Thursday, June 24, 2010
Team Macro Man look at the rates market and cannot help but scratch their collective heads. The mess that is the Eurozone, along with a swathe of disappointing US data, have moved several metrics that they look at to levels that imply very high probabilities of a deflationary outcome. Now, Team Macro Man definitely agrees that things are not so rosy at the moment and the recent news in the housing market amplifies that view, but for the purposes of illustration they would like to invite readers to take a look at deflationary Japan. The level of the EuroYen interest rate curve can give us some sort of benchmark (whatever that means - see yesterday's post!) as to gauging a market-based probability of a deflationary outcome. Specifically, the spread between the 2nd and 6th futures (which is roughly the yield spread between the 3m3m and 3m15m forward rates) is a measure of the probability of a recovery-driven rate hiking cycle or, alternatively, a measure of the likelihood that are rates on hold for a long time. In Japan (see chart below: white is the 2nd/6th futures spread, orange is the BoJ Target rate) during the "all hope is lost" stage of the crisis, from late-2000 until the end of QE in 2006, the 2nd/6th spread traded an average of 20bps (green line), and for the period when the banking crisis became systemic in mid-1997 until the end of QE it averaged 29bps (blue line).
Back to the US. The below chart shows the equivalent Eurodollar 2nd/6th spread (white line) vs. the Fed Funds rate (orange) at 50bps. Only twice before has the Eurodollar curve been this flat when the Fed were not either expected to cut rates or already in the midst of a cutting cycle, once in June/July 2003 when (similarly to today) core-CPI was trending downwards, fears of deflation reached a peak and Dubya decided he wanted to take a vacation in Mesopotamia, and then in February/March 2009 when global growth was being repriced sharply downwards as Timmy G couldn't seem to persuade the market that he had a plan to get the crap out of the banking system. Taking the above Euroyen spread of 20bps for a deflationary outcome and 250bps of hikes being a U-shaped recovery (as per 2004-5) we can then imply the market-based probability of deflation. i.e. - 50bps = p*20bps+(1-p)*250bps, which give a probability of about 87% (or 82% adjusting for the term structure of the FRA/OIS curve) which, to Team Macro Man, looks way too high.
Of course, this begs the questions "So what is going to cause it to turn around?". In March 2009, it was a combination of Count Vikula saying that Citi was profitable in Q1 coupled with one of Uncle Ben's fireside chats. Unfortunately, given the shit show that is European policymaking, Team Macro Man cannot imagine Mangler Merkel & Co. coming out with any positive news on the Southern front though, perhaps the upcoming US
earnings lying season may provide some reassurance. In July 2003, as a result of rates falling so low and the curve being so flat, a massive mortgage refinancing wave was sparked and with it, a very large convexity-led sell-off in rates markets.
What is the likelihood of a similar event now?
The below chart shows MBA Mortgage Refinancing Applications (white), the 30yr Current Coupon FNM (green) and BankRate.com's 30yr Refinancing Rate (orange). You can clearly see the refinancing waves in 2003, in early-2008 and in early-2009, and recently refinancing applications have begun to drift higher, but in nothing like the volumes of those previous spikes, despite mortgage rates being at record lows. Of course, given what appears to be a double dip in housing, or at best an L-shaped recovery, many are in negative equity. But even taking that into account at these levels, a large majority of households have a 50bps incentive to refinance, and mortgage delinquencies fell for the first time since 2008, from 13.6% to 12.7%. Now, one data point does not make a trend, but something is up here.
The fact that most MBS now trade above par suggests that the market has fully embraced the view that prepayment risk is negligible, and the fact that the Fed now owns a very large chunk of the mortgage market and doesn't hedge means that there is much less convexity in the market, but Team Macro Man can't help but think it all seems a bit too easy and this view has become widespread. It is interesting that since the beginning of June, the open interest in Red & Green Eurodollars is a carbon copy of the price action, and has grown by 12%, suggesting that punters having been building these double dip positions in size. It seems to TMM that the market is setting itself up for a pain trade...
In summary, it looks like we have a market pricing a double dip deflationary move, in our eyes, to excess. Especially when considering the dichotomy we are picking up between the deflationistas and inflationistas. Now either the gold bugs have had Hubble space telescopes fitted to their portfolio models and are happy trading for a long way forward or something is about to crack. The way things are currently positioned we favour a crack in Fixed income led by the mortgage market.