Is The Fed's Balance Sheet Unwind About To Crash The Market, Again?
Almost six months ago we discussed the dramatic shifts that were about to occur (and indeed did occur) the last time the New York Fed tried to unwind the toxic AIG sludge that is more prosaically known as Maiden Lane II. At the time, the failure of a previous auction as dealers were unwilling to take up even modest sizes of the morose mortgage portfolio was the green light for a realization that even a small unwind of the Fed's bloated balance sheet would not be tolerated by a deleveraging and unwilling-to-bear-risk-at-anything-like-a-supposed-market-rate trading community. Today, we saw the first glimmerings of the same concerns as chatter of Goldman's (and others) interest in some of the lurid loans sent credit reeling. As the WSJ reports, this meant the Fed had to quietly seek confirming bids (BWICs) from other market participants to judge whether Goldman's bid offered value.
The discreteness of the inquiries sent ABX and CMBX (the credit derivative indices used to hedge many of these mortgage-backed securities) tumbling with ABX having its first down day since before Christmas and its largest drop in almost two months. The knock-on effect of the potential off-market (or perhaps more reality-based) pricing that Goldman is bidding this time can have (just as it did last time when the Fed halted the auction process as the market could not stand the supply) dramatic impacts as dealers seek efficient (and critically liquid) hedges for their worrisome inventories of junk.
The underperformance (and heavy volume) in HYG (the high-yield bond ETF we spend so much time discussing) since the new-year suggests one such hedging program (well timed and hidden by record start-of-year fund inflows from a clueless public which one would have thought would raise prices of the increasingly important bond ETF) as the market's ramp of late is very reminiscent of the pre-auction-fail-and-crash we saw in late June, early July last year as credit markets awoke to the reality of their own balance sheet holes once again.
The ABX index (the credit derivative index that would be closest to hedging the positions that other dealers will face a re-mark-to-market on should the NY Fed sell at a below market-price to Goldman) shown in black on the chart and HYG (the high-yield bond ETF which has become incredibly liquid and trades at almost double the volume of just a year ago currently) shown in orange are at very similar levels to the last NY Fed auction that was halted for lack of demand (or unwillingness to extend balance sheets). The green ovals show the market's performance of each is also notably similar with a significant ramp into the auction in the hope of encouraging risk-on appetite (Goldman aren't dummies).
Interestingly this time, we have seen very little (if any) high-yield issuance as demand appears to have dried up almost entirely (or been crowded out by impressive distressed yields in European sovereigns for those willing to extend and pretend). Investment grade issuance has picked up into this ramp though concessions remain high (lenders want their pound of flesh to flip or garner liquidity premia).
The point is - while stock markets are rallying, financials are rallying, and homebuilders are rallying (as we are told again and again that the bottom is in housing), helped perhaps by the huge surge in M2 recently, just as they were in June of last year (XHB - the homebuilder ETF rallied almost 9% leading up to the failed auction, XLF - the financials ETF rallied over 6%, and the S&P rallied almost 7% in that month alone), credit markets are far less enthusiastic (and downright dismal today in the most liquid and closest hedges) and the last time the New York Fed tried and failed to unwind even a small amount of the Maiden Lane II book, when the markets weren't facing anything like as big a fundamental (EU recession, China slowing, US recoupling) and technical (huge supply overhang from European issuance and lagging financial and non-financial calendars - especially high yield) headwinds, we saw a very significant sell-off in the two months following (the red arrow above and below).
It appears that we have some new metrics to monitor on a daily basis instead of the now-secured EUR-USD basis swap and BTP yields and this time, its a little more tricky to manage all the way up and down the credit quality spectrum of liquidity as dealers rush for any and every liquid hedge from PrimeX, ABX, CMBX, HY, HYG, IG, and LQD they can get their hands on...
Perhaps as we somewhat sarcastically noted in June, the post QE2 timing of the June failed auction and its impact could have been the ammunition to set up a QE3 infusion...and now with almost 10% rise in the USD since August (and obvious impact on US company earnings already) perhaps its time to hit the reset button, print, and devalue a little to juice Q1 earnings which are seeing downgrades galore.
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