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Unidentified Financial Objects
Earthquakes in China! Volcanoes in Iceland canceling flights from Europe! Mysterious fireballs streaking across the night sky!
Maybe, just maybe, this is what finally ends the bull market in stocks: the End of the World. I knew there was something that could do it (perhaps perceiving this risk, stocks only rallied 0.1% today).
Trend changes happen from time to time, of course, with no apparent trigger at all – at some point, the portfolio of potential risks simply begins to outweigh, at the current price, the prospects for future gain. The portfolio of risks for stocks as well as bonds continues to grow; for stocks, after earnings season, we will actually add the new worry “next quarter may not be as rosy” but in the meantime here is a small list of worries:
- How long can the Treasury keep selling debt at a pace of a couple trillion per year (1+ trillion in new money)
- How much will the Volcker rule reducing liquidity (you know, it’s quite difficult to merely cross a block trade of 20 million shares without taking some prop risk. I’m just sayin’),
- Greece/Portugal/Ireland/Italy/Spain
- The prospect of higher taxes next year
- A Fed error: tightening
- A Fed error: not tightening
- Commercial real estate
- The unemployment rate
- The fact that the GSEs are increasing their combined debt again (FNM+FRE debt at 1.6 trillion at end of Feb, 1.67 trillion now, a few months after Congress removed the cap on the guarantee)
- Technical resistance on major stock indices (see Chart below, source Bloomberg)
- Frickin’ exploding mountains and UFOs
Resistance? Weak, but one more worry
Although it is tempting, I won’t throw “Initial Claims” in there, because although the 484k today was 44k above expectations, and looks suspiciously like Claims is just oscillating in a range between 450 and 485k (see Chart below, source Bloomberg), the BLS says that last week’s surprise and this week’s surprise are both due to Easter week vacation distortions. If that is true, then over the next couple of weeks the combined 60-65k surprise will be unwound. If we do not see a 3 handle, or at least low 400s, then we can revisit then.
Sure looks like noise, but we ought to know soon.
The rest of the data was strong enough. Industrial Production appeared weak at +0.1%, but that was mainly due to a plunge in utilities output. Factory output, which is the piece we care more about, was +0.9%, which is a healthy rise. Empire Manufacturing, too, was strong (31.86 vs 24.00 expected), although it’s a volatile series, and Philly Fed was as-expected at 20.2. the NAHB Housing Market Index rose to near recent highs, which isn’t of great importance but Housing Starts is tomorrow.
Rates fell slightly, with 10y yields down to 3.84%, but interestingly inflation swaps rose: 1y CPI was +9bps and 2y was +6bps. That’s a big move in a quiet market. Maybe that’s another concern. Although for my money, I’m going with frickin’ UFOs.
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An update on a prior commentary:
On March 28th I wrote a piece about the current value in long TIPS (link here) in which I noted that in the long run, real GDP-per-capita grows at around a 2% pace; so therefore should corporate earnings if they are a consistent share of the economy; and therefore so should stock price indices. In the January/February Financial Analysts Journal one of the authors of the original observation I was updating – Bradford Cornell – concluded that over the long run, investors should anticipate real returns on common stock to average no more than about 4 percent, which was approximately 2% real growth plus dividends. But he said something else that is interesting since some of the comments I received after I wrote that piece suggested that there were biases I was missing (which if true would imply higher returns for stocks…no one argued for lower). Cornell points out a bias that works in the other direction. According to his summary in the CFA Digest, “…in the long run, real earnings can grow at a rate no faster than real GDP. Those real earnings, however, are the real earnings for the economy as a whole. The real earnings growth that existing investors can expect may be less because of dilution that occurs when new shares are issued, primarily by start-ups.” Good point.
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On Friday, the increasingly-optimistic consensus (that may be another worry?) pegs Housing Starts at 610k, rising from 575k. As I have pointed out on occasion, 600k is a significant level for this series to exceed, but a far cry indeed from the old levels over 2mm units per year prior to the bust. Also out tomorrow is the University of Michigan confidence index (Consensus: 75.0 from 73.6); the forecasts would represent a high for the recovery to date.
