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

Please, click here to read this letter in .pdf format: may-4-2009

Finally, Friday came with the data on the ISM Index, which was at 40.1 vs. expected of 38.4. On an absolute basis, main street still looks awful, but everyone makes the case that the so called “second derivative” is signaling there is light at the end of the tunnel. As I have been repeating since March 18th, the positive news relies on the Treasuries, GSE debt and securities purchases by the Fed. On Friday, the sell-off in Treasuries continued. The yield on the 30-yr Tsy is now above 4%. And yield, agency and credit curves have steepened considerably during last week. The news on Chrysler and the delay in the release of the stress tests results have left stocks on a wait-and-see mode. The S&P500 at 877.52pts is up a bit over 1% in the week. The inflationist policy in April has pushed a lot of short-covering in the credit space. The CDX IG12 ended at 163/165bps. But High Grade, High Yield, Loans, Convertibles and Mortgages have all tightened significantly too.

May 1st, 2009: 30-yr Treasury (white) vs. S&P500 (orange)

Source: Bloomberg Analysis: Tincho’s Letter

Some brief comments on 3 issues the markets have lately been paying attention to:

1. Steepened credit curves: Most analysis on this is either descriptive or focused on the specific fundamentals. This is short sighted. The steepening is the natural outcome of the inflationist process. It could also be called re-leverage. The different degrees of steepening and liquidity points we see are another proof of the non-neutrality of inflation, which is also impacting correlation in structured credit. Think of this: Without central banks, the only inverted curves you would ever see would be at the single-name level. But we do have central banks…
2. Sovereign CDS: The recent tightening in this space is purely technical. Like any other spread, the sovereign spread should compensate for expected losses: spread = prob. of default x loss given default. In the case of developed sovereigns, the probability of default would be that of systemic collapse, after which huge inflation surges, resulting in a considerable currency debasement (=loss given default or loss given systemic collapse). Now, this probability has not yet fully disappeared, while the currency debasement is just starting. Thus, from a fundamental perspective, sovereign spreads should be widening. And they are, but this is only taking place in the bond market (i.e. Treasuries), where yields keep climbing.
3. Banks stress tests: The US Govt. wants well capitalized banks. This is all idiocy. In our leveraged world, it is a mistake to think that the banks’ capital’s task is to allow the redemption of funds, when clients have lost confidence in their banks. The confidence that banks and the loans they have issued enjoy is indivisible. No risk management policy or capital requirements adopted on the banks’ initiative or forced upon them can remedy this. Given the ongoing inflationist policy, regurgitating this issue only brings unnecessary political risk to the table = If the Fed will keep bidding on assets and print our way out of this, they should shut up and just do it! Asking for more capital or more lending or even targeting an inflation rate is hypocrisy and it only adds expensive noise (volatility) to a trend!

This week is heavy in Treasury supply: $35bn 3-yr auction (Tues), $22 bn 10-yr (Wed), and $14 bn 30-yr (Thur). With Transmission spreads (LIBOR, LIBOR-OIS and Comm. Paper) collapsing, what could bring a reversal (lower lows in stocks, wider wides in credit)? POLITICS! Behaviour like the one shown in the chart above, between 10:30am and 2pm, when govt. debt and stocks enter or exit for the same doors AND the outlet valve of foreign exchange acts as a thermometer, MUST BE AVOIDED. (What happened on Friday between 10:30am and 2pm, AND AFTER?)

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.