November 2007


Please be advised that the charting system at Markit.com is not working properly. For example, if you look at the ABX-HE-AAA 07-2 you’ll see that the price is 71.81%, well above the 66.41% that you can see on the chart. ABX indices “recovered” last week, if you can call this “recover” :-)

You probably know from the quite popular book “Ahead of the Curve” that employment numbers are in general a lagging indicator. Please note that the book’s charts are actually based on revised numbers, so the initial report is double useless – first because it is lagging, second because it will be revised in the unknown direction.

On top of that my favorite blog “Sudden debt” gave one more reason that in this economic cycle the employment numbers are more lagging than before. Please read here to get more details.

So, when the November nonfarm payroll numbers will be released next Friday, December the 7th you should:

  • Understand that the numbers released at December 7 will give you the right numbers only for October, November numbers will be revised later
  • Understand that October employment numbers released next week will give you the state of the economy back in September and say almost nothing about October
  • Understand that September is so far away already that it hardly matters
  • Ignore those numbers, toss them out the window

I understand that all news channels will try to tell you how important the NFP numbers are. They are wrong

Libor (which is publicly available here with 1 day delay) is on the run. Something horrible just happened with 1-month rate, which went from 4.82% to 5.22% in one day. That could be an all-time record of panic. The 3-month rate climbed to 5.12% for a spread of 62bps above Fed target rate.

The stock market is very stupid and it will not pay attention to Libor until the chain reaction leads to something more understandable to stock traders. Like some kind of blowup or default, which will probably happen in 4-8 week timeframe. I’m bullish for now.

For now the conclusion is very simple: I put the chance of Fed rate cut in December at 90%. They just have to cut facing the next wave of financial meltdown

The official Santa Claus rally just started. The reasons are:

  • Credit default swaps are up
  • Junk bonds are up
  • McClellan oscillator tuned up, finally
  • Advance-decline indicator is sharply up
  • Because it’s Christmas time

Of course I do expect some kind of sell-off in the remaining two days of this week but it won’t go as low as past Monday lows, that was the bottom, methink.
We will continue our scheduled bearish programming next year :-)

No, it doesn’t mean I will stop posting, but my posts for the rest of the year will be bullish :-)

Update. The Libor spread problem I’ve pointed in the comments yesterday is charted here:

20 year record that we are observing. Feds will have to cut in December, no doubt I have about that. Should give the market what it wants, for now, i.e. Santa Claus rally will continue for the next few weeks

I want to partially answer a very nice comment from Tech Guy here. The main concern here is that we probably passed the peak of oil output back in 2005 and it seems that we will never ever reach the same output as it was two years ago.

It seems like it’s true. But let me to point out at the supply-demand part of the equation. I think for this economic cycle the oil bull market is almost over. It will probably do the last hoorrah run to $110 and then we’ll go into the bear market and I think oil will go as low as $50. Consumption will be pretty low. Lets talk about the next cycle.

We have all kind of oil depending on its price. I think we have only few months left of $50 oil and few years of $60 oil. (All prices are in current dollars, inflation adjusted for the future).

We probably have another 10 years of $70 oil and 20 years of $90 oil. But when the price goes up the consumption period will extend. I think we have at least 50 years of $150 oil and maybe 200 years of $200 oil. That (250 years) should be enough to finally come with fusion power. Nice job for our grand-sons :-)

What $150 oil means to us? I think we don’t need to go far for examples. The whole Europe is effectively living in the $150 oil for the last 5-10 years. The $6-$8 price per gallon is pretty much what it means. As far as I (and you) can see Europe is doing just fine. And I think we’ll be doing fine, after the coming economic crisis will make all the necessary adjustments.

Of course the low and middle-class people will not commute 20+ miles anymore. The suburbia will be left to upper middle class and most people will just move close to work. Believe me, it’s absolutely nothing wrong in living in the apartment in the 20 story apartment building and using mass transit for a short 3-5 miles commute to work. A billion of people is living like that and our population will live like that as soon as in 20 years. The upper mid class will still occupy the suburbia, but they will move closer to work, maybe 10-15 miles, no more than that. The railroads and 40+ miles/gallon cars will provide perfect and affordable transportation. As another alternative a short 3-5 miles trip to the nearest park-and-ride facility will do the job. Of course the bear market in suburbia real estate will continue as long as I see from now and going forward. A lot of homes will have to be abandoned and owned by Chinese and Middle-East investors.

I’m not pessimistic at all, oil has to be expensive and it will be, we will adopt perfectly well, we will just live differently

So C just borrowed $7.5 billion at the 11% rate, and those are convertible bonds, meaning the lender may get even more (as I recall when Countrywide placed a convertible bond few months ago they got a 2% interest on that).

