Tuesday, August 20, 2013 - 10 Year and Jackson Hole

10 Year and Jackson Hole

by Sinclair Noe

DOW – 7 = 15,002
SPX + 6 = 1652
NAS + 24 = 3613
10 YR YLD - .07 = 2.81%
OIL - .77 = 106.33
GOLD + 5.30 = 1371.90
SILV - .16 = 23.13

One number keeps standing out from the daily scorecard. The yield on the 10 year note. That is the benchmark for interest rates. As a standalone figure, of course, the yield on 10-year Treasuries is small. But the amount of money it impacts worldwide is flat-out staggering. Out of the estimated $1.5 quadrillion dollars' worth of derivatives on the planet right now, roughly $500 trillion is specifically related to interest rates. So you can see why the 10-year gets so much attention.

Many investors believe the Fed controls interest rates. That's not true; they merely influence them. Rates are set by trades in the market. And if interest rates rise much further, the support the Fed is counting on in the bond markets may not be there. In fact, it may be running the opposite direction. Foreign custody holdings of US Treasuries continue to decline, which implies that our trading partners are not comfortable with treasuries, so they're moving to other assets.

Meanwhile, emerging markets from Brazil to Indonesia have raised borrowing costs in 2013 to try to aid their currencies as the prospect of reduced US monetary stimulus curbs demand for assets in developing nations. The $3.9 trillion of cash that flowed into emerging markets over the past four years has started to reverse since taper talk started back in May. Asia still has potential in the next three years or more, but in the shorter term, momentum has turned a bit.

Institutional managers - read pension fund administrators, foreign banks, and ETFs - who would have normally been big buyers, are paring back because they don't want the exposure that comes with 10-year paper or longer-term assets in a rising rate environment.

Money managers are seeing extremely high levels of redemption requests and withdrawals from bonds. PIMCO, for example, experienced a $7.5 billion hit last month as money headed for the exits. The presumption is that the money is rotating into stocks, but the data suggests a solid portion is simply going back under the mattress. Somebody has to make up the gap; the only one big enough is the Fed. But if $85 billion a month isn't good enough, you've got to wonder how much is.

So, this week the Fed policymakers are headed to Jackson Hole Wyoming for an annual retreat. The Fed heads will talk about their role; the Fed followers will cogitate; the economic thinkers will theorize about the critical information regarding potential shifts in macroeconomic policy. Investors look to the meeting to bring a healthy, if fleeting, shot in the arm to the markets and share prices. Nearly any unexpected remark or errant word coming from the proceedings has the ability to rock the markets.

The markets have come increasingly unglued from economic reality, and are really just responding to Bernanke's speeches. Typically we see a bump folllowing the Jackson Hole get together. In each year, with each speech given in the Grand Tetons, the Dow has experienced triple-digit jumps: 119 points in 2007, 197 points in 2008, 155 points in 2009, last year it was a 151 point gain.

Perhaps unsurprisingly, in each instance but one (in 2009, when he announced the worst of the Great Recession was over), Bernanke spoke about or reiterated the Fed's willingness to intervene in difficult economic circumstances. These words were promptly followed up with a demonstration, most recently with the never-ending rounds of quantitative easing. Clearly, the markets love this talk, the markets have become addicted to the Fed juicing the markets, even if the juice hasn't spilled over to Main Street.

Bernanke has spoken at every Jackson Hole meeting since he took over the chairmanship. Chairmen Ben won't be in Jackson Hole this week. Bank of England Governor Mark Carney won't be there. The ECB Pres, Mario Draghi won't be there. Larry Summers won't be there. Janet Yellen will be there but she isn't scheduled to give a keynote speech. The conference still might move the markets, or it might prove a bit of a snoozer. As exciting as Jackson Hole has been for investors over the past three decades, it wouldn't be wise to plan for any triple-digit jumps this year. Anyone looking for a quick bump out of Jackson Hole should look elsewhere. Specifically, look to the next Fed meeting Sept. 18-19, when Bernanke has another press conference.

