Wednesday, June 10, 2009

Thinking The Unthinkable: The Treasury Black Swan, And The LIBOR-UST Inversion

The below piece is a good analysis of a hypothetical Treasury/Dollar black swan event, courtesy of Eugenio Aleman from, surprisngly, Wells Fargo. Eugenio does the classic Taleb thought experiment: what happens if the unthinkable become not just thinkable, but reality. Agree or disagree, now that we have gotten to a point where 6 sigma events are a daily ocurrence, it might be prudent to consider all the alternatives.
Thinking the Unthinkable

Several years ago, economists were saying that a new Great Depression was unthinkable, or even impossible, because we had learned from the 1930s. Today, we are teetering on the edge of a worldwide recession that could very well become a depression, at least according to those self-proclaimed “Doctors of Doom.” On this note, I would like to discuss another “taboo” subject related to the U.S. dollar and closely linked to monetary and fiscal policy. And while this topic is a highly unlikely event, one of those events that Nassim Taleb would call a black swan, it suffices to remember how unlikely a collapse in home prices was several years ago. Remember?

In previous reports, I have touched upon the concerns I have regarding the overstretching of the federal government as well as of monetary policy while the Federal Reserve tries to maintain its independence and its ability, or willingness, to dry the U.S. economy of the current excess liquidity. Furthermore, we heard this week the Fed Chairman’s congressional testimony on the perils of excessive fiscal deficits and the effects these deficits are having on interest rates at a time when the Federal Reserve is intervening in the economy to try to keep interest rates low.

Now, what I call “thinking the unthinkable” is what if, because of all these issues, individuals across the world start dumping U.S. dollar notes, i.e., U.S. dollar bills? We have heard that “rogue” states, like Iran, Venezuela, Nicaragua, Bolivia, as well as not-so-rogue states like China, Brazil, Argentina, Russia, etc., have been discussing a way to go from a dollar pattern for multilateral trade to another country’s or a combination of countries’ currencies in order to achieve independence from U.S. monetary policy decisions. While these attempts, or at least the noise they produce in the media, have increased during the last year or so, my biggest concern is not with what these countries may do, but what individuals across the world may do if they believe the U.S. dollar is in trouble. Why? Because one of the advantages the U.S. Federal Reserve has over almost all of the rest of the world’s central banks is that there seems to be an almost infinite demand for U.S. dollars in the world, which has made the Federal Reserve’s job a lot easier than that of other central banks, even those from developed countries. Furthermore, approximately three-fourths of U.S. dollar bills are in foreign hands or foreign safe deposit boxes or mattresses, and an about-face by individuals across the world regarding these holdings of U.S. currency could be a huge blow to the value of the U.S. dollar, U.S. debt and the Federal Reserve’s monetary policy. Why? Because all those holdings of U.S. dollar bills are basically a free loan from foreigners to the U.S. government, and if there is a massive run against the U.S. dollar across the world then the Federal Reserve will have to sell U.S. Treasuries to exchange for those U.S. dollars being returned to the country, which means that the U.S. Federal debt and interest payments on that debt will increase further. This means that we will go from paying nothing on our “currency” loans to having to pay interest on those U.S. Treasuries that will be used to sterilize the massive influx of U.S. dollar bills into the U.S. economy, putting further pressure on interest rates.

If we add the nervousness from Chinese officials regarding U.S. debt issues, then we understand the reason why we had Treasury secretary Timothy Geithner in China last week “calming” Chinese officials concerned with the massive U.S. fiscal deficits. I remember similar trips from the Bush administration’s Treasury officials pleading with Chinese officials for them to continue to buy GSEs (Freddie Mac and Freddie Mae) paper just before the financial markets imploded. But the situation today is even more delicate because of the impressive amounts of U.S. Treasuries s we will have to issue during the next several years in order to pay for all the programs we have put together to minimize the fallout from this crisis. Furthermore, if China and other countries do not keep buying U.S. Treasuries, then interest rates are going to skyrocket. This is one of the reasons why Bernanke was so adamant against fiscal deficits in his latest congressional appearance. Of course, the U.S. government knows that the Chinese are in a very difficult position: if they don’t buy U.S. Treasuries, then the Chinese currency is going to appreciate against the U.S. dollar and thus Chinese exports to the U.S., and consequently, Chinese economic growth will falter. The U.S. and China are like Siamese twins joined at the chest and sharing one heart. This is something that will probably keep Chinese demand for Treasuries elevated during the next several years. However, this is not a guarantee, especially if the Chinese recovery is temporary and they have to keep on spending resources on more fiscal stimulus rather than on buying U.S. Treasuries.

And of course, all these issues will have an important, weakening effect on the U.S. dollar. I know that many analysts continue to remain very bullish on the U.S. dollar, especially because many other countries in the world, especially the European countries, appear to be in even worse shape than the U.S. economy. This means that these countries will also have to keep interest rates down while continuing to spend their way out of recession. Thus, this will probably put a lot of pressure on the euro and other currencies going forward. However, the more we travel down this road the closer we are going to get to the U.S. dollar’s day of reckoning. Thus, my perspective for the U.S. dollar is not very good. And now comes the caveat. Having said this, what is the next best thing? Hugo Chavez’s Venezuelan peso? Putin’s Russian rubble? The Iranian rial? The Chinese renminbi? Kirchner’s Argentine peso? Lula da Silva’s Brazilian real? That is, the U.S. dollar is still second to none!
I owe a hat tip to a reader here: forget who sent me this.

