Dow in positive territory

S&P 500: +1.32 (+0.14%)

The Dow has crossed into positive territory six times this year, but had not closed in the black until today. Meanwhile, the S&P 500 chalked up another weekly win and has now posted gains in 12 of the last 14 weeks.

In what was a relatively quite day in terms of market moving news, a malfunction of three computer servers at the New York Stock Exchange (NYSE) caused the suspension of floor trading about 200 stocks, all of which reopened for trading later in the day.

The beginning of a new era
Starting next week, Cliff and I will be changing our format to our Afternoon posts. This will hopefully result in more consistency and structure. These changes will also likely result in more frequent posts instead of a couple giant posts at the end of the day. Of course, we will still have many of the same things you have come to love: the fixed income table, the quick hits, and in-depth analysis.

Stay tuned...


Quick Hits

• Beyond the Underwear Index: Four Other Odd Economic Indicators
• High Gas Prices Could Slow Recovery
• Bernanke Success May Come at Cost of Congress Curbing Fed Power

Peter J. Lazaroff

Fixed Income Recap

The two-year finished up 3/32, and the ten-year was higher by 18/32. The curve flattened 2 basis points on the day, and currently sits at +251 bps.

It was a quiet day in bonds. Treasurys rallied for the entire session on weakness in stocks, and managed to maintain their rally despite the turnaround in the equity markets in the last 30 minutes of trading. The frenzy from a few days ago subsided and for the first time in a while we had a plain old summer Friday in the bond market. There are no auctions or Fed purchases scheduled for next week so the market will get a break before activity resumes the following week.

Have a great evening.

Cliff J. Reynolds Jr., Junior Analyst

Daily Insight

U.S. stocks rose to a seven-month high before easing back in the final moments of trading to the June 2 close of 944 (the very recent high mark) on the S&P 500. Lower Treasury yields eased concerns that higher borrowing costs will stifle an economic recovery. Another rally in the price of oil, and think about that for a moment as we talk about higher interest rates, helped energy-related shares propel the broad market to within 5% of the Election Day close.

Utility, telecom, basic material and health-care shares also performed well. Again, consumer-related and industrial shares failed to gain ground, which doesn’t exactly illustrate conviction with regard to economic recovery.

The S&P 500 has broken through the 950 level on an intraday basis for a third time now since last closing at that number back on October 21. We will probably need to break through that level to go higher; we’ve been stuck at the top end of this range for nine-straight session now. There’s still a lot of money on the sidelines and you know people want in after this 40% move from the wicked low of 666, but it may take a big bang economic number to drive us higher here over the near term rather than these readings that only look good compared to very low lows.


Market Activity for June 11, 2009


Treasury Auction, Rates and the Economy

The $11 billion 30-year Treasury auction went well yesterday, but of course the strong bid-to-cover ratio of 2.68 came at a much higher price to the government. The median bid on the previous auction was 4.185% and the one before that was 3.415%. Yesterday’s auction was executed with a 4.684% median yield. We have a record $3 trillion in government debt being issued this year alone and another $2 trillion (based on current estimates) for 2010. If there is anyone out there who hasn’t considered that higher rates will be an issue for the expansion, when it occurs, well maybe it’s a worthwhile exercise.

Further, unless the government screws up so royally as to stop an expansion in the monetary base, that is 10 times larger than any in the post-WWII era, from propelling economic growth then we’re going to have higher commodity prices that will jolt rates higher as well.

We want the economy to progress, we want stocks to go higher, we want risk-taking to occur, but they must occur for the right reasons otherwise we’ll be pushed back into another contraction much sooner than I think many realize. So, the interest-rate concerns waned yesterday, and they will certainly ebb and flow over the near term, but this daily vacillation of emotions should be telling us something.

These are things the equity investor needs to think about in this environment. If the horizon is long-term in nature, then find your risk level (and we should all know it now after what we’ve gone through over the past 10 months) and stick with it. But there is a tendency among many to attempt to recapture losses, its human nature. If this is the thought, just be very careful, we’re dealing with vast uncertainties both within and outside the economic world.

Oil Rises Again

Crude for July delivery continued to push higher, closing at $72.50 per barrel yesterday.

Stocks and oil have had a positive relationship over the past five months, and largely since the financial crisis took hold in September -- meaning they’ve been moving in tandem. Now with oil over $70 per barrel it’s likely they’ll begin to trade in an inverse relationship, which means it is even more important right now to get a grip on monetary policy and while the Fed won’t do anything substantial, they could make some comments and mild moves (refusing to increase quantitative easing and maybe boosting fed funds to 0.50%) that may be enough to strike a balance between oil and stocks and get the former to head down slightly and stocks to hold steady here.

Jobless Claims

The Labor Department reported initial jobless claims fell 24,000 – the market expected a decline of just 6,000 – to 601,000 for the week ended June 6. We’ve seen a nice trend off of the week ended March 27 high put in at 674,000 in claims, but let’s face it a number at this is level is difficult to get too excited about. What we’re dealing with here is steps, mild steps in a process to improvement, this is true regarding all economic data points and the same is true for jobless claims.

The four-week average of initial claims fell 10,500 to 621,750.

Continuing claims extended their record-setting streak to 19 weeks – the prior week’s data showed a halt to this record-setting trend when released but that number has now been revised higher to show it did make another new high. Claims jumped again in terms of this latest data (for the week ended May 30) – there’s a one-week lag between continuing and initial. This is bad news for the labor market -- yes, we’ve known it is weak, but some light at the end of the tunnel would be helpful – as it shows the degree of fragility has not improved.

The insured unemployment rate (as most readers know, this is the jobless rate among those eligible for unemployment benefits) held at 5.1%. This number closely tracks the direction of the overall unemployment rate so may be showing we’re close to topping out. It’s difficult to see this as the case, it seems we’ll blow through the 10% level sometime in early 2010, but the data is suggesting – assuming a subsequent week doesn’t show a jump – the overall jobless rate may peak at 10% or slightly below.


