A View from the Trenches

A View from the Trenches, September 1st, 2009: Staying the course

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I am sure you will disagree with me, but I think that yesterday was an uneventful day. Yes, stocks in China had a hell of a sell-off, but….was anyone surprised? Was anyone surprised to see stocks in North America finish less than 1% lower? Perhaps the flag was the drop in the price of crude, below $70. But besides that, a good indication of the mood in the markets is that in the Credit space, the IG12 index was up by only 3bps, while the HY12 index was actually down by 1/4 of a point.

We first postulated on August 19th (www.sibileau.com/martin/2009/08/19 ) the thesis that interest rates are going to stay low longer than anticipated. Since then, the market seems to side with this notion, as both the Bank of America’s Rates strategy team and Goldman Sachs’ Global Economics team explicitly elaborated on it (BofA’s “Global Rates Focus” and GS’ “US Economics Analyst: 09/34 - The Outlook for Fed Policy”, both published last Friday). In the Goldman Sachs the document, it is interesting to note the notorious global approach to the subject, even though it specifically deals with the Fed. Thus, in general, I think that the global coordination of central banks is becoming more and more evident to the investing community.

I do not blame the obscure, bearish forecasters for taking the stand that government intervention will not work. I believe it has a lot to do with the academic tradition of handling the analysis of financial crisis at the single economy level. There is nothing wrong with that, for that had always been the case until 2008 (One could, with a lot of hindsight, make the comment that if the global financial cooperation is avoided, the global military “cooperation” replaces it, as the case of World War II shows). To picture this point, I thought there was no better chart than that of the price of the gold. This chart (source: Bloomberg) shows the evolution of the price since the start of the crisis. It didn’t stop rising until central banks assumed a leading role with the bankruptcy of Bear Stearns and since then, it has not gone anywhere, trading with a very wide range. The vertical lines signal key events: The collapse of Lehman, and the beginning of the Obama administration. The underperformance of gold therefore is the best witness we have, to attest that global (not local) intervention is about to write a new chapter in economic history. But to be fair, it won’t be a nice one, because there is still a lot of fiscal deficits to subsidize (i.e. central banks monetizing deficits) or cross-subsidize (central banks from some nations subsidizing the fiscal deficits of other nations, as in the case of Canada, that issues $3BN in federal government bonds in USD to push a bid out of the Canadian dollar, depreciating the financial assets of Canadian taxpayers who save in Canadian dollars, in favor of US note holders).

Disclaimer: The comments expressed in this publication are my own personal opinions only and do not necessarily reflect the positions or opinions of my employer. I prepared and distributed this publication as an independent activity, outside my regular salaried work. No part of the compensation I receive from my current employer was, is or will be directly or indirectly related to any comments or personal views expressed in this publication. All comments are based upon my current knowledge. You should conduct independent research to verify the validity of any statements made in this publication before basing any decisions upon those statements. The information contained herein is not necessarily complete and its accuracy is not guaranteed. The comments expressed in this publication provide general information only. Neither the information nor any opinion expressed constitutes a solicitation, an offer or an invitation to make an offer, to buy or sell any securities or other financial instrument or any derivative related to such securities or instruments. The comments expressed in this publication are not intended to provide personal investment advice and they do not take into account the specific investment objectives, financial situation and the particular needs of any specific person.

A View from theTrenches, August 31st, 2009: What keeps the rally going?

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Back from a brief vacation, a week later, I sit here trying to summarize what happened last week, and what may continue to happen…On August 4th (www.sibileau.com/martin/2009/08/04 ), I had updated my forecast and said that equities could reach higher levels, from the stagnant range they were in July. I reaffirmed this view on August 18th (www.sibileau.com/martin/2009/08/18 ) and do so once more today. Of course, in credit land, the tightening may continue, following the rally in equities. (I’m sorry; I should not call it a rally, but asset inflation).  What drives this trend?
1.-Liquidity
For a hundredth time, I show below (source: Bloomberg) the chart with the 3-month Libor –Overnight Index swap spread. It is still making lower lows, with a close of 16.75bps last Friday. How much lower can it go? Before this mess unfolded, it was stable at 10bps, suggesting that it still has some room to tighten.

