Commercial Paper, T Bills, EUROdeposits: Expanded Version

Expanded Version, Submitted FX Trader Magazine, July Publication.

Commercial Paper, T Bills and Eurodeposit Rates

Commercial Paper was introduced as a variable interest rate employed as a means to rebuild America after the Civil War in the 1860’s. Due to its variable interest, Commercial Paper was the trade able interest rate 50 years prior to Federal Reserve introduction, 55 years prior to Fed Funds introduction, 65 years prior to T Bill introduction, 57 years prior to FED Open Market Operations, 30 years prior to Dow Jones Index introduction, many years prior to individual stock introduction and long before consideration was given to nation to nation interest rates.

Commercial Paper interest would later assist to build yield curve maturities and cross border deposit rates such as Libor, Euro, money market and other deposit rates such as Certificate of Deposits. Commercial Paper assisted in later introduction of General Collateral interest rates as a conduit to borrow against securities. Commercial Paper is the foundational interest rate especially in a primitive banking system of the 1860’s and beyond.

From the 1860’s, Commercial Paper funded Freight and Railroad shipments, Freight and Railroad Insurance, passenger services, research, inventions, travel . The list to fund successful growth under pure capitalism is endless. What drove Commercial Paper rates was the Agricultural plant and harvest cycles. As corporations formed and grew from 14th amendment Supreme Court recognition as persons, Commercial Paper funded Receivables, Inventories, bank operations, Finance companies, Loans, broker dealer operations, money market and mutual funds. Again the list is endless.

As Commercial Paper, corporations and other markets developed, Commercial Paper was split into two main sections and hold as traded markets today: Financials and Non Financials. Most important inside the US is Non Financials while most important for corporations and offshore locations is Financials. Non Financials is clearly the driver as more issuers exist historically, more participants, larger market, greater finance needs and the market is US centered.

Calomiris, Himmelberg and Wachtel in a 1995 paper titled Commercial Paper, Corporate Finance and the Business Cycle: A Microeconomic Perspective report Commercial Paper Financial and Non Financial issuance quadrupled from 534 in 1973 to 1905 in 1994. By end 1991, holders with a 5% share accounted for Mutual Funds 33.9%, Households, Trusts and Non Profits 29.3%, All Retirement Plans 10.2% and 9.4% in Non Farm Corporate.

To offer what the vital import of Commercial Paper means to markets and traders today, Kacperczyk and Schnabl provide solid statistics as they viewed Commercial Paper in terms of the crisis in a 2009 NBER paper, ” When Safe Proved Risky”.
In 1990, the size of Commercial Paper markets were USD 558 billion and grew to 5 trillion by 2007 with 1.97 trillion outstanding. Financials V Non Financials accounted for 40.1% of the market while asset backed Commercial Paper accounted for 56.8%. The corollary was the $ 940 billion T Bill market. Not much changed today as the CP main, most important, most vital Finance Rate. Consider Friday Fed Funds volume was USD 61 billion, dead closed as usual at 0.37 and a tiny fraction of the Commercial Paper market. Consider the impending 2008 crisis was first seen long before in the Commercial Paper market. Ben Bernanke in a 1990 NBER paper and others over many years highlighted Commercial Paper as a leading indicator.

Like T Bills, Commercial Paper is issued at a discount, redeemed at face value yet exempt from SEC registration. The difference is T Bills are secured by US backing while Commercial Paper debt is unsecured. Long maturities are maximum 270 days yet average durations are 30 day deals with Rollover ability. Consider a 30 day deal at 100,000 face value purchased at 85,000 offers Bond Equivalent yields annualized at 214%, 107 % semi annual and 53% quarterly. Interest is not exempt like T Bills and its why Commercial Paper both Financials and Non Financials trade between T Bills and Libor. Current Commercial Paper rates trades between T Bills and Eurodeposit rates and informs correct positioning under healthy markets.

