Notes From Underground: The OATS Prove a Better Sale

In late April I wrote a blog post titled, “Why Bill Gross Is Right and Wrong.” I noted that Bill Gross’s call on selling German bunds was inherently correct but the French OATS–the French 10-year note, would be the more profitable sale. The yield differential at the time was 23 basis points but with the news out of Europe on Friday, the differential widened to 38 basis points. The area of concern for me is that with Germany maintaining twin surpluses–trade and budget–the ECB QE program would enhance the demand for German assets in a world of diminishing supply. The French budget and current account deficits, as well as a trade deficit, means the underlying fundamentals of the French economy are much weaker than Germany’s.

The purpose of revisiting the call is not to boast but merely point out the need for creative thought, not just the crunching of numbers. The action in the European sovereign debt market on Friday was driven by the fundamentals of fear due to the Greeks finally coming to a “final solution” on its situation with the three major creditors. The market action was just as expected as the best sovereign credit in Europe, Germany, was the bond of choice for European investors. Further, it appears as if the ECB did little QE buying as it wanted to allow the volatility to play out and let he market suffer its losses–more of Mario Draghi’s, GET USED TO IT. It will be a difficult market this summer as traders have to be forever vigilante about the battle between fundamentals and potential ECB purchases, which will provide support to any bond selloff.

The market action on Friday was complicated by the late rally in the currency markets as the DOLLAR was sold, despite stronger retail sales data. Also, German Chancellor Merkel noted that the recent EURO strength was not beneficial for Spain and Ireland (she conveniently forgot Italy and France). This is the second time in a week we have had a major world leader discuss currency values so it puts to rest any nonsense from the G-7 or G-20 about no currency intervention.

***I want to respond to regular commenter Shocked To Find Gambling’s remarks on the June 3 blog post about the Fed’s policies and its effect upon the entire economy. Shocked believes that is important for the FED to raise rates regardless of the impact on bond markets. Shocked enumerates eight points of beneficial outcomes if the FED were to actually raise rates. Bottom line is that Shocked believes raising the fed funds rate would restore a sense of the “free market” being the arbiter of the cost of credit.

I WOULD LIKE THE FED TO RESTORE THE MARKET MECHANISM to the pricing of credit but the FED is terrified of returning the bond markets to domination. Academics seeking to prove the correctness of their models and theories have wreaked havoc throughout history. How much blood and treasure have been spent promoting the theoretical constructs of the self-anointed philosopher kings? The FED may desire to end the Great EXPERIMENT but it just isn’t certain how. The simultaneous use of its IOER and O/N RRP tools seems to be the desired approach but the FED FUNDS will have to be lifted off the zero bound.

During the past two years there have been comments about the need for the FED to sell some of its Treasuries and drain some of the excess reserves. Ben Bernanke opined that the FED could just hold all of its assets until the redemption date. The FED clips coupons and gives its interest earnings back to the U.S. Treasury so theoretically there is no need to be in a hurry to sell off the balance sheet. I always thought the Bernanke view of maintaining a large balance sheet and remitting the interest earnings back to the Treasury seemed like a perpetual money machine.

In The Money Illusion by Irving Fisher, he notes the same point in his view on how the U.S. Treasury acted to finance WWI.

“I remember once, when taking part in a speaking tour to help raise money for Liberty Loans, that a fellow speaker, a clergyman not versed in economics, appealed to his audience as follows: Lend money to Uncle Sam! That is, Buy Liberty Bonds. If you haven’t any money to buy bonds with, go to your bank and borrow it. If the bank asks for security, tell them you’ll let it have the bonds you buy with the money they lend you. It’s like perpetual motion.”

Entering the realm of QE was easy. Exiting will be another story. Can you imagine Chair Yellen telling U.S. investors that they will have to learn to live with the volatility? Maybe at Wednesday’s press conference.

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3 Responses to “Notes From Underground: The OATS Prove a Better Sale”

  1. nwwindwatcher Says:

    It is a perpetual money machine for Treasury, until the Fed lets their balance sheet roll off. In FY 2014, the Fed’s Deposit of Earnings or Rebate to Treasury was 31% of Corporate Income Tax receipts. The $99.2B in rebate to Treasury was greater than the combined corporate taxes paid by the USA’s 7 largest corporate taxpayers, Exxon, Chevron, Apple, Wells Fargo, JPM, WalMart and Conoco. The threatened increase in Fed Funds will impact Interest Expense to Treasury as is widely discussed. But how will Treasury replace the revenue equivalent of the 7 largest Corporate taxpayers as QE rolls off?

  2. asherz Says:

    In order to keep some semblance of credibility, the Fed will have to have a token rate increase, .25 a one and done or .50, a two and a drop of the second shoe. But that’s it as their third mandate is to keep the equity and bond markets buoyant. Allowing rates to be determined by the markets would bring devastation to the recipients of the tens of trillions in new debt issued since 2008, and chaos to our national budget with over $18 trillion requiring debt service. Central Banks with their heretofore untried experimentation have caused global malinvestment in unprecedrnted amounts. They are between the proverbial rock and hard place. Greece is only the first crack in the Tower of Babel that has reached the skies. As a well known wag has been saying for the last few years, “There are no more markets, just interventions.” It was fun while it lasted, but at some point the musicians get tired, the music stops and the dancers collapse.

  3. ShockedToFindGambling Says:

    Yra- Good post.Thanks for commenting on my Propaganda.

    To clarify a bit, I believe that current FED ZIRP is deflationary……

    1) No one fully trusts the economy, because of ZIRP/QE. Everyone, including the FED, thinks that there is at least some chance the economy will collapse when the FED starts tightening and draining. This is holding back spending and investment by people and companies.

    2) At this point in the business cycle, the interest income lost by savers is a bigger drag on the economy, than the interest expense saved by borrowers, is a spur to growth. Borrowers have had years to refinance their, businesses, houses, cars, so the incremental advantage of ZIRP for borrowers is declining.

    3) The interest income lost to savers is immediate and cannot be made back in the future. ZIRP helps to load up consumers with debt, weakens their balance sheets, and steals from future consumer sales.

    I do not believe that anyone is capable of timing a tightening under the current economic conditions. The FED is as likely to tighten just as a new recession is beginning, as at some other point in the business cycle, especially 6 years into the recovery.

    Therefore, I think the FED should let the Fed Funds rate freely float, and let the market allocate credit based on real-time supply and demand (after fixing the problem with excess reserves).

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