Coming Bear Market in Bonds

WHO'S NOT SELLING BONDS?
First, the US Treasury has hundreds of billions of dollars of bonds to sell to fund the trillion dollar deficits Congress is mandating.

Second, the Federal Reserve will be selling the trillions of dollars of securities they have purchased in the recent expansion of the monetary base.

Third, and finally, any investor who owns bonds will be selling to avoid the coming bear market.

Paterson is advising its clients to continue to extend the maturity of liabilities past the 5 year mark, and look at 10 year liabilities, or more.

TACTICS
Continue to shorten the maturity of assets and use money market arbitrage to improve earnings.

Consider borrowing long term deposits.

Use extreme caution on long term lending.

STRATEGY
Warn senior management and the board that a disaster is in the offing.

The flood of money recently added by the Fed will either cause inflation or increases in long term interest rates - or both.

Credit Spreads at 800 Basis Points

The spread between Baa credits and 10 year US Treasuries reached 800 basis points.



The cost of long-term corporate debt has declined more than 100 BPs, but is still at historic spreads to Treasuries.

MONEY CONTINUES TO GROW
The Fed's policy of adding reserves to the system continued in the past two weeks, and the monetary base is now twice it's value in September of 2008.



Here is the raw data.

2008-09-10 874.703
2008-09-24 939.395
2008-10-08 1014.655
2008-10-22 1174.106
2008-11-05 1265.015
2008-11-19 1506.539
2008-12-03 1502.872
2008-12-17 1689.661
2008-12-31 1728.184
2009-01-14 1773.924

Paterson is confident that the Fed's action to support the fixed income markets with massive purchases of securities will shorten the recession by many years.

REAL ESTATE LENDING RESUMES
Even as the economy continues to deteriorate from the collapse in wealth in the stock and property markets, the business of lending is stabilizing.

In California the number of homes sold last month increased nearly 200%.

As this trend continues, the housing market will stabilize.

However, do not expect the trend of the last 20 years to resume. Growth in the value of real estate was caused by the decline in interest rates due to the elimination of inflation. That game is over.

SUMMARY
The Fed's actions to stabilize money growth are succeeding, suggesting a resumption of economic growth in months, not years.

Residential real estate lending - at prudent underwriting standards - is safe again. It is unlikely we will see much more of a sell-off in residential real estate.

Commercial real estate is in much worse shape and should be avoided except for unique situations. The economy has much farther to go to see a bottom.

New lows in stocks. As the magnitude of the disaster grows, there is a significant probability we will see new lows in the stock markets. If this happens, it will probably present a buying opportunity. Look for record volume in shares traded as the signal we've seen the bottom.

However, do not expect a quick rebound. Paterson expects a double or triple bottom in stocks before all selling is done.

TACTICS
Continue money market arbitrage. Paterson is advising clients to take advantage of the double digit yields in high quality short term paper. These assets can be funded profitably with deposits and the book matched nearly to the day.

Do not run a mis-matched book.

Avoid commercial real estate.

Expand prudent residential real estate lending and sell all long-term assets in the secondary market.

Balance sheet lending is extremely risky.

STRATEGY
Make senior management and the Board aware of the successes of the risk management team. Suggest bonuses for continued excellent performance.

Cooperate with regulators to understand their concerns and allay their fears.

Money Explosion Continues

Growth in the monetary base continues.



Since September, 2008 when the monetary base stood at $870 billion, the Fed has added more than $800 billion to the base.

With stimulus like this, the recession will be shortened by years, bringing the return to growth in the next year or two.

OTHER MONEY NUMBERS
MZM which had been stagnant, is now growing.

Here is the raw data.



Here is the rate of growth data.



M2 Growth Signals Economic Recovery

M2 is a leading indicator, signaling both financial and commercial expansion.



The rate of growth in M2 is soaring, approaching 10%



COMMERCIAL AND INDUSTRIAL LOANS

The problem now is to get banks to lend.



Though flush with cash, thanks to Fed actions, Banks are reluctant to lend to Commercial and Industrial companies for two reasons.

One, the uncertainty of every company's balance sheet in this world of Interest Rate and Credit Default swaps. Until this confusion is cleared away, very few financial institutions will take the risk of lending.

Two, economic uncertainty also brings a halt to lending. As economic activity collapses, even good companies might not be able to pay back their loans.



REAL ESTATE LOANS

The surprising fact is real estate loans are holding up well.



INTEREST RATES AND SPREADS

Credit spreads have stopped widening.



Of all the signs that the credit crisis is ending, this is the one most watched by forecasters.

The drop in BAA yields by 100 basis points is a sign that lower quality credits are finding buyers.

SUMMARY, TACTICS, AND STRATEGY

In summary, the Fed's aggressive expansion of the monetary base has shortened a 10 year depression into a 3 year recession.

Though it is not time to invest or lend yet, that time will soon be here.

