Across the Curve

As Brent and WTI prices ebb and flow from local and global fundamentals and risk premia, Morgan Stanley notes that to be bullish from here, one would need to believe a supply disruption is coming. Considering conflict with Iran, sustained Middle East tensions, and the potential for sustained supply disruption their flowchart of price expectations notes that prices follow inventories and that as price rises, fundamentals will weaken (as without an OPEC production cut, inventories would balloon by 2Q12) and therefore to maintain current prices across the curve, supply risk premia must continue to grow. They raise their estimate for 2012 average Brent price to $105/bbl from $100/bbl which leaves them bearish given the forward curve priced around $115/bbl, as their base case adjusts to a belief that Middle East tensions persist but a conflict with Iran does not occur as they address QE3 expectations and EM inflation/hard landing concerns.

The real meaning of a treasury bear market may not be a flight out of treasuries into another asset class. Rather it real import could be the lack of liquidity available anywhere for nearly any asset class... Liquidity acts in a financial system like ample water, ambient temperature, and clean air act in an ecosystem. It makes trading strategies proliferate. Further, it makes meaningful intermediation possible, fostering the growth in high yield bonds and marketable loans. Yes, derivatives like vanilla stock options and others too. A financial system without liquidity is like a tropical ecosystem dried into a desert. Without liquidity, it is an open question whether the arbitrage pricing revolution will outlast the antiquated mark-ups of reinsurers. Liquidity makes random processes stationary, which is crucial to make the probabilistic foundations of risk neutral pricing work. Is it intuitively possible to price (and even more buy and sell) credit and interest rate risk without some liquidity in the underlying? How can a bank generate carry when the curve is flat and there is no appreciable differential anywhere that has a minimum tolerance of liquidity?

Did the first (of many) European LTRO buy just one month of marginal improvement? According to a compilation of analyst views by Bloomberg, who looked at today's mixed Spanish auction results when the country sold €4.56 billion of three-, four- and five-year government bonds, the easy money may have been made. Because while average yields fell for all three lines at the auctions, maintaining the trend at Spanish debt sales so far this year, it was the internals that showed weakness and could indicate that the marginal benefit from the first LTRO is now ending, even as the real task - the longer-dated bonds 10 years and great - still have to see much if any carry trade benefit at auction. Lastly, anyone hoping for a full carry flush from the European banks has to give up all hope: ECB announced its deposit facility usage rose to €486.4 billion, up €14 billion overnight. And with that we now know what the LTRO half-life is.

Whether it was FX majors, the Treasury complex, or the economically-sensitive commodity markets, the 'negative' shift from yesterday's open (USD up, TSY yields down, Commodities down) plateaued overnight and retraced throughout the day today. Equities and credit however managed to make new highs (while all these other risk-related assets did not) as they stayed in sync for the afternoon (double-topping on lower volume) as financials outperformed (MS +5% for example) on what we can only imagine was Greek rumors (which later proved as usual to be completely false). Oil dropped markedly into the close, heading for $97 as Gold remains the week's winner (though Silver and Copper won on the day). The USD is flat (leaking higher in the late day) to yesterday's pre-market after trying and failing at 1.32 against the EUR (which is the underperformer vs USD on the week for now -0.48%). Treasuries sold off, adding 3-7bps across the curve (though still lower yields on the week) and while 30Y underperformed, 2s10s30s did not move much as the rest of the curve pivoted. The last 30 mins of the day saw ES pull back from its lonely highs to test VWAP (and IG and HY credit also fell with it) as open to close, credit underperformed, and cheap hedge IG was moving more negatively than beta would suggest. By the close, ES had pulled back (lower) to converge with CONTEXT (proxy for broad risk assets) and fell below VWAP as once again average trade size picked up significantly to the downside.

