Thursday, October 28, 2010

You know QE expectations are getting a bit out of hand when...

So the ECB's 3m LTRO ended up with a larger take up than expected, causing short-dated EONIAs to collapse (see chart below, white), and so, of course, the Schatz yield (orange) decided it was in fact not going to follow. This is a common frustration for TMM - it's difficult enough getting the Macro right let alone making any money off it. Nevertheless, TMM firmly believe that as the money markets in the Eurozone thaw, along with Club Med worries once again surfacing that the front end will gradually rally.

In other news, TMM would like to pay their respects to the passing of Argentina's Nestor Kirchner, for the reaction in Argentine assets was simply astounding, with the stock market up 10%. Now TMM don't bear any ill feeling to President Kirchner, but it just goes to show what can happen when economic policy is run essentially by printing money to fund deficit spending and ignoring inflation by claiming that it has only gone up due to "one-off" factors. Kirchner, of course, decided to alter the inflation statistics such that these large "one-offs" were stripped out, something that reminds TMM very much of that other guy that loves printing money and ignoring inflation by claiming it is due to "one-offs"... their arch-nemesis, Mervyn King. Of course, he isn't quite so explicit as to alter the actual statistics, he uses another approach: rubbish one index, and focus on "inflation ex-energy, ex-food, ex-VAT, after currency moves, ex-..etc etc". TMM's blood pressure is rising so they won't comment on Adam Posen's claims that "if the UK recovery was going to be inflationary, it would have been evident by now" aside from pointing said Posen to RPI running at 4.6% y/y.

But back to printing money. With markets in "QE-on/QE-off" mode rather than just "risk-on/risk-off" TMM thought that it was worth considering whether QE expectations were getting a bit out of hand over the past week and would like to invite readers to post their own metrics:

You know QE expectations are getting a bit out of hand when...

  1. Goldman calls for $2trn.
  2. Rumours fly around that the Fed may eventually do $4trn.
  3. China starts complaining that the Fed is about to purchase $1trn of USTs despite buying a similar amount themselves.
  4. Xerox is up 36% since Jackson Hole.
  5. Your Mom calls you asking what QE is.
  6. The BoJ buys a promissory note from TMM for $1bn whose principal is equal to their combined yearend bonuses price in Gold today.
  7. IBM issues a super long bond.
  8. Mexico issues a really super duper long bond.
  9. You find out that both of these organisations have a guy who had Bernanke as a thesis advisor in their Economics PhD program before joining their respective Treasury departments.
  10. Greek tourist-tat shops sell QE wallets three times the size of normal ones.
  11. The guy that trades European Telecoms on the Equity floor explains to you how QE works.
  12. The TDI (Taxi Driver Index) flashes Red when your taxi driver starts using QE to justify the Gold he bought in May.
  13. A word score of 36 in Scrabble is nicknamed "scoring a QE" in old folks homes.
  14. Your FX sales shag starts giving you minute by minute updates about 10s30s, but doesn't know what "10s30s" is.
  15. Handing out an extra 200,000 quid to all players when any one goes bankrupt is now mandatory and in the official rules of Monopoly.
  16. The DPI (Dinner Party Index) flashes Red when you are in Islington and the Guardianistas around the table start debating just how much more QE is needed.
  17. Your Mom calls you back and asks if she should put her 401k in Gold to hedge against inflation.
  18. Bill Gross, an otherwise nice guy, goes on a rampage, and while not naming names is clearly not happy with the FOMC right now.
  19. The UK decides to privatise the Royal Mint.
  20. Your Mom calls you again and explains to you how QE works.

Wednesday, October 27, 2010

Benoit Mandelbrot, RIP

What a shame the great Benoit Mandelbrot died 2 weeks ago. He would have had plenty to tell us about the fractal nature of markets. Whether it is the way price charts show patterns regardless of time scale (ask any fib or Elliott supporter, they relish it) or even down to the fractal nature of "what if" analysis. With 7bn people, each with a few billion brain cells, it takes a while before you get down to the binary calls. And so it is with macro. Each piece of information we have is a small weight on either side of the balance of outcomes. The skill is in attributing the correct weight to each piece. Every news headline scrolling across a news screen affects YOUR market in some tiny way. We used to play a markets version of 6 degrees of separation with our new interns to get them thinking in relevant ways. Headline - Danube levels fall 8cm? Perhaps that's marginal enough to stop some bulk shipping or increase stream traffic due to lower flow and how would that affect Hungarian or Balkan trade data. Etc etc. We mention this because yesterday was a case in point. We decided that what for many was probably the Nth degree of nerdy micro, to us is one of those grains of sand that can tip the balance. And as such needed comment.

The complexity of this analogy is added to when you consider that behavior of each individual grain of sand has its own probability distribution. At which point we go all quantum. And you could quite easily say that markets only express one value or another once we look at them! Prof Schrödinger's Cat like.

Just as a coastline is the sum of the grains of sand along the shore, so macro is the sum of the micro. But of course we can't just simply keep track of so many micro elements at once and instead like to categorize them by ordering them into families we can easily deal with. We create implicit rules that we think identify these categories and detest it when those rules break down. Correlation is a wonderful concept when it works. A sort of glue for the Grand Unified Theory of Markets that allows us to create "fire-and- forget " trading models. But when the correlation glue breaks down, as we are now seeing, we are forced back to the micro to rebuild our macro models.

At any rate, please excuse our foray into matters philosophical. It's been a relatively quiet time in the mkts, as everyone collectively holds their breath in anticipation of the Big Bad Ben. So we leave you with this. Mandelbrot may be gone, but fractal markets have been and will be with us always. We are just glad that the great man died peacefully and wasn't a victim of foul play (which is, we suspect, the fate that befell Paul the Octopus, who just knew too damn much). Otherwise it would have taken the cops a very very long time to draw the chalk line around the body.

Tuesday, October 26, 2010

A Basis For Cross-border Re-leveraging

Many years ago, when certain members of TMM were fresh-faced graduates learning about curve building and how best to get the desk breakfasts, they were told that "the basis never moves". Of course, things that "never move" or "never happen" tend to follow Murphy's Law... and indeed, in August 2007, basis spreads everywhere started to blow out, resulting eventually in even single stock guys having a Libor-OIS ticker on their screen. TMM, like many, has become accustomed to esoteric portions of the financial system having a large impact upon prices, and in recent days there has been some excitement about the moves in Swedish and Sterling Basis Swaps. At the risk of boring our readership to death, TMM will attempt to an explanation at the weird goings on of the basis swap market... as a warning, this is a bit wonkish.

