Market Recap: Vive Las Vegas

Volatility, de-leveraging and banking system dislocations drove trading this week as the spoos made a round trip from 1430 Monday to 1510 on Wednesday back down to 1451 at the close. Some historical developments in credit reared their ugly face in the form of wider spreads as the Fed and ECB injected liquidity to stem panic selling of levered assets. Fed funds opened at 6% Friday morning at it took the Fed 3 injections of $38 billion to get it down. Banks were hoarding cash and this sets up a critical tete-a-tete Monday between the bond market and the Fed when the repos are reversed.

International Interests: Storm the Bastille!

Last week on CNBC, the wise Art Cashion of UBS noted the key for the market is whether yen carry trades go from voluntary liquidations to involuntary liquidations. Meaning that we can have an orderly de-leveraging but if the margins calls come forced from banks it can get ugly. This week the currency markets ironically seemed to take a back seat as the carry trade pairs became subject to de-leveraging in underlying collateral such as stocks, bonds and commodities, rather than the volatility of the yen. Both the USDJPY and EURJPY almost traded tick for tick with the SPX and DAX respectively. Central bank liquidity injections kept the yen well bid v the dollar and euro as traders shied away from risk positions. Nevertheless, the credit cycle reversal we have been anticipating is underway and since we think the Fed will be easing by chunks rather than increments, expect the dollar to be under pressure as the negative sentiment grows. That being said, there are hundreds of billions being evaporated from the financial system. The loan market has shut down and spreads are widening. We have long said a credit crunch would be long term bullish for the DXY and this evidence is why we will look to buy on a new low. Cash and short term treasuries should continue to outperform in this scenario and we see no evidence yet that this thesis is in jeopardy. As for next week, anything goes as active central banks make speculating this week a hazardous business. The Bank of England’s absence from the global liquidity injection confirms our belief that they are the tightest central bank and would thus still look to hide in sterling for the immediate future.

Bottom Line: The tables turned a bit on the carry trade this week as it was no longer about the yen as much as about the forced liquidation of underlying collateral. These markets will start battling with each other as price discovery of collateral continues to drive volatility in all markets. We have been agnostic on carry trade pairs for this reason of un-quantifiable risks and will remain risk averse. We are looking for a spot to get long dollars as they are rapidly disappearing from the financial economy.

Cost of Capital: Mssrs. Trichette et Bernanke, En Garde!

The flight to quality was surprisingly muted this week as spreads continued to widen with foreign central banks injecting liquidity like mad. The curve continued to trade steeper with 2s/10s at the widest level since the tightening stopped in 2005. As the Fed and ECB came in Thursday and Friday the LIBOR spreads blew out reminiscent of the action during 12/15/00, two weeks before the Fed eased 50bps inter-meeting. Currently we are seeing a real battle between the markets and the global central banks as the market is demanding more risk premium as the banks attempt to ease. The risk is the Fed continues to inject but spreads continue to widen and mute the effect. I believe this risk is highly probable of occurring a la 2001 during the last Fed easing campaign when 2s/10s went from -50bps to +250bps by the end of 2003. The direction of treasury prices is not nearly as important now as the spread of the yield curve. I believe we are entering a very unstable environment and the low bet principal protection of the front end is where money will hide v the volatile long end where the uncertainty will raise the term premium. Next week the economic calendar is full with inflation and TIC data to keep the market edgy. Both of those indicators have implications for the curve so it will be interesting to see how it reacts to the releases. Central banks are again expected to be active this week and it’s not out of the realm of possibility that we get an emergency ease from the Fed or ECB. All this likely puts pressure on the curve so we will continue to hold 5YR notes and look to buy on pullbacks (this week it got within 2bps of our target buying level of 4.75%). Growth in the services industry, now our most robust, has to be at a standstill with the debt market locked up. It’s unclear how much the seizing up of credit is affecting consumption but, Q3 GDP estimates likely are coming down and the nominal growth rate could be dipping under 4% which keeps the short end an attractive risk/reward.

Bottom Line: We are witnessing an historical credit event and the integrity of the central bank system is on the line. The markets are raising credit costs while the central banks are trying to lower them. Who wins? I’ll always bet on the markets as the saying, “don’t fight the Fed”, is put to the test. In a credit cycle reversal when banks are no longer the main lenders, it is questionable whether the Fed can exert the same influences as the past. In fact this time they could have the opposite affect.

