Across the Curve
Another session in which the market continues to be "cautiously optimistic" about Europe, but is confused about Cyprus which keeps sending the wrong signals: in the aftermath of the Diesel-Boom fiasco, the announcement that the preciously announced reopening of banks was also subsequently "retracted" and pushed back to at least Thursday, did little to soothe fears that anyone in Europe has any idea what they are doing. Additional confusion comes from the fact that the Chairman of the Bank of Cyprus moments ago submitted his resignation: recall that this is the bank that is supposed to survive, unlike its unluckier Laiki competitor which was made into a sacrificial lamb. This confusion has so far prevented the arrival of the traditional post-Europe open ramp, as the EURUSD is locked in a range below its 200 DMA and it is unclear what if anything can push it higher, despite the Yen increasingly becoming the funding currency of choice.
A few observations about growth and policy backdrop that is shaping the investment climate. It is a large overview that may be helpful to start the week.
For most portfolio managers, investable assets can be thought of as sitting somewhere on the risk-return curve. If we look at the risk-return curve today it is obvious that 75% of global financial assets are now locking in real losses, unless of course, inflation collapses and deflation takes hold in the major economies. If we are spared a massive deflationary wave the assets at the bottom left of the curve will lose 1.5% real per year for the next five years. This means that, for global assets to stay roughly in the same place, equities will need to provide a real return of 4.5% per year for five years. However, it is important to note that such returns will only serve to compensate for the capital destruction taking place in the fixed income market. Real returns on equities of 4.5% will not leave us any richer compared to our starting level. This means that investors will have spent five years on a treadmill running to stand still. When you consider that no asset growth was registered in the previous five years, we are facing a whole decade devoid of capital accumulation. Given the world’s aging population, isn’t this bound to be problematic?
Sometimes, it feels good to hope. But since last September, nothing has really changed. At least not fundamentally. The zero-interest rate policies were going to encourage share buybacks, dividend payments and any method to allow the extraction of whatever real value is still available to extract from corporations/businesses by their owners. This meant leverage was going to increase, unemployment would remain high, capital expenditures were going to decrease and the risk of defaults was to going to rise. A year later, all these symptoms are starting to surface. One more reason to avoid stocks and be long gold. But in my view, it will take longer than many believe, for these imbalances to burst "...As long as the people of the EU put up with this situation and the EU Council (…) effectively kills democracy at the national level AND as long as the Fed continues to extend US dollar swaps, this status quo will remain… Whenever the political sustainability of the EU is challenged, we will see a run for liquidity... The trend is for asset inflation, and will last as long as the people of the EU and the US do not challenge the political status quo..." Unemployment and the tolerance of those unemployed will tell us when the time has come.
With the Fed purchasing $45 billion in Treasury securities across the curve each month, keeping a consistent picture of Ben Bernanke's consolidated, risk-adjusted holdings can be somewhat problematic: the best way to do this is to represent the Fed's $3 trillion balance sheet, of which $1.7 trillion is in Treasurys, in the form of ten year equivalents. A ten-year equivalent is the amount of 10-year notes that must be held by the Fed in order to remove the same amount of interest rate risk from the market as its current holdings. This allows for a uniform representation that eliminates the duration variance along the curve. Looked in this light it may come as a surprise to some that as of this moment, the Fed now owns some 29% of the entire amount of marketable ten-year equivalents outstanding in the entire US bond market.
There may be rotation out of bonds (there isn't), but don't tell the Direct bidders, who submitted a total $22 billion in bids for today's $35 billion Two Year auction, and well below last month's $18.2 billion, and were hit on just under half of this tendered amount, taking down a massive $10.4 billion, or precisely 29.99% of the entire auction. This was the second highest Direct takedown in history only less than October's 35.41%. What is curious is that Indirect buyers, traditionally strong buyers of the 2 Year point on the curve, and taking down on average 31% in the past year, were left with just 18% of the auction, slightly better than last month's record low 17.7%, and the second lowest as far as our time series goes. The balance of 52%, as always, was left to the Primary Dealers, who will promptly turn around and flip it back to the Fed at the first opportunity now that the Fed is monetizing across the curve and not just to the right of the belly. Other metrics of today's auction included a 3.77 Bid to Cover, roughly in line with the trailing 12 month average, and higher than December's 3.59, while the final high yield was not surprisingly, 0.288, just inside of the 0.289% When Issued at 1 PM trading. Overall hardly a flight from Treasurys, at least in the segment where the nominal return is absolutely laughable, and an indication that nobody believes for a second that ZIRP may be ending any time soon.
Call it "X Date", call it "D(elinquent/efault)-Day", call it what you will: it is simply the day past which the US government will no longer be able to rely on "extraordinary measure" to delay the day of reckoning, and will be unable to pay all its bills without recourse to additional debt. It is not the day when the US defaults, at least not defaults on its debt. It will begin "defaulting" on various financial obligations, such as not paying due bills on time and in full, but since this is something Europe's periphery has been doing for years, it is hardly catastrophic. It will hardly be pleasant, however, as some 40% of government obligations go unfunded, and the US is converted to a walking, talking bankruptcy as unsecured claimants rush to demand priority, as the market, long living on hope and prayer, realizes that only now is it truly without a cliff under its feet, and most importantly, as suddenly $500 billion in maturing debt between February 15 and March 1 finds itself in a very, very precarious position.
