Until the end of last month and as outlined in June’s letter, calm and confidence was not only reflected in the equity markets but in numerous gauges related to U.S financial conditions and the shadow banking system. In this context a recent report from the Federal Reserve Bank of Atlanta attempts to measure the shadow Federal Funds Rate (“SFFR’) based on a model that was developed from Wu and Xia. Since December 2008 the Federal Funds Rate has been in the 0 to ¼ percent range targeted by the Federal Open Market Committee. This 50 page research report is used to summarize the macroeconomic effect of unconventional monetary policy at the zero lower bound. In the bank’s own words; “The result gives us a tool for measuring the effect on monetary policy at zero lower bounds”. Based on their analysis the SFFR level had roughly flat lined for two years ending July 2013 in the range of -1.25 to -1.5%, but in the past year declined sharply and in the past two months has hovered in the vicinity of -3.00%. The extremely low levels on the SFFR had a beneficial impact on several other Federal Reserve reports that reflect US financial health. Composites of these measures from government reports were detailed month as they were at the most favorable levels in 20 years. The liquidity spigot is not just domestically evident, the shadow banking system in Europe has surged as well.
In the first three weeks of May the S&P’s trading range was extremely compressed at roughly 1% with the previous 13 weeks having been limited to a 5% range, representing a measure of suppressed volatility that has not been seen in 8 years. In addition, numerous volatility measures also moved to the lowest levels in years, as is the case with VIX, which fell below 11 last month, the lowest since February 2007. Entering the month of June the S&P broke above this narrow range and advanced in the first three weeks despite the turmoil in Iraq. The S&P has rallied in the last two months without a single daily gain or loss +/- 1%, a rarity as well, with a prior occurrence in 1995. Furthermore, the S&P finished in the top 25% of the daily trading range (the S&P point change from the previous day/ the S&P daily range) in the first 20 trading days of the month, which is an unusual occurrence, having been seen less than a dozen times in the past 55 years. This trend continued into month end, driving the 40 day average of the formula into the top 31% of the daily range. This has occurred just one other time going back 55 years, having last manifested in the middle of May, 1995. The present backdrop is different than in May 1995 as the S&P then traded sideways the previous year and experienced a 10% correction induced by the Federal Reserve raising rates.
One of the biggest surprises this year has been the sharp decline in long term interest rates despite the Federal Reserve’s monthly removal of $10 billion in bond purchases to gradually reduce quantitative easing. Numerous market commentators have put forth explanations for the rate decline, touching on short covering, limited supply, economic woes, weather etc. A factor which has only been partly discussed is the correlation between European rates and US rates, especially the link between the German Bund and the US 10- year Treasury. These two have been loosely tethered to one another for more than 25 years. In the last sovereign debt crisis during the summer of 2012 Italian and Spanish long term rates stood at 7%, and have since dramatically declined, ending last year yielding 4.1%.