Behavioral Macro

Do you think the selling in the Treasury complex is over—at least until next Friday’s NFP? It you are a trader, this is really the only question you have to ask yourself right now.

There has been massive pain in the fixed income world over the past three weeks. The backup in Treasury yields finally attained the speed necessary to shake carry traders across the FI spectrum into shedding risk. It got particularly ugly in EM local fixed income and currencies (more on that later). The risk-shedding eventually spilled over into the equity markets.

Odds are good now that we are at that kind of win-win juncture for FI risk that you don’t that often see. Kind of a David Tepper moment for FI traders. I think the selling in the T-plex has been strong enough for long enough that it would take big fundamental news to drive them further down from here. And I can’t see anything important enough in front of the NFP to fit that bill.

This leaves us with two basic scenarios. One, if the equity market rebounds, the ‘fear discount’ now built into a lot of FI instruments will come out and Treasuries should stabilize if not rally, given the speed, fear and volume behind the recent selling.

Two, if, instead, the equity market sells off further from this point—which we got a taste of on Friday—then Treasuries will rally, as they tend to when risk aversion rises far enough or fast enough in equities. In fact, we got a taste of this on Friday as well. This scenario should trigger at a minimum a modest rally in the some of the FI instruments hit hardest by the bond selloff.

Both scenarios have implications for the dollar and tend to be bearish, but more on that below.

Of course, if your scenario doesn’t envision Treasuries stabilizing, then you stay just out of the way.

If, however it does, you then have to consider the follow-up, investor question as well: Has the market too aggressively discounted the timing of the Fed’s exit process? This is not the same as the first question. If you believe the answer to this question is also yes, then this is probably a good entry point to buy beaten up FI instruments for a longer timeframe, not just for a trade (FWIW, less than 3 months is the trading bucket, more than 3 the investment bucket).

Three FI sectors warrant separate discussion here, IMO: Agency mortgage REITs, currencies and EM local currency bonds.

Agency Mortgage REITs

-  Selloff started last September

- The sector is now retail-dominated and emotional 

- I put the current discount to NAV at ~10%—but this is a guesstimate, conditioned in no small part by the magnitude of the decline in book value last quarter

-  The sector is in cyclical downswing, but discount to NAV and carry offer good protection right now against being wrong, even when dividends are cut.

Ccy, PMs and EM local FI

Correlations have been low, making things tricky. Positioning is heavy and will be the driving force in the near term, IMO, especially if the equity market tumbles further. If you believe USTs will stabilize, you are likely to see a decent rally in funding and hedging currencies (EUR, GBP, AUD, NZD, CAD), and in JPY where positioning is so heavy even higher UST yields were unable to lift USDJPY. You’ll also likely see a squeeze in precious metals, where a lot of shorter-term traders and CTAs are positioned short. Even though I dislike precious metals in the longer term, I think odds right now favor an especially good trading opportunity in the gold miners. There’s a fair number of people long dollars against the majors and precious metals at this point. Caveat: short dollars anywhere except JPY gets a lot trickier if USTs stabilize and SPX sells off hard.

It is less clear how much EM currencies rally if the big dollar sells off, if at all. This is an area where there still is short-dollar positioning, and, frankly, it is humongous. USDMXN has moved 80 big figures and long-term holders were only just roused from their slumber last Wednesday. My guess is any rally in EM currencies will be used by institutional investors to lighten up, driven by this wake up call and their longer term cyclical views.

The big trade for many macro types has been long EM currencies and short a basket of developed currencies. This allows macro guys to be long EM ccys while diversifying away much of the EURUSD risk by using a funding basket. Shorting AUD hedges SPX and Asia slowdown risk as well. This trade is as old as dirt. Problem is there are many more guys holding dirt these days. And RM, both dedicated and crossover, have piled into EM local ccy bonds (look at the ticker $EDD). Few outside the asset class know how large it has grown relative to the target market. And those in the asset class have kept mum to increase AUM.

These local bonds are too difficult to sell in size, so if redemptions get large enough where RM funds have to reduce bond holdings, it will get ugly. In the meantime, the big investors will buy dollars against their EM local bond holdings to protect those positions as best they can. Few investors in EM local ccys bonds realize the extent to which overall returns in the space are driven by currency and not the bonds themselves.

