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Want To Trade The Interest Rate Swap/Treasury Bond Spread? Think Twice.

The spread between five-year OTC interest rate swap yields and five-year Treasury yields has recently turned negative. In theory, this spread measures the cost depositors charge for bearing the extra credit risk of bank deposits. Should you buy this spread, expecting a return to positive spreads? Trades based on the yield economics are risky in the very inefficient IRS market. The press has awakened to an unexpected development on the long end of the interest rate swap (“IRS”) yield curve. IRS rates for 5-year maturities and longer are trading below Treasury rates for the same maturities. This spread is, in theory , a measure of the difference between the credit risk of Treasury debt and unsecured wholesale unsecured bank debt of the same maturity. But in reality this spread is obviously vulnerable to divergence from the theory. The chart shows the 5-year swap rate against the 5-year constant maturity Treasury curve over the past six months. A few things stand out. The IRS yield exceeded the Treasury yield during most of the period. The problem, if we should call it that, begins with the early-October run-up in Treasury rates, as displayed in the graph below, produced by FRED, the St. Louis Fed’s database. Several issues that distinguish IRS markets from Treasury markets might have come into play at that point. What are the trading implications of this development? With the listing of 5-year IRS futures by the CME Group (NASDAQ: CME ), it is possible for non-banks to trade the expected spread between 5-year IRS futures (CBOT : F1U) and 5-year Treasury note futures (CBOT : ZF). (click to enlarge) But the negative cash market spread is telling us that an analysis of the credit risk of prime banks is secondary in trading this spread successfully at present. There is no assurance that buying this negative spread will return a quick profit. Economic forces will be secondary determinants of this spread until the OTC IRS itself trades in a secondary market. At the moment, determination of swap rates is the dominion of roughly 20 large banks that face a multitude of other problems. On the other hand, if you meet these conditions: You are a non-bank corporate or financial institutions borrower, but not an IRS dealer. You can finance your operations at interest costs tied to 6-month LIBOR for the foreseeable future. You have a productive use for long-term debt. Run – do not walk – to your nearest swap dealer and pay fixed on an appropriately sized IRS at a negative spread to Treasuries. OTC swap dealers do provide long-term interest cost protection. It will take five or more years for the swap to unwind and provide the cheap long-term cost of money that you seek, but if that is consistent with your business plan, very little can go wrong. [But if there is any chance that you will change your mind (as several municipalities have done), do not enter this transaction. There is no more iron-clad commitment than an IRS. It is not a bond. You can’t buy it back.] The IRS/Treasury spread is a close relative of the TED Spread [difference between the Treasury bill rate and the Eurodollar (LIBOR) rate of the same maturity.] The TED spread is thought to represent the cost to prime London banks of the added credit risk their short term unsecured debt represented relative to that of the U.S. Treasury. In spite of the problematic history of LIBOR pricing, the TED spread has been and will remain, positive. LIBOR is indeed problematic. Within months of the listing of Eurodollar futures (CME : ED), LIBOR became something other than a market yield. London offered the services of the British Bankers Association in polling specified bank employees in London branches to form a poll on LIBOR. This was not good news for believers in market forces. Most readers are aware of the sorry history of this “LIBOR fixing,” with billions in legal settlements of lawsuits resulting from manipulation of this poll on a market price. If you are not familiar with the LIBOR scandal, read here . LIBOR, the interest rate index fundamental to the determination of swap values, is an estimate of the market yield on unsecured wholesale bank debt. These bank debt instruments, London branch deposits, are securities in the same sense that Treasuries are. And nobody questions that they are riskier than the U.S. Treasury bills. But as we learned, the LIBOR rate is not exactly the price at which these deposits are traded. For example if, for some foolish reason, roughly 10 of the 18 banks asked on a daily basis to provide LIBOR, undertook to bring three- and six-month LIBOR rates below the Treasury rates at those maturities, they could make that happen without a single transaction. We learned from the LIBOR scandal that 18 large banks have unfortunate employees that have been cursed with the task of providing an answer to the following imponderable question every day. ICE LIBOR Question: “At what rate could you borrow funds, were you to do so by asking for and then accepting interbank offers in a reasonable market size just prior to 11 am London time?” There is no compensation this side of $1 billion that would entice me to accept this job. The reason is simple. This person is very likely to be sued, perhaps criminally, and will have no credible economic explanation for the values provided. Consider the plight of this person if employed, for example, to produce Citibank’s (NYSE: C ) rate. Of the 18 banks polled each day, 17 know at what price Citibank could borrow under the (poorly specified) circumstances of the question. The only bank that does not is Citibank, which cannot lend to itself. Worse, none of the 18 banks know the minimum rate at which Citibank could borrow, which is the number requested. Yet this Citibank must make