After the violent reaction to the idea of tapering QE this summer, the FOMC members went on a mission to convince skeptical dollar markets that tapering was not tightening. Where the FOMC sees an adjustment to the toolkit, or the tactical approach, the overall strategy of loose monetary “stimulation” is, in their estimation, unassailable. Obviously, the funding markets disagreed; vehemently.

So, as part of the December “surprise” (to everyone but the dollar markets) taper, the Fed justified and highlighted this difference between tactics and strategy by simply making up a number that sounded like it would be consistent with this “forward guidance” of strategy. I suppose it was meant to diffuse any dollar market confusion about its tactics.

It’s usually not my practice to highlight or (over) analyze knee-jerk reactions to these kinds of major events. We really won’t know how markets will react, in full, for some time. It may even be into next month given that the next few weeks will be lightly attended (by historical pattern).

With that caveat in mind, I think this is an exception. Dollar markets have been contemplating this eventuality for months and have turned in the “taper” direction since October 23. So while this is still a knee-jerk reaction, perhaps there is less jerk to it than would otherwise be encompassed.

The initial reaction was, as with so many other markets, confusion about which direction to pursue. Unlike the stock market, which now seems to use any news event as an excuse to buy, dollar markets sold off rather hard in the wake of yesterday’s news. Initially, yesterday afternoon, most of the heaviest selling was concentrated in the middle part of the curve – 2017 to 2020. This morning, selling has been far more broad-based, with as many as 5bp being subtracted from prices in late 2014 and 2015.

ABOOK Dec 2013 Eurodollars selloff after taper3 ABOOK Dec 2013 Eurodollars selloff after taper2

In many tenors, eurodollar futures prices are down, cumulatively across yesterday and this morning, nearly 20bp. As you would surmise from the connections between funding and positioning, US treasury prices are falling as well. The 10-year UST was trading up to 2.94% this morning.

While price action in recent weeks has been relatively muted, the selloff of the past two days seems to have re-established the tightening channel (again, with caution in mind over immediate results without the benefit of more time and observation).

ABOOK Dec 2013 Eurodollars Dec 19

With a broader view of chronology, we see that the futures curve is still mostly inside of the widest/tightest points reached in early September. Again, there is symmetry to that observation since UST prices are largely inside their widest yields.

ABOOK Dec 2013 Eurodollars Volatile

In the outer months/years futures prices and rates are now tighter relative to the lows of September 4. It appears as if the curve is moving entirely in that direction out past 2015. In other words, forward guidance is “working” but only in the years relevant to that ideal. That leaves the rest of the funding curve open to interpretation, and thus tightening down the curve.

The larger point here isn’t even the absolute levels of rates and futures prices. Perhaps far more important is the introduction of volatility into these funding markets. Prior to May 1 and the serious taper talk that was introduced, leading to the violent selloff/tightening, the futures curve was noticeably devoid of volatility (suspiciously so, given what had transpired in swap prices and spreads).

ABOOK Dec 2013 Eurodollars Volatile No

The curve was extremely well-behaved and reflected, I think, the widespread idea that QE was, in fact, open ended and if not fully permanent, semi-permanent. In a finance world where volatility rules all, especially balance sheet capacity (which is the true limitation or reserve for modern banking), greater volatility can translate into nothing but tightening.

Any bank operating its risk measures as VaR and vega will see higher volatility and be forced to either rein back risk positions or add further hedges. In either case the results are the same. But in terms of volatility, it is, as in 2007-08, a self-reinforcing mechanism. The more volatility that appears, the more banks have to hedge or reduce balance sheet capacity, leading to more volatility, and so on.

What we have here that we can reasonably assume as valid is that the initial reaction to taper was to tighten, and that is akin to greater volatility. I can’t imagine that was intended, but then again, the FOMC has shown a remarkable ability to actually demonstrate how little they appreciate modern finance and “money.” Then again, they are stuck in the trap they created.

 

Click here to sign up for our free weekly e-newsletter.

“Wealth preservation and accumulation through thoughtful investing.”

For information on Alhambra Investment Partners’ money management services and global portfolio approach to capital preservation, contact us at: jhudak@4kb.d43.myftpupload.com or 561-686-6844 . You can also book an appointment for a free, no-obligation consultation using our contact form.