Wednesday, February 09, 2005


Don't you hate it when black tar from a newly paved road gets all over your car? Today, oil inventories declined and you would believe the sticky black stuff spilled everywhere.

Airlines were hit hard. The mess didn't stop there. Most sectors went down. Little stocks in particular but almost all stock groups. Oil services were one of few exceptions. (RDC and PDE up about 13% in about one month were holding last I looked). The really big exception was bonds.

High oil prices are like a tax on the economy. The bond market has been predicting a slower economy and low inflation. High oil prices would slow the economy more.

The long end of the bond curve has gone down for months. A few days ago, the decline had worked its way down to the five year and indeed the five year note rate has dropped like a rock today.

Folks are mentioning the "R" word. Not frequently enough but it is at least being used (6,830 times in Google news articles today). You will hear folks say that the flat curve predicts a recession. I would argue that it is natural to go through a tightening phase after a strong recovery without going into recession. A flat curve normally occurs after a steep run up in long and short rates. Long rates typically drop during a recession, they pull short rates down with them and the low rates stimulate the economy-starting the next business cycle. Recessions are sneaky, you don't know for sure you are in one until it is almost over.

Guess who is making some serious money off the decline in long rates. Take a look at Lehman Brothers (LEH). Have you seen a nicer stock move lately? LEH had a great quarter ending November 30 and the market clearly anticipates LEH will report a huge quarter through February. LEH is one of the "big boys" (Papa John's term for the market makers).

In the old days, most banks and savings and loans made their money "borrowing short and lending long". This is risky business. In 1973-74 scores of banks and savings and loans went out of business after getting caught with long-term low rate loans funded by sky high short rate money. Since that time, laws and regulations have discouraged your average everyday bank from playing the game. Most banks practice a game of matching assets to liabilities while earning fees for anything they do.

Investment bankers are a different story and Lehman has been one of the best practitioners. Six months ago, Lehman and other dealers were able to borrow at 1 year treasury rates of 1% while buying 30 year bonds yielding 5.5%. Those bonds have appreciated better than 20% in value and the buyers earned an interest rate spread the whole way. Big profits for the "big boys"; those with the wisdom and heart to play this game.

There is no telling how many players have jumped on the trade recently (as happens near the end of every speculative move) but, it is clear that there has been piling-on. The longest bonds have dropped the most but the trade has been working its way down the curve. The ten year has dropped for a few weeks and the five year for a few days. Today, the 5 year is falling like a rock. With the trade moving toward the short end, the trade is about over.

The lower the yields go the greater the risk of borrowing short to lend long. The short rate that started out at 1% is now up to 2.5% and all but the "big boys" have to pay a spread above the actual rate. The long rate that was 5.5% is down to 4.3%. The original spread even for the "big boys" has been reduced from 4.5% to 1.8%. The really important thing to understand is that the value of the 1 year note changes very little but the value of the 30 year bond is very volatile. No one wants to borrow short and lend long if long rates have much probability of moving up.

In the face of rising short interest rates (the fed has been soaking up excess liquidity) and in the face of big profits being made in bonds and real estate, something had to give. Today the stock market dropped. The speculators that are jumping on the bond move are not the wise old Lehman traders. These guys are getting in on the tale end but they are never-the-less sucking money out of stocks to invest in bonds.

No one can know how long until the move is over. The move down the curve is a good sign but what would really bring this to a halt would be a strong employment report.

I came very close to borrowing a couple of million to buy bonds when rates were 5.5% but could not get comfortable enough to pull the trigger. As usual, the trade was not obvious at the time. Hind sight is 20/20. There was a strong possibility that one should wait until 6 or 7% was reached and 5.5% did not seem very high with the economy growing at about an 8% nominal rate.

Now I sit at the other end of the trade wondering how soon it will all be over. The bond traders at Pimco have put out some pretty scary thoughts. However there are just too many positives to cause me to run for cover. With real estate already super hot, low long-term rates will not cool it down. The average long-term mortgage rate quote is 5.48%. Not bad since the average house was up about 9% last year. Americans are buying second, third and fourth homes.

Another way to look at the current market is if the public is willing to keep piles of money in short-term accounts earning 1 or 2 percent, why shouldn't a Lehman Brothers take advantage. After Lehman cashes out the bonds, why should it not make its next move in stocks. After all, stocks are now very very cheap relative to bonds.

One interesting question is, Will a recession help Bush get Social Security reform passed? President Bush can make a name as one of the great presidents of all time if he gets SS reform done. Passing a bill through the Senate is going to be tough. Many Republicans will not openly support the plan unless they see it will pass.

If the most important pending legislation was making the Bush tax cuts permanent, then a weak economy would be helpful. SS reform would be easier to pass if young folks are hungering over the right to invest in the market. The investments will not occur until 2009 but a strong market would help Mr. Bush sell the deal.

Real estate and growth stocks have an r square of 63. Basically stocks and real estate move together only 63% of the time. The rub is ahead of us. The next time the market gets real strong, short and long rates will move up with the stock market and real estate lending will be crunched. In the mean time, lets hope that the drop in bond yields is about over. A further decline could drag the stocks down more and make a recession more likely. It is always ironic how so many things cut two ways. The decline in long rates make stocks more valuable relative to bonds but when players are piling their money into bonds stocks temporarily suffer.


Jack's Old Merrill Pal said...

My six year old daughter, Hannah, loves to play "Old Maid". She especially enjoys it when I let her see my cards, the cards are see-through when held up to the light. When I let her "see my cards", she wins every time.

Unfortunately, Lehman has many of the same advantages my daughter has. They have access to much more information and thus can see the market cards. Small spreads like today's bonds v borrowing make it a very risky game.

After all I would never bet against Hannah when she can see cards!