I don’t see any proximate triggers for an equity selloff, or for that matter for a bond selloff. But I don’t think the risks are balanced. I believe that for very different reasons, the tail risk on both of them is to lower prices. I can argue higher-price scenarios for both of them, but I just don’t find them plausible. But who knows, if the Men In Black come and flashy-thing me, I might just forget all my worries and learn to love the rally.
Rotten Only At The Core
The financial news networks are abuzz about earnings, but for me the focus is on the fact that Core CPI matched the lowest year-on-year core reading in 44 years, as it printed flat and +1.1% y/y. Now, when Core hit that level a few years ago, as I have discussed previously, it was more of a concern because Shelter was actually biasing the number higher; for all of the angst we will hear about deflation threat this time around there really isn’t much of one. Core inflation, ex-housing, is still +2.5% year/year, a bit down from the highs but still well above the +1.6% of last January and still clearly rising. The scary spike may have passed, though about 57% of the core-ex-housing index is still rising faster than 3.5%, including core Transportation, Medical Care, and Other Goods & Services. Going slower than general core inflation? Only Housing, Recreation, and Apparel…and these latter two are only about 12% of the ex-Housing core.
Still, the downward pressure on core inflation, which is coming largely from housing, ought to be ebbing soon. The model I follow perceives pressure into early Q4, but the low could come as early as next month when the y/y number ought to drop simply because the +0.25% print of April ’09 print exits the data window. That might even push core inflation below 1% as measured.
The Cleveland Fed Median CPI, which is normally a superior measure to the core CPI but also suffers from the “Shelter bias,” is already at +0.6%.
Less important than what these screen prints imply for future inflation – which is to say, not very much, since they are polluted by the bubble unwind – is what they imply for monetary policy. There is, in my mind, almost no chance that the Federal Reserve will tighten policy while core inflation is under 1% (even if that’s not the right measure) and at 44-year lows at the same time that unemployment is over 9% and still near 80-year highs. It just isn’t happening.
The Chairman, of course, can’t say that, and so he and the Committee need to make it sound as if they are very focused on the mission of restraining inflation. The forward inflation curve, as I noted a few days ago, doesn’t entirely believe them, but so far they have an amazing amount of credibility considering that it’s hard to figure out how the country survives this amount of debt without at least a modest amount of inflation…unless, of course, Congress balances the budget (ha! ha! ha!).
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Speaking of Congress, I saw today that some chucklehead on the Hill has proposed a bill to prohibit airlines from charging fees for carry-on luggage (as a discount airline recently proposed). I might have missed that day in Civics class, but what exactly is the State’s compelling interest in carry-on luggage fees? For myself, I could care less whether there are luggage fees or not, because it isn’t like having them (or not) will change the cost of air travel on average. It will just change how those costs are distributed, and if it gives me another way to potentially avoid my share, then bully for me. But it does frighten me that anyone in the Legislative branch perceives that the government has anything to say about how a private business in a competitive industry charges for its services.
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The soft inflation numbers, strong Retail Sales figures (+0.7% ex-auto, with an upward revision to last month), and jubilant Intel earnings gave equity shorts no chance. S&Ps ended +1.1%, with TYM0 -9.5/32nds and the 10y yield at 3.86%. Tomorrow, Intial Claims (Consensus: 440k) are expected to retrace last week’s jump to 460k, which was quite a buzzkill for those expecting robust growth. Consensus estimates for Empire Manufacturing are at 24.0 (vs 22.86 last month), and Industrial Production and Capacity Utilization (Consensus: +0.7% and 73.3%) are also expected to be strong. The Philly Fed index anchors the list of important releases (Consensus: 20.0 from 18.9), but also keep an ear out for Volcker at 3pm. He is speaking on Financial Risks, and my guess is that he’ll say we should solve that problem by stopping banks from trading. It will help the Administration to have the former Chairman paint a scary picture of the risks, so that’s what I expect to hear.
