A View from the Trenches, September 3rd, 2009: "Staying the course II"
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The last 24 hours have been marked again by policy. As we wrote
yesterday, by now (after Geithner’s statement) the market has accepted
the idea that interest rates may well remain untouched (at least in the
most relevant currency areas). Two additional elements here: 1) in the
dollars bloc (Australia, Canada and New Zealand), as the recession is
milder, the easy money may have to be pulled out earlier than later,
and 2) in emerging markets (debt-loaded emerging markets) there may be
a need to keep monetizing stimulus packages, particularly if China
slows down to more sustainable activity levels, but such over
monetization would bring a run against their currencies. This last
point is relevant. A run against an emerging market’s currency would
not necessarily be supportive of the USD, if the same is triggered by a
wave of defaults affecting the country’s financial system. It could
potentially be supportive of gold, if the big guys (G-8 countries)
don’t lend a timely hand.
Thus, prices continue to adjust to this new outlook, first drafted
by “A View from the Trenches” on August 19th, , ahead of the curve. We
therefore see the dollars not depreciating but trading in range, as
risk assets correct (consequence of element #1 above) and we start to
see an interesting arbitrage within emerging markets. Although money at
this stage seems on aggregate to leave emerging markets, the fact is
that there is a lot of differentiation. There is no better example than
the cross Brazilian Real /Mexican Peso, to reflect this point. The same
is evident in sovereign credit default swaps, which have already begun
to communicate this view. I have more to say about this new paradigm of
global monetary coordination and in the coming week, I will present a
“bonus” research note on it, proposing an analytical method to the
problem.
In my view, the relevant action yesterday took place in Fixed
Income, as stocks ended almost flat (chart 1 below, S&P500 intraday
vs. 30-yr Treasury) and the CDX IG12 index closed at 125bps, (+3bps). I
looked at my screens and could not understand why (as you see in the
chart below, source: Bloomberg) Treasuries (long-end) rallied in the
absence of a broad sell-off. This could not be a flight-to-safety
trade, with the 3-mo Libor- OIS spread (chart at the bottom, source:
Bloomberg) making a lower low, at 15.35bps. So, here’s my two cents
(and am open to feedback): Given the new outlook for low rates, a new
refinancing wave in mortgages could be on the way, even more so if the
constructive macro backdrop remains. Under this scenario, mortgage
investors would need to unwind their previous duration hedges: They had
sold Treasuries (long-term) and now need to buy them back. This could
explain the flattening move yesterday. An interesting article from
Morgan Stanley’s Janaki Rao “Convexity Update: The Rally Is Not the
Pain Trade”, published yesterday in the afternoon doesn’t side with my
view, which makes me think that maybe the sell off in Agencies by
Central Banks in the last weeks and yesterday’s news on Capmark are
actually the answer to this counter intuitive action. I am only
following Occam’s razor principle here…
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