Bond Market Update
by Brad Tottle
Gimme Shelter
November 17th, 2008
It’s true; certain barometers of the credit market have shown improvement over the last four weeks. 3-month LIBOR has fallen from 4.82% to 2.24%. As a result both the TED spread and the LIBOR/OIS spread (see chart) have come in from their respective peaks yet remain highly elevated to historical norms. The commercial paper market expanded, thanks to the purchases by the Federal Reserve. Credit spreads came in as asset allocation trades and a hint of risk taking crept into the market. Yet, all of this improvement happened since the passage of the Troubled Asset Relief Program, or TARP, that was to be used to purchase troubled assets from the banks in order to allow them to recapitalize and increase lending. This seemed good in theory but the basic problem was the price; meaning, at what price would the taxpayers not get hurt, while also affording the banks to deleverage in an orderly fashion? In reality there was no price at which the government could step in and accomplish this since some banks with large exposures were holding them at hold-to-maturity valuations. Even the investment banks that had to mark their loans to a model or a market (if possible) still would not likely get in line to take a substantial hit to their already depleted capital since the government price would most likely be meaningfully below their held values.
The Treasury tried to pave the way for some of the losses to be taken by using a portion of TARP funds to directly inject capital into the “Divine 9.” But the Treasury Secretary announced last week that due to the rapid deterioration in both the commercial paper market, and now the asset-backed securities market, the TARP funds were going to be more devoted to purchases in these dysfunctional markets as well as used to support a broader scope of potential firms other than money center banks. Many firms are jostling for position under the protective cover of the TARP and access to the federal tap. Investment banks becoming commercial banks, financial companies like American Express following suit as of last week. Some insurers like The Hartford, Genworth, and Lincoln Financial are buying small banks and applying for savings & loan holding company status in order to get access to federal funds while broadening their funding base via deposits. AIG and Freddie Mac need more help than initially thought and now the automakers are coming to Washington with hat in hand. Clearly the TARP is getting a bit... stretched. The Federal Reserve has done its fair share of the heavy lifting through rate cuts, larger repos, and its ever-expanding facilities. Let’s review, shall we? So far we have the Term Auction Facility (TAF), Primary Dealer Credit Facility (PDCF), the Term Securities Lending Facility (TSLF), the Asset Backed Commercial Paper and Money Market Mutual Fund Liquidity Facility (????), the Commercial Paper Funding Facility (CPFF) and the Money Market Investor Funding Facility (MIFF). Also put in place were vast currency swap lines with other central banks to aide in the fight against the current financial pandemic. Not to be outdone, the FDIC has stepped into the fray with its Temporary Liquidity Guarantee Program, which serves as a backstop for any new bank holding company debt issued, between October 14th and June 2009, yet another big motivation to become a bank/S&L holding company. Even General Electric’s financial unit GE Capital Corp figured out a way to access the program through its ownership of an industrial loan company and a federal savings bank. Guaranteeing bank debt could have unintended consequences in the overnight funds market which would only serve to undermine the recent improvement in the inter-bank market. Also, existing debt would have to be reevaluated even with the guarantee as the companies’ obligations increase and there is another hand in front of existing claims.
All of these steps have been taken to foster more liquidity in a market that froze in the wake of Lehman. I have said in the past what makes this credit crunch much more intense than anything else we have seen is that we are dealing with a lack of confidence in collateralized debt, as opposed to only unsecured debt and that the reliance on cheap and easy short-term funding has hit a wall. Our propensity as a nation to rely heavily on credit to live our lives only serves to amplify the problem. And so when I see modest improvements in the credit markets I try and allow myself to believe that the worst is behind us but unfortunately I do not believe that to be the case. That is mainly because the underlying problem of troubled assets on the balance sheets remains and as such, credit growth is likely to remain suppressed from normal levels for quite some time. The fourth quarter could contain even more writedowns, pressuring spreads back towards the wides of October. Simply put, credit cycles happen in quarters and years not weeks and months. We have begun a new deleveraging phase where credit is contracting while also becoming more expensive which could persist well into the next several years. Given the lagged effect of changes in the credit cycle we can only guess how much growth and spending will contract, as the bank’s purse strings stay pinched. The new administration will have to address the troubled housing market head on and most likely implement another stimulus plan in order to try and change the trajectory we are on. It would appear that We, the People have to save We, the People, for better or worse. In the meantime while we debate over what is fair and unfair and who is to blame the government will have to continue being the lender of last resort and the cheese that stands alone on the buy side.
