The title of this post has already been taken

The obvious title of this post, to continue a theme, has already been taken. But the message is still valid. So far this week, signs of distress and, yes, panic, remain evident in financial markets despite the unchanged close in US equities yesterday.

The newsflow has not been particularly encouraging:
* Capital One closes its mortgage business
* Thornburg Mortgage has puked some of its portfolio and taken a charge
* Solent Capital, a UK hedge fund/SIV manager, considers changing its name to 'Insolvent Capital'
* Rumours abound of a UK insurer going bust
* Queues are beginning to form at CB discount windows

Remarkably, the yield on 1 month US Treasury bills traded below 1.3% yesterday. That is pretty amazing, given that Fed funds remain at 5.25% and that 1 month LIBOR fixed at 5.50% yesterday. Whoever was buying bills at those levels was presumably not doing so as part of any kind of investment strategy. If ever you needed proof that focus has shifted to return of capital rather than return on capital, that is it.

Everyone's new favourite indicator, of course, is the TED spread, which was last relevant to global markets at roughly the time that Liar's Poker was published. This indicator measures the difference between the yield on three month Treasury bills and 3 month LIBOR, the interbank borrowing rate. Like swap spreads, it is used to measure the level of distress/panic/praying in the financial system. The current reading is not particularly pretty.
The current reading is the highest since 1987- or is it? While the three month TED spread was wider than 2.5% in 1987 (and substantially wider than that in the 70's and early 80's), those reading came with interest rates at or close to double digits. Expressed as a ratio (i.e., the current 3 month LIBOR rate is 1.71 times the 3m T-bill yield), the spread is the widest that Macro Man can find in his data set. So quite clearly, there is indeed panic on the streets of London....and Frankfurt...and New York...and Tokyo.

Another sign of distress has been the complete implosion of the Russian basket trade, where rouble weakness has more than wiped out the last two revaluations by the CBR. While not fail-safe, this trade was widely thought to have the best risk/reward characteristics in EM-land. Indeed, until a couple of weeks ago Macro Man was involved in his real job. The dislocation this morning suggests, like the TED spread, that positions are being liquidated out of necessity rather than desire.
For the brave, this environment can ultimately set up some real bargains. However, it is important to wait until the period of maximum pain and panic. Something tells Macro Man that we're not there yet. Thus, while the CBR is, to their credit, offering the basket just above current levels, this is no gurantee that it cannot widen further. After all, the ecu basket trade, for those that remember, widened much more substantially in September/October 1998, only a couple of months before it was guaranteed to go out at par. The message here is that nothing is guaranteed and that everything can move more than you'd think.
If Macro Man has maintained one purely financial market theme this year, it is that volatility is likely to be higher in the future than it has been in the past. One rationale for that view is that monetary conditions, while not restrictive, are no longer ludicrously easy. The chart below illustrates a proxy for global monetary conditions (where 0 is neutral, below there is easy, above there is restrictive) overlaid with a moving average of VIX. There is a reasonable correlation over long periods of time, and the policy indicator has been hinting at higher volatility for some time- one reason for Macro Man's conviction that vol has been set to rise, and his preference for hedging risk positions when the opportunity arises.


Tomorrow, Macro Man will look at global liquidity conditions and why he remains, in the medium term, constructive on risky assets.





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Anonymous
admin
August 21, 2007 at 3:40 PM ×

MacroMan,

Your global monetary policy index looks very interesting and your insights always enlightening. Is the index just a weighted average of the major CB's target rates demeaned to 0?

Also, the Nymex NatGas action certainly suggests an Amaranth 2.0 (Citadel???) situation.

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Macro Man
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August 21, 2007 at 3:51 PM ×

The policy index is a GDP weighted index that looks at CB policy rates relative to a simple concept of neutrality. The construct is simple enough but the output is very similar to somewhat more sophistcated measures like Taylor rules. A reading of -1 indicates that rates are 1% below neutral.

On Nat Gas, it could be another blow up, thoguh I suspect that someone like Citadel is much too diversified to come under serious stress from one commodity trade(r). Note, though, that yesterday's futures volume appears to have been less than accompanying the rally earlier in the month, so if someone has hit the panic button then presumably nat gas will go a lot lower.

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tmcgee
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August 21, 2007 at 4:05 PM ×

somehow, it all goes back to the smiths/morrissey...a testament to art, if unintended.

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Anonymous
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August 21, 2007 at 5:49 PM ×

dear MM,

Yesterday you said " S&P low is already seen"

today you say "max pain and panic is yet to come"

what exactly is your prognosis dear ?

What abt EM stocks (esp india) ?

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Macro Man
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August 21, 2007 at 7:23 PM ×

The point of maximum pain for global markets is not necessarily the point at which the S&P 500 reaches its low.

EM, for example, has tended to operate with a lag in recent years, reaching price extremes after those points have been reached in developed markets.

Certainly the rouble, for example, has reached an extreme today not matched elsewhere!

I still think that the next downleg in global markets will start from a modestly higher level than we currently see today.

That downleg, which will be noisy and seem horrible, will in my view NOT see a new extreme low reached on the S&P 500. I could, of course, be wrong, but would anticipate putting some money where my mouth is.

However, I would expect EM indices, particularly in $ denominated terms, reach new lows for the move. Maybe not all EM indices, but certainly the popular ones, which are likely to be the most crowded and the least sold (up til now.) I would count India among those.

Brazil, as well, which is one reason I am very likely to lower my offer in EWZ much closer to market in the very near future.

Sorry for the confusion; I am certainly not trying to say apples yesterday and oranges today, and thus be correct no matter what happens. If the SPX makes a new low, or a new high before touching 1400, I will have been wrong, and admit as much.

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Anonymous
admin
August 22, 2007 at 3:00 AM ×

Dear MM,

Thanks and well explained.

I was just worried if you lost the touch with those long sunbaths on the beach. ;-)

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Anonymous
admin
August 22, 2007 at 4:45 AM ×

MacroMan

I enjoy reading your blog. Very interesting. Keep up the good work.
Thanks.

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Anonymous
admin
August 22, 2007 at 7:39 AM ×

Hi MM,

There are two other data series that have a long-term correlation with the VIX and are actually leading by ~24 months. 1) Credit growth "Nonfarm Nonfinancial Corp Bus: Credit Market Instruments YoY growth" from the Fed Fund Flows report I think and 2)the 3m-10yr UST spread. Both were pointing to higher volatility this year.

Regards,

FR

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Anonymous
admin
August 22, 2007 at 12:58 PM ×

not only are swap spreads wider, but the (usd) 2s/10s swap spread curve is inverted for the first time since, what, 1994?

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Macro Man
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August 22, 2007 at 1:54 PM ×

I also look at C&I industrial loans as a leading indicator of volatility (i.e., representing corporate risk-taking and leverage); this measure should correlate very closely with your first factor, FR.

BBG shows the swap spread curve inverting briefly in February 1997, but frankly I cannot remember it and it may well be a bad print. Certainly flat or inverted swap spread curves have no tended to accompany docile markets!

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August 24, 2007 at 6:05 PM ×

I was told that the TED Spread is "no longer traded." Can a TED Spread position still be traded?

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Macro Man
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August 24, 2007 at 6:08 PM ×

You can certainly create it through buying/selling bills and borrowing/lending in the interbank market. However, the breakdown in the ability to transact large size in these markets probably has reduced the attractiveness of doing these kinds of trades.

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