I know EM fundamentals are better in most EM countries these days, but that is not much of a defense once we tip over into the liquidation mindset—and odds are good that we have. The participation in the asset class is just much, much broader than it has ever been. Plus, the sell-side market-making is a lot thinner. So, even if you think USTs stabilize, this is not the asset class to play. Many large players will be looking for the exit on any decent bid.

I spend more time than I probably should exchanging views with other market participants, most of whom are friends. It can take up a lot of time. My exchanges with one guy in particular, a macro guy with a strong background in economics, usually capture best where I’m at. I’ve posted my side of these exchanges a few times in the past. The similarity in backgrounds usually leads to a very efficient exchange of ideas—even when we don’t agree. We just speak the same language.

I had the impulse this weekend to write up my views because I changed my positioning last week. But, busy with other stuff, I never got around to it. Lucky, my macro/economist friend wrote me an email today soliciting my views. This forced me to hammer them out. Here they are, excising, of course, the personal pleasantries in the first para, and the salutation in the last:

“As for the markets, I just took down much of my long equity exposure, the day USDJPY broke 100. I think the dollar has more to rally and, even though the correlation to equities has been low, if for whatever reason the dollar rally accelerates, stocks could take a breather. I have had a good run so I don’t mind taking equity risk down and re-assessing. I am keeping positions in less than a handful of key equity names and will continue to watch. Still have long AAPL, short precious metals, for example.

My only high conviction positions right now are: being long dollars (biggest position is USDMXN, which I think is technically most vulnerable) and short silver, gold and a little bit of oil. My view on there being a bubble in commodities that is unwinding has not changed, despite the mini-crash in precious metals last month. On a scale of 1-10, risk is now a 5 for the book. I had been running closer to 9 for a while.

I am still bullish on the fundamentals in the US. Europe’s day of reckoning will come, but in my base case it is a fair ways down the road. EM will grow less than expected, but expectations are not too high. I don’t expect any blowup in EM. Further upside in USDJPY is mostly idiosyncratic here, and fairly heavily positioned, but USDJPY coming off hard would be one of the clearest indications of risk off/position liquidation I can think of.

I feel there is too much fear of a Fed exit (there is risk, of course, but IMO we are overpricing it, both in timing and magnitude of impact). And the wedge between valuations and fundamentals is less than what ppl argue, not least because the macro continues to heal under the surface (HH debt better, jobs slowly better, budget improving fast and not “priced in”).

US growth will still be anemic—structural/latent globalization issues will keep a lid on US wage growth, but too many ppl are too deeply pessimistic and are hanging their hats on the Fed blowing things up—because all their theses so far have been wrong. It’s like at the end of the football game and the team is betting everything on the long pass (the Hail Mary play) because they are so far behind in the score.

The above language may seem a bit cryptic and not fully fleshed out, but I hope it’s better than not putting the views out at all.

There is zero correlation between the Fed printing and the money supply. If you don’t believe this, you owe it to yourself to study up on monetary policy until you do.

This is an issue that brings them out of the bunker like no other in economics. But if you are an investor, trader or economist, understanding—and I mean really understanding, not just recycling things you overheard on a trading desk or recall from econ 101—the mechanics of monetary policy should be at the top of your checklist. With the US, Japan, the UK and maybe soon Europe all with their pedals to the monetary metal, more hinges on understanding this now than ever before.

And, as we saw this week, even many of the Titans of finance and economics have it wrong.

“Wrong? You’re saying they’re wrong? They have tons of money. They have long track records. I mean, they’ve seen it all.  How can you say that? That’s just arrogant.  Besides, did I mention they have tons of money?”

Here’s why the Titans are wrong

Brad DeLong had an entertaining piece on whales, super whales and men who hate the Fed, but the answer is much simpler than the one he offers. In fact, if you’ve ever been in the belly of a hedge fund, you know the answer to most everything is much simpler than it appears to the mere mortals on the outside.

The bottom line is the titans are working from the wrong playbook. We’re all, to varying degrees, slaves to our experiences. Their formative experiences, almost to a man, were in the early 80s. This is when they built their knowledge and assembled their financial playbooks. They learned words like Milton Freidman, money multiplier, Paul Volcker, Ronald Reagan, and the superneutrality of money. Above all, they internalized one dictum: real men have hard money.

