Market Anticipating Another Fed Rate Cut as Money Markets Tighten Again
From Deutsche Bank: “The overnight fed funds rate is starting to trade consistently below target, just as it did in August, with the effective fed funds rate at 4.28-4.29 in the last two days. Fed funds-LIBOR basis swaps have also risen by about 3 bp. This is a sign of a growing tightness in the money market. While not as extreme as in August, when liquidity completely dried up, ABCP and financial paper are again only rolling at very short terms. Inventory capacity is also likely to be light as November year end for some dealers approaches.”
From Merrill Lynch: “Fed funds futures pricing in more than 70%+ odds of a Fed rate cut…Did anyone see this coming after last week’s hawkish press statement? It’s not as
if the Fed wants to ease – it just may not have any choice.”
From Barclays: “Symbolizing the negative sentiment surrounding banks, after weeks of
resetting lower, 3 mth LIBOR nudged higher. 2 yr swap spreads have also widened more than 10 bp over the past week, and are now within 5 bp of the widening seen at the peak of the liquidity crunch in mid-August.”
From Goldman Sachs: “The outcome of the Dec 11 FOMC meeting is up in the air. The message from last week's statement was that the committee, taken as a whole, doesn't want to cut again unless forced to do so by much weaker data or another sharp rise in risk aversion…[But we] are sticking with our forecast of a cut on Dec 11 for now.”
Rating Agency Boosts Loss Estimate at Citi
From Bloomberg: “Citigroup Inc., the world's biggest bank, may have losses from asset-backed bonds of as much as $13.7 billion, roughly equal to the company's profit so far this year…The bank may have to write down an additional $2.7 billion of subprime mortgage-backed and related securities, CreditSights Inc. said today. Citigroup said on Nov. 4 that securities it holds may have lost $11 billion of value…Additional writedowns may balloon to $21.1 billion if off- balance-sheet units are included…That compares with potential losses of $5.4 billion for Bank of America Corp. in Charlotte, North Carolina, the third-biggest U.S. bank, and $4.1 billion for New York-based JPMorgan Chase & Co., the second-biggest, CreditSights said. ``Citigroup causes us the most concern of the big banks,'' the analysts said in a report today. ``Citi's risk is further amplified by its relatively weak capital position,'' reducing its flexibility in responding to crises…The shares have fallen 17 percent in a week, and reached a four-year low today. The analysts cited New York-based Citigroup's business structuring collateralized debt obligations and its leading position in setting up off-balance-sheet units that it now may have to take back on its books. With the exception of Merrill Lynch & Co., which last month reported $8.4 billion of writedowns in the third quarter and may be on the hook for another $9.4 billion, the potential losses related to CDOs at the three major banks in absolute terms dwarf those of the largest brokers. Lehman Brothers Holdings Inc., Bear Stearns Cos., Goldman Sachs Group Inc. and Morgan Stanley, all based in New York, stand to lose as much as a quarter of their equity, according to CreditSights.”
Downgrading Mortgage Insurers May Be Next Major Market Concern
From Market News International: “The latest news from the besieged financial sector this morning includes a statement by Fitch late last night saying that it was reviewing its capital adequacy analysis for the monoline insurers, expecting to reach a conclusion in the next 4-6 weeks. One possible conclusion could be that some of the companies would no longer meet the capital requirement for a triple A rating which would obviously have a knock-on effect on the debt that the companies guarantee compounding the weakness in the structured product markets.”
From Deutsche Bank: “Fitch yesterday announced that it would re-evaluate the ratings of the monocline insurance companies in light of the downgrades in highly-rated subprime securities and CDOs. The worst case scenario for the markets is if a downgrade of the monolines caused a widespread downgrade of much AAA paper. However, we think that it will take some time for the downgrades to occur, if they do, and that the monolines will likely be able to raise capital to keep their rating. But the crucial market events we are monitoring are any further substantial downgrades in AAA subprime paper, or a correlated credit/mortgage move, similar to what happened in July and August.”
From UBS: “The recent performance in monoline insurance stocks has finally woken up the rates markets. Credit deterioration in the subprime mortgage market and ratings downgrades in RMBS have forced the rating agencies to re-calibrate their risk models to reassess capital adequacy in the financial guarantee industry. The ramifications of ratings downgrades among the monoline insurers are significant if the AAA claims-paying ability of many of these insurers is gutted as home prices slide. Watch this space; this has the potential to be the next Big Thing.”
