Notes From Underground: You Will Learn To Live With Volatility

Last Wednesday, ECB President Mario Draghi warned the traders and investors in sovereign debt and other credit markets that great volatility would be the cornerstone of activity and the market would have to learn to deal with it. The problem with this scenario is, I believe, that the ECB is the progenitor of most of the violent price movement. Remember, the ECB QE program means that the Frankfurt bank has a great deal of fire power to move markets–to the tune of 60 billion euros ($72 billion) a month, which was close to what the FED was purchasing at the height of its QE program. Traders and investors have no heads-up as to when the ECB will be buying and therefore subject to being stopped out of trades at any time.

Yesterday, sovereign bond markets were crushed as sellers were bringing 10-year bunds back to some level of normalcy (the BUND yield rose to more than 1%). The financial news attributes every move to news about GREECE but from my trading seat that is pure nonsense. If it was a genuine reaction to Greek news then the European sovereigns would trade in a more rational way: Good news from Greece would have a more favorable impact on French and Italian bond futures while negative news would put a bid to the highest quality DEBT, German bunds, with a selloff in Italian 10-years, and, to a lesser extent, the FRENCH OATS. But that is not how the market trades: It is  all about ECB purchases. As Bill Gross and others opined last month, the BUNDS at a yield of 0.05% was ABSURD.

The recent assault on the sovereign debt markets has corrected some of the absurdity but without ECB support  some buyers are being very cautious, not wanting to catch the proverbial “falling piano.” Mario Draghi is probably content to allow German yields to approach some normalcy as that placates the critics of ECB policy within the German political establishment. The ABSURD low yields of May were creating a political headache for Merkel’s ruling coalition for the politically unaccountable ECB was repressing a nation of savers. Angst toward the ECB was going to be played out upon Chancellor Merkel’s CDU/CSU political base.

Mohamed El-Erian is correct in stating that global bond prices are being set in Frankfurt. The ECB has the financial wherewithal to destabilize markets on a minute-to-minute basis. The ECB‘s ability is enhanced by last week’s Couere speech to Brevan Howard clients. THE ECB CAN PLAY WITH THE MONTHLY QE NUMBERS TO TRY TO GUARANTEE OUTCOMES. IF NEED BE THE ECB COULD DECIDE TO SPEND JULY’S QE BUDGET IN JUNE. Yes, it’s all about learning to live, love and laugh with volatility. The only wish I have is for a cash line with the ECB like the European bond dealers.

***Yesterday, Bloomberg published a piece, “Axel Weber Tells Yellen, Draghi and Co: You’re Doing It Wrong.” Long-time readers of NOTES know that I have great respect for Axel Weber when I wrote a piece back in 2011 lamenting that Chancellor Merkel had failed to support Weber for the ECB Presidency and caved into then French President Nikolas Sarkozy’s push for Mario Draghi. The French were fearful of a notorious hard-money advocate, and a German, attaining the ECB Presidency. As usual, Weber  offers no diplomatic view. The Bloomberg article states: “Weber’s thesis is that the strategy, which focuses on hitting an arbitrary target for price increases in a selection of consumer goods,only views the monetary world with one eye. As a result, it ignores the kind of financial buildups in asset prices and indebtedness that caused the last meltdown.”

Further, Weber says: “CPI-focused monetary policy is distorting economic structures, blocking growth-enhancing creative destruction, creating moral hazard, and sowing the seeds for future instability and leads to excessively expansionary and asymmetric monetary policy.” Yes, Herr Weber is a proponent of monetarism in which money supply is an important element of sound monetary policy. He taught at the University of Chicago after his resignation from the ECB Executive Council and has softened his strictly money supply view to include monetary aggregates, credit, exchange rates and commodity prices to a successful approach to central bank policy.

The Weber analysis is important because it reflects on the view that CENTRAL BANK POLICY IS NOT ROCKET SCIENCE. There are many well researched views about effective qualitative monetary policy. The cult-like followers of the FED are a problem for financial stability. The amen-corner that appears on CNBC and other financial news outlets have a single mantra: Please, just keep the spigots open so the stock market can elevate on a wave of liquidity.

