Your overconfidence is your weakness

Apparently everything is doing just swimmingly. So much so that the Fed is going to hike rates later this year. Check out Fed Fund implied rates for the October meeting...



And for December...

So by December the odds of any rate cut are near zero, and there is a 60% chance of some kind of rate hike. Don't buy it. Instead buy the 2-year. Look, I think I'm a relatively optimistic guy, but the housing bust will take time to work through. In the mean time, consumer spending will be pinched and that will ultimately prove disinflationary. I know I got a violent reaction in the comments to yesterday's post on this subject, but I just can't buy that the money supply is expanding with banks universally pulling back on credit.

Meanwhile agricultural commodities continue to fall, which really belies the "oil is up because of the dollar" argument. Here is the chart...

While agriculture is still way up for the last 12-months and therefore should continue to pressure retail food prices for a while, this trend is a net positive for inflation expectations.

Anyway, former credit market pariah iStar Financial is coming with a new unsecured bond deal today. About a 30bps new issue concession, which isn't too bad all things considered. Swap spreads are crashing in, with 2-year swaps falling 6bps in the last 2 days, and hitting its lowest level since 4/7.

I continue to trade my personal money from the short side in stocks, if anyone cares.

These aren't the prices you're looking for...

Inflation has become a dominant theme in investment markets recently. There is considerable debate over what measure of inflation is the best one. My fellow blogger Barry Ritholtz has derisively referred to "Core" figures as "inflation minus inflation" in the past.

But if you thinking as an investor, and are reading this site looking for trading ideas, the answer to the inflation debate is obvious. Inflation is what the Fed thinks it is. Period.

What do I mean? First of all, think about why you care about inflation, again thinking solely in terms of trading strategies. You care because inflation influences monetary policy and interest rates. You care because higher inflation will cause the Fed to hike rates, causing a myriad of ripple effects throughout the economy.

Thinking in those terms, its clear that the measure of inflation you should care most about is the same measure the Fed cares most about. Currently that is Core PCE. Some other measures are gaining popularity within the Fed, including the Median CPI, calculated by the Cleveland Fed and the Trimmed Mean PCE, calculated by the Dallas Fed. Both the Cleveland Fed President Sandra Pianalto and Dallas Fed President Richard Fisher are currently voting members of the FOMC. So if they care, you should care.

But what about rapidly rising food and energy costs? As far as the Fed is concerned, those cost increases results in an increase in the cost of living, but not inflation in the monetary sense. Remember that the Fed is in charge of the money supply. The theory goes that if every consumer suddenly had more money to spend (because the money supply increased) and the supply of goods were held constant, the price of all goods would have to increase.

Thinking about inflation in those terms, Core-style measures make sense. Trimmed Mean and Median make even more sense. Because you are trying to measure a generalized movement in prices, not movements that are the result of specific supply and demand factors for a given good. A perfect example is the effect of ethanol requirements on food prices. Clearly ethanol is crowding out other food production, creating upward pressure on food prices. And yet this effect has nothing to do with the money supply and therefore isn't the Fed's problem.

Express all the outrage you want over the rising cost of living. As long as the Fed doesn't think its their problem, it isn't going to influence their decisions. If it doesn't influence their decisions, should it influence your trading? No.

The Fed will continue to be more concerned with the current recession and less concerned with inflation. Fed economists realize that its difficult to get rising inflation without rising wages. Its simple supply and demand. If consumers don't have more money to spend, they can't bid up the price of goods. Its simple math. Hence as long as wage growth remains tepid we can conclude that food and energy price increases have to do with supply and demand in those markets and not generalized inflation.

What about the dollar? I believe a depreciation of the dollar can be a symptom of inflation. Obviously a dollar that buys fewer goods is the very definition of inflation. But the trading value of the dollar is influenced by various things, most notably interest rate differentials. Interest rates are low in the U.S. and high in Europe. Dollar gets weaker. Through in the account deficits and you have plenty of reasons for dollar weakness. Besides, whatever happens with the dollar, we still need consumer spending to increase in nominal terms to make the basic math of inflation work.

What about M1? M2? or M3? Economists have soured on these measures in recent years as changes in banking as well as foreign holdings of cash have rendered simple measures of the money supply invalid. But I'll indulge those who hang on to the classics. Let's assume the Fed prints $10,000 in new cash for every man, woman, and child in the U.S. and just gives it away. But all that cash just gets stuffed under citizen's mattresses and never sees the light of day. Do we have any inflation? Granted, this is a silly example, but it drives home the point: if consumers don't spend, we don't have any inflation. And consumers won't increase their spending unless they are seeing an increase in wages.

And we know the trend in wages: down. While job losses to date have been relatively minor, negative job growth is negative job growth. Besides that, the historical trend has been for job losses to continue even after the recession is over. I haven't even mentioned home prices yet, which are destroying wealth and will continue to hamper spending. Consumers are going to remain pinched for the next 1-2 years, perhaps longer. Its just not too likely generalized inflation will accelerate given this backdrop.

Am I dismissing food and energy price increases as meaningless? No, just saying that rising prices in those markets don't have anything to do with money, and therefore won't influence the Fed's decisions. Want to do something about energy costs? Buy a hybrid car. Want to do something about food prices? Write your congressman. The Fed ain't going to help.

Freddie Mac and CPI: You've had a busy day!

Treasury bonds got hit hard yesterday after retail sales posted a decent gain. I continue to be confounded by the recent spate of non-recessionary economic figures. But with housing showing no signs of bottoming in the near term, I'm sticking with a recessionary view.

