By ContraryInvestor.com | 7 May 2009
We believe the concept of perception versus reality is an extremely important distinction in the current economic cycle and circumstances of the moment. And remember, it’s not that potential misperceptions being priced into financial assets at any point in time are somehow bad, but rather that THE issue of importance to us is making sure we are in touch with [undoctored, unassuming, unbiased] reality at every point in time. That is necessary if we hope to make a judgment about whether what the markets are discounting is 'correct' or otherwise.
If you ask us, trying to make an informed judgment about this distinction is literally crucial to ongoing investment decision-making and risk management. You already know financial markets are not moved by reality 100% of the time. Far from it. Greed, emotion, fear, distress, etc. all get to take turns driving the financial market pricing bus. We just hope to be smart enough to know when a reckless driver has the wheel.
We’ve been talking a lot about the equity market as of late. Time to take a much needed and very important detour in this discussion. Right to the point, we want to review the character of the credit market as we currently see it. Certainly a general sense of optimism has risen as the equity market has levitated. And that sense of optimism leads naturally to the thought that the economy and general financial market conditions MUST be getting better because rising equities are simply foreshadowing such an outcome.
In other words, history has 'taught us' that equities lead and so, if equities are rising, the implication is that better days lie ahead. But in the current cycle, we all know that credit market issues have been the locus of distress and the exact cause for a dramatic loss of wealth in financial assets really globally. So although it’s certainly fun to watch the equity markets romp higher, it’s the credit markets that deserve a really big piece of our attention. As we see it, better days lie ahead as a generic comment only when both the equity and credit markets are healing in simultaneous fashion.
Before jumping into some data and historical relationships, one more quick comment. A very cursory and superficial glance at a number of key credit market relationships could indeed lead one to believe that the healing process for the credit markets has also begun. But as we look at the facts underlying a number of headline credit market indicators a different picture emerges entirely. A much different picture.
For as we look at the data, we believe the bottom line is that the Fed has all of its fingers stuck in the holes of the macro credit market dike. At least up to now, this multiple fingers in the dike approach by the Fed and friends to dealing with very threatening credit market issues can indeed create a superficial perception that at least 'the initial rumblings of healing' are upon us. But we believe a number of these "managed" credit market indicators have created a misperception about the supposed recovery of the credit markets in the broader and more important sense.
Although we’ll walk through the data piece by piece, as we see it, the credit markets are far from healthy and are not recovering as per the perceptions embedded in the current run in equities. If there is to be an Achilles Heel in the equity rally of the moment, it’s the bare realities of the US credit markets. Let’s get right to it.
A first, necessary step to lay the groundwork is a review of the highlights of the Fed current balance sheet as of the middle of April. Have a look and we’ll have some quick comments.
| Highlight Components of Fed Balance Sheet ($billions) | |||
| Component | April 15, 2009 Balance | April 15, 2008 Balance | Change |
| Reserve Bank Credit | $2,169 | $866 | $1,303 |
| UST's | 526 | 549 | (23) |
| Agency Securities | 61 | 0 | 61 |
| MBS | 356 | 0 | 356 |
| Term Auction Credit (think LIBOR) | 456 | 0 | 456 |
| Commercial Paper Funding Facility | 238 | 0 | 238 |
| Liquidity Swaps | 294 | 38 | 256 |
| Maiden Lane LLC's (AIG) | 72 | 0 | 72 |
| Credit Extended to AIG | 45 | 0 | 45 |
As you can see, we are comparing the Fed balance sheet as of April 15 of this year with April 15th a year ago. What is in between are the credit market blowups that really began last summer and have caused the Fed/Treasury/Administration to take actions most would have considered unimaginable only a short time ago. First, the Reserve Bank Credit number is an approximation of the total size of the Fed balance sheet. And yes, it has more than doubled in the last year and will certainly have tripled probably somewhere in the months directly ahead, with more to come in terms of expansion.