What is the main C business? I guess lending money. The best business customers are getting prime rate, which is 7.5%. Mortgage interests are between 6.5% and 9%, unless you offer a mortgage to a homeless unemployed, which probably will pay much more than that.

So now C is officially losing few % on every $ they lend.

As people say they are the largest subprime borrower on the planet now. Next step will be selling assets and cutting dividends

Update: Mish made much more accurate analysis

Back in Sept 10 3-month Libor was 5.72% while Fed target rate was 5.25%, i.e. the spread was 48bps. Now Libor is 5.04% and the spread is 54bps. Sounds like a record to me.

Just to put this in prospective – back in January the spread was 11bps and was unchanged during the March panic (what kind of panic it was?). The first time it rose this year it was August 10, it went to 25bps.

The Feds did three cuts but the effect is like they did only one. The money are expensive

Since long ago I was planning to write a separate article on the benefits of the recession. But today I came across the Marketwatch article covering the topic pretty well. In short, the recession is a necessary part of the economic cycle, the way the economy is fixing itself.

Am I suggesting that I don’t care that people feel the pain during the recession? No, I care, but I think that they have to feel the pain, like any medicine is painful.

If the problem is that we off-shored our production away to China and became a nation of real-estate brokers that just borrow the money from China and sell homes and mortgages to each other then I think the fix of the problem will be that all those fat-assed people seating behind glass doors in various agencies lose their jobs, foreclose their homes and go to factories and start assembling a new generation of fuel-efficient cars and windmill electricity generators.

And the new generation will know that if you want to live well you need to work with your hands or your head and not flipping real estate

Please never forget about one of the biggest elephants in the room – credit default swap market. The total notional value of CDS outstanding is estimated to be $43 trillion. So far it’s only a notional value, but who knows what happens next. Let me remind how CDS works.

Every new CDS contract is created by the bond underwriter and is initially priced at 100%. The insurance seller (usually a hedge fund) will assume the default risk and starts receiving the coupon payment. There is no money changing hands when the first sell is made. If the contract gets down in price to, say, 99% then the insurance seller need to pay 1% to get rid of the contract to another hedge fund that agreed to assume the risk.

Now there is a question of margin. The clearing system is watching the price changes in each contract, assuming they trade frequently, and is requiring additional margin every time the contract is losing some value. It is not much different from short positions. You can think about it as a big short market with $43 trillion outstanding notional value that tracks prices that move in a direction opposite from the corporate bond market.

And CDS do change in price now. Posted at the Mish blog, here is the GMAC ResCap CDS (priced as spread):

rescap cds

Most homebuilders are also experiencing the CDS failure, check charts here.

The whole system works only because the market is very liquid, prices are quoted several times per day and margin calls are calculated and met promptly. When the default expectations are low this whole $43 trillion market could be traded with only $200 billion of liquidity and remain properly capitalized. You can think about CDS as of flying butterflies, they are very light and pretty.

Let think what happens when the recession comes. From Spring of 2000 to Spring of 2003 the junk bond market lost 35% of price (check SHIAX chart). If the CDS market will ever lose 35% of its value it will amount into $15 trillion of capitalization required to maintain its liquidity.

I’m sorry, but there is no $15 trillion in that system to float the CDS market! We probably can collect that much is we sell 90% of the stock market, or crush all commodities to historic lows, whatever it requires. My gosh, there is only $4+ trillion of treasury bonds out there. Even if we sell all the treasuries we still need $11 trillion more for that margin call! Wait a minute, did it happen before?

Yes it did. In 1931 the treasury market unexpectedly collapsed (it happened during very short time) from the yield 2% up to 6%, the 7-year maximum. Of course it was a buying opportunity of a lifetime, because rates went back to 2% in 1934 and then below 1% in 1940s.

This spike happened not because of any inflation expectations, it was a deflationary environment. Not because of any worry about Treasury solvency – they had all the money to service the debt, and the debt was quite small. It happened because it was a severe credit crunch and there was not enough money in the system to buy treasuries at that fantastic discount. Nobody had any damn money!

I think that when the CDS market will finally start to move (it will take time, it’s a huge market) it will drain trillions and trillions of liquidity, like a giant sponge. It will require a huge sell-off in all the markets to fill the margin calls, the stocks, bonds, commodities – they all will have to go down big time, just to fill the gap.

That will be a deflationary environment of the Kondratieff Winter

Yesterday and today we finally got some crash on the junk bonds market, which was probably overdue. On top of that fresh new lows in the credit default swaps market. Now I can firmly say that that today low (S&P at 1416 at close) is quite far from the bottom.

Lower we go from here

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