Fighting Fire with a Flamethrower

last week’s big story about the JPM $2b trading loss highlights what we perceive to be a major risk factor in the market and banking system, that is the consensus and regulators are still focused on the wrong risks.  There is no better risk manager on Wall Street than Jamie Dimon and all you have to do to find out how intense he is in the risk department is read A Demon of our own Design by Richard Bookstaber to get a sense of his focus.  It would be highly unlikely that JPM would face this kind of a loss on a bad investment or loan and the fact that this occurred in the credit hedging book gives us more confidence that Mr. Dimon will right the ship.  The details are still trickling out but the miscalculation of Value-at-Risk (VAR) suggests they had too much delta and maybe too much gamma in the CDX position.  They were actually over-hedged.

After the news broke everyone started to pile on, Fitch downgrades and S&P lowered outlook.  In a barrage of “I told you sos” the financial media loved criticizing JPM all day for playing in the credit derivatives market seen as a major contributor to the financial crisis.  People in D.C. caused for an investigation and you heard rumblings of whether JPM violated the Volcker Rule and even the need to bring back Glass Steagall.  As usual we think everyone is getting this wrong.

Credit derivatives were a major contributor but not because of what most people think.  It’s not because the credit goes bad, it’s because the structure goes bad.  Since the crisis of 2008 the Fed has continued to focus on credit markets and liquifying the system by printing money and pushing down long term interest rates to stimulate borrowing and refinancing.  Mr. Bernanke likes to highlight the benefits of low interest rates but there is a cost and its getting to be more and more severe as time goes on.

The cost of negative interest rates is that someone has to buy that bond and make that loan.  That someone is the banking system that is currently loading up on long duration negative coupon negative convex assets.  Ironically, the Fed by focusing on the risks that didn’t cause the meltdown, credit deterioration, is increasing the risks that did cause the meltdown, negative convexity.

As we stated in Upside Down Monetary Policy we pointed to the correlation between the Fed Funds rate and the Loan to Deposit Ratio at US banks over the implied carry in the curve with the amount of securities banks hold as a percentage of total credit.  The last time banks owned this many securities and the carry started to flatten, in ’94 and ’04 it preceded major back ups in yields.  The very fact that this time these banks are holding negative coupons makes this much riskier.  Many banks have no doubt been buying higher yielding callable paper to compensate for the lower yields but that extra yield is not free, you are short the volatility.

That brings us to the current situation in the bond market.  As we have been suspecting for a couple of months, an equity market correction would be the catalyst to propel bond prices to new highs and thus far that play book is working.  The TY_F contract has seen new all time highs after holding our 132-00 support level.  The short base by the large specs continues to support prices and though they’ve covered some they still have a long way to go.  The consensus views these rising prices (falling yields) as a discount of slower growth but we caution that interpretation.  Bernanke long ago took the discount out of the discount rate and we think price is being driven by a short squeeze that could be the last leg of the bull market.

Chart: Bloomberg

We aren’t worried about the shorts covering and taking us higher, we are worried about what happens when they are flat.  The Fed has been a major bid under this market as have been the shorts.  The Fed supposedly will be walking away in June and the shorts may be finally flat by then.  If the Fed is wrong and Gross is right about stock v flow we could be in for a very bumpy ride this summer.  Ironically it would be because the Fed threw gasoline on the fire they started in the first place and we know Bernanke loves blowing up his own trades.

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Slicing and Dicing

On April 17th in Like a Hot Knife Through Warm Butter we posited that the $SPX was tracing out a B wave retracement that was chopping up shorts and confusing many market participants.

We have seen some bears in the street start to turn bullish on this rally as they get squeezed and see the potential for a breakout.  This sentiment shift as we see a 3 wave move into the 618 sets up for a great risk/reward short opportunity once we get the April expiration out of the way.  As always risk management is crucial so don’t get married to a position.  If this is a B wave up it could last much longer than we expect so stay nimble and use tight stops.

