Yield Curve

By the time Operation Twist (1) ends in just over 40 days time, on June 30, Fed Chairman Ben Bernanke, according to his previously announced "loose" target, will hope to have extended the average maturity of all bonds in the System Open Market Account (SOMA) to a record of roughly 100 months from 75 month at the onset of the program in October 2011. After all the sole purpose of Twist was to load up the Fed's portfolio with duration, forcing the rest of the market to shift its investing curve even further into risky assets, as the Fed will have effectively onboarded the bulk of securities in the 3-4% return interval. Now as we showed back in early April, hopes that the Fed will simply continue with Operation Twist 2 after the end of "season" 1, as suggested by some clueless "access journalists" who merely relay what they are told by higher powers, are completely misguided as the Fed simply does not have enough short-term securities (1-3 years) to sell, and would have at most 2 months of inventory for a continued sterilized operation. Which however, does not mean that the Fed can not be quietly ramping up its operations in the ongoing Twisting episode. Because as Stone McCarthy demonstrates, as of the past week, the Fed has already surpassed its 100 month maturity target of 100 months, and is at 102.82 months as of May 16. And this is with 6 more weeks of Twist to go: at the current rate of SOMA purchases, the Fed will have a total portfolio average maturity of just shy of 110 months by June 30! Which means that contrary to market expectations of what the Fed's own stated goal may have been, Bernanke will have gobbled up nearly 40% more long-dated Flow relative to estimates! In other words, Ben does not need to do a full blown Operation Twist 2 episode: by the time Twist 1 is over, he will have attained nearly 40% of the goals of the next potential sterilized operation.

A rare moment of optimism from David Rosenberg: "I've said it once and I'll say it again. And believe me, this is no intent to wrap myself up in stars and stripes. But there is a strong possibility that I see a flicker of light come November. The U.S. has great demographics with over 80 million millennials that will power the next bull market in housing, likely three years from now. After an unprecedented two straight years of a decline in the stock of vehicles on the road, we do have pent-up demand for autos. I coined the term "manufacturing renaissance" back when I toiled for Mother Merrill and this is happening on the back of sharply improved cost competitiveness. Oil production and mining services are booming. Cheap natural gas is a boon to many industries. A boom in Chinese travel to the U.S. has triggered a secular growth phase in the tourism and leisure industry. The trend towards frugality has opened up doors for do-it-yourselfers, private labels and discounting stores.... Few folks saw it at the time. But it's worth remembering, especially now as we face this latest round of economic weakness and market turbulence. It is exactly in periods of distress that the best buying opportunities are borne...and believe it or not, when new disruptive technologies are formed to power the next sustainable bull market and economic expansion. Something tells me that we are just one recession and one last leg down in the market away from crossing over the other side of the mountain. And believe me, nobody is in a bigger hurry to get there, than yours truly. At the risk of perhaps getting too far ahead of myself, but you may end up calling me a perma-bull (at that stage, I must warn you, folks like Jim Paulsen will have thrown in the towel)."

We are in the last innings of a very bad ball game. We are coping with the crash of a 30-year–long debt super-cycle and the aftermath of an unsustainable bubble. Quantitative easing is making it worse by facilitating more public-sector borrowing and preventing debt liquidation in the private sector—both erroneous steps in my view. The federal government is not getting its financial house in order. We are on the edge of a crisis in the bond markets. It has already happened in Europe and will be coming to our neighborhood soon. The Fed is destroying the capital market by pegging and manipulating the price of money and debt capital. Interest rates signal nothing anymore because they are zero. Capital markets are at the heart of capitalism and they are not working.

Stocks are currently priced for a 10% growth rate which makes bonds a safer investment in the current environment which cannot deliver 10% rates of returns. We are no longer in the era of capital appreciation and growth. The “baby boomers” are driving the demand for income which will keep pressure on finding yield which in turn reduces buying pressure on stocks. This is why even with the current stock market rally since the 2009 lows - equity funds have seen continual outflows. The “Capital Preservation” crowd will continue to grow relative to the “Capital Appreciation” crowd.... According to the recent McKinsey study the debt deleveraging cycles, in normal historical recessionary cycles, lasted on average six to seven years, with total debt as a percentage of GDP declining by roughly 25 percent. More importantly, while GDP contracted in the initial years of the deleveraging cycle it rebounded in the later years.

