Tuesday, February 22, 2011
While TMM's usual policy is not to wear their Armchair General's uniform in the office , they cannot resist passing a brief comment. Libya is now the third country in as many weeks to be brought to its knees by the Twatterati, and we are beginning to wonder whether or not markets will be able to shrug off the deepening regional crisis. The pictures of Gaddaffi waving an umbrella from a van to show he was not in Venezuela reminded us of a book we once read by the BBC's John Simpson who recalled that while being interviewed, said dictator spent the entire time loudly breaking wind while waving a fly swatter around. And regardless of the UK's somewhat, err, poorly-timed diplomatic overtures toward the country, Gaddaffi is not your run of the mill dictator, sitting a little closer to Kim Jong Il than to Mubarak.
So why do we bring this up? Well, aside from the fact that Libya is the 17th largest producer of crude oil (see chart below, courtesy of TMM's mates at Nomura), the presence of mercenaries, the Air force firing at protesters (OK, some are now abandoning the guy), runways destroyed, squabbling Gaddaffi brothers each commanding various regiments of the army and opposition forces reported to be in control of the East of the country that, to TMM, this starting to look a hell of a lot like a civil war. With protests picking up again in Yemen, and a demonstration planned for Thursday in Saudi Arabia, TMM wonders where this ends. It is worth noting that WTI is now just under 10% higher than where it was last Friday when the US went home for the long weekend and, as TMM's sharp mate RightField pointed out, the contract roll to April will have the front month trading $98 tomorrow and the mainstream media talking about $100 oil and the potential hit to consumption. TMM read a few pieces this morning pointing out that each $1 jump in crude wipes out $100bn in annualised GDP when fully processed through the economy.
That being said TMM are not sure that our non-prediction and subsequent commentary about the cheapness of WTI vol applies in any way, shape or form right now. Looking at the vol skew in listed WTI calls you really have to wonder what that person bidding up June silly is thinking:
Though we are thinking that we could well get an "Oil Shock Nuevo" where appropriate price levels are determined by Islamic clerics, or production is shut down whilst internal conflict extends, that type of price impact would last longer than June and more likely extend well past next December. So, for something more fancy that just shouting MINE oil, then we are thinking of rolling out option exposure as we are of the opinion that short dated crude vol is something you can happily put a fork in – it’s done. If we are going to $120 the really scary news is that we probably are not going to be coming back any time prior to early 2012.
OK, TMM are now changing out of their uniforms and back into their regular clothes...
Before the most recent surge in Middle Eastern/North African unrest, TMM had been struck by just how bearish punters seemed to be getting of the US rates market, mainly on the back of worries about EM inflation and the recent acceleration of US growth data. However, TMM would note that the Fed do not actually particularly care about headline inflation, instead focusing on core inflation, as seen in their recent commentaries. And, unlike in the UK, there is very little evidence of headline price pressures feeding into the core. In fact, TMM's model of core CPI, based upon the 1yr lagged output gap (see chart below - orange line; actual core-CPI - white line), seems to do a pretty good job of explaining the broad trend. On this model, core CPI is only projected to reach 1.4% by the end of 2012, a level well-below what the Fed believe to be "mandate consistent".
Plugging the above model for 1yr ahead core-CPI into a Taylor-type Rule provides a forward-looking version of what would be considered "appropriate" policy under this framework (chart below, white line; actual Fed Funds Target - orange line). Policy is still way too tight on this metric and expected to be so for the next couple of years.
Ah, you say, but doesn't the QE2 stance indicate looser policy? Yes, of course, it is much more difficult to quantify this, but one "guess" as to how stimulative the Fed is might be to look at the growth in narrow measures of money. The chart below is identical to the above but also includes YoY M1 money supply growth (green line, inverse scale) which by and large appears to expand/contract at changing rates depending on the Fed's stance (something that will, no doubt, be reassuring to Monetarists). Ignoring the base effects related to Y2K and 9/11, there is close enough relationship to make this a believable proxy for the stance of monetary policy. On this basis, monetary policy became too tight throughout the course of 2010 until the Fed began to reinvest MBS proceeds and announced QE2. However, even under the assumed path of QE2, M1 growth would not be growing quickly enough to be consistent with a very negative Fed Funds rate and also suggests that rather than being a "stock" variable, QE impacts the monetary stance as a "flow" variable. While this may look as though we are using the MDI (Moist Digit Indicator, "finger in air" and lacking intellectual rigor, as a rough rule of thumb, TMM find it hard to believe that a Fed run by the World's most prominent monetary economist is going to be hiking rates any time in the next year and probably not even in the next two years.
On that basis, TMM have to conclude that the market is overpricing the probability of rate hikes (see chart below - 3mL forwards - purple, Fed Fund forwards - red, spot OIS - blue line), and that the front-end looks ripe for a purchase...