Macro: The End of QE-topia

Negative rate is much more than what it says on the label. One of the cornerstones of modern finance is what is called present value (PV). PV is used to evaluate real projects, value financial investments or price derivatives, you name it. Surprisingly, based on my personal experience, it appears many practitioners and investors are unaware of the fundamental assumption on which this all encompassing concept of PV is delicately balanced - an assumption of a properly functional lending and borrowing market. Without that, there is no mean to transfer values across time back and forth, and PV loses its real meaning. Negative rates makes one question the validity of this assumption.

Central banks, it appears, are having a hard time. Last week's BoJ's underwhelming policy outcome was scorned off by the markets with an emphatic rally in Yen and sell-off in JGBs. This week BoE is widely expected to kick-in with some Brexit easing, and the markets so far has greeted the possibility with a renewed sell-off in FTSE 100. ECB is also expected to up the ante with another QE extension sometime later this year, and the European equities do not seem overjoyed about it. To contrast, S&P 500 seems pretty much nonchalant about a plausible Fed hike. The usual QE-led risk rally, it appears, are drawing to an end. In fact a few are already calling out for a regime change - from QE to deflation dominance (or lack of demand).

In the wake of the Great Financial Crisis, most central bank carried out a massive amount of monetary stimulus. One way to track the global monetary stimulus beyond policy rates is to track the combined balance sheet of major central banks¹, as we see below.

Few would argue against the unprecedented monetary stimulus led mostly by the Fed which served a crucial purpose during and after the crisis to restore confidence, liquidity and growth conditions. However, the effectiveness of QEs from other central banks have arguably been much weaker. ECB QE is so far hardly "successful".

Also, over time, the impact to real economy has grown visibly less dramatic. Below chart (left one) shows the growth in global major central bank balance sheet  vis-à-vis growth in M2 money supply as well as bank lending across major economies². Since the abatement of the European Sovereign Crisis in Q3 2012, all the measures have started moving in lock-step. What is more, the magnitude of global M2 growth has been lower than central bank balance sheet growth, meaning less bang for the QE bucks. The bank lending growth has been even lower than that. It is hardly a surprise we started to have quite a bit of noise around the effectiveness of QE and monetary stimulus around that time and since.

It is not hard to see why. As the right hand chart³ shows, irrespective of what the central banks have been doing, the global private sector still continues with deleveraging (with some exception, like US corporates). The excess savings - especially for Euro area (and a large contraction in dis-savings in the US as well) clearly underscores the problem. This arguably is an expected outcome of a balance sheet recession - wherein the private sector, afflicted with too much debt and in a process to repair their balance sheet, will try to increase savings and desist from borrowing no matter how low the lending rates are pushed down by QE. This is less a question about pricing and more about the capacity and willingness to borrow. On top, the increased regulatory burdens and negative interest rates certainly did not help the banking sector much to upsize their loan books. The combined effect - anemic global demand and as a result, stunted global investments (not helped by pre-crisis built-up over-capacity in certain sectors) - was given a new moniker, secular stagnation.

Economies can be stimulated using many forms and jargon. But in any case, to boost demand it must work to enable the demand side to afford it. And this increase demand must be paid for by either increased debt (i.e. borrowing) or equity (like increased transfer or wage). Monetary policy, in practice, mostly tend to fund this increased demand through debt in its standard transmission channel through banks. In a scenario where many are focused on reducing leverage, it is no surprise that this will have a less-than-expected impact. Monetary policy can enhanced equity based spending as well, like through wealth effect or inducing an increase in wage through increased inflation expectation. While this has worked in the US, for the rest of the world, especially in Euro Area and in Japan, this has hardly been the case. The dis-inflation remains very much alive.

There are some recent trends, however, that is slowly becoming a theme - and it involves the other side of the stimulus coin. 2015 has been the first year after the extra-ordinary time during the crisis, that major global economies have experienced a reversal of a combined fiscal tightening (see below⁴ on the left). We are past the fiascoes like sales tax hike in Japan and the excessive focus on balanced budget in Europe. And a few countries like Canada and Japan have already stated fiscal stimulus as their explicit policy tools. US may see similar moves after the election. Of course the downside of the government playing the role of "consumer of the last resort" is that this comes at a cost of debt concentration at government sector. 

We are on a cusp right now. Global consumption, despite all the allegation, has shown considerable resilience (although much away from their pre-crisis period, see chart⁵ above on the right). What we want now, more than ever, is avoiding any policy mistake. Given the fragile nature and very low margin of error on the policy side, it will be hard to recover from one. We are past the days of equity rallies with every new round of monetary easing. Markets will focus more and more on the underlying growth. This growth will of course have some costs - the key policy issue will be how to allocate that in a balanced manner between the fiscal and monetary side of this. One-sided efforts from central banks - increasingly larger asset purchase from a rather finite pool in a world characterized by negative interest rates and safe asset shortage - is perhaps past its used-by date.

