The end of RoRo, or is it? Last week, Kit Juckes at SocGen was one of many analysts who, after looking at the latest FOMC minutes, found fit to arrive at one overriding conclusion: the era of Risk-on, Risk-off (RoRo) investing is arguably coming to an end. As he explained (our emphasis): The FOMC minutes told us what we already knew, that some members are unsure of the effect of further QE and by and large, the Fed is leaning towards ending QE at some point, perhaps the end of 2013. The Treasury market reaction is amplified because US retail investors are now (finally) shifting out of bonds and into equities. Whether there is a bubble in current bond pricing is debatable, but most models, and common sense, would suggest yields are lower (50bp?) than they would be in the absence of Fed buying. The "risk-on/risk-off" regime is based on the premise that good economic data in the US are bad for the dollar because the Fed is on hold for ever and US yields are so low that yield-hungry investors are squeezed out of US markets and into foreign currencies. If the traditional relationship between US yields and economic data is restored, the "risk-on/risk-off" regime will come to an end (not before time), and stronger US data will be dollar supportive. This is going to happen at some point this year, and the overnight move is a taste of how it plays out. Only a taste however, as the FOMC is still too split and a change in Fed direction is still a long way away. A very logical analysis. Though, we are not entirely convinced. It all depends, we would say, on what the motivating force for the end of QE really is. If it's a return to growth and better overall macro data, then yes, fair enough. However if it's a move to offset the "new purpose of government debt being the provision of safe assets to the system" - even if unwittingly - then no, we don't think it's necessarily the end of risk-off and risk-on at all. It's fair to say that the move in the 30-year Treasury has been significant in the last month: This naturally signals something. But what? One of the three following explanations seems logical: 1) Something really has fundamentally changed and the shift in the curve represents a new reality, one which does genuinely augur growth, a higher employment rate and the correct sort of inflation - all thanks to the Fed's QEternity and Evans Rule approaches. 2) Nothing has fundamentally changed and the shift in the curve represents a major mispricing, brought on by the end Operation Twist, which can be seized upon to lock-in some much sought after arbitrage return. 3) Nothing has fundamentally changed, but people believe that for some reason it really has. The mispricing is not being seized upon in the usual manner but inspiring positioning in line with our first point. Point 2, of course, was really RoRo. Good macro data became bearish for the dollar because it implied less easing from the Fed. Bad macro data was bullish for the dollar because it implied more easing from the Fed. The respective risk-on risk-off positioning was the market falling in line to profit from the pattern. Bad macro data simply created expectations of further easing, which was an opportunity to profit from a soon to be expensive curve - based on the assumption that the Fed would act, but that its actions would never be enough to turn things around convincingly. Good macro data, meanwhile, did the opposite. It made the curve an expensive place to hide out, as it upped the chances of it getting cheaper, and thus created an incentive to seek arbitrage opportunity elsewhere. The proverbial "risk on." All of which is really about arbitraging yields against real-yield and breakeven rate assumptions. You had the opportunity to benefit from yields being priced too high relative to where inflation would eventually come in - thus an opportunity to lock-in carry. Something most likely accompanied by falling real yields - the rate which you expect to receive after inflation - based on incorrectly priced inflation views, extrapolated from rising breakeven rates. Or, you didn't. And if you didn't that was because yields were perfectly priced relative to where actual inflation would eventually come in, or - much more likely in short term bonds - because yields were priced below the level needed to compensate for inflation, as breakeven rates were not high enough. Another way of putting it: yields were overcompensating for deflation and in so doing charging an ever more "unreasonable" capital charge. Something which most likely would have been accompanied by steady real rates, or in the latter's case - and we know this will sound weird, but we are in a looking glass universe - rising real rate expectations, the result of falling breakeven rates. This is well illustrated by the real yield curve - as derived from US Tips - which has been turning structurally negative since 2009. Note the following chart from UBS's Chris Lupoli from the summer of 2012. It makes the point especially well: The way to read this chart is like a snapshot of the real yield curve over time. The two-year, five-year and 10-year intersections reflect the respective moment each one of those bonds entered negative territory for the first time. As Lupoli notes it reflects a growing negativity of the real yield curve. But, as he also noted at the time, it seems also to reveal a choke level beyond which real yields will not - or cannot - get more negative. We would argue this is the last line of Fed defence. Here's an updated version of the chart using real yields from the US Treasury, excluding the two-year rate for which we did not have historic data: It's notable that the slide in the five-year real-yield (dark blue) deeper into negative territory occurred on September 14, 2012, the day QEterntiy was announced. Also notable is the fact that the 20-year rate has been slipping in and out of negative territory intermittently ever since Lupoli's chart above was produced - thus leaving only the good old 30-year rate completely free of what we would now describe as a "deflation charge." Furthermore, even though our chart doesn't show it, we can confirm that the latest quote on the January 2015 TIPs rate at -1.45 continues to support