A year back, three quarters of the Fed balance sheet largely consisted of US Treasury holdings (63%) and repurchase agreements (12%). Today, Treasuries don’t even account for 25% of the Fed balance sheet and repo’s are but a memory. You can easily see in the table above what is now held by the Fed. And, to the point, it’s largely 'broader US credit market instruments' [[of dubious value: normxxx]]. Let’s start from the top and we’ll comment on each.
The Fed has been buying agency securities— most heavily since Fannie and Freddie became wards of the US taxpayer last summer. And without question Fed action has been necessary, in part, to offset the sales of Federal agency bonds by the foreign community, of which there have been plenty over the last half-year.
For now this is a very small portion of the total Fed balance sheet. In all honesty, we believe the Fed impact on the credit market character of Agency paper has not been as strong as the now surely implicit guarantee of Fan and Fred debt by the US government. Nominal yields on agency paper have dropped like a rock over the last year.
This only could have taken place if investors truly believed the US government would back up any and all Agency debt (which they most surely will). The Fed balance sheet has also helped in this neck of the credit market woods make conditions "appear" as if they are improving with spreads between Agency and Government debt contracting meaningfully over the last year. So between the Fed and the (now more than implied) Government guarantee of Agency debt, this area of the credit market looks to be healing. Of course without the Government and Fed intervention, it would be a catastrophic disaster, probably the locus of massive default.
On to more direct Fed perceptual 'aids'. Next up on the Fed balance sheet hit parade are mortgage-backed securities. You know that Fed has announced they would buy $750 billion of MBS using 'printed' money as per their March FOMC meeting communiqué. As of April 15th, they are now the proud owners of close to half that amount with $356 billion of MBS paper held.
You already know that the Fed’s stated intent in this action is to get US conventional mortgage rates down (close the yield spread between mortgages and Treasuries), and that they have done. They’ve suggested that the magic target is a mortgage rate near 4% on conventional loans and we’re not quite there yet. Expect them to continue buying up MBS paper.
But the point is that what we see the Fed doing is essentially offsetting the contraction in MBS security issuance in the public asset backed markets. The following chart is clear on the history of home mortgages within the asset-backed complex. It has imploded, so in has stepped the Fed to put one big finger in one of the largest credit market holes in the dike.
Let’s face it, if these markets were actually healing, the asset-backed markets would not be contracting, but that’s not the case at all. The asset-backed market for residential mortgages is broken. Perceptually the Fed has simply offset this contraction and is providing mortgage rates that would not exist if not for heavy Fed involvement.
So, are the signals being sent by the MBS market embodied in lower yields indicative of healing credit markets, or a Fed that cannot remove its fingers from the dike lest the dike burst? Of course this also points to a discussion we will save for a later day about when and if Fed involvement here can abate (how does not any time soon sound?).
As a very quick tangent, please be aware that the dynamics playing out in the residential mortgage markets are very similar to what is now beginning in the commercial real estate markets. We devoted an entire discussion to commercial RE markets earlier this year. Here’s our bet, before the current cycle is over the Fed will without question use their balance sheet to help offset exactly what you see below.
It’s either that or the banks are about to take some [further] serious losses right between the eyes. And we already know from Fed/Treasury/Administration actions as of late that the banks and investment banks are considered sacrosanct. They will be "saved" at all costs, regardless of the holes blown in the US government balance sheet.
We included a quick peek at recent Markit.com BBB rated commercial mortgage backed securities spreads since last October. Healing? C’mon, this part of the credit market is gasping for breath.
Okay, next at bat on the current Fed balance sheet is term auction credit. What was the term auction credit facility really set up for? In the direct words of the Fed themselves, the TAF "could help ensure that liquidity provisions can be disseminated efficiently even when the unsecured interbank markets are under stress". What is the headline representation of the "unsecured interbank markets"? Easy— LIBOR (the London interbank offer rate).
Point blank, we believe the TAF was set up to 'talk' LIBOR down, if you will. And this is exactly what has happened as is clear in the chart below. Gone is the "distress" seen in LIBOR during the October period of last year, long gone. And as you already know, LIBOR is one of the key headline "symbols" of global credit market conditions. Good to know all is well, right?
