Tagged: interest rates

Easy Riders

It’s been so easy making money on stocks around the planet that the actual easy money has been forgotten.

The European Central Bank Thursday is expected to signal intent to curtail long-running mass purchases of corporate debt. Of course the Federal Reserve, the American central bank, sees higher interest rates yet last raised in March, so who do you believe?

And why should you care?

Because there are two giant macro inputs to stocks, investors and public companies:  currencies and interest rates.  Central banks pull the biggest levers affecting both.  Stocks are denominated in currencies that when fluctuating can spawn violent ripples (2008 was a huge spike in the dollar).

With central banks coordinating currency policies to smooth fluctuations, price volatility has appeared to vanish. It’s not gone, however. It’s just stabilized – like the amazing stabilization technology in my Google Pixel phone. Whizzing down the road on a bike I can hold my camera behind me and film followers and the video is dead stock still. Nary a jitter. The central bank of phones.

If I wipe out on the bike, no amount of stabilization will compensate. That’s not an intended analogy but maybe it’s apropos.  We’ve all been easy riders.  Stocks don’t fall, they just rise.  Prices hardly vary save to pop periodically.

Back to the ECB, a Wall Street Journal article yesterday offers perspective. Last year the ECB bought $115 billion of corporate bonds, more than the entire eligible supply of $103 billion.

One result is high-risk companies are getting investment grade financing with a taxpayer guarantee. The thinking is that buying risky corporate borrowings drives more economic output. But the public was outraged about backstops for giant banks in the financial crisis.  One wonders how taxpayers will respond if those bonds fall apart.

The WSJ article notes that a mere 0.2% tick up for bond yields would wipe out a year’s worth of returns (because the value of the bonds would decline, and bond buyers are now chasing rising prices more than yield).

The ECB isn’t buying bank bonds, but it’s bought so much other issuance that a quarter of continental investment grade corporate debt has negative yields. Investors are paying for the privilege of owning them because prices keep rising (it’s a bit like equities where rich multiples mean investors are paying for the privilege of one-way stocks).

Low interest rates remove a clarion call about the value of money and the presence of risk. Investors priced out of high-yield bonds by central banks instead look to other even riskier things for returns. Those traditionally buying investment grade instruments are forced to move to higher risk too, for a desired return.

Everywhere risk increases yet paradoxically it appears to vanish, because interest rates say there is none and all prices rise.

For investor-relations professionals today, it’s a reminder of how important your job is.  So many things besides story now populate your whiteboard, ranging from passive investment, to a shrinking sellside, to macro factors. Keep execs informed.

And investors, never forget that your assets are as good as the stability of the money denominating them, and creating value is hard work. We’ve been easy riders a long time. We may get a hint Thursday from the ECB of hills ahead.

Balancing Act

If you want to know what a business is capable of doing, look at its balance sheet.

If you want to know what the Federal Reserve is capable of doing too, look at its balance sheet. Having scrutinized it, Karen and I are leaving today to ride bikes in the Pyrenees and will return if the Fed survives.

Just kidding.  Except for the Pyrenees. We’ll report back on Catalonia in a couple weeks.

Meanwhile, there is again a glaring focus on the Fed as markets shudder. Clients know our Sentiment Index had a “four handle” at 4.9/10.0 Sept 8, the first negative read since early July. Volatility bloomed. As with weather, the market reflects preceding patterns.

It’s the same with the Fed’s balance sheet. Monday with Rick Santelli on CNBC’s Squawk on the Street I attempted to describe in a handful of seconds that the Fed can breathe in and breath out and impact rates and market stability.

Simplifying, the Fed has two levers for pushing rates up and down. When the Fed buys assets like mortgages or Treasuries from the big banks supporting our payments system (called the primary dealers), the supply of money expands, which makes credit cheaper and pushes down rates.  These are bank reserves.

On the opposite side, the Fed can borrow money from banks, tightening supply and prompting an increase in borrowing costs.  These are called Reverse Repurchase Agreements (RRPs).

We described last week how both changed little over the two decades preceding 2008. Tweaking one or the other was simple and economical. Need to tighten 2-3%? Boost RRPs by $10 billion.

But now bank reserves are $2.3 trillion, 26,000% more than historical levels. RRPs are 1000% higher than history at $300 billion. The three-to-one ratio the Fed long maintained is now one-to-26.

These facts produce a paradox that traps the Fed. Twenty-five basis points, the increase expected when or if the Fed moves, is no biggie against $10 billion of reserves.  But the Fed pays interest on reserves (and RRPs). Now 50 basis points, the rate would jump 50%.

The interest expense alone boggles the mind. Plus, the government will lose money. A rider on the December transportation-funding bill passed by Congress requires the Fed to send earnings on its massive portfolio over $10 billion to the US Treasury general fund.

