Tuesday, July 17, 2012

Hamlet Act III

When TMM gathered this morning around the vast cherry wood conference table in the echoing caverns hewn from granite in the TMM-cave, the messages our ambassadors brought from the four corners of the earth were all stories of a strange new theme.

European corps buying EUR/USD - cant hold back those hedges any longer?

The Energy complex bottoming out.

Large buying of AUD not dominated as usual by corporates .

It's TMMs favourite turn "mood change" date: 16th-18th of July. Call it superstition but we like it.

And, most interestingly "they" are selling negative yield.

TMM's ears always prick up when they start to hear rumours and chatter about a change in behaviour from central banks and SWFs. As the largest players in markets, it is unwise to pick a fight with them. So we found it particularly interesting to hear that those central banks that had been the usual buyers of Schatz, Dutch T-Bills and other such prized 'risk-free' assets have been reportedly seen selling such paper. Perhaps reserve managers really don't care too much for negative yields? Given that this money has now found itself into the semi-Core - driving something of a short squeeze (particularly in that country our Yank friends love to be short of: France), TMM can't help but think that the ECB Governing Council must be feeling pretty pleased with themselves. For it appears that, rather than the assumed "short Gamma" at zero yield position in response to being faced with negative yields as a result of the ECB's deposit rate to zero, end users are voting with their feet. Such a compression of T-Bill yields across the EMU-complex could well be argued to be evidence that not only does monetary policy still have teeth, but that it also works as presumed via the channel of forcing investors to take more risk - in terms of extension along the duration and credit curves.

Which is why TMM think a lot of the recent discussion around whether the shift of cash from the ECB's deposit facility into its current account facility means anything or not is mostly noise, as is the debate over whether Fed should follow suit and cut the IOER. Because the operational aspect of bank reserves is kind of irrelevant in this case. If TMM were members of the FOMC, they would be viewing this credit and duration switch with great interest, because the evidence from Europe suggests that while the banking system is content to sit on excess reserves in the context of risk aversion (amongst other things), it seems that end users - such as money marketfunds, central banks and SWFs - have a something of an aversion to negative yields. In TMM's view, that is a far better argument for the cutting of the rate paid on excess reserves than any operational one they have seen to date.

Which brings us on to Chairman Bernanke's speech today.

One of the questions TMM set themselves was whether or not the Fed would do QE3. And having taken a closer look, they reckon it is indeed coming. Now many market participants argue that the hurdle for QE3 is very high, that with the election only months away, a stated opposition to QE from the Tin Foil Beanie Brigade Republican Party, the data has not yet deteriorated far enough in order for the Fed to risk political controversy. Sceptics also point to measures of inflation expectations, such as the 5y5y TIPS Breakeven and the Fed's "cleaned" version of it (see chart below) as not yet low enough to trigger a response from the Fed. TMM disagree on both points: the Fed certainly prefer to avoid political controversy, but history suggests that if the Fed believe they need to act, they will. An historical exposition on this subject is clearly well beyond the scope of your humble bloggers, but just two examples would be the Fed's multiple rate hikes in the run up to the 2004 election and their dramatic rate cuts, balance sheet expansion (e.g. AIG/Maiden Lane II/III) in Autumn 2008, though TMM concede that this latter period was one of crisis.

And what about breakevens? On this issue, TMM reckon that the market has merely become attuned to the fact that should accommodation be required, the Fed will provide it. Under such circumstances, the prior-presumed 2% level is not a required condition given that the Fed will too know that the market will be pricing in some likelihood of QE3 - i.e. the new "low strike" on this is probably somewhat higher. A similar argument relates to Financial Conditions, and the Equity market in particular. It is certainly hard to argue that these have tightened to the degree that signals pain in past easings in recent years, but TMM also reckon that the Fed will too be aware that these markets are also pricing a degree of policy easing. Simply put, TMM do not think that these represent much of a barrier for the Fed.

So will the FOMC feel compelled to act? As above, TMM reckon at the end of the day, it does not come down to the equity market alone. It is growth expectations that will ultimately decide whether the Fed move. And TMM reckon they will, for the following reasons:

One of those old trading adages TMM learned when they were desk juniors was that when ISM moves sub-50, the Fed cut rates, which in our brave new ZIRP complex interest rate world probably now means "when ISM moves sub-50, the Fed ease policy". Now this hasn't always been the case, but certainly over the past twenty years, TMM can only see two real occasions where the Fed had not eased within two meetings: (i) most recently, Dec 2007 - and the Fed would probably now agree with hindsight that they should have cut rates then, and (ii) Aug 1996 - which turned out to be a "one month blip". To those, you could probably add Aug 2000, which again, the Fed would probably agree they were too late to cut rates, responding with a 50bp intermeeting rate cut in Jan 2001 followed by a further 50bp cut at that month's meeting. Anyway, you get the idea - see chart below of initially reported ISM vs. subsequent Fed easing.

