The treacherous bipolar nature of the equity market was visible Thursday. This week’s job loss numbers and monthly retail sale numbers from Wal-Mart (NYSE:WMT) and Target (NYSE:TGT) came in better than expected. The ES futures opened near their overnight high of 929.50. However the gap-up opening level could not be sustained. Equities were sold right from the get-go, with the small-cap Russell2000 and the tech heavy Nasdaq leading the decline. These indices were weak Wednesday too, showing the emergence of risk aversion. Risk aversion was visible with defensive sectors like Healthcare, Utilities and Consumer Staples doing well.
Traders who bought near the open in anticipation of another bull-fest were left with losses, accelerating the downside. In some way the sell-off was expected. The market had rallied into the official stress test result release and some profit-taking was bound to happen.
30 Year Treasury Auction Stuns the Market
The big news of the day was the result of the 30 year bond auction by the Treasury where the yield (4.288%) needed to cover the supply was much higher than expected. Prior to the results of the auction the bonds were yielding 4.183%. The huge gap was a big shock and equities sold off hard, led by the financials. I will discuss the implication of this auction later in the article.
Stress Tests: Run-Up Precedes Capital Raise
As I had alluded to earlier this week, the big upswing in financial shares in the pre-market session on Wednesday (in spite of the shocking news about Bank of America needing $35B in new capital), suggested some active market participation by Big Money. The leak about Bank of America’s capital need emboldened bears who loaded up shorts overnight, only to cover as the equities took off pre-market causing a massive short-squeeze. The action suggested that Wall Street wanted to provide support to up-coming secondary offerings. On a cue, after the test results were announced, Wells Fargo and Morgan Stanley came out with announcements for secondary equity offerings.
Stress Tests: Regional Banks in Tougher Situation
Last night I had also suggested that the lack of any leaks about regional banks suggested a greater risk of disappointment. The regional bank ETF (NYSEARCA:RKH) gapped up at open to a high of 76.37 only to sell-off to close near the lows at 68.66, down 5.31% from the previous day’s close, which was much worse than the losses on the XLF and the KBE. Though the absolute amount of capital required by the regional banks is an order of magnitude smaller than the large banks, it a significant when measured against their existing equity. KeyCorp, Regions Financial Corp, GMAC and Fifth Third Bancorp will have some challenges in raising the capital, and may need government assistance. There is also a risk that their balance sheets may take more severe hits thanks to their concentrated risk in commercial real estate. It is likely that some of these banks will be acquired by other stronger banks.
Long Dated Bond Yields: One of the Steepest Yield Curves Ever!
The news of the day of course is the price-action at the long end of the treasury curve. Though the Fed has succeeded in keeping short term rates low, it has lost control at the long end of the curve. The Quantitative Easing announcement in March was supposed to keep a lid on long bond yields. However the lack of any follow-through emphasis in the April FOMC meeting emboldened the bond vigilantes and yields are now running wild.
The 30 Year bond yield is now at the level seen just prior to the Lehman Brother’s collapse in September and the 10 Year bond is also in the same region. The spread between the TYX (4.261%) and TNX (3.295%) is approaching 100bp. Even sharper is the difference between 2year and 30year rates. It now stands at 326 bps. According to Across the Curve, the highest level ever for this spread was 367bps in October 1992. At that time the 30 year bond traded at 7.29%; rates are 3% lower today.
Negative Implications of Steep Yield Curve
A steep yield curve is typically seen at the beginning of a major economic recovery. It is considered a good sign for banks which can borrow at low short term rates but lend at high long term rates. A steep yield curve is also considered a sign of impending inflation.
The problem of course is that there is no inflation in sight with capacity utilization at historic lows and wages depressed thanks to high unemployment. Asset prices continue to decline and are likely to negatively affect the financial system. The steep yield curve is also derailing the Fed’s efforts to help re-inflate asset prices. It is also a very negative sign for US tax-payers in the face of rising Federal deficit, and will increase borrowing costs for State and municipal governments who are issuing record amount of debt to help bridge the gap between income (via taxes) and spending.
Housing Market Recovery: Low Mortgage Rates Are Critical
In order to recapitalize the balance sheets of US home-owners, the Fed wants ample availability of long term mortgages (30 Years) with low fixed rates. Low mortgage rates are also needed to allow new home buyers to afford their homes. The recovery of asset prices, including homes is critical for the financial system to heal. High bond yields are going to throw a spanner in that plan. 30 year mortgage rates are already rising, and are likely to jump much higher as the TNX continues to go up (it is up 80bp since early March).
Tax Payer Burden
The US treasury will be issuing a large amount of debt in the next few quarters to finance the stimulus package and the multiple bail-outs coming out of Washington. Higher rates on the long end of the curve means that the debt-servicing burden on US taxpayers, and their children, is going to be higher. This is likely to result in higher taxes going forward, which will put a damper on consumer spending and economic growth.
Green Shoots Under Attack
The US economy is at the cusp of turnaround, with better than expected economic news showing a slowdown in the rate of contraction and possible bottoming of the economy. The FOMC took a gamble by not emphasizing quantitative easing; it gave a signal that the economy was improving to help the overall investor sentiment. This improvement in sentiment may have helped drive equity prices higher. It will also help banks raise capital from private sources. However, the cost is higher yields which are now going to attack the Green Shoots at the roots.
Now that the stress test results are out and the banks will be able to raise capital by issuing additional equity to private investors, I hope the Fed changes its tune a bit and cuts down on the cheerleading. According to the Fed's internal calculations, the Fed rate needs to be at -5% to be consistent with the current economic conditions. Fed talk should reflect that reality to help bring bond yields down.
I took a big hit in my TLT holdings today. I violated one of the basic rules of trading: I averaged down the cost of my position. I am close to a capitulation point, where any further increase in yields will force me to take the loss. If there is any solace, the TLT is approaching a long term trend line which I hope will arrest the slide and help me scale out.
The weakness in technology allowed me to close my AAPL shorts at a good profit. The 129.60 target as suggested by the megaphone pattern was made, and AAPL traded as low as 127.90. I also closed my FAZ position during the mid-day weakness in the financials. However thanks to large gap-up at open in the financial, I took some loss on the position since I decided to close it sooner than I normally would have. I also rolled my IYR puts to the next month’s expiration since the euphoria of the stress test results may not give enough time for a pull back.
My decision yesterday to take profits on the in the money TSO call positions, while maintaining a bullish bias with out of money calls served me well as the stock pulled back all the way to $16.07 from a high of $18.77. The refiners are trading at a very low valuation and are ripe candidates for a takeover, as the economy stabilizes.
I scaled out of some of my put positions in Fortress Investment Group (NYSE:FIG) and added a bearish put spread on Capital One (NYSE:COF) which had a big gap-up open on the news that it does not need to raise more capital.
Tomorrow’s non-farm pay-rolls report is going to be an important factor in determining where the market heads next. A report in line with what ADP reported this Wednesday can provide the equity markets a big spark while putting bonds under further pressure.