Carry Trade

Another day, another 12 swings of greater than 0.75% in S&P futures as volume slid to the lowest in a week and second lowest in two weeks. Credit and equity markets stayed largely in sync (as they have for the last few days - with slight beta-adjusted underperformance of credit) until around lunchtime and then a funny thing happened to investment grade credit. At around 12:30ET, the most liquid credit index, IG17, gapped tighter as ES and HY reversed briefly off the highs and then IG did not stop - compressing 3-4bps more into the close - notably outperforming HY and ES (its far higher beta cousins). At the same time, the less liquid but hugely levered (and exposed to correlation traders, tail-, and jump-risks), IG9, cracked very notably tighter (from our runs around 15bps) to 147bps. IG9 had held up as markets rallied but this move's magnitude and velocity suggest more than just some hedge adjustments and while the rest of the risk assets we cover were all levitating, this 'capitulation' stands out among them. Dollar weakness of course helped fuel the equity strength and commodities and PMs pushed on all day with gold the most subdued.

The squeeze continued in equities as indices of the most-shorted names handily outperformed the broad market but it was the general aggression with which equity's moved relative to both credit and broad risk assets that will raise eyebrows as rumor after refutation after no-news after denial seemed to have full optionality with all the upside (hope) and no downside (reality). Equities and credit stayed relatively close together until the early afternoon but as we headed into the last hour or two equities were making higher highs as credit lower highs. Combined with underlying relative weakness in financial stocks, net-selling in bonds, and negligible compression in their CDS, it seemed equities may just be tottering but an upper cut from Gasbag and a left cross by YHOO/MSFT and ES took off to the races - well beyond credit, broad-risk-assets, and sense. After hours, ES pulled back closer to fair with credit indices and context but remains considerably 'better-looking' than most other assets would infer.

What was already a relatively volatile morning as we lead up to the European close, paused for an hour or two until the FOMC statement was released. Immediately, stocks ripped and dipped, the TSY curve started to flatten - pivoting around the 7-10Y, the USD took off, commodities and PMs dropped, and credit cracked wider. Somewhat interestingly, while all this chaos was occurring, ES remained relatively well behaved with regard a broad basket of risk assets - which while not a positive per se, did indicate that this was a very broad de-risking and not simply an overly excitable US equity market prone to vicious dips, rallies, and retracements. It seems very obvious now, and fit with our indications of an exuberant equity market relative to the 2s10s30s fly, credit, and risk in general, that the rally in equities (which baffled anyone with common sense given the background of worsening macro data) was on pure hope and perhaps the sell-off's harshness today will have burned a few fingers as it seems the Bernanke Put strike just moved a lot further out-of-the-money.

UPDATE: Appended some equity-credit relative-value perspective.

Congratulations Ben: you succeeded in getting the 30s to a near record low level (and by far the lowest for 2011) , which also means that the entire curve will soon be flat as a pancake, killing Net Interest Margin, aka curve carry for the banks, momentarily. Good bye Bank of America. Have fun riding that bear market rally with no financial leadership for the next several years.

In what is probably the riskiest escalation of the second credit crisis to date, IFR has released information that was until now speculated, but not confirmed, namely that European banks not only continue to make a mockery out of LiEbor by posting whatever rates they deem appropriate (for the simple reason they don't use interbank funding), while in the meantime going directly to US banks, using shadow, and hence completely unregulated conduits, in the form of private repo arrangements with "at least three of the five biggest US banks." Now where this is interesting is that as Zero Hedge disclosed three months ago, the bulk of the cash generated for the pendancy of QE2 went not to US banks, but to US-based branches of foreign banks. Which probably means that there is a roadblock to repatriating the US held cash (even in exchange for perfectly legitimate receivable debits). Because one would think that this is where the first source of cash for troubled banks would come from. Assuming it hasn't been repatriated already, or is not stuck in some IOER-GC carry trade that generates virtually no return (and when the Fed lowers IOER even more, absolutely no return). Alas this means that the 3M USD Libor which we update every day is substantially under-representing the true funding squeeze in Europe. Even worse, it means that US banks have lent us tens, if not hundreds of billions of cash, in exchange for collateral that could be virtually anything, and which collateral bypasses traditional Fed supervision. As a result, US banks can and will go hog wild in lending repo dollars (at big collateral haircuts but still) to European banks until everyone suddenly runs out of money, and the Fed realizes it has to not only fill traditional liquidity holes, but a massive shadow banking shortfall, precisely the stuff that none other than the Fed has been warning about over and over. Just like in 2008 when the big hit to the system came not from traditional sources of risk but perfectly innocuous and thus ignored money markets, so the same will happen this time, as the biggest crunch will come completely out of left field. It always does.

