Wednesday, February 28, 2007


Yesterday's global stock market weakness is a warning bell of worse to come, not some passing "expected correction".
  1. The yield curve inversion (Fed Funds minus 10 year Treasury yield) has now reached 75 basis points, a situation that statistically signaled a recession 80% of the time.
  2. Real estate (an extremely important sector, see Feb. 25 post below) is continuing to weaken. The ABX indexes are still plunging and serious weakness is now apparent all the way to the AA tranches. This is not just market psychology, either. The underlying mortgage-backed securities are all reporting interest shortfalls (the amounts can be found on the same link as PDF documents). Take a look also at the CMBX indexes linked to commercial mortgages - they are plunging now, too: the BB tranche went from a spread of 200 bp to 322, the BBB- from 75bp to 155 bp and the BBB tranche from 50 bp to 112.
  3. The CDX indexes of US credit default swaps just took massive hits yesterday. The high yield (aka junk) category spread jumped by a massive 40 bp to 252 bp and the investment grade by 5 bp to 35bp. I think there is much more weakness ahead for the CDS sector as the virtuous cycle turns vicious.
  4. Both the yen and the swiss franc strengthened considerably against the dollar (yen from 120.50 to 118.20, the franc from 1.24 to 1.22). Their carry trades, the providers of extra cheap global financing for speculative purposes, are in unwinding mode.
  5. Speaking of unwinding, financial leverage has reached every nook and cranny of the planet from Australian mines to Zimbabwean stocks. It took years for this condition to arise and the reversal won't just cause a solitary hiccup.
Most of the money lost in markets is due to "bargain hunting" or "doubling down" after strong exit signals are mis-interpreted as buying-opportunity corrections. Don't try to catch falling knives.

Tuesday, February 27, 2007

The Next Likely Shoe To Drop
..and Some Signals to Use As Early Warnings

The woes of the sub-prime mortgage market are well documented by now, even if their negative effects are not yet completely manifest across the financial world. This being a "forward-looking" blog, we ask ourselves: "Where's the next trouble spot?"

My #1 candidate is Credit Derivatives for high yield corporate bonds, i.e. "junk". As the economy enters a more recessionary environment the ability of highly leveraged companies to service their debt will be seriously impaired. Rating agencies now have "junk" ratings on more companies than ever before, even as default rates are at or near a historic low. Moody's reported that the global speculative bond default rate in 2006 was at the lowest level in 25 years at just 1.57% vs. an average 4.9%. I hasten to point out that, by definition, "average" is a midpoint: such defaults can exceed 10% during bad years (see chart, click to enlarge).

Source: Moody's via ProFund Advisors

One sign of speculative excess in the high-yield market is the record number and dollar amount of LBO's done by private equity and takeover firms, financed with junk bonds and bank loans. Bloomberg reports that nine of the ten largest ever LBO's in the US were done during 2006. The total amount for debt-financed takeovers came to $735 billion, a record.

The combination of ample Asian/petrodollar savings and low interest rate carry financing (e.g. see post from 2/2/07 below, for a brief explanation of the yen carry trade) has created an ample supply of leveraged liquidity, while the explosive growth of credit derivatives is lulling investors and speculators alike into believing that risk is dead. Indeed, popular Credit Default Swap indexes for high yield and investment grade bonds are very near all time highs - see for example Markit's CDX indexes.

The virtuous cycle of: more liquidity = easier financing terms = fewer defaults = less risk = more LBO's is obviously going to come to an end at some point, though some analysts think it will last forever because financial innovation has created a permanent low risk environment (i.e. "It's different this time..." - we've heard this before, with catastrophic consequences).

What can serve as early warnings of a change in the liquidity tide? We could look at "real time" indicators of market trends at the sources:
  1. Pay close attention to the USD/JPY exchange rate. A strengthening of the yen is sure to create losses in the carry trade and liquidity withdrawal. Likewise for the Swiss franc, albeit to a lesser degree.
  2. Follow the Shanghai A Share index for signs of Chinese speculative capital destruction. It has now gone vertical, almost +100% in just the past 6 months. (Note: as luck would have it, closed down 9% today).
  3. Petrodollar capital is more difficult to trace and follow, particularly since the major Middle East producers tend to invest abroad. A good alternative is the Russian stock market index, up 60% since last July. Following the price of crude oil is also a good idea, though it is complicated by many exogenous events and parameters, frequently resulting in counter-balancing effects.
One last remark: In the short term markets mostly depend on expectations instead of fact; sometimes they even create their own bubble-encapsulated reality, best explained as: "They are up because they are going up". This is the Chinese Year of The Golden Pig, one that comes only every 60 years and is supposedly a harbinger of riches and good fortune. Given the storied passion of the Chinese for gambling, I am sure their market discounted the "fact" well in advance and is now issuing pork chop-suey warnings.

