The Ex Ante: Liquidity Trap Revisited - Will They Take the Bait?
March 29, 2008
The 10YR yield closed at 3.44% on Friday only 15bps off the lows of the year and 30bps off the lows set in 2002 when the market was facing deflation fears. When the Fed eased 75bps on 3/18 they faded market expectations for 100bps and coupled with their easing of restrictions at the discount window (allowing broker dealers to access with non-treasury collateral), regained some control over the credit markets. Since then the dollar stopped making daily new lows, bids began emerging for mortgage debt and spreads have stopped widening. The yield curve as measured by the 2s/10s spread has flattened slightly by ~15bps with the 2YR yield lifting suggesting there is some risk aversion coming unwound. Markets are still shaky but for now it appears most of the puking has subsided and we are riding out the storm.
Prior to the 3/18 meeting, we had suggested the Fed would not take the funds rate below the core PCE deflator which on Friday came in at 2.1% (YOY). By lowing rates below their preferred measurement of inflation they would be giving the green light to sell the dollar forcing food and energy costs even higher. Recall our memo.
Memo to Ben Bernanke: Stop Easing - We don't have an interest rate problem - We have a credit, collateral and confidence problem - The more you ease the more credit spreads widen and the lower the present value of the assets fall - A stabilizing currency will stabilize the spreads and put a floor under the value of these assets.
Hopefully he heeded this advice and has stopped the bleeding in the dollar and for now put a cap on commodity prices and risk premiums. We think the Fed is either done or one and done at the April meeting taking the funds to 2.00%. Bernanke does not want to be seen as repeating the failures of Greenspan by leaving interest rates below the inflation rate which is what got us in trouble in the first place: Free money and a subsequent credit bubble.
Will they take the bait?
If we assume the Fed is basically done with this easing cycle we need to consider the effects in the banking system and bond market. We think there is an inflection point coming in the next 6 months and the bond market will be our crystal ball.
The banking system is facing a big decision as they consider the implication of a bottom in the funds rate. CFOs are staring at potentially the cheapest borrowing costs they will be seeing for some time and not wanting to miss the boat will be looking to lock in as much cheap long term funds as possible to meet future loan demand at potentially widening net interest margins (the difference between their cost of funds and their interest earned on assets). There is not much debate as to whether the banks will be looking to lock in long term cheap funding once they perceive the Fed is done, but there is debate as to whether there is any real economic demand for this money. In other words, will the economy take the bait? We think the answer will be the first signal of whether we will experience a liquidity trap and will look to the bond market to provide the clues.
We can see a scenario where the Fed is done, banks are lending, bond yields lift and risk premiums on mortgages narrow. The 10YR yield could presumably back up to the 4.25% area which is essentially 50% retracement from last years peak in yields around 5.25% (ironically as a result of BSC hedge funds puking their positions). This is what we want. We want to see treasury yields rise because it is indicative of the demand for money and risk coming back. Unfortunately we think if we get this back up in yields it will be a big head fake. We hope we're wrong.
How will this play out? We think the CFOs of banks who loaded up on cheap borrowing at the discount window and via FHLB advances will be sitting on a glut of cash that they will not be able to lend. Ultimately there will be no demand for money because consumers and investors will not have the capacity or the willingness to take on more debt to finance declining collateral values and decelerating cash flows. In See: Liquidity Trap we pointed to both the 10YR and 30YR contracts as making a push for the previous 2002 highs and that: This has important implications for the economy and corporate profits because it puts the old 2003 highs in play which corresponded with a 3% 10YR note yield. Under that rate environment expect credit contraction, little to no growth or demand for money spawning deflationary conditions a la Japan. This is clearly the biggest risk.
Therefore we are on the lookout for a back up in treasury yields as investors rotate out of the flight to quality trade and into some attractive risk premiums. We also see banks loading the boat at these seemingly cheap funding costs and that the action in the bond market will give us the heads up as to whether they are successful in deploying that capital. If we see the 10YR yield stop lifting and (god forbid) heading back lower, flattening the curve and taking out the 2002 lows the market is telling us there is no demand for credit and these CFOs will be forced into the pain trade of placing those borrowings in low coupon treasuries at potentially flat net interest margins. If this scenario unfolds the Fed funds rate will be headed much lower potentially below the 2003 lows of 1.00%. Bank CFOs will have wished they hadn't loaded the boat at 2.25% as that's what their coupons will be paying.
What's the Trade?
If the market is bottoming it's no doubt financials look cheap. Many are trading at discounts to book value and have been slashing overhead. That said, these institutions are about to get the regulatory hammer dropped on their practices. Capital ratios will rise and leverage ratios will decline producing much lower return on equity. What will GS earnings be at half of the leverage? This sector represents a classic value trap as their multiples will explode as net income collapses. We are avoiding the sector.
We still like technology despite their exposure to the weakening economy and subsequent decelerating revenue growth. We love their cash rich and debt free balance sheets and with tech down 15% on the year trading at historically low multiples, we think they offer a compelling risk/reward in this de-leveraging environment. If we are bottoming and they receive a flight to their quality balance sheets the gains could easily return double digits on the year (+25% from here?) if they can trade back to last year's highs. Additionally we see the tech sector as a big beneficiary of the rebate checks to be sent out in the next few months. (We imagine a lot of iphones and macbooks will be on the shopping list of consumers. At least they are on ours.)
On the flip side, despite our earlier enthusiasm for the group, we are fading the material sector as they arguably are one of the most exposed to a deflationary environment from a strengthening dollar to lower commodity prices to declining capital investment. We often monitor letter X (US Steel) as a proxy for this sector and for the larger industrial economy. Dom pointed out this potential ending diagonal in X which if broken to the downside could drive some heavy selling. Taking that interpretation with a potential bottoming in the dollar and a deflationary economic environment and we are cautious on the group as their upside appears limited.
TTC will close soon to new membership.
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