Monday, December 15, 2008

How Was That Rate Cut A Surprise?

So the fed cut - more than expected - but in line with where rates were anyway. the market responded by taking the yield curve flatter - 10 yr now at 2.19, and the Euro and yen rallied hard, with smaller rallies in other currencies. I had been expecting dollar weakness but not this soon and not this big. I misjudged market reception to what I thought was a recognized fed move to ZIRP.

What to do on the dollar now? I suspect that ECB and BOE are right behind us with ZIRP like moves. The IMF is scolding the ECB pretty hard on their very slow moves on rates. That would mean that both the ECB and BoE take rates down from here, while we can't go any further. I think it's also safe to assume the problems in the Euro banking system have yet to fully play - massive exposure to junk loans and Eastern European debt. With deflation picking up serious steam in the next few months, central banks will follow the US down. At a peak of $1.45, the Euro looks overbought. We wont even discuss the pouind as that is not a currency we'd consider buying.

The game theory with the growth in money supply by the fed suggests that if the fed fails to convince the markets that it will keep rates at this level for YEARS, then we are unlikely to see a significant uptick in lending. The only way to end the liquidity trap of the Fed making credit essentially free but the banks not willing to on lend the money is if banks know they will have these insanely easy credit terms with the Fed indefinately.

If the Fed builds up a big enough WW position in US Treasuries at 1.50%-3.0%, which is the likely scenario over the next 18 months, and expands money supply, at some stage there will be a big game of chicken. If the Fed’s policy actions work, Bernanke and Co will be forced to normalise rates to prevent excess inflation - and in the process will inflect massive losses on those buying now at 2.25%. That does suggest a long term basis for US$ deprecitation. I can't think of better hedges against the long term decline of the dollar than German Eurobonds and gold. The bulk of the problems in the Euroland banking system should be appearant by Q1/Q2 next year.

On the TBT trade, well, I guess we're averaging in. I started liking it at $48, loved it at $40 and I guess I'm infatuated at $35. Given that ZIRP is here to stay for a while, the ten year looks an easy lock on 1.5%; ZIRP has been entrenched policy in Japan for over a decade now and their 10 yr is 1.28%. So I guess TBT can go lower from here. I just can't help but view this massive move down of the US Treasury yield curve as simply the last resting place of the Greenspan liquidity buble. I am having trouble understanding how it will be deflated by the Fed without a serious impact on the US$.

Another big miss has been not finding the right vehicle for getting long the high grade corporate bonds. Thanks, Helen, for pointing out the LQD. Would have been a great trade back in Oct/Nov. We'll keep it on the list of things to watch. Corporate defaults are just getting started, so I assume we'll have opportunities to buy the LQD back in the 80's next year. The upward tick in corporate default rates - 3.5% as of November - has been slow compared to previous recessions due to alot of reasons; between the huge unused credit balances companies still have access to at banks and the incredibly crappy loan structures of the past few years that essentially have no real covenants, we may not see a real spike in defaults until well into '09.

More on High grade Bonds...

"Leveraged loans had a particularly rough month with the average senior secured loan losing over 20 points in value and now trading in the mid 60s. The sell-off was largely driven by forced liquidations as hedge funds face substantial redemptions in the run-in to New Year. This is how crazy the loan market is: The worst ever default rate for senior secured loans is about 8%. If you assume a 35% annual default rate and a 50% recovery rate, your IRR to maturity is now in excess of 22%, using no leverage whatsoever. Either this is the investment opportunity of the century, or equity markets have seriously underestimated the economic downturn, and things are likely to get a whole lot worse for equity investors." - a quote from the FT.

"Investing before the peak of defaults in the past 2 cycles resulted in high Yield returns of 45% in 1991 and 28% in 2003. Those returns are a consequence of allowing bankruptcy to clean out future default uncertainty, resulting in better quality companies surviving and a reduction in the cost of credit and an improvement in its availability… Despite its headline figure of 30% cumulative default rates across 2009-11, the scenario of quick credit resolution should be hoped for as the economic implication of slow version increases cumulative defaults to 50%.

"Abrupt withdrawal of credit is the key factor that distinguishes the current default cycle from those in the past… At the highest yields in a decade, high grade corporate bonds yield over 8%, offering a competitive return to equity with lower risk. Following stocks’ 40% decline and substantial volatility, reduction to over-allocations in equity may provide a key source of support for credit returns in 2009. Our recommendations favor a high quality portfolio as default risk in leveraged finance keeps us waiting for more clarity on the emerging credit cycle before venturing into the more tempting 22% levels offered in high yield." - from the BofA credit team.

