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Oily, Easy, and Incumbents
It always confuses me when the market responds vigorously to the denial of a rumor that I hadn’t heard, or thought peripherally important at best. This morning, we came in to find the stock market aggressively higher because China’s central bank denied that it was thinking of selling it Eurobond holdings. I had heard this rumor late yesterday, but didn’t even bother mentioning it in my commentary because first, the market didn’t seem to react to the rumor and second, it is an absurd rumor – China can no more divest itself of Euros than it can divest itself of dollars, unless it wants to stop running trade surpluses as well (this is not to say that it must buy sovereign bonds with that currency, however!).
But it was enough: on a comparatively quiet trading day (it was only the 6th trading day this month with volume under 1.4bln shares; in April there were 18 such days) before a long weekend for Memorial Day, no one seemed to have the heart to sell. It was the biggest up day since the Monday after the “flash crash,” with the S&P finishing +3.3%. The economic data was no help, with Initial Claims still firmly in the range at 460k (a trifling amount above expectations), but Barton Biggs may have been.
Barton Biggs said that the stock market is ready to “pop” any day now because it’s “very, very oversold.” Mr. Biggs thinks that partly because at the top he was looking for another 10%, and we’re down 10%…so of course he thinks it’s oversold. “I wouldn’t be surprised to see us go to a new recovery high, just to make everybody squirm,” he said. Everybody squirm? It sounds like he thinks the market is short. The squirmers are the bulls right now, and at new highs I think the vast majority of investors would be dancing in the streets. After all, by definition in markets for corporate claims (bonds and stocks, as opposed to swaps and futures) more people are long than short. And how exactly do we get the rally of 2009-2010 if everyone was getting short? At least the people who think this is “panic selling” have it right that the market was net long to begin with.
There was also a bit of a sigh of relief when the Coast Guard reported the Gulf of Mexico oil leak has been at least temporarily plugged (BP, however, would ‘neither confirm nor deny,’ which sounds like the lawyers picked up the phone). I’m not sure that this should have much market impact, but it does remove something that could have been a potential negative down the road (if the leak stays plugged). The environmental damage is enormously tragic, but the long-term issue is really what the whole episode does to the future prospects of energy exploration. A friend of mine had what I thought was a pretty even-handed – and brief – analysis on the econo-political ramifications at his blog here.
I think it is unrelated, but energy markets jumped 3-5% today, helping to support inflation markets where breakevens were up 5-10bps across the curve. Most of that rise, though, was due to the beating inflicted on rates generally. The September 10y Note futures fell 27/32nds with the 10y note yield up to 3.34%. It didn’t help Treasuries that all three note auctions this week (2y, 5y, 7y) had tails, although the bid to cover ratios weren’t bad. I take that to mean probably that at these yields, bidders just wanted a little more cushion but overall demand seems adequate.
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If you need a reason to be optimistic about stocks and bearish about fixed-income over the next couple of months, consider that the mid-term elections are fast approaching and I would guess that no one on Capitol Hill is relishing going to the polls with Unemployment still over 9% and people staring a “second dip” of the recession right in the face. Both fiscal and monetary authorities are starting to ramp up already. There has been talk about another “mini-stimulus” bill of “only” a couple hundred billion dollars (son, I remember when a couple hundred billion was a major stimulus!), although I presume it would be enacted in a way to generate the most votes (targeted spending) rather than the most economic advantage (delay the huge tax increases slated for next year), and that means it is likely to be more spending to no good advantage. Of course, we haven’t seen the bill but are you confident it will be a good one that spends money wisely and well?
At the same time, I feel fairly confident the Fed will be trying to resuscitate the money supply. I have been surprised, and a little scared, that the central banks around the world have not only eased back on the monetary throttle but have applied brakes on the quantity of money. Year-on-year M2 growth reached 1.1% in March; while inflation is caused by longer-term swings and this slow growth merely dampens the huge spike of the prior year (M2 growth was 10.4% year-over-year by late 2008, and much faster than that of course an an annualized basis quarter-over-quarter), I am surprised that the monetary authorities have let this happen while bank credit is still contracting and the signs of a resurgence in money velocity are still fairly uncertain.
However, it’s a cinch that won’t continue into the elections, and over the last four weeks the M2 money supply has been growing at a 19% pace. It’s a short sample, but I doubt that’s entirely unintentional. Faster money growth helps the situation in Europe, and it also helps the good folks in Congress fend off the election of the Ron Paul brigades who would like to “End the Fed.”
I’m still not taking a position, because it isn’t clear to me that impotent (that will get caught in some spam filters) taxing and spending from Congress and surging money growth will do anything more than pressure bond prices. But I could be wrong, and being short quality assets (Treasuries) and long risky assets (stocks) doesn’t seem like it has a payoff sufficient to compensate for the not-insignificant chance that investors suddenly figure out the long-term picture ain’t bright.
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This commentary will not be published on Monday as it is a national holiday; since my experience has also been that almost no one reads the commentary that is right before the long weekend either, I won’t be publishing on Friday either. I’ll write again on Tuesday. In the meantime, have a contemplative Memorial Day.
The Key Is “One By One”
Charles McKay said it 170 years ago, and until now it appeared to be true:
Men, it has been well said, think in herds; it will be seen that they go mad in herds, while they only recover their senses slowly, and one by one. (Extraordinary Popular Delusions and the Madness of Crowds)
That is, it seemed that way until today. Inexplicably, the stock market jumped overnight and on the open today. I say “inexplicably,” but there was no shortage of attempts to explain it. My favorite was the list on “reasons for a market rebound” given by one CNBC guest, who clearly was up all night trying to think of reasons to be bullish. Reason number 1: “The European debt crisis is unlikely to get much worse.” Well, that’s the question, isn’t it? I guess if you know that, you’re already well ahead of me.
Unfortunately, the current indications are that the crisis is indeed getting worse. In a Wall Street Journal article today, it was reported that “Spain’s Banco Bilbao Vizcaya Argentaria, or BBVA, has been unable to renew roughly $1 billion of short-term funding in the U.S. commercial-paper market since the beginning of the month, according to people familiar with the matter.” This fact is made worse by the fact that (also noted in the article) new SEC regulations for money funds go into effect this Friday; these regulations are supposedly designed to forestall another credit crisis by…if I follow the reasoning…decreasing the supply of term credit:
Money-market fund managers try to buy relatively safe assets and hold them for a short time. A money-market panic in 2008 contributed to the broader squeeze in corporate credit.