We are not watching this spread alone. Last week, Michael Cloherty (Bank of America) pointed out that Libor may not be a reliable metric lately, given the wide range in offered rates (3-mo Libor was 34.75bps on Friday and Mr. Cloherty estimated the range at 18bps, which is significant vis-à-vis 34.75bps). Why do I bring this up? Because I was exactly expecting this sort of cautionary comment. The answer to this is that the absolute level does not count. What matters is the relative level, the trend. We should not care about the exactitude of a spread at 16bps. That’s not the story. The story is that this spread was above 100bps in March and is now at 16.75bps. Liquidity is out there chasing risk, and as long as we see this indicator, we may see the bid for risk continuing.
2. - Global Coordination in monetary policies
By now, it should be pretty clear that global coordination has been the stability factor in this crisis. As we said countless times, global coordination is what makes this crisis different from any other one in the past and it is the factor that has made this rally stable. In summary, liquidity fueled the rally and global coordination provided the stability for the rally not to be killed by the bears. It was on July 27th, a month ago; when we explicitly suggested this thesis (Implicitly, we suggested it on April 21st, when we said that all currencies are being debased in calculated order, denying gold the chance of playing a lucrative asset). A month ago, we said central banks can thwart any rebellion. This is what we saw two weeks ago happen in China and last week in Canada. In China, the Renmimbi is being “driven” to appreciate, with the central bank restricting liquidity growth and changing the composition of its assets both by asset class and maturity, while in Canada, the Federal Government plans to sell USD bonds, to boost foreign-exchange reserves and support lending by the International Monetary Fund. That is at least the official excuse. The most idiotic ground to justify this bail out on the USD was that Canada needed to diversify its sources of funding! What nonsense is that? We have capital flowing in spite of all the latest horrible fiscal policy and we even have the luxury of issuing bonds in our own currency, yet our government decides to ask investors to buy USD if they want to go long Canada risk? This is a perfect example of my point that we are going to see global coordination to a degree never seen before, and any rebellion will be dealt with swiftly.
When will the rally stop? The rally will stop if and when, having a fiscal problem erupted within one (important) country, the rest of the coordinating countries (also important) refuse or are unable to lend a hand. If that happens, the price of gold would jump, destroying any currency’s chance to be a reserve asset.

Disclaimer: The comments expressed in this publication are my own personal opinions only and do not necessarily reflect the positions or opinions of my employer. I prepared and distributed this publication as an independent activity, outside my regular salaried work. No part of the compensation I receive from my current employer was, is or will be directly or indirectly related to any comments or personal views expressed in this publication. All comments are based upon my current knowledge. You should conduct independent research to verify the validity of any statements made in this publication before basing any decisions upon those statements. The information contained herein is not necessarily complete and its accuracy is not guaranteed. The comments expressed in this publication provide general information only. Neither the information nor any opinion expressed constitutes a solicitation, an offer or an invitation to make an offer, to buy or sell any securities or other financial instrument or any derivative related to such securities or instruments. The comments expressed in this publication are not intended to provide personal investment advice and they do not take into account the specific investment objectives, financial situation and the particular needs of any specific person.

A View from the Trenches, August 20th, 2009: Focus on China

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What a day! As we wrote on Tuesday that it was possible to have both treasuries and stocks rallying, we saw exactly just that happening in front of our eyes a day later, to the surprise of many. Who would have thought that with stocks losing 4.86% in Shangai overnight we were going to see a weaker USD and stronger stocks? Don’t let the herd fool you! Don’t listen to those who say that the surprise in oil inventory data is what drove stocks higher yesterday. Here’s the facts, you decide: The swap from Agency debt to Treasuries continued to play overnight yesterday, as shown in the chart below (source: Bloomberg), with the 30-yr Treasury rallying from 102-16 to 104+ by 8:30am (the yield curve flattened vs. last Friday close). The 3-mo Libor-OIS spread continued to collapse to 23.17bps yesterday, as the 3-mo Libor reached 41.87bps! This is hardly a normal situation of course, but to finish, let’s also remember that after 8:12am the EUR/JPY cross began to shoot up from 132.12. Thus, stocks were flat until obviously, the oil inventory data was released at 10:30am. But again, the wave had begun much earlier than that. Oil did not save the day, but it fuelled the push to higher levels:

For those not familiar with the spread shown above, here’s the math: Spread = Agency debt spread – Treasury spread
Given that Treasuries rallied (=Treasury spread ↓) and the Spread widened (=↑), the Agency debt spread either remained unchanged or went up (it actually went up). Thus:    Spread ↑ = Agency debt spread ↑ - Treasury spread ↓

