Wednesday, March 31, 2010

The Debts of the Spenders: Explaining Negative 10 Year Swap Rates

The yield inversion is a sign of hedging risk against more volatility in the coming months as desks are worried about a potential rise in rate risk.

One possibility behind LIBOR being less than the 10 year yield is that major banks are not positioned properly for it and will lose heavily. But this is not the same thing as a "Black Swan" type event that some commentators are calling for. Certainly not as bad as when the TED spread >4 in Fall 2008. Eurodollar forward contracts are not pricing in disaster as they continue to reflect a belief in ZIRP through the end of 2010.

Indeed, the Fed has stated it has no intentions to raise interest rates soon as they are still testing ways to withdraw the quantitative easing policy that was initiated.

There are three Fed meetings between now and the expiration of the Sept Eurodollar contract (9/13).

Apr 27-28

June 22-23

Aug 10

The job and housing market remain very weak. Inflation remains in check.

In fact, the negative swap rate seems to be NORMAL given the search for yield among fund managers (e.g. demand for higher-yielding assets such as corporate bonds and emerging market securities). A bond is a contract that involves at least two parties. The fund manager buyers are one party. The other is the bond issuer seeking to hedge risk (primarily interest rate risk) .

With low interest rates projected to stay (and the majority of corporate deals still dollar denominated) at ZIRP for the remainder of 2010 and all these corporate borrowers (bond issuers) seeking to sell their debt it is no wonder that swaps turned negative.

But what of the timing you ask at the end of March? The timing can be explained by the end of Bernanke's TOMO MBS program. With the Fed seeking to exit the agency debt market, there are players eagerly waiting to enter the private market again (agency debt market dried up by Q3 2007). There are even NEW private securitization deals happening again (my colleagues at the NY Bar say there are signs of greater deal flow again in the pipeline). The nature of corporate America is to shy away from risk so while they are all eager to make some money they are also reluctant to make the first move. All this explains the heavy demand for swaps.

Tuesday, March 30, 2010

The Debts of the Spenders: Will the Private Sector Replace the Fed as a Buyer of Cheap Mortgages?

This is the thought provoking question asked in a recent Bloomberg article that posits the possibility of private investors returning to the mortgage bond market after the Federal Reserve is due to end its agency TOMO buying programing of Fannie and Freddie linked debt. The Fed's program has been instrumental in keeping long dated (10+ years) fixed rate mortgages below 5%-7% for over a year but is due to expire within a few days. It seems like such a long time ago but the Fed's intervention in the agency debt market was designed to be a temporary measure

The article's writer cites the narrowing spread as indication of just such a transition:

In December 2008, two weeks before the start of the Fed bond-buying program, the spread between the 10-year government bond yield and the average U.S. 30-year fixed mortgage rate was 3.07 percentage points, the widest since 1986, as investors demanded higher payment to compensate for risk. Last week, the difference was 1.14 percentage points, narrower than the 20-year average of 1.65 percentage points.

“Private buyers are going back into the market to pick up where the Fed is leaving off,” said David Berson, chief economist of PMI Group Inc. in Walnut Creek, California. “Credit spreads have narrowed significantly, and not just for mortgages, because investors believe the worst of the financial crisis is behind us.

Fed policy makers have made it clear in statements following the end of rate-setting meetings that they will restart the mortgage-bond buying program if needed, according to Pandl. That “backstop” has reassured investors and encouraged them to re-enter the market, he said.

Much of the demand for mortgage bonds is coming from money managers seeking to diversify their portfolios, said Berson, of PMI Group.

“Investors are full up with Treasuries,” he said. “They haven’t been able to diversify into mortgage bonds because the Fed has been buying the bulk of them. Give them an opportunity to diversify into that market, and they will.”


Additional reading:

Monday, March 29, 2010

The Debts of the Spenders: The US Health Care Bill

Much of the significant tax impact appears to be delayed, but some of the current highlights include:

- An additional 0.9% Medicare payroll tax on income in excess of $200,000 for singles or $250,000 for married couples.
- An additional 3.8% Medicare "unearned income" tax on investment income to the extent it exceeds the same $200,000 for singles and $250,000 for married couples threshold - calculated as a 3.8% tax on the LESSER of investment income or the excess of the taxpayer's income over the aforementioned thresholds.
- A 40% nondeductible excise tax on insurance companies and plan administrators on high cost ("cadillac") insurance plans, if the premiums exceed $10,200 of individuals or $27,500 for families (limits adjusted for inflation).

Saturday, March 27, 2010

The Debts of the Lenders: China's Growing Bubble

The US - China relationship used to be marked about hand wringing recriminations about human rights and Taiwanese arms sales. Those still exist but have been relegated to the backburner before the realpolitik of economic change. China's insistence on keeping a yuan-dollar peg has resulted in a growing amount of inflation and speculative bubbles building up within the country's borders. Shut off from access to Western capital outlets (and after the events of 2008 can you really blame the country's regulators for being suspicious of US-British style finance), Chinese speculators have instead poured money into the country's dual vehicles of wealth acquisition - the stock and property markets.

Indeed, these market malinvestments have resulted in some pretty distorted changes:

SHANGHAI, China — In what may be the hottest real estate market on the planet, one fact of life seems extra cruel. In Shanghai, young women expect their boyfriends to buy a home before proposing.

“There’s a joke that goes Shanghai women can’t find husbands because they want a house, a car and a RMB1 million [$150,000] income,” said 28-year-old (male) sales rep Su Bei.

In truth, choosier women even go as far as to require that a spouse-to-be have paid off the mortgage entirely before popping the question.


HONG KONG—One is a China state tobacco company. Another, a Japanese ramen chain. And finally, there is an obscure Hong Kong semiconductor maker.

What they have in common: They are some of the latest companies to jump onto the real-estate bandwagon as prices soar to gravity-defying levels in Hong Kong and mainland China. Some experts see the growing involvement of nontraditional players as yet more troubling evidence of froth in both property markets.

Last week, a small maker of diodes and transistors called Sino-Tech International Holdings Ltd. shocked investors by announcing that it was "diversifying into the property sector," buying a luxury three-story residence in Hong Kong's swank Peak district for more than HK$280 million (US$36 million) in cash, one of the biggest sums ever for a property here.


The Debts of the World: Low (US) Interest Rates Continue to Dominate Discussion

It's been a while since I last posted because I have been busy with other things in my life. Like focusing on passing 2 state bar exams and working full time. Anyway, I have certainly not been idle on the investment front.

The ongoing credit driven events in Greece and China have driven government yield premiums to higher highs as can be seen here in this dynamic yield curve chart that is overlaid with the benchmark US S&P stock market index:

Is this signs of a normalization?

Late last August, the markets were driven by the inverse dollar - risk premium trade where a lower dollar was directly correlated with higher asset prices in risk related trades such as commodities (and commodity linked currencies like the Aussie Dollar) and equities (particularly emerging market equities). Now, that correlation seems to have weakened with the dollar rising in tandem with benchmark interest rates.

Indeed, markets are continuing to price in a market driven by low US interest rates through the end of 2010 as evidenced by the Eurodollar futures contract (there are 3 more contract dates left in 2010 - June, September, and December. All 3 show that traders expect a continuation of low rates. For brevity purposes, the nearest contract date, June, is listed here).