My Diary 372 --- Staying With Short, Checking the Fed, Knowing t

My Diary 372 --- Staying With Short, Checking the Fed, Knowing the Unknown

January 28, 2008

For all the drama in markets and policy front over the past week, it seems inter-meeting cut has only given some temporary relief to the global stock market, which is still suffering from recession fears, instead of rejoicing the Fed’s 75bp +50bps rate cut and a possible bailout of bond insurers by regulators. Asian markets today fell due to rumor of more European Banks in trouble. Our regional major benchmarks set for the biggest monthly decline since 911 with even SHCOMP down 7.19%, NIKKEI fallen 3.97% and HSI losing 4.25%. Bonds fell with 2yr@2.13 and 10yr@ 3.54, while gold topped $918/lb. The US Dollar weakened to EUR1.4709 and YEN106.52.

So is Bernanke the white knight in shining armor or is his desperate move too late to stave off the US recession that markets assume we already have? I am concerned that the Fed will not be able to solve all the woes so easily and that we may still have some further pain on credits. Current fed funds futures are pricing in a 95% chance of 100bps or more of cuts by April. That seems way too aggressive, given inflation concerns, but with Bernanke's clear panic, perhaps it is what is about to happen.

A recession may certainly be underway, but the real answer won't be known for a couple of months. Markets are surely assuming a recession and more importantly a deep one, so from a valuation standpoint I have to wonder if most of the bad news is already priced in? 

There is a lot of interesting ground to cover, let us get started with our US mess, but please note that China's heaviest snowstorms in five decades crushed homes, grounded flights, disrupted electricity and left hundreds of thousands of travelers stranded, a week before millions take to the roads for CNY.

Staying With Short

I seem to recall a period in 2003 where the market was abuzz with rumors of deflation amidst a bout of slow economic growth.  The Fed was purportedly considering an attempt to twist the yield curve and pursue "non-traditional" monetary policy approaches. What has changed and what are the risks? Clearly the US outlook is far worse now than in 2005, but that is offset by better fundamentals of EM countries to face this recession.

Having said so, the US economy may well be in much worse condition that the  market initially realized or admitted, and we still do not have good information about how much subprime garbage was out there and where it would show up. Thus, it's still early to tell whether the US economy will face a V or U shaped recession, but valuations and risk-reward is becoming more balanced, especially if the V shaped scenario plays out.

Talking about bad shape, I do not believe that there is enough data to automatically assume that the US will face a deep recession but rate cuts although helpful inevitably take time to bite and won't improve market sentiment on its own unless data supports a softer economic landing than is currently assumed. The extreme volatility we have seen both ways in recent days is symptomatic of a shift in overall sentiment, at least for the near term. 

USTs have been in rally mode since the end of Dec with yields on the 5yr UST falling in a straight line and the market is expecting more sell off to continue into next week as we head into the FOMC meeting. Regardless of accusations that Mr. Ben jumped the gun by going 75bps earlier last week, the Fed will go 50bps at the end of this month. They have started down this path and with their credibility under threat, they have to get in front of this problem now. There has been considerable coverage given to the view that the Fed were duped into their 75bps move by the unwind of the Soc Gen rogue traders equity futures positions, and therefore they will be more hesitant to move 50 at the next meeting. I don't buy into that.  To reverse their ultra aggressive stance on monetary policy and disappoint the market with either no move or a 25bps would be disastrous for the Fed's already shredded credibility.  Based on this assessment, equities are going to continue to rally and bond are going to remain under pressure. 

The week ahead will probably be another volatile one, with the focus on the US FOMC meeting and rate decision due out on Wednesday. The market has been fluctuating between expectations of a 25bp and a 50bp rate cut, with the latest US federal funds futures data by Bloomberg indicating a higher probability (70%) of a 50bp versus a 25bp (30% probability) cut. In addition, much key economic data in the US, such as new home sales, ISM, and non-farm payroll, are to be released, which could result in further big moves in the market. A slew of month-end data from various Asian economies, including trade and CPI numbers, should provide further indications on the impact of a slowing US economy.

