Fed up of waiting

This year the Xmas decorations appear to have gone up earlier than ever leaving the wait for Xmas inexorably long. And so it has been with the wait for Santa Ben. But at last it is FOMC Eve and we are sure we are not alone in feeling jubilation that finally Santa is about to come down the chimney and leave all of us market participants the presents we've been waiting patiently for. He always gives good presents. Let's just hope that he doesn't forget to include the batteries.

In terms of anticipation, the FX option market is pricing the highest overnight volatility (see chart below) since the depths of the EMU-crisis in May. And for good reason. We are unsure exactly what market expectations are, although it seems something in the region of $500-600 Gigadollars over six months is the consensus, at least from the surveys we have seen from economists and traders. But even if we knew the outcome of today's meeting, we have no idea how markets will react, with contradicting anecdotes about positioning and reactions leading them to conclude that sitting on the sidelines seems like the best strategy.

As readers know, we don't do predictions . We do "non predictions". So in line with tradition, TMM predict that the Fed will NOT announce more than $700bn and will NOT announce less than $400bn over a six month period (or equivalent). Now this is something of a cop out, but not for good reason. Experience suggests that the Fed will try their damnedest to avoid surprising the market in a bad way, and the recent leaks and furore about the Primary Dealer questionnaire illustrate that they have a pretty good handle on things. That suggests the downside floor is pretty high. On the upside, we are sure that the FOMC will be utterly delighted by the increase in inflation expectations since Jackson Hole, with 5y5y TIPS Breakevens (see chart below, white line) surging 1.17% to 3.09%, essentially equaling the highs back in April. Now this would suggest that the Fed would be cautious in terms of driving breakevens even higher for fear of deanchoring inflation expectations. The truth, as always, is somewhat more nuanced, as the Fed's own model for deriving inflation expectations from TIPS (attempting to strip out the usual caveats: funding, inflation risk premia and valuation of the deflation floor) has not risen quite as much, by 68bps (see chart below, orange line). Unsurprisingly, a good portion of this is inflation risk premia: QE2 is essentially the last roll of the Dice - there is nothing left after this. A more careful look at the chart shows that while 5y5y Breakevens did not reach March 2009 lows, the Fed's measure *did*, and was within a whisper of the levels reached in late-2008. Anyway, the point here is that the 5y5y breakeven is more followed by market participants and thus the Fed is left with a difficult balancing act between that, which argues caution, and their own model, which suggests there is more scope. In TMM's book, that argues that the upside surprise is also capped.

That being said, if you want the upside on the EM bubble and QE look no further than Hong Kong as the team a large US ex-investment bank have pointed out. Hong Kong is an odd market because thanks to the USD peg it is basically a China fundamentals story powered by USD liquidity dynamics. Whereas the Shanghai Composite tends to move in line with mainland fundamentals and liquidity conditions HK tends to be driven by what is going on in the markets more broadly. The best way to demonstrate this is looking at the premium/discount between companies with both a Shanghai and Hong Kong listing. As can be seen here, Chalco, one of our least favorite companies traded at a truly bizarre premium onshore in China in 2007 as liquidity was flush onshore, rates were high in the USD market and there was something of a property investment crackdown underway. That collapsed into mid-08 as aggressive China monetary tightening came through and loosening went on in the US. The difference this time of course is that now liquidity is flush everywhere and if anything China is cracking down on property again and talking about tighter loan quotas. For those not brave enough to play the “limit long HK, damn the torpedoes” game buying the H share premium does look fairly sensible as EM countries including China have to brace for impact from the QE Tsunami.

The other side effect of the QE announcement is to lift the veil on everything else that has been ticking on in the background for the past 3 weeks. European news as been completely shrouded and as the market has been holding its collective breath. Actually the analogy we would prefer is it has been gagging with its hand over its mouth on a bad Irish/Greek prawn waiting for the speeches to be over before it legs it to the toilets and chucks its Euro guts up. Six months ago Irish spreads going to where they are now together with bombs going off in Athens' Embassies as someone tries to incite revolution may just have seen EUR/CHF FALL. Not Rally. We are are pretty close to reloading EUR/CHF shorts just in case (we also like the soothsayer signals in it). We cant be that far off SNB relief exit levels either. It also ties in with our view on Euro rates.

Ooooooo.. is it Christmas yet? Pleeeaaase can it be. We are just SO excited, can we open it now please? Or just peak inside the paper ???