To define healthy markets, Commercial Paper trades in between Eurodeposit and T Bill rates as a protection to markets, ongoing investments, investors and issuers. If banks and markets implode and bank lending and borrowing fails then Commercial Paper markets allow business continuation at a historically higher yet fairly reasonable Finance rate. A deviation of positions warns of trouble ahead because of the unsecured V secured aspects to assigning interest and because of the historic negative correlation from bank lending to higher Commercial Paper rates.

While the focus remains on Fed Funds as insight into Fed hold or raise, Fed Funds and Libor rates rarely move. What is known regarding FED Funds from a recently posted article is Fed Funds rates are overbought to 10 year monthly averages and bumping against 95% bands on a vast majority of the 10 year averages. Eurodeposit rates as a proxy to Libor remain in the same unmovable and overbought condition as Fed Funds.

Fed funds at 0.37 is dead center of the new Fed target range since the first raise from 0.25 – 0.50. Fed Funds is held above 0.25 purposefully by General Collateral /Repurchase Agreement rates at 0.25. The rate at 0.25 is the deal able rate for Fed rollovers of securities through the System Open Market Account and a created tool to support Fed Funds in classic Keynesian traditions.

From Keynes, the Fed inserted an extra interest rate to allow the full control over Fed Funds while maintaining high balance sheets with rollover ability. Speculative markets and volatility was replaced by focus on Finance and a forced direction of monies. From the Fed’s traditional role 1914 — 2008 to add or subtract daily funds to maintain markets as a service to participants, the Fed post 2008 created markets, directed prices and even controls volatility.

Volatility hasn’t been seen in markets since pre 2008 and complaints from central banks in minutes and statements regarding volatility is a conditioning effect to inform as to trade in future markets. The word accommodative will remain a mainstay long into the future. Under 0.25, the traditional increase stimulus, lower interest rate conundrum was broke to now control both.
To understand unmovable Libor is to know Commercial Paper Financials is the location for US subsidiaries offshore to borrow, lend and fund current business. In current 1 month terms, Commercial Paper Financial rates are 0.43 V Eurodeposit rates at 0.48. Not bad for GE, Toyota, GM, automobile and manufacturing companies and others offshore in need to Finance operations. Any subsidiary company with US operations, any foreign company with US operations conducts business in Commercial Paper Financials. To understand the proper health of Fed Funds, Financing abilities and rates is to view Finance Rates in Commercial Paper.

Commercial Paper Financials and Nonfinancials, T Bills and Eurodeposit rates were viewed in successive 1 month averages 1 to 8 years out to 2008 or 96 months. The commonalities are 1 year averages drive prices in every financial instrument. Every financial instrument should trade at maximums 15 to 23 basis points lower. Averages 2 – 7 years in every financial instrument are massively overbought to the 99% and beyond bands. All averages are beyond maximum peaks but rather at massive significant points. Eight year averages support current prices except Eurodeposit rates at 0.53 against current 0.48. Commercial Paper 1 month Financials are most overbought followed by T Bills, Commercial Paper Non Financials then Eurodeposits.

Commercial Paper 1 month Non Financial averages varied from 1.3% lows to 1.8% highs while 1 month Financials varied 1.2% to 1.7%. T Bills varied from 1.02% to 1.2% while Eurodeposits varied from 2.1% to 3.10%. T Bills in terms of averages are farily lifeless as the variation fails to explain its high signal except in the 8 year average where its revealed 0.147 is fast approaching bottoms. What variation reveals is inside current prices in all financial instruments is pure noise, unexplainable, a meaningless price, a lost meandering ship.

Commercial Paper Financial and Non as well as Eurodeposits can all handle the overbought correction however all three are the rates to watch closely as insights to Fed Funds because prices are near bottoms. One aspect to the Peak problem is explained by eight years of averages without movements and Fed control.

Targets in Commercial Paper 1 Month Non Financials are located from 0.18 to 0.23 from current 0.33. Current price is supported by the eight year average at 0.25 and one year at 0.19. Commercial Paper Financial targets are located from 0.20 to 0.36 from current 0.43. Current price is supported by the 8 year average at 0.29 and 1 year average at 0.22.