This morning Freddie Mac reported a loss that was less than expected. I plan to post more on this as I read more detail. I really want to understand how Fannie Mae posts such a bad number yet Freddie manages to post a more mild loss. In other words, either Fannie is really doing something wrong or Freddie's numbers aren't all they seem to be. The stock was up 8% overseas. I'm going to try to hear the conference call today and will post what I think. Please post your comments.

Offsetting this was a slightly better than expected CPI number (Core 0.1% vs. exp. of 0.2%). Treasuries had been down 1/2 point before the number and are now flat. Technicals remain crappy for intermediate bonds so I'm cautious. On the upside (in yield), I think the next technical level on 10's should be at 4.05, although 4% might wind up being a psychological level and thus producing some resistance there. On the downside, as proven in recent days, we can easily slide into the 3.70's on a short-term move. I feel like we have some gaps to fill between 3.88 and 3.95%.

Meanwhile the BBA has "put LIBOR under review" and will announce any changes on May 30. People I've talked to think more New York banks will be added to the US $ survey, which I'd think would cause LIBOR to post a bit lower. Anyway, angst over LIBOR continues, and is pressuring swap spreads. 2-year spreads moved almost 4bps wider yesterday and are another 1.5bps wider today.

When we heard about Alderaan...

Yesterday's market sell off walked and talked a little like the fear trading that dominated the first quarter of 2008. Particularly the sudden drop in the stock market around 2:30 with no real explanation looked a little spooky. Recent market rallies in both stocks and credit have been 100% about a modest decline in risk aversion. The belief was that the worst case scenario had been taken off the table, so while the real economy isn't good, the panicky market gyrations were no longer justified. Could that improved sentiment reverse? Was yesterday the start of something bad?

Well, we speak bonds here, and there are some interesting, and maybe telling, indicators from the bond markets. First, CDS moved significantly wider yesterday. The CDX.IG.10 index (which is a basket of investment-grade CDS) moved 10bps wider, the biggest single day widening since April 8. I haven't seen the final CDX number, but should be 1-2bps wider today. That would mark the fourth day in a row in which the IG index moved wider. I'd characterize a single-day move of 10bps as pretty extreme, although during the January-March period, there were several 20bps single-day moves.

Brokerage credits, which were at the epicentre of the fear trades, were also wider on Wednesday. Lehman +5, Merrill +6, Morgan Stanley +3 and Goldman +7. Broker paper was largely unchanged today. Here is were the movement didn't look much like the pre-Bear Stearns world, with brokerage paper outperforming the market generally.

Cash bonds, which you may remember are those things with coupons and maturities that people used to trade in the olden days, were little changed. Lehman's new senior 10-year note was bid as tight as +275 and as wide as +290 on Tuesday, but settled in at +285 and was stuck there through Wednesday and Thursday. When you see cash bonds unchanged and CDS wider, its most likely that fast money is pushing the market. Real money tends to buy cash bonds, fast money tends to play in derivatives. That seems especially true given that the CDX indices underperformed typically high beta individual names.

Meanwhile, non-credit spreads were well-behaved. Interest rate swap spreads were tighter, with both the 2 and 10-year spread moving about 1.5bps tighter, and followed through today moving another 3bps tighter. Fannie Mae senior debt spreads, which had moved about 6bps wider on Tuesday after their ugly earnings report, moved 3bps tigher on Wednesday and another 3bps tighter on Tuesday.

So what's the conclusion? The Fed really changed the game when they bailed out Bear Stearns and opened their balance sheet up to the remaining investment banks. The "run on the bank" scenario has been rendered impossible. So a return to the fear trading of January-March wouldn't make a lot of sense.

A better explanation is that the market is struggling to price a world where liquidity is improving but real economics are deteriorating. It felt to me like the market, especially stocks, had become a bit too optimistic in recent days, with some even talking like we won't have any recession at all.

Don't confuse economic data that's "better than expected" with "good." Now if you ask me where the stock and credit markets will be in a year, I'd say both will be better than today. Looking one year out, we'll probably be through this recession, housing will have bottomed, and there will be much more earnings clarity. But in the near term, I think we need a little more of a recession concession.

Clumsy and Random Thoughts

I wish I had time to write extended and thoughtful pieces on each of these thoughts. And hey, if my ad revenue increases by a mere factor of 50 I can probably quit my job and just write all the time!