In an effort to prevent another such crisis, the Securities and Exchange Commission is requiring money funds to hold more-liquid and higher-quality assets, effective Friday.
The new rules will shorten the maximum weighted average maturity of a fund’s portfolio to 60 days from 90 days. Funds also will have to maintain a minimum of 10% of assets in securities that mature in one day and 30% in securities that mature in one week.
Perhaps the critical piece of the argument is that by making it more difficult for money funds to lend to unregulated “Shadow Banking” institutions (as Paul McCulley coined the term, for example see his comment here) such as off-balance sheet asset-backed commercial paper conduits, hedge funds, etc, the SEC is forcing them to reduce their scale. It doesn’t seem like a bad idea, but preventing money funds from investing my cash in anything but T-Bills seems a rather circuitous route to get to that conclusion, if that is in fact the reasoning.
In addition to the news out of Spain came word (see for example the Financial Times article here) that the UK and France are rejecting the “bank tax” plan that was championed by Germany. This is just one small example of the fact that the various EU governments are enjoying something less than complete unanimity when it comes to addressing the crisis. Compare this to our own banking crisis, in which the bickering of Connecticut and New York would not have been relevant since the federal government was in charge overall. The patchwork of political economies in Europe are greatly complicating the issue, and although the VIX dropped briefly below 25 today on the notion that the crisis is nearly over (it did, however, finish at 35 when stocks turned south; the S&P ended -0.6% and just a smidge above the lows for the year), the underlying issues are not only unsolved, they may well be intractable. For a humorous analysis of the problem, follow this link (I love the Aussies!).
None of the above should be taken to imply that there was not some good news today. Indeed, in a rare show of comprehension (it must be pure chance) Rep. Barney Frank said that the requirement in financial regulation legislation that banks separate from their swaps desks “goes too far.” I clearly need to reconsider my own position if by some chance I happen to be on the same side as Mr. Frank, but I think I still agree. Now, I don’t know what his alternative is. My alternative is to regulate leverage and risk – which the regulators already have the authority to do, not to mention the “independent” rating agencies – and then leave them alone. I would pay special attention to funding risk; the notion that banks should finance their complex long-term derivatives books with substantial amounts of commercial paper that can vanish in an instant – especially if the SEC has its way (see above) – is crazy and it should be a red flag risk for bank managements and regulators. Companies, and especially banks, don’t generally die from losses; they die from an inability to get funding, and when that is short-term funding there is a regular potential for crisis. Most of a bank’s funding, if it is involved in complex endeavors, should be long-term (many hedge funds, for example Citadel, have gone about securing against this key risk themselves by issuing bonds).
Also in the good news category was the huge leap in New Home Sales. While Durable Goods was somewhat weak, -1.0% ex-transportation, that was counterbalanced by an upward revision to last month. New Home Sales, however, were just plain strong. Sales came in at 504k, versus 425k expected. The next couple of months, as the tax incentives expire, will be key. Another positive sign, apparently, was the fact that the inventory of new homes for sale is actually at a multi-decade low (see Chart, Source Bloomberg). However, that is partly because the shadow inventory of existing homes are starting to come onto the market, and this is crowding out the market for new homes (see second Chart below, Source Bloomberg).
First the good news: New Home inventory at an all-time low.
...And the bad news: Existing Homes for sale still swamp the market
One final piece of good news for the New York area, although this probably did not affect the market, concerned the awarding of the 2014 Super Bowl to New Jersey. This will be the first Super Bowl played outdoors in a cold-weather city in many years, but that will not stop fans here from going. New York/New Jersey is a great place to be a sports fan. Even funnier, to Giants fans, was Jerry Jones’ comment about whether he’d mind playing in a cold-weather Super Bowl:
“Oh, I will take that any day,” Jones said. “I’ll go up and play with the lights out … when the moon is on the wrong side of the sun.”
I have news for Mr. Jones – if the moon is on the other side of the Sun from the Earth, we are in very very deep trouble.
The smattering of good news, and the new-found willingness to mostly ignore the bad news again, at least for most of the day, helped push bonds lower. The 10y Note contract fell 16.5/32nds and the 10y yield rose to 3.20%. The Treasury’s sale of 5y notes helped keep a lid on things as well. Inflation markets recovered marginally.
On Thursday, the key release will not be the GDP revision of Q1 data (Consensus: 3.4% revision from 3.2%) but rather Initial Claims (Consensus: 455k from 471k). Recall the surprise last week when Claims jumped; one week does not a trend make, but with two points you can start to draw a line…if Claims refuses to drop back down, some economists will begin to get nervous.
It is a little surprising to me that stocks weren’t able to sustain even a modest overnight gain given the news, and we are shaping up for a trade potentially much lower if the February lows fail to support prices. I think that a retracement like this, with people regaining their sanity “one by one,” is the best outcome at the moment. What we have to be wary of is if investors suddenly become sane in herds.
Don’t Stop Believin’
Tuesday saw yet another huge rally off of deep intraday lows. The stock market, at one point down nearly 3%, ended the day flat on heavy volume of 1.8 billion shares. The VIX, at one time during the day around 44, ended at 34.61.
These are not staid, sedate, institutional-style flows we are seeing. The common thought is that the volume and the swings are coming courtesy of hedge fund business, and I am sure that is part of it. However, I believe there is probably also some significant hedging of equity derivatives that is driving flows. Dealers who are short options, either explicitly or embedded in deals, tried to buy them back where they could (pushing the VIX higher) or, if the price is too egregious, they are forced to delta hedge. That would cause buying on rallies and selling on declines. Now, there’s no way for me to establish whether this is in fact happening, so it’s 100% speculation on my part. But the volume and the large swings in both directions just smack to me of short-gamma activity.
