Yield Curve

Over the weekend, we commented on Dylan Grice's seminal analysis which excoriates the central planning "fools", who are perpetually caught in the "lost pilot" paradigm, whereby the world's central planners increasingly operate by the mantra of “I have no idea where we’re going, but we’re making good time!” and which confirms that in the absence of real resolutions to problems created by a century of flawed economic models, the only option is to continue doubling down until terminal failure. Basically, the take home message there is that once "economists" get lost in trying to correct the errata their own models output as a result of faulty assumptions (which they always are able to "explain away" as one time events), they drift ever further into unknown territory until finally we end up with such monetary aberrations as "liquidity traps", "zero bound yields" and, soon, NIRP (which comes after ZIRP), if indeed the Treasury proceeds with negative yields beginning in May under the tutelage of the Goldman-JPM chaired Treasury Borrowing Advisory Committee. Today, it is Bill Gross who takes the Grice perspective one step further, and looks at implications for liquidity, and the lack thereof, in a world where one of the three primary functions of modern financial intermediaries - maturity transformation (the other two being credit and liquidity transformation) is terminally broken. He then juxtaposes this in the context of Hyman Minsky's monetary theories, and concludes: "What incentive does a US bank have to extend maturity to a two- or three-year term when Treasury rates at that level of the curve are below the 25 basis points available to them overnight from the Fed? What incentive does Pimco or banks have to buy five-year Treasuries at 75bp when the maximum upside capital gain is two per cent of par and the downside substantially more?" In other words, Pimco is finally grasping just how ZIRP is punking it and its clients. It also means that very soon all the maturity, and soon, credit risk of the world will be on the shoulders of the Fed, which in turn labor under a false economic paradigm. And one wonders why nobody has any faith left in these here "capital markets"...

Following our note on the flattening (and update on the steepening) in the Chinese yield curve (RMB 10Y - 2Y to be specific) last November, we have continued to keep an eye on the relationship between the Shanghai Composite and the bond market for signals that all is not well in the recent 'soft-landing' rally. While Chinese shares have seen their best January ever, the RMB curve has flattened quite notably. As Morgan Stanley points out in an FX Pulse update today, the yield curve is an early indicator for local shares, which should not be a surprise given the still restricted Chinese capital account. While we have seen this kind of divergence in the US (where given free capital flows the relationship between yield urves and the equity market has loosened over the past 30 years), in China the relationship is still tight and further flattening of the Chinese curve would call into question the equity market rally (and soft-landing thesis). The flattening RMB yield curve suggests the local bond market has become skeptical of Chinese growth prospects. Should the RMB curve flatten further from here, the anticipated decline of commodity currencies (AUD most specifically for US equity carry traders) could be sooner than expected.

While sounding just a tad preachy in his February newsletter, Bill Gross' latest summary piece on the economy, on the Fed's forray into infinite ZIRP, into maturity transformation, and the lack thereof, on the Fed's massive blunder in treating the liquidity trap, but most importantly on what the transition from a levering to delevering global economy means, is a must read. First: on the fatal flaw in the Fed's plan: "when rational or irrational fear persuades an investor to be more concerned about the return of her money than on her money then liquidity can be trapped in a mattress, a bank account or a five basis point Treasury bill. But that commonsensical observation is well known to Fed policymakers, economic historians and certainly citizens on Main Street." And secondly, here is why the party is over: "Where does credit go when it dies? It goes back to where it came from. It delevers, it slows and inhibits economic growth, and it turns economic theory upside down, ultimately challenging the wisdom of policymakers. We’ll all be making this up as we go along for what may seem like an eternity. A 30-50 year virtuous cycle of credit expansion which has produced outsize paranormal returns for financial assets – bonds, stocks, real estate and commodities alike – is now delevering because of excessive “risk” and the “price” of money at the zero-bound. We are witnessing the death of abundance and the borning of austerity, for what may be a long, long time." Yet most troubling is that even Gross, a long-time member of the status quo, now sees what has been obvious only to fringe blogs for years: "Recent central bank behavior, including that of the U.S. Fed, provides assurances that short and intermediate yields will not change, and therefore bond prices are not likely threatened on the downside. Still, zero-bound money may kill as opposed to create credit. Developed economies where these low yields reside may suffer accordingly. It may as well, induce inflationary distortions that give a rise to commodities and gold as store of value alternatives when there is little value left in paper." Let that sink in for a second, and let it further sink in what happens when $1.3 trillion Pimco decides to open a gold fund. Physical preferably...

