Thursday, September 28, 2006

AAA idea, CCC results

One of the reasons why I started this blog was because there are a lot of issues relating to the bond market that don’t get much attention from the media or other blogs. A good example is credit ratings agencies. The Senate recently passed a bill attempting to encourage more competition among ratings agencies. The idea gets a AAA, but I’m afraid it won’t make much difference.

First a little background. There are basically 3 major ratings agencies for bonds: Moody’s, Standard & Poors, and Fitch. The first two dominate the market. The WSJ reports that they “control” 80% of the market. I’m not sure how they are measuring “control,” because most bonds are rated by multiple agencies. Regardless, suffice to say that Moody’s and S&P are, for all practical purposes, a duopoly in the ratings business.

The complaints I hear about the ratings agencies are two-fold. First, they are notoriously behind the market. Typically a bond has sold off several months in advance of a ratings cut. I posted about this several weeks ago in regards to Ford bonds. In April 2005, when Ford was rated A3 by Moody’s, their bonds were trading 200bps wide to typical BBB-rated names. That was the month that Moody’s first put Ford on negative watch. Just over a year later, the bonds are rated B3. So Ford bonds are trading like they are junk-rated when Moody’s still had them rated A3.

Second is that the ratings agencies are paid by the issuer. So if Disney Corp wants to sell some bonds, it pays S&P and Moody’s to give them a rating. This creates an obvious conflict of interest. On the other hand, who else is going to pay the agencies? They could charge a fee to investors to see their research, but with literally hundreds of thousands of bonds to rate, what would motivate them to rate smaller deals? There are many subscription-based credit research firms, such as Credit Sights, claim to do a better job than the big 2. Maybe so, but generally they only cover larger corporate issuers. They can’t cover the zillions of ABS or municipal deals that S&P and Moody’s do.

I’m not sure what this action by congress is going to do to solve either of these problems. I’ve already said why I think the conflict of interest will be hard to solve. Maybe more competition would make the agencies more responsive, but how to create competition? The reason why Moody’s and S&P dominate the market is because investors trust their ratings more so than any other company. Bond issues rated only by Fitch or some other agency trade at a substantial discount to those rated by Moody’s and S&P. For an issuer, this means that any overt cost savings from going with Fitch as opposed to the big 2 is eliminated in increased interest cost.

Could the market "trust" a third or fourth credit agency? Maybe, but it would take a long period of time for the agency to gain a positive reputation. During that period, the agency would likely lose money, as they would have to convince issuers to pay for their ratings without being to prove that the rating will help lower interest cost. So entering the market would be extremely risky, and I have to wonder whether anyone will be willing to take the risk.

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Wednesday, September 27, 2006

So much for that...

OK, merely hours ago, I claimed that intra-day buying would gain momentum. Based on that, you would have gone long the bond market early today and wound up losing your shirt this afternoon. The 10-year finished the day down 1/8.

Apparantly, the market sold off on housing data, but I'm wondering about that. Look at the figures below (Source: Department of Commerce):

New Home Sales:
June: 1,091
July: 1,009
August: 1,050
August 2005: 1,271

Months Supply:
June: 6.3
July: 7.0
August: 6.6
August 2005: 4.6

Bear in mind that the July figure was originally reported as 1,076, so it isn't as though we drew a trend line from 1,091 to 1,009 and are now relieved at 1,050. Housing is still weak. I think it will remain weak until the excess inventory is worked off. The billion dollar question is how much pain will be required to work off the inventory?

I've argued that home prices are sticky on the downside, because people are very reluctant to put their home up for sale at a loss. In many cases, people just can't put their home up for sale at a loss. Let's say I buy a $200,000 house with 10% down. The house declines in value by 5%. Now I've invested $20,000 and have a $10,000 loss. I want to buy a bigger home for $300,000. I have to pay off a $180,000 loan with sale proceeds of $190,000. In order for me to put 10% down again, I've got to come up with $20,000 in cash. If I'm like most Americans, I haven't saved very much, so coming up with the cash would be difficult.

So what do I do? I just stay in my current house. Ride out the housing downturn.

If people delay their decision to trade up in houses, the effect is to lower supply. I think this creates a floor to how far home prices can fall in general. Maybe not so much in a given area, particularly those where investor speculation was rampant, but nationwide. This is why I'm not terribly bearish on housing, and why I don't think housing will compel the Fed to cut rates early in 2007.

