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A Tale Of Two Liquidity Measures, Submitted by JM
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can someone please explain in english what this means to me? and my investing future. how about something on interest rate swaps
Basically it means that you're fucked unless you hold all your wealth in something like, say, physical Gold.
It doesn't mean that at all.
If it doesn't it should - otherwise its just drivel.
Stop minding the bullion shop. Go call your mother.
Sorry I hurt your sentiments. I hope you were not expecting to be awarded the nobel prize for the drivel you just posted (not that idiots aren't awarded one).
The core issue of investing is the issue of inflation. Everyone and their mother is unclear about it. Every investing decision rests on taking a view in inflation expectations.
By conventional measures, liquidity seems to abound. Work-horse measure like commercial paper to t-bill spreads are at extreme lows, usually signalling tightening or inflation coming fast.
So why is Bernanke not tightening? Why with historically high excess reserves is there no flaming rises in prices (as opposed to relative scarcity and overt price manipulation in some commodities)?
Maybe another measure of liquidity is needed, one that reflects a world where a bank can have assets on book multiples greater than the GDP of the country in which it is domiciled. Or derivatives markets so much larger than the commercial paper market that what happens to commercial paper is really irrelevant to overall liquidity conditions.
This is an attempt to develop a new measure of liquidity that reflects these realities and explains why things aren't working the way people think they should.
The new measure makes a central assumption... the relationship between interest rate swaps and treasuries is amenable to analysis using cash-synthetic basis constructs, Not saying the relationship is perfect, or that IRS is a CDS to treasuries. Just saying these instruments are substitue instruments, especially at long and mid curve. See article for why this makes sense (or doesn't).
If you do accept the assumption, then maybe Ben's "extended period" crap is understandable from a certain point of view. Maybe it explains why the Fed has Qeased and printed their @#!*% off and we are still on a slow untergang.
This article is technical and in part just creative brainstorming. Even if the central assumption doesn't hold, it still contributes to the whole liquidity mystery.
nice work jm !
Do you even know what is inflation?
Bernanke is not tightening because he’s scared sh*tless it would tip us into outright deflation.
Richard’s Koo’s presentation on “balance sheet recessions” (posted here on ZH a while back) sets out a cogent argument for why rates aren’t rising based on fundamentals.
On the other hand, markets may well soon demand higher rates from many if not all sovereigns. The BIS warned in a March paper that the path of a number of countries is unsustainable and that drastic action is called for. The authors went on to say, “This leads us to conclude that the question is when markets will start putting pressure on governments, not if.” (http://www.bis.org/publ/work300.pdf?noframes=1)
I’ve been watching 5- and 10-year swaps spreads since the 10Y went negative for a few days a month or two ago. Using H.15 monthly averages, the 5Y was negative for April and the 10Y is headed in the same direction.
Using that same H.15 monthly data, I calculated the implicit 5Y 5Y forward spread, which goes negative in October 2013. I don’t like what I see, but I’m not convinced it’s not some artifact of the data that I’m just overlooking.
Tried inserting some of my graphs into my comment, but they don’t take.
I agree that if the underlying process driving things stays constant, you will see negative swap spreads all over the curve, simply becasue of the supply.
I can't see government debt issuance and fully backstopped financial systems (the current underlying processes) remaining constant. Reduced treasury issuance and higher credit risk reflected in LIBOR implies a higher swap spread.
Another thing I try to incorparte in my thinking is that human systems inherently break correlations because humans learn, adapt, and act irrationally at times. So mean reversion based on cointegration is thus something to suspect.
I've uploaded a new DOW chart.
http://www.zerohedge.com/forum/latest-market-outlook-0
http://stockmarket618.wordpress.com
Financials are going to get ROCKED. As they get EXPOSED.
Banksters are being Exposed now.
Run Banksters!!! Run!!!
Deflation, prices go down. CRB is going to crash like a stone.
WHY? Because they have been rigggingg the TRADES
The very reason most here have been buying gold or silver.
Not me, but most.
During Deflation, CASH IS KING, in my book.
http://bit.ly/BkGWc
Be careful where you put it. Credit Union, Community Bank, Regional if you must.
If last week doesn't show you how rigged Stocks are, nothing will.
and everybody needs beer, has beer. Unless you say: DAMN, I NEED A BEER! Then you mostly haven't got beer so you'll need beer.
I'll trade you beer for silver. 1 liter per quarter oz.
Don't like that price?
Tough, brew your own!
Seconding dcb, this is a little difficult for the layperson to follow. Some of the points are counter-intuitive (if I understood the statement) such as banks not selling t-bills when monetary policy is tight.
