Market Update 12 14 10 _ Let's blow of the FOMC statement

Let’s blow off the Fed today

The short story from the Fed is this…“nothing has changed.”  Fed Funds will stay where it is and they continue to see the rate staying “exceptionally low for an extended period.”  They will also continue the QE2 program as originally announced.  By all rights today’s Fed statement should have sparked a rally in the Treasury market.  Ironically…the market sold off a bit more.

There is nothing new in today’s statement…it basically provides a short list of modest positives and then offsets each of them with a longer list of significant negatives.  See if you can find something in the following statements from today’s release that gets you fired up on the economy:

-          “…recovery is continuing, though at a rate that has been insufficient to bring down unemployment”

-          “household spending increasing at moderate pace, but remains constrained by high unemployment, modest income growth, lower housing wealth, and tight credit.”  This one might be my favorite part of the statement…it’s like someone saying you’re kind of nice, but ugly, boring, short tempered and vain at the same time.  This is not glowing praise for the economy.

-          “business spending on equipment and software rising, though less rapidly than earlier in the year.”

-          “Long term inflation expectations remain stable but measures of underlying inflation have continued to trend downward.”

This is a pretty dim report on the economy that offers no light at the end of the tunnel.

The Fed has two jobs: maximize employment and keep inflation in check.  They are nowhere close to achieving either of those goals currently.  As they look ahead they don’t see that they will be close to those goals anytime soon. 

Going forward the Fed will keep rates at zero and they will continue the QE2 purchase program.

Frustration ahead for the Fed

So far the Fed has gotten nothing they wanted from the QE2 program.  We are at a point where the Fed sees the economy still in a bad spot…but they now have borrowing costs rising.  This will undoubtedly be viewed by the Fed as a threat that will choke off what little headway the recovery has.  To their end they’ve said they will continue the QE2 program…but given the results they’ve had so far with QE2 it wouldn’t surprise me to see them try to pull another rabbit out of their hat.  I have no idea what it might be…but I know they can’t be watching borrowing costs rising without wringing their collective hands.   

If you have any questions on this material just let me know.

 

Market Update _ 12 9 10 _ Whoa Nelly

Whoa Nelly!

I was watching cartoons with my kids the other day…OK…they were actually watching them with ME but the point is still the same.  There is an old Loony Tunes episode where Yosemite Sam is riding a camel through the desert chasing Bugs Bunny.  The camel is running at full speed when Yosemite Sam pulls back on the reigns and yells “Whoa!”  The camel completely ignores the command and continues charging across the sands.  Again our lovable loser yanks on the reigns and shouts even louder “I said WHOA!”  Still he runs.  Ultimately, he takes out a rifle and clobbers the camel hard over the head, knocking him unconscious and dropping him to the ground as he screams “when I saaaay Whoa…I meeeeean WHOA!!!”  This episode reminds me of how the Fed must be feeling today.

They’ve taken a lot of steps to keep rates low, yet the market is charging to the upside.  I envision a scenario in the not too distant future where Bernanke breaks out some serious QE2 funds, clobbers the market on the head, and screams screams “when I saaay low…I meeeean LOW!”

Frustrating at best

I can only imagine the frustration at the Bernanke household.  He has been working diligently to solve some very serious problems and he’s spending hundreds of billions of dollars and taking criticism from every corner of the world in the process.  Ben probably comes home at night, doesn’t say a word to anyone through dinner, sulks on the couch watching sports center until everyone else falls asleep, then he gets online and starts making angry posts in economic forums in support of QE2.  It’s got to be a tough existence right about now.

What’s up with the selloff?

Most of the ideas being offered for this week’s pullback revolve around the general theme of increased expectations for future economic growth. 

I don’t agree that it’s the sole (or even predominant) explanation for this week’s activity.  If you were selling Treasuries to position yourself for an economic expansion you’d be moving into things that would directly benefit from the expansion…stocks and commodities.  To date that hasn’t happened.  The Dow is basically unchanged from the 11/4/10 announcement of QE2 and from the recent announcement of the new tax initiatives.  Additionally, commodities as measured by the Bloomberg Commodities Composite curve are also unchanged over the same time periods.

Dow Jones on:

11/4/10 - 11,434

12/6/10 – 11,362

12/10/10 – 11,349

This doesn’t have the look of a market being fueled by investors betting on an economic recovery.

Bloomberg Commodities Index:

11/4/10 – 1,534

12/6/10 – 1,530

12/9/10 - 1,537

Commodities also unchanged over this period. 

So where is the money going?  It would seem that it’s being parked in cash for the time being…and cash isn’t where you go if you want to bet on a comeback.

Potential sources for this week’s volatility include but are not limited to:

-          Speculation that tax initiatives will boost the economy

-          European worries continue to reverberate through Treasury market

-          Bond Vigilantes punishing Fed and Congress for poor policy decisions

-          Portfolio Duration rebalancing

-          Unwinding of the deflation trade by various parties

-          Year end liquidity concerns

-          People taking gains before they disappear

There is no shortage of potential sources of explanation…whether this pullback lasts is another story.

Who would have thought you could make money by shorting the Treasury right after the Unemployment Rate jumped from 9.60% to 9.80%?

Despite the pullback in prices and the higher yields they’ve brought us…the underlying economic data are still fairly poor.  The Fed is still looking at 9.80% unemployment and inflation running at a lower level than they’d like.  The Fed is just starting to spend their QE2 money, they’ve got a lot left to spend, and they are already talking openly about increasing the size of the program if necessary.

It would seem that we have some potential for a street brawl between the bond vigilantes and the Fed.  Every time I think this market is getting boring it comes up with something new.

Unemployment Benefits…or the benefits of being unemployed

One of the benefits of my job is that I get to speak with a lot of people who are “on the front lines” so to speak.  Bankers are in the heart of every community in this country and they have a very good idea of how the local economy is doing. 

This morning I was having a conversation with an old banker friend of mine and he gave me some remarkable insight on the unemployment situation.  I’ll preface this story by saying that when I look at the size of the average unemployment check…$302 per week…I see an incentive to not be unemployed.  In my mind I can’t picture a person who would want to live on the government dime rather than make their own way.  I figure most people will try to get off of the unemployment rolls as quickly as possible, get back to work, and take command of their own destiny.  That’s my perspective because that’s how I think…it’s how I view the world…it’s how everyone reading this e-mail views the world.

My friend on the other hand has some very direct experience with this unemployment program that we have in place.  He told me several stories but the best might be of his friend that runs a manufacturing plant.  This guy needs to expand his production schedule because he just got some new contracts.  Keep in mind he resides in a county that carries the highest rate of unemployment in his state…there are literally people sitting around everywhere with nothing to do.  So he needs to add a bunch of jobs that pay nearly $20/hr.  He warns everyone to get to the plant early because these jobs are going to go quickly.  Several weeks later he still doesn’t have the positions filled.  In the words of Jerry Seinfeld…WHAT is the DEAL with THAT?

Apparently the people that came and looked at the jobs didn’t like the hours.  They’d rather get paid by the government to not work 24 hours a day than to get $20/hr to work when they are needed.

You can imagine how frustrated this guy is every night when he goes home…he’s surrounded by unemployed people and he can’t fill the jobs he needs to grow his business.  So he goes home one night and his neighbor yells over to him to come have a beer.  Great…he could use one.  He walks over to the neighbor’s house and the neighbor tells him to check out his new lawn tractor.  Our man’s jaw hits the floor.  The neighbor has been on unemployment for 80 weeks.  This guy can’t fill jobs at the factory…and the unemployed guy is buying new lawn tractors.  He feels sick…he no longer wants a beer…he goes home.