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Durable goods, non-durable orders

So last week I was skeptical about the Philly Fed survey, as it seemed like an outlier. I thought yesterday’s Richmond Fed survey backed up my position, as it came in at a reasonably strong +9. But today’s Durable Goods number puts the bond bulls back in control. Overall goods orders came in at -0.5% vs. Bloomberg survey of +0.5%, and ex-Trans came in at -2.0% vs. survey of +0.5%.

So the 10yr was down 10 ticks yesterday, but is gaining it all back today. I’d say that short-term, the capitulation trade may continue, which means that sell-offs will be short-lived and buying will gain momentum over the course of a trading day. In order for the market to move definitively the other direction, we will need to get the capitulators out of the way, or get a clear signal from the Fed that there won’t be any easing soon.


Tuesday, September 26, 2006

Gone Fisher-ing in Mexico

FRB of Dallas president Richard Fisher tried really really hard to explain to the world that inflation is still a problem in a speech he gave in Mexico yesterday. Please read it. Please read it and tell me why the 10-yr was up 3/8 of a point yesterday. In order for you to read that AND think the Fed will probably cut in January, you have to either assume he is jaw-boning and doesn't really mean it, or he is unrepresentative of the opinions on the FOMC.

To the former, that's possible. But if he (and others) talk like this in public and then cut rates in a few months anyway, doesn't that hurt their hard won credibility? Isn't that contrary to their stated goal of increased transparency?

As for being unrepresentative, please find the dissenting opinion. Find the FOMC member or FRB president who is talking about how poor growth is and how we need to ease monetary policy pronto.

I think the Fed stays at 5.25% for most of 2007. That's consistent with the messages we are hearing from Fed governors. Why the market doesn't believe them, I'm not sure.

Monday, September 25, 2006

Bond Traders Lose $1 Billion?

In a classic example of a headline that means less than it sounds, this from Bloomberg News: Bond Traders Lost $1 Billion From Trace, Study Shows.

The study was about the TRACE system, which requires dealers to disclose trading levels on corporate bonds within 15 minutes of the trade. The idea is that investors can see where bonds have been trading, and are therefore not ripped off by the brokerage firm. Bonds trade with implied commissions, meaning that investors rarely know how much the brokerage firm made on the trade. For example, at any given moment, Merrill Lynch may be making a market in Time Warner 2012 bonds at +110/106, meaning that they would buy bonds at a spread of +110 and sell them at +106. The 4bps differential is the commission to Merrill Lynch traders/salespeople.

The TRACE system has been operating since July 2002, and has been expanded to municipals recently. The study claims that the average corporate bond bid/ask spread narrowed from 16bps to 8bps in the year after TRACE was introduced. The story doesn't make it totally clear how they got from 8bps in tightening to $1 billion lost. It seems like they figured how much tightening occurred on average and multiplied that by how much trading occurred. The study is due to be published in the Journal of Financial Economics within the next 6-months, and was written by Kuman Venkateraman, Hendrik Bessembinder, and William Maxwell.

I have to actually read this study before I believe it. I'm highly skeptical of the $1 billion figure, because as the story mentions, trading overall has increased since 2002. In fact, all I keep hearing about is how much money big brokerage firms are making on bond trading. I also think natural competition, particularly for hedge fund business, is pushing spreads tighter. So some of the bid/ask tightening might be TRACE-related, but some might not be.

I've always thought TRACE wasn't all it was cracked up to be, because many bonds don't trade every day, and sometimes trades are misreported (intentionally or not). So it isn't always good information to look at the TRACE feed for a bond. I think more information is better than less, and I think the Bond Market Association's objections to TRACE are self-serving. So I'm all for TRACE, I just think a lot of retail investors won't know how to read the TRACE feed properly and therefore won't be any better off than before the system was in place.

To be sure, tighter bid/ask is making the retail and mid-sized institutional market tougher. The story mentions brokerages eliminating some/all of their corporate bonds research departments. I hear anecdotally from salespeople that used to do a lot of corporate bond business that times are tough. I know several people who have left the bond sales business. Over the last 30 years or so, we've seen the American consumer choose lower prices over better service time and time again see the rise of Wal-Mart and Southwest Airlines, the decline of full-service gas stations, etc. Looks like corporate bonds are no different.

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Friday, September 22, 2006

The big mo'

It looks like Europe and Asian investors are capitulating as well, as the bond market has rallied another 1/4 point overnight. I don't talk a lot about technicals on this blog, but I note that on an RSI basis, the 10-year has reached extreme over-bought conditions 3 times in the last 60 days. I don't need to tell you that the market eventually moved higher each time.

We get the Richmond Fed index Tuesday at 10AM. Its very similar to the Philly Fed that sparked the big rally yesterday. A strong reading would spark a serious sell-off, and confirm my suspicion that the Philly figure from yesterday was an aberration.

