In An Unexpected Outcome, Trump Tax Reform Blew Up The Treasury Market

Over the past week we have shown on several occasions that there once again appears to be a sharp, sudden dollar-funding liquidity strain in global markets, manifesting itself in a dramatic widening in FX basis swaps, which - in this particular case - has flowed through in the forward discount for USDJPY spiking from around 0.04 yen to around 0.23 yen overnight. As Bloomberg speculated, this discount for buying yen at future dates widened sharply as non-U.S. banks, which typically buy dollars now with sell-back contracts at a future date, scrambled to procure greenbacks for the year-end.

However, as Deutsche Bank"s Masao Muraki explains, this particular dollar funding shortage is more than just the traditional year-end window dressing or some secret bank funding panic.

Instead, the DB strategist observes that the USD funding costs for Japanese insurers and banks to invest in US Treasuries - which have surged reaching a post-financial-crisis high of 2.35% on 15 Dec - are determined by three things, namely (1) the difference in US and Japanese risk-free rates (OIS), (2) the difference in US and Japanese interbank risk premiums (Libor-OIS), and (3) basis swaps, which illustrate the imbalance in currency-hedged US and Japanese investments.

In this particular case, widening of (1) as a result of Fed rate hikes and tightening of dollar funding conditions inside the US (2) and outside the US (3) have occurred simultaneously. This is shown in the chart below.

What is causing this? Unlike on previous occasions when dollar funding costs blew out due to concerns over the credit and viability of the Japanese and European banks, this time the Fed"s rate hikes could be spurring outflows from the US, European, and Japanese banks’ deposits inside the US. Absent indicators to the contrary, this appears to be the correct explanation since it"s not just Yen funding costs that are soaring. In fact, at present EUR/USD basis swaps are widening more than USD/JPY basis swaps.

According to Deutsche, it is possible that an increase in hedged US investments by Europeans could be indirectly affecting Japan, and that market participants could also be conscious of the risk that the repatriation tax system could spur a massive flow-back into the US, of funds held overseas by US companies

In fact, one can draw one particularly troubling conclusion: the sharp basis swap moves appear to have been catalyzed by the recently passed Trump tax reform.

• Corporate tax reform in the US

The United States House of Representatives and Senate recently passed a tax reform bill that lowers the corporate tax rate from 35% to 21% starting 2018. Lowering corporate taxes would likely accelerate the pace of Fed rate hikes, which could trigger a shift from dollar deposits to Government MMFs. Revisions to interest tax deductions would encourage companies to repay corporate bonds and could spur a decrease in dollar deposits (however, demand to bank loan could also weaken).

• Repatriation tax system

The tax bill also includes the abolishment of taxation (currently 35%) on dividend payments from overseas subsidiaries. However, overseas subsidiaries" retained earnings would be subject to a one-time tax. It is expected that this repatriation tax system would result in reserves held overseas by US companies (we estimate 90% are USD-denominated) flowing back into the US. This could create tighter conditions for USD financing outside the US.

Which leads to a bizarre outcome, that while the GOP tax reform may benefit corporate America, it appears set to punish America itself as buyers of US Treasurys suddenly require far greater yields to offset the surge in funding costs!

* * *

Whatever the cause behind these sharp funding shortages, one thing is clear - dollar funding costs (FX hedging costs) for both Japanese and European insurers and banks to invest in US Treasuries are surging (with Japanese buyers and reached a post-financial-crisis high of 2.35% on 15 Dec. And in terms of practical implications for the treasury market this means that, all else equal, marginal demand for US paper is about to plunge for one simple reason: the FX-hedged yields on US Treasurys have plunged to (negative) levels never seen before (unless of course foreign investors buy US Treasurys unhedged).

To demonstrate this point, the chart below from Deutsche Bank shows the yields on currency-hedged US Treasuries from the perspective of Japanese investors. Japanese financial institutions tend to use 3-month FX forwards when they invest in hedged foreign bonds. Annualized hedge costs have recently risen to 2.33%, which means that investments in 10y US Treasuries result in virtually no yield. Furthermore, yields from investment in shorter than 10y US Treasuries would be less than JGBs and result in negative spreads. This means that unless funding costs slide, Japanese buyers will simple pick JGBs over TSYs, eliminating one of the biggest sources of Treasury demand in receng years.

There is another consideration: as Deutsche Bank notes, whenever it is time to roll over a hedge, financial institutions need to decide whether to (A) sell US Treasuries or (B) hold them as unhedged foreign bonds. Engaging in (B) on a large scale would be difficult unless the institution"s outlook calls for yen depreciation. After implementing (A), institutions should then choose to invest in high-yielding US MBS (high interest rate risk), medium- to low-rated corporate bonds (high credit risk), European and other sovereign bonds, or to reinvest in JGBs.

Moving away from Japan, and looking at Europe one finds an even more dramatic slide in hedged TSY yields, which net of hedge costs have plunged to -0.6%, by far the lowest - and most negative - on record, something we highlighted yesterday in "There"s Never Been A Worse Time For A European Investor To Buy US Treasuries" .

The conclusion is that as a result of the recent surge in funding costs, seemingly in response to the nuances of Trump tax reform as explained above, suddenly buying US Treasurys is no longer an economic option for virtually all foreign buyers! Needless to say, something will need to change because if funding costs stay where they are, yields across the curve will have to jump for US Treasurys to once again be an attractive purchase for foreign buyers, which as a reminder comprise the majority of TSY buyers in recent years.

What is the outlook? Some parting thoughts from Deutsche, which writes that according to the chart below, fundings costs will likely continue widening as the Fed raises interest rates.