While I certainly understand the good that unemployment insurance can do…some of the examples you see in practice point out that there is a lot of room for improvement in this program.  It would seem that with adequate oversight we might be able to make this a much more productive…and less expensive program. 

If you have any questions or if there is anything I can be doing for you just let me know.

Regards,

Steve Scaramastro, SVP

800-311-0707

 

Market Update 12 1 10 _ Employment figures

 

The ADP Employment data this morning is putting the market in an optimistic mood.  The ADP Employment Report is derived from a database of 500,000 US businesses that employ roughly 24 million people across all 19 of the major NAICS (North American Industrial Classifications).  Each month they survey 365,000 of these businesses to determine how many jobs they’ve added.  This month the Bloomberg Survey expected the ADP Employment Change to show that 70k jobs were added when in fact it came in at 93k jobs.  Additionally the prior month level was revised upward from 43K to 82K. 

 

Stock futures are up on the data and the 10-year is trading off.  The 10-year Treasury is currently off almost a point to trade at a 2.90% yield.  Tomorrow we have Initial Jobless Claims and Continuing Claims...these are generally bigger market movers than the ADP figure so if they disappoint we should see this 2.90% level on the 10-year drop. 

 

Last month we saw that 407k people filed for Initial Jobless Claims.  This month the forecast is for 424K to get in that line.  Continuing Claims last month stood at 4.182 million…the estimate for this month is slightly higher at 4.2 million.  A word of caution is needed here…as jobless benefits expire for millions of people going forward the Continuing Claims figures will become less reliable as an indicator of the state of the employment market. 

 

Some interesting figures on Unemployment

 

Estimates from the Labor Department are that without another extension roughly 2 million people will lose benefits by the end of December.  The average unemployment benefit check in the US is currently $302.90 per week.  Multiply that by the 2 million people losing benefits this month and you’re looking at $618 million that won’t be fed into the economy each week through this program ($2.5 billion per month).  It’s also interesting to note that if you annualize the average unemployment check it puts you right about at the Federal Poverty Line if you have 2 people in your family.   

 

That’s all the data for today.  If you have any questions or if there is anything I can be doing for you just let me know.

 

Steve Scaramastro, SVP

800-311-0707  

Market Update 11 30 10 _ The Fed defends QE2

We’ve heard from a number of Fed officials over the last few weeks.  Three that stand out for the color they provide are the statements from Bernanke, Pianalto, and Kocherlakota.

 

Pianalto describes why she voted the way she did on QE2.  Her speech was given in the aftermath of a blistering round of criticism levied against the Fed for their QE2 plans.  Kocherlakota provides some insight into the “communication value” of QE2 and what it is really telling us.  Finally, Bernanke gives a broad overview of where the economy is currently, and then spends a significant amount of time taking academic shots at other countries.

 

Pianalto

 

She begins by providing the standard boiler-plate that everyone gives at the start of a big picture economic address…we avoided the next great depression…financial collapse…world-wide apocalypse…cats sleeping with dogs…yada yada yada. 

 

Any time you read a statement from a Fed member it’s important to keep in mind that they have the dual mandate of full employment and price stability.  That’s academic talk for keep everyone employed and don’t let prices get out of hand.  Now let’s move on to the important stuff. 

 

She voted for QE2 over her concern about our “uncomfortably low” rate of inflation and the high rate of unemployment.  She notes that over 15 million Americans are unemployed.  In October the economy added 150,000 jobs...this number forms the basis for an interesting point.  In normal times we have 150,000 NEW workers entering the job market each month (as people graduate from high school or college and look for jobs).  So to maintain a given level of unemployment you need to add at least that many jobs on a monthly basis.  The October number is barely enough to get those people to work…much less to start making any progress at putting the other 15 million back to work. This gives some shape to the number of jobs we will have to start posting on a monthly basis to start making a dent in the unemployment rate.  Whatever the number is…it will have to be way higher than 150,000.

 

Cyclical or Structural?

 

Another fact that the Fed wrestles with is the nature of our unemployment.  Cyclical unemployment is your run of the mill stuff…people lose jobs, they are out of work for some period of time and then they go back to work in roughly the same capacity. 

 

Structural unemployment is far more sinister.  This is where the job goes away and it doesn’t come back.  Workers stay unemployed for a much longer time period and ultimately many of them will take jobs for which they have no skills.  This leads to lower productivity, lower pay, and a lower standard of living.  If you multiply this phenomenon across millions of workers you can begin to grasp the magnitude of the problem.

 

Is our unemployment problem cyclical or structural?  Pianalto says that their studies at the Cleveland Fed show that our current situation (while very worrisome) is still a cyclical problem. 

 

While the good news is that we have a cyclical problem vs. the more sinister structural problem, the fact remains that the longer the unemployment rate stays elevated the worse the potential damage is to the economy.  With regard to the Unemployment Rate she doesn’t expect it “to fall below 8.00% before 2013.”  That is an important figure…the Cleveland Fed President…a voting member…expects the unemployment rate to remain above 8.00% for at least two more years.  In my view forecasting the unemployment rate two years from now is like Ray Charles shooting skeet…good luck getting anywhere close to the target.  The fact that her best guess is “it won’t be below 8.00% before 2013” is kind of scary. 

 

With the unemployment piece out of the way let’s move on to her thoughts on inflation.  The Fed’s comfort level on inflation is 2.00%.  As a rule of thumb if inflation is higher than 2.00% they will tighten monetary policy, if it is below 2.00% they will loosen monetary policy.  What could be easier?  They could do that and be having hot wings by noon.

 

When considering inflation, Pianalto prefers to use “core” measures rather than CPI as she believes they provide a truer picture than CPI alone.  Her measures show inflation falling to levels that are unacceptable.  An example she gives is from the October CPI data.  When they drilled down into the data they found that 40% of the items in the basket witnessed price declines while only 12% saw increases of more than 3%. 

 

Inflation expectations are another important consideration.  The most recent analytics from the Cleveland Fed showed that inflation expectations remain “below 1.50% for 10 years and below 2.00% as far as the eye can see”.  Given that their preferred range is 2.00% you start to see why she voted for QE2.  Keep these figures in mind as you formulate your own expectations for how long Fed Funds will remain at zero.  A voting member that uses Fed Funds to influence inflation trends is saying that without QE2 she was seeing at least 10-years of no-reason-to-raise-rates.

 

She points out that while she doesn’t expect outright deflation, she understands that our current scenario of high unemployment and very low inflation are risk factors for deflation.  Additionally she’d be happy to see positive surprises…but there is very little room for any negative surprises in the data.  For these reasons she voted in support of QE2.

 

It is also important to point out that most Fed members seem to support the idea that QE2 will have a modest impact at best…but the alternative is bad enough that it’s not worth the risk of inaction.  Additionally I pick up a rock solid belief from almost every Fed speech I read that they believe they will have no problem at all in pulling back the various stimulus measures if inflation becomes an issue.  They simply have no doubt about their ability to fight inflation if and when the need should arise.

 

In summarizing Pianalto’s views on QE2 I’d have to say it feels like a Hail Mary pass…it’s not something you throw when you’re ahead.  You’ve got little to lose and something to gain so why not throw it?  She saw 10-years of below target inflation (i.e. no reason to raise fed funds) without QE2…so we can reasonably expect that with QE2 she expects inflation to pick up sometime before 10 years…at the same time she expects QE2 results to be modest and unemployment to remain above 8% through 2013.  This doesn’t paint a picture of someone that expects to raise fed funds in the next few years. 

