t Shadow Capitalism
reality and other asset classes to determine the extent to
MARKET COMMENTARY BY NAUFAL SANAULLAH
Thursday, October 7, 2010
A delve into the current discounting of QE expectations and
its market implications going forward
A great piece from TMM earlier this week revisited a most
pertinent topic being traded in markets presently: QE
expectations. It spurred a more granular exploration into the
dynamics in discounting Fed easing by yours truly, as the
TMM offered both relevant analysis and interesting
conclusions.
To (slightly) paraphrase Warren Buffett, the market is not a
discounting mechanism as much as a voting machine,
particularly in the short term. This explains the dynamics
behind the market’s reflexivity that George Soros refers to.
Market participants pick sides on the argument at the margin
(which can be inadvertent at times, such as when an
exogenous variable impacts the market before traders
conceived of discounting its impact one way or another), and
although in the long run it pays to be among the traders who
are right in regards to the argument at the margin (make
money), in the short run the more relevant “side” is that of
the traders who are winning the argument (price action and
lagging/coincident dataflow going in their favor). As those
who are winning yet “wrong” profit, confirmation bias
leverages the market further in their thesis (especially as
trend-followers and momo traders piggy-back their theses),
and when the argument finally hits a tipping point where
those who are “winning” stop winning, then “reality” hits the
market and those who are “right” take on a windfall.
How this relates to TMM’s piece is in their investigation into
the scenarios being discounted in fixed income presently.
Acknowledging the argument being traded at the margin is
the first step toward successfully profiting in the market (the
next step is identifying who the “right” side of the argument
to get a fundamental bias and then identifying the “winning”
side to get a positioning bias in the near-term). The argument
is always an isolated variable that manifests differently in
different markets, and the key to trading is in finding specific
assumptions that are discounted in the pricing of certain
markets or securities that are either inconsistent with
(coincident) reality or with other asset pricing. This is at the
heart of the concept of creating alpha via arbing mispricings
in the market. TMM do a good job of isolating variables
pertinent to QE and then analyzing their compatibility with
which the argument at the margin (QE expectations) is priced
in, as well as how these dynamics will impact markets going
forward.
The argument at the margin presently driving fixed income is
Fed QE demand. However, the re-pricing of Tsys under this
premise alone leads to essentially non-existent inflation
expectations implied in yields. The Fed’s success in generating
inflation/growth is essential for analyzing the wisdom behind
current expectations.
What took the BoJ nine years to do (ZIRP), the Fed
accomplished in merely sixteen months. Never before has
there been a case of a central bank so determined to “force”
inflation and growth. Even after engulfing the entire MBS
market, the Fed is going to a second round of QE to support
the US economy, and this willingness to reflate at all costs
renders QE’s efficacy in inflating the only pertinent variable.
And with a $2.3t balance sheet, with almost half of it sloshing
in excess reserves picking up a risk-free 25bps (and
consequently representing $15-20t in a normalized money
velocity environment, which would result if/when IOER is
lowered [8-10x being “normalized” reserve multiplier and 10x
being multiplier implied by the 10bps reserve requirement]),
the Fed has plenty capacity to forcibly generate inflation and
nominal growth.
The Fed’s policies have been increasingly ad-hoc and months
after suggesting micro-managing the IOER will be an effective
method for stabilizing prices to desired levels, Bernanke & co.
have in recent weeks suggested that the second round of QE
will come in the form of gradual and reactionary injections.
Although this presumably allows the Fed to precisely alter
liquid money supply to generate target inflation levels, each
successive liquidity injection decreases confidence in QE’s
efficacy.
But so long as there is an implicitly (more accurately,
effectively explicitly) easing Fed unwilling to stop printing
until target inflation and growth rates are met, inflation is a
foregone conclusion. This renders current fixed income
valuations highly skewed.
TMM’s piece argues for the existence of bond market
mispricing with observations about two key metrics: real
rates of Tsy return and 12mo bill yields relation to excess
reserves. The real rates of return help to isolate inflation
expectation, while the bill yield/bank reserve relationship
isolates QE expectations.
5yr real rates (CPI-adjusted) are negative and 10yr real rates
are around 45bps, which is to be expected as the market
discounts Bernanke’s bond bid. However, on a longer term
timeframe, who is willing to lend to the US Treasury on a 10yr
basis at 0.45% inflation-adjusted (and realistically even less,
considering CPI calculation methodology)? TMM goes on to
discuss the 5y5y forward real rate, which expectedly have
plunged as the market discount’s QE demand for Tsys, but
the impact of the QE demand has yet to occur, since inflation
expectations have gone nowhere and the 5y5y forward real
rate has yet to normalize.
Meanwhile, TMM provides a great proxy for isolating QE
expectations, by pitting 12mo bill yields against excess
reserves (inverted), with reserves representing current actual
conditions and the bill yields discounting expected levels of
reserve injections (ceteris paribus, which is quite so the case
presently due to the 0-25bps quasi-ZIRP in place by the Fed).
Republished below is TMM’s chart; at an average of about
