Daily Insight

U.S. stocks fell for the first time in five sessions as a preliminary jobs report suggested the economy shed more payroll positions than forecast in May and a pull-back in commodity prices put the hurt on basic material and energy shares.

The latest data out of the service sector, which failed to advance toward expansion mode to the degree expected, also put a dent in the prospects for economic growth and thus caused some to question the current market valuation – at least for the day.

Further, comments from Fed Chairman Bernanke to Congress on the unsustainable nature of fiscal policy (and let’s hope he’s thinking the same of monetary policy for which he is tasked to watch over) didn’t exactly give investors a feeling of comfort and nor should it. That said, the broad market did pare earlier losses in the final 30 minutes of trading and one has to expect these pull-backs anyway after the run we’ve been on. (Oh, and on that Bernanke testimony to Congress, Blackrock better watch out. More than once I heard a member of Congress mention the “no bid” phrase regarding the firm’s cooperation with the Fed in facilitating their programs. It appears that the Halliburton syndrome has officially arrived within the financial sector. This is why the PPIP is dead even before it arrives.)


Market Activity for June 3, 2009


Geithner in China

Treasury Secretary Tim Geithner was in China earlier this week and the trip, at least on the surface, showed meaningful cooperation between the U.S. and China may be possible. Geithner has learned to refrain from calling the Chinese a currency manipulator, which was a really amateur thing to do especially since we’ll be issuing $3.25 trillion in government debt this year alone and our own Fed can certainly be accused of the same thing (it happens to be the reality under a fiat money structure), and they seem to be targeting their stimulus in a way that invokes domestic demand, which will be helpful for global GDP as the U.S. consumer gets things in order.

Now, some comments from Geithner were not only laughable, and news is he was laughed at by one audience, but full-blown mendacity on parade. His statements that the Fed is currently independent of political pressures and will focus on currency stability simply does not comport with reality. He also stated the administration is determined to quickly get back to historical averages in terms of the deficit-to-GDP ratio. That would mean reducing the deficit from the post WWII high of 12% for fiscal 2009 (which is double the previous post-WWII record) to 2.5%. Um, there’s just one little problem, much of the stimulus spending is targeted to entitlement programs that will be added to the baseline budget, not to mention the government health-care plan they are determined to burden the economy with – that means vast sums of spending will be added to the budget in a structural way.

Nevertheless, if indeed the U.S. and China are going to be cooperating more closely over the next couple of years this will be a major plus for global growth (and we’ll need all the positives we can get our hands on) and will help stability in other regards as well.

Corporate Profits

We’ve heard a lot of how most, 66% in fact, S&P 500 members beat earnings expectations last quarter – yes, Q1 operating earnings fell 33.5% but they did beat very low estimates. What we haven’t heard much of is that 70% of firms missed top-line (sales) expectations.

What does this mean? Well, it shows that cost-cutting has been extremely aggressive. And we know this as five million payroll positions have been slashed over the past nine months and businesses spending has plunged 26% year-over-year. This means that we should see relatively high-powered corporate profits a couple of quarters out as it will take little boost in demand to boost the bottom line.

However, without policies that incentive producers to produce, engage in capital spending plans and move from a stance of caution to one of optimism that allows for some risk taking, then employment may take a prolonged period of time to expand. The poor sales results illustrate the depressed level of consumer activity and if job growth fails to rebound a year after the economy recovers (one can’t expect job growth any sooner than that even coming out of a mild contraction, which this one is not) then consumer activity will remain weak and the bounce in corporate profits will be short-lived.

The Preliminary Jobs Reports

The Challenger Job Cuts survey (the measure of layoff announcements via the outplacement firm Challenger, Gray & Christmas) showed substantial improvement for May. The survey measured that layoff announcements fell to the lowest level since the economic world changed in September – up 7.4% from the year-ago period, down from 47% in April and 180% in March.

Planned firings rose to 111,182, compared to 103,522 in May 2008. The computer, chemical and auto industries announced the biggest cutbacks, accounting for 53% of layoffs. Challenger did state that they expect the pace of layoffs to accelerate again in the latter half of the third quarter as auto companies restructure.

The other survey, the ADP Employment report, and one that is more appropriate to the official monthly jobs data, measured that 532,000 payrolls positions were cut in May – a bit more than the market was expecting. The April figure was revised up to show a loss of 545,000 jobs from the initially reported loss of 491,000, which could indicate Friday’s official data will show a downward revision for the month.

A decline of roughly 530,000 jobs for May is pretty much in line with what the weekly jobless claims and monthly factory and service sector reports are showing. A decline of this magnitude is certainly an improvement from the 600k-700k losses that occurred in late-2008/early-2009 but this level remains much worse than the monthly jobs cuts we see during most recessions – in fact worse than every recession since the 1949 contraction.

According to ADP, medium-sized firms (50-499 employees) led the cuts by reducing payrolls 223,000 last month. Small firms cuts 209,000 and large firms reduced payrolls by 100,000. It may take a three-four months still but eventually we’ll see the level of job losses ease to a level of 200,00-300,000, which is commensurate with the normal recession. And that appears to be where we are at this point in the economy, back to an environment that looks more like the typical recession in most cases. A main issue is the consumer is going to have stronger headwinds to deal with than is normally the case as we come out of this one and as personal consumption declines to 65% of GDP from 72% it will result in lower rates of growth.

ISM Service-Sector

The Institute for Supply Management reported that their index of service-sector activity contracted for an eight-straight month, although at a slower rate. The measure came in at 44.0 for May, up mildly from the 43.7 recorded for April.

We really needed this reading to move closer to 50 (the line of demarcation between expansion and contraction) and the new orders index within the report did not move in the right direction (fell to 44.4 from 47.0), which doesn’t suggest we’ll see much improvement, if any, in the June reading. In terms of new orders, respondents commented: “Capital purchases has been curtailed.”

Further, while the inventory gauge did improve to 47.0 from 43.0 respondents stated that they are “working down current inventories” and “shorter lead times.” This doesn’t suggest much optimism regarding sales for the next few months. Beyond that though, these comments do indicate when the inventory dynamic does catalyze production it should offer a nice boost to the economy, but we’re not there yet.

The employment index continued to improve from deep contraction mode but the latest reading of 39.0 suggests no help from the service sector on the job front. Comments were a bit conflicting. The more negative: “Layoffs and non-replacement of attrition continue to lower overall employee populations.” The more upbeat comment was: “hired some line workers for small increase in demand.”

Have a great day!


Brent Vondera

Quick Hits

• Bernanke Warns Long-Term U.S. Budget Deficits Threaten Financial Stability
• All the Way Back for the Bond Market
• Rising government bond rates prove policy works

Daily Insight

U.S. stocks fought off another tough day for the dollar (down 10% over the past six weeks against a basket of six major currencies), instead focusing on a very positive pending homes sales report for April as a reason to push prices higher and extend the winning streak to four sessions.

