The Daily Reckoning - Convergence Under The Bed Spread (Dan Denning)

verfasst von Firmian, 24.10.2003, 11:57

-->Convergence Under The Bed Spread

The Daily Reckoning

Paris, France

Thursday, 23 October 2003

----------------------

*** Dow down... Tokyo Dow down, too -- 554 points... Watch
out!

*** Bonds are rising... gold soaring...

*** Dollar falling... people working harder for less... oh, la
la... Financial Reckoning Day on Al Jezeerah... Bill
O'Reilly... and more!


----------------------

We don't know any more than anyone else, but this rally looks as
though it has finally exhausted itself, having retracted just a
bit over half of its losses from 2000-20002.

The Dow fell 149 points yesterday. And this morning, the Tokyo
market is down 554 points, for a 5% loss. It looks dangerous,
dear reader; it looks dangerous. October is not over.

Despite all the blabber, stocks are still at near-record high
prices... after the most stimulating gush of money and credit in
history. But how many more tax cuts will there be? How much
more will interest rates be cut? How much deeper into mortgage
debt are householders willing to go?

Of course, everyone still expects the 'recovery,' now blossoming
so sweetly in investors' imaginations, to bear fruit. At least
until after the elections next year, growing conditions should be
good, they think; both the Fed and the Bush administration will
pour on all the liquidity they can pump... and spread manure
around everywhere. Who doubts that higher sales and earnings
will soon bud out... leading to plump, juicy stock price gains?

And yet, what administration... what Fed chairman... ever
wanted a slump? What kind of morons were running the Fed in the
1930s?

That was, of course, a long time ago, and much progress in
central banking has been undoubtedly been made. But didn't the
Japanese try out all the miracle grow of modern macro-management?
Didn't they spread the manure so thickly that it began to stink?
Didn't they open all the spigots, valves, sluices and
floodgates? Didn't they drop interest rates to zero and hold
them there for more than 5 years?

Sometimes, dear reader, things happen that you don't want to
happen... and that you do everything you can to avoid. When you
eat too much, you gain weight -- like it or not. When you spend
too much, you grow poorer -- whether you realize it or not. This
is so obvious, we hate to bring it up. But who believes it? The
lumpen -- economists, investors, analysts, presidents -- seem to
think people can go deeper and deeper into debt, forever, and
still get richer!

Ah, but it is a cold, cold world we're livin' in... as Percy
Sledge put it. And, here in the Northern Hemisphere, it gets
colder every day.

And what's this? Looks like the pump done broke down... in a
recent week in September, the money supply, M3, actually fell by
$38 billion. Could be a fluke or something... or it could be
the end of the world. We'll have to wait to find out.

But what's this? Bonds are rising. If there really were a
recovery developing, bonds would be falling, foretelling higher
interest rates and higher levels of inflation. Instead, bonds
seem to be looking ahead to more of a Japan-style slump.

We don't know what will happen, but we would be careful...

Over to Eric in New York...

----------------------

Eric Fry with the news from Wall Street...

- All sunshine makes a desert, as the saying goes... but only
farmers and new lovers seem to welcome the rain. Investors do
not. Down here on Wall Street, all sunshine makes investors very
rich... and very complacent. As long as the ascendant Nasdaq is
casting a warm glow across investment portfolios from coast to
coast, investors don't give a thought to inclement weather.

- But yesterday, a sudden cloudburst of sell orders drowned the
major equity averages in a deluge of losses. The Dow Jones
Industrial Average found itself gasping for breath as it sank 149
points to 9,598, and the Nasdaq Composite dipped 2.2% to 1,898,
its first close below 1,900 in two weeks.

- The dollar also struggled to stay afloat yesterday -- slipping
more than 1% against the euro to $1.181. The so-called resource
currencies are faring particularly well against the foundering
greenback. Yesterday, the Canadian dollar touched 76.7 U.S cents,
a new 10-year high. The Australian dollar, trailing close behind
its Canadian counterpart, reached U.S.$0.7044, its highest value
versus the U.S. dollar in six years.

