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HomeA Bear Flattener
Posted by Larry Doyle on June 8th, 2009 2:25 PM |
For those actively involved in financial markets, the term “bear flattener” is common knowledge. For those not actively involved in the markets, let’s quickly address this concept, what drives it, and what it may mean for the economy.
Let’s break the “bear flattener” into its component parts.
Bear: short for bearish, this term implies declining valuations or prices for whatever security or market sector is being analyzed.
Flattener: analysis of the U.S Treasury yield curve (or the yield curve for any market sector) is typically referenced in terms of whether the curve is flattening or steepening. Reflect back on Algebra II and the concept of slope. Yield curve analysis is all about the slope of the curve.
A flattening of the slope of the curve implies that rates for short maturities are rising faster than rates on longer maturies. In a rising rate environment, bond prices are declining thus the flattening is a bear flattener. If rates were falling but short maturity rates were not falling as much as long maturities, then the flattening would be considered a “bull” flattener.
What does a bear flattener portend for the economy? Typically a bear flattener is an indication of an economic contraction. Why? The rise in rates is usually a function of an increase in rates by the Federal Reserve. Why would the Fed raise rates? To slow the economy, the pace of inflation/expected inflation, or a combination of the two.
Let’s quickly review today’s price action across the U.S. Treasury yield curve. For purposes of measuring the slope of the curve, market analysts typically look at the relative performance and changes in rates on the 2yr Treasury note and the 10yr Treasury note. In today’s price action:
2yr Treasury note has increased by 8 basis points to 1.38%
10yr Treasury note has increased by 3 basis points to 3.86
The 2/10 slope thus equates to 2.48% or 248 basis points. The curve has flattened by 5 basis points today.
Be mindful that although the curve has flattened today as well as the last week (the slope peaked at approximately 275 basis points), the curve started the year at a rather flat level of 1.52% (152 basis points).
A steepening curve is beneficial to financial companies and typically, though not always, indicates an improving economy. A steepening curve can also be a harbinger of inflation as the increase in long term rates is a sign that inflation is likely to increase.
A flattening curve is typically an indication of a slowing economy and is definitely not beneficial to financial companies as funding costs increase.
As evidenced in my initial post this morning, Bernanke Conundrum, the market will often adjust interest rates and bond prices well before the Fed actually changes interest rates and Fed policy.
Thus, despite what market analysts or government officials may say, the slope of the yield curve speaks volumes.
Why don’t you engage your better half this evening with, “Did you see that bear flattener today?” Who knows, it may take your relationship into an entirely new realm as you navigate the economic landscape!!
LD
Where Is Finra’s 2008 Annual Report?
Posted by Larry Doyle on June 8th, 2009 10:33 AM |
Finra released its 2007 Annual Report in mid-April 2008. Here it is June 8, 2009 and Finra has yet to release its 2008 Annual Report. What is going on? Aside from speculating, I called Finra this morning to inquire.
A source from within Finra’s Media Source division informed me to call back in a month. I questioned how and why in a period of economic and market dislocation, and with a heightened sensitivity on increased regulatory transparency, that Finra is being less transparent. I received a healthy dose of red tape and little direction. I have a call into Finra spokesman Herb Perone. That said, June 8, 2009 and no Annual Report. “Call back in a month.”
Why do I want to review Finra’s 2008 Annual Report? I know that fines and sanctions collected by Finra diminished by approximately 30% over the last year. The WSJ highlighted that information and I expounded upon it in writing, How Courageous is Mary Schapiro? My specific area of interest is a review of Finra’s investments within their own internal portfolio.
Recall that from their investment portfolio, Finra sold $647 million (position as of year end 2006) of Auction Rate Securities in Spring 2007. What did Finra do with their investments in hedge funds, fund of funds, private equity, common equities, and fixed income? Would Finra be so forthcoming as to provide insight as to why they needed to raise all that cash from the Auction Rate Securities liquidation?
