My Diary 391--- DigestingFed Statement; Finding Market Bottom

My Diary 391 --- Digesting Fed Statement; Checking Credit Fundamentals; Finding Market Bottom; Testing Dollar & Commodity

March 20, 2008

Contrary to the market expectation of a 100bp rate cut, the Fed delivered only a 75bp cut with two dissents. The question is will such an aggressive rate cut work? It seems that the movements of stock prices and credit spreads before & after the Easter Holiday are the key signals of how successful the Fed cut appears…If asset prices tumble again, then the Fed has more to do or they may not able to do more……

Judged from the overnight global markets, the Fed does fail again and the “Two Man” (Goldman & Lehman) only cheered market for 24hours……after S&P500 (+4.2%) rallied the most in 5 years yesterday, US Stocks retreated (S&P -2.4%) due to plunging commodity prices (base metals -3%, gold -10%) and an insurer (Security Capital Assurance) tried to cancel $3.1bn protection on Merrill Lynch mortgage bonds. Else where, Euro area equities lost 1%, MSCI AxJ fell 1.3%. 1MWTI price slumped nearly +$7 to $102/bbl after the Energy Dep reported a dropped US fuel demand last week…Wow, Bears pay attention here …In the rates market, 2yr UST yield slid 14bp to 1.457 and 10yr decreased 15bp to 3.328 and the shape of yield curve is flattening due to falling long-term yields…Another bearish signal …O/N USD Libor fell 73bp to 2.65 and Fed Fund future is now pricing in 82% of 50bp cut on April 30. Currency wise, The YEN (99.15) regained versus the USD, while the Dollar held steady against the EUR (1.5597).

Overall, the consensus-beaten 1Q08 results from Lehman (81c/sh), Goldman ($3.23/sh), Morgan Stanley ($1.45/sh) clearly won't be the last of the write-downs for the broker/banking sector with commentaries from both houses suggesting of further US weakness and no light at the end of the tunnel……As a result, my best guess is any near-term equity rallies would be short-lived when markets recognize that broker/bank may well remain in the edge as US economic and mortgage data progressively worsens over coming months…

In short, the Fed's 75bp rate cut is neither here nor there for finding a permanent solution for the current cycle of credit unwinding and market distrust……With a wave of new economic data coming in, plus the substantial corrections among major asset classes, it is time to a full round fundamental health check……

Digesting the Fed Statement

The Fed’s Statement was short, citing weak growth and financial difficulties. The only surprise was that there were two dissenters --- Plosser and Fisher. Inflation front, the Fed said that – “inflation has been elevated, and some indicators of inflation expectations have risen, plus the Committee expects inflation to moderate in coming quarters” – this is something what has happened and should not be seen as the view of the Fed. Indeed, Inflation is still on uptrend as US core PPI (+0.5%) outpaced the analysts' expectations, the most since Nov2006. But as the economy slows, and employment conditions weaken, wage pressures and inflation expectations are likely to ease. In the other hand, the Fed Statement looks like to pain the US growth path as a deep “U-shaped” recovery as US consumers need to do now what US firms did 7yr ago --- spending less, saving more and getting their B/S in shape.

In the street, many private-sector economists think the economy is already in a recession, albeit a mild one for the moment as consumer spending has yet to fall and exports remain supportive of overall growth. But the signs are ominous for what Fed officials call an adverse "feedback loop" in which economic and market difficulties become self-feeding. Housing continued its nosedive as Feb building permits drop 7.8%, the biggest decline in 13yr, while single-family housing starts sink to 17yr low. MBA index (buy or refinance) fell 2.9% last week to 652, the lowest level of the year. Having said so, mortgage rates are mixed as 3-yr conventional FRM rates fallen about 20bp so far this week, but jumbo rates (7.12%) stay at their elevated level, pushing the spread to conventional mortgage rates to 139bp……This is a frustrating sign to Mr. Bernanke……

In addition, the back-to-back declines in employment, weak retail sales and a surprisingly large drop in factory output suggest that housing weakness is spreading to other sectors. Talking about US consumptions, some statistics may help explain the broad picture. Over the past 4 years, the amount of MEW was a staggering $1.8tn --- a number just under one-tenth of home prices at their peak. To put the $1.8tn in another perspective, it averaged $112bn per quarter over this period since 2003. When compares this figure with the recent US fiscal stimulus of $152bn, which was portrayed as being big, but in fact is only 1/3 bigger than the amount people took out of their homes to spend each quarter….

Bottom-line: 2008 US growth is likely on 0.5% to 1% range. I would expect FFR will go further 100bps because aggressive monetary policy is helping various economic entities to rebuilt their balance sheets and reducing the systemic risk. In terms of the yield curve, as the FFR has fallen, inflation gradually wane along with weaker growth, the yield curve would then flatten.

Checking the Credit Fundamentals

By cutting rates aggressively and quickly, it seems that the Fed views both weak growth and asset deflation as the biggest problems for the US economy. As a result, policymakers are working hard to bring down the risk premium in order to allow the benefit of falling Treasury yields to be transmitted to the corporate sector. With three of the five US brokers having reported so far, their better than expected results and sound liquidity metrics should boost investor confidence in the near term, due to the clarity around the sustainability of the US brokers. However, we’re still far from out of the woods from an asset quality perspective. Today, the OFHEO reduced the 30% surplus capital requirement of GSEs to 20%, effective immediately. This frees up about $3bn in capital at Fannie and Freddie, which will provide $200bn of immediate liquidity to the mortgage market, and allow the GSEs to purchase or guarantee about $2tn in mortgages this year…will this easing be able to stabilize the panicky markets?

