Suppose you own a business and 1/3rd of your product is being bought by a single customer. What if this biggest customer tells you that as of June, he or she will stop buying? What do you do with your inventory? Exactly! You liquidate it in a fire sale! You had been selling what this biggest customer was buying, and then buying what you thought this customer would buy next. This has been precisely our thesis No. 1. As the chart below shows, after the Fed’s announcement at 2:15pm yesterday, Treasuries (long-end) sold off. (There was also profit taking in the Agency market):

The FOMC (Federal Open Market Committee) expressed no change in the plans to buy $1.25 Tr of Agency mortgage-backed securities, $200 bn of Agency debt and $300 bn of Treasuries. There was also no change to the fed funds target range. At 1:22 pm, Mr.Volcker, Chairman of the newly formed Economic Recovery Advisory Board and Chairman of the Fed between 1979 and 1983, had said that the current administration was committed to supporting banks. I think that led the market (and me) to believe there was going to be an upsize in Fed’s Treasuries purchases and, as the chart shows, that pushed Treasuries up (for a short time). The FOMC said the economy continued to contracting, but at a slower pace (GDP -6.1% q/q annualized).

I can’t understand stocks. The S&P 500 shot up on the news, and although it ended lower, it was still +2.16% (873.64pts). Why is this hard for me to see? If the long-term (30-yr) risk-free yield rose above 4% post-FOMC and the USD fell against the Euro and the Canadian dollar (=outflow of capital), why are stocks higher? (The USD rose against the yen and Pound, but this reflects and does not explain the rise of stocks). Isn’t a risk-free 4% yield good enough? Maybe it isn’t so risk-free … To make things more interesting, Treasuries in the short-end (2- yrs) had a solid bid, steepening the curve at close. Before I continue, I must say, thesis no. 3 (proposed on Friday) was refuted yesterday (= I was wrong!). There was no announcement of an exit strategy and stocks went up. I could say that to stop buying (FOMC statement) somehow indicates the way out (exit) of this mess, but I think the Fed is only bluffing, and it will keep buying anyway…Perhaps, we may have to first look at the credit markets. The CDX IG12 index finished at 168 bps (-9bps) and the High Yield index also did well, about 2 pts up. Even the leveraged loan LCDX index rose more than 1 pt. What is this supposed to mean? Maybe the market is seeing a light at the end of the tunnel. Perhaps the Chrysler negotiations are positive, the distressed debt exchanges we are witnessing will really avoid defaults, perhaps the bank issuance coming outside of the FDIC-backed program (Goldman Sachs sold yesterday $2BN 6% 5-yr notes priced at T+410bps) is also a good sign. If this is the case, the market may wait for a confirmation this Friday, with the release of the ISM Manufacturing Index, before it moves anywhere (Readers’ feedback is welcome)…On this basis, I will wait until Friday, before I reject thesis No. 3. ONE LAST THOUGHT: If we are comfortable with a 4% long-term yield, with double-digit debt exchanges, with oil going higher on oversupply and stocks higher on awful news, maybe Keynes was right when he said that (refer April 28th letter): “…when output has increased and prices have risen, the effect of this on liquidity-preference will be to increase the quantity of money necessary to maintain a given rate of interest…” (General Theory, Chapter 13, published in 1936). We may indeed need more money to maintain the higher yields, to repay the double-digit maturities, a barrel of oil, Citibank shares or my morning coffee! I only hope that more money is also needed to pay your and my salary!

The markets continued suffering from the pig flu contagion yesterday. But the big picture did not change. Speculation over further capitalization needs brought major banks’ equities down: Bank of America -9%, Citi -5.9% and Wells Fargo -3.8%, among others. As well, Chrysler’s banks were in negotiation to reach an agreement with the US government to exchange $6.9BN in secured debt for $2BN in cash. There were however positive economic data, as the S&P Case Schiller Home Price Index was minimally better than expected, at 143.17 and the Consumer Confidence index was at 39.2 vs. expected 29.7. Did stocks trade on fundamentals and did not fall further because of these news? The S&P500 ended at 855.16pts (-0.27%). The CDX IG12 index closed flat at 177bps.
The Federal Open Market Committee started its 2-day meeting yesterday. But the Fed did not buy Treasuries and at the 30-yr level, the yield is already at 3.95%. The market continued to buy into Agency debt, with spreads over Treasuries tightening to lower levels. It seems that the Fed’s intervention in this market is creating a huge distortion. One can only wonder what will happen once this bid disappears. The distortion has long legs, as any other monetary distortion. Not only prices between mortgages and Treasuries have converged but with it, a new wave of mortgage refinancing is taking place. Simultaneously, REITS (Real Estate Investment Trusts) issuances have recently outperformed the High Grade corporate index: Boston Properties completed a $215MM construction financing, Camden Property launched a tendered offer on $258MM, and Vornado announced a common share offering and Kimco Realty Corp. closed a $220MM unsecured Term Loan.
Sure, these transactions were expensive for the issuers, but they still carried on with them…Is there something wrong with it?

