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Our first edition will be published on Tuesday January 3rd, 2012.











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Aged to Perdition

Greece is still a mess and will continue go be a mess. The bottom line is that the growth rate of the country is not sufficiently robust to support the generous entitlements to which the Greek people have become accustomed. The draconian austerity measures needed to keep Greece out of default are economically and culturally unfeasible. One would be asking to Greek people to cease being Greek (the same can be said for austerity measures needed to save Portugal, Spain and, possibly, Italy). Greece will default. It may conduct an orderly default by negotiating with creditors or it may default in a disorderly fashion and leave the Eurozone. Greece may default now, in December or next year, but default it will. The sooner the investor community, banks and European regulators acknowledge the better.


Economic troubles are not unique to Europe. The United States has its own issues, as evidenced by Friday’s Nonfarm Payrolls report. I am not referring to the latest print of 80,000, but to the upward revisions of the prior data. How can upward revisions be bad news? If the revisions just get you up to about the replacement rate when population expansion is accounted for, that is not very good. There is a current phenomenon which can make the data seem better than it might really be.

At one time 200,000 new jobs were needed every month to keep pace with the growing population. Last year 150,000 new jobs became the benchmark. Now, some are saying it may only take 125,000 jobs to keep pace with the population. The result could be that the unemployment rate falls more rapidly than what many economists and the Fed predict. However, this does little for economic activity.

The unemployment rate had been in the past a good indicator of current prevailing economic conditions. However, increased productivity and slowing population growth may erode the reliability of the unemployment rate. Increased productivity and outsourcing have reduced the need for workers. This has helped to keep the unemployment rate stubbornly high during the current recovery. Now we may see the unemployment rate because the number of U.S. workers is shrinking. This addition by subtraction may cause the unemployment rate to fall. However, with fewer workers (for whatever reason) economic activity must slow.

Fewer workers mean fewer consumers, fewer home buyers, fewer car buyers, etc. Currently, there are more than enough homes to meet the needs of the U.S. population growth for more than a decade. If population growth slows further, it could even take longer for housing and the remainder of the economy to recover. Slowing population growth means an aging population. One only needs to look at Europe where the ratio of workers versus the number of retirees is about one to one.

This does not mean that the best days of the U.S. are behind us. It only means as conditions, trends and phenomena change we must change with it. This is why using the words “always” and “never” in economic forecasting and economic strategies is very dangerous (and foolish).

A Hole in the Deal

Europe finally agreed on a solution to the Greek question, sort of. European leaders persuaded banks holding Greek debt to accept 50% haircuts and have given banks until next June to raise capital. Banks will raise capital from private sources if they are able and from government sources, if necessary. This is not, we repeat not, a Greek default. Greece is not haircutting investors. European banks are voluntarily accepting a 50% haircut. Investors not agreeing to a voluntary haircut will receive 100% of par for their Greek debt at maturity, if Greece is solvent at the time. Among those NOT participating in the haircut is the IMF. The result is not a 50% reduction in debt for Greece, but according to sources on the street, something closer to 20%.

I mentioned earlier in this piece that this was sort of a final solution. We say sort of because there are details which need to be worked out. For instance, European officials agreed to expand the size of the EFSF to $1.4 trillion, but there are no details as to who is adding what capital to the program. Banks have been told to recapitalize, from private sources if possible and from government sources if necessary. Specifics of how banks may be able to receive public recapitalization and what restrictions may be put on such banks (dividend cuts, pay restrictions, core asset, etc.) have yet to be worked out. The way it stands is that banks which are unable to raise sufficient capital in the open market must first tap their national governments and only approach the EFSF as a last resort. Banks have until June 2012 to recapitalize. No word of what action might be taken, should a bank run into difficulties prior to raising sufficient capital.

The threat of contagion persists. It is possible that public pressure could force the governments of Portugal, Spain and Italy to request haircuts of some degree. Given the size of the Spanish and, especially, the Italian government bond market, even small haircuts to the sovereign debt issued by the European periphery’s two largest members could significantly affect banks and necessitate even more capital raising.

The EU did win not-specific support for the expansion of the EFSF from both Japan and China. China’s Premier Hu Jintao told Chinese television that he hoped measures taken in Europe will stabilize markets.

Which banks might need recapitalization? The Wall Street Journal reported that British and Irish banks will probably not need recapitalizations. However, banks in Germany, France and remaining periphery nations will probably need additional capital. Bloomberg News is reporting that French Banks BNP Paribas and Societe Generale (the two largest banks in France) are hastening cuts in their trading books (believed to be a combined $1.5 trillion, to avoid having to raise capital. French banks have already scaled back dollar-funded lending operations for items such as aircraft. Now BNP Paribas and Societe Generale are reluctantly shrinking their trading and derivative businesses. One European fund manager told Bloomberg News:

“It’s a striking sin of pride. They all want to keep their rankings, but French banks risk not having the necessary capitalization.”

European banks may find it increasingly difficult to shed assets at anything close to their fair values. As one London analyst told Bloomberg News:

“Everybody is trying to reduce risk-weighted assets as soon as possible. They’ve already all started, but they’ll probably find it harder than expected because the environment is clearly getting tougher.”


When a crowd tries to escape from a burning building via one door, some people get burned.



Already the holes in the deal are letting light in. For one, this does nothing for Greece. Oh sure, it reduces the country’s debt load for awhile, but unless Greece stops its profligate ways, its debt load will rise. However, since Greece can only obtain financing from the EU, it will default. It is nearly impossible for Greece to avoid a default. The contagion then spreads to Portugal. If it ever makes it as far as Italy, watch out. Italy has the third largest government bond market in the world. Just a10% haircut on Italian debt would cause turmoil among European banks.

Europe is a mess. Officials do not know how to pay for the “solution” or even or how the haircuts will be acknowledged. Meanwhile Europe hurtles toward recession. The rescue is nothing of the sort. Greece may end up leaving the euro (but not the EU) and devalue its way out of its mess. It is Greece’s only hope.

The bond markets are already telling us the bloom is off the Greek rose. Italy had to pay higher interest rates with its 10-year yield topping 6.00% on Friday. Spreads of periphery debt widened versus German bunds and money flowed back into U.S. treasuries.

I would advise investors not to be sucked in by stock jockey pundits and look at the situation for what it is. The periphery is an unsustainable mess. Common and preferred dividends are likely going away for awhile. If you must invest in Europe, be at a senior level on corporate capital structures. If not, invest in the U.S., at least we can keep printing money. :o

Europe to Your Ears

Housing Starts rose more than expected on the strength of multi-family construction, such as apartments and condominiums as an increasing number of Americans choose renting over home purchases. This was the strongest read for multi-family construction since October 2008. Building Permits fell to a five-month low as a glut of existing homes, a backlog of foreclosures and real estate values, which continue to decline, weigh heavily on the home building industry. Moody’s analyst Aaron Smith told Bloomberg News prior to the report:




“Through the volatility, the trend in starts appears to have picked up, though the level is still historically low. Multifamily activity is trending higher as the shift from homeownership to renting boosts demand for rental units and brings down vacancy rates.”


This does little to help single family home owners who have seen their home values tumble from their bubble peaks. At the risk of sounding like a broken record (for those of you who remember records), housing cannot recover until the excess supply of homes is absorbed. Accomplishing this is becoming increasingly difficult as the U.S. economy seems to have hit cruising speed at a modest pace, lending standards remain tight (but closer to traditional standards) and changes to demographics have young adults choosing to rent in urban settings while eschewing the suburban McMansions of older generations.



As has been the case for the past several years, CPI has, to a large extent, decoupled from PPI as producers remain unable or unwilling to pass, or fully pass, price increase on to consumers. Inflation, as measured by CPI, increased at its slowest pace in three months. This lends credence to the Fed’s view that inflation pressures could moderate in the coming months. It is also a signal the businesses may be losing pricing power or are concerned that consumer demand may slacken and are working to maintain or increase their market share.

Core CPI MoM rose by the smallest amount (0.1%) since last March. Moody’s Senior Economist Ryan Sweet stated:

“Inflation is playing out according to the Fed’s script. The economy is sluggish and businesses are very hesitant to pass on higher input costs to consumers. Consumers are very price sensitive right now.”

Leading the way toward slower inflation were the biggest drop in clothing prices since 1998, lower prices for both new and used vehicles and the smallest increase in rents in four months.


Late yesterday, the markets were startled by a report by The Guardian newspaper that France and Germany had ostensibly agreed to a deal to infuse three-trillion euros into the EFSF as part of a solution to the European sovereign debt crisis. Shortly thereafter European officials, including German Chancellor Angela Merkel, refused to confirm that The Guardian’s story was accurate. However, information leaking out to the financial press indicates that The Guardian’s report may have an air of truth about it.

CNBC reported (yeah, we know it’s CNBC) that EU officials are close to a deal in which France and Germany would contribute three-trillion euros to the EFSF which would act as an insurance plan for banks. The plan would have banks take more aggressive haircuts on Greek debt (specifics were not given, but the prior haircut amount most recently discussed was 50%) and banks would recapitalize with private money instead of government funds, Investors would theoretically be comforted by the three-trillion euro insurance fund waiting in the wings should a bank need more capital or is unable to raise sufficient capital on its own from private sources.

This sounds encouraging. Indeed, the markets were encouraged when the possibility of the three-trillion insurance fund was announced late yesterday, but whether or not it works in practice remains to be seen. The question becomes: Will investors infuse capital in banks in which European governments do not have a stake with only an insurance fund sitting on the sidelines?

