Market Update 4 15 11 _ Signals in the noise

Tough to read the signals when there’s so much noise.

Last night I awoke to a distant clap of thunder at 2:30 AM.  Shortly thereafter a tremendous wind picked up and with it came a violent thunderstorm and the requisite downpour that made so much noise that I couldn’t immediately return to sleep.  As I lay there two thoughts were on my mind…how much damage would this do to the house?…and when will my daughter run from the thunder and show up beside the bed?

Before I could assign probabilities to either scenario my thoughts were interrupted by a distant wailing sound.  The noise came to me in peaks and valleys as the storm’s intensity ebbed and flowed.  This noise concerned me because it could be one of only two things…both very familiar to people in my part of the world.  It’s either a train pushing its way through the storm or it’s a tornado siren…one requires no action and the other requires immediate attention.

Ultimately it turned out to be the wail of a freight train’s horn reaching me through the wind and rain, ultimately it took my daughter about 5 minutes to come looking for momma…and ultimately I lay there a while longer in the darkness comparing my recent train/tornado conundrum to the current state of economic affairs. 

Those who are attempting to determine which way this economy and market are heading are dealing with some of the same issues that I dealt with last night.  There are signals available that may help decipher the appropriate course of action but they are at times inconclusive and seemingly pointing toward different paths…each with a drastically different outcome.

In a recent webinar we discussed the Fed’s outlook on interest rates.  The FOMC committee is increasingly split into two camps.  One says that achieving the Feds dual mandate of full employment and price stability must come first.  The other says that the appropriate action is to reverse course on QE2 and normalize rates before the dual mandate is achieved in order to reduce the risk of unintended consequences.

Who will win? 

Currently there seems to be more support for those who desire to achieve the dual mandate first and keep rates “exceptionally low for an extended period”.  Based on what we’ve heard from the Fed the QE2 program is likely to continue unabated through its scheduled conclusion in June.  From that point it’s reasonable to consider that the Fed will wait and watch the data before taking their next step.  In other words it seems unlikely that we’ll get to the end of QE2 in June and see the Fed immediately begin to tighten.   

So how long will they wait?  As always…they will be data dependent.  I would expect that any move to tighten would be preceded by analyzing several periods of data to ensure that we have a sustainable trend of growth.  Any tightening (whether a reversal of QE2 or an outright increase in the overnight rate) would also be preceded by a great deal of communication from the Fed.  There won’t be any surprise moves from the Fed on this issue.  They’ve gone to great lengths to let us know that communication is a high priority item for them.  They understand that the complexity of their current monetary policy necessitates clear communication of any plan that begins to reverse our current course. 

So after the June 2011 conclusion of QE2 we should expect some period of time where the Fed monitors the data, comes up with a plan for raising rates, and communicates that plan to all interested parties.  One could easily see this process taking months or quarters.  As a reference point the Bloomberg Survey data doesn’t show an expectation for higher Fed Funds levels until 1Q 2012.

What are they waiting for?

Business cycles evolve over long time periods so it’s easy to lose one’s feel for how the course of monetary policy unfolds.  Given our current state of affairs I thought it might be interesting to look back at the last tightening cycle that began in June 2004.  I won’t suggest that this cycle will be like any particular cycle from the past…what I’m more interested in is seeing just how much positive data the Fed had to have piled up in front of them before they decided to begin a tightening.

It is interesting to note that after the last recession we had 12 months between the first mention of “firming of spending and markedly improved financial conditions” and the first rate hike by the Fed.

In the 6/25/03 FOMC statement the Fed saw:

-          Robust growth in productivity

-          Firming in spending

-          Markedly improved financial conditions

-          Labor and product markets stabilizing

Even against that macro-economic backdrop the Fed thought that an accommodative policy was the right one and they left rates low.

Skipping forward 6 months to December of 2003 we get an FOMC statement that sees:

-          Robust growth in productivity

-          Output expanding briskly

-          Labor market improving modestly

-          Low inflation

-          Considerable resource slack

Again the Fed left rates low…they have a lot of things moving in the right direction but it will still be six months before the Fed tightens. 

Now let’s look at our most recent FOMC statement from March 2011:

-          Recovery on firmer footing

-          Conditions in labor market improving gradually

-          Spending continues to expand

-          Housing and non-res. Investment depressed

-          Long term inflation stable

-          Short term inflation subdued

While our last FOMC statement looks somewhat similar to the Dec 2003 statement there are a host of very important distinctions between the two time periods.

Capacity utilization, consumer spending, and inflation expectations are fairly similar when compared between the two periods. In 2004 however the Fed was in a pretty good spot with regard to their dual mandate…unemployment was 5.6% and inflation was running at 2.2%.  Both numbers were manageable if not optimal.  Another major difference is the fact that the housing market wasn’t in shambles in 2004.

These are just a few of the items we could look at when studying this issue but I think it helps to note that in June of 2004 the Fed was starting from a much less perilous position than they are today…by comparison it was easy to raise rates in the summer of 2004.

Today they are failing on both counts of their dual mandate…the unemployment rate is at 8.9%, and inflation is below their 2% comfort level as measured by Personal Core Expenditures (PCE) at 0.9%.  Additionally they are still actively engaged in easing as they are 3 months from completing their most recent monetary easing plan (QE2).

Based on history and our current position it’s easy for me to see how it could be 1Q of 2012 at the earliest before they begin tightening.  As always they will be data dependent and they will continue to telegraph their plans before they take action. 

