Archive
Fire Hoses Pumping Again
The authorities in Europe are currently manning the fire hoses and pumping like mad. Whether their efforts douse the fire, or even hit the target, is a question yet to be answered. What is sure is that whatever is left will be thoroughly soaked. Fire or not, a flood is assured.
Today the Bank of England announced an increase in its purchases of covered bonds (a.k.a. quantitative easing) of £75bln (about $115bln). The ECB said it would buy €40bln (~$53bln) in covered bonds as well, and also provide unlimited loans of around 1 year in maturity to banks.
Again, the efficacy of these measures in forestalling the European banking crisis may be in doubt, but there is no doubt (or should be none) about the inflationary potential of pouring more money into the financial system. Commodities markets responded today – commodities often trade with the highest ‘beta’ to changes in near-term inflation expectations – with the DJUBS index rising 1.7% led by energy, industrial metals, and precious metals. Inflation swaps rose about 8bps as well. The 10y Treasury yield is back to almost 2% (1.99%). Surely, part of the equity rally today (the S&P popped another 1.8%) was due to the widespread belief that inflation pushes stock prices higher.
It might be fair to observe that by providing these funds now, instead of after Greece defaults, policymakers are for a change trying to build a fence at the top of the cliff instead of sending an ambulance to the bottom. There is the question of whether it’s the right cliff, but to whatever extent these measures help – and I am somewhat skeptical on this point – there are to be commended for implementing them before the fact. After all, nearly all Euro area banks keep passing stress tests, so they clearly don’t need this help yet, right? Uh, well, maybe.
Beware of thinking of the BOE/ECB policy as having only European effects. Approximately 2/3 of domestic US inflation (according to a 2005 paper by Ciccarelli and Mojon at the ECB) is sourced from global factors, such as profligate monetary policy pursued by other central banks. Liquidity is fungible, after all. US M2 has recently been rising, and there is some evidence that this may be resulting from a movement of bank balances from shaky Euro-area banks to US dollar-based banks. It is naïve to think this is unrelated to the provision of exceptional liquidity we are seeing now. Maybe that causality looks backwards – it was partly the exodus of balances that caused funding pressures which then precipitated further QE, rather than QE causing (directly) a rise in US M2 – but they are causally connected in any case.
Our strategies continue to be overweight in commodities versus underweight in TIPS and equities.
Tomorrow brings the Employment Report (Consensus: 55k payrolls, 9.1% Unemployment Rate). I think investors seem to be expecting a pretty decent number, after the ADP report earlier this week remained around 90k, making last month’s unchanged Payrolls report look like the outlier. A 75k or 100k print wouldn’t be anything to write home about, but it would help validate expectations. If the stock market rallies on such a print, I will be looking to sell into it with the intention of holding a small short over the weekend. I wouldn’t do that if stocks were trading down, but right now it feels like a lot of good news from Europe and elsewhere has been fully discounted.
Making Things Worse
Markets continued Monday’s late strength on the renewed optimism about Dexia being saved or broken up cleanly, on the talk that the IMF would be contributing to the rescue of European banks, and on the hope that a coordinated rescue was in the works. The rally continued despite the fact that the latest plan has Dexia being stripped of the good assets and just left as a bad bank without any capital injections, that the director of the IMF’s European Department said ‘we are not contemplating any market involvement with the EFSF’, and that German Chancellor Angela Merkel said the European rescue fund not only wasn’t being used for a coordinated rescue, but that it was “only a last resort” for banks.
The fact that the market continued higher despite the complete dashing of the hopes that had driven it higher in the last minutes of Monday’s session surely means that the market is no longer trading on hopes; it’s trading on dreams. We must remember that what the most-optimistic dreamers are wishing for is for a large, multinational coalition of politicians to come up with a workable plan to save a mess decades in the making. There is no shame in betting that politicians will be unable to discover a workable plan even if one is staring them in the face – and the fact that if there is any salvation left it must be seen through a very narrow window indeed makes it highly unlikely in my view that help is on the way in a useful sense.
