Working For The Weekend

www.mksense.blogspot.com The week is winding down. We can almost taste the weekend, but there is much to do and discuss before our weekly respite. Jobless claims came in higher than expected. Some media outlets tried to portray the initial Jobless Claims number as being positive, but in reality, today's report was the same as last week's initial reading and last week's number was revised higher. Not good news. Continuing Claims was higher than last week's initial number and the upwardly revised number as well as the street consensus. This in spite of both benefit extensions and people falling off of the rolls. The week is winding down. We can almost taste the weekend, but there is much to do and discuss before our weekly respite. Jobless claims cam in higher than expected. Some media outlets tried to portray the initial Jobless Claims number as being positive, but in reality, today's report was the same as last week's initial reading and last week's number was revised higher. Not good news. Continuing Claims was higher than last week's initial number and the upwardly revised number as well as the street consensus. This in spite of both benefit extensions and people falling off of the rolls. The treasury market does not consider today's data to be a positive. The price of the 10-year treasury is up 10/32s to yield 3.53%. The price of the 30-year government bond is up 23/32s to yield 4.44% This in spite of new supply of U.S. treasuries via the 3-year, 10-year and today's 30-year auctions. Yesterday's new supply of 10-year's was well received. Indirect bidders, which includes foreign central banks, made up 41% of the overall buyers. This was in line with the expected 42%. Bid to cover was 2.96 versus a recent average of 3.04, but this was good considering the 10-year priced at 3.54%. The U.S. may not be pretty from debt standpoint, but we are currently the least ugly girl at the dance . The media was batting 1.000 today when it reported that the bond market sold off due to a weaker-than-expected auction. The sell off was so brief if you blinked, you missed it. Prices on the long end of the curve finished the day near the highs for the day. After all, the street may have been expecting a 4.47% long bond, but 4.49% doesn't exactly mean the bond vigilantes are back. Indirect bidders were a bit soft accounting for 32.5% of the auction, down from 36.8% in the prior auction. Primary dealers (banks and investment banks) accounted for 45.7%, up from 37.7% in the prior auction. Things are calming down in Europe. Investors are less worried about an immediate Greek default, but the prevailing opinion is that rather than solving the problems in Greece, the can has been kicked down the road. This is why the euro continues to trend lower versus the dollar. Unlike some on the Street, I am not ready to declare the EU and the euro failed experiments, but the idea that Europe would be a legitimate rival to the U.S. c'est morts. The undertaking by the EU is truly Heraclean. Pandora's box has been opened and all the evils of the world (using debt to pay debt) have been released. More disturbing is that the hoi polloi are becoming desensitized to debt-derived stimulus. This is what got us into this tragedy. Volcker tightened and beat inflation. Then he eased. When inflation began to heat up, he eased again. Rarely did Mr. Volcker or his successor, Mr. Greenspan, ever fully remove the stimulus. when the economy would begin to sputter, along came the Fed (Greenspan Put?) to make leverage cheap. Can't get much easier than now. The problem is that GUM (great unwashed masses) believe that the stimulated economy is normal and that credit checks and lending standards are Draconian. Fed Vice Chairman Kohn stated at a monetary conference in Ottawa that the Fed's policy of keeping rates at a given level should not be unconditional. However, he also said that Fed policy would not become less accommodative. He also said that central banks should not accept higher levels of inflation to have more room to cut during a recession. With the economy slowly recovering it is unlikely that the Fed will move quickly, sharply or very high. Today, I have a financial adviser ask me about floating rate bonds and preferreds. He asked why the big push for floaters when most have coupons which float off of LIBOR when LIBOR is low and probably will not rise very high, very soon? Houston, we have comprehension! Tell your friends. I am looking for more subscribers.

It's All Relative

People do it. Businesses do it. Even continents with Greece do it. Let's lever. Lets lever up. The EU announced a €750 billion bailout for anyone and everyone who may be distressed. The deal consists of €440 billion from the EU governments, €60 billion from an EU emergency fund and €250 billion from the IMF. The ECB has finally relented and will engage in quantitative easing and purchase Euro governments and private bonds "to ensure depth and liquidity. The Bank of England will also maintain its quantitative easing policies. The Fed has also stepped up and will open currency swap lines with the ECB. What the Fed would do is print dollars and exchange them for euros to help provide liquidity for European banks. Any hopes of the Fed raising the Fed Funds rate this year have faded.

This still does not guarantee that Greece is out of the woods. Greece would still have to repair its broken economy and somehow find a way to repay its debt or repay the debt it would owe the aforementioned consortium. Equity markets love this because today's announcement likely means an even more extended period of very low rates and a continuation of too big to fail. Equity care not for fundamental reforms, just a continuation of accommodative policy.The can is merely being kicked down the road.

