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#RatesRising - Stage 5: Acceptance?

Takeaway: Interest rate volatility is declining as investors accept economic reality and the positive implications of #RatesRising.

What the *&%! Just Happened” headlined yesterday’s release of GMO’s quarterly investment letter.   While the title is probably accurate in capturing the prevailing, post-Taper announcement sentiment of the larger investment community, that the initial inflection in a bond bubble 30Y’s in the making occurred with some price convexity, and not a wimper, shouldn’t be particularly surprising.  


In fact, if you have been long U.S. growth for the last 8 months, the Taper announcement itself was more a confirmation of economic reality than a prodigious central planning event.  The acceleration in the domestic macro data since late November and the slow creep higher in the 10-2 spread were heralding some measure of a policy shift.


In so much as a widening in the yield spread <--> expectations for QE Taper <--> Improving Domestic Macro, is a transitive relationship, the recent “bear steepening” in rates should be taken as positive confirmation of an improving domestic growth outlook.  This first step function move higher in yields is simply the market adjusting to the positive gravity of the domestic economic data and the implications of a sober policy response. 


In essence, the initial move in rates represents the ball under water moving towards being only half-submerged. 


From here, particularly given the Fed’s much communicated ‘data dependency’, the next 100+ bps higher should be viewed more as a growth dependent return to interest rate normalcy than a tightening in the conventional sense.  If the fundamental data is such that the controlling, dovish contingent at the fed is willing to signal a rate increase - even a small, gestural increase  -  we’d argue that pro-growth exposure should continue to outperform in the run-up to that event.


As we’ve moved past the acute response phase, the market has seemingly come to accept and price in a reduced flow of fed stimulus.   We detailed the implications of #RatesRising on our 3Q13 Macro Themes call last week (replay>> HERE, materials >> HERE).  We’d highlight a couple of incremental events of the last week:  


ACCEPTING REALITY:  Measures of implied interest rate volatility in the options markets have dropped precipitously over the last couple weeks.  Seemingly, the market has absorbed the acute impacts of the initial announcement with investor angst ebbing alongside initial portfolio re-adjustments.


#RatesRising -  Stage 5: Acceptance? - Treasury Volatility


TAPER TIMELINE:  Alongside lower volatility and a newly range-bound 10Y, today’s main policy related headline from Bloomberg that the consensus expectation of economists for Fed tapering (to the tune of $20B) to begin in September is further evidence that the market is getting comfortable in delineating the impacts of tapering vs. tightening.    


Given the practical aspects of implementing a tapering which, practically, means they will reduce the flow of purchases and subsequently monitor the impact before implementing incremental reductions, a September start makes sense.  With Bernanke likely stepping down come January, initiating the reversal of unprecedented policy initiatives which he captained makes sense from a continuity and (Bernanke) legacy perspective.   It also gives policy makers sufficient runway for scaling back purchases with an early eye towards a complete cessation come mid 2014. 


Also, implicit in the reduction in QE purchases is that QE was, in some manner, successful in its objective. This gives the FED and QE as a policy some credibility should they need to re-accelerate easing at some point in the future.   


SEASONALITY REMINDER:  As it relates to the expectation for tapering to begin in September - recall that the seasonal distortion present in the reported employment and economic data will build as a headwind thru August before again flipping to a tailwind over the Sept-March period.   Any prospective delay in tapering due to perceived/optical weakening in the data over the next 6 weeks should be short-lived as the impact of the distortion reverses come September.  Further, any negative drag associated with reduced stimulus may be partially masked by the positive seasonal tailwind as we move towards year-end and through 1Q14. 


(Not So) LATENT RISK:  Duration (price sensitivity to interest rate movement) on 10Y treasuries remains near peak levels while high yield and IG spreads remain near trough levels.  Despite the recent diminuendo in interest rate volatility, risk associated with another expedited back-up in yields remains very much alive across the fixed income spectrum.


#RatesRising -  Stage 5: Acceptance? - Duration   corporate Spreads


Quantitative Setup:  10Y Treasury Yields remain in Bullish Formation (Bullish across TRADE, TREND, & TAIL Durations) with immediate support and resistance at 2.45% and 2.75%, respectively. 


