Tag Archives: Treasuries

On Inflation and Bonds… in < 140 Characters

Today I saw an interesting tweet from Jennifer Ablan:

And based on a daily move like this…

you get the impression there’s a divergence.  Stocks have a gangbuster move to the upside while bond yields have been moving lower.  Is Goldilocks appearing again?  Hardly.

But I had a response for her:

Yes, I cited Japan as the example.  But I don’t think they’re going to be alone.  Indeed, there are a couple of ways to look at inflation.  One is just prices paid and you can use the Consumer Price Index or the Personal Consumption Expenditure index.  Well, by either measure, they’re headed lower:

PCE hasn’t fallen the way CPI has but they are both still going lower.  Why?  Because as Steve Keen demonstrated with his Minsky-based approach, aggregate demand is falling because private debt is collapsing and unemployment is rising:

And the 2/10 spread has responded in kind:

One point I’d make is that when you step back and see what’s going on in bonds, unemployment, inflation and debt is there could be a new feedback loop between these things that has taken root.  I don’t know the mechanics of it, but I’d say there’s a link between these phenomena going on.

And it isn’t pretty.  Just ask the Japanese how well things turned out for them the last 20 years…

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Filed under finance, government, macro, Markets, Way Forward

At The Precipice: The Choices We Make vs. The Choices We’re Forced to Make

Author/Editor’s Note: You are about to embark on reading a post that is long, wonkish and meandering.  So while I admit it being this way, I will make no apologies for it.  This post is what it is.

This is a tough post for me to do.  Tough because so many discussions that seem disjointed and siloed, are in fact ones in which I see connections and I think the topics are interdependent: you can’t discuss X without discussing Y and Z.  So on that note, I’m going to talk about the inflation/deflation *and* the expansionist/austerian debates.  There’s a smattering of other things in here, too.  Like the unemployment conundrum.  Or Green technology.

Because while those topics are worthy of having separate discussions, you can’t come to any satisfying conclusions about any of them without looking at the first two debates, which are inextricably linked, and trying to tie them together with the other topics. It’s ambitious, I know, but I’m going to attempt it.  But with Jackson Pollack as a navigator and both Hunter S. Thompson and Jack Kerouac sitting in the back seat of this car, there’s no telling how this will come out.

I’ve read just about everything written over the past couple of weeks, discussed a lot of this stuff with folks on Twitter.  On blog comment forums.  And all I can say is I’m struggling to come to terms with this stuff, just like other folks I’ve discussed it with, and that has led me to come to some really profound – yet uneasy – conclusions which I’ll get to later on.

Inflation vs. Deflation

There’s been a lot of ink spilled on this.  Are we being confronted with one?  With both?  Let’s consider a few things in answering that.  First, a look at core CPI:

Not inflationary by any measure.  Prices are collapsing as a at least two effects I can think of are hitting the labor markets: persistence in long-term unemployment and under-employment: the folks who work part-time but are ready and willing to work full-time if a job is available.  Both of these effects are eventually reflected in GDP, personal income and last but not least, tax receipts.  Both of these effects are providing downward pressure to prices, plus they force people to choose products/retailers they wouldn’t choose before.  So the actual basket of stuff that’s getting sold now is different than the basket of stuff that was being sold before when people either had jobs or the jobs they had then paid them more.  Chalk that up as the choices we’re forced to make.

Another thing about inflation is the use of debt to fuel asset purchases and consumption.  Easy credit – and appetites that had been whetted by easy access to credit – had fueled a lot of purchases we had seen before the onset of the recession, and the levels of consumption we had seen conditioned others – such as auto manufacturers, strip mall developers, etc. – to expect those growth rates in consumption (and at that those nominal levels) going forward.  Well, this next chart shows that’s not happening:

About the only thing we can cheer about here is that the rate of decay is slower than it was the past year.  But it’s still declining as debt is shunned – a choice that can fall either in the camp of choices we can make or the camp of choices we’re forced to make.  A comment I saw on this struck me as being interesting, both right and wrong at the same time:

In one sense that’s true, and in another, it’s not.  I think in a macro, aggregate demand context, it’s very true.  Somehow we need to get back to the levels – think about the debate between growth rates and levels – we saw in that time frame.  But there has to be some product or some asset that would induce that kind of demand again.  Well, has that occurred?  Are securitized markets improving?  Well, you tell me.  Are they?

Did that make you choke on something?  If so, you don’t want to see this one:

Forget about securitized credit for a second.  This is bigger than that.  These two charts are about debt revulsion and market illiquidity.  This is not coming back. The king is dead.  Long live the king.