I wish I could get to the end of this Market Update with a smoking gun in my hand and say “The Fed will raise rates on (insert date here)” but the issue is far too complicated.  The best we can do is listen to the Fed as they debate the issue and keep in mind that their dual mandate of maximum employment and inflation will be their guide. 

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 4_12_11: From headlights to nukes...it's a global economy

Last night I had to replace a headlight socket in the wife’s car.  This should be an easy 5 minute job…you cut some wires…you splice some wires…a little electrical tape and you’re done.  Well about 30 minutes into my 5 minute job I start to laugh at the absurdity of the whole thing.  A Taiwanese company made a replacement part for a German car, that was subsequently sold to a guy in Tennessee…and everyone involved expected this to work.  It didn’t really go as anyone planned.  After burning 30 minutes, laughing at the intricacies of international commerce that are in play, making some redneck modifications to the parts, and contributing a few dollars to the “swearing jar” I get the job done and shut the hood.  This morning I come in to work and I find that the intricacies of international commerce and a globally linked economy are not done with me.  The 10-year Treasury is up three-quarters of a point this morning on news that Japan has increased the severity level of their nuclear crisis from a 5 to a 7. 

 

A “5” is apparently the way to admit you have a problem but that you have control over it (ie It’s just a drink or four).  A “7” is the end of the line…the worst rating there is (ie you admit you have a problem…but you’re admitting it to the judge at your DUI hearing).  Well Japan is in front of the DUI judge today…and the world doesn’t like it…so they are once again fleeing to the safety of US Treasuries.  The 10-year was trading as high as 3.59% yesterday…today it has lost 11 bps in yield to trade at 3.48%.

 

There isn’t a lot of economic data to discuss today…the market is almost entirely driven by concerns over Japans nuclear crisis.  What this means for the world’s third largest economy (and it’s follow on effect for the global economy) remains to be seen, but it certainly doesn’t imply anything positive for growth.  It should also serve as more cover for the Fed to complete their planned QE2 purchases.

 

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

What's in a number?

 

Close vs. exactly

 

Last night the family was sitting around watching American Idol.  It’s a simple concept…people sing…other people vote…somebody wins.  It’s good clean family entertainment.  My son is just getting a feel for this whole interactive voting deal and he’s interested in casting a vote.  So he calls the number on the screen expecting to be prompted to vote on his favorite singer.

 

I was busy rigging up some fishing reels while he was making his call to vote so I wasn’t paying 100% attention…but I hear enough in the background that I know something went wrong.

 

I hear him tell his momma “Uh…I think something’s not right.”  About the time I turn around he’s handing the phone to his momma…and from the look on momma’s face when she gets on the phone I have no doubt that something is wrong.  While I’ve never seen that particular look on her face I have seen looks from the same “family of looks” that she uses when something ain’t right. 

 

It turns out he missed the actual phone number by one digit…and rather than getting prompted to vote for his favorite singer he got a recording of a woman who was prompting him to call a much more controversial number where he could “party” with her and she’d presumably charge him by the minute.  Thankfully 11 year old boys aren’t terribly interested in phone-call-partying with adult women or I might have had some unexpected charges on the bill this month. 

 

It was a typical move by a sleazy marketing company…get a number that is a common mis-dial of a very popular number so you increase your hit count.  I can’t fault them for the tactic but it highlights the importance of getting the number exactly right…versus getting close. 

 

This morning Jobless Claims got “close” to the survey numbers but didn’t get it exactly.  Continuing Claims were expected to post a 3.75 million level…the actual number was 3.771 million.  Initial Jobless Claims also missed the mark by posting a 397,000 figure vs. an expectation of 376,000.  Missing the number on the high side didn’t sit well with the market today. 

 

Treasuries are trading higher in price on this morning’s data and are heading toward the low end of the recent range.  The 10-year Treasury is currently yielding 3.42%.  The domestic stock indices are down as well.  The Dow is off over 220 points and just fell through the 12,000 level.  Interestingly enough…oil is off $2.50 to trade at $101.90.  That is down from its recent high of $105.44.

 

The irony in all of this is that the day that PIMCO’s Bill Gross says Treasury yields may be too low to sustain interest in them…and he sells all he owns…Treasuries begin a two day rally that pushes yields even lower.  There is clearly still plenty of appetite for US Treasuries on the planet.  For what it’s worth PIMCO still owns Treasuries…they are just very short.  They essentially went to cash and if you’re in cash that means money markets, and money market funds are stuffed to the gills with short Treasuries.

 

Tomorrow we get some additional economic data in the form of Retail Sales, Michigan Confidence, and Business Inventories.   

 

TGIF?

 

Tomorrow is Friday (and the official Day of Rage in Saudi Arabia).  As I’m studying this market and trying to keep up with all of the moving parts I always like to step back and look at the big picture.  Sometimes a more big-picture look can help things jump out at you.  As I was looking at this big picture a subtle trend became evident.  This trend has been developing over the last several weeks.  The unrest in Libya began about three weeks ago.  Each week since then we’ve had a trading pattern where the 10-year Treasury sees its lowest daily yield on Friday each week.  Below are the high and low weekly yields on the 10-year Treasury.

 

Wednesday 23 Feb. saw a 3.49% yield…by Friday 25 Feb. it was at a 3.42%

 

Thursday 03 Mar. saw a 3.585 yield…by the close on Friday 04 Mar. it was at a 3.49%

 

Tuesday 08 Mar. saw a 3.56% yield…today is Thursday and we’re down to a 3.43%

 

Tomorrow is Friday and this trend looks likely to continue as the unrest in the Middle East continues to be a flashpoint.  What does this mean?  It means that if you expect this trend to hold and you’re in the market to buy then you may want to wait until next week…and if you’re selling then Friday is your friend as long as the unrest continues.

