A View from the Trenches, September 14th, 2009: "Liquidity still rules"
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Let me begin by saying that last Friday’s action in the markets was very interesting. This is a view that I don’t think analysts would share. But nevertheless, I am willing to go on record here describing what I think took place on Friday, ignoring the fact that nobody else has made a comment on it. The chart below (source: Bloomberg) depicts the spread between the 5-yr Fannie Mae issue and its 5-yr benchmark (on-the-run Treasury). As you can see, this spread broke to the upside in two occasions on Friday: At 2am and at 11am Eastern Time:
Here’s what I think unfolded at 11am: The Fed was to buy Agency debt and by 11am, they had bought $2.8BN out of $6.2BN (45% hit ratio). The largest purchases were $761MM of FHLB 3.625% Oct/13, $492MM FNMA 5% Apr/15 and $485MM FNMA 2.75% Mar/14. Right after this, all the risk trades started to unwind: Crude oil, gold (commodities) fell; equities fell, Treasuries continued to appreciate, the USD gained vs. the CAD and the EUR and I even heard of some violent moves to short the CDX HY index (i.e. the credit default swap index for high yield names). Below and in this order, I show the charts for 1) Crude oil, 2) S&P500 index and 3) Canadian dollar vs. USD, so you can get a better picture of my point:
What happened?
I think the market had been waiting for the Fed to include on-the-run issues in its Agency debt purchases, which closed at 11am on Friday. Why is this relevant? A week before, Bank of America’s Rates team (Global Rates Focus, “Caution and Prudence”, September 4th, 2009) had suggested that the Fed would include on-the-runs to speed up its purchases and ensure that it reaches the $200BN ceiling of its Agency debt purchase program. The report also noted that the correlation between agency debt and swaps had been decreasing, forcing dealers to use on-the-runs to hedge off-the-runs exposure. What does this all mean? It means that it could explain why the on-the-run spread between Agency debt and Treasuries (first chart above) shows the jump at 11 am, as on-the-run Agencies are sold (spread widens) to hedge the off-the-run exposure affected by the Fed‘s purchases. However, what are we left to think about the sell-off in the rest of the markets? I think there is a little bit more to this story, than the consequences of hedging needs by some Agencies dealers here. Let’ see:
Axioms:
1. The Fed needs to hit its $200BN purchase ceiling in Agency debt.
2. At the current pace, it can only hit this ceiling if it buys on-the-runs
Thesis:
If the Fed does not buy on-the-runs, it is not in a hurry to hit the $200BN ceiling = The ceiling will not be reached = This is the beginning of an exit strategy = The Fed may not increase interest rates soon, but in order to avoid a further depreciation of the USD, the Fed intends to slow down or even not provide all the liquidity it had previously promised.
Demonstration:
If the exclusion of on-the-runs means that the Fed is unwinding its liquidity programs, the markets should sell off and the USD should appreciate.
As you can see, the chart above, in my view constitutes the proof of my thesis: The markets actually did sell off in violent fashion right after 11am. I must say (warn you) that I read and reread the standard market closing commentaries and not a single one of them seemed to have paid attention to this. I leave to the reader to judge the reasonableness of this conclusion (feedback welcome).
But if I am right, here are a few conclusions to take away:
1. Considering all the positive economic data releases that we saw last week, the sell off makes it very clear that the financial situation is still really weak worldwide.
2. We are not seeing a recovery but a bubble. Bubbles live off liquidity and die when liquidity is withdrawn.
3. All investments should be made in very liquid instruments
4. If you paid close attention to the first chart, you will have noticed that the first jump in the spread between Agencies and Treasuries occurred after 2 am…This is very suspicious to me. Did a Central Bank in Asia know already that the Fed was not going to buy on-the-runs and swapped for Treasuries?
5. If the answer to question no. 4 is positive, we are seeing a serious and strong coordination among central banks = Gold will face real challenges to break to the upside.
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