MARKET RECAP: Root Down

Volatility continued to rule trading in equity and bond markets this week as the Bear Stearns hedge fund blow up and subsequent liquidation by lenders who owned collateral for their loans drove risk aversion with the front end of the yield curve continuing to outperform all assets. The sell off in US stocks, while deep, seemed orderly considering all the negative news hitting the tape. In addition the euro and dollar both traded to new highs v the yen which indicates there were no widespread carry trade liquidations. This indicates to us that the equity and bond markets may have weathered this storm for now and could trade with a positive bias this week into the FOMC meeting and 2nd quarter end.

INTERNATIONAL INTEREST: Trouble No More

Strangely with all the risk aversion in stocks and bonds the yen carry trade seemed unfazed with the dollar, sterling and euro all making new highs v the yen even as their respective stock markets sold off. This gives us reason to believe that the selling in equities could be corrective and consolidating. This weekend Trichet and Bernanke join the rest of the world’s central bankers at the BIS in Basel to discuss, what else, excessive risk taking and carry trades. It will be interesting to see if they cast any official warning or merely lend some “slapping of the wrist” rhetoric. Benign comments out of Basel could give carry trader further encouragement next week driving the yen even lower. We can’t help but believe in the relative value in the yen with the Japanese economy now growing faster than the US, Britain and the Euro Zone. A sharp reversal from a new low should be taken seriously as the yen is ripe for a rally and could drive general risk aversion in all asset classes.Next week the FOMC meets in a 2 day meeting ending on Thursday to decide interest rate policy. The dollar will be looking for any hint from the statement as to the bias and thus whether they still see risks balanced towards inflation. As long as the Fed remains on hold and concerned about inflation (tight) that should keep the dollar bid.

Bottom Line: The yen carry trade seemed to shrug off turmoil in the credit and equity markets this week as widening spreads may have only raised the appetite to lock in better carry. For this reason we believe the markets have weathered the storm for now as no de-leveraging of carry trades seemed to take place. We also believe this could provide support for equity prices in the coming week but remain cautious and on the lookout for a reversal in the yen.

COST OF CAPITAL: Jesus Christ Superstar

The bond market was roiled by the come to Jesus meeting in the CDO market which was given a huge dose of reality when the true market came to price the Bear Stearns (NYSE: BSC) distressed assets at a fraction of their carried book value. We were expecting some risk aversion or a widening of risky credit and were bullish on treasuries with the idea of a pending flight to quality. This event was somewhat different due to the mortgage derivatives and the duration hedges that are required due to negative convexity of mortgage bonds. In order to meet redemptions the funds looked to be selling the more liquid treasuries which put pressure on the whole coupon curve with the front end seeing most of the flight bid. We noticed the widening of the 90 day LIBOR and 90 day T-Bill spread a couple of weeks ago and assumed the market was beginning to discount a Fed ease. What appears to be happening is unwinding of flatteners and positioning of steepeners by the PBOC and PIMCO. Of course Bill Gross waited last week to recommend the trade as he raised his target for 10YR yields while at the same time suggesting the Fed will have to ease by the end of the year. With a Fed on hold and operating a hawkish policy, that would inherently be bullish for the curve leaning flat as the inflation premium would in theory remain low but we respect the powerful forces of momentum and sentiment.

Next week the markets will be facing more CDO news, a slew of economic data and a Fed meeting. We have been bullish on treasuries due to the potential risk aversion and decelerating economic growth. We have to respect the capital preservation bias towards the front end of the curve and would concentrate duration needs in the 5YR sector (as the risk of more CDO liquidations could put pressure on the long end) while reminding readers what we’ve been preaching for weeks, when liquidity is tight as the yield curve suggests, cash is a better relative value. That was never more evident than this past week.

Bottom Line: The poor boring bond market rattled Wall Street this week as the dirty little secrets of the leveraged collateralized debt markets were exposed by a liquidity event at a Bear Stearns hedge fund. We remain bullish on treasuries due to the strong credit quality and think that a continued tight Fed policy would anchor the long end’s inflation premium. However we also put a high price on liquidity and for this reason would prefer to stay within 5YR duration unless your risk tolerance is high.

