The Fed’s Touch and Go.
When a novice pilots are learning how to land an airplane they practice what are known as touch and goes. When pilots practice touch and goes the let the wheels of their aircraft barely make contact with the runway. They never fully land. Instead they pull back on the stick and climb away. For the past 25 years the Fed has been conducting touch and goes with the U.S. economy.
A look back at Fed policy bears this out. In 1981 the Fed began a 25-year policy of easing (lower interest rates), lowering the Fed Funds rate from an inflation busting high of 20% to an eventual affective 0.00% in 2009. One would think that the Fed Funds rate fluctuated much during that time and although that is correct, the chart looks more like a downward stair case than a typical peak and valley formation. The Fed rarely raised the Fed Funds rates back to (or even close to) to rates seen during the prior tightening cycle (in some cases not even to rates seen as neutral.
Let’s look at the history of Fed Funds rates since 1981. We will leave out the punitively-high rates of the early 80s. Let’s begin in the late 1980s when rates were somewhat “normal”.
February 1988 (peak of rate cycle) Fed Funds 9.75%
February 1991 (approximately half way point) 6.25%
September 1992 bottom of rate same rate cycle) 3.00%
Here is the next cycle:
May 2000 (peak of rate cycle) 6.00%.
June 2003 (bottom of cycle (1.00%). Stayed at 1.00% until June 2004.
June 2006 (Peak of rate cycle) 5.25%
December 2008 (bottom of rate cycle) 0.00% to 0.25%)
Can you see the problem? The Fed never landed the economy. It merely conducted a series of touch and goes! This created what we now know to be a dangerous dynamic. Ever lower rates made refinancing and the use of home equity for spending drive growth beyond structural limits and pushed home prices high as more people could afford homes due to lower rates and little in the way of core inflation. We all began to view ever rising home prices, cheap loans and buying whatever we wished to as normal. It wasn’t. The Fed kept the economy in the air for over 20-years, never letting it refuel (correct). Now it is out of fuel.
What is needed to refuel the U.S. economy? Asset price correction, but that sets up another dangerous dynamic, especially when the stigma of walking away from contractual obligations, such as mortgages, is all but gone. Home prices, auto prices and wages in those and related industries rose to levels which are unsustainable. However, asset prices ad incomes must reset to fundamental levels.
The Fed’s solution is to cause inflation and weaken the dollar. In theory this could help. It may have kept us out of a depression thus far, but inflationary and dollar-weakening policies can only have limited benefits when borrowing is constrained, wages cannot rise (cost of leaving raises would make it easier for Americans to pay their mortgages as they are repaying debt created with dollars which are more valuable than the dollars which they are paying), and increased U.S. exports have only a limited benefit due to the relatively small portion of manufacturing in the overall economy (efficient businesses needs few new workers).
Much has been made of the “new normal” of slow growth. Current growth is not the “new normal” no more than the booms of the mid 1980s – 2006 was normal. Once we go through several more years of slow growth and falling home prices growth and employment will level off somewhere between the boom years and today’s bust. What does this mean in numbers? Although no one can say for sure, growth leveling off between 2.00% and 3.00% and unemployment between 7.00% and 8.00% could be where the economy improves to following another several years of pain.
The Fed can slow this correction, but cannot prevent it beaus the Fed has cyclical tools and today’s problems are structural.
Happy Halloween!!!
Sunday, October 31, 2010
Wednesday, October 27, 2010
Borrowed Time
www.mksense.blogspot.com
Bill Gross (rightly) criticizes QE2, Jeremy Grantham (correctly) explains how we got into this economic mess and why structural changes will prevent a return to the economy of the past 20 years and the size a pace of QE2 comes into question and panic grips the market. The prospects of a modest QE2 pushed stocks and commodities lower and the dollar higher. The stronger dollar and the resulting rise of commodity prices is an obvious relationship, but what some investors just don't get is why QE2 drives equity prices.
The knee-jerk response is: The equity market responds positively to QE2 because QE2 will increase growth. Sorry boys and girls, no one except for CNBC anchors believe that (and not even all of them believe it). Another response might be that QE2 will weaken the dollar and increase exports and that will keep balance sheets healthy. That is true, but that isn't the main reason.
The driving factor is leverage. QE2 involves buying treasuries which keeps rates low. This makes leverage cheap. Stocks are being bought with this cheap leverage. Unless this cheap leverage continues or we see a sharp economic recovery the equity market could see a correction. Fortunately for equity investors QE2 is coming to some degree. This will put of the day of reckoning for awhile. However, cheap leverage can't last forever and the economy is structurally incapable of the growth to which we have become accustomed. Beware high yield bonds as well.
I strongly suggest reading Jeremy Grantham's GMO report.
Tell your friends. I am looking for more subscribers.
