A question of yield

Macro Man needs to keep it kind of short today as he is in the process of migrating to a new computer and he needs to work on "the build" ce soir.  It's just as well, as yesterday's markets were fairly dull, albeit with a few notable twists.  Although the euro closed largely unchanged on the day, for example, it still managed to hit its lowest level since April...and this with US fixed income putting in an all-too-rare-of-late rally to boot!

Of course, not all fixed income rallies are created equal, particularly when it pertains to currencies.   After all, the interest rates paid and received by FX punters via the FX swap market sometimes bear only a passing resemblance to yields displayed in other markets.   Such is the case at the moment, where the difference between yields in the FX swap market and those in the (fictional) interbank lending market, i.e. basis swaps, are widening sharply.

We've seen this film before, of course; during both the GFC and the European sovereign crisis, EUR/USD basis swaps blew out, indicating a sharp rise in USD borrowing costs for those wishing to lend euros.   This was largely a function of the need for dollars and the creditworthiness of Eurozone banks at the time.

Fast forward to today, and we are once again seeing basis swaps widen....and not just in euros.  Basis swaps in other currencies are also widening sharply, indicating a rise in USD funding costs well above those implied by looking at a list of LIBOR rates.  The chart below illustrates the fall in 3 month basis swaps for the euro, yen, and sterling.  (Note that in basis swaps it is assumed that dollar rates are a given, so they are quoted in terms of yield differential for the non-USD currency.  A negative price indicates a lower relative yield for the non-$ currency; in practice, this actually represents a higher yield for USD.)

Why is this happening?  Obviously in the case of 3 month, the turn over the new year plays a part, as banks tend to hoard liquidity over the period.   That having been said, basis swaps have widened throughout the entire curve, even as far as 10 years, so there is clearly something else going on.   Concerns over Fed tightening probably also play a part; there is less appetite to lend dollars if the perception is that yields are going to rise.  One used to see that in LIBOR in the run up to Fed rate hikes, but obviously LIBOR is a fiction these days (though one that has the imprimatur of the authorities, so that's OK!)  Most importantly, and probably inevitably, the brave new world of regulation is having an impact via balance sheet charges and other disincentives to provide liquidity.

The upshot is that the effective yield that one earns from owning dollars via FX forwards is rising quite nicely...providing an extra kicker for greenback beyond that of the relative policy deltas of the Fed and ECB.

More vanilla yields also appear to be strongly tilted in favour of the dollar.   The 5 year government bond spread between the US and Germany is quite close to all time highs since German unification.  It's quite striking, actually; the spread has never been anything close to this wide with money market yields at current levels.   Then again, the last time Germany had a legitimately dovish central banker in charge of monetary policy was probably during the Weimar Republic; certainly the prior history of the chart doesn't include any QE bond-buying!

As an aside, the contemporary correlation of EUR/USD to these yield spreads isn't actually that great.   Going back to 1990, the correlation with the 5 year spread is -0.29, and the correlation with the 3m spread is just -0.2.   That having been said, with yields so low and the relative delta of monetary policy shifting in favor of the US for the first time in many people's careers, it is unsurprising that these shifts are having an outsized impact.

Nevertheless, it is worth asking whether European yields have already compressed too far.  The 2y2y swap yield, which presumably post-dates the ECB's QE program, is priced at just 30 bps.  That's lower than the lowest spot 2y swap rate in the US during the entire QE/ZIRP/forward guidance fandango.  OK, you say, but the ECB depo rate is negative and a-fixin' to get more so.

Fine.  Central bank deposit rates rates are already more negative in Sweden and Denmark (which pegs to the euro and has had to run a super-dovish monetary policy to avoid undue upward currency  pressure.)   If we look at a chart of 2y2y yields in each of these currencies, the euro is notable for the paucity of its yield.


In fairness, euro 2y2y rates have been lower than the Scandis throughout the past several years, despite those currencies having lower interest rates, etc.  As such, pointing at the low euro yield in comparison with theirs isn't exactly a compelling reason to pay Europe.

That being said, it is notable that SEK 2y2y yields have not approached their spring lows despite an increase in Riksbank QE.  Macro Man would not be surprised to see a similar dynamic play out in Europe.   It might be a little premature, but paying something like 2y2y Europe is going to look awfully attractive sometime soon, both as an outright trade and as a hedge against short euro positions.   For the time being, Macro Man will watch and wait....and hope the yields grind even lower.

