Thinking Caps On – Grab a Coffee – Sales/Trading Commentary

From: JJ LANDO
At: May 14 2013 07:41:14

Consider the following thought experiment. These are the scenarios:
A. The Treasury decides that it will fund itself 30% more in Overnight Bills and reduce issuance across the curve.
B. The Fed announces it will increase QE by 30% (it will remit the net income of this activity back to the Treasury like taxes)
C. Congress announces a new tax on all passive income from USTs, to holders both at home and abroad (ie Central Banks), for all new-issue USTs
D. Lew pre-announces that we will ‘selectively default’ and apply a haircut of on all future Treasury coupon payments of new issues.

Here’s what’s funny. Most intelligent market participants will say things like:
A. Stocks down a few percent on fear of downgrade. Economy slightly weaker or unchanged.
B. Stocks up 5-10% and economy grows another 1% for 1-2yrs; monetary stimulus.
C. Stocks down 5-10% on tax hike (like last year) that maybe corrects. Economy slows 1-2% for a year or so because it’s a tax hike (ie fiscal consolidation).
D. Stocks down 80% and we go into a great depression on steroids. All investment dollars flee the US. I can’t tell you what happens next because my Bloomberg account gets shut down. They might even declare an Internet Holiday.

Here’s what’s craziest: THESE ARE ALL THE SAME THING. The name and the process is different, the OPTICS is different, but the net is the same. There’s the government and there’s everyone else. The government either pays more out – in interest payments or transfer payments or vendor payments, or it takes back more in taxes or default or interest ‘savings.’ Everything the government net gets in ‘revenue’ the rest of the world loses in income. Everything the government dissaves (deficits) the rest of the world saves. Equal and opposite.

[You need to further get around the idea that reserves are overnight bills and there’s no such thing as ‘monetary base’ – just interest rates; that lower discount rates are lower no matter how you get there; that rate cuts are taxes are austerity, even considering the benefit to risk assets from ‘lower riskfree discount rates’… it’s all basically true if you think abt it long and hard].

Here we are, almost 550 rate cuts into this thing, and inflation everywhere with QE is basically falling (see chart), and incomes are falling everywhere but in the top brackets (see page 9 here for a TRULY SOBERING CHART)… let us never forget that the goal is TO IMPROVE PEOPLE’S QUALITY OF LIFE NOT TO JUICE GDP . Thus economics as a whole also has some major shortcomings. Exporting your way to prosperity is the same as turning your entire population into servants to foreign masters. Disinflation due to lower input costs or better goods or technological gains are good things. HOWEVER if suddenly 20-somethings find social currency in free online friend status rather than cars and houses and weddings – if it makes them happy that’s great but it is also a downward shift in the demand curve that if isn’t replaced leads to someone somewhere being unemployed. These are different issues that shouldn’t all be swept under the ‘disinflation’ rug.

But I digress. Where am I going with all this?
Let’s pretend risk is now in the last 6m-18m phase where everything rallies, everyone in the pool, everyone chases any risk premium to sell, and the underlying income trends are irrelevant. Since I also will posit the Fed isn’t hiking in the next 18 months, I now believe the Fed will entirely miss this risk cycle. Which means they are on hold beyond any trading horizon. So what triggers the end of the cycle? Most would argue – the fear that they ‘tighten’ or ‘hike’ or ‘aren’t on hold anymore.’
To that I disagree…the income and earnings just isn’t there and QE is hurting…in fact the reason the consumer is now tracking +3-4% has been due to a decline in the savings rate (1-handle in q1 as tax hikes hit) that is prone to reverse…it’s MUCH more likely is what triggers the end is that the world starts to understand that QE is a lot like a tax (+ some ‘Richfare’) rather than a stimulus…and that lower rates do raise asset prices for the asset rich but lower incomes and the net to the median person is not what it appears…I see progress on this day every front…TBAC is starting to get it…the inflation markets are starting to get it… we’ll get there … low rates forever…buy blues..

Thoughts/Response to Bill Gross Piece


[Skip to the end]

Well stated and agreed!!!

A few highlights(mine), below:

On Thu, Jan 7, 2010 at 8:57 AM, Lando, Joseph wrote:

In a bit of a surprising philosophical shift, Bill Gross came out yesterday strongly bearish and firmly in the camp of the deficit hawks: Link . My reaction:

1. Any major tightening of financial conditions due to a spike in rates right now, particularly back-end rates, would just be met with more QE anyway. That much was certainly clear in the Fed Minutes yesterday.

2. Given a battle between the fundamental input of deflation and the technical factor of supply, deflation will win hands down. And though many seem to disagree, the data and the Fed and our own economists still think risks are tilted the other way. This input is making the 100-200bp difference in 10yr yields. Supply issues make the ‘1-2 standard deviations rich/cheap’ (speaking in Sudoku terms) differences of 20-30bps. Which wins?

3. I actually think the technicals are the other way. New supply of private label AAA securities is down 1T MORE than Treasury supply is UP. De-levering is, BY DEFINTION, a reduction in the overall supply of investible term fixed income assets. Here’s a picture from a couple months ago from our Global Markets group.

4. The yield curve is offering more yield enhancement than EITHER vol OR credit spread to the investment community. Not to mention Treasuries are 0% weighted (AND state/local tax-advantaged). Where do you think banks will turn to generate NIM? At some point, they will change their behavior. Look at CURVE vs both VOL and CREDIT regression below. Perhaps most notably…


5. The deficit hawk premise is flawed to begin with. Government buys a bridge, bridgebuilder buys a coat, coatmaker deposits or saves the money…it’s a closed loop in which deficit spending CREATES the precise funding for the deficit itself. All that moves around is DURATION as the need for 10yr savings or 30yr savings is swapped around vs the demand for say, overnight savings (like T-bills or banks reserves). Deficits in the US (unlike a Muni or a EU power or a Corporation) don’t have a problem funding. The ‘problem’ is if the Treasury wants to issue 30yr paper and people only really want 5yr paper. Actually, the market sells off when the sum of all borrowers’ duration is longer than the sum of all the lender’s preferences/liabilities. Not when there is a mismatch in AMOUNT. The AMOUNT is the same! Which takes us to…

6. Japan.

7. I also respectfully but strongly disagree with Gross’ interpretation of QE. The Fed has actually been swapping the bank and fixed-income universe OUT of their term treasuries and mortgages and into cash. By definition they have actually been crowding OUT overall NIM in the universe. And generating revenue for the Treasury. It’s actually an investor tax not a bailout. When they step away, those (and by parity zero-sum principles they are there) who were swapped out of their investments and into cash will swap back into term duration. Asset transfers themselves are zero sum. Additionally, in getting mortgage rates down, the Fed has been TEMPERING the pace of de-levering by ensuring mortgage refi’s can continue. They ‘made happen’ many of the mortgages that they bought. It’s a very self-regulating supply universe. If they slow down, there are just plain fewer mortgages being originated for people to buy, and the pace of overall deleveraging picks back up, and well…it’s not bearish, for sure.

8. Actually I hope 10s go to 4.25 because that just means there will be more to make in the big rally that I think starts in 6 weeks or so when the data turns back from fiscal stimulus withdrawal, and the Treasury’s ‘extension of average maturity’ program – what is TRULY the cause of the steepening of the yield curve – tapers off. For now, am only tactical in the back-end.

But that’s why we all have a market and life, as ever, will remain interesting in fixed income this year.






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