Bill Gross: Do you trust him?

No... but he's got no love for the Empire, I can tell you that.


This morning, S&P put the AAA rating of the United Kingdom on negative outlook. Generally when S&P puts a negative outlook, it merely means they leaning toward a downgrade without any particular urgency. In this case, S&P says they need to see some progress made by an incoming British government on their burgeoning debt.


Since the U.K. is generally seen as the third most stable (U.S., Germany) of the big western economies, its not a big leap to say that the U.S. could be next. Its a perfectly legitimate concern. S&P mentions their concern that British debt could rise to 83% of GDP by 2013. In the U.S., its already 80%!

What would happen if the U.S. lost its AAA? Very hard to say. Foreign investors would still have the problem of finding someplace to put their money. I'd be surprised if the U.S. would lose its AAA rating, but say, France and Germany hold on to their ratings. Japan is already AA. It might result in a revision of how foreigners view ratings in general.


In other news, how is General Electric AA+ and stable if the U.K. needs to be downgraded? How is Assured Guaranty still AAA and stable?


Enter Bill Gross, always eager to talk his position. He stokes the fire by saying that the Treasury market is selling off due to ratings fears. Maybe. Indeed, I've heard that Asia is selling today. But always remember, when Bill Gross talks, he is always always always talking from position. So I'm assuming Gross is short Treasuries and today is adding.


I don't think really think the whole ratings thing makes sense to explain the Treasury sell-off. Here is the intra-day on Treasuries. S&P comes out with their report on the U.K. at 4:20 AM.





Treasuries are actually higher all during the Asian and European sessions, and its only once the U.S. session really gets going that the bond market sells off.

A better explanation is the continued belief that the Fed is defending some level on Treasuries. Admittedly, I thought they would, but the evidence is clear that they aren't. Here are the Fed's Treasury purchases since the program began:





Traders keep hoping the Fed will increase their POMO buys, whereas this chart clearly shows they keeping to the $7-8 billion range in the belly and about $3 billion on the long end. Their reluctance to increase purchases shows they either have no particular target or their target is much higher than where we are.

No sense in getting in the way of the Treasury negative momentum here. I'm probably not a buyer until 3.60%.

Treasuries and Stocks: If he could be turned...

Interesting to watch the Treasury market turn weaker today even as losses in stocks accelerate. I've been feeling for a while that the classic negative correlation between Treasury and stock prices will break down, at least on a day-by-day basis.

1) Any significant rise in Treasury prices will force consumer borrowing rates higher. There isn't much room for further spread tightening, especially in mortgages. So higher Treasuries probably means lower stocks.

2) Foreign buying is critical if Treasury yields are to remain low. Foreigners are more likely to buy when the dollar looks stable. The dollar is more likely to be stable if the economic picture is decent, and thus stocks advancing.

3) The stock market would probably welcome additional quantitative easing from the Fed. Based on yesterday's minutes, I expect any additional QE to be aimed squarely at the Treasury market. So Treasuries and stocks would both rally.

For what its worth, yesterday's minutes also indicated that the Fed doesn't have any particular 10-year yield in mind to defend. Or at least, if they do, that number is much higher than where we are. If the Fed cared about 3% or even 3.25%, the talk of expanding QE would have been more urgent.

Could you argue that allowing the 10-year to move from 2.50% to 3.25% is a de facto tightening of monetary policy? Maybe not, because most non-Treasury borrowing rates are lower today than 2 months ago, and thus you can't claim that credit availability has declined. However, I certainly think if they allow the 10-year to move much past 3.25%, they you will start seeing yields away from Treasuries back up as well. That will indicate tighter policy, which would be bearish for the economy.

I suppose I could hot wire this thing...

I expect the Federal Reserve to announce a program to buy long-term U.S. Treasuries. If not at today's meeting, then soon. Interestingly, most commentators I read don't expect the Fed to move in this direction, but to me it seems too easy not to do it.

The Fed's big fear is deflation. We know the Fed has had the printing presses in high gear for several months now, yet still consumer prices barely move. Today we got CPI, a meager 0.2% over the last year. The cash the Fed is producing isn't turning into consumption. As I've said many times, if consumers don't spend more money, at least nominally, there can't be inflation.

Inflation nuts like to complain about the rapid growth of monetary aggregates. M2 for example has risen 9.8% in the last year, or $736 billion dollars. But note that this has almost all translated into excess reserves at banks, which have gone from about $1 billion a year ago, to $622 billion today. In practical terms, money available for consumption is falling.

If the Fed wants to create inflation, it is going to need to overwhelm banks desires for additional excess reserves. That's going to be very tough given that banks are looking at continued increases in loss reserves (despite Citi/BofA's claim that they are profitable). BCA is predicting an additional $1 trillion in losses at banks before the credit crisis is over.

To this end, the TALF is great idea. This program aims to stimulate consumer lending directly, bypassing banks, by reinvigorating the asset-backed securitization market. Already Nissan is doing an auto loan securitization tomorrow, and another major manufacturer is going to follow suit this week. These two deals will combine for $5 billion.

