QE2 Sinks Munis - Time to Buy?

Muni bond investors felt that sinking feeling last week as their longer-term munis were swamped in the wake of QE2. "Munis in Trouble" headlined this jaw dropping chart of PIMCO's muni fund (courtesy The Big Picture):

A quick scan of the blogosphere will show boatloads of doom & gloom prognostication for the muni market. The collapse continued today and shows no sign of abating. Advisors are recommending an exit strategy, out of munis. 

Out here in the Left Coast of Cali-for-nia, the morning stories were about how the deficit is widening to over $25B, a number previously thought inconceivable. The exiting governator, Arnold Schwarzenegger, is trying to call a special session to deal with it, but the Democrat legislature would rather wait for the second coming of Jerry Brown. Maybe he can find a way to save their pensions and government salaries by cutting, well, what exactly? The Golden State has no defense budget to slash. Muni advisors look this way and see Greece. 

Yet munis are one of the few markets left with real investors, and only modest speculative interest. An attempt to turn the staid muni market into a feast for rapacious financial innovation fell apart during the past two years. The muni buyer may have heartburn but is unlikely to roll out quickly. The Muni ETFs are more likely to suffer as investors take to the lifeboats.

I own California munis, and think it will soon be time to buy more. Let me lay out my four reasons:

1. Seasonal factors are softening rates
2. Buying interest remains strong
3. Munis trade on technicals, and track Treasury changes most closely
4. Fundamentals are trickier than normal but do not presage defaults

1) Seasonal factors have momentarily spiked rates: the muni market is about to absorb a lot of issues, about half coming from California. The Federal Buy America Bond program may expire soon, putting more pressure on the traditional muni market to issue more. While the muni market is relatively steady, it does swing down before big issues and up after. This is usually a good time to be a buyer. 

These seasonal factors also include the impact of the election. The choice of Jerry Brown over Meg Whitman in California is hard to parse for bondholders: she would likely have been as stymied as Arnold Schwarzenegger in getting the State's finances under control; and maybe Jerry will "go to China" and whack the unions. One can dream. Outside of California, the election put more austerity governments into the States, which should be good for bonds.

The election has also thrown into doubt some props for munis from the Federal government. Citicorp did a good analysis of this, noting that regulatory uncertainty was causing weakness in munis. With clarity in the new Congress, munis should improve.   

The election has also made the extension of the Bush tax cuts more likely. I am doubtful it would have much impact, but it may have helped cause the momentary bond weakness. While it makes the tax advantages of munis a little less valuable than they would have been otherwise, the size of the rate increase it the upper bracket is modest (3%). Oversold ... 

2) Buying interest remains strong, still twice the selling interest:

Actual flows into munis have weakened recently, well off their heights over the summer. This is as expected: buying interest abates as rates rise. As the rate spikes flattens, buyers should return. Oversold ... 

3) Munis trade much more on technicals than fundamentals, given their historic default rate. They respond the most to changes in Treasury rates, and this is why we have seen recent plunges.

Noteworthy to me is that the biggest drop are in longer-term munis, tracking the drop in the long bond. Mid-term munis have not moved that much, at least not quality issues.

In some respects you could argue that QE2 is working, at least to drive up inflationary expectations: the long bond yields have continued to rise. The Fed said it was not planning to buy long bonds. Ergo, rising on inflation fears. 

What is most concerning is the wake of QE is also lifting the mid-term Treasuries, the 2-yr and 5-yr, bonds specifically target by the Fed for lower rates (chart from Doug Short):

My take on this is the markets are over-reacting. The bond vigilantes are out in force. Op-eds appear urging the Fed to back off QE. The rise of the ten-year may now be reflecting an expectation of QE being cancelled! Nuts. The Fed will not risk its own credibility (at least not that way - if QE2 is a bust, it will suffer). 

Side note: the markets do not reflect the best price. Markets flow from one extreme to another. Does anyone believe in the efficient market hypotheses anymore? Markets are always overreacting, to one side or the other. 