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The Fed’s weekly H8 report released several days ago showed that bank credit had jumped nearly $400bln in the week ended March 10th. If this was a legitimate jump, it would be a huge development as it would indicate that banks were suddenly lending. Alas, it turns out that the rise in total commercial bank credit includes $377.8bln that are merely off-balance-sheet vehicles coming on-balance-sheet and being included in reports to the Fed. According to a note in the Fed’s H.8 report:
As of the week ending March 31, 2010, domestically chartered banks and foreign-related institutions had consolidated onto their balance sheets the following assets and liabilities of off-balance-sheet vehicles owing to the adoption of FASB’s Financial Accounting Statements No. 166 (FAS 166), Accounting for Transfers of Financial Assets, and No. 167 (FAS 167), Amendments to FASB Interpretation No. 46(R). Domestically chartered commercial banks consolidated $377.8 billion in assets and liabilities.
I point this out so that, if you read somewhere about the huge jump in commercial bank credit, you won’t get super excited. The chart below shows that bank credit is still contracting at previously-unprecedented rates on a year-on-year basis (source: Federal Reserve; green area is corrected for the discontinuity caused by the conversion of Morgan Stanley and Goldman Sachs to bank holding companies).
Bank Credit continues to contract; recent jump was caused by definition change
So I will amend what I said above, to strengthen the conclusion: the Fed isn’t about to start pulling back when every indication of Keynesian stress is absent and credit continues to contract while the FOMC still has pedal-to-the-metal. It isn’t necessary that they do so for rates to rise, however.
They May Cancel My Subscription, But…
“Never underestimate,” said Gene Epstein in his column in Barron’s last week, “the power of nonsense to move the market.” And he should know.
Epstein, as an economist, makes an adequate journalist. I generally skim his columns for amusement purposes; with plenty of Wall Street economists out there who have even less excuse to be plain wrong as much as they are, it doesn’t usually seem worthwhile to pile on the guy. But over the last few months he has gone on and on and on about something he believes he has figured out that everyone else is oblivious to. He argues that the continuing decline of consumer credit isn’t worrisome at all, because it confuses a stock with a flow. But, says Epstein, we shouldn’t worry about the decline in credit, which can be from paying off loans or defaulting; only the new loans matter because those are the ones being used to buy stuff.
It doesn’t seem to occur to Epstein that while thousands of economists over a period of decades can certainly be wrong, you ought to have a really compelling reason that people don’t get it. In this case, he’s just spewing nonsense.
Consider a person who uses his credit card to buy a new computer for $1,000. The next month, he can do one of two things: he can pay off the credit card, or he can spend that $1,000 (that he would otherwise put toward that balance) on something else. Choosing the latter is clearly the same effect as paying off the credit card and then borrowing $1,000 to buy something new, whereas in the former case, the $1,000 does not get spent but saved. That is the only choice for each dollar: save, or spend? It is easy to see that if there is more saving (or less dis-saving), spending is higher, all else equal. [Note that I am not making the value judgment about whether this is a good habit. My own attitude is more along the lines of this all-time classic skit from Saturday Night Live: Don’t Buy Stuff You Cannot Afford.]
Epstein asserts that we should ignore the retirements of debt and only focus on the new loans. But as I just pointed out, keeping an outstanding balance produces the exact same result that paying the balance off and taking out a new loan does. There is no difference. Epstein gets confused because he thinks of the “debt pay-downers” and the “new borrowers” as different people, which of course they usually are. But the changes in the stock of savings, net of debt, is what matters to consumption…whether it is one person doing the saving and borrowing, or millions.
Now, a decline in credit isn’t bad per se, especially in the long run. Increasing societal savings tends to lower the real cost of capital for productive enterprises (which capital comes of course from savings, since savings is necessarily equal to investment). And a lower real cost of capital for productive enterprises tends to lead to greater growth in the long run…which is, incidentally, why deflation is such a bad thing. So I am not arguing that we shouldn’t be paying down debt. Indeed, if the government sector keeps borrowing then our private borrowing will continue to be crowded out anyway and I think that is partly what is happening. But Epstein’s tortured explanation about how a decline in credit doesn’t imply lower private consumption (all else equal) is just wrong.
