Previously discussed historical evidence via the data has demonstrated that rising inflation and high inflation are negative drivers of equity appreciation.

The previous two interest rate cuts have produced negative returns for equities, yet, the call goes out to the Federal Reserve for further interest rate cuts.

The rate cuts are not intended for the equity market primarily. The Fed, while aware that higher equity prices are important for healing the Bank’s Balance Sheets, that the first stop must be via the Bond market.

They [Fed] are however very concerned with the Bond market, specifically the MBS section and increasingly the ABS area.

Why?

A very brief primer on Bonds is necessary. At the most basic level, there are two types of Bond, a “Perpetual” or a Bond that never repays principal, and all cash-flows [interest] are coupon based, and, Discount Bonds, or, zero’s, which pay all principal and interest at maturity.

The volatility of a “Perpetual” is exactly proportionate to percentage changes in yield at any level of yields.

The volatility of a “Discount” is not proportionate to changes in yield, but rather to “basis points changes” in yield.

Time for some numbers……………

Increase in price volatility by increase in maturity on a yield increase from 7.11% to 9.48%

Maturity…………………………..………….Price Volatility

…………………………………………3% coupon……….8% coupon

1year…………………………………….-2.23%………………..-2.21%

5years……………………………………-10.0%………………..-9.14%

10years………………………………….-17.23%………………-14.79%

20years………………………………….-25.0%………………..-20.64%

30years………………………………….-27.20%………………..-23.09%

Perpetual………………………………..-25.0%………………….-25.0%

Basics of the MBS market

*MBS are Bonds secured by residential property

*Comprised of “Pass throughs” & “Collateralized mortgage obligations” [CMO]

*Payments received monthly [interest + principal]

*Prepayment and Extension risk

These characteristics and structure of MBS & CMO alter significantly their functioning within a portfolio.

Repayments are caused by;

*Curtailments

*Refinancing

*Home sales

*Defaults

Extension risks are caused by;

*Increasing interest rates

*Lack of house sales

*Falling refinancing

This double whammy has a name, and it is called “Negative convexity”. Negative convexity, ignoring the mathematics simply means that MBS securities are far more volatile in the wrong direction for investors.

They decline more in value than other bonds in a rising interest rate environment, and appreciate less than other Bonds when interest rates fall.

Additionally the MBS securities have been financially engineered to further alter these basic characteristics, we have;

*Interest only [IO]

*Principal only [PO]

*PAC structures

*Z-tranches

*Inverse Floaters

The effects of these engineered securities’ are untested, with no-one really fully understanding how they will react, so far it would be fair to say, not well.

Currently in the MBS market [Bond market] we have the following conditions;

*Rising interest rates [from where these MBS securities were originated]

*Increasing defaults

*Credit downgrades from ratings Agencies [S&P, Moody’s]

*Falling house sales

*Marked-to-market prices being marked

*Forced Regulatory sales being triggered

The volatility that is being experienced within the Bond market is quite possibly the highest for some number of generations; we have the financial sector literally imploding.

E*Trade sold $3.1 Billion of bonds for some $350 million, or approximately $0.11 on the $1.00, the Banks, carrying not only the underlying bonds, but, an additional $45 TRILLION in CDS instruments are hanging on by a very thin thread.

The Fed will cut rates, not because they want to…..inflation is knifing upwards, the dollar is under extreme pressure, but because they have to, to save the financial institutions and I include in that; Banks, Insurance Co’s, Pension Funds and any other holders of public money.

Greenspan through his efforts to save consumer spending in the face of massive levels of destroyed paper wealth of the average person via the stock market crash of 2000, particularly the NASDAQ, restored their paper wealth via the real estate market.

Unfortunately, this bubble is now leaking gas at an increasing rate. The problem is magnified however that the financial institutions that hold assets within insurance products, annuities, and pension assets, have been caught holding the financial paper of this latest bubble. The banks are struggling to save their Balance Sheets, and it is not inconceivable that a major Tier 1 Bank, a Citibank, could yet go under.

Thus we have the increasingly desperate lowering of interest rates to try and influence volatility in a positive direction, by restoring value to these assets. Due to the negative convexity, this unfortunately is not easy, as they simply do not respond to the upside in the same manner as the downside, added in downgrades, and the Fed has a nightmare scenario unfolding.

Thus, as an equity investor, you must pay attention to the effects of falling interest rates will potentially have on inflation. Equities are an inflation hedge, but not for the reasons generally proposed. It is rather the addition of huge amounts of new capital…something that happens over time. Thus, short term aggressive inflation damages equity values.

As in any bear market there will be significant rallies to the upside, followed by significant declines. The bear will not resolve quickly, as, the Bank’s have [again] dug a fairly deep hole that they must gradually climb out of.