Wednesday, January 31, 2007

Bernake: Everything is proceeding according to my design!

The Fed's statement today projects increased optimism that the economy will continue to grow at a reasonable clip while inflation moderates. You will excuse Ben Bernanke from patting himself on the back just a bit.

Its very hard to read that statement and think a cut is coming any time soon. As commenter Dimitri points out, there is no reason for an inversion if the Fed isn't cutting. And if the Fed isn't cutting, there is no way for bonds to rally in any meaningful way from here.

And yet, I'm feeling short-term bullish on bonds. Economic data has been too one-sided recently, and that never keeps up. I see the Fed cutting once or twice in 2007, probably late in the year. The cut will come not because the Fed is changing direction, more as a tweak. I hearken back to something William Poole said a couple months ago. Paraphrasing, he said that monetary policy should be as tight as it needs to be, but no tighter. Historically, we can see that is exactly the attitude the Fed often takes. Most of the recent rate tightening periods have been followed by one or two cuts.

So here are my trades: play a mild bull steepener with very low volatility. MBS are a good way to play this. Also long dated callable agencies, but I don't like that trade as much as MBS. Long dated callables get crushed if the curve does a bull flattener, whereas MBS still do alright. Favor 2-year bonds over floaters if you need to be short-term. Favor 5-7 year bonds over 2 and 10-year bonds.

Someday I'll do a whole post on callable agencies, which are very popular among retail investors, but are usually not as attractive as people think.

Tuesday, January 30, 2007

TIPS redux...

I wrote about how much I hate TIPS recently. My opinion on them is less about trading and more about fundamentals. Capital Spectator has a post today on the subject, which is a pretty good one. Unlike my commentary, they have some trading ideas. I think if you read my piece and their piece together, you can see where I'm coming from, but you can also see that even if the long-term fundamental value is poor, trading opportunities can always arise.

Whither private equity?

The Wall Street Journal has printed three good stories on new developments in the private equity market, all of which suggest the salad days are waning.

This one indicates that the FTC is looking at large private equity funds more and more like conglomerates. This suggests that deals are going to go through greater anti-trust scrutiny, particularly among the larger funds. This could turn into a particular problem within certain industries which lend themselves more readily to going private.

Another article describes a classic principal-agent problem. In this case, CEO's may be pursuing deals with private equity without the board's knowledge, and therefore the deal could be worked out where the CEO benefits more so than shareholders. If a CEO is negotiating without the board's knowledge, you have to ask yourself why. In other words, if I'm a CEO and I think I have a deal which benefits shareholders, I'd go to the board with it. However, if the deal benefits me and not shareholders particularly, I'd probably keep it to myself. The principal-agent problem is probably the biggest issue facing capitalist economies today, in my opinion. Greed is good, as long as the greedy are only rewarded when they are productive.

A third article wonders if recent events surrounding the Clear Channel deal are a harbinger of things to come. In that case, some major shareholders are questioning whether they are really benefiting from the deal. Henry Ellenbogen of T. Rowe Price has a great quote, which is related to the principal-agent problem described above: "As a marketplace, you can't have an asset where people run it poorly, and put in incentives for them to cash it out at a lower price"

Anyway, I think most private equity deals work because the economics of the deal work. Those deals will continue to work, and private equity will continue to pursue those types of deals. However, it seems likely that boards will start asking for bigger and bigger premiums to get deals done. Its simple supply and demand. If you know that private equity has tons of cash it needs to put to work, it should follow that the price of doing deals will rise. As far as controlling CEO's, I think this is very much wrapped up in the compensation issue that has gotten so much press lately. Boards must become stronger and control the agents they hire.

Monday, January 29, 2007

Tanned, rested, and ready

I’m back from vacationing with the mouse. Had a great time, but what does it say about me that I’m walking through Fantasy Land wondering how Disney calculates what revenue to put against what rides and how they decide when to replace one?