Swings in nominal fixed-income markets are more muted – the market just seems to move one way! The June 10y Note contract (which will shortly be deliverable and so open interest is rolling to Sep) rallied 16/32nds with the 10y yield falling to 3.17%. This happened despite the furious rally in stocks and the large jump in Consumer Confidence to 63.3! Remember, though, that Consumer Confidence is neutral at 100, so this level means that consumers are now finally as confident as they were at the absolute depths of the last recession (see Chart below, source Bloomberg).
The current "optimism" would have been deep pessimism in 2003.
By contrast, the ABC Consumer Comfort Index has barely moved off its lows and is well below the 2003 levels (see Chart below, Source Bloomberg).
ABC Consumer Comfort still near the lows.
The difference in these two measures captures a key insight into the Conference Board’s improvement. The former number includes a forward-looking expectations component, while the latter only measures current conditions. Indeed, if you compare the ABC figure to the Consumer Confidence “Present Situation” part of the index there is no discrepancy, as the chart below illustrates.
The improvement in confidence is all guesswork about the future.
This is less comforting to me than if the improvement was based on stuff that consumers were actually seeing, rather than what they were expecting to see. In a similar vein, the “Jobs Hard To Get” subindex, while improving slightly, hasn’t improved significantly at all.
And yet, on financial news networks today there were discussions about the “risk of a double dip.” A double dip? With Unemployment still well above 9%, shouldn’t we resolve the first dip first? It is hard for me to see how a second “dip” from here would be distinguishable as a second recession given the current levels of resource underutilization. But it is consistent with what Consumer Confidence is saying – people are looking forward as if they expect the expansion (an organic expansion, not one based entirely on government spending, as the recent quarters have been) to begin any minute. It is the same optimism that brought stocks to a level that was discounting such an expansion, and it unfortunately means that confidence may well be due for a depressing mark-to-market unless growth miraculously starts to boom.
There are few signs of that, and despite the rally back today market conditions are still ugly. The 2011 TIPS got cheaper still today, with inflation swaps down further, and bid/offer spreads on TIPS grew back towards levels last seen in late 2008 and early 2009. For the Jan-2011 TIPS, an 8-month piece of paper, the bid/offer spread quoted on one dealer’s screen was 14/32nds, for a grand total of $5mm size. The 10y TIPS are nearly 1 point wide bid/offer.
I don’t know what tomorrow brings, market-wise, but I remain pretty happy to not be a part of it. I suspect we still have further to go on the downside. Trending markets have bounces/retracements, but when a bounce happens intraday, like it did today, that often helps delay a longer bounce. Economically speaking, we will get data on Wednesday from Durable Goods for April (Consensus: +1.4%, +0.5% ex-transportation) and New Home Sales for April (Consensus: 425k). In the market’s current mood, I think these will be viewed as “old news” and not elicit a lasting reaction.
No Picnic, But No Panic Either
The bond market was remarkably calm today, and stocks traded at a fraction of the volumes we saw last week, with only a 12-point or so range on the S&P cash index until the end of the day (SPX ended -1.3%). The VIX dropped back into the high-30s after spending part of Friday in the high-40s.
Say what you will about the level of the stock market, but I will make two observations. First, if the market was ‘oversold’ on Thursday on a short-term basis, it surely is no longer so after a rally day on Friday and a lethargic mostly-sideways trade today. Second, all of the folks who seemed on Friday to be eager to “buy into the panic” may be a bit early…we are not so removed from the panic of 2008 that we have forgotten, have we? “Panics” don’t end in a week, and they don’t cover 4%.
If there is anything that better exemplifies the way the investing public has been brainwashed by the equity cult, I can’t think of it at the moment. A 4% decline in a week is “a panic” and a buying opportunity.
It has taken decades to get here from the days when dividend yields were expected to be higher than bond yields since the equity stakeholder had a junior interest. Of course, the love affair with claims on residual value (that is, equity) isn’t quite as bad as it was in the late 1990s, but I guess that’s partly the point. A decade later, with broad equity indices 30% lower in nominal terms from the 2000 highs and around 44% in real terms (see Chart), investors still see 4.2% over one week as a panic!
Real S&P (simply SPX/ NSA CPI here)
Folks, there is talk among serious people with considerable public policy chops about whether the Euro might be headed for a breakup at some point; whether this may happen next month or next year or next decade, the very fact that this is a plausible notion is a big deal. Taxes are due to be cranked up in the U.S. over the next few years (both income taxes as well as other taxes such as the substantial ones attached to the health care bill), and government spending in the Eurozone is surely going to be declining with half of the EU implementing austerity measures. Bank lending has been contracting for well over a year, but Congress is responding by gutting the same industry they bailed out. Policymakers need the money to continue to fund the GSEs, as mortgage delinquencies and defaults continue to rise. Some panic might not be terribly misplaced.
Now, the economic data isn’t bad, but hardly gangbusters. Employment growth (admittedly, usually a lagging indicator) is tepid. The home sales numbers have been improving (today, Existing Home Sales was 5.77mm versus 5.65mm expected and 5.36mm last month), but it is off a very low base and may be related to expiring tax incentives…the jury is still out, in other words. Tomorrow we will get the Richmond Fed Index (Consensus: 25 vs 30 a month ago), Consumer Confidence (Consensus: 58.9 vs 57.9), and the Case-Shiller index (Consensus: -0.3% m/m, +2.5% y/y compared with +0.6% y/y last). Consumer Confidence is a potential weak link, since the unpopular health care bill (63% want the bill repealed) and the Euro crisis have been in the news for a month, but Confidence in the medium-term is driven by jobs. If conditions are truly improving, then “Jobs Hard To Get” should start to fall with more alacrity and Consumer Confidence ought to rise further.
While we are a long way from anything that looks like panic, that isn’t the same as saying that the market is healthy and behaving normally. Indeed, markets continue to look and act more than a little nervous. The behavior of the front end of the TIPS curve, where the Jan-11 maturity whistled from a yield of -1.22% on May 3rd to +0.30% today … that is, a 152 basis-point rise in yields, albeit small basis points … is one example of particular interest to me given that it is a market of focus for me. The Jan-11s only about six months of inflation accretion remaining, so this wild swing amounts to a huge change in near-term inflation expectations. That yield on May 3rd represented market expectations for a terminal NSA CPI value of 219.22, or something like 1.5% annualized inflation over the period from Feb ’10 to October/November ’10. The current yield implies a terminal index of 217.85, meaning almost no change in prices from now until October/November. (Put another way: at an 0.3% real yield, and 9-month nominal paper yielding around 0.3%, any net inflation at all means you’re better off owning that instrument). While declining energy quotes offer the possibility of net deflation over that period, it still seems a little unlikely to me.
