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So Much for the January Effect!

One month ago, I wrote a piece explaining that January has historically been a month of strong returns in the European and US high yield markets – see here. (At this point I’d like to add that I was pointing out a statistical anomaly, and was not predicting a January rally – I concluded that the high yield markets were still not pricing in the risk of recession!).

January was a shocker. European high yield fell by 4.6%, the worst month since July 2002. This is particularly alarming considering that there weren’t actually any defaults. Meanwhile the US high yield market fell by a more modest 1.4%, not as bad as last November, but still the worst January since 1990.

Much of the weakness in high yield can be attributed to the sharp falls in equities, because the two markets are fairly closely correlated. The DAX fell by 15% in January, while the S&P 500 fell by 6%. The underperformance of the DAX no doubt has something to do with the underperformance of European high yield.


European underperformance was probably also due to the European high yield market having got slightly out of synch with the US in 2006-07. As the chart shows (click chart to enlarge), US and European high yield spreads have historically tracked eachother very closely. In 2006-07, however, US high yield spreads crept above European high yield spreads, and the European high yield market had a bit of catching up to do.

Sentiment in the high yield market remains poor, and the lack of risk appetite and the drop in demand for high yield bonds has meant that there has not been any issuance in the European high yield market for six months on the trot. However, European BB rated bonds now yield 5.5% over government bonds, and having contended for some time that high yield was an expensive asset class, I believe we have now reached levels that can be described as fair (or dare I say it, ‘attractive’) value.


Monoline insurers – what’s going on?

Monoline insurers have become a very hot topic, and worries about their demise have made financial markets very jumpy. MBIA, the world’s largest monoline insurer, yesterday posted a Q4 loss of $2.3bn. Ambac, the second biggest monoline insurer, posted a Q4 loss of $3.3bn last week, and Fitch ratings agency reacted to cutting Ambac’s credit rating from AAA to AA (this is a very significant event – see below). Before explaining what’s going on with monoline insurers, it’s worth explaining what monoline insurers actually do.

The first thing a monoline insurance company needs is a AAA rating (ratings agencies need to be convinced the company has a solid business model, cutting edge risk systems, and sufficient capital for the risks inherent in the business). Then, the monoline insurance company insures a bond holder against the risk of the bond defaulting. If the bond defaults, the monoline insurer continues to pay the coupons of the defaulted entity as if the bond had not defaulted. The monolines’ reward for taking this risk is that they receive a slice of the coupon or interest payments that the bond holder receives. The monoline’s guarantee means that the bond is now effectively AAA rated, even if it may only have been single-A rated originally.This process is called ‘ wrapping’.

Monolines started off by wrapping US municipal bonds, local authority bonds or single company bonds. Munis and local authority bonds are attractive to wrap, because they offer a premium over US treasuries (they’re not explicitly guaranteed by the US government, and are often rated A and BBB). But as the monoline industry got more competitive and corporate bond spreads tightened, most monolines became more aggressive. Rather than just focusing on quasi-government bonds, monolines started wrapping ever more exotic bonds, to the point that some monoline insurers began wrapping structured credit exposed to the crumbling US sub-prime mortgage market.

That is really how we have ended up where we are today, in a pretty perfect vicious circle: as structured finance deals are downgraded, their monoline backers have to write down losses and themselves get downgraded. The wrapped CDO holder is now really no better off than the unwrapped CDO holder (in fact he’s worse off, as he’s paid away an insurance premium to the monoline at every coupon date!)

Monolines very quickly need an injection of capital from somewhere, otherwise they will be downgraded. And if they are downgraded, their business models cease to function (some lower rated monolines do exist, but only by insuring junk bonds rather than AAA rated bonds – after all, who would buy insurance on a AAA rated wrap when the insurance company itself is only ‘A’ rated?).

If the monoline insurers collapse, then investment banks will be in even deeper trouble than they are today. Many investment banks have bought protection from the monolines so that they can hedge structured credit exposure on their own balance sheets in order to insulate themselves from making losses. But if the monolines go bust, then the investment banks are left with a worthless insurance contract, and a whole lot more exposure to structured credit and sub-prime.

It’s not just the investment banks that would be in trouble. Monolines guarantee about $2.4 trillion worth of bonds with their AAA rating, and if the monolines are downgraded, then hundreds of thousands of other bonds would be downgraded too. This would spark a wave of forced selling from investors such as pension funds, and then we would see (yet another) wave of writedowns from the investment banks.

Do we think that the monoline business model will return to its operating state prior to the current crisis? Absolutely not. They are too highly levered, they don’t have enough capital for a AAA rating, and they don’t have enough capital to provide sufficient protection to investors. Their reputations are in tatters. But will they be allowed to fail totally? We don’t think so, because there are plenty of bond holders that have a very clear motivation to ensure that the monolines don’t disappear. In a rather bizarre twist, it looks like the investment banks are going to have to club together and rescue the companies from which they’ve bought insurance. If you like analogies, it’s a bit like taking out insurance on your home, only to find that when your house burns down, you have to give the insurance company a load more money to stop it from going bust.