On the dollar, there are actually two ways to view the direction of the greenback right now. One take is the safety trade has waned and that means a move from the safe-haven of the Treasury market and into riskier assets, which would be a positive signal. The competing view is that currency traders see monetary policy as unsound for longer-term price stability and the current fiscal policy as reckless. Since the Treasury market rallied yesterday its kind if difficult to go with the former, at least in terms of yesterday’s activity.

On the positive side of things, the latest pending home sales data was very upbeat, and comes on the heels of two-straight gains (February and March) – this suggests existing homes sales will bounce from the very low levels of the past few months. More on this below.

Commodity-related basic material shares led yesterday’s advance with consumer staple and health-care shares not far behind – a little sector rotation out of financials and tech and into those traditional sectors of safety as traders may be hedging bets regarding the near-term direction of the market.


Market Activity for June 2, 2009


Commodity Prices

Commodity-related shares have led this three-month rally; the S&P 500 index that tracks basic material stocks has jumped 55% since early March and commodity prices in general have bounced 30% from their seven-year low as measured by the CRB. While we believe this sector will remain an area investors should have exposure to over the next 12-18 months, the whole commodity theme has become very consensus and that does cause very short–term concerns. We may see these stocks, and commodity prices specifically, pull-back -- whatever the trigger for that move may be; the likelihood of a pullback before marching higher again seems pretty elevated in my opinion. The continually shrinking dollar (as measured against other currencies) coupled with large and specifically targeted stimulus spending out of China should be enough to lead this group higher, but probably not without some retracement first.

Credit Spreads

A recurring theme I view as appropriate is to remain carful and cautious in this economic and geopolitical environment. It is really nice to see the equity markets advance like this but it can also cause people to put down their guard and when emotions get going investors are sometimes compelled to increase their exposure to riskier assets. But in light of what I’ve been calling reckless fiscal and monetary policy, along with geopolitical risks that certainly seem heightened, there may be additional troubles to deal with – rough spots that may reemerge over the next year or two as the market reacts to massive levels of government spending, the largest budget deficits as a percentage of GDP since WWII and the ramifications of very easy monetary policy and the eventual unwinding of this very aggressive stance that Bernanke and Co currently have in place.

With regard to monetary policy one has to be particularly leery with respect to the tendency for the market to send the wrong signals; or more appropriately put, it can result in activity that may be misconstrued by market participants. Make no mistake, whether it be the fiscal or monetary stance these actions have costs. They may ease the downside, as certainly monetary policy action has, in the short term, but there will be consequences down the road – the question is, how far down this road do the consequences lurk?

This brings us to credit spreads – the narrowing of these spreads to be exact -- which is one of the main positives that has clearly fueled this stock market rally from the deep depths of the March 9 low. That is, the spread between corporate yields and Treasurys has compressed, which is normally a sign risk appetites have increased and a major reason investors are seeing the all clear signal. When investors are more willing to take risk, this generally means the risk of default and economic trouble has subsided.

AA Corporate Spreads

But has it? Is there a chance the rush into corporate bonds is more a function of the Fed’s action than anything else? Since the Fed has pushed cash and equivalent yields, and until very recently yields across the entire curve, lower than would otherwise be the case, this may be engendering another situation in which investors are not appropriately assessing risk as they hunt for yield. If there’s nothing to this idea, then the narrowing in corporate spreads over Treasurys is a good thing – even if spreads do remain wide from a historical perspective. If there is something to this idea, however, then there could be another level of nasty to deal with in the not-too-distant future and that alone is reason to keep up your guard and refrain from getting aggressive here.

Pending Home Sales

Pending home sales rose for a third-straight month in April, according to the National Association of Realtors. Pending sales of existing home jumped 6.7% for April, blowing by the expectation of just a 0.5% increase. (We’re on quite a nice little streak of the data beating expectations here; Monday it was better-than-expected manufacturing and construction spending reports and now this one) The increase was fueled by a 32.6% surge in pending sales in the Northeast and a 9.8% rise in the Midwest. Pending sales were up 1.8% in the West region; the South declined 0.2%.

The April rise follows a nice 3.2% advance for March, and portends existing home sales will bounce from the very low levels in which they presently reside – most of these pending orders will result in existing home sales over the following two months as those sales are not counted until contracts close. Assuming these desired purchases do not run into trouble along the process (the loss of a job or the financing falls apart) May and June existing sales will look good.

This morning all eyes will be on the preliminary employment reports (the Challenger Job Cuts Announcement survey and the ADP Employment report) that precede the official monthly jobs report, which will be released on Friday. We also have Fed Chairman Bernanke on Capitol Hill, which always received attention. In addition, the ISM service-sector survey for May will be released at 9CT and it will need to advance toward the 50 mark (the line of demarcation between expansion and contraction) in order to expand upon the relatively good reports of the past two days.

Have a great day!


Brent Vondera

Fixed Income Recap

Volatility eased in Treasurys today as a mild rally followed yesterday’s massacre. The two-year finished flat, and the ten-year was higher by 31/64. The benchmark curve flattened by 6 basis points, to end the day at +266 bps. A basis point represents .01%.

The ten-year TIPS breakeven, (the yield difference between the nominal and inflation protected Treasurys used to gauge the market’s inflation expectations), reached 2% today for the first time since September. The 10-year inflation protected Treasury was up .97%, while the nominal Treasury was up only .51%. The graph below details the last 12 months of inflation expectations as measured by the TIPS breakeven.

Have a great evening.

Cliff J. Reynolds Jr., Junior Analyst

UNFI, WAG

S&P 500: +1.87 (+0.20%)


United Natural Foods (UNFI) +11.80%
United Natural Foods, an organic and natural foods distributor, reported quarterly profit that beat market expectations thanks to lower fuel costs and tighter expense control.

Improvement in gross margin was driven by the specialty division, which was created from the Millbrook acquisition in November 2007. United also managed to decrease operating expenses by implementing expense control programs across all divisions, lower diesel fuel prices, and operational improvements in distribution centers.

United reaffirmed its sales guidance for fiscal 2009 and raised its EPS guidance range to $1.34 to $1.38 from the previous range of $1.28 to $1.36. The company said the revised guidance reflects the impact of improved operating efficiencies and cost controls. They also lowered the fiscal 2009 capex guidance by 25 percent.

Just like grocery shoppers, supermarkets have been trading-down by seeking less-expensive suppliers of its merchandise. United Natural Foods can benefit from this trend since they have the scale to generate operational efficiencies and, thus keep costs low. United’s rivals, the biggest of which is less than half the size of United and barely profitable, do not have this luxury.


Walgreen Company (WAG) +1.54%
Walgreen reported same-store sales in May increased 1 percent and pharmacy sales, which accounted for 65 percent of total sales, increased despite the introduction of lower-priced generic drugs.

Total sales in May were $5.37 billion, an increase of 6.1 percent year-over-year. Comparable front-end (non-pharmacy) sales rose 0.2 percent while comparable pharmacy sales rose 1.5 percent. Walgreen said comparable pharmacy sales were negatively impacted by 4.5 percentage points due to generic introductions in the last 12 months.


