Just ahead of the week's big Fed events, and with the sour taste of the BOE's zigging and zagging left in the mouth, Macro Man cannot help but observe an unusual confluence of curious market pricing. To wit, the SPX is near all time highs, while both bond prices and the DXY have also performed very strongly.
Economists are familiar with the term "impossible trinity", referring to the fact that a nation cannot have an open capital account, an independent sovereign monetary policy, and a fixed exchange rate simultaneously. You can try, of course, but it always ends in tears (see Asia, 1997-98.)
In any event, since the advent of the euro as a credible alternative to the dollar as a reserve currency, in market terms it has been something of an impossible trinity to observe a strong equity market (meaning risk appetite is high), a strong bond market (demonstrating ample monetary liquidity), and a strong dollar (which has tended to benefit from either risk aversion or interest rate support.)
To demonstrate the anomaly of current market pricing, Macro Man constructed a simple index, wherein he took current pricing of the SPX, DXY, and 10y bonds (approximated by using the inverse of 10y swap rates), calculated the rolling 1 year percentile ranks for each market, and averaged them. As the chart below illustrates, the current average (98.4th percentile) is the highest since the Internet bubble and its immediate aftermath, when the euro suffered from significant credibility issues (where are you now, Oskar Lafontaine?)
Now, perhaps we're observing a regime shift as the market prices the DXY off of European rates rather than US ones., while assuming (as some commenters have asserted) that rates are never going up again. Perhaps. The other alternative is that markets are currently holding a highly unstable equilibrium, which will come undone when subjected to some sort of shock, such as...oh....a hawkish surprise from the Fed.
There is of course no guarantee that this will come this week. Nevertheless, those loading up on Spooz, bonds, and USD's should be aware at just how unusual the current market pricing is. Forewarned is forearmed!
Economists are familiar with the term "impossible trinity", referring to the fact that a nation cannot have an open capital account, an independent sovereign monetary policy, and a fixed exchange rate simultaneously. You can try, of course, but it always ends in tears (see Asia, 1997-98.)
In any event, since the advent of the euro as a credible alternative to the dollar as a reserve currency, in market terms it has been something of an impossible trinity to observe a strong equity market (meaning risk appetite is high), a strong bond market (demonstrating ample monetary liquidity), and a strong dollar (which has tended to benefit from either risk aversion or interest rate support.)
To demonstrate the anomaly of current market pricing, Macro Man constructed a simple index, wherein he took current pricing of the SPX, DXY, and 10y bonds (approximated by using the inverse of 10y swap rates), calculated the rolling 1 year percentile ranks for each market, and averaged them. As the chart below illustrates, the current average (98.4th percentile) is the highest since the Internet bubble and its immediate aftermath, when the euro suffered from significant credibility issues (where are you now, Oskar Lafontaine?)
Now, perhaps we're observing a regime shift as the market prices the DXY off of European rates rather than US ones., while assuming (as some commenters have asserted) that rates are never going up again. Perhaps. The other alternative is that markets are currently holding a highly unstable equilibrium, which will come undone when subjected to some sort of shock, such as...oh....a hawkish surprise from the Fed.
There is of course no guarantee that this will come this week. Nevertheless, those loading up on Spooz, bonds, and USD's should be aware at just how unusual the current market pricing is. Forewarned is forearmed!
42 comments
Click here for commentsThis is why I will always read this blog. Thank you MM.
ReplyGreat post!
ReplySilly Season continues. Vol sellers in charge. Rates never going up. Jeremy Siegel all over the tube. Don't fight the Fed. Never short a dull market.
ReplyThe posts and the comments over the last couple of days have been some of the most insightful you can possibly find around; and at bargain price as well (inflation my ass).
ReplyI don't feel I could add a great deal on the debates here so I just wanted to express my gratitude to MM and all the commentators.
Hope you get a Bberg soon MM.
Matador
Brilliant MM, allow me an example from my own little world, when bonds in the periphery start trading like safe havens, something us wrong. ... I think a new taper tantrum is just around the corner.
ReplyClaus
@Claus - I respectfully disagree - isn't what caused the last tapir tantrum that it was not broadcast well - it was just a side comment in a presser? If by taper_tantrum_v2 you just mean that rates are set to rise sharply, wouldn't the canary in the coal mine be the high-yield complex, which has rallied very hard off the recent lows?
ReplyThe only thing "wrong" now is that the old models are not working and markets have reached some kind of tipping point where the liquidity is overflowing.
Everyone I talk to is behind their benchmarks (again) and skeptical. Its going to be a global dash-for-trash into EOY.
Mr T is a fantastic addition to the comments section.