Bill Gross (rightly) criticizes QE2, Jeremy Grantham (correctly) explains how we got into this economic mess and why structural changes will prevent a return to the economy of the past 20 years and the size a pace of QE2 comes into question and panic grips the market. The prospects of a modest QE2 pushed stocks and commodities lower and the dollar higher. The stronger dollar and the resulting rise of commodity prices is an obvious relationship, but what some investors just don't get is why QE2 drives equity prices.
The knee-jerk response is: The equity market responds positively to QE2 because QE2 will increase growth. Sorry boys and girls, no one except for CNBC anchors believe that (and not even all of them believe it). Another response might be that QE2 will weaken the dollar and increase exports and that will keep balance sheets healthy. That is true, but that isn't the main reason.
The driving factor is leverage. QE2 involves buying treasuries which keeps rates low. This makes leverage cheap. Stocks are being bought with this cheap leverage. Unless this cheap leverage continues or we see a sharp economic recovery the equity market could see a correction. Fortunately for equity investors QE2 is coming to some degree. This will put of the day of reckoning for awhile. However, cheap leverage can't last forever and the economy is structurally incapable of the growth to which we have become accustomed. Beware high yield bonds as well.
I strongly suggest reading Jeremy Grantham's GMO report.
Tell your friends. I am looking for more subscribers.
Monday, October 25, 2010
Mortgaging the Future
When last I published, I discussed mortgage put-backs. I discussed how that could lock up the mortgage market and further hinder a recovery of the housing market. That scenario appears to be playing out. After enduring two weeks of bashig by politicians, investors and the GSEs (yeah, like they are in a position to criticize), banks are beginning to take a stand against there critics. Even Bank of America is going to fight against put-backs.It is easy to point one's finger at the banks, the are not solely culpable.
There is enough blame to go around. Banks slackened their underwriting standards and in the frenzy to write an increasing number of mortgages, banks chose to overwork underwriting departments and may have let a few (or not so few) bad mortgages slip through the cracks. After all, the banks and the credit ratings services had complete and, as we have discovered, misplaced confidence in quantitative models which, as with all models, were backward looking and couldn't account for the unknown unknowns.
However, blame has to be placed on the investors themselves who conveniently did not ask questions regarding the quality of and underwriting accuracy of the underlying mortgages. The banks will have to cough up money, but the large banks have the cash to create reserve funds and can easily raise more capital in this market and raise it cheaply. The demise of large banks is greatly exaggerated, including Bank of America. Regional banks could be a different story.
The end result is likely to be a very modest recovery and soft growth and spending for years to come as the banks find religion and perform proper due diligence. The days of credit for all are over. Any inflation we see (and we could see it) is more likely to be the result of a devalued dollar than growth. We will see a recovery, but it will feel like a prolonged mild inflation. Waiting for unemployment to dip below 8.00%? Good luck!. Getting it below 9.00% will be a challenge.
Investors believe the Fed will succeed in generating inflation as they bought today's TIPS auction with a negative yield to maturity for the first time in history. Inflation, yes. Growth, kind of.
There is enough blame to go around. Banks slackened their underwriting standards and in the frenzy to write an increasing number of mortgages, banks chose to overwork underwriting departments and may have let a few (or not so few) bad mortgages slip through the cracks. After all, the banks and the credit ratings services had complete and, as we have discovered, misplaced confidence in quantitative models which, as with all models, were backward looking and couldn't account for the unknown unknowns.
However, blame has to be placed on the investors themselves who conveniently did not ask questions regarding the quality of and underwriting accuracy of the underlying mortgages. The banks will have to cough up money, but the large banks have the cash to create reserve funds and can easily raise more capital in this market and raise it cheaply. The demise of large banks is greatly exaggerated, including Bank of America. Regional banks could be a different story.
The end result is likely to be a very modest recovery and soft growth and spending for years to come as the banks find religion and perform proper due diligence. The days of credit for all are over. Any inflation we see (and we could see it) is more likely to be the result of a devalued dollar than growth. We will see a recovery, but it will feel like a prolonged mild inflation. Waiting for unemployment to dip below 8.00%? Good luck!. Getting it below 9.00% will be a challenge.
Investors believe the Fed will succeed in generating inflation as they bought today's TIPS auction with a negative yield to maturity for the first time in history. Inflation, yes. Growth, kind of.
Monday, October 18, 2010
Put Back
The Mortgage Industry has dominated the financial headlines in recent days. At first the financial press and market participants were focused on the mortgage moratorium and the missed revenues (from servicing mortgages), higher operating costs and potential fines which could arise from this debacle. However, my attention was immediately drawn to the possibility that investors may request that banks take back securities backed by trouble mortgages at par due to a lack of due diligence, faulty underwriting procedures, lack of disclosure, etc. After a few days of the so-called “put back” story taking a back seat, it finally popped today.
