6/11/08 (Tough Talk, Bond Auctions, Jobs Sick?)

Traders,

Another very weak opening, but we did rebound to a rather flat close, slowly building a short-term support type area. However, it doesn’t mean that we should be looking for opportunities, but rather look to secure positions and remain nimble. Global confidence is beginning to erode, even in emerging markets. Higher fuel, energy, and food prices are taking their toll and inflation IS a lurking concern.

Bernanke and Paulson have been TALKING tough – as if they ARE for a STRONG dollar – but their policy so far has been everything BUT! “Strong Talk” however is having a short-term affect. It allows them to give the impression that they are for the strong dollar and concerned about inflation (as IF they are ready to raise rates) without actually having to raise them. It is a great “head fake” and has brought strength back to the dollar in the short-term and has even gotten several pundits speculating that Bernanke is going to now RAISE rates at the end of the year. However, Goldman and other firms are not expecting ANY rate HIKES and in fact expect (in some cases) more rate cuts!

If we strip away all the “Tough Talk” about defending the dollar, do we REALLY think they will raise rates? The reality is that they have cut the rates fast and hard, continue to offer special deals at the discount window, and continue to inject capital. Lehman and several other financial institutions are still treading water, lending is tight, and there is a continued concern. Bernanke cut the rates to keep the financial sector’s credit crisis from turning into a collapse – he is NOT about to start raising rates and the problem lingers.

For now it’s just talk – if he actually was going to raise rates the financial institutions will form a lynch mob outside his door. None-the-less he strategy of talking tough has given the dollar a short-term boost, but how long will that really last when reality sets in that he is just talking tough. It reminds me of the President Candidates saying one thing and doing another. Remember Obama talking about repealing NAFTA and then telling the Canadians, Oh that is just talk – I am not REALLY going to do anything. Same is true for Bernanke – for now!

_____________________________________________
Bond Auction Rates fall as refinancing slows

As money becomes tight and the auction-bond market has recently failed with rates rocketing above 20% on borrowed money vs. the dropping return on their investments - the need to refinance debt had become paramount. Many are leaving the auction market, which was the traditional route for low volatile financing. However, when the big banks, who set those low interest rates, left town (because they needed the money) the smaller funding companies demanded higher and higher rates – money was no doubt tight and still is. What to do?

Well – tax payers come to the rescue – the SEC let borrowers (muni-bonds) use taxpayer funds to bid on their OWN bonds. Of course the rates would drop! They just hit a new low of 2.99%. Supposedly this is to give them time to figure out how (or who to go to) to restructure their debt.

I am not necessarily in favor of such a tactic, since it rewards poor financial decisions. This is the “beef” I have. A bond is raised for a real need, investors buy that bond. Now instead of the money raiser using the money for the intended purpose – they are instead INVESTED in the market – based on the thought they are actually creating an arbitrage (borrowing money at a cheap rate and investing in other bonds that pay a higher rate). These new found geniuses, who clearly do not understand what the word arbitrage actually means, have got themselves into a serious pickle. Here is why, they have borrowed money at an auction rate, let’s say 4%. Now that bond goes to auction every x-amount of days. Their expectation is that it has ALWAYS been 4% so they never expect it to rise (FIRST MISTAKE).

Then they used that borrowed money to invest in corporate bonds that are paying 6%, they base this on the AAA credit rating by Moody’s and since a AAA rating is as SAFE as a US Treasury, they are convinced there is NO RISK (Second Mistake). Now they just got whacked on both sides of this equation (which CLEARLY is NOT an ARBITRAGE). The auction rates started to fail as the big banks that were lending them the money decided NOT to offer any more money as credit lines tightened. This sent that “guaranteed” rate of 4% up to 8%, 10%, 15%, in some cases 20%. The borrower clearly could NOT pay that rate – but they couldn’t default they had to eat it until the next auction. Then their AAA (“Safe as a Treasury”) bond investment started failing and in some cases defaulting. It’s not that they are NOT getting a return, in some cases they are actually LOOSING principal.

So what is the answer? Hey – let’s just borrow MORE money from the tax payer (based on future tax expectations) and loan the money to our selves. Of course they are going to loan money to themselves for ridiculously cheap rates (say 2-3%) even lower than what they had been traditionally getting from the auction markets. But how long can that joke last?

