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

800-311-0707

 

 

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.

 

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

 

 

 

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

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:

 

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

 

 

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