Tactics
Continue money market arbitrage, extending deposit maturities to 2 years, and adding high-yield assets.

Spreads of 1,000 basis points on AAA quality credits are not uncommon.

Stragegy
Prepare senior management and the board for continued earnings enhancement thanks to the investment department. Focus attention on finding high-yield assets.

Apology

For the past three months Paterson has been busy working with existing and new clients to avoid the disaster in the credit markets.

My apologies to students, casual readers, and potential clients for the absence of this weblog.

Paterson is back, explaining the situation and suggesting tactical and strategic plans for dealing with the extended downturn.

Markets at Major Turning Points

Gold at Major Support










Most of the evidence suggests the bounce will be small, and prices will continue to drop. But, traders don't bet it that way.

Bond Refunding Successful
US Treasury sold $27 billion of notes and bonds following the largest increase in CPI since the Volcker years.

Treasury Note Futures









Treasury Bond Futures









Note that ond prices surged following a successful auction.

Corporate Bond Spreads Falling











Stocks finding Support

NYSE Composite











S&P 500











Russell 2000











SUMMARY
10 years from now this time will be seen as a major turning point in stocks. With inflation banished, and the bull market in bonds ended, only stocks will have the investment potential for the future.

Remember, stock prices rise when interest rates come down and stay down.

Fed and Treasury Up Again

Recent moves by the US Treasury to purchase equity in Fannie and Freddie tell us two things.

1. They are in danger of going bankrupt.
2. The treasury will not allow them to go out of business.

Even though shareholders might lose all their money, the companies will still be reconstituted by injections of US government cash.

Along with this announcement came the news that the Fed will lend to the mortgage buying behemoths if necessary.

These two actions will support home lending by ensuring the ability to sell mortgages in the secondary market.

Stock Market at Support

Investors will be watching the stock market closely for the next few weeks at prices approach support levels seen twice before in the last 6 months.

NYSE Composite


S&P 500


Russell 2000


Technical traders will be buying the Index here, and selling if the market trades below these levels.

SUMMARY
The usual rule is to buy the market when the situation looks bleakest.

That certainly is the case here.

Inflation and the Bond Market

Bonds sank through support this month and are now back at May's support levels, now resistance for this instrument.



The question now is how low will prices go, and how high will long rates rise?

To answer this question we look at the money supply and the dollar. The first causes inflaton, and the second makes inflation worse.

MONEY SUPPLY
The monetary base is growing, but growth has been slowing for years.



This is a good sign for inflation, showing the Fed's commitment to control the supply of high-powered money.

In recent months, however, growth has accelerated slightly, but not enough to cause inflation.



Bank generated money has grown substantially in the past years, as businesses work their way through the recent Fed-caused disaster.



In recent months, growth in this leading indicator has slowed, leading to renewed confidence in the Fed's management of interest rates and the money supply.

In summary, inflationary pressures are not building, and there is no need to raise interest rates.

INFLATION AND THE DOLLAR
Price rises in the United States are connected to the falling dollar. Import prices are soaring as international demand for primary commodities pulls at suppliers.



The rise in commodity prices is directly related to the fall in the value of the dollar.



Notice the plunge in the dollar in 2006, and the simultaneous rise in PPI.

TACTICS
Prudent A/L managers will continue to lengthen liability maturities, shorten asset maturities, and work for higher spreads in lending.

Money market arbitrage is more profitable than ever, and those clients pursuing this activity have found their yields soaring dramatically.

The key to this business is a careful analysis of credit quality. High quality credits have been pushed off the curve hundreds of basis points, providing opportunities for lenders with excess cash.

STRATEGY
Now is the time to report to senior management and the Board on the A/L condition of the portfolio.

The institution is liquid, carrying good credits, good spreads, and profitable liabilities. In short, we are ready to lend to our existing customers, and prepared to take business from our weaker competitors.

The Asset/Liability department can take a bow.

End of a 25 Year Bull Market in Bonds

The bull market in bonds is over. Never again will investors see a run like this.

Since Paul Volcker crushed inflation back in 1980 bond yields have made new lows with every cycle.



10 year US Treasury notes peaked at 15% in 1981, and have fallen consistently till the lows of 3.5% in 2003.

During this period real estate values boomed as capitalization rates fell and the cost of borrowing tumbled.

Refinances further fueled the mortgage banking business, bringing profits to finance companies.

Companies like GE, which based their growth on this trend will now see that portion of their earnings disappear, never to return again.

STRATEGY
For diversified companies, reduce expectations of future growth from financial activities. Explain to senior management and the board that lower interest rates will not happen again - ever.

For finance companies, explain to senior management and the board that the competition in the finance arena is about to get as tough as it gets, with more competitors chasing every deal, and lowering profits in order to compete.

TACTICS
Asset and Liability Management will dominate the discussion on adding assets and liabilities.

As the Fed moves to more market-based allocation of Fed Funds, expect to see more volatility at the short end of the curve.

