Please, click here to read this article in pdf format: may-28-2009

The Fed is being challenged. Let’s mince no words here.  The Fed yesterday bought a $6BN in May/12 to Aug/13 securities. By now, the Fed has reached $131BN of the scheduled $300BN. At close, all yields except at the front end were touching new highs and the curve continued to steepen. The S&P 500 closed at 893.06 (-1.90%), while credit was not so hurt: The CDX IG12 was only a bit wider at 147, even after GM bondholders rejected the Treasury’s plan to wipe their rights, leaving little options but an expected bankruptcy.

As we have endlessly discussed, I always believed in two things: 1) The Fed will have to size up its Treasury purchase program; 2) This is a spiraling situation (spiraling of what? Of everything! Remember Newton’s First Law of Motion: Every body persists in its state of being at rest or of moving uniformly straight forward, except insofar as it is compelled to change its state by force impressed (Philosophiæ Naturalis Principia Mathematica, 1687). Any object today, as soon as it is subject to an external force, spirals. The Fed impresses a force on Treasuries and their yield spirals, which triggered the spiral sale in mortgages, which triggers an increase in mortgage rates, which triggers a decrease in mortgage refinancing, which triggers a slow down in the housing market recovery, which triggers a sale of equities that need to reprice activity recovery assumptions, which triggers stop losses, which triggers FURTHER liquidity requirements, which triggers repatriation of USD….which requires a bigger intervention of the Fed, fuelling the spiral again…This is nothing new for us, since in this letter, we have been boringly and relentlessly repeating that the further the Fed will buy, the further the market will sell. We even called this Thesis No. 1! All of a sudden, this is news this week everywhere. Yet, there are analysts recommending long Treasury positions, and amazed at reality. Amazed at oil increasing to $63.14/barrel!
The yield curve steepened big time yesterday, with a lot of buying in the front-end by foreign central banks…Some friends asked me how this all affects us Canadians. When foreign central banks put these dubious US Treasury notes in the asset side of their balance sheets, they do so by increasing their liabilities (their own notes, the foreign country’s respective currency) at the same time. These irresponsible central banks are importing inflation to their respective countries. They are debasing the medium of exchange used by their countries’ citizens, the same citizens that on top of this fraud have to pay their taxes. This is the ruin of global savings. I know I sound bitter here, but the situation does warrant it. Now, back to the question: How is Canada affected? Positively. Why? By default! What do I mean? I mean that because Canada does NOT buy into this, does not hoard US notes, we….for now at least, keep saving ourselves and our kids’ future.
I attach below two charts. On the left side, we can see how once the 30-yr Treasury price fell to $95, the Canadian dollar lost vs. the USD. What happened? This price or support level was critical and when it was broken, it triggered a sell-off and a liquidity call: USD had to be purchased. Thus, the Canadian dollar did not respond to fundamentals here. On the right side, we can see that equities (S&P500 index) closely followed Treasuries. What was the link? The housing market. Two factors defined that link: The sell off in mortgages, which started a few days ago, and the news yesterday that the Mortgage Bankers Association’s weekly mortgage applications survey had fallen 14.2%.

Please, click here to read this article in pdf format: may-27-2009

Yesterday’s action clearly seems to give merit to our main thesis so far: That the sell off in Treasuries leaves investors with liquidity that needs to be put to use. With the 2-yr $40BN auction that took place yesterday, the yield curve steepened 5.5bps to 258.9bps. The auction went well, with $117.5BN in bids for the issue and foreign official (i.e. central banks) bidders were not alone. However, the S&P500 closed at 910.33 (+2.63%), while crude and the Canadian dollar ended at $62.32 (+1.1%) and 1.1170 CAD/USD respectively. The charts to the right show how synchronized this trend is becoming. There are other forces at play here of course. The so called convexity hedging in mortgages is present and this market is suffering from the increasing long-term yields. The 30-yr swap spread compressed further and now is at -27.02bps. But this analysis is beyond the scope of our letter. Finally, the Fed bought $1.55BN in TIPS yesterday.
In summary, investors are leaving sovereign risk in search of risk assets, to avoid the cost of the debasement of the USD. This is a perfectly rational behavior. It would be irrational not to leave Treasury bay and sail forth.

