News, News, News – Ignore it all

The story is in the Treasuries. Equities, currencies, commodities, real estate...they are all secondary to bonds.Viewing the remainder of this article requires a Subscription

Fed raises discount rate

Yesterday, after the close, the Fed raised the discount rate from 50 to 75 basis points.Viewing the remainder of this article requires a Subscription

What we’re watching unfold…

Warning: This post has nothing new for readers of our newsletter.Viewing the remainder of this article requires a Subscription

Watch the 10-Year

Everyone is talking about Plosser discussing selling off the Fed's MBS hoard. It's obviously necessary, but completely unfeasible given a still shaky housing market and no lending. Additionally, it would fly in the face of the Fed's QE campaign.Viewing the remainder of this article requires a Subscription

It’s always easier to give advice…

We were great at giving advice to Japan throughout their lost 2 going on 3 decades, and we're great at giving advice to Europe on whether and how to deal with Greece.Viewing the remainder of this article requires a Subscription

10-year auction was mediocre

Bid to cover was still 2.67, direct bidders was at a recent high of 13%, which is interesting. Not sure why that is. In the meantime, yields crept up towards the 3.7% mark. More interestingly, the credit default swaps (CDS) on 5 yr bonds is at 53 bps, which is up from 36 bps in January.Viewing the remainder of this article requires a Subscription

PIMCO introduces a new bond index – and shorts the entire developed world in the process

The Barclays Global Agg Index is a cap weighted index where as a countries debt rises, so does the representation in the index.Viewing the remainder of this article requires a Subscription

This story was definitely under-reported: A must read from the Financial Times.

I saw this story in the Financial Times and was surprised that I didn't see it all over the place. It relates to China punishing the US over arms sales to Taiwan, by halting purchases of Treasuries.Viewing the remainder of this article requires a Subscription

It makes me uneasy when too many people agree with me…

All over the place, I see signs that people agree with me, and it's making me increasingly uncomfortable:

1. The End of the Bond Bull Market: Barry Ritholz writes in The Big Picture that the bond bull market we've been seeing since 1981 looks like it might be ending.

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Bank of England Halts Bond Purchases, Obama Supports Free Trade, where we went wrong, and more

The carnage from yesterday masked a lot of interesting news bits, some good, some bad, some just plain confusing:

• For starters, CBS Marketwatch ran a story about Bank of England Halts Bond Purchases. As central banks around the world face up to the reality that even they are not bigger than the markets, quantitative easing programs are likely to be pulled back. We’re seeing it in England, but as the PIIGS come under continued fire, they’ll also be mandated to cut back fiscal spending. Unlike the US, the PIIGS are closer to states in that they have limited leeway on deficits and printing. It might actually end up being their saving grace if they can get their PR story straight.

• On our side of the pond, President Obama made a step in the right direction by going against his party, and coming out in support of free trade. The NY Times ran the following story: White House Unveils Plan to Double U.S. Exports. While encouraging, the language did not contain the commitment that we’d prefer to see, and I’m afraid that this is all just talk.

But in announcing the new strategy, the commerce secretary, Gary Locke, did not say when the administration might send Congress three completed free-trade accords — with Colombia, Panama and South Korea. Many trade specialists say that is essential to prod other countries to negotiate with the United States. But the move is likely to cause a rift with Mr. Obama’s liberal supporters in the Democratic Party, as well as free-trade opponents in the Republican Party.

So we’re left holding our breath. I don’t think the Obama administration will have the political will or power to go against their base of unions and left and right wing protectionists. In fact, I wouldn’t be surprised to see protectionist measures implemented over the course of the year.

• Obviously, Australia left it’s interest rates unchanged. Screwed the carry trade for a lot of people yesterday, but was not that surprising to us. Remember, we’re long USD vs. JPY and vs. EUO. We just believe that USD will still be the beneficiary of the unwinding of risk as must happen. We should have been like Wells Fargo, who shorting the carry trade on the yield curve, and taken more aggressive positions in long USD.

• Where we went wrong: We’ve allocated a small portion of our portfolio to a metals portfolio. We built a position in gold and maintained it. We increased our exposure by building positions in SLV, PALL, and PPLT. We got in too late and should have diversified some of our gold holdings earlier. We are down between 8-18% on the positions. While it’s painful, we continue to hold these positions. First, the individual positions are small. Second, the entire position in metals is relatively small. Third, we maintain that the reasoning behind owning exposure to physical metals continues and we’re happy about the diversification into metals other than gold. We’re not in copper at all. Additionally, today we added a small exposure to GDX as the spread between GDX and GLD seems to imply that there is more potential for outperformance in the miners than in the physical. Here’s the chart from StockCharts.com:

This is the ratio of GLD:GDX. It’s not at the hyperextended levels of Oct. 2008, when the ratio was over 4, but it still looks like the valuation of the miners is low relative to the price of gold.

