Deflation probabilities’ uptick

March 24, 2011 Longer-term deflation probabilities move up slightly Prices of Treasury Inflation-Protected Securities (TIPS) with similar maturity dates in 2015 can be used to measure probabilities of a net decline in the consumer price index over the five-year period starting in early 2010.

Treasury Borrowing Advisory Committee

The Great Vega Short

Artemis Capital just put out this interesting report (HT: ZeroHedge) about the Fed conducting the largest ever short of vol in history:

The Great Vega Short

In theory the Federal Reserve is now the largest volatility trader in the world because current monetary policy is akin to shorting massive amounts of volatility and assuming tail risk. The current regime of monetary and fiscal stimulus is similar to writing a naked put on the entire financial system with margin backed by the US debt. The premium received from the sale of the naked put is financed via demand for our debt and redistributed to the investor class to re-flate underlying asset prices and depress volatility. The theory is that the reinvestment of this premium by investors into underling risk assets ensures the Fed’s naked put is never exercised. In effect, the Federal Reserve is constantly shorting vega on a systematic level. This stimulus regime socializes “tail risk” to generate short-term prosperity. If asset prices drop the Fed is forced to sell more volatility to artificially support prices. This will work as long as (1) asset prices do not collapse too far or; (2) taxpayer funded margin is unlimited. If either of these two conditions are not met the asymmetrical return distribution of the strategy will result in complete ruin. It is a martingale process, similar to constantly doubling down your bet while gambling (with better odds though). It works only if your bankroll is unlimited.

Read the full report here.

This doesn’t end well, but the timing is difficult.

The Fed can’t manage the economy, but they can still do interesting research

The Breadth of Disinflation

By Bart Hobijn and Colin Gardiner

In recent months, inflation as measured by the personal consumption expenditures price index has been trending lower. This slowdown, known as disinflation, has raised concerns that inflation might actually drop below zero and enter a period of deflation. An examination of the distribution of inflation rates across the range of goods and services that compose the index suggests that downward pressures on inflation are relatively high by historical standards.

For the full paper, click here. I continue to believe that debt deflation will put downward pressure on the traditional stores of value (real estate, equity, bonds), while monetary and fiscal policies will haphazardly put pressures on “needs” or inputs – biflation. This will have the effect of squeezing margins, and increasing pricing uncertainty, which in turn will make it difficult for businesses to invest and plan. Coupled with high unemployment, increasing unfunded pension liabilities, and geopolitical instability, the “fingers of instability” which we have discussed in the past are now long and networked – meaning a small disturbance can have large consequences.

If I had $600 Billion, I’d be rich

The Fed cam out with QEII and the essence is that there will be $600B pumped into the market for the next 8 months in the hopes of stimulating economic growth. I won’t go into the differing opinions of whether QEII will actually work, but simply state mine: if QEI didn’t work, why would QEII? We don’t have a liquidity problem that can be solved with more POMO activities. We have credit/faith problem, which isn’t solved with free money; quite the contrary, something that is free isn’t worth anything.

When the dust settles, I don’t think this round of QE will make much of any difference. The focus now is the turning point in the yen, the turning of Chinese growth numbers which I believe will come in over the next few months, and the breakdown of the euro (Ireland and Greece are only the beginning). The dollar will look like a superstar compared to the alternative, and will squeeze nay-sayers.

10 o’clock check in

Where to begin today? We’re a little late on the uptake because so much is new and so much is old.

The dollar continues its downward spiral with Singapore joining the rest of the world against the USD and Bernanke’s campaign for inflation. The currency wars are raging, and I’m not sure if winning is good.

Meanwhile, August trade balance is at -$46.3 billion – worse than expected. Assuming it doesn’t get revised even lower, it will still have a negative impact on GDP revisions for Q3. At the same time, the China bashing continues in Washington (as if that’s the problem).

PPI came in a 0.4%. We have been discussing the duality of the market – inflation in expenses, deflation in wealth. Well, food and energy were the main drivers of the increase. Sans those, and PPI was only 0.1%. That being said, most people don’t exclude energy and food prices from their monthly bills, so the average person is feeling it in their pocketbook.

Jobless claims came in at 462K (up from 445K), and the prior number was revised higher (no surprise).

On the other side of sanity, Paul Krugman discusses the need to increase QE by $8-$10 Trillion, while on the same day, the St. Louis Fed comes out with a report on why QE is bound to fail. It’s a mad world.

You thought equities would sell the news…

Buy the rumor sell the news (of QEII) – at least that’s what the analysts were telling us this morning. Well, the Fed notes came out and QEII is on its way and somehow the desired policy is wagging the numbers rather than the other way around, so recession fears are lowered, growth tepid, but positive, etc.

