Wednesday, July 18, 2007

A previously undiscovered scientific experiment

Well, well, well. It looks like we have a new entry for the hedge fund lexicon:

"the Cioffi machine is broken" - So sorry, but all your money is gone.

That the NAV of the riskier Bear Stearns credit fund is zero should come to a surprise to nobody bar a few Buhhist hermits living in the upper reaches of the Himalayas. On the margin, perhaps the fact that the "good" fund is only returning 9 cents on the dollar has disappointed a few people (namely, the unlucky investors), but let's face it- the difference between the 9 cent reality and the 15-20 cent expectation is really just different shades of red.

That the dollar, equities, and credit should have sold off so sharply after the BSC announcement belies a market that is acting on instinct to sell whenever they hear bad news from subprime. One could almost call it a Pavlovian response.

Regular readers will recall that Macro Man takes an occasional interest in science and attempts to pattern his investment decisions around the scientific method insofar as possible. They will no doubt appreciate his gratification when, in the course of his scientific reading, Macro Man discovered the findings of some of Dr. Ivan Pavlov's unpublished experiments. The results are set out below:

Moving on to more serious matters, the newsflow is coming fast and furious this week. Yesterday saw higher-than-expected inflation in the UK, and while today's earnings data were soft the unemployment rate was lower than expected. Glenn Stevens made an interesting speech overnight which appeared to accept the high level of the Aussie dollar; this comes in sharp contrast to the dismay expressed by Kiwi policymakers, which explains why long AUD/NZD is such a popular (though, to date, underperforming) position amongst macro punters.

Yesterday also saw the release of a rather fascinating set of TIC data from the US. While Macro Man generally disdains high frequency analysis of this data, as it resembles rearview driving, there is occasionally an interesting explanatory nugget to be found. The May data was such a case. That the inflow was a record $126 billion is of passing interest, though given the rise in the DXY during the month it probably shouldn't come as a big surprise.

The real interest is in the details. Basically, central banks are completely absent from the data- according to the Treasury, the US managed to fund its external deficit just fine thanks to private sector financing. Now, there are no doubt some holes in the data- Brad Setser, who follows this data much more closely than Macro Man does or cares to, has some suspicions that CB purchases came through the secondary market in London. And there may be an element to that.

However, given the 27 bp rise in 10 year yields during May, an Occam's Razor approach would probably yield the conclusion that the price-insensitive buyer took a break in May, which is exactly what the TIC data suggests. Moreover, despite the ongoing concerns over US growth and credit, the inflow into US corporate securities was MASSIVE. There was a net $72 billion invested into corporate bonds, and a further $42 billion invested into US equities. Both were records, with the equity inflow being 50% higher than the previous monthly record.

Quite frankly, Macro Man isn't really sure what to make of that. It seems a bit premature for the soverign wealth funds to be stepping up to the plate, but would certainly represent the sort of size that those institutions could shift. It is premature to conclude that the rest of the world has begun to see value in US equities on the basis of one month worth of data. However, if the June TIC shows a similarly large inflow, it would provide a useful explanation of how and why the US equity market has managed to shrug off the seemingly endless torrent of bad news on subprime and housing generally (another horrible NAHB last night, incidentally.)

Today, of course, sees the rel;ease of CPI in the US (and Canada) and, more significantly, Big Ben's semiannual testimony before Congress. While he will almost certainly mark down the growth and inflation forecasts for 2007, Macro Man does not expect him to alter the outlook for 2008.

More significantly, Macro Man does not expect BB to turn more dovish on inflation. To do so would prompt the obvious rejoinder from the committee: "Then, given subprime and housing, why the *&$@ don't you cut rates?" Moreover, to play down the cost of living would fly in the face of common sense, given that US households have to pay for food and energy.

Macro Man is alo wary of the equivalent testimony last year, when Bernanke disappointed those looking for hawkish testimony by throwing a bone to the doves. This served to reverse the prevailing market trend of the past couple of months, as the DXY chart above illustrates. With the dollar index at a similar (though opposite) extreme today, Macro Man is wary that Big Ben could sound relatively hawkish, leading to a sell-off in bonds and a short squeeze in the dollar. While this won't necessarily represent an end to the trend of dollar weakness against Europe and the dollar bloc, it is enough to encourage Macro Man in his prior posture of staying away from the weak dollar train. After all, the TIC data appears to demonstrate that contrary to popular belief, in the absence of central bank bids the dollar needn't fall forever.


Anonymous said...

macroman -- to continue the conversation from the earlier thread -- i would agree that central banks stepped back from the treasury market (tho probably not quite by as much as indicated in the US data -- some of the $20b plus in net UK treasury purchases likely came from central banks). in addition to the price action, both china and korea seem to have shifted toward agencies in a big way. that trend then got stronger in early june -- here the FRBNY data agrees directionally with the TIC.

