March 4. Ch-ch-ch-changes

Every time I thought I’d got it made, It seemed the taste was not so sweet.   -David Bowie/Changes

We put the cart of asset prices before the horse of enterprise.  Jim Grant, Nov 2014 speech


Chart above is from Advisor Perspectives, market capitalization to GDP.  The dotcom high was 151%, the last reading on this chart is 138.5 from early February, but the latest figure is actually 141%.  Clearly, with interest rates low, there is justification for higher asset values relative to growth.

However, there are a lot of changes occurring.  It’s worth noting that week to week differences weren’t particularly large.  While stocks were moderately lower, Nasdaq and Russell were only down around 1% on the week, with spirited rallies on Friday.  The five year note was nearly unchanged at 3.126%, tens were -1.7 bps to 2.853% and the thirty year bond -3 bps to 312.6%.

The changes are the following: First, Powell’s testimony indicates de-emphasis of asset prices as a determinant of the real economy.  Second, the US is pushing for trade changes that could blow-up into a war.  Third, China is addressing large financial imbalances.  Fourth, central banks are less stimulative and rates are edging higher. Fifth, inflation pressures are building.

Powell’s dismissal of stock valuations is going to put the Fed on a collision course with Trump, even though Trump’s tariffs were the primary catalyst for selling pressure last week.  Just for good measure, Trump also threatened a retaliatory tax on European autos.  The tariffs are putting the US on a collision course with China.  While China said it doesn’t want a trade war with the US, there is some speculation that both Japan and China might sell US treasuries in response.  From a Reuters article, one portfolio manager said “They already own a lot of them.  They would be shooting themselves in the foot.” Just standing aside and watching the US degrade its own fiscal position with huge treasury issuance might also be considered as shooting oneself in the foot.  Supply is coming from the US Treasury and from the Fed through QT.  All against a backdrop of a weaker dollar and potentially higher inflation.  If there were ever a time for China to make a point with sales of reserves, this is it.  The wind is currently at her back.  It’s not as if Xi has to worry about political backlash as he is now President for Life.  A bigger issue for China is cracking down on financial excesses within its own economy (which may reverberate globally as China has become a larger slice of world GDP).  In terms of Japan, Kuroda said last week that the BOJ might consider an exit to its stimulus in late 2019 as inflation approaches target.  In short, there is really nothing in the week’s news that is particularly friendly for asset prices.

Once again I am going to mention Gundlach’s question:  “When the next recession hits, will it be bond friendly?” Robust growth is not likely to be good for bonds; we already know that.  The total duration of US marketable debt outstanding is now near a record of just over 70 months (the historical average since 1980 is 59.5 months). Even a fall in equity prices might not be supportive of bonds in the current environment.  There are some indications that shorter maturities might benefit from a stock swoon, but the market is still setting up for continued hikes.   For example, there has been heavy buying of EDU8 9750/9737 put spreads, and on Friday, there was a buyer of 100k EDZ8 9725/9712 put spreads for 1.75.  This latter trade reflects a view of 4 hikes by year end.

News this week includes the outcome of Italian elections. Brainard speaks on Tuesday evening. Employment report on Friday.

Posted on March 4, 2018 at 10:57 am by alexmanzara · Permalink
In: Eurodollar Options

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