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.