Retail Sales for May

The Commerce Department reported that retail sales for May rose 0.5% after two months of decline of 0.2% (which was revised up from -0.4%) and 1.2%, respectively. The ex-auto reading rose the same, up 0.5% as well.

Although the headline figure showed a nice increase, looking within the data there is little evidence of an underlying rebound in spending. The ex-gasoline figure rose just 0.2%, which is hardly impressive after the past two readings. Further, even if people, like me, do not believe consumer activity can rebound in a sustained way due to strong headwinds, you would still think there’d be a stronger bounce after the deep contraction in activity since September – the fact that it can’t muster more of an uptick is telling.

In terms of some of the components, the clothing store segment showed a welcome rise after two months of nasty, but this was offset by a 0.7% drop in department stores, a 0.1% decline in sporting and book stores, a 0.4% drop in non-store retail and a 0.2% fall among general merchandise. Also, I like to watch the eating & drinking component to gauge the directional degree of consumer activity (this component is driven the bar scene and this group is less susceptible to downturns); it rose just 0.1% after a 0.2% rise in April and a 1.0% decline March.

And this brings us to gas station receipts, the component that drove the overall reading as it jumped 3.6% for the month. Again, the overall reading was up 0.5% but just 0.2% ex-gasoline. This jump was due to the 18% increase in prices at the pump, a trend – if it continues – that will sap dollars from other aspects of the retail sales report.

Finally, retail sales ex gasoline, autos and building materials – the number that flows directly to the personal consumption component of the GDP report – came in flat for May. In fact, it is flat (down slightly but a statistically insignificant decline) for the first two months of the current quarter.

It’s pretty unlikely, as a result, that the personal consumption side of GDP will offer the key economic reading much if anything this quarter. As a result, we’ll depend on government, business spending and inventory building to boost growth, which is why GDP will post another negative reading for Q2. By the third quarter we’ll end this contraction and see a mild rise in GDP and by the fourth the inventory dynamic and government spending should kick in to drive the reading to a fairly strong positive print.

Business Inventories

Business retail inventories fell for the eighth-straight month, down 1.1% in April. All segments reduced stockpiles, but what’s driving inventory liquidation the most is the auto sector, which slashed stockpiles 2.4% -- and by 17.4% over the past 12 months.

Business sales fell 0.3% in April, after a 1.8% decline in March. Sales have been crushed over the past nine months, down 17% at an annual rate as firms went into full-blown caution mode following the financial/credit crisis.

While the inventory-to-sales ratio remains elevated, once sales do bounce, even if that bounce is mild, this ratio will come down to a more appropriate level in short order. I don’t believe we’re quite there yet, but another quarter out the inventory dynamic will begin to catalyze GDP. This cycle of inventory liquidation will have run its course within a couple of months.


Have a great weekend!


Brent Vondera

Fixed Income Recap

A strong Treasury auction helped bonds have a good day for a change. The two-year finished up 2/32, and the ten-year was higher by 23/32. The curve flattened 6 basis points on the day, and currently sits at +253 bps.

After a string of questionable auctions Treasurys rallied today after the market was surprised to see strong demand for long term government debt in today’s 30-year auction. The $11 billion auction came in at a high yield of 4.72% with a bid/cover ratio of 2.68, higher than the 2.31 average from the previous four 30-year auctions.

Although we have seen very strong demand as of late, it is only coming at a higher cost for the Treasury in the form of higher interest rates. Today was the exception after two consecutive auctions that pushed yields higher, and the market saw today’s result as a sign of strength. But today should definitely be taken with a grain of salt. The yield on the ten-year has risen 115 basis points since the failed UK Treasury auction on March 25 that began the latest batch of fears that soon there will be no one willing to lend to the Treasury. Even if there are plenty of worries about the soundness of the dollar going forward, investors are naturally going to like 3.85% better than 2.7%. The example is overly simplified but you get my point.

Have a great evening.

Cliff J. Reynolds Jr., Junior Analyst

QCOM, UNH

S&P 500: +5.74 (+0.61%)

There has been very little news on the individual company level. Economic data continues to improve, or at least get less bad, but the story line to watch these days are the Treasury sales. I won’t go to deep into the details – Cliff does a much better job covering the topic – but its hard to not mention that the sale of 30-year bonds drew the highest yield in almost two years.

Record government spending and massive debt issuance is increasing inflation concerns among investors, as is the rise in commodity prices.

Qualcomm (QCOM) -0.02%
Qualcomm raised its fiscal third quarter revenue and operating income guidance, which CEO Paul Jacobs said is based on stronger-than-expected demand for “more data-capable chipsets and increased licensing revenues driven part by advanced 3G network upgrades.”


UnitedHealth Group (UNH) -6.53%
UnitedHealth fell in response to an analyst downgrade at Oppenheimer & co., which cited margin declines in its Medicare business. According to the report, UnitedHealth’s bids for 2010 Medicare Advantage contracts assume the U.S. will lower reimbursement rates for doctors 21 percent.

The report argues that is unlikely to happen and leaves UnitedHealth vulnerable to higher costs if Congress rescinds the cuts. The analyst goes on to estimate that the mispricing may cost the company 4 percent, or $780 million, in operating earnings.

WellPoint (WLP) also traded lower for most of the day, but finished near positive territory.


Quick Hits

• Fed Is Slowing Pace of Treasury Purchases as Traders Pine for More Buying
• Wal-Mart Leads Corporate Credit Rally on Jobs, Sales Data
  

Peter J. Lazaroff

Daily Insight

U.S. stocks got off to a good start yesterday, but quickly fizzled on concerns over inflation and the prospect for higher interest rates. The major indices held in there remarkably well based on these concerns and a weak $19 billion 10-year Treasury auction. Roughly 46% of the high-yield bid (3.99%) was filled – the four-auction average is 31%. Basically, it took a considerably higher yield to get bids for this auction and the results do not bode well for today’s 30-year auction.

