A great piece from TMM earlier this week revisited a most pertinent topic being traded in markets presently: QE expectations. It spurred a more granular exploration into the dynamics in discounting Fed easing by yours truly, as the TMM offered both relevant analysis and interesting conclusions.
To (slightly) paraphrase Warren Buffett, the market is not a discounting mechanism as much as a voting machine, particularly in the short term. This explains the dynamics behind the market’s reflexivity that George Soros refers to. Market participants pick sides on the argument at the margin (which can be inadvertent at times, such as when an exogenous variable impacts the market before traders conceived of discounting its impact one way or another), and although in the long run it pays to be among the traders who are right in regards to the argument at the margin (make money), in the short run the more relevant “side” is that of the traders who are winning the argument (price action and lagging/coincident dataflow going in their favor). As those who are winning yet “wrong” profit, confirmation bias leverages the market further in their thesis (especially as trend-followers and momo traders piggy-back their theses), and when the argument finally hits a tipping point where those who are “winning” stop winning, then “reality” hits the market and those who are “right” take on a windfall.
How this relates to TMM’s piece is in their investigation into the scenarios being discounted in fixed income presently. Acknowledging the argument being traded at the margin is the first step toward successfully profiting in the market (the next step is identifying who the “right” side of the argument to get a fundamental bias and then identifying the “winning” side to get a positioning bias in the near-term). The argument is always an isolated variable that manifests differently in different markets, and the key to trading is in finding specific assumptions that are discounted in the pricing of certain markets or securities that are either inconsistent with (coincident) reality or with other asset pricing. This is at the heart of the concept of creating alpha via arbing mispricings in the market. TMM do a good job of isolating variables pertinent to QE and then analyzing their compatibility with reality and other asset classes to determine the extent to which the argument at the margin (QE expectations) is priced in, as well as how these dynamics will impact markets going forward.
The argument at the margin presently driving fixed income is Fed QE demand. However, the re-pricing of Treasuries under this premise alone leads to essentially non-existent inflation expectations implied in yields. The Fed’s success in generating inflation/growth is essential for analyzing the wisdom behind current expectations.
What took the BoJ nine years to do (ZIRP), the Fed accomplished in merely sixteen months. Never before has there been a case of a central bank so determined to “force” inflation and growth. Even after engulfing the entire MBS market, the Fed is going to a second round of QE to support the US economy, and this willingness to reflate at all costs renders QE’s efficacy in inflating the only pertinent variable. And with a $2.3t balance sheet, with almost half of it sloshing in excess reserves picking up a risk-free 25bps (and consequently representing $15-20t in a normalized money velocity environment, which would result if/when IOER is lowered [8-10x being “normalized” reserve multiplier and 10x being multiplier implied by the 10bps reserve requirement]), the Fed has plenty capacity to forcibly generate inflation and nominal growth.
The Fed’s policies have been increasingly ad-hoc and months after suggesting micro-managing the IOER will be an effective method for stabilizing prices to desired levels, Bernanke & co. have in recent weeks suggested that the second round of QE will come in the form of gradual and reactionary injections. Although this presumably allows the Fed to precisely alter liquid money supply to generate target inflation levels, each successive liquidity injection decreases confidence in QE’s efficacy.
But so long as there is an implicitly (more accurately, effectively explicitly) easing Fed unwilling to stop printing until target inflation and growth rates are met, inflation is a foregone conclusion. This renders current fixed income valuations highly skewed.
TMM’s piece argues for the existence of bond market mispricing with observations about two key metrics: real rates of Tsy return and 12mo bill yields relation to excess reserves. The real rates of return help to isolate inflation expectation, while the bill yield/bank reserve relationship isolates QE expectations.
5yr real rates (CPI-adjusted) are negative and 10yr real rates are around 45bps, which is to be expected as the market discounts Bernanke’s bond bid. However, on a longer term timeframe, who is willing to lend to the US Treasury on a 10yr basis at 0.45% inflation-adjusted (and realistically even less, considering CPI calculation methodology)? TMM goes on to discuss the 5y5y forward real rate, which expectedly have plunged as the market discount’s QE demand for Tsys, but the impact of the QE demand has yet to occur, since inflation expectations have gone nowhere and the 5y5y forward real rate has yet to normalize.
