PrefBlog

Headline inflation in the US came in a 4.3% yoy today, powered by Food (+4.8%) and Energy (+21.4%). The core rate, which excludes these two items, was +2.3% yoy. Not a good report, according to economists surveyed by the WSJ – the Fed is now caught between a rock and a hard place on rates. Stagflation, anyone?

On what might possibly be a related note, William C. Dudley, EVP of the Fed, gave a speech on TIPS (hat tip: WSJ Blogs and Economist’s View):

Put simply, I come here to praise TIPS… In my opinion, the benefits of the TIPS program significantly exceed the costs of the program.
…
we might start by comparing the difference in funding costs to the Treasury of TIPS versus a program of comparable duration nominal Treasuries.

But we should also be careful not to ignore other potential benefits of the TIPS program. As I see it, these potential benefits include:

• Greater diversification of the Treasury’s funding sources, which presumably has favorable implications for the Treasury’s funding costs.
• The potential for TIPS issuance to reduce the variability of the U.S. government’s net financial position.
• Access to a market-determined measure of inflation expectations that can help inform the conduct of monetary policy.
• The provision of a virtually risk-free investment that provides value to risk-averse investors.

One point that was discussed during Canada’s introduction of RRBs (Real Return Bonds) was that this indexing makes it at least a little bit more difficult for the government to deliberately inflate away the debt – which is also, explicitly, an argument in favour of borrowing in foreign currencies.

Continuing with the inflationary theme, Tommaso Monacelli of the Università Bocconi, Milan has written a very hawkish piece regarding the recent ECB decision to leave policy rates unchanged:

Can the ECB publish inflation forecasts between 2 and 3 percent and decide not to raise interest rates? Given that its explicit mandate is to keep inflation below but close to 2 percent, what type of signal is the Bank sending to the markets, especially as regards its own credibility?
…

In this mounting inflation context, more than ever, the lack of transparency in the ECB policy points to the need of a more rigorous (arguably “scientific”) framework in which its policy decisions can be rationalized. Much of the recent literature describes the optimal conduct of monetary policy in terms of ‘inflation forecast targeting’. Two are the basic ingredients. First, a numerical target for inflation (as it is well-known from the experience of many countries in the world that have adopted inflation targeting, including emerging-market economies). Second, and more importantly, a management of the path of interest rates such that in each period the inflation forecast at some horizon, and conditional on that same instrument path, are in line with the inflation target.

He also criticizes what he sees as a somewhat circular reasoning process:

Reading carefully through the technical notes in small print (not really an example of transparency), one observes that the staff projections are based on the markets’ expectations of future interest rates. Hence they are conditional not on the future interest rate path that the Bank itself foresees as most likely, but on the interest rate path that the markets foresee as most likely.

The projection for 2008 inflation does indeed note:

The technical assumptions about interest rates and both oil and non-energy commodity prices are based on market expectations, with a cut-off date of 14 November 2007. With regard to short-term interest rates, as measured by the three-month EURIBOR, market expectations are derived from forward rates, reflecting a snapshot of the yield curve at the cut-off date. They imply an average level of 4.9% in the fourth quarter of 2007, falling to 4.5% in 2008 and 4.3% in 2009. The market expectations for euro area ten-year nominal government bond yields imply a flat profile at their mid-November level of 4.3%. The baseline projection also includes the assumption that bank lending spreads will rise slightly over the projection horizon, reflecting the current episode of heightened risk consciousness in financial markets.

… but saying that this is in small print seems to me to be overstating the case a little! The iterative process that leads to the final Euroland forecast has led to the forecast:

On the basis of the information available up to 23 November 2007, Eurosystem staff have prepared projections for macroeconomic developments in the euro area.1 Average annual real GDP growth is projected to be between 2.4% and 2.8% in 2007, between 1.5% and 2.5% in 2008, and between 1.6% and 2.6% in 2009. The average rate of increase in the overall HICP is projected to be between 2.0% and 2.2% in 2007, between 2.0% and 3.0% in 2008, and between 1.2% and 2.4% in 2009.

“HICP” is the “Harmonised Index of Consumer Prices”. I don’t see anything wrong with the system myself … it seems to me that basing projections on market expectations is as good as any other method and better than most. After having prepared these projections, the output (HICP) may be examined and if it’s outside the desired range then the actual policy decision may be made taking the expectation as a guide.

The most interesting part of all this, however, is that the spectre of inflation is intruding more often into public debate. Should stagflation become a more credible threat than it is now, I suspect policy makers will favour the stag- over the -flation and tighten even faster than they are currently easing … which could have major implications for long-bonds and therefore preferreds.

Mind you, though, the market as represented by LIBOR is ignoring the policy makers … at least for now:

The rates banks charge each other for three-month loans held at seven-year highs for a second day after policy makers in the U.S., U.K., Canada, Switzerland and the euro region agreed to ease the logjam in short-term credit markets. The cost of borrowing in euros stayed at 4.95 percent, the British Bankers’ Association said today, up from last month’s low of 4.57 percent and 3.68 percent a year ago.

“The market clearly doesn’t believe central banks can do anything about this crisis,” said Nathalie Fillet, senior interest-rate strategist at BNP Paribas SA in London. “This is not going to be a magical solution to the problem.”

