Spreads

If you haven’t seen this, you should take a look. The 2-30 spread is at all-time highs. Yes, that’s all-time highs.

There are 2 options: either the curve is anticipatory and inflation is going to run higher, or the curve is wrong and the current inflation fears are hype. Both sides have valid arguments, and for those that say the market is always right, I’ll counter that markets tend to be wrong especially around turning points. Just food for thought.

Relevant ETFs: TLT, TBT, AGG, MUB, TIPS

Boot-strapping, RVs, and Making Markets

…a simple discussion of market making and how volatility and the lack of market makers lead to $0.01 prices

For many years I was a market maker in the commodities space, specifically in the electricity markets. Producers, consumers, hedgers, and speculators all would contact me for quotes on numerous locations and forward delivery dates, which often enough were not quoted elsewhere. What’s a good sell side market maker to do? You make a price and hope your curves are close enough that you don’t get killed. How did I formulate a market for a utility customer looking to buy, lets say for example, 2011 delivery for the Month of May peak hours into Boston? To be honest, a lot of boot strapping and prayers that correlations will hold up.

Power for delivery in Boston, is a basis to the primary regional market for New England, in this case called MassHub. MassHub is often priced as a spread to New York – Zone G (essentially the Hudson valley) or the Mid-Atlantic market known as PJM. Power in Boston is also heavily correlated to the delivered price of gas in the city known as Algonquin (which is itself based on other gas locations). The price for May 2011 is also closely associated with the price of May 2010, April 2011, and June 2011, and to a lesser extent, May of 2012. Markets are usually most liquid in the front of the curve, so everything starts there. You can easily see this by looking at trade volumes for any futures contract, and see how the volume drops considerably after the first few months of delivery. These other similar markets allow me to “bootstrap” a curve from the relative value versus other products.

From a combination of cross commodities spreads and ratios, combined with historical spread settlements, traders gain confidence that when they sell power for Boston delivery in May of 2011, they can go out, buy some PJM for May 2010, buy a NY-G May 2010/2011 time spread, and perhaps buy a similar amount of Q2’11 NYG/MassHub spread. Add in some gas basis spread to get from PJM to NY-G and perhaps a power spread to get from MassHub to Boston, and you are nearly home. Seems like a lot of trades to make a deal, but it’s these kind of market makers and spread traders that support a huge marketplace with several dozen locations across 15-20 years of delivery. Does it make sense that 2010 June natural gas delivered to Houston is the basis for 2022 power delivered to Cincinnati? Not really, but through dozens of traders spreading across regions, times, and products, the market works as a giant interconnected web of spreads all holding each other up.

At the end of the day, traders “Mark the Book”, and by that I mean they enter their estimates for market curves several years out, on a month by month basis, for often several dozen locations. Are there visible quotes on the screens or exchanges or in the OTC broker market to validate these curves? Often not. Most of the exchanges and brokers rely on yesterday’s spread differences or spread markets.

What happens during times of volatility when some of the spread traders pull their markets or widen them considerably across all of the spreads? Bid/offers become scarce. If someone has to sell, because they were tapped on the shoulder or something changed in their other positions, there may not be a “rational” market. If someone had to sell something at “market”, and there was no one willing to spread into the position, then technically there may not be a bid at all. Rationally, someone should have bid for Accenture against a spread to the futures or some other stock, but those spread offers were not there. Sounds a lot like of what happened yesterday when the NYSE was on “pause” and the other exchanges found themselves with no rational bids.

Market fundamentals, price momentum, historical cash settles, the size of the order and the nature of the counterparty all clearly contribute to any price, but at any instant, the current prices for associated markets matter the most. If the price of the first delivery month of natural gas disappeared, I would not be able to calculate any ratios of power to gas and most likely not be able to get any other power prices to spread to. Lacking that information, I might bid $0.01.