Damn, looks like most of the new computer build will have to wait til tomorrow...
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Anonymous
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November 11, 2015 at 11:55 AM ×

Hi Macro man,
I'm an individual investor, so I cannot do swaps. But is paying the 2y2 comparable to shorting the Euro-Schatz future ? that i can do...

cheers

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Macro Man
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November 11, 2015 at 12:10 PM ×

It's more akin shorting Bobl while buying Schatz. The best way to replicate it is actually through selling Euribor contracts 9-16 while owning contracts 1-8, but that becomes a bit time- and commission-intensive.

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washedup
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November 11, 2015 at 1:36 PM ×

Macro Man - way to go keeping it short!

Some chatter regarding how the decline in corporate bond inventories and the anomalous move in swap spreads are related - not clear to me how/why exactly, but these days my default assumption is that everything is inter-related, so no quibbles.

TLT is at a pretty interesting juncture here - wonder if markets will do the reverse of the Nov-Jan move last year - would be poetic.

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abee crombie
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November 11, 2015 at 2:24 PM ×

Happy singles day to all my free spending asian friends. The numbers coming out of Alibaba are just nuts...~13B today vs 1.35B in the US on cybermonday.... wtf

Great post mm, thanks for some color on the swaps market

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Anonymous
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November 11, 2015 at 2:40 PM ×

Stunning...
BBG:"Companies in the United States have taken advantage of low interest rates to issue record levels of debt over the past few years to fund buybacks and M&A. This has driven the total amount of debt on balance sheets to more than double pre-crisis levels," Goldman Sachs analysts headed by Robert Boroujerdi wrote in the note, acquired by Bloomberg.

ISI calculates that over the past 21 months there have been 1,441 M&A deals totalling $8.2T

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Anonymous
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November 11, 2015 at 2:47 PM ×

BBG:The dollar has advanced at least 1 percent against all of its 10 developed-nation peers this month.

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Leftback
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November 11, 2015 at 6:15 PM ×

LB fancies some US fixed income here, and for now Hammock Capital is long some TLT calls for a short-term trade. MM makes the point that US yields are attractive on a relative basis and that yields have pushed up quite a bit in recent weeks. Good time for a modest mean reversion trade, we think, especially with some of those end of year balance sheet dynamics starting to show up already. The 25bps hike was priced in long ago, US inflation is in hiding for now, and the next Fed hike seems to be a dim and distant prospect, certainly for the time being.

We would be surprised if US10y and things like mREITs didn't rally at some point before EoY '15. We think it's TWINE time for US high quality fixed income including munis and related yield plays like REITs and MLPs ... the selling is way overdone.

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washedup
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November 11, 2015 at 9:13 PM ×

LB - do u think long TLT is currently consistent with risk off (esp us equities) or with risk on? My ST trailing correlations are down to the lowest I've seen in a while.
I like mREITS too but I am too bruised and battered on them to even replay any arguments - its in that corner of the portfolio I label 'nothing to see here till 2018, move along now'....

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Anonymous
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November 11, 2015 at 9:40 PM ×

The fall will be epic...
"The Green Street Commercial Property Price Index edged up to 120.6 in October, having nearly doubled from its crash-low in May 2009. It’s now 20.6% higher than it had been at the peak of the prior totally crazy bubble that blew up and collapsed with such spectacular financial pyrotechnics:

http://www.greenstreetadvisors.com/about/page/cppi/

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Leftback
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November 11, 2015 at 10:44 PM ×

Long TLT is always consistent with risk off in US credit (widening spreads), and HY is already showing signs of stress here. Although yields might squeeze up for a brief period as equities decline, the steep drops in equities always seem to be associated with lower Treasury yields, so in general long TLT is equivalent to risk off in equities, yes. The (negative) correlation btw SPY and TLT is poor when equities are drifting higher on low volume, e.g. July, the summer silly season - but it does tend to come back with a bang when liquidity is scarce and markets are under stress. Just have a feeling that is where we are headed again fairly soon.

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Mr. T
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November 11, 2015 at 10:52 PM ×

I think the real question is why is commercial real estate underperforming so badly. 'spoos are +160% in the same time period.

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Anonymous
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November 11, 2015 at 10:56 PM ×

Looks like we may be getting ready to see some bursts in volatility

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Johnny C
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November 20, 2015 at 1:07 PM ×

Surely replication involved just selling bor months 9-16 ( without being long 1-8)

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