- It seems that the U.S. Treasury may have printed one dollar
bill too many. Foreign central banks and foreign investors have
more than enough dollars already, and seem to be running out of
places to stash them. The darn things are everywhere. Your New
York editor is doing his part to contain the proliferation of
dollar bills. Whenever he sees a dollar bill lying on the ground,
he stoops to pick it up... He hates litter.

- While the dollar and U.S. stocks were both sinking yesterday,
the demand for financial lifejackets surged -- 10-year Treasury
bonds gained 22/32, dropping their yield to 4.26% from 4.35% at
the previous close, and gold climbed $4.80 at $386.80 an ounce.
Earlier in the session, the December gold contract touched an
intraday high of $388 -- its highest level since late September.
Since Friday, the price of gold has jumped a dazzling $14.60 per
ounce. Gold mining companies rejoiced in the yellow metal's
strength, as the Amex Gold Bugs Index added 1.4%.

- The most surprising aspect of yesterday's stock market sell-off
was that it hadn't happened earlier. A"correction" was long
overdue, based on the most recent sentiment readings. Folks had
become so certain that each new day would bring another day of
stock market gains, they rarely considered the alternative: a day
(or two or three) of losses.

- The nation's investors have rarely exhibited such universal
exuberance. Let's take a quick tour of the latest investors
sentiment readings. The four most widely followed gauges of
investor sentiment -- Bullish Consensus, AAII, Investor's
Intelligence and Marketvane -- all registered extremes of bullish
sentiment as of Tuesday evening, immediately before yesterday's
trouncing. In fact, as professional sentiment-watcher Christopher
Cadbury observes, all four of the gauges showed that greater than
57% of those surveyed are bullish.

- Never before have all four sentiment indicators produced
bullish readings above 57% at the same time. The AAII survey, for
example, which polls members of the American Association of
Individual Investors, finds that 60.3% of its members are
bullish, versus only 13.8% who are bearish. These sorts of
extreme readings often presage the end of stock market rallies.
At best, bullish sentiment does not reach an extreme when the
buying is good.

- Cadbury also notes that all three of the CBOE's options
volatility indices have tumbled to multi-year lows, which
indicates multi-year highs in investors' complacency. The CBOE's
Market Volatility Indices -- known by their various symbols VIX,
VNX and VXO -- are known as Wall Street's"fear gauges" because
they track the prices of various options. Simply stated,
expensive options indicate high levels of fear, and inexpensive
options indicate complacency.

-"A spike in the VIX often occurs near major market bottoms,"
Reuters explains."As the market recovers and investor fear
subsides, VIX levels tend to fall, suggesting an overly
optimistic market susceptible to setbacks."

- As of Tuesday's close, the VXO Index of S&P 100 at-the-money
option prices had dropped to a 5-year low, the VIX index had
slipped to a 7-year low and the VNX index, which tracks Nasdaq
option pricing, had tumbled to an 8-year low. The fact that these
indices have all dropped to multi-year lows says loud and clear
that investor complacency has soared to a multi-year high.
Complacency is in a bull market.

- Net-net, given the fact that stocks are not a bargain and the
fact that the lumpeninvestoriat loves them anyway, the cautious
investors may wish to remain cautious for a while longer. The
cavalier investor will prefer to ignore all warning signs, on his
way to amassing large paper profits and then losing them shortly
thereafter.

----------------------
Bill Bonner, back in Paris...

*** Amazon came out with an earnings announcement yesterday. If
you ignore what CNN calls"all the bad stuff" the River of No
Returns earned 11 cents per share last quarter. Investors were
disappointed. The stock dropped 9%.

*** Oh, la la... the dollar got hit hard yesterday -- down to
nearly $1.18 per euro. The Australian dollar is at a 6-year
high.

*** Arrgh! The price of gold shot up $4.80 to $386, well above
our new $370 buying target. It keeps slipping away from us.

*** Of course, over the past year, you could have made a lot of
money by not following our advice on companies such as
Amazon.com. The stock rose 900% from its low of Jan. 2002.
Instead, we have had you plodding along with gold -- up only 25%
or so.

Feeling lucky? Well, here's our chance to get even with the tech
buyers. Sell the techs, dear reader, sell the techs.

