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Rising Libor and bond yields.

Negative swap spreads, Eurodollar curve, repo effects.

Compliance, expectations, liquidity, Fed action.

Last Time Out

"25-54 yr old prime earners peaking at 101083 in Nov. 2007; today at 97628, for a net decline of 3.5M prime earning jobs during this "recovery". No real jobs, just McJobs for McPay."

"Above note, 55yrs+ in Nov. 2007 at 26376, now at 34353, for a net increase of 8 million employed. Not for sheer enjoyment and mostly out of economic necessity. The above attests to no real jobs, just McJobs for McPay and work till you die?" - 08/08 - Best Performance?

Trebek queries: an absurd pretense intended to create a pleasant or respectable appearance. What is...

A Charade?

Romance and suspense ensue in Paris as a woman is pursued by several men who want a fortune her murdered husband had stolen. But who can she trust? Directed by Stanley Donen, written by Peter Stone and Marc Behm, and starring Cary Grant and Audrey Hepburn. The cast also features Walter Matthau, James Coburn, George Kennedy, Dominique Minot, Ned Glass, and Jacques Marin.

With one of cinema's classic pairings, the film is notable for its screenplay, especially the repartee between Grant and Hepburn, for having been filmed on location in Paris, and for Maurice Binder's (of Bond film fame) dazzling opening sequence titles and Henry Mancini's suspenseful theme song. Charade spans three genres: suspense thriller, romance and comedy and has also been referred to as "the best Hitchcock movie that Hitchcock never made".

Charade was remade as The Truth About Charlie (2002). Starring Mark Wahlberg and Thandie Newton. Directed by Jonathan Demme. Peter Stone so disliked the remake that he refused his story credit on it, and is instead credited as Peter Joshua, one of Grant's character's aliases in Charade.

A rise in Libor, Eurodollar futures and repo fails, what's hiding there? The "dollar", suitable collateral, a lack thereof on both, duration mismatches in riskier carry trades, and the ensuing liquidity issues when those positions unwind in a thinly traded market? Moving West...

Perhaps we can find answers in the recent sell-off in bonds, which raised the yield curve and in particular the long end... let's ignore any MSM misdirection or disinformation aka inflation or increased monetary flows via economic recovery and get to the bottom of this Charade...

As noted above, market rates are rising (US dollar Libor) and dislocating from the "natural" rate which has been negative for quite some time. Is this a by-product of misguided monetary policy implemented by those who think to control the "natural" rate and influence market rates and an entire economy by targeting a single rate? But, I digress.

Moving West, I interpret rising Libor, concomitant with a flattened ED (Eurodollar) curve versus the long bond rate, currently acting divergent to the long-term downward trend, to say that we may have reached an inflection or tipping point of sorts. Negative rates, swap spreads and dollar carry trades are all factors. Bear with me, pun intended.

Dat You Uncle ED?

Eurodollar futures provide an effective means for companies and banks to secure an interest rate for money it plans to borrow or lend in the future. The Eurodollar contract is used to hedge against yield curve changes over multiple years into the future.

Pricing patterns in the Eurodollar futures market are very much a reflection or mirror of conditions prevailing in the money markets and moving outward on the yield curve.

A flattened ED yield curve is saying lower long-term flows in dollar deposits held outside the US. Are US bond yields attempting to say higher long-term rates in the US and why? There are expectations, liquidity and regulatory constraints to consider.

Anchored Expectations?

As for expectations, continued monetary and economic constriction would disagree with the rosy MSM narrative. Higher US long and short rates would not be due to increased monetary flows due to inflation caused by economic recovery, but rather...

Due to further reduction in flows, lower expectations, less dollars available, less dollar liquidity, higher risk premiums charged for those needing those dollars inside or outside our banking system confines.


As for liquidity, is the move from long to short bond duration a shortening of portfolio duration? Perhaps due to mismatches? This could be in anticipation of rising long-term yields and the bond yield curve steepening.

Could greater liquidity through short-term redemption of principal be the real motivation? Short-term duration provides more liquidity versus long-term duration. Or could the move out of long-term bonds just be a reaction to impending regulatory requirements? Viz. again, the need to hold more short term or liquid paper with more "moneyness"?

Ultimately, could this be affected by a change in market supply and demand conditions that increases the demand for short-term liabilities relative to their supply? Why have bonds and in particular long-term bonds, continued to sell off past the Sept. 30th quarter ending?


Banks and other financial institutions are having to get into position to comply with the October 14th deadline for money market funds and floating NAVs. There will be two types of money market funds.

Type 1 will have a floating NAV and not "break the buck," and it will hold short-term paper similar to the HQLA (high-quality liquid asset) 100% test. Type 2 might pay a higher interest rate and hold paper not meeting 100% under the HQLA rules. This type will include holding commercial paper ((NYSE:CP)).

At quarter end, when banks want bonds off the books to free up cash for regulatory balance sheet purposes, window dressing, they enter into a swap spread. A swap spread is for example: what an AA-rated financial institution would pay above the US government to borrow money.