Put back has a much greater potential for losses for the banks. Estimates from around the street range from about $60 billion to almost $200 billion. This has investors concerned that some large banks will not be long for this world. This should not be the primary concern, at least not for the large money center banks. The large banks should be sufficiently well-capitalized to survive this. The real question is: Can the economy survive this?
Oh, have I frightened you? If I have it is with good reason. The housing market to which we have become accustomed was predicated on high-volume, “efficient underwriting” (speed was paramount) and securitization. If it becomes more difficult to foreclose on properties, if it becomes more expensive for banks to do underwrite and process mortgages (more people instead of robo-signers), if securitization becomes more difficult (investors may want high-quality mortgages, rather than simply having first claim on a pool of dubious assets), the housing market has little chance of a speedy recovery. The same would be true for the broader economy.
The number one question asked since September 2008 is: How to we get back to where we were in 2006 or 2007? The answer is we don’t (or at least we shouldn’t). Cutting corners, packaging mortgages into nearly indecipherable structures and granting credit to anyone who could fog a mirror is not a recipe for success. Those who whish to return to the past are either selfish or hopelessly stupid. Unfortunately, there is no shortage of stupid and / or selfish people. Look for continued policies designed to avoid accepting the reality that home values rose too far, too fast and that lending standards are a good thing. I say, let home prices reset and let people bargain hunt. That is the only way to fix the housing market and economy, structurally.
Put back has a much greater potential for losses for the banks. Estimates from around the street range from about $60 billion to almost $200 billion. This has investors concerned that some large banks will not be long for this world. This should not be the primary concern, at least not for the large money center banks. The large banks should be sufficiently well-capitalized to survive this. The real question is: Can the economy survive this?
Oh, have I frightened you? If I have it is with good reason. The housing market to which we have become accustomed was predicated on high-volume, “efficient underwriting” (speed was paramount) and securitization. If it becomes more difficult to foreclose on properties, if it becomes more expensive for banks to do underwrite and process mortgages (more people instead of robo-signers), if securitization becomes more difficult (investors may want high-quality mortgages, rather than simply having first claim on a pool of dubious assets), the housing market has little chance of a speedy recovery. The same would be true for the broader economy.
The number one question asked since September 2008 is: How to we get back to where we were in 2006 or 2007? The answer is we don’t (or at least we shouldn’t). Cutting corners, packaging mortgages into nearly indecipherable structures and granting credit to anyone who could fog a mirror is not a recipe for success. Those who whish to return to the past are either selfish or hopelessly stupid. Unfortunately, there is no shortage of stupid and / or selfish people. Look for continued policies designed to avoid accepting the reality that home values rose too far, too fast and that lending standards are a good thing. I say, let home prices reset and let people bargain hunt. That is the only way to fix the housing market and economy, structurally.
Friday, October 15, 2010
Who Own The Mortgages? Owns!
Panic has gripped the markets. Apparently, banks have not been observing the proprieties when foreclosing on delinquent home owners. This has cause some banks to halt foreclosure proceedings while proper due diligence is under taken and paperwork is processed in accordance with the stated rules and regulations. This has many investors selling their corporate bond and preferred holdings of large banks, especially Bank of America. Relax folks, although bank bottom lines could be hit due to increased legal expenses and overhead to properly process foreclosures, it is unlikely that the damage will be enough to sink any of the large banks, including Bank of America, worry warts.
Remember back in 2009 when regulators required banks to raise what seemed like an unusually large amounts of capital (especially tangible common equity tier-1 capital)? This was done because government overseers were concerned of what could happen should government stimulus fail to stabilize the housing market and eventually push home prices higher. Currently, the large money center banks should have enough capital to weather another 2008, if necessary. This is one reason (the inability to securitize non-GSE-qualifying mortgages being another) that banks are reluctant to lend. They are hoarding capital. This is not to say that banks will be unaffected, poor earnings could be in their futures (for a variety of reasons), but corporate defaults large banks are an improbability at this time.
Investors in private label MBS, CDOs and SIVs have more to worry about than do corporate bond investors. It is not clear, in some cases, who actually owns a mortgage and who is just a servicer. There are situations in which banks may be foreclosing in propertied when the have no legal right to do so. This could be due to incomplete or incorrect documentation during the securitization process. If this can be proved, banks may have to take back at par the mortgage-backed vehicles currently held by investors. The problem is that many of these vehicles contain mortgages which have taken principal losses and will never be worth par no matter how long they are held. This is the main reason that suspending mark-to-market was not a permanent fix.
Sure, it calmed investors’ fears as banks did not have to recognize unrealized losses, but now losses are being realized and many investors of finding that out the hard way. If one large group of investors can win a judgment versus an issuer, the flood gates could open for more litigation and lock up what is left of the mortgage market. That would practically kill the housing market. However, it is unlikely that these doomsdays scenarios play themselves out. It is more likely that foreclosures continue and many private label MBS issued from late 2005 through early 2008 will experience losses.