Food For Thought

So the RBA decided to stick it to the market once again, this time by hiking, accompanied by a pretty hawkish statement highlighting in particular that the slowdown in China looks to be less severe than previously thought. Indeed, TMM cannot help but think that yesterday's PMI data out of both the US and China have firmly moved the RBA back into hiking mode more broadly. A re-acceleration of the industrial cycle in the US is clearly bullish for its export partners (we're looking at you Mexico...), and what appears to have merely been a mid-cycle slowdown in China means that there is unlikely to be much let up in demand for things in "God's Country". But the increasing meme of Asian inflation which was added to by the Reserve Bank of India citing food prices for its own hike overnight and the possibility of QE-leakage is all adding to our previously mentioned fears of asset bubbles in Emerging Markets.

About a year ago, TMM heard a bit of shoe-phone that at a meeting of Chinese Mandarins, after one such mandarin gave a presentation upon the risks to the economy from the stock market and other potential asset bubbles within China, Premier Wen simply replied something along the following lines: "I've seen the stock market go from 2000 to 6000 and then back to 2000 and now back up to 3000... I know how to deal about that... What I want to know about is food inflation". And so, with China's Food CPI running at 8% YoY (see chart below), and slightly-less-manipulated data that TMM look at suggesting it is running far higher, the alarm bells are ringing.

But it's not just Asia. Turkey printed an upside surprise in CPI last week, with Food price inflation running at an eye-watering 15.33%, and headline CPI now running at 9.24% vs a low of 7.6% in July. Yet 5yr Xccy Swaps (see chart below) are sub-8%...

...And India, with Wholesale Prices rising at just shy of 17% (see first chart below), the 5yr OIS is hovering around 7% (see second chart below).

Now TMM totally get the QE-leakage story in terms of capital flows into Emerging Markets, but the idea that EM rates markets will be bulletproof in the face of an inflation scare seems baloney to them. The flip side of the QE-leakage story is that inflation is fueled by attempted FX intervention and domestic money supply expansion. The RBI's, and the PBoC's, recent rate hikes merely signal further moves in this respect. It seems to us that the trade here is to pay rates in EM vs being long the currencies, rather than just sitting long of both the currency and the bonds on the "search for yield" argument.

It's all looking a bit too much like 2006 in EM for TMM.

Elsewhere TMM are somewhat bemused by the Anglo/French defense deal. Would it not save a lot of time, money and angst if the UK went direct to doing a defense deal with the Chinese? Apart from the obvious benefits of making a pact with the biggest bully in the playground, we are unaware of any large national monuments in the UK dedicated to famous triumphs over the Chinese that will obviously need renaming. Unlike Trafalgar Square and Waterloo Station and surrounding environs. Of course we would happily rename the British Boxer dog in case they felt it was anything to do with a rebellion.

What a Load of Central Bankers

Here we are, the roar of finely tuned trading machines on the grid, waiting for the green lights from the central banks, is deafening. Well we wish it was. Its actually pretty dead as every feasible permutation of QE has been discussed ad nauseam (today's lucky winner is ex-Fed member Meyer with 5 Terabucks). In fact looking back at a chart of anything just shows what an un-October month October really was. I suppose the "surprise" this October was in the "no surprise". Which makes for an exciting end of year as the pressure to perform has now been compressed into the last 2 months.

But before we kick off we have to get through this week's CB-fest. So we have been doing our own spying on them, looking for clues. We didn’t really find anything of great surprise.

Fed - Have just been lent the "Euro-millions" lotto machine to use in deciding how much QE to do. Awaiting for the game show style announcement on Wednesday... "And the first number tonight is 15, the second is...

BoJ - We heard singing from their windows of an ironic version of the Vapours classic. Only this time it is "We are turning USA".

RBA - Lots of giggling and herbal smells - "you know what? We are in such a wonderful place why don't we let you lot decide on rates? We are just so high on commodities we really don’t care about the odd 0.25% anymore. In fact just leave it to that journo in a mac, you all seem to pay more attention to him than us anyway".

ECB - Saw Paul McKenna enter the building with a large watch on a long chain muttering "look into my eyes, not around my eyes, into my eyes .. Europe is just fine and those blow outs today in euro-peripheries are just the market's way of saying how wonderful your policies are. Oh and don’t forget to say Viiigiiiilent".