If it also turns out, as I expect, that inflation fears are overblown, the long bond should reverse as these fears are seen as overblown. Even if QE leads to later inflation, the typical lag from pump priming to inflation is as long as two years. Oversold ... 

4) Fundamentals are looking tricky. Default risk is rising. Usually munis are not held to maturity, but traded, but if default risk rises too fast, all bets are off. 

There are some disturbing signs. Cities in California are dropping services, such as police. Near where I live, San Carlos is disbanding a police force that it has had for 85 years. Over the coast range from San Carlos, Half Moon Bay is considering unincorporating (it gets a half its revenues from tourism, which is down). In both cases the problem falls into the lap of the county sheriff. 

The event that almost sent shudders into the muni market happened in Harrisburg, Pennsylvania. Harrisburg dropped $3.3M in payments for its munis. At the last minute, the State came in and covered. It is now hard to see how Harrisburg escapes bankruptcy; they are exploring bankruptcy as an option. Payments may then be postponed, but the bonds usually have highest priority and should be safe, at least as to principal.

When the California city of Vallejo went bankrupt, the biggest fear was not muni default but some sort of deal between the city unions and the bondholders, politically improving the priority of union pay over bond payments. In California, we shall find which side of that divide Jerry Brown lives on. If he picks the wrong side, the California bond market will slap him hard. If he is unable to bridge that incredible budget gap with bonds, he will have to quickly run for President again. Jerry in 2012! Whichever, the wrong choice will not persist. 

The risk to munis will be the highest over the next two years, as States finally deal with their budget shortfalls instead of kicking the can down the road. A pretty good summary of the situation is here, and is captured in this chart. Federal support is largely ending this year, and so the day of reckoning has finally come:

Muni defaults are said to be "soaring", but they are still at low levels, and look in 2010 to only get back to default levels of 1992, a far cry from the fear of wholesale collapse of muni payments. 

My take is that the fears are grossly overblown. Weakness in munis separates the wheat from the chaff. A lot of munis are not well-backed by the State or city credit; they reflect industrial projects and special districts. Those sorts of projects are at risk, and most of the stories of muni default, such as this one about Jefferson County Alabama, are really about special projects (in this case sewers) plus plain old corruption. (The irony in that case is the bonds in question were to finance a federally-mandated improvement in sewers rather than local need.) The coming Calif budget cuts may wreak havoc on the junior claims in the muni stack, but the general obligation bonds are untouchable.

The past decade has been a Lost Decade for equities, but a good one for munis. This chart shows how a muni ETF has grown from 1400 to 3100 since 2000, for a 120% return. Contrary Investor, author of the accompanying article, said that looking back, the correct choice would have been to liquidate equities at the bubble peak and rollover into munis. 

They take the classic contrarian position that the best time to go in is when everyone thinks you are nuts. We are not quite there with munis, as buying interest remains solid. They give several canaries in the muni goldmine, including any sharp break in the key funds, such as PIMCO - which is the chart at the top! So is the end of munis at hand?

My canary is the Dollar. If inflation is truly at hand, the Dollar will continue to drop well beyond the levels it has recently bounced off of. Instead, we now seem to have a recovery of the buck. It as bounced quite fast off the recent low, and has breached the recent downward channel to the upside. Dollar strength should call into question all the over-reaction about inflation and with it the continuation of rising bond rates. In the end the muni market is technical and responds to the larger trends in the bond market. 

Comments

[Hockthefarm]

Yelnick:

That's quite a return for muni's this century. Wow.

Placed an order today for Gary Shilling's new book:

The Age of Deleveraging: Investment Strategies for a Decade of Slow Growth and Deflation. He appears to like the dollar, the long bond and select energy plays per the Amazon skim. Should be a good holiday read.

If he is right, default should be the main risk for munis going forward. If munis don't default in this environment, they never will. As for Jerry Brown, way too old. A pure political hack. I sat beside MW on a long plane ride about 10 years ago. Was she ever bright. Not sure brains is the answer to California's problems, so the next few years should be interesting.