Sunday, February 25, 2007

The US Economy by Sector
The Extreme Importance of Real Estate

The US economy has changed very significantly over the years (chart below, click to enlarge). Manufacturing has been off-shored and replaced by professional/business services, finance and education and healthcare. Broadly speaking, today the five top categories equally account for 62% of GDP (1970 figures in parentheses) :

Real Estate: 12.7% (10.5%)
Wholesale and Retail Trade: 12.6% (14.5%)
Government: 12.6% (15.2%)
Manufacturing: 12.1% (22.7%)
Professional and Business Services: 11.7% (5.4%)

and another two equally share another 15%:

Education and Healthcare Services: 7.8% (3.9%)
Finance and Insurance: 7.7% (4.1%)

One immediate observation: the closely related real estate and construction sectors account for a combined 17.6% of value-added in the economy, larger by far than any other. The current bubble-popping in this sector will impact the economy far more heavily than some think (see below about jobs).

The finance sector does not appear to be nearly as important, making up only 7.7% of GDP. In simple terms, don't expect strength in finance to bail out the economy from its real estate weakness.

There is another way to look at the economic importance of each sector: by the percentage of jobs related to each one versus their impact on GDP. The next chart compares the percentage of total jobs in each sector vs. each sector's percentage of GDP.

One extreme discrepancy immediately pops out: the real estate sector creates 12.7% of economic activity, but accounts for only 1.6% of all jobs! There is a very, very important message here: real estate's economic "surplus" subsidizes millions of other jobs, particularly in education, healthcare, entertainment and recreation where much less GDP is produced in relation to employment.

If we chart the ratio of GDP/Jobs for each sector this imbalance becomes starkly obvious. Only mining and utilities comes close, but they contribute relatively little to overall GDP. Real estate is unique, in that it is tops in GDP creation AND accounts for so few jobs directly. (Data from the Bureau of Economic Analysis).

The message here is very clear: the extreme 8-to-1 GDP/jobs ratio means that a downturn in real estate can translate to a sudden spike in unemployment in supposedly unrelated sectors of the economy and a rapid plunge into recession. The bursting bubble in housing bears VERY close watching...

Friday, February 23, 2007

About Liquidity and Risk

All financial and asset markets depend on fresh money coming in to push them higher, i.e. ever increasing "liquidity". This has certainly been the case during the past few years, as the Fed cut rates to avoid a deflationary spiral in 2001-02 and the ECB and BOJ already had very low rates. After the US and the EU started raising rates, the global speculators' fraternity turned to the yen, the Swiss franc and the Chinese won, which kept on providing tanker-fulls of liquidity through a variety of carry trades and/or low inflation. Debt levels soared everywhere (that's what liquidity actually is, more debt).

But there are clear signs that the excess is now coming to an end. Consider:
  1. After the housing bubble burst and the sub-prime loan debacle, US lending practices are finally tightening. Short term rates are already pretty high.
  2. The ECB has been raising rates gradually and shows no sign of stopping any time soon.
  3. The BOE already has high rates and has shown it is not shy about raising them more, even unexpectedly, if need be.
  4. The BOJ has finally started raising rates as well, though most still think it is a reluctant "tightener". In my experience, when central banks start moving rates up (or down) they do not pause until...they stop.
  5. The Swiss National Bank has just announced it will start raising rates, too.
  6. The People's Bank of China has raised banks' reserve requirements to 10%, the fifth time it has done so in eight months.
Are speculators listening? Certainly not.

Stock markets are zooming from New York to Frankfurt to Tokyo and all points in between. Indexes in the US, Brazil, Mexico, China, all over Europe, Turkey...are all making new highs. But this a hyper-global event: markets are going vertical also in Iceland, Mauritius, Kenya, Namibia, Botswana, Ghana - even Zimbabwe, the very model of a failed economy (how very, very sad).

The reason is this: the global financial system is now ruled by hedge and private equity funds, plus an enormous array of structured finance products for retail consumption, instead of the traditional institutional and individual investors. Those funds are by design short-term, risk- loving speculators who are compensated as a percentage of gains but, very crucially, do not share in the losses. Such an arrangement constantly raises the risk exposure and leverage of the funds, as they seek to maintain high returns. This strategy was very profitable when their assets were relatively small, but now that they have taken over entire markets excess returns are mathematically impossible to achieve, despite ever more risk and leverage. The speculators are essentially trapped in their own momentum-play strategy, a merry-go-round that spins faster and faster as the riders grip the poles tighter and tighter, fearing lower returns if they let go.