Do you see? The data driving the Fed aren’t economic but financial. It’s about the Fed’s balance sheet. And government coffers, dented if the Fed starts paying more interest.

They may still hike but it’s a hindrance. And there’s more. The same giant banks providing margin accounts to traders and derivatives to institutional investors are partners called primary dealers helping implement Fed policy. When the Fed moved $100 billion to RRPs out of excess reserves Sept 1 at the same time that its balance sheet shrank slightly, the impact rippled through all the banks financing hedges and margin-trading.

That ripple is the current tsunami hitting the stock market. The Fed has already unwound these RRPs, returning $100 billion to excess reserves. But the damage was done. The Fed tried similar tactics in December last year when it hiked for the first time since 2006, and markets caved in January and the Fed had to pump up excess reserves by $500 billion – much more than it had moved out of the money supply – before markets stopped falling.

And the Fed oversteered.  Markets shot like a rocket into May, flummoxing all. Our Sentiment pegged the positive needle for weeks.

The same happened around the Brexit vote. The Fed was in the process of tightening by lowering excess reserves and lifting RRPs.  The markets imploded. In two weeks, the Fed reversed. The market shot up, once more prompting global head-scratching.

The Fed cannot seem to calibrate its levers without overshooting or undershooting and in any case creating chaos in stocks and bonds. There is no better evidence of the folly in the size of its balance sheet.

Is there a way out? Sure. The Fed could write off 80% of its balance sheet and put us back to pre-crisis leverage.  But interest rates would explode and the entire globe would fall into depression because that would be a restructuring, a technical default.

Is there another way out?  Yes. Normalize rates and take our chances. But that demands a fortitude that’s missing in the sort of jittery lever-yanking one can observe on the Fed’s balance sheet.

The Blue Whale

Last week US jobs were weak and the market welcomed the news.   

We tend to laugh or snort when stocks do the opposite of what they should. But if the market is powered by an economy that’s weaker than expected, why should it rise?

And if you’re an investor-relations professional or in the investment business, you need to understand these outcomes even if you’d prefer to go to the dentist for molar removal.

“It’s the Fed,” you say, rubbing your jaw. 

All right, it’s the Federal Reserve.  What does that mean?

“I’m not sure,” you say.

“What do you think it means?”

“That when The Fed raises rates the economy is better and borrowing will cost more.”

Stop. What?

Study the data pouring forth from the government and the private sector and you’ll see that when you’re doing better, borrowing costs…wait for it…LESS.  

Yes, a strong credit score – a good personal economy – means you pay less to borrow than those with weak personal economies.  Miss a payment and the rate slams UP.

“Yeah, but what the Fed was trying to do was get people to spend,” you explain. “They keep rates low to juice the economy with consumption, and when it starts to overheat and there’s too much borrowing, then they slow it down by raising rates.” 

Okay. I follow that.  But why is it a good idea to get people to spend if borrowing too much money is what created the financial crisis?  And where’s the growth by the way?

“Look,” you say.  “I’ve got a dental appointment I need to get to.” 

The Fed has got everyone thinking it’s the Millennium Falcon in Star Wars and the economic data are TIE Fighters to line up in the sights and then…boom!  We hike rates. 

That’s as absurd as fueling economic recovery with a seven-year teaser rate prompting people to borrow and spend.

Forget that. Here’s the real dilemma for the Fed. Last Thursday before the jobs data the Fed’s balance sheet shrank to the smallest level since I believe Oct 9, 2014 when it was $4.496 trillion.  It was $4.503 trillion, down about $20 billion week over week.  And Reverse Repurchases exploded to $442 billion, $100 billion more than a week earlier.

That’s tightening.  With an “RRP,” the Fed borrows from banks to take money out of the counted supply.  When bank reserves rise because the Fed buys debts, the money supply increases.  It’s like fishing line. Let some out, reel some in.

So maybe the Fed wants to raise rates and then if the dollar spikes and assets like stocks and bonds fall, it can reverse these and flood markets with money. After all, when the Fed hiked by 25 basis points last December, stocks and bonds nearly imploded. Remember January 2016?

But here’s the problem.  Prior to 2008, bank reserves ran about $10 billion (and didn’t change in a decade).  RRPs ran about $35 billion, twice the size of reserves, and changed maybe $3 billion over a whole year.  Moving rates 100 basis points was no biggie, like hauling in a minnow on your steelhead fishing line.

Now the Fed has $442 billion of RRPs and it’s paying about 25 basis point of interest on them.  Bank reserves that pre-crisis were $10 billion are today $2.3 trillion, 26,000% higher.  Now the Fed has a fly rod with test line and it’s trying to land a blue whale.

It’s potentially catastrophic. If the Fed raises to 50 basis points, unless there’s a better place for bank reserves to go, money could stampede to RRPs, causing the dollar to skyrocket and stocks and bonds (and oil) to implode – as they nearly did in January. 

