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Wednesday, August 25, 2010


By Claus Vistesen: Copenhagen

Perhaps it would be a good time for investors and analysts alike to lean back and have a good bottle of Pinot Noir and let markets be markets. Surely, with the likes of Hindenburg Omens still getting its share of the tape and with the macro backdrop turning decidedly sour, it seems a prudent momen to kick back and just accept risk-off as it is.

And indeed, macro news has been awful lately. Both real economic and housing activity in the US have resumed their downward path, in Europe Ireland got a knock by the S&P, and in general hitherto positive voices have either retreated into the rabbit hole or turned very cautious. Basically, after leafing through a lot of independent as well as buy/sell side research I am pretty convinced that analysts and investors are in brace yourselves mode since they are all frontloading the recession/double dip theme; "You know, it MIGHT happen but we still don't think it will and even if it does happen, it is still a low probability event". This is called covering your a'' and the fact that many research houses who were formerly sure that the US would see no douple dip are now backtracking is significant in itself. Of course, this is understandable given the underlying change in the flow of economic data, but the real interesting there is that while their models do not support the idea of a double dip, the wording are tilted in favor of a return to recession in H02-10 (in the US; i.e. I think a recession in Europe is given). Personally, I welcome such deviance from models when circumstances call for it and even I have to admit that the economic picture in the US is very poor at the moment.

The only real straw which we are pinning our hopes on at the moment is that the Fed will step up and pull another trick out of QE-hat or that somehow Germany is going to save the world (and here). On the former, Tracy Alloway poured some cold water on that idea today and on the latter, someone forgot to tell these people that Germany actually depends on others to get their growth. We can always look to emerging markets someone would say, but the problem here is that momentum in H02-10 is almost certain to falter. I am not talking about recession of a slump but in relative terms and as the OECD still struggles to find even a positive rate of trend growth a slowdown in the emerging world will make itself felt.

For investors then, it seems that short of staying nimble and trying to scoop up some value as the market corrects lower, there is always the US bond bonanza to dig into. Now, I know that bonds look overbought and that yields are at all time low, but just understand that bonds may very rally even more and yields slump further. The suggestion made recently by David Rosenberg that the US yield curve might actually flatten from the long end is very important in my opinion as it indicates how the Fed is likely to continue intervening in this market. I recently asked a friend of mine what he thought of all this and he returned the following quote form a director of a fixed income strategy outfit;

Suppose the Congress controlled the production of all the lemons in US. Then assume the Federal Reserve decided that it was going to use its balance sheet to buy lemons as a means of adding liquidity into the market when times were tough. While the government ramped up lemon production during tough times, the Fed not only bought most of those lemons, but sent out a clear message that it stands ready to buy a whole bunch more lemons if the economy falters. Finally, suppose that the government started changing the rules and regulations forcing financial institutions to hold more lemons rather than limes - as lemons were deemed the only safe fruit. What happens to the price of lemons? The answer is a 2.50% 10 year note!

These are not "market prices". The Congress, Fed and Treasury are controlling the supply, demand and the rules of the game in the US government bond market. And make no mistake - lemon production is ripping higher. Eventually people will realize there are not enough Corona bottles to stuff those lemons into and there will be lemonade all over the streets. Until then, please remember that this will go down as one of the greatest examples government price control and manipulation in history. Maybe soon we will be lining up at 15th and Constitution in DC - at the doors of the Treasury on odd and even days depending on our birthdays - in order to buy limited supplies of those precious lemons!! There is a great book by two gentlemen from the Hoover institution. The stories span 10,000 years but they all have one thing in common - when governments distort asset prices, bad things happen. It is an easy and fun read. I encourage you to grab a copy.

Finally, it has been a humbling summer watching 10 year rates move to these levels. I remain steadfast in the view that we are at least 75 to 100bps expensive in long term rates. But with the supply, demand and rules fixed by the Fed/Treasury/Congress Troika, I probably should have been more prepared for this - mea culpa. In any case, I'll fall back on one of the better calls we have had and that is in MBS space where price manipulation is just as rampant. In fact, we can see that as the Fed has decided not to treat MBS like lemons anymore, they were quickly turned to lemonade. Once again my market screens are all red in MBS - days with 5yr futures down 5 tics and FBCL6.5s down 11 tics are amazing to watch. The 5.5/4.5 swap which peaked at 5-15 has fallen to 2 points since April. There is a lot of pain in the MBS world and it may be a good preview to what happens when government price manipulation schemes unravel. Good luck trading!

The only thing risk lovers can reasonably hope for on the back of the current macro picture is that markets move Sideways from here.