• It seems increasingly obvious that Bank of America is buying Countrywide for reasons beyond normal economics (which is what I had thought when it was announced). I suspect that CFC has significant liabilities to BAC which makes the de facto price BAC is paying less than the $7/share. Of course, that doesn't explain why they don't try to negotiate something lower now. Anyway, I'm really pissed off about Bank of America's claim of "no assurance" about Countrywide's debt. I'm not a holder of anything related to either company, so its really nothing to me. But its total bullshit that Bank of America could gain the economic benefit of owning Countrywide without the economic risk. This is exactly like the SIV mentality. Just keep Countrywide as a off-balance sheet, highly leveraged mortgage play! When has a plan like that gone wrong?
• I think the markets are too optimistic right now. We've seen very few economic reports which indicate actual strength. Most have indicated things are better than expected. And look, that's fine. We've gone from deep recession with a banking crisis to a mild recession with banks successfully raising capital. Great. But I don't buy why the S&P will keep moving higher without economic reports which are actually good. Same goes for Treasuries, especially 5 years and in. I think they are oversold. For what its worth, I personally bought some S&P puts near the close yesterday.
• Credit is tougher because its coming off such a huge trough. So I don't feel like getting short credit even though I acknowledge that should the S&P pull back 5% or so that spreads will almost have to widen. I just think the fundamentals behind credit are too good to fool around with short-term technicals. I feel like you run a serious risk of getting your fingers blown off.
• On Treasuries: one problem is that technicals are pretty bad. There might be psychological support around 4% on 10's, but its broken decisively through the 120 MA after bouncing a couple times off the 3.87 level. I saw 3.90% as significant resistance, but its trying to break that today as well. Then I don't see anything between here and 4.07%. Plus you have plain old supply coming, with a 10-year auction today. So I think the play in the short-term is a bear steepener, but that's purely on technicals.
• No one really knows why Fannie Mae rallied on ugly earnings. The most logical answer is OFHEO's annoucement that they'd be lifting some capital restrictions, which should make FNM more profitable in the future. It fits with the fact that Fannie Mae debt spreads widened modestly from about +55 on 10-year senior bonds to about +60. I think you can't discount short covering as part of the problem. We might be in a place where shorting mortgage-exposed companies just ain't going to work.
• UBS is exiting the muni business, and are looking to sell the unit. They were the #3 underwriter, so it would have to be someone quite large to buy the business. Let's see, who among the large dealers doesn't have much in munis? I know! Bear Stear--... Er... Actually I don't know who the hell will buy UBS' muni unit. If they do want to make a move they need to do it fast. Otherwise rivals will start picking off the best muni bankers one by one until finally there is nothing left of the unit worth buying. One reader and I had a off-line chat about this and he suggested that there could be a re-regionalization movement in municipals. In other words, a movement away from consolidation in New York and toward mid-sized dealers gaining more power in that market. Lately spreads (meaning commission spreads) have been wider, especially in secondary trading. If that keeps up, look for regional brokerages to benefit.
• I'm watching the MCDX closely. I think if the 5-year hits 50 or so, its a screaming sell.

MCDX: Once munis start down the dark path...

From the people who brought you the ABX, now comes the MCDX, a basket of municipal credit default swaps (CDS). The index will begin trading on May 6 with three, five, and ten year tenors. Markit set the coupon for the MCDX last Thursday night at 35, 35, and 40bps respectively. It started trading today, and traded wider, closing at 42bps for the 5yr tenor and 48bps for the 10-year.

This is a potential game changer in the municipal market. First, we'll go over what the MCDX is, and then how it might change municipals forever.

The MCDX is going to be very similar to the CDX or ABX indices currently trading. It will represent a basket of 50 equally weighted municipal CDS. You can see the list of credits here. These will be recognized by municipal traders as more or less the 50 largest regular issuers of bonds. There are a few AAA credits in there, but mostly AA and A-rated credits. If rated on Moody's Global Scale, the one where Moody's attempts to match muni ratings with corporate ratings, almost all of these issues would be AAA.

There are 26 "general obligation" issuers. These issuers have the legal authority to levy taxes and have pledged their full taxing power to bond holders. 21 of these are states, the other 5 are local municipalities: New York, Los Angeles, Los Angeles School District, Phoenix, and Clark County Nevada.

There are also 24 "revenue" issuers, who don't have any taxing power. The items in the MCDX are of the "essential service" variety, including water and sewer systems, public power, and transportation. The term "essential service" implies that while the issuer does not have taxing power, the local government would have a strong incentive to ensure continued operation. Tobacco and health care issuers are explicitly excluded from the index.

Here is how the index works. A buyer of protection on the MCDX has essentially bought equal amounts of protection on the 50 names in the index. So a $10 million notional trade in the MCDX is de facto $200,000 in protection on each of the 50 names. Should any of the names default, the buyer of protection would deliver an eligible obligation of the issuer to the seller of protection at par. Markit has provided a list of CUSIPs as examples of eligible obligations. Any bond which is pari passu with the listed CUSIP would be eligible.

So why should you care? To date, trading in municipal CDS has been very light, and with good reason. Default rates of general obligation and essential service municipals are almost non-existent. There is a limited number of large and frequent issuers outside of these two categories. So demand from hedgers for specific names is light. There might be demand from speculators who want to bet on the contagion hitting munis. But such a buyer would prefer to make a generalized bet on municipal credit as opposed to picking out individual credits.

The MCDX solves both these problems. Trading desks who want to hedge against municipal credit spreads generally widening can use the basket as a on-going hedge. It wouldn't really matter if the particular names in the index don't match the names the desk owns, since the hedge is really a macro/contagion position. If California runs into major budget problems, odds are that New York CDS would widen at the same time. Obviously this is a better product for a speculator who wants to bet on a broad municipal contagion. So the MCDX is bound to be a hell of a lot more liquid than the single name market ever was.

The implications for the muni market are huge. First of all, it would seem the MCDX will more or less dictate the price of muni bond insurance. It will also heavily influence the spread between insured and uninsured munis. I've heard some talk that such a product would be another nail in the muni insurance coffin, but not so fast. The muni market will remain retail driven, and mom-and-pop investors don't buy CDS. They will still demand insurance.

The MCDX will also heavily influence how munis trade on a given day, especially in institutional size. If dealer desks start using the MCDX to hedge their books, then the daily movement in the index will become part of their P&L. In other sectors, when traders hedges are up, they are a little more willing to cut the price on their long position. The same will happen in munis. If the MCDX is 3bps wider on the day, traders will be willing to sell their bonds 3bps wider too. Well, maybe 2bps anyway. Traders aren't generous people.