As if to drive home this point, Europe’s space agency announced that it is sending a spaceship on a scientific mission to the sun. Asked about the technical complexities of conducting a mission in the thousand-degree heat near the sun, Sarkozy declared “but we have solved this problem. We are going at night.”[1]
Interest rates rose today, and commodities rallied along with inflation swaps. The better-than-expected print from ADP (91k versus 75k expectations) provided some following wind to these moves. It was definitely as encouraging as a sub-100k number might be, considering the growth fears that loomed all-too-recently.
I am all for being optimistic about the possible outcomes, but I insist on being realistic and thinking about what might actually cause things to improve. To be sure, animal spirits in the economy can spontaneously reverse but I see no reason why they should at the moment. Moreover, policymakers keep looking for ways to make things worse. The U.S. Congress is considering a punitive move against China. Some lawmakers are proposing a surtax on millionaires. The Fed is working very hard to completely obliterate the funding status of pension plans by pushing yields ever lower at the long end – which at this point can be fairly obviously seen to be impotent in terms of provoking mortgage refinancing so only the bad parts of lower rates remain.
And while I’m on the subject of Operation Twist, let me point out a sinister side effect of it. When the Fed did QE1 and QE2, they noted in various speeches that the balance sheet expansion could be unwound directly (by selling the bonds back into the market) but also could return to normal naturally as the Fed allowed maturing bonds to simply roll out of the portfolio without being reinvested. By selling the short bonds and replacing them with longer bonds, the Fed is eliminating the ‘natural contraction of the balance sheet’ option. The balance sheet will now have very few bonds primed to mature in the next few years.
This means that if the Fed decides it wants to permanently shrink the balance sheet (to soak up some of the excess reserves, for example if inflation began to accelerate) it will have no choice but to sell bonds into the market to do so. Now, SOMA chief Brian Sack has made it clear that he believes buying bonds lowers rates but selling them does not – but those of us with market experience beg to differ. When the Fed was buying trillions, it had a ready seller in the Treasury. But when it goes to sell those bonds, it will be competing with the Treasury.
If the Fed needs to sell $1 trillion of bonds at the same time the Treasury is raising $1 trillion in new money, we have an unprecedented supply of bonds on our hands. It is akin to the ‘mortgage extension’ waves that have periodically shoved rates violently higher when mortgage portfolios get naturally longer in a bond market selloff (forcing those portfolio managers to sell bonds into the selloff). But it is much, much larger in magnitude, and it comes at a time when the Street has been told not to take proprietary risks – which in a normal selloff, it does in order to ‘temporally distinermediate.’[2]
Prior to Twist, the best chance that we wouldn’t have to confront a sharp bond market selloff at some point was that the portfolio might be slowly unwound through maturity of its holdings. This will no longer be possible. Moreover, the timing of the Feds’ exit isn’t entirely in their hands. Right now there are massive reserves which have been passing into transactional money only slowly. The money multiplier remains depressed, although it is rising again slowly now that the Fed is no longer adding reserves via QE2 (see Chart). If it starts to rise again, the Fed will need to withdraw the reserves fairly rapidly or face a serious inflation issue and/or a potential dollar crash.
M2 divided by the adjusted monetary base. The effect of QE is clearly visible, but when QE stops the multiplier has tended to rise...
If the money multiplier rebounds in an expansion, as banks feel more confident and start to lend more aggressively, then rates will likely already be rising and the Fed will be forced to unload bonds into rising rates. This means that rates will correct in such a case much further than they otherwise would. This is not a trading recommendation: I have no idea when this will happen. But if it happened, then instead of letting long rates adjust gradually to 4-5%, they might suddenly be shooting to 7% or higher.
The second possibility is that the money multiplier might naturally revert to its ‘normal’ level through some other mechanism. Remember, we’ve never done this so we’re really not sure, whatever they tell you, that it will work the way the textbooks say it should. Nothing so far has, anyway! If the money multiplier starts to revert naturally somehow, then the Fed really faces a nasty situation in which it will have to decide whether to let the money supply explode or aggressively sop up liquidity and drive interest rates higher in the process.
