Today's WSJ has an article on possible insider trading in CDS titled "Can Anyone Police Swaps?" Its a follow-up from an article I commented on back in July. The gist is that investment bankers may have tipped off some people in the hedge fund community about impending transactions involving HCA and Anadarko Petroleum.
First of all, it isn't as though Average Joe investor is getting ripped off here. We're talking about the CDS market, where the sizes are such that only professionals are involved. Second, as I said back in July, it was already all over the place that HCA was a LBO target. The Journal itself reported so days before the alleged insider trader occurred.
Legally, yes, its insider trading if you know something for a fact while the rest of the world only knows it as a rumor. And if such a thing became rampant, the market's credibility would be damaged, ala China's stock market. So I'm not excusing insider trading. I will say that hedge funds make up an inordinate percentage of big dealer's trading business. With so much money at stake, and with hedge funds able to steer business however they choose, brokerages are going to go out of their way to win trades. This might meant that information sometimes slips. Its not ideal, but is it really that damaging?
I'm suspicious that any attempt to regulate the CDS market will result in greater costs for all investors with minimal benefit. The stock market has far more regulation, but it seems there is no reason why this same trade couldn't have occurred on the NYSE as the CDS market had the circumstances been different.
Bonds, Credit Default Swaps, Hedge Funds, HCA, Anadarko Petroleum
Thursday, August 31, 2006
Today's WSJ has an article on possible insider trading in CDS titled "Can Anyone Police Swaps?" Its a follow-up from an article I commented on back in July. The gist is that investment bankers may have tipped off some people in the hedge fund community about impending transactions involving HCA and Anadarko Petroleum.
Wednesday, August 30, 2006
Yesterday's journal included an article on hedge funds invoking rarely used covenants to force companies to pay off all their debt. I wrote about the issue of covenants a while ago here. Basically I said they were used as a means to force companies into paying concessions and less as a means of protecting the credit worthiness of the borrower. I may have been simplistic in my reasoning, but I stand by the idea. The story in the Journal reiterates the point I was trying to make.
Let's say you are ABC hedge fund and you have debt of UNH. The covenants allow you to force the company to repay all debt if the company does not report financials on time. The company is indeed late on reporting, and you go ahead and declare them in technical default. The way the story writes it, UNH would be forced to repay ALL of their 5.8% 2036 issue which was just issued in March at +119. The market for this issue now is 118/113, so that gives the bonds a 4 point discount at the moment. If UNH were forced to repay this issue, ABC hedge fund would make a quick 4%.
Now let's say for the sake of argument, that UNH was unable to issue new bonds. We know they don't have $850 million in cash, so forcing the technical default could cause an actual default. Would this serve the interests of ABC hedge fund? Of course not. They wanted to make the quick 4%. So what would the hedge funds do? They'd simply negotiate some payout with UNH and move on.
The article also mentions VTSS, which is a stock I once lost a boatload on. Anyway, VTSS faces the very real possibility of being forced into chapter 11 as a result of a technical default. In that case, the hedge funds apparently want to take control of the company and force a sale.
Is there a problem with all this? Heck no. Companies should face a penalty for not being able to report on time. If you are UNH, it may cost you a couple million to make the problem go away. If you are VTSS, it may spell the end. I have a hard time feeling sorry for either company.
Funny quotes from the story:
"There used to be a kind of brotherhood of bond investors, where you didn't want to be the guy who turned the kid in to the teacher because he wasn't wearing a shirt with a collar," said Kirk Davenport, a partner at law firm Latham & Watkins in New York. But now, it is "outweighed by the desire to make a lot of money."
Yeah Kirk, things were much better when the investment business was run by a bunch of white guys drinking martinis and watching out for each other. I hear Japan continued that tradition for a while after we gave it up. Dunno how well that worked out.
Andrew Redleaf is chief executive at Whitebox Advisors LLC, a $1.6 billion group of hedge funds that use the technical-default tactic. "Bondholders used to be extremely lazy," says Mr. Redleaf, whose firm holds bonds for both UnitedHealth and BearingPoint Inc., a consulting firm that also missed its filing deadline. "Part and parcel of what investors do is assert their rights, whether they're shareholders, bondholders or otherwise."
A lot of bond holders still are pretty lazy.
Bonds, Bankruptcy, Corporate Bonds, Hedge Funds, United Healthcare, Vitesse Semiconductor
Dallas Fed president Richard Fischer gave one of the best speeches on inflation I've read recently, and in it, reiterates a point I've been trying to make about the Fed:
"Inflation is a bit like having a measuring stick that grows or shrinks from one month to the next; the “doohickeys” and “doodads” that need to fit together, in this case, are prices for money or goods today and in the future. You get the picture. The consequences of a randomly varying dollar value would be severe. It doesn’t take a [Nobel laurate like] Finn Kydland to conclude that low and predictable inflation is preferable to high and variable inflation and that low and predictable inflation should be the goal of your central bank. "
Did you catch it? "Predictable inflation should be the goal of your central bank." Not avoiding recessions. Not bailing out the housing market. Not low unemployment. Not politics. Not the stock market. Not the banking industry. Predictable inflation. The Fed will only concern itself with other issues insofaras they further their goal of predictable inflation.