Now, let’s go to the difficult part: Understanding what happened. In my view, we need to focus on China. The waves are coming from there. I will make an assumption here: Given that activity in Agencies took place overnight, I will assume the purchase of Treasuries is coming from Asia. Why would someone buy Treasuries? The only explanation I find is that that someone believes or perhaps KNOWS that interest rates are going to remain low longer than what most of us anticipate. Suppose that someone was the central bank of China.  The swap from Agencies to Treasuries represents a change in the composition of the asset side of the bank’s balance sheet. But if Treasuries (which are reserves to the central bank) rally:

1.    Would it not be easier for the central bank to appreciate the Renmimbi?
2.    And if the Renmimbi gained vs. the USD, should Chinese stocks not fall, as the appreciation affects the export sector? (Did this actually not happen since the start of the swap trade?)
3.    And if China is richer in terms of USD, could it also not afford more commodities traded in USD terms, like oil? (Did a rise in oil prices not happen in the last days?)
4.    Should the USD not only fall vs. the Renmimbi but against the EUR as well? (As it did today)
5.    Should a weaker USD not affect stocks in the US in a positive way, at least in the short-term? (As it happened today?)
6.    Should it also not allow firms to refinance their debt, driving credit spreads tighter? (As it may happen later on?)
The question is how this would be coordinated, if coordination is possible. What is in the works? A new stimulus package? Is this sustainable? And if it makes sense (or not…I am not sure myself), why was it not done earlier?

Disclaimer: The comments expressed in this publication are my own personal opinions only and do not necessarily reflect the positions or opinions of my employer. I prepared and distributed this publication as an independent activity, outside my regular salaried work. No part of the compensation I receive from my current employer was, is or will be directly or indirectly related to any comments or personal views expressed in this publication. All comments are based upon my current knowledge. You should conduct independent research to verify the validity of any statements made in this publication before basing any decisions upon those statements. The information contained herein is not necessarily complete and its accuracy is not guaranteed. The comments expressed in this publication provide general information only. Neither the information nor any opinion expressed constitutes a solicitation, an offer or an invitation to make an offer, to buy or sell any securities or other financial instrument or any derivative related to such securities or instruments. The comments expressed in this publication are not intended to provide personal investment advice and they do not take into account the specific investment objectives, financial situation and the particular needs of any specific person.

A View from the Trenches, August 19th, 2009: Thinking out loud

Please, click here to read this article in pdf format: www.sibileau.com/martin

If you read most daily comments from yesterday, you will leave with the impression that nothing really substantial has taken place lately, perhaps on grounds that that trading was on slim volume. When some sort of fundamental analysis is proposed, it is also on the basis of the latest macro data releases (i.e. Producer Price Index, Housing, etc.) only.
However, something happened early this morning that I thought was rather strange. As soon as I started watching my usual charts I found that the EUR/JPY cross and the CAD were plunging, together with oil, as the 30-yr Treasury bond was in full force approaching the $103 level. With these figures, it was clear to me that stocks were to sell off yesterday, and I could not understand how Asia’s and Europe’s equity indexes were recovering. Below, I show the 30-yr Treasury intraday and the S&P500 (source: Bloomberg):

I was totally lost, until I came across a morning research note recommending selling 2-yr Agency debt (i.e. a security issued by US government sponsored agency, like Fannie Mae). I read the analysis and the recommendation made a lot of sense. Only then, did I put the two and two together: On Monday, as I discussed here, the “rumor” went out that China would buy mortgages. Why would China, owner of Treasuries, change these for mortgages that are so expensive? And then again, I realized that the latest sell-off we saw in stocks started in Asia…Now, I believed in conspiracy theories again!
If my intuition was right, we should have seen the spread between 2-yr Agencies and Treasuries react to this by widening, as 2-yr Agency debt was being swapped for Treasuries (i.e. investors sell Agencies = Agency spreads widen, and buy Treasuries = Treasury spreads tighten). Thus, I looked for the magic chart, and this is what I found (source: Bloomberg):

As you can see, this trade has been significant in the last two sessions and…it starts early, with Monday’s activity developing overnight in Asia. This has two immediate and very strong implications, as well as ramifications: (1) as this swap takes place within fixed income assets, we can perfectly see both Treasuries AND stocks rally, which is counterintuitive. The proof is in the 3-mo Libor-OIS spread that continued to collapse, reaching 23.85bps yesterday. In the process, if this comes from overseas, we can see volatility in the FX markets (i.e. EUR/JPY) and (2) this swap suggests to me interest rates may remain low longer than what you or I would think. If this is correct, jump-to-default risk can further fall and drag credit even tighter!

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A View from the Trenches, August 18th, 2009: Which way is it going to go?