Quick Hits

• Emerging Markets Most Costly Since ’07 on Fund Flood
• One Explanation Why Google Isn’t In the Dow Industrials
  

Peter Lazaroff

Daily Insight

U.S. stocks rallied strong, ripping through that 930 wall on the S&P 500 to finish a three-session streak that has put in a new six-month high. All that money on the sidelines we had been talking about four months ago -- $3.9 trillion in money market funds as of March – continues to flood into stocks. Industrials, consumer discretionary and energy shares led the advance. (Crude is closing in on $70 per barrel, up another couple of bucks yesterday)

A couple of better-than-expected economic reports helped investor optimism, especially the ISM number that is showing early signs of making progress. The Institute for Supply Management’s economists believe a sustained move above 41.2 is consistent with economic expansion and since yesterday’s reading came in above that level it worked as a big catalyst to yesterday’s rally. The key word here is sustained, and that is where the questions arise.

S&P 500 1000, the last time we saw this mark was on Election day (November 4), is just a pitch shot away now. We have those who bailed at much lower levels scrambling to get a piece of this market; surely fund managers who have to compete with broad-market returns are in full-blown panic mode and are rushing in as well.

Nevertheless, the S&P 500 has jumped 40% from the March 9 low and it is tough to see a lot more upside as uncertainties abound. Then again, I’ve been saying this since 900, which is where I see the upper limit of fair value when factoring in both economically endogenous (higher tax rates, massive deficits, the capital sapping reality of much higher government spending, and a monetary policy that will have to be unwound at some point) and exogenous issues (geopolitical risks). Things may run beyond what makes sense here as is typically the case, just as we had witnessed to the downside, but over the next several months the market will reflect the aforementioned risks – remember the credit markets also still need to show they can stand on their own when the Fed does remove its several funding facilities.

Market Activity for June 1, 2009


Personal Income and Spending

The Commerce Department reported that personal income rose 0.5% in April and disposable personal income (DPI) – this is after-tax income – jumped 1.1% for the month. (The DPI reading was boosted by reduced personal current taxes and increased government social benefit payments associated with the American Recovery & Reinvestment Act of 2009)

Private wages and salaries fell for the seventh-straight month; however, government wages and salaries increased, which kept the overall wage and salary component of the PI data flat – it came in at 0.0%.

Proprietor’s income rose 0.4% for the month thanks to a 16.2% jump in farm income. Nonfarm proprietor’s income rose 0.1% after a 0.7% decline in March.

Rental income was also positive after three months of large declines (down 3.6%, 2.8% and 3.6%), up 3.1% in April.

So for the first time in a number of months we’ve seen some private sector components of the data add to incomes. Still, the private wage and salary data remains depressed and this number will have to come around in order for incomes to gain in a sustained manner.

In terms of the government side, social benefits rose 2.3% in April, up 14.3% year-over-year. Unemployment insurance jumped 8.6% for the month, up 115% over the past 12 months. The government components account for 20% of total personal income and at the current trajectory that percentage will be rising.

Personal spending fell for a second-straight month, and for the eighth month in 10, as rising unemployment and wealth destruction prompt households to boost cash savings. Spending on durables (autos, appliance, furniture, etc.) fell 0.6% and is down 10% year-on-year. Outlays for non-durables fell 0.7%, down 7.3% over the past 12 months. Spending on services rose 0.2% in April and is up 3% year-on-year.

The personal savings rate jumped to 5.7% in April.

The price gauge tied to this data (known as the personal consumption expenditures index, or PCE) rose 0.4% on a year-over-year basis – it is only reported on an annual basis. The core PCE, which excludes food and energy, accelerated to 0.3% in April, up from the 0.2% increase in March. This core reading is now up 2.7% at an annual rate over the past four months, which is above the Fed’s stated comfort zone for this measure is 1.5%-2.0%. However, they aren’t much bothered by this at the time as the overall inflation gauges are showing prices to be flat in an overall sense – certainly some components such as food and energy are on the rise.

ISM

The Institute for Supply Management’s measure of nationwide manufacturing activity continued to march from deep lows, posting the most salient move year as the May reading hit 42.8 – up from 40.1 in April. This shows contraction in the manufacturing sector is easing (a reading above 50 needs to be achieved to mark activity is expanding).

As we’ve talked about over the past month, ISM manufacturing needs to move to 45, if it does that’ll be a signal we’re really on to something – while this level means the sector remains in contraction mode it is commensurate with mildly positive GDP, something around 1.3% at a real annual rate. ISM manufacturing has been in contraction mode for 16-straight months.

The reading didn’t only beat the expectation, but was viewed in a significantly more positive light after that ugly reading we received from Chicago PMI (factory activity for the region) on Friday. The test here will be how the factory sector reacts to auto-plant shutdowns and whether the index will be able to sustain a moved above that 41.2 mark mentioned above.

The new orders index, probably the most important sub-index of the survey right now as it’s the main leading indicator, jumped to 51.1. That’s the first move into expansion for this figure since November 2007 and surely helped to juice the equity market.

On the other hand, the employment and inventory readings remain deep in contraction mode and we’ll need to see some improvement here before getting too carried away. Employment will take a while to approach the 50 level, but the 40 handle will have to be hit. Same is true for the inventory gauge. That figure moved down to 32.9 from 33.6 and a bounce back into the 40s will need to be seen in order to foretell the current level of business caution is waning.

It is difficult to see this sector moving to expansion mode, a multi-month move above 50 and sticking there, anytime in 2009 as businesses remain very cautious and are unlikely to boost capital spending much over the next several months. The survey has a section that touches on what respondents are saying and this aspect of the report will be key to watch.

Factories that make machinery equipment stated they “don’t see any major customers looking to place business until mid-2010 at the earliest.”

Further, respondents within the computer and electronics arena stated: “some amount of havoc is about to erupt, with companies pushing for increased capacity when suppliers have taken capacity offline.” No doubt one can see the positive side of this comment, but is that bounce-back effect realistic over the next few months if the capacity is not there? What’s more, this could have an affect on prices, thus increasing the chances of a quick and substantial run up within the inflation gauges. We’ll keep our eye on these comments over the next two months in particular.

Construction Spending

Finally, the Commerce Department also reported construction spending for April beat the market’s expectation, rising 0.8% -- destroying the expected1.5% decline. The surprise, and the driver of the overall number, came from private sector commercial construction, which rose a strong 1.8% and followed a robust 2.6% in March. Frankly, we don’t know what’s going on here, except that this is the backlog of jobs coming through the pipe – there certainly aren’t many new projects occurring.

On the private residential side, activity also increased, up 0.6%, but this followed a series of large monthly declines that ranged -3.6% to -10.4%. The public side continued to contract as state governments, most of which are being run by people with zero regard to managing finances properly, are in a world of hurt now that tax revenues are in the tank.