Lastly, a y-o-y chart on total bank credit.  Note that on a y-o-y basis, we’ve gotten to a point where credit is just not falling as fast; that’s not the same as growth:

As Kevin Depew observed in a spectacular piece at Minyanville:

Make no mistake, there are the same underlying economic problems here that exist all across America in cities both small and large: too much real estate development, too few home buyers; too many cars, too few cars buyers; in short, too much malinvestment, thanks to decades of artificially cheap credit.

via Five Things You Need to Know: The Modern Stealth Depression Revisited | Markets | Minyanville.com.

So there you have it.  Artificially cheap credit and malinvestment, and fewer financial intermediares to give credit to us.  You could easily make parallels to agribusiness, where our food supply is controlled by a small number of national players, juiced on artificially cheap corn.  But that’s a whole other discussion, that can only be done after watching Food, Inc.

But with respect to the deflation in credit that is happening after seeing those two charts, frankly it doesn’t scare me.  Because as I had heard and read about in understanding addiction “the mind that brought you here will not be the mind that leads you out of here.”  We’ve got to find something else that can lead us out of this morass of corroding debt and overindulgent consumption.  That means giving up the ghost that more of the same will get us out of here.  It won’t.

But that won’t stop people from trying to go back to what was done before and try to make it work.  Charles Mackay’s classic is filled with such behavior, where people thought the road back to recovery was paved by the habits and assets that brought them to the brink the in the first place, only to see those efforts fail. Yet we try it over and over again.  In short, not only does this sort of behavior exemplify Albert Einstein’s definition of insanity, we want to repeat the definition to ourselves to make sure we get it right.

So that’s in favor of the case for deflation.  But what about inflation?  Also, what are to make of the run-up in the price of gold – the classic inflationary hedge?

This came up at Street Meet, which I had the privilege of attending.  Is this move an inflationary hedge?  Sure, by many it is.  But with all due respect, I offered that there was a second motivation, which is a real psychological shift: the move has nothing to do with inflation or deflation, but a move to store value in gold as a hedge against poor decisions made by central banks.  The fact of the matter is, central banks have lost the modicum of trust they had. Over the past three years, how many times have you read about something *good* a central banker has done?  Outside of the droning of some economists, not much.  The move to physical commodities as a store of value away from paper/fiat currency is a revolt against central banks.  Taken to its ultimate end, we won’t need an “End the Fed” bill to render them obsolete; just settle transactions in anything but paper money.  No potency cocktail of ginseng, Viagra or Cialis would help them at that point.

And meanwhile, yields head lower for Treasuries:

That’s a 20 year chart.  Here’s a 5 year:

Which is also having an unintended consequence, which factors into the austerity/expansionary debate.  Risky assets are also yielding less as well:

This is on a 20yr chart.  They want to head lower, and they will head lower.  One other thing to note: look at the sweeping parabolic nature of Baa rates from the last downturn in ’00 to the current one.  I bet if I found a parabola to fit that trend, the coefficients this time around would be bigger than the coefficients on the mini parabolas you see in the ’90s.  Why?  The convexity of yields.  Also, looking at the time periods between the cycles, I am starting to think that we’ve compressed economic cycles now with all of the cheap liquidity and stimulus.  That subject is probably more open for debate than the compression of market cycles, which is another topic we touched on at Street Meet and one where folks could easily agree that cycles in markets have compressed.

At any rate, here’s a 2 year chart:

The channel that had formed is breaking down, as 10yr yields head lower.  Another way to look at this?  Spreads between Baa bonds and 30yr Treasuries.  The Baa yields published daily are yields for bonds with more than 20 yrs left to maturity, so the spread to 30yr Treasuries can serve as a risk-free proxy:

As I, as well as others pointed out, defaults on high yield and leveraged loans/bonds are much lower than everyone has expected.  I’ve said it before, but I’ll say it again: we may be watching a new feedback loop form between rates and defaults.  Central banks pushed liquidity into the market, suppressing rates on, well,  everything.  High yield assets benefit as default rates head lower, thereby making them less risky compared to higher quality assets.  Risk compression is in play, and it may not end anytime soon.

But this is an important facet to the next debate.  A debate where the discussion of interest rates almost never gets discussed.