The results have been:
  1. A massive collapse of risk premiums. This sounds benign, until you see it from the other direction: the assumption of more and more risk.
  2. A similar collapse in volatility. Some see it as apathy, but they are wrong: instead, everyone is looking over his shoulder, anxious to jump off the spinning Nickelodeon, but not wanting to be first off the gilded horsey (or Golden Piggy, given the Chinese New Year).
So what can happen to the Merry-Go-Rounders?

If you expect the riders to get off on their own you are new at this. Such situations always end thus: the operator finally slams on the brakes to protect his precious machine and the riders are thrown off violently, careening and crashing onto the hard pavement, some expiring on the spot, others breaking every bone they own.

I do have one more observation, related to my previous post (The Paulsen Put). If riders believe the operator is not going to stop the ride soon, or that he will do it nice and slow, then they believe in the Paulsen Put.

If, and this is the absolute worst scenario, the operator himself thinks "what the heck, let them have fun forever, they pay me by the turn" then we might as well be prepared to order a new carousel because the old one will soon be thimble-sticks.

Tuesday, February 20, 2007

The Paulsen Put

Can the US Secretary of Treasury prevent markets from fluctuating? And why are speculators acting as if Mr. Paulsen has single-handedly provided every one of them a free at-the-money put, backed by the full faith and credit of the US? (Or if not the US, then at least Goldman Sachs?).

Someone once asked Bernard M. Baruch what the market would do and he famously answered: "It will fluctuate". I never thought I would see the day when that is considered a wrong answer.

Friday, February 16, 2007

Housing Bust Continues

The chart below shows housing construction starts in the US since 1960. The latest data for January 2007 were reported yesterday, down 14.3% to 1.408 million units started on an annualized basis. There had previously been some talk of construction stabilizing as better weather in November and December slightly boosted seasonally adjusted numbers. But the bust is now back on.Previous boom-bust cycles lasted about 6-8 years as measured trough to trough, meaning the average construction boom lasted about 3-4 years. However, the latest boom started back in 1991 and lasted 15 years. Notice also that during the bust leg starts bottomed out consistently at around 800.000 units/year and that we are still far above that level.

Given the length of the boom that just ended, many more houses were built this time, overshooting the "natural" housing demand that comes from new household formation. In the end, the market was driven by speculators who bought overpriced houses expecting to flip them for a quick profit (to whom?) - a bubble. Notice how the number of new houses sold jumped abruptly in 2002-05 (chart below).
But many of those houses are now sitting empty and are just adding to inventory. A record 2.7% of houses in the US are now vacant and for sale only - that's 2.1 million houses (chart below).
Keep in mind that inventory will keep rising for a while longer because builders still have a near record number of houses being completed from projects that started 12-24 months ago (chart below). The very latest number released yesterday showed a seasonally adjusted 1.88 million completions in January on an annualized basis - still very high.
Seen together, the relatively small drop in average house prices so far (chart below) and the record number of empty houses for sale mean that owners are still "sitting" on their properties hoping for a turn. Well, hope dies last, because... is apparent from all of the above that the trough of the housing cycle is still ahead of us. Given the previous excess, this time the bust will be deeper and longer, lasting until the excess inventory of unsold houses is worked off. This can happen in two ways: (a) builders will severely curtail new construction, far below the 800.000 unit/year "normal" trough and (b) house prices will drop significantly to attract new buyers. Either way, the economy will be severely affected:

If condition (a) predominates, unemployment will rise sharply because housing creates jobs in many fields besides construction (materials, shipping, retail, housing services). If (b), then the financial/banking side of the economy will be hit hardest with mortgage delinquencies and defaults rising sharply as lower prices causes home equity to evaporate and even turn negative.

So far we have seen both (a) and (b) happening in relatively modest ways: builders have reduced housing starts but are still running far above trough levels and finance has been hit hard only in the sub-prime category which accounts for ~14% of all existing mortgages. The ABX group of indexes just made new lows yesterday, signifying that the cost of such risky mortgage loans is now completely prohibitive. Interestingly, it is not only the BBB/BBB- tranches that are getting hammered: the weakness has spread into the A rated tranches as well, pointing to higher lending costs beyond the sub-prime area.