Such an approach was discussed in the U.S. in the fall of 2008. However, financial institutions needing to recapitalize only did so after the U.S. government bought a state in those troubled banks. In other words, investors wanted governments to have skin in the game before they committed their own capital.

How the banks are recapitalized carries implications for investors in preferreds issued by European banks. If banks can recapitalized without government (taxpayer) assistance, preferred dividends for those banks may continue unabated. However, banks needing direct government investments could be forced to suspend dividends as per last week’s suggestion by the European Commission. We favor large domestic banks over their European counterparts.



Will the proposed three-trillion euro insurance fund calm the markets and solve the European sovereign debt crisis? That question can only be answered by market participants. Not necessarily those who are currently moving the equity and fixed income markets, but by those who will decide whether or not to commit their capital in the form of common equity investments in European banks. One thing is for sure, European officials had better agree on a solution very soon as reports coming out of Greece today are pointing to a disorderly outcome in more ways than one.



Moody’s downgraded Spain by two notches to A1, and keeps it on negative outlook, citing vulnerabilities from high levels of debt in the Spanish banking and corporate sectors. Earlier on Tuesday, S&P downgraded 24 Italian banks and financial firms. Spanish media reports a new European bank stress test could apply haircuts of up to 20% on Spanish sovereign debt.



Speaking of banks, have readers looked past what appear to be encouraging headlines and really analyzed earnings? If you have, you would have noticed a recurring trend. The biggest profit gains have been from banks marking down their outstanding debt. This accepted accounting practice assumes banks could retire their outstanding public debt below par value or at a lower price than in the same quarter a year ago because it can be purchased at a discount or at lower prices in the open market. Of course the reason it is trading at a discount or lower prices from the same period a year ago is because current bank financing costs are higher, making such debt repurchases unlikely. Accounting gains are usually brushed aside by market participants. Another trend has been sharp declines in investment banking revenues as banks adjust to new financial regulations which nearly eliminate proprietary trading.

Although it is very unlikely that any of the large U.S. financial institutions have difficulty servicing their debts, the best values on a risk-to-reward basis may exist in the bonds issued by banks with large traditional banking businesses, as well as regional banks located outside the most troubled real estate markets. Subordinated notes issued by banks offer yields which rival many high yield bonds, but more moderate investors can pick up attractive yields in senior bank debt. The sweetest spot on the bank and finance credit curve is in the 5-year to 10-year range, but good values can be found in 15-year step ups and short-term buyers can find good value in bank debt in the two-year to three-year area of the curve. Also, $1,000 par senior notes offer better values than their long-term $25-par brethren, especially those with coupons below 7.00% which are unlikely to be called at their first scheduled call date, if ever.

The Undead Economy

Recent economic data indicates that the economy is not quite dead. However, it is not quite alive either. Consumer spending picked up in August, but recent measures of consumer confidence indicate that consumers are remaining jittery. Home prices remain depressed and the existing neglected stock of homes decomposing in the field. The unemployment rate remains at a disturbing 9.1%, but that only counts people who applied for jobs during the past four weeks. The real unemployment / underemployment rate (the U6 report from the Labor Department) stands at 16.5%. Meanwhile policy makers point figures at one another and youthful protesters being encouraged by celebrities, who believe that they have earned their millions in a manner the deem to be respectable, to demonize people who have made large sums of money in other ways, and by political opportunists.


Meanwhile EU officials fiddle while Greece burns, but what the heck, the Greeks are fiddling faster than anyone. Defaults and hits to the banks are coming. Major capital raises and possible bank dividend cuts are coming. A European recession is on the way and emerging economies are beginning to slow. Unfortunately, the fiscal policy response has been embarrassingly poor. All we can come up with is tax the rich, more regulation, demonization and schemes to spend on big union infrastructure programs. It would be better to help boost the private sector by simplifying regulations and the tax code as well as changing forthcoming healthcare rules from an overreaching plan to ration care into a scheme to make care more affordable and therefore more available.

Meanwhile the Fed does what it can to keep money accessible and affordable. However, it cannot force firms and households to borrow and spend. The U.S economy will trudge along. This will have implications for the fixed income markets. Interest rate products (U.S. treasuries and Agency senior notes) will see yields fall. Some credit products, such as high grade bonds from the industrial, energy, telecom and utility sectors should see yields move lower with U.S. treasuries. However, high grade bank, finance and insurance bonds could see credit spreads widen and yields remain about where they are or even rise, somewhat. High yield is another story.

Higher benchmarks could mean higher yields in high grade corporate bonds. This could begin to pull investors up the credit quality scale. If sufficiently attractive returns are available in A-rated paper, investors may move up from BBB-rated bonds. BB investors may move to BBB and B and CCC investors may move to BB. The result could be significantly wider credit spreads for the very bottom of the high yield universe. Wider spreads and higher U.S. treasury benchmark yields could make it difficult, if not impossible for very-low-rated companies to refinance debt. As we said yesterday, the best risk versus reward values in high yield reside in BB-rated paper five years and shorter.

We have just experienced the best of the golden age for high yield debt. While there could be further upside for very-low-rated bonds in the near term, should the economy regain some traction while the Fed leaves policy very accommodative, your potential downside far outweighs your upside due to the current environment of low benchmark yields and relatively narrow credit spreads.

Although we have been vocal about the richness of the high yield markets for several months, we are not alone. Today’s Wall Street Journal “Credit Markets” column discusses high yield fund managers lightening up on their high yield corporate bond exposure:


“After riding a two-year rally in U.S. "junk" bonds, some high-yield bond-fund managers are looking elsewhere for returns.”
“Some fund managers said they are worried that U.S. companies selling below-investment-grade, or junk, bonds aren't compensating investors enough for the risk, especially as the economy slows. So, they are putting more money into other assets they consider better value and less risky, such as corporate debt in Europe or emerging markets, commercial mortgage-backed securities and convertible bonds.”
We would use caution when investing in the asset classes mentioned in the article (it is almost impossible for retail investors to invest in Commercial MBS) and European and EM debt are aggressive ideas, but even the fund managers believe that high yield corporates may be getting a little rich. Again, high yield bonds are most appropriate for aggressive investors and the best values on a risk versus reward basis tend to lie five years and in on the curve among BB-rated companies.

We have received questions regarding finding relative values in the preferred markets. Currently, preferreds are trading with tight spreads to bonds issued by respective companies. Investors may wish to consider swapping out of preferreds (which tend to have long maturities or are perpetual and are very subordinate on corporate capital structures) and consider purchasing bonds (particularly senior note, although there are attractive subordinate notes) in the 7-year to 15-year area of the curve. One can earn attractive returns, lower duration and, in most instances, climb several rungs on the capital structure.

Please Don't While They Fiddle About

Twisting by the Pool



I economic data has been lackluster (I am being kind), European leaders are in denial and the Fed has taken dancing lessons.

The economy is slowing. Is any one really surprised? With food and fuel prices elevated going into the third quarter, how in the world did anyone believe that consumers would keep on spending? When prices of goods with inelastic demand curves rise, consumers must make choices, if incomes were rising the situation might be different, but with employment in the dumps, wage growth is just not happening.

Some thought it was just a matter of time before companies making handsome profits exporting affordable goods (thanks to the weak U.S. dollar) would hire workers. However, few pundits were paying attention to new factories going up overseas or the cheap financing paying for new equipment and more efficient processes here in the U.S. Machines are cheaper than humans.

What will these pundits say now that the U.S. dollar has rallied against most major currencies? The one blessing is that the consumption tax on households has been reduced as lower food and energy prices, resulting from the stronger dollar, could put discretionary cash in the hands of consumers. Worst case is that households can delever (pay off debts) more quickly. Speaking of taxes, will somebody tell the President that we tax and spend too much and that temporary stimulus does a better job encouraging consumers to save or pay existing debts rather than spend? How are consumers to make large purchases, such as an automobile, when the extra cash in their budget lasts for a year and their loan is for five years? We won’t even the discuss the folly of limiting the tax benefit of municipal bonds and creating infrastructure banks. I am not even sure if the Federal Government has the power to tax municipal bonds used to fund essential services and projects.

Then there is the Fed. I come here to praise Mr. Bernanke, not to bury him. It is thanks to him that we have avoided recession as the President and Congress fiddle while America burns (Roman enough for you? Yeah, yeah I am mixing Nero and Julius Caesar, but cut me some slack). Seriously, the Fed is supposed to foster full employment and price stability. It is not supposed to keep the economy growing while the executive and legislative branches of the government bicker and pursue their own interests. However, this is exactly what has happened for the past two decades. Please stop looking for the Fed to solve all problems. The problems are structural, fiscal and not monetary. When will that penetrate the thick skulls of politicians, pundits, market participants and consumers?!!!!!!!!

Meanwhile all the Fed can do is dance, dance, dance, dance to keep the economy out of recession. Mr. Bernanke had better have his dancing legs ready because it looks like fiddling time in DC.

Cauliflower Power

According to today’s Nonfarm Payrolls Report, the U.S. economy added no, nil, nada, zero jobs in the month of August. Nonfarm Payrolls data for July and June were revised lower by a combined 56,000 jobs. Although it is true that the strike at Verizon contributed to the majority of the 48,000 jobs lost in the information sector, adding back each and every lost communications job would have resulted in a print of 48,000 new jobs. Pundits should stop trying to spin the economic data.


