Malaise and The GSEs

Last Week's Initial Jobless claims ticked higher to 484,000 - the highest number since February of this year. Continuing claims fell to 4.452K from a prior revised 4,570K (up from 4,537K). It is believed that many displaced workers who fell off of the continuing claims roles fell onto the roles of extended benefits rather than finding jobs. High unemployment obviously crimps consumer demand, thereby dampening the recovery. However, it also conditions people to become more frugal. Those of us who have parents or grandparents who experienced the Great Depression know that their spending habits were much more conservative than those of the generations which followed.

Import Prices came in higher than the prior month, but lower than the consensus forecast. Prices here moderated be declines in building materials, metals and machinery. These were the sectors which were expected to lead the recovery. Nomura chief economist David Resler told Bloomberg News: "With the unemployment rate still quite high, resources idle everywhere, it’s pretty clear to me that we shouldn’t have much in the way of inflation."

CPI rose for the first time since March, but prices were not up across the board. CPI was driven higher by rents, used cars, tobacco and clothing. These are not exactly signs of an economic recovery. In fact, higher rents often signal the opposite as former home owners are forced to rent living quarters thereby creating increased demand which results in higher rents. Most other sectors experienced price declines. Retail sales rose, but when auto sales and gasoline purchases are removed, consumers actually purchased fewer goods than the prior month. Although today's numbers do not paint a recessionary picture, they do appear to portend modest, but positive, growth.


This is bad news for investors in LIBOR and CPI floaters. I have seen CPI floaters' coupons drop to 0.00%. We do not need deflation for that to happen, only for the year over year inflation rate to be unchanged. The price of the benchmark 10-year note is unchanged to yield 2.72. The price of the 30-year government bond is up 10/32s to yield 3.90%. Ladder and focus on the belly of the curve. Snap up step-ups (corporate or agency) as they are among the better fixed income values in the markets.

Monday's Wall Street Journal Credit Markets column discusses the recent swing to bullish sentiment in the treasury market. The median forecast for 10-year note at year end is a yield of 2.88%. However, that is including Morgan Stanley's forecast of 3.50% (down from 5.50%). MS is also forecasting second half 2010 growth at 3.3%. This is what makes markets. Mort Zuckerman's editorial in the Journal may have been a bit pessimistic, but his description of the changed dynamics of the U.S. economy is correct. Gerald O'Driscoll's editorial explains that the Fed cannot solve the economic problems we are facing. He correctly states:



"In most cases, investment booms drive industries with sound fundamentals. When the cheap credit keeps flowing, however, fundamentals are forgotten and the process evolves into a mania (to use the old-fashioned term). What cannot be sustained will not be, so the boom ends in a crisis."

"In these scenarios, the collapse of demand is a consequence—not the cause—of the bust. Policies to address crises must get cause and effect right."



Cause and effect are often confused in this industry. One oft confused indicator is the yield curve (and its shape_. Many consider the shape of the yield curve as a predictor of future economic conditions. On the surface it is difficult to dispute this. One can see the relationship between a flat(ter) curve and economic slowdowns time and time again. However, there are a cadre of bond people (of which I am one) who believe that the yield curve reflects rather than predicts,. What it reflects is disinflationary Fed policy. The Fed raises short-term rates to quash inflation pressures, long-term rates stop rising and often fall resulting in a flat yield curve. The yield curve merely confirms what everyone should have already seen coming by watching the Fed. It goes flat after steps have been taking to moderate growth. It is a lagging to coincidental indicator of where the economy is heading. The Fed is the premier indicator of growth and inflation. Currently Fed policy and commentary is forecasting sluggish times ahead.



Freddie and Fannie have been the topic of discussion this week In Washington DC. Treasury Secretary Tim Geithner, Pimco's Bill Gross and a host of mortgage professionals, economists and academics discuss the role played by the GSEs in the financial crisis and what is to become of them. Pimco's Bill Gross believes that the GSE's should be nationalized. Pay no attention to his long positions in their bonds. Treasury Secretary Tim Geithner expressed the opinion that government should play a smaller role in the mortgage market. I am sure his comments are reverberating throughout the Democratic side of the aisle in Congress.

Many legislators, mainly Democrats, were and continue to be supporters of GSEs in their public / private forms. Congress had its cake and was eating it too. Congress directed the GSE to engage in unprofitable and often dangerous activities, such as backing and securitizing mortgages taken out by borrowers who could ill afford to repay them all in the name of social justice. However, it was the private sector (stock and bond holders) which financed the GSEs. The government is in a sticky situation.. The GSEs are engaging in business which would result in government crackdowns (if not bankruptcy) if undertaken by banks. However, with nine out of ten mortgages being GSE-backed. Not much can be done about the GSEs at this time. Bonds should be ok, but common and preferreds are likely to be worthless. The can gets kicked down the road some more.