Ugh, indeed.

Little did your author know when he titled Friday's post how tragically accurate the sentiment would be.   The horrific attacks on Paris hit close to home as your author was a resident 20 something years ago and still has friends there.  The tragedy of modern life is that senseless acts of violence are not only a regular feature, but also brought to the public's attention in real time to terrify and dismay via a dizzying array of media.  There's not often much call for French Symbolist poetry on financial websites, but in some ways, 'tis truly Une Saison en Enfer.

Unfortunately, such events are often used by adherents of various political camps to assign blame to supporters of opposing views.   The reality is that the answer to "how and why did this happen?" is considerably more nuanced than "not enough guns" or "too many guns" or "too many immigrants."  Similarly, the solution- if there is one- will be more complex than simply carpet-bombing certain patches of the desert.  Beyond anything else, such an approach leads to tragic collateral damage, as we've seen recently.

Although Macro Man was not previously familiar with the Jordanian journalist Fouad Hussein, over the weekend he saw a link to a 10-year old article in Der Spiegel summarizing a book from Mr. Hussein in which he lays out al-Qaeda's 20 year roadmap.  (H/T: @political_fun via @Nictrades.)  It's really quite chilling how accurate the playbook has been to date.

Ultimately, such a complex problem is going to generate a wide variety of views.   It's not your author's place to tell you how or what to think, but he would request that any ongoing comments on the subject be thoughtful and non-inflammatory.

It's always difficult to analyze markets through the prism of tragedies like this without feeling a little mercenary.  Perhaps Macro Man is scarred from hearing an unsavoury colleague half-gloat that he was long CHF once on the morning of another very well-known terrorist attack.

Generally speaking, Macro Man's view is that market estimation of the real economic impact of such events- and thus their impact on price- is generally over-stated.  Probably the closest analogue we have is the Madrid train bombings; looking at a chart of Spanish GDP growth over the period, could you pick out which quarter saw the bombings without looking it up?

The conundrum, of course, is that markets were already looking ropy before the Paris attacks, and while it's important not to over-react, by the same token it's equally vital not to ignore the underlying momentum and narrative.  For choice, Macro Man could easily see an opening gap lower in European equities (such as we've observed in Spooz) before rallying to unched or slightly up on the day.  After that...well, we'll see, but let's just say that there's a reason your author doesn't refer to himself as 'Day Trader Man'.

Elsewhere, China took a step closer to joining the SDR with a statement from Christine Lagarde stating that the IMF's technical paper has found that the RMB meets the criteria for inclusion.  A vote will be held to rubber stamp the decision later this month.

What impact will it have?   Not a whole lot, to be honest.   It seems likely that the RMB will have roughly the same weight as the GBP or JPY- that is, roughly 10%.   Given that the total SDR allocations outstanding are ~ 204 billion ($282 billion at current exchange rates), that would suggest that the RMB would comprise roughly $28 billion of that.

Of course, SDRs are units of account rather than currencies, and as such they sit in an account until the holders want need to exchange them for the basket of underlying currencies.   It would seem highly unlikely that that every single holder of every single SDR would wish to redeem, thus creating demand for $28 billion worth of RMB. 

In reality, the actual transactional flow should be fairly modest; China's inclusion in the SDR is more a signalling mechanism about the internationalization of the RMB than anything else.  Eventually, this will need to mean a more free floating FX regime; after all, what's the point of including the renminbi if it's just going to act like Dollar Jr.?

How the authorities accomplish this with the current capital outflow pressure and a still massive trade surplus is a tricky question.   In reality, there are two equilibrium exchange rate levels for China:  one for the trade account (<6 account="" and="" capital="" for="" one="" the="">7).  Stuck in the middle is perhaps the least worst outcome, as long as the PBOC can manage it, until the two equilibria come back in line.

It is for this reason that Macro Man expects general stability in the RMB exchange rate for a considerable period, though he recognizes and acknowledges the attraction of getting long USD/CNH at the right price (i.e, on dips rather than rallies.)  Hopefully, in the coming months and years we can spend a lot of time talking about these sorts of issuese and very little on religion, terrorism, and warfare.
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Eurokopek
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November 16, 2015 at 9:22 AM ×

Surprised TRY hasn't really moved. Should we get more action in the middle east now, can we hope TRY gets double punished for being in the region and for being negatively correlated with oil prices?

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Booger
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November 16, 2015 at 11:05 AM ×

Great article MM. It will be interesting to see where usd.cnh heads in the next year. There may well be considerable disagreement beneath the surface amongst the Chinese hierarchy about where this needs to be.