Meanwhile, the curve has steepened about 4bps in the last 2 days. 2-10 slope was as low as -8bps and is now -4bps. That's telling me the market sees cuts sooner rather than later. If the market thought cuts would happen eventually but more like 2008 rather than early 2007, we'd flatten.

Once again, I'm hawking the steepener bet. If you look at my scenario analysis from yesterday, I contend that in either of those scenarios, we steepen out.

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Thursday, September 21, 2006


The bulls are charging in the Treasury market after the Philly Fed index gave its worst showing in 3+ years. I rarely post graphs of historical economic data, but I was curious myself, so here it is.

The number is so poor, and so far off the previous, that it smells a little like an aberration. From the sudden rally in Treasuries, it looks like some PM’s capitulated after seeing this number, figuring that no better entry point is coming. This isn’t the end of the capitulation trade, though, because there is still plenty of money on the sidelines. That “sidelines” cash is exactly what keeps me from actually being short duration here.

The Philly Fed figure is a survey (methodology piece here), and I hate surveys as economic indicators. I believe in the adage that actions speak louder than words, and a survey is just words, whereas we can observe the actions of various economic agents directly. The Philly Fed’s survey is done as a diffusion index where the respondent is asked to simply answer whether various measures of business activity will be higher, lower, or about the same. I think that method is better than most, but still imperfect. I’d rather just look at what actual factor orders are rather than what people in the Philly Fed region think they will be.

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Fed's a snore, market is a bore

Its been a long time since a Fed announcement day has left us with so little to talk about. Basically, the situation is exactly the same as it was yesterday morning. The Fed gave us no good hints about how it feels.

Supposed Fed mouth piece Greg Ip wrote in today's WSJ that the Fed seems more likely to hike than cut next, but "has become more confident that standing pat is justified." That is exactly what I have been saying. However, as I've been lamenting, and as Ip also mentions in his article, the bond market is clearly pricing in a greater likelihood of cuts than hikes.

So that makes it a good time to revisit the Fed Fund path analysis I've posted a couple times before (here and here). At those times I saw "too much too fast," as I pointed out that the market seemed to be pricing in multiple cuts. It occurs to me that markets are made by disagreements. If we all agreed on the value of things, no one would ever trade anything.

So I decided to model two scenarios. One where the Fed aggressively cuts rates in 2007, and one where they hike once then stay pat. I ran several iterations of both until I came to a pretty reasonable path, the average of which explains the current shape of the yield curve. Its admittedly simplistic, but it shows how the curve could reach equilibrium at current levels if the market viewed these two scenarios as having exactly 50% probability each.

In the first, the Fed hikes at the end of this year, then is basically on pause from then on. In the second scenario, the Fed cuts a total of 100bps in 2007, and another 50bps in 2008. This is fairly similar to UBS' forecast, so its hardly out of the mainstream.

My conclusion? Scenario 2 is possible, but I'd call it less than 50% probability. Scenario 1 seems much more likely. If you think these are the two most likely scenarios, but you think scenario 1 is 60% and scenario 2 is 40%, short interest rates.

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Wednesday, September 20, 2006

Lawyers vs. Detectives

A lawyer's job is to argue a position, regardless of what s/he actually believes. If a lawyer is defending an accused criminal, his/her responsibility is to zealously defend the client, not to seek out facts in an attempt to get to the truth. Its okay for a lawyer to look at all facts through the lens of how it exonerates the client, even if such an interpretation is unlikely.

A detective's job is to start with no presupposition, and simply find the truth. In an ideal world, the detective would dispassionately seek out facts and interprete them in conjunction with other facts in the case, and his/her own experience investigating crime.

Detectives can get in trouble when they arrest a suspect, then begin to view all evidence in terms of how it relates to the suspect already in custody. The result might be that exculpatory evidence is ignored, or else evidence that could be interpreted multiple ways is only viewed in one way.

Investors have to remember that we are detectives, not lawyers. By this I mean, we need to look at evidence about our investments objectively and dispassionately. Unfortunately, a lot of investors act like lawyers, where their current positions are the client. Every piece of evidence is viewed in terms of how it could benefit the investors' portfolio bets. Say I'm long the Thai Baht. Yesterday I hear there is a coup in Thailand. Given the situation and the price of the Baht, the currency is either a good investment or not. The fact that I was long the Baht before the coup is irrelevant, as long as I remember that I'm a detective. If I allow myself to become a lawyer, then I will start from the supposition that the Baht should rise, and then seek evidence that concurs with this view.

