This final sketch - a tad delayed given Santa was in town.
Let’s try to make interest rates work for us. One of the first places to look - one’s portfolio.
The last 10 years have been good to bond holders. Fine. But recalling what we learned earlier, if we still hold bonds then perhaps an adjustment is in order, especially if maturities are far down the road. It’s not likely we want to keep it all there if interest rates are header higher.
Or perhaps we own fixed income mutual funds; perhaps some of those holding are offshore, perhaps sovereign debt (Ger., UK, Finland, Spanish, etc.). Maybe a few of us even own this debt outright. Here too, an adjustment may be in order. With very recent downgrades of Greek and Spanish debt, sovereign risk is assuming center stage. This is something quite new, at least for advanced economies, forcing many of them to pay more for their borrowing regardless one's outlook for the inflation component.
Finally, let’s look at the dollar. The dollar's rise from all-time lows is at least partially due to the expectation that the Fed will begin raising interest rates sooner than previously expected. Higher interest rates, coming off a base of zero, can hardly be considered a threat to economic activity, although as we know now, they are a threat to fixed income prices. But there’s another aspect to consider. Higher interest rates might in fact benefit a good many of us, those who have significantly more floating-rate assets (e.g., bank CDs and money market funds) than floating-rate debt (e.g., adjustable rate mortgages). Just a thought.
Take a look at the yield curve from time to time:(http://www.bloomberg.com/markets/rates/index.html.
We’ve got some tools; add to them, then go for it.
Robert Craven
Thursday, December 31, 2009
Friday, December 18, 2009
Interest Rates III
Interest rates, continued.
The Term Funds market is the largest slush fund in the world. This is where US banks come to take care of business. Some banks are flush, some banks are short; they work things out. All banks have reserve requirements to meet and other short-term needs. Here is where they come to fund these liabilities. Maturities are from o/n to two weeks, some even longer. Banks lend/borrow to/from one another, without collateral. This is the heart of bank liquidity. Early Q4, 2008 this market seized up; it locked in place. As a result we were only weeks away from a free fall, one which would have made the Great Depression look like a party. Only thanks to the G-20's quick maneuvering were we spared.
In Q4, trust vanished. No single world institution trusted any other (notwithstanding decades worth of relationship). No one knew just how poisoned collateralized mortgage paper really was, or, who owned how much of it. The banks lied to each other, and, to regulators. Thus, even though funds extended in the term funds market are of a very short maturity, no one was sure if they’d get anything back.
We all remember that time. To most of us, there was an uneasy feeling, but of exactly what we weren’t sure. Major world financial institutions on the other hand, being players, feared they might not see another sunrise. They knew the implications. In what is called a "flight to quality" they sought shelter in short term US obligations - Treasury bills. These offered the least specific credit risk (visited earlier) of anywhere else in the world and no inflation risk. Recalling our anchor, prices erupted, and yields plummeted, so that the 90 Tbill yielded a tick or two away from 0%!
Next, the Fed came to life, pumping money into the system. To do this they target Fed Funds, the O/N rate in the term funds market, as a gauge of tension. The rate had been 2% end of Q3; the Fed cut it to 0.25%, effectively 0%. This means one thing - all the money you guys need is there for the taking. But, it did not help. It was, like the old saying goes - pushing on a string.
Finally, G-20 central banks guaranteed inter-bank transactions. Slowly, normalcy returned to the world’s liquidity situation. Since that time, the Fed has expanded its balance sheet, buying practically anything under the sun - they can buy a herd of longhorn steers if they want The Fed is using its balance sheet to support the housing market and economy generally (a process effective over the near term but fraught with danger).
