Thursday, April 24, 2008

Treasuries: This far, no further!

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

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

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

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

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

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

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

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

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

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


Chris Wheeler said...

I think you could make the argument that the US economy is currently in deflation, not inflation. Housing is a major component of spending, and housing prices are still free falling. Wouldn't that have deflationary effects?

Offsetting the decline in housing prices are increases in energy and commodity prices. For the manufacturing sector, the extraordinary run up in raw material prices (without a corresponding increase in domestic demand) is still working its way through the system.

Overall, the deflationary and inflationary forces seem to be balancing out so far.

Anonymous said...

Chris Wheeler: Housing is a major component of spending, and housing prices are still free falling. Wouldn't that have deflationary effects?

If housing price decline is deflationary, than why wasn't the massive run-up in prices in previous years inflationary?

Prices were up 15% annually during the boom, roughly the same amount they are down annually now.

It doesnt make any sense that housing would effect things in one direction (down) but not the other

Anonymous said...

The ugliest thing about mortgage securities is that they always pay principal the fastest when you least want it. When rates drop, suddenly you have a lot of money to reinvest. When rates go up, principal is returned at a much slower rate.

steve said...

amusing to watch and listen to back-and-forth re mbs when last i reckon AI was short 'duration' and not for nuthin, as fixed income manager, being short duration over recent few weeks (not easy call AHEAD of time for most), someone out there must give AI the 'hat-tip' for being so ....

AI, being tasked with fixed income mkts investing for his client base, has made an OUTstanding call -- tough for me to admit that i missed this very call -- as an independent strategist, 'calls' are about all i've got. would put question then to AI -- are you viewing this as a trend-changer and adding to durational short position OR are you banking your 'good call' and moving towards more neutral stance?

I've been doing loads of work and thinking about things, especially in relationship to other recent (similar) episodes like 2003, 2001 and 90/91. first thing that strikes me is that 'duration surveys' out there avail to us all (JPM and SMR come to mind) would indicate a very much more NEUTRAL stance in mkt right now (compartively speaking) and therefore room to buy this dip IF so desired.

ALSO, the way in which this sell-off was accompanied by tremendous curve-flattening is striking - Said another way, the very well-advertised smart money (pimco, loomis sayles and blackrock for example) has been getting OUT of steepening trades - booking profits ... after reading thru some other strat notes and comments this morning, the general takeaways from history are that these flattening selloffs in easing cycles 'start with steepening and then move to flattening for the second part of the move, and 2s in '92 and '01-02 backed up 120bp and 132bp, respectively. Since March 2s have back up 118 bp, or pretty much on par with prior episodes.'

The point is that in my opinion, the bear flattening is at/near the end of its run, not the middle of a move or beginning of a new phase.

Simple conclusion (? from a guy who missed last little hiccup in ylds ?), buying the front end of the curve (or reducing a short-duration stance somewhat?) seems prudent at this point, especially after such a GREAT call on your part. Curious if you've already booked some profits or continue to keep duration below your bogey?


Accrued Interest said...

I'm still light on duration, but don't have a steepener on anymore.

I think there was too much money chasing the steepener trade, and that's why we flattened so violently. I think the near-term inflation story supports a steep curve, but the Fed will be hiking within the next 9-12 months, and that will ultimately flatten the curve pretty good. Especially if it turns into a double dip recession.

steve B said...

Fed hikes in the next 9-12 months almost guarantees a double dip recession, putting even more pressure on housing. Expect another round of mortgage resets if hikes truly materialize.

gramps said...

Even with the barrage of news stories and books discussion the effects of globalization -- its amazing that we are still exclusively focused on U.S. based economic indicators.

The unemployment number doesnt really tell us anything useful. Is there a shortage of skilled workers or a shortage / surplus of hourly time clock punchers? It makes a HUGE difference.

When oil was around $10/bbl (eg most of the 1990s, who wanted to become a petroleum engineer? It was a dead end job- anyone with brains wanted to be a doctor, lawyer, investment banker. Lots of 20 and 30 something petro engineers quit and changed careers because there was no money, and seniority made sure that whatever money there was went to the "old guys".

