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The Bond Market Disagrees With The Fed: So What’s New About That?

The US Federal Reserve through its Chair Janet Yellen has been making clear in recent meetings and speeches that the “federal funds” overnight interest rate (close to zero) is going to be with us for a “considerable” period of time, possibly lasting until 2016, so long as unemployment stays above and inflation stays below the Fed’s targets of “full employment” around 94.5% and “core” inflation of around 2%. Just now both bond market professionals and the Fed know we are below each target by about 100 basis points (1/100th of a percent). But that’s where any agreement between them ends and where the bond market begins its latest quarrel with the Fed. 

Bond traders always seem to think they know more than the Fed about money and the economy. Just listen to Rick Santelli on CNBC any day of the week: nothing new there. What’s new is the bond market seems to waver between two completely opposite assessments of why the Fed is wrong, both of which cannot be true: (1) that the economy is far weaker than the Fed gives it credit for (and is flirting with recession); and (2) that the economy is far stronger than the Fed realizes (and is flirting with inflation).  Just now the first premise seems to be winning out, but the second always lurks under the surface. The combination makes bond prices a spurious guide to equity investors.

Yet commentator after commentator on CNBC and elsewhere keep warning the equity market that “the bond market is trying to tell us something” important. Rick Santelli went so far as to say that the bond rate “yield curve” is forecasting a new US recession. For a while, equity markets seemed to be intensely listening to its schizophrenic financial neighbor: every time the price of ten-year Treasury notes retreated (causing interest rate yields to fall) during the course of recent trading day, the equity market sold off very noticeably.

If the ten-year rallied and yields temporarily fell, equities would broadly rally in price also, even stopping for the moment the precipitous slide in the market value of so-called “momentum” growth companies in biotech and “new tech” areas like social and internet media, cloud computing, enhanced data security and even electric cars. These stocks had rapidly fallen out of favor with the onset of a rash of IPO’s and secondary offerings and insider sales in these sectors, with investors rotating away from them to so-called “value” stocks with far lower P/E ratios (and far lower earnings growth). This is in part under sway of the Fed’s bond market critics who argue that its Quantitative Easing (QE) programs have actually held back a more normal “return” to robust growth and that, as QE finally stops, the emerging strong economy will “lift all boats,” even heretofore growth laggards like Cisco and Intel. Why risk money on the high beta highfliers when you can get more from a quick pop from the “Dogs of NASDAQ” with less downside risk (since they are down so far already).

Sounds logical, but you have to buy both premises: that the economy will be coming back gangbusters, and that the likes of Cisco and Oracle can regain market share leadership from the newcomers like Salesforce.com and Workday and that have beaten them in the market during the tough years we have just come through.  And you also have to disagree, of course, with the notion that the current bond market pricing is forecasting a recession, which would be a reason to get into cash, not a Cisco.

The Fed has announced both the tapered end of QE by the end of this fall and its intention to continue, however, with highly accommodative interest rate restraint until late 2015 at the earliest to give the economy the best chance to reach both its healthy employment and inflation targets by 2016. Bond traders seem to think both policies are wrong: that, on “free market’ principles, QE should already have been ended and that short term interest rates should be…here things get interesting….raised sooner  rather than later because credit trading is not yet normalized but nonetheless should for now trade lower because the economy is actually in worse shape than the Fed realizes, at both the short end and the long end. Which makes for the classic ‘flattening of the yield curve” that often predicts recession! In short, bond traders seem to have seen Steve Martin’s “The Man With Two Brains” so often they have forgotten it was a comedy. And these are the folks the equity markets are supposed to pay attention to?

But could it possibly be that the Fed, not the bond market, that has its head straight? That the Fed realizes that the “weather deniers” in the bond pits are wrong to dismiss any relationship of the past winter’s excesses  to December through February shortfalls in retail sales, construction activity and factory orders (all of which interim trends clearly have reversed in March according to actual data)? That the Fed realizes that a flight to Treasuries has been triggered far more by the crisis in Ukraine than by the bond trader mantra that the economic sky is falling in the US? That the Fed, moreover, has been able to pull off the tapered end of QE without the massive run-up in ten-year Treasury rates (that would have killed the slowly-emerging housing/mortgage recovery) feared last summer when QE tapering was first mooted by Chairman Bernanke. Indeed, money has flowed into Treasuries – perhaps more by happenstance (think Putin) than design, but better to be lucky than scared in most aspects of life.