Housing market : Down down, deeper and down

The US housing market is getting worse and worse, and the UK looks set to follow it.

Yesterday saw the monthly update on the disaster that is the US housing market. Figures showed that the downturn is accelerating – the S&P/Case-Shiller Composite-20 Index showed that the US house prices fell 7.7% in the year to the end of last November. The S&P/Case-Shiller Composite-10 Index (which covers the 10 main US metropolitan markets and has a longer history – see graph) showed that house prices fell 8.4% in the year to the end of last November, the steepest fall since the index began in 1987. This is bad enough, but digging below the headline year-on-year numbers reveal a startling trend in the house prices. Taking the quarterly house price change, and annualising it, shows that the Composite-20 index fell 16.2%, while the composite-10 index fell 16.6%, which shows that the downward trend is quickly accelerating.

Then today we had the UK release of what I believe is perhaps the most important UK economic indicator, the number of mortgage approvals. We have discussed mortgage approvals numerous times on this blog (see here for our last comment), but it’s worth a brief recap. The housing market is the transmission mechanism for monetary policy – when the housing market is strong, the Bank of England increases interest rates to stop the economy from overheating. Higher interest rates slow the housing market, then consumer spending and economic growth both slow (both with a lag), then inflation falls (with a further lag), and finally unemployment starts rising as companies react to weaker growth by cutting costs. Any predictor of what’s happening to the housing market is therefore worth its weight in gold to figuring out what’s going to happen to the broader economy.

As you can see from this chart (click the chart to enlarge), today’s mortgage approvals number was shockingly bad. Since we last wrote about mortgage approvals we’ve made a slight adjustment to mortgage approvals, where we now adjust for the fact that the total UK housing stock has gradually increased over time. This makes recent mortgage approval data much more comparable to historical data, and improves the predictive powers of the mortgage approvals on the housing market. As you can see from the chart, the dramatic slump in mortgage approvals spells woe for UK home owners, and UK house prices look set to fall further over the next six months. The graph suggests that by the summer we’ll be seeing a year-on-year decline of around 5%.

What does a collapsing housing market mean for the central banks? It means that economic growth is set to fall very sharply. The US Federal Reserve is acutely aware of the risks, as a falling US housing market has always historically resulted in or coincided with recession. The Federal Reserve is being very active in slashing interest rates but the Bank of England has been slower to react, having cut rates only once so far. With UK rates at 5.5%, many rate cuts will surely follow. The Bank of England will not be maintaining the status quo.


US economy: hard landing or soft landing?

A stream of poor economic data and some horrendous writedowns from the big banks have meant that risky assets have been walloped. The iTraxx crossover has shot out from 340 to 470 since the start of the year, and most of the world’s equity markets are down between 10 and 15%.

The recent release that I’d like to focus on is last week’s Philly Fed number (or the Federal Reserve Bank of Philadelphia’s Business Outlook Survey, to give it its full name), which has been an excellent leading indicator of US growth going back 40 years. Prior to the announcement, market consensus had been for a reading of -1.0, a slight improvement on November’s -5.7. The market consensus got it very badly wrong though, and the Philly Fed number was actually -20.9, the weakest reading for six years. According to my chart (click to enlarge), a reading of -20.9 means a US growth rate of zero should follow.

Looking back over the 40 year history, the Philly Fed survey has only gone slightly wrong as a predictor on two occasions. The first was in Q2 1995, when confidence was dented by Mexico’s financial crisis, which coincided with the Federal Reserve hiking rates very aggressively (the Fed took rates from 3% to 6% from February 1994 to February 1995). The Federal Reserve averted a serious slowdown by cutting rates over the second half of 1995, and the US economy experienced a soft landing rather than a hard landing.

The only other wonky reading was in September 1998, which followed Russia’s default and the LTCM crisis. Although emerging market economies were in turmoil, the US economy was relatively unscathed, helped by the Fed cutting rates very rapidly from 5.5% in September 1998 to 4.75% in November 1998. Despite the financial mess at the time, though, the Philly Fed survey still only fell to -14.1, which is still quite a bit better than last week’s number.

The Fed has applied the usual dose of medicine to this crisis by cutting interest rates rapidly, but will it be enough to prevent a hard landing? I don’t think so. The financial crises of 1994-5 and 1998 came at a time when the US economy was already fairly strong, and it was able to withstand the shock. This financial crisis, however, has come at a time when growth was already weak, and the housing market was already falling. I think the Fed will continue cutting rates to avert recession, but I don’t think it will be enough.


Happy new year?!

