Issue 90 - July 8, 2013


Half Time 2013

The second quarter of 2013 was a tale of two seasons. April and May witnessed continued economic improvement and coincident performance gains across many asset classes. However, with the June 19th Federal Reserve announcement that the future path of open market securities purchases would be “Data Dependent”, global markets reacted in a sharply negative fashion. Chairman Ben Bernanke may have thought he was simply stating the obvious; that the extraordinary measures of “Quantitative Easing” policy would not continue indefinitely. Markets, nonetheless, behaved as if he had ended the policy and raised the benchmark rate in one fell swoop. US 10 year notes finished June by rising 90 basis points from 1.60% to 2.50% while the S&P dropped 4%. Why did markets interpret his comments in such a negative manner? We alluded to this in our previous newsletter when we noted,

The market had been assuming that when the Federal Reserve would begin to reduce or “taper” purchases, whenever that might be, that this would be a one way trend. It would be well telegraphed and anticipated. This is the “Greenspan” way.

However, while the markets may have presumed that the one way tapering is a “fait accompli”, we might respectfully suggest that the view from ground level has many of the necessary but not all of the sufficient ingredients for such a widely held view. Recall that many of these one way pundits are the folks who brought us “green shoots” in 2009 and who have kept their bond investors buried in the short end of the yield curve for over four years; the opportunity cost of which will not be remedied even with this recent rise in rates. Improving housing and auto sales as well as the steadily evolving energy picture do augur for better domestic economics. However, the current pace of GDP and inflation remain well below specified targets and if the Fed is to be believed, then the data not the calendar will drive both the pace and direction of any changes to their policies.

The current round of “Quantitative Easing” is known as QE3, and was established back in September of 2012. At that time, the Federal Reserve added $40 billion of open market purchases of mortgage backed securities to its $45 billion run rate of US Treasury purchases. Analysts such as David Rosenberg have posited that in this last round, the addition of the mortgage securities was really an insurance policy to offset any potential impacts of the Fiscal Cliff or Sequestration. As the economy has weathered these events, the committee may well feel that they are in a reasonable position to begin the process of returning to their previous policy. However, that policy still included a 0% benchmark rate and $45 billion of purchases making it a far cry form the “Cold Turkey” policy the market has been recently pricing in.

Shape of Things to Come

Interest rates do not trade in isolation. Rates simply do not go higher or lower in lock step. There is also the matter of which rates the pundits are specifically referencing when they confidently predict “higher rates”? Are they talking about short term rates or long term rates; treasuries, mortgages, municipals, or high yield? (They may not really care – many “pundits” are stock analysts and hating bonds all the time allows them to claim that they are “pragmatic” rather than permanent bulls.) Let’s consider then what might lie ahead for municipal bonds if the economy continues to improve at its current pace.

The yield curve as defined by the series of US Treasuries from 1 month to 30 years is living and dynamic. All other interest bearing securities trade off of the yield curve and those spreads are as variable as the curve itself. Supply and demand of various products give the bond market multiple dimensions. If we look back over the past decade, we can see immediately that the Yield Curve has had a number of different shapes even during the period of zero benchmark rates since December of 2008.

In addition, you can see that municipal spreads have varied tremendously during this time. The net effect of the different curves combined with the various spreads have given longer term municipal bonds a relatively healthy yield over the period. That is to say that when longer US Treasury rates traded at lower absolute levels, municipals traded at wider spreads and when the longer US Treasury rates traded at higher absolute levels, these spreads compressed.

Much of the current debate on bond rates in general focuses on the total return of these securities rather than the income and long term capital preservation qualities of these securities. First, this is very much an institutional perspective where taxes play no role. Individual investors, who have earned coupons of 4% and upwards tax free for these many years, will continue to earn their 4% and upwards despite the trading prices of their bonds. Short term total return gains are fully taxable at 40%+. The impact of taxable gains dramatically reduces the benefits of the tax free income. Secondly, advisors who attempt to immunize “their” assets under management from variations in bond prices do no service to their clients as they inevitably invest for them in short term instruments which provide very little in the way of income. Finally, in constructing modern day bond ladders by beginning with longer term bonds that roll down the yield curve, our clients now own bonds of various maturities while having enjoyed much higher and stable incomes. As bonds mature or are called, these proceeds can be reinvested at the higher rates we are currently seeing. We should also note that the income component has allowed our clients to take a longer term investment view and to act opportunistically over these past years.