This understanding implies that an increase in bank reserves deposited at the Fed (i.e. “printing”) eventually feeds credit growth and thereby inflationary pressures; in other words, no base money increase, no credit growth. Only one problem: reality disagrees.

Here are the facts

From 1981 to 2006 total credit assets held by US financial institutions grew by $32.3 trillion (744%). How much do you think bank reserves at the Federal Reserve grew by over that same period? They fell by $6.5 billion.

How is that possible? I thought in a fractional reserve system base money had to grow for credit to expand?

The answer is structural. The financial deregulation that began in the early 80s (significantly, the abolition of regulation Q) and the consequent development of repo markets fundamentally changed the transmission mechanism of monetary policy. Collateral lending is now king. Today, length of collateral chains and haircut rates—neither of which are determined by the Fed—define the upper bounds of the money supply, not base money and reserve requirements.

What about the relationship to inflation? Isn’t base money correlated to that? Here’s a graph, from this piece by central banking expert Peter Stella.

The X axis shows 5-yr growth rate of base money (loosely defined) and the Y axis shows annual yoy inflation. That’s right. Nobody home here, either.

Don’t confuse liquidity with credit

The Federal Reserve only provides liquidity. The amount of liquidity it puts in the reserve system has no direct impact on the issuance of credit by banks or shadow banks. Only banks and shadow banks can create credit. And they lend either out of cash on hand or by repo-ing treasuries, mortgages, or deposits, if cash on hand is insufficient. And collateral that is pledged once can be pledged over and over and over (collateral chain). So, even though credit increases, the total amount of banking reserves on deposit at the Fed remains unchanged (though composition across banks may change).

So if the banks and shadow banks can just as easily repo their Treasury and mortgage holdings to finance lending, and there is no link between base money and credit creation, why is the Fed doing QE in the first place?

By keeping rates low well out the yield curve and providing comfort that the Fed will be there to fight the risk of recession and deflation, it creates an environment that enables, over time, a normalization of risk taking in the real economy. Our revealed belief is that the Fed can chop these nastier outcomes off the left-hand side of the distribution. As a result we start feeling better about putting our getting our money back out of the mattress and putting it back to work.

Risk taking always starts in financial markets, but eventually bleeds it way into the real economy. And, if you listen carefully, you can hear over the pitched squeals of fixed income investors, who are suffering from sticker shock and low yields, that this is exactly what’s transpiring. The time bought with aggressive monetary policy is allowing household balance sheets to the labor market to slowly heal. Heck, even the fiscal position is rapidly improving.

Again, it is important to underscore that it is the indirect psychological effects from Fed support and the low cost of capital—not the popularly imagined injection of Fed liquidity into stock markets—that have gotten investors to mobilize their idle cash from money market accounts, increase margin, and take financial risk. It is our money, not the Fed’s, that’s driving this rally. Ironically, if we all understood monetary policy better, the Fed’s policies would be working far less well. Thank God for small favors.

This is not a semantic point. I can hear traders saying “yeah, whatever, who cares, don’t fight the Fed, just buy”. But this concept has huge implications for the phase where the Fed decides to remove the training wheels. If the Fed money is not directly propping up the stock market and the economy underneath has been healing, the much talked about wedge between “Fed-induced valuations” and “the fundamentals” is likely considerably smaller than the consensus seems to think. It’s less “artificial”. In short, what all this means is the day the Fed lets up off the gas might give us a blip, or maybe that long-awaited correction, but ultimately the Policy Bears will end up getting crushed, again.

The other, more mechanical, implication is that financial sector lending is neither nourished nor constrained by base money growth. The truth is the Fed’s monetary policy can influence only the price at which lending transacts. The main determinant of credit growth, therefore, really just boils down to risk appetite: whether banks and shadow banks want to lend and whether others want to borrow. Do they feel secure in their wealth and their jobs? Do they see others around them making money? Do they see other banks gaining market share? 

These questions drive money growth more than the interest rate and base money. And the fact that it is less about the price of money and more about the mental state of borrowers and lenders is something many people have a hard time wrapping their heads around—in large part because of what Econ 101 misguidedly taught us about the primacy of price, incentives and rational behavior. If you answer the behavioral questions and ignore the endless misinformation about base money—even when it’s coming from the titans of finance—as an investor you’ll be much better off.