I try to keep things in perspective and can only think that all these movements in relative prices (among different asset markets) are possible because investors rely on a STEADY rate of new money supply. But tension, nervousness around this assumption is necessarily going to increase. If I am looking correctly at the chart below (intraday graph for yesterday), the relationship that we had been relying on (Thesis No. 1) between Treasuries and stocks seems to be weaker and weaker.

Given all the rumors on stress tests results, pig flu, automotive sector bankruptcy and the FOMC meeting, I guess I would have to expect certain noise reflected in the chart. But I don’t think this is just noise. And I believe that volatility in exchange rates and equities (VIX Index) as well as spread compression in Agency debt is somehow indicating a certain discomfort. Personally, I don’t want to call this a correction, because I think we are not seeing a fundamental trend. The so called rally has not been a trend, but a mere reallocation of assets fueled by a Fed that buys approximately 1/3 of the US Govt. debt. This brings me back to the thesis No. 3, proposed on the April 27th letter: “Knowledge of an exit plan is a condition for the stocks AND credit markets NOT to fall”. Since April 27th, we have had no news on the subject, and the S&P500 is -1.3%. The thesis, for now, cannot been refuted.

Yesterday was another forgettable session. News of the pig flu, of the Federal Deposit Insurance Corp. Chairman Sheila Bair seeking authority to close “systemically important” financial firms, and of GM’s bondholders’ rejection of the $27BN debt-for-equity swap shaped a tense range trading day. The S&P500 closed -1% at 857.51pts. Treasuries had significantly dropped by noon, but managed to close up in a flight-to-safety move, driven by fears of a pig flu spreading. This same flu pushed Mexico’s credit default from 300bps to approx. 330bps. The Fed bought $7 billion in Sep/13 to Feb/16 Treasuries. Agency debt continued to tighten vs. Treasuries (1 to 2bps) and CDX IG12 finished flat, at 176bps. And we should leave things here.
While we wait for more policy decisions (FOMC meeting today and tomorrow, Fed purchase of Treasury coupons on Thursday), I thought it would be interesting to reflect not on the origins of this crisis, but on the origins of the ideas that shaped the response to this crisis. Most of you would agree that Mr. Keynes’ ideas are behind the policies being implemented these days. Therefore, let’s analyze Keynes’ thoughts on what to expect from a financial crisis.
John M. Keynes’s main work was the “General Theory of Employment, Interest and Money”, published in 1936. Today, we only need to deal with chapter 13. This chapter is titled “The General Theory of the Rate of Interest”.
Keynes was a very practical man. For him: “…the rate of interest is…the “price” which equilibrates the desire to hold wealth in the form of cash with the available quantity of cash…” If we follow him, at close of yesterday, the benchmark (Feb/39 Treasury) price for holding USD cash long term was 3.84% p.a.
Keynes warned that: “…circumstances can develop in which even a large increase in the quantity of money may exert a comparatively small influence on the rate of interest…” Yes, this applies to the $300BN Treasury purchase program by the Fed. I let the reader judge the degree of influence this program has had so far (1 month later) on the rate of interest.
Keynes offered an explanation for these circumstances. He wrote that: “whilst an increase in the quantity of money may be expected… to reduce the rate of interest, this will not happen if the liquidity-preferences of the public are increasing more than the quantity of money” This should be self-explanatory and consistent with the necessary conclusion from our Thesis no.1 “Sell that which the US Govt. is buying and buy that which the US Govt. will buy (Tincho’s letter, April 6th 2009)”. Keynes further added that: “…whilst a decline in the rate of interest may be expected … to increase the volume of investment, this will not happen if the schedule of the marginal efficiency of capital is falling more rapidly than the rate of interest…” What is the “marginal efficiency of capital”? Basically, it is the (IRR) internal rate of return (refer Chapter 11 of the General Theory). Given a rate of discount, the IRR of a stock is driven by its dividends and final value. Since the beginning of the current crisis, dividends have been continuously cut or eliminated altogether, while stock prices have been falling. It is obvious then that the marginal efficiency of capital was falling until the current rally took place, in late February 2009. Is the marginal efficiency of capital STILL falling more rapidly than the rate of interest? I am not sure, because: a) we still ignore what level of losses the financial system may face in the future b) this ignorance means that we also have uncertainty on how expensive it will be to finance future investments c) given (a) and (b), we don’t know what the final inflation level will be, as the Fed continues to pump liquidity into a broken system. (On September 18, 2008, Goldman Sachs’ US Portfolio Strategy team published an analysis in line with Keynes’ approach. The publication suggested that the implied S&P500 trough for this crisis was at 1,000 points, consistent with a dividend yield of 2.9% for the S&P500 index).
Keynes continued his exposition saying that: “…whilst an increase in the volume of investment may be expected … to increase employment, this may not happen if the propensity to consume is falling off…” If I am right and the Obama administration is guided by these Keynesian ideas, we should therefore expect further policy from the Fed and the Treasury to address the retail credit market and the personal income tax structure, respectively, to boost consumption.
Finally, Keynes says something rather ominous: “…if employment increases, prices will rise in a degree partly governed by the shapes of the physical supply functions, and partly by the liability of the wage-unit to rise in terms of money…”. Essentially, the final rise in prices that we may expect will depend on how we address productivity issues today (i.e. physical supply functions…Will we keep wasting money on the auto sector?) and how our current politicians reshape the labour market today (i.e. contract negotiations with unions, etc. that determine the liability of the wage-unit to rise in terms of money).
The final sentence is perhaps the most relevant. Keynes wrote that “…when output has increased and prices have risen, the effect of this on liquidity-preference will be to increase the quantity of money necessary to maintain a given rate of interest…”. THIS STRONGLY SUGGESTS THAT AN EXIT STRATEGY BY THE FED MAY BE COUNTERPRODUCTIVE. INFLATION MAY HIGH ENOUGH FOR US TO NEED TODAY’S INCREASE IN THE QUANTITY OF MONEY TO MAINTAIN THE RATE OF INTEREST AT THE END OF THIS EXPERIMENT.

