In case you were under clouds, here is a picture collection of the recent perigean moon (Saturday, March 19). Hat tip to Cynthia Heard.
Now to markets.
U.S. stocks celebrated a terrific quarter. Within it, there was an Egypt-MENA-Libya-Tsunami event-induced and much needed 7%-10% correction. The world did not end and the bull market resumed. Energy, industrials and materials were among the leaders. Cumberland’s U.S. ETF accounts were and are overweight all three sectors and had a good quarter.
Ed Yardeni notes how record U.S. corporate profits persist. Dr. Ed wrote, “After-tax corporate profits from current production rose to a record $1,250.2 billion. It is up 61.4% from the most recent cyclical low during Q4-2008. It is 7.9% above the previous cyclical peak during Q3-2006, and undoubtedly heading higher this year.”
We agree completely with Dr. Ed. Cumberland’s U.S. ETF accounts remain fully invested. We note that the rate-of-change of year-over-year quarterly profits is peaking. It is still strongly positive, just not in as powerful an uptrend as during the last two years of recovery.
Peaking of our NIPA profit-based, rate-of-change indicator is not a sell signal, it is a warning signal. The current level of our rate-of-change indicator means we could have a few more months of a bull market for U.S. stocks, or we could have a couple more years. This indicator’s history tells us that, today, we cannot know which will occur. The same indicator has a perfect record at calling stock market bottoms. The most recent confirmation of this was in the quarter that included the March 2009 low. So we note that the timing efficacy of this indicator is asymmetric.
Muniland saw its 20th week of tax-free Muni mutual fund redemptions. The total five-month’s redemptions now exceed $40 billion (Ned Davis Research). Last week’s redemption total was down to $404 million. We expect the redemption-based, forced selling to continue to “dry up.” When it has run its course, a strong muni rally could restore the Muni-Treasury spreads to more normalcy. Cumberland remains favourable toward longer-term, tax-free Munis and to taxable BABs, although Muniland headline risk remains a factor with which we must contend.
The spread of the “Whitney virus” continues, although some abatement seems to be occurring. Peak weekly withdrawals were over $4 billion and followed on the heels of the famous (infamous?) 60 Minutes TV interview of Ms. Whitney. Some readers challenged my assertion that Whitney predicted “50 to 100 large defaults in 2011.” The TV tape tells all. She was asked that question in December of 2010. She specifically said, in the next twelve months. That sure looks like 2011 to me.
We thank readers for their many emails regarding our piece entitled “Muni Defaults: Whitney and Roubini.” If you missed it, the link is: http://www.cumber.com/commentary.aspx?file=032611.asp. Cumberland’s website has it posted; see www.cumber.com.
Headline risk remains high in Muniland. The latest story originates from DeKalb County, Georgia where the market witnessed credit rating downgrades. Natalie Cohen (Wells Fargo) tells the story well:
“The current fiscal stress discussion focuses on the trickle-down of state cuts to local government; however, spats between governments occasionally, in our view, produce negative fiscal events. In the case of DeKalb County, Georgia, the city of Dunwoody began the process of incorporating in 2006: the incorporation was initially rejected but was later approved after a regime change in the state legislature, and Dunwoody became a city in 2008. The city represents about 5% of the population but 11.8% of the property tax base for the county. About $18 million in excise and business taxes also left the county for the new city in 2009—a permanent loss. More important, the Perimeter Mall, a super-regional mall that is anchored by Macy’s, Bloomingdale’s, Dillard’s and Nordstrom is located in the new city now out of reach from county taxation.
Add to this the soft economy and the unwillingness of county officials to raise taxes or substantially reduce expenses and the county has put itself into deep financial trouble. The county was a member of S&P’s AAA-rated club as recently as the beginning of January 2011. The rating agency lowered the county’s rating to AA- then BBB and then suspended it for lack of information (2009 was its most recent audit). When S&P compared the county with its AAA peers, the county was alone with a negative 3.5% fund balance (as a percentage of spending) and a negative 5.4% unrestricted fund balance. Between 2008 and 2009, the county’s net assets fell by nearly $40 million—not a fatal amount, but S&P indicated further decline in 2010 and insufficient action to manage its finances.”
Readers may note that Cumberland’s internal rating system tracks late filings as one of its negative indicators and uses them as a warning sign. Cumberland does not hold any DeKalb County bonds.