Bonds, Fed, Inflation,Economics, Monetary Policy
On my Bloomberg yesterday, I saw the following headlines.
*FED MINUTES SAY AUGUST RATE DECISIONS 'WAS A CLOSE CALL'
*FED MINUTES SAY ADDITIONAL FIRMING COULD WELL BE NEEDED
*LACKER ARGUED GROWTH UNLIKELY TO SLOW ENOUGH TO CUT INFLATION
And I thought, well, the market's going to hate that. Sounds like there is a decent chance of the Fed hiking again.
Then I read a little further, and there is a lot more talk about weaker economics, particularly in housing, than previous Fed communications. I look up and see the 10-year has rallied from down 1/4 point to up 1/8. Taking the minutes as a whole, it sure seems like the Fed has growing concern about slowing growth.
So while the "close call" quote grabbed headlines on both Bloomberg and the WSJ, the Fed sees cooling growth as helping to keep inflation in check. So bond market rallies.
Here is my bold opinion.
1) The FOMC is legitimately unsure as to whether they have done enough policy tightening to stem the rise in inflation. They paused in August because they think they have done enough, but are truly unsure.
2) They want to make it crystal clear to consumers, industry, and the financial markets that they have no fear about continuing to hike rates if necessary. In fact, my bet is that most Fed economists would like the world to believe they would create a recession rather than face accelerating inflation. They are careful not to say such a thing for fear of political fall out from people like Maryland's own Paul Sarbanes. But having read many text books and academic papers by people who are now (or were) at the Fed, I really think that's what they believe.
3) They aren't especially worried about a recession, but know that their own manipulation of interest rates is wreaking havoc on the housing market. Given that it is perhaps the most important asset market in the world, they have real concerns about upsetting equilibrium in this market. Of course, this is a problem of their own making (see 1% Fed Funds in 2003), but that's water under the bridge.
4) Because most people have mortgages which are deep out of the money (see 1% Fed Funds in 2003), the Fed may not have much power to do anything about a housing crash even if they wanted to. If there is a real crash, and it coincides with a rise in home mortgage defaults, this has serious implications for the banking industry.
5) So the best course of action is to hold rates right where they are for a long while, and allow the economy to get used to this level of interest rates. Home prices will correct a bit, but as incomes rise over time, so will activity in the housing market. Corporations will have a better handle on borrowing costs when making long-term plans. The curve will steepen, bringing back the carry trade and improving profits at banks. The Fed maintains its inflation fighting cred, because it didn't cut rates in a panic after seeing a few ugly data releases.
If that happens, my duration neutral steepener play should work. I'd guess it will result in a mild bear steepener, maybe something of a twist, with the 2-year falling 10-20bps and the 10-year rising 10-20bps.
Bonds, Fed, Inflation,Economics, Monetary Policy, Housing Market
Tuesday, August 29, 2006
I'm picking up on this debate a bit late, so I apologize in advance.
On Thursday, the Wall Street Journal ran this op-ed piece by Arthur Laffer. In it he claimed:
"Fortunately, the Treasury has over the recent past begun to issue an instrument called the Treasury Inflation-Protected Security (TIPS) in a wide range of maturities including a 10-year note. The yield on this TIPS note is for all practical purposes the expected real yield over the horizon of the maturity of the note."
To which Bret Swanson replied:
"Dr. Laffer says expected inflation gleaned from TIPS bonds is the best predictor of inflation, but in fact TIPS have not been very good at all at predicting inflation."
Other blogs are writing about this debate, including a couple of my favorites: Capital Spectator, and Macroblog (here and here).
You should read all these pieces, because they both make various points, all of which are interesting to econgeeks like myself. Anyway, I'll weigh in on the debate as to whether TIPS can be used as an estimation of the markets inflation prediction or whether the TIPS spread rarely predicts CPI correctly. They are both right.
As I've written before (here for example), the forward yield curve is an unbiased predictor of future rates. Because the rates market is impacted by innumerable variables, no predictor could possibly be particularly accurate. In fact, efficient markets theory tells us that as soon as a predictor became known, it would become part of the current price and therefore cease to be an effective predictor. That being said, the slope of the yield curve tells us something about where the market thinks rates (and the economy) is headed.
TIPS spread is similar. The wider the spread, the more inflation the market expects and vice versa. But inflation is a complex thing, and there are many possible paths inflation might take. To take an example from statistics, the mean of a sample is an unbiased predictor of the mean of the population. But odds of the mean of the sample being exactly the mean of the population? Close to zero.
Take another example. Every year, Las Vegas puts out odds on who will win the Super Bowl. Every year there is a favorite. Without having any data on the subject, I'll wager that the pre-season favorite wins the Super Bowl less than 10% of the time. Why? Because any random injury, or wind-blown kick, or tipped interception can change the course of a game and therefore a whole season. Not to mention how athletes will progress or age is extremely difficult to predict. Does that mean that the Vegas odds are meaningless numbers? Of course not. The preseason favorite probably does have the best chance of winning, its just that there are so many possibilities even the most likely scenario is still fairly unlikely.
So the TIPS spread is a valuable indicator of what the market expects for future inflation. Intermediate-termed TIPS spreads are a particularly good indicator of Fed credibility. So long as 5-10 year TIPS spreads are hovering in the 2-3% range, the market is telling you that it expects inflation to generally remain under control.
