Friday, November 19, 2010

Armageddon Coming to a Bond Market near You

11/19/2010 Portland, Oregon – Pop in your mints…
Activity in the markets today almost appeared normal.  Stocks and Commodities up, the dollar and bonds slightly down.  It is like watching waves lap gently onto the shore while under the water a vicious whirlpool is gaining steam and angry clouds form overhead.  What is in store?  A hurricane? An earthquake followed by a Tsunami?  Or will it all disappear and turn into just a lazy day at the beach?
Personally we were hoping that the lazy days had returned.  But after what we heard this morning, we are certain that a magnificent storm is on the way and it is best to at a minimum get out of the water and perhaps move inland.
The forecast took shape this morning as we attended a breakfast where the speakers focused on Cash Management Strategies.  For the most part the presentation was a basic review of the use of credit lines, bank accounts, CDs, spreadsheets, etc.  At The Mint, we are too focused on secondary effects to get much out of obvious practical steps and generally tune this part out and enjoy the free coffee and rolls.  We do, however, have our radar out to detect seismic events that appear disguised as innocuous comments during otherwise innocent breakfast presentations.  Today, halfway through our apple turnover, two large blips appeared on our radar.
First, the speaker noted that there are $14 billion of dollars worth of letters of credit that are up for renewal in 2011 in their industry alone.  A year over year increase of 700%!  Most of these letters of credit must be rolled over (renewed) for the bonds that they back to be worth anything.  The speaker considered her organization lucky to have been able to renew their organization's letter with Banco Santander as many of the US Banks are simply not writing them anymore.  As an additional kick in the pants, the organization is being asked to have 250 days of cash on hand, a much stricter covenant, up from 200 previously.  The bank originally requested 300.  Blip 1 on the radar!  Incoming threat to bond market.  Could be a bird.
Second, and more significantly if you follow large cash movements, the FDIC is changing their rules as of January 1, 2011 to permanently raise the insured limit up to $250,000 and to cover non-interest bearing accounts without limit Blip 2 on the Mint's radar!  Definitely not a bird! Approximately two months to evacuate the bond market!  Up until now, anyone who has a ton of liquidity in the form of dollars that they need to access on short notice has been forced to either find feeble comfort that their bank will not fail or to find a work around the FDIC limit to assure that all of the funds are secure (in other words, they will get all of their money back if their bank fails).  The "work around" for most firms takes the form of investing excess funds in what are known as "Repo's" which pay literally pennies of interest on millions of dollars that buy bonds overnight, before the bank may fail, and then sell them in the morning, providing liquidity while the bank is safely open.  This arrangement is commonly known as a "Sweep" account.  That yields are non-existent speaks to the fact that everyone and their mother is now employing this strategy.
Sweep accounts are currently expensive relative to yields and the FDIC rules effective January 1 will give customers who simply want liquidity the option to leave the money in the bank, earn 20 to 60 basis points of "interest" via service fee credits (as opposed to 1 to 2 basis points in the Sweep accounts) and have those dollars fully insured.
So what happens when everybody and their mother decides to leave their tonnage of liquidity in the banking system overnight instead of purchasing "Repo's", which is just a fancy way of purchasing bonds? 
We must admit that we have absolutely no idea but that will not keep us from guessing!  Our current guess is that 1) The cash movements caused by this FDIC rule change will mean round two of Armageddon in the bond / fixed income markets and that 2) the FED's quantitative easing program is timed to fight Armageddon against what could be a wholesale collapse of world-wide fixed income markets that could play out in early 2011.  In more colorful terms, our guess is that the FDIC is unwittingly preparing to squeeze the mushroom shaped dollar debt sponge!!!
Will the FDIC Wring out the Debt Sponge?
A Caveat to this story:  The Municipal Bond market has depended upon government stimulus funds to leverage huge amounts of recent offerings to cover unsustainable spending at all levels of government.  These stimulus funds will phase out between January and June of 2011.  On cue, the FED is now on the verge of buying up Municipal Bonds.  Just think of it as Blip 3 on the Mint's radar.
It is all coming together, fellow taxpayer.  Now you know why the Irish are being forced to accept a bailout even though they don't intend to borrow until June 2011.  The government there has no idea that Armageddon is upon them and that the fixed income markets as we have come to know them may not exist in June 2011.  At least not one willing to accept 7% on Irish debt. 
No wonder Ben Bernanke and his fellow of Central Bankers of the world are throwing caution to the wind as they shamelessly print more money.
What else can they do?
Stay Fresh!
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*See FED Perceived Economic Effect Rate Chart at bottom of blog.  This rate is the FED Target rate with a 39 month lag, representing the time it takes for the FED Target rate changes to affect the real economy.  This is a 39 months head start that the FED member banks have on the rest of us on using the new money that is created.