Thursday, October 18, 2012

Buying the wrong tails

The Chinese data overnight isn't a game changer, but supports the increasing sense seen both in data elsewhere and in prices that China has indeed had a soft-landing and is beginning to recover. Of course, while the lack of catastrophe and the turn in the Pork cycle means that easing is unlikely to be aggressive (2008/9-style), in the absence of "new" news to conflate the Asian recovery story that the trend is in place. As indeed it appears to be in markets in general, as somehow Spain has managed to get its 10yr bond yield down to 5.5% despite a lack of ECB buying. Remarkable.

Now, onto something else that's been bugging TMM and spurred something of a debate. What is going on with the seeming monotonic collapse in the Libor fixings and commensurate cheapness of the 2yr USTs. It seems somewhat incredible to consider that 2yr swap spreads at 9bps sit at close to their record tights given all the Libor shenanigans, and general concerns about bank solvency in Europe. But that is where we are.

And when compared with Schatz, in particular, it seems even more confusing. TMM totally get the EMU-break up option priced into Schatz. The trouble is, that while the pay off in such an event will of course be massive, the probability of it being triggered was always pretty low. And put in the context of what appears to be a drive in Europe towards fiscal union (of a sorts) and the ECB's determination to "do whatever it takes to preserve the Euro" (see OMTs...), even the most sceptical would have to concede that the probability of a Euro-break up has fallen by a significant degree.

But upon drilling down into the constituents making up the swap spread, comparing 2yr UST with OIS and Schatz with EONIA, it seems that the value of the liquidity option priced into Treasuries is less than that priced into Schatz, at -11bps vs. 7bps. This relative premium began to appear in Spring 2010 as the Euro-crisis flung itself centre stage and reached its wide just prior to the LTRO.

Though the Schatz leg especially has retraced quite a bit since the Greek election, TMM still reckon that this relative pricing is wrong. Because back in the old days (well, not even that long ago), when there was a liquidity crisis, or EM crisis or even any old "risk-off" event, it was the front-end of the UST curve that saw the greatest flight to quality and associated liquidity premium. And in all such events, German short-end paper underperformed the US. Of course, that all changed in 2010. Or did it? Since then, the majority of liquidity events have been Europe-centred, and particularly around the potential break up of EMU. So given the Deutschemark call option, it certainly makes sense. But TMM have found themselves wondering if the market is mispricing the relative liquidity premia here: Schatz may well have performed better in recent history, but it is only likely to perform in an EMU-breakup event, while USTs can perform in any idiosyncratic risk shock (Iran, a Brazil blow up, a Chinese government collapse etc etc).

A discussion with fellow punters yesterday afternoon saw TMM's view met with some scepticism... even suggesting things like FRA-OIS could go to zero (more on that below...), or that there is no point trying to buy 2yr Notes until Operation Twist is done, given that O/N General Collateral is 30-ish bps. The latter is certainly a reasonable view, but by the time Operation Twist is done, the market will likely have moved already. And TMM were always taught that when liquidity appears abundant everywhere, it's worth shipping some in as a hedge against a long risk portfolio... of course, the daily P&L bleed becomes frustrating and it's very easy to then stop out... only to see the thing rip back up straight away, leaving your book exposed. Lessons learned the hard way. But it does seem to TMM as though perhaps the market is so focused on EMU break up risk that it has forgotten everything else that can happen and is buying the wrong tails. It's also worth noting, that usually you only get *really* paid to own convexity when an idiosyncratic "unknown unknown" event hits.

Anyway, back to relative valuations.