Lupoli's choke level observation, even though the real yield did fall very near to the choke point upon the September 14 announcement. Fed support So why won't real rates go much lower? We'd argue it's because - contrary to popular belief - the Fed is not suppressing rates at all. Rather, and most notably on the short end - it has been supporting them. The rationale for this being that the Fed doesn't want negative yields to fuel a self-enforcing capital-destruction cycle. Operation Twist, in many ways, was all about relieving the pressure of inadequate safe asset supply in the short-end of the market. By doing so, the Fed ensured money market funds and other safety-minded investors would no longer have to crowd each other while competing over an ever smaller pool of safe assets - suffering capital charges in the process. That means Operation Twist may have changed the nature of RoRo. Before Operation Twist, RoRo was a push and pull force emanating from either long-term or short-term yield mispricing. When long-term yields became overly attractive, they encouraged risk-off behaviour as investors flocked to lock-in the mispriced carry opportunity. Conversely, when short-term yields began to carry too much of a deflation charge due to the crowding out effect, risk-on behaviour was encouraged instead. But with Operation Twist, you saw the Fed intervening to support short-term rates synthetically. This arguably led to an altogether new form of mispricing - one which misvalued the deflation charge, and in so doing muted the "risk-on" signal rather substantially. But what of unraveling correlations? With Operation Twist off the table, however, it stands to reason that the "risk-on" signal may have been turned back up. Couple that with a reignited QE programme - which has the potential to gobble up yet more safe assets from the market or fire-up the "risk on" signal even further - and it's clear that there's still the potential for a major risk-off reversal at some point. As we've already stressed, the fact that this hasn't happened yet either suggests that the Fed's latest round of Jedi mindtricks has genuinely changed the fundamentals or (more likely in our opinion) it's amplified the "risk on" mispricing signal, making it seem more convincing than usual. Yet advocates of the "end of RoRo" theory point to one more factor to support their case: the unraveling of some long-standing correlations. The most talked about one being gold. The clue to what's really going on therefore, we propose, potentially lies in the gold market. As we've already argued we believe that gold may have come up against its own choke level. What's more, we don't believe it can successfully penetrate through this level unless rates fall further below the zero-bound and through that last line of Fed defence. We make this assumption based on the the fact that the moment gold hit its choke level corresponded to almost exactly when the two-year real yield came up against its own (Fed influenced) support. Consequently, Gold coming up against its choke level is confusing all the usual correlations that used to apply to gold. Indeed, any opportunity to capture a better than anticipated real-yield is now a bearish signal for gold. It's fair to say, every time real-yield expectations rise - due either to low CPI prints, QE talk or overly aggressive conventional bond sell-offs - one can now logically expect gold to fall. On the flip side, when real-yield expectations fall, gold can now be expected to rise, though - and this is an important caveat - only ever as far as its choke level. That makes gold's recent reaction to both further QE and the Fed's talking up of inflation expectations somewhat telling: We're sure many goldbugs are currently highly confused. How can it be, they're probably wondering, that talked up inflation expectations by the Fed and QE balance sheet expansion aren't making gold go ballistic? We propose it's because gold is actually confirming our point that RoRo has either been taken to another level of intensity or that the fundamentals have truly been shifted positively. In which case, no more need for gold. At least, not unless the capital charge associated with other comparable "safe" investments becomes so massive that gold once again becomes appealing. However, if you're still risk averse, there's also currently a unique opportunity to capture capital-protection and some safe yield in the 30-year US Treasury - which is arguably much more enticing than staying in zero-yielding gold. As to why the 30-year, of all the bonds, has come to present such an opportunity for the safety conscious... An educated guess would be relief over the fiscal cliff, but also - and perhaps more significantly - the end of the buying support from the end of Operation Twist. Which leaves us with a capital flow story that arguably looks a little like this: Gold money => Treasuries. US Treasury money => blue-chip equities. Blue-chip equity money => More risky equity/high yield/EM. It's worth noting that high yield yield-to worst rates have hit their lowest level ever. In short, this may be the after-effects of the Fed having doubled up and thrown everything it has at the problem. All of which either represents one of the biggest, meanest "risk on" moves of recent times - one which has potential to burn a long time - or one that will, as ever, inevitably decompose the moment risk averse investors begin to believe safe assets are fairly priced again. Or, for that matter, when macro data begins to disappoint. If the latter is true, the risk-off reversal stands to be large enough to take us through the now established choke levels for both gold and real-rates. The only thing standing between this latest Fed move being a success or not is thus where the additional liquidity ends up flowing. Hence why the Fed is doing everything it can - communications bluffs and last lines of defence - to ensure the market doesn't have any incentive to direct that liquidity into safety. Related links: It Appears The Post-2008 Global Trading Environment Is Finally Reversing - Business Insider Capping the gold price - FT Alphaville TIPs are the best - FT Alphaville On the new purpose of government debt - FT Alphaville