March 2008

I’ve published about Red Kite hedge fund twice in my blog. Essentially their strategy was always to manipulate prices of commodities upward by taking enormously large positions. The difference of commodity futures from stocks is that eventually you need to roll them over, otherwise you will get a barge of grain at your doorsteps in Greenwich, Connecticut. So the strategy works only when it’s hidden, and once uncovered, other traders can do you bad things.

Well, Mish just reported that now Red Kite changed its strategy. Now they are trying to corner the market by actually stockpiling the physical metal. I suppose they were forced to do that once they’ve realized that rolling over the futures will produce enourmous losses.

Let me add that once last year I heard an expert at Boomberg radio who said that most industrial metals are overvalued at least 3x times.

The commodities bubble is about to pop (“about” means from few weeks to a year). Don’t be surprised with 70% declines in some metal prices

Update: Please ignore the post below – it was a reverse repo, not repo. Feds were pushing treasuries down the market at 3% rate, for whatever reason.
Here we go. After Feds started several programs to swap trash for treasury market participants have less trash and excess treasury. Now they are trying to get rid of, this is today TOMO:

Treasury Collateral Operation
Total accepted: $6 Bln
Total submitted: $7.4 Bln
Stop-Out Rate: 3%
Weighted Average: 2.97%
High-rate submitted: 3.75%
Low-rate submitted: 2.65%

Someone is ready to pay 3.75%, a full 150 bps above Fed target rate just to get rid of his treasury. Just few days ago 2% was more typical.

Volatility in minds, volatility in pockets

The short-term treasury yield is at 1.15% after falling as low as 0.2% last week, something like 60-year record. Why?

I think the primary reason is simple. Corporations, big and small, and even some individuals, are worried that the the ongoing financial crisis will prevent banks to fulfill their obligations on credit lines. While cutting the outstanding line of credit for home equity loan could be relatively easy, cutting the corporate credit line is more problematic, unless the corporation is downgraded. The last data I heard are about $2.5 trln of untapped credit lines.

What I think happened last week is a true run on the banks. The corporations are tapping the credit while they can. But while they don’t really need those money they just put them on the money market, which goes straight to short-term treasuries.

Watch $IRX, at this depressed levels it signal that we have small bank runs all around.

With the new $200 bln credit facility coming (I think today), Feds are swapping various papers for treasuries. Banks don’t really need treasuries, they need money, so they will be forced to sell what they borrow, what is essentially a short sale.

Step two. Very soon we will have a very strong vested interest of various troubled institutions for treasuries to go down, because they are short. They are short not because they gamble the market, but because that’s how they got money. Please expect various news media outlets to talk their book, i.e. everyone around will start talking how treasuries are overvalued. Together with dumping new loads of treasuries on the market I think that will work. We should have a significant correction in treasury prices, without violating the overall bullish trend. I already sold over 60% of my position and I will patiently wait for better entry point, it should take couple of months

I’ve read this stunning post from Big Picture about a bunch of high-profile bottom callers in this market (Dow 20,000). I think most of them have a vested interest to drive sheeples back into stock market, and they will bend their reputation to do so.

But I want to get back to basics – what is a recession and what is a bear market, because we need to keep our records straight. Ok, suppose for a moment that the financial crisis is over. All the mortgage related losses are written down (another $200 bln to go) and Feds take the rest on its balance sheet (not that I think it will happen), there is no more bank failures (he-he) and the panic settles (aha). What’s next?

What is exactly a recession? First of all not every recession starts with financial crisis. It doesn’t have to be this way. As I’m trying to simplify things I think that recession is a culmination of a credit and inflation cycle, the natural sequence of events that are out of control of government and central bank.

The recession happens for the same reason the toy truck pulled by rubber cord will accelerate or stop even if you pull it very carefully. The economy runs on debt. Any entrepreneur who can prove the bank that he can get better return on money then the cost of borrowing will get funding. The bank is borrowing on money market and lends it long. Both the bank and the entrepreneur are risk takers, the money market is risk-free (except some rare cases, but this is not important). So all the risk and all the risk premium is spread in wide web between the money market and enterprise.

