U.S. stocks were all over the map yesterday, moving 2.0% to the downside at its lowest point – while the market waited for the FOMC decision and more importantly how authorities would deal with AIG – but rallied hard in the final 90 minutes of trading on word the Fed would provide a loan to AIG and the FOMC held pat as the inflation gauges barely moved even with oil’s large move lower.
The S&P 500 moved between gain and loss at least 10 times yesterday, and the chart below paints the picture as investors weighed the fate of the largest insurer and the cascading effects that would results from an AIG bankruptcy. What occurred in the credit markets yesterday was hugely concerning.
We’ve heard people say credit markets had seized up and for a year now, but this letter has provided evidence that this had not occurred – at least not in a broad sense. Well, over the past two trading sessions it occurred as the credit markets were very much frozen and it definitely had an effect on the Fed’s and Treasury’s decision to take action regarding AIG.
Market Activity for September 16 2008
Financial and energy shares led the indices higher, but the gains were widespread as all but two of the major industry groups gained ground.
On AIG, the Federal Reserve decided to provide an $85 billion loan and in return the Treasury Department will receive warrants representing the right to a 79.9% stake in AIG. AIG would commit to sell a basket of assets (its several business units both insurance and non-insurance) within a certain time frame. The loan has duration of 24 months at a rate of three-month LIBOR plus 850 basis points. That equals 11.25% and one would think guarantees AIG will not play around with getting these businesses sold. This should not adversely affect the taxpayer – outside of unintended consequences that we cannot grasp at this point – as the government will very likely make money off of this action.
In other market news, the $62 billion Primary Fund of the Reserve (a New York money-market firm) broke the buck (NAV went below $1) due to investments in bonds issued by Lehman. It’s been 14 years since a money-market fund has fell below $1 – one has to go back to the Orange County bankruptcy in 1994. This underlines the reckless risk that has been undertaken for amazingly little boost in return.
AIG is Lehman on steroids and it seems a collapse needed to be avoided. The firm was a major seller of credit-default swaps (insurance default on assets tied to corporate and mortgage securities). Bankruptcy would force financial institutions globally to take huge write-downs as a result.
Let’s hope this month marks the bottom in this chaotic situation, but one can’t say so with confidence. One thing is for sure with this whole mess, risk is getting re-priced and it will be a long time before risk management become as reckless as it became over the past several years. Each company and manager is responsible for their own actions, but personally I lay the ultimate blame at the feet of the FOMC.
Gasoline Prices
Wholesale gasoline prices continued to plunge, falling another 4.74% to $2.44 per gallon yesterday, even as the combo of Hurricanes Gustav and Ike have forced 6.3 million barrels a day of refining capacity to shut down in Louisiana and Texas. Gasoline supplies are at their lowest point in eight years, according to the Energy Department.
At some point prices will reflect this situation, or maybe prices are simply returning to levels prior to the Fed’s abrupt easing campaign that caused hedge funds to flow into the energy trade as a way to guard against inflation. I’m skeptical energy prices will remain at these levels considering heightened geopolitical concerns, which have been ignored with all that is going on in the credit markets.
Further, the energy bill working its way through Congress is a sham. It continues to lock up 85% of the outer continental shelf (OTC), restricts oil-shale production and does not offer royalties to states that lie along 15% of the OTC that is available for production. One big joke.
On the economic front, the Labor Department reported that the consumer price index eased in August, but not by much even as the energy component fell substantially. Food prices rose 0.6% in August and accelerated to 6.1% year-over-year (YOY) from 6.0% in July.
For the overall index, (including everything) CPI declined 0.1% in August and decelerated on a YOY basis to 5.4% from 5.6% in July.
The core rate, which excludes both food and energy – a measure the Fed watches closely – remained unchanged at 2.5% on a year-over-year basis.
The Cleveland Federal Reserve Bank’s Mean CPI – this measure takes a weighted mean of the CPI and gives one the sense what inflation is doing outside of wild swings in certain components – remained unchanged at 3.3%.
