Repo Releveraging

In Q1, Primary Dealers have re-leveraged significantly by about 16% in aggregate judging by outstanding Repos (see chart below). This is about average for the past 5yrs (excepting Q1 2008 when large off-balance sheet exposures from SIVs were brought back on-balance sheet). However, it is worth noting that outstanding repos are now back to the levels of a year ago.

There are two possible conclusions to make from this development:

• either dealers have been loading up on the rates carry trade, or


• balance sheets are no longer as constrained as they have been over the past year, and this balance sheet expansion argues that aggregate credit is now expanding.

I am obviously talking my book now, but if it is the former, then the rates market is vulnerable to a positioning unwind, and if it is the latter, then growth is likely to be significantly stronger than expected and Fed tightening a lot closer. My personal view, however, is that it is the former, and the price action in rates markets would support this view.

UK Elections for Investors

I've been meaning to write something on the election for a while, so thought this poll (http://www.timesonline.co.uk/tol/news/politics/article7054655.ece) was as good an excuse to do it. Populus/The Times have polled 100 marginal constituencies (seats 51-151) putting both Labour and the Conservatives on 38% of the vote, representing a 6.7% swing to the Tories. The headline focuses on the Tories & Labour being "neck and neck in the marginals" (news of an inevitable victory doesn't sell papers!). However, this actually is pretty much where the Tories need to be in order to get an overall Majority. There are a lot of misconceptions about the national polls and the seats, majorities and hung parliaments that they supposedly translate into, and as someone who has been sad enough to watch the 1979 and 1992 election coverage start to finish (you can see it here if you're interested http://www.youtube.com/user/ajs41) I think it's worth highlighting these.

In particular, the Uniform National Swing (UNS) is the most frequently quoted approach in the Media and accepted by non-professionals. This basically does what it says on the tin: a swing in the survey group is extrapolated uniformly on a nationwide basis for the three main parties, and the rest (SNP etc.) are held constant. The simplicity of this approach is obviously quite attractive, but historically, it has not been a particularly good predictor of the eventual result - most notably in 1979 and 1992. This is a result of several phenomena which have been observed, particularly in relatively close elections. For example, the poster-child of the 1992 election was the "shy Tory" effect, where many voters are embarrassed to say that they will vote Tory as it is distinctly "un-cool" - I note Lily Allen dedicating her "F*** you" song to David Cameron last week.

The second phenomena is the discrepancy between marginal constituencies and core constituencies. As a result of a large amount of funding (usually from the Tories), there is a very large focus upon campaigning in marginal constituencies which tends to increase the swing within them. Indeed, the above Populus/Times poll suggests that this swing is to the tune of about 1.5-2% higher than recent nationwide surveys would suggest. As a result of desperation to "keep the other lot out", the core vote in the incumbent's constituencies also tends to increase, which serves to lower the national average but to no "useful" avail in terms of extra Parliamentary seats.

The third phenomena is the much-hyped "tactical voting" effect, which is harder to pin down. A study of the 1997 election (Impact of Tactical Voting in Recent British Elections. J.E. Curtis et al) suggests that 2% of the Liberal Democrat vote went to Labour and 1% went to the Conservatives - i.e. a 2-1 proportion. It is worth noting that the Liberal Democrats are polling 2-3% lower where they were in 2005 - this effect could be something of a wildcard in this election. Indeed, SNP/PC may play an important part in this. For a much more detailed and extensive discussion of these factors, I highly recommend reading UK Polling Report (http://ukpollingreport.co.uk/blog/) and Political Betting (http://www2.politicalbetting.com/) and in particular its articles on UNS (http://politicalbetting.com/index.php/archives/2010/03/07/andy-cooke-on-the-uns-part-2/ and http://politicalbetting.com/index.php/archives/2010/03/03/andy-cooke-on-the-uns-part-1/) and their seat model (http://politicalbetting.com/index.php/archives/2010/02/25/launching-the-andy-cooke-seats-calculator-final-version/)which takes these effects into account.

But back to the Populus/Times poll.