Watch the 10-Year

Everyone is talking about Plosser discussing selling off the Fed’s MBS hoard. It’s obviously necessary, but completely unfeasible given a still shaky housing market and no lending. Additionally, it would fly in the face of the Fed’s QE campaign. Lastly, who’s going to buy the securities?

http://www.marketwatch.com/story/fed-should-sell-mortgage-backed-bonds-plosser-2010-02-17

So the Fed is left holding the bag for now. You’d think that at least they should start tightening requirements and lending a bit less, instead of trying to dump their holdings. But alas, no.

Instead, the government is taking over private debt on a monumental scale. For an excellent analysis of where do we see deleveraging (and NOT), check this out: http://www.ritholtz.com/blog/2010/02/is-the-second-leg-of-the-credit-crisis-starting/. The conclusion from this article is:

The “Great Recession” has essentially only resulted in deleveraging of the financial sector. The overall levels of debt are still rising, thanks to a very modest deleveraging of the non-financial sector and a big releveraging of the government sector.

Was the only problem that the financial sector was too leveraged?  If so, the Great Recession returned the markets to sane debt levels.  If not, then the government releveraging has prevented the correction and deleveraging needed to put the credit crisis firmly behind us.  We fear the latter may be closer to the truth and the credit crisis is only partially complete.  The next major deleveraging will occur in the government sector.

Is this what widening sovereign CDS rates are telling us?

My answer: Yes!!

Connect The Dots 06-05-09

This issue of CTD was written with significant input from Thatsabet and others. All charts and tables are from Bloomberg.

Equities:            The week started off with the much anticipated official bankruptcy of GM. A clear case of sell the rumor, buy the news, the market shrugged off the immediate implications and started higher. Yes, GM and C are going to be replaced in the Dow Industrials by TRV and CSCO. The academic literature would suggest that GM and C will now go on to outperform TRV and CSCO, but this is a recap of the week. For those interested, check out New Evidence on Stock Price Effects Associated with Charges in the S&P 500 Index, by Anthony W. Lynch and Richard R. Mendenhall (http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1298790) and countless others.

The main story this week in the equity markets was the 2-10 spread in bonds (see our bonds summary). The moves in bonds and FX are signaling some big mispricings (adjustments?). For starters, check out this chart:

This is the SPX and EUR/JPY. EUR/JPY is the ultimate carry pair and has been a pretty good barometer of risk in the global markets. While the rise of EUR/USD is at politically sensitive levels after the recent rise, the JPY is also at critical levels. Thatsabet believes that should the 94.5 level be violated, it might lead to an unwind in the EURJPY which in turn could cause an unwind and lead to pressure on global equities.

Thatsabet also points out that many people like Japanese equities here for a long-term investment. The Japanese are 20 years ahead of us in their path to clear the imbalances of bubbles. The chart below shows the correlation of the US 10-year yield and the NKY. Depending on the cause of the rise in US yields, the JPY could get stronger as Japanese repatriate their currency and drive their local markets higher. Full disclosure, I have been increasing exposure in client accounts to small cap Japanese equities for the past few months for fundamental, valuation reasons, but this confirms some of our initial hypotheses. The Japanese small cap stocks represent some of the best value opportunities globally at this juncture. We have been buying JOF and other yen exposure.

This week is full of charts because the pictures really capture a thousand words. So three more charts:

First, SPXFX – This is the SPX from the March lows until now valued in different currencies. In USD terms, we have experienced the biggest rally since the 1930’s, yet in AUD terms, the market is only up roughly 5%. The currency markets are not confirming the equity strength and are calling into question the US’s ability to fund its future liabilities.

Second, XLFSPX – This is what the banks (XLF) have done relative to the SPX since 07. This spread is still trending lower until we see that .15 is decisively taken out. More time is needed in order to determine the validity of this rally. Thatsabet compared buying XLF here to buying XLK (technology) in 2001.