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1. source: national central banks
2. source: national central banks, IMF, Bloomberg
3. source: national statistics offices, IMF
4. source: national statistics offices, national central banks
5. source: national statistics offices, Bloomberg

Trade Idea: Positioning For ECB

The expectation for the next ECB is running high. Many from ECB, including Mr. Draghi, has already talked up further measures. There are already talks of telescopic monetary policy taxation in the air. And a lot of speculations to follow.

The ECB announced QE at the end of Jan this year. Then the market priced in QE aggressively as well, and yet ECB over-delivered. The continuation of the movement past the announcement and well past the start date is a proof of that. This time as well the market has priced in possibilities of further measures aggressively. The question is this time, will they deliver, or over-deliver?

The recent moves in the market in many way resembles the time period before the last QE announcement. And at the same time differs in some crucial details. The major similarities: 1) selling off in Euro, 2) rally in the front-end and major differences are 1) remarkable steadiness of the long-end and 2) steepening of the curve. In the figure below we show the excess moves in rates and slopes (relative to the US). The Blue columns are the move in the last QE. Red one current moves and the green columns shows what the current move should be if we adjust for the move in Euro (that is we assume the euro move correctly prices expectation and compare rates move based on that). As we can see the move in the front end much stronger than before, and reverse for the long end. In fact corrected for euro, the move in 10y is about fair. While 8th euro futures rallied most and 30y did much less than expected.

The bone of contention here is of course what exactly will the ECB do. As clear from the picture above, the market is fully or to a large extent pricing in an action in the front end, that is, a significant depo cut. And with all the stories of -20/-50 tiers or -35 flat or all other possible combination, it is hard to say what happens if ECB does a significant deposit cut. There is no reason to believe they cannot exceed expectation. So perhaps short end move is justified.

But here is the key. Whatever be the depo cut, it is in itself not important. It is plausibly true that the point of this depo cut is simply to make the QE program more tenable. With 15% of euro area govies trading below current depo, the ECB has a strong incentive. The question is if they do deliver, what does that mean for long end. It does not mean we have an increased supply, nor it means depo is reflationary. All it does it to save the QE program by making more bonds eligible. I have not checked for euro area, but based on Germany distribution of yields and amount outstanding, roughly a move from -20 to -35bps makes 84b more available. With a capital key of 18% that is ball-park 470b more papers to buy for ECB, approx. 8 months worth of QE. This is significant. But we also have to count in the feed-back response, as the market may potentially push the curve further down, and thus neutralizing a part of the impact the ECB hoped to create. So if this depo rate comes with any significant expansion of QE in terms of time or size, the long end should be biased for rally. And if the depo rate cut does not match market expectation, the short end will sell off back to previous levels.

And while we have all these, another point to note is the levels of vols. The implieds are way to high compared to delivered. But if we adjust for the Fed hike expectation (by computing implied/realized premiums in EUR over USD), the front ends are still cheaper compared to long end on a realized basis, with 5y around fair.

I believe whatever ECB does, it will hardly be a lasting change. Europe needs fiscal stimulus now. Monetary policy is just a tool to avoid falling behind, but can hardly give a large push ahead. Whatever the move follow the momentum, and then position for a fall back. ECB claims the QE has "clearly" worked, but the real rates in euro area were back at the 2014 levels at end of August, before the new QE expectation kicked in.

The trade here: A convex flattening position in 5s30s or 5s10s. If not through spread options, given the vol richness and underlying directionality, buying the belly payer vs. long end looks better than the alternative in a risk-reward consideration.  Otherwise a Nothing. Wait till the announcement and no point trying to fade the market from here.

EDIT (3-Dec-2015:08:55 UTC): The hidden risk to this view is the ECB doing away with the yield-floor limit for QE eligibility. That may lead to a large upward correction in long term yield and a significant steepening.

Economics: The Myth of "Quantitative Tightening"

It is the latest populist theory doing the rounds in the financial media. Even the mainstream media is now flooded with this now. See here and here

To see why it does not make much sense, we need to understand what quantitative easing actually is, in terms of Economic models.

The standard Keynesian model is the famous IS-LM model. This captures the goods and money markets equilibrium simultaneously in an economy. The IS curve of the model, derived from the equilibrium of output and aggregate demand, captures the goods market equilibrium. It outlines the combinations of interest rates and economic output for which such equilibrium is possible. It is a downward sloping curve, as for a given level of external factors, a higher interest reduces the investment spending and hence output. The second part of the model is the LM curve. Derived from the demand of money, it captures the combination of interest rates and output for which the money market is in equilibrium. This is an upward sloping curve, as for a given amount of money stock, the demand for money goes up with higher income and lower interest. For more on this look here for a quick introduction. The entire economy is at equilibrium at the intersection of these two curves, which implies simultaneous equilibrium in goods and money markets.