From Bank of America: “Credit spreads in banks, brokers and monoline insurers now substantially exceed the levels of the summer credit crisis, illustrating the fear in the market… Further illustrating the rating agency reaction to the spread of revaluation and downgrade issues in Super Senior CDO positions, Fitch warned of potential downgrades in monoline insurers below AAA, due to increasing pressure on their capital cushion from exposure to mezzanine CDO risk. FGIC, AMBAC, and MBIA were placed at high, medium, and low probability for downgrade, respectively.”
From Dow Jones: “If the company on review can’t raise capital or come up with a strategy to minimize its risk in a month, a ratings downgrade would follow. The AAA rating is the highest on the credit rating scale. A loss of this rating by one or more of the insurers would rattle the $2.5 trillion municipal bond market since insured bonds are based on the credit rating of the insurer, and because more than half of the annual volume
has been insured for the last several years. A downgrade then would cause the value of most affected bonds to fall, as well as cast doubt on the ability of the others to maintain their ratings… The derivatives market, however, has been betting the insurers’ ratings are in jeopardy. Based on the credit default swaps of the triple-A rated insurance units as of Friday, derivatives investors were trading Ambac, MBIA Inc., FGIC and Assured Guaranty as solidly speculative, or junk companies, according to Moody’s Implied Ratings Service.”
From UBS: “Ambac today issued a statement disputing Morgan Stanley's loss estimates for the monoline industry, and FGIC posted a press release vowing to work with Fitch to maintain their AAA credit rating.”
Bankers and Builders Warn That Housing Problems Far From Ending
From Merrill Lynch: “Homebuilders down 1.4% after Centex said the housing market is not recovering – not just that, but that it could take years to recover. Credit default swaps deteriorated a further 4.5 bps too, to their worst levels in three months. The VIX index jumped 1.3 points to 24.31.”
From Lehman: “Reuters reports central bankers past and present warned of more pain to come for the U.S. economy and that banks worldwide could take several months yet to
reveal their full losses from U.S. subprime mortgage lending. Bank of England Governor Mervyn King said banks would take some considerable time to flush out total losses related to mass defaults on U.S. mortgages leant to people ill-equipped to pay. "We have several more months to get through before the banks have revealed all the losses that have occurred, and have taken measures to finance their obligations that result from that, but we're going in the right direction," King told the BBC. Greenspan told a forum in Tokyo that high inventories of unsold homes presented a major risk to the U.S. economy and that he was not sanguine about how quickly the glut could be reduced. Soros said in a lecture at New York University that the U.S. economy was on the verge of a serious correction and that the Federal Reserve may be underestimating the potential slowdown.”
From MNI: “Soros sees very serious economic correction from sub-prime crisis, while PIMCO's Gross says crisis is far from over …”
From Merrill Lynch: “Tony Jackson in the FT estimates the total losses could top 1 trillion dollars globally from the implosion in subprime and related credit, including what is warehoused in leveraged loans and repacking assets sitting on bank balance sheets. So much for the $200 billion worst-case scenario months ago by pundits claiming that what we are seeing unfold is nothing compared to the S&L crisis in the early 1990s. Nice call. Keep in mind that rating agencies like S&P have downgraded just $47 billion of the $1 trillion of subprime CDOs it has rated since 2005. According to the NYT, Fitch is considering downgrading more than 25% of – get this – the AAA-Rated bonds issued by US CDO’s. This follows on the move to place 47% of AA-rated bonds on creditwatch for possible downgrade. Knock-on effects could lead to a downward spiral as AAA-bond holders have no option but to liquidate their CDO holdings, which would then further depress their prices and prompt more asset writedowns. Some insurance firms and pension funds may emerge as forced sellers depending on how severe the downgrades prove to be.”
Signs of a Slowing Economy and Possible Impacts
From Bank of America: “Year-over-year change in the 13-week average of income tax withholdings slowed to 5.5%, the second week below 6%, suggesting payroll growth may soon slow.”
From Merrill Lynch: “CEO confidence weakened for the third month in a row in October as per the Chief Executive Magazine survey …the level of confidence is down to its lowest since July/03 – right after the Fed cut the funds rate to 1.0%.”