The Fed doesn’t HAVE to take the money it borrows via RRPs, but it says about $2 trillion of Treasuries (collateral) are eligible. The Fed can tighten confidently only if there’s enough demand from the economy to keep the blue whale away. 

Look around. The Bear Stearns Moment of the Week is the bankruptcy of Hanjin Shipping.  It’s among the ten biggest shipping companies in the world, moving the goods of global commerce. When Bear Stearns and Lehman failed we discovered the world had a financial crisis. When Hanjin folds, you have a budding economic crisis. 

So that’s the truth. What matters isn’t if there are 150,000 jobs (which isn’t enough to offset the traditional attrition rule-of-thumb of 1% of the workforce so don’t be fooled) but what the blue whale will do.  Disturb it and things start coming apart.

The Fed doesn’t want to do that, but it can’t figure out how to get the blue whale off the hook either.  And this you see is a much bigger deal than if you make your numbers. The market wants to know the Fed will keep feeding it line. Or a line. 

 

Bait and Switch

If I could explain monetary policy using mainly actual English words, would you still rather slit your wrists than read it?

Tough one, huh. As you consider it, people everywhere are wondering if the Federal Reserve will lift interest rates in June. You’ve no doubt heard the chatter at the grocery store and in line at Starbucks.

No? Well, since the Fed looms over the stock market like a thunderhead on the plains, we better weigh it too. Whatever the Fed decides, it’ll be contradictory.

Here’s why. Suppose you got a credit card with a low introductory rate meant to encourage you to use it. You rack up bills at Nordstrom and Amazon. To thank you for doing as it hoped – spending – your card company raises the rate.  Now you’re paying a lot more interest.  So you spend less, to the dismay of Nordstrom and Amazon.

The Fed is the credit card company and you and your spending beneficiaries are the economy. But where the credit-card company wants future income via interest on your spending, the Fed hopes sustained teaser rates will drive permanent growth by causing businesses to hire people and make more stuff.  Ah, but teaser-rate spending is temporal.

The logical hard-drive crash gets worse. The Fed follows how much you make and spend. To track inflation, it meters the latter with what’s called “Personal Consumption Expenditures” (PCE). But PCE is also the largest part of how we measure economic growth. How can it be both?

Good question – and one I’ve not heard an economist ask a central banker. But it implies that much of GDP is just higher prices. Your money doesn’t go as far as it did.

Think about it. The Fed on one hand targets inflation around 2% (PCE is 1.6%), trying to create it with teaser-rate credit-card spending. But if it passes 2%, then the Fed wants to slow it down – and yet personal consumption is key to economic growth.

The credit card company must say when your teaser rate ends.  The Fed?  It’s kept everyone guessing, periodically yanking us this way or that, for seven years. Perhaps the reason the Fed is in a logical do-loop is because measuring consumption as both growth and inflation is an impossible balancing act.

Economic growth was 0.5% in the first quarter, and PCE is 1.6%.  If prices are rising faster than economic growth, isn’t that actually contraction?  Rising debt and rising prices are the enemies of prosperity because they diminish the capacity of consumers to buy things. Yet the Fed encourages rising debt and rising prices.

No wonder the stock market is consumed with arbitrage. And now, US consumers have as much debt as in 2007 but can afford it less because money doesn’t go as far.

What should the Fed do? Raising rates is baiting and switching. Not raising is robbing savers (and inflation steals from everyone). The Fed should not have offered a seven-year teaser rate without telling anyone. But the damage is done. Let’s stop.  Purchasing power is the engine of wealth, so we need monetary policy that preserves the value of money – the opposite of current programs. Let’s reverse course.

Hard? Yes. But it beats a do-loop of rising prices and rising debt.

Dollars and Sense

I looked back at what we wrote Dec 2, 2008. It was two weeks before Madoff (pronounced “made off” we’d observed bemusedly) became synonymous with fraud. Markets were approaching ramming speed into the Mar 2009 financial-crisis nadir.

In that environment on this date then, we introduced you to Ronin Capital, a Chicago proprietary trader. It had exploded through the equity data we were tracking. Today it’s a top-twenty proprietary trader in equities but not the runway model.

Yet it’s thriving. It has 350 employees. Its regulatory filings show $9.5 billion of assets including financial instruments valued at $6.4 billion, with government securities comprising $4.5 billion, derivatives about $1.1 billion, and equities about $700 million.

As the Federal Reserve contemplates a rate-increase in two weeks, Ronin Capital is a microcosm for the whole market. Its asset-mix describes what we see behaviorally in your trading, clients: Leveraged assets, dollars shifting from equity trading to derivatives, producing declining volumes and paradoxically rising prices. In a word, arbitrage.