Anyway, lot to talk about and I’ll try to get to it all over the course of the week. First, what happened to the Asian bid? As a recent commenter asked, and as I've noted a couple times recently, it seems as though the Asia bid for U.S. bonds has been weak for a couple months now. The 10-year has moved from the 4.40% range in early December, to now 4.88%. But its not just the level of rates in general. High quality spreads are wider, most notably for MBS and swaps. To me, this is a strong indicator that typical long-term buyers have been staying out of the market. Anecdotally, that long-term buyer seems to be Asia.

And yet, has the trade deficit declined in any meaningful way? Is the glut of foreign savings now over? The answer is no.

So it seems there is little doubt that Asia has been absent from the market recently. Perhaps there is some degree of currency diversification going on. But has the Asia buyer exited the U.S. market? No way. Something fundamental would have to change, and yet nothing about the fundamentals has changed.

Put it this way, which would you rather bet on

A) an entire continent changing their core investment strategy over the course of two months for no particular reason


B) some short-term technical issue preventing a group of buyers from being active for a short period of time.

Yeah, me too.

So I’m continuing to buy MBS on recent weakness. Can’t say when they will tighten, but I feel confident that they will.

Friday, January 19, 2007

Bond Bears are in control

Yesterday we got strong CPI, Housing Starts, and Philly Fed figures. So the market rallied. Today we get nothing worth talking about (I'm looking at you Consumer Confidence), but we sell off.

My instinct is that the market is ahead of itself, and that for the moment, everyone is on one side of the trade. As evidence, note that while the 10-year moved from 4.60 on 1/4 to 4.77 now, swap spreads also moved 2bps wider. That points to a buyers strike. This is where real money accounts simply accumulate cash, unwilling to buy anything feeling sure better prices will soon be available.

To me, this is a bullish short-term scenario. Eventually, buyers will have to come in, and if we get any kind of weaker economic signals coming up, buyers will rush in. Rates will then fall much faster than they have risen over the last 6 weeks or so. I've got my money where my mouth is on this one. I'm perfectly willing to bet on a low 4.60% figure in the next 3-4 weeks.

Wednesday, January 17, 2007

Individually, none of the data points from today was very compelling. But considering that PPI, Industrial Production, Capacity Utilization, NAHB Index, and the Beige Book were all strong, it stands to reason that we are selling off. The 2-year is actually attractive in my mind, for the first time in a while.

Its time to at least think about what the curve would look like if we get no Fed cuts in 2007. It depends mostly on what inflation looks like at the end of this year. If inflation picks back up toward the end of the year, then the curve will move in a bear steepener fashion. 2-year 5.45%, 10-year 5.75-6.00% depending on the severity of the inflation fear. For this scenario to pass, housing probably has to be clearly in a recovery, and economic indicators have to be pointing positively. That will have the market fearing more rate hikes in the future.

Alternatively, we could get a Goldilocks scenario, where inflation remains low. That probably means that housing is slowly recovering and consumer spending is tepid, but income figures and business investment remain strong. In this case, the market will still probably see Bernanke's next move as a cut, so the curve remains inverted. Most likely very near current levels. Of course, if the curve basically remains right here it is, the best spot on the curve will be in very short-term bonds. Owning anything longer than 2-years will just be a drag on carry.

Personally, I still think we'll get a cut or two. That's going to make the 5-10-year area of the curve as the best performer.

Tuesday, January 16, 2007

Mr. Independent

First let me say that I'm more than a little surprised that Kelly Clarkson has a career. I mean, I'm not a big fan of her genre, but she has multiple legitimate hits. Did anyone expect a legitimate career from any American Idol contestant?

Anyway, Rep. Barney Frank (D, MA), chair of the House Financial Services Committee, will have other economists giving their view after Bernanke's February testifies before the committee in February. This according to the Wall Street Journal.

