May 5, 2010

According to the Institute for Supply Management, the Manufacturing sector grew at the fastest rate since 2004. The ISM Manufacturing Index, which is one of the key reports monitored by the Federal Reserve in setting monetary policy, came in at a roaring level of 60.4 for March on Monday signaling expansionary economic activity. A reading above 50 typically signals economic expansion and the index has surpassed 60 only nine times (not including today’s print) in the last 25 years. Usually, when manufacturing activity gets hot, it stays hot for several months. Those nine occurrences can be broken down into two separate periods.

The last time the index entered the 60’s from depressed levels was in December 2003, six months after the Federal Reserve lowered short term borrowing rates to a then low of 1.00 percent to spur economic activity. In June 2004 and after a string of Index readings of above 60 in six out of the seven following months, the Fed changed course, tightened policy ,and jacked up the Fed Funds target by 25 basis points.

Prior to that, the Index posted readings above 60 in three out of four months beginning in September 1987 (right before Black Monday). As with the case in 2004, 6 months after the initial reading, the Fed changed course and tightened policy and jacked up the Fed Funds target by a quarter percent.

ISM Manufacturing and Federal Funds Rate

Back to now, there are rumblings that the economy is on the road to recovery and a Fed rate hike is in the not too distant future, as soon as late 2010 or early 2011. At the last FOMC meeting, Thomas M. Hoenig was the lone dissenter of current policy and stated that continuing to communicate expected low levels of the federal funds rate for an extended period of time was no longer warranted.

According to a Bloomberg survey of economists, the Federal Reserve will be increasing rates by quarter point increments as early as the 3rd Quarter of this year. Furthermore, J.P. Morgan’s Treasury Client Survey which includes institutional fund managers are 92 percent neutral or bearish on U.S. Treasury prices.

In my view, and unlike the aforementioned situations, the Federal Reserve currently has their hands tied and will not be raising rates for quite some time, possibly mid to late 2011 at the earliest.

In both periods, conditions were healthy enough where the economy could handle tighter monetary policy. Specifically, consumer confidence was relatively high as people were optimistic with economic conditions and loan growth was positive. The University Michigan Survey of Consumer Confidence Sentiment averaged 89.9 in the 1987 episode and 95.4 in the 2003 time frame. According to data provided by Federal Reserve, Consumer Credit during those periods increased on average 3.5 billion and 9.4 billion per month, respectively.

A positive outlook, which is facilitated by improving employment conditions, allows people to borrow and spend more, which in turn creates more jobs and improves activity. Indeed it is a circle but a spark needs to be somewhere.

Unfortunately, people in the US see the world through gray colored glasses and with a half empty view these days as the Michigan Confidence Sentiment is currently at a depressed 72.2 reading. This is further supported by the lack of demand for borrowing. Consumer Credit has been declining in 12 out of the last 13 months with an average decrease of 8.9 billion per month. Economists are expecting the latest release which is due on May 7th to be another decline of 4 billion. While the error between actual and expected can be large with equally big revisions to prior numbers, the signs are not encouraging.

Consumer Credit Historical Chart

The Federal Reserve has pumped a tremendous amount of liquidity into the system and has made the current environment accommodative to borrowing. Typically when short term rates are low, a bank can borrow short at one rate and lend farther out the maturity spectrum at a higher rate. This spread results in profit for the banks. However, money is stagnant as it sits there as excess reserves on bank balance sheets. Instead of lending, banks are buying safer Treasuries according to a Bloomberg report. Essentially, they can still capture a spread but with no credit risk.

It’s a healthy and prudent trade for a bank but isn’t exactly what the Federal Reserve had in mind in trying to promote economic growth. For Bernanke and company, creating an environment suited for borrowing when no one is in the mood for borrowing is like pushing on a string.

The government needs to start implementing programs designed at job creation, with an emphasis on the private side, to create that spark. Unfortunately, tax dollars have been spent on other programs and any additions will be faced with strong opposition going forward. In the absence of that, the destruction of excessive debt in some form or fashion needs to occur in order to promote sustainable growth.

Outside of either defaulting or paying it off, the only way to achieve debt destruction is through the passage of time. Apparently this is evident by the recent decline in Consumer Credit as borrowers are content with the debt that they currently have. With higher taxes on the horizon and a slow job recovery, an age of austerity will redefine the way we do business here in the US. Because of this, we will not be seeing loan generation by banks for the foreseeable future which will in turn, keep the Federal Reserve on hold.

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May 4, 2010 

There is something about fund managers and strategists who constantly believe that there is this mythical average or mean in the markets. Perhaps it comes from our study of economics where there is a natural balance of opposing forces of supply and demand, i.e. equilibrium. I am sure it exists (that is, in a vacuum that is devoid of investor’s time horizon). However, in my experience as a fund manager of close to 15 years, equilibrium has always been elusive. 

