The Bond Vigilantes Are Back

No post yesterday, but I’m back today.

The euphoria of the rate cuts is slowly receding and traders are beginning to take a good hard look. The US dollar has therefore accelerated its decline. Gold continues to squeeze quietly higher and crude oil is stubbornly sticking to record highs. These developments are not at all unexpected… and the really fun stuff is only just getting started: INTEREST RATES ARE QUIETLY SNEAKING HIGHER.

The Fed cuts rates, and rates on the long end of the yield curve starts moving up. The Bond Vigilantes are back! (It is truly a pity they ever left.) On Tuesday, the day of the 50 point cut, 1- year rates actually climbed! Yesterday things accelerated with rates moving higher across the curve. The Bear Steepener is back.

European Manufacturing, Services Growth Slows (Update3): “Europe's manufacturing and service industries grew at the slowest pace in two years this month after a sudden increase in credit costs hurt banks, adding to evidence that economic growth is waning.

Royal Bank of Scotland Group Plc said today a preliminary estimate of its composite index fell to 54.5 in September from 57.4 in August. That's the lowest since September 2005 and below the 56.9 median of 15 forecasts in a Bloomberg News survey. A reading above 50 indicates growth.”

Not entirely unexpected considering the recent financial market turmoil. Factor in a flying Euro now that the Fed has sabotaged the US dollar and its hard to imagine Europe competing all that well with imports from the dollar pegged Yuan or the always weak Yen.

Merkel Backs Independent ECB; Sarkozy Seeks Rate Cut (Update2): “German Chancellor Angela Merkel said Germany would resist any attempts to influence the European Central Bank as French President Nicolas Sarkozy pressed for lower interest rates.

“We will resist any attempt to challenge the central bank's independence,” Merkel said at an event in Frankfurt last night to mark the German Bundesbank's 50th anniversary. The “slightest suspicion” that Europe is in two minds about the ECB's freedom from political interference “would threaten the euro's stability,” Merkel said.”

Let the war of words begin. One central bank for many many very DIFFERENT countries with unique economic needs will result in a mixed bag of winners and losers. But which is which?

BOE's King Blames U.K. Law for Foiling Bank Rescue (Update6): “”We're hemmed in by four pieces of legislation,'' King told a parliamentary committee in London today. “The interaction between different pieces of unconnected legislation made it almost impossible for us to act as a lender of last resort in the way that I would prefer.”

Northern Rock, whose roots date to 1850, is the U.K.'s third-biggest mortgage lender, with loans worth 17.4 billion pounds ($35 billion) as of June 30. Its shares fell 28 percent 185 pence today after the Treasury limited a guarantee it made to back deposits. The stock has fallen 85 percent since February.”

Flip flop. First a BLANKET guarantee. Then a few conditions and limits… That does not inspire confidence. I personally would have closed all my accounts long ago as this is not a risk worth taking.

“King said U.K. company takeover rules make it impossible for regulators to organize the quick sale of a failing bank. He said an EU banking law implemented in 2005 prevented covert lending to support Northern Rock, requiring authorities to announce when a loan has been made.”

Shell, Saudis to Spend $7 Billion on Texas Refinery (Update5): “Royal Dutch Shell Plc and Saudi Arabia will spend $7 billion to more than double the size of their Texas oil refinery, the biggest U.S. expansion in fuel production in three decades.

The joint venture, Motiva Enterprises LLC, will boost capacity at the Port Arthur oil refinery by 325,000 barrels a day, making it the largest in the U.S., by 2010. The facility will process 600,000 barrels a day of crude oil, Motiva said today in a statement. In April last year, the cost was estimated at more than $3 billion.”

Classic. The ‘too little too late’ approach. But hey, at least now they are finally undergoing the “biggest expansion in fuel production in three decades”. It should come online in 2010 AFTER high oil prices have chocked off economic growth… Brilliant. Just brilliant.