I think the overall point is that new-fangled financial instruments (interest rate swaps) are more popular than treasury paper, even though they give a lower return, because you can sell them quicker and more reliably(!)than you can sell treasury paper on the secondary market! And, that you can leverage your money more in the IRS's (maybe?). The whole point is that this trend toward lower swap spreads means that the financial system is short of cash and has contains way too much treasury paper that may not be convertible into cash if cash is needed to, say, meet margin calls?
I think that this points to the possiblity of a liquidity crisis when anything that is liquid (such as stocks and commodities) may be sold (at whatever price they will bring) because otherwise the firm (or person) may end up defaulting and be wiped out.
Not sure I got this right, but if it I am correct, this seems impossible as much as the printing presses (or the digital equivalent) has been running for two years. Maybe most of that money has already disappeared due to debt destruction and we are still in that process and we are about to reach a point where either another huge infusion of cash is required or the next Lehman Bros will happen?
Hope this was not just confused babbling and added a little to the understanding of the article.
I'm not sure what is counterintuitive about holding t-bills and selling paper of lesser credit risk when liquidity is tight. Probably my confused writing got in the way of understanding or maybe I'm missing something.
Observation: the liquidity measures like comm pap/t-bill spread is at historic lows and yet the Fed is talking about an extended period of low poilcy rates.
The only explanation.justification is that something else is at work that traditional measures aren't capturing. You guess it: IRS.
The way I appraoched the liquidity issue used the tools of the basis trade. The mechanism in the write-up specifies the factors in a basis trade. They incorporate the hedging motive for IRS, the return motive for either, and the other dynamics too.
Whether you disagree with using basis trade tools or not, the issues of supply and that some buyers prefer swaps even though they yield less than a credit-risk free substitute is an eyebrow raiser. The best way to explain it is that liquidity isn't as abundant as some think, and IRS are capital efficient relative to treasuries. Thus their yield can be extremely low or even negative relative to treasuries.
Repo optionality is the wild card for treasuries and it explains the spikes in the swap spread you observe in the 5Y chart.
The only thing smoking here is ZH's vetting process.
Well, we'll all get fried because of this IRS business. That much I understand.
But honestly, there are rules to writing a theoretical paper. What is the question here? What is the answer? Is this a stream of stream of consciousness or what?
Sometimes it is useful to be creative, think outside the box, and get feedback from peers.
There are very few venues to do this for technical quant-stuff. ZH graciously allows me to do it here.
HAHAHHHAHAHAAHHHAHAHAHHHHHAAAAAHAHAHHAHHHAHAHAHHHAAA!!!!
Not many people have looked at this very specific problem at this very specific angle, and not many would be willing to read your brainstorming-stream-of-conciousness-paper over 3 times just to understand what the it's really about. You are therefore excluding 90% of potential contributors.
Correct me if I'm wrong:
Your point is that people prefer a synthetic instrument to a cash instrument even if the latter yields better, which you diagnose as a symptom of inadequate liquidity.
But are you sure that's the only possible explanation? (no idea myself, tbh)
And, where is all the liquidity gone? Okay, the shadow banking system sucks in liquidity like a vacuum cleaner, but if your diagnosis is correct, it looks like there's a huge drain somewhere. Where? With no direction on this one, this is all just a hypothesis..
When you write that "the core of the financial system is itself insolvent" - that's the weakest part IMHO. The problem AS YOU FORMULATE IT is about LIQUIDITY, not SOLVENCY. If you are linking the two, please explain how, otherwise I don't get it.
And lastly, there's indeed nothing here which is "technical" (as in "technical analysis") or "quant" (as in "quantitative finance"). You'll have to find a better word.))
Hey. If you already know what a basis trade is and are familiar with swap spreads, then at least the concept is not really that tough a read, although my skills as a writer are surely lacking. Guaranteed I'm not going to play porfessor and fit a textbook into a guestpost. Not everything has to be for 90% percent of readers. Sorry.
Am I sure that is the only explanation? No. Presented is a way to interpret the strange behavior going on using tools from a different area of finance.
Regarding the vacuum leading to nowhere... the vaccuum is dollar destruction. It is as simple as lending out money that is not paid back. Given leveraged positions you have to cover, which leads to unwinding positions. Which in turn leads to insolvency/liquidity. One symptom of insolvency is the lack of liquidity.
You are distorting what I wrote, which is not good. I never said smth should be for 90% of readers.
Writing a piece which requires a certain level of knowledge is not the same as expecting others to tune in to your brainstorming session. Like, for an analytical paper to have no "conclusion" at the end is hmm.. weird, even if it's just as a guest post.
"the vaccuum is dollar destruction". I believe it's not. No dollar is "destroyed" in a monetary sense when assets on the balance sheet decline in value or are wiped out. Very few assets are actually money. However, an institution with "illiquid" assets (a modern oxymoron for mark-to-myth), if it wants to avoid insolvency (which is: not enough liquid assets to pay off current liabilities), will need a lot of cash (which will not need to be repaid - causing a spike in current liabilities - any time soon) to roll over its positions. It's for that reason, actually, for a financial institution having a lot of cash on the balance sheet is usually NOT a sign of health at all - which many commentators somehow don't realize.