If anything, the TIPS spread overstates the market's expectations for future inflation. This is because TIPS are like insurance against inflation. For any investor where inflation is part of their liability stream, like a pension fund with a COLA increase in their benefit payments, TIPS are a way of controlling that liability. Therefore, the TIPS market probably has a premium priced into it, particularly in long-dated issues.
So will we have an inflation spike? Maybe. But the market is certainly not betting on it.
Bonds, Inflation, Federal Reserve, TIPS
Monday, August 28, 2006
Tropical Storm Ernesto is over Cuba and headed for Florida. Oil prices are falling considerably on the hope that Ernesto will give all the Gulf area oil and gas production facilities a miss.
Meanwhile, bonds are a bit lower, probably due to dealers pricing in a concession to the 2 and 5-year auctions this week. You could also have some consolidation here. As I've said, the market has rallied hard the last few weeks, and we now need some data pointing to a steeper economic downturn in order to further fuel the rally. I've eliminated all my directional bets and am setting up for a steepener.
Bonds, Oil, Hurricane Ernesto
Over the weekend, the Enterprise Bankruptcy Law was approved by the Standing Committee of China's National Peoples Congress. I'm not an expert on Chinese politics, but I'm told that actual votes by the Chinese congress are a formality. By the time it gets to that point, a consensus has already been reached.
Anyway, the bill basically creates a western-style bankruptcy code, where creditors have the first shot at any asset recovery in a bankruptcy proceeding. Currently, employees must be paid their salaries before creditors have any rights to recovery.
This is just another in a long line of slow reforms by the Chinese Communist government. As I was reading the article in the Journal about the new bankruptcy law, I got to thinking about the disaster that is Russia. When Mikhail Gorbachev began implementing Perestroika, I'm sure he and some of his more optimistic economic advisors imagined some kind of free-market/socialist hybrid, taking the best from both worlds. Of course, it took only about 5 years of "reforms" for the entire government to collapse. I remember reading papers and books written in the mid 1990's about why Perestoika was doomed to fail from the beginning, in large part because once you start reforms, the government's dictatorial hold on society cracks. The power vacuum causes the government to implode. The result is what Russia is today: a society ruled by oligarchs and an economy in dismal shape. Such a system is closer to the czarist days than anything else.
But then there's China. Their economy has grown at least an 8% rate every year since 2001. Their government appears stable. While resistance to various reforms has certainly cropped up, it seems as though the government has the will to continue reforms.
I'd argue they are already much further along than Russia ever was. Maybe they've learned from the Russian experience. Maybe they have a clearer goal. And maybe they won't pull it off and China will devolve into the same kind of fractured society that Russia is now.
Russia, China, bankruptcy
Saturday, August 26, 2006
They were singing...
Bye, bye Mr. Rubin guy,
Drove my Jaguar to find a buyer,
cause our cash is running dry.
And them good ole boys
are driving Tundras
and Honda Ridgeline
Saying this could be the year that Ford dies.
This could be the year that Ford dies.
Citigroup has many various dealings with the Ford corporation. In order for Robert Rubin to be worried about a conflict, something very big is coming. We'll see what it is, but either way, I think its clearly desperation time at Ford. Good luck, Bill.
Ford, autos, bankruptcy, Jaguar, Robert Rubin, Citigroup,
Thursday, August 24, 2006
Ford family members are claiming they are considering going private according to USA Today. This is the funniest thing I've heard all week. They would be the first company in history to buy out all shareholders with cash on hand. We'd need to invent a new term, because it isn't an LBO. CBO?
David Andrew Taylor, author of great blog titled Dismally, wrote a post about the yield curve yesterday. I made a comment, he replied, and it got my blogging juices flowing, so I thought I'd make a more indepth comment here.
There has been considerable discussion about how good a forward indicator the slope of the yield curve is. Back in March, some dude named Ben Bernanke said the following:
"In previous episodes when an inverted yield curve was followed by recession, the level of interest rates was quite high, consistent with considerable financial restraint, this time, both short- and long-term interest rates -- in nominal and real terms -- are relatively low by historical standards."
Dr. Greenspan made similar comments just before retiring.
I think the Fed is down playing the inversion to serve their own purposes. As I've commented before when writing about the forward yield curve, longer-term rates are unbiased predictors of short-term rates. So if long-term rates are lower than short-term rates, than means that the market widely anticipates falling short-term rates. Why would short-term rates fall? Because the Fed is cutting. Why would the Fed cut? Because the economy stinks.
Is Greenspan and Bernanke suggesting they don't believe in efficient markets? That long-term rates move randomly and traders ignore the likely future path of short-term rates? I seriously doubt it. More likely, they believe that the curve is a perfectly good indicator of where short-term rates are going, but that they wanted longer rates to rise. They knew that their goal of tightening the money supply would be better served by rising long-term rates. They also wanted the market to presume the Fed was going to continue to hike their target rate for some time. By dismissing the inverted yield curve, they are emphasizing their focus on fighting inflation.
