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Treasury Supply Set to Increase . . . By Trillions

This note was originally published January 21, 2011 at 15:46 in Macro

 

Conclusion: We believe U.S. Treasury issuance over the coming three years could be ~34% higher than expectations.  Increasing supply is bad for price.

 

Position: Short Treasuries via the etf SHY

 

On a very basic level, supply and demand set the market price for any good, commodity, or product that is “traded”.  So, as supply increases, demand must match it, or price will decline.  Obviously in practice, especially when trading the global financial markets, it is slightly more complicated.  That said, large moves in either future demand or future supply still do matter.  As it relates to Treasuries, we believe future supply will be much higher than consensus expects primarily because the U.S. deficit will be higher than expected.

 

Currently, the Congressional Budget Office (CBO), which we consider consensus for this purpose, projects that the federal budget deficit for 2011, 2012 and 2013 will be $-1,066BN, $-665BN, and $-525BN, respectively.  This is a combined deficit of $-2.3TN.  (Yes, that is a big number.)  So, all else being equal and setting aside any maturities, the United States will have to issue $2.3TN in treasuries to fund the CBO’s projected budget deficit over the next three years.  So if we accept that there is ~$14TN in government debt outstanding (Source: usdebtclock.org), then the outstanding government debt over the next three years will grow 16%.   That is, supply is going up.  Given this outlook, it does make sense that interest rates on 30-year Treasuries are moving higher, as noted in the chart below.

 

Treasury Supply Set to Increase . . . By Trillions - 1

 

Interestingly, we think that the CBO’s budget deficit projections are low, and perhaps meaningfully so. Currently Hedgeye’s U.S. budget deficit projections for 2011, 2012, and 2013 are $-1.2TN, $-1.0TN, and $-0.9TN, respectively.  Combined, this is a total deficit for the ensuing three years of $3.1TN.  In aggregate, our projections are $800BN more than the CBO, or 34% higher for the three year period.  The implication being that the issuance of U.S. Treasuries may be almost 34% higher than “consensus” expects over the coming three years.  No doubt some of this is priced in, but our models have supply growing at an accelerated rate relative to what is likely priced in. And the questions remains, who is going to buy these treasuries?

 

Increasingly, of course, foreigners will have to buy more Treasuries, which is geopolitical risk for U.S. sovereignty.  We highlighted this risk in an Op-ed to Canada’s Globe and Mail, where we wrote:

 

“Dependence on foreign oil is a real economic and strategic risk for the United States, but what about the risk related to its dependence on foreign debt financing? The combination of a low domestic savings rates and lack of government savings (that is, a massive deficit) means that the U.S. will continue to rely on foreign financing to bridge deficits well into the future.”

 

As we reviewed the most recent TIC data, it is clear that the amount of foreign buying is increasing.  In fact, foreign ownership is up 16% y-o-y.  So, which nation is buying all this U.S. debt.  Well, the answer is unclear.  In the chart below, we’ve highlighted the nation that appears to be buying the bulk of his new issuance . . . the United Kingdom.  “UK Holdings” has increased their holdings of U.S. Treasury Securities by $356BN year-over-year, which is growth of 229%! In reality, it isn’t the United Kingdom buying the Treasuries, but other sovereignties buying debt through the United Kingdom.  Most likely the Chinese, who have to continue to buy U.S. dollar paper to maintain their exchange rate at parity.

 

Increasingly as the U.S. funds its deficit with more Treasury issuance, investors will undoubtedly demand higher rates.  Along with this, if the Chinese are indeed saying one thing, that is questioning the value of Treasuries, but continuing to buy via “UK Holdings” then the global market for U.S. Treasuries becomes even murkier, which can’t be positive for price.

 

Daryl G. Jones

Managing Director

 

Treasury Supply Set to Increase . . . By Trillions - 2


Treasury Supply Set to Increase . . . By Trillions

Conclusion: We believe U.S. Treasury issuance over the coming three years could be ~34% higher than expectations.  Increasing supply is bad for price.

 

Position: Short Treasuries via the etf SHY

 

On a very basic level, supply and demand set the market price for any good, commodity, or product that is “traded”.  So, as supply increases, demand must match it, or price will decline.  Obviously in practice, especially when trading the global financial markets, it is slightly more complicated.  That said, large moves in either future demand or future supply still do matter.  As it relates to Treasuries, we believe future supply will be much higher than consensus expects primarily because the U.S. deficit will be higher than expected.

