Archive for January 25, 2011

Keep Your Bonds

January 25, 2011 3 comments

The volumes ended up higher today, albeit still weak, and after trading down all day stocks ended up unchanged. Momentum is ebbing, but to that observation I must fairly add the suffix “again” since momentum has ebbed a couple of times already in this bull run. The true believers don’t need momentum, so it won’t bother them; the true disbelievers are already short. The story increasingly is about what happens to the guys in the middle, who are uncommitted.

Those investors have a little more of a boost from today’s potpourri of news. The European Financial Stability Facility (EFSF, aka “the European bailout fund”) sold €5bln of bonds to finance the bailout of Ireland, but received orders for about nine times that amount. In my mind, they ought to say “yours” and sell the full €45bln before investors stop and think carefully about who is guaranteeing the bonds. “Europe” is the answer. To paraphrase Henry Kissinger, who do we call when we want the redemption proceeds? Look, I didn’t read the prospectus, but I know this: when I send them 5 billion, they’re going to send it to Ireland. If Ireland doesn’t give it back, there are no assets left in the Facility so…am I trusting that all of the various countries will pony up the money and pay me back without haircuts?

Really? Keep your bonds, I’ll keep my money. At least if I buy Johnson & Johnson bonds, there’s something to seize if they go under.

Still, whether the success of the auction was predicated on the gullibility of investors or a need to appear to be part of the solution (some 43% of the bonds went to central banks, governments, and agencies), there is no doubt that it was a success. And that got Spain thinking. So Spain’s rescue fund, called the Fondo de Reestructuracion Ordenada Bancaria (fondly, FROB) is reportedly to sell a few billion euros’ worth of bonds. After all, says Spanish Finance Minister Salgado, the banks only need about €20bln in extra capital (Moody’s says the real number may be as high as €89bln). Well, at least in the case of FROB I know who to call.

There was one piece of weak economic news, in the form of significant downward guidance from Johnson & Johnson (JNJ) about their full-year sales for 2011. If you want to give the economy credit for GE earnings (although as some readers noted, revenues being up 1% when the economy is expanding by 2% or 3% and the Fed is providing massive liquidity doesn’t exactly constitute a home run even if operating and financial leverage turns those revenues into good-looking earnings), then you have to consider whether JNJ – also a mega-company that sells a wide variety of products although not as wide a variety of GE, to be sure – is sending the opposite signal.

But in my mind, that niggling negative is more than compensated for by two items. The first is the sharp improvement in the Jobs Hard To Get subindex of the Consumer Confidence report to a marginal new low of 43.4 (see Chart). It is worth remembering, though, that the prior low came in June of last year, when the Census was busy hiring scores of thousands of new workers. Hammer that point back into line, and the current decline starts to look more legitimate.

The man on the street says jobs aren't QUITE as hard to get as they were.

Now, this doesn’t ensure that we are going to have rapid job growth, but it supports the decline in Jobless Claims. The Employment indicators are now mostly consonant, and it is fair to conclude that the jobs picture is indeed improving. This is no longer just a statistical wiggle.

That doesn’t mean the market will improve because that depends to a large extent on valuation. And there’s no guarantee that the economy will continue to generate jobs as budget cuts at the state and local level, energy price increases, and an eventual end to QE2 all drag on growth. But for a quarter or two at least, we probably will have decent growth. Some of the dark clouds are parting, although in my opinion they will be back eventually because we have seemingly solved nothing and there is still the little detail of how to unwind all of this manufactured performance without causing a repeat. I am not sure it is possible. But that isn’t today’s concern.

Another economic positive is a bit less obvious. I suppose I would even call it “Fed-watcher esoterica.” This article entitled “Treasury Will Likely Cut Fed Bill Program as Debt Limit Nears” concerns the Supplementary Financing Program, in which the Treasury has sold (and rolls, as necessary) some $200bln in short-term Treasury Bills and sends the money to the Fed (the Fed so far has not sought to issue its own bills, although there is some talk about doing that). That action effectively sops up $200bln in liquidity (what the Fed does, or did, with that money is less important for our purposes).

However, the $200bln counts towards the federal government’s debt limit, so as the debt ceiling approaches the Treasury might want to let those bills mature as that would give it $200bln more in headroom.

But the effect of doing so and sending $200bln back to the investors who owned the bills is exactly the same as if the Fed added another $200bln to QE2. This will force the Fed to do one of a small menu of things; here are a few (I don’t claim this list is exhaustive, but it covers the main bases).

  • Issue its own bills. It isn’t clear whether it has the legal authority to do so, and it certainly would be a subtle nuance not anticipated by the Congress when they put a debt ceiling in place to let another agency with the (presumably) full faith and credit of the federal government issue as much is it likes as long as it doesn’t say “U.S. Treasury” on it.
  • Begin to do very large reverse repos in which the Fed lends out its securities portfolio and borrows cash, draining reserves. The Fed believes they can do this in large size but $200bln is a mammoth operation in this sphere. It does have the securities to lend, thanks to all of the asset purchase of the last few years.
  • Sell some of its securities portfolio to drain the reserves longer-term. It’s hard to believe they would do this at the same time they are buying securities through QE2.
  • Reduce the targeted QE2 by $200bln. This seems the most-plausible possibility, especially if you think the economy is recovering and no longer needs the Fed to anchor interest rates. But what do you think the market reaction would be to such an announcement?
  • Accept the extra $200bln as QE2+. The current quantitative easing campaign is progressing as rapidly as is operationally feasible for the Desk; if the Committee still believes that QE2 is necessary this may even be welcome.

The decision is muddied by the fact that the Treasury won’t know for sure if it’s going to need this headroom until it sees how long the Congress dithers (don’t get me wrong, I’d love to see the Congress dither).

Perhaps the combination of this thought process – there may shortly be another $200bln in liquidity added to the economy, unless the Fed specifically drains it – and the weakness in European periphery bond markets is what drove bond yields down a bit today. Rates are still in a range, with the 10y yield at 3.32% and near the low of the 3.28%-3.48% zone. Oddly, however, inflation swaps declined slightly – so perhaps I’m reading too much into the esoterica (it would certainly seem to have the possibility of inflationary outcomes).

Tomorrow’s discussions will initially revolve around the content of the State of the Union Address tonight. However, since that content is no more meaty than it ever is, attention will rapidly shift to New Home Sales (Consensus: 300k from 290k) at 10:00ET and the Fed announcement later in the day. New Home Sales is not likely to be any meatier than the SotU speech, and certainly the significance of any number around 300k is slight, but at least it will provide an excuse for a change of topic.

The Fed announcement a bit after 2pm is not expected to be any more interesting than the SotU, with a similar tired sameness. But there is the potential, albeit small, for a change in policy triggered by the SFP developments above or by the combination of a more-hawkish Committee makeup and a somewhat stronger economy. That is a long shot, though. It does warrant a note that almost any surprising change to the Fed’s policy or implied bias through the vehicle of the statement is likely to be bearish for equities and bonds as well…the FOMC is not about to become more dovish at this point.

Categories: Federal Reserve, Liquidity