On September 26, when we wrote "As US Default Risk Spikes To 5-Month High, Here Is How To Trade The Debt Ceiling Showdown", we suggested a simple 1M/1Y Bill flattener, which has since resulted in a massive profit to those who put on the trade with appropriate leverage, leading to the steepest outright inversion the short-end curve has seen on record. For those who engaged in this trade, it may be time to book profits and move on, as the risk of a negative catalyst - a shutdown/debt ceiling resolution - gets higher with every passing day that we move closer to the October 17 X-Date. However, those who wish to remain engaged in the short end of the bond market where the highest convexity to the daily newsflow can be found, one possible alternative trade is to shift away from cash markets, and into shadow banking, via the repo pathway.
Another day, another shut government and 1-month T-Bills have surged another 6bps to 18.5bps. Those who read our suggestion from Sept 26 to hedge the political stupidity and debt ceiling debate and put on the 1M1Y flattener have seen the fastest plunge and inversion (to negative!) in the curve since early 2009. Despite the relative calm in repo markets, which is likely due to expectations that any technical default will be for a minim al length, the short-term bills most likely to be affected (the 10/31/13 T-Bills) are seeing the largest daily deterioration yet as traders exit and price in the possibility of missed payment. 1Y USA CDS has spiked by a massive 26bps to 65bps, higher than during the Lehman crisis and second only to Summer 2011.
It would appear that Warren Buffett's reassurance this morning that crossing the debt ceiling won't be so bad (trumpeted by any and all equity pitch men since) is being entirely ignored by the bond market. 1-month Treasury bill yields are soaring this morning - up 5bps at 12.5bps now (having touched 16bps - the highest yield in almost 3 years and notably higher than during the 2011 debt ceiling debacle). 1Y USA CDS are also up 3bps at 38.5bps this morning - notably inverted still. Of course, equity markets are surging back to open green for retail investors ignoring Obama's warning last night and Lew's "default has potential to be catastrophic" note this morning. In the meantime, the 1M1Y flattener trade we suggested goes from strength to strength as an indicator of market stress.
Earlier in the week we noted the spike in the cost of protecting against a technical default on US Treasuries. While well below "record" wides of 2011, a very interesting event has occurred. The cost of 1Y protection has surged higher than the 5Y protection - something we have only seen in the summer of 2011. However, this time it's different as the inversion is even greater than in 2011 - although not the most liquid instrument in the world - implying a greater chance (albeit a small probability) of a postponed payment in US Treasuries. As we noted previously, there is a way to trade this away from CDS-land.
As we head for the fateful FOMC announcement on September 18, US data have continued to moderate. Accordingly, the consensus seems to be converging on a $10-15 billion initial reduction in monthly purchases (mostly focused on the Treasury side and less so on MBS) with any 'tightening' talk tempered by exaggerated forward-guidance discussions and the potential to drop thresholds to appear more easy for longer, since as CS notes, assuming Fed policymakers have learned anything in the last four months, they must know that the markets view “tapering” as “tightening,” even though they themselves for the most part do not. Thus, they are going to need to sugar-coat the message of tapering somehow. But as UBS notes, political risks have grown and there is little clarity on the Fed's thinking about the housing market. This leaves 3 crucial surprise scenarios for the FOMC "Taper" outcome.
Something is way off: either the unemployment data is very much wrong and the real unemployment rate is far higher especially when normalized for the collapsing labor participation rate and the surge in part-time and temp workers, or the GDP calculation is incorrect and the economy is growing at a 4%+ rate. (It isn't). The scarier implication is that in addition to all other seasonally adjusted economic data points which have become painfully unreliable, daily Treasury tax receipts must also now be added to the docket of meaningless and corrupt data points. The question of just how the Treasury could explain a massive (and deficit boosting) cash discrepancy could only be answered if somehow the Fed is found to be parking cash directly into the Treasury's secret basement.
Earlier this morning the BoJ introduced a comprehensive change to its monetary policy framework. The asset purchasing program will be merged with the outright JGB purchase program (rinban), and JGB purchases will be expanded to include all maturities, including 40-year bonds. The pace of JGB purchases by the BoJ will be accelerated to ¥7trn per month from just under ¥4trn currently (on a gross basis), and purchases of ETFs and J-REITs will also be increased. The main operating target for money market operations was changed to a monetary base control (a quantitative index) from the uncollateralized overnight call rate.