DB then also warns that the repatriation tax system that was just passed into law, coupled with ongoing Fed rate hikes, will indirectly result in the widening of dollar funding conditions in and outside of the US. And the punchline: if these indeed continue to widen, and US long-term interest rates stay at a low level, "this would restrict investments in US Treasuries by Japanese financial institutions relying on short-term dollar funding." This could then lead to a sharp move higher in US yields - and rates- as the US finds it needs an aggressive increase in foreign demand to finance the widest US budget deficit in years. 

In other words, by pounding the table on - and recently passing - tax reform, Donald Trump appears to have sown the seeds of the equity market"s own destruction, because remember that the one thing that can bring the house of manipulated cards down faster than you can say covfefe, not to mention burst the equity bubble, is a sharp move higher in long-term yields, rates, and ultimately - inflation.

More Evidence BoJ Desperate To Steepen Yield Curve

Two days ago, we highlighted how Bank of Japan officials have been briefing Reuters about reducing its monetary stimulus earlier than markets had been expecting – around 1Q 2018 rather than later in the year. In particular, the yield curve control (YCC) is likely to be eased from the current target of zero percent for 10-year JGB yields. It seems the BoJ became frustrated that markets had failed to respond to his hints about the “reversal rate”, i.e. that central banks can lower rates too far and damage financial institutions and the provision of credit in the economy. The one (former) BoJ official who was prepared to go on the record explained.

“Reversal rate is a pretty shocking word to come out of the mouth of a BOJ governor. It’s unthinkable the BOJ would insert it in Kuroda’s speech without any policy intention,” said Takahide Kiuchi, who was a BOJ board member until July.

 

The BOJ may allow long-term rates to rise more by shifting its long-term rate target to five-year yields from 10-year yields around the first quarter of next year, Kiuchi said. “The BOJ could put a positive spin on the move by saying it can more effectively reflate growth by keeping short-term borrowing costs low while allowing longer yields to rise.”

We might assume that the BoJ is becoming obsessed with steepening the yield curve and we got confirmation of this overnight. A story which flashed up on Bloomberg about the BoJ tapering bond purchases at the super long end.

BOJ Bond Cut Shows Desire to Steepen Yield Curve: Merrill Lynch

 

Bank of Japan’s slight cut in buying of bonds maturing in more than 25 years suggests its desire to steepen the yield curve, says Shuichi Obsaki, chief rates strategist for Japan at Bank of America Merrill Lynch.

 

Yield curve has been flattening of late and the BOJ is probably sending a message that it wants the super-long yield curve to steepen.

In terms of the mechanics, the BoJ today cut its purchases of bonds maturing in more than 25 years to 90 billion Yen from 100 billion yen at the previous offer on 17 November 2017. This was the first cut since March. JGB yields rose on the news in Friday trading, as Bloomberg reports.

JGB yields rose across the curve after the BOJ trimmed outright debt purchase in the super long sector.

 

BOJ reduced purchases of bonds with maturity of more than 25 years by 10b yen to 90b yen; it was the bank’s first cut in the sector since March.

 

Purchase volume for the 10-to-25-year zone was unchanged at 200b

 

JGB futures closed regular day down 0.13 at 151.02; key futures suffered the biggest intraday loss since Oct. 2, losing as much as 0.21

 

10-year cash bond yield rises 0.5bp to 0.025%; 20-year yield gains 1bp to 0.57%; 30-year climbs 2.5bps to 0.830%

 

Falls in JGB futures were exaggerated by sharp rise on Wednesday

It appears that the BoJ had become panicked by the yield curve flattening after reports that the government might reduce the issuance of super-long bonds in the next fiscal year, i.e. to March 2019. On Wednesday, there was a meeting between officials from Japan’s Ministry of Finance and primary dealers to discuss the plans for issuance in the next fiscal year.

While inflation is remains far below its 2% target, the BoJ is being forced into a policy reversal due to the damage its NIRP/ZIRP policy is doing to the financial sector. However, it’s portraying its defeat as  a victory via the supposed reflationary signalling of steepening yield curve. It’s utter nonsense and a shameful reflection on the depths which central bankers will stoop to.

"The Nightmare Scenario" Revisited: Albert Edwards Lays Out The Next "Black Monday"

Is it the onset of a recession or the fear of a recession that causes a crash? That is what SocGen"s bear (or, as he calls himself this time, wolf) Albert Edwards contemplated on the 30th anniversary of Black Monday, before reaching the conclusion that it"s the latter. Having taken several weeks off from publishing his ill-named global strategy "weekly" report to meet with clients, Edwards finds that most clients "seem to harbour similar fears as I, namely that the QE-driven bubble will burst at some stage and lay low the global economy, just as it did in 2007." Yet where clients differ, is on the timing of said burst:

"despite my bearish (or is it wolfish) howling, virtually no clients think the denouement will come any time soon and that the equity bull market should have at least 12-18 months left to run. Most can see nothing on the immediate horizon that might burst this bubble."

So, doing his public service to boost the overall sense of dread, and perhaps fear, Albert takes it upon himself to reprise recent discussions with clients, and in his latest letter explains "what might catch them out in the near term." To do this, Edwards focuses first and foremost on the catalysts behind the abovementioned 1987 "Black Monday" crash.

A retrospective macro-narrative was inevitably wrapped around the ?Black Monday? 19 October 1987 equity market crash. My 30-year recollection is pretty good: 1987 saw a buoyant equity market rising briskly through most of the year as the oil price recovered from the previous year?s collapse (from $30 to $8, see chart below). After a year in the doldrums the US economy started to accelerate notably through 1987 as the impact of 1986 interest rate cuts and a lower dollar worked. By the time of the Oct crash the US ISM had surged from 50 at the start of the year to over 60 - a level seldom ever reached (see chart below). Amazingly the ISM has just last month exceeded 60.0 for only the second time since 1987. Spooky!