 

Currently, the Congressional Budget Office (CBO), which we consider consensus for this purpose, projects that the federal budget deficit for 2011, 2012 and 2013 will be $-1,066BN, $-665BN, and $-525BN, respectively.  This is a combined deficit of $-2.3TN.  (Yes, that is a big number.)  So, all else being equal and setting aside any maturities, the United States will have to issue $2.3TN in treasuries to fund the CBO’s projected budget deficit over the next three years.  So if we accept that there is ~$14TN in government debt outstanding (Source: usdebtclock.org), then the outstanding government debt over the next three years will grow 16%.   That is, supply is going up.  Given this outlook, it does make sense that interest rates on 30-year Treasuries are moving higher, as noted in the chart below.

 

Treasury Supply Set to Increase . . . By Trillions - 1

 

Interestingly, we think that the CBO’s budget deficit projections are low, and perhaps meaningfully so. Currently Hedgeye’s U.S. budget deficit projections for 2011, 2012, and 2013 are $-1.2TN, $-1.0TN, and $-0.9TN, respectively.  Combined, this is a total deficit for the ensuing three years of $3.1TN.  In aggregate, our projections are $800BN more than the CBO, or 34% higher for the three year period.  The implication being that the issuance of U.S. Treasuries may be almost 34% higher than “consensus” expects over the coming three years.  No doubt some of this is priced in, but our models have supply growing at an accelerated rate relative to what is likely priced in. And the questions remains, who is going to buy these treasuries?

 

Increasingly, of course, foreigners will have to buy more Treasuries, which is geopolitical risk for U.S. sovereignty.  We highlighted this risk in an Op-ed to Canada’s Globe and Mail, where we wrote:

 

“Dependence on foreign oil is a real economic and strategic risk for the United States, but what about the risk related to its dependence on foreign debt financing? The combination of a low domestic savings rates and lack of government savings (that is, a massive deficit) means that the U.S. will continue to rely on foreign financing to bridge deficits well into the future.”

 

As we reviewed the most recent TIC data, it is clear that the amount of foreign buying is increasing.  In fact, foreign ownership is up 16% y-o-y.  So, which nation is buying all this U.S. debt.  Well, the answer is unclear.  In the chart below, we’ve highlighted the nation that appears to be buying the bulk of his new issuance . . . the United Kingdom.  “UK Holdings” has increased their holdings of U.S. Treasury Securities by $356BN year-over-year, which is growth of 229%! In reality, it isn’t the United Kingdom buying the Treasuries, but other sovereignties buying debt through the United Kingdom.  Most likely the Chinese, who have to continue to buy U.S. dollar paper to maintain their exchange rate at parity.

 

Increasingly as the U.S. funds its deficit with more Treasury issuance, investors will undoubtedly demand higher rates.  Along with this, if the Chinese are indeed saying one thing, that is questioning the value of Treasuries, but continuing to buy via “UK Holdings” then the global market for U.S. Treasuries becomes even murkier, which can’t be positive for price.

 

Daryl G. Jones

Managing Director

 

Treasury Supply Set to Increase . . . By Trillions - 2


JNY Miss: Proactively Predictable

 

It’s been a while since a miss did not phase me whatsoever.  JNY has been one of our favorite short ideas. But importantly, it is not done. Three considerations…

 

1)  I’d call this a ‘mini-miss’. Yes, numbers are coming down, but are still based in part on ‘strong brand performance,’ selective price increases, and mid-single digit revenue growth.  Do you want to give them a free pass on that? Be my guess.

 

2)  There will be another one of these. Keep in mind that JNY values inventory on the lower of ‘cost or market’ and then layers this over FIFO accounting. Translation = gross margin weakness today is using raw materials procured anywhere between 6-12 months ago, and includes ‘rebound demand’ of msd comps.

 

3)  By mid-year we’ll be looking at ‘normalized’ demand, on top of raw materials being purchased today. Then we get to witness first hand the gong show that ensues as the supply chain beats itself up to protect margin, or find some growth.

