Please, click here to read this article in pdf format: august-31-2009

Back from a brief vacation, a week later, I sit here trying to summarize what happened last week, and what may continue to happen…On August 4th (www.sibileau.com/martin/2009/08/04 ), I had updated my forecast and said that equities could reach higher levels, from the stagnant range they were in July. I reaffirmed this view on August 18th (www.sibileau.com/martin/2009/08/18 ) and do so once more today. Of course, in credit land, the tightening may continue, following the rally in equities. (I’m sorry; I should not call it a rally, but asset inflation).  What drives this trend?
1.-Liquidity
For a hundredth time, I show below (source: Bloomberg) the chart with the 3-month Libor –Overnight Index swap spread. It is still making lower lows, with a close of 16.75bps last Friday. How much lower can it go? Before this mess unfolded, it was stable at 10bps, suggesting that it still has some room to tighten.

We are not watching this spread alone. Last week, Michael Cloherty (Bank of America) pointed out that Libor may not be a reliable metric lately, given the wide range in offered rates (3-mo Libor was 34.75bps on Friday and Mr. Cloherty estimated the range at 18bps, which is significant vis-à-vis 34.75bps). Why do I bring this up? Because I was exactly expecting this sort of cautionary comment. The answer to this is that the absolute level does not count. What matters is the relative level, the trend. We should not care about the exactitude of a spread at 16bps. That’s not the story. The story is that this spread was above 100bps in March and is now at 16.75bps. Liquidity is out there chasing risk, and as long as we see this indicator, we may see the bid for risk continuing.
2. – Global Coordination in monetary policies
By now, it should be pretty clear that global coordination has been the stability factor in this crisis. As we said countless times, global coordination is what makes this crisis different from any other one in the past and it is the factor that has made this rally stable. In summary, liquidity fueled the rally and global coordination provided the stability for the rally not to be killed by the bears. It was on July 27th, a month ago; when we explicitly suggested this thesis (Implicitly, we suggested it on April 21st, when we said that all currencies are being debased in calculated order, denying gold the chance of playing a lucrative asset). A month ago, we said central banks can thwart any rebellion. This is what we saw two weeks ago happen in China and last week in Canada. In China, the Renmimbi is being “driven” to appreciate, with the central bank restricting liquidity growth and changing the composition of its assets both by asset class and maturity, while in Canada, the Federal Government plans to sell USD bonds, to boost foreign-exchange reserves and support lending by the International Monetary Fund. That is at least the official excuse. The most idiotic ground to justify this bail out on the USD was that Canada needed to diversify its sources of funding! What nonsense is that? We have capital flowing in spite of all the latest horrible fiscal policy and we even have the luxury of issuing bonds in our own currency, yet our government decides to ask investors to buy USD if they want to go long Canada risk? This is a perfect example of my point that we are going to see global coordination to a degree never seen before, and any rebellion will be dealt with swiftly.
When will the rally stop? The rally will stop if and when, having a fiscal problem erupted within one (important) country, the rest of the coordinating countries (also important) refuse or are unable to lend a hand. If that happens, the price of gold would jump, destroying any currency’s chance to be a reserve asset.

Please, click here to read this article in pdf format: august-20-2009

What a day! As we wrote on Tuesday that it was possible to have both treasuries and stocks rallying, we saw exactly just that happening in front of our eyes a day later, to the surprise of many. Who would have thought that with stocks losing 4.86% in Shangai overnight we were going to see a weaker USD and stronger stocks? Don’t let the herd fool you! Don’t listen to those who say that the surprise in oil inventory data is what drove stocks higher yesterday. Here’s the facts, you decide: The swap from Agency debt to Treasuries continued to play overnight yesterday, as shown in the chart below (source: Bloomberg), with the 30-yr Treasury rallying from 102-16 to 104+ by 8:30am (the yield curve flattened vs. last Friday close). The 3-mo Libor-OIS spread continued to collapse to 23.17bps yesterday, as the 3-mo Libor reached 41.87bps! This is hardly a normal situation of course, but to finish, let’s also remember that after 8:12am the EUR/JPY cross began to shoot up from 132.12. Thus, stocks were flat until obviously, the oil inventory data was released at 10:30am. But again, the wave had begun much earlier than that. Oil did not save the day, but it fuelled the push to higher levels:

For those not familiar with the spread shown above, here’s the math: Spread = Agency debt spread – Treasury spread
Given that Treasuries rallied (=Treasury spread ↓) and the Spread widened (=↑), the Agency debt spread either remained unchanged or went up (it actually went up). Thus:    Spread ↑ = Agency debt spread ↑ – Treasury spread ↓

Now, let’s go to the difficult part: Understanding what happened. In my view, we need to focus on China. The waves are coming from there. I will make an assumption here: Given that activity in Agencies took place overnight, I will assume the purchase of Treasuries is coming from Asia. Why would someone buy Treasuries? The only explanation I find is that that someone believes or perhaps KNOWS that interest rates are going to remain low longer than what most of us anticipate. Suppose that someone was the central bank of China.  The swap from Agencies to Treasuries represents a change in the composition of the asset side of the bank’s balance sheet. But if Treasuries (which are reserves to the central bank) rally:

1.    Would it not be easier for the central bank to appreciate the Renmimbi?
2.    And if the Renmimbi gained vs. the USD, should Chinese stocks not fall, as the appreciation affects the export sector? (Did this actually not happen since the start of the swap trade?)
3.    And if China is richer in terms of USD, could it also not afford more commodities traded in USD terms, like oil? (Did a rise in oil prices not happen in the last days?)
4.    Should the USD not only fall vs. the Renmimbi but against the EUR as well? (As it did today)
5.    Should a weaker USD not affect stocks in the US in a positive way, at least in the short-term? (As it happened today?)
6.    Should it also not allow firms to refinance their debt, driving credit spreads tighter? (As it may happen later on?)
The question is how this would be coordinated, if coordination is possible. What is in the works? A new stimulus package? Is this sustainable? And if it makes sense (or not…I am not sure myself), why was it not done earlier?

Please, click here to read this article in pdf format: august-19-2009

If you read most daily comments from yesterday, you will leave with the impression that nothing really substantial has taken place lately, perhaps on grounds that that trading was on slim volume. When some sort of fundamental analysis is proposed, it is also on the basis of the latest macro data releases (i.e. Producer Price Index, Housing, etc.) only.
However, something happened early this morning that I thought was rather strange. As soon as I started watching my usual charts I found that the EUR/JPY cross and the CAD were plunging, together with oil, as the 30-yr Treasury bond was in full force approaching the $103 level. With these figures, it was clear to me that stocks were to sell off yesterday, and I could not understand how Asia’s and Europe’s equity indexes were recovering. Below, I show the 30-yr Treasury intraday and the S&P500 (source: Bloomberg):

I was totally lost, until I came across a morning research note recommending selling 2-yr Agency debt (i.e. a security issued by US government sponsored agency, like Fannie Mae). I read the analysis and the recommendation made a lot of sense. Only then, did I put the two and two together: On Monday, as I discussed here, the “rumor” went out that China would buy mortgages. Why would China, owner of Treasuries, change these for mortgages that are so expensive? And then again, I realized that the latest sell-off we saw in stocks started in Asia…Now, I believed in conspiracy theories again!
If my intuition was right, we should have seen the spread between 2-yr Agencies and Treasuries react to this by widening, as 2-yr Agency debt was being swapped for Treasuries (i.e. investors sell Agencies = Agency spreads widen, and buy Treasuries = Treasury spreads tighten). Thus, I looked for the magic chart, and this is what I found (source: Bloomberg):

As you can see, this trade has been significant in the last two sessions and…it starts early, with Monday’s activity developing overnight in Asia. This has two immediate and very strong implications, as well as ramifications: (1) as this swap takes place within fixed income assets, we can perfectly see both Treasuries AND stocks rally, which is counterintuitive. The proof is in the 3-mo Libor-OIS spread that continued to collapse, reaching 23.85bps yesterday. In the process, if this comes from overseas, we can see volatility in the FX markets (i.e. EUR/JPY) and (2) this swap suggests to me interest rates may remain low longer than what you or I would think. If this is correct, jump-to-default risk can further fall and drag credit even tighter!

Please, click here to read this article in pdf format: august-18-2009

Inevitably, we need to discuss yesterday’s events. I must confess I read and reread all sorts of comments dating back to two weeks ago, encompassing a wide spectrum of opinions. There are the uber bears, telling us we are going to revisit the March lows, the optimist who point at macro data (i.e. New York Empire Manufacturing Index above consensus estimate of +4, rising to +12.1), and the cautious, who look for catalysts for a move on either direction. I want to believe I can include myself in the last category.
 