Our thesis, first proposed in March is now news. What is the next rumor to buy then? How can we get ahead of the curve? Repeat with me: “Emerging markets”. But we have to be VERY careful here. Not all emerging markets are made equal. To begin with, something like the famous BRIC (Brazil, Russia, India and China) is to me the most heterogeneous lot you can ever find and makes a horrible EMPIRICIST, INDUCTIVE investment thesis (Repeat with me: “Induction is sterile”). And yet, induction is the worst cancer Western Thought has had since the end of World War II. Without further ado, in upcoming letters we will seek to propose a new investment thesis for Emerging markets. It will be DEDUCTIVE. It will be TESTABLE. For instance, I believe that consistent with the flight from the USD, the market may want to adopt a beta neutral approach to emerging markets investing.
What do I mean by this? Well, if you think of beta as the relationship between (covariance) the emerging markets’ risk and US sovereign risk, to be neutral, you may want to invest in a long/short pair trade: Long emerging markets that will benefit from this situation and short emerging markets that will suffer (eventually) from this situation. What criteria may make the difference here? I am still working on this. But remembering the ‘70s and ‘80s, I can suggest these: Foreign exchange regime (flexible = good, pegged/fixed = bad), Private debt/GDP, Public debt/Tax revenue, (Imports + Exports)/GDP (Higher = better), Commodities exporters vs. importers (exporter = good, importers = not so good).

Please, click here to read this article in pdf format: may-26-2009

Markets were closed yesterday in the USA and UK. In yesterday’s letter, I indicated that the only viable exit strategy is to cut spending. In a more formal way, the always impeccable analysis of Michael Cloherty (Bank of America/Merrill Lynch, “Global Rates Strategy”, May 21st 2009) suggested that an exit strategy, in its first phase (Cloherty identifies three necessary phases) will consist in the Fed stopping its purchases. It’s true, it needs to start there. However, for purchases to stop, we also need fiscal deficits to stop. Why?
This is connected to my view of how the system will adjust to the ongoing monetary expansion: Higher prices, lower USD (only temporarily, until REAL interest rates pick up again), higher unemployment. I know I threw this thesis out, without explaining myself. I also implied credit can rally within this context. Let’s see how this can happen:

-Higher prices:
As mentioned numerous times, the sell off in Treasuries leaves investors with capital that needs to be put to use. The proceeds of the sale are further allocated away from US risk: In commodities, emerging markets (equities and credit) and eventually stocks. The capital flowing out of the USA challenges the speed at which the Fed creates new money. New money is being printed, new money leaves the country. As long as the speed is higher than that of other currencies (our case now), the USD depreciates. With this outflow too, NOMINAL interest rates begin to rise (Yield curve steepens: http://sibileau.com/martin/2009/05/07/ ). This is a spiraling process.

-Credit rallies:
As NOMINAL interest rates and prices increase, REAL interest rates decrease. The higher NOMINAL stock valuations open a window of opportunity for firms to deleverage by accessing the equity markets (this is for instance the case with REITS (real estate income trusts) in April: See the letter from April 29th: http://sibileau.com/martin/2009/04/29 ). Firms also have access to debt refinancing, as banks count with liquidity. The refinancing consists in pushing maturities to longer terms, to make the EXPECTED REAL interest rate as low as possible. This is also a spiraling process: As firms successfully deleverage, they are more likely to obtain capital expenditures financing. New projects, as prices stabilize (=no longer fall), add further value to stocks, although not for all firms at an equal pace. Here is where inflation shows its unfairness, as the problem is not rising prices, but some prices rising more than others.