More technically, Fed funds/LIBOR swaps continue to trend wider even though Friday and Monday saw some general calming in the market. The jump in 1-year Fed Funds/LIBOR, which roughly indicates the cost of 3-month unsecured money compared to collateralized Fed Funds from 14 basis points (daily average Fed Funds+14bps versus 3mo LIBOR flat, paid quarterly) in late April to 59bps now is a big move, but more impressive to me are the movements in longer-dated FF/L swaps. Shown below is the 5y FF/L swap (Source: Bloomberg). Compare the rapidity of the recent move to the larger, but slower rise in 2007-08.
Maybe there's some panic, but it isn't retail
So perhaps there are some panicky undercurrents, and conceivably this could be a prelude to actual panic. But it isn’t the retail investor who is panicking yet. We can bottom without a panic, of course, and it would be nice if we do so, but suggesting that everyone else is losing their heads to make ourselves feel good about being Cool Hand Luke – it doesn’t appear to really be happening yet.
I am not entirely sure what it will look like, but I suspect we’ll know it when we see it.
Know When To Walk Away
Occasionally (and this seems like an excellent occasion) it is worthwhile to step back and, rather than considering the investing attributes of the market, ask whether it is necessary to act on any decision today.
Reading various columns and periodicals (Barron’s, Bloomberg, etc) today, something struck me. Every one of them asks a question along the lines of “Is the market in a correction that should be bought, or is it starting a new bearish leg that should be sold?” In some sense this is not different from the discourse during any other week. CNBC, especially, makes it a habit to ask its guests what they would be buying right now (and occasionally, what they would be selling right now).
But shouldn’t the discourse be a bit different at the moment? Isn’t the market acting somewhat…er…unusually?
I had a rhetorical writing professor once who would respond (to almost assertion), “So what?” Her point was that the rhetorician is responsible for persuading the audience that the points raised are not just germane to the argument but develop it inexorably, so that conclusion B necessarily follows from premise A.
And so my question is, as a trader’s/investor’s question always should be: “So what?” Maybe the market is merely correcting, and perhaps it is finished doing so. The VIX, volumes, interest rates, and other measures of market stress such as interbank lending spreads have rapidly expanded to the levels we were accustomed to seeing in the crisis, and maybe that means the correction is over or nearly over. Maybe the market is beginning a new down leg in a secular bear market. After all, just because it would have been profitable to sell the VIX the last time it was at 45% doesn’t mean that it is profitable to do so now. Let’s assume that I have reached a conclusion, either that this is a correction or that it is the end of a bear-market rally and another leg down is unfolding. The question really is, “so what?”
In thinking about (and explaining) trading decisions, I often find a card-playing analogy to be illuminating. A game like Texas Hold-Em is a simple game that, as they say, takes a lifetime to master…but the parameters are constrained. That is, there is always the same number of cards, the rank of hands is unambiguous, and the order of play is defined and immutable. You always know what your hand holds. And the decisions required are always the same: bet or raise? How many chips to put into the pot? Or instead, should I check or fold? And that’s it. The analogy to investing is probably obvious: at a macro level, before any security analysis, the question is buy or sell, and how much?
And that is, of course, what all the commentators focus on: determining whether we should be buying, or selling (maybe Omaha Hi-Lo is a better card playing analogy; you can win by getting the best high hand, or the best low hand). But what about sitting out this hand? A key question facing any card player who doesn’t have the absolute best possible hand (“the nuts,” in poker lingo) is whether the return offered by the pot in the event of a win (the “pot odds”) make it worthwhile to remain in the hand, or if it is better to discard the hand and wait for better cards. But market commentators seem often to neglect this question. Maybe it’s better to sit this one out?
All observers can agree that right now, market prospects are extremely uncertain. What the elevated level of the VIX is saying is that many participants are concerned about the prospects of a severe move. While it is admittedly true that the more that investors buy protection, the less likely it is that they feel pressured to sell when the market trades lower – which is one reason high levels of implied volatility tend to be associated with, and may even be causal of, near-term market bottoms – the question of whether we are at a local minimum in the market and “due for a bounce” may be moot. Why do I need to catch the bottom? Why not wait until the picture becomes clearer?
True, the market is 10% cheaper than it was a month ago. But the prospects are also a lot more near-term uncertain than they were a month ago. It isn’t clear to me that I need to be putting chips into the pot right now. (And by the way, the toughest lesson I ever had to learn as a trader was that doing nothing is often the right thing.) And the risks are not symmetrical – there may be only a small chance of a -10% day or a -20% week, but there is a vanishingly-small chance of an up 10% day or up 20% week. Stocks go “up on the staircase and down on the escalator,” and this means that uncertain situations deserve special respect. I think we are in this sort of situation right now.
One clear difference between cards and the markets: in cards, you can win with a bad hand by bluffing your opponent into folding. In the markets, you can only win by being in the market when the odds are good, and out when the odds are not in your favor. It is okay to choose not to play.
Down Does Not Equal Oversold
Well, I said that I thought we would revisit the flash-crash lows, and we seem to be well on the way there with today’s 3.9% decline on heavy volume of better than 2bln shares. I thought that would happen (although I didn’t think it would happen so quickly) since the reason the market was declining – it was pricing in a normal, or even faster-than-normal, recovery and was even a bit frothy for that, while the trends in global growth seem to be rolling over and the fissures in the financial system seem to be growing wider – had nothing to do with the sudden breakdown in liquidity we saw that one day.
But the perennial bulls seem perplexed by the mathematics, as they always are. They seem not to understand the mathematical reality that for most developed nations, debt and deficits are so large and demographic trends so poor that lower spending and/or higher taxes and/or monetization are inevitable. They are enthusiastically invested in over-levered financial institutions that have not gotten significantly less levered, and moreover whose market valuations imply ongoing high leverage, wide spread, and high turnover (all of which are threatened by regulation). They welcome government intervention in messy markets, not recognizing that little good can come of quickly-written, populist government policies designed to damage the entities that add liquidity to markets, to erect barriers against trade, and to manipulate markets.
