Food For Thought: Ideal Interest Rate versus the Yield Curve

Posted on May 7, 2009 by BMWFan

On April 27, FT carried an article which showed that an internal study at the Fed suggested that the ideal interest for the current economic situation was -5%.

Today the 2yr-30yr bond yield spread stands at 325 bp.

According to Across The Curve the highest level reached by this spread was 367bp, when the 2 year bond yielded 3.60 and the 30 year yielded 7.29 in October 1992.

This is an extreme divergence. On one hand, the Fed feels that it needs to go to negative interest rates to prevent deflation.

On the o

ther hand

the yield curve is at one of its steepest levels, ever.

This is a divergence of historic proportions and shows a market which is not balanced.

I am not sure for how long such an unstable state can continue.

However, such imbalances typically do not end well for many market participant
——————–
Update:
The spread between fixed rate mortgages and 10 year yields has contracted substantially to a level typically seen when the risk associated with mortgages is considered negligible.

This is a result of the Fed’ s policy to buy MBS.

However if the yields continue to move higher, mortgage rates have nowhere to go but up.

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Treacherous Thursday: A Bull Trap before the Stress Test Results

Posted on May 7, 2009 by BMWFan

The treacherous bipolar nature of the equity market was visible today. This week’s Job Loss numbers and monthly retail sale numbers from Wal-Mart and Target came better than expected. The ES futures opened near their overnight high of 929.50. However the gap-up opening level could not be sustained.

Equities were sold right from the get-go, with the small-cap Russell2000 and the tech heavy Nasdaq leading the decline. Risk aversion was visible with defensive sectors like Healthcare, Utilities and Consumer Staples doing well.

Traders who bought near the open in anticipation of another bull-fest were left with losses, accelerating the downside.

In some way the sell-off was expected.

The market had rallied into the official stress test result release and some profit-taking was bound to happen.

30 Year Treasury Auction Stuns the Market

The big news of the day was the result of the 30 year bond auction by the Treasury where the yield (4.288%) needed to cover the supply was much higher than expected. Prior to the results of the auction the bonds were yielding 4.183%. The huge gap was a big shock and equities sold off hard, led by the financials. I will discuss the implication of this auction later in the article.

Stress Tests: Run-Up Precedes Capital Raise

As I had alluded to earlier this week, the big upswing in financial shares in the pre-market session on Wednesday ( in spite of the shocking news about Bank of America needing $35B in new capital), suggested some active market participation by Big Money. The leak about Bank of America’s capital need emboldened bears who loaded up shorts overnight, only to cover as the equities took off pre-market causing a massive short-squeeze. The action suggested that Wall Street wanted to provide support to up-coming secondary offerings. On a cue, after the test results were announced, Wells Fargo and Morgan Stanley came out with announcements for secondary equity offerings.

Stress Tests: Regional Banks in Tougher Situation

Last night I had also suggested that the lack of any leaks about regional banks suggested a greater risk of disappointment. The regional bank ETF (RKH) gapped up at open to a high of 76.37 only to sell-off to close near the lows at 68.66, down 5.31% from the previous day’s close, which was much worse than the losses on the XLF and the KBE. Though the absolute amount of capital required by the regional banks is an order of magnitude smaller than the large banks, it a significant when measured against their existing equity. KeyCorp, Regions F inancial Corp, GMAC and Fifth Third Bancorp will have some challenges

in raising the capital, and may need government assistance. There is also a risk that their balance sheets may take more severe hits thanks to their concentrated risk in commercial real estate. It is likely that some of these banks will be acquired by other stronger banks.

Long Dated Bond Yields: One of the Steepest Yield Curve, Ever!
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Stress Tests: Uneasy Silence About Regional Banks

Posted on May 7, 2009 by BMWFan

The Wall Street Journal has a nice article outlining the financial situ ation

at the major banks, and an impressive graphic which goes with it.

But for Bank of America which does need to raise a substantial amount of capital, most big banks have come out relatively unscathed.

Media Campaign Gets a Big Thumbs Up

The administration has done an excellent job in managing the market during this process. The banks have been under strict instructions not to say anything about the results.

However, the results have been selectively leaked to the media. The leaks have reinforced the belief that the banks are in a much better shape than some of the nay-sayers were claiming. This has resulted in a massive rally in financials this week, further helping the ability of the banks which need capital to raise capital if needed.

Regional Banks: Where are the Leaks

?

If there is one glaring gap in the leaks is that there is a virtual black-out about the health fo the regional banks.

There has been no leaks about the capital requirements at the regional banks BB&T, Fifth Third, KeyCorp, PNC Financial, Regions Financial, SunTrust and US Bancorp. Many of these banks, especially Regions, do not have a large cushion of preferred capital to convert

to common.

Risk Concentration: Geographical and Commercial Real Estate

More important, they have a large exposure to commercial real estate and construction investing.

Unlike the large banks whose exposure is primarily to consumers via credit-cards, auto-loand and of course home mortgages, the smaller regional banks are tied much closer to the business activity in their local

region and are hence less diversifed goegraphically.

