Wednesday, May 29, 2013 - Behind the Curtain

Behind the Curtain

by Sinclair Noe

DOW – 106 = 15,302
SPX – 11 = 1648
NAS – 21 = 3467
10 YR YLD - .01 = 2.12%
OIL – 2.12 = 92.89
GOLD + 11.30 = 1393.70
SILV + .19 = 22.56

Earlier today, I listened to one of the talking heads on CNBC trying to explain why the markets were up yesterday and down today. It was very entertaining.

When mortgage interest rates fall, the probability that an individual will re-finance a mortgage increases. When mortgage interest rates increase, the likelihood of a re-financing of the mortgage goes down. Therefore, in a rising rate environment, the average life of a pool of mortgages increases. For example, if a bond fund held Mortgage Backed Securities (MBS) with an assumed 10-year average life, and interest rates rose, the average life of the MBS portfolio would be extended for a few years. The last thing that a bond manager wants in a rising rate environment is to have the average maturity of the portfolio extended, as this adds to the losses. As a result, MBS players hedge their portfolios against “duration risk” by shorting Treasuries. The higher rates go, and the speed that rates are increasing, forces more and more selling.

Is there a level of support that we can watch? There is, and it's probably 2.2% to 2.5% on the 10-year bond that will bring out an avalanche of selling. The 2.2% tipping point is very close to where the T-bond sits today. Others say we have a huge concentration of bonds that would go out of the money around 2.5% - again, very close to where we are.

The more the price on the 10-year drops, and the higher the yield climbs, the more selling is required. Is the Big Sell-off going to happen? That depends on the performance of the bond market, and on how the dealer community is positioning themselves against event risk.

There are risks: generally speaking, and in regards to ‘taper’ of QE, soon as the Fed pulls back, we will see a spike/knee-jerk higher in rates (which we are seeing in ‘anticipation’ of this happening). Remember, all the movement we've seen in bonds in the past two weeks is just from jawboning about the possibility of taper.

Bernanke has recently said that the Fed is in the process of  changing the monthly QE purchases. Here's a big question to be considered – does taper of QE indicate the economy is better? That would be the reason to raise rates; the economy is improving – raise rates; everything else is artificial, or just an attempt to tamp down an impending asset bubble.

Yesterday, we heard that consumer confidence was up, a big jump in May to 76.2. It sounds like everybody believes the economy is improving. And while the confidence numbers are up, they're not out of the gutter. The average consumer confidence number during a recession is about 79, and even with our recent boost, we're still lagging below that low bar. The May data shows the highest measure of consumer confidence since February 2008. That was a time in which a housing crash was already well underway, and only a month before before Bear Stearns collapsed and confirmed that the country was in a financial crisis.

Yesterday, we also had the S&P/Case-Shiller House Price Index posting a 10.9% increase year over year in March. Well, that certainly sounds like things are improving. Except, in nominal terms, the Case-Shiller National index (SA) is back to the third quarter of 2003 levels. Inflation adjusted, prices are back to the second quarter of 2000. The biggest price gains were noted in Phoenix, Las Vegas, and San Francisco; all areas that were smashed by the housing crash. So, in some ways, the great rebound in housing is just another stage in the foreclosure crisis. And that is a crisis that is not yet finished.

Last year $192 billion-dollars was lost as a result of foreclosures.  On average per household, this number equates to about $1,700 of loss in 2012. The foreclosure crisis is still ongoing despite the fact that foreclosure volumes are on the decline. Why are the number of foreclosures on the decline? Last month, three major banks, including Citigroup, JPMorgan Chase, and Wells Fargo, halted all their sales of homes in foreclosure; this also reduced the supply of homes on the market. The apparent problem is that the banks still weren't following the rules for foreclosures, in violation of the national mortgage settlement. The reduction in housing supply, then, is largely artificial.