As a side note: illiquidity is a symptom of insolvency, but not always of insolvency.
Mark to myth won't last forever, and default means your claim on contracted money is severely impaired ... or poof it's gone.
Heightened credit risk is the heightened sense that your claims on contracted money will go poof. Thus credit risk is intrinsic to liquidity problems.
True there is a difference between a solvency and illiquidity. Credit risk is the common tie.
Make sense?
Yes.
I guess if indeed we are still experiencing a liquidity problem (not just the underlying solvency problem) as per your analysis, it means that all the US Gov't stopgap measures - while averting a catastrophic collapse of the shadow banking system - have not even stabilized it. It is bursting at the seams waiting for a "sudden death" moment.
Print baby print?
However, is it possible that the IRS market data may be distorted by the fact that FNM and FRE are huge users of these instruments, on the long side, and are bleeding a lot of cash in favor of the banks? Which means there is a huge artificial subsidized market for these swaps?
Just a guess.
Spot on. FNM and FRE and banks have a huge hedging motive, and that motive is a part of basis trading.
I don't know where capital is safe anymore. It's hard to be zen in times like these.
I know there are a lot of goldbugs here, but holding actual currency might be the solution.
the asset bubbles now include sovereign debt. it's overvalued.
stocks are over valued because future earnings of companies are going to be massivley taxed.
so, holding stocks or T Bill's (or any other bond for that matter) is going to result in a serious devaluation of your holding.
if you are holding green, you will be able to withstand it.
gold? who's really going to want it when the SHTF? the price will collapse. it's just another asset bubble.
values will still be measured in dollars. everything will just have less value.
I guess this means I think deflation is on the horizon.
lol.
Heh, I see the comments and will attempt to simplify. Interest rate swaps allow any bank to lay off, or take on. risk to suit the risk that comes from their client flows or a preferred risk. This can happen anywhere along the curve so for example you can put a whole bunch of risk down on just the 20 year part, or be long risk in the two year against short the ten year. The logic can get quite arcane when you get down to the equivalence of the maturity ladders (banks have positions maturing every day for the next fifty years in various sizes).
When the Fed or the Govt guarantees the banks, then there is no difference in credit risk between banks and governments. Hence no need for a credit differential. The other aspects (CD's, commercial paper holdings etc) are important to banks to manage the bricks and mortars of their balance sheets. But really, these represent the sleight of hand that passes for getting round regulations on capital structures and getting free Fed money and laying it off.
One key aspect I took down from JM was that we are left with the paradigm that if the Fed or the market could do anything to fix this problem they would have done it already and not left us in this mess as it implies that banks and the Fed set the level of economic growth, employment and inflation. Of course, they can't and don't. That comes from the real world not the fake world based on a "fiat" system (print whatever you like borrowing is limitless).
The other aspect I took was that there i still not enough data available on the dealing costs of money over the life time of a swap. Stay with me here. LIBOR is the ask price of money between banks with similar standing. In a 5 year interest rate swap, one party pays LIBOR (usually 90 day or 180 day) and receives fixed coupons for 5 years. The swap starts at zero present value since the markets set rates today for the full five years, so all coupons are known. Once the deal is struck there is a profit and loss (think about a 5 year bond going up and down in value as its yield moves). What isn't factored in to these studies is the actual cost of dealing. That is the bid side of LIBOR, called LIBID, and the spread for dealing in 5 year treasuries. In theexample of a five year swap, the bank paying LIBOR (90 day or 180 day) has to actually get LIBOR from somewhere. If the bank lends, it receives LIBID, not LIBOR so it is always down the toilet for the gap between bid and offer. Doesn't amount to much when the Fed is giving banks money for nothing and banks can buy treasuries at 3%, but if the spread between LIBOR and LIBID gets to 1/4% per annum, then the bank paying LIBOR is down the toilet for 1.25% over the five year life of the swap. Increase the LIBID/LIBOR spread to 1/2% and the term to 10 or 30 years and pretty soon the gap becomes a significant (and unaccounted for) drain on p/l. I will leave the cost of turning over swaps themselves and the fixed leg for another day.
The unfortunate thing is also that counterparty risk is only negligible whilst movements are small. I have exchanged views with JM about "gap risk" when we get a shock to rates and there simply isn't enough collateral out there (or counterparty bank capital on issue) to cover the loss on one side of the trade. For example, lets say the whole interest rate swap market is 500 trillion and has a 5 year duration. If the market "gaps" by 1% up or down, over, say one week, then the profit/loss need for collateral is 1% x 5 years x 500 trillion, that is 25 trillion dollars. There simply isnt enough collateral of sufficient quality (most collateral is cash or US treasury bills/notes, you get variable haircuts on A and AA paper - see how this goes round and round with the Goverment growing bonds by 1.4 trillion and rolling 400 billion of t/bills a day?) to deliver and secure the profits.
