Last week's article Bernanke's Misfired Shot Heard 'Round the World
generated a lot of attention when the FT's Izabella Kaminska referenced my market theory on the Alphaville
blog. I appreciate all the comments and feedback and I am glad to see my analysis of the situation is being debated. It's not that I believe I have the answer to what is driving market volatility; I am simply trying to offer a potential scenario that the consensus (including the Fed) isn't considering. Though the fact that my hypothesis has gained traction is enough to tell me no one really knows for sure exactly what's going on.
I have been monitoring the unwinding of QE since QE III was initiated, so this chaotic behavior is all making perfect sense. On October 22 of last year in Charting a Course Balancing Open-Ended QE and the QE Asset Reflation Correlation Trade
, I warned:
Most investors are looking toward 2013, worried about the results of the election and whether the fiscal cliff gets resolved. These are the known risks. The unknown risk is what I am worried about. To me, that is how and when QE comes undone. The big trade in 2013 might not be about the effect of a fiscal policy debacle; it might be about the effect of a monetary policy debacle.
On January 7 in Is US Growth Blowing Out or the QE Carry Trade Blowing Up?
I was already offering a different interpretation of market price action:
So here we are at a critical juncture. Both bond yields and stocks appear to breaking out, but it is not clear what is driving the price action. Is this a product of US growth accelerating or a QE short USD carry trade that is unwinding? It’s still not clear, and neither side has an edge. It will be very difficult to position for the move, likely breeding an environment of increased volatility. The market is not going to make this easy on anyone, but if you are patient, stick to your discipline, and, as I said last week, leave your bias at the door; the market should begin to provide more answers as we progress through the ensuing months.
Then, I wrote back on April 22 in Gold, Interest, an the Great USD Short Unwind
Due to Fed policy over the past decade, market prices have been the function of a bunch of USD short carry trades that on the surface look very complex. These trades come in many forms including emerging market bonds, multinational stocks, gold, TIPS, and farm land. Whether short the dollar explicitly through leverage or implicitly through exposure, the risk is the same and very simple to analyze.
The initial reaction to the yen collapse has been an explosive rally in risk assets. As the smoke clears we are starting to witness the true macro effects of dollar strength with falling nominal yields, rising real yields, and collapsing commodity prices. This is exactly type of price action you would expect if the great short USD carry trade was unwinding, and I don’t think investors currently appreciate the significance of what that means or how ugly it could get.
Despite mounting evidence that the presence of this short USD carry trade is responsible for wreaking havoc in global markets, thus far it does not appear to be appreciated by Chairman Bernanke or other Fed officials. Back on June 14 as the unraveling was gaining momentum and it was clear Fed officials were at a loss as to why bond yields were exploding higher, I proclaimed in a tweet
that its not the market that doesn't get monetary policy, its monetary policy that doesn't get the market.
This was perfectly evident in Bernanke’s post-FOMC meeting press conference
ROBIN HARDING. Mr. Chairman, you’ve always argued that it’s the stock of assets that the Federal Reserve holds which affects long-term interest rates. How do you reconcile that with a very sharp rise in real interest rates that we’ve seen in recent weeks? And do you think the market is correctly interpreting what you think is most likely to be the future path of the Federal Reserve’s stock of assets?
CHAIRMAN BERNANKE. Well, we were a little puzzled by that. It was bigger than can be explained I think by changes in the ultimate stock of asset purchases within reasonable ranges. So I think we have to conclude that there are other factors at work as well, including, again, some optimism about the economy, maybe some uncertainty arising. So, I’m agreeing with you that it seems larger than can be explained by a changing view of monetary policy.
It’s difficult to judge whether the markets are in sync or not. Generally speaking though, I think that what I’ve seen from analysts and market participants is not wildly different from what, you know, the Committee is thinking and trying to—as I try today to communicate.
God help us… Real rates are rising because QE has failed to stimulate aggregate demand. The short USD carry trade was predicated on the Fed’s negative real rate regime, and that rates are rising is the single most important catalyst behind the unwind.
The June FOMC post mortem has been a pathetic attempt to talk down market rates since its obvious participants don’t misunderstand the Fed’s policy actions. Last week Fed speakers including Dudley, Williams, Stein, Fisher and Powell all hit the tape with the exact same message: This is just a big misunderstanding. This is just a misinterpretation of policy. Well glad that’s all cleared up. By focusing on the price movement as a misinterpretation, Fed officials are making it clear they don’t understand there is a liquidation going on and this is a growing risk factor. They don’t get that it's not the size the market reaction that’s relevant; it's the size of the trade. Ironically just as they confused QE flow for an easing discount when yields fell, they are now confusing a tightening discount for QE carry trade unwind flow. The more they miss this market interpretation, the more they reduce their policy efficacy. Arguably the damage has already been done.
Of course no one knows for sure how big the trade, is but by analyzing the catalyst, we can monitor flows and positioning to estimate the magnitude. The primary goal of any QE program is to lower interest rates when they have hit the zero bound, in effect making them negative. Real interest rates as measured by the 10-year TIPS yield dropped below 1.0% in late 2011 and dropped below 0.0% throughout 2012, troughing in September. Based on the negative real rate catalyst supporting the QE carry trade, the max execution window looks to be essentially September 2011 – September 2012.