Next, it is not just ISM that has moved lower, yesterday's retail sales number was especially disappointing, and many PhDs are now looking for 1.1-1.4% GDP for Q2, a pretty poor outcome. TMM would also note that while the bond market has priced this data deterioration to a degree (see chart below, brown/pink lines), economists are still in the process of catching up (yellow line), and the "real" expectation for 2012 GDP growth is probably closer to 1.6%. That is clearly well-below trend. And speaking of trends, the past three months of Payroll data have been very disappointing. Couple that with falling inflation both at the headline and core level (regardless of the recent spike in grains prices), and it is pretty hard to argue that monetary policy should not be eased.

So TMM are forced to conclude that QE3 is coming by the autumn unless the recent ISM print proves to be a one-off... and if it does, then markets are likely to rerate growth expectations higher, taking on the view that we have just had yet another mid-cycle slowdown. But that is a discussion for another day...

Back to Humphrey Hawkins.

Taking the above into account, TMM reckon the Chairman is unlikely to signal imminent QE3 as the committee will likely want to see the upcoming ISM & NFP prints before pressing the panic button. But in line with the current concerns in markets that policy might be impotent, that he will highlight the potential new measures that the FOMC could embark upon. This approach has been long founded, and forms a key part of TMM's thinking on the Fed, based upon the Transcripts from the April 2001 FOMC Teleconference which concluded it was better for the Fed to be seen to have the tools to "fix things" than to be seen "powerless". Following such a testimony, TMM reckon the August data dump and FOMC meeting will set the stage for whether QE3 comes in September.

TMM have shipped in some Oct 1700 strikes in Gold, and have their finger on the trigger to sell USD across the board should the above transpire. TMM sense an especially high level of scepticism with respect to the likelihood of a hint/preannouncement and the potential for disappointment today. But would note that they cannot remember many occasions where the Chairman has not "out-doved" the market.

Good luck all.


Anonymous said...

This analysis is really hilarious.
US is spending 10% of GDP in deficit to grow below 2% in nominal terms. What trend growth exactly are you referring to? And $400bn in MBS purchases when mortgage rates are at record low is not going to do much for slowdown in China and Europe or you expect "decoupling"?

cpmppi said...

Anon @ 12.36,

Have you been using Occam's Razor again? Take care not to cut yourself.


amplitudeinthehouse said...

Just sneak this in before BB fronts...pretty confident it's not a one off (ISM) , there's to many collaborators around the globe.

Therefore the question for longer term players... where is there any significant systemic risk



because this other shitshow is about to begin any minute.

abee crombie said...

sounds very much like teppers argument around Qe2.. I dunno though, equities quite a bit higher now.. I think earnings (and expectations of them) drive that market now.. but you are right the play on the BB printing is probably the dollar

but I dont get where TMM is seeing negative rates reverse..schatz, swiss, danish all still negative.. france has dropped with it but as long as we have negative rates out there, IMHO things are messed up

Leftback said...

Very good, TMM. You more or less nailed the remarks of the Chairman and the response to it. At the moment, nobody expects the market to hold up without QE3, but it just keeps on drifting up because earnings haven't cratered.

As pointed out here by several sages, markets rarely form a top on bad news and lower rates. Bears might want to consider the following:

a) Europe might actually agree on something.
b) China might stop slowing down at some point.
c) Bernanke will go big - if and when he QEazes.
d) NIRP vehicles and the investors who love them.
e) US corporates are stripped to the bones.

All of these are enough to scare away shorts, long enough for this market to drift sideways or slightly higher for longer than most think possible. All of that money salted away in short dated government debt will make excellent fuel for the fire once the spark is provided....

Anonymous said...

Negative yields haven't reversed yet. Moreover, you have to keep in mind that the Central Bank flow that was described is just one of the things that's occurring out there. Moreover, what's important is that this aversion to negative yields on behalf of this particular audience is a new development.

To be sure, there's other audiences out there who are still price-insensitive to the extent that they are happy to own Schatz etc at negative yields. However, I would expect the CB flows to become more significant as time goes on. Obviously, this is all assuming the regime doesn't change and the European situation doesn't deteriorate further (a big "if, for sure). Furthermore, there are signs that this CB bid for non-zero yielding assets is spreading to stuff like very short-dated Spain (1y Letras is yielding 3.75% and funds at 0.03%).

All curious developments indeed, as TMM mentioned.

Leftback said...

This morning's bears were repelled quite easily, a frustrating market for all. Perhaps the Wizard's cunning is being underestimated again. For as long as the QE3 isn't actually enacted, the threat of it still hangs over the bears like the Sword of Damocles*.

* Midfielder for Panathinaikos and a possible future Greek finance minister.

Leftback said...

There seem to be a lot of bear tracks in the forest this summer. So many in fact, it makes you wonder whether it's time for a midsummer bear hunt:

Short Interest at Very High Levels

abee crombie said...

LB, nice point about market tops but the onus is still on the bulls to make a new high.

April was it and at that time there was quite a bit of optimism. If we breach it, with the current negative sentiment, then you are correct.