Quarter-End Negative Swap Spreads?

Companies and institutional investors exchange floating rates of interest for fixed rates via a swap contract. The swap spread is the cost of funds for that institution vs US government rates. Swap spreads on 30-yr UST have been negative since 2008. In Sept. 2015, the 10-yr UST swap spread went negative.

That negative condition in swap spreads does not indicate that the US government is a bigger risk than a private party. Nor does that negative condition indicate that there is an over-abundance of treasuries being sold into the market.

The indication is that balance sheet availability of cash to take up those T-notes is lacking. Viz. capital requirements and reduced balance sheet capacity are furthering a lack of liquidity. Trading Treasuries and swaps relies on funding via the repurchase or repo market.

The Swap?

In an interest rate swap, both parties receive payments based upon floating rates. The bank enters into a fixed rate receiver position, which duplicates the coupon they were receiving before they sold the bond. Their counterparty is a fixed rate payer who will receive payments from the bank.

The payer must post the collateral and can therefore dictate the terms of the swap. Viz. they are the only babe at the bar when the fleet comes in for liberty. Therefore, they can pay next to nothing or less than USTs for their end.

An interest rate swap is a two-way street, netted out at the end. The receiver (bank) hopes that floating rates (Libor) decline, reducing the amount they will pay. The payer (posting the collateral) hopes that floating rates increase, increasing the amount they will receive. Rising US dollar Libor means that receivers are paying more, payers are paying less.

The Repo Effect?

For example, the new capital restraints for money market funds and floating NAVs have limited the use of repo, which in turn has impacted swap trading volume and pricing. Why? Due to the new capital restraints, there has been a reduction in market makers who were previously willing to provide that capacity. They live for the turn, no money, no honey.

In the past, hedge funds would reverse any swap inversion (negative spread). Banks will not consume precious capital by having a repo trade sitting on their balance sheet. With that market-making space vacated, those funds wanting to reverse an inversion can no longer rely upon the repo market to buy USTs and enter into a pay fixed swap. For that lack of access to repo and those market makers participation, those trades have failed and concomitant, repo fails have also rocketed.

Off Balance Sheet?

With a lack of capital, collateral and balance sheet capacity seeming to be the order of the day, many participants are obtaining their swap spread/UST hedging positions, via off balance sheet synthetic futures "strips".

Rather than combining an OTC spot-starting interest rate swap ((NYSE:IRS)) with a Treasury security, traders can futurize this spread by combining a deliverable swap future and U.S. Treasury future. CME has both products which achieve closely correlated outcomes with significant capital efficiencies.

Since these futures can be utilized without requiring transferring positions between margin accounts, margin account requirements would be reduced, and it is possible to accumulate large off balance sheet exposures.

Deja Vecu?

Now think about the above, but not just from a banks perspective, but many central banks around the globe, which have been "kicking the can" due to the strong "dollar" with forward dollar swaps aka currency interest rate swaps. Chinese and EM food for thought?

Worse yet, how much debt and derivative exposure, on and off balance sheet, is tied to Libor and or related metrics? Hint, hint, nudge, nudge, wink, wink, deja vu? No deja vecu, as in, been there done that.

The E-$'s contraction is a world-wide exogenous factor... Open market operations attempt to neutralize or reinforce all independent factors affecting reserves. I.e., the exogenous Eurodollar factor is either "washed out" or "mopped up". - Salmo Trutta

Yes, OMOs can attempt to address the ED factor in reserves. Trebek queries: Outside the confines, unregulated and off balance sheet all have meaning and sometimes unintended consequences. What are all synonymous with ED (Eurodollar)?

Are You - BORed Yet?

Note above, Pound Sterling Libor has declined.

Note above, Euro, Swiss Franc and Yen Libor have declined and are negative. These conditions are reflected in the overnight Libor rate for all currencies mentioned above. Would the two charts above indicate that the rise in Libor is isolated to the US?

Above note, ON (overnight) Shibor skyrocketing. This is the cost of overnight loan funds for onshore (Shanghai) Chinese RMB. Note the spike above 2.30 on 09/19/2016.

Above note, three-month Hibor skyrocketing since September. Chart courtesy of Alhambra Investment Partners.

Above note, ON Hibor skyrocketing to a record 23.8% on 09/19/16. This is the cost of overnight loan funds for offshore (Hong Kong) Chinese RMB, which was a bit tight to say the least.

As stated earlier in our discussion, US dollar Libor is rising, and so it would seem CNH Hibor and CNH Shibor are as well. Meaning that rising Libor or cost of interbank loan funds is not isolated to the US, but only those who are lacking those "dollars" and perhaps those who are engaging in carry trades to obtain them. Involvement of the Eurodollar market, interest rate swaps and forward dollar swaps being supreme.


Market rates are further dislocating (rising Libor) from the "natural" rate. Viz. for the US, the gap between risk (non-HQLA) and riskless (HQLA) continues to widen.