I was thinking on the weekend about what would happen if the Fed increased rates:
1. They have said they will do this by increasing IOER and FFR
2. The media will see increased IOER is a transfer payment to the banking system
3. The effect of this: did Japan do this in the past. Has this ever been tried before (increasing EFFR via IOER???). Would this be likely to increase or reduce monetary velocity ?? One assumes that increased rates would affect borrowers the same and have the same cooling effect, but there would be an opposite injection into the banking system of the increased transfer payment/IOER amount. The increase in bank capital would increase lending but they would be less incentivized to lend...
4. There might well be a large political reaction to increasing IOER.

The idea of increasing transfer payments to the banking system at 0.5%, or god forbid eventually 4% would go down like a cold wet turd, so I suspect for this reason alone, and despite the consensus going full on the other way, Yellen will find a reason to pike out. It is just way too risky for the Fed in an election year, they could well get annihilated by either party for this policy and then the other party will have to follow in crucifying the Fed. Fed powers might be limited and that is against the number one institutional imperative.

Assuming there is a fed hike and there is a public reaction, where are they left except to stop there until they reduce their balance sheet? They obviously cannot increase IOER to 4%. Which brings us back to square one, which is that it would be far more efficient and less politically risky to tighten by reducing their balance sheet than via IOER. Which they must know and I presume this is what they will do before cutting out IOER when they actually get serious about tightening.

We live in interesting and uncharted waters as far as monetary policy goes...

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Booger
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November 16, 2015 at 11:35 AM ×

Increasing IOER, tightening for the economy but increasing transfers and easing to the banking system, is the more I think about it, unlikely to go down well with the public.

IOER in itself could be argued as a form of fiscal policy in disguise. How could they defend from accusations of over-reach ? At 4% IOER would equal roughly the current budget deficit. The transfer even at 0.5% appears significant.

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November 16, 2015 at 12:40 PM ×

"The conundrum, of course, is that markets were already looking ropy before the Paris attacks, and while it's important not to over-react, by the same token it's equally vital not to ignore the underlying momentum and narrative."

Very well said MM. Technicals were poor into this, and instead of a high volume reversal, markets are likely to see a muted response. Tough to have conviction in positions.

Qui n’avance pas, recule

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abee crombie
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November 16, 2015 at 1:19 PM ×

Wow really interesting der spiegel article. Thanks.
Very cloudy markets, imo, I'm just looking at hy. That's the key for me.

Poor fed. If markets keep going down they are just going to reduce any credibly they had and put them in a no win situation.

Doesn't China have a closed capital account. So yes put your money in but good luck getting it back on your terms. Anyways it's all part of their obor expansionism.

I'll save my thoughts on radical Islam for another time.

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washedup
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November 16, 2015 at 1:39 PM ×

boog - I wondered the same when they first came up this idea along with the reverse repo, but the IOER mechanism has been well publicized for a long time, and if it was going to be turned into a political lightning rod it would have done so by now. It's certainly possible its been waiting for a 'ted cruz type' to come along, but its not an easy one to explain to the public anyway.

Interesting sentiment turn on this board - is this the year of the bad boozy Santa? And as if janet yellen didn't have enough on her plate, Bill Maher said she looked like 'Newt Gingrich in drag'.

Cruel, cruel playground - somewhere Bernanke is doing high-fives with greenspan for making well-timed exits.

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Leftback
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November 16, 2015 at 4:56 PM ×

We liked US fixed income last week on weakening Q4 US data (the much-hyped November NFP number notwithstanding) and we do not see any reason to change our view. Inflation continues to weaken, driven by lower commodity inputs for the time being. There could be all kinds of silly buggers going on in Spoos this week, as it is equity options expiration on Friday. It's quite likely we will elect not to play this week, and simply spend the time looking at charts instead.

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Mr. T
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November 16, 2015 at 6:01 PM ×

I don't understand how IOER is supposed to work as a viable alternative to FFR. Higher IOER rates would raise market rates but with continued collateral damage to the nonfinancial economy and a pretty awful PR situation. (Sorry Joe, you cant get a mortgage because the fed is paying off the banks to not loan you money). Compare this to lowering FR balance sheet size which would also raise rates, sends happy "recovery" messages, does not look like bank handouts etc. I suspect if IOER rates are raised reserves will very quickly jump again which just makes a return to normal even more distant.