There has been a certain amount of sensationalism regarding the deal – Accrued Interest doesn’t buy it:

Waldman says it’s a bailout because the Fed is offering loans that other banks wouldn’t be willing to offer. Here again, any bank who went to the discount window would borrow under the same terms. Does the continued existence of the discount window constitute a bailout? Put another way, banks would never use the discount window if financing was available elsewhere at similar costs elsewhere. So any time a bank uses the discount window, it’s a bailout by Waldman’s definition. This is why I am loathe to use that term.

Which brings us to the highly interesting topic of dissing the banks. Moody’s dissed Citibank today:

Moody’s Investors Service downgraded the long-term ratings of Citigroup Inc. (Citigroup) (senior to Aa3 from Aa2) and lowered the Bank Financial Strength Rating (BFSR) of Citibank, N.A. (Citibank) to B from A-. The rating on Citibank for long-term deposits and senior debt was lowered to Aa1 from Aaa. The rating outlook is stable.

The downgrade was prompted by Moody’s view that Citigroup’s capital ratios will remain low. According to Senior Vice President Sean Jones, “this situation is likely because management will need to take sizable write-downs against its subprime RMBS and CDO portfolio.” The bank is also expected to make significant sustained provisions against its residential mortgage book, which is over $200 billion. These charges are likely to occur when Citigroup’s normal earnings power is depressed, particularly in the United States.

“During 2008,” the analyst said, “Citigroup’s weak earnings should prohibit the bank from rapidly restoring capital ratios, despite its recent issuance of $7.5 billion hybrid capital.”
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For Citigroup’s ratings to be upgraded, the company would need to rebuild its capital ratios to levels maintained prior to 2007. As well, the firm’s pre-provision earnings power has to return to its previous strong level, while reducing its concentration risks.

The company’s failure to restore its capital ratios in the medium term would possibly lead to a further downgrade

Remember the BCE/Teachers deal? It is not, repeat: not, being renegotiated:

BCE Inc. (TSX, NYSE: BCE) is today issuing a statement in response to certain rumours in the market regarding the status of its definitive agreement to be acquired by an investor group led by Teachers’ Private Capital, the private investment arm of the Ontario Teachers’ Pension Plan, Providence Equity Partners Inc. and Madison Dearborn Partners, LLC (the Investor Group).

While it is BCE’s policy not to comment on market rumours or speculation, in the interest of its shareholders, the company is today confirming that neither BCE nor its Board of Directors is involved in any discussions regarding any renegotiation of any of the terms of the definitive agreement entered into on June 29, 2007.

Under the terms of the definitive agreement, the Investor Group has agreed to acquire all of BCE’s outstanding common shares for $42.75 per share in cash and all of BCE’s outstanding preferred shares at prices set out in the definitive agreement.

And you’ll have to parse the significance of that yourselves, because I’m not touching it!

There may be a certain amount of turmoil in the US markets Monday, as the Moody’s announcement on Monolines is digested:

Moody’s Investors Service has updated its evaluation of US mortgage market stress on the ratings of financial guaranty companies, and has considered those companies’ plans for strengthening capitalization, as well as their developing strategies. The following actions are the result of that evaluation. The Aaa ratings of Financial Guaranty Insurance Company and XL Capital Assurance Inc. were placed on review for possible downgrade. The Aaa ratings of MBIA Insurance Corporation and CIFG Guaranty were affirmed, but the rating outlooks changed to negative. The Aaa ratings of Ambac Assurance Corporation, Assured Guaranty Corp, and Financial Security Assurance Inc. and the Aa3 rating of Radian Asset Assurance were all affirmed with a stable outlook.
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As a result of these reviews, the Moody’s-rated securities that are “wrapped” or guaranteed by FGIC and XL Capital Assurance are also placed under review for possible downgrade. A full list of these securities will be made available later this evening under “Ratings Lists” on the company’s website at http://www.moodys.com/guarantors
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Moody’s will also be hosting a teleconference on Monday, December 17 at 11:00 EST/16:00 GMT/17:00 CET to discuss these actions in further detail. To register for this teleconference, go to www.moodys.com/events.

There was supposed to be an announcement about the Montreal Accord and Canadian ABCP today … after the close … later, but I don’t see anything yet! Apparently, the banks are getting sticky about liquidity guarantees:

Bank of Canada Governor David Dodge and governor designate Mark Carney pushed the bank chief executives on a conference call Thursday night to make commitments for liquidity backup that could be as much as $1-billion for some of the big five banks, said people familiar with the situation.

The liquidity issue is one of the final hurdles in the hoped for re-jig of the frozen short-term debt, which if successful, would help to avoid a meltdown that could have massive ripple effects in financial markets.

I confess, I don’t understand why a liquidity guaranty is important – the entire purpose of the plan is to avoid the necessity for refinancing prior to the new notes’ maturity.

Another very active day in the preferred share market, with weak prices. Tax-loss selling? Sheer boneheadism? You tell me. The BAM issues continue to get hurt badly, which seems to me somewhat mysterious.

There were fifty-three other index-included $25.00-equivalent issues trading over 10,000 shares today.

This entry was posted on Friday, December 14th, 2007 at 10:45 pm and is filed under Market Action. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.