 

And now a more difficult name to pronounce than my own

 

Minneapolis Fed President Narayana Kocherlakota also spoke recently.  He will become a voting member in 2011 and he provided his thoughts on QE2 as well. 

 

Kocherlakota provides us with a target inflation range of 1.50% to 2.50%.  He uses PCE  (personal consumption expenditures) as his benchmark for inflation.  Over the first three quarters of 2010 this measure has averaged “roughly 1.00% at an annualized rate…and is drifting downward.”  Over the prior two years this measure averaged 1.6%.  So this inflation measure is also at the low end of their acceptable range and is moving lower. 

 

Two other factors Kocherlakota points out are that over the last 5 quarters since we “recovered” from the recession the Unemployment Rate has risen slightly; and that GDP has run at only 3.00% and is falling…averaging only 2.00% over the last two quarters.  Some recovery, huh?

 

So he essentially echoes’s the same sentiments as Pianalto: high unemployment, and alarmingly low inflation are on his mind.

 

Actions speak louder than words

 

Over this business cycle the Fed has told us that one way they can manage market expectations is through communication.  Kocherlakota tells us that QE2 can be viewed as a non-verbal communication.  What is it that we should take away from this non-verbal message from the Fed?  Let’s hear it straight from the horse’s mouth:

 

“The November FOMC statement says that the committee will keep the fed funds target range exceptionally low for as long as conditions warrant.  The statement also predicts that exceptionally low fed funds rates are likely to be warranted for an “extended period” of time.  In this way the statement provides explicit communication about the FOMC’s future plans for short-term rates and also shapes the level of current longer-term interest rates. 

 

QE provides a significant supplement to this explicit verbal communication.  The use of QE indicates that the FOMC is likely to keep its target interest rate lower for an even longer period of time.  Indeed, one could readily argue that buying $600 billion of Treasuries is a much more convincing form of communication of the FOMC’s plans than any words could ever be.”

 

Sparking runaway inflation?

 

Kocherlakota addresses criticism that QE2 will spark a wildfire of inflation.  There are two parts to his argument that QE2 won’t serve as “kindling” for a future inflation fire. 

 

First, his basic premise is that there are already over $1 Trillion in excess bank reserves sitting on balance sheets currently…and those trillion dollars have not sparked runaway inflation because they aren’t being lent out.  So his question for the inflation folks is: how will another $600 billion of un-lent excess reserves do something that the first trillion didn’t do?

 

Secondly he points out that the Fed has the tools to fight inflation and that they have the political will to fight it as well.  There is no doubt in his mind that they can and will contain inflation if it starts getting out of hand.

 

He also states that he expects any results of QE2 to be modest.

 

Bernanke is last at bat

 

Chairman Bernanke also spoke…a lot.  Much of his speaking was directed at the differences between established and emerging market economies.  Things like exchange rates and international capital flows dominated much of his discussion.  One could boil this section down to “emerging market countries that blame U.S. monetary policy for their problems need to realize that their problems are their own big-fat-fault because they won’t allow their currencies to float like everybody else does.  If they’d drop or alter their export led growth models things would be better for everyone”.  I’ve taken some liberties there but I think my synopsis conveys the underlying tone of the argument, and I think it is far more interesting to read than the original as well. 

 

The statements he made on the domestic situation run parallel to those made by Pianalto and Kocherlakota.  I could summarize Bernanke’s position by saying the unemployment situation is unacceptable, monetary policy can do only so much but we have to do everything we can within this framework to support the economy, the Fed has the ability to drain the swamp of liquidity when they need to, and that someone needs to balance the budget or this is all for naught. 

 

With regard to his global view one could probably sum it up with the old argument that Americans need to save more and spend less and the Chinese need to save less and spend more.

 

In the end

 

Ultimately the Fed came out of their corner defending their QE2 votes.  They clearly view QE2 as a necessary project that will provide marginal improvement to the economy.  This is done to stave off the potential negatives associated with a further deterioration of the economic data…notably higher unemployment and low inflation.  You wrap all of this up with assurances that the Fed absolutely can and will put the brakes on inflation when it comes back and you get a big expensive program that everyone agrees will have marginal results at best.  What’s not to love? 

 

If you have any questions on this material just let me know.

 

Steve Scaramastro, SVP

800-311-0707

 

Market Update 11 17 10 _ QE2 and the Law of Gross Tonnage

Last week I was fishing on Pickwick Lake.  This is one of several river-lakes that exist on the Tennessee River system and it provides power through its TVA hydro-electric dam, tens of thousands of acres of recreational areas, and important shipping lanes for commerce.

Night had fallen, I was still fishing, and I didn’t have a care in the world.  This is the kind of place that makes you understand how Huck Finn must have felt…it’s just you and the river and nothing else.  At one point I heard some commotion around the bend…it sounded like guys loading a boat on one of the islands in the middle of the river.  A few minutes later it started getting bright, as if the sun itself were about to come around the corner.  Soon enough a very large tugboat rounded the bend pushing 3 immense barges.  This thing was humongous.  I imagine this thing ran several hundred feet end-to-end.  It was B-I-G.

In maritime navigation there is an unwritten rule known as “the law of gross tonnage”.  This rule states that even though you may have the right of way…you don’t want to push the issue with a much larger craft.  As the captain of an 18 foot aluminum hull bass boat I’m acutely aware of which side of the “law of gross tonnage” I fall on in this situation.  If big bertha needs room in the shipping channel then she’s gettin’ it…because I stand no chance of living if I get in her way.  Ultimately this behemoth crawls past me and moves down the river into the night with its two huge spotlights looking out like giant eyes and lighting up the channel a mile ahead.

I make a mental note to stay alert for these things and then I get back to fishing.  A short time later I decide to depart.  I dial up the coordinates for my truck on the GPS, point the boat south, and head down river enjoying the cool air and the stars above.  As I navigate back toward my launch site I come upon the beast again.  It is taking up much of the shipping channel and I consider passing it to save time.  A quick review of the situation yields a long list of things that can go wrong by passing this beast in the dark and a very short list of positives.   They likely can’t see me on radar or by sight and the channel is very narrow so I could run aground or get crushed.  Ultimately I figure better safe than sorry so I hang back a few hundred yards and I’ll just float along behind them until I get where I need to go.

Not long after I settle in at what I deem to be an appropriate following distance I notice some very strange activity.  The boat is acting very squirrely.  The stern is just shifting back and forth and vibrating and the entire boat just feels…shaky.  I’m only doing 5 MPH and there is no wake being put out by this barge…but something is definitely not right.  It took a moment but eventually I realized that I was in the “wheel wash” of the giant barge ahead of me.  The propellers on these boats move so much water that they create a huge swath of turbulence behind them.  As it turns out this is a very dangerous place to be.

Days later I sit at my desk, looking at my Bloomberg and I watch the market deal with the “wheel wash” put out by the Fed.  Like the Tugboat on the river the Fed is the big force in the market right now, they are pushing a huge load of money into Treasuries and their actions will create a significant amount of turbulence along the way.  The last three days of trading have been turbulent to say the least.  We’ve seen the 10-year Treasury trade from a low of 2.60% on 11/12/10 to a high of 2.96% on 11/16/10 to the current 2.82%. 

What should we expect?

The Fed is just beginning on their QE2 journey.  They are pushing a barge filled with $900 billion dollars into this market and they will be leaving lower rates in their wake.  To date they’ve only invested $28 billion.  While Treasury yields have popped up recently I don’t expect that trend to hold up in the wake of QE2.  I continue to view pullbacks as buying opportunities.  I think there will be some opportunity to take advantage of the turbulence as the Fed proceeds.