-Higher unemployment:
The aforementioned process drives a complete MISALLOCATION of resources. New projects, debt refinancing, equity issuance, prices not falling…all these amazing things can only happen because they are supported by a STEADY SPEED of money supply (remember the new metric: newly printed USD per week). However, as firms were caught in the deleveraging process not so long ago, they are not willing to either bring hiring to pre-crisis levels or even increase it, regardless of their late increase in output. Firms are aware of the distortion in RELATIVE prices (The same distortion they took advantage of to refinance their liabilities or deleverage via equity issuances.).

But the constant increase in money supply finds an outlet valve in the foreign exchange market. As the USD further depreciates, this trend also spirals and USD note holders run for the exit. Ultimately, the Fed loses the battle and reality sets in. Treasuries purchases stop and real interest rates increase. This is when the resource misallocation is exposed naked. A new, much harder reallocation has to take place now. Labour has to accommodate. Unemployment remains high. Discontent is everywhere, a new policy is sought. Liberals lose. The right takes over, wins the election and starts selling government assets (privatization), fighting hated unions, and cuts costs to create surpluses. The USD appreciates and takes everyone by surprise. Suddenly, emerging markets are no longer so interesting. Money leaves these countries and flees back to the USA.

Emerging markets realize that while they had the easy money, they missed the chance to improve their productivity, the chance to “use the capital to push forward the much needed structural reforms”, as we will certainly read from an IMF report some day into the near future. But really, how can you not miss such opportunity. The No. 1 rule in Economics is that that which is free is wasted…You should never blame the pigs, but the hand that feeds them!
Will Canada be one of those commodity markets that a few years from now will wake up to realize the party is over? No, as long as two necessary and perhaps sufficient conditions are confirmed: 1) The Canadian dollar remains within a free and flexible exchange regime (and this includes no further regulation on Canadian banks) and 2) The government does not distort relative prices by running into deficits to save unprofitable businesses (i.e. Automotive).

Please, click here to read this article in pdf format: may-25-2009

After last week’s action, I really don’t know what to write about. There is nothing really new, but only more of what we have been discussing so far. And that is sad. The market is pushing the Fed to assert a speed of money supply. What do I mean by speed? Fresh, newly printed USD per week! As we got used to understand certain speed metrics like kilometers per hour or annual returns, we now have to get used to newly printed USD per week. (When I lived in Argentina, for instance, people had gotten used to read the level of reserves of the central bank and the government bonds yield, next to the weather forecast in newspapers). We will now need to get used to read the speed of USD supply on a weekly basis. And expectations are built on this speed rate. For instance, next week, we have $101BN (Yes, one hundred and one BILLION) of US Treasuries being auctioned: $40BN in 2-yr notes on May 26, $35BN in 5-yr notes on May 27 and $26BN in 7-yr notes on May 28. The Treasury also sells $61 billion in three-month and six-month bills weekly auction on May 26. With this in mind, the negative outlook on UK’s AAA rating, the comments about the US losing its AAA rating, and the Fed’s refusal to bail out Municipal debt, the world runs for cover. The yield on the 30-yr note closed at 4.384%. The process we outlined in our letter of May 7th seems to be taking off (yield curve reflecting inflation expectations are to take a leading role, bringing REAL interest rates down). I reproduce the chart from May 7th (below left) and the change in the yield curve, since May 15th (below right):

As we said endless times, the market uses the window provided by the Fed to sell Treasuries and put its capital away from the hands of Mr. Geithner and Bernanke. How can they escape? By buying assets that are as liquid as possible and as removed as possible from these hands. Buying gold? Not really. The IMF and other central banks still have some dry powder to shoot the price of this metal down. Other currencies? Only as long as the speed of their respective supply is LOWER than that of the USD. Note that we are not saying other currencies need not be subject to Quantitative Easing policies. At this stage, it really doesn’t matter any longer. Who else can spit out $101Bn in a week? All the cards have been shown, friends… What matters is speed! Whoever prints the fastest its problems away will set the benchmark. So, what asset is left? Yes, you guessed right: Oil! Oil cannot be manipulated by the Fed. Yes, the US can sell stocks from their Strategic Reserve. They could have done so earlier, and for whatever reason (perhaps related to the Saudi lobby), they didn’t. Oil is produced mainly outside of the USA and is the blood of the USA. Liquidity is thus assured. Can the price of crude still be affected by a slow recovery in GDP? Yes. But supply can be cut as well. And I don’t think we are going to see strong capital expenditures after the price action of 2008. Companies are going to be very careful on this front, and will not spend in anticipation of higher prices.