As to whether we have a recession or not, I think its a bit of semantics. I mean, if real growth averages under 1% for 4 quarters, does it really matter whether two of those quarters happen to be negative or not? I think that between 3Q 2007 and 3Q 2008, we will see GDP growth average 1-2%. That's plenty weak to cause a bond market rally. That's really all I care about.
P.S. Blogger's spell check rejects the word "blogging." That's your deep thought for the day.
The price action in the bond market the last 2 days shows that technicals are moving the market, not fundamentals. Yesterday we had a poor housing figure and the bond market sold off. Then around 1:30, it rallied back to flat. I happened to be on a plane coming back from St. Louis, so maybe there was more to it, but looking at the chart it LOOKS like accounts desperate to use any sell off as an entry point.
Then today, we get a pretty strong durables figure (ex. trans), but the market is actually up slightly. Why? It looks to me like cash is flowing into the market, some bears are capitulating a little, and so the bulls have to be proven wrong before the market will move the other way.
So what's the market trying to tell us? The people waiting for 5.25% have given in and aren't waiting any more. If you want to play a short-term retracement back to 4.90%, that's a reasonably play and should be made now. But as a PM, I'm getting neutral on duration and setting up for the great steepening of 2007.
In other news, I found the following blog, indexed, and although it really has little to do with economics, it SOUNDS like economist humor. Anyway, its hilarious. Check it out.
Tuesday, August 22, 2006
FRB of Chicago president Michael Moskow said that the Fed may yet resume rate hikes if inflation gets out of hand in a speech to the McLean County Chamber of Commerce. My international economics professor from college would have called this a "candy is dandy" statement, meaning that its an obvious truth.
Taken in isolation, the quote is totally vacuous. Obviously, if inflation ramps up, the Fed will hike again. But think about the post 1994 Fed's MO. They try very very very very very very hard to not surprise the market. If they think the financial markets are missing the message, they go out and give speeches to guide the market.
Let's say, for the sake of argument, that the Fed really is pausing, and they have no intention of cutting rates any time soon. In fact, let's say that at least some members of the FOMC want to hike rates 1-2 more times for good measure. Well then, the 40bps rally in the bond market over the last 6-weeks is hardly justified. So maybe Moskow is out there to remind marketeers that the Fed is still focused on inflation, and rate cuts are not a given.
Anyway, given the incredible volatility in the 10-year today (up 1 tick, wait... up 1/2 tick), it doesn't look like traders agree with my hypothesis. But hey, disagreements make markets.
Can investors who lose money in a fund sue those who make money by timing their investment better? Sound ridiculous? It does to me, but according to today's WSJ investors trying to do just that. It's a little less ridiculous because the investors in question lost money due to fraud rather than plain vanilla investment losses. Therefore, the investors that "made" money in the funds were really just the fortunate first ones out of a Ponzi scheme.
Regardless, if any of these suits were to prevail, it would set an awful precedent. In these cases, there was blatant fraud, but what about more nebulous cases? Tort lawyers are very creative, and they will comb every failed hedge fund for anyplace they can argue "negligence" or "misrepresentation."
Plus, what about investors who no longer have the money? If I put $100,000 into a hedge fund, then walk away with $300,000 and buy a nice beach house with the money, you are telling me that a judge might order me to pay back the $300,000 5 years later? Investors hate unquantifiable risks. The risk that a fund might be fraudulent is one thing. The risk that any time I make a withdrawal that someone may come after me for the money years later is entirely different.
There is a good chance these law suits will fly under the radar, because the cases involve real fraud. But I think big hedge fund managers would do well to pay attention.
Several recent posts have been about the forward curve (here, and here) which is simply using the shape of the yield curve to indicate what the market has priced in for future short-term rates. There have been some misconceptions about the analysis, which I'd like to address.
First, the forward curve is simply a reflection of market opinion. If you want to make a 6-month investment, you can either buy a 6-month bond or two consecutive 3-month bonds. You know what the 6-month rate is, so you have to consider where you think the 3-month rate will be 3-months from now. You'll only buy the 3-month if you think the compounded rate of today's 3-month plus the forward 3-month will yield more than today's 6-month.
Since bond buyers are making these kinds of decisions all the time, we assume that the market is efficient, and therefore the 6-month rate is equal to today's 3-month compounded with the forward 3-month. This is why academics say the forward curve is an "unbiased predictor of future rates."
Unbiased, sure, but how accurate? Well, on the very short-term part of the yield curve, its OK. But for longer-term rates, its terrible. Why? Because if the forward curve encompasses all current opinions about the market. But market participants have varied opinions, and so some will be right and some will be wrong. For example, right now there are people calling for a recession in 2007, but others calling for an inflation spike. These are two possible paths for the economy and hence rates. These are two bets currently priced into the market. But they won't both be right. Rates will actually move on whichever turns out to be right.
Its exactly like stocks. Efficient markets theory says that the current stock price encompasses all known information about a stock. That would imply that the price wouldn't chance over time. But of course, it does, because new information is always emerging.
