April 25, 2008

Lots of speculation and exhortation in the air about the Fed FOMC meeting next week! Econbrowser‘s James Hamilton wants the rate constant at 2.25%:

…there is a compelling case that by rapidly bringing the yield on short-term Treasury bills well below the prevailing inflation rate, the Fed has played a role in the significant depreciation of the dollar and increase in the dollar price of virtually every storable commodity that we’ve seen since the beginning of January.

If the Fed surprises the market with a pause, we should have unambiguous confirmation or refutation of the hypothesis that the Fed has been contributing to the commodity price run-up within 48 hours of the FOMC’s announcement. That knowledge in itself would also be extremely valuable– valuable to the Fed in calculating how to chart its course from here, and valuable in terms of making clear to the public why sometimes higher interest rates are the better choice for public policy.

Accrued Interest, however, is watching the unemployment numbers with more interest:

I think the worst of the liquidity crisis is past us, but we still have a weak economy will still be dealing with housing-related problems for a while. That will probably keep the Fed in a easy money mode for a while, which will be supportive of interest rates generally.

The thing to watch is primarily inflation data. I think bad housing data is mostly priced in (today’s rally supports this thesis), and while it could turn out worse than currently expected, inflation is actually the more important element for rates. Food and energy inflation has been problematic for a while, but the leakage into core inflation measures has been mild so far. The Fed has been gambling that it could afford to cut rates to improve liquidity because weaker employment would take care of the inflation problem.

If either employment is not as weak as currently expected and/or unemployment fails to contain inflation, the Fed will make a U-turn on rates.

Traders of 2-Years are betting there will be a pause:

“There’s been quite a shift in bond-market sentiment over the past few weeks,” said Nick Stamenkovic, a fixed-income strategist at RIA Capital Market Ltd. in Edinburgh. “The market has become increasingly confident that the worst is over for the financial sector and that the Fed is nearing the end of its easing cycle.”

Government bonds have lost 1.3 percent in April, indexes compiled by Merrill Lynch & Co. showed. The last time the securities declined was in June, when they fell 0.5 percent. The drop is the steepest since July 2003, when they shed 1.9 percent.

The two-year U.S. Treasury note yield rose to a three-month high of 2.50 percent today, before trading at 2.39 percent by 10:40 a.m. in New York, according to bond broker BGCantor Market Data. It has risen 65 basis points in the last two weeks. Yesterday’s government auction of $19 billion of five-year notes drew the least demand since 2003.

And, while financial companies are having to pay up for term money, they are able to issue in size:

Citigroup Inc. and Merrill Lynch & Co. led $43.3 billion of U.S. corporate bond sales, the busiest week on record, as financial companies sold debt at the highest yields since May 2001.

Sales compare with $31.2 billion last week and an average this year of $18 billion, according to data compiled by Bloomberg. Citigroup, the biggest U.S. bank by assets, sold $6 billion of hybrid bonds in the company’s largest public debt offering, while New York-based securities firm Merrill Lynch raised $9.55 billion by issuing debt and preferred securities.

On the other hand, the 30-day Fed Funds Contract is showing expectations of a hair over 2.00% until September, in line with the consensus reported by the WSJ of ‘one more, then stop’. Finally, the Cleveland Fed’s analysis of the options on this contract show an overwhelming expectation of 2.00%, with the “2.25% prediction” coming out of nowhere to take second place from the once strongly challenging “1.75% prediction”. We shall see!

There is a good story on Credit Rating Agencies published by the New York Times magazine:

Though some have proposed requiring that agencies with official recognition charge investors, rather than issuers, a more practical reform may be for the government to stop certifying agencies altogether.

Then, if the Fed or other regulators wanted to restrict what sorts of bonds could be owned by banks, or by pension funds or by anyone else in need of protection, they would have to do it themselves — not farm the job out to Moody’s. The ratings agencies would still exist, but stripped of their official imprimatur, their ratings would lose a little of their aura, and investors might trust in them a bit less. Moody’s itself favors doing away with the official designation, and it, like S.&P., embraces the idea that investors should not “rely” on ratings for buy-and-sell decisions.

It’s all reasonably fair minded – as reasonable as one can expect, these days! The author saves himself the unpleasant experience of PrefBlog’s wrath by prefacing his suggestion that the Fed, inter alia bring credit analysis in house with the word “if”.

It’s all craziness. There is no good way to forecast credit. It’s all forecasting, as prone to error and changing circumstances as any other forecast … you do the best you can and diversify, by name, by asset class, by any other source of risk exposure. The only solution for such apparent failures of forecasting as sub-prime and Canadian ABCP is to say something along the lines of … “You put all your money in this stuff and now it’s all gone? Well, you’re stupid. Go away.” But it won’t happen.

My other quibble with the author’s conclusion is:

This leaves an awkward question, with respect to insanely complex structured securities: What can they rely on? The agencies seem utterly too involved to serve as a neutral arbiter, and the banks are sure to invent new and equally hard-to-assess vehicles in the future.

