The Market Radar

We anticipate, monitor, and comment on market moving global economic and geopolitical issues.  No dark side brooding, no wanting the world to end, no political rants.  Traders, investors, policymakers, or market observers can’t  afford to ignore us.

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French Oat-German Bund 10-year Spread

The Oat-Bund spread came in 8 bps last week probably on the back of a new poll showing the centrist. Emmanuel Macron, gaining ground.

Macron is opening it up in second round polling, 30 points ahead of Le Pen,  but 43 percent of French still are undecided.  W-T-F?

A Le Pen victory, though far behind in second round polling, poses an existential threat to modern Europe.   A low probability, but high impact event.   And probably why Euro stocks have really not taken off even as the economies improve and populism on the continent seems to be receding.


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US Sector ETF Performance – March 24

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Global Risk Monitor – March 24

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A Few Thoughts On Why Health Care Went Down

OK, comrades, let’s check our partisanship at the door and deal with some real analysis on the health care bill that just went down in flames.

Here are a few of our thoughts on why the Trump/Ryan healthcare bill to repeal and replace Obamacare went down and some economics behind it.  We covet your comments.

1)  Most important, the bill had no support throughout the country.   The latest poll released Thursday afternoon showed that only 17 percent of the country supported the plan.

The Quinnipiac University poll, released Thursday afternoon, shows fewer than one-in-five voters, 17 percent, approve of the Republican plan to replace Obamacare. The majority, 56 percent, disapprove, with slightly more than a quarter, 26 percent, undecided on the proposal.- Politico

2)  Ceteris Paribus (all other things equal) doesn’t hold in negotiations.  Almost every concession Trump/Ryan made to the hard-right Freedom Caucus resulted in a loss of moderate Republicans, such as the Tuesday Group.   The last straw seemed to be the gutting of the services provided by a typical insurance policy.

House Republicans leaders promised hard-right conservatives yet another concession on the health care bill on Wednesday, but it has already lost key support from House moderates and may seriously endanger their chances of getting the bill through the Senate. Ahead of the vote on Thursday, GOP leaders said the Senate would gut Obamacare’s Essential Health Benefits rule after the House passes the American Health Care Act.

That rule requires insurance plans to cover a basic minimum of health care services. These benefits include maternity and newborn care, pediatric care, emergency services, substance abuse treatment, and prescription drugs. Organizations representing 400,000 doctors wrote a letter to Congressional leaders earlier this year asking them to keep these requirements in a replacement of Obamacare. – Think Progress.

3) The legislation was a “corner solution.”   That is,  it only had the support of Republicans and was not a nonpartisan bill.  President Trump sounds like he has learned through this process that the country wants affordable health care for all and will reach out to Democrats on the next iteration.  This should neuter the Freedom Caucus in blocking the next bill.

4) Bad numbers.  The CBO’s estimate that 24 million would be kicked off health care and 14 million next year, in an election year, was devastating.

CBO and JCT estimate that, in 2018, 14 million more people would be uninsured under the legislation than under current law. Most of that increase would stem from repealing the penalties associated with the individual mandate. Some of those people would choose not to have insurance because they chose to be covered by insurance under current law only to avoid paying the penalties, and some people would forgo insurance in response to higher premiums.  – CBO

5)  Conservatives complained health care premiums did not come down enough.  Bingo!   There are many other reasons health insurance premiums are rising rather than just Obamacare.  Premiums were skyrocketing before Obamacare.  We know firsthand.  Second, the simple demographic dynamics of the U.S. of an aging population are a fundamental reason why insurance costs are rising.  The pool of insured is getting older and hence the higher costs.  This is the whole philosophical basis behind Medicare — older folks are priced out the insurance market and need government subsidies.

6) Bad economics.   The health care act would have had a deleterious economic impact.  The Achilles heel of the economy is the disparity in the distribution of income and wealth, probably at its worst in the nation’s history.  If you provide relief to the higher income groups, who have much lower marginal propensities to consume and tax the lower income groups through higher healthcare costs, who have higher marginal propensities to consume, economic activity is depressed.

the American Health Care Act, and the results are not pretty. An $883 billion tax cut, $274 billion of it going to the richest 2%. $880 billion stripped from Medicaid. And 24 million fewer insured individuals over the next ten years. – Forbes

That is is kind of mean, no?

7) The bill was rushed.  It should have been debated and tweaked through the normal committee process and will in the next iteration, which will need 60 votes in the Senate. Therefore a bipartisan bill.