 

Day of Rage

 

I’m not terribly angry about anything so I’m not participating in tomorrow’s Day of Rage.  Not wanting to be left out of the festivities though I’ve scheduled my own event.  I call it a Day of Fishing.  I will be out tomorrow, floating around on a lake where I can ponder all things fishing and many things economic…but because I am a high-tech-redneck I will still be available if you need anything. 

 

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

 

 

 

 

 

 

 

FW: Market Update 2 11 11 _ Treasury, the GSE's and Bob Marley

Bob Marley on the GSE’s…Everything’s gonna be alright

The Treasury Department released their paper today that outlined potential plans to deal with Fannie and Freddie.  I’ll tell you up front that this is going to be a lengthy process with a lot of headline news and no shortage of ignorant/inflammatory statements from politicians on how they are going to handle this.  This process will undoubtedly generate a huge amount of interest from boards of directors and shareholders. 

I picture a scene where your two smallest shareholders are having lunch and watching TV at a local restaurant.  The news-caster says “Fannie and Freddie are going to be dismantled…”  As one shareholder chokes on his lunch the other one explains to the waitress that they need their check pronto because the bank is going under.  Meanwhile back at the ranch, you, the bank President/CFO/Treasurer are in your office peacefully readying board presentations, reports for the auditors, the call report, loan committee paperwork, and stuff for the examiners.  Your phone rings and an all too familiar number pops up on the caller ID.  Despite the urge to let it go to voicemail you stop what you are doing and answer it.  It’s “two-share Vern” the second smallest holder of your common stock.

Vern stutters and sputters and asks “Is the bank still open?”

You: “Yeah Vern…it’s normal business hours today…have you been drinking?”

Vern: “No but Bob just choked on a sandwich and I heard that our bonds aren’t going to pay us back.”

You: “Where did you hear that?”

Vern: “On the TV.”

You: “The same TV that told you Aliens built the pyramids?”

Vern: “No, that was at the house, this one was down at the restaurant.”

You: “Chill Vern…the bonds are good…there is no logical basis for the bonds to default and besides that, the Treasury has been backing them for a while now, and as recently as this morning, no less than the Treasury Secretary himself said that they will stand behind the GSE’s to ensure they can fulfill all of their obligations.”

Vern: “OK…but do you know how to do the Heimlich maneuver?  If you don’t then just make one less copy of the financials for the next meeting because Bob might not make it.”

Nothing new under the sun

Rather than reinvent the wheel on this topic I thought it would be more efficient to give you the very short story up front, and then include a write-up I did last year on this same topic.  I’ve written on the topic several times over the last three years and each time it’s been with the same view…your GSE debt is safe. 

Treasury Secretary Geithner must have been reading my stuff because today he said: 

“As the market improves and Fannie Mae and Freddie Mac are wound down, it should be clear that the government is committed to ensuring that Fannie Mae and Freddie Mac have sufficient capital to perform under any guarantees issued now or in the future and the ability to meet any of their debt obligations.”

 

Below is a Market Update piece from March of 2010.  This was in response to some very inflammatory rhetoric from Congressman Barney Frank regarding the GSE’s.  My hope is that as you get questions from the board and other interested parties you will be able to simply hit the forward button on this e-mail and provide the inquisitors with all the info they need on this topic. 

There will be a lot more reporting on this issue as it unfolds.  The important thing to note on the front end is that your GSE debt is in great shape, and will be paid back in full.  At some point in the future there may be a new entity fulfilling the roles previously occupied by the GSE’s…but that won’t impact the source of repayment of your bonds.  The US Treasury has gone out of its way at every turn in this process to let bond holders know that the GSE’s will have the capital they need to fulfill their obligations…that much is known. 

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

Steve Scaramastro, SVP

800-311-0707

 

 

Why Barney Frank is wrong…and I am right        

Barney, Barney, Barney…today Mr. Frank is in “fear monger” mode.  I don’t know if he is trying to flex a little muscle to get some attention or if he is trying to prove that ignorance truly knows no bounds inside the halls of Congress.  This morning he made a statement to effect that the future of Fannie and Freddie debt holders might involve haircuts or bonds not being paid back at all. 

Mr. Frank either doesn’t understand the nature of the global financial system, or he’s willing to look like a complete buffoon to get some attention.

Before anyone gets too worked up about Barney’s statements let me point out a few facts, and then we’ll look at why we will never see anything like what he just mentioned.

In the beginning

Fannie and Freddie were created by the by the government, they were allowed to trade in the market with lower risk premiums due to their quasi-government nature (the implied full faith and credit), and they were mismanaged by the government (think “congress appointing their cronies to positions within the GSE’s and forcing them to lower their lending standards and help create this mess in the process”).  They have become so large that their debt is distributed throughout the global financial system, and I don’t know of a single bank in this country that doesn’t own their paper.  If you buy bonds and you don’t own GSE paper then you are in an exceptionally small minority of institutions.  Another material point is that they currently have “unlimited” lines of capital from the US Government.  The government owns responsibility of the GSE’s…Barney Frank can’t come out and say he’s bailing anyone out by allowing the GSE’s to meet their commitments.  The politicians created the mess at the GSE’s and they are responsible for cleaning it up.

If Mr. Frank thinks that he has the ability to force a “haircut” on the holders of this paper then he needs to be tested for drug use right now.  This is a move that would destroy much of the US banking system virtually overnight…it would also extend to foreign countries…some of whom own a tremendous amount of our debt and who would quite willingly punish us by dumping it on the market and causing interest rates to skyrocket.