#RatesRising -  Stage 5: Acceptance? - 10Y levels



Christian B. Drake

Senior Analyst 


HEDGEYE TV Presents #RATESRISING Q3 2013 Macro Theme


"POP!" goes the bubble as interest rates start to rise, reversing the most asymmetrical set of relationships on our Macro screen. Hedgeye CEO Keith McCullough goes out a macro limb and says we are not likely to see the 2012 lows on 10-year bond yields ever again. Moreover, McCullough shows that as the slope for interest rates turns up, so much that has been tied to declining rates will unravel.


"Miami Vice" Meets the SEC?

Takeaway: Are we witnessing the coming of a tougher SEC?

This note was originally published July 23, 2013 at 15:18 in Compliance

The SEC’s new chair, Mary Jo White, was a high-profile prosecutor as head of the Office of the United States Attorney for the Southern District of New York (known to its occupants as simply “the Office”).  She then became a rock-star white collar defense attorney, heading the litigation practice at Debevoise & Plimpton, from whence President Obama plucked her in January and tossed her into the lions’ den of Congressional confirmation hearings  (see our piece on the nomination in Fortune).  There was hand-wringing aplenty over concerns she might be soft on her former clients.  Now there appears to be a glimmer of hope that she may be a tough sheriff after all.


"Miami Vice" Meets the SEC? - mjw


The Good Part

Last week the SEC accused the city of Miami of misleading investors in a series of muni bond offerings.  The SEC charged the city and its former budget director with fraud in three 2009 bond offerings totaling $153.5 million, saying budget director Michael Boudreaux made false statements and material omissions regarding the city’s finances, orchestrating fraudulent transfers of funds “to mask increasing deficits in the General Fund, which is viewed by investors and bond rating agencies as a key indicator of financial health.”  The SEC says this caused the bond offerings to receive favorable ratings from the rating agencies, until the city’s Office of Independent Auditor General flagged the improper transfers, causing them to be unwound.  This led in turn to an across-the-board downgrade of the city’s debt.


SEC Co-Director of Enforcement George Canellos says “we will hold accountable not only municipalities, but also individual municipal officials for fraudulent disclosures to investors.”



The Really Good Part

One short paragraph in the SEC release has sparked considerable interest: “The SEC’s action also charges Miami with violating a cease-and-desist order that was entered against the city in 2003 based on similar misconduct.  This is the first time the SEC has alleged further wrongdoing by a municipality subject to an existing SEC cease-and-desist order.” [Emphasis added]


One of the biggest criticisms of the SEC has been its rush to settle enforcement cases, rather than trying them (see our Hedgeye e-book Fixing A Broken Wall Street for detailed analysis of this, and of other nasty stuff about Wall Street you will wish you had never found out.)  In settlements, finance professionals who may have been guilty of fraud generally walk away unscathed.  Even under rough-and-tumble former federal prosecutor Robert Khuzami – himself a former White protégé at “the Office” – the SEC settled for some big numbers, from Goldman Sachs for example, but did little in the area of identifying bankers who had significantly contributed to the financial meltdown.


Enforcement settlements with individuals routinely contain the expression “neither admit nor deny,” while settlements with companies almost never name individuals, as though fraud, negligence and rampant greed arose like some mysterious vapor from the earth.  This has perpetuated an aura of invincibility around the very worst practices in our industry, protecting Bad Actors from ever having to pay the piper.


Alongside the “neither admit nor deny wrongdoing” bit, there’s routinely a clause that says, “Even though we don’t admit that we did anything wrong, whatever it is we’re not admitting to, we promise we will never do it again.”  A reasonable command of English should enable you to see that piece will never be applied.  How do you charge someone with a repeat offense when you accepted them “neither admitting nor denying” the first offense?


For the first time, the SEC is acting as though a prior cease-and-desist order had teeth.  Critics are saying White does not go far enough, that she should go after “a real Wall Street insider,” instead of a non-financial player like the City of Miami.  We recognize that wheels turn very slowly in the world of regulation.  Indeed, if Congress gets its way, those wheels are likely to turn not at all, as we saw White valiantly taking up the case for increased funding for the Commission – a case her predecessor made in vain to a Congress whose election campaigns are paid for by the investment banks.  (Yep, it really is that simple.)


