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Fixed Income Update 2012-07-30

A market move of the kind saw at the end of last week is hard to comprehend. Two stories caused the dramatic moves. Firstly both the WSJ and the NY Times ran stories at the beginning of the last week declaring that the FOMC was ready to act at this week's FOMC meeting. Reading the articles there was no new news and was just a regurgitation of previous Fed speakers. But the equity market jumped on this supposed news, and then on Thursday the news wires and TV channels were reporting that the ECB President had changed course and was now advocating huge market intervention in the bond markets of Spain and Italy. The actual quote which the markets reacted to mostly was this " Within our mandate, the ECB is ready to do whatever it takes to preserve the euro. And believe me, it will be enough." The important part for me was the first three words he used "Within our mandate". To me that is pretty clear- it does not mean any new measures than before. So as is always possible the ECB could launch another LTRO, it could announce the resumption of sovereign bond purchases of the peripheral countries and it is more than likely that the ECB's deposit rate currently at zero will be cut a further 25bp  into negative territory. ( I have attached the full text of Draghi's speech for you to read at your leisure)

However I do not think that another LTRO is truly on the cards since rumours persist that the major Euro banks are in fact looking to repay the previous LTRO's due to the cut in the discount rate at the first opportunity in December. After having used the previous LTRO's as a funding cushion, those banks have been able to raise financing already or have already reduced their balance sheets, means banks just have little need for another financing. The argument inside the ECB for another LTRO will just not be there unless it is for the purchase of the peripheral sovereign bond markets. That is against the ECB's mandate.

The market also is over estimating the power of the ECB in making Sovereign Bond Purchases to lower the yields on Spanish and Italian bonds. In the two previous purchase programs that the ECB has launched, the market rallied every day into the time where the ECB was expected to enter the market, making the ECB pay a higher price, and then sold off afterwards. And the certainty is that the SMP was used by foreign investors to reduce their holdings of peripheral debt not increase them, making the funding of Spain and Italy harder not easier. Then there is the issue of subordination. Every time the ECB intervenes in the markets , the level of subordination that current holders of the debt increases.  Because if there was a debt restructuring, the ECB would demand repayment in full of its holdings as happened in Greece. That means that investors in Spanish and Italian bonds will demand higher not lower yields to hold the debt.

Given the rise of yields in Spain over the past week, the timing of the ECB President's comments may well have been aimed more at preventing the failing of a Spanish auction of 2yr, 4yr and 10yr Bonds just prior to the ECB announcing the results of its meeting on August 2nd. The previous auction had been exceptionally weak and given the rise in 2yr yields, from July 18th to July 25th, the yield rose from 4.84% to 6.94%, there would have been a real risk that the auction would have failed. 2yr Spanish bond yields are now back at 4.8% just in time for the auction. So even if the ECB does nothing, the auction calendar is then fairly light for August giving the ECB sometime to breathe. And all the time negotiations continue in Greece over the cost-cuts needed for the release of the next-tranche of aid due in September. At the moment the negotiations seem to be failing and there is a growing possibility that the current Greek government coalition will fall leading to new elections.

And so to the chances of the Fed announcing QE3 on Wednesday night.

I have always expected that disinflation/deflation fears would grow inside the Fed in Q3 of this year. As of yet though those fears will not be of a concern to the Fed. Just look at the last Phli Fed report where the survey indicated a rise in price expectations. It took it out of negative territory and will not provide an argument for QE3.

And on top of that, the other reason behind the Fed's decision to implement QE3 would be to reduce the level of implied volatility in interest rate markets. A rise in implied volatility would raise the cost of mortgages as it raises the cost of hedging out the early repayment risk.

Now the level of Implied Volatility in the 10yr Swap market has remained elevated but is not currently rising. It is being helped by a fall in historical volatility as the market expects 10yr Swap rates to have a base at or around 1.5%. It is perhaps another reason why QE3 will not occur, in fact the Fed may not want the market to price in further significant falls in longer-term US Interest Rates. Because the lower they go, I would expect the market to raise the level of implied volatility as it buys protection against an expected normalisation of interest rates. Given that QE is such a new experiment for the Fed it must be learning from how it has impacted the markets in the past. As such the lessons will have been learnt that another bout of long-end asset purchases will not have the effect that it would wish for.

It is in fact the front-end of the US yield curve that is seeing a rise in both historical and implied volatility. This is due to the market expecting further measures from the FOMC to be announced as regards the removal of Interest on Excess Reserves (unlikely at this meeting and maybe never as it weakens Banks) and the very likely extension of the guidance that the Fed will give as to how long the Fed Funds rate will stay at very low levels. They are likely to extend the end of 2014 to the end of 2015. So the front-end of the yield curve should benefit this time round from the FOMC meeting and this will steepen the yield curve initially. The curve steepening should lead to a fall in the Implied Volatilities of the 10yr Swap rate. This is what the FOMC will want to see.

So the Risk markets will be underwhelmed I am sure by the announcements from the FOMC and the ECB this week.

Given that the last two announcements of QE have led to strong rallies in both Gold and Equities, it has been these two markets that have risen the most over the past week in the expectation of QE. Therefore it will be these markets that will have the most to lose.

Gold has rallied 2% in US$ over the last week, but is up nearly 5% since the Gold market began to expect another round of QE after the May US Employment report on June 1st.  It will be this that has to be reversed. So expect gold after Thursday to sell-off markedly especially in US$ terms. In Euro, the sell-off may be tempered by a rise in the credit spreads of European Financial institutions and a large sell-off in the Euro versus the US$. But even here a move back to €1270/toz should be expected.  The expectation of QE has added over €120/toz to the fair value of EuroGold.

US S&P 500 is up over 9% since the May Employment report, it is possible that even here a removal of QE3 expectations should see a significant decline, and a 5% decline has to be very likely.

So, the arguments are still there to remain long duration and avoiding risk assets.

[ba-button link="http://www.coininvest.com/wiki/wp-content/uploads/2012/07/Draghi-Speech.pdf" color="red" target="self"]Draghi Speech[/ba-button]

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