Generalised risk events seem to arise about once a year... often twice, but let's be conservative. In days past, this has sometimes meant as much as a 20bps move in spreads. Of course, now, there is bucket loads of liquidity everywhere, supplied by the world's central banks. So it is probably fair to accept that such moves will be less than in the past, but again, liquidity often appears to be an illusion when the sh1t hits the fan. Anyway, this is only a back of the envelope exercise, so let's guess we only move 12bps which would be about 60% of prior moves (and would roughly corroborate with the move seen ahead of the Greek election). On the Schatz side, in a full break up we could imagine a price move of say 20%, which is roughly something like a 900bps move. TMM would argue that policymaker commitment has reduced the probability of such an event to something like 1% per year. So the expectations would be 12bps per year for the UST (100%*12bps) and 9bps/year for the Schatz (1%*900bps). TMM are perhaps being a bit naughty here given that Schatz would also rally in a generalised risk off, but then, in an EMU-break up event, UST would arguably rally significantly too, so it's not too much of a stretch to argue that the liquidity option priced into 2yr Notes looks like it is now too cheap relative to that priced into Schatz.

Onto the other part of swap spreads... Libor...

The Wheatley Review - amongst the general amount of liquidity everywhere - has driven Libor fixings down as banks crowd for fear of getting sued and given the fact that US Financial CP rates are around 15bps, there's certainly the argument that Libor should be lower given the concept of bearing some resemblance to "market-traded" rates. The trouble is, the Libor spikes of the past couple of years have never been about US banks: instead, by the marginal borrower from Europe, and the overall rate is going to be a blended average of all these borrowers. The chart below shows the US Financial CP rate (orange) as a proxy for US banks, Natixis 90d USD CP (red line) as a proxy for the higher-quality banks in core-Europe issuing directly in the US, the rate implied from borrowing at 3m Euribor domestically and swapping into USD (for those European banks that are able to borrow privately in Europe, but not directly in the US), the rate implied from borrowing at the ECB's MRO/LTRO and then swapping into USD (for those banks that are unable to borrow from anyone apart from the ECB). Obviously, since Draghi's game-changing speech, all of these measures have moved lower. The question is, how much lower can these now move, given the dramatic normalisation seen so far?

It's not easy to know how to weight the above measures, but given this is all a back-of-the-envelope exercise, a simple regression is probably the best way to get a sense of things (see chart below). And looking at that, it's possible to argue that the 3m Libor fixings have over-shot the actual funding market improvement.

Putting all of the above together, TMM reckon buying 2yr Swap Spreads in the US, buying 2yr Notes outright (assuming Ben keeps his promise) and buying 2yr Notes vs. Schatz all look like reasonable ways to get some tail hedges on the book.


abee crombie said...

TMM, I am not all that familiar with SWAPs but if do look back at the Shactz vs EOINA (GDBR@ - EUSWE2) since 2005, the current spread is actually about average for the period.

Can you help me understand why I want to buy a US 2 year swap spread out right? what am I betting on?

abee crombie said...

for LB

" UBS Launches MORL Leveraged Mortgage REIT ETN "

Leftback said...

Abee, hilarious. Usually when a Swiss bank issues such an ETN, they begin borrowing its shares rather soon afterwards (for example, CS introduced the delightful TVIX virus, I mean, investment vehicle).

The underlying index, MORT, is already looking slightly bearish.... 20% haircut, sir? Buy it back at $22.

Leftback said...

Romney takes a flight to Heathrow, leafing through some binders looking for women cabinet members.

He breezes through customs and immigration, waits in the queue for a taxi and finally jumps in a cab.

Cabbie turns to him and says: "Where to, Guv'nor?"

Anonymous said...

GOOG rug pull.

Leftback said...

There seems to be a new trend for unscheduled earnings releases in the middle of the trading day when there is no volume. It's always a monster miss on a "kitchen sink write-downs" job. We call this strategy "Hide the Tape Bomb" (in plain sight), and unfortunately it does create these mini flash crashes via HFTs. Hope nobody tries to get away with this during the next liquidity crunch.

Surely they should be fined for market disruptions like this? It also makes it look like the management are all 12. We don't own this (b/c it has no yield), outside of some exposure via QQQ.