In their defense, bond traders argue that QE has failed because interest rates actually went up during its heyday. But the Fed was not looking to drive down rates.  It understood that longer term interest rates would rise with the economic recovery it was trying to stimulate by holding short-term interest rates down. It simply was using QE III to keep that increase within reasonable limits –-which even bond traders would have to agree it did.

Ever since the Great Recession hit, bond traders’ many apologists have criticized every single move the Fed has made, predicting both doom (rampant inflation) and gloom (a return to recession) – two phenomena that rarely, if ever, accompany each other! Perhaps the equity markets should indeed watch the bond markets carefully, not for ancient wisdom, but for signs of such inherent incoherence, and act accordingly. Maybe the Fed after all has the more correct and balanced view –  that the economy is getting better, but needs more help to get really well, and the bond traders just need to get over it.

By Terry Connelly, Dean Emeritus, Ageno School of Business, Golden Gate University

Terry Connelly is an economic expert and dean emeritus of the Ageno School of Business at Golden Gate University in San Francisco. Terry holds a law degree from NYU School of Law and his professional history includes positions with Ernst & Young Australia, the Queensland University of Technology Graduate School of Business, New York law firm Cravath, Swaine & Moore, global chief of staff at Salomon Brothers investment banking firm and global head of investment banking at Cowen & Company. In conjunction with Golden Gate University President Dan Angel, Terry co-authored Riptide: The New Normal In Higher Education.

 

 

 

 

 

 

 

 

 

 

 

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April Showers Hit Markets: Bring An Umbrella To Trade

Previously published on The Huffington Post

Forces at work from Tokyo to Kiev have been roiling the US stock market for a couple of week. But the financial sushi that is now on the menu in Japan, and Russia’s “Crimea of the Century” are only part of the story.

Japan is trying at long last to revive its moribund and literally “deflated” economy by a combination of easy money (to spur needed domestic inflation, weaken the yen and grow exports), structural reforms and a major sales tax increase to reduce the overwhelming level of government debt brought about by decades of fruitless “stimulus” overspending on unneeded infrastructure. Sounds good. But traders in the US have come to fear that Japan’s Fed is not pumping out easy money fast enough to offset the tax increase, which in turn will slow rather than stimulate the Japanese economy and cause the yen to rise undermining the traders’ so-called ‘carry trade’ – borrowing cheap yen to convert into dollar equities thus boosting US equity prices. If everyone unwinds the “carry” at once – as has been occurring recently – equities fall hard, especially while the US Federal Reserve is slowly but surely unwinding its own extraordinary quantitative easing program. The whole scenario also threatens the positive outlook for enhanced global economic growth that we started this year with, further undercutting equities.

The Russian invasion and annexing of Crimea has gradually added to global growth worries and equity jitters, but obviously not because of any financially strategic characteristics of Crimea. With a US president facing political pressure to prove he can ‘stand up to Putin’ from a public that nonetheless has utterly no stomach for military intervention in Ukraine, the only “weapons” available are economic sanctions of the “this will hurt me more than it hurts you” variety. The “personal” sanctions against Putin’s oligarch cronies are not the equity traders’ problem. But moving to the next level of sanctions on trade with Russia, ultimately including energy products like oil and gas, would impose pain for the entire European economy, which has enough troubles of its own from the Eurozone crisis hangover.

Other sources of energy imports, including from the US, can’t possibly come through fast enough to spare Europe a recession if Russia further destabilizes the eastern Ukraine or even invades and the West is forced to go to “DefCon 4” level trade sanctions. As a result, nervous traders are watching the Ukraine/Russia border even more closely than the CIA. (Why didn’t they borrow some of NSA’s tricks and snoop the Vlad-phone before Putin made his move?)