Austerity vs. Expansionism

This discussion and the inflation/deflation one are linked.  If inflation is the issue, austerity is will correct it.  Deflation on the other hand, is different.  In a deflationary environment, consumption and/or investment is encouraged as the capital inflows kick-start economic activity.  But when there are charts like this…

and this…

It’s bothersome.  The debt keeps increasing and to listen to the expansionists, it needs to keep expanding.  Because governments are the only ones that can fill the void and consume while the private sector repairs their balance sheets, for which there’s no guessing how long that can take.  Indeed, this is one of the basic tenets to Richard Koo’s framework for dealing with balance sheet recessions.  Plus, looking at Japanese bond yields, they’ve only gone lower as inflation has become a distant memory.  And that was 20 years ago.  Indeed, the biggest takeaway in my mind from Koo is that instead of bemoaning the Japanese experience, we should be embracing it.  Sure there are some things that they did wrong (lack of structural reform, banks not charging off losses, big banks that got bigger – gee why does this all sound so familiar), but by and large,  the policy of governments taking on ever larger deficits to stop deflation is something to be accepted, not fought.  I can see in one sense that is true.  As I read and re-read posts and comments on this debate, there are a couple of things I see as true: there is no magic debt/GDP percentage where everything goes bust and as interest rates head lower, the interest burden is lessened, which allows more debt to be taken on.  Indeed, it’s like a feedback loop sprouts up out of nowhere as a result.  Like a weed staring at you in your driveway which forces you to ask “how did this get here?”

But is that how we want our government to operate?  Taking on debt so we don’t have to?  I realize the comparison to Japan is not a perfect one, for at least two reasons: the difference in savings rates and the composition of their debt market: practically all domestic investors.  Indeed the sovereign default question is puzzling when one looks at Japan, because while their debt/GDP keeps rising, the only talk of default comes from outside of their borders – not within.  This chart is as of end of last year, but it still gets the point across:

But GDP growth has not resumed in a robust manner, it has languished and continues to do so.  Personally, in Japan I see an economy that has spent a lot of public bucks and gotten very little bang for it all.  It just seems to me there has to be a better use of all of that money.

And then I read this (emphasis, mine):

What we haven’t yet experienced—at least in a sustained manner—is deflation. That, combined with the enormous fiscal stimulus, may explain why unemployment has stabilized to some degree now despite sustained private sector deleveraging, whereas it rose consistently in the 1930s….

Whether this success can continue is now a moot point: the most recent inflation data suggests that the success of “the logic of the printing press” may be short-lived. The stubborn failure of the “V-shaped recovery” to display itself also reiterates the message of Figure 7: there has not been a sustained recovery in economic growth and unemployment since 1970 without an increase in private debt relative to GDP. For that unlikely revival to occur today, the economy would need to take a productive turn for the better at a time that its debt burden is the greatest it has ever been..

via Steve Keen’s Scary Minsky Model « naked capitalism.

Here’s the figure:

Keynesians and MMTers beware.  This speaks to secular deflation: a large, demographic and psychological shift away from the use of debt. Debt-induced growth won’t work if there’s no appetite to take it on and there’s no productive use for it that has a greater benefit than the costs of servicing it.  Maybe Keynes got it wrong.  Perhaps it should be the Paradox of Debt instead of the Paradox of Thrift: societies resist taking on debt just as they should take it on, because they already took on so much beforehand.  I’ve heard the argument before that that shouldn’t matter because a government can always print more money to cover the interest.  And risk inducing hyperinflation as a result?  Because governments don’t know what the optimal quantity of money is better than any one of us do.  Plus, taken to its extreme, that kind of outcome can be viewed as a technical default.  The political risk of being the next Zimbabwe or Wiemar Republic is very real, currency standards (fiat vs. gold) notwithstanding.

And it might actually be worse.  If you can’t trust a government to act prudently with respect to fiscal matters, how can you trust that rules that are made by that body are fair?  That they are enforced fairly?  Or interpreted reasonably? Again, these are conversations that are thought of in isolation, but can only be treated in a satisfying way when discussed concurrently.  Chalk this up as a choice we can make – for now.

But the austerity argument has its own warts.  Cutting safety nets is largely out of the question, because as Andy Grove wrote in Bloomberg Businessweek:

I fled Hungary as a young man in 1956 to come to the U.S. Growing up in the Soviet bloc, I witnessed first-hand the perils of both government overreach and a stratified population. Most Americans probably aren’t aware that there was a time in this country when tanks and cavalry were massed on Pennsylvania Avenue to chase away the unemployed. It was 1932; thousands of jobless veterans were demonstrating outside the White House. Soldiers with fixed bayonets and live ammunition moved in on them, and herded them away from the White House. In America! Unemployment is corrosive.

via Andy Grove: How America Can Create Jobs – BusinessWeek.

I very much value what others who have fled oppression in such countries as Hungary in the 1950s have to say because they’ve seen what oppressive, overreaching governments are capable of.  Are we there yet?  No, but when you see things like this – on Independence Day no less – it makes me wonder how close we are.