Investors in debt (including preferreds) could be impacted by recent developments. If banks are force to absorb losses it is unlikely that they will exercise early capital event clauses afforded by the implementation of the Dodd bill. Instead banks could leave trust preferreds outstanding as long as they can be applied toward tier-1 capital. That means that trust preferreds could remain outstanding until at least 2013, if not longer.
Many investors have become fearful of Countrywide bonds and preferreds. Investors need to understand that Countrywide debt and preferred securities are legal obligations of Bank of America. This is not the case with Merrill debt and trust preferreds. It is unlikely that BAC will default so Countrywide debt and preferreds should be alright, albeit a bit volatile. I would be more concerned about regional banks exposed to Florida and Nevada more than any of the large banks.
Well there you have it. This is my take on the mortgage debacle as I see it at this time. If policymakers would only have permitted home prices to reset early in 2008 when mortgage credit was still available, real estate values probably would not have fallen as far as they have and regulators could have reigned in bad practices. Let’s hope that every one has learned from their mistakes.
Remember back in 2009 when regulators required banks to raise what seemed like an unusually large amounts of capital (especially tangible common equity tier-1 capital)? This was done because government overseers were concerned of what could happen should government stimulus fail to stabilize the housing market and eventually push home prices higher. Currently, the large money center banks should have enough capital to weather another 2008, if necessary. This is one reason (the inability to securitize non-GSE-qualifying mortgages being another) that banks are reluctant to lend. They are hoarding capital. This is not to say that banks will be unaffected, poor earnings could be in their futures (for a variety of reasons), but corporate defaults large banks are an improbability at this time.
Investors in private label MBS, CDOs and SIVs have more to worry about than do corporate bond investors. It is not clear, in some cases, who actually owns a mortgage and who is just a servicer. There are situations in which banks may be foreclosing in propertied when the have no legal right to do so. This could be due to incomplete or incorrect documentation during the securitization process. If this can be proved, banks may have to take back at par the mortgage-backed vehicles currently held by investors. The problem is that many of these vehicles contain mortgages which have taken principal losses and will never be worth par no matter how long they are held. This is the main reason that suspending mark-to-market was not a permanent fix.
Sure, it calmed investors’ fears as banks did not have to recognize unrealized losses, but now losses are being realized and many investors of finding that out the hard way. If one large group of investors can win a judgment versus an issuer, the flood gates could open for more litigation and lock up what is left of the mortgage market. That would practically kill the housing market. However, it is unlikely that these doomsdays scenarios play themselves out. It is more likely that foreclosures continue and many private label MBS issued from late 2005 through early 2008 will experience losses.
Investors in debt (including preferreds) could be impacted by recent developments. If banks are force to absorb losses it is unlikely that they will exercise early capital event clauses afforded by the implementation of the Dodd bill. Instead banks could leave trust preferreds outstanding as long as they can be applied toward tier-1 capital. That means that trust preferreds could remain outstanding until at least 2013, if not longer.
Many investors have become fearful of Countrywide bonds and preferreds. Investors need to understand that Countrywide debt and preferred securities are legal obligations of Bank of America. This is not the case with Merrill debt and trust preferreds. It is unlikely that BAC will default so Countrywide debt and preferreds should be alright, albeit a bit volatile. I would be more concerned about regional banks exposed to Florida and Nevada more than any of the large banks.
Well there you have it. This is my take on the mortgage debacle as I see it at this time. If policymakers would only have permitted home prices to reset early in 2008 when mortgage credit was still available, real estate values probably would not have fallen as far as they have and regulators could have reigned in bad practices. Let’s hope that every one has learned from their mistakes.
Thursday, October 7, 2010
Twilight Zone
Today brought us more disappointing Jobless Claims data. Initial Jobless came in at 445,000 versus a street consensus of 455,000. The prior data was revised upward from 453,000 to 456,000. Continuing claims came in at 4,462,000 versus a street consensus of 4,450,000 and a prior revised 4,510,000 (up from 4,457,000). In spite of what some pundits espoused this morning, these are troubling numbers. It is true that initial claims dropped a bit, but claims over 400,000 is troubling. Even more troubling is that fact that continuing jobless claims and the extended benefits roll remain stubbornly high. In fact, the number of Americans on extended benefits increased by 257,000 to 5.14 million. This brings the total number of Americans receiving unemployment benefits to 9,602.000. The fact that businesses are slowing the pace of hiring does not cut it. Some economists believe it could take years to replace the approximately 8 million jobs lost since the recession began. The problem is that at the same time, the U.S. population will increase. This is like a cat chasing a string. Every time we seem to make progress the goal remains seemingly just out of reach.
What does this mean for tomorrow's employment data? It is obvious that recent data has not been encouraging, but it may nit translate directly into the Nonfarm Payrolls and Unemployment Rate data. Such data is subject to various quirks via the way the data is gathered and by their formulas. Remember a few years ago when the Nonfarm Payrolls number undercounted approximately 800,000 jobs over the course of a year or so? The consensus estimate for NFP is 0. However, whether the number comes in -50k or +50k, it matters little as either would be disappointing.
