A Taste of Honey

The following is an excerpt from our daily commentary. Subcrivers get this and much more: The economy is constantly evolving. Although there are some traits common to economies which have existed during the 236 years of U.S. history, there have also been great differences. “Things” don’t just happen. This is why we are critical of technical analysis over the long term. Although data and patterns can be used to great effect in the near term, once there are structural changes to the economy and secular changes to markets, technical analysis (without considering the context of the times) is much less useful. With this in mind, we believe that the FOMC will extend its guidance for extraordinary policy accommodation until, at least, 2015 and could announce open ended bond purchases (probably focused on MBS). The first actual Fed Funds rate hike might not come to a year or more after that. However, that assumes that domestic fiscal policies remain dysfunctional and global economic conditions remain impaired. Although this is our base case scenario, we are not so audacious to state with certainty that, economic conditions will remain impaired for the next three to five years. It is also not a certainty that the Fed will do anything more than jawbone today. We believe that the best way to position for the next several years is to ladder portfolios, focus investments on the five-year to seven-year area of the curve, but having an adequate portion of one’s portfolio in the in the two-year to four-year area of the curve, as well as on the 10-year to 15-year area of the curve. What percentage of one’s fixed income portfolio should be place on specific areas of the curve? That depends on investors’ goals, objectives and risk tolerance. We like the so-called belly of the curve (intermediate portion). We would tend to underweight the short end of the curve, overweight the intermediate portion and have moderate exposure out to 15 years, but this is gross generalization. Portfolios should be constructed to match investors’ needs. As we speak with market participants and investors, we pay close attention to their fears. Investors tend to fear inflation and rising rates. This is mostly due to concerns that the Fed will be slow to react to a strengthening economy or that Fed money printing will lead to devaluation-related inflation. However, market participants fear that the Fed will run out of options to fuel the liquidity-related strength in risk assets and to keep the economy above water before fiscal policy makers adjust policies to reflect new realities. We are in the market participants’ camp. We would be thrilled if the biggest problem we faced was repositioning portfolios to reflect strong growth and related inflation pressures. However, we believe that to be an unlikely scenario for the near future. We do not put much credence in a weak currency inflation scenario. The rest of the word is in the same boat. The worst thing for many export-driven economies is for their home currencies to weaken versus the dollar (listen to the noise emanating from Japan). They will do what they can to support the dollar. The U.S. dollar could exhibit some weakness in the near-term, but as with QE1 and QE2, the dollar will find support rather quickly. It is for this reason that we believe that Fed policies are creating trading opportunities, rather than investment opportunities, in risk assets, such as equities, high yield debt and metals. These trading opportunities may perform well for six months, a year, maybe longer, but we do not see the foundations for long-term secular bull markets in these asset classes. Even if the “Fiscal Cliff” is avoided, necessary spending cuts (and probably some tax increases) will place a drag on the economy. A shrinking labor force and less affluent retirees could result in less consumer spending than in the past. The U.S. economy will continue to evolve and adapt. This could feel painful at times, but it is a necessary process. As the Theory of Evolution teaches us; it is adapt or die. Follow us on LinkedIn by joiningg the Bond Squad group. It is open to everyone. Tom Byrne tom@bond-squad.com. www.bond-squad.com www.mksense.blogspot.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.

A Seariver Runs Dry

I cannot believe I failed to mention thiis, especially since I once made a market in this bond and my best friend and former bond partner reminded me last week. The much misunderstood Seariver Maritume 0.00% due 09/1/12 has matured. What makes this passing special was that it was one of three tax-deferred corporate "zero" in the markets. The beneficiary of an IRS loophole in the 1980s and grandfathered by the courts the former Exxon Shipping bond was misunderstood by many market participants and investors. As a tax-deferred bond, investors did not pay tax on accretion (phantom income) annually, as with traditiional corporate zeros. Instead, tax was paid on the entire accretion at maturity. This made it an oustanding bond for minors and retirement accounts. The only other tax-deferred zeros are the Ally (GMAC) Units (of $10,000) 0.00% due 12/1/12 and the Ally 0.00% due 6/15/15. Thanks to tax law changes, no such tax-deferred corproate bonds will be issued again. The Ally 0.00% of 6/15/15 are offered at a yield-to-worst in the neigborhood of 4.87%. Both Ally bonds are currently callable at their accreted value, but since the accreted value of the 15s is about 93.961, a call isn't likely. The main problem with these (besides being obligations of Ally) is that they trade rather infrequently.