We would like to believe this is a first engagement in what will become a revolution in the way the SEC approaches cases.  We have been highly critical of the SEC’s culture of compromise, the “rush to settlement” mentality, but we also realize that big changes must be wrought incrementally.  We agree with the on-line posters, bloggers and other commentators who say that, while she is about going after repeat offenders, White should withdraw the SEC’s objections to Judge Jed Rackoff’s ruling that ordered Citigroup and the SEC to try their case over a $1 billion fraud.  This case was put on ice when the judge rejected a proposed settlement, saying the lack of specificity – no individuals named, no admission of wrongdoing or even negligence – made it impossible to determine whether the settlement was in the public interest.  “You are asking me to exercise my authority, but not my judgment,” said Rackoff.  In an utterly bizarre turn of events, Citi and the SEC joined forces asking a higher court to set aside Judge Rackoff’s ruling, leaving Rackoff to watch from the sidelines, as judicial procedure prohibits him from appearing to defend his own ruling in the appeals court.


As we wrote at the time – and wrote, and wrote, and wrote – Citigroup was the deformed phoenix that rose from the ashes of Glass Steagall.  Under President Clinton, the law of the land was eviscerated to enable Sanford Weill to consummate a merger that created a financial behemoth.  In the heat of the financial crisis, FDIC chair Sheila Bair persistently railed that Citi was terribly managed and dangerously unstable and in need of being broken up to avoid further disaster.


The rationale for settlements in the legal system is judicial economy: you can’t throw all the resources of the courts at every case.  As slowly as the wheels of justice now turn, they would instantly grind to a halt if all the resources of lawyers, judges, juries and courtroom personnel had to roll into motion every time someone was accused of an offense.


In the Citi case, this makes no sense.  The courts push for settlements in order to save their resources for Really Big Cases with particularly high stakes, cases that will establish game-changing precedents.  If ever there was a case deserving of the court’s full attention, it is SEC v. Citi.  The nation’s securities watchdog pitted against a titanic financial firm – the very firm whose existence caused the protections of Glass Steagall to be shunted aside.  This is the very case for which judicial economy was created.  For all the inconvenience it may have created for Sandy Weill, Glass Steagall had the overwhelming advantage of being simple: do this, don’t do that.  Markets can live with unreasonable regulations, but they can’t live with uncertainty.  Dodd Frank is a recipe for a decade of haggling.  Glass Steagall is simple.


White should finish what she started, moving expeditiously from the City of Miami to the courtrooms of lower Manhattan.  The best thing that could happen to restore confidence in America’s ability to regulate its markets would be for the SEC to withdraw the objection and try the case.  With Ms. White at the head of the team, we have the utmost confidence that the government’s case will be well prepared.  And for all that we don’t much like Citi, we are by no means certain the SEC’s case would be a slam-dunk.


But whatever the outcome, it would send the message that the days of shadowy dealings between regulators and regulatees are over, that justice isn’t for sale, and that market transparency is more important that winning or losing big cases.


We strongly urge Chairman White to take on the Citi case.  Whatever the outcome, we must declare Too Big To Fail also means Too Big To Settle.



Moshe Silver

Managing Director / Chief Compliance Officer






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According to Bloomberg Businessweek, CCTV has reported that the ice at a KFC restaurant in Beijing was found to be unsanitary.  Initial reports indicate that the ice contained 20x more bacteria than the national limit and 13x more bacteria than toilet bowl water.  The stock is down 90bps on the day.


We view this as a minor setback to YUM and maintain our bullish view on the long-term prospects of the company.  However, it is important to note that the turn we foresee in 4Q same-store sales is at risk if this turns into a real public relations nightmare.  


You can read the full story here: http://buswk.co/1aGVhaQ




Howard Penney

Managing Director




Regional gamers are in for a tough earnings season if PENN is any indication. The problem is deeper than just market softness.  



The table below details the soft quarter just posted by PENN.  The quarter met recently reduced Street estimates but guidance was well below consensus.  As we wrote about in our 07/15/13 preview, we expect an ugly earnings season from regional gaming companies.  Might this earnings season finally be the negative fundamental catalyst we’ve been waiting for?  We think so.  Valuations have expanded, rightfully so given the real estate angle to which these companies are now viewed.  However, estimates are clearly too high and massive long-term headwinds remains – that is, market saturation and a declining base of slot players.  Baby Boomers are passing on and younger generations refuse to embrace slot play as a leisure pursuit. 