 

While one may disagree on the causes, Edwards makes one thing very clear: to hime it was all painfully memorable, and he recalls events from 30 years ago "as if it were yesterday (actually I can?t remember yesterday.)" And whether it was the fear of a recession, or something else, once the selling started, it wouldn"t stop until a fifth of market values were wiped out.

Of course the machines took over the selling in the form of Portfolio Insurance programmes, but speaking to my colleague Andrew Lapthorne, he reminds me we also have similarly pro-cyclical ?doomsday? vehicles today - with so much money being run by volatility targeting, risk parity and CTA/trend following quant funds. A fascinating article by stockmarket guru Robert Shiller in a NY Times article to mark the 30th anniversary of the crash, suggests that it was not the Portfolio Insurance that was responsible for the crash, as most official post-mortems suggested, but fear passed by word of mouth. Shiller thinks, in the internet age, there is even more scope for fear to spread like wildfire to set off a market crash - which would of course be limited to 20% in any one day due to circuit breaker rules.

Putting it together, Edwards concludes that "the trigger for the 1987 crash was the fear of US recession caused by the likelihood of US rate rises to stem a hypothetical dollar collapse."

I am clear in my mind both at the time and now, that the US equity market was priced for a continuation of rapid economic and profit growth and this was under threat. The Dow was on nose-bleed valuations, especially as it had ignored the bond sell-off for most of 1997 (was it really 30 years ago that US 10y yields briefly crawled back above 10% - the last time we would see double-digit yields). None of this would have mattered if the US equity market had been cheap. In my view the record 25% ‘Black Monday’ October 19 decline was due to a horrendously expensive equity market suddenly confronted with the fear of recession. Equity valuations matter.

Fast forward to today, when equity valuations matter again; in fact, as Goldman and virtually all other banks agree, company valuations have never been higher.  And yet nobody cares, at least none of Edwards" clients. He admits that at this moment, SocGen"s clients fear "very little it appears in the near term." Oh, everyone knows stocks are a bubble, but after nearly a decade of crying valuation bubble wolf, so to speak, with no effect whatsoever, "oe thing we hear consistently is that they are not interested in being told equity valuations are expensive. They have been for a while and that does not seem to stop the market going up!"

But, "valuation DOES eventually matter" Edwards writes, as it did 30 years ago, in 1987, when "in the immediate aftermath of the crash, the extreme expense of US equities certainly was clearly a major contributing factor."

So could 1987 happen again, and if so, what would be the catalyst that nobody can see?

The answer to the first, according to Edwards, is that "of course it could. It could happen tomorrow given the extreme expense of US equities and the near universal consensus of a continued acceleration in the economic cycle ? despite the Fed also in the midst of a tightening cycle.As the excellent David Rosenberg of Gluskin Sheff points out, of the13 post war Fed tightening cycles, 10 have ended in unexpected recession."

And, as observed above, one may not even an actual recession, just the fear of one, to start the next 20% plunge: "at these extremes of equity valuation it might not even be an actual recession that produces the next precipitous equity bear market, but the fear of a recession, however misguided that fear may or may not be."

* * *

And yet, as Edwards started off his letter, while "fears" may be pervasive, few clients (or traders, or analysts, or pundits) believe there is a catalyst for a quick and sudden reversal in the market"s nearly 9 year momentum is in the immediate future. But is that accurate?

"Is there anything out there that can cause a rapid change in market expectations of future economic growth? Not according to most investors we speak to. But let?s try and think of some things that we maybe need to watch out for."

Here, in addition to the latent overhang of overvaluation, one main concern is "the expectation, or more importantly the fear of more rapid Fed rate rises threatening the economic recovery might be one thing to watch out for." Yet while Janet Yellen"s replacement at the Fed will hardly seek to pursue tighter monetary policy, they may have no choice if the recent spike in averae hourly earnings proves to be long-lasting and widespread:

wage inflation has been the dog that didn?t bark this year - or indeed the wolf that didn?t howl. Wage inflation actually slowed this year against the expectations of some naysayer commentators (ie me) of an acceleration (and yes I do mean an acceleration rather than a rise). But it was notable that in the September payroll release, average hourly earnings jumped sharply to 2.9% - a high for this cycle (see chart below).

While many have explained the recent spike in inflation as being a transitory consequence of the two Hurricanes to slam the US this summer, "if for whatever reason it is not an aberration and the Phillips Curve is reasserting itself, similarly high wage inflation data in the months ahead could cause a rapid reappraisal of the pace of Fed rate hikes. At these high equity valuations, that could really scare investors."

Going back to what Deutsche Bank discussed two weeks ago, namely that the Fed is trapped in the 60 bps of space between the short and long end, Edwards writes that any expectation of faster rate hikes will impact the yield curve, which has already been flattening rapidly - a usual prelude to decelerating economic activity. Furthermore, "the dollar is likely to reverse the weakness we have seen since the start of this year, which was in large part a result of an unwinding of ultra long speculative dollar positioning against the euro (as suggested by the CFTC data)."

That has now completely reversed and speculators are very short the dollar. The catalyst for the resumption of the dollar?s rise may have been a sharp recent widening of the US 2y spreads with both Germany and Japan as investors embrace the near certainty of a December US rate hike, but this could go considerably further if investors actually begin to believe the Fed?s own forecasts of future interest rates (ie the Fed dots).