The headlines are littered with complaints about this program…from foreign leaders to economists it is difficult to find anyone outside of the Fed who is a big fan of it.  I don’t expect those complaints to change the course of this ship.  Almost as if it were in response to the criticism we’ve had several Fed members come out this week and speak in support of QE2.  Just today Bernanke spoke to the Senate Banking Committee and he said that QE2 could create 700,000 jobs over the next two years.  They see this is a very beneficial program on a number of levels.  I wouldn’t hold my breath waiting for the Fed to come out, admit this was all a big mistake, and cancel the spending. 

What’s on the horizon?

This morning we had CPI numbers that lend credence to the Feds argument that disinflation is still a problem.  Every measure of CPI came out lower than the survey estimates.  Tomorrow we get Initial Jobless Claims, Continuing Claims, Philly Fed Index, and next week is full of data. 

The Fed will be buying bonds each day this week.  They have roughly $105 billion to put to work this month and to date they’ve only spent $28 billion.  The next FOMC meeting is on 12/14/10.

What are banks doing?

Activity lately has been brisk with a lot of money being put to work in lower coupon MBS.  This week we saw a lot of 15 yr 3.00% MBS with par handles on them.  This type of structure has a very large fan base.

Additionally we are seeing a continued trend of banks taking gains prior to year end.

If you have any questions or if there is anything else I can be doing for you just let me know.

Steve Scaramastro, SVP

800-311-0707

 

Market Update 11 4 10 _ The day after QE2

Traction

Well…it took a day but the market is smellin’ what Bernanke is cookin’.  After yesterday’s FOMC announcement that QE2 was a “go”…the market pulled back a bit.  The 30 year bond had obvious reason to sell off…it will receive no material price support from QE2.  The short end of the curve however will see the bulk of the Feds dollars.  In my view the most interesting thing to happen yesterday was that the 10-year Treasury traded off immediately after the announcement.  It didn’t make much sense and I wrote yesterday that I wouldn’t count on it staying above 2.60% for long.  Mortgages are priced off the 10-year Treasury, and a refi wave is a significant part of the Feds plans, so you know they aren’t going to let the 10-year yield remain elevated.

This morning it appears that yesterday’s FOMC announcement has been fully digested by the market.  The 10-year Treasury is up over ¾’s of a point in price to trade at 2.48%.  It’s difficult to see rates going any higher in the face of the Fed spending $850 to $900 Billion in Treasuries over the next 8 months.  On the upside…for those who were upset that China was the single largest holder of US Treasury debt…rest easy…the Fed will have the title by the end of QE2.  Some really quick math shows they will own roughly $1.2 Trillion in Treasuries by that point…China only has around $800 Billion.  

What’s gonna happen?

There are several pieces of this puzzle at work.  The first impact is that the Fed drives the Treasury curve lower.  Most products that banks invest in are spread to the Treasury curve.  If spreads don’t change and the Treasury curve drops then you will have lower yielding investment options.  We all get that. 

If spreads widen as the curve drops then the downshift in yields will be less pronounced.  Spreads are not likely to widen however as one of the goals of this QE2 program is to make Treasury yields so low that it pushes people out of this sector and into other asset classes.   When investors get to the next market with decent spreads they will squeeze it until the juice runs out…then they will move to the next one and do the same.

The future that the Fed sees is one where spreads on all types of risky assets get tighter…yields will drop on everything as money flees low yielding Treasuries and moves into the next best level.  Agency, MBS, and Corporate bond yields will drop, stock prices will rise, people will feel rich because their holdings have increased in value and while they won’t become the spenders they used to be…they will at least move in that direction.

This leg of the QE2 strategy is to re-inflate asset prices which will usher in the “wealth effect” and get people to spend more.  The wealth effect just means that if you “feel” rich you’ll “act” rich.  For the record I’m not saying I agree with this plan of action…I’m just saying that’s what their plan is…I don’t want anyone trying to kill the messenger here.

The second impact is the Fed’s desire to ignite a refi wave.  This has been an elusive goal from the outset.  It’s important to them, and they are determined to get this done.  If people can refi they will have extra spending money…plain and simple.  Not everyone can refi…but those that can…will.  Driving the 10-year Treasury lower and keeping it low is an important piece of this plan.

We are already seeing increasing prepay activity.  The refi index has more than doubled since May. 

Here is an important point that you probably haven’t heard anyone mention.  While the Refi index will not likely return to the highs we saw back in 2003…it doesn’t have to get that high to wreak havoc.   

In 2003 the mortgage market was very efficient.  Hundreds of mortgage companies were pushing lots of new products that helped virtually anyone refinance.  The refi index surged to 10,000 (recent lows have been in the 1,800 range).  300+ mortgage companies are now out of business, you actually need income to get a loan, borrowers are underwater, and it’s more difficult to refinance now.  So it’s unlikely that we will see another 10,000 print on the refi index…but we don’t need to.

MBS are now trading at much higher premiums than we saw during 2003 so you don’t need speeds to come in as fast to do as much damage.  A lower speed can now cause a lot of damage because many investors are carrying MBS on the books at prices far higher than we saw in 2003. 

Now what?

Where does this leave bank investment portfolios?  It leaves us in a place where the Fed is committed to holding the overnight rate at zero, and just as committed to driving the 1 to 10 year portion of the curve lower as well. 

If you were in the camp that thought the Fed would be raising rates next year it looks like you need to pack up the tent and move.  QE2 won’t even be completed until 2Q 2011.  It’s difficult to see how they’d be raising rates immediately after QE2 expires…and this assumes that they don’t extend it like they did QE1.  To give you an idea of where some of the bigger players see this going, Goldman Sachs predicts that the Fed won’t raise rates until 2015.  It’s officially one day since the announcement of QE2 and the headlines are already appearing about QE3…this market doesn’t appear to have a lot of confidence that QE2 is going to be the fix to all of our woes.

Random notes on investments

MBS

If you are a buyer of MBS we continue to push structure as the primary consideration.  With premiums where they are we continue to prefer the lowest premium we can find, and/or the best structures we can get (those that minimize both the incentive to refi and the risk of negative yields).  Choices are admittedly limited, but as rates drop we will be seeing more low coupon MBS come to market at lower prices which should help.

The landscape is currently littered with bonds that have negative yields under prepay scenarios that aren’t far off current levels.  We have a report that can show your book yield under the 1, 3, and 6 month historical CPR speeds, AS WELL AS the Bloomberg Prepay Model shock scenarios.  If you own any MBS at higher premiums you will want to see this report.  If you were pursuing a strategy of buying high premium MBS because they wouldn’t prepay then you definitely want to see this report. 

If you’d like me to run this report for you just shoot me a copy of your most recent bond accounting report (including your book price).  If you send this in electronic format (excel or PDF) it should be less than 24 hour turn-around time on the report.

AGY

The Agency market continues to see a huge amount of step-up structures.  Step-ups remain a popular way to pick up yield in the Agency market. 

Shorter final Agency paper is-what-it-is…yields are low and getting lower.  This morning a new issue 3 yr non-call 3 month came at 0.80%.  In some cases (as recently as this morning) we can find very low premium CMO’s that beat short agency callables under almost all rate scenarios. 

Muni

Muni’s continue to do well as a wide swath of this curve still offers spreads of +100 to Treasuries.

SBA

For those that want yield 20 year Fixed Rate SBA bonds continue to sell briskly.  These offer a full faith and credit (zero risk weight) investment with an average life anywhere from 5 to 10 years and yields north of 3.00%.  These trade with larger premiums (105 to 112) but historically they’ve paid slowly.