The truth is that the economy, which had only gained limited traction since the recession ended two years ago, is sputtering. Politicians, pundits and the American people should stop looking to the Fed for solutions. The Fed has done almost all it can do. QE3 will be like pushing on a string. The best it can do is to “twist” and move its bond holdings farther out on the yield curve (10-year or so) to have a direct effect on driving down mortgage rates. The Fed can also set inflation, growth and employment targets to instill confidence among capital market participants. All of this is well and good, but these are cyclical tools to remedy cyclical problems. The troubles facing the U.S. economy are of a structural nature.

The problems facing the U.S. economy are:

1) Too many homes and too few qualified buyers. Not all of it is due to exceptionally tight lending standards. There are far too many homes even if banks adhered to any kind of prudent lending standard.


2) U.S Households are overleveraged. Just as a person must work through a hangover after a long weekend of partying and alcoholic imbibing, U.S households must endure a period of pain as they correct imbalances on their personal balances sheets. The idea of curing too much debt by having consumers incur more debt is nonsensical and irresponsible.


3) The U.S. offers businesses very few comparative advantages versus their global competitors. The U.S. has the second highest corporate tax in the free world. On economically-stagnant Japan has a higher corporate tax rate. U.S. businesses are reluctant to repatriate dollars earned overseas. Instead money is held, spent and invested overseas. Production occurs close to local customers as well. The actions taken by the National Labor Relations Board attempting to block Boeing from opening a factory in low-tax, non-union South Carolina demonstrates how anti-business or current crop of policymakers really are.


This is not about political ideology or social justice, it is about a malfunctioning alleged market economy that has been hamstrung for far too long by nonsensical, albeit well-intentioned, government policies the negative effects of which have been offset by Fed policy since the early 1990s. The Fed can do no more. It is time for policymakers to hold their collective noses and eat the cauliflower that are economically-friendly policies to get the growth engine running.

Bond investors may have read articles this week, one from Bloomberg News and one in the Wall Street Journal, which espoused the opinion that the bond market held a positive outlook for the economy because the yield curve (between its short-term and long-term benchmarks, the two-year and 10-year treasury notes was positively-sloped by a fairly sleep 200 or so basis points. The articles each stated, correctly, that the U.S. economy has never fallen into recession when the yield curve was positively sloped and that the curve flattens or inverts before that happened.

At the risk of insulting the intelligence of the two respective authors, are they kidding? The Fed has the Fed Funds rate at effectively zero. Since Fed monetary policy rules the short end of the yield curve, the two year note is anchored below 20 basis points. However, the 10-year is beyond the Fed’s influence. Ten-year yields respond to growth and inflation expectations. A 10-year treasury yield in the low 2.00% area reflects very poor growth. We could see it dip below 2.00% and remain there for an extended period of time if and when the Fed begins reallocating its holdings farther on the curve. However, because of extremely low short-term rates, the yield curve cannot go flat or invert.

The yield curve is about the journey, not the destination, especially in this environment. The fact that, prior to today, the curve between two-years and 10-years had flattened by approximately 70 basis points since the end of June is a more accurate indicator of the bond market’s sentiments regarding the U.S. economy.

The September 20th – 21st FOMC meeting should be interesting. Following today’s employment data we are likely to see one hawk, Minnesota Fed President Narayana Kocherlakota, defect to the doves. However, I do not believe we will see a full-blown QE3. The Fed is more likely to set targets (jawboning), either hard or soft, and announce that it is going to perform extension swaps farther out on the yield curve.

With commodity inflation already elevated and blamed for much of the slowdown in consumer demand and for hampering job creation, aggressive easing could be death for the U.S. economy with the holidays and winter’s cold just months away.

I would wish everyone a happy labor day, but these are not very happy times for labor in the U.S.

The Grand Teton Blues (or Jackson Hole or Bust)

This weekend the Fed will conduct its annual conference in Jackson Hole, Wyoming. With the exception that CPI Core inflation is running at 1.8% this year versus 0.9% last August, the agenda at this year’s conference will be remarkably similar.

As with last year’s meeting, the U.S economy has hit a soft patch. As with last year, the Fed his being looked to for answers. However unlike last year, the Fed is almost out of ammo. All it can really do is move its bond holdings farther out on the yield curve. This would permit the Fed to keep policy accommodation in place and keep long-term rates low. QE, like traditional easing, can be and should be inflationary. This is why long-term rates rose IN SPITE of increased Fed purchases of debt during QE2.

Some believe (equity market participants) that the Fed is poised to announce or at least hint at QE3. Good luck with that. The benefits of QE are so diminished at this point that even if new bond purchases would be on the long end of the curve, long-term rates would probably rise somewhat as market participants hit the Fed’s bid until the economy slows again when they resume buying long-dated treasuries.

The problems with the U.S. economy are of a structural nature. All the cyclical tools in the world are not going to fix these problems. Making the U.S. more business friendly on the tax, regulation and labor cost front are what is needed. When housing finally clears in another five years or so the healing will pick up speed. This is providing that the structural problems are rectified. Until then, the words slow and arduous will be used to describe U.S. economic growth.

Target Sighted

The Fed stated that it plans on keeping the Fed Funds rate between 0.00% and 0.25% until at least mid-2013. Although it is not surprising that the Fed would remain extraordinarily accommodative for that long, it is surprising that the Fed would set a target. The Fed has not traditionally set targets. However, Fed Chairman Bernanke has in his academic past spoken positively about targeting.

By setting this target time frame, the Fed takes the mystery out of policy for the next two years. This makes it easier for lenders, borrowers, and businesses to make strategic decisions. It also provides clarity for investors. The Fed is sending a message. That message is: Get out of cash and floating-rate securities based on short-term benchmarks and into high-dividend paying stocks, high grade bonds seven to ten years out (especially banks, finance companies and insurance) and BB-rated high yield bonds 5 years and in.

Preferreds had cheapened up recently, but they rebounded late in today’s trading session. There maybe some value left it that asset class. Step-up notes offer some value here as many have attractive yields-to-call if rates do remain low and they are called away, but provide cushion should rates rise.

Play defense, but vigilance is a very good defense.

P.S. Indirect bidders (which include foreign central banks) purchased almost 47% of today’s 3-year treasury note auction versus a 36% average for the past 10 auctions. So much for the exodus from the AA+ U.S. treasury.

The Bond Market Explained

What a week in the bond market. Prices of U.S. treasuries rallied following an agreement between both parties in congress and the president to raise the debt ceiling and cut spending by $2.5 trillion. This follows a week when investors purchased large quantities of treasuries in a flight to safety in the event that the U.S. failed to raise the debt ceiling. Confused yet? Let me explain.

Investors purchased treasuries the week before a debt ceiling an agreement was reached because if the U.S. did not raise the debt ceiling the global financial system and capital markets around the globe could have been thrown into turmoil. Meanwhile the U.S. would most likely have serviced its dent, uninterrupted, instead choosing to withhold payments to government spending programs, pensions and salaries. So if turmoil was avoided, why did prices of U.S. treasuries continue to rally?


The rise in U.S. treasury prices was due in part to the budget cuts and the fear that the U.S. would not be able to inject further stimulus if economic data indicated it was needed. The market fears a near stagnant U.S. economy or, worse a recession. Recent data suggests that growth may indeed be slowing. Some of the slowdown can be blamed on supply disruptions in Japan and a consumer squeezed by higher food and energy prices. Although those headwinds appear to be temporary, new, possibly stronger and longer-lasting headwinds appear to be on the horizon, headwinds which should keep growth and interest rates low. Let’s discuss:


1) Spending cuts / higher taxes: Spending cuts and higher taxes are part of the plan to address America’s budgets crisis. These will create headwinds by removing money from the pockets of many consumers. Taxes are straightforward. The more taxes one pays, the fewer dollars one has left to spend. Budget cuts are less intuitive, but when you think about it makes sense. Budgets cuts mean the firing of government workers and fewer purchases of goods and services by government agencies. Although one can argue that such measures are good over the long haul, headwinds are created by such measures in the near term. The U.S. is undertaking austerity measures similar to those European periphery countries should undertake, but refuse to do.

2) Europe: Europe is a mess. European leaders are choosing to throw cash at the problems whenever the bond market votes with its feet and shows its reluctance to finance periphery nations, at least not at affordable rates. The markets are losing their patience. The recent rally in U.S. treasuries is due in part to a no vote on the way European officials are handling their ever-growing crisis.

3) Global Slowdown: The Global economy is slowing. China is fighting its own real estate bubble and is trying to slow inflation with less accommodative polices. This does not mean that China will stop growing. The country is so far behind developed nations in the west it cannot help but growing. It can grow at a robust pace almost by accident. However, if this is all the growth we can get in our economy based on exports (the exportation of manufactured goods has been one of the few bright spots in the U.S. recovery) with China in an economic bubble, what happens when overseas demand slackens?

4) A strapped U.S. consumer: The U.S. consumer is overleveraged and is sitting on depressed real estate. Add to this plight, no wage growth and more layoffs and the consumer is in no position to lead the economy back from the depths of despair. It could be many years before the consumer can lead the way and even then he might read more cautiously.

Consumers will spend again, but they are in the midst of an economic hangover. Just as in an alcohol-induced hangover, one must take some time to recover from one’s drunken binge. But fear not, they will drink again, but it is possible they will be a bit more responsible the next time around. Surveys of the under-30 set indicate that they eschew the 4,000 square foot McMansions and $50,000 SUVs. Older consumers are also learning to spend more judiciously. Consumer spending may peak at levels seen in the 1980s or before when the consumer is back in the game.

