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Today's Market WrapUp 09.11.2007 Mon Tue Wed Thu Fri Barbera Archive The View From 30,000
Feet Since mid August, the US Stock market has recovered nearly 60% of its prior decline, which spanned a mid July high near 1550 to a mid August low at 1370 using the S&P 500. For the S&P, the recovery from 1370 to 1460 (and as high as 1496 on Sept 4th), has set fear aside of the Credit Crunch, and renewed investor's optimism. In foreign markets, the recovery has been even more strongly pronounced, with Asian stock markets like Hong Kong, Korea and Singapore (not to even mention China) moving back to the vicinity of their former highs. So is that really all we have to deal with, a 10% decline in the US Market, and an even more shallow sell off in foreign markets? Could we already be getting back onto the path to prosperity? In our view, the answer to that question is a resounding “Hell No,” and with it a major warning to very short term oriented investors to step back and take in the view from 30,000 feet, as there is very serious pain potentially directly ahead.
Above: an unweighted view of Asian Share prices, (China, Singapore, Korea, Hong Kong) moving back up to the vicinity of former highs. But before delving into the markets, let’s start with a look at the recent developments in what has been the ongoing, and to date, unrelenting change in the state of global credit markets. While most of us do not have the time to read any number of newspapers each day, for those watching the state affairs in the credit markets, the state of affairs is somewhere between “bleak” and “grim” with wide scale overtones for the outlook on future global growth. Of course, who could blame the average individual for not seeing what has taken place largely behind the cover of closed doors over the last few years? Until the last few weeks, the terms CLO (Collateralized Loan Obligations ), CDO (credit default obligation), ABCP (asset backed commercial paper), ABS (asset back securities), CDS (Credit Default Swaps), CPDO’s (Constant Proportion Debt Obligations), SIV’s (Structured Investment Vehicles), SIV Lites, and Conduits, have been far off from the public’s investment view. Yet, it is these derivatives and holding entities which are wholly intertwined in the spider web that is the “structured finance” credit markets of the new millennium. To this end, we see no hint that the credit default worries centering around CDO’s and infecting the ABCP market have abated. Instead, over the last two weeks, the spreads on London based Libor 3 month borrowing over Fed Funds have continued to widen out.
Above: the Yield on 3 Month ECU Libor paper has continued to climb, moving UP .50 basis points since late July.
Above: British Pound – 3 Month Libor Rates, Yields are accelerating sharply higher as lending confidence is extremely fragile with many borrowers unwilling to take on the credit risks of even the world's largest banks. CPDOs
Rated AAA May Risk Default, CreditSights Says (Update2) Sept. 6 (Bloomberg) -- Credit derivatives awarded the top ratings by Moody's Investors Service and Standard & Poor's may be as vulnerable to default as high-risk, high-yield bonds, according to independent research firm CreditSights Inc. Constant proportion debt obligations, known as CPDOs, use credit-default swaps to speculate that a group of companies with investment-grade ratings will repay their debt. An increase in credit rating cuts for investment-grade companies may cause losses that CPDOs would struggle to recoup, CreditSights said in a report entitled ``Distressed CPDOs: We're Doomed!'' ``If you assume defaults and downgrades come in bunches rather than being evenly spaced out, CPDOs' default rates are more what you would expect for low junk ratings than for AAA,'' David Watts, a CreditSights analyst in London, said in a telephone interview yesterday. And this from Germany on Citicorp (C ) and its SIV’s: New York, NY (aktiencheck.de AG) - the Citigroup Inc,. the largest banking company in the USA, is in press data according to with more than 100 billion dollar with so mentioned "Structured Investment Vehicles" (SIV). This reports to "the Wall Street journal" on Wednesday. According to the report serious problems could result in connection with the SIV's, which are seized outside of the company balance (sheet) of the credit institute. Investors are afraid possible losses by adjustments of value on/within the Investment vehicles contained net assets as well as in connection with possible problems with the sales of Commercial PAPERS, which serve for refinancing of the SIV's, are called it in the article. The Citigroup sees no problems in view of the high quality of the Assets and the solid financing of the SIV's. SIV’s are guessed/advised due to the problems arisen last in connection with the US crisis and the distortions at the international credit markets in disrepute. “It’s a matter of trust” says Robert Kessler, head of Kesslet Investment Advisors, a Denver based manager of Treasury Securities. While Libor rates are based on the rates between some of the world's largest banks, shaky confidence has led the market to demand higher yields on inter-bank lending versus the Fed Funds Rate and Treasuries, which are seen as risk free. The widening yield spreads in recent days have been quite dramatic, and have served to strengthened overseas currencies. Yet the big downside risk ahead still resides in the US Credit Market where the long march of “resetting” adjustable rate mortgages has just begun. Looking out over the next 12 months, the US is facing a monumental series of ‘resets’ to its pile of Adjustable Rate Mortgages on the order of $50 to $60 Billion dollars per month, with some months north of $70 billion. In this light, the surge in recent weeks in overseas Libor Rates is potentially devastating news for the US Homeowner because within the US, increases on Adjustable Rate Mortgages are tied to the LIBOR Rate, and NOT the Fed Funds Rate. In fact, a recent article by Randall Forsyth in Barron’s pointed out that most resets will take place at several points ABOVE LIBOR. “This means that some of those borrowers may face mortgage rates of close to 10%, with the recent rise in Libor rates exacerbating this squeeze.” Consequently, even if the Fed lowers the Fed Funds rate by 25 basis points, the offsetting rise in Libor Rate imply that for most borrowers, there will be no benefit whatsoever. From Bankrate.com, “The LIBOR is among the most common of benchmark interest rate indexes used to make adjustments to adjustable rate mortgages. This page also lists some other less-common indexes.”