Floating Rate SBA’s are at the other end of the spectrum.  If you are concerned about rising rates/inflation then you can get a full faith and credit piece that floats quarterly off of Libor with no cap.  Structures vary.

That’s all folks

That’s it for now.  The market is rallying, yields are going lower, and stocks are moving higher.  If you have money to spend I would spend it sooner rather than later.  If you think these yields are ugly just wait until you see them after the Fed has spent another Trillion dollars on Treasuries. 

If you have any questions or if there is anything I can do for you just let me know.

Steve Scaramastro, SVP

800-311-0707 

 

The short story on the FOMC statement

 

The Fed announced that they will buy a total of $850 to $900 Billion worth of Treasury securities through the end of the 2^nd quarter of 2011.

 

$600 Billion of this will be new money…the remainder is the reinvestment of portfolio cash flows.

 

They will distribute their purchases per the following schedule (from the FRB NY website):

 

 

 

Market activity thus far has been interesting.  The long end of the Treasury curve is left out in the cold…they won’t be buying much there at all.  As you might expect the long end has sold off a good bit.  I looked at the 30-year just before the announcement and it was up almost a point.  Since the announcement it has given up that amount…and then fallen another point and a half to trade at 4.03%.  The market knows that the long end will receive no support so there is no point in being there.

 

The short end of the curve (the 1 to 10 year range) is also undergoing some interesting changes.  The 10-year Treasury actually pulled back (down in price, up in yield) after the announcement.  Prior to the announcement it was trading at a 2.53% and it is now at a 2.60%.  I’m not sure what is driving the pullback…there is a LOT of noise in this market.  The Fed is clearly on a mission to drive rates lower so it would seem that any pullback to higher rates in here will be short lived.

 

Time will tell…but the Fed has shown their cards.  They are betting on lower rates, they are willing to spend a LOT of money to it done, and they can print as much money as they need to stay in the game.

 

If you have any questions or if there is anything I can be doing for you just let me know.

 

Steve Scaramastro, SVP

800-311-0707

Market Update 10 26 10 _ Remember the Good ol' Days?

The good ol’ days?

Remember the good ol’ days?  I’m not talking about the 1950’s (I wasn’t around back then but given how long the show Happy Days was on the air I assume they were some good years)…I’m talking about mid-2008 when a gallon of gas and the 10-year Treasury were both at 3.92.

That was a time when the biggest complaint I heard was “OMG I’m paying soooo much for gas.”  Times were simpler then.  Fed Funds was at 2.00% and the FOMC was worried about inflation.  Bernanke and Co. hadn’t started manipulating the Treasury, Agency, and MBS markets yet.  Bonds were being called but we could reinvest in MBS at spreads anywhere from +180 to +250 over Treasuries (at a time when Treasury yields still reflected investor sentiment).

Fast forward 2 years.  It’s late 2010 and we are nowhere near the end of the troubled road we travel.  The Fed has cut the overnight rate to zero.  Treasury yields along with Agency and MBS spreads have all been forced artificially low by the Feds actions, and many at the Fed are pushing for an even larger balance sheet expansion to support the recovery and depress yield levels even further.

The yardstick we’ve been given by New York Fed President Dudley is that the Fed can achieve an “equivalent” Fed Funds Rate reduction of 50 to 75 basis points by purchasing $500 Billion worth of Treasury bonds.  Remember when $100 Billion was a big number?  That’s a Rodney Dangerfield number now-a-days…it gets no respect.  The first big number we saw was when Bernanke and Paulson got together in late 2008 and came up with a plan to spend $200 Billion to support the GSE’s…it was a staggering sum at the time…now that seems to be the minimum increment for “fixing” things.

Where are we now?

We are eight days away from the next FOMC meeting.  We are also seven days away from mid-term elections.  Both of these events are casting a long shadow over the markets right now.  

It is widely expected that the Fed will announce a new round of Quantitative Easing at its next meeting.  I personally think it’s a terrible idea that will prove to be long on costs and short on benefits but to date nobody from the Fed has called for my opinion…so you have to hear it instead.  We’ll know in a few days which direction they’ll decide to go.

It is also widely expected that there will be a big shift in the political balance of power.  Almost everyone I speak with is praying for gridlock on Capitol Hill.  Everyone knows that neither party has the magical answer to the problems we face.  It looks like the business community is just hoping for an environment where neither party has enough power to do anything stupid or more expensive than what has been done to date.

What is everyone doing?

I get this question a lot.  With rates at their current levels everyone is looking for ideas.  The trading activity lately can be broken down into a few groups.

The first group is taking gains.  As we head into the 4^th quarter a lot of banks have some holes to plug and they are using gains in the portfolio to bridge the gap.  Whether you are trying to offset loan losses or just bump earnings for the year there are a number of swaps that will work.  The most common swap is selling higher coupon MBS with large gains and reinvesting in longer final muni’s or Agencies. 

The next group of is looking for yield.  This group has been buying 10 and 15 year step ups with 2.50% to 3.00% front-end coupons and have big enough steps that if the bond does go to maturity then they can live with the yield.

The floating rate group is concerned about rising rates and has been buying 5 to 7 year corporate fixed-to-float type structures and Agency Hybrid ARMs.

The Full Faith and Credit Group.  This is the group that wants zero risk-weighted securities and the vehicles of choice in this arena are SBA fixed and floating rate securities, GNMA MBS (both fixed and hybrid ARM structures), and USDA guaranteed loans.  There are other full faith and credit options such as Treasury bonds and FDIC insured corporate paper but the yields on those products are low enough that they don’t have a big following among bank investors.

 Why would anyone extend in this environment?

You might be asking “why would anyone extend in this environment?”  It’s a valid question.  In a world where we only buy one or two bonds I can see how one might question the wisdom of purchasing a long final maturity in this environment.  The reality though is that we buy and own portfolios of bonds…not just one or two.  It’s how this portfolio of bonds acts in concert with each other that dictates how well it performs over time. 

A very short portfolio will do very well if rates rise quickly and it will do poorly if rates remain steady or drop.

A very long portfolio will do very well if rates drop or if they remain constant, and it will do poorly if rates rise.

A balanced portfolio will perform relatively well in all rate scenarios.  If rates remain steady or drop, the longer bonds in the portfolio will deliver the yield (and gains) you need for earnings.  If rates rise, your longer bonds will be at lower rates and have losses but the short end of your portfolio will all be able to re-price upward and take advantage of current rates.  The balanced portfolio tends to outperform other portfolios over time.

What we’ve seen over the last two years is a large migration to very short portfolios.  As rates dropped and bonds were called many portfolios shifted toward shorter durations.  It was an easy thing to do for a while.  Everything the government was doing seemed inflationary, and reinvestment options on the short end were still acceptable.  Now however, we’re not seeing any inflation and rates are exceptionally low…this is a much more complicated environment.

Portfolios with durations of 1.5 years or less are essentially laying on a very defensive bet that rates will rise in the very near future.  While it’s possible that they could rise, there are many indications that rates will remain low for quite a bit longer. 

The first and perhaps strongest indication is that the Fed itself is still maintaining its pledge to keep rates “exceptionally low for an extended period of time”.  Furthermore they are aggressively talking up the idea of forcing rates even lower than their current levels via another round of Quantitative Easing (Treasury purchases). 

Extremely short or long durations are basically big bets on the direction of rates.  Big bets on interest rates are generally not something that community banks do.  Historically the high performing institutions maintain a balanced portfolio across interest rate environments.