But this will soon change as the federal government’s fiscal stimulus begins to kick in a few months from now. I guess all of those “shovel ready” projects we heard so much of back in January and February involved a slight bit of hyperbole, as we discussed back then. Eventually these projects will make it through the state appropriations process and get rolling, but it is likely to come at a time in which the economy has already begun to move into expansion mode.

Have a great day!


Brent Vondera, Senior Analyst

Fixed Income Recap

Treasuries continued the volatility from last week and completely erased the gains from the last two trading sessions. The two-year finished down 2/32, and the ten-year was lower by 1 47/64. The benchmark curve steepened by 18 basis points, to end the day at +272 bps. A basis point represents .01%.

The graph below shows the rate volatility continued from last week.

The market is clearly disjointed. Fears that the US Treasury is going to lose its AAA credit rating push yields 30 bps higher one day, while rumors of more quantitative easing from the Federal Reserve bring them right back down the next. The market won’t be able to establish a true equilibrium until we can gain a better understanding of what the Fed is thinking. Rates have moved higher across the board since the Fed first announced the security purchasing program, and they are less than half way done. If the Fed sees the rate spike as a sign of economic health, then they are less likely to increase their purchase commitments. However, if Bernanke & Co. feels the need to further subsidize borrowing in order to avert a deepening recession, they is more quantitative easing on the way.

Have a great evening.

Cliff J. Reynolds Jr., Junior Analyst

May 2009 Recap

The S&P 500 finished higher for the third consecutive month and moved into positive territory for the year. The three-month winning streak, in which the S&P 500 gained 25.8 percent, is the biggest three-month gain since August 1938. With financial market conditions improving, investor confidence is growing as is the expectation for an eventual recovery in the global economy.

The VIX index, which is often used to gauge fear and volatility in the market via the prices investors are willing to pay for protective options, slid below 29 for the first time since last September. Although the measure has greatly improved from the end of 2008, when the index was in the high 70s and low 80s, the VIX remains well above the historical norm.

All asset classes posted gains in May, led by commodities and emerging markets. Commodity shipping rates, as measured by the Baltic Dry Index, suggest world trade is starting to pick up. The Baltic Dry Index jumped to an eight-month high after falling 94 percent in the second half of 2008. Oil futures had their biggest monthly percentage gain in a decade, up 29.7 percent. The rise in commodity prices signals that reflationary policy is gaining traction.

Emerging markets have been outperforming developed international markets this year due to healthier financial institutions, cheapened currencies, current account surpluses, and faster economic growth. China’s $4 trillion yuan ($586 billion) stimulus aimed at reviving the world’s fastest growing economy has been met with high levels of optimism. Demand is also expected to increase in India as the government increases investments in ports, roads, and bridges. Expectations are very high, maybe dangerously high, so any pullback would not be surprising.

Supply concerns and a stronger stock market forced Treasury yields higher. The longer end of the curve underperformed as the Fed’s efforts to keep longer term rates lower proved to be ineffective. Higher yielding longer-term Treasuries filtered into the mortgage market, bringing the 30-year fixed rates to 5.11 percent, up from 4.55 percent a month ago.

Peter Lazaroff, Junior Analyst
Cliff Reynolds, Junior Analyst

ITW upgrade, CSCO in the Dow 30

S&P 500: +23.73 (+2.58%)

Illinois Tool Works (ITW) +11.03%
ITW surged as Credit Suisse upgraded the diversified manufacturer from Neutral to Outperform. The upgrade was made on the basis of an attractive valuation at the current price. The analyst expects margins to double from 5 percent in the first quarter to 10 percent in the fourth quarter “reflecting restructuring benefits, stable markets and less acquisition headwind.”

The report also refers to the company’s history of strong acquisitions and reasonable debt levels as reasons to expect Illinois Tool Works to use the downturn to buy good assets at cheap valuations.


Cisco Systems (CSCO) +5.41%
Cisco will be added to the Dow Jones Industrial Average, effective June 8. Congrats to those who voted for the tech company in last month’s post on the subject.


Quick Hits

• Citigroup Stuck With Bernanke Ownership Offer American Banks Vow to Refuse
• Gross, Grantham, Bogle Lift Lid on ‘New Normal’
• Travelers, Cisco and the Dow 30
  

Peter Lazaroff, Junior Analyst

Daily Insight

U.S. stocks rallied in the final hour of trading on Friday to finish the first three-month gain for the S&P 500 since hitting the record 1565 in October 2007, as commodity-related shares lead the charge. Despite the 36% rally from the wicked 666 low of March 9 the market remains 41% below that record high.

Stocks were able, again, to brush aside ugly economic data and one wonders how long this is probable. Right now we’re going on hopes for an Asian recovery (I think what is currently known tells us there will be some rough waters to get through in June and July domestically); the record bounce in Japan’s latest industrial production reading and the third month of expansion within the manufacturing sector in China has really boosted expectations regarding a recovery in the Pacific Rim. For sure, very targeted and large fiscal stimulus out of China will help things over the next several months, but China remains an export-driven country and with the U.S. consumer pretty weak here I find it hard to believe that region won’t run into its troubles spots as well over the next few months.

I think the data will begin to record much more solid results by the fall, but between auto-production shutdowns, a business community that remains very cautious and a consumer still being hit by 500K-plus monthly jobs losses we’re not there yet.

For the week, the S&P 500 gained 3.62%, marking the 10th week of gain out of the past 12.

This week will be an important one. Will we be able to get past that 930 wall, or not? It’s worthwhile to notice how, on Wednesday, that the market gave back nearly Tuesday’s entire 5.9% surge after hitting 929. This week will bring both manufacturing and service-sector ISM numbers and the May jobs report, none of which should be inspiring. It will be interesting to watch how the market responds to these figures as it may be telling for near term activity (next three months) I believe. Then next week we get big 10 and 30-year Treasury auctions, they better go well.

Market Activity for May 29, 2009


Washington Motors (WM) – that ticker is available now that Washington Mutual is no longer around

I wanted to refrain from mentioning the GM thing because the entire situation is so pathetic, but it’s become obligatory to state that what has been known as General Motors will finally file for bankruptcy this morning. Now, Washington will run the company, which pretty much seals the deal for how the business will perform over the next several years. You think GM had troubles before, wait until the company is run based upon a short-term political focus rather than a framework that at least in some respect has profit as the goal.

Notice that the UAW Health-Care Trust will receive 17.5% in the new company, down from 38% in the former plan. It appears the UAW desired an additional stake in dividend-paying preferred shares, and higher level on the totem pole if things go bad, rather the nearly 40% stake via common shares – I guess they aren’t too optimistic on the viability of the company either. This of course makes what has been reported as a “sweetened deal” for unsecured bond holders, who will not only get a 10% equity stake but now another 15% in warrants, maybe not so sweet after all. Good luck with those warrants.