Last Friday, the US markets’ (bonds, equities and foreign exchange) dynamics was unworthy of a first-world country. When all markets are driven by speculation on what the Secretary of the Treasury or the Chairman of the Fed may or may not say, the great nation dreamed by Jefferson, Hamilton, and Franklin is in peril. Until Wednesday, we had seen a reallocation of resources take place. We saw investors selling Treasuries and buying stocks or vice versa. On Friday, we saw Treasuries and stocks and USD trade in tandem until 2:15pm, when the Treasury released its White Paper on the banks’ stress tests. This is scary. This is systemic risk at its best…During the day, the other important news was the always closer bankruptcy of GM and Chrysler and, last but not least, the accusation by Bank of America’s Lewis that his management team

 

were forced by Paulson and Bernanke to acquire Merrill… The S&P500 finished +1.5% (866.23 pts) and the 30-yr Treasury plunged to 93-13 (by 4pm). In credit, the CDX IG12 tightened 6bp, to 174bp, and the Fed bought another $3.6BN of GSE debt (2-4 yr maturities). Today, we have the Fed’s purchase of Treasury coupons (Sep/13 to Feb/16).

The market is concerned about the Fed’s effectiveness in keeping yields low while at the same time it buys billions of government debt. I look at this from another angle: I think that the market needs details on how the Fed will carry out an “exit strategy”. An “exit strategy” is a plan to take liquidity out of the system, after pumping in billions through a quantitative easing program (for a simplified discussion on quantitative easing, refer the April 23rd letter). Thus, from today, I will propose Thesis No. 3: “Knowledge of an exit plan is a condition for the stocks AND credit markets NOT to fall”. It will be very difficult to see stocks sustaining the rally without a minor hint on how to exit. Why is this so important? As I said before, think of yourself when you keep eating those cakes in Xmas… you feel a lot better when you tell yourself that in January you will start a new diet. Not many analysts have speculated on the details of an exit strategy. Michael Cloherty (Bank of America-Merrill Lynch, Rates Strategy Team) wrote perhaps the most insightful research on the subject so far (Global rate focus report, April 21st, 2009). There is an important assumption in his description: The Fed would start tightening only after two milestones have taken place: 1) The build-up of reserves (driven by the purchase of distressed securities) has peaked and 2) Reserves have been reduced to normal levels ($5 to $10BN). According to Mr. Cloherty, we are STILL $1.282 trillions away from milestone No. 1! This perspective scares me. Why? Because such policy is based on the belief of an inverse relationship between Output gap (i.e. Potential GDP minus Real GDP) and inflation. The wider the difference between a nation’s potential and real GDP, the lower the inflation. Therefore, the Fed would only be worried AFTER reserves have been reduced to normal levels = AFTER billions in loans have been issued. This can only make sense, if the Fed believes that a price level increases AFTER the Output gap decreases (thanks to the loans that were issued, which took reserves down to normal levels). Please, take any history book and find a nation, since the times of the Byzantine Empire, where a nation’s output gap has decreased debasing the currency! On future letters, I will elaborate more on the exit plan, because it will SIGNIFICANTLY influence markets’ action in May. But here’s my two cents: The real exit strategy involves Fiscal policy. Monetary policy alone can only fail. And we have heard NOTHING on the fiscal front so far, except perhaps in Canada, where I think we have more certainty about fiscal than monetary policy!

