Blue Light Special

On December 27, 2018, a mysterious blue light illuminated the Manhattan skyline, as, reportedly, a power plant electric transformer blew-up in Queens.  At the same time, news was circulating that Sears Holdings had just days to stay alive, awaiting a proposal from Eddie Lampert’s, ESL Investments. 

Now, stay with me here…  Sears bought K-Mart.  K-Mart used to run “blue light specials” on sale items, where a blue light bulb would flash over featured products.  CNBC ran an article in the beginning of October which noted that “Total real estate sales in Manhattan fell 11% in the third quarter compared with the previous year”…”Prices fell, inventory jumped and discounts were higher and more common.”  “The average price of a Manhattan apartment fell 4% during the quarter…”  And that’s before stocks fell out of bed in Q4.  It was obviously a BLUE LIGHT SPECIAL on Manhattan real estate and the stock market.  Or an alien invasion.  Take your pick. 

There were a few amusing comments, but I especially liked this one by @michelledean  

Sort of depressing to know that the apocalypse will begin with people on twitter posting, “What the f**k was that”

There are a lot of people in the financial markets looking at recent activity and asking the same question. It’s not such a stretch to think that markets were already, well, stretched.  At the end of Q3 2018, market cap to GDP was 146% essentially at the same level as the Nasdaq inspired peak in Q1 2000.  Corporate debt to GDP is at a record (though a Moody’s piece by John Lonski from Sept 2018 notes that NET Corporate Debt to GDP is a more accurate measure and is not flashing any warnings).  However, consider this, as of end of July 2018, a CNBC article reported that AAPL had $244b in cash.  Having participated in this year’s repatriation tax break, AAPL bought back shares– I would suspect right up to the peak at the end of September.  In any case, ‘Cash & Short Term Investment Growth’ reads as follows on the balance sheet:  31-Mar-18, +13.98%, 30-Jun-18, -19.3%, 30-Sept-18, -6.58%.  Sequential declines. AAPL was spending cash to buy back shares in a rising market, which, of course, many companies did, some by using cash flow and some by borrowing.  In any case, balance sheets weaken at the margin, leading to the largest percentage ever of investment grade debt sitting just above junk.  This activity is sort of parallel to the mortgage withdrawals of 2006/2007.  Borrow money from an asset (rising home prices) and spend it on other things.  Feels good for a while.  I am only using AAPL as an example because it was pointed out to me by a client (thanks TW). There was also a NY Times article that noted, “Among companies in the S&P 500, each of the five largest quarterly stock buybacks on record was by Apple” (a total of $43.5 billion in the first half of 2018).  As of Friday’s close, every one of those share buybacks in 2018 is a loser. 

Now I want to mention a few market indicators.  First, EDH19/EDH20 calendar spread plunged 10 bps this week from -3.5 to -13.5.  In the past two weeks it has declined by 22 bps from +8.5 on Dec 14.  What’s notable is that the market is essentially moving up the timetable for a Fed policy reversal.  As of Dec 20, EDZ19/EDZ20 was the most negative one-year calendar at  -18.  At that time EDH9/H0 was -0.5, M9/M0 -8.5, U9/U0 -15.5.  Now U9/U0 is the lowest at -18.5.  Z9/Z0 actually firmed by half a bp on the week to -15.5.  The Jan’19/Jan’20 FF spread has gone from POSITIVE 11.5 to NEGATIVE 1 in a week.  

How does the Fed respond?  As I mentioned last week, the fastest ‘hike to ease’ in the modern era was Greenspan, with a hike on Sept 22, 1987 to 7.25%, followed by a cut just one month later on Oct 19, 1987 to 6.75% (the 1987 crash).  The current Fed has the face-saving option of altering the balance sheet reduction schedule, rather than overtly admitting a policy era and genuflecting to Trump by cutting the FF target.  Now, some people don’t think the $50 billion in balance sheet run-off is important.  I would only say that cumulative flows eventually have an impact, and stock market action since October is a case in point.  Share buybacks were also important on the way up, but hit a wall of declining efficacy at the margin.  The last straw.

