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PIMCO founder and co-CIO Bill Gross spoke with Bloomberg Television’s Tom Keene today about the launch of the Total Return ETF, investment strategy and the ISDA’s decision on Greek debt.

Gross said that the ETF is “really a mom-and-pop type of thing from my standpoint.” He also said that the ISDA has yet to make a final call on Greek default-swaps and that “it’s not a slam dunk…we expect the next few days, perhaps next few weeks, to ultimately send the ISDA committee back for one final vote.”

Transcript after jump

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Bruce Krasting: I worked on Wall Street for twenty five years. This blog is my take on the financial issues of the day. I was an FX trader during the early days of the ‘snake’ and the EMS. Derivatives on currencies were new then. I was part of that. That was with Citi. Later I worked for Drexel and got to understand a bit about balance sheet structure and corporate bonds from Mike Milken. I was involved with a Macro hedge fund later. That worked out all right, but it is not an easy road. There was one tough week and I thought, “Maybe I should do something else for a year or two.” That was fifteen years ago. I love the markets. How they weave together. For twenty five years I woke up thinking, “What am I going to do today to make some money in the market”. I don’t do that any longer. But I miss it.

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Warning: Wonkish

When you stick your neck out and make prognostications about the future, sometimes you’re going to be wrong. I’m certainly no exception. But when it comes to really big misses, I think Meredith Whitney’s call for a monster blow-out of the Municipal Bond market is on top of the list.

Meredith is a smart lady. That being the case, it’s worth looking into why she was so wrong. A report this weekend from the Bond Buyer provides a partial answer:

A 32% ($138B) YoY decline is a very big relative change. The drop in long-term financing was not offset by increases in short-term debt; that category fell by 7.4% ($5B).

The drop in total borrowings is almost exclusively a result of the 46% ($129B) in the “New Money” category. The drop in New Money debt issuance is a consequence of hundreds of cities and states collectively saying:

We’re in a pinch on revenues. Let’s not spend any money we don’t have to for the time being. We’re going to have put off the construction of the new (Sewer plant, overpass, water treatment facility, school, whatever). The last thing we want to do is go to the Muni market and borrow any more.

As a result of many individual decisions to defer infrastructure projects, the Munis have kicked the can down road. They have eliminated the current and future expenses related to these projects. With that, they have stabilized the trajectory of their debt growth and improved short-term cash liquidity (by having less ST debt). In the process, they have created a shortage of muni bonds (relative to expectations) in the market.

Thus, all may appear well in muni land. A successful re-balancing has taken place, for the time being. If the munis can continue to push off infrastructure projects, they will not suffer the fate that Ms. Whitney feared they might.

I said that the munis had “kicked the can down the road”. In this case, it’s quite a different form of can kicking. When the Federal government raises the debt ceiling, we all say, “They kicked the can”. But the munis are doing (pretty much) the exact opposite, so Can Kicking would appear to be an improper/unfair description of what is happening with Munis. I think it’s still valid, deferring infrastructure investments is another form of kicking.

Like most Kicking efforts, it will end badly sooner or later. I’m looking at a potential example as I write. One of NYC’s reservoirs is about a half mile away. A $60mm NYC/NYS funded construction plan was shelved a month ago. Could this become one of those examples where Kicking goes badly? Consider this daisy-chain.

The Croton Reservoir is part of a chain of reservoirs that provide water for NYC. It’s large (22 miles), but it’s small in comparisons to the big man-made lakes further upstate. Croton is important because it connects directly to those upstate reservoirs via an underground tunnel. That tunnel goes north, and then west. It is 1,000 feet deep where it meets the Hudson River.

A bit of physics. The upstate reservoirs are 1,000 feet above the sea and the tunnel is 1,000 below. The tunnel is (was) large enough to drive a truck through so the water pressure at the lowest part of the tunnel is enormous. What might you expect from a 75 year old tunnel under that much pressure? A leak? Sure.

This is one hell of a leak. As much as 35 million gallons a day was the estimate seven years ago. There is evidence that rate has since accelerated. That comes to  13 billion gallons a year, which is sufficient for 250,000 average Americans. Think Orlando, Madison, Winston-Salem or Reno. Each of these cities uses about as much water as NYC is leaking. In China, this much water would meet the needs of 1.7mm people, In Bangladesh it would be sufficient for 3mm. It’s enough to fill 650,000 in-ground swimming pools. That’s a leak.