After reading today's Wall Street Journal, I felt as though I was in an episode of the "Twilight Zone". An article on page A8 states that the Fed is considering higher inflation as a way to stimulate spending and growth. The thinking is that if inflation is allowed to run faster than the Fed's alleged target of about 2.00% (let's say to 4.00%), consumers would be further disincentivized to save and would spend more aggressively. What is happening here? Is Bernanke the anti-Volcker? Maybe, maybe not. The problem is that Bernanke realizes just how impaired the U.S. economy is. He, along with other policy makers are trying to avoid a deflationary correction of asset prices, home prices in particular. That could be an exercise in futility.
This morning on CNBC, Pimco's Mohammed El-Ehrian stated that part of the problem is that Americans and policy makers want it all. They want banks to lend, but de-risk. They want consumers to spend, but not severely deleverage while strengthening household balance sheets. It cannot be done. Something has to give. A few years ago it was not uncommon for home values to double in a year or two. Did anyone with a shred of common sense really believe that was sustainable? No, but common sense was eschewed in favor of optimism and models. Reality can be ignored only so long. It is time to pay the piper and he is not cheap.
Former Wall Street Junk Bond "Star" Michael Milken writes in today's Journal his remedies for what ails the U.S. economy. Especially helpful and insightful is his analysis of the housing debacle. He states:
"My early academic research showed that investments in loans against real estate were worse investments than loans to businesses. Collateralized loans to U.S. companies, which create nearly all American jobs, have stood the test of time. Meanwhile, investors have suffered some $1 trillion in losses on supposedly safe mortgage-backed assets. Consider how many more jobs small businesses would have created if they'd enjoyed the same terms we gave homeowners-easy access to 30-year, government-guaranteed loans at near-prime rates with no prepayment penalties. Those terms encouraged larger houses-the average size doubled in a generation to 2,500 square feet, even as family size shrank. This required more land farther from cities, and we bought bigger cars for longer, energy-wasting commutes."
He continues:
"American policy makers got it backwards: In the long run, jobs support housing, not the other way around."
I believe Mr. Milken is spot on. Relying on ever-higher home prices, ever more new construction and ever easier access to credit (and the resulting over-leveraged consumer) is a recipe for disaster, as we have recently seen.
There has been much China bashing emanating form Capitol Hill and from Europe. China is being roundly criticized for undervaluing its currency. China snapped back that letting its currency appreciate by the 20%+ that many of its critics are calling for would result in economic hardship for China. For years we have stated that China will do what is right for China. However, the U.S. will do what is right for the U.S. All Fed Chairman Ben Bernanke is doing is to devalue the dollar. His problem is that he cannot devalue the dollar versus the yuan as China has its currency pegged to the dollar. Japan, South Korea and Brazil have all taken action to halt or moderate the rise of their currencies. There is speculation that the EU and the UK may not be far behind.
Why would Mr. Bernanke risk a currency war which could strain international trade relations? Because he realizes just how bad the economy is. He cares little about foreign economies. He responsibilities lie between the Atlantic and Pacific oceans. Just as Chinese officials will do what the believe to be right for China, Fed officials will do what the believe is right for America.
We are in a race to the bottom in which global economies are trying to grab the largest possible slice of a shrinking pie. V-shaped recovery? We don't see it, at least not for consumers. Since consumers ARE America, a recovery which leaves them behind is no recovery at all.
What does this mean for tomorrow's employment data? It is obvious that recent data has not been encouraging, but it may nit translate directly into the Nonfarm Payrolls and Unemployment Rate data. Such data is subject to various quirks via the way the data is gathered and by their formulas. Remember a few years ago when the Nonfarm Payrolls number undercounted approximately 800,000 jobs over the course of a year or so? The consensus estimate for NFP is 0. However, whether the number comes in -50k or +50k, it matters little as either would be disappointing.
After reading today's Wall Street Journal, I felt as though I was in an episode of the "Twilight Zone". An article on page A8 states that the Fed is considering higher inflation as a way to stimulate spending and growth. The thinking is that if inflation is allowed to run faster than the Fed's alleged target of about 2.00% (let's say to 4.00%), consumers would be further disincentivized to save and would spend more aggressively. What is happening here? Is Bernanke the anti-Volcker? Maybe, maybe not. The problem is that Bernanke realizes just how impaired the U.S. economy is. He, along with other policy makers are trying to avoid a deflationary correction of asset prices, home prices in particular. That could be an exercise in futility.
