Yield Curve

When it comes to insight into what is on Ben Bernanke, nobody is quite as capable as the firm that runs not only the NY Fed, but virtually every other central bank in the world: Goldman Sachs. Below we present Jan Hatzius' thoughts on what to expect when Bernanke takes the stand at 10 am today when he delivers the first day of his semi-annual Humphrey Hawkins presentation to Congress. Many expect him to hint at more QE, and lately a tempest in a teapot (to use the parlance of our times) has erupted over the possibility that the Fed will lower IOER to 0 or even negative. Here is what Goldman has to say about that: "we do not expect an IOER cut at this time." In fact, Goldman is rather skeptical Bernanke will hit at much if anything, especially with bond yields already at record lows: after all, how much more frontrunning of the Fed's bond or MBS purchases is there? Instead look for much more grilling on the Fed's role in Lieborgate: congress is now realizing it is woefully behind its UK political cousins when it comes to reaping points from years of global Libor manipulation. More importantly, Maxine et al have finally finished all those "Libor for absolute corrupt idiots" books they ordered almost a month ago so they are truly prepared.

Just under two years ago, when we mocked then Morgan Stanley's analyst Jim Caron's call for a surge in long-dated yields on the back of an improvement in the economy (not something more realistic like the Fed losing all control of the TSY curve), we penned "Visualizing The Past Of The Treasury Yield Curve, And Deconstructing The Great Confusion Surrounding Its Future" in which we said that contrary to pervasive expectations of a bull steepener, the treasury curve would continue flattening more and more, until the whole thing would become one big pancake. Today, we have decided to revisit that post: in short - Jim Caron was fired by Morgan Stanley as head of rates following 3 consecutive years of bad calls starting in 2009 (only to be rehired in June as a Portfolio Manager... oops), while our view that sooner or later the 2s30s will be 0 bps is over one third complete.

A generation of market participants has grown up knowing only the era of central bankers and the 'Great Moderation' of (most of) the last two decades elevated their status significantly. While central bankers are generally very well aware of the limits of their own power, financial markets seem inclined to overstress the direct scope of monetary policy in the real world.

If markets fall, investors need only to run to central bankers, and Ben Bernanke and his ilk will put on a sticking plaster and offer a liquidity lollipop to the investment community for being such brave little soldiers in the face of adversity

Monetary policy impacts the real economy because it is transmitted to the real economy through the money transmission mechanism. This has become particularly important in the current environment, where, as UBS' Paul Donovan notes, some aspects of that transmission mechanism have become damaged in some economies. Simplifying the monetary transmission mechanism into four very broad categories: the cost of capital; the willingness to lend; the willingness to save; and the foreign exchange rate; UBS finds strains in each that negate some or all of a central bank's stimulus efforts. In the current climate, it may well be that the state of the monetary transmission mechanism is even more important than monetary policy decisions themselves. Some monetary policy makers may be at the limits of their influence.

The idea that short-duration bond funds are a good bet due to “the FED’s complete control with regards to suppressing and maintaining short-term interest rates” is completely wrong on every level; they’ve been a losing investment in real terms for most of the last 5 years, and the Fed is determined to keep it that way. The Fed’s control over nominal interest rates is precisely the reason that I wouldn’t want to invest in treasuries; not only has it consistently made bonds into a real losing proposition, but it also creates a good deal of systemic currency risk. Simply, the Fed will — in the pursuit of low-rates — monetise to the point of endangering the dollar’s already-under-threat reserve currency status. The only things that would turn bonds into a winning proposition — rising interest rates, or deflation — are anathema to the Fed, and explicitly opposed by every dimension of current Fed policy. Of course, creating artificial demand for treasuries to control nominal rates has blowback; if the buyers are not there, the Fed must inflate the currency. Hiding inflation is hard, so it is preferable to a central bank that old money is used; this is why Japan has mandated that financial institutions buy treasuries, and why I fear that if we continue on this trajectory, that the United States and other Western economies may do the same thing.

The Fed, by buying Treasuries is making insolvent banks even more insolvent. It is a short-term gain (liquidity) for a long-term disaster: banks need as much collateral as they can get their hands on right now. And with Treasuries rallying (raising the value of the banks' assets) any aggressive Fed program to take Treasuries out of the system would be a MAJOR step towards another solvency Crisis a la 2008.

