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.