this guess every day. Given the disastrous events of recent years and the legal jeopardy described above, I am sure the LIBOR providers do their very best to guess this rate correctly these days. There is little likelihood that LIBOR is anything other than a very good guess at the 11:00 AM cost of bank money in London. The likelihood of LIBOR falling below the Treasury rate is nil. Why is the IRS rate different from LIBOR? Mostly because it is more obscure. Nobody is going to jail because the spread is out of line right now. But it is no less important to the dealer banks. Various authors search for an economic explanation for an IRS rate less than the Treasury rate. Resist this urge. There is no economic answer. The dominant economic explanation in the press doesn’t wash. This explanation posits that these unseemly low IRS rates are the result of the incredibly safe IRS clearing houses. The argument goes that the new OTC clearing facilities are less credit risky than the U.S. government. This dubious notion, it is suggested, is perhaps due to an implicit government guarantee, resulting from exchanges’ designation as “systemically important utilities.” Such explanations are based on a total misunderstanding of the credit risk associated with entering a swap and could not be more mistaken. IRS trades are credit risky. But the credit risk in question has no direct relationship to the IRS yield. The credit risk exists on both sides of the trade. Each party to the trade is at risk to the other. As a result, there is no reason for either side to pay for the credit risk it creates unless its credit risk is dramatically different from its counterparty. This is not the case for the dealer swap transactions upon which market pricing is based. The heart of the matter is that LIBOR swap rates are based on the dealers’ prices in trades with each other. For the specifics of how IRS prices are determined, l refer the reader to a rather terse explanation from LCH:Clearnet , the largest clearer of IRS globally. The root of the pricing problem is that IRS trades, like LIBOR, are not negotiable and thus inevitably guesses. LCH:Clearnet’s methodology does not specify the guesser. I have no reason to doubt that the effort to guess the market price of IRS is as sincere as that for LIBOR. I expect that the negative value of the Treasury/IRS spread caught the dealer’s attention and that the optics did not amuse them, another reason to believe the prices are close to the market’s transaction prices. Here is a short list of market issues that could be leading to the negative spread. (click to enlarge) Liquidity. As the Chart below indicates, the volume of cleared IRS has been falling steadily for the past two years. This suggests fewer dealer trades. JasonC also shows that U.S. dealer notional principal amounts (NPA) have been falling steadily over the same period, another indicator of falling liquidity in this market. The market may have become less efficient, and the dealers’ ability to change pricing as market conditions change may be reduced. Valuation Issues. An IRS (if you set the credit risk between parties aside) is a zero-sum game. Every dollar one trader earns as IRS rates change is lost by another. Since most IRS are trades between the 10 largest dealers, I cannot imagine that the trading community as a whole benefits directly from unchanging interest rates, whether up or down. The same may not be said of individual dealers of course, so the possibility that one or more specific banks is losing value as interest rates rise is real. But I don’t think one or a few banks losing money would slow the rise in IRS long-term rates. Changing rates do have a substantial and important indirect negative effect on all banks. There is a reporting issue associated with changing rates. Bank derivative risk reporting basically involves two measures of performance. Banks report their derivatives NPA and derivatives net asset value (cash value in the case of a hypothetical sale.) A run-up in interest rates has a substantial effect on every bank’s net asset value. It has no effect on the net asset value of the system as a whole, since every dollar earned in the zero-sum swap market is also lost elsewhere. But regulators base their estimates of the risk exposure of the banks’ swap books on this number. And both negative market values and positive market values rise as rates change. Even an increase in a bank’s swap book net asset value is a negative for bank regulators. This factor could create an incentive to moderate changes in swap rates, especially if there were a substantial probability that these increases would be reversed. The Whack-a-Mole Factor. Finally, I think it would not be surprising if individual banks are as reluctant in the IRS market as they are in the LIBOR market to release estimates of market yields higher or lower than the herd’s reported average. IRS estimated rates are no less subjective than LIBOR rates, since there are no secondary market prices. There has not been a scandal in IRS markets analogous to that in the LIBOR markets. In fact, this is one of the few OTC markets in which there has been no such scandal. But who wants to be first? All in all, I do not find this temporary divergence of IRS rates from their theoretical relationship to Treasury rates very alarming. None of my suggested reasons leads to any kind of financial disaster. But the absence of pricing efficiency in the IRS market is another of the gradually collecting indicators that this market is more expensive to operate and less efficient in performing its risk-transfer function than we should expect. And trading this spread based on bank credit risk estimates is dangerous right now. As presently constituted, the IRS market is hazardous to traders other than dealer banks and their customers. And that is its most important flaw.

