July 31. The Market Accepts Q2 GDP. Does the Fed?

On Friday, Q2 GDP growth based on preliminary source data was released at just 1.2%, versus what had been the Blue Chip Consensus of 2.3 to 2.5%.  Because of the snow and cold weather (oh wait, that was Q1’s excuse…).  Skimming through the categories, Gov’t consumption expenditures and investment were DOWN 0.9%.  On the other hand, Intellectual Property was UP 3.5%.  Take a look at the citizens around you.  Make sense?  Personal consumption expenditures were up 4.2%.  Now THAT is something I understand… the crowning achievement of the US:  the American consumer as the global engine of growth.

In any event, Atlanta’s GDP Now forecast had already been taken down to 1.8% after Thursday’s inventories and trade data. I would bet that this number will be closer to the final mark.  However, sub-2% growth after sub-1% in the first quarter isn’t exactly robust.

Yields and the dollar sank, as the US ‘divergence of growth versus the rest of the world’ appeared to be less divergent than initially thought.  The ten year yield fell nearly 11 bps on the week to just 145.8.  I wonder if Esther George would still have dissented in favor of an immediate hike if she saw this data. Probably so, as SF Fed’s Williams said after the data, “There is definitely a data stream that could come through in the next couple of months that I would think would be supportive of two rate increases.”  In an extremely insightful addendum, he also noted, “There’s data we could get that wouldn’t be supportive of that and it could be supportive of one maybe, or of none.”  In other words, ‘we simply don’t have a handle on things.’  Dallas Fed President Kaplan was more transparent in comments Friday, saying the current period the U.S. central bank faces now is going to be “as or more difficult” than financial crisis. (BBG).  He also said that we can’t continue to allow fiscal policy paralysis, and that the neutral rate has gone down.

Rightly or wrongly, market pricing across the US interest rate curve continues to reflect an economy that is simply stuck in the mud.  Note that the first seven one-year Eurodollar calendar spreads are between 12 and 13 bps.  That’s all the way from Sept’16/Sept’17 (12.5) to March’18/March’19 (13.0).  One year spreads generally indicate the amount of potential hiking in a given year.  At just 1/8th %, these spreads show that the market is collectively giving the Fed the middle finger with respect to tightening plans.  It’s the same message being given to entrenched institutional structures across the globe.

A couple of other notes about GDP.   Analysts noted that a part of the softness was due to a decline in inventories, which could easily reverse.  Perhaps, but the inventory to sales ratio is still quite elevated at 1.4 (chart link on bottom of page).  Secondly, as noted above, gov’t spending was weak.  On this score, I would note that Fed’l Gov’t Debt Growth (proxy for spending) was 5% in 2015, and 4.6% in Q1 2016.  Government debt to GDP in the US is 104%. http://www.tradingeconomics.com/united-states/government-debt-to-gdp   Although a large infrastructure program would likely cause a boost in growth, total gov’t debt levels are at levels which cause concern.  And gov’t debt growing at over 4% in a 2% economy isn’t a recipe for success, it’s what sparked the European austerity programs.

At the same time, market participants are being coerced into reaching for lower yields, which offer little cushion against downturns, to which they are arguably more susceptible.  One might think that implied vol would have to remain slightly elevated to compensate for this risk.  But the search for yield is so overwhelming that it smothers premium as well.  As Pat Clarke said, “I think I saw a couple of basis points scurrying around in the corner that I have to catch.”  A mental image of futility.

For example, the VIX closed Friday at 11.87, near the low of the year, (and the low of the past five years).  From Reuters: “… the S&P 500 traded in a less-than-1 percent range throughout the 12 sessions to Friday, a lull not seen in data going back to 1970, according to Ryan Detrick, the senior market strategist at LPL Financial.”  In eurodollars, an example of premium compression occurred Friday, as the red pack 9900 straddle strip (2nd year, Sept’17, Dec’17, Mar’18 and Jun’18)  was sold down to 207 from a settle of 213.5 Thursday. (Settled Friday at 207.5).  These sales are occurring in spite of a pretty big data week in the US, with ISM Monday (expected 53.0), and Employment on Friday (NFP 180k, avg hourly earnings 0.2).  Bank of England meeting is Thursday.

Compression is apparent in the front end of the market as well.  On Friday the 3 month Libor setting was 0.7591, a price of 99.2409.  EDU6 settled 99.21, just over 3 bps away.  The 9925 straddle settled 8.5, 4 bps in the money.  August/October FF spread (which isolates odds of a Sept FOMC hike) settled 2.5, or just 10% odds of a hike.  The narrowing of the spread between Libor and EDU6 likely signifies that front end pressure associated with money market reform has run its course.

Just a couple of other notes.  The Sept Crude Oil contract fell nearly 6% on the week.  Auto sales appear to be in a slowdown, and restaurant sales are weakening.  From Stifel:  “… the simultaneous [-1.5%] to [-2%] deceleration of Restaurant industry comps across all categories during 2Q16, within our most recent Stifel Sales Survey reflects the start of a US Restaurant Recession.  … if history is a guide, we warn investors that restaurant industry sales tend to be the ‘Canary that Lays the Recessionary Egg’ (i.e. the current -2% cut-back in dining out sales is a possible harbinger of a -2%-plus cut-back in the US consumers’ entire spending basket within 3-to-9 months.”

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7/22/2016 7/29/2016 chg
UST 2Y 70.2 66.3 -3.9
UST 5Y 111.8 103.3 -8.5
UST 10Y 156.6 145.8 -10.8
UST 30Y 228.7 218.4 -10.3
GERM 2Y -61.2 -62.5 -1.3
GERM 10Y -3.0 -11.9 -8.9
EURO$ Z6/Z7 18.5 12.0 -6.5
EURO$ Z7/Z8 14.5 12.5 -2.0
EUR 109.80 111.76 1.96
CRUDE (1st cont) 44.19 41.60 -2.59
SPX 2175.03 2173.60 -1.43
VIX 12.56 11.87 -0.69

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https://fred.stlouisfed.org/series/ISRATIO?cid=98

Posted on July 31, 2016 at 5:27 pm by alexmanzara · Permalink
In: Eurodollar Options

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