Which brings us to a topic Edwards discussed most recently at the end of August, namely the "Nightmare Scenario" for investors.

The nightmare scenario for equities would be if US wage inflation flickers back to life and investors not only decide that they are too far behind the Fed dots, but they also decide that the Fed itself is behind the tightening curve. In that scenario yields would jump sharply higher across the curve, but especially at the short end and the dollar would soar.

Ironically, as an aside, two weeks ago New River"s Eric Peters defined the "Nightmare Scenario" - from the perspective of the next Fed chair - as the opposite: a world in which inflation and wages do not rise, effectively boxing the central bank into continuing to inflate the biggest asset bubble ever leading to a historic crash. To this, we imagine Edwards" response would be that the crash - as is - would be devastating enough.

How to determine if the market is on the verge of said "nightmare scenario" looking at market indicators? "Two critical long-term trend-lines to watch: First our head of technical analysis, Stephanie Aymes, highlights that the breakout point for the 30y downtrend in the dollar against the yen is around Y123/$ (chart left below). Second, as 10y US yields ?smash? above the multi-month support of 2.4%, they can rise all the way to 3% and still be in a bull market (see below)."

Indeed, while many have pointed out the recent breakout in the 10Y above the critical - for the past 6 months - support level of 2.42%, a stronger dollar may be as much, if not more, of a negative factor.

The equity markets? rise this year has been fuelled by profits growth and the expectation of a continuation of the current [weak dollar] trend. Much of that rise in US profits is the direct result of the dollar’s weakness so far this year. Take a look at the two charts below, both comparing US and Japanese profits. On the left, we show forward earnings expectations (TOPIX and S&P500) while on the right we show whole economy profits measures. The key difference is that the stockmarket profits measures have considerably more exposure to overseas earnings and the currency as well as not including smaller and unquoted companies. Hence it is notable that Japanese whole economy profits have considerably outperformed Japanese stockmarket profits, while on the other hand it is startling how US whole economy profits have underperformed US stockmarket profits. I think it?s mainly down to dollar weakness this year.

It"s not just nosebleed valuations, rising rates, a spike in the dollar, however: Edwards also brings attention to the bubble in corporate credit markets, or as he puts it, "corporate debt will be the 2007-like vortex of debility in the next downturn. Even the moderate, reasonable, and usually well behind-the-curve, IMF suggests a staggering 20% of US corporates are at risk of default in the next economic downturn." More:

I certainly believe QE has also inflated US corporate debt prices way above what they otherwise should be. Indeed looking at the top left-hand chart, it is clear that typically, the corporate debt market would be in revolt by now in the face of the cyclical debauchment of corporate balance sheets. The fact that both yields and spreads are near all-time lows is, like over-extended equity valuations, a ticking time-bomb waiting to go off. (The chart on the left uses top-down corporate balance sheet data from the Federal Reserve Z1 Flow of Funds book. But the right-hand chart is stockmarket data from Datastream and shows a higher peak recently for quoted stocks, tying up closely with Andrew Lapthorne?s bottom-up analysis. )

There is one last catalyst: China.

Finally a word on China...which does not seem to concern clients at the moment. Incredible when you consider that a little over a year ago China was investors? number one concern. What changed was that the dollar?s weakness this year subdued jitters about renminbi devaluation and the plunge in Chinese reserves.... although on the surface the Chinese economy looks stable, increasingly volatile swings in credit policy are necessary to keep the show on the road ? most apparent in the boom and bust cycle in house prices (see left-hand chart below). A stronger dollar may necessitate another shift towards easy Chinese policy, including a weaker renminbi. That could cause trouble.

And, of course, the overarching factor behind all of the above is the Fedral Reserve. Which brings us to the conclusion:

So a reappraisal in the market?s expectations on the pace of Fed rate hikes, perhaps because of higher than expected wage inflation data, would likely trigger both a rise in yields along the length of a flattening curve and a resumption in the dollar bull market. When the equity market is ridiculously expensive and priced for profits perfection, these events (or indeed as in 1987, the FEAR of these events) could prove catastrophic for QE inflated equity markets.

Which, for those who have followed Edwards" warnings, is in line with his long-running narrative, and which - one day - will prove prescient. For now, however, just do what the algos do and BTFD.

In Latest Reversal, Trump Weighs Tying Debt Limit Increase To Harvey Disaster Aid

This afternoon, we showed that even as stocks were pushing back to all time highs, a part of the Treasury market was turmoiling as the "debt ceiling" T-Bill spread (Sept/Oct) blew out to the widest level on record.

There were several possible catalysts suggested for this spike in concerns about a favorable outcome of the debt ceiling negotiation, which has to be concluded ahead of the Treasury"s X Date, now expected as early as October 1: some cited Steven Mnuchin"s interview on CNBC, in which the Treasury Secretary said that the additional spending needed to help Texas recover from Hurricane Harvey may reduce the amount of time Congress has to increase the federal debt limit; another possibility was month-end liquidity needs and relative positioning across the curve. But the most likely explanation is that earlier today the chairman of the conservative House Freedom Caucus said aid for victims of Hurricane Harvey should not be part of a vehicle to raise the debt ceiling.

Quoted by The Hill, Rep. Mark Meadows (R-N.C.), a Trump ally who leads the conservative caucus, said disaster aid should pass on its own, apart from separate measures the government must pick up in September to raise the nation"s borrowing limit and fund the government.

“The Harvey relief would pass on its own, and to use that as a vehicle to get people to vote for a debt ceiling is not appropriate,” he said an interview with The Washington Post, signaling agreement with what Trump"s approach on the matter has been. It would “send the wrong message” to add $15 to $20 billion of spending while increasing the debt ceiling, Meadows added.