Market-Makers Compare Coming Prices For: Major Market Index ETFs

Summary Behavioral Analysis of the players moving big blocks of securities in and out of $-Billion portfolios provides insights into their expectations for price changes in coming months. Portfolio Managers have delved deeply into the fundamentals urging shifts in capital allocations; now they take actions on their private, unpublished conclusions. These block transactions reveal why. Multi-$Million trades strain market capacity, require temporary capital liquidity facilitation and negotiating help, but are necessary to accomplish significant asset reallocations in big-$ funds. Market-making firms provide that assistance, but only when they can sidestep risks involved by hedge deals intricately designed to transfer exposures to willing (at a price) speculators. Analysis of the prices paid and deal structures involved tell how far coming securities prices are likely to range. Those prospects, good and bad, can be directly compared. This is a Behavioral Analysis of Informed Expectations It follows a rational examination of what experienced, well-informed, highly-motivated professionals normally do, acting in their own best interests. It pits knowledgeable judgments of probable risks during bounded time periods against likely rewards of price changes, both up and down. It involves the skillful arbitrage of contracts demanding specific performances under defined circumstances. Ones traded in regulated markets for derivative securities, usually involving operational and/or financial leverage. The skill sets required for successful practice of these arts are not quickly or easily learned. The conduct of required practices are not widely allowed or casually granted. It makes good economic sense to contract-out the capabilities involved to those high up on the learning curve and reliability scale. It requires, from all parties involved, trust, but verification. What results is a communal judgment about the likely boundaries of price change during defined periods of future time. Those judgments get hammered out in markets between buyers and sellers of risk and of reward. The questions being answered are no longer “Why” buy or sell the subject, but “What Price” makes sense to pay or receive. All involved have their views; the associated hedge agreements translate possibilities into enforceable realities. We simply translate the realities into specific price ranges. Then the risk and benefit possibilities can be compared on common footings. A history of what has followed prior similar implied forecasts may provide further qualitative flavor to belief and influence of the forecasts. Certainty is a rare outcome. Subjects of this analysis Major market indexes are tracked by Exchange Traded Funds of different varieties; all of the major variants are covered here. There are the simple, direct price trackers of indexes that cannot be invested in directly, ETFs often used by market professionals. The ETFs more frequently traded in by public investors may carry prices at levels more conveniently accommodated by portfolios of individual investors. There are leveraged long ETFs with prices structurally engineered (and maintained) to move 2x or 3x the movement of the index being tracked. And there are leveraged short ETFs engineered and maintained to move the inverse of the price of the index being tracked. Here is a quick review of the market characteristics of this article’s subjects, their securities names and symbols and position now in current-year price ranges. Figure 1 (click to enlarge) These symbols are arranged first by the Indexes which can’t be directly invested in, then for each of those indexes the most widely utilized unleveraged ETF, the most heavily long-leveraged ETF, and the inverse, or short-structured ETF. There is no well-recognized symbol for an Index of mid-cap stocks, but three rows of ETFs in the same character sequence as the pattern for the recognized four (boldfaced) indexes close the table. Market liquidity is addressed in the first four columns of Figure 1. What leaps out is the huge capital commitment made, apparently by individual investors, of $66 billion in the Vanguard Mid-Cap ETF (NYSEARCA: VO ). At its average daily volume of trading, less than half a million shares, it would take 5 years for all investors to escape. Other ProShares mid-cap ETFs, like the ProShares Ultra MidCap 400 ETF ( MVV) and the ProShares UltraShort MidCap400 ETF ( MZZ ), also have less liquid involvements of double-digit days to turn over the capital investments, while most other index ETFs need less than 10 days. The largest, the SPDR S&P 500 Trust ETF (NYSEARCA: SPY ) needs only 6 market days to replace its whole commitment. The trade-spread cost to trade these ETFs is typically in single basis points of hundredths of a percent. That is in the same region of a $7 commission on a $10,000 trade ticket. Price-earnings ratios for these subjects range from 15 times earnings to 22 times. But appear to be of little influence in differentiating between their selection for portfolio participation. Notions of capital size or leverage seem to be of