T Bills from current 0.25 targets 0.11 to 0.20. Current price is supported at the 8 year average at 0.147 and 1 year at 0.10. Eurodeposits from current 0.48 finds resistance in the 8 year average at 0.53 and targets are located at 0.32 to 0.43. Price is supported at the 1 year average at 0.30 followed by the 7 year average at 0.28 then 6 year at 0.26 and 5 year at 0.25. Eurodeposits at 0.48 is not only bumping against 0.53 at the 8 year average but also bumps against the Fed headline at 0.50. Doesn’t seem likely Eurodeposits can trade higher than headline at 0.50 without a further rate hike from Yellen as correct Eurodeposit position is below headline.

The basis of this story is shortest term interest rates including Fed Funds are miles overbought and in dire need of corrections. Corrections may mean bottoms are here. Commercial Paper interest rates are deep insights to Fed Funds rather than Fed Funds itself as exclusive focus due to unmovability.

Commercial Paper rates actually see movements because its a far larger, liquid and safe market made of much more sophisticated dealers and investors. Normal deals begin at $100,000 and $250,000. Is overbought worth thr risk to commit further cash and to a lost price. Can Yellen raise under overbought interest rates, must a correction come first, will prices correct by the June and upcoming Fed meetings.

Typically central banks move when interest rates reach oversold or overbought but hardly move when a price is range bound. Timing is irrelevant as to an election but most important to the monthly meetings is budget cycles. They all watch prices daily. Interest rate movement is a wholesale change and central banks don’t like change. It explains why central banks are slow to move on interest rate changes and why they wait to overbought or oversold, always reactionary and never forward in responses. I’m still not convinced Yellen is ready to move Fed Funds higher unless bottoms and oversold are seen.

To further understand the growth of markets in relation to Financial and Non Financial Commercial Paper in the modern day, 1934 began the first ever views and accountability of Treasury International Capital or better known as TIC data to answer questions such as dollar amounts of securities foreigners are buying and selling and dollar amounts Americans are buying and selling in foreign securities. The process was a long affair to implementation.

In the 1970’s, data was reported every five years but Treasury as the first and dominant institution before Federal Reserve creation, assumed control of TIC data from the now defunct Office of Federal Statistical Policy and Standards. Treasury determined in the 1980’s the Fed should be provided with TIC data and this period began quarterly reviews of TIC to expand in the year 2000’s to monthlies and now annual and historic.

The investment idea was capital leaving X nation informs prices fall and become cheap so capital flows back into X nation to purchase lower priced financial instruments. When prices rise, capital leaves again so this system of capital flows provided a world balance to capital flows.

What is understood is long and short term purchases and sales in Treasury Bonds, Agency Bonds, Corporate Bonds and Stocks. More importantly is money flows are understood, quantifiable as well as overall specific buys and sells from individual nations. China and Japan for many years remain the largest holders of US securities with China easily number one as holdings in billions from February 2016 amount to 1252.3 V 1133.1 for Japan. Carribbean Banking Centers as third account for 261.1 and a new category of Oil Exporters amount to 281.0 billion. The UK lost its traditional position as third and fell to current 7th.

Companies such as Lipper, Morningstar and EPFR Global provide fund flows and asset allocation data in daily, weekly and monthly periods. Data is offered by sector, by nation, by financial instrument, by funds and equipped with extraordinarily detailed charts and commentary. Most important to interest rates and Commercial Paper in particular is Mutual Funds and Money market money flows as $24 trillion or so investment monies traverse the world in search of yield, gains and finance abilities.

What assisted Commercial Paper markets and interest rates in particular was the 1980 passage of the Depository Institution Deregulation and Monetary Control Act to reveal no restrictions on interest rates an institution could offer on deposits. The act deregulated interest rates and opened the free float in interest rates. As a sidebar, every decade either by reforms or crashes ushers in new market arrangements to last a full decade on average. Post 2008 is focused on control.

