Sept 18. A Hawkish Pass

The Fed is not going to hike on Wednesday.  The data has been weak, and the market has been reminded repeatedly of data-dependency, even though the data is utterly unimportant in the context of a shift in both internal central bank polices and external perceptions thereof.  Most importantly it’s a political decision.  The Fed has no desire to insert itself into the political process any more than it already has.  The last thing Yellen wants to be accused of is throwing the election or engendering a large stock market sell off a mere six weeks in front of voting day (from the FOMC announcement).   There has already been a tightening with the rise in Libor, and even though that adjustment is probably significantly over, the money market reform end date is October 14, which is just 4 weeks away.  There’s no upside to tightening now when the market is pricing low odds, as Yellen can simply use the press conference to signal the move in December.


You might recall the above scene from Trading Places, where Mortimer Duke has just enticed Billy Ray Valentine (Capricorn) into his chauffeur driven limousine by waving a bottle and saying “Whiskey!  All you want.”   In the current case, Mr Valentine is the public, the Duke brothers are the Fed and other CBs, and the whiskey is NIRP and QE.

The premise of the movie is a bet between Mortimer and Randolph Duke about the benefits of good breeding versus growing up in disadvantaged circumstances.  A wager on a social experiment of nature vs nurture.  It’s a metaphor for the current state of the markets.  You probably remember that Billy Ray is rather suspicious of the Dukes at the outset, but then he goes along with the plan, not initially understanding he’s being played.  In a similar way, the Fed and other central banks have engineered a grand experiment of negative rates, quantitative easing and forward guidance, on the public that won’t completely take the bait.  Oh of course in some ways they have fun with it.  Billy Ray starts off with a big party.  The corporate hierarchy takes free money, loading up on debt for stock buybacks to juice up earnings per share.  But at the end it’s a big mess as the guests are shown the door.

Bernanke put out a blog this week saying that “Economic THEORY suggests that aggregate demand responds to the real rate of interest, which is the nominal (market) interest rate minus the public’s expected rate of inflation.”  Randolph Duke was similarly taken with pseudo-scientific notions.

Joseph Stiglitz had a somewhat interesting clip explaining his frustration about government debt.  The gist of his argument is that you have to compare debt against assets (as one would ordinarily do in a business) to evaluate the entire picture.  However, with government debt, people simply focus on its growth and nominal level, not at all on the increase in assets like improved infrastructure and more educated people (human capital).  He infers that gov’t ‘investments’ will ‘pay off’.  He says [the gov’t] “can borrow at minus pct, you’ve got a 20-30% real return. It’s foolish not to make those kinds of investments.”  What have we actually seen?   Total debt has exploded, but GDP hasn’t grown that much.  A business might say, it’s not WORTH taking debt to expand capex in this environment.

We’re nearing the point where the pseudo-scientific premise of central bank policy is crumbling.  This idea is even more apparent with the Bank of Japan, which also meets this week.  While the US yield curve from 2’s on back has been in a ripping rally this month, a shift by Japan to focus on NIRP as the centerpiece of its policy, while shying away from QE and (perhaps) ETF purchases could further steepen global curves.  Consider the 5/30 spread in Japan.  In February it was as high as 130 bps, and then proceeded to collapse to 37 by the end of June.  As of Friday it’s 76.  5/30 in the US has gone from 104 to 129 this month.  If the Fed passes and the BoJ moves forward on the idea of a reverse twist (relying on NIRP and buying shorter term rather than longer maturities), then short curve positions will be in full on exit mode.

The Dukes’ experiment completely imploded when Valentine and Louis Winthorpe III realized that they were being treated like pawns.   It’s a cautionary tale for the Central Banks of the world.

“Just be yourself sir, they can never take that away from you.”  –Coleman (Winthorpe’s butler) to Billy Ray Valentine.


9/9/2016 9/16/2016 chg
UST 2Y 78.8 77.4 -1.4
UST 5Y 122.3 120.7 -1.6
UST 10Y 167.1 170.0 2.9
UST 30Y 239.0 244.8 5.8
GERM 2Y -63.1 -65.3 -2.2
GERM 10Y 1.1 0.7 -0.4
EURO$ Z6/Z7 16.0 16.0 0.0
EURO$ Z7/Z8 14.0 15.0 1.0
EUR 112.34 111.57 -0.77
CRUDE (1st cont) 46.46 43.62 -2.84
SPX 2127.81 2139.16 11.35
VIX 17.50 15.37 -2.13


Posted on September 18, 2016 at 6:02 pm by alexmanzara · Permalink
In: Eurodollar Options

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