The Path Forward for Detroit

Credit markets are constantly evolving and no market more so at this time than municipals. On March 25th, Michigan’s Governor, Rick Snyder, appointed Kevin Orr to act as Detroit’s Emergency Financial Manager. Mr. Orr is an accomplished bankruptcy attorney having most recently worked for Jones Day in Washington DC. He is familiar with matters in Michigan, from his background as a Michigan Wolverine Alumni and as part of the team representing Chrysler in its proceedings in 2009. On June 15th, he suspended payments on $2 billion of unsecured debt, making Detroit the most populous city to default since Cleveland in 1978. Detroit’s challenges had been acknowledged if not completely quantified for some time. The city of 700,000 had a population of more than 1.8 million in 1950. It has lost a quarter of its population and 40% of its tax receipts since 2000. The extreme financial stress that Detroit is now under will invariably test a number of widely held municipal tenets; among them what is the value of taxing authority without a sufficient tax base?

Detroit has some $20 billion in long term liabilities of which over $11 billion is unsecured. Of this, $9 billion is owed to retirees in healthcare and pension benefits. Of the balance, the outstanding “Unlimited Tax General Obligations” were included. This is of great interest to the bond market as these bonds have traditionally been viewed as some of the safest given the taxing authority and yet Mr. Orr has offered only 10 cents on the dollar to the holders of these bonds in his initial negotiation. There is simply not the tax base to service let alone repay these debts.

The $5.3 billion in secured debts which include the essential service water and sewer bonds will continue to pay as their respective revenue streams are dedicated. In addition, bond insurers have underwritten polices on over $8.5 billion of both secured and unsecured bonds. Three of the six underwriters have already stated their intention to make any timely payments of interest and principal as necessary. The remaining firms are working on terms that will allow them to make payments along slightly altered schedules.

The implications of Detroit’s process for municipal investors will be far reaching. To the extent that bond holders are treated per their contractual expectations; this would be a strong affirmation. The elephant in this living room just as it is in Stockton and San Bernardino is the retiree element. If there is not a tax base to support these legacy costs, how can they ever be serviced? There are simply not enough current costs or other debt service to cut in order to square these circles. Hopefully Mr. Orr will be able to use his considerable skill to negotiate a path forward for Detroit and all of its constituencies.

Second Half Outlook

With the recent back up in rates, tax free municipal bonds can once again be purchased for yields above 4%. This is due in large part to haphazard selling which hit the bond market as a result of the Federal Reserve’s recent comments. Investment firms such as Pimco saw tremendous outflows and the market is still in the process of digesting the entire inventory that came up for sale. Dislocations such as these are typically good buying opportunities as in addition to higher rates, we tend to also see many unique high quality issuers whose bonds might have been initially been sold to just one buyer.

On the equity side we have seen markets pull back from the highs in May. However, double digit year to date returns remain in domestic markets. With less pushing from the Federal Reserve potentially in the wings, markets will naturally become more attune to upcoming earnings reports. This is a positive development. Whatever the attribution of the committee’s policies on equity markets, corporate earnings have not received the attention they deserve. Now, Jim Bianco for instance, will argue that the earnings have not been that great to warrant current multiples and that economy really only deserves a “Gentleman’s C”. But his view discounts or dismisses the improvements in the quality of the earnings and the tremendous improvement in balance sheets. Translation: a little more organic economic pulling will have powerful bottom line implications. For example, we are now back to auto sales numbers that rival pre-crisis levels. Jim would say big deal. But the big deal difference is that car companies used to break even at these levels and now they break even with some 25% less in sales. This phenomenon is not exclusive to the auto companies. Many industries have developed efficiencies only dreamt of four or five years ago.

As always, we will be attentive to changes and opportunities as the quarter unfolds. We look forward to seeing many of you in the coming weeks.

Best Wishes,

Jen & Patsy


In this Edition

  • Half Time 2013
  • Shape of Things to Come
  • The Path Forward for Detroit
  • Second Half Outlook

Huntington Steele

925 4th Avenue
Suite 3700
Seattle, WA 98104



Past Issues

89 - 05.31.13
Strong Hands/ #1 The New Federal Funds/ #2 Income as a Commodity/ #3 New Buyers, Fewer Markets, New Terms/ #4 Changing Demands for Leverage/ Measuring Our Multi Speed World with a 12 inch Ruler

88 - 03.27.13
European Union?/ Global Arbitrage/ 1940s Fed

87 - 03.08.13
Pulling & Pushing/ Deus ex Machina/ Perfect as the Enemy

86 - 01.04.13
The Fiscal Alps/ The Paradox & the Rub/ Next up - Zero Rates Forever/ 2013: Promises & Plausibility/ On a Positive Note

85 - 12.13.12
Giving Sausage a Bad Name/ Drowning in a River 2 Feet Deep/ Scarcity in US Treasuries

84 - 09.19.12
Plus Ça Change/ Fantasia meets the Euro Zone/ Cue the Federal Reserve/ Shifting Transmission/ Bottom's Up