***The main argument in the financial markets is when will the FED move to raise interest rates off the zero floor. Many of the world’s best thinkers are locked in a battle trying to discern when the appropriate time to raise rates will be. The FED had muddied the discussion through its t-shirt promotion of its data dependent. The problem is the FED has the keys to the data computer and keeps changing the codes. Last week, Rick Santelli had Jim Bianco and Jeff Gundlach on for 10 minutes to discuss the bond markets and the recent volatility. Rick asked both guests, “Do you think the Fed will raise rates in 2015?” Both said NO and Rick added his NO so it was unanimous.

My views are that the FED will raise rates in July and this is based on a view that is not data dependent but rather procedural in nature. The FED needs to get the FUNDS RATE off of zero to 25 basis points so it can test its tools and get a better sense of how to remove excess bank reserves from the daily workings of monetary policy, besides solely relying on the Interest On Excess Reserves (IOER) rate. My belief is based on gaining some sense of how the financial plumbing will perform when the market has daily financing needs. The Fed has experimented with a QE program and needs to know how to extricate the excess reserves before they become the sort of problem that Axel Weber fears. There are many powerful and thoughtful voices on both sides of the discussion, but a particularly interesting one appeared in today’s Financial Times.

Brevan Howard Chief U.S. Economist Jason Cummins wrote a piece titled, “The Fed risks inflating another housing bubble.” It is interesting that the world’s prime BOND TRADER, not investor, is raising concerns about the Fed delaying too long to raise rates. Cummins closes with a warning to the Fed: “There are good macroeconomic reasons to stimulate aggregate demand through an interest-rate sensitive sector like housing.” In an effort to bring demand forward it does make economic sense because the multiplier effect from housing is the most powerful of all demand-stoking tools. But the risks are great  if the Fed remains too accommodative for too long.

It seems that Brevan Howard is in the camp of an early Fed move to remove the threat of a new housing crisis. Cummins added: “To delay normalization of interest rates is to risk repeating the mistake of the last business cycle, which was to create a house price bubble that overburdened many households.” Let discussion about the FED timetable continue and with these powerful voices on both sides of the argument. YOU MUST LEARN TO LIVE WITH VOLATILITY.

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15 Responses to “Notes From Underground: You Will Learn To Live With Volatility”

  1. arthur Says:

    Markets love volatility – Christine Lagarde.

  2. mikegre2014 Says:

    I also think they’ll raise rates before September, just to be done with it already.

  3. Alex Says:

    Volume + volatility = Good

    Lack of volume + volatility – Bad

    Lack of volume + summer markets + volatility = Very bad

    Seen a little bit too much of number 2 this week in FX. Hope that’s not a trend leading to a Devil’s market, number 3. In such a case, doesn’t matter how good you are, or your analysis, the market will probably get ya.

  4. Joe Says:

    It was once assumed traders loved volatility. Yes, back when they were able to stand within arms reach of an order filler.

  5. ShockedToFindGambling Says:

    Yra- I don’t understand why the FED has to raise the Fed Funds rate, before draining.

    The FED will give the banks bonds and get back cash. Why do you need Fed Funds higher to do this? The FED will have the cash.

    There is a shortage of Treasuries in the economy and an excess at the Fed, which draining will help to solve.

    Also by draining, they will be decreasing excess reserves and nudging Fed Funds higher, thereby getting the markets ready for the tightening.

    It seems to me the draining is the perfect move, before officially raising the Fed Funds rate.

    What am I missing?

  6. yra Says:

    shocked–as usual point on.The problem is the Fed does not wish to shrink its balance sheet which is why the excess reserves are left in the system.If they would shrink the balance sheet first you wouldn’t need to raise the rate off the zero floor but the Fed seems fearful of selling bonds in the market for the damage they may do to the long end which is why we have to watch the curves.I BELIEVE from my experiences that if the FED raised rates the long end would stabilize and the curves would flatten which would aid the Fed but they are too fearful of testing this and I know my opinion is different then Gundlach and others–but let the test begin and as usual your question and point is well taken

  7. ShockedToFindGambling Says:


    The FED could drain, selling T-Notes in the 2-7 year range, which should flatten the curve, both by the note sale and the drain. This should stabilize the long end, at least on a relative basis.

