Daily Note – The Homecoming

Rough SeasSummary:

United States: Strange moves afoot in US bond land

United States: Blockbuster GDP Report

China: A look back at China’s money market tightness late this week (and forward to what’s coming next week)

Eurozone: ECB’s Weidmann says they are ready to act if needed

Eurozone: German vs. French yield spread breaking higher






Good morning. It is what my mother would call a “filthy” morning here in Dublin, lashing rain and ferocious wind. Perfect Christmas weather.

The radio tells me that most of the ferries to and from Britain have been cancelled which means thousands of emigrants coming home from England at Christmas may have to suffer a long wait in Holyhead, Wales. Many Irish people have ghastly tales of stopovers in Holyhead; let’s just say it’s no Venice Beach.

The annual pilgrimage home to our mothers for Christmas is something of a right of passage for millions of us. In Ireland it is usually a voyage from another country and, since 400,000 of us have left this island since 2008, this year will be no different. However, the annual homecoming isn’t limited to us, as all over the rest of the world, millions are on the road, in the air or on the sea heading to where we call home for a few days of too much booze, food and the odd family row. For anyone about to make the pilgrimage today download  this to see the funny side of things if, God forbid, things take a turn.

Years ago when I worked on a trading floor in the City, the London Dublin corridor – the busiest air route in the world – was jammed in the days coming up to the 25th. Rather than the interminable delays at Heathrow, some people chose to head up the M6 towards Manchester and then turn left to the ports of either Liverpool or North Wales. In this sub-tribe of travellers, there was always a certain type of bloke who simply “had” to drive home at Christmas. This was the lad with the big flash English motor – a type of pre-Top Gear, Irish Jeremy Clarkson. He knew there was no point being a “successful” emigrant, if you couldn’t show the locals at home how well you were doing “over”. (“Over” in many parts of Ireland, particularly the deep south, means “over there” which is just about anywhere foreign.)

One Christmas, I took a lift with one of these heads, in the flyest machine a white man can cruise in – the Porsche 911. After trying to break the sound barrier on the motorway, we screeched in to Holyhead on a day like today, and yes, the boat was cancelled. Can you imagine the psychological damage done to this poor misfortunate who would have less time  to show off to  his old school friends who had stayed at home? He was livid. If you want to get a handle on why status possessions such as the top of the range motor don’t actually make us happy over Christmas have a look at this . I can’t think of a better time of the year to read it!

Despite being petrified on the drive, I learnt a very valuable lesson from this bloke. He was a trader who had made lots of lolly that year by being short emerging markets – almost before emerging markets became an asset class. He had been ahead of everyone else.

In contrast, I had been caught flat-footed by the March 1994 Fed tightening, which had spilled over into Mexico, prompting the Tequila crisis, in much the same way as “tapering” has been felt most extremely in emerging markets today.

Economists try to see logic in a trade, so we couldn’t see that with leverage, all assets in emerging markets would be sold off, irrespective of the specifics of each particular economy. Nor did we understand fully how cutting off the flow of credit at the top would impact on all the lesser assets that had been benefiting from the Fed’s munificence.

To visualise what happens when the Fed’s monetary taps are open, have a look at this:

The trader versus economist lesson is something I have never forgotten. It was instrumental in my short 5 year paper trade in the US which I told you about in last Tuesday’s note ahead of the FOMC. My view, outlined in the launch note, was that the US economy might be a bit stronger than many economists think – the reasons are outlined here and are well understood, but not factored in.

This reticence to see better than expected outcomes may be psychological.

One thing I have noticed over the years is that in the boom, the consensus tends to more optimistic than reality; and in the recovery, when people still have the trauma of the crash in their minds, the consensus tends- for some time – to be more pessimistic than the reality.

For whatever reason, I thought there was a small opportunity it.

Let’s examine this in a bit more detail here, because the US bond market has been strange for these past few days.

United States: Strange moves afoot in US bond land

Look at the chart below to see the impact on prices since the close on December 17th.