BETA MAXIMUS: When Blackstone Friday Comes, I'm gonna stake my claim

The much heralded Blackstone IPO (NYSE: BX) went off with a thud as it was trumped by continuing selling in stocks due to fears and risk aversion due to the Bear Stearns hedge fund liquidation. As we have pointed out in recent issues, stocks are not in charge of their own destiny and this continues to be evident as prices are being driven by interest rates, fears of leveraged fund liquidations and tightness in credit markets which could spell doom for the LBO boom which has been responsible for the underlying bid in equity valuations. Last week we pointed out that the spread between intermediate grade corporate bonds (cost of capital) and the cash flow yield on the S&P (return on capital) had narrowed to even, removing the arbitrage many private equity firms had been exploiting. The market typically won’t allow such an arbitrage to exist before sucking out the last fraction of spread to take it away. It will be interesting to watch the recent LBOs for signs of financing difficulty and whether corporations will continue to borrow money to buy back stock. The great recapitalization boom (issuing debt to buy equity) that the stock market has enjoyed for the past few years could come to a grinding halt with the cost of debt capital rising closer to cost of equity capital just at the time when balance sheets were re-levered to take advantage of the low bond yields. We continue to recommend using rallies to lighten up as we think the volatility will continue and this week’s sell-off was potentially a head fake before a trip to a new high. We continue to monitor the yen carry trade for evidence of de-leveraging and despite the stress in the CDO market there did not appear to be any unwinding of carry trades. That being said this market can turn on a dime so it is not time to get cute but rather remain defensive and hide in short term high quality fixed income.

Bottom Line: Stocks are continued to be held hostage by the bond market and fears of a liquidity crises in the leveraged loan market. We think there are higher prices to come this week as traders look towards the FOMC meeting and quarter end, but remain very defensive and reiterate our strategy of using rallies to lighten up long positions.

DUKE & DUKE: This ain’t no party - This ain’t no disco

Crude oil continued it’s attempt at a break out of consolidation on geo-political concerns but was unable to penetrate the $70 level. Last week we mentioned that the crude market was potentially discounting some news as traders were looking to break out of the range. That somewhat happened with issues in Nigeria and Iran but was not enough to bring in heavy buying or scare the shorts. Crude remains a big x factor in the global markets and could be the catalyst for moves either way. Consider the petro-dollar theory behind rising asset prices which implies that the higher crude travels, the more money Middle Easterners have to invest in financial assets. Also consider the consequences of a crude and gas spike which could put pressure on the dollar and bond prices which would in turn put pressure on other asset valuations. We don’t have a firm opinion one way or the other as the odds seem to be relatively even. For this reason we remain on the sidelines and prefer to watch the cause and effects on other markets.

Bottom Line: At this point crude could go either way, but we are leaning towards a breakout of the range. We have little confidence on the impact on other assets prices as we can build an argument either way. For this reason we are on the sidelines and prefer to use the contract as an indicator of risk premiums.

THE EX ANTE FACTOR: Medicated Goo

Whether trading currencies, bonds, stocks or commodities the one underlying factor that has been driving asset prices has been the credit cycle. Weakening the dollar, natural resource boom, real estate boom, LBO boom, recapitalization boom have all been products of the credit cycle which showed signs of contraction this week. We have been pointing to the peaking of the credit cycle and the potentially negative implications on all asset prices. We have also been preparing for tighter liquidity conditions by raising cash and utilizing capital preservation investment strategies. The Bear Stearns mortgage hedge fund blow up is a perfect example of this tightening credit and the value of cash when the market becomes illiquid. It is debatable whether this hedge fund event was isolated or the tip of the iceberg. The issue surrounding the pricing of collateralized leveraged instruments and the discrepancy between “book value” and “current market value” seem to suggest the problem could be more widespread than the pundits suggest. We concede that a perfect storm may have created this event, but would not discount that as to being isolated due to our theory of the catalysts for the chain reaction.