This would reflect the impact on interest rates caused by the aforementioned type 2 or non-HQLA money market funds aka the ones holding the riskier collateral. This also means that the cost of funding to lending institutions is rising, and those increased costs will be passed through to all borrowers.

Increased dollar Libor and RMB (internal Shibor, external Hibor) rates are precipitating a rise in cost of loan funds. Viz. global liquidity based "dollar" demand from banks, EMs and China.

It is estimated that $28T in debt is tied to US dollar Libor and a 100 basis point increase would cost an additional $280B annually. Since last year, three-month Libor has risen 50 basis points. It is estimated that each 1% increase in market interest rates, costs the bond market $1T in losses.

Fed Action?

Through their inaction and seeming incoherent monetary policy, the Fed has painted themselves into a corner. Since we "recovered" long ago, according to the narrative, the Fed should have been raising long ago to get ahead of the curve and pay the piper. The whole ZIRP to NIRP would have been avoided.

Currently, the pool of available loan funds is contracting, resulting in rising market rates. The Fed could misconstrue this to indicate inflation on the horizon, and raise rates in December. Will they?

"A sharp deceleration or even drop in prices, like economic output, should lead to an equal or sharper rise in prices (or output) after the weakness passes."


And that's exactly what's going to happen in 2017. The bond bubble bursts. And stagflation will accelerate. - Salmo Trutta

Moving Forward?

Perhaps a post-election admission, it's not getting better, it's getting worse, we catch cold, they catch the flu. Message in a bottle, no rescue coming for ROW from US, further capital strangulation, less spending, less income, further contraction in the global economic climate.

New capital requirements continue to absorb the excess reserves that were created by the central banks in their QE operations. Less balance sheet capacity, less supply, higher "dollar" and higher demand for those dollars, not because of healthy reasons Viz. transactional volume went up, or monetary flows increased because the economic climate improved.

But because of unhealthy reasons, due to the continuance of contractionary monetary policies, a furtherance of economic contraction, and monetary flow contraction, further hampering liquidity and raising the risk premiums to obtain those much needed dollars.

Bottom line, the widening of spread between risk (market) and riskless (government) could cause a systemic shock or dysrhythmia in the form of a concomitant decline in availability and rise in cost of those loan funds, which will cause further constriction across the economic spectrum.

In any event, rising cost of funds rates would prick the global bond and reflated global RE bubbles. As both deflated, equities would be chased up in a final crescendo, leaving one question, when does that overvalued asset join the other two? TBD.

Would like to thank you folks fer kindly droppin' in. You're all invited back again to this locality. To have a heapin' helpin' of Nattering hospitality. Naybob that is. Set a spell, take your shoes off. Y'all come back now, y'hear!

This is our 107th in a series of thematically related missives, which will attempt to identify the macroeconomic forces with potential to adversely affect capital, commodity, equity, bond and asset markets.

I wish to dedicate this missive to one of my mentors, Salmo Trutta, who is a prolific commenter on SA. Without Salmo's tutelage and insistence on not masticating and spoon-feeding the baby ducks, as in learning the hard way by doing the leg work and earning it, this missive would not have been possible. To you "Proximo"... "win the crowd and win your freedom" - Spaniard.


Investing is an inherently risky activity, and investors must always be prepared to potentially lose some or all of an investment's value. Past performance is, of course, no guarantee of future results.

Before investing, investors should consider carefully the investment objectives, risks, charges and expenses of an investment vehicle. This and other important information is contained in the prospectus and summary prospectus, which can be obtained from the principal or a financial advisor. Prospective investors should read the prospectus carefully before investing.

Market Plays

As for how all of the above ties into the potential and partial list of market plays below... the market, as a whole, could be influenced, and this could tie into any list of investments or assets. Those listed below happen to influence the indices more than most.

There are many macroeconomic cross sector and market asset correlations involved that affect your investments. Economic conditions, the Eurodollar, global dollar debt and monetary policy all influence the valuation of the above and market plays below, via King Dollar's value, credit spreads, swap spread pricing, market making, liquidity, monetary supply and velocity, just to name a few. For a complete missive series listing covering those subject and more click here.

The potential global economic developments discussed in this missive could affect numerous capital and asset markets, sectors, indexes, commodities, forex, bonds, mutual funds, ETFs and stocks.

A List of 17 Potential Market Plays (Long or Short?): Apple Computer (NASDAQ:AAPL); Google (NASDAQ:GOOG); Facebook (NASDAQ:FB); Microsoft (NASDAQ:MSFT); Citigroup (NYSE:C); General Electric (NYSE:GE); Cisco (NASDAQ:CSCO); Bank of America (NYSE:BAC); Amazon (NASDAQ:AMZN); Tesla (NASDAQ:TSLA); S&P 500 Trust ETF (NYSEARCA:SPY); Ford (NYSE:F); Starbucks (NASDAQ:SBUX); Intel (NASDAQ:INTC); AT&T (NYSE:T); IBM (NYSE:IBM); Exxon Mobil (NYSE:XOM).

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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