Is the Economy's Number(s) Up?

The second-quarter GDP data indicate that the economy grew at a paltry 1.3%. The data was probably heavily influenced by the so-called “snap-back” from the mild winter which padded first-quarter numbers. However, economists were figuring the snap-back into their estimates which resulted in a Street consensus forecast of 1.7% Q2 GDP. Some pundits criticized this gloomy outlook. Upon the release of the 1.3% final reading of Q2 GDP, they promptly pointed to the better retail sales and consumer sentiment seen during the third quarter. Admittedly, Q3 data might look a bit better than the Q2 data (the Street consensus forecast calls for 1.8% GDP in the third quarter), but the September data is casting doubt on that outcome. Most disturbing are the Durable Goods and Personal Income data. Household incomes barely budged, but prices, particularly prices of goods which consumers cannot easily reduce consumption (such as food and energy), edged higher. It is true that fuel prices have dropped during the past two weeks, but that is due to demand destruction and the fear or more demand destruction. In other words, the markets fear a broad global slowdown thereby reducing energy consumption. At best, consumers may be able to tread water. However, if the slowdown intensifies, we could see the moderate gains in job creation and the meager wage growth we have thus far experienced in 2012 turn flat or even negative. However, we should note that, versus inflation (as measured by PCE), household incomes actually fell by 0.3% in August. Remember, August was supposed to be the (latest) month that the economy finally turned. Durable Goods Orders were most troubling. We usually do not focus much on the headline number due to the volatility of the transportation component (particularly commercial aircraft), but Durable Goods Orders fell off the table last month. It was reported that Boeing received an order for just one aircraft in August. The Street consensus forecast of -5.0% had built in downturn in transportation orders. To have a drop of 13.2% is reflective or recessionary data. Apologists for the economy had not legs on which to stand when the core number also turned negative, coming in at -1.6%. Following the poor August Durable Goods data, supporters of a sustained recovery waited with great anticipation for Friday’s release of the Chicago Purchasing Manager report. This report is considered a good bellwether for manufacturing throughout the U.S. and is greatly influenced by the automotive industry. Surely, it was thought, that the Chicago Purchasing Manager data would indicate that the economy remains on a path (albeit a bumpy one) to recovery. Their hearts sunk when the report indicated that manufacturing activity contracted for the first time since September 2009. There are times when an index, such as the Chicago PMI, can trend negative due to drops in components which are considered less critical than others. However, the drop was precipitated by a decline in the New Orders component, which fell from a relatively good 54.8 to a troubling 47.4. In fact, all components fell with the exception of Supplier Deliveries (52.1 versus a prior 49.9) and Prices Paid (63.2 versus a prior 57.0). However, all that meant was that businesses may have over-ordered raw materials and components from suppliers and they paid more to do so. The results could be fewer components and materials ordered in October and a pause in hiring. We do not see much impetus for the economy to gain momentum the last three months of the year. Tom Byrne tom@bond-squad.com. www.bond-squad.com www.mksense.blogspot.com 347-927-7823 Twitter: @Bond_Squad Disclaimer: The opinions expressed in this publication are those of the author. They are not, nor should they be considered solicitations to purchase or sell securities.

The people are revolting! They stink on ice.