BoE - Saw a large package arrived marked The Gaucho Grill with Argentina postmarks. We suspect it was bought from the Kirchner estate having previously been used to incinerate all traces of inflation contaminants from your otherwise tenderest of data.

Back to sleep.

You know QE expectations are getting a bit out of hand when...

So the ECB's 3m LTRO ended up with a larger take up than expected, causing short-dated EONIAs to collapse (see chart below, white), and so, of course, the Schatz yield (orange) decided it was in fact not going to follow. This is a common frustration for TMM - it's difficult enough getting the Macro right let alone making any money off it. Nevertheless, TMM firmly believe that as the money markets in the Eurozone thaw, along with Club Med worries once again surfacing that the front end will gradually rally.

In other news, TMM would like to pay their respects to the passing of Argentina's Nestor Kirchner, for the reaction in Argentine assets was simply astounding, with the stock market up 10%. Now TMM don't bear any ill feeling to President Kirchner, but it just goes to show what can happen when economic policy is run essentially by printing money to fund deficit spending and ignoring inflation by claiming that it has only gone up due to "one-off" factors. Kirchner, of course, decided to alter the inflation statistics such that these large "one-offs" were stripped out, something that reminds TMM very much of that other guy that loves printing money and ignoring inflation by claiming it is due to "one-offs"... their arch-nemesis, Mervyn King. Of course, he isn't quite so explicit as to alter the actual statistics, he uses another approach: rubbish one index, and focus on "inflation ex-energy, ex-food, ex-VAT, after currency moves, ex-..etc etc". TMM's blood pressure is rising so they won't comment on Adam Posen's claims that "if the UK recovery was going to be inflationary, it would have been evident by now" aside from pointing said Posen to RPI running at 4.6% y/y.

But back to printing money. With markets in "QE-on/QE-off" mode rather than just "risk-on/risk-off" TMM thought that it was worth considering whether QE expectations were getting a bit out of hand over the past week and would like to invite readers to post their own metrics:

You know QE expectations are getting a bit out of hand when...

1. Goldman calls for $2trn.
2. Rumours fly around that the Fed may eventually do $4trn.
3. China starts complaining that the Fed is about to purchase $1trn of USTs despite buying a similar amount themselves.
4. Xerox is up 36% since Jackson Hole.
5. Your Mom calls you asking what QE is.
6. The BoJ buys a promissory note from TMM for $1bn whose principal is equal to their combined yearend bonuses price in Gold today.
7. IBM issues a super long bond.
8. Mexico issues a really super duper long bond.
9. You find out that both of these organisations have a guy who had Bernanke as a thesis advisor in their Economics PhD program before joining their respective Treasury departments.
10. Greek tourist-tat shops sell QE wallets three times the size of normal ones.
11. The guy that trades European Telecoms on the Equity floor explains to you how QE works.
12. The TDI (Taxi Driver Index) flashes Red when your taxi driver starts using QE to justify the Gold he bought in May.
13. A word score of 36 in Scrabble is nicknamed "scoring a QE" in old folks homes.
14. Your FX sales shag starts giving you minute by minute updates about 10s30s, but doesn't know what "10s30s" is.
15. Handing out an extra 200,000 quid to all players when any one goes bankrupt is now mandatory and in the official rules of Monopoly.
16. The DPI (Dinner Party Index) flashes Red when you are in Islington and the Guardianistas around the table start debating just how much more QE is needed.
17. Your Mom calls you back and asks if she should put her 401k in Gold to hedge against inflation.
18. Bill Gross, an otherwise nice guy, goes on a rampage, and while not naming names is clearly not happy with the FOMC right now.
19. The UK decides to privatise the Royal Mint.
20. Your Mom calls you again and explains to you how QE works.

Benoit Mandelbrot, RIP

What a shame the great Benoit Mandelbrot died 2 weeks ago. He would have had plenty to tell us about the fractal nature of markets. Whether it is the way price charts show patterns regardless of time scale (ask any fib or Elliott supporter, they relish it) or even down to the fractal nature of "what if" analysis. With 7bn people, each with a few billion brain cells, it takes a while before you get down to the binary calls. And so it is with macro. Each piece of information we have is a small weight on either side of the balance of outcomes. The skill is in attributing the correct weight to each piece. Every news headline scrolling across a news screen affects YOUR market in some tiny way. We used to play a markets version of 6 degrees of separation with our new interns to get them thinking in relevant ways. Headline - Danube levels fall 8cm? Perhaps that's marginal enough to stop some bulk shipping or increase stream traffic due to lower flow and how would that affect Hungarian or Balkan trade data. Etc etc. We mention this because yesterday was a case in point. We decided that what for many was probably the Nth degree of nerdy micro, to us is one of those grains of sand that can tip the balance. And as such needed comment.