Reply@ Mr T ... perhaps, but I am old fashioned in the end. When stocks and bonds move inversely to each other (as they have in some sense in Germany recently for example), I think you can buy dips. But when they start moving in unison, I get scared because that means that they could unravel together again. The end game for me here is exactly such a scenario ... I suppose the question is whether we are here now. Incidentally, I have been (and am) pretty much in Leftback's boat on rates and that the market is telling is that it doesn't believe in the US recovery, hence curve flattening and not steepening.
ReplyAs for high yield as the canary in the coal mine ... you have no idea how much I agree with you and I concede that this particular part of the market has been very resilient after the initial wobble in August. Again, the lack of liquidity here also means that this market will give very little "initial" warning ... it will just be NO BID. Bid/ask spreads are the new "interbank rates" anno 2014.
Generally though, I think the notion that the only driving force of the Taper Tantrum was that it wasn't "announced" is a bit complacent. They can announce as much as they want, but the problem is that the market might just start to interpret the data in a way that does not agree with an unhedged long any yield and risk assets.
One thing that is clear to me in Europe for example is that with periphery now running an external deficit and completely unchanged fundamentals ... something is going to snap very soon.
Claus
Thank you for the great post.
ReplyThe self made index shows this Trinity can last quite a long time looking back at the 90s.
I would just note that the interest rate support you are referring too is indeed very much present. UST treasury yields offer an historically high pick up vs Germany and another dozen European countries (including Spain on the 10y!) plus Japan and Swiss of course. The trend of paying US IRS swap vs receiving EUR IRS 10y has worked formidably so far coming from -60bp to 135 in 3 years. That is the story about the relative recovery story of US vs EUR.
This little snippet on Market Watch
ReplyData from the little-noticed financial accounts report show the American people have $10.8 trillion parked in cash, bank accounts and money-market funds that pay little or no interest. At the end of the first quarter, low-yielding assets totaled 84.5% of annual disposable personal income, the highest share in 23 years. Sure, people need to keep some money handy to pay their bills and some folks might have a few hundred or a few thousand in a rainy-day fund, but no one needs immediate access to the equivalent of 11 months of income. In essence, there’s $10.8 trillion stuffed into mattresses. That $10.8 trillion hoard represents a failure of Fed policy.
Since the Fed began quantitative easing in September 2012, U.S. households have socked away $1.17 trillion in their low-yield accounts. That means that 95% of the Fed’s $1.24 trillion QE3 ended up not in bubbly markets but in a safe and boring bank account.
@ Anon at 8.27,
ReplyYep, I agree with that which MM also hints to in the post. Indeed, I suppose that if the mighty Bund is now in the driving seat of the global interest rate edifice, the Trinity noted above follows logically, which tend take me back to the eurozone bond markets as a whole. Yields in the periphery traded like high yield credit instruments up until a few months ago, and now they are safe havens?! I don't buy it ... I am not saying that this is big fall from grace in the hunt for yield, but I think we are about to get a scare!
Such a scare could, in my view, be triggered by a return to a world where US 10y yields squeeze higher and upsets risk asset longs. Stranger things have happened you know ...
Claus
what do you mean by calculating the 1 year rolling percentile? What did you calculate to build the chart?
ReplyIsn't the US yield curve flattening in advance of monetary policy tightening (as textbooks say it should) and the surprise is the flattening of yield curves where policy is to be eased? Or is this just a function of the level of short dated rates. Or are European investors are moving from cash to bonds (I always think of pensions being invested in stocks in US, property in Germany and FI in Germany/Japan) and so much cash chasing so little return. I dont understand why foreign investors are going to buy bunds at 1% with the EUR falling.
ReplyI should read my posts more carefully! Meant to read property in UK
Replythat trinity is the end stage indeed - folks pursuing anything US - stocks, bonds, credit
Replybecause anywhere else looks dodgy
@ mr T. i am betting my house this cannot last until EOY
to wit European stocks are 8% down already vs. US return to the high
when Europe gives, you always see that last binge buying into US assets
we are exactly in October 2007
Yes Melee, but I suppose you could argue that the 2y in the US has not, yet, really priced any significant hiking cycle. Ultimately, I agree with you though ... this is very much textbook bond market action ... one would also assume that if the Fed really jacks up the hawkishness, we could get closer to the classic recession signal of all recession signals, the yield curve inversion. But then that brings us to Spoos ... if the bond market is telling us that the Fed is about to take on the hiking boots, what the heck are stocks and credit doing here?