However, I think to analyze QE, it is better to switch from IS-LM model to IS-MP. It is a variation of the IS-LM model which retains the same IS curve, but replaces the LM curve, by an MP curve (MP stands for Monetary Policy). The advantage is primarily two-folds. Firstly, unlike the implicit assumption in IS-LM model, most modern central banks do not target money stock, but rather a policy rate - which is explicit in the MP model. Secondly, the IS-LM is a bit ambiguous. Ideally the relevant interest rates for IS curve is the real interest rate, and nominal interest rates for the LM curve. So effectively it is a bit round-about to incorporate inflation directly in IS-LM. And as we will see QE is largely about (expected) inflation. For more details on IS-MP, look here (opens PDF and a bit wonkish)

Figure below shows a typical IS-MP curve. As mentioned before, the IS remains as it is. The MP is upward sloping. Which makes sense as most central banks uses a Taylor Rule approach to determine the appropriate level of real rate to target, balancing output and inflation. For a central bank targeting purely a real rate (i.e. inflation targeting), the MP curve will be horizontal.

In the IS-MP model, the economic shocks can be analyzed in a manner very similar to the IS-LM model. Suppose the economy is initially at equilibrium E0 with output at potential output of y0. If there is an external negative shock to aggregate demand (like the 2008 crisis), the IS curve shifts to the left (IS' in the plot), along with a drop in output y1 (which is below the potential output) at a new equilibrium of E1. The response of the monetary authority is to shift the MP curve towards right sufficiently (expansionary policy) so that the equilibrium point E1 shifts to E2, which brings the output back to potential, but at a lower real rate (r'). How the shifting of MP to right is actually achieved depends on many things. For a normal economy with sufficiently high nominal interest rates and stable inflation expectation, manipulating the nominal rate (setting fed funds etc) can achieve it. In case of a positive shock the dynamics works in the reverse. This is what central banks do in a nutshell.

The question is what happens if the nominal rates are not high enough (the so called liquidity trap). Or the initial shock is so large that to change real rate enough to reach the equilibrium E2, the nominal interest rate has to become negative (with a given inflation expectation). Obviously, this is not likely to work. Here the interest rate implies the general level of rates. Forcing the general level of nominal rates to negative territory is quite a challenge (if desirable at all), as people can just hold cash instead of bank deposits (thus avoiding negative interest rates, i.e. paying fees to park cash at banks).

The way out is to tweak the other component of the real rate. That is inflation expectation. If the demand is lower than potential, the inflation and inflation expectation has already started creeping towards a lower base. If the central bank can convince people that it is not going to stay low for long, and jack up the expectation, that can reduce the real rate, even at a zero nominal bound. Which in turn spark real activities. Quantitative easing is a tool to achieve just that. In fact we can express real interest rates as below (as a matter of definition):

Long term real rates = average path over expected future nominal rates + term premium - expected inflation.

Even at zero lower bound, the central banks can use tools to manipulate any of the three terms to achieve its objective. For example, the "forward guidance", adopted by Fed, is a tool to manipulate the first term. General asset purchase influence the second term. And depending on how the QE is planned and communicated it can influence the inflation expectation. In fact the standard way how QE works is mainly two channels - a) the portfolio re-balancing channel, which compresses the term premium, and b) the inflation expectation channel. And together they can work exactly like the expansionary monetary policy in the diagram above. Even at the zero nominal bound. That is pretty much what quantitative easing is. So by definition, "Quantitative Tightening" will work in reverse. 

But, we are not talking about quantitative tightening by the domestic central bank here (i.e. the Fed), but rather foreign central banks. To analyze that, we need to extend out model to an open economy.

Much of the things remain the same. The stuffs that change are two-folds. Firstly, the IS curve is now influenced by the real exchange rate (opens PDF, a brief primer). An appreciation of dollar in real term will make imports attractive for domestic consumers and export costly for overseas consumers. So this works like a negative shock to the IS curve (domestic output), a shift to the left. Secondly, we also need to incorporate the foreign exchange market equilibrium, captured in the line BP (abbreviation for Balance of Payment). This equates the demand for foreign exchange (import over export) and supply (net FX inflows, ignoring central bank reserve changes, which is only applicable for pegged currencies or managed floats). For perfect capital mobility, this will be a horizontal line, as we can have only one interest rate at which we can have equilibrium. At every other rate, large inflows or outflows will overwhelm and restore balance. For general capital mobility, we have an upward sloping curve. The equilibrium for an open economy is achieved in the intersection of all three curves - IS, LM and BP