Why would the 5-year note sell off the most while the long bond rallied? Remember, the lower the price, the higher the yield.


As I outlined in the launch note, the 5 year note is my preferred short (looking for higher rates) on the basis of higher rates next year but also crucially because fixed income investors have clustered in this part of the curve.

And while this general picture explains some of the moves post the FOMC last Wednesday, it doesn’t explain all of it.

Something much more fundamental may be going on.

The answer has to do with how the market was positioning prior to this event. Many traders – following the consensus economic view –  had the following two basic expectations:

  • Taper is coming next year and the impact should raise long-term rates
  • The Fed will keep short term rates near zero for a long time

The trade that takes advantage of this view is the so-called “steepener” trade. This involves being long short-term treasuries and short long-term treasuries and is how the market was positioned going into the FOMC announcement.

But a combination of the “early” taper, stronger than expected economic data (Housing Starts, Industrial Production and GDP), and a less than stellar 5-year note auction, flipped expectations.

After five years of deleveraging, deflation and deep, deep recession it is easy to be taken by surprise.

But what if the US economy unexpectedly accelerates?

The Fed will be forced to push short-term rates up faster than originally expected.

The market started to price in a higher probability of just such an event after the Wednesday FOMC meeting. As an illustration, take a look at the June-2015 fed funds futures contract.

Early Tighning

The steepener trade had pushed the first rate hike expectations further out in time (higher futures price = lower expected fed funds rate).

But the announcement, combined with improved economic data, forced a selloff in the contract – with the market now expecting the first hike by the middle of 2015.

This earlier-rate-hike scenario impacts shorter-term treasuries more than it does longer-dated notes/bonds.

The adjustment in expectations forced an unwind of the steepener trade, creating the “flattening” move in the yield curve we see in the chart above.

Anecdotal evidence suggests that this unwind ended up being quite painful for a number of market participants who had piled into the trade, particularly those that were long 5 year notes and short the 30 year.

What this tells us is that regardless of the economic forecasts, the market is moving to price in a far better outlook for growth in the US than economists expect.

Have a second look at the launch note on predictions for 2014 as this may not be the only surprise which brings opportunity.

United States: Blockbuster GDP Report 


The US economy is, I think, moving ahead, but I could be wrong and I am a little bit worried about the element of inventories in the GDP figures. After all inventories are things you produced but didn’t sell. So we need to see them coming down and by extension this can only happen with a meaningful increase in final demand or exports now and in the next few months.

PCE prices were a tad lower adding to the weaker inflation picture. This sounds like the wonderful “goldilocks” scenario of not too hot and not too cold, but let’s wait and see.

Q3 Corporate profits were revised down to 2.4% from 3.3% expected which shouldn’t be a good sign for stocks – for detail on what is happening here, have a look at the Karl Marx section of the launch note.

Taken together, the growth figures imply an expansion rate of 2013 growth at +2.5% on a Q4/Q4 basis, up from +2.0% in 2012 and 2011. This is quite impressive given the 1.75% of GDP federal fiscal drag this year from the tax hikes and sequester spending cuts, plus the additional short-term drag from the government shutdown.

All in all, as we approach Christmas Day, the US can look back on 2013 as a turning point year. The best indicator of the change is the announcement of the “peak stimulus” moment last Wednesday. There are risks we will explore next week, but now let’s talk about China which is again revealing the limitations of intervention post bubble.

China: A look back at China’s money market tightness late this week (and forward to what’s coming next week)

Before talking detail I think it is worth reminding ourselves of what is going on in China. After a few years of massive lending, which drove up property prices, there are widespread fears that too many buildings were built and the prices of these are now falling and indeed, the extent of the falls have been masked.

If this is the case, two factors come into play: one is macroeconomic which will affect the growth rate and the other microeconomic, which will affect the banks.