That's the sanguine outlook. Not much happens in Jackson Hole. But the Fed and talk of taper has been the prime mover in the market for the best part of the year (you could easily argue that it's been longer),

Thin summer volumes, bull trap head-fake and slightly better data exposed treasury market weakness; it’s no longer just fear of tapering but also uncertainty regarding the next Fed Chair. This past week the US rates market displayed unusual behavior as it didn’t require much in order for bonds to get crushed. We wait for the FOMC minutes and other key Fed events ahead to gauge what lies ahead for treasuries. The biggest risk to the bond market and tactical bullish trades is the combination of tapering fears and the election of a more hawkish Chairperson. In such a scenario it wouldn’t be surprising that investors just sit on the sidelines and see how high rates can go if a hawkish Fed nominee is announced, with an overshoot meaningfully above 3% possible. Stocks then would be under pressure as bonds become enticing again and asset allocation adjustments eventually reverse the flows back into bonds, at least on a short-term trade.

Intermediate, as in to the year end, there is a widespread expectation for us to pop out of the summer doldrums and enjoy a year end rally. When everyone expects something, anything can happen, and it's not always what everyone expects. In other words, we're starting to hear rumblings that the Fed is losing control of the bond markets, and as 10-year yields tap dance toward 3%, there is speculation and rumor, and some of the arguments are compelling, but only to a point.

Bottom line? The Fed is ultimately in control, contrary to what some are claiming. Might just be a little lag time in tamping down rates, that’s all. The lessons from the BOJ should be enough to quell those who doubt this. And the BOJ can do nothing that our Fed can’t do on this side of the pond. If the Fed wants a 2, 3 or 4% 10 yr treasury note then they’re damn well going to get just that. Maybe the FOMC likes rates at 2.8%. Maybe they like them at 3.5%. I just don’t think they like the parabolic rise. That can be fixed in due course if they so desire.

What else is going on in business? Well Barnes & Noble just reported stunning losses for the last quarter. At a conference call following the release of results, analysts called the company's leaders slow and ineffective. They zeroed in on the company's Nook e-reader as a sign of failure, demanding payout for "long-suffering" shareholders. Barnes & Noble reported a loss of $87 million in the last quarter, and it attributed about $54.6 million of that to its Nook unit. The struggle over the Nook comes at a time when e-books have decimated the traditional publishing business. The Nook has also struggled to compete with other tablets and e-readers, most notably the iPad and Kindle.

Retailers had a hard day today. JC Penney same store sales down 11% from a year ago in the quarter to August 3 as the department store posted a $586m net loss. But its shares, which closed 6 per cent higher, were bolstered by assurances from management that business was not as bad as it once was.

Best Buy, the electronics retailer, met a better reception from investors as cost cutting helped it to report its first net profit in a year, even though like-for-like sales – at stores open at least a year – fell 0.6 per cent. Its shares closed 13.2 per cent higher.

Meanwhile a bankruptcy judge has approved Kodak's plan to emerge from court oversight, paving the way for it to recreate itself as a new, much smaller company focused on commercial and packaging printing. Kodak said it hopes to emerge from bankruptcy protection as early as Sept. 3. Founded by George Eastman in 1880, Eastman Kodak Co. is credited with popularizing photography at the start of the 20th century and was known all over the world for its Brownie and Instamatic cameras and its yellow-and-red film boxes. The new company won't make cameras anymore.

The long, painful process for Detroit’s bankruptcy is under way.  Unlike corporations that file for Chapter 11 bankruptcy protection, municipalities and other governments seeking to file for Chapter 9 are required to prove that they are eligible. A trial to consider Detroit’s eligibility for bankruptcy is scheduled for Oct. 23. I think everyone conceded that Detroit was a municipality as required by the statute. But the public employees union did argue that Chapter 9 itself is unconstitutional

First is the argument that Michigan’s Constitution prohibits modification of the pensions, and thus prohibits a Chapter 9 filing, where they might be modified. What Michigan’s Constitution actually provides is that pension benefits “shall be a contractual obligation thereof which shall not be diminished or impaired thereby.” By calling the benefits a contract, the state’s Constitution invokes the federal Constitution, which has a Contracts Clause that prohibits the states from passing any law impairing contracts. The same kind of provision also appears in Article I, Section 10 of the Michigan Constitution. Then there is debate about whether pensioners or bondholders should be paid. There will be a lot of talk about morality as well as contractual obligations. I'd like to say this will be interesting, but the truth is it will just be sad.