Lastly, let’s head to the emerging markets. From 2003 to 2007, with reflation and decoupling a virtual given, the emerging markets continued to outperform relative to the SPX. Then, the world stopped. EEM fell off a cliff (at a rate significantly faster than the SPX – remember this is the ratio of EEM:SPX). Just as violently, the ratio shot right back up. Thatsabet defines himself as a cautious decoupler. I personally don’t believe the decoupling trade or mentality. I believe that the interconnected nature of the currency, bond, and equity markets along with labor mobility, decrease in international trade barriers, etc. means that decoupling is not the driver of the trade. It’s the reason we look at NKY and TNX and examine the interconnectedness of markets now more than ever. Decoupling will be a topic we discuss at greater length in the next few weeks.

Bonds:              LQDTLT – This is what being long LQD (Corporate Debt) and short Treasuries has produced:                           

Since the break in 4Q07, corporate debt has been in a bear mkt. What is now occurring is either an “exhale” and corporate debt is cheap (concur) or the markets are realizing that the US government has taken over the leverage from the private citizen and will have to issue more debt to fund the fiscal gaps. Thatsabet goes so far as to think that over the next several years, US GOVT yields will be higher than corporate debt and emerging market debt. I tend to disagree in the near to medium term, at least.

Looking at US 10-year yields, we are approaching 3.9% and may test the 4% levels. What are the implications for home refinancings, which have already slowed? What about asset allocation models for big institutions? At what point will they be comfortable with the yield and move from stocks to bonds? At what point will the higher yields be an impediment to any imminent growth? Just as critical will be the shape of the yield curve. A flat or inverted yield curve often signals a coming recession (it also makes it extremely difficult for banks to make money). We have been seeing a steepening yield curve with the 2-10 spread rising to levels not seen since the 70’s or longer. A steep yield curve implies that investors do not want to own long dated fixed income securities, often because of fear of inflation. Julian Robertson (article posted) is playing this for size. Pretty amazing seeing that it is already historically wide. He thinks yields are headed to 7% and possibly as high as 18%.

Currencies:       The sentiment this week has been one of mixed messages. Dollar negative news continues, with gold rallying, yet no clear winner on the other side. The Euro continues to face its own headwinds, despite some recent strengths, and no viable alternative to the USD. The GBP is going through its own issues with Gordon’s government facing mounting pressures. Safe havens are becoming scarce.

Commodities:   Check out the CRB in USD and EUR since Mid Feb (prior to rally). Broad index is up only 10% vs 25% in USD. The affects from USD weakness is being felt more by the US and USD fixed currencies. Either the USD catches a bid and fast or the world better quickly adjust to ever higher CRB prices.

This is gold in USD AUD EUR JPY since the start of the 4Q08 selloff. Gold is positive in every FX to the tune of 20% except JPY which has been bid due to the carry unwind. I expect the XAUEUR to be the next blast off as the EURUSD is bound to correct. With everyone focused on DXY and the 78-80 level one needs to understand that the index is 57% EUR. The EU members will be finding it difficult to export with such a strong FX. A correction is in the cards.

On the energy front, oil is hitting the $70 mark and being used as evidence of a recovery. This is a chart of Mexico’s Oil Production. Their production seems to have peaked in 2003 and has been steadily declining since. Can they ramp up production or is the peak theory crowd correct? If the peak oil crowd is correct, what will happen to energy prices when demand really does rebound?

Economy:         Jobs. Jobs. Jobs. US Initial Jobless Claims: We are currently at the highest level since 1979 (give or take). With today’s figures out, the unemployment rate is at 9.4%. That’s almost 1 in 10 people unemployed AND that’s with the numbers calculated very differently than 30 years ago. At the same time, Steve Ballmer of Microsoft threatened to move jobs abroad if the current administration continues to move towards making it prohibitively expensive to hire workers in the US. With labor movement into the US reversing as opportunities in emerging markets relative to the US increase, where will the growth come from? From where will we get the young people needed to balance our aging population. Note this chart was from yesterday and doesn’t include this mornings numbers.

And to top it off, our usual performance tables…first, are the major markets we’re following, and second are the main sectors’ performances relative to the S&P500.