Jun

13

VN1) It had always seemed to me that the big differential between the rate of interest on the high yield debt, leverage buyout loans and mortgages and the treasury bond rate was a silver lining to make all the assets owned by the banks quite profitable even in a recession. Say they were earning 10% nominal on those assets with a 10% default rate of 10%. That was still 9% , and much more than the 3% available on treasuries or the fed funds rate they needed to borrow at. But now, the treasury rate is creeping up to 5% , and the differential doesn't look that attractive.

I always look at simple things like that.

My favorite mantra for fixed income has been that when the Fed makes tightening noises, this is very bullish because it keeps the long term inflation rate down.

I believe that's worked for 30 years or so, but now the interaction with the staggering amounts of leverage on the banks balance sheets adds an additional layer of complexity.

still with stocks reeling again, no way can the Fed raise interest rates as this would precipitate more problems in the differential that would truly create a lack of profitability on the income side as well as a weak balance sheet.

One realizes this is simplistic reasoning and would appreciate feedback on how predictions and tests and profits might be considered.

2) When in the merger bus in the 70's , we ran into buyers saying all the time " Why should I pay more than book for a company like this as it cant earn a return on its assets any better than average, and its activities could be duplicated. Much now seems to be clear about the brokerages and related financial institutions . Its clear that the relatively high rates of return on equity that they made, were because of high leverage and there was a corresponding low return on assets. Now that the assets have to be reduced, one is left with a ratchet brining both the bas assets and the return figure down. The Wall Street Journal in an article on Lehman says. " until Leh can prove that it has a future and find a way to regain lost investor trust, there is no reason to see why the shares should tradve above ( adjusted discounted book). Or why a potential buyer if the firm decides it can't survive on its own should pay much more ".

That's exactly what the potential buyers of companies in industries that were selling below book in the 70's used to tell me. The situation exacerbated by higher interest rates, so interest rates must go down considerably so that the problem is solved.

One realizes that the stable door is being locked late here, and that's why I concentrate on the interest rate prediction. The stock market vigilantes must show the world that interest rates must come down soon. 

John Floyd adds:

I was recently invited to speak to the ECB in Frankfurt. Below are some of the key questions I raised for them as they address the challenges going forward. I also gave them an investment example from 2001 which I thought was fitting given the similarities are remarkable with the current situation, oil/food have been substituted for mad cows. Given the singularity of their mandate and the fixed system they operate in I think the challenges are formidable. Milton Friedman does a much better job than me at recognizing this, and for anyone interested I suggest you take a look at his writings on the topic.

What is striking about much of the central bank rhetoric and action over the past year or so, particularly the Fed, is the extreme swings in the views, incorrectly in many cases. Along with that the investment houses have been wagged by the prices in changing their views, i.e. the changes yesterday by some banks for Fed tightening shortly.

Given the dynamics of what is happening on the banks, credit, and real economy it seems unlikely the central banks will tighten to the extent priced by the markets (+100bp by the Fed in the next 6-8 months, etc.). As the ECB has done in recent days expect some backtracking from the Fed, especially if the USD and oil calm down a bit.

Some more quantitative testing of these ideas and the resultant trading opportunities is probably warranted.

Some Key Issues Presented to ECB last week

Macro Economic Picture How does the European economy withstand the multiple external shocks that it is being exposed to? For example, the large appreciation of the Euro, substantially higher oil and food prices, credit problems facing European banks, and a significantly weaker United States economy.

The challenge of the Euro area is that some countries need higher rates to slow inflation (France and Germany) while others might need lower rates to offset the effect of housing slowdowns (Ireland and Spain). How is the circle squared? What are the prospects of expanding the Euro area to new members?

FX Is there a competitive problem with a strong EUR, especially versus CNY? What are the chances of intervention and what would the outcome be?

Inflation Primary attention is given to keeping inflation below 2% target. Does a slower European economy bring inflation down from 3.5% to target? What sort of gap is needed between the product and labor market to achieve the goal?

Credit How does the credit crises affect European Banks? And how might it impact lending behavior? How large are the losses and why does the pace of recognition seem to be slower than in the US?

Lending Window Are there limits to the lending to banks in places like Spain with real problems because of declining housing and foreign borrowing?

2001 rate trade

In Q1 of 2001 the prevailing market view was that the ECB would continue to tighten monetary policy given inflation above the 2% target. One of the great concerns of the ECB was that wage pressure would intensify over the course of the year, thereby placing upward pressure on prices. The ECB was concerned that with unemployment around the level estimated to be full employment (8.3%) above trend growth (estimated at 2.5%) would lead to accelerating wages. In contrast, it was the fund's view that the most likely outcome would be below trend growth, and the increase in inflation was largely attributable to sharp increases in food and energy prices. Regarding growth, the reasons it was expected to lag were two-fold: first, the slowdown in the U.S. would be greater than commonly expected and exert a negative force on Europe, and second, surveys indicated that consumer and business confidence were falling across Europe suggesting a sharp deceleration in domestic activity. For example, the expectation sub-component of the IFO survey pointed to sub 1% growth over the year beginning in the fourth quarter of 2001. Importantly, growth in this range would cause the unemployment rate to rise above the full employment level, with the consequence that wages would withdraw, not add, to inflationary pressure. As this outcome became apparent, the ECB would become more confident that inflation would fall below target and ease monetary policy. In terms of inflation it was believed that food prices were event driven, due to foot and mouth disease, they were not part of an inflationary process. Energy prices were expected to go lower as global economic weakness would exert downward pressure on prices throughout the year.