5) Banks: Banks are not going to lend to anyone but the most qualified borrowers. This is for several reasons. First: It is not easy to securitize loans to lower or even mid-quality borrowers, at least not at rates which would entice borrowers. Investors are demanding higher rates of return for investing in such loans and there are fewer of these investors.

Secondly: Banks will not hold them on their balance sheets. For one thing, they could be criticized by regulators for having too much risk on their balance sheets. Another factor keeping banks from lending to higher-risk borrowers is that politicians will accuse banks of predatory lending if they lend to those whose ability to service their debt is in question.

Instead, banks will continue to engage in a carry trade in which they borrow at near-zero-percent rates on the short end and purchase 10-year treasury notes. Even with a rate of 2.50% on the 10-year U.S. treasury note, banks can earn over 200 basis points without incurring much, if any, risk.

Some may criticize my thesis and point out that the S&P’s recent downgrading of the U.S. sovereign credit rating to AA+ will cause a selloff of U.S. treasuries. Any such selloff will be short-lived (and a bit stupid). Most investors who buy large quantities of U.S. treasuries can still own them even if they are not AAA-rated. They have an exemption for U.S. government debt.

What could push long-term U.S. rates higher is if the Fed engages in QE3 or similar stimulus. When the Fed instituted QE1 and, especially, QE2 long-term rates trended higher. This confounded investors and Fed officials alike. I have explained this earlier (the Wall Street Journal finally explained this weekend) that quantitative easing, like traditional easing, is inflationary in nature. It tends to weaken the dollar and pushes prices and long-term rates higher. This is exactly what happened with the first two rounds of QE. The positive effects on growth diminished with each round of QE, but the negative effects on inflation (pushing it higher) increased. A QE3 would likely cause this trend to continue.

An idea of the Fed eliminating the 0.25% rate paid to institutions for deposits held at the Fed has been floated. The thinking is that if banks are no longer earning this 0.25% they might be more inclined to lend that capital. More likely results would be the purchasing of U.S. treasuries or expense cuts (layoffs and the canceling of expenditures). This would put a heavier lid on long-term interest rates.


Weighing the data, recent economic data, large layoffs announced by businesses, government policy decisions (necessary though they were) and the lack of arrows in the Fed’s quiver, poor economic growth and relatively low interest rates appear to be what is in store for at least the next year. I would not be surprised if the Fed funds rate was left unchanged throughout 2012 and beyond. If someone approaches you with the idea of buying floating-rate securities pegged off of short-term reference rates don’t walk, run!


Hang in their folks. We will all get through this, but it will take time, patience and belt-tightening.

The Dismal Science

One day it looks as though the U.S. could default on its debt and the price of the 10-year U.S. treasury rallies. The next day it looks as though the U.S. will raise its debt ceiling, the price of the 10-year note rallies. The U.S. could get downgraded by S&P, the 10-year note rallies. Moody’s affirms the U.S. AAA credit rating, the price of the 10-year U.S. treasury rallies. Concerns abound that the new budget legislation could put a modest drag on U.S. economic growth, the price of the 10-year note rallies. The slowing economy could cause the Fed to maintain or increase economic stimulus, the price of the 10-year note rises. One could be forgiven for believing that there is a bubble on the long end of the treasury curve. Whether or not that is true depends on how one defines a bubble.

Can the yield of the 10-year treasury note remain in the neighborhood of 2.60%? Over the long term, probably not, but it could remain range traded in the high 2.00% to low 3.00% area for an extended period of time. Note the words “extended period.” These are the same words the Fed has used to communicate how long it plans on keeping monetary policy exceptionally accommodative. When the FOMC meets next week, it is very likely that the Fed once again uses the phrase “extended period.”




The Fed is likely to remain exceptionally accommodative because recent data indicate that the economy is slowing. It was bad enough that consumer spending never ramped up as hoped, but now there are signs that the Global economy might be slowing. Although it is true that if countries like China slowed somewhat, their growth would still be robust, but put this into perspective: It has taken booming developing economies and the largest and longest-lasting infusion of economic stimulus since the Great Depression just to get us this far.


Possible future Fed actions are limited. QE3 is almost certainly out of the question, but the Fed could continue to reinvest maturing QE assets and hold off on asset sales and policy rate increases. This will keep short-term rates punitively low and push investors farther out on the yield curve. There have been suggestions that the Fed should eliminate the 0.25% rate it pays on deposits at the Fed to force banks to use that capital for lending. The counterargument is by doing so foreign banks (which have very large deposits at the Fed) and money market funds (which deposit a significant portion of their capital with the Fed) would be harmed.

I make the argument that as long as the curve is steep, banks would prefer to borrow on the short end of the curve and invest in 10-year notes to pick up almost 250 basis points. This so called carry trade may earn banks less than what they would earn by engaging in mortgage lending, but by purchasing the 10-year treasury note (effectively lending to Uncle Sam) banks do not have to be concerned about securitizing loans, dealing with delinquencies and foreclosures or running afoul of regulators by lending to those who cannot afford to pay or by carrying too much risk on their own books if the loans cannot be securitized. What incentives do banks have to lend to all but the most pristine borrowers? Not much from what we can see. Of course, what other borrowers than those who are very creditworthy and who are not over leveraged desire financing at this time?



Most other Americans are trying to climb out from under a mountain of debt accumulated during the most recent economic bubble. Several years were required accumulate such debt; many years are likely to be required to dispose of it. With unemployment expected to remain stubbornly high for years to come, the ability of consumers to repay their debts will probably be impaired. Consumer spending is also likely to be less than that to which we have become accustomed. As consumer spending makes up more than two-thirds of U.S. economic activity, economic growth could be below historical trends.


Readers know that I was never in the V-shaped recovery / spiking interest rate camp. I was of the opinion that the Fed would be very slow to tighten policy (I even correctly predicted how the Fed would remove accommodation). However, I also believed that long-term yields would rise gradually to the mid / high 3.00% area (further steepening the yield curve) as the economy grew at a below-trend pace (2.0% to 2.5%). However, recent and troubling economic data are pointing to “soft-patch 2011” or worse. This has sent the yield of the 10-year treasury note below 2.60%.

The bond market is pricing in a slowdown. Troubles in Europe and slower growth in emerging nations are causing the flight to safety. Even moves my central banks to increase gold holdings hasn’t stopped the rally on the long end of the curve. If economic data continues to disappoint (and I find it hard to believe that it will not), the Fed could remain on the sidelines throughout 2012 and the yield of the 10-year treasury note could become range traded between 2.50% and 3.00%. I would keep my exposure to LIBOR floaters very light. I will be back following Friday’s employment data.

Paranoia

Here I sit, watching the news of on again, off again votes on the debt ceiling. Every so often some talking head comes on and attempts to scare the be-Jesus out of viewers that the U.S. government is going to default on its debt obligations. What a load of grade “A” manure.



Prices of U.S. treasuries trended higher today due to concerns that the battle over the raising the debt ceiling is going to harm economic growth. Say what? Debt ceiling concerns are causing investors to flock to the safety of U.S. treasuries. The market is telling us that a U.S. default (an actual failure to pay its debts) is very unlikely. If the U.S. actually defaulted on its public debt, the 2008 financial crisis would look like a picnic by comparison. This is not to say that policymakers are sure to reach an agreement prior to next week’s deadline. However, The U.S. treasury has enough revenue to service its debts if it suspended payments to government programs, pensions and salaries.



Reaching a debt ceiling agreement does not necessarily mean that the economy is out of the woods. As I have said previously, a deal which raises taxes, cuts spending or both would probably hinder growth. As one fixed income strategist told Bloomberg News:





“The market is trading on a combination of anxiety over the debt ceiling overhang and on the concerns that budget cuts could bring. Sentiment seems to be fairly positive for Treasuries.”



What should investors do? The first thing is not to panic. As difficult as it might be for some clients who are avid CNBC viewers, they should avoid panic selling of fixed income assets based on media hype. If one has a well constructed, diversified portfolio, one should be able to weather “the storm” rather well. We would advise investors to take advantage of any weakness the debt ceiling debacle has caused in the fixed income markets, but there really hasn’t been any.





Another day and another "okay" treasury auction. Today the treasury auctioned $29 billion of seven-year notes. The new notes priced to yield 2.28% on stronger demand than seen at the previous auction. The bid-to-cover ratio rose to 2.63 from a prior 2.62. Although the new seven-year note priced higher than an expected 2.256%, today's yield of 2.28% was the lowest yield at auction for a seven-year U.S. treasury since last November's 2.25% due 11/30/17. Indirect bidders, which include foreign central banks, purchased 39.6% of the deal, up from a prior 32.2%.



When taken at face value, today's auction was just alright. However, considering that the U.S. is just days before hitting its current debt ceiling, today's auction was fairly well received. 





Oh, if you think that I am off base that the U.S Treasury will prioritize debt (bond) payments. Check out this story from Bloomberg News:

“The U.S. Treasury will give priority to making interest payments to holders of government bonds when due if lawmakers fail to reach an agreement to raise the debt ceiling, according to an administration official.”


“The official requested anonymity because no announcement has been made. The Treasury has said about $90 billion in debt matures on Aug. 4 and more than $30 billion in interest comes due Aug. 15. Overall, more than $500 billion matures in August.”