Our markets and economy are screaming for increased transparency and regulation in an attempt to reinstill a measure of investor confidence.
Finra is prominently situated as a Wall Street regulatory body. Finra is currently being less transparent than a year ago. Why? Ms. Schapiro at the SEC and Richard Ketchum, new head of Finra, can TALK all they want about increased transparency and stiffer regulations. Talk is cheap. Information is everything.
“Call back in a month…” does NOT get it done.
LD
Bernanke Conundrum
Posted by Larry Doyle on June 8th, 2009 7:27 AM |
Overnight markets indicate that Treasury prices are lower and interest rates subsequently higher (remember the inverse relationship between bond prices and interest rates). 2yr Treasury notes are trading at 1.33% and 10yr Treasury notes are trading at 3.85% (both are .03% higher from Friday’s close).
If interest rates are higher, clearly that move must be an indication that economic activity is improving and equity markets should be higher overnight, correct? In “normal” economic times, perhaps that line of reasoning would hold water, but in the Uncle Sam economy, we need to go deeper.
Equity futures indicate our stock markets will open lower by approximately 1%. What’s going on? Welcome to the Bernanke conundrum! What is the riddle wrapped inside our economic enigma? How can Fed chair Ben Bernanke nurse our economy back to health while at the same time maintaining the necessary fiscal independence, integrity, and discipline of robust Fed policy?
Big Ben has used aggressive measures to backstop a wide swath of our markets. In the process, he has created a fair amount of stability but with an effective government guarantee “insurance” policy as the cost of stability. Some of these policies have lessened in size as certain sectors have normalized. However, the major Fed programs remain in place. What are these?
1. quantitative easing: commitment to buy $1.3 trillion in total of Treasury and mortgage-backed securities in an attempt to keep these rates down. Then why are rates rising? More on this in a second.
2. commitment to provide necessary liquidity as needed to support the “wards of the state” including Freddie Mac, Fannie Mae, GM, AIG, Citigroup.
These programs in conjunction with the massive deficit spending programs undertaken by the Obama administration have ballooned our expected funding needs in calendar 2009 to upwards of $3 trillion, a fourfold increase over prior years.
In my opinion, interest rates are moving up much less on any real signs of economic improvement than on these funding needs and very real signs of a monetary printing press malfunction. What’s that? With the Fed Funds rate at 0-.25%, the Fed is literally flooding the economy with cash. Where is that cash going? Is it flowing through to the economy? Not really.
The cash is pouring into the banking system to cushion and support financial institutions from the ongoing losses connected to rising defaults on credit cards, residential mortgages, commercial real estate, and corporate loans.
The market is now very clearly sending a signal to Bernanke, Geithner, Obama and team that if they want to continue their programs as designed (and they do and will), the price, that is the rate of interest, is going up. Why?
The market is very concerned that the flood of liquidity will lead to inflation if not rampant inflation and potentially hyperinflation. How does Bernanke head that off?
Withdraw the very liquidity that he has found so necessary to pour into the financial system. How does he do that?Two ways.
1. increase the Fed Funds rate: that is, make borrowing more expensive.
2. reverse the quantitative easing program so that the Fed actually sells Treasury and mortgage-backed securities into the market and takes liquidity out in the process. What are the impacts of both those maneuvers? Higher interest rates.
In fact, interest rates are moving higher already in anticipation of Bernanke being forced to make these moves. Can Bernanke “thread this needle?” What will happen if interest rates move higher?
Slow the economy, especially housing given higher mortgage rates, and lower earnings especially for financial institutions. To wit, our equity markets are lower overnight.
Nobody said this was going to be easy.
