Bond Indigestion Makes Markets Belch

Investors have been gorging on Treasuries and other bonds lately as they flee the risk of equities. They may have had all they can stomach, if the latest German bond auction is any indication:

A German sovereign bond auction failed on Wednesday as investors shunned one of the most liquid and safe assets in the world in a warning for governments seeking to raise record amounts of debt to stimulate slowing economies.

The fate of the first eurozone bond auction of 2009 signals trouble ahead as governments around the world hope to issue an estimated $3,000bn in debt this year, three times more than in 2008.

There will be more bond auction failures this year, perhaps even an unprecedented one in the market for U.S. Treasuries. Our Chinese creditors are getting tired of risking their domestic stability to feed Uncle Sam's profligacy:

China has bought more than $1 trillion of American debt, but as the global downturn has intensified, Beijing is starting to keep more of its money at home, a move that could have painful effects for American borrowers.

Would the American people even notice if the U.S. government failed to clear a Treasury auction? Not if Helicopter Ben has any say in the matter. The multi-acronymic lending facilities that the Fed has created to print money can easily be used to clean up a government bond auction in the event of a panicked call from the Treasury Department. Once that precedent is set, it can and will be used more frequently as other foreign central banks opt to spend currency reserves at home. That's how the U.S. dollar will be debased in 2009.

I remain long gold. Now you know why.

The Haiku of Finance for 01/07/09

Small business layoffs
The economy's backbone
Gets even weaker

Small Biz Feels Pinch While Big Biz Pinches Pensions

Job losses have disappointed even the most pessimistic observers:

The battered U.S. job market may be losing one of its last remaining sources of strength as small businesses begin aggressively cutting payrolls in the face of a dismal holiday shopping season.

A report on Wednesday showed private sector job losses of 693,000 in December, far greater than economists had expected. Small businesses accounted for an unusually large 40 percent of the decline, according to the figures from ADP Employer Services and Macroeconomic Advisers.

Small businesses (and small-cap publicly held companies) are usually the last to report the results of an economic downturn and the first to show signs of life in an upturn. That's because they have a lot more flexibility in decisionmaking on pricing, ordering, and hiring or firing people. The news that small biz is just now beginning to react to a recession that is over a year old signals that they've absorbed as much pain from declining earnings as they can stand and will have to seriously cut costs, starting with employee headcount. The economy has a lot farther to fall.

Oh, by the way, when the economy does recover, fixed-income retirees (Baby Boomers who didn't save) risk having a lot less spending power:

Volatile markets have saddled U.S. companies with a $409 billion deficit on pension plans, reversing a $60 billion surplus a year earlier, and will cut into earnings in 2009, consulting firm Mercer said.
(snip)

The shortfall suggests that more companies will have to pump cash into their pension plans to ensure they can meet their commitments to retirees.

The article notes that the pension plan deficits will negatively affect corporate balance sheets. I'm sure they will also have to impact income statements as cash is diverted from other uses to fund the plans. Companies are now faced with the unpleasant choice of cutting pension benefits or funding plans to the point where their business prospects (and thus future share prices) are decimated. Say goodbye to earnings growth!

No wonder the markets finally dropped today. Investors will hopefully start shedding the optimistic sentiments they've been harboring since Christmas. When they've finally capitulated, I'll be ready to buy.

Nota bene: Anthony J. Alfidi has uncovered short calls on SPY and IWM in anticipation of further declines in price.

The Haiku of Finance for 01/06/09

Merger arbs tempt me
Just pick the right strategy
And keep playing them

New Year's Resolutions on Special Situation Investing

I don't normally make personal New Year's Resolutions, but in my capacity as a business leader I can apply some to my company.

