Pernicious

June 23, 2019 – Weekly Comment

Lawrence Lindsey was interviewed on CNBC by Kelly Evans on Friday.  He said a couple of things that strike at the heart of monetary policy.  One interesting quote: most people don’t want inflation; central banks want it “because if you have a little higher inflation then you have a little more wiggle room.”  He was then asked about low long term rates and he said, sure, they hurt savers. “…but there’s even a more pernicious effect of low long term rates, and that is that you get a zombie economy …any business that can service debt at low rates stays in business, therefore there’s no creative destruction.” He added that he would not cut rates now. 

Many commentators blamed the administration for tax cuts and other fiscal stimulus at the beginning of 2018, saying it was at the wrong time given full employment.  Now, the Fed is coming under the same attack for easing policy with record low unemployment and stocks near all time highs. Perhaps the real problem has been identified by Lindsey: ZOMBIES.  They’ve gone global and hold prices down in a negative spiral.  Lower rates, which encourage zombies, which keeps employment high but lowers inflation expectations, which in turn, spurs a call for lower rates.  Someone has to kill these things!

When the financial crisis was in full storm, the federal government shifted bad private debts on to the government’s balance sheet.  Central banks cut rates to the zero bound.  In the US, banks were forced to merge and bolster capital. Sure, one goal was to help over-mortgaged households.  But the broader objective was to save the financial architecture.  Without a strong banking/financial system the smooth transmission of monetary policy locks up, and the loss of confidence is catastrophic.   In Europe, the move to zero (and below) didn’t come with the same sort of banking stringency.  Hence, the banking system wasn’t ‘saved’ and still seems to be choked with bad debts that need to be extinguished or isolated through bad banks, etc.  Lowering rates further can’t help the situation, though that seems to be the ECB’s course of action.  Higher rates and a positive curve help build capital. 

Brainard also gave an interesting speech on Friday.  Here are a couple of excerpts:

My own assessment is that the most likely path for the economy remains solid. The latest data suggest that consumer spending is robust, and consumer confidence is high. Although the pace of payroll gains has moderated recently, unemployment is at a 50-year low, wages are growing, participation in the labor force has expanded, and unemployment insurance claims are at cycle lows. Despite recent volatility, financial conditions overall remain supportive. [This sounds an awful lot like an argument for hiking!]

In addition, recent indicators of inflation and inflation expectations have been disappointing, making it all the more important to sustain the economy’s momentum [ I guess the declines are NOT transitory]

The downside risks, if they materialize, could weigh on economic activity. Basic principles of risk management in a low neutral rate environment with compressed conventional policy space would argue for softening the expected path of policy when risks shift to the downside. [ Insurance cut, but I’m not sure if it prevents, or causes, mayhem ]

However, when equilibrium interest rates are low, we have less room to cut interest rates and less room to buffer the economy using our conventional tools. [Here comes something new? ]

We heard in Chicago that most members of the public care a lot about the job market and the cost of credit, but they are not aware of our communications about monetary policy.

First of all, these clips are all from the same speech.  I have the highest respect for Brainard, but is this a cohesive message?  Maybe it’s good the public doesn’t know about the Fed’s ‘communications’.  Employment is at a 50 year low but some risks MAY materialize and so we need to change path?  The markets parse the Fed’s communications, the public views the resulting prices.  That’s the transmission mechanism.  Below is a chart showing how the market has interpreted the Fed and has communicated its response, through pricing.  In mid-September, the Fed hiked.  At the time, 3 month libor was 2.35%.  The Fed then hiked in December.  At that time, 3 month libor topped at 2.82%, so very nearly 50 bps higher.  Since then the Fed has NOT eased.  But the market has.  Three month libor is again at 2.35%, thus reversing the last two hikes.  [Red vertical lines denote hikes]

Round trip in 3 month libor since September…without an actual ease

In fact, financial conditions have loosened dramatically in the past several months.  Short end rates are shown above.  Long term rates as defined by the ten year have fallen from over 3% in Q3 of last year to printing just under 2% this week.  Stocks are near all time highs.  The BBB corporate spread which started the year around 190 bps, fell 12 ths week to 151.  Strength in the dollar had indicated tight conditions, but DXY gave way this week, closing decisively below the 200 DMA.  The yield curve has signaled a tight Fed, but even that is changing, with a new high in 5/30 this week to 79 bps.  A year ago this spread was around 25 bps. 

