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

Growing up in an arid ranch in northwestern Patagonia (Province of Neuquén), I remember that one summer evening, I noticed a very small crack in one of the many irrigation channel gates that we had for the alfalfa lots. Only a thin thread of water was running through it. I was too tired to fix it and went to bed thinking I would take care of it, first thing in the morning. In the middle of the night, I heard somebody knocking on the door. This person had come to tell me the thin thread of water had grown into a river, flooding the whole field, and compromising the foundation of one of the warehouses. By the time I arrived to scene, the small crack looked like a strait in the ocean; and I had to fix it in the darkness of night. This happened about 22 years ago, but the lesson was well learned and is still remembered. Today’s FOMC’s statement (http://federalreserve.gov/newsevents/press/monetary/20090624a.htm ) reminded me of that night 22 years ago. The Fed knows it has a problem, but seems to have decided to ignore it. Or have they? I don’t want to waste intellectual capital here, but an alternative way to interpret this is to think that the Fed wants to keep some freedom to surprise us. There are literally thousands of papers in the Theory of Games that analyze the benefits and disadvantages of predictability in monetary policy. In my humble opinion, when policy makers engage in these games, investors are left with only one winning move: Not to play! Certainly, not everyone has the luxury of choosing to abandon. However, the verdict was unanimous. With yesterday’s announcement, the yield curve steepened (see chart below). Besides this, the markets are trying to recover from last Monday’s plunge: The S&P 500 ended 0.65% up at 900.94, while the CDX IG 12 tightened 4 bps to 141 bps. Oil is trying to get back to the $70/bl level (closed at $68.52). The recovery was helped with the release yesterday, of Durable Goods orders coming higher than expected, up 1.8% month/month in May Vs. consensus of -0.9% month/month.

More generally and following the concept above, it looks like the “not-to-play” move is becoming popular. I can think of the share price of Citigroup, for instance. In my view, we could see this price way higher, if Citi was not so sensitive to the US government. It is, and the market does not want to play with Citi. Another example is the latest shows of wisdom by Mr. Carney, governor of the Bank of Canada. He surprised the markets first with his public concerns on the sudden appreciation of the Canadian dollar and later (on Tuesday), with the declaration that “Canada’s recession is as deep as in the US”. What did the market do?  Decided not to play and the Canadian dollar plunged.

When investors decide not to play, naturally, investments are delayed. What follows is an interesting comment on this issue, from John M. Keynes, in his famous work “The General Theory of Employment, Interest and Money” (Ch. 12): “…The state of confidence, as they term it, is a matter to which practical men always pay the closest and most anxious attention. But economists have not analysed it carefully and have been content, as a rule, to discuss it in general terms. In particular it has not been made clear that its relevance to economic problems comes in through its important influence on the schedule of the marginal efficiency of capital. There are not two separate factors affecting the rate of investment, namely, the schedule of the marginal efficiency of capital and the state of confidence. The state of confidence is relevant because it is one of the major factors determining the former, which is the same thing as the investment demand-schedule…”

(I will be traveling next week and will not be able to write this daily letter. “A View from the Trenches’ will be distributed again on July 6th. Have a nice week!)

UST Yield Curve: June 23rd (red) vs. June 24th (white) 2009

(Source: Bloomberg)