This brings us conveniently to the Yield Curve - the pattern of US interest rates from O/N to 30 years. This is a very handy tool. We should all keep an eye on it. In Jan/08, FF’s were 3.5%, 90 day LIBOR (another short-term measure) was 3.31%, the 2 yr Treasury 2.19%, the 10yr 3.56% and the 30 yr 4.27%. At this writing, FF’s at 0.14%, 90 day LIBOR is 0.25%, the 2 yr, 0.85%, the 10 yr 3.55% and the 30 yr, 4.48%. Whoa! Quite a story this gives up. Observe how short rates out to 2 yrs are in the cellar compared to the period just ahead of sub-prime concerns, yet observe how the 10 and 30 yr yields are near the same levels. Given what we learned earlier what does this tell us? Easy. Everyone in the world wants to own short paper as is obvious by the exceptionally high prices, thus negligible yields. We know why. No one is investing, no one is hiring. Most are content to sit on it. Keep it short and safe. What about the long end, 363 basis points (a b.p. =’s one hundredth of 1%) over the 2 yr vs only 208 in Jan/08? That tells us that because short term rates are so cheap, the world’s markets are beginning to price in inflation, that is, an expansion of that component in the summary yield. This is the message of a steeper yield curve. This is not reality necessarily but consensus anticipation of reality, right now. The 30 year is cheaper (lower price, higher yield) than it was almost two years ago, but the economy is weaker. This should be the other way around should it not? If this situation continues, it will be a read flag to the Fed; for the moment however, the recovery is too fragile for the Fed to begin to reverse its past actions.
In the next and final sketch of this series we’ll look at more practical considerations, a tad closer to home.
Robert Craven
The Term Funds market is the largest slush fund in the world. This is where US banks come to take care of business. Some banks are flush, some banks are short; they work things out. All banks have reserve requirements to meet and other short-term needs. Here is where they come to fund these liabilities. Maturities are from o/n to two weeks, some even longer. Banks lend/borrow to/from one another, without collateral. This is the heart of bank liquidity. Early Q4, 2008 this market seized up; it locked in place. As a result we were only weeks away from a free fall, one which would have made the Great Depression look like a party. Only thanks to the G-20's quick maneuvering were we spared.
In Q4, trust vanished. No single world institution trusted any other (notwithstanding decades worth of relationship). No one knew just how poisoned collateralized mortgage paper really was, or, who owned how much of it. The banks lied to each other, and, to regulators. Thus, even though funds extended in the term funds market are of a very short maturity, no one was sure if they’d get anything back.
We all remember that time. To most of us, there was an uneasy feeling, but of exactly what we weren’t sure. Major world financial institutions on the other hand, being players, feared they might not see another sunrise. They knew the implications. In what is called a "flight to quality" they sought shelter in short term US obligations - Treasury bills. These offered the least specific credit risk (visited earlier) of anywhere else in the world and no inflation risk. Recalling our anchor, prices erupted, and yields plummeted, so that the 90 Tbill yielded a tick or two away from 0%!
Next, the Fed came to life, pumping money into the system. To do this they target Fed Funds, the O/N rate in the term funds market, as a gauge of tension. The rate had been 2% end of Q3; the Fed cut it to 0.25%, effectively 0%. This means one thing - all the money you guys need is there for the taking. But, it did not help. It was, like the old saying goes - pushing on a string.
Finally, G-20 central banks guaranteed inter-bank transactions. Slowly, normalcy returned to the world’s liquidity situation. Since that time, the Fed has expanded its balance sheet, buying practically anything under the sun - they can buy a herd of longhorn steers if they want The Fed is using its balance sheet to support the housing market and economy generally (a process effective over the near term but fraught with danger).
This brings us conveniently to the Yield Curve - the pattern of US interest rates from O/N to 30 years. This is a very handy tool. We should all keep an eye on it. In Jan/08, FF’s were 3.5%, 90 day LIBOR (another short-term measure) was 3.31%, the 2 yr Treasury 2.19%, the 10yr 3.56% and the 30 yr 4.27%. At this writing, FF’s at 0.14%, 90 day LIBOR is 0.25%, the 2 yr, 0.85%, the 10 yr 3.55% and the 30 yr, 4.48%. Whoa! Quite a story this gives up. Observe how short rates out to 2 yrs are in the cellar compared to the period just ahead of sub-prime concerns, yet observe how the 10 and 30 yr yields are near the same levels. Given what we learned earlier what does this tell us? Easy. Everyone in the world wants to own short paper as is obvious by the exceptionally high prices, thus negligible yields. We know why. No one is investing, no one is hiring. Most are content to sit on it. Keep it short and safe. What about the long end, 363 basis points (a b.p. =’s one hundredth of 1%) over the 2 yr vs only 208 in Jan/08? That tells us that because short term rates are so cheap, the world’s markets are beginning to price in inflation, that is, an expansion of that component in the summary yield. This is the message of a steeper yield curve. This is not reality necessarily but consensus anticipation of reality, right now. The 30 year is cheaper (lower price, higher yield) than it was almost two years ago, but the economy is weaker. This should be the other way around should it not? If this situation continues, it will be a read flag to the Fed; for the moment however, the recovery is too fragile for the Fed to begin to reverse its past actions.
