Wednesday, December 30, 2009

Yield Curve Near Historically High End of its Range

The yield curve has been the subject of an increasing amount of chatter in recent weeks, as long-term interest rates rise and short-term rates remain low. Some stories have suggested that the curve is at record highs, but based on the official definition from the NY Fed, while the yield curve spread is extremely high, it is not quite at a record.

According to literature from the NY Fed's website, the yield curve is defined as, "the spread between the interest rates on the ten-year Treasury note and the three-month Treasury bill." On a historical basis it has been "a valuable forecasting predicting recessions two to six quarters ahead."

Using the Fed's definition of the yield curve, the chart below shows the historical spread between the yields on the 3-month and 10-year US Treasury (in basis points). As shown in the chart below, the current level of the yield curve is nearly two standard deviations above its historical average. The only other time that the spread got this wide was back in August 1982.

Yield Curve123009

Might the recovery be more robust than widely expected? Wall Street’s most respected pessimist thinks so.

Illustration by André Carrilho

Blessedly, 2009 did not turn out to be the utter catastrophe many once feared it would be—no bank runs, no bread lines, no sport-hunting of the rich. But it’s far from certain whether the worst has been truly averted, or, to use a phrase that became fashionable, the can was merely kicked down the road. The signals are, at best, mixed. Jobs are still being lost, if not at the same wildfire rate. Many small businesses lack credit, not to mention customers. So what lies ahead?

Between the yahoos who tout every market uptick as the stirrings of the next boom and the doom peddlers who cling to their prophecies of societal breakdown, a consensus has cohered around what investment strategist John Mauldin, a hero of the blogosphere, calls “the muddle-through economy,” a protracted period of elevated unemployment rates and sluggish growth. Federal Reserve chairman Ben Bernanke, who once spoke of “green shoots,” now describes the “considerable headwinds” that the economy faces. Goldman Sachs economist Jan Hatzius sees double-digit unemployment persisting through the end of 2011.

Within this school of forecasters, a popular approach is to characterize the United States in terms of other countries’ trademark miseries. So we are Japan— a major Paul Krugman meme—staring down the barrel of our own “lost decade” of deflation, zombie banks, and cultural inertia. Or we are Europe, afflicted by the “sclerosis” of high structural unemployment and gigantic government. Or, as former IMF official Simon Johnson asserts, we are “a banana republic,” debasing our once-mighty currency by recklessly printing it to cover our debts.

But describing current conditions is only part of the game. Correctly calling the next crisis is the great status bake-off of economics. Which is why it was bracing to receive a recent investment newsletter from one of the most distinguished pessimists on Wall Street with this headline: “On the Coming Shortage of Labor.”

It was not a joke.

The bi-weekly newsletter, Grant’s Interest Rate Observer, is published from a picturesque office on Wall Street overlooking Trinity Church. The proprietor is a former journalist turned finance philosopher named James Grant, who—in addition to turning out the newsletter, which costs subscribers $850 a year, and hosting conferences at the Plaza Hotel that feature some of the sharpest minds in the investing business—has written six books, including a history of debt (surprisingly engaging) and a biography of John Adams (better than David McCullough’s, some say). But his ample intelligence has often left him out of sync with the animal spirits that rule Wall Street. Over a quarter-century in which the economy mostly boomed, Grant stayed mostly gloomy. His view has been that the economy is a Frankenstein creation of cheap credit that drove up prices and instilled a false sense of prosperous stability.

At critical moments, such as the great collapse of the eighties boom, this analysis proved brave and useful, swelling Grant’s subscriber rolls and turning him into a star of sorts. But it also led to him advising caution and restraint as some of the most vigorous bull markets in history commenced. Indeed, the nineties was not kind to pessimists. “In this business,” he says, “everything is cyclical, including one’s evident IQ. One goes from genius to moron all too quickly. And so I went from being regarded as one of the brighter people on Wall Street to being, let’s see, a perma-bear, and there was truth in that. I wasn’t supple enough, wasn’t flexible enough. I was in love with our story, which had been so successful, and didn’t see the world change.”

Having made this mistake more than once, Grant is determined never to make it again. The financial crisis ratified many of his core convictions about the pitfalls of debt and loose monetary policy, and the panic of people who didn’t see the crisis coming produced great opportunities for those who did. The transition from bear to bull was difficult for Grant, but before 2008 was over, he was recommending to his subscribers that they shop for bargains, including, yes, houses in Detroit. “One year ago, we turned bullish on tradable bank debt, certain ‘toxic’ mortgages, junk bonds and other such unwanted debris,” he says. “In March, we turned bullish on bank stocks. And now we are bullish on the economy.”

Grant’s optimism is built on two pillars. The first is his analysis of cyclical trends. Like a rubber ball thrown against pavement, the U.S. economy has historically bounced back with a force roughly approximate to that with which it fell. So the tepid recoveries of the early nineties and early aughts, the ones that preoccupy many analysts today because job growth was so torturously slow in both cases, were just the predictable aftermath of what Grant describes as “toy recessions.” A better model for our present circumstances, he says, is the early eighties, when the economy was in shambles (double-digit unemployment then, too) and then suddenly, to the shock of learned people everywhere, staged a stupendous recovery. Yes, there are seemingly unique impediments to such a recovery this time around—the indebtedness of U.S. consumers, to name one—but there are always such seemingly unique impediments, and the U.S. economy has repeatedly demonstrated the power to adapt.

This is especially true in the emotional, highly fraught area of unemployment. In a worrying climate of dying professions, it’s hard to get a grip on what takes their place. “Though we humans do our best,” he wrote, “we usually underestimate the capacity of market economies to reinvent the nature of work.” How exactly it will work this time, says Grant, we don’t know. We never know until after the fact.