Anyway, I received a comment that my forward curve analysis should be based on LIBOR swaps not Treasury rates. That's debatable. O/N LIBOR and Fed Funds are normally right on top of each other, whereas there is normally a negative spread between T-Bills and Fed Funds (about 8bps based on O/N rates). Point for LIBOR. On the other hand, there is a special bid for T-Bills from government money market funds which doesn't exist for 2-5 year notes. Also, the LIBOR curve is almost always steeper than the Treasury curve. So the difference between the 2-year and 5-year swap rate may have less to do with Fed activity and more to do with this natural slope difference. I'd say both analysis have merit, so I'm going to show both, except I'm going to subtract 8bps from the FF rate and use that as the basis for the Treasury analysis.
Monday, August 21, 2006
Since I started this blog in early July, I've made many brash predictions. Unlike other forecasters, I'm willing to go ahead and review what went well and what didn't.
1) I called for the 10-year rate to rise on 7/5, and stuck with that prediction until 8/14. In that time, the 10-year yield fell 22bps. I thought the Fed would hike to 5.50% and then hang there for several months. The Fed actually stopped at 5.25%, and now the market is pricing in cuts by mid-2007. The 10-year may make a technical reversal, but it will be minor. I don't see a lot of upside, though, so I think its worth being neutral on rates generally.
2) On 7/6, I said I favored A-rated corporates over BBB-rated issues, on the theory that credit conditions are too easy. Since then, the Merrill Lynch A-rated index has tightened by 1bps (using OAS) while the BBB-rated index has widened by 1bps. Its moving in the right direction, but this is more of a 6-12 month trade so we'll have to check back.
3) On 7/7, I predicted corporate spreads would tighten, because too many PM's were short corporates in their portfolios. I believed that eventually, they'd be forced to come into the market, causing spreads to tighten. The Merrill Lynch Corporate Master index OAS is flat since then, but again, I'd view this as at least a 6-month trade, so we'll see. Incidentally, I think that if A-rated issues outperform BBB-rated, its evidence of just this sort of movement by managers. If you don't like corporates, but feel compelled to put cash to work, you're going to buy higher-rated stuff first.
4) Also on 7/7, I said I thought MBS spreads might widen on volatility fear, but that MBS would outperform on carry, so I was long MBS. Well, I was right to be long, but wrong on the reason. MBS spreads have tightened substantially since then, from +64 to +51. The Fed has been even more transparent than I thought, making it obvious when they were pausing and leaving the market with little doubt (right or wrong) about further hikes. So there likely won't be a vol scare. This is a case of better to be lucky than right.
5) On 7/14, I said I'd "sell the heck out of TIPS." Since then, the Jan 2016 TIP is up 1.86% vs. 1.76% for the Feb 2016 Treasury (price only). Not much there. 5-year issues underperformed (+0.58% for TIP vs. 1.05% for Tsy), but the inflation adjustment cuts the underperformance down to about 25bps, so not much there either. I'm narrowing this prediction down to the 2-5-year area. I think there is a much better chance of sharply lower inflation (maybe because oil prices hold steady) than sharply higher.
6) Finally, on 7/25 I said the curve would steepen. Since then, the 2-10 slope has declined from -5 to -4bps. Not much there, but the 2-30 slope has moved from +1 to +10. I still like a steepener, favoring 5-7 year issues over other parts of the curve. Hard to say how long this might take, and its possible there is deeper inversion if the Fed is looking like a cut sooner than later. Even so, I see the 30-year trailing intermediate-term issues.
Mixed bag. 1 clearly wrong, 2 kind of right but need more time to see. 2 more are neutral, and 1 was right but for the wrong reasons. I'll check back in later.
Friday, August 18, 2006
After two tepid inflation reports, the bond market now seems to have established a new consensus for where the economy is headed. There is now close to 40bps of inversion between Fed Funds and the 2-year, meaning that the market expects multiple Fed Funds cuts in the near future. If you assume the Fed is cutting, you are also assuming inflation won't be a problem. I respectfully disagree with those who say that the Fed's primary goal is to avoid a recession. The economists at the Fed believe their dual mandate is best served by maintaining long-term price stability first, and allowing unemployment to solve itself over time. We need only to look back at 2001 to see that aggressive rate cuts do not cure unemployment, at least not quickly.
So, for the moment, let's take it as a given that rising inflation is not going to be a problem in 2007. What then should we be looking for over the next 6-12 months? The answer: how weak will the economy get? Weak enough to cause a recession? Weak enough to cause another deflation scare? Is this 1995 or 2001?
A soft landing, more like 1995, will result in only a couple Fed cuts, tighter spreads, and normalized curve. Long-term rates would likely be at or even slightly above current levels.
A deflation scare, more like 2001, would result in many Fed cuts, wider spreads, and a very steep curve. All rates would likely be sharply lower than current levels.
I think it comes down to consumer spending. Do current pressures from rising fuel costs and falling home prices cause consumers to pull back substantially? Or, is the housing market problem more localized and consumers need only to moderate their behavior?
For long-term investors, there is more risk being short duration here. The chance of sharply lower rates far outweighs the chance of sharply higher rates. The best bet is probably on a steeper curve, since eventually we know the curve will normalize, so while a deeper inversion is possible, it will be temporary.
Wednesday, August 16, 2006
I'm out of the office today working on completing a transaction proposal, so my commentary will be brief.