Lengthen liability maturities and focus on solid spreads.

Credit spreads widen

Credit spreads continue to widen as the Federal Reserve props up the Treasury market while it lowers short-term rates.

First, we review the Fed's recent policy of lowering short-term rates.



In a clear indication of the disaster of the policy of slow-and-steady short-term rate increases since 2004, the Fed has lowered short term-interest rates in a panic.

In the next chart below, we see the effects of the Federal Reserve's policy of pulling down long-term interest rates by purchases in the open market.



While this is occurring, credit spreads for other types of securities continues to widen. The latest casualty in this episode are auction-rate securities. In several recent episodes, auctioned securities have exceeded 15%.

This data carries a clear implication: Lengthen the maturity of liabilities. Had these institutions lengthened liability maturities, as Paterson has repeatedly recommended, they would not be in this situation.

LENGTHENING LIABILITY MATURITIES
When the Fed stops supporting US Treasuries, as it must, and interest rates rise in response to a weaker dollar and rising inflation, the yield curve will steepen and long-term interest rates will soar, adding two-five percent to liability costs: between $20,000 and $50,000 per million per year.

This is a potential increase of 40-100% of liability costs!

DOLLAR DETERIORATION CONTINUES

Paterson finds a continuation of the loss of purchasing power of the dollar, making exports more competitive, imports more expensive, and foreign earnings more valuable to US companies.

The chart below shows the trade-weighted value of the dollar.



Given Fed policy, Paterson sees no reason for this to change and for the dollar to continue to lose value.

TRADING RISK
After the multi-billion dollar loss by a French trader, one would think that trading rules and monitoring would have precluded unauthorized trades. It is not so.

In the recent debacle, a trader in wheat lost more than $100 million. In a bull marktet! Where was the supervision?

Though these problems are not specifically related to interest rates or monetary policy, they are an effect of fluctuating prices.

TACTICAL ASSET AND LIABILITY MANAGEMENT
Increase liability maturities, shorten asset maturities, and work money market spreads for income.

The debacle in the bond market is generating extraordinary returns on high-quality credits which can be funded with matching maturity liabilities. Some clients have experienced a 10% rate of return on select securities over a 6 month horizon.

Credit hedges must be evaluated daily during this time.

Currency hedges must be extended and widened to include currencies with low money growth.

STRATEGY
Though Paterson did not foresee the extent of the credit debacle, we can react to it with prudent actions.

First, the policy of money market arbitrage has proven to be a solid earnings gain.

Second, the policy of eliminating variable rate assets has insulated the portfolio from credit losses.

Finally, the policy of lengthening liability maturities has strenghted the balance sheet with fixed rates.

Senior management must keep the board informed about the deteriorating bond market and be prepared to hedge interest rates, credit risk, and currencies.

Spreads Widen in Flight to Quality

In the past month, the debt and equity markets fluctuated widely in the face of economic and financial uncertainty.

Most surprising is the rally in US Treasuries following November's quarterly refunding.



As the chart shows, bond futures rallied from 114 to 119 before retracing to the 116 level today.

At the same time, spreads between Treasuries and BAA Corporates have widened more than 60 basis points.



EQUITY MARKET REACTION
The NYSE composite at first fell dramatically, signaling either a rise in long term interest rates of a decline in earnings.

As did the bond market, the equity market is retracing its steps.



MONEY SUPPLY
While all this is happening, the money supply growth accelerated exclusively from bank lending.

As the chart below shows, the Monetary Base has grown at a relatively mild 3% while MZM is growing faster every month.



INFLATION IS COMING
Money growth in excess of GDP growth causes inflation.

In its attempt to mitigate the damage from the Fed-caused rise in short term rates, the Fed has chosen to reflate the economy and allow banks to pour money into the system. This will cause inflation to rise in 6-18 months.

The Fed will then have to start raising rates again, and will probably push the economy into a recession in order to get money under control again.

SUMMARY
Until then, credit and equity markets will remain confused.

TACTICS
Money market arbitrage will continue to generate solid earnings.

Continue to reduce exposure to long term assets.

Re-evaluate asset pricing spreads to ensure an adequate return on risky lending.

Consider lengthening liability maturities further.

STRATEGY
Emphasize to senior management and the Board the dangers of money growth on inflation and interest rates.

Prepare them for action to lengthen liability maturities.

Discuss trading and hedging policies and procedures in preparation for future increases in long term interest rates.

Stock markets making new highs

In the month since the end of the correction, all major stock market indexes have surged to new highs.

The bull market is intact and will move higher in the months and years to come.

Get long and get rich.

STOCK PRICE INDEXES
First, the New York Stock Exchange Composite



Second, the S&P 500


Finally, the Nasdaq 100


GOLD
Gold prices are a puzzle. I would expect them to be surging with bonds falling.




BONDS
Bonds are at major support. The gold charts suggest this is the time to buy bonds.