Alright, this caption is somewhat gratuitous, but it isn’t often that we can work in Mel Brooks’ material. We are, of course, referring to the demonstrations in Spain and Greece which have turned violent. The basis for the protests is opposition to budget cuts and regulations changes. The protests began peacefully, but our old friends, the anarchists, arrived on the scene and made their presence known by instilling violence and, in Greece, throwing Molotov Cocktails. These developments are casting doubt on whether or not the eurozone can remain intact. In response, the vigilantes pushed the yield of Spain’s 10-year note to over 6.00%. This is the first time since September 6th, when ECB President, Mario Draghi, announced that the ECB’s plan to engage in unlimited bond buying, if conditions are met and formal bailouts are requested. Spain’s’ Prime Minister Mariano Rajoy told the Wall Street Journal that Spain will “100 percent” seek a rescue if borrowing costs stayed “too high.” The question is: Will the people stand idly by and allow Mr. Rajoy to agree to austerity, reforms and a dilution of Spanish sovereignty? The markets are, once again, becoming concerned that things might end badly for the eurozone. However, although U.S. equity prices a trending lower and the prices of long-dated U.S. Treasuries are rallying, the price action we have seen this morning appears to be underreacting to overnight developments in Europe. In truth they are not underreacting. They are merely continuing the trend which began last week. The market began to lose faith in the ability of the money-printing crowd (A.K.A. central bankers) to engineer economic recoveries on their own. This is a good thing because central bankers cannot do it alone. Fiscal policy makers will have to react, sooner or later. This is the two-month anniversary of Mario Draghi’s promise to do whatever it takes to keep the eurozone together. The color from the market participants and pundits is quite telling as to where allegiances lie (or lay). Most U.S.-based market participants, strategists and commentators have cast doubt on the ability of European leaders to successfully engineer a true periphery restructuring and solution. Their European counterparts fire back stating that; U.S. market participants do not truly understand the situation in Europe. This disagreement is most evident in their outlooks for the euro versus the dollar. European and Europhile market participants continue to point to Fed policy as the reason the value of the U.S. dollar must decline and why U.S. interest rates have to rise. U.S. market participants point to the fact that, what the ECB is proposing is exactly the same thing. Whether the ECB buys bonds or the eurozone fragments, the result is a bad outcome for Europe. If can kicking becomes the overarching strategy, how could the euro not decline? In times of trouble, capital will gravitate to the currency of country which is best able to weather a storm and which has the most comparative advantages over its peers. Please do not point to China as having a comparative advantage over the U.S. Yes, it can produce “widgets” more cost-effectively, but that is where the advantages end. Property rights and the free flow of capital are fairly important advantages which China just does not have at this time. This could be good news for investors in U.S. assets and anyone who owns and spends dollars. For in spite of the Fed’s desire to ease monetary conditions, the U.S. dollar refuses to weaken. This is good for consumers looking to spend, but bad for export-driven businesses. What does it mean for jobs? Probably not much as increased exports may not translate into mass hiring. With the global economy sputtering and China’s “landing” being somewhat harder than many had anticipated, the U.S. will not be able to export its way out of the doldrums. Foreign central banks will see to that as well. We will know more about the direction of Europe this later this week when Spain and France announce their new budgets. Is it just us or does France seem like not only the periphery’s enable, but a periphery “wanna be?” So much for the bubble in Treasuries. Tom Byrne tom@bond-squad.com. www.bond-squad.com www.mksense.blogspot.com 347-927-7823 Twitter: @Bond_Squad Disclaimer: The opinions expressed in this publication are those of the author. They are not, nor should they be considered solicitations to purchase or sell securities.

Bubble Gum - What CDS is Telling Us

Are junk bonds mispriced? Money began to flow into the nether regions of the credit markets from income-oriented investors and from speculators who have left the equity market and are choosing to speculate in, what we like to call, equities with a coupon (and some recovery potential). Many investors who have acquired junk bonds try to convince us (and themselves) that they are not really speculating. They espouse the belief that the new reality is one of lower defaults and easier access to credit (at lower rates) than in the past. If you replace “junk-rated corporation” with “subprime mortgage borrower” and the today’s junk bond argument is similar to the Housing Bubble’s subprime argument. The thirst for yield and desire to speculate for total return purposes has created a junk bond market with valuations which cannot be justified by corporate credit health. The expected compression between yields found on junk bonds and U.S. Treasuries has, largely, already taken place. We should note that bonds at the very bottom of the credit ratings scale often trade on a dollar-price basis, rather than on a spreads basis. This means that sophisticated market participants are trading them on a perceived recovery value basis. When bonds trade on a dollar price basis, it is an indication that market participants are not expecting to receive par at maturity. We have just gone through optimal years for junk bonds. Much retail money has flowed into junk. If there is a bubble in the fixed income markets, we believe it lies in the nether regions of the junk market. What about the idea that these bonds could rally further on an improving economy? Fed policy has brought the rally forward. I. E. Much, if not all, of it has already occurred. One way to see if there is a bubble brewing in junk bonds is to compare bid side credit spread on cash bonds versus bid side CDS for the same issuer. Let’s use JC Penney as an example. The bid side spread for the JCP 7.95% due 4/1/17 is about 617 basis points over the 5-year Treasury. The institutionally driven CDS market is setting the cost to buy protection for 5-year JCP at about 765 basis points. If we are to believe that institutional market participants are better equipped to judge risk (and Bond Squad firmly believes this to be true), the cash bond market is under estimating JCP’s risk of default. If an institution wanted five-year exposure in JCP, it would be better off selling protection at 765 basis points in the CDS market, rather than buying JCP 5-year debt. One can simulate (even synthesize) A JCP bond by selling 10mm JCP CDS and buying 10mm 5-year Treasury strips. Notice that we used a size of 10mm notional. That is the typical quoted size in the CDS market. The high grade market may be getting rich as well. Let’s look at Alcoa. The AA 5.55 due 2/1/2017 are being bid around a spread of 195 basis points over the 5-year Treasury. Five-year AA CDS is spread around 295 basis points. Again we have a 100 basis point disconnect. Although the Alcoa bond offers an attractive yield for an investment grade credit, it appears rich versus CDS. Let’s look at CVS: The CVS 5.75% due 6/1/17 are being bid at +.70 to the five year. Five-year CVS CDS is at 45 basis points. It appears that, with CVS, investors are over estimating risk versus the CDS market. That JCP and AA bonds are trading at narrower spreads than their respective CDS tells us that it could be the thirst for yield is inflating the prices of bonds offering relatively high yields. This alludes to an underestimation of risk by investors. Consider CVS. The CDS spread for CVS is less than that for CVS bonds. This tells us that retail investors (or funds which must buy bonds instead of derivatives) are avoiding CVS bonds due to their 1.30%-ish yield. Relatively speaking, CVS credit spreads are overestimating credit risk versus what the CDS market believes. Using CDS spreads as a guide is not fool proof. As we have seen in the past, CDS market participants can also misread a situation. However, they have rarely got it more wrong than the bond market, especially when smaller investors are active in the respective cash bond market. We believe that CDS spreads give us a guide as to where risk should be priced. It is not fool proof, but it offers a good guide. Taking that into consideration, it appears that riskier credit market assets are getting a bit rich, with some in a full-blown bubble. The CDS geeks have formulas which they use to gauge default probabilities. It is possible to ascertain the market’s default probability estimates via CDS spreads. Buy running the CDS spreads for CVS, AA and JCP through the International Swaps and Derivatives Association’s Fair Value Model, we get the following default projections for our three aforementioned companies, five years out. CVS: 4.00% AA: 24.00% JCP: 49.00% Whether or not these estimates correctly estimate default probability is a subject of debate, however, they are used when pricing risk. We would not want to be the one facing angry investors should the nearly 50/50 default probability of JCP come up tails when we were betting heads. Bond Squad never simply goes with gut feelings, nor do we blindly run with the herd. We are always looking more deeply into market valuations to see what might be “cheap” and what might be a trap. Bond Squad Subscription Info: http://www.bond-squad.com/subscription.htm Tom Byrne tom@bond-squad.com. www.bond-squad.com www.mksense.blogspot.com 347-927-7823 Twitter: @Bond_Squad Disclaimer: The opinions expressed in this publication are those of the author. They are not, nor should they be considered solicitations to purchase or sell securities.