Consider the events of the past 12 months. In May of 2006 bond yields were rising and tipped the scales of the global stock market rally while unwinding carry trades. Bonds reversed on a flight to quality trade as investors clearly were in risk aversion mode bidding up bond prices as stocks corrected during the summer months. It wasn’t stress in the stock markets even as many bears were calling a major top in equities, but rather, Amaranth, a $6b energy hedge fund, that blew up on highly leveraged (doubling down) bets in energy markets. As Amaranth was in distress the flight to quality bid in treasuries intensified driving the 10YR well below 5.00% catching another highly leveraged hedge fund, Vega Select a $1b fund , who was short bonds, to cover positions and close down later that fall. So as the waters calmed through the end of the year, equity prices and carry trades continued through February as the Shanghai Composite was rallying in magnitude, reminiscent of the 2000 Nasdaq. Enter the Chinese who upon trying to curb speculative investments by raising interest rates took to raising taxes on stock brokerage accounts driving a steep sell off that rippled throughout global equity markets. During this market turmoil and interesting development occurred as US treasury bills started rallying and diverging from the implied 90 day LIBOR or Fed funds rate. It is unclear whether related to the stock market correction, but it appeared that the PBOC was allocating out of longer dated treasuries and into shorter more liquid T-Bills. The street looked very long treasuries as many were discounting a Fed ease and the slowing housing market was keeping the long end bid as mortgage funds were hedging against lower rates and accelerating prepayments. The steepening bias from the PBOC did not seem to abate and when the government announced an allocation of funds to Blackstone this only exacerbated fears that China was selling duration. The sub-prime tranches of the collateralized debt market were coming under severe pressure as defaults and foreclosures were rising so the holders of these leveraged instruments were facing a double whammy of rising yields and defaults. As the 10YR started creeping through the 4.75% level mortgage funds were selling duration hedges which intensified the selling sending the 10YR to 5.00% in 2 weeks. As the Bear Stearns hedge fund started to report losses in the fund moving from a reported -6% to -18% in a week redemptions hit and the highly leveraged fund was forced to raise cash. They couldn’t sell the illiquid CDOs which were already difficult to price in the open market so they had to sell treasuries or their duration hedges to meet redemptions. This snowballed as the street piled on the trade sending the 10YR to 5.30% just a week after breaching 5.00% in some of the most volatile trading in recent memory in treasuries. Would this hedge fund have shut down regardless of rising bond yields? Probably, due to their credit and leverage profile. But these events should be a warning signal of what can happen when leverage is elevated and your creditors call the loans. This time PBOC in effect re-priced their perceived risk of owning longer dated treasuries. The ripple effect has been that now previously mis-priced derivatives are being priced by the open market (not Wall Street back offices) and the holders are receiving a big dose of reality in the discounted bids.

We do not want to jump on the conspiracy soapbox of the effects of China selling treasuries but rather prefer to use this global macro example of the perils of low risk premiums, high leverage and waning liquidity. We have been pounding the table on the benefits of cash and the relative value of owning liquidity when liquidity is tight. This week was a perfect example.

What is the discount?

With the continued selling in stocks and stabilizing in bond yields this week, the implied premiums favored equities by the end of the week suggesting we could see some buying. The implied risk premium provided by stocks over 10YR treasuries jumped 17bps while the implied equity risk premium over comparable bonds rose 12bps.

The implied returns offered by current yields are consistent with the annualized return investors earned by owning the S&P 500 ten years ago. With the S&P 500 price up roughly 6% in 2007 adding the dividend of 1.8% we view the stock market as fully valued and are defensive at this stage in the cycle.

Bottom Line: Continue to use rallies in stocks to raise cash and rotate into money market, sub-5YR duration treasuries as the market should continue to pay for liquidity in the coming months and years.