The S&P500 is currently hovering around 800, almost -50% off of its October 2007 high. And while the first optimistic pieces are starting to pop up in main street media, a number of sources – including some of Wall Street’s powerhouses – suggest that the S&P500 will bottom in the 650-700 area. That’s another -12% to -19% from where we are today. If you take a look at the below flurry of indicators (courtesy of JPM/Bloomberg/OECD) you get a sense for what these predictions are based on: bad news across the board.
What do you think – are we anywhere close to a bottom?
Over the last few days there has been plenty of press about how and why Geithner’s annoucement of the rescue plan on Tuesday spooked the markets. The Dow ended the day down -4.6%, financials were down somewhere around -10%.
That’s the equity side of things. Corporate bonds suffered, too, on Tuesday as money flowed back to the perceived safety of Treasuries – but at least CDS showed no knee-jerk reaction to the Geithner plan: they did widen, but not materially. A silver lining?
CDS on Select Banks (US & Intl) through February 13, 2009
This is a visual addendum to my earlier post about inflation vs. deflation and the quantity theory of money. As a reminder, Friedman postulates that inflation is caused by an increase in the money supply; the quantity theory of money in its simple form states that the amount of money in an economy multiplied by its velocity equals the real value of goods in the economy times the price level, or M*V = P*Q. So an increase in the money supply, ceteris paribus, should result in an increase in price levels.
As I noted last month, the US monetary base has recently seen drastic increases. We haven’t seen rising inflation, though, because all the additional money that the Fed has been printing is getting soaked up by banks upping their reserves. FT Alphaville’s Stacey-Marie Ishmael posted an impressive chart yesterday showing this decrease in the velocity of money.
You can find the original here. And if you’re sifting through the FT Alphaville archives, also take a look at the hyperinflation scenario that Morgan Stanley sees as a (not highly likely, but realistic) possibility.
The government is adding to the bailout tab almost daily, and no slowdown is in sight. The total cost of equity infusions for financial institutions, guarantees and lending facilities to date is estimated anywhere between $4 and $8 trillion, depending on which programs are included in the count. The following chart shows some of the biggest ticket items in the US budget over the last 200 years, adjusted for inflation (i.e. in today’s dollars).
Below is the same chart, this time including the 2008 / 2009 bailout package (using the most conservative end of the range with an estimated total cost to date of $4.3 trillion). For reference, the total cost of World War II to the US was roughly $3.6 trillion.
Remind me why people are still talking about “deleveraging”?
A week ago, Standard & Poor’s published the November results for its Case-Shiller home price indexes. The seasonally adjusted 20 cities aggregate index is now down -25.1% since its peak in July 2006. Common sentiment on the Street is that home prices have further to fall, and the numbers cited range anywhere from an additional -10% to -40% of declines before we see a bottom. No surprise there.
It’s also no surprise that delinquencies and default rates are rising as more and more borrowers are under water on their mortgages and can’t afford the monthly payments anymore because of rate resets and rising unemployment. What is surprising, though, is the historical connection between home price appreciation (HPA) and loss severity, i.e. the actual loss incurred by a lender after foreclosure. In times of rising home prices, a lender will barely lose money even if a borrower defaults: the delinquent borrower is forced out of the house, the property is put back on the market and the lender recovers most of the unpaid loan balance through the sale of the foreclosed property in an auction. Now take a look at this chart which I found in a recent presentation by T2 Partners:
The chart shows a scary connection between home price appreciation and loss severity. With 10% HPA per annum, a lender gets 95% of his money back if the borrower defaults. With a more modest increase in house prices of 3% per year, severity is at 60% – i.e. the lender gets only 40% of his money back. The above chart should be taken with a grain of salt since it is based on only five years of data and I have not been able to confirm the loan type, but it is powerful. Based on this picture, what will the loss severity be in an environment of rapidly falling home prices?
I’ve written a some commentary on why I believe that the Treasury bubble is going to burst sooner or later. There are, however, a number of reasons for why what we’re seeing in the Treasury market may not be a bubble after all. The arguments below are taken from sources such as Capital Daily, Brad Setser, Merrill Lynch, Goldman Sachs and comments on my previous posts.
Argument #1: Low yields are justified as we are entering a period of sustained economic downturn, prolonged ZIRP and low inflation if not deflation.
If things continue to get worse, Treasuries may well continue to be the preferred safe haven asset for domestic and foreign investors alike. The general view coming out of Davos seems to be that we are in a severe global recession that will last through (or even beyond) the end of 2009. Market expectations, though, are still overly optimistic: Fed Funds futures are pricing in a rate increase by the end of the year. As market expectations slowly converge with economic reality, risk appetite will stay low and Treasury prices will remain steady. I personally believe this is the strongest argument against the ‘bubble’ hypothesis.
