Signs of the Times

By: Bob Hoye | Mon, Dec 24, 2007
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The following is from our weekly Pivotal Events that was published for our subscribers on December 19, 2007.


From A Year Ago:

"Ameranth will be seen as a speed bump in the history of the hedge fund business."

- Dow Jones Marketwatch, December 29, 2006

That was the big fund that went under in the natgas market.

"Volatility is low for a reason. Equity fundamentals are excellent."

- Wall Street Journal, December 30, 2006
Equity Strategist at Standard & Poors

Obviously not a credit analyst.

"Junk Has Never Been So Fashionable"

- Wall Street Journal, January 4, 2007

Compelled by fashion, junk narrowed to unprecedented spreads of 425 bps, over treasuries, in May and have widened due to a developing revulsion for risk. This has driven the spread out to 835 bps, with junk bond prices falling by some 25 points.

* * * * *

From This Year:

On December 10 the Fed cut administered rates and the stock market plunged. On CNBC, Larry Kudlow advised: "I wouldn't panic. Investors should stay in for the long-term. Goldilocks is alive and well."

"The central bank helicopters are planning a co-ordinated drop of liquidity on troubled waters. The money to be dropped is not that large. But if this does not work, more will surely follow. The helicopters will fly again and again. One point is clear: central banks must be pretty worried to take such joint action ... It is easy to understand why central banks should have decided to take such heroic action. Confidence has fled the markets in a four-month long episode of 'revulsion'." (emphasis added)

- Martin Wolfe in Financial Times, December 14, 2007

In June we began noting that the two main policy tools would be to lower interest rates and to inject more credit into the system. Our view has been that short-dated market rates always decline in a post-boom credit contraction, and that the senior central bank usually follows the market change by a few months. Also short rates, such as treasury bills decline until the contraction ends.

The other point we have been making is that credit has been overly employed, which makes the idea of attempting to add yet more credit seem rather naïve.

Although it is attractively simple, their only hope is that both lenders and borrowers will become as reckless as they collectively were a couple of years ago. This is highly unlikely as the credit markets began a cyclical change in May that even in an ordinary contraction would have a long way to go before most inappropriately positioned speculators capitulate.

Another point to consider is that last summer's "brilliant" injections of liquidity did not go to the damaged sectors, but naturally flowed to where it could be employed. And that was into hot sectors such as base metals, crude oil and grain prices. The first two have completed what could be called market climaxes, and the latter seems almost there.

It is an old observation, but for the Fed to party it needs rising asset prices and a full complement of the usual reckless party animals.

If this was still on there would be no talk about "helicopters".

Stock Market: Generally, our view seems to be working out. Some of the more acute problems were likely to be cleared in November. Often during the initial phase of a cyclical credit contraction, markets could then recover in December.

However and although the credit imbalances are immense, the action in November was not severe enough to conclude the grind. Technically, the rally was likely to make it into mid month and in the sense of "close enough" this has been the case.

The other expectation was the probability of bad news reports of discovered huge write-offs, or even insolvencies. There has been some such reports as well as the bad news of the big multi-central bank bailout fund, that have been disquieting.

Then in January, the financial sector will be reporting results from the fourth quarter, and it is worth recalling that in October the street was confident that the third quarter news was the worst that could be dished out. Sort of like "the worst thing since unsliced bread".

In looking at the big picture, some of the components of the cyclical bull market are no longer in the game. In May, we noted that a boom can run some 12 to 16 months against an inverted yield curve. This is was the basis of our conclusion that the boom would end with "rational exuberance" as the curve reversed to steepening and a contraction credit contraction would follow.

Credit Spreads are in an interesting condition. Coming out of the pressures in November, the spread market was likely to find some relief into December and this has been the case.

The A rated sub-prime rallied from 33.59 on November 23 to 48.36 on Thursday. Yesterday's price was 42.36, and colour comment from today's trade in London puts it down a further couple of points. The close arrived in time for this deadline, and it's at 39.89. This, along with our Bank Trading Guide is becoming a "heads up" for the next travail.

In the meantime, traditional corporate spreads sensitive to the stock market such as junk were also expected to improve and this has been the case. But, the BBB has kept on widening. At 138 bps, over treasuries, in early November this unfashionable spread has widened out to 178 bps. This one provided a long lead to the August panic.

Spreads are definitely indicating another phase of liquidity concerns, which could come to the forefront as in August when the AAA sub-prime dropped and the money market suffered a 25-beep jump in yield.

The Yield Curve is also playing the part it played before things hit the fan last summer. Steepening took the whole curve (bonds to bills) from 113 bps in mid November to 179 on Friday. Some relief has brought this in to 154 bps.

The series of impromptu and now becoming huge infusions of central bank credit out of thin air into the marketplace seems to be keeping short rates, such as dealer commercial paper and Libor, down. The August panic was given a good shove when these two did the quick 25 bps jump in yield.

Going the other way, any decline in the treasury bill rate should be read as a warning. That has and will be due to the flight to liquidity, not Fed policy.

Traders have been aggressively positioned for steepening and investors sold the last bond rally to become defensive in the 4 to 5-year maturities.

The "rational" part was that June was the sixteenth month since the curve became inverted, and it had reversed by the end of May.

In June we concluded that the change in the credit markets was likely cyclical, and this was indicating that following their speculative peaks base metals would likely suffer a cyclical decline as well. New low prices were confirmed in early December.

Another important commodity sector - the grains - seems to be close to a concluding climax. The importance is that the senior central banks need rising asset classes to make their desperate "stimulations" effective. The old pushing on a string problem.

Of course, the terrific rally in crude oil was also supportive to the overall stock market, but it seems in a seasonal decline.

Other important aspects included the Shanghai market as well as the Baltic Freight Rate, and these are no longer in the game.

On the day to day influences, the curve steepened until Friday and wants to take a rest. Traditional credit spreads after suffering severe, but not ultimate widening, have been quiet over the past two weeks. The AAA sub-prime mortgage bond has been rallying for four weeks.

Perhaps our key call of the year was made in July when the impressive changes prompted the conclusion that the credit markets were in the biggest train wreck in history. A series of announcements by policymakers right up to this week's grand co-operation seem in line with this.



Bob Hoye

Author: Bob Hoye

Bob Hoye
Institutional Advisors

Bob Hoye

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