This is not to say that a downgrade is out of the question. It is actually very possible and, in my opinion, warranted. That could push long-term yields higher, at least in the near term, but nearly any debt ceiling deal imaginable is likely to include some combination of spending cuts and tax increase. The economic headwinds generated by such a deal will likely keep inflation, and therefore long-term interest rates, relatively low. Any rise of long-term bond yields could be relatively modest.

A downgrade of U.S. treasuries could have a larger impact on credit spreads of municipal and corporate debt. If as U.S. downgrade does occur, look for credit spreads to widen. The lower the credit rating the greater the widening,

That is enough for now. Back to the soap opera that is Washington.

It's Been A Long Time

It’s been a while since I have written. Truthfully there has not been much about which to write. I could go on and on explaining why U.S. treasuries have been range traded. Or why the Fed will not act to raise rates until at least mid-2012. I could send out a big “I told you so” about the Fed exiting out of QE assets early in the tightening process.

I could discuss how the high yield market is over priced, as are high-grade industrial bonds. Even the energy sector is trading stupid-tight with BBB-rated issuers like Arcelor Mittal trading at similar levels as AA-rated GE Capital (which had strong earnings).

Trading and sales desks continue to push floating rate paper onto fearful investors who do not under stand how the product works. Given the outlook for interest rates and Fed policy and the disconnect between said securities long-dated maturities (some are perpetual) and their coupon benchmarks (most often three-month U.S. dollar LIBOR). It could be a long while before floaters perform well. Meanwhile, investors are stuck with dismal rates of return. Fixed-to-float notes and step-ups are better alternatives. A laddered custom portfolio is the best way to invest in the fixed income markets.

Where are all the so-called gurus who used espoused technical reasons for higher rates? What happened to the much-feared exodus out of the U.S, dollar? What happened to China’s rebalancing of its foreign debt holdings (China is currently carrying its biggest holding of U.S. treasuries thus far in 2011)? It was all bupkus. Beware the alarmists who predict the end. They should go back to airports and street corners where they belong.

Have a great weekend.

Tough Job

Just a quick read on today’s employment data from my vacation.

June Nonfarm Payrolls, well let’s just say it, sucked. The economy only added 18,000 jobs. The private sector added 57,000 jobs, but the government cut 39,000 jobs. Temporary employment declined by 12,000. This is important because temporary employment data are often good indicators for future hiring trends. Job data was revised lower for May and April. The unemployment rate rose to 9.2%, the highest since last December. Today’s print of 18,000 new jobs is the poorest showing since last September.


If there is anything positive one can take away from this dismal number it is that recent ISM and ADP data indicated that the employment picture may not be quite so dismal. However, even those respective reports indicate that job growth is poor.

It comes down to fundamentals. The only ways we can get employment beyond the 200,000 jobs per month needed to bring down the unemployment rate is to either generate more consumer spending (not likely as consumers cannot and will not borrow to spend) or make U.S. labor more price competitive with external labor sources. This can be done with wage and benefits cuts, a weaker U.S. dollar or both. This is the new normal for at least the next few years.

Yields of U.S. treasuries and interest rates should remain low for an extended period of time.

A Call from the Mountains

I interrupt my vacation to bring you an update on the markets. Although I am not in my battle chair the view from my mountain is quite clear.



The yield of the 10-year U.S. treasury has been rising all this week and was 3.12% at my last observation today. Some have been pointing to the end of QE2 and the lack of Fed buying of U.S. treasuries for higher long-term interest rates. Bear scat! The reason for the selloff of U.S. treasuries is the approval of austerity measures by the Greek Parliament and the reduced probabilities of default and contagion.



Speaking of Greece (and bear scat), German banks have agreed to voluntarily exchange their Greek debt with maturities out to 2014 for longer dated Greek debt. It is not yet clear if the ratings agencies will consider it a default. If it walks like a duck and quacks like a duck... you get the picture.



Well that it is all for now. Jusqu’a semaine

Mid-Year Review

Yes folks, it is that time of the year. It is the time of the year for me to take a holiday. For the following two weeks, Making Sense will be conspicuously absent from you inbox. Fear not, I will be back on July 11th.



But before I go, we would like to recap the first half of 2011. Here goes:



The recovery was sluggish; the natural disasters in Japan, the sovereign debt crisis in Europe, a declining housing market and poor job growth conspired to send long-term interest rates lower. This was especially true following the Fed's decision to end QE2 purchases at the end of June, but to continue to reinvest maturing assets.



The Fed's decisions to end QE2 bond purchases sent the blogosphere into a tizzy with predictions of spiking interest rates due to a lack of demand for U.S. treasuries once the Fed ceased purchasing U.S debt. Surprise! Rates went in the other direction as most of the alarmists (few of whom were actually fixed income market participants) failed to understand that the cessation of QE2 was potentially disinflationary (think quantitative tightening).


What does the second half of the year hold in store? The consensus forecast among Wall Street economists calls for sluggish economic growth. Headline CPI (including food and energy) is forecast to run at an annual rate of 3.00% for 2011 before falling to 2.20% for 2012. If this forecast is anywhere close to reality there should only be modest pressure on long-term interest rates and almost no change to short-term rates, such as Fed Funds and Three-Month LIBOR. In fact, it is not inconceivable that the Fed keeps Fed Funds unchanged throughout all of 2012.

This is not to say that there will be no Fed tightening. Should the Fed cease reinvesting its maturing QE assets or begins to sell them, that would be a form of (quantitative) tightening. The Fed could, in theory, sell its QE assets and effectively raise policy rates approximately 100 basis points without touching the Fed Funds rate (see Taylor Rule).

Don't look for consumers to ride to the rescue. They are deleveraging and will continue to do so. Gone are the days of easy credit and a new SUV every two years. This is a healthy, but painful development.

See ya in two weeks.

Back By Popular Demand

I have had requests for an updated blog considering all that has been happening in the markets and the economy. While low treasury yields, a measure of disinflation, a double-dip in real estate values and poor job growth may be breaking news to many investors and market participants, they have all been subjects of previous editions of this blog.

Here is the quick and dirty analysis of the fixed income world as we know it. During the first quarter of this year, the economy was finally gaining momentum however, because it was dependent on historically-accommodative Fed policy and U.S. manufacturing, much of which was export related the economy was very susceptible to disruptive events. The disaster in Japan provided such a disruption. Job growth and wage growth are also needed for the economy to march forward. Except for what appears to be a bounce-back from a snowy winter, job growth is disappointing.

Face it folks, the economy will trudge forward. Growth could top 3.5% the second half of 2011, but much more than that will be difficult. Next year, growth will struggle to reach 3.0%, but that is ok as it is approximately the 235-year average growth rate for the U.S.

Tomorrow I will discuss how various areas of the fixed income market might behave during the next six-to-twelve months.

The Soft Patch Gazette

This week was filled with disappointing economic data. Today’s Nonfarm Payrolls report was just the icing on a very stale cake. Employers added the fewest number of workers in eight months during the month of May. Some of the drop in the pace of hiring is probably due to supply shocks from Japan, but part of the cause of soft job growth may be structural. Without an exploding tech sector and McMansion Happy Meal financing in the real estate sector job creation remains challenging. The print of 54,000 new jobs was below even the post pessimistic estimate of 65,000 within the Bloomberg survey of economists.

Some economists and strategists have opined that May’s poor number may be “transitory.” This is probably true, but some economists, such believe that the Nonfarm Payroll prints of over 200,000 in February, March and April were not reflective of U.s. employment fundamentals, but were the result of hiring playing catch-up from the poor numbers seen in December and, especially, January which were greatly influenced by severe weather experienced in many parts of the U.S.


One Wall Street economist told Bloomberg News:


“These are pretty bleak numbers. Some of the engines of hiring just went away. Combined with the slowdown in consumer spending, it raises concern that the slowing in hiring could be with us for a while.”


Folks we are in another soft patch. Although the disaster in Japan exacerbated the problem, it was not the cause. Poor job growth, an impaired housing market and a debt-laden consumer are conspiring to keep growth sluggish. Slowing of major foreign currencies is adding to the economic headwinds.




Manufacturing expanded at a slower pace in May (the slowest pace in over a year) as higher commodities prices and supply disruptions due to the earthquake and tsunami in Japan. However, a modestly stronger U.S. dollar (which can hurt U.S. exports) and measures taken by policymakers in China and India to slow growth and combat inflation may also be partially to blame.

Businesses are spending less on new equipment after modernizing and increasing efficiency during the past two years. One economist told Bloomberg News:

“We’re seeing some loss of momentum. Unless there’s ample growth in demand, orders will be stagnant. Businesses are hesitant to move heavily in terms of investment. They’ve gone through replacing outdated equipment and now there’s less reason to spend.”




Recent housing, employment and manufacturing data have some pundits predicting doom and gloom for the economy going forward. This view may be as misplaced as the views of those who were predicting a robust v-shaped recovery. Fundamentals appear to be in place for a modest, albeit bumpy, recovery.




As we stated yesterday. The pessimism which appears to be building among some market participants may be due to overly optimistic assumptions going into the recovery. We have stated many times that a robust v-shaped recovery was not likely because it would probably require the kind of leveraged spending and strong real estate market which had been prevalent during the past two decades. Today’s Wall Street Journal editorial page contains a very good description of the current economic recovery and explains why housing cannot and should not be relied upon to rescue the economy. The Journal states:


“The clamor to boost housing as an economic savior is especially odd because we've tried this before with dire or fruitless results. The start of the last decade's mania was Federal Reserve Chairman Alan Greenspan's attempt to boost housing to substitute for the impact of the dot-com crash and 9/11. It worked for a while but created the bubble that led to the panic and meltdown.”