    The FED seems afraid to do anything. They say the economy is strengthening, but don’t act like it.

    We are over 6 years into the recovery. By the time they tighten, we will likely be on the brink of the next recession.

  8. kevinwaspi Says:

    You raise a good point, one that is supported by the current holdings of treasury securities by the fed. As per Table #2 of the most recent Fed Condition statement H.4.1 (see ) treasury holdings with final maturities between 1-5 years total $1.1 T. That said, I point out that another $586 B are in 5-10 year, and over $644 B are “over 10 years”. If I were a bank, and began selling my 1-5 year holdings with any vigor in the current rate environment, WITH THE OBJECTIVE of raising rates, the “value at risk” due to my concentration (and growing proportion) of holdings in the 10+ year bucket would make my regulator scream with horror. This does not include the additional $1.7 T in MBS on the balance sheet with end maturities in the “over 10 year” category. My regulator should certainly question my sanity, or at the very least, ask me where the soon to be needed addition to capital was going to come from!

    Of course, we all know that the Fed is not a bank, and that they have no regulator. Problem solved.

  9. ShockedToFindGambling Says:


    Thanks. I didn’t know what breakdown of Treasuries at the FED was.

    BTW, most 30 year MBS are considered to perform about like 10 Year Treasury Notes, due to prepayments. If rates go up a lot, they perform more like 20 Year bonds (fewer people prepay and the maturity extends). If rates go down a lot, most people refi and the bonds mostly disappear.

    As you point out, if long rates go up a lot, the FED will have huge mark to market losses on their Long Treasuries and MBS.

    I don’t know if that matters to the FED.

    • kevinwaspi Says:

      Yes, you are right about MBS and their behavior with interest rate changes. From the perspective of the holder, these have always been the ultimate in the “heads I lose, tails I lose” proposition. The “negative convexity” these animals exhibit when rates move has always made them one of the least attractive investables to my way of looking at them, especially given the yield spread to treasuries they trade at. Lastly, in terms of price volatility, regardless of the security, we all know that duration of any security Maximizes with lower starting yields, everything else equal. In conclusion, the last thing I’d want to own when rates are at record lows and expected to rise would be MBS, but again, you’re right, what does that matter to the fed!

  10. yra Says:

    To All:Great additions to the blog and helps create one of the most informative real time analysis of the market.Politics are to be analyzed for potential market impact otherwise left to the bar stools and a shot and beer.Thanks for all the input and Shocked you will soon get an answer to your previous thoughts–it will come out of my recent re-reading of Irving Fisher

  11. Chicken Says:

    Would that be more of the same road kill bull flattener returning, they’ve been pretty much run over lately. Wow, 10 year rates sure were low……

  12. Dan DeRose Jr Says:

    Yra and co., In addition to not shrinking the balance sheet, the Fed doesn’t want to startle the narrative just yet. If they were to say they’re selling, there would be no small amount of havoc across the yield curve. That said, if they just use reverse repos to drain the carbon copy of their own QE ops, no one will be the wiser (curves flatten, long end should remain calm).

    Heck, maybe this whole endeavor has been more effective as a duration black hole than a wealth stimulator.

  13. arthur Says:

    FYI: Market Opinion

  14. Joe Says:

    Fed’s Toolkit Debate More Interesting Than ‘Power Play’:Barclays
    2015-06-12 15:43:36.496 GMT

    By Alexandra Harris
         (Bloomberg) — Fed’s decisions about to “deploy its
    existing toolkit” are “far more interesting than the power-
    play debate,” Barclays strategist Joseph Abate writes in note.

      * Most effective approach is using both IOER, RRP together,
        “like the blades of a scissor”
        * Requires setting wide enough spread to encourage bank
          arbitrage trading; might even require removing O/N RRP
          cap upon liftoff
      * NOTE: Idea presented in June 9 WSJ editorial, “Misreading
        the Fed on a Rate Increase,” suggests that a disagreement
        between FOMC and Board of Governors over who sets rates
        could prevent them from hike

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