A more balanced approach is what we tend to gravitate toward.  Given the extraordinary duration compression in most portfolios over the last two years you can view the purchase of longer final bonds not as extension…but as more of a rebalancing of portfolio duration.   If you historically run a portfolio duration of 3 to 5 years, but you are currently at 1.5 then you may have some room to pick up yield by returning your portfolio duration to your target range without taking undue risk.

That’s all great Steve…but you’re not the one in the hot seat

Having said all of that I also understand that I don’t have to answer to, or explain anything to shareholders, a board of directors, or regulators.  These people may not understand (or care) about portfolio management.  When rates rise many of these people will look at only one thing…the “unrealized loss” column on a bond-by-bond basis…and they will ask “what were you thinking buying this bond right here?”  They won’t care how much better off they were during those low rate years because of your efforts to maintain a properly balanced fixed income portfolio that generated a higher risk adjusted return than your peers.  All they will care about is the one number they can understand…the unrealized loss column.

I know that there are times when no amount of reason, logic, or well articulated explanation will be satisfactory for some of these folks.  I understand that there are times when you can win the battle but lose the war.  So ultimately I understand than many people would like to maintain a balanced portfolio, but the pain of having to explain things at a later date outweighs the benefits associated with taking such actions today. 

In closing

If you have any questions on strategies that work in this environment, whether it’s a swap to take gains or a rebalancing of portfolio duration, just let me know.  If you shoot me a copy of your current portfolio I can run analytics and bring ideas that might work for you.

Steve Scaramastro, SVP

800-311-0707

 

Market Update 10 5 10 _ The Fed, Quantitative Easing, and your future

The big issue looming over the market currently is Quantitative Easing.  We have a number of very influential Fed members speaking publicly in support of more QE.  The more Fed speeches I read the less I doubt that they will do it.  The Fed maintains that they are data dependent...and the data continue to point toward weakness.  This morning we got more data and these numbers would support those Fed members in favor of another round of QE. 

The ADP Employment Change figure was expected to post a positive 20k reading…the release was actually -39k.  The market is rallying strongly on this data.  The 10-year Treasury is trading up ¾’s of a point to trade at 2.38%.  This is what it looks like when the market begins to price in more QE.  If everyone knows that the Fed will be in the market buying Treasuries over the next year then market participants will want to take positions before the Fed starts putting money to work.  The market buys now while rates are high rather than waiting until after the Fed throws $500 billion to $1 trillion into the market and squashes yield levels.  Yep…you read that right…I said “while rates are high”.    The next FOMC meeting is on 11/3/10.  It is widely anticipated that they will announce the next round of QE at that meeting. 

If the Fed starts another round of QE they aren’t going to push rates down just for a month or two and just by 10 bps or so…this will be a longer term deal.  Will it be a year?  Two years?  It’s impossible to tell how long they will keep rates low…but we know it’s not going to be a short period of time.  We’re three years into this business cycle, Fed Funds is at zero percent, the Fed says it’s going to stay there for a long time, and they are about to embark on another massive round of quantitative easing.  Again I think of the economist in Japan and when it was that they realized that they were in a “lost decade”?

Where will yields be after QE?

Bank of America recently changed their forecast for the 10-year Treasury based specifically on a scenario of another round of QE.  Based on this expectation they’ve lowered their forecast on the 10-year Treasury…for 1Q 2011…to 2.00%. 

That is a remarkable forecast.  Keep in mind that at the height of the crisis…during the economy’s darkest hours…the 10-year Treasury only hit a low of 2.08%.  Now B-of-A says the next round of QE will push the 10-year yield even lower than that.  It’s difficult to get your head around that number…but it provides a glimpse into what the near to mid-term future could look like under a new Quantitative Easing program.

What to do?

It looks like the stars are aligning for another round of QE.  If you expect this to happen, and if you anticipate having to put any money to work over the next quarter or two (or four for that matter)…you may want to consider buying bonds right now rather than waiting and doing it after the steamroller has come through.  As low as investment yields look right now…they will be a whole lot lower after the next round of Treasury purchases by the Fed. 

It’s really a question of “do they” or “don’t they”.  If they do embark on another round of QE then rates are going lower…no doubt about it...the entire goal of QE is to drive rates into the dirt.  If they don’t do the QE then we’ll likely see rates stay in the range we’ve been in over the last 6 months or so. 

Given the current landscape there appears to be very little downside to accelerating your bond purchases.  It sounds crazy doesn’t it?  I can hear many of you shouting at the computer right now “why in the world would I load up at these levels?”  The answer is because the levels we have today are going to look great after the Fed starts buying more Treasury bonds, and in six months time you’ll probably be staring at this screen asking yourself “why didn’t I buy back then?”  Rather than wait until the 10-year is trading near or under 2.00% why not put that money to work now and lock in the extra yield?

At best you get in at much higher rates than will be available after the Fed starts the next round of QE.  Your worst case is limited because the economy still stinks and nobody is talking about raising rates any time soon.

You have some upside to purchasing before the next round of QE, and little downside if you buy and they don’t do it.  It’s essentially buying out of self-defense. 

If you have any questions or if there is anything I can be doing for you just let me know.

Steve Scaramastro, SVP

800-311-0707

 

Market Update 10 4 10 _ Quantitative Easing and the Karate Kid

Quantitative Easing and the Karate Kid

I got home Friday evening shortly before the wife picked up the kids from Karate.  After a few minutes I heard the garage door open, and I knew the kids would be excited to tell me all about their first day so I went to meet them.  My seven year old daughter got out of momma’s car wearing a karate uniform, flip-flops, and a pony tail.  It was quite a sight.  With all the interest of an adoring parent I walked over and asked her how her first karate lesson went.  She responded immediately by launching her tiny seven year old fist directly into my mid-section with Bruce-Lee-like-ferocity.  After a brief discussion about not using your new karate powers on people that aren’t attacking you I congratulated her on the well executed strike.

As I pondered the incident later it began to remind me of the Feds Quantitative Easing program.  What good is acquiring a new tool (karate or quantitative easing for that matter) if you don’t intend to use it?  The Fed hasn’t brought up the topic of Quantitative Easing because they don’t intend to execute it.  In an era that history will record as one with unusual clarity in Fed communications, they have brought the QE topic center stage. 

A few weeks ago we had St. Louis Fed President Bullard come out and discuss how a new round of QE should look.  Specifically he stated that in his mind any new Quantitative Easing would be done through the purchase of Treasury securities rather than via more Agency purchases.  He also said that he would expect a degree of flexibility in the program that would allow the Fed to buy at any point on the Treasury curve that they deemed appropriate.  A few days later the FOMC announced that they would be using their MBS cash flows to purchase longer dated Treasury securities. 

The announcement to purchase Treasuries with MBS cash flows was as much an indicator of a sentiment shift inside the Fed as it was about the direction of Treasury yields.  A rough calculation showed that they may have $200 billion per year in MBS cash flows to play with.  In and of itself this isn’t expected to cause a huge shift in yields.  However…the fact that they felt this was even necessary was the biggest news as it opened the door for further action.

Now that they’ve cracked the ice by using MBS cash flows to fund Treasury purchases, let’s look at the prospect for additional purchases.  Its speech time at the Fed.  Now is the time when the voting members go on the road, talk to various groups around the country and use these platforms to tell us what’s on their mind.  This is essentially a window into the next FOMC meeting.  With that in mind let’s look at the latest speech from the New York Fed President…William Dudley.

Dudley speaks

On October 1^st, 2010 Dudley spoke to the Society of American Business Editors and Writers at their Fall Conference.  Sounds like a real hum-dinger doesn’t it? 

