By Paul Azeff and Kory Bobrow
"One of the penalties of not participating in politics is that you will be governed by your inferiors." - Plato
"The budget should be balanced, the treasury should be refilled, public debt should be reduced, the arrogance of officialdom should be tempered and controlled, assistance to foreign lands should be curtailed lest Rome become bankrupt, the mobs should be forced to work and not depend on government for subsistence. " - Attributed to Cicero
"Where we should have been by the Lehman crisis event. In the next seven weeks, this crazy lunatic who's running the Fed increased the balance sheet of the Fed by $900 billion, in seven weeks. In other words, they expanded the balance sheet of the Fed as rapidly in seven weeks as it had occurred during the first 93 years of its existence. And that's not all, as they say on late night TV: in the next six weeks they added another $900 billion. So in thirteen weeks they tripled the balance sheet of the Fed." - David Stockman, Director of the Office of Management and Budget (OMB) under US President Ronald Reagan
"Interest on debts grows without rain." - Yiddish Proverb
"By giving the government unlimited powers, the most arbitrary rule can be made legal; and in this way a democracy may set up the most complete despotism imaginable." - Friedrich Hayek, "The Road to Serfdom"
"... it is dangerous to be right when the government is wrong." - Voltaire
Before we get into our latest commentary, we'd like to wish our readers a very healthy, happy and profitable New Year. For those of you who were worried about the world ending on December 21st, well, we'll try to give you a few new things to worry about this year, OK?
It's been a while since we last wrote, partly because we couldn't bring ourselves to add to the clamor over the "Fiscal Cliff". In fact, just writing those words is painful. But we'd be remiss if we didn't say anything, so here goes: a deal that resolves $40-60 billion dollars of a trillion dollar problem is meaningless. That's the other reason we didn't write anything about it earlier, the quotes we include in each Bottom Line would have taken up more space than our commentary!
What has prompted us to pick up the pen and write again today are some recent developments that bear discussing. We think that these recent developments are providing a short-term opportunity in the Treasury markets.
But first, a quick look back: recall that when last we met, the U.S. Federal Reserve had taken the unprecedented step of extending Quantitative Easing (QE) indefinitely, tying their purchases of $85 billion a month in Treasury securities to two specific targets: unemployment below 6.5% (currently 7.7%), and inflation above 2.5% (currently 2.2%). Since then, the "Fiscal Cliff" was "resolved" and last week the minutes of that very same Fed meeting were released, and all hell broke loose in the Treasury markets! Prior to the January 1st Cliff agreement and the release of the minutes, the benchmark 30-year Treasury was trading at a 2.87% yield. After the release of the minutes, we saw yields soar to as high as 3.177%! That's a huge move for Treasuries, especially in such a short period of time. So what are market participants thinking to drive yields so much higher?
The resolution (for a couple of months, anyway) of the Fiscal Cliff seems to have driven animal spirits, prompting people to reach for more risky assets in search of higher profits. This prompted a move out of what were considered "safe" assets, like Treasuries and gold. But the minutes of the Fed meeting really roiled the markets, so it's worth examining them for a minute or two.
Essentially, the minutes suggested that some members of the Committee want to stop the QE bond purchases prior to the end of 2013. If this were in fact to happen, it would be significant, because the Fed has become by far the largest single purchaser of Treasuries, accounting for over 90% of the purchases of new debt issuances! But the chances of this happening are pretty slim, in our view, for several reasons.
First, allowing interest rates to rise would have an immediate cooling effect on the extremely fragile housing market. As Treasury yields (especially the 10-year) are the benchmark against which mortgages are set, any rise allowed in rates would immediately increase the cost of mortgages. This would be a big deal in any case, but the announcement yesterday of a multibillion-dollar bank settlement makes a near-term end to QE even less likely.
The deal, as announced, absolves banks of liability arising from their "Robo-signing" misdeeds (if you don't know about this, and you should, Google the words "Linda Green 60 Minutes"; trust us, it's worth it!), and gives homeowners cash in exchange for agreeing that they do in fact owe money to the bank that thinks it owns the mortgage. Yes, if this sounds absurd, it's because it is.