That's all well and good, but it won't address the problem that consumers might not want to borrow. Household liabilities are currently 134% of disposable income, according to the Fed's Flow of Funds report. In addition, households have also seen their net worth decline by $13 trillion. Consumers must continue to save aggressively in order to offset these losses. And despite what some Keynesians say, consumers need to have a decent asset base before a lasting recovery can take hold.

But a lasting recovery can't happen under deflation. Deflation has more destructive power than half the starfleet. Deflation will push home prices even lower, thus exacerbate the problem of negative home equity specifically, and wealth destruction generally.

Currently the Fed is buying Agency debt and Agency mortgage-backed securities (MBS). That program has been a success so far in bringing down spreads on those bonds, especially considering the massive flight away from these securities by foreign buyers.

But that's just the thing: the Fed has brought down the spread on these bonds. The Fed program has helped prevent mortgage rates from rising in recent weeks as Treasury rates rose. But we won't see mortgage rates actually fall until Treasury rates fall. Remember that MBS typically have servicing spread of 50bps, meaning that if investors will buy MBS with a 5% coupon, that translates into a 5.5% actual mortgage rate. So if the Fed wants to see mortgage rates at 4.5%, they have to get investors to buy mortgage bonds at 4%. Investors simply aren't going to buy a mortgage security at a 4% yield if the 10-year Treasury is at 3%.

Forcing Treasury rates lower will be relatively easy. The Bank of England has already set the precedent. On March 5, the Bank of England announced it would be purchasing up to £75 billion in gilts over the next three months. The day after the announcement, even before the first actual purchase, the 10-year Gilt had already fallen by 30bps.

When Treasury yields fall, it puts indirect pressure on all other yields. No other segment of the investing world is so instrumental in pricing so many other investments. The Fed could buy MBS, and bring MBS rates lower, then buy corporates to bring those rates lower, then buy ABS, and munis and CMBS, etc. etc. Or it can just buy Treasury bonds and bring all rates lower at once.

Not only would forcing Treasury yields lower be impactful, it would also easier to achieve. The MBS market is about $8.9 trillion and is made up of thousands of individual securities. By contrast, there is only one 10-year Treasury bond, with about $40 billion outstanding. All the Fed has to do is target the 10-year Treasury and all rates will react substantially from there.

Time for Tips

Deflation is the new buzzword, especially now that the Consumer Price Index has declined or remained flat four months in a row. But that being said, its time to consider intermediate and long-term Treasury Inflation Protected Securities, or TIPS. Its one thing to price in deflation in the near term, but these bonds have priced in zero inflation for the long-term. But given the various stimulus plans currently in place and/or about to be enacted, long-term inflation remains inevitable.

First, take a look at the TIPS "Breakeven" curve. This is simply the nominal yield on a TIPS minus the yield on a traditional Treasury bond with approximately the same maturity. One can infer that this is the "priced in" inflation rate over a given period. All are quoted as of January 9.

5-years: -0.40%
10-years: 0.55%
20-years: 0.103%
30-years: 1.23%

Roughly speaking, if actual CPI comes in higher than those breakeven numbers, the TIPS will outperform the Treasury. If CPI is lower, then the Treasury outperforms.

Might the CPI decline by 0.40% per year for the next 5 years? Or rise by a meager 0.55% for the next 10? Consider the Fed's current tactics.

• Cut the Fed Funds target to basically zero
• Agreed to buy $500 billion in agency MBS
• Agreed to buy $100 billion in GSE debt
• Have or will extend funding to asset-backed securities, commercial paper, among other securities
• Promised to "employ all available tools to promote the resumption of sustainable economic growth and to preserve price stability."

All these things are funded by creating bank reserves. Or as Fed Chairman Bernanke said in 2002, "But the U.S. government has a technology, called a printing press (or, today, its electronic equivalent), that allows it to produce as many U.S. dollars as it wishes at essentially no cost." That electronic equivalent is the creation of bank reserves. The Fed is printing money.

In a deflationary environment, printing money is the right policy. Had Japan followed a similar path, their generation-long malaise may have been shorter and less severe. But regardless of whether its the right policy, printing money is a highly inexact tool. The Fed will undoubtedly err on the side of creating too much money, as deflation is a much bigger threat. But given this, it is extremely likely that the Fed will wind up creating too much money, and thus create price inflation. To suggest that over a 10-year period, inflation will average zero is to suggest that the Fed will create just enough money to offset the private sector slowdown. That is giving the Fed way too much credit.

The best play here is in longer TIPS, at least 10-years. Short-term, CPI might print very low indeed, which results in a lower realized coupon for the investor. But over the course of the next 3-6 months, the market will start to realize that deflation is going to be a 1 or 2 year phenomenon, followed by a period of elevated inflation. So there is a chance that over 5-years, inflation is (on average) pretty low, but over longer periods, inflation protection will garner a premium.