B waves always last longer than you think they should and typically if the market is doing something we can’t figure out, we assume it’s a B wave.  This was move up to the 1415 fit that description well and even as many were looking for a breakout, we stuck to our guns and continued to go with the plan.  It was the initial 3 wave move from 1357 that kept us on the right side, looking for an eventual violent C wave once the B was finished beating up on the shorts.  Tuesday’s better than expected ISM number was just the catalyst needed to squeeze them one last time in what ended up turning into a nice head & shoulders top going into Friday’s NFP.

The weaker than expected employment picture didn’t start out as a puke.  We even heard on morning news that maybe the muted reaction (ES -5 points) was the market expected more QE from the Fed.  We knew the C was in play and caution was warranted.  In other words, C waves always punish the dip buying that had been so easy in the B wave.

Chart: Bloomberg

The question for investors is how this C wave will continue to unfold.  As you can see on the chart we have laid out 2 basic scenarios and either are in play.  The first scenario is a deep C wave that targets 1340 support (4 of lessor degree) that everyone already sees.  As we said in “Warm Butter” we think if the 1340 level is in play it will be sliced through, if nothing else to trigger stops and bring in some heightened fear.  We will find subsequent lower support when we get there but just eyeballing we think 1300 is definitely a possibility.  The alternative scenario is for the market to trace out a larger Triangle wave 4 pattern that corresponds to the 10% Oct/Nov 2011 correction.  If we are in a triangle the market should look to find support in this 1360/1370 area and with the 60 minute RSI on the floor this is a distinct possibility.  If nothing else the RSI should be good for a bounce.

We commented to a friend that how this unfolds could be up to how the shorts played Friday.  The COT report showed large specs to be near the flattest they have been ES since last August.  There was likely few who were positioned for the 20 handle sell-off so if they piled on in the afternoon, then the pressure could be to the upside for more torturous whipsaw.  If they didn’t re-short and the market is still weighted to the long side, the deeper C would be in play after the RSI rising to generate more energy for the 1340 test.

Corrections are designed to shake you out of positions on both sides so try to avoid too much emotion and go with what the market gives you.  Knowing these scenarios in advance will hopefully guide you as we approach the end of the month and summer trading.  This is the essence of ex ante analysis.

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Upside Down Monetary Policy

we think one of the more interesting aspects of monetary policy is that conventional wisdom thinks the Fed controls interest rates and stimulates lending but depending on how you look at it, the bond market and banking system are often doing quite the opposite as what the Fed’s policy intends.

From a simple perspective, if you look at the yield curve, the market tends to counter balance Fed policy.  The curve steepens when the Fed is perceived to be too easy and flattens when the Fed is too tight.

In addition to the curve the banking system seems to respond in a counter balance.  As you can see in the chart, when the Fed lowers interest rates the loan to deposit ratio falls and when they tighten it rises.  So when the Fed eases, banks decrease lending and when they tighten, banks increase lending.  In addition, when the Fed eases and the curve steepens, banks in lieu of making more loans buy more securities to take advantage of the carry.  When the Fed tightens and the curve flattens banks rotate back into loans.

Chart: Bloomberg

taking this evidence you would conclude that the Fed is constantly working against themselves.  If they truly wanted to stimulate lending, looking at these trends they should raise interest rates, flatten the curve and flush the banks out of their carry trades.  Of course that has its own ramifications with the loads of negative coupon negative convexity positions currently on bank balance sheets.  Nevertheless, with the loan-t0-deposit ratio near previous lows and the curve already flattening due to the compression from Operation Twist, ironically the Fed is actually quasi tightening and making the carry trade less attractive so the demand for securities by the banking system may be finally starting to wane.

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Stock v Flow – Bernanke v Gross

on Monday we addressed the Stock v Flow debate and posited that while the Fed believes its the stock that matters, what really matters is what the market believes.

Monday we stated:

Ultimately it doesn’t matter what the Fed believes but what the market believes.  And if the Fed thinks we can get through the maturity wall of supply that is coming down the pike without some concession by the market when coupons are negative they could be in for a rude awakening.  Anything can happen but we think the jury is still out and if stocks don’t crater this summer like last year it will be interesting to see who steps in to buy all this supply at negative yields.