Fortis to Raise EU13.4 Billion to Fund ABN Purchase (Update3): “Fortis, part of a group seeking to buy ABN Amro Holding NV in the biggest banking takeover, plans to sell 13.4 billion euros ($18.8 billion) of stock to existing shareholders to help fund the acquisition.

Fortis will sell the shares for 15 euros apiece, the bank said in a statement today, or 44 percent less than yesterday's closing price of 26.63 euros in Brussels. The sale, Europe's second-largest rights offer behind France Telecom SA's 15 billion-euro offering in 2003, will begin Sept. 25.”

WOW. 44%. I guess the ‘irrational exuberance’ that fueled these deals is long gone. But it does look like this will be the preferred route of clearing these large deals that are already in the pipeline.

The First Suicidal Cuts

Pop went all my stops. Well, turns out all that talk about ‘no bailouts’ and ‘the dangers of moral hazard’ were just that: TALK. Bernanke did not learn from Greenspan’s mistakes.

I can’t stress this enough: The consequences of these actions in the long run are going to be SEVERE. The medicine is ALL wrong. Loose monetary policy caused this problem in the first place. Loose monetary policy can’t be the cure.

Although short term interest rates fell as a result of the rate cut the curve steepened as long term rates actually increased. The Bond market can already taste a jump in future inflation…

Most mortgages are priced based on the long-term rates. So, after the rate cut, things are looking WORSE for mortgage rates.

With these actions, I have lost a most of my respect for Bernanke and the Fed.

Fed Lowers Rate to 4.75 Percent, First Cut Since 2003 (Update6): “The Federal Reserve lowered its benchmark interest rate by a half point to 4.75 percent, the first cut in four years, to protect the U.S. from sinking into a recession sparked by fallout from the housing-market collapse.”

Rogers, Faber Say Fed Rate Cuts Will Spur a Recession (Update4): “Interest rate cuts by Federal Reserve Chairman Ben S. Bernanke will spur inflation, cause the U.S. dollar to collapse and push the world's largest economy into recession, investors Jim Rogers and Marc Faber said.”

This is ECON 101. I remember sitting in class maximizing and minimizing the areas under curves, shifting demand and supplies lines and otherwise toying with economic models. A couple of months from now this rate cut will have had the effect on the economy of SLAMMING ON THE BRAKES as commodity and import prices do a MOONSHOT.

The average American consumer is going to pay more at the pump as crude and gasoline rise. That plasma TV manufactured in Asia and imported will cost more as the US dollar accelerates its decline. Finally, rates will start to RISE as foreigners pull their capital. Think about it: The Fed fund rate in Canada is 4.5%. The Fed fund rate in the US just dropped from 5.25% to 4.75%. First, the spread is practically gone. Second, the Canadian currency is rising because commodities are rising and the country is running a budget AND current account SURPLUS. Why would the Chinese or anybody else invest in a DECLINING currency at such UNATTRACTIVE yields when they have much better and SAFER options?

“The cause of the problems we have today, they are due to artificially low interest rates, expansionary monetary policies and extremely rapid credit growth that was fueled by a totally irresponsible Fed,” said Faber, who oversees about $300 million as managing director of Hong Kong-based investment advisory company Marc Faber Ltd. “It's suicidal to cut interest rates.

The dollar's going to collapse, the bond market's going to collapse. There's going to be a lot of problems in the U.S.”

Time to let the market digest these developments. Time to see if cooler heads prevail.

To Cut Or Not To Cut

Today is the big day. To cut or not to cut. That is the question.

Bernanke Weighs Recession Risk Against Bailout Charge (Update1): “The Federal Reserve will probably cut its benchmark interest rate today for the first time in four years, seeking insurance against a recession. The main question is how big a policy Chairman Ben S. Bernanke is ready to buy.

While a quarter-point reduction in the federal funds rate may not be enough to bolster growth and investor confidence, a half-point cut might fan inflation and be perceived as giving in to pressure from Wall Street firms that made bad bets, especially in the market for securities backed by subprime mortgages.”

