Disconnects

Sigh. And so the long dark winter is upon us. When Macro Man left the house this morning, it was absolutely pitch black for the first time since last March. Although the weather remains reasonably mild (it's warmer in late September than it was in late July), the onset of autumn is well and truly here. Once daylight savings is reversed in October, daylight will be for lunchtimes and weekends only.

Whether the winter proves to be one of happiness or discontent remains to be seen, of course. Financial markets are busy developing historical analogies to the current environment. Is it the aggressive asset price reflation of 1998? The recession/stock market rally of 1991? Or perhaps even the 'Fed behind the inflation curve' episode of April 2006?

At this juncture it is difficult to say, for of course history may rhyme but it rarely repeats verbatim. What does seem clear, however, is that there is currently a disconnect in financial markets. Now, disconnects are strange animals. They can occasionally be sources of rich opportunity in what Macro Man jokingly refers to as Heinz trades (Heinz--> ketchup-->catch up, in which an outlier eventually returns to 'correct' pricing.) But they can equally be a source of intense frustration, because there is no guarantee that the ketchup comes out of the bottle, so to speak.

What is striking now is the degree of easing priced into the eurodollar curve, and by extension that short end of the Treasury curve, with the "gas on the fire" response of risk asset markets both before and since the Bubble Boy's 50-beep gift last week.

If we compare the eurodollar strip with last Friday's three month LIBOR fixing, we see that the strip is discounting three month interbank rates more than 0.75% lower by the middle of next year. Some of that no doubt represents a compression in the spread between LIBOR and Fed Funds, but some of it undoubtedly is pricing in further rate cuts.
Now, if you believe that the housing market is a black hole at the centre of the universe which is

slowly devouring anything unlucky enough to come within range of its event horizon, then you probably think this easing is justified, or perhaps even not enough. But if that really were the case, wouldn't we expect to see continued signs of distress in other, presumably forward-looking asset markets? At the moment, that's not really the case.

The commerical paper market, for example, has taken significant steps towards normalization. While the spread between the crap and the quality is still higher than it was before the summer, the yields on formerly-distressed segments of that market have returned to pre-crisis levels. And while CP outstanding contineus to fall, albeit at a more modest pace, demand has re-emerged for corporate debt, with a number of names rushing to issue last week during the risk-asset love-fest.

Indeed, the euro crossover index, erstwhile barometer of all things wrong with credit-land, is back within hailing distance of its tights despite the apparently obvious deterioration in the fundamental backdrop. While this index has its flaws as an indicator, it certainly captures the prevailing theme of collapsing risk premia. It is now not terribly difficult to mount an argument that current levels inadequately provision for likely defaults.

The equity picture is well known. The 'lambda' and the 'W' might as well be consigned to the Linear B alphabet, because as scenarios they are extinct. The chart below shows MSCI World, but could you really pick it out of a lineup when presented against charts of the SPX, DAX, FTSE, et al?

Commodities, meanwhile, began rallying soon after the Fed's initial discount rate cut and haven't stopped since. Now, part of this rally may be down to the continued resilience of China, et. al. as an independent driver of global growth, but at least some of it, in Macro Man's view, represents the inflationary consequences of an overly-lax global monetary policy. BB's cut has only exacerbated the issue.

So credit, equities, and commodities are saying that the cut was unneccessary and represented gas on the fire. The yield curve and breakevens are saying inflation is going up. Yet fixed income is pricing for more rate cuts ahead. How credible is this?

Not, in Macro Man's view, though there is of course no guarantee that these markets will "normalize" any time soon. But the fact that US household net worth continued to rise in Q2, despite the weakness of housing, is telling; it suggests to Macro Man that the residential black hole is not at the centre of the universe. While one could argue that the impending creation of CIC could have a supportive effect on risk assets, Macro Man finds it difficult to credit that CIC will exert much, if any, influence in the near term.

Macro Man's bias, therefore, is to look to fade the eurodollar strip...though he plans to wait a coupleof days to hopefully allow implied vols to fall a bit. The one thing he is on the lookout for is an abrupt about-face from the Fed, a la May 2006; if BB takes a look at things and believes the market is "dissing" his credibility (steeper curve, surging breakevens, exploding risk assets, collapsing dollar), he may feel compelled to defend his honour. And if the Fed chair does indicate that he gives a hoot about preserving the purchasing power of the currency, then the resulting squeeze could be very nasty indeed.

On a portfolio housekeeping note, SPY went ex-div on Friday. The dip in the stock price this month will be added back in next month via the payment of the dividend.