Short End Musings

OK, first things first. Sadly, the last few days have seen the emergence of a particularly boorish class of troll in the comments section, all of whom appear dedicated to proving the proposition that half the world has a double digit IQ. While Macro Man does not enjoy moderating/deleting abusive comments from cretins, neither does he wish to see himself or this space overrun by drooling vermin. He has therefore decided to impose a registration requirement on comments; while it may prove irksome for regular commenters to register for some sort of OpenUser ID, it will hopefully separate the wheat from the raw sewage, so to speak.

And now, on with the show. Today sees the monthly sacrifice at the altar of statistical noise, the US payroll figures, and there seems to be a school of thought that last month's snow will depress the data artificially. While this may in fact be the case, the recent rally in fixed income suggests to Macro Man that risks lay in the other direction.

White/red eurodollars seem to be extremely well-populated; given that, it was very curious indeed to see effective Fed funds tick up to six month highs yesterday. There were all sorts of stories circulating, from limiting GSE lending in FF to domestic institutions to the withdrawal of the GSEs from the funds market altogether. Either way, effective funds (and by extension, LIBOR) bear watching; from Macro Man's perch, the strip is already priced to perfection.
While focus in the US and Europe remains on the (admittedly glacial) progression of exit strategies, in the third member of the G3 the policy bias is rather in the other direction. The Japanese press is full of leaked stories today that the BOJ will expand its extraordinary measures to "support the economy", which an observer might reasonably translate as "weaken the yen."

However, it is not immediately clear that extending/increasing term lending in the money markets will have much, if any, impact. The US- Japan 3 month money spread is more or less zero, and is currently bounded at just 25 bps in favour of the $. Moreover, the relationship between LIBOR spreads and USD/JPY is indifferent at best; the weekly correlation since 2000 is 0.33, but as the scatter plot below demonstrates, there is a pretty wide dispersion of regimes. (The current observation is in red.)
Ten year swap spreads have historically had a much stronger relationship (corr = 0.57) with USD/JPY, both because of the correlation with outward bond flow and given the veritable Fuji of toxic exotic structures that link the exchange rate with swap yield differentials.
To be sure, there have been different regimes in the swap differential- USD/JPY relationship as well, but the link has generally been much stronger than with front end yield spreads. As you can see, the current observation shows USD/JPY as cheap against both the linear and polynomial regressions by some 5-15%. So while the literal impact of an extension of BOJ policy might be limited, the signalling value might be greater. Of course, all bets are off until the end of the month, with reams of JPY reportedly scheduled for repatriation under Japan's HIA program.

As that flow runs its course, however, 'twill be tempting to have a pop at the long USD/JPY trade closer to the end of the month, though for many punters it may be a case of "thrice bitten, fourth time shy." Macro Man can only hope that the recent proliferation of trolls is amongst them....