But wait…someone out there is actually recognizing a problem? Could it be? Maybe, because while equities are up as I write this, the 10 year is down (yield up):

I’m not calling a top in bonds – I’ve been short for too long, but foreign holders might not be happy anymore with a weak currency and little yield. Something has to break further to bring some semblance of logic back, but this might be a start.

Fed – deflation fears dominate

First, click here if you want to see the statement in its entirety.

Second, note that Hoenig was a lone dissenter.

Third, the Fed is confirming slow growth and fearing deflationary pressures and stands ready to inject further liquidity.

Fourth, predictions of an imminent announcement of QEII were premature, although Fed bond purchases continue without such announcement and rates are incredibly low. Could they go lower? For sure, but again, I don’t think 10 year rates will fall below 2 (I don’t even think they’ll get to 2 – but it’s an easy round number to point to).

Euro is going to 1.32 as we speak.

Yen is stronger as well at 85.2.

Gold went from down to up in 10 minutes.

And the market is up over 50 points as I write this.

More to come…

From the Fed: Future Recession Risks

Future Recession Risks

by Travis J. Berge and Oscar Jorda

An unstable economic environment has rekindled talk of a double-dip recession. The Conference Board’s Leading Economic Index provides data for predicting the probability of a recession but is limited by the weight assigned to its indicators and the varying efficacy of those indicators over different time horizons. Statistical experiments with LEI data can mitigate these limitations and suggest that a recessionary relapse is a significant possibility sometime in the next two years.

For the full paper, click here.

There’s nothing more to say. The Fed is starting to recognize that risks remain to the downside. It supports the view that rates will be kept low for the foreseeable future.

Curious Trading by Federal Reserve Advisor May Result in JPMorgan Chase $1.264 Billion Windfall

In the future, books will be written and PhD dissertations will analyze just how much the taxpayers and investors got screwed by some big players and the government, but for now, we hold our breath. As a start, the following is a must read, and while the intricacies might be overwhelming, the opening paragraph and conclusion are important:

Opening:
Since the Federal Reserve Bank of New York finished purchasing $1.25 trillion in mortgage backed securities in March 2010, it has continued to support those markets with billions in so-called dollar rolls. Even as this is not well known, what is less well known is that the advisor to the Fed’s other MBS portfolio also continues to actively trade the account. The annual turnover appears to be 12%. One has to ask what the purpose of this turnover is, given it was sold to the public as a portfolio simply being wound down. Just what has BlackRock been selling off and who is buying the discards? (Could it be the Fed itself?) Is this a case of getting stronger paper into the portfolio for the benefit of JPMorgan Chase, run by President Obama’s “Favorite Banker”, Jamie Dimon? Will an easily overlooked disclosure in the portfolio’s audit allow a $1.264 billion windfall payment to JP Morgan in the coming weeks? Nothing can be known for sure unless the Federal Reserve provides further data. But the trading in the portfolio and its valuation is very suspicious. Below is some background followed by a forensic analysis of what is known to date, with a discussion of what further data needs to be provided by the Fed to gain a full understanding of what BlackRock is attempting to accomplish with the unusually heavy trading in Maiden Lane.

Conclusion:

While it would be necessary to obtain all agreements related to the formation, acquisition and management of Maiden Lane LLC to determine exactly what occurred, a reasonable guess would be as follows. Maiden Lane’s substantial losses in the wake of the Lehman collapse in the Fall of 2008 made it unlikely the portfolio would ever regain its value and allow it to repay the $1.15 billion loan plus accrued interest to JPMC. In January, 2009, the New York Fed began its purchasing program of Agency MBS, and over the next fifteen months would purchase a total of $1.25 trillion of such securities. BlackRock would aggressively trade the very same classes of derivatives during this time, taking advantage of the Federal Reserve’s support of the MBS market and perhaps trading directly with the NY Fed. In April, 2009, the NY Fed would post the 2008 Maiden Lane audit and a disclosure to its website that allowed JPMC an early payout of its $1.15 billion loan plus accrued interest ahead of the NY Fed. Over the next year, BlackRock would methodically trade and value the Maiden Lane portfolio higher.

The two year early payout window for JPMC of June 26, 2010 is quickly approaching; however, the last quarterly valuation is as of March 31, 2010. Though mortgage backed securities have largely rallied throughout May on a flight to quality basis (being putatively government insured), Maiden Lane’s commercial mortgage loan portfolio has likely taken further hits since the April 2010 write downs, especially since it has 83.1% hospitality exposure. The second quarter 2010 revaluation will not be released until the end of July, 2010—itself largely based on mark-to-model accounting.