83 - 08.21.12
Summer Time Slows but the Lawyers are busy/ Whatever it Takes/ Heavy Weight Fight

82 - 06.29.12
Half Time 2012/ 19 Euro Summits - A Tiger by the Tail/ The Crystal Ball

81 - 06.11.12
Next Chapter/ Election Lessons/ A Gentleman's C/ Opportunities

80 - 05.10.12
Choices/ Texas Hedge/ Outcomes

79 - 04.09.12
13,000 x 1,400/ Lessons Learned/ It's Not Insider Trading When Congress Does It/ Crystal Ball

78 - 03.21.12
Goldman's Casablanca Moment/ Mr. Macy meet Mr. Gimbel/ The Fiduciary Standard - The Gold Standard

77 - 03.05.12
Punxsutawney Greece/ Foaming the Runway/ "The Euro Crisis is Behind Us/ Healing Hoopla/ What Price Income?

76 - 01.09.12
2012 - The Continuum/ Europe - Working in the Injury Time/ "Risk On - Risk Off"/ The Road Ahead

75 - 12.05.11
The Problem/ What Could Go Wrong/ Compound Interest/ Germany or Bust/ The Cavalry/ Stress Tests/ Next Chapters/ MF Global

74 - 09.29.11
Broken Transmission/ Chickens and Eggs/ Where to?

73 - 08.29.11
The Confluence/ The ECB/ US Economy - Distinction without a Difference/ A Different Kind of Exit/ Gold as a Thermos/ Where to Now?

72 - 06.28.11
Sovereign, Central, Commercial/ Why we call them "Banksters"/ "Extended Period" just got a lot longer/ Forward.

71 - 05.24.11
The Question is... How Many Years?/ "Unexpected" Housing Weakness/ P.I.G.S. Can't Fly/ Stages.

70 - 04.11.11
Inflation for thee, but not for me/ On the Other Hand .

69 - 04.05.11
Implications - A Bevy & A Wedge/ Implications - Quantitative Easing 2.0/ Implications - Rules Rules Rules/ Catching Up with the Can.

68 - 03.03.11
What Ever Happened to Housing?/ Where Do Loans Come From?/
Where Do Loans Go?/ The Last Straw/ The Path Forward/ Equity/ Clearing Mechanism/ Restart Your Securitization Engines.

67 - 01.10.11
Curiosity of the Federal Reserve/ Complacency & Fragility

66 - 11.12.10
Phew/ Taxes and Employment/ Quantitative Easing Returns/ Incentives & Unintended Consequences/ Dear Mr. President

65 - 09.28.10
Progress in the Absence of Milestones/ Changing Nature/ Correlations & Valuations/ Synthetic Securities

64 - 08.18.10
A Tricky Diagnosis/ Traditional Treatment/ Bad Medicine/ New Age Medicine/ Homeowners/ The Banks/ Pension Plans/ Bull Flattening

63 - 06.17.10
Hip & Groovy/ The Trouble with Zombies

62 - 05.24.10
Next Sequel/ 2012

61 - 05.04.10
Intensity/ Principles versus Rules

60 - 04.01.10
Grand Isle to Lincoln
/ Mile Post 312/ Mile Post 353/ Mile Post 399/ P.I.G.S. are a Problem

59 - 02.17.10
Surprise, Surprise, Surprise/ P.I.G.S. Matter/ Leverage vs. Debt/ Going Forward



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Market Highlights

6/29/12 3/30/12 12/30/11 12/31/10 12/31/09 12/31/08 12/31/07
14,560 13,104 12,880 13,212 12,218 11,578 10,428
S&P 500 US


1,564 1,426 1,362 1,408 1,258 1,258 1,115
Nasdaq US
3,252 3,020 2,935 3,092 2,605 2,653 2,269
EAFE Int'l Equity
1,678 1,604 1,423 1,553 1,413 1,658 1,581
5 Yr Treasury 1.40 .82 .74 .75 1.07 .85 2.02 2.71
5 Yr AAA Muni 1.56 .88 .9 .86 1.03 .94 1.75
10 Yr Treasury
1.98 1.81 1.73 2.28 1.96 3.38 3.92
10 Yr AAA Muni
2.13 1.99 2.05 2.24 2.08 3.44 3.26
30 Yr Treasury 3.48 3.13 2.94 2.78 3.33 2.914 4.325
30 Yr AAA Muni 4.10 3.21 3.16 3.56 3.72 3.82 4.9
EUR Currency 1.31 1.29 1.32 1.26 1.33 1.29 1.34
JPY Currency 99.05 94.28 86.10 79.49 82.08 77.36 81.32
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