For the uninitiated, a basis swap is an exchange of two Floating Rate Notes (FRNs) paying different floating rates, and essentially come in two forms: (i) both floating rates are in the same currency, so there is no principal exchange (known as a tenor basis swap - Libor-OIS spreads are an example of these, but also 3m Libor vs. 6m Libor), or (ii) the floating rates are in different currencies (known as a cross-currency basis swap , see chart below- the EUR/USD basis is an example of these). Bond Maths 101 tells us that an FRN that pays the risk free rate is worth its face value because regardless of where risk free rates move, you can borrow at the risk free rate, but the bond pays you that very same rate. Obviously, that is not really a particularly good approximation of the real world, but bear with us for a minute... If there is an exchange of two FRNs in different currencies both paying the risk free rates in those currencies, then the exchange is "fair", however, if one of the Notes pays a rate with credit risk embedded, the exchange is not fair, and a Basis Spread needs to be subtracted from that note's floating coupons in order to equalise the credit risk (or, by market convention, is added to the lower risk note's coupons in the case of tenor basis swaps and to the foreign currency leg for cross-currency basis swaps. Intuitively, 6m Libor has more embedded credit risk (and liquidity risk - more on that later) than 3m Libor, so a swap of 3m Libor vs. 6m Libor would need a spread added to the 3m Libor leg to make the swap fair.

Taking the argument a bit further, one can see the term structure of the tenor basis swaps in each currency relative to risk free rates (for the sake of simplicity, we assume these to be OIS/Fed Funds/SONIA/EONIA etc, though there are plenty of caveats here) effectively gives a profile of the riskiness embedded not just in each Libor rate, but also over term. If the structure is steep (i.e. 12m Libor vs. OIS is quite a bit wider than 1m Libor vs. OIS), then there is either a perceived increased credit risk, or alternatively, liquidity constraints or liquidity-based demand for longer-term funding. Thus, the relative steepness of the two term structures should have at least some determination upon the cross-currency basis - i.e. if the steepening is due to credit concerns then the cross currency basis would move more *negative* (this is the cause behind the well-known "Japan Premium"), but if it is due to term liquidity preference rather than credit constraints, this would move the cross-currency basis *positive* as it would become more attractive to issue debt overseas and swap it back into domestic currency.

So that's the wonkish stuff out of the way. In the real world, these effects are usually dwarfed by longer-dated issuance being swapped between currencies for yield pickup by corporates and supra-nationals in the case of the medium/long-end, while in the short term by the immediate short-term funding needs of the banking system. The poster child for this was the EUR/USD 3m Basis (see chart below)in the immediate aftermath of the Lehman bankruptcy as foreign banks struggled to fund their USD assets via the FX Swap/Basis Swap markets. The EUR/USD basis moving negative has thus evoked memories of USD-funding shortages, most recently in late-April/May as concerns about the solvency of the European banking system in the presence of possibly insolvent sovereigns came to the fore.

So in recent days, when the SEKUSD (1y - white line)and GBPUSD (1y - brown line) basis swaps had large moves positive, it raised fears of a liquidity crisis in those currencies...

But TMM think there is another explanation, related to the textbook gumpf above. For the sake of tractability, TMM have rebased the tenor basis structure relative to OIS (which we take as the risk free rate, this isn't strictly accurate due to compounding, but it shouldn't affect the overall picture) in the UK (chart below, 1yr basis swaps: 12m Libor vs. SONIA - white line, 6m Libor vs. SONIA - brown line, 3m Libor vs. SONIA - yellow line and 1m Libor vs. SONIA - green line)...

...and in the US (see second chart below: 12m Libor vs. FFUND - white line, 6m Libor vs. FFUND -orange line, 3m Libor vs. FFUND - yellow line and 1m Libor vs. FFUND - green line):

It is pretty easy to see that in the US the term structure has not really changed all that much from early-2010, but in the UK it has steepened as 6m and 12m have either stayed wide or moved wider. This is interesting, because the BoE's Special Liquidity Scheme is to roll off shortly, and UK banks have been attempting to replace that funding longer-term, and this may account for the widening of these bases. This looks to TMM like the liquidity-driven term structure steepening argument from above. It is perhaps no coincidence that recently there has been a pickup in cross-currency funded issuance of RMBS in the UK given that GBPUSD basis swaps were still negative despite the moves in the basis term structure. Indeed, as market makers had kept themselves long of Dollar-funding in case of another Dollar funding squeeze, it is also perhaps not surprising that the move has been violent as FX Forward books were forced to stop out of their position. These moves would indeed drive the cross-currency basis more positive.

In addition, TMM find it hard to believe that it will not have gone unnoticed that FOMC LLC is about to print a shed load of USDs, making funding in USD a much easier proposition. With printing presses around the world not having the same productivity rate as that of the Federal Reserve, TMM thinks it makes sense for the international banking system to begin *re-leveraging* on a cross-border basis. The evidence from the UK and Sweden (related to some covered bond shenanigans) suggests that these guys are paying attention doing this. As far as credit growth goes in countries not undergoing the dreaded balance sheet recession (as regular readers know, TMM does not think the UK falls into the same category as the US, and today's GDP numbers certainly back that view up), a re-leveraging in cross-border banking is bullish. On that basis (pun intended), TMM would expect this to spread to other currencies as funding is raised in the US to buy/roll-over foreign assets. An unexpected side effect of QE2 perhaps, to add to the expected one of asset bubbles likely in Emerging Markets....

TMM wonder which esoteric portion of the market will be the next to show signs of getting tipsy on Old Ben's Bourbon.

And finally, TMM couldn't help but chuckle at the Australian Green Party's insertion of a number of root vegetables into the behinds of the merger arb guys...

Monday, October 25, 2010

Things the G20 Can't Organize

TMM were disappointed by the G20 like, oh, you know, most people who think there's a good chance that if we don't resolve global imbalances we might have a trade war and possibly even a real war to say nothing of the currency war underway. So, today TMM are putting their fingers which range from "ooh, that's a bit warm" (EURSGD) to "yup, that lava really does make your hand spontaneously combust" (AUDCHF) into buckets of ice and thought we'd note a few things the G20 can't organize.

1) A piss up in a brewery....
2) A lay in a Macau.....
3) A gangland shooting in a favela.....

We are open to further suggestions from our readers. Suffice to say that even when things do work out in our books on days like this you really have to wonder whether there are going to be markets, per se, a few years from now. Between global climate change and global imbalances the world is showing  that it can't fix any problems that require coordination, even if it is very mutually beneficial and the downside is absolutely awful.

Friday, October 22, 2010

Have a break... buy some S*** Schatz

While the market's attention has been focused squarely on QE2 and currency wars, quietly bubbling underneath the surface has been the significant tightening of Eurozone financial conditions, with the EUR TWI up about 7% in the past month and money market rates up about 40bps (in EONIA) over the same period. TMM's arch-nemesis Darth Weber has struck many a blow to those who have been either short EUR or long the front-ends, with his persistent protestations (subsequently slapped down by Baron von Trichet) that the toxic waste dumped by Club Med on the ECB's balance sheet should promptly be sent to Sellafield. At the same time, numerous ECB members have warned that banks should not rely or become addicted to the ECB's liquidity programmes in the form of the unlimited allotments, and so the banks listened, last month's 3m LTRO had no take up. "Hurrah! The European banking system is OK! The crisis is over!", the Eurostriches claimed. But it all looks to TMM to have been something of a fuck up, given the subsequent squeeze in EONIA. Not to mention the 5%-odd contraction in the ECB's balance sheet over that same period...