The Journal opines about government programs to boost or halt the fall of home prices:

“Their main result, other than subsidizing some Americans at the expense of others, has been to sustain the housing recession over a longer period of time. The price decline would have been sharper without them, but the recovery would have happened sooner and would probably be well underway by now.”

Their opinion is along the line of our comments made in March 2008 (six months prior to the financial crisis). We suggested that home prices be permitted to retreat to levels at which buyers would be attracted. However, if prices were permitted to fall in March of 2008, while credit was still fairly easy to obtain and the full extent of the mortgage mess not yet known, it is possible that bargain hunters may have entered the market prior to home prices falling to current levels or lower. Worst case probably would have been what the Journal suggests.

The Journal continues:
“Prices are continuing to fall again because we still have too much housing stock. That excess needs to be cleared, and the inevitable foreclosures need to be processed and the homes resold before prices can find a new bottom. After years of forlorn attempts at price levitation, rapidly clearing that stock to find that bottom ought to be the main goal of housing policy. Only then will a recovery begin.”

The Journal ends with:
“Housing is a major part of the U.S. economy but it needs to shrink from its artificial, subsidized share of U.S. wealth to a level that is sustainable based on population, income and productivity growth. A healthier economy must be built on capital investment in plant and equipment, new ideas and new companies. We need an investment boom, not another housing bubble.”
If it were this simple, why haven’t policymakers followed the Journal’s suggested course? It comes down to politics. It is difficult for politicians to say to their constituents that it could be years or even a decade or more before their home values recover.
Why did the Fed and other policymakers use housing as a way to engineer an economic recovery? Probably because it was the easiest way to generate rapid growth. The thinking of the time was that banks would not lend money to those who could not repay and that the resulting consumer spending would bleed over into other sectors of the economy and result in a broad-based, self-sustaining expansion. As we now know, that was not going to happen.
In the absence of leveraged consumer spending, the recovery is likely to be modest, bumpy and lengthy. As another Journal article explains: It is not the absence of credit which is the problem, but the lack of demand for credit.
It is the realization that economic growth and job growth may not be poised to leap forward which has pushed the yield of the 10-year U.S. treasury note lower in recent weeks. The Fed’s decision to end QE2 this month, but continue to reinvest maturing assets, has also strengthened the U.S. treasury prices. Lastly, the fact that the Fed is removing stimulus, albeit modestly, by halting QE2, which is somewhat deflationary, has sent investors back into U.S. treasuries.
The 10-year note is widely considered to be a barometer of fixed income market sentiment regarding growth and inflation. The bond market appears to be telling us that it is not especially concerned with inflation pressures building and it is not looking forward to robust economic growth. Some market participants, such as Pimco’s Bill Gross, warn that once QE2 ceases later this month U.S. treasury prices could fall as there are no buyers to replace the Fed.
This may or may not be true. However, the bond market is much more proactive than reactive. If bond market participants believed that that the price of the 10-year U.S. treasury note would plummet because the Fed would be purchasing fewer bonds, it is unlikely that there would be so much buy-side interest now.
It is not the base case scenario of Citi strategists for long-term yields to trend lower going forward. However, Citi’s Q4 2011 10-year treasury yield forecast was lowered from 3.70% to 3.60%. The street consensus forecast remains at 3.82%. There has been no change to either the Citi forecast or the street consensus estimate both of which call for the first 25 basis point Fed Funds rate hike to occur sometime in the first quarter of 2012. However, such forecasts are always subject to change based on economic conditions.
There have been some rumblings regarding a possible QE3. such talk is probably premature. However, if the economic “soft patch” is more lengthy than many are forecasting, it is possible that the Fed delays policy tightening longer than what is currently expected. Investors should be more fearful of slow growth than higher interest rates during the remainder of 2011.


In the late 1940s and 1950s, 10-year treasury yields were similar to today’s yields. It wasn’t until Cold War spending and infrastructure spending was ramped up that long-term rates began to rise. They really took off during the 1960s and 1970s as increased social spending, Cold War spending, higher taxes, accommodative Fed policy which was focused on employment and not on inflation permitted rates to explode upward. Beginning in the 1980s, then Fed Chairman Paul Volcker’s focus on inflation and his subsequent success resulted in a three decade decline of long-term interest rates. It is possible that we already have reverted to the norm or just below it.

Technical strategists may look at this chart and its various data points and look for trends and events which periodically repeated. It is our view (remember we are trading types and not strategists) that the markets (including the bond market) respond to economic conditions, global events and policies set by human beings. Events do not just occur in patterns. Fate does not exist in the bond market.

Welcome To The Camp

Since the Dodd financial regulation bill (and specifically the Collins amendment) was signed into law questions arose about when and if banks would call in their trust preferreds. One camp believed that banks would call in all of their trust preferreds as soon as possible as that form of capital made little sense for banks now that they would lose their Tier-1 capital treatment beginning 2013. Another camp believed that banks would not begin to call in trust preferreds until they actually began to lose their Tier-1 eligibility.

Then there was my camp. I thought that banks would call in trust preferreds whenever it was most economically advantageous to do so. Besides the Tier-1 aspect of trust preferreds, there is the cost of finance aspect. I was of the opinion that banks would choose to call in their highest coupon issues first and that banks are free to determine when the capital event, which is required to trigger an early call occurred. I warned readers that a bank could decide to call in a high-coupon trust preferred, not only before 2013, but at anytime.


Today, Fifth Third back called in their 8.875% FTBprC. It will be called on 6/17/11 at a price of 25. This was bad news for investors who purchased shared recently (up to this morning) at over $26.00 per share. I will warn readers once again; don’t buy high-coupon, high-premium trust preferreds thinking that the will be around until their first call dates and don’t buy low-coupon preferreds at deep discounts thinking that they will be called in the near future at par. Neither scenario is economically advantageous for issuers. Calls are always executed when it is the best interest of the issuer, not investors.

On the QT

Whatever happened to rising interest rates? The newswires were hot with stories of hyper inflation and soaring interest rates. The stories stoked fear from two angles. One school of thought said that if the Fed kept QE2 rolling it would foster inflation, and therefore, higher interest rates. The second school of thought believed that if the Fed ends QE2, there would be little support for treasury price and long-term interest rates would rise. In other words, no matter what actions the Fed took, long-term interest rates were heading higher. Not so fast Sparky. There appears to be much misunderstanding regarding how QE2 (and QE1 for that matter) affected the bond market.

When the Fed ended QE1 last year, long-term interest rates declined (helped by Euro troubles). When the Fed announced the possibility of QE2, long-term rates began to climb. Long-term rates hit their highest levels since early 2010 last December following the launch of QE2. Now, with the Fed’s announcement that QE2 will end on schedule in June, but that the Fed will reinvest maturing assets, long-term U.S. treasury yields have fallen. The yield of the benchmark 10-year not dropped to 3.16% the other day.

The recent fall of long-term interest rates is not as counterintuitive as it may appear at first glance. When the Fed halted QE1 it was considered to be disinflationary. Many market participants took off their risk trades and headed into U.S. treasuries. When the Fed moved toward QE2, risk trades went back on and really took off when QE2 was launched. Risk trades include speculating in equities, commodities and junk bonds. Now with QE2 likely coming to an end, but with the economy showing a bit more life than last year, long-term rates have fallen, but have not plummeted as in 2010.

This does not mean that long-term rates will not trend higher. However, they are more likely to creep higher rather than experience a spike. The street consensus as per a Bloomberg Survey indicates a consensus opinion of below 4.00% for the yield of the 10-year U.S. treasury note for year-end 2011.

The street consensus forecast for Fed Funds indicates no change to the Fed Funds rate this year with the first Fed action coming in Q1 2012. Three-month LIBOR, which is greatly influenced by the Fed Funds rate, has fallen from .33% to .26% during the past month. The one year forecast for three-month LIBOR is in the .75% to 1.00% area. Investors buying floating rate paper may be very disappointed with their investment choice.

Why may the rise of short-term rate be modest? This is because growth is not expected to be strong enough to move above the U.S. historical trend rate of 3.1%. Also, it must be remembered that QE is a form of easing (lowering rates in alternative fashion). Therefore, the removal of QE stimulus must be regarded as QT or Quantitative Tightening. When QT and rate increases are factored in together, it appears unlikely that the Fed will have to raise the Fed Funds rate very high during the coming interest rate / economic cycle, possibly not higher than 2.00%. I think we may be in for a few boring years as the economy adapts to new realities and housing prices languish until population growth provides the market with QUALIFIED buyers.

Grow Job

Yesterday’s employment data was reasonably strong with the economy adding 244,000 jobs. Although this is only 44,000 more jobs necessary to keep pace with population growth, it far exceeded the street consensus estimate of 185,000. Does this mean that job growth is set rocket higher? Probably not, as there are too many headwinds facing the U.S. / global economy.

Hiring at this pace will barely make a dent in the bloated number of people on the unemployment roles. Budgets cuts necessary to pass an agreement on raising the debt ceiling (or to keep the U.S. solvent without raising the debt ceiling), a persistently weak housing market and signs of slowing in emerging market economies promise to keep job growth, and the U.S. economic growth, modest. The fact that there are over 7 million people receiving unemployment benefits means that at anything close to the current pace, it could be several years or more to bring the unemployment rate down below 7.00%. If course by then the economic cycle could start a normal downward trend and nip the job recovery in the bud.