It gets worse. The leak was first detected in 1988. Therefore something like 15 million swimming pools worth of drinkable water have been pissed into the ocean. It’s so bad that areas on either side of the tunnel have sinkholes. People have been forced to move. Properties have been condemned. And the sinkholes keep getting bigger.

There are already dozens of lawsuits on this. They are after the State and the City who own and maintain the reservoirs. The judges have all sided against the City and State, and there have been promises to fix the damn leak for years. A few years ago, a formal plan was put together.

This is no small engineering matter. A new tunnel will be built that connects the old tunnel before and after the break. Once completed, the old tunnel will be cemented closed. The diversion tunnel will be ½ mile long. Recall that this is 1,000 below sea level, any construction/mining this deep is both difficult and dangerous (the bends). Those normal risks are, however, trumped by risks that the nearby existing tunnel breaches during construction of the diversion tunnel. The water pressure in the tunnel is sufficient to crush a submarine. Read the rest of this entry »

We’re baffled anybody still looks to the U.S. bond market for signals of future economic activity, inflation, or even risk aversion.  Case in point is today’s 7-year bond auction, which CNBC’s Rick Santelli rated an eleven on a scale of ten, i.e., a slam dunk!

Go no further, however, than the chart below to see which maturities on the yield curve are the most repressed.  Prior to today’s auction, for example, the Fed owned 43 percent of all Treasury coupon securities maturing in 2019 and more than 50 percent in three of the seven issues maturing in that year.

Yesterday we caught PIMCO’s very bright and articulate Mohammad El –Erian promoting the “seven-year bucket” in an interview with CNBC,

…make sure you have some gold, some oil, and concentrate your bond exposure in the five to seven-year bucket.

Known for “Fed Surfing” or getting in front of, or riding along with, the U.S. central bank’s market interventions, don’t you think PIMCO likes the seven-year, in part,  because that is where Mr. Bernanke is camped out?   Front running the Fed has paid handsomely for many and we doubt it is fully dominated by macro views of inflation, economic growth,  Chinese hard landings, or risk aversion.

The information we divined from today’s successful bond auction?   Especially, in a maturity that has been gagged and bound by Fed intervention?   Absolutely nuttin’!

Finally, we view long-term Treasury interest rates as one of, if not, the most important price in the world.  Because of direct financial repression the information it now provides and the signal it sends, which is so important to capital allocation decisions,  has, at best, been severely distorted.  No wonder corporations are hoarding cash and reluctant to invest.

Click chart to enlarge and for better resolution.

We’ve updated our database of the Federal Reserve’s ownership of the U.S. Treasury coupon curve.  The resulting chart highlights a couple of interesting issues about its structure and holdings of outstanding notes and bonds.

First, though nothing new, it shows the relatively small stock of longer dated securities and illustrates the ease at which the Fed can repress longer term interest rates and engineer short squeezes.   The result has been the castration of the bond market vigilante and early grave for many hedge fund managers.

Second, the Fed holds over 40 percent of the Treasuries outstanding in several of the years in which they mature.  In many of the specific maturities, the Fed owns up 60-70 percent of the total outstanding issue.  The Fed had to “relax” its self imposed 35 percent limit on SOMA holdings of individual issues and included recently issued securities in order to execute its maturity extension program announced last September.

It’s going be interesting to see how longer-term interest rates behave as the economy regains some of its mojo and money comes out of the Treasury safe haven.    The Fed has yet to fight the markets in its repression of long rates as Operation Twist has been riding the tail winds of positive market psychology and strong demand for safe havens due to Europe’s sovereign debt and banking crisis.   See chart below.

As the issuance and stock of longer dated Treasuries increase with a larger structural U.S. budget deficit the Fed will need more firepower than just the interest earnings and roll off of maturing securities to keep rates from rising, in our opinion.   They will need an even bigger bazooka if they are seen falling behind the curve on the economy or inflation.  They will need a tactical nuke if the markets begin to lose confidence in the U.S. government’s fiscal and debt policies and starts to price credit risk.   As the greatest QB in NFL history once said, “Confidence is a very fragile thing.”