8) The Upshot.  Aside from the Freedom Caucus, we believe the American government, Republicans, in particular,  have learned from this political disaster, the large majority of the country wants universal affordable health care and the next bill will be one to repair Obamacare.  This marks a philosophical win for President Obama.

How will the loss affect President Trump’s agenda going forward?   Not positive, but hard to assess its lasting impact.  He is definitely weakened politically, however.   Will the Freedom Caucus now feel more emboldened to block tax reform if it adds to the budget deficit?    This keeps the disastrous Border Tax Adjustment (BAT) in play, which is tantamount to the government playing Dr. Frankenstien with the U.S. economy.

We did warn last month of policy overreach by a president who lost the majority of the vote — 25K people rallies, aside.

What worries us most is the government is misinterpreting the November victory as a big mandate, which leads to policy overreach and massive pushback by the population resulting in social instability.  – GMM, February 2017

Stay tuned.

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Bad Santa, Bad Globalization

Go no further than the following segment on Sunday’s 6o Minutes about imported labor to understand the creation of Trumpism and the mess we find ourselves in today.  UCSF, part of the University of California, the largest private employer in  California should be ashamed.

Totally disgusting.  First,  the UC system is not a profit based organization.  Second,  Janet Napolitano probably makes north of US$1 million and she is importing labor to replace $60 K per annum workers?   And then asks them to retrain their replacements?  Shame.

Recall we have posted serveral pieces on how international trade and finance academic literature has not kept up with the real world.  The prevailing assumption in graduate school was labor and capital immobility.   No longer.  Complicated.

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The Broken Bond Market

The Fed tightens on Wednesday and bonds rally.  What the hay?

GaveKal, Jeff Gundlach,  and Jim Bianco nailed it in that every spec and their mother are/were short 10-year Treasuries.

Source: Quandl (see here for interactive chart)

But this is only a small part of the story:  The global bond markets are broken.

There are no signals, there is no noise.  Trying to infer any sense of economic or financial information from bond yields is futile.

QE Distortion
The intervention into the bond markets by central banks through quantitative easing (QE) in the big four sovereign bond markets – U.S., Japan, Eurozone, and UK – has created a structural shortage of risk-free instruments and distorted the most important price in the world — the yield on 10-year hard currency sovereign bonds.

Furthermore, past QE in the U.S, coupled with the recycling of foreign capital flows back into the U.S. bond market, has, in particular, created an acute structural shortage of longer-term Treasury securities.  The totality of short positions of the fast money in both the cash and derivatives market are probably a much larger proportion of the effective float of longer-term marketable Treasury securities than what the market currently perceives.  Hence the stickiness of U.S. bond yields.

Fed and Foreign Ownership of the U.S. Yield Curve
The table and chart below illustrate just how small the actual float of longer-term marketable U.S. Treasury securities is available to traders and investors.  The data show the Fed owns about 35 percent of Treasury securities with maturities 10-years or longer. Note the data only include notes and bonds and excludes T-Bills.

The Fed’s holdings combined with foreign ownership of longer maturities — more than 1-year — exceeds 80 percent of marketable Treasuries outstanding.   The Fed combined with just foreign official holdings, mainly, foreign central banks,  is 65 percent of maturities longer than 1-year.  Thus, almost 2/3rds of tradeable Treasuries longer than 1-year are held by entities with no sensitivity to market forces.

Note, the Treasury International Capital  (TIC) data does not break down foreign holdings by year of maturity, only by short-term and long-term – that is, greater than 1-year.




Foreign Holding of Treasuries
We hear a lot these days about a 1994 bond market debacle.  We lived through that bond bear and it wasn’t fun.   However, the microstructure of the Treasury market  is entirely different today than it was back then.

First,  the Fed did not hold long-term Treasuries.   Second,  foreign holdings of Treasuries were only about 15 percent of the outstanding debt versus around 50 percent today and everybody, including, Ross Perot, who said the trade was “a no brainer”,  were levered long riding the yield curve – short short-term, long long-term.

Foreign inflows,  mainly the result of the recycling of U.S. current account deficits,  resulted in Alan Greenspan’s bond market conundrum and the Fed losing control of the yield curve just prior to the 2007-08 financial crisis.

In this environment, long-term interest rates have trended lower in recent months even as the Federal Reserve has raised the level of the target federal funds rate by 150 basis points. This development contrasts with most experience, which suggests that, other things being equal, increasing short-term interest rates are normally accompanied by a rise in longer-term yields.