Jobless Claims Make No Claim on an Improving Economy

Initial Jobless Claims came in at 382,000. This was down from last week’s prior revised 385,000, but was unchanged from last week’s initial read. The Street had expected a decline to 375,000. Continuing Claims continue their downward trend coming in at 3,272,000 down from a prior revised 3,304,000 (up from an initial read of 3,283,000). The Street had forecast 3,300,000 continuing claims. The prevailing sentiment is that the majority of American’s who left the unemployment benefits rolls simply exhausted benefits. The number of Americans receiving emergency extended benefits fell by about 60,700 to 2.16 million. Again, the prevailing view is that many of the people who fell off the extended benefit rolls simply exhausted benefits. Ryan Sweet, a senior economist at Moody’s Analytics Inc., weighed on the data: “The problems are more on the hiring side than the layoffs side. If they panic and start cutting workers that would raise an immediate red flag because layoffs would be a recipe for another recession.” A positive development is that retailer, Kohl’s, announced that it plans on hiring 52,700 temporary holiday season workers. This is ten percent more than last year. A not-quite-so-good development is that Bank of America will cut 16,000 jobs by year end. Of course most of the 52,700 workers hire by Kohl’s will be laid off as well, following the holidays. If there are truly positive developments in the job market, will someone please point them out to us? Tom Byrne tom@bond-squad.com. www.bond-squad.com www.mksense.blogspot.com 347-927-7823 Twitter: @Bond_Squad Disclaimer: The opinions expressed in this publication are those of the author. They are not, nor should they be considered solicitations to purchase or sell securities.

Sugar, Sugar: Has the Fed's sweetness run out already?

Man, we thought the sugar-rush effects of QE would be temporary, but we did not believe that they would fade this quickly. Since yesterday, we have commodity prices decline and prices of U.S. Treasuries rise. In fact, oil prices fell so sharply yesterday that there were concerns that a so-called “fat-finger” erroneous trade was placed. Word is that the price decline was due to the flattening of a large long position in oil. This caused other market participants to sell oil futures and the bearish sentiment spread throughout commodities. It could be that, market participants believe that the struggling global economy could reduce the demand for crude oil and the dollar (along with gold, which is another $10.00 an ounce) will remain the global reserve and safe haven currency. We believe that the Fed will do everything it can to fight deflation (which is a real possibility of the global economy continues to slow). However, we do not see rampant inflation or sky-rocketing oil prices at the present time. The situation could change down the road, if the Fed is not vigilant. Tom Byrne tom@bond-squad.com. www.bond-squad.com www.mksense.blogspot.com 347-927-7823 Twitter: @Bond_Squad Disclaimer: The opinions expressed in this publication are those of the author. They are not, nor should they be considered solicitations to purchase or sell securities.

