The Nike Recovery

Making Sense Newsletter 1/28/10 The Nike Recovery Just Do It www.mksense.blogspot.com Ever since the government's stimulus plans were put into effect the debate gas raged among market participants, economists. politicians and media talking heads (like the have a clue) over what shape the economic recovery will take. Market bulls exclaimed that copious amounts of stimulus and pent-up consumer demand would lead to a sharp V-shaped recovery "as always." Pay no attention to record amount of household debt, depleted investment values and unemployment. Others believed that we would see a W-shaped recovery. The W represents a steep decline, a sharp, stimulus-driven recovery followed by another steep drop as stimulus is removed which is then followed by another sharp fundamentals-driven expansion. This kind of recovery could happen if the Fed removed stimulus early or quickly. That is obviously not in the cards. The Fed does not want to risk a second recession. Although Wednesday's FOMC statement was somewhat more optimistic than others in the recent past, it was clear that the Fed was not overjoyed by the spectacular progress being made in the way of economic expansion. This is evidenced by no changes to Fed Policy. Another possibility is a Nike swish-shaped recovery. A chart of U.S. GDP would take the shape of a Nike swish as it measures a steep decline and a long, gradual recover. Recent Economic data and recovery trends experienced during the past two decades point to a swish-shaped recovery. A V-shaped recovery depends on consumer spending. Consumers are tapped out. The have record amounts of household debt, unemployment is high and underemployment is even higher. Also dragging in the economic recovery is the fact that low mortgage rates, 0% financing and large price incentives by automakers during the housing bubble has resulted in consumers currently own homes and vehicles which meet their needs and are financed at very low if not zero percent (in the case of auto loans) interest rates. The U.S has a mature economy. Mature economies cannot grow at a very fast pace. 3% to 4% is about as fast as we can realistically can expect without excessive stimulus. However, in a mature economy, consumer demand is like energy or matter. It cannot be created or destroyed. It can only change form. Stimulating the U.S. economy buy dropping rates merely brings demand forward or changes housing demand from renting to owning. When the stimulus is gone, the situation corrects itself. The Fed is between a rock and a hard place. If it removes stimulus to soon or too quickly it risks either stalling the economic recover or sending the U.S. back into recession. If it keeps rates too low too long it risks weakening the dollar which could cause prices of imported commodities, such as oil, to rise. This would place a heavy burden on consumers. The removal of the Fed's quantitative easing is also problematic. The prime reason by far for the modest recovery in housing has been due to the Fed buying treasuries, agencies and agency mortgage-backed bonds. The Fed said yesterday that it is going to stick to its schedule of removing its quantitative easing, in spite of the fact that recent housing data has been disappointing. This runs counter to the opinion of many economists who believe that the Fed will not remove stimulus while unemployment remains high. In the 1970s, then Fed chairman, Arthur Burns used unemployment as a determining factor for Fed policy. He resisted raising rates because of high unemployment, in spite of raging inflation. It too Paul Volcker to break the back inflation by raising rates in spite of high unemployment Fed chairman Bernanke has been derisively called "Helicopter Ben" because of his advocating strong stimulus to avert or soften economic recessions. However, Mr. Bernanke is very intelligent. He knows he cannot keep the economy overly stimulated. Look for quantitative easing to be removed in 2010 and Fed Funds to rise in 2011. Long-term rates should begin to rise again to stay (at least for this cycle) in the second half of this year. However, because of the drag on the economy from high household debt and unemployment which will remain stubbornly high due to technology-driven productivity gains (many displaced workers will not be re-hired, period) inflation and associated long-term interest rates should not blow out. However, long-term rates will creep higher. This puts investors between a rock and a hard place. If one over allocates on the short end of the curve one receives very little in the way of yield. So little that one is likely to not catch up to yields which currently exist on the 10-year of the curve, at any time during this cycle, never mind as an average yield while rolling maturing money. However, even a rate increase of 100 basis points on the 10-year area of the curve can result in losses in the 8 point area. The best bet for fixed income investors is to ladder or bar-bell a portfolio from two years to ten years. Ten-year bonds should be from companies which are expected to have improving business models which can result in credit spread tightening to offset the rise of long-term rates. Industrials, oil producers and retailers such as Wal-Mart should be avoided except by very risk averse investors. They are rich. JPM and GS bonds and preferreds are becoming rich. Regional Bells, certain utilities and bands such as BAC (along with explicitly-back Countrywide and implicitly-backed Merrill), Fifth-Third and PNC-owned National City offer better values. Callable agency paper offer the best values in the 3 to 7 year belly of the curve. Have a great weekend. Tell your friends. I am looking for more subscribers.