We disagree with management that their issues are not something to worry about over the long-term.  US same store gaming revenues may continue to be under pressure for years to come due to the demographics.  Management also dismissed the impact of saturation yet many of their properties are facing new competition.  That would at least partially explain why trips are down – demographics also contributes.  And there is more to come.  We think we will continue to see new markets open in the US as states continue to face long-term budgetary issues.




We’ve reduced our 2013 and 2014 EBITDA estimates to $825 and $867 million, respectively, pre-split.  Note that we remain slightly above PENN’s new guidance for 2013 of $805 million.  Following the drop in stock price and estimates, PENN now trades at 8.5x 2014 EV/EBITDA which seems fair.  On a sum of the parts valuation basis, post-split, we value OpCo and PropCo combined at a range of $39-54.  The midpoint of our valuation range falls a little below where PENN currently trades.  


In an effort to evaluate performance and as a follow up to our YouTube, we compare how the quarter measured up to previous management commentary and guidance




  • WORSE:  A big cut in guidance confirms our regional gaming thesis. It's not just the economy.  Demographics are a big headwind. Our model predicted a tough June but a flattish July. With management portraying July as similar to June, underlying demand is actually getting worse.




  • WORSE:  While spend per visit hasn't changed much, visitiation count has decreased a couple of % points.  Consumers are more conservative with their discretionary spending.  July trends are similar to June's.
  • PREVIOUSLY:  "Most of our data suggests that the weather had a big impact on visitation. We didn't see much change in spend per visit at our core properties year-over-year. Most of the effect was admission trends and visitation trends that I think were either impacted by new competition in our markets or weather-related. It doesn't seem to be any change in consumer spending when they do visit our properties. It's been more of the same, generally flat."


  • WORSE:  Horseshoe Cincinnati has been very aggressive with discounting, pressuring Hollywood Columbus results, which has significantly underperformed expectations.  Cleveland is another market that is highly promotional.
  • PREVIOUSLY:  "I would continue to characterize overall the promotional activity across these regional markets as fairly stable."


  • WORSE:  Mgmt says margins and market share at its Columbus facility are below their expectations.  Its Toledo property's top line results have met their expectations though operating margins were weaker than they anticipated.  
  • PREVIOUSLY:  "I think you're going to see another build that will start in the July-August timeframe as we hit the summer months as well. We're still working on marketing activities to continue to expose our new property to customers for the first time, and that's gone very well. Our repeat visitation has been very, very strong; our database growth continues to be very, very strong. So, this is very typical what we've seen in how Penn National opens a property in both Toledo and Columbus."


  • SAME:  Received approval from the Ohio Racing Commission for the relocation of Beulah Park in Columbus to Austintown in Mahoning Valley and for Raceway Park in Toledo to move to Dayton.  Both facilities expected to open 2H 2014.  PENN will be conservative with the slot count.
  • PREVIOUSLY:  "The two next projects are Youngstown and Dayton racetracks. Capital spend, which includes $125 million for license, basically a relocation fee and a gaming license. And so we're looking to $267 million and $257 million of cap spend, which will happen over the course of the next year and a half. We expect to open sometime in 2014." 


  • SAME:  No changes to financing costs.  Mgmt sees no obstacles to completing the spin-off.
  • PREVIOUSLY:  "Next steps, we have to finalize the Carlino Group agreement. We need to finalize our financing agreements with our banks. We also have to start the process of refinancing of all of PENN's existing debt and putting in place the bank agreement, as well as the bonds for the transaction going forward. And then we would expect that in the fourth quarter that we'll complete the spin and the E&P purge will happen hopefully in the first quarter of 2014, at which point in time, we'll make our REIT election."


  • SAME:  Governor has given cafe operators 90 days to collect their signatures. Senate legislation has passed a bill enforcing the ban.  Mgmt is hopeful the House will come back in early September and support the bill.
  • PREVIOUSLY:  "My expectation is once the internet cafes do get contained, we will see improved business volumes, and it's just going to be a wait and see approach on how we address the overall count in the Columbus operation. But I would expect at this point that the 2,500 count that we have there today will get us through 2013."


  • SAME:  Had significant construction disruption in 2Q.  Remains on schedule with 5 months left of construction and on budget.  $61MM have been spent with $32.8MM remaining on capex.
  • PREVIOUSLY:  "We're planning to spend roughly $61 million in total to rehab the property. One of the things about purchasing an asset from Harrah's was we recognized that there have been some deferred maintenance and also that the property needed to be refreshed and obviously the slot product needed some updating."

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