Consider the now-conventional analysis of the U.S. economy over the last decade: It was, we have had drilled into us, built on the swampy ground of real-estate speculation and the feverish spending of borrowed money. Okay, sure. But it was also about the explosion of information technology, the concomitant surge in productivity, and unprecedented access to low-cost labor, both domestically (Latin American immigrants) and globally (Chinese), which lowered the prices of goods and services for all Americans. These conditions, unlike the housing market, have not gone away.

Grant’s second cause for optimism is an observation about human nature, summed up by an epigram he borrowed from the late British economist Arthur C. Pigou: “The error of optimism dies in the crisis, but in dying it gives birth to an error of pessimism. This new error is born not an infant, but a giant.” As peculiar as our economic circumstances may seem to us right now, the way people behave has a certain reassuring constancy—which is to say, we freak out and then we get over it.

Though economic forecasting is a major part of what his subscribers pay him for, Grant considers much of it a pseudo-intellectual parlor game. “Mindful that the future is a mystery,” he wrote in recent newsletter, “we do not pretend to know what nobody can know.” The past offers only so much help. In the industrial history of the United States, there have only been about 30 economic recoveries, a minuscule sample size. (If somebody touted a medical breakthrough based on a study of 30 patients, who would rush to sign up for this new wonder drug?) As for the data itself, consider that the dominant measure of economic activity, gross domestic product, is an antique that does a poor job of capturing the intangible investments that abound in the information economy. The numbers that drive the markets up and down, like jobless figures, are glorified guesses subject to constant revision. The latest issue of Grant’s Interest Rate Observer notes that annualized GDP growth for the third quarter of 1983 has been revised ten times, including just this fall! How much can we possibly know about the future if we’re still unsure about 1983?

Grant, too, harbors deep concerns about what lies beyond the bounce-back. He sees long-term problems in the government’s massive efforts to save the economy, especially the low interest rates that Bernanke shows little inclination to raise. “Inflation is upon us,” he says. “Not too much money chasing too few goods, but too much money. The object of the money’s desire varies from one cycle to another. It could chase skirts, toothpaste, and automobiles, as it did in the seventies. Or it could chase stocks, houses, or income-producing buildings, as it did a few years back.”

Grant, in other words, hasn’t forsaken pessimism so much as postponed it. Hyper inflation could produce the kind of volatility that enables traders to make a killing while the rest of us suffer sticker shock in the breakfast-cereal aisle. Then it’ll be the sport-hunting vigilantes who are doing the chasing.

Dow Yield Versus Treasury Yield

There has been quite a bit of chatter recently about the widening spread between the yield on 10-Year Treasuries and the dividend yield for stocks. Currently, the 10-Year Treasury Note is yielding 3.84% versus the Dow's dividend yield of roughly 2.6%. One of the arguments for stocks at the bottom of the bear earlier this year was that they were yielding more than Treasuries. As shown below, that hadn't happened in nearly 50 years. The consensus for 2010 is that stocks will rise (dividend yields lower) while the 10-Year yield will rise as well. This would make the spread tick lower into the "red zone" in the chart below. You be the judge on whether this will be a negative for stocks or not.


Sunday, December 20, 2009


Below we highlight the percent of world stock market cap that various countries make up and how the numbers have changed this year. As shown, the US remains the biggest country with its stocks making up 29.61% of world market cap. This is more than three times Japan's representation in second place at 7.68%. At the start of the year, the US had 32.75% of world market cap, so its representation is down 9% in 2009 even though US equity markets are up. At 7.27%, China overtook the UK in third place in 2009 and is closing in on Japan.

Brazil's percent of world market cap increased the most in 2009 at 58.2%. Its weighting has gone from 1.84% to 2.92%. Indonesia, India, Australia, Turkey, China, Russia, and Taiwan have all seen their weightings increase by 25% or more this year. On the flip side, Japan has lost the most market share of the developed countries, declining from 10.28% to 7.68%.



Since November 9th, the S&P 500 has essentially traded sideways. We broke the index into deciles (10 groups of 50 stocks) based on market cap and then calculated the average performance of stocks in each decile since 11/9 to see what impact a company's size has had on the market recently. As shown below, the two deciles (100 stocks) of the biggest stocks in the S&P 500 are up just slightly (about 0.20%), while the rest of the deciles have averaged a gain of more than 2%. Clearly the blue chip stocks have been holding the markets back during this sideways trading pattern.


Do TIPS Work?

Are Treasury Inflation Protected Securities (TIPS), for which the Treasury adjusts the principal based on the Consumer Price Index for all urban consumers (CPI-U), effective as an inflation hedge? In their September 2009 paper entitled "A TIPS Scorecard: Are TIPS Accomplishing What They Were Supposed to Accomplish? Can They Be Improved?", Michelle Barnes, Zvi Bodie, Robert Triest and Christina Wang evaluate the progress of the TIPS market toward providing: (1) consumers with a hedge against real interest rate risk; (2) holders of nominal bonds with a hedge against inflation risk; and, (3) everyone with a reliable indicator of expected inflation. Using inflation rate and bond yield data available since the introduction of TIPS in September 1997, they conclude that:

  • TIPS provide a good real-return hedge, despite CPI measurement error and possible demographic differences among TIPS investors. TIPS indexed to CPI are as good as TIPS indexed to other inflation measures, because inflation risk is largely independent of the measure used.
  • TIPS better protect long-term, buy-and-hold investors than investors who hold TIPS for less than the full maturity. Over relatively short horizons, bond price volatility overwhelms the relatively small deviations between actual and expected inflation.
  • The inflation rate implied by the difference in yields between nominal Treasury and TIPS markets are neither clean measures of expected future inflation nor likely to be good predictors of future inflation (see chart below).
  • A "ladder" of TIPS, with maturities linked to anticipated expenditure timeframes, would help investors in or near retirement hedge against inflation in nominal expenses over time.