“But,” says CNBC, “the markets must be oversold.” Over and over throughout the day today, the talking heads did not ask whether the markets are oversold, but instead “How oversold are we?” But why would they think the market is oversold? Because it went down? Down doesn’t equal oversold. Technical oscillators are showing the market neutral to just slightly south of neutral (daily 5-3-3 stochastics on the S&P are around 50%; 14-day RSI is at 31%). Moreover, in trending markets (as any neophyte technician is aware) markets can become overbought or oversold and stay that way for a long time. “Oversold,” in short, is the last refuge of people who recognize that the fundamentals don’t support their thesis, so they’re hoping to at least get a bounce to sell into.
It is evidently not the case that the economy is improving rapidly. Initial Claims were 471,000, considerably above expectations and right back into the old range. Maybe hiring is up, but firing is just as robust. (The best part of today’s release, though, was the ill-phrased Bloomberg headline saying “More Americans unexpectedly file claims for jobless benefits.” Really? How do you unexpectedly file? Do you wake up in the morning and discover that in a drunken stupor last night you accidentally filed for unemployment? ‘Wow, that was unexpected!’)
The Philly Fed index was on consensus, but the New Orders and Number of Employees sub-indices weakened a bit: not the sign of an imminent collapse, but neither the sign of a broadening and strengthening recovery.
Bond traders certainly have changed their minds recently about the state of the economy. While the rally in the bond market arguably began as a flight to quality, two elements of the recent trade suggest there is more than that to the rally now. First, the yield curve today was flattening during the rally (TYM0 +22.5/32nds; 10y yields down to 3.26%), meaning that investors were reaching for longer-dated bonds. In a flight-to-quality, typically the curve steepens as it rallies (to be sure, the fact that the Fed made clear yesterday that they aren’t about to be selling Treasuries any time soon probably helps the supply/demand dynamic for longer bonds as well). Second, market-based measures of inflation expectations declined sharply again with inflation swaps closing 10 to 16bps lower across the curve.
Indeed, TIPS yields at the short end of the curve actually rose; short-dated TIPS have been over-owned because investors have been looking for a inflation protection without having to be long duration in real yields that are at historically low levels. For the first time in a while, forward inflation expectations are topping out no higher than 3%. From today’s closing inflation swaps curve, we can divine the market’s expectations for calendar-year (Dec/Dec) inflation:
2010: 1.2%
2011: 1.3%
2012: 2.1%
2013: 2.4%
2014: 2.6%
2015: 2.8%
2016-2017: 2.9%
2018-2020: 3.0%
TIPS are still not cheap, as real yields are quite low; however, they are increasingly getting cheap to nominal Treasuries again. Short-dated TIPS at 0% real yields are not too bad any more, compared to nominal Treasuries near 0% nominal yields!
But, although I generally shy away from discussing particular securities, I will mention one that I bought today. It is a preferred stock issued by SLM Corp which acts like a floating-rate inflation-linked bond with a maturity in 2017. The symbol is OSM; I bought some today at a price of 16. The notional value of the bond is 25, and it pays a coupon of CPI+2%, so together with the discount the effective yield is CPI+10% approximately. Of course, I have credit exposure to SLM, which isn’t the greatest, but even stripping out the value of the credit (which I could do if there were exchange-traded CDS) the payout is roughly CPI+5%. The fact that it is a preferred security means I am senior to the common, which will be small comfort if the firm goes under but leaves me with a chance of recovery in a bankruptcy.
That is, however, the only foray I am making onto the stock exchange these days. If the market continues to fall, I am willing to buy some stuff, but my usual neighborhood (high-dividend-paying, low-leverage, low-PE names) carries some added risk given all the talk about changing the taxation of dividends. If there were an appreciable relative increase in the tax on dividend income, and it seems this is plausible, then the stocks I tend to hold will be getting cheaper, and some of them will cut dividends (DO, which is controlled by a family that likes to take big dividends, for example, might well display less of a preference for that sort of distribution; CHKE mentioned in its annual report the possibility that it may cut its dividend if there are adverse tax-law changes). Since it is well known that companies that pay higher dividends tend to have higher earnings growth (see for example this paper), this leaves me scratching my head about how cheap the non-dividend payers would have to be before I’ll simply trust management to do right by me. Pretty cheap, is the answer.
We may well have a chance to buy cheap equities. Remember, Richard Russell has warned that stocks trading where they are now could be a precursor to a “major crash.” Nouriel Roubini, always a cheerful chap, says we are going down another 20% (which isn’t too bad given how much we have rallied over the last year). The Senate is moving to a final vote on financial regulatory reform. Coincidence? Sure.
If The View Is Bad, Don’t Look
Inflation came in a teensy bit weaker than the consensus expected. Headline inflation fell 0.1% (actually -0.069%) and core CPI was flat (actually +0.047%). Owner’s Equivalent Rent was unchanged, and core inflation ex-shelter actually fell to 2.2% on a year-on-year basis. That may be encouraging (if you are worried about inflation taking off due to the incredible injection of money in 2008-09) or scary (if you look at the current money growth and lending data and are worried about deflation being the phenomenon we ought to worry about).
I haven’t been worried about deflation, despite the decline in core, because that decline was almost entirely a shelter phenomenon. It is still, predominantly, a shelter phenomenon but the rapid decline in the money aggregates combined with a slackening in broad price pressures is at least cause for concern. Certainly, it makes a rise in short rates any time this year a distant long shot unless money and credit growth picks up (and I thought it was unlikely rates would be hiked even if money and credit was skating along smoothly). More on that in a moment.
Now, before we read too much into the decline of ex-housing core inflation a few caveats are in order. First, one consequence of removing the big, slow-moving elephant from the index is that the remnant is more volatile, and therefore any given month is less important when measured against the underlying hypothesis. Also, part of the decline in the year-on-year core-ex-shelter number this month is due to the removal of last year’s April figure, which was somewhat higher than the trend. Some bounce-back next month is likely. Finally, core inflation still shows a longer-term, broad upswing that is only modestly less worrisome given the decline over the last few months (see chart below).
