Tuesday, April 22, 2008

Its against my programming to call bottoms

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

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

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

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

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

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


Anonymous said...

So are we running out of sellers? Isn't that what you said would be the only thing stop the free fall?

Accrued Interest said...

In credit? It sure feels like it.

gramps said...

Hi AI-

More traveling, so I missed your last post.

What we need for a bottom / what would make me not be bearish is pretty simple:

No economically motivated player is going to want to lend until real interest rates (ie after inflation) are positive.

Non-US central banks and our own helicopter pilot in the U.S. are not interested in making profits -- but for those who are, the U.S. bond market doesn't make any sense right now.

Even Bill Gross (who seems to have been calling for Fed easing the last 15 years?) is now saying that the U.S. Treasury market is the biggest bubble in the world-- and he is right.

On a hedged basis (long whatever credit product, short Treasuries), other bonds may or may not be good-- but on an outright basis, even if the spreads (credit, optionality, whatever) have bottomed, the base interest rates off which these spreads are calculated are in a massive central bank induced panic bubble.

Oil prices, food prices, gold prices -- whatever commodity you want to look at are ALL way up year over year. For the monetarists out there, M2 and MZM are both up more than 6% yoy (according to the Fed's own website).

An inflationary mindset takes hold if the average Joe thinks prices are going to keep going up -- NOT if some academic inflation model says so. The radio station in my area is running a listener contest to compensate people for the rising cost of living -- they are doing that because costs are skyrocketing and because even the radio jockey's know this perception is 1000x more important than what Bernanke or Taylor happen to think.

Inflation, measured the way "normal" people measure it, is way up. Measured in commodity prices, its up double digits yoy. Measured in M2 or MZM, its up more than 6% yoy. No serious investor puts any faith in CPI anymore -- just ask your TIPs trader how boring the last 6-9 months have been. TIPs trading has all but collapsed.

So **WHEN** (not if) all the 20-something bond traders finally figure out just how devastating inflation is to bonds -- we may start to see positive real interest rates again... and that is when you can call a bottom in bonds.

Once the Olympics are over, China is going to be forced to look long and hard at its policies. I doubt they are able to truly "cut off" the deadbeats in the U.S. (at least not abruptly)-- but they would be fools to not dramatically ramp up their existing efforts to create new markets and diversify their exports. They don't need to STOP buying U.S. bonds, they just need to slow down their purchases -- divert small amounts toward building other export markets.

Best case scenario: the U.S. will be delevering /inflating away its debt for about another 8-10 years-- meaning we won't be a big enough growth market to keep China's economy from imploding. Remember, China needs about 7% GDP growth just to absorb workers coming into the cities. China's leadership desperately wants to stay in power, so 7% GDP growth is a mandatory minimum, not ideal. The U.S. economy will not provide that by itself. China must diversify away for their own survival.

Americans will keep borrowing until someone cuts us off-- we have demonstrated this. But we are already at the limits of our ability to service debt. That doesn't mean we won't grow at all -- but at the margin, debt growth will be much slower.

For the last 15-20 years, the U.S. has been the consumer of last resort for the world... we are no longer able to fill that role. The markets are transitioning to a new paradigm, even if Bernanke hasn't figured it out yet.

shankar said...


Let's wait till Friday and we'll revisit about how you are feeling.

- Shankar

evangelist said...


what you said may be right about rates/spread products being over valued according to your inflation argument. However, where is all that investment $, which is now presumably in cash, going to go? What better investments are out there in the world that is arguably "cheaper" than U.S. spread products once you factor in the local inflation risks? Gold is already above $900!

Thai said...

evangelist, you don't think EM currencies?

How long can they tolerate this inflation?

gramps said...


It sounds like your argument is that there is way too much money sloshing around, and it has to be invested somewhere...

Well, too much money sloshing around is pretty much the definition (and monetarists might argue the cause) of inflation.

It also pretty much shoots down the illiquidity argument. There is plenty of money around -- so much that it can't find an economically viable home. It gets invested in Treasuries by default.

I never believed there was a liquidity issue -- I think its very rational for investors not to throw good money after bad. Its not a liquidity problem if I don't want to lend money to people who I don't believe will pay me back.

Unfortunately for Bernanke, the USD is no longer the only game in town. There are alternatives (albeit imperfect in their own ways). In particular, there is no alternative bond market that is as deep and liquid as Treasuries -- so even though investors are diversifying away from the USD, they cannot avoid it entirely (yet).

Unfortunately, I think the actions by the Fed and Bank of England are making a bad situation worse. The US in particular talked down at all the Asian economies 10 years ago, telling them (ordering them?) not to bail out their political cronies. We told them they must let the bad businesses fail... Now, we refuse to take our own medicine.

So what started as a really bad insolvency problem has now morphed into a Fed leadership and credibility problem.

When bank CEOs lay off people by the thousands, and then pay themselves tens of millions for failing -- it only makes the credibility problem worse. Its not just that the businesses are insolvent -- even if they had more credit, the basic business model is flawed and its being run by kleptomaniacs. Hardly the stuff that will establish a bottom.

That will have negative consequences on U.S. standards of living for at least a couple generations. I think AI is trivializing how bad this debt addiction is for the United States. Our children will not enjoy the same standard of living that we did.

And our fate is no longer in our hands. If the U.S. remains the dominant economic power, it will be because the Chinese dropped the ball and we "won" by default.

James said...

"The answer is that our financial system has become too intertwined. It has become too reliant on the continued solvency of all its players. Had Bear Stearns been allowed to fail, banks world wide would have lost their counter-party on various derivative transactions. A bank that assumed it had hedged some of its credit risk on a particular borrower would suddenly have all that credit risk back in its lap. I don't need to paint the picture as to the level of contagion that would ensue. I'm not even talking about fear here, merely that many financial institutions were relying on hedges in so many ways, that to suddenly lose a counter-party would be disastrous."

This should prove without a doubt that this system is screwed. There is no way this will last in the long run. If I was the fed I would be working constantly on a plan that would mitigate the fallout from failure. We've all seen entire countries and empires fail.