The Fed Funds rate is the daily cost at which banks with reserves at the Fed loan them to each other.  The Fed last raised it June 29, 2006 to 5.25%, marking a pre-crisis zenith. As the housing market trembled, the Fed backpedaled to 4.25% by December 2007. On Dec 16, 2008 the Fed cut to 0.00%-0.25%, where it remains.

Since the Fed began tracking these rates following departure from the gold standard in 1971, the previous low was 1% in June 2003 as the economy was trudging up from the 9/11 swale. The high was 20% (overnight!) in May 1981.  It’s averaged about 5%.

Now for almost ten years – the life of the benchmark US Treasury – there has been no rate-increase. Since 2008, it’s been close to free for big banks to loan each other money. Backing up to Nov 30, 2006, the Fed’s balance sheet showed bank reserves at $8.9 billion, lower than (but statistically similar to) $11.2 billion at Nov 29, 1996. But at Nov 27, 2015, the Fed held $2.6 trillion of bank reserves, an increase of 29,000%.

Lest you seethe, this money was manufactured by the Fed and paid to banks that bought government debt and our mortgages.  It didn’t exist outside the Fed.

The construction of the financial instruments held by Ronin Capital describes how these polices have affected market activity.  First, the pillar of the asset base is government debt, the most abundant security in the world (a commodity – something available everywhere – cannot be the safest asset, by the way).  Governments need buyers for debt so rules manufacture a market. All the big banks hold gobs of government debt.

Second, Ronin holds equity swaps, equity options, options on futures, and currency forward contracts which collectively are 34% greater than underlying equity assets. We infer that Ronin makes money by leveraging into short-term directional trades in options and currencies. It’s worked well. It did in real estate too ten years ago, until mortgage-backed derivatives devalued as appreciation in the underlying asset, houses, stalled.

Ronin Capital, big banks, derivatives, currencies, equities and interest rates are interlaced. When money lacks inherent worth, speculation increases. Government debt is today’s real estate market underpinning massive leverage in today’s mortgage-backed securities, the sea of derivatives delivering short-term arbitrage profits.

To see the potential Fed rate increase Dec 16 as but a step toward normalization is to misunderstand the foundation of capital today. Raising rates to 0.25%-0.50% is good. But it’s at least 29,005% different from raising rates to 5.25% in 2006.

You don’t have to grasp all the mechanics, IR professionals. You do have to understand that if fundamentals have been marginalized by arbitrage the past seven years, wait till the calculus in arbitrage changes.  It’s happening already. We saw a steep drop in shorting the past two weeks. Sounds good, right? But it means borrowing is tightening.

Don’t blame Ronin Capital for adapting.  In fact, forget blame, though it’s apparent where it lies. Let’s instead think about the implication for our task in the equity market. It’s about to get a lot more interesting, and not because of fundamentals.

The good news is that it’s never been more vital to measure your market structure and report facts to management. This is when IR careers are made.

Risk-Free Return

Everybody is talking about the weather. Why doesn’t somebody do something?

This witticism on human futility is often attributed to Mark Twain but traces to Twain’s friend and collaborator Charles Dudley Warner. A century later, it’s still funny.

There’s a lot of hand-wringing going on about interest rates, which from the IR chair may seem irrelevant until you consider that your equity cost of capital cannot be calculated without knowing the risk-free rate.

That and a piece in Institutional Investor Magazine some weeks back brought to my view by alert reader Pam Murphy got me thinking about how investors are behaving – which hits closer to investor-relations than anything.

When I say hands are wrung about rates, I mean will they go up? We’ve not had normalized costs of capital since…hm, good question. Go to treasurydirect.gov and check rates for I-Bonds, the federal-government savings coupon. I-Bonds pay a combination of a fixed rate plus an inflation adjustment. Guess what the fixed rate is? 0.00%. The inflation-adjusted return May-Oct 2013 is 1.18%.EE-Bonds with no inflation adjustment yield 0.20% annually. This is a 20-year maturity instrument. Prior to 1995, these bonds averaged ten-year maturities and never paid less than 4% annually, often over 7%. If the I-Bond pegs inflation at 1.18% every six months, translating to 2.36% annually, is the risk-free rate of return a -2.16%? (more…)

What Would a Bookie Do?

We have good news and bad news.

The good news is that investors have put more funds to work in equities during January. We track behaviors – investment, speculation, the crowd following trends and managing risk. We’ve seen increased investment behavior in the past twenty trading days for clients. That’s good, even if your stock or sector wasn’t on the receiving end. It means more competition for shares, and that generally is a boon to stock prices.

What’s the bad news? We see wide disparity between prices investors think are correct for shares, and the prices the market sets. We’ve developed measures for looking at how trades execute in context of others to separate what we might call intermediation from where the orders that attracted intermediaries were priced when they entered the market.

Aren’t these prices one and the same, what with the efficient market and all? Au Contraire. That would be too simple. (more…)