The accompanying statement today will be the most analyzed in a long time. The Fed needs to avoid the perception of bailing out the markets, lenders or borrowers while effectively tackling the credit crunch. A tough job indeed.

Lehman Profit Beats Estimates as Equities Offset Mortgage Woes: “Lehman Brothers Holdings Inc., the largest U.S. underwriter of mortgage-backed bonds, said profit fell less than expected as fees from equities trading and investment banking offset some losses from subprime home loans.

Net income fell 3 percent to $887 million, or $1.54 a share, in the third quarter from $916 million, or $1.57, a year earlier, the New York-based company said today in a statement. The average estimate of 16 analysts surveyed by Bloomberg was $1.48 a share.”

At first glance it would appear the Lehman weathered the storm.

“Lehman may have to fund $16 billion of loan commitments to leveraged buyouts at a loss because investors are reluctant to buy that type of debt, Citigroup Inc. analyst Prashant Bhatia estimated last month.”

A closer look at the numbers is still warranted.

Northern Rock, Rivals' Shares Rise on State Guarantee (Update2): “Northern Rock Plc, the U.K. mortgage lender that sought an emergency bailout last week, rose in London trading after the government stepped in to stop a run on the bank.

Shares of Newcastle, England-based Northern Rock rose 9.6 percent to 309.75 pence as of 9:10 a.m. after falling 56 percent in the past two days. Rival Alliance & Leicester Plc, which fell the most in a decade yesterday, gained 26 percent to 753.5 pence and Bradford & Bingley Plc was up 5.8 percent to 295.25 pence.”

Yesterday, as the panic spread from Northern Rock to other financial institutions in the UK, the BOE stepped in with a guarantee of Northern Rock deposits. Maybe that will calm people down a bit and halt the wave of withdrawals.

Bank of England Makes Emergency Loans to U.K. Banks (Update2): “Bank of England made emergency loans to U.K. banks to bolster the financial system, saying it received “intelligence” that demand for money may prolong a surge in overnight borrowing costs.

The central bank said it loaned 4.4 billion pounds ($8.8 billion) of “exceptional” funds at its benchmark interest rate of 5.75 percent today in London, and will offer the same amount on Sept. 20 in seven-day debt. The overnight rate banks charge to lend in pounds soared 60 basis points to 6.47 percent yesterday, the most since June.”

Well, so much for that grand speech on bailouts and moral hazard leading to increased future risky behavior…

Home Foreclosures Doubled in August on Loan Rates (Update1): “The number of Americans who may lose their homes to foreclosure more than doubled in August from a year earlier as subprime borrowers with adjustable-rate mortgages saw their monthly payments rise, RealtyTrac Inc. said.

Lenders sent notices of default or the equivalent to 108,716 homeowners in August, up from 42,144 in August 2006, RealtyTrac said today. It was the highest recorded in a study that goes back to 2005. California led with 41,714 notices and Florida was second with 26,203.”

Expect these numbers to worsen dramatically later in the year as the bulk of the rate resets will kick in then.

“There are lots of people who bought homes they could only afford at the teaser rates, and now have very few options.

U.S. Producer Prices Index Drops 1.4% in August; Core Up 0.2%: “Prices paid to U.S. producers fell more than forecast in August, diminishing concern over inflation as the Federal Reserve considers lowering interest rates.

The 1.4 percent decrease, the biggest since October, followed a 0.6 percent increase in July, the Labor Department said today in Washington. So-called core producer prices, which exclude fuel and food costs, rose 0.2 percent, after a 0.1 percent gain the month before.”

These numbers are deceiving. The headline rate dropped. A lot. Granted. However, the drop was led by a 6.6% decline in energy costs. Prices have since trickled higher already. The core rate was expected to come in at 0.1%, but still came in at 0.2%. The Fed, as they have said many times, emphasizing the core rates. The rumors of the death of inflation are still greatly exaggerated.

Another Paper Tiger?