Meanwhile, TMM provides a great proxy for isolating QE expectations, by pitting 12mo bill yields against excess reserves (inverted), with reserves representing current actual conditions and the bill yields discounting expected levels of reserve injections (ceteris paribus, which is quite so the case presently due to the 0-25bps quasi-ZIRP in place by the Fed). Republished below is TMM’s chart; at an average of about $180b per 10bps in 12mo yields, the current 20bps bills yield represents a projected $1.38t Fed balance sheet, a little under $400b of QE expectations.
click to enlarge
I suspect the Fed will begin its QEII by announcing $300b of Tsy purchases next month, the same amount of Tsys purchased in QEI. As the economy improves/stalls, I expect the Fed to continue regular purchase announcements of varying amounts, and expect about $1-1.5t in purchases altogether. Initially, as has been suggested by Bank of America’s Priya Mesa (who believes QEII will match QEI in duration demand), falling yields will lead to higher prepayment rates, and with “QE Lite” as the pertinent precedent, the Fed will reinvest the increasingly more MBS proceeds into Tsys, a positive feedback system of sorts which may augment the Fed’s Tsy demand. However, this of course assumes declining yields.
Due to negative/zero real rates of return present in the short-end of the Tsy curve, once the initial round of QE (presumably to be announced next month) is priced into Tsys, the argument at the margin will change from imminent Fed demand in the near-term to the long-term value in holding Tsys. As TMM suggest, the Fed is targeting core CPI around 225bps, and 10yr yields below 200-220bps represent no real return if the Fed is successful in reflating. Once the 5y5y real forwards normalize, this will cause a strong influx of supply in Tsys due to rising inflation expectations, and at this point a rising yield environment would be the likelier situation.
In this case, prepayment rates will actually fall, so although the Fed may originally be upwardly revising its QE amount estimates due to rising refinanciability, as inflation expectations normalize, the opposite effect will occur and the Fed will ease less than originally expected.
Currently, a poor economic backdrop and low inflation lends structural bullishness to USTs. The addition of QE expectations spurred more demand for Tsys, and the two theses are piggy-backing off of each other in a self-reinforcing loop. However, as inflation expectations normalize, the QE-based UST demand (already declining as a function of time due) will go down, and the rising inflation expectations will lend structural bearishness to Tsys. In this case, the market will look to debt ratios and serviceability ratios as the argument at the margin, at which point some much longer-term themes building up in fixed income could play out. Also, as a function of rising yields in USTs, USDJPY could rally significantly, and that could trigger issues in the JGB market, something quite unexpected by the consensus presently.
For now, I remain long USTs, but look to be selling in the 2-2.2% area (where there is strong technical support for yields). As forward real rates and inflation expectations start rising, I’ll look to get short US fixed income in size.
In the near-term, due to the scenarios currently discounted in USTs, I think the QE trade is about priced-in, and assuming a $500b initial QEII announcement (a very aggressive assumption for the sake of conservative conclusions), 80% is already priced into 12mo bill yields. Of course, 80% of an idea being discounted is not a reason to get on the other side; 120-150%+ discounting is a more acceptable contrarian trigger. Still, assuming the $300b I (and many others) expect, bill yields are discounting 130%+ of the thesis.
This has near-term impacts on risk assets, as the decoupling caused by QE expectations gives way to more structural themes, and many of those arguments are risk-bearish and USD-bullish. In the new normal of today, the status quo is decoupling as developed economies deal with debt overhangs and zombie industries while low-yielding G10 currencies encourage carry trades bullish for EM and magnify the structural relative strength in EM economies. However, the new normal also has a higher periodicity of crisis, each instance of which leads to a rush to USD liquidity and sharp recoupling. The result is low-growth developed economy markets and volatile boom-bust cycles in EMs (that do not grow their way into developed economies). My contention is that the USD short trade is getting crowded, although not necessarily yet at a breaking point, which sows the seeds for a contagion event, most likely stemming from the Eurozone.
According to last week’s CFTC Commitment of Traders data, specs currently boast a $26b net-short position in USD, about equal to that at 2009 lows in USD. The catalyst to unwind the shorts back then was the introduction of the Eurozone crisis and I expect the same origin this time around.
The August French trade balance missed by $9b Thursday, suggesting the euro’s recent rally is starting to cut into export competitiveness. Considering EURUSD averaged around 1.30 in August, the currency impact on exports may be much worse and exhibit a deteriorating influence in future data. Factoring in the 900 pip premium EURUSD currently has to August mean levels, the export situation appears even worse on the margin. German trade balance data later this week will provide more clarity.
The rise in EURUSD (and accompanied liquidity drain) may catalyze another dip in Eurozone exports/growth, confidence, and perceived creditworthiness. Additionally, if any of the periphery needs to access the EFSF, it will do so at its impractical 800bps cost of borrowing, which will mean much more dovish measures being necessary. This would be very bearish for the euro, yet I consider it more likely than not.
According to CFTC COT data, specs are positioned about $30b net-long euros, just under the positioning at 2009 highs. Though I agree that QEII is very bearish USD, the data seems to imply that USD is selling off under the same thesis/argument as EUR rallying, and considering the unsustainability of the latter, USD could see some near-term strength as a function of this thesis unwinding.