Core ex-Shelter is calming down some but still in a clear uptrend.
It is fairly likely, I think, that the decline in housing is affecting other, related items. Despite the decline in core ex-shelter, the spread between the rate of change of that measure and the rate of change of shelter itself is still near the widest on record (see chart below). This means that (a) the bubble unwind is still clearly influencing the core numbers and (b) therefore, it still makes sense to look at the ex-shelter numbers since these numbers are likely to converge, more likely to the non-bubble-unwind part, once the unwind is complete.
Shelter is still the clear dog.
Although the inflation numbers didn’t miss by very much, the inflation-linked bond market was thumped like an unwelcome Yuppie in a biker bar. Inflation swaps fell 7-10bps, although that is mostly a guess since the market was generally offered without a bid for much of the day. Inflation bond breakevens fell a bit more than that, with breakeven inflation at the very front of the curve off about 25bps. That’s a pretty big drop for a near-expectation number, but with the way the global economy is looking … and more to the point, the health of the global financial community … traders can be forgiven for recalling how buying modest weakness in 2008 was rewarded with a severe beating in a room without exits. Capital dedicated to arbitrage has never made it all the way back, nor even most of the way back, but the capital that is at work ironing out inefficiencies wants to make sure it sticks around to get the really cheap stuff in the next blowup.
Which, it bears noting, could come soon. Apparently no less a light than Dow Theorist Richard Russell has suggested that if stocks trade below the May 7th low, a “major crash” could very well be in store (as opposed to those pesky minor crashes, I suppose). I can’t say that I can dismiss this out of hand. Volumes continue to be pretty high in equities as prices keep slipping lower (the S&P finished -0.5% today after being down almost 2% at one point), and other measures of stress are not receding quickly as they did the first half-dozen times we had a scare. The 10y note is at 3.365%, only slightly better today even though the FOMC minutes made clear that asset sales are not likely to be on the horizon, and that removes one big potential seller from that market.
The description of the economy in the FOMC minutes generally echoed what dealer economists have been saying, that growth is recovering nicely although employment (a lagging indicator) and some other pesky things aren’t yet behaving. Two of those pesky things are mortgage delinquencies and foreclosures, which were released today (for Q1) at an all-time high (see Chart: the second-highest isn’t even close). Delinquencies should be a lagging indicator, especially now since there are a lot of properties on which lenders have been forbearing from foreclosing because of the market, but it does mean that the supply overhang in housing should stay higher for longer, and that doesn’t augur well for the full recovery of the construction sector or of consumer spending.
Foreclosures (white) and Delinquencies are both still rising!
The FOMC minutes also made, surprisingly, only passing comment on the Greek crisis, and it seemed to have little effect on the Committee’s deliberations. This seems incredible, since as of late April the crisis was already in full flower. The staff appeared to naïvely believe that the authorities in Europe could easily contain the crisis, or in any event the troubles of small Greece weren’t likely to be a big event for the US. The good news is that since the Fed was purely relying on low core inflation staying low for a while as their excuse for keeping rates low (also gleaned from the minutes), there is very little risk of rates being raised for the foreseeable future. The bad news is that the FOMC appeared to be badly uninformed about the severity of the European developments and the implication for banks foreign and domestic.
Those implications of course are still unfolding, and we won’t know the full extent of the crisis or the damage from it for some time, I would guess. It will take even longer to assess that damage if policymakers follow the lead of the Bank of Italy, who on Tuesday evening declared that banks who hold European sovereigns in their available-for-sale portfolio would not need to charge losses in those instruments against capital. Apparently transparency is a good thing, unless what we see through the window is bad and then we draw the curtains.
Also not wanting to look, apparently is Senator Dodd. This morning, the Senator was considering a compromise to the financial Armageddon bill (not its official title) that would first have required that the implications of the dramatic step of separating swap dealers from their stable parent entities be studied before the rule was enacted. By the afternoon, however, he had publicly renounced the idea of looking before we leap. Really, what could go wrong with such a carefully conceived plan? They did after all spend whole weeks, even a couple of months, thinking about it.
Time-out! New Rules!
It is always important to remember that when you are investing or trading, while the rules appear to be clearly spelled out they may be changed at any time. This can be dangerous if you believe you are playing by Marquess of Queensberry rules when instead the game is now Ultimate Fighting. In particular, policymakers are prone to change the rules according to whim if they feel the game is moving against them; this seems to grow more prevalent these days since policymakers seem not to remember why the rules are there in the first place (the answer, of course, is that regular and predictable rules are necessary to attract the most capital into capital markets, which lowers the overall societal cost of capital and reduces the frictional costs of illiquidity).
Today, the German banking regulator banned short selling and credit default swaps of euro-area government bonds, as well as naked short selling in shares of ten German banks and insurance companies. Conveniently, this comes after the ECB had already bought a bunch of euro-area government bonds; apparently, having the ability to print money was not viewed as enough of an advantage over those powerful hedge funds and investment banks who are out to destroy the dream of European union!
The effect of the ban, among other things, will probably be to reduce credit lines extended to German banks by other banks, who always have assumed they had the option to hedge significant credit risk by buying protection on those names in the CDS market (the regulator seemed to suggest an exception if the CDS is used for hedging, but since CDS are very rarely pure punts – they’re almost always hedging something – it isn’t clear just what they mean). Since I would be surprised if other euro area regulators do not follow suit, there is some chance that we have just seen the torch-carrying mob set fire to their own town.
Completely ignore what happens in the short term. I am not sure if the ban applies to existing positions; if it does, then you will see a massive credit rally as short-sellers (both speculators and hedgers) have to scramble to unwind positions that everyone knows they must unwind. But the question is what happens thereafter, when no one can hedge the credit risk of their counterparty; moreover, even using the CDS market as an early-warning indicator of distress will become less useful since it is the short sellers who transmit those signals.
This is I think one of the main reasons the stock market declined today (S&P -1.4% after starting the day with a strong gain for the second day in a row), implied vols rose and bonds rallied (TYM0 was +20/32nds and 10y note yields fell to a mere 3.38%). It certainly wasn’t the economic data: Housing Starts rose more than expected to 672k and PPI was near-expectations.
