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

A Macro Classic?

Classic_CokeMacro trades come in two flavors, modern and classic. Modern trades are short term, liquidity driven, mean reverting market dislocations. You stare at the screen, pounce, make or lose your money, and exit. Symmetric risk, big premium for risk management and timing. Classic trades are long term, cyclical shifts in the investment landscape. Classic trades take advantage of the myopic nature markets – extrapolating the present. Classic trades have the potential to make big money, because the risks are asymmetric and the herd is against you.

We think we see a macro classic – inflation. Take a look at this study from the St. Louis Fed… https://www.stlouisfed.org/on-the-economy/2016/february/future-oil-price-consistent-inflation-expectations. Current inflation expectations imply a future crude oil price of $0 under a semi-reasonable set of assumptions. Quibble with the model if you like, but you cannot escape the fact that current market pricing anticipate little future inflation. Am I able to predict what will drive future inflation….No. Like the card counter in blackjack, however, the deck sure looks rich.

Certain funds that Mount Lucas manages may or may not, from time to time, have positions which seek to realize an exposure to future inflation.  There is no guarantee that such positions, if established, will be established timely and exited profitably.

The Fed: Think Local Act Global?

Is the Fed the world’s central bank or a domestic institution? As we see it, this is the key question for the Fed at its next meeting. The economic data since the last meeting, looked at in isolation, should lead them to continue hiking the Fed Funds rate – simply put, the unemployment rate now stands at 4.9%, and inflation has made further progress back to the target with core CPI at 2.2%. The charts below show the progress toward the dual mandate. On the employment side we look at the unemployment rate against the NAIRU measure. On the inflation side we use the sticky and flexible price series.

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Convergence of Consensus

potd-horses_3003379kSince we have been in the business, and well before, sentiment measures have been used to gauge the popularity of trades –everyone of age remembers the MarketVane sheets. It is our sense that there is a more rapid convergence to consensus than ever before – that is, investors, in response to changing data, coalesce around a forward view very quickly. We hope to add some statistical meat to this idea over the next few months, but for the time being let’s begin with an anecdotal example. Continue reading

The U.S. as a Small Open Economy?

Back in the day, macroeconomists used one of two models to think about how central banks steer economies. For a big economy, with modest international trade and capital flows, the model ignored the rest of the world. The central bank, by changing liquidity conditions, raised and lowered interest rates. Changing interest rate levels drove interest sensitive sectors up and down, thereby tightening or loosening slack in the economy. Inflation rose or fell, depending upon the tightness or slack in domestic markets. For a small economy, with large international trade and capital flows, the model highlighted rest of the world dynamics. In this model, global capital markets set the interest rate. The central bank, by changing liquidity conditions, raised or lowered the value of the currency. A rising currency would restrain growth and weigh on inflation. A currency in retreat would do the opposite. The U.S. was the poster child for the large closed economy. Canada was the prototypical small open economy. Continue reading

Everyone is in a lather about…

…the disconnect between retail sales and jobs.  But check out this chart:

retail sales

The same thing happened in the mid 90’s, an absolute boom period.  What was going on….? Gas prices collapsed, just like now. Gas as a percentage of total sales has dropped by a third. Even stripping out gasoline isn’t totally clean either – the likes of Costco, Walmart and WaWa all sell gas as well.

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