From: DANIEL.DAVIES at flemings.com Date: Tue, 28 Mar 2000 07:44:46 +0100
>Daniel Davies writes in his daily commentary today:
>>All in all, the confidence of the US Treasury and equity markets stan=
ds
in
>>stark contrast to the turmoil that is developing in domestic credit
>>markets.
>Daniel, could you amplify on this for the people?
>Doug
Actually, at this section of a rather bizarre macro rant in today's Banks Daily, I'm channelling Peter Warburton, our chief economist and a fairly serious bear. The point is that once more, the swap spread has gone through the roof (70bp to 120bp since Jan). My personal view is that the swap spread has given its signal altogether too many times in the last few years to be treated as a reliable indicator. But it *is* now at an all-time high. I think that this is a genuine "swap window" (condition where it's possible to make free money by borrowing fixed and swapping into floating), created by a shortage of Treasury paper at the long end. But Warby notes that the corporate bond spread has also ticked up 10-20bp since the last raise. It certainly looks as if the cost of debt is rising faster than the cost of equity. Meanwhile, the Fed has extended the triparty repo agreements (meant to keep liquidity up for Y2K until next year, possibly because it doesn't like the idea of the banks trying to liquidate a bunch of corporate bond and commercial paper collateral all at once.
Bottom line; even though nothing's happened to equity markets, or to the government bonds, "the markets" are beginning to sense a genuine will to tighten, and liquidity broadly defined is getting tighter.
My comment (appended below, with Peter's after it) was a speculative look at what kind of psychological state the equity market has to be in to be ignoring the evidence of credit spreads. Subtext fans will perhaps appreciate the long discussions of "humping" in the yield curve, which have gathered me a certain amount of ribald abuse today.
clear as mud.
cheers
dd
(follows -- first DD's comment, then PJW's)
US financial markets Superrationality? Haven't had a macro rant for a while, but this one was inspired by Peter Warburton's most recent notes on the US economy and markets (attached). We just got to thinking this morning; what would have to be true for rational expectations to be true of the US financial markets? Specifically, we want to be able to a)explain the humping in the Treasury bond market without making reference to technical factors and b) have an explanation of that humping which is consistent with the level of the equity market.
The answers raise an interesting hypothesis about stock market psychology (well, DD finds it interesting anyway). If one takes a purist, expectations-hypothesis view of the bond market, then it seems to be telling us that Greenspan will be able to control inflation within eighteen months by raising interest rates to somewhere below 7% (the highest yield in the market is on the two-year note, yielding 6.65% despite its benchmark status). And the level of the equity market would suggest that the market believes that this will be the softest of soft landings - effectively that AG will be able to bring US inflation back under control with no disruption to the technology sector.
Specifically, in order to bring the bond and equity markets into consistency with one another, we have to believe that Greenspan can tighten money without crunching credit - that the capital markets will respond to even half-point rises by merely raising the cost of capital rather than by rationing it and cutting off capital flows to speculative projects entirely.
In order to believe this, we have to think that participants in the capital markets not only have rational expectations, but are "superrational" - they all know that they are rational, and know that everyone else is, and know that everyone knows that everyone is, and so on. Without this condition, it would be rational for people to assume that some level of interest rates would set off a market panic, in which case it wouldn't be possible to hold the equity market consistent with the bond market story.
If the American stock market has managed to come to this view, then it's a new development for stock market psychology. Effectively, the rational expectations ethos has become ingrained in the market players (probably because they're all brainwashed MBAs these days), and the religion of efficient markets has achieved the status of conventional wisdom. That's interesting, as a feat of what Trevor Petch (our insurance analyst) referred to as a "feat of collective hallucination" when discussing the nature of tracking stocks. Is it sustainable?
Probably not. For one thing, the rational expectations view of the market is almost certainly the wrong one right now ? the humping is due to lack of supply, and the movement in swap spreads represents a genuine swap window which is no doubt being exploited right now (I guess that means buy Morgan Stanley and other top swaps houses). For another, superrationality is extremely unlikely to prevail in practice. There is just no reason to believe that the on/off nature of capital markets has changed at all. And the effects of a market which believes rationally that all palyers have become rational are not easily distinguishable from the effects of more or less unthinking boosterism. So, we maintain the view that there's probably going to be an almighty crash one of these days. Until then .... Here's Peter's notes.
US Credit market Turning the screw
The gloves are off in the battle for supremacy in the US credit system between Wall Street and the policymakers. Fed staffers are adamant that a double-(50bp) raise has become necessary and the minutes of the last FOMC suggest that the decision makers are leaning towards the idea also. As has often been the case, Mr Greenspan is holding out on them. There were two notable reactions to the utterly predictable 25 basis point rises in Fed funds (to 6%) and discount rate (to 5.5%) on Tuesday. The equity and Treasury bond market reaction was one of impudence; the Dow held on to the pre-emptory gains from last week and added some more while technology stocks recovered from their recent hiccup. 5-year bonds continued their rally from the yield high of 6.76% on 10 February. On the other hand, the credit markets have reacted nervously to the confirmation of Fed intentions. The contrast is summed up in the 2 figures shown below.
The swaps market reaction is particularly striking. The steep ascent in the 10-year spread since mid-January is suggestive of a significant deterioration of credit conditions in the derivatives markets, spilling out into the asset-backed and corporate bond markets. So far, most of the widening of corporate bond spreads is attributable to the restricted supply considerations in the US Treasury market. US agency debt is poised to take over as the effective 10-year benchmark.
Other interesting developments have been the decision to extend the deadline for the cancellation of the triparty repurchase agreements (originally justified on Y2K grounds) from April 2000 to January 2001. These repos differ in that they cover a much broader spectrum of collateral instruments than regular repos. Second, the US Fed has recently proposed much tighter capital standards for all investment banking activities of US commercial banks. Implementation of the proposed 50% capital charge on all merchant banking investments is unlikely since it will be vigorously opposed by banks and their investment banking customers - especially technology companies. Third, there has been mounting pressure on the Fed to announce higher margin requirements for technology stocks.
All in all, the confidence of the US Treasury and equity markets stands in stark contrast to the turmoil that is developing in domestic credit markets. It would be inaccurate to conclude that this week's tightening has had no effect.