In my opinion, the Swiss and Brazilian moves signaled the true beginning of the global currency wars. The depreciation race to the bottom has begun. Trade wars will be next. This is just getting started. Once FX interventions fail, governments suffering from falling exports will attempt to protect local champions via protective taxes, tariffs and the limiting of certain imports. Affected governments and industries will retaliate for their own loss of exports and so on and so forth. Welcome to the currency wars....Bottom line: now is a great time to get out of govt paper and many miles away from the large US and European banks. I am a broken record on this but you should own gold and silver miners, fertilizer companies, oil companies and water companies. Some technology stocks could make sense and reasonable exposure to Asia and Latam. Corporate bonds of companies providing any of the products listed above (gold/silver, fertilizers, oil and water) makes a ton of sense. I would avoid the large multi-nationals here as I think trade wars are coming and their cash flows from foreign operations are about to come under fire.

While we often pick on Morgan Stanley's Jim Caron (the same guy who year after year after year keeps predicting the yield on the 10 year will soar, and not just soar, but soar for all the wrong reasons, such as bull steepening and what not), has just diametrically changed his tune, by bringing us, drumroll please, Operation Torque. To wit: "Policy makers in both the US and Europe get back to work in September, and this month will be rife with deliberations on stimulus and market support policies. In our view, a duration extension to the Fed's SOMA portfolio is an optimal policy tool to engender easing. This can initially be done through extending the duration of reinvestments from MBS and agency holdings but may ultimately culminate in selling shorter-duration USTs in its SOMA portfolio in exchange for buying longer duration assets (‘Operation Torque’, as we at Morgan Stanley have dubbed it)." Why 2 Years? Because as per the August 9 FOMC statement, we know that there will no rate hike for the next 2 Years, and hence no duration risk. Which means that the Fed can sell an infinite amount of paper into a mid-2013 horizon without worrying about demand destruction. And by doing so it will, as we have been predicting since May, expand the duration of its portfolio, in the process pushing investors into risky assets for the third time in as many years. But there is a twist...

What are the chances rate volatility, excess supply from a burst bubble and insolvent banks causes a CRE crash on both sides of the Atlantic? Yeah, if only all test questios were that easy...

One of the key catalysts for Wednesday's market rout which originated in Europe came following news that Chinese banks had cut down on their credit lines to Europe, which highlighted the key threat to the European banking system: access to liquidity. The Chinese reaction is merely a symptom of a much deeper underlying ailment: the increasing lack of counterparty confidence across various funding markets, both traditional and shadow, which has continued to accelerate over the past week, a development summarized effectively by the latest report in the International Financing Review which uses some powerful words (of the type that European bureaucrats hate) to explain where Europe stands right now: "credit taps run dry for European lenders, setting scene for liquidity crisis." For those strapped for time the take home message is that: "with bond markets shut and investors unwilling to buy asset-backed securities, the repo market – for some banks the sole remaining source of private funding – has become the most recent tap to run dry, with some investment banks pulling credit lines worth tens of billions of euros in recent weeks." This is very disturbing as with liquidity windows shut, Europe's bank have no recourse on how to roll the €4.8 trillion in wholesale and interbank funding which expires in the next two years. End result: the only recourse is the ECB, which unlike the Fed, is not suited to be a lender of last resort and has been morphing into that role over the past year kicking and screaming. And when that fails, there are the Fed's liquidity swap lines. Too bad that the liabilities in the European banking system are orders of magnitude bigger than in the US, and should this liquidity crisis transform into its next and more virulent phase, even the Fed will find it does not have enough capital to prevent a worldwide short squeeze on the world's carry trade funding currency (once known as the reserve currency).