It could also start to chip away at some of the old habits of muni buyers. Today municipals are traded mostly on yield. Even if the Treasury bond market is mildly up on the day, muni traders usually don't mark their positions higher. If the MCDX becomes heavily used as a hedging vehicle, traders will want to quote their offerings in terms of their hedges. Thus you are likely to see offering levels altered more often, and possibly even starting to be quoted on spread.

Right off the bat, it almost has to widen. There are going to be more natural buyers of protection (anyone who has a large muni portfolio) than sellers (speculators). So I wouldn't read too much into the movement of the first month of trading. Given that the natural sellers of the MCDX are probably mostly hedge funds and prop desks, I expect municipals to be permanently more correlated with corporate bonds.

All participants in the muni market should become familiar with the MCDX, even if you have no intention of actually trading it. Like the CDX and the ABX before, it has strong potential to alter the market substantially.

Corporate Spreads: You truly belong here among the clouds

My last post created a fair amount of e-mail response (for some reason not much in the comments), but one Anonymous poster did some work based on Moody's data from 1960, and came up with +140 as a "fair value" CDS level. Obviously that's wildly different from my +34 number. For those who didn't read my post, I wasn't claiming that +34 was the right level for corporate bonds, merely that an anticipated increase in defaults due to the current recession doesn't really suggest much widening in investment-grade.

Now I know AI's readers love to dive deep into the data, so here is Moody's default rates from 1960-2006.

The tiny blue lines are actual investment-grade defaults. That never gets above 0.51%. I've only included that because if I didn't, someone would ask. The relevant number for IG investors is the "All-Rated" number, which is in red. See, if you buy an investment-grade bond, odds are good that it would get downgraded to junk before it actually defaults. So looking at IG defaults only sort of hides the reality. The All-Rated number basically shows you defaults as a percentage of all bonds. Now that probably overstated IG defaults, but better to be conservative in a study like this.

Anyway, I've highlights three spikes: 1970, 1990, and 2001. This supports the idea that defaults tend to be centered around periods of poor economics. Not surprising.

My analysis was based on a 4.6% 10-year cumulative default rate. This is based on the default rate for bonds which were rated Baa at the beginning of any 10-year period within Moody's study period. Given that none of the actual spikes in my graphic are over 4.6% (and that the graphic includes all bonds), I think my spike analysis is valid. Its at least a fair illustration.

So anyway, I've asked the Anonymous poster to elaborate on his study, because it sounds like he's done some good work, and yet come to a conclusion that's radically different from mine.

If anyone would like an Excel copy of Moody's 2006 default study, e-mail me. accruedint *at* gmail.com.

What are corporate bonds worth in a recession?

Corporate bonds just finished one of their best months in recent history. Coming off the historic wide spread levels of March, investment-grade corporate bonds tightened by 38bps during April, according to Lehman Brothers, outperforming Treasury bonds by 245bps. That's the best monthly performance for corporate bonds since 1988.

And yet its widely acknowledged that the real economy is quite weak, and corporate defaults will invariably rise as the economy falls into recession. So how can corporate bonds tighten given the economic backdrop?


The short answer is that there is one price for corporate bonds under a liquidity crisis and another under a bad economy. So we're transitioning from the former to the later.

See, the reality is that for investment-grade corporate bonds, liquidity matters much more than run-of-the-mill economics. To see what I mean, consider this simple valuation model for a generic Baa-rate corporate bond.

According to Moody's, the average 10-year cumulative default rate for a Baa-rated issue is 4.6%. In other words, buy a random portfolio of Baa-rated bonds and hold them blindly for 10-years, you'd expect 4.6% to default. The average recovery rate given default for unsecured bonds is 38%. So over 10-years, you'd expect 4.6% of your Baa bonds to default, giving you expected credit losses of 2.85% (4.6% defaults times 62% loss given default).

If default risk were evenly distributed over time, one would have an expected credit loss of 0.285% per year for 10-years. This implies that if corporate bonds were to pay a mere 28.5bps above the risk-free rate, that would, exactly compensate an investor for default risk. Of course, we know that corporate bonds don't trade anywhere near that level, but hold that thought for now. We'll get back to that.

In reality, defaults do not occur evenly over time, but are more likely during period of weak economics. So let's say that the 4.6% default rate is the right cumulative number, but that all those defaults happen in a single year. In other words, over our 10-year horizon, one of those years is a recession, and all the defaults happen in that one year. We could then do a simple discounting calculation to figure the NPV of the expected loss.

We assume that for every $100 par, the investor will suffer $2.85 in credit losses in the recession year. Let's further assume that under normal circumstances, investors assume that there will be a recession at some point during the 10-year horizon, but are unsure as to when it might occur, and therefore assume it will happen in the 5th year. Using the current 10-year swap rate (4.48%) as the base rate, the portfolio of corporate bonds would have to pay a spread of 27bps above the base rate to compensate for credit losses in the 5th year.

Here is my math, in case you want to check it.



Now let's assume that the recession happens in the first year. If the losses are accelerated into the first year, the required spread rises. But only by 7bps. The required spread goes from 27bps to 34bps.
I know, I know. You are getting ready to fire off a nasty comment, claiming some kind of witchcraft over these numbers. OK, think about it logically. Investment-grade companies typically have reasonable balance sheets and relatively stable business models. Otherwise they wouldn't be investment-grade. Take companies like Comcast or Kraft or FedEx. All Baa-rated. Have the odds of these companies going bankrupt really increased by a large degree just because we've entered a recession?

Of course, 34bps isn't even in the ballpark of where corporate bonds have historically traded, even in good times. That's because in real life, investors demand a spread that compensates them for expected credit losses and the uncertainty surrounding credit losses. In a recession, its that uncertainty that rises. So realistically, the spread should change by more than just 7bps as we enter recession.