Hey, this was cuddle time-week! A big Hug for everyone: Bonds, Equities, Periphery, ah, Periphery bonds! Greece…
As Super Mario said himself on Friday, albeit in a different context: “We were living in a Fairy World”. Cute way of spelling it out.
Fairies, rainbows, wonderful world… Let’s put IZ on the case!
"Somewhere Over The Rainbow" (Bunds 1,38% -6; Spain 5,30% -30; Stoxx 2580 +1,1%; EUR 1,301 +50)
In a world where flow is the new QE, this week is an alignment of the stars for long-end US treasury traders.
Today is the 2nd of the long-end UST auctions for the month of November. 16bln 30yrs will be sold to the market at 1pm...largest single DV01 event of the monthly cycle. Can we game the US Govt??
Will 24bln more 10yr notes be enough to satisfy this Risk Off demand? Enquiring minds want to know...
Romney's selection of Paul Ryan as his veep clarifies the policy debate (forcing typically middle-of-the-road voters to become more polarized to the size of government) into the November election and materially changes the odds of the fiscal cliff's resolution. As Morgan Stanley's Vince Reinhart notes, "by tying one side to an explicit plan for fiscal consolidation, the Ryan selection makes it much more likely that the campaign will focus on the appropriate role of the government. That is, the debate will be about the right level of federal expenditure relative to national income, the progressivity of the tax system, and the extent to which family incomes are protected on the downside by Washington, DC." Although theoretically the Ryan pick raises the chance of a benign, before-the-election resolution to the fiscal cliff 'issue', it also worsens the likely outcome if the legislative stand-off continues into 2013 - which the odds suggest is the case.
A week ago we brought you Elliott Management's summary opinion on US paper: "We Make This Recommendation To Our Friends: If You Own US Debt Sell It Now." Today, Bill Gross doubles down.
Gross: The #Fed is where bad bonds go to die. Today it was 10-years. Tomorrow 30-years. Stay short my friends.
— PIMCO (@PIMCO) August 14, 2012
With all eyes firmly planted on Spain, the little-Escudo-that-could has quietly slipped off the heading-into-the-abyss list of the mainstream media. Little was made this week of the fact that 10Y Portuguese bond yields dropped to seven-month lows - except by us of course where we explained that this is almost entirely due to the CDS-Bond basis trade 'arb-du-jour' that has placed a technical bid under Portuguese bonds. Between the help from LTRO and the fact that ISDA is under-pressure to improve/amend CDS rules to 'honor the spirit of the CDS contract to the fullest extent' which implicitly reduces the massive 'event' premium uncertainty between CDS and Bond risks for distressed-names (thanks to the ECB's actions in Greece), every bond in the short- to mid-term maturity of Portugal appears notably rich - with only the longest-dated bonds reflecting the crisis that remains. As we described in detail here, the real Debt/GDP of Portugal is around 140% (notably higher than the EC estimates of 111% once contingent liabilities are take account of) and the issues that face this small nation are entirely unresolved with bank recapitalization needs of at least EUR12bn and a highly indebted private sector. The bottom-line is that optically-pleasing bond improvements recently have been entirely due to synthetic credit arbitrage and, as Morgan Stanley notes, the nation remains mired in the three risks of contingent liabilities, bank recap needs, and a grossly indebted private sector; leaving a second bailout very likely by September 2012 and the challenging debt dynamics likely to mean a restructuring.
We have been rather vociferous in our table-pounding that even if a Greek PSI deal is achieved (in reality as opposed to what is claimed by headlines only to fall apart a month later), then Greece remains mired in an unsustainable situation that will likely mean further restructuring in the future. JPMorgan's Michael Cembalest agrees and notes that Debt/GDP will remain well above 100% post-deal but is more concerned at the implications (just as we noted earlier in the week) of the process itself including ECB preferred credit status, retroactive CACs (law changes), and CDS trigger aversions. In his words, the debt exchange is a bit of a farce and we reiterate our note from a few days ago - if this deal is so close, why is the 1Y GGB (AUG 2012) price trading -8.75% at EUR 28.75 (or 466% yield) and while longer-dated prices are rallying (maybe bear flattener unwinds), the moves are de minimus (-17bps today on a yield of 3353bps?) as selling pressure is clearly in the short-end not being rolled into the long-end as some surmise.