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Batter Up!

Friday is shaping up as a very interesting day!

Initial Claims today came in as expected, 439k (440k expected), with last week revised up very slightly. This provided the last excuse any economist would have for changing his/her forecast for tomorrow’s data, and after ADP surely many of them wanted a good excuse. Goldman dropped its forecast from 275k to 200k; it appears that Deutsche is holding out for their 350k wish. Good luck with that.

Bloomberg attributed today’s equity rally (SPX +0.7%) in part to the “decline in claims.” Gosh, am I crazy or is that grasping at straws? A 1k miss from expectations (coupled with an upward revision to the prior week)? That news outlet also (and more plausibly) tagged the stronger-than-expected ISM report (59.6 vs 57.0 expected) as another reason for the equity rally, but I think my comment yesterday unconsciously identified the real reason: we made it past March 31st without the world coming to an end along with the Fed purchases.

Speaking of Fed purchases, how is that working out for them? The Federal Reserve was forced to reveal how its investments in Maiden Lane I (Bear), II and III (AIG) were performing, and more specifically what they own. The answer is that what they own you wouldn’t want your mom to own. Maiden Lane II is trading 44 cents on the dollar and much of it is CCC or CC rated; Maiden Lane III is at 39 cents on the dollar. Bloomberg didn’t have an estimate for Maiden Lane I, because it involves derivatives and they were unable to estimate the value.

The bottom line there is that the Fed will lose tens of billions of dollars on the Maiden Lane investments that we were assured fit the bill for what they were allowed to accept as collateral. On top of that, the Fed now owns $1.25 trillion of mortgage-backed securities on which they will end up with more tens of billions of losses especially once rates rise. If there was ever a threat to the survival of the Federal Reserve as a politically-independent agency, that threat is likely to come to a head over the next couple of years when those billions are reported – unless the FOMC manages to engineer a perfect landing for the economy (don’t hold your breath).

But back to the equity market for a bit. I saw on the TV today that Borders, a bookseller, was up 46% on better-than-expected sales. That sort of response to good news reminds me more of the turn-of-the-century bubble than of the fear-and-loathing of 2008. I assume that most of the positive variance came from sales of Atlast Shrugged and constitutional law books, but still…

June Note futures fell 7/32nds, with 10y yields at 3.87%. Crude oil reached 18-month highs over $85/bbl.

I mentioned earlier that ISM was stronger-than-expected. But, significantly perhaps (at least, when considered with all of the other days, the Employment subindex actually declined slightly (although it remained above 50). So let’s review the data we have to hand about the underlying trend in Employment. Initial Claims haven’t really done anything the last couple of months to suggest a significant change from the underlying 450k or so trend. The Consumer Confidence “Jobs Hard to Get” response hasn’t moved from its range. The Employment subindex of the ISM declined slightly. And ADP showed a contraction of the labor force.

What is leading to the high expectations (Consensus 184k, although that hasn’t been updated since the ADP figure and probably is more like 125k or 150k) is a general sense that economists have that the economy must be improving by now, plus some notion that there should be “payback” for last month’s miss which was considered to be due to the weather.

Maybe so. Last month a million people said they had a job but couldn’t work because of the weather. Some of that is normal but that was much higher than is normal. As I discussed last month, though, we have no way of knowing how many (if any) of those people would have been counted as employed but were not. Remember that many of them may have appeared as employed anyway, if they were able to work as little as one hour that week. A single hour.

Lots of other indicators last month showed improvement, so there is doubtless something positive going on; moreover, this month 75,000-100,000 Census workers will be added to the rolls so the null hypothesis here should definitely be for something positive. A negative print would be a massive shock. Expectations are for the  Rate to remain unchanged at 9.7%.

The bond market is clearly under some pressure, but there is now quite a bit of risk in both directions. The ADP report changed the complexion of tomorrow’s data. With the bond market scheduled to close at the crazy hour of 11am and the equity markets closed, the prudent thing to do is to go into tomorrow with no exposure. There is considerable risk on both sides.

But what if you have slight exposure, but are short gamma? If you are long mortgages, and rates rise above 4% or so, you are going to be getting longer the market as those mortgages extend in duration. Who is long those options, to provide the delta to those people who are short? A friend of mine with experience in MBS tells me there is no “magic level” at which the MBS extensions really start to ad lots of duration to the market, but it appears that long-mortgage accounts will have a general need to shed duration once rates are above 4% or so. Tomorrow’s number could easily vault us there is Deutsche is even in the ballpark of being correct.

There is, in short, a lot of risk headed into tomorrow.

All of this will be made more interesting by the thin market conditions. Several years ago, people would have faded the “tail” of the move in these kind of markets, providing liquidity to a market that wanted to overshoot, in expectations of making abnormal rents by doing so. After the crisis, the desire to do so is no longer as strong (and, it should be noted, under the Volcker rule the number of accounts able to provide that speculative liquidity would be greatly reduced). So Friday is likely to be more-interesting-than-normal, and I think will have big significance to the market trend for a while.

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