Argument #2: There is no reason to be concerned about the increase in issuance because the economic and financial conditions which prompt this increase simultaneously prompt a flight to safety.
Yes, issuance is increasing drastically – but it is increasing only because of the dire state of the economy, which goes hand in hand with a generally pessimistic outlook, high volatility with poor equities returns, low risk appetite, and investors’ flight to safety. This is an argument that I don’t buy, because you can easily reverse it: increasing issuance of Treasury bonds is a byproduct of the government’s attempt to restore investor confidence. Once the government succeeds, the flight to safety will abate and Treasury prices are going to come down.
Argument #3: Increased issuance and potentially stagnating foreign demand will be offset by increasing domestic savings rates, particularly by baby boomers.
Changing demographics may be a driving factor behind keeping Treasury supply and demand balanced despite increasing issuance and the potential drop off of foreign demand. The domestic savings rate is increasing, and the urgent need of baby boomers to save in order to fund their retirement will provide an increasing source of demand for Treasuries.
I’m on the edge about this argument. It is true that we are seeing an increase in the savings rate today after its short dip into negative territory in 2005. It is also true that the roughly 78m baby boomers are facing a savings crunch which was drastically exacerbated by the developments of the last eighteen months. At the same time, though, according to Corridor Inc. 20% of baby boomers have stopped contributing to retirement plans due to economic hardship. This leaves us with roughly 62.4m baby boomers who are actively saving. Some quick back-of-the-envelope math with simplified assumptions: the 2009 budget deficit is expected to reach $1.2 trillion, representing a ~10% increase to current national debt outstanding ($10.6 trillion). If we assume that Chinese demand falls off a cliff and China does not increase its ~$750 billion of Treasury holdings by 10% in fiscal 2009 (big assumption, I know), a demand gap of roughly $70 to $80 billion would need to be filled – translating into $1,100 of additional savings per baby boomer. That seems plausible in my opinion. At the same time there are so many moving parts in this equation – foreign demand, dollar strength or weakness, domestic risk appetite, savings rates – that I can only say: I don’t know what’s going to happen, but the sheer magnitude of the increase in supply makes me feel uncomfortable.
Argument #4: The government is firmly committed to quantitative easing and will keep yields down.
Ben Bernanke has made clear that the Fed is prepared to buy Treasuries, and the US government has strong incentives to keep rates as low as possible. Increasing yields in longer-dated Treasuries mean the housing market will continue to spiral downward as rates on fixed rate mortgages increase and other collateralized loans become more expensive. The negative wealth effect created by increasing borrowing costs will translate into even lower consumer confidence and consumer spending, and the effect will be doubly negative because borrowing is particularly important in times of high unemployment as credit is needed to bridge the income gap. I do believe that the government is fully committed to doing everything they can to keep yields low – but I also believe that what the government actually can do is limited; at some point, the government will run out of resources to keep yields down. To put numbers to it: a record $1.2 trillion of new issuance is expected in 2009; the Fed currently owns $475 billion of Treasuries, and the Fed’s total balance sheet stands at $2 trillion – but only because it has grown by more than 100% over the last twelve months. In my mind, if foreign and private domestic buyers decide to exit the Treasuries market there will be a whole that’s too big for the Federal Reserve to plug. At that point, quantitative easing will fail and the Treasury bubble will burst.
My verdict remains as before: I like short-dated Treasuries in a portfolio as disaster insurance, but would stay away from the long end of the curve because I am worried that yields will return to higher levels sooner or later. What do you think? In your opinion, what is the strongest argument in favor of Treasuries and against the ‘bubble’ hypothesis?
As the title says, this one is just for fun: a chart of the price of CDS on 10 year US Treasuries from April 2008 through January 27. The CDS priced at 68 bps today, after having hit a record high of 75 bps in the first week of December. According to FT Alphaville, the same contract trades around 2 (!) bps points in normal times. I should mention that the concept of CDS on US sovereign debt is somewhat flawed in my opinion (Who buys these things? Do people really think their counterparty will be around to honor the CDS if the US defaults? Isn’t the market too thinly traded for prices to be meaningful?), but their development is still interesting to watch. The chart below includes annotations on a few major Wall Street and Main Street events.
If you’re interested in commentary, I recommend the recent pieces by Greg Ip, Dean Baker and Felix Salmon for further reading. And if you have any thoughts on how sensible or flawed the notion of CDS on US Treasuries is, post a comment and let us know!