But back to the safety net issue and what to cut.  There’s obviously little wiggle room on one side of the equation – the safety nets.  They’ve become interwoven into the fabric of our society and the best thing we can do is strive to ensure fraud, waste and abuse are minimized.  Eliminating it is a joke so when politicians talk in such absolute terms, I just laugh.  Or holding up unemployment extensions for the sake of the deficit?  Please.  Nevermind the fact we’ve got whole departments of the Federal government where  nobody knows what they do, how effectively they do it or what it costs to keep all those folks in their “jobs.”  Talk is the most inflated currency out there.

But then you read things like this:

President Barack Obama Friday signed a law giving consumers already in the process of buying a home three extra months to close the deal and still get a popular tax credit from the government.

Homebuyers that signed the contract by April 30 but failed to go to closing by the original June 30 deadline have until September 30 to finish their purchases.

Homebuyers with contracts signed by April 30 who failed to go to closing by the original June 30 deadline will now have until September 30 to complete their purchases.

via Housing Fix: Obama Signs 3-Month Extension of Homebuyer Credit – CNBC.

You just can’t help but feel, well, deflated.  The old saying of “good money chasing after bad” applies.  Just as it did with TARP.  With Bear Stearns.  With AIG.  Pork-barreled projects stuffed into legislation at the 11th hour, 59th minute.  Need I pile on?  So when folks tell me it doesn’t matter how it gets spent, just as long as it does get spent, I have to disagree.  Throwing money at the things that got us into this situation will not be the things that get us out of it.  Nor will wasteful pork-barrel spending.

Also to the austerians’ credit, there is a valid case to be made for government and entitlement restructuring.  The current way healthcare benefits like Medicare are collected and distributed is one area ripe for restructuring.  Social Security is another.

True market reforms are what’s needed, not just debating about levels and amounts of stuff to increase or decrease.  I like the way Joe Wiesenthal expressed it:

Lost in this debate is any discussion of what actually goes into a competitive or dynamic economy. There are so many factors that go into this. Let’s just rattle off a few that could have an effect:

  • Immigration
  • Education
  • Tax fairness
  • Labor mobility
  • Labor flexibility
  • Environmental policy
  • Demographics
  • Family planning policy
  • Health policy
  • Agricultural policy
  • The weather
  • Corruption

We could probably go on forever, listing factors that would help determine whether a given economy was competitive or not. And yet this stimulus vs. austerity debate ignores all these things, as both sides pretend that these are secondary, as opposed to foundational, aspects of what makes the economy hum.

via Why It’s Time To End The Whole “Stimulus Vs. Austerity” Debate.

And I couldn’t agree more.  Rather than take this time to really sit down and think what it’s going to take to move us forward, we’re mired in squabbling and posturing.  It’s easy to do because it’s lazy.  Most people would rather argue about throwing money – or not throwing money – at a problem because these topics make most people’s heads hurt.  But in reality it just sets the table for the last two things I’m going to look at.

Jobs and Green Tech

By now, we all know that unemployment has basically held steady, at 9.5%.  And the participation rate continues to be a negative on the economy.  So I took a look at both of them, together in this chart:

Looking at this chart, we can see that unemployment – when compared to labor force participation – hasn’t been this bad since the recessions of the ’80s.  The ’80s marked another transformational period in this country as we saw the decline of manufacturing and the rise of the service-based and information-based economies.  This becomes very clear when you see capacity utilization:

The lower lows are a sign of technological innovation taking root in each phase of the economy.  Automated manufacturing uprooted people from working in manufacturing several decades ago and we’re seeing something similar in our current economy as we’re able to produce more with less.  This presents us with a couple of problems.  First, as we get more efficient, we have to find better uses for capital that give us returns we want.  This is a huge issue as Keen pointed out earlier: we need better returns on capital to fund our debt.  We’re not finding it now and we need something – an innovation – a radical breakthrough in something from somewhere, anywhere – to get us there.  Second, there’s this issue :

Over the past couple of weeks I have been fascinated with the topic of overpopulation as I explained in my last post that “overpopulation was the greatest threat to sustainability in my book.”

Long story short he believed that the two classes capitalists and landlords (where Labor was considered equipment of the land) a typical feudalistic setup, population unchecked would grow at an exponential rate or geometric ratio.

via BankrChick (Tonight I do).

So overpopulation while we get more efficient and yet at the same time, we need to conserve more of our resources.  Not an easy task.

This is where Green tech could fill the void.  The theory being that Green tech would allow us to make something again and put people back to work while at the same time, if we export our products (not the technology and there’s a big difference between the two in terms of exporting), we can solve it all.  Mr. Birds 1 & 2, you’ve just been killed by one green, eco-friendly stone.