Anyone can fall into the lawyering trap. I recently saw a research report from a top 10 Wall Street investment bank that said that the coup was actually a reduction in uncertainty in Thailand. Maybe I'm wrong, but this sure sounds like the logic of a lawyer defending his position rather than a detective seeking facts.


Tuesday, September 19, 2006

Attention passengers: All U.S. Treasury flights to quality have been canceled

In 2002, news of a coup in Thailand would have put a serious bid into the Treasury market. Traders would have called it a "flight to quality," or a situation where investors are selling risky assets and buying safe assets, like U.S. Treasuries, causing the U.S. bond market to rally.

Today, as tanks surround the Thai Prime Minister's office, the Treasury market had no reaction. Sure, the 10-year is up 1/2 point, but it had already made that move by about 9:45 on the weak PPI and housing starts figures. The Thai Baht didn't start moving until 11AM, which is when the Thai Prime Minister Thaksin Shinawatra declared a state of emergency from New York.

So why no move? I think there are a few possibilities I'll throw out there for discussion.

1) The market anticipated political turmoil in Thailand, so this isn't really news. Doesn't seem like it. The Baht had been strengthening for most of the last 6 weeks, then a sudden sell-off today.

2) Thailand isn't that important. Not buying that. Granted, its not a geo-political event on the scale of 9/11, or were there to be a coup in Russia or Iran, but Thailand is a major economy among the emerging markets. EM has been a hot investment prone to dumping. Plus the U.S. stock market has moved markedly lower after the news in Thailand.

3) U.S. Treasuries aren't the only "flight to quality" asset. Could be. Maybe money is flowing into Gilts and Bunds too. Based on the futures markets, the Gilt market is up today, but not much since 11AM. The Bund market has rallied mildly post 11AM. It might be that with the "flight" assets spread around 4-5 markets around the world, that it is having a mild impact on any given market.

To me this is the most plausible explanation, and it may hint at things to come. If Asian investors fearing local turmoil are spreading their assets in Europe and the U.S. instead of just the U.S., does this mean that foreigners are going to be less of a force in the U.S. market? Was that foreign purchases figure we saw the other day just the beginning?

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Monday, September 18, 2006

First Ever Accrued Interest Blog Roll

Two very good blog posts today that I'll link here with minimal comment:

Capital Spectator has my back on the view that inflation is always and everywhere a monetary phenomenon. I've already posted on this subject too many times, so I'll leave it at that.

Economics, Markets, and Probabilities says the Fed wants to be more transparent. What better way than with an inflation target?

Sea of liquidity recedes just a bit...

Foreigners bought about $33 billion in U.S. securities in July, down from $75 billion in June. The bond market is off about 3/8 on the news. As has been widely reported, foreigners have been buying U.S. securities like they are going out of style for the last 3-4 years, which has propped up bond market prices, corporate and MBS spreads, etc.

I've talked a lot about the amount of liquidity in the financial system, and how much the bond market has benefited. I can't take this one data point and assume that situation has changed in any substantive way. What's more concerning for U.S. investors would be if foreigners are diversifying their portfolios into other currencies. We'll just have to wait and see.

Reader Steve Feiss has made a couple comments about technical conditions in the Treasury market, which I have tried to answer in full blown posts, although I realized I didn't give him credit in the last point I wrote in response to him. Anyway, the foreign bid is the 900 billion dollar technical gorilla in the U.S. bond market. If that bid were to go away, all bets are off.

I believe in order for that to happen, we'd have to close our current account trade deficit. That's seriously unlikely. As long as we're importing goods, foreigners will have to export dollars. They have to buy SOMETHING with those dollars.


Blaming the system

The Bush Administration has backed off an ambitious plan to change the fundamental nature of Fannie Mae and Freddie Mac and now seems to be settling for relatively minor changes in how the two mortgage GSE's are regulated.

This probably reflects a political reality that the White House needs to pick its battles (no pun intended). Their original plan was an attempt to reduce Fannie and Freddie's considerable market power by forcing them to reduce the size of their mortgage investment portfolio. There was also talk of eliminating the symbolic credit line the two have with the Treasury. This would have further reduced the power of the GSE's, because it would have decreased the funding advantage they have over competitors like Washington Mutual and Countrywide.

While I suspect the change of heart has more to do with politics than economics, I don't think this is the time to be tightening regulations surrounding the mortgage GSE's. Whatever you think of Fannie Mae and Freddie Mac, they undoubtedly reduce mortgage rates, which supports housing prices. The housing market could use all the help it can get right now.

