Friday, August 27, 2010

Market Update 8 17 10 _ Bernanke Speaks and moves the markets

 

Bernanke spoke today in Jackson Hole, Wyoming. While it’s tempting to deliver some commentary on the wisdom of government workers jetting off to Jackson Hole on the public dime I’ll skip it and get on to the analysis of the speech. Who knows maybe I’ll shoot a resume’ over to the Fed so I can write these updates from Jackson Hole instead of Memphis, TN.

 

The full speech is 20 pages long. Because I know that bankers are busy people I’ve taken the liberty of summarizing this riveting piece of Central Bank literature to its core concepts so that you can get back to counting up how much money you made selling Fed Funds last night.

 

The short story:

 

- Recovery slower than expected

- Consumers shoring up personal balance sheets

- Business spending will slow from pace of first half

- Housing will stink for a while

- High unemployment will be persistent and disconcerting

- Don’t expect any significant disinflation

- Inflation should remain low then slowly rise toward target

- Fed discusses four “tools” for providing additional stimulus

- Reasonable to expect some increased growth in 2011

 

The bulk of his commentary was used to introduce and discuss the “tools and strategies” available to the Fed to fight any further deterioration in economic conditions. These are the tools discussed internally at the Fed and Bernanke went out of his way to provide color on the plans as well as the pro’s and con’s of each option. I thought this was a remarkable amount of clarity from a Fed Chairman…the Fed went out of their way to let everyone know what they are considering as well as acknowledging the risks, payoffs, and in some cases probability of using the tools.

 

The four tools (and I’m not referring to the other Fed governors)

 

1 – Additional Asset Purchases

 

Pro’s – Lowers borrowing costs quickly

 

Cons’ – Lack of experience with this option creates uncertainty on its quantitative effects.

 

My take – The Fed will likely use this as the main tool. The others all provide only modest or temporary changes in rates.

 

2 – Ease financial conditions through communication (i.e. change the language in the FOMC statement)

 

Pro’s – Quickly communicate change

 

Cons – Difficult to convey policy intentions with sufficient precision and conditionality

 

My take – They can try to talk the market one way or the other but ultimately they need to “walk the walk” so to speak. Talk will only get you so far…if the market doesn’t believe that you have the ability or the desire to follow through then the effect of your statements will be short lived. A recent example of this was the introduction of their asset purchase program…the market jumped on the announcement but then came right back to where it started when they realized nothing was being done yet.  Ultimately the Fed had to start actually buying the bonds to get the effect they wanted. Words are cheap and fleeting…but two trillion dollars leaves a mark.

 

3 – Lower the rate paid on Excess Reserves (currently 25 bps)

 

Pro’s – Would provide banks incentive to increase lending to non-financial borrowers or participants in short term money markets

 

Con’s – Used in isolation the effect of this tool would be very small

 

My Take – Wouldn’t be used on its own…would be used as part of a much larger plan. This might be used if they get into a bigger fight than they expected and need to pull out all of the stops. They might be able to implement this to get a bit more juice out of a bigger squeeze so to speak.

 

4 – Increase the inflation target

 

This should fall in the “honorable mention” category.  Bernanke dismisses this thought outright by stating that there is no support for this idea at the FOMC. If they aren’t considering it I figured there’s not much point in describing it…just know that if you hear anyone speaking about raising the inflation target that it’s time to go grab a cigarette or play some solitaire.

 

The Market Reacts

Market reaction has been notable. Since the release of this speech the 10-year Treasury has pulled back almost a point and a half to trade at 2.63%. That is a full 20 bps more yield than the 2.43% level it hit earlier this week. The 30 year is seeing a bit more volatility than it’s used to in recent trading sessions.  It is off just over 3-points to trade at 3.765%...a full 30 basis points higher than yesterday’s low of 3.46%.

 

Will it last?

It doesn’t feel like the beginning of a sustained pullback to much higher yield levels. The fundamentals that drove us to this point on the curve are still very much with us. The only difference is that today we just got word that the Fed has some plans in place if things should get worse.  This speech is a classic example of the use of statements to move the markets. We’ll see how long the impact of this speech lasts…if it’s like prior examples of the strategy then we could easily be back to where we started before long.

 

Thursday, August 12, 2010

Interpolated Yield Curve forecast

Each month Bloomberg surveys 60 to 70 economists to get their estimates of where Fed Funds, the 2-year Treasury, and the 10-year Treasury will be over the next several quarters.  I take this data and interpolate for the points in between the survey data to create the attached report.  This allows us to get a broad view of where various economists see interest rates going over the coming quarters.