Hope this helps, there will always be questions, even by the experts. Single deals are easy, systemic risks resulting from trillions of dollars of deals are more problematic to try and diagnose and get to the bottom of!
The demand for collateral can be
Happy Mother's Day, Hooligan.
If I understand, yours is a different tack arriving at the same point: LIBOR is a bogus foundation to a megatrillion derivatives market. I agree.
The paradox: high quality collateral is crap until it is needed. When it goes special at repo because of a crisis, it is more precious than gold-uranium alloy.
BIS wants to control this cycle by making margining "smoothed over the cycle". Seems impossible to me, as the paradox goes to the very core of credit risk and its kinky twin sister liquidity.
jm- I would like to thank you for answering my question. I really need to learn about irs which I do not know anything about. I like the cerebral nature of the discussion. I try to look at Libor. as far as I was concerned we were in another bubble once libor was "normal". since I believe the lior rate did not reflect counter party risk for years I think the normal was wrong. therefore a new normal libor would better reflect the risks we know are in the system. we should almost never get back to "normal" until the system has been deleveraged.
I was also worried when spreads between corporates and treasuries became "low". I find it a bit strange that some emerging market economies which are in better health than the us pay more. wondering when this will invert, or when stocks fall seeing emerging spreads tighten.
not sure I said it right, but thoughts.
I am told that you can invert the price action of lqd (corporate bond index) with markitt (sp) cds spreads. I saw a graph once. used this as a tool to time my shorts failry well before.
I don't know a lot about LQD, but roughly the difference between IBoxx and CDX is a cash-synthetic basis.
Check to make sure you don't have a maturity mismatch (different instrument maturities) between the two instruments you track.
Hooligan:
Is there a way to trade the LIBOR-LIBID spread?
JM, yes I hear that the ECB/Fed/BoE et al are giving out free banking licenses to enable you to quote outrageous spreads on 90 day LIBID/LIBOR (say 0.1% / 1.1% against a refi rate of 0.5%) . The ECB will then lend money to you at 0.1% and simultaenously take it off you at 1.1% giving you an instant 1.0% trading profit. The only snag is you have to form a commission called the Gold Man Commision and I have bagged that one, so I'm busy talking to the ECB as we speak saying "mine a billion @ 0.1%" followed by "yours a billion @ 1.1%".
Joking aside, you can be a bank to trade the interbank or an interbank broker. That's it, you might be able to arb dealing spreads via the same day/tom/tom next spot f/x markets, but short of being a market participant you are locked out of arbing the private banking market (43 banks for Euribor for example). You could possibly do it by negotiating large lines with SWF's and pushing the market around by withholding SWF money until you got the rate you wanted over the course of the morning between the 6 am open and the 11 am LIBOR fixing, but really this is risk management not arbing the spread widening (getting inside bid/offers).
Still makes me laugh that 11 am fixing has any relevance to anyone on the planet, people dont even drink tea for elevenses anymore. More is traded away from the fix in the interbank that at the time of the fix, so it it s coincidental reference rate, actually dealt by no-one. I mean does anyone really think that 600 trillion of swaps should be priced off a commodity that doesnt exist and can't physically be dealt? It's not investable.
I am pondering your views on the new liquidity measure. It will take me a while, maybe years! heh..Certainly it makes intuitive sense that the price of money (value) should be determined by the instrument that is most actively traded. As you know I think the collateral mechanism is not right. Perhaps its dealers salaries/bonuses/overallbank profits, since this is the point of taking the position. Why go through all the aggravation of delivering collateral. Anyway, it looks like we have pissed the Gekko off for not speaking clear English. So whatever new instrument that evolves, it will need tobe called something like the carbon credit or pollution tax credit or something to reflect the availability of toxic assets that can be used. I will try andbe more careful about my musings if I think he is reading it thats for sure. Pak seems like a smart bastard so I will watch out for him/her.
If I could find a market that actually went ahead and defaulted I'd put my money there. I can't find one. Also, I hear North Korea has started a SWF. Big SovX CDS desk.
Thanks for the info. I just want to know how many times some panel bank on the panel has lied about their offer rate just to look as rosy-cheeked as the other whores in the window. I'll take the over on a million.
Note that EURIBOR isn't the funding vehicle for this mess. It's all eurodollar LIBOR. Those idiots screwed around during the crisis so long that they lost total control of the situation.
Pak's cool, I think I came off as an ass. Didn't mean to.
Stay real.