WM investors better hope that gasoline prices soar because the government is going to demand the automaker produce very small “efficient” (what exactly is efficient anyway? Is 275 horsepower that achieves 25 mpg inefficient? Does a car need to be small, and likely more dangerous, and high mpg to be termed efficient?) autos that Americans in the aggregate do not want. This stuff works in Europe where birthrates are nil, but it’s kind of tough to stuff the family of four into the Chevy Cavalier and have the peace of mind that they’ll be relatively safe as the Mrs. carts them around town or you all take off on that summer trip. But fear not, because between restrictions on domestic energy production and the way the Fed will pummel the dollar you can be assured that pump prices are going much higher. And speaking of the dollar…

Dollar Down

The dollar really got hammered last week as the estimate for government debt issuance in 2009 has jumped to 3.25 trillion, up from the already unprecedented $2.5 trillion. (That’s as a percentage of GDP, and outside of WWII). Further, I don’t think anyone believes the Fed is going to put a halt to monetizing the debt (buying Treasury securities and inflating away the debt in terms of nominal GDP) and that means the printing press will be working overtime


First revision to Q1 GDP

The Commerce Department reported that first-quarter GDP was revised up to show the economy contracted at a 5.7% real annual rate rather than the 6.1% initially estimated last month. Still, the fourth quarter of 2008 and the first-quarter of 2009 combined to mark the worst two-quarter contraction since the 1957-58 recession – that period posted -4.2% in Q4 1957 followed by -10.4% in Q1 1958.

So what caused the upward revision? A lower-than-initially estimated reduction in business inventories added 0.45 point back to GDP (still companies cut stockpiles by the largest amount since records began in 1947) and net exports added 0.19 point (the decline in exports was less than the decline in imports, but both did decline: down 10.7% for exports and down 17.5% on imports). A narrower trade gap adds to GDP.

These adjustments more than offset a substantial downward revision to the personal consumption component – the largest aspect of gross domestic product. The initial personal consumption figure of +2.2% (again, remember this is in real terms at an annual rate) never made sense based on the personal spending figures for the period, which we touched on at the time of the initial GDP report last month. The reading was revised down to 1.5%, which makes more sense based upon the chained $ quarter-over-quarter consumption figure within the personal spending data, which is what one watches to gauge this GDP component.

We’ll get the April personal spending reading today and this will help us gauge how consumer activity is going for the current quarter. I suspect it will show another decline and am not confident personal consumption will offer much support to Q2 GDP.

Chicago PMI

The Chicago Purchasing Managers Index stated factory activity contracted at a faster pace in May, showing the state of manufacturing remains precarious. The reading came in at 34.9 after April’s bounce to 40.1 from the nearly 30-year low of 31.4 in March. A number below 50 indicates activity contracted.

That April rebound had many believing the manufacturing sector was on the rebound, as a number of economic data sets have given economists the old head fake – this is why defenders are supposed to remain focused on the body, not the head – the same is true for economic data, focus on multi-month trends rather than getting all excited about one month pops.

We have also discussed over the past month how it will be important to rely on the other regional factory surveys, rather than Chicago. Chicago is usually the most important one to watch for signals of what’s occurring nationwide, but with its significant exposure to the auto industry the plant idling for May and June are going to put pressure on Chicago. Nevertheless, that fact that the readings took such a blow last month shows that other areas likely endured damage as well.

The new orders index, a sub-index of the overall report, illustrates things won’t get much better for June.

The employment index was slammed back to a new low.

This morning we get the personal income and spending figures for April, one of the big readings of the week. We’ll also get ISM manufacturing for May. The big big report will come on Friday with the release of the May jobs report.


Have a great day!


Brent Vondera, Senior Analyst

DELL, SO, MON, PG

S&P 500: +12.31 (+1.36%)


Dell (DELL) +0.78%
Dell reported less revenues and profit than last year, but the company still managed to beat analyst’s earnings expectations for the first quarter thanks to cost reductions.

CFO Brian Gladden said sales fell because of less demand from business customers and Dell’s decision to avoid price cuts. Dell said signals about the demand environment are mixed, but the company is preparing for what it believes will be a “powerful replacement cycle,” due to new products from Microsoft (MSFT) and Intel (INTC).

The company did not provide a specific financial outlook, but did announce it would slash another $1 billion in costs. That added to the $3 billion it had already pledged to cut annually within two years. Gladden sees the biggest opportunity for saving money in the cost of goods sold, including expenses from manufacturing and supplies.


Southern Company (SO) +0.42%
Southern Company announced it will manage and operate the U.S. Department on Energy’s new National Carbon Capture Center, which will develop and test advanced technologies to capture carbon dioxide from coal-based power plants. Arch Coal (ACI) and Peabody Energy (BTU) are among other partners.


Monsanto (MON) +3.99%
Earlier this week, Monsanto said earnings this fiscal year will be at the low end of its previous forecast because of stronger-than expected competition in its Roundup herbicide business.

The company is sacrificing Roundup sales volume to maintain prices amid increased competition from cheaper generic glyphosate herbicide from China. CEO Hugh Grant was surprised at how quickly and how much Chinese generic versions recently reached global markets. The generic version retails for about $20 a gallon, compared with $30 for Monsanto’s Roundup Grand.

The company expects growth in seeds to offset any decline in Roundup sales.

Procter & Gamble (PG) -1.24%
Yesterday, P&G said fiscal 2010 profit may rise as much as 4 percent as it introduces new products and doubles its distribution capacity in emerging markets.

The company raised some prices in some markets to cover fluctuating exchange rates, although it had to cut prices in categories such as fabric care and tissues to maintain its share.

On the topic of the balance sheet, the company’s primary use for cash will be to maintain its credit rating (Aa3 at Moody’s and AA- at S&P), but will also be used to expand its manufacturing capacity and to maintain the dividend. P&G will stop share repurchase program until the economy improves.


Quick Hits

• New Model Army?
• The Fed’s Balance Sheet
  

Peter Lazaroff, Junior Analyst

Fixed Income Recap

Treasuries rallied for the second day in a row leaving most of the curve unchanged for the week. The two-year finished up 5/64, and the ten-year was higher by 1 7/32. The benchmark curve flattened by 11 basis points, to end the week at +253.5 bps, flatter than we began the week believe it or not. A basis point represents .01%.

Mortgage rates as measured by the Fannie Mae 60-day Commitment Rate spiked 48 basis points yesterday to 5.21%. I normally quote the Mortgage Bankers Association Survey, which is only updated weekly. The Fannie Mae Commitment Rate is a rate commonly used in the mortgage origination industry, and is updated daily. Although it is not reflected in the graph the rate pulled back to 5.11% today.

It was certainly a wild week in rates but we really didn’t get anywhere. Mortgage rates are likely to stay above 5% after this week’s volatility, while the market waits to see if the Fed makes a move. The graph below shows the ten-year Treasury yield starting the week at 3.45%, and ending at 3.456%. If you took the week off you didn’t miss anything.

Next week is without an auction or a Fed purchase in the Treasury market, leaving traders with a few less worries.

Have a great evening.