I was less than pleased with Friday’s price action. Enough bad news had come out, such as the Northern Rock bailout in the UK, that European markets were down significantly and North American futures were all nicely in the red pre-market. The gap down turned into an amazing Gap Fade trade. I would be lying if I wasn’t nervously eyeing the stops on my short positions. The charts are suddenly exhibiting way too much strength and the potential for a Bullish breakout from the August trading range is a very real possibility.

King, BOE Face `Crisis of Confidence' After Rescue (Update3): “Bank of England Governor Mervyn King has spent the past month trying to stay above the fray as the U.S. subprime-mortgage collapse roiled credit markets. Now he's getting dragged in, whether he likes it or not.

Two days after King, 59, told lawmakers on Sept. 12 that central banks should avoid giving the impression they will help lenders that made bad decisions, the Bank of England provided emergency funds to Northern Rock Plc in the biggest bailout of a British bank in three decades.

“It's a crisis of confidence, and the bank is confused,” said Patrick Minford, an economics professor at Cardiff University who advised former Prime Minister Margaret Thatcher. “They want to be hands-off, but in this situation they can't be. I don't think this has done King any good.””

Swervin’ Mervyn the Paper Tiger. HOLD THE LINE DAMMIT. MacroMan takes Mervyn to task in great detail with his post The Return of Swervin’ Mervin.

Northern Rock Stock Tumbles Further Amid Run on Bank (Update2): “Northern Rock Plc, the U.K. mortgage lender bailed out by the Bank of England last week, tumbled to a seven-year low in London trading after customers lined up at branches across the country to withdraw their savings.

Shares of Newcastle-based Northern Rock fell 32 percent to 299.75 pence as of 10:45 a.m. in London, leaving the fourth- largest U.K. mortgage company with a market value of 1.26 billion pounds ($2.5 billion). Merrill Lynch & Co. halved its earnings estimate for 2007 and said future profit is “little more than guesswork.” Analysts said the bank may be split up or acquired.”

The bank run continues. Who will be next? Where do you do your banking?

Credit Suisse, Citigroup Take Losses on Debt to Keep LBOs Alive: “Credit Suisse Group, Citigroup Inc. and JPMorgan Chase & Co. are taking losses on leveraged buyout loans to keep transactions alive and get debt off their books.”

Let the wheeling and dealing begin. The banks are getting desperate as they need to free up cold hard cash to prop up their SIVs and conduits. The hung bridges from these LBOs are tying up a lot of much needed capital.

“The decision to sell debt at a discount follows similar moves by lenders, including New York-based Citigroup and JPMorgan, in the takeovers of Alliance Boots Plc and Allison Transmission Inc. Banks are trying to lure investors back to high-yield loans and limit losses on an estimated $320 billion that they have committed to fund LBOs.”

Goldman's Global Equity Fund Lost 1.8% at Start of September: “Goldman Sachs Group Inc.'s Global Equity Opportunities hedge fund lost 1.8 percent in the first week of September, extending the slide that led to last month's $3 billion cash injection.

Global Equity, with $7.5 billion in assets, fell 23 percent in August, its steepest monthly decline, as rising credit costs roiled stock markets, said two Goldman investors, who declined to be identified. Goldman, the second-largest U.S. manager of hedge funds, shored up the investment pool after it dropped more than 30 percent in the first two weeks of last month.

Goldman pumped $2 billion into Global Equity and lined up $1 billion from investors including Maurice “Hank” Greenberg, the former chairman of American International Group Inc., and billionaire Eli Broad. August also was the worst month for Goldman's Global Alpha hedge fund, once the New York-based firm's biggest, which fell 22.5 percent and received $1.6 billion of redemption notices.”

The longer these funds struggle, the more likely it is that redemptions will accelerate and turn things into a death spiral of forced liquidations by hedgies across asset classes.

Greenspan's Miscues Haunt Bernanke as Fed Weighs Cut (Update1): “Federal Reserve Chairman Ben S. Bernanke is grappling with what predecessor Alan Greenspan might call a conundrum.