From Goldman Sachs: “Beneath the headlines, several of the more forward-looking indicators do point to a meaningful slowdown. Consumer confidence has continued to edge down in recent months, and the Fed's latest loan officer survey shows weaker credit demand as well as reduced credit availability not just in the mortgage but also in consumer, industrial, and commercial real estate areas. Perhaps the most vulnerable area is private nonresidential structures investment (office, retail, industrial, etc.). The latest yoy growth rate in this part of the GDP accounts is +12% in real terms, but both the loan officer survey and the sharp rise in the price of default protection on commercial real estate point to a sharp slowdown going forward, with a risk of significant year-on-year declines. Although private nonresidential structures investment only accounts for 3.4% of GDP, a swing from the current rapid expansion to a contraction in this area could easily take ½ percentage point from GDP growth over the next year. Even the labor market data remain very much consistent with a slowdown if you look beyond the headline payroll number. The clearest piece of evidence is the sharp drop in the employment/population ratio by 0.6 percentage point over the last 12 months. This is the largest drop ever outside of recessions (there were two drops of similar magnitude in 1952 and 1963, but every one since then has been associated with recession). The employment/population data are based on the household survey, which unlike the payroll figures does not get substantially revised and has been a reliable indicator of underlying labor market weakness for many years, at least if you average out the massive month-to-month volatility by looking at 6-12 month changes. ”
From JP Morgan: “The September JOLTS continued to show gradual softening in the labor market. The hires rate edged down a tenth of a percent, while the separation rate and job openings rate did not change. The private sector quit rate also dipped to its lowest level since early 2005, indicating workers were having more trouble finding new jobs while they were still employed or were less confident they could find a new job if they quit their current one.”
From Morgan Stanley: “Following the housing slump, the liquidity crunch and surging energy prices, a credit downturn now threatens a real recession. In our view, it will feel like a recession in some respects. Although the risks of a downturn have risen to about 40%, we still think the economy can escape a real contraction. Housing demand, consumer and capital spending, and inventory liquidation likely will depress output. But strong global growth and government outlays will be offsetting. A weakening economy and decelerating rents likely will win the inflation tug-of-war over rising energy, food and import prices for now. We think the Fed has some more work to do. Although we continue to think that the yield curve will steepen over time, Treasuries are now rich, in our view. For now, the global/US growth and policy dichotomy will continue to drive performance in currencies and asset markets. The risks for growth are skewed to near-term weakness, and growth near zero over the next few months is possible. Moreover, the sources of that weakness imply that the economy is more vulnerable to shocks than at any time since 2001.”
From Handelsbanken: “The details of the latest Senior Loan Officer Survey should be seen as a warning to the equity bulls that banks are in the process of reducing the liquidity that they provide the economy. Banks are in a unique position in the economy in that they can either amplify or dampen monetary policy decisions. As such, the broad-based tightening in lending standards depicted in the November 5 report suggests that banks are likely to internalize the benefits of the rate cuts already executed and likely to be undertaken in the months ahead. Banks need to rebuild capital and add to reserves for non-performing loan balances, implying that the reduction in lending will weigh on the economy for an extended period. A reduction in bank willingness to lend also means that banks are more likely to add to their portfolio of highly liquid securities in the period ahead in order to exploit the positive slope of the yield curve. A shift in focus from lending to portfolio accumulation will probably keep the equity bulls long the broad market and playing the growth overvalue trade until it becomes clear that the holiday shopping season is going to be disappointing. A relatively high earnings yield has kept asset allocators long stocks through the early stages of the sub-prime meltdown, but this logic will wear thin as it becomes clear holiday spending will prove to be disappointing. Not only have banks reduced their willingness to lend in the residential mortgage market, but they have cut back significantly in every other loan category, especially those areas aimed at the consumer. Less availability to credit, when combined with $95 a barrel oil and layoffs in the auto industry, ensure consumers will feel the pinch this holiday season.”