Please, click here to read this article in pdf format: june-24-2009

(On yesterday’s letter, there was an error. On the first sentence, I meant to say that the Treasury was auctioning $104BN in T-bills and coupons this week. Instead, I said the Fed was. This is what happens when I write at midnight!)
I don’t usually follow macro statistics, but monetary aggregates and cash flows. However, two metrics left me thinking yesterday. First, it was the May release of Existing Home Sales. After reaching record lows for 30-yr mortgage rates in May, the months’ supply of unsold homes fell only to 9.6 months, from 10.1. With mortgage rates going up since then, further improvement in residential real estate is only a leap of faith away!
Secondly, I suddenly remembered that at the Facultad de Ciencias Económicas, in Buenos Aires, one learned that, as a rule of thumb, an ongoing government deficit that represents more than 5% of GDP is only a time bomb. Now, if only the gross US Federal debt is supposed to reach $10 trillions by 2010, it may be licit to think that servicing the US aggregate fiscal debt (federal + state + municipal + agencies) should easily represent more than 5% of GDP…I say “should” because unfortunately I could not find in any website precise data on this. Interestingly enough, this issue is altogether ignored in research reports, which usually make reference to fiscal deficits of other countries…
In summary, the fundamental dilemma we face on June 24th 2009 is how to effectively keep mortgage rates at a low level to encourage refinancing, which will drive home purchases and put a floor to home prices, while simultaneously the Fed monetizes deficits ($300BN scheduled for 2009), pushing nominal rates up (ref. www.sibileau.com/martin/2009/06/03 ). See, the problem lies in the deficits. We should not be focusing on what the Fed will say tomorrow at the close of its FOMC meeting. They cannot change the bottom line. Instead, we should be demanding from Mr. Geithner a healthy budget. Now, investors don’t think that will happen (and I agree) and therefore have retrenched, trying to defend every penny they made in this “rally”.  Equity and credit markets managed to keep relatively flat yesterday: S&P 500 up 0.2%, while CDX IG12 was 1 bp tighter at 144 bps. If you have been following the letters, you should not be surprised. Since day one, our thesis has been that as long as the Fed and all the other central banks keep flooding us with liquidity and feed us with daily announcements, we can see prices NOT falling (See www.sibileau.com/martin/2009/04/14 ), which would suggest that, in order to solve the aforementioned dilemma, in the continuous presence of deficits, asset prices NEED to fall, to make room for the government deficit. How do you think will this be sorted out? In the meantime, I thought I would show the “evolution” of the on-the-run UST yield curve, from June 8th, when we first sensed the current plateau, until yesterday. As we’ve been proposing, a sell off in equities should not bring an inversion of the curve, because the sell off would not be caused by illiquidity: 3-month LIBOR is at 0.6075%.

Please, click here to read this article in pdf format: june-23-2009

This week, the Treasury is scheduled to sell $104BN. Yesterday, the Fed bought $7.5BN of them. As our last week’s letters suggested, the Fed has run out of time, governments are playing déjà vu policies, the markets “castled” on Thursday and yesterday, they retrenched…The chart below shows a “panoramic” view of the situation (left side) and the micro view of it (right side, source: Bloomberg). The left side of it was already described on April 14th (www.sibileau.com/martin/2009/04/14 ). Unfortunately, since the beginning of the month, in the absence of clarity (on an exit strategy) and the presence of regulatory noise (stress tests, TARP funds, credit derivatives markets, regulatory frameworks, etc.), the inflationary process has reached a plateau. We absolutely need to see, as soon as possible, bond issuances that will finance capital expenditures or M&A. Yesterday’s announcement of Xstrata’s proposal for a “merger of equals” with Anglo American was a good start (Anglo’s board rejected it already). But it was not enough to prevent the massive flight to Treasuries. Equities sold off (S&P 500 dropping 3.06% to 893.04pts), as crude had a serious plunge, from $73/bl last week to $66.93. Volatility spiked, with the VIX index jumping 11.36%, from 27.99 to 31.17…

Is there any hope left? If so, we will have to look at the action in the credit markets. Both the CDX Inv. Grade and High yield indices finished unchanged yesterday (at 4pm). But they are certainly wider compared to last week. The right side of the chart below shows how the USD strengthened vs. the Canadian dollar, a commodity currency, as the 30-yr Treasury rallied. There was not a lot of volume in Treasuries and, yes, it is true that the Canadian dollar in particular owes its weakness to Mr. Carney’s public concerns on the impact of the currency’s appreciation. We cannot blame Mr. Carney, since his is a difficult task (if not inconsistent): The Bank of Canada’s Act of 1934 (http://www.bankofcanada.ca/pdf/act_loi_boc_bdc.pdf ) says that Mr. Carney’s goals are: 1) To control and protect the external value of the national monetary unit; 2) To mitigate by its influence fluctuations in the general level of production, trade, prices and employment and 3) To promote the economic and financial welfare of Canada! Thus, expressing his concerns on goal no. 2, Mr. Carney failed us on goal no. 1. His public declarations since last week have very much depreciated (by my account at least) our currency 7 US cents/CAD (from 1.08 to 1.15). This mark-to-market “tax” on our purchasing power, was not approved by Parliament, obviously!