This is turning out to be another not-so-great month for the Alpha-D's special situations options plays. Today I closed out my short calls on WB (now WFC), MER (now BAC), AW (now RSG), and APPX (now contingent rights APCVZ, plus ABII). The plays on the two financial stocks made me some money, but the garbage hauler and the drug maker cost me quite a bit. The risk premia on the latter two were actually increasing rather than declining as their expiration dates approached. I would have been left with the unfavorable option of converting the holdings to a buy-write strategy by going long the underlying stock. My problem with that is that I simply don't know the waste management or pharmaceutical industries well enough to publish covered research on their stocks, so I decided to close out the options at losses rather than take on more enterprise risk.

So should I give up M&A action? Heck no! There's too much easy money on that table for me to walk away. I've learned my lessons:

1. I will only write uncovered calls on M+A targets that are purchased in all-cash offers. I really bought myself some trouble when the APPX options transformed into contingent rights that were hard for me to value in terms of cash flow, book value, or anything else.

2. I will consider going long the target stock in all cash offers. I missed out on some money to be made on other plays I executed well in 2008 (Budweiser) by not buying the target firm.

3. I will consider going short the acquirer in both cash and stock deals. This is one way I could have made some money on the two losing plays above. Shorting acquirers (or selling uncovered calls) is a way to participate in merger arbitrage without exposing myself to the converted options of the target firms in all-stock or cash-stock deals. Of course, taking a position in the acquirer brings its own risk that the acquirer's share price could increase. "There are no solutions, only changed problems." My old MBA professor's wisdom is never far away.

I therefore resolve to be more diligent with Alfidi Capital's special situation investing for 2009. You can read my elaboration of all of my lessons learned in my upcoming annual report for 2008. You'll be able to find it on the Alfidi Capital main site by the end of January.

The Haiku of Finance for 01/05/09

Asian market bonds
CDS bets turn bearish
Waiting to bottom

Bad Bond News in Asia

Markets are discounting Asian governments' efforts to stimulate their way back to prosperity:

The Markit iTraxx Japan index of credit-default swaps, the benchmark gauge of 50 investment-grade companies including All Nippon Airways Co. and Japan Tobacco Inc., rose 9 basis points to 276 at 10:39 a.m. in Tokyo, according to BNP Paribas SA prices. Benchmarks in Asia outside Japan and Australia also rose, indicating strengthening perceptions that companies may default on their debt.

Institutional bond investors are hedging the chance that their Asian corporate bonds are exposed to default risk. Not all bond investors are so fretful. Some appear to be regaining their risk appetite and seeking out higher yields in emerging markets (near bottom of this article):

Emerging-market bonds are starting to draw investors. The extra yield they demand to own the debt instead of Treasuries fell to 6.94 percentage points from 8.62 percentage points in October, according to JPMorgan’s EMBI+ Index.

Of course, not all emerging market bonds are issued by Asian companies. I'm not long Asian bonds, so CDS hedging and yield chases don't immediately concern me. What does interest me is that bearish bets on higher-yielding bonds indicate pessimism on corporate earnings in Asia and other emerging markets. This strengthens my bearish outlook for emerging market equities, so I will continue to wait for further declines in VWO before going long.

Nota bene: Anthony J. Alfidi is long FXI with covered calls. He is short uncovered calls on VWO.

The Haiku of Finance for 01/04/09

First full trading week
Bad news releases coming
Here comes next leg down

The Haiku of Finance for 01/03/09

Go from ZIRP to NIRP
Fed churns out more quant easing
Pump up bond bubbles

How Low Can the Fed Go? All the Way to NIRP

Fed leaders are signalling their willingness to further shred the value of the U.S. dollar and investors' money market accounts through more quantitative easing:

A grim economic outlook highlights the need for the Federal Reserve to step up quantitative measures to boost growth, with official interest rates already effectively at zero, Charles Evans, president of the Chicago Fed, said on Saturday.

Evans said that based on the outlook for rising unemployment, falling industrial production and a wider output gap, economic models suggest rates should be below zero.

However, there is some dissension in the Fed's ranks. Another Fedster thinks it wise to hedge bets and prepare to address the inflationary future that the Fed's policies have made very likely:

Setting an explicit inflation target would help the U.S. Federal Reserve keep deflation at bay now that interest rates have been cut to almost zero, a top central banker said on Saturday.