In the next and final sketch of this series we’ll look at more practical considerations, a tad closer to home.
Robert Craven
Wednesday, December 16, 2009
Interest Rates II
We continue with interest rates.
All of us encounter interest rates, either as borrowers or as creditors (investors) or both. And for a lot of us, casualty is a big mystery. What forces move these things? Greenspan for example and other "experts" make them out to be nothing if not bewildering. But in fact the basics are not bewildering at all. We can fetch all the tools we need to make our lives more comfortable around and about interest rates.
Before we can translate economic activity into interest rates we need to know the fundamentals; we’re not launching a satellite here folks, just developing an anchor. After we have done that, we can take a look at a real life petri dish, the breakdown of Q4, 2008, and the follow through. We hope to acquire some tools in the process.
What is interest? It is in fact an aggregate composed of three elements. First, the pure or base rate, second, the inflationary premium (or lack of) and finally, the credit risk, that is, risk of default specific to the debtor. Assume you own the debt (bonds) of a corporation. The maturity is 10 years and the coupon is 6%. Of that 6%, perhaps 3% is the base, or fair rate at which, all else equal, you will lend money to a near riskless credit, and that borrower will pay for the privilege. That leaves 3%. One and one half percent assume is due to inflationary expectations, that is, the expected corrosion in value due to a weakening currency that you will demand over 10 years. Finally, the remaining 1 ½ % is credit risk, that risk the market has assigned to the probability that the borrower which owes you money, will fail. This all adds up to 6%. The calculation, the process is usually more complex; we don’t care. For our purpose, this is enough.
Next, we must understand how the movement in interest rates impacts debt prices. Very simple - interest up, price down / interest down, price up. Back to our example - bonds at 6%. Assume you are the owner of one bond (usually in denominations of $1000). The coupon of 6% pays $60 annually. You decide to sell, not waiting for maturity. But assume a recession has interceded so that interest rates are now 3% for similar credits. Only a fool would give the buyer $60 a year or 6% when the market rate is 3%. You adjust the bond price and demand $2000. The $60 coupon now yields 3%. That’s all there is to if folks. This is the core or heart of the process.
Institutional markets trade interest rate-bearing instruments regularly, in billions of dollars equivalent every day. These trades, no matter how complex, always adhere to the two rules above. It is instructive to look at a few of these. For example, speculators may sell short US treasuries if they believe interest rates are headed higher (interest up, price down) with the intent to buy back the bonds cheaper at a profit. Easy. Here they are targeting the inflation component noted earlier. Or, major world banks may trade interest bearing instruments relative to one another, so-called spread trades. For example, if Morgan believes that the recovery in the UK will significantly lag that in the US, Morgan will buy UK Gilts (gov’t bonds) and sell US Treasuries. The bank (speculator) does not know where UK or US interest rates are going outright and doesn’t need to. All it needs to make a profit is for US rates to move higher, quicker than those counterparts in the UK (in this case, presumably because the US recovery will pressure rates higher, faster - the bet). This trade then focuses on relative inflation. US debt prices will fall faster than UK debt prices so the bank will make more on the US side than it loses on the UK side. Easy. Finally, a speculator may expect Germany to be downgraded as a result of the recent financial turmoil. He will buy US debt and sell Euro debt, with no particular view to relative growth at all, but specifically to creditworthiness, expecting Euro debt prices to fall relative to US as soon as the downgrade becomes reality. Here the target is the credit risk, the other of our three components.
