Please, click here to read this article in pdf format: february-12-2010

(This is the last day of the week and “A View from the Trenches” will not be published again until February 25th, as we will be traveling.)

The statement released by European authorities yesterday was a mere expression of support for Greece, explicitly denying a request by Greece, for financial aid. The markets accordingly sold all things European, including and in particular Spanish financials. The picture does not look so good and yet, stocks outside the Euro zone (except for Athens, of course) rallied yesterday.

What do we make of this?
On one hand, we had another Treasuries auction yesterday. This time for $16BN 30-yrs, with the yield rising to 4.72%. The UST 2y10y curve ended 4bps steeper at 285bps. The Czech Republic was also deceived when it raised 15-yr debt on Wednesday and Greek banks seem to be facing funding problems. We also face significant uncertainty with the latest developments in Iran.  But on the other hand, the markets received some “optimistic” releases too. Continuing job claims in the US kept their downward trend, Australia also saw an improvement in its labour market and the CPI reading in China was stronger than expected.

Briefly, of one thing we may be certain: Capital is flowing out of the Eurozone and into the rest of the world. But at the same time, capital seemed yesterday to also be preferring commodities and basic materials, which puzzles us, because the macroeconomic backdrop is bearish for us.

In our view, we should not see yesterday’s rally in North American stocks and credit, as well as in crude and oil, as a bullish signal, after the EU meeting’s statement. Why? Because for this rally to be interpreted as bullish, the Euro should have rallied as well! It didn’t and in fact plunged from a tall cliff, specially against the Canadian dollar. A reduction in the purchasing power of the Eurozone should not be seen as something positive for global growth (= for oil demand and hence for the Canadian market!)

Interestingly enough, Freddie Mac yesterday announced that it will buy practically all 120+days delinquent mortgage loans from its fixed rate and adjustable rate mortgage Participation Certificate securities. We had foreseen a move of this type and discussed it in December and on our first letter of 2010 (www.sibileau.com/martin/2010/01/04 ). This is what we wrote then:

“…As credit spreads are already very low again, the increase in sovereign risk (yield) should make debt a less profitable investment, when compared against equity. In December, I associated this process with USD strength. Now, I am not so sure. Since my 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 me that the USD strength will be only a relative notion in 2010. I 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)…”

Back to the impressive strength shown yesterday by the Canadian Dollar. At yesterday’s open, you needed 1.0621 CAD to buy 1 USD. At close, 1.05 were enough. The CAD was even stronger of course vs. the Euro, finishing at 1.4383 CAD/EUR, from 1.4591 at open. What granted such a move?  In our view, the strength in the CAD was not fully reflected in the stocks market (TSX 60), which closed +1.32% higher, at 11,435.49pts. We think instead this movement may have mostly reflected a shift in central banks’ reserves, out of the EUR and into the CAD. What makes us think so? The relatively flat performance of crude oil, which still doesn’t break through its bearish trend.

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?)

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.