E-piphany

The Employment report – really the only item of significance before this long holiday weekend – probably ended up raising more questions than it answered. In one sense, this is good news. If the report had been exceptionally weak, then there would be fewer questions but we wouldn’t have liked the answers. At least this report holds out some hope!

Private jobs in the report grew a bit faster-than-expected at 67k, but with some reasonable upward revisions to prior months. There were fewer subtractions for Census workers (which is strange since you would think we should have that number pretty clearly – just call the darn Census Department). Manufacturing employment contracted, but one month of contraction is not much to get exercised about.

The Unemployment Rate rose to 9.642%, as a rebound in the workforce did, as expected, raise the ‘Rate. I wonder if the report would have been considered as much of a positive if the ‘Rate had rounded up to 9.7%? The bottom line there is that with private payrolls growing 50-100k, if indeed it is that strong, the Unemployment Rate shouldn’t decline much if at all (absent the disturbing trend of people leaving the workforce).

The index of hours worked didn’t move, which isn’t the best of news. All in all, this was better-than-expected but still a pretty dismal number for an economy that is supposed to be expanding robustly by now.

I was initially excited to see that the median and average durations of unemployment plunged (see Chart of median unemployment duration). This would be great news…except for the fact that it is artificially lowered by the fact that several hundred thousand workers (the Census workers) have only been unemployed for a handful of weeks. Anyone who likes clean data will be very glad when that elephant has finished passing through the python.

If only this sharp improvement were real!

When the number printed it was pretty obviously going to be bearish for bonds and bullish for stocks, but after two days of watching bonds getting beaten up I was surprised to see the 10y Note contract down a full point in the early going. Both stocks and bonds reached their extremes within a few minutes of the report and then retraced some of those extremes. Still, equities rallied to end near the highs, with the S&P recording a 1.3% gain, and 10y yields finished at the somehow-generous-sounding 2.70%. The 5y inflation swap rose to 1.53%; 10y ended at 2.09%.

The VIX declined sharply but – surprising, considering how much equity prices have risen and the fact that some event risk passed – managed to hold recent lows. That seems like non-confirmation to me. I believe I have become tactically bearish with this rally.

While the report holds out hope, it also confuses policymaking in the near future. Again, that might not be a bad thing; we have arguably had too many erstwhile saviors over the last couple of years. However, the particular challenge we confront over the next couple of months does, in fact, beg for someone to do something. At least, I imagine that is how it will be read in Washington. For even if the recent, admittedly short skein of surprisingly bad numbers is what turns out to be the aberration, and not the Employment Report and the ISM report, there is still the issue that next year we’re going to get some very bad fiscal news (on Federal as well as municipal fronts). To the extent that the economic news is not so bad that it forces Congress to extend the Bush tax cuts (which still carries its own risks, don’t forget, because of the burgeoning debt – it makes the Federal Reserve’s job even more urgent.

Extending tax cuts: good (especially if spending is rolled back responsibly). Quantitative easing: bad. But, as I have pointed out before, QE has the virtue of needing no confirming vote of the populace. That is supposed to make the Fed resistant to the unwelcome urges of the proletariat. Ironically, in this case it makes them more exposed to the unwelcome urges of the parliament.

There is one other piece of news worth noting today. Apparently, Goldman is shutting its “Principal Strategies” (that is, proprietary trading) unit; this follows the JPM news earlier this week. Of, course, all of the banks will be shutting down proprietary trading – the Volcker Rule makes it very hard to just spin the units out – so it isn’t “news” in that sense. But it is significant when all of this liquidity leaves the markets (especially, heading into the normally less-liquid quarter of the year).

It isn’t only in the units named “proprietary trading” where proprietary trading occurs, though, and that’s where the big effects will be felt. Unless banks feel like relying on the forbearance of the regulators…and that seems a bad idea given that the torches have already been lit and passed around…then proprietary trading that augments market-making activities will also be curtailed.

If you’re not attached to the financial markets you might not understand what I mean. Let me give a real-world example. Once upon a time, I was trading inflation derivatives on a desk at a big bank. We were speaking to a particular counterparty about the possibility that they might issue a large inflation-linked note. If they issued that note, they would want to swap the flows back into Libor because that was how they, like many institutions, evaluated their financing. At the time, the size of the potential issue was huge relative to the size of the inflation-linked derivatives market – it was probably six weeks’ worth of interbank volume at the time – and I was going to be asked to quote the swap for the customer.

I began to carefully buy my hedge in the market as we worked on convincing the customer to do the deal. The more of my hedge I got on, the better my quote could be for them (because once the deal hit the screens there was no way I’d ever get the hedge off well, and I’d have to charge for that fact). However, it was clearly my risk (actually, the bank’s risk) that if the deal didn’t happen, I would have to unwind my hedge. I accumulated about a third of the hedge, which took almost two weeks.

Folks, this is “proprietary trading.” I was taking a calculated risk so that I could make an aggressive price – or at least, not a bad price – for the customer and increase the odds that the deal would get done. If I could just manage to break even on my hedge, the bank would make good money underwriting the deal; of course, there was also the possibility that I might actually make money on the deal in the inflation book (although at the time that consideration was secondary). Keep in mind too that in doing these trades, I was also providing liquidity to someone on the other side of the market.

In the event, the deal didn’t happen. The hedge that I had accumulated over two weeks I now had to unwind over the next two weeks. I recall that I lost about a quarter of a million dollars on that round-trip, and felt lucky to have done so.

The postscript is that the client eventually did a similar deal with another bank that had apparently not set up for it. That bank foisted the bonds, and the hedge, in a package together, to a bunch of hedge funds. Several weeks later, the hedge funds wanted to unwind part of their risk … and the bank wasn’t there to provide the liquidity. It was a mess, and lost that bank money, prestige, and probably clients, and damaged the inflation-linked bond market. No large deal has been done in the U.S. inflation market in the half-decade since then, despite the fact that the interbank volume now is multiples of what it was back then.

This sort of trading, which is clearly proprietary risk-taking, happens all the time. Without it, many of those deals don’t happen because the deal requires that all of the liquidity be priced at once and the cost to do so is prohibitive. The banks make money by figuring out the most efficient way to source liquidity, partly through “temporal disintermediation”: spreading the hedge over time. I have seen this happen personally in debt and commodity transactions, and it happens in equity transactions as well. I continue to believe that the Volcker rule will be very destructive to liquidity in many markets, and not just because the JPM and GS of the world shut their prop books. Just wait and see.

Monday is the Labor Day holiday in the U.S., so I will not be writing a commentary then. This column will return on Tuesday.