As of a few hours ago, Goldman's Francesco Garzarelli has officially told the firm's clients to go ahead and short 10 Year Treasurys via March 2012 futures, with a 126-00 target. While Garzarelli is hardly Stolper (and we will have more on the latest Stolpering out in a second), the fact that Goldman is now openly buying Treasurys two days ahead of this week's FOMC statement makes us wonder just how much of a rates positive statement will the Fed make on Wednesday at 2:15 pm. From Goldman: "Since the end of last August, we have argued that 10-yr US Treasury yields would not be able to sustain levels much below 2% in this cycle. Yields have traded in a tight range around an average 2% since September, including so far into 2012. We are now of the view that a break to the upside, to 2.25-2.50%, is likely and recommend going tactically short. Using Mar-12 futures contracts, which closed on Friday at 130-08, we would aim for a target of 126-00 and stops on a close above 132-00." As a reminder, don't do what Goldman says, do what it does, especially when one looks the firm's Top 6 trades for 2012, of which 5 are losing money, and 2 have been stopped out less than a month into the year.

Are the markets already front running a potential announcement of a third round of Quantitative Easing (QE 3)?   Maybe so.  We had expected QE3 at the end of last summer as the economy weakened substantially from the impact of the Japanese earthquake/debt ceiling debate/Eurozone crisis trifecta.  However, with political pressures running high due to the raging battle in Congress raising the debt ceiling there was little support from the public for further intervention.  Furthermore, with inflation, as measured by CPI, already outside of the Fed's comfort zone, the Fed opted to institute "Operation Twist" (O.T.) instead. With the Euro-Crisis on the broiler, another debt ceiling debate approaching, the U.S. economy struggling along as Europe slips into a recession and corporate earnings being revised down there are plenty of reasons for stocks to decline in price.  Yet, they have continued to inch up.  With short interest on stocks having plunged in recent weeks it certainly sounds like the markets are betting on something happening and soon.

Yesterday, in a must read post, Gluskin Sheff's David Rosenberg played the devil's advocate and presented a much needed experiment in contrarianism, attempting to unravel what it is that bulls may be seeing in the economy and the market (an analysis which may have to be revised after today's pro forma 400K in initial claims and deplorable retail sales update). While we don't know if anyone was converted into the permabullish fold as a result, it certainly was useful to have a view of what "sliding down the wall of satisfaction" means currently . Today, Rosie is back to his traditional skeptical self with today's publication of the "Laments of a Bear", which is yet another must read inverse view of everything that yesterday was not. Our advise to readers: be aware of both sides of the argument and make up your own mind. Plus at the end of the day the only thing that really matters is what side of the bed Bernanke wakes up on...

In his latest letter, Bill Gross, obviously for his own reasons, essentially channels Zero Hedge, and repeats everything we have been saying over the past 3 years. We'll take that as a compliment. Next thing you know he will convert the TRF into a gold-only physical fund in anticipation of the wrong-end of the "fat tail" hitting reality head on at full speed, and sending the entire house of centrally planned cards crashing down. "How many ways can you say “it’s different this time?” There’s “abnormal,” “subnormal,” “paranormal” and of course “new normal.” Mohamed El-Erian’s awakening phrase of several years past has virtually been adopted into the lexicon these days, but now it has an almost antiquated vapor to it that reflected calmer seas in 2011 as opposed to the possibility of a perfect storm in 2012. The New Normal as PIMCO and other economists would describe it was a world of muted western growth, high unemployment and relatively orderly delevering. Now we appear to be morphing into a world with much fatter tails, bordering on bimodal. It’s as if the Earth now has two moons instead of one and both are growing in size like a cancerous tumor that may threaten the financial tides, oceans and economic life as we have known it for the past half century. Welcome to 2012...For 2012, in the face of a delevering zero-bound interest rate world, investors must lower return expectations. 2–5% for stocks, bonds and commodities are expected long term returns for global financial markets that have been pushed to the zero bound, a world where substantial real price appreciation is getting close to mathematically improbable. Adjust your expectations, prepare for bimodal outcomes. It is different this time and will continue to be for a number of years. The New Normal is “Sub,” “Ab,” “Para” and then some. The financial markets and global economies are at great risk."

Writing as someone who was strongly stock-oriented for most of a long investing career, I can assert that at today's low dividend yields, it is difficult to see stocks as strong trees on which to rely. The Smithers parameters provide cautionary evidence for the bulls who point to current "low" price-earnings ratios and "sunny skies almost forever" views of corporate profits and predict stock market returns well above bond yields for years to come.