Start Me Up

Making Sense Newsletter 1/21/10 Start Me Up Understanding TIPs www.mksense.blogspot.com I have received an increasing number of orders to purchase U.S. government inflation index bonds, more commonly known as TIPs. I have noticed two trends while fielding these calls. First, many clients and some financial advisers are trying to time the market to make a big score when inflation spikes. Secondly, they don't know what makes TIPs tick. Unlike traditional U.S. treasury notes and government bonds, TIPs have two components which affect their performance. There is the stated maturity which is influenced by Fed interest rate policies on the short end of the curve and inflation on the long end of the curve. However, unlike traditional U.S. treasuries TIPs have inflation indices which adjust up or down with inflation as measured by the CPI Urban Consumer Index Non-seasonally Adjusted (CPURNSA). As the index rises or falls so do TIPs indices. The principal face of a TIP is adjusted using the factor. The amount of accrued interest paid is calculated using the adjusted face. The fact that it is the principal is adjusted is often overlooked by investors. If one is purchasing 10m TIPs at 101 with an inflation index of 1.02 the principal cost is $10,302 (10m x 101 x 1.02). Forgetting the TIPs index often results in trade errors when TIPs are purchased as bonds may be costlier than they appear when only the quantity and price are considered (don't forget about accrued interest as well). Not accounting for the inflation index can lead to another, potentially more serious, problem. We know that TIPs indices adjust up when inflation rise, but they also adjust lower when inflation falls. It is possible to lose money on TIPs when inflation falls. Inflation does not have to go negative. It only has to be less positive than when you purchased your TIPs. The good thing about a TIP is that its index cannot be below 1.00 at maturity. However, it could move below 1.00 during its life. This can lead to losses should an investor need to liquidate his or her investment prior to maturity. The knee-jerk response would be to point out that if inflation fell, interest rates would fall and that would support the price of the bond. This is somewhat correct, but the price of a TIP is far more influenced by movements in its inflation index than by interest rates. Not understanding what influences TIP valuations can lead to costly strategic mistakes. The majority of the calls I receive from financial advisers wishing to purchase TIPs are orders to buy short-term TIPs. Their thinking is that inflation will be very positive in the early stages of the economic recovery as is usually the case. What they fail to recognize is that the belief that inflation will rise in the near term is already baked into short-term TIPs prices resulting in high premiums. They also fail to recognize is that inflation measured by the CPURNSA has been moving higher thereby pushing inflation indices on short-term TIPs higher. It is not uncommon to see two or more point premiums on short-term TIPs and inflation indices significantly above 1.00.The danger here comes from the possibility of moderating inflation. Many economists are calling for the economy to cool off to a growth rate in the low to mid 2.00% area with below trend job growth. If this forecast plays out owners of short-term TIPs could get clobbered. TIPs coupons are very low. If inflation moderates considerably, falling indices and prices amortizing back to par could result in net losses even if TIPs are held to maturity. Those looking to buy TIPs for real intended use (to hedge a portfolio of bonds) may want to consider 10-year TIPs. When I suggest 10-year TIPs many FAs ask if I am crazy or how long I have been in the business. They point to the fact that the 10-year portion of the curve is very volatile, experiencing sharp price swings when long-term rates move. Again, these critics are missing the key element within a TIP, the inflation index. We already discussed how the price of a TIP is more greatly influenced by its inflation index because adjusting for inflation is its true purpose. We also know that long-term rates rise when inflation rises. This can cause the price of the 10-year treasury note to fall, often dramatically. However, at the same time the 10-year treasury note is falling due to rising rates, the 10-year TIP should rise thanks to higher inflation expectations. This is exactly what has happened since March 2009. What if inflation falls? if that happens all TIPs will lose value, but since the 10-year TIP has longer to go before maturity and that it is unlikely that the U.S. falls into a long-term deflationary trend as Japan did 10-year TIPs will hold their value better than shorter-term TIPs which do not have the time to experience a new inflationary cycle farther down the road. The best way to buy a TIP as a hedge is to buy whichever TIP has the lowest price AND (more importantly) the lowest inflation index. Such TIPs will experience the same kind of gains as shorter-term TIPS with high indices and high premiums in an inflationary environment, but should be less negatively impacted in a deflationary environment. What about TIPs funds and ETFs. The are good ways to speculate on TIPs as they are diversified among more than one TIP, but that also means that they probably hold TIPs which can be disadvantaged under short-term deflationary conditions. TIPs were designed as a hedging vehicle and not as a vehicle with which to speculate. Only an actual TIP can be used to hedge a portfolio of bonds. If you have any further questions regarding TIPs or other bonds feel free to drop me a line. Tell your friends. I am looking for more subscribers.

