QE 2 Much

Tuesday, October 05, 2010

TMM make no secret of the fact that they struggle with the current love-athon in bond markets which rests on the idea that rates will be held low until the year 3000 along with FOMC LLC's asset allocation switch out of paper & ink and into USTs. The price action across assets and, in particular, the Dollar & Treasuries are clearly indicative that the macro community has decided that *this* is "The Trade" for Q4. And it may well be, but the speed with which things have moved gives TMM grounds for caution. As TMM's good friend Mr Macro at Nomura is fond of saying, QE is designed to increase inflation expectations, so if there is an open-ended commitment to undertake further QE until inflation is sufficiently high (the Fed's unofficial core PCE target is ~1.75%, with the core CPI sitting about 0.5% higher than that), then buying 10yrs at 2.45% is going to produce a real return of something like 20bps. It just does not make sense.

"Ah", you say, "but that is the point, to get real rates as low as possible". Well, Team Easy B have certainly managed that, sending 5yr real rates negative and 10yr real rates to around 0.65% - not much higher than the above back-of-the-envelope calculation. In fact, since equity markets peaked in April, the 5yr real rate has fallen 63bp (see chart below, white line), the 10yr real rate has fallen 75bps (orange line) and the 5y5y forward real rate (i.e. the market's view of the long-run real rate of return, usual TIPS-related caveats apply) has fallen over 100bps. Following the line of argument that QE lowers real rates, we can see that when the Fed announced QE back in March 2009 the 10yr real rate moved by about 50bps, as did the 5y5y real rate. In recent weeks, as the market has moved to expect more QE, they have both moved about 57bps. Now, as QE is designed to increase inflation expectations and support growth, if the Fed is successful, one would expect the long-run real rate (which is essentially a measure of real trend growth) to mean-revert back towards the 2-2.5% range. Post-QE1, this did indeed happen, even as the spot-starting real yields fell, reflecting easy policy in the near-term but "normal" policy (if there exists such a thing), in the medium to long-term. Sure, it's possible that it stays low or moves even lower, reflecting Ben's bid, but the inflation expectations component of yields will have to move higher. On this metric, at least, it doesn't look like there is much room for nominal yields to rally much further.

So just how much QE is the market expecting? A number of academics have attempted to answer this question, but it's obviously pretty difficult and subjective to attribute just how much of market moves are due to QE announcements. In fact, many of these attempts are more propaganda pieces aimed at showing people just how well central banks did (read any BoE report on this for more details...!). Now TMM is unconvinced that QE operates through anything other than the "shock and awe" channel, which is policymakers' best weapon in the fight to reflate markets and animal spirits. Its use in March 2009 was clearly along this line, though the recent arguments from various Fed members have been more along the lines that the Fed will drip feed QE on a month by month basis. The trouble with this approach is that the market is a heroin addict and the effect of each subsequent $100bn monetary hit fades away and soon enough we will be back in the situation whereby the Fed is labeled "out of bullets". TMM does not think this argument is lost on the Fed, though the loss of the outstandingly savvy Don Kohn makes the former more likely.

But we digress. In TMM's view, one of the purest ways of working out the market's QE expectations is to look at the relationship between 12m T-Bills and excess reserves at Federal Reserve banks. Although not a perfect measure, under QE one would expect 12m bills to follow Fed excess reserves reasonably well as bank Treasury departments manage their short term cash balances. Certainly since the introduction of the 0-0.25% band for Fed Funds, this relationship has held well (see chart below, white line - 12m T-Bill yield, pink line - reserve balances). However, since the EMU crisis and the downturn in US economic data, this measure has diverged as expectations of further QE have grown, and is now consistent with the Fed's excess reserves expanding by ~$350bn to about $1.34tn.

Now, TMM did a brief survey of some of their macro mates yesterday, yielding the expectation that the Fed will announce an initial programme of about $300bn, which is reasonably close to this number and, along with the moves in real rates goes a long way to suggesting that QE is already priced in by markets. Of course, markets are only really vulnerable to turns when positioning is all one way. As we have mentioned before, getting positioning data in the rates market is very difficult because so much of it is OTC. But one metric, TMM like to use is the CFTC duration-adjusted non-commercial speculator net position as a fraction of overall open interest (see first chart below) in USTs and a similar metric for Eurodollar futures (see second chart below). While these only capture a fraction of speculative positioning in markets, they *do* capture a significant portion of its *trend-following* position by virtue of how the droids CTAs execute their trades. As can be seen below, these are both at levels not seen since early-2008. In the context of hedge funds managing, say, 70% of the money they were pre-crisis and employing half the leverage, their power is something like 35% of what it was pre-crisis, so on this risk-adjusted basis, positioning is exceptionally long.

The point here is that anything less than "shock and awe" QE is priced in, and *at best* bonds stay where they are, or at worst, a 2003-like reflationary-driven convexity sell-off is on its way.

