Monthly Archives: December 2012

Too much money, not enough paper, redux

In my October 18th piece, Too much money, not enough paper, I pointed out that the Fed’s LSAP programs had created an excess of money and a scarcity of interest-bearing assets, a period I’ve jokingly referred to as The Great Incredible Paper Chase for the last year. In that post I mentioned that “debt issuers have done what any rational party would have done when there is more demand than supply of a good they can produce, they've stepped up production.” And that, “As long as the Fed is expanding their balance sheet, the market will have the capacity to absorb new issuance.” Since the onset of the first LSAP program, corporate bond debt has grown by $1,386B (+34.4%)  while non-financial business (corporate and non-) excluding corporate bond debt has shrunk by $765B (-5.18%). However, despite this breath-taking corporate debt issuance and record-setting deficits (supply), long-term rates have managed to fall for all four of the years in question thanks to $1,277B in balance sheet expansion by the Fed.

On December 12th, the Fed announced a new LSAP program aimed at replacing Operation Twist 2 in which the Fed will buy $45B in notes and bonds in an attempt to “maintain downward pressure on longer-term interest rates.” For those of you keeping score, that—when combined with the Agency MBS purchases of $40B—amounts to $85B in monthly Fed Balance Sheet expansion, or $1,020B/yr. The actions were pooh-poohed by many a commentator and talking-head that don’t know their Ps from their Ls, many of which, as usual, called for higher rates, in no doubt riding the coat-tails of a certain Westport, CT hedge fund manager who predicted that “at some point” there would be a vast fortune to be made by “someone” by “shorting bonds.” Your not-so-humble correspondent would like to remind you know that said commentators have absolutely no clue how supply and demand actually work and said hedge fund managers are merely trying to scare you into indecision. While it is true that the FOMC’s September 2012 announcement to buy $40B/mo. in Agency MBS has had little effect so far, commentators are ignorant as to prepayment and settlement mechanics of the TBA market which mean that, while the risk has changed hands already, the cash and product are lagging a few weeks behind. But make no mistake, the balance sheet will swell (in fact, it just started doing so ~7wks ago) and once the full effect is felt there will be an increasingly acute shortage of yield-bearing high quality assets. In particular, my calculations indicate there is $87.6B in as-of today unsettled Agency MBS purchases due to settle in the next 8 weeks.

To put the LSAP numbers in context, according to the Federal Reserve’s Z.1 release, the combined private sector, as of the latest reported quarter, is creating debt at a yearly rate of $345B/yr. (+1.08%), of which $481B (+2.54%) can be attributed to non-financial business and -$132B (-1.04%) can be attributed to households ex-student loans owned by the federal government (1). The bulk of household deleveraging took place through mortgage debt reduction (by repayment or cancellation) of $270B (-2.78%) and the bulk of business credit creation took place in the corporate bond market, where bond issuance was an astonishing $426B (+8.55%). The state & local government sector had no significant change in debt issuance, with long-term municipal security issuance remaining relatively unchanged at $3.2B (+0.10%). In that same period, federal debt held by the public increased by $1,142B (+11.27%) and  total Agency- and GSE-Backed security liabilities shrank by $41B (-0.54%) despite growth in the mortgage market share, growth which will be difficult to repeat without a TARP-like program open to households with non-Agency backed mortgages. In fact, even though the economy-wide deleveraging has stopped, outside of auto loans, student loans and corporate bonds, deleveraging and net negative security issuance remains an ongoing theme.

At the of this writing, our good-for-nothing legislators still have not managed to produce a budget, which means that I am unable to give you a read on next year’s deficit, but assuming a deficit range of $900B-$1,200B and continued net negative supply in the Agency- and GSE-Backed security markets to the tune of $0 to $40B, it is quite probable that net issuance of (credit) risk-free assets will be either flat or negative in 2013. That is to say, there will be even more money and even less paper ($1,107.6B to be precise; $1,020B in new purchases and $87.6B unsettled Agency MBS purchases). Add to that the approximately $1,500B in accounts currently covered by TAG, much of which I expect to move to T-Bills and other high-quality money market instruments, and it may very well be that the theme of 2013 will be one of a scarcity of high-quality collateral as we face net negative supply and increasing demand, which is something that I urge those of you who do know your Ps from your Ls to consider before going all-in shorting treasuries intoxicated by some fantasy of Soros-esque riches and fame.

  1. we subtract these so as not to double-count as we consider these to ultimately be public obligations

Bad Swap

The budget deal is washing markets back and forth in the range but something important is coming out of it. The Administration is hoping to gain near term capital but may be making a mistake. Treasury Sec.Geithner's work in the last debt ceiling fiasco was never acknowledged. The administration is now swapping an austerity battle for a debt ceiling war in Feb/March.

This is a bad swap in our opinion. Threat of default is a difficult canard to throw oneself on. Whomever assumes the Treasury Sec. role will have little power and face emboldened opposition. The near term should remain positive but the weeks between President's Day and St Patrick's Day are shaping up to be brutal.

Double Dog Dare Ya



There's a running gag in the old Warner Bros. cartoons where Yosemite Sam keeps crossing the line in the ground that Bugs Bunny keeps drawing until something catastrophic happens. So it goes with the long awaited arrival of 2013. The media-hyped cliff date seems now poised to morph into a President's Day debt ceiling battle. Going over the cliff is now seen as an opportunity to vote for tax cuts for some in 2013 rather than a tax increase in 2012.

The one constant we keep hearing is that "the market" will cheer a deal and punish a Congressional fumble. This analysis is testimony to the extremely myopic structure of modern capital markets. A muddle through approach remains most likely and the least attachable to Mr. Market's initial direction. Unlike the equity weakness that has persisted since the Plan B mess, the term structure of rates has retained some incline.

The degree of the rates incline is far more important to us than the legislative cliff. Debt ceiling shenanigans can complicate this positive market evaluation, overlooked for sexier stock market flailing. We are preparing for Reformation approach to the debt problem. Instruments of indebtedness will be anthropomorphized as evil. That we, US citizens, are the primary creditors to our our own future will be lost in the red faced and high decibel outrage we see coming.

2012 was about European problems and the US election. Our hope for 2013 is that we do not swap positions. We find ourselves in much the same situation as January of last year, uncomfortably among the rebel forces known as the optimists.

5 for 2012

Here's the short list of market musings from 2012:

1) Most people's opinion of a market is fabricated by the net change when asked.

2) Market "journalism" is now POV cheerleader slant. The most common example is the "Here's why the market just moved..." uselessness.

3) People change their minds, often and quickly. Over a short enough time frame, everybody's right.

4) Markets have morphed from long boring advance and intermittent calamity to constant calamity promotion and short bursts of wealth and capital formation. As such, they have lost their utility.

5) As always- You can't have a crisis where everyone is looking. You can experience volatility but vol (contrary to modern CB stability holy grail) does not mean crisis.

bonus observation- You're a "rogue trader" if the P/L is negative, if up you're a "rising star."

Tmro - 5 for 2013

About that rant …

Third, the national debt is not a net burden on future generations. Even if it gives rise to future tax liabilities (and some of it will), these will be transfers from taxpayers to bond holders. This may have disagreeable distributional consequences. But trying to reduce it now willbe a net burden on future generations: income will be lowered immediately, profits will fall, pension funds will be diminished, investment projects will be canceled or postponed, and houses, hospitals, and schools will not be built. Future generations will be worse off, having been deprived of assets that they might otherwise have had.