So it’s not so tough after all, understanding interest rates and price movement. We’re getting there, that is, closer to acquiring the tools we need to make our own decisions about interest rates and our investments.
In the next sketch we will look at the near meltdown in the world debt/interest rate markets, Q4, ‘08. That process will further assist our own ends, which reside much closer to home.
Robert Craven
All of us encounter interest rates, either as borrowers or as creditors (investors) or both. And for a lot of us, casualty is a big mystery. What forces move these things? Greenspan for example and other "experts" make them out to be nothing if not bewildering. But in fact the basics are not bewildering at all. We can fetch all the tools we need to make our lives more comfortable around and about interest rates.
Before we can translate economic activity into interest rates we need to know the fundamentals; we’re not launching a satellite here folks, just developing an anchor. After we have done that, we can take a look at a real life petri dish, the breakdown of Q4, 2008, and the follow through. We hope to acquire some tools in the process.
What is interest? It is in fact an aggregate composed of three elements. First, the pure or base rate, second, the inflationary premium (or lack of) and finally, the credit risk, that is, risk of default specific to the debtor. Assume you own the debt (bonds) of a corporation. The maturity is 10 years and the coupon is 6%. Of that 6%, perhaps 3% is the base, or fair rate at which, all else equal, you will lend money to a near riskless credit, and that borrower will pay for the privilege. That leaves 3%. One and one half percent assume is due to inflationary expectations, that is, the expected corrosion in value due to a weakening currency that you will demand over 10 years. Finally, the remaining 1 ½ % is credit risk, that risk the market has assigned to the probability that the borrower which owes you money, will fail. This all adds up to 6%. The calculation, the process is usually more complex; we don’t care. For our purpose, this is enough.
Next, we must understand how the movement in interest rates impacts debt prices. Very simple - interest up, price down / interest down, price up. Back to our example - bonds at 6%. Assume you are the owner of one bond (usually in denominations of $1000). The coupon of 6% pays $60 annually. You decide to sell, not waiting for maturity. But assume a recession has interceded so that interest rates are now 3% for similar credits. Only a fool would give the buyer $60 a year or 6% when the market rate is 3%. You adjust the bond price and demand $2000. The $60 coupon now yields 3%. That’s all there is to if folks. This is the core or heart of the process.
Institutional markets trade interest rate-bearing instruments regularly, in billions of dollars equivalent every day. These trades, no matter how complex, always adhere to the two rules above. It is instructive to look at a few of these. For example, speculators may sell short US treasuries if they believe interest rates are headed higher (interest up, price down) with the intent to buy back the bonds cheaper at a profit. Easy. Here they are targeting the inflation component noted earlier. Or, major world banks may trade interest bearing instruments relative to one another, so-called spread trades. For example, if Morgan believes that the recovery in the UK will significantly lag that in the US, Morgan will buy UK Gilts (gov’t bonds) and sell US Treasuries. The bank (speculator) does not know where UK or US interest rates are going outright and doesn’t need to. All it needs to make a profit is for US rates to move higher, quicker than those counterparts in the UK (in this case, presumably because the US recovery will pressure rates higher, faster - the bet). This trade then focuses on relative inflation. US debt prices will fall faster than UK debt prices so the bank will make more on the US side than it loses on the UK side. Easy. Finally, a speculator may expect Germany to be downgraded as a result of the recent financial turmoil. He will buy US debt and sell Euro debt, with no particular view to relative growth at all, but specifically to creditworthiness, expecting Euro debt prices to fall relative to US as soon as the downgrade becomes reality. Here the target is the credit risk, the other of our three components.
So it’s not so tough after all, understanding interest rates and price movement. We’re getting there, that is, closer to acquiring the tools we need to make our own decisions about interest rates and our investments.
In the next sketch we will look at the near meltdown in the world debt/interest rate markets, Q4, ‘08. That process will further assist our own ends, which reside much closer to home.
