Wednesday, December 29, 2010

Shorter is Better

Today's auction of $29 billion in 7-year Treasuries was average, with a bid-to-cover ratio of 2.88, almost exactly the rolling ten average of 2.86.

Of the three auctions this week, there was lots of demand for the 2-year issue, less demand than usual for the 10-year issue, and average demand for the 7-year issue. Investors don't want to hold longer term debt.

Some analysts think today's issue was worse than it appears, because it is the last issue of this year, and portfolio managers wanted to get cash off their balance sheet before their investors saw it. Maybe so, but it is clear that the appetite for debt owed by the U.S. is limited. Rates are rising rapidly, making interest carry heavier for taxpayers.

This is a problem that would quickly be corrected by adopting the recommendations of last month's Deficit Commission!

Tuesday, December 28, 2010

What a difference 8 years make . . .

Yesterday, there was a very successful auction of 2-year Treasuries. Today, there was a barely successful auction of 10-year Treasuries. The bid-to-cover ratio dropped from 3.71 to 2.61. In addition, foreign interest dropped significantly.

The market is saying they don't want to hold any bonds longer than 2-years because longer-term bonds will lose value due to inflation sometime after 2-years but within 10-years.

Forewarned is forearmed.

Monday, December 27, 2010

Almost Too Good . . .

The market can be much more volatile when few people are trading. That's because one big trade can really push the market one way or the other. The period between Christmas and New Year's Day is always a slow trading time.

When I realized the U.S. was planning to sell $35 billion in 2-year Treasury bonds today, I was a little worried and wondered why they didn't wait until next week.

Fortunately, the auction went far better than expected. The last ten auctions produced a 3.31 bid-to-cover ratio. That means the Treasury could have sold 3.31 times as much as offered. Today, it was 3.71 times. The strong demand for our debt is amazing. While the Fed has been buying some of the Treasury bonds, foreign governments have actually started to increase their purchases. Those who worry the bond vigilantes will stop buying our bonds didn't find any support for that argument today.

By the way, I am one of those who worry about bond vigilantes! What kept the vigilantes at bay was that the interest rate paid to the bond buyers today increased from about 0.71% to 0.74%, which is a big one-day jump.

Tomorrow, the Treasury will be auctioning off another $35 billion in 5-year bonds, and I'll be watching . . .

Sunday, December 26, 2010

Zombie Christmas?

I spent Christmas reading John Quiggin's new book titled "Zombie Economics: How Dead Ideas Still Walk Among Us." It began with Keynes' great belief that "Practical men, who believe themselves to be quite exempt from any intellectual influences, are usually the slaves of some defunct economist." I believe that statement is true.

Since Quiggin is a Keynesian economist, I expected he would lambast the Austrian school of economics, the Supply school, the Monetarist school or some other school. Instead, he took pointed aim at certain investment beliefs. While such beliefs do reflect some views of "defunct economists," investment strategy really in a separate discipline.

For example, he took aim at the notion of "The Great Moderation," which was a popular belief before the Global Financial Crisis and was popularized by Fed Head Ben Bermanke. That notion suggests that the worst effects of business cycles have largely been curbed by the much more limited regulation of Wall Street, as well as the increased ingenuity of the Fed. It is clear that the de-regulation of Wall Street was excessive, which I wrote about years ago. However, it was not clear to me just how ingenuous the Fed had become. Bernanke was slow getting started but finally did a great job. Score one for Quiggin that The Great Moderation was a zombie idea that more de-regulation is always better!

Another example, he took aim at the notion of "Efficient Markets," which suggests that the market price of an asset is correct since it reflects all available information and that investors react to new information is similar, predictable ways. I've never believed that, although there is a possibility it might work for large cap stocks but nowhere else. Score another one for Quiggin that Efficient Market was another zombie idea that the market always knows better and understands more quickly.

Quiggin refers to these ideas and many others as zombies, because they still walk around despite being quite dead, i.e., that they are still practiced despite being wrong, that they are like practical men who are slaves to some defunct econmist.