There is one thing that housing prices do accomplish, however: the so-called "wealth effect." Along with a booming stock prices, higher property values make people feel rich. This then encourages them to go out and spend money. Here's the problem with the wealth effect, you have to realize your gains. In other words, you would have to sell your stocks and your real estate and put the profit in your wallet, otherwise the wealth effect is so much smoke and mirrors, and you're spending money you don't really have. Which is one thing that Americans have apparently mastered.

Half of working Americans now earn less than they did 10 years ago, adjusted for inflation. Middle class incomes have barely budged in 44 years. Around 12 million people are unemployed, about 40% of whom have been out of work for six months or more. Remember the Summer of 2012? All the politicians were talking about jobs, jobs, jobs. Now, they can't even spell it. Poverty is on the rise, and it would be in your face and on the sidewalks except that now we have food stamps, so we don't have to look at the lines of people waiting outside soup kitchens like in the Great Depression. Still, 15% of the country depends on foods stamps.

For people who do have jobs, the quality of the jobs continues to decline, and if you were thinking about retiring, well, you probably are having to re-think your personal exit strategy. According to a recent Gallup survey, 37% of nonretired Americans claim that they will quit working after age 65. A decade ago, that percentage was 22, and in 1995, only 14% guessed they'd be retiring after 65. Is it possible that work is now more fulfilling for so many more people? Were so many employers discriminating against willing 65-year-olds a couple decades ago? Not likely. People are working longer to keep food on the table and a roof over their head.

Besides not having saved enough, today's would-be retiring baby boomers have more debt. The Census Bureau reports that from 2000-2011, the largest percentage increases in median household debt were in the 55-64 age bracket (up 64%, to $70,000) and the 65-and-over bracket (more than doubling, to $26,000). And while many were taking on more debt, median net worth (assets minus liabilities) for all age groups fell. In 2000, median net worth was $81,821. In 2005, median net worth had jumped to $106,585, before dropping to $68,828 in 2011 (in 2011 constant dollars).

In 1985 taxable money market funds were yielding 7.71%. A one-year CD was yielding 8.53%. Nowadays, CD's and money market funds offer rates that start with a decimal point. The Fed has been forcing people into the equity market and if you just don't have the stomach for stocks, you've been forced into the bond market.

The Fed's bond holdings alone have almost tripled since March 2008. And since last fall, the Fed has purchased mortgaged-backed securities and bonds by $85 billion each month. As a result, Fed's holdings in securities will amount to $4 trillion by the year-end of 2013. At the same time, the balance sheets of the big four central banks (the Fed, European Central Bank, Bank of Japan, and People's Bank of China) have more than quadrupled from $3 trillion to more than $13 trillion during the past half a decade.

As rounds of QE have pushed nominal interest rates below the rate of inflation in the United States, it was hoped that negative "real" interest rates would encourage lending and borrowing, and thus to stimulate economic activity. But this is growth by addiction, not growth by fundamentals.

Ben Bernanke knows this economy is not strong. This is no time to back away from trying to prop up the economy. Or as Bernanke said: “A premature tightening of monetary policy could lead interest rates to rise temporarily but would also carry a substantial risk of slowing or ending the economic recovery and causing inflation to fall further.”

Is the economy in better shape than a couple of years ago? Yes, but it's a little early to break into a chorus of “Happy Days are Here Again”. While economic growth has picked up, it remains anemic at 2.2 percent real GDP growth on average since the end of the recession in mid-2009. As long as the US is growing well below potential; about 2.2 percent since the Great Recession/depression, inflation risks remain low and disinflation is the new normal, which serves as a still another reason to keep interest rates low. A lot of people would like to press the idea that the economy is improving; Congress can keep ignoring the unemployment and equality crises and enjoy ginning up imaginary problems.

“The loss of output and earnings associated with high unemployment reduces revenues and increases spending on income-support programs, thereby leading to larger budget deficits and higher levels of public debt than would otherwise occur.” At least that's what Bernanke claimed in his recent testimony to Congress. Maybe Winston Churchill said It better: “Americans can always be counted on to do the right thing, after they have exhausted all other possibilities.”