The following chart, taken from the paper, shows in simplified form how the nominal Treasury yield can be broken down into a TIPS part (expected real rate plus a real rate risk premium) and an inflation compensation part (expected inflation plus an inflation risk premium). This diagram illustrates why there is no easy way to extract the expected inflation rate from the difference between nominal and TIPS yields.

In summary, TIPS work reasonably well as an inflation hedge for long-term holders, but they are not particularly useful in measuring inflation expectations.

Thursday, December 17, 2009

Alpha versus beta?

Alpha beta separation? Can't beat beta? Beta based asset allocation is supposedly the driver of returns. Many papers claim that it is almost all that matters. That mistake has dominated conventional wisdom for too long. They reached that sample biased conclusion because asset allocation is what the selected investors focused on. Setting a stock/bond/alternatives mix determines variability of returns ONLY if you emphasize it. It is easy to debunk this portfolio construction "axiom" if you seek reliable performance.

Suppose corporate pensions were required to invest 100% in the plan sponsor's equity. Then we would conclude that security selection drove returns. If investors flipped coins each month to be 100% stocks or bonds then market timing would be the factor. You only have to look at a few conventional portfolios to see that "choose your betas" asset allocation needs NEW thinking. Some say that long term investors should have more in risky assets due to the alleged higher "expected" return. Instead investors would be wise to focus on the alpha/beta weight. For anyone with lower risk tolerances and dislike of deep drawdowns, alpha gets the vote.

The true determinant of superior risk-adjusted returns is investment SKILL not the percentage in different UNSKILLED asset classes. If the "seminal" studies had confined their analysis to high frequency portfolios obviously they would find that ability at high frequency trading drives performance! Is it valuable information to "discover" that asset allocators' returns largely depend on their asset allocation? More importantly EVERY high performing portfolio over the long term focused on alpha so why spend so much time and money on beta?

It's been a great decade for the S&P500. No beta for index fund fans but every day had an opportunity set of 500 fluctuating securities to capture alpha. It was an even better 25 years for the Nikkei. Again no beta but vast alpha was generated from security selection and timing by those with skill. In aggregate, "stocks" can and do underperform "bonds" for decades. 60/40 sounded prudent until rephrased as 90/10 risk. Why have a risk appetite when equity indices fail to compensate with sufficient reward even in bull markets. Last century's 8% return on 16% volatility was an insult but a negative total return with even more risk is absurd.

The more vituperative commentary on hedge funds, the more cash one should invest in alpha vendors. Why tie up precious capital in high risk beta when lower risk alpha is available? Better to identify mispricings and arbitrages than invest in "the market" itself. It is safer to minimize market exposure and analyze specific securities to short sell and buy. Most portfolios are still very beta biased while some investors implement a beta plus alpha model. The INEVITABLE progression is to alpha only which has a superior efficient frontier. I do not understand why investors should surrender wealth to the volatility of long only beta.

Selecting the RIGHT betas at the RIGHT time is a form of alpha anyway. Choosing the WHICH and WHEN of asset classes takes as much talent and expertise as at the security level. I have no idea where the markets are going in the long term but will not take the risk of finding out. Asset and security selection, timing and hedging skill, though rare, are the only properties a conservative investor can rely on if they need adequate and consistent absolute returns. Beta is passive but do we live in a world that rewards passivity in any activity? I don't think so which is why they are called ACTIVITIES. Alpha comes from acumen-driven ACTION.

Alpha/beta separation is trendy but beta tends to swamp alpha as we saw in the downs and ups of 2008/9. That was the error inherent in the awful portable alpha idea. It was a beta-centric way of getting people into hedge funds but failed because it kept asset allocation front and centre. It diluted the absolute return attribute and changed it into a relative return enhanced index product. The alpha/beta separation framework still has too much risk budget in beta. Why bother with beta at all? Cheap beta is expensive considering its risk. Risk and cost conscious investors favor alpha.

Successful investing is about leveraging your informational, structural and analytical advantages or outsourcing to those that do. Let's look at some portfolios that did well over long periods but didn't asset allocate, instead focusing on security selection or timing. A low frequency trading firm like Warren Buffett's Berkshire Hathaway identifies specific multiyear opportunities in currencies, commodities, stock and bond markets, derivatives and event driven special situations. In contrast the high frequency trading of Jim Simons' Medallion Fund times thousands of liquid securities over shorter holding periods down to microseconds. Munehisa Honma's managed futures fund specialised in trading one security in multiple time frames. Producing alpha depends on the knowledge and technology edge being applied to the appropriate time horizon.

Beta bets drive most portfolios because that is what most investors do. It is like the people who assume carbon is necessary for life because the science they know and only lifeforms they have analyzed are carbon-based. The anthropic principle applied to finance! It is false logic similar to the "all swans are white because every swan I encounter is white" phenomenon. Asset allocation fit nicely into the established body of theory which is why it remains popular despite its weakness. Efficient, unbeatable markets imply the non-existence of skill! Choose beta because alpha is just "random" luck in a zero sum game? Beta people like index funds because they want you to invest in "the market". But the safest way to achieve absolute returns at the total portfolio level is to be alpha-centric.