 

The point is that no one should use this as an announcement as an indication of ‘ok, the blow ups are here, now I can selectively buy.’ Quite the opposite. The blowups are here, and will accelerate throughout the year.

 

Here’s a YouTube of JNY’s guidance today vs. 13 weeks back.

 

JNY Miss: Proactively Predictable - JNY Youtube 1 11


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Bullish on Brazil (and Other Emerging Markets)?

Conclusion: Much like China and India, we believe the Brazilian central bank will continue to tighten the screws on its monetary policy over the intermediate term. Further, we don’t think a pending slowdown in Brazil’s domestic growth as well as a deceleration in global growth is fully priced into Brazilian equities.

 

We’ve been getting a lot of questions over the past few weeks asking us whether or not we would like to get long Brazil here. The quick answer is, “no”, largely due to the quantitative setup: Brazilian equities are broken TRADE and are flirting with being broken TREND.

 

Bullish on Brazil (and Other Emerging Markets)? - 2

 

From a fundamental perspective, the question remains, "Do you really want to be getting long anything emerging markets right here and now?"

 

Our answer there is, “no”, as well. We’ve been advising clients to reduce their EM exposure for the last 2-3 months, citing these three reasons: 

  1. Slowing Growth Globally: growth, particularly in the bigger, more meaningful EM driver-seat economies (China, India and Brazil) is likely to slow in 1H11 due to:
  2. Accelerating Inflation Globally: rising inflationary pressures which will beget tightening of monetary policy and cause:
  3. Compounding Interconnected Risk: global EM redemptions are likely to accelerate as funds managers decrease their beta exposure due declines in the “Big 3” (China, India and Brazil) EM equity markets. Rising volatility and accelerating muni market risk in the US won’t help either. Don’t forget the structural issues associated with Europe’s PIIGiesS can’t be covered up by piling on more debt, irrespective of declining yields at recent auctions. No one ever beat a drug addiction by getting more drugs at lower prices… 

The real question investors should be asking is: “What’s an emerging market equity worth if topline growth is decelerating due to slowing GDP growth and margins are compressing due to COGS inflation?” Probably the same as a domestic equity is worth with the same setup = less.

 

The bullish storytelling about buying Brazil or other EMs on the pullback(s) lies in the hope that earnings growth could be maintained as rising costs are passed through to consumers. A handful of recently-ousted Tunisian and Indian officials will advise against that.

 

Moving back to Brazil, as we expected, new Central Bank President Alexandre Tombini hiked the benchmark Selic rate +50bps on Wednesday to 11.25%. The language within the associated press release signaled to investors that Brazil may be less hawkish on the margin with respect to raising interest rates, which are now the highest real interest rates in the G20.

 

Bullish on Brazil (and Other Emerging Markets)? - 3

 

We caution, however, that this is not a buying opportunity. The bank reiterated that it will remain steadfast in containing the “surge in consumer credit” via “macro-prudential measures” (i.e. reserve requirement hikes, etc.) to get inflation back in line with their target of +4.5% YoY. To a small extent, the measures have been effective in boosting the cost of capital throughout the economy: average consumer loan rates rose in December for the second consecutive month to 6.79% vs. 6.74% in November.

 

They’ll will need to hope their “macro-prudential” measures increase in effectiveness because we don’t see inflation in Brazil as an issue that is going to be solved with Wednesday’s +50bps rate hike and a +5bps backup in consumer borrowing rates. Further, efforts to prevent the real from appreciating (three measures in the last two weeks alone) only reduce the effectiveness of any tightening of monetary policy.

 

Both the market and the “economists” see it our way as well: investor expectations for Brazilian inflation over the next two years, as measured by the breakeven spread between Brazil’s inflation-linked and fixed rate bonds, rose to +6.5% – the highest since November 2008; a survey of economists regarding Brazil’s 2011 inflation rate rose for the sixth straight week last week, climbing to +5.42% vs. +5.34% prior.

 

In summary, much like China and India, we don’t think the Brazilian central bank is done tightening the screws on its monetary policy over the intermediate term. Of course, the question then becomes, “When is that all priced in?” Judging the by the first chart above, we’d posit there’s more pricing in to be done.The Ber-nank may be able to trick US investors by inflating domestic real GDP growth by understating CPI, but the rest of the world isn’t buying the hoax. Inflation kills emerging markets.