A bunch of blogs have weighed in on this: Greg Mankiw and Calculated Risk among them. I can hardly claim to have a better opinion than someone like Mankiw, so I won't try to. But to me, its troubling. Very troubling. I hope this is nothing more than Frank trying to look important and/or spread the lime light around to other economists who have DEM on their voters card. If that's all it is, then fine. I mean, if reasonable economists like Paul Krugman want to give an alternative view of how monetary policy is going, then I can't see the harm. I mean, people like that make their opinions known now, so what's the difference if they testify before congress?

On the other hand, if there are any steps at all that diminish the Fed's independence one iota, its the wrong move. People hotly debate policy issues with relatively minor impact, like small cuts or hikes in taxes. But if the Fed's independence is compromised, we're back to the 1970's. Get those those WIN pins back out.

I used to tell people that I voted based on a single issue: free trade. All other policy actions are debatable, but free trade is a proven good. If any serious politician begins to question the Fed's level of independence, then I'll have to add another issue.

Before the dark times... before the Empire

A very weak Empire Manufacturing number initially put a bid in the bond market, but now the market is fading a bit. After being up around 10 ticks earlier in the day, the 10-year is now only up 1/8. Swaps had been 1/2 bps tighter, now unchanged.

I think the fact that swaps have widened at the same time as the 10-year selling off is indicating cash sitting on the sidelines. Asia is still absent, as they have been in recent weeks, which backs up my idea. If that's right, then even moderately weaker economic news in the coming weeks could bring a significant rally.

Fed Funds futures are now showing an overwhelming odds of no move between now and May. Using Cleveland Fed estimations, the odds of a 5.25% Fed Funds rate in May was around 45% in late December, now 73%. Also in mid-December, the odds of two cuts (i.e., 4.75% funds rate) was over 20%, now only 2%.

Friday, January 12, 2007

U.S. bond market and the price of fish and chips

The rising price of buying a pint at the pub is scaring Mervyn King and company. In a surprise move yesterday, the Bank of England hiked their benchmark repurchase rate to 5.25%, a five-year high. Good, now that its the same as Fed Funds, I can remember it better.

Today we got a surprisingly strong retail sales figure. This was particularly surprising given how dour the Christmas reports were from many big retailers.

December and January have not been kind to bond bulls. But it sure feels like the market is oversold. I still think the Fed will wind up cutting once or twice, and that will allow the 10-year to end the year close to where it is now. My prediction piece said 4.90%, so as we approach that number I'm likely to increase duration. I think we'll see a rally down to 4.50% or so at some point and I plan to profit from it.

Thursday, January 11, 2007

EOP back up for sale...

Not sure if this is a story about a botched bond tender, or really a bigger story about how much money is chasing a finite number of deals. Anyway, a rival bid for EOP is forthcoming from a group led by Starwood Capital. One thing that is a bit fishy to me is why Starwood et. al. didn't show up to make an offer before now. In the muni market there is a saying: "every time someone touches a bond, it gets more expensive." Which means that once one person buys the bond, they are going to want a profit to sell it again. So if you are the 3rd person to see the offering, you are paying too much. I can't help but think Starwood is in this position now.

Anyway, what's more interesting for bond market types, is the fact that lowly bond holders are the ones holding Blackstone up from making this deal final. It seems that AIG wants a full make-whole call on the unsecured bonds it holds, and will accept nothing less. While most of EOP's debt was taken out at make-whole levels, their 7.25% '28, 7.5% '29, and 7.875% '31 issues were not. Blackstone originally offered to take them out at +160, and recently sweetened it to +70. But AIG and friends want the +20-+30 make whole call, which according to Reuters is worth $140 million. I didn't do the math myself, but that's real money, even to AIG.

This is playing out a bit like the story I described in an earlier post, for those interested in more detail.

Anyway, we are all wondering at what point private equity will run out of deals to make. I fell confident that at some point, some private equity deals will blow up, and it will be because private equity has too much cash chasing too few deals. But really, private equity will always exist because of certain systemic inefficiencies in the public markets. So the best private equity shops will resist the temptation to chase bad deals. As for the rest... well...