This has always been the dilemma following QE1 and QE2, but as I said there was always the possibility that the exposures might just roll off naturally, or at least enough of them would that sopping up the extra liquidity would be less problematic.
But now, like all policymakers everywhere seem to keep doing, the Fed has made things worse.
[1] The Sarkozy response is fictional, but ask yourself whether you didn’t have just a moment of doubt about that.
[2] This is a fancy term that means a dealer buys when the seller shows up, then sells when the buyer eventually shows up. If there is no dealer to do this, then if a seller needs to sell he can only sell to the buyers present at that moment. When there are no dealers to temporally disintermediate, you get flash crashes.
We’re Not There Yet
A lot can change in two weeks. I have been half a world away since mid-September, during which the Fed announced “Operation Twist II,” Italy and her banks were downgraded, along with Bank of America, Wells Fargo, and the Greek banks. Stocks predictably declined on all of this news, although not by very much. Only today, after continued discussion about the breaking up of Dexia bank, did the S&P finally decline 20% from the prior highs, technically making this a bear market.
That’s the proper appellation for the market, despite the 4% rally in the final forty minutes in a furious short-covering move triggered by the shocking, shocking, rumor that the EU is thinking about how to recapitalize European banks. Bloomberg attributed the rally to comments by Olli Rehn, carried in the Financial Times, that there is an “increasingly shared view” about the necessity for coordinated action on the crisis.
Obviously, that is anything but news. The real reason we got the rally is that stocks didn’t break after passing below recent lows, and shorts chose to cover (and then, as the rally gained steam, were forced to cover) rather than take headline risk overnight.
Late in the day, an announcement was made that Dexia would be split into a bad bank and a less-bad bank and massive guarantees put into place from France and Belgium. Two countries breaking up and backstopping one bank isn’t exactly what I would consider ‘coordinated action’ on the crisis, but who am I to question the French?
But headlines aren’t really all that important right now, in my view. If they were, then we certainly got plenty of them today from Fed Chairman Bernanke – and it didn’t move the market. In testimony before Congress, Bernanke stated (in some cases, as paraphrased by Bloomberg):
- Inflation has begun to moderate. Well, it is, but it’s headline inflation that is moderating. Core inflation is accelerating.
- The Fed is prepared to take further action as appropriate. It hasn’t been appropriate since (arguably) 2008. I think he means “if we continue to be scared at the prospect of continued healing.”
- Recovery from the crisis has been much less robust than hoped. Yeah, absolutely true. Specifically, we’re experiencing another crisis.
Seriously, the failure of the market to respond to a promise that the Fed is prepared to keep on firing both barrels, even if the gun is loaded with expensive blanks, was surprising. Either the Chairman’s credibility is waning, or the market’s confidence that further Fed action is a good thing is evaporating, or both. I personally think that’s appropriate.
I must say that I am amazed to come back to find nominal yields even lower than they were when I left. I did write on September 5th about the strong seasonal pattern in bonds and that “the window for a selloff is closed for now,” but I must admit I was skeptical that yields would actually fall from the 1.99% level on the 10y note where they were at the time. We are indeed approaching a point (on the calendar and on the yield level) where shorting bonds in anticipation of a year-end liquidity washout may make sense. I will be looking for an opportunity to do that over the next couple of weeks.
Now that most people seem to expect Greece to eventually default – which has been my base case for more than a year – the opportunity to short bonds might occur once the announcement actually happens. I expect that if/when Greece does throw in the towel, we’ll also get a perverse rally in equities as well. The reasoning will be that ‘the worst is behind us and they have had plenty of time to prepare for this.’ This trade surfaces from time to time, and it’s always maddeningly stupid. Stocks will rally when this happens, after an initial dip, and we will all pull our hair out because we know the next trade after that will be the realization that even though banks and others have had plenty of time to prepare, all of the actions of the politicians to date have been designed to prevent any such preparation (by, for example, marking bonds correctly or selling them).