In such a scenario, negative demand shock can be countered as before. Assuming a floating exchange rate regime, an expansionary monetary policy, reducing fed fund target or QE as the case may be, pushes the MP curve towards the right to MP'. Given the lower rates, the new point is below the BP curve, which implies an imbalance in the FX markets. In this case, the dollar becomes cheaper in real terms, leading to simultaneous increase in net export (IS shifts right to IS') as well as improvement in current account (BP shifts right to BP'). This changes the output from y0 to y1 at a lower interest rate levels. The equilibrium changes from E0 to E2. Notice the change in real interest rate is less than the previous case. A tightening works in the reverse.

Now "Quantitative Tightening" by PBoC or other central banks, (i.e. selling of treasuries) is a totally different beast. PBoC has NOT decided overnight that it is the monetary authority for United States, and is NOT trying INDEPENDENTLY to influence the monetary policy for dollars. Nor it can change the total dollar money stocks. It is selling treasury because of its own monetary policy aim, which is to maintain the Yuan trading range.

So in effect, in the above diagram, nothing changes. No dollar monetary base, nor real exchange rate, nor inflation expectation to move any of the curves. There is a potential of changing the term premium. But assuming it is selling foreign reserves for the purpose of exchange rate targeting, it must be selling not only treasury but all other reserve currencies as well. That means it will require a huge selling by PBoC to achieve a modest increase in the term premium. Which is unlikely. 

Also a QE or reverse for a large bond markets like US treasury (approx USD 16 trillion outstanding) primarily works through inflation expectation than portfolio re-balancing channel. For example, the episodes of previous QEs by the Fed actually saw a modest increase in treasury yields, but an overall reduction in real yields (as computed through breakevens). In addition, the Chinese FX reserve can be around USD 3.6 trillions on paper, but given the size of the economy and exports and imports, China must maintain a part of it as a safe guard as per IMF recommendation (opens PDF). So effectively a much less amount is available for this so called Quantitative Tightening.

And lastly, the entire point of treasury selling of China is maintaining the FX policy. The recent capital outflows increased the devaluation pressure on China, and PBoC is selling dollars and buying Yuan to protect the range. So effectively it is keeping Yuan artificially overvalued, one can argue. And that means, if they do not do that, i.e. stops selling treasuries, that will actually have an worsening impact on the US, as USD real exchange rate appreciates and shifts the IS curve towards left.

Now enough of theories. Let's look at some hard data. How much net selling is happening anyways in treasuries - based on TIC data as of end of June 2015.

Hardly anything that suggests "Quantitative Tightening"!

Although official ownership of long term treasuries has gone down, this is more than compensated by increase in private ownership. The only countries where we have seen total treasury ownership going down is Japan and the Switzerland + Benelux block. And on overall basis foreign ownership of treasuries is on a steady upward path, after a sizable reduction for a brief period of Taper Tantrum back in 2013.

Only Fed can do a real quantitative tightening. "Quantitative Tightening" by PBoC is mostly a nonsense.

Nevertheless, what is interesting in this entire model thingy is the dynamics. You might have noticed how the entire thing works. Any monetary policy changes in response to a negative shock in demand lowers the real rate. Similarly a positive demand shock will increase the real rate for the same potential output. Interestingly in recent times, the demand shock distribution has been highly negatively skewed (you can have a look at the real GDP distribution since 80). It is hardly a surprise ever since we have a constant downward drifts in general rates levels. Forget about secular stagnation and other interesting theories. Even in a perfectly normal economy, a negatively skewed demand shock distribution, along with Keynesian central bank, implies rates will have a tendency to drift down and eventually hit the zero lower bound and get stuck there. There are only two ways out. Either reigniting the animal spirits and optimisms of the industrial revolutions or the post-war period. Or a higher inflation target. Else downward yields are far more likely than a sharp sell-off in rates. No matter which foreign central banks are re-adjusting their FX reserve.

US Asset Flows + The Thing That is Chinese Stock Market

Flows into/out of/ within the US. Treasury released the TIC data last week (for May). This is how it looks (international flows in to the US)

 

 

International flows in to treasuries picked up this year since Q3 last year, mostly driven by private flows (as opposed to official, i.e. other central banks and sovereign wealth funds). The total official year-on-year growth in flows in negative territory for the first time (apart from a flirting with it early 2014). However total flows still positive, money continues to be pumped into treasuries by foreigners. Negative flows since March this year mostly driven by the financial centers, i.e. the UK, Belgium, so is China (Mainland) and Hong Kong put together. However, Caribbean (presumably a good proxy for hedge fund flows) has been quite positive.