Wednesday, January 10, 2007

Here's a tip, don't buy TIPS

In case you haven't noticed, TIPS had a horrible 2006. The Lehman Treasury index returned 3.08% while the TIPS index only returned 0.41%. I'm really not a fan of TIPS. Take a look at this graph:

The blue is Core CPI (year over year, that's how TIPS payout). The red is the contribution to total CPI from food and energy. Visually, its obvious that the red is much more volatile than the blue. In fact, the standard deviation of core CPI is 0.40 vs. 0.87 for food and energy, more than twice as volatile.

TIPS payout on total CPI, so if food and energy are contributing the majority of volatility in total CPI, then it is also the major contributor to TIPS returns. To me, TIPS are like owning a Treasury bond plus a tiny long position in commodities. So why not just buy a small piece of a commodity fund?

If you are really more concerned about principal stability, buy floating-rate bonds. A diversified portfolio of high quality floaters should yield in the 5.20% range right now. Floating-rates rise whenever the Fed hikes rates, so if you are worried about inflation, odds are the Fed is worried too. If you own the TIP, inflation actually has to happen in order for you to get paid. If you own a floater, you benefit from the Fed fighting against inflation, which is what they are likely to do.

The TIPS market was created by the Treasury because they believed that investors would pay up for inflation protection, even more than their actual inflation expectations. In other words, if you think CPI will be 3%, and the Treasury rate is 5%, some investors will buy the TIP at 1.75%, because completely eliminating inflation risk has value in and of itself. In particular, the Treasury had pension funds in mind, who often have CPI-linked liabilities which TIPS would help hedge.

Regular investors who buy TIPS are therefore paying a price as though they have a liability to hedge, when in fact, they do not. In my mind, this almost guarantees the investor is paying too much for inflation protection, and other options, such as floaters or commodities are a better idea.

Another day another sell-off

The 10-year is down 1/4 today on light news. Moskow and Fischer (not on the website) both seemed concerned about inflation and happy with where rates are in speeches today. That's not really news, but the market sold-off anyway. I'm suspicious that this has a lot to do with rate locking for corporate deals.

The curve is also about 1bp steeper. June FF contracts are at 94.80, which implies very low odds of a cut by then.

I added a little duration today. I feel sentiment has gotten a little ahead of itself and any bad economic news will cause us to rally back toward 4.50%. Maybe we'll continue to get strong economic news from here, and my prediction of a 4.90% will come sooner than I thought, but I just don't think so.

Tuesday, January 09, 2007

Coincidence? I think NOT!

Commenter MM sent me this link, which was part of a larger article commenting on the same WSJ piece I panned yesterday. Do I claim this chart is all coincidence? Not at all.

What if I had a chart of average speed of baseballs pitched in each inning of all games. Let's say that the chart showed that the average speed for innings 1-8 was 87mph. But the average speed for the 9th was 91mph. I'm making these numbers up, so just go with it.

Now imagine you are at a Yankees game. Mike Mussina was the starting pitcher and he's pitched a pretty good game: 8 innings, 2 runs, 116 pitches. He strolls out to the mound to start the 9th. You say to the guy sitting next to you, "I saw a chart showing that on average, the fastest pitches in a game come in the 9th inning! Mussina had been throwing in the upper 80's all game, but I bet he throws 90 this inning!"

Mmmmm... the logic sounds a little fuzzy doesn't it? Turns out the reason why pitch speed is higher in the 9th inning is because teams so often bring in their fireballing closer. It doesn't have anything to do with the 9th inning per se. Put another way, there may be correlation between inning and pitch speed, but the inning itself isn't the cause of the faster speed. The relationship exists, but its an indirect one.

So to conclude this analogy: teams often bring in their closer in the 9th inning. The closer tends to throw a very fast fastball. Because of this, average pitch speed around the major leagues is higher in the 9th inning than any other inning.

I think its the same for today's inverted curve. The Fed usually cuts short-term rates when the economy is weakening. The curve inverts when the Fed appears likely to cut short-term rates. Therefore, it is often the case that the curve inverts ahead of the economy weakening. The relationship is indirect.