The optimist case is the easiest to grasp. In the case of the ultra bearish, the logic is flawless. Therefore, if we do not agree with it, we must disagree with their assumptions. The main assumption seems to be that government intervention will not change anything. But the rally we had since March 18th started precisely with the announcement of the Fed’s quantitative easing policies (and died when the Fed declared last week they would not extend the Treasuries purchase program). It may be true (it actually is) that, in the end, in the long term, the intervention we see will be sterile. We cannot see sustainable economic growth when fiscal deficits are monetized. But at the same time, if we appreciate that the intervention since March (to be more precise, since Dec 5th 2008, when the Fed first started purchasing securities, in a very muted way though) did generate the asset inflation of 2009, we must at least not ignore that increased intervention in the face of a generalized sell-off is still a possibility. We saw the Bank of England opting for such alternative only a few days ago.
 
On Thursday (“A visible inconsistency”, www.sibileau.com/martin/2009/08/13 ) I wrote that, in my view, as long as the US fiscal deficit continues with the resulting supply of Treasuries, the monetization is likely to continue, but in another form. I think we can safely say that today’s announcement on the extension of the Term Asset-Backed Securities Loan Facility (TALF) to Jun/10 for new Commercial mortgage-backed securities (CMBS) and to Mar/10 for other assets, constitutes an alternative way to monetize. After all, what does the US Treasury borrow money for, if not to bail out private failures (i.e. in the real estate market)?
 
Another interesting development is the announcement or should I say rumor (by Reuters early yesterday. Bloomberg, at 7:40am, reported that it could neither be confirmed nor denied) that the China Investment Corp. would buy $2BN of US mortgages under the Treasury-backed Public-Private Investment Plan.   In any case, we first proposed this alternative on June 1st (“What could China do?” www.sibileau.com/martin/2009/06/01 ), which would make sense as a coordinating policy to avoid the collapse of the USD. I never thought it would be implemented and the fact that is now a rumor raises a flag. However, let’s be clear: A $2BN transaction in a trillion-dollar market is laughable. But $2BN is better than nothing.
 
Thus, in general, although governments may not be all that successful in avoiding a feared sell-off, I don’t think we can just ignore the weight of their interventions. Having said this, another fact that makes me not so ultra bearish (for now at least!) is the low levels of the 3-mo Libor – OIS spread. This spread was 1.16% higher yesterday, but at the 24bps mark it is certainly not signaling stress yet. We’ll closely look at its evolution in the coming days.
 
Lastly, I could not help noticing that unlike previous sessions, when the S&P500 was always closing to the upside in the last hour, yesterday, it didn’t. Sometimes, I am superstitious too! Please, see the chart below (source: Bloomberg)

Please, click here to read this article in pdf format: august-17-2009

I thought it would be worthwhile to start the week describing how the last one ended. Today’s letter will be merely descriptive (vs. the typical analytical format) and full of charts, but I think that sometimes, there is value in induction.

With positive news out of Europe early Friday, it seemed it was going to be a good day across the Atlantic. The surprise came when, suddenly, the 30-yr Treasury rallied in early trading. With this rally, the yield curve was going to have an interesting flattening move by the end of the week (see charts below). However, early in the morning the USD was not appreciating, but the EUR/JPY was falling. Why would the USD not rally as well? Someone suggested it was a signal that the USD was becoming “the” carry currency, in line with what had happened to Japan. But if that was the case, we should have seen risk being bid (equities rising overseas, credit tightening), and that did not happen. In the meantime, crude (at around 8am ET) was holding its weight. One could still hope…until it just plunged. Obviously, volatility increased. Where is the inconsistency? As you can see, the 3-mo Libor-OIS spread kept making lower lows (did that liquidity end up in Treasuries?), while sovereign credit default swaps remain extremely cheap. Can this reversal lead us back to March/09 levels, if bad macro news keep coming and the Fed is really not going to monetize any more fiscal debt? I think this is only half of the problem. I think the other half is that the global coordination we saw in 2008 is loosing strength in 2009. The Bank of England led the way with its decision to increase its quantitative easing program. Others should follow, but are in denial mode. We should not ignore the VIX index, which is telling us correlation (systemic risk) is still alive.
(Source: Bloomberg)