The capital markets had a love affair with the European bailout plan, but that love affair was short-lived. Equity markets trended lower today and the euro weakened versus the dollar closing in NY at 1.26.


I have been commenting for several months that both long-term and short-term rates are unlikely to rise very far in the current year. I stand by my opinions. With the Fed now providing a line of credit to the ECB and lingering concerns about interbank lending it is unlikely the Fed will be tightening before 2011.

Many readers have belabored the point that the U.S. has issued huge amounts of debt and printed copious amounts of money, insisting that the results would be inflationary and that rates would trend higher. Some even pointed to Morgan Stanley's forecast calling for a 5.50% 10-year treasury note by year end and Fed tightening to begin in the third quarter of 2010. I countered with the belief that if our trading partners are in the same boat, our rates and our inflation would remain in check. Well not only is this playing out, Morgan Stanley gave in and adjusted its forecast. The firm is now forecasting a 4.50% 10-year by the end of 2010, down from 5.50% and pushed its forecast for the beginning of Fed tightening until the first quarter of 2010.

Inflation is a relative phenomenon. Interest rates and currency values are relative phenomena. Nothing is absolute. The dollar's reserve currency status should result in moderate U.S. inflation and relatively low U,S, interest rates. However, the expected 100 bps increase of long-term rates is enough to significantly and negatively impact principal values of longer-term investments such as very long-dated corporate bonds and low-coupon preferreds.


Current and expected conditions make LIBOR-based floater a poor proposition, but more on that later.

Welcome to the Machine

Did we all have fun today? First we had Greece doing its best to kill itself. Then when the market was in full panic, the machines took over. At approximately 2:40 PM EDT, the DJIA suddenly dropped about 700 points for at total of 1,000 points for the day. Stocks such as PG dropped below $40. Some printed in the pennies then as quickly as it started, the market rebounded almost all the way back to where it was about 20 minutes prior. What happened?

Computers are what happened. As the pace of orders quickened, the NYSE's systems are programmed to slow down. This means that they basically halt trading for 30 seconds to a minute. However, stocks do not trade only on the NYSE. NYSE listed stocks also trade on NASDAQ and on ECNs. ECNs (electronic communications networks) are private systems which facilitate trades for subscribers.

However, these trades are reported to the consolidated tape. ECNs are not required to halt trading when the NYSE or NASDAQ does. This makes the ECNs the best bids or best offers. Often the best bid or offer on an ECN is much different than what was last posted on the exchange. Market orders will be executed at the best available price. If one wanted to sell a stock at 2:40 PM today when the exchange took a breather the ECNs did not.

Many market sell orders were sent to ECNs where the bids were low. The low prints set Wall Street firms' computers in motion. Trading in microseconds, they executed literally thousands of algorithm-driven orders in a short period of time, driving the market lower. Once the machines finished selling the farm, the sell side pressure abated and the markets recovered to almost where they had been just prior to the selling frenzy. It appears as the NYSE and NASDAQ are going to cancel select trades executed after 2:40 PM.

Although the problems with equity trading systems are newsworthy, but the problem lie in Europe and with our shaky recovery. Europe refuses to accept reality. Greece is impaired (I am being kind). It either needs to leave the euro or it needs to restructure its debt. All the reassurances by ECB President Jean-Claude Trichet did nothing to calm market fears, nor should they. The EU IS NOT the United States of Europe. A better description would be the Confederate States of Europe with each member having a strong state government and a strong local identity.


The EU had better act fast to keep Greek problems from spreading. Portugal is read to fall over the edge into the economic abyss. The problem is with the banks. Banks use their domestic treasury securities as collateral to borrow in the repo market and from the ECB. If their home governments are impaired, the bonds will not be loaned against at their full value. Banks may only have to put up more bonds as collateral for a given amount of borrowing. Europe has problems.

This is not surprising to me. European banks were generally believed to be more damaged from the imploding housing bubble than U.S. banks. There is little dynamism and entrepreneurship in the Old World. Those who believed that the euro would be the next reserve currency after the dollar got a rude awakening in recent weeks.

The U.S. dollar is THE reserve currency. No other currency is as secure and no other economy is as dynamic. This pushed the yield of the 10-year treasury below 3.40%. Does this mean that long-term rates are going to trend even lower? Perhaps for awhile. After all, there are investors such as foreign central banks, insurance companies and various trusts which must own debt. However, other investors can diversify beyond debt and will instead buy gold. This will limit further rate declines.

What this does mean is that the 10-year is not visiting the 5.00% area any time soon. In fact, with poor job growth, strong productivity, and moderating retail sales, combined with lower profits from the stronger dollar, we may nit see a 4.00% 10-year this year. The Fed will also remain in the sidelines. Although I don't think we will experience a double dip recession, we could see the growth chart flatten a bit. The lesson to be learned here is that growth from borrowed money can never be considered sustainable.