Come a Little Bit Closer

Do you think that U.S. Consumers are near the end of the delebveraging process? Think again. We have been asked: How much deleveraging must U.S. households complete before the economy begins to pick up speed? We are of the opinion that U.S. household debt to income must go back, at least, to levels seen prior to the housing bubble, if not prior to the tech bubble. The following chart displays U.S. household debt as compiled by the Fed: U.S. Household Dept (SAAR) since 1980 (source: Bloomberg & Fed):

As you can see, just to get to levels seen prior to the housing bubble (2000 to 2004), debt would need to be slashed nearly in half. Either household debt falls to come more in line with incomes or income rise to service the debt. Even more telling is the chart which displays household disposable income after debt service: Federal Reserve US Financial Obligations Household Debt Service Ratio Total:

If we want to see the economy experience trend or above-trend growth, we need to get the Household debt service ratio in line with past periods of robust growth. Again, this can be done by shedding debt or increasing incomes. Neither appears to be happening at a rapid pace. To subscribe to Bond Squad go to: http://www.bond-squad.com/subscription.htm Tom Byrne tom@bond-squad.com. www.bond-squad.com www.mksense.blogspot.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.

Free Sample

We have decided to make this week's "In the Trenches" report available to everyone. In this week's edition, we discuss Jobs, the ECB, the Fed and we dig deep into a popular bond fund. We hope you find this as valuable as the hundreds of financial professionals and and investors who subscribe to Bond Squad. http://www.bond-squad.com/articles.htm

Where have all the workers gone?