Robert Craven
Monday, December 14, 2009
Interest Rates
We thought it very timely to comment on interest rates. This sketch is the first of a series. The topic is sure to put a bunch of folks quickly to sleep; the irony of course is that we’re all impacted one way or the other by these pesky little things. They’re key stuff. The better grasp we have as to causality and direction, the better shape our personal balance sheets.
OK. Where to start? How about the near meltdown of Q4, 2008? We all remember that. The guy down the road with three cars up on blocks in his front yard, falls behind in his mortgage payments, and the economy of Iceland implodes. Whoa now! I'm missing a few pieces of this puzzle myself, but hey, that about wraps it up.
A lot of lousy mortgages were handed out to this guy and his drinking buddies. P.J. O’Rourke, always the tutor, takes it from there: "Wall Street looked at the worthless paper and thought, ‘How can we make a buck off this?’ The answer was to wrap it in a bow. Take a wide enough variety of lousy mortgages--some from the East, some from the West, some from the cities, some from the suburbs, some from shacks, some from McMansions–bundle them together and put pressure on the bond rating agencies to do fancy risk management math, and you get a ‘collateralized debt obligation’ with a triple-A rating. Good as cash. Until it wasn't."
So that was a shock of the first order. Indeed, come mid-Dec/08 we find Fed Funds at 0.25%, the 2yr Treasury at 0.92%, the 10 year at 2.10% and the 30 yr at 2.60%; these were collapsed levels. Why? And, we find the dollar in the cellar, one Euro buying $1.4446. But so what? What’s all this mean? What’s "Fed Funds" and what’s the two year? Why should we care? And the Fed was up to something then too. What was it?
Change was compressed into a very brief time frame during this period. This provides a useful lab for us to fetch a notion of the dynamics impacting interest rates, our single purpose in this exercise. Once we do that we can develop a view for the direction of interest rates, the course of least resistance over the near term. Better than a stick in the eye any day.
Robert Craven
OK. Where to start? How about the near meltdown of Q4, 2008? We all remember that. The guy down the road with three cars up on blocks in his front yard, falls behind in his mortgage payments, and the economy of Iceland implodes. Whoa now! I'm missing a few pieces of this puzzle myself, but hey, that about wraps it up.
A lot of lousy mortgages were handed out to this guy and his drinking buddies. P.J. O’Rourke, always the tutor, takes it from there: "Wall Street looked at the worthless paper and thought, ‘How can we make a buck off this?’ The answer was to wrap it in a bow. Take a wide enough variety of lousy mortgages--some from the East, some from the West, some from the cities, some from the suburbs, some from shacks, some from McMansions–bundle them together and put pressure on the bond rating agencies to do fancy risk management math, and you get a ‘collateralized debt obligation’ with a triple-A rating. Good as cash. Until it wasn't."
So that was a shock of the first order. Indeed, come mid-Dec/08 we find Fed Funds at 0.25%, the 2yr Treasury at 0.92%, the 10 year at 2.10% and the 30 yr at 2.60%; these were collapsed levels. Why? And, we find the dollar in the cellar, one Euro buying $1.4446. But so what? What’s all this mean? What’s "Fed Funds" and what’s the two year? Why should we care? And the Fed was up to something then too. What was it?
Change was compressed into a very brief time frame during this period. This provides a useful lab for us to fetch a notion of the dynamics impacting interest rates, our single purpose in this exercise. Once we do that we can develop a view for the direction of interest rates, the course of least resistance over the near term. Better than a stick in the eye any day.
Robert Craven
Friday, December 11, 2009
Spending
This economy continues to work miracles. Today we received Nov Retail Sales which at + 1.3% were about double expectations. The gains were relatively broad based, led by sales of gasoline and of vehicles, but most spending categories improved.
Whoa! Consumers continue to spend amid high unemployment, relatively stagnant income growth, rising foreclosures, high energy costs and tight credit. In several past blogs, including the last we cautioned that sales would linger along with lingering unemployment. Consumers are not going gang busters for sure but they're a heck of a lot more active than we expected them to be.