You’ll notice from the section titled “Change from Previous Months Survey” that expectations for Fed Funds and the 2-year have dropped the most.  The Median forecast for the 2-year Treasury in 3Q 2011 in this month’s survey is a 1.60%...that is down from a 1.85% in July and a 2.40% in August.

You’ll also see from the report that forecasts dropped for almost every forecast period…the exception is the near term Fed Funds forecasts.  It’s not much of a surprise, after all how difficult is it to forecast “0 percent” for two quarters when the Fed just got done saying that rates will remain exceptionally low for an extended period?

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

 

BB interpolated survey 8 11 10.png

 

 

Wednesday, August 11, 2010

Market Update: Follow up on last weeks Prepay Update letter

I thought this afternoon would be a good time to provide a follow up on last weeks Market Update titled “Very Important Update on MBS prepays” that discussed rumors of a new effort to generate refi activity.  The e-mail discussed selling higher coupon MBS to lock in gains and/or avoid an increase in prepays that would erode gains and burn down yield. 

The idea was to first decide if you thought this was a realistic risk factor.  If you didn’t view it as a risk then there would be nothing to do. 

For those that viewed the risk as material we discussed quickly identifying bonds that you wanted to sell and to do so before the market reacted and began pricing this risk in.  The idea was that prices on higher coupon MBS would drop, and prices on the lower coupon MBS would rise (and put further downward pressure on reinvestment yields).

This afternoon the market began pricing in this risk.  MBS with maturities of 15 years or longer and coupons higher than 5.00% are trading lower today despite a big rally in the Treasury market.  The 10-year Treasury is up 21/32’s right now to offer a 2.68% yield while MBS prices on the aforementioned coupons are down anywhere from 4/32’s to 7/32’s this afternoon.  At the same time, prices on the lower coupon MBS are trading higher.  This is exactly what we warned of in last week’s e-mail.  Many investors have already made their decisions and have taken appropriate action. 

For those that are still on the fence it might be helpful to note that bids are starting to fade and prices are rising on reinvestment options.

As we said from the outset, each investor will have to make their own decision as to whether or not this risk factor has a high enough probability to compel one to act.  If you don’t view this as a material risk factor then you can move on to more productive things.  If you fall into the camp that is concerned about this issue then you should note that your timeline for action just got shorter.  The market is beginning to move against this trade.

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

Steve Scaramastro, SVP

800-311-0707

Friday, August 6, 2010

Market Update: 8 6 10 _ Treasuries Rally into the weekend

We got some much anticipated economic data this morning and there appears to be a huge gap between the markets view of this data and the view of the market commentators.  I was on my way in to work when the data was released so I listened to it on Bloomberg radio.  They put such a positive spin on every number that I thought Treasury yields must be rising.  Imagine my surprise when I get to my desk and the 10-year Treasury price is going straight up.

Below is a screenshot that shows a breakdown of this morning’s numbers:

eco 8 6 10.png

 

I took the liberty of highlighting the numbers in green, yellow, or red to point out which direction the releases were in relation to the survey data.  Green numbers beat the survey, red were worse, and I used yellow on the Unemployment rate because it was unchanged from last month.

On the surface it might appear that there was more good news than bad.  However, not all numbers carry the same importance.  The market is reacting this morning largely to the Change in Non-Farm and Private Payrolls figures.  These not only missed the estimate  this month but were both subject to large downward revisions last month.  Notice that in the “Prior” column, last month’s release for Non-Farm Payrolls was -125k jobs…but the revision took that down to -221k jobs.  Likewise the Private Payrolls were reduced downward 62% last month.  Private Payrolls doesn’t have a lot more room to give on downward revisions before it goes negative. 

The 10-year Treasury is up 21/32’s this morning to trade at a 2.84%.  We last saw this level on 4/15/09.  That’s all the news to report at the moment.  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

 

 

Thursday, August 5, 2010

FW: Very important update on MBS and prepays

The next scary story

We have maintained over this entire cycle that if the government wants something then the government will get it.  It goes in the same category as “you don’t spit into the wind, you don’t pull the mask off the ol’ Long Ranger and you don’t mess around with Slim”.  This outlook is the primary reason that we have cautioned everyone away from high premium MBS as long as we could.  The longer the final maturity and the higher the premium the less we liked it.  When most of the world was squawking that “nobody can refi so there is no risk in big premiums” we took a more cautious, and I believe a bigger picture view.  It has been our belief that there are more risk factors at work in this market than the normal, easy to predict factors.  Once the government gets involved there is a huge wild-card at play…and it’s terribly difficult to figure out how the card will be played.