Beta vendors don't manage risk, don't time and outsource security selection to benchmark construction firms. They stay fully invested even in bear markets! A beta-centric portfolio is where investors decide a policy or strategic asset allocation and then look around for managers to basically deliver the return from that asset class and hopefully a bit of alpha on top from tracking error constrained active mandates. Most long only funds have an R-squared with their benchmark over 70% - ie beta explains most of their returns. Alpha strategies and manager selection shouldn't be secondary but that is the result when RISKY beta bets dominate the allocation of investment capital.

Alpha vendors see a market of securities offering long/short opportunities over numerous time horizons within and between asset classes. An alpha centric portfolio is where investors hire managers to analyze, trade and hedge. Of course you have to be very good and work extremely hard to find alpha. Any manager that depends on beta is NOT running a hedge fund. A truly efficient portfolio does not pollute itself with any beta. Dismissing all hedge funds is like avoiding all stocks because of Enron, Worldcom and Nortel. Don't invest in fixed-income because some bonds default?

Naturally pure alpha sources do not fit well into the beta allocation process that some find so compelling. Since they are not assets, treating hedge funds as an asset class is wrong. The dispersion of returns across the industry is very high. So variable that AVERAGE performance has little meaning. 10,000 hedge funds, 10,000 strategies. People like to know if "hedge funds" were up or down each month. But what does that mean? Some made money and some lost money. Likewise I am often asked where I think the "market" is going. That is a beta question. Some stocks go up and others go down. Seek alpha.

Do I want "hedge funds" that outperform? No. I want hedge funds that make money which is a different target. I know that good hedge funds will have high risk-adjusted returns and bad ones will not. Alternative beta is just another beta and is therefore to be avoided. Most betas are becoming more correlated whether by geography or the equity/credit/real estate connection to the economy. I am not concerned whether a hedge fund manager's strategy is "market neutral" or not. But they MUST be able to deliver absolute returns that are "economy neutral".

Alpha is the TRUE diversifier because there are so MANY different ways of generating it. Focus on alpha if you want reliable performance regardless of the economy. Why pay attention to asset classes when investing in different SKILL-BASED STRATEGIES makes more sense? For the risk averse conservative investor alpha and beta is inferior to an alpha only portfolio. And leave the speculators to their beta only bets.

Monday, December 14, 2009

A steeper path to follow

Sovereign debt yield curves are steepening.

On Thursday, US 30-year yields hit four-month highs after a government long-dated auction received poor demand and revived worries over the federal budget deficit.

With reason. Outstanding Treasury debt currently looks like this:

US Treasury outstanding debt - Bloomberg

In fact, according to Bloomberg, the Treasury yield curve has now hit its steepest since at least 1980. Here at least is how today’s curves compare to those in 2007.

As they stand today:
Yield curves - Bloomberg

And how they stood two years ago:

Yield curves 2007 - Bloomberg

And for those interested to see how US liabilities have been dispersed, here’s the current distribution of US public debt according to TreasuryDirect:

US debt distribution - Treasury direct

Tuesday, December 08, 2009

The death of sec lending in prime brokerages?

Dec 7th, 2009 |

hardly knew yaThe world is full of middle-men: Walk into a car dealership to purchase a car and you go through a salesperson, who takes a cut for showing you the car; walk through a house or apartment and the real estate broker takes a cut for opening the doors and closets.

Like it or not, and as counter-intuitive as it sometimes may be, it is the way transactions work.

So it’s been with the securities, or “sec” lenders: institutions that have access to “lendable” securities. Asset managers who have securities under management, custodian banks holding securities for third parties or third party lenders who access securities automatically via the asset holder’s custodian have for years taken a nice slice of the pie to lend back out stocks to others who need them.

In its most basic form, sec lending is where a loan results in a transfer of title/ownership to the borrower, who is obligated to return the same type and amount of securities. The loaned securities are collateralized, typically 102-105%, reducing the lender’s credit exposure to the borrower (as illustrated in the chart below provided to by automated securities lending and borrowing marketplace Automated Equity Finance Markets (AQS) – click to enlarge).

sec lending 530

When the banking and financial systems were functioning normally, all of this was considered par for the course. Indeed, for long/short and short-only hedge funds in particular, the ability to go to their prime broker for their sec lending needs was a value-added proposition not even questioned.

At least until Bear Stearns blew up, Lehman Brothers was allowed to go bankrupt and all H-E-double-hockey-sticks broke loose, bringing into question for the first time the notion of whether too big to fail – and too big not to be concerned with the physical securities your prime broker was lending back out to someone else at a profit – were going to get taken away from you.

It was this kind of talk that dominated the Securities Lending Debate produced by consulting firm Finadium and Markets Media and held in New York last week as part of Markets Media’s Global Markets Summit.

Among the many key points of debate: the use of multiple primes, the need for speed, liquidity and premium pricing in the form of new, accessible platforms, the notion of “bundled” services for hedge funds and the concept of “central” borrowing – literally going back to the old five-day settlement cycle, where all securities going through a central clearing house get settled within a specific period. Also of note, sec lending spreads are still at historically wide standards, meaning there is still profit to be made in lending out securities (as the data below collected by Finadium shows):

sec lending

But by far the most contentious point of debate were projected changes in prime brokerage – in the sec lending food chain, that is – and what will inevitably mean fundamental changes in the prime brokerage business model.

“I think it’s going to be a significant trend for 2010,” noted Josh Galper, Finadium’s managing principal, who opened up the forum at the Waldorf Astoria hotel last week and hosted the event. “I can see at this time the development of two separate markets: hedge funds borrowing securities lending from prime brokers versus hedge funds engaging in borrowing from electronic markets and other non-prime broker dominated venues.”

Galper said that driving the anticipated trend will be hedge funds who want to go to lenders directly, rather than finagle with their prime brokers. Also driving the trend will inevitably be regulatory oversight of both sec lending and short selling, with the SEC and others recasting rules concerning leverage, margin requirements and how over-the-counter derivatives and other instruments are viewed and regulated.

