As We See It: Yen Intervention

The big story in the past week was the massive currency intervention by the Bank of Japan (BOJ). Hard to know exactly how much went through, but reports were in the range of $70bn on Friday alone. FX interventions by major central banks are less frequent than they were years ago. This was the first BOJ buy side intervention since 1998. There is a pretty simple reason we don’t see intervention much anymore – it does not work. Let’s have a quick look at what’s going on.

Against the trend of most other central banks, BOJ policy has been to maintain low interest rates and keep long term yields under 25bps (a policy called yield curve control, YCC), despite rising inflation and a global backdrop of major economy yields rising substantially. They have been the principal buyer of Japanese Bonds, leading to a crash in liquidity. In recent weeks we have seen multi day streaks when the benchmark ten-year bond (the JGB as it’s known) has not traded. Forcing long-term interest rates to below market levels (the 10y swap market has rates around 70bps) has created massive pressure on the currency, and the BOJ has tried to stem the tide.

Intervention is like trying to hold 100 ping pong balls underwater at the same time – sooner or later one will pop up. As long as the BOJ keeps interest rates artificially low and continues yield curve control, the currency will eventually, intervention or not, get blasted. When the Fed is guiding market yields close to 5% and even the Europeans are raising 75bps a meeting, the policy gaps are untenable. Something has to give. As we write this, the BOJ is intervening again – they moved the currency about 1 percent, and then it immediately sold off again.

So why is the BOJ doing this. Japan is by far the most indebted major economy. That was fine as long as rates were low. What changes that calculus is – you guessed it – inflation. Unwinding these policies is like landing a jumbo jet on a football field. As the now ex UK PM Truss found out, the room to maneuver can shrink pretty quick.

Source: Bloomberg

As We See It: Commodities Peak? – A Lotta Bit of Yes And A Lotta Bit of No

Here’s a question in everybody’s mind – Have we seen the top in commodity prices? We can see both sides of the argument.

Yes. The Fed is going to move far enough to break things, that will push us into a recession or worse, and commodity prices fall in recessions. It’s global too, with Europe and Japan falling out of bed. China won’t come to the rescue this time either, with the Ponzi bubble that is China real estate deflating and Covid lockdown mania. With the USD on a tear recently, for those overseas buying things priced in USD it’s even worse. Oil in Europe and the UK is through 2008 spike highs already, demand destruction ensued then and will now. Forget it, the commodity trade is over.

No. Virtually every commodity, from grain to oil to electricity to butter of all things is tight.

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One great example, beef. Beef is one of the few commodities that has risen very little over the last year. Why is that, you ask. Because US ranchers have been liquidating the herds and putting that beef on the market, as costs have risen.  That has kept near term prices lower, but if the economy recovers, the herd will not be rebuilt fast enough and prices will rise rapidly. A classic whipsaw, and it’s happening everywhere. Prices have risen because of supply issues, and raising rates will not help supply as it raises the cost of production. Should the Fed take its foot off the brake, supply will not be replenished fast enough to satisfy instantaneous new demand. Result – higher prices, a bit down the road.

Last week we said – watch rents.  Look at this chart. If we have seen peak hawkishness, get bullish commodities.

As We See It: CPI

The reaction to last week’s CPI print was pretty dramatic. We see a couple of related factors:

  • Given the fall in gas prices, the S&P had bumped off the bottom in anticipation of a soft print. Positioning went from negative to perhaps modestly positive. CPI caught the market on the wrong foot.
  • Gas prices as reported in the CPI did fall as expected, but just about everything else went up (see graph below). Everyone knows gas fell because of releases from the Strategic Petroleum reserve. That policy is the definition of “transitory” (they will need to buy it back, no less). With everything else going up, inflation fears pulled a Lazarus.

Watch rents. Lagging but steady inflation indicator, closely tied to wages.

Source: Bloomberg

The Inflation Supertanker

I recently had a conversation with a colleague about the idea that portfolios over the last 40 years have been conditioned for falling interest rates. If that supertanker makes a turn, a lot of money will be on a collision course. He said in 1984 there was an equal and opposite issue … buying bonds for the prior 20 years had been a fool’s errand. The cycle climaxed in June 1984 with a hot GDP, a low inflation print and a collapse in bonds. Even though inflation was low, no one wanted to own them.