And if the high bids drove this auction, where do you think rates are going over the next couple of years as there is a tremendous level of bond issuance coming? It’s increasingly difficult to gauge these days with the Fed printing money to monetize the debt and heightened geopolitical risks that can drive the safety trade again. Notwithstanding, it is pretty obvious interest rates will go much higher, but for all of the issues such a move in borrowing costs has for economic growth over the next couple of years, it does create opportunities on the fixed income side of the portfolio for investors willing to be patient.

Utilities, energy, telecom and basic materials were among the 10 major industry groups that managed to close on the plus side. It’s fairly bizarre that interest-rate sensitive utility shares performed so well on a day in which yields across the curve rose, but a Republican measure to block the mandatory cap on carbon emissions, which is contained in legislation passed by the House Energy and Commerce Committee last month, offered the shares support.

Financials, consumer-related and industrial shares led the decliners.


Market Activity for June 10, 2009


Crude Continues to Run

The weekly Energy Department report showed U.S. oil supplies fell 4.38 million barrels to 361.6 million – an increase of 100,000 barrels was expected. Crude stockpiles remain 11% above the five-year average, but this is down from 27% just two weeks back. Gasoline inventories also fell, down 1.5 million barrels as an increase of 750,000 was expected; they are now 4% below the five-year average. Refining activity has begun to pick up, which is a main reason oil supplies fell. Gasoline supplies failed to rise as gasoline demand rose last week.

The wholesale price of gasoline has returned to $2.00 per gallon, the first time it has hit that mark since October – this results in a $2.50-$2.60 pump price, most of that spread goes to taxes. I’ve got a feeling $2.60 per gallon is going to look pretty darned good several month out. One can see these prices exploding to the upside when global production comes back, not to mention even the scare of a hurricane hitting the Gulf coast this summer.

In the meantime, it’s likely we’ll see a pullback in prices, as is normally the case after a run such as the one we’ve seen over the past few months, before resuming the march higher. We’ve done nothing though to ease the chances of price spikes.

We continue our dangerous policy of domestic production restrictions – it seems to me if policymaker have a real desire to create jobs (as opposed to creating work via public programs), removing these restrictions would have been a great way to boost high-paying manufacturing positions; alas, nothing. In addition, we have both fiscal and monetary policies that have poured in the ingredients for the perfect storm of much higher energy prices. Oil tanker rates on the Saudi Arabia to Asia route have increased every day since May 27, up 50% during this period (but still at just half of the elevated average of the past four-years). Only a continued state of severe economic weakness will keep energy prices from charging ahead. Or, actions by the Fed could put a lid on the commodity run – I can fit only so much into these daily letters, we’ll touch on this idea tomorrow.

Mortgage Applications

The Mortgage Bankers Association reported their index of mortgage applications fell for a third-straight week, declining 7.2% for the week ended June 5. This followed declines of 16.2% and 14.2% in the previous two weeks.

Re-financing activity, which made up 75% of the index just a few weeks back is all but dead right now as mortgage rates have moved well above the magically 5.00% level – that is the line of demarcation, anything below means the refi wave rolls; above it, forget about it. Now refis make up less than 60% of the index after consecutive weekly declines of 11.8%, 24.1% and 18.9%, respectively. The 30-year fixed mortgage rate has jumped from 4.43% (although the actually market rate was more like 4.65%) to 5.57% last week – and is likely to come out at 5.75% next week. While this remains an extremely low level from a historical perspective, housing market activity will shut down at a rate that approaches 6.00% based on the still very fragile labor market environment.

The good news is that purchases continue to increase, up 1% last week and the third-straight week of gains. I doubt though that purchase will continue to roll if the 30-year mortgage rate goes much beyond this level.


Trade Figures

The U.S. trade deficit widened just a bit in April as the decline in exports outpaced the decline in imports for the second-straight month. (Normally trade deficits widen when imports rise more than exports but this is not the case currently as global trade has been smashed due to the economic distortions related to last fall’s financial crisis and all that has occurred hence)

For the month, the deficit rose 2.2% to $29.2 billion, but remains at a low level especially when one looks at the real (inflation-adjusted) figure excluding petroleum. (As we continue to restrict domestic energy production – and reality will at some point slap us silly and reverse this destructive and idiotic policy – we now import 70% of our petro-related energy needs. As oil prices rise -- average price per barrel was $46.60 in April and now we’re at $70 -- this will push the trade deficit wider over the course of the next 18-24 months, so we watch the price-adjusted ex-petro reading to see how the figures are behaving outside of this policy induced effect)


We look at these trade figures for two main reasons right here. First, is too view the direction imports take as this is a great indication of what the consumer is doing. While imports fell 1.4% in April, the pace of decline has eased substantially from the 5%-7% monthly declines of the past two quarters. Second, exports give us a sign of what is occurring in overseas markets, specifically we’re looking for improvement within the Pacific Rim as China’s stimulus is substantial and infrastructure focused.

U.S. exports fell 2.3% in April, following a 2.0% decline in March – these figures were posting 6% declines at the beginning of the year. Imports fell 1.4% (down 2.0% when excluding petro) after coming in flat for March (and down 1.2% ex-petro). So while the import data has improved from the deep contractions of the fourth and first quarters it actually worsened on a month-over-month basis when excluding petro imports.

Consumer goods imports did rise 1.1% in April but this was driven by a 6% rise in pharmaceutical imports; apparel, autos, food and beverages were down. On the business side of imports, capital goods fell a substantial 3.1%, which was worse than the 1.9% decline in March.