A well-timed leak of an Obama-Boehner meeting this evening provided enough exuberance to allow algos to lift the markets (futures and ETFs first) from 'about to break the lows' to VWAP (to the tick!). S&P 500 futures picked off VWAP perfectly and slid back. The Dow and the S&P spent the afternoon stuck at unchanged on the week before the rally-monkey saved the day (as did Financials). Treasury yields continue to bleed higher (now up around 10bps on the week). Silver dislocated (worse) from its commodity peers who have recoupled +/-0.3% on the week (even as the USD is -0.6% on the week). Gold and silver (as we noted earlier) really fell out of love from the start of the day-session but silver was starting to recover into the close. AAPL was very close to its lowest close in 10 months (but again was rescued by some rampant white house leak about a totally fruitless rumor) though ended at a critical VWAP support level. By way of record-breakers - today marked the first time that we have seen stocks negative from the day before a QE announcement to the day after (no matter what Bob Pisani tells you). Equities tumbled into the close (after ringing the bell at VWAP) ending near the lows after-hours leaving financials and energy practically unchanged on the week. VIX jumped 0.5 vols to 16.4% and HYG had a very weak day on significant volume. But apart from that...
Markets getting back to some normality with the Periphery still recovering, although less today after the auctions, Bunds 5 wider on the week, Italy 10, but Spain 7 tighter across the curve from last Friday. Equities and Risk oblivious to that anyway and synching with the US. Getting difficult to find something crisp out there with reduced news flow and volatility. Excitement to be found in the US on FC developments, now that Greece, Spain and Italy are seemingly off the table and that the FED has moved to QE4.
"When It's Sleepy Time Down South" (Bunds 1,35% +1; Spain 5,38% +4; Stoxx 2622 -0,2%; EUR 1,308 +40)
No one wants to mention that the Fed Chairman has changed the rules of the game in the middle of the game but there you are; a backsliding Federal Reserve Bank whose statements are only crafted for the moment and future moments may be brief; we just don’t know. Apparently we have transitioned to a “whatever is convenient” policy at the Fed and we all should bear that in mind when assessing probable actions. When money talks, nobody pays any attention to the grammar. The Treasury issues, the Fed prints money and buys, the cost of financing for the country is incredibly low and the yields for investors are paltry. In the risk markets there will now be a demand as instigated by the Fed, that overwhelms the supply of new issuance. Between the coupons paid and the maturities for 2013 the figure is about $1 trillion in excess demand more than estimated forthcoming supply. Given the 36% loss in wealth that took place in America during the 2008/2009 period the odds of an asset allocation shift out of bonds and into equities is de minimis in my opinion and so the “Great Compression” will continue.
Looks like yesterday put into practice: Let’s thank everyone to turn around markets, when they sink. Nothing to break the barn stomp in Periphery bonds (but themselves). Italy brilliantly stuffed its primary dealer at a 2-year low. Core EGBs holding quite steady, given ROn in Risk and Periphery. Strong US GDP revision – but, as expected anyway. Given the actual level in Risk, good numbers are seen as given. Nothing weak, no more, never. Swimming in a Sea of (Risk) Love. Watch the Event / Headline risk on FC (& Greece. The math still seems quite odd…). Hard Periphery (especially Spain) slap-back in the afternoon, though.
"Sea Of Love" (Bunds 1,37% unch; Spain 5,32% +1; Stoxx 2579 +1,3%; EUR 1,298 +50)
Ok. It’s not that the Greek deal is nothing. But then again, third strike. Eventually expected, or at least hoped for. Hence, lack of concrete follow-through. So, now it’s there. And now what? You Ain’t Seen Nothing Yet? What is there to see??? Pitch the markets some input, something concrete, something to feed off, something to see!
"You Ain't Seen Nothing Yet" (Bunds 1,43% +2; Spain 5,51% -9; Stoxx 2538 -0,2%; EUR 1,293 -30)
Hard pressed to find anything remotely exciting today. Equities losing a little shine, but understandable given last week’s 5% rush (and 14% tightening in Credit). Bonds stuck in range. Fiscal Cliff hailing back (in yet rather timid manner, though). Waiting on Greek rescue revelations. Yawn!
"Sailing" (Bunds 1,41% -3; Spain 5,6% unch; Stoxx 2542 -0,4%; EUR 1,296 unch)
Greece? Sorry, what’s with Greece? French downgrade. Unexpected, but then again not that much. So what? Fiscal Cliff? As no one speaks about it, it can be ignored. Risk? If it doesn’t fall, it has to rise.
"Rise To The Occasion" (Bunds 1,43% +2; Spain 5,7% -9; Stoxx 2518 +0,4%; EUR 1,282 +10)
The US crashing close yesterday was cushioned in Europe by better than expected (backward-looking) GDP figures in Germany and France. EZ in recession nevertheless. Limited fall-out, albeit lower (equity) levels tested. Periphery okay’ish, then good on better Italian GDP. Spain tag along with limited own dynamics, mainly trailing Risk assessment. EGBs difficult to move lower from here. Watching the US. Someone. Please. Show the way.
"Are You Gonna Go My Way? " (Bunds 1,34% +0; Spain 5,89% -3; Stoxx 2459% -0,6%; EUR 1,279 +50)