Tighter lending conditions obviously removes marginal demand from the housing market at a time when supply is high and expanding. It won't be long before average prices also reflect this new housing market reality, if only for a very simple reason: all those vacant homes for sale incur mortgage payments, taxes, insurance, etc. while their owners have to live somewhere else, incurring another set of expenses. They can't re-finance either, because lending conditions are tighter and prices are not rising to create excess equity. At some point the weakest owners will be forced to throw in the towel and either default or sell at a distressed price, bringing down overall house values. Renting out this excess inventory is not really an attractive option, since rents are currently far below carry costs (chart below). In any case, a move towards renting and away from ownership removes even more marginal buying demand.

Bottom line: we are still quite far from seeing the trough and things will get much more challenging for all involved, including Goldilocks. I believe her la-di-da attitude towards credit risk is dangerously short-sighted.

Thursday, February 15, 2007

Margin Debt

Margin debt tracked by the NYSE has now risen back to its all time high reached in March 2000 (see chart below, 12/06 latest). Back then all popular equity indexes were making new highs, more or less concurrently: Dow Jones, S&P 500, Nasdaq - it was a broad-based bubble. Given that NASDAQ is presently nowhere near its all-time high, margin debt is today more concentrated and probably used for speculative purchases of today’s darlings: the financial stocks that right now make up 23% of S&P 500 capitalization.

A simple comparison: in March 2000 S&P 500 was at 1550 and in December 2006 at 1420, or 8.5% lower, yet margin debt was the same. This means that
as a percentage of capitalization leverage is now more extreme than even during the 2000 top.

Notice also how margin balance growth has gone vertical, just like it did in 2000.

Who Owns Ya Baby?

Firstly, I remind all of you that Reader Contest #1 is ongoing (see previous post). My personal answer nolo contendere, of course (I cannot win my own contest, now can I?) is that Prof. Irving Fisher's ghost is back. But please feel free to submit your own irreverent entries. Goldilock's gruel tastes awful cold, so grab it while it is still "just right".

Today's post will be another chart - foreign ownership of US marketable Treasury securities, i.e. the percentage of government debt (ex Social Security) that is being financed by foreigners. The Federal Reserve/US Treasury data show that as of 3Q2006 almost 50% of such debt is held by foreign entities (mostly central banks, i.e. foreign governments), double the percentage from just 10 years ago. A lamentable (and dangerous) condition for the government of The World's Sole Superpower.

Foreign ownership is not limited to just government debt, however: according to the US Treasury (PDF file) as of June 2005 (2006 data will be released March 30 2007) foreigners also owned almost 20% of all US corporate debt, 14% of agency debt and 10% of equities, also up significantly in the past 10 years (7.8%, 5.4% and 5.1% respectively).

Wednesday, February 14, 2007

Reader Contest #1

Who's Tetyevsky and why did he just proclaim:

There's ``an ideal economy, no defaults, fewer downgrades and plenty of liquidity with a broadening investor base,'' Tetyevsky said.

Hint: He's talking his own book.

Correct answers win signed photos of Goldilocks.
Most creative answer gets to have dinner with Goldilocks - only warm porridge served, sorry.
Retail Structured "Investing"

Regular readers of this blog are familiar with my views on the role played by hedge and private equity funds in collapsing volatility and risk premiums. But it is unfair to point the finger just at them and ignore retail investors who are just as guilty of "selling" volatility and risk, though they may not realize it.

I am referring to the myriad of structured deposit products out there that promise returns based on the performance of commodities, stocks, indexes or currencies, capped on both sides (i.e. maximum return of x%, minimum 0%). The sales pitch is easy and straightforward: you can make as much as, say, 10% if S&P 500 goes over 1600 and your principal is guaranteed. There are also "double-no-touch" products: e.g. you will make 10% if USD/EUR does not go below 1.27 OR over 1.33 within 3 months (please note that all numbers are purely hypothetical). The list of structured products is endless: I have seen offerings on agricultural and energy commodities, equity indexes, currencies, even real estate. Of course it all boils down to this: retail investors are selling volatility and/or buying risk at one level and the arranger of the product turns around and immediately covers it at the wholesale market, pocketing the difference. The whole process naturally drives down overall risk premiums and volatilities.

If you ask any retail investor who bought such a product, he will proudly tell you he is investing in soybeans, stocks or whatever and that he cannot lose, besides. Nothing could be further from the truth, of course, as what he is in fact doing is selling puts, calls or both, backed by exactly that "can't lose" provision: getting no interest on his money for as long as the structured product is slated to run is not exactly "no loss". Recommend to that self-same investor to provide you $500.000 interest-free for 3 years and at the same time to buy a 3 year call on soybean futures and see what he says...likely it will go like this: "What kind of fool do you think I am to give you my money for free? And am I crazy to speculate in commodity options, eh? No sir, I am a conservative, risk averse investor - now get out of my office before I have you thrown out".

