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.

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Martin
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September 24, 2007 at 11:29 AM ×

Nice post MM. However I'd like your thoughts on market reactions if/when we see CPI inflation above 4%.

I just did some back-of-the-envelope calculations, and given the recent run-up in gasoline prices, together with base effects we should see CPI inflation at 4.0 percent in October and about 4.4 percent in November.

This will of course dampen real consumption - when it is looking glum already, but could maybe fuel inflation fears again.

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V&A
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September 24, 2007 at 12:10 PM ×

Interesting post macrodude.
We are not so sure about this disconnect between eds and other asset classes.
To start with, eds price in a probability that things go wrong, ie approximately a 30% chance of a recession. Now you could argue that other assets should price in a similar probability.
We believe the disconnect comes from the fact that the growth outlook is still looking good for the global economy but that the US situation is not as bullish at all.
Eurodollars look at the US economy whereas the S&P and commodities look at the global economy (US majors can do well despite a slowing domestic economy, cf Cisco)...

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Macro Man
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September 24, 2007 at 12:55 PM ×

Martin, I have made those very calculations myself, and arrived at similar numbers. It's why I have referred in the past to 'base effect Nirvana' turning into 'base effect Hades'. It's also why I am suspicious of current market pricing.

Market reaction will depend on Fed reaction, I think. As long as the Fed takes the attitude that growth matters more and/or core inflation remains contained, you'll see curves steepen, breakevens rise, commodities in the stratosphere, and the buck under pressure. If/when the Fed says "whoa Nellie" and expresses concern, then the dollar will catch a bid against everything (except maybe long-dated Treasury bonds). Of all the historical analogues being bandied about, I am thinking that last spring is the one that is closest to the current situation.

V&A, you're right's about EDs representing a distribution rather than a single forecast. But I'd argue that a distribution whose mean is centered around current strip pricing remains inconsistent with some asset pricing, notably credit. It's true, though, that US equity performance over thelast 6 months has been highly correlated with size; DJIA > OEX > SPX > R2000.

It's one of he reasons why I am watching the disconnect but not trading it at the moment; my perception is that mispricing is not egregious enough to suggest an immenent Heinz trade. Hence the desire to see ED vol come off to make for a better risk/reward option trade...

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Anantha
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September 25, 2007 at 4:26 AM ×

Yes, I am glad you mentioned the "Disconnects". Isn't it amazing that the financial risk indicators are back to July or even better levels wiping clean the talk of "worst credit crunch of my life-time, worst in 25 years", etc.

Is it just a return to normal pricing or is there something more to it?

I tender a hypothesis:

With a display of histrionics that would have put even Bollywood films to shame, Wall Street types beat their breasts in public and with borrowed hands, when two were not enough, over events that they characterized as a crisis that has not been seen in a long time. Discount rates were cut and liquidity support was given. Central bank lending horizons were lengthened. Acceptable collateral categories were extended even to toilet paper rolls. It was just as well for that was the only paper that was not marked to model. These were not enough. Financial institutions wanted their familiar diet of low interest rates. The issue was not relief from distress, but sustaining the business model built on low interest rates and debt. In other words, the message was: Grant us relief from follies, but also help us to commit more of it again, or else.

The logic is simple. Not only should they be shielded from facing the consequences of their misdeeds, but they also ought to be rewarded for them. Martin Wolf observed aptly in "The Bank loses a game of chicken", Financial Times, 21 September, that Mervyn King, governor of the Bank of England, played a game of chickens with the world's most irresponsible industry and he lost.

This was a watershed moment. There are a few ways to restore semblance of discipline and order and hope that the industry heeds larger considerations other than their year-end bonuses and stock options.

A credible whistle-blower emerges, one central banker is willing to sacrifice himself standing up to the industry's blackmail or something in the real economy or financial system blows up spectacularly that all are woken up from their reverie.

We await the third.

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Anonymous
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September 25, 2007 at 5:03 PM ×

BB reverse course? I'd be shocked if he has the cojones to defy the markets anytime soon but hopefully he at least now realizes that the Greenspan playbook is obsolete.

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