But don't kid yourself about how high spreads should be just because GDP growth is weak. According to Lehman Brothers, the average investment grade bond spread is now 218bps, 50bps tighter than the all-time wides hit on March 17.

But spreads are still 115bps above their long-term average. Despite how far corporate bonds have come, there is plenty of room to move tighter. Plenty.

But spreads are still 115bps above their long-term average.

Despite how far corporate bonds have come, there is plenty of room to move tighter. Plenty.

After the number: Strong am I with the Force, but not that strong

So much for my morning prediction. There is extensive commentary on the street that says this number isn't strong by any means. The manufacturing report also showed a lot of inventory building and was positively impacted by higher oil prices. So none of these reports are good. I think the flattish stock market now makes more sense than how we opened.

What I said in April still stands. I think employment is the most over-rated statistic as far as making investment decisions.

That being said, if job losses putz around at -75,000 for a few months and then recover, that would be a very mild recession. I think the recovery will be tepid, slowed by both Fed hikes and consumer weakness. Consumers are going to have to spend a long time repairing their balance sheets.

So the bottom line is that I'm willing to add duration in spread product at higher rate levels. I'm starting to sour on the steepener trade, and will move to a flattener outright if we keep seeing better economic numbers.

Ahead of Non-Farm Payrolls

I'm feeling a bit bullish on rates ahead of payrolls today. The markets feel a little too sanguine about the recession we're current in, and so I think a NFP number that's even in-line with the forecast (-75k) will cause rates to rally a bit. I expect a steepener.

The ADP report actually showed a gain of 10,000 jobs on Wednesday, which I don't give much credence. BUT... if it were to be that NFP came out with a similar number, then it means I'm wrong about a significant recession. If that happens, I'm backing way off on duration, and would expect a big flattener. Call it a 2% probability event, but an event I'm ready to act on if it happens.

Meanwhile there is a story out there that Bank of America might not back Countrywide's debt post merger. Not sure how that could work legally, but CFC CDS is about 40bps wider (from a 170 to 210 on the offer side). Looks like their cash bonds are 1 point lower across the board.

Buying in corporate bonds has been very impressive the last 2 days. On the 30th, I kind of dismissed it as just month-end buying, but it seemed to continue yesterday. We saw bigger days as the real meltdown was fading, in mid March and early April. But this week hasn't given us any real news, and still demand is strong. Its a good sign. LIBOR and swap spreads have been drifting lower as well. More detailed commentary after the number...

The Fed and looking away to the future

The Treasury market has spent most of April backing away from financial disaster levels. The 2-year Treasury closed at 1.34% on 3/17, the day Bear Stearns was bailed out/purchased by J.P. Morgan. On Friday the 2-year traded as high as 2.50%. Similarly, the 5-year closed at 2.20% on 3/17, and traded as high as 3.24% on Friday.

When the 2-year traded down to the 1.30's it reflected a number of problems, including fear, illiquidity in other rates product, and the expectation that the Fed would continue aggressive rate cuts. Since then all three of these elements have backed off to some degree. But one thing that hasn't changed at all is the fact that the real economy is quite weak. It may be that the worst of bank writedowns are past us, but housing prices are showing no signs of bottoming. Yesterday, the Case-Shiller index showed home prices declined by 12.7% in 20 large metro areas over the 12 months ending in February. Inventories remain high, and there are still many delinquencies that are going to turn into foreclosures. While it does appear that we are now working through the housing problems, the fundamentals simply don't support a turnaround in the very near term.

We also know that in past recessions, unemployment tends to remain high, or even continues to rise, even after the economy starts growing again. This pattern will be present in this recession as well. Yes I know, 1Q GDP came out positive this morning, but there was a significant inventory effect. I'm going to keep calling this a recession until I'm really proved otherwise (which I doubt). Anyway, even if you presume a relatively mild recession, we're going to have elevated unemployment for a while.

So where does this leave the Fed? Today we got a 25bps cut, with the statement still sounding quite dovish. Those that are calling this statement "hawkish" are speaking relative to recent statements. Unless the Fed's favorite inflation gauges start rising, or the Fed really believes inflation expectations are rising, there will be no impetus for hikes any time in 2008.

Look back at the 2-year Treasury. The long-term spread between short-term inter-bank lending rates and Treasury rates is about 40bps. So if Fed Funds were going to remain at 2.25% for the next 2 years, fair value for the 2-year Treasury would be 1.85%. So with the 2-year actually in the 2.30% range, the market seems to be expecting Fed Funds to average something like 2.70% over the next 2-years.

Feels to me like that expectation is a bit high. If the Fed holds at 2% for 9 months, the Fed would have to hike 112bps immediately thereafter for Funds to average 2.70%. The hike would have to be more extreme if we used a discounting method rather than a straight average. Of course, there are any number of patterns that could justify current rates, but all of them would involve aggressive Fed hikes by early 2009.

And to assume the Fed starts hiking aggressively in early 2009 also assumes that housing and employment start showing some real signs of improvement by then. I'm not going to say it can't happen, but that seems like a very optimistic scenario. In other words, it seems that the odds of the recession being deeper or longer than what is priced in is relatively high, whereas a more optimistic scenario is just not very realistic.

As I said in a previous piece, inflation is the wildcard. If we see some real pass-through effects from food and energy then the Fed will have no choice but to hike rates. At that point the yield curve would flatten severely, possibly even causing the 10-30 year maturities to rally while the 2-7 year maturities sell off.