The complexity of this analogy is added to when you consider that behavior of each individual grain of sand has its own probability distribution. At which point we go all quantum. And you could quite easily say that markets only express one value or another once we look at them! Prof Schrödinger's Cat like.

Just as a coastline is the sum of the grains of sand along the shore, so macro is the sum of the micro. But of course we can't just simply keep track of so many micro elements at once and instead like to categorize them by ordering them into families we can easily deal with. We create implicit rules that we think identify these categories and detest it when those rules break down. Correlation is a wonderful concept when it works. A sort of glue for the Grand Unified Theory of Markets that allows us to create "fire-and- forget " trading models. But when the correlation glue breaks down, as we are now seeing, we are forced back to the micro to rebuild our macro models.

At any rate, please excuse our foray into matters philosophical. It's been a relatively quiet time in the mkts, as everyone collectively holds their breath in anticipation of the Big Bad Ben. So we leave you with this. Mandelbrot may be gone, but fractal markets have been and will be with us always. We are just glad that the great man died peacefully and wasn't a victim of foul play (which is, we suspect, the fate that befell Paul the Octopus, who just knew too damn much). Otherwise it would have taken the cops a very very long time to draw the chalk line around the body.

A Basis For Cross-border Re-leveraging

Many years ago, when certain members of TMM were fresh-faced graduates learning about curve building and how best to get the desk breakfasts, they were told that "the basis never moves". Of course, things that "never move" or "never happen" tend to follow Murphy's Law... and indeed, in August 2007, basis spreads everywhere started to blow out, resulting eventually in even single stock guys having a Libor-OIS ticker on their screen. TMM, like many, has become accustomed to esoteric portions of the financial system having a large impact upon prices, and in recent days there has been some excitement about the moves in Swedish and Sterling Basis Swaps. At the risk of boring our readership to death, TMM will attempt to an explanation at the weird goings on of the basis swap market... as a warning, this is a bit wonkish.

For the uninitiated, a basis swap is an exchange of two Floating Rate Notes (FRNs) paying different floating rates, and essentially come in two forms: (i) both floating rates are in the same currency, so there is no principal exchange (known as a tenor basis swap - Libor-OIS spreads are an example of these, but also 3m Libor vs. 6m Libor), or (ii) the floating rates are in different currencies (known as a cross-currency basis swap , see chart below- the EUR/USD basis is an example of these). Bond Maths 101 tells us that an FRN that pays the risk free rate is worth its face value because regardless of where risk free rates move, you can borrow at the risk free rate, but the bond pays you that very same rate. Obviously, that is not really a particularly good approximation of the real world, but bear with us for a minute... If there is an exchange of two FRNs in different currencies both paying the risk free rates in those currencies, then the exchange is "fair", however, if one of the Notes pays a rate with credit risk embedded, the exchange is not fair, and a Basis Spread needs to be subtracted from that note's floating coupons in order to equalise the credit risk (or, by market convention, is added to the lower risk note's coupons in the case of tenor basis swaps and to the foreign currency leg for cross-currency basis swaps. Intuitively, 6m Libor has more embedded credit risk (and liquidity risk - more on that later) than 3m Libor, so a swap of 3m Libor vs. 6m Libor would need a spread added to the 3m Libor leg to make the swap fair.

Taking the argument a bit further, one can see the term structure of the tenor basis swaps in each currency relative to risk free rates (for the sake of simplicity, we assume these to be OIS/Fed Funds/SONIA/EONIA etc, though there are plenty of caveats here) effectively gives a profile of the riskiness embedded not just in each Libor rate, but also over term. If the structure is steep (i.e. 12m Libor vs. OIS is quite a bit wider than 1m Libor vs. OIS), then there is either a perceived increased credit risk, or alternatively, liquidity constraints or liquidity-based demand for longer-term funding. Thus, the relative steepness of the two term structures should have at least some determination upon the cross-currency basis - i.e. if the steepening is due to credit concerns then the cross currency basis would move more *negative* (this is the cause behind the well-known "Japan Premium"), but if it is due to term liquidity preference rather than credit constraints, this would move the cross-currency basis *positive* as it would become more attractive to issue debt overseas and swap it back into domestic currency.

