All Things in Moderation

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S&P futures are up 3 points after having been down 12 points in the overnight session. A drop in Euro sovereign yields seems to account for the better tone. China’s non-manufacturing PMI dropped to 55.2 in May from 56.1 in April, indicating that their economy is decelerating. The 10-year yield has increased to 1.5% and mortgage backed securities are down a tick.

This week will be a relatively data-light week, in contrast to last week (especially Friday). However, there will be lots of Fed-speak all week and investors will be parsing each statement for further clues regarding QE.  It may turn out that the Fed conducts Operation Twist by purchasing MBS instead of Treasuries.

One of the reasons why this recovery has proven to be so unsatisfying has been the lack of construction activity, which usually leads the economy out of a recession. The Atlantic has a chart that shows construction jobs as a percent of total jobs is at levels not seen since 1946.

Laurie Goodman of Amherst Securities weighs in on how regulators are creating a credit crunch.

Chart:  Construction jobs as a percent of total jobs:

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Ugly.  That is all you can say this morning.  Equity markets are reeling after a slew of disappointing economic reports this morning.  The 10-year is trading at 1.46%. MBS are trading higher as well. The German 2-year bund actually has a negative yield. 

The unemployment rate ticked up to 8.2% and the economy added just 69,000 jobs last month. The labor force participation rate rose to 63.8%, reversing April’s decline. The average workweek declined, which bodes ill for future hiring. 

With the massive rally in the 10-year, you would think Operation Twist would be put on the back burner. You would be wrong. Federal Reserve Bank of Boston head Eric Rosengren is advocating continuing Operation Twist (where the Fed buys long-dated bonds and sells short-dated paper in an attempt to lower long-term rates). Given the massive rally we have experienced in the 10 year, May’s jobs report should have been great. Anyone think June’s report is going to be great?

Facebook’s IPO is instructive in that it shows how the relationship between issuer and bank has become more important than the relationship between investor and investment bank. Many moons ago, when I was in business school, we used to ask why IPOs popped so much on day 1. A pop in the stock meant that issuers were leaving money on the table. One explanation was that while an investment bank would get a deal from an issuer maybe once every few years, they had to deal with their buy-side clients every day. So they were more interested in keeping Fidelity happy than they were in keeping XYZ.com happy. Which meant IPOs were usually under-priced. 

Fast forward to today:  Facebook was a disaster if you were an investor. But the investor’s loss was Facebook’s gain. The banks managed to sell as many shares as possible at as high a price as possible. What has changed?  IMO commissions and spreads. When I started in the business, institutions paid a nickle a share to trade a stock. Bid/Ask spreads were 1/8. Sales and trading was a lucrative business that was conducted over the phone.  Nowadays, you can trade inside the penny spread, and commissions are 1/4 of a cent a share. Everything is automated. Sales and trading is a loss-leader business, which means banks are more interested in keeping issuers happy than they are keeping investors happy. If Fidelity is mad, who cares?  Morgan Stanley isn’t making anything from them anyway…

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Equity markets are flat after yesterday’s bloodbath, while bonds continue to rally.  The 10 year is trading at 1.59%. MBS are up as well. Lest anyone think this is strictly a US phenomenon, yields in the “safe” European countries like Switzerland, Denmark, Germany are even lower. On the other hand, Greek debt now yields 30.6%, which is pretty much the same level it was before default. 

Today is Jobs Day with a slew of labor-related economic releases at 8:30. Challenger has already said that announced job cuts were up 67% YOY in May.  This is a notoriously volatile index because one large employer (in this case HP) can dominate the month, so you have to focus on the trends and here 10 out of the last months showed increases. On the other hand, announced job cuts don’t always happen so take it with a grain of salt.  That said, there aren’t a lot of forward-looking labor measures out there.

Initial Jobless Claims came in at 383k, higher than the 370k estimate. The ADP Employment change report predicts 133k jobs were added in May.  1Q GDP was revised downward to 1.9%, in line with expectations. Consumption, exports, and residential fixed investment (finally!) drove Q1 GDP growth.

Delays in foreclosures and recent incentives by the Obama administration are making short sales more attractive to lenders than foreclosures.  Short sales were up 25% from a year ago as opposed to bank-owned sales which dropped 15%.  More aggressive pricing on the part of lenders is driving the increase.