A mythical recovery gives cover to a lot of irresponsible people hoping that Americans won't look behind the curtain.

Thursday, October 18, 2012 - The Only Day Like it Ever

The Only Day Like it Ever

by Sinclair Noe

DOW – 8 = 13,548

SPX – 3 = 1457
NAS – 31 = 3072
10 YR YLD +.01 = 1.83%
OIL un = 92.09
GOLD – 8.30 = 1742.60
SILV - .38 = 32.92
PLAT – 19.00 = 1651.00

Do you remember where you were 25 years ago? It was a Sunday; 1987. The news of the day was that Nancy Reagan had been hospitalized with cancer; there was a threat of war with Iran and within 24 hours the US was shelling Iranian oil platforms; there were concerns about Germany's currency; the United States, wanting to prop up the dollar and restrict inflation, tightened policy faster than the Europeans. US pressure on Germany to change its monetary policy was one of the factors that unnerved investors.The stock market had a wave of steady selling on Friday and the Dow dropped 108 points. Most people really weren't aware; this was before we all had computers and smart phones and tablets. Maybe you read about the Friday sell-off in the Sunday newspaper. Maybe you thought about selling a little bit of your portfolio, but the truth is that it was already too late.

Halfway around the world, the dollar-backed Hong Kong markets were chopped down 10%. And then the crash spread. European bond markets collapsed, which caused interest-sensitive savings and loans and money center banks to plunge. Monday morning, October 19, 1987 the crash washed across lower Manhattan. In a flash, the Dow crumbled and by the end of Black Monday the Dow had dropped 508 points, wiping out 23% of market value.

The 1987 villain was something called portfolio insurance. It was a product that used stock index futures and options to assure institutional investors that they need not worry if market prices seemed to be unreasonably high. Portfolio insurance would let them get out with minimal damage if markets ever began to fall. They would simply sell ever-increasing numbers of futures contracts, a process known as dynamic hedging. The short position in futures contracts would offset the losses caused by falls in the stocks they owned.

Portfolio insurance did not start the widespread selling of stocks in 1987. But it made sure that the process got out of hand. As computers dictated that more and more futures be sold, the buyers of those futures not only insisted on sharply lower prices but also hedged their positions by selling the underlying stocks. That drove prices down further, and produced more sell orders from the computers. At the time, many people generally understood how portfolio insurance worked, but there was a belief that its very nature would assure that it could not cause panic. Everyone would know the selling was not coming from anyone with inside information, so others would be willing to step in and buy to take advantage of bargains. Or so it was believed.

The crash had been predicted. Congressman Edward Markey had issued repeated warnings, largely unheeded. Paul Tudor Jones predicted the crash, traded accordingly and profited greatly. But almost everybody else got burned. After the crash, the markets managed to rebound sweetly over the next couple of years, but most investors were once bitten, twice shy.

What really caused the Crash of 87? We can speculate but we can't say with certainty.

Twenty five years later, and the US is still on the verge of war with Iran, the European currency situation is still fragile, portfolio insurance has been replaced by derivatives and High Frequency Traders

What we do know is that don't know much.

Dallas Federal Reserve President Richard Fisher recently offered a stunning assessment about our policy-making central bankers down in Washington: "Nobody really knows what will work to get the economy back on course. And nobody-in fact, no central bank anywhere on the planet-has the experience of successfully navigating a return home from the place in which we now find ourselves. No central bank-not, at least, the Federal Reserve-has ever been on this cruise before."

Did you ever meet someone who has a gambling problem? Probably, I think we all know someone with strange desire to bet on almost anything: football games, horse races, slot machines, the stock market. The Federal Reserve has placed a big bet that they can buy up $40 billion or so worth of mortgage backed securities each and every month until the housing market recovers, and not just recovers but shows enough strength to lift the labor market on its shoulders.