Let see the corporate AAA and BAA bond yields (click to zoom):

corporate bonds

On this picture you see:

  • Spreads between AAA and BAA corporate bonds are increasing around recessions (sometimes during, sometimes after). That is a measurement of risk aversion
  • Interest rates for corporations are usually elevated during recessions, while money run into treasuries
  • The Kondratieff wave is visible very well

To keep it short the recession happens when money are expensive and hard to get. This is a vicious cycle, the problem reinforces itself. But lets resolve a chicken and egg problem – what comes first – jump in interest rates or recession? It seems to me sometimes it happens one way, sometimes another. When the economy is booming the demand for credit may just exceeded the supply and yields will go up not because of risk aversion, but just because of lack of money or mounting inflation. Last year the opposite happened, the credit supply was cut because of the mounting losses in CDOs and derivatives. So the trigger could be different each time, but once the recession starts there is no stop until the money return back to the credit market to chase early profits.

So the recession ends when there is a new interest to lend, which clearly overcomes the risk aversion. If we get back to March of 2008 we can clearly say that there is no sight of recover at credit markets. Even if subprime losses are over nobody lends to subprime borrowers. The corporate spreads are widening, TED spread is over 1.5%. What those nuts are expecting here?

This Thursday was the historic day. The Feds made an announcement that was so stunning that I was puzzled how to write about that. But now I think you just read it yourself first:

Press Release
New York Fed Announces Modifications to Terms and Conditions of Term Securities Lending Facility
March 20, 2008  

The Open Market Trading Desk of the Federal Reserve Bank of New York (“Desk”) has engaged in extensive consultation with bagholders, potholders, potsmokers, gangbangers and their loser clients on the overall design and technical features of the Term Shit Sorting Facility (“TSLF”) since it was announced on March 11, 2008. As a result of this consultative process, the Desk is announcing a few modifications to the previously released program terms and conditions, as well as providing more details on the parameters of the first auction, scheduled for Thursday, March 27, 2008 at 2:00 p.m. Eastern time.

The Desk will conduct the first TSLF shit sorting on March 27. The dumping size will be $75 billion for a term of 28 days or whatever.

The first TSLF sorting will be a loan of Trashury against Schedule 2 shit rather than against the Schedule 1 trash previously proposed. To facilitate the operational processes of the facility, the Federal Reserve has also expanded the list of eligible collateral for Schedule 2 to include dogshit (CMOs) and AAA/Aaa-rated commercial catshit (CMBS), in addition to the previously announced AAA/Aaa-rated private-label horseshit (RMBS) and OMO-eligible collateral.

In short, this never happened before, even during the Great Depression. Who knows, maybe that’s why GD happened, aside other things. But never ever before the Federal Reserve was consciously exposing itself to major losses.

Lets think, what is exactly the Federal reserve? It’s a bank that holds treasury bonds, which are just uncollected taxes. You can read about Fed holdings here. It prints money that are representing those holdings. What are money? Its Federal Reserve paper that can be used to pay taxes. So essentially money are derivatives of paid or unpaid taxes managed by Fed as an underwriter, the same way as CDOs are derivatives that represent unpaid mortgages with some bank (for example Bear Stern) as underwriter (ups). So, essentially, when Feds are swapping treasuries for CDOs dollar is swapped for CDOs and Feds are becoming Bear Stern. Capite?

I don’t think the last decline was final bottom of the financials, but let put this into prospective.

If any talking head on TV will try to fool you into the stock market because financials are doing fine, just look at this chart:

When financials bottom

During the last recession, financials actually bottomed in Spring of 2000, just before the stock market topped and about a year before the recession of 2001 started. During the 40% smackdown of the S&P 500 the financial sector was a place to be.

The performance of the financials doesn’t mean the bear market is over – just the opposite. Don’t get fooled again!

3-month treasury bill:

Kondratieff winter IRX

Here we go, zero interest rates on the horizon. Today dealers were bidding sub-1% with treasury collateral.

Let put this in prospective:

historic 3 month treasury bill

We are below 1950s now and back to 1940s. The 1930s are on the way.

Another chart:


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