LD
First Pacific Advisor’s Atteberry and Rodriguez Provide Macro Perspective
Posted by Larry Doyle on June 7th, 2009 2:29 PM |
Hat tip to MC for sharing this brief but rich interview our Economic All-Stars Tom Atteberry and Bob Rodriguez gave at last week’s Morningstar Investment Conference. Atteberry and Rodriguez take a macro perspective. In my opinion, their experience, wisdom, and long term focus are not only a pleasure but also a necessity as we move forward slowly but steadily in the Brave New World of the Uncle Sam Economy.
LD
Join Me Tonight at 8PM for NoQuarter Radio’s Sense on Cents with Larry Doyle
Posted by Larry Doyle on June 7th, 2009 7:32 AM |
UPDATE: The show has concluded, but you can listen to a recording in its entirety by clicking the Play button on the audio player below. Once the playback has started, you can fast forward or rewind to any portion of the show by clicking at any point along the play bar.
*********************
Please join me Sunday evening from 8-9 p.m. ET for NoQuarter Radio’s Sense on Cents with Larry Doyle. I believe we are now entering the next stage of the Brave New World of the Uncle Sam Economy. As we navigate the trails in this leg of our journey, our primary focus will be on interest rates. We experienced a dramatic spike in global rates over the course of the last few weeks. What do these spikes mean? Will they persist? Do we need to “lighten the weight of our packs” to successfully traverse these hills and valleys? Do the moves in rates indicate that “inflation” is just around the bend?
Listen to NQR’s Sense on Cents with Larry Doyle tonight from 8-9PM as I address all of these angles. Additionally, I am thrilled to have Luke Fry of 12th Street Capital join me to address these topics and developments in and around the world of mortgage-backed securities. Luke is a senior salesman at 12th Street Capital, a leading broker-dealer with untold expertise in the mortgage business. Prior to 12th Street, Mr. Fry was a Managing Director at Knight Libertas, LLC where he was responsible for providing market insight and analysis in mortgage and asset-backed structured products to a wide range of clients that included hedge funds, money managers, insurance companies and banks. Mr. Fry was hired as the first salesperson on the ABS/MBS desk at Libertas Partners and helped expand the group to over 12 salespeople while seeing the company through a merger in July 2008 with Knight Capital Group, the largest U.S. equity market maker. (more…)
About Those Interest Rates
Posted by Larry Doyle on June 6th, 2009 9:49 AM |
A sharp move higher in interest rates has received a lot of attention lately. In fact, I now believe the focus on interest rates will move to center stage in our Brave New World of the Uncle Sam Economy. Allow me to comment.
I spent my entire career on Wall Street within the bond market, so my professional life has been consumed by interest rates. I don’t know if that is necessarily a good thing, but that’s for another day.
What are interest rates?
Very simply, the interest rate – for whatever financial product – is the “price of money.”
What are the components of interest rates for respective financial products?
Interest rates are determined by three factors:
1. a general level of rates of return in the economy and market: this level is typically viewed by focusing on the shorter maturity U.S. government securities. Uncle Sam is viewed as the benchmark from which all other interest rates are compared. Uncle Sam’s own creditworthiness is coming into question, but that can be a topic for a separate post.
2. a risk component: this factor addresses the creditworthiness of the borrower (be it a global government, a corporation, a municipality, or an individual). Additionally, while most bonds focus on the risk component as being a function of creditworthiness, there are other risk factors as well, including prepayment risk for mortgages.
3. inflation/deflation: this factor addresses how fixed future returns on bonds are impacted by the general change of prices in the economy. The presence of inflation (a rising level of prices) erodes the value of fixed future returns. In a similar fashion, the presence of deflation (a declining level of prices) increases the value of fixed future returns.
Utilizing these three factors, one is prepared to more effectively understand the nature of interest rates, both from a static standpoint and in a dynamic environment.
Utilizing these components, how and why do interest rates change in a dynamic economy?
Let’s recall that the valuation of any financial product (a stock, bond, currency, commodity) is determined in a dynamic market setting by buyers and sellers assessing three variables:
1. fundamental analysis: from our trusty Investing primer (right sidebar), we see this variable defined as:
an investor can perform fundamental analysis on a bond’s value by looking at economic factors, such as interest rates and the overall state of the economy, and information about the bond issuer, such as potential changes in credit ratings.