One useful observation from all this: the selling of risk premiums and volatility has now arrived and expanded widely into the retail market. When anything reaches retail, however, it is - by definition - fully priced. Watch out above because.. who is now left to sell?

Tuesday, February 13, 2007

Just A Chart

This is a short entry: just a picture of the financial leverage of US households. The chart below shows the historical ratio of household debt to total household financial assets (bank deposits, securities, mutual funds, etc). The ratio can be interpreted as the overall "margin" of American households and it is now at an all time high, having jumped sharply in the past 6 years. Data from the Federal Reserve, current through 3Q2006.

Monday, February 12, 2007

Living The Borrowed LifeTM

I had a great idea last night. It was Sunday and the prospect of another Monday at work, digging up beetroots and cabbages, focused my mind to less toilsome means of enrichment. (OK, so I’m not really a farmer – but I toil just as hard. Well, almost).

I figured I could easily convince my banker to extend a loan on the value of my house. Did I say “convince”? Heck, those guys nowadays are throwing money at anyone who can hold a pen or fog a mirror and I can do both, plus walk and chew gum. Therefore, I am an excellent credit risk. The bank manager is an agreeable fellow who makes bonuses based on volume, so he’s not too particular about appraisals and such. We agreed that my 15-year old 98 m2 apartment out in the booniest of boonies, the one I got from my great-aunt Edna when she passed away last summer as she was picking cucumbers, is worth…325.000 euro. We picked a nice round number (it could even be true, honest!). I’ll borrow just 300.000 euro against that – let’s not be greedy, eh?

As luck would have it, this bank is belatedly trying to break into the mortgage business and is offering dirt cheap rates, slightly below O/N LIBOR, fixed for 2 years (what are they gonna do, make it up on volume?). After that, it’s going to LIBOR +125 bp, but hey, two years? That’s like, science fiction time horizon. Space Odyssey vee-eye-eye stuff. But I’m not finished yet – you see, I don't want to pick another root vegetable for as long as I live.

Here’s what I’m gonna do, instead: I will deposit the cash with another bank (I seem to have lots of friends in banking these days) one that will let me write some credit default swaps on Ecuador bonds on 10:1 leverage. Happy days: annual income comes in at 1000 bp on 3.000.000 worth of bonds. That’s 300.000 euro per year, if you’re not too friendly with finance.

But am I a spendthrift fool? Oh no! Instead of wasting my money on fast cars and slow women, I’ll make do with just the slow women and re-invest the rest. So, year two I’ll have 450.000 to invest and my income will likewise jump to 450.000. On year three I will be up to 750.000 and on year four I’ll gross 1.350.000 (ain’t exponential finance grand?).

On the fifth year I will be collecting 2.550.000 euros and that’s when I will draw the line. I am a man of modest needs and high risk aversion – it’s not as if I will be plunging into junior securities like OTC stocks. Strict association with senior securities like bonds and mortgages for me, thank you very much. What did you take me for, a speculator?

All right, all right…so I did stretch reality a bit above. My great aunt’s name was not Edna.

But as for the rest, just call your friendly bank's dealing room and casually mention synthetic CDO's, CDS, CPDS...and soon your rutabaga will be served on a plate alongside crevettes flambees avec anise et poires.

Because you too should be Living The Borrowed LifeTM

Warning: Hey kids, don't try this at home. You will end up burning down the whole town.

Rent An Office - Get A Bridge For Free

Let's say you are NOT an investment bank, hedge fund or private equity fund. You're not even a run-of-the-mill asset management firm, but a sole professional like a doctor, accountant or lawyer. You need some office space to house your business, around 1 500 sq. ft. (~140 sq. meters) - not a whole lot, but then again you are just now beginning to move up from the junior leagues. According to Bloomberg , this is how much you will need to pay in annual rent, on average:

Midtown Manhattan: $93 000
London West End: $318 000
Central Tokyo: $217 000
Hong Kong: $174 000

That's just rent, mind you. It does not include extras like a secretary, cleaning services and utilities. Add it all up and you're talking half a million dollars for London - per year. Certainly a dollar doesn't buy you much in London these days (and neither does one pound) but five hundred thousand of them should buy you more than a small office and someone to answer the phones for a year. And how about Tokyo, for chrissakes? I thought they were having deflation for the last century and a half and that the yen was in the dumpster. I must have been misinformed. I will make allowances for Hong Kong because it is a crowded place - though I fail to see the allure of renting space in a sardine can.

