Are Money Markets Warning Of An Unknown Unknown?

Regular readers know that we don't merely look at traditional assets when analyzing the broader market. In our current state of much higher than average volatility of volatilitythings are definitely not the way them seem on the surface.

It has been deftly espoused that there are two types of unknowns - known unknowns and unknown unknowns.
— Business Of Finance

The rosy portrait traditional markets paint are deceptive in the prospect that they lead participants to believe that lackluster trends will continue persisting, albeit in a "muddle through" manner.

We've spoken at large about how less followed markets have conventionally signaled, for lack of a better term, directional changes of a broader latitude. Such markets include the volatility markets, where looking at a particular spectrum of volatility can yield what the naked eye doesn't see.

An adept understanding of what drives risk flows will further help us in confidently maneuvering in bogged down wasteland, where you never really know what will greet you at the next turnThe retail trader, as odd as it may seem, has never need less equipped to deal with this type of situation.

Different Unknowns

7 years of zero interest rates have distorted markets and their pricing engines on an unimaginable scale. Models that price risk, and dictate where billions of dollars flow into on a daily basis have been so badly screwed by artificially suppressed borrowing costs that a positive shock to the system knows no bounds.
— Business Of Finance

It has been deftly espoused that there are two types of unknowns - known unknowns and unknown unknowns. And because risk is most commonly associated with uncertainty (i.e. unknowns), there are some risks that can never be completely hedged against - unknown risks.

Putting things in the present scenario of a market held hostage by none other than the Federal Reserve, we can begin to appreciate the  analogy of unknown unknowns. We know that the golden question is of a Fed liftoff. Uncertainties that branch off include the magnitude of such a rate hike, and the timing of which. These are known unknowns - uncertainties that we know are present, but that of which we don't know the outcome.

The insidiousness gamut is what comes after. Welcome to the game of unknown unknownsWhat happens when the Fed takes its 7-year long foothold in zero bound interest rates? How would markets react as a direct consequence, and the filter down effects higher rates would have on the U.S. and global economy. As they say, when a butterfly flaps it wings in Florence, a cyclone brews in Hawaii.

It not just us that are feeling this way. The comprehension that you're dealing with a risk that hasn't been as difficult to both quantify and qualify since the onset of the 2008 Global Financial Crisis. Numerous financial markets seem to be indicating the same thing too.

Watching The World's Largest Market

 Eurodollar futures for delivery in June 2018 (28 months out) have been on a stead uptrend since June 2015, indicating that the Eurodollar deposit rate (short term interbank outside USD) has been sliding despite talks of a Fed liftoff.  Chart courtesy of Alhambra Investment Partners

Eurodollar futures for delivery in June 2018 (28 months out) have been on a stead uptrend since June 2015, indicating that the Eurodollar deposit rate (short term interbank outside USD) has been sliding despite talks of a Fed liftoff.

Chart courtesy of Alhambra Investment Partners

 This graph plot shows 9 futures contracts from the front month onwards at different dates. The plot depicts the leveling off on Eurodollar prices as we head out from the front month, which might indicate a weakening recovery (macro wise).  Chart courtesy of Alhambra Investment Partners

This graph plot shows 9 futures contracts from the front month onwards at different dates. The plot depicts the leveling off on Eurodollar prices as we head out from the front month, which might indicate a weakening recovery (macro wise).

Chart courtesy of Alhambra Investment Partners

Besides the volatility markets, which we have already expressed our views on, something very queer is happening in the U.S. dollar money markets. By money markets, we're specifically referring to interest rate swaps, repurchase agreements, and Eurodollars.

This may sound German to many of our readers but understand that most big banks and financial institutions, entities that have the firepower to move entire markets at their will, the money markets are by far the most instrumental market to their fluid operation.

Liquidity as they say, is plentiful when you don't need it and scarce when everyone wants it. Think of the money markets like a diving pool. The deeper the pool, the higher up you can take a leap from.

Would you dare take a jump into a child's pool from a 10-meter high spring board? Hell no, because you'll probably end up with a disabled lower half. Diving athletes however routinely take plunges into Olympic-styled pools with no issues. That's because they have 3 meters of liquid which allows their bodies to rapidly decelerate without any terminal impact.