This morning on CNBC, Pimco's Mohammed El-Ehrian stated that part of the problem is that Americans and policy makers want it all. They want banks to lend, but de-risk. They want consumers to spend, but not severely deleverage while strengthening household balance sheets. It cannot be done. Something has to give. A few years ago it was not uncommon for home values to double in a year or two. Did anyone with a shred of common sense really believe that was sustainable? No, but common sense was eschewed in favor of optimism and models. Reality can be ignored only so long. It is time to pay the piper and he is not cheap.
Former Wall Street Junk Bond "Star" Michael Milken writes in today's Journal his remedies for what ails the U.S. economy. Especially helpful and insightful is his analysis of the housing debacle. He states:
"My early academic research showed that investments in loans against real estate were worse investments than loans to businesses. Collateralized loans to U.S. companies, which create nearly all American jobs, have stood the test of time. Meanwhile, investors have suffered some $1 trillion in losses on supposedly safe mortgage-backed assets. Consider how many more jobs small businesses would have created if they'd enjoyed the same terms we gave homeowners-easy access to 30-year, government-guaranteed loans at near-prime rates with no prepayment penalties. Those terms encouraged larger houses-the average size doubled in a generation to 2,500 square feet, even as family size shrank. This required more land farther from cities, and we bought bigger cars for longer, energy-wasting commutes."
He continues:
"American policy makers got it backwards: In the long run, jobs support housing, not the other way around."
I believe Mr. Milken is spot on. Relying on ever-higher home prices, ever more new construction and ever easier access to credit (and the resulting over-leveraged consumer) is a recipe for disaster, as we have recently seen.
There has been much China bashing emanating form Capitol Hill and from Europe. China is being roundly criticized for undervaluing its currency. China snapped back that letting its currency appreciate by the 20%+ that many of its critics are calling for would result in economic hardship for China. For years we have stated that China will do what is right for China. However, the U.S. will do what is right for the U.S. All Fed Chairman Ben Bernanke is doing is to devalue the dollar. His problem is that he cannot devalue the dollar versus the yuan as China has its currency pegged to the dollar. Japan, South Korea and Brazil have all taken action to halt or moderate the rise of their currencies. There is speculation that the EU and the UK may not be far behind.
Why would Mr. Bernanke risk a currency war which could strain international trade relations? Because he realizes just how bad the economy is. He cares little about foreign economies. He responsibilities lie between the Atlantic and Pacific oceans. Just as Chinese officials will do what the believe to be right for China, Fed officials will do what the believe is right for America.
We are in a race to the bottom in which global economies are trying to grab the largest possible slice of a shrinking pie. V-shaped recovery? We don't see it, at least not for consumers. Since consumers ARE America, a recovery which leaves them behind is no recovery at all.
Saturday, October 2, 2010
Welcome to the Bubble (or, Bonds or Bust)
The cries warning us about a so-called bond bubble have been emanating ever more loudly from the street. Sages warn is that there is more upside risk to interest rates than down side reward. No kidding, did theses financial oracles figure this all out on their own? With the Fed funds rates effectively zero and the 10-year not hovering around 2.50% it doesn’t take a rocket scientist or some one with supernatural gifts to draw that conclusion. However, low rates to not a bubble make.
A bubble occurs when investors pile into an asset class, market, etc. irrationally. When calmer heads prevail and profit taking begins the bubble bursts. However, there is nothing irrational about today’s interest rate levels. Inflation is relatively tame. Job growth is lackluster. Banks are disincentivized to lend for both economic and political reasons. Consumers are still over leveraged. What in the world, outside an exodus from the dollar by investors large and small would push rates higher at this time? The answer is nothing, yet.
The truth is that the ability for investors to exit the dollar en masse is limited. Consider this: Gold hits a new high nearly every day. Some foreign central banks are actively, if not desperately, trying to halt the rise of their currencies. Yet long-term U.S. rates remain historically very low. Some of this can be attributed to quantitative easing and the threat of QE2, but it is more the reasons why more QE may be necessary, not the QE itself which is keeping rates low on the long end of the curve.
What are the reasons the Fed believes more QE may be necessary?
1). Consumers are not borrowing. It is true many are simply over leveraged and cannot borrow, but many do have access for credit but see little need to borrow. The Fed hopes to keep rates low (if not push them lower as has happened since the threat of more QE was announced) to entice those who can obtain credit to come off of the sidelines.
2) Businesses benefit from low borrowing costs. U.S. corporations have flooded the market with new debt. Large bond deals have come to market almost every day for the past several months. This cheap source of borrowed funds, which provide debt service expense savings, have contributed to stronger balance sheets and higher profits. If consumers spend less and business activity is modest, the Fed has helped make transactions which do occur more profitable. As evidenced by the Durable Goods. GDP and regional business activity reports, businesses are using this cheap source of funds to buy new, more efficient equipment. However, this does little for hiring.
Some economists have pointed out that increased higher has always followed such spending. This may again be true, but the hiring which does take place may be smaller in scale than in the past, pay lower wages than to what workers have become accustomed and may be created off shore.