In terms of exports, consumer goods fell 3.1%, capital goods fell 3.4% and industrial supplies fell 5.6% -- the declines in consumer and industrial supplies worsened on a month-over-month basis, while the decline in capital goods improved a bit. Overall, these figures do not illustrate a jump in activity has occurred (at least as of April) as a result of global stimulus plans. I believe these numbers, particularly from the Pacific Rim, will improve markedly as we get into the summer months; the industrial production and manufacturing figures in Asia have bounced nicely and this should show up in the next few monthly trade figures.

In terms of U.S. exports to regions and countries:

Exports to Europe fell 9.8%; exports to Mexico down 4.4%; to Brazil down by 5.6%; to the Pacific Rim, down 8.6% (down 7.2% for China, down 13.5% for Japan and down 4.5% for Asia NICS – newly industrialized countries). All of these figures were worse than the previous month and on a year-over-year basis as well.

So, still no evidence via these trade figures of re-merging economic activity on the international scene, although this data has a huge lag to it; we’ll see how the May and June data shapes up. Again, we suspect by June we’ll see improvement, particularly from Asia.

Budget Deficit for May

The Treasury Department reported that the budget deficit for May came in at $189.7 billion and $991.9 fiscal-year-to-date (FYTD), putting the fiscal 2009 shortfall on pace to come in at 12-13% of GDP (double the previous post-WWII record) – although it’s difficult to gauge as just 6% of the $787 billion stimulus program has been sent out thus far; the deficit could go higher than one can currently extrapolate.

Individual tax receipts came in 23% lower FYTD (the government’s fiscal year ends in September). Corporate tax rates have been obliterated, off by 61% FYTD.

On the other side of the old ledger, spending rose 5.8% -- not bad relative to what’s to come – and is up 18.7% FYTD; yikes!

I guess over the next few couple of years I can just save us all time by skipping the specifics on this dating and simply state: It’s large, period.

Today’s Watch List

This morning we get jobless claims, May retail sales and Bank of America CEO Ken Lewis on Capitol Hill.

Jobless claims are expected to remain above the very elevated 600k level and continuing claims are expected to make a new high – that would be a big blow in my opinion as continuing claims finally halted the 17-week streak of making a record high just last week.

Retail sales may offer the market a boost today as it is likely activity bounced after two-straight months of decline. These retail figures are going to be all over the map for a while; pretty much two-three months of decline followed by a one-two month bounce; with the labor market in the shape it is in and the time it will take for the consumer to get things right in terms of debt (now that joblessness is high and incomes flat) I don’t see how retail activity goes on a sustained upswing.

Finally, we have Mr. Lewis on Capitol Hill as he will be grilled as to what he knew and when he knew it in terms of the Merrill deal, specifically referring to the big time losses BofA shareholders had to absorb almost immediately after the deal was done. The big news though is not about Lewis, but whether or not the government threatened BofA to do the Merrill deal. It’s ultimately BofA’s fault for initially rushing into the thing, but when they began to have some doubts about the acquisition there are reports that Bernanke and Paulson threatened the firm not to back out.

I think Bernanke will end up taking the political fall for this; he’s already going to take the fall if the economy fails to bounce back substantively. His term is up in 2010. At which point, enter Larry Summers. If this turns out to be the case, it will erase even the remote chance that the Fed is currently independent from the political class (and there are some readers out there, I know, that believe this is a joke of an assumption anyway, and I agree).


Have a great day!


Brent Vondera

What will drive oil prices going forward?

S&P 500: -3.28 (-0.35%)

Markets fell despite a strong start as climbing oil prices and increasing interest rates caused investors to worry that inflation will prevent a rapid economic recovery. In recent weeks, rising oil prices have been interpreted as a sign that the economy will return to growth, but the pace of gains is now causing some concern. What will drive oil prices going forward?

Bulls point to increasing demand in China, but bears question whether China’s demand offsets lower consumption in other developed nations.

OPEC’s production cuts is another common bull argument, but OPEC historically has difficulty maintaining discipline and some members desperately need to sell crude to make their budgets work.

The weakening U.S. dollar supports higher oil prices, but the Euro-zone’s troubles and the potential for tighter monetary policy in the U.S. gives the bears reason to believe the U.S. dollar could strengthen in the future, thus causing lower oil prices.

Another common bull case is that the U.S. economy is bottoming and will soon return to growth. While this may turn out to be true, higher oil prices may be the straw that breaks the back of U.S. consumers that are already dealing with high debt levels as well as lower home and investment values.


Quick Hits

• Tracking the Nation’s Bank Failures
• E-Mails Show Fed Pressure on Bank of America
  

Peter J. Lazaroff

Fixed Income Recap

Yesterday’s gains in the Treasury market were all but wiped out today as Fed again failed to reign in long term rates on an auction day. The two-year finished down 3/32, and the ten-year was lower by 4/32. The curve steepened 3 basis points on the day, and currently sits at +258 bps.

Bonds took a beating today after a well bid auction came in at a higher than expected yield. The bid/cover ratio for the auction was 2.62, higher than the 2.5 average, and the high yield on the reopened note was 3.99%, 5 basis points higher than where they were trading in the secondary market.

Long term rates have been on the rise for a while now. The Fed’s efforts to keep long term rates low through Treasury purchases have failed, or maybe without the Fed the ten-year would be at 5% instead of 4%. Who knows? But short term rates have followed the longer end of the curve higher in the past week, on speculation that the Fed might reverse trend and raise short term rates.

The 45 basis point spike in the yield on the two-year is way too much, way too quick in my view. The Fed is only 40% through the MBS buying program that is scheduled to take until the end of the year, and 50% through the Treasury buying program that should be wrapped up by late summer. I just can’t see the Fed hiking short term rates while still forcing the long end lower, especially since most recent FOMC meeting commentary still noted concern for less than healthy levels of inflation in the near future and the need to keep the federal funds rate at exceptionally low levels for an extended period of time. This more than likely represents a buying opportunity in the short end.