AUM GrowthOf course, speculating on how the sec lending and prime brokerage businesses pan out over the next few years is all about what part of the industry you reside in. For their part, the prime brokers aren’t going to walk away from something that provides both value-added and makes them additional money. At the same time, non-prime broker service providers, in particular custodians and others who are either getting into or expanding their sec lending game, aren’t about to throw away an opportunity either.

There are also new ways to skin cats, so to speak — ways of doing the long/short game that so far only third parties and less-known markets can accommodate.

One thing is for sure: the Lehman debacle – in particular the Lehman UK debacle – has made the entire alternatives industry re-think how it looks at sec lending, and how best orchestrate it safely, securely and cost-efficiently.

The prime brokers that offer it up as value-added service at competitive rates likely won’t have much to worry about. The only thing they’ll need to get used to is some additional competition.

Wednesday, November 11, 2009

Barrick shuts hedge book as world gold supply runs out

Aaron Regent, president of the Canadian gold giant, said that global output has been falling by roughly 1m ounces a year since the start of the decade. Total mine supply has dropped by 10pc as ore quality erodes, implying that the roaring bull market of the last eight years may have further to run.

"There is a strong case to be made that we are already at 'peak gold'," he told The Daily Telegraph at the RBC's annual gold conference in London.

"Production peaked around 2000 and it has been in decline ever since, and we forecast that decline to continue. It is increasingly difficult to find ore," he said.

Ore grades have fallen from around 12 grams per tonne in 1950 to nearer 3 grams in the US, Canada, and Australia. South Africa's output has halved since peaking in 1970.

The supply crunch has helped push gold to an all-time high, reaching $1,118 an ounce at one stage yesterday. The key driver over recent days has been the move by India's central bank to soak up half of the gold being sold by the International Monetary Fund. It is the latest sign that the rising powers of Asia and the commodity bloc are growing wary of Western paper money and debt.

China has quietly doubled holdings to 1,054 tonnes and is thought to be adding gradually on price dips, creating a market floor. Gold remains a tiny fraction of its $2.3 trillion in foreign reserves.

Gold exchange-traded funds (ETFs) – dubbed the "People's Central Bank" – have accumulated 1,778 tonnes, making them the fifth biggest holder after the US, Germany, France, and Italy.

Ross Norman, director of, said exploration budgets had tripled since the start of the decade with stubbornly disappointing results so far.

Output fell a further 14pc in South Africa last year as companies were forced to dig ever deeper - at greater cost - to replace depleted reserves, not helped by "social uplift" rules and power cuts. Harmony Gold said yesterday that it may close two more mines over coming months due to poor ore grades.

Mr Norman said the "false mine of central banks" had been the only new source of gold supply this decade as they auction off reserves, but they are switching sides to become net buyers.

Barrick is moving fast to wind down the remaining 3m ounces of its infamous hedge book over the next twelve months, an implicit bet on rising gold prices over time.

Mr Regent said the company had waited too long to ditch the policy, which has made the company enemy number one among 'gold bug' enthusiasts. The hedges oblige Barrick to deliver part of its gold into futures contracts set long ago at levels far below today's spot prices.

The strategy worked well in the falling market of the 1990s, but has cost the company dear in lost profits this decade. "Hindsight is always 20/20," said Mr Regent, who was appointed from the outside earlier this year.

Barrick bit the bullet in the third quarter, taking a $5.7bn charge against earnings on hedge contracts. Liberation is at last in sight. In 2001 the hedge book topped 20m ounces.

Mr Regent said the hedge policy has weighed badly on the share price and irked investors, becoming a bone of contention at every meeting. The financial crisis brought matters to a head as markets fretted about counterparty risk. "It was clear to me that there were a significant number of institutions who wouldn't invest in Barrick because of the hedge book," he said.

Barrick produced 1.9m ounces of gold last quarter, down from 1.95m a year earlier. Costs have been "trending down" to $456 an ounce, though rising energy prices pose a fresh threat. Total reserves are 139m ounces, far ahead of rival Newmont Mining at 86m.

The hedge book venture has not been a happy one, but those who predicted that Barrick would eventually "blow up" on its contracts may owe the company an apology.

Monday, November 09, 2009

IMF: Dollar Carry-Trade Creating Bubbles Around The World

The International Monetary Fund (IMF) highlighted the fact that low interest rates in the U.S., plus an apparent "one-way" bet against the dollar has created a global dollar carry-trade that is driving capital flows into emerging markets.

If not handled properly, this will lead to emerging market asset bubbles, which arguably have already begun to inflate.

We've highlighted before how places like Hong Kong are seeing property prices go through the roof due to low U.S. interest rates.

The fact that the IMF is increasingly vocal on the subject suggests that this process is really starting to become quite substantial phenomenon in many countries.

IMF: There are indications that the U.S. dollar is now serving as the funding currency for carry trades. These trades may be contributing to upward pressure on the euro and some emerging economy currencies. Emerging economy authorities have been responding to capital inflows by accumulating reserves, and, in some cases, with capital controls and other measures, to slow the pace of appreciation. Capital flows driven by yield differentials are complicating monetary policy responses in those economies where there may be a need to tighten—particularly in Asia.


Some emerging economies may need to absorb capital inflows and at the same time avoid compromising domestic financial and price stability. With interest rates in advanced economies set to remain low for an extended period, and emerging economies poised to recover at a faster pace, the recent flow of capital into these economies may continue.

Read a PDF of the IMF's recent report here.

