January 20, 2010
Earnings Season starts slowly
Equity markets traded in a sluggish fashion last week, remaining relatively flat through the first four days, before a sell off on Friday caused the S&P 500 index to lose 0.8% for the week and the Dow Jones Industrial Average fell a marginal 0.1%.
The sell off was precipitated by a mixed earnings report from JP Morgan, with revenues of $25.24 billion, against consensus estimates of $26.21 billion. The investment banking division took in $1.9 billion from higher trading and fees, but the retail division lost $400 million during the quarter, primarily related to rising mortgage defaults. It was a swift reminder that every day consumers are not sharing in the same glee that is propelling the stock markets.
The Treasury Department provided an update on its Home Affordable Modification Program (HAMP), designed to modify mortgages for homeowners struggling with their present payment. Over 1.1 million homeowners received offers to modify their mortgage. Interest rate reductions occurred in 100% of the cases, with the median monthly payment falling by over $500 to $830.
Notably absent from the Treasury report is a discussion around the number of individuals re-defaulting following initiation of a modification.
On the economic front, the major area of disappointment was December retail sales, which fell by 0.3%, well below the consensus estimate of a 0.5% gain.
Figures for November were revised up to reflect a 1.8% gain, offering hope that an early Thanksgiving pulled demand forward this season.
Will 2010 be the year Treasuries Broke down?
This time of year is generally marked by replays of Martin Luther King, Jr’s famous “I have a dream speech.” This year, Timothy Geithner, Secretary of the Treasury, is likely having nightmares about what 2010 holds in store.
Behind the consternation is a complex problem - $2.1 trillion, the approximate amount of financing conducted by Geithner and friends last year. Fortunately, the US was the beneficiary of an unusual investment environment in 2009.
First, interest rates fell to generational lows after the Federal Reserve struggled to contain an economic crisis unseen in nearly a century and second, there existed a belief that US debt represented one of the truly safe investments during a period when all risky assets declined in tandem.
The problem for the Treasury moving forward is twofold. For one, interest rates have nowhere to go but up. At the end of 2009, the average interest rate on all outstanding US debt stood at 3.3%, a far cry from the previous ten-year average of 5.0%, and even farther from the 30-year average of 7.4%. With $2.5 trillion of debt maturing in the next several years, simple arithmetic shows the burden of a 1% rise in interest rates.
Secondarily, the Treasury is living on borrowed time. In recent years, the average maturity of debt outstanding fell considerably, from 6 years earlier in the decade to a shade over 4 years at present – the lowest level among all G7 economies. There were many reasons for that to happen, from the discontinuation of the 30-year issuance to sanguine economic conditions allowing the government to roll down existing debts.
But, there is a catch. Investors are growing increasingly uncomfortable with the inflationary pressures associated with the $12 trillion+ worth of liquidity added to the system by various government parties. Add in the recent decision to offer Fannie and Freddie a blank check and investors have reason to fret.
This is rearing its head through an ever steeper yield curve (the yield differential between short-term and long-term bonds). Rates on 10-year bonds have steadily risen since the final trading day of November, having gone from 3.2% to 3.7% last week. That 1% rate increase suddenly doesn’t seem so far away.
If the first several auctions of the year are any indication, there are reasons to feel confident for the time being. Across $84 billion worth of auctions last week, investors stepped to the plate, pushing yields to the lowest levels of 2010.
Primary market dealers are estimating that the Treasury will need to borrow $1.2 trillion to $1.75 trillion in fiscal 2010, followed by $725 billion to $1.4 trillion in FY2011. Ironically, the US is benefitting from the flight-to-safety trades as negative information continues to surface about Dubai, Greece, Spain, etc.
For now, credit default swap markets, which have historically been a good leading indicator of ratings moves, are not pricing in the possibility of a ratings downgrade for the US. Geithner may be able to navigate his way through the murky waters of 2010, but debt will begin approaching uncomfortable levels in the next 5 years. As Moody’s pointed out late in December, debt to GDP and interest cost to government revenues are the two key indicators to watch in the coming decade.
Debt/GDP, currently at 53.5%, will soar to 70% by 2012, while interest to revenue will surge from 8.4% to 13% at that point. Barring a major meltdown, the Treasury should not have trouble tapping the markets in 2010, but a truer test of its mettle will occur in 2011 and beyond.
The week ahead
Economic news is on the light side this week with the focus turning squarely to earnings reports. The Treasury Department is taking a break from issuance for the moment.
Key companies to report earnings this week include IBM, Citigroup, Bank of America, Morgan Stanley, Starbuck’s, Goldman Sachs, Google and General Electric.
Around the globe, the International Monetary Fund is holding a conference on “Exiting from High Public Debt” on Tuesday. The conference is expected to talk about the implications of rising public debt and what can be done to reverse the trend. The Asian Financial Forum convenes in Hong Kong on Wednesday and Thursday to discuss the future of financial markets in Asia.
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