I'm very surprised the market has reacted so positively to the CPI figure today. I thought it would have taken a pretty big miss on the downside to create another substantial rally. Now we can read yesterday's price action as muted waiting for confirmation today. I guess I underestimated the power of all that cash sitting on the sidelines.
Tuesday, August 15, 2006
Core PPI actually fell 0.3% last month, surprising the market and putting a charge into bond bulls. The 10-year is up 1/2.
Now it sets up that tomorrow's CPI figure can either confirm and allow the rally to stand, or contradict and erase some or all of today's gains. I don't know what its going to be, but take a look at the chart of month-over-month core CPI vs. PPI.
1) PPI is more volatile than CPI. The monthly standard deviation for PPI is 0.196 vs. 0.083 for CPI.
2) PPI and CPI aren't very well correlated: 0.138. That tells you that there is almost no relationship between the core PPI and core CPI figure for a given month.
3) Three times over the last two years (not counting today), PPI came out negative. CPI never has.
Now, maybe core CPI will also be especially low, but given this very weak relationship between the two numbers, I wouldn't bet on it. Of course, given how the market is flying today, it looks like every one else is.
One of the key questions for markets over the next 12-months is whether the housing slowdown and rise in energy prices will cause significant cooling in consumer spending. Home Depot should be one company to watch to tell whether this is happening. Today the company released earnings that showed both bottom line and revenue growth. So far, so good. Same store sales were about unchanged. I think we'll need another 1-2 quarters before we can start drawing conclusions.
Inflation reports should set the tone for the week. PPI today, CPI tomorrow.
Monday, August 14, 2006
The 10-year failed to break a key resistance point at 4.88% (got close on 8/4) and has now sold off 10bps or 3/4 of a point. Same with the 30-year, which hit a resistance point at 4.99 on 8/4 and has backed up almost 12bps since.
Given this backup I thought I'd revisit the Fed Funds path analysis I did a couple weeks ago. It now looks like 2 cuts, not 3, are priced in assuming the Fed does not hike again. I also ran it assuming the Fed hikes again in November, since the futures market is telling us there is a decent chance of another FF hike sometime this year.
Here is how I'd interpret this. The 2, 3 and 5-year have decent value here but with little upside. I'd move to a neutral duration position, wait for something like 5.05%, and get long.
Thursday, August 10, 2006
In yesterday's Market Beat Serena Ng commented about the decline of covenants in bank loan deals. These are certain restrictions placed on the borrower for protection of the lender. Common covenants include maintenance of certain minimum debt or interest coverage ratios, restrictions on new issuance of debt, requirements to pay down debt early or pay a higher coupon if certain adverse events occur, etc.
Here are the dirty little secrets about covenants.
1. Ratings agencies don't assign higher ratings to pieces of debt with covenants. I'm sure if I write "Rating agencies don't care about covenants," someone will e-mail me and claim otherwise. But in my experience dealing with public finance covenants, it is quite rare that the covenants are a major factor in a rating. A rating is all about financial strength of the operation, not about whatever promises management makes.
2. Banks commonly allow borrowers to break the covenant. They just charge a fee for renegotiating terms of the loan. So the bank is more interested in getting a fee than enforcing the covenant.
3. Hedge funds and banks and CLOs (not mentioned in the WSJ article, but a big part of the issue) are obviously more interested in getting the loan done than negotiating a bunch of covenants. Otherwise they'd still be asking for the covenants.
So why should we be so worried about the decline of covenants? It seems like very few market participants care.
I think we are right to be worried, but not because of the lack covenants per se. A covenant is just a promise by management to remain relatively conservative in their capital allocation. But covenants didn't stop Enron from fiddling with their accounting. I'm sure they passed all their covenants with flying colors in 2000. The real problem is what the decline of covenants signals.
Most recessions are caused by a misallocation of capital. Capital takes time to be reallocated, and during that time economic growth suffers. When credit conditions are too loose, there is a good chance that capital is being allocated poorly. So it isn't the covenants themselves that are the problem. The fact that borrowers have the negotiating power in this market, as evidenced by the decline of covenants, suggests credit conditions are very loose indeed.
Wednesday, August 09, 2006
Treasury market is weaker overnight. 10-year is down 6 ticks, 30-year down 3/8. Its a little bit of a steepener, so I'd say this has a lot to do with the street building a concession into the auctions over the next two days.
Corporates and MBS liked the Fed's statement, as spreads were generally tighter. Spread product would prefer to see a long period where the Fed stays out of the picture.
Rethinking price action yesterday, with the 2-year rallying and the long-end flat/lower, I wonder if it wasn't curve trades that dominated trading. I had thought there were too many bulls in the market generally, but yesterday looked like traders unwinding flattener trades.
We'll see how this auction goes. I'm happy to continue with a short bet on the 10-year. There just isn't any upside.
Tuesday, August 08, 2006
In case you didn't hear, no rate hike today.
Anyway, I argued that the Treasury market would sell off after the Fed. Well, the 30-year did. The 10-year was flat, and the short end rallied a bit. Fairly big steepener from both 2-10 and 2-30.
Going into it, I thought there were too many bulls in the bond market, and I figured that a somewhat hawkish Fed statement might smoke 'em out. I read a statement like the following: "Nonetheless, the Committee judges that some inflation risks remain. The extent and timing of any additional firming that may be needed to address these risks will depend on the evolution of the outlook for both inflation and economic growth, as implied by incoming information."