***"Overseas jobs putting pressure on U.S. salaries," says a
headline in the Atlanta Constitution-Journal. Well... what do
you expect? In a globalized economy, there is bound to be
competition on labor costs, as well as other prices. Are
America's high wages doomed? Well, maybe. The only way they
could be preserved would be with massive capital investment and
training, which would keep the output per hour so high that
companies could afford to spend more for much more highly-skilled
labor. This is how Switzerland, Germany, France and other
European nations have managed to stay in business. But in
America, there has been very little capital investment... less
and less, in fact, as the economy has shifted towards consumption
over the past 50 years. There is no way a consumer economy can
keep wages high.

*** Speaking of hourly wage rates, we note that Americans already
work far longer than others. High capital investments allow
people to produce more per hour. In the absence of investments in
new equipment and factories, Americans have been forced to work
longer and harder -- usually at service jobs -- just to maintain
standards of living. Research Addison did for our book Financial
Reckoning Day shows average hours worked rose nearly 12% between
1973 and 2000. Real incomes barely rose at all. For men, they
actually fell a little.

It is a cold, cold world we're livin' in, dear reader. A cold,
cold world...

*** Speaking of the book, we note with a touch of irony, that the
book is featured -- right next to the bellicose Bill O'Reilly --
on the Al Jezeerah website. We have no idea if they liked it...
or even what they were saying about it... because the text is in
Arabic. There doesn't appear to be a way to order the book from
the site, so for all we know they are pinpointing us as examples
of imperialist tyrants..."the great Satan" personified...

We're told, too, that displays are now being set up in Borders
and other bookstores around the country. Perhaps you can find a
copy in your local bookstore. If you do, please be sure to let us
know. You can be the DR's eyes and ears on this project. Just
send an e-mail to Addison here: addisonw@agora-eu.com with the
details... location, etc.

*** And speaking of O'Reilly, we're scheduled to speak in New
Orleans at 10 AM on Saturday morning, November 1st. O'Reilly, the
conference's keynote, goes on at 11 AM. First, Arabic
cyberspace... then New Orleans over Halloween... what's next?
Santa suits and a book signing in New York? Oh, la, la...

----------------------

The Daily Reckoning PRESENTS: Strategic Investment's Daniel
Denning (our very own green-saronged analyst!) explores the
possibility of a falling credit rating for US government debt --
banana republic style!

CONVERGENCE UNDER THE BED SPREAD
by Dan Denning

Illusions often die a sudden and not-so respectable death.

The other day on the Paris Metro, an overweight, middle aged
woman took to the center of the car and muttered under her breath
repeatedly"Pere Noel est Morte." Santa Claus is dead.

While this was not news to me (nor was it exactly true, in the
sense that Santa Claus doesn't really exist), it was quite
shocking to the handful of children within ear shot. A crash in
the Santa index ensued.

Such is the fate of misplaced faith, which brings us to the U.S.
bond market. The conventional way to measure general systemic
risk in the U.S. bond market is known as the TED spread. It's the
market's measure of how close we are to total financial meltdown
-- the much anticipated"Financial Reckoning Day"...

Technically speaking, the TED spread is the difference between
interest rates on the 90-day U.S. Treasury and the 90-day
Eurodollar deposit contract. Eurodollars are dollar-denominated
deposits held by commercial banks outside the United States and
in Europe. All things being equal, when they are packaged up and
sold like U.S. bonds, the issuer must pay a slightly higher
interest rate than on the 90-day T-bill.

The issuer pays the higher interest rate because the U.S.
government collects its revenues at the barrel of a gun, and
commercial banks do not. This, presumably, makes the U.S.
government a"safer" credit risk, e.g. less likely to default.
And so the Feds don't have to pay as high an interest rate to
attract buyers.

The TED spread measures systemic risk. It's premised on the
belief that the U.S. bond market is the financial world's safe
haven of last resort. But what, to borrow a phrase from Michael
Moore, if that's a big fat lie?