Cliff J. Reynolds Jr., Junior Analyst

Daily Insight

U.S. stocks, after struggling to find their direction during the morning session rallied in the afternoon. Energy shares led the upswing as oil prices look ready to take on the $70 per barrel handle; crude closed at $65.08 yesterday and is above $66 this morning. Financials were the next best performing sector as the Treasury market rallied, easing Wednesday’s concern over higher borrowing costs.

The market is in a gray area here, a state of confusion you might say, as the S&P 500 has traded in a tight range of 880 as the support and 925 as the resistance, just ahead of the 930 wall, over the past 20 sessions. I’m thinking very near term economic data is going to push us below that 880 level but it’s pretty clear that those who have not participated in this rally from the March 9 flagitious low of 666 are holding things up as they want in on the action.

Word that the Fed will boost their purchases of Treasury securities encouraged buying within the market place, full blown monetization of government debt is very likely but that’s another story. A $26 billion seven-year auction also went swimmingly, helping the Treasury market to rally and financials went along for the ride as the worry over a spike in rates eased, for now. One could say this is also why energy stocks jumped, the Fed’s actions will drive the dollar lower over time and that means higher commodity prices.

Treasury auctions are going to be more important than ever due to both fiscal and monetary policy decisions. A big test for this market will be the 10 and 30-year auctions scheduled for June 11 and 12, assuming Monday’s personal spending figure doesn’t blow a hole in the floor.

The day’s economic data was certainly no help; as we touched on yesterday, the market is holding up remarkably well considering what we’re seeing – more on the data below. Beyond the strong session for energy and financials all major industry groups, save consumer discretionary, closed to the plus side.


Market Activity for May 28, 2009


Jobless Claims

The Labor Department stated initial jobless claims fell 13,000 to 623,000 for the week ended May 23, beating the expectation by a bit, which was for a move to 627,000.
The four-week average fell 3,000 to 626,800.

Continuing claims made the 17th straight record high in the latest week, jumping another 110,000 to 6.788 million.

The insured unemployment rate, the jobless rate for those eligible for benefits, rose another tick to 5.1% -- the highest level since December 1982 when the post-WWII record unemployment rate of 10.8% was hit . This rate closely tracks the direction of the overall unemployment rate and you can expect it to blow past 9% when the May jobs report is released in a week.

This real-time data is illustrating there’s very little improvement within the labor market. We should not see a number like the 740,000 in payroll losses posted in January but a range of 530,000-600,000 appears to be in the cards for a couple of months still.

This level of losses cannot go on for much longer, although the auto-industry woes may make it a reality for longer than one would think possible, but it appears it may be a while before we move back to 300,000 in monthly job losses, which was the peak range for the last two recessions and the 2001 downturn.

Durable Goods Orders

The Commerce Department released their latest durable goods report, which showed orders rose 1.9% in April after a huge downward revision to the March data. The 1.9% bounce follows a 2.1% decline in orders for March (previously reported as a 0.8% decline). Durables were driven by a 2.7% increase in the vehicle and auto parts component and machinery orders – problem is we’d like to see something other than autos driving the reading because we know it’s not going to be of help over the next couple of months as auto plants will be idled.

Durable goods have endured the worst contraction in orders since the late 1940s.

Excluding transportation, orders rose 0.8% after a 2.7% decline in March – this number was revised down big time too, initially reported as a 0.6% decline.

The non-defense capital goods ex-aircraft component (a proxy for business spending) registered another large monthly decline, down 1.5%. On a three-month annualized basis, the decline has improved nicely, down 28.6% compared to the -44.2% last month that was affected by the massive 12.3% plunge in business spending orders during January. Needless to say, this rate of decline, while improved, shows businesses are still in a mode of heavy caution.

On a year-over-year basis, business spending is down 26.4%. This is the number to watch as we desperately need the business side of the economy to pull us out of this situation since the consumer will need additional time to get their bearings again. Unfortunately, the government has inserted itself as the economic driver. The consequence of this decision will be a crowding out of private sector activity as capital will be sapped via higher tax rates and debt purchases as result of the outsized deficit spending.

New Home Sales

The Commerce Department released new home sales for April, showing activity rose 0.3% to 352,000 units at an annual rate – the expectation was for sales to hit 360,000. This follows a 3% decline for March. New home sales are down 34% from the year-ago period. The record low of 329,000 units was hit in January, which was 76% below the peak hit in July 2005.

The lowest mortgage rates in 60 years and tax credits to first-time buyers have helped sales stabilize, albeit at the lowest levels since 1982.

The median price of a new home actually rose 3.7% last month, coming in at 209,700 – the figure is down 14.9% over the past year.

The number of new homes available for sale remains below the long-term average. This signals that the inventory to sales ratio will plunge once sales rebound in a significant way. The issue in the near term is the labor market, as we discussed yesterday; home sales don’t have much of a chance until job losses ease. Beyond that, sales will still have to fight headwinds as current fiscal and monetary policy will eventually drive interest rates higher.

On that inventory/sales figure, the supply of new homes relative to the rate of sales, the trend is moving in the right direction at least.

Delinquencies

In a separate housing market report, the Mortgage Bankers Association stated delinquencies as a percentage of all mortgage loans jumped again in the first quarter to 9.12%. This reading includes loans that are at least 30 days late. The delinquency rate among prime loans hit 6.06%; for subprime loans the rate hit 24.95%.

The percentage of seriously delinquent loans, those 90 days late, hit 7.24%, which means the foreclosure rate will rise – as of the first quarter that foreclosures made up 3.85% of all mortgage loans..

Today’s Data

This morning all eyes will be on Chicago PMI, a measure of factory activity in that region. Yes, we’ll get the first revision to Q1 GDP, which will get attention, but that Chicago reading will be the big one. The number made really good progress last month from a very low reading of 31.4 in March. The market will need to see progress continue, making its way to the mid 40s – a reading below 50 marks contraction but a solid move into the 40 handle will be enough to excite people.


Have a great weekend!


Brent Vondera, Senior Analyst

Fixed Income Recap

Treasuries rallied today after a number of issues plagued the market on Wednesday. The two-year finished up 1/32, and the ten-year was higher by a point. The benchmark curve flattened by 10 basis points, and currently sits at +265 bps. A basis point represents .01%.

The Treasury auctioned $26 billion in seven-year notes at a yield of 3.3%,

The Federal Reserve, who still denies having a specific target for certain interest rates such as residential mortgages, is definitely being forced to make a decision with rates moving higher. Thirty-year mortgage rates have dropped from 5.98% in November 2008, before the Fed announced the initial $500 billion in agency MBS purchases, to its current level of 4.81%. These record low levels are likely to rise due to the recent run-up in Treasury yields, but if we begin to see mortgage rates creep in to the 5%-5.15% area will that force the Fed to take action? If yes, then how?

