Yield Curve

Risks surrounding the looming release of the latest jobs report by the BLS later on in the session failed to weigh on sentiment and heading into the North American open, stocks in Europe are seen higher across the board. The SMI index in Switzerland outperformed its peers since the get-go, with Swatch Group trading up over 3% after the company said that it expects good results for 2013 at operating profit and net income level. At the same time, in spite of stocks trading in the green, Bunds remained better bid, with peripheral bond yield spreads wider as market participants booked profits following the aggressive tightening observed earlier in the week amid solid Spanish bond auctions, as well as syndications by Ireland and Portugal. Fake Chinese trade data failed to boost Chinese stocks, which dropped anoter 0.7% and is just 13 points above 2000 as Shanghai remains one of the world's worst performing markets since the financial crisis. The yoyoing Nikkei was largely unchanged. All eyes today will be fixed on the headline streamer at 8:30 when the latest nonfarm payrolls report is released.

Unintended consequences may have developed from QE policies that are not fully understood.  They may materialize more clearly during the withdrawal process.  Any of a number of obstacles could push the Fed ‘off course’ from the smooth landing that its baseline scenario suggests: 

• Certainly, expanding the balance sheet by over $3 trillion has had a significant impact on valuations, market functioning, and asset allocation, so those effects could cause some market turbulence as they revert back to normal.
• Emerging markets, which benefited heavily in the early years of QE, have recently shown some disruptions, such as, slowing economic growth, weakening currencies, and capital outflows.
• Political and social concerns about income and wealth inequalities have grown due to the use of asset prices as a policy tool.
• Structural unemployment from long-term joblessness and technological advancement cannot be addressed through easy money.
• Politics is still polarizing, which in turn creates on-going economic headwinds.

A look at the technical condition of the fx market, interest rate differentials, central bank developments and the data due out in the week ahead.  

"We simulated an adverse interest rate shock to estimate losses by bond funds from an instantaneous parallel shift in the yield curve of 100 basis points from current levels. We then compared the impact of such losses in today’s context to loss rates from a similar hypothetical scenario during the three previous periods of U.S. monetary policy tightening. Losses during each tightening cycle are calculated by averaging monthly estimated losses, where the Barclays Capital U.S. Aggregate Bond Index is used as a proxy for duration and mutual fund bond holdings are based on data from the Investment Company Institute. Figure 15 shows that losses could rise to nearly $200 billion, underscoring that current bond portfolios are vulnerable to a sudden, unanticipated rise in long-term rates."

• the risk of runs and asset fire sales in repurchase (repo) markets;
• excessive credit risk-taking and weaker underwriting standards;
• exposure to duration risk in the event of a sudden, unanticipated rise in interest rates;
• exposure to shocks from greater risk-taking when volatility is low;
• the risk of impaired trading liquidity;
• spillovers to and from emerging markets;
• operational risk from automated trading systems, including high-frequency trading; and
• unresolved risks associated with uncertainty about the U.S. fiscal outlook.

After the fireworks following yesterday's weak 10yr auction, tensions were high going into today's 30yr bond auction.

We warned here (and here most recently), the most insidious way in which the Fed's ZIRP policy is now bleeding not only the middle class dry, but is forcing companies to reallocate cash in ways that benefit corporate shareholders at the present, at the expense of investing prudently for growth 2 or 3 years down the road. It seems the message is being heard loud and very clear among 'some' of the FOMC members; most notably Richard Fisher:

"Without fiscal policy that incentivizes rather than discourages U.S. capex (capital expenditure), this accommodative monetary policy aimed at reducing unemployment (especially structural unemployment) or improving the quality of jobs is rendered flaccid and less than optimally effective... I would feel more comfortable were we to remove ourselves as soon as possible from interfering with the normal price-setting functioning of financial markets."

Perhaps Yellen (and others) will listen this time?

It is only fitting that on the morning in which Europe levied the largest cartel fine in history against the criminal syndicate known as "banks", that Goldman Sachs would issue its #6 "Top Trade Recommendation" for 2014 which just happens to be, wait for it, a "long position in large-cap bank indices in the US, Europe and Japan." Supposedly, in a reflexive back and forth that should make one's head spin, this also includes Goldman Sachs (unless they specifically excluded FDIC-insured hedge funds, which we don't think was the case). So is Goldman recommending... itself? Joking aside, this means Goldman is now dumping its bank exposure to muppets.

