Notes From Underground: The Markets Are Reacting to Rising Interst Rates, While Equities Continue to Roll On (And Fed Anticipates a Roll Off)

In post-Memorial Day trading the BONDS had a large selloff as yields on long-term debt rose dramatically. The U.S. DOLLAR followed the rate increase and rose against all major currencies. Let’s reflect: Equities are impervious to rising long-term interest but the DOLLAR attracts foreign investors in search of a little more yield. The fact that the short-end of the curve is anchored by the FED, the result is that the 2/10 U.S. yield curve is steepening and actually made 52-week highs today as it rose to 186 basis points. The STEEPENING YIELD CURVE is aiding financial stocks. The 2/10 has increased to 184 from 145 basis points during the last three weeks, which has helped banks and other financials to pick up 40 EXTRA POINTS in yield by selling the short-end and buying the longer end. This is an interesting situation for usually steepening curves will put pressure on a currency.

But with a zero interest policy being the order of the day for many central banks, this time may be different … for a while. The global thirst for yield will lead some investors to look at the U.S. 10- and 30-year DEBT to lock in higher yields;just not yet as investors are only certain about equities … for now. The short-end of the interest rate market will be on hold for quite a while regardless of whatever the Fed does with its QE program.

***Last week Bloomberg had a story by Jim Brunsden, “EU CURBS on BANKS’ USE of CLIENT ASSETS as COLLATERAL.” The news out of the EU was that the European Commission was going to try to limit if not curtail the rehypothecation of collateral of clients assets by banks. When banks need capital, many time they will utilize a clients bonds as collateral to raise cash. It’s only a short-term need and the counterparty is also deemed to be sound. Unless you have a Lehman type event. “Uncertainty about who holds an asset can fuel panic in times of market stress,” according to the EU release. The new plan wouldn’t allow the reuse of client collateral without the owner’s consent. The use of this type of collateral is the backbone of cheaper repo financing and allows the shadow banking system to work. While the idea of limiting the daisy chain of collateral in the repo market is worth pursuing, it’s not a good idea at the present time.The European financial system is starved for capital and if the repo market is impeded it will cause another bout of credit contraction.

ECB President Mario Draghi must have been aware of this move by the EU COMMISSION, which is why he has put forward the need to create a more robust ABS (asset-backed security) market. If questionable loans to small- and medium-sized could be packaged into a marketable security and used as collateral with the ECB, then the effects of curtailing rehypothecation could be minimized. But timing this is going to be very difficult for the European policymakers. If the EU goes ahead with a non-rehypothecation agreement the BONDS will rally and European equities will come under great pressure for curtailing credit in a recession reminds Ben Bernanke of the FED and U.S.TREASURY in 1937.

***Tomorrow morning at 9:00 CST, the Bank of Canada will announce its interest rate intentions and economic outlook. I expect no change to the current 1.0% overnight rate. The Canadian DOLLAR has weakened against its U.S. counterpart so the BOC will be in no hurry to cut rates and allow the currency weakness to filter through the Canadian economy. This is also the last meeting of current Governor Mark Carney before he heads to the U.K. to become the Governor of the Bank of England. I would like to buy the Canadian Dollar on a sizeable selloff after the rate decision. For cash market participants, I would love to see a 1.05 level. As always, do your own technicals and be ready to act if the opportunity arises. Governor Carney leaves the Canadian economy in very sound shape relative to the other major, developed financial systems. The housing market is a little overextended but the Canadian authorities have been attempting to “taper” the extension of credit in real estate–sometimes a bubble can be spotted and deflated (macro prudential regulation anyone)?


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5 Responses to “Notes From Underground: The Markets Are Reacting to Rising Interst Rates, While Equities Continue to Roll On (And Fed Anticipates a Roll Off)”

  1. rudy koehler Says:

    Canada Rules?

    the Canadian authoriities tapering of housing market is just them pressing the undo button on changes they made over past decade.

    Our authorities took the rules and started relaxing them in a decde ago (25 to 40 yr amortization, 5% deposit etc versus 10-15%) and now we are just reverting back to the rules of the old days.

    Of course interest rates being so low does wind up driving up cost of housing stock were demand exceeds supply (2+2=?)

    It also helps that our tax laws due not allow for mortgage deductatily by home owners. No carrot here to overextend.

  2. Dustin L. Says:

    Yra- Do you have any recommended reading on understanding yield curves? Your blog is great for teaching about it but I thought you might also have some recommended sources one could take a look at as well. BTW, The Rotten Heart of Europe is absolutely superb!

  3. Dustin L. Says:

    Also, I found the comments made in the following article to be unusually blunt for a public statement and would seem an accurate reflection of just how heated the currency war is getting in SE Asia.

  4. yra harris Says:

    Dustin –will get back to you on the best sources and spread the word on the Rotten Heart

  5. yra harris Says:

    rudy–thanks for the additional view.You make the case even more—no bubble here we can’t deflate

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