Gift to Wall Street

September 19, 2007

Today’s 50 bps rate cut in the Fed Funds and Discount Rate has set everybody into a frenzy, and for good reason.  It’s hard not to feel great – my accounts were up 2.72% today. 

For the inflation-obsessed, today was a great chance to prove the point that Fed policy continues to be inflationary.  The Dollar fell hard today against foreign currencies, gold, oil, and agriculture commodities.


Was the rate cut appropriate?

There are well-reasoned arguments on both sides of this debate but something has me feeling uneasy about this rate cut.

Bernanke promised not to bail out the banks and hedge funds that lent recklessly during the boom.  If the rate cut isn’t a bailout, then why is everybody on Wall Street so damned excited today?  The rate cut has instantly helped to “reflate” asset prices.  This is hugely helpful to banks, brokerages, and the people that work there – bonuses are being saved by the Fed.

Practically speaking, the Fed really didn’t have much of a choice today — everybody expected at least 25bps and the bond market expected 50.  Without this rate cut we would have had a resumption of the crazy volatility and almost certainly a worsening of the credit crunch.

By cutting rates today, the Fed is sending the message that they are more concerned with preventing a recession than they are about protecting the value of the Dollar.  I won’t be selling my gold any time soon!


Great Buying Opportunity: Municipal Bonds

September 12, 2007

Back in early July when I wrote my Q2 ’07 Portfolio Review, I wrote about how I had created a “cash management account” where I segregated money which I anticipated needing in the next two to three years. The idea was to physically separate the money so that I wouldn’t be so tempted to trade with it.

It hasn’t exactly worked out as planned but I think it’s OK. My new goal for this account now is to maximize my after-tax returns. I am allowing myself to actively manage the account, with one caveat: I’m not going to ever use leverage.

In July and August I had all the cash parked in Yen. This turned out to be a good trade. As the fixed income markets broke down in August, the Yen has rallied sharply. On Friday I sold my position for a 4.01% profit which includes a miniscule amount of interest. Nothing spectacular, but it turned to be a lot better than municipal bonds (which is what I had thought of buying instead).

Speaking of which, the selloff in Munis has provided us a really great buying opportunity — I swapped out of Yen and bought shares of GHYIX . This fund invests in high yield (higher risk) municipal bonds from around the country. When I bought the fund last week, the yield was 4.8%. Since I don’t have to pay Federal taxes on this interest, my after tax yield is slightly above 5.13%. Not only is the yield very attractive, but I think the fund itself will appreciate as the fixed income markets return to normal over the coming months.


On this subject there’s a great article on MSN Money by Tim Middleton. He lists three high quality, low cost, municipal bond funds you can easily and cheaply buy in your brokerage account. He also makes a great point about why it’s important to buy a fund with a low expense ratio:

The municipal bond market place has hazards for investors. In addition to above-average interest-rate risk, many muni funds accept significant credit risk as they reach out for higher yields. The average long muni fund has an expense ratio of 1.07%, meaning its manager spends a fifth of investment income paying himself. Since investors would notice such a huge price tag, managers patch it over with higher-yielding – i.e., riskier – bonds.

More Bad News for the future of the USD

August 25, 2007

More news that the countries which hold the largest US Dollar reserves are beginning to “diversify” into other currencies and investments. Friday’s WSJ has an interesting article ($link) about the future of the Kuwaiti sovereign wealth fund:

The Gulf petro-states control a vast hoard of investable funds, one that is sure to grow vaster. Combined, government investment arms in Kuwait, Saudi Arabia, Dubai, Abu Dhabi and Qatar hold an estimated $1.5 trillion. That gives them potential to sway the course of broad global financial markets, including exchange and interest rates, the now-slowed buyout boom and the global credit dislocations stemming from US subprime mortgages.

The Middle East’s government investment arms are at the fulcrum of a longer-term shift in global financial flows from the West’s developed markets to the faster-growing economies of India, China, Southeast Asia and Turkey, places where many Middle Easterners see their fortunes lying in the future. Mr Al-Sa’ad is cutting the portion of the portfolio invested in the U.S. and Europe to less than 70% from about 90%. “Why invest in 2%-growth economies when you can invest in 8%-growth economies?” he asks.

That shift might lower the appetite for low-yielding investments such as the bonds the U.S. government must sell in large numbers to finance its budget and trade deficits. All else being equal, reduced buying of Treasuries and other U.S. securities would tend to weaken the dollar and make U.S. exports more competitive globally, but also burden businesses and consumers in the U.S. by pushing up interest rates.

I highlighted what I think are the most important takeaways of this news, neither of which is positive for the future of the US Dollar:

1. Because of the massive amount of US Dollars and US Treasuries owned by our trading partners, they probably have as much influence on the US economy as does the Federal Reserve.

2. As countries such as Kuwait and China create “sovereign wealth funds”, they will diversify out of US Treasuries into investments with stronger growth potential.

An End to the Debt Bubble?

August 17, 2007

Credit Crunch
Run on the Bank

Sub-Prime Meltdown

Housing Bubble

Central Banks Inject Liquidity

These terms are being thrown around left and right these days and I’ve read and talked so much about it that my brain is about to explode from serious information overload. Here’s my attempt to present the big-picture synopsis of what’s been happening.

Part I: How We Got Here:

Low Interest Rates:
Starting in 2001, after the dot-com crash and 9-11, the economy was teetering on the edge of recession. To stimulate economic activity, the Fed began to lower interest rates. From the corresponding chart (, we can see that interest rates across the whole economy fell dramatically.

Along with lower interest rates — beginning with those set by the Federal Reserve — there was also a dramatic increase in the money supply.