2. technical analysis: again using our Investing primer:
A method of evaluating securities by analyzing statistics generated by market activity, such as past prices and volume. Technical analysts do not attempt to measure a security’s intrinsic value, but instead use charts and other tools to identify patterns that can suggest future activity.
3. market psychology: the Investing primer educates us on this variable as well:
The overall sentiment or feeling that the market is experiencing at any particular time. Greed, fear, expectations and circumstances are all factors that contribute to the group’s overall investing mentality or sentiment.
While conventional financial theory describes situations in which all the players in the market behave rationally, not accounting for the emotional aspect of the market can sometimes lead to unexpected outcomes that can’t be predicted by simply looking at the fundamentals.
Utilizing these tools, let’s review the prevailing level of interest rates in our economy from a chart provided on a daily basis at the WSJ Market Data page linked here at Sense on Cents.
We can assess how all the short term interest rates have come down over the last three years in response to the recession. We are now faced, though, with a move higher in rates given the increased risks of inflation, along with massive demand by global governments, corporations, municipalities, and individuals for credit. That demand, like any demand, is driving the price of money (the interest rate) higher. Is this demand being generated by improvements in the economy, the need to refinance existing debt, or a combination of the two?
Welcome to the word of interest rate analysis for fixed income investments (bonds).
Please share your thoughts, questions and concerns so we can all most effectively navigate the economic landscape.
For more on this topic:
Is The Government Bond Bubble Getting Ready to Burst?
May 21, 2009
Mortgage Refi Activity Is Driving Rates Higher
May 26, 2009
The Wheels Have Come Off Barack’s Bond Bus
May 27, 2009
I will also address the dynamics driving interest rates extensively during my NQR Sense on Cents radio show Sunday evening June 7th from 8-9pm.
LD
P.S. If you like what you see here at Sense on Cents, please add the site to your favorites, share with your friends, and visit/comment often!! Thanks!!
Front End Springs a Leak
Posted by Larry Doyle on June 5th, 2009 4:57 PM |
In a manner of speaking, the management of our economy has been nothing short of a major overhaul of a tired old ship. When the tide went out, the base of our ship was exposed as being filled with holes.
Little did we know at the time, but through many of those holes a number of “pirates” were running off with a whole lot of booty. In the process, many market participants riding along on the main deck were thrown overboard by the economic storm that hit our economy and markets over the last two years.
We do not have the luxury of bringing our ship into port for an overhaul. We have had to continue to sail this ship while trying to repair it. In that spirit, by necessity we have had to add significant ballast (liquidity) in our hull. In so doing, we need to recognize that the ballast can itself be inflammatory if the engine generates a spark.
In purely economic terms, this morning’s non-farm payroll number of -345k jobs was a hint of a spark. While various sectors of the market gyrated today, the front end of our ship, that is the front end of our yield curve, sprung a serious leak. How so? Interest rates on short term Treasury notes increased a DRAMATIC 35 basis points. Why?
Traders are already pricing in an expectation that the Federal Reserve will be forced to increase the Fed Funds rate prior to any hint of inflation or even the expectation of inflation gains a foothold. Bloomberg sheds color on this likelihood, Traders Begin to Speculate Fed Will Need to Tighten:
Traders are beginning to price in expectations the Federal Reserve will raise interest rates this year as the recession shows signs of abating.
Federal-funds futures contracts on the Chicago Board of Trade show a 70 percent probability the central bank will lift its target rate for overnight bank borrowing to at least 0.5 percent by November after a report today showed the U.S. economy shed the fewest jobs in May in eight months. Rate-increase odds were 27 percent yesterday.