No wonder there’s still talk of quanto easing and reassurance from the FOMC that interest rates will stay at “exceptionally low levels…at least through late 2014″ even as the stock market moves back to levels not seen since before the Lehman Crisis.   Either stocks are wrong at pricing a better future than a U.S. monetary policy still in crisis mode or it will need more QE crack to keep the buzz alive and momentum intact.

We’re the first to admit nobody knows the future, most of all us,  but we smell a potential fight or flight in the bond market, comrades.  An Arab Spring in the bond pit, if you will.    With oil prices north of $100 and rising rents, which is the largest component of the CPI, it is our sense the Fed better be able “to float like a butterfly and sting like a bee.”

We know it’s too early, but maybe this potential macro swan — rising interest rates and an emerging crisis of confidence in the Federal Reserve and the U.S. G’s fiscal and debt policies — has a fatter tail than currently perceived and should be on the radar.  You never know,  for sure, until you do, but then it’s too late.   Thus, we will constantly remind ourselves of this in the new bull market in stocks — i.e., to make sure we panic before everyone else.

As they say in the ring, “Ladies and Gentleman, Let’s get ready to rumble!”

Click on charts to enlarge and for better resolution.

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click for audio

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One of my favorite sections of Barron’s each week is the Review/Preview — including a weekly question where they ask “They Said What?” Its a weekly must read.

This week, they asked the loaded Is the Rally in Treasury Bonds Over?

Here are the answers:

David Goldman
Principal, Macrostrategy.com
“There has been a near-perfect inverse correlation between commodities and term yields, and that shows that the Treasury market is starting to worry about inflation, as well it should. The big commodity-price recovery is bad for bonds. Asian demand will lift commodity prices, so bonds will underperform.”

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Jim O’Sullivan
Economist, MarketWatch forecaster of the year, 2011
“It’s hard to get too bearish on bond yields near term, but chances are yields will be up more than down in coming months, if the economy grows modestly.”

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David Rosenberg
Chief economist and strategist, Gluskin Sheff
“No. By the time it’s over, the yield curve will have mean-reverted to 200 basis points from today’s 275 basis-point gap. Since the Fed will keep short rates at zero through 2014, the inevitable flattening of the curve will occur via much lower long-term yields.”

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Jason Hsu
Chief Investment Officer, Research Affiliates
“It’s anyone’s guess whether Treasuries will move up or down in the next six to 12 months. But the secular yield decline has probably reached its bottom.”

Fascinating stuff.

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Source:
They Said What? U.S. Bonds
CHRISTOPHER C. WILLIAMS  
Barron’s January 28, 2012
http://online.barrons.com/article/SB50001424052748704895604577178961898660908.html

Marc Faber, publisher of the Gloom, Boom & Doom report, talks about the outlook for stocks versus bonds and his investment strategy. He speaks with Sara Eisen and Erik Schatzker on Bloomberg Television’s “InsideTrack.”

Jan. 20 (Bloomberg)

I love these giant long term charts. This one covers more than two centuries. It looks at long term US interest rates — the 30 year bond where available:

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Click to enlarge:

Source: What Drives The Bond Market?
Chicago CFA Handout by Bianco Research LLC
January 18, 2011

The following comes from an asset manager, formerly of New York, since relocated to Colorado. Because of his employer’s rules on publishing, this is anonymous. We shall call him  The Bond Specialist. I know him and his colleagues for many years, and can attest to his 35 year career on Wall Street.

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2011 was a confusing year from start to finish on Wall Street and the arrival of 2012 is not offering much relief. Today the popular message is that the economy is getting better in the U.S. and problems abroad can be overcome. Recession has been avoided and “escape velocity” will be achieved in the second half. Our economy can “decouple” from Europe and some of the big developing nations that have seen their economies slow such as China, India and Russia, now that they have run into trouble. Most economists and stock market strategists seem to have cut and pasted their 2011 forecast into their 2012 forecast. (How is that for the pot calling the kettle black?) But the concerns that clouded the outlook a year ago only seem to have gotten deeper. The positive messaging is focused on the following;

-The politicians will kick the can down the road and therefore avoid the kind of austerity that could derail the recovery. The Fed will engage in more quantitative easing (a euphemism for money-printing) if the economy or the stock market falters.