While the idea of the interventionist suppression of short-term 'normal' volatility leading to extreme volatility scenarios is not new, hearing it explained so transparently by a current (and practicing) central banker is still somewhat shocking. As Buba's Jens Weidmann recent speech at Harvard attests, "The idea of monetary policy safeguarding stability on multiple fronts is alluring. But by giving in to that allure, we would likely end up in a world even less stable than before."

If yesterday Goldman was pitching going long of the S&P in AUD terms (the world renowned Goldman newsletter may cost $29.95 but is only paid in soft dollars) as its first revealed Top Trade of 2014, today's follow up exposes Top Trade #2: which is to "Go long 5-year EONIA vs. short 5-year US Treasuries." Goldman adds: "The yield differential between these two financial instruments is currently -61bp, and we expect it to reach around -130bp. On the forwards, the differential is priced at around -95bp at the end of 2014 at the time of writing. We have set the stop-loss on the trade at a spread of -35bp. The choice of Treasuries over OIS or LIBOR on the short leg is motivated by the fact that yields on the former could underperform more than they have already in relative space as the Fed scales down its asset purchase program."

It is time for the centrally-planned markets to "try" for the round number trifecta of 16000, 1800 and 4000 again, although it may be a tad more difficult on a day in which there is no double POMO and just $2.75-$3.50 billion will be injected by the NY Fed into the S&P - perhaps it is Bitcoin that will hit the nice round number of $1000 first? Overnight, the Chinese Plenum news rerun finally was priced in and the SHComp closed red, as did the Nikkei 225 as the Asian euphoria based on communist promises about what may happen by 2020 fades.  What's worse, the Chinese 7-day repo rate is up 140bp this morning to 6.63% amid talk of tightening domestic liquidity conditions, and back to levels seen during the June liquidity squeeze. All this is happening as China continues leaking more details and hope of what reform the mercantilist country can achieve, and how much internal consumption the export-driven country can attain: overnight there were also additional reports of interest rate liberalization and that the PBOC are to set up a floating CNY rate. Good luck with that.

This week an article in Euromoney points out that liquidity in bond markets is drying up. The blame is laid at the door of regulations designed to increase banks' capital relative to their balance sheets. Furthermore, the article informs us, new regulations restricting the gearing on repo transactions are likely to make things worse, not only reducing bond market liquidity further, but also affecting credit markets. The reason this will be so is that in a repurchase agreement a bank supplies credit to non-banks for the period of the repo. One could take another equally valid point of view: the reason for deteriorating liquidity in bond markets is due in part to yields being unnaturally low.

The philosophical roots of Janet Yellen's economics voodoo, it seems, are in many ways even more appalling than the Bernanke paradigm (which in turn is based on Bernanke's erroneous interpretation of what caused the Great Depression, which he obtained in essence from Milton Friedman). The following excerpt perfectly encapsulates her philosophy (which is thoroughly Keynesian and downright scary): Fed Vice Chairman Yellen laid out what she called the 'Yale macroeconomics paradigm' in a speech to a reunion of the economics department in April 1999. "Will capitalist economies operate at full employment in the absence of routine intervention? Certainly not," said Yellen, then chairman of President Bill Clinton's Council of Economic Advisers. "Do policy makers have the knowledge and ability to improve macroeconomic outcomes rather than make matters worse? Yes," although there is "uncertainty with which to contend." She couldn't be more wrong if she tried. We cannot even call someone like that an 'economist', because the above is in our opinion an example of utter economic illiteracy.

Here we go again, creating another asset bubble for the third time in a decade and a half, is how Monument Securities' Paul Mylchreest begins his latest must-read Thunder Road report. As Eckhard Tolle once wrote, “the primary cause of unhappiness is never the situation but your thoughts about it," and that seems apt right now. After Lehman, policy makers went “all-in” on bailouts/ZIRP/QE etc. This avoided an “all-out” collapse and bought time in which a self-sustaining recovery could materialize. The Fed’s tapering threat showed that, five years on from Lehman, the recovery was still not self-sustaining. Mylchreest's study of long-wave (Kondratieff) cycles, however, leaves us concerned as to whether it ever will be. More commentators are having doubts; and the problem looming into view is that we might need a new "plan." The (rhetorical) question then is "Have we really got to the point where it's just about more and more QE, corralling more and more flow into the equity market until it becomes (unsustainably) 'top-heavy'?"

If there is one single event that could derail the euro experiment it is the German Federal Constitutional Court ruling on the European Stability Mechanism (ESM) and Outright Market Transactions (OMT).