We are beginning to hear of a new push by the government to ignite a refi wave.  The idea behind this strategy is nothing new…refi’s will lower monthly payments which will put more money in consumers’ pockets and also reduce the rate of foreclosures which will in turn help home prices in general.  What’s not to love?  While I try not to involve politics in any of these write-ups I would be remiss in my duties if I didn’t point out that this idea is being pushed just a short time before a very important election cycle.

The idea to get refi’s going has been an ongoing theme with the Fed and the Administration.  Thus far it has been difficult to implement despite some very drastic efforts.  The current idea that is being kicked around is that the GSE’s will waive or provide for much more lenient LTV and FICO requirements which will make it a slam dunk to get refi’s going.

If this happens prepays will go through the roof on longer final/higher coupon MBS.  This means a few things for investors. 

1 – If you bought high coupon MBS at lower premiums a few years ago you have big gains.  These gains will quickly evaporate as the market shifts toward expectations of the refi wave…the bid will go away on your bond. 

2 – If you bought the high coupon MBS more recently…and therefore at a huge premium…then you could be introduced to negative book yields as you are forced to burn down that premium over a very short time horizon.

3 – Yields on available lower coupon MBS will likely drop as a massive wave of refi generated cash flow is reinvested into the sector.

What should you do? 

There are two answers here.

First…if you don’t think this will happen…then you don’t have to do anything.

Second…if you fall into the camp that does see this happening then you’ll want to take some action in advance.  The first thing to consider is selling bonds that are in the strike zone so you can capture gains rather than let the market erode them as prepay expectations get priced in.  It would really stink to be in a “rates unchanged” environment yet watch the “unrealized gain” section of your bond accounting report drop like a rock. 

If you recall a few months ago when the GSE’s decided to clear the “log jam” of late pays in their pools, prepays spiked and traders quit bidding bonds.  There was a period of time where you couldn’t sell your MBS.  Someone might throw out a low-ball bid that was several points below market but the reality was that you had two choices… get scalped or don’t sell.  It was an anxious month.

OK so I sell…now what?

The next issue is what to go back into.  I would think that the most popular route (based on current market activity) would be to refinance into Full Faith and Credit, low coupon ARM structures.  If you do this before everyone rushes for the door you will get both the benefit of higher prices on the sell side and higher yields on the buy side.

These aren’t great choices…but you can’t hope for much better given that the plan itself is a terrible idea.

It’s important to note that this is not a done deal yet.  Portfolio managers will have to make their own determinations as to whether this plan will come to fruition or if it will die in the planning stage.

Once you make the first decision as to the probability of occurrence you can begin making plans for your next move.  If the refi wave comes history will record two types of investors…those that got out of the way early and those that got crushed.

If you would like us to help you identify and monitor bonds that may be in the strike zone just shoot us a copy of your most recent bond accounting report.  We have the analytics to quickly identify bonds that are likely to be exposed to this event and we can quickly provide swap ideas to remove you from harm’s way.

If you have any questions on this material or if there is anything I can be doing for you please let me know.  I’ve included links to two stories on this topic for reference.

http://www.investors.com/NewsAndAnalysis/Article.aspx?id=117087239&source=Newsfeed&Ntt=Slam

http://www.marketwatch.com/story/could-the-government-create-a-backdoor-stimulus-2010-08-04?dist=WSJfeed&siteid=WSJ

 

Steve Scaramastro, SVP

800-311-0707

 

Wednesday, August 4, 2010

Market Update 8 4 10 _ The heat index is 90 over Fed Funds and deflation is the talk of the day

It’s August in Memphis, Tennessee and the heat and humidity hang in the air as heavily as the phrase “double-dip” at an FOMC meeting.  It’s so hot and wet outside that even the mosquitoes are on strike.  As I walk through the neighborhood there are no people on the porches to say hello to…everyone has retreated inside air-conditioned fortresses and they are praying for November and the change in the weather that comes with it.   It’s 9:00 PM and I’m sweating bullets as I walk lazily down the street with the dog and my thoughts.  With weather like this it’s no wonder that music we know as “the blues” was born here.