What does all of this tell us? It shows that inflation remains sticky and is counter to the Fed’s prediction that overall price activity would come lower along with the decline in energy. (This is where their Keynesian models lead them in the wrong direction)
And speaking of the Fed, the FOMC (the group that determines monetary policy) made the correct decision (in my view) yesterday by keeping their fed funds target rate unchanged at 2.00%. Monetary policy needs to be devoted to price stability – and as just mentioned – their assumption that inflation would come lower simply because energy price have plunged has failed to come to fruition. The members of the FOMC have been mugged by reality and this obviously drove their decision yesterday.
Further, jacking rates lower is what got us into this mess in the first place – keeping rates too low for too long subsidized debt, encouraged financial institutions to abandon risk management and created a commodity spike. The Fed has many other tools with which to provide liquidity and it is about time they held the line on fed funds even as the Street was demanding a cut – fed funds futures had the probability of a cut at 80% prior to the announcement.
The central bank added liquidity through their open market operations yesterday morning. This was needed to get the effective fed funds rate to a level that is closer to their target –although it remained above their desired mark for most of the day as banks hoard cash in this uncertain environment.
Also, the Fed auctioned $20 billion in 28-day repos for mortgage-backed securities as an additional way to increase liquidity into the system. (This is part of the TSLF – or Term Securities Lending Facility in which they broadened the types of collateral, in this case mortgage-backed paper, for its 19 primary dealers for a set period. This temporarily raising the amount of money available in the banking system. At the end of this 28-day period they return the securities to the dealers, and they cash to the Fed.)
In the statement that accompanies the rate decision, the FOMC stated they will continue to address market turmoil with emergency lending (noting, “[s]trains in financial markets have increased significantly”) and the prior easing actions should promote moderate economic growth over time. Their statement, “the inflation outlook remains uncertain” clearly illustrates the latest inflation gauges played a major role in deciding to hold their fed funds target unchanged.
The current economic weakness is not due to lack of demand for goods and services, but because of poor risk management. It is a good thing the Fed held the line.
Have a great day!
Brent Vondera, Senior Analyst
The S&P 500 moved between gain and loss at least 10 times yesterday, and the chart below paints the picture as investors weighed the fate of the largest insurer and the cascading effects that would results from an AIG bankruptcy. What occurred in the credit markets yesterday was hugely concerning.
We’ve heard people say credit markets had seized up and for a year now, but this letter has provided evidence that this had not occurred – at least not in a broad sense. Well, over the past two trading sessions it occurred as the credit markets were very much frozen and it definitely had an effect on the Fed’s and Treasury’s decision to take action regarding AIG.
Market Activity for September 16 2008
Financial and energy shares led the indices higher, but the gains were widespread as all but two of the major industry groups gained ground.On AIG, the Federal Reserve decided to provide an $85 billion loan and in return the Treasury Department will receive warrants representing the right to a 79.9% stake in AIG. AIG would commit to sell a basket of assets (its several business units both insurance and non-insurance) within a certain time frame. The loan has duration of 24 months at a rate of three-month LIBOR plus 850 basis points. That equals 11.25% and one would think guarantees AIG will not play around with getting these businesses sold. This should not adversely affect the taxpayer – outside of unintended consequences that we cannot grasp at this point – as the government will very likely make money off of this action.
In other market news, the $62 billion Primary Fund of the Reserve (a New York money-market firm) broke the buck (NAV went below $1) due to investments in bonds issued by Lehman. It’s been 14 years since a money-market fund has fell below $1 – one has to go back to the Orange County bankruptcy in 1994. This underlines the reckless risk that has been undertaken for amazingly little boost in return.
AIG is Lehman on steroids and it seems a collapse needed to be avoided. The firm was a major seller of credit-default swaps (insurance default on assets tied to corporate and mortgage securities). Bankruptcy would force financial institutions globally to take huge write-downs as a result.