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Inevitably, we need to discuss yesterday’s events. I must confess I read and reread all sorts of comments dating back to two weeks ago, encompassing a wide spectrum of opinions. There are the uber bears, telling us we are going to revisit the March lows, the optimist who point at macro data (i.e. New York Empire Manufacturing Index above consensus estimate of +4, rising to +12.1), and the cautious, who look for catalysts for a move on either direction. I want to believe I can include myself in the last category.

The optimist case is the easiest to grasp. In the case of the ultra bearish, the logic is flawless. Therefore, if we do not agree with it, we must disagree with their assumptions. The main assumption seems to be that government intervention will not change anything. But the rally we had since March 18th started precisely with the announcement of the Fed’s quantitative easing policies (and died when the Fed declared last week they would not extend the Treasuries purchase program). It may be true (it actually is) that, in the end, in the long term, the intervention we see will be sterile. We cannot see sustainable economic growth when fiscal deficits are monetized. But at the same time, if we appreciate that the intervention since March (to be more precise, since Dec 5th 2008, when the Fed first started purchasing securities, in a very muted way though) did generate the asset inflation of 2009, we must at least not ignore that increased intervention in the face of a generalized sell-off is still a possibility. We saw the Bank of England opting for such alternative only a few days ago.
 
On Thursday (“A visible inconsistency”, www.sibileau.com/martin/2009/08/13 ) I wrote that, in my view, as long as the US fiscal deficit continues with the resulting supply of Treasuries, the monetization is likely to continue, but in another form. I think we can safely say that today’s announcement on the extension of the Term Asset-Backed Securities Loan Facility (TALF) to Jun/10 for new Commercial mortgage-backed securities (CMBS) and to Mar/10 for other assets, constitutes an alternative way to monetize. After all, what does the US Treasury borrow money for, if not to bail out private failures (i.e. in the real estate market)?
 
Another interesting development is the announcement or should I say rumor (by Reuters early yesterday. Bloomberg, at 7:40am, reported that it could neither be confirmed nor denied) that the China Investment Corp. would buy $2BN of US mortgages under the Treasury-backed Public-Private Investment Plan.   In any case, we first proposed this alternative on June 1st (“What could China do?” www.sibileau.com/martin/2009/06/01 ), which would make sense as a coordinating policy to avoid the collapse of the USD. I never thought it would be implemented and the fact that is now a rumor raises a flag. However, let’s be clear: A $2BN transaction in a trillion-dollar market is laughable. But $2BN is better than nothing.
 
Thus, in general, although governments may not be all that successful in avoiding a feared sell-off, I don’t think we can just ignore the weight of their interventions. Having said this, another fact that makes me not so ultra bearish (for now at least!) is the low levels of the 3-mo Libor – OIS spread. This spread was 1.16% higher yesterday, but at the 24bps mark it is certainly not signaling stress yet. We’ll closely look at its evolution in the coming days.
 
Lastly, I could not help noticing that unlike previous sessions, when the S&P500 was always closing to the upside in the last hour, yesterday, it didn’t. Sometimes, I am superstitious too! Please, see the chart below (source: Bloomberg)

Disclaimer: The comments expressed in this publication are my own personal opinions only and do not necessarily reflect the positions or opinions of my employer. I prepared and distributed this publication as an independent activity, outside my regular salaried work. No part of the compensation I receive from my current employer was, is or will be directly or indirectly related to any comments or personal views expressed in this publication. All comments are based upon my current knowledge. You should conduct independent research to verify the validity of any statements made in this publication before basing any decisions upon those statements. The information contained herein is not necessarily complete and its accuracy is not guaranteed. The comments expressed in this publication provide general information only. Neither the information nor any opinion expressed constitutes a solicitation, an offer or an invitation to make an offer, to buy or sell any securities or other financial instrument or any derivative related to such securities or instruments. The comments expressed in this publication are not intended to provide personal investment advice and they do not take into account the specific investment objectives, financial situation and the particular needs of any specific person.

A View from the Trenches, August 17th, 2009: Back to March levels?

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I thought it would be worthwhile to start the week describing how the last one ended. Today’s letter will be merely descriptive (vs. the typical analytical format) and full of charts, but I think that sometimes, there is value in induction.