Over the past two weeks, the Fed and other central banks (ECB) have intervened with overwhelming commitment to ensure a well functioning financial market. The Fed has backed up its massive step of orchestrating the take-out of Bear Stearns and instituting the Primary Dealer Credit Facility (PDCF) by moving to lower the Fed funds rate by 75bp to 2.25% on Tuesday. By so doing, they have managed to avoid massive counterparty failure and further asset devaluations. I think these strong signals from the Fed that it will not sit back and watch the economy or financial markets collapse will undoubtedly boost market confidence. But the ultimate question is whether central bankers have win the liquidity battle……The answer is Yes and No. The pull back in 2yr&10yr USSS from their peak of 111bp and 91bp (06Mar) does reflect an easing of the tight liquidity conditions. However, swap spreads in EU (2yr 06Mar +21bp) and UK (2yr +28bp) continue to drift wider, suggesting liquidity and funding remains challenging and concerns over European banks…..See the CS headline today, and I do believe the looming risks around European and UK banking system……Certainly, BOE and ECB should play their leaderships, if their homelands are facing a similar loss of confidence and liquidity squeeze in US.

Thus far, the market has been unable to sustain a tightening spread on any Fed action and the question remains will this time be any different or have we reached an inflection point for liquidity? Over the past few days, credit indices continue to be volatile with positive responses to better than expected broker earnings, the cut to the Fed funds rate and the quick resolution of the Bear Stearns situation. CDS Spreads have narrowed with iTraxx IG at 177bp (-40bp) and HY at 563bp (-77bp). However, overnight iTraxx IG AxJ rose 5bp to 186. I think the focus remains on the deteriorating macroeconomic backdrop and its impact on credit fundamentals and ultimately spread performance.

Finding the Market Bottom

From the macro point of view, the on-going deleveraging is a highly unpredictable process and a hanging-over question is how far we are approaching the bottom of stock market. I think several recent market events and indicators are helpful to unravel this difficult question --- 1) the serious liquidity crisis associated with Bear Sterns is a strong indication that deleveraging remains very powerful. Judging from the credit spreads, illiquidity is still the big problem facing financial institutions, and banks are being forced to shrink their balance sheets; 2) the root cause of recent financial crisis is still the decline of US housing price. Judging from the recent housing related data (you name it), there is no sign that housing sector will stop from falling in the near term. Time seems to be the only cure; 3) historically, rising oil and industrial commodity prices are big draggers for stocks price, which may add a few % downside to the market …… Thus, global stock markets will continue to be highly unstable and calling the absolute low is a tricky practice……

Having said so, today HSI test the low of 21000 for a few times and volumes decelerated toward PM session. Chinese corporate earnings are largely positive with Li Ning+60%, CM+32%, BoCOM+65%, QQ +47%, PingAn+1.4X, CMB+1.2X and Alibaba+3X…The results may add some power to the “decoupling” camp...... In addition, HK banks have followed the Fed and cut the prime and savings rate by 50bps, implying I will earn nothing from banks……Better than putting it in stock market these days…Near term, it is probably unrealistic to expect HK stocks to advance, when S&P remains jittery and when HK sentiment has not approached extremely pessimistic as analysts just start to aggressively downgrade earnings. Historically, stocks have tended to perform poorly until de-rating well advanced.

A-shares had a strong intra-day from -6% to +3% due to a rumor that stamp duty tax could be cut to 0.2% from 0.3% and pilot program of margin trading could also be launched. So far, market valuation has corrected 40% over the past 5 months and is now m at 21X08PE based on consensus earnings. So far, nobody thinks that China's economic growth trend has fundamentally changed……liquidity, market sentiment and corporate earnings quality are the three near-term concerns.

Testing the Dollar and Commodity

Yes, the worst is not over as US Dollar has fallen sharply against the EUR (1.5746 now) and YEN (98.31) by yesterday. Market is forecasting the US Dollar may fall to 92 YEN and 1.60EUR in one month…With USD plunging to multi-decade lows, the same “bottom-looking” question emerges. Here I summarized a few points I noted over the past few days --- 1) the most obvious one is the need for US credit markets to resume their proper function, so that the Fed will not reflate the economy "at all costs"; 2) the expectation of US economic growth needs to stabilize as consensus views of the economy have plunged along with confidence and house prices; 3) technicals may offer some support, as has been the case throughout the past 6 years…. Actually, I am seeing it now in the BBG….YEN=100, EUR=1.5449…

To the Commodities, the instinct response to the takeover of Bear Stearns was to liquidate speculative positions amid fear of margin calls…but the sell-off yesterday was clearly the result of a slowing economic growth and USD recovery. Gold and oil prices fell by 6% and 5.7% respectively. Most of the key LME base metals like copper, zinc and aluminum have also dropped 5% to 8%. YTD, growth for the metals was 2% to 21% and the strength in price was primarily driven by strong demand from China and a string of supply disruptions, i.e. port congestion in Australia, extended rainy season in Indonesia and the snowstorm in China. Going forward, such a cyclical sector with high price is likely to be challenged by a weakening in global economy and demand. Yes, China’s importance as a major consumer of commodities cannot be underestimated as demand has been growing at more than 1.5X GDP growth…… the on-going supply constraints, and low inventory levels will remain the two fundamental underpinning factors, plus a dollar-bearish prospect……

Good night, my dear friends!