I was intrigued and pressed the conversation with our resident bond historian and partner, Paul DeRosa. His response below:

It was the bond buying opportunity of the 20th century. The long period of inflation and the large deficits run by the Reagan administration conditioned people to believe inflation was only temporarily low and that it would return, as it had in 1980. I bought 250 million of the 13 ¾ of May 2014 and was down 10 million on the trade before I wrote the buy ticket. With the funds rate at something like 11.5%, the yield curve actually got steeper rather than flatter. The current situation is something like the inverse of that period. We’ve had a long period of low inflation, and a lot of people still think it is temporary. So, I would expect rates to rise grudgingly and the yield curve to stay flat. The good thing about finance is that illusion eventually has to face reality. By late summer of 1984, the high interest rates had the economy on its proverbial tail. Payroll employment started to sag. I remember buying a boatload of the Treasury 4-yr Note in September, but it still was very hard to get people to accept lower yields. To keep from worrying about it I played squash at the New York AC, but checked the market between games.

Just to finish this up, 1985 was a pretty good year for the bond market, but the big break came in Spring of 1986, when the crude oil price collapsed. It took a big external event to change expectations about inflation. I completely missed that move because I misread the situation. The stock market also rallied, and I couldn’t figure out how bonds could rally with the stock market so strong. Well, the answer, of course, was the stock market was rallying because it saw rates falling.

Pricing Escape Velocity – The Rubber Hits Abbey Road

The chart below is fascinating to us, particularly in light of the fairly modest in magnitude, but quite speedy rise in UK yields. The chart shows the difference between futures prices for sterling 3 month LIBOR expiring in September 2022 and 3 years later, in September 2025. They price at 100 minus the interest rate, so a price of 99.5 equates to a 0.5% prevailing rate at expiry. Roughly speaking, individually the contracts can be interpreted as the markets best pricing for interest rates at those points in time, the spread between them gives a look at how the path is priced to get there.

A year ago, rates were priced to be at about zero in September 2022, and not much higher – maybe 1 hike – by September 2025. At a starting point of functionally zero rates – that’s a pretty poor prognosis for 5 years time. Earlier this year, the spread between contracts increased as the nearer maturity contract dropped a little in price – implying higher yields – while the longer maturity contract fell more in price. The spread widened to a high of 78bps in early summer. That’s the market roughly saying things are a bit better economically – over the next few years we will see about a hike per year.

The interesting part is not even the most recent drop in the September 2022 contract, as the market is pulling forward all those hikes into the next 1 year. Higher inflation and a better economy allowing the Bank of England to hike. So far so good, a bit aggressive maybe, but sure, probably some natural gas inflation in there. The interesting part to our eye is that the spread has collapsed. It is as if the market is saying ‘Sure you can hike now – but you’ll get to 1% and have to stop as the economy can’t withstand it, that’ll be it, maybe you’ll end up cutting again’. Now there are other things at play here in terms of pricing along the curves and longer rates being driven by other things – but as a fairly clean barometer its reasonable. The rubber is hitting the road on markets determining escape velocity. Will we get a self-sustaining recovery and a more normal economy that can sustain these yield levels and maybe higher as things take off? Or not? Its fascinating to watch play out…

Source: Bloomberg

Stresses In The Bond and Funding Markets: Post Mortem

We wrote a few times during the depths of March and April on stresses we were seeing in bond, credit and funding markets. It was clear things were not functioning correctly. It was equally clear that both monetary and fiscal policymakers were trying as hard as they could to counteract. Now that some time has passed much more detailed examinations are coming out that are well worth reading to get a better idea of how the plumbing works, and sometimes gets blocked.

The first is from the NY Fed Liberty Street Economics blog and details the Feds Large-Scale Repo program.

The second is in the Financial Times (paywall) and details the moves we witnessed in the US Treasury markets:

The third is from Josh Younger of J.P. Morgan writing for the Council on Foreign Relations:

All succinct and detailed pieces that will explain a lot of what went on.

 

 

Stresses In The Bond and Funding Markets: Update 2.0

We are now a couple of weeks on from the last update we wrote looking at the actions the Fed had taken to stabilize bond and funding markets. Given last Thursday began with further announcements of expanding efforts to help, it seems a good time to revisit where things stand now. The commercial paper program is now up and running and we should be seeing the first of the “Economic Impact Payments” hitting household accounts right around now.

First, a recap of the most recent actions. April 9th saw the Fed announce actions to provide up to $2.3 trillion in loans to support the economy. They are doing this in a few ways, financing the loans banks are making to small businesses under the Paycheck Protection Program. This is the program that gives small businesses a direct incentive to keep workers on the payroll, via loan forgiveness if all employees are kept on the payroll for 8 weeks post the first disbursal. Coupled with the expanded Unemployment Insurance benefits, the goal is to minimize the income shock as much as possible to workers by either increased benefits to laid off workers or aiding companies in paying wages to keep people employed through this period.