But in the short-term, it looks like the 2-5 year part of the curve is relatively cheap. If you have cash sitting around, now is probably a good entry point.

Treasuries: This far, no further!

The Treasury market continues to struggle to find a right value given improved market liquidity but still weak economics.

Last Friday the Dow soared over 200 points. At mid-day, the Treasury market was acting the way you'd expect, the 10-year fell nearly 1 point, its yield reaching as high as 3.85%. And yet by the end of the day, with stocks still soaring, the 10-year had rallied to a small gain on the day, finishing the day at 3.71%. There was no late day economic release or spooky trading in one of the brokerages or any such thing. Buyers just came in.

Monday morning the Treasury made another run at higher rates, this time despite disappointing earnings from Bank of America and a weak open in stocks. By about 9:30, the 10-year rate had risen 6bps to 3.77%. Once again, however, the market found only buyers at those higher levels, and by the end of the day, the 10-year was unchanged at 3.71%. Once again, there was no particular news that fueled the rally. In fact, both commodities and stocks rallied modestly toward the end of Monday, both of which should be negative for bond prices.

On Thursday we finally got a selloff that held, despite a real ugly housing release. The 10-year finished at 3.83% and the 2-year at 2.38%.

So what's next? In the long term, real money investors don't tend to own a lot of Treasuries. Mutual funds are marketed on yield, and you don't generate yield by holding a bunch of government notes. Same goes with retail investors. In normal times, they tend to chase yield, which will never be in Treasuries. In time, these investors will return to their more normal buying habits, which will result in yields rising.

But in the intermediate term, it may take a little more evidence of economic improvement before Treasury rates make another substantial move higher. I think the worst of the liquidity crisis is past us, but we still have a weak economy will still be dealing with housing-related problems for a while. That will probably keep the Fed in a easy money mode for a while, which will be supportive of interest rates generally.

The thing to watch is primarily inflation data. I think bad housing data is mostly priced in (today's rally supports this thesis), and while it could turn out worse than currently expected, inflation is actually the more important element for rates. Food and energy inflation has been problematic for a while, but the leakage into core inflation measures has been mild so far. The Fed has been gambling that it could afford to cut rates to improve liquidity because weaker employment would take care of the inflation problem.

If either employment is not as weak as currently expected and/or unemployment fails to contain inflation, the Fed will make a U-turn on rates. It is widely agreed among Fed economists that recessions may come and go, but elevated inflation expectations can be difficult (and painful) to bring down. Even if it means creating a double recession (or prolonging the current recession), they will do it to avoid creating higher inflation expectations.

The way to play this is to own cash-flow producing bonds. Agency mortgage-backed bonds are a good choice, as they return principal cash flow every month. This gives one the chance to earn an attractive yield and still have the chance to reinvest principal cash flow at higher rates should inflation tick up. iShares has an exchange traded fund that follows the Lehman Fixed-Rate MBS index, its ticker is MBB.

I don't like Treasury Inflation Protected Securities (TIPS) here. The problem is that TIPS pay investors based on realized inflation, not the threat of inflation. Its very possible that the Fed gets out ahead of inflation expectations, and TIPS returns are unexciting. On the other hand, shorter duration bonds, like MBS, will tend to perform well whether rates rise because of Fed activity or inflation, which seems like a better bet.

ABX: Nothing can stop that now...

I've written recently that liquidity in the market is improving. Ultimately this will help pull us out of our current recession. Without liquidity, lending would never recover, and therefore housing would never recover. With liquidity, time will eventually bring both back to normal levels.

But lest you think I'm some dead brained bull, please understand that everything isn't OK. Look at the ABX indices, and notice how many of those prices are basically at their all-time lows. We've seen everything from credit to municipals to agency MBS show substantail improvement, but the good vibrations don't extend to home equity CDS.

That's because the improvement in other bond sectors reflects a recovery in liquidity. But liquidity isn't the problem in subprime lending. That's especially true for the A and BBB-rated portions of the ABX (which, by the way, is based on original rating). The BBB portions will pay some interest cash flow from here on out, but that's about it. Forget about principal. And that's not going to change. There will be a continued erosion of the ABX BBB prices as those lingering interest payments are made.

Ambac update...

S&P says the 1Q loss won't impact Ambac's rating, claiming that the loss was within their projections. It isn't on their website yet. More commentary as it becomes available.

Ambac: Wanna buy some death sticks?

You can read the actual news for yourself. Bottom line is they lost about 2 1/2 times their market value. Let that roll around in your mind for a while. CDS on Ambac's insurance sub (i.e., the AAA entity) is quoted at +750/year, up about 40bps. The parent company is 17 points up front +500bps/year, up 2 points from yesterday.

Haven't heard anything from the ratings agencies yet. As I've argued before, their AAA/Aaa rating on insured bonds is kind of academic at this point. They have $16 billion in claims paying resources, which means that they can probably pay off all insured bonds with cash to spare. Whether that merits a AAA or not is a matter of opinion. I think Ambac's stock is complete shit, but I also think shorting their insurance sub is dumb.

I'd also point out that the general market doesn't care much about Ambac's results. Dunno exactly how the stock market will open here, but the futures suggest slightly positive. Credit spreads away from monolines are opening mostly unchanged. Would there be any chance of a positive open given these results from Ambac 3 months ago?

