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:

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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.

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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.

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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.

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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

The False Precision Black Hole

When I started at Commodities Corporation in 1979, we managed $100MM dollars. We had computers that sat on raised floors in climate controlled rooms. We were state of the art….and we still had 100 employees. Alas, fees were higher, but my point is that advancing data availability and data processing has been a boon to the investment industry.

But there has been an unmistakable downside to all this power and information, what my partner Roger has christened “false precision”. Everyone has lots of data and the power to manipulate it with ease. All questions can be answered with “hard numbers”. Risks can be fully calibrated (see previous post, A Note on Risk). Nowhere has this thinking reached more heroic levels of absurdity than at your Federal Reserve. From a Chairman Yellen speech, circa 2012:

Although simple rules provide a useful starting point in determining appropriate policy, they by no means deserve the “last word”–especially in current circumstances. An alternative approach, also illustrated in figure 10, is to compute an “optimal control” path for the federal funds rate using an economic model–FRB/US, in this case. Such a path is chosen to minimize the value of a specific “loss function” conditional on a baseline forecast of economic conditions. The loss function attempts to quantify the social costs resulting from deviations of inflation from the Committee’s longer-run goal and from deviations of unemployment from its longer-run normal rate. The solid green line with dots in figure 10 shows the “optimal control” path for the federal funds rate, again conditioned on the illustrative baseline outlook. This policy involves keeping the federal funds rate close to zero until late 2015, four quarters longer than the balanced-approach rule prescription and several years longer than the Taylor rule. Importantly, optimal control calls for a later lift-off date even though this benchmark–unlike the simple policy rules–implicitly takes full account of the additional stimulus to real activity and inflation being provided over time by the Federal Reserve’s other policy tool, the past and projected changes to the size and maturity of its securities holdings.

Lord have mercy! Can she really think this can work? Is there any Fed model that caught 2008, 1998, 1987, or any other market moving event? This is the event horizon of the false precision black hole. But don’t worry, just throw a bunch of junk mortgages in a bucket, stir, and voila – AAA. It’s all right here in this spreadsheet.