One point to add here is that BOA and Wells Fargo’s numbers reflected a broad deterioration in US asset quality and stress on more than just the US sub-prime customer. Moreover, two significant new pieces of information regarding the bail-out of monoline insurers and the creation of  the last resort in mortgage market by setting up a Federal Homeownership Preservation Corporation still seems sketchy and no one can be sure that these entities are going to prevent a prolonged recession.

Bottom_line: in the near term, we will see further pressure on markets as US macro data is likely to deteriorate furthera and this will keep volatility high...... Staying with short ....

Checking the Fed

After hiking for the final time at the June 2006 FOMC meeting, the Fed went on hold for 15 months before easing, the longest such period following a tightening cycle since 1980.  But the Fed clearly burst the housing bubble over 2006-07.

Certainly, I am not in any camp who want to critize the Fed by surpring the market with 75bps cut. But it was the largest reduction in the lending rate since the Fed began using it as its main policy target in 1988 in the wake of the October 1987 stock market crash. The action occurred even though outside of the financial markets, the recent flow of economic news (Michigan Confidence and Initial Job Claims), has been more in line with a period of slow growth than a  deep recession -- whatever the stock market thinks. Now with the sudden 75bps cut, the Fed is throwing fuel on the volatile market fire by being part of the panic rather than part of the solution. 

In this perspective Mr. Ben is behaving in a re-active ( while Alan Greenspan was to lead the market) and has been forced into a corner over another 50bp easing this week, which begs the question why they didn't do 125bp all at once...Does a  week make so much difference in monetary policy?  If the Fed's so worried about  equities why don't they buy them...that's what HKMA and BoJ have done in the past.  If they're not worried about equities, why the emergency easing and in such strong fashion?  In the words, it makes no sense... Maybe Fed really knows the markets don’t know...... go to the next note......

Knowing the Unknown

According to the Bloomberg, the monoline insurance companies like Ambac and MBIA are in worse shape than most realize ($200bn capital needed to maintain AAA rating), the counter-party risk in the $45 trillion CDS market is much worse than we realize, and the exposure by various banks to their problems is much larger than currently understood. It seems that the Fed understands this, and realizes that they have been behind the curve but need to catch up.

Quoting the BBG statistics, MBIA's total exposure to bonds backed by mortgages and CDOs was disclosed to be $30.6 billion, including $8.14 billion of holdings of CDO-squareds. You can easily bet that the $8 billion in CDO-squareds is gone. It is a matter of time and MBIA's market cap is about $1.78 billion with its stock, which traded just under $68 per share last October, dropped to $14 per share. In addition, MBIA was being priced as a weak CCC-rated credit when it issued its bonds last week. It is now being priced for a bankruptcy. The performance of MBIA's 14% bond issue will prove to have been the death knell for this business. Yes, MBIA is still rated AAA. Ratings downgrades are just a matter of time.

And that is just the credit default swaps (CDSs) from the monolines. What about the trillions that are guaranteed by banks and hedge funds? There are a total of $45 trillion CDSs outstanding. No one is really sure who owes what and to whom, and what is the risk that there may be no one to pay that CDS when it comes due? The entire mess is going to have to be unwound in the coming quarters. It may take a year or more.

According to Paul Fenner with Barclays Capital, banks that raised $72 billion to shore up capital depleted by subprime-related losses may require another $143 billion should credit rating firms downgrade bond insurers. Barclays' estimates are based on banks holding as much as 75% of the $820 billion of structured securities guaranteed by bond insurers. Looking at different angle, banks will need at least $22 billion if bonds covered by insurers, led by MBIA Inc. and Ambac Assurance Corp., are cut one level from AAA, and 6X more than that for downgrades by four steps to A.... Who is going to throw in more money, GIC, CIC or S(aud)IC.....

So coming back tot the Fed recent Fed cut, If the market is wrong and the Fed was responding to the stock market, then we will likely not see a cut this next week. But if we get another 50bps cut, as I think we will, then it means the Fed is responding to concerns about the credit crisis. And we will get more down the road, maybe until 2% or below.

Good night, my dear friends