Secondary effect

Any failure to pay 100% principal WILL result in a downgrade.  There is no way around it.  Fannie and Freddie would be immediately downgraded to “D” by the ratings agencies.  Now a “D” in high school was a passing grade for me…but for the GSE’s it stands for “Default” and it occupies the absolute lowest rung on the credit ratings scale.  This downgrade would cause a massive secondary effect.

To help you visualize the impact of a downgrade I’d like you to think back to all of the Gulf War footage we got to see on TV.  Footage where an F15 Strike Eagle drops a laser guided 500 lb bomb right on top of a tank…you get the initial explosion which is pretty impressive, but then you get what is called a “secondary”.  The “secondary” is where the fun really starts…it’s where all of the fuel and ammo that was onboard that tank blows up as a result of the first explosion.  The secondary is what spreads the damage far beyond what would have been done by the initial impact.

The secondary effect from any failure to pay on the part of the GSE’s will come right after the downgrade.  Every bank in the country that owns this paper will have an immediate and ginormous loss that runs straight through to capital.  If you have 30% of your assets in the portfolio and 80% of that goes into default you’ve got a real problem.  Imagine the impact to capital if you have to mark all of your Agency debt from 100 down to say…20.

Your losses will be compounded because you’re not allowed to own “D” rated paper which means you will be forced to realize the loss by selling it.  When you go to sell your junk bonds you’ll quickly realize that a crowd has formed because everyone is selling their bonds.  More and more people sell which pushes prices lower and lower in what is commonly referred to as a fire-sale.  The GSE market will spiral into the deck where it will leave a giant smoking crater similar in size and historical significance to the meteor impact that killed the dinosaurs (I’m watching a lot of Discovery Channel lately so please forgive the analogy).  And this is just the impact on the domestic banking system.

Now look at the situation faced by foreign central banks.  Some of these folks are ALREADY talking about selling US Securities…this type of action will solidify and accelerate those plans.  This will add even more selling.  “Panic selling” doesn’t really begin to describe that activity that will be taking place at this point.  I wouldn’t expect US Treasuries to be the safe haven after this.  I don’t think investors will continue to view debt from the same folks that just blew up the financial system with the GSE default as “safe”. 

If you’d like to take it further you could even move on to how many American citizens would have their retirement savings wiped out by this move.  It will be tough to get reelected after you torpedo the entire country’s banks, jobs, and retirement dreams.  Feel free to come up with some more and shoot them back to me…the possibilities are almost endless.

And do you think anyone would be willing to buy a US “Housing Finance” bond EVER in the future after this fiasco? 

Prove it

Lest you think I am merely being an alarmist look at the “secondary effect” we got from the failure of Lehman Brothers.   Lehman is a much smaller institution than the GSE’s yet their demise pushed the US financial system to the verge of collapse.  When the powers-that-be decided that Lehman was where the bailouts stopped it set in motion a very unintended set of consequences.

Lehman’s default shook the foundation of our economy because their debt was widely held by money market funds.  Money markets are tremendously important pools of capital that provide the liquidity for our economy.  These funds are the oil in our economic engine.  When Lehman defaulted it caused losses in money market funds.  Money market funds aren’t supposed to “do” losses.  You put a dollar in and you get a dollar out.  If you get less than a dollar than the fund “broke the buck” as we say.  Breaking the buck is the death knell for a money market fund.  So Lehman caused a lot of losses for money market funds.  Losses were so widespread that concern that began as a ripple from a corporate bond default, then formed waves, which in turn became a tsunami.

Half of the liquidity in money market funds in the country was poised to leave OVERNIGHT.  The sell orders were on the books and ready to be executed when the firms that run the order books raised the alarm.  Treasury got a phone call describing the carnage that was about to unfold and they immediately put a Full Faith and Credit Guaranty on all money market funds to avoid the panic.  Think about that for a moment…they let Lehman fail and in turn were forced to insure all money market funds in the country against loss.  This huge impact was just from the default of a single corporate issuer…Lehman Brothers.  This example should provide some very recent insight into what type of events can be triggered by a default of a big institution.  If Lehman can do that much damage just think of what the GSE’s hold in store.

In summary

SO…the GSE’s fail to pay or force a haircut, they kill most of the banks in the country in the process (through OTTI capital write-downs on their GSE debt), they anger foreign central banks to the point that they sell their holdings partly out of self defense and partly as a punitive measure, the secondary effect that we love so much roils through to the rest of the investing world in the form massive liquidations in response to the  downgrade to “D” and giant swathes of the American public see their retirement portfolios wiped out.

In my opinion there is nobody in politics that is going to light the fuse on that scenario.  If your goal were to destroy the US economy and set us on an equal economic footing with say…Kurdistan…then I’d say it’s a good plan.  Short of that…ain’t gonna happen.

I believe that my view on the GSE’s is far closer to reality than Mr. Franks’.  It seems to me that the most likely scenario is that existing debt of the GSE’s gets “grandfathered” into a Full Faith and Credit status, then they can re-invent the GSE’s and release them into the wild as healthy institutions whose debt going forward will have a much clearer status. 

This allows you to avoid nuking the financial system, and at the same time privatize a function that should have been private this entire time anyway.  It moves a few trillion worth of obligations onto the Federal balance sheet but hey…that doesn’t seem to bother anyone nowadays.

Wrap it up already

In summary the GSE’s do not have the ability to miss a payment or force a haircut on bondholders.  The markets seem to agree with this assertion as well…they are unmoved by Barney’s blabbering today.  Don’t lose any sleep over the misguided ramblings of one Congressman. 