Following three-in-a-row weak macro prints, the market broadly speaking is not happy. The S&P is 10 points off its pre-Case-Shiller highs, EURUSD is dropping rapidly back towards 1.31, Treasury yields are falling 3-5bps across the curve, and Commodities are giving back their spike gains from pre-US day session open. FX carry seems like a major driver for now with AUDJPY and EURJPY most notable while the drop in the curve and levels of the Treasury complex are adding to downward pressure on stocks. Credit and equity markets are dropping in lockstep for now (with HYG more volatile than its peers). The rally in European sovereigns has stalled here as longer-dated spreads are now widening off their intraday tights (10Y BTP back up to 6% yield) while PGBs give back some of their ECB-enthused rally (~20bps off tights now). US equities and CONTEXT (the broad risk proxy) are in line as they drop here.

Citi's Steven Englander shares his outlook on what the key things to look out for, in the 8:30 am press conference, are. One variable in his forecast has already been presented: the cut was 25 bps not 50 bps. As he says: "By contrast, if they did 50bps and indicated that more aggressive measures might be forthcoming, the pendulum could swing to positive." In other words, the kneejerk jump in EURUSD following the ECB has been largely misguided for now, especially with forward EONIA rates jumping across the curve confirming that European liquidity is about to get far tigher all over again.

Following late November's disastrous 10 year Bund auction, in which the goal seekers saw everything from a failure of the repo market to the Bundesbank trying to fail the auction on purpose, yet which was nothing more than a simple case of little demand and high supply, today, following a steady leak wider in yields in the entire bund curve, Germany sold €4.09 billion in 1.25% 5 year bonds, with the maximum amount of €5 billion selling easily following bids for a total of €8.67 billion. The Buba retained €0.91 billion, which it always does, and is not an indication of some ulterior motive to have the ECB bailout Europe. As expected the Bid To Cover was a soaring 2.1x compared to 1.5x on the last 5 year auction on November 2. In other words, a stunning success and demonstrating what happens when you actually have demand for paper following a decline in prices. Below are the Wall Street responses to this strong auction. So that takes care of that. What is more important, and why futures are down is that as expected, yesterday's deux ex FT was promptly denied by Germany after a "senior German official" spoke to Reuters and said they are "not sure if summit will reach conclusion on using IMF funds in eurozone crisis" and "can't forsee running EFSF and ESM simultaneously". They have also said they are "more pessimistic than last week on overall summit deal". In other words, look for many moresuccessful Bund auctions as things resume their downward trajectory all over again.

Equity and Credit markets rallied significantly on the day with credit catching up to equity's recent strength in an unusually biased move. The higher beta XOver (high yield European credit) and Subordinated financial credit outperformed close to close but lags overall relative to equity and investment grade credit, suggesting less than stellar demand to lay out new risk and more likely shorts covering in a hurry. Seniors underperformed Subs in financials - again suggesting some covering on the SEN-SUB decompression trade on the back of the ratings actions this week. Sovereign spread moves were actually largely unimpressive with spread curves flattening, some decompressing, and the fulcrum security BTPs, not exactly ripping across the curve.

As usual, the bond market has already an idea on how this will pan out. Looking at various yield curves we get the following picture:

- Greece is “off the chart” (in the “toast” zone)
- Portugal will not make it as debt and interest is not sustainable and the EFSF struggles to raise bailout funds.
- The “soft Euro-zone” could survive by aggressive monetarization of debt by the ECB – once the German hardliners quit. Inflation would probably follow in a few years, but that is another question.
- The “hard Euro-zone” would consist of Germany and the Netherlands. They unilaterally quit the Euro-zone and introduce a pegged currency pair.
- France is really the only unsolved question in this puzzle. Bond yields have peeled away from Germany a bit too far. Historically, France was a “soft” currency country with frequent realignments of exchange rate under the European ERM (Exchange Rate Mechanism). Given the strong political ties France will probably be forced to stay married to Germany, but it will be an unhappy marriage, with an eventual break-up at a later date.
- I have included Hungary just out of curiosity, since their love-hate relationship with the IMF is slightly entertaining.

UPDATE: CONTEXT - the broad basket of risk assets has now caught up and is supporting post-stress-test equity weakness after hours as TSYs slide lower in yield.

