Buying the wrong tails

The Chinese data overnight isn't a game changer, but supports the increasing sense seen both in data elsewhere and in prices that China has indeed had a soft-landing and is beginning to recover. Of course, while the lack of catastrophe and the turn in the Pork cycle means that easing is unlikely to be aggressive (2008/9-style), in the absence of "new" news to conflate the Asian recovery story that the trend is in place. As indeed it appears to be in markets in general, as somehow Spain has managed to get its 10yr bond yield down to 5.5% despite a lack of ECB buying. Remarkable.

Now, onto something else that's been bugging TMM and spurred something of a debate. What is going on with the seeming monotonic collapse in the Libor fixings and commensurate cheapness of the 2yr USTs. It seems somewhat incredible to consider that 2yr swap spreads at 9bps sit at close to their record tights given all the Libor shenanigans, and general concerns about bank solvency in Europe. But that is where we are.

And when compared with Schatz, in particular, it seems even more confusing. TMM totally get the EMU-break up option priced into Schatz. The trouble is, that while the pay off in such an event will of course be massive, the probability of it being triggered was always pretty low. And put in the context of what appears to be a drive in Europe towards fiscal union (of a sorts) and the ECB's determination to "do whatever it takes to preserve the Euro" (see OMTs...), even the most sceptical would have to concede that the probability of a Euro-break up has fallen by a significant degree.

But upon drilling down into the constituents making up the swap spread, comparing 2yr UST with OIS and Schatz with EONIA, it seems that the value of the liquidity option priced into Treasuries is less than that priced into Schatz, at -11bps vs. 7bps. This relative premium began to appear in Spring 2010 as the Euro-crisis flung itself centre stage and reached its wide just prior to the LTRO.

Though the Schatz leg especially has retraced quite a bit since the Greek election, TMM still reckon that this relative pricing is wrong. Because back in the old days (well, not even that long ago), when there was a liquidity crisis, or EM crisis or even any old "risk-off" event, it was the front-end of the UST curve that saw the greatest flight to quality and associated liquidity premium. And in all such events, German short-end paper underperformed the US. Of course, that all changed in 2010. Or did it? Since then, the majority of liquidity events have been Europe-centred, and particularly around the potential break up of EMU. So given the Deutschemark call option, it certainly makes sense. But TMM have found themselves wondering if the market is mispricing the relative liquidity premia here: Schatz may well have performed better in recent history, but it is only likely to perform in an EMU-breakup event, while USTs can perform in any idiosyncratic risk shock (Iran, a Brazil blow up, a Chinese government collapse etc etc).

A discussion with fellow punters yesterday afternoon saw TMM's view met with some scepticism... even suggesting things like FRA-OIS could go to zero (more on that below...), or that there is no point trying to buy 2yr Notes until Operation Twist is done, given that O/N General Collateral is 30-ish bps. The latter is certainly a reasonable view, but by the time Operation Twist is done, the market will likely have moved already. And TMM were always taught that when liquidity appears abundant everywhere, it's worth shipping some in as a hedge against a long risk portfolio... of course, the daily P&L bleed becomes frustrating and it's very easy to then stop out... only to see the thing rip back up straight away, leaving your book exposed. Lessons learned the hard way. But it does seem to TMM as though perhaps the market is so focused on EMU break up risk that it has forgotten everything else that can happen and is buying the wrong tails. It's also worth noting, that usually you only get *really* paid to own convexity when an idiosyncratic "unknown unknown" event hits.

Anyway, back to relative valuations.

Generalised risk events seem to arise about once a year... often twice, but let's be conservative. In days past, this has sometimes meant as much as a 20bps move in spreads. Of course, now, there is bucket loads of liquidity everywhere, supplied by the world's central banks. So it is probably fair to accept that such moves will be less than in the past, but again, liquidity often appears to be an illusion when the sh1t hits the fan. Anyway, this is only a back of the envelope exercise, so let's guess we only move 12bps which would be about 60% of prior moves (and would roughly corroborate with the move seen ahead of the Greek election). On the Schatz side, in a full break up we could imagine a price move of say 20%, which is roughly something like a 900bps move. TMM would argue that policymaker commitment has reduced the probability of such an event to something like 1% per year. So the expectations would be 12bps per year for the UST (100%*12bps) and 9bps/year for the Schatz (1%*900bps). TMM are perhaps being a bit naughty here given that Schatz would also rally in a generalised risk off, but then, in an EMU-break up event, UST would arguably rally significantly too, so it's not too much of a stretch to argue that the liquidity option priced into 2yr Notes looks like it is now too cheap relative to that priced into Schatz.

Onto the other part of swap spreads... Libor...

The Wheatley Review - amongst the general amount of liquidity everywhere - has driven Libor fixings down as banks crowd for fear of getting sued and given the fact that US Financial CP rates are around 15bps, there's certainly the argument that Libor should be lower given the concept of bearing some resemblance to "market-traded" rates. The trouble is, the Libor spikes of the past couple of years have never been about US banks: instead, by the marginal borrower from Europe, and the overall rate is going to be a blended average of all these borrowers. The chart below shows the US Financial CP rate (orange) as a proxy for US banks, Natixis 90d USD CP (red line) as a proxy for the higher-quality banks in core-Europe issuing directly in the US, the rate implied from borrowing at 3m Euribor domestically and swapping into USD (for those European banks that are able to borrow privately in Europe, but not directly in the US), the rate implied from borrowing at the ECB's MRO/LTRO and then swapping into USD (for those banks that are unable to borrow from anyone apart from the ECB). Obviously, since Draghi's game-changing speech, all of these measures have moved lower. The question is, how much lower can these now move, given the dramatic normalisation seen so far?

It's not easy to know how to weight the above measures, but given this is all a back-of-the-envelope exercise, a simple regression is probably the best way to get a sense of things (see chart below). And looking at that, it's possible to argue that the 3m Libor fixings have over-shot the actual funding market improvement.

Putting all of the above together, TMM reckon buying 2yr Swap Spreads in the US, buying 2yr Notes outright (assuming Ben keeps his promise) and buying 2yr Notes vs. Schatz all look like reasonable ways to get some tail hedges on the book.