Ironically, as we showed previously, it was precisely the Harvey disaster that prompted Goldman yesterday to lower its odds for a government shutdown from 50% to 33%, on the assumption that it would make conservatives more agreeable to a compromise, when in fact precisely the opposite appears to have happened, and the new dynamic is now playing out in the market where the odds of a government shutdown have never been greater.

Well, late on Thursday the dynamic changed yet again, as Trump now appears to have changed his mind, and instead of seeking a "clean" debt ceiling increase as he did as recently as one week ago, when he adopted the Democratic Party"s (and Steven Mnuchin"s) position and bucking conservatives who traditionally demand new curbs on spending in exchange for authorizing more debt, Bloomberg reported that Trump is now weighing tying the debt limit increase to the initial $5.95 billion request in disaster relief for Hurricane Harvey.

According to Bloomberg, the White House request, which could be unveiled as soon as tomorrow, would include $5.5 billion to FEMA and the remainder to the Small Business Administration. The request is being prepared primarily to cover funding demands through the Sept. 30 end of the federal fiscal year.

Earlier in the day, Texas Republican Senator Weber said Congress will most likely vote on the "first phase" of emergency relief money for Hurricane Harvey in mid-September, which however did not incorporate Trump"s revised plan and/or schedule.

Tying the debt limit increase to a Harvey bill is intended to ease early passage of a debt limit increase and avoid a potential stand-off over what could potentially escalate into a technical default - the outcome that is violently spooking the Bill market - and could rattle financial markets, one of the officials said. According to Bloomberg sources, "the White House would like to extend the debt limit long enough to move back the threat of a U.S. default until after Congress can deal with funding for the full federal fiscal year and tax legislation the Trump administration backs."

In other words, yet another can kicking, one which would likely push back the debt limit debate to some time in December.

How likely is the success of this latest U-turn by Trump? Bloomberg writes that administration officials have already begun talks with congressional leaders about the new approach. It remains to be seen if Trump will be able to win over enough Democrats to silence what, at least as of this moment, appears to be staunch opposition by the Freedom Caucus which also succeeded in sinking Trump"s first attempt at repealing Obamacare back in March.

Mediocre, Tailing 7 Year Auction Following Yesterday's Short Squeeze

After two surprisingly strong auctions earlier in the week, when the Treasury sold both 2 and 5 Year paper to unexpectedly brisk demand ahead of the FOMC meeting, which bounced despite a record high short interest in 2Y futs, moments ago the last auction of the week closed when $28 billion in 7 Year paper was sold at a high yield of 2.126%, tailing the When Issued 2.122%, and the highest yield since 2.215% in March.

The internals were mediocre, with the bid-to-cover of 2.54 better than last month"s 2.461%, if right on top of the six auction average of 2.54%.  Indirect bidders took down 67.7%, also better than last month"s 67.4%  and above the 6MMA of 69.3%, as direct bidders were awarded 11.6%, more than the 9.4% taken down in June and the 6 auction average of 10.4%. Finally, Dealers were left with 20.6%, the lowest since April"s record low 8.8% and below the 6MMA 20.2%.

While the auction was not nearly as exciting as the last two, perhaps much of that has to do with the post-Fed rally observed yesterday, which forced short covering, mostly on the short end, but also broadly across the curve. And with less shorts to squeeze, the result was a rather mediocre auction.

Japan Is Dumping A Record Amount Of Foreign Bonds: Here Are The Implications

Back in February, around the time Bloomberg caught up to what we had been discussing for the past year, namely the historic dumping of US Treasurys by offshore official investors (such as central banks and reserve managers, just as the selling had in fact reversed and foreigners had resumed buying once more) we noticed that it was not China but Japan that had emerged as one of the most aggressive sellers of Treasuries following material Mark-to-Market losses on existing TSY holdings, prompting the foremost ex-Fed shadow banking expert Zoltan Poszar to declare the selling "a deer in the headlights moment".

Fast forward two months, when according to the latest update from Deutsche Bank, Japan"s revulsion to fixed income products has accelerateed, and the Pacific island was a net seller of foreign bonds again in the past week, divesting another $12bn worth of securities. It was not only the third straight week of selling out of Japan, according to MOF data, but more remarkably, the the year-to-date divestment of $66bn in foreign bonds YTD is the biggest since 2002, the first full year of such data is available.

What is prompting the sudden liquidation? According to Deustche, "profit-taking most likely explains Japan’s selling."

Ten-year Treasury yields declined in April to a lower level than any previous month since the Trump election. In the process, yen cross-currency basis has tightened to levels not seen since January 2016. Japanese investors use the yen basis (or more precisely, their derivative FX forwards) to hedge the currency risk of their coupon flows from non-yen bonds. The basis tightens when there is a drop in demand to swap yen for dollar.

The next chart, which shows the distinctive inverse relationship between cumulative Japanese purchases of foreign bonds and the 3m yen basis, should be useful to anyone still confused by what has been the biggest driver behind the gradual drop and sudden recent spike in the USD-JPY currency basis: it all has to do with Japanese TSY demand, and hedging costs (which we pointed out had risen so high last August it made TSYs and JGBs look equally priced to Japanese investors).

However, it"s not just the Yen basis (and thus relative USD shortage) that is impacted by the Japanese appetite (or lack thereof) for US paper. As the Deutsche fixed income team writes, the lack of love shown by Japanese investors for Treasuries might also be responsible for low 3m Libor fixings and the collapse in Libor/FF spreads.