 

On other assets, the corporate bond turned a corner and now in positive territory, while equities outflows continue.

 

On domestic front, the total equities flows to mutual funds flattened out mid last year, but allocation to world equities still strong. And bonds funds flows have seen a comeback since start of the year, after a minor hiccup Sep last year (which is interesting, as that coincides with a strong sell-off US equities). Also money markets flows picked up, perhaps pointing towards a more defensive stance among fund managers and other institutional allocators. Flow to bonds outside US (including ETFs) has diminished quite a lot since Jan, after a strong pick up last year around March (not shown here).

 

 

Key takeaways: 1) treasuries are yet to be become hot potatoes among investors in view of rising rates 2) too many folks missed out the strong sustained equity rally in the US and in no mood to get back 3) overall institutions seems to be holding most cash in recent times. This hardly makes a case for a sharp correction in US equities - not by a rate hike at least. A force from outside is a different matter altogether.

And on the later point, here is a comparison between NASDAQ Composite and Shanghai Composite from a long term investing point of view. This shows average growth of the cash indices vs. volume weighted price (VWAP) since beginning July last year (when the Chinese equity rally took off, click to enlarge).

 

The point is, Chinese equities are still up on YTD basis, even after the recent carnage (15% YTD and 83% if you invested start of last year). One way to estimate the damage is comparing the VWAP price with an average price. The scenario of VWAP being lower than average price is a really bad one, as that signifies volumes in selloff was larger and on a net basis offsets the gain during the rally. In plain English: more people lost money than gained. The chart above captures this. The VWAP and average lines are close to each other for NASDAQ composite but the VWAP is outperforming the average for Shanghai Composite so far. So as of now, the market is still up in China, and no hidden catastrophic pain than it appears. Of course two things can offset this conclusion: Who came in last? If it is the regular Joes (with a higher marginal consumption to income ratio) then it is bad for consumption part of the GDP. Secondly we have the recency effect, this kind of sell off is unnerving. Where do you invest in China if you are the little guy? real estates are not looking great, bank deposits is value eroding, and equities, they simply has taken you for a ride. Increase in central bank liquidity is not that effective in a risk-off scenario.

Upcoming bid data release: US Q2 GDP advance estimate and Employee Cost Index, both on this Thursday.

Inflation: It is Still a Long and Winding Road Ahead

With the commodities seemingly bottoming out, we have quite a strong reversal of moods in the market about deflation. Suddenly there is lot less worry about disinflation and lot more chatter about rate hikes. It is true since the bottom in Jan, Brent is up 42%, WTI  36% and the broader CRB commodity index is up `9% since the troughs around middle March. And breakeven inflation market followed the suit across markets, in EUR, USD and GBP. 

However, we are perhaps far from writing off the disinflation fears. The goods prices, including energy prices, have bounced back from the bottoms, but the services shows a very different story. And I believe this is the story of the underlying inflation pressure once the base effects and transitory effects settle down.

The Euro area is really really far from coming out of dis-inflationary pressure. The MUICP service YoY prints has been, and still is, steadily going down in a trend that started mid 2011. There was an interesting article from the excellent IMFDirect blog about the NPA dead-weight on the banking sector. This is definitely NOT helping. As mentioned earlier, the QE impact in Euro has been less successful in terms of inflation and real rates, spectacular as it was in terms of nominal levels and exchange rate.

And as expected, UK services are quite in sync with the Euro area following the downward trend. The only one robust among this is US. 

Last week's large sell off in rates was triggered by Euro zone rates (perhaps supported by the M3 and the ECI prints from the US). However, this is no repricing of economic outlook. The sell off has been entirely in real rates, with breakeven hardly moving much. This shows the sell off was definitely driven by QE positioning. Most likely the players front running ECB has a sudden change in mind and scampering to get out, triggering lots of stop losses. 

And as Goldman Sachs explains, this can definitely be a self-fulfilling cycle. ECB pledge to buy papers floored at negative 20 bps means players can push the price of any papers subject to that floor (unlike long term investors who will abhor the negative yields). So as more and more bonds get in to negative zone, less and less papers are available for ECB to buy. So this will push down the prices of longer and longer dated papers down without any concern about fundamentals. And unfortunately it works in the other direction as well. A significant sell off can trigger further sell offs.

And this makes taking directional views on euro rates very hard. 30y swaps moved from a bottom of 72 bps to current 113 bps in merely a week! This makes the whole market very sensitive to issuance calendar determining supply. 

ECB: Negative Rates Strikes Again!