For me, the take-away was one remarkable sentence that said "From the inside, ideology usually looks like common sense." Amen! That is why I believe in situational economics or selectively picking whatever makes sense from each school of economics, depending on the economic variables. If I am a slave to a defunct economist, then I am a slave to a very large number of them.

So, that's what I did for Christmas. Sometimes, I miss having kids at home . . . oh, well.

Thursday, December 23, 2010

Full Circle

Surviving veterans of the European front in World War II show pride in toppling Hitler. Few take any credit for establishing the dollar as the world's "reserve currency," but it was terribly important.

Immediately after the war, the victorious Allies met in Geneva to begin mapping the Marshall Plan for the reconstruction of Europe. One of the many things they did was to require international contracts that be denominated in dollars. In other words, if a French firm wanted to buy something from an English firm, there was no argument as to whether they would pay with French francs or English pounds. They had to pay with U.S. dollars. The thinking behind this was that it would remove any incentive for a nation to debase its own currency as a means to minimize their debt. It was a form of monetary discipline.

Because the dollar then became the world's sole reserve currency, we needed to supply the world with enough dollars to do business, which also created a huge demand to own our bonds. We certainly took advantage of that prerogative, didn't we?

Meanwhile, Europe witnessed the discipline imposed by a common currency, making it receptive to adopting the Euro in 1995, which immediately became another reserve currency, creating international demand for that new currency, as well as their bonds. I doubt the veterans sitting in Geneva in 1945 would have ever imagined how successful their work was. They created not only the world's first reserve currency but also the second!

Unfortunately, the Europeans took even greater advantage of having a reserve currency and issued enough bonds to get into trouble. In 2010, there has been lots of debate as to whether the Euro will survive, given the debt problems in Europe.

But, which nation would be most unhappy to see the dollar become the sole reserve currency again? China!
Does that nation have the ability to "save" the Euro? Yes!
Will it? Yes!
Should you worry about the collapse of the Euro? No!
Do you think the WWII veterans knew China would bail out Europe, after they had saved it . . . history is like a football, it bounces funny.

Wednesday, December 22, 2010

Q3 GDP Growth

Today, the Commerce Department announced that growth in the third quarter was slightly better than previously released, i.e., 2.6% versus 2.5%. It continues the stream of good economic news.

Growth in the first quarter was a whopping 3.7%, while the stock market was very bullish. Growth in the second quarter was a relatively sluggish (but still positive) 1.7%, and we saw a bear market.

With an accelerating rate for the third quarter and the stream of good economic news recently, I expect the fourth quarter GDP growth will be well over 3%.

Most analysts expect our GDP growth for all of 2011 to be about 3.5%. I listened to one this morning who expects 4.5% growth, which would be huge for us but puny compared to the 10% growth rates China and India have grown accustomed to.

With all the bullish news, it is not surprising that the Volatility Index has gotten quite low, suggesting the market is over-bought, which supports my expectation that the bear will return in late Winter or early Spring but won't be here long.

Season to Celebrate

The S&P is now at the highest level since September of 2008. The Dow has been up ten out of the last eleven days. The Bull is back?? Of course, the volume of trading has been very low, making the recent good performance of the market less reliable. Obviously, traders and investors are taking the rest of the year off and good for them!

The market mood right now is like the warm afterglow from a good bottle of chardonnay. Enjoy it, but get ready for next year!

This is a good time to look at your portfolio for tax planning. Most people have some tax loss carryforward from previous years. If so, consider taking some of this year's capital gains, as they will essentially be tax-free, and reposition that cash. Some analysts fear next week will be a bad week in the market for this reason, I doubt that. The Obama-McConnell tax deal postponed tax hikes on capital gains (and dividends) for another two years. So, a pending tax hike is no reason to sell before year-end.

I'll be discussing next year's forecast in this space, but the reader should be developing their own thoughts as well.