Insights to Commercial Paper and Fed Funds are found in Fed Surveys to Market Participants and Primary Dealers as to views on Fed Funds rises or falls. Primary Dealers are opinions of the highest quality and smartest assessments. Secondly, Commercial Paper Financial and Non Financial maturities are located at 1, 2 and 3 month durations while Eurodeposit rate maturities are found in 1, 3 and 6 months. What’s important regarding Commercial Paper in the 1 month maturity is correspondence to 1 month T Bills. Both rates offer solid bottoms to protect markets from crashes. The 2 month rate lacks a corresponding Treasury Yield and is a vital rate not only to US markets but the UK because the UK is deficient in the 2 month maturity.

Commercial Paper interest rates span a 156 year tradition in the US under continuous daily trade except for a few years in the 1930’s depression. Commercial Paper interest is the most important interest rate the world over because it informs not only healthy markets but Fed Funds rises and falls, capital flows and prices in currencies as well as other financial instruments.

Brian Twomey, Inside the Currency Market,

EUR/JPY Paper: Pt 2 Modern Trader Mag

By Brian Twomey Modern Trader Magazine, Part 2 EUR/JPY Paper, Charts missing

April 28, 2016 • Reprints

Carry trades are a method to borrow at a low interest rate and lend at a higher one. The trade is played out through the currency markets. However, currency relationships are not necessarily stable, and it’s important to analyze how a particular cross rate behaves over time.

Last month, we began a demonstration of this analysis for some popular cross rates using regression analysis to investigate how the EUR/JPY switches allegiance between the EUR/USD, USD/JPY in terms of a carry trade, particularly surrounding the 2008 financial crisis. This month we take a closer look at how the carry trade itself has evolved over time and examine how economic drivers have affected the cross-pair carry trade balance.

Anatomy of a carry trade
Carry trades are based on forex points per day, per month or per year. They answer the question of how many pips are earned to carry positions. The indispensable aspect is the trader should earn more points than are paid to be compensated enough to offset price depreciation in the long currency pair position.

The complexity of carry trades changed in 1994 when closing spot prices were marked to market; therefore, gains and losses were marked daily. Previously, forex points ran throughout the life of the contract term as traders earned the difference cumulatively without showing daily mark-to-market losses, allowing carry trade positions to be held to maturity. Losses, risk/reward and crash risk all depend on earning enough of a cushion in points to protect against adverse price developments.

Forex points are calculated from the closing spot price multiplied by the interest differential, divided by the day count, multiplied by the number of spot lots or futures contracts.

Findings suggest that carry trades contain two distinct revenue streams. One is interest differential income and the other price appreciation. Both are based on the theory of expectation. The sine qua non is to define interest differential in terms of nominal vs. real interest rates through time or in longer 20- to 50-year terms.

Price appreciation/depreciation is then defined in terms of carry trade holding periods and the length of time in trades. Essentially, a forex point is the interest differential, and is employed as a predictor of future spot prices, but it is also defined as the cost to carry positions and formally referred to as the forward discount. Currency risk is not necessarily on the investment side of the long position, but on the cost or borrow side, which may not continue to finance the long position sufficiently.

The EUR/JPY experienced temporary price and permanent interest rate depreciation pre- and post-2008. The beginning of 2000 saw EUR/JPY paying 5.75% vs. 0.50% pre-2008 vs. 0.25% and 0.1% post-2008. Carry trade losses and gains in forex points are based on the length of time in a position. Possible losses were experienced from reduced disbursements post-2008. Current price trades in excess of returns pre- and post-2008; 131.39
pre-2008 and 121.30 post-2008.

Carry trade and EUR/JPY
The EUR/JPY is a currency pair whose position is found within the boundaries of the EUR/USD and USD/JPY. Because EUR/JPY is derived from EUR/USD and USD/JPY by U.S. dollar subtraction, boundaries must hold residual constants or the EUR/JPY transforms into a free-floating financial instrument without a connection to EUR/USD or USD/JPY.