That sounds like there is a good chance that the next move is up, even if its not for a few months. And maybe the next move isn't up, but if the next move until more like the end of 2007, the 2-year rate doesn't make much sense.
Something is up at BP. I don't follow the company, don't own stock or bonds of theirs, but something just ain't right. Within the last year, BP has gone through all of the following, courtesy of the Wall Street Journal:
"Among the problems it has faced: an explosion last year at BP's Texas City, Texas, refinery that killed 15; a large oil spill at Prudhoe Bay earlier this year; and allegations of energy-market manipulation by BP traders this summer."
Plus now an corroded pipeline is causing the company to shut down their Prudhoe Bay oil field. As an outsider, it seems grossly irresponsible that the corrosion was allowed to go so far as to cause a complete shut down of an entire oil field. Couple this with the other problems, and it just sounds like a company that is cutting corners.
As an investor, nothing makes me more nervous than a company that seems all too willing to cut corners. That kind of attitude permeates an organization, and often results in cultivating less than honest people. See trading scandal. The company may also start sacrificing the long-term for the short-term, like ignoring basic maintenance to cut expenses now. See pipeline problem.
Again, I haven't done in depth research into BP, but where there is smoke...
Fed Day. As per my post yesterday, the Treasury curve is pricing in multiple rate cuts for next year. In order for the Treasury market to rally, the Fed would have to do one or more of the following:
- Not only pause at this meeting, but make it clear that there will be no additional rate hikes for the rest of this year. This would be in stark contrast to the very measured language of the last two years. Even if they pause now, they are likely to leave the door open for more hikes if need be.
- Emphasize economic weakness in an attempt to ready the market for rate cuts in 2007. Why would they do those so soon? If they need to cut rates in early-mid 2007, they can certainly wait until closer to that time to warn the market.
- Hint that the Fed may get involved to prevent a housing market collapse. This would imply that Bernanke & co. would cut rates in order to take pressure off housing prices. Such talk would be self-defeating. People would hold off buying houses in the hopes that mortgage rates would soon fall. Bernanke also does not want to be seen as interfering in asset prices. If the Fed thinks that housing is a problem, they can cut rates without implying that they are targeting housing prices.
- Dismiss the continued pressure from energy prices as being irrelevant to inflation. This would not be consistent with the Fed's stated belief in expectations theory. Even if the economists at the Fed believe energy prices will not cause inflation, the public remembers the 1970's and associates energy prices with inflation.
I believe the Fed will sound more hawkish than the market currently expects, and therefore I'm bearish on Treasuries today.
Monday, August 07, 2006
On June 28, the 2-year closed at a yield of 5.28%. Right now it yields 4.93%. We all know what changed -- it is now widely assumed that the Fed will not hike rates on Wednesday, the first pause in 768 meetings. Or something like that. It is also widely assumed that there may be one more hike, perhaps in September, but that will be the last for the foreseeable future.
Is this justified or is it too far too fast. I took a look at some possible Fed Funds paths that would justify both where the 2yr, the 3yr, and the 5yr Treasuries are currently priced. To do this I assumed that the expected return on the 2yr is the same as the expected return of investing in overnight Fed Funds every day for the next 2 years. Same for the 3yr and 5yr. This is the arbitrage-free pricing theory of the yield curve.
I ran two scenarios. One where the Fed is already done hiking rates. The other where they make one more hike in September. I then played around with various points at which the Fed could start cutting rates, how much they would cut rates, and at what point another hiking cycle would begin. The point was not to make a projection of what the Fed will do, but to see what the Treasury market has priced in. I picked the one that both produced the current result but also resulted in a reasonable Fed path. Here is the graph:
If the Fed doesn't hike in September, they'd have to cut 3 times beginning in June 2007, with rates falling as low as 4.50%, to justify the 2-year. There would then need to be two hikes sometime between 2008 and 2010. The ending Fed Funds level would be 5%.
If the Fed does hike in September, it would need to be more aggressive in 2007, with 5 rate cuts between June and December. Fed Funds would bottom out at 4.25%. There would then need to be 2 hikes in 2008 and another in 2010.
Anyone can quibble with this analysis, because there are literally hundreds of possible paths. However, the point here is that for anyone to be bullish on the front-end of the yield curve, you have to be projecting more than 3 cuts in 2007 and more than 5 cuts if the Fed hikes again this year. I think that's a stretch.
Friday, August 04, 2006
I think NFP puts a nail in the tightening cycle. I've said all along that when they do finally pause, they're done. That's how the market is reacting.
The 2-year is working its way through 4.90%. That implies two rate cuts some time within the next 12-months. I continue to feel that is a bit optimistic. Not impossible, just a bit optimistic. I'd certainly say that today's price action leaves little left for bulls, especially on the front end.
Thursday, August 03, 2006
I am a big fan of inflation targeting. I think a soft target, the sort that Ben Bernanke publicly advocated prior to becoming Fed chair, is the logical extension of the Fed's current philosophy of transparency. Inflation targeting would cement the inflation-fighting credibility that the Fed earned during the 1980's and 1990's, and likely lead to less volatile markets.