On the occasion of 3 month euribor turning negative for the first time in history, here is a quick look at the policy rate corridor in Euro Area

What you see before the 2008 crisis is the original intention. The eonia and euribor tracking each other and the policy rate (refi rate) closely. The deposit rate and and the marginal lending facilities are uncollateralize lending and borrowing rates for bank with ECB. So naturally they straddle the other market and policy rates.

Then something changed after the crisis. Immediately after, and more emphatically in later half of 2012, the market rates (euribor and eonia) decoupled from the policy rate (refi). Finally ECB caught up in 2013. But eonia still trades below zero consistently. And today 3m euribor fixes below zero for the first time. Germany is negative till 8 year. 10y bunds on its way to trade below zero. Investors are ready to lend money to Germany for a meager 50bps for 30 year!

And we have quite a few months of QE left for ECB! A few more possibly if the inflation remains stubbornly moribund beyond 2016. Draghi categorically mentioned no further cut in depo. ECB under Draghi has been less prone to make statements in advance, or as Mr Draghi says, "pre-commit", without solid reason. So we can, for the moment, assume depo stays at negative 20bps.

The success of ECB QE is ultimately measured in inflation and inflation expectation. On this measure so far it has been moderate (see here). It remains to be seen if the bonds shortage issue come up in near future how ECB is going to handle that, without further cutting depo rate. 

Meanwhile we can assume they will not, and paying eonia on that assumption is the natural trade.

Widow Maker : The Latest Avatar?

Ever since Draghi declared "whatever it takes" in 2012, traders have constantly put their bets on euro rates long end normalization. The arguments were many - take your picks from below 

1) a pick up in credit situation (touted since 2012, there are early signs appearing this year)

2) resolution of debt crisis (it is perhaps not a "crisis" any more, but certainly not resolved either)

3) pick up in growth (we have seen consumption recovered a bit, but not enough) and general good feeling/ green shoots

4) add your custom reason here ... (bond vigilantes, anyone?)

Since then, the euro long end rallied a 170-180bps (swaps and Germany long dated papers). To be fair the rally started in full throttle in 2014. But even then, the euro long end normalization trades have hardly paid off. This year itself, the euro long end rallied another 70+ bps, with no sign of a reversal. The question is will the inflation and QE chase each other out and make the long end "normalized" sometimes in near future, or are the long ends already normalized at current levels and we do not know it yet.

In Japan the 30y swap trades around 1.3% area, whereas in Europe it is down to around 0.70%. The 5s30s yield curve spread at 110bps for Japan vs a meager 55bps for Euro. And the reason is as below

Japan and Euro area has similar amount around 10y and more, but Euro area is more skewed towards long dated. On top, ECB QE has had a much stronger impact than BoJ, partly because initial BoJ QEs were weak in comparison. In a yield chasing environment, 10y point on JPY curve sounds a more suitable comparison point for 30y euro swaps. And to get there, we have some ways to go. The JPY 10y swaps trade at 0.50%, and the JPY 5s10s at 25bps. To do a Euro long end normalization trade two things are required. A stop loss large enough to see the bottom, and patience. 

So the message is simple: if you are not in a downside protected positive carry trade with a longer term trading horizon, you probably should not be in it.

And for this same reason (economies aside), UK long end is more vulnerable to further rally than the US.

Trade Idea: The Short Story of the Long End (USD/GBP/EUR)

Post FOMC minutes, here is a quick look at the current levels of the yield curves across USD, GBP and EUR. Below table gives a snap of how the market currently prices the start of the rate hike cycles (lift-off), the pace of hiking, and the terminal equilibrium policy rates.

As we can see the terminal rate, as well as the pace of hike is highest in case of the US, followed by the UK and the Euro area. This is interesting, esp the change in these since start of 2014. The repricing of lift-off has been large for Euro, by 11 quarters (which is mostly explained by ECB commitment of 2 years worth of QE). For others the lift-off re-pricing has been rather small (almost none for the US and 3 quarters for GBP). What has been remarkably massive is the re-pricing of the terminal rate. Around 190bps for Euro, 145bps for the US and 120bps for the UK. Also note the large re-pricing of the UK pace of hikes, Which is evident in the large push-out of the peak rate timing for (this may be influenced by mismatching supply demand of long end gilts).

I further took these current curves and applied some scenarios on the base case. The scenarios are 1) a 50bps sell-off in terminal rates with faster than expected rate path (the optimistic scenario) 2) a 50bps sell-off in terminal rates with slower pace of hikes (growth with subdued inflation) 3) a 25bps downward revision of terminal rates (a recession scenario) and 4) global convergence - the large global economies converge to a common overall long term rate based on GDP weighted long term nominal trend growth (which turns out to be around 2%).