Throughout this entire crisis (going back to 2007), the governments and central banks have made efforts to “fix” certain things. If LIBOR gets too high, then they take action, that at least temporarily improves LIBOR. Those who look at the “improved” data and think the problem has been fixed have been proven wrong, as the market exposes other holes and eventually even the government and central bank money can’t keep the prices artificial for too long without forever increasing the amount of public money at risk. There may be no better example of that phenomena than the Euro Basis Swaps. To some degree, this rate measures the difficulty that European companies (banks) have when trying to get dollars. The First “globally coordinated” action in September brought the rate back from-110 to -80. That faded until it hit an almost scary -160. The Second “globally coordinated” swap line action got us all the way back to -110 (about the same level that had sparked the first action). We retraced some of those gains, saw fresh gains on the back of LTRO, but again have stabilized at rates that are worse than what the policy makers have targeted. Where would these rates be without intervention? Should we be happy about the improvement, or should we be concerned that in spite of all the intervention, this is the best they could do?

If there is one cross asset correlation that defined 2011 (and the greater part of 2010), it was that of the Euro-Dollar (EURUSD) currency pair and the S&P 500, which have correlated with near unison nearly all of the time. And yet, the stability of this correlation may be getting unglued, because as Goldman insinuated in its market roundup note from yesterday, it is "reasonable to think that the ... reflexive relationship between EURUSD and SPX...will take some time to break, but this correlation should start to fray." Why? Because, "like the FED before them, the ECB is aggressively expanding their balance sheet." Which brings us to the point of this article: much to the dismay of the armies of disgruntled bankers and investors demanding that the ECB print right now, the ECB has in fact been printing, as shown the other day. Only it has not done so in the conventional sense where it assumes an "asset" on its balance sheet while expanding a monetary liability, but indirectly through shadow conduits, such as repo and other liquidity backstops, also as shown yesterday, where no new currency actually enters the system, yet whereby the balance sheet expands just as efficiently (and in doing so, dilutes the underlying currency). It is well known that it has been our contention that in this centrally planned world the only thing that matters is the global provisioning of liquidity by the monetary authority, as the ultimate marginal determinant of Risk On behavior (and inversely Risk Off), is how much ZIRPy cash do speculators (and more importantly Prime Brokers) have at their possession (for outright and (re)hypothecated purchasing purposes). So here we would like to make a distinction: it is not so much how much cash one global monetary central planner will provide to markets, but how much the various standalone central banks will inject, in whole or in part. We contend that for 2012 the key qualifier will be "in part" with the ECB and the Fed printing (either outright or via repo) in staggered regimes, and thus the primary determinant of "risk", the EURUSD, will be the relative ratio of the two balance sheets. This can be seen on the charts below, the first of which shows just how dramatic the ECB expansion has been in the past 6 months, and the second showing the correlation between the EURUSD and the ratio of the Fed to the ECB.

Since the 2012 Outlooks have now slowed to a drip, its appears retrospectives are the stocking-filler of choice for the week. Goldman's economist group reflects on their '10 Questions for 2011', released at the end of December 2010, and finds they were correct seven times. The tricky thing about judging the 'score' is the magnitude of the error - or more importantly the magnitude of the question's impact on trading views. Jan Hatzius and his team have had their moments this year, for better or worse, in economic sickness or health but they have largely been accurate at predicting Fed policy (or should we say 'directing/suggesting' Fed policy), but were significantly off (along with emajority of the Birinyi-ruler-based extrapolators from the sell-side) on growth (high) expectations and inflation (low) expectations. Nevertheless, the lessons learned from over-estimating the speed of healing from the credit crisis and the disin- / de-flationary effects of a large output gap (which BARCAP would argue is not as wide) when inflation is already low and inflation expectations well anchored are critical for not making the same overly-optimistic mistake into 2012.

