To the casual market observer, last week’s price action appeared to be dependent on every headline out of Washington. Strike that. Most market observers and participants were fixated on every headline out of Washington, waiting with bated breath for a sign that Congress was going to raise the debt ceiling and avoid default.
The bond market is front and center in this political circus, but not for the reasons that you might expect. There is no fear of default in the bond market in terms of getting paid principal, but there is fear of when that principal will get paid. This fear is reflected in the T-bill and repo market where this collateral is posted for credit.
As I said last week in US Economy About to Hit the Vortex of a Structural Trap
A large contingency of Treasury owners don’t necessarily hold these securities for income. They hold them for collateral against other loans for other investments. The risk-free securities are ironclad collateral for leverage all around the world. There is a scenario that a default could wreak havoc in the repo market, which would ripple throughout asset market for which the repo market provides funding. If margins get called, assets get liquidated. Trying to determine where the necessary bid develops is unquantifiable. You could see asset price dislocation like never before.
You have been seeing hints of this phenomenon in the Treasury bill market where the 1-month T-bill that matures on October 31 has inverted to the balance of the bill curve. This is not because investors fear getting paid their interest; it’s because they fear that they aren’t going to be able to access the cash to pay off their loan. There is no liquidity in this market because of the uncertainty, so the need for cash is driving extreme volatility. The closer we get to D-Day (default day), the more this market will pucker up.
With another 1-month T-bill auction on deck for Tuesday, bond traders sat down at their screens and witnessed something that had never happened before. The 1-month TED spread (T-bill - LIBOR) was inverted with 1-month bills trading higher than 1-month LIBOR. Tuesday’s auction for 1-month bills due November 7 was a complete mess. The "when-issued"
(pre-auction priced security) bill was trading at a yield of 20 basis points (bps) going into the auction and quickly backed up 10bps as pricing approached, only to tail 5 more bps to eventually price at 35bps. The idea of a 15bps auction tail is inconceivable. If you saw this type of tail at a coupon auction, it would be considered a crash. The bond market was firing a shot across Washington’s bow. Quit messing around.
The carnage in the bill curve didn’t stop with the auction. On Thursday, with reports that Fidelity and other large money market funds were liquidating their bill holdings that matured inside the Treasury’s default window, the 10/17/13 bills due on the Treasury’s D-day traded as high as 50bps. On Monday these bills were at 10bps. Money market rates are not supposed to move like this. This is no joke.
In a brief message to clients on Friday, Brean Capital market strategist Russ Certo reiterated this view:
Repo financing markets, collateralized lending markets, showed market and/or counterparty stress arguably for the first time since 2008 credit markets. General collateral (GC) had compressed to 5 basis points in recent months before government funding considerations and ebbed higher to 12 basis points yesterday. Mortgage repo yesterday morning elevated to 22 basis points, another "credit" tiering, which we haven’t seen in nearly five years.
As the debacle in Washington continues, the area of sensitivity in the money market curve may roll, move, and lengthen as days lapse. I’m afraid that this phenomena, if continues, may also impact year end liquidity. As we all know, "window dressing" and year-end financing considerations are enormous as corporations, banks, and other financial players aspire to maximize cash and marketable securities as on balance sheet as a snapshot for financial statements and reporting. Ironically, the very same securities that are in play with uncertainty of principal and interest, maturity and payment are the very same high quality securities that normally qualify for "window dressing" for bank/dealer and other financial reporting purposes.
I hope, and one could anticipate, gridlock in Washington to subside, but when managers allocate financing and liquidity, they plan on it being there. Ironically, some of the securities that are earmarked for this purpose may be subject to spiking rates, collateral and repo exclusion, and the physical inability to clear or determine principal and interest. It is not clear to me what cash balances are even measurable during this period.
This is not some default conspiracy theory. Not being able to measure cash? The market is pricing liquid cash as if it weren’t liquid.
Never mind that the most liquid securities in the world are no longer liquid. The stock market only seems to care if there is a deal, regardless of what it might look like. With the prospect of a meager six-week extension of the debt ceiling, the stock market waged one of the biggest rallies of the year. But with the prospect of a deal to avert catastrophe until Thanksgiving, did portfolio managers all of the sudden decide that it was safe to pile into risk? I don’t think so.
