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Heroin Addicts

in central banks/FX by
heroin

It was just a few days ago when we showed you how, once you take into account FX hedging, buying US government debt is actually not as good of an idea as it seems if you’re a Japanese investor buying safes and stashing cash to escape negative yields.

As it turns out, the global USD crunch has eliminated the yield pickup, jeopardizing the bid for US government paper (if not US corporate paper) and putting yet another wrinkle in the warped financial universe space-time continuum.

Well, on Tuesday, Citi is out with some new commentary on this very same subject that we’ve been discussing for months. Here’s an excerpt:

“We think recent non-US Central Bank actions, actual and anticipated, are playing a role. In Japan, the BoJ’s “comprehensive assessment” of monetary policy due 21 September is likely to try to reduce (so called) excess flattening of the yield curve. We assume the only reason the BoJ wants a steeper curve, where the Fed and Operation Twist once wanted a flatter one, is that they think this will help banks’ profitability, offsetting the impact of NIRP (perhaps it will also help insurance companies’ carry). But to achieve a steeper curve probably relies on buying fewer (or even selling) long dated bonds. This either implies tapering of QE – likely to provoke a tightening overall of FCIs – or that buying at the short end becomes even bigger, driving front end yields ever more negative. As this occurs, the incentive for Japanese investors to buy foreign bonds like USTs would fall even more (because FX hedging costs would rise and long end spreads fall) relative to extending duration locally. As we have shown before, recent market movements already leave Japanese investors unlikely to choose FX hedged USTs over longer duration JGBs. Note how closely the JGB curve steepening recently has been correlated with 10y USTs. Actually the JGB curve turned up slightly before UST yields but it’s effectively the same trade. Similarly, the inaction at the 8 September ECB meeting has generated a steepening in the EA core bond yield curve. Again, higher yields and an increased FX hedging cost make for a reduced incentive to buy FX hedged Treasuries out of core Europe.”

hedge

(Charts: Citi)

So you can see what’s happening here, right? Driving investors out the curve and down the risk ladder. The thing is, they have to maintain this. There’s too much money betting on it. If they (central banks) pull it now, it’ll be like a heroin addict going through withdrawals.

Hedge Problem: US Bonds Aren’t As Attractive As They Seem

in Credit/Debt by
hedge

One of the reasons Main Street got blindsided in 2008 was Wall Street’s penchant for obfuscation. When you, as a retail investor, hear something like “collateralized debt obligation,” you have a very understandable tendency to tune out. It’s like Stephen Colbert once famously said: “You’re-a-bore is what someone says when you mention EURIBOR.”

But the thing you need to understand is that these supposedly esoteric, complex concepts and instruments are actually far simpler to understand that your average corporate balance sheet (especially in this era of non-GAAP crap):

gaap

(Chart: Morgan Stanley)

Some of the more interesting commentary we read today came (characteristically) from Bloomberg’s Richard Breslow. Here’s an excerpt:

“But whether it was the ECB waiting, Fed speakers pressing or, more likely, 30-year JGBs “backing up” to 50bps, global bonds decided some caution was in order. And in the world of extraordinary monetary “largesse,” bonds are the global investing bellwether. Everything else follows their lead. Lo and behold, we learn that Japanese investors last week were sellers of foreign bonds — in size. Turns out that with swap rates such as they are, U.S. yields just aren’t as attractive as they look at first blush.

So that’s important. It sounds complicated but it’s not. Think about it. You’re literally paying Tokyo to loan them money (negative yields on JGBs), so why not just buy US Treasurys which, while the yields are admittedly paltry, at least they are above zero. Well, that makes sense, but you want to currency hedge your position right? Because who knows what USDJPY is going to do going forward. Well, as we’ve documented elsewhere, the global dollar funding crunch has actually driven up the cost of FX hedging to the point where the trade is no longer worth it. Have a look:

hedge

(Chart: Deutsche Bank)

That’s actually an extremely important chart. Basically, Japanese investors can no longer pick up any yield versus Japanese govies thanks to the rising cost of hedging the USD. Why should you care? Well because what that means is they’ll have to do one of two things: 1) take more duration risk, or 2) move down the quality ladder.

Pay attention to these dynamics, because these are the kinds of supposedly “obscure” things that drive flows.

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