But in my mind, it won’t in its current state, for two reasons.  First, let’s start with the job creation issue.  I went back to Andy Grove on this:

Such is the case with advanced batteries. It has taken years and many false starts, but finally we are about to witness mass-produced electric cars and trucks. They all rely on lithium-ion batteries. What microprocessors are to computing, batteries are to electric vehicles. Unlike with microprocessors, the U.S. share of lithium-ion battery production is tiny (figure-E).

That’s a problem. A new industry needs an effective ecosystem in which technology knowhow accumulates, experience builds on experience, and close relationships develop between supplier and customer. The U.S. lost its lead in batteries 30 years ago when it stopped making consumer electronics devices. Whoever made batteries then gained the exposure and relationships needed to learn to supply batteries for the more demanding laptop PC market, and after that, for the even more demanding automobile market. U.S. companies did not participate in the first phase and consequently were not in the running for all that followed. I doubt they will ever catch up.

via Andy Grove: How America Can Create Jobs – BusinessWeek.

He’s saying we’ve been out of the game for so long we may not be able to compete in this new area.  I don’t necessarily agree.  We’re at a disadvantage yes.  But in my mind, Green tech isn’t good enough yet.  Ethanol cars?  Please, you’re harvesting an ag crop to turn it into fuel, plus you have to burn billions of BTUs to turn it from starchy sugary food into something you can use in a car.  Yes, cellulosic ethanol may be better because there’s less refining that has to be done, but you’re still faced with the fact that you’re using a fuel that will 1) not be as efficient as gasoline (your vehicle’s range is diminished) and 2) is actually corrosive to the engine since ethanol is a form of alcohol and it burns quickly and dryly.  Electric cars?  After watching this review by the guys at Top Gear and reading this rebuttal from Tesla (note the charging time and compare that to the time it takes to fill up a petrol car), it’s clear to me that electrics aren’t ready for primetime, Tesla’s IPO be damned.

There are other cars that might be though, and in comparing the two, it raises a point I want to make: green tech, to be palatable,  needs to raise the bar.  Planting a solar farm 20 football fields wide and 20 football fields long of solar panels out in the middle of nowhere isn’t going to help us if there’s a better use for the land and we tear up miles more of land to get the power from the solar farm to a generation station that can put that power on the grid.  There has to be a better way to do this that fits the lives we live today or offers us something better than we already have.  Otherwise it will fail.

Which leads me back to the austerity/expansionist debate: why isn’t the government investing more in this?  High speed rail could substitute air travel as it’s cleaner and can be more efficient (and possibly more convenient), but nobody is talking about setting up an incubator to research it.  Government can step in there.  What about other alternative energy sources and investing in more R&D in the other issues like making power transmission more efficient – so things like wind and solar power make more sense?  Instead we’re bailing out car manufacturers that are slaves to fossil fuel technology, but our economy as a whole has moved past volume production in this manner for at least 3 decades.  The things that got us to this precipice will not be the things that will lead us away from it.  The government has the opportunity to be the biggest angel investor ever and they’re not taking the chance to do it.  That’s disappointing.

So What Do We Do Now?

But I’m hopeful.  Maybe we should realize, as Kevin Depew says “the time for preparations and battening down the hatches has passed. It’s here.”

Which echoes Joe Wiesenthal’s sentiment.  We need to focus on the bigger picture issues.  Education for our children is still going to be an issue that will still be there.  Care for an aging population is still going to be with us, as well as figuring out what our economy can produce as those of us who follow the Baby Boom have to keep things moving somehow.  These are all things we can still choose to do something about, even as other things we can’t do anything about (the trajectory of real estate prices, for example) head along their own paths.  We don’t have to let our actions or even our lives be governed by that stuff.

I don’t know about you, but I’m glad that we don’t have to let those things dictate outcomes.  Because on this Independence Day weekend, I’ll take the power of choice – the freedom to choose, in fact – any day of the week over the alternative.

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The 6.30 Libor Earthquake, Aftershocks and Tsunamis

First, let’s update our Dollar/Euro Libor spread chart.  That’s the one that really matters now because looking at the Libor curves in isolation won’t help us understand what’s going on:

Across all maturities, we saw rates increase about 1bp from Wednesday into Thursday.  Not a healthy sign.  Indeed, I along with others were wondering about the €310bn that didn’t settle and it’s looking more and more like the liquidity it provided is gone and now there’s a mad scramble – a tsunami of buying, if you will – for Euros:

But if you’re watching the Euro-Yen cross like I am, you still need to use the Dollar-Yen as a crossing pair to get a Euro-Yen quote. The last time I checked, the Euro-Yen cross was at 110.039. In a word, ugly.  That cross has been the great carry trade cross for years, so any movements in this cross should be noted and heeded.