The details:

In US money markets where Japanese banks also raise dollars, the rates they’ve been paying on commercial paper and certificates of deposit have narrowed vis-a-vis the rates they pay on repos. CP and CD rates are of course used by banks as the main input for daily Libor submissions. Three of the 17 contributing banks to USD Libor are also Japanese. The narrowing of rates Japanese banks pay to borrow dollar using CP/CDs versus repos is further evidence that unsecured funding costs have dropped, which is reflected in the tightening in Libor-FF spreads.

That said, the recent revulsion toward fixed income products out of Japan will probably not last for two reasons.

First, as DB notes, April typically tends to be a month when Japanese investors sell foreign assets as they take profits at the start of the fiscal year. Seasonality would suggest that Japan becomes a buyer again in May, with especially strong appetite for foreign bonds in the July to September period. Consequently, we would look for Libor-FF spreads to find some support in the coming month, especially if Treasury yields become attractive again.

The second reason comes from BofA.

In a recent report, the bank"s FX and rates strategists published a piece summarizing the investment plans of nine Japanese life insurance companies for the first half of their fiscal year (which began April 1st). This is what BofA found:

Over the past few years in particular, insurers have been amassing foreign bonds, and particularly US Treasuries, but that fund flow will probably change if US rate hikes continue. Foreign bond investment is increasingly dependent on yields, FX, and FX hedge costs, and will probably become more fluid. In the United States, rate hikes are expected to continue, so the USD/JPY hedge cost cannot be expected to decline much. As par the plans announced, many will likely be less active in hedging foreign bond than last year. Investment in unhedged foreign bonds is expected to be heavily dependent on levels of FX relative to assumptions (see below), and it is more likely to increase. Domestic yields have sunk due to the BoJ’s negative interest rate policy, making fund management in JGBs difficult and prompting the major insurers to stop selling a number of yen-denominated life insurance products.

In other words, the story remains largely the same in that domestic yields are too low for buying JGBs, and life insurers remain without any other option but to buy foreign bonds (Figure 1). However in a key change foreign bond purchases are likely to take place increasingly on a currency unhedged basis (Figure 2), which has two major implications for both Treasurys and US corporate bonds.

First it reduces the need to reach for yield, which means less buying of BBBs and BBs and longer maturities; however it also means that Treasurys across the curve are suddenly far more attractive to Japanese buyers as investors will no longer need to offset up to 80 bps in hedging costs.

Second Japanese life insurance buying is likely to be less steady and more tactical, depending on interest rates and FX. This means more (less) buying when rates vol is low (high). The FX assumption is that the USD/JPY is in the range 100-125 and will increase toward fiscal year end. That means currently at 111 we are in the middle of the range, but since the dollar is expected to appreciate buying will take place here and increase should the dollar weaken, decrease should it strengthen.

This dynamic, together with recent technicals (recall earlier we showed that Treasury futures traders had just experienced the biggest short squeeze in history), mean that the reflation trade could be further jeopardized due to yet another feedback loop linking a weaker dollar (and thus USDJPY), with lower yields, which in turn leads to even more weakness in the USD, and so n. Ultimately, it will be up to the Fed to break this latest adverse feedback loop, although with the US economy growing at just 0.7% in Q1, it will take a significant leap of faith by Yellen and the "data dependent" Fed that US output will recover by Q2 when the Fed is expected to hike by another 25 bps.

Bond Bears Battered To 5-Month Lows But Rate-Hike Bets Top $3.2 Trillion

Since their peak "shortedness" in mid-January, US Treasury bond bears have covered 500,000 10-year-equivalent contracts, reducing the net speculative short to its lowest since before Thanksgiving 2016.

At the same time, however, Eurodollar shorts (bets on Fed rate hikes) have soared to a new record high (over $3.2 trillion notional).

However, both the absolute level of Treasury yields and the short-term eurodollar curve (bets on The Fed"s path in the next 18 months) are losing their faith in Trumpflation and Janet Yellen.

Bloomberg"s Tanvir Sandhu notes that the intermediate and long-term Treasury yields have broken down from this year’s ranges and are now at their post-election lows, given the confluence of global political-risk events and increased doubts about the prospects for sizable tax reform. Investors need to quantify how much of President Donald Trump’s policy agenda is left in the price and the risks if policy disappoints.

Deutsche Bank now sees the balance of risks as tilted toward still lower yields across the curve in the near term. Last week we revised our forecasts to reflect a near term dip in 10y yields toward 2%, with yields ending the current quarter at 2.25% and climbing to 2.75% by the end of 2017. 

This path reflects concern for risk off conditions driven by the French electoral process, significant delays or even failure of pro-growth tax reform in the US, a possible slowdown in “soft” indicators such as our excess liquidity metric, and positioning. 

However, there remains a plausible path to higher rates. If the French electoral process is not acutely disruptive, if progress is eventually made on tax reform, and if the data remain resilient then rates should rise again and the Fed could push on. In this sort of scenario the Fed’s trade-off between balance sheet reduction and rate hikes would likely come into greater focus.

However, for now, futures positioning and options skews show bond bears losing the fight.

As Bloomberg reports, the cost of options to bet that U.S. yields will fall in the near term has now moved higher than those to position for an increase. With volatility beyond three-month expiries still relatively low, this boosts the appeal of hedging against mounting geopolitical risks via spread options. Short-dated skews on 10-year rates have turned negative, with receivers trading at a premium to payers. The flattening of short-dated skews increases the attractiveness to hedge against lower rates via receiver spreads. These skews tend to predict subsequent changes in underlying rates, with flatter skews since December having indicated risks to duration shorts.