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Bonds were surprisingly buoyant today. Some of that was due to early rumors that central banks were buying fixed income instruments, but technical factors came into play as well – since bonds have failed to break down, for now at least, some of the bid was doubtless short-covering as TYM futures moved to the highest level since March 24th (+10.5/32nds, 3.81% 10y yields). There may also be some incremental nervousness about the CPI data due out tomorrow; the memory of the negative core print two months ago lingers.
That being said, the fear of another weak core CPI print (the consensus calls for +0.1% on headline, +0.1% on core) doesn’t seem to linger much among TIPS investors, who have pushed 10y breakevens back above 2.30% and 10y inflation near 2.70%. One-year CPI swaps are at 1.30%, near the highs of the last year (see Chart below) and probably giving some credit to the possibility of a lower near-term core print.
Personally, I think the consensus estimates for CPI are about right, with risks symmetrical around the core at +0.1%. Those prints would make the year-on-year CPI rise to +2.4% from 2.1% and the core to drop to 1.2%, a new cyclical low and only a bit above the 44-year lows at 1.1% (reached in 2003 during the deflation scare). Of course, conditions this time are very different, with most of the deflation being caused by the unwinding of an asset bubble in housing, but lower readings in core CPI will give the doves on the FRB some further excuse to keep policy loose for longer. The disinflationary tendencies to core, even including housing, are exaggerated at the moment but I still don’t expect the bottom in core CPI to come until early Q4.
Retail Sales (Consensus: +1.2%/+0.5% ex-auto) is also due out tomorrow; the Beige Book and more Bernanke testimony will provide a little more grist for the mill of Wednesday’s trading. I remain bearish on bonds.
Is Time On Our Side?
A week away, and nothing has really changed. The 10y yield is still around 3.84%. Stocks are still going up (although the Dow broke 11,000! Yay! By the way, when did anyone start caring about 11,000?). Greece is still in trouble, and there is still a rescue package for them. Really, this time. No, seriously. This time they mean it.
An important part of trading is figuring out whether time is on your side, or working against you. Right now, if you are a bond bull then time is against you. Every week brings billions in further supply. Every week that the data doesn’t start to roll over decreases the chances that we will have a double-dip recession and increases the chances that banks may begin to divest Treasuries in favor of making loans. Every week gets us closer to the day when the Fed hikes rates modestly, and the bond market overreacts. Every week brings us nearer to the day when some central banks start pulling back on liquidity, hurting all asset markets (and with some chance of a discontinuity in some of them).
To be sure, I don’t think that we need a strong economic recovery to produce higher interest rates. The monetary pressures on the global economy are all towards higher inflation, and those pressures will produce inflation at some interval. Right now, monetarists are selling bonds to Keynesians. All that economic strength (or just a pause in the sequential blow-ups) would do is cause those Keynesians to turn around and sell the bonds to…whom?
The market looks somewhat confused – except for equities, of course, where investors are often wrong but never in doubt. The zero-coupon inflation curve has a peculiar shape in that the curve of 1-year inflation forwards (1year inflation, 1 year forward; 1 year inflation, 2 years forward, etc) is upward sloping until 1-year inflation, 7 years forward. At that point, the curve projects 3.15% every year from the 8th year onward. Almost exactly (see chart below).
This is a rather peculiar shape.
I am not correcting here for convexity, but there isn’t broad agreement on which way that should bend the curve, anyway. I can’t decide if this illustrates that the market is pessimistic, that the Fed is going to let inflation slip up that high, or optimistic that the Fed won’t let inflation get out of hand. I rather suspect that investors aren’t sure either.