ReplyClaus
@Mr T. I second Polemic's gesture, welcome to the 'A-Team'
ReplyRegarding the wall of liquidity/ portfolio positioning thesis, doesn't it now make equities the tail that wag the dog by confusing liquidity with confidence, thus coming back to MM's trilogy. Sadly I think the result is that we all are becoming hyper - sensitive to equity markets and their inevitable 4-10% pullbacks/rotation along the road.
For the record I think we are in a secular bull equity market but that likely the cyclical one is long in the tooth. I leave you with a little PTJ
"There is no training — classroom or otherwise — that can prepare for trading the last third of a move, whether it’s the end of a bull market or the end of a bear market. There’s typically no logic to it; irrationality reigns supreme, and no class can teach what to do during that brief, volatile reign. The only way to learn how to trade during that last, exquisite third of a move is to do it, or, more precisely, live it."
Call me naive, but I think the 2nd half will play out exactly as consensus was expecting for the 1st half: U.S. economy gains steam and interest rates and the dollar creep up.
ReplyI am in Rosie's camp: No reason to panic at the first rate hike.
Now if I only knew what stocks will do in such a scenario... my best guess is mildly down and the same sector rotation as after the taper talk: cyclicals and euro periphery up, bond proxies and safe havens down.
In Oct 2007 MBS had already started to default. What is failing now?
Replythanks guys, I appreciate the kind words.
Replycredit card, student loans, Argentina or Portugal are quite irrelevant since ISDA made sure there ain't such thing like a default anymore
Replyby October 2007 i mean the cross asset picture - a last attempt in the US equities when the rest of the world under performs at lower highs
and similar credit compression starting to roll over - after too much money chased awful yield, a position similar to shorting convexity
and a much uglier picture in fixed income.
it is that last leg Abee just mentioned, it just happens, the bulk of the corporate buy back has been executed and it is getting harder to find buyers for that market
at some point in March 2009 sellers capitulated, too and you really wondered why they'd sell at such a level.
I'm not a huge fan of the Axioma models but they are widely used and do a good job (too good in some cases) of predicting risk. This recent whitepaper seems relevant to the discussion.
ReplyDrawdowns Looming? It's Not in the Numbers...
While some will surely use data like this to illustrate their point that we are topping ("when risk managers see the only risk of underperformance etc"), the results are based on a large amount of data and consistent with intuition about when markets have historically broken. As someone short index puts (one of those hopeless vol sellers...), I hope the data is right.
Nico G.
ReplyWhat we are missing from 2007 is inflation, that is the big difference. You dont see too many countries overheating like we did in '07
If indeed the Spooz are topping, which i think has a good probability, i think you will get more than enough time and evidence to get out. No need to get short just yet
I think some of us are over-obsessed with Spoos, which are being chased higher by a combination of the clueless and the relative safety large cap crowd. The IWM and the DAX are the best place to look at what we think are the real market dynamics, and both of these indices have shown weakness most of this calendar year.
ReplyRe: US flatteners v steepeners, many are looking at the dynamics of past tightening cycles which follow on the heels of conventional recoveries/expansions. Once can't forget the strong anchoring effect of ZIRP and QE, which makes an inversion almost impossible. Those bonds are staying inside Dame Janet's petticoat for a really long time, folks.
Here is a great article, far more erudite than my simplistic rants, and a cracking chart that shows The Japanese QE Experience - it shows how you can easily have a recession without a YC inversion once you cross to The Dark Side. Compliments to whoever put this together:
Yield Curve and Recessions
We now return you to your regularly scheduled summer silly season trading. Welcome Mr T!
"you will get more than enough time and evidence to get out. No need to get short just yet" hedgie friends said the same again, late 2007 - they were waiting for the telegraph
Replythen Socgen hit the tape on Martin Luther King monday, unwinding the famed 'Kerviel unauthorised punt' and suddenly it was too late. After a shitty week, the spoos were limit down in globex the next Monday
none of my buddies could short in time and felt it was then too late to do so - some managed to short the 1430 kiss back and trail well into 2009 - it boils down to your trading style
i was short since late 2006. European banks only peaked in april 2007. i'd rather be short too early, and suffer like hell, than not short at all, make no money on the way down all the time thinking 'damm i HAD seen it'.
I'd rather suffer on a early trade than miss a trade that i had seen coming. Call me a fool. To each their own timeframe and tolerance to losses. As you well know, one month of down can annihilate 12 months of grind up. You'd have to be 12 times faster to catch the momentum down
inflation is too ethereal a concept for me to grab. There is inflation in French wine, there is inflation in art, Sothebys hit the 2007 top, a favourite bubbly indicator for some. There is inflation in London housing and if you check yachts anchored in Mykonos 2014 don't look too shabby
most countries are still repairing their balance sheet, they are broken there is no way to overheat this time around, 2008 damage is still hidden in every book - national, corporate and private.