A few weeks back, Addison Wiggin and I attended a luncheon in
London offered by the folks at Arbor Research. Their lead
research analyst, Jim Bianco, gave a riveting account of
derivatives risks at Fannie Mae and Freddie Mac. After Jim's
speech, I asked him, over sandwiches, what I perceived to be a
natural question."What would happen if the credit quality of
U.S. government debt were to be downgraded?" citing as possible
causes the Treasury's implied guarantee of Fannie and Freddie.
[Similar themes are explored, by the way, by Antony Mueller, in
his essay:

The End Of Dollar Supremacy?
http://www.dailyreckoning.com/body_headline.cfm?id=3497

"It would never happen," Bianco replied,"That would mean the end
of the modern financial system." Needless to say, Jim's response
got me thinking.

If the U.S. bond market isn't as safe as you've been told, how
would you know? How can you actually measure how close we are to
the day of gloom and doom and $8,000 gold?

You'd begin to have an idea that the world was going to hell in a
hand-basket if you could measure the spread between U.S. debt
(which WE know to be risky) and debt that the market considers
risky, namely baseline emerging market debt (BED).

A BED spread, you say? Ask... and you shall receive.

The BED spread (or BS as it's been called by a few readers) is
the proprietary indicator I developed to keep track of how close
the U.S. government is to losing its reputation for
creditworthiness.

To get it, I established a spread between emerging market debt
and U.S. government debt. If I'm right about the U.S. bond market
losing its gold-standard reputation, the spread should converge
over time. U.S. government bond yields will rise as the dollar
falls. And emerging market debt yields will fall, as it becomes
comparatively less risky than dollar-denominated debt.

You COULD come up with an indicator by comparing the 10-year
Treasury note with, say, an equivalent Argentine or Russian
government note. But I prefer to take a broader measure of
emerging market debt versus U.S. government debt. I picked two
closed-end bond funds, GVT and EMD.

GVT is the Morgan Stanley Government Income Trust. One hundred
percent of the fund's assets are dollar denominated. When I first
calculated the BED spread, about three weeks ago, GVT yielded
4.18%. That was higher than the yield on the 10-year note at the
time (4.04%.) But GVT is an excellent proxy for the market's
general perception of the creditworthiness of the U.S. government
because it's a"basket" of government bonds. Here are its top
five holdings and allocations:

1. U.S. Treasuries 30.28%
2. Short-term bonds 27.99%
3. Fannie Mae bonds 23.02%
4. Freddie Mac bonds 11.96%
5. Ginnie Mae bonds 6.75%

To represent the other side of the spread, emerging market debt,
look at EMD, the Salomon Brothers Emerging Market bond index.
Eighty-eight percent of the fund's holdings are in sovereign
(government) debt. While it's not absolute, you're basically
comparing apples to apples... the bonds of emerging market
governments versus Uncle Sam's bonds. Here is how EMD's top five
holdings are allocated:

1. Brazil 23.57%
2. Mexico 20.87%
3. Russia 17.97%
4. Colombia 5.08%
5. Ecuador 5.05%

When I first calculated the BED spread, EMD yielded 9.76%. So
about three weeks ago, the BED spread was 5.58%. Based on the
wide spread, the market did NOT perceive a great deal of risk in
U.S. government debt. But that would soon change...

The second time I calculated the BED spread, the yield on EMD
fell to 9.59%, while GVT's yield was up to 4.22%. In bond speak,
that means bond prices are up for EMD and down for DVT (yields
and prices move in the opposite direction).

The new BED spread was 5.37%. Convergence approacheth. And it's
precisely what you'd expect, given the news in the bond market
that week. Why?

First, Moody's Investors Service upgraded the rating on Russia's
foreign-currency bonds by two levels. Russia's Eurobonds were
upgraded to Baa3 -- the lowest investment grade level -- from
Ba2. Specifically, Russia's 5% dollar bond due in 2030 gained
2.65 cents on the dollar in one day.

That particular bond is the most traded emerging market Eurobond.
And it was bound to help EMD. While 17% of the fund's total
assets are in Russian debt, its single largest holding is $7.7
million worth of Russian government bonds -- about 10% of its
total portfolio.

Second, emerging market debt yields are converging with U.S.
Treasury yields, because what's good for Russia is turning out to
be good for other emerging market bonds, including Brazil.
Brazil's 8% bond due in 2014, which is THE MOST widely traded
emerging market bond, rose that week too, as yields fell.
Brazilian bonds constitute 23.5% of EMD's portfolio, and four of
its 10 largest particular holdings.