Speaking of the unemployment rate, many investors were confused about how the unemployment rated could tick higher from 8.8% to 9.0% in the face of better-than-expected job growth. This was due to how the so-called household survey is conducted. If a respondent answers that they are not working, but not actively seeking employment they are not considered to be unemployed. However, if a non-working respondent answers that they are seeking employment they are considered to be unemployed. Typically, as job prospects improve, non-working respondents become more confident and answer that they are seeking employment. Because of this, a rising unemployment rate in conjunction with a stronger Nonfarm Payrolls report is considered a positive phenomenon.

All signs continue to point toward a sustainable, but modest recovery. However, the fun may be over for commodities and the equity markets. Make no mistake, the spike in commodities prices during the past year was due in large part to Fed policy which weakened the dollar and had the potential (at least in theory) to cause a robust “v-shaped” recovery. Now we are seeing speculators take their profits and are going home. With their support out of the commodities prices have plummeted.

The equity markets have also benefited from Fed policy as low corporate financing rates and a weaker dollar making U.S.-made goods price-competitive in overseas markets. The result has been a sharp and stout balance sheet recovery. As the Fed removes stimulus, the equity markets could experience a correction. Sell in May and go away could be a good strategy this year. Autumn could be a better time to re-enter the equity markets.

I would wager many investors have interpreted the drop in commodities prices, especially oil prices, as being anti-inflationary. Au contraire, a drop in oil prices should make more consumer cash available to be spent in other, more productive, areas of the economy. Lower oil prices could in fact cause the Fed to act somewhat more aggressively to tighten monetary policy. To those who believed the Fed should have raised rates to combat higher oil prices my thinking may be confusing, but this speaks to the lack of knowledge of what inflation is measured and occurs within the investor community,

If the trend of weakening commodities continues the Fed may be better able to remove stimulus. The first action y the Fed will be to end QE2 purchases. Next, the Fed could cease re-investing maturing QE2 assets and increase the interest rate paid in reserved kept at the Fed. . Then the Fed is likely to engage in a combination of Fed Funds rate hikes and the selling of QE (1 and 2) assets,

Fed Funds rate hikes will likely be modest, few and, possibly, far between. Remember quantitative easing? Well the ending and removal of quantitative easing is quantitative tightening, Investors waiting for high Fed Funds rates are likely to be disappointed during the forthcoming economic cycle. Since U.S. dollar LIBOR is very much linked to the Fed Funds rate, Libor-based floating rates and preferreds are likely to disappoint investors.

Does this mean we will be faced with a stagnant economy in the near future? Probably not, but we could experience trend growth of approximately 3.00% during the next three to five years. What about unemployment? Without a bubble such as what we experience in tech during the 90s and housing during the first decade of the 2000s, the unemployment rate could remain above 7.00%.

Investors must understand that the growth experiences from the mid 80s to 2006 was not fundamentally sustainable, but was rather a Fed-induced and supported recovery from the poor policies of the mid-60s to the late 70s. As with every policy, the Fed’s overshot its mark with two bubbles (tech and housing) near the end of its run.

The low rate, high growth of the middle first decade of the 2000s was called the “Great Moderation.” I think “the “Great Moderation” will occur over the next five years or so. Growth, inflation and employment will all me moderate. After that, your guess is as good as mine.

No Surprises From the Fed

The FOMC concluded its meeting and released its statement. Later in the afternoon, Fed chairman Bernanke held the first ever post-meeting press conference. Nothing stated by the FOMC or by Mr. Bernanke himself was surprising, at least not to me.

This was not necessarily the case to many market participants, the airwaves were filled with comments made by pundits predicting language leaving open the possibility of an early end to QE2. Others predicted that the Fed would announce that it would consider not reinvesting the proceeds of maturing assets. Others still were predicting that the Fed would drop “extended period” from its statement regarding the Fed Finds rate. Alas, none of these were to be,

The Fed decided to permit QE2 to run its course, announced that it plans to reinvest proceeds from maturing QE2 assets and that policy will remain accommodative for an extended period of time. The decision to leave the course of policy unchanged was unanimous. Even Philadelphia Fed president Plosser and Dallas Fed president Fischer, two outspoken inflation hawks and QE2 critics voted for staying the course.

In his statement read at the press conference, Fed chairman Bernanke stated his case for staying the course, expressed concern that the growth may be moderating and called inflation pressures transitory. What Mr. Bernanke my mean is that food and energy prices are self-limiting and, in the case of oil prices, at least partially driven by speculation. The Fed has traditionally resisted being held hostage by speculators.

Arguments that the Fed could help the economy by raising rates, strengthening the dollar and putting more money back into the hands of the consumer. Although this idea has its merits, it must be acknowledged that the recovery we have seen thus far is a balance sheet recovery due to cheap corporate financing and favorable exchange rates for export business. Raising the Fed funds rate before employment and housing recovers could send corporate profits and the equity markets plummeting, the results could include a new round layoffs and further depression in the housing sector (Mr. Bernanke’s description of housing was “depressed”).

So what does this mean for interest rates? It obviously means that short-term rates, such as Fed Funds and three-month LIBOR will remain low. It could mean that long-term rates remain somewhat low. However, long-term rates could rise modestly as Fed policy will remain accommodative and foster some inflationary pressures. The opposite could occur when the Fed begins to tighten as disinflationary policies could result a halt to rising long-term rates before they gain much traction, but that is probably a year away.

Many readers will respond that they do not agree with Fed policy and therefore will choose investment strategies which run counter to Fed policy. One bets against the Fed at one’s own risk, The Fed sets policy, not me and not you. My personal view is that the economy needs a cleansing from borrowing and we as a nation must learn to live with in its means, However, that is not only impractical at this time because it would likely result in a recession which could be crippling, but also is not consistent with the Fed’s dual mandates of price stability and job growth. My views of what should be done are irrelevant. We only need to understand what the Fed will do and why and invest accordingly.

Make no mistake; the Fed cannot fix the economy. Mr. Bernanke knows that as well as anyone. He is just trying to keep things chugging along until the boys and girls on Capitol Hill make the necessary tough choices to make the economy fundamentally sound. What those choices are is a discussion for another day.

FYI: May begins my final year at my place of employment.

It's Been a Long Time

It has been a while since I posted commentary. Let's discuss recent events.

Retail sales rose for the ninth consecutive month, albeit at a slower pace, as consumers continue to spend in the face of higher food and energy prices. The increase of retail sales indicates that prices might not havee risen high enough to snuff out consumer spending, but may have risen high enough to slow it down. This could be an example of the economic headwinds which he have discusses previously. The economic headwinds may not be stiff enough to stop the U.S. recovery, but could be enough to slow it down.



It should also be mentioned that a recent pick up in hiring is probably helping consumers to keep pace with higher food and energy costs, but consumers are also being helped by the one-year suspension of payroll taxes. Temporary tax cuts usually carry temporary benefits for consumption. The benefits tend to wane months before the temporary tax cuts end. It is not inconceivable that the benefits of the temporary tax cuts begin to provide diminishing returns with regard to consumer spending in the coming months.





Many economists were encouraged by the increased consumer spending across a broad spectrum of the economy. However, retailers such as Wal-Mart are concerned that higher commodities prices will continue to squeeze consumers. Yesterday Rosalind Brewer, the president of Wal-Mart’s “Wal-Mart East” division said the following during an investor presentation:



“We still see our customer financially strapped. We see the shopper’s wallet being stretched a lot more.”



Wal-Mart’s experiences are worth watching as many of its customers are of the lower-income and middle-income variety. Higher food and energy prices tend to act like a regressive tax on consumption. This means that lower-income consumers are usually impacted the hardest. It is encouraging see that consumer spending continues to increase, but the deceleration is concerning. As physics teaches us, deceleration is actually acceleration in the other direction.



Worries about higher food and energy prices squeezing consumers are beginning to appear among market participants. An article in today’s Wall Street Journal discusses the recent drop in commodities prices and how concerns about a squeezed consumer and slower economic growth could be behind the decline.



Yesterday’s decline in stocks, oil and basic goods has raised concerns that commodities prices have become too expensive for consumers who continue to deal with high unemployment and stagnant wages. Government data released yesterday reported a decline of U.S. exports in February, the first decline since August 2010. Many industry economists continue to lower growth estimates for 2011.



One market participant told Bloomberg News:







"The potential for a slowdown in the global growth story has finally come to fruition. I'm not saying we're going to get a recession, but if you look at the range of growth estimates for the year, people are coming in more toward the bottom of the range. It looks like expectations are on the muted side."

Many pundits and most consumers point to soaring gasoline prices as evidence of inflation. To anyone who must drive to work or to shuttle one’s family from place to place, higher fuel prices are inflationary. However, to the bond market and to many Fed officials inflation is not yet a problem.



We would caution investors against making fixed investment decisions based whether they or some pundit believes the Fed is wrong. It matters not what they believe the Fed should do about higher food and energy prices. It does not matter what we believe the Fed should do about higher food and energy prices. It only matters what the FOMC (specifically Ben Bernanke) believes the Fed should do about higher food and energy prices (or prices and growth as a whole for that matter). Bet against the Fed at your own risk.



