Archive - Aug 2010

The chart below shows the UST yield curve over the past 20 years: as is more than obvious, every single point left of the 10 Year is at record tights. The only question on everyone's lips is where do we go from here. And that is where the confusion really hits. The confusion is further intensified by the sudden collapse in the 2s10s and the 2s10s30s butterfly. The odd thing here is that a flattening move as violent as recently seen in these two curves, has historically preceded a rise in the Federal Funds rate as can be seen in the chart to the right, before the Fed began tightening in 1999 and in 2004. In other words a flattening has traditionally been a leading indicator to an economic improvement (as liquidity extraction tends to go side by side with a pick up in inflation and thus economic growth). Alas, this time around, a tight monetary policy is the last thing on the Fed's mind, and the economy is only starting to demonstrate it is rolling over into a second and more violent recessionary round. In essence, the Fed's interventionist intention of purchasing the entire curve (including the long-end), as recently announced by the FRBNY, has completely dislocated all leading signaling by the curve itself. As a result, speculation is now rampant as to what may or may not happen. A case in point are the divergent opinions of Bank of America and Morgan Stanley. While the former Merrill Lynch is advocating an outright 10s30s flattener, Morgan Stanley is sticking to its guns and continues to push for a steeper curve: this in spite of the collapse in the 2s10s from a records steepeness of almost 290 bps in May, to under 220 bps as of Friday's close: the over 25% collapse is enough to blow up most of the funds who had positioned themselves for further steepness. At least Morgan Stanley is consistent. Yet both banks urge clients to hedge their trades and provide creative ways to do so, as both realize the likelihood of being wrong, now that the Fed is openly the biggest market participant, is probably higher than the inverse.

The FDA and NOAA say that Gulf seafood is fine. President Obama ate a fish taco yesterday made with Gulf fish.

So does that mean Gulf seafood is safe to eat?

A few days ago, IRA's Chris Whalen had a good summary of why and how the next bubble is currently brewing in the Structured Notes space. For those unfamiliar with this particular product, we present a recent Bloomberg brief on the Structured Note market which has quietly grown from a side freakshow into the prime time spectacle. In brief - there has been $25.85 billion in YTD structured note issuance, and over $60 billion in global interest-linked note volumes. An amusing excerpt from the brief: "Sales of notes linked to wheat jumped this month after Russia’s worst drought in 50 years spurred a surge in the price of futures contracts on the grain. Banks including DZ Bank AG and Royal Bank of Scotland Group Plc, issued 82 wheat-linked warrants this month, compared with a total of 159 in the first seven months of the year, according to data compiled by Scoach, the structured products trading platform run by Deutsche Boerse AG and Switzerland’s SWX Group. The listed notes, called knock-out warrants, offer investors a leveraged way to bet on the price of wheat." For all those who thought Wall Street was dormant in the post-CDO implosion vacuum, this is a rough wake up call - it appears no matter what, idiots and their money are promptly parted, and the world's foremost financial innovators will always find a way (and a product) to guarantee that. And it is very refreshing to see that Germany's DZ Bank has almost learned from the CDO bubble: the questionably solvent German bank dominates the Structured Note market with $7.2 billion in issuance to date, followed closely by such stalwarts of financial stability as Barclays and Deutsche Bank.

The American public thinks they are rugged individualists, who come
to conclusions based upon sound reason and a rational thought process.
The truth is that the vast majority of Americans act like a herd of
cattle or a horde of lemmings. Throughout history there have been many
instances of mass delusion. They include the South Sea Company bubble,
Mississippi Company bubble, Dutch Tulip bubble, and Salem witch trials.
It appears that mass delusion has replaced baseball as the
national past-time in America. In the space of the last 15 years the
American public have fallen for the three whopper delusions:

1. Buy stocks for the long run
2. Homes are always a great investment
3. Globalization will benefit all Americans

The week's notable moves in swaps, swaptions, yields, asset swaps and mortgages. Pay particular attention to the fireworks in the 6.0 swap, the 4.5/5.0 swap, and the 4.5 butterfly. Thank you Fed.

A fundamental knowledge of Theta is imperative in order to understand the mechanics and construction of option strategies. In many cases, Theta is either the profit engine or the means by which experienced option traders reduce the cost of opening a new position. Theta can even take an ETF that pays no dividend and create a monthly income stream utilizing a technique known as a covered call write. The most exciting thing about options is their versatility. You can trade them in so many different ways. A trader can define a positions’ risk with unbelievable precision. When traded properly utilizing hard stops, options offer traders opportunities that stocks and futures simply cannot provide. Theta allows option traders to write spreads which generally offer nice returns with very limited risk.

