Citi Shouldn't Sleep

Credit default swap spreads have come in for all banks since hitting their wides at the beginning of March. Most spreads are trading close to the pre-Lehman levels of last summer. Not great, but a great improvement as it reflects a general easing of financial counterparty concerns that is also evident in two-year swap rates trading around 40 -- a respectable recessionary level.

The main exception is Citi. As the chart below from Bloomberg LP illustrates, 5-year CDS is well in from the wides of March, to 350bps from around 650bps. Improvement, yes, but the spread is still trading wide to its year-end 2008 level let alone where Citi CDS spreads traded before the Lehman affair. Credit markets have improved but holders of Citi debt are still willing to pay up for insurance against default.


t default.

Krugman's Inlfation Scare

Mr. Krugman writes in the Times today on whether all that is being done today creates an inflation problem tomorrow. Basically it comes down to two things -- how bad is the economy really (short deep recession or prolonged weak growth) and how does the Fed/Treasury handle the unwind when the recovery comes. On the first point, I think the jury is still out in the sense that in 1980 we had a similar spasm when credit controls were put in place and a quick bounce, only to be followed by a deeper recession that broadly impacted the nonfinancial sector. We probably aren't Japan in the 90s or the U.S. in the 30s but on the other hand it takes a long time for recoveries to take hold, witness the rebound post the 90-91 recession and the 2001 turndown. As to the second point, if Greenspan's Fed is any guide (no reason it should be but it is the only recent guidepost we have) the Fed will stay too easy for too long.

I think Krugman hits on the head, however, when he writes:

But does the big inflation scare make any sense? Basically, no — with one caveat I’ll get to later. And I suspect that the scare is at least partly about politics rather than economics.

First things first. It’s important to realize that there’s no hint of inflationary pressures in the economy right now. Consumer prices are lower now than they were a year ago, and wage increases have stalled in the face of high unemployment. Deflation, not inflation, is the clear and present danger.

So if prices aren’t rising, why the inflation worries? Some claim that the Federal Reserve is printing lots of money, which must be inflationary, while others claim that budget deficits will eventually force the U.S. government to inflate away its debt.

The first story is just wrong. The second could be right, but isn’t.

Later he writes:

Now, it’s true that the Fed has taken unprecedented actions lately. More specifically, it has been buying lots of debt both from the government and from the private sector, and paying for these purchases by crediting banks with extra reserves. And in ordinary times, this would be highly inflationary: banks, flush with reserves, would increase loans, which would drive up demand, which would push up prices.

But these aren’t ordinary times. Banks aren’t lending out their extra reserves. They’re just sitting on them — in effect, they’re sending the money right back to the Fed. So the Fed isn’t really printing money after all.

The chart below underscores Mr. Krugman's point --



Last point -- is inflation only what the CPI and GDP deflators say it is?

Stock Market Performance & The Misery Index

The combination of easy monetary and fiscal policies has never been kind to equity market performance, at least in the post-war. By performance, I am looking at the ratio of the Dow Industrial Average to GDP. Since 1947 the mean and the median have averaged 0.76 but averages, as Mark Twain noted, are as useful as having your head in the oven and feet in the ice box and saying the average temperature is 72 degrees. This ratio fluctuates and has trended up or down for extended periods of time (see chart below).

Equity market performance is being measured as the DJIA divided by GDP because this ratio is the reason why money with an investment horizon approaching infinity invests in equities versus bonds. Bonds will return the coupon but the stock market will return the economy's growth. Investment horizons less than infinity make this investment tactic a bit problematic, as we have seen in the past few years. Consequently, if one believes we are entering or are already in a period when the equity market underperforms the economy then a large equity allocation doesn't make much sense.

As for what causes longer-term trends in the ratio, the Misery Index (unemployment rate plus the year-over-year percent change in core CPI) seems to be a fairly good indicator -- a negative correlation of -0.79. As for what drives the Index, it seems to be periods of tight versus easy macroeconomic policy. The era of tight macro policy that began on a Saturday night in October 1979 ended during the fourth quarter of 2001 when the dot.com bust recession collided with the beginning of the war on terror. If you believe we will be in the current easy policy mix for the foreseeable future, and it has hard to see how we won't be, the equity market will have its ups and downs and perhaps even more ups than downs but relative to economic growth the overall market will underperform.