The commercial real estate market is going through a painful recalibration where inves tors now expect much higher cap rates as the massive risk taking of the past few years is coming back

to haunt the markets.

If the economy resets at a smaller size before growing up, it may take years for the excess capacity to be absorbed forcing many of the leveraged deals used to finance new commercial real estate to tether on the verge of bankruptcy.

Time to Book Profit

s?

As I noted in an earlier post, I have established a position in FAZ, in anticipation of some pr

ofit taking.

I am also concerned that the lack of any leaks about the regional banks does not portend well for what we are likely to hear.

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ADP Report Triggers a Bear Hunt

Posted on May 6, 2009 by BMWFan

Last night I had written that the ES futures were down significantly after the news that Bank Of America needed $35B in new capital as a result of the stress tests. Perhaps this would be the signal for the long awaited pull-back. I was hoping (and still hope) for a test of the 875 which would then help drive the next leg up of the rally. Not only did the ES futures recover much of the lost ground during European Trading, but the surprisingly optimistic ADP jobs report sent them into the positive, leading to a gap-up open.

The Making of a Bear Hunt

The drop in the futures last night had indicated that the bearish investors were finally getting a chance to force a pull-back. However, the ADP job numbers created a giant short-squeeze.

What was surprising was the way the financials responded.

Bank of America which was down 11% in European Trading gapped up and opened 10% higher! And this was a bank which was being forced to undergo a massive amount of dilution!

The market behavior showed how over-eager bears are pushing the rally along. There is an underlying bid in the market which is buying any dips. These are the investors who have lost their patience waiting for a pullback and are now jumping in at the first pullback.

The bearish investors get trapped in their short positions, since they are unable to push the market down. They then rush to cover pushing the market higher.

Bank Rally: A pre-cursor to Secondary Equity Offerings?

This spurt in the share price of banks is creating an opportunity for undercapitalized financial institutions to issue new stock. The rate at which the banks rose in the relatively thinly trade pre-market hours after the ADP job report suggests that there may have been a concerted effort by the Street to provide support to the banks. Providing support to sectors which need to issue new equity via secondary offerings is standard operating procedure on the Street.

Divergence: Nasdaq100 and Russell2000 Show Some Reduction In Risk Appetite
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An Inside Day: But a Pullback is Imminent

Posted on May 5, 2009 by BMWFan

The equity markets had an inside day

today. Most indices traded well in the upper end of yesterday’s range. The SPX formed a double bottom at the 897 level and closed strong.

However as I write this post the S&P futures are down 11 points.

It seems this was a result of a news item that Bank of America needs $34B in new capital based on the stress test results. Though BAC has declined to comment, I expect a distribution day tomorrow with traders now having ample reason to take profits.

In today’s post I will analyze two charts, one for Apple and for the 30 year treasury (TLT).

Apple: Forming a Megaphone Top

Apple’s stock has been on a tear since the rally began and closed higher today.

However today it formed an interesting pattern called the Broadening Top or a Megaphone Pattern. This is a pattern which marks a reversal at the top of a long bullish run.

If the weakness in the equity market continues into tomorrow’s session, I expect the breakdown to occur tomorrow to complete the pattern.

I commented on twitter as this pattern developed throughout the day. I noticed it forming during the afternoon and

the pattern continued to follow a text-book pattern till the close of the day. Based on the pattern, Apple should first reach a downside target of around 131.20, and then assuming the lower trend line breaks, go down to touch 130, or even lower to 129.60 (from a pure pattern perspective).

You can follow my twitter updates on my blog also.

Long Bond (30 year): Poised to Break Downtrend

As I have posted I have a long position in the TLT which I have kept during the sell-off; I had hedged a portion with TBT calls which I no longer hold.

As the chart shows for ZB, the 30year bond futures show, the price has formed some sort of a bottom and is poised to break back up.

As I write this article the futures are trading at 122’265, above the resistance line in the chart.

I expect the long bond to retrace at least to the 123’065 level (23.6% retracement) or even to the 38.2% level (124’055) before this up move is done.

If the BAC story is true risk appetite is going to wane a bit, and yields should pull back.

This is likely to be good for the green-shoots

to continue growing.

My Portfolio

I have built a short position in Apple today via outright equity shorts and puts. I expect to book profits on any weakness tomorrow.

I will also start scaling out of my TLT positions if this surge in bonds continues. I did scale out my

IYR puts today and will continue to do so on any further weakness.

I am hoping that we pull back to the 875 level on the S&P, test it.

A test of that level will reassure a lot of bulls and also weaken the bearish sentiment.

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Monday Review: Animal Spirits Overcome Stress Test

Posted on May 4, 2009 by BMWFan

In my post over the weekend I had written that the Stress Tests for Banks are unlikely to have a vpxl made easy

During the middle of the day a headline claiming that Wells Fargo too will have to raise additional capital hit the wires. It hardly caused a blip on the screens. Later in the day S&P placed a large number of banks on negative credit watch. That news too caused a sell-off which was over within the blink of an eye.


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