Rumors

My how the bond market reacted to the RUMOR that the ECB was going to cap interest rates. It rained on the very thin bond market when the ECB announced that there was no truth to the rumor. Rate caps and direct bond buying is unlikely to occur as long as Germany is opposed. Germany will continue to say "nein" until the periphery governments agree to conditions and reforms. Do not believe stories to the contrary. Much has been made of the damage to the German economy and the potential for higher interest rates should the eurozone fragment. The truth is that, if Germany has to support the periphery, its economy will be equally damaged and, as we have seen in recent weeks, its borrowing costs would probably rise. If Germany is going to experience pain either way, it might as well eliminate the source of the pain in the process. JPM is out with a new perpetual preferred. Price talk is in the 5.50% to 5.75% area. Will someone tell us why it is better than JPMprI? Please do not say: If the new preferred is called in five years you are better off. We will take the other side of that bet all day long. We would need to "out-Japan" Japan for that to happen. www.bond-squad.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.

Leading Indicators are Leading Us Where?

Leading Indicators were up 0.4% versus a Street consensus of 0.2% and a prior revised -0.4% (down from -0.3%). Headlines following the report decried that expansion is underway. Does not anyone look at the tables? The data components indicate that much of the cause for a positive reading of Leading Indicators was due to Stock Prices (0.10%), Interest Rate Spread (0.15%), Building Permits (0.18%)and Jobless Claims (0.18%). Readers are probably wondering: what is wrong with that? There is nothing wrong with having these positive components, but we do not believe that they tell the entire story. For one; higher stock prices only tell us that the demand for dividends and better earnings (until recently) have created investor demand. Building permits are encouraging, but they are centered at the upper end of the market and are centered on larger builders. New Home Construction also delays the price recovery of existing homes, keeping many home owners underwater. Jobless claims were juiced in July by a lack of seasonal auto plant closures. August data has seen more "normalized" figures in the mid-360,000 range. Although these are truly positive developments, they were nearly offset by some negative developments. For instance, the work week, which was up 0.7% in June was flat in July. If this persists, it would not be good for job creation. ISM New Orders were down .15%. Consumer Expectations and Economic Conditions was down 0.10%. The data indicates a modest recovery which is vulnerable to the fiscal cliff. It also indicates that, while the economy may not need QE3, it certainly cannot with stand the removal of policy accommodation. Notice how price of U.S. Treasuries are rallying today, in spite of the "good" leading indicators data? This is because of a few factors. 1) The numbers were better, but not fantastic. 2) The yields of long-dated Treasuries are reaching a point at which buyers might be attracted. 3) The prospects for QE in September have dimmed, somewhat. Remember, all easing, quantitative or traditional, is potentially inflationary and can put upward pressure on long-term interest rates (unless the Fed "twists" and buys long-dated securities to artificially hold down yields).' 4) It is the weekend. There is short covering underway. 5)Does anyone really believe that, with many market participants on the beach, this week's bond market action is truly indicative of broad market participant sentiment. Lastly, beware the Interest Rate Spread component of Leading Indicators. The component is reporting that the yield curve has steepened. Not good for curve-flattening strategies, such as some structured notes and Libor-floaters. Fear not, we believe that the curve will flatten, if only a bit, when market participants return in September. www.bond-squad.com 347-927-7823 Twitter: @Bond_Squad

Where do Rates Rate?

Ho-hum Jobless Claims data. Initial Claims were up 2,000 from to 366,000 from a prior revised 364,000 (up from 361,000). The Street had expected 365,000 new claims. Initial Claims appear to be settling in to a range of 360,000 to 370,000. This would indicate monthly job growth in the low 100,000s. Continuing Claims came in at 3,305,000. This was down from a prior revised 3,336,000 (up from 3,332,000). The Street forecast was for 3,300,000 Continuing Claims. This does not include 2.36 million people (down 63,900) receiving Emergency extended benefits. Housing Starts declined more than expected in July, coming in at -1.1% versus a Street consensus of -0.5%. This was not surprising as Building Permits had declined 3.1% in June. Building Permits are a proxy for future Housing Starts. July Building Permits increased 6.8% versus a Street consensus of 1.2%. This should translate to healthy August Housing Starts data. Encouraging was that of the 812,000 new building permits, 513,000 were for single-family homes. Recent earnings report indicate that large home builders have seen an increase in demand. However, demand appears to be the province of the large home builders, rather than broadly-based demand. Increased new home demand is a double-edged sword. On one hand, increased demand for new home sales usually results in job creation at the construction and supplier level. On the other hand, it combats overall real estate price recovery. This helps to keep consumers constrained and, in many cases, underwater in their current home. It appears that the economy continues to recover slowly and will continue to do so, unless policymakers undermine the recovery for political purposes. Improved economic data has some fixed income market participants thinking that QE3 is not the "sure thing" they once believed (we thought it was questionable all along). This is thought by some to be the cause of the recent spike of long-term Treasury yields. Although this may have been the genesis of higher long-term rates, the move has been exacerbated by thin markets and a reduced flight to safety from Europe as the continent is "on holiday." Do you doubt our analysis of rising rates? Consider that fact that German bunds (the other safe haven investment) have also seen a spike in yields. The 10-year bund has seen its yield rise from a recent low of 1.16% on 7/22/12 to a recent high of 1.56%. yesterday. Although some of the rise is due to concerns that a largely German-funded bailout of Spain would put upward pressure on German rates (it would likely do so as more debt without matching revenues often equals higher rates), the fact that rates began to Spike the last week of July and continued into August, when many Europeans are away from their posts is not a coincidence. We would not be surprised if the trend for rising rates stalls or reverses in September. The end of QE could mean the end of long-term asset purchases, but it could also mean the end of inflation-inducing monetary policy. Remember, long-term rates spiked at the times of QE1 and QE2. For information regarding Bond Squad subscriptions; go to: www.bond-squad.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.