Gold and Silver outperformed their less precious commodity cohorts today as equities (and credit in general) managed a see-saw day centered around a dud IMF-bazooka and more-of-the-same from the FOMC. Stock and Bond markets stayed in sync early on as risk was decidedly off this morning following the weak GDP print though we do note that IG protection was bid even as stocks managed a small rally across the open. Equity and CDS indices tracked each other (as liquidity in the latter is low this week already) but the IMF-credit-line news jagged both notably higher and out of sync with HYG (the high-yield ETF) once again, and then as the FOMC minutes offered little immediate hope of QE3, reality set back in and equity and credit markets drifted back to the reality of HYG's risk aversion. The late day plunge in ES on the back of the stress-test announcement is not being followed by IG, HY, or CONTEXT for now as Gold and Oil were flat, FX marginally lower USD though TSYs were the main driver of risk weakness ending at the day's low yields and their lowest yield since 10/05. Implied Correlation diverged upward from index vol into the close suggesting strong macro-protection demand even as VIX leaked lower. Equities remain in catch-up-to-credit-weakness mode and given the reaction to today's mini-IMF-bazooka, we suspect derisking is here for the week.

Much has been made of "unintended consequences" of various policies.  Even ZIRP is gaining more attention.  ZIRP punishes savers. ZIRP forces bond managers to move out in duration or down in credit quality to get enough income to provide some semblance of a return after fees.  ZIRP may be encouraging people to wait on home purchases as they don't think interest rates or mortgages will rise anytime soon.  ZIRP has played a role in the credit crisis as well.  As has the SNAC protocol for CDS (which enabled - among other things - a fixed and lower running cost in CDS contracts) when combined with ZIRP means there is minimal carrying cost on the amount of up front premium paid in the case of credit shorts.

Even the squid has a bad day once in a while.

Credit markets were far less sanguine into the close than equity markets as ES managed to get back to day session highs (and beyond). IG and HY credit markets closed much nearer their lows of the day and while broad-based risk assets rallied off the morning lows, the late day surge in stocks was entirely idiosyncratic! HYG outperformed HY while HY secondary bonds were much more balanced (net buying to selling) today than in recent days. It certainly appeared credit market participants were much less comfortable holding into the Greek vote and uncertainty of the weekend than equity players. The USD was noisy all day but rallied into the close (as the EUR drifted back under 1.38) and Gold trod water as oil managed a modest rally while silver and copper lost more ground on the week. TSYs rallied only modestly today with the belly outperforming as we saw major duration reduction in corporate bond trading on the day as the long-end was net sold. VIX rose modestly into the close, disconnecting from stocks - like every other asset class.

While the Raiders may have succeeded against Denver tonight, Silver-and-Black Gold (and real gold) are leaking lower as macro data and European/Chinese leader chatter is trumping any more unidentifed-rumor-mongers (URMs). Aussie business confidence fell to its lowest since APR09 and fell its most MoM since OCT08, French CPI came a little hot, and Merkel warned everyone to keep their mouths shut (our rough translation/interpretation) for fear of more uncertainty in financial markets and an "uncontrolled insolvency" in Greece.

Markets are trading sharply lower this morning after yesterday’s late afternoon rally on the change in language in the Fed statement that will keep short interest rates essentially at zero until 2013.  As I have stated before, I believe they will ultimately be forced to keep rates low forever, or at least until the bond market vigilantes eventually rise up and shock the world by demonstrating that indeed you can fight the fed.  Which begs the question, who will be the George Soros that breaks the US Fed?  We’ll see.  In any case, by 2013, it’s highly likely that the US will have over $16tr in debt.  If the average rate across the curve in 2013 is only 4%, which is low by any historical standard, then our annual interest payment will be over $600bn, or almost 30% of annual tax revenues.  So the Fed faces problems on a number of fronts.  They have to be seen as actively trying to do something so they continue to manipulate the price of money to artificial levels which only serves to send misleading signals throughout the economy.  QE1 and QE2 have come and gone and yet unemployment remains sticky above 9%.  Their balance sheet remains abnormally large and their policy tools to manipulate the market is dwindling.  Now add to that the reality of the math of our huge fiscal debt and deficits.  No matter which way you spin it, we have some tough times ahead that will involve some asset prices falling (commercial/residential real estate and other levered assets), other asset prices rising (agricultural land, commodities, gold/silver) and the façade that the Fed is all-powerful to come crashing to the ground.