Stock Market Returns Lost in Translation

One of the side effects of a weaker dollar is that the returns for foreign investors who invest in US assets are diminished. While the value of the asset may rise in dollar terms, if the dollar is losing value, the investor takes a hit when they convert their funds back into their domestic currency. For example, while the S&P 500 has risen 20.2% so far this year in US dollars, investors outside of the US have generally seen much less impressive returns. In the table below, we looked at the YTD returns of the S&P 500 for investors in various currencies. Of the currencies we looked at, the only one that has seen a benefit from the currency translation is the Argentinian Peso. Returns have been diminished once fluctuations are taken into account for all other currencies. And of course some countries have been affected more than others. So far this year, Brazilian investors who bought the S&P 500 at the end of last year have lost nearly 12 reals for every 100 they invested on January 1st.

Currency returns

Short Seller: Dump Munis

A short seller sounds an alarm over states' deficits -- and bonds. Muni managers demur.

JAMES CHANOS, THE FAMED SHORT SELLER who was among the first to foresee the collapse of Enron, recently sounded the alarm on the municipal-bond market -- in the hallowed halls of the New York Historical Society, no less.

The "cracking of state and local municipalities is coming," he predicted at a recent meeting attended by Barron's staffer Susan Witty, adding that he wouldn't touch munis.

In a subsequent telephone interview with this columnist, Chanos said, "State and local municipal finance are a mess and going to get worse."

It's not just the recession, which has reduced tax receipts. Rather, he says the poor economy "is masking real problems in municipal cost structures." The big problem, he says, is "the platinum-plated health-care and retirement benefits" given to state and local workers. "It's all coming home to roost" as boomers start to retire.

California faces a $60 billion deficit, and the politicians there believe that in "a worst-case scenario, the federal government will bail them out," says Chanos. "If the feds do bail them out, as I believe they will," the state's bonds will likely lose their federal tax exemption, he adds.

He didn't mention New York, but he could have. Gov. David Paterson and the state legislature, controlled by the governor's own Democratic Party, are playing a game of chicken about where to find budget cuts to address a soaring deficit now estimated at $3.2 billion. Paterson has also warned that the state could run out of money to pay its bills before the end of the year.

Neighbor New Jersey faces an $8 billion structural deficit next year -- one reasons the normally blue state's voters elected Republican Chris Christie as governor last week. Ex-Governor James McGreevy had bonded for current-account expenses before he resigned, and the bonding was stopped by the state's courts. His Democratic successor, former Goldman Sachs honcho Jon Corzine, promised property-tax relief to the middle class but couldn't deliver, and therefore got the boot.

Given the scope of the problem, "munis are a bad bet," says Chanos.

But some muni asset managers beg to differ: "In the history of the market, going back to the Civil War," there have only been very isolated defaults, says Tom Spalding, senior investment officer at Nuveen Asset Management, with $63 billion of munis under management.

Chanos' retort: "Just because it hasn't happened doesn't mean it won't."

Gary Pollack, head of fixed-income trading at Deutsche Bank Private Wealth Management, with $6 billion in munis, says municipal governments, "are in the business of building public projects." To do that, they need access to the capital markets.

Yes, there's headline risk and there's downgrade risk from the credit-rating agencies, says Pollack. "But municipal governments have broad fiscal powers to balance the budget" to meet their payments in a timely fashion.

Moody's chief economist John Lonski says that "2010 will be the year of tax increases by local and state governments to close budgetary gaps."

Read his lips.

THE LATEST EMPLOYMENT DATA, released Friday, showed that the unemployment rate topped 10% (hitting 10.2%, to be exact) in October. That's the first time it exceeded 10% in 26 years.

"You can't doubt the impact of 10% on consumer behavior," especially given the record 5.4% drop in third-quarter employment income, which was first tracked in the 1950s, says Lonski. It also couldn't come at a worse time, just ahead of the holiday shopping season.

Retailers have braced for the worst. The unemployment rate for U.S. retail companies jumped to 9.9% last month, its highest level in the current recession, from 9.2% in September. Some 40,000 jobs were lost.

As for the near-0% interest-rate policy of the Federal Reserve, which it reaffirmed last week, "it would be premature to brace for the inevitable hike in fed funds," says Lonski. He doesn't see rates rising until August 2010 "at the earliest."

That's because the Fed doesn't see the private sector leading the recovery without the Fed's own stimulus programs, and those of the U.S. Treasury. "The Fed is very much concerned about the sustainability of the recovery," he says.

LONG TREASURIES AT FIRST rallied on the unemployment news, including a 190,000 drop in October's payrolls and a revised 219,000 decline in September, but pulled back ahead of this week's humongous supply.

The yield on the benchmark 10-year Treasury note ended the week at 3.50%, up from 3.38% the week before, as Treasury prices, which move inversely to yield, lost ground.

The Treasury Department is scheduled to sell $40 billion in three-year notes, $25 billion in 10-year notes and $16 billion in 30-year bonds as part of the refunding supply to raise cash for the fourth quarter.

Treasury won't have a major buyer this time, as the Fed last month completed its $300 billion Treasury-purchases program, essentially a policy of printing money.

One final note about the employment picture, and it's a positive one: The number of U.S. workers filing new claims for jobless benefits fell in the latest week (ended Oct. 31) more than economists expected -- by 20,000, to 512,000. That's the lowest level since Jan. 3. Economists anticipated a drop of just 5,000, according to Dow Jones Newswires.

The four-week moving average of new claims fell by 3,000, to 523,750, the lowest level since Jan. 10.

"Jobless claims are the best leading indicator" of where the employment picture is heading, says Lonski.


Bond Supply Looms: U.S. government securities were under pressure last week, despite unemployment moving above 10% for the first time in 26 years, as the Treasury Department readied a record $81 billion in new supply for this week.

