American (or European) Py

This morning the European Central Bank made some very accommodative moves.  While the details are a little wonky, here is a rough summary (emphasis on “rough”):

  • Targeted Long-Term Refinancing Operations (TLRTO):  These operations are designed to “grease” the monetary policy transmission mechanism so accommodation becomes reflected in the “real” economy.  To make the operation more attractive to banks they may eliminate the premiums charged to banks and lower the benchmark rate.  Today’s announcement lowered the cost of funding to 0.10% above benchmark.
  • ECB to purchase ABS:  The idea here is for the banks to bundle various securitized loans and sell them to the ECB.  Today’s plan includes both new and existing Asset Based Securities and Residential Mortgage Backed Securities.
  • Lowered Rates:
    • Rates on main refinance operations were lowered to 0.05%
    • Rates on marginal lending were lowered to 0.30%
    • Rates on deposit facility were cut by 0.10% to -0.20%.  Yes.  Those little dashes in front of the percentages indicate that banks will be paying interest on the money they deposit at the ECB.

In the wake of this, rates on 2-year paper in eight European countries went negative; with the lowest negative rate being paid to Switzerland (-0.119%) and the highest negative going to Austria (-0.049%).  I think I’d balk at the privilege of paying the Swiss 0.119% to give them the use of my money.  But hey, that’s just me because apparently someone is willing or the rate wouldn’t be where it is!

As I write this, the EUR/USD has fallen 1.60% to 1.2939 – the ECB having (at least for now) the desired impact of hammering down the Euro.

In Europe, reactions in the equity markets were generally positive.  The DAX gained 1.02%, the FTSE gained 0.06%, and the CAC 40 gained 1.65%.

That’s a pretty healthy reaction.  It seems that draconian fixes are considered bullish while the underlying problems necessitating these fixes are ignored.  A money manager has to make his numbers each quarter, so I suppose that’s understandable on some level.

The US markets were generally positive early in the day, but the gains faded after the 159, 648th rumor came out of Ukraine.  This was the most recent of the 79, 824 bad news rumors, and it took the markets fractionally lower.

Early this week I linked an article about “liquidity traps.”  Roughly (again) defined, a liquidity trap is where injections of cash by a central bank into the private banking system fails to decrease interest rates because there is a prevailing belief that interest rates will soon rise.  Similarly, if the cash is not being deployed due to “hoarding” there is little impact on creating inflation (which a few countries could use right now…  Italy, I’m talking to you).  This is described as M * V = Py, where M is the money supply, V is the velocity of money, and Py is the product of price and units.  An increase in Py would be evidence of inflation.

Since there is no question that the Fed and the ECB are ramping up the “M”, and there is little evidence of an increase in “Py”, one could deduce that “V” is the lollygagger.  To wit, here is a quote from the St. Louis Fed’s website:

“During the first and second quarters of 2014, the velocity of the monetary base was at 4.4, its slowest pace on record. This means that every dollar in the monetary base was spent only 4.4 times in the economy during the past year, down from 17.2 just prior to the recession. This implies that the unprecedented monetary base increase driven by the Fed’s large money injections through its large-scale asset purchase programs has failed to cause at least a one-for-one proportional increase in nominal GDP. Thus, it is precisely the sharp decline in velocity that has offset the sharp increase in money supply, leading to the almost no change in nominal GDP.”  – Economist Yi Wen and Research Associate Maria Arias in a St. Louis Fed article:

Now, in full disclosure, the concept of the liquidity trap is a construct of Keynesian economics.  The Austrian School would argue that the lack of velocity during these periods of low interest rates is a result of previous mal-investment and the discounting of an assets value at an extremely low rate (time preference).

I wish I definitively knew the cause of the flaccid “V”, but after witnessing 5 years’ of ramping up “M”, I’m beginning to side with the Keynesians on this one.  It would seem that much mal-investment would have worked through the system at this point, resulting in some juicy Py.

Mmmmm.  Juicy Py.



The POMO Show-mo: If I could animate, it would be in Slow Mo, but that’s a WordPress No-No.

Permanent Open Market Operations.  POMO.

That’s government-speak for the Fed buying gobs of Treasuries and Agency Mortgage-Backed Securities (MBS).