Monday, January 08, 2007

Grading the WSJ's understanding of yield curves...

Today's Wall Street Journal article titled "Grading Bonds on Inverted Curve" by Michael Hudson has me feeling frustrated. I must vent.

The yield curve inverts for exactly one reason. Bond traders believe that short rates are likely to fall in the near future and therefore are willing to lock in longer-term investment rates even though those rates are lower than short-term rates.

Think of it this way. You can buy a 3-month bond or a 10-year bond. Right now the 3-month bond is yielding 4.92% and the 10-year 4.65%. If you thought rates were going to remain stable, you'd buy the 3-month bond. However, if you thought that 3-month rates would be lower than 4.65% for the next 10-years, you'd rather lock in the 10-year rate now.

So there I've explained in simple English exactly why the yield curve inverts. There is nothing more magical to it.

Here is why I'm frustrated. Because Mr. Hudson and a myriad of other commentators are obsessed with linking the inverted yield curve with a possible recession. Do you know why the yield curve often inverts ahead of a recession? Because during a recession, the Fed is usually cutting rates. That's right folks. The inversion happens because the Fed is cutting short-term rates. The relationship with any impending recession is indirect.

Now let's talk about today's economy. The Fed seems likely to cut rates once or twice in 2007, with or without a recession. So that puts the Fed Funds rate at 4.75%. Short-term Treasuries normally trade through Fed Funds, an average of 8bps. So if Funds are at 4.75% and there is normally 8bps between Funds and T-Bills, then 3-month bills are at 4.67%, damn close to where the 10-year is today. Throw in that there is some chance that the economy will get even weaker and the Fed will cut more aggressively, well then it seems like the 10-year is priced about right.

The thing is, you don't need new-fangled ideas about how the world has changed to explain today's yield curve in light of the consensus that there will be no recession. All you need are basic bond fundamentals.

LBO rumors now swirling around the entire S&P 500...

Or so it feels...

Home Depot bonds continue to get crushed, although it would seem odd that you'd hire a new CEO so he can negotiate with a private equity buyer. I don't own the name so I'm not following it too closely, but what seems more likely is an aggressive leveraging up. Their 2016 issue went from something like +75 before Thanksgiving to +100 right after the LBO rumor surfaced, to +123/120 now.

Yesterday I heard Target might be a, ahem, target. Dunno if that was pure rumor or not. The CDS moved 4bps wider, which doesn't seem like much, but its from 7/10 to 11/14. Take it for what its worth.

The story is similar with Federated Department Stores. A buyout of Federated has been out there before. Looks like cash bonds are about 3 wider and CDS about 8 wider today.

Cash bonds in Alltel seem to be stabilizing, but the credit curve is steeper. Before the LBO story, the '12's were 155/145 and the '32's were 270/260. Now the 12's are quoted 150/145 and the '32's are 295/285. The '32's are about 5-10bps better than 2 days ago. CDS are getting completely destroyed by comparison. On 12/28, 5yr AT CDS were 70/73, now 117/120. So I riddle the readers this: why are the '12's, which are basically 5-year bonds, unchanged while the CDS are getting hammered? Normally you'd assume it has to do with covenants, and Alltel does have a non-subordination covenant. This means that the company cannot take on new secured debt without also securing existing debt. Is someone making a play that Alltel will tender their existing bonds in the event of a buyout? If so, why haven't the '32's and '16's performed better? Both are about 25bps wider.

Speaking of Alltel, I found the following story from Businessweek back in December:

One outfit wired as the next takeover, some say, is Alltel, a Little Rock provider of telecom services, mainly in small towns and rural markets. "Its widely used CDMA [code division multiple access] wireless technology makes it a natural target for Verizon -- also a user of CDMA," says Tavis McCourt of investment firm Morgan Keegan. Verizon, he says, would profit from its "substantial customer base and extremely profitable operations."

Of course, it was December 2004.

Friday, January 05, 2007

5.25 today, 5.25 tomorrow, 5.25 all year?