Fast forward to present. The "old guys" are retiring or in management. The 30 and 40 something engineers don't exist (they changed careers 10yrs earlier). No matter what OPEC does or doesn't do, there is a worldwide shortage of petroleum engineers. Assuming a high school kid decides to become a petro engineer, he/she needs 4 years of college plus say 10 years of "real world experience" working under an old guy to learn the ropes. That's 14 years before the petroleum engineer shortage can be addressed. Will a large group of kids decide to go into petro engineering? Well, only if they see oil prices high and they think oil will stay high. If oil is going to head back down again, it would be a bad career choice.

This is a world wide problem. There is no Fed Funds rate, easy or tight, that will address it. All the central banks in the world acting in unison have no influence what-so-ever. OPEC has a marginal influence at best (despite all the conspiracy theories, OPEC has a long track record of cheating and not being able to hold prices where they want them).

Oil prices (energy prices more generally) flow into every part of the economy, even if the folks at the BLS choose not to see it.

Enough about petroleum engineers. Who among the readers of this blog wants to be a farmer? Farmers have either lost money or broken even for decades. Your fate is determined by mother nature and WTO policies far more than whether you work hard or not. Oh, and by the way the fuel to run your tractor will now cost more, as will the fertilizer (which is made from natural gas).

Oh, I almost forgot to mention: you need to irrigate your crops with water. However, powerful real estate developers have built massive developments with zero trees and no resevior systems. So you are going to have to fight with cities (which have more voters) to get potable water.

I could keep going, but I already mentioned energy, food and water. People can survive without mortgage brokers -- but without food and water we won't last very long.

There has been massive neglect of critical infrastructure. We are going to pay for this -- either through massive infrastructure spending (which doesn't seem to be in the cards as yet) -- or else through massive cost of living increases.

When Greenspan lowered rates way too far, and neglected his regulatory duties (allowing non-banks to offer 95% LTV loans) and then further messed things up with his "Greenspan Put" (which further encouraged excessive leverage) -- economic resources were diverted away from other sectors and into finance. To a certain degree, this might not matter -- but taken to the extremes Greenspan did in the late 1990s, it started causing problems. When Greenspan (with Bernanke's encouragement) lowered rates to 1% -- it pretty much guaranteed a huge problem. Suddenly, everyone was a mortgage broker or a real estate developer.

The muni workers who are supposed to plan communities (the local planning and zoning boards) saw all the extra tax revenue coming in from real estate transfer taxes and voted themselves massive benefits raises. No one asked if the environment or infrastructure could handle the developments.

No one wants a power plant in their backyard, so where was the power going to come from? Many cities around the country already have water shortages, so how can the water utility provide water to the new homes? Oh, and how are people going to get to these homes? There is no new public transportation, and there were no new road construction projects (certainly nothing on the same scale as new homes anyway).

Face it: we have some pretty massive infrastructure problems that will force the cost of living to keep rising unless and until they are addressed.

To get people to invest in those projects you need a positive real return on bonds used to finance them.

If the central bank instead lowers nominal rates to bail out failed banks, the investments will not happen. If anything, the failed banks continue to create new problems.

The Fed doesn't have the resources to save all the insolvent banks in the country -- even if it was good policy. Bear Stearns is tiny compared to Citi, JPM or BAC -- and yet the bailout has taxed the Fed almost to the max.

I don't want to start another argument with AI about whether a bank getting recapitalized is a case of "bankruptcy". Legally it isn't, but economically, these banks are effectively bankrupt and are being forced to raise new capital. The new capital being raised is a significant percentage of total market capital -- effectively there are new owners, since the old shares are so diluted. These banks have failed, even if they didn't file chapter 7.

Everything I talked about so far has zero dependence on what the Fed does or doesnt do. Bernanke is powerless to stop it, so lets stop kidding ourselves that all we need is a little more liquidity. Its a structural problem, not a liquidity problem.