UPDATE
Still no word from the ratings agencies. I'll point out that Moody's and S&P have previously argued that mark-to-market losses aren't indicitive of actual cash losses, and therefore the MTM losses Ambac is currently reporting aren't relevant. Not all of their $11/share loss was MTM, but worth considering. I still don't buy Ambac as a long-term profitable company. Maybe they can survive primarily as a reinsurer, but they'll never make it as a major muni insurer again. No way.

Its against my programming to call bottoms

Friday's discussion on bearish market sentiment was really great. Thanks for all who commented.

Most of the comments seemed to focus on stock prices. As a bond pro, I spend my time thinking more about yield spreads, both in credit and other sectors. As discussed many times (many, many, many times), there were two elements causing spreads to widen: poor liquidity and weaker economics.

Liquidity has improved dramatically since the Bear Stearns bailout. The feeling is totally different than in some of the other false rallies (in credit) we've experienced since September. Previously, any hiccup would cause spreads to move drastically wider. There were times when we moved a bit tighter, then some writedown would be announced, and it would all go to hell again. It isn't as though we haven't had hiccups the last couple weeks. The 200 point sell-off on GE's earnings is an example (I wrote about this here). Or Wachovia's need for more cash. Or Bank of America's weak earnings report. Now these events are taken in stride. Spreads have moved wider on certain days, but its controlled, more reasonable. Not panicky. I won't say that spreads (especially in CDS) aren't still volatile. The massive amount of shorts in CDS that have been or are being covered is seeing to that.

Plus the correlation of spreads has broken down. Now it isn't necessarily true that agency debt, MBS, and credit all move the same direction on any given day. Hell municipals had become highly correlated with credit spreads. Now it seems that these spreads are moving on their own supply and demand conditions, not on liquidity fear.

So am I calling a bottom? Well, I don't really invest that way, so if I didn't have a blog, I wouldn't really think about a "bottom" very much. I try to stick to fundamentals and spend only a little time on technicals. Liquidity is part of any fundamental analysis of a bond, so indeed it became tough to value many different bonds in recent months. And deep fundamental investors tend to be a little early, seeing the fundamentals shift and/or pricing (un)attractive before the market actually shifts.

But yeah, if you stick a gun to my head, I'd say we've seen the wides in credit spreads. Not because the economic problems are solved, but because liquidity has improved to the point that people are willing to be opportunistic. That will put a lid on how far investment-grade names will move before yield hungry investors come in. Issuers will be able to come to market with new issues, and the wheels of the credit market will continue to churn.

Ultra-Bears: I take it back!

I have a question for the bearish readers of Accrued Interest. I've corresponded with many of you and have heard many well-reasoned arguments for a bearish future. And here I'm not talking about those who think the recent stock rally has gone a bit too far and are looking for a 2% pullback. No. I'm talking about those who think that stocks will be lower over the next 2 years, or even longer.

So here is food for discussion in the comment section. If you are this kind of bear, what would convince you that you are wrong? In other words, what evidence could reasonably appear which would convince you that your bearish stance won't work out?

I ask this out of selfish motivations. The ultra-bears have been right so far. I mean, I was dismissive of some of the worst case scenarios which people presented over the last year or so. But on the other hand, I do not believe that things are so bad that we won't get through it. And I also think that the financial markets will recover faster and ahead of the economy as a whole. So remaining short, or even on the sidelines, is a dangerous game right now. And I want to hear from intelligent people who have actual money they are using to bet against the U.S. recovering.

And I want to hear what would convince you to cover your short and potentially go the other way. Because that's the true sign of a well-thought out trade. Everyone always has a reason why they make the trade, but a good trader also has an exit plan in case s/he is wrong. Let's hear it.

Rise Lord LIBOR!!

When trying to gauge the market's generalized view of counter-party risk, swap spreads are a good place to start. This is the spread between Treasury securities and the fixed leg of a plain-vanilla interest rate swap. Since there is necessarily some bank or brokerage as the counter-party of such a swap, the spread is a good indication of counter-party risk.



So it comes as little surprise that swap spreads have been elevated in recent months. 2-year swap spreads averaged 40bps during the first half of 2007, recently spiked above 100bps just before the Bear Stearns collapse. Afterwards, it declined into a more stable trading range in the low 80's.



But in the last week, spreads appear to be spiking again, having risen 13bps in the last three trading days, from 83 to 96bps on Thursday, and briefly crossing +100bps. (On the chart, Libor is in orange and 2-year swaps in white).







Is it a return of the liquidity crunch? Its a bit of a conundrum, because most other indicators have been pointing the other way. The VIX has declined over 3 points in the this week. The CDX indices are significantly tighter: investment grade -19bps this week and high yield -56bps. Bank and brokerage CDS are also markedly tighter. Wachovia and Citigroup are both about 25bps tighter, Lehman, Merrill, and Morgan Stanley are all at least 30bps tighter.


Perhaps the answer lies in some wishful thinking on the part of European banks. According to the Wall Street Journal, official Libor fixings have not reflected the real cost of intra-bank borrowing. 3-month Libor, for example, was fixed at 2.73% on Wednesday, but I have been hearing actual bank lending is happening at levels more like 3%. This had lead some to question whether the banks that help set Libor are being entirely honest about the levels being supplied.

This morning, 3-month Libor was fixed at 2.91%, suggesting that maybe these banks are starting to fess up.

I'm not going to comment on potential manipulation, since I'm in no position to speculate on such a thing. But Libor has been rising lately. After falling to 2.54% on March 18, the same day the Fed cut its target rate by 75bps, Libor has steadily risen to this moring's level of 2.91%. That obviously has an impact on swap spreads.