• Lastly, I want to discuss Treasuries. In 1992, as Soros was breaking the Bank of England, the trade was a simple understanding that no entity nor government is stronger than the market on a long term basis. We have been getting comments and notes about how we can see a continued debt deflationary environment, with a stronger dollar, and lower Treasuries. In the 1970’s, the thinking was that inflation and growth went hand in hand. Stimulate inflation and you’ll get to full employment (sound familiar?). Instead, we had a previously unimaginable situation where we had inflation and no growth, and with it a new term: stagflation. In my mind, we can enter a period where people will want to hoard dollars and not lend it out to the government. It’s the worst possible world for the Fed, whereby they will face higher borrowing costs without stimulating any inflation since the velocity of money will go down. If fiscal policy doesn’t cut government spending, we will be in a very weak position with very few places to hide. Once spending does start, we will face the specter of inflation that will continue to put downward pressures on Treasuries, this time on the short end. We are stuck and the losers will be the holders of long-dated Treasuries. For the Treasury market to rally from here, an investor would have to believe that the Fed, Treasuries, and government can orchestrate a “soft-landing” where domestic savings rates inch up, foreigners continue to want to finance our deficits, trade balances magically and incrementally improve, etc. I’m not a big believer.

Anticipation and why we’re not writing about the Euro

I’m seeing stories left and right about Greece…and Portugal…and Spain…and the EURO. I’m not surprised, but I feel like this is by now an old story for our readers. Europe is facing an unsustainable situation and it was only a question of timing for when would the “Union” come under fire. So now, everyone is talking about the PIIGS, or Greek spreads (not taramosalata), etc. but I feel like they should have been discussing these issues months ago. Instead, just a few months back, everyone was talking about the death of the dollar and shifting to the Euro to diversify reserves. I just couldn’t believe that Russian central bankers would get that right. For investors (as opposed to traders), you had to be set up months ago, and had to wait a while. Traders can now try to jump on the bandwagon, but the investor who was looking at the valuations and positioning of the major player could sit back and look at it unfold. So for us, there’s nothing to write about the Euro here. It’s still in trouble. We’re maintaining our short position versus the dollar (not adding, not taking anything off), and we continue to wait.

So now the question is how do we position ourselves for the future. Looking forward, the bond market seems to be the area that needs the attention. Why? Because it is the most heavily manipulated market right now. Let’s try to describe the real estate market to an outsider (in it’s current form): well, homeowners can’t afford the houses on the market, so the government taxes them so that they can give them a credit, then it provides them with cheaper financing than they deserve, thereby taking on risk, which it (the government) doesn’t know how to value and keeps off its balance sheet. Does that sound like a market you’d want to invest in? Probably not. Taking that description to the Treasury market, the government provides 0% financing (look how well that worked out for GM) to banks so that they can in turn lend it out, which they do. They lend it out to the government by buying longer dated bonds, which in turn is given right back to the banks for more cheap financing. If this sounds like an Enron type scheme, where there’s no economic value to the transaction, only the middle man gets a cut, or a large Ponzi scheme that is bound to fail as soon as one party runs out of suckers, then you understand our contention that the Treasury market is unsustainable. We are probably off on the timing, but we usually are early as we try to build positions in anticipation.

The inflation/deflation debate will be meaningless for the bond market. We can have deflation and declining bonds (just like we can have inflation with no growth, which was assumed to never happen prior to the 1970’s). Rates have to go up to reflect how expensive it is to lock up money and provide financing in an uncertain environment. The government can manage short term rates, but it’s the long-term rates that will tell the story. Bonds might stage safe-haven rallies, but the support will ultimately fail, as investors shy away from providing the US government with cheap financing. How many times can the Senate increase the debt ceiling? See related story: http://www.bloomberg.com/apps/news?pid=newsarchive&sid=as..HY4pCfZc.

If you haven’t seen it, please read Reinhart and Rogoff’s piece This Time Is Different piece, highlighting the tipping points for debt to GDP levels (happens to be 90%, the US is currently at 84% if you don’t use accrual methodology and don’t count Fannie and Freddie as government liabilities).