In the midst of these growth-threatening circumstances, along came 60-Minutes worth of Michael Lewis’ latest exposure of Wall Street excess (“The Flash Boys”) undermining confidence just when confidence is what investors need most. Lewis revealed in plain English the millisecond advantage high-speed, computer-driven traders have enjoyed –- with the profit-related connivance of the major stock exchanges and the unwitting assistance of SEC market reformers – allowing them to jump ahead of buy or sell “market” orders from you or me or the biggest institutional traders to make gazillions of risk-free penny profits by forcing us to pay more than what our computer screens tell us is the “market’ piece. Simple, computer-elegant, virtually un-measurable and probably legal front-running.

While the Lewis book no doubt caused some 60-Minute retail investors to pull their money out of stocks, professional traders haven’t really been moved to dump equities by the notion that their customers are being nano-skimmed. They are more concerned by Lewis’s reminder of the power of computer-driven trades set to algorithms that can trigger massive and sudden market sell orders based on momentary and even accidental extraordinary price changes in single stocks or ETF’s.

The famous “Flash Crash” a couple of years ago was just such an event. The Lewis book effectively underscores the fact that we can’t get really get to the bottom of the chain of events that actually caused that sudden market collapse because our trade monitoring devices can’t get down to the millisecond level. The ‘pings” of such trades simply are undecipherable with current market-policing technology – they are effectively lost in the vast Indian Ocean of dark- pool private exchanges that sprang up in response to the regulatory reforms designed to open up the stock exchange oligopoly to more competition and thereby lower “spreads” between bid and ask prices. It did so, but to so a fine degree of fault that traders can’t really tell that their pockets are being picked. (By the way, the flash crash happened in May, so no surprise that equity traders start to get nervous memories in April.)

Finally, the “rotating correction’ – from bio-techs to cloud computing to big data and finally to anything with a high P/E multiple – that has rolled through the equity markets in the first week of April was triggered by a couple of oddly interpreted events. First, Congressman Henry Waxman of California (a retiring but not shy Democrat) and a couple of his Party colleagues wrote a letter to Gilead asking why the company was charging $1000 per pill ($84,000 per full treatment) for the newly approved and highly effective Hepatitis C drug. Note Waxman is a Democrat and thus virtually impotent in the Tea Party dominated House of Representatives. But never mind. Traders dumped Gilead like a failed Phase III trial and took the whole biotech world down with it purportedly on fear that there was a serious threat to drug pricing going forward. Nonsense – at least from the government. But when the largest pharmacy benefits manager, Express Scripts, took up the same cause this week, the threat at least looked a little more real. No doubt many biotechs were trading in bubble-land — but not particularly Gilead.

Then a couple of high-flying technology and biotech companies had the gall to do a secondary offering in the midst of a great run for IPO’s in the same sectors over the first quarter and into early April. Our beloved equity traders are supposedly strong free-market capitalism advocates, who urge our politicians to keep the tax breaks in place for the venture capitalists who deserve the rewards of their successful investment because they are such prolific ‘job creators.”

But when the VC’s have the nerve to cash in those chips with secondary offering of their own shares that dare dilute the sleepy traders by surprise — somehow they didn’t notice those stocks were also at bubble-land prices – there is hell to pay for the rest of the shareholders, as those traders joined the secondary sellers in unloading their own inflated shares, taking profits and continuing to sell down if only to preserve capital for a later run.

Many market commentators broadly praised this “multiple correction” as portending an overall return to a more “normalized” trading environment without the extreme multiple expansion of the last couple of years that some prominent voices believe is more attributable to the Fed’s money than the companies’ revenues or even their profitability (which for some as yet is non-existent). But more than a few healthy babies have been thrown out with this bath. Warning to the commentators: be careful what you wash for!

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By Terry Connelly, Dean Emeritus, Ageno School of Business, Golden Gate University

Terry Connelly is an economic expert and dean emeritus of the Ageno School of Business at Golden Gate University in San Francisco. Terry holds a law degree from NYU School of Law and his professional history includes positions with Ernst & Young Australia, the Queensland University of Technology Graduate School of Business, New York law firm Cravath, Swaine & Moore, global chief of staff at Salomon Brothers investment banking firm and global head of investment banking at Cowen & Company. In conjunction with Golden Gate University President Dan Angel, Terry co-authored Riptide: The New Normal In Higher Education.