I’ve used this tiny podium in a handful of older posts to present my opinion of the grand experiment known as POMO.  Repeat readers will recall that my pet peeves generally fall into two main categories of fully-intended (but oft-denied) consequences:   1) Financial Repression – punish savers until they move into risk assets, and 2) Market Distortion – levitate the stock market to create a wealth effect and consumer confidence.  As to point #1, it’s self-explanatory and not worthy of much deeper analysis.  As for #2, I’ll let the following graph do the talking.  The orange line is the S&P 500 while the white line is POMO. (Click on chart to enlarge)


Today, however, I’m adding #3.  Witness the mREIT.  An mREIT is a mortgage-based Real Estate Investment Trust.  In simple terms, they borrow money at low rates (usually via repo) and invest the borrowings in higher yielding long-term mortgage securities and profiting from the spread.  mREITS come in two flavors:  Agency mREITS and non-Agency mREITS.

The distinction is huge.  We’ll circle back to it in a minute.

Monetary policy is holding down the cost of short-term borrowing at nearly zero – an advantage in the borrowing costs for both Agency and non-Agency mREITS.  With such cheap borrowing, mREITS have bloated the amount of mortgage assets on their books.  The bloat allows huge dividend payments to mREIT investors – a cool drink of water in an otherwise yield-parched world.   And the short-term kicker for Agency mREIT’s specifically was the amount of Agency MBS the Fed would be purchasing as part of POMO.  To provide some perspective, they will be buying $26 billion this month.  These purchases increase the value of MBS which, in turn, resulted in increases in the stock price of Agency mREIT’s.

What more could a yield seeking investor want?  Big dividends, rising share price, and an implicit government guarantee on the underlying investment.

Then came the AGNC earnings report.  AGNC is a large Agency mREIT.  During the first quarter, AGNC had a huge earnings miss driven by two factors; both of which are related to Fed activity and POMO.  First, the high-priced MBS on AGNC’s books (higher due to POMO buying) tumbled by $837 million ($2.21 per share) as the market began to anticipate an end to QE and POMO due to stronger economic reports.  Second, spreads fell from 1.63% in 4Q2012 to 1.52% this quarter.  Despite the market pricing down MBS, the constant buying by the Fed via POMO continued to compress the spreads.  Viewed YOY, spreads declined from 2.31% in 1Q 2012 to 1.52% as mentioned above.

The impact of these dynamics was further expansion of financial repression.  Investors needing yield who moved into Agency mREITS were delivered these returns for the day:

AGNC                                    -7.3% (it was down 9% at its day low)

NLY                                        -2.6%

CYS                                         -1.5%

ARR                                        -1.7%

And this on a day when the S&P 500 closed up 1.05%

To paraphrase the most interesting man in the world, “I don’t always seek yield, but when I do it’s always hedged.  Stay cautious my friends.” – LL


Clowns to the Left of Me, Jokers to the Right

We frequently blog about the structural strains put on the market by algorithmic and high frequency trading.  We’ve also blogged (more than a few times) about the distortions in price discovery caused by central bank intervention, zero interest rate policy, etc. (most recently pointing out that 80% of the annual equity premium since 1994 was attributable to trading in the 24 hours before a Fed announcement).

This morning, however, saw a convergence of the two we seldom get to “enjoy.”

First, today’s episode of “Algos Gone Wild” was set at the NYSE, where 148 symbols began trading wildly and with ludicrous volumes at the open.  While there seems to be some linkage to Knight Capital, the specifics are not yet clear.  What we do know is that these stocks started swinging inexplicably by magnitudes of 10% or more.

A quote from a director of floor trading:  “Stocks are moving all over the place, they are weird, and they are trading like millions of shares 100 shares at a time.”

An example, provided by CNBC, would be Molycorp.  This stock traded 5.7 million shares in the first 45 minutes of trading.  Typically, Molycorp trades about 2.65 million shares per day.

If there is an upside to this story, the NYSE quickly halting the affected stocks may very well have averted another flash crash.  Small consolation in the scheme of things.

While the algo drama was unfolding, Louis Bacon put out a letter regarding his multi-billion dollar Moore Global Investments fund.  Bacon is voluntarily returning $2 billion to his investors, for the following reasons:

  • “The markets have been riskier and less liquid.”
  • “Markets are increasingly distorted by central banks’ attempts to squeeze drops of growth from an over-indebted private sector across much of the developed world.”
  • The US markets are hindered by “a caustic political environment and an anti-business administration.”
  • “The [Eurozone] banking authorities have been a special case in ineptitude, [waiting to raise bank capital] until it is largely infeasible.”
  • “Disaster Economics, where assets are valued based on their ability to withstand a lurking disaster as opposed to what they may yield or earn, is now the prism through which investors are pricing markets.”

Pretty strong words from the 238th richest American and uber-successful hedge fund manager since 1987.

To get some sense of how prevalent the Louis Bacon-type behavior has become in the hedge fund industry, Google “hedge funds calling it quits.”  Bring a cup of coffee, because you’ll be spending a lot of time reading your computer screen.

