ZERO HEDGE reports
Diapason Securities’ Sean Corrigan is rapidly emerging as one of our favorite macro commentators. With his dose of weekly skepticism, he has quickly assumed the position vacated by Goldman Sachs’ Jan Hatzius when it comes to the 3Ms: market, monetary and macroeconomic commentary (courtesy of the now well-known and very infamous flipping by the German strategist on his outlook on the economy). In his latest outlook piece, Corrigan dissects recent moves in the bond market, noticing a 6 sigma, three-decade statistical aberration when it comes to the 2s5s30s butterfly, and continuing through the implications of increasing bond vol on other risk assets (a topic which we believe will receive much more focus in the coming weeks and months), on fund flows (his views on the implications of the December Z.1 statement are worth the price of admission alone), on the cooling off of the European “economic miracle”, and lastly, on what China’s refusal to attempt a soft landing means for global risk. His conclusion is as always absolutely spot on: “in short, that risk assets can continue to rise, pro tem, it also means that RISK itself will be climbing inexorably up the scale and on into the danger zone.”
From Sean Corrigan’s December 17 edition of Money, Macro and Markets
As the increase in the total of US Federal debt outstanding since the LEH-AIG collapse reached the $4 trillion mark, another week began and another sell-off took place in the bond market, with 2004 Euro$ now a cool 140bps off their early November highs in one of those classic, up by the stairs, down by the escalator moves to unwind the previous four months’, Fed”inspired rally.
Only a little less dramatic has been the thumping taken by the belly of the curve where ” for example ” the 2Ã—5-30 butterfly has jumped 120+bps in just five weeks, a sizzling six-sigma move in a three-decade statistical record.
When we note that this was preceded by a 3? sigma, 28-year outperformance of the middle versus the wings, taking it then to a series record low ” and that half the rejection move occurred just during the past week ” we can perhaps grasp some measure of the dislocation being suffered (as well as give vent to our usual despair at the idea that modern financial markets somehow exist to assist in the rational allocation of scarce capital!)
Interest rate markets had, of course, been under pressure in any case ” partly as a result of the slow diffusion of core European creditworthiness out to its prodigal fringe, via the ECB and its market support operations; partly because basis swaps showed “˜Zone banks were again scrambling for USD roll-overs; and partly due to the year end reallocation of funds into an equity market which had only struggled back to par as late as early September, but which finally made a new high on the very day the bond rout began.
It did little to deter the liquidation/allocation switch when Tweedledee and Tweedledum agreed not to have a battle over the US budget but just to let everyone eat cake (or, rather, pork) instead. Given that November saw the worst deficit on record in seasonal terms (despite the pick-up in receipts attributable to the weak recovery), it was no surprise that the Ghosts of Bond Vigilantes Past were moving the furniture about at the prospect of another large slug of deficit finance.
All in all, Blackhawk Ben must be well pleased with himself: since his infamous Jackson Hole address, the S&P500 has returned no less than 25% in excess of 7-10yr USTs, with the S&P600 Small Cap adding a further 10% on top of that.
Fully living up to their embarrassingly undifferentiated, “˜risk asset’ status, commodities ” as per the DCI index ” have matched the broad equity market more or less bp for bp, tracing out an r2 with them of 0.95 over the past six months and never varying by more than 5% from the mean of their combined ratio.
At least until the point where the market again feels happy to hold bonds for income, rather than playing them, as everything else, for leveraged beta on their capital value, both the potential widening of the deficit and the Fed’s decision to help fill it should continue to be of help to equities and commodities. With the private sector still frying to pay down debt (with one rather glaring exception we shall come to in a moment), government incontinence is the fuel on which the printing press will run. As the following graphs, reveal, this has, indeed, become the primary mechanism for inflating prices in the US.
Remember, that for as long as people accept the money it spends into existence, a maintenance ” or even a debilitating over-expansion ” of the quantity of the medium of exchange needs no other agency than a determined treasury acting in concert with its willing accomplices at either the central bank alone, or among the commercial counterparts over which that engine of inflation broods and clucks, in addition.
Though we have yet to parse the report in detail (thanks to the demands made by a hefty year-end writing project with which we are currently wrestling), a cursory glance at the quarterly Flow of Funds release did reveal some interesting quirks in the vexed matter of “˜deleveraging’.
For instance, the household sector seems to have disposed of a signal $540 billion (all numbers saar) in corporate and foreign bonds in the third quarter, but a closer inspection shows that the bulk of this could be set against a net $400bln contraction in outstanding ABS paper (bonds -$460b1n; CP +$60b1n) which was effectively the flipside of that same household bloc paying down (or defaulting on) $290b1n of its own stock of mortgage and credit card debt (the rest of the ABS paydown comprising another incestuous-cancellation of GSE holdings). Again, non-corporate business ” shrinking its collective balance sheet once more ” relieved itself of $118bln in mortgages, more or less accounting for the registered $100bln reduction in funding corporation loans.