$180b per 10bps in 12mo yields, the current 20bps bills yield
represents a projected $1.38t Fed balance sheet, a little
under $400b of QE expectations.
I suspect the Fed will begin its QEII by announcing $300b of
Tsy purchases next month, the same amount of Tsys
purchased in QEI. As the economy improves/stalls, I expect
the Fed to continue regular purchase announcements of
varying amounts, and expect about $1-1.5t in purchases
altogether. Initially, as has been suggested by Bank of
America’s Priya Mesa (who believes QEII will match QEI in
duration demand), falling yields will lead to higher
prepayment rates, and with “QE Lite” as the pertinent
precedent, the Fed will reinvest the increasingly more MBS
proceeds into Tsys, a positive feedback system of sorts which
may augment the Fed’s Tsy demand (see this Zero Hedge
piece). However, this of course assumes declining yields.
Due to negative/zero real rates of return present in the short-
end of the Tsy curve, once the initial round of QE (presumably
to be announced next month) is priced into Tsys, the
argument at the margin will change from imminent Fed
demand in the near-term to the long-term value in holding
Tsys. As TMM suggest, the Fed is targeting core CPI around
225bps, and 10yr yields below 200-220bps represent no real
return if the Fed is successful in reflating. Once the 5y5y real
forwards normalize, this will cause a strong influx of supply in
Tsys due to rising inflation expectations, and at this point a
rising yield environment would be the likelier situation.
In this case, prepayment rates will actually fall, so although
the Fed may originally be upwardly revising its QE amount
estimates due to rising refinanciability, as inflation
expectations normalize, the opposite effect will occur and the
Fed will ease less than originally expected.
Currently, a poor economic backdrop and low inflation lends
structural bullishness to USTs. The addition of QE
expectations spurred more demand for Tsys, and the two
theses are piggy-backing off of each other in a self-reinforcing
loop. However, as inflation expectations normalize, the QE-
based UST demand (already declining as a function of time
due) will go down, and the rising inflation expectations will
lend structural bearishness to Tsys. In this case, the market
will look to debt ratios and serviceability ratios as the
argument at the margin, at which point some much longer-
term themes building up in fixed income could play out. Also,
as a function of rising yields in USTs, USDJPY could rally
significantly, and that could trigger issues in the JGB market,
something quite unexpected by the consensus presently.
For now, I remain long USTs, but look to be selling in the 2-
2.2% area (where there is strong technical support for yields).
As forward real rates and inflation expectations start rising,
I’ll look to get short US fixed income in size.
In the near-term, due to the scenarios currently discounted in
USTs, I think the QE trade is about priced-in, and assuming a
$500b initial QEII announcement (a very aggressive
assumption for the sake of conservative conclusions), 80% is
already priced into 12mo bill yields. Of course, 80% of an idea
being discounted is not a reason to get on the other side;
120-150%+ discounting is a more acceptable contrarian
trigger. Still, assuming the $300b I (and many others) expect,
bill yields are discounting 130%+ of the thesis.
This has near-term impacts on risk assets, as the decoupling
caused by QE expectations gives way to more structural
themes, and many of those arguments are risk-bearish and
USD-bullish. In the new normal of today, the status quo is
decoupling as developed economies deal with debt
overhangs and zombie industries while low-yielding G10
currencies encourage carry trades bullish for EM and magnify
the structural relative strength in EM economies. However,
the new normal also has a higher periodicity of crisis, each
instance of which leads to a rush to USD liquidity and sharp
recoupling. The result is low-growth developed economy
markets and volatile boom-bust cycles in EMs (that do not
grow their way into developed economies). My contention is
that the USD short trade is getting crowded, although not
necessarily yet at a breaking point, which sows the seeds for
a contagion event, most likely stemming from the Eurozone.
According to last week’s CFTC Commitment of Traders data,
specs currently boast a $26b net-short position in USD, about
equal to that at 2009 lows in USD. The catalyst to unwind the
shorts back then was the introduction of the Eurozone crisis
and I expect the same origin this time around.
The August French trade balance missed by $9b earlier today,
suggesting the euro’s recent rally is starting to cut into export
competitiveness. Considering EURUSD averaged around 1.30
in August, the currency impact on exports may be much
worse and exhibit a deteriorating influence in future data.
Factoring in the 900 pip premium EURUSD currently has to
August mean levels, the export situation appears even worse
on the margin. German trade balance data later this week will
provide more clarity.
reverts back to new dataflow and structural economic
strength/weakness.
The gold ETF, GLD, is currently trading down about a percent
on more than 2x average daily volume (about halfway
through the trading day), forming a bearish engulfing candle.
Concurrently, EURUSD is down 40 pips on the day and 150
pips off today’s highs. I went short EURUSD at 1.3980 at the
50% Fibo retracement from 2008 highs and ahead of the 1.40
level traders being watched as a profit-taking zone. With this
move in gold, I have higher conviction that the euro has
started a correction in the near-term and have gone short
gold as well to position myself short the hot-money QE
argument that I think is being unwound. Gold reverting back
to its $1265/oz breakout level from FOMC day on September
21 would be constructive and a zone at which I would
consider buying PMs.