The FRBNY data tho doesn't suggest any fall in agency demand in may, and I would think that there is a pretty clear treasury/ agency arbitrage that would keep the treasury/ agency spread from widening too much, and thus agency demand is a close substitute for treasury demand. agency demand didn't really disappear -- per the FRBNY data -- til early June.

and then there is the mystery of where the money is going if not into US bonds -- reserve growth in may was absolutely massive (and april was strong) so there is a lot of money that has to be going somewhere.

agree tho that it seems a bit early to attribute some of the big surge in foreign demand for equities to SWFs -- especially when there was a lot of recorded inflows from regions with known funds (the gulf). And I am most curious why foreign private investors decided to buy so much corporate debt -- there seems to be some risk that they bought at the peak of the market. strong inflows tho would explain the $'s rebound in may -- and on that basis, i would expect smaller inflows in june.

but, as i said on my blog, i am a bit confused -- corp/ equity buying isn't really consistent with disguised central bank activity, and central banks clearly had a lot of money to put somewhere in May -- so a lot of money disappeared without an obvious trace. And china led the pack -- recorded inflows to the US are running at less than 20%of Chinese reserve growth in q2 ..


Macro Man said...

Yeah, I can accept that there has been a substitution effect out of Treasuries and into Agencies. But even if one assumes that CBs/SWFs accounted for ALL of the net flow into UST and Agencies (which just about match the custody data), there is still another $75 billion of net pvt sector inflow into the US, which is pretty darned impressive.

Some of the corp bond flow may relate to issuance, though I do not know offhand if May was a particularly heavy month. It is the equity flow that I find interesting. Now, I know that in May the story of SWFs buying equities started to gain currency- I myself attended a lunch with a clued-in China economist who basically has called everything right about CIC, including the name, so far. And the message we got from this guy is that CIC will be buying stocks.

So perhaps the equity inflow is a scramble to frontrun CIC and others. But, as I noted, one data point isn't sufficient to reach any conclusions, which is why I think the June data will be interesting.

Macro Man said...

Oh, and my working assumption for the moment is that the intervention proceeds went on deposit for reallocation into other assets (and curencies) in Jube/July.

Anonymous said...

The T-note/T-bill divergence we saw in May goes a long way toward explaining TIC dynamics. Bills rallied 9bps while 10-yrs sold off by 27. Adds increasing weight to the argument that reserve managers are "liquifying" a portion of their holdings in preparation for a reallocation... Last chance to buy INDU on a 13 handle?

Macro Man said...

..unless Ben drops the hammer in a minute. Of course, I'd wonder why you'd want INDU to begin with, being a SPY man myself... ;)

m* said...

Macroman - thoughtful comments on the TIC data and today's setup in general. Thanks.

Anonymous said...

anonymous -- good point on bills v bonds. the problem i have there is that the tic data shows a significant fall in official holdings of t-bills -- at least onshore (i..e in the us/ shows up in the US data). both China and India reduced their t-bill holdings, and in aggregate, there was a net fall in exposure.

MM -- i saw from another source that there was a surge in corp bond issuance in may, which presumably is part of the story.

and it is possible, you know, that some folks just like us equities -- and would like them even if they weren't trying to front run some SWFs. You don't need to be all that plugged in, by the way, to conclude that the CIC -- or is it the SIC, i see both -- will buy equities; you wouldn't set up a fund to buy the exact same thing SAFE already buys ...

to me the interesting question is whether it will buy as many US equities as SAFE buys US bonds -- or whether it will follow ADIA's lead and try to have more say EM exposure, of KIA's lead and have more european exposure. If it wants more non-US exposure, well, China's net sales of $ would need to rise unless safe increases its dollar holdings to offset CIC's dollar sales ...


Macro Man said...

Brad, to me it wasn't the rise in equity inflow so much as the magnitude of the increase that was striking; the previous record was $28 billion in a month and May registered $42 billion.

It certainly suggests that SOMETHING changed in May, and the prominence of SWF stories is as good a hypothesis as any. (If anyone knows of any other explanation, by all means share...)

I think it's pretty obvious that CIC won't keep the same currency composition in the equity portfolio as SAFE has. A 70% weighting in US equities makes no sense from an alpha driven global perspective.

Perhaps SAFE is "pre-diversifying" now in expectation of doing relatively little once CIC is humming? Probably not, but it's nice to dream a dream...

Anonymous said...

MM -- do you think the increased equity TIC flow could be a 2nd-order commodity play (go after Exxon Mobil, say)? me thinks anyone delving into US equities in a broad sense right now is playing a dangerous game, but why not go after Alcoa and BHP?

Macro Man said...

Maybe...though that begs the question of why US investors didn't engage in a similar orgy for foreign resource firms, of which there are plenty. While there was a pickup in US demand for foreign stocks, the net all-in equity flow (foreign demand for US stocks - US demand for foreign stocks) was also at a record high.

Scott said...

Wouldn't the fall in the dollar and foreign expectations that the dollar will stay at these lower levels drive some of the buying?