It must be a bit of a nightmare for punters. How many little guys got bounced out of GOOG, down 10% at the bottom today? This happened last year with a whole lot of REITs, all plummeted 10-20% all at once, was never even investigated, as far as I can tell.

Anonymous said...

C Says'
Actually LB looking at GOOG price action/vol I think thi stock was already on the way up between 725-750 and thereafter it was on the back of long long termers (who won't care too much about this action, and bag holders who have probably been well flushed.
I doubt if the numbers surprised those sellers.

Anonymous said...

That should read SOLD on the way up etc etc

Leftback said...

preftera 95Options expiration ahead, we can expect tomorrow will be a "bunch of malarkey", as they say over here. It's been predictably quiet in FX and rates today. See you on Monday.

Anonymous said...

C says'
Interesting end to the week.

Europe and Europe ! That massive currency dislocation issue earlier this year pummelled the hell of some businesses whilst it was raging. I'm sure we are seeing in Q3 the effects of that on some earnings reports. Problem is some of these companies carry huge expectations that they can keep knocking the ball out of the park and even a temporary interruption in that suffices to create disproportionate chaos.

A key question for me is this. Austerity policies in Europe were always going to have some knock on effect to global growth and therefore corporate performance.Through blatant mismanagement that process escalated to the giddy height of an outright currency panic which while it lasted ramped up it's effect on business conditions. So the question really is ,have we perhaps seen the maximum impact of this and will future quarters show rebound from the severity seen?

If you think the answer to that question is yes then I presume you will be looking to pick up equity effected by the fallout.

Anonymous said...

C Says'
By the way I was reading this;

"The company, Air Fuel Synthesis, then uses the carbon dioxide and hydrogen to produce methanol which in turn is passed through a gasoline fuel reactor, creating petrol.
Company officials say they had produced five litres of petrol in less than three months from a small refinery in Stockton-on-Tees, Teesside.
The fuel that is produced can be used in any regular petrol tank and, if renewable energy is used to provide the electricity it could become “completely carbon neutral”.

I was kind of left with that uncomfortable feeling that sometimes we tend to end up chasing our tail around until we end up disappearing upon our own arse.

I refer to an issue which as yet is still to accepted in an overwhelming sense,climate change. Arising out of that agreements to influence this issue via carbon related policies which then lead to increased costs in the energy indusrty and of course to consumers. Then in response to that we see arising reneewables etc.
Following on from that we then see this kind of spin off which if using renewables goes to deal with carbon levels which fulfil our policy on this issue of climate chase on which we still agree to disagre!!
Phew,have a good weekend.

abee crombie said...

I am looking to get back in some the mREITs soon but I'm not so sure lower prices will come so fast. I hope.

I've been listening to a lot of HF chatter about non-agency mortgages. Seems like the space is getting a lot of attention, bc you can 'find' paper with 4-8% yield, with little downside and potential upside in the low teens. I think the space is only going to get more crowded as M&A arbs, distressed and other credit ppl increasingly move towards this areas as there really isnt much else going on in the markets to find those types of yields (Euro debt deleveraging from banks, from what I hear, there isnt much there yet)

But since the mReits are agency based perhaps I am barking up the wrong tree

Leftback said...

Not all mREITs are agency-based, a few specialized in some real subprime, just have to kick the tires and see what's under the hood, I guess. There are also the CMBS players as well. Complex arena.

For those interested in US rates, we have been playing a steepener on and off. The rationale behind this is based on expectations of less than horrible outcomes in Europe and US, leading to a flow of funds out of safety vehicles like USTs, bunds and gilts.

There is also some iterative logic to this macro trade, based on the fact that rates at the long end rose after the announcements of QE1 and QE2 (by about 100 bps over 3-4 month), as beautifully illustrated in this chart by Doug Short:

UST Yields and QE Episodes

For the time being, Operation Twist continues to support the long end of the curve but expiration of OT will remove this buffer. In the mean time, the efforts of the Bernank appear to be directed towards making the MBS spread tighter than a gnat's bum, thereby flattening mortgage rates, even in the face of a mildly reflating rising rate environment:

QE3 and 30y Mortgage Rates

Leftback said...