Good luck with the muni's

Hock

[Account Deleted]

S&P 500 Futures before opening bell
http://niftychartsandpatterns.blogspot.com/2010/11/s-500-futures-before-opening-bell_16.html

[MHD]

AS Karl D. says, you are either getting the buy of the century, or will have your head handed to you on a plate!

[Roger D.]

The JNK Daily

Looking good.

Roger D.

http://www.screencast.com/users/fast996/folders/Default/media/ff8224b8-c774-4598-ae68-6f02b90da592

[Neo Tzu]

Sharp x-wave rally due next week into the 15 week highs, then the SHARP SLAM down into the Dec. 1 Gann cycle low....

[Roger D.]

They sure have sold the REIT's with gusto since the top. It looks like the DJR is in a 3rd wave here too with a 4th and 5th to follow. Bernanke, the market is sending you a message...go back to Princeton where you belong.

Roger D.

[Neo Tzu]

Any traders out there who have ever tried to explain to others what you do for a living will enjoy this....

http://www.xtranormal.com/watch/7107529/

[Dsquare]

Neo, that count is just dumb IMO.

[Neo Tzu]

Dsquare, my count is rooted in time and cycles its NOT Prechter Elliott or Neely Elliott.

You'll see how it works when next weeks x-wave rally fails and is followed by an a-wave selloff into early December.

You'll see.

[Neo Tzu]

This whole Elliott double-three correction pattern that began October 13, 2010 is due to complete December 23, 2010 +/- when the bull market resumes.

[I've Been Prechterized]

"Bernanke, the market is sending you a message...go back to Princeton where you belong." - Roger D.

Roger,

Perhaps you should go back to working the "Fry-o-Lator" at your local Mickey D's.

You'd be making more money that way than littering this blog with your absurd posts over the last year and a half and missing out on the greatest stock market rally in a generation!

[Roger D.]

At least I'm not responsible for the gretest fraud perpatrated on a nation inall human history. Quit your fucking dribble and go back into your hole,coward.

To bad you lost your ass today. You should have listened to me when I said this market would top on November 10th. Plus nobody gives a rat's ass about you or me.

It's funny how all you bulls can't be found when the market goes down,but can sure dish it out when it goes up.

GFY I've been fuckitised by Ben Bernanke

Roger D.

[Neo Tzu]

Since the late August Lows, we have had 5 corrections lasting 1-2 trading days....they are as follows (approximate)

8/31 low = 24+ SPX points
9/23 low = 26- SPX points
10/4 low = 25+ SPX points
10/19 low = 26- SPX points
10/27 low = 24+ SPX points

The Gann Rules for a real CIT (Change in Trend) to down is the decline should last longer than 2 TD and must exceed the largest decline which was that 26 SPX points.

So far the SPX has surpassed the 2 TD and 26 point RULE which means the trend has officially turned to down and you should no longer heavily buy dips, but instead sell rallies.

I plan to AGGRESSIVELY short any rally that appears next week based on the Gann trend and my X-wave count.

[KKD]

moment of silence for the bulls

http://www.youtube.com/watch?v=p1gfOcrStkc

[Goldonomic.com]

We warned for a Bond and Treasury debacle already in 2009. After Greece & Co. the US Municipalities sit in deep problems....We're coming out of the eye of the storm and this time BOND holders will be wiped out. Governments have NEVER paid back their debts and this time won't be different.

[DG]

You should have listened to me when I said this market would top on November 10th.

Why? Anyone who heard you say the market would top on every other day of the preceding 11 months and 9 days would have known you were wrong then, so why listen to you on November 10th? What? Because you were extra-special super-duper absolutely-positively sure it would top? Like the other 300 times you were extra-special super-duper absolutely-positively sure it would top?

Do you have even the slightest clue how pathetic it is to be beating your chest about calling the top when you have hundreds of failed top calls littering the blog? Deluded old man.

Dsquare, my count is rooted in time and cycles its NOT Prechter Elliott or Neely Elliott.