How Temporary is Temporary

Monetary stimulus is supposed to be temporary in nature, both in terms of how long it is kept in place, and in how long it provides benefits to the markets and economy. With the Fed's decision to keep policy accommodative ad ifinitum, will the effects of Fed policy last as long? There is evidence that the benefits of Fed policy wanes over time. We believe that QE3 will be largely ineffectual in terms of job creation. Even if the Fed could lower mortgage rates 50 basis points, it would do little to spur new borrowing or more refinancing. Consumers who can refinance would probably use the newfound cash to pay down other debts. This might benefit the economy down the road, but not immediately. However, the most likely result would be to keep many households, which are now struggling to get by, from imploding financially. As we demonstrated with several charts this past week, households have a long way to go just to reach a sustainable debt to income ratio. We expect the rally in commodities and decline in the value of the dollar to be temporary. Why? Because governments around the world are also trying to devalue their currencies. Once foreign central banks work their magic, we believe that we will see long-term yields settle in and the dollar slide to halt or, even, reverse. Here are some interesting charts: U.S. 10-year since 2009 (source: Bloomberg):

As you can see, the yield of the 10-year rose during the times surrounding QE1 (2009) and QE2 (late 2010). Each time the 10-year yield reset back to or below the levels seen prior to QE (admittedly helped by the “twist,” which is not going away). During 2012, the 10-year yield has been influenced by a slowing global economy. This has caused a flight to safety among investors. As we mentioned previously, foreign central banks have also done their share to keep a lid on long-term U.S. interest rates. We expect this to continue. A similar pattern exists in the value of the euro versus the dollar:

Notice that the biggest spikes were around the times of QE1 and Qe2 (2009 and 2010). We expect Europe to remain dysfunctional is looking to engage in open-ended money printing of its own. If history repeats itself, currency speculators may be singing “there’s no place like home for the holidays” by year end. Oil prices demonstrate somewhat different, but not altogether dissimilar pattern:

Oil prices began to rise on 2009 with the discussion and eventual launch of QE1. It spiked with the launch of QE2. It fell with the soft patch in mid-2011 and spiked on the mild winter, which provided market participants with false hope that the economy was gaining traction. Oil fell again with yet another soft patch before spiking following Fed (and ECB) comments that more easing is on the way). We believe oil prices could remain elevated heading into the winter. The weaker dollar (albeit probably temporary) and, what many meteorologists are forecasting to be, a harsh winter in the Northeastern United States (the region which carries most of the nation’s demand for home heating oil) maintain upward price pressures for crude oil. However, unless our elected officials can make real progress on fiscal policies, we could see another soft patch begin to materialize in the second quarter of 2013. If we fall off the so-called “Fiscal Cliff,” the soft patch could coincide with the 2013 calendar. Tom Byrne tom@bond-squad.com. www.bond-squad.com www.mksense.blogspot.com 347-927-7823 Twitter: @Bond_Squad Disclaimer: The opinions expressed in this publication are those of the author. They are not, nor should they be considered solicitations to purchase or sell securities.

End of Days

The Fed let the markets have it with both barrels. Although the shots will be largely ineffectual for economic growth, they could prove damaging for certain fixed income vechicles, Libor Floaters. Why Libor floaters you ask? Because the yield curve will steepen. What the Fed is doing is potentially inflationary. Although continued twisting will buffer the rise of long-term rates, there could be upward pressure on long-term rates. However, the Fed will ensure that short-term rates are anchored at very low levels. Since Libor is sensitive to the Fed Funds rate, it, and coupons which adjust off of Libor, will also be low. Investors who believe that higher Fed rates are not too far off had better read the text of the Fed statement which read: “To support continued progress toward maximum employment and price stability, the Committee expects that a highly accommodative stance of monetary policy will remain appropriate for a considerable time after the economic recovery strengthens. In particular, the Committee also decided today to keep the target range for the federal funds rate at 0 to 1/4 percent and currently anticipates that exceptionally low levels for the federal funds rate are likely to be warranted at least through mid-2015.” This means that, unless the economy gains traction more quickly than anticipated and/or a more hawkish Fed Chairman succeeds Mr. Bernanke in 2014, Fed Funds and Libor will remain low for a long time. The same might not be true for longer-term rates if the Fed is willing to keep policy accommodative even as the economy gains traction “for a considerable time.” To make a long story short: Libor Floaters have had their day in the sun.

