@ the open 1-31-12

What ‘s the FRBNY been up to –

It’s been some time since we’ve taken a look at the SOMA (System Open Market Account) holdings of the Federal Reserve Bank of New York. Suffice it to say that over the course of the last eleven months they’ve been busy. The net additions to the US Treasury holdings in the account (as of 1/25/12) has been $422.25 billion. There has been a net addition of $267.2 billion to the balance sheet itself and a run-off of $155.1 billion of Agency and RMBS paper.

Over the last week the FRBNY sold $8.7 billion of paper maturing between 1.5 and 2 years out and bought 18.7 billion of paper maturing between 6 and 30 years out. Clearly Bernanke continues to try and flatten the Treasury curve but there is clearly resistance to the 1.8% level in 10 year treasuries as what took us below that level (albeit briefly) was once again the fear of a double dip recession caused by a collapse of the EMU and its consequent knock-on effects on the Far East.

At this point, I believe that the Federal Reserve is “pushing on a string”. Getting people to believe that you’re going to keep short term rates near zero for the next 18 months is one thing, convincing investors that a 1.8% US Treasury is going to be a good investment over the next 10 years (unless the world moves to the gold standard) is a completely different proposition. Any signs of global growth and the market will start the curve steepening process to come. My bigger question is the following…”is the FRBNY hedging its portfolio duration extension move via the swap market?” in other words are they in anyway mitigating the risk from the recent portfolio configuration change implied by “Operation Twist” or QE 2 ½ . Consider what they’ve done in the last week…the FRBNY sold $9 billion of 2 year paper (1.99 “effective duration” or “risk” as Bloomberg likes to call it) and bought $19 billion of roughly 10 year avg. paper (8.96 “effective duration”). So in the last week they’ve added what amounts to $1.52 billion of risk for every 100 bps rise in the yield curve (here I’m assuming a parallel shift in the curve between 2’s and 10’s). This is the “operation twist” trade and if the FRBNY did the same trade for one year and added roughly the same risk each week that means that they’ve added $79.2 billion of risk for every 1% rise in the curve. Ok, now just for grins let’s look back to the beginning of 1962, 50 years seems like a decent time period, since that time the average yield on the 10 year has been 6.71% or 484 basis points higher than today’s 10 year…

now we will likely never see a “shock” move up 484 bps but removing ourselves from that reality would imply that the FRBNY has added some $383.4 billion of risk to the tax payers by virtue of this move in US Treasury purchases. Now while this is obviously simplistic it’s no more draconian than the regulatory scenarios that have been laid at the feet of the banks and you don’t even hear a whisper about this risk.

Equity Markets – Asian markets were mostly higher in overnight trading as the late closing markets outperformed the early closing markets as Europe opened higher this morning on hopes of a debt exchange agreement in Greece and news that the EU leadership approved the early setup of the ESM at €500 billion…less than hoped for but more than originally envisioned. The European indices are at or near their highs for the session as the unemployment rate in Germany bested expectations by 0.1% setting a new 20-year low of 6.7%. This has some hoping that the EMU may be able to grow its way out of its problems. Domestic futures are modestly higher this morning awaiting news on employment cost trends and housing market price changes as well as economic outlooks from Milwaukee and Chicago…we also get earnings today from 27 of the S&P 500.

News , Macro & Events

Economic Releases

• Q4 Employment cost index…+0.4% v. +0.3%
• November Caseshiller home price index…last was 140.30
• November Caseshiller 20 City Composite index change (MoM)…-0.5% v. -0.62%
• November Caseshiller 20 City Composite (YoY)…-3.3% v. -3.4%
• January Chicago purchasing managers index…63.0 v. 62.2
• January Milwaukee NAPM survey …57.5 v. 57.8

Events – none today

Earnings – today we get 27 of the S&P 500 announcing earnings and it’s an industrial heavy day with the likes of : Exxon (XOM) ; US Steel (X); Archer Daniels (ADM); UPS; Illinois Tool (ITW); Tyco (TYC); Danaher (DHR) and Avery Dennison (AVY).