Quite bearish out there....

Investor Sentiment Declines

Since this is a crowd that is interested in momo stocks like Chipotle, Google etc., this is perhaps understandable. It's also encouraging.

Anonymous said...

which mREITs are you chaps keep on? In the genre I'm eyeing CHKR, WMC
AMTG and DX.

Leftback said...

Back to the 50 DMA again on SPX. It's not exactly unknown for profit taking to occur on expiration and/or the following Monday. VIX up 10% (but only to 16.50) and we can expect sentiment to be pretty bearish by Monday morning. Not much complacency out there today. All the elements are in place for a bounce.

Pretty soon we might have to dust off this old classic:


abee crombie said...

timber! 1420 -1400 critical in SPX for support. 3rd times a charm. Cant say I'm as bullish as LB but i did cover some shorts ... doubtful close will on a good note. Monday will probably be dead, so we'll need to see a turn around tuesday

Leftback said...

Classic Op Ex washout and absolute carnage in a few momo names, but probably not of lasting significance.

Not a lot of "Macro" about today's sell off from this observer's point of view. The ultimate safe haven trade, DX, is stuck at 79,60 and the 10 year has only come in 7 bps. No panic here, at least not so far.

amps said...

TMM, is there any chance you can throw up something about Total Productivity vs Capital Investment one of these day's ...around the world....throw in employment too.

amplitudeinthehouse said...

The close last week doesn't need description, but continuing the theme around the NFP print, we don't like risk until we see Europe producing another reason to go since having moved on from our last QE2 trades where I was shocked into action to quickly implement tight stop losses therefore preventing an unmitagating disaster, amps remembers quite well the talk on the street (literally) before placing an all or nothing bet on the cable. The whisper was " you should you should " go long risk.. now amps doesn't like to finger the blame at anyone else when a trade doesn't go as expected..but since that little affair we've decide to incorporate and new indicator to the TMM glossary..

FUCK YOU Indicator

How does it work?

Simple, it's an CONtrarian indicator, just stroll around your local streets for a couple hours before the market opens and make note of the amount of



you hear.

Then calculate which is the majority and bet the house against it..

And for you pendantics outthere, if it's a split decision then use you photographic memory to picture the people that voted and anyone of a fashionista persuasion should be CHUCK OUT........

Anonymous said...

It seems that the news flow did turn a bit to the worse while BBG-noise did not. Good enough indicator to go tactical short

Leftback said...

Rather than get all touchy-feely on a Monday after options expiration, why not look at some data? Let's first examine what has been a remarkably accurate macro risk indicator, the EUR/JPY cross:


As you can see, this cross has been LOLHOR since late July. Now take a look at the Baltic Dry Index since September:

Baltic Dry Index

LB would suggest there is no cause for alarm here. Carry On Punting.

Leftback said...

Falling Knife du jour..


Anonymous said...

BDIY is a bit of a following indicator

WellRed said...

Pre-close rally appears to vindicate LB here. Won't know for sure until tomorrow, but if I were a betting man...

Leftback said...

Today played out pretty much as we had imagined it, although the selling went on a bit longer than we had expected. EURJPY closed near the high of the day.

We re-entered the steepener trade in the afternoon. Tomorrow FRBNY brings another $7B of supply to the Tsy market at the short end so we may well see some weakness in the Treasury complex, irrespective of the economic data.

Leftback said...

Anyway, better be careful about making any macro predictions (or TMM's Non Predictions) next time you are in Italy:

Italian Seismologists Jailed

Anonymous said...

C Says'
I'd normally guesstimate purely technically that we now have a consolidation bottom in place.

Anonymous said...

C Says
For a technical call I'd have been much happeier to have seen it supported overnight thereby catching some poeple offside at the open.Without it beomes much more random for the week.