Start Me Up

I have received an increasing number of orders to purchase U.S. government inflation index bonds, more commonly known as TIPs. I have noticed two trends while fielding these calls. First, many clients and some financial advisers are trying to time the market to make a big score when inflation spikes. Secondly, they don't know what makes TIPs tick.

Unlike traditional U.S. treasury notes and government bonds, TIPs have two components which affect their performance. There is the stated maturity which is influenced by Fed interest rate policies on the short end of the curve and inflation on the long end of the curve. However, unlike traditional U.S. treasuries TIPs have inflation indices which adjust up or down with inflation as measured by the CPI Urban Consumer Index Non-seasonally Adjusted (CPURNSA). As the index rises or falls so do TIPs indices. The principal face of a TIP is adjusted using the factor. The amount of accrued interest paid is calculated using the adjusted face.

The fact that it is the principal is adjusted is often overlooked by investors. If one is purchasing 10m TIPs at 101 with an inflation index of 1.02 the principal cost is $10,302 (10m x 101 x 1.02). Forgetting the TIPs index often results in trade errors when TIPs are purchased as bonds may be costlier than they appear when only the quantity and price are considered (don't forget about accrued interest as well). Not accounting for the inflation index can lead to another, potentially more serious, problem.

We know that TIPs indices adjust up when inflation rise, but they also adjust lower when inflation falls. It is possible to lose money on TIPs when inflation falls. Inflation does not have to go negative. It only has to be less positive than when you purchased your TIPs. The good thing about a TIP is that its index cannot be below 1.00 at maturity. However, it could move below 1.00 during its life. This can lead to losses should an investor need to liquidate his or her investment prior to maturity. The knee-jerk response would be to point out that if inflation fell, interest rates would fall and that would support the price of the bond. This is somewhat correct, but the price of a TIP is far more influenced by movements in its inflation index than by interest rates. Not understanding what influences TIP valuations can lead to costly strategic mistakes.

The majority of the calls I receive from financial advisers wishing to purchase TIPs are orders to buy short-term TIPs. Their thinking is that inflation will be very positive in the early stages of the economic recovery as is usually the case. What they fail to recognize is that the belief that inflation will rise in the near term is already baked into short-term TIPs prices resulting in high premiums. They also fail to recognize is that inflation measured by the CPURNSA has been moving higher thereby pushing inflation indices on short-term TIPs higher. It is not uncommon to see two or more point premiums on short-term TIPs and inflation indices significantly above 1.00.The danger here comes from the possibility of moderating inflation.

Many economists are calling for the economy to cool off to a growth rate in the low to mid 2.00% area with below trend job growth. If this forecast plays out owners of short-term TIPs could get clobbered. TIPs coupons are very low. If inflation moderates considerably, falling indices and prices amortizing back to par could result in net losses even if TIPs are held to maturity. Those looking to buy TIPs for real intended use (to hedge a portfolio of bonds) may want to consider 10-year TIPs.

