E-piphany

We wrote off last week’s dull equity trading to the fact that the U.S. had a holiday in the middle of the trading week. Despite some interesting data, including weak Employment news on Friday that moves us closer to another Fed action (as I wrote on Friday), trading was lethargic. I’ve been chronicling the decline in equity volumes for a while now. It has become unusual to break 900mm shares unless there is an options or futures expiration, or a month-end. Cumulative year-to-date volumes are only 81% of last year’s volumes, and only 58% of the last 5 years’ volumes (see Chart, source Bloomberg).

Sure, some of this is due to the moving of share volumes off of traditional exchanges, but that doesn’t explain that much of the trend – if you measure other volumes, instead of NYSE volumes, you get a similar story. I hold that a lot of this is due to the crusade against high-frequency trading (some of which is actually market-making), some of it is due to new SEC and CFTC rules concerning reporting, and a significant part is due to Volcker Rule restrictions. Hopefully, some of it is also due to public disenchantment with the stock market as a path to easy wealth – that would be a healthy development.

But we’re not exactly going through a boring time in the markets. Just a couple of weeks ago we had a really exciting European summit, and on virtually every day since we have unwound the significance of what happened then. Today, ECB head Mario Draghi said that the ESM (which is supposed to recapitalize Spanish banks) will not be functional until 2013. Oh, and Italy and Germany still need to give their final approvals.

Spanish yields in the meantime continue to slip higher, with the 10y Spanish yield back above 7% today. U.S. bonds weren’t asleep: the 10y Treasury rallied 4bps to 1.51% (10y TIPS rallied to -0.60%). But stocks snoozed, even when President Obama announced his intention to seek an extension of the Bush tax cuts for all taxpayers earning less than $250,000 per year. That ought to have launched stocks higher, and in years past certainly would have. It’s a bad sign for the President when the market takes his big announcement as being nothing more than a cynical political ploy. Hey, even if it is a cynical political ploy, it ought to be supportive of equity values since it removes one reason to sell stocks this year to take gains under a lower tax regime!

Commodities certainly weren’t asleep: the DJ-UBS added another 2% today, with across-the-board strength in Crude (+1.8%) and Gasoline (+1.6%), Grains (+3.6%, now up 25% over the last month), Softs (+2.0%, up 12.6% over the last month), Precious Metals (+0.9%), and Industrial Metals (+1.0%). Where did that come from?

I admit to bias here. Readers know that for a long time I have been pounding the drum for commodities as the cheapest conventional asset class (and which provides inflation protection besides). Partly, this rally – for the DJ-UBS, it’s 7% over the last 7 trading days – is due to the asset class being semi-loathed and certainly under-owned. Yes, grains are shooting higher because of Midwestern drought, but what about Nymex Crude? Sugar? Coffee?

I think there may also be an inkling from the so-called ‘smart-money’ along the lines of what I wrote Friday. The weak data recently increases the odds of QE3, at least in the form of an elimination of interest paid on excess reserves. Europe has already taken that step, with some immediate effects:

1. JP Morgan, Blackrock, and Goldman closed their European money market funds to new money after the ECB lowered the floor rate. This was the Fed’s stated fear, that ultra-low rates could cause the money market industry to close down. Then who would buy the Treasury’s TBills?!
2. The first French T-Bill auction after the ECB rate cut resulted in negative yields (for the first time), joining Germany and the Netherlands in doing so. It turns out that all we will do by letting the money funds go out of business is to save a layer of fees! By the way, I still think that if money funds just reorganize into a form where there is no forced $1 share price, then problem solved. Maybe that takes legislation, but it certainly insurmountable.
3. Commodities launched higher. While the launch occurred prior to the actual rate cut, it wasn’t like the cut was a complete shock.

The real question, as central banks eliminate these floors, is what happens next. What should happen if the Fed stopped paying interest on excess reserves, or made it a penalty rate?

The Federal Reserve has made much ado about how their large-scale asset purchases (LSAP) have “acted like” a further easing of interest rates. But I am not so sure of that. The money went into vaults, and short term interest rates didn’t decline. The effect on longer-term interest rates is unclear – while it’s plausible to think a ‘portfolio balance channel’ drove long-term rates lower, it’s hard to read the magnitude of such an effect with the huge amount of noise from changing issuance patterns, various flight-to-quality events, and so on. If the Fed wants to see how much LSAP affected short-term interest rates, then let the market find the clearing price! If the Fed declared that there would now be a -2% penalty rate to keep money at the Fed, I have no doubt that the clearing rate for overnight rates in the U.S. would be clearly negative. And there’s nothing at all wrong with that, philosophically. Repo rates already trade negative from time to time, as do T-Bills. The market can cope. Really.

But if the Fed did that – said “take your money back,” essentially – where would it go? It would definitely in that case push the short end of the yield curve even lower, perhaps even out to 2-years, and by extension the entire curve would be affected since longer-term rates are after all just impounded expectations of short rates.[1] More importantly, some banks would choose to make more loans rather than endure negative carry on reserves. With commercial bank credit now growing at a post-2008 high rate of 6.0% over the last year, this seems less important, but if the Fed believes they can do something about growth, this is the thing they can do and I think a prime candidate for what they will do. Some of this cash also will flow into assets that historically earn zero real returns: commodities, for example.

Now, in Europe it is harder to figure out what will happen. If banks can give money back to the ECB rather than experiencing increasing negative carry, they may. I don’t remember if the LTRO allows that. European banks seem to be increasingly stuffed to the gills with sovereign paper, and are probably less able than U.S. banks to extend loans given the sorry state of their balance sheets. Gold at least stores well, but there’s a lot of volatility there, and it means dollar exposure as well.

I don’t know the answer, but the freeing of short rates to go negative is potentially a game-changer. I think it’s far more important than more asset purchases, especially because investors are likely to be somewhat clueless about how important it is and what it should do to the inflation outlook. That cluelessness is important, because the last thing in the world that central bankers want to do is “unanchor” inflation expectations. (Personally, I don’t think inflation expectations matter, but the important thing is that the central bankers think so).