Stocks, too, are again approaching levels where it may be appropriate to start buying to get closer to a neutral position. Our 10-year projections for equities’ real returns (which were only 2.58% at year-end 2010) have now risen to 3.4%. That’s pretty slim, but it’s getting better.
At the same time, commodities are also growing more attractive. The knee-jerk reaction to the ‘growth slowdown’ trade, pushing the dollar higher in a flight-to-quality and commodities lower, is predictable but nonsensical. The current circumstances augur increasingly desperate monetary policy maneuvers, as Bernanke hinted today are still on the table. While the dollar could conceivably rally because other countries’ central banks might out-print the Fed, there is no question that a large majority of the world’s meaningful central banks have their fingers hovering over the monetary print button. As I’ve written repeatedly, the supply/demand analysis of commodity prices, which suggests lower prices due to slackening demand, is myopic in an environment when the value of money relative to real stuff is highly likely to diminish appreciably. I am not talking about one particular commodity here, but all commodities (and to a lesser extent, real estate).
However, I am not anxious to jump into these asset classes, nor to short bonds just yet. Partly, this is because I think there is a fairly large chance that we are still due a big crunch in Europe, but partly because I haven’t seen any sign of a washout yet. I am intrigued with the behavior of the VIX (see Chart, source Bloomberg), which has been doing something really remarkable. After the spike above 45 in early August, it has never retreated below 30. For two months, it has remained elevated without spiking further. This is unusual, as I think the chart makes clear. Ordinarily, the VIX will spike, then retreat. It almost never spikes, then remains at that level.
What goes up, must come down. Or mustn't it?
Sometimes, on the way down, the VIX will pause and consolidate at an elevated level, as in early 2009. But on the way up – frankly, I can’t find another example of the same sort of behavior.
The bullish interpretation of the phenomenon would be that investors have been aggressively buying insurance for a while and so won’t be pressured to sell if the market declines further. But this interpretation ignores that there are as many sellers of options as buyers, and those investors will need to sell to delta-hedge shorts in a decline (or vice-versa in a rally). Ordinarily, short-gamma investors are more anxious to delta-hedge than outright long investors, but my main point here is that the bullish interpretation doesn’t hold much water. The bearish interpretation is just that the initial spike in the VIX apparently was not considered overdone, as spikes usually are…and that makes me wonder what is next.
Strictly speaking, what is next is ADP tomorrow. The consensus call for 73k new jobs seems to me a little optimistic on the heels of an overshoot last month (in the sense that last month’s 91k on ADP overshot the 0k on Payrolls).
But then, optimism is still out there. For example, despite the fact that I can’t think of a single “good bank/bad bank” plan that has ever actually been consummated as such, they keep being proposed and the market keeps acting as if it’s a terrific idea. But there’s a reason such plans don’t actually happen. Suppose you are a Dexia bondholder and the firm splits into two entities. To which entity does the debt belong? Bondholders will surely object if they suddenly have bonds of a “bad bank” as the good assets are cleaved off. But if the debt goes with the good bank, then how good of a bank is it? Equity holders don’t mind holding pieces of both, because a portfolio of two options always has at least as much value as a single option on the conjoined underlying, and usually more. But bondholders have the opposite problem, and since the creditors typically have rights they can be counted on to object. So a good bank/bad bank split only happens if the government takes the bad bank (as, for example, when the Fed agreed to take the “Maiden Lane” assets out of Bear so that JPM could consume the ‘good bank’).
And if France and Belgium take the bad bank, with its €566bln in assets as of year-end (thanks to Peter Tchir for that number), then how long will those entities retain their own ratings? No, I think there is plenty of room for optimism to turn less sunny, and so I wait with my equity-buy and bond-sell lists ready, but don’t expect to use them for a little while yet.