The macroeconomic impact is that the normal post-credit boom environment is not one where the economy falls, rights itself and then resumes growth again. In contrast, it is years of deflation in asset prices, which implodes balance sheets and leads to very serious debt deflation a la Japan or, closer to home, Ireland or Spain. This process is best outlined in Irving Fisher’s seminal paper on debt deflation here.

In the microeconomic sphere, banks stop lending to each other because they fear that the banks they are lending to are holding lots of these bad assets on their balance sheet and will suffer bad loans and will run out of cash. So the banks stop trusting each other, short-term liquidity dries up and interbank rates shoot up.

The latter is happening right now and we hope it doesn’t presage the former, but who knows.  On the basis that hope is never a strategy, stay on the side lines unless you have to be involved.

The Chinese benchmark seven-day bond repurchase contract began rising on Wednesday. The rise accelerated when the PBOC refrained from injecting cash into the system during regularly scheduled open market operations on Thursday.

The PBOC usually gives no comment or explanation for its decision to stay out of the market, but when money rates rose quickly on Thursday, it did issue a statement – informally, over Weibo, China’s equivalent to Twitter: “If necessary… (authorities) will continue to provide liquidity support to qualified financial institutions via SLO”.

Rates jumped again on Friday, after opening lower. The 7-day repo hit as high as 9.9% on Friday.

There is no reason to think the liquidity crunch will pass any time soon, because the big issue of bad loans remains.

The bad loans issue is made all the more complex by the emergence of a shadow-banking industry in recent years.

The PBOC is trying to balance efforts to curtail widespread shadow-banking activities and at the same time, make sure that ordinary financial institutions can meet their day-to-day funding needs.

The PBOC wants to let the market play a greater role but risks driving interest rates higher, thereby squeezing speculators and shadow financiers by forcing them to pay more for the money they borrow.

On the other hand, the central bank wants to allow adequate liquidity to the interbank lending market to ensure there is no freeze in lending that could set off a wave of defaults among banks (worse case).

It’s a difficult balancing act, which few in the past, anywhere, have pulled off.

Eurozone: ECB’s Weidmann says they are ready to act if needed

Weidman of the BUBA did his usual over the weekend, warning that low interest rates have side effects that increase the longer they stay low. He is talking his own book here because property prices in Germany are on the rise as deflation stalks the rest of the Eurozone.

Not surprisingly, he went on to say that deflation risk is very limited. And in a typical Bundesbank line, he warned that there is risk that governments and the private sector get used to cheap money and neglect structural reforms.

In relation to a new LTRO and “negative rates”, he said traditional instruments are less effective when interest rates are close to zero and he can’t rule out banks passing on costs of negative deposit rates in loan costs – implying the spread between deposits and loans could rise.

He is sceptical of central banks trying to force banks to lend to certain sectors and regions. If the ECB does more LTRO’s then they should discourage banks from buying govt bonds as carry-trades. This is a typical German view of how the monetary union works, but what the Germans still fail to grasp is that they have got into bed with all sorts of promiscuous partners and their sense of what is normal, acceptable and moral, is not shared by their new partners.

Eurozone: German vs French yield spread breaking higher

One partner that has been a very pliant bedfellow of the Germans is France. Ever since Mitterrand’s 1982 volte face and pursuit of the Franc Fort, France has tried to convince the world that it is a mini-Germany. I have my doubts and believe that there is at least as good a chance that it turns out to be a bigger version of Italy rather than a smaller version of Germany.

I  note with keen interest ahead of the final Q3 GDP reading in France on Tuesday, that the spread (yield) of French debt relative to German debt is beginning to rise again. See chart below.


Despite all the hype around the periphery, it will be France that forces the ECB’s hand in the coming months. The French economy looks like it will contract again in the first half of next year, unemployment is still rising, the government is incapable of reform and the president is a laughing stock. Keep an eye on this one.

Now I have to head out to get the last of the presents. Have a great Christmas, hold your tongue when one of the family annoys you and travel home safely.

The next note will be on the 27th. Happy Christmas!



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