Divestor – Page 299 – Canadian Finance, Economics and Fiscal Analysis

The Trillion Dollar Euro Bailout

The European Union Bank is effectively going “all-in” by pledging $1 trillion in collateral to shore up the economies in the Eurozone.

What people should be fully aware of is that while this might delay the financial issues concerning the countries in the Eurozone, this is not going to solve the underlying problems – too many entitlements promised to people and not enough money to pay the corresponding liabilities. The only solutions are to reduce the entitlements (which is difficult to achieve politically) or raise revenues.

Clearly by stalling for time, they are hoping something might happen that would alleviate themselves of the fiscal mess they are in, but by stalling any action that would clean up the mess, it will just make it worse in the future when the proverbial excrement hits the fan.

It is my market opinion that we have not seen the end of this by any means. How to play this profitably is difficult – increasing cash allocation and playing the risk aversion card seems to be wise until such a time it becomes evident that the markets have discounted sufficient risk to account for the soverign debt mess that is looming.

The United States is not immune to this, but economists do know that countries such as the United Kingdom, other European countries and Japan are more likely to face these big macroeconomic/demographic issues before the USA will.

Countries like Canada, relatively speaking, are in decent shape. While old age security payments and guaranteed income supplements will increase as the baby boomer generation retires, entitlement payments are relatively low and can be managed. Our pension plan (CPP) is solvent and funded by real assets generating real returns (although how those assets will perform in a global debt default remains to be seen). The big liability, accrued healthcare spending, is the big political hot potato. The Canadian economy seems poised to take advantage of one major trend, mainly that consumption of energy will continue to increase – our oil industry is going to boom assuming there is no massive deflation of debt and international trade.

I still have no idea whether the deflationary or inflationary theory will win out.

Canadian Interest Rate Projections – May 2010

I figure it would be helpful to see what the Canadian interest rate futures are doing and to make some projections as to what the market is saying about future rate increases:

Month / Strike	Bid Price	Ask Price	Settl. Price	Net Change	Vol.
+ 10 MA	0.000	0.000	99.375	0.000	0
+ 10 JN	99.150	99.160	99.250	-0.100	14740
+ 10 JL	0.000	0.000	99.365	0.000	0
+ 10 SE	98.730	98.740	98.820	-0.080	22075
+ 10 DE	98.340	98.350	98.410	-0.060	29381
+ 11 MR	98.050	98.060	98.100	-0.050	8873
+ 11 JN	97.740	97.770	97.810	-0.060	2777
+ 11 SE	97.440	97.480	97.550	-0.080	2076
+ 11 DE	97.220	97.270	97.310	-0.070	216
+ 12 MR	96.910	97.150	97.060	-0.250	1
+ 12 JN	96.550	96.930	96.860	0.000	0

My projection for the Bank of Canada overnight interest rate level is the following:

June 1, 2010 (+0.50% to 0.75%)
July 20, 2010 (+0.25% to 1.00%)
September 8, 2010 (+0.25% to 1.25%)
October 19, 2010 (+0.25% to 1.50%)
December 7, 2010 (+0.25% to 1.75%)

What has changed since my last projection is that the initial rate increase in June 1, 2010 will be 0.50% instead of 0.75%. I still see subsequent rate increases of 0.25% at each scheduled announcement. You can probably thank the European debt situation for this change.

Although Canada’s economy is much less linked to Europe than it is to the USA, it is enough to factor into the economic calculation. In particular, the Euro has dropped significantly and this will lessen the competitiveness of Canadian exports into the Euro market.

That said, relative to the US dollar, the Canadian dollar has slipped a little, but this probably isn’t enough to take into consideration other than “wait and see”.

Long-term rate projections, which is more relevant for mortgage pricing, has had rates drop over the past two weeks. 5-year bond rates are 2.74%, while the 10-year is at 3.47%, which is roughly the rates seen in the past three quarters. If the market stabilizes at the existing level, I would not be shocked to see a 5-year fixed mortgage rate offered at 4.00% in the next couple weeks.

Aftermath of the May 6 financial earthquake

I have been diligently scanning the markets with respect to the very volatile trading session on Thursday.

Implied volatility on the S&P 500 is still at around 36-37%, which is considerably higher than the average of 16-17% it was in the month of April. Option traders buying volatility would have done very well, but volatility spikes are just as difficult to predict as price spikes.

I find it odd that income-bearing equity tends to be trading lower, but income-bearing preferred shares and bonds are relatively stable. This could be due to the decrease in the implied future interest rates.

My long-term corporate debt issues, however, have taken quite a haircut over the past few days. I trimmed some of the position last month at yields I thought were pretty low (around 8%-8.5% for 20-year paper), but didn’t sell enough as it is now trading about 150bps higher. One of the advantages of dealing with debt (debt that you know has a very high chance of not defaulting) is that you don’t stand to “lose” that much opportunity cost by waiting – you will receive your coupon payments and wait for a better opportunity to sell when yields go lower, or accumulate if yields go higher.

The net damage report for this week is about 6%, but I do not see any reason why the intrinsic value of my portfolio has dropped any – the investments that I do have should continue to generate roughly the same projected amounts of positive after-tax cash flows. The income being produced is significant and should continue to be this way.

Market history lesson – April 4, 2000

Today’s trading reminded me very sharply of what happened on April 4, 2000 when the Nasdaq fell by about 13% but recovered to end the day nearly flat. The CNNFN article has a few charts.

Ten days later, the Nasdaq was down 20%. The following week, the Nasdaq was up 10%.

For the next few months the Nasdaq gyrated, but peaked at the end of August before resuming its descent in September 2000, all the way until October 2002 when it plunged down to about 1200.

Is history repeating? I don’t know.

Is it a good time to be on margin? Probably not. The volatility will kill you.