The Fed’s MBS purchase commitments currently stand at 150% of 2009 supply and 25% of the market as a whole, how much more can they really buy? The Fed runs the serious risk of just inflating the recession away, through huge amounts of quantitative easing, only to have to trounce the next economic rebound to avoid hyperinflation. TALF has already been expanded to the point where the Fed is beginning to take some really questionable assets, on to their balance sheet, (subprime credit card loans and commercial real estate for example). When the Fed becomes such a major market participant, risk can’t be accurately measured by the private sector. Also not favorable for the long term.

Monetary policy, including quantitative easing, has a lagging effect. There is no doubt that the Fed has created a simulative rate environment, so the best course of action in my view would be to give it a chance to work. Even if it means no more 4.75% mortgages.

Have a great evening.

Cliff J. Reynolds Jr., Junior Analyst

Daily Insight

U.S. stocks gave back most of Tuesday’s gains on news that the number of banks on the FDIC’s “problem list” climbed to the highest level in 15 years, concerns over government debt and comments from JP Morgan that credit-card defaults will continue to climb.

Banks are finding it difficult to build reserves fast enough to keep the ratio of reserves to non-performing assets static and that causes concern about loan activity and the degree of economic recovery. Frankly, based on the numbers we’re seeing on the delinquency front across a broad base of loans the stock market is taking the news remarkably well.

This is something we’ve talked about for a while, credit-card default rates -- along with commercial real estate losses that may not yet be halfway through the cycle – are going to cause trouble for some time. The very positively sloped yield curve (banks borrow near zero and lend much higher) will keep interest-income margins elevated, but I don’t see how it offsets these other major challenges.

As credit-card lines continue to be cut (exacerbated by legislation capping late fees and interest rates) it will put additional pressure on consumer activity. Consumer spending as a percentage of GDP will work its way from 72% of GDP back to the historic average of 65%, which will mean slower growth rates. If government policy were focused on spurring the business side of the economy, we’d be able to offset this drag a bit, but policies are doing nothing but scaring business and keeping managers cautious – not helpful.

And speaking of that positively sloped yield curve the spread between Treasury two and 10-year notes widened to a record on concern massive government debt issuance will overwhelm those Fed efforts to keep borrowing costs low. The degree of the slope generally portends the magnitude of the economic rebound (the more positive the better), but these are not normal times and if long-end interest rates spike because traders are worried about enormous levels of debt issuance rather than because the prospects of recovery has increased, you can forget about a meaningful recovery. The Treasury auctioned $35 billion of five-year notes and traders sent long-end yields much higher as a result.

The latest home sales data failed to offer a counterbalance to the aforementioned weights. Existing home sales did rise, as we’ll discuss below, but only from very depressed levels – there’s a difference between stabilizing at very low levels and a pure rebound.

Housing needs economic growth to rebound, not the other way around. Economists continually state a necessary condition for economic recovery is a housing rebound. This is backwards; until the labor market improves substantially you can’t have a significant bounce in housing and until the economy recovers you can’t have labor market improvement. The Fed can work on pushing mortgage rates down all they want, and it will certainly help - although not without longer-term ramifications – but when the economy continues to shed 500k-600k payroll positions a month there’s not much anyone can do. It just takes time.

Market Activity for May 27, 2009


Crude Oil

The price of crude for July delivery rose to a six-month high yesterday, now nicely ensconced above $60, closing at $63.13 per barrel. Signs of increasing demand out of Asia (China’s stimulus is beginning to take root and they are also surely stockpiling commodities for fear of future price spikes), word OPEC will cut production and speculation that the weekly energy report will show a drawdown in gasoline inventories all helped push the price higher. (We now know this morning the worry of an OPEC production cut was not necessary as the cartel has decided to leave production unchanged; crude prices have barely budged though, don just a nickel this morning)

One wonders how the consumer will react to higher gasoline prices this summer. The plunge in pump prices from last summer’s spike definitely helped cushion the blow of reduced incomes. If the retail price of gasoline holds below $2.50 per gallon (roughly $2.00 wholesale) it shouldn’t present a problem. However, if we push to $3.00 at the pump…well, that’s just one more obstacle.

Mortgage Applications

The Mortgage Bankers Association reported its mortgage applications index fell 14.2% during the week ended May 22, which followed a 2.3% increase for the previous week.

Refinancing activity, which currently makes up 70% of the index, slid 18.9% last week after a 4.5% uptick in the prior period. Purchases managed a 1.0% gain after falling 4.4% in the previous week. It appears the refinancing wave that took place in March and April has pretty much run its course. Either that or those who have not yet refied, and have the equity to do so, are waiting for a 4.5% fixed 30-year mortgage rate before pulling the trigger – not sure they’re going to get that number, but one never knows; if the Fed increases its mortgage-backed securities purchases it could happen. As the market has recently overwhelmed the Fed’s work in driving rates lower one can bet Bernanke & Co. will be increasing their Treasury and mortgage-backed purchases.

As discussed above, it will take some meaningful improvement in the labor markets to get home buying fired up again. The affordability index is at an all-time high – meaning it has never been a better time based on the combination of prices and mortgage rates – but the labor market is the prevailing factor; if potential home buyers loss their job, or the probability of this occurring is elevated – and it clearly is – they’ll hold off. As we move closer to the summer months it is becoming increasingly evident there really is nothing the Fed can do to spark home sales.

In the meantime, let’s hope their attempt does not cause additional problems 18-24 months down the road that then results in an economic double-dip – the chances of this occurring, another recession after, say, four quarters of GDP growth, are definitely elevated.

Existing Home Sales

The National Association of Realtors reported that existing home sales rose 2.9% in April, beating the expectation, to an annual rate of 4.68 million units. The data was driven by a 6.4% pop in multi-family units (condos and co-ops). Single-family sales rose 2.5% after falling 3.3% in March.

The median price for total existing homes slid 15.4% from the year-ago period, it currently sits at $170,200; the price for single-family units alone is down 14.9% compared to April 2008, currently at $169,800 – the peak of $230,900 was hit in July 2006.

Distressed properties (much of which involves foreclosures) made up 45% of all sales last month – only the most intense bargain hunting is occurring. First-time buyers accounted for 40% of sales, driven by tax-credits.

It appears we’ve hit bottom in the housing market, but one can’t say much beyond that. Existing home sales remain below the February reading. I focus on the Feb. number because that month was surrounded by ultra-low record readings of 4.5 million units (again, at an annual rate) for January and March – this latest data only appears to be an improvement based on those extremely depressed levels. Same is true when looking at only the single-family units.

By region, the Northeast and West posted sales gains of 11.8% and 11.1%, respectively. Sales in the Midwest and South were flat.

The supply figures continue to show there are a lot of properties to work off still. The single-family homes available for sale jumped a bit last month, rising to 3.34 million units from 3.06 million.

When matching supply against the current sales rate the glut continues at there are still 9.6 months’ worth of single-family existing homes on the market. Same is true when we add in multi-family units, as the total existing home inventory/sales ratio moved back up to 10.2 months’ worth.


Have a great day!