Lastly, do your financial advisor a big favor and start asking yourself if your investment objectives have changed? More importantly, has your tolerance for risk changed? If you are not sure, you need to call your advisor . . . now!

Monday, December 20, 2010

Crisis Investing

An investor takes a longer term view. He looks at those sectors and nations where growth looks most promising and then positions his portfolio to benefit from that growth.

A trader takes a short term view, sometimes in minutes. If war breaks out between the two Koreas, you can expect both the U.S. dollar and gold to rise together, which happens very seldom. You will see the Kospi stock exchange tank. All world markets will swoon for some period. A trader would be buying gold and dollars this morning and shorting the market indexes for Asia.

Of course, if there is no war, his gold and dollar investments will quickly lose value. More importantly, he could get wiped out by his short positions, where loss can be unlimited, if those Asian stock markets rally. His investment is based on some events happening and the fear that surrounds them. He is not interested in economics. This is not investing. This is called gambling.

Saturday, December 18, 2010

End Times ??

I was only thirteen years old in 1960, when establishment Republican Henry Cabot Lodge was the running mate of Richard Nixon in the presidential campaign, that they lost to John Kennedy. I recall Lodge being criticised by the John Birch Society and some religious groups as being supportive of a one-world government, which they believed was described in the Bible as the last step before the End Times.

Another establishment Republican, David Rockefeller, finally established the organization that Lodge favored, called The Trilateral Commission in 1973 to coordinate economic policies between the U.S., Europe, and Japan. It still exists today and does almost nothing except make each country more sensitive to the impact of its own economic policies on its two most important trading partners.

Recently, my mother asked me to read "The Coming Economic Armageddon" by Dr. David Jeremiah. Although it never mentioned the Trilateral Commission, I was reminded of it throughout the book. It begins with the classic (but true) argument from Austrian economics that we are living beyond our means, proceeding to the Bible's prediction of a one-world-government. It cites the current effort to improve international regulation of major banks as ominous. However, I reject the argument that globalization will cause the End Times.

Despite this ham-fisted effort to blend Austrian economics with Biblical prophecy, Dr. Jeremiah does an excellent job of discussing three very important subjects that seems to give laryngitis to elected politicians:

First, "we spend more on national defense than China, Japan, Russia, Europe, and several other nations combined."

Second, "the average federal worker's pay is now $71,206, much higher than the average private worker's pay of $40,331."

Third, he discusses at some length that politicians like to talk about the relatively minor problems with our annual budget, instead of talking about the much more serious problems with our over-promised long-term commitments to Social Security and Medicare.

While I cannot recommend this book to others, I did appreciate the trip down Memory Lane, especially with Henry Cabot Lodge, one of my all-time favorite politicians.

Should I Be Worried?

I've been predicting a slow but steady recovery for the economy. Of course, the stock market is only loosely related to the economy. The market has improved this year more than the economy has.

But, expectations for the stock market next year are awfully high. The S&P closed yesterday at 1244. Goldman Sachs predicts it will close at 1450 at the end of next year. That's up 16.5%. J.P.Morgan predicts it will close at 1425. Barclay's predicts 1420, while Bank of America predicts 1400.

The highest prediction is Deutsche Bank at 1550, up 24.6% from now.

If they are correct, we should substantially increase our allocation to stocks. (If they are not correct, what's new?)

I am bullish for next year but not that bullish. Probably in the early Spring, the market will get too far ahead of the economy and stall again, like it did this summer. Then, I expect it will recover and continue upwards . . . but not to 1550.

Historically, the third year of a presidential administration is the best year for the stock market . . . I hope so!

Thursday, December 16, 2010

A Patriot's Lament

Last night, I watched The History Channel. (Yes, economists do watch The History Channel but only because there is no Economics Channel.) The show was about the Third Reich and showed the suffering of ordinary people. Not to be disrespectful, but it also showed their inconvenience. They had shortages of consumer goods and electricity. They even had tax increases.