The bond vigilantes have invaded Europe and are saying enough with throwing money at problems. Enough with not acknowledging losses. Enough with borrowing one's way out of trouble. The same could and would happen in the U.S. except we are the only game in town and major commodities trade in dollars. This means market participants need to own dollars. Only by the grace of the size of our economy go we.


Investors have trouble distinguishing credit products from interest rate products. They believe that all bonds move up and down together. Not so. Corporate bonds and preferreds are credit products and in times of crisis and recovery, credit market yields and treasury yields can move in opposite directions. That is what has been happening in recent weeks.

I have been suggesting that investors sell their long bond and preferred positions unless they absolutely need income. Hold off now. Spreads have widened. I would wait until the next round of recovery. I still wouldn't buy more out on the long end, but maybe hold on for now. Floaters and TIPS should only be used as hedges for specific events and not as opportunities to hit home runs. That would be a low percentage play given what is likely on the horizon.


Lastly, because gold will be the other reserve currency, I do not think long-term rate will go much lower. Therefore I went long TBT today. We may not see high long-term rates, but we will eventually see higher rates than today. Everything is relative.

Cinco De Mayo

Decent numbers today as the ADP report indicated that surveyed businesses added 32,000 jobs versus a street consensus of 30,000 and a prior revised 19,000 (up from a -23,000). The service sector added 50,000 jobs while the construction sector pared 49,000 jobs. Factories added 29,000 workers. The street will now eagerly await Friday's Nonfarm Payrolls report. The street consensus is calling for the job growth of 189,000 (100,000 in the private sector). This is not much above the pace necessary to keep up with population growth, but it sure beats the alternative.

The big question is: "When will job growth be sufficiently robust to significantly reduce the unemployment rate?" That could be some time in coming as productivity gains, troubles in Europe and a strengthening dollar (which increases prices of U.S.-made goods) threaten to curb both economic and job growth.

If the strength of the U.S. dollar persists, interest rates will remain low on both ends of the curve. Long-term rates are influenced by inflation expectations and pressure. A stronger dollar means it takes fewer dollars to buy goods and services. That is disinflationary (deflationary in the extreme). Since a strong dollar is disinflationary the Fed would likely keep short-term rates low in such a scenario as raising short-term rates would only exacerbate disinflationary pressures. Rising rates will be a long and drawn-out process which probably won't begin until the end of the year.

As one economist reminded me last month: "We must realize that the absolutes in this recovery will likely be lower than to what we have become accustomed." Peak growth is likely to be milder than observed during the last two bubbles. The unemployment rate is unlikely to see a 5 handle (maybe not even a 6 handle). Fed Funds will not have to be raised very high to manage inflation and growth (this would mean LIBOR rates remain relatively low). Inflation should remain under control thanks to a U.S. economy which is relatively better than those of its trading partners.Today the treasury announced that it is shrinking the size of next week's new debt issuance. The reduced supply should help keep rates in check.

The folks are rioting in Greece. Greeks are protesting austerity measures by demonstrating, rioting and even setting fire to a building in Athens. Austerity measures required of Greece to receive EU and IMF aid are being met with anger. This behavior is not going to play well among the citizens of nations who are doing the bailing out. Political backlash in these countries could jeopardize a Greek aid package. There is a growing sentiment around the street that a debt restructuring may lie down the road, even with the current rescue plan. Too big to fail may not prevail.

With rates at or bear historic lows and the prospects good for some degree of rising rates, investors are asking where on the curve they should invest. The knee-jerk response is to stay short. That could be a problem if the Fed raises rates gradually and not very high. However, overweighting the very long end of the curve in search of yield carries its own risk. The answer, in my opinion, is to ladder two-years to 10-years and to overweight the belly of the curve (5 to 7 years). Doing so should give investors an attractive average yield, permit investors to roll up with higher short-term rates should the Fed become aggressive and still earn high income from the 10-year area of the curve should rates remain tame. I would not venture out past 10-years at this time. This includes preferreds (fixed or floater).

Blood In The Markets

Blood In The Markets "Blood on the streets Runs a river of sadness. Blood in the streets, It's up to my thighs." ~ The Doors