“North Korea and Syria were the straw that broke the camel’s back, but now we have a new range,” said Glen Capelo, a trader at Mischler Financial. He pegs it at about 2.05 percent to 2.4 percent for the 10-year yield, after it’d been stuck between 2.3 percent and 2.65 percent.

For bond bears, “we’re not going to know anything for a while,” on the timing of Trump’s fiscal-policy agenda, Capelo said. “The onus now is that the hard data has to turn higher.”

Gold Surges, USDJPY, Yields Slide As Markets Finally Respond To Latest Set Of Economic, Geopolitical Shocks

With markets shut on Good Friday, even as the one-two knockout punch of the worst monthly core CPI print in 7 years hit...

... coupled with a miss in March retail sales, which suffered their biggest two month drop in 2 years...

... on Sunday night traders were desperate to catch up, or rather down to, the USDJPY which was the only instrument that traded through Friday"s data dump, and which at last check was trading at 108.34, nearly 100 pips below the Friday open, sliding further in early Japanese trading as the last holdouts on the reflation trade capitulate in panic, further pressured by fears over the rapidly deterioating situation in North Korea.

As one would expect, a surge in the yen means continued weakness in the dollar, and sure enough on Sunday night, Donald Trump"s recent bid for a weaker greenback has been the market"s command.

Predictably, and contrary to virtually every sellside analyst"s prediction for ongoing levitation in interest rates, US TSY yields have tumbled across the curve, with 5-year yields down as much as 5bps at 1.72%, lowest since Nov. 18, while the benchmark 10-year yield has slide 4bps to 2.20%, also the lowest since the election.

Perhaps the one asset class where the reflation revulsion has not been observed yet is S&P futures, as the E-mini stubbornly holds out to selling pressure and is barely lower on the session following Thursday"s sharp drop.

However, while equity markets may be ignoring the moves in FX and rates, gold is hardly waiting, and on Sunday night evening was trading above $1,290/oz, the highest price since the Trump electiomn... 

... and poised for a key double resistance breakout.

While the spike in gold is hardly a surprise in light of last week"s economic data and this weekend"s North Korean events, with spot not trading there was little opportunity for traders to take advantage of what many expected would be a sharp jump in the yellow metal. Except... that"s not quite true: as we noted on Friday, while spot may have be closed, physical vendors such as Ampex were happy to sell gold, and even better, at Thursday"s depressed price.

Gold arb trade: Physical dealers like Apmex are still stuck at Thursday"s gold price

— zerohedge (@zerohedge) April 14, 2017

Finally, before we forget, there was another asset class that was surging overnight: the Turkish lire, which has been on fire ever since Erdogan won the popular mandate to become dictator, and which just as Barclays predicted, would lead to a spike in the Turkish currency... if only for a the very near future.

Mediocre, Tailing 30Y Auction Concludes This Week's Treasury Issuance

With the 30Y trading comfortably in repo today, with no tightness as indicated by the +0.7% repo rate, it seemed possible that the auction would join this week"s previous 2 auctions of 3 and 10 Year paper by printing with a modest tail. So when the Treasury announced results from today"s 29-Year 10-Month reopening, few were surprised that the High Yield of 2.938% tailed the When Issued of 2.929% by 0.9bps, suggesting yet another mediocre auction. 27.01% of the bids at the high yield were accepted.

The internals confirmed the poor result: the bid/cover was 2.23, down from 2.34 at last month"s auction and below the 2.31% 6 month average. This was the lowest bid to cover since November 2016.

Indirect bidders took down 64.5% of the auction, just above the 62.9% average, while Direct bidders took down 5.8% of the auction, a sharp drop from last month"s 13.1%, and below the 6 month average of 8.4%. Dealers were left with 29.7% of the allotment.

The conclusion of this week"s TSY issuance left quite a bit to be desired in terms of primary demand, and since the recurring tails suggest that many of the TSY shorts have been mostly closed out, it implies a growing possibility that a new layer of shorts will be put across the curve in the near future.

Why China Unexpectedly Hiked Rates 10 Hours After The Fed

As we reported on Wednesday evening, something interesting took place on Thursday morning in Beijing: in a case of eerie coordination, China tightened monetary conditions across many of the PBOC"s liquidity-providing conduits just 10 hours after the Fed raised its own interest rate by 0.25% for only the third time in a decade.

The oddly matched rate hikes, prompted Bloomberg to think back to the mysterious "Shanghai Accord" of February 2016, which took place during the peak days of last year"s global capital markets crisis, and whose closed-door decisions - to this day kept away from the public - prompted the market rally that continues to this day. As Bloomberg wrote, the coordinated "response suggests that pledges by the Group of 20 economies a little over a year ago in Shanghai to "carefully calibrate and clearly communicate" policies may not have been hollow after all."

That said, it was not the first time the People’s Bank of China has acted on the heels of a Fed move. At the peak of the financial crisis, the PBOC cut lending rates after six of its counterparts, including the Fed, had announced a simultaneous rate cut. That October 2008 move enhanced China’s emerging reputation as a global player on the international economic-policy circuit. “Growth divergence is morphing into growth synchronization," said Chua Hak Bin, a Singapore-based senior economist with Maybank. "Policy divergence was also a narrative for those expecting a strong dollar, but that is moving now to policy synchronization.”

Coordinated or not, as of last night financial conditions in China, like in the US, have become incrementally tighter even if both the Chinese and US stock markets failed to respond accordingly.

So, for those curious what China did - after all the days of shotgun Interest rate or RRR moves appear to be on hibernation for the time being - here is a convenient primer from SocGen"s Wei Yao explaining not only the mechanics, but the reason why.