 

Don’t be swindled; have a great weekend.

 

Darius Dale


MCD: STREET IS LOVIN’ IT

The Golden Arches are still infallible in the eyes of the sell-side.

 

Whenever you find yourself on the side of the majority, it’s time to pause and reflect.

-Mark Twain

 

A week ago, I held a conference call on MCD and the lofty expectations that I feel the company is unlikely to meet in 2011.  The Black Book I published that day detailing my thesis kicked off with a Mark Twain quote.   I think another of his quotes, above, would have worked equally well.  The Street adores MCD and is not keen to attach any real conditions to that affection.

 

In the days following my bearish conference call with clients I have heard plenty of push-back.  Having had time over the past week to think through my thesis further, my confidence in my thesis is high.  Several positive sell-side notes have helped bolster the price this week; to be clear, my call is for MCD to miss investor expectations from a sales and margins perspective for the year 2011.  I would like to take a few of the key points the bulls have made and address them.

 

In no particular order:

 

Bull case: MCD can pull the trigger on price increases in 2011, giving significant resilience to comparable restaurant sales growth.

 

Hedgeye Thought:  MCD has held back on price increases during 2010 and the value proposition that the chain offers is a large part of its success.  Given the outlook for the U.S. consumer in 2011, I would be less-than-confident in MCD’s ability to take pricing without significantly impacting traffic given the fragile nature of the U.S. economy’s “recovery”.   In addition, increased prices will only drive more consumers to the $1 menu, which is an unprofitable proposition.  Housing headwinds and anemic job growth, coupled with rising costs, will pressure the consumer this year.

 

 

Bull case: MCD benefits in times of rising food costs.   There is a 0.45 correlation between at-home inflation and fast food traffic. 

 

Hedgeye Thought:  First of all, I would be hesitant to wager too much on a correlation of 0.45.  Rising costs are a problem for the MCD system.  I am including a chart of beef, below, and one can clearly see the parabolic year-over-year move that QSR chains are enduring at the moment.  Without a doubt, the franchise model insulates shareholders somewhat from this risk but ultimately, with franchisees competing with other restaurants for value-seeking customers, the cost will have to be passed on to customers – many of whom are feeling a similar squeeze in terms of inflation (gas, education, food, clothing).  The reality is top line trends and input costs cannot be considered in isolation of the other.   I am not sure the MCD customer is ready for a price hike at this point. 

 

MCD: STREET IS LOVIN’ IT - beef costs

 

Bull case: New menu items will continue to drive sales at MCD and they will easily gain leverage and offset cost increases.

 

Hedgeye Thought:  In the Hedgeye MCD Black Book, published last week, I discuss the over-complication of MCD’s menu and the knock-on impact on operations.  This morning, a note published by Janney Montgomery, albeit with a “Buy” rating, detailed a survey of franchisees with some interesting commentary pertaining to the menu.  One question was “Is the menu overly complicated?”  While some of the answers cited expressed no desire to reduce or simplify the menu, the vast majority expressed an emphatic view that the menu was not only confusing customers, but also confusing employees and compounding operational difficulties.  The development that franchisees are facing increasing costs and conflict with Oak Brook is not positive for MCD.

 

 

Bull case: Inflation may be an issue, but it’s a sum zero game and competitors will likely take price before MCD, allowing them to take more price and drive same-store sales.

 

Hedgeye Thought:  That may be true conceptually but, absent any magic tricks; MCD cannot persuade consumers to keep paying for smoothies, frappes and lattes at higher prices.  As I illustrated in my Black Book published last week, frappes and smoothies accounted for more than 100% of same-store sales growth in 2Q and 3Q, respectively.  As prices are increased, consumers will purchase less of these discretionary items.  In 2011, this would mean pressure on margins year-over-year given that beverages are higher margin products than more staple products such as burgers.  With a complicated menu creating operational inefficiency, an increase in customer focus on low average check items will not help franchisees’ profitability.  Other “margin enhancing” initiatives being touted by many on the sell-side are also unproven at best.  24 hour restaurant openings, in particular, is not a new initiative and an idea I am less-than-convinced about.  BKC did not find this initiative accretive to their earnings.

 

Howard Penney

Managing Director


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