A Taste of Honey

The following is an excerpt from our daily commentary. Subcrivers get this and much more: The economy is constantly evolving. Although there are some traits common to economies which have existed during the 236 years of U.S. history, there have also been great differences. “Things” don’t just happen. This is why we are critical of technical analysis over the long term. Although data and patterns can be used to great effect in the near term, once there are structural changes to the economy and secular changes to markets, technical analysis (without considering the context of the times) is much less useful. With this in mind, we believe that the FOMC will extend its guidance for extraordinary policy accommodation until, at least, 2015 and could announce open ended bond purchases (probably focused on MBS). The first actual Fed Funds rate hike might not come to a year or more after that. However, that assumes that domestic fiscal policies remain dysfunctional and global economic conditions remain impaired. Although this is our base case scenario, we are not so audacious to state with certainty that, economic conditions will remain impaired for the next three to five years. It is also not a certainty that the Fed will do anything more than jawbone today. We believe that the best way to position for the next several years is to ladder portfolios, focus investments on the five-year to seven-year area of the curve, but having an adequate portion of one’s portfolio in the in the two-year to four-year area of the curve, as well as on the 10-year to 15-year area of the curve. What percentage of one’s fixed income portfolio should be place on specific areas of the curve? That depends on investors’ goals, objectives and risk tolerance. We like the so-called belly of the curve (intermediate portion). We would tend to underweight the short end of the curve, overweight the intermediate portion and have moderate exposure out to 15 years, but this is gross generalization. Portfolios should be constructed to match investors’ needs. As we speak with market participants and investors, we pay close attention to their fears. Investors tend to fear inflation and rising rates. This is mostly due to concerns that the Fed will be slow to react to a strengthening economy or that Fed money printing will lead to devaluation-related inflation. However, market participants fear that the Fed will run out of options to fuel the liquidity-related strength in risk assets and to keep the economy above water before fiscal policy makers adjust policies to reflect new realities. We are in the market participants’ camp. We would be thrilled if the biggest problem we faced was repositioning portfolios to reflect strong growth and related inflation pressures. However, we believe that to be an unlikely scenario for the near future. We do not put much credence in a weak currency inflation scenario. The rest of the word is in the same boat. The worst thing for many export-driven economies is for their home currencies to weaken versus the dollar (listen to the noise emanating from Japan). They will do what they can to support the dollar. The U.S. dollar could exhibit some weakness in the near-term, but as with QE1 and QE2, the dollar will find support rather quickly. It is for this reason that we believe that Fed policies are creating trading opportunities, rather than investment opportunities, in risk assets, such as equities, high yield debt and metals. These trading opportunities may perform well for six months, a year, maybe longer, but we do not see the foundations for long-term secular bull markets in these asset classes. Even if the “Fiscal Cliff” is avoided, necessary spending cuts (and probably some tax increases) will place a drag on the economy. A shrinking labor force and less affluent retirees could result in less consumer spending than in the past. The U.S. economy will continue to evolve and adapt. This could feel painful at times, but it is a necessary process. As the Theory of Evolution teaches us; it is adapt or die. Follow us on LinkedIn by joiningg the Bond Squad group. It is open to everyone. Tom Byrne tom@bond-squad.com. www.bond-squad.com www.mksense.blogspot.com 347-927-7823 Twitter: @Bond_Squad Disclaimer: The opinions expressed in this publication are those of the author. They are not, nor should they be considered solicitations to purchase or sell securities.

A Seariver Runs Dry

I cannot believe I failed to mention thiis, especially since I once made a market in this bond and my best friend and former bond partner reminded me last week. The much misunderstood Seariver Maritume 0.00% due 09/1/12 has matured. What makes this passing special was that it was one of three tax-deferred corporate "zero" in the markets. The beneficiary of an IRS loophole in the 1980s and grandfathered by the courts the former Exxon Shipping bond was misunderstood by many market participants and investors. As a tax-deferred bond, investors did not pay tax on accretion (phantom income) annually, as with traditiional corporate zeros. Instead, tax was paid on the entire accretion at maturity. This made it an oustanding bond for minors and retirement accounts. The only other tax-deferred zeros are the Ally (GMAC) Units (of $10,000) 0.00% due 12/1/12 and the Ally 0.00% due 6/15/15. Thanks to tax law changes, no such tax-deferred corproate bonds will be issued again. The Ally 0.00% of 6/15/15 are offered at a yield-to-worst in the neigborhood of 4.87%. Both Ally bonds are currently callable at their accreted value, but since the accreted value of the 15s is about 93.961, a call isn't likely. The main problem with these (besides being obligations of Ally) is that they trade rather infrequently.

Come a Little Bit Closer

Do you think that U.S. Consumers are near the end of the delebveraging process? Think again. We have been asked: How much deleveraging must U.S. households complete before the economy begins to pick up speed? We are of the opinion that U.S. household debt to income must go back, at least, to levels seen prior to the housing bubble, if not prior to the tech bubble. The following chart displays U.S. household debt as compiled by the Fed: U.S. Household Dept (SAAR) since 1980 (source: Bloomberg & Fed):

As you can see, just to get to levels seen prior to the housing bubble (2000 to 2004), debt would need to be slashed nearly in half. Either household debt falls to come more in line with incomes or income rise to service the debt. Even more telling is the chart which displays household disposable income after debt service: Federal Reserve US Financial Obligations Household Debt Service Ratio Total:

If we want to see the economy experience trend or above-trend growth, we need to get the Household debt service ratio in line with past periods of robust growth. Again, this can be done by shedding debt or increasing incomes. Neither appears to be happening at a rapid pace. To subscribe to Bond Squad go to: http://www.bond-squad.com/subscription.htm Tom Byrne tom@bond-squad.com. www.bond-squad.com www.mksense.blogspot.com 347-927-7823 Twitter: @Bond_Squad Disclaimer: The opinions expressed in this publication are those of the author. They are not, nor should they be considered solicitations to purchase or sell securities.