At yesterday’s Fed press conference Bernanke gave us further assurance that the Fed believes when Operation Twist ends in June interest rates would not be affected because the stock of Treasuries on the Fed’s balance sheet would remain the same even though they were exiting the market.

Steven Beckner of MNI asked the Chairman point blank:

There’s been some concern in markets about what will happen to bond yields at the expiration of Operation Twist on June 30th and some speculation on what the Fed might do–might need to do to keep downward pressure on yields. Is that a concern that you share and even your colleagues feel the need not to disappoint these kinds of market expectations?

Bernanke (emphasis ours) :

There’s some disagreement, I think, about exactly how balance sheet actions by the Federal Reserve affect Treasury yields and other asset prices. The view that we have generally taken at the Fed in which I think–for which I think the evidence is pretty good is that it’s the quantity of securities held by the Fed at a given time, rather than the new purchases, the flow of new purchases, which is the primary determinant of interest rates. And if that is–if that theory is correct, then at such time that our purchases come to an end, there should be relatively minimal effects on interest rates at that time.


Today Bill Gross was interviewed on Bloomberg to let us know his view which differs from Bernanke and seems to agree more with what we said on Monday (starting at about 8:20):

the Fed says this is a stock type of argument…  I don’t necessarily take that view, I take a flow view that basically says hey, at 1.95% not much of a value there, so let’s see if the Fed doesn’t buy them let’s see who else will and so you know it will be an interesting experiment at the end of June if the Fed doesn’t do QE but for the moment I think the 10YR stays about where it is.

That almost sounds like a dare and is very similar to the point we made.  Gross was betting on QE 3 and now we might infer from his comments that it was because he takes the flow view and that at the end of Operation Twist the Fed will be forced to come back in to support the market.  However if they don’t extend the buying program the market will need to fill a big demand void therefore we might now infer that Gross is turning seller.  Who will step up to the plate?  The Fed v market tete a tete is about to get very interesting.  We obviously agree with Gross and think the market will win.  As we have stated before, Risk in Risk-Free is rising:

Between QE 2 and Operation Twist, the Fed has gobbled up close to 100% of net new issuance.  It would be naive to think that at a removal of the single largest source of demand in the bond market would not have an impact regardless of the size of the balance sheet.  Without the Fed propping up the market and with virtually the entire curve sporting negative coupons we see little incentive for bond investors to step in and take up the slack.

Sell in May and go away might be applying to the bond market, not the stock market…

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Chalk One Up For The Hawks

One of the more interesting outcomes from Bernanke’s press conference today was the question asked by the NYTimes reporter who asked why the Fed wasn’t doing more to stimulate in order to bring down unemployment at a faster rate.  Clearly the reporter was echoing his colleague Paul Krugman‘s argument that Bernanke the Fed Chairman was not following the advice of Bernanke the academic.  Krugman is a outspoken Keynesian and thinks we are in a liquidity trap so you have to take his side with a grain of salt.  Nevertheless the response from Bernanke was quite telling as it in our opinion took a key policy response in a Nominal GDP target which has been in consideration in economic circles as a way to close the output gap off the table.

BernankeI guess the question is, does it make sense to actively seek a higher inflation rate in order to achieve a slightly increased reduction – a slightly increased pace of reduction in the unemployment rate?

The view of the committee is that would be very reckless.  We have we, the Federal Reserve, have spent 30 years building up credibility for low and stable inflation which has proved extremely valuable in that we’ve been able to take strong accommodative actions in the last four, five years to support the economy without leading to an un-anchoring of inflation expectations or a destabilization of inflation.  To risk that asset for what I think would be tentative and perhaps doubtful gains on the real side would be, I think, unwise thing to do.

WOW.  That is not an explicit denial of NGDP targeting but it sure sounds close as he referenced targeting higher inflation and not receiving “real” growth.  This is correct in our view and a NGDP target was one of the biggest risks we saw in risk assets as we believed it would put significant pressure on multiples.  Now not targeting NGDP is net/net bearish for earnings growth but it should be bullish for multiples or less bearish.  In other words you aren’t going to get any 6% nominal growth but you also won’t have the 4% inflation which would likely rock the bond market and crush multiples.