As discussed in the last Bond Market Update the funding for many of the aforementioned steps will come in the form of fresh treasury supply. Last week the Treasury auctioned off $20 billion in 10-year notes and re-opened the existing 30-year for another $10 billion. The 10-year auction went fairly well with only a small yield tail to where the pre-market screens indicated. The 30-year however tailed by 11 basis points with over 80% allotted at the high yield of 4.31%. The bid to cover was the lowest since February 2006. This sent back-end rates soaring as investors started to come to grips with the reality that supply could outstrip demand. But Friday saw a sharp reversal as mortgages and agencies weakened and investment grade spreads inched wider in light trading. The street wanted to play it safe into the weekend meeting of the G-20. Still, with fear and loathing dominating the front-end of the curve while supply and (eventually) inflation looming in the back-end the steepness of the yield curve, specifically the yield spread between 2s and 10s, could far surpass the steepest levels seen during the last two curve steepening phases. While there has been a bout of profit taking in the steepener trade as of late the pullback really only stands as a fresh entry point into further steepening.
Fed Cuts But Supply Looms
November 3rd, 2008
As expected, the Federal Open Markets Committee cut its benchmark overnight rate 50 basis points to 1%, citing a slowing in economic growth due to a decline in consumer spending. The Fed directly acknowledged the ongoing downside risks to growth in the wake of the credit freeze by stating that, “...the intensification of financial turmoil is likely to exert additional restraint on spending, partly by further reducing the ability of households and business to obtain credit.” Perhaps more surprising was the rate cut by the Bank of Japan on Friday in response to slowing growth. The Bank of Japan originally seemed reluctant to follow suit with the global easing initiative already seen by the ECB and the Bank of England since its target rate was already at 50 basis points. The rate cut was an odd 20 basis points instead of a full quarter, suggesting that the BOJ is trying to leave room for another rate cut if needed without putting the target at zero. The Fed’s rate cut didn’t come as a shock given the effective fed funds rate had traded at or below the 1% level quite regularly as of late. Yields actually rose on the week as the street began adjusting for what is sure to be a large ramp up in Treasury issuance. Even Treasury Undersecretary Anthony Ryan stated early in the week “This year’s financing needs will be unprecedented.” With most estimates expecting the supply to come in the back end of the curve that was the area that saw the largest shift in yields with 10 & 30-year yields both up roughly 27 basis points on the week. The Securities Industry and Financial Markets Association (SIFMA) estimates that this quarter’s Treasury supply will likely be triple that of last quarter with an estimated $388 billion hitting the street. Due up this week will be auctions for $18 billion in new 10-year Treasuries and a $7 billion re-opening of the current 30-year.