How about … rely on your own credit analysis or don’t buy it?

The vote on the Canadian ABCP restructuring has, apparently, approved the proposed plan, although with some reservations:

However, Jeffrey Carhart, a representative for the ad hoc committee read a statement prepared by the group disputing part of the plan that could potentially release certain financial institutions from lawsuits over selling ABCP to their clients.

“Those who are voting Yes by proxy are preserving their ability to argue both the validity and fairness of the planned release” from legal challenges, Carhart read.

… and the final (?) hurdle comes next week:

Mr. Crawford acknowledged that the committee has “some work to do next week” to face the legal challenges, which the judge overseeing the restructuring will consider at a fairness hearing scheduled for next Friday. Without the judge’s approval, the plan cannot go ahead.

In a ruling this week, the judge said that the corporate challengers had raised “very forceful arguments” about “a very serious issue of law” – whether the plan to extend immunity from lawsuits is legal.

I’ll just bet the corporate challengers have raised very forceful arguments! In some cases, it would appear that glorified bookkeepers recklessly overinvested in the asset class … the investing corporations could well be looking at a few investor lawsuits themselves.

On another topic, the Ontario Teachers Pension Plan has released its 2007 results (hat tip:FWF). Very impressive! Most debates regarding the value of active management implicitly consider all active managers to be equal, which is not the case … active management needs to be marketted, with the result that (i) marketers are in control of the process, not investment managers, and (ii) even investment managers must give some thought to explaining their choices. The split is not passive/active, but passive/active-captive/active-marketted. I have no data, but I’m willing to bet a nickel that active-captive, as a class, handsomely outperforms its benchmarks.

Note that these indices are experimental; the absolute and relative daily values are expected to change in the final version. In this version, index values are based at 1,000.0 on 2006-6-30
Index Mean Current Yield (at bid) Mean YTW Mean Average Trading Value Mean Mod Dur (YTW) Issues Day’s Perf. Index Value
Ratchet 5.02% 5.07% 33,026 15.4 2 +0.1624% 1,092.4
Fixed-Floater 4.75% 5.07% 62,482 15.37 8 -0.2442% 1,051.3
Floater 4.46% 4.50% 61,761 16.41 2 +0.9502% 844.8
Op. Retract 4.85% 3.41% 88,900 3.41 15 -0.0167% 1,049.9
Split-Share 5.32% 5.84% 85,484 4.07 14 +0.1828% 1,039.9
Interest Bearing 6.16% 6.09% 62,370 3.86 3 +0.1353% 1,100.2
Perpetual-Premium 5.90% 5.56% 181,252 7.33 7 +0.2439% 1,020.7
Perpetual-Discount 5.71% 5.74% 305,433 13.90 64 +0.0020% 915.8
Major Price Changes
Issue Index Change Notes
BCE.PR.I FixFloat -1.2757%  
IAG.PR.A PerpetualDiscount -1.1876% Now with a pre-tax bid-YTW of 5.59% based on a bid of 20.80 and a limitMaturity.
BAM.PR.I OpRet -1.0980% Now with a pre-tax bid-YTW of 5.43% based on a bid of 25.22 and a softMaturity 2013-12-30 at 25.00. Compare with BAM.PR.H (4.96% to 2012-3-30) and BAM.PR.J (5.31% to 2018-3-30).
PWF.PR.I PerpetualPremium +1.3121% Now with a pre-tax bid-YTW of 5.49% based on a bid of 25.48 and a call 2012-5-30 at 25.00.
BAM.PR.K Floater +1.3587%  
Volume Highlights
Issue Index Volume Notes
RY.PR.B PerpetualDiscount 177,300 Nesbitt crossed 100,000 at 20.89, then RBC crossed 75,000 at 20.89 on special settlement. Now with a pre-tax bid-YTW of 5.66% based on a bid of 20.80 and a limitMaturity.
TD.PR.R PerpetualDiscount 122,700 Nesbitt bought 20,000 from Anonymous at 25.00. Now with a pre-tax bid-YTW of 5.67% based on a bid of 25.00 and a limitMaturity.
WN.PR.B Scraps (would be OpRet but there are credit concerns) 113,800 Nesbitt crossed 107,200 at 25.10. Now with a pre-tax bid-YTW of 5.42% based on a bid of 25.02 and a softMaturity 2009-6-30 at 25.00.
BNS.PR.K PerpetualDiscount 92,900 Now with a pre-tax bid-YTW of 5.52% based on a bid of 21.80 and a limitMaturity.
BMO.PR.K PerpetualDiscount 91,590 Now with a pre-tax bid-YTW of 5.83% based on a bid of 22.91 and a limitMaturity.
MFC.PR.A OpRet 68,910 Now with a pre-tax bid-YTW of 3.85% based on a bid of 25.55 and a softMaturity 2015-12-18 at 25.00.

There were twenty-one other index-included $25-pv-equivalent issues trading over 10,000 shares today.

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