Let’s hope this month marks the bottom in this chaotic situation, but one can’t say so with confidence. One thing is for sure with this whole mess, risk is getting re-priced and it will be a long time before risk management become as reckless as it became over the past several years. Each company and manager is responsible for their own actions, but personally I lay the ultimate blame at the feet of the FOMC.
Gasoline Prices
Wholesale gasoline prices continued to plunge, falling another 4.74% to $2.44 per gallon yesterday, even as the combo of Hurricanes Gustav and Ike have forced 6.3 million barrels a day of refining capacity to shut down in Louisiana and Texas. Gasoline supplies are at their lowest point in eight years, according to the Energy Department.
At some point prices will reflect this situation, or maybe prices are simply returning to levels prior to the Fed’s abrupt easing campaign that caused hedge funds to flow into the energy trade as a way to guard against inflation. I’m skeptical energy prices will remain at these levels considering heightened geopolitical concerns, which have been ignored with all that is going on in the credit markets.
Further, the energy bill working its way through Congress is a sham. It continues to lock up 85% of the outer continental shelf (OTC), restricts oil-shale production and does not offer royalties to states that lie along 15% of the OTC that is available for production. One big joke.
On the economic front, the Labor Department reported that the consumer price index eased in August, but not by much even as the energy component fell substantially. Food prices rose 0.6% in August and accelerated to 6.1% year-over-year (YOY) from 6.0% in July.
For the overall index, (including everything) CPI declined 0.1% in August and decelerated on a YOY basis to 5.4% from 5.6% in July.
The core rate, which excludes both food and energy – a measure the Fed watches closely – remained unchanged at 2.5% on a year-over-year basis.
The Cleveland Federal Reserve Bank’s Mean CPI – this measure takes a weighted mean of the CPI and gives one the sense what inflation is doing outside of wild swings in certain components – remained unchanged at 3.3%.
What does all of this tell us? It shows that inflation remains sticky and is counter to the Fed’s prediction that overall price activity would come lower along with the decline in energy. (This is where their Keynesian models lead them in the wrong direction)
And speaking of the Fed, the FOMC (the group that determines monetary policy) made the correct decision (in my view) yesterday by keeping their fed funds target rate unchanged at 2.00%. Monetary policy needs to be devoted to price stability – and as just mentioned – their assumption that inflation would come lower simply because energy price have plunged has failed to come to fruition. The members of the FOMC have been mugged by reality and this obviously drove their decision yesterday.
Further, jacking rates lower is what got us into this mess in the first place – keeping rates too low for too long subsidized debt, encouraged financial institutions to abandon risk management and created a commodity spike. The Fed has many other tools with which to provide liquidity and it is about time they held the line on fed funds even as the Street was demanding a cut – fed funds futures had the probability of a cut at 80% prior to the announcement.
The central bank added liquidity through their open market operations yesterday morning. This was needed to get the effective fed funds rate to a level that is closer to their target –although it remained above their desired mark for most of the day as banks hoard cash in this uncertain environment.
Also, the Fed auctioned $20 billion in 28-day repos for mortgage-backed securities as an additional way to increase liquidity into the system. (This is part of the TSLF – or Term Securities Lending Facility in which they broadened the types of collateral, in this case mortgage-backed paper, for its 19 primary dealers for a set period. This temporarily raising the amount of money available in the banking system. At the end of this 28-day period they return the securities to the dealers, and they cash to the Fed.)
In the statement that accompanies the rate decision, the FOMC stated they will continue to address market turmoil with emergency lending (noting, “[s]trains in financial markets have increased significantly”) and the prior easing actions should promote moderate economic growth over time. Their statement, “the inflation outlook remains uncertain” clearly illustrates the latest inflation gauges played a major role in deciding to hold their fed funds target unchanged.
The current economic weakness is not due to lack of demand for goods and services, but because of poor risk management. It is a good thing the Fed held the line.
Have a great day!
Brent Vondera, Senior Analyst
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