Beta Maximus: Price Fixe Marche…

When Cramerica was capitulating last Friday we started looking for a bounce in the major indices and Monday morning despite a gap lower the market put in a nice low as it seemed the shorts were leaning to heavy as momentum slowed. Traders got further relief from the Fed on Tuesday when they seemed confident in the credit markets and growth of economy. Not exactly what they wanted to hear but it was enough to press the shorts who took the market up right into our target area of 1505, peaking at 1510.50 before rolling over hard Wednesday afternoon. CNBC blamed the selling on rumors that GS was having hedge fund problems that were soon denied (though later reported their in-house Alpha fund is -26% ytd) driving a mad scramble higher into the close. Shorts were left feeling trapped and longs relieved but 12 hours later woke up to a 15 point gap on problems in Europe and the ECB injection of 60b euros ($80b) into the banking system. That proved to be further catalyst for selling and liquidation with the markets closing on the lows of 1558 at the close Thursday. We were looking for a bounce and got it. Sticking with the strategy of selling bounces has served us well as selling the 50% retrace to 1500 was the prudent move considering the sell off into the weekend. Next week’s option expiration should provide some upward pressure as put holders look to lock in profits. We are not ready to nibble at prices with so much price discovery going on. There is no need to be a hero and provide liquidity to hedge fund liquidations. That being said the selling still feels corrective and there could be a nice buying opportunity coming in the near future. Markets always adjust to the downside faster than they deviate on the upside and this correction could be relatively brief. Whether that’s in 2 months or 2 years we can’t tell but we feel confident the market will let us know.

Bottom Line: Equity market volatility remained elevated as the credit market turmoil is rippling throughout the financial economy affecting spreads and valuations across asset classes. We have been preparing for these days and are sitting comfortable on stable positions. Investors are urged to proceed with caution and let the scared leveraged money sort this out in the street before committing fresh cash.

Duke & Duke: Fall of Versailles

Gold moves back to front and center this week with all the activity in money markets, central bank interventions and a flight to quality. We are not bullish on gold during a credit cycle reversal but acknowledge it could benefit with central banks injecting liquidity and potentially lowering interest rates. At this point we view gold will resume its inverse relationship to the USD and could rally on a new low but should reverse lower on a dollar rally.

Bottom Line: The unprecedented central bank intervention this week is what gold bugs dream about. Gold was better bid Friday but still remained far below its recent peak and we would not get caught up in the supposed benefits of the ultimate hard asset. That trade has come and gone. Since we expect the inverse correlation of the greenback and gold to resume and since we expect the dollar will rally soon, we will avoid owning gold or any other metal.

Ex Ante Factor: coup d’etat

The unraveling of the credit cycle we have been anticipating for months is upon us. Last week’s emergency intervention by global central banks highlights the severity of the banking system’s seizure and it is still unclear what next week will bring. When the Fed has to intervene thrice in one day to get the Fed funds rate from 6.00% down to their target of 5.25% it was clear the banking system is on edge and hoarding cash. As we ended this past week, there were reported more losses in bond mutual funds, quant hedge funds and a continuing widening of risk spreads. One of our indicators is the spread between 90 day LIBOR and 90 day T-Bills which Friday widened to 100bps and is suggesting an ease is around the corner. We have been convinced the Fed is too tight and the evidence is coming to light. A leveraged economy can not continue to grow when the cost of capital is higher than the return on capital and that is the predicament we now find ourselves. Even more troubling is the idea that cost of capital is rising even further at the very time the return on capital is falling suggesting the impact on growth could get worse. We are expecting this to continue and considering the yield curve’s behavior during the last easing campaign would be expecting risk premiums to rise and growth to slow. If 2s/10s steepens back out to 200bps like during the last easing cycle and the Fed lowers to 4% which we see as a minimum, 10YR note yields could rise to 6.00%-6.50% from today’s level of 4.75%. That could put bond yields which currently are trading 200-300bps wider than Gov’ts at 9.00%-10.00% assuming some further widening of corporate spreads. The bond/equity capitalization arbitrage has been removed and with cost of capital rising we expect the equity valuations to fall further.

Next week we expect central banks to remain active and more troubling headlines from the financial sector. There will be a tough battle between bulls and bears and the Fed will try to referee. In our opinion there is no way to handicap the coming days and market reaction and since we have been preparing for this environment for some time, prefer to sit on the sidelines and let the scared money duke it out over the next few sessions. As we have preached for months, sell rallies and buy pullbacks in 2YR and 5YR note treasuries.

What is the discount?
Last week we pointed to the widening of risk premium to a level which should bring in some buyers of stocks v bonds. That occurred to the tune of a narrowing of the risk premium of the S&P 500 v US 10YR notes by 24bps. Unfortunately for owners of stocks, the spread is now closer to the 2007 average indicating stocks no longer are relatively as cheap. In early July we pointed out that the S&P was roughly 200bps overvalued with our projected long term annualized upside 2007 return. Using that same metric we see the S&P as much as 300bps undervalued with its return of 3.5% on the year. This could also provide some support for prices but we caution that the economy is slowing and earnings should be expected to slow as revenues and stock buybacks decrease. These numbers should start to change and depending on the level of earnings revisions, these valuations could look too high even at today’s perceived discounted levels.

Bottom Line: Investors who have read this letter over the past few weeks would have ideally sold out of risky stocks and bonds having rolled cash into 5YR note treasuries and cash. No other strategy on the board has a better risk/reward profile for this environment and we see no reason to change or adjust. The credit cycle reversal likely won’t bottom any time soon though there could be bounces along the way. We are sitting pretty and will collect our risk free coupon from the government while we watch anxiously from the sidelines.