The equity market may seem to be reacting to the headlines, but it’s a little more complicated than that. Both the bond and equity markets are in the midst of a cyclical shift that started in May. The cyclical shift involves real interest rates and the market discounts for inflation expectations.
Last week, I used the debacle in Washington to reintroduce the concept of the structural trap. But while political incompetence plays an important role, the key variable in how this governs market prices is in the inflation discount.
As Robert Dugger wrote in "Structural Traps, Politics, and Monetary Policy"
The presence of a structural trap not only makes the traditional solution harder (need higher inflation), it may make it impossible absent a currency crash. The reason is, the nature of a structural trap is such that it makes the creation of credible inflation expectations impossible. Deflation is the result of massive excess capacity, and economic agents know this. Unless the excess capacity is eliminated, no credible inflation expectation can be created. Extreme monetary ease without excess capacity reduction perpetuates deflation because it prevents restructuring from happening.
The Fed’s quantitative easing (QE) program is focused on engineering inflation expectations to lower real interest rates. Since peaking in 2009 on deflationary fears surrounding the financial crisis, QE has increased the inflation discount, real interest rates have been falling, and the curve has been steepening.
That all changed in May of this year. The tapering debate is being completely misinterpreted. It’s not about the Fed not buying bonds; it’s about the Fed not defending its inflation target. The market isn’t repricing less buying; it’s repricing lower inflation expectations. Nominal rates are rising because real rates are rising.
When Bernanke confirmed that the Fed was preparing to pull back from its QE program during his May congressional testimony, the cyclical shift was underway. The market shifted the pricing of inflation expectations, and real rates began to rise. This is the most important variable governing market prices.
Falling real rates steepened the risk curve, which means that credit spreads outperformed equity multiples. The rally in equities has simply been a function of multiple expansion on the back of credit spread compression. However, since May, this relationship has been diverging as real rates rise and the risk curve flattens.
The conventional belief is that the equity multiple is a function of growth expectations. But in reality, it is a function of the cost of capital. All else being equal, if the cost of credit falls, the cost of equity will fall, in turn raising the multiple. If real rates are beginning a rising cyclical change, it will be difficult for equity multiples to continue to expand. This is the reason that the equity rally has stalled.
When the Fed decided to forego tapering at its September meeting, it was primarily due to actual inflation trending below its 2% target, but it was also due to falling inflation expectations. Since then, market indications of inflation expectations in the yield curve, real yields, and gold have not reacted the way that you might have thought they would. The curve and inflation breakevens in real yields did steepen in anticipation of the Fed decision not to taper, but since then, there has not been much further follow-through. Has the market already shrugged off further QE or is it in a holding pattern of uncertainty?
On Wednesday, we finally got some clarity on the future of monetary policy. The initial reaction to the appointment of Janet Yellen to chair the Federal Reserve has been that she is more dovish than Bernanke and will likely continue the status quo monetary policy of "money printing" and forward guidance. There is even speculation that she will hold the Fed funds rate at zero for much longer than Bernanke’s FOMC had forecasted. Regardless, her biggest task is going to be to re-engineer inflation expectations, and the market will begin to price this in before she takes the helm.
If we continue to see curve flattening and inflation breakevens fall going into the last couple months of the year, Yellen is going to be inheriting a difficult task. The proof is in the pricing. Just because the Fed is dovish doesn’t mean that policy is easy or that the market is pricing higher inflation premiums. If we are in a structural trap and Dugger is correct about monetary policy failing to engineer "credible" inflation expectations, then we are going to see the market trump the Fed.
Everyone is focused on the market’s reaction to what’s going on in Washington. But instead of watching what’s happening on Capitol Hill, we should be watching what’s going on at the Federal Reserve. From a monetary policy point of view, it’s all about inflation expectations, and the status quo is not going to cut it. The structural trap is a big blob of excess capacity, destroying every inch of aggregate demand in its path. Unless steps are taken to address this excess capacity, the deflationary pressures are going to persist, weighing on the economy and asset price multiples.