For Once, a Consequential Fed Meeting

Wednesday’s conclusion of the first Fed meeting of 2012 may herald a new working majority at the Board more closely aligned with Chairrman Ben Bernanke’s view of the economy and the role of the Fed in supporting employement as well as restraining inflation. What would be the consequences?

First, the identification  of an inflation rate of 2% , give or take a few basis points, as the specific target of Fed policy. Secondly, related to that objective, a new transparency with respect to the individual expectation of the Reserve  Board members as to the likely course of interest rates over the next several quarters and indeed as far out as 2014. This will not be revealed by name but by a sort of collective range of projections, dropping off the highs and the lows to try to contain market speculation as to who on the Board  specifically is the high or the low. Thirdly, related to these projections, would be a change in the language of the Fed’s starement heretofore guaranteeing low interest rates through mid-2013 — words will be added to in effect EXTEND the period of low rates into 2014. And finally, there may even be an initiation of a form of QE3 — the Fed’ s version of stimulus — this time focused squarely on the housing market by way of extending the Fed’s purchases of bonds from Treasuries to mortgage-backed securities.

All four of these actions may not be reflected in the official post-meeting statement ,and some may come out shortly after the meeting. But any one of these four actions would lead the financial markets to anticipate the other three in due course. The main concern, if and when the entire policy package comes together, is whether the markets will somehow misinterpret the Fed’s “new transparency” in ways which the Fed does not intend and would soon have to correct, especially in the face of continued market nervousness about the Euro debt crisis. (The US markets simply have yet to understand that all negotiations continue on to the next Euro “Summit” —  because no side can politically or financially afford to leave an impression that they gave in too soon – this is all that is really going on with the Greek debt issue.)

It’s Still A Greek Haircut — Short Back and Sides

Here’s what’s going on with the European Debt Crisis, and particularly the Greek bond “haircut” negotiations; the fact that the barbershop closed over the long three-day weekend is of much more moment than the Standard & Poor’s downgrade of most Eurozone sovereign credits, which was widely anticipated by the financial markets (we should have guessed they would do it on Friday the 13th).

Here’s the deal:

Greece owes more money to its bondholders than it can ever afford to pay off, so the Eurozone “leaders” came to an agreement with the representatives of the major bank holders of Greek bonds back in December that the holders  would take a 50% haircut on the face value of their holdings in an exchange of those securities for new Greek bonds of considerably longer duration; but they deferred setting the  exact terms of exchange, including importantly the interest rate they would be paid on the new longer term debt  That rate — if set too low – would of course constitute an even deeper ‘haircut’ on the total value of their  holdings.

Most of the banking institutions holding  Greek sovereign debt can ill afford write-down on their balance sheet beyond 50%, which would put them in potential need for financial bailouts from their governments (the same governments S & P just downgraded, in part because of this very risk. But of course these governments would also have to pony- up more money to Greece if the interest rate is set so high on the new bonds that Greece can’t afford to pay the it off when due! It is this “balance of terror” that negotiators in December  felt would  lead to a rational, face-saving (as well as other-parts -of -the-anatomy-saving) deal on the interest rate that all parties could live with, by now.

Most of these bank holders bought the debt early on, but only some have the protection of hedges with credit default swaps, which would  theoretically (depending on the solvency of the counter-party) pay 100% of face value if Greece forced a haircut by legislation and thereby actually “defaulted”. The existing bonds are governed by Greek  law, which Greece could at least try to change to force harsher terms on the holders. Thus  the banks are  being “asked”   to choose between getting 50% or less of face value by “voluntary’ agreement, or, in a some but not all cases, take their chances on getting 100% through their CDS “insurance” under circumstances where the whole financial system might nonetheless collapse (a la Lehman) around them — and their insurers — because a forced conversion would likely foreshadow  a disorderly Greek default, which is exactly what most everyone has been trying to avoid! look like a voluntary haircut deal to me.

