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Bernard Thomas'  Instablog

Over two decades in the fixed income market in sales and trading.
My blog:
mksense.blogspot.com
  • Give Thanks for Central Banks
    This Thanksgiving we have much for which to be thankful. We live in the greatest country on earth. We have the love of our family and friends to brighten our lives and we (hopefully) have our health. There is something else for which we all should be thankful, foreign central banks. Thanks to indirect bidders (which consist primarily of foreign central banks), this week's treasury auctions (2-year, 5-year and 7-year) went very well. In fact today's 7-year auction was she strongest since last July. Not surprisingly, prices of long-dated treasuries rallied following the auction. What was surprising was the selloff of long-dated treasuries just prior to the auction. Did people really think that the auction would be a flop? For the past two months, predictions of waning interest among foreign central banks have been rampant. These predictions have been base on text book theory instead of reality.
     
        Text books tell us that when a country lowers short-term interest rates, issues large amounts of debt relative to GDP and attempts to devalue its way out of a financial crisis, inflation and higher long-term rates are the result. The text books are correct in most circumstances, but not when it pertains to the U.S., not now. The U.S. is unique in that it is the largest market place for goods produced around the globe. This means that exporting nations need to moderate the dollar's slide by purchasing dollars (in the form of U.S. treasuries) which simultaneously results in selling their home currencies. Failure to do this results in exporters either raising prices (which could result in reduced market share) or smaller profit margins. Foreign central banks must either purchase dollars or peg their home currencies to the dollar as China has done. Pegging to the dollar has its own internal inflationary consequences so it is usually command economies, such as China, which engage in this practice as they can dictate prices and supply of goods to their consumers. At some point the U.S. may not be the dominant market place, but that day is not yet on the horizon. Look for continued strong buying of U.S. treasuries until inflation pressures resulting from growth take hold.
     
        Growth driven inflation is not yet on the horizon because bank cannot lend the way they had in the past because they cannot securitize and sell low-quality loans to unsuspecting buyers (with the help of cooperative ratings agencies). Borrowers will have to prove their creditworthiness. Consumer borrowing will return to levels which were common before 25 years of rate declines and financial engineering by quants who have no clue why historical data was what it was, only that it was.
        I had an interesting conversation with a financial adviser who was shocked that Moody's may downgrade bank preferreds, She stated that she believed that the bank troubles were past and that the stock market, oil prices and gold prices were up on string growth expectations. I explained to her that radioactive assets continue to poison the balance sheets of many banks, large and small and that commodity prices and the equity markets are rallying due to the weaker dollar. She was dumbfounded by my assessment. I am no genius. Most fixed income traders, analysts and strategists know exactly why certain assets prices are rallying. the problem is that most financial advisers are equity oriented. The U.S. treasury market is the best gauge of economic and inflation out look. It is what makes that market tick. The treasury market is telling us that economic will be unspectacular for some time. This is your father's economy. Get used to it.
     
    Happy Thanksgiving. Disclosure: No positions'
    Tags: C, BAC, JPM, PNC, WFC, Fed, Treasury, China, Dow
    Nov 25 10:48 pm | Link | Comment!
  • Toppy Markets - Equities and Credit Markets Overdone
    I was discussing the markets with a very experienced an knowledgeable colleague about how "toppy" the equity market is. I told him it is "Mae West" toppy. It is "Dolly Parton" toppy. The tell-tale signs for us is the retail order flow into riskier vehicles and equity market participants positive spin on nearly economic report. Today, retail sales came in below the street consensus and the prior month's data was adjusted down. Empire Manufacturing came in well below economists expectations. Fed Chairman Ben Bernanke warns of headwinds ahead and the need for continued extraordinary monetary accommodation. In response the equity market rose 136 points.News reports indicate that many equity market experts were encouraged that retail sales turned positive. However, the fixed income market had a much different response.
     
        Fixed income market participants took the weak economic data and Mr. Bernanke's comments for what they were and the result was a sharp rally of the prices of long-dated treasuries. Is it that the fixed income experts are smarter than the equity experts? Not really, it is just that the fixed income market participants are more honest. The equity geeks know that the economic fundamentals do not justify current equity market levels. They are hoping that they can force a self-fulfilling prophecy. That the weak dollar is helping to fuel the rally encourages the equity participants. They don't care why the market is up, only that it is up. That is until they want to take profits and then they are the first out the door.
     