Ah, but look at Manhattan: a BARGAIN. Of course Midtown includes places like 40 St. at 9th Avenue where you need an up-armored Humvee after 8 pm, but still... for a measly $150 000 per year you too can have "NY NY 10001" printed on your business card, right above that prestigious (212) area code for your telephone. Oh, and did I mention that the federal government is planning to install radiation detectors at all city entrance points? So if a crazy is planning to detonate a dirty bomb in the vivinity, chances are the cloud will not reach your office - depending on prevailing winds, of course.

Tell you what, though... because you are such a nice person, if you sign a five year lease RIGHT NOW, I will also throw in this nice bridge you can see from the window. I know, I know ... it only goes to Jersey (ugh), but milk has to come from somewhere, right? And trust me, you don't want to move to London - you only get a drafty stone Tower as a bonus if you sign a lease there...

Saturday, February 10, 2007

Sub-Prime Canaries

Sub-prime loans account for 14% of all US home mortgages, or some $1.4 trillion. Around 11% of those are already in trouble and some analysts expect that percentage to double, resulting in $280 billion in losses for lenders. This is not such a huge number within the context of a ~$14 trillion US economy, though it will mean substantial earnings cuts for those associated with the mortgage business. The news is out and the haircuts have begun with a vengeance (just look at the ABX indexes).

That's the rosy picture. Now the gray one.

Sub-prime lending is likely just the canary in the coal mine: the weakest go first. Tighter lending conditions will also affect other borrowers (once burned..) and the continuing drop in house prices will make it very difficult to refinance, even if interest rates decline, because remaining equity will be lower or even negative. The Fed would have to take interest rates down to almost zero to spark significant activity - a very unlikely prospect right now.

In addition, housing is a prime economic driver. Though it only accounts for 6% of GDP directly, studies have shown that the overall effect is around 25% (furniture, appliances, services, finance..). In a US economy emasculated of domestic manufacturing, a weakness in the housing market will have knock on effects for quite a while.

From the financial perspective, the creation of trillions in credit derivatives has firmly connected equities to credit risk and a self-reinforcing feedback loop is in operation. Weakness in credit conditions and perceptions will quickly find its way in the stock market, which will feed back negative signals to the credit markets. What was until now a virtuous cycle of continuously shrinking risk and volatility premiums can quickly turn into a negative one. This type of financial system sickness may be as unresponsive to lower interest rates as it was apathetic to higher ones. The reason is simple: it is the return of principal that is at stake here, not the cost of lending it.

Now, add to this unpleasant punch the "mickey": leverage. The hedge fund industry alone has $1.3 trillion in capital and it is not shy when it comes to borrowing against it to put on all manner of speculative positions. The private equity business has also expanded rapidly in recent years, also funding LBO's and takeovers with borrowed money.

It is plain to see that the canary has expired. The coal miners that run for the surface first will survive, but those that think the canary is just another silly bird that died of a tummy ache from eating too much seed...

Thursday, February 8, 2007

Oil Prices and Interest Rates

Energy is included in every product and service and thus its price greatly influences inflation, which in turn affects interest rates. We logically expect interest rates to rise and fall significantly with the movement of oil prices and that is precisely what happened - at least until 1998.

The chart below shows the price of oil and the yield of the 10 year US Treasury bond (annual averages). There is a clear correlation in their movement until 1998 but a sharp divergence afterwards. Mathematical correlation is a very high 0.77 (max. = 1.00) between 1970 and 1998, but thereafter it goes to -0.37, i.e. interest rates kept going down even as oil prices soared. Yet another interest rate conundrum?

Not really: the Chinese export juggernaut has kept US consumer inflation low, as the ready availability of ultra-cheap labor and the yuan/dollar currency peg are keeping a lid on final prices (at the expense of the domestic US manufacturing sector, of course).

How long can this go on? Until China creates a substantial consumer-oriented middle class of its own, one that demands a better standard of living, i.e. higher real wages and better social benefits like vacation with pay, medical care and state pensions. This will not only raise labor costs and export prices, but it will further increase China's oil demand - at which point it will be off to the races for US consumer inflation.

Unless, of course, final consumer demand in the US collapses first from a debt implosion. Either way it will not be pretty - Goldilocks is a fairy tale, after all.

Wednesday, February 7, 2007

How To Become "Rich"

Method 1
Start with someone else's money, known as OPM (Other People's Money). Sell lots and lots of naked credit derivatives and volatility calls on margin, backed by said OPM as collateral. Book the proceeds as profits, take out your 25% cut quarterly. Repeat until:

a) Your "rich" goal is reached or,
b) Success goes to your head and you think you are as smart as Warren Buffett - so why not be just as rich? or,
c) It all collapses. You do not care because all those previous 25% cuts have added up to a nifty sum. The losses on OPM are OPP (Other People's Problem).