PS: i now read your post LB and could not agree more i too use dax as the main leading index, and it ain't pretty
ReplyMr. T,
ReplyThe paper you linked makes several arbitrary variable selections. Personally, it reeks of severe over-optimization.
Best Regards.
Good point on yield curves and recessions LB, but I really never bought the idea that the US is japan ;) ... ... Oh and a very belated welcome Mr. T ...
ReplyClaus
C Says
ReplyAs to the Trinity concept I have little idea, but found the historic look interesting. However, individually I see just cause for the $ and US govt yield to be attractive relative to their peers. Growth rate,energy external dependence losing ground etc.
May be growth is desultory by historic standards ,but it's been the best of a lousy bunch. The third leg, US equity less so only because to me the goods news has been priced in for quite sometime. Moreover a stronger $ will do to large caps balance sheets what it does the world over. Weak currency ,equity strength and the converse.
Anon 8.47
$10 billion 'parked' should be thought of in demographics. No matter what the Fed does a large tranche of that belongs to the aging population and they are not going to be chasing yield. They are going to be protecting capital against volatility. That's just like the Sun rising in the morning and yes that also equates to the access figure of 11 months and for them even more. No surprise there at all. To understand it you just need to be old enough to have your best earning days behind you.
Indeed taken in broader context people in large have had a couple of really nasty smacks in just over a decade and realise job security ain't what it once was so the readies on tap makes sense.
I suppose you could say that central banks have and regulators have only themselves to blame for contributing to such learned behaviour. Unlearning it is probably a lengthy business.
Agree,there's no point going over how the banks and regulators have condition segments of the market, that's sure to be spoken of in the years to come.
ReplyI will say though , that having been neutral the SP500 just before my last trip away the timing seemed right to move into euro credit and have a flutter at Shatin and prevent any hidden misalignment on the trading desk from coming to light thereby creating a debacle...but there was a push against it..
Thanks a lot fuckwit!
Sorry guys about the language, but you have to believe me ..that was the best I could!
ReplySorry again for my language, but I think it's time to quit trading with the boys in NY ...yes , they seriously lack judgement!
ReplyThe language is fine .. chill. As long as there is no nasty aggression between commenters . Otherwise it's a bit like seeing your kids fight. You love em all and you wish they'd love each other !
ReplyPol, glad you can tolerate it..it's not the losing trades that disappoint as we've all been there and it's becoming all to amusing now , it's just I've come to realize that overall I've only had one winner the boys on that desk and I doubt they even knew it!
ReplyBut here am thumping my fuckin head into a Bloomberg screen thinking I can produce a winner again.It's time to stop placing sentimental trades and trade whats it in front of you. Fuck sentimentality I'm sticking to trading local assets.
C Says
ReplyThe "Russians are invading" (again) which means it must be Friday (again). BTD because it's just my online order from Waitrose on it's way.
Actually, in this upside down world I expect we are only a blip away from Equities rallying upon news of an invasion. Tonight I will rewatch One Flew Over The Cuckoos Nest again and see if I can't get into synch.
ReplyPol, I forgot to mention, don't flash your membership card to the Wall Street cigar club...it's like a free pass for people to piss ya!
ReplyI never understood cigar clubs. They seemed to be for people who didn't smoke to go and pretend they knew everything about smoking. Bit like 45 year olds buying oversize motorbikes and all the kit once they pass their midlife crisis bike test.
ReplyCigar clubs should only allow members that already hold a 20 Marlies a day licence.
You had to mention bikes , didn't you.
ReplyIt's Fed day today, I wonder what position the P/L is going to be in a week from now once these sentimental trades are abolished and the NY desk is cut.
Wishy washy Yellen..I guess in the grand scheme it could be considered hawkish vs her other speeches, but not very
ReplyIts ironic how the Fed is worried about the 'slack' in the labour market, those who still havent found a job. And how do they help them, buy doing QE and 0% rates so rich ppl can get more rich. If indeed it is structural, should not uncle sam get involved? But with an upcoming republican house i doubt anything sensible like that happens.
Gotta love blunt tools
Can only speak from personal experience, but the best thing she could do to get your author back to work is to raise rates, like, yesterday.
ReplyFederal Reserve Board staff developed a labor market conditions index from 19 labor market indicators, including four I just discussed. This broadly based metric supports the conclusion that the labor market has improved significantly over the past year, but it also suggests that the decline in the unemployment rate over this period somewhat overstates the improvement in overall labor market conditions.
Replyhttp://www.federalreserve.gov/econresdata/notes/feds-notes/2014/assessing-the-change-in-labor-market-conditions-20140522.html