Notes From Underground: TOTO Is Out of Kansas and Back In Washington

Will TOTO bite the wizard behind the curtain? Toto, in this case, is not Dorothy’s dog but rather the market’s obsession with taper on/taper off, or TOTO. Today’s trading proved to be a “ball of confusion” as the market emerged from a relatively quiet weekend to open in a taper off mode as the bonds and equities were bid. The currency markets were relatively quiet as were the precious metals. Mid-morning, though, the long end of the Treasury curve began to sell off and the yield curve went from a flattening bias to steepening, which seemed to represent the market adopting a taper on bias. However, the currency and precious metals markets reacted contra to previous correlations and rallied as the yields on the long-end of the curve rose. (Again, very confusing in regards to recent patterns.) The BONDS closed toward the lows but the metals and equities held their rallies, which leads me to believe that the market has adapted to the idea of a Fed tapering being tied to a change in the language of forward guidance.

If the language is changed by the FED to imply a lower threshold on the unemployment level, a further steepening of the curve will take place and this will not harm risk assets until the long end gets to a price that prevents borrowing for autos and homes. BUT, if the curve steepens dramatically, banks and mortgage lenders will ramp up the use of ARMS (adjustable rate mortgages). Also, most auto loans are for five years or less and will not be greatly impacted if the yield curve on the front end stays well anchored. Today’s market action certainly paid homage to the power of forward guidance and the Fed’s verbal desires to maintain short-term interest rates at the zero bound. But the confusion in today’s price action across the entire global asset class is a harbinger of  the volatility that awaits the markets after the FOMC statement and the Bernanke press conference on Wednesday. Oh yes, and these are thin holiday markets.

***I promised some perspective of where we are in terms of the Fed’s impact on the debt markets since QE2 and QE3 were announced.

QE2 (announced Nov. 3, 2010): The 5-year note opened at 1.15% and closed at 1.10%. The 10-year note opened at 2.58% and closed at 2.57%. The 30-year bond opened at 3.92% and closed at 4.03%. The 10/30 curve steepened dramatically on the QE announcement as the markets feared the Fed’s ability to creat inflation and thus bought the shorter end of the curve.

QE3 (announced Sept. 13, 2012): The 5-year note opened at 0.68% and closed at 0.64%. The 10-year note opened at 1.75% and closed at 1.72%. The 30-year bond opened at 2.91% and closed at 2.93%. Similar to QE2, the announcement was determined to be a negative for the longest end of the curve.

As of Dec. 16, the 5-year note opened at 1.52%, the 10-year opened at 2.86% and the 30-year bond opened at 3.86%. Since the beginning of QE3 and its subsequent purchase announcement of $85 billion in assets a month, interest rates have risen sharply. The market has already tightened for the FED so Chairman Bernanke meets the markets’ price action and officially begin the tapering. It is important to note that the Fed’s QE3 program began on the heels of the major problems in Europe and followed on the actions of the ECB ‘s promise to do whatever it takes, which is a big piece of why rates were so incredibly low when QE3 began. As interest rates along the yield curve have risen, the S&Ps have gained a “mere” 23 percent in the face of rising yields. Now that is the Wizardry of the Fed. So what happened to TOTO?

***Europe, yes we will always have Paris. The bulls have crowded into the European financial stocks as they are deemed to be very undervalued relative to the U.S. asset class.News about the European economy continues to be mixed as the peripherals “improve,” Germany remains solid and France cannot get any “SATISTRACTION.” The French economy continues to struggle and today’s PMI services and manufacturing data were horrendous. The French economy is a “DRAG ON EUROPE AND IT IS GETTING OLD.” The problem with the sputtering economy is that the French banks own so much sovereign debt and any downgrade to the French credit rating could have a very negative effect on the lending ability of French institutions. In addition to the bad news from France was the release of a study by the European Banking Authority (EBA) detailing the increase in the sovereign bond holdings of EU domestic banks.

In the FT story, “Eurozone Sovereign Bondholdings Rise,” banking editor Patrick Jenkins reports that “new data published on Monday by the EBA revealed that the proportion of EU sovereign bonds owned by domestic banks had edged up from 64 percent three years ago to 66 percent at the end of June. BUT IN THE WEAKER EUROZONE COUNTRIES THE RATIO JUMPED DRAMATICALLY,TO AS MUCH AS 99 PERCENT” (emphasis mine). There is now a tightly wound feedback loop between the banks and the sovereigns and this now means that the ECB will be bailing out the sovereign governments if they are forced to bail out the banks. Which is in contravention of European Union law.

Also, and of great importance, banks do not have to hold capital against sovereign debt because under Basel regulations, sovereign debt has been classed as risk free. The Germans are right to rebuff efforts for a banking union that brings with it legacy debts. If the European stress tests are at all legitimate, there will have to be a massive capital raise for the European domestic banks. THIS IS A VERY DANGEROUS SITUATION. I wonder if Europe’s biggest bank is going to be blown away and land on Bundesbank President Jens Weidmann. Did anyone see TOTO?


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4 Responses to “Notes From Underground: TOTO Is Out of Kansas and Back In Washington”

  1. hershel h herrendorf Says:

    Hi Yra,  we need to catch up………. Im in Miami, when do you have some time…… talk happy holidays   Hershel H Herrendorf

    786 463 1133   Florida

  2. arthur Says:

    Gold’s resurgence may require a moment when central banks explicitly agree to a higher inflation target or when they declare that inflation is now subordinate to their unemployment mandate. That moment may yet come.

  3. yra Says:

    Arthur–I agree totally–hence the focus on the steepener

  4. Chicken Says:

    Most excellent yra, glorious plate of meat and potatoes!

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