But now come some  hedge funds (the only lower form on the financial system’s Tree of Life apparently lower than Bain & Company in a Newt Gingrich taxonomy) that bought up Greek sovereign debt a the current market rate of t20-25% of face value, looking to cash in on the 50% haircut deal that they thought  would be a 100% windfall for themselves. And they have the Gaul (some of them may be French) to be so upset by the low interest rate Greece proposes to pay on their new bonds (with a push from the IMF,  Greece’s lender of last resort, which loves its own pocket book more than the hedge funds’ for sure) that they are threatening to walk away from any “voluntary” deal — I guess because just a 75% profit in a couple months isn’t enough). Greece being aware of this has threatened to change Greek law on the hedgies to force them to go along with a haircut deal struck with a majority of holders (the banks stuck, as described above,  between a rock and a hard place), knowing that this amounts to a default that could bring down the whole Euro house —  including Greece, as their Finance Minister well knows. The hedge funds seem tempted to bet that, rather than see that event happen, even the new Iron Lady of Europe, Frau Merkel, will come up with the  dough to let Greece pay a high enough  interest rate on the new bonds to keep the hedgies in hedge heaven.

Do we see any public spirited citizens in the room? This is not the first time the hedge funds or the Greeks  have played chicken with the world economy. My guess is that sometime in the next week Merkel will politely but firmly tell them  to stop the games or go to hell (namely, back to the drachma). This posture  worked in December with a slightly different cast of characters, and it worked with Berlusconi. But we may have a return to the wilder market days of last fall for a few moments this coming week or two before the dust settles. The effects of S&P’s downgrades can wait on this, because the too-easy ‘solution’ of letting Greece default is too much like the pre-Lehman “moral hazard’ talk that caused us all the trouble in the first place.Because if Greece is the new Lehman, then Italy, or Spain, or even France, is the next AIG, Merrill Lynch, or Bank of America, with or without further downgrades. But definitely without the lender of last resort that the Fed and the US Congress were able to be…unless the Iron Lady takes off the leash she holds on the ECB — dream on hedgies!

 

Better Fed Than Dead

Terry Connelly is dean emeritus of the Ageno School of Business at Golden Gate University and is frequently quoted on business, financial, and economic issues by Bay Area local, as well as national, news media.

 

Traders ares speculating that the fed is bound to disappoint the markets on wednesday as there is really nothing much they can do tohelp the economy grwo any more, and nothing much that they can agree on in any event. I think they are wrong, on both counts.

 

As to the second matter first — Ben Bernanke’s background is not in the corporate world, where a Board of Directors, like the Fed’s Open Market Committee at least in structure and mission, is expected to be unanimous or nothing at all. Instead, the Chairman’s background is steeped in academic strcuture. Like any dean of a strong minded faculty (including myself, although I have lived in the other world of business, too), he knows that no faculty is likely to be unanimous about anything, and it does not bother him particularly even he has two or three public dissenters to Fed policy. And he gets great marks from his colleagues for courtesy and openness. Most faculties prefer to debate more than decide, anyway, because down deep they have mutual respect for their diverse opinions, no matter have pointed their disagreements. Ben will do a deal with majority support and not hold out for the “perfection’ of unanimity. You don’t have a specially-extended  two-day meeting and then do nothing; unless you want to contribute to market carnage.

 

And what ‘s to be done? Lengthening the maturity of the Fed’s balance sheet (the so-called “twist’) was sexier  when it was really just a teenage dance move, but it would help hold down longer-term interest rates that are the base for mortgages and consumer loans. Lowering the interest rate it pays banks to keep their excess reserves on deposit with the Fed will also help at the margin to push them to lend, finally. (This step should be staged to prevent a huge washover of deposits into money market funds and risking their valuation.) Both these moves would be welcomed by the financial markets, especially in terms of reducing the current obsession with every choreographed move in the Greek default process, as the “troika” of EU. ECB and IMF negotiators string bailout approval VERY PREDICTABLY BUT ALSO INEVITABLY  to the last minute so as to hold in check the negative public  opinion in Germany about spending more money on the Greeks. (They cannot afford to be scene as anything other than the strictest of lenders, so they drag things out to create that impression while the markets forget that it was just last week that Merkel and Sarkozy said the deal would get done! Traders can be downright stupid at times.)

And, by the way, don’t let this loose talk that we’d all be better off just to let Greece default right now (rather than waiting until 2013 when the lead countries of the European Community get their banks in shape to sustain losses in a managed default) get the better of your memory. That’s what folks said about “letting Lehman fail” before the great mistake (predicted in this blog) that triggered the Great Recession. Moral: don’t listen to the drumbeat on CNBC, ever!