With positive news out of Europe early Friday, it seemed it was going to be a good day across the Atlantic. The surprise came when, suddenly, the 30-yr Treasury rallied in early trading. With this rally, the yield curve was going to have an interesting flattening move by the end of the week (see charts below). However, early in the morning the USD was not appreciating, but the EUR/JPY was falling. Why would the USD not rally as well? Someone suggested it was a signal that the USD was becoming “the” carry currency, in line with what had happened to Japan. But if that was the case, we should have seen risk being bid (equities rising overseas, credit tightening), and that did not happen. In the meantime, crude (at around 8am ET) was holding its weight. One could still hope…until it just plunged. Obviously, volatility increased. Where is the inconsistency? As you can see, the 3-mo Libor-OIS spread kept making lower lows (did that liquidity end up in Treasuries?), while sovereign credit default swaps remain extremely cheap. Can this reversal lead us back to March/09 levels, if bad macro news keep coming and the Fed is really not going to monetize any more fiscal debt? I think this is only half of the problem. I think the other half is that the global coordination we saw in 2008 is loosing strength in 2009. The Bank of England led the way with its decision to increase its quantitative easing program. Others should follow, but are in denial mode. We should not ignore the VIX index, which is telling us correlation (systemic risk) is still alive.

(Source: Bloomberg)

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A View from the Trenches, August 13th, 2009: A Visible Inconsistency

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Let me begin with the obvious: the 3-mo Libor - Overnight Index Swap spread. It made a new low. 3-mo Libor was 44.97bps, driving this spread to 26.07bps. The system is increasingly receiving liquidity, which needs to be placed somewhere, and hence, after the explicit FOMC announcement on low rates for a long time, Treasuries sold and equities rallied.

Before I go any further anywhere, I need to make a quick stop and discuss the FOMC statement released yesterday. The most significant paragraph, in my view, was the one related to the ongoing monetization of the US federal fiscal deficit. The FOMC wrote the following: “…the Federal Reserve is in the process of buying $300 billion of Treasury securities. To promote a smooth transition in markets as these purchases of Treasury securities are completed, the Committee has decided to gradually slow the pace of these transactions and anticipates that the full amount will be purchased by the end of October. The Committee will continue to evaluate the timing and overall amounts of its purchases of securities in light of the evolving economic outlook and conditions in financial markets…”

As you may have read many times by now, I had a strong view that this purchase program was going to be upsized. I still am, even in the face of this statement. Why? Because the supply of Treasuries will still be there and someone will have to buy it. The problem is not the Fed’s policies with regards to supplying liquidity. The problem is the fiscal deficits, and personally, I can’t see these coming down in the near term. Therefore, the monetization is likely to continue, albeit perhaps not in its present form. To some extent, the market sided with this view post statement, as investors wondered who’s going to be there to bid the 20-30% the Fed has been swallowing. In the chart below (source: Bloomberg), we can see how the 2-10 yr Treasury spread widened intraday, expressing the view:

In my letter of August 4th (”Updating the forecast”: www.sibileau.com/martin/2009/08/04 ), I proposed the possibility that stocks could go higher. Since then, the S&P500 is basically unchanged, having tried the 1012.78 level yesterday, after the FOMC statement. Having said this, I can see stocks higher, but not without the public sector taking the heat. This is based on the fact that stocks are, in my view, being bought with the liquidity that central banks have been pumping. If that was the case, with governments’ debt levels increasing, the natural reaction would be to see sovereign credit default swaps rising along. Yet, this is definitely not happening, and constitutes an INCONSISTENCY…unless…unless the real levels of debt are expected to drop, as currencies get debased. Simple, isn’t it? Let’s recap: If we see stocks increasing thanks to additional liquidity provided by quantitative easing policies worldwide, we should see deterioration in the credit ratings of the governments that fuel this risk transfer. It did happen in the case of the UK, when it first launched its own quantitative easing program, and it has also been clear in the case of Canada where, given the lack of quantitative easing policies, the country’s credit default swap is not even quoted. But lately, sovereign credit default swaps have compressed significantly. And this only signals future conflict, future competition for financing between public and private sectors worldwide. In the meantime, as demand pick-up is not visible, capital expenditures or M&A financing is anemic and therefore, the conflict is muted.

Should the conflict be supportive of gold? Not if the debasement is coordinated. In the ’60s / ’70s, we had people like De Gaulle in Europe or Mao Tse-Tung in Asia, and of course, we had a Cold War going on. Coordination was not possible. Today, the political classes of the world are on the same program: They have to defend the status quo, be it in North America, Western or Eastern Europe, Asia and of course, in Latin America.