The negative real interest rate regime was the principal catalyst behind the QE carry trade with respect to emerging market credit, and as I have been pointing out, we can see this shift in positioning by analyzing USD foreign exchange reserve flows.
USD FX Reserves Deposited at the Fed Vs. Real Rates
During the financial crisis, as the Fed was exploding their balance sheet you would see an increasing percentage of USD FX reserves deposited back at the Fed in their custodial account data. The percentage of USD FX reserves deposited at the Fed peaked in 2009 at 98% with only $60 billion of the $2.8 trillion not showing up in custodial accounts. USD reserves at the Fed plateaued through 2010, however in September 2011, as real interest rates fell below 1.0%, there was a noticeable drop-off in reserves getting deposited back at the Fed.
As real interest rates continued to fall below 0.0%, more USD reserves were invested elsewhere, presumably in emerging market credit. Thus it is no coincidence that in September 2012, as real interest rates troughed, reserves not deposited at the Fed peaked at over $500 billion. Leverage that number and you can get an idea of how large the trade may be in emerging markets. As the trade delevers I would expect to see these FX reserves begin to show up back in custodial accounts, however thus far there is no evidence this is happening. The last report showed reserves deposited were essentially unchanged on the year at $3.29 trillion.
Last week I focused on the eurodollar strip as ground zero for the carry trade unwind, and nowhere is this misunderstanding paradox better displayed than in this market. Eurodollars are 90 day LIBOR futures contracts that are used to price USD credit across the global banking system. Instead of looking at the curve steepening as a reaction to Fed rate hike expectations, look at it from the perspective of a giant convergence trade predicated on zero interest rate policy. The eurodollar convergence trade is the epitome of the QE carry trade.
Eurodollar Large Specs Vs. Spreads
Over the same time USD reserves held at the Fed saw a noticeable decline between September 2011 and September 2012, speculative positions in eurodollars saw a noticeable increase. In 2011, when the Fed extended guidance for their ZIRP to mid-2013, it was a gift to leveraged speculators who wanted to finance carry trades for a specified period of time. In 2012 they moved the expiration to 2014 and finally to 2015. The longer the guidance, the longer duration you could leverage.
The eurodollar market not only priced financing costs for this leverage, but it also allowed investors to ride the strip as yields converged towards zero. What a deal: a eurodollar convergence position whereby you buy contracts in these outer years and sell the front months is an easy way to maximize leverage to this strategy. Not only were you long eurodollars by virtue of your financing costs, you could buy eurodollars for a free ride down the curve. It was a win/win.
Hedge funds no doubt hopped on this trade big in 2012 as large speculators' net position went from short 800K contracts to long over 1 million, which is a notional exposure of $1 trillion. Speculative longs peaked in September just as the peak of USD FX reserves that were invested abroad. This is not a coincidence. With spreads blowing apart the curve over the past couple of months, this large spec position has come down significantly. With positions virtually flat, you would think much of the trade has been taken off, however there has been some conspicuous activity that may suggest otherwise.
Reportedly there has been heavy put option activity over the past several weeks. This put position would benefit from rising rates and looks to be massive. Eurodollar strip prices are already discounting very high LIBOR rates, so it wouldn’t make much sense for banks to be continuing to hedge against even higher interest rates. This position looks to be speculative in nature. If I had to guess, either some very large global macro funds are in dire need of hedging a convergence trade, or it’s a speculative position to front-run the unwinding of such a trade. This is not a misunderstanding. This is big money. This is a blow up.
As evidenced by flows and positioning, it looks like this trade is deep and one-sided. While we have seen some carnage, it’s not clear what the aftermath will bring or who is going to take the other side. Thanks to unintended consequences of Dodd-Frank, the sell-side will likely sit this one out. That's been evident in the lack of liquidity going into quarter end. With the buy-side having to provide liquidity for their own position, it is not clear where the clearing price is. My guess is it’s not in line.
Going into the June FOMC meeting I wrote
that it was the most important of Bernanke’s tenure. Coming out of that meeting there has no doubt been a big misunderstanding between markets and policy. Bernanke says the bond market misunderstands Fed policy but it’s looking more like the Fed misunderstands the bond market. What the Fed doesn’t seem to get is that the bond market is making policy irrelevant, and even if they finally figure this out, there’s probably nothing they can do about it. The damage has been done.
Misunderstanding or not, the bond market has eliminated a lot of capital in a very short period of time. Leveraged long term investors have been torched and capital deployment has been frozen. This unwind has been about a reduction in long term capital and Bernanke’s insistence on vague threshold guidance for QE now make it virtually impossible to put this long term capital back to work. How can an investor have confidence to buy a long term bond? How can a bank have confidence to make a long term loan? The answer is that the risk premium is going significantly higher. In the ensuing months we will no doubt see this how this market adjustment evolves into an economic adjustment.
The untold story about this market episode is the damage on investor psyche. It will be very difficult to make a long term capital allocation decision under this dark cloud of policy uncertainty. Regardless of whether they hold off on tapering or extend guidance on zero percent interest rates, confidence has taken a big hit. That will destroy investment in long duration assets, banking system credit creation, and capital investment. That is something we can all understand.