The Fed cut the target rate to the record low range of zero to 0.25 percent in December as the economy lapsed into the worst recession in decades. President Barack Obama and Fed Chairman Ben S. Bernanke have committed $12.8 trillion to thaw frozen credit markets and ramped up government spending to revive growth. The Fed last raised borrowing costs in June 2006, when policy makers pushed the rate to 5.25 percent.
Fed governors and Fed chair Bernanke now face a serious quandary. Economic data will remain decidedly weak. Unemployment will continue to increase. Consumers are going to remain strapped. Corporations will face challenges. Municipalities will encounter an ongoing decline in tax revenues. Nobody is going to truly feel like the economy is improving to the point that the Fed should even think about increasing interest rates. Then why is the market starting to price that reality into the market? Let’s go back into the hull.
The bowels of our ship are flush with liquidity and given any sort of traction in the economy, the velocity and growth in the money supply will drive inflation.
What is Big Ben and team to do? The market is raising interest rates on him rather than his raising interest rates on the market. In the process, a very fragile economy will now be forced to deal with higher interest costs along with anemic growth.
What do I see on our economic horizon? In my opinion, today’s price action took us in the direction of the island known as Stagflation.
Please share your thoughts and comments.
LD
Sense on Cents Navigates the Markets
Posted by Larry Doyle on June 5th, 2009 12:41 PM |
Navigating the markets on the day in which the employment report is released is always fascinating. Why? Typically the release of new and meaningful information generates very heavy volume; as such, the market moves can be measured with greater weight. Let’s take our equipment and head out along the trail . . .
Equities: major market equity averages opened very firm after the positive tone embedded in the non-farm payroll component of this morning’s report.
As the day has moved along, though, these indices have all faded. The DJIA is up approximately .4% as of this writing. The S&P 500 and tech heavy Nasdaq are unchanged relative to Thursday’s closing levels.
Particular industry groups that have had outsized moves are mortgage finance (-2.2%) and industrials (+.93%). What’s going on here? The mortgage finance companies are negatively impacted by higher interest rates (more on that in a moment). The industrials are likely benefitting from the perception that the economy may be slowly turning the corner.
Bonds: this is where the real action is occuring!! Various sectors of the bond market are down anywhere from .25% to 1%. It appears the only bond sector improving on the day is the high yield space (+1-1.5%) as it is benefitting from the perception of lessened credit risk.
The biggest loser on the day is the front end of the U.S. Treasury market which has backed up an EYE-POPPING 25 basis points. The intermediate to long end of the Treasury yield curve has backed off by 5 to 15 basis points.
Bonds are faced with 3 major hurdles:
1. massive supply: as global governments, corporations, municipalities, and individuals all look for credit.
2. inflation : as much as analysts will point to the lack of any wage pressures, the fact is that the U.S. has so much liquidity in the system that any hint of an economic spark will be akin to dropping a match on dry hay. The Fed can only dampen the “hay field” by withdrawing liquidity from the economy. How? Increase the Fed Funds rate or sell Treasury or mortgage assets currently on its books. What would that mean? Push interest rates even higher, especially on the front end of the yield curve. What would that do? Slow the economy.
3. the Fed: Big Ben, (Turbo-Tim as well) and team may find themselves between the proverbial rock (a fragile economy) and a hard place (fears of increasing inflation) sooner than they think.
Currencies: the greenback is doing better on the day. This seems counterintuitive to an economy regaining its footing with investors taking on a greater risk appetite. What’s happening? In my opinion, the greenback is anticipating that Bernanke and the Fed may have to “think” about increasing the Fed Funds rate.
Commodities: slightly weaker on the day.
Other news of note . . . Bloomberg releases a story highlighting the charade being played by banks in “generating” earnings. The fact is banks have benefitted tremendously by “accounting” maneuvers and as such are “masking” sizable losses. Regular readers of Sense on Cents have witnessed my addressing these issues. That said, I recommend: Bank Profits From Accounting Rules Mask Looming Loan Losses.