Posted by cpmppi at 4:35 PM  


QE is not just about knocking long term rates down. It is about pumping more money into the system . This can lead to equities being bought regardless on long term interest rates. Not so easy to work out if QE2 in already in the equity markets.

GC said...
11:33 AM  

Hi GC,

Apologies, perhaps the post was not completely clear.

This is not about long term interest rates, it's about *real* rates in the medium to long term. Fed policy can lower spot starting real interest rates, which yes, will pump money into equities or 100yr Mexican debt (we are in shock that a country that has defaulted 7 times can issue 100yr paper at 6.1% just 16years later...). But the *forward-starting* real interest rate for a period considered the medium-to-long term has to mean revert around the market's view of real trend growth (which for the past 10yrs or so has been about 2-2.75%).

The point here is that if the Fed is successful in reflating (and TMM would certainly view a large equity rally as evidence of success), then the fwd-starting inflation component of bond yields *has* to move higher. Given that the fwd-starting real component cannot move much lower (given that even in the "New Normal", we are talking, say, 1.5% real trend growth). In that scenario, bonds sell-off".

As for how much the equity market has priced in, we are open to suggestions...

Hope that helps,

cpmppi said...
12:02 PM  

Your analysis sounds good, but....


mythoughts said...
1:33 PM  

Hi - I'm a global macro PM in NY, and I've been reading this blog for a while now, and I like it a lot. I have a blog myself where I discuss my views daily. Not sure if people here are are interested in any more opinions, but here is the link. Most of my thoughts and trade ideas are in the commentary sections.

2:51 PM  

Speaking of QE, when do Euro Fin Mnstrs take a card from the Fed's playbook and say enough is enough? Euro now looking to poke through 1.40... the currency seems to be the whipping boy of the world's QE move...

Jim said...
3:14 PM  

The pattern might be repeating again with a big rally into earnings and then a capitulation. The last 7 quarters have gone that way. Pretty ugly moves in the cloud computing names today (EQIX) and CoT shows a big build in NQ shorts.
Let the games begin.

PS Droid ~ CTA ? hmmm

Nic said...
6:28 PM  

Zimbabwe announced today that it plans to issue a new 200-year security to compete with the recent debt issue initiatives by Greece and Mexico.

Questioned in Bulawayo by financial journalists, while taking part in a sale of 3 year old heifers, Zimbabwe's Oxford-educated High Chancellor Mustapha Uwonga reassured the markets that there would be no problem in Zimbabwe's ability to support the new 10.0% yielding Mugabe Bonds. "Here in Zimbabwe, we have noo problem to support dese bonds. There is absolutely noo shortage of currency in our country, and each issue will also be backed by a supply of our legendary bullocks."

Leftback said...
1:21 AM  

Great post guys. Say what you will about double-dip, 2.4% for 10-years???. The exit plan, when it does come (2011?, 2012?, doesn't matter b/c its coming before 2020), is going to be massive for rates vol. The further the fed gets in deep with QE, the more likely their exit will be a massively market-disrupting events, generally biased to huge rate rises of course. Look at Dec '09. Anyone looking to outright sell treasuries today is going to get stopped out (that's the way these things usually go), but I gotta figure a 5-10y call on the 5yr point can make you a millionaire if you can stick it out for 5 years. I see 3.7% currently on 5y5y spot fwd. It's gotta go to 4.5% once we're through all the dips ;-)

jaguaracer said...
3:02 AM  

TMM,my guess 750B, but with a different touch then last time,they'll outline exactly how much and when under certain "revelant conditions at that juncture of time" prevailing, this part may prove opaque to us layman no doubt, I think they'll want to come across with your shock and awe but not signal to the market that they expect the economy to fall into a hole.

Been looking into the concept of Self-Similarity lately, QE cousin?

Looking at the Bonds, yeah, defintely nice trade setting up there,Open Interest seems to have lowered of late, don't think we'll miss the boat when that one comes about, though a few false starts(QoQ growth) may stand inbetween us and that time I'm afraid.

FX said...
5:57 AM  

hmm so buying USTs aint working? sounds like we have the future rational for helicopter nuking equities. moving up the capital structure if you will. (not that they haven't, long time ago)

QE 6.5: Fed prepares for $1.5T in AAPL purchases to spur iPong sales?

scrilla said...
6:28 AM  

TMM, can you post your Bloomberg custom indices (CIX) on the blog? I'm an avid reader and often use some of your posts to learn new things on my Bloomberg terminal. On occasion I'm unable to recreate some of your custom indices and would find it helpful to see the ones you use. Thanks again for your great blog!

10:05 PM  
Nic said...
5:37 AM  

No Nuts No Glory,

If you send me an email with the CIXs that you want, I'd be happy to send them to you.

cpmppi at gmail dot com

cpmppi said...
3:55 PM  

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