Despite any positive economic signals, there is unquestionably a certain amount of hatch-battening going on. Market measures of inflation continue to decline, with 1y inflation swaps down to 0.95% and 2y swaps down to 1.40%. This doesn’t necessarily mean that inflation-linked bonds are great bargains here. A commentator on CNBC recommended TIPS at 2.20%; since no TIPS bond has a real yield over 1.74%, I am not sure of the relevance of the recommendation! However, TIPS certainly seem cheap to Treasuries here. While there is a chance that inflation remains quiescent because the global economy continues to thrash about like a drowning man, that possibility is priced into the market. If you buy TIPS and inflation stays low, in other words, you will probably be about as well off as if you bought nominal Treasuries. But if central banks start printing and inflation spikes, you are hands-down better off in TIPS. For your fixed-income bucket, TIPS are the better alternative here I think. Outside of that comparison, though, it is a tougher call.
TIPS have been cheapening lately partly because of expectations for tomorrow’s CPI number and also because declining energy prices imply lower inflation accretion a couple of months down the road. The consensus call for Wednesday’s release is +0.1% on headline inflation and +0.1% on core inflation, bringing the year-on-year core figure down to +1.0%. That central tendency comes from the fact that the last three core inflation prints are -0.1%, +0.1%, and +0.0% and the last six imply an annualized core inflation rate of a mere +0.6%. So, if you’re just looking at the averages, your naive forecast will be around 0.0% or 0.1%.
I think there is some possibility that we print a +0.2% this month, although I wouldn’t expect that to signal a reversal in the downward trend of core yet. But the recent rapid decline in core seems to be a bit ahead of where my models suggest it should be (that being said, recall that I have mentioned recently some of the concerns I have about dynamics in the current economy that most models, mine included, may not be picking up). The January core CPI print of -0.1% was a surprise by 0.2%, and the March print of flat was an 0.1% surprise. Economists may be overcorrecting, and certainly the market is bracing for another surprise.
There is no question that the delayed reaction of rents to downward pressure in housing prices is what is causing the sagging core inflation rate, and the core ex-housing continues to rise smartly. The guess on core CPI right now comes down to whether you think rents have caught up or not to the housing decline. I think we still have a quarter or two to go of softness in Owners Equivalent Rent, but at this point I would probably consider a stab at the long side in inflation…if there wasn’t an Ultimate Fighting Championship going on in the markets.
In the afternoon tomorrow, the minutes of the Fed’s April 28th meeting will be released. It is worth reading these to see what effect the turmoil in Europe is having on the deliberations about domestic monetary policy. I suspect that, whatever the Fed’s plans had been about normalizing the statement to reflect a nearer-term interest in raising rates a smidgen, they are on hold for now and will be until the latest storm passes. I’ll be looking at the minutes to see if that suspicion is borne out.
To Get Those Twenty, They’ll Destroy The Market
A decline on Friday and on Monday? The equity market selloff threatened to enter a new phase, as stocks fell on Friday in fear of what might happen over the weekend, but then declined again on Monday shortly after the open despite the fact that no further bad news emerged from Europe.
Unless, of course, one counts the threat from the Greek Prime Minister, who promised to probe the role U.S. banks played in the crisis. It’s amazing any of these banks ever existed, when you think about it. From what I hear, they caused the housing crisis, the subprime mortgage crisis, the European crisis; together with hedge funds they caused the California energy crisis a few years ago and the gasoline price gauging following Katrina. I heard they were involved in the Civil War, and there is a rumor that Pontius Pilate worked for J.P. Morgan. Is anyone willing to take responsibility for anything any more or is everything the fault of the banks? How, exactly, did the banks cause the huge Greek fiscal deficit? Good heavens.
To be sure, bankers are not angels and we saw another stomach-churning example of that today in a Bloomberg story about a particular issue of “reverse convertible” securities. A reverse convertible is a note, usually short-term, that pays a high fixed rate of interest and returns principal as long as certain conditions do not occur. The particular condition of interest in a reverse convertible is that the underlying equity security cannot fall more than X% on any day during the note’s life. If those conditions do occur, then the investor instead owns the stock in question, usually at the original price (that is, the investor gets the entire decline of the stock). In this particular instance, JP Morgan issued a 2-month security that paid a 64% annual rate of interest as long as TIVO didn’t fall 25% from the starting price on any day during the note’s life. If TIVO did fall that far, then the buyer of the reverse convertible instead owned TIVO at the price it was at when the security was issued (in other words, an instant 25% or more loss).
The problem with this security is not the structure, which is fairly easy to understand as long as it is fully explained. The problem is that it is ridiculously hard to price – technically, the buyer of the note is selling a naked knock-in, in-the-money put option, which you as the investor have no chance at all of correctly evaluating. As a consequence, JPM not only makes its disclosed 1.75% selling concession – which is pretty egregious for a 2-month note, anyway – but also probably makes another 3% or more on the hedging of the option, and this profit is not disclosed. The fact that such a product is marketed at all with this sort of margin is unconscionable. Unlike CDS, interest rate swaps, and inflation swaps, each of which serves a clear function, it is clear this product is designed only for one thing: to separate fools from their money.
So, while I continue to object to the Volcker rule and all of the dangerous legislation that is currently being pushed through Congress, and I feel sympathetic for all of the good people on Wall Street who work hard to innovate useful products to help intermediate risk for their clients and who take a reasonable compensation for doing so, it absolutely turns my stomach that those people are being lumped in with the people who innovated, priced, and marketed reverse convertibles, as well as the legal and compliance architecture that said such a rip-off deal is okay. Wall Street confronts, unfortunately, rather the reverse of God’s policy with Sodom: policymakers will destroy the city for the sake of the twenty wicked within, no matter how many innocents are brought low in the process.
