August 2007


Among all the economic stats coming in the next couple of weeks only very few are important, and they all come within the next few days.

My general rule is:

When the economy and stock market are close to the top watch the weakest points, because that’s where the economy will crack. On the bottom, try to find the strongest points, because they will drive the economy back up

Right now pretty much everything is not important. Employment stats and inflation are noise, I’m not interested. Real estate is already dead, I’m not interested to see those starts and completions. All those consumer sentiments, factory orders, “leading” indicators – not important.

The weakest points that could be observed in the immediate future are consumer spending and commercial paper market, that’s it. The relevant incoming data are:

  1. Aug 31st Personal consumption expenditures
  2. Sep 4th Auto sales
  3. Sep 6th Commercial paper stats

That’s all I want to know for now, and, frankly, I expect no good

You probably know that I think about economy as an inflationary/deflationary wave. The current moment could (with some probability) become a turning point from inflation into deflation. The chart that hints me about this development is the ratio between CCI commodities index and total return of treasury bonds:

Inflation/deflation ratio

It is not totally clear yet (at least to me – good chartists say more) but the chart seems like a potential topping pattern. There is a small head and shoulders pattern in June-July period. The whole fragment from February could also be regarded as a developing head and shoulders. And finally two trading weeks below 200 DMA could not be ignored.

When 50 DMA will cross down through 200 DMA the Feds will cut rates. I think this chart is more reliable indication of inflation than the CPI or PCE deflators reports. This chart is the voice of the whole market, because both $CCI and $DJCBTI are traded with trillions of dollars. We will know for sure what Feds will do in September

Yesterday I heard interview on Doomboomberg radio with a professional historian who studies the history of debt. He made couple of interesting points, for example one is related to my bullish sentiment toward the Treasury debt.

He said in the whole history of the World the government debt was never ever paid back. Instead, eventually every government debt is:

  1. restructured
  2. canceled
  3. defaulted

So our US Treasury bonds will have to go, eventually, one of those routes. Despite the AAA rating the priced-in probability of the default is, must, and never be zero, which means treasury bond yield will always have some premium above inflation.

You know that I’m bullish Treasury bonds based on my deflationary expectations, but now I believe that the entry points into position must be selected carefully and the amount of investment must be proportional to other investments. There is a big difference between Japanese government bonds that yielded 1% at one point our Treasury bonds. Japan is a next exporter with very healthy combined country balance sheet. It doesn’t matter that the balance sheet of the Japanese government is not so good as long as the country as the whole is healthy. After all, government can always raise taxes if the tax base is rich. The future of Japanese government debt from the list above is 1. restructured

Another interesting point the guy did was related to the collateral of our debt. He says that our government is refusing to allow foreign corporations to own our “strategic” businesses, which is pretty much every all the good corporations.

If Chinese cannot convert our bad debt into owning Boeing and Exxon Mobile, why should they bother to lend us any money? After all, it is crystal clear that our debt will never be paid off so the only reason to lend is to expect that they will be allowed to pick the gems of American corporate world as the refund for the defaulting debt.

And one funny point he made concerning the nature of debt and our current prosperity.

In fact anyone can create new debt, for example the tenant who did not pay the rent creates new debt. But this debt is useless for the landlord, can’t go and buy groceries for that debt.

What happens instead in our economy is that when tenant can’t pay the rent he goes to the bank, borrows money and pays the rent. It results in economic prosperity, because the landlord made profit, the bank made profit on debt payments, the debt is packaged into CDO and sold on the secondary market, which creates liquidity. The pension fund, which purchased the packaged debt paper is posting profit, because the yield on this debt is well above treasury bonds but the packaging magic made it AAA. The default rate is low, the money supply is growing.

But at the end of the day it all happened because there is a renter who can’t pay his rent

It is said about Chrysler’s new owner hedge fund Cerberus:

The smallest of the three automakers needs to negotiate more immediate savings to raise cash for operations, said the people, who don’t want to be named because the discussions aren’t public.

It seems that private equity funds (I also call them Kings of Junk) that were hit badly by recent junk bond crash are engaged in violent cost cutting at the companies they now own. That will include lay-offs, unprofitable branch closures and chopping corporations into something that could be re-sold to other hedge funds.

We’ll sure hear about that more very soon

The February crash happened because of subprime MBS panic.

The July-August crash happened because of subprime MBS panic and LBO secondary debt market panic.

Subprime mortgage market is gone. LBO market is gone. So the market is recovering. Next, there are several problems in the pipeline that will prompt the next sell-off, whenever it happens:

  • Commercial papers market
  • General, non subprime mortgage papers market including jumbo loans and neg-arm loans made to the people with good credit
  • Commercial real estate debt market
  • Hedge fund redemptions

I don’t know which one will hit us the most, here I want to give more details about the commercial paper market.

Here is a page tracking commercial paper market that was very boring for several years and now finally came into move. This is discount rate spread:

a2p2 spread

As you can see the market is charging a lot more for a very slight risk increase. No wonder that the outstanding paper is in decline:

outstanding commercial paper

The pipeline of the commercial papers that are expiring is in hundreds of billions, so the capital-intensive businesses will take a hit on bottom line very soon

When ¥ien topped last week at 112 ¥/$ we would thought that the carry trade is dead. Today it’s back to 117.

Those guys will never learn :-)

My own definition of the term credit crunch (which I’ve posted before) is:

Credit crunch is when lenders do not compete with each other

Let’s get to news. Today it was announced that several banks just borrowed $2 billion from the newly opened discount window.

So the question is – if Citibank has huge capital, why it does not lend those $500 million to its clients itself? Can it lend?

Of course it can. The problem is – it doesn’t want to

Just saw a commercial ad on TV from Capital One, they advertise “Home loans with a fixed rate below prime”.

Holy cow! The prime rate is 8.25%. So all they can say about their loans is that the rate is below 8.25%.

It will take couple of weeks before the new mortgage conditions will bubble up to the related statistics, like home sales, default rates and consumer spending.

I think we are more or less in the recession right now, but we will be firmly in the recession by the end of September, so I expect negative Q4 GDP growth

The McClellan oscillator:

McClellan

Looks like if finally bounced off the bottom and now we can face couple of weeks of up and sideways market actions.

All the credit default swaps bounced from the lows, junk bonds are not falling anymore, Feds are believed to be in full control.

In conclusion, longs should patiently wait before exiting the market and short must patiently wait before shorting more

I like pictures worth thousand words. This is money market price:

Money market

We are at the levels we’ve being after September 11 2001. This is not just recessionary. Last time this happened it was 6 months after the recession started.

So I think we are already firmly in the recession by now (I’m writing this at August 20). The official statistics will need couple of months to catch up with reality, but it will mark this recession start at August 2007.

Or even before that, who knows?

Update. It was the biggest decline in Treasury Bill yield since World War II (there is no charts of that period). It’s 65 year record that we saw today

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