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There are lots of reasons to be skeptical of the linear stock-market rally, but low volume isn’t one of them. An article I saw last week, during my vacation, (here) suggested that the rally has weak underpinnings because of the low volume. This is one of those times when the “art” of technical analysis is supposed to trump whatever science its practitioners claim for it. Volumes are lower, and will stay lower I suspect, because high-speed trading and market-making is being actively discouraged by regulators and the Administration generally. Most of the volume that we see these days – and one reason that volume has been losing its value as an indicator anyway – is scalping. If you lift the high-speed trader who in turn tightens the bid or lifts the better offer, double the volume trades although liquidity was only demanded once. This exaggerates the volume statistics. Moreover, the very low cost of trading, as reflected in tight bid-offer spreads, leads to more trading since it lowers the cost of hedging and makes more-frequent hedging more feasible. As bid-offer spreads widen, because of building momentum for the “Volcker Rule,” then volumes will naturally decline as a symptom of the lower liquidity. These are not per se bearish developments. Although I have argued that lower liquidity implies lower stock prices over time, by itself this is no reason to become bearish if you weren’t already.
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I tend to use vacations to catch up on reading, as much as I can with two young children. And wow, did I read a great book last week. Richard Bookstaber wrote a book in 2007 called A Demon of Our Own Design: Markets, Hedge Funds, and the Perils of Financial Innovation
The specialists at the NYSE tried to elicit more buyers by dropping the price, but there was a limit to how much more buying interest they could attract. No matter how quickly the price was dropped, the decision making by the equity investors took time; unlike the twitch-quick futures pit traders, they made portfolio adjustments only after reasoned consideration. With their limited capital, the specialists were not willing to wait for the process to unfold, and their increasingly aggressive offers ended up backfiring. Prices dropped so violently that many potential buyers started to wonder what was happening and backed off completely. (page 20)
Bookstaber also has a number of observations about liquidity providers and the importance of liquidity providers that are very poignant today, as the Administration considers rules designed to make “proprietary trading” (also known as providing liquidity by substituting time for price) more difficult.
Liquidity providers provide a valuable economic function. Their business is to keep capital readily available for investment and to apply their expertise in risk management and market judgment. They look for instances of a differential between price and value, and as they trade to exploit that differential, they provide liquidity to the market. in short, they take risk, use their talents, and absorb the opportunity cost of maintaining ready capital. For this, they receive an economic return.(page 214)
In a very interesting analogy, Bookstaber argues that liquidity provision not only has direct economic value (look, he says, at the difference in price between two instruments that differ only in liquidity, like on- and off-the-run bonds, and you can see there is an economic consequence to illiquidity) but also a social value: “It provides economic freedom. It allows wealth to be accessed and used to take new opportunities.” And to demonstrate this, he reaches back to medieval England where there was no liquidity for wealth (because land could not be transferred).
Now, this book was written before the latest crisis, and as such it is well worth reading in light of what has happened and some of the knee-jerk responses that are resulting. In fact, he predicts some of those responses (although he figured they’d come after hedge funds, and instead they came after Wall Streeters themselves), but argues very persuasively for the importance of the economic function that these weasels provide. “But blaming hedge funds is a bit like The Simpsons episode in which a meteorite hits Springfield and the townspeople gather, shouting, ‘Let’s burn down the observatory so this never happens again!'”
In a nutshell, he argues that crises – such as the one that was about to happen when the book was published – stem from a combination of two factors: market complexity and tight coupling. Market complexity, which increases with more regulation rather than decreases, means that not only are there known unknowns, but there are unknown unknowns and, moreover, the market’s response to these unknown unknowns, when they happen, is not necessarily linear. And tight coupling means that there is no release valve; things happen too fast to figure out what to do next. In talking about crises, he draws an analogy to other disasters, like Chernobyl and the ValueJet crash in Florida a few years ago. It makes for compelling reading. I wholeheartedly recommend this pre-crisis book to anyone who is trying hard to understand the crisis in retrospect, and who thinks they know how to fix the problems at hand.
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There is no important data out tomorrow: Trade Balance for Feb, Import Price Indices; Chairman Bernanke speaks in the evening on financial literacy, which is probably not market-moving anyway, but Richmond Fed President Lacker is going to be talking about the economic outlook. These speeches seem to move the market less than they once did, since we all figure that the Fed will tell us well in advance before they do anything, but there really isn’t much else on the docket. On Wednesday, we will get CPI…but I’ll talk about that tomorrow.