So the market has completely latched on to the idea that LTRO is back-door QE. Does this make any sense and can it even work? So banks can borrow money for up to 3 years from the ECB.  They can buy sovereign bonds with that money.  Those bonds would be posted as collateral at the ECB. The bull case would have banks buying lots of European Sovereign Debt with this program. The purchases would be focused on Italian and Spanish bonds with maturities less than 3 years. Buying bonds with a  maturity longer than the repo facility is risky.  The banks would need to be assured they can roll the debt at the end of the repo period.  Some may be convinced, but the bulk of the purchases will be 3 years and in so that they loans can be repaid with the redemption proceeds. So banks buy the bonds and earn the carry and all is good?  Not so fast. The LTRO can help the banks with their existing funding problems without a doubt, but it is unclear that encourages new bond purchases. I think we have already seen the initial impact.  There will be significant interest in tapping the LTRO for existing positions.  Some small amount of incremental purchases may occur at the time, but the banks will use this to finance existing positions. Now we will wait to see rates do well, but will be disappointed.  The big banks with risk management departments will decide to decline.  The risk/reward just won’t be attractive to them. In the end, this won’t do much for the sovereign debt market, but will shine a spotlight on which banks should be shorted and will possibly expedite their default.

The market's reaction to Draghi's comments over the last week have been visceral in its schizophrenia. While his 'temporary' provisions, three-year LTROs specifically, provide a life-line of liquidity (a la TLGP - and how is that working out for the US banks having to roll now?), they hardly address the real underlying problem of the vicious circle between sovereign debt's now-risky nature and financial balance sheets bloated with zero-risk-weighted re-hypothecated peripheral bonds. The last week has seen a roller-coaster of Senior-Sub debt decompression and compression, liquidation-like drops in commodities, lower correlation across European sovereign debt, and significant dispersion in high- and low-beta equity and credit markets (notably as we have previously discussed, some of which will have been driven by index roll technicals). The issue comes down to whether this is the Bazooka (buy-buy-buy) or not enough (fade-the-rallies) and BARCAP's macro sales and European Banks' research team have, like the rest of the market, been exchanging views on this perspective. While their take on the liquidity explosion is that it doesn't solve the almost unsolvable solvency problem but it the deeper insight that perhaps it is not the actual mechanics of this liquidity bazooka but the perception that democracy itself has been suspended in favor of bank and sovereign survival that interests us more. Furthermore, they do an excellent job on breaking down the mythical carry trade potential of these LTROs and mutual sovereign financing benefits since near-term (carry-trade) profit potential would be offset by additional sovereign risk - meaning that funding markets could stay closed for longer. Once again the issue of collateralization, risk-weightings, and deleveraging are front-and-center as bank 'managers' and politicians may be at loggerheads on the carry-trade-savior potential and the ECB's status on the balance sheet only serves to further subordinate existing bondholders.

For the most part, today's FOMC decision is expected to be a non-event, if indeed Jon Hilsenrath is still the proper "distribution" venue for the Fed, with Bernanke expected to focus on "communicating" clearer. There is of course the chance that the Fed has finally realized that the only successful Fed announcement, is that which surprises the market, and in the off chance it wishes to clean itself of allegations it is leaking news to the WSJ, and on the other hand indeed stun the market, there is that modest possibility the Fed may preannounce QE3 today, something which Bill Gross is actively preparing for, by loading up on MBS - the security that Citi expects will be monetized to the tune of $700 billion in 2012. Furthermore, SocGen is convinced the Fed will announce QE in a month, so will 30 days this way or that truly matter? After all, it is an election year... plus the hedge funds really need that year end rally, or else the closure of up to 25% of the underperformers will send shock waves within the rehypothecation conduit of Prime Broker shadow funding.

In his book “More money than God”, Sebastian Mallaby describes how George Soros received a signal from Helmut Schlesinger (president of Bundesbank at that time), to go ahead and speculate on a devaluation of the Italian Lira and the British Pound. Germany had enjoyed a boost from the integration of Eastern Germany, which, partially due to a generous 1:1 exchange offer for the Eastern German Mark, led to unacceptably high inflation. Despite numerous warnings from the Bundesbank, fiscal policies did nothing to reign into the growing threat to price stability. Seeing its advice ignored, the Bundesbank fought back and raised its discount rate all the way to 8.75%. This caused problems for other European countries, who were forced to follow the Bundesbank unless they wanted to risk a weakening of their currencies. They had to apply a restrictive monetary policy despite their own economies just recovering from the recession of the early 90?s. According to Mallaby, British finance minister Lamont had insulted Schlesinger at a meeting, trying to extract a promise to cut German interest rates. Despite Schlesinger’s refusal, Lamont led the press to believe Schlesinger had made concessions.The “payback” didn’t wait for long; Schlesinger publicly denied any intention of cutting rates. He also expressed low confidence in the fixed relationships among European currencies, particularly the “unsoundness” of the Italian Lira.