The comments expressed in this website and daily letters are my own personal opinions only and do not necessarily reflect the positions or opinions of my employer or its affiliates. All comments are based upon my current knowledge and my own personal experiences. You should conduct independent research to verify the validity of any statements made in this website before basing any decisions upon those statements. In addition, any views or opinions expressed by visitors to this website are theirs and do not necessarily reflect mine. My comments provide general information only. Neither the information nor any opinion expressed constitutes a solicitation, an offer or an invitation to make an offer, to buy or sell any securities or other financial instrument or any derivative related to such securities or instruments (e.g., options, futures, warrants, and contracts for differences). My comments are not intended to provide personal investment advice and they do not take into account the specific investment objectives, financial situation and the particular needs of any specific person.

A View from the Trenches, August 12th, 2009: More questions than answers

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Back from a brief vacation, I have more questions than answers. Since last week, it is obvious the general outlook is more uncertain. I’ve been endlessly trying to figure out how a recovery can take place when aggregate demand doesn’t seem to be picking up, interest rates can only rise and defaults are materializing.

What has saved us so far? The injection of liquidity via quantitative easing. Perhaps that is the indicator we must watch like a hawk. Here, I follow the already famous 3-mo Libor - Overnight index swap spread, or the cost banks face to rent their balance sheet (Feedback on this metric is welcome). Once again, I am including its corresponding chart below (source Bloomberg). As you can see, this spread has been making lower lows every day, which is an amazing fact. And I am inclined to believe we will not see a material sell-off in equities or a material widening in credit as long as this spread remains falling:

Another thesis I’ve been giving credit to is the importance of global coordination in monetary policies. However, last week, the Bank of England surprised with the announcement it would extend its quantitative easing transactions, to GBP175BN. This move, I think, shows a fracture in the front. That it happened should surprise nobody, particularly when it involves the British government. Great Britain showed independence when it decided not to join the Euro back in the ’90s; it showed it again when it took the lead last year announcing the capital injections to financial institutions and it shows it again with the latest move. Will the Fed follow? Some analysts expect the Fed to keep silent on this tomorrow, at the close of the FOMC meeting. That may be true, but I think that there is a lot of anxiety around the extension of the $300BN Treasury purchase program and silence will be costly.

In any case, the underlying lesson here is that as countries see themselves past the liquidity crisis of 2008 and each of them faces different challenges for their respective paths back to growth, they will more and more openly dissolve the coordinated front that we witnessed last year, taking their own roads, scratching their own backs. As long as none of them takes the wrong road, the path to recovery should be clear. However, that is not guaranteed.

What this new reality certainly brings is higher volatility in capital flows and hence, in the FX market. The latest depreciation in the CAD constitutes, in my view, a good example. Although impossible to prove, I don’t think the CAD is weaker because the USD is stronger, but because of domestic uncertainties in terms of fiscal and monetary policies, the latest of which is the embarrassing announcement that the Nortel transaction will be reviewed.

The comments expressed in this website and daily letters are my own personal opinions only and do not necessarily reflect the positions or opinions of my employer or its affiliates. All comments are based upon my current knowledge and my own personal experiences. You should conduct independent research to verify the validity of any statements made in this website before basing any decisions upon those statements. In addition, any views or opinions expressed by visitors to this website are theirs and do not necessarily reflect mine. The information contained herein is not necessarily complete and its accuracy is not guaranteed. My comments provide general information only. Neither the information nor any opinion expressed constitutes a solicitation, an offer or an invitation to make an offer, to buy or sell any securities or other financial instrument or any derivative related to such securities or instruments (e.g., options, futures, warrants, and contracts for differences). My comments are not intended to provide personal investment advice and they do not take into account the specific investment objectives, financial situation and the particular needs of any specific person.

A View from the Trenches, August 6th, 2009: "Not so fast!"

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I am a bit more confused today than I was yesterday. I was hoping to see a bear flattening in the yield curve, indicating that implementation of an exit strategy by the Fed was in the works. A bear flattener is a move in rates where short-term rates increase faster than long-term rates, with the gap between the two compressing. Seen from another angle, in a bear flattener, short-term bond prices fall faster than long-term bond prices. And this has not happened this week so far. The chart below shows that in fact, the opposite took place and rather violently, in the last trading hours yesterday. What happened? One of the possible explanations is that with today below consensus macro data releases (Employment and ISM Non-Manuf. Composite), the horizon for any sooner rather than later rate increase dissipated into oblivion. Adding fuel to the sell-off, there was also mortgage-related selling:

Chart 1: US Treasury Actives: Yield curve change since last Friday (source: Bloomberg)