The rise in EURUSD (and accompanied liquidity drain) may

catalyze another dip in Eurozone exports/growth, confidence,
and perceived creditworthiness. Additionally, if any of the
periphery needs to access the EFSF, it will do so at its
impractical 800bps cost of borrowing, which will mean much
more dovish measures being necessary. This would be very
bearish for the euro, yet I consider it more likely than not.

According to CFTC COT data, specs are positioned about $30b

net-long euros, just under the positioning at 2009 highs.
Though I agree that QEII is very bearish USD, the data seems
to imply that USD is selling off under the same
thesis/argument as EUR rallying, and considering the
unsustainability of the latter, USD could see some near-term
strength as a function of this thesis unwinding.

Gold has been rallying in tandem with EUR, which is quite
counterintuitive considering that perhaps gold’s biggest bull
argument is the Eurozone sovereign debt crisis. Again, the
argument at the margin is QE, but when this argument has
discounted EURUSD at 1.40, it may be time to reassess its
effect on other asset classes as well. Though I remain very
bullish on precious metals on the 5-7yr time horizon, I expect
a correction in gold and EURUSD soon, as the QE thesis is
discounted in the near-term and the argument at the margin
I agree that QEII is a gamechanger and that it will be a
(justifiably) pertinent variable going forward. However,
market fluctuations since Fed day in late September appear
to me to be “late money” chasing a thesis that was already
being discounted and chasing a justifiably underowned proxy
for the thesis (EURUSD) that will be the first to be unwound,
with the implications pervading across asset classes. Once the
QE flows that manifested in (in my opinion the flawed)
argument that is driving gold and euro higher in tandem and
USTs discounting negative real rates of return are unwound,
and EURUSD trades lower, the QE bid will probably come
back in and with the weak hands flushed out, a resumption of
the trend will likely be in order, especially in gold.
And the canary in the coalmine, of course, is sovereign
creditworthiness. Though it is sparking little deliberation, the
SOMA limits on Fed holdings of individual issues will require
the Treasury to ramp up its issuance to meet implicit Fed
demand. This is as close as the Fed will get to outright
monetization in my opinion, as the Treasury is issuing debt
strictly because of the Fed’s appetite for USTs. This is
obviously a sovereign debt concern, and although I don’t
expect any sovereign solvency crisis in America, rising yields
(if and when they do occur) due to rising inflation
expectations combined with the “stealth” monetization and
the quickly-declining average outstanding UST duration &
marginal GDP impact per dollar of UST debt will bring back
trading arguments concerned with sovereign
creditworthiness. US CDS spreads has been rising since the
financial crisis first hit, as have other G10 sovereign CDS
spreads. These fears (particularly regarding US) abate during
periods of low/non-existent inflation expectation, but as the
Long /ZN | 125’15 | stop 124’20 | +1’22
Long EUR/CAD | 1.3860 | stop 1.3785 | +310 pips
Short MON | 53.62 | stop 55.10 | +10.50%
Long /ES | 1151.00 | stop 1147 | +0.22%
Short APOL | 51.90 | stop 54.00 | +3.66%
Short USD/JPY | 83.35 | stop 84.15 | +100 pips
Short GBP/NZD | 2.1154 | stop 2.1194 | -15 pips
Short EUR/USD | 1.3980 | stop 1.4050 | +100 pips
NEW TRADES
Short UGL | 63.47 | stop 65.00
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DISCLAIMER: Nothing contained anywhere in this commentary, including
analysis and trade ideas, constitutes or should be construed as investing or
financial advice, suggestion, or recommendation. Please consult a financial
professional and do due diligence before engaging in any purchase or sale of
securities.

Fed pulls out all the stops to recalibrate expectations to its

target, sovereign credit themes will resurface.

Going back to the premise of this piece, the importance of

identifying the prevailing argument at the margin, typically
the cycle of how theses/arguments get discounted begins
with fixed income derivatives, as specific isolated variables
discount expectations, moving onto fixed income and FX spot,
leading the move, flowing into equity and other risk (like
copper and AUD) reacting, and eventually leading to
confirmation bias causing an exaggerated discounting of the
thesis in underowned assets expressing the thesis. In today’s
context, the QE thesis began in UST real rates, flowing into
nominal UST yields plunging, leading to USD selling off and
equity and copper rallying, finally resulting in EUR and crude
oil rallying on reflation expectations. Every significant trade
thesis sees its thesis manifest from leading to coincident to
lagging asset classes, and with oil breaking out and EURUSD
up 1200 pips since Fed day, the QE thesis has reached
counterintuitive and unsustainable expressions. This is not
much of a surprise, as after an abysmal H1 2010, hedgies
surely went all-in into levered beta exposure to risk vis
underowned USD crosses like EURUSD into Q3 end, and with
a new quarter at hand, an important psychological profit-
taking level at EURUSD 1.40, and structural fundamental
bearishness in oil and EURUSD, they will be equally eager to
close their positions on the first sign of weakness.

OPEN TRADES