In August I posted a comment explaining why the US unemployment rate was to climb sharply (see here) and this is now happening. On Friday it was announced that the US unemployment rate jumped to 5.0% in December, up from 4.7% in November and ahead of expectations of 4.8%. Non-farm payrolls only rose by 18 thousand, the weakest figure since August 2003. Equity markets have slumped 2% on the news and the high yield market has also sold off.

The fact that the US unemployment rate is now at a two year high has inevitably grabed the headlines, but it’s not actually the level of unemployment that matters, it’s the change in the unemployment rate.


The 'January Effect' – a boost for high yield?

The ‘January Effect‘ is a relatively well known stock market anomaly, whereby equities have historically performed better in January than in any other month of the year. Most explanations for the January effect focus on how tax-conscious investors sell stocks in December that are down for the calendar year, in order to write off losses against their capital gains. This behaviour pushes the prices of these poorly performing stocks lower, but bargain hunters then buy these artificially cheap stocks at the beginning of January, thus pushing their prices up. I suspect that this theory only goes some way to explaining the January effect, as it would suggest that stocks should do badly in December but this doesn’t seem to be the case.

Anyway, I thought I’d have a look at the US high yield bond market, and interestingly it tells a similar story. This chart (click to enlarge) shows that high yield bonds in the US have on average returned 1.7% in Januaries since 1987, half a percent ahead of the next best month. The same pattern can be seen in Europe, where Januaries have outperformed the next best month by 0.7% on average (although it’s harder to draw conclusions because European data only goes back to 1997). The tax explanation for the January effect makes less sense for high yield bonds, because individual investors don’t typically buy individual high yield bonds. What we’re probably seeing here is the fairly close correlation between high yield bonds and equities.

As readers of this blog will be aware, our view is that the high yield market is not pricing in the risk of recession right now (for example, see here). High yield has performed poorly over the past six months, and we’ve heard decidedly little from the rally monkey recently (this is something that a trader from an investment bank used to send to the market on a good day in order to get those animal spirits going). Will we be hearing a bit more from the monkey next month?

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Fed Monetary Policy game – "Fed Guru Reappointed"

Have a go at the Fed’s online monetary policy game (click here), where you take the role of Chairman Bernanke in setting rates in the face of a number of economic scenarios. I’ve just been reappointed as Fed Chairman thanks to my “solid” policies. The game seems to reward mimmicking the Fed’s past actions – success will come by marching interest rates to the top of the hill, then marching them all the way back down again.

On an unrelated note, a book recommendation. Tim Harford’s “The Undercover Economist” is a brilliant look at real world economics. Did you know, for example, that low end computer printers are often identical to the more expensive models, but have had a chip added to slow them down? He also explains why the secondhand car market is utterly disfunctional – imagine half the secondhand cars on the market are great runners (peaches) and half are bangers (lemons), but all look pretty much the same to an untrained eye. If a peach is worth £4000, and a lemon worth £1000, and the buyer can’t tell the difference, the “fair” average price is £2500. However, the seller can tell the difference, having already owned the car. If the seller has a peach, he won’t sell for £2500 as he knows that it’s worth £4000, not £2500. Thus the only cars that come onto the market are lemons – and if you buy a secondhand car, you are buying a lemon. This “inside” information distorts the efficient market for both buyer and seller. Plenty more interesting anecdotes covering everything from the economics of coffee shops, to the benefits of road pricing (“we recognise that food, clothes and housing cannot be free or we would quickly run out of them. It is because roads are free that we have run out of spare road space”).

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The Bond Vigilantes Christmas Quiz – the answers and the winners

Thank you for all your entries. The winner is Nick Tudball of BNP Paribas, with 19 out of 20. There was a tie for second and third, with James Mitchell of UBS and Sara Swinden (who I suspect sits near to Nick Tudball) of BNP Paribas, both on 17 out of 20. We had a draw for second place, and James won. The average score was 13.6. The highest M&G entry came from Sophie Gray in our marketing team. Prizes will be sent out shortly!

The answers are as follows:

1. What was hidden in the coffee beans in Beverley Hills Cop?
A surprising number of people – mainly our investment bank counterparties – said cocaine. It was in fact bearer bond certificates.

2. What is the largest single living organism in the UK, and is also the nickname of a Nottingham Forest player?
It’s the Major Oak, a giant tree in Sherwood Forest. It’s also the nickname of Wes Morgan, a stocky Forest defender.

3. Where would you find a creature whose hobby is collecting and polishing rocks, an airship, a tiny family with eight children and a red blanket?
"In the Night Garden", the brilliantly calming pre-bedtime BBC children’s programme.

4. Who covered "Stop me if you’ve heard this one before" by The Smiths and had a top ten hit earlier this year? And it’s NOWHERE NEAR AS GOOD as the original.
Mark Ronson (and the more geekish added "featuring Daniel Merriweather").