…In the current episode, however, the more-distant forward rates declined at the same time that short-term rates were rising. Indeed, the tenth-year tranche, which yielded 6-1/2 percent last June, is now at about 5-1/4 percent. During the same period, comparable real forward rates derived from quotes on Treasury inflation-indexed debt fell significantly as well, suggesting that only a portion of the decline in nominal forward rates in distant tranches is attributable to a drop in long-term inflation expectations. – Alan Greenspan,  Feb 2005

A paper published by the Federal Reserve Board (FRB) in 2012 estimated the impact on interest rates of the capital flow recycling into the U.S. bond market,

We find that a $100 billion increase in foreign official inflows into U.S. Treasury notes and bonds lowers the 5-year yield by roughly 40 to 60 basis points in the short run. However, our VAR analysis shows that in the long-run, when we allow foreign private investors to react to the effects induced by a shock to foreign official holdings, the estimated effect is roughly -20 basis points per $100 billion. Putting these results into context, between 1995 and 2010 China acquired roughly $1.1 trillion in U.S. Treasury notes and bonds. A literal interpretation of our long-run estimates suggests that if China had not accumulated any foreign exchange reserves during this period, and therefore not acquired these $1.1 trillion in Treasuries, all else equal, the 5-year Treasury yield would have been roughly 2 percentage points higher by 2010. This effect is large enough to have implications for the effectiveness of monetary policy. – FRB

Extrapolating the above analysis to the current stock of foreign official Treasury holdings of around $4 trillion leads to nonsensical results, such as the 5-year yield should be 800 basis points higher than it is today.   Obviously, the analysis should truncate the dependent variable – 5-year note yield — and ceteris paribus (other things being equal) does not hold in the real world.

But we should not miss the article’s main point that market interest rates would be much higher if not for foreign central bank interventions into their FX markets and the recycling of those reserves back into the Treasury market.    We take the above analysis seriously but not literally and wonder if the Trump Administration considers it when they rail on “so-called” currency manipulators.

The Yield Curve During Monetary Tightening
We have looked at the data and constructed some charts that show that in monetary tightening cycles in the U.S. the yield curve (10-2 years) usually flattens.



In only two of the past six tightenings did the 10-year bond rise in yield from the day of the first tightening to the day of the first easing.  This is entirely possible due to the fact the Fed often “tightens until something breaks” and the bond market front runs the expected easing cycle.

During the 2004-07 tightening cycle,  the era of the Greenspan bond market conundrum,  for example, the 10-year yield managed to rise only a maximum of 64 bps during the entire cycle from a beginning yield of 4.62 percent to a cycle high yield of 5.26 percent.   This as Greenspan raised the fed funds rate by 4.25 percent, from 1.0 percent to 5.25 percent.

Was the market forecasting the coming financial crisis?   Hardly.

Alan Greenspan blames the Fed’s loss of control of the yield curve, mainly due to the recycling of capital flows by foreign central banks,  as a major cause of the housing bubble.  Notice the importance of the 10-year yield on the allocation of resources and on how its distortion can be at the root of financial and economic bubbles.

This Time Is Different
Those dreaded words, “this time is different.”   We should warn readers that this time is truly different, however.   When the Fed first raised interest rates in December 2015, for example, the 10-year yield was at 2.24 percent and more than 50-75 percent lower than at the beginning of any other monetary tightening cycle over the past 30 years.  There are many “unprecedents” in this cycle and therefore more uncertainty.


Forecasting With The Yield Curve
Given the technical distortion of the bond market, we find it kind of silly with statements such as “what is the bond market telling us?”   Nothing!

There is no price discovery.  Given the intervention and distortion to bond yields caused by the Fed and foreign central banks, who knows what the right interest rate is for longer-term Treasury securities.

We will never forget the words of a prominent market strategist when rates were super depressed.

“ We’re in a depression. That is what the bond market is telling us.”

Even at the Friday close,  we hear equity traders are worried about why the 10-year yield is so low and fell after Wednesday’s Fed tightening.

Information Feedback Loops
One of just many dangers of the lack of price discovery in the bond market is the potential formation of positive feedback loops, where other markets fail to discount these distortions and act accordingly.   That is, for example, the equity markets sell off because they freak out interest rates are declining when they should be rising.  Or the private sector fails to invest in CapX as they wrongly anticipate an economic downturn because of falling or excessively low bond yields.   Their actions thus become a self-fulfilling prophecy.

A flatter than normal yield curve could also adversely affect bank lendingLook at how financial stocks have been underperforming recently as the yield curve has flattened about 7 bps this year.