Above: near term Libor Rates from BankRate.com. Note the huge surge in yields on the One month Libor Rate to 5.80%, up from 5.33% -- THAT’s UP .50 basis points in the last 4 weeks! Similar gains are also showing on the 3 Month Libor and 6 Month Libor yields.
Above: the 3 Month T-Bill to Commercial Paper Spread has continued widening… In addition to the widening LIBOR – Treasury Spreads, the more than 2 Trillion dollar Commercial Paper market is still a long way from healed. In fact, even as the stock markets of the world have rallied over the last few weeks, Commercial Paper to Treasury Spreads have continued to widen out, suggesting a continued credit crunch. In our view, the fact that failing confidence has continued to put upside pressure on yields, and is now directly impacting (negatively) the Adjustable Rate Market, suggests a dim view is appropriate for the US Economic Outlook moving forward. After all, in recent years, much of the economic growth seen in the United States has been spending derived from Mortgage Equity Withdrawal (MEW), as home owners tapped the accumulated appreciation in their homes like an ATM machine. As the credit crunch forces more homes into foreclosure, and forces more Home Equity borrowing to pay higher yields, the resulting slow down in discretionary spending is likely to be profound. This morning Fed Chairmen Bernanke gave a speech aimed at encouraging Americans to save more in order to reduce the cavernous size of US Global Trade Imbalances. Of course for years Asset Inflation has replaced real savings in the US, as the Savings Rate has moved into negative territory. Unfortunately, any cut back in spending to rebuild the Savings Rate at home will have profound negative implications for future US economic growth, as estimates suggest that for each one point gain in the Savings Rate, GDP will fall by .65 to .70 basis points. Assuming an advance back to a “normal” savings rate of 7% to 8% would imply a swan dive in economic output consistent with a very deep economic contraction. In the next chart, we update the view of US Consumer Spending by plotting a quarterly Rate of Change on the index for Personal Consumption Expenditures. Going back over the last 30 to 40 years, readings below 1.00 have been absolute indicators of recession and economic contraction. As can be seen over the last two decades, each sequential cycle has been successively weaker, with this most recent cycle arguably by far the weakest of all. That bearish case would be enhanced even more if we were looking at this cycle of hesitant economic growth overlaid against a portrait of unprecedented debt growth, where debt growth has been parabolic, requiring ever higher ratios of debt to generate the same unit of GDP growth.
Above: The Annual Rate of Change on the index of Personal Consumption Expenditures. In the next chart, we align the NAPM Housing Market Index with the index of Personal Consumption Expenditures. The inflection points and directional trends over the years have been striking with the HDI Index now plunging head long across the range of the last 15 years, suggesting that PCE is likely to follow in the months ahead. Historically, the HDI has led the trend in PCE Consumer Spending by about six months.
Above: the NAPM Housing Market Index leads the trend in Consumer Spending… not encouraging based on recent action. So what does this mean for the markets? In our view, and summed up in one word -- disappointment. For US investors, and especially the high pressure, institutional Wall Street crowd, the deep and unabiding concern of the moment is that the “Fed is falling behind.” These folks see the downside action in housing, the severe nature of the credit crunch and are panicked that the Fed may not save the day in time. In this vein, it seems to us that the recovery rally in equity markets over the last few weeks has been predicated entirely on this HOPE. Yet, next week will reveal whether or not that HOPE is well grounded. Our studied view of the situation suggests that we are now closing in on a potentially historic point of inflection as anything less then a 50 basis point rate cut is unlikely to satisfy the hungry Wall Street hedge fund den of thieves. Will the Fed cut rates? In our view they will by .25 basis points. They may even cut the discount rate by an additional 50 basis points, but the celebratory party in response to that type of Fed action will likely be very short lived. Hamstringing the Fed at the present time is the relatively solid trend of recent economic reports, with GDP growth near 4%, stronger than expected, and retail sales generally still holding up fairly well. Of course, these are very likely lagging indicators, with the GDP report benefiting by under-reporting inflation and a one off build up of inventories in area’s like Automobiles, where domestic manufacturers have been building inventory in case of a UAW Strike later this year. In addition, any 50 basis point cut by the Fed at this time who ring out loudly throughout the credit markets the sound of panic, sure to be echoed over and over again in the form of further credit spread widening. With the US Dollar already on the ropes, and undoubtedly frayed nerves running the show at the ECB and the Bank of Japan, where in both cases Export Industry led growth IS the name of the game, a further complete breakdown in the Dollar Index would have far reaching recessionary implications for both Europe and Japan. As a result, the Fed is very likely to maintain its gradualist approach while at the same time trying to play up the most encouraging signs of economic growth. To those who remain in the Fed Aggressive Rate Cut camp, we include some recent comments made by various Federal Reserve Bank presidents. Reading the tone of these reports, it appears we are a long way from aggressive Fed