C.M.O. 8.29.2011

He said: “Most of the economic policies that support robust economic growth in the long run are outside the province of the central bank.  To achieve economic and financial stability, U.S. fiscal policy must be placed on a sustainable path that ensures that debt relative to national income is at least stable or, preferably, declining over time.”

He also said: the “very deep slump” in the housing market and the aftereffects of the financial crisis continue to restrain US. economic growth, adding that the divisive debate focused on the federal debt limit “disrupted financial markets and probably the economy as well”; while announcing that the next meeting of the Board of Governors of the Federal Reserve would be expanded by 100% (from  1 day to two) “to allow a fuller discussion” of the Fed’s options which he described as “a range of tools that could be used” in an effort to keep his, yours and my chin up with the statement that “growth in the second half looks likely to improve”, while calling for “good, proactive housing policy”.

The Chairman of the Federal Reserve mentioned the d-word (deflation) six times in his speech on Friday after not mentioning once last year.  RBS economists also noted that “Unlike last year, there was no discussion of the tools that could be employed” and “in fact, the specific tools under consideration were not even named.”

The Dow Jones Industrial Average first interpreted these remarks negatively as one might expect and dropped 211 points before rising 355.72 points to close 134.72 points higher at 11284.54.  If that’s not making lemonade out of lemons I’m not sure what is.

Robert S. “Steve” Miller, non-executive chairman of American International Group Inc. (AIG) said after Mr. Bernanke spoke, “He has driven interest rates as low as they can go, interest rates are not the problem for investment.  The problem for investment relates to concerns for the economy and worries about fiscal policy.”

If, in all of this, the market has decided that the policies that keep everyone waiting for the “Bernanke Put” are ultimately more destructive than the short term fix (which could actually be harder to comprehend) then maybe the zero rate junkies have decided to enter rehab.

And speaking of junk or in this case its high-yield bond equivalent, offerings of below investment grade debt were at there lowest level in August to date since December of 2008.  The return for the month reached a negative 5.1% in the 26 days that have passed this month.  Trading volumes have also decreased to about $3.46BN last week versus $4.72BN for the other weeks this August and $4.74BN per week this year.  Spreads in the below BBB world widened to 766bps which was the widest since November of 2009 and should be compared to 587bps at the end of July.

What is interesting in all of this is that the default rate on junk bonds fell to 2% in June down from 11.7% in 2009 and 3.3% in 2010.  A similar state occurred during the beginning of the financial crisis as the world appeared to be going to hell in a hand basket and high yield debt sold off precipitously only to have default rates come in way under what was projected hence making the genre a very profitable investment.  David Steinberg, a portfolio manager at Mast Capital Management is not a believer in a repeat however as he was recently quoted as saying, “I’m short and getting shorter”.

Long time readers of this space know that the investment theme here is that credit spreads are a good indicator of stock price movement.  To that end the current increase in spreads on high-yield, investment grade and cross-over names would lead one to believe the direction off equity prices is lower.

This theory was put to the test this week with the DJIA rising 466.89 points or 4.32%; the S&P 500 rocketing 53.27 points for a 4.74% rise and the NASDAQ soaring 138.01 points to ratchet 5.89% higher.  Describing that kind of equity price movement in an environment of widening credit spreads Mr. Steinberg simply said that stock investors were “smoking Jackson Hole Hopium.”  There’s that junkie again.

Enjoy the week.

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