The curve is sharply higher and flatter on today's strong NFP and hourly earnings figures. As I've posted in the past, that tells you the market is pushing back the first Fed cut. A quick look at FF futures shows there is virtually no chance of a Fed cut before April, only a small chance in May, and something like 50/50 for June. This might change a good deal during the day, as its likely to be quite a volatile market today.

I'm curious to see if we test the 4.75% level that we hit at the end of December.

How I'm going to play my 2007 forecast...

In response to yesterday's column on mt 2007 forecast, one reader asked the following:

Could you also make a recommendation as how to play these scenarios vis-a-vis "most likely" vs. "possible "

Good question. The whole reason why I think about "most likely" vs. "possible" is because I accept that the world economy is extremely dynamic, and for anyone to claim that they have good visibility on how the economy is going to look in a year's time is kidding themselves. So I break down my thinking on the economy into possibilities and probabilities. I wrote a post on this concept back in September.

So you want to build a portfolio which will perform well in the scenario you think is most likely, but will still perform OK in scenarios you think are fair possibilities. Obviously you can't plan for everything, but one way to do this is to weight your portfolio bets more heavily in areas where both forecasts are consistent. In addition, you avoid making bets that would only perform well in a single scenario, particularly when the payoff isn't so great.

For example, yesterday I predicted that intermediate-term rates were likely to rise. On the other hand, I think that if a recession were to occur, intermediate term rates would fall rapidly. So if I only followed my primary forecast, I'd be short duration. But the risk/reward is actually poor on such a bet. Because I think there is a strong possibility of a small move up in rates, but a smaller possibility of a big move down in rates, the bet is skewed against me. Stay neutral duration.

Now corporate spreads seem likely to widen either way. Maybe a little, maybe a lot. High yield seems poised to perform poorly either way. Maybe a little, maybe a lot. MBS look at least OK in both scenarios. So I'm overweight MBS, avoiding high-yield, and staying in higher-quality corporate names.

I also think the curve steepens either way. I didn't mention this, but I think its possible that if the recession scenario happens, we get a deeper inversion initially. So I'm protecting against this by owning some 30-year paper, but concentrating your positions in the 5-10 year area. I also own a small non-inversion note position, to given me a big pop if my steepener comes through.

Thoughts on forecasting...

I thought I'd through in some thoughts on forecasting while waiting for the NFP number and wondering how it is that every single day exactly two people are looking for me on

I throw out a lot of short-term forecasts on this blog, e.g., saying what I think will happen later this week or even later on the same day. I do this less because that's how I manage money, more because that's the best way to hear what the market is telling you. If spreads are tighter and rates are lower and the curve is steeper, what's that telling you? If the stock market is down severely but bonds are flat and MBS are tighter, what's that telling you? If the CDS are wider on a particular corporate bond, but the cash bonds are not moving as much, what's that telling you?

Some PM's take the attitude that any shift from one day to the next doesn't have much impact on their portfolio performance and isn't likely to change their minds on their economic view. I don't disagree with that. But if you don't watch what's happening every day, then you can't say you understand why the market is doing what its doing. And if you don't understand why, then you can't say you've considered the "market opinion" and either accepted or rejected it.

Anyway, some have observed that I seem to make short-term predictions that are contrary to long-term predictions. Why not? I can see how the market seems to be positioned and make a guess as to how it might shake out. Doesn't change my broad economic opinion.

So, as Steve noted in a comment on Wednesday, my prediction on Wednesday's rally stalling and reflattening started out good, but hasn't followed through. The 10-year topped out on Wednesday around 99-28, and fell off to 99-24 at the end of the day, but the curve stayed at -10bps. Now we've rallied all the way to 100-9. (Steve: I'm looking for your Fed thing.)

Anyway, I'm going to keep making short-term predictions, even if they are consistently wrong, because it helps with the thinking process.