But I also wanted to take a look at some other trading activities in futures:

Surely with the correlations we’ve grown accustomed to, a rise in the EURUSD should mean stocks, commodities and well, everything that is not cash is headed higher.  But right now, it doesn’t because of the banking issues in Europe.  Gold collapsing the way it did was rather stunning, frankly.  And the fact that crude oil, in the midst of the summer vacation/driving season coupled with a natural disaster of epic proportions, couldn’t maintain the trend line on the daily chart that would imply $80/bbl, is telling.  And the message seems rather ominous and foreboding:

Meanwhile, two Treasury ETFs, SHY (iShares 1-3 yr Treasuries) and TLT (iShares 20+ yr Treasuries) have benefited from the safe haven bid.  If you executed a bear flattener by shorting the SHY and going long  the TLT, you would’ve had a very nice 6 months, in spite of the gains in the SHY:

My point in showing all of these charts?  It’s to try and present/describe a macro level picture that shows one simple message: the problems in Europe can’t – and shouldn’t – be underestimated and the spillover/contagion/whatever buzzword you want to use that means “spreading” are the worst kinds of scenarios you can think of: higher probability and high severity.  I characterize them as “higher probability” for two reasons:

  1. Never underestimate people’s ability to underestimate tail events.
  2. The probability of a spooky tail event occurring  is increasing.

I don’t know how long the EURUSD “rally” lasts.  It will last as long as banks in Europe are afraid their balance sheets are too illiquid.  It could be over in days, weeks or months.  I don’t know.  But I do know that trade is not acting the same way it would have in the past for a reason.

This will be an interesting month…

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Clean-up On Aisle 6!! That’s the LIBOR Aisle

Warning: Involves math concepts (no Greek letters though) and general wonkishness

I mentioned Dr. Donald van Deventer’s work in a post from earlier this week, and I felt he wrote about some really interesting – and telling – issues that may be present in the LIBOR and funding markets.  I’m going to touch on them, what they mean, and why I think they’re important.

Let’s start with a key observation he makes:

We’ve observed two trends in recent entries on this blog. The first trend is to note the relatively modest volume in corporate and sovereign credit default swaps that has been reported by www.dtcc.com. The second is to note that the implied forecast for interest rate swap spreads has recently been strongly affected by Eurodollar quotations on the Federal Reserve’s statistical release H15. Movements in 1, 3, and 6 month Eurodollar rates reported by the Fed have moved in stair-step fashion and in diverse ways for the three short term rates. These movements have been so concerning that we asked the same question we posed in the CDS market: Are the rates we’re seeing really real?

via Kamakura Blog – Kamakura Blog: Default Probabilities and Libor (Updated June 8, 2010).

Indeed.  The things he noted regarding CDS data – and the lack of true liquidity – can actually be extrapolated across a variety of industries.  Whether its a concentration of assets and deposits in financial services or the oligopoly that Food, Inc. takes on in food processing, it seems like we have a cross section of our economy where there are fewer – yet much larger – businesses we’re relying on to provide us with the goods and services we want and need.  Don sees it in the CDS data, making the analogy between inter-dealer CDS trading and used car dealers trading/swapping auto inventory.  His question about the legitimacy of quoted rates is a valid, yet pointed one.  Hopefully we can shed some light on this.

FIrst, here’s a paper from the BBA which shows how they calculate Libor:

The important thing to remember is the Libor fixings are an average.  Outlier banks are thrown out.  Plus, I imagine you can have different panels at each maturity.  Indeed as Don points out:

By definition, this calculation process will generally result in Libor quotes that are “too low” for much of the panel and too high for some of the panel banks as well.  During this period, the long held image of the Eurodollar deposit market as a homogeneous market where all but the worst banks paid the same rates was clearly inconsistent with the reality of the market place.

So in that sense, rates quoted may not match the reality of the marketplace.  But to the point Don made about different banks paying different rates, which violates the general principle of homogeneity, we see that here in the US as well.  It’s why Countrywide, Washington Mutual, IndyMac and others would pay more for deposits than other institutions during the beginning of the credit crunch.  High payout rates on deposits imply a bank could be in trouble.

Also Don’s post had this chart:

I replicated the 1mth constant maturity Treasury and 1mth Eurodollar rates in the following chart, but with updated data:

The two time series had a correlation of 0.39, so while it exists, it’s somewhat weak.  The correlation strengthens as you go to 3mth rates (0.53) and at 6mth rates it’s higher still (0.61).  I also went ahead and created a chart that shows a 5 day moving average of these rates, thinking that we may see something in a moving average chart that we don’t see in a chart that just shows coinciding rate moves.