Weaker Dollar Hasn’t Accelerated Gains in Core Consumer Inflation Yet
From Deutsche Bank: “While favorable for the trade deficit outlook, some economists are beginning to worry that a weaker dollar will lead to rising import prices and hence inflationary pressures at the consumer level. We do not view this as a major threat for a couple of reasons: First, the improving trade picture is not only due to a weaker dollar, it is also stemming from slowing US domestic demand, most of it in residential investment. We believe that we are unlikely to see significant consumer inflation if the pace of household spending is deteriorating-and there is some tentative evidence suggesting that this is occurring as of late. Anecdotes from retailers have not been very upbeat, and the latest retail sales figures showed weakness in several discretionary spending categories. Last week we learned that the core PCE deflator held steady at 1.8% y/y-a low last visited in February 2004. This brings us to the second reason why we do not believe an orderly decline in the dollar will be inflationary: core consumer goods prices, as measured by the CPI, are actually in a state of deflation. They are presently down about 0.9% y/y. Over the past five years, even though the rise in non-petroleum import prices averaged roughly 2% y/y, core CPI goods prices over that same period fell by an average of 0.6% y/y. Rising non-petroleum import prices have not led to core goods inflation to date, and we doubt this will occur in the coming quarters if consumer demand slackens.”
Dollar Breaking Important Technical Levels
From Merrill Lynch: “The dollar is weaker across the board…Euro breaking to a lifetime high of 1.45, the Canadian dollar through 1.08 on the upside, the Aussie has crossed above the 92.5 cent mark, and the Rand has moved to 6.5, which is a 27-year high. Gold is still surging – up $13 to $820/oz – within distance now of the Jan/80 peak of $850.”
From Barclays: “Dollar depreciation continues to threaten important long-term levels against a broad spectrum of currencies. EUR/USD, the biggest FX market of all, will rally off our charts when it breaks above 1.4535 (equivalent to the USD/DEM low in 1995). Clearly these are historic times for the dollar and there is little yet in price that suggests the move is over. Indeed, with USD/CHF [Swiss franc] breaking channel support this morning the greater risk is that the downtrend intensifies over the rest of the week.”
From Credit Suisse: “The G4’s "on-hold-with-moderate-risk-of-lower-rates" stance contrasts with policy in many emerging markets, which remains centred on the risk of further tightening and exacerbates the tension already seen in the currency markets.”
From Bear Stearns: “Gold has topped $820, reflecting a new run on the dollar. The dollar has also hit new lows relative to the euro and oil. The U.S. is in the odd position of asserting that a currency reflects a country's economic fundamentals even as the dollar continues its six-year plunge.”
From Dow Jones: “Not only is the Japanese currency likely to benefit from higher levels of global risk aversion that will prompt further unwinding of carry trades, it should also cash in on falling interest rate differentials.”
Gold’s Price Appreciation Accelerating
From Barclays: “Gold prices stormed passed the $800 barrier on Friday and are now trading less than $40 away from their all-time nominal high. For the first eight months of this year, prices failed to breach the $700 mark and instead traded between a range of $602-$694/oz. However, anticipation of Fed rate easing coupled with concerns of the impact of credit market problems on economic growth provided a new catalyst and enabled gold not only to overcome the $700 hurdle but to also take less than two months to conquer the next $100. This makes the year-to-date price appreciation 6% greater than this time last year. Prices have benefited from the safe-haven buying triggered by geopolitical and broader financial markets concerns as well as higher inflation expectations triggered by the record high oil prices.”
From Bloomberg: “Prices for commodities reached a record high as a slumping dollar boosted demand for raw materials including gold, oil and copper as a hedge against inflation. The UBS Bloomberg CMCI Index of 26 commodities rose as much as 1.6 percent to 1,81.644, the highest ever. Commodities have gained 5.8 percent in the last month, while the Standard & Poor's 500 Index fell 2.3 percent. Gold climbed to a 27-year high today and oil surged to a record. The index is up 23 percent this year, heading for a sixth straight annual gain, as the dollar's 9.4 percent decline against the euro increased the appeal of alternative investments and made raw materials cheaper for buyers holding other currencies. Higher prices have boosted profits for producers including BHP Billiton Ltd., the world's biggest miner, and Exxon Mobil Corp., the largest oil producer.”
