Given our long history and experience in fixed income markets, and our belief that bonds lead all other markets, we always keep an eye on the very front end of the bond market, or what is called the money market (bonds and fixed income investments that are less than 1yr to maturity). We have three indicators we watch that reflect short term liquidity in the US market.
1. 3mos Libor - This is an inter-bank lending rate. In other words, it is the rate at which one large bank will lend to another for 3mos. It is a signal of confidence among all banks. The fact that it is widening tells us that there is arguably some concern about lending to competing banks.
2. TED Spread - This is the difference between that 3mos Libor and a 3mos US T-Bill rate. Again, if it widening out, it means that competing banks are putting a premium on lending to each other...not a good thing.
3. US 3mos Commercial Paper - This is the spread vs US 3mos T-bills that US companies can issue commercial paper (CP). The reason this is so important is that most large companies issue CP as part of the normal course in funding operations and for working capital purposes. Maybe some people in Canada remember the ABCP debacle? They were entirely funded with short term CP so when it widens, or worse yet, that issuer loses access to the CP market, then you get an ABCP problem. We are not saying this might happen but a widening spread is generally not good for the capital markets.
In general, when investors shun corporate lending (CP,corporate bonds, etc) and require more "spread/yield" in favour of investing in much safer Government bonds, capital markets tend to do poorly. This is also a form of monetary conditions being tightened by market participants (independent of the Fed which obviously hasn't, and may not need to tighten).
We seem to be "widening" over the past month or two so this bears watching very closely.
We have written a bit over the last few months (both here: http://www.highrockcapital.ca/1/post/2015/04/us-1q15-gdp-and-the-fomc.html and here: http://www.highrockcapital.ca/1/post/2015/03/why-the-fomc-wont-raise-rates-this-year.html) about why we thought the Fed would not raise interest rates.
Today at 2pm was a much-anticipated FOMC meeting with about 50% of Wall St Economists expecting the Fed to raise rates by 25bps for the first time in almost 10yrs. Low and behold, they did not.
Here is a simple explanation why they didn't, and more importantly, why they won't for way longer than people think: Every nation on earth (save for the USA) has been devaluing their currencies to export their own deflation to the USA. And the the U$ has strengthened by about 15% YTD, which has the affect of tightening monetary conditions in the USA on it's own...who needs to Fed?! So the Q becomes, is the USA economy strong enough to import all of this deflation from all of these nations around the world, and turn it into inflation??
Answer--> we think not.
A couple of months ago, I was on BNN and said we thought the TSX could hit 13,500 points - which at the time was over a 1,000 point drop. I was sort of laughed at by the show's host. Well, that happened, and in fact, it went to a 12,700 low on August 24th, which was the Flash Crash. Today we sit around 13,400.
So why did we think the TSX could drop by over 1,000 points or about 7%?
Simple. Central Banks the world over, save for the Federal Reserve Bank in the USA, have been playing a game of what I call, "Global Competitive Currency Devaluation" for the past 4yrs. That is to say, all of these nations are stuck with way too much structural debt and had a hard time getting inflation to develop and accelerate their economies out of the slow growth they have been in really since the Credit Crisis of 08/09. So they cut short term interest rates to Zero which provides two key objectives: 1) Zero interest rates help develop borrowing, leverage and economic growth and 2) Zero interest rates help devalue that nation's currency (which may sound undesirable if your travel) which helps that them export. (Remember, during periods of inflation, you want to hold debt (leverage) because prices go up and you get the benefit of rising prices but during periods of deflation (or even disinflation) you want no debt at all because prices are falling and you lose more money. Gov'ts and corps are long too much debt and with the prospect of deflation, they scrambled to find a solution).
All these nations were doing this at the same time (competitively) because they all wanted to race to have the best chance of selling products and services into what the world sees as a strengthening US economy.
As this was happening and accelerating over the past year, it appeared that deflation seemed to be picking up, at least as was being played out in commodity markets,most of which began to get hit hard, and even in long (10yr and 30yr bonds) bonds around the world which rallied like crazy (the enemy of long gov't bonds is inflation so the fact they have been rallying means they not only weren't afraid of inflation, they probably saw deflation on the horizon).
So that was our view at the time in June when we said we thought that the TSX could drop to 13,500...it was largely related to the fact that the TSX has a high commodity weight and we saw the exportation of deflation by every nation on earth (save for the US) as somewhat negative.
Well all that would be fine and dandy but then a completely unexpected (Expect the Unexpected) happened...China gets into the fray in August and decides to devalue the Yuan! Crazy. The G20 has been putting pressure on China the Re-value the Yuan higher for the last 10yrs...not lower!! So now the world sees that China needs to devalue their currency too so their exports are more competitive to the US market. That exacerbated the sell-off thru August.
But the real issue is what China is now doing. All nation's central banks hold foreign exchange reserves which are largely held in U$ (and invested in US gov't bonds or treasury bonds). But then as China starts to see further pressure on the Yuan to go lower, it needs to step in and sell U$ and buy Yuan to help support the Yuan from dropping further thus lowering their foreign exchange reserves. And to make matters worse, their stock markets start to drop hard so they step in to buy Chinese stocks and...you guessed it, they need to sell U$ treasury bonds and buy Chinese stocks. Both of these open market activities leave China (and other central bankers around the world, especially in Emerging Markets) with fewer foreign exchange reserves. It is usually somewhat negative and dangerous for a central bank to reduce its foreign exchange reserves.
Lots of macro economic theory on currencies and central bank operations. Bottom line is we believe that these nations and central banks around the world will continue to attempt to export their deflation to the shores of the USA. Will the US economy be strong enough to absorb that deflation and actually inflate it's economy (and stocks)? Not sure right now but given the US central bank (The Fed) meets next week to decide on raising o/n interest rates, we might get some insight into what they are thinking. It bears watching.