Stocks vs Bonds...

"Recent Investment Outlooks and indeed, discussions in PIMCO's Investment Committee and Secular Forums for the past several years have pointed to the necessity to view current changes as not only non-cyclical, but non-secular. They are, in fact, likely to be transgenerational. We will not go back to what we have known and gotten used to. It's like comparing Newton and Einstein: both were right but their rules governed entirely different domains. We are now morphing towards a world where the government fist is being substituted for the invisible hand, where regulation trumps Wild West capitalism, and where corporate profits are no longer a function of leverage, cheap financing and the rather mindless ability to make a deal with other people's money.

"My transgenerational stock market outlook is this: stocks are cheap when valued within the context of a financed-based economy once dominated by leverage, cheap financing, and even lower corporate tax rates. That world, however, is in our past not our future. More regulation, lower leverage, higher taxes, and a lack of entrepreneurial testosterone are what we must get used to – that and a government checkbook that allows for healing, but crowds the private sector into an awkward and less productive corner. Dow 5,000? We don't have to go there if current domestic and global policies are focused on asset price support and eventual recapitalization of lending institutions. But 14,000 is a stretch as well. One only has to recognize that roughly 20% of bank capital is now owned by the U.S. government and that a near proportionate share of profits will flow in that direction as well. Better to own corporate bonds than corporate stocks..." from Bill Gross at PIMCO.

On Oil...

So far, the OPEC nations are not cutting back any significant amount of production compared with the destruction in demand. Oil is backing up in the system. Energy economist Philip Verleger suggests that OPEC should execute an "astounding 7.7 million barrels per day" just to restore market balance today. Global demand is down by over 5 million barrels a day to 81.6 million barrels a day. Non-OPEC countries produce almost 50 million barrels of oil. OPEC produces roughly 31 million, plus there are some other OPEC sources of about 5 million barrels equivalent in natural gas liquids. Thus, Verleger says OPEC oil production needs to drop by almost 25%, to somewhere under 24 million barrels a day. Think Iran or Venezuela will cut that much, given their need for cash to fund their regimes? Will Russia join OPEC and cut production? It will be interesting to watch Iran and Venezuela in the coming year scramble to maintain power.
Turn Yer Head For A Second And...

Just when you think it can't get worse. Madoff? Are you kidding me? $50b? That's about 1/2% of the US economy. The Mother of all ponzi's. Ponzi himself would be astonished. The good thing is the market is so used to bad news that it didn't really register much concern. What greater way could you come up with to point out the failings of the US capital markets? Capitalism needs an efficient and transparent market for capital. We don't have one.

We have a lot going on this week - OPEC meets, the Fed meets, GS and MS report - and I've been AWOL for a week, so there is a lot to catch up on. I've been in the bush on an outer island; I caught some waves, got bit by a dog, a regular solomon experience. on return, I have had a couple days to reflect on the changes in the last week and what seems clear is the following:

one, delevering has ways to go - this is a once in a century debacle and adjustment will take time; two, '09 will be a mess and growth will be moderate for years to come - no debt to fuel the fire anymore; three, the dollar must go down - massive debt issuances and low rates from quantitative easing will see to it; four, treasuries have almost bottomed - they may stay low for a long time, but looking on the short side is a good bet; five, high grade corporates have factored in a default rate worse than the 1930's and are the best bet for a rally in the next 3-6 months; and six, you can't slow the US consumer down without a corresponding impact in its manufacturing partner - Asia.

The short dollar call is the most interesting because of the recent rally in the Euro and Yen. It seems as though the market doesn't like the fact that the US current account deficit has expanded again, Madoff has dropped a $50b bomb and the Big Three might go bankrupt causing a massive round of CDS defaults. The jobless numbers didn't help and neither did the $500b-1t Obama fiscal plan making the rounds. These are the near term events.

Longer term, the market smells the '09 trillion dollar deficit and the massive treasury funding needs coming; it's looking at the expansion of the Fed's balance sheet with crappy assets and the likelihood of TARP 3 and TARP4 ; and it's looking at the current 0% yield on recent 30 day issuances. Growing risk matched by declining yield? Something has to give and it won't be interest rates - we can't afford that - so it must be the dollar. We can buy FXE or gold or the short dollar Profund.

Given that outlook, rates may not move up that much in the next 1-2 years, but we can be sure they can't fall much more. At a 0.5% Fed funds rate, money market funds are barely breaking even and that pretty much limits any move to 0%. That leaves the longer end of the yield curve, which has moved down aggressively over the past month to 2.60% for the 10 year. This move is a direct result of the quantitative easing policy of the Fed and can only be sustained by running the printing presses. At some stage of dollar weakness (and US inflation), the Fed will have to stop the game and rates will normalize. I wanted to be short T's a month ago, and would have burned, but the rationale is much better now. TBT is the ticker.