More Signs of Peak Oil Problems in U.S. Reserve Growth
From Barclays: “In supply-related news, data released yesterday by the EIA shows that US oil reserves fell by 4% in 2006 to total 20.9bn barrels. The Gulf of Mexico Federal Offshore and Alaska – which account for 40% of total US crude oil production – recorded declines in proven reserves of 10% and 7% respectively due to downwards revisions and fewer new discoveries. Utah reported the largest increase followed by Colorado and New Mexico. The DOE also adds that total discoveries of crude oil were 577mn barrels in 2006 almost 50% below the prior 10 year average. Noticeably, reserves additions didn’t keep up pace with production despite a 5% fall in output. This in our view provides further evidence of the difficulty to maintain decent production and discovery rates in mature producing areas, where fields are ageing fast and big discoveries are far less common than they were in the past.”
MISC
From Deutsche Bank: “Fannie Mae announced it would announce its earnings on Friday, and expect to be fully current on its reporting by then. This would put pressure on OFHEO to relax its 30% capital surplus requirement, and would be a preview of the market's reaction to Freddie Mac's earnings announcement on November 20th.”
From Merrill Lynch: “30 pct of the growth in household credit this cycle, a credit cycle without precedent, was fuelled by off-balance-sheet asset-backed securities…”
From Lehman: “Many are saying [credit] cards are the next "shoe to drop" and COF [Capital One] outlook for 08 has worsened materially since 10/18…[“ New forecast captures: elevated card delinquencies to persist and not cure during the fourth quarter [and] "the effect if housing markets were to continue their substantial degradation."]”
From Bank of America: “Redbook reported that same-store sales were 1.9% above a year ago, the same pace as the prior weak but below the 2.1% average pace in October.”
From Merrill Lynch: “Banks reporting tightening standards on C&I Loans to small firms rose to 9.6% – the highest since 2003. The situation for large and medium sized firms looks just as bad, with 19.2% reporting tightening standards, up from 7.5% in 3Q and the highest level since 2003. Speaking of businesses, we’ve been told how commercial real estate would keep the broad real estate market from collapsing – and that this would keep employment losses in construction from rolling over. The Fed’s survey does not offer much support to that view and suggests that commercial construction will be the next shoe to drop. The percentage of respondents reporting tightening standards for commercial real estate loans rose to 50% – the highest since 4Q 1990 – and yes, that quarter witnessed an economy already in recession.”
From Dow Jones: “Hovnanian Enterprises Inc. maintains that buyers are sticking with their “Deal of the Century” contracts. The New Jersey-based home builder said the cancellation rate from the company’s September fire sale, which generated about 2,100 gross sales, remains below normal. “We absolutely moved a lot of homes,” said Chief Executive Ara Hovnanian…But the success of the fire sale was short lived. Early Tuesday, Hovnanian said the October sales pace in most of its markets “significantly deteriorated” compared to recent months and cancellations for the fiscal-2007 fourth quarter were 40% of gross contracts.”
From Dow Jones: “IndyMac Bancorp Inc. posted a bigger-than-expected third quarter
loss as surging bad loans forced the company to pump up credit reserves by 47%... IndyMac, the No. 2 home-mortgage lender by volume that is not owned by a commercial or investment bank, posted a net loss of $202.7 million, …The loss was more than five times wider than the …lender had projected two months ago, but paled in comparison to the $1.2 billion third-quarter loss posted by its bigger rival, Countrywide Financial Corp. IndyMac Chief Executive Mike Perry attributed the company’s deeper-than-expected loss to a sharp jump in past-due loans in September, including both home mortgages and loans it lent to home builders. As a result, it decided to set aside more money for future loan losses. “Clearly this quarter, we did a poor job managing credit risk,” Perry said during a conference call.”
From FTN: “Japan’s leading economic index fell to zero in September for the first time in a decade, signaling the economy may be in trouble again.”
From Goldman Sachs: “We have pushed back our forecast for the next interest rate hike [in Japan] to July-September 2008 from January-March. Downside risks are clearly increasing in the economy due to overseas economic factors and special factors dampening construction investment. We expect GDP growth to continue running at a pace below the economy’s potential growth rate through the end of the year. The expected pickup in CPI inflation beginning in January-March is largely attributable to price increases on petroleum-related products and food, not to a pickup in growth in unit labor costs, which is what is needed for sustained rate hike.”