If credit is the last line of defense, can we see credit rally with Treasury yields rising? (As you notice, I am already assuming that yields will continue to rise) In JP Morgan’s June 19th issue of “Credit Market Outlook & Strategy”, the question is raised. In the report, it is suggested that as Treasuries yield rise, bond yields rise too. This increase in bond yields should encourage investors to invest in credit. The increase in Treasury yields, suggests the report is due to “increased inflationary concerns”.
What is the main assumption behind this thesis? Defaults don’t increase, as yields increase. Therefore, we are left to believe that the increase in bond yields is only reflecting future inflation. Under which circumstances does inflation NOT lead to defaults? In the theoretical construction of mainstream economists, inflation does not lead to defaults because it is neutral: The “general” level of prices rises, as ALL prices rise at the same time… But this is not realistic. Therefore, if inflation does bring defaults, do you think credit can rally with Treasury yields rising?

(Please find chart in pdf document: june-23-20091)

Please, click here to read this article in pdf format: june-22-2009

The chart below, which shows last Friday’s intraday action in 30-yr Treasuries vs. the S&P500 Index, says it all: Retrenchment. Indeed, personally, I don’t think we have made any progress last week. This is perhaps reflected in wider credit spreads (CDX IG12 20 bps wider, to 143bps), lower equity prices, and the action in mortgages last Thursday.

I have recently been thinking at the ultra-macro level. Bear with me, please. I’ve come to realize that since the French Revolution, humans have been growing up, have been raised, have been educated and are educating their children under the paradigm that proposes that value can be added by “creation”, by “innovation”. When we don’t innovate, when we don’t create, we assume no value is created.  But now think of the children in Ancient Greece: They grew up listening to the story of the sacking of Troy. Pillaging was honorable and Achilles was legendary three thousand years ago. There was honor in conquering. Value was added by taking, not creating. This notion must have lasted a while, because even under Elizabeth I, people were fascinated with characters like Francis Drake (and understandably so, given what Sir Drake contributed to the kingdom’s coffers). However, in those days, there was consistency between politics and economics. The political apparatus, the legal system, encouraged monopolies, sacking, taking from other nations, while our current “value creation” paradigm is not consistent. We are told we add value innovating. But our legal systems encourage oligopolies every time our central banks and governments decide to bail out dinosaurs; mediocrity, when economic success is taxed at increasing rates; and paralysis, when relative prices are manipulated and we ignore the future value of today’s medium of exchange. But value creation only works if people can accumulate capital. To accumulate capital, people must save. To save, people must know, ex ante, that what they save will be safe. Saving is boring and hard. It means restricting consumption today, in favor of consumption tomorrow. The British played this game right for a century, between say 1815 and 1914, thanks in many ways to David Ricardo. But then, then people thought they could cheat a bit. We thought we could get away without the hardships of saving, as long as we managed an “optimal” speed of money supply. We experimented a lot with it, particularly after World War II. Today, the latest expression of this illusion is the famous Taylor’s rule (http://en.wikipedia.org/wiki/Taylor_rule ). The illusion continues as we anxiously await now the FOMC meeting to tell us, on June 24th, what the monetization speed will be, what assets it will use (Treasuries, agency debt, mortgages). Uncertainty is preventing investors from putting their savings to work. More so, when we read of major regulatory reforms every week. The bottom line? I think we can step to the sidelines in equities and Treasuries. Will sellers of Treasuries continue to reallocate funds to credit? I don’t know. The waters are divided here, with some analysts on either side, both in investment grade and high yield. But under uncertainty and inconsistency, liquidity gains relevance once more, favoring index positions, vs. single names… What is left to trade this week? Event risk? I don’t like it…