I’m sorry if I’ve gone on longer than you or I wanted…but I can get passionate about these topics.  Halfway through this piece it began looking more like a manifesto of some sort rather than a market update but some things just need to be said.  In my view it is pure ignorance for someone of Frank’s stature to be spouting off in such an irresponsible manner on a topic like this.  I can only imagine the phone calls his secretary is fielding this morning…most of them from people far more important than me.  “Congressman Frank you’ve got Bernanke on line 1, Geithner line 2, Obama line 3, and some fixed income guy from Memphis on 4…”

I hope everyone has a great weekend.  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 2 9 11 _ Higher and steeper...where are we now?

 

The Pullback

 

From December 13^th to January 28^th the 10-year Treasury averaged around a 3.40%.  Then at the end of January it began a nice run to the upside and is now trading at 3.70%.  In two weeks we’ve had a 30 basis point improvement in yield on the 10 year Treasury.  On 1/28/11 the yield difference between the 2 year and the 10 year Treasury was 278 bps…today it is 287 bps.  So the yield curve today is both higher and steeper than it was two weeks ago.

 

Why?

 

There has been a range of economic data coming in a little better than the survey estimates over the last few weeks.  There isn’t a runaway trend of positive news by any stretch of the imagination, but when you’re down in the dumps any good news is reason to celebrate.  For example:

 

Personal Consumption was up 4.4% vs. the estimate of 4.0%

 

Michigan Confidence was 74.2 vs. the estimate of 73.3

 

Personal Spending up 0.7% vs. the estimate of 0.5%

 

Chicago Purchasing Managers report posted 68.8 vs. the estimate of 64.5

 

ISM Manufacturing posted 60.8 vs. the estimate of 58

 

Domestic Vehicle Sales of 9.59 million vs. 9.42 million…although GM and Chrysler are still using taxpayer money to subsidize their operations so I’m not sure this is a great number.  On a side note it really agitated me to watch tax-payer funded Super Bowl commercials that cost millions of dollars per minute…even worse they were pitching tiny hybrid vehicles that nobody wants to drive.  The one saving grace was the 426 Horsepower Camaro…but even that is using taxpayer money so it tarnished the whole thing a bit.

 

Inflation still under control as measured by the PCE deflator (the Feds preferred gauge)

 

Unemployment Rate dropped from 9.50% to 9.00% (it’s debatable if this is really good news as much of the change may not have come from people going back to work)

 

 

Wow…that’s a lot of good news…everything is better right?  Not really. 

 

GDP on an annualized basis posted 3.2% in Jan vs. a 3.4% estimate

 

Dallas Fed Manufacturing report posted 10.9 vs. an estimate for a higher level of 15

 

Construction spending was down month-over-month

 

Initial Jobless Claims still above 400,000 a month

 

Continuing Claims still running near 4 million

 

Payrolls data missed the mark by a huge margin in January

 

And it’s starting to sound like a cliché but it has to be said…the housing market is still a mess. 

 

 

So where does this leave us?

 

This is a bit of a staging area for yields.  Investors have been living with a lot of fear over the last few years.  Now that some of the fear is subsiding they are making some adjustments.  If you are a money manager banking on a recovery then you move early.  You sell Treasuries while you still have gains and you buy other risky assets while their prices are still fairly depressed.  Treasury prices drop (pushing yields higher) and the price of other risky assets (such as stocks) rise.

 

This adjustment process is more art than science.  If you move early and you are right then you post big fat positive returns, your shareholders love you, you get your picture on the cover of Bloomberg magazine, and you keep your job.

 

If you wait until you’re certain that the recovery will be robust and everything is going to be great again…then you’ve waited too long and you’ll get low prices on the sale of your Treasuries, stock prices will be higher than you wanted to pay, you will post returns far below your peers, you will be fired, and your name will be mud on internet investing forums around the world.  The early bird got the worm and you go hungry.  We’re seeing some of this now…the early birds are positioning.  Is it too early?  As with most things in economics it’s difficult to say for sure.

 

Clearly the fear of a double-dip recession has faded from the market.  The economy has some traction and has been able to generate a few positive bits of data to show that things are getting a little better.

 

However…there are still tremendous obstacles to be overcome.  Most people are still forecasting Unemployment to remain elevated for years, the Fed is still tracking core inflation that is running at levels below their target levels, and they are committed to holding rates low under those circumstances. 

 

Where does this leave us?

 

Currently it leaves us with a very steep yield curve and indications from the Fed that it will remain that way for an extended period (the survey data say Fed Funds will be unchanged through 1Q of 2012).  We have been given a very nice pop in yields over the last two weeks and this is widely viewed as a buying opportunity.  I don’t know of anyone that is calling for a continuous improvement in yields from this level…I’m not saying we couldn’t pop higher…but I know of nobody that is calling for it and we are already at record levels of steepness.  In fact this morning (with no data) we’re seeing some resistance.  The 10 year yield is dropping back below 3.70% and we’re hearing things like “oversold” in conversations about the Treasury market. 

 

It’s human nature to see a 30 bps run-up in yields and think “I’ll wait because it’s going to keep going up.”  Generally this leads to the next bit of human nature…the part where we say “Ah!  I should have bought while the yields were higher!”

 

One way to avoid this is to take at least some money and put it to work at these levels.  You don’t have to load the boat to take advantage of the pullback.  We do portfolio analytics for thousands of fixed income portfolios and those that perform best over time tend to be those that invest consistently rather than trying to time the markets. 