Overall, the market seems to agree with the secular stagnation theorists more than ever. It also prices in a convergence of global inflation. We indeed have a core inflation convergence (somewhat) for UK and US already. And given UK imports a lot more from Euro area than exports, the case of imported disinflation is strong. The US is more likely to have a higher potential growth than the UK, and is less burdened with Euro area disinflation. Add these up and we may have more that 50bps that is currently priced in, room for long end divergence.

On a relative basis, I think the pricing of terminal rates are okay, except may be a bit too pessimistic. The pace looks balanced too, with an upside risks to faster hike if inflation picks up unexpectedly. Individually, the lift-off for UK is perhaps too early and the pace is too low. I would rather imagine BoE avoiding hiking unless they must. There has been much less talk about bubbles in the UK. And even the London house prices seems to be on course correction. For the US, the lift off seems more or less fine, and the pace possibly as well. But the terminal rates a bit too pessimistic. Given post crisis average nominal GDP in excess of 3.7%, a terminal rates around 2.5% denotes upside around 100bps. On Euro area, well we have QE. It is still not clear the long end has found a support at the current levels. Not to mention Greece and other distraction. And if we have QE extended beyond what is currently promised then everything looks pretty much fair there. Except we have very little downside to go short rates at these levels.

Trade #1: USD 10s30s steepener vs GBP - rationale: see the point on imported disinflation. Also the tight supply and natural long end gilt demand, and a historically tight spread all support this trade. Also historical market rates over the policy rates has been higher for USD than GBP. I prefer 10s30s than other points for this steepener trade. 

Trade #2: Buy USD 1y30y payers vs GBP - rationale: Similar as above, structured through 30y rates, selling the GBP 30y payers. The USD vs. GBP 1y30y vol spread is historically near the tightest levels seen. The election perhaps does not justify all of it.

Trade #3: Long end upside in EUR - rationale: Well we can't go much lower than this and NOT have a prolonged recession. On the brighter side, we can go up quite a bit. The best way to express is outright on the long end. As this has the most asymmetric upside. Can be structured as positive carry trade through bottom right payer spreads. Else through mid-curves at zero cost to carry through 2y in to bottom right forward payer spreads. The vols are relatively cheaper beyond 2y expiries.

Trade #4: Pay UK 2s5s vs US 2s5s - rationale: in case the lift-off date and the pace gets corrected in the UK after the election. And by that time US gets nearer to the lift-off date, leading to relative under-performance of 2y to 5y.

Trade #5: Pay EUR 5s30s vs US - rationale: Euro normalization, vs. downside protection in US for a recession. It is more efficient to express this view via spread options than outright swaps, with chances of large adverse surprise

Finally a brief history of significant sell off in US rates since the 90s. Table below shows change in rates and spreads in bps (Equity is change in S&P in percentage points) over the period of the sell off. The rows highlighted shows cases where long end rates sold off while the policy rate was actually lowered.

All data from Bloomberg.

UK Budget Market Reaction

Large rally  in European rates, which is led by UK rates. For a change! 

"Gilts Rise as Osborne Budget Leaves Sales Lower Than Estimated"

Or so says the headline. Really? UK DMO estimates a GBP 133 billion issuance against analysts expectation of GBP 147 billion. That causes the long end to rally 8bps at pixel time although it is GBP 126 billion more than last year? There is something seriously missing from the narrative.

Rather it is mostly seems BoE minutes pricing out rate hikes any time soon, as well as repricing of terminal rates. The UK PMI has been weak, wage growth not encouraging, the ECB QE driven outflows from Eurozone sure to hit UK gilts and BoE is nowhere as willing to consider rate hikes as the Fed. Also is there any housing correction in London? As a result the 2s5s flattens 4bps, 5y spread between US and UK widens 7bps, and the overall move is bullish led by the belly.

UK long end has further room to go. So stay bullish. 

What is more interesting is the catch up of the GBP long end gamma vol, relative to US. In terms of realized vols, I think US performed better. Too much priced in for the Election?

ECB QE: What to Expect When You Are Expecting!

Some quick charts on the expected QE from ECB

The first chart shows the maturity distribution of sovereign debts across euro are countries as well the US and the UK. Except Greece, most of the other countries in Euro area are front-loaded. However, Germany, with the highest capital contribution to the ECB has the least amount in the near maturity bucket.