"Now would be a particularly good time to do that because you have this possibility of expectations drifting off to deflation or a lot of inflation," James Bullard, president of the St Louis Federal Reserve Bank, told a panel discussion during the annual meeting of the American Economics Association.

Nowhere in the article does Mr. Bullard say the Fed should actually curtail its quant easing. He seems to say the Fed should take stronger steps to "signal" its concern about inflation, as if somehow the economy's deflationary output decline can do the Fed's inflation-fighting work all by itself. The risk in whistling past the graveyard like this is that one may not know where the graveyard ends. Combining quant easing with declining goods availability actually widens the graveyard, so the Fed's governors will need all the lungpower they can muster.

I'm not the only independent observer who thinks the Fed has risked the health of both its balance sheet and the U.S. dollar on a wild macroeconomic experiment:

The Federal Reserve has embarked on a campaign of unsupervised industrial policy to end the country's financial crisis, a move that could undermine its independence, a former top U.S. official said on Saturday.

John Taylor, who was under secretary of treasury for international affairs from 2001 to 2005, said the explosive growth of the Fed's balance sheet since September was "unbelievable."

Unfortunately, Helicopter Ben is flying at full speed and has no time to read those kinds of warnings. Now that the U.S. has won the central bankers' race to ZIRP, the next race will be about NIRP: Negative Interest Rate Policy.

It's no longer a question of whether the Fed will pursue negative real rates. That die is cast. The bond bubble thus has further to run, at least a quarter or two. After that, serious inflation will be baked in to the U.S. economy and gold will be a very attractive alternative to the dollar.

Full disclosure: I'm long IAU and GDX but not GLD. I'm seriously considering buying more of IAU and GDX, or even selling puts against GLD (which now has a much deeper option chain than IAU).

The Haiku of Finance for 01/02/09

Loss of confidence
Treasury pumps zombie cash
Taxpayer will bleed

More Dead Banks to be Re-Animated

In the 1980s, the horror movie Re-Animator portrayed a mad scientist obsessed with bringing dead bodies back to life. Today the real-life mad scientists in the U.S. Treasury Department have performed that feat with companies like AIG and Citigroup that should by any account be dead.

The Treasury Department is making plans to do this over and over again:

Treasury said participation by other companies in such a program would be weighed on a case-by-case basis. Treasury said it would consider, among other things, whether the "destabilization" of a financial institution could threaten the viability of creditors and others. It also would weigh the extent to which the institution faced a loss of confidence because of the troubled assets it held.

In other words, when the next wave of defaults hits option-ARMs and prime mortgages, every major bank in America will be "destabilized" and face a "loss of confidence." Last fall's solvency crunch will play itself out all over again by the end of 2Q09.

Can I make money from dead banks? I did in 2008! Maybe it's time for to make some short plays on XLF again. I'll let you know if I decide to re-animate this strategy later this month. It's not dead yet, and I could make some killer profits. I hope I haven't bored you to death with my puns.

The Limerick of Finance for 01/01/09

Bank stocks that get merged go away
But their options may very well stay
I can handle the choice
Without raising my voice
That I may end up having to pay

The Haiku of Finance for 01/01/09

All-stock deals have closed
So what happens to options?
Sometimes they're still here

Mother Merrill and Wobbly Wachovia Finally Gone

Merrill Lynch and Wachovia have completed their scheduled disappearance into the annals of brokerage and banking:

Bank of America Corp. said Thursday it has completed its $19.4 billion all-stock purchase of Merrill Lynch & Co., while Wells Fargo & Co. said it has completed its $12.7 billion all-stock purchase of Wachovia Corp.

I still hold some uncovered short calls on both of these collapsed institutions. It remains to be seen whether the options will be erased or converted to options on Bank of America and Wells Fargo. These are all-stock deals, so I may see some legacy exposure. We shall see in the next few days.