Welcome to Bond Market Conundrum 2.0.

Asset prices are artificially elevated and foreign exchange rates are distorted due to the repression of the risk-free interest rates because of lack of supply.   Capital has been misallocated and the Fed has once again lost control of the yield curve simply by the very fact it owns the yield curve.

Monetary policymakers probably won’t regain control of the yield curve until they begin to reduce their balance sheets and the supply/demand balance moves closer to equilibrium.

That’s when we suspect everybody and their mother will front run the central bank selling and we will have the real bond market debacle some in the market have been expecting. Will or can that day ever come?  We don’t know.

Of course,  governments could go on a tax cut/spending binge and increase the primary supply of government bonds.   Possible but doubtful and a longer term story,  if any.

Until then?   We still believe bonds are in a slow bleed bear market, which will see fits of massive nutcracking short covering, as interest rates slowly drift higher.

Remember,  there are no signals, there is no noise.   Here’s to hoping the markets understand that.

A Few Caveats
The data points presented above should be taken as rough, but good, approximations.  The dates of each source of data may differ and the same is true for the different data sources.

Furthermore, we may be entirely wrong in our conclusions.

Abraham Lincoln used to tell a story as a young Illinois circuit court lawyer when trying to convince the jury to render a verdict in his favor.

The story goes that Lawyer Lincoln was worried he had not convinced the jury during the closing argument of a civil case against a railroad.   The jurors had gone to lunch to deliberate.  Lincoln followed them and interrupted their dessert with a story about a farmer’s son gripped by panic,

“Pa, Pa, the hired man and sis are in the hay mow and she’s lifting up her skirt and he’s letting down his pants and they’re afixin’ to pee on the hay.” “Son, you got your facts absolutely right, but you’re drawing the wrong conclusion.”

The jury ruled in Lincoln’s favor.

Similarly, when looking at data and charts — the facts —  we often draw the wrong conclusion about future direction.

Stay tuned.

Data Appendix

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French Oat-German Bund 10-year Spread

But our sense is and what we are seeing in the European street is that these countries are repelled and more willing to run away from Trump rather than attracted to and running to him.
–  Global Macro Monitor,  February 8, 2017

We wrote this last month sensing that the European street was repulsed by Donald Trump.

No doubt Europe’s misgivings about the new American president were reflected in the surprise defeat of the “Dutch Trump”,  Geert Wilders,  in Wednesday’s general elections in the Netherlands general elections.   Wilders’s Party for Freedom finished a disappointing second, winning 20 seats versus the current government’s People’s Party for Freedom and Democracy, which won 33.   Just a month ago Wilders was expected to win 35 seats.   We shouldn’t underestimate the damage the Wilders campaign has done to the body politic in Northern Europe, however.

Nevertheless,  we also posted this on February 8th,  even believing Wilders would win 35 seats:

Sorry, Geert, no prime ministership.   March 15th Dutch elections?  Yawn!  – GMM,  February 8, 2017

We were surprised that the setback to European populism given Wednesday’s defeat in the Netherlands did not result in a further tightening of the  Oat-Bund spread, which widened a de minimis 3 bps this week.

UBS does warn about the complacency resulting from the Wednesday’s populist defeat.

“The unconvincing populist performance in the Netherlands may weigh on French voters’ sense of urgency when heading for the ballots for their elections,” a team of analysts at UBS said in a note.

“Hence, we caution against extrapolating the Dutch results, and continue to see a 40 percent chance of a Le Pen victory in France,” UBS analysts added.  – UBS via CNBC

Wow! A 40 percent probability of a Le Pen victory.  That is certainly not priced and is way above our probability.  Expect increased volatility until the final votes are counted in the second round on May 7th.   Stay tuned.


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US Sector ETF Performance – March 17

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Global Risk Monitor – March 17

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COTD: The Monetary Transmission Mechanism

On  FOMC eve we thought you’d find the following chart from the IMF’s Global Financial Stability Report useful.

The traditional discussion of monetary policy transmission emphasizes how changes in interest rates affect investment and consumption decisions.  These channels operate through changes in the user cost of capital, intertemporal substitution effects, and wealth effects.  Similarly, changes in interest rates can induce exchange rate changes and therefore influence net exports.  Although important, these channels for the transmission of monetary policy do not assign a particular role to financial intermediaries and, to a large extent, do not affect banks and nonbanks differently.
IMF_Monetary Transmission
(COTD = Chart of the Day)
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