors have looked to Europe as a replacement for the U.S. to invest for growth. It is true that the former Eastern Bloc nations experienced robust growth, but that was do to their playing catch up to Western Europe. Portugal, Italy, Greece, Spain (PIGS) along with the former Eastern Bloc nations took advantage of cheap financing and an almost insatiable investor appetite for all things European to lever up as a way to fuel growth. Now they are saddled with an enormous deficits relative to their size and, since these countries are not market places for goods like the U.S., no one has to invest in their sovereign debt.

Many people view the EU as a United States of Europe. This is not the case. The EU as loose confederation of nations, a trading bloc if you will. Yes there is the ECB, but it does not have authority over sovereign banks and banking systems. That falls to sovereign central banks and governments. To be sure there are many people in larger European economies, such as France and Germany, who do not want their tax dollars bailing out countries which overextended themselves. I believe that EU governments will rescue the PIGS as not doing so would comprise the integrity of the union.

Things are not all that rosy on this side of the Atlantic either. Jobs data has been lack luster. Yes, the unemployment rate fell to 9.7%, but the economy continues to bleed jobs. Construction jobs led the way in losses. Market bulls made arguments such as: 1) If not for construction jobs losses we would have added jobs. 2) Companies continue to add temporary workers, a sign that a recovery is in progress. 3) Employment always lags. It will catch up, eventually.

Although these arguments are not necessarily incorrect, they do not depict a situation in which we see companies open up the doors for new permanent jobs. Due to productivity gains, more economic activity is required than ever before to create jobs. Much of the economic recover has been via inventory management and business to business activity. This can only do so much. Some economists say to be patient. Eventually consumers will stop deleveraging and take on more debt. Have these economists taken a good look at household debt levels. Even if banks began a repeat performance of irresponsible lending (which is not happening until a new brood of business grads are hatched from their Ivy League coops a time sufficiently in the future for the recent mistakes to be forgotten), consumers cannot afford to service such debt. It was consumers inability to service their current debt when many more of them were working that got us into this mess.

What does this mean for the markets? Long-term treasury rates will creep higher (as will mortgage rates) as the Fed removes its quantitative easing of purchasing treasuries, agencies and agency mortgage backed securities. This will cause the yield curve to steepen as the Fed will keep shirt-term rates at 0% to .25% for most or all of 2010. In 2011 we are likely to see a bear flattener in which short term rates rise towards long-term rates. I would recommend LIBOR-based floating rate preferreds heading into such an environment, but their current trading levels, spreads over LIBOR and their floor coupons of 3% to 4% (which are perfectly positioned to not benefit much from what promises to be mild Fed tightening) make them unattractive propositions.

Corporate credit spreads have tightened nicely during the past year. Many experts believe that will continue. I agree, but further tightening will be much more modest and sector (and even name) specific. Industrials, utilities and telecoms have little room to tighten. Financials have some room, but the better names such as GS and JPM have little more tightening left. If jobs continue to lag, productivity gains slow and the benefits of inventory management wanes we could even experience renewed spread widening. In such a scenario, the dollar would be the currency which benefits the most.

"No the sun's gone to hell
And the moon's riding high
Let me bid you farewell"
















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Groundhog Day

Sorry for the belated post from 2/2/10:

www.mksense.blogspot.com Today being Groundhog Day I thought it a good time to look ahead to see what the economy may look like during the next six quarters. Unlike the illustrious Punxatawney Phil, I do not rely on my shadow to forecast upcoming economic conditions. Instead, I listen to comments made by the people at the center of the economy. These people would be CEOs, bank executives and small and medium size business owners. Although there businesses and locales may be very different, most are of the opinion that the economic recovery will be modest and gradual. Just today, the CEO of BP said the oil giant is forecasting a long, gradual recovery. A board member of Bremen Bank (Missouri) told the Wall Street Journal that the demand for credit by business clients is very light. They are instead paying off their current debts and are getting lean and mean to do so. In various Fed reports, businesses are reporting that they are reluctant to hire. Increased productivity and expected lackluster consumer demand is hindering job growth. On article on the Wall Street Journal website quotes Whirlpool CEO Jeff Fettig as saying that the company will reduce capacity in 2010. Ford CEO Alan Mulally is forecasting U.S. car and truck sales to come in the 11 million to 12 million range. The recent high water mark came in 2005 when 17 million vehicles were sold in the U.S., spurred on by massive rebates and 0% financing. Huntsman Chemical said that when and if the Chemical industry has to ramp up production, it will build facilities overseas rather than hire more expensive U.S. workers. Things are not all that rosy overseas. Many European economies (Greece, Spain, Portugal, Ireland, Italy and some former Eastern Bloc nations) have serious economic problems which threaten to bring down their sovereign financial systems. Since the EU is a loose confederation and the ECB's powers are limited, it is not clear what aid, if any, these troubled nations will receive. Last week China took steps to slow its economy. Today Australia, which relies on exports to China for much of its economic strength, unexpectedly decided to leave its benchmark rate at 3.75%. The Reserve Bank of Australia is concerned that global economic growth could be more modest. Action in the fixed income markets has been quieter than usual as market participants are focused on Friday's Non-farm Payrolls number. The street consensus is calling for the addition of 8,000 jobs. Although this would be the second positive report in three months, 8,000 jobs doesn't even keep pace with Americans entering the workforce and, although a lagging indicator, is far below what would be expected at this point of an economic recovery. I think Bill Gross is right. There will be a "new norm." Tell your friends. I am looking for more subscribers.