It reminded me of an evening a year or two ago, when one of my dearest friends and "forever clients" was sitting on my couch, lamenting the fact there was so little she could do for our warriors in Afghanistan and Iraq. A patriot, she wanted to suffer at least some inconvenience in their behalf. Instead, the President told her to go to Disney World and then gave her two tax cuts. While the President's instinct was to protect the status quo, he ignored the nobility of her emotion.

I think of her comments often. We are still a great people, and we deserve better government than we have. This lady would have taken a tax increase, a Social Security decrease, a Medicare decrease or whatever for her country.

Unlike Glen Beck, I have not given up on Americans. We are still a great people and will rise to meet the occassion. When austerity comes to America, there will, of course, be some riots, like the ones we're seeing in Greece and Ireland now, but we will handle it better than our politicians think. Bring it on!

Wednesday, December 15, 2010

Drumroll, please . . .

Yesterday, the stock market reached the highest point in over two years.

Does that mean the party is over? No, of course not!

Does that mean we will get back to our 2007 market high? Yes, but not in 2011.

Does that mean we face smooth sailing? Absolutely not! December and January are usually the two best months of the year for the market. We've been in a rally mode since July. It is time for the market to take a break and consolidate soon. February would be a logical time.

What about the market experiencing a double-dip? That is always possible. Market corrections normally occur because of cyclical factors, which I don't expect anytime soon. Sometimes, they are a result of an event, such as a financial collapss, which are sudden, like heart attacks. That scares me a lot and is the reason I hold so few bank stocks.

We're definitely in a recovery mode but remain subject to financial heart attacks.

Manana Economics

I love that expression . . . manana economics. It covers those areas of economics that can be dealt with tomorrow, i.e., where kicking the can down the road is a good idea.

Fareed Zakaria is a native of India with a Ph.D. from Harvard and writes a column for Newsweek, as well as being a CNN contributor. He coined the term referring to the inability of the U.S. to deal with its deficit problem, pointing out the new $900 billion tax cut extension only adds to the problem.

He also referred to the inability of the U.S. to tackle unpleasant and painful subjects as a disease of modern democracy.

Some drug addicts need an intervention by loved ones to deal with their addiction problems. Will loved ones provide the intervention that the U.S. needs or will it be bond vigilantes?

How time flies . . . it was only a week ago that the presidential deficit commission made their recommendations . . . seems like ancient history now?

Yesterday, for the first time, the bond rating agency of Moody's even put us on warning that we must deal with the problem. If we lose our AAA rating, the cost of borrowing will increase, making it even harder to manage the burden of our huge debt . . . tick . . . tick . . . tick . . .

Tuesday, December 14, 2010

A Grain of Salt

The Wall Street Journal just released their latest survey of economists. Generally, they are more optimistic!

The economy grew at 2.5% in the third quarter. Estimates for the fourth quarter were raised from 2.4% to 2.6% and 3.0% for the first half of 2011.

Also, they reduced the odds of a double-dip recession from 22% to only 15%, another good sign.

This survey was conducted prior to the tax deal. Presumably, the extension of existing tax cuts was "baked into" their thinking, but not the payroll tax reduction nor unemployment stimulus. A new survey would likely be more optimistic.

Things are certainly getting better . . . slowly!

Tax Cut Deal

Yesterday, the Senate took the first step in creating certainty about our tax burden next year. A believer in Supply-Side economics will be delighted because there are tax cuts. A believer in Keynesian economics will be relieved we didn't increase taxes during a recession. A believer in Austrian economics will be horrified that we made the deficit crisis worse.

I don't recall who said this but I've never forgotten the idea that "all great thinkers are mere followers of some dead economist." (Of course, the creator of supply-side economics, Arthur Laffer, is still very much alive.)

Putting aside all the pretty theories, the reality is that there will be a day within the next few years when the market will no longer buy U.S. bonds, unless the rate is very high and maybe not even then. We can argue the fine points of many economic theories, in addition to the Big Three. But, the bond vigilantes are not economists.