Free Sample

We have decided to make this week's "In the Trenches" report available to everyone. In this week's edition, we discuss Jobs, the ECB, the Fed and we dig deep into a popular bond fund. We hope you find this as valuable as the hundreds of financial professionals and and investors who subscribe to Bond Squad. http://www.bond-squad.com/articles.htm

Where have all the workers gone?

Nonfarm Payrolls data indicate that the economy added 96,000 (seasonally-adjusted) jobs in August. This number threw Bond Squad and the street a curveball. The Street revised its forecast for job growth higher (to 130,000) following a better-than-expected ADP report. We front ran the Street by forecasting 130,000 jobs last week, due to strong July data. ADP often throws curveballs and we were not about to swing. However, the so-called “establishment survey” threw us a curveball when the BLS revised July data lower. July Nonfarm Payrolls were revised lower by 22,000 to 141,000 from an initial read of 163,000. Although we did not believe that the stronger economic data observed in July would be sustainable at this time, we did not believe we would see downward revisions. We also believed that there would be some spillover from the phenomenon of automotive factories remaining open in July. Auto sales were strong and we believed that hiring would creep higher in August. What has apparently occurred is that workers were not recalled in August because they were not laid off in July. This is seasonality wreaking havoc on the numbers. Seasonal adjustments account for layoffs in July and call backs in August. Neither has occurred this year. The result was good July data and a payback in August. Even though seasonality can cause volatility in the data, taking the average of the July and August data probably paints a good picture of job growth for the past two months. The resulting average Nonfarm Payrolls data for July and August is 118,500. Nearly every economist on the Street has stated that recent economic data is consistent with job growth in the low 100,000s. No Time to Wallow in the Mire The economy appears to be mired in the low-to-mid-100,000s. Nonfarm Payrolls has averaged 73,000 jobs per month since the recession ended in July 2009, but it has averaged 146,000 since December 2010 (the first full month after QE1). Goldman Sachs Chief Economist, Jan Hatzius, pointed out that Nonfarm Payrolls averaged 153,000 in 2011, but only 139,000 in 2012, thus far. What this comparison leaves out is that the average for the first eight months of 2011 yielded average job growth of 143,000, closer to this year’s average. Calendar year 2011 benefitted, not only from a spike in job growth at the beginning of the year (as did 2012), but a spike in hiring heading into the holiday season. Nonfarm Payrolls since January 2011 (Source: Bloomberg): Though not precisely correlated, the patterns of 2011 and 2012 are similar. Could we see a spike in hiring heading into this holiday season? It is possible, but gains in holiday hiring could be offset by a reduction or stagnation in the workforce among export driven companies. Due to a faltering global economy and the “Fiscal Cliff” fast approaching, companies' incentive to hire in the fourth-quarter of 2012 could be less than it was a year ago. Surrender, Surrender Today’s depressing data goes beyond the disappointing Nonfarm Payrolls data. It even goes beyond the 15,000 jobs lost in manufacturing (in spite of strong automotive industry data). The household data tells a troubling story. The headlines report that the Unemployment Rate declined from 8.3% (actually 8.25%) to 8.1% (actually 8.111%). However, the “household survey” reports that the decline came not from workers finding jobs, but from workers leaving the workforce. The size of the workforce contracted. The labor force participation rate fell to 63.5%, the lowest since 1981. The number of people in the labor force (Americans who are working or looking for work) fell by 368,000. To put this into perspective, the data indicates that more than three-times the number of people left the labor force than found jobs! Temporary workers declined by 5,000. Increased hiring of temporary workers is believed to indicate an improving job market. Ergo, a decline in the number of temporary workers does not bode well for job seekers. Why the big discrepancy between the BLS data and the ADP data? ADP measures job growth among companies for which it provides payrolls services. Among these companies are many retailers, restaurants and healthcare –related firms. The data from these sectors were fairly strong. According to the data; Retailers added 6,000 jobs, restaurants hired 28,000 workers, and the healthcare industry added nearly 17,000 jobs. Of these, only healthcare is likely to continue expanding at a robust pace. Other than in healthcare, jobs created do not appear to be what one might consider well-paying. That 80s Show Today’s data are filled with interesting tidbits. One is that, if the labor force was the same size as it was in the beginning of 2009, the unemployment rate would be over 11%. How about wage growth? What wage growth? On a month-over-month basis, wage growth was flat. On a year-over-year basis, wage growth maintained its pace of 1.7%. This is just keeping up with the pace of inflation. However, the rate of inflation (as per headline CPI) has declined during the past year from 3.8% in August 2011 to 1.4% in August 2012. Core inflation increased to 2.2% in August 2012 from 2.0% in August 2011. This indicates that a good portion of the increase in consumer spending might have been from lower food and energy prices. Average Weekly Hours for July was revised to 34.4 from 34.5. This figure was repeated in August. Not only is job growth problematic, those who have jobs are not seeing their hours increase. Typically, rising hours worked data is a precursor for increased hiring. Instead, they have trended slightly lower from a 2012 peak of 34.6 (during the warm winter). U.S. Labor Participation since 1980 (source: Bloomberg): Judging by the recent run-up in energy prices and the probable effects from the drought in the Mid-west, the consumer will experience what is, in effect, a tax increase heading into the all-important holiday season. Add to the equation a potentially harsh winter for the Northeast and winter 2012-2013 could be a drag on growth, just in time for the “Fiscal Cliff.” Déjà vu All Over Again Enough of crunching the data and opining on their causes, readers want to know what this means for Fed policy, interest rates and the fixed income markets. Today’s data dramatically increase the chances that the Fed does something at next week’s FOMC meeting (9/12-9/13). Whether or not it engages in asset purchases (and to what degree) remains to be seen. The markets have reacted to the increased probability of Fed intervention by sending Treasury yields lower and commodity prices higher. Usually easing, whether it is traditional or quantitative, results in rising long-term rates. After all, easing is designed to promote growth which generates inflation. However, the market is assuming that the Fed is incentivized with keeping long-term borrowing costs low. Helping that scenario along is that higher food and energy prices could put the brakes on consumption and core inflation. It seems that we have discussed this before. We do not believe that QE3 will do much to boost hiring. However, the Fed has a mandate of full employment (in addition to price stability). It will do whatever it can to add however many jobs QE can generate, as long as inflation remains under control. Those who do not like the Fed’s course of action should cease blaming the Fed and blame the fiscal policy makers who are really responsible for forcing the Fed’s hand. The prospect for low rates for an extended period of time should be good for high grade corporate bonds, high yield bonds, municipal bonds, preferreds and dividend paying equities. We would consider high grade corporate bonds, the upper-tier of high yield, municipal bonds and dividend paying equities as investment opportunities. The remaining asset classes may present trading opportunities, but investors tend to become complacent and overlook the true risk present in these volatile asset classes. In reality, high-risk assets remain high-risk assets. High-volatility assets remain high-volatility assets. We are temporarily in an environment which benefits these assets. When the world “normalizes” investors could be “whip-sawed” when the market reassesses risk in a more traditional fashion

