Achtung Baby!

Surprisingly negative news from the German bond market this morning set the stage for yet another day of losses in global equities.  The $6 billion Euro 10-year bond auction failed to find adequate bids, resulting in the Germans being forced to take down over $2 billion Euros of their own bonds.

This was the worst bond auction in Germany since the introduction of the Euro.

The ripple effects were instantaneous, with yields in Italy and Spain rising to the point where the ECB was forced to intervene and lend pricing support.  Further, the Euro fell dramatically versus the USD and the US equity futures tumbled.

Since November 15, the Dow Jones Industrial Average has fallen nearly 7%.

The prevailing school of thought regarding this auction goes something like this:  German bond buyers essentially went “on strike” in order to pressure Germany into allowing the ECB to exercise more power to stem the crisis.  It would be nice if that school of thought turns out to be true.  Otherwise, the word contagion comes to mind.

But, Germany wasn’t alone in pressuring the markets today.  China and Belgium had a hand in the mess as well.  China’s Purchasing Manager’s Index fell to 48 (a number below 50 indicates contraction).  This sent commodities (as well as stocks) broadly lower.  As for Belgium, a rumor began circulating that they will be unable to pay their share of the Dexia bailout.  This would place the burden of the bailout on France — and this is a burden that could result in a French debt downgrade.

As is usual on these “flight to quality” days, US Treasuries were aggressively purchased; with the 10-year yield falling to 1.9%.  This is somewhat ironic, considering the uber-committee managed to squander its opportunity to begin working off the US deficits just a few days ago.

We continue to favor high cash balances and well-hedged income positions in this environment.  Holding cash with a negative real yield is painful… but not nearly as painful as the alternative.

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.”

The 1960’s called. They want the Twist back.

In the 1960’s, the Federal Reserve embarked on a maneuver known as the Twist.  Simply put, the Twist involved the Fed selling short-dated Treasuries and using the proceeds to buy longer-dated Treasuries.   Legend has it that this would drive down borrowing costs and stimulate economic growth.

I mention this due to today’s market activity in gold, Treasuries, and stocks.  To wit:

  • Gold — Gold fell by $94.10 today.  This would not be expected if the gold markets anticipated QE3 coming this Friday.  QE3 would further debase the US Dollar and gold, as a dollar-denominated commodity, would be a beneficiary.  Conversely, no QE3 would be a disappointment for gold.
  • Treasuries — the 5-year Treasury saw its yield jump by 7.76% today to close at a yield of 1.01%.  If Treasuries were anticipating QE3, we should have seen yields on the short-end drop, not spike.
  • Stocks — the DJIA tacked on 144 points today, finishing the past 2 days with a 4.3% gain.  This could indicate anticipation of QE3, or it could mean something entirely different…

Which leads me to the Twist.

The Twist would have little if any impact on the value of the dollar — hence the disappointed gold market.  The Twist would cause short-end yields to rise as the Fed sells off short bonds — hence the rising yields on the short-end.  The Twist would be advantageous to stocks if (elusive) economic growth came from lowering long-term rates.

Taken by themselves, each point doesn’t particularly say anything.  But taken together, the markets may be telegraphing their opinion that the Twist is upon us.

Stepping back, the Twist may be the most sensible solution at this point.  Any kind of massive QE3 would be met with overwhelming political resistance.  A total lack of QE3 would be met with overwhelming stock market disappointment.  The Twist, on the other hand, helps savers by increasing short rates and helps borrowers by lowering the long ones.  It should help stocks as mentioned earlier.  The Twist won’t help gold, but the Twist doesn’t care about that.  It’s been said by the author of the Twist (Bernanke, not Checker) that “gold isn’t a currency, ” so who should care about the value of that “barbarous relic.”

I guess we’ll have to wait until Friday to see if the markets have any ability to predict Fed policy.

Until then…  it’s just around and around and up and down.