much more import. Where behavioral analysis contributes Investor preferences among these ETFs during the past year are indicated in the last two columns of Figure 1, reflecting on their price range experiences in that period, shown in the prior two columns. The Nasdaq 100 index [NDX] fluctuated the most, by 25% low to high, while the S&P500 traveled by only 14%. From a portfolio management viewpoint, what matters most is where holdings are priced now, compared with where their prices may go in coming months. Prices are, after all, what determine the progress of wealth-building, and are what can be a source of expenditure provision as an alternative to interest or dividend income. Ultimately price changes are the principal portfolio performance score-keeping agent. Where prices are now, in comparison to where they have been provides perspective as to what may be coming next. If prices are high in their past year’s range, for them to go higher means that their surroundings must also increase. If price is low relative to prior year scope, a price increase represents recovery. As you think about the security’s environment, does it seem likely in coming months to be one of stability, of increase, or of possible decline? How would such change be likely to impact the security under consideration? First there is a need to be aware of what has recently been going on. The measure for that is the 52-week Range Index. The 52 week RI tells what proportion of the price range of the last 52 weeks is below the present price. A strong, rising investment likely will have a large part of its past-year price range under where it is now. Something above 50, the mid-point of the range is likely, all the way up into the 90’s. At the top of its year’s experience the 52wRI will be 100. At the bottom the 52wRI will be zero. All the 52wRI can do is provide perspective. A look to the future requires a forecast. With that, expressed in terms of prospective price changes, both up and down, a forecast Range Index, 4cRI or just RI, gives a sense of the balance between upcoming reward and risk. This is what behavioral analysis of the actions of large investment organizations, dealing with the professional market-making community, can do. The process of making possible changes of focus for sizable chunks of capital produces the careful thinking that lies behind such forecasts of likely coming prices. Hedging-implied price range forecasts While the four boldfaced widely-recognized market indexes in Figure 1 can’t be directly invested in, professionals in the market-making community use security derivatives of them to perform large-scale hedging of portfolios on an asset class-wide basis. Hence we have forecast implications for those four indexes, as well as for the ETFs listed. Figure 2 tells what the professional hedging activities of the market-makers imply for price range extremes of the symbols of Figure 1, in the same sequence. Columns 2 through 5 are forecast or current data, the remaining columns are historical records of market behavior subsequent to prior instances of forecasts like those of the present. Figure 2 (click to enlarge) A lot of information is contained here, much of potential importance. Some study is deserved. Exactly the same evaluation process is used to derive the price range forecasts in columns 2 and 3 for all the Indexes and ETFs, regardless of leverage or inversion. Column 7’s values are what determine the specifics of columns 6 and 8-15. Each security’s row may present quite different prior conditions from other rows, but that is what is needed in order to make meaningful comparisons between the ETFs today for their appropriate potential future actions. Column 7 tells what balance exists between the prospects for upside price change and downside price change in the forecasts of columns 2 and 3 relative to column 4. The Range Index numbers in column 7 tells of the whole forecast price range between each row of columns 2 and 3, what percentage lies between column 3 and 4. It is what part of the forecast price range that is below the current market quote. That proportion is used to identify similar prior forecasts made in the past 5 years’ market days, counted in column 12. Those prior forecasts produce the histories displayed in the remaining columns. Of most basic interest to all investment considerations is the tradeoff between RISK and REWARD. Column 5 calculates the reward prospect as the upside percentage price change limit of column 2 above column 4. Proper appraisal of RISK requires recognition that it is not a static condition, but is of variable threat, depending on its surroundings. When the risk tree falls in an empty forest of a portfolio not containing that holding, you have no hearing of it, no concern. It is only the period when the subject security is in the portfolio that there is a risk exposure. So we look at each subject security’s price drawdown experiences during prior periods of similar Range Index holdings. And we look for the worst (most extreme) drawdowns, because that is when investors are most likely to accept a loss by selling out, rather than holding on for a recovery and for