The money markets are to banks and financial institutions like diving pools are to professional divers. In a healthy construct, we always want a good amount of liquidity in the world's money markets. Well, at least in the U.S. dollar and euro markets. Short term funding has been cheapened for most entities rated above investment grade, courtesy of years of ZIRP (zero interest rate policy).

Sexy Swaps

In the corporate and interbank funding markets, there exists an financial derivative for counter-parties to transfer risks they don't wish to bear entirely. Welcome to the world of swaps. Swaps are basically agreements between two parties to exchange cash flows for a price (usually known as the swap basis). There are many forms of swaps, but we are referring to interest rate swaps in this piece.

Interest rate swaps allow holders of fixed rate debt securities (usually bonds) to swap cash flows with a counter-party. Within a fixed-for-floating swap agreement, the initiator pays a fixed rate on a notional value, and receives a floating rate plus a spread (usually LIBOR + spread, for USD funding markets).
 Spreads of U.S. dollar swap over their respective treasury maturities have traded in abnormally low levels since 2008 after the bankruptcy of Lehman Brothers. The 30-year swap spread has been negative for almost the entirety of 7 years. The 10-year swap spread recently went negative after doing so 3 times in 2010, making this one of only 4 times since Lehman that 10-year swap spreads have trade under zero. The 5-year swap spread is also on the brink of being negative.  Chart courtesy of Zero Hedge

Spreads of U.S. dollar swap over their respective treasury maturities have traded in abnormally low levels since 2008 after the bankruptcy of Lehman Brothers. The 30-year swap spread has been negative for almost the entirety of 7 years. The 10-year swap spread recently went negative after doing so 3 times in 2010, making this one of only 4 times since Lehman that 10-year swap spreads have trade under zero. The 5-year swap spread is also on the brink of being negative.

Chart courtesy of Zero Hedge

You can see how interest rate swaps can be used to mitigate risk large corporations, banks, and financial institutions may face. When borrowing costs are expected to rise, probably inline with the current consensus amongst corporates, there is a heightened impetus to hedge against rising interest rates (and the associated double whammy stemming from widening credit spreads in a tightening cycle). Corporate borrowers will engage in fixed-for-floating swaps with dealers to essentially pay today's rate for any debt issuance in the future (where rates are expected to be higher).

 A truncated view since mid-2014 of the gradual down trend in both the 5-year and 10-year swap spread.  Chart courtesy of Alhambra Investment Partners

A truncated view since mid-2014 of the gradual down trend in both the 5-year and 10-year swap spread.

Chart courtesy of Alhambra Investment Partners

Swaps are also a cost effective way for banks and hedge funds to speculate on both the directionality and convexities of interest rates (treasury yields). To appreciate this point, the Bank Of International Settlements (BIS) estimated the total outstanding notional amount on interest rate swaps to be $381trn (December 2014), with a marketable value or $14trn! Interest rate swaps make up the single largest share of the global OTC derivatives pie, so understand that we're dealing with a market that is in the league of trillions.

The correlation between swap spreads and liquidity at dealers is usually positive. We frequently monitor swap spreads because they are perhaps singlehandedly the most comprehensive barometer of stress in the world's largest funding market.

A swap spread is the spread (difference) between what the fixed rate payer (of the swap) pays for receiving floating, and the prevailing yield of a U.S. treasury of equal tenure as the swap.
 A truncated view of the 2-year swap spread showing spreads taking a dive after the August FOMC event which signaled a more hawkish than dovish slant on the an eventual liftoff on the Fed Funds rate. To be noted, the 2-year swap spread has never been negative post Lehman. At least not yet.   Chart courtesy of Alhambra Investment Partners

A truncated view of the 2-year swap spread showing spreads taking a dive after the August FOMC event which signaled a more hawkish than dovish slant on the an eventual liftoff on the Fed Funds rate. To be noted, the 2-year swap spread has never been negative post Lehman. At least not yet. 