Brent Vondera, Senior Analyst

Fixed Income Recap

The two-year finished down 1/64, and the ten-year was lower by 1 12/32. The benchmark curve steepened by 12 basis points, and currently sits at +275 bps. A basis point represents .01%.

The recent selloff in Treasurys has pushed the yield curve to its steepest point on record, 1 basis point higher than the previous record set on October 13th 2003. Yield curve shape is based on a variety of factors, including liquidity differences between different Treasury issues and expectations for interest rates in the future. I will touch more on the reasons for the spike in longer-term rates below.

Treasurys were lower again today after $35 billion in 5-year notes came to market. The bid/cover ratio, the ratio of bids submitted to bonds sold, was 2.32, a sign of good demand compared to a 2.19 average for the last four auctions. More supply comes tomorrow when the Treasury will auction $26 billion in seven-year notes.

The increased supply is certainly making its presence felt in the market but it doesn’t deserve all the credit for the recent selloff. With all the talk of a Q3-Q4 end to the recession many are starting to wonder what will come of all the excess liquidity in the market. If the Fed is unable to pull the liquidity from the market appropriately, then inflation, simply defined as too much money chasing too few goods, will result. A larger than expected rate of inflation spells danger for investors who aim to protect the purchasing power of their savings.

Today’s auction results seem to point more towards inflation concerns rather than supply. Today’s supply was no surprise. The market has known about the record Treasury issuance that will be coming this year for some time now. The strong demand is just coming at a higher price for the US Treasury as investors look to protect against inflation. TIPS outperformed comparable nominal Treasurys by 75 basis points today, showing investor’s preference for inflation-indexed bonds compared to nominal (non-adjusted) Treasurys.

Have a great evening.

Cliff J. Reynolds Jr., Junior Analyst

Fixed Income Recap

The two-year finished down 3/64, and the ten-year was lower by 45/64. The benchmark curve steepened by 6 basis points, and currently sits at +256 bps. A basis point represents .01%.

With no economic data and a shortened trading session in bond land, the market turned its focus to next week’s supply. The Treasury will issue $100 billion in 2’s, 5’s and 7’s next week, and if the market told us anything the past two days, demand for government paper is not nearly what it was a few months ago.

The media has really beaten the “US Treasury to lose its AAA credit rating” story to death. Standard and Poor’s got the ball rolling yesterday when they put the UK’s AAA credit rating on negative watch. Meaning they are still AAA but the credit agency is just revisiting the analysis.

There’s no doubt that this administration is spending borrowed funds at a frightening pace, and unless the Fed ups its participation through additional quantitative easing we will definitely see higher rates on Treasury borrowing for the rest of the year. But to say that investors should begin to worry about the credit of the US Treasury is a little much.

A lot of global money flooded into Treasuries during the collapse of the credit markets driving yields to record lows and the dollar to multi-year highs. That trend is reversing now more because of an increase in inflation expectations than a broad based currency meltdown, sorry CNBC. When economic activity picks up, inflation will begin to show itself, but even higher than average inflation from these price levels is far from destabilizing. The exposure this is getting in the media is just way too much.

Have a great evening.

Cliff J. Reynolds Jr., Junior Analyst

Fixed Income Recap

The two-year finished down 3/64, and the ten-year was lower by 1 & 33/64. The benchmark curve steepened by 15 basis points, and currently sits at +250 bps. A basis point represents .01%.

The Fed has purchased $123 billion in longer dated Treasuries since it began its current quantitative easing campaign on March 25. The target amount currently stands at $300 billion, but according to the minutes from the April FOMC meeting, some Fed officials are open to increasing that amount.

Primary dealers took those comments into consideration today when they submitted $45.7 billion in Treasuries to be purchased by the Fed, roughly 50% more than the average. Only $7.4 billion on the $45.7 billion were accepted by the Fed. The Ten-year sold off more than a point immediately after the results were announced.

Investors fearing rising rates are eager to dispose of Treasuries in favor of investments that will fare better in an inflationary environment. Dealers called the Fed’s bluff and today’s price action shows how that can backfire.

Have a great evening.

Cliff J. Reynolds Jr., Junior Analyst

Fixed Income Recap

The two-year finished up 3/64, and the ten-year was lower by 7/64. The benchmark curve steepened by 4 basis points, and currently sits at +235.5 bps. A basis point represents .01%.

There were no Fed purchases or Treasury auctions today. The Fed will buy Treasury notes tomorrow and Thursday.

TALF
The $1 trillion Term Asset-Backed Securities Loan Facility was created by the Fed to aid the flow of credit to consumers by providing liquidity for securities backed by loans for credit cards, equipment dealer floor plans and small businesses. It was expanded May 1st to include newly issued Commercial Mortgage Backed Securities (CMBS) and previously eligible TALF loans maturing in 5 years, (the previous limit was 3).

The program was expanded again today to include already issued AAA rated CMBS to spur more participation in the program. The first TALF auction on May 2nd took in $10.5 billion in securities and the auction scheduled for June 2nd doesn’t look like it will be much bigger.

Today’s announcement greatly expands the universe for TALF eligible securities. According to Bloomberg, only $35 billion in TALF bonds have been created this year. In comparison, $12.2 billion in CMBS were created last year, down from the record $237 billion sold in 2007, and although many of them aren’t rated AAA, this gives many more opportunities for firms to participate. Whether it makes sense for the Fed to take all this extra risk onto their balance sheet is another story.

Have a great evening.

Cliff J. Reynolds Jr., Junior Analyst

Fixed Income Recap

Investors fled the safety trade today as stocks rallied hard. The two-year finished down 7/64, and the ten-year was lower by 53/64. The benchmark curve steepened by 4 basis points, and currently sits at +232 bps. A basis point represents .01%.

The Fed purchased $3.18 billion in longer dated Treasuries with maturities from 8/15/19 to 2/15/26. Cumulative Fed purchases stand at $107.89 billion, still a ways from their target of $300 billion that is scheduled to finish in September.

TED Spread Continues to Fall

The spread between 3-month T-bills and 3-month Libor, dubbed the TED Spread, is widely used to measure credit market functionality. 3M Libor is the rate used by banks to lend each other money for a three month period, so unlike Treasuries, Libor lenders are exposed to default risk. When credit tightens and banks become less willing to take the risk involved in lending to each other, they move to T-bills to avoid the default risk and still maintain liquidity. As a result Libor rises and the yield on T-bills falls, widening the TED Spread. This is what happened in September and October of last year.

Three Month Libor has fallen every session since March 27th, including a 4.1 basis point decline today, bringing the TED Spread to its lowest level since August 2007.

However, on a relative basis, one would thing TED has a ways to go. For example, on August 8th 2007, the last time the TED Spread was this low, 3-month T-bills were at 4.95%. This indicates that although the TED Spread has come in from the extremely wide levels of last fall, it remains high on a relative basis. The current relative spread, which compares the nominal spread to the current rate environment, is still elevated at 389.2%, compared to just 8.7% in 2007.

Have a great evening.

Cliff J. Reynolds Jr., Junior Analyst