Maybe more than any other headline credit market indicator of the moment we believe Fed actions have distorted what used to be the prior "risk based" message of LIBOR. And that cuts right to the conceptual heart of government intervention. Just how the heck can the private sector assess risk and allocate capital correctly and efficiently when the Fed/Treasury/Administration is acting to 'help' "mispriced" assets and risk measures?
In our eyes, there will be no true recovery in the economy and capital markets until risk is being priced appropriately and all risks are known (the issue of transparency). Make no mistake about it, the decline in LIBOR is not a result of credit market healing and the lessening of risk perceptions. It’s a result of the Fed TAF. And so, once again, how do they step away from this intervention?
Onward to the wonderful world of commercial paper. In the table above we’re showing you that one-year ago, the Fed owned zero commercial paper. Let us shed just a bit more light on this. As of the late summer of last year, the Fed owned zero commercial paper. In response to the post-Lehman blow-up that rippled through money markets and the commercial paper market, the Fed hastily set up its own commercial paper funding facility and has so far purchased close to $240 billion in said paper. At the height of activity, the Fed owned close to $360 billion in CP, but has been able to lessen the load just a bit since the peak.
But the key is that Fed CP exposure has held steady near $240 billion all year in 2009— the sign of a market that is not healing on its own. And this is especially important in light of the fact that the commercial paper markets have actually been contracting in total since 2009 began. Meaning? The Fed holds a larger percentage of the total CP market today than was the case at the turn of the year.
The following chart comes to us directly from our wonderful friends at the Fed. Looking at the Fed balance sheet, they now own close to 15% of total US commercial paper outstanding. You can see that commercial paper outstanding in all categories continues to contract. This is not a picture of a recovering or vibrant credit market. Not by a long shot.
The message is clear. Commercial paper markets are not healing. Not only is total volume down as is seen in the chart above, so is new issuance this year. And at the same time, the percentage of total CP market paper held by the Fed has been growing in 2009. One more time, without the Fed finger in the CP dike, just what would this market look like? (Answer: You probably do not want to know.)
Clean up batter in our wonderful little US credit market review is corporate paper. We’ve saved the simplest for last. In the following two charts we are looking at very simple corporate credit spreads. We’re using the Moody’s Aaa and Baa yields set against the 10-year US Treasury yield and running the numbers back four decades. The charts tell their own visual story quite elegantly. Lower quality Baa corporate bond yield spreads as of March month end rest very near a four decade high. Same deal goes for better quality Aaa corporate bond spreads.
Without question this very big corner of the US credit market space is not only not healing, it has been exhibiting heightened stress this year. And what is the big differentiating factor between US corporate credit markets and US credit market character as exemplified by LIBOR, commercial paper, mortgage backed securities and government agency paper? Easy and very important— the Fed is not involved!!! At least not yet. Get the picture? Of course you do.
We’ll keep the summary short because we’re sure you understand what is happening here. As we see it, the BIG bottom line message is that the Fed is creating the impression or perception of healing in pockets of the US credit market. For those not willing to or literally unable to understand what is happening behind the scenes, many a headline credit market perception is actually a misperception when a light is actually shown on the facts of these various market segments.
Where the Fed is involved, the perception of healing or stabilization can be created. Where they are not involved (corporate markets), continued stress is still plainly visible. In the endgame, we believe credit market investors are smart. They are less emotional than equity investors. We believe many know exactly what is going on and the true character of supposed healing that has taken place with the Fed sticking all of its fingers in the US credit market dike that has cracked and has certainly not been repaired.
Alternatively, we believe equity investors caught up in the momentum of the moment need to keep a sharp eye on exactly what is happening in the credit markets. After all, the Fed/Treasury/Administration is compelling us to do so as they constantly focus on "unfreezing" the credit markets. Absent the influence of the Fed, these markets are not yet recovering. Absent the Fed, the credit market patient is unable to get out of bed and walk on his/her own.