It's getting hot out again. Especially on Wall Street.

David Galland:
You were involved with Harry Browne during the last great inflation in
the U.S. How does the increase in the money supply that kicked off in
2007-2008 compare in terms of scale to what went on leading up to the
inflation in the ‘70s?

Terry Coxon: The
comparison is pretty muddled. In terms of the M1 money supply – the
total of checkable deposits and hand-to-hand currency – we haven’t yet
gotten near the persistently high growth rate that occurred in the
1970s. But the growth in the monetary base has been far more rapid than
what happened in the 1970s. There is some time delay between growth in
the monetary base and growth in M1, but to make the picture really
cloudy, I'm afraid the comparison turns out not to be very useful.
Unlike in the 1970s, the Federal Reserve is now paying interest to banks
on their reserves.

Technically the title of this post is wrong: the truth is that nobody could possibly know or predict what a bank run would looks like in details suffice to say that it would have terminal and devastating results on the global economy. One needs only remember what happened when the Reserve Fund broke the buck and the $3 billion money market industry was at risk of unwinding (for those who do not, Paul Kanjorski does a good summary here). What we do, however, wish to demonstrate is the tenuous balance between physical money - yes, just like precious metals, there is actual "physical money", better known as currency in circulation - and more abstract, confidence-based, "electronic money." Now when it comes to talking about systemic instability, pundits often enjoy bringing up the case of the $600+ trillion (recently discussed here in a different capacity) in synthetic derivatives, whose implosion would "wipe out the world." While that may indeed be the case (the memory of the CDS-precipitated AIG implosion is still all too fresh), since nobody really can comprehend the side effects of the collapse of global derivative system, which by some estimates is over $1 quadrillion when combining exchange and OTC based derivatives, it is largely based on pure conjecture. And, as we demonstrate below, one doesn't even need to do get that high up in the pyramid of credit money. The truth is that should there be an American bank run, what would happen is the conversion of all electronic dollars into physical dollars, as retail Americans rush to empty their checking and savings accounts, exit their money markets, while institutional America converts all "shadow" liabilities into hard dollar assets (Zero Hedge has a specific methodology of defining what liabilities make up the shadow banking system). The truth is that should there be a D-Day in the American banking system and there is a global scramble for physical paper (ignore gold) the conversion ratio for binary dollars into hard ones could be as high as 30 to 1. Which begs the question: should one apply a 90% discount when evaluating their electronic dollar exposure? That, and many other questions too...

Financial power is to achieve what military conquest had done in times past.

All the talk about a dollar currency crisis is getting ahead of itself. Quoting Mises won’t make it happen overnight. It takes years, even decades for a reserve currency to dissipate. Instead of wholesale collapse, the most likely outcome is a steady decline in the dollar over an extended period of time. Of course there is a tail possibility of a collapse, and that is why hedges exist. But the high likelihood trend is persistent policy action to drive the dollar lower with respect the United States trading partners’ currencies, combined with a decline in the dollar’s use as a vehicle currency. This means serious dollar weakness for the next three years (or more), but not collapse.

Zero Hedge was the first to observe the curious phenomenon of the collapse in the General Collateral-IOER carry trade following the implementation of the FDIC assessment rate back in early April (discussed in depth here) which continues to force repo rates far below where they would ordinarily be (and is generating an undue amount of stress on short end rates, impacting money markets, repo, and other shadow economy components, and also substantially complicating an unwind by the Fed if and when one occurs). But that's not all. As Barclays' Joseph Abate points out, another consequence, which is rapidly becoming appreciate by repo market players, is that up to a third of all Treasury repo volume now trades at sub zero rates, making life for money markets a living hell, which perhaps that was the goal all along... And while the fails rates for the time being has not picked up substantially (liquidity is still ample although if the Fed continues to pummel the market with its foolhardy sale of Maiden Lane II securities this may change, more on this later), it does present a complication for the Fed, should Bernanke decided to halt securities reinvestment. Granted it appears this will not be a major worry at a time when some believe QE3 is a given, and others believe QE2 Lite will be precisely the ineffectual, yet critical reinvestment of maturity securities.