In a way this weather is analogous to the market.  The government intervention hangs so thick in the air that it affects everything…and everyone is sweating.  No product is immune from the heavy hand of the Fed and the Government and investors are singing the blues.  Many investors are no longer on their front porch and wanting to talk…they’ve retreated inside the air conditioned confines of the bank and find the discomfort of selling Fed Funds at 25 bps preferable to being on the front porch talking about bonds.  In a way it’s hard to blame them.  Nominal yield levels are so low that even I find myself periodically asking “Really?  The yield is THAT low?”

From a purely investment portfolio standpoint (that is ignoring asset/liability and liquidity concerns for a moment) we are presented with an ugly set of options.  The combined actions of the Fed and the Government have created an environment of low yields and high uncertainty.  The Fed’s asset purchase program has crushed spreads on investments, and their monetary policy is keeping the short interest rates exceptionally low “for an extended period”.  

What is an investor to do?  The short answer is that it’s not much different than before…you’re just doing it at lower rates.  Asset/Liability concerns are still addressed first, then liquidity, then investment structure, yield, and price volatility.  We’ll talk about these a bit further down the page.  Before that lets briefly look at the two issues that currently dominate the discussion.

Inflation or deflation?

Up until very recently the Fed has maintained that they are concerned about inflation.  That is understandable as the Feds dual mandate says they must maintain maximum employment and price stability (i.e. they must keep inflation in check).  From the outset of this business cycle the Fed has focused exclusively on inflation and virtually ignored the “D” word…Deflation. 

In fact we’ve asked some very pointed questions of the Fed Presidents that we’ve been able to corner.  It’s always a bit funny to me that Fed Presidents show up at meetings such as the Economic Club of Memphis and they get the usual cabal of business owners who have general concerns about the economy but really don’t have enough knowledge to launch a serious question.  Then we come in.   Sometimes I’m there by myself…other times there will be a whole table of us…Fixed Income Salesmen. 

Oh, they must loathe us.  We have the knowledge to ask some tough questions and we have absolutely nothing to lose by asking them.  So…if we rewind the tape a few years we find ourselves at a meeting where Fed President Sue Bies is the speaker.  I worked for Sue a number of years ago and it was good to see here come back to Memphis.  With the formalities and dinner out of the way we got on with the speech and the Q&A. 

After a bunch of softball questions from the crowd Sue recognized our table to provide the next question.   Will Taylor, Director of our office launched one at her.  He asked her what the Feds plan was for deflation.  The room was silent and our Fed official verbally parried and spun past the question and returned an answer about inflation, then she tried to move on to the next question.  Before she could do that Will pounced on her with a clarification that he had asked specifically about deflation not inflation and he wanted to know what the Feds plans were to combat this threat if it were to materialize.  The short answer was that the Fed had no plan to combat deflation…then the answer returned again to inflation.  She moved on to the next question and we stared at our mass produced desserts and banquet hall coffee and cogitated on our newly found knowledge that the Fed had no plan they could implement to combat deflation.  It was a sobering moment.

Over the next several years the Fed would continue to ignore deflation as a threat and focus instead on inflation. By most measures we don’t have an inflation problem on our hands.  The one exception I can proffer immediately would be that of hot wings.  I was driving home the other night and I passed a guy on the sidewalk waving a sign that said “50 cent Wings.”  I said out loud “wow…I remember nickel wing night.”  I couldn’t bear to ponder what a bucket of beer would cost at that joint. 

So to say there is no inflation anywhere would be incorrect.  However…on average we’ve had disinflation for a period of time followed by very subdued inflation currently.  The Fed would love nothing more than for some inflation to pop up.  It’s the easiest thing in the world to fight…you just raise rates...and since they are starting at zero percent the Fed really has a lot of ammo with which to fight the war on inflation.

Deflation however is another story.  How do you combat falling price levels?  This is a very dangerous thing as it relates to entities that are highly leveraged.  In this situation the value of the asset falls but the value of the debt you hold remains the same.  You become more underwater as deflation sets in.  As prices fall you become less and less able to liquidate the asset to discharge the debt.  Margin calls come next as your LTV numbers get out of whack, then comes the forced selling which causes prices to decrease at an even faster rate, which in turn worsens your debt ratios which triggers even more margin calls.  This is what Irving Fisher called the Debt-Deflation spiral and his works conclude that this ends only after an almost universal bankruptcy. 

His solution is to “re-flate” asset prices back to the levels at which the debt was contracted on them.  The implication there is for the government to spend their way out of deflation…or monkey with the system to get prices back to where they were before deflation set in.  There are no pretty solutions for deflation.  So far we’ve seen the government do a little of both (think huge stimulus bill and mortgage modification programs). 

