Land of the Lost

Trade Balance data indicates that the trade deficit widened as imports of consumer goods increased while U.S. exports decreased. According to the data, the increase of consumer imports was due more to inventory replenishment after months of inventory depletion rather than increased consumption. Also adding to the wider trade deficit was a decrease of U.S. exports of equipment and machinery as emerging economies attempt to rein in expansion. Today's data indicates that second quarter GDP will be revised lower. Moody's senior economist Aaron Smith had this to say:


"Clearly not all of these imports of consumer goods are being purchased or consumed and some of it is going into inventories. It’s consistent with slower global growth. We’re going to get less of a boost from exports in the second half versus the first half."


The Fed painted a more solemn picture of U.S. economic recovery. This has apparently caught some market participants off guard. Why? I have no idea. Anyone with any historical perspective of growth and policy and has looked around at the state of the consumer (not to mention forthcoming tax and regulatory changes) could have figured out that the economy was not poised to roar back. Businesses will only add workers if they must. Business is reactive on the employment front because technology and outsourcing has made being proactive hiring unproductive.

The Fed indicated that it will keep the Fed Funds rate low for an (even more) extended period of time. It will also use proceeds from its maturing mortgage-backed securities to purchase treasuries with maturities ranging from 2-years to 10-years. The market is rallying on such news. One dissenter was Kansas City Fed President Thomas Hoeing. Mr. Hoenig believes such accommodation does more harm than good. He opined that such extreme accommodation does little to boost economic activity in this environment, but it could create inflation problems down the road should the economy change /recover structurally (there is that word again). I tend to agree with Mr. Hoenig and Pimco's Bill Gross. This is not cyclical economic issue, but a structural issue.

The economy is not structurally able to maintain levels of activity to which we have become accustomed.without continued stimulus. However, the Fed cannot entice consumers to borrow when they are already over-leveraged and are upside-down in their homes. The Fed cannot force banks to lend when it does not make sense to do so other than with top-flight borrowers. They have difficulty securitizing Alt-A and subprime loans and they do not whish to carry such risk on balance sheets. Not only would that be a poor business decision in this environment, but could incur the wrath of government regulators for taking too much risk, not to mention being accused of "forcing" loans upon those who can not afford them.


Look folks, floaters are not attractive at this time. Short-term rates are not rising and in spite of the rally on the long end of the curve, the slope of the yield curve will remain very much positively sloped. Step-ups remain a more attractive option, although they are rallying for obvious reasons. What is rallying counterintuitively are 10-year TIPS (and TIPS ETFs). Apparently retail investors feel more comfortable buying 10-year tips because they are less fearful of higher interest farther rout on the curve. They are shooting themselves in the foot. 10-year TIPS tend to do WELL when long-term rates rise as this usually means inflation pressures are materializing. Treasuries and TIPS are supposed to move in opposite directions. One is supposed to hedge the other. Clients just don't get it.


Laddering is still the best strategy and the belly of the curve (5 to 7 years) is the best place to overweight if one was inclined to overweight a spot on the curve. Currently it makes little sense to extend past 10-years unless clients are very desperate for every last basis point of income. One can get nearly 75% of the slope of the entire yield curve without extending past 10 years.


10-year treasuries extended their rally following a very good auction. Here are the results:

Yield came in at 2.730% vs. 3.119% in July.
Indirect bids 45.82% vs. 34.98% Avg 12 auctions
Bid-cover 3.04x vs. 2.98x Avg 12

The percentage of indirect bids is most impressive to me. Recent auction data has indicated that indirect purchases (which includes foreign central banks) softened a bit, but auctions were bolstered by strong domestic demand. Today's results indicated that foreign investors are very much back in the game. They were undoubtedly discouraged by the Fed's assessment of the recovery and were encouraged to by treasuries following the Fed's commitment to do the same.


U.S. treasury yields are at levels which are pricing in a double this recession. This however may be due to a flight to quality, account rebalancing and traders rejiggering hedges. However, if fear of a double dip recession strengthens a self fulfilling prophecy could result.

Don't expect the Fed to spark a strong expansion. The U.S. economy is not structured for such a rebound at this time and forthcoming regulation, tax policy and health care rules will cause significant head winds for business expansion and hiring. Unless there is a sea change in DC we could be in for a lost decade.