Now TMM totally get the German strength story, but find it difficult to believe that this will continue as the US is slowing, and certainly not while the rest of the Eurozone is undergoing a large fiscal adjustment. The feedback mechanisms with the banking system are material, and at a time where peripheral bonds still don't look too healthy, a tightening of financial conditions is just going to end in tears in TMM's view. A more realistic reason for these moves, the Team believe, is that the banks behaved liked good little bunnies and didn't bid for cash, then subsequently discovered that there was actually a lot less cash available than they expected, and that they'd have to pay up for it. In addition, the September LTRO matured on Christmas Eve, which is not a particularly great time for liquidity to roll off when the bank's Treasury departments would rather be doing the last minute shopping for the kids. Whatever the reason, it's clear that the liquidity situation has become somewhat dire (see chart below, average current account holdings in the current maintenance period - orange line) and EONIA (white line) has spiked higher, causing something of a sell-off in the front-end.

TMM have learned over the years that trying to pick up positions in the front end of Europe usually ends up with Darth Weber removing their fingers with his light saber, and to this point they have had their hands securely tied behind their backs. But with the October LTRO next week, there are grounds to expect a large take-up: EONIA is high, Euribor is above 1%, and the period of the operation covers the year-turn, a time when funding is often difficult, so Treasury managers prefer to cover their turn-funding in advance. If, as TMM expect, take up is high, then EONIA should begin to fall off and the downside pressure on the European front-end should reduce. Dec10 Euribor (chart below - brown line) is pricing 3m rates at 1.15%, now even if EONIA hits 1%, that puts 3m Euribor at about 1.3%, so the downside is pretty small there. But the juice in Schatz looks to be bigger, sitting at 1% and at the bottom of the trend channel.

A cheeky long in the normally shit Schatz with a tight stop looks like good risk reward to us.

Thursday, October 21, 2010

Twenty IFs

It's one of those days today when its hard to get ones thoughts straight and TMM wondered whether a different version of 20 Questions would be in order to lighten our mood so they would like to ask their readers 20 "Ifs"

  1. If you had a thousand ounces of gold in coin in your sock drawer would you:(a) gloat, (b) sell it, or (c) debate the size and strength of the sock drawer.
  2. If you had to chose the most apt word or phrase from the list below for current markets which would it be: destroy, deal or unleash destruction, unleash the hurricane, nuke ruin, ruinate, bring to ruin, lay in ruins, play or raise hob with; throw into disorder, upheave; wreck, wrack, shipwreck; damn, seal the doom of, condemn, confound; devastate, desolate, waste, lay waste, ravage, havoc, wreak havoc, despoil, depredate; vandalize; decimate; devour, consume, engorge, gobble, gobble up, swallow up; gut, gut with fire, incinerate, vaporize, ravage with fire and sword; dissolve, lyse.
  3. If a coach breaks down on a three lane highway in London at rush hour do you: (a) quickly tow it out of the way with your police Land Rover, (b) filter traffic past it whilst waiting for a tow truck, or (c) close the whole road down and divert all traffic. (TIP: If you are Kent Police making the choice last night, you go for (c).
  4. If you were a central banker, which one would you be? (or ARE you, if you are reading this).
  5. If you were a policy maker which one would you be? (and as per above).
  6. If you were given a small Caribbean island would you: (a) retire to it, (b) set up an offshore haven for Hedge funds, (c) establish a bank, or (d) try and recreate a Jurassic park (combination of (b) & (c)).
  7. If you had to chose between owning a kilo of the following which would you choose: (a) Yttrium, (b) Lithium, ( c) Germanium, or (d) an "A" Class.
  8. If you had to take one of the following jobs which one would you chose:(a) banker, (b) estate (realty) agent, (c) Fed Chairman, or (d) road sweeper for a London Local Council.
  9. If a face can launch a thousand ships, whose face would you then most like to park them on?
  10. If you were a placard waver outside the upcoming G20, what would your placard say?
  11. If you had to riot in protest over upcoming spending cuts, which country's riots would you choose?
  12. If you were are a South east Asian equities fund manager are you currently: (a) on the beach, (b) retired, (c) buying a new house with your wife, or (d) remembering the Asian crisis and absolutely terrified of what happened last time you felt like this.
  13. If you were an equity salesperson in Japan (paid in USDs) , once you're done with work you are:(a) living off Raman and cheese given how bonuses are looking for this year, (b) leaving the country, or (c) selling yourself at a gentleman's establishment in Ginza.
  14. If you could corner one market, what would it be: (a) silver, (b) rare earth metals, (c) cabbage patch dolls, or (d) cocoa
  15. If you were to stretch the surface area of your lungs over a tennis court: (a) they would only cover half of it, (b) they would easily exceed the area of the court, (c) you would die, (d) Health & Safety 13b has a clause forbidding it.
  16. If you have a roaring hangover you would: (a) call in sick, (b) come in on time, consume bacon butties and coffee, then do as little as possible telling folks you are working on a special project, (c) arrange a huge lunch with a broker or client and get long again, or (d) you don't get hangovers because you are a reformed alcoholic who is now a workaholic instead and has no tolerance for your staff EVER doing anything but work.
  17. If you ran fixed income trading at an investment bank and regulators and clients wanted to move derivatives trading on-exchange to reduce systemic risk and increase transparency, you would: (a) agree, and accept that your business will shrink due to increased competition and transparency, but hey, never mind it's all about having a free and transparent market, right? All in the greater good. (b) Try and confuse the politicians by coming up with some bullshit argument about how banks are in a unique position to provide liquidity, and that it is already a free market and that doing this would actually reduce transparency and competition. We need to keep all the spread business we can. (c) Wait, didn't you work with us before? This is NOT how this is meant to go down. You are screwing this up for everyone, Gary. Or (d) Fuck them, give me my bonus.
  18. If you traded OTC markets and a technology company tried to bring together you and others in your product area in order to create a new centralised electronic market for trading your product, would you: (a) say, "Wow, what a brilliant idea, this will improve transparency and liquidity and really improve the market", (b) note what happened to Spot FX traders when EBS came online and think "there's no way they're taking my broker lunches away and replacing them with a computer with no expense account" and utterly refuse to trade on the new system. Or (c) Fuck them, give me my bonus.
  19. If you were a hedge fund manager who has had a bad year, you see strikes in Europe are mounting, with the French firing tear gas at school children, the Portuguese can't get agreement to pass their budget and peripheral bonds still trade like Lehman stock. Do you: (a) Sell EURUSD because Europe's falling apart and Europe needs looser financial conditions, (b) To hell with macroeconomics, buy EURUSD because it's trending up and you need to make some cash before Dec 31, (c) shut up shop because you'll never make your high water mark back and start a new fund, or (d) QEQEQEQEQEQEQEQEQE I cant hear the question I've got my fingers in my ears QEQEQEQEQE.
  20. And of course.... If you think china will ever stop taking the piss with FX, when would that be ? a) never.