This means the Fed will monetize nearly 50% of the entire US budget deficit in 2013. That will boost its balance sheet from the current $2.8 trillion to approximately $4 trillion , or 24% of GDP, by the end of next year. With more money available, and at lower rates, that money will then work its way through the economy. Businesses would use the cheap money to expand. The idea is that, flush with cash and with fewer opportunities for higher returns, the banks will boost their lending to businesses and consumers, which is the basic idea of traditional banking. The problem is that traditional banking is pretty much dead; replaced by a casino mentality.

So, far the Fed's QE to Infinity and Beyond hasn't pushed down mortgage rates as much as you might anticipate. QE has pushed down rates on Mortgage Backed Securities but not mortgage rates. The banks are sitting on the proceeds from the MBS purchases, rather than passing the money on to customers in the form of lower interest rates; it has really helped increase the margins for the banks; not much help for the customers. William Dudley, President of the New York Fed recently talked about the problem, that the transmission mechanism is broken. He didn't seem to offer a solution, but the Fed is certainly aware.

The banks are not content to just pick up the wider margins, just as a hard core gambler is never content to walk away from the casino, even after the pit boss tells you the roulette wheel is broken. The banks are now leveraging the MBS market. UBS has just launched a 16-times-leveraged MBS ETN. The ETN stands for Exchange Traded Note, and it's an unsecured, unsubordinated debt security; this specific one is called the ETRACS Monthly Pay 2x Leveraged Mortgage REIT, offers double the return of the Market Vectors Global Mortgage REITs Index – itself an investment vehicle with 8 times leverage to mortgage-backed securities.

The idea appears to be that with the Fed acting as a buyer-of-last-resort that prices will take a smooth upward trajectory and that 16:1 leverage makes sense for retail investors as a bet on a sure thing. Yes, you heard right, in the chase for yield 1.75% MBS pools is just too low, so the gambling junkies on Wall Street lever up 8 times; then the gambling junkies at UBS figure to double down

And it may seem like a sure thing because the Fed is backstopping the MBS market, but if you step away from the crack pipe, a closer examination of QE to Infinity and Beyond reveals some holes in the backstop. The Fed could change the transmission mechanism and buy other assets. Let's say that one year from now, the economy is no better off, the Fed could decide they need a fresh approach; no more MBS purchases instead they'll buy up student loan debt or whatever. Let's say that one year from now the economy has shown a tremendous improvement, housing has come roaring back and the jobs picture is bright and glossy and inflation is rearing its ugly head; the Fed backs out of MBS purchases and tries to clean up their books.

What the Fed hasn't figured out is that the bankers are just gamblers. That's the result of the repeal of Glass-Steagall, which demolished the wall between traditional banking and the risk-taking investment banks; now banks could gamble with FDIC insured deposits backing their bets. Toss in the Commodity Modernization Act of 2000, kind of like portfolio insurance on steroids, and the result was the Crash of 2008. Now the banks are short of cash, but they're still neck-deep in the $650 trillion-dollar derivatives casino. And their gambling addiction requires their absolute attention. And just like the addict, they take their money to the table rather than paying their rent.

Practically speaking, the world of high finance has become more dangerous than ever and traditional banking customers have become all but irrelevant. Why write 16 mortgages when you can write just one and leverage it 16 times? The nation's banks once went out of their way to find reasons to give money out. No longer.

So growth slows to a crawl. This results in balance sheet destruction once productive assets go into decline. Corporations cut costs, delay investments, fire workers. Consumers cut back, tighten belts, deleverage and shun debt, even if it's free. Ultimately, demand craters.

The Federal Reserve is probably trying to prevent a deleveraging depression. Maybe they'll be successful. It's a hard slog without fiscal stimulus, and with the dysfunctional Congress, we know not to count on that. One thing I would like to see is a reinstatement of Glass-Steagall. Either you're an investment bank or a commercial bank - but you can't be both. If you're trading derivatives, you're on your own. If you're lending to consumers and businesses, you get the FDIC insurance and the implicit backing of the federal government. If we could just get the bankers away from the casino, maybe we could get them to do their job; you know, a safe repository, a steady lender, circulating money through the economy.