When I suggest 10-year TIPs many FAs ask if I am crazy or how long I have been in the business. They point to the fact that the 10-year portion of the curve is very volatile, experiencing sharp price swings when long-term rates move. Again, these critics are missing the key element within a TIP, the inflation index.

We already discussed how the price of a TIP is more greatly influenced by its inflation index because adjusting for inflation is its true purpose. We also know that long-term rates rise when inflation rises. This can cause the price of the 10-year treasury note to fall, often dramatically. However, at the same time the 10-year treasury note is falling due to rising rates, the 10-year TIP should rise thanks to higher inflation expectations. This is exactly what has happened since March 2009.

What if inflation falls? if that happens all TIPs will lose value, but since the 10-year TIP has longer to go before maturity and that it is unlikely that the U.S. falls into a long-term deflationary trend as Japan did 10-year TIPs will hold their value better than shorter-term TIPs which do not have the time to experience a new inflationary cycle farther down the road.

The best way to buy a TIP as a hedge is to buy whichever TIP has the lowest price AND (more importantly) the lowest inflation index. Such TIPs will experience the same kind of gains as shorter-term TIPS with high indices and high premiums in an inflationary environment, but should be less negatively impacted in a deflationary environment.

What about TIPs funds and ETFs. The are good ways to speculate on TIPs as they are diversified among more than one TIP, but that also means that they probably hold TIPs which can be disadvantaged under short-term deflationary conditions. TIPs were designed as a hedging vehicle and not as a vehicle with which to speculate. Only an actual TIP can be used to hedge a portfolio of bonds.

Under Pressure

Today, the equity markets started out bad and then went down hill. The day started with poorer-than-expected economic data. Jobless claims climbed as displaced workers filed claims following the holidays. The Philly Fed report indicated that economic activity slipped. Housing starts for December were down 4% versus November.

As if there needed to be more downward pressure on stocks, China announced that it was ordering its banks to scale back lending to slow down its economy and to thwart a growing housing bubble. China is a command economy and its leadership commanded that banks reduce lending. Slower Chinese growths sent metals and raw materials stocks lower.

The icing on the cake came from President Obama. The president announced plans for banks to withdraw from proprietary trading and hedge fund related activities. These businesses are sources of significant income for banks. The result was falling financial stock prices.

However, today was a good day for bonds. China's actions should result increased purchases of U.S. treasuries and prices responded accordingly. The President's announcement,although bad for bank stocks due to reduced earnings potential, was good for bank bonds as more conservative business activities should reduce default risk.

Forcing banks to withdraw form market making activities (proprietary trading) could have a far reaching impact in investors. Without market makers there is no bond markets or OTC equity market. Without market makers there is no new issue underwriting as a proprietary desk is necessary to support new deals.

What about investors who use money managers? They are not immune either. Money managers do not make markets. They do not trade for their own accounts. The relay on the liquidity provided by markets makers (proprietary trading desks) to buy and sell bonds. This is why the claim that investing with money managers results in better executions. They are at the mercy of the very same market makers managed money supporters claimed could be avoided or bettered.

Banks may have ways around this. They could separate their investment banking businesses into separate,but wholly owned subsidiaries. This would permit an investment bank to fail while the FDIC insured bank parent would be unaffected. This kind of arrangement exists among many utilities, Ford and Ford Motor Credit and Bank of America and Merrill Lynch. I get the feeling that the President doesn't under stand the financial system. However, his adviser, Paul Volcker does. Mr. Volcker knows that market makers are needed for capital markets to function. I think we will see financial firms broken up into pieces, banks and investment banks.

Today's economic events underscore another reality. There has been a market recovery thanks to banks and raw material producers, but not an economic recovery. Until job growth returns. Productivity gains by firms during the past year promises to keep job growth below trend. This should bode well for bonds with the exception of TIPs. I plan on writing a TIPs primer this weekend.

Have fun!

