What would happen to market liquidity if ECB owned all the decent-yielding paper?

Outlook:

It might be just a fun tidbit, but it might not… Today GOP presidential candidate Trump has an op-ed in the WSH headlined “Ending China’s Currency Manipulation” in which he will name China a manipulator on Day One.

This comes the morning of the third television debate at 9 pm tonight, co-sponsored by none other than the WSJ and the Fox Business channel. Everyone has to use “channel finder” to find out where the Fox Business channel can be found. It’s not the most-watched channel around. In the debate, who will want to talk about biographical details or the other presumed topics now that Trump is grabbing the theme? The other candidate will have to scramble to get ready (and that’s not a bad thing).

In the op-ed, Trump says he would also explicitly acknowledge that China is not a market economy and extorts intellectual property to allow foreign companies into its markets. He calls for countervailing tariffs to cut the giant trade deficit. He also wants a 10% tax on corporate profit repatriation and a flat 15% corporate tax.

The emotional appeal of the op-ed rant is undeniable. Never mind that the current trade system embodies exactly the laissez-faire principles that the Republicans supposedly embrace. Imposing tariffs enlarges government in the world where Plubs want smaller government. We have no idea whether a president can single-handedly override the whole Treasury apparatus of the semi-annual review of currency manipulation, which took years to put in place. Here’s where an announcement effect might trump institutions even without the force of “officialdom.” Applying tariffs faces the same legal obstacles, not only in Congress but also with respect to various treaties, including the WTO. Presumably Trump would just withdraw from the treaties, setting off who knows what retaliatory reactions. And the last time we had a low repatriation tax, it brought back some capital, but the verdict at the time was that it created no jobs.

Trump’s ideas are simplistic and obvious but not practical or workable under the current international system. And yet they are most appealing! We look forward to the economists showing up on the Sunday morning TV shows to rebut Trump, plus the foreign commentators, which will probably include many central bank heads and finance ministers, if not prime ministers. The first headline would be “US Seeks to Start Currency War.” The central reason not to dismantle the current system is precisely that mercan-tilist policies incite retaliation. Ask France. And the drift to using other currencies for trade would turn into a torrent. And who would buy US sovereign debt then?

This is going to be fun. Charles Darwin said “Great is the power of steady misrepresentation.” Remember that when mulling over Republican tax “ideas.”

Meanwhile, things are going on in the bond market that are terribly hard to grasp. Despite large issuance of corporates this week, Goldman claims dealer inventories are abnormally low. "We are increasingly of the view that 'the tide is going out' on corporate bond market liquidity." Remember that last month, NY Fed Dudley said worries about liquidity are overdone. Well, he started it. We have been seeing a constant flood of articles about liquidity fear, many from Barron’s (whose reasoning is so murky from ideological bias that we generally avoid it).

We confess to not understanding how such a large and varied market can tangle itself into gridlock. And yet the MBS market is a little kerfuffled. Market News writes “… the topic of mortgage-convexity is beginning to circulate. And while this selling has faded through the years as the Fed owns more and more of the outstanding MBS universe, it is still worth paying attention. Negative convexity hedging costs have been low in this range-bound environment, said Nomura's head of MBS strategy Ohmsatya Ravi, but if the 10-year continues to selloff towards 2.40% this positive will end and volatility could also rise.” Huh?

Evidently the issue, at least for some, is that governments in the form of central banks own too much of the bond market. Governments should be issuers, not holders. When they hold, they deprive the private players of price-discovery. Well, that makes sense.

Europe may have a liquidity problem, too. In Portugal, yields are rising strongly and reached 2.88% yesterday on political turmoil, up 21 bp in a day and a 5-month high. The FT reports “The 10-year yield has climbed 0.58 percentage points since the start of October amid intense political uncertainty. In the same period, Italian 10-year yields have risen just 0.09 percentage points.” Moreover, Portugal is up for review by rating agency DBRS on Friday. “The rating is crucial, because at least an investment grade rating is required for a country to be eligible for the ECB’s QE programme.”

Ah, there’s the crux. If we understand the ECB rules on QE, it cannot buy any paper that is not investment grade or that has a yield lower than the deposit rate, currently -0.20%. Chandler reports the Netherlands issued a 3-year with a yield of -0.27%, not only a record low but not qualifying for the QE program. Plenty of high-rated German paper doesn’t qualify, either. This is why talk of the ECB cutting the deposit rate by another 10 points is not silly—it would add to the pool of acceptable assets the ECB is allowed to buy. This is a form of liquidity problem. What would happen to general market liquidity if the ECB owned all the decent-yielding paper?

Two things: talk of Greece coming back to the private market next year doesn’t look so far-fetched. And boy, Australia and New Zealand sure have nice yields these days.

Today is a Tuesday, the standard day for a retracement after a big move the week before. And tomorrow is a holiday, sort of, in the US. Technically banks are closed, we hold parades celebrating veterans, and furniture is on sale. We honestly don’t know whether the US holiday will affect FX trading. But it’s probably a good idea to get square, anyway.