Wednesday, October 20, 2010

I bought a Chevy Vega, but I want it to be a Mercedes

We have woken up ths morning to find our desks covered in "relax, don't worry, the correction is over" pieces. But TMM think too many technical supports have cracked so we are not jumping on this renewed USD sell fest. There is too much relief at the relief. Instead we are waiting for the still-overweight droids to respond to their rolling momentum models and continue to buy USDs back. Even if Voldemort and his death eaters are currently happy to take the other side. So whilst waiting for the second showing of the "path of most pain" TMM will have a look at a subject we have thus far kept pretty quiet on. The whole Mortgage-gate thing. And this headline yesterday was just too much to let it go:

TMM is led to believe by the mortgage experts that losses related to put-backs could come as high as $100bn, but a good chunk - perhaps 50% of GSE put-backs - of these losses have already been taken. In the grand scheme of things, that is not a particularly large number (anyone remember the time when a $2bn loss would move Spooz 2%...?! How things have changed...), and unlikely to result in further capital needs at the banks. But TMM, like many others, was particularly surprised to see that the NY Fed, along with PIMCO, is attempting to put-back a good chunk of mortgages to Bank of America. Now, this is quite a big deal as far as TMM are concerned, as not only have the two largest buyers of mortgages decided to try and get some money back, but one of them is the Fed. Apologies for the cliché, but don't fight the Fed. BoA is going to take a bath on this. But, as above, that's not the real problem here, as this is just transferring cash from one group to another.

The *real* problem, in TMM's view, is the impact upon the securitisation machine going forward. Now, after the tumult of the past few years, the machine was not really in great shape anyway. TMM suspect that the legal and administrative nightmare that has arisen will result in significant changes to the originate-to-distribute model above and beyond those that have already been implements post-crisis. Securitisation was conceived because it was thought that it would (a) reduce the risk to investors by providing embedded diversification, and (b) allow banks to move assets off balance sheet in order to extend more credit without being exposed to the existing loans. Well it turns out that it has failed on both fronts, both in the form of concentrated losses, and the complex paperwork attached to securitisation resulting in loans coming back on balance sheet at Par. It doesn't look so smart now, does it?

That's not to say securitisation is a bad thing, it has clearly had the intended benefits, just not to the degree to which originally conceived. But going forward, it seems that an additional administrative overhead as a result of Mortgage-gate will be put on the process, slowing the machine down and reducing the amount of credit extended. To TMM, that sounds like the Velocity of Money is going to take a further hit at a time when it has already fallen hard as result of the crisis. TMM have generally been pretty optimistic in terms of the amount of deleveraging needed, and the amount of progress made to date, but this gives cause to re-asses. The below chart shows the logarithm of the ratio of debt outstanding to M2 for Households (white line), Household Mortgage debt (brown line) and Corporate (yellow line). Post DotCom crash, corporates deleveraged aggressively and, as evidenced by the very large amount of cash held on balance sheets, are underleveraged with respect to the long-run trend. As the story goes, households just kept leveraging at unsustainable rates and have a lot to do. Of course, the amount of deleveraging is determined by how much of the financial innovation over the past 30yrs has permanently affected the velocity of money, and how much of that is gone forever more.

TMM can see four potential scenarios, with current market expectations lying somewhere in between numbers 1) and 2):

  1. The jump in household leverage post 2001 was purely due to the shadow banking system and related mortgage bubble. If it is only that portion of velocity that is being unwound, then eyeballing the below chart, there is probably another ~10% to go, and the post-Smithsonian Agreement trend (see chart below, green line)) is probably intact. This is the optimistic scenario.
  2. The originate-to-distribute model is severely impaired, there is a disintermediation of credit led by banks moving away from securitisation as their primary means of extending credit. The velocity of money falls further and the financial system moves to a hybrid securitisation plus more European-style bank-based one. In this scenario, it is reasonable to conclude that much of the developments in credit markets since the mid-1990s are reversed and the sustainable ratio for household debt moves down towards the pre-1994 trend (see chart below, red line), which implies something like a further 25% fall in household leverage. This is the bearish scenario.
  3. On top of the above, households develop an aversion to debt, Glass-Stegal returns either explicitly, or by default as a result of bank behaviour. Virtually all the innovation gains of the past 30yrs are wiped out and the economy turns Japanese. The ratio falls towards its pre-1983 trendline (see chart below, white line), by about 33%. This is the uber-bearish scenario of the Roubinis of the World.
  4. But TMM think there is another scenario, that will be music to the Gold Bugs' ears. Prior to the 1971 Smithsonian agreement, the Gold Exchange Standard effectively limited credit extension and the velocity of money. One of the more conspiracy-related extensions of the current chatter regarding a global agreement on currencies is that the QE enacted by the Fed will eventually become a permanent part of their balance sheet. The argument goes that policymakers want Gold to go up to $2500 at which point the Gold on the Fed's balance sheet will be re-valued, and the currency backed by 1/3rd Gold as part of a basket, i.e. - the monetary system moves back to something like it was pre-1971. Now under the rigidities of such a monetary system, it might be expected that the sustainable ratio would have to fall to the pre-1971 trend (pink line), by something like 40%. Of course, as a result of the QE being permanent, much of this adjustment will have been made by the denominator of the equation, rather than the numerator...

...and then TMM took off their Tin Foil Beanies...

Back to Mortgage-gate. TMM think that the ultimate scenario lies somewhere between 1) and 2), but closer to the former than the latter. The trouble is that the repercussions of Mortgage-gate are to move us a little closer to the second scenario. In that respect, at least, scandal is something of a growth shock.

Tuesday, October 19, 2010

Bubble Bubble Toil and Trouble

There is a *lot* of talk going around the market of bubbles these days. The FT is making a lot of noise about bubbles in EM which frankly we could have written ourselves:

“The degree of euphoria surrounding some emerging economies is already troubling. The Indian and Indonesian stock markets are trading at price earnings ratios of over 40 times, based on ten-year average earnings. You would surely need a hundred years of fortitude to buy Mexico’s recently-issued 100-year bond at a yield of 5.6 per cent. Bubble and bust in China, on which the world is now so dependent for growth and optimism, would likely tank the commodities markets, set off a second round of deflation, and end the emerging markets boom in the most spectacular way possible.”

That, of course, is hardly the only one they are positing, others include:

Gold (here and here),


Online gaming,

Etc, etc.

TMM are finding plenty of anecdotal evidence these days from positioning in BRL forwards, AUD and other carry currencies and, conversely, the amount of effort central banks and governments in these countries are putting into vain efforts to slow appreciation here. To wit, look at the efforts of Brazil here, South Africa’s towel throwing here, to say nothing of Korea, Japan and the Panda in the room, China.

That being said, while valuation is often a good guide its generally a shocking indicator for timing. Many equity markets are now historically expensive (Southeast Asia, India, list goes on) and EM local FX yields continue to get ground down by the weight of capital flows. Short of putting a 100% tax on all interest and capital gains from their bonds, it’s hard to see exactly what they can do in a world this starved of carry. Once again, while TMM are leaning

to the short side now this kind of navel gazing doesn’t appear to have an obvious resolution: leaning against the CBs makes a lot of sense and while the equities aren’t cheap so long as you aren’t limit long exporters you won’t have to come into work one Monday, see “Plaza II” on your screens and have 15% of your book facing a world in which their FX is 15% higher and their net income margins just went negative in perpetuity.