The only thing the Fed can do is prevent true price discovery, and to subsidize failed banks with taxpayer money. When the Fed lends to banks at the FF rate (2% or so at the moment) and then another branch of the government (the Treasury) borrows that money back at 3.5-4.0% (say the 5y or 10y Treasury yield) -- effectively Bernanke is giving 1.5% of taxpayer subsidy to failed banks.

Money doesnt grow on trees, not even if the Fed prints it. That 1.5% subsidy will be paid for either with higher taxes, lower government spending or by inflation.

Even the regulated banks have become too big to be effectively managed. There was a good piece on this in Friday's FT
Banking reform must begin in boardroom
. The article doesn't mention that Bob Rubin is running Citi, and he certainly has a good banking / trading background, not to mention a stint as Treasury Secretary. Rubin says he didnt understand many of the risks Citi had on its books.

Back in the 1970s -- the last time we went through this foolishness-- every company wanted to be a big gigantic conglomerate. General Mills (which makes cereals) decided to buy textile manufacturers (because they also use "mills"?). That was one of the less stupid moves.

You may remember that Peter Lynch called this "diworsification" in his book One Up on Wall Street. Jack Welch made a name for himself getting GE out of all the stupid industries it was in, and focusing on a handfull of businesses where GE had a competitive advantage.

Yes, I know Citi/JPM/BAC want to be all things to all people. The nicest thing I can say is that history says otherwise. You simply cannot specialize in everything -- its an oxymoron. The boards and CEOs of Citi/JPM/BAC will never understand the complex securities they deal with as well as people who specialize in them. That means smaller more specialized firms will eat Big Bank's lunch -- and it means the traders on Big Banks trading floors will always know more of what's going on than the CEO. Traders have learned the hard way that they work for themselves -- the CEO will fire them while giving himself a pay raise (this is happening right now). Since CEO's don't play fair with traders, why would traders play fair with CEO's?

Current Treasury Secretary Paulson thinks these problems can be fixed by putting all regulatory authority under the Fed -- the Fed that jacked rates, ignored its supervisory duties, and issued the market a free put?

We had at least 7-8 years of craziness (arguably more like 15yrs). Its pretty hard to believe all the underlying imbalances have been fixed after 9 months or so of central bank meddling with liquidity rules.

Long term, these financial conglomerates will collapse under their own weight. But if history is any guide, we must endure a decade of disco balls and bell bottom pants first.

Short term, the U.S. consumer is no longer ABLE to be the global consumer of last resort. That will have enormous impact on our trading strategies for the next 2-3 years...

Unsympathetic said...

" Its very possible that the Fed gets out ahead of inflation expectations "

Or, the Fed could just redefine how they choose to define inflation so that they don't have to increase their payments on TIPS or those pesky senior citizens.

The classic mantra for this chicanery in all business is "move the goalposts and declare victory." Because this seems to be Bush's legacy, look for more of the same.

Anonymous said...


Why would you think the farmers are not making money ?

Food prices are sky high... \I guess agri is a good business to get into.

For eg:- MY cousin grows mangoes and I am a banker. Next year I am sure he will make more money than me (now I am not even sure if I hyave a job next year)

pls explicate on the agri business not being able to make money

your rest of the post is fantastic as ever...

Dr. Dan

gramps said...

Anon 8:40

I do not know if farmers are profitable right now. Crop prices are obviously higher, but then some crops are sold forward to finance purchases and/or to lock in a minimum price the farmer will get. Also, fuel costs (from oil) and fertilizer costs (from natural gas) are way up. Possibly higher revenues and probably higher costs -- not sure how that plays out.

But over the longer term, I don't know any "rich" farmers. I keep hearing about Willie Nelson doing Farm Aid, and the ever declining number of family farms. There have been periods of reprieve, but farms have been on the decline for decades... And all of this is happening in spite of government price subsidies and massive trade barriers. Without price subsidies and trade barriers, would there be any farms left in the developed world or would food production have shifted to third world countries?

The government has assured that uneconomic players stay in the market, while blocking 3rd world players that all too obviously have massive cost advantages. Economically, its a totally inefficient situation, with economic resources being allocated according to politics, not economics -- and even then the farmers are not "rolling in it".