Thursday, January 04, 2007

2007 Forecast

Well, everyone else is doing it, so I will too. What might be different about my prediction column is that I’m going to write it the way I make portfolio decisions. There will be two elements. First, the most likely scenario, and second a less likely, but possible scenario. When I build portfolios, I try to perform best in the most likely scenarios, but also perform at least OK in the possible scenarios.

I’m going to go out on several limbs here, making as specific a forecast as possible. Most forecasters don’t do this as it makes it easier to claim you were right later. Still, why not be detailed? The odds of all my forecasts coming to fruition are low anyway. Why not explain in detail the timing, levels and reasons why I think what I do. The reader is smart enough to agree or disagree or call me an idiot.

Without further adieu…

Economy: Most likely - Mild slowdown with decelerating inflation.
Housing will weigh on the economy in 2007, in terms of lost jobs from construction and reduced mortgage equity extraction. However home price declines will be modest in most areas and the housing market will clearly be recovering by the end of the year. Business investment will remain strong, and this will help keep any decline in consumer spending from causing a more severe slowdown in overall growth.

Possible - Recession with deflation scare.
This would most likely occur because consumer spending is weaker than I expect, which leads us into recession. This might be because the housing market is worse than I expect, or that business spending pulls back resulting in layoffs. Weaker U.S. imports will cause a global slowdown, pushing energy prices lower. If this comes to fruition, the Fed’s current monetary stance will turn out to be too tight, resulting in rapidly declining inflation figures in mid to late 2007, possibly bringing back talk of a deflation.

Fed Funds: Most likely - 4.75%.
The Fed traditionally takes one or two hikes back after a tightening campaign. Once it becomes clear inflation is slowing, the Fed will make two cuts. The first will likely be in June and the second most likely in August. At that point, the market will price in no further Fed action for some time.

Possible - 3.25%.
If the economy does slip into recession, the Fed will be forced to act quickly. Since it will probably already be May or June before they make their first cut, look for the Fed to cut at every meeting for the rest of the year, possibly including a 50bps cut at some point.

10-year Treasury: Most likely – 4.90%
There are currently more than 2 Fed cuts priced into the market, so when the more bullish bond investors are disappointed, rates will wind up rising. For most of the year, the 10-year will hang around 4.50%, possibly rallying even further, but once it becomes clear the Fed is done (probably 4Q) the 10-year rate will move rapidly higher. Intermediate and long-term rates will also be under pressure from Europe, where rates will be rising more significantly. Keeping rates from rising more rapidly will be the generalized belief that the Fed will be on hold at 4.75% for some time as well as continued demand from overseas.

Possible – 3.70%.
If a recession hits and the Fed cuts aggressively, longer-term rates will have to fall. 10-year rates will bottom out sometime around August then hold for the rest of the year.

2-year Treasury: Most likely – 4.70%
The 2-year will be stuck near where they are now all year. Currently, the 2-year has some period of 5.25% priced in, and some period with rates 75 bps lower. While I think the Fed will only cut twice, the period of 5.25% currently priced in will be eliminated, resulting in a lower 2-year than we have now. Note that this doesn't mean that buying the existing 2-year will necessarily be profitable. I’m speaking of the 2-year that is sold in December 2007. This implies a dead-flat slope between Fed Funds and the 2-year, and a slightly positive slope between 2-10.

Possible – 3.35%.
If the recessionary scenario emerges, the 2-year should follow the funds rate down, but some steepness will emerge toward the end of the year. The steepness theory is based on looking back at the 2001-2003 cutting cycle. Fed funds vs. 2-year Treasury remained inverted for only 6-months after the first cut, even though the Fed continued to cut rates for two more years.

Investment-grade Corporates: Most likely – Mildly wider, outperforms Treasuries.
While I see corporate profits remaining fairly strong, corporate spreads will likely suffer due to increased supply and continued shareholder-friendly activity. However, the widening will not be enough to overwhelm the income effect. Financials will outperform industrials.

Possible – Much wider, underperforms Treasuries considerably.
Corporate spreads are historically tight, so should corporate profits come under pressure, spreads will widen considerably.