Trying To Get Through

The debate continues among economists as to whether or not this economic recovery will be similar to others in the recent. On one side we have equity-oriented economists who believe that a robust recovery has to materialize. Their reasoning is that it "always" happens. On the other side are the fixed income enthusiasts, such as Bill Gross and the boys at Pimco. Their argument is that the circumstances surrounding the economy matter. I am going to side with Mr. Gross on this one.

This may come as a shock to many readers as I have been an outspoken critic of Bill Gross and his tendency to talk his book after he has placed his bets. This however does not mean that his bets are incorrect. Pimco is calling for a "new normal" rate of growth, a rate of growth resulting from economic activity based on income rather than leverage. Pimco puts the expected rate of growth at approximately 2.00% over the long haul. Other economists see little difference between today's recovery and those of the past. Bank of Tokyo - Mitsubishi UFJ chief financial economist Christopher Rupkey told Bloomberg News:

"We've had financial-market crises and big workforce changes before, and growth has pretty consistently come in around 2.5 percent over the past 50 to 60 years."

Historcal data can give us clues about what we may expect to happen, but we must but past events in their proper perspectives. During the 1950s and 1960s there was very little foreign competition for jobs. Economic stimulus resulted in job growth and economic recovery. Since the Paul Volcker years, two decades of Fed stimulus, without the stimulus ever fully, being removed, sparked strong economic growth. Growth which cannot be sustained without such stimulus. There lies the problem. The Fed cannot cut rates further. It has been forced to engage in quantitative easy by purchasing treasury notes, MBS and agency debt. This could leave the Fed very exposed when long term rates rise. Fortunately, that will not be happening soon, at least not in a big way.

Yields on the long end of the yield curve fell as China once again ordered banks to reduce lending. This will hinder China's (questionable) ability to lead the world out of recession. Also helping to push rates lower was the news that net foreign securities purchases increased by approximately $100 billion in December. No folks, foreign central banks are not abandoning the dollar. They need to manage their exchange rates and inflation is not among their current concerns.

Disappointing corporate earnings, especially from Morgan Stanley and Citi, along with a drop in IBM's revenues sent the stock market plunging and attracted even more buyers to the 10-year U.S. treasury note.

The Producer Price Index reiterated what last week's CPI report told us. Inflation is not a problem at this time. This makes TIPs unattractive except as a permanent inflation hedge within a diversified portfolio. The best value is the 1.375 due 1.20 as it trades near 100 and has an inflation index near 1.00. This minimizes one's downside exposure to deflation, but allows investors to fully benefit from rising inflation.

Basically it all comes down to this. Unless high-risk loans can be written at low rates, economic activity will be lackluster. Investors who will acceot high risk for low yields are scarce at this time.

Thank You For Your Support

I have received many calls from financial advisers who ask me where they can find "three to five year GNMA bonds yielding 4.00% or more." When I tell them that no such security exists I usually get one of three responses.

1) "They certainly exists because my client is being offered such bonds by a competitor."

2) "Sure they exist, I found some in your inventory."

3) "You don't know what your talking about. May I please speak to someone who has more experience."

These responses highlight the dearth of knowledge in the financial advisory business when it comes to Mortgage Back securities (MBS). Let's first understand just what an MBS is.

MBS can come in a variety of flavors, but they fall into two main categories, pass-throughs and collateralized mortgage obligations (CMOs). A pass through does just what its name purports. Interest and principal paid by mortgage holders is passed through to bond holders. CMOs are more complex, too complex to discuss completely in this space. However we can discuss certain important aspects of CMOS.

MBS cash flows are inherently unpredictable. One never knows just how much principal or interest will be paid each month. This is because there is know way to know how much principle will be paid. In a large pool of mortgages there will be borrowers who pay back more principal than required as they attempt to pay off there homes early. Principal can also be paid back early when borrowers refinance mortgages or selling their homes. This is why is to average life rather than maturity which is referred. CMOs are structured to make cash flows somewhat less unpredictable.

CMOs are broken up into pieces called tranches. Each tranche is structured to payoff during a certain time period in the future. This known as a tranches window. But if cash flows are unpredictable, how can a security backed by mortgages, which have unpredictable cash flows, be carved up into tranches which have somewhat predictable cash flows. The answer is the support bond.

