Hugh Hendry December Commentary

Mr. Hugh Hendry's December commentary has been floating around the internet for a few days and I thought I'd share it with my loyal readers.  As always his letters are an interesting read, seamlessly combining the literary and financial.

Hugh Hendry / Ecletica Fund December 2010 commentary





His main thrust is the monetary stimulus by central bankers is not enough to outweigh the massive consumer deleveraging going on right now.  It is an epic tug of war and Hugh Hendry is on the side of further deleveraging and deflation (for now)  Please read.

ht: ZeroHedge

Inflation update

With the recent rise in interest rates I thought revisiting inflation rates would be helpful.

3 data series on this graph [click to enlarge]:
Blue for total Consumer Price Index (CPI) aka 'inflation'
Red for inflation minus (food and energy)
Green for housing subset

Notice how overall inflation tends to peak at the onset of a recession.
Headline inflation is still very low overall at near 1%
Housing inflation is still negative.
Inflation less food and energy is at a low for this timeline and is trending down.  Yes, we all need to eat and consume energy but both of those items are extremely volatile and stripping them out of the data series can provide additional useful information.

China comes to mind when people speak about energy and food inflation and like almost every other basic commodity the Middle Kingdom overshadows other negative factors such as Europe's continuing austerity drive and our own tepid domestic growth.  To me it appears whichever way China goes the energy, food, metals, etc. complex will follow.

Consumer credit update

Consumer credit data was recently released and the deleveraging continues.  This time I've shown the change in consumer credit over the entire data series so one can see how infrequently consumer credit declines.

The rate of decline is turning around, or so it seems.

This next graph shows a slightly different story (Thanks to @dafowc of declineandfallofwesterncivilization.blogspot.com)

Remove lending by Sallie Mae and the Federal government and the rate of decline has not been arrested.  Furthermore you can see this is a new phenomenon.

Very curious . . .  

More thoughts on the muni market

My previous post on the muni market needed some more information.  (Ready, Fire, Aim)
Bond Girl over at self-evident.org highlights some recent events which most likely were the catalyst for the most recent downdraft in the muni market.

The pending expiration of the Build America Bond (BAB) program has pulled supply forward, and this is going to seesaw over the next several weeks.  Since the BAB program was initiated, most issuers have structured their new issues with the sense that they will go to either the tax-exempt or taxable market, whichever is more advantageous at the time. . . 

What is going on now is that muni issuers are scrambling to get deals done to take advantage of the program before it expires, and this is pulling the number of new issues that would ordinarily be coming to market forward.  So the looming expiration of the BAB program is creating the very conditions it was created to alleviate.

I suggest reading the entire article for some additional info on the current situation. As I mentioned in my previous post  it is unusual for muni bonds to trade at a higher yield to treasuries as the muni's have a tax benefit.  The current situation is unusual and bears further attention.

Some perspective on the muni bond market

There's been some recent news regarding how municipal bond prices are dropping and California is having some problems selling new muni debt.  Looking back one can see the relative drop in municipal bond prices is not new and its been going on since May.

Observing the ratio of the etf's MUB (nationwide muni bond fund) to IEF (7-10 year US Treasury bond fund) can be instructive as it shows the relative value of two bond funds with almost the same duration (7.58 vs 7.26)

The relative decline in MUB is more dramatic when observed in this fashion versus an absolute basis. Furthermore looking at each etf's yield is interesting:
MUB 12 month yield: 3.71%
IEF 12 month yield: 3.00%
In other words a tax free bond fund is yielding 71 basis points more than a treasury fund with the same interest rate risk.  This 'shouldn't be' as muni bonds are tax free and a safe investment, right?  The markets are telling you something here; the perceived credit risk of muni bonds is increasing.

Source:
Stockcharts MUB:IEF
etf MUB home page
etf IEF home page

edit:  I have a followup post to this entry which you should read as well.

The flogging will continue until morale improves

The Federal Reserve recently announced they will purchase another 600 Billion in US Treasury bonds (commonly called Quantitative Easing 2 or QE2)  I am working on a longer email regarding how our current financial situation is very different from previous recessions and recoveries but the Federal Reserve's QE 2 announcement deserved some commentary. 

The markets did not really respond until after reading Fed Chairman Ben Bernanke's article in the Washington Post on November 4:

For example, lower mortgage rates will make housing more affordable and allow more homeowners to refinance. Lower corporate bond rates will encourage investment. And higher stock prices will boost consumer wealth and help increase confidence, which can also spur spending.

In short Fed Chairman Ben Bernanke wants higher stock prices so you'll feel better about yourself and go buy more stuff.  
Will it work?  
I have my serious doubts (as I'll expand upon in later emails).   The banks already have so much unused money they deposit the excess at the Federal Reserve. (973 billion as of October 10)  How is another 600 billion going to change the situation? 

So why is the Fed printing? Because they can and they feel like they can't do anything else. It looks like an easy painless solution but in the long term it will not fix the problem of too much debt in America. 

The problem with QE2 is the money being created is not going where Mr. Bernanke would like it to, the real US economy.  If you look at the market's reaction before and after the announcement one sees the money shifting into commodities and emerging economies while simultaneously weakening the US dollar.   The Fed is taking the easy way out by attempting to prop up and paper over our structural problems.

Lest you think this is merely the ranting of a crazed financial advisor former Federal Reserve Chairman Paul Volcker stated the QE2 plan won't help much as well: (Yahoo, November 5, 2010)

Volcker told a business audience in Seoul that the Fed's bond plan is obviously an attempt to spur the U.S. economy but "is not the kind of action that's likely to change the general picture that I've described as slow and labored recovery over a period of time."

The Wall Street Journal (November 4, 2010) expresses caution as well:

The Fed is essentially lending enough money to the government to fund its operations for several months, something called "monetizing the debt."

In normal times, this is one of the great taboos of central banking because it is seen as a step toward spiraling inflation and because it risks encouraging reckless government spending.

Financial markets Thursday responded warmly to the Fed move, but outspoken critics of the policy issued full-throated critiques.

"It is doubtful the Fed decision will produce any results," Brazilian Finance Minister Guido Mantega told reporters following a cabinet meeting with Brazilian President Luiz Inacio Lula da Silva. Officials in Brazil, which averaged 850% annual inflation in the 1990s, have been critical of the Fed's easy-money policies because they are spurring price pressures abroad and could encourage new asset bubbles outside the U.S.

If all else fails, keep doing what you did before seems to be the rule at the Federal Reserve.  By his actions Ben Bernanke is attempting to artificially raise asset prices and reduce the value of the dollar.  We shall see if he is sucessful, but what happens when the crutch of QE money is removed? 

Hugh Hendry Watch -- October 28 on BBC

Hedge fund manager Hugh Hendry was recently on the BBC.  While his comments are directed towards the British economic situation they are very relevant to the situation in America.  Watch the entire clip.




Youtube link

ht InfectiousGreed