-Interest rates and inflation have nowhere to go but up so the least attractive place to put your money is in the bond market. That is, unless you keep the maturities short and stick with “spread product” like corporate bonds and bonds issued by foreign governments.

-The S&P 500 will be up 10% by year end. I have been in the business for 35 years and for the last 20, the prediction for the market has always been “up 10% or more”. The rationale changes but the upside prediction does not. This year the place to be is “dividend paying stocks” that pay so much more than Treasury notes and have a great track record of increasing dividends. Also, the 3rd and 4th years of the Presidential Cycle are usually positive for stocks. Last year the emphasis was on domestic small cap, international and emerging market stocks because of their superior growth potential.

-The dollar will be weak because our fiscal and monetary situation is worse than those other countries that we have decoupled from since they are in so much trouble. Gold will be higher because some Central Banks are substituting gold for dollars as a reserve asset and lots of women will be getting married in India.

-Commodity prices will be higher in general. Oil and fertilizer are in short supply and all the rural Chinese are planning to motor on down to Kentucky Fried Chicken for some protein sooner or later.

-The housing market and home prices are finding a bottom.

Based on the popular forecast for 2012, you can buy practically anything but long term bonds and probably do just fine as long as you are diversified.

That is not the way it worked in 2011 and it seems to me to be even less likely in 2012. The S&P 500 was exactly unchanged in price for the year, providing only a 2% dividend return. It was like a video game where many aliens were destroyed and many points were scored, but it was game over on December 30th and we will have to put another quarter in on January 3rd. Small capitalization stocks (Russell 2000) were down 5% and the Dow Jones Industrial Average, the home of dividend paying stocks, was up 6%. European and Emerging Market indexes generally delivered double digit losses. They all had big swings during 2011, but the big story was how many times that the stock indexes were up or down more than 1% (100 Dow points) or more in a day. It seemed like all of them.

Gold and silver roared earlier in the year, but gold is down 18% from a high of $1900 just since September and silver peaked in May at $50. It is now $28. Gold was up 11% in 2011 and silver was down 10%. The dollar index was flat. Oil was up 9% but natural gas was down 37% to a multi-year low. Copper was down 22%. Corn was flat and wheat was down 18%. For the most part, confusion reigned.

But there was no confusion in the bond market. In 2011, the most abhorred investment vehicles; long term Treasury bonds and long term Municipal bonds were the two best performing major asset classes. After a swoon in January, long term bonds just marched up in price (down in yield) practically without interruption for the remainder of the year. As is always the case when interest rates are declining, the longest maturity and highest quality bonds perform the best. The 2039 Treasury Strip (0% coupon bond) returned 62% in 2011 and the average leveraged Closed End Municipal Bond fund returned 21%. Closed End Build America Bond funds, which contain taxable municipals where the Federal government pays 35% of the interest, did even better with an average return of 28% in 2011. The important question to ask is: in what ways will 2012 be different and how will it be similar?

As previously mentioned, the majority of pundits think that, even though they missed the boat in 2011, it is only a matter of timing and it will sail in 2012. That sentiment is understandable, but the expectation that the economy is going to return to a trend of expanding organic growth and a return to the secular credit expansion lacks credibility (no pun intended). To paraphrase Bob Farrell, in the early stages of a new secular paradigm the market is adapting to a new set of rules while most market participants are still playing by the old rules. But the old paradigm of credit expansion must resume if stocks and commodities are to appreciate, housing prices are to stabilize, the government is to avoid raising taxes and slashing spending and interest rates are to rise. As disappointing as it is, a far less rosy outcome is more likely.

The magnitude of the economic reversal that occurred in 2007 has left the developed world with an enormous debt overhang that will require a very long period of time to unwind. That is why our economy has not responded very much to the enormous amount of monetary (0% interest rates) and fiscal ($1.5 trillion annual deficits) stimulus that has been delivered in the last 3 years. That is also why Europe seems to be going through a fiscal crisis similar to what we already went through 3 years ago. Austerity is engulfing the developed world.

