Please, click here to read this article in pdf format: march-2-2010

We will be brief today, for nothing of macroeconomic consequence has taken place in the past 24hrs. The action that caught our attention yesterday was in the foreign exchange market (the market that never lies). In particular, we refer to the action in the Canadian dollar. The cross with the Euro gained (i.e. the CAD rose against the Euro) 2.3 cents intraday, and although (or because) the TSX composite closed +0.85% higher, we can only deduct that the demand for Canadian dollars did not reflect a pari-passu demand for Canadian assets. Therefore, our intuition is that with yesterday’s calm, the demand for Canadian dollars that did not end in assets was a demand for reserve purposes, at a central bank. We are open to alternative suggestions to explain this phenomenon but any of these explanations would also have to address how the Canadian dollar did so perform on a day where neither oil nor gold rallied.

Was the CAD rally based on the news that the Canadian economy expanded at a 5%  annualized rate in the fourth quarter (faster than forecasted by the Bank of Canada)? We doubt it because a) the CAD’s sensitivity to interest rate gap (i.e. with the higher than expected growth rate the market revises its forecast on policy rates) has been low, and b) the strength was not uniform but clearly against the Euro.

On another note, in an interesting report, Bank of America estimated yesterday that approximately $160BN will flow to private investors by the end of 2010, as a result of the buyout of delinquent mortgage loans by Fannie Mae and Freddie Mac (refer: “The long and short of delinquency buyouts”, in Situation Room, Bank of America Merrill Lynch Credit Strategy, March 1, 2010). At “A View from the Trenches” we had anticipated the consequences of this operation back on January 4th, when we wrote:

“ …Since (our) last letter of 2009, the US Treasury announced it would lift the cap on the Preferred Stock Purchase Program (refer Michael Cloherty’s “Removing the PSPP ceiling: Treasury’s unlimited support”, Bank of America’ “US Agencies” report of Dec 29/09). This explicit show of support for agency debt (which I assumed it was going to smoothly disappear in 2010) tells (us) that the USD strength will be only a relative notion in 2010. (We) say relative because the strength should show vs. those countries that explicitly decide to import USD inflation (i.e. Brazil) or face serious fiscal problems (i.e. Euro zone), while the weakness should show vs. those countries that will profit from the credit-inflated recovery (Emerging markets or commodity currencies, like the CAD)… “

We stand by these comments and the market is proving us right. What we did not grasp back then was the magnitude of this operation ($160BN of private liquidity) under certain loan delinquency level assumptions that can further deteriorate, if the recovery process disappoints. We invite readers to closely monitor activity in the GSE market for this is serious enough to keep the dream of asset inflation alive.

(Note: Mainstream economists use the term “asset inflation” to refer to bubbles, because their theory of inflation is wrongfully based on the non-neutrality of money, as implied by the exchange equation: M*V = P*Q. Therefore, they treat bubbles as an aberration that can only be addressed with regulation)

Martin Sibileau

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.