Wednesday, October 28, 2009

Current Pullback: S&P Performance Based on Beta Deciles

While it's not surprising, the highest beta stocks are getting killed during the current pullback. As shown below, the 50 stocks in the S&P 500 with the highest betas are down 8.72% since 10/19, while the 50 stocks with the lowest betas are only down 2.11%.


Small Caps Stumble

While the S&P 500 is testing its 50-day moving average today, the smallcap Russell 2,000 looks much worse. As shown below, the Russell 2,000 failed to make a new high along with the S&P 500 earlier this month, and today the index broke below its lows from late September/early October. With the index now below its sideways trading range from the last couple months, the trend looks to be down.


GLD’s mysterious disappearing gold-bar list

There have been some strange goings on in the world of ETF gold bar holdings of late.

Gold bug extraordinaire Professor Antal Fekete shines a light on the case of the SPDR GLD specifically –the largest of the gold-backed ETF funds in the US in terms of money managed. In a report published about two weeks ago Fekete notes the fund’s listed bars shrank rather mysteriously as of October 2.

As he explained:

Another story is about GLD, a leading gold ETF, which publishes its bar-list every Friday at the close of business, reporting the serial number of every bar in inventory. The list is customarily well over a thousand pages long. But, lo and behold, on Friday, October 2, and on Friday, October 9, the bar-list shrank to a mere couple hundred pages, with no explanation offered.

The equally gold-buggy Rob Kirby writing in Market Oracle blog, meanwhile, offered a little more detail on the actual discrepancies:

# on Friday, Sept. 25 — the list was 1,381 pages long
# on Friday, Oct. 2 — the list was 208 pages long
# on Friday, Oct. 9 — the list was 195 pages long
# then, on Wednesday, Oct. 14 — after questions were being raised about the strange machinations with the bar list in chat rooms on the internet — the list was back up to 855 pages long.

The latest October 23 list, though appeared to return to more normal proportions running at some 1291 pages.

So what gives? To be honest, we’re not really sure.

To shed some light, we tried contacting GLD’s marketing agent State Street Global Markets, but haven’t as yet had a definitive reply.

While we wait for one, however, we shall point out that on October 16 the CME exchange group announced that from October 19 it would allow gold to be used as collateral on margin accounts in all its markets as an alternative to debt or equities. According to the CME the move came “in response to customers’ wish to use their gold holdings more efficiently.”

The CME also said that on an initial basis it would use JP Morgan Chase as the only custodian for gold deposited as collateral with the exchange, making the bank one of the key beneficiaries — especially in the event it happened to be in any way short of allocated gold.

JP Morgan, by the way, happens to be a GLD authorised participant, as well as the second largest holder of GLD shares according to SEC filings as monitored by Bloomberg:

SPDR GLD holdings

Friday, October 23, 2009

The Merrill Lynch High Yield Master II Index, often used when assessing the
state of the broad High Yield market, suggests that Junk bonds have returned
a whooping 51% year-to-date, thereby outperforming the SPX by a cool 29%.

I am notoriously sceptical about indices (reasons include geometric returns
versus dollar weighted returns, index inclusion/exclusion problem, changes
in share of CCC rated paper, etc). Looking at High Yield mutual fund indices
only partly solves such issues as these indices have their own flaws but f.i.
Lipper's HY index ytd return was in the low 40's and thereby almost 10
percentage points (so actually 20%) lower than the Master II's.

Mid August 2008 was the time when the HY market started its bold down
move of -31% in less than three months.

Since that same August 2008 the ML index recovered and has eventually
returned roughly +14%, indicating that everyone in HY land should be well
ahead of their high water marks (which I doubt) and have outperformed the
SPX by 28% during that time.

Issuers went into this period with very high leverage and during that same
period reported earnings plunged to a degree not seen seen since 1871
(by 99%, that is), with y-o-y industrial production at -10.7%, y-o-y retail sales
down -5.3% and capacity utilization at 66.6%.

Defaults have so far come in somewhat below consensus expectation but some
issuers just had their chance to buy some time by extending their maturity
profile selling new crap debt, some did exchange offers and/or were able to raise
some capital. However, things don't nearly look as good as indices may suggest in
my view.

So here is my conundrum, which is actually two-fold:

1) High Yield indexes show stellar performance (even those including only
investable mutual funds, such as Lipper), implying investors in HY land
should be well ahead of their high water marks. Is that actually the case?
And if it is not - which I assume - where has all the positive index performance
come from?

2) A very serious deterioration on the operations front meets a return of some
+14% for the asset class since August 08. Why is it the case? Looks like the
markets are incredibly confident they can buy themselves out of the doldrums.

Not sure if these questions best be addressed by micro- or macro economists
as the former seem to be mostly wrong on particular things with the later being
just as wrong in general.

Thursday, October 22, 2009

David P. Goldman has an excellent post, which makes it crystal clear why we saw a housing bubble and the explosion dicey AAA-rated CDOs that caused so much hurt when it all went bust.

No, it wasn't Wall Street greed. As we've seen others put it, blaming greed for Wall Street's collapse is like blaming gravity for a plane crash. It's not an answer.:

Every sort of idiotic expanation is offered by academic economists for the financial crisis. Explaining the crisis has become a major industry. The academics by and large haven’t a clue. Grass might as well grow where their classrooms now stand. Wall Street greed and absence of risk management was the usual answer. That’s silly. The investors who bought subprime assets in 2006 weren’t any greedier than when they bought prime assets in 2004. The difference is that monstrous demand crushed the returns on prime assets.

Uh-oh. This sounds a lot like Alan Greenspan's "Savings Glut" idea. And since we all know that Alan Greenspan must be a total idiot eager to unload any blame for the crisis, it just can't correct.