Few have been as steadfast in their correct call that the US economy sugar high of the first quarter was nothing but a liquidity-driven, hot weather-facilitated uptick in the economy, which has now ended with a thud, as seen by the recent epic collapse in all high-frequency economic indicators, which have not translated into a market crash simply because the market is absolutely convinced that the worse things get, the more likely the Fed is to come in with another round of nominal value dilution. Perhaps: it is unclear if the Fed will risk a spike in inflation in Q2 especially since as one of the respondents in today's Chicago PMI warned very prudently that Chinese inflation is about to hit America in the next 60 days. That said, here are some of today's must read observations on where we stand currently, on why 1937-38 may be the next imminent calendar period deja vu, and most importantly, the fact that Rosie now too has realized that the next credit bubble is student debt as we have been warning since last summer.

Krugmann fails to address even a single one of the arguments forwarded by Spitznagel. This is no surprise, as he has often demonstrated he does not even understand the arguments of the Austrians and moreover has frequently shown that his style of debate consists largely of attempts to knock down straw men.  After appraising us of his economic ignorance (see the idea that time preferences can actually 'go negative' implied by his argument on the natural interest rate above), he finally closes a truly Orwellian screed by claiming that everybody who is critical of the Fed and the financial elite is guilty of being 'Orwellian'. As we often say, you really couldn't make this up.

"It won't be long before CPI is back above 1%", we promise, this time - we really mean it - is seemingly how the BoJ defends its decision to follow Einstein's definition of insanity  by doing the same thing over and over again expecting a different outcome (Nov 2008 was the last time CPI was above 1% YoY). Admittedly, at some point the ever-increasing BoJ balance-sheet-to-GDP will become too much even for a nation hell-bent on printing its way out of chronic deflation only to be punched-and-kicked by a balance-sheet-recession so deep and full of deleveragers. The facts are that the BoJ will expand its LSAP-equivalent program by JPY10tn (USD123bn) - raising the 'stock' - but maintaining the same pace of JGB-buying at JPY1.8tn per month - leaving the 'flow' stable - hence extending the program by around six months. At the same time they have extended the maturity of JGB purchases from 2Y to 3Y (try and wring a little more duration out of an already starved yield curve). USDJPY was entirely confused out of the gate and rallied immediately only to about-face and sell-off up to 81.45 before already giving back half of its losses to pre-BoJ anouncement. The JPY sell-off implicit carry moves did nothing to move US equity futures (which limped up 1-2pts and then gave it back) and even the NKY has retraced 65% of its post-BoJ gains. Perhaps it is all about the flow and the need for that second derivative to be constantly rising after all? Whether it is repatriation flows or carry-unwinds, JPY devaluation (as we have discussed Andy Xie's perspective on) may just have to be done 'forcefully' as opposed to 'suggestively'.

"In the last three plus years, central banks have had little choice but to do the unsustainable in order to sustain the unsustainable until others do the sustainable to restore sustainability!" is how PIMCO's El-Erian introduces the game-theoretic catastrophe that is potentially occurring around us. In a lecture to the St.Louis Fed, the moustachioed maestro of monetary munificence states "let me say right here that the analysis will suggest that central banks can no longer – indeed, should no longer – carry the bulk of the policy burden" and "it is a recognition of the declining effectiveness of central banks’ tools in countering deleveraging forces amid impediments to growth that dominate the outlook. It is also about the growing risk of collateral damage and unintended circumstances." It appears that we have reached the legitimate point of – and the need for – much greater debate on whether the benefits of such unusual central bank activism sufficiently justify the costs and risks. This is not an issue of central banks’ desire to do good in a world facing an “unusually uncertain” outlook. Rather, it relates to questions about diminishing returns and the eroding potency of the current policy stances. The question is will investors remain "numb and sedated…. by the money sloshing around the system?" or will "the welfare of millions in the United States, if not billions of people around the world, will have suffered greatly if central banks end up in the unpleasant position of having to clean up after a parade of advanced nations that headed straight into a global recession and a disorderly debt deflation." Of course, it is a rhetorical question.