Correlation is 0.41, so it’s still weak.  Then I went ahead and created a chart of the spread between the two rates:

The spread is moving higher, which implies the 1mth CMT is very well bid, as those rates have been heading south while the Eurodollar rates are headed north.  What does that mean?  Well, it means risk in the banks is headed higher.  As Don says, Libor and Eurodollar rates only have a correlation of 50.9%, so it’s still weak.  But take a look at what he points out right after that:

BBA Libor series correlation with panel average default rate: 35.5%
Federal Reserve H15 series correlation with panel default rate: 85.0%

The Eurodollar rates have very high correlation with the panel default rate which tells me three things:

  • The dash for dollars is still on full bore.  Eurodollar rates are rising because dollars are scarce.  The Euro is irrelevant.
  • Libor rates don’t accurately reflect default risk, and that’s partially by design.  Winsorizing the data (removing extreme values) will always give you an incomplete picture because the riskiest firms are eliminated along with the least risky.  Libor only works as a reflection of credit risk when there is a systemic issue and that’s rare.
  • Lastly, the Eurodollar put strategy for playing a bear flattener is the best way to go if you believe there’s a funding issue in the credit space or you just want to express views on the shape of the curve.

That’s it for now, class dismissed.

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Another Look At The 2Yr Treasury – 3Mth LIBOR Spread

Wanted to take another look at this, briefly.  Here’s the chart I had from an earlier post that looked at this tantalizing subject (well, for me it is, anyway):

That was a 20 year chart.  Let’s take a look at smaller timeframes.  First, here’s a chart that shows the two yields moving together through time:

Other than the summer of ’08 where we saw a divergence (timing difference is actually a better term) in rates, these two time series performed quite similarly.  So let’s take a look at another chart of the spread:

That black vertical line is the low in the series, and it occurred in October of ’08.  Turns out it was 5 months almost to the day before we saw the March lows in stocks from which the market rallied off of.  I’m not suggesting this spread is a leading indicator.  I haven’t run any statistical tests or anything like that. 

But this should serve as a reminder for an equity investor to consider taking some cues from the credit markets.  Even looking at things from a capital structure perspective it makes sense.  Why?  Just look at the capital strucutre.  Equity investors are the last to get their money.  So if credit markets are showing stress, it should serve as a warning to equity markets to be wary.

The last chart to look at is here:

The blue line represents support that has been in place for over a year.  It has been decisively broken and the trend is to head lower.  How fast will it head lower and how far remain to be seen. 

But I can only imagine what it will take to make this spread widen out again, though.

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About the Spread Between 2yr Treasuries and 3mth LIBOR

Wanted to follow-up on an item I read about last week that a couple of my friends on Twitter brought to my attention:

If LIBOR continues to creep up and reaches, say, 75 bps, it no longer will be economical for banks to own US 2-year notes. In that case the US Treasury market will be in trouble. That’s when you head for the bomb shelter.

via Inner Workings » Blog Archive » …unless LIBOR hits 75 bps, in which case head for the shelter.

As if we needed any more arcane spreads to monitor, here’s the 2yr Treasury – 3mth Libor spread.  This chart has 20 years of daily spreads.

Couple of things to note: first, like other term structure-based spreads, spreads tighten in good times and widen in bad times.  This makes sense because as the economy gets worse, short term rates are lowered in an effort to stimulate the economy again.  Then as things improve, short-term rates get tightened.  Second, over the last twenty years it seems this spread has been in a range of roughly +/- 150bps.

But the current recession hasn’t been like the others.  I drew in that blue line to denote that despite the credit easing by the Fed (let’s be clear: monetary policy based on raising/lowering interest rates is really credit tightening/easing, read this), spreads have not widened like they have in the past.  They’ve remained tighter, even stubbornly so.  Also, negative dips have become bigger, so it gives one the sense that spreads here will not behave the way they have before.  It also shows me we’re going to have a flatter curve, which is something others have been forecasting as well.  Flatter curves, thinner spreads.  Not a recipe for a robust banking sector.

So what does it mean?  At the least, there’s another spread to keep watch over.  Second, as a friend of mine pointed out:

The convexity issue is concerning.  I’ve been saying for a little while now that convexity in rates was dangerous, mostly because of where we are in absolute rate levels.  So the possibility of a new trend taking shape here of lower highs and lower lows I think is a bad sign.  The days of increasing marginal utility for our money supply and credit system may be drawing to an end.  Added credit is not helping and may very well be making things tougher than they already are.

Also, the sovereign debt calendar really picks up in July.  France, Germany and a large part of the continent all have paper to roll, and all of the problems we were dealing with before are still there.  So behavior of this spread will be key over the next few months.