After two days of solid gains, European equities continue the upward trend and are seen higher at the North American crossover, with the Basic Materials sector leading the way, followed by financials. The moves in equities follow overnight reports from Chinese press, once again calling for the PBOC to slash their RRR, as well as expectations that this Thursday both the ECB and the BoE will conduct monetary easing, possibly boosting future commodity demand. In the fixed income markets, the European 2s/30s curve continues to see bear-steepening following last night’s announcement from the Dutch Central Bank that has changed Dutch insurers’ Solvency II interest rate curve; modifying the maturities in which the firms must hold assets towards the longer-end. Today also saw official confirmation from the Irish debt agency that they are to return to capital markets with T-bill issuance on July 5th, their first return to the market since 2010. Investor reaction to this news is evident in the shorter-end of the Irish yield curve, where the 2-yr bond yield spread against their German counterpart is firmly indicating the risk of returning to the market; currently wider by around 20bps.

It's another one of those hope-fueled days in Europe as European stock indices across evey nation close comfortably in the green as the EU Summit begins. Germany has taken all the substantive things off the table and Cyprus and Portugal threw in the towel but nevertheless, stocks are 1-2.5% higher (with Italy and Spain outperforming). We assume this is reflexive pricing of 'the crisis is now so scary that the ECB will have to do something' but it seems the FX and Sovereign bond market missed that pre-emptive hope-driven view as Portugal yields/spreads spiked, Spain pushed back up to 6.93% and saw further flattening in its yield curve (as short-dated LTRO-enthused bonds underperform dramatically) as 2s10s is almost back to six-month pre-LTRO levels. Italian spreads pulled off their worst levels to close mixed but remains over 40bps wider on the week. EURUSD closed down over 35 pips at 1.2450 and stocks were in a world of their own also relative to credit markets today.

Hours before Spain is expected to present the bank "assessment" from Roland Berger and Oliver Wyman on its comprehensive bank insolvency status, the country sold €2.22 billion of two-, three- and five-year government bonds, in a sale which saw solid demand but yields that are simply laughable and are completely unsustainable, culminating with a record yield on 5 year paper. Per Reuters, the Treasury sold 700 million euros worth of a 2-year bond, 918 million euros worth of a 3-year bond and 602 million euros of a 5-year bond, beating a target to issue up to 2 billion euros of the debt... In a nutshell: big demand for paper that will leave Spain pennyless. Not very surprising, and as Elisabeth Afseth from Investec summarized, "They got it away, it's about the most positive thing you can say about it." Elsewhere the German economy continues to deteriorate from carrying the weight of the PIIGS on its shoulders, with the Mfg PMI and Services PMI both missing estimates of 45.2 and 51.5, and printing at 44.7 and 50.3, respectively. This was a 3 year low for German PMI and now all but confirms that the economy will enter a recession at the next GDP update. But all this pales in comparison with the latest update of the Greek comedy where we learn that the three parties forming Greece's new coalition government have agreed to ask lenders for two more years to meet fiscal targets under an international bailout that is keeping the country from bankruptcy, a party official said on Thursday. This came a few hours after a German parliamentary group officially spoke against a time trade-off for Greece. Which means that beggas will not be choosers after all.

The always pragmatic Art Cashin summarizes today's 12:30pm FOMC announcement. In summary: "look for the Fed to dangle a big carrot - some semi-specific course of action that would be put in place if the labor markets continue to worsen. Net/net, he needs to keep the door wide open and maybe outline certain milestone “triggers” that will allow the Fed to act later in an election year without being accused of being overtly political." Said otherwise, the happy ending will likely be deferred one more time. The market may not be very happy.

Not like it should come as any surprise that the bank that first among peers "discovered" that flow, not stock matters, implying the Fed may literally never be able to stop monetizing, is expecting the FOMC to "ease monetary policy on June 20", but nonetheless here is the full just released Q&A from Goldman's Jan Hatzius, who just happens to be a Pound and Pence drinking buddy of former Goldmanite Bill Dudley, who just happens to run the New York Fed. Connects the dots. Implicit is that a big dollop of Large Scale Asset Purchases is imminent. That said, if the Fed does disappoint on June 20, and merely extends the maturity of bonds that it will sell as part of a Twist extension from 3 to 4 years, as the bond market appears to be implying (as first warned by Zero Hedge), then all bets are truly off. On the other hand, note where Goldman says: "However, it is also possible that the program would be specified as a "flow" of purchases of perhaps $50bn-$75bn per month." If that happens, gold is going to $2000, $3000, hell, $10,000 very soon, as it means the Fed will not stop printing ever again. Period.