Given the outsized rally in Treasuries yesterday, you would have expected a commensurate drop in mortgage rates.  But that didn’t happen. Mortgage rates are moving lower only grudgingly as rates fall, indicating that we may be reaching a floor, or at least further drops will be very hard to come by.

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A sloppy tape to start the day as Euro fears take center stage. Spanish credit default swaps are at 522 basis points, an all-time high. Troubled Spanish lender Bankia continues to fall. Greek sovereign debt is over 30%. The beneficiary of the risk-off trade is the US 10-year, where yields are down 6 basis points. Meanwhile, oil cannot get out of its own way, with WTI down 15% this month.

The 10-year yield is flirting with the Sep low of 1.673%.  MBS are unchd, and we are witnessing a similar phenomenon as last fall, where the 10 year rallied and MBS underperformed. The spread between the Freddie Mac generic 30 year fixed mortgage and the 10-year bond yield is 2.04%.  Here is a chart of the generic 30 year fixed rate mortgage, the 10-year bond, and the spread between the two. 

While mortgage rates are falling as the yield on the 10 year falls, they are falling much more slowly. So, if you are facing a lock decision, you have are faced with a bit of a conundrum:  If the 10 year yield continues to fall, mortgage rates might not participate. In other words, we may be reaching a floor in mortgage rates.  Which means you might as well lock.  On the other hand, if the 10 year yield starts backing up, mortgage rates should rise much slower since they really didn’t fall that much to begin with.  Which means you have some room to wait and see what happens, and you might want to float. So, lock or float?  IMO, when markets crack, they crack quickly. And the 10 year is at very lofty levels. It could go from 1.7% to 2.4% in a hurry. The risk is more skewed towards mortgage rates increasing quickly than falling quickly. I would lean short in mortgage rates, or in other words, lock.

Part of the reason why the recovery has been so halting has been that the job market for those in their prime earnings years has been horrendous. Instead of making the top salaries of their lives (which they need to pay for college for their kids and also retirement savings), many people in their prime earnings years are either unemployed or underemployed.  This is a huge drag on the economy. 

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Markets are higher this morning on hopes of stimulus in China. Spain is working on a rescue plan for Bankia, its 3rd largest lender. Spanish banking woes have pushed their sovereign debt to around 6.5%, close to the highs of last November. While Greek and Spanish fears are pushing sovereign yields higher, we have not seen a corresponding rise in EURIBOR / OIS, which is a signal that the banking system in Europe is taking a sanguine view, at least for now.  Meanwhile, Treasuries and bonds are higher, with the 10 year bond now at 1.73%

The S&P Case-Schiller index posted a slight sequential gain in March, but was still down 3% YOY, and made a new post-crisis low. Nationwide, house prices on average are back at their mid-2002 levels. That said, the pace of the decline has definitely slowed.

Chart:  Case-Schiller

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Markets are flat overall this morning, which makes sense.  Given the fact we have a 3 day weekend and we may have a resolution on the Greek situation, you would have to be certifiably insane to carry positions over the weekend.  Bonds close early today, and I suspect most of the Street will be on the L.I.E. by noon. 

No economic data with the exception of University of Michigan confidence at 9:55 this morning. University of Michigan consumer confidence really just tells you where gas prices were last month (h/t Ron at MCM). Consumer sentiment and the Triple A Gas Price index have a -.52 correlation with a 1 month lag.  

Are people who bought Facebook stock in the initial frenzy getting a do-over?  Sounds like it. The underwriters are claiming they made $100 million supporting the stock. I can see how they made money supporting the stock on the open.  I can’t see how they made money supporting it at the close since it opened down a couple of bucks the next day. Unless they were shorting it in the 40s.