In summary, we are clearly entering the next stage of the Brave New World of the Uncle Sam Economy. The key attribute of this phase will be higher interest rates.
LD
Unemployment Report June 5, 2009 >> UPDATE
Posted by Larry Doyle on June 5th, 2009 5:45 AM |
UPDATED AS OF 9:15AM
The report was surprisingly strong on one front but with reason for caution as well!! Let’s dive right in.
Before this morning’s numbers were released:
The widely anticipated June Unemployment Report covering the month of May is due out this morning at 8:30 am (EST). Will this report show signs of improving trends in the pace of layoffs? I remain quite skeptical about the data connoting ongoing improvements while simultaneous negative revisions receive limited focus. We have experienced ongoing layoffs within the private sector with some pickup in government hiring. I believe we will likely see a pickup in layoffs at the state and local levels as tax receipts continue to disappoint.
In regard to revisions versus the actual report, let’s revisit what I wrote a month ago in my commentary for the May Unemployment Report:
On the face, the report appears better than expected but given the additional job losses in the revised numbers for February (an additional 18k jobs) and March (an additional 48k jobs) we are still in the 600k average job loss for the month. Private sector lost 611k jobs while government added 72k jobs with a lot of those people being temporary workers employed by the Census Bureau. The fact that temporary government workers are factored into overall employment, in my opinion, is stretching the integrity of the report. Health care added 17k jobs, manufacturing lost 149k jobs, construction lost 110k jobs, financial services lost 40k jobs.
Expectations for this morning’s report, as well as previous months’ data, are as follows:
(Note: please check back shortly after 8:30am when I will post the actual for June unemployment statistics, along with my post-report commentary.)
Unemployment Rate
April 8.5%
May 8.9%
Expectation for June: 9.2% (recall how the base case for the Bank Stress Tests was 8.9%. Here we are in June and have exceeded 9%. I think it is a lock that we hit 10% and not inconceivable that we push 11% by year end.)
Actual for June: 9.4%
Post report comment: this rate is substantially higher than the expectation of 9.2% and implies that we will almost certainly get to 10% sooner than expected.
Non-Farm Payroll (click here for definition of this term)
April: loss of 663k
May: loss of 539k
Expectation for June: loss of 520k
Actual June report: loss of 345k
Revisions: April and May combined gained 82k jobs
Post report comment: a much better than expected number with positive revisions to prior months. May was revised from -539k to -504k.
Average Hourly Earnings
April: +.2
May : +.1
Expectation for June: +.1%
Actual June report: +.1%
Post report comment: as expected. No surprise that wages are under control with slack employment. This number does not support any expectation of a pickup in consumer demand and retail sales.
Average Hourly Workweek
April : 33.2 hours
May: 33.2 hours
Expectation for June:33.2 hours
Actual June report: 33.1 hours
Post report comment: this number is weaker than expected. It does not support any expectation of a pickup in new orders driving a rebuilding of inventories.
7am: equity index futures are higher by.4%. The 10yr Treasury is trading at 3.74%. The 2yr Treasury is trading at .97%.
Post report market reaction: equity index futures jumped from .4 to 1.4% while bonds have sold off. The 10yr initially moved higher to 3.87% but is now at 3.82%. The biggest move in the bond market, though, is on the front end of the curve. The 2yr has increased by 25 basis points to 1.22%!!! Of all the numbers and moves, this should attract the most attention. Why?
The market is telling the Fed the following: if in fact the economy has bottomed in terms of a slowing in job losses, then a degree of economic traction will lead to inflation (even without a pickup in wages). The Fed may need to revisit the idea of leaving the Fed Funds rate at 0-.25% for the foreseeable future.
The “patient” is stabilizing, but still faces numerous side effects from all the procedures!!
If you like what you read and see here, please put Sense on Cents (www.senseoncents.com) in your favorites, and visit and comment often. Thanks!
LD