Nonfarm Payrolls data indicate that the economy added 96,000 (seasonally-adjusted) jobs in August. This number threw Bond Squad and the street a curveball. The Street revised its forecast for job growth higher (to 130,000) following a better-than-expected ADP report. We front ran the Street by forecasting 130,000 jobs last week, due to strong July data. ADP often throws curveballs and we were not about to swing. However, the so-called “establishment survey” threw us a curveball when the BLS revised July data lower. July Nonfarm Payrolls were revised lower by 22,000 to 141,000 from an initial read of 163,000. Although we did not believe that the stronger economic data observed in July would be sustainable at this time, we did not believe we would see downward revisions. We also believed that there would be some spillover from the phenomenon of automotive factories remaining open in July. Auto sales were strong and we believed that hiring would creep higher in August. What has apparently occurred is that workers were not recalled in August because they were not laid off in July. This is seasonality wreaking havoc on the numbers. Seasonal adjustments account for layoffs in July and call backs in August. Neither has occurred this year. The result was good July data and a payback in August. Even though seasonality can cause volatility in the data, taking the average of the July and August data probably paints a good picture of job growth for the past two months. The resulting average Nonfarm Payrolls data for July and August is 118,500. Nearly every economist on the Street has stated that recent economic data is consistent with job growth in the low 100,000s. No Time to Wallow in the Mire The economy appears to be mired in the low-to-mid-100,000s. Nonfarm Payrolls has averaged 73,000 jobs per month since the recession ended in July 2009, but it has averaged 146,000 since December 2010 (the first full month after QE1). Goldman Sachs Chief Economist, Jan Hatzius, pointed out that Nonfarm Payrolls averaged 153,000 in 2011, but only 139,000 in 2012, thus far. What this comparison leaves out is that the average for the first eight months of 2011 yielded average job growth of 143,000, closer to this year’s average. Calendar year 2011 benefitted, not only from a spike in job growth at the beginning of the year (as did 2012), but a spike in hiring heading into the holiday season. Nonfarm Payrolls since January 2011 (Source: Bloomberg): Though not precisely correlated, the patterns of 2011 and 2012 are similar. Could we see a spike in hiring heading into this holiday season? It is possible, but gains in holiday hiring could be offset by a reduction or stagnation in the workforce among export driven companies. Due to a faltering global economy and the “Fiscal Cliff” fast approaching, companies' incentive to hire in the fourth-quarter of 2012 could be less than it was a year ago. Surrender, Surrender Today’s depressing data goes beyond the disappointing Nonfarm Payrolls data. It even goes beyond the 15,000 jobs lost in manufacturing (in spite of strong automotive industry data). The household data tells a troubling story. The headlines report that the Unemployment Rate declined from 8.3% (actually 8.25%) to 8.1% (actually 8.111%). However, the “household survey” reports that the decline came not from workers finding jobs, but from workers leaving the workforce. The size of the workforce contracted. The labor force participation rate fell to 63.5%, the lowest since 1981. The number of people in the labor force (Americans who are working or looking for work) fell by 368,000. To put this into perspective, the data indicates that more than three-times the number of people left the labor force than found jobs! Temporary workers declined by 5,000. Increased hiring of temporary workers is believed to indicate an improving job market. Ergo, a decline in the number of temporary workers does not bode well for job seekers. Why the big discrepancy between the BLS data and the ADP data? ADP measures job growth among companies for which it provides payrolls services. Among these companies are many retailers, restaurants and healthcare –related firms. The data from these sectors were fairly strong. According to the data; Retailers added 6,000 jobs, restaurants hired 28,000 workers, and the healthcare industry added nearly 17,000 jobs. Of these, only healthcare is likely to continue expanding at a robust pace. Other than in healthcare, jobs created do not appear to be what one might consider well-paying. That 80s Show Today’s data are filled with interesting tidbits. One is that, if the labor force was the same size as it was in the beginning of 2009, the unemployment rate would be over 11%. How about wage growth? What wage growth? On a month-over-month basis, wage growth was flat. On a year-over-year basis, wage growth maintained its pace of 1.7%. This is just keeping up with the pace of inflation. However, the rate of inflation (as per headline CPI) has declined during the past year from 3.8% in August 2011 to 1.4% in August 2012. Core inflation increased to 2.2% in August 2012 from 2.0% in August 2011. This indicates that a good portion of the increase in consumer spending might have been from lower food and energy prices. Average Weekly Hours for July was revised to 34.4 from 34.5. This figure was repeated in August. Not only is job growth problematic, those who have jobs are not seeing their hours increase. Typically, rising hours worked data is a precursor for increased hiring. Instead, they have trended slightly lower from a 2012 peak of 34.6 (during the warm winter). U.S. Labor Participation since 1980 (source: Bloomberg): Judging by the recent run-up in energy prices and the probable effects from the drought in the Mid-west, the consumer will experience what is, in effect, a tax increase heading into the all-important holiday season. Add to the equation a potentially harsh winter for the Northeast and winter 2012-2013 could be a drag on growth, just in time for the “Fiscal Cliff.” Déjà vu All Over Again Enough of crunching the data and opining on their causes, readers want to know what this means for Fed policy, interest rates and the fixed income markets. Today’s data dramatically increase the chances that the Fed does something at next week’s FOMC meeting (9/12-9/13). Whether or not it engages in asset purchases (and to what degree) remains to be seen. The markets have reacted to the increased probability of Fed intervention by sending Treasury yields lower and commodity prices higher. Usually easing, whether it is traditional or quantitative, results in rising long-term rates. After all, easing is designed to promote growth which generates inflation. However, the market is assuming that the Fed is incentivized with keeping long-term borrowing costs low. Helping that scenario along is that higher food and energy prices could put the brakes on consumption and core inflation. It seems that we have discussed this before. We do not believe that QE3 will do much to boost hiring. However, the Fed has a mandate of full employment (in addition to price stability). It will do whatever it can to add however many jobs QE can generate, as long as inflation remains under control. Those who do not like the Fed’s course of action should cease blaming the Fed and blame the fiscal policy makers who are really responsible for forcing the Fed’s hand. The prospect for low rates for an extended period of time should be good for high grade corporate bonds, high yield bonds, municipal bonds, preferreds and dividend paying equities. We would consider high grade corporate bonds, the upper-tier of high yield, municipal bonds and dividend paying equities as investment opportunities. The remaining asset classes may present trading opportunities, but investors tend to become complacent and overlook the true risk present in these volatile asset classes. In reality, high-risk assets remain high-risk assets. High-volatility assets remain high-volatility assets. We are temporarily in an environment which benefits these assets. When the world “normalizes” investors could be “whip-sawed” when the market reassesses risk in a more traditional fashion

