A View from the Trenches, September 30th, 2009: The trend is your friend.
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Below, I show two charts (source: Bloomberg). On the left, we can
see the 3-mo Libor – Overnight Index Swap spread. As we repeated
countless times, in the past, we were confident that the rally in
stocks and credit was going to continue as long as we saw this spread
compress. We followed it from its 83+bps level at the end of April to
its 2009 low of 10.29bps, reached on September 18th. Since then, the
trend has been unequivocally from the lower left to the upper right. On
the 22nd, we turned neutral on equities. To the right, we can see the
change in the US yield curve, from Sep 21 to date. It is visibly
flatter.
Are we witnessing a retreat, a flight-to-safety? The USD index
(DXY), which indicates the general international value of the USD has
risen from 76.42 to 77.08. It is not much, but it is a signal and since
September 18th, the DXY seems to be very correlated with the 3-mo Libor
– OIS spread. I do not want to make straightforward conclusions out of
the 3-mo Libor – OIS spread, because there are excessively many parts
moving around in the rates space lately, which diminish the predictive
power of the trend. One of them, for instance, is the speculation (ref.
Bank of America’s Global Rate Focus report, Sep 25/09) that in 2010, as
part of its exit strategy, the Fed will need to take on $500BN in
reverse repo transactions. This volume is too high, when compared with
the average $219BN in Treasuries, Agency and MBS, which suggests a huge
crowding out effect on Commercial Paper, out of which Libor is based.
Thus, depending on how near and how violently the market forecasts the
reversal move take place, the recent trend highlighted in the charts
above may or may not continue. The impact on the equities and forex
markets is noticeable. The impact on credit, not so much.
Corporate credit seems to be enjoying the benefit of some sort of
inertia. The flow of cash out money funds and into credit has not
stopped, as investors keep crowding the boat in search of whatever
yield is left to take. I do not blame them. After all, that was the
purpose of the quantitative easing policies. The hope that this flow of
capital will trigger a wave of investments is perhaps a long way from
materializing. However, the flow is the necessary condition. It is not
a sufficient, but a necessary condition.
In conclusion, the trend in the 3-mo Libor – OIS spread, Treasuries,
the value of the USD and, last but not least, the political changes
taking place in Europe and the Middle East continue to make me
comfortable with my position on the sidelines. If the aforementioned
trends show continued strength, I will have no choice but to turn
bearish…
Lastly, the Fed bought yesterday $3.BN in Treasuries (May/12- Nov/13
maturity range), leaving only $7BN to complete its $300BN purchase
plan. It seems it was yesterday when I first wrote that I was convinced
the Fed would upsize this program. Was it successful though?
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