Here in my town, the expectation of property taxes (which just came out last week) is showing a HUGE short fall. Local governments are going to have to cut spending, but if they just pre-borrowed money to float these bonds – they are going to wake up to a shocker!

While this borrowing from the tax payer to avoid default has put the auction bond problem on the back burner for now – it has done NOTHING to solve the problem – just band aiding a hemorrhage.

This is important in that it could put serious pressure in the 4th quarter and into 2009 and the 100s of billions in bonds will need to eventually borrower it again from somewhere – because borrowing from the tax payer was expected to be a short-term solution to allow them to restructure their debt. But since no one is willing to lend them money (except at very high rates) – they are going to find themselves back in that pickle and this story will rise again from the ashes.

It could cause force selling of the investment paper they continue to hold – which could put more pressure on the market and dollar.

So – what do you think would happen if Bernanke raised rates?

_________________________________________________________________
Futures Pre-Open

The futures saw a little pop in the pre-market as expectations of interest rates might rise – yeah I know it makes no sense – but that is what the talking heads are saying. Regardless they are coming off in the pre-market as they over-shot the cash basket and Arb traders saw a free short in the pre-market against a very weak basket (which is easy to buy). Expect the spread to collapse well into the opening.

_________________________________________________________________
Support / Resistance

It does look like we are creating some support areas at these levels as the indices begin to consolidate. However – be skeptical and don’t get sucked into getting naked long any hard deltas – unless fully hedged with some gamma.

INDU 12200 / 12500 (I wouldn’t really call 12200 a support and I wouldn’t really call 12500 a resistance – there is just too much hidden volatility. It does seem that the market is just consolidating waiting for news – good or bad – before making a move. However – we need to keep an eye on that 12200 level – we have closed 3 days above it. We need to continue to do so.)

NDX 1950 / 2000 (We visited 1950 the other day and saw huge volatility in the index yesterday – APPLE has been a big whipsaw in there DOWN than UP. The most visited story about the whole APPLE meeting was actually Steve Jobs appearance. I hate to spread rumors – but it is the most talked about story about the Apple Conference - rumors abound from cancer returning to viruses, etc. – they are all rumors but according to CNBC the most visited story (and responses) was Steve Jobs health. Apple of course says he has just lost some weight - maybe because he is a Vegan and on some new diet – but he sure did not look healthy. How much is APPLE worth without it’s rock star? He took the company from $4 billion in rev to over $100 billion. He is one of the best CEOs in the country. I hope it is just a diet and nothing more.)

SPX 1350 / 1400 (We are down near the support area - a place to maybe get long – I would use soft delta, but would have gamma on my sheets so that I would flip to short below the 1350 line. Key area – watch 1350)

RUT 720 / 740-750 (We are clearly in the middle of the range and out of the resistance band – we however clearly above support. The RUT is a fairly good indicator of money flow and it current still has not come off hard yet. If we remain above the 720 line, even as other indices fall off, we could see support return to the market as a whole. Watch the 720 area!!!)

__________________________________________________________________
Conclusion

The market is still facing major hurdles and no matter what Bernanke or Paulson SAYS it is their actions and policies that we need to judge – since their words mean little. Remember – they have been preaching that the “CORE” measure of inflation has been in checked and has shown no sign of inflation concern (of course if they continue to look at the Core of the CPI – they will NEVER see inflation). That story has been preached since August of 2007, but food, oil, and energy have gone up and the dollar has gone down. If that is NOT inflation – then I really don’t know what Bernanke is talking about. Now their story changes – 180 degrees – now they ARE concerned about inflation, WHAT? A nation can NOT expect an economy to remain healthy if the fiat currency continues to slide. They have poured so much money into the system via every method possible that it is flooded. It’s like trying to start your car, but you have kept your foot on the gas pedal and flooded your engine. You are going to just have to wait – or take the plugs out and dry them. You can’t have a spark if everything is soaked!

However, even the tough talk doesn’t mean they CAN without pulling the plug on the banking sector (again). Additionally the bond market is going to need money very soon and with the failure of MBIA and AMBAC (a trillion in insurance) he can’t really believe that he can raise rates as credit lines are still very tight.

I think volatility is still the game – and traders need to be nimble from short-to-long (even intraday). Investors need to be able to hedge and get liquid fast – when and if necessary.