The Bank of England, one of the world's most prominent inflation targeters, hiked their benchmark rate by 0.25% to 4.75%. The ECB followed by also raising rates by 0.25% to 3.00%.
U.S. investors should take more than a passing interest in these moves, even if they hold no foreign investments. First of all, the BoE hike was unexpected, as Mervyn King & co. appeared to have completed a tightening cycle back in late 2004, and their most recent move had been a rate cut last August. Secondly, if Bernanke eventually succeeds in moving the U.S. central bank towards the British model, these sorts of "tweaking" moves should become more common.
Inflation targeting is based on the rational expectations hypothesis, which states that actual inflation next year will be similar to expected inflation this year. If you want to keep inflation low, first keep future expectations low.
So, in order for an inflation target to work, the public has to believe the central bank will do whatever it takes to keep inflation at the target. This means that if inflation drifts just a little high, then the central bank must tighten monetary policy. If they don't, then the public will start to form expectations that differ from the target, thus defeating its purpose.
If the U.S. eventually adopts an inflation target, look for more volatility of short-term rates, because it will be more difficult to tell whether the next move will be a hike or a cut. But also look for more stability in long-term rates, because investors will have faith that the Fed will prevent long-run inflation (or deflation) from developing. Stable long-term rates will mean cheaper funding for corporations and mortgage loans, and should be quite a boon to the economy.
Wednesday, August 02, 2006
S&P put Time Warner (BBB+) on negative watch. Analyst Heather Goodchild cited "business and execution risks associated with the company's planned shift in strategies at AOL." For whatever reason, Heather failed to mention this blog's commentary from earlier today on the media industry. Admittedly, the phrase "business and execution risk" wasn't specifically used, but then again, only business consultants use phrases like that anyway.
I'm hearing a lot of people call S&P's move surprising, given that TWX was just removed from negative watch in March. But according to Tim Annett of the Wall Street Journal, AOL subscription fees accounted for 1/5 of Time Warner's revenue. Losing that much revenue almost has to create near-term risks that weren't evident in March.
TWX '12's are 3bp wider on the day to +114.
The ADP payroll survey came out at +99k. If that follows through to the official NFP report, would be a big downside miss. No one is paying this any mind, after how badly last month's ADP report missed. Fool me once, shame on me and all that.
I'm not so sure. Obviously the ADP payroll survey is imperfect. But is their survey better than the economists that Bloomberg surveys ahead of NFP? Aren't those guys basically just guessing? At least ADP's estimate is based on hard data. Should we all ignore an useful piece of data just because it was wildly wrong one month? If we took that attitude, wouldn't we wind up throwing out MANY economic statistics released by official sources?
Time Warner turned a profit of over $1 billion last quarter, which was in line with expectations. I see their well-traded 2012 issue 1bp wider at +113, supposedly because their debt load keeps growing. The company prefers to buy back stock rather than reduce debt and/or keep cash on balance sheet. They have bought back more than $9 billion in stock in 2006 while their net debt has increased from $18 billion to $22 billion. Clearly a weakening credit.
Media bonds have been clear underperformers. The graph below shows the change in spreads on 10-year bonds for four big median companies -- CBS, News Corp, Time Warner and Viacom (blue lines) versus the Merrill Lynch Corporate Master. Higher spread = badness.
So besides News Corp, everything is 8-18bp wider than corporates in general. On a 10-year bond, 10bp of widening is equivalent to a 0.75% price loss.
Probably more so than any other broad industry category, media companies face a direct challenge from changing technology. Big media needs mass audiences. But people are increasingly splintered on the type of entertainment they seek. Whereas once you could assume all of America was watching the same TV show or had seen the same movie, we now have more entertainment options. Not just more cable channels, but also video games and internet portals. Also, whether the much ballyhooed "long-tail" theory turns out to be right or not, its clear that the decreased cost of both production and distribution is and will result in even more entertainment options in the future.
Media is now scrambling to provide more diverse content, but it is questionable whether big media can make a format like YouTube provide enough profit to impact their gigantic infrastructure. Big media needs big ad dollars to survive. But big advertisers have been hesitant to advertise on individual YouTube or MySpace sites because of concerns about the content. So Pepsi won't buy blanket advertising space on YouTube for fear that their ad would show next to some racy video, or even a sketch lampooning Pepsi products. With no control over the content, there is nothing to prevent that from happening. If big media puts too much control over the content, it will kill what makes YouTube and MySpace so popular.
For the curious, Disney bonds have held in during this period, but Disney is traditionally a VERY VERY VERY VERY tight bond versus the media universe. As one trader once said to me, "Who wants to be short Mickey Mouse?"
Tuesday, August 01, 2006
The PCE deflator, as well as personal income/spending were all in line with expectations. However, because the bond market was priced for perfection, we're getting a little sell-off here. 10's down 1/4, Bond down 1/2.
We'll see if there is follow-through after the 10AM numbers.
Its a very heavy data day, with news on inflation (PCE deflator, ISM prices paid), manufacturing (ISM), housing (pending home sales), and consumer spending (personal spending, vehicle sales).
As I keep repeating, sentiment is overly bullish here, so anything but very positive releases is likely to result in something of a sell off. 10's are already down about 1/8.