The solution to underfunded Baby Boomers on the threshold of retirement, a $15 trillion national debt (plus unfunded liabilities), bad assets in the global banking system and sovereign fiscal crisis in Europe and Japan (to name a few) is not a return to an expanding credit cycle. The solution is going to include a large dose of paying the piper, which works against economic growth. Paying down debt is a powerfully deflationary force and central bankers will be trying to cushion it by keeping short term borrowing rates at rock bottom for the next couple of years, at least.

Generally speaking, the only two economic forces that correlate to the trend in long term interest rates are Fed policy and inflation. Other than hope, there is little solid rationale for the Fed becoming restrictive or the 30 year downtrend in inflation reversing any time soon. In 2011, the yield on 10 year Treasury notes declined from 3.3% to 1.9% and the yield on 30 year Treasury bonds declined from 4.4% to 2.9%. There is a high likelihood that the bond market stages a repeat performance of 2011 in 2012, if not quite to the same magnitude. Rates have declined in lock-step with inflation since 1981. In addition, a clear trend toward risk aversion and a desire to invest for income is developing among individual investors who remain generally underexposed to the bond market compared to their allocation in stocks, real estate and bank deposits.

As far as the stock, real estate and commodities markets are concerned, they all displayed an enormous amount of risk (as measured by volatility) and nothing consistent in the way of positive returns in 2011. We may not be so lucky in 2012. Financial and political pressures appear to be mounting globally and the “green shoots” displayed in some of the consumer spending and employment data of late here in the U.S. have not been accompanied by improving household finances. The savings rate has come down and household income has not kept up with what little inflation we have experienced.

I won’t go into real estate or commodities here, but as far as stocks go, profit margins appear to be peaking along with profit growth and global trade is at risk of succumbing to increased protectionism. “Dividend paying stocks” are tough to argue against, but two quotes come to mind. The first is Bob Farrell’s Rule #9; “When all the experts and forecasts agree, something else is going to happen.” The second is from Yogi Berra; “Nobody goes there anymore, it’s too crowded.” Think Intel or Microsoft in 2000. The story was right but Intel still dropped from $76 per share to $12 per share. Back then, the fact that they did not pay a dividend was a reason to buy: they were retaining all their earnings to power their growth. I like hamburgers as much as the next guy, but at $101 per share up from $60 two years ago and yielding less than 3%, McDonald’s seems risky.

All that being said, interest rates can only drop so much. David Rosenberg, who was one of the few who got the call right on interest rates for 2011, expects the 10 year and 30 year Treasury yields to dip below 1 ½% and 2%, respectively in 2012. A decline of that magnitude would deliver substantial total returns at the long end of the Treasury market, though not quite as great as the 2011 return. If we see 2% on the 30 year Treasury bond, that may be the end for the Great Bull Market in Bonds that began in 1981.

On the other hand, long term investment grade municipal and Build America bonds offer yields near 5% and the leveraged closed end funds that invest in them yield between 6 ½% and 7 ¼%. It would seem that demand for those vehicles should remain strong in 2012, barring a severe reversal in municipal credit quality, which has been on the rise in the past year. Municipal bond issuance is down substantially from years past, restricting supply.

Along with all the uncertainty that we face in the coming year, investment risk appears to be mounting.

Our current asset allocation seems appropriate considering the deflationary risks that we have identified. I remain very concerned about avoiding dogma and overstaying our welcome in this defensive strategy. However, preservation of cash flow and preservation of capital are the most basic investment objectives for those of you who have accumulated substantial wealth. In the meantime, we have enjoyed excellent absolute and relative performance, particularly on a risk-adjusted basis, in 2011.

I hope that you will share this information with friends, family and associates. Many investors are very confused about how to position their portfolios and could benefit from at least being exposed to our perspective.

Happy New Year,

TBS

December 19^th marks one year since Meredith Whitney appeared on the CBS newsmagazine 60 Minutes and sent the municipal bond market into a tailspin from which it took months to recover.  To recap that event:  Ms. Whitney, a noted bank analyst, appeared on 60 Minutes and forecast “hundreds of billions” in municipal defaults during 2011.  The result was a two- to three-month siege on the municipal bond market, which was already in the throes of a supply bulge because the Build America Bonds (BABs) program had expired.