What do you do?

If your outlook is for inflation then you buy short maturities or floating rate bonds.  As bad as bond yields are they are almost universally better than the rate offered on Fed Funds.  Make sure you have you’re A/L and liquidity bases covered and then make sure the bonds you are buying match your outlook on rates.  If you are having trouble coming to a decision on an interest rate forecast you might start with the monthly survey data that I put out and make changes from there.

If your outlook is for deflation then you buy the longest bonds you can find.  Most banks can’t execute a “best case” plan for deflation because the ultimate bonds for that scenario would be the longest final maturity, lowest coupon bonds you can find.  We’re talking something like a 30 year zero-coupon bond.  First of all you’d have to have the ability to buy such a product…and not many banks do.  Secondly you’d have to have the guts to buy such an instrument…it could easily turn into accidental suicide. 

If you are wrong on the “deflation/longest maturity you can buy scenario” then you are very…very…wrong.  You are the type of wrong that gets your name on a billboard in town with bad words printed underneath.  You are the type of wrong where everyone who works at the bank ever again will be told the story of how wrong you were.  It’s the kind of wrong that has you saying things like “it seemed like a good idea at the time” as you cry in your beer and tell the bartender how you were so right until the impossible happened.  Lucky for us we all have policy constraints that would keep us from embarking on such an ambitious plan even if it were to come to us.   

The real point here is that if your forecast is for deflation then you need to be extending duration.  Buy longer product that has call protection.  This will provide higher yields (yes…current yields will seem high if deflation visits us), large gains, and will insulate you from having to make reinvestment decisions on those dollars in a deflationary environment.

What is the definition of risk?

A long time ago I read that a good definition of risk is that more things can happen than will happen.  The point of a risk manager is to navigate through this uncertainty.  Generally this involves not making any big bets one way or the other.  If the ship is properly loaded you can take some waves and not capsize.  If on the other hand you have loaded the boat all to one side you stand a good chance of losing the ship when you encounter the wrong wave, wind, or current. 

So we start Asset/Liability management.  Once we have our earnings insulated from adverse interest rate moves we can move on to liquidity.  After we establish that we’ve got the necessary liquidity to fund our upcoming obligations we can move on to the final step.  Given our prior constraints, how do we deploy our investment dollars to maximize our earnings? 

Rates up or down?  You call it.

Rates up

Our interest rate forecast will guide this process (remember…if you don’t have one we can provide some guidance).  If we expect rates to begin moving higher in the next year or two then you either buy short final maturities or you buy floating rate product.   Short final maturities obviously have a significant drawback right now…they offer very little in the way of yield.  But such is the price for staying short.  No risk, no reward.  A 2.5 year non-call 1 year callable will bring roughly 1.00% currently.  While that is an awfully skinny yield it beats Fed Funds by 75 basis points and it insures that you’ll have all of your dollars back to reinvest inside of two and a half years. 

Floating rate product offers more options for the short buyer.  The two most popular vehicles in this arena have been Hybrid ARM MBS and corporate floaters.  There are pros and cons to each, but they represent higher yielding options for those that want to stay short.   In this arena we’re not talking about short FINAL maturities…we are talking about the time until the instrument re-prices.  A hybrid ARM has a 30 year final…but it re-prices on a much shorter basis which keeps your coupon near the current market and reduces price volatility.  The point here is that you have options that allow you to minimize your price volatility yet pick up more yield than you could on a short final maturity product. 

Rates down

If on the other hand you expect rates to fall then you need to extend your duration and get call protection.  Think bullets.  Possibly the best bond for this scenario would be a zero-coupon bullet municipal bond in the 10 to 20 year maturity range.  This offers call protection and a great deal of yield.  Currently you can get yields well north of 6% on AAA rated Texas PSF insured municipal paper.

Another popular option among buyers with this outlook has been 7 to 10 year Agency bullets. 

I’ve got no idea

If you’re unsure which way this thing will go then maybe you consider a barbell strategy.  Most investment portfolios are very short right now.  As bonds have been called many investors have replaced them with very short instruments.  This leaves room for some longer final maturities that will allow you to pick up yield without saddling the entire portfolio with undue risk.  So the barbell keeps a great deal of money in the short buckets to fund your liquidity needs, and still allows you to generate some earnings on the longer maturities.  How long you go is up to you. 

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

Steve Scaramastro, SVP

800-311-0707