Have a great evening.

Cliff J. Reynolds Jr., Junior Analyst

Daily Insight

Most U.S. stocks ended higher on Tuesday after Texas Instruments stated demand improved for wireless semiconductors and analog chips, and energy and metals prices resumed their run higher after a two-day respite – the price of oil for July deliver closed four cents below $70 per barrel.

The major indices were also helped by a successful $35 billion auction of three-year Treasury notes. Treasury auctions are normally a non-event, but as the government is in the process of driving the deficit-to-GDP ratio to double-digit rates over the next two years (the long-term average is 2.4% with the post-WWII record being 5.6%) and high single digits for the next several years at least…well auctions are becoming quite the event. When they go well, stocks will be fine. If/when they don’t, watch out.

As a result of the TI news and the commodity rally, technology, energy and basic material shares led the broad market higher. Consumer staple, utility and health-care shares were the biggest losers. We’ve some early inflation and interest rate fears rumbling throughout the market and consumer staple and utility names have a difficult time when that’s the case. Health-care has traded lower for five-straight session as the administration’s national “one-payer” system has received more press.

Market Activity for June 9, 2009

Chrysler Can Proceed

The stay order issued by Justice Ginsburg on Monday night has been lifted and Chrysler can proceed with its sale to Fiat – well, as we mentioned yesterday “sale” may be the wrong word as Fiat isn’t paying for these assets, just engaging in technology sharing as they put it. More important than that, I think this is a troubling setback for contact law as junior creditors were put in front of senior bondholders, but maybe I’m over-reacting. Contract and property-right law isn’t that important, it’s just the backbone of our system.

Up, Up and Away

The price of crude has hit the $70 handle this morning and one wonders what price will trigger another wild wave of Washington populism – you know, calls for “windfall” profit taxes and attacks on speculators. Of course, politicians would never think of looking inward to their own policies that drive the dollar down and cause traders, investors and governments to run for the inflation hedge of commodities. And among those looking to hedge dollar weakness there probably is none more powerful than China right now. There is no way for China to aggressively reduce its dollar exposure without hammering their current positions, such as the $700 billion in Treasury securities they own. But they can stockpile hard assets, and oil is certainly one, in order to hedge against dollar weakness and the expectation that it will lose additional purchasing power.


Auction Goes Well

A record-tying auction of $35 billion of three-year Treasury notes went swimmingly yesterday as it was very well bid at a yield of 1.96% -- even a bit below the forecast. The bid-to-cover ratio, which measures demand by comparing the number of bids with the amount of securities sold, came in at 2.82 – a high number.

Treasury auctions have become a jittery event lately as investors go into days in which there’s an offering worried that things won’t go well and yields may spike. As we touched on yesterday, there shouldn’t be a big issue with demand over the short term as yields have been pushed to levels that make buyers comfortable, for now. Still, these auctions will be watched closely and if the bid-to-cover falls below 2 it may cause havoc. It is tough to see the market willing to accept these yields for very much longer but for now we seem to be ok. We’ll get 10 and 30-year auctions over the next two days and they better go well.

Wholesale Inventories

The Commerce Department gave us our first look at the current quarter’s inventory picture yesterday by way of wholesale inventories and it didn’t get off to a great start. However, the numbers appeared to be worse on the surface than they actual were due to auto-industry woes.

Inventories at U.S. wholesalers fell a larger-than-expected 1.4% in April, marking the eighth straight month of decline. In addition, the March data was revised down, which may cause a slight downward revision to the final print of Q1 GDP. However, much of the decline was due to another massive scale-back in auto stockpiles, which are now down 14.3% year-over-year – GM will idle 13 plants for as long as nine weeks and currently has seven shut down.

The sales data within the report showed caution among firms may be waning. Distributor sales fell 0.4% after a substantial 2.4% plunge in March and. Wholesaler sales have declined in nine of the past 10 months – down a big 19.5% year-over-year. This figure too was weighed down by the auto sector, which will remain a trouble spot for some time still, as sales within this segment got hammered, down 7.8% for the month and off by 36.2% year-over-year.

The wholesale inventory/sales ratio declined a bit but remains near an eight year high. We went into this recession at a historically low level of inventories, particularly for that point in the business cycle, but the crushing blow to the sales side caused the figure to spike. Therefore, it won’t take much of an increase in demand to bring this ratio significantly lower. As of April, it would take 1.31 months to deplete stockpiles based on the current sales rates. The record low of 1.10 months worth was hit in June 2008.

The best data on the inventory picture will come on Thursday via the business inventories figure. This data includes retail-sector stockpiles and will offer a better indication of how the management of inventories, and the effect sales had on the inventory of goods, began the current quarter. It’s likely we’ll see another reduction in business inventories for the quarter, but much milder than the previous quarter’s record liquidation. The inventory dynamic, the production needed to rebuild stockpiles even on the slightest boost in demand, should help to push GDP positive for the first time in five quarters by Q3.

Athwart History

I ran across an article a couple of nights ago that reminded me of the story of three scientists trapped at the bottom of a deep well – a physicist, an engineer and an economist; you probably know where I’m going with this already. The physicist is forced to admit that there is no law of physics that will help them. The engineer admits he’s of no help without tools and material. Only the economist is without concern; he proposes they begin with the assumption that they have a ladder.

And this is essentially what the fiscal stimulus is all about. There is this assumption that simply because the government is spending massive amounts of money – a ladder to economic growth as some see it – that by definition the economy must rebound in a sustainable way, net jobs will be created, and the entire system shall enjoy a much more solid foundation. (Surely the geniuses in Washington know how to allocate scarce resource in a more efficient manner than the market is able – ie. cap and trade, health care, lending, autos, etc -, right?). Well, there is no point in history with which this is the case; this after all is certainly not a new idea, it is the way of the long past (monarchy, feudalism, empire, theocracy, military junta, communism, modern European socialism) no matter the system of government.

