Gleacher Market Commentary

From Russ Certo, head of rates at Gleacher.

Maybe it’s all the rain lately but my funny bone is tingling.  This week the FOMC conducts a two day meeting whereby Fed officials will clarify intentions regarding the perceived closure (or not) of QE2 and the policy body will also address growing concerns (or not) about inflation.  To mark a new era in Fed communications, Chairman Bernanke will hold a press conference at the conclusion of the FOMC on Wednesday.  This conference has all the makings of its predecessor, historically volatile semi-annual Humphrey Hawkins testimonies on monetary policy in front of Congress.  It’s a good thing since in the past month alone sixteen different Fed policymakers (did you know there were that many?) have given more than forty formal addresses, in addition to television, newspaper and newswire interviews.  And Congress isn’t in this week.

What is the Fed  so worried about?  Why all the tele-graphing?  And why the unprecedented change of the Chairman actually having to give three selective press conferences over the next six months?  Is there increased confusion regarding Fed policies or does the establishment have such a meteoric job that it requires such dummying down of intentions?   In a
shortened holiday trading session on Thursday and possibly not widely circulated, WSJ’s John Hilsenrath authored a fine piece setting the stage for the Chairman’s message this week.  Read the fine print.

Forget the almost biblical (and seemingly commonplace these days) fare affecting markets these days like twisters, S&P ratings outlook changes, tsunamis, blizzards, Middle East revolutions (tens of thousands of violent demonstrators in Syria on Friday), sovereign bankruptcy prospects deficit/debt limit battles, taxpayer revolts (globally thinking Germany and Finnish last week) the markets really want to focus on what Chairman Bernanke thinks about inflation and how he consequently intends to tweak policy.  To be or not to be.  More or less stimulus.

Again, gaining explicit guidance from the Chairman (Fed or Treasury?) as there were rumors last week that China could float its currency.  A litany of reports about revaluations, tightening, globally coordinated BRIC currency conferences and leaks of the pursuit of and soon to be global commodities like oil trading in renminbis around the corner.  This is all inflationary and Washington has actually been pushing Beijing to let the Yuan rise against the dollar with the likely desire to increase exports but also with the certain consequence of importing massive amounts of inflation.

It’s starting.  "Signs of Trade Disruptions Emerge on Third Day of Protests Spurred by Inflation in SHANGHAI.  A sign of rising tensions and people are finding it more difficult to make ends meet."   Maybe there are mutually convenient objectives with these two central banks?  A stronger Yuan may assist Chinese policymakers in tightening conditions and help tame
inflation IN CHINA and it will help Ben Bernanke target inflation  "expectations" in the U.S.

That is the point!  And so early in the commentary.  CHAIRMAN BERNANKE APPEARS TO BE ACHIVING HIS OBJECTIVES.  The USD has hit its lowest point since the 2008 financial crises last week.   Before the crisis, the dollar had lost more than 40% of its value against a basket during a steady six year decline.  And I’ll be damned, it is headed right back there.  The USD is 5% away from its all time low, hit in March 2008 as tracked by the USD index, which dates back to 1971.  Be careful for what you ask for and how does it feel to be DELIBERATELY devalued by central bank and Treasury?

If the Chairman’s goals are to target and increase inflation expectations, the USD is the signature, the flag hallmark expression.  But there are others.

The collective inflation expressions and musings of policy aren’t just observable in foreign exchange rates but in actual loss of purchasing power. It is happening not just in China but here.  See the NYT tells you so as companies are "camouflaging price creep" as they are NOW raising prices on shelves.  In recent months clothing makers used an array of tactics to keep prices flat, whether by improving production to lower-cost countries, using cheaper fabrics or ordering earlier to lock in prices.   UNTIL NOW as retailers have begun to RAISE PRICES but are quietly not broadcasting it for competitive reasons.  American Eagle, Brooks Brothers, Aeropostale, The Children’s Place, Pacific Sunwear.

Just in time for the spring house-painting season, paint prices are heading higher, another price of rising commodities rippling through to consumers’ pockets.  "We do have pricing power."  AkzNobel, PPG Industries, Sherwin Williams.  Hey Warren Buffet wasn’t as think as you dumb he was for owning Sherwin Williams, an apparent student of history inflation hedge.  Hey, a simple business he understands.  He’s no dummy; he understands that governments since the history of time have striven to abrogate their debt by devaluing creditors through the use of inflation to monetize debt obligations.  Nice purchase on that paint proxy.

Anyone who remotely participates in markets can witness the valuation "expectations" that the Fed has targeted.  We know Chairman Greenspan denied in a steadfast fashion years ago that the FED did NOT TARGET ASSET PRICES (like houses) nor did it consider asset price inflation in its monetary policy decision making.   In failing to understand that basic metric, see
where that policy miscue has landed us NOW?

This new regime isn’t afraid to admit that it targets valuations in markets.   For a quip let’s list a few.  Cotton (+150%), corn (~70%), wheat, soybeans, gas (33% from a year ago), oil, copper, SILVER (31 year high, up 2% to 5% a day including Friday), industrial spreads, equities (up 90%), gold (all time nominal highs above $1500/oz), don’t make me go on as this
paragraph isn’t that long, and TIP BREAKEVENS.