I came across this testimony from a community banker regarding the unintended consequences of Dodd-Frank and the Volcker rule. The biggest one is that the regulators swung at Goldman and Morgan, they ducked, and the regulator ended up slugging all the small fry right in the jaw. When you have 15% of your staff handling regulatory matters and 12% of your operating budget is compliance there is a problem. He notes that regulatory costs as a percent of operating costs is 2.5x the costs for big banks. The Volcker rule alone will require the drafting of policies and procedures to ensure the East Podunk Savings and Loan doesn’t inadvertently set up a trading desk and start slinging around credit default swaps 

He also notes some major problems with the “ability to repay” test on mortgage origination and on the CFPB’s characterization of pricing risk as “predatory lending.”  The net result may be to drive community banks out of entire lines of business because of regulatory risk.  Will the powers that be listen?  I doubt they will do anything more than make perfunctory statements that these regulations were not meant to impact small banks. They will listen to this guy instead. 

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Markets are giving up earlier gains on the back of some disappointing economic reports. Euro sovereigns are higher with the exception of Greece which now yields 30% and Portugal. Bonds are down a point and MBS are down a few ticks as well.

The Durable Goods headline number came in at +.2%, more or less in line with expectations, but DG ex transportation fell .6%. Cap Goods orders and shipments both fell. This metric tracks business investment and is an ominous sign for the economy.  This might explain why HP is laying off 27,000 workers.  

Initial Jobless claims came in at 370k, in line with expectations.

Freddie Mac released their Economic and Housing Outlook yesterday. It mainly re-hashes data we have already seen. They are of the view that housing is at or near bottom and that rental vacancies are at 9-year lows.

The housing market had another positive data point with the Toll Brother’s earnings announcement. Toll is in the McMansion business, so this report focuses more on the high end. Q2 revenues rose 14% YOY, but signed contracts increased 51%.  Backlog was up 49%. Granted, we are coming off of a low base, but you are starting to see some life in homebuilding. Doug Yearley, CEO said “It appears that the housing market has moved into a new and stronger phase of recovery as we have experienced broad-based improvement across most of our regions over the past six months. The spring selling season has been the most robust and sustained since the downturn began.”  Granted, he is talking his book, but still…

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Markets are lower this morning on GREXIT (Greek exit) fears and a lousy earnings report from Dell. Euro sovereign yields are generally lower, with the exception of Greece which is 22 basis points higher and approaching 30%. Remember, this is the post-reorg debt that is trading here. Their debt was trading around 35% before Greece did their restructuring about 10 weeks ago. The stress in Europe is pushing down bond yields here and MBS are up as well.

While the migration to tablets is hurting Dell, they also noted corporations are delaying spending.  Is it because IT spending is slowing in general, or is it that corporations have learned not to beta-test Microsoft operating systems (in this case Windows 8)? 

The Congressional Budget Office weighs in on Taxmageddon. Punch line: The budget deficit will drop by $560 billion, and real GDP growth will be .5%, with a contraction of 1.3% in 1H and an expansion of 2.3% in 2H. Remember the government operates on a Sep fiscal, so they are predicting recession in the Sep 12 – Mar 13 time period. If we cancel the tax increases and spending cuts, CBO estimates that real GDP growth would be about 4.4% in real (not nominal) terms in CY13. That is an aggressive (with a capital “A”) forecast. 

DealBook has an interesting article on the possible unintended consequences of breaking up the big banks.

In other news, the NAR has declared the housing recovery to be underway. The MBA reported that mortgage applications increased 3.8% last week. New home sales in April were 343k, an increase of 3.3% MOM. The FHFA House Price index showed an increase of .55% QOQ and .5% YOY.  This is the first increase since early 2007.  Remember the FHFA index only looks at conforming loans, which is more of the “core” housing market.  It has proven to be a much less volatile index than Case-Schiller or RPX. 

Chart:  FHFA House Price Index:

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Markets are generally firmer this morning on hopes of further stimulus out of China and Europe. Euro sovereign yields are lower. US bond futures are down a point and MBS are down slightly.  MBS underperformed bonds in the rally, so they should outperform as bonds retrace.

Richmond Fed came in below expectations. This survey looks at the service sector for Richmond, Baltimore and Charlotte. Revenues actually contracted in May. They note that service providers expect stronger customer demand over the next six months, while retailers do not. 

Existing Home Sales came in at 4.62MM annualized.  5.5 million is about “average.”  The number is up 10% YOY. The lack of distressed sales and the seasonal move towards bigger houses increased the median price 10% from 161,100 to 177,400. Overall, it notes that the headwinds in the real estate sector are abating.