Ten-Year Treasury Yields -- Back To 2.5% Before Year End

Here is a quick look at the bond market sell off (yields rise / prices fall) that has been the trend since the year began. Without getting too deep into the technicals, the yield rally has about run out of steam. Before the year is out it would not surprise me to see 10-year yields trading around 2.5%. Now I know that runs counter to the fundamental information that is in front of us, but more often than not the fundamentals eventually validate the technical outlook. Just to underscore the technical view, here is a longer-term weekly chart --


Bottom line, and there are a lot more techincal indicators I could confuse you with, but it is way too soon to call an end to the bond market rally that began in 1982. Do I believe the long rally is coming to an end? Absolutely yes but it is best to recognize when market is in a counter trend move and not get too far ahead of the technical picture. In other words, let's get technical confirmation of a long-term trend change in yields before betting most of the ranch on a rush to higher bond yields.

Crude Oil Prices Since 1861

Oil prices have an impact, no doubt, and the above chart attempts to show the impact against the broader scope of history. There are two ways to gauge the impact of an increase in prices, the real dollar level and the rate of increase in nominal terms. To do that I charted the average annual price since 1861 in 2007 dollars and the nominal price against a log scale.

In real dollar terms, the 2008 annual average of $97.26/barrel was the highest since the $107.38/barrel average set in 1864 ($93.08 in 1980). From a rate of change perspective the run ups during the Civil War and during the past couple of years were about the same. Neither period comes close to the rapid increase in the 1970s. That hit to the economy was much more devastating. We were paying an historically high price last year but coming from where oil prices were the economic impact wasn't nearly as great as when suit lapels were ridiculously wide.

The reason for bringing this up is that oil is back on the rise and while the increases have been modest to date the price of crude will accelerate to the upside within the next 6 months. There will be lots of talk about the real level being so high but because prices will be rising from current levels the negative impact on the economy will not be as great as the high price would indicate. Still, higher prices are higher prices and so this seems a good time to buy a hybrid car.

Ford's Tombstone For Wall Street

Too small for most of you to read, my apologies, so let me list the managing underwriters: Blyth & Co., First Boston, Goldman, Kuhn Loeb, Lehman, Merrill Lynch, White Weld. In the next line are bulge bracket firms: Eastman Dillon, Glore Forgan, Harriman Ripley, Kidder Peabody, Lazard Freres, Smith Barney, Stone & Webster, Union Securities, Dean Witter. Among those in the next category of underwriters: A.G. Becker, duPont & Co., Alex Brown, Hayden Stone, L.F. Rothschild, and Salomon Brothers & Hutzler.

Aside from being an interesting bit nostalgia of a world gone by, the tombstone is also reminder. Wall Street firms have always failed and disappeared yet the business of intermediating funds in the capital markets has continued to grow because of the needs of the nonfinancial economy. As long as the nonfinancial sector is healthy, the financial side will reinvent itself and fulfill its economic role. We see this happening now.

Policymaker's rushing to save investment firms first to the neglect of homeowners where the problem was rooted will prove out over time to have been wrong headed. Hopefully the economic rules makers will take another lesson from the tombstone -- lots of smallish firms got done the underwriting of the biggest IPO to date. And not one of them proved too big to fail.

Inflation Expectations, Credit Spreads & The Dollar.

The above chart illustrates the breakeven inflation rate between the TII 2% 7/15/14 and the generic 5-year Treasury. Breakeven rate is currently 0.76%. That means that inflation needs to have that annual average over the next 5 years to make an investor indifferent to owning the nominal 5-year versus the TIP. If inflation is higher, the TIP is the better investment.

Breakevens are simply the market consensus on what inflation is expected over the coming 5 years. Considering all the talk about current Fed and Tsy policy leading to inflation, the bond vigilantes seem a bit less concerned.

True, the market is no longer pricing in outright deflation as it did post the Lehman bankruptcy but the inflation outlook, considering all the stimulus, is sitting well below the 2% breakeven inflation rate prior to the current downturn.

Interestingly, but not surprising, the pull back from the brink is similarly reflected in recovering equity and credit markets. Namely, depression pricing is out but no one is yet willing to make the bet on full recovery. If you are instead more upbeat on the outlook, there is plenty of upside left for investors in the credit and equity markets -- and TIPs are generally a good buy versus Treasurys.

