Market Overview

Gleacher Rates Head Certo on Seismic Undercurrents: Collateralization, Style Drift, and TARGET2

Russ Certo's market comments are among the best we've had the privilege to read in this job. Gleacher's head of rates trading's eye for long-term market shifts transcends much in our opinion (high signal-to-noise ratio).

Russ sat down with Benzinga Radio to outline a few of the themes that have been popping up in his commentary lately as issues that will likely define 2012: namely, the imbalance of payments in the eurozone, the rapid collateralization of Europe, and the Federal Reserve's increasing assumption of duties in both markets and policy circles.

To listen to the original Benzinga Radio interview, click here.

What are we to expect from the ECB in 2012?

Russ Certo: There's been a number of notes that have come out underneath the surface of most of the mainstream headlines that we see in markets [on TARGET2] … It was almost a ledgering or mechanism whereby central banks sweep their balances with other central banks.

I think it is representative of something far more significant for markets. The vehicle to rearrange and provide the proper liquidity provisioning [for the Eurosystem] is TARGET2.

It's a washing out through the washing machine and the dryer of the comings and goings of these different demands - or flights from quality and flights to quality in Europe. The ECB is essentially managing these flows, and what's happening is you are creating assets and liabilities on certain balance sheets within the central banking community of Europe.

I would suggest that the Bundesbank is the obvious creditor, which essentially has assets now which are these liabilities for other countries, to the tune of 600 billion euro.

The rest of the world thinks there is a very bland, benign kind of calm right now. There are extreme imbalances that are essentially being calmed through this TARGET2.

There are geopolitical risks. God forbid there be a breakup of the euro. Many people are proponents of a breakup because the natural markets would value activity properly, instead of having the hands of intervention, both in the political community and central bank community.

Any sort of breakup would lend risk to these balance sheet exposures. In short, the Bundesbank has the greatest skin in the game, per say, in this community. They are lending their balance sheet, essentially, to these other central banks through the TARGET2 mechanism, which ultimately has them on the hook.

One could make the argument that through certain types of communications and facilities set up in the fourth quarter - namely foreign exchange lines between some of the major central banks in the world - that the central banks that own printing presses, like the U.S. Federal Reserve, could ultimately be the source of the liquidity that would then, in turn, feed into these TARGET2 provisions in Europe.

So, not a very obvious, on-the-surface observation, but it's the piping of central bank policy that is stretched in ways that are unconventional. These are numbers that are uncharted - the growth and transformation of these balance sheets are of epic traditional proportion.

We have a very benign, low vol, experience today trading in markets. There is not a lot of fear factor, or VIX, or vol priced into these scenarios. Yet, some seasoned eyes would note these imbalances in these other areas that are underneath the surface of the marketplace that make these sort of players extremely uncomfortable.

They aren't observable to Main Street, per se, and even to a large portion of the financial community, and yet they exist. One has to ask the question: Why do they exist? And is that a normal economic property?

What are your thoughts on the collateralization of Europe?

Russ Certo: All sorts of different kinds of regulators - whether it's Office of the Comptroller of the Currency, the Federal Reserve, the FSA, Basel - were all involved in the coalescing of unintended consequences of policies that led up to the crisis to begin with.

There is seemingly a tacit acknowledgement - or meandering effort - by these regulators to remediate some of these. That's what we're getting at with the relaxing of these collateral policies.

Literally, this past week, Basel made comment that they are requiring Tier-1 capital ratios - higher quality capital formation - within these entities that are linked, the large, global, money center banks, which are linked to the sovereign crisis.

As Bridgewater recently suggested, you have insolvent sovereign entities backstopping insolvent banks, and insolvent banks backstopping insolvent sovereigns. That is a reference to an astute firm, and there are plenty of others.

There is a balance between striving for higher quality, tier-1 acceptance and uniformity and the recognition that the immediacy of implementation is more of a concept of austerity that is not even completely desired at the moment.

It's a catch-22 because of the delicacy and magnitude of the imbalances in the marketplace.

With regard to TARGET2, how long can the ECB sustain such activity?

Russ Certo: Both the ECB's and the Fed's balance sheets are approaching $3 trillion. I remember in brief history when the Fed's balance sheet wasn't even at $1 trillion. In the last five years, you've had a tripling of the balance sheet essentially, and more or less the same at the ECB.

At cocktail parties, when we are discussing flavorful conversation with our peers, it's not clear that the average person on Main Street that sees a low volatility proposition in the beginning of the new year in the equity markets - most of those people aren't necessarily aware of the great lengths at which the policy community has stretched its resources.

Debt-to-GDP ratios are not normal. When you look at the notional size of balance sheets of the central banks, these TARGET2 considerations, the relaxing of certain types of collateral requirements, which you noted, and the host of other mechanisms - like the Fed imparting its wisdom on housing finance - one should ask why are those types of monetary phenomena occurring?

Should we be comfortable with those metrics which are clear and identifiable versus some of the scratch-the-surface metrics of pure S&P 500 performance or performance of other risk assets like commodities or gold.