Asia, Europe & USA

• EU government leaders met in Brussels and agreed to accelerate the startup of the permanent bailout facility..the so-called European Stabilization Mechanism or ESM. The fund is initially envisioned to have €500 billion access to funding (from somewhere)…remember that Legarde wanted the EU leadership to make this fund €1 trillion so that she could then try to get the rest of the world to pony up additional funds to the IMF to bring it to €1 trillion as well…doesn’t look like that’s going to happen. But having set up the ESM, the leadership left the summit meeting with no agreement over how to plug the widening gap in Greece’s budget shortfall and the lack of action taken by the Greek government throughout the entire process (2 years +) has frustrated the efforts of others to help them out. NOW we get Portugal falling apart in the credit markets and soon they will be looking for additional bailout monies if they can’t go to the capital markets for debt extensions (€166 billion of debt 24.5 billion of which comes due this year).
• The German unemployment rate fell more than expected to a 20 year low in January to 6.7%
• As for the new “fiscal pact” the EU leadership completed the treaty that will speed up sanctions against high-deficit states
• Japanese factory production rose 4% in December as manufacturers ran overtime to make up for lost inventory due to the flooding in Thailand that interrupted logistical supply lines for the country’s manufacturers. This result bested the 3% estimate of economists but likely remains a “one-off” inventory re-stock
• Belgium will auction €1.2 billion of 6 month paper today and Spain will auction 3, 4 and 5 year paper
• Banco Santander released a statement that the bank took out €7 billion in December LTRO borrowings from the ECB (3 billion in Spain and 4 billion in Portugal) and deposited the funds with the ECB
• Bob Doll is lining up on the “Fed won’t do QE3” side while Bill Gross is lining up on the “Fed will do QE3 side”…
• The Chinese Federation of Logistics and Purchasing will release their manufacturing index tomorrow…the median forecast is for the index to decline to 49.6 from 50.3 in December
• Irish banks are the majority of lenders who agreed to shift about 30% of Irish government debt coming due in 2014 to mature in 2015…this amounts to about 5 billion euro of debt in 2014 which is a critical year for the Irish government as the bailout package runs out in 2013 and the country faces a maturity cliff in 2014 when it remains unclear if the capital markets will agree to fund Irish debt offerings.
• Panamax charter rates are down 53% since January 1st and could get worse as the fleet expansion outstrips even the highest number of coal cargo shipments in history. Coal maritime shipments are expected to rise 3.6% this year to 956 million metric tons. Day rates on Panamax are likely to average around $12,000 this year according to industry sources…down from $25,000 per day in 2010. Break even rates are around $13,000 per day.

Credit Markets –

Sovereign CDS – spreads are mostly tighter in western European sovereigns this morning with the exception of Greece and Portugal…Portugal is now reported on a “points up front” basis and has continued to widen since it was taken to below investment grade earlier in the month by S&P…Fitch later joined the downgrade party but the damage was already done and the inability to get anything accomplished on the Greek debt exchange has the market concerned that Portugal will meet the same dismal fate…I personally think that this will be avoided but right now it’s best to give a wide berth to this runaway train.

OIS – overnight index swap spread differentials between borrowing in euro and borrowing in dollars continues to shrink as the ECB has the European banking system awash in liquidity for the time being…the last quote was – 30.3 basis points which takes us back to the lows of last summer before the wheels came off.

US corporate CDS – spreads widened yesterday with the equity markets trading lower and volatility higher amid growing concern about the fate of the EMU…the worst performer was the leveraged loan index (LCDX) which widened by 14 basis points to 331 basis points (still tighter by 102 basis points from year’s end). Meanwhile, the high yield index widened by 11 basis points to +570 bps (an improvement of 109 bps on the year to date). Investment grade was the top performer widening by only 2 bps to end the day at +103 bps…17 bps better than at year’s end. Remember the trade off in fixed income land is volatility…you want higher yields you accept higher volatility as the offset. As always the key is in knowing how much volatility you can stomach (what economists call your degree of risk aversion).

Energy Markets – WTI is flying this morning, up 1.6% in sympathy with the European equity indices and on the hope that some debt exchange agreement will eventually be hit upon in Greece…Iranian tensions and output halts in Sudan and Nigeria are helping to keep upward pressure on prices. The spread between WTI and Brent remains well over $11/barrel.

Futures – natural gas is slightly lower this morning with the futures strip trading at $3.08 on average…oil futures remain essentially flat over the next year with the average strip price of $101.14 making the energy equivalence ratio roughly 5.5x (the energy equivalence of natural gas is 5.5x cheaper than the same energy equivalent output from a barrel of oil)…in other words, if you filled your car up with $75 of gasoline the rough compressed natural gas equivalent would cost you $13.70…makes you think.

Phillip Pennell, CFA
Turnberry Capital Management
(203) 861-2708 (Direct)
(203) 861-2700 (Trading)
(203) 917-2255 (Mobile)

The information included in the above discussion is not intended to be used as a basis for making investment decisions nor should it be construed as a recommendation by the author to buy or sell any specific security. Individuals should consult their investment advisor prior to making any investment decisions.