QE & The Laurel-Yanny Distortion

Via Global Macro Monitor,

Interesting clip from Wired,  interviewing  a neuroscientist explaining how people get the sound Laurel and Yanny name so different.

The interview is profound if you take the principles and apply them to the markets.  It’s all about reading the correct signals  — such as low or high frequencies –to determine what you hear.

Money Quotes: 

Neuroscientist:  It sounds a lot like Yanny to me…The clip is distorted so it has a lot of high frequency information in it, more than usual. and I just might be better at hearing these high frequencies than you…

Q:  What about hearing Laurel one day and Yanny the next?  

Neuroscientist:  That is mysterious and plays into our expectations…In psychology they call this a bistable illusion…

The difference between what speech sounds we hear depends on what frequencies are in those sounds…The difference between Laurel and Yanny is whether the information is low frequency, like Laurel,  or high frequency, like Yanny. 

Bistable illusion, indeed.

I call it being whipsawed.

QE Effects

Our biggest critique of quantitative easing (QE) is that central banks have drowned out, or, at best, distorted market signals, making it much more difficult to read, access, trade, and invest in the markets.

The distorted market signals also result in extremely divergent market views and perceptions.   You see a Laurel market,  I see a Yanny market.

Some don’t care, however, and just want to make money, and to make money, you have to be in the game.  As Chuck Prince infamously said,

As long as the music is playing, you’ve got to get up and dance, We’re still dancing  – Chuck Prince, former Citigroup CEO, July 2007

That is probably where most of the market is, and certainly the modus operandi of Wall Street.   It’s all about the year-end bonus, Che.

Distorted Signals

What is a U.S. 10-year bond yield at 3 percent signalling when nominal GDP is growing at 5 percent plus?    What is the market signal of Portugal’s 10-year sovereign yield trading 117 bps through the U.S. 10-year note yield?  Or a 10-year JGB at 5 bps?   Does anyone care anymore?

It’s difficult to ascertain considering  how the Fed and other central banks, who are not price sensitive,  are majority owners in the U.S. and other sovereign yield curves.

Treasury Auctions

Even though QE ended in the U.S. in 2014, its legacy still hangs around in the Treasury auctions.   The Fed, for example, took down around 20 percent of the U.S. Treasury auctions in May.

In order to constrain the direct financing of the Treasury by the central bank,  the Federal Reserve Act only allowed the Fed to buy and sell Treasury securities in the secondary market.  That changed after the great financial crisis (GFC) as the Fed’s SOMA portfolioregularly participates in the auctions, though with noncompetitive bids,  as notes and bonds in their portfolio mature and a portion are reinvested back into the market.  Technically, SOMA participation in Treasury auctions does not constitute direct financing.

Nevertheless, the Fed’s participation in the auctions still distorts the market clearing yield by allowing the U.S. government to issue more notes and bonds at a lower yield.

QT Will Start To Bind Fed Participation In Auctions

The quantitative tightening caps  will  step up to $30 billion per month in September and begin to exceed the amount of notes and bonds maturing in the SOMA portfolio.   That is the Fed’s participation in the Treasury auctions will begin to wane, and in many months going forward,  will be net zero.

We suspect when the market internalizes that the Fed will be out of most of the monthly auctions, interest rate volatility will increase at the same time the Treasury is ramping up supply.  Our view of much higher long-term yields will then likely be realized.

As always,  we may be wrong.

Stay tuned, Yanny.