High-yield Corporates: Most likely – Wider, underperforms investment-grade corporates.
High-yield has suffered historically low default rates over the last 2 years, and issuance volume has been increasing since 2002. Historically, this has been a recipe for higher default rates. I think this begins happening in mid-2007.

Possible – Dramatically wider.
The same idea as investment grade corporates, but even more so when dealing with high-yield.

MBS spreads: Most likely - Tighter.
MBS will benefit from increased buying by foreigners and banks, and supply will remain tight as housing activity is light.

Possible – Wider on higher volatility
Should rates fall substantially, both convexity problems and higher volatility will push spreads wider. Protection against this includes buying FNCL 5’s, which have decent convexity.

Please keep all laughing to a minimum.

Wednesday, January 03, 2007

A bit of a bull steepener on ADP report

The ADP employment survey is out, showing a 40,000 decline in employment. According to Bloomberg, economists had been expecting a 120,000 increase. That's a hell of a miss, and its giving the rate cut crowd something to work with this morning. We're 1bp steeper 2-10.

I expect the real action may be at 2pm today, when the Fed minutes come out. The minutes rarely say anything of substance that various Fed speeches haven't already said, but for whatever reason the market seems to react more to the minutes. To my eyes, the Fed speeches have not said anything new lately. While the Fed acknowledges that the housing market is soft, they don't see any bleed through to the broad economy. The odds of a recession are low. While inflation remains a bit higher than desired, policy actions to date need time to work. All this leads the Fed to keep rates where they are, and the direction of the next move will be data dependent.

So my bet would be that the minutes wind up flattening the curve, with the whole rally tempering a bit.

Tuesday, January 02, 2007

Real yields at 2001 levels

Econbrowser, an excellent blog for the econ geek, has a piece out today showing that real interest rates in the U.S. are at 2001 levels, using various measures of real interest rates.

Dr. Chinn opines that the rise in real rates makes it hard to argue that the savings glut is keeping rates low. Of course, its possible that rates would be even higher if not for the heavy foreign savings. Anyway, food for thought.

As I've said in the past, foreign buying isn't going to reverse or even stop real soon. It may well slow down, but the result would likely be a slow move higher in rates. So slow, in fact, that no one would notice. We'd also start seeing pressure on corporate and MBS spreads.

News on the LBO front...

Last week, Equity Office Properties announced the terms of tender offers for their outstanding debt. As I said was likely in a previous post, the tenders include consent from the tendering bond holder to eliminate certain bond covenants. The tender appears to be occurring at make-whole levels. Credit to commenter Fixed Income Guy who predicted that the tenders would be at or very near MW levels. So EOP's benchmark 4 3/4 '14 issue has gone from the +90 range before the LBO to +20. That's a 4.3% price increase. Wish I could say I made that trade.

As I predicted, the CDS were not invited to the party. EOP's 5yr CDS was quoted to me at 29/34 a couple days before the LBO was announced. Now 45/50. No hedge is perfect.

Meanwhile, the Times of London is reporting that Verizon Wireless is interested in acquiring Alltel. Without doing any complex analysis, I'd think that Verizon Wireless could offer more than any group of private equity buyers. I say this because if I'm a private equity fund looking to buy Alltel, my exit strategy would be to sell the stake to another telecom. If another telecom is willing to buy Alltel now, but a private equity fund bids more, what's the exit strategy?

As to what the bonds do in reaction to the latest story from the Times, we'll have to wait 'till tomorrow. A lot of people are out today due to President Ford's funeral. We really didn't get much read on how the Wall Street Journal article speculating on a LBO moved the bond anyway. It could well be that the market believes either a merger or LBO are possible, and so the spread volatility goes way up for the next few weeks while this all gets worked out. Before the hubbub, AT's 7 '16 issue was +190ish. Rumor was the CDS were out between 20 and 35 on Friday. I'll bet the bonds tighten to +180 or so by the end of this week. As I said before, I own the bonds, so I'm not completely unbiased here. But still, I think a buyout from another telecom is more plausible than private equity.