Saved By The Bell? Maybe Not.
It is on days like this that I realize just how little most of the investing world cares about fixed-income. To be sure, the big investors and the smart ones (despite popular opinion, there is some overlap between these sets, but perhaps not as much as we might like) care about bonds, and of course they should – and especially inflation-indexed bonds, since the investor’s fundamental goal is to maximize real after-tax wealth over time subject to risk appetite. But people still think stocks are the sexy asset. Evidence: CNBC barely bothered to broadcast today; it carried the Employment number and then turned away from news and toward “interest programming.”
Probably, no one will read this comment. My Friday comments never get read as much as comments the rest of the week, which is one reason I often delay publishing them until Sunday. In this case, however, I will be on vacation in the Cayman Islands come Sunday, and for the next week, so whether anyone reads it or not, here it comes:
The Employment data was not too far from expectations, especially when revisions are included (quite far from Deutsche Bank’s expectations, but not from most economists’). The Payrolls figure of 162,000 new jobs was pretty close to the ~180k consensus, and there were upward revisions to prior months. Now, while the headlines all weekend will trumped the strongest jobs growth in years, a fair reading of the numbers would temper enthusiasm somewhat. First, part of the jobs growth in the last two months has obviously been due to the hiring of Census workers, a temporary chore. In February and March combined, the Census Bureau added 63,000 workers. Moreover, it isn’t really fair to look at just March, which contained the weather snap-back, without considering February’s weather-dampened data. Averaging the two, net of Census workers, gives us a whopping 42k new jobs per month of underlying jobs growth. Certainly, that’s better than we had last year, but nothing to write home about – it’s still quite a bit less than the number needed to keep the Unemployment Rate stable over time. Indeed, the Unemployment Rate just missed an uptick, moving to 9.749%.
Internals to the data confirm the overall sense: this represents a modest, but very modest, improvement over recent trends. There is certainly nothing there that suggests the recovery is suddenly igniting in the way recoveries tend to. Normal recoveries, that is.
The bond market traded down on the number, fairly aggressively. What I read into that, despite the thin conditions, is that the bears are in control: no one seemed to want to dig into this at all to see if there was much to it (and there isn’t anything very exciting or surprisingly-strong, at least, to trigger such a move).
I am in the same camp. While I think the feeling that seems to be growing again that there are “green shoots” in this economy – maybe that happens every spring – are going to turn out to be disappointed, I am not bullish on bonds. As I have written here recently, I am bearish in the near-term as I think we’ll go through 4% on 10 year yields fairly easily now. The market closed with the 10y at 3.95%, so that’s not a big call – we may have gotten there today if the market hadn’t been scheduled to close at 11:00 ET! There are other support levels nearby, including a very big one that I think stands a decent chance of giving way. I have been using the chart below for years to argue that the secular bull market was still in place. Plotted are 10-year Treasury yields, monthly close, on a logarithmic scale (such long-term and large-scale moves usually need to be on log scale. The upper end of that channel? Right now, the line is at 4.14%.
The Big Test Comes Soon
As I said, there are some near-term support levels for the market, including 4% and that 4.14%. But we are also in a period that is very challenging for market bulls anyway. In 18 of the last 29 years, 10-year yields have risen in the 30 days following April 2nd, by an average of 14bps (the average includes the rallies as well as the selloffs. The average move, conditional on the fact that there was a selloff that year, was 32bps). See Chart below.
Tailwind To The Bearish Case
What is the driver, if it isn’t that there really are “green shoots”? Well, additional Treasury supply doesn’t hurt. But, while the recent plunge in the growth rate of money and credit numbers (see Chart below, source Bloomberg) may be good for inflation expectations in the long run…with a whole lot of caveats to that, by the way, which will make for a column another day…they are not very supportive of asset markets. Money’s gotta come from somewhere to buy assets.
If Assets Are Going Up, Where Will The Money Come From?
As noted above, I am out next week on vacation, and I will not be posting commentaries from the beach. I’ll return with something fresh to say. Maybe.
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.