Dudley begins his remarks by acknowledging that this recovery has been very tepid.  He also reminds us that the dual mandate of the Fed is to maintain full employment and price stability.  Everything the Fed says and does needs to be measured against this set of goals.  Given the current set of conditions Dudley views the current levels of inflation and employment, along with their expected timelines for improvement to be “wholly unsatisfactory”.  He goes on to state that it looks to be “several years before employment and inflation return to levels consistent with the Federal Reserve’s dual mandate.”

A portion of the speech is the kind of canned recap of the financial crisis that we are all used to reading.  In this speech it is used to lay the groundwork to get to this conclusion: The recovery has lost steam and hit a soft patch…soft patches in the recovery process tend to occur…but this soft patch is more worrisome than others.  The first difference between this soft patch and others is that it is longer in duration.   The second difference (and one that concerns them greatly) is that it is occurring at a time when the overnight rate is already at zero percent.  From both a monetary and fiscal policy perspective they have done everything they can to get a fire going under this economy…but so far all they’ve gotten is a little smoke…and even that is fading.

Next he touches on some familiar topics like the lack of household savings and how the housing market and cheap credit provided the ammo for consumers to fuel their spending binge.  Basically he says that it took a while for this problem to build up, and now that it has crashed it will take a considerable time to recover.  He sees some favorable trends in the household sector and to ensure that they continue “the economic environment needs to become more supportive”.  Notice that he didn’t say “stay” supportive…he said “needs to become more” supportive.  This is not a sit and wait attitude…the only way you can read that is that more action must be taken. 

What can they do?

The way Dudley sees it there are two things that the Fed can do to help this process move along.  First is that they can communicate better about what they are trying to do and how they will do it.  Second is that they can increase the level of monetary stimulus through their balance sheet. 

On the first point (communication) he states that by clearly expressing their intent to return inflation levels toward the Feds preferred range they can help anchor inflation expectations.  This in turn should reduce the probability of further disinflation or (and he mentions the really scary scenario here)…the debt deflation spiral.  If you would like to review the Debt Deflation Spiral you can pull out the Market Update piece I wrote on 12/18/08.  If you don’t have it just let me know and I can shoot you a copy.

The Fed has been placing a heavy emphasis on their need for clear communication of their intent…this is a huge sign to those of us in the market that we need to be listening to what they are saying in these types of speeches.  They will be broadcasting their intent frequently and in more concise terms than many of us are used to hearing from Fed officials.  Gone is the era of “Greenspan speak” where Fed officials spoke in vague circular references with the apparent intent of befuddling anyone who heard them.  This Bernanke led Federal Reserve understands the importance of communication and will be uncharacteristically transparent in their statements.  Our most recent example might be this speech by Dudley as he lays his thoughts on more quantitative easing.

How much will they buy?

The plot thickens with this speech as Dudley provides us a yardstick for measuring the effect of more QE but doesn’t give us a hint as to how much he’d like to see.  By his estimates a $500 billion purchase of Treasury debt would provide the equivalent of a reduction in the Fed Funds rate of one-half to three-quarters of a point.  He cautions that this relationship depends on the market’s perception of how long the Fed will hold these securities.

From here you can use this yardstick to scale the potential magnitude of their purchases.  If they are in the news saying they think an additional 50 bps of easing would be warranted then you know they are looking at around $500 billion in purchases.  If 100 to 125 bps seems to be  preferred, then it’s on the order of $1 Trillion in purchases.  Now that we have this yardstick we can put it together with other speeches to get a gauge of what might be coming. 

Why lower rates?

You might be asking yourself “why lower rates”?  Money is already cheap enough…people that don’t qualify for a 5% loan won’t magically qualify for a 4% loan.  Much of the reasoning goes back to the goal that has proved most elusive for both the Fed and the politicians…a refi wave.

They have talked about generating refi activity from day one of this crisis.  Consumer spending drives 2/3’s of GDP…it is a high priority item.  The consumer has been reeling; he has been rocked in all quarters of his life.  His job is in jeopardy, his home is in jeopardy, his 401k has been crushed, and his very lifestyle is in danger.  He has been deleveraging out of self defense and he just doesn’t have the discretionary income to spend right now. 

What does all of this have to do with lowering rates?  If they can ignite a refi wave then they can get an extra few-hundred dollars per month into the pockets of millions of consumers.  Whether they spend it immediately or use it to accelerate the liquidation of existing debt it will help speed our time to recovery.

Below is a list of positives that Dudley lists for lowering interest rates via another round of QE:

-          Support the value of assets

-          Make housing more affordable

-          Support consumption by enabling households to refi

-          Facilitate debt restructurings that allow negative equity borrowers to refi

-          Reduce the cost of capital for businesses

It comes down to this

The bottom line:  absolute levels of unemployment and inflation, along with the time frame over which they are expected to improve are unacceptable.  The longer this situation exists the more exposed we are to another shock.  Right now the economy is in the ditch...if we stay here long enough then the next “shock” could bury us. 

It’s a bit like the kid on the playground that walks in front of the swing-set and gets wrecked.  You cringe watching it but then you realize that things are in danger of getting much worse because as he’s trying to square himself away and get back up…here comes the swing again.  Dudley would really like us to not be hit twice by the swing and he views Quantitative Easing as the tool to shield us from that blow.

Dudley concludes with this statement: “Thus, I conclude that further action is likely to be warranted unless the economic outlook evolves in a way that makes me more confident that we will see better outcomes for both employment and inflation before too long.”

So there you have it…if there isn’t an immediate and robust reversal in the data then Dudley is going to vote for another round of QE.  How much will it be?  Who knows…but the yardstick he laid out is measured in $500 billion increments.

If you have any questions on this material or if there is anything I can be doing for you just let me know.

Steve Scaramastro, SVP

800-311-0707

 

Market Update 9 20 10 _ Night fishing, Policy, and Unintended Consequences

Night fishing, policy makers, and the law of unintended consequences

This weekend I took the family to the lake.  This was a new lake for me, I’d heard a lot about it and now I was ready to enjoy it.  Fishing was my primary goal…I was going to fish until I couldn’t make one more cast.  I’d go out three or four times each day.  The last trip of the day was always the most peaceful, it was made after the kids were down for the night and the lake was empty and dark.  I’d slip away from the dock around 10 PM and I’d just go find a place to fish, kill the motor, and enjoy the absolute solitude of fishing under the stars.

This time of year the nights are getting cool so there really aren’t many bugs to contend with.  Pickwick Lake is a deep and picturesque river-lake that is surrounded by the high forested hills and rocky cliff faces of Tennessee, Mississippi, and Alabama.  I stood on the casting deck of my boat alone in the cool night air, bathed in the light of a full moon, gently bobbing on the smooth blue-black surface of this deep lake, and I was in awe of the stars set against the crest line of the hills that surrounded me.  Cast after cast I made toward the bank.  My goal of relaxing was slowly but surely materializing.  Each cast washed away a bit of stress...I was no longer thinking about work, the house, the yard, the FDIC, the Fed, nothing.  About the time I was hitting my rhythm with the casts I noticed something out of the corner of my eye in the silvery moon-lit darkness to my right.  I looked over and it was a BAT coming straight at my face!

Well it seems that the aforementioned “lack of bugs” this time of year that I find so pleasing is a sign that other things are happening as well. Each time I cast I take a small lure on the end of my line and I whip it behind me and then launch it through the air as far as I can.  I then retrieve it and do this all over again.  To me it’s a fun and relaxing thing.  To a bat that isn’t getting enough to eat it looks a whole lot like an easy meal…and this chow bell was ringing loud and often.

