As a student, I once heard a professor say that US Treasuries were necessary for the market to establish a benchmark or a risk-free rate. Without Treasuries, the market had no benchmark and without benchmark, there was no market. It didn’t make sense to me. A few days later, I had to interview Dr. Julio H. G. Olivera (one of Argentina’s most eminent economists) and I asked his opinion on this issue. Interestingly, Dr. Olivera referred me some correspondence he had exchanged on the subject during the 60’s with Sir John R. Hicks (mostly known for creating the IS-LM model). Apparently, Sir Hicks had a short but solid answer: “The merchant makes the market”… Yesterday, the Fed purchased $3.0 bn in the Aug/15 to Feb/26 range. This amount was considered small vs. the $11.7bn submitted and disappointing, given the recent rise in yields. The market sold off again (the 30-yr traded below $90 right after 11am, its yield closed at 4.044%), but managed to regain strength, on the negative news coming from the auto sector. The movements were followed by the credit markets, with the CDX IG12 first trading around 169 but closing at 161. In credit, volatility was driven by short-covering and by the news on the automotive sector. In spite of plenty of economic data (maybe the most relevant being the Initial jobless claims dropping 14,000 to 631,000), the stock market ended almost flat: S&P500 at 872.81pts. (-0.1%). As I mentioned yesterday, I believe the market may be waiting for a confirmation on positive outlook, with the ISM Manufacturing Index and stress tests results, before it moves anywhere. The chart below left shows the action:

Back to Sir Hicks’ statement, I kept thinking about those “merchants who make the market”. Starting today, the Fed will require traders to pay a 3% penalty on what is called a “fail”, or an uncompleted trade. Any tax on transactions brings down liquidity and this will be the case for the $7 tr/day repo market, where investors sell short Treasuries, in order to hedge their investments against inflation. If the merchants leave, who is then to make the market? What will happen to the benchmark? In answer to the first question, UBS’ Fixed Income and FX Research team suggested yesterday that investors looking to hedge are now leaving the repo market and going to the swap market (30-yr point) to exchange their floating cash flows for fixed (I will elaborate more about this in future letters). The second question is more open, and demands an open answer. Without fiduciary media of exchange, the benchmark interest rate would be the productivity rate of a stable and relevant market player, with low volatility. But we live in a world of fiduciary media of exchange. We then replace productivity for the capacity of governments to raise taxes to repay their debts. And we cannot avoid volatility. When we have uncertainty on what the inflation rate will be, we have uncertainty on the purchasing power of future collected taxes. Uncertainty destroys benchmarks. Will the US Treasury be irrelevant? Who knows… Among developed nations, Canada may have the lowest financial uncertainty these days. If the price of uncertainty is represented by interest rates, the chart above right shows how strongly correlated the price of the Canadian currency is with the uncertainty over the benchmark (US 30-yr Treasury). The stronger the sell off in Treasuries (higher yields), the higher the Canadian dollar. This goes against the theory that explains foreign exchange movements by the difference in expected inflation rates. The Canadian dollar should appreciate when the Fed buys Treasuries, becasue these purchases expand the supply of money, which will bring higher USD prices in the future. In the past days, however, the Canadian dollar appreciated when the Fed DID NOT purchase Treasuries and these sold off. Why? Is certainty “priceless” these days?