3) The third reason is policy-driven economic headwinds. Higher business and personal taxes, unclear effects of new healthcare legislation (apparently HHS secretary, Kathleen Sebelius will have a good amount of discretion to decide which corporate health plans are acceptable and which are not. It is good to be the queen.), concern among banks as to what their capital requirements will be and anti-business rhetoric from the Obama administration are doing much to dampen growth.
Businesses don’t have to hire. Consumers don’t have to spend beyond sustenance levels and banks do not have to lend if the reward of doing so does not justify the risk. No amount of Capitol Hill bluster is going to change that. Many pundits have pointed to one of my aforementioned reasons, but it is truly all three which are responsible for the disappointing recovery.
The upshot of this is that rates will stay low for an extended period of time. Cash is not the place to wait as rates are punitively low. The long and of the curve is not an optimal destination because a 100 basis point rise in long-term rates could result in 10+ point price declines on bonds.
There are ways to soften the blow of rising rates without holding in cash with very little yield. One can ladder. Not all areas of the curve lose value in the same fashion. Like everything in life investing is about balance. While a 30-year bond may lose 12 points worth or principal value for a 100 basis point rise in rates a 10-year bond may lose 7 points, a 5-year bond 3 points and a 2-year bond only one point. By laddering ones bond portfolio, possibly focusing on the so-called belly of the curve (5 to 7 years out), as it is usually the most stable in a changing rate environment, one can obtain decent yields without taking excessive interest rate volatility.
One also should understand that not all bonds react the same way to changing interest rates. Some bonds, such as U.S. treasuries, are interest rate products. Where rates go, they go (the Fed influences the short end while inflation expectations influence the long end). However, some bonds, such as corporate bonds are credit products. Although interest rates an affect their trading levels. Their credit spreads versus treasury benchmarks also play apart. The changing of credit spreads due to balance sheet strength or weakness and investor demand for portfolio diversification can affect credit spreads.
We have seen this in action. In the extreme we saw yields for bank ad finance bonds rise in 2008 and early 2009 even though treasury yields fell. Their credit spreads widened due to balance sheet and viability concerns. Their yields did not follow interest rates. Once it became apparent that the largest banks were not going to fail, their credit spreads narrowed (to a point) and their yields fell more than treasury yields for a period of time. Less volatile sectors such as utilities and companies in the consumer product sectors did not experience such spread widening and flowed treasury yields lower, often out pacing the drop in rates as credit spreads narrowed as investors looking for yield sold their bank bonds and purchased utility or industrial sector bonds hoping to get even a small yield pickup over treasuries.
Rising interest rates may be offset somewhat by purchasing bonds which are trading at credit spreads which remain wider than their historic norms. This leads us back to the banks. Bonds of the large money center banks and large regional banks are still trading wide to treasuries. In some cases 50 to 100 basis points wide. If rates rise due to an economic recovery, these credit spreads could narrow 50 to 100 basis points effectively offsetting the first 50 to 100 basis point rise in long-term rates.
However, the story could be very different for bonds in other sectors. In an effort to earn returns above treasuries, but take on minimal risk, many investors purchased bonds in less volatile sectors and companies. If rates rise due to improving economic conditions, investors may sell their bonds trading at very tight spreads (MSFT, WMT, JNJ, etc.) and buy bonds in sectors or companies that were, until now, a bit to risky for their tastes (BAC, MS, GS, etc.). For this reason the yields of industrial sector bonds could rise even faster and more sharply than treasury yields as their safety is no longer needed.
When investing in fixed income one must understand the mechanics of the various products. By mixing in credit products with interest rate products and spreading ones assets across the curve (only out to10 years or so as one can pick up 75% of the slope of the curve without incurring the volatility of the very log end of the curve). One can earn attractive returns without being blown up by any bursting “bubbles”
I forgot to mention: Preferreds are rich and floater to not necessarily protect you from rising rates. It all depends on how much they float, off of what benchmark they float and off of what benchmark they trade.
Later.
A bubble occurs when investors pile into an asset class, market, etc. irrationally. When calmer heads prevail and profit taking begins the bubble bursts. However, there is nothing irrational about today’s interest rate levels. Inflation is relatively tame. Job growth is lackluster. Banks are disincentivized to lend for both economic and political reasons. Consumers are still over leveraged. What in the world, outside an exodus from the dollar by investors large and small would push rates higher at this time? The answer is nothing, yet.
The truth is that the ability for investors to exit the dollar en masse is limited. Consider this: Gold hits a new high nearly every day. Some foreign central banks are actively, if not desperately, trying to halt the rise of their currencies. Yet long-term U.S. rates remain historically very low. Some of this can be attributed to quantitative easing and the threat of QE2, but it is more the reasons why more QE may be necessary, not the QE itself which is keeping rates low on the long end of the curve.
What are the reasons the Fed believes more QE may be necessary?