Back from Biblical times to present day, the stock market ended +0.1% higher after clawing back from being down around 2%. It was an impressive comeback, but would have been more impressive had the market been down on bona fide bad news. Sure the Empire Manufacturing index was weak at +19.11, but this is a volatile series. I think that, since it is May data and it is plausible to imagine that European stresses could be reflected in domestic manufacturing data, it is worth watching other manufacturing surveys, but this isn’t the reason the market plunged. Nor, of course, is the rise in the NAHB index, which is mildly bullish. That index went to post-crisis highs at 22, although as the chart below (Source: Bloomberg) shows this isn’t really anything to write home about yet. Clearly, though, there is some improvement from Depression-level sentiment among home builders.
Construction Sentiment Is Improving (But A Long Way To Go)
While stocks ended up with a scratch, other internal signs give continued cause for nervousness. Inflation measures dropped another 3-5bps (the 1y inflation swap actually fell 13bps and is now at an even 1%), but even so the June 10y Note contract fell 6/32nds and the 10y yield rose to 3.48%. The combination of those two things implies that real yields rose, but they are so sharply negative as it is that I am afraid we can’t glean much information from that.
Tomorrow, we get the first of the inflation numbers this week. That would be the PPI (Consensus: +0.1%, +0.1% ex-food-and-energy), which is generally an unimportant number to inflation people but fairly important to other people who think that PPI is a useful indicator. More interesting, to me, is the Housing Starts number (Consensus: 650k from 626k), which is expected to record the highest reading since 2008…but at a level which, like the NAHB index, is hardly cause for celebration yet.
I remain concerned about the near-term direction of the stock market and the medium-term direction of the bond market, although in the latter case I don’t feel any desire to fade the downtrend in rates just yet.
Never Complain. Never Explain.
The key news of the day, of course, was that NBC canceled long-running show Law & Order after 20 years. The leaves NBC with only the various spin-offs: Law & Order Special Victims Unit, Law & Order Criminal Intent, and Law & Order Los Angeles. Asked about the cancellation, the producer Dick Wolf released a statement through his publicist that read only “Never complain. Never explain.”[1]
Eurozone politicians might take a page from Mr. Wolf’s book, because the combination of complaining and explaining just keeps making people nervous (U.S. politicians learned this in 2008, when just about any statement by Paulson, Bernanke, Bush, Obama, McCain, or Giselle caused the market to go into a spin). Markets were abuzz this morning with the news that French Prime Minister Sarkozy had apparently threatened to remove France from the Euro if Germany refused to support Greece (last weekend). The other European leaders were considering the possibility when the PM added that this meant also that Les Bleus would not participate in the World Cup this year, completely wrecking the bracket setup.[2] The Germans capitulated.
Add to this Chancellor Merkel’s remarks on the tape this morning; speaking in Munich, she admitted that “Europe is in a very, very serious situation,” and said that success is not yet guaranteed.
It seems that € 1 trillion is an awfully lot to spend if it doesn’t even guarantee success, isn’t it? As I’ve pointed out, though – as have others – the package is nowhere near that size when one considers that much of the commitment is in the form of loan guarantees and the IMF hasn’t signed up for its part yet.
The markets seemed to think that this was a little too much complaining, and perhaps a little too much explaining as Merkel also seemed to suggest that the crisis was very valuable in terms of forcing all governments to start making sacrifices. Hmmm, I don’t know what those sacrifices are going to be, but I am willing to bet it isn’t going to be stimulative! Bonds agreed, with the June 10y note contract +29/32nds on the day with the 10y yield down to 3.44%. Stocks agreed, with the S&P -1.9% for the day on rising volume (1.47 billion shares); European bourses fared much worse with the Eurostoxx50 -4.7%. The VIX popped to 31.24, second-highest of this leg of the crisis, and inflation expectations fell 6-8bps across the curve. Oil dropped 4.2%. The Euro plunged to $1.235, and weakened some against sterling as well. Even gold could barely manage a positive close (+0.3%)!
All of this came despite Retail Sales a touch stronger than expected (considering revisions) and with Industrial Production and Michigan Confidence near expectations. But as has so often been the case recently, the economic data points do not matter much. It is old news, in some sense. Fine, so the U.S. economy was gathering momentum before this latest in a veritable flock of black swans flew by. The data just doesn’t matter much, so unless you’re pretty sure you know where the next news bulletin is going to hit the only thing an investor can prudently do is focus on risk control.
Next week, although it probably doesn’t matter, the data flow is a little heavier than it was this week. Empire Manufacturing (Consensus: 30.0 from 31.86) is released at 8:30ET on Monday, and the NAHB Housing Market Index (Consensus: 20 from 19) comes out at 1:00ET. The rest of the week will hold Housing Starts, PPI and CPI, the FOMC minutes, Initial Claims and Philly Fed. This creates at least the theoretical possibility that domestic markets might trade on domestic news and data, but this will depend on whether the situation in Europe looks more like it did on Monday of this week (all is calm!), or more like it did today (the world will end tomorrow!). Who knows, perhaps there will be another €1 trillion package this weekend…that was good for 3 days or so anyway of relative peace. It’s not like there’s any substance behind the figures; maybe they’ll announce a “gazillion-euro” package. If they can eschew explaining or complaining when it is announced, maybe it will even stick.
Although it is much less compelling theater, we need to also keep an eye on the developments in the financial reform bill. Two senators are pushing to include language to prohibit the trading of swaps over the phone, in the name of ‘transparency.’ They think the dealers will really hate that because they’ll lose the ability to rip off clients (that’s not the way the senators put it, but that’s essentially what they mean). I imagine the dealers won’t like it, because many times the only way to work size is anonymously with a trusted interbank broker, but you know who will like it even less? Firms with big hedging needs. Dealers can always choose not to offer more liquidity to clients than they can lay off, but the same cannot be said of their clients. The GSEs, in particular, will be creamed by this rule, if it is put into effect. The only way to move a couple of billion of 10-year swaps without destroying the market is to do it quietly. If the GSEs and other mortgage hedgers are forced to go on the screens, hedging will get orders of magnitude more difficult.
That is only the latest damaging rule in the legislation. It is rapidly getting to be a Frankenstein’s monster not just in the sense that it is assembled of a lot of parts that don’t match well, but also that it is likely to have a life of its own and go on a killing spree.
This is one circumstance where it might make some sense to explain, so that we don’t later have to complain!
[1] This is not a joke. He really did release a 4-word statement.
[2] This, however, is a joke.