While the market is not yet ready to price in recovery, the markets are still discounting 100bps of tightening by the Fed over the next 12 months. Go figure -- if inflation is less than 1% going forward count on the Fed staying right where it is. And if past is prologue, the Fed will be quantitatively easing long after it needs to. If you think, on the other hand, that the Fed might have to tighten to support the dollar think again. Not only won't they, a weaker dollar is part of the recovery program.

Financial Credit Spreads -- Back From The Brink Far From Normal

The above chart from Bloomberg compares the yield on a Goldman Sachs note -- 5.5% due 11/15/2014 with a generic 5-year Treasury.

Before the financial world imploded, the spread between the two was generally inside of 80bps. As things went from bad to worse the spread widened and seemed to be topping out at around 300bps until Lehman's bankruptcy shot the spread out to 855bp and the spread has been narrowing ever since. Narrowing but at 330bps, the pre-Lehman levels, and that seems to be about it.

Investors have obviosuly pulled back from an Armaggedon outlook to something a bit more routine, like a recession. Another way to look at this is that the financial system may now be relatively solvent but the system's exposure to the nonfinancial sector is keeping a few people from getting a good night's sleep.

Unemployment Claims In Relative Context

Today's report on unemployment claims wasn't particularly heartening and no claim here that the end to the climb is near. But all the talk about record levels is getting a bit ahead of the story. The chart above compares the level of claims to the level as a percent of workers covered by unemployment insurance. The rate (red line, left scale) is effectively 5.0%. During the 1981-82 recession the rate peaked at 5.4% and during the 1974-75 recession the rate peaked at 7%.

While this is the worst downturn since the 80-82 recession period, to claim record levels is to ignore the record level of employment and population. In sum, the economy has not reached the rate of unemployment of the earlier recessions yet alone rates suggestive of a depression. To get to 5.4% another 535,000 workers would need to join the claims line and to reach 7.0% about 2.7 million more workers would need to be displaced. From where I sit, odds of another 3 million people being thrown out of work (5 more months of +600,000) seem small.

Forward Thinking On U.S. Interest Rates

The table above, printed from Bloomberg, is a matrix of forward Treasury yields. Forward yields are derived from the shape of the yield curve and the shape reflects the market's expectation of what is to come by discounting what is known today. More specifically, it is where the market believes the Federal funds rate will be. This is especially true at the shorter maturities whose level and slope are almost entirely dependent on market expectations for what the Fed is going to do.

At present, for example, the two-year Treasury is yielding 83bp but it is priced to yield 1.75% in a year's time. From an investor's standpoint, assuming you are looking to park money in Treasurys for two years, you can buy the two-year at 83bp or you can buy the one-year and roll the money into a new one-year in one year's time. If you choose to buy the one-year at 42bp today and the one-year yield in one year's time is higher than 1.29% then you are better off buying the one-year and rolling at maturity. If the one-year is lower in a year's time, better off buying the two-year today.

In other words, if you want to make a buck bet against the curve one way or the other. And the curve today is assuming that the 0 to 25bp funds rate range will be over and funds will be trading at 1% in a year's time. I am not saying where the funds rate will be but it pays to know how the market is priced before deciding how to invest.

Geithner, China And The $

This from the WSJ today, a transcript of Secy Geithner's conversation with PBS's Charlie Rose last Wednesday -

Mr. Geithner: "But I would say there were three types of broad errors of policy and policy both here and around the world. One was that monetary policy around the world was too loose too long. And that created this just huge boom in asset prices, money chasing risk. People trying to get a higher return. That was just overwhelmingly powerful."

Mr. Rose: "It was too easy."

Mr. Geithner: "It was too easy, yes. In some ways less so here in the United States, but it was true globally. Real interest rates were very low for a long period of time."

Mr. Rose: "Now, that's an observation. The mistake was that monetary policy was not by the Fed, was not . . ."

Mr. Geithner: "Globally is what matters."

Mr. Rose: "By central bankers around the world."

Take this as background to today's announcement on Geithner's travel plans that I picked up from MarketWatch --

U.S. Treasury Secretary Timothy Geithner will go to Beijing, China, for talks with top Chinese economic officials on June 1 and 2, the Treasury announced Tuesday. It will be his first trip to China since taking office this year. Geithner hopes to strengthen U.S.-China economic ties "to promote stable, balanced and sustained economic growth in the two nations," the department said.