At issue is whether today's U.S. economy most resembles 1998, when Greenspan may have been too eager to cut interest rates, or 2000-2001, when he may have been too slow. The trouble is, the situation now resembles a bit of both.

That increases the danger as the Fed's Open Market Committee meets tomorrow to decide on interest-rate policy. If Bernanke and his colleagues aim to avoid the mistake of 1998 and opt for caution, they risk a recession. If they push ahead with big rate cuts and growth proves resilient, they could find themselves with rising inflation, fueled by record oil prices and a slumping dollar.”

The stakes are ridiculously higher this time. It is my position that Greenspan responded far to aggressively in both cases with rate cuts and that the current mess is the result. The Mess That Greenspan Made by Tim Iacono argues just that in great detail.

France says must prepare for possible war with Iran: “French Foreign Minister Bernard Kouchner said on Sunday his country must prepare for the possibility of war against Iran over its nuclear programme, but he did not believe any such action was imminent.

“We must prepare for the worst,” Kouchner said in an interview, adding: “The worst, sir, is war.”

Asked about the preparations, he said it was normal to prepare for various eventualities.”

The global geopolitical situation is heating up again. Is it possible that the old European strategy of “we oppose whatever Bush says and do the exact opposite of what he does” is slowly changing as European leaders start to plan for a post Bush world? The mystery airstrike by Israel on Syria earlier in the month is also raising some eyebrows.

Kill The Greenspan Put

North American indices have spent the early part of this week trickling higher in anticipation of Fed action early next week. I’m expecting a modestly negative bias today on profit taking and position squaring in advance of a busy week next week.

Commercial Paper Slump Eases; Asset-Backed Drop Slows (Update6): “The decline in the U.S. commercial paper market slowed last week, prompting speculation that the worst of the short-term credit rout may be over.

U.S. stocks rose and Treasuries fell after the Federal Reserve reported short-term debt dropped by $8.2 billion, compared with a decline of $54.1 billion a week earlier. That coincided with Countrywide Financial Corp. obtaining new financing and banks finding buyers for loans to fund Kohlberg Kravis Roberts & Co.'s buyout of Alliance Boots.”

In my opinion, it is premature to call a bottom here. Things are just starting to fall apart in other markets like the UK:

Northern Rock Gets Emergency Bank of England Funding (Update4): “Northern Rock Plc got emergency funding from the Bank of England, the biggest bailout of a British lender in 30 years, after a freeze in money markets left the mortgage provider unable to finance itself.

Northern Rock shares plunged as much as 26 percent to a six- year low after the company said today the central bank will provide an unspecified amount of credit. The Newcastle, England- based bank is the U.K.'s third-biggest lender by gross mortgages with loans worth 17.4 billion pounds ($35 billion) as of June 30.”

At the end of yesterday’s post, Bill Gross The Ninja, I discussed how the first cracks are now appearing in the UK real estate bubble.

“Northern Rock is the U.K.'s worst performing bank stock this year. Its shares fell 46 percent through yesterday, compared with the 12 percent drop of the nine-member FTSE All Share Banks Index. The stock fell 137 pence to 502 pence as of 10:45 a.m. in London, valuing the lender at 2.11 billion pounds.

“The outlook for Northern Rock as an independent entity does not look good,” said Sandy Chen, a London-based analyst at Panmure Gordon & Co., who has a “sell” rating on the stock.”

House Prices Plunge $20 000: “Calgary's resale housing market, which has set a scorching pace for the past two years, has dramatically cooled, with the average price for single-family homes plunging by about $20,000 in August, according to a local realtor.”

Calgary is at the heart of Canada’s commodity lead boom. Real estate prices in Calgary and surrounding areas like Fort McMurray have shot to ridiculous levels that rival and even exceed the excesses seen in the most speculative US markets. The first cracks are starting to appear DESPITE STUBBORNLY HIGH COMMODITY PRICES.