To that end, TMM are holding off a bit on the anti-bubble trade obvious positions and going for slightly more subtle and less volatile crosses – short AUDSGD, short EURCHF are a lot less hair raising than USD crosses for now. However, we have found one corner of the market that has now conclusively jumped the shark – rare earth metals.

Rare earth metals have been covered extensively elsewhere, but a wiki is not a bad place to start. The long and the short of this market is this: these elements are crucial in a number of applications for which they make up almost none of the cost. As a result, demand is pretty inelastic and buyers will take what they can for what they can and are not all that fussed about pricing, hence the market is very much a supply side driven game.

The supply side has been in the news a lot because China has recently worked out that it owns about 85% of world production and has decided to start flexing its muscles, particularly with respect to Japan where Hitachi Metals is from. See the production history below:

Hitachi has the patent on neodymium-boron magnets which are used for just about everything and which require neodymium, a rare earth metal. In an effort to move more manufacturing for high-tech products to China and probably due to no small amount of Japan bear-baiting China has restricted exports of these products.

TMM have one thing to say: bad move. Putting on our consulting/industrial organization hats for just one second if you 1) own a market 2) have customers that couldn’t care less about pricing within reason why would you cut them off and give them no choice but to create competitors? This kind of behavior is the quintessence of short term greedy which may work at a hedge fund but hardly makes for great strategic thinking. Cue the ramp in rare earth metals like Cerium seen below:

From what TMM understands has made the likes of the hedge fund / commods trading houses like Trafigura, Glencore, and Red Kite very happy these days. Not that equity punters haven’t had a good time with it, see Lynas Corp, an emerging Australian producer seen below:

The only problem with this trade is this: if prices stay even vaguely close to these levels for an extended period of time then every single prospective mine in this space WILL get built. Additionally, after the Chinese experience it seems that end users of these products are very much inclined to throw in the towel on buying at spot and instead vertically integrate by buying a deposit at an earlier stage of development for less. As most industrial organization and antitrust experts could tell you there isn’t much difference between a monopoly and an oligopoly in terms of pricing especially when their cash costs are much the same. You might not get cut off, but you will get gouged.

To that end, TMM are calling out those who value these companies assuming current spot metal prices for what they are: idiots. The mother of all squeezes for physical in this space does not translate to permanently higher prices and while there are no futures or ETFs for these metals those piling into LYC and the like are asking for trouble. TMM’s informal poll of the Asian metals and equities trader space finds this position to not be incredibly crowded with a large number of momentum monkeys and not the kind of guys you like to see in these trades, i.e,. - the guys who trade physical. TMM instead prefers to play the takeout game and judging by recent price action in the likes of Greenland Minerals and Energy, we aren’t far from wrong.

Big deposit held by junior in need of funding is a much better story than big deposit held by funded mid cap that is already in development for the likes of Hitachi.

As we go to press, China have offered another of their pre-G20 offerings with a rate rise. Now we may not see this do anything more than give them a negotiating feather, considering its effect on commodities and Chinese shares, it may just be enough to help us deflate the rare earth metals bubble.

Monday, October 18, 2010

Rummaging in the Toybox

We might have just set a new record for the amount of time the market has been able to focus on just one subject, but at last the Attention Deficit and Hyperactivity Disorder kids are restless. It's looking unlikely that they will be able to maintain such QE focus for the 2 weeks running up to the FOMC, and they are looking for new toys.

So what's in the ADHD market kids' toybox?

The new mortgage scandals - A new version of an old toy - like computer controlled Lego. This is interesting but not good enough on its own to shock the market. In fact it may well suit policy. You take the banks (who after their disgraceful display of two fingers to the world with their 2009 profits need a public slap) and stitch them up with a "Kerviel"-type financial penalty hanging over their heads. You then either arrange to loosen the noose around their necks in exchange for more responsible behaviour OR you insist that they do indeed empty their coffers to feed the starving populace and then use any further QE as a life-support system for them as they cope with that together with Basel III. This effectively means that any new QE goes to Joe Public end-user instead of getting locked up in corporate balance sheets. Neat, however it is once again the over-profligate borrower who gets bailed out at the expense of the cautious saver.

Plaza 2 - 1980s classic Cabbage patch kids. While the market is rife with chat that November's G20 meeting will yield a Seoul Accord, TMM just cannot see it given that the man who woke up the World's media to the idea of a currency war, Senhor Mantega, is apparently not going to be attending. Now, whether or not this is a US/China/Europe issue, whereby the rest of Asia will just follow China's lead, is irrelevant. The G7 ceded the lead in Global Policymaking to the G20 and, what with the BRIC craze, it seems very unlikely that such a monumentally important policy move would happen without the Brazilian contingent. Of course when the trade wars do boot off, we are waiting to buy every "next door" country possible, as the likes of Mexico fit the last screw in otherwise Chinese goods, label them "Made in Mexico" and ship North. There is no better business than acting as a middle man between rich folks who hate each other.

Europe - last toy to be played with, never properly put away, with pieces now hidden under the sofas and rugs. A pet frustration here is that the eurocrap has successfully been swept under the US QE carpet, but now is a perfect time for someone to ask "what's that smell"? Can the market really ignore 1.2 million people on the streets of France, fuel supplies depleting and Charles De Gaulle airport under threat? Well yes, they obviously can, as the market felt it was Trichet's comments effectively isolating Weber that were more influential. But as we have mentioned before the French students always get an "A" in rioting and are normally forgiven these days with patriotic sighs of "Ahhh, fond memories of 1968, let them have the fun we did." Germany must be wetting themselves in mirth as they see the own goals around them while they go on to print ever more encouraging data.

Gold - The Meccano at the bottom of the box, been there forever, you get excited about building it into something, only to find half of the necessary bits are missing and it collapses. God forbid we say anything on gold. We know what happens. We trust that the FT journos who have been pumping out "gold bubble" stories since Friday have had their names changed and moved to safe houses to avoid the hail of AK47 bullets, tins of spam, beans and bottled water that will be flying their way.

China - Scrabble. Picking real words from random letters. Comfortingly familiar and always good for a rainy day. We sometimes think that Chinese officials just use a "word bag" to come up with their statements. We just tried it and got " Policy Wen yes US higher no FX Chinese interests steady correct". See? Almost a Reuters headline!

But perhaps this market is even more ADHD than even we expected and, after looking in the toybox, gets instantly distracted again and rediscovers the QE game on the floor. Price action so far today seems to suggest this may be the case.

Friday, October 15, 2010

Picture worth a thousand words

As Macro Man referred to his progeny as his Macro boys, so Team Macro Man also have their own pack of brats. Who we will now on refer to as the Macro Minors. We were rather impressed when one of said Macro Minors, with perfectly topical timing (and also possibly an eye on the Frieze Art Fair), created this (click to enlarge):

Thursday, October 14, 2010

Good Trips and Bad Trips in Macro

TMM can’t help but notice that with FX moves like this all reasonable expectations or predictions of price levels makes discussing commodity target prices or inflation pretty surreal. It’s a mathematical fact that if the dollar goes to zero then silver in dollars goes to infinity and for the meantime the dollar debasement theme song appears to be Primal Scream's "Don't Fight It, Feel It".