Monday, December 13, 2010

Half Full or Half Empty

When the Fed announced QE2, they expected interest rates would fall. At first, everything went as expected. Now, those rates have started to rise. Ten-year Treasury bonds now pay 3.36%, which is a six-month high.

One reason for interest rates to rise is that the Fed is causing it intentionally, which is not the case. Another reason is that the economy is improving, which makes it more expensive to sell bonds, and there has certainly been a great deal of good economic news recently. Yet another reason for rates to rise is that bondbuyers see inflation ahead, which I think is more likely.

In other ways, the rising interest rates may be sending a bullish signal or a bearish signal to the market.

Because long-term rates are moving up faster than short-term rates, I suspect the market will continue to rise slowly for some extended period, before encountering the obvious signs of inflation.

Wednesday, December 8, 2010

Attack of the Vigilantes

We've often mentioned the bond vigilantes who could cause unimaginable trouble for the U.S. and greatly increase the burden of paying interest on our huge national debt.

Today, our Treasury Department auctioned off $21 billion in 10-year bonds. Fewer bidders wanted the bonds. The bid-to-cover ratio was 2.92 compared to a recent average of 3.12. And, those bidders are demanding we pay a higher rate of interest, now 3.34% up from 3% a few weeks ago.

It could get a lot worse!

We've been running huge deficits for 8 years. We've spent hundreds of billions on stimulus. Yesterday, we learned the President and the Republicans added to the deficit by extending the tax cut. Today, a senior official at the Chinese Central Bank said Europe was a better credit risk than the U.S. We have no plan to deal with the growing deficit. Is it any wonder that bond buyers are worried about inflation and demanding higher rates to take risk of inflation and credit?

The bond vigilantes may get here before we expected. If so, sitting in cash would make me comfortable.

Tuesday, December 7, 2010

Reducing Uncertainty

Last night, the President announced a bi-partisan deal to extend the tax cuts for another two years, which reduced uncertainty. This morning, the Dow futures are up 81 points at this hour. You'll recall the inverse relationship between uncertainty and the markets.

It should be a good day for the markets! It is probably not significant enough to say it should be a good week, so let's enjoy the day. Of course, uncertainty will start to rise again before the two year extension comes up for renewal, and we'll have to re-invent the wheel.

Since there is now some faint hope that bi-partisanship may actually be possible, I do hope they will tackle the more thorny deficit problem, where every ox will be gored, including Social Security and Medicare.

Nonetheless . . . Good Start!

Monday, December 6, 2010


Normally, I am careful to avoid any discussion of politics, finding it seldom helpful. Both parties spin shamelessly. So, it may have been surprising to see me quoted twice in The Virginian-Pilot last Friday, referring to comments I made to a Senate hearing on redistricting.

Redistricting is as exciting as watching paint dry but terribly important. Because the borders of voting districts had been gerry-mandered years ago to limit the black vote, it was necessary to correct that wrong. But, in doing so, we have produced "safe" districts, i.e., districts that are safely Republican or safely Democratic, districts where incumbents oftentimes don't even face a challenger.

I summarized a book called "The Tipping Point" which pointed out how a single small change can produce a very large change. My point to the Senators was that the tipping point was the design of safe districts, because it eliminated moderate politicians. Safe Republican districts will not produce a moderate Republican, as they must pander to their base. Likewise, safe Democratic districts will not produce a moderate Democrat for the same reason.

I described this as "the politicians picking their voters instead of the voters picking their politicians".

I also likened the current situation to "an alcoholic who cannot be helped until he admits he has a problem. I suspect legislators will not be able to to fix this problem until they articulate it themselves and admit they have a problem. It is called partisanship."

Sunday, December 5, 2010

The Schizophrenic Economist

It has been fascinating, if saddening, to observe the political spinning around expiration of the Bush and Obama tax cuts this month. (Don't forget a third of Obama's $787 billion Stimulus bill was also a tax cut.)