The Administration's stated long-term goal is to reduce the systematic risk posed by Fannie Mae and Freddie Mac. Systematic risk is a hard thing to get a handle on. I think we can all agree that if one GSE is bankrupt, not only would the other likely be in deep trouble, but many banks around the world would also likely be in trouble. The economic event that causes one of the GSE's to go bankrupt would also cause serious problems for all sorts of financial institutions.

But I wonder whether the contagion effect has much to do with Fannie Mae or Freddie Mac being so large? I mean, say we have a 40% decline in home prices around the country, leading to massive defaults, and eventually toppling the mortgage GSE's. The problem in that scenario isn't that Fannie Mae or Freddie Mac are so large, the problem is we had a housing market bubble. The systematic risk is that housing is such a large percentage of total assets in the U.S. I don't think there is anything you can do to the GSE's to resolve that issue.

On the other hand, what if one of the GSE's suffers a Barings Bank-type collapse, that doesn't have anything to do with broad economics. That might wind up being costly if the Treasury has to bail them out, but would it really be as bad as the S&L crisis? Or LTCM? The solution may wind up being similar to LTCM. Long-Term's problem was not their positions as much as it was their leverage. The Fed orchestrated a buyout of Long-Term's assets by various Wall Street firms.

If Fannie or Freddie went under because of a rouge trader, it would be pretty similar. You'd have a large pool of well-performing assets that needed to be liquidated to cover losses in other investments. In order to prevent a contagion in the mortgage market, some scheme would need to be developed to liquidate the assets in an orderly manner. But because an orderly liquidation would be in every one's interests, just like it was in the LTCM case, something could surely be worked out.

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Friday, September 15, 2006

Caroline Baum misses the inflation target

Caroline Baum's piece on Bloomberg News today (U.S. Inflation Measure May Be Rotten at the Core) a deep misunderstanding of what inflation means to a macro economist. Its also exactly what I blogged about the other day.

Speaking about using core CPI because it eliminates two volatile prices, Baum says...

"It sounds nice, but when you think about it, it doesn't make sense. Taken at face value, Bernanke is saying the Fed would be happy to see inflation rise as long as the core rate doesn't budge from its comfort zone. Huh?"

Bernanke's job is to control the money supply. If the price of banana's quadruples because of a crop failure, that doesn't have anything to do with the money supply. If the Fed were to react to this isolated price change by raising rates to "control inflation," that would imply that the level of money depends partially on the quality of banana harvests. In the words of Caroline Baum, Huh?

Inflation is too many dollars chasing too few goods. It isn't CPI. It isn't PCE. Those are ways we attempt to measure inflation. If the Fed starts targeting gasoline prices to keep CPI down, then they are targeting a statistic, not actual inflation. That's like saying Kelly Holcumb is a better QB the Peyton Manning, because the former had a better completion percentage last year. Huh? Statistics are just ways we try to measure things. The statistic should never be an end of itself.

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Is the United States of America Bankrupt?

I'm finally getting around to reading the July/August issue of the FRB of St. Louis' Review publication. If you don't subscribe, I'd highly recommend it. You can subscribe for free by clicking here.

In this issue, Dr. Laurence Kotlikoff wrote a piece titled Is the United States Bankrupt? The piece is on the net here. In it he makes some interesting arguments.

1) Bankruptcy can occur even when a country has no debt. That's obviously true, but not something anyone ever talks about. As long as one has liabilities of any kind, bankruptcy is a possibility.

2) It then follows that debt ratios are not the ultimate measure of financial solvency. Particularly when the entity has a large number of long-term, non-debt, liabilities, such as Social Security. Debt as a percentage of GDP is bandied about alot, but isn't too meaningful. I will add that a nation's GDP is not the assets of the government, but of the people within the nation. It isn't a good measure of the government's assets.

3) Its challenging to get a handle on the solvency of a nation because national accounting isn't much like corporate or personal accounting.

4) Nations often lack the political will to deal with long-term financial issues, since often the "creditors" involved in programs like Social Security have considerable political clout. In addition, elections occur in the short-run, where the problems we're describing are long-term.

I'd make the following points. First of all, I think we'd all agree that the U.S. would be better off reducing its long-term liabilities. This would be achieved if we would simply run a balanced budget, including debt service and funding Social Security in some reasonable manner. Given our current situation, I'd agree with Dr. Kotikoff that eventually we'd go bankrupt.

However, I argue that no one is bankrupt until they've defaulted on some kind of payment. The U.S. will continue to be solvent until no one will extend us credit. At some point, the government will be forced to deal with the Social Security issue. I also think some party will run on a fiscal discipline platform in the near future, because I think Americans want to think of ourselves as responsible.