Since 3-month Libor is the floating side of a plain-vanilla swap, and Libor has been rising, it follows that the fixed side must rise as well. That explains why swap spreads are moving. But its doesn't explain why Libor itself has been rising, especially if it really should be even higher. How to reconcile the lack of liquidity implied by rising Libor with otherwise tighter credit spreads?

I think this signals a shift in the credit cycle. Until now the focus has been primarily on structured products: SIV, CDO, ABS, etc. Those are primarily the domain of the large financial institutions. I.e., the names that trade in CDS routinely, that get reported on CNBC every day, and by the way, the same names that have been taking all the write downs. The Lehman's and Citi's and Merrill's.

Maybe tighter CDS spreads in these names is indicating that those institutions have taken (or reserved for) most of the losses they are likely to take. But what about smaller banks? The regional and local banks that may never have been involved in a CDO, but might also have a lot more risk in a single borrower or category of borrowers. Perhaps 2.90% is in the right ballpark for Lloyds Bank, who is part of the Libor survey, but not for the local bank in Norwich.

And what about Europe in general? Libor is set by a survey of 16 banks, only two of which are American. It has long been said that Libor is really a indication of where European banks can borrow in U.S. dollars. So rising Libor may say more about tight liquidity in Europe than in the U.S. A combination of tough liquidity in Europe and among smaller banks would explain the divergence between CDS spreads and Libor spreads.


To me, this sends two cautions. First, it should remind anyone who thinks the liquidity crunch is over, that it ain't. Liquidity does seem to be improving in the U.S. bond market, which is a very positive sign. So maybe the worst case scenario has been taken out. But this will be a long process.

Second, it should caution those who are short the dollar. If the next phase of the credit crunch hits Europe as hard as it hits the U.S., then we may see the Bank of England and the European Central Bank get more aggressive with rate cuts. Indeed today there are stories that the BoE is working on a plan to inject more liquidity into the banking system. That would ease pressure on the dollar. Given how popular short dollar trades have been, any reversal may be violent.

By the way... please vote in the new polls. I'm curious.

Wachovia vs. Retail Sales: FIGHT!

I haven't read enough on Wachovia to make a lucid commentary. I'll only say that I'm suspicious when a bank shows a relatively small loss, but decides to raise a very large amount of cash.

Anyway, Wachovia bonds opened up mildly wider, say 3bps, but wound up about 6bps tighter on the day. Now about 20bps tighter than 3/31.

Bank/broker stocks got hammered today on the theory that Wachovia's writedown portends ugly things for upcoming earnings. There might have been an element of concern that more banks would be issuing new common shares as well. I am 100% with this line of thinking. Banks and brokers are going to take a long time to rejigger the business model. Its possible that this quarter is the last of the big writedowns, but that we see mediocre earnings growth from here. Therefore in order to buy bank/brokerage stocks, the valuation really has to be right.

In the credit complex, the big names were mostly unchanged to slightly tighter. Lehman unchanged, Citi unchanged, Merrill unchanged. Actually Lehman and Merrill's subnotes were quoted 5bps tighter on the day. Just glancing at CDS runs, it looks like more names are wider than not, although all moves are pretty small.

MBS were wider by about 6bps as swaps were 5bps wider. That's an unusually large move for swaps by recent standards. I haven't found anyone who seems to have a compelling theory as to why. Smells like people altering their hedges for whatever reason.

Treasuries were weak too, and steepened by 3bps. I still like steepener trades. The Fed isn't going to be hiking for several months, and that should anchor the short end. But as the economy starts to bottom out, inflation will become the bigger concern, pushing longer rates higher. That ain't happening tomorrow, but it will happen.

General Electric: The Krayt Dragon Call

Today was a very unusual day, when contrasted against the rest of 2008. We saw stocks get hammered mostly on GE's earnings, but in the bond world, spread product did OK. I see the CDX.IG about 1bp wider, and the CDX.HY 3bps tighter. CDS on GE itself moved 9bps wider, with similar moves for the brokers.

Swap spreads were unchanged. MBS and agency debt both about 1bps wider.

The municipal curve flattened, 10-yr rates fell 7bps and 30-yr fell 9bps. That compares favorably to Treasuries which fell 7bps and 5bps respectively.

Anyway, this is all notable because for most of 2008, anytime there was bad economic news, spread product of all sorts got hammered. I did a quick look at the other days in 2008 when the Dow fell 200 points or more, and then looked at what happened to the CDX.HY.

Pre-Bear Stearns Day
1/2 Dow -221, CDX +15
1/4 Dow -256, CDX +27
1/8 Dow -238, CDX -1
1/11 Dow -245, CDX -5
1/15 Dow -277, CDX +8
1/17 Dow -307, CDX +14
2/5 Dow -370, CDX +31
2/29 Dow -316, CDX +22
3/6 Dow -215, CDX +24

Post-Bear Stearns Day

3/19 Dow -293, CDX -25
4/11 Dow -256, CDX -4

That makes +15 the median move on the CDX.HY given a 200 point drop in the Dow pre Bear Stearns. I'm pretty sure if we did the same exercise for more staid securities, like municipals or agency MBS, we'd see a similar pattern, where severe days in stocks almost always resulted in ugly days for spread bonds.

This seems to support the idea that the liquidity crisis is slowly lifting. It isn't over, mind you, but its on the right path. We're left with a real economy recession, and the markets need to work out what the right price should be for various risks in a world where liquidity is slowly improving but the real economy is declining.

Today's move looks like pricing a real economy recession, rather than a financial crisis. Not great news for the stock investors reading this blog, but relatively good news for those hoping to avoid another Great Depression.