New Treasury supply will certainly pressure yields higher, but by how much depends on two factors; new issuance in other areas of the bond market and foreign demand. The first factor seems intuitive; there will most likely be lower corporate new issuance than what we saw this year (and certainly less than the blockbuster year of 2007) and mortgage issuance is likely to stay subdued until housing shows signs of recovery. Of course, there could be a refinancing-induced wave of supply, but this would require long-end rates to stay relatively low. In either event, the lack of supply in other markets will likely offset some of the supply from Treasury but only partially at best. The bigger factor that will influence rates is whether or not foreign investment will continue to flow into Treasuries at a time when growth prospects look dim, deficit spending looks ominous, and let’s face it, those countries who have historically been large purchasers of our debt are facing problems of their own. If the big foreign central banks have to take a more defensive posture at home, it means lower reserves to invest abroad. Such large supply could raise rates and cheapen the dollar thus raising the question; how exactly will this stop the asset deflation in the US? Simply put the government is returning to Keynesian undertones in that it must spend to promote others to spend. In the wake of the credit freeze the Treasury is finding that it must also invest so that others invest, whether it is equity interests, direct capital infusions or commercial paper purchases. Just last week we saw the first auction of the Fed’s new Commercial Paper Financing Facility (CPFF) during which the Bank of New York purchased $144 billion in 30-day commercial paper ranging from financial to asset-backed. The Fed expects to continue to expand this facility upwards of $1 trillion in the hopes that by them buying they will bring back the largest buyers of commercial paper, the money funds who continue to boycott new issuance amid a wave of withdrawals. It does appear that the mass exodus has slowed from the money funds but it will take some more time to see just how effective the CPFF is at bringing back the buyers, especially since the Fed is purchasing the paper below market rates, essentially “crowding out” the natural buyers (the 2a7 money market mutual funds). Speaking of those natural buyers, they will be getting their own relief facility to encourage term extension in money market assets. The Federal Reserve will implement its Money Market Investor Funding Facility (MMIFP) through which it will purchase money market assets from 2a7 money market mutual funds in exchange for subordinated asset-backed commercial paper (ABCP). The sale of the subordinated ABCP, along with the secured lending from the Federal Reserve via the MMIFF, will fund the special purpose vehicle’s purchases from the money funds. This program is meant to complement the CPFF and help bring market rates down by acting as intermediary. The Fed is taking these two coordinated efforts straight to the heart of the short-term funding markets since the inability for even non-financials to fund themselves only serves to intensify the current slowdown, as they noted in their statement. Other facilities due this week will be the results for the 84-day Treasury Auction Facility and the Term Securities Lending Facility. The market will be keyed in to see if the need for general collateral changed markedly.
The week ahead carries the payroll/unemployment data, which is likely to remain unflattering. The Fed tends to follow the jobs market and so I thought it a good time to revisit a chart I have shown many times; The Fed Funds Target Rate Movements against Continuing Jobless Claims (graphed inverted). As continuing claims accelerate, the Fed has moved to an easing bias, even in past episodes where inflation was often cited as a concern. The Fed not only took rates down when continuing claims escalated but also kept them low until there was a sizeable drop in the claims data. This time should be no different and it does seem to leave the door open for more easing however implausible it may seem. Remember, just over 6 weeks ago we were still expecting the Fed to stay on hold into next year with a chance for a hike in the 1st or 2nd quarter. Of course, that was before the downfall of Indy Mac, Lehman, Wamu, the conservatorship of both GSEs and AIG, the proposed takeovers of Merrill Lynch and Wachovia and the subsequent equity market malaise. It seems that these days the old rulebook for what is possible and what seems improbable was written on an etch-a-sketch; gone in a flash amid a good shaking. As the bias remains for further accommodation and additional supply, the steepening bias in the curve should persist. The curve tried to flatten at the end of the week but the month-end re-allocation by large balanced funds (who were largely out of balance due to a flight to quality) re-enforced the steepening trend of late.
The author of this material is a Proprietary Trader/Desk Strategist in the Fixed Income Division of Raymond James & Associates, not a Research Analyst. Any opinions expressed may differ from opinions expressed by other divisions of Raymond James including our Equity Research Department and are subject to change without notice. The data and information contained herein was obtained from sources considered to be reliable, but Raymond James does not guarantee its accuracy and/or completeness. Neither the information nor any opinions expressed constitutes a solicitation for the purchase or sale of any security referred to herein. This material may include analysis of sectors, securities, and/or derivatives that Raymond James may have positions, long or short, held proprietarily. Raymond James may have also performed investment-banking services for the issuers of such securities. Investors should discuss the risks inherent in bond with their Raymond James Financial advisor. Risks include, but are not limited to, changes in interest rates, credit quality, volatility, and duration. Past performance is no assurance of future performance.