So in short, we won't go bankrupt. Not now anyway.

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CPI in line, bit of a relief rally...

CPI came in right where the Bloomberg consensus was: 0.2% MoM, 3.8% YoY. The bond market is rallying a bit on the news, probably more of a relief than anything else. We saw the market slowly drift downward yesterday, but I heard volume was very light in Treasuries. That probably means the real money was waiting for today's numbers, and once they came in, yesterday's sell off disappeared.

Capacity Utilization comes out at 9:15. It is an under appreciated statistic because the Fed looks at it carefully. I'm not that big a fan of its importance in explaining inflation, because to me it smacks of Phillips Curve thinking, but those guys are smarter than me so what the heck. May as well focus on what they're focusing on.

Thursday, September 14, 2006

Price action on the 10-year has been odd today. Before the 8:30 numbers, the 10-year was at 101-1, up 6 ticks or so. After the number, and I think the focus was on import prices primarily and less so retail sales, we dropped down to 100-25. At that point I thought there would be support, because there are enough people looking for an entry here that would stem the sell off. For about 2 hours, that looked right, as we were back above 100-30 by 11AM. Now its fading again, and we’re back around 100-25.

Corporate bonds have been weaker. Lehman’s Credit OAS doesn’t show it, but most of the names I follow are 2-5 weaker over the last 3-4 days. I don’t think this is anything more than the ebb and flow of markets. Higher rated corporate bonds have decent value here, because a resteepening of the yield curve will support spreads of these credits through any economic weakness, and you’ll just collect the carry.

Anyway, its a boring day waiting for CPI tomorrow. Every inflation figure really matters now, with the market assuming Fed cuts coming up, we need tame inflation to keep that trade alive.

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Wednesday, September 13, 2006

Energy prices: inflation or growth pressure?

Do rising energy prices cause inflation or do they weigh on growth? This debate has been raging for most of the last 2 years, as oil prices seem to have continuously risen. Now, with gas prices down around 20% over the last couple months, the debate has reversed: will falling prices stoke growth or ease inflationary pressures? The WSJ wrote an article posing just this question today.

In my opinion, its a matter of general corporate pricing power. Gasoline is an input in almost every physical good produced anywhere, because almost every thing needs to be shipped at some point during the production cycle. So if producers have strong pricing power, they will pass the increased cost onto consumers. That's inflationary. If they don't have any pricing power, it just hurts profits. That hurts growth.

I'd argue that producer pricing power has a lot to do with how easy monetary policy is. So if the Fed wants to be sure rising energy prices don't pass onto consumers, they should keep rates elevated. Granted, that would mean the Fed is intentionally choosing to harm growth to protect against inflation, but I think that's a trade-off the Fed will accept.

So I'd argue that if gas prices stay lower, that will improve U.S. growth, all else being equal.

What does this do for inflation? Probably not much right now. From an expectations theory perspective it could have a significant impact. I've argued that gas prices are a dominant factor in how average consumers view inflation. Gas is highly volatile, people buy it repeatedly, and every one sees the price advertised prominently as they are driving down the street. No other price is quite like that. Most consumers also remember the inflationary impact of gas in the late 70's. Put that all together, and I think regular consumers see higher gas and think inflation.

The Fed is very concerned with inflation expectations, so if the decline in gas continues and inflation expectations diminish, that could give the Fed some comfort.

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Monday, September 11, 2006

What's the best inflation measure? Depends on who's asking.

I'm back from a brief hiatus. Our office has moved, and it hasn't left much time for blogging. Now everything is in place, and its back to work.

There is considerable debate on the blogosphere about what's the best inflation measure. There is CPI, Core CPI, Median CPI, Trimmed Mean CPI, as well as each of these in PCE form.

There are many who argue that core inflation understates inflation. If Joe Consumer has to pay more for gas, then his cost of living has clearly gone up. I think that's right. So if you are looking for a measure of cost of living increases, headline CPI is your number. That is a perfectly legitimate way of looking at inflation.

But if you are concerned with monetary policy, then better to take a monetarist's view on inflation. So if we assume...

P = M / Q

Where P is the price level, M is the money supply, and Q is the quantity of goods.

... then inflation (or change in the price level) is a function of the change in M and Q.

Economists try to measure M and Q directly, but for various reasons most economists agree that we can't get accurate enough results to calculate P from these figures.

So we have to try to measure P by observing market prices. But by looking at my equation, we see that if a change in P is caused by a change in M, all prices would be impacted similarly. Unfortunately, when we look at real market prices, we don't see them all moving in the same way. That's because each good is subject to its own supply and demand factors in addition to a universal money supply factor. If we are concerned with whether we have the right supply of money, then what we really want to do is isolate the money factor from the good-specific factors.