And while we are on the topic of Treasuries, here is another insightful piece from reader Gary Jefferey, who touches on an issue that has received surprisingly little attention lately: the 1 Year UST - 1 Yr LIBOR inversion, as well as touching on many other relevant issues.
Friday’s Bear Flattening in the Bond Market contains critical market information

The US Treasury market had one of the most interesting price action days on Friday 5th June 2009, and reveals a significant shift in the global monetary forces.

What Happened?

The 2 and 3 year part of the curve widened by 35-40bp, whereas the long end (10yr+) sold off a more modest c.10bp. With a 25-30bp bear market curve flattening (2/10’s).

So much information here, but the main messages centre on:

• Bond market positioning;
• Repo & General Collateral Conditions;
• Risk appetite positioning;
• Fed/ Central Bank responses


All of the hot money (levered) in the bond market has been sitting very long the front end of the UST curve earning the steep roll down, and short the long end. Friday’s price action would have gone through a significant number of stop levels, triggering the first wave of deleveraging on this trade (yes there is more to come).

What has the Market Realized?

It has realized that the US Treasury market and the USD Libor markets are about to massively unhinge, or at least have the potential to unhinge without a “new” form of Fed/Central bank policy intervention. Remember these markets are the Fed/ Central Bank’s “cash spigots” to the world.

1. Fed/ Central banks have proven they can get Libor rates where they want, and look like they can hold them there (policy works).
2. UST treasury market is much harder to control, as absent Quantitative Easing (QE – talk more about this later) the free market sets the price.
3. Everyone has been crowding the front end of the curve for a variety of reasons. The hot money was doing it to earn effectively a levered return on the very steep front end roll down and pick up a little bit extra for the repo.
4. The UST issuance calendar is relentless and this flooding of the market can only ultimately result in General Collateral conditions not only relaxing, but taking a near medium term holiday. For the moment though the level of short interest in longer dated UST (hot money) and MBS convexity paying is keeping some repo margins solid , however, this to should be viewed as a speculative bubble waiting to pop once outright UST levels stabilize.
5. As a result, the short end roll down trade can now only be effectively levered in the Libor market. However, hot money is likely to stay on the sidelines of this trade until/if/when the Fed/Central Bank’s become more explicit in their short end cash target commitments.

Why the Fear Now?

Green shoots…….. But if you are highly levered investor and the trade is really crowded (UST curve Bull Market Steepening) it would only take one freak (non-trend friendly) monthly/quarterly number to completely push through your stop level. With plenty more stimulus money still to be spent and sporadic inventory re-builds this is easily foreseeable. One number may break the market but it takes plenty of good numbers to signal a “recovery”.

What Does All this Mean?

- Front end of the UST and Libor markets are going to massively invert. With 1yr Libor staying 100bp+ through (lower) than 1yr UST. The price action will be very rocky as we will see a series of rapid deleveraging events in the price action.
- Fed/ Central banks likely to become more explicit in their commitments to holding down cash rates. This is actually only going to increase the curve inversion, as levered money will only play the curve roll down in Libor once commitments are more explicit (basically its capital guaranteed trade courtesy of the Fed/ Central banks commitment – trades like this are heavily levered).
- The UST market will continue with a bear market flattening, but once the 10yr stabilizes the trade is over.
- So the next question is? Where on the UST curve is the Fed going to aim its QE arrow? Are they going to target at particular point with US$300bn firepower or go for an overall downward parallel shift? US$300 billion is a lot, but it is only 1/6th of this year’s net issuance (roughly).
- If they want to keep money in the UST market then QE needs to be focused on the short end 1-3yr, otherwise the levered money will prefer to play in Libor. BUT – here is the trillion dollar but….the long end of the UST would get absolutely smashed if this was announced. I think the Fed has maybe realized it is better off to say nothing.
- Absent Fed announcing QE in the short end – the Libor markets are going to be absolutely flooded with ex-UST hot money once Fed/Central banks become more explicit in their short end cash targets – statements like this will commence a “gold rush” to high beta risk assets. Market is currently using high beta as a rough and quick proxy for high yield (i.e. inflation proofing).
- So in effect the start of the “unhinging” of the UST market is causing a rush to risk assets. Market bears please realize this – its not because risk assets are suddenly looking so much better that prices are rising, but rather that the only massive, liquid alternative is looking less well now.
- When will levered Libor money return to the front end of the UST? My guess is if market chatter around specific 2-3yr QE targeting starts surfacing regularly, or once Fed/Central bank commitment to short end cash targets ease. Absent this I think the hot money will now demand a trade ROE of 25%; it’s a true risk equity trade that’s not capital guaranteed (Fed implied). Assumed maximum leverage would be around 10x given the lumpy/ volatile price action. That’s why the 2yr UST note will have a 2% big figure in the not too distant future.

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