Since interest rates are lower, demand for money will be higher. The Fed sees to it that money will be available through its “open market operations.” Most often, the Fed will engage in repurchase agreements (repos) with the money center banks (Citibank, JPMorgan, Bank of America, etc.). Essentially a repo transaction is when a bank deposits collateral (loans) at the Fed and receives cash in exchange. This cash is then lent to the bank’s customers who are eager to borrow money at low interest rates.

The other option is for the Fed to buy Treasuries from the banks (outright purchases). The Fed buys Treasuries with freshly printed currency, thus dramatically increasing the money supply. As I understand it, the Fed rarely does this because it is considered more permanent and it can be highly inflationary.

Over the past few years, the Fed was not buying US Treasuries but our foreign trading partners certainly were!

In 2006, the US trade deficit was nearly $764 billion: the US bought $764 billion more stuff from the rest of the world than the rest of the world bought from us.

What happened to all of those dollar bills sent to our trading partners? A great deal of them found their way right back into the USA through the purchase of US Treasuries and T-Bills. Consider the massive foreign currency reserves held by the Chinese government: as of June, 2007 they stood at nearly $1.4 trilion. Of this amount, it is estimated that the vast majority is held US Treasuries and other USD debt instruments.

And let’s not forget that the US was not the only country with a stimulative interest rate environment. Interest rates and availability of loans from Japan was another hugely stimulative factor.

Increased Risk Appetite:
With so much money available at such low interest rates, the collective risk appetite of market participants across the globe increased. All of this newly created money had to flow somewhere. Because of China’s willingness to produce consumer goods at such low prices, the increased money did not, by and large, slosh into the prices of consumer goods. Instead it sloshed into asset prices: bonds, stocks, commodities, wine, art, and especially REAL ESTATE.

The new money certainly helped to push home prices higher. The other major factor was the increased risk tolerance and demand for risky loans. Wall Street banks created new “structured products” which were sold to investors all over the world. Leveraged products such as CDO’s & CMO’s were created and promised increased yield with low risk to investors. These products contained lots of subprime and Alt-A mortgages yet they managed to receive AAA ratings from S&P, Moody’s & Fitch.

Typically, banks are very careful about who they lend money to because they want to get paid back. In this latest cycle, the borrower’s ability to repay was irrelevant because the mortgage brokers immediately sold the loans to Wall Street. Because of these new products and the strong market to sell them into, Wall Street had a voracious appetite for risky home loans.

Yesterday’s WSJ has a must-read free article about a family in California who bought a $567,000 house with a combined income of $90,000, and NO-MONEY DOWN. Their mortgage was an interest-only, adjustable rate mortgage. At the start, their yearly payments on the loan were $38,400. After a reset which is coming shortly, the mortgage will cost them $50,000 per year. It doesn’t take a financially sophisticated person to realize that this mortgage is totally unaffordable!

But it’s OK because housing prices only go up, right? Wrong – the price appreciation in many neighborhoods was driven by the hysteria and availability of easy loans. Without that, prices must fall.

To be continued…

What’s up with interest rates?

July 5, 2007

There has been a lot of volatility in the fixed income markets in the past few months. Here are some highlites, and some great links to check out for further reading:

What happened:
* In May, Treasuries sold off big-time, sending yields on the 10-year soaring. This also caused a 10% loss of principal to bond holders.
* Two heavily-leveraged Bear Stearns hedge funds might be imploding. The possible liquidation of the funds — both of which own risky debt instruments such as CDO’s and subprime mortgages — could have serious consequences for the entire market.

Where do we stand:
* Yields on Treasuries have risen and the yield curve is no longer inverted.
* If you are a “subprime” borrower, it is much more difficult to get a loan
* Despite all of this, interest rates are still very low on a relative (historical) basis. Money/liquidity is still very plentiful — as is evidenced by the ongoing M&A/Private Equity boom.

My Take:
With interest rates, I think it’s important to think about where they’re going, not just where they are now. With strong global growth and inflation, I would bet on higher interest rates in the future. If true, this suggests a pretty strong headwind for economic growth and for stocks in particular.

As much as ever, it seems that China and certain Middle Eastern countries control the fate of the global debt markets. The Chinese government holds more than $600 billion in US Treasuries. Their aggressive buying of short term notes is one good reason why interest rates have been so low, allowing US consumers to live way beyond their means for the last few years. In the short-run, this situation works out great for us — we are able to import a whole lot of stuff and all we give them in return is dollar bills. Even better, we don’t even have to pay them back…. You can be sure that the dollars we use to pay our debts back will be worth a lot less than those we are borrowing now.

The Chinese might be perfectly happy with this arrangement though because it creates stability at home… Now that 1 billion people know that it’s possible to get rich and improve their lives, they all badly want to do it. Problem is, with an economy that is still largely manufacturing-based, it’s very difficult to create jobs for the 20 million graduates Chinese universities pump out each year. The country needs 10% GDP growth rate to keep things stable.

So what do the above two paragraphs have to do with the fixed income markets/interest rates? A lot, I think. The Chinese (along with other major holders of US debt) have an incredible amount of control over the US economy. Not least of which is US interest rates — witness the inverted yield curve after no fewer than 6 fed funds rate increases; Starting in 2002 when Greenspan raised interest rates to prevent inflation, long term interest rates have actually declined. So, at least for now (and at least through the Beijing Olympics in 2008), China does not want a destabilized bond market.

Follow these links for some excellent, and non-boring, commentary about recent happenings in the fixed income markets:

*Calculated Risk blog post about a great NYT article
*Two articles by Jubak:
* Deepening Debt Crises hits Close to Home
* Can Bond Market Stand to be Exposed?
*Bill Gross commentary