Another interesting development in the last days has occurred in the correlation space. We dealt with this a few days ago (www.sibileau.com/martin/2009/07/29 ). We said that investors would be wrong to expect that correlation (of defaults) fall with systemic risk:”…Perhaps what misleads investors here is that systemic risk may not be falling, but evolving, switching from liquidity risk in its purest form (lack of financing) to inflation risk (lack of profitability, as costs rise or don’t fall as quick as revenue, while short-term financing becomes more expensive due to a crowding-out effect created by fiscal deficits)…“. In particular, we took the structural approach and said that: “… If you believe that correlation of defaults is a product of correlation in equities (in their expected returns) and their respective volatility, it will be easier to get the picture…”. Interestingly enough, Bank of America’s Credit Strategy team put a note yesterday on this issue (Situation Room: “Credit 25, VIX 0”), suggesting that while individual stock volatilities (within S&P500) did decline, the VIX did not react because an offsetting increase in implied correlation (in returns within the S&P 500 stock portfolio).
This takes me back to a point I am starting to emphasize more and more lately: Global coordination of monetary policies. Yesterday, we referred to the evolution (decreasing) in the Libor-OIS spread. On this subject, a friend and reader kindly sent us a chart (reproduced below) published by the Bank of Canada in its July 2009 Monetary Policy Report (source: Bloomberg). This chart shows the spread between the main (i.e. US, UK, EUR, CAD) 3-month interbank offered rates and their respective overnight index swaps. At first sight, the correlation among them is impressive. Notice too that the absolute differences among these spreads have been steadily decreasing, suggesting a radical change in the factors driving FX dynamics going forward (=if illiquidity drove the value of the USD up in 2008, this is no longer the case in 2009).

Disclaimer:The comments expressed in this publication are my own personal opinions only and do not necessarily reflect the positions or opinions of my employer. I prepared and distributed this publication as an independent activity, outside my regular salaried work. No part of the compensation I receive from my current employer was, is or will be directly or indirectly related to any comments or personal views expressed in this publication. All comments are based upon my current knowledge. You should conduct independent research to verify the validity of any statements made in this publication before basing any decisions upon those statements. The information contained herein is not necessarily complete and its accuracy is not guaranteed. The comments expressed in this publication provide general information only. Neither the information nor any opinion expressed constitutes a solicitation, an offer or an invitation to make an offer, to buy or sell any securities or other financial instrument or any derivative related to such securities or instruments. The comments expressed in this publication are not intended to provide personal investment advice and they do not take into account the specific investment objectives, financial situation and the particular needs of any specific person.

A View from the Trenches, August 5th, 2009: An interesting day

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Very interesting trading session yesterday… As you can see in Chart 1 below, the morning started with a very weak USD and a steepening move in Treasuries. By 1pm, when the $31BN 4-week bills auction took place, the 2039s had plunged from 98-08 to 95-25, lifting stocks and bringing the VIX index from 26.16pts to 24.93pts. The response didn’t take long, and as you can see, in the next hour, the Canadian dollar gave back a cent. However, it was also influential the Bank of Canada’s C$1BN term purchase and resale agreement transaction, which goes to my point that the global coordination in monetary policy is at the order of the day and any rebellion will be thwarted with violence by central banks around the world!

Chart 1: Intraday 30-yr Treasury vs. CAD        Chart 2: US Yield Curve  (Source: Bloomberg)

The yield curve remained slightly steeper though (Chart 2), but at least we saw consistency in the FX market, rewarding the USD. I don’t want to get too much ahead of myself, but this obviously indicates strength in rally in stocks. However, we can’t believe in everything we see, right? To concentrate on what matters, liquidity, I thought I would show again a chart on the Libor-OIS spread (Chart 3). As I’ve written before, this spread measures for banks the cost of “renting” their balance sheet. As it cheapens, liquidity is reallocated. And cheapened it has. In the last week, it has fallen from 29.4bps to 27bps. The trend is from the upper left to the lower right, unequivocally. As long as we see this trend drifting to pre-crisis conditions (around 10bps) we should see a bid for risk assets, both in credit and equities, but…the CDX Inv. Grade index closed +1.5bps wider today (unlike High Yield 12), at 112.5/113.5bps. Do you think this is a “technical”?

Chart 3: Libor – OIS spread, July 20th to August 4th, 2009

(Source: Bloomberg)

Disclaimer:The comments expressed in this publication are my own personal opinions only and do not necessarily reflect the positions or opinions of my employer. I prepared and distributed this publication as an independent activity, outside my regular salaried work. No part of the compensation I receive from my current employer was, is or will be directly or indirectly related to any comments or personal views expressed in this publication. All comments are based upon my current knowledge. You should conduct independent research to verify the validity of any statements made in this publication before basing any decisions upon those statements. The information contained herein is not necessarily complete and its accuracy is not guaranteed. The comments expressed in this publication provide general information only. Neither the information nor any opinion expressed constitutes a solicitation, an offer or an invitation to make an offer, to buy or sell any securities or other financial instrument or any derivative related to such securities or instruments. The comments expressed in this publication are not intended to provide personal investment advice and they do not take into account the specific investment objectives, financial situation and the particular needs of any specific person.