 That bat dive-bombed my head until I quit fishing.  I had to put the pole down and go somewhere else.  I don’t know that it takes a lot in the way of explaining to relay to you how un-nerving it is to have a huge bat dive-bombing your face at midnight…under a full moon…when you’re out in the middle of nowhere.  I don’t mind bats in general…I spend a lot of time outdoors and they don’t bother me in the slightest.  However…this was the first time I’ve had a huge bat dive so close to my head that I could hear his wings beating the air in rapid fire style.  Up until that point I’d never considered how fast their wings move…let me tell you it’s quick.  This might be one of those few times when it’s a good thing that there is nobody around for miles to hear you scream as I have an image to uphold.

My perfect plan for relaxation ran smack into the law of unintended consequences.  My casting lures at night signaled to the bat that there was food near my head…big easy to catch food and it wasn’t leaving until it got some. 

Monetary and fiscal policy in uncharted waters

This morning I was reliving my trip and I realized that there are some similarities between night fishing on a new lake and conducting monetary and fiscal policy in this environment.  Night fishing a new lake is a difficult proposition.  You are in unfamiliar waters, you can’t see any of the navigation aids, you can’t see the shore, nor any hazards that may lie in front of you, you are almost blind…so you have to slow down and do things in a more cautious manner.  Even then…when you know you need to exercise more caution things can still go wrong…and they may not be the things that were on your list of potential problems. 

My list of concerns for fishing were short but serious and included other boats running without navigation lights, an unforeseen obstacle in the dark water, and being unable to see the shoreline as I approach to cast.  It was a short but manageable list and I had a plan to deal with each of these.  The unintended consequence that I simply did not anticipate was that my lure would show up to echo-locating bats as a big fat juicy meal at a time when such things were lacking.  Despite all of my planning and risk management steps my own actions ultimately caused the majority of my problems. 

Those conducting monetary and fiscal policy are night fishing right now.  The economy is in uncharted waters, there are plenty of hazards to worry about, policy makers have to move cautiously, and the actions they take will carry consequences to places beyond the immediately obvious.

There is no shortage of problems to contend with in our current lackluster economy; high unemployment, a terrible housing market, a highly leveraged consumer, state governments beginning to run into trouble, GSE’s that are still bleeding money, and the list goes on.  Many of these problems do not have easy solutions.  We’ve spent a lot of money thus far trying to fix these problems…but to date we’ve not seen much progress.  Thus is the nature of the beast in a massive deleveraging process. The consumer has spent years worth of future earnings…now they have to try to pay it back in a time when their income is declining or disappearing.  This will take some time to right itself. 

In the absence of consumer spending (which has historically been 2/3’s of GDP) we get a more inefficient replacement in the form of government spending.  There has been no shortage of this type of spending.  This money has been thrown far and wide in an effort to stimulate the economy.  We’ve had the first time home buyers program (twice), the cash for clunkers program, several extensions of unemployment benefits…you name it…we’ve spent it. 

As I see the government casting money out this-way-and-that, I can’t help but wonder…where is the bat?  Where is the unintended consequence of our actions?  I could come up with a whole list of potential issues...but in the end the problem may come out of nowhere as suddenly as my echo-locating friend on the lake.  Until then I guess we’ll keep casting.

 

FW: Market Update 9 2 10 _ What do a coal miner and the economy have in common?

I was reading the news about the Chilean miners that are trapped 2,500 feet below the surface of the earth and I realized that there is a corollary for our economy in the making here.  There are tremendous difficulties associated with their rescue and many had written them off for dead at the outset.  Now however, there appears to be some hope.  They can communicate with the men, they can get food down to them, and eventually they should be able to drill a hole large enough to rescue them from their dire predicament.  It’s going to take a long time, a lot of money, and a great deal of emotional and physical difficulty but it’s possible for them to come out of this alive.  That is truly great news and they’ll probably all get big movie contracts after they get rescued.  I figure if Hollywood can make a movie with nothing more for a story than Tom Hanks, a raft, and a volley-ball then this miner story should be a slam dunk.  

There is one man in the bunch though that serves as an interesting corollary to our economic predicament.  Yonni Barrios is one of the men who is stuck underground in Chile.  By all reported measures he is a hero to his teammates as he has delivered first aid, provided flu shots and more importantly provided leadership in a time of great uncertainty.  Much like the economy Yonni’s future looked to have some dark times coming as he was buried 2,500 feet below the surface a few weeks ago.  As the world rallied around them, and great steps were taken to effect their rescue the clouds hovering over their future lightened in color and the worst of the threats seemed to pass.  The future of these miners is heading toward a very happy ending at this point…except for Yonni’s.

Yonni’s problem (much like the problems our economy faces) is that while he might escape the worst potential outcome…he still has some very serious problems to deal with once he gets passed the immediate threat.  You see…Yonni’s problem is that while he was trapped under the earth fighting for his life…his wife bumped into his girlfriend at a vigil being held half a mile above him.  Yep…I’ll let that sink in for a minute.  Picture the scene…a candle light vigil in the barren wind-swept foothills on a cool Chilean evening…a very somber yet hopeful energy fills the air.  His wife was calling his name aloud…and then she heard someone else calling his name aloud…they sought each other out and I can only imagine how the conversation unfolded from there.  If it were my wife I imagine they’d have to restrain her to keep her from plugging the air hole they had drilled for me.

I don’t know if anyone has alerted Yonni to what awaits him on the surface when they get him out in December…maybe they avoided the topic to keep his spirits up…but he runs the real (and ironic) risk of rescuers pulling him up from 2,500 feet only to have his wife put him back 6 feet under when he gets there.

The FOMC, the economy, and Yonni’s girlfriend

The Fed has been dealing with a situation that is conceptually similar to Yonni’s.  The economy appears to be headed in a direction with fewer dark clouds hanging over it…but there remain significant obstacles to getting things back to normal.

The FOMC minutes showed that while the Fed believes we’re not faced with the threat of imminent deflation or inflation there remain significant obstacles as we move forward.  Unemployment, housing, and consumer spending are essentially like Yonni’s girlfriend…they represent significant obstacles to things getting back to “normal”.  So while we might have avoided the worst of the danger we’re far from being out of the woods (or copper mine for that matter).

Initial Jobless Claims were released this morning at 472,000 vs. a 475,000 expectation…very much in line.  Continuing Claims achieved similar results posting 4.456 million vs. an expectation of 4.45 million.  Continuing the recent trend both numbers had prior month revisions that took last month’s numbers to levels that were a bit worse than originally thought.

The market is off a bit on this news today.  The 10-year is currently trading at a 2.62%. 

Pessimist of the week award

In perhaps the most pessimistic change of view this week Bank of America revised their 1^st quarter 2010 forecast on the 10-year Treasury downward to 2.00%.  TWO PERCENT by 1Q 2011.  To put things in perspective the cycle low on the 10-year is a 2.08%.  We achieved that low point at the height of the economic melt-down.  B-of-A predicts we will punch through that level shortly.  I find it a stretch…but that’s just one man’s opinion.

Their forecast is based on the premise that the Fed will spend $500 to $750 billion to purchase Treasury bonds in another round of quantitative easing to support the economy. 

As a counterpoint we have at least two Fed officials speaking this week stating that they are reluctant to do any more quantitative easing.  They maintain that any additional measures will require a very thorough cost-benefit analysis, and they liken more quantitative easing to “pushing on a string”.  

If you have any questions or if there is anything I can be doing for you just let me know.

Steve Scaramastro, SVP

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