Underinflation

CPI (2.1% YoY, 0.0% MoM)was milder than PPI (2.5% YoY, 0.3% MoM), indicating that Businesses are reluctant to pass higher costs onto consumers. This resumes a trend which has persisted for the past decade, having taken a hiatus as fuel prices fell during the past year. This could be a sign that businesses are seeking to grab market share. This makes sense to us as it has been large, dominant, players in various sectors of the economy which have reported the best earnings numbers. Home building has improved, but has been centered among the large homebuilders. Retailing has picked up, but it is the so-called "big box" stores which have reported the most impressive results. The demand pie is smaller so the bigger companies are using economies of scale to garner a bigger slice of the smaller pie. Foreign Purchases of U.S. Securities rose by only $16.7B versus a prior revised $121.3 billion. Purchases of Treasuries increased by $32.5 billion, but corporate bond purchases declined by $24 billion. Judging by rising treasury yields and tighter credit spreads, that trend may be reversing in August. However, August is a poor month to use to judge sea changes. Liquidity is usually poor in August and markets appear to be thinner than usual this August. Empire Manufacturing data indicate that manufacturing in the New York Region contracted in August, after rising a modestly-good 7.39 last month. Slow consumer demand during the first half of the year reduced the need for inventory replenishment. However, June Empire Manufacturing was 2.29 (not much inventory replacement there either). May was the month for inventory replacement with Empire Manufacturing coming in at 17.09. We also believe that the auto plant phenomenon also influenced the July report of 7.39 (pushing it higher than it might have been otherwise). Industrial Production and Capacity Utilization trended higher in July. Auto manufacturer activity influenced the data. Prices of U.S. Treasuries are higher on thin volume. The yield of the 10-year Treasury stands at 1.76%. If we get to 1.80%, sales and shorts could enter the markets. Even if that does not happen at 1.80%, it could happen when the market participants return in September (or following the Fed's Jackson Hole conference.) Meanwhile, credit spreads in the investment grade market and the upper-end of the high yield market continue to grind tighter. To subscribe or receive a free trial go to www.bond-squad.com

What Is Inflation? High Yield: We told you so!