As a result of boundary changes, notionally, the Conservatives (based upon the 2005 election) will have 214 seats (vs. the 198 they won in 2005). That means that in order to secure an overall majority in the Commons they need to win an additional 112 seats (see http://ukpollingreport.co.uk/guide/conservative-target-seats). The 6.7% swing in this poll suggests that they will get 97 Labour seats, but that does not take into account the Liberal Democrat/SNP etc marginals in which the Tories can also expect to pick up some seats. Unfortunately, there has not been a poll of CON/LDEM constituencies since last summer (it showed a 5.5% swing to the Tories, which would indicate a Tory gain of 21 seats which would provide a clear majority), so until there is a new poll it is difficult to say just how many of these the Tories will pick up. However, even assuming that the Tories do not pick up any of the smaller-party seats (though they do look likely to take Perth & North Perthshire and Angus), in order to take the 15 LDEM seats required to reach the magic number of 326, they would need a swing of 4.25% from the Liberals. Including Perth & North Perthshire and Angus which look like a sure-win for the Tories, the swing required falls to just 3.5% which is not too different from the Liberal Democrat's national performance fall from 2005.

The point I'm trying to make is that the Tories do not actually need to perform that much better than they are currently in order to be sure of a working majority, and in fact, under the current poll results probably already notionally have one. This is in stark contrast to the market's pricing of a hung parliament in GBP and in Gilts.

Of course, all of the above misses probably the "key" issue: the election is as much a choice between Brown and Cameron as individuals as was the 2008 US Election between Obama and McCain, and the 1997 election one between Blair and Major. Faced with five more years of Brown - experience aside - when it comes to that choice at the ballot box, I think the Tories are on for a landslide. There is clear evidence that the Labour party is swinging to the Left, as evidenced by the rise and rise of Ed Balls and the placing of union backers in Labour safe seats (http://www.timesonline.co.uk/tol/news/politics/article7054578.ece). One of the most surprising outcomes of the financial crisis is just how little the political consensus shifted to the Left, globally (the US Healthcare issue is something completely different), and shows that the socialism vs. free market capitalism war was settled a long time ago. Labour looks like it's heading for the political nether-land.

UPDATE: The details of the Populus/Times poll are out (http://populuslimited.com/uploads/download_pdf-070310-The-Times-The-Times-Marginal-Seats-Poll---March-2010.pdf) and page 7 asks the question of LibDem, UKIP etc voters in constituencies where they have no chance of winning and it is clearly a two-horse race between Labour and the Conservatives whether they would vote for Labour or the Conservatives.

13% said they would vote Tory (unchanged from 2005), while 11% said they would vote Labour (down from 12% in 2005). So tactical voting looks as though it will help the Tories more than it will Labour.

1993-redux?

Since the introduction of QE, the level of excess reserves has had a reasonably tight correlation with the level of short-term interest rates (reassuring for the monetarists!). There are reasonable grounds to expect these to rise somewhat, at the margin. Firstly, the recent discount rate hike has removed some of the safety net for the banking system and is likely to be hiked further as part of the normalisation process. Under this assumption, it is reasonable to expect that the current ~$8bn of discount window borrowing will fall as private financing elsewhere starts to appear more attractive.

Secondly, the Treasury recently announced that the Supplementary Financing Programme (SFP) will be reinstated to $200bn. By way of background, this programme was introduced in Autumn 2008 to help the NY Fed regain control of the Effective Fed Funds Rate at a time when the Federal Reserve was undertaking exceptionally large interventions in the financial market (it effectively took the entire interbank funding market onto its balance sheet). In Autumn 2009, the Treasury was running very close to the debt limit at a time when the Administration was trying to steer Healthcare reform through Congress. To avoid introducing further potential Congressional grandstanding, they decided against asking for a formal increase in the debt limit until the Healthcare measure had progressed. Instead, they announced that they would run down the SPF to provide bridge finance which, in effect, put an additional $200bn of excess reserves into the banking system, contributing to the last-gap jump in the Liquidity Trade in November. The re-announcement of the programme represents the reversal of this, as Congress approved an increase in the debt limit back in January.

Now, while neither of these moves represent an explicit tightening of monetary policy under the FOMC's current framework of targeting the Federal Funds Rate (and several FOMC members immediately came out insisting that both moves were not tightening), a $200bn+ reserve drain will inevitably have some form of impact on market rates. The below chart shows Excess Reserves in the banking system (inverse scale - Brown line), the Effective Fed Funds Rate (Green line) and the 12m T-Bill rate (White Line) and, as per above, the brown line is about to turn higher. Many market participants viewed the recent Fed actions as representing a tightening, and many insisted it was not. Interestingly, those that viewed it as a tightening were generally not core-participants in the Rates market, but rather were concentrated in other asset classes. Rates market participants immediately faded the immediate sell-off in the front-end on these moves. So who is "right"? Is this a case of "watch what we do, not what we say"?.