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washedup
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November 16, 2015 at 6:20 PM ×

booger/T - not sure if read this article, but it would explain the complexity a lot better than I would:

http://www.nytimes.com/2015/09/13/business/economy/the-feds-policy-mechanics-retool-for-a-rise-in-interest-rates.html

FWIW of course you are absolutely right in saying that reducing the balance sheet is a better way to go - but given PBoC and oil exporting countries' actions you would get about $2-3 TN of selling in a 1-2 year period - the only way there would be a demand for those bonds by pvt funds, individuals, and sectors would be if 1) there is a high demand for substitution from other asset classes (cough, equities) or 2) yields compensate buyers a bit more than they currently do, thereby impacting demand.

So IOER is a cheap trick designed to bribe the banks further so the fed can demonstrate a rate raise without impacting the economy - its wrong at many levels of course, but is it really that surprising?

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abee crombie
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November 16, 2015 at 6:23 PM ×

if the Fed reduces its balance sheet, its gonna hit the MBS market hard, not that the players there dont know its coming but it wont be good for housing. Not sure Fed wants to do that either.

If I recall, most of the big banks need a steep yield curve to really make money, not just higher short/IOER rates. JPM will earn an extra $3B in Pre Tax Net Income for 100bps higher vs $21B for F2015. However this isnt my area of expertise, FWIW

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abee crombie
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November 16, 2015 at 6:27 PM ×

vs 21B in expected Net income, so about an extra 10% after tax. Its big, but not game changing. Cutting expenses is bigger for most banks

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Leftback
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November 16, 2015 at 6:46 PM ×

mREIT equity prices are discounting a rate hike or three, as well as a slow unwind of the balance sheet. Now imagine that lot doesn't happen, or happens m-u-c-h slower than expected, in part b/c younger Joe Sixpacks still can't afford a house even at these rates, let alone mortgage rates >4%, so the US housing market is actually piss weak outside the East and West Coast honeypots. If mortgage rates run up to 5% there will be another mini-crash in prices. Good news, but it will not happen.

Ben Bernanke said many times that the balance sheet would just run off slowly over time as the MBS and Treasuries matured, and I have no reason to doubt that was his intent, so concerns over MBS seem exaggerated, hence the book value of mREITs is likely going to remain even higher for longer into the future than has been suggested. This asset class will have another monster rally in 2016. Quality mREITs are probably trading at a 20-50% discount.

Short positions in US10y are growing among the speculative community. Even if the Fed does hike in December it will be a buy the news event at the long end of the curve. As always in these cases the move down in yields will be stronger and last longer than anyone has anticipated. Inflation drivers are still falling b/c of the over-supply of crude oil and recent USD strength. This recent action is all a bit 2010, except we are in a range that tops out at 2.50% instead of 4.00% on the 10y. The spread to bunds is still wide. All of the ingredients are in place for a "surprise" rally in US Treasurys.

Mr Gundlach would seem to agree with us, and has opined this week on the deteriorating state of equity markets. With the Teppers and Dalios also apparently preserving capital, we'd suggest a glance at the actions of the smarter breed of punter..

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Anonymous
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November 16, 2015 at 6:47 PM ×

Crouching China. Hidden Deflation.

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abee crombie
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November 16, 2015 at 8:43 PM ×

nice rally from the beaten down sectors. If by tom afternoon this holds, I think that was it and time to go dumpster diving. HYG finally has a green candle.

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CV
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November 16, 2015 at 10:41 PM ×

Always interesting when LB and Gundlach starts to have sniff at the long bond ;). Work has got in the way of commenting in the last couple of weeks, but I have been lurking. I can see a few short-term banana skins in equity land, but I would not be surprised to see this melt-up continue well into Q1 next year. It won't be straight up all the way, but the direction is clear to me. The monetary policy divergence story is set to get another leg with the "expected" CB action in December, but you have to wonder whether we are seeing the last gasp of that particular trend. Of course, I would not want to bet on that just yet by doing something stupid like, buying the euro ;).

I hear you on bunds LB! But I also think a taper tantrum is waiting around the corner in that market as German inflation zooms to normality, and investors take profit from front running Draghi into December. Q1 could be interesting!

More specifically, I also wonder whether you won't be able to buy some long-end U.S. yield at about 2.5%-to-3.0% in Q1/Q2, as the reflation story gets more traction. The thing is ... if Yellen moves and the world doesn't end, we could well get a couple of quarters of "everything is fine" steepener before the curve turns. Not easy that one!

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