        Another sign that the equity (and fixed income credit markets) may be overdone are comments that certain phenomena "always" follows data which we are seeing now. Always is a long time and can the data can be selectively gathered by using time periods advantageous to one's argument. I say that "always" is a word that we should "never" use. Have we ever had current levels of household debt before? No. Have we ever had an economic malaise with interest rates already affective at zero? No. Have we ever had a global economy with a fierce battle for market share before? No.
     
        What many "experts" decline to discuss is that current levels of unemployment were last seen in the early 1980s, before nearly three decades of ever-lower interest rates. The fact is that the robust growth and very low unemployment experienced since the 1980s are fundamentally unsustainable. They were fueled by ever lower interest rates and ever easier lending standards which resulted in ever higher home price which resulted in ever more home equity to be used to buy lifestyles unattainable by way of income alone. The problem is that such home price increases (and the resulting growth in home equity) is unsustainable. Now we have reverted to the mean, maybe a little below the mean, but current economic activity is much closer to fundamental levels than the credit-fueled spending binges of the 1990s and 2000. Bill Gross has it right, get conservative now.

    Disclosure: No positions
    Tags: C, BAC, JPM, Fed, Dow, Whitney
    Nov 16 11:36 pm | Link | Comment!
  • Floaters and the Yield Curve
     As I expected, the 10-year treasury was very well received. The bid to cover ratio was a string 2.81 versus an average of 2.61 for the last 10 auctions. The indirect bidders (which includes foreign central banks) came it at 47.3% versus a prior 47.4%. The 30-year auction was a bit softer than expected, at least on the surface. The bid to cover ration for the 30-year government bond slipped to 2.26 from 2.39 average for the last 10 auctions. Foreign central bank buying remained strong. 
     
        Last week's auctions cause prices on the long end of the curve to rally, but that did not help the U.S. dollar as investors continue to invest in foreign currencies. I think that bubbles exist in foreign currencies, equities, high yield bonds and some high grade bonds. Joining me in the camp is Bill Gross of PIMCO. Bill believes that those markets are over done and U.S. treasuries are the place to be. It is difficult for me to say this as a long-time corporate bond trader, but the credit markets are overdone here. Spreads between 10-year industrials, such as Wal-Mart are well under 100 basis points. Verizon and ATT paper are in the 100 basis point area. Only in the bank and finance arena does some value exist. That is because there could still be some bad news (but not fatal news) ahead. The more retail participation the more overvalued the asset class at this time. This goes double for floating rate notes.
     
        I have been through the floater story before. I still have financial advisors buying floaters at tight spreads and very low yields in an effort to eliminate interest rate or, in the case of CPI floaters, inflation risk. These products do no such things. If floaters eliminated these risks for investors, they would create such risks for the issuers!!! Why is it so difficult for advisers and investors to understand this? It irks me when advisers tell me they know better and that I am wrong. Please, I don't tell financial advisers how to do estate planning, don't tell me how bonds work. Bonds have been my specialty for over 20 years.
     
        Libor-based floaters do best when the yield curve is flat and the coupon benchmark (LIBOR) and the trading benchmarks (10-year or 30-year treasuries) are similar. This is why their prices are at discounts even though long-term rates have crept up. Fixed-rated bonds and preferreds have rallied tremendously. Most LIBOR floaters are so far below their floor coupons based on calculations that it is going to take 300 or more basis points of Fed tightening before these securities can move above their floor coupons. By that time we could be into the next part of the economic cycles heading towards lower inflation and lower long-term rates and the Fed once again easing.
     
     
        CPI floaters adjust off of the year-over-year change of the rate of inflation based on the CPI Urban Consumer Index (non-seasonally adjusted). If inflation, YoY, is at 3.00% for two consecutive years, your coupon FALLS to its spread over the index. If inflation declines from 3.00% to 2.00%, your coupon drops. The coupon would be spread off of a negative calculation. Anyone buying these for inflation protection should be tested for drugs. Buying floaters is to SPECULATE that the observed benchmark will perform in a certain fashion. LIBOR floaters do best when the curve flattens and CPI floaters do bets when the RATE OF INFLATION rises. TIPs are rich as well, but at least a case can be made to have a hedge versus inflation. The best strategy for rising rates or inflation is to ladder or barbell a portfolio.

    Disclosure: No Positions
    Tags: C, MS, BAC, JPM, Fed, Treasury, Pimco
    Nov 15 12:46 pm | Link | Comment!
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