On Friday, JP Morgan recommended that the flight-to-quality bid we have seen in the Treasury markets will eventually fade and rates will sell off. Their Fixed Income Markets Weekly, dated April 30, 2010 stated: 

“Thus, this week’s flight-to quality bid likely reflects fears around the potential for Greece’s fiscal issues to snowball into a European banking crisis, something we believe policymakers will almost certainly seek to avoid. Indeed, the late-week rally in Greek spreads as well as the Athens Stock Exchange index suggests that markets are beginning to price in this expectation as well. Thus, flight-to-quality pressures are unlikely to sustain low Treasury yields. In sum, given these factors, we now turn underweight duration” 

In addition, J.P. Morgan’s Treasury Client Survey which includes institutional fund managers are 92 percent neutral or bearish on U.S. Treasury prices implying that Greece is not an issue and the U.S. is on the road to recovery. 

According to a Bloomberg survey of economists, the Federal Reserve will be increasing rates by quarter point increments as early as the 3rd Quarter of this year. 

Obviously, no one sent JP Morgan and many of the institutional world the memo of Greece contagion and the possible demise of the Euro. Let’s not forget what is happening in China as the government sent another round of tightening. 

Flight-to-quality trades occur when uncertainty hits the market. In this case, we don’t know how deep the rabbit hole is. What was once rational becomes emotional as fear overcomes investor’s decision making. So when investors start looking for the exit, not only do they run but they “George Costanza” it and run people over in the process. This explains the crashes that occur throughout history and recurring black swan sightings. 

Typically, option volatility spikes as market participants drive up the price for options as a hedge against current positions. Sometimes, investors will do whatever it takes to protect the farm. Below is the Merrill Lynch MOVE Index that captures option volatility for Treasuries across the curve.

Merrill Lynch MOVE Index - 2005 to Today

As you can see, volatility spiked in 2007 and lasted for almost a year. After subsiding, volatility spiked again as the bear market took shape in the fall of 2008 before subsiding the following January. If you go back further to the early part of this decade, you can see more spikes that last equally as long.

Merrill Lynch MOVE Index - 2000 to 2005

Uncertainty and flight to quality trades certainly fade. There is no doubt about that since mathematically volatility cannot go in one direction forever. The only question is how long will it take to subside. Given the severity of what is happening in Europe and the possibility of contagion among developed markets, uncertainty, high volatility and flight-to-quality trades might last for awhile. There is nothing elusive about that. The situation is real. This much is certain.

May 4, 2010

“The road to hell is paved with positive carry.” –Bond market adage

The S&P 500 is down by more than 2 percent and the Volatility Index aka VIX is shooting up by more than 23 percent percent to the mid-20’s level.  Credit spreads typically move in lock-step with Volatility as uncertainty rattles corporate bond market investors.

VIX and Credit Spreads 10-Year History

The correlation between volatility and spreads is very high as illustrated in the chart.  The correlation over this time frame is 0.88 for Investment Grade bonds and 0.93 for High Yield bonds (A 1.00 correlation means the two move in lock-step in the same direction while a -1.00 means they move in opposite directions.  A correlation of 0.00 means that they are practically unrelated.)

Interestingly in early 2008, credit spreads widened more than what the relationship implied at that time.  In March 2008, spreads spiked (by almost 54 basis points to 852) while equity volatility remained the same (VIX stayed in the mid-20’s).  As we all know shortly after, Lehman brothers collapsed and equities started its tumble on its way to a Bear market lasting until March 2009. 

Credit spreads can sometimes signal a bumpy road and market pressure well before the equity markets. It doesn’t occur all the time but when it does, it certainly requires notice. Going forward, divergence in the relationship is something to monitor to determine if this sell off in equities is short-term in nature or the beginning of another journey down a bear market road. Stay tuned.

What?!?

His blog recap states:

What’s bad for the European Union, Cramer said during Monday’s Stop Trading!, may be good for the US.  He thinks the EU’s debt problems have helped fuel the rally we’ve seen in the American markets.

“This is a gigantic movement of capital out of Europe to the United States,” Cramer said.

If we look at 2008, the Dollar, which illustrates a demand for liquidity and flows into and out of the U.S., rallied shortly after the collapse of Lehman Brothers. Despite this and contrary to Cramer’s premise, the S&P 500 continued to collapse, which sent bond yields to historical lows.  Sure, money flows and low bond yields are bullish for stocks but that scenario is favorable over the long term.  Low borrowing costs spurs investment, which in turn increases profitability.  What we are dealing with is the here and now.

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