So now, we wait in anticipation. And once everyone realizes what’s happening, we’ll already have to start searching for the next place to wait. Investing is all about the waiting.

TARP overseer says bank bailout program has mixed results

Why is this story going by with no reaction? I have to admit that often, some news stories are so obvious and out there, that I don’t bother to post them because it feels like they’re already plastered all over the place. I assumed this was one of those stories that would be all over the blogosphere, newswires, etc. And yet, I haven’t found a lot of reactions (or at least as many as I’d expected).

Here’s the quote that summarizes it all for me:

…”Stated another way, even if TARP saved our financial system from driving off a cliff back in 2008, absent meaningful reform, we are still driving on the same winding mountain road, but this time in a faster car,” said the report…

Read the full article here:

http://www.marketwatch.com/story/overseer-bank-bailout-program-has-mixed-results-2010-01-31

The report goes on to criticize TARP for not stimulating lending, failing on the mortgage modification front, and most importantly, continuing to distort the asset markets, specifically housing!! So a government report comes out, criticizes a program that is going to be expanded for not achieving its stated goals, then goes on to state that the entire program is distorting prices and may yet lead to another asset bubble!?!?! Why are people not reacting to this? Is it so obvious that they’ve already priced it into the markets? I don’t think so. In fact, I think no one wants to listen. But the bond market will start listening soon (first). As Fannie and Freddie continue to hold up the housing market, we can only continue the charade for so long. Look for 10-year yields to break through 4% in the upcoming months.

Interestingly, Wells Fargo might have just gotten our vote of confidence, by being on the other side of the carry trade and sacrificing gobs of money (very scientific) to take off risk. What does it say about the other banks? http://www.bloomberg.com/apps/news?pid=20601109&sid=aM.IPx7G5hAw&pos=13

Is deflation winning out?

In the ongoing debate between inflation and deflation, we’ve heard both sides, tried to look to the historical record for guidance, sought comfort from statistics and experts, yet in the end have come up with strong arguments on all sides. We’re not even sure all the information is conflicting anymore, but in the end, we have to define and quantify a bias, a world view, a story that binds the different pieces together. We find ourselves continually biased towards deflation. It’s colored our decisions, and impacted our investments, and still we find ourselves now with seemingly conflicting investing ideas: short bonds and long metals sounds like it might be inflationary trades, underweight equity and long cash sound like they are deflationary trades. Underweight real estate, overweight India and zero weight to China – how do those all fit in? Are they hedges against each other? Compounding each other?

Let’s start with some basics. Deflation happens when an organization loses pricing power. It happens when organizations need to find lower market clearing prices. It can happen in positive ways (for example, by paying $500 for a laptop with the computing power that cost $5,000 a few short years ago) or negative ways (for example, when you’re house sells for 15% less than it did 3 years ago). It is initially painful to the seller, and especially painful to the levered seller. For the buyer, it feels great – initially. Until it doesn’t. At some point, the buyer decides that it’s worthwhile to wait longer for an even better deal. At some point after that, the buyer realizes that whatever product of service he/she is selling will probably also need to be discounted in order to clear, at which point a bit of fear sets in. And there’s the danger. On a more macro level – organizations that lose pricing power face a squeeze on margins. Those that are levered then face a squeeze on financing. On a more macro level – trade goes down, protectionism looks like a good idea, and then it’s over. At some point market clearing prices are reached, companies that survive with strong balance sheets regain pricing power, etc.

Why go through this exercise? Let’s think through the organizations we have to analyze: people, households, companies, governments. As we go through each organization, we find deflationary forces:

1. People – labor is not in control these days. Wages are stagnant, at best. Unemployment is at 10% and if you’re using good statistics, closer to 18%. If anything, wages will be put under pressure in the near future.
2. Households – continue to be indebted, even though many are trying to lower it. Residential real estate has been nationalized, with 95% of new mortgage originations occurring through GSE’s. Real estate has not stabilized, and commercial real estate is about to roll over.
3. Companies – retails has actually held up better than expected, but credit card defaults are rising and the consumer will require more and more sales (deflation) to purchase. Internal demand from Asia hasn’t materialize (yet). Most importantly, margins have risen to such high levels off the back of squeezing costs. Margins going forward will be tough without an increase in revenues, which hasn’t come.
4. Governments – governments can lose pricing power as well. Japan has been a startling anomaly, but I wouldn’t depend on it continuing or working for others. With debt to GDP starting to hit important levels, government bonds will lose their appeal, and with it, their pricing power. So, prices will have to go on sale. We’re seeing it already in the municipal bond market. We’re seeing it with sovereigns like Greece. We’ll see it with Treasuries as well. If the US government loses pricing power, won’t the dollar fall as well? Actually, it might not. The dollar will still be needed for trade, for a safe haven, and as a relative trade against the worse government situations in Japan and Europe, so we can have a situation where the dollar is up and the Treasuries are down.

