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.


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