the higher price objective that induced the investment originally. Columns 5 and 6 are side by side not of an accident. While not the only consideration in investing, this is an important place to start when making comparisons between alternative investment choices. To that end, a picture comparison of these Index and ETF current Risk~Reward tradeoffs is instructive. Please see Figure 3. Figure 3 (used with permission) In this map the dotted diagonal line marks the points where upside price change Prospect (green horizontal scale) equals typical maximum price drawdown Experiences (red vertical scale). Of considerable interest is that the subjects all tend to cluster loosely about that watershed. This despite the fact that several short structured ETF subjects are present, along with several strongly (3x) leveraged ETFs of twin subject matter. If we were in a cheap market situation, or a threatening overpriced one, there would be strong clustering of each type of ETF structure, long and short, with emphasis by the leveraged ones. Instead, this is a mildly confused market with no clear indication of which way it may head next. Well, what about differing focus of investment subjects – giant capitalizations of the DJIA, or technology biases of the NDX, or small capitalizations of the RUT? The most restrained and best advantaged tradeoff is in [2] for the NDX index. Its ETFs are the PowerShares QQQ Trust ETF ( QQQ) at [17] and the leveraged ProShares UltraPro QQQ ETF ( TQQQ) at [8]. The short ProShares UltraPro Short QQQ ETF ( SQQQ) has strong upside prospects, along with ample risk involvement. Only the ProShares UltraPro Short Russell 2000 ETF ( SRTY) at [12] appears more hazardous, and without adequate redeeming reward proportions. Its levered relative, the ProShares UltraPro Russell 2000 ETF ( URTY) at [1], of the RUT and the iShares Russell 2000 ETF ( IWM) clan, may be over-reaching a bit. This kind of comparing between alternative investments is what often distinguishes the experienced investor from the neophyte. There are so many intriguing possible stories of investment bonanzas that it may be difficult to keep focus. And for the newbie investor deciding on what combinations of attributes may be most important is a daunting challenge. An advantage of the behavioral analysis approach is that price prospects suggested by fundamental and competitive analysis are being vetted by experienced, well-informed market professionals on both sides of the trade. Looking back at figure 2, there is a condition that may disrupt the organized notions drawn from Figure 3. Column 8 tells what proportion of the prior similar forecasts persevered in recovering from those worst-case drawdowns, and for the resolute holder turned into profitable outcomes, often reaching their targeted price objectives. Batting averages of 7 out of 8 and 9 out of 10 are quite possible to accomplish by active investors. Column 10 tells how large the payoffs were, not only of the recoveries, but including the losses. And those gains, in comparison with the forecast promises of column 5 offer a measure of the credibility of the forecast. There will be circumstances where credibility will be low and recovery odds worse than 50-50. When such conditions appear pervasive, cash is a low-risk temporary investment, sometimes the treasured resource. Conclusion Major market indexes currently present an array of reward-to-risk alternatives, but not in any clearcut organization shouting “do this, don’t do that.” Safety-seekers might favor Nasdaq stocks or ETFs over other securities, but the advantages are hardly compelling. At present elaborate preference systems do not offer much advantage, but that may be a passing condition. There are major benefits from using behavioral analysis to extend and enrich conventional fundamental analysis. A principal plus is the ability to make opportunity comparisons between very dissimilar situations. Additional comparative studies of ETFs are in preparation, they should provide further profit opportunities, as they already have this year.

Market Lab Report – Premarket Pulse 11/19/15

Major averages rose yesterday on mixed volume with the S&P 500 closing firmly above its 200-day moving average, though its volume was lower. The S&P 500 and NASDAQ Composite are roughly 2% from their all-time highs. So far this year, each time the market has made new highs it has quickly rolled over into 2% to 4% corrections in the major averages, taking leading stocks down much faster. This underscores the point of being nimble in this environment, quick to cut losses, and quick to take gains when you have them in context with the stock’s chart. The Fed minutes revealed that, for the first time, most Fed members are open to a rate hike when they meet December 15-16. This news seemed to help the general markets rally as this was taken as a sign that the economy is robust enough to weather a rate hike. This would be the first rate hike in 9 years. Cloud-based IT software company NOW had a pocket pivot. Earnings are strongly accelerating, sales remain robust, institutional sponsorship has grown over the last 4 quarters, group rank 5.