Powell and Williams already softened the neutral rate risk by saying we’re now at the lower bound.  Last Friday (Dec 21) Williams said the Fed could change the balance sheet reduction schedule, or stop it.  On the administration’s side, Trump tweeted that he had made good progress on a phone call with Xi this weekend.  He also opened the door to a lesser sum than $5 billion for border security.  This is an important point:  Markets are increasingly calling the policy shots.  It harkens back to Clinton in 1994, when Greenspan said that a credible deficit reduction plan was necessary to placate markets.  From Bob Woodward’s book The Agenda: “Clinton’s face turned red with anger and disbelief. ‘You mean to tell me that the success of the program and my reelection hinges on the Federal Reserve and a bunch of ——- bond traders?’”  [Result, credible budget] On Friday CNBC’s Scott Wapner reported that a senior Trump admin official called a large investor asking what needed to be done to turn the market, characterizing the tone of the inquiry as ‘desperate’.  The advice was 1) stop criticizing Powell, 2) stop turnover in the WH ranks 3) cut a deal with China.

The circular nature of policy meddling presents a bit of a conundrum.  If Trump starts cutting deals to push stocks up, it strengthens the hand of the Fed to continue policy normalization, and lean against (artificial?) asset appreciation.

I can envision the following scenario: Early January: deal struck with China.  A Trump ‘win’ and softening of border wall demands leads to an end of the gov’t shutdown.  Stocks stabilize or rally, giving the Fed some breathing room.  At the January 30 FOMC the Fed announces changes to the balance sheet reduction program.  This lends further support to stocks, but yields on longer maturities rise.  (Shouldn’t yields decline?  Well, when the Fed announced QE programs, it was stocks that rose, and bonds that fell.  The same could happen here).

Of course, it could be that a China deal proves elusive, with XI pressing his advantage now that Trump appears weaker.  There were some large treasury call spread buyers on Friday that seem to reflect concern that this stock rally won’t last: +40k FVG 114.25/115.25 cs bought from 20.5 to 22 (New position, settled 22 vs FVH9 114-14).  And, +50k TYG 121.5/123.5 cs bought from 30 to 33 (New position, settled 33 vs 121-20).  The 115.25 strike in FV is approx. 17 bps away, and the 123.5 strike is approx. 25 bps away.


Feb/April FF spread settled 1.5, a new low, -2.5 on the week. May/July settled +0.5 and August/October -0.5.  As mentioned above Jan’19/Jan’20 FF settled -1.0.  I.e. no hikes in 2019.

A few updates: 3EU 9800c (EDU22 underlying, 9737.5s) settled at 8.75, plus 2.5 on the week, with the total long 250k (These were bought 3.5 to 5.5; the market may never get to strike, but otm calls still make money).  0EJ 9712/9737c 1×2 settled -6.0 (original rec to buy +0.25).  This latter trade is the sort of disaster that has fueled the bid on a scramble to exit.

As cited during the week, three month libor is at a rate (2.792%) which is now above EDH9 and EDF9 for that matter.  EDF9 closed 9724.75 or 2.7525% and EDH9 9729 or 2.71%.  Therefore, convergence would suggest limited upside for these two contracts.  (Chart is 3m libor vs the rate on EDH9, now inverted).

The chart below is the ten year yield.  It has broken a trendline from mid-2016.  The 38.2 retrace is 2.52%, which would approximately equate to TYH9 123-08.  

US Ten Year Treasury yield

The chart below shows the red to green euro$ pack spread (2nd to 3rd year).  As noted, it hasn’t been positive since August.  On Thursday it finally settled 0, though on Friday it went back to -1.125.  Reds have led the way higher as stocks fell and near calendar spreads imploded.  This and other spreads are now indicating that the Fed may have to ease.  Interestingly, the steepening move at the start of the year was due to tax stimulus and the idea of strong forward inflation and growth.  But the end-of-year rebound telegraphs an opposite macroeconomic backdrop.  My interpretation is more uncertainty and volatility.



12/21/2018 12/28/2018 chg
UST 2Y 263.3 253.4 -9.9
UST 5Y 265.5 257.0 -8.5
UST 10Y 279.0 273.4 -5.6
UST 30Y 302.7 304.1 1.4
GERM 2Y -60.2 -60.9 -0.7
GERM 10Y 25.0 24.2 -0.8
JPN 30Y 74.2 70.4 -3.8
EURO$ H9/H0 -3.5 -13.5 -10.0
EURO$ H0/H1 -11.0 -9.0 2.0
EUR 113.70 114.43 0.73
CRUDE (1st cont) 45.59 45.33 -0.26
SPX 2416.62 2485.74 69.12
VIX 30.11 28.34 -1.77
Posted on December 30, 2018 at 8:02 am by alexmanzara · Permalink
In: Eurodollar Options

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