How The Fed Is Creating An ‘Incredible Mispricing Of Risk’ Reply

How The Fed Is Creating An ‘Incredible Mispricing Of Risk’

Earlier this week I published a piece on the CFA Institute’s Inside Investing section titled: Mortgage REITs: Does Doubling the Leverage Make Them a Good Investment?  The post was my response to UBS launching an ETN that provides 2x leverage on a basket of already heavily levered mortgage REITs “mREITs”.

In short, I believe it’s a dangerous product as many investors in the underlying REITs have little idea how 10%+ yields are being generated.  Moreover, they don’t understand the scenarios that could lead to a significant decline in share prices.  To paraphrase the great Howard Marks, “…do not confuse adding leverage to an existing investment with increasing return…if you take a 10% return in a security and lever it up 4x and after financing costs generate 15-20% returns, you haven’t increased your returns, you’ve just increased your leverage and significantly increased your risk, but you’ve also got a 20-25% downside threat”.  I think this thinking certainly applies to mortgage REITs today.

A bigger threat is upon us

Last week Annaly Capital’s CEO Wellington Denahan-Norris (who this week replaced the late Michael Farrell who tragically passed away), said some very interesting comments to Bloomberg on the state of the risk markets.  After discussing the impact of the Fed buying Agency MBS she said:

“It’s not just at the mortgage REITs where the returns in this market are being put under assault, It’s the general global landscape where you have an incredible mispricing of risk that’s being delivered at the hands of academics at the central banks of the world.

I could not have said it better myself.  I am firmly in the camp that both credit and duration is being dramatically mispriced due to the actions of the Fed.  They’ve created a reckless chase for yield that is being driven not so much by greed, but rather by needs based investing.  The yield piñata has burst and participants far and wide are scurrying to accumulate what they can across all sectors of the fixed income markets: IG corporates, CMBS, Non-Agency MBS, High Yield, Levered Loans, Munis, and others.

While equity focused investors don’t see the direct impacts of the Fed’s purchases, the spillover is pronounced in fixed income and is causing imbalances far and wide.  When I read the article about UBS’ new 2x leverage mREIT product, I couldn’t help but think that we are starting to see signs of these policies backfiring as the chase for yield has reached a more than unhealthy level.

By: David SchawelEconomic Musings source: BusinessInsider.com

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Why I am leaving the Empire, by Darth Vader Reply

TODAY is my last day at the Empire.

 

‘I no longer have the pride, or the belief’

After almost 12 years, first as a summer intern, then in the Death Star and now in London, I believe I have worked here long enough to understand the trajectory of its culture, its people and its massive, genocidal space machines. And I can honestly say that the environment now is as toxic and destructive as I have ever seen it.

To put the problem in the simplest terms, throttling people with your mind continues to be sidelined in the way the firm operates and thinks about making people dead.

The Empire is one of the galaxy’s largest and most important oppressive regimes and it is too integral to galactic murder to continue to act this way. The firm has veered so far from the place I joined right out of Yoda College that I can no longer in good conscience point menacingly and say that I identify with what it stands for.

For more than a decade I recruited and mentored candidates, some of whom were my secret children, through our gruelling interview process. In 2006 I managed the summer intern program in detecting strange disturbances in the Force for the 80 younglings who made the cut.

I knew it was time to leave when I realised I could no longer speak to these students inside their heads and tell them what a great place this was to work.

How did we get here? The Empire changed the way it thought about leadership. Leadership used to be about ideas, setting an example and killing your former mentor with a light sabre. Today, if you make enough money you will be promoted into a position of influence, even if you have a disturbing lack of faith.

What are three quick ways to become a leader? a) Execute on the firm’s ‘axes’, which is Empire-speak for persuading your clients to invest in ‘prime-quality’ residential building plots on Alderaan that don’t exist and have not existed since we blew it up. b) ‘Hunt Elephants’. In English: get your clients – some of whom are sophisticated, and some of whom aren’t – to tempt their friends to Cloud City and then betray them. c) Hand over rebel smugglers to an incredibly fat gangster.

When I was a first-year analyst I didn’t know where the bathroom was, or how to tie my shoelaces telepathically. I was taught to be concerned with learning the ropes, finding out what a protocol droid was and putting my helmet on properly
so people could not see my badly damaged head.

My proudest moments in life – the pod race, being lured over to the Dark Side and winning a bronze medal for mind control ping-pong at the Midi-Chlorian Games – known as the Jedi Olympics – have all come through hard work, with no shortcuts.

The Empire today has become too much about shortcuts and not enough about remote strangulation. It just doesn’t feel right to me anymore.