 

If you have liquidity lying around doing nothing you should be quite happy to see this pullback…the market has given us a great opportunity to pick up some yield that wasn’t there two weeks ago. 

 

And remember…if you call in and say “Ah I should have bought when rates were higher” it’s only human nature for me to say “Ah…I told you so”.   I wouldn’t really say that though…because you’d fire me. 

 

Yields on virtually everything are higher over the last two weeks.  The 3 to 5 year spot on the curve has seen a lot of activity due to the steepness…a small increase in duration garners a nice pickup in yield on this curve.  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

 

FOMC...By unanimous decision

 

My kids were excited that it was Fed Day

 

I mentioned in passing to the wife last night that today was Fed Day.  Little did I expect this statement to catch the ears of my kids who are in 5^th and 3^rd grade.  They immediately perked up and asked “tomorrow is Fed Day?”  I was shocked.  Most adults don’t know what Fed Day is, yet public schools are apparently teaching elementary school kids about monetary policy now-a-days.  Maybe there is hope for the future. 

 

So I acknowledged that yes…tomorrow is Fed Day.  They then asked me if they got the day off from school.  I was far too eager to give them credit for learning about monetary policy…they simply heard something that sounded like an official holiday and they didn’t want a day off to get past them.  They were the only people I ran into that were excited about Fed Day…and ultimately it even let them down. 

 

It was easy to forget that today was Fed Day.  It’s been so predictable for so long that it’s difficult to maintain any level of suspense over the next statement from the Fed.  Today they voted to again keep the overnight rate “exceptionally low for an extended period of time”.  This time however, it was a unanimous decision…there was no dissent.  For as long as I can remember Tom Hoenig has dissented against the opinion of his fellow Fed members.  His voice will no longer be heard.  He has rotated off the list of voting members.

 

There are four new voting members and there was some speculation as to how these new voices would sound on voting day.  They sounded off in unison today in support of the Feds current plan.  As of today the Fed will keep rates low and they will continue with QE2.  I picture a room full of Fed governors that is a little more relaxed this time around.  There are four new members to chat with and nobody has to make an effort to avoid eye contact with Hoenig, or to suffer through another one of his speeches outlining his opposition to the rest of the group.

 

The Statement

 

The short story is that our “recovery” isn’t moving quickly enough.  Unemployment is still too high, long term inflation is stable, core inflation is still decelerating, housing still stinks, credit is still tight, and household wealth is still depressed.  Those are not ingredients in a recipe for monetary tightening. 

 

The next FOMC meeting is on 3/15/11.  As always the Fed will continue to monitor the data as they come in and will re-evaluate their plans as needed.  Until then we’ll have to live with the exceptionally low rates for an extended period.  If you have any questions or if there is anything I can be doing for you just let me know.

 

The full FOMC statement is attached. 

 

Regards,

 

Steve Scaramastro, SVP

800-311-0707

 

Market Update _ 2010 Year in Review

A question

What do the years 2009, 2010, and 2011 have in common? 

They all started with Fed Funds at zero and the FOMC statement telling us that rates will remain low for a long time.  If there is one thing we’ve learned about this Fed over the last few years it’s that when they say they are going to do something…they mean it.   

So we begin 2011 with the Fed broadcasting that rates are expected to remain “exceptionally low” for an “extended period”. 

Monetary Policy

Economic conditions will determine when they raise the rate…and to date the Fed continues to see only modest economic progress set against a backdrop of an atrocious unemployment rate and declining levels of inflation.  This is not a scenario under which they will be raising rates. 

We recently got the minutes from the last FOMC meeting of 2010.  The statement points out that progress toward the Feds dual mandate of maximum employment and price stability has been “disappointingly slow”.  This has solidified their support for the originally planned QE2 purchases.  Like it or not…QE2 will continue.

The unemployment rate is running just under 10% currently.  Several Fed members have stated recently that they expect this rate to remain elevated for the next few years.  They also state that inflation continues to trend lower and if left alone…could continue for years and endanger the economy.  While most at the Fed discount the potential for outright deflation they will not tolerate the current trend. 

The summary on the Monetary Policy side is that unemployment is unacceptably high, inflation is running too low, and the rest of the numbers are modestly positive but pretty weak…the Fed will not raise rates while this situation exists.  These will be important points to consider as you make your plans for 2011.

What phrase could sum up the year?

“Government Spending” might be the best summation for 2010.  We saw the extension of unemployment benefits to 99 weeks, we got $900 billion worth of QE2 on the schedule, the first time homebuyers credit was extended, you name it they spent money on it.  Our government spent so much money (that it didn’t actually have) that it prompted statements from ratings agencies and foreign countries that these actions could ultimately affect our credit rating…and therefore our borrowing costs.  We spent so much that even the Fed warned Congress that the current trajectory on the fiscal side was unsustainable and that the Fed couldn’t fix everything by itself. 

Among the multitude of problems that come with rampant government spending is the fact that it is not as efficient as private sector spending at producing results.  I was reminded of this recently on…of all things…a duck hunt.  There aren’t many parallels between the two because duck hunting provides a venue for entertainment and family time that government spending obviously can’t…but the one similarity made me laugh.

Our duck lodge sits in the Mississippi delta.  The delta is a wide expanse of agricultural land that sits between the Mississippi river on the west and the rolling hills of central Mississippi on the east.  It plays a vital role in the migratory patterns of all manner of waterfowl and it is a great place to go when you want to “get away” from life for a bit.  I went to the lodge on a Tuesday night and I had the whole place to myself.  I spent a few minutes in the freezing darkness, gazing up at the ink-black winter sky and taking in the billions of stars that are visible in such a remote area.  Once I was satisfied that I was truly away from civilization I went inside and hit the rack early.   The following morning I got to watch the sun rise on some of the best wetlands habitat that this country has to offer.  There are few getaways that are better than this…its great “down time”. 