All of these organizations seem to me to point to a contraction of margins on all fronts, loss of pricing power, consolidation, retrenchment, and balance sheet rewinds to the pre-”stock option/insanely low interest rate/agency-moral hazard games of manager vs. owner/etc.” times.

We continue to mistrust rallies at these valuations, and are wary of people screaming to buy the dips.

Suburbanization of Poverty

What are the policy implications of this study? I’m not sure, but I can see strains on local governments, especially with reduced tax collections. A recent column on CBS Marketwatch concludes that muni’s might be a better deal right now, but given the strain on local governments and the inability to print their way out, maybe the bond market is trying to tell us that local governments are in deeper trouble than we might think (http://www.marketwatch.com/story/surprise-munis-yield-more-than-treasurys-2010-01-26).

The Suburbanization of Poverty: Trends in Metropolitan America, 2000 to 2008

Elizabeth Kneebone, Senior Research Analyst, Metropolitan Policy Program
Emily Garr, Senior Research Assistant, Metropolitan Policy Program

The Brookings Institution

January 20, 2010 —

An analysis of the location of poverty in America, particularly in the nation’s 95 largest metro areas in 2000, 2007, and 2008 reveals that:

By 2008, suburbs were home to the largest and fastest-growing poor population in the country. Between 2000 and 2008, suburbs in the country’s largest metro areas saw their poor population grow by 25 percent—almost five times faster than primary cities and well ahead of the growth seen in smaller metro areas and non-metropolitan communities. As a result, by 2008 large suburbs were home to 1.5 million more poor than their primary cities and housed almost one-third of the nation’s poor overall.

• Midwestern cities and suburbs experienced by far the largest poverty rate increases over the decade. Led by increasing poverty in auto manufacturing metro areas—like Grand Rapids and Youngstown—Midwestern city and suburban poverty rates climbed 3.0 and 2.2 percentage points, respectively. At the same time, Northeastern metros—led by New York and Worcester— actually saw poverty rates in their primary cities decline, while collectively their suburbs experienced a slight increase.
• In 2008, 91.6 million people—more than 30 percent of the nation’s population—fell below 200 percent of the federal poverty level. More individuals lived in families with incomes between 100 and 200 percent of poverty line (52.5 million) than below the poverty line (39.1 million) in 2008. Between 2000 and 2008, large suburbs saw the fastest growing low-income populations across community types and the greatest uptick in the share of the population living under 200 percent of poverty.
• Western cities and Florida suburbs were among the first to see the effects of the “Great Recession” translate into significant increases in poverty between 2007 and 2008. Sun Belt metro areas hit hardest by the collapse of the housing market saw significant gains in poverty between 2007 and 2008, with suburban increases clustered in Florida metro areas—like Miami, Tampa, and Palm Bay—and city poverty increases most prevalent in Western metro areas— like Los Angeles, Riverside, and Phoenix. Based on increases in unemployment over the past year, Sun Belt metro areas are also likely to experience the largest increases in poverty in 2009.

Over the course of this decade, two economic downturns translated into a significant rise in poverty, nationally and in many of the country’s metropolitan and non-metropolitan communities. Suburbs saw by far the greatest growth in their poor population and by 2008 had become home to the largest share of the nation’s poor. These trends are likely to continue in the wake of the latest downturn, given its toll on traditionally more suburbanized industries and the faster pace of growth in suburban unemployment. This ongoing shift in the geography of American poverty increasingly requires regional scale collaboration by policymakers and social service providers in order to effectively address the needs of a poor population that is increasingly suburban.

http://www.brookings.edu/papers/2010/0120_poverty_kneebone.aspx?p=1

Return-Free Risk

Treasury sells $10 bln in 1-month bills at 0%

NEW YORK (MarketWatch) — The Treasury Department sold $10 billion in 1-month bills on Tuesday at a rate of 0%, the fourth time since December that the government has sold the short-term securities for no yield at all. Bidders offered to buy 5.55 times the amount of debt being sold. Later in the session, the government will auction $44 billion in 2-year notes.

Click here for source story.