Here is where this logic train is heading. Obviously if you are trying to isolate the money supply factor, then taking a straight average of the prices of all goods doesn't make much sense. The average would be influenced by outlier prices, and we know the outliers must be the ones most impacted by good-specific factors. Take gasoline prices. Gas prices have risen in recent periods due to increased cost of inputs (oil) and supply constraints (e.g., refinery capacity shortages). This doesn't have much to do with a rising money supply.

Core CPI/PCE attempts to isolate this factor by ignoring food and energy, which tend to be quite volatile. That's a start, but it could well be that any number of prices are unusually influenced by good-specific factors.

So this leads us to the trimmed mean measure. This is where the most volatile PCE components are eliminated each month, regardless of what they might be, and an average is taken from the remaining. I think that's as close as we're going to get to isolating the money effect without going through some serious data massaging. Currently, the FRB of Dallas is keeping the measure. They've recently published a Power Point presentation on the subject, available here.

As you can see on page 21 of the presentation, the trimmed mean has been stubbornly high, suggesting to me that the Fed is more likely to at best hold rates where they are. Maybe the bond market is coming around to this way of thinking. The 10-year has fallen 3/4 of a point in the last 6 trading days.

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Wednesday, September 06, 2006

Mail Time!

Reader Steve Feiss wrote a long and thoughtful comment the other day, which I thought deserved its own post. I can tell Steve is a bond guy by his proclivity for colloquialisms. Anyway, I'm not going to go through his point piece by piece, but rather try to explain myself a little better in hopes that answer his question.

Investing is a game of probabilities. If there is one thing I've learned in the investing business, its that. Most people, even some professionals, don't realize that. When I'm making trades and putting positions on, I know a certain percentage of my ideas won't work. Not because I didn't do enough research or I made some mistake in execution, but because the dice just didn't tumble my way.

If someone offered you 7/6 odds that a roll of a single die would come up anything but 5, you'd take that bet every time. Granted, you may well lose, but he's not paying you the correct odds. If you can keep playing over and over, eventually you will win lots of money. But even if you can only play once, you should take the bet. Even if the die comes up 5, it was still the right bet.

Economics and investing isn't random like dice, but there are so many variables that interact with each other, every forecast has a gigantic error term to it. You may look at economic conditions and predict that inflation will rise. So you short bonds. But then Fed acts in a way that counter-acts the forces you had observed. The long end rallies and your short gets killed. That was the story for many bond managers in 2004-2005, myself included. Good analysis, events just didn't fall our way.

But you can't let the time the die falls on 5 to discourage you. Let's take my view on interest rates, for example. I have argued that the curve has priced in multiple Fed cuts, and I didn't think that was justified. Is it because I think there is absolutely no chance the Fed will cut multiple times in 2007? No. Is it because I'm 100% sure the Fed will hike again some time in the next 6 months? Wrong again. Its because I look out at the pantheon of possibilities and I see several that result in the Fed hiking again, several more where the Fed goes on hold, and others where the Fed cuts. I just think that the most probable is the Fed stays on hold for a long while, followed by a hike or two, followed by a cut or two late in 2007. The curve seems to have multiple cuts priced in early in 2007. I just don't see that as particularly probable. Possible, but not probable.

I'm basing this on the persistence of trimmed-mean CPI. I'm basing it on the growth in jobs and personal income, which I think can offset a decline in MEW at least somewhat. I'm basing it on the fact that capacity utilization is the highest its been since 2000. I'm basing it on the idea that the Fed will fight inflation no matter the costs.

I've taken a duration neutral stance, however, because I think the chances of a large bond market rally are greater than a large sell off. By this I mean, if we are headed into a recession, the Fed may have to cut very aggressively to have an impact. We may see the 10-year fall into the 3's again if it gets bad enough. On the other hand, I can't see the 10-year rising to 6% any time soon. There would be no reasonable justification for it. So put the forecast together, I see little upside in Treasury prices, but only so much downside. Not much money to be made betting on rates.

On the other hand, almost every scenario I imagine winds up with a steeper yield curve. So that's the bet I'm making. To me, that's the 7/6 odds in the market today.

Steve mentions in his comments a host of reasons why the Treasury market may catch a bid. Any of those are possible. Again, its the reason why I'm not short duration here. There are plenty of scenarios where rates are lower next year. I think its the minority of scenarios, but still, that possibility exists.

All this is what makes investing so hard. Sometimes there is negative feedback from good decisions and positive feedback from bad decisions. You have to stay cold and logical, and always side with the best probabilities.