But let's carry on. Here's a research note he wrote for Cantor Fitzgerald in 2006.

In C.S. Lewis’s “Screwtape Letters,” an old devil gives practical advice to a novice demon. Diabolical amounts of leverage compressed credit spreads during 2005. Wrong as the market may be about inherent risk, it is likely to stay wrong, as the Fed backs off from aggressive tightening, the threatened curve inversion fails to materialize, absolute yield levels remain low, and investors enhance returns through leverage.

Investors are not piling into levered synthetic BBB structures because they are complacent about credit risk. On the contrary, all the investors I know are scared to death. But as long as the average U.S. pension fund requires returns of 8.75% to meet its long-term obligations, and the aggregate corporate bond index yields just over 5%, institutional investors will continue to pick up nickels on the slope of the volcano. Sponsorship of ever-more-esoteric structures is a failsafe symptom of yield dearth. Investment banks are selling AAA-rated synthetic CDO principal with coupon indexed to the performance of the equity tranche, like the old range accrual notes that brought down Orange County in 1996. Trust Preferreds, REITs, Chinese loans, home equity and a wide variety of other assets have entered the lists of CDO collateral.

That phenomenon, combined with excess savings from Asia -- again, with the same mission of finding yield -- spurred the insane creation of all these structured products.

This chart shows the inverse relationship between foreign purchases and spreads on agency debt. The greater the demand from Asia, the cheaper funding became, and the more mortgages they could write.

He has other charts showing a similer phenomenon. Cash coming in from overseas depressed rates on everything.

As he ominously concludes:

The financial crisis may have calmed down, but the sources of the crisis remain unchanged: the industrial world is unable to fund the greatest retirement wave in history at current returns. Everything that seems to offer yield turns almost instantly into a mini-bubble. This time, as I’ve argued, it’s the “troubled assets” that TARP was supposed to take off banks’ books. They have doubled in price during the past three to four months, just as losses are starting to creep up.

This is all see-able now. Demand for junk, as we've noted several times, is off the charts. And the toxic assets held by the banks, as he notes, have soared. It's hard to imagine a solid, compelling investment not immediately soaring to the moon (followed by a crash) in this environment.

This is also a reminder of how silly and counterproductive the Washington theatrics, and the outrage about bonuses and greed are. They're not the issue, and limiting them won't accomplish jack.

You blinked and you missed it! The best for distressed has apparently come and gone

For several years leading up to the big Credit Crunch of ’08, experts and pundits alike were pointing to hedge funds focused on the distressed market as the next group in line to clean up.

Yet time and again it never seemed to really happen; through the subprime crisis in the summer of ’07 and through the first round of the credit crunch, expectations were that buying up virtually every kind of distressed security would be an easy, no-brainer windfall.

Boy was that an understatement.

Of course, 2008 wasn’t great for distressed guys either, but as the rest of the world focused on trying to keep ahead of the game in ‘09, distressed-focused shops were out there grabbing loot.

Stuart Kovensky, co-COO of New Jersey-based Onex Credit Partners, a distressed debt shop, told attendees at an AIMA luncheon last Thursday that the opportunities this year have been “fantastic”.

“In 2009 we bought debt at fantastic prices – because people had to sell,” noted Kovensky, who along with financial newsletter notables Dennis Gartman and Scivest Capital’s John Schmitz participated in a panel discussion on what’s next for the economy, financial markets, and, of course, hedge funds.

In terms of the amount of distressed debt available at bargain-bin prices, “the sponge – the cash out there – wasn’t big enough to absorb it,” Kovensky said.

The reasons are fairly obvious: starting with the U.S. housing market collapse, which in of itself has generated distressed opportunities, and expanding into other areas as the U.S. and global economies recoiled.

Barclay - 524

In turn, the amount of defaults and accompanying opportunities to take on unwanted, undervalued, unloved debt have skyrocketed, said Kovensky, who with Gartman and Schmitz tackled everything from the end of the leverage-driven era to why the profit cycle and economic cycle have zero correlation.

Among Kovensky’s firm’s crowning achievements, he says, was buying Las Vegas Sands’ Tier 1 debt at 38 cents on the dollar, backed by the company’s real estate assets. Their year-to-date returns: up more than 48% — more than souble the 22.58% average through September, as measured by Barclay Group in the snapshot above.

But according to Kovensky, the party is already over. While deleveraging is still clearly underway, fire sales are less common as companies find different ways to restructure their debt.

While that still spells opportunity, “it won’t be anything like this year.”

Chapters 22 and 33

There may be opportunity in repeat offenders this year though. A new study by distressed debt guru, professor Ed Altman of NYU (see related posts) says that the number of companies that emerge from bankruptcy only to go back into it (via “Chapter 22″) is growing. According to data cited by Altman and colleagues Tushar Kant and Thongchai Rattanaruengyot even find some companies scoring the mythical hat-trick of bankruptcies (or so-called “Chapter 33″).


Altman concludes that his ubiquitous Z-Score can be used to predict the likelihood of a company slipping back into a coma.

This suggests that the party may not be quite over for distressed debt funds. In fact, Onex last week unveiled that it is planning an IPO of Kovensky’s fund, called the OCP Credit Strategy Fund, giving retail investors the chance to buy a piece of the longer-term payoffs it hopes to achieve.

You blinked – and you missed the distressed debt party. But the after-party is looking like it could be fairly sweet too.

Lunch is for wimps

Lunch is for wimps
It's not a question of enough, pal. It's a zero sum game, somebody wins, somebody loses. Money itself isn't lost or made, it's simply transferred from one perception to another.