Aside from the major stock indexes, many markets are giving signs of impending disaster.  Most clearly this can be seen through interest rate futures/options, where trades are being piled into at ever higher call strikes.  It wasn’t long ago that there was large buying of October EDV9 9800/9825 call spreads around 3.0 bps, (then out-of-the-money, but now in, as EDZ9 settled 9811.5).  Currently the favored long call strikes are above 9900, which of course, requires sub-1% fed funds.  There is once again continuous buying of 100 strike calls (in EDM20, U20, Z20 and H21, total 100c open interest is 500k).  Besides the rally in rate futures, the gold/silver ratio is at its highest level since the early 1990’s, and is threatening new highs.  Bitcoin has pierced 10,000.  The ratio of SPX to the Russell has plunged to nearly match the low at the depth of the early 2016 wash-out (oil and commodity rout, EM unravel, corporate spreads jacked).  Banking shares have severely lagged the general rally.  Mfg and Service PMI surveys released last week indicate a further drop in inflation expectations  In the last few weeks the amount of sovereign debt trading at negative rates has gone from just under $12 trillion to $13 trillion.  Charts are attached at bottom.

This week attention is focused on the meeting between Trump and Xi, which almost certainly will result in ‘progress’ and the promise to re-engage in high level talks.  It’s too early for Trump to announce a deal.  The Democratic presidential debates will air on Wednesday and Thursday, to see who can promise to give away more.  Perhaps it’s in Xi’s interest to wait for the election with the hope of a new administration.  On Friday we’ll get Core PCE price deflator, expected at 1.6%.  Tuesday Powell speaks with the opportunity to hone his message: RATE CUTS AND ADDITIONAL ACCOMMODATION. 

Economic Outlook and Monetary Policy Review  1:00 pm, June 25

At C. Peter McColough Series on International Economics: A Conversation with Jerome H. Powell, New York, N.Y.

OTHER MARKET/TRADE THOUGHTS

Heavy buying this week of 0EH 9925 calls.  The main trade was +9925/9975c 2×3 with settles of 5.25 and 1.0 or 7.5 in the package (traded 8 on Friday).  These two strikes now have the most open interest of any midcurve calls, with 269k and 320k.  Underlying EDH1 has been the peak contract on the ED curve, settling at 9846.0.  That price in and of itself is pretty astounding, suggesting a FF target around 1.375%.  But the 9925 strike is another 75 lower.  Let’s just go to zero and get it over with, right Neel?  On the other hand, EDH21 is nearly 200 bps higher in yield than ERH21 at 100.42.

October Fed Funds which cover the July and Sept FOMC meetings, settled 9815.5, 52 bps lower in yield than front July FFN9 which settled 9763.5.  This suggests certainty of at least a half percent cut, and of course July/August at -31 means that a cut of 50 at the July meeting is priced at over 60%.  The last link of the chain has now responded, with the dollar (DXY) closing at the week’s low below the 200 DMA.  It’s an invitation for the curve to steepen.  If Trump hasn’t already blown out the deficit, then a taste of what the Dems could do will come this week. 

6/14/2019 6/21/2019 chg
UST 2Y 184.9 178.0 -6.9
UST 5Y 184.4 180.7 -3.7
UST 10Y 209.1 206.4 -2.7
UST 30Y 259.1 258.9 -0.2
GERM 2Y -69.3 -73.7 -4.4
GERM 10Y -25.5 -28.5 -3.0
JPN 30Y 36.0 32.8 -3.2
EURO$ Z9/Z0 -33.5 -33.0 0.5
EURO$ Z0/Z1 7.0 9.0 2.0
EUR 112.11 113.70 1.59
CRUDE (1st cont) 52.77 57.43 4.66
SPX 2886.98 2950.46 63.48
VIX 15.28 15.40 0.12

Last week’s Mfg PMI at 50.3 suggests lower Core PCE price
Long term gold/silver ratio
Ratio of SPX to Russell
Banks badly lagging….they ain’t buyin’ it SPX green, KBW Bank index white

BBB Corp spread.  Stays low because Central Banks promise to keep zombies alive

Posted on June 23, 2019 at 12:09 pm by alexmanzara · Permalink
In: Eurodollar Options

Leave a Reply