www.mksense.blogspot.com Today there was blood in the markets. That is because that there was blood in the streets in the city of Athens, blood in the streets in the city of Lisbon. There may soon be blood in the streets in the city of Madrid. The bond vigilantes were put in force and the are seeing the Greece bailout measures for what they are, insufficient thus far. The concerns pervading the capital markets are that 1) Austerity measures may not be enough and debt restructuring may be necessary. 2) Greece may have to leave the Euro to devalue its way out of its troubles. 3) The contagion spreads beyond Greece to Portugal, Spain and to other European nations fracturing the confederation, rendering impotent as an economic bloc. Small investors have been expecting too big to fail to rule as it has since 2008 (unless you were Lehman or WaMu. Bond vigilantes think otherwise. The problems in Europe are severe. We are not talking about dubious assets with mark to myth valuations. We are talking about nations which are borderline (if not actually) insolvent. It is going to take more than restricting civil service pensions and benefits to pay for the kind of assistance Greece requires. Typically a nation, such as the U.S. can print money and issue debt to finance its deficits. The attractiveness of buying sovereign debt is that the issuing nation can usually make good on the return of your principal, albeit in a devalued state. EU members cannot issue currency on their own. They are like U.S. states without the cultural bonds and sense of common cause. The troubles in Greece have sent investors scurrying from the Euro into the dollar. This has sent both long-term U.S. interest rates and U.S. equity prices plummeting. Interest rates fell on strong demand for safe assets (obviously) and U.S. equities fell due to the strong dollar which affects price valuations and makes U.S. goods more expensive overseas, potentially damaging the manufacturing-led recovery. The question remains: Will this flight to safety push long-term rates even lower? Some experts, such as economists Goldman Sachs believe that the yield of the 10-year treasury is heading toward the low 3.00% area. The folks on Morgan Stanley's institutional department are of the opinion that the 10-year yield is heading into the mid 5.00% range by the end of this year. Although either scenario can play out, I don't think either will. For the Goldman scenario to play out, investors would have to become frightened to the point where they abandon foreign treasuries and credit products and plow money into U.S. treasuries. This is what has started recently, but with the U.S. also borrowing its way out of an economic hole (you didn't think the recovery was this strong on its own, did you?) so, other than central banks, their appetite for U.S. treasuries will have its limits. Gold could be the choice of non central bank investors looking for safety. Central bank and other investors needing safe income (pensions, insurance companies, etc.) will continue to purchase U.S. treasuries keeping yields in the mid to high 3,00% area for the foreseeable future. Even when it rises, mid to high 4.00% is about all we may see during this cycle. The Fed will see to that by removing stimulus and taking a modest tightening bias. It will only take a mild tightening to keep the economy from over heating. If the European contagion spreads, reigning in the economy will be the least of the Fed's problems. Those expecting TIPS and floaters to yield windfalls are likely to be disappointed. They should only be used as hedges to protect against higher inflation and a flatter yield curve, respectively and then only as a part of a laddered and diversified portfolio. Laddering 2-years to 10-years using a variety of products such as CDs, agencies and corporates, overweighting the belly of the curve, 5 to 7 years, may be the best way to approach the coming years. Tell your friends. I am looking for more subscribers.

Bank On It

Today we saw good economic numbers. Personal income and personal spending numbers were better, as expected. ISM Manufacturing was impressive. Auto sales were strong, although GM and Ford missed expectations. PCE indicates that inflation is in check. The equity markets shrugged off this weekend's attempted bombing in New York City and a massive oil spill in the Gulf of Mexico and gained over 143 points. Things are looking good. However, there is still an area of concern, lending.

Banks are not lending to small businesses and individuals as they had during the last expansion. Now they have these silly things call lending standards. Borrowers have to qualify for low rates or credit at all.

It is not all the banks. Businesses and consumers are deleveraging. The demand for credit is down significantly. The Wall Street Journal reports that many business owners do not want to return to the wild days of over-borrowing. This could moderate growth down the road, once the stimulus is scaled down and eventually removed.

This is not such a sophisticated concept. Stimulus removed should equal more moderate and sustainable levels of growth. Those levels will probably be more modest than to what many Americans have become accustomed. Another phenomenon to which many investors may not be expecting is the small amount of tightening necessary to manage the economy.

The Fed Funds rate may not have to be taken that high to reign in whatever inflation materializes. It is not like there will be much lending to curb. Higher rates would put pressure on public corporations, especially those with lower credit ratings. One hundred basis points of higher borrowing costs can be the difference between good and great earnings for investment grade companies and life and death for junk bond issuers.

I don't think we will see Fed Funds breach 3.50% during the coming tightening cycle (I think I am being generous in my forecast). This means that three-month LIBOR won't be much higher. Developing trends mean that floaters and TIPS should only be used as hedges and not as ways to outperform.

Guess Again

Think the problems surfacing about CDO and CDS structures are new revelations? Guess again. The following is what I wrote on May 20th, 2008:


I did a conference call with a branch office of a major investment firm. Again, the question came up asking when CDO prices recover, will firms take writeups. Many people mistakenly believe that CDOs are simply backed by subprime mortgages which will recover when the economy recovers. Not true.

Many (most) CDOs are backed, not just by mortgages, but by credit cards, auto loans, LBO loans, other CDOs and just about any piece of garbage that could have been squeezed into them. Some were "synthetic" CDOs backed by credit default swaps. These vehicles may eventually trade at better levels (some are not trading at all), but I have a better chance of becoming Queen of England than many CDOs have of trading at par or paying off to make investors whole.