A View from the Trenches, August 4th, 2009: "Updating the forecast"

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We are back from a relaxing time with friends, at the shores of Lake Huron, only to find that I may have now to update my views. Let’s see:

-Equities:
Everyone always needs a benchmark. To judge my view on equities, I read on Friday the voice that is perhaps the most bearish in the market, the one that calls for lower lows before 2010 (S&P500 below 666). For the sake of honesty, this analyst (that will remain anonymous) is calling for an S&P500 reaching 1022-1050pts before October, when the sell-off should begin (The sell-off would be triggered by disappointing sales figures and weak consumer data). Thus, so far, things (including yesterday’s close at 1002.63, +1.53%) are playing out according to plan. However, the analysis is a bit inconsistent, in my opinion. It calls for inflation after the sell-off (within the next 12 months, with oil and gold at above $100 and $1,500 respectively) and it bases the pessimism in the naturally intuitive failure that the transfer of losses from private to public sector represents. I believe the inconsistency with an inflationary scenario (i.e. asset prices falling and consumer prices rising) is clear by now. The other point, the one about the failure in transferring losses, well, that is precisely what makes this crisis unique. I would say that such failure is a certainty, when you deal with local, closed economies. However, when you have global coordination of monetary policies by the biggest central banks (i.e. liquidity suppliers) ensuring the market remains liquid; well…a forced sell-off seems unlikely. In conclusion, given the high respect I have for this analyst’s opinions, if the sell-off will come when macro data disappoints and so far the data is not disappointing, and if you share my view that a globally coordinated debasement can be successful, you should believe we cannot see equity prices falling. If we cannot see equity prices falling and macro data continues to improve, then sooner rather than later, we should be seeing higher equity prices. Thus, I have to update my view about errant, stagnant equity prices, in favor of higher levels. Perhaps a key level to hold this view in S&P500 can be 944pts.

-Yield curve:
Until now, I firmly believed the yield curve would remain steep. It was a view that played well. However, from now on, I am in doubt. Late action and speeches by the Fed indicate that an exit strategy would favor an increase in short-term interest rates. The increase would be driven by interest paid on reserves and of course, the Fed’s withdrawal from Treasury auctions. However, as I’ve been relentlessly repeating, the problem is the fiscal deficits. And I think you would side with me if I said that I don’t think these deficits will decrease. The deficits for 2009 and 2010 are estimated to be approx. $1.35 trillion and $1.23 trillion respectively, without including any healthcare reform. How big is this? To put it in perspective, on July 29th, Bank of America’s Credit Strategy team published a report (Situation Room: “Rolling over the mountain of High Yield debt”), where they expressed concern on the market’s capacity to refinance high yield loan maturities estimated at $361BN, starting in 2013. If $361BN four years down the road is of concern….how about $1.23 trillion just next year???!!!! You can now pretty much see how significant the crowding-out effect is starting to be. Each dollar that goes to buy Treasuries should in theory (that is, if is hasn’t been printed out of nowhere!) not be available to refinance high yield debt. Therefore, with ongoing stratospheric fiscal deficits until at least 2011, any increase in short term rates will be validated by the Treasury. The question then arises on the value of the USD….If we are going to have higher short-term rates, should we not see the USD gaining value? It is possible, but it is certainly too early for me to answer this. I remain very vigilant then.

Onto other things now, I have been doing a fair amount of reading this long weekend. In general, I’ve found a certain level of complacency. Analysts are beginning to point to favorable economic data to validate the rally in equities and credit. Even relative value trades (i.e. HY loans vs. HY bonds) are recommended on the basis of better economic metrics. Make no mistake; as much as this crisis was all about de-leveraging, this rally is all about re-leveraging. It is all playing out on the back of enormous amounts of monetized debt that will have to be paid, sooner or later. Yes, it can take years to become visible, but the tears will be there nonetheless. In fact, if all this nonsense of financial regulation ends up being passed in the US Congress (and in other countries as well), the pain will be unbearable. And if this monetization is ever challenged by the markets or faces political obstacles leading to un-coordination, the dream we are currently living will turn into a horrible nightmare in no time.