FRA-OIS spreads. This is a spread of a forward rate agreement to swap fixed interest payments at some point in the future compared with the overnight index swap rate. Think of it as a measure of the risk or cost for banks to borrow in the future relative to a risk free rate. A forward TED Spread. It reached almost 80bps, and has since settled in around 50bps. Still a bit high, but notably lower.

FRA-OIS update2

Source: Bloomberg

The Fed’s Commercial Paper Funding Facility became operational in the first half of April. This facility was announced earlier in the month – per the NY Fed – “to enhance the liquidity of the commercial paper market by increasing the availability of term commercial paper funding to issuers and by providing greater assurance to both issuers and investors that firms and municipalities will be able to roll over their maturing commercial paper.” The facility is a Special Purpose Vehicle, funded through the Department of the Treasury to hold commercial paper. Eligible issuers also include municipalities, and an issuer is able to repurchase its own outstanding commercial paper and finance it through the SPV. This space took a while longer to show signs of healing, and has a ways to go still, but some positive signs in the rates below.

CommercialPaper update2

Source: Bloomberg

On-the-run/Off-the-run Treasury spreads. Benchmark points on the yield curve – those at the 2y, 5y and 10y point for example – are of particular interest to market participants and are generally the most liquid parts of the curve, and have futures contracts tied to them. The US Treasury curve has many bonds of all maturities, including bonds that have similar characteristics to the benchmark points – like a bond maturing a month before or after the current benchmark point. Being so close in terms of maturity and having the same risk free issuer, these bonds normally trade more or less in lockstep. At the height of the bond market dislocations, they began to move apart. The resumption of very large scale US Treasury purchases from the Fed have worked in reducing the anomalies in this space. The chart shows a measure of the pricing dislocations – a number between -1/+1 is normal, we are now back in that range.

OffTheRun update2

Source: Bloomberg

Cross currency swap rates.The chart below shows Japanese Yen (JPY) funding costs. Roughly speaking this measures the extra cost over unsecured rates to swap JPY for USD at some future point. A Japanese company may swap JPY for USD today, with a 3m term. The cost of this should normally be the difference in relative unsecured lending rates (Libor etc). In periods of funding stress, a premium appears, which is the basis. The Fed eased the terms of its existing major swap lines and broadened the countries that can access the liquidity to include Brazil, Mexico, Australia South Korea and Australia amongst others. The updated chart for Japanese Yen shows the strain reducing substantially.

CrossCurrencySwaps update2

Source: Bloomberg

Credit spreads moved out aggressively in March. The Fed actions to launch two credit facilities backing corporate credit markets, a Primary Market Corporate Credit Facility for new bond and loan issuances and a Secondary Market Corporate Credit Facility to provide liquidity for outstanding corporate bonds has so far worked to narrow spreads and calm nerves.

creditspreads update2

Source: Bloomberg

At pixel time for the last update the Fed was rolling out a plan to lend as much as $500 billion to states and local government to aid them through this period. Spreads continue to stabilize here, and we are starting to see a return to issuance, with about double the number of offerings the next couple of days than last week.

Munis update2

Source: Bloomberg

One other area to keep an eye on as it pertains to credit availability, and also as it acts as something of an accelerant to activity. Mortgage spreads. These have moved wider on credit concerns, plumbing problems with mortgage buyers and refi demand. Part of the goal of lowering rates is to allow for widespread refinancing of mortgages and lower rates to grease the wheels of housing more generally. The more mortgage rates can track government rates down to new lows, the better. The chart below shows the difference between the Bankrate 30Y Mortgage National Average Rate and the US Ten Year Government bond.

mortgagespreads update2

Source: Bloomberg

So what to make of all these actions? Well first, time to update some priors. Even though rates were low, the Fed had room to act. Is it out of room now? We doubt it. If one has learned anything it is that a newly minted, awfully acronym-ed, facility can spring up and get funded fairly quickly. But don’t take our word for it – Fed Chair Powell literally went on the Today Show and told us – ‘We’re not going to run out of ammunition’. It is also worth noting that it is easier politically for programs to be extended in time and buying power now that they are here than it is to get them over the finish line first time round. To our eye, the policy actions from both the Fed and Congress are like using a pole to cross a ravine. It doesn’t matter how deep the ravine is, scary as it is to look down, it matters how wide it is. The real economy beginning to open up in the next couple of months will be welcome relief for all – many more quarters like this and the Fed and Congress will have to go back to the drawing board.