After a few hours of peaceful solitude in the duck blind (interrupted occasionally by the blast of a 12 gauge pump action shotgun) I gathered all of my gear, loaded it onto my 4-wheeler, and headed back to the lodge.  At one point I stopped and looked back over my shoulder to watch some birds that were working a hole on the north end of the property.  As I looked back I caught a glimpse of the gear bag on the back of my machine and the irony of the whole situation hit me.  I’m riding a $4,000 ATV that is loaded with expensive decoys, ammo, a gun, waders, heavy hunting jacket, duck calls etc.  I’m rolling across the wetlands with about $7,000 worth of gear…and I’ve got a grand total of 4 ducks strapped to the top of the decoy bag.  I had to laugh looking at the situation.  This is without a doubt the most cost inefficient thing I’ve ever done. 

If this weren’t a recreational activity there is no way I could justify my participation in the event.  The cost that morning was roughly $1,750 per bird.  Chicken is WAY cheaper.  The scene reminded me of the stories of $400 government hammers, and $2,000 government toilets, and of the inefficient nature of government spending in general.

Now obviously there are a whole host of benefits to duck hunting beyond the ducks themselves…but me paying $1,750 per duck instead of $5.00 per chicken at a grocery store reminded me a lot of the government paying someone $7,000 to buy a house today that they would have bought on their own in the next 18 months anyway…it’s a pretty inefficient way to get the job done. 

At least I get some fun stories out of the duck hunting…I don’t hear any bureaucrats sitting around telling stories about how much fun they had last weekend with their family and friends luring homebuyers into real estate offices with tax credits.

The Review

The Short story

For those in a hurry just skim the bullet points below for quick refresher of last year’s events. 

What happened last year?  How will 2010 be remembered?  Here is the short story:

-          2010 starts with Fed Funds at zero

-          Who Dat?  Saints win the Super Bowl

-          New Home Buyers credit extended

-          GSE’s clear “logjam” of late paying loans from pools…prepays have one month spike

-          Goldman execs appear before congress

-          Global economic problems spread

-          Austerity measures spur riots in Europe

-          Fed announces $600 billion QE2 program (up to $900 billion with MBS portfolio cash flows)

-          Inflation trending lower causes concern at fed

-          Outright deflation fears wane

-          Unemployment continues to climb

-          Double dip recession fears fade

-          10-year Treasury trades down to a 2.41% yield

-          Curve steepens dramatically in 4^th Quarter and 10-year rises to 3.50%

-          Recovery is underway but is modest and vulnerable to shocks

-          Fed leaves rates at zero, and maintains that they will stay exceptionally low for extended time

-          Year of the Step Up…every day the new issue screens are filled with step ups

-          Unemployment benefits extended to 99 weeks

-          Housing still in the dumps

-          The Fed still owns the $1.5 Trillion in Agency debt they bought in 2009

-          Tiger Woods wins zero tournaments

 

The longer story

When you look at the activity in 2010 it is dramatically different than prior years.  2008 saw a massive meltdown that threatened the existence of Wall Street, the banking system, and our economy.  2009 saw drastic steps taken to stabilize the situation.  By the time 2010 rolled around there was some discussion of a double-dip scenario and of deflation but things seemed more stable.  2010 was when everyone was looking for solutions that would get people back to work.

On the investment side

When you think of investments in 2010 you have to think of Step-Ups, huge premiums on MBS, and gains in everyone’s portfolio.  For most of the year the New Issue monitor on Bloomberg showed that the majority of the new issues from the GSE’s were step-ups.  This was largely a reflection of investor sentiment.  Many buyers wanted the yield associated with the longer paper, but wanted some protection in case rates rose…thus step-ups became a huge part of the investment landscape.  At some point in time it became difficult to find a straight Agency Callable.

On the MBS front it became difficult to find a bond that didn’t trade north of $105.  When the 10-year Treasury yield drops to the 2.40% range and MBS spreads are tight it leads to huge premiums.  This is great for the bonds you already own at lower prices, but it created significant challenges for new purchases.  Structure was the name of the game at that point.  It became very important to pick structures that would provide some natural disincentive to prepay activity.  Things like lower coupons and shorter amortization schedules were in high demand.

For much of the year the comments were along the lines of “I really don’t like the yield levels…but at least our bond accounting looks good.”  Then the 4^th quarter hit.  In November the Fed announced its QE2 program.  The goal of the program was to keep rates low to support asset prices and enable low cost borrowing by consumers.  This did not work out as the Fed planned.  QE2 actually coincided with the beginning of a sustained pullback in prices that caused yields to rush higher.  Now borrowing costs are higher for everyone and refi activity has slowed.

The run-up in yields has caused a significant drop in the “gains” column on the bond accounting reports. 

Why did we see the run-up in rates?  Many explanations have been tossed about.  They include but are not limited to:

-          Concern over our debt load is causing risk premiums to rise. 

-          It’s a reversal of the deflation/double-dip trade. 

-          Speculation that the new tax initiatives will spur economic growth. 

-          Bond vigilantes are punishing the Fed and Congress for poor decisions. 

-          Portfolio duration rebalancing. 

-          Year end liquidity concerns. 

-          Investors taking gains for year end. 

Inflation? 