On the other side of the spread -- the U.S. government side --
there was trouble in agency security land. Agency securities are
otherwise known as the mortgage-backed bonds issued by Freddie
Mac and Fannie Mae. And like a dream it can't wake up from, the
market is slowly recognizing how many bad credit risks Freddie
and Fannie have taken... and how this directly implicates the
creditworthiness of the U.S. government, whose implied guarantee
of agency debt made it possible for Freddie and Fannie to get so
overextended in the first place.

The problem reared its ugly head in Atlanta and Pittsburgh a week
ago. Federal Home Loan Banks in both cities reported losses of $9
million and $7 million, respectively, for the third quarter. Both
banks claimed the losses came from low mortgage rates"pinching
off" interest income on their derivatives holdings.

Perverse, isn't it? It's those same low interest rates that have
kept mortgage issuance and refinancing activity so high. Yet even
what's been historically good for the mortgage lenders is now
turning out to be a problem.

Granted, $9 million and $7 million losses won't break the bank.
But the $200 million loss reported by the New York FHLB last
month gets closer to breakage. THAT loss was chalked up to bad
investments. And that brings us to the heart of the issue, with
agency debt in particular and U.S. government debt in general.

Freddie and Fannie have been issuing mortgage-backed debt at a
ferocious pace in the era of historically low mortgage rates.
It's dangerous risk-taking predicated on the ability of new
homeowners to pay off mortgages AND the appetite of bond
investors for mortgage backed securities. Yet that's exactly the
kind of investment that went bad in New York. And that's the
investment that will likely go bad all over the country.

To keep expanding, the housing boom must attract more and more
buyers. The voracious need for new buyers forces Freddie and
Fannie to lend to riskier borrowers. To keep the boom going, the
market extends more and more generous offers to less and less
qualified buyers.

Eventually, Fannie and Freddie will be on the hook in two ways.
They will have made loans to homeowners who can't pay. And they
will have packaged up those loans and sold them as bonds to
bondholders who will, I'm guessing, demand payment.

Who will pay the bondholders when the homeowners default? The
U.S. government? Santa Claus? The Daily Reckoning Paris office?
You?

The U.S. government ALREADY has its hands full paying its own
sovereign debt, not to mention Social Security, Medicare, and
Medicaid. GVT, which has 30% of its holdings in Treasuries and
35% in agencies, is a great proxy for the credit problems of the
U.S. government.

We saw it again this week, as the Treasury department reported a
$374 billion deficit for the fiscal year ended in September. That
number was better than the White House predicted back in July.
But it's not exactly good. And it wasn't exactly good for the BED
spread.

As of this writing, EMD yields 9.50% and GVT yields 4.24% for a
spread of 5.26. That's three weeks in a row of convergence...
from 5.58 to 5.37 to 5.26.

The spread would be even larger if Treasuries still didn't enjoy
their reputation as safe havens. Yields on the 10-year note
climbed as high as 4.46% before stocks retreated when the
Conference Board reported that the leading economic indicators
fell in September.

And who knows, after all? I could be completely wrong. Perhaps
10-year notes won't rise much beyond 5%, if that. But I suspect
otherwise. I suspect there is looming chaos in the bond market,
spawned by Fannie, Freddie, and the simple belief that U.S. bonds
will always be accepted as safe and dependable.

If you believe that, I'd like to introduce you to my big, fat
friend in his bright red suit.

Warm regards,

Dan Denning,
for The Daily Reckoning

P.S. EMD and GVT are not perfectly representative of the yields
on the underlying bonds in their respective portfolios. This is a
function of how closed-end funds calculate yield. But in general,
the BED spread gives you a pretty solid way to measure the
big-picture perception of creditworthiness in the market.

And it's also an excellent indicator for when to try and make
money by"selling the dollar."

Thread gesperrt

 

gesamter Thread:

• The Daily Reckoning - Convergence Under The Bed Spread (Dan Denning) - Firmian, 24.10.2003, 11:57
  • Spread zwischen Emerging Mkts und US Gov Bonds gestern 4.79 - Tendenz abwärts - kingsolomon, 24.10.2003, 13:09