Method 2

You are the CEO of a medium-to-large listed company "A" whose stock is widely distributed. Find suitable takeover target, preferably a tightly controlled unlisted company "B" and have a friendly chat with its owner (a listed company will do even better, if it is tightly controlled). Get "A" to borrow or sell shares for a few $ billion in OPM. Make inflated cash tender offer for "B" and take a kickback from "B"s owner, in cash. DO NOT repeat too often. In fact, better to gracefully retire soon thereafter.

Method 2a (Variation on a theme)

You are the principal in a private equity fund "A", well provided with equity OPM and borrowed OPM. Repeat same steps as "Method 2", only DO NOT retire. As soon as market conditions allow after the conclusion of the deal with "B", find another suitable large public company "C" and have a friendly chat with its CEO. Arrange to sell "B" to "C" at an inflated cash price by applying the proper cash incentive to "C"'s boss. Book profit and take your 25% share. Repeat as often as possible until the (a), (b) or (c) conditions above are met.

Method 3 (Time-tested and bullet proof)

Start with lots and lots of money of your own, enough to qualify you as "super-rich". Meet anyone of the characters above and agree to provide OPM. Stay put while they present mark-to-market evidence that you are now "filthy rich" and do not attempt to exit. It won't be long before it all goes up in smoke and you are relegated to the ranks of the merely "rich". If you are truly dumb enough to believe that wealth is repeatedly created from thin air and attempt to double up as the smoke starts rising, you will be further downgraded from "rich" to "destitute".

Tuesday, February 6, 2007

The Hybrid Market

The astronomical rise of credit derivatives from less than $1 trillion in 2001 to likely $35 trillion at the end of 2006 has undoubtedly been the hot topic in finance. Credit Default Swaps are responsible for bringing down the cost of borrowing to record lows - investment grade companies now pay around 30 basis points - just 0.30% - over what the US Treasury pays to borrow. Lower rated, or "junk", bonds are issued around 235 basis points over Treasurys.

So here is a question:

Does it pay to invest in cash bonds anymore? If a bond buyer is paid so little to provide his capital to a borrower, why bother? Why not just buy a Treasury bond?

For one, that will result in even lower returns and for another there just aren't enough Treasurys issued, even if one wanted to do that (I never thought I would ever say that the US government doesn't have enough debt!).

So what are bond investors to do? In this brave new world of derivative finance what they do is buy stocks, often coupled with CDS's. The rationale is that current stock prices, just like bonds before them, do not adequately reflect the low risks associated with owning them - i.e. "low" stock prices are a reflection of high risk premiums. Buy buying stocks plus cheap credit protection via the proper CDS's they aim to get the upside potential of stocks and the downside protection of bonds.

This strategy results in a circuitous logic: "bond" investors rely on the stockmarket for signals of financial risk and "stock" investors follow bonds (or rather CDS's) for the same thing. Instead of a traditional countercyclical relationship between stock and bond markets, we now have a self-reinforcing, feedback loop hybrid market for which perceptions can only be always positive - or always negative once it turns.

Monday, February 5, 2007

Volatility Compression and Convergence

The chart below (from the ECB's monthly bulletin) compares volatility for euro area, US and Japanese stocks. It's a converging world out there - as far as everyone's risk perceptions are concerned. Evidence of complacency becoming a global virus.

Of Honey Bears and Worker Bees

Take your standard grizzly bear. She loves honey and in spring and summer she makes trouble for the poor worker bees that try to mind their own honey-business. But, as in all things natural, the bear's sweet tooth serves the purpose of keeping the bee population down. Come winter, the bear goes into hibernation and the bees are left alone for a while. The bear-bee life goes on, as always, in cycles. Up, down - up, down.

Isn't dynamic stability boring, though? During the winter the bees decided they needed a better honey regime. They plan to share as little of their honey as possible with that pesky bear.

The bees came up with a new bear-raid remediation plan: they split up their beehives into smaller units and stuck them here and there, instead of having just a few large ones. Clever little bees...little hives everywhere. Spread the risk around, eh? And because the bear has been extending her hibernation recently (did the bees slip her a mickey?) there are lots and lots of hives around.

The bear finally wakes up (she always does) and she's REALLY hungry from her over-extended hibernation. She looks around and her eyes light up! There's a hive just outside her den - she quickly gobbles up the honey but it was too little - the hive was too small. But she is a happy bear, nevertheless, because no more than ten bear-paw paces away there is another hive and then another and yet another. Before you know it the bear is feasting on one hive after another and the bees are helpless because they are just too few of them in each hive to make trouble for the bear. Then, another sort of bee-trouble arises: as the bearish news fly from one hive to another bee-panic sets in and it's every bee for herself. Not really much choice: sit tight and get eaten or fly to safety - but fly to where? Every hive is too small to accommodate excess bee-refugees and there is no beehive big enough to organize a counter-attack.