As Han Solo would say “I have a bad feeling about this…”

Indeed, so do I…

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So A Monetarist Walks Into A Bar… The Futility in Central Banking

I want to follow up some recent posts I wrote on where we are and where we’re potentially headed.  First, I want to offer two pairs of charts, some may be familiar but others may not.  Take a look at the first pair: levels of M3 in the Eurozone and MZM here in the US:

My those sure look correlated.  They show the growth of aggregate money supply over time.  It should be noted money supply growth has plateaued and started turning negative in a pretty significant manner.  These are 30 year charts showing the growth of money supply at an exponential rate.  That trend has been broken.  Rather decisively.

Here’s the same data, presented in annual growth rates:

The fact is these monetary aggregates are shrinking and that shrinking is accelerating.

The question is why.  In a time where stability is but a pipe-dream, why are we seeing this now?  Ideally, money supply should still be growing to foster, as central banks put it, “price stability” and its cousin “financial stability.”  There’s one theory I want to explore, but I may not do a good job of it in any one particular post, so bear with me.  I do have a train of thought, I promise.  It  just might take me a few posts to flesh this out and this is part of the process.

Recall our euro and dollar Libor spread curve where I represent the spread between the two rates as a curve:

The spread is flattening across the curve, and the only way I can see to relieve the pressure is to resume the issuance of central bank liquidity swaps, but so far there hasn’t been much borrowing…

I think we need to see this rise almost parabolically to relieve those funding pressures.  Do we need $600bn like at the peak in September ’08?  Maybe not now, but there may be a need for several hundred billion, as the real sovereign debt issuance is still ahead of us in the months of June and July.  And the potential for banks to re-liquefy their balance sheets seems pretty high.

The question is why haven’t we seen more use.  I have to credit Tom Keene with pointing me to this post from Stanford economist John Taylor.  Anyone who has a monetary policy rule named after them garners my respect, but I have to admit I disagree with him a little on this post:

Note, however, that the recent increase—visible in the right part of the chart—is very small compared with the jumps in 2007 and 2008.

via Economics One: The Fed’s Swap Loans and Libor – OIS Spread.

In absolute terms, yes.  In levels of volatility, yes.  But given the liquidity and money – in the form of debt, mind you – that has been thrown at these spreads as well as the rate cuts we’ve seen, it’s still disturbing to me.  “Convexity kills” to paraphrase Al Davis’ well-worn expression “speed kills” in pro football.

But in the same post, Professor Taylor also gives us a possible reason why we haven’t seen more borrowing:

I have argued since the start of the crisis that the Fed should provide daily (not just weekly) balance sheet data so people outside the Fed can evaluate the impacts of its programs on the markets, but this is all we have. It is not clear why the loans have declined so rapidly. Perhaps criticism about participating in the European bailout led the Fed to discourage the use of the swap loans under the program at a time when the Fed is trying to prevent the Congress from reducing its independence. Or perhaps the interest rate (1.24 percent) was simply too high.

*Gulp!!* 124bps is too much to pay?  That speaks to a very weak banking sector.  Here’s a screen shot from the ECB of the operation:

Turns out, dollar funding has gotten a lot more expensive. 123 bps for a week. Last week, it was 124bps for 3mth dollar swaps.  Either pawnbrokers have overrun the ECB, or more likely, the desperation in European funding markets is just getting more desperate.  Bigger swaps, higher rates and shorter maturities.  That’s not a funding market that is stable.

So in the meantime, dollar Libor rises:

Which, presents another problem:

If LIBOR continues to creep up and reaches, say, 75 bps, it no longer will be economical for banks to own US 2-year notes. In that case the US Treasury market will be in trouble. That’s when you head for the bomb shelter.

via Inner Workings » Blog Archive » …unless LIBOR hits 75 bps, in which case head for the shelter.

Make no mistake: traders playing a curve steepener strategy would be slaughtered like enemies of the Corleone crime family.  So may I suggest another bear flattener?  Start selling 2yr Treasury futures and taking down 10yr futures.  Or, if you want to use an option strategy, buy 2yr puts & sell 10yr puts to give you some more flexibility.  The CME Group has done a good job of outlining this in a strategy paper.  I embedded it here:

So the bottom line is this: the quantity of money out there isn’t enough to subdue funding costs/risks.  More is needed, but we’re unsure how much.  So in the meantime, spreads between dollar Libor & 2yr rates need to be watched because we might see “The Mother of All Bear Flatteners” hit the market.

All against a backdrop where adding more liquidity probably won’t help…

Are we having fun yet?

Don’t think any monetarists are at the moment…

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