Accordingly, the NY Fed should be circumspect as it considers whether or not to repay JPMC prior to the next revaluation inasmuch as Maiden Lane was, by BlackRock’s own numbers, $2.519 billion underwater with respect to the total loan principal and accrued interest as of March 31, 2010. Should such payment be made and the second quarter revaluation reveal that Maiden is now in the black—thus, perhaps justifying the payout retroactively–the exposure to Level 3 assets would probably not be adequately measured by BlackRock’s model to provide enough of a cushion against future deterioration in its $4 billion commercial loan portfolio. An early payout to JPMC is a bet on the health of commercial real estate loans made to the hospitality industry at a time when underwriting standards were at a multi-decade low. The latest April write downs will not be the last.

Finally, while it is remotely possible that Maiden Lane is simply the best hedged and managed portfolio of modern times, it is important to recall that its purpose was to wind down and recover as much as could be expected for the taxpayers, with JP Morgan Chase taking the first $1.15 billion in losses. If Maiden Lane is eventually able to pay back the NY Fed and JPMC in full, it will be the result of BlackRock’s MBS trading, which was directly and/or indirectly subsidized by the Fed through its MBS purchase program. As the Fed’s $1.25 trillion in MBS assets are only reported at par and were acquired to support the market (meaning bought high and sold low), it would be difficult to justify a payback of any amount to JPMC until the Federal Reserve can demonstrate it has liquidated all of its MBS holdings without a loss.

For the full article, click here.

OIS, Fed swaps, and Europe

Why would the Fed loan money to Europe when Europe doesn’t want to lend money to Europe?

The Federal Reserve has a lever it can pull to help European officials combat a worsening financial crisis: Reducing the interest rate it charges on U.S. dollar loans it makes through the European Central Bank to dollar-starved commercial banks in Europe. The move, though not a cure-all, could relieve some of the strains in European money markets.

The loans currently are priced one percentage point above a market rate called Overnight Indexed Swaps (OIS), which tracks the expected path of the Fed’s benchmark federal funds rate. The loans are set above OIS to discourage foreign banks from using the government program too aggressively. But the Fed could reduce that penalty to encourage more borrowing and ease some of the financial strain on foreign banks in need of dollars.

For the full article, click here.

So the euro sucks, European banks don’t trust each other and LIBOR is rising (although still incredibly low by historical standards), and the Eurozone countries can’t get it together to figure out a way to provide liquidity to each other. Should the Fed help? Definitely. Sometimes politics and stability are more important than economics. So the Fed set up swap lines priced off OIS. Again, contrary to the article above, the interest charged is pretty low given the fact that each European country should have a negative FICO score. Now, the markets are discussing ways for the Fed to renegotiate for a lower rate! Incredible and highly dangerous. The thinking is that by lending to other central banks, the US is limiting its own exposure (the euro can always be printed). It begs the question – the US taxpayer is footing the bill, so are we getting a good deal? I don’t think so. Even at 1% over OIS I think it’s a bad deal, but at least it’s something that would make the Eurozone countries a little hesitant to borrow too much. Do we really want to encourage European countries to borrow from us, then pay us back in valueless euros? What’s the benefit and cost? Some at the Fed would argue that the instability caused by not reducing the rates would be too costly. I would argue that like all inflation it is a stealth tax being imposed on America and the taxpayers will bear the ultimate cost, probably by owning devalued euros and obligations denominated in them.

Fed in a tough spot

Pity Bernanke: he makes one joke about helicopters and he’s locked into a policy of competitive devaluation. Forget consumer spending, savings rate, and all the other fudged numbers that will be coming out in the next few days and weeks – at least forget about them in the near term. As we’ve said recently, the currency markets and Treasury markets are the ones to watch as they are dictating large-scale capital moves. But I’m not here to discuss the currency markets per se. What is the Fed facing right now?

Through a years-long process of quantitative easing and insanely low rates the Fed was hoping to get a whiff of inflation. Politicians were praying that Fannie and Freddie could survive long enough to bolster the real estate market. And the world was looking to China to lead us up. Well, not unexpectedly, the euro is failing, which means the dollar is going up. This is exactly the opposite of what the Fed had in mind. With an uncontrollable deflationary move, US firms become less competitive worldwide, the export sector will suffer, and financial assets look increasingly vulnerable. Had the Fed not used up all of its firepower, they might try QE NOW, but alas, they are virtually impotent. Sure they can print and drive race to the bottom through competitive devaluation, but I don’t think even they would want to go that far.

The best solution now is not monetary but fiscal. By reducing the national debt level the government can actually step in front of the devaluation and lead it. It will give us some dry powder to bail out certain state and municipal governments that will need it in the next few months. If done through strong leadership, the country will follow. When FDR, Eisenhower, JFK, Churchill (most famously) and other strong personalities asked their countries to sacrifice, it did not lead to their political downfall, on the contrary, they came out of it stronger than ever.