Tips breakevens?  This is possibly the most relevant, imminent and important point of this comment and trading THIS WEEK.  The tip breakeven, the difference in rates between the 10 year treasury note and the 10 year tip, is back to the PRE-CRISES levels of 2006.  This chart is prospectively or should be the key to monetary policy making THIS WEEK.  If the Fed is targeting inflation expectations, then they surely must be observing the valuation relationship of tip breakevens and extrapolate the last time this relationship traded at this level was PRE-crises and consistent back all the way to 2006.  LOOK at the chart.  It’s compelling.

And more.  This administration has SQUASHED VOLATILITY, admittedly an objective not likely discussed at cocktail parties in Washington.  The VIX index is another barometer that has touched levels that haven’t been seen since before the financial crisis.  Thursday this index hit a low that hadn’t been seen since 2007.  There are some limits (and gross misunderstandings) to what VIX actually represents but to understand this measure see this link.

Or this one.

Both from this weekend.  Or call me to discuss.

Expectations?  Has the Fed achieved in elevating inflation expectations?  "Watch Your Step" was the cover story of Barron’s this weekend and in the latest Big Money Poll exposes that nearly 60% of America’s money managers are bullish about the stock market’s prospects.

According to Ned Davis, the Fed (and Treasury) has succeeded in pushing cash in money-market funds (by consumers) to 17.4%, down from 47% in March of 2009.  Did you know that was the objective of monetary policy, to force inflict extreme pain on geezers who need to live on fixed income and liquidity accounts to pile it into the market?  Stocks climbed towards their highest level since 2011 this week.

Consumers must be spending as of the 137 companies in the S&P 500 that have reported first quarter earnings results, three out of four have beaten profit forecasts, better than the 17 year average.  Just 14% have
missed.  Trimming costs but earnings translate into ………………………..wage increases?

I guess CEOs, CFOs, and COOs are feeling better.  Companies have already spent 140% more this year on mergers than last, and 81% more on share buybacks.  Certainly, these executives must be feeling confident enough to expand.  Policies seemed to have affected their "expectations".

What can Chairman Bernanke do to positively impact the other pressing debate of our time (and this week), the credit rating debate which is  impacted by chronic deficit spending, particularly in light of a ratings change which trashed the dollar?  Is a gradual revaluation of the USD against a basket of currencies or, let’s say, against the Yuan a different control experiment with different consequences than a dollar crisis based on a downgrade, a credit event?  We aren’t there yet (but the USD is) and clients are asking the broader implications of mulit-asset performance if the almighty U.S.A. received a credit downgrade.  I sent some very topical thoughts late Thursday.

I know, the naysayers have written off the events of last week as a political event (isn’t every valuation a political event at the moment?).  However,

S&P and Moody’s may have brought you highest ratings on sub-prime mortgages and radio silence on Enron and WorldCom but independent and widely respected alternative rating agency, Egan-Jones, thinks otherwise.  Egan-Jones’ ratings are paid for by institutional investors, not issuers and has had a much better track record in recognizing "imbalances" than the other two and did so back on March 1st.   Egan-Jones put the U.S. government on NEGATIVE WATCH, a further step down the credit ladder from a negative outlook.  Barron’s current yield suggests this means a downgrade to double-A-plus is more
likely than not.    The Current Yield column title is "Debt Downgrade Likelier Than Not".

Mind you, as you try to figure out this mess, realize that six states now have better credit profiles than Uncle Sam.  Delaware, Indiana, Iowa, Maryland, Minnesota, and Missouri all have a stronger credit than the nation.  So do four U.S. companies, ExxonMobil, Johnson and Johnson, Microsoft, and ADP.

Even more numbing is the fact that little noticed, S&P also revised its outlook negative on three financial clearinghouses (FICC, NSCC, and OCC).  And did the same for DTC which provides custody and settlement service for stock trading.  S&P did NOT revise its outlook on 402 state and local borrowers that it rates triple-A even though many receive assistance from the U.S. Federal Government.   Looks like we need to do some credit work.   Helicopter Ben, maybe you’ll need to HIKE rates to defend the USD or the scope of decline when all this credit work is done.

This is a very different meeting for Chairman Ben Bernanke than others in recent past.  He has the cover of overwhelming empirical evidence of having achieved his goals of truly altering inflation expectations as noted above.  In fact, he has been so successful that his approval ratings hover near all time lows, and just slightly higher than Congress approval ratings also at all time lows.  So, effective that many clients from what I hear would like to begin the tarring and feathering.  Isn’t that the truest barometer and indication of his own success, the lowest approval rating?  He also has the cover of a weak dollar, in which communication of gradualist responsible tightening schemes could lend support.  Gradualist schemes like allowing Fed portfolio to run off, asset sales, matched sales, term deposit offerings of Fed, interest on reserves or even token discount hikes.

Which brings us back to the big credit rating and USD valuation challenge at the moment, unabated SPENDING.  Without broadly reliving this debate, there was one item in weekend press which conveniently highlights the problem.  As part of the health care law, the federal government restricts states’ ability to save money by narrowing eligibility for the program or charging more for coverage.  So, even though states are broke, Medicaid budgets which are imposed on them are busting their budgets, like in Maine.  They are legislatively PROHIBITED from cutting some of the largest and fastest growing, if not the largest, costs.  Note Egan-Jones and S&P.


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