Chart courtesy of Alhambra Investment Partners

Quite a mouthful but it is crucial that we understand this before we make our analysis. Lower spreads generally mean that banks are willing to swap fixed-for-floating rates for cheaper, which might signify ample liquidity in the interbank funding markets which is usually synonymous with a recovering banking sector. Higher spreads often denote the opposite.

Swap spreads have a tendency to stray far off from their 5-year averages but they almost never go negative. A positive swap spread is to finance like gravity is to physics; it's almost a law of finance that swap spreads must be positive because it is extremely unlikely that the risk of lending to the U.S. government can exceed the risk of leading to a corporation credit rated at IG.

A "Perverted" Market

 A detailed view at the daily resolution of the 2-year and 10-year swap spread. Swap spreads started breaking out to the downside from their respective ranges in August and remains in a down trend.   Chart courtesy of Bloomberg

A detailed view at the daily resolution of the 2-year and 10-year swap spread. Swap spreads started breaking out to the downside from their respective ranges in August and remains in a down trend. 

Chart courtesy of Bloomberg

But rules are to be broken. Earlier last week, the 10-year swap spread went negative for the first time since 2010, making this one of the only 4 occasions since 2007 that spreads have defined financial gravity. The 5-year swap spread is on the verge of being negative, which if happens would make it the first ever in history. Mainstream financial media have branded this as "perverted" for obvious reasons.

Post Lehman, the combination of a secular bear market in yields, deleveraging across the financial industry, and the introduction of new interest rate dynamics have caused swap spreads to trade at historically abnormal levels. The 30-year swap spread for instance has been negative since 3Q08 and has never popped above zero since. So, this phenomenon is both convoluted and acceptable at the same time.

 Another possible reason for low to negative swap spreads in recent times might be a record holders of U.S. treasuries at dealers, surpassing $900bn in September. When dealers have this much stock in hand, the supply of fixed-for-floating offers suppresses swap spreads, even though there might have not been a surge in demand from hedgers. This, in a sense, can be deemed a supply pushed rather than a demand pulled issue.  Chart courtesy of Bloomberg

Another possible reason for low to negative swap spreads in recent times might be a record holders of U.S. treasuries at dealers, surpassing $900bn in September. When dealers have this much stock in hand, the supply of fixed-for-floating offers suppresses swap spreads, even though there might have not been a surge in demand from hedgers. This, in a sense, can be deemed a supply pushed rather than a demand pulled issue.

Chart courtesy of Bloomberg

But is there more to negative swap spreads? When taken in isolation, it doesn't seem to raise too many eyebrows. However, when put in context of the macro environment and in conjunction of price action seen in other markets, there has to be more. For this, we turn to the good people over at Alhambra Investment Partners. We agree with all of their points, and could not have said it better ourselves.

The take away condensation for readers would be to prepare for unknown unknowns, as we mentioned in the onset. 7 years of zero interest rates have distorted markets and their pricing engines on an unimaginable scale. Models that price risk, and dictate where billions of dollars flow into on a daily basis have been so badly screwed by artificially suppressed borrowing costs that a positive shock to the system knows no bounds.

Plainly said, we don't know what to expect. You can't hedge a risk you haven't yet seen. Be cautious!

Ignore Swap Spreads At Your Own Peril

By Alhambra Investment Partners:

"The theme since August 24 in wholesale funding, eurodollar and Asian “dollar”, has been that even the global and intense liquidation was not enough to square the mighty imbalance that has been building. It’s a frightening prospect, but in money markets everywhere that is the only interpretation left. The media, unable to make heads or tails, finds small nuggets of accounts that seem to fit actual events while most importantly preserving the idea the “dollar” world hasn’t endured in the middle of almost open chaos. That last part “can’t” be because the Fed and economists keep saying it is impossible.
First, some relevant history. The interest rate swap rate is quoted as the counterparty paying fixed to receive some floating (usually tied to LIBOR, which is why eurodollar futures are entangled). Since there is credit risk involved in counterparties, it had always been assumed that the swap rate would have to trade above the relevant UST rate since the US government is assumed to be without it. That all changed during the panic in 2008.
October 23, 2008, was an unusual day in credit markets even within a vast sea of unusual days. Credit and “exotics” desks at banks were left scrambling to figure out how it was possible that the 30-year swap rate could trade less than the 30-year treasury. It was thought one of those immutable laws of finance that no such might occur, to the point there were stories (apocryphal or not, the tale is about the scale of disbelief) that some trading machines were never programmed to accept a negative swap spread input. The surface tension about such things was decoded under the typical generalities that stand for analysis; if the 30-year swap spread was negative that might suggest the “market” thinking about a bankrupt US government.
A negative swap spread on its surface seems to indicate that the “market” views counterparty risk as less than risk of investing in the same maturity UST. That was never the case, however, as bank balance sheet capacity was simply collapsing leading to all sorts of irregularities; thus the problem of mainstream interpretations that stay close to the surface rather than recognize the wholesale origin (chaos and disorder) beneath. On the basis a comprehensive view of the 30-year swap spread, the sea of illiquidity is brightly and fully illuminated as once more “dollar waves” crashing the global financial system – the second much more devastating than the first.
Worse, as you can see plainly above, there was a third “dollar” wave that started in early to mid-January 2009 well after TARP, ZIRP and even QE1 (once more dispelling any heroics on the part of economists at the Fed who still had no idea what to do), accounting for the final crash to the March lows.
So you can begin to fill out the broad picture as October 2008 wore on, even though the worst of the broader market panic seemed to have been left behind. The demand for fixed side hedging was only increasing as the money dealers were both withdrawing and being unwritten in their assumed steadiness (not just ratings downgrades but very visible capital deficiencies and worse in terms of extrapolations at that moment). It was in every sense a rerun of the credit default swap reversal that had nearly brought it all down in March 2008 and then again with Lehman, Wachovia and, of course, AIG that September. In short, the “buy side” was in desperation for more hedging lest their portfolios and leverage employments tend too far uncovered while the dealers were in no position to supply it; desperate demand and no supply means prices adjust quite severely, which in this case pushed the swap rate, the quoted fixed part, below the UST rate for the first time ever (not that the swap rate history was all that long by then).
One main point of emphasis for that column was that every time this occurred thereafter there was a mainstream attempt to dismiss it while simply assuming some benign explanation dutifully quoting the usual “fixed income trader.” When swap spreads turned negative again in early 2010, for example, media stories of corporate fixed income volume filled the space to assure that all was still quite well; obviously it wasn’t given what happened not long after. Loyally replaying that very same tendency, earlier this year we received the same bland message, “ignore the turn in swaps because it’s just fixed income being more normal.”
Any actual catalog of swap spreads, especially since the “dollar” began “rising”, shows that to be utterly false. There is nothing at all benign about negative spreads, especially now, after August 24, where they are still sinking in every maturity.
It isn’t just the 30s, again, as this sinking has infected even the benchmark 10s and further up into the short end maturities (while the spread of spreads, 10s minus 5s, continues to expand).
In what might be the most conclusive indication of illiquidity in the entire spectrum of them, and the most troubling, the compression in swap spreads could not be more clear in terms of interpretation at the 2s.
Either corporate issuers suddenly decided that the week after August 19 was the perfect time to issue at maximum (because companies always float more debt during global liquidations?), or dealer capacity was so strained that it broke open all the way down to the 2-year maturity in swaps. And the truly disturbing part, again, where all the very dark interpretations lie, is what has occurred thereafter, namely that spreads are still decompressing everywhere more than a month afterward. Either companies are going nuts at worse spreads and prices (think leveraged loan prices and even AAA-spreads) or dealer-driven liquidity is seriously and durably impaired.
In that view, the eurodollar curve is confirmed as are junk bubble prices and even stocks that can’t seem to gain any footing in the aftermath (though, we are told repeatedly, they “should” have). You can only claim this is “normalizing” behavior if you accept that “normal” is the eurodollar decay and that illiquidity is the actual base condition; which it is proving to be as QE fantasy is the aberration.
Heading toward the quarter end, this should be quite concerning rather than, like LIBOR, ignored or rationalized yet again as if it were welcome and expected."