5. Name the TV show which has a beer in it with the same name as our telecoms analyst.
The Simpsons, and Duff Beer – our telecoms analyst is Simon Duff.

Northern Rock Crisis.

7. If this was a joke, how would you get two whales in a mini?
Down the M4 and across the Severn Bridge, or variations thereof.

8. In which book/film does Sherman McCoy trade Giscard bonds?
Tom Wolfe’s "Bonfire of the Vanities" – published in 1987. The Giscard Bond, issued by the French government, had coupons and maturity value linked to the French Franc value of a fixed weight of gold.

9. How does the gilt trader played by Paul McGann in the 80s thriller "Dealers" get to work every day?
In a seaplane which he landed on the Thames at Tower Bridge (it was the 1980s, crazy times).

 10. What’s this film?
 Anchorman: The Legend of Ron Burgundy.



11. Whose bond desk does Michael Lewis work on in "Liars Poker"?
Salomon Bros (now Citibank). Three trainspotters named the actual heads of desk that Michael Lewis worked for.

 12. Who is this? Neil Armstrong – first man on the  moon. Not Richard Woolnough, as one person submitted.

13. He had a Scottish father, and his mum was Swiss. Both died in a climbing accident. He studied oriental languages at Cambridge, and fought with the Navy in WWII. From then on we know much more about him. Who is he?
James Bond.

14. Which member of the M&G bond team has seen Big Daddy fight Giant Haystacks, live, not once but twice?
Richard Woolnough, manager of the M&G Optimal Income Fund, M&G Corporate Bond Fund and M&G Strategic Corporate Bond Fund, astronaut.

15. Which chef has got the most Michelin stars in total for his restaurants around the world?
Joel Robuchon with a total of 17 stars – he overtook Alain Ducasse and Gordon Ramsay with the recent publication of Michelin’s Japan guide.

16. Which of these gilts has the longer modified duration? Treasury 4 3/4% March 2020 or Treasury 8% June 2021?
The 2020 bond – although it’s shorter in maturity, its lower coupon extends its duration beyond that of the 2021 bond.

17. Which film’s climax revolves around the price of frozen orange juice futures?
Trading Places.

18. What did The Fall do 24 of, more than any other band?
The Fall recorded 24 "John Peel Sessions". David Gedge also has 24 sessions, but with different bands (Wedding Present, Cinerama).

19. M&G’s banking credit analyst represents Scotland at which sport?
Tamara Burnell represents Scotland at Korfball.

20. Who is the greatest football manager of all time, Brian Clough or Bill Shankly?
Brian Clough.


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Last chance to enter the Bond Vigilantes Christmas Quiz!

The closing date for entries is tomorrow – Friday 21st December – at 5 pm. Winners will be announced next week sometime, depending on how quickly we can get the entries marked – think of us as you tuck in to your Christmas lunch, we shall be in the office wading through sacks of quiz entries by candlelight. Bah.

You can find the quiz here. It is deliberately tricky, so the winning score won’t be 20. Email or fax us your entry. Good luck, and have a great Christmas.


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Stable conditions

‘Tis the season to be jolly, and is the time of year when I have the delights of seeing my children in the traditional nativity play. The story is familiar to all of us. At this time of year our thoughts also focus on the potential for giving, or in my children’s case, receiving gifts.

Quite appropriately in the financial world, the central banks want stable conditions (unlike Mary and Joseph, who would have rather been in the inn). The UK’s very own leading wise man, the appropriately named Mr King, provided Northern Rock with a further gift yesterday by roughly doubling the Bank of England’s commitment to £56 billion. The Northern Light continues to glow, albeit dimly.

One of the kings in the nativity brought the gift of gold. Our King’s recent promise to Northern Rock equates to roughly 39 tonnes of gold, but sadly the Bank of England has only around 31 tonnes of gold in its vaults.

The second king brought Frankincense, which is usually mixed with oils to anoint new born infants. Will our king manage to oversee the rebirth of Northern Rock? Can the company’s reputation be salvaged? Will Mr Branson’s virgin birth be delivered?

The third king brought myrrh, an embalming material traditionally used at funerals. Our King told the Treasury Select Committee yesterday that “a painful adjustment faces the global banking sector over the next few months as losses are revealed and new capital is raised to repair bank balance sheets”. I think that the effects of the credit crunch have much further to run – given that UBS (arguably the most cautious and reputation-obsessed investment bank) announced that it has lost $10bn on AAA-rated CDO exposure, you can be sure that the tidings to come from the banking sector will not be of comfort and joy.

Mr King is not the only wise man bearing gifts – the ECB have injected €350 billion worth of Euros into the system. The desire for a return to stability, peace and quiet is evident. But will the recent central bank activity and the season’s extra liquidity be remembered as a Christmas nativity, or will it be Christmas naivety?


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