Feb 26. Fat tails

“The ECB has a monetary policy that is not geared to Germany, rather it is tailored (to countries) from Portugal to Slovenia or Slovakia. If we still had the (German) D-Mark it would surely have a different value than the euro does at the moment. But this is an independent monetary policy over which I have no influence as German chancellor.”

I missed this quote, which occurred last Saturday, 18-Feb.  Merkel was responding to criticism from the Trump administration that Germany is benefitting from an under-valued euro.  Innocuous enough, but in the context of last week’s price action it takes on considerably more importance.

The German schatz (2 year) plunged nearly 14 bps in yield this week to minus 94.7, and the bund fell 11.6 to 18.6.  The upcoming French elections have refocused the market on the possibility of a euro break up.  Given the “it’ll never happen” attitude pre-Brexit and pre-Trump, it’s causing traders to be a little more circumspect regarding fat tails.  The question becomes, “what is the ultimate denomination of German debt?”  and not “what is the correct yield level?”

It was July 26, 2012 when Draghi uttered his famous promise, “Within our mandate, the ECB is ready to do whatever it takes to preserve the euro. And believe me, it will be enough.”  The five year anniversary is in 150 days.  He probably wasn’t thinking about Le Pen.  On the chart below, which is the spread between Germany and Italy 10 year yield, the left hand side with the spike above 500 bps was the situation Draghi confronted.  He stopped it cold and by the start of 2013, the spread had halved to 250 bps.  Currently, stress is rising again, with the particular spread below, currently just over 200 bps, as high as it’s been since early ’14.  While I highlighted Italy/Germany, it is the same directional picture with France/Germany and other sovereign spreads as well.

The lowest 2 year rate I have seen is Switzerland at -111.  I recall a friend of mine asking me, (with stupendous timing, about a month before the SNB broke the euro peg), if I could find him a price on the CME floor for euroswiss options.  I told him, repeatedly, that no one would make a price, but he insisted I check around every few days.  He then called a friend at a bank who said, “we are only making prices for our largest and best clients; it’s a binary event.”  Well, we are living in a binary event world.  Fake, real.  White, black.  The models run along continuous paths, but we all know that trades don’t always work out that way.  I had another friend mention (and I didn’t personally check this) that market makers in bobl options were making bid/ask 10 wide on Friday, normally 2.  What can the model tell us about the ‘correct’ yield level for short end German debt?  Not much.

Anyway, I am no expert in German debt instruments, but I do know that treasuries experienced a sympathetic flight to quality (and/or short covering) rally on Friday.  Both fives and tens fell over 10 bps on the week, to 1.803 and 2.315. As noted last week, US swap spreads continue to widen.  Typically, I would associate this with risk-off.  However, US stocks remain extremely well bid, though small caps (supposedly more encouraged by Trump’s deregulation policies) have recently had the air seep out relative to large caps.  As Doug Noland of CBB said, ‘Defensive stocks outperformed this week, while “Trump reflation” wagers underperformed. ‘  Big cap defensive stocks appear to be recipients of USD ftq buying.   Key this week will be the market’s reaction to Trump’s speech before Congress on Tuesday night.

Below is a chart of Ten Year treasury vol in white, and the ten year swap spread in blue.  Since November there has been a fairly large divergence, with treasury vol generally easing since the election spike, and the swap spread surging.  As mentioned previously, there has been significant buying of June FV and TY calls vs May, a play on the outcome of the French election.  In my opinion, June treasury vol should push much closer to 6 (or higher) rather than Friday’s mark of 5.3.

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Moving away from Europe and the US for a second, I would footnote news from China that Guo Shuqing, “…considered by many as a passionate reformist”, was named as new Chairman of the China Banking Regulatory Commission.  From Reuters*: Banking assets over the last five years have more than doubled, helping to push the volume of non-performing loans at Chinese commercial banks to 1.51 trillion yuan by the end of last year, the highest since 2005.Guo [Shuqing] will work closely with China’s powerful central bank, which is tightening oversight of the surging asset management industry that has drawn the eye of investors seeking high yields and quick profits.

While the US has seen investor confidence in growth surge due to potential deregulation and tax relief, the opposite trend appears to be happening in China.  A regulatory crackdown on runaway debt dynamics in China will stifle growth in the short term.  Given that China has contributed about 40% of global growth compared to around 10% for the US **, it’s worth keeping in mind.

While the America First theme permeates most of the financial press, I would note that the Fed has often warned of international headwinds as an excuse to forestall rate increases.  While US growth, solid employment data, frothy asset prices, and increasing inflation levels provide ample ammunition for the Fed to decide to raise rates March 15, turbulence in non-US markets will likely exert a restraining influence.  (March and April Fed Fund contracts now reflect around 30% chance of a hike at the next FOMC meeting).  Let’s not forget lingering problems with Greece, with Germany’s deputy finance minister Jens Spahn saying this weekend that there will be no haircuts on previous loans.

Perhaps Yellen will touch on these subjects in her speech on Friday.  Just a reminder, the employment report will be released the following Friday, March 10.  Effectively, Yellen’s speech will be the last one prior to the blackout period.

 

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2/17/2017 2/24/2017 chg
UST 2Y 122.2 114.3 -7.9
UST 5Y 190.8 180.3 -10.5
UST 10Y 242.4 231.5 -10.9
UST 30Y 302.9 295.3 -7.6
GERM 2Y -81.0 -94.7 -13.7
GERM 10Y 30.2 18.6 -11.6
JPN 30Y 92.0 84.6 -7.4
EURO$ M7/M8 51.5 46.0 -5.5
EURO$ M8/M9 37.0 34.0 -3.0
EUR 106.15 105.62 -0.53
CRUDE (1st cont) 53.78 53.99 0.21
SPX 2351.16 2367.34 16.18
VIX 11.49 11.47 -0.02

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http://www.economist.com/news/science-and-technology/21717324-fears-californias-huge-oroville-dam-might-fail-have-subsidedfor-time-being-drought

http://uk.reuters.com/article/us-germany-security-merkel-euro-idUKKBN15X07C

http://www.reuters.com/article/us-china-banks-regulator-appointment-idUSKBN1640CT

** https://www.weforum.org/agenda/2016/09/why-china-is-central-to-global-growth

Posted on February 26, 2017 at 6:19 pm by alexmanzara · Permalink
In: Eurodollar Options

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