Draghi Net

Word out of Europe is that the ECB will launch a “sterilized” bond buying scheme by purchasing short-term sovereign debt in the secondary market. “Sterilized” means that the ECB would absorb the money set loose in the markets from bond buying. It could accomplish this by borrowing the money back at a yet-to-be-determined interest rate. By going the sterilized route, the ECB could counteract the potential inflationary and currency-devaluating effects of monetary easing. What a minute, isn’t monetary policy supposed to add to the money supply? Isn’t some measure of currency devaluation desirable to boost exports, etc.? You can stop rubbing your eyes, ECB President, Mario Draghi, has not gone mad. He has a different objective than the pro-bailout speculators. The pro-bailout camp desires money printing, some currency devaluation and a continuation of the status quo on the periphery. Mr. Draghi simply wishes to keep the eurozone intact while structural reforms can be gradually implemented. This is clearly a rescue of the eurozone, rather than a growth stimulus program. Germany is exercising influence over the ECB as it has been the Germans who have expressed fears about inflation. Strings are attached to this bond buying. There will be criteria attached to the bond buying scheme. There will likely be memoranda of understanding and fiscal criteria for any country involved in the bond buying program. This includes asking for an official bailout and opening up its economic books. As of now, the only countries which would qualify for such bond buying are Greece, Portugal and Ireland. Spain and Italy have not asked for bailouts. The prospects for Italian and Spanish bond buying tomorrow (following the ECB meeting) are very slim. As such, the markets reacted and corrected back to pre-rumor levels. The days of money throwing are over. Strings will be (and should be) attached, if only because the Germans are the grownups in the room. Even if the ECB would rather broaden the scope of the bond buying program, unlimited bond buying is a difficult proposition. It is difficult because the ECB cannot print money. It has not ability to print euros. The printing of currency has to come via a unanimous agreement by eurozone members. We do not see the Germans agreeing to wanton money printing. Let’s Make a Deal What lies ahead for the eurozone? There are basically three scenarios: 1) The eurozone moves closer to the French/periphery economic model. 2) The eurozone moves closer to the German model. 3) The eurozone fragments. Our view is that, unless there are dramatic culture shifts, scenario number three seems the most likely outcome. Like a Surgeon Investors and speculators looking for a magic cure for Europe are likely to be disappointed. Sometimes the herbal cures don’t work and surgery is necessary. The only question is: Where will the cutting occur? Will it be sovereign governments restructuring their economies or cutting free of the eurozone. Tom subscribe to Bond Squad please got to: http://www.bond-squad.com/subscription.htm Tom Byrne tom@bond-squad.com. www.bond-squad.com www.mksense.blogspot.com 347-927-7823 Twitter: @Bond_Squad

Inflation Hedging? Oh Lord!