These are indeed weird times.  Navigating them requires extreme care in both capital allocation decisions and sizing of positions.

To paraphrase the 1972 song by Stealers Wheel:  “Fed to the left of me, algos to the right.  Here I am stuck in the middle.”



I usually reserve the tongue-in-cheek blog posts for Fridays.  Most people are usually doing interesting things on Friday;  generally reducing the amount of people who read our attempts at wit.  As it is, tomorrow looks to be pretty busy here at Altair, so this week’s post arrives on a Thursday.  I apologize in advance.

Today’s theme:  Big Things that are Smaller than Apple.

Apple’s market capitalization has now surpassed 1/2 trillion USD.  Arguably, that’s pretty large.  What follows is a list we’ve compiled of things smaller than this tech juggernaut.

  • The Gross Domestic Products of: Switzerland, Poland, Sweden, Norway, Saudi Arabia, and Taiwan.  Upon hearing the news (honestly), Poland felt the need to respond by stating that GDP is only a measure of one year’s production.  That said, the country of Poland is actually worth more than Apple (I guess they used some kind of NPV calculation or discounted cash flow model).  So… “Take that” Apple.
  • Worldwide lottery sales
  • The entire US retail sector’s market cap
  • The value of all NFL franchises combined, then multiplied by 10
  • All the gold at the New York Fed (which happens to be the world’s largest holder of gold)
  • The entire US bank bailout multiplied by 1.25
  • The entire US meat industry
  • The total revenues of the global mobile phone market
  • 2010 US corporate tax receipts, multiplied by 2.5
  • The combined cost of the Space Shuttle Program plus the Apollo space program
  • Every home in Atlanta, GA…  combined

Yet, despite its size, there are still a handful of things larger than Apple:

  • Political rhetoric
  • Central bank hubris
  • Poland’s self-image
  • The monthly number of high frequency trading “orders” that are withdrawn without being executed
  • 6 months of US deficit spending
  • The number of Republican primary debates held in 2011-2012

Who knows, by next week Apple may be bigger than those.

While compiling a list like this, I can’t help but get nostalgic for the past decade.  Names like Cisco Systems and Applied Materials were the objects of similar comparison.  For the 200+ hedge funds now holding Apple, it’s been a great 2012-to-date.  Let’s hope that the story ends differently this time than it did last decade.


Please… no more Chubby Checker…

On August 24 we had a blog post speculating that the next version of Fed easing would come in the form of Operation Twist.  We made a Chubby Checker joke, too — thinking ourselves somewhat witty!  After spending today in front of a CNBC-blaring TV, I’m regretting the pun.  Their bumper music…  ALL DAY…  has been Chubby Checker’s Twist.  Please…  no more Chubby Checker.

Now, as far as the real Operation Twist is concerned, the details were released today.  Overall, the goal is to lower long-term interest rates to 1) drop mortgage refi costs, 2) stimulate demand, and 3) replay the (now classic) move of forcing people into risk assets to create a wealth effect.

The bullet point details are as follows:

  • The Fed Funds target rate will remain between zero a 0.25% through mid-2013
  • The Fed will sell Treasuries with less than three years of remaining maturity and buy Treasuries with between 6 and 30 years of remaining maturity with the proceeds
  • The size of Operation Twist will be $400 billion
  • 2/3 of the longer dated purchases will be below 10 years of remaining maturity, the other 1/3 will be longer than 10 years
  • The Fed will continue buying mortgage-backed bonds with the proceeds of maturing mortgage-backed bonds

As might be expected, the announcement spurred a buying rally in longer-dated Treasuries.  Yield on the 10-year fell to a 60 year low of 1.86% while the 30-year yielded down to an  even 3.00%.

The Treasury rally, combined with numerous bank downgrades sent the stock market markedly lower, with the Dow Jones Industrial Average closing at a loss of nearly 285 points.  Bank of America, one of the downgraded stocks, fell 7.5% while Wells Fargo dropped 3.9%.

If the Twist performs as advertised, it could put further downward pressure on bank stocks as the yield curve flattens — thereby reducing the spread of which banks have become so fond.

To be truthful, I understand the mechanics of the Fed’s action but I’m baffled by the logic.  This continued tinkering on the margin of monetary policy at a time when adjustments to fiscal policy are impossible seems quite likely to end poorly.  We’ll be watching things carefully over the next number of days to get a better sense of the impact on risk assets.  Monetary twisting hasn’t been done in 50-odd years, so we don’t have much history to rely upon.

And the broken record says…  “It’s a good time to keep net exposures low.”