A support bond is true to its name. It supports the other tranches in the deal. If rates fall and many borrowers refinance their mortgages or take advantage of lower rates and buy a more expensive home the support tranche absorbs the flood of returned principal to keep the other cash flow of the other tranches more predictable. If rates rise and prepayments slow, the support tranche will receive little or no principal returns for extended periods of time. Instead, the cash flow goes to the other tranches of the deal. It is not uncommon for a support bond to have an average life of one year if rates fall 100 basis point and also extend out to an average life of 20 years or more if interest rates rise by 100 basis points. It is support bonds which are being shown to your clients.

Unscrupulous or (more likely) unknowledgeable salespeople are pitching clients with support bonds, which are being priced using fast prepayment speeds thanks to the tremendous amount of Fed stimulus promoting refinancing, as short-term vehicles. It would be bad enough if advisers were viewing average lives as being the time when one would receive all of one's principal, but that is not accurate. Worse still is that average lives of MBS change with financial conditions. Worse still is the fact that the least predictable tranches are being pitched to investors who need short-term and predictable return of principal. The is despicable behavior.

This is a very low interest rate environment. Government guaranteed short-term securities with yields above 4.00% to not exist. Don't be taken in.

Dimons Are Forever

Today was an inglorious start to the holiday weekend on Wall Street. Banking Powerhouse. JP Morgan, reported earnings which quadrupled. In spite of the dramatic increase in revenue, all was not rosy with the JPM report. Although JPM reported considerable earnings increases among its M&A and its investment banking fees, fixed income trading revenues (the prime earnings driver during 2009) fell 45% quarter over quarter. Equity trading revenues were flat. Securities underwriting revenues were strong. JPM CEO Jamie Dimon stated the financial sector may reach an "inflection point" by mid 2010 but stressed that "we're not there yet." He also said that JPM will probably not raise its common stock dividend until the firm saw signs of a sustained recovery. He did not expect that to occur before mid year. I believe that JPM bonds and preferreds are fairly priced if not somewhat rich at current levels.

In response to JPM's earning concerns and unspectacular economic data, the Dow Jones industrial average fell 100.90 points. The long end of the treasury curve rallied sharply as investors pared back inflation bets. All but the most bullish economists are forecasting sustained, but modest growth at levels far below what has come to be expected following a sharp recession.

What is troubling for me is that the current modest expansion is primarily the result of unprecedented Fed easing. I believe the Fed will cause an asset bubble at some point. It may not be a severe asset bubble and it may not be the result of what it has done thus far, but rather the result of what it may or may not do down the road. If the Fed is too slow to remove the stimulus we could experience another asset bubble in housing. However, that will take some time and the bubble is unlikely to be as severe as the one just prior as it is unlikely that investors will delve into the securities and derivative structures necessary to spark such a bubble so soon after the one which just past. That will take a new crew of brainiacs who know much about theory and have little, if any, practical knowledge.

One area where a bubble may exist is in the high yield markets. The extraordinary Fed easing has sent investors peering into the darkest corners of the fixed income markets looking for yield. The result has been a stellar performance among junk credits, in spite of elevated corporate defaults. This could play out one of two ways. On the positive side, distressed companies have been able to borrow and refinance debt making survival and recovery more like it. On the negative side, there are undoubtedly some companies undeserving of investor confidence and could implode a few years down the road once this new debt has to be refinanced at more normal (whatever that means going forward) interest rates.

There are two ways to approach high yield investing. One can pick out high yield credits in strong or necessary sectors, such as utilities or consumer staples. If one does one's homework and does not become a yield hog, one can pick up some yield without incurring an inordinate or reckless amount of risk. For those who are making a truly speculative play where income is a secondary concern a high yield mutual fund probably makes sense.

I have received many calls and e-mails from financial advisers asking for information regarding three to five year GNMA MBS securities. They do not exist. Sometime during the next several days I will compose a primer on MBS and what kind of securities actually being peddled to you and your clients.