Now that QE Lite, or whatever one calls it, is here, the most appropriate market strategy reverts back to March of 2009, when life was very simple: "Buy what the Fed is buying." And with the benefit of QE1 in hindsight, namely the Fed's prior purchase of $700 billion in Treasurys in 2009, it is possible to determine precisely which bonds the Fed will focus on, and which are likely to be excluded, thus benefiting the least from the latest bout of monetization. Morgan Stanley has come up with a list of which bonds are likely to be targeted by the Fed in the upcoming 5 Open Market Operations beginning on August 17 and continuing through September 1. Those looking for a quick (and levered) return on investment will be wise to pick up the issues determined as most likely to be monetized, while potentially shorting those that are ineligible for buybacks.

Norway's fund dropped $25 billion in the second quarter, pummeled by the European debt crisis and BP's downturn after the Gulf of Mexico spill.

Forward treasury rates, which are very close Fed Fund rate expectations, can be extracted from the treasury curve. If the treasury market is smart money, it's worth listening.

HP stock has taken a bath since Mark Hurd's resignation. The question that arises is whether HP is oversold in the short-term, and due for a bounce in line with the fundamentals of being one of the largest technology companies in the world in terms of revenues.

Until I began to examine the Dodd-Frank financial overhaul bill I had no idea that it would so significantly change the direction of the United States. It's scope is so vast and pervasive that it is difficult to grasp its totality. I wrote this article to try to explain this and why I believe it is so important for us to understand it. Because of its complexity it was not possible to do this briefly, so I wrote this major "white paper" and divided it into four parts to make it easier to digest. Please stick with me for the next few days; your eyes will be opened. This is Part 3 of 4.

This story reminds me of the good old days. Deals get done for funny reasons.

Some days ago, Business Week pointed out that "Warren Buffett shortened the duration of bonds held by his Berkshire Hathaway Inc. after warning that deficit spending could force inflation higher." As the article further pointed out, twenty-one percent of holdings including Treasuries, municipal debt,
foreign-government securities and corporate bonds were due in one year
or less as of June 30, Omaha, Nebraska-based Berkshire said in a filing
Aug. 6. That compares with 18 percent on March 31, and 16 percent at the
end of last year’s second quarter. The conclusion: "It may be a sign that Buffett expects interest rates to start rising, maybe sooner than the conventional wisdom." Yet very curiously, as we pointed out, another capital markets titan, Bill Gross with his trillion+ in fixed income securities courtesy of Pimco's numerous asset managers, has done precisely the opposite. As the chart below demonstrates, Gross' flagship Total Return Fund has been doing the inverse of Buffett, and has been actively increasing the duration of his bonds over the past two years, with the current blended maturity profile being the most long-end weighted in years: in fact the percentage of bonds maturing in 3 years or less is now the lowest it has been since October 2008. Using the above logic, it would signify that, unlike Buffett, Gross is now more primed for deflation than ever. In the great inflation-deflation debate, this will be the primetime heavyweight cagematch to watch. Between Buffett's empire and Pimco's FI monopoly, one of the two will have to lose. Our question of the weekend is who will it be?

After a brief hiatus, Jim O'Neill is back, and this time is taking it easy on taunting the bears. In his weekly letter he has some rather lucid questions, the first one of them being the observation of the paradox of the surging Chinese trade deficit in light of the weakening renminbi. O'Neill states: "the GS trade weighted CNY has actually weakened by around 1.75pct since
they “ de-pegged”, by “undershooting” the rise of the Euro, Yen et al." Don't anyone tell Schumer that China's whole revaluation bluff was nothing but (and in fact a smokescreen for further devaluation) or there will be more theatrical demands for blood. O'Neill also looks at recent Chinese regulatory developments and notes that the push "to bring any off balance sheet vehicles for disguised lending, back on
the balance sheet, and to be prepared to raise fresh capital" is sensible but hopes that "if this is going to be implemented, if necessary, offsetting stimulatory measures would be introduced." Sure enough, China also has to pay for the Keynesian funeral for a long, long time. Not surprisingly, O'Neill looks at the one-time record pick up in the German economy courtesy of a massive EUR devaluation and extrapolates far into the millennia: "there seems to be a belief that Germany is on the verge of a jobs “ miracle” , and there is more and more talk of a period of stronger domestic demand." Sorry no. It is nothing like that and is purely a function of the ever more volatile seesawing in key FX crosses, on a trendline to global deleveraging contraction. Germany merely borrowed from the future courtesy of a plunge in EURUSD. It is already paying for this now and this quarter's data will be a major disappointment.

In a surprising act of lucidity, David Kostin recently reduced his 2010 S&P target from 1,250 to 1,200. Now, the Goldman strategist has penned his own version of David Rosenberg's SIRP (Safety and Income at A Reasonable Price), by introducing two strategies for a low GDP environment: Low Operating Leverage And Dividend Growth (LOL-DG - yes, we prefer Rosenberg's acronym).Hopefully, this means that the GARP abortion is finally dead and buried.