Yesterday we had a number of sizeable mergers, with Eaton buying Cooper Industries for 12.8 billion, DaVita buying Healthcare Partners for 4.5B and Wanda Group buying AMC. Generally speaking, mergers are a good sign for the markets and the economy in general.

Andrew Ross Sorkin has a good column on why Glass Steagall wouldn’t have prevented the crisis. The Glass-Steagall issue has become a facile explanation of what went wrong. Elizabeth Warren even acknowledges this – one of the reasons she has been pushing reinstating GS – even if it wouldn’t have prevented the financial crisis – is that it is an easy issue for the public to understand and “you can build public attention behind.”  And there you have it. Never mind that nobody else in the world (the UK, Europe, Japan, Canada) separates commercial and investment banking, or even draws a distinction between the two. 

What was the rationale behind Glass-Steagall in the first place?  Poorly underwritten deals (for example, Facebook).  Facebook was the quintessential poorly underwritten deal.  An underwritten deal means that the investment banks (primarily Morgan Stanley) actually write a check to the company and buy 421MM shares at 38. It then places those shares with institutional investors.  If the deal is handled well, Morgan Stanley sells all the stock, collects its fee and moves on. This deal did not go well, obviously. Institutional investors sold into the market and FB was in danger of breaking price. Morgan Stanley stood in the market and bought everything that the market was willing to sell at the offer price. (If an IPO breaks price on the first day, that is a MAJOR embarrassment to the investment bank). So Morgan Stanley is now lugging millions of Facebook shares that it bought in the market at 38. The stock is trading at 32.65. Huge loss. Pre-Glass Steagall, what would they do?  Sell the stock to their captive commercial bank at 38. (Hey, we bumped up your allocation to 5 million shares)  Institutional investors will pull their money out quickly if they sense an investment bank is in trouble.  Depositors at a sleepy commercial bank?  Not so much.  Note:  This was done more with bond issues than stock issues, but the rationale remains the same. In the Great Depression, commercial banks were failing and it turned out their assets were not home mortgages or commercial loans – they were all the lousy deals their sister investment bank couldn’t unload. That is why we had Glass-Steagall – to prevent commercial banks from being repositories for losing positions. 

Fast forward to the financial crisis – commercial banks weren’t failing because they bought CDO-squared issues from their investment banking divisions. Or because Citi was stuffing its retail bank with LBO paper it couldn’t unload. The reason we had a financial crisis is because we had a residential real estate bubble.  Every bank in the US is exposed to residential real estate in some way, shape, or form. And it didn’t matter whether you were exposed to residential real estate through a mortgage backed security or through holding whole loans on your balance sheet.  The small community banks who wouldn’t know a CDO from a codfish blew up just the same as the big integrated banks 

Probably the single best thing regulators could do to prevent a re-occurrence would be to deal with the cascading counterparty risk from OTC derivatives. They should demand that OTC derivatives become standardized and exchange-traded with a central clearing party, position limits, and open interest disclosure. That would have prevented AIG from taking the positions it did and exposing all of its counterparties when it failed.

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Markets are generally firmer this morning on comments from Chinese Premier Wen Jiabao supporting further measures to boost the economy. Euro sovereign sovereign spreads are a touch wider. Bonds and MBS are down.

The Chicago Fed National Activity Index rose .11 in April after falling .44 in March. This basically means that the economy is growing at its historical trend. Anything between -.7 and +.7 is considered on trend. Production was a positive factor, while consumption was negative. Employment was neutral.

Is the Fed more optimistic about future growth than Wall Street?  It appears to be the case. The average Wall Street growth forecast for 2012 is 2.3%, while the Fed is forecasting 2.4% – 2.9% growth. One explanation is that the Fed underestimates how much the credit-multiplier breaks down in the aftermath of asset bubbles. Meanwhile, the TIPS market is trimming its inflation forecast and giving Ben Bernake the room to maneuver.

Facebook has broken the IPO price in the pre-open and is trading at 36.51.  5.6 million shares have traded. Bob Griefeld, CEO of NASDAQ, blamed software glitches for the problems with trading FB on Friday where customer sell orders were delayed on the open.

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