Posts Tagged ‘fed president’

The Healing Power of Quarter-End

Ah, it is so nice to be in this illiquid period right before quarter-end, when interested parties can easily ramp up prices to where they need them to be in order to get good end-of-period marks. One would think this game would diminish somewhat, given the crusades against the LIBOR and possibly FX price-setting conspiracies, but there’s no conspiracy here. There’s no need for investors and dealers to discuss putting the stock market up; everyone knows it happens and everyone knows why. The hedgies who flush microcaps higher because they can ought to be stopped, but there’s no way to stop the general tendency, especially when you have very clear indications of when that trade is supposed to begin…such as when Fed officials show up and start chanting “stocks shouldn’t go down!” in unison.

For the last couple of days, Fed officials have been out in force saying that the “market overreacted.” (Mostly, they mean the bond market, but for many people “the market” equals “stocks” because they think CNBC is about “markets” rather than “stocks”.) Today, New York Fed President Dudley, Fed Governor Powell, and Atlanta Fed President Lockhart pursued the overreaction theory in separate speeches, echoing Minneapolis Fed President Kocherlakota’s sentiment from yesterday. Yes, yes, we all know that everyone else will treat that as a signal to get long again (both stocks and bonds) into quarter-end, but what it really shows is that utter cluelessness of the people in charge at the Fed. Powell said that “Market adjustments since May have been larger than would be justified by any reasonable reassessment of the path of policy.” Well, duh. As I pointed out a while ago – before the real selloff – such a virulent selloff was entirely to be expected at some point due to convexity demands. The most-virulent part of the selloff may have coincided with Bernanke’s statements last week, and that might have triggered some of the convexity selling, but the degree of selloff had nothing to do with the Fed.

Someone should tell these guys that not everything is controlled by the Fed. Sometimes, rates move for other reasons.

To be sure, the Fed is correct about the fact that their communication is helping to cause the volatility. But it isn’t because they haven’t been clear enough, or that what they said was misinterpreted. The problem is too much communication, and making the path of policy (and any inflections in that policy path) crystal clear. When policymakers are opaque about monetary policy, then investors change their opinions stochastically, at random intervals; when policymakers set off a flare for every minor change in the trajectory, all investors change positions simultaneously. Transparency not only doesn’t reduce volatility, it is a prescription for creating volatility.

Clarity on the fiscal and regulatory front, incidentally, is quite different. Volatility in business ventures is high enough already to ensure that entrepreneurs don’t have an incentive to get too far out over their skis no matter how clear the regulatory environment, and decisions made in a business context don’t have the hair-trigger half-life of decisions in financial markets. Uncertainty, when long-term decisions have to be made, impairs that decision-making. But uncertainty is good when decisions are easily reversible and the cause of volatility is that consecutive orders to sell aren’t spread out enough. For stable markets, you want buys and sells to come all jumbled up, rather than all the buys together or all the sells together. For maximum economic growth, you want risk-takers to have the ability to make long-term decisions with confidence.

So while equity markets have rallied as we approach quarter-end, I don’t think this rally will far outlast quarter-end, because there are just too many negatives at the moment for equities – high multiples, rising interest rates, softening global growth, a less-benign regulatory environment etc. The selloff in stocks was never very bad (compared to bonds), because there’s not the same kind of convexity problem in stocks, but it also has a lot further to go than bonds do.

Fixed-income markets have rallied along with stocks, with TIPS leading the way up as they led the way down. The interpretation here is different, because in the case of the bond market we are looking at the well-known phenomenon of convexity selling. My advice for fixed-income investors, from long and painful experience, is this: don’t jump in with both feet yet. These bounces are normal in this kind of flush. It does probably mean we are closer to the end of the flush than to the beginning, but usually you need a period of a couple of weeks of sideways action before you can start to retrace the “convexity selling” damage and get back to something like fair value.

The healing period is necessary because every prospective bond buyer knows (or should know) that there are large trapped sellers out there who are waiting to pitch bonds overboard (at the new, improved levels!) if there is any sign of further market weakness. The rally over the last few days is fast money, doing what they think the news is telling them to do, and they will be back out as quickly as they got in.