Let’s just hope equity investors have it dead right in their happy anticipation in recent months. For if what they are discounting is correct, especially in financial sector issues, the US credit markets should very soon be involved in a Lazarus event— an immediate 'rising from the dead'. But for now, it’s really the Fed holding up most of the credit markets, from which they cannot have a current exit plan by any stretch of the imagination.
The credit markets ARE the issue for the current cycle. We need to keep this firmly in mind. We’ll be updating this analysis intermittently as we move through 2009.
The Road Ahead… The Fed moving into all out monetization mode is a new construct for today’s investment community. We’re going to be navigating ahead with few historical guideposts. The poster child reference point for quantitative easing in the modern era is clearly the experience of Japan, and that’s not necessarily a comforting experiential outcome.
As we’re sure you already know, Japan was very late in the game in its own post equity and real estate bubble reconciliation cycle when it decided to pull the QE monetary policy trigger. The Bank of Japan officially announced its intention to 'print' money to buy sovereign debt on March 19 of 2001. Within a month of the announcement, the Nikkei had rallied just over 19%. Post the rally peak, the Nikkei never saw this level again for four and one half years and proceeded to lose almost 48% of its value over the next year and three quarters post the initial QE announcement rally.
We believe there are a number of absolutely key differential points we need to keep in mind when trying to benchmark what will be significant US quantitative easing efforts ahead against the experience of Japan. In our minds THE key differential is that Japan began their quantitative easing during a period in which the country as a whole was running a very large surplus. Conditions for the US could not be further opposite at the moment.
Japan began their QE efforts when household savings in Japan was quite high and had been for years prior. Again, quite the opposite of the current US circumstances. Bottom line? Japan began QE from a position of internal financial strength. The US now begins QE after not having been able to internally fund its own borrowing for many moons, being already heavily indebted and in a huge deficit position. And so now deficit spending in the US is to move into hyper drive, supported in large part by Fed sponsored QE? A huge contrast to the experience of Japan.
From our perspective, we see Japan’s experience as a country that chose to undertake QE as a proactive monetary policy choice. And it did so from a position of surplus and savings rich financial strength. Alternatively, as we hope we made clear, the Fed is not moving to QE as a proactive choice or within the context of greater US financial surplus and savings strength, but is rather being forced to undertake QE as quite simply there is no other buyer large enough to finance US Treasury issuance.
In our minds, a glaring differential and potentially a key differentiation point in terms of forward economic and financial market outcomes. Without sounding melodramatic, please do not forget these key points. We believe that to blindly assume a relatively benign outcome for the US in terms of forward interest rates, global capital flows and currency valuation, as very much was the case for Japan post embarking on QE, will be a huge mistake.
As the initial experience in Japan, US equities have so far responded favorably to the supposedly magic drug of monetization. But we need to ask ourselves in the larger picture, can US equities build an intermediate or longer term bull market case based on the rationale of massive government deficit spending supported by a Fed that will print money to fund it seemingly without limit? Can it really be that within the context of the global economy of the moment, the key competitive advantage of the US is a printing press?
Make no mistake about it, monetization can positively influence economic and financial market outcomes for a time. We need to respect this fact. Greenspan proved this in spades during the late 1990’s pre-Y2K liquidity extravaganza in the US. As you’ll remember, the NASDAQ doubled. Of course the aftermath was none too pleasant, and continues as such to this day.
As we have mentioned, we believe the key to navigating the investment environment ahead is to anticipate the unintended consequences of current government spending and Fed actions. Over the years it has been our experience that the most important drivers of asset prices are not the outcomes that can be seen and/or anticipated by the many, but rather the unseen outcomes that only the few dare anticipate. Hasn’t this exactly been the case since equity market highs of 2007? We believe it will continue to be so ahead.
ß
Normxxx
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The contents of any third-party letters/reports above do not necessarily reflect the opinions or viewpoint of normxxx. They are provided for informational/educational purposes only.
The content of any message or post by normxxx anywhere on this site is not to be construed as constituting market or investment advice. Such is intended for educational purposes only. Individuals should always consult with their own advisors for specific investment advice.
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