Talking the Talk, They will Walk the Walk

You can talk the talk. Do you walk the walk?
- Full Metal Jacket

Well it didn't take to long for things to get dicey again in Europe.  Even though Greece was restructured 3 weeks ago, and the ECB lent ~$1 Trillion of LTRO funds, bond rates in Italy and Spain are climbing higher.  On March 1, the 10 year Spanish bond was 4.87%.  Today Spanish rates hit 6%.  This is important because as the 10 year bond moves towards 7%, it means investors have lost confidence the Spain can resolve its budget deficit and make good on its debts.  7% is the line in the sand as this is when Greece, Ireland and Portugal needed bailouts.

Source: Bloomberg

Almost on cue, the ECB restarts talk about it's bond buying program.  From the Telegraph: ECB may act to bring down Spanish borrowing costs

Benoit Coeure, an executive director of the ECB, said the bank could restart its sovereign bond buying programme in a move likely to antagonize Germany but relieve a spiralling political, economic and social crisis in Spain.

Mr Coeure said that market fears over Spain were "not justified" but he added: "Will the ECB intervene? We have an instrument, the securities markets programme [SMP] which hasn't been used recently but it still exists."

Bond traders were soothed by the comments. The yield on Spain's benchmark 10-year bonds was pulled back from 6pc on Tuesday to 5.88pc, while the yield on Italy's 10-year debt also dropped marginally, to 5.54pc. 

Mr Rajoy delivered a strongly-worded speech to parliament insisting that it was "as clear as day" that Spain would not need a Greek-style bail-out.

Occasionally I'm asked how did I know things were going to blow-up in 2007.  My first clue was when the word "contained" was used by Ben Bernanke and Hank Paulson with regard to subprime mortgages.  Mike Mish Shedlock shred those claims to pieces using examples of Washington Mutual mortgages.  Another clue came from Paulson's claim that the US would not need to take over Fannie Mae and Freddie Mac.  When things are officially denied like that, watch out because it's going to happen.

Rajoy is right in that Spain will not need a Greek-style bailout - it's going to need a Spanish-style bailout because Spain's economy is more than double the size of Greece, Portugal, and Ireland combined.

We've Seen This Movie Before

The movie I refer to is how the ECB, IMF, and EU treated Greece's fiscal problems.  Currently Spain is sticking to cutting its budget though I've read that the EU wants it to raise taxes as well.  I expect to hear more about selling national assets to pay down debt.  When the ECB starts buying more Spanish bonds, then start to watch Spanish banks as they are reported to have been buying Spanish bonds using the LTRO money.  As these bonds have dropped in price, the losses to banks are building.  Worse if there is a Spanish restructuring, remember that the ECB gets paid in full while investors and banks get shellacked.

The only way Spain does not get bailed out is if it leaves the EU first.  What are the odds the politicians go that route?

And in the U.S.

The one direct affect of Spain should be falling bond rates in the U.S. as investors seek a place of refuge.  Ironically when bonds rates rose a few weeks ago, I wondered if people had forgotten that the LTRO in Europe simply bought time - it didn't solve anything.  Maybe most people thought it bought 3 years of time.  Regardless, bond rates in the U.S. should stay lower as questions about Europe and questions of the U.S.'s recovery remain in focus.

And about that U.S. recovery, it seems the best we can get is conflicting data.  What I might find humorous, if it wasn't so maddening, is how the good data took hopes of a new quantitative easing program off the table - but then unexpected bad data (in the form of the March employment numbers) immediately raised the hopes for such a program again.  The reason I, as a stay-at-home dad, find this maddening is that it resembles my two year old's temper tantrums.  Give us QE3 or watch the stock market tank.

What's worse is I see the Fed giving in as they have every time the stock market threatened to fall.  From Advisor Perspectives: Fed Intervention and the Market

I'm not the only one who sees the Fed giving in.  From Bloomberg: Gross Cuts Treasuries, Raises Mortgages in Fed Buy Bet

Bill Gross, who runs the world’s biggest bond fund at Pacific Investment Management Co., cut holdings of Treasuries last month to 32 percent, the lowest since December, and raised mortgages to the most since 2009.

Gross reduced the proportion of U.S. government and Treasury debt in the $252.4 billion Total Return Fund in March from 37 percent of assets in February, according to a report on the company’s website today.

Bill Gross, co-chief investment officer of Pacific Investment Management Co. (PIMCO), speaks during an alumni event hosted by UCLA Anderson School of Management in Beverly Hills on Nov. 17, 2011. Photographer: Andrew Harrer/Bloomberg

He raised the fund’s holdings of mortgages to 53 percent last month, the highest since June 2009, from 52 percent in February, in a bet that the Federal Reserve will buy the securities in a new round of purchases. Newport Beach, California-based Pimco doesn’t comment directly on monthly changes in its portfolio holdings.

The Fed will probably shift focus to buying mortgage securities to keep borrowing rates low when its so-called Operation Twist program ends in June, Gross said in a March 28 interview on Bloomberg Television’s “InBusiness with Margaret Brennan.”

Bill Gross successfully front ran previous Fed easing, meaning he bought treasuries and mortgages at a lower price to sell them to the Fed at a higher price.  Can it work again?  As the Fed has consistently talked the talk and walked the walk, I wouldn't bet against it.

Parting Thoughts

I've read recently that you have to trade (invest) the market you have, not the market that you want.  It made me think if I ever have invested in a market that I want.  Thinking back to when I got started in 1998, that was the final legs of the Internet bubble.  Afterwards, the Federal Reserve slashed rates so low and kept them there so long, that the housing bubble formed and kicked off the debt crisis.  Now global central banks are printing trillions in an effort to get things back to normal.

However what is normal? Looking back, it seems that all I have experienced in financial markets is managed by interest rate setting central bankers. When do bond markets finally say "enough" and start selling (thus raising interest rates)?

Perhaps what I really need to answer is what would make me sell my bond mutual funds.  Quantitative easing 3?  More Congressional stimulus? More tax cuts without offsetting spending cuts?  Maybe even no spending cuts?  More government borrowing?

As it is late, I'm going to let these questions go unanswered though I have a bunch of thoughts swirling through my head.


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