Result: one happy fat bear, millions of homeless bees. And the price of honey goes up, way up.

Friday, February 2, 2007

How Big Is The Yen Carry Trade?

Attention has recently been focused once again on the yen carry trade and its effects on global liquidity and asset inflation. The EU is concerned and wants to step on the brakes, while the US does not. One can only surmise that US investment banks and funds are making a bundle from it.

First a definition: the yen carry trade consists of borrowing yen at near zero interest rates (the Bank of Japan equivalent of the Fed funds rate is at 0.25%) and immediately selling the yen for another currency to invest at higher rates. The low-cost yen loan is "carrying" the high yield investment.

For example, one such trade would be to borrow yen at 0.25%, sell them for dollars in the spot FX market and deposit the dollars at a bank for 5.25%. If the dollar/yen exchange rate does not change at all there will be a net gain of 5.00% in one year - this is called "the carry". In practice, the gains could be much greater because such trades are frequently done on margin and could result in 5 or even 10 times leverage - the gains would be 25% or 50%. Naturally, the high leverage would also mean very high losses if the trade goes against the speculator.

There are three risks: (a) that yen rates go higher, increasing the borrowing cost, (b) that dollar rates go down, decreasing the return and (c) that the yen exchange rate strengthens against the dollar requiring more dollars to repay the yen loan. Nothing prevents any two of the above, or even all three, from occurring at the same time. That would be very damaging to the speculator, of course.

But how much money is out there pursuing such yen carry trades? No one knows for sure, but I think it is somewhere between $1 to $2 trillion and I will explain why.

The easiest, one-step process to put on a carry trade is to do a foreign exchange forward swap. It consists of selling yen for dollars at today's spot exchange rate and agreeing to buy them back on a pre-determined forward date and at a pre-determined exchange rate. I will spare you the math and tell you right away that the difference in the two exchange rates (forward minus spot) translates to the difference between the two interest rates. Such trades are extremely common between banks and other financial institutions and can be put on for anything from one day to one year.

Once again we turn to our trusty Bank of International Sttlements (BIS) for data. As of the end of June 2006 there were the equivalent of $3.8 trillion in such yen forward swaps vs. $2.3 trillion just five years earlier. For a country with near zero economic growth and zero interest rates for a decade, a 65% jump in FX swaps can only point to very widespread speculation.

Source: BIS

Thursday, February 1, 2007

Is It Goldilocks or Pollyana on Dope?

The current view is that we are in a Goldilocks economy: not too hot - not too cold and very benign for all sorts of portfolio investments from junk bonds to technology shares. Yesterday's US GDP report, though preliminary and subject to revision, came to amplify exactly this assessment: real growth accelerated to a 3.5% annualized rate from 2% in the previous quarter and CPI inflation remained low (2.1%). The PCE deflator, a measure of inflation that tracks personal consumption, came in at -0.8%, the first negative reading since 1961 mostly due to the sudden plunge in oil prices. Markets cheered loudly - for the most part. The one notable exception was found in mortgage bonds backed by sub-prime home equity loans which continue to take a beating: the BBB and BBB- rated ABX indexes dropped heavily to fresh all-time lows. Even the presumably solid A and AA tranches are now weakening, though not as much.

This may point to a rather important obstacle in the Goldilocks scenario going forward: If you look at the GDP report carefully you will see that 3.05% out of the reported 3.50% growth (i.e. 87%) came from increased personal consumption which, once again, rose faster than incomes resulting in negative savings and more borrowing. This marks the 7th consecutive quarter of Americans dipping into savings to sustain spending (see chart below).

It is clear that the economy is being propped up by unsustainable consumer behavior: i.e. spending more than income and continuously inflating debt. You may recall from previous postings (see Dec. 18, 2006) that the US economy is now "hooked" on debt: it takes the addition of 4.1 dollars of more debt to generate just one extra dollar of GDP. It resembles the hard-core junkie who needs ever increasing doses of smack to produce a satisfactory high. Add the already record high debt load (327% of GDP) plus the negative savings rate and it looks like the junkie is doping up even with a bad case of pneumonia and heart disease. Pretty soon the next dose will be fatal.

This does not look like a Goldilocks economy to me. A better analogy is that Pollyana is looking at things through her rose colored dope induced haze. Think of the ABX index as a drug councelor warning her she has to lay off the hard stuff and check into a clinic.