As we have written previously, the first few post-Whitney months were marked by huge redemptions in municipal bond funds.

One can see that the redemptions approached hemorrhage levels in the early part of 2011.  They got LESS negative as the spring wore on, and finally began to turn positive during the fall.  It is important to note that while the mostly retail-oriented municipal bond funds were having crushing outflows, sending longer-maturity yields skyrocketing, the demand for the TAXABLE versions of the same credits (BABs) was sending BABs yields lower, as pension funds, foreign buyers, and charitable foundations scooped up the generous yields afforded by year-end 2010 BABs issuance.  This was one of the clear signs that the Whitney-led meltdown was one related to liquidity and not to overall credit concern.

One can see from the chart that the skyrocketing of intermediate and LONGER term yields that occurred due to the 60 Minutesbroadcast continued unabated through mid-January.  This, of course, correlated with the massive amount of bond fund liquidations. And then began the long trip down in longer yields that has continued until now.

What were the keys to the turnaround?

Credit

State governments recently finished the seventh consecutive quarter of rising tax receipts.  This followed five straight quarters of declines from the fall of 2008 through the end of 2009.  To be sure, many states and cities are still struggling to rein in rising pension costs, as well as dealing with the loss of federal dollars.  But many states have made deep cuts in expenses and, in most cases, budget gaps have been closed without reliance on one-time solutions.  The market dealt with the bankruptcies of Harrisburg, PA and Jefferson County, AL without seeing a backup in overall tax-free yields.  It treated these bankruptcies as “one-off events, caused by specific problems of municipal malfeasance, and not as being indicative of overall municipal health.  As we have also written, overall financial health is better at the state level than at the local level – but all levels of government have been learning how to do more with less.

Supply

The sharp decline in long-term interest rates has spurred on issuers in recent months.  However, even with robust issuance at year end, 2011 is poised to finish with under $300 billion in total municipal bond issuance, a far cry from the $433 billion of issuance in 2010.  There is clearly a greater air of austerity at many different levels of municipal government, from the state level down to towns.  Certainly, in many cases, additional bond debt is being voted down by electorates.  In addition, many issuers decided to forego issuing bonds at the very high interest-rate levels that Meredith-mania caused in the early part of this year.  And, once the Build America Bonds program expired at the end of 2010, many officials decided to forego projects that might have been financed with the federally subsidized BABs.

Demand

Again, the municipal bond mutual fund flows tell a lot of the story. Much of the bond fund selling was replaced with INDIVIDUAL bond purchases earlier in the year.  But now bond fund flow has turned positive and should show overall positive flows for calendar year 2011.  Volatility in the equity markets has caused money to be pulled from stock funds and, presumably, some of this has found its way into the municipal bond market.  In addition, the prospect of higher taxes has also pushed investors toward tax-free municipals.  Although the rise in federal marginal tax rates now looks like it might be on hold until AFTER the 2012 election, northeastern states like New York, New Jersey, and Connecticut have seen a hike in marginal income taxes, thus raising demand for tax-exempt income.  We expect more states to raise income taxes at the margin in 2012 – and, no doubt, to aim the increases at higher-income individuals.

So as we head into the last two weeks of 2011, we can look at how tax-exempt yields stack up against US Treasuries on a relative basis now and in the middle of the Meredith meltdown last January.  There is no question that munis are cheaper, on a relative basis, across the whole yield curve, particularly on the front end.  But it is extremely important to note that municipal yields have moved in the same direction (down) as Treasuries – just not as much. The Congressional squabble over the debt ceiling, the downgrade of the United States by Standard & Poor’s, and the Federal Reserve announcement of its “Operation Twist “ in September all led to drops in Treasury yields, and munis – begrudgingly, in some cases – followed along.  The muni market fought those events off, along with the Harrisburg and Jefferson County situations, and made the long trip back from the despair of a year ago.  And for that we are thankful.

Happy Holidays!

Source:
Meredith Redux – One Year Later
Cumberland Advisors Commentary by John Mousseau
December 19, 2011