One of the most remarkable observations, with respect to interest rate markets, has been the stability of front-end carry trades following the view that policy rates will be on hold for a very long time. In fact, the best risk-adjusted trade of 2009 was long EDZ9 and, so far, EDZ0 is making a strong claim to the 2010 title itself. This view has been supported by continued dovish rhetoric from central bankers and academics (most notable the Rogoff & Reinhart study that highlights a significant amount of evidence that implies that post-financial crisis recoveries tend to be L-shaped) and suggestions that global output gaps are very wide. All of these points are valid to some extent, but the price action, as well as the outright level of the front-end, is beginning to overprice these issues and it is becoming obvious that the trade is no longer fundamentally-driven and is now a pure momentum-driven trade. I will attempt to show this below.

The below chart shows a forward-looking Taylor Rule estimate using the average economist estimates for core PCE inflation and unemployment. These estimates are consistent with an L-shaped recovery and very gradual fall in the unemployment rate where the size of the output gap exerts downward pressure on core inflation. Under these conditions, the forward Taylor Rule suggests that the policy rate 1yr forward should be -1%. This, of course, does not take into account the effect of QE upon monetary policy. Calculating the impact of QE is obviously exceptionally difficult and, perhaps, somewhat subjective, but several months ago Goldman Sachs did try to do this. By utilising the equivalent easing of their Financial Conditions Index of a 100bps Fed Funds cut, they were able to estimate the quantity of asset purchases that would be consistent with such a move by comparing the QE-effect upon their Financial Conditions Index, coming to the conclusion that this quantity was about $1trn. By the end of Q1, the Fed will have purchased a cumulative $1.75trn, which under the above assumption, can be thought of as roughly equivalent to 175bps of additional easing.

Adding this into the below chart, we can see that the optimal Fed Funds rate 1yr forward should be 0.75% if the assets held on the Fed's balance sheet remain unchanged. This is pretty much where Fed Funds futures are priced, however that does not take into account term premium (which according to back Eurodollars is about 15bps/year), so the equilibrium forward rate should be something like 0.9%. This is somewhat back-of-the-envelope analysis, but it is illustrative that expecting further extension in the front-end is purely dependent upon the growth outlook deteriorating further. Also interesting is the average economist expectation for the path of the Fed Funds rate, which is for it to sit at 1.25% in one year's time. The point here is that the rates market already prices in an L-shaped recovery.

The next thing I want to draw attention to is speculative positioning (see chart below), which now sits at its longest since the CFTC began collating the data in 1995. As market-wide liquidity is lower post-crisis, on a liquidity-adjusted basis, the net-length is effectively larger than it appears. The performance of front-end carry trades has attracted further momentum buying - in particular, since the beginning of March, Open Interest in the front seven contracts has increased by over 160k contracts, or about ~$4m/bp in PV01 terms, with brokers reporting that the price data shows that the majority of this volume has been traded on the offer side of the price, suggesting that the market is increasing its length further.

But it is not only speculators that are playing the carry trade. The steepness of the curve has encouraged Commercial banks to pile into Treasuries, now holding the largest amount on record (see first chart below), with an average duration of about 5.5yrs. Relative to Nominal GDP (second chart below) the holdings are not quite as extreme as they were in 1993, but given bank balance sheets are in much worse state as a result of the current crisis, the effect of losses from a Treasury market sell-off will be far more dramatic. It is also worth noting that the peaks in this ratio in both July 2003 and March 2004 at levels very similar to those at present were respective peaks in the rate market and met with very aggressive sell-offs.

The remaining rates market participants are Bank Swap Desks for whom there are no positioning data, but anecdotally I am led to believe that they also have the carry trade on in significant size. It is worth noting that the swap market is significantly larger than it was in the early-1990s (in 1993, according to ISDA, outstanding Interest Rate Derivatives totalled $8.474trn, while in 2009 they totalled $414trn.). Indeed, from a balance sheet perspective, it is more efficient to express this trade in swaps rather than bonds, so this would suggest that the true size of the carry trade is much larger and that the UST holdings data understates the true size of the carry trade.

So the point I'm trying to get across is that the front-end is over-shooting as a function of momentum (perhaps CTAs are in on the action) and speculators chasing carry-returns. It's an accident waiting to happen.