While residual constants hold firm, the EUR/JPY may change allegiance year to year, period to period or possibly crash to crash. An allegiance switch implies that the EUR/JPY boundaries range from small to wide within EUR/USD or USD/JPY residual variances.

The assumption that the EUR/JPY maintains a perfect 0.5 balance between the EUR/USD and USD/JPY was not found; however, that does not imply a 0.5 balance is not possible. Perfect balance further implies the EUR/JPY lacks allegiance and is solely independent of EUR/USD or USD/JPY.

An explanation of perfect balance is that the EUR/USD and USD/JPY ranges varied widely enough against each other and reached polar opposite extremes. Because EUR/USD and USD/JPY are completely opposite pairs whose relationship barely hold a statistical relationship, EUR/JPY is allowed to roam freely between both pairs. Findings suggest, however, that EUR/JPY is influenced by either the EUR/USD or the USD/JPY, but not both. So a 0.5 balance may be fleeting.

The EUR/JPY carry trade is then defined further to include either EUR/USD or USD/JPY. To view EUR/JPY exclusively in carry trade terms ignores the comprehensiveness contained within carry trades.

Money supply
A fundamental economic theory that caused EUR/JPY to change its status from pre- to post-2008 can be viewed in money supply terms, rather than as a wholesale EUR/JPY positional shift. Housing was the cause; the effect was central banks adopting quantitative easing stimulus.

As we know, interest rates share an adverse relationship to money supply. Interest rates since 2008 continuously dropped for all nations as more money was issued. Nations then experienced a Keynesian liquidity trap dilemma with countries dropping the interest rate to either zero or near zero. Low interest rates create a small price movement environment for EUR/JPY because of shrinkage of the interest differential.

Quantitative easing led to a wholesale economic change adopted by many nations as “stimulus spending,” a significant shift from previous 1980s-era supply side practices. Keynesian economics is a focus on the demand side of an economy, while its corollary focuses on supply. Both define EUR/JPY as an economic insight, a price, a carry trade and currency pair alignment.

Cross rate shift
The EUR/JPY as a carry trade is defined based on its attachment to either EUR/USD or USD/JPY, but not both. As we saw here, the EUR/JPY cross rates attachment to the EUR/USD vs. USD/JPY fluctuated throughout the 15-year period post- and pre-2008. This is evident on both weekly and monthly data (see “Crisis diversion,” below).

We examined the carry trade in the EUR/JPY by using 5,532 exchange rates, weekly and monthly, for the entire period. We saw that the perfect EUR/JPY 0.5 balance between the EUR/USD and USD/JPY was not seen over a consistent, measurable time frame, although it may have been in place during fleeting instances.

One fundamental reason why the EUR/JPY changed loyalty from the EUR/USD to the USD/JPY was a result of governmental adoption of quantitative easing (see “Switching horses,” below). If EUR/JPY had a chance to reestablish its EUR/USD attachment, the drop in interest rates and Keynes liquidity trap for all nations appeared to fail under that occurrence. By examining 12 separate data samples —much of which was shown last month as weekly data—we examined EUR/JPY loyalties and allegiance switches in a step by step approach.

Covariance was the preeminent statistic that we used to understand how and to what extent EUR/JPY transferred its loyalty from EUR/USD to USD/JPY. Slopes and regression lines served as the pictorial result to demonstrate how price traveled. The most pronounced regression lines were seen in USD/JPY, because of a complete line reversal.

While this study was limited to the relationships among three popular cross rates, the analysis should not end there. Traders in all cross rates and currencies would do well to understand the depth and consistency of the relationships between the markets they trade. Further analysis is warranted to explore how shifts in these relationships might portend price changes that may offer further opportunity to exploit market inefficiencies.

About the Author
Brian Twomey is an independent trader and author of “Inside the Currency Market: Mechanics, Valuation and Strategies.”