My inner-Keynesian economist is afraid consumer demand will decrease if they are paying more in taxes, so the tax cut should be extended. My inner-Austrian economist is afraid of the mounting deficit and a possible attack by the bond vigilantes, so the tax cut should NOT be extended. My inner-Suppy-Side economist knows there is NEVER a good time to raise taxes, so the tax cut should certainly be extended FOREVER.

Maybe, we shouldn't be so harsh on politicians when economists cannot even agree on an economic problem.

I was wrong . . . I hope!

When was the last time you heard the word "deficit" used so often? I'll bet I heard it or read it more often last week than the last two years combined. That's a good thing!

When President Obama first appointed the Deficit Commission, I was disappointed the Republican Party did not support that effort and felt it would therefore just be another waste of time, like the 1987 Social Security Commission chaired by Alan Greenspan.

Like an alcoholic cannot be helped until they admit they have a problem, America has actually started to talk seriously about the problem of our deficit and the tradeoffs of each solution. That's a good thing!

I tend to think of our political system as too impotent to do more than talk, but maybe the beauty of our "system" is that we can deal with tough problems . . . but not until we are on the edge of the abyss. That's a bad thing!

Friday, December 3, 2010

There are tides . . . and there are tides

Recently, I blogged that market reflects tidal changes in certainty and uncertainty. The market goes down when uncertainty goes up and vice versa. Increasing certainty is good for the market.

An old and dear friend sent me a Shakespearean quote from his play Julius Caesar saying
There is a tide in the affairs of men, which, taken at the flood, leads on to fortune;
The context was that Brutus and Cassius were debating whether to continue attacking with exhausted troops or to rest for awhile. Brutus argued above that it was time to strike, even with tired soldiers.

From an investing perspective, it may suggest taking larger individual postions when the level of confidence is higher. However, from a geo-political perspective, it suggests China should not be reluctant to exert its economic influence. It is still pre-mature to exert military influence, but that day is coming.

Hopefully, the Chinese do not read Shakespeare!

Awful . . . but fishy

Today's Jobs Report was awful! Economists were expecting 144 thousand jobs were created and were stunned when they learned only 39 thousand were created. Given the steady flow of relatively good economic data over the past few months, this is a surprise . . . a fishy surprise.

Data for last month's Jobs Report was increased from 151 thousand to 172 thousand. So, we created 172 thousand jobs last month, had a month of good data, but only produced 39 thousand this month . . . something is wrong.

In addition, the unemployment rate jumped to 9.8%. It is normal for the unemployment rate to increase when the job market turns around, as people begin flooding back into the market and start looking again. So, why did so many people start looking again, since we were producing fewer jobs.

I expect next month's report will show a substantial upward revision to the 39 thousand this month.

In the meantime, this report increases the likelihood that the Fed will continue its quantitative easing program, that Congress will extend the Bush & Obama tax cuts, and that unemployment benefits will be extended.

Thursday, December 2, 2010

Like A Colossus

It was no secret that small, unassuming, professorial Ben Bernanke straddles the U.S. like a colossus. I have long felt that his "out-of-the-box" thinking and long study of The Great Depression made him extraordinarily effective as head of our Fed during the dark days of the Global Financial Crisis. I think he did a great job!

But, who knew he was also straddling the world? We learned yesterday that the Fed made $3.3 trillion in short term liquidity loans during the crisis, almost all of which have been repaid in full. While most of that went to U.S. firms, a surprising amount assisted foreign firms. (Because the report is 2,100 pages long, describing all transactions in all programs, the total is not yet available.)

In addition, there is now a rumor that the Fed will contribute to the European bailout fund, so it could handle a bailout of bigger nations, like Spain or Italy, probably preserving the European Union. The power of a "reserve currency" is greater than reasonable, but not unlimited.

Like a colossus . . .