Not sure how you are using "time" per se, but there are definitely uses for it in trading. "Cycles" are WAY too imprecise. Essentially, I don't want to use any time-related variable with a standard deviation. Way too easy to rationalize staying in a trade just one more day and getting whacked as a result or getting out because the cycle's "done" and missing another day of gains.

Also, not that wave theory has a monopoly on Progress Labels, but if you're not using wave theory, how can you call what you have a "count"?

On another note, I know in some quarters it's bad form to quote yourself and how awesome you are, but, damn, I'm awesome! Nailed the high of the range within 7 points. :) This is how you call a top, with one post made within a few days or a couple weeks, max, with a specific price target, not post after post after post.

http://yelnick.typepad.com/yelnick/2010/11/qe-stumbles-at-the-starting-blocks.html?cid=6a00d8341c563953ef0133f5ceb8aa970b#comment-6a00d8341c563953ef0133f5ceb8aa970b

BTW, that XLF breakout does appear to have failed. Although, in the bulls' defense, it is retracing the breakout from 14.50 slower than it happened, at least relative to the last few points of the breakout, so there is still some logical reason to believe that the bullish undertone is still intact. So, yes, we could still go back up.

Governments have NEVER paid back their debts and this time won't be different.

Why would they? Governments are just mafias with better PR. You ever see the mafia pay back debts? Yeah, right, they pay you back with two to the back of the head. Government sends the tax man after you and bleeds you dry, with the same end result.

[trendlines]

Hang Seng Index: Support at 23000 again

Since the break above 23000, HSI traced out a successful back-test once, before resuming higher towards 25000. An overbought negative divergence created a sharp move lower, coinciding with the dip in the SSEC. Although now oversold on the hourly, the initial support at 22500 did not hold up. Next solid support level is at 23000, with additional help from the rising channel line. A second successful retest might see us range-bound between 23000-25000 for a while, before launching higher towards 27000 area. A break below 23000, will be bearish medium-term.

http://trendlines618.blogspot.com/2010/11/hang-seng-index-support-at-23000-again.html

[Frontrunner]

November 10th wasn´t the TOP. All indices will today resume the (LAST) upmove to complete the whole upmove from the july bottom. Sorry Roger, wolf! wolf! again and again...

[OracleLurker]

that wasn't much of a 4th wave if the 5th is starting today...

[Frontrunner]

Don´t count it as a 4th, give it a better try...

[Account Deleted]

Dow Jones Futures before opening bell
http://niftychartsandpatterns.blogspot.com/2010/11/dow-jones-futures-before-opening-bell.html

[Account Deleted]

Dow Jones Futures before opening bell
http://niftychartsandpatterns.blogspot.com/2010/11/dow-jones-futures-before-opening-bell.html

[Just watchin]

Actually, there is a lot of contempt/anger directed at Bernanke and Greenspan by Idiott Wavers.

If Idiott Wavers were such scientific, impartial students of the world they wouldn't be so angry and bitter and contemptuous.

But they are. And that idiotic appealing-to-morons cartoon recently posted to this site is a perfect example.

Idiott Wave is for people who didn't get the love and approval they needed as kids so they pretend they know so much more than all those other "idiots" out there.

But they're the idiotts. And if they gamble on their idiottic theories they are the poorer for it.

[Neo Tzu]

Full Moon lows due this week - 15 week highs due next week - 13 week lows due early December....this isnt a wave 4 either, its much more bullish than that once these lows are in.

[Neo Tzu]

Get ready Roger, my wave count says the SPX is headed above 1850 by 2013.

[Neo Tzu]

I re-adjusted my c-wave, I dont think its over yet.

[Account Deleted]

G !!

Do u think market has topped out and this whole rally from March 09 has ended and we are in a C leg (of whatever a Triangle or a FLAT).

Can u please post your Latest count on SNP500.

Thanx in Advance
VB

[Account Deleted]

DG !!

Do u think market has topped out and this whole rally from March 09 has ended and we are in a C leg (of whatever a Triangle or a FLAT).

Can u please post your Latest count on SNP500.

Thanx in Advance
VB