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The Ex Ante Factor: The Low Spark of High-Yield Boys

The percentage you're paying is too high priced
while you're living beyond all your means.
And the man in the suit has just bought a new car
from the profit he's made on your dreams.
But today you just swear that the man was shot dead
by a gun that didn't make any noise.
But it wasn't the bullet that laid him to rest
was the low spark of high-heeled boys.

The Low Spark of High-Heeled Boys
Jim Capaldi and Steve Winwood, Traffic

This week was relatively uneventful for the equity markets considering all the activity. We had simultaneous "come to Jesus" sessions in Congress with the bond insurers v Ackman and the Bernanke/Paulson two-headed monster v the bureaucratic blowhards, we saw mass municipal auction failures where some tax free rates hit double digits in various areas of the country and we executed this ridiculous "stimulus" bill designed to drive consumer and business spending on useless crap. Despite these catalysts, the stock markets just seemed to drift around in listless trading looking for direction.

While most pundits and analysts were focusing on whether the housing market bottomed or whether the S&P needed to retest the Jan lows prior to an advance, the bond market was providing answers under their nose. We consider the yield curve the single best economic and market indicator and yet it is rarely cited as significant. This week it made a new cycle high, just shy of 200bps in the 2s/10s spread, which puts it within striking distance of previous cycle highs near 275bps in 2002 and 250bps 1992. While we expect to see it continue to steepen into the March 18 Fed meeting, the yield curve presumably is nearing a peak. When it stops steepening and begins to flatten, we believe how it flattens will be giving the answers to how the housing market shakes out and whether we continue to see de-leveraging of assets.

We don't want to see the curve flatten in this low rate environment. It suggests the bond market is trying to stimulate the economy and that monetary policy is still too tight. If the curve flattens and the 2YR is pushing higher and faster than the 10YR it still is discounting slow growth but the risk aversion trade would be coming unwound and it would be a net positive for the capital markets and risk premiums. If the curve flattens and the 10YR is pushing lower it is suggestive of much larger systemic problems. Housing would not be bottoming in this scenario and likely neither would the carnage in the securities they collateralize.

We have been monitoring this rally in the 10YR and long-bond contract and have been anticipating a new high. We don't believe the bonds have come all this way just to turn back lower after the 10YR yield hit 3.45% only 35bps from new lows. A flattening curve paints two slow growth scenarios, neither of which will be fun. Bond yields across the curve are below the rate of inflation which suggests we are already in a recession and growth is decelerating rapidly.

The question the yield curve will be answering is how long and how deep is the slowdown. We think portfolio managers and CFOs will try everything to avoid owning 10YR coupons at 3.25% and hedge funds will be standing there to short highs in the contract. Therefore, if yields get down to previous lows and actually continue lower while flattening the curve it will suggest the market and economy are in much worse shape and in need of a much lower cost of capital to generate positive returns. That equals a long term low return environment for all assets.


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