We’ll see what happens next week. On the one hand, dealers will have more ability to hold positions (although they’re not supposed to, under the Volcker Rule); on the other hand, quarter end will be past and any inclination to hold off to avoid making a bad situation worse will be past as well. It will still be fairly illiquid, with a half-day on Wednesday, the Independence Day holiday on Thursday, and then Payrolls on Friday. I suspect we will see a resumption of prior trends in fixed-income and equities – although I hasten to add as a reminder that there will eventually be a rally off these rates. I just don’t think we’ve exhausted all of the sellers yet.

Son Of “Risk Off”

March 22, 2012 5 comments

Although the last few days’ worth of trading is consistent with the type of trade we have periodically seen over the last year or two, referred to with the hackneyed description “the risk-off trade,” it isn’t much risk and it isn’t far off.

After a 21% rally in the S&P since November, prices now stand a whopping 1.2% off the highs. Wow, time to get in!

After 10-year note yields rose 45bps in two weeks, they have now fallen 10bps. Be still, my heart!

Spanish 10-year yields, down from 7% in November to 4.8% earlier this month, have reversed the February rally from 5.41% to 4.80% to return to 5.47% – only 153bps below the high yields. Calamity!

Ten-year inflation swaps, which began the year at 2.25% and closed at a high of 2.75% two days ago, drooped all the way to 2.68% today. Tantamount to deflation!

Hey folks, cool it. Nothing much has changed, yet. Initial Claims today was 348k when 350k was expected. Housing Starts on Tuesday recorded 698k rather than 700k. Existing Home Sales showed 4.59mm rather than 4.61mm. There are disappointments, and then there are disappointments. This is the disappointment that sends a stock lower if the company doesn’t beat the “whisper number,” even if the earnings are still great.

Markets will, though, probably get a boost from the comments of Chicago Fed President Evans, who commented in a speech after the markets closed that “clearly more accommodation would be appropriate.” I assume he is speaking about monetary policy and not the size of his hotel room, and if so then it’s a remarkable statement to be made about an economy that’s growing at or above a 2% rate of growth. Dallas Fed President Fisher, on the hawkish side of the spectrum, says on the contrary that he won’t support further quantitative easing, but that’s not really a surprise. In any event, there’s clearly disagreement at the Fed about further QE. That’s almost mind-blowing to me given that we are not in a state of crisis, most policymakers tell us we shouldn’t worry about a resumption of financial crisis, and economic growth is doing fine (although it’s not booming!) with the exception of some clear signs of inflationary pressures. If they can’t get fair unanimity about holding off on QE3 now, then either they know the chances of further disaster are not as remote as they say, or QE3 will be on the table forever.

This was, in any case, roughly the right place for the bond selloff to take a pause. The chart below gives the very-long-term monthly closing chart of the secular bull market in bonds. As with any long-term chart of a series bounded by zero, as nominal yields are, the chart makes the most sense logarithmically. The very regular decline in yields had a false breakout in 2008, a re-test of the lower line (which I took at the time as the turning point of the whole bull market, incorrectly), and then a more-durable breakout over the last year.

The selloff so far has taken us slightly inside the lower trendline, which is an unstable position. Either yields should move somewhat higher from here, exiting the area of the trendline, or this should represent just a re-test of the breakout and lower yields are to persist for a while. My view is that the selloff we are currently experiencing, which is in line with normal seasonal patterns, should result in no less than a return to the channel and a migration back slowly towards 3% 10-year yields. However, we have to keep in mind that the breakout from the natural, secular decline corresponds to the Fed’s direct and almost unprecedented manipulation of long-term interest rates (I say “almost” because the Fed back in the 1940s pegged long-term interest rates, but the market was much smaller then).

This chart, as much as any other, shows how unnatural the intervention has been, in disturbing the market’s natural rhythms. That also means that the Federal Reserve is rowing against the tide, but so far they have been successful. I can’t rule out the possibility that a QE3 might hold rates near 2% (although it is hard to see them much lower than that, in any case, while there are massive deficits and rising inflation), but I take the bearish view.

Although TIPS remain expensive, they are nonetheless still cheap to nominal bonds. Now that breakevens are 35bps wider they aren’t as cheap as they were, but I still vastly prefer to own TIPS at a -0.10% real yield than nominal Treasuries at 2.28%: what could well end up being a much worse real yield.

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