I hope this can be a wake-up call. Make killing people in terrifying and unstoppable ways the focal point of your business again. Without it you will not exist. Weed out the morally bankrupt people, no matter how much non-existent Alderaan real estate they sell. And get the culture right again, so people want to make millions of voices cry out in terror before being suddenly silenced.

 

Source: http://www.thedailymash.co.uk

Poor US earning season so far and not expected to get any better. Reply

Roughly one third of the S&P has reported earnings so far, with another third reporting in the next five days and almighty AAPL on deck Thursday evening, and if there is one word to describe what has happened so far, that word would be “ugly.” The same word would be used to describe how Q4 is shaping up to be. And that word will be very a optimistic prediction of what 2013 will bring unless a major catalyst develops that pushes Congress to resolve the fiscal cliff situation. So far that catalyst is missing. But going back to Q3 earnings, here is how Goldman’s David Kostin summarizes events to date: “3Q reporting season is roughly one third finished. Two early conclusions: (1) Information Technology results have been startlingly weak with high-profile revenue disappointments by the four horsemen: MSFT, GOOG, IBM, and ORCL. (2) EPS guidance for 4Q has been overwhelmingly negative across all S&P 500 sectors with 18 of 20 firms lowering 4Q earnings guidance by a median of 5%. Analysts have lowered 4Q EPS estimates for stocks already reported by 0.4%. We expect further EPS cuts of 6% loom ahead. Firms reporting next week: AAPL, T, PG, MRK, CMCSA, AMZN, COP, AMGN, OXY, MO, UTX, MMM, CAT, DD, and FCX

 

Source: ZeroHedge

Bond Wars: Chinese Advisor Calls For Japanese Bond Dump Reply

Earlier today we casually wondered whether the US stands to lose more by supporting China or Japan in their escalating diplomatic spat, considering the threat of a US Treasury sell off is certainly not negligible, a dilemma complicated by the fact that as today’s TIC data indicated both nations own almost the same amount of US paper, just over $1.1 trillion. In a stunning turn of events, it appears that China has taken our thought experiment a step further and as the Telegraph’s Ambrose Evans-Pritchard reports, based on a recommendation by Jin Baisong from the Chinese Academy of International Trade (a branch of the commerce ministry) China is actively considering “using its power as Japan’s biggest creditor with $230bn (£141bn) of bonds to “impose sanctions on Japan in the most effective manner” and bring Tokyo’s festering fiscal crisis to a head.” I.e., dump Japan’s bonds en masse.

Should this stunning recommendation be enacted, not only would it be the first time in world history that insurmountable credit is used as a weapon of retaliation, it would mark a clear phase transition in the evolution of modern warfare: from outright military incursions, to FX wars, to trade wars, culminating with “bond wars” which could in the span of minutes cripple the entire Japanese fiscal house of cards still standing solely due to the myth that unserviceable debt can be pushed off into perpetuity (as previously discussed here).

Not needing further explanation is the reality that should China commence a wholesale Japanese bond dump, it may well lead to that long anticipated Japanese bond market collapse, as creditor after creditor proceeds to sell into a market in which the BOJ is the buyer of only resort in the best case, and into a bidless market in the worst.

The immediate outcome would be soaring inflation as the BOJ is forced to monetize debt for dear life, buying up first hundreds of billions, then trillions in the secondary market to avoid a complete rout, matched by trillions of reserves created out of thin air which may or may not be halted by the Japanese deflationary gate, and which most certainly could waterfall into the economy especially if Japanese citizens take this as an all clear signal that the Japanese economy is about to be crippled in all out economic warfare with the most dangerous such opponent, and one which just defected from the “global insolvent creditor” game of Mutual Assured Destruction.

Further complicating things is that Japan has no clear means of retaliation: it owns no Chinese bonds of its own it can dump as a containment measure. Instead, Japan is at best left with the threat of damages incurred on the Chinese economy should Japan be lost as a trading parting. It appears, however, that to China such a gambit is no longer a major concern:

Mr Jin said China can afford to sacrifice its “low-value-added” exports to Japan at a small cost. By contrast, Japan relies on Chinese demand to keep its economy afloat and stave off “irreversible” decline.

 

“It’s clear that China can deal a heavy blow to the Japanese economy without hurting itself too much,” he said. It is unclear whether he was speaking with the full backing of the Politburo or whether sales of Japanese debt would do much damage. The Bank of Japan could counter the move with bond purchases. Any weakening of the yen would be welcome.

Yes, but any offsetting Japanese hyperinflation would not, which is precisely what would happen if after 30+ years of dormancy the Japanese bond vigilantes were woken up by none other than a cuddly Panda bear with very murderous intentions.

Ironically, this terminal bond war escalation would also mean that Japan’s last ditch alternative is to threaten the US with dumping America’s bonds in turn if the US i) does not step up on behalf of Japan and ii) if Japan is forced to promptly convert debt from one denomination into another. The fallout effect would be most dramatic.