Last week, a subscriber (a very knowledgeable subscriber) asked us about the Lord Abbett Inflation Focused Fund. As a bond-oriented firm, we have not delved too deeply into funds. We understand how they work (maybe that is why we have not focused on them), but we understand that they do make sense for many investors. With this is mind, we gave the Lord Abbett Inflation Focused Fund a good going over. Our reader’s question centered on the use of inflation-related swaps (CPI swaps, if you will), along with various fixed income instruments to, as the fund’s mission statement proclaims: “The Fund's objective is to seek to outperform the Consumer Price Index over full economic cycles. The Fund invests in a portfolio of fixed-income securities and using a combination of inflation-indexed securities and inflation-linked derivatives to seek to maximize inflation-adjusted returns. “ After reading that, investors might expect to find a veritable cornucopia if inflation linked bonds, sitting there just waiting to reap the rewards of rising inflation. However, a quick look at the fund’s top holdings tells a different story. Top Holdings (MHD) Position % Net GP 8 ¼ 05/01/16 3.05k 1.080% JPM 3.45 03/01/16 1.95k .671% FHMS K019 A1 2.00k .662% FH 848738 1.86k .622% FH 848703 1.80k .592% FH 1Q1355 1.83k .581% DBUBS 2011-LC1A A1 1.52k .521% C 5 ½ 04/11/13 1.53k .511% FH 1Q1358 1.69k .507% HPQ 4 ½ 03/01/13 1.50k .499% There is not a single inflation-indexed bond among the top ten holdings. In fact, the only adjustable-rate securities are the four Freddie Mac MBS structures (all beginning with “FH.” The FHMS is a fixed-coupon MBS) and they float off of Libor, not CPI. If we dig down through the next 10 holdings, we find a similar story. One also might be excused for believing that the fund would have performed poorly as inflation fell during the past year, but the data says otherwise (see the following chart): Comparison of fund LIFFX and U.S. CPI YoY (Source: Bloomberg): Contrary to what investors might have believed, the fund performed fairly well, even as inflation declined. By now, some readers are probably scratching their heads, but the answer to this paradox can be found right in the fund’s mission statement, which says: “The Fund's objective is to seek to outperform the Consumer Price Index over full economic cycles.” Nowhere does the fund state that its goal is to provide long exposure to rising inflation. It merely states a goal of “outperforming CPI over full economic cycles.” During the past year, if one took a disinflationary or even a neutral inflation stance, one would have outperformed CPI! Although we cannot see in which derivatives, such as swaps the manager has invested (derivatives markets are very opaque), but judging by the performance of the fund, the manager has probably has engaged in an inflation-neutral strategy (a strategy we have advocated for several years). What if the environment changes and inflation begins to heat up? Although rampant inflation is not yet on the horizon, it could pose a threat someday. What would the manager do? When we look at the fund, most of the top holdings have short or intermediate maturities or average lives. The manager has positioned the fund so to be nimble should the inflation environment change. When income is desired, we nearly always choose a portfolio of bonds over a bond fund, if for nothing else but bonds having final maturities and predictable income streams, whereas funds do not. However, where speculation, total return and, as in the case of inflation, hedging is desired, a well-constructed and well managed fund can provide the diversification (many of the MBS structures in the fund would not be available to retail investors) and discipline most investors cannot obtain on their own. Discipline is a very important word in this discussion. All too often, when an investor asks his or her financial advisor for inflation protection, the investor believes that a position which benefits from rising inflation is needed. Most investors are not qualified to make inflation projections and could be misled by price certain price fluctuations in their daily lives which might not show up as an increase in the year-over-year change of the rate of inflation which is necessary for most CPI-linked bonds to outperform. A fund, such as this (one with which we have no connection whatsoever), can provide some inflation protection, with the discipline of trained professionals reducing the possibilities that one might be looking in the wrong direction, inflation wise. If you would like to discuss inflation, hedging or derivatives, drop us a line. Tom Byrne tom@bond-squad.com. www.bond-squad.com www.mksense.blogspot.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.