 

 

Stresses In The Bond and Funding Markets: Update

We wanted to post an update to our previous entry on Stresses in the Bond and Funding Markets and the Fed response. Over the last few days we have seen substantial easing in some of these markets as central bank actions have begun to filter through. Not all markets see the plumbing impacts immediately, as it can take some time for money to reach the target. Payments have to settle, loans extended, bond market programs fired up with funding and the like. The charts below are the same ones we showed before, in the eye of the storm (or at least we hope that was the eye).

FRA-OIS spreads. This is a spread of a forward rate agreement to swap fixed interest payments at some point in the future compared with the overnight index swap rate. Think of it as a measure of the risk or cost for banks to borrow in the future relative to a risk free rate. A forward TED Spread. It reached almost 80bps, and has since settled in around 50bps. Still a bit high, but notably lower.

FRA-OIS update

Source: Bloomberg

Commercial Paper markets continue to be wide. The Feds Commercial Paper Funding Facility becomes operational in the first half of April. This facility was announced earlier in the month – per the NY Fed – “to enhance the liquidity of the commercial paper market by increasing the availability of term commercial paper funding to issuers and by providing greater assurance to both issuers and investors that firms and municipalities will be able to roll over their maturing commercial paper.” The facility is a Special Purpose Vehicle, funded through the Department of the Treasury to hold commercial paper. Eligible issuers also include municipalities, and an issuer is able to repurchase its own outstanding commercial paper and finance it through the SPV. Watch this space.

CommercialPaper update

Source: Bloomberg

On-the-run/Off-the-run Treasury spreads. Benchmark points on the yield curve – those at the 2y, 5y and 10y point for example – are of particular interest to market participants and are generally the most liquid parts of the curve, and have futures contracts tied to them. The US Treasury curve has many bonds of all maturities, including bonds that have similar characteristics to the benchmark points – like a bond maturing a month before or after the current benchmark point. Being so close in terms of maturity and having the same risk free issuer, these bonds normally trade more or less in lockstep. Late last week, they began to move apart. The resumption of very large scale US Treasury purchases from the Fed have worked in reducing the anomalies in this space. The chart shows a measure of the pricing dislocations – a number between -1/+1 is normal, we are now back in that range.

OffTheRun update

Source: Bloomberg

Cross currency swap rates.The chart below shows Japanese Yen (JPY) funding costs. Roughly speaking this measures the extra cost over unsecured rates to swap JPY for USD at some future point. A Japanese company may swap JPY for USD today, with a 3m term. The cost of this should normally be the difference in relative unsecured lending rates (Libor etc). In periods of funding stress, a premium appears, which is the basis. The Fed eased the terms of its existing major swap lines and broadened the countries that can access the liquidity to include Brazil, Mexico, Australia South Korea and Australia among others. The updated chart for Japanese Yen shows the strain reducing substantially.

CrossCurrencySwaps update

Source: Bloomberg

LIBOR spreadsmeasure the spreads in different maturities of LIBOR rates. These can shift with expectations of upcoming monetary policy action, but generally speaking need to be kept orderly for markets to function well. As the market expected and wanted a cut to zero, rates moved considerably, this arguably called for the Fed to pull forward its planned cut. The Fed cut for second time on Sunday March 15th (and then cancelled the regular March meeting).

LiborSpreads update

Source: Bloomberg

The Fed’s goal here is to implement monetary policy – where stresses arise they will try and squash them. The capital ratios that are binding – reduced. Discount window stigma – gone. Overseas dollar costs going up – swap lines. Mortgages rates up a little – $200bn of MBS purchases. Treasury curve one-the-run/off-the-run blowing out, $500bn to fix. FRA-OIS spreads – squashed. Commercial paper blowing out – fire up the program. At times like these one starts to hear that the Fed must now be out of bullets. Rates are zero after all and what more can they do? Well people have said this for a while and here we are. The Fed is immensely powerful in dealing with this type of event, and clearly this time has acted very quickly and in particularly large size. As we write, another story comes up highlighting the impact on a different area where the Fed is now active, in corporate bonds. AAA CLO spreads have halved in two days. Municipal bond spreads were another area shifting out. The chart below shows the AAA muni yield as a percentage of the same duration US Treasury (relevant due to the different tax implications). So what did the Fed do – squashed it.

Munis update

Source: Bloomberg

Stresses In The Bond and Funding Markets

The last few days have seen some stresses in the bond and funding markets. The charts below illustrate a few of these, we then detail why the Fed intervened and cut again. The stresses are coming at a time when markets are fearful of the size of the sudden stop in economic activity we are witnessing due to actions being taken to defeat the coronavirus pandemic. Some sections of the economy are seeing large and fast drops in revenues, with a double whammy hit to the oil patch driven by the Saudi/Russia/OPEC actions in the oil price. Businesses are beginning to draw on revolving lines of credit in order to weather the storm. Markets are dropping, also contributing to the disruptions as positions are unwound into illiquid markets. At times like these, disruptions can be seen in different places.