From JP Morgan: “Today’s report on German industrial orders shows that the trend growth rate in orders turned negative over the course of 3Q07. These data are volatile but their sharp deceleration is seconded by the plunge in the German manufacturing PMI’s new orders index, which is down 10% points since June. Considering that Germany is an important supplier of capital goods, the orders data may be signaling a weaker trajectory for global capex.”
From Goldman Sachs: “Two potential tax changes could have implications for the municipal bond market, though they are likely to take months or years to play out. First, the Supreme Court heard arguments today in Kentucky v. Davis, which could end the in-state tax exemption of municipal bond interest. Second, recently proposed federal tax legislation would reform individual taxes and could impact demand for municipal securities. We expect the Supreme Court to leave state taxation of municipal bonds unchanged, based on the tone of today’s arguments, but any ruling changing state tax treatment would be a negative for the municipal market. However, longer term tax changes on the federal level would have a more positive impact on municipal bonds relative to other securities, and we expect some of these changes to become law after the 2008 election.”
From Bloomberg: “When Goldman Sachs Group Inc. employees cash their year-end checks, they'll have enough money to buy Bear Stearns Cos. Goldman, the biggest and most profitable U.S. securities firm, has set aside $16.9 billion to pay salaries, benefits and bonuses in the first nine months of 2007, according to the company's third-quarter earnings report. The stock market values Bear Stearns Cos., the fifth-biggest firm, at $14.7 billion.”
End-of-Day Market Update
From Deutsche Bank: “The absence of verifiable bad news (there has been continued screen chatter about further write-downs amongst Wall St's banks) has seen equity markets stabilize over the past 24 hours. As I write, the S&P500 is up modestly and even the financial sector is in the black. That has done little to help the Dollar, however, which has made a new low overnight. Again the strongest gains have been `enjoyed' by the commodity currencies, especially the CAD, with gold and oil rising to new highs - gains that can not be simply put down to US weakness alone. The stability in equity markets has carried through to credit markets where spreads have narrowed a little.”
From UBS: “Treasuries staged a rally in the early going (more rumors of bank write-downs), but retreated again in the afternoon to finish lower on the day… TIPS saw better buying across the board …and breakevens widened 4-5 bps across most maturities… Spreads widened out earlier in the day, but closed only modestly wider. Agencies saw better selling in 5- and 10-year paper, and Freddie Mac announced $3B of a new 2-year issue. Agencies cheapened 1bp to Libor through most of the curve, and 2bp in the front end. Mortgages had a wild day, opening up 2 ticks tighter. After $3B of selling, they went 10 ticks wider before narrowing to 4 ticks wider after some late day bargain-hunting.”
From Bloomberg: “U.S. stocks rose the most in four days, led by energy and metals producers… Today's gains were led by this year's best performing industries. Energy companies in the S&P 500 have rallied 29 percent since December, the top advance among 10 groups, as oil prices climb toward $100 a barrel. Producers of raw materials have added 23 percent as an expanding global economy boosts demand… Financial shares have dropped 12 percent as a group in the past month as firms announced writedowns on their holdings of mortgage securities and corporate loans, and investors speculated more losses lie ahead.”
From RBSGC: “The market continued to edge lower -- trading primarily off of the grind higher in equities -- a painful dynamic to be sure. Stocks dipped mid-morning, supporting Treasuries, in fact marking the highs of the day, before reversing, with the major indices gaining 0.6-0.9% on the day… The market's apprehension about the potential for further credit-related announcements seemed to be a consistent theme -- with several bounces throughout the day as rumors circulated about additional write-downs and losses yet to be realized. Regardless of the validity of this speculation, the market remains primed to trade off the rumors.”
From Barclays: “The flight to quality stalled on Tuesday, and the yield curve bear steepened.”
Three month T-Bill yield fell 2bp to 3.74%.
Two year T-Note yield rose 3bp to 3.99%
Ten year T-Note yield rose3.5bp to 4.37%
Dow rose 118 to 13,661
S&P 500 rose 18 to 1520
Dollar index fell .38 to 76.04 to new record closing low
Yen weakened by .16 yen to 114.71 per dollar
Euro rose .009 to 1.456, a new record high close
Gold rallied $18 to $825 [All time futures high $873 in January, 1980]
Oil rose $2.79 to $96.77, another new all-time closing high
*All prices as of 4:30pm