Good morning,

Interesting day yesterday… It’s true, most assets traded within range and that in itself is boring. But what is interesting is precisely to understand the reason for this range trading. As I said on April 13th “…Yields on Treasuries are already NOT falling and the Fed will engage in a spiraling process (i.e. upsizing the $300bn debt purchase program) against those who repudiate the US Treasury debt…” I think the market is only recently (during this week) timidly starting to share this view. From reading different analysts, I get the impression that the market still believes that existing long-term (30-yr) yields can be maintained in the short-term, in spite of the impressive future financing needs of the US Treasury. This would explain why we have not yet seen a more directional trading path in Treasuries. At the same time, this continues to corroborate our thesis No. 1: “When the Fed injects liquidity, asset prices rise. When the Fed does not inject liquidity, asset prices fall”. Please, note the immediate conclusion this thesis drives us to: “Sell that which the US Govt. is buying and buy that which the US Govt. will buy (A View from the Trenches Letter, April 6th 2009)”.

Thus, the question the market is asking lately is: “What (How much more) will the US Govt. buy? As long as the market ignores how much more/what the US Govt. will buy, the market will not sell that which the US Govt. is buying. That is also called range trading. That is what I think happened this week so far. Yesterday, the Fed bought $7Bn of $15.99bn in Treasury submitted offers (from May/12 to May/13). Perhaps the other significant transaction yesterday was the new Freddie Mac $4.5bn 5-yr issue, at T+65bps (which tightened to 62.25bps at close). The mentioned uncertainty over what/how much will be purchased will be clouding the next two weeks, when there will be no announcements on Treasuries supply.
As you can see in the chart below (right) the 30-yr Treasury did not show any defined intraday trend. Neither did the S&P500, which finished +0.99% at 851.92 pts, on the back of Financials.

What traded even higher was the TSX Index: +1.40%, closing at 9,409.50 pts. The TSX increased driven by Materials. Of course, the most relevant news in Canada came at 10:30 am from the Bank of Canada, which in a press release on the Bank’s Monetary Policy Report stated that it already has: “…the appropriate policy stance to move the economy back to full production capacity and to achieve the 2% inflation target…” . The Bank explained that such stance is possible thanks to its policy rate 25 bps lower (on Tuesday), and “conditionally” committing  to leaving the overnight target rate (for reference, see yesterday’s letter on this rate) to the current level until the end of the second quarter of 2010.

I must confess I was happy on this news, for it meant that Canada continues to seek non-monetary options to address its non-monetary problems. And the Canadian dollar strengthened 1.011% on the news, from 1.2380 to 1.2240 CAD/USD.
Now, the news surprised the market, which was certainly expecting some sort of (at least in a shy way) declaration by the Bank of Canada, that quantitative easing is coming. The Bank merely said that it would consider using it, if required. The Bank’s new guidance does not follow the global inflationary approach of other big Central Banks. According to our thesis No. 2, under this circumstance, the price of gold should rise. Our thesis no. 2 (refer letters of April 16th and 21st) says that: “When there is global coordination of inflationary monetary policies, gold cannot be a safe and lucrative asset. When inflationary monetary policies are not globally coordinated, gold is a safe and lucrative asset”. We tested this thesis yesterday at 10:30am again, and it was corroborated: Gold immediately shot up from $897/oz to $907/oz (see chart above right). This also made me happy, because there’s never anything more practical than a good theory!

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