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9 Comments so far

  1. steve leslie on June 13, 2008 12:11 pm

    I am in no way a practitioner of the dismal science. I do listen intently to those far wiser than I. Talking points that make the most sense. Fed has stopped lowering interest rates. Their goal is to protect economy and banks and worry about inflation later. Take out fuel and go to core inflation and things appear more tame as evidenced by today's number. Paulson is jawboning to support the dollar. Seems as though the dollar is finding support and even been rallying on Paulson's talking about supporting it. Obama has not received as much of a bump in polls as expected. Financial markets look closely to the likelihood of an Obama presidency. It has been noted in the past primary when Obama did well against Clinton the market went down the day after. Stocks are in a range until otherwise. Newton's Second Law applies. Seems the object is at rest between 12000 and 12600 or therabouts. Lack of liquidity is hampering the market's going in any serious direction either way. Summer doldrums are upon us. Therefore the stock market is drifting, with the Dow down about 8% year to date. sl.

  2. Gary Rogan on June 13, 2008 2:48 pm

    Why wouldn’t the Fed raise the rates and force more mergers? As long as some balance sheets are significantly stronger than others and the Fed still has the ability to force mergers, that seems like the only way for the Fed to behave.

  3. gabe on June 13, 2008 5:10 pm

    come back to earth. nothing’s coming down soon and in the best case the rates stay where they are. p*ulson’s recent visit to the sheikhs, which prompted ben’s ASAP public promise to do good should be self explanatory. fed’s policy is dictated from beduins’ tents nowadays unfortunately. and I haven’t included that little elf, trichet, in the equation yet. they’ve been waiting for this moment for 40 years.

    another nugget of entertainment is here: “We have conveyed to the U.S. government that a strong U.S. dollar is in the interest of the U.S. economy,'’ Zhu Guangyao, an assistant minister at China’s Finance Ministry said last week.” gotta love the irony of it all.

    http://www.bloomberg.com/apps/news?pid=20601039&sid=aP.VpLrg.H38&refer=home

    so yeah, I’d say a few banks are not at the top of priorities list right now.

  4. Ronald Weber on June 14, 2008 5:31 am

    I think that the market has recognized the dilemna faced by the Fed: 1) keep the yield curve steep and you save the banking system (or at least save time) even if that means too much inflation or 2)raise rates to “fight” inflation at the cost of “sacrifying” the banks!
    From a historical perspective and becuase of the Fed’s dual mandate (unlike the ECB) I think that option 1) will prevail.
    At least Japan didn’t have to worry about inflation when it bailed out its banks trough the “i” curve!

  5. Marco Loureiro on June 14, 2008 12:55 pm

    The 5-yr rate of change in the CPI just rose to a fresh 12 year high. Adjust 10-year TIPS derived expected inflation at an 11-year high.

    Room for lower rates? I don’t think so…
    Time to swallow that nasty tasting medicine. If not, that so called “bubble” in commodities is about to get even bubblier.

  6. Lon Evans on June 15, 2008 3:22 am

    Dear Victor, As an important aspect of your 'testing' seems to consist of a retrospective evaluation as to prior similarities, do you know of a recent, or not so recent, parallel to the situation described in your first comment? It would be interesting to compare how prior (like) situations worked themselves out, and if such do not exist, well, "batten down the hatches, Aubrey." lon lon

  7. David Whitesel on June 15, 2008 11:40 am

    Re; Mr Floyds contribution “The challenge of the Euro area is that some countries need higher rates to slow inflation (France and Germany) while others might need lower rates to offset the effect of housing slowdowns (Ireland and Spain). How is the circle squared? What are the prospects of expanding the Euro area to new members?”

    This outtake illustrates that single value determinations will not be possible and a solution to the inquiry resides in moving the argument to Friedrich Hayeks view that the only descriptor of value, in cross country analysis, is limited to the time shapes of outputs derviable, from each/any particular countries supply of capital.

    Hence the goal to derive for the EU a single valued currency, is fantasy, due to the lack of multi phase identification within the logics of the present conflict, between resident populations and the governing elites.

    Regards the liklihood of expanding Euro to new members?

    Ireland just voted against the Lisbon accords, and that by itself points to the probable demand for more plebecites and a return to the security of when a countries currency values were directly tied to the time shapes of outputs, derviable from each countries supply of capital.

    me thinks the euro is in trouble and for very good reasons.

  8. Ronald Weber on June 15, 2008 3:00 pm

    I agree, I think the ex-Bundesbank team is “in charge” again and it wants the so-called PIGS (Portugal, Italy, Greece and Spain) out of the Euro! To be followed…

  9. anonymous on June 16, 2008 10:17 pm

    there have been several articles on the fed funds futures contracts and their predictions as to where rates may go. they are clearly predicting higher rates in the near future. one could examine other instances where the fed put rates "on hold" and see how well the fed fund futures predicted the next rate change. i would be interested in seeing some results, as this testing is probably beyond my capabilities.

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