Let’s think ahead of the next phase: What can work as an exit strategy? Clearly, monetary policy cannot work. They will keep trying with currency swap agreements, they will abuse the IMF to extend USD-backed lines to emerging markets, they will press China into inflation by pushing them to keep hoarding Treasuries, they will threaten to sell gold, they will raise taxes, they will further regulate every piece of the financial system …But they will only be delaying the inevitable…So, what can work as an exit strategy? Spending cuts. Will this happen? No! So…how does the system adjust? With higher prices, lower USD, higher unemployment. Can credit rally in this context? Is David Rosenberg right when he says the March 9 lows in stocks are to be tested again? Remember how those petrodollars of the ‘70s originated Latin America’s foreign debt (The same debt that was defaulted in the early ‘80s)?  Isn’t that proof enough of how credit can rally?

Please, click here to read this article in pdf format: may-21-2009

Under a common textbook approach, if someone would have told me that the 2pm release of the April FOMC minutes yesterday made reference to continued weakness and that the Fed had considered boosting its purchases of assets to secure a stronger economic recovery, I would have expected the following chain reaction: 1) Sell-off in equities, 2) rally in Treasuries, 3) higher USD due to deleveraging and repatriation (given how correlated international markets are = other equity indices would have also sold off too) and 4) lower commodities (energy in particular). That’s the norm, that’s what you get under a typical “walrasian” method (León Walras, 1834-1910, pioneered the method to analyze the markets under the ideal of a general equilibrium, where the markets’ excess demands (or cash flows, in our case) must equal zero).
No, the markets did not behave that way. The S&P500 did sell after 3pm, closing at 903.47 (-0.51%), Treasuries did rally, but the USD weakened and crude oil reached $62/bl and gold broke through the $930’s/oz. Does this make sense to you? To me, it does. I hear the message. It is a clear message: Given the ongoing political risk in the USA, if money is going to stay in that country, it will be allocated to those assets that get a clear bid by the Fed: Treasuries, Mortgages, Agency debt. Otherwise, money is going to leave the country. The market does not want to take private sector risk. The USA is not a country to “accumulate” stock of capital. The USA is not capitalist = it does not seek to grow by building on its stock of capital. I thought I would show the chart below, from yesterday. It is vox populi that the Canadian dollar follows the price of crude oil. It is therefore thought that the relation weaker USD –> higher crude oil –>higher Canadian dollar holds. Yesterday, after the release of oil inventories data at 10:30 am, the Canadian dollar did not react. You may say it traded higher before the data release, but that is speculation. What is not speculation is the reaction to the FOMC minutes after 2pm… Perhaps we actually have two independent relationships? Weaker USD–> higher crude oil and riskier US –> higher Canadian dollar…

Yesterday, the Fed bought approx. $10.8BN of Treasuries and GSE debentures through the two purchases in the 4-10- yr range: $3.079BN of the 4yr to 6yr (GSE) maturities and $7.7BN of the 7yr – 10yr (UST). The 2yr-10yr curve steepened 1 bp.
As we have discussed at length here, I don’t believe the Fed will just stop at the $300bn Treasuries purchase program. And I think by now, the market is starting to share this view. Should credit continue to rally then? Can we see a sell off in Treasuries and wider credit spreads, as the Fed steps up? What would prevent this scenario? An exit plan?