Draghi Net

Word out of Europe is that the ECB will launch a “sterilized” bond buying scheme by purchasing short-term sovereign debt in the secondary market. “Sterilized” means that the ECB would absorb the money set loose in the markets from bond buying. It could accomplish this by borrowing the money back at a yet-to-be-determined interest rate. By going the sterilized route, the ECB could counteract the potential inflationary and currency-devaluating effects of monetary easing. What a minute, isn’t monetary policy supposed to add to the money supply? Isn’t some measure of currency devaluation desirable to boost exports, etc.? You can stop rubbing your eyes, ECB President, Mario Draghi, has not gone mad. He has a different objective than the pro-bailout speculators. The pro-bailout camp desires money printing, some currency devaluation and a continuation of the status quo on the periphery. Mr. Draghi simply wishes to keep the eurozone intact while structural reforms can be gradually implemented. This is clearly a rescue of the eurozone, rather than a growth stimulus program. Germany is exercising influence over the ECB as it has been the Germans who have expressed fears about inflation. Strings are attached to this bond buying. There will be criteria attached to the bond buying scheme. There will likely be memoranda of understanding and fiscal criteria for any country involved in the bond buying program. This includes asking for an official bailout and opening up its economic books. As of now, the only countries which would qualify for such bond buying are Greece, Portugal and Ireland. Spain and Italy have not asked for bailouts. The prospects for Italian and Spanish bond buying tomorrow (following the ECB meeting) are very slim. As such, the markets reacted and corrected back to pre-rumor levels. The days of money throwing are over. Strings will be (and should be) attached, if only because the Germans are the grownups in the room. Even if the ECB would rather broaden the scope of the bond buying program, unlimited bond buying is a difficult proposition. It is difficult because the ECB cannot print money. It has not ability to print euros. The printing of currency has to come via a unanimous agreement by eurozone members. We do not see the Germans agreeing to wanton money printing. Let’s Make a Deal What lies ahead for the eurozone? There are basically three scenarios: 1) The eurozone moves closer to the French/periphery economic model. 2) The eurozone moves closer to the German model. 3) The eurozone fragments. Our view is that, unless there are dramatic culture shifts, scenario number three seems the most likely outcome. Like a Surgeon Investors and speculators looking for a magic cure for Europe are likely to be disappointed. Sometimes the herbal cures don’t work and surgery is necessary. The only question is: Where will the cutting occur? Will it be sovereign governments restructuring their economies or cutting free of the eurozone. Tom subscribe to Bond Squad please got to: http://www.bond-squad.com/subscription.htm Tom Byrne tom@bond-squad.com. www.bond-squad.com www.mksense.blogspot.com 347-927-7823 Twitter: @Bond_Squad

Inflation Hedging? Oh Lord!