I would suggest that there are pockets of investors around town that look at the Fed with an extremely proactive proclamation about housing finance, which deviates from its traditional charter - striving for moderate long-term rates, full employment, and stable prices.

Now, you see (to kick off a new year!), the Fed opining about housing finance, which is not a traditional metric for the Federal Reserve, or the repo market, which is another white paper that was released.

Those are the questions and occurrences that people have that are trying to evaluate what they perceive to be risks in the marketplace. Why is the Fed going through extraordinary communicative and active engagement and behavior to markets and other government bodies, taking a stand on non-traditional, chartered goals?

Why has there been no reform in the repo market?

Russ Certo: The repo pursuits, or paper, I think is again exemplary of chock-full policy maneuvers regarding imbalances. There are a lot of different blocking-and-tackling mechanisms occurring within the central bank and policy community to get whole, get back onside.

This paper acknowledges exposures and imbalances. Again, I think it's actually a responsible task to highlight these, but policy is generally geared toward managing expectations. There is a fine line between the Fed's openness and rising to the surface of responsible awareness to imbalances versus essentially alienating or alarming your constituency.

This is a point that has been made in reference to interest rates being held steady through 2013, and some new formations this week, beating around the bush about maybe looking even beyond to 2014.

The benefit you get in terms of accommodative policy and its impact on markets versus what I would call a fear factor, or unintended consequence, which is the tertiary response - what does the Fed know? What are they so afraid of?

Maybe if the Fed started hiking rates, maybe I realize I need to refinance that home now, or make that investment to get the low rate. It's almost stifling consumption in some ways versus injecting a liquidity function into the market.

These repo papers and white papers on housing finance can be thrown in the category of delicate communications because if one peers deeper into these, even at face value, it raises a question. The Fed is balancing the expectations of the marketplace, and it has to do so delicately.

It's a positive expression of counterparty risk, but these risks have been around for a long time. They weren't addressed necessarily after Long Term Capital or pre-credit crisis. The limited amount of counterparties doing business with each other, whether it's in repo or interest-rate swaps or GSE counterparties, which are finite.

We realize that the money center banks have these intimate relationships with other money center banks, not only through repo but through other pricing mechanisms and derivative relationships.

I would extrapolate that to a lot of press last weekend whereby there was a fair amount of discussion, both in the New York Times and Barron's, regarding money market funds. The analogy was made: What is the difference between your passbook savings account and a money market fund?

What people don't realize is that a lot of their money market funds are not federally guaranteed by the FDIC. Yet, as a "safe haven" - this is another one of these metrics - why has so much money fled to the money market funds? Are people aware of the inherent risks they have in those funds versus where funds are protected in bank deposits?

All of these things are related. The identification of these exposures, where the money is meandering to at any one point in time around the world, and what the feedback mechanism is with central banks and the regulatory community with the marketplace.

What are your thoughts on Tuesday's UST auction?

Russ Certo: I think the Fed has plenty of firepower. I think the US Treasury is confident, if not complacent, when the optics of the yield structure in the United States lend credibility to what has already transpired.

I think that is the perception by those internal bodies. I wouldn't necessarily suggest that it is credibility. I would suggest that there is no other place to go.

It's a cryptic kind of world, where many are aware of these imbalances, and many aren't, so you see dichotomy everywhere. There is very smart, global, institutional capital preservation flows, and yet there is an agnosticism to the risks in the market, all at once.

I think the Fed has the firepower to communicate and manage a rate structure - as a matter of fact, I think that's where we are going. The other policy alternatives that we may be looking at here in 2012 could be a pegged rate structure or a compression of rate structure.

Those are things that aren't very sexy. They aren't necessarily an advocation of increased financial flows.

I wouldn't really bet against the Federal Reserve and some of the sources of demand here, which are some private acknowledgement of some of the imbalances globally and nowhere else to go versus the Fed's arsenal of tools to manage the rate structure.

I'm somewhat bullish on the rate structure. We know these are not natural rates. There are financially repressed expressions here in global interest rate markets. There are negative real yields - yields that don't compensate for inflation risk.

Inflation is higher than the rate of return you're getting in these instruments, yet these vehicles that allow you to gain liquidity and coupons and purchasing power - they are outperforming despite the fact that they aren't even meeting the stated objectives of central banks in creating inflation.

Yet, they tend to be a storehouse of wealth. The long end of the bond market returned near 25 percent total rate of return last year. I don't see any of that going away.

These are not natural rates. Rates should be closer to 7 percent based on averages going back to the 1960s, but that's not the market that we're in. At least for the foreseeable future, I see the rate outlook to be firm, and I don't expect that these auctions will have a tough time getting done.

Russ wanted us to include a point he made off-air. Speaking about the recent Fed paper on housing policy: "That was a big thing in my book, here. I thought that was extremely clever of the Fed, and is policy in and of itself. It raised an issue in a fashion which did not assign blame explicitly, but essentially pointed to a limitation. It wasn't a threat, but it was a kind word with a gun."

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