“The average sale price dropped primarily because of a decline in the sales of luxury homes, those over a million dollars.”

A closer look at the data reveals that most of the drop was caused by a drop in luxury home sales, therefore disproportionately pulling down the mean price. HOWEVER, when an 850 square foot condo costs $362 000 and commands a $300 condo fee, even those with salaries of $70 000 are living beyond their means.

Fidelity's Shah Expects Sharper Swings in Markets (Update1): “Fidelity International Ltd.'s Sanjeev Shah, who's taking over the 3.1 billion-pound ($6.3 billion) U.K. Special Situations Fund from Anthony Bolton, said the current turmoil in markets will get worse.

“The environment has changed and it will get more volatile,” Shah said in an interview. “There is more uncertainty in the market in terms of economic outlook.””

I post what some of the big players are thinking because it is important. These thoughts are self-fulfilling prophesies first and then contrarian indicators second. As the hedgies, traders and other managers start to get concerned they will act accordingly and asset prices will behave accordingly. In this case EVERYBODY is reducing their risk exposure. That means rallies are being sold and valuations are contracting. Expect lower highs and lower lows until everybody is fully de-levered and re-trenched.

TraderFeed has great posts on market and trader psychology with the recent post Using Emotion to Change Emotion being particularly relevant during these times of market uncertainty and heightened volatility.
AfraidToTrade has great posts about managing emotions and building sound trading strategies that overcome your trading fears. The Psychology section of the blog is a great resource.

China Raises Rates for Fifth Time to Cool Economy (Update2): “China raised interest rates for the fifth time since March to curb the fastest inflation since 1996 and damp speculation in stocks and real estate.

The benchmark one-year lending rate will increase to a nine- year high of 7.29 percent from 7.02 percent, starting tomorrow, the central bank said today on its Web site. The one-year deposit rate will rise to 3.87 percent from 3.6 percent.”

Stomping on the brakes again… eventually they’ll get this thing to slow down… or skid out because this wild behemoth really isn’t easy to control at all.

Ease Money-Market Crisis by Letting Banks Go Bust: Mark Gilbert: “It's far from certain that lower central-bank rates would unfreeze the money markets. Moreover, central bankers are probably willing to sacrifice smaller lenders so the pain is enough to make financiers more cautious about future investments, provided there's no threat to general stability.”

The Banke of England however, has a different opinion and as I’ve argued in We Need Another Volcker, I believe it is the correct approach.

“The Bank of England, by contrast, has been adamant that it won't rescue the money markets by accepting low-grade collateral, or by offering three-month cash. Indeed, the Fed and the ECB were rebuked yesterday, albeit obliquely, by U.K. central bank Governor Mervyn King for bailing out commercial banks.

King sounds determined to take advantage of the current contagion to try to extinguish the notion of a “Greenspan put” or “Bernanke put,” the idea that central banks will always ride to the rescue.

The U.K. central-bank chief said helping commercial banks salvage their “risky or reckless lending” is especially dangerous because it “encourages the view that as long as a bank takes the same sort of risks that other banks are taking then it is more likely that their liquidity problems will be insured ex post by the central bank.””

The death of the “Central bank put” would beneficial to all in the long run as market participants are firmly reminded that the risks they take are ACTUALLY their own. The current system of privatizing profits and socializing the losses is disgusting and perversion of capitalism.

“The correct number of banks to fail when a credit bubble bursts is not zero. If the best way to avoid the mispricing of risk in future is to sacrifice some of the less-prudent lenders on the altar of liquidity, then let the culling commence. That is especially the case if it erases the perception that central banks will always act as lenders of last resort, even to institutions that don't deserve to survive.” [Emphasis mine]

Think about it. The Fed injects liquidity and cuts rates. What kind of lesson will that send to the irresponsible lenders and consumers of credit? What will that do to their FUTURE behavior towards risk? How big will the NEXT bubble therefore be?