June 19th, 2009 Intraday: 30-yr Treasury vs. S&P500 Index (orange)

Source: Bloomberg                                Analysis: A View from the Trenches

Please, click here to read this article in pdf format: june-18-20091

One has the feeling the markets are sort of “castling”, as in a chess game. Castling is an interesting move. It allows reassigning resources (the rook) but also, in my opinion, it puts the ball back in your opponent’s court (the Fed). So, the recent rally in Treasuries, mortgages and the USD looks like castling to me. Castling is a defensive move. Thus, equities are lower (S&P500 closed at 910.71pts or -0.14% and credit is wider (the CDX IG 12 index has widened 17bps so far this week).
But we should never compare the capital markets with a chess board. They are not a zero-sum game and they are not determined, but are instead full of uncertainty. Therefore, I question the efficiency of castling this time!

Perhaps the most bizarre thing is the performance of Canadian risk assets. Only a few weeks ago, there was euphoria with Canada and the Canadian dollar. Today, the 2.33% drop in the S&P TSX Composite index to 10,067.26 was remarkable, when compared to the US action. It is clear by now that the insinuation of the official party to run a deficit is hurting. But maybe the rumor, the speculation that the Bank of Canada will manipulate the foreign exchange market is hurting more. On top of that, pessimistic economic data fuels the idea that the government will welcome demagogic policies. Which brings me to my next thought: How can the Fed dream of (as reported by Bloomberg yesterday) committing to a period of stable rates, while it simultaneously has to monetize deficits with purchases of uncertain final size? It is inconsistencies like this one that in the long term generate conflict…

As we outlined on June 2nd (“Meanwhile in Canada”, www.sibileau.com/martin/2009/06/02 ) and June 1st (“What can China do?”, www.sibileau.com/martin/2009/06/01 ), Canada will only profit from this crisis as long as two 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. Both conditions have NOT been met so far. We have heard from the Governor of the BOC concerns on the appreciation of the Canadian dollar and we have seen taxpayers’ monies being compromised to save unsustainable jobs in the automotive industry first, and in the pulp and paper sector now.
Why is Canada afraid of a strong currency? A strong currency means we can consume more of that the rest of the world produces. It means we can obtain capital goods from overseas at cheaper prices to improve our productivity. We deserve it! We earned it! Canada is presented with a great opportunity, but refuses to take it.  The equity and foreign exchange markets are speaking loudly of this.

Yesterday’s announcement on enhanced regulation in the US financial markets brought the equity price of financials down, as we naturally expected. While the BRIC nations meet, engage in stronger multilateral trade and capital flow exchanges, the reaction in the US is to continue the hostility towards capital markets. Special reference is always made to the credit derivatives market. Even defenders of capitalism like George Soros, who has also been influenced by the Austrian School of Economics (thanks to Karl Popper), believes that credit derivatives are instruments to blame for this crisis. Let me say this about the issue: Bureaucrats hate the credit derivatives market because derivatives tell it like it is! Derivatives provide transparency; allow a multiplicity of investors to express a view. Therefore, the full force of regulation is going to fall hard upon non-banks.

Credit derivatives are necessary, add value, provide efficiency and speed economic recovery. How? The current deleveraging process has generated a lot of idle capacity. To make sense of this extra capacity, companies need to achieve economies of scale. To get this scale, firms usually merge with or acquire competitors, to reduce costs and defend the prices of their output…
Who is going to finance the necessary M&A activity when the time comes? Banks? With what capital? If banks are denied capital relief by hedging leverage buy-out transactions in the credit derivatives markets, large syndicated deals will become very expensive or avoided at all. And that, friends, that is a huge burden on any economic system, particularly those that depend heavily on leverage. The burden is ridiculous, because after so many years of financial innovation, human beings are not going to profit from it. Rejection of credit derivatives based on volatility concerns sounds as idiotic as rejecting marriage to avoid the risk of having a divorce!