So that's the wonkish stuff out of the way. In the real world, these effects are usually dwarfed by longer-dated issuance being swapped between currencies for yield pickup by corporates and supra-nationals in the case of the medium/long-end, while in the short term by the immediate short-term funding needs of the banking system. The poster child for this was the EUR/USD 3m Basis (see chart below)in the immediate aftermath of the Lehman bankruptcy as foreign banks struggled to fund their USD assets via the FX Swap/Basis Swap markets. The EUR/USD basis moving negative has thus evoked memories of USD-funding shortages, most recently in late-April/May as concerns about the solvency of the European banking system in the presence of possibly insolvent sovereigns came to the fore.

So in recent days, when the SEKUSD (1y - white line)and GBPUSD (1y - brown line) basis swaps had large moves positive, it raised fears of a liquidity crisis in those currencies...

But TMM think there is another explanation, related to the textbook gumpf above. For the sake of tractability, TMM have rebased the tenor basis structure relative to OIS (which we take as the risk free rate, this isn't strictly accurate due to compounding, but it shouldn't affect the overall picture) in the UK (chart below, 1yr basis swaps: 12m Libor vs. SONIA - white line, 6m Libor vs. SONIA - brown line, 3m Libor vs. SONIA - yellow line and 1m Libor vs. SONIA - green line)...

...and in the US (see second chart below: 12m Libor vs. FFUND - white line, 6m Libor vs. FFUND -orange line, 3m Libor vs. FFUND - yellow line and 1m Libor vs. FFUND - green line):

It is pretty easy to see that in the US the term structure has not really changed all that much from early-2010, but in the UK it has steepened as 6m and 12m have either stayed wide or moved wider. This is interesting, because the BoE's Special Liquidity Scheme is to roll off shortly, and UK banks have been attempting to replace that funding longer-term, and this may account for the widening of these bases. This looks to TMM like the liquidity-driven term structure steepening argument from above. It is perhaps no coincidence that recently there has been a pickup in cross-currency funded issuance of RMBS in the UK given that GBPUSD basis swaps were still negative despite the moves in the basis term structure. Indeed, as market makers had kept themselves long of Dollar-funding in case of another Dollar funding squeeze, it is also perhaps not surprising that the move has been violent as FX Forward books were forced to stop out of their position. These moves would indeed drive the cross-currency basis more positive.

In addition, TMM find it hard to believe that it will not have gone unnoticed that FOMC LLC is about to print a shed load of USDs, making funding in USD a much easier proposition. With printing presses around the world not having the same productivity rate as that of the Federal Reserve, TMM thinks it makes sense for the international banking system to begin *re-leveraging* on a cross-border basis. The evidence from the UK and Sweden (related to some covered bond shenanigans) suggests that these guys are paying attention doing this. As far as credit growth goes in countries not undergoing the dreaded balance sheet recession (as regular readers know, TMM does not think the UK falls into the same category as the US, and today's GDP numbers certainly back that view up), a re-leveraging in cross-border banking is bullish. On that basis (pun intended), TMM would expect this to spread to other currencies as funding is raised in the US to buy/roll-over foreign assets. An unexpected side effect of QE2 perhaps, to add to the expected one of asset bubbles likely in Emerging Markets....

TMM wonder which esoteric portion of the market will be the next to show signs of getting tipsy on Old Ben's Bourbon.

And finally, TMM couldn't help but chuckle at the Australian Green Party's insertion of a number of root vegetables into the behinds of the merger arb guys...

Things the G20 Can't Organize

TMM were disappointed by the G20 like, oh, you know, most people who think there's a good chance that if we don't resolve global imbalances we might have a trade war and possibly even a real war to say nothing of the currency war underway. So, today TMM are putting their fingers which range from "ooh, that's a bit warm" (EURSGD) to "yup, that lava really does make your hand spontaneously combust" (AUDCHF) into buckets of ice and thought we'd note a few things the G20 can't organize.

1) A piss up in a brewery....

2) A lay in a Macau.....

3) A gangland shooting in a favela.....

We are open to further suggestions from our readers. Suffice to say that even when things do work out in our books on days like this you really have to wonder whether there are going to be markets, per se, a few years from now. Between global climate change and global imbalances the world is showing  that it can't fix any problems that require coordination, even if it is very mutually beneficial and the downside is absolutely awful.