Long time readers will remember that I've panned TIPS in the past as a quasi-commodity play. I haven't changed that opinion generally, but now I think its clear that both commodities and core inflation should be rising rapidly from here, at least to where final CPI is in the 3's and probably the 4's, with upside much higher.

There are several TIPS funds, including iShares Barclays TIPS Bond (ticker is TIP) and the Western Asset Inflation Management Fund (IMF).

One warning is to beware of the correlation between TIPS and other bets you might have. I mentioned commodities already, but currency plays too might be highly correlated with a TIPS trade.

Disclosure: Long TIPS directly, do not own any TIPS funds.

2009 Forecast Episode II: Deflation Strikes Back

This is Part II of a indeterminate series on the Accrued Interest 2009 Forecast. Here I'll focus on general interest rates and Treasury Bonds.


The question on many lips is are Treasury bonds a bubble? I've already said that fighting deflation will be the major theme of 2009. Deflation will remain the primary concern of the Fed until housing prices start to recover. I don't see that happening until 2010. Until housing prices start to rise, we'll see persistently poor final consumer demand. This in turn keeps the velocity of money low and thus the money supply contracting.


I have a very simplistic mental model for Treasury rates. Real interest rates should reflect the opportunity cost of money. Thus a short-term Treasury rate should be the opportunity cost plus an inflation premium. Longer-term rates should reflect both opportunity cost, inflation, and a term premium. When economic growth is weak, opportunities are less, and thus interest rates should fall.


If we have negative inflation, then short-term Treasury rates should be extremely low. Near zero makes sense for T-Bills (although negative yields is questionable at best). Less than 1% makes sense for the 2-year. So I see no bubble on the front end of the Treasury curve. Not that there is a ton of upside on the 2-year at 0.75%, but could it go to 0.50%? Sure.


Longer Treasury bonds are the better bubble candidates. One might be able to argue that in the short term, both growth and inflation will be negative, thus the equilibrium nominal short-term rate should probably be negative. But longer term, we'll eventually have both growth and inflation, and thus long-term Treasuries should not be approaching Japanese-like levels.

So when the 10-year was pushing 2%, it felt bubbly. But still I resist the bubble label. To me, Treasury rates are clearly below "fair value" but given the extreme liquidity and economic circumstances, I doubt the 10-year can move above 3% until at least 4Q 2009. I think long-term Treasuries remain over-valued until its obvious that inflation is going to eventually become a problem.

What about Treasury supply you ask? Won't the massive debt load eventually push rates much higher? While acknowledging that supply is an obvious negative for prices always and everywhere, as it is, Treasury supply is clearly not overwhelming demand. The 3-year and 10-year auctions from last week went quite well.

Besides the theory that government debt crowds out private investment doesn't hold water right now. Private lending ain't happening in areas where the government isn't subsidizing. In essence, the Treasury is leveraging because the private sector can't.

Eventually, the Fed's programs will result in much higher inflation, and thus Treasury rates will rise substantially. But I think this is a year or more away, too far away to recommend a short.

The problem for real money investors is that Treasury yields are so low, that you pretty much have to own something else. The yield advantage on short-term Agencies versus short-term Treasuries is so large that there isn't any logical scenario where the Treasury outperforms. Therefore I'm playing this by remaining underweight Treasury bonds, but owning stuff that can appreciate if Treasury rates fall. This includes bullet agencies, and some very high quality corporates.

TALF: Quicker, easier, more seductive

The Fed has expanded the Term Asset-Backed Loan Facility (TALF), which AI first discussed here. Here is the quick recap of the facility.

1) Fed will loan funds for purchase of recently issued ABS. This was clarified to mean ABS issued after January 1, 2009 made up of loans no older than October 2007. The ABS must be rated AAA, and be made up of student loans, auto loans, small business loans, or credit cards.

2) Loans will be non-recourse and not marked-to-market. The borrower will not have to deal with margin calls due to price declines.

3) The loan term will be up to 3-years, originally was only 1 year. That is extremely positive for the potential success of this program. See below.

4) The loan rate will be set at "yield spreads higher than in more normal market conditions but lower than in the highly illiquid market conditions that have prevailed during the recent credit market turmoil." In other words, lower than the rate paid on the asset.

So what has the Fed done here? Created an easy arbitrage. All investors have to do is do accurate credit work, and this is a guaranteed profit. Note that the 3-year term seals this thing. 3-years is basically the entire life span of most eligible collateral, so it eliminates the last thing an investor needed to worry about. Given a 1-year term, investors would have worried that the end of 1-year, new financing might not be available. But by the end of 3-years, the asset will be all but gone.

Also through this facility, the Fed can really control consumer lending rates. The rate on newly issued AAA ABS will be stuck at a level slightly higher than the Fed's lending rate. Banks which are currently hoarding cash will fall over themselves to buy ABS and pledge them into this facility.

Now don't read this as especially bullish for the overall economy. I still see this as a facility intended to aide in quantitative easing, and not a "fix" for the recession. Or put another way, a means of preventing the economy from getting still worse. But as far as ABS go? Should get that market rolling again.