FRA-OIS spreads. This is a spread of a forward rate agreement to swap fixed interest payments at some point in the future compared with the overnight index swap rate. Think of it as a measure of the risk or cost for banks to borrow in the future relative to a risk free rate. A forward TED Spread.

FRA-OIS

Source: Bloomberg

Commercial Paper markets began to show signs of strain. This is a lifeblood market that companies use to borrow short term and fund everyday expenses at terms of under a year. Having rates increase and access to funding drop at a crucial time is a clear threat to the ability of the real economy to weather a storm. Given the impact of states shutting down for short periods, companies need to be able to borrow to cover real economic weakness.

CommercialPaper

Source: Bloomberg

On-the-run/Off-the-run Treasury spreads. Benchmark points on the yield curve – those at the 2y, 5y and 10y points for example – are of particular interest to market participants and are generally the most liquid parts of the curve, and have futures contracts tied to them. The US Treasury curve has many bonds of all maturities, including bonds that have similar characteristics to the benchmark points – like a bond maturing a month before or after the current benchmark point. Being so close in terms of maturity and having the same risk free issuer, these bonds normally trade more or less in lockstep. Late last week, they began to move apart. An example below – the green/red column shows a Z-Score of individual bond spreads of similar maturities roughly 10 years out.

OffTheRun

Source: Bloomberg, 3/16/2020

Cross currency swap rates. The chart below shows Japanese Yen (JPY) funding costs. Roughly speaking this measures the extra cost over unsecured rates to swap JPY for USD at some future point. A Japanese company may swap JPY for USD today, with a 3m term. The cost of this should normally be the difference in relative unsecured lending rates (Libor etc). In periods of funding stress, a premium appears, which is the basis.

CrossCurrencySwaps

Source: Bloomberg

LIBOR spreads measures the spreads in different maturities of LIBOR rates. These can shift with expectations of upcoming monetary policy action, but generally speaking need to be kept orderly for markets to function well. As the market expected and wanted a cut to zero, rates moved considerably, this arguably called for the Fed to pull forward its planned cut. Below is overnight vs 1 month.

LiborSpreads

Source: Bloomberg

The Fed delivered a second inter-meeting cut on Sunday in response to the coronavirus and to try and alleviate these funding stresses to allow better transmission of monetary policy. The FOMC lowered the federal funds rate by 100bps to a target range of 0 to 0.25 percent, as well as providing forward guidance, noting that they expect “to maintain this target range until it is confident that the economy has weathered recent events and is on track to achieve its maximum employment and price stability goals.”

Alongside this, the FOMC announced a program to purchase assets of $700bn, split $500bn in Treasury securities and $200bn in agency mortgage backed securities. The statement spoke of wanting to ‘support smooth market functioning’. These purchases began yesterday. Note that in QE3 the peak pace was some $85bn per month. Make no mistake – these purchases are huge. The FOMC also made a plethora of changes to other parts of the plumbing aimed at improving the efficacy of market plumbing and conducting policy, including lowering the discount window spread, reducing the rates on OIS on swaps with foreign central banks and eliminated reserve requirements. Today they have announced the establishment of a Commercial Paper Funding Facility.

The Feds goal here is to implement monetary policy – where stresses arise they will try and squash them. The capital ratios that are binding – reduced. Discount window stigma – gone. Overseas dollar costs going up – swap lines. Mortgages rates up a little – $200bn of MBS purchases. Treasury curve on-the-run/off-the-run blowing out – $500bn to fix. FRA-OIS spreads – squashed. Commercial paper blowing out – fire up the program. Did it work? Well it is early, but so far it looks like some of these have eased. They are worth keeping an eye on. By way of example, the easiest one to keep an eye on updated through todays close. FRA-OIS dropped a lot today.

FRA-OIS v2

Source: Bloomberg

Trend Following in a Low Rate Environment

Can trend following make money in a low rate environment, and is it all bonds?

We often get asked whether trend following strategies can make money in a low interest rate environment, or in a similar vein, if trend following is just a levered long bond position that’s now run its course. In short, we think that higher rates can help some aspects of trend following strategies, but certainly should not be a driver of a long term allocation decision. The portfolio benefit of an allocation to trend following to an investor or plan with more traditional equity and credit market exposures is not solely – or even largely – driven by the fixed income exposure. Using a simple trend following model in commercial markets (commodity, fixed income and currency – we explain here why we think that’s the right approach) below we break down the sources of returns in times of crisis, and suggest an economic rationale as to why it isn’t just about bonds.

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