Bernanke gets a lot of heat for being so dovish but we think this was one of the more hawkish moments and statements of his career.  Clearly the hawks on the FOMC have made a statement and put their foot down on this issue of generating higher inflation to spur nominal spending.  Chalk one up for the hawks!

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Risk in Risk-Free

while the $AAPL love fest is going on after hours and the $SP_F is higher looking to trap shorts tomorrow morning we think investors need to be aware of the potential risk in the $TY_F contract especially in light of tomorrow’s FOMC meeting.

Earlier this week we noted that with the large short position by the large speculators/hedge funds (-174m) in addition to the heavily weighted June call (59m) v put(32m) open interest the market seemed to be very unbalanced going into the meeting as we sit right below all time highs in the contract just north of 132-00.  We noted with the Fed on Deck Something’s Got to Give.

Chart: Bloomberg

With the Fed on tap to provide an updated forecasts for growth, inflation and a policy timeline in addition to the subsequent press conference with Bernanke there is ample opportunity for something to go wrong.  Below in a 60 minute time frame we show the diagonal developing and you can see we have a narrowing apex from which the market will look to break out of at some point.  We can’t be sure which way it breaks but when it goes it should be a large move.  If it breaks to the upside you could see a spectacular short squeeze and as evidenced by Barron’s poll this weekend that showed 81% bearish we certainly think the risk is to the upside.  But make no mistake about it, if the lower parallel breaks this thing could crater.

Chart: Bloomberg

As we have stated yesterday the big debate by Fed watchers is if the low interest rate regime is a function of the reduced stock or increased flow.  The bias on the Fed is that it is due to decreased stock so we believe there is little concern by Bernanke or Yellen or Dudley that rates will go up as long as they keep the balance sheet size the same.  However we think this bias is misplaced and if it weren’t for a massive flight to quality due to last year’s stock market crash that was ironically a byproduct of the end of QE, we don’t think yields would have fallen as far as they did.  Between QE 2 and Operation Twist, the Fed has gobbled up close to 100% of net new issuance.  It would be naive to think that at a removal of the single largest source of demand in the bond market would not have an impact regardless of the size of the balance sheet.  Without the Fed propping up the market and with virtually the entire curve sporting negative coupons we see little incentive for bond investors to step in and take up the slack.  We shall soon see and tomorrow the market might be starting to discount that lack of demand come June…

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Stock v Flow – What Does the Market Believe?

this morning we read an Bloomberg article discussing comments made by Fed Vice Chair Janet Yellen in relation to the end of Operation Twist.  She said that when the program ends in June it will not amount to tightening policy (God forbid) and put forth the notion that it is the size of the balance sheet that is creating easy conditions, not the flow of purchases.

Yellen is raising a very important point that we must all be aware of in the debate between stock v flow.  Essentially the debate is whether the Fed has lowered bond yields by reducing the supply of USTs (stock) or whether yields are being pushed lower by the open market purchases (flow).  The Fed is operating under the belief or assumption may be a better way of saying, that it is the reduced stock of USTs that is keeping yields low.  This is a very important distinction because that assumes that when Operation Twist ends in June the Fed thinks yields will continue to stay low.

The problem is we really don’t know and it’s probably a combination of stock and flow at the margin.  During QE 2 and Operation Twist, the Fed has bought close to 100% equivalent of net new issuance from the Treasury, obviously representing the largest single source of demand.  When that demand walks away, someone has to fill that void to absorb the supply.  After QE 2 ended last year the stock market crashed so the demand came from a flight to quality.  Bernanke thought the reduced stock was responsible but stocks didn’t crash, would bonds have been bid up all else equal?  Tough to say.

Ultimately it doesn’t matter what the Fed believes but what the market believes.  And if the Fed thinks we can get through the maturity wall of supply that is coming down the pike without some concession by the market when coupons are negative they could be in for a rude awakening.  Anything can happen but we think the jury is still out and if stocks don’t crater this summer like last year it will be interesting to see who steps in to buy all this supply at negative yields.

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