Remember also that President Obama had a private chat with Chinese President Jintao in London at the G30 on March 31. Remember again that earlier this year there was Joseph E. Gagnon's working paper (February 2009) "Currency Crashes in Industrial Countries: Much Ado About Nothing?"

LeCarre's creation "George Smiley" used to implore his spies to do their sums when they were faced with lots of clues and no conclusion. Doing my sums I strongly believe that the official Washington stance is that the coming upturn in the global economy is not going to include China creating massive imbalances by supporting its trade surplus with yuan sales / dollar buys. The U.S. can let the dollar depreciate against the Asian mercantilists the hard way (quick, volatile, downdraft) or the easy way (managed decline over several years) -- it is China's choice. Their policy is the reason they are holding too much dollar debt and they are faced with the consequences of their actions.

With the Yuan and the Yen allowed to rise free-market levels (expect the $HK peg of 8 to the US$ to break), the U.S. economy builds its recovery on exports and import substitution and some inflationary impact boosting asset valuations. This is not, as some would believe, the end of the U.S. economy. Quite the opposite, it is the beginning of a better balanced economy, domestic and global.

A strong currency matched up with a persistent trade deficit puts downward pressure on labor (see the falling wages /profit mix relative to GDP since 1982). With the dollar floating against the countries where the U.S. trade deficit resides, wages will reclaim some of their share of GDP. With a cheaper dollar and low interest rates, the corporate income that has increasingly gone to the financial sector since 1982 will be shifting back to the nonfinancial sector.

Yield Curve & Unemployment

There has been a lot of talk lately about the steepening of the yield curve, as if this is a bad thing. Even the Fed seems bent on keeping longer term yields from getting too high and aborting mortgage activity -- refinancing and otherwise. Truth is a steep yield is a necessary although not an entirely sufficient requirement for economic recovery. The curve is not a talisman, it works as a forecast of economic activity because it indicates whether banks are making money or not. When they are they lend and when they aren't they don't.

The chart above illustrates the historic interplay of Fed policy, the curve and unemployment. Before every recession the Fed tightens, the curve flattens until it goes negative and then the recession begins and unemployment rises.

Since 1982 it takes less and less of a rise in the funds rate to create a negative yield curve and not as negative a curve to tip the economy into recession. While the curve doesn't need to get as negative to send the economy into a tailspin it is taking steeper positive yield curves with a lower funds rates to get the economy restarted. Employment, as always, follows with a lag.

A good part of these dynamics of the past 30 years relates to lower inflation rates but a good part also owes to the increased and increasing indebtedness of the economy, corporate and household. It does not take much of an increase in high real interest rates to make leverage a burden and create the subsequent drop in activity. Conversely, with so much debt on the books and inflation low it takes a much longer period of low rates and a steep yield curve to get credit creation growing at the rate where an economic recovery can take hold.

The yield curve is finally steep enough to begin to turn the economy and put a cap on the unemployment rate -- if the Fed lets well enough alone. At this stage of a downturn, a market pricing in concerns about inflation and crowding out is a good thing -- it means investors are thinking recovery not depression. There is a whole cadre of healthy financial institutions ready to step in and fill the void left by the financial leaders of the past cycle. Still, every cycle since 1982 has taken that much longer for recovery to take hold and get unemployment back to pre-recession lows. This cycle will prove the same and more so. At least the bottom seems to be behind us.

Less Stress For Bank CDS

Given how today's markets were driven by leaks on stress tested capital needs, this chart from Bloomberg informs that the debt markets shared the optimism of the equity market. Although these charts from the Bloomberg aren't always the easiest to see the general slope of the lines are pretty clear -- CDS spreads have been narrowing since the end of March. Today, not surprisingly, saw a sharp drop in the pricing for bank CDS (BAC, C, JPM, WFC) . In particular C, whose 5 year spread closed at 439bp, it was 606bp on Apr 28. While some banks are perceived to have less default risk than others, namely JPM, all CDS are higher than they were last summer.

Markets are pricing to a risk/reward plateau that compensates fairly (in my opinion) for holding securities while waiting to see whether a recovery is underway sooner rather than later and to some forecasters much later than that.