• PPI was higher than expected on price increases for drugs, tobacco and vehicles. • Lower fuel prices are beginning to lift consumer spending. Are lower fuel prices inflationary? • JPM prices a new five-year note at +135 to the five-year Treasury. Spread tightening is in full swing. • Bloomberg reports that high yield investors and fund managers move up the quality and liquidity scale. Bond Squad suggested such a strategy many months ago. • Is Bond Squad really on vacation? Which data set tells the real inflation story, the headline data or the core data? Headline PPI indicates that inflation is a non-event. However, the core data indicate that inflation is beginning to heat up. The answer to the question of why there is a big discrepancy between the headline and core PPI readings lies in gasoline prices. On a year-over-year basis, gasoline prices are down 7.9%! The price decline in a good (commodity) which has a very inelastic demand curve has resulted in more free cash for with consumers can use to spend. We have argued that higher fuel prices can have a deflationary and sales-sapping effect on the overall economy. Other than the Fed and supply-side economists, we have had few advocates in our corner. For the past decade, the trend has been one of higher fuel prices. In spite of the fact that the higher headline inflation data clearly constrained consumers (requiring extraordinary Fed accommodation in 2003 to spark consumer spending, helping to inflate the housing bubble), many pundits held the belief that inflation is inflation and that the Fed should tighten regardless of from whence it comes. Simple theories for simple minds we guess. The evidence points to the fact that lower fuel prices (and lower prices of necessities with inelastic demand curves) can spark inflation in the broader economy as consumers begin to spend their newly-found surplus income in sectors of the economy which are far more influential on economic growth. However, for our theory to be proved correct, lower prices for goods with inelastic demand curve would need to translate into better retail sales data. Voila, retail sales increased last month as fuel prices fell. To be fair, fuel prices fell in May (-8.9% MoM) April (-1.7%) and March (-2.0%) while Retail Sales (ex-autos and gasoline) increase only in March, but consumers are cautious. During those months, the savings rate increased. Consumers finally began spending their surplus cash in July. The high yield bond game may be entering the fourth quarter. Bloomberg News is reporting that high yield fund managers are moving into more liquid high yield bonds. The article states: “High-yield fund managers investing a record $44.9 billion of deposits this year are selecting bonds they can sell more easily if investors start withdrawing the money. Even as the Standard & Poor’s 500 index returned 3.4 percent since the end of June, typically a benefit to the riskiest debt, the highest- rated junk bonds have outperformed the lowest-ranked by 0.4 percentage point, Bank of America Merrill Lynch index data show.” Barclays credit strategist, Michael Kessler, stated: “Investors are right to be nervous about holding less- liquid paper. What’s different now is that it’s happening during a pretty significant rally.” What today’s article states, Bond Squad has been saying for many months. This is yet another instance where Bond Squad subscribers have been ahead of the curve. If anyone would like a copy of the article, drop us a line. For complete reports and much more, subscribe to Bond Squad. The following packages are available: Subscribe for 1-year and receive "Making Sense" Full Access (daily e-newsletter and phone access to Tom directly during business hours of 8am EST- 4pm EST) at the discounted price of $250. If you prefer to receive the Reports Only (with no access to Tom directly), the rate is just $150 per year. www.bond-squad.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.

Bond Squad Makes Sense

We have re-started our blog. This was Bicycle Repairman's (a friend of Bond Squad and knower of all things fixed income) fixed income blog for years. This blog will give Bond Squad Subscribers and potential clients an opportunity to interact with Bond Squad and the greater fixed income community. Although we are on vacation this week, we would like to post a few items. Preferreds: CNBC's Jim Cramer says that the performance of preferreds, especially Dutch preferreds is good indicators of market sentiment. Sorry Jim, preferreds are among the worst indicators. They are primarily retail products and purchased without a good understanding of their risks (primarily duration risk). Many retail investors buy them believing that they will be called in five years (or at their first call dates). That happened during the three decades of rate declines (corporations were able to refinance at lower rates), but those days are gone. This should be painfully obvious!!! Preferreds will do "ok" as long as long-term rates remain low. Move the 10-year yield up 200 basis points and watch preferreds lose a few points of their price. Bond Funds: Investors have been plowing money into bond funds. Much of this has been due to their performance since 2009. What many investors may not realize is that bond funds have outperformed largely because of Fed policies low rates, tighter spreads, etc.)This reminds us when we were young traders and the Fed was easing. It seemed that every day, we would simply profit by marking to market. We would adjust our hedges accordingly and simply rake in the cash. The next year, when the Fed was tightening, we discovered that we had to work for a living. Investors could find themselves "working for a living" in a few years. Those who have laddered their portfolios will probably just need to roll maturing assets. Where on the curve they should invest will depend on rates, spreads and the shape of the yield curve. Bond Squad can help. Sprint: We have long been fans of Sprint bonds. With the fastest network in the industry and management which is now focusing on shedding dead (or nearly dead) businesses, Sprint is an interesting company which could find itself as an acquirer or acquiree. Smith Barney: SB we hardly knew you! Next month, Morgan Stanley will permanently retire the Smith Barney name. This is an inglorious end to an iconic Wall Street name. We enjoyed our time as part of the Smith Barney family. Smith Barney Financial Advisors were among the best trained, most knowledgeable and client-oriented professionals on the retail side of the business. We will not let the traditions of Smith Barney fade away. We will carry on the ethics and focus on customer service which was hallmarks of Smith Barney. We consider ourselves to be a little slice of SB in a Mad, Mad, Mad, Mad World. We will post from time to time during our vacation week. If the response from the field is favorable, we will continue to post snippets. However, Bond Squad subscribers will continue to get in-depth coverage. The blog is good, but it is no substitute for the real thing.

Up and Running

Our dream is now a reality. The Bond Squad website is up and running. After more than a decade of composing an internal use only market commentary and strategy report, “Making Sense,” for a large financial institution, the Bond Squad is now offering its knowledge and market insights to the public. At its peak, Making Sense had more than 9,000 readers. If 9,000 financial professionals found “Making Sense” and the talents of the Bond Squad valuable, you probably will as well.









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Our first edition will be published on Tuesday January 3rd, 2012.











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