Two months ago, as we were carefully reading the latest Goldman explanation of how the firm had completely missed something Zero Hedge predicted back in January, namely the record warm winter's impact on skewing seasonal adjustments for payroll data (which has since validated our day 1 of 2012 predication that 2012 will be a carbon-copy replica of 2011, and which has made the comedy value of another Goldman masterpiece, that of Jim O'Neill's idiotic "2012: Not a Repeat of 2010 or 2011" soar through the roof) we stumbled upon something we knew was about to get much, much more airplay: Goldman's quiet and out of place admission that what matters for a country's central bank is the flow of its purchases, not the stock (another massive economic misconception we have been trying to debunk since the beginning). Recall these words: "...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..." This is how we summarized this observation two months ago (pardon the all caps): "UNLESS THE FED IS ACTIVELY ENGAGING IN MONETIZATION AT EVERY GIVEN MOMENT, THE IMPACT FROM EASING DIMINISHES PROGRESSIVELY, ULTIMATELY APPROACHING ZERO AND SUBSEQUENTLY BECOMING NEGATIVE!"

We all know that things are bad and getting worse. Goldman's Jan Hatzius take this opportunity to summarize all the various ways in which the global economy is floundering and once again floats the Goldman solution to everything: More QE, this time with a Bill Gross twist, pun and all, where the Fed again pulls a 2009 and goes for MBS: "Our confidence that the FOMC will ease policy once more at the June 19-20 meeting has also grown... Our baseline remains that Fed officials will purchase a mixture of mortgages and long-term Treasuries, financed via balance sheet expansion and possibly coupled with an extension of the forward guidance into 2015. This would be considerably more powerful than an extension of Operation Twist or other ways of changing the composition of the balance sheet, which are possible alternatives but are limited by the relatively modest amount ($200bn) of short-term paper that is still available for sale on the Fed's balance sheet." Well, if anything, global or Fed-based easing will most likely not come before the Greek June 17 elections - after all Greek confidence has to be crushed heading into the Euro referendum, and the only way to do this is by facilitating collapsing markets. So those hoping for a groundbreaking ECB announcement on June 6 will be disappointed. But June 20? That is fair game. We look forward to seeing PIMCO MBS holdings rise to a new all time high when the monthly TRF update is posted in a few days. Also look for something like this in the EURUSD if and when Bernanke surprises few at 2:15 pm on June 20.

Risk-averse sentiment dominated the session yet again as market participants continued to focus on Spain and speculated whether the country will soon be forced to seek some sort of monetary assistance. As a result, credit markets continued to deteriorate, with the EURUSD cross-currency basis-swaps under pressure, while the spread between Spanish and German benchmark bonds widened to a fresh Euro-era wide level. Less than impressive demand for the latest Italian debt issuance where 2017 was underbid by EUR 0.20, while the 2022 issue was underbid by EUR 0.30 also resulted in aggressive bond yield spread widening. However, as we head into the North American open, reports that the EU is willing to envisage direct ESM bank recapitalizations saw Bunds spike lower by around 33ticks and EUR/USD by 44pips to the upside. EU stocks made an impressive recovery, but remain in negative territory. Going forward, the second half of the session will see the release of latest housing data (pending home sales), as well as the weekly API report.

For the first time ever, 3 year Japanese government bond (JGB) yields are trading below 1 year JGB yields as the world's inexorable desire to repatriate, delever, and seek safety while reaching for as much term yield as is still 'safe' come home to roost. With Swiss rates already grossly negative and German rates rapidly converging, the world's (d)evolution (since evolution conjures a rebirth into something better) is shifting investors out the yield curve as ZIRP is here to stay forever, wherever you look in so-called developed economies (who can print their own money). In the last 4-5 weeks, 3Y Japanese bond yields have dropped 6bps to around 10bps (pretty much the same as every other maturity inside of 3Y) as the entire yield curve gradually flattens pushing out investor's perception of 'cash' to longer- and longer-maturities. Be careful what you wish for US equity investors, as the Keynesian Endpoint is upon us (and perhaps, just perhaps that is why Central Banks of the world are checking to the Fed, the ECB is playing hardball, and the Fed remains on hold unless apocalypse occurs - which, by the way, is not an 8% retracement of a 30% straight line rally).

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.