C.M.O. 5.22.2009

Credit Market Overview
May 22, 2009

The telegraph was one of the earliest forms of long distance communication. Longer than you can ride and shout from horseback, send smoke signals or spend hoping the carrier pigeon doesn’t soak up any lead on his way back home.

Like “Coke” and “Xerox”, “telegraph” has also become a generic term to denote the indication of one’s intended motive. Think The Babe pointing towards the fence in the ’32 World Series, Joe Namath, who’s raised index finger has been copied in every set of team colors imaginable and how can we leave out the Three Stooges and Marx Brothers whose antics are so predictable it adds to the anticipation of the laugh to come.

The U.S. Government has been doing a little “telegraphing” itself as of late. Unfortunately, however, this one doesn’t end with somebody getting a ring or millions of people enjoying a hearty guffaw. It ends with higher interest rates, a lower Dollar and inflation well above a nickel and heading towards double figures.

Now, as with Joe and the Babe, certainty only comes after the fact and if the events of the last little while have taught us anything it is that things can change very quickly so this is no raised index finger and there is no pointing going on. (At least not yet, anyway.) More, just observations, like a set of directions with landmarks to watch out for. Some of which are beginning to appear, hence today’s topic.

There was a precipitous drop in the price of U.S Treasuries yesterday. It was caused, possibly, by the announcement that S&P had put the U.K. on negative credit watch. The connection the pundits were making is that the two economies are very similar and the crisis of confidence has been handled similarly in both economies so the issuance of massive amounts of debt (18% relative to GDP) by our friends across the pond is a premonition of what’s to come back here in the colonies.

Many people, including Milton Friedman in his book Money Mischief, predicted the consequences of using huge amounts of debt by the Government to cure economic problems such as the ones we are now experiencing and they, the consequences, look a lot like a devalued Dollar and inflation that begins to increase at an increasing rate.

The yield on the UST 10-year has been as high as ~5.25% going back to July of 2006 and June of 2007. It has also been down very close to 2% (January 2009) and yesterday closed at ~3.35%.

Financing for $1.197TN in congressionally approved spending plus additional government bond issuance brings the expected issuance total up to $2.1TN for 2009 according to Barclays Capital. This should be compared to $880 in 2008.

Besides the increased issuance you must also consider the Fed’s quantitative easing strategy or more easily put; robbing Peter to pay Paul. We are now buying debt at relatively high prices when there is an awful lot of “telegraphing” going on that rates are headed up and not down.

Since, as we all know, the price/yield relationship in bonds, owning Treasuries doesn’t appear to be the smartest trade at the moment. Sean Kelleher, a partner at JGC Management over there in “Joisey” estimates that the Trillion dollars worth of debt the Fed now owns could become 2TN in fairly short order. A 1% increase rates on that amount could cost you and me about $140BN in price depreciation.

And we don’t even get the right-off!

Happy Memorial Day weekend! See ya Tuesday!

Jim Delaney