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Tuesday, September 05, 2006

Junk is the right word for it

A commenter recently asked my opinion of high-yield spreads, so I'll give it. But first, let's go over the facts.

First, junk is not like the boring old corporate bonds I'm more involved with. If you take two high quality corporate names in similar industries, like Bear Stearns and Lehman Brothers, they are going to tend to move together. That's because almost all investment grade companies are in good financial shape, the probability of default is remote. If Lehman Brothers misses earnings by 5 cents, it doesn't really change anything about their credit worthiness. It would take a either severe turn of fortune or a very sustained period of poor performance to take down a company like Lehman. So bonds tend to move day to day on the general market appetite for corporate risk, and less on anything company specific.

Junk is completely different. Those companies have relatively weak financials, and it wouldn't take as much to push them into default. Junk bonds move more like stocks: there is a general market element but there is also a very strong company specific element. That means if you are good (or lucky) you can pick the right junk bonds and perform quite well even when spreads generally are widening. Now, I can make an argument that a lot of "successful" junk managers have been more lucky than right, but that's a post for another day.

Below are junk spreads are very tight compared to recent history. They aren't as tight as some people seem to think. Take a look at the chart below.

The blue line represents the current swap spread (spread over LIBOR swaps) and the green line is the median for this time period. I used the Merrill Lynch High Yield Master Index. The current spread is 276 and the median is 340. So the current spread is about 66bps tighter than average. Looking at the graph, though, its hard to say whether the median is a good indicator of "typical" spreads. From 1997-2000 and most of 2003-2006, spreads where generally between 200 and 400. But from 2001-mid 2003, spreads persistently higher than +500. So I'm not sure historical averages tells the story.

I attack the question a different way. According to Moody's, from 1983-2005, 35.5% of all "Speculative Grade" corporate bond issues will default by the 10th year after issuance (Source: Default and Recovery Rates of Corporate Bond Issuers: 1920-2005). The average recovery rate after default for all bonds was 36% for the same period. Using these numbers, you'd figure that if you owned a diversified portfolio of junk issues, 35.5% of them would default over 10 years, and you would take a 64% loss on that portion of your portfolio. That's a cumulative loss of 22.7%. In addition to taking the loss, you lose earning power on the bonds that default. So how much annual spread do you need to make up for the expected credit losses?

In order to have truly "made up" for the losses, I figure the high-yield portfolio has to perform at least as well as a portfolio of AAA/AA corporates. This is why I use the swap spread as the basis for the analysis. If you use Treasuries, then you are really ignoring the primary alternative to a high-yield portfolio: an investment grade corporate portfolio. I then use Moody's data to estimate when each loss will occur and therefore how much coupon income is lost.

So how much spread do you need? The answer is 331bps over swaps. A long way from where we are now. What does that mean? That if the default and recovery experience over the next 10-years is similar to the period of 1983 to 2005, junk bonds will underperform high-grade corporate bonds. It is obvious from this analysis that the market is pricing in better than average default and recovery rates for junk rated bonds. This despite the fact that credit conditions have been unusually easy for the last 3-years, which as I've blogged before, typically results in a period where defaults are unusually high. My recommendation? Don't buy junk.

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Friday, September 01, 2006

Almost on cue...

Now the 10-year is flat on the day, so it seems that indeed the early morning sell off was nothing but a head fake.

I'm liking David Andrew Taylor (of the excellent forex blog Dismally) more and more all the time, mainly because he seems to agree with me. Anyway, he comments today that "if you are one of those that feels there is going to be no recession, you're dead on right..... up until the point where the Fed is forced to make it happen."

Now, I'm not a big fan of Keynesian thinking (which he has mentioned as his economic alma mater), but no matter how you look at it, the Fed is quite capable of creating a recession by hiking rates further from here. And as I've said over and over, they have no qualms about doing so. I'd argue that the persistent job growth we've seen isn't the lynch pin that David claims it is, rather the persistence in trimmed-mean CPI. (Macroblog had a great post about the inflation issue today.) Regardless, reasonable men may differ, but in this case we're coming to the same conclusion. Another rate hike(s) are more likely than the market suspects.

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Hello? Is there anyone on the trading floor?

Today is the kind of day where there are more traders in their cars heading for the beach than there are slinging bonds. With NFP coming in right in line, those that did stay in town are probably headed for the golf course.

The 10-year is selling off (down 1/4) but I think it has more to do with post month-end selling, with relatively low volume exaggerating any move. Barring any news between now and Tuesday, I'd look for a bounce back.