This Is The Note That Has Led To A Modest, If Transitory Bounce, In The Market

The reason for the ramp in risk as attributed by various buyside desks as to what recently has become the trademark of more hope, prayer and magic from Jefferies' (yes, Jefferies is driving the market for once, who wouldathunk it) David "SPOOS" Zervos, whose latest note that the Fed will follow the ECB and cut its overnight excess reserves rate to -0.25% has picked up some traction, and is causing a modest rise in risk markets. Here is the problem: the Fed will NOT do this, and certainly will not do this for months and months as not only would it destroy the US money market, general colalteral, unsecured and virtually every other overnight market instantaneously (and not even Ben is that dumb to trade a few trillion in private sector overnight funding for 10% in the S&P), but even as Zervos says this is nothing short of a thought experiment in what may happen: "Whether it happens or not is not the point. The issue is that we are not priced for it AT ALL." Correct David: they are unprepared because it will not happen. The Fed will do much more LSAP, and even that other flow-based lunacy, NGDP targeting, before it decides to blow up overnight markets (not to mention destroy the entire Primary Dealer risk analytics system all of which is based on positive flow from Reserves). Because if the Fed telegraphs it is ending the inflows from reserves experiment started 3 years ago, we better be having 4% GDP growth. Reality check: we have 1.1% Q2 annualized GDP. Finally, that whole ECB experiment with negative Deposit Rates led to... absolutely nothing... correction: it led to yet another plunge in Spanish and Italian yields: something the Fed is quite aware of.

Extract from Zervos, whose clutching at straws has become quite legendary in the sell-side community

Besides all the travel last week, I was also quite busy talking to folks about the front end of the US Treasury curve. The commentary I put out on 12-July entitled "The ECB makes the Fed looks foolish" got a lot of folks interested in the idea of a lower IOER in the US. Whether it happens or not is not the point. The issue is that we are not priced for it AT ALL. And with the Swiss 2yr at -43bps, the German 2yr at - 5bps and the French 2yr at +14bps; the US 2yr looks as cheap as Prague! If Ben decides that a 0 deposit rate in Europe gives him a green light to whack the IOER, 2s will rip!! Owning 2s outright and levered has a ton of optionality. There is a few ticks of downside for a point or more of upside. Going into a dovish August 1 FOMC, this feels like a great risk reward trade.


From my perspective, the ECB has done a fantastic job in promoting the idea that 0, or possibly negative, deposit rates can be an effective force in monetary policy. Last week I attached a piece by Greg Mankiw on negative nominal rates. Here is another good one from Willem Buiter - These guys are not quacks! Its a VERY interesting policy exercise.


The quote from the last FOMC minutes suggested the Fed wanted a "new tool". Well here ya go Ben, take the IOER to -25bps, take 2s to -50bps and watch banks start setting LIBOR negative!! If you really want to push the portfolio balance channel this will wake up all the sleeply reserve managers with liquidity needs in USD. Of course as short rates plunge into negative territory, inflation expectations will rise sharply. It will be important to not expect too much love for the long end if this happens. And like I said above, even if this is a low probability event, the mere possibility of it happening makes levered longs in the front end a fantastic trade! No one is prepared for it. Just ask yourself how many risk management departments have shocked 2yr notes to -50bps and 3ml to -30bps in their VAR analytics. Not many!!


Of course that 0 yield on cash might propel some entrepreneural vault salespersons to start a cash USD ETF. Just like the Gold ETF or the potential copper ETF, we could put dollars in a vault and sell shares. The storage and security costs would easily be 50bps or more, so Ben has a little room to experiment before that option creates a genuine move to mattresses and vaults. In the mean time I'm off the spoos + blues idea and back onto the original spoos + 2s trade - the same old weightings, 100m Spoo + 100k/01 in 2s. With negative 2s in play, spoos should rocket!!!


That's it for today! This coming week I will spend some time with clients in Italy before heading down to Corfu for the annual Zervos family pilgrimage. My writings will slow after the Bernanke testimony this week. Ill pick everything back up when I return for the August 1st FOMC meeting. Buy some 2s!! Good luck trading.