Last week, a subscriber (a very knowledgeable subscriber) asked us about the Lord Abbett Inflation Focused Fund. As a bond-oriented firm, we have not delved too deeply into funds. We understand how they work (maybe that is why we have not focused on them), but we understand that they do make sense for many investors. With this is mind, we gave the Lord Abbett Inflation Focused Fund a good going over. Our reader’s question centered on the use of inflation-related swaps (CPI swaps, if you will), along with various fixed income instruments to, as the fund’s mission statement proclaims: “The Fund's objective is to seek to outperform the Consumer Price Index over full economic cycles. The Fund invests in a portfolio of fixed-income securities and using a combination of inflation-indexed securities and inflation-linked derivatives to seek to maximize inflation-adjusted returns. “ After reading that, investors might expect to find a veritable cornucopia if inflation linked bonds, sitting there just waiting to reap the rewards of rising inflation. However, a quick look at the fund’s top holdings tells a different story. Top Holdings (MHD) Position % Net GP 8 ¼ 05/01/16 3.05k 1.080% JPM 3.45 03/01/16 1.95k .671% FHMS K019 A1 2.00k .662% FH 848738 1.86k .622% FH 848703 1.80k .592% FH 1Q1355 1.83k .581% DBUBS 2011-LC1A A1 1.52k .521% C 5 ½ 04/11/13 1.53k .511% FH 1Q1358 1.69k .507% HPQ 4 ½ 03/01/13 1.50k .499% There is not a single inflation-indexed bond among the top ten holdings. In fact, the only adjustable-rate securities are the four Freddie Mac MBS structures (all beginning with “FH.” The FHMS is a fixed-coupon MBS) and they float off of Libor, not CPI. If we dig down through the next 10 holdings, we find a similar story. One also might be excused for believing that the fund would have performed poorly as inflation fell during the past year, but the data says otherwise (see the following chart): Comparison of fund LIFFX and U.S. CPI YoY (Source: Bloomberg): Contrary to what investors might have believed, the fund performed fairly well, even as inflation declined. By now, some readers are probably scratching their heads, but the answer to this paradox can be found right in the fund’s mission statement, which says: “The Fund's objective is to seek to outperform the Consumer Price Index over full economic cycles.” Nowhere does the fund state that its goal is to provide long exposure to rising inflation. It merely states a goal of “outperforming CPI over full economic cycles.” During the past year, if one took a disinflationary or even a neutral inflation stance, one would have outperformed CPI! Although we cannot see in which derivatives, such as swaps the manager has invested (derivatives markets are very opaque), but judging by the performance of the fund, the manager has probably has engaged in an inflation-neutral strategy (a strategy we have advocated for several years). What if the environment changes and inflation begins to heat up? Although rampant inflation is not yet on the horizon, it could pose a threat someday. What would the manager do? When we look at the fund, most of the top holdings have short or intermediate maturities or average lives. The manager has positioned the fund so to be nimble should the inflation environment change. When income is desired, we nearly always choose a portfolio of bonds over a bond fund, if for nothing else but bonds having final maturities and predictable income streams, whereas funds do not. However, where speculation, total return and, as in the case of inflation, hedging is desired, a well-constructed and well managed fund can provide the diversification (many of the MBS structures in the fund would not be available to retail investors) and discipline most investors cannot obtain on their own. Discipline is a very important word in this discussion. All too often, when an investor asks his or her financial advisor for inflation protection, the investor believes that a position which benefits from rising inflation is needed. Most investors are not qualified to make inflation projections and could be misled by price certain price fluctuations in their daily lives which might not show up as an increase in the year-over-year change of the rate of inflation which is necessary for most CPI-linked bonds to outperform. A fund, such as this (one with which we have no connection whatsoever), can provide some inflation protection, with the discipline of trained professionals reducing the possibilities that one might be looking in the wrong direction, inflation wise. If you would like to discuss inflation, hedging or derivatives, drop us a line. Tom Byrne tom@bond-squad.com. www.bond-squad.com www.mksense.blogspot.com 347-927-7823 Twitter: @Bond_Squad Disclaimer: The opinions expressed in this publication are those of the author. They are not, nor should they be considered solicitations to purchase or sell securities.