Conversely, we have democratic capitalism that in 233 years of our official existence has enabled the most prosperous society in history to become just that. There isn’t an argument. Ok, even if we haven’t been a full-blown capitalist system in a long time, we are a blend of capitalism and socialism with a mix of 80/20. Sorry, but it doesn’t work at 20/80, which based on the current trajectory we are on pace to devolve to in about a decade.

We know what works (and I’m not talking about a utopia, just the best there is to offer relative to everything else), but sometimes we have these spells in which the country wants to go against that which comports with reality. We’re in one of those spells right now.


Have a great day!


Brent Vondera

Quick Hits

• Bond Dealers Say Futures Traders Wong on Federal Reserve Rate Speculation
• Bull-Market Story Awaits Goldman Sachs Blessing

Peter J. Lazaroff

Fixed Income Recap

Treasurys had a good day after a strong three-year auction this morning. The two-year finished up 6/32, and the ten-year was higher by 4/32. The curve steepened 8 basis points on the day, and currently sits at +255 bps.

The Treasury auctioned $35 billion in three-year notes today at a yield of 1.96% with a bid/cover of 2.82, higher than the 2.54 average for the past four auctions. Indirect bidders, including foreign central banks, took down 43.8% of the allotted amount but only made up 19.6% of the total bids tendered by the Treasury. A sign that regardless of all the chatter in the media, foreign Treasury buyers are still willing to pay up for the full faith and credit of the US government.

TARP
The Treasury Department gave a “thumbs up” to ten banks who received TARP money, allowing them to repay the government’s investment. Although the Treasury did not provide any names ten banks have announced they will be paying the Treasury back today. The list includes every bank that wasn’t required to raise capital after the stress test, except for MetLife, plus a few who have successfully raised enough new capital. Those missing from the list include Bank of America, who had the largest capital shortfall from the stress test, and Wells Fargo, who entered the credit crisis relatively strong but has stumbled lately as a result of their acquisition of Wachovia.

The Treasury will receive about $70 billion if all ten decide to repay the entire TARP investment, but the Treasury will still retain the warrants it received when the banks initially received the funds. Firms will have the right to repurchase the warrants, said to be in the “several billion dollar range”, according to Treasury Secretary Geithner.

Here’s a quick article on the issue of the Treasury’s warrants. Link

Have a great evening.

Cliff J. Reynolds Jr., Junior Analyst

Daily Insight

U.S. stocks engaged in a wild ride (can I still say that based on the intraday swings we’ve witnessed over the past eight months?), beginning the session lower on inflation and interest-rate concerns but paring those losses in the final hour of trading. In fact, the rally that took place with an hour left in the session moved the broad market nicely into positive territory, only to give it back in the waning minutes.

Why the rally at the end there? Well, it appeared to be a comment from Princeton professor Paul Krugman in which he stated not to be surprised if the official end of the recession ends up being sometime this summer. If this was the reason for the reversal in stocks, it probably shouldn’t be much of a surprise that the rally fizzled in a matter of 30 minutes as it was just on Friday in which the Nobel laureate stated he had a hard time seeing what might drive a “full” economic recovery, and that the economy was not recovering, but just that “things were getting worse more slowly,” as quoted by Bloomberg News.

Anyway, it was a quiet day as we were without an economic release so the market can have a tendency to vacillate on even the slightest of comments and that appears to be what occurred on Monday.

In terms of breadth, volume was light as just 1.1 billion shares traded on the Big Board, roughly 20% below the three-month average. Two stocks fell for every one rose on the NYSE.

Market Activity for June 8, 2009

Chrysler Deal Stayed

Bondholders have successfully put a halt to the Chrysler sale (if you can call it that, Fiat is putting up no money for the assets, just what they call technology sharing) as junior creditors were put in front of senior creditors – a clear violation of contract law. Justice Ginsburg has issued a stay order until the Supreme Court decides. We should commend the creditors who have staged this injunction. Surely they are engaging in this process because of their duty to get the most for their investors, but in the meantime they are also making a stand for contract law – you start messing with contract law and property rights and this system is in big trouble.

The Potential Interest-Rate Wall

The bond market is putting it to Bernanke as traders push Treasury rates higher (not that rates are high, they are most certainly not, but we’re talking about the degree of the move) and threaten to crush what appears to be the first broader-based improvement in the home sales since the housing market correction began. The purchase data within mortgage applications, the pending home sales figures and possibly even evidence within actual home sales offer optimism that some bounce from very low levels of activity is on the horizon.

But concerns over fiscal policy have brought back the bond vigilantes and as a result the yield on the 10-year Treasury note has jumped to 3.85% from 2.20% at the start of 2009. The good news is the spread between mortgage rates and Treasury yields (and the narrowing of corporate bond spreads too, as we touched on last week, even if they remain historically wide) has narrowed dramatically. But it doesn’t take much to shut down any nascent bounce in housing at this point. The 30-year mortgage rate will likely hit 5.50% this week, up from 4.70% in late April. This means home prices will have to fall further to offset the move in rates and keep affordability extremely advantageous – and an extreme advantage with regard to affordability is necessary right now as the very fragile labor market will continue to weigh on the housing market and economy as a whole.

So the question is, will Bernanke and Co. increase their Treasury and mortgage-backed security purchases, or hold off? My bet is they will signal an increase in these purchases within a few weeks and thus take quantitative easing to another level. If they do, rates may just trend down again in the very short term as traders seek to make quick profits in the Treasury market. However, these decisions will have costs to bear down the road and the market will eventually overwhelm the Fed’s actions and push rates higher. It will take some time for interest rates to get to levels that cause real economic damage, but the ingredients seem to be there – a brew that will send rates much higher over the next couple of years.