As one astute market observer pointed out in a recent Bloomberg chat “it's like teenagers with a bottle of vodka in the park”. Quite. Despite all the fun of playing this game, certain members of TMM are having a recurring dream where they are on the train on the way to school and fall asleep. When they wake up they are at the last stop and the train is full of Terminators and you are John Connor.

Having played some of the spivvier metals some of TMM are taking their cash off the table since these charts look awfully CTA heavy. Similarly the price action in some previously dormant gold names gives us pause: sure it was a value proposition a month ago, but 40% in a month? Come on.

So if dollar debasement/long gold and precious metals feel a bit crowded where do you go? The problem is that the “lean against Asian Central Banks” trade has run really hard and the legislative action has already ratcheted up. Thailand has imposed taxes on local FX government bonds’ income payments, and look at the chart below: its as if everyone woke up post the euro crisis and decided to load the boat on Asian carry. Indonesian 20 year, Thai 20 year and the Asia Dividend yield index from ze Germans have all done exactly the same thing. Returns that haven’t been realized in FX have been made on yield compression, big time.

While equities still look good to ok they might not all do so if the CBs throw in the towel and these currencies are up 10-15%. There are signs of this happening with Russia moving bands yesterday and MAS allowing SGD to strengthen today.

We are also not blind to other catalysts out there to turn some of these acutely overextended trades around. QE we have discussed extensively but no one seems to think it will do much good for anything except asset prices which might give pause to the Beard, especially given what the theme song of the US house is likely to be post midterm elections. We even now have Bill Gross and Medley (allegedly) weighing in on the issue, But much more importantly Mr T has laid down a marker in Gold, with a landmark interview on Bloomberg.

All we need now is a call on EURUSD from Gisele for a full house.

With Ron Paul and his tea bag/party/Dachau re-enactment society/whatever cousins calling for action on China and less of the monetary easing Ben Bernanke is calling for it may not be the most politically prudent move for the Beard to print here if he wants to keep his job. Even some of those Southern Democrats and Freshwater Economists including Hoenig and Fisher on the FOMC are calling “no more”.

Watch this space. TMM are moving to more liquid positions and keeping an eye on well informed Asian CBs – something is up. If the walls start bleeding and we wake up at that last train stop in a carriage full of killer robots we are going to assume that our good macro trip of the last few months is definitively over courtesy of the Beard and/or some deal, however shoddy, on global imbalances.

Wednesday, October 13, 2010


Given yesterday's once again eye-watering inflation numbers out of the UK, TMM decided it was time for another look at UK policymaking, and it seems to us that the UK is undergoing a serious bout of Mervynflation. As far as TMM can tell, policymakers just haven't learned arguably the most important lesson of the crisis which is that groupthink amongst economic policymakers is very dangerous. And seeing the steady stream of calls for renewed monetary easing from such policymakers around the World post-Jackson Hole, gives TMM cause for concern. In particular, Adam Posen's recent eloquence making the case for a second round of QE in the UK. While Dr Posen can claim significant expertise with respect to the Japanese experience, TMM are now convinced that his line of argument ignores the most important considerations, those he clearly knows least about... THE UK. It is easy to see the attractiveness of the Depressionary view of the World post-crisis where deflationary forces caused by exceptionally large output gaps mean that the downside risk is very real and the evidence in the US is indeed worrying in this respect when we look at measures of resource utilisation. But this just isn't the case in the UK, as we will attempt to argue in this piece. TMM is concerned that this deflationary tunnel-vision by the Bank of England, and economic policymakers in general, as a result of the Jackson Hole consensus is causing a serious policy error in the UK.

Team BoE have been at pains to argue that the reason for the consistent upside surprises in UK inflation have been as a result of "one off factors" such as the large currency depreciation and the VAT hikes. Given we are now two years on from the collapse of Sterling, it is hard to argue that there is any remaining pass-through from this effect. As for the other "one off factor", TMM have attempted to strip out the VAT effects from core-CPI (see chart below: headline CPI - white, CPI ex-indirect tax - pink, core CPI - brown, core-CPI ex-VAT - green), and while this measure of inflation sits a lot lower than the headline, at 1.5%, it is still around the average level that core-CPI has been at since the BoE was given independent control of monetary policy. Since the emergence of China et al, a wedge between the headline and core-CPIs has opened up, something that policymakers regard as being a "one off", as energy and raw material prices are pushed higher. As regular readers will know, TMM believe this is unlikely to stop as the economies of these countries grow, and thus it is very hard to get sustained deflation in headline CPI. But the point here is that ex-everything-the-BoE-thinks-are-one-offs, inflation is pretty much where it has been for the past 13yrs. As some wags have commented in the past, inflation ex-everything is zero.... we're not fooled.

OK, so what about the relative picture? The below chart shows UK core-CPI (white line), UK core-CPI ex-VAT (yellow line), Eurozone core-HICP (green line) and US core-CPI (brown line). It is pretty clear that both US and EU core-CPI have been gradually trending lower, and to the lows of their historical ranges, but the UK measure is nowhere near the negative levels it fell to in 2000. As far as this chart goes, it is possible to construct a deflationary argument in the US & Eurozone, but laughable as far as the UK is concerned.

"Ah," you say, "but what about the output gap? That chart only tells you what has happened, not what is going to happen. Growth is going to be very slow, unemployment is going to rise when the public sector spending cuts start, and we will have a double dip". Well, the trouble with this argument is that the UK is not the US, the output gap is a lot smaller as unemployment didn't rise anything like as much as economists expected, and has begun to fall (see chart below -white line, inverted), while manufacturing capacity utilisation (yellow line) and the CBI's capacity utilisation survey (orange line) have both retraced a large amount of their fall and are either at or approaching the levels of the past 15yrs. As a wise colleague once said to TMM, the trouble with measuring the output gap is that you're trying to fit a line using past data that is going to be revised, using present data that will also be revised in order to predict where you think future potential output will be (that will also be revised). TMM is thus of the view that making policy based upon something so transient is somewhat short-sighted.

In terms of the public spending cuts, as Ben Broadbent (TMM's favourite UK economist) at GS keeps pointing out, the public sector job losses are equivalent to 0.4% negative job growth, while the private sector is adding jobs at a rate of 1.6%, which will comfortably offset the loss of those public sector jobs. A recent OECD study also finds that in the UK the fiscal multiplier is something like zero, plus or minus 0.1 (!). As we've pointed out before, the two periods of strongest growth in the past 30yrs were during periods of fiscal retrenchments... now, that may or may not be due to FX rate falls or monetary policy, but that is a subject for another day.

The other argument the BoE put forward is that wage growth is tepid. But this misses the point. Once inflation shows up in wages, it is too late... Anyone remember the wage-price spirals of the 1970s??? Today's wage data seems to suggest that the rate of pay increases (see chart below) is beginning to turn back up again...