Without getting into the arcane, nitty-gritty details, suffice it to say that when the mortgages were bundled together into securitized products, so many mortgages were being re-titled that the system was overwhelmed, and the "solution" was high-speed fraud on an unprecedented scale, where fake "bank executives" signed off on the title transfer documents. The fallout from this was that hundreds of thousands, if not millions, of American homeowners and their supposed mortgage-holders were left uncertain of who in fact held the title and the right to the mortgage on a given house. This prompted many homeowners to hold off paying anything on their mortgages, as they were (reasonably) uncertain that they were paying the right entity! It also stopped banks from foreclosing on hundreds of thousands, if not millions, of delinquent homeowners, as the banks couldn't prove that they were owed any money!
So what's the brilliant solution to this brilliant mess? Have homeowners sign off on a document that states that, yes, in fact, the bank that thinks it owns the title is in fact owed the mortgage money, in exchange for compensation of up to $125,000 in cash and/or a reduction in the amount owed. But one of the implications of this move is that the "shadow inventory" of houses that should have been foreclosed upon but weren't will now start along the foreclosure process, and many of them will finally find their way onto the market. In an environment like this, where the inventory of unsold homes is about to rise substantially, the last thing anyone wants to see is higher mortgage rates. And have a look at the chart below showing U.S. mortgage applications fall off a cliff over the last few weeks, to a 52-week low. Does this sound like an environment where Bernanke and Co. will stop QE? Didn't think so...
Another reason why the Fed is unlikely to stop QE? History. We are in complete agreement with Art Cashin here: The Fed has been spectacularly bad at predicting economic growth, and, perhaps unsurprisingly, has generally expected better growth in the economy than what has actually occurred. One open question is why do the Fed minutes of the meeting where the board decided to extend QE indefinitely suggest that at the same meeting, several Fed board members were expressing their concern about doing just that? Well, if you were able to go on record as thinking something as absurd as indefinite monthly $85 billion purchases of Treasuries was a bad idea, while still being able to take credit for the idea if it works, wouldn't you? We think that when it comes to the Fed, what's important is not what the Fed members say, but what they do. And what they did, was to extend QE indefinitely. As Milton Friedman famously said, nothing is so permanent as a temporary government program.
There's also the tiny issue of the debt ceiling negotiations. In our view, the outcome of these discussions slated to occur in a couple of months' time is likely to be positive for Treasuries: either the Republicans will manage to force through substantive cuts to entitlement programs like Medicare, which would be bullish for Treasuries, or there will be some kind of stalemate again, in which case money should move in to Treasuries as people look to reduce risk. We'll leave it to our readers to guess which of the two scenarios we think is the more likely!
When the U.S. economy shows real, sustainable growth, it will be time to get concerned about the Treasuries. Unfortunately, we're not anywhere close to that day yet. As David Rosenberg points out, we are in a seasonally weak period for bonds, and the last time sentiment on the Treasuries was this negative, we saw a 70 basis point move down in yield in the ensuing three months. We think we could see a similar move this time around. And that's the Bottom Line.
Finally, before we leave you, just a quick comment on gold, as it has seen a big pullback over the last few weeks. With (serious?) talk of Trillion-dollar coins, Paul Krugman's name coming up as Treasury Secretary Tim Geithner's replacement, and a new regime in Japan determined to do anything to keep up with the Joneses when it comes to debasing their currency, including buying European Stability Mechanism (ESM) bonds, let's just say that there are worse places you could put your money than precious metals. Like in Yen, for instance. But that's a story for another day. We'll leave the last word to a man who has provided a treasure trove of good quotes over the years:
Gold, unlike all other commodities, is a currency...and the major thrust in the demand for gold is not for jewelry. It's not for anything other than an escape from what is perceived to be a fiat money system, paper money, that seems to be deteriorating. - Alan Greenspan, ex-US Federal Reserve Chairman, August 23, 2011