As Yao notes, the PBoC followed the Fed closely, at least timing-wise, and raised the rates on its major liquidity management tools by 10bp across the curve today, earlier than many had expected. After the hikes, the rate on the 7D reverse repo operations - the most critical of all - is now at 2.45%.

The central bank, in its press release, stressed that these interbank rate hikes simply follow the market"s development, thus not true policy rate hikes, and only hikes of benchmark lending and deposit rates count. Nevertheless, it also listed four classical rate-hike reasons for the interbank rate changes: the economic recovery, rising inflation (particularly that of housing), strong credit growth and Fed"s rate hikes.

SocGen"s interpretation of this statement is:

1. The PBoC is responding to the fundamentals of growth, inflation and financial stability. And it is looking through the low food prices, which have suppressed CPI, and paying due attention to domestic asset bubbles and credit growth.


2. But it still prefers a tightening approach so as to match its neutral stance, which means that adjusting interbank liquidity and interbank rates will likely remain the main actions. This may be because the headline CPI is muted after all, or because it has to change its policy rates from benchmark deposit/lending rates to interbank-linked rates sooner or later and so better start practicing now. In any case, it does not want the market to get ahead itself and price in too much tightening, just like the Fed.


3. Fed"s policy and US-China interest rate differentials do play a role in PBoC"s consideration. It may not be a very big role, as offering 10bp for every 25bp from the Fed is at best half-hearted help to the RMB. However, the Fed"s action offered the PBoC a timing to make the move, appearing to support the argument that the interbank rate hikes are “following the market”.

Given PBoC"s latest move and our view that growth stability will stay until the end of 2017, SocGen now expects further interbank rate hikes: 20bp in 2Q, 10bp in 3Q and no change in 4Q.

The equally critical development to watch is the evolution of interbank market rates as resulted from PBoC"s daily liquidity management. The trend of these market rates leads the changes of rates on PBoC"s instruments, thus a more timely indication of PBoC"s intention. Before today"s moves, the 28-day moving average of the 7d repo was already 50bp above the low back in August 2016.

Finally, while China has traditionally shied away from criticizing the Fed using conventional channels, in a surprising editorial in the Economic Information Daily, the authors said that China should be wary of a "spillover effect" from the Fed rate hikes, warning that “selfish” US interest rate policies have historically triggered crises in many other nations, the newspaper says in its front-page commentary. Finally, it warned that frequent Fed rate hikes may have “serious impact” on global economy.

Keep a close eye on tonight"s reverse repo facility: if China is really concerned, it very well may "hike" again.

How Trump Changed The Market: Goldman Explains

In the first stage of the Trump Rally (from the election to year-end), investors appeared to hedge as the market rallied. However, since the start of the new year, Goldman Sachs" proprietary macro hedging indicator has traded along with equities, suggesting that investors are buying stocks and discarding protection. As Goldman"s John Marshall and Katherine Fogertey explain, the Trump rally has changed the market - Investors Stopped Hedging.

As the Goldman duo notes, Long-dated liquid hedge costs at a multi-year low, and explains:

The cost of liquid long-dated hedges in equity and credit has collectively reached its lowest level in six years following the decline this week. The last time macro hedge costs were near this level across assets was in July 2015 (see Exhibit 1).

While not likely the cause of the pullback in August of 2015 (the mini-flash crash), the lack of hedges in investor portfolios likely exacerbated the sell-off.

Methodology for Chart above: We track the liquidity premium that investors are paying by hedging with terms that are considered more liquid in each asset. We estimate the cost of hedging with 3 year 55% OTM SPX puts and 10 year CDS protection relative to the cost of hedging with 10 year puts and 3 year CDS protection. Our CDS measure is the weighted average cost of single name CDS protection for S&P 500 companies in the weight that those companies are in the S&P 500 index.

 

How do we gauge the intensity of macro hedging?

We monitor the relative cost of hedging across the curve for SPX equity options and the CDS protection in S&P 500 names (see Exhibit 2).

Specifically, we find that when investors hedge in times of stress, they rush towards the part of the term structure which is the most liquid. In the credit market, longer dated hedges are more liquid (5+ years) relative to the options market where there is little reactivity or liquidity in 5+ year options. The relative liquidity is in short-dated equity options (3 years or less).

Hedges: 1-3 year Equity puts; 5+ year CDS protection

In times of stress, investors must be selective and buy hedges that have not already been bid up by other investors; given the lack of liquidity premium being put on some of the more popular parts of the curve, we see these highly liquid areas as unusually attractive for investors that see risk of a market pullback. Buyers of these hedges are likely to see the largest boost should there be a correlated market decline. 

As Goldman warns, our indicator is now in-line with its most complacent level in the past six years, suggesting investors are generally unhedged across both equities and credit.

Bond Yields Are Crashing

With net speculative positioning starting to unwind from its historically record short crowd, yields across the curve (and in Eurodollars) are starting to fall.

With 30Y back below 3.00% today, 10Y yields have broken below 2017 closing lows and are near intraday lows back to November.

It"s not just Treasuries, Bund yields collapsed today, accelerating lower into the close...

So much for the reflation trade...

Bonds & Bullion Are Surging As Small Caps Give Up 2017 Gains

Following Friday"s plunge in bond and bullion prices, dollar weakness (on Trump"s comments), Brexit uncertainty, and looming inauguration appear to have sent a ripple of anxiety through capital markets sending Treasury yields tumbling (6-8bps lower across the curve), gold prices soaring (above $1215), and stocks tumbling (Small Caps back in the red for 2017)...

And stocks sinking once again...