...And Nominal GDP (chart below, white line) has reached a new peak, even as Real GDP (brown line) is still well-below its peak. The answer here is inflation, and as far as the guy on the street is concerned, the economy is nominal GDP - the money illusion is real (excuse the pun).

But back to the BoE... TMM have updated their UK Taylor Rule (see chart below) which is based upon the unemployment gap and consensus economic forecasts. The brown line is using straight core-CPI, while the purple line uses core-CPI adjusted for the VAT effects, and both suggest that policy is too loose, and that rates should be around 2%. To be talking about doing more QE when policy is already too loose seems somewhat loopy to TMM.

The extent to which the BoE have allowed inflation to rise and continue to set policy too loose has begun to have a material impact upon inflation expectations, and TMM are surprised that the BoE have allowed these to begin to de-anchor, something they put down to the economic groupthink of Jackson Hole. The Fed, for example, usually respond either with rhetoric or action when two of the following measures of inflation expectations begin to de-anchor: (i) professional forecasters, (ii) market-based and (iii) survey-based. Well, the charts below seem to suggest all of those have in the UK. Professional forecasters have raised their long-term inflation expectations from around 2% to 2.5% (chart below, blue dots):

The market-based measure implied by 5y5y fwd breakevens has settled into a higher range of 3-3.5% vs. pre-2007 range 2.5-3.1% (see chart below, white line), and have stayed high, even as the equivalent measures in the US (orange line) and EU (yellow line) have moved lower as deflation fears have grown:

And the BoE's own inflation expectations survey shows a clear de-anchoring:

TMM's question for the BoE is "At what point do you accept you have got this wrong?". While conspiracy theories have grown that this is all part of a grand plan to inflate and reduce the real debt burden for both households and the government, TMM think it is more to do with groupthink than anything sinister. The trouble is, we have no idea at what point the BoE will finally respond... 4% CPI? For the time being, both Sterling and Gilts have to be a sell on rallies given the inflation tail risk.

Tuesday, October 12, 2010

I'll never let you go, Ben

TMM was surprised to see that the renowned dove, Jenet Yellen, in her first speech as Fed Vice Chairperson chose to warn about the dangers of policy being too loose. As we noted last week, the QE2 mania has permeated many asset classes with anything from 350 Gigadollars to 1 Teradollar or even more. The question is, with these numbers flying around whether it is possible for there to be an upside surprise in terms of QE announced? TMM note that historically, the Fed have argued that they do not wish to be seen as monitizing the Federal debt, and as such, a ceiling at the level of net issuance is appropriate. Given that hard limit, TMM is beginning to wonder if QE2 the appropriate name. It certainly seems as if the trade is so crowded that the lifeboats have had to be ditched to make room. And that, all of a sudden, makes it look more like the Titantic...

...has an iceberg been spotted?

As has often been the case in the "macro is everything" world post-2008, correlation has been comically tight amongst thematic trades. Look no further than Fortescue, an Australian iron ore producer for an AUD proxy. Long term pricing for iron ore by most analysts worth their salt is 50% down from here which makes this all the more remarkable: if this company hits its numbers then iron ore demand has to go up a lot at at time when China is planning on reorienting its growth path to less fixed asset investment.

Similarly, those in the know aren't arguing about whether AUD is fair value but more just how many sigmas worth of deviation we are looking at here. TMM estimates range from 1.7 to 3. Hardly a great long term buy unless you really think the USD is going down the toilet, in which case there are better things to buy.

It is TMM's view that once again, people's risk models may not be picking up just how much risk they have on and how correlated their books may have become. Which means that those riding the QE2 might want to look at alternative transport or at least know where the lifeboats are.

Friday, October 08, 2010

Nobel Currency Peace Prize

As signs begin to materialise of a turn in the Dollar and Gold after Wednesday's TIPS-mania (even if it may only prove to be a temporary pause), TMM was amused to see their arch-enemy Voldemort lower the USDCNY fix by quite a chunk following their holiday. Masterful Realpolitik ahead of the G20 meetings. TMM was also amused to see Moody's floating the suggestion that they might upgrade China's sovereign rating which the FX market took as a reason for AUD and the likes to jump 25pips. Hmm... given that the evil capitalist running dog ratings agencies have usually been well-behind the curve on ratings, TMM struggle to believe that this is new news, but whatever... In terms of la guerra de la moneda, TMM are re-reading Nineteen-Eighty Four for guidance as to what happens next as they have noted eerie similarities between its perpetual protagonists of war, Eurasia, Eastasia and Oceania and current global FX policy.

As opposed to the Nobel committee which is clearly a bunch of New York Times editors moonlighting on a Swedish boondoggle. TMM applaud the awarding of the Nobel Peace prize to a Chinese dissident (certainly more deserving than the dissident in the White House). But we would like to propose that next year the Nobel Committee introduce a Nobel Currency Peace Prize. Malaysia and Australia being the obvious contenders. We would also suggest that it be retrospectively awarded to Japan for years 2008 and 2009, but then instantly rescinded after recent doping tests proved positive.

But back to the QE-hysteria... Mr Bullard put the cat amongst the pigeons by suggesting that QE is not a done deal, and that the economy hasn't slowed enough to make QE obvious. Now, while TMM expect (as does just about everyone else) that the Fed will definitely do QE2, whether there is 350 Gigabucks or 1 Terabuck priced into the market, it is clear that such a comment coming from the Fed member who was the first to argue for renewed QE a few months ago means that the Fed is unlikely to follow any shock and awe type approach. And that means that QE is overpriced, as far as TMM is concerned. Those who still own the best trades of the last month or two probably will need a stretcher to get them off the pitch at this point: Palladium and Silver are both down 4.5% or so and if April/May is anything to go by the cliff diving may have only just begun. TMM have learned the hard way that trying to hold this stuff all the way to the top and sell after the turn never works – better to take the money and run more often than not.

And finally, to today's random number generator... no, TMM is not talking about the Euromillions lottery, but the Non-Farm Payroll print. Why people continue to pay attention to such a statistically insignificant number continues to baffle TMM but, for the record, TMM's private payroll model (see chart below, model - orange line, official private payroll change -white line)is forecasting a zero private payroll gains. Against the Bloomberg consensus of +75k, that would be a disappointment (although, to caveat, TMM's model underestimated official payrolls for a good part of the last year). Good luck to us all.

Thursday, October 07, 2010


Well, if TMM thought that the move in real rates, gold et al was overdone yesterday, this morning they find themselves even more surprised. 10yr Real rates took a 20bps dive yesterday, while breakevens widened and nominal yields fell 10bps. Some combination. We even read many reports of TIPS dealers receiving requests from accounts that have never traded TIPS before which we read as a classic mania-like/capitulatory signal. TMM remembers all those equity accounts selling EURUSD at the height of the Europanic, buying Libor-OIS spread wideners, as well as buying BP CDS at 1000bps. Receiving a message from an FX shag talking about real rates and TIPS yesterday afternoon comfortably fits with this hypothesis (unless of course this was an example of a macro-blog positive feedback loop).