Source: Bloomberg

The second chart shows the holding patterns across different sovereigns, split in to MFIs (monetary financial institutions including banks and central banks), Other FIs (insurance, pension funds etc), Other residents (individuals, non-fin corporates and governments social securities holdings etc) and finally non-residents. Note for Euro area countries, non-residents may include residents from other euro zone countries. Except for Spain, domestic banks holdings are comparatively low, given they are the primary player for QE auctions. Which is potentially significant especially if the other holders are sticky (held till maturity)

Source: Bruegel data base

The third chart shows a scenario of possible pressure from ECB QE. This assumes a EUR 500b size and focus on less than or equal to 3 year maturities (as indicated in previous similar policies, including OMTs), and ECB buys according to capital contribution. Also assumes incremental net new issuance will be small. The chart shows target purchase for each country as a percentage of total outstanding of the within target maturity bucket, as well as percentage of bonds held by MFIs (assuming, conservatively, 50% of the non-resident is held by other euro area MFIs). Note the significant pressure on Germany as well as France, Netherlands and Portugal. (Greece may not be in chart as ECB already holds significant amount).

We opened the year with continued sell off in EUR and flows in to bonds. The broader question on the long end rates is now NOT about Europe anymore, but about US. How much of the flows we have seen in to long end US in 2014 will continue. Will we see carry flows from Europe in US rates. And more fundamentally, what drove the US long end down? An expectation of subdued inflation in spite of improving economy (i.e. risk neutral rates remaining down) or is it purely flow driven compressing the term premium?

I hope to have a model to look in to this sometime. The answer will guide what kind of rates transmission on the long end we will see when the eventual lift-off happens. Will we see a sharp sell-off in the long end from reversing flows? Or will we continue to have a subdued transmission to the long end from Fed hikes, as we have seen in past hiking cycles progressively since mid 80s?

This is NOT Nuts, Where is the Crash?

The secret of making money in the market is to bet against it and then be right as well. As a far-fetched corollary, we can also say when everyone is worried about a market crash, that is perhaps not the best time to actually position for a crash. Even if they are central bankers warning of over-valuation of certain stocks or warning of outright market crash. Central bankers have not shown particular excellence and consistency in timing the markets. Keywords charts for "asset bubbles" and especially "market crash" bursting through the roofs here!

So here we take a look at the global market valuation. We have all range of valuations, from downright moribund Russian stocks to upbeat Mexico. And these excludes much of emerging and frontier markets. As good as a time to stay invested for long term, as any other time. And look for value.

And the markets seem to understand. We have hardly seen any great shift in momentum in equity flow. We have seen recent outflows in emerging market debt, high yield and developed markets equities. And also some increased flows in to US and core Europe bond funds. But before you listen to financial analysts and talking heads, there are very little evidence of flight to safety here. On longer term, what we are seeing is NOT rotation, rather a reflation, i.e. money continues to flow in to both bonds and equities. This is corroborated by central banks flows of funds accounts, as well as other higher frequency flow data. The amount of recent outflows from US equities is dwarfed by the amount pumped in since the financial crisis.

There are reason to believe these latest rounds flows in to bonds has little to do with safe heaven demand. The unforeseen consequences of changes in regulatory landscape (BASEL 3, SOLVENCY 2, all leading to higher bonds demands) and austerity and stress on balanced budget (leading to lower supply) may be the major driver. Clearly yield chasing has been significant as well, but there is some amount of caution out there - see the recent outflows of high yields. The real dangers are the developed economies getting in to the next recession following a natural business cycles from a much lower peak than past recoveries, and a China problem. But none of these present an extreme tail scenario to me. And if your expectation is a total Chinese melt-down, then heaven save us! So unless we see a central bank induced shock therapy gone wrong, a crash may never come anytime soon. At least not when everyone is looking for it! 

And even if it does arrive, probably it will be safer to stay in equities than in fixed income

And, oh, if someone tells you the evidence of irrational exuberance in the equity market is the insane levels of margin debt on NYSE and/or the cheapening of put skew, just sigh and shake your heads.

Macro Views Series: A Global Asset Shortage?

Following austerity and fiscal prudence across majority of developed economies, the budget gaps across countries narrowed considerably. This means bonds supply is going to be lower in future. US had the biggest squeeze in deficit, while Germany already runs a balanced budget. To top this, non-sovereign fixed income supply is low as well. Mainly driven by a large fall in mortgage related issuance in the US and Europe, still recovering from the momentary lapse of reasons before the financial crisis

This along with low interest rates, low inflation expectation,  and large central bank balance sheet size, means that not only there is a shortage of safe asset, there can as well be a shortage of assets in general

Most G7 economies offer negative or very low real return – apart from the longer end of European peripheries (based on absolute return (FX Hedged), US and UK the belly of the curves, seem still cheap). In a word, there is little left on the upside for bonds for long term investors. Especially if you are looking for upside and NOT the carry 

Granted equity valuation is anything but cheap on most parameters. But compared to low bond yields, the relative valuation is attractive.  Especially true if inflation picks up from these low levels (Note: the earning yield above is NOT adjusted for leverage).

So if you are not managing grandmas' retirement fund, the equity upside and valuation still remains compelling, compared to other alternatives. Especially from an absolute return point of view.