Real Growth & The Real Cost of Money & Timing The Upturn

I have been using the above chart to indicate turns in the economy for a long time. Some definitions first since the chart may be too small to read the fine print. My definition of real commercial paper is the 90-day rate for nonfinancial commercial paper minus quarterly growth in nominal GDP. If the cost of carrying inventory is greater than the economy's growth money is expensive and visa versa. The real cost of paper tends to peak around the middle to end of the cycle and for the current period that seems about right.

Paper rates are coming down and by all indications the economic decline is slowing. I know all about deflation raising the cost of money but my measure is against nominal growth not price inflation -- which is a measure of dubious value. Main point is that the cost of money and the nominal economy have begun to move closer together and an upturn is closer than the consensus would have us believe. If you think the economists are all correct along with Soros Roubini et al, the capital markets are narrowing spreads and raising equity values. Not to levels suggesting robust growth ahead but to levels that are a fair risk/reward plateau to wait to see whether the upturn is coming or contraction continues into 2010.

Masters of the Universe Go Back To The Future

In the excellent tongue-in-cheek commentary in which Caroline Baum on Bloomberg excels she notes today that the days of the bond trader, specifically the government bond trader, may be coming back to its heyday of the 1980s. Back in this time of interest rate volatility and huge and growing budget deficits relative to GDP (kind of like today, but the Reaganites choose to forget all this) everyone was clamoring to be a primary dealer and get in on the action. Of course what is profitable today is not true about tomorrow and if there is one thing the "Street" knows what to do is over invest in some part of the market, go over the falls with it, and then reinvent itself in order to get back to earning the margin that pays for the bankers yachts. She writes:

"Even as banks swallowed up other banks, events were conspiring to reduce the allure of primary dealership. The availability of brokers’ screens to non-dealers increased transparency and chipped away at bid-ask spreads. The Japanese invasion of the 1980s -- first as investors, then as primary dealers -- disrupted the cushy franchise of dealers, who socialized with one another and were known to get together to “coup” an auction (collusion by any other name).

Feast or Famine

Electronic trading increased liquidity in the market, making it cheaper and easier to buy and sell plain-vanilla Treasuries. Customer business became a loss-leader for primary dealers, many of whom reinvented themselves as proprietary traders to justify (and underwrite) their existence.

By the time the federal budget swung into surplus in the late 1990s, there were still 37 primary dealers sitting around picking their noses, worrying what they’d do in a world with no Treasury bonds. (Don’t laugh: This was a real concern, especially for the Fed in its conduct of open-market operations.)"

I remember lots of government salesmen and traders losing their jobs between 1987 and 1991 and, in fact, the late 1980s was the peak of broker/dealer employment in NYC. The Street recovered and employment grew as the firms found that next best thing -- high yield followed by securitization -- exploited it and eventually overinvested in labor and capital. So as firms go over the falls with the implosion of securitized markets, they are ready if not already deploying capital into the next best thing. Ms. Baum writes further --

"In a curious twist of fate, the Treasury finds itself facing monstrous financing needs with only a handful of primary dealers to underwrite the debt. . . . .

Back to Basics

The result has been a widening of bid-ask spreads, which means an opportunity to make money the old-fashioned way. The steep yield curve is an added inducement.

Dealers can buy, say, a 10-year Treasury note yielding more than 3 percent and finance it (borrow against the securities) at the overnight repo rate of 0.2 percent.

No wonder some broker-dealers are applying to the New York Fed to become a primary dealer. At least one dropout is looking for readmission.

Not only is it a good time to be a primary dealer, it’s a great time to be a bank -- assuming you aren’t one already. The Fed is practically giving money away to almost anyone that asks."

The Street gravitates to where demand is growing faster than inventory and both are growing rapidly. There is lots of Treasury inventory here with more on the way and lots of demand given all the cash on the sidelines and the return of a trade deficit once GDP turns positive. Further, because rates are so low the derivatives geniuses will now be figuring low cost ways to cover the downside risk once interest rates begin the inevitable climb. How about a product pooling longer-dated Treasurys and then breaking it up into tranches with different sensitivities to interest rate risk. Before everyone gets up in arms remember this -- the government must know that it can't put an end to this behavior at the same time that it is flooding the system with cash and debt.