The investor needs to be careful not to get too carried away, you must keep your guard up. We may just see some high-powered corporate profit growth a couple of quarters out, as businesses have slashed and burned expenses – it will take very little increase in demand to drive the bottom line. That’s the good news. But the potential interest-rate wall the economy will likely have to deal with will make an economic expansion short-lived. (Of course, there’s a caveat with everything. We have heightened geopolitical risks that may very well keep rates low despite policy that screams higher rates to those who have studied these things. But if some sort of event is sparked, this is yet another reason to remain cautious.) If anything, what I’m trying to say here is, as has been the message over the past couple of weeks, we may enter into a period that gets people juiced but beware of taking on too much risk; there is the natural tendency to take on more risk when things get rolling, but this is not the typical business cycle; this is not the typical investing environment. The economy and stock market will face substantial headwinds over the next couple of years

In my view higher rates are needed in order to wash out what has become an improper assessment of risk within the market place (as investors hunt, in some cases in a panic, for yield due to the Fed’s very easy policy stance). While this will cause economic damage, likely shutting down what I see will be a four-quarter rebound in economic growth beginning slowing in the third-quarter of 2009 and picking up some steam by the fourth, this will also present an opportunity for fixed income investing. We are likely to see the most attractive yields on this side of the portfolio in a decade.


Today we begin a three-day series of auctions as $65 billion of three, 10 and 30-year Treasurys are issued. I suspect these auctions will enjoy plenty of demand, but certainly these events are accompanied by a level of anxiety within the marketplace that has not been seen in 30 years. Eventually though, it’s tough to see how the market does not demand higher yields as both fiscal and monetary policy are not conducive for a stable dollar value.

This Week’s Data

We were without an economic release yesterday, but get back to it today and some very important data later in the week.

This morning the Commerce Department releases April wholesale inventories, and while this data has a substantial lag to it, it’s important as it will bring the first broad-based look at inventory management for the first month of the current quarter. Inventory liquidation has been one of the main drags on GDP over the past two quarters and we’ll see how that dynamic is shaping up for this period. Odds are we’ll see stockpiles were scaled back some more during April, although at a reduced rates relative to the past few months. By June we believe there’s a good shot that production will pick up as firms begin the rebuilding process.

On Wednesday we get the trade balance for April and the monthly budget statement for May.

The trade figures will be closely watched as investors look for clues that the Pacific Rim is bouncing back. China’s large and infrastructure-focused spending should help the region rebound and evidence will show up in our exports to the region. It may be a bit early to expect much, positive developments are likely a couple of months out, but this is why we watch the data – a positive surprise will be big for this market.

The budget numbers will show we’re on pace for a fiscal 2009 budget shortfall of $1.5 trillion, marking a post-WWII deficit-to-GDP record that surpasses the previous mark by double.

On Thursday, we get the always important jobless claims data. We look for another mild reduction in claims, yet the figure will probably hold above the very elevated 600k level.

Another big report on Thursday will be retail sales for May. It will take some time for the consumer to get things right again. The debt amassed over the past decade was manageable, very manageable in many cases when unemployment was at 5% and incomes were growing at a nice clip. But that has changed, and coupled with the crushing blow to the consumer’s two largest savings vehicles, it’s going to take a while for consumer activity to begin a sustained upward trajectory again. In the meantime we’ll see ebbs and flows and let’s hope May posts a good reading after five of the past eight months have posted huge monthly declines.

On Friday we round things out with the University of Michigan’s consumer confidence reading for June. The consumer confidence numbers over the past two months have bounced from deep depths. The market will need to see additional progress is being made.


Have a great day!


Brent Vondera

Fixed Income Recap

Treasuries bounced around with stocks today but finished down slightly. The two-year finished down 6/32, and the ten-year was lower by 12/32. The flattening trend continued today as the benchmark curve flattened by 6 basis points, to end the day at +247 bps.

The Treasury will auction $19 billion in 10-year notes and $11 billion in 30-year bonds this week offset by only one Fed purchase on Wednesday.

Thirty-year fixed mortgage rates have risen to 5.35%, the highest level since November 25. It was well understood that the market could not sustain 4.75% mortgages for very long, so the sudden jump is not completely unexpected. 5%-5.5% looks like a range that the market can sustain for a while, barring any expansion in the Fed’s quantitative easing campaign, which I think is unlikely at this point.

Have a great evening.

Cliff J. Reynolds Jr., Junior Analyst

Recovery scenarios, U.S. coal supply

S&P 500: -0.95 (-0.10%)

What kind of recovery lies ahead?
Most investors seem to believe stocks bottomed in March, but many remain on the sidelines and are eager for a pullback. That begs the question: what kind of recovery lies ahead?

The front page of today’s Wall Street Journal featured an article, titled Land Mines Pockmark Road to Recovery, which looks at the three widely-accepted scenarios for the market and economy.

The first scenario is that massive amounts of government spending and easy monetary policy will allow the economy to have a classic “V-shaped” recovery. The second scenario is that inflation will ultimately force the government to slam on the breaks, which would trigger a “W-shaped” recovery – a concern that has been regularly expressed by Brent in his Daily Insights. The final scenario is that government action fails to stimulate the economy at all, in which case we would have a more sluggish or “L-shaped” recovery.


U.S. supply of coal may be less than we thought
This article is another front pager from the Wall Street Journal. The article explains that the U.S. may have fewer coal reserves than the current Department of Energy estimates suggest. Part of the reason that coal reserves have been overstated is that they include coal that is too difficult and/or unprofitable to mine.

If there were, in fact, lower coal supply than originally thought, then coal prices could get a much-needed boost and coal producers like Arch Coal (ACI) and Peabody Energy (BTU) would turn bigger profits. Recently, coal producers have struggled as stockpiles continue to grow and worldwide demand has stalled.

Producers are cutting output in response to the supply/demand dynamic. ACI and BTU are trimming their output for the year 393 million tons to 345 million-370 million tons, a 6-12 percent decrease.