Robert Craven
Whoa! Consumers continue to spend amid high unemployment, relatively stagnant income growth, rising foreclosures, high energy costs and tight credit. In several past blogs, including the last we cautioned that sales would linger along with lingering unemployment. Consumers are not going gang busters for sure but they're a heck of a lot more active than we expected them to be.
Robert Craven
Tuesday, December 8, 2009
A Self-Inflicted Wound
We’ve highlighted in past blogs just why this recovery lacks steam, contrasting it unfavorably to others during this country’s recent economic history. Indeed, there are certainly sectors which have shown renewed vigor, past few months; still, that sector most important to income and spending power - employment, the real engine - lags the rest. Let’s take a look.
We received the key Nov employment report on Dec/4. Results were rosier than expected. Jobs fell by the smallest amount of this recession. Also, the prior two months were revised to show much smaller job losses, indicating that there has indeed been improvement, meaning - slower deterioration. Although 7.156MM jobs have been destroyed since the beginning of the recession (Dec/07) the pace of job losses has slowed dramatically over the past 6 months.
Does this mean we have been wrong about jobs as a retardant, and wrong to pin the cause on the obvious - the left’s invasive agenda? Of course not. In other recoveries the jobs sector was much more vigorous. Not this time. Despite the relatively good news Dec/4, the level of employment remains at its lowest level since Mar/04. That is not to say that this economy is not working near-miracles in the act of resuscitation. It is indeed. It will just take a heck of a long time to recover all those lost jobs. Why? Nobody, we mean nobody, is excited to hire.
For example, Dan DiMicco, CEO of steelmaker Nucor Corp, told the WSJ that, "‘Companies large and small are saying, ‘I am not going to do anything until these things - health care, climate legislation - go away or are resolved.’" We also hear from Porta-King CEO Steve Schulte who told USA Today that his company is not investing because, "proposals in Congress to tackle climate change and overhaul health care would raise costs." Fred Lampropoulos, founder and chief of Merit Medical Systems Inc., told Obama that businesses were uncertain about investment because, "there’s such an aggressive legislative agenda that businesspeople don’t really know what they out to do." That uncertainty, he said, "is really holding back jobs."
So you can be a lefty and own a business, just don’t complain when you see your gross off 30%. This is a self-inflicted wound. Your party's footprints are all over Ground Zero, getting us into this mess; now you're making it all the more difficult to get us out. Shameful.
Robert Craven
We received the key Nov employment report on Dec/4. Results were rosier than expected. Jobs fell by the smallest amount of this recession. Also, the prior two months were revised to show much smaller job losses, indicating that there has indeed been improvement, meaning - slower deterioration. Although 7.156MM jobs have been destroyed since the beginning of the recession (Dec/07) the pace of job losses has slowed dramatically over the past 6 months.
Does this mean we have been wrong about jobs as a retardant, and wrong to pin the cause on the obvious - the left’s invasive agenda? Of course not. In other recoveries the jobs sector was much more vigorous. Not this time. Despite the relatively good news Dec/4, the level of employment remains at its lowest level since Mar/04. That is not to say that this economy is not working near-miracles in the act of resuscitation. It is indeed. It will just take a heck of a long time to recover all those lost jobs. Why? Nobody, we mean nobody, is excited to hire.
For example, Dan DiMicco, CEO of steelmaker Nucor Corp, told the WSJ that, "‘Companies large and small are saying, ‘I am not going to do anything until these things - health care, climate legislation - go away or are resolved.’" We also hear from Porta-King CEO Steve Schulte who told USA Today that his company is not investing because, "proposals in Congress to tackle climate change and overhaul health care would raise costs." Fred Lampropoulos, founder and chief of Merit Medical Systems Inc., told Obama that businesses were uncertain about investment because, "there’s such an aggressive legislative agenda that businesspeople don’t really know what they out to do." That uncertainty, he said, "is really holding back jobs."
So you can be a lefty and own a business, just don’t complain when you see your gross off 30%. This is a self-inflicted wound. Your party's footprints are all over Ground Zero, getting us into this mess; now you're making it all the more difficult to get us out. Shameful.
Robert Craven
Subscribe to:
Posts (Atom)