The Miyagi Market

Back in 1984, there was a popular movie called "The Karate Kid". Mr. Miyagi was the mentor, teaching karate to a kid. Because karate moves are complicated, he simplified one move by telling the kid "Wax on, wax off".

The stock market has become "Risk on, risk off". Yesterday was obviously "risk on", as investors flooded into the market, taking risk. All day, good economic news rolled out, and investors continued taking risk, driving the Dow up 249 points.

The ISM Index came in better than expected. The ADP report on jobs was much better than expected. The Fed issued its Beige Book showing 10 out of 12 regions of the country are growing economically. Even the automakers reported good sales increases. Cyber-mondays sales were up 16% over last year, which is a good indicator that the consumer is getting healthier, finally! And, there was a strong rumor that the European Union would start a quantitative easing program like the U.S. With all that bullish data, it is not surprising that taking risk was more attractive to investors.

Not so surprisingly, all asset classes rose, which shouldn't happen under Modern Portfolio Theory.

For someone who studies the market daily, it is amusing to see it reduced to a simple rule-of-thumb like "risk on, risk off". Even Mr. Miyagi would be amused!

Wednesday, December 1, 2010

Thinking About Friday

The first Friday of each month is the most important Friday to the market, because that is the day that the monthly "Jobs Report" is issued. The current forecast is an increase in jobs of about 144,000 and the unemployment rate holding at 9.6%.

Creating that many jobs is certainly much better than losing 700,000 jobs a month, like we were doing just two years ago. We're going in the right direction but way too slowly.

This morning, we learned that productivity is still growing strongly, at 2.3%, while employment costs were down 0.1%. That means business is still getting more and more work out of the existing workers, who are grateful for the job and not complaining or asking for raises.

As I've said many times already, the bottom of this recession is not V-shaped, suggesting a sharp rebound. It is not U-shaped, suggesting we'll bump along the bottom before enjoying a sharp recovery. It is not W-shaped, suggesting we'll slip back into recovery. Instead, it is shaped like the Nike Swoosh, suggesting a long, slow recovery.

That also means unemployment will remain high a very long time. While painful, compare our 9.6% with Spain (20.6%), Ireland (14.0%), Greece (12.2%), or Portugal (11.1%). Frankly, that's a painful comparison, because those nations are teetering on the brink of financial ruin.

Recent forecasts of our Jobs Report have been overly pessimistic. Let's hope we do better than 144,000 this Friday! Go Team, Go!

Credit Default Swaps . . . Not So Boring

If I own a bond issued by AT&T, there is a possibility AT&T will not repay the bond at maturity. If I get worried about that, then I can buy insurance to protect me from that possibility of AT&T defaulting. Essentially, it guarantees I'll get repaid. The risk of the bond issuer defaulting is transferred or swapped to another company, often an insurance company. Of course, I have to pay for this insurance by paying a fee to the new company. They're not going to take on that risk for nothing.

Say, a year later, I'm no longer worried about AT&T being able to repay the loan. But, I still have this insurance or credit default swap that I purchased earlier. To recover some of the money I spent, I can sell it to someone who is still worried about AT&T. They may pay me more or less than I paid. It is a market driven price. If more investors have become worried about AT&T, then I will probably be able to sell it for more than I paid, making a profit. Some firms make a very good living just trading in Credit Default Swaps.

Are you asleep yet?

You can do the same for bonds issued by the U.S. government. Fortunately, the cost of buying such insurance against a U.S. default is very cheap, because we still have a AAA rating. If I own a bond issued by the government of Portugal due in 5 years and want insurance or a CDS that I will be repaid, the current price is about $54,490 per million. For Greece, it is $95,480, indicating investors are still more worried about Greece than Portugal.

Here's the interesting part . . .

Watching the changes in these prices tell you a great deal about the expected financial stability of other countries. When the bond market turns against you, this is where it shows up first. When the cost of Credit Default Swaps start rising, somebody out there in the marketplace probably knows more about something than you do, and it is time to start digging!

Now, was that really so boring?