We do not hold Jefferson County, Alabama either. They have lost a court case and may file Chapter 9. That would make them a record-setting local government bankruptcy, and would certainly make the national news and exacerbate “headline risk.” It could cause the uninformed retail mutual fund investor to force more selling by redeeming mutual funds. We would view such an event as a buying opportunity. Remember: Munis are idiosyncratic. There are nearly 90,000 separate jurisdictions and they are quite different in their structures. Painting this asset class with one broad brush is an error, in our view.
Lastly, we must get to a bizarre new development in the financial system; it impacts American banks.
Did the FDIC usurp the FOMC? Maybe. Starting April 1, the FDIC asset-based premium assessed on US banks will include the $1.4 trillion of excess reserves that those banks have deposited with the Federal Reserve. The banks have been buying cash in the Federal Funds market, lending that cash to the Fed, and earning a spread on those funds. This was a riskless arbitrage for the banks: pay 10 to 15 basis points for overnight money and lend it to the riskless Fed at 25 basis points. Note that the Fed Funds target rate is set by the FOMC at 0-25 basis points, while the Board of Governors of the Fed sets the interest on reserves (IOR). The FDIC is an agency that operates independently of the Federal Reserve.
The FDIC assessment is a different rate, depending on the size of the bank. Valerie Miles (Southwest Securities) summed it up well:
“There have been a lot of questions today as to why overnight financing is so low and why short term assets have disappeared. Although quarter end restrictions have been an issue, the real culprit has been the FDIC implementation of an expanded assessment base that begins today. The base now includes all tier 1 assets and applies to all domestic banks. The reason this is so significant is that some banks borrow cash in the open market and leave that cash at the Fed. The Fed is currently paying .25 bps on excess reserves.
So if a bank borrows cash at .15 bps and leaves that cash at the Fed, it will earn .25 bps creating a positive .10 bps in carry on a risk free arbitrage. The new FDIC regulation will include cash in its assessment, which will cause the bank to pay a “fee” for that cash it has borrowed. If that fee is say .10 bps, then the carry is gone and there is no arbitrage trading opportunity. So now domestic banks will no longer leave their cash at the Fed and invest it in the marketplace via Fed Funds. This extra cash will cause financing levels to drop, the Fed Funds effective to collapse and the demand for short-term assets such as Treasury bills to increase. Today’s market reaction gives credence to this argument. Banks have flooded the funds market with cash causing overnight financing to drop to zero. Treasury bills have dropped in yield significantly as 3 month bills traded from .10 to .05 and year bills from .28 to .23.”
Barclays noted how “repo rates” plunged and how repo collateral traded to a negative interest rate. Barclays explained their view:
“The expanded assessment base lowers the effective return that banks receive for holding cash at the Fed – by the amount of the assessment rate. Assuming that banks want to preserve the spread they make from arbitraging the effective funds rate and the IOER rate, they are likely to lower the rate at which they purchase liquidity from the GSEs – by the assessment rate. With few alternatives, the GSEs have little choice but to accept the now lower return on their liquidity. As a result, the effective funds rate should decline.
“Estimating the effect on the effective funds rate is difficult, because it depends on the size of the assessment and the ability of the GSEs to find alternatives for placing their extra cash. The FDIC notes that the new assessment rate on ‘large and complex institutions’ will be 2.5-45bp – which leaves a wide scope for estimates of the decline in the effective funds rate. Keep in mind that non-US banks, which currently hold sizeable balances at the Fed (exceeding $300bn), are not subject to the FDIC assessment. Our sense is that they will lower the rate that they bid for overnight cash in the Fed funds market to match what their US competitors are willing to pay – thereby increasing their arbitrage returns.”
The FDIC has forced the Fed Funds rate lower by imposing a fee on U.S. banks. The GSEs are the ones who pay the price of this decision, by earning less. The foreign banks benefit the most since they can receive the higher reserve deposit rate but do not pay the FDIC fee. And everyone but the FOMC, which is supposed to set it, currently manipulates the Fed Funds rate. As Yakov Smirnoff says, “America, what a country!” Yes, Yakov, America is some great country! Where else would you find a subsidy handed to foreign banks while the domestic banking system is trying to recover?
Rome is the destination of our Tuesday-night flight. GIC events begin Wednesday. We extend best wishes for a speedy recovery to our personal friend and GIC colleague Paul Horne. He spent months of effort working on this superb meeting and now cannot attend. Paul, we will cover for you as best as we can, but we must publicly acknowledge that you, and your organising partner, GIC member Vincenzo Sciarretta, deserve the credit for our stellar lineup.
Readers in Europe who can get to Rome Wednesday are welcome. There are still about 7 empty spots in the GIC delegation. Details are found at www.interdependence.org.
Ciao, buon giorno, Roma.