In short, this article is hardly negative news for coal producers. Longer-term, both ACI and BTU ought to benefit as the global economy eventually starts to recover thanks to their size, diverse operations, and fairly healthy cash positions.


Quick Hits

• Will the Fed Tighten Credit This Year?
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Peter J. Lazaroff

Daily Insight

U.S. stocks ended flat on Friday as a smaller-than-expected decline in monthly payrolls offset other negative job-market internals and a larger-than-expected jump in the unemployment rate.

Concerns over higher borrowing costs also weighed on the equity markets and this will ultimately be the cause of an economic double-dip. At some point interest rates will reflect the massive deficit spending we’ll engage in over the next few years and if inflation takes hold as well, it’s really just at matter of time.

I’ve argued in the past that it is inflation expectations that drive rates and not deficit spending, as history bears out. However, that was when budget deficits averaged 2.5% of GDP and would hit 5% on the high end. Current policy will push the budget deficit to 13% of GDP this year and between 10%-15% for 2010. Since much of the stimulus plan is focused toward entitlement spending, there’s a real threat that much of these outlays will work their way into the baseline of the budget and will be politically difficult to drive back out. As a result, things may change in a way that fiscal policy does drive borrowing costs higher. The Fed will likely keep a lid on this increase in borrowing costs for a while, but the market will eventually overcome Fed action if we remain on this fiscal path.

Industrial and information technology shares led the gainers, while the financials and commodity-related shares (such as basic materials and energy names) led the decliners. Nine stocks fell for every seven that rose on the NYSE. Some 1.2 billion shares traded on the Big Board, roughly 15% below the three-month average.

For the week, the major indices performed well again, the 13th winning week out of the past 15. The Dow average gained 3.09%; the S&P 500 added 2.28%; the tech-laden NASDAQ Composite jumped 4.23%; the S&P 400 (mid cap) picked up 3.58%; and the Russell 2000 (small cap) rallied 5.74%.

Market Activity for June 5, 2009


May Jobs Report

The Labor Department reported that payrolls declined 345,000 in May, a huge positive surprise as it was well-below the expectation for a 525k reduction. This is the least number of monthly job losses in eight months, yet remains elevated -- back to the peak level of losses we see during the typical recession. So this is another sign, all of which occurring over the past two weeks, that the economy has improved from a deep recession to a contraction that appears more typical.

The prior month was revised to show improvement as 504,000 payroll positions were said to be cut, down from the 539,000 reported last month. The March number was also revised up to show 652k positions were lost, up from a loss of 699k – a reduction in losses of 82,000 for the two months combined. This is a pretty complete signal the worst of the labor-market contraction has been seen. Too, the recession will probably be called to have officially ended this month, although the announcement will not come from the NBER (the arbiter of such things) for several months.

In terms of specifics, goods-producing sectors continue to lead the losses, shedding 225,000 in May – although much improved from the previous three-month average of -294,000. The construction component saw a decline of 59,000 (also an improvement from the -110k of past few months). Manufacturing continues to shed jobs at a troubling rate (auto-sector playing a role here), losing 156,000 last month.

Service-producing industries really reduced their job slashing of the previous few months as just 120k were cut. That’s down big from -318k of the past three months. Trade and transportation cut 54,000 positions (down from -115k in April); retail shed just 18,000 (down from -42k average of past three months); the financial sector lost 30,000 (down from the average of -47k of the previous three months).

Health-care and education continues to be the sole bright spot as the segment added 44,000 positions last month. However, the latest ISM service-sector reading showed that the health-care industry has run into some issues of late and one has to wonder if this segment can continue to add to payrolls.

The unemployment rate jumped to 9.4%, the highest level since July 1983 (although back then it was falling from the post-WWII record high of 10.8%), probably as college graduates entered the job market but could not find employment.

The U4 unemployment rate rose again to 9.8% from 9.3% in April. (The headline unemployment rate measures only those workers who have looked for work over the past four weeks; it excludes those known as discouraged workers – people who have looked for work sometime over the past 12 months but not during the four weeks covered by this monthly jobs report. This U4 figure includes those “discouraged workers.”)

The U6 unemployment rate jumped to 16.4% from 15.8% in April. (This number adds is discouraged workers, plus those working part-time for economic reasons – could not find full-time work so settled for part-time hours)

The mean duration of unemployment made another new high (since records began in 1947), moving up to 22.5 weeks from 21.4 for April.

The percentage of those out of work for at least 27 weeks eased, falling to 27.0% of those unemployed vs. 27.2% in April.

The average weekly hours of production fell back to the March low of 33.1 from 33.2 hours printed for the April data. This is another important reading to watch. As the economy recovers and production bounces back, firms will obviously increase hours worked. For this latest reading, even though employers slashed jobs at a much reduced rate coming off of the Lehman/financial-crisis panic, they also cut hours worked – not exactly a good sign regarding production activity.

So to summarize, the news that a vastly reduced number of payrolls was slashed for the month is very good news. However, this number remains elevated and the fact that the duration of unemployment continues to rise, the percentage of those out of work for at least 27 weeks remains near the high, the U4 and U6 numbers jumped, and hours worked failed to increase shows that the job market remains quite fragile. Stability is likely a long way off.

Further, the degree of decline in the number of jobs lost (compared to the previous month in which 504k were cut) does not jibe with the quite consistent and elevated nature of jobless claims. Thus, either a significant downward revision to the May data will occur (next month) or there was substantial hiring that offset some of the firings that the jobless claims data captures. I think the former is a real risk that could rile the stock market next month.

This negative view of the labor market does not change our mind that the economy will rebound a quarter to two out. We continue to believe GDP will print a mild positive reading for the third quarter and a fairly strong positive by the fourth. The inventory dynamic will catalyze production and there is a lot of global stimulus out there, even if these policies are short-sighted.


Have a great day!


Brent Vondera