A View from the Trenches, August 19th, 2009: Thinking out loud
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If you read most daily comments from yesterday, you will leave with the
impression that nothing really substantial has taken place lately,
perhaps on grounds that that trading was on slim volume. When some sort
of fundamental analysis is proposed, it is also on the basis of the
latest macro data releases (i.e. Producer Price Index, Housing, etc.)
only.
However, something happened early this morning that I thought was
rather strange. As soon as I started watching my usual charts I found
that the EUR/JPY cross and the CAD were plunging, together with oil, as
the 30-yr Treasury bond was in full force approaching the $103 level.
With these figures, it was clear to me that stocks were to sell off
yesterday, and I could not understand how Asia’s and Europe’s equity
indexes were recovering. Below, I show the 30-yr Treasury intraday and
the S&P500 (source: Bloomberg):
I was totally lost, until I came across a morning research note
recommending selling 2-yr Agency debt (i.e. a security issued by US
government sponsored agency, like Fannie Mae). I read the analysis and
the recommendation made a lot of sense. Only then, did I put the two
and two together: On Monday, as I discussed here, the “rumor” went out
that China would buy mortgages. Why would China, owner of Treasuries,
change these for mortgages that are so expensive? And then again, I
realized that the latest sell-off we saw in stocks started in Asia…Now,
I believed in conspiracy theories again!
If my intuition was right, we should have seen the spread between 2-yr
Agencies and Treasuries react to this by widening, as 2-yr Agency debt
was being swapped for Treasuries (i.e. investors sell Agencies = Agency
spreads widen, and buy Treasuries = Treasury spreads tighten). Thus, I
looked for the magic chart, and this is what I found (source:
Bloomberg):
As you can see, this trade has been significant in the last two
sessions and…it starts early, with Monday’s activity developing
overnight in Asia. This has two immediate and very strong implications,
as well as ramifications: (1) as this swap takes place within fixed
income assets, we can perfectly see both Treasuries AND stocks rally,
which is counterintuitive. The proof is in the 3-mo Libor-OIS spread
that continued to collapse, reaching 23.85bps yesterday. In the
process, if this comes from overseas, we can see volatility in the FX
markets (i.e. EUR/JPY) and (2) this swap suggests to me interest rates
may remain low longer than what you or I would think. If this is correct, jump-to-default risk can further fall and drag credit even tighter!
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