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Bond Market's Memo to the Fed: This Is Not a Misunderstanding, This Is a Blow-Up


By focusing on price movement as a misinterpretation of policy, Fed officials are making it clear they don't understand there's a liquidation going on -- and this is a growing risk factor.

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.
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