If you want to participate in a recovery rally in the US corporate sector, why not play at the high end of the balance sheet - high grade debt, instead of the least secure part of the balance sheet - common equity? At rates of 8%++ for high grade corporate credit with a potential for a serious rally in value, this seems like a sensible approach. I believe our endgame from this 50 year end-of-cycle carnage will place income above capital appreciation in the priorities of investors. That would mean you want a long term position in high grade bonds anyway. There must be some simple investment grade bond etf's to play. And you don't need to go too far out on the curve to get a decent yield or bounce on a rally.

What about gold? Well, if the dollar is going down in the longer term, and US inflation is headed up, seems that gold will perform well against the dollar for some time to come. As a hedge again Other Awful Things Happening, it seems helpful. Think about it: the largest economy in the world - by a factor of 3 - is taking a big gamble that the world will still hold its debt/currency despite a massive expansion in both. We live in a fiat currency world, and just 40 years ago the dollar was backed by gold. In a time of uncertainty, will we need to go back to a gold backing? Will we need to have all Fed currency liabilities backed by gold? Based on what we have in Ft Knox, that would price gold at $6-7,000/oz. You can own GLD, CEF, DGP or the gold stocks in GDX.

Finally, about Asia. They are more dependent than ever on exports, but their national and corporate balance sheets are strong and under-levered. They are flush with FX reserves. They will need them. If the US consumer contracts by 5% (a minimal guess), then China would need to expand its consumer spending by 40%. Not gonna happen. There is a very large export focused manufacturing base in Asia that will see a big chunck of business dissappear - some serious adjustments will be required. When those adjustments happen, this part of the world will be the Most Likely to Succeed.

As far as the expected equity rally goes, I'm getting bored waiting. The reports from Q4 and guidance for '09 will be nasty. The Obama fiscal plan has made the rounds and the market couldn't stay above 9,000. The hedge and mutual fund redemptions are still coming, so selling pressure remains. There is a lot of cash on the sidelines; what now will suck it into the market? I still own SSO for the trade and am underwater by only 15% now... Meanwhile some names have surged on the US infrastructure plans and look like good shorts. ACM comes to mind.

Monday, December 01, 2008

The Bubba Call

“If you have a deflationary shock, the only instrument that will perform will be government debt,” said Hendry, 39, whose Eclectica Fund returned 38 percent this year, putting it in the top 1 percent of 1,817 funds tracked by Bloomberg. “Inflation is going to be back some day. But forget the next 12 years; it’s the next 12 months that matter.”

So, the Call is to keep the majority of powder dry, focusing on short term government bonds including munis, and start looking for well managed corporate bond funds. Bond prices have effectively priced in a once in a century default rate and look attractive. We have time to find the right funds. Build a position in gold, slowly, through the deflationary cycle ahead. For the same reasons TIPS are looking interesting - if we are looking for the 10yr to bottom at 2.50%, we are almost there. The amount of monetary stimulus, WW, coming over the next 12 months almost guarantees big inflation and currency stability concerns in the long run.

More bank write offs are coming from credit card, commercial RE and corporate loan defaults, a potential full nationalization of banks is ahead of us, plus we have potential sovereign defaults as well. Credit has been shut off to the US consumer; the delevering process is less than half way finished. The WW slowdown is massive and moving very quickly, and there is little central banks can do about it. We are winding down an unsustainable system based on debt (and fiat currency) that took more than 30 years to build. This will take time.

Within this backdrop of deep concern for the global economy and global markets, we are beginning to see a few positive signs - mainly that the Fed's latest moves are making a difference in market liquidity. With the return of liquidity comes the chance to avert insolvency and default for the better companies.

I am hoping this can make the case for a sizable rally. Historically, bear markets have provided some juicy 30-50% rallies amidst the destruction. I am looking for the seeds of hope that could put together a big move. So far, the flow of information continues to be overwhelmingly bad and so rallies have simply fizzled.

But if you are like me, and you can't help yourself and want a little trading action (death by a thousand cuts), then starting around this level seems like a good entry point for long positions. Stay away from banks, use broad, liquid index ETF's (DIA, SPY, etc) and I recommend stops. With daily volatility of 5-10%, expect to get taken out of positions frequently when using stops. It will be frustrating. Of course, we may look back and realize that there was a trade at this point, only it was to be short the market...