Many investors harbor a large reservoir of fear over the potential for inflation that QE2 brings with it.  The thought process is that pushing $900 billion into the market will provide the kindling for a massive bout of inflation. 

Minneapolis Fed President (and soon to be voting member) Kocherlakota addressed this thought directly in a speech recently.  His position is that there are already over a trillion dollars in excess reserves sitting on bank balance sheets currently…and those haven’t sparked any inflation at all.  In fact even with that massive amount of excess reserves in the market inflation is actually trending lower.  With this in mind, he says that another $600 to $900 billion won’t do anything that the first trillion didn’t do. 

Another thing to keep in mind on the inflation front is that everyone at the Fed is confident that if inflation becomes an issue that they have the ability to efficiently and effectively pull back the liquidity that they’ve provided the markets, thus choking off any potential for runaway inflation.

It’s also worthy of note that it’s difficult to find anyone outside of the Fed that has the same degree of confidence in that plan.

Now vs. then

While many economic indicators have been posting modestly positive results recently it’s interesting to note where some of the other indicators are as we begin the New Year. 

Fed Funds today 0 to 0.25%, 1-year ago 0 to 0.25%

10 year Treasury today 3.39%, 1-year ago 3.81%

Unemployment Rate today 9.80%, 1-year ago 9.70%

CPI Year over Year today 1.1%, 1-year ago 2.6%

Consumer Confidence today 52.5, 1-year ago 56.5 (in Feb of ’07 this was running at 111.2)

 

On the horizon in 2011

Monetary policy

There are at least four things we know about monetary policy in 2011. 

1 -The Fed isn’t happy with the Unemployment Rate. 

2 - They aren’t happy with the inflation rate. 

3 - They’ve told us that rates will remain exceptionally low for an extended period of time. 

4 - They started saying that in 2009 and we are still at zero.

Some Fed members (like Pianalto) have come out and stated that they expect the unemployment rate to remain elevated for years.  It is difficult to find anyone that thinks it will drop below 8.50% before the year 2013.  It is hard to envision the Fed raising rates before there is significant downward momentum in the unemployment rate.

Municipalities

Municipalities will be big in the headlines in 2011.  This is widely considered to be “the next big bailout”.  The recession has compounded an already complex set of problems that face many municipalities around the country.  

Regulators have ramped up their attention on muni’s and they would love to see a thick file of backup that shows you are keeping on top of the financials of the muni issuers you own.  We can provide a portfolio review of your municipal holdings that will help greatly when it comes showing the regulators you are staying current.  If you would like us to run this for you just shoot me a copy of your portfolio. 

If you have the ability to do so, now would be a good time to consider dumping credits that might keep you up at night if we start to see an uptick in worrisome municipal headlines.

Higher rates?

While it’s never possible to call rates we can certainly use the pieces of data we have in front of us to help guide our outlook.

We know that the Fed doesn’t want to raise the short end.  They continue to tell us at every opportunity that the overnight rate will remain exceptionally low for an extended period.  We also know that they are continuing (with almost unanimous support) the QE2 purchases which should serve to offset further increases in yields to some degree.

That doesn’t mean that the rest of the curve can’t go up though right?  Right.  When long term yields rise faster than short term yields it is called a steepening.  We commonly measure the steepness of the yield curve as the yield difference between the 2-year Treasury and the 10-year Treasury.  Using this method we can make some comparisons.  

Over the last 34 years the average spread between these two points on the curve over has been 83 basis points ( I use 34 years because that is as far back as Bloomberg will allow me to go using a weekly figure).  The record spread was 287 basis points (4/16/10) and the current spread is 270 basis points.  We are operating very close to record spread levels in the current market.

While it is certainly possible for the curve to steepen even more than it is today…and to break all existing records for steepness…it would seem that there are some limits to how high rates can go with the Fed anchoring the short end at zero and the market already pushing record spread levels.

Fannie and Freddie?

What of Fannie and Freddie?  It seems like they barely make the news now-a-days.  Once every few months they’ll show up looking for a few hundred billion to plug some losses but nobody really pays attention anymore.  The idea is to ultimately remove them from “conservatorship” status and into something more permanent.  None of the powers-that-be have offered any solutions to this problem and nobody seems gung-ho to tackle the problem right away. 

Regardless of how they proceed with the GSE’s the most logical outcome is that any existing debt will be “grandfathered” so to speak and will be backed by the Government.  What will replace the GSE’s is anybody’s guess…but the one thing we know is that the Government can’t afford an attempt to force a haircut on anyone’s GSE debt.  The carnage from that tactic would make the melt-down of 2008 look like a picnic. 

They are still out there

The Fed wants you to make loans, the regulators are still criticizing you for making loans, and people like this next guy are still coming in and asking for loans.  I was talking with a friend of mine shortly before Christmas and he relayed this story to me.  A guy comes into his bank.  This guy hasn’t had a driver’s license in 20 years because he’s had so many DUI’s.  He owes a neighboring state $44,000 in fines and fees, he owes his current state $1,500 fines, he owes the casino’s money, he is unemployed, and he went home the other day and his girlfriend told him she’s pregnant.  So what does he do?  He goes down to the bank and asks for a $7,000 loan.

I know this isn’t indicative of the “average” loan customer that comes in the door…but it points out the fact that not all borrowers have really come to grips with reality yet.  Who knows…some may have never had a grip to begin with. 

If you have any questions or if there is anything I can be doing for you just let me know.  If you have any bond-buying friends that you think would like to receive these updates please let me know and I’ll get them on the distribution list as well. 

 

Thanks,

Steve Scaramastro, SVP

800-311-0707