ZIRP revisited

We wrote about the quirks of the Fed zero interest rate policy a while ago, and the limits of monetary policy at these levels. A few readers wrote me to ask about specific implications for trades and investable ideas, but at the time, most of the information was academic. Now, as the Fed programs trail off (although I have a feeling some will continue for a while longer) some traders are pointing to very real and scary implication. Institutional Risk Analytics has a fantastic piece by Alan Boyce, in which he shows how the Fed has managed to maintain the facade, discusses the coming increase in interest rate volatility, and the implications for the Fed and traders. There’s also a great summary on ZeroHedge, which I encourage you to read. For those trading or hedging in any credit market, this is an important development to watch, and more and more traders will come to grips with the implications in the coming years.

Fed raises discount rate

Yesterday, after the close, the Fed raised the discount rate from 50 to 75 basis points. http://www.bloomberg.com/apps/news?pid=20601087&sid=akOfpZxuLUc4

I don’t envy Bernanke. Poor guy has no good options. If he raises rates and the markets go down, he gets blamed, and the Robert Reich’s of the world scream. If he doesn’t raise rates, markets start to fear inflation, and every Hayekian (economist, that is) starts talking about the end of the world. In the end, it doesn’t matter. The Fed doesn’t control long term rates, which are a more realistic barometer, and those rates have been rising. The 2-10 spread is at historic highs, and the Fed was forced to raise short term rates (a bit), just to pretend to stop the free ride that banks are getting.

In the meantime, we posted yesterday, that while banks show a slight delevering, the rest of the economy is still levered and not going down yet. We anticipate that this will start changing in the next few months and quarters. In the meantime, inflationary pressures are muted, mostly because the 30% of the CPI composed of owners-equivalent rent continues to go down – and should maintain it’s trend for a while. It would seem that all is well on that front.

So what else am I thinking about? Well, WMT and DELL both show signs of margin compression, which we have been anticipating. Gold is holding up well, and is at all time highs when priced in euros. 10-yr yields are up. And all that said, the market is holding up better than we anticipated. Maybe that’s a sign it will continue rising for a while. Our timing is never that great, since our calls tend to be a bit early. So we continue to look to valuations, and hold defensive positions, including cash.

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. Yet, we’re incredibly bad at following our own advice, from propping up zombie banks to dealing with states with unfunded liabilities.

We have written often about the coming crisis in the municipal debt markets, and it seems like others are recognizing the problems as well. Barry Ritholz recently posted the following:

Insolvent European vs. American States

While all the investing world seems to be utterly fixated on the outcome of Greece’s solvency woes, perhaps we need to step back and put this into perspective.

Portugal, Ireland, Italy Greece and Spain are in varied degrees of difficulty; but how significant are the PIIGS’ debts to the world’s economy? (If they require a workout, perhaps they can what we do. Give them lower rates and an extended term and/or a cramdown to their lenders).

In contrast, consider the distressed United States: How do our own economic “pigs” measure up? In terms of economic importance relative to the world, aren’t the bigger US States that are in deep distress more important (GDP sizewise)?

Consider the size of the budget issues and debt load in dollar and percentage terms for just these six states relative to their European cousins:

You Can’t Put Lipstick on These PIGS:

California
Budget gap (as a % of the total budget): 22%
Gap: $22.2 billion

New York
Budget gap (as a % of the total budget): 9.8%
Gap: $5.5 billion

Florida
Budget gap (as a % of the total budget): 19.9%
Gap: $5.1 billion

New Jersey
Budget gap (as a % of the total budget): 7.7%
Gap: $2.5 billion

Arizona
Budget gap (as a % of the total budget): 19.9%
Gap: $2 billion

Nevada
Budget gap (as a % of the total budget): 16%
Gap: $1.2 billion

All data for fiscal year 2008
Source Businessweek

All by itself, the insolvent nation-state of California is the 8th largest economy in the world. Its the size of France. According to the CIA Factbook, Greece is number 34. That is a lot of hyperventilating about a relatively small impact to global GDP. Italy is 11, Spain is 13, Portugal is 50, and Ireland is 56.

Additionally, in the US, we have 43 of the 50 states in some form of financial distress.

Perhaps the solution to California’s woes is for Arnold (who is from Austria) to have California join the EU. Then, they might qualify for a bailout from Germany . . .

http://www.ritholtz.com/blog/2010/02/insolvent-european-vs-american-states/

And others have begun to point out the same issues. Ritholz doesn’t even mention the $2 trillion in unfunded pension liabilities, the increase in Medicaid costs that are far outpacing inflation and growth, and the mistaken estimates for receipts that are consistently coming in short.

The main difference, of course, is that there isn’t any doubt about whether the Federal government will bail out California, or Arizona, or New York. In return for the bailout, states will continue to lose the little power they have left. On the other hand, the federal government will gain an unimaginable increase in liabilities that are not currently accounted for by the market. The result continues to point to higher rates.