It is unclear if China will proceed with this “scorched bond” step: should this happen there is likely no turning back as it would force a market test of the entire developed world. And as our readers know all too well, the entire developed world is insolvent, and the only reason why it has perpetuated the illustion that all is well, is because being a closed system, nobody has the incentive to defect. Until now that is, when suddenly over a piece of rock in the East China Sea, China may find itself pulling the pin on the global debt grenade.

And even if this is not the final denouement, the market appears to already be pricing in several not much more favorable outcomes:

Markets are already starting to price in an arms race in Asia. Shares of China’s North Navigation Control Technology, which makes missile systems, have jumped 30pc in recent days.

 

China is becoming self-sufficient in defence. It was the world’s biggest net importer of weapons six years ago. It fell to fourth place last year.

 

Japan is at the other extreme. An official report this year – “A Strategy for Survival” – said Japan’s spending on its “Self-Defence Force” had shrunk by 4pc in 10 years. It called for “urgent” action to rebuild the country’s military.

One thing here is certain: Japan picked on the wrong country when two weeks ago it “purchased” the disputed Senkaku Islands. If it thought that China would just forgive and forget with a wink, it was dead wrong.

It now has several two options: undo all that has happened in the past fortnight, in the process suffering tremendous diplomatic humiliation, leaving Senkaku in the “no man’s land” where they belong, or push on, and suffer the consequences. And the consequences for the country represented by the question market in the chart below, would be tragically severe, as would they for the entire “developed”, insolvent and daisy-chained world

 

Source: Zerohedge

It’s Just Getting Stupid! Reply

As Cantor’s Peter Cecchini notes today:

“when things are this senseless, a reversion to sensibility will occur again at some point.”

His view is to be long vol and as the disconnect between the economic cycle and stocks continues to grow, we present three mind-numbing charts of the exuberant hopefulness that is now priced in (oh yeah, aside from AAPL actually selling some iPhones in pre-order). Whether it is earnings hockey-sticks, global growth ramps, or fiscal cliff resolutions, it seems the market can only see the silver-lining. We temper that extreme bullish view with the fact that all the monetary policy good news has to be out now – for Ben hath made it so with QEternity.

These three factors – weak economic growth, powerful monetary policy and elevated public policy uncertainty – remain the critical drivers of performance and with weakening data, the market is all the more dependent on central bank life support – and following the rally through the Fed signalling period to 1460, much of the monetary policy related rally seems to be priced in, with the market already discounting considerable data improvement. With already high oil, gasoline and food prices, the Fed’s balance sheet expansion risks driving down the dollar, boosting commodities and dampening consumption and thus growth.  

As this chart comparing P/E multiples to the ISM New Orders index, we need to see some serious unicorn-conjuring for these valuations to be sustained…

 

One tool often utilized to assess the attractiveness of equities relative to other assets is the equity risk premium (ERP), also known as the Fed model or the difference between the forward earnings yield and the yield on the 10 year U.S. Treasury. We have argued, based in part on the prior period of extreme financial repression in the U.S. following WWII, that a sustained contraction in the ERP and expansion of the PE multiple was unlikely until the Fed began the policy normalization process. Integrating inflation and a ratio of stock to bond market volatility paints a far less compelling picture for equity market valuation. We are at least 3 years from any normalization of Fed policy (according to them) and thus…

the following chart (or real rates vs P/E multiples) suggests current valuations are unsustainable at best, or down-right crash-worthy as you simply can’t fight the cash-flow forever…

 

 

The reach for yield and safety has led investors to push into mega caps – defensive ingredients including lower betas, lower earnings volatility, and lower P/E multiples as well as higher dividend yields. This has pushed the relative median P/E of the mega caps notably above smaller (and higher beta) stocks – as the somewhat odd beta-defying rally of the last few weeks took hold

Our point here is that 1) the spread between LTM and NTM PE is gaping (something that we saw in the run-up to the peak in 2008), and 2) that the mega-caps which dominate the indices (which everyone watches including Ben) are ‘over-valued’ rightly or wrongly relative to less-defensive stocks… leaving plenty of room for rotational risk-off as well as reality disconnects

 

 

On balance, Barclays are less bullish than they were at this time in either of the last 2 years. Investors seem to mis-remember history; monetary policy was not the only driver of the rallies following QE2 and Operation Twist. In the signalling period prior to QE2’s launch, and in the immediate aftermath of its commencement, both the economic and public policy outlooks were improving.

[They] remain relatively cautious given a weaker economic outlook and no clear trend in the polls to provide confidence that the U.S. can avoid the potential massive tax hike scheduled for January 1, 2013

 

Source: Zerohedge