Thus far the Fed has given us hints of what it may do going forward. It is probable that the Fed continues QE2 through June as planned, but then ceases bond purchases for the purpose of quantitative easing. That in itself could be considered policy tightening because it potentially removes price support (yield suppression) for the bond market. Higher yields in the open markets could curb inflation (and growth).



However, the cessation of QE2 may not have the effect on interest rates that most people expect. We would like to bring you back to last year when the Fed halted bond purchases as it let QE1 wind down. Following the cessation of QE1 (and other government stimulus measures), the yield of the 10-year treasury note fell.

Why did the yield of the 10-year U.S. treasury note fall when the Fed ended QE1 purchases and rise when the Fed announced it would purchase bonds to keep real interest rates at accommodative levels? The markets viewed the cessation of QE1 as disinflationary (the soft patch into which the U.S. economy fell was largely blamed on the removal of government stimulus). The markets viewed the possibility followed by the implementation of QE2 as being potentially inflationary.


When one stops to think, these were logical reactions. Why else would the Fed engage in quantitative easing except to stimulate consumption and economic growth which are usually inflationary in their effect? The drop in rates following the cessation of QE1 likely reflected market sentiment that a double-dip recession was possible. The response to QE2 was a kind of relief price selloff / yield rally. So what do fixed income market participants believe is coming down the pike? For that we turn to the Bloomberg survey

Truth About Jobs

Friday’s employment data were considered, by some estimates, to be the first true sign that employment is beginning to gain some traction. You may recall that the January data was believed to have been negatively impacted by inclement weather throughout much of the country. This was followed by a strong report in February, but much of the improvement was credited to a snap back in hiring (a make up effect) from the weather-influenced January data.



We believe that one economist summed it up well when he said:





“It’s not a blow-out number but all in all, it’s a good report.”





Most data components indicated improvements. Even government job cuts slowed from a prior -46,000 to -14,000. Professional and Business services (+78,000), Education and Health (45,000), Health and Social Assistance (45,000) and Leisure and Hospitality (37,000) led the sectors reporting gains. The Information sector came in at -4,000 and Transportation and Warehouse did not add any jobs. Manufacturing added 17,000 jobs. The forecast called for a gain of 30,000 new manufacturing jobs.



The so-called household survey reported a drop in the unemployment rate from 8.9% to 8.8%, even as the labor force increased by 160,000. However, the labor force participation rate remained unchanged at 64.2%. This is still below participation rate of 64.9% from years ago.



How can the labor force expand, but the participation rate increase? This is the result of an expanding U.S. population. It is generally agreed that the U.S. economy needs to add approximately 200,000 new jobs each month just to keep pace with the expanding population.



Not all of the numbers were good. Average Hourly Earnings were unchanged on a month-over-month basis and remained unchanged at a pace of +1.7% on a year-over-year basis. Therein lies the problem. Wages are not keeping pace with commodities prices. Consumers, especially middle-income and lower-income consumers, are being squeezed and must make difficult decisions between discretionary spending and heating their homes, fueling their car, putting enough food on the table or taking vacations, buying new appliances, or improving their homes.



Many businesses are also being squeezed. The Average Hourly Earnings data and the Average Weekly Hours data indicate that business spending on labor has not kept pace with corporate profits. Many businesses continue to find it difficult to pass along price increases to consumers as consumers may put off purchases rather than pay higher prices. To compensate for a lack of pricing power, companies continue to squeeze workers by trying to get more production from them and not offering much in the way of pay increases. Unless wage growth takes hold, higher commodities prices could be a drag on consumption. Even the Fed (and individual Fed officials) have lowered their growth forecasts.



Speaking of Fed officials, Minneapolis Fed president Narayana Kocherlakota stated in an interview that the Fed may need to raise short-term interest rates by year-end if underlying inflation rises. Inflation hawks and bond bears (who are usually equity bulls) ran with this story and began predicting an interest rate blow-out to anyone who would listen.



Mr. Kocherlakota believes that higher commodities prices may bleed into core inflation and require the Fed to raise rates. He uses the oft-cited Taylor Rule (which we have mentioned previously) to support his case for higher policy rates. Mr. Kocherlakota believes that inflationary pressures could result in a 75 basis point Fed Funds rate increase according to the Taylor Rule. He makes no mention of whether or not the 75 basis point increase would follow, precede or accompany a selling of U.S. treasury securities holdings accumulated between two rounds of quantitative easing.



According the Taylor Rule, an effectively negative Fed Funds rate was required to boost price pressures (and economic growth) prior to the Feds launch of two rounds of quantitative easing. A 75 basis point increase of the Fed Funs rate may only get the effective Fed Funds rate back to 0.00% or so if QE holdings remain on the Fed’s balance sheet.



We do not dispute that the Fed will change its bias to one of less accommodative Fed policies, but how it may begin to tighten remains unclear. The Fed could remove much stimulus by selling its U.S. treasury holdings without raising the Fed Funds rate. Simply not purchasing additional U.S. treasuries would result in effective tightening of monetary policy. Whether the Fed chooses to first raise rates or reduce the size of its balance sheet remains a question, but it is likely that the first move the Fed will make is to cease QE2 purchases in June.



Although they do not get the media attention given to the inflation hawks, there are a number of Fed officials who do not believe that QE2 purchases will be curtailed. Cleveland Fed president Sandra Pianalto said yesterday that “several important factors will keep inflation in check" and that among them, are "the continuing slow growth in wages, which helps determine the cost of producing goods and services and, in turn, the prices set by firms" and "retailers' reluctance to raise prices in the face of strong competition and soft business conditions."





This morning, New York Fed president William Dudley said in a speech in San Juan, Puerto Rico that he currently does not see a reason for reversing Fed policy in what remains a “still tenuous” recovery. He also termed the recovery as being “far from the mark” of the Fed’s goals of full employment and price stability. It is believed that Mr. Dudley’s view of the economy and Fed policy is similar to that of Fed Chairman Ben Bernanke. Also, the New York Fed president is usually the most influential of the presidents of the regional Fed banks.



Mr. Dudley went on to state:



“We must not be overly optimistic about the growth outlook. A stronger recovery with more rapid progress toward our dual mandate objectives is what we have been seeking. This is welcome and not a reason to reverse course.”





We would like to be clear that there is little contention on the street that the Fed will begin removing stimulus. However, how, when and to what degree the Fed removes stimulus is the subject of much disagreement. Based on recent comments from Fed chairman Bernanke and New York Fed president Dudley, the first step in removing Fed stimulus is likely to be the follow through on QE2 in June. Following that, it is likely the Fed will analyze economic data and gauge the markets’ reaction to both the economic data and the ending of QE2. If the recovery looks like it is gaining more traction and / or core inflation begins to spike, the Fed could raise the Fed Funds rate, begin reducing the size of its balance sheet or a combination of both.



Judging by the pace of the recovery, the population-replacement-like pace of job growth, a lack of wage growth and the lack of business pricing power that has been observed thus far, it is probably unlikely that we will see a spike in shot-term interest rates. Using Mr. Kocherlakota's favored Taylor rule as a guide and considering the unprecedented stimulus it has required just to get the economy to the current pace of recovery, it might turn out that not much tightening will be necessary to reign in inflation end keep growth under control. We doubt that many Fed officials are fearful of an overheating economy.





Following this morning’s economic data prices of long-dated treasuries are little changed. The price of the benchmark 10-year U.S. treasury note is up 3/32s to yield 3.46%. The price of the 30-year U.S. government bond is up 4/32s to yield 4.50%.



There is a possible phenomenon which some investors may have failed to consider, that being the possibility that the removal of Fed stimulus is considered by market participants to be anti-inflationary resulting moderating the rise of long-term interest rates. You might recall that following the launch of QE2 last November, long-term treasury yields began to rise due to fears that the latest round of Fed stimulus would prove to be inflationary. The reverse may be true when QE is halted and, eventually, removed.



When the Fed raises the Fed Funds rate, the response from fixed income market participants (at some point during the tightening cycle) is that the Fed has tightened more than enough to combat inflation and begins to move capital farther out on the yield curve. Since QE is akin to lowering the Fed Funds rate, the removal of QE2 could have the same effect as raising the Fed fund rate.



Bloomberg has posted a revised interest rate forecast as per their survey of fixed income market participants. The current year-end 2011 forecasts are as follows:



Interest Rate Forecasts Q4 2011 Q1 2012 Q2 2012



30-year: 4.95% 5.14% 5.23%



10-year: 3.89% 4.10% 4.21%



2-year: 1.33% 1.68% 1.95%



3-month USD LIBOR 0.62% 0.89% 1.27%



Fed Funds Target Rate .25% 0.50% 1.00%





As you can see, the street does not believe that interest rates are poised to take off, but rather rise gradually. If these forecasts come close to fruition, a laddered portfolio with a duration on the belly of the curve 5 to 7 years out (with maturities out top 10 years) may prove to be advantageous. Step-ups could provide some cushion against modestly higher long-term rates, but floaters adjusting off of short-term benchmarks, such as LIBOR, may disappoint investors.





The truth of the matter is that the recovery sucks. This is due to two factors.



1) The economy is not fundamentally capable of growth rates seen during recoveries of the past two decades. A perfect storm of evermore accommodative Fed policies and ever easier lending standards combined to fuel economic growth by promoting borrowing.



2) Consumers will have to continue to deleverage.



The economy will recover slowly and peak at what will be a disappointing level for many Americans spoiled by getting what they want when the want it.