easing. From the Philadelphia Federal Reserve Bank president, Charles Plosser on Saturday: “I believe disruptions in financial markets can be addressed using the tools available to the Fed without necessarily having to make a shift in the overall direction of monetary policy. It is not appropriate for the Fed to ensure against financial volatility per se, or against individuals or firms taking losses or failing.” “I believe it is important to understand and appreciate this underlying stability of the economy in the face of temporary disturbances as we seek to assess monetary policy in the face of developments in housing.” Plosser concluded by stating that “it is not yet certain whether the tight credit and financial turmoil is a “temporary disturbance’ that would throw the economy off track or a ‘shock’ that would require a rate cut.” From the Federal Reserve Bank president Jeffery Lacker: “Interest Rate policy needs to be guided by the outlook for real spending and inflation. Financial turbulence has the potential to change the assessment of the appropriate rate if it induces a sufficient revision in growth or inflation prospects. Financial market volatility, in and of itself, does NOT require a change in the target federal fund rate, in my view.” As a result, our inclination is that this ‘hopeful’ period of relative calm, predicated on the desire for a global reflation and dramatic central bank intervention, will see the hopes dashed in the wake of next Tuesday’s Fed announcement. That is not to say that the initial reaction to a Fed Rate cut will be down even a quarter of a point cut may produce a rally for a day or two. However, looking out beyond the initial response, which is invariably misplaced, the next move of real consequence is likely to be in response to a ‘let down,’ and in that vein, a downside cascade of selling may be unleashed in the wake of next week's announcement. For the Asian markets, and other equity markets that went down LESS than the US in recent weeks, the dawning psychological awareness that the US Consumer Market is headed for a protracted slow down, 29% of global spending, may soon come to the fore. Over the last few weeks, one theory posited for the strength in these markets has been China centric and Asian community centric growth decoupling for the growth rates of the US. Yet this proposition is whole heartedly untested, and from the existing data, ex-export growth shows quite clearly that for the balance of the last decade, it has been the US Consumer that has been the major support prop for economies world wide. As money has sought refuge in many of these foreign markets, they have remained at near record valuation multiples and at hefty levels of over-extended – overbought technical conditions. The breather, the respite, or worse, the correction or bear market, is still overdue, historically overdue. When it comes, the capital using these markets as a safe haven may be flushed out, triggering a large unwinding of hedge positions, not only in the foreign emerging market but also in the closely linked commodity/natural resource theme which has moved in virtual lock step with the Asian Equity markets. In our view, the prospect of a Double Top in the Unweighted Asian Stock Market Composite suggests that a large disappoint could be in the offing as these economies, whose growth has been predicated largely on the US Consumer, come to the revolting conclusion that the US big spender is inextricably out of cash.
Above: Four Unweighted Asian Markets (Singapore, China, Hong Kong and Korea) – Is this a final Double Top Reversal almost at hand? We will be watching MACD on the Asian Equity Markets very carefully in coming weeks, as a downside reversal in that indicator and a failing top could be the key elements to alert traders that the next major leg down in this burgeoning global bear could be getting underway. A final note on the action in Treasury markets today, where Rick Santelli of CNBC stated early on that falling bond yields were discounting a recession, even though the US Dollar has been losing value steadily in recent sessions. A cogent interpretation by a seasoned pro, a falling Dollar should, it would seem, put upward pressure on long term paper as a result of the very likely eventual outcome of Import Price Inflation. In the early going, it was assumed that yields were favoring the bearish economic outlook derived from a projected, and very likely outcome of continued housing market weakness. Yet, by the end of the day, long term 10 year yields ended higher by .04 basis points, suggesting that potentially some type of more important low may ultimately form at these levels. For the Fed, cutting interest rates too rapidly, and abandoning the gradualist approach, would very likely run the risk of casting wide open the US Dollar Pandora’s Box, something the Fed would be wise to avoid, as rising long term yields against the backdrop of a deepening recession would be the fast ticket into a much larger, and even more painful world of hurt, (perhaps Doug Casey’s Greater Depression?). If the Fed wants a lower Dollar, because people vote in election years (next year) and unemployment speaks louder then the value of paper money, it most certainly wants an orderly dollar decline, not a rout, and to that end, it is possible that a less aggressive Fed ‘rate cut’ response next week could trigger a reversal in recent dollar ‘sell side’ flows. The DJIA closed Tuesday at a reading of 13,313.35, up 185.50 or 1.41%, the S&P at 1471.49, up 19.79 or 1.36% with the NASDAQ ending at 2597.28, up 38.17 or 1.49%. The 10 Year Bond Yield ended at 4.36%, UP .04 basis points while nearby Comex Gold gained $8.90 to close at $721.10. That’s all for now, Frank Barbera Copyright © 2007 All rights reserved. CONTACT
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