Meanwhile, commercial banks and the foreign sector between them issued -$330b1n in bonds, more or less satisfying the $345b1n in demand for paper emanating from Lifers and mutual funds.
This effectively left foreign banks domiciled in the US (+$440b1n) and bank holding companies ($98b1n) to finance the hearty $490b1n appetite for more credit expressed by non-financial corporates ” something which should have been a cheer to all those anxiously awaiting the next debt-fuelled orgy of ill-judged hiring and gross malinvestment.What a shame, then, that the funds were put to no more productive use than manipulating the P/E ratio ” while hiding executive comp dilutions ” by buying back $370bln of equity (the largest amount since Bear, Stearns went under) and in financing a $113 billion inventory accumulation which was the largest in the 58-year record.The markets have not exactly been kind to European fixed income, either, with mid-strip contracts adding 75bps and a whole series of chart lines giving way. Basis swaps have also been heading south once more; forex risk-returns have not shown much follow through since their initial, feeble bounce and ” whisper it ” peripheral yields and spreads are moving the wrong way, once more. The battle for the Euro is by no means over yet.
Part of the problem for the market is that ” unlike in the US ” the business of reinvigorating the flow of money peaked no less than 22 months ago and has been decelerating ever since (though this has been offset somewhat by the more aggressive use to which this money is being put, at least in Germany).
If past is in anyway prologue, the story for the next few quarters should be one of relative disappointment in economic performance, with the disappointment in economic performance, with the IfO and the business revenues (to which the survey tends to respond) peaking out and headline inflation potentially catching up.
In these same German revenue data can be seen the global dichotomy, writ in rather large letters and bearing the rubric: “˜Go EAST, young man!”
Tellingly, the domestic component of sales is still some 10% below its peak of almost three years ago (with domestic consumer goods a woeful 13% off their best). Similarly, sales to the benighted Eurozone lie 11.5% from the top for the category. Contrast this lingering depression with the score for non-EZ exports (only 4.3% down) and the capital goods portion of these latter (-3.0%) and we can see that the Chinese Greater Co-Prosperity Sphere is still of primary importance in helping keep economic activity going elsewhere in the world.
Thus, the crucial significance of this past weekend’s Chinese Central Economic Work Conference and its seemingly pusillanimous decision not to raise interest rates in the face of rapidly mounting consumer prices and a pace of monetary creation which has quickened again in the past two months.One can only suppose that the Chinese have clung to the hard lesson that there is nary a single successful instance of a “˜soft landing’ being engineered, once a malinvestment boom has truly taken hold, but have not followed the reasoning through to the necessary conclusion that the longer remedial action is postponed, the higher the eventual bill tends to become.
Perhaps they hope that food prices will come down at the next harvest (or that they can import ” and subsidise ” enough grain to supplement the domestic supply). Perhaps they fear a further influx of “˜hot money’ and doubt their ability to sterilize the same. Perhaps they are dimly aware of the size of the tiger to whose tail they are clinging ” frightened it will devour them in an inflationary upsurge if they do not fight it and equally terrified that its claws will shred them if they if do not keep it fed instead with sufficient credit to support the vast array of sub-economic projects they have called into existence these past few years.
If this last is the case, they might just be keeping their fingers crossed that the deceleration in real money supply already in evidence for some time past will temper the pace of industrial activity and even allow for an amelioration of the rate of price rises, as has typically happened in the past.
The problem with relying on the working of such a macroeconomic comovement to spare them this toughest of decisions, however, is that it both makes the fatal mistake of assuming ceteris is indeed paribus AND that the inevitable magnitudes and delays ” inherent in what is not, after all, a law of hard, physical science, but merely a dim mirror of the combined effects of millions of subjective human choices ” will not come to bite them most grievously in the behind.
That the debate may not yet be fully settled may be seen in the official Xinhau mouthpiece which ran a post-Conference piece saying, correctly, that:-
“It is one thing to be patient with the fight against inflation, it is another thing to make an urgent and exact diagnosis of the root cause of mounting inflationary pressures. In fact, after the country announced a record harvest for this year, it has become clear that the latest round of inflation is not so much about food supply as the double-digit food price hikes suggested.”
“If that is the case, Chinese policymakers should promptly acknowledge excess liquidity as the main culprit behind soaring inflation. It is high time to take the firewood from under the cauldron as 5.1 percent consumer inflation in November is biting deeply into the pocket of Chinese consumers, who can currently enjoy a one-year interest rate of only 2.5 percent for their deposits.”
In the meantime, what we can say is that for so long as they fail to act, the malign effects of too-easy money being drawn into its own self-fuelling vortex of higher prices, a larger collateral, more concentrated leverage, and fleetingly greater gains will not receive much of a check from one of its main contributors.
If this means, in short, that risk assets can continue to rise, pro tem, it also means that RISK itself will be climbing inexorably up the scale and on into the danger zone.
Originally posted here:
Sean Corrigan On Six Sigma Events In The Bond Curve, “Inexorably Rising Risk”, And Other Observations
Tagged with: bond, eur/dollar, gold, goldman