Gold has been rallying in tandem with EUR, which is quite counterintuitive considering that perhaps gold’s biggest bull argument is the Eurozone sovereign debt crisis. Again, the argument at the margin is QE, but when this argument has discounted EURUSD at 1.40, it may be time to reassess its effect on other asset classes as well. Though I remain very bullish on precious metals on the 5-7yr time horizon, I expect a correction in gold and EURUSD soon, as the QE thesis is discounted in the near-term and the argument at the margin reverts back to new dataflow and structural economic strength/weakness.
The gold ETF, GLD, is currently trading down about a percent on more than 2x average daily volume (about halfway through Thursday), forming a bearish engulfing candle. Concurrently, EURUSD is down 40 pips on the day and 150 pips off Thursday’s highs. I went short EURUSD at 1.3980 at the 50% Fibo retracement from 2008 highs and ahead of the 1.40 level traders being watched as a profit-taking zone. With this move in gold, I have higher conviction that the euro has started a correction in the near-term and have gone short gold as well to position myself short the hot-money QE argument that I think is being unwound. Gold reverting back to its $1265/oz breakout level from FOMC day on September 21 would be constructive and a zone at which I would consider buying PMs.
I agree that QEII is a gamechanger and that it will be a (justifiably) pertinent variable going forward. However, market fluctuations since Fed day in late September appear to me to be “late money” chasing a thesis that was already being discounted and chasing a justifiably underowned proxy for the thesis (EURUSD) that will be the first to be unwound, with the implications pervading across asset classes. Once the QE flows that manifested in (in my opinion the flawed) argument that is driving gold and euro higher in tandem and USTs discounting negative real rates of return are unwound, and EURUSD trades lower, the QE bid will probably come back in and with the weak hands flushed out, a resumption of the trend will likely be in order, especially in gold.
And the canary in the coalmine, of course, is sovereign creditworthiness. Though it is sparking little deliberation, the SOMA limits on Fed holdings of individual issues will require the Treasury to ramp up its issuance to meet implicit Fed demand. This is as close as the Fed will get to outright monetization in my opinion, as the Treasury is issuing debt strictly because of the Fed’s appetite for USTs. This is obviously a sovereign debt concern, and although I don’t expect any sovereign solvency crisis in America, rising yields (if and when they do occur) due to rising inflation expectations combined with the “stealth” monetization and the quickly-declining average outstanding UST duration & marginal GDP impact per dollar of UST debt will bring back trading arguments concerned with sovereign creditworthiness. US CDS spreads has been rising since the financial crisis first hit, as have other G10 sovereign CDS spreads. These fears (particularly regarding US) abate during periods of low/non-existent inflation expectation, but as the Fed pulls out all the stops to recalibrate expectations to its target, sovereign credit themes will resurface.
Going back to the premise of this piece, the importance of identifying the prevailing argument at the margin, typically the cycle of how theses/arguments get discounted begins with fixed income derivatives, as specific isolated variables discount expectations, moving onto fixed income and FX spot, leading the move, flowing into equity and other risk (like copper and AUD) reacting, and eventually leading to confirmation bias causing an exaggerated discounting of the thesis in underowned assets expressing the thesis. In today’s context, the QE thesis began in UST real rates, flowing into nominal UST yields plunging, leading to USD selling off and equity and copper rallying, finally resulting in EUR and crude oil rallying on reflation expectations. Every significant trade thesis sees its thesis manifest from leading to coincident to lagging asset classes, and with oil breaking out and EURUSD up 1200 pips since Fed day, the QE thesis has reached counterintuitive and unsustainable expressions. This is not much of a surprise, as after an abysmal H1 2010, hedgies surely went all-in into levered beta exposure to risk vis underowned USD crosses like EURUSD into Q3 end, and with a new quarter at hand, an important psychological profit-taking level at EURUSD 1.40, and structural fundamental bearishness in oil and EURUSD, they will be equally eager to close their positions on the first sign of weakness.
Long /ZN | 125’15 | stop 124’20 | +1’22
Long EUR/CAD | 1.3860 | stop 1.3785 | +310 pips
Short MON | 53.62 | stop 55.10 | +10.50%
Long /ES | 1151.00 | stop 1147 | +0.22%
Short APOL | 51.90 | stop 54.00 | +3.66%
Short USD/JPY | 83.35 | stop 84.15 | +100 pips
Short GBP/NZD | 2.1154 | stop 2.1194 | -15 pips
Short EUR/USD | 1.3980 | stop 1.4050 | +100 pips
Short EUR/SGD | 1.8245 | stop 1.8320 | +65 pips
Short GBP/SGD | 2.0735 | 2.0915 | +5 pips
Short UGL | 63.47 | stop 65.00