In a few weeks the Treasury will most likely launch Floating Rate Notes. Will that be the signal to get out of Dodge? If history is any precedent, and especially the 1951 Accord... you bet.

The one sentence that may change everything: "...we have found some evidence that at the very long end of the yield curve, where Operation Twist is concentrated, it may be not just the stock of securities held by the Fed but also the ongoing flow of purchases that matters for yields..."

• China's Central Banker to Fed: Act Responsibly (WSJ)
• Spain's debt to jump to 78 percent of GDP: De Guindos (Reuters)
• Rajoy Needs All the Luck He Can Get (WSJ)
• Spain Faces Risks in Budget Refit (WSJ)
• Top JP Morgan banker resigns to fight abuse fine (Reuters)
• Reinhart-Rogoff See No Quick U.S. Recovery Even as Data Improve (Bloomberg)
• Program to help spur spending in domestic sector (China Daily)
• Barnier hits out at lobbying ‘rearguard’ (FT)
• U.S. CEOs' take-home pay climbs on stock awards (Reuters)

In the not quite 100 years since the founding of your institution, America has exchanged central banking for a kind of central planning and the gold standard for what I will call the Ph.D. standard. I regret the changes and will propose reforms, or, I suppose, re-reforms, as my program is very much in accord with that of the founders of this institution. Have you ever read the Federal Reserve Act? The authorizing legislation projected a body “to provide for the establishment of the Federal Reserve banks, to furnish an elastic currency, to afford means of rediscounting commercial paper and to establish a more effective supervision of banking in the United States, and for other purposes.” By now can we identify the operative phrase? Of course: “for other purposes.” As you prepare to mark the Fed’s centenary, may I urge you to reflect on just how far you have wandered from the intentions of the founders? The institution they envisioned would operate passively, through the discount window. It would not create credit but rather liquefy the existing stock of credit by turning good-quality commercial bills into cash— temporarily. This it would do according to the demands of the seasons and the cycle. The Fed would respond to the community, not try to anticipate or lead it. It would not override the price mechanism— as today’s Fed seems to do at every available opportunity—but yield to it.

With ZIRP and LTRO it is hard to get a good read on the Spanish yield curve and what anything means.  Spanish 10 year yields have risen 9 days in a row, 5 year yields have moved higher 8 out of 9 days, and the 2 year has been much more mixed, until recently. The 2 year yield is out 19 bps in those 9 days, but 18 bps of that move has occurred the last 2 days.  The 2 year bond fits the sweet spot of LTRO, is likely to be held by banks in non mark to market accounts, so it has been stable, but it has even started to leak a little.  The move is small, almost trivial, yet with all the things working to support 2 year bonds, it is curious that it is able to widen at all, let alone 18 bps in 2 days.

Following the latest temporary swoon in gold, the PM naysayers have once again crawled out of the woodwork, like a well tuned Swiss watch (made of 24K gold of course). Of course, they all crawl right back into their hole never to be heard of again until the next temporary drop and so on ad inf. Naturally, the latest incursion of "weak hand" gold longs is screaming bloody murder because the paper representation of the value of their hard, non-dilutable, physical gold is being slammed for one reason or another. Ironically, these same people tend to forget that the primary driver behind the value of gold is not for it to be replaced from paper into paper at some point in the future, but to provide the basis for a solid currency following the reset of a terminally unstable system, unstable precisely due to its reliance on infinitely dilutable currency, and as such any cheaper entry point is to be applauded. Yet it seems it is time for a refresh. Luckily, SocGen's Dylan Grice has coined just that with a brief explanation of "when to sell gold" which while having a modestly different view on the intrinsic value of gold, should provide some comfort to those for whom gold is not a speculative vehicle, but a true buy and hold investment for the future. And in this day and age of exponentially growing central bank balance sheets (chart), this should be everyone but the die hard CNBC fanatics. In brief: "Eventually, there will be a crisis of such magnitude that the political winds change direction, and become blustering gales forcing us onto the course of fiscal sustainability. Until it does, the temptation to inflate will remain, as will economists with spurious mathematical rationalisations as to why such inflation will make everything OK. Until it does, the outlook will remain favorable for gold. But eventually, majority opinion will accept the painful contractionary medicine because it will have to. That will be the  time to sell gold."