1). Consumers are not borrowing. It is true many are simply over leveraged and cannot borrow, but many do have access for credit but see little need to borrow. The Fed hopes to keep rates low (if not push them lower as has happened since the threat of more QE was announced) to entice those who can obtain credit to come off of the sidelines.
2) Businesses benefit from low borrowing costs. U.S. corporations have flooded the market with new debt. Large bond deals have come to market almost every day for the past several months. This cheap source of borrowed funds, which provide debt service expense savings, have contributed to stronger balance sheets and higher profits. If consumers spend less and business activity is modest, the Fed has helped make transactions which do occur more profitable. As evidenced by the Durable Goods. GDP and regional business activity reports, businesses are using this cheap source of funds to buy new, more efficient equipment. However, this does little for hiring.
Some economists have pointed out that increased higher has always followed such spending. This may again be true, but the hiring which does take place may be smaller in scale than in the past, pay lower wages than to what workers have become accustomed and may be created off shore.
3) The third reason is policy-driven economic headwinds. Higher business and personal taxes, unclear effects of new healthcare legislation (apparently HHS secretary, Kathleen Sebelius will have a good amount of discretion to decide which corporate health plans are acceptable and which are not. It is good to be the queen.), concern among banks as to what their capital requirements will be and anti-business rhetoric from the Obama administration are doing much to dampen growth.
Businesses don’t have to hire. Consumers don’t have to spend beyond sustenance levels and banks do not have to lend if the reward of doing so does not justify the risk. No amount of Capitol Hill bluster is going to change that. Many pundits have pointed to one of my aforementioned reasons, but it is truly all three which are responsible for the disappointing recovery.
The upshot of this is that rates will stay low for an extended period of time. Cash is not the place to wait as rates are punitively low. The long and of the curve is not an optimal destination because a 100 basis point rise in long-term rates could result in 10+ point price declines on bonds.
There are ways to soften the blow of rising rates without holding in cash with very little yield. One can ladder. Not all areas of the curve lose value in the same fashion. Like everything in life investing is about balance. While a 30-year bond may lose 12 points worth or principal value for a 100 basis point rise in rates a 10-year bond may lose 7 points, a 5-year bond 3 points and a 2-year bond only one point. By laddering ones bond portfolio, possibly focusing on the so-called belly of the curve (5 to 7 years out), as it is usually the most stable in a changing rate environment, one can obtain decent yields without taking excessive interest rate volatility.
One also should understand that not all bonds react the same way to changing interest rates. Some bonds, such as U.S. treasuries, are interest rate products. Where rates go, they go (the Fed influences the short end while inflation expectations influence the long end). However, some bonds, such as corporate bonds are credit products. Although interest rates an affect their trading levels. Their credit spreads versus treasury benchmarks also play apart. The changing of credit spreads due to balance sheet strength or weakness and investor demand for portfolio diversification can affect credit spreads.
We have seen this in action. In the extreme we saw yields for bank ad finance bonds rise in 2008 and early 2009 even though treasury yields fell. Their credit spreads widened due to balance sheet and viability concerns. Their yields did not follow interest rates. Once it became apparent that the largest banks were not going to fail, their credit spreads narrowed (to a point) and their yields fell more than treasury yields for a period of time. Less volatile sectors such as utilities and companies in the consumer product sectors did not experience such spread widening and flowed treasury yields lower, often out pacing the drop in rates as credit spreads narrowed as investors looking for yield sold their bank bonds and purchased utility or industrial sector bonds hoping to get even a small yield pickup over treasuries.
Rising interest rates may be offset somewhat by purchasing bonds which are trading at credit spreads which remain wider than their historic norms. This leads us back to the banks. Bonds of the large money center banks and large regional banks are still trading wide to treasuries. In some cases 50 to 100 basis points wide. If rates rise due to an economic recovery, these credit spreads could narrow 50 to 100 basis points effectively offsetting the first 50 to 100 basis point rise in long-term rates.
However, the story could be very different for bonds in other sectors. In an effort to earn returns above treasuries, but take on minimal risk, many investors purchased bonds in less volatile sectors and companies. If rates rise due to improving economic conditions, investors may sell their bonds trading at very tight spreads (MSFT, WMT, JNJ, etc.) and buy bonds in sectors or companies that were, until now, a bit to risky for their tastes (BAC, MS, GS, etc.). For this reason the yields of industrial sector bonds could rise even faster and more sharply than treasury yields as their safety is no longer needed.
When investing in fixed income one must understand the mechanics of the various products. By mixing in credit products with interest rate products and spreading ones assets across the curve (only out to10 years or so as one can pick up 75% of the slope of the curve without incurring the volatility of the very log end of the curve). One can earn attractive returns without being blown up by any bursting “bubbles”
I forgot to mention: Preferreds are rich and floater to not necessarily protect you from rising rates. It all depends on how much they float, off of what benchmark they float and off of what benchmark they trade.
Later.
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