All Things in Moderation

Vital Statistics:

Markets are higher this morning after China cut interest rates to boost their economy. The benchmark lending rate will drop from 6.56% to 6.31%, effective tomorrow (such precision!). The allowed discount from the benchmark was widened from 10% to 20%.  Initial Jobless Claims in the US came in at 377k, more or less in line with expectations. Bonds and MBS are flat.

Given last Friday’s dismal jobs report, the market was definitely concerned about the Fed’s Beige Book survey which was released yesterday afternoon. Overall, the tone of the report did not confirm fears of an imminent slowdown. The Fed reported that “overall economic activity expanded at a moderate pace” and that “Economic outlooks remain positive, but contacts were slightly more guarded in their optimism.”

In another positive datapoint for the real estate industry, homebuilder Hovnanian reported better than expected earnings yesterday, with a 50% increase in backlog and a 52% increase in contracts. Perhaps this portends the rise in housing starts and construction we have been waiting for since 2008.

To get an idea how cheap stocks are compared to bonds right now, consider the fact that the 10 year yields about 1.65%, while the dividend yield on the S&P 500 is 2.2%. A dividend yield (let alone earnings yield) higher than the 10-year is a rare event. If you look at the ratio of the 10 year to the dividend yield, it reached  just over 60% last week, and the last couple times it reached that level (2008 and fall of 2011), it portended a huge stock market rally. At any rate, it seems to trigger asset allocation decisions and may account for some of the velocity of the moves in the S&P futures and the bond futures. It also means buy stocks and sell bonds.  Or borrow money long term.

Chart:  Ratio of the 10-year bond yield to the S&P 500 dividend yield:

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S&P futures are higher this morning on hopes of further stimulus in Europe.  The ECB left interest rates unchanged. The world seems to be backing away from the ledge a little, selling government bonds and taking more risk. Mortgage rates moved lower only grudgingly last week, so we should expect them to stay more or less stable as the 10-year yield backs up. Nonfarm productivity came in lower than expected, as did unit labor costs. The Fed’s Beige Book will be released mid-afternoon.

CoreLogic’s April Home Price Index showed a year-over-year gain of about 1%.  Excluding distressed sales, they rose almost 2%. They also introduced a new metric – the Pending Home Price Index – which indicates the trend in prices. This month, the Pending HPI predicts another 2% from April to May. Month-on-month increases are normal seasonal behavior, but year on year increases are more a sign that prices are bottoming.

Clear Capital is reporting more or less the same thing in its June Home Data Index Market Report. It notes that national home prices grew on both a quarterly and yearly basis for the first time since August 2010. Dr Alex Villacorta, Director of Research said:  “While gains in national home prices over the quarter and year were minimal in May, there are encouraging trends continuing to play out and gaining momentum beneath the surface.  Strength in REO-only price trends as well as some early indications of price gains spreading from low tier sections to the mid, and higher priced homes is helping confirm that the country continues to make progress on its recovery, and we are expecting to see improvements extend of the next several months.” RTWT.

Given that the mortgage market more or less IS Fannie, Fred, and Ginnie the question now is what to do with them. The Community Mortgage Lenders Association has sent a white paper to the government recommending that we reduce the GSE’s involvement in the secondary market to around 33% and that there be an explicit backstop fee paid to the government. 

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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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