But TMM can't help but wonder how much of the current market excitement is also due to "Bigfiguritis". A disease which is seeing outbreaks of almost pandemic proportions. Cases have been reported in Eur/usd with 1.4000, dow 11000, NDX 2000, USDKRW 1100, AAPL 300 and even Palladium at 600. The Goldbugs have just got over a case at 1300 and are in remission until 1500. Oh and whilst on Gold, we can't help notice that the move in gold has not been driven by ETF flows but more by miners removing their remaining hedges. All we can say is that there is less protection for the producers in the market than a Bay Area sex party in 1978. Let the band play on...

Bigfiguritis is highly infectious and historically was transmitted via whispering. However, modern means of communication have seen a surge in cases transmitted by the media via electronic methods. Bloomberg is a prime culprit.

Signs and symptoms
- presents as irrational binary behavioural responses to normal curve distributed probabilities, accompanied by hysteria, fevers and agues. Extreme cases may elicit a rash of highly infectious parity party invitations. Symptoms can also present similarly to "St Vitus' Dance".

Treatment - Bigfiguritis in FX patients normally responds well to a simple dose of "WELL, TRY INVERTING THE PRICE AND TELL ME HOW YOU FEEL NOW". Recent studies in EUR/USD at 1.4000 have seen very good responses with follow ups of "SEE? IT'S JUST 0.714285714 - NOT SO CLEVER NOW HUH??" However, if there is no response it may be a case of the often fatal Parityitis, which does not respond to price inversion and is currently endemic in Australia. The only known treatment for Parityitis is removing the patient from the source of infection and palliative care. Bigfiguritis in other asset classes is harder to manage as reciprocals of stock indices and commodity prices are often rejected by the patient.

- recovery from Bigfiguritis and Parityitis can be a long process with patients often suffering from a feeling of deep loss. A person may report feeling "sad" or "empty", may cry frequently and exhibit irritability. This should be managed with either "Don’t worry there will be another one along soon, I'm sure" or with "Well, we all thought it would get there, never mind". However, Bigfiguritis in the media or broker market presents no such ongoing complications with the patient swiftly forgetting and even denying they had ever suffered from it.

The Great Bigfiguritis of 1300:

So for today we will sit quietly - gowned, masked and gloved - trying our damnedest not to become infected as we hand out treatments.

Tuesday, October 05, 2010

QE 2 Much

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.

Kerv Flattening

TMM are back from the weekend and for those of us who look at all things EM, and particularly Asia, there isn't much to say except that we are seeing more of the same. The Hot Money Shuffle (unrelated to a similar-sounding Rolling Stones song) is in full effect: "Fund Flows YTD flat to China? Get me a stick of HSCEI. Indonesia busting through all time highs? Call in the droids CTAs."

The question is "Where does it all end?". Even the great and good of investing like Jeremy Grantham are calling for an EM bubble and to date we're well on track. All the hallmarks of a great bubble in Southeast Asia are here: hard to borrow stocks, poor-ish liquidity in futures for some markets and valuations which are getting toppy, but as it's hard to call a turn there are few sellers apart from insiders. All the more, TMM are having a hard time identifying the fatal flaw here - as much as many of us are natural contrarians, it's never a good idea to step in front of a bus if you're nowhere near the bus stop. Readers are welcome to suggest how this all ends out here because we are out of ideas.

Instead, we leave you with yet another compelling bull market case for Asia, this time in Airlines. TMM is not alone in complaining about airlines in the US and Europe, and after seeing this video of a Cebu Air flight safety demo we feel entirely justified in doing so. If you look on Bloomberg, the company is pending listing, leading some to the logical conclusion that this is a killer viral marketing campaign. Despite TMM's fairly bullish views on oil and particularly Tapis its hard not to buy in - airlines are 80% macro risks and 20% marketing and these guys seem to have the latter down pat: Which is more than we can say for JetBlue.

And finally, to the title of our post... TMM has to hand it to the French, handing Jerome Kervial a EUR 4.9bn fine and five years in jail. He must be thinking to himself "Sacre Bleu! I should've waited to write my book until after declaring bankruptcy". We are referring Mr Brown's Gold trading to the same court hoping for a similar punishment.

Friday, October 01, 2010

Friday Euramblings

Hands up if you are glad September is over and hands up if you are now kicking yourself for predicting the big picture nicely but getting stuffed by that traders nemesis .. T t t t ttttiiiimming... The sooner we get this QE thing over and done with and get back to focusing on the rest of the world, the better, as far as we are concerned.

We will be doing some more in depth posts next week but for today we are sorry, it's more ramblings.

Following on from our last post's theme of "say one thing and do another", Greece's passing of a tax avoidance package gets an A for Audacity. But then it probably won't matter that much if they are just planning on selling the nation to the Chinese anyway, as Wen offers them a "cunning plan". Does this involve a couple of reserved berths in the Kalamaki Marina for the odd grey Chinese vessel? Mind you, as one friend pointed out, if the Chinese are interested in buying Greek assets someone might want to let the British Museum know.

Ireland is OK now apparently - please move along, there is nothing to see. The corpses have been whisked away in blacked-out ECB vans. Very X-Files.

Belgium Reynders is saying that more regulation is needed for ratings agencies BUT NO PENALTIES. Errr.., we are sure they'll promise to behave.

Oh and did anyone notice that Belgium held an air traffic strike 3 days ago? Do people still fly to Belgium? We thought they had gone all "train" years ago and just maintain air traffic control to stuff up everybody else's holidays. Mind you if you are UK based you won't have heard ANY news recently as the "asteroid hitting earth" type coverage on the Labour Party has jammed all other news signals.

Portugal's general strike is called for Nov 24th. Is that far enough forward? We wonder if a US investment bank could structure some "civil unrest products" that effectively roll up all the strikes to an "off balance-news-sheet" forward date far enough off to mean it will be some other administration's problem when they really blow up?

But once again the Euro currency is at the mercy of the US QE mob and the E.M. interventionistas. At least equity land has woken up. Estoxx got toasted through the futures as soon as US came in and that just opens up our mibometer even further. In fact, the mibometer is a great indicator of the very moment that the markets switched from euronews to a gimlet-eyed focus on US QE. On Fed day European equities and eur/usd parted company and have been diverging ever since.

Of course, it's obvious that the last thing that the PIISers actually need is a stronger currency now, so it is natural that their equities dump. But it isn't the fact that this is happening that is a surprise, just the ADHD way the markets reacted (but that’s OK because it's genetic you know, poor dear).

So the big question that TMM (and, they are sure, the rest of the market) are asking themselves is "Will today's macro data confirm that the mini-turndown since the Spring is over and, therefore, is The Trade "risk-on-into-year-end" "? If the data is good, it's pretty hard to argue that it is not...

TMM's doctor mates have reported that the outbreak of Eurostrichitis that began in Brussels has spread to as unlikely places as Greenwich and Mayfair. And TMM know very well that when investors are given a dose of monetary heroin (QE), while suffering from acute Eurostrichitis, it is dangerous to stand in front of the Europhoria.

It has even infected the MRSA resistant Greek bond market (see the above chart of 4y GGB yield).