Feb 10, 2019. Interest rate lethargy

What is the market telling us?  First I would point to the short term interest rate calendar spreads.  On the Eurodollar curve, the lowest one-year calendar is Sept’19/Sept’20 which closed at a new monthly low of -20.  In the beginning of January, just prior to Powell’s dovish shift on Jan 4, the lowest one-year spread was -28 and that was June’19/June’20.  At that time March’19/March’20 settled -27.0.  Just after the change of tone by Powell, spreads all rallied.  In fact, by late January, EDH9/EDH0 had surged all the way back up to positive territory, settling at +1 on 25-Jan.  EDM9/EDM0 rallied back to -7.5.  But now, even though risk assets have shaken off a bad December, interest rate markets are decidedly forecasting a lack of economic vigor that will result in Fed eases and lower global rates. 

It’s not just the euro$ curve.  Euribor calendar spreads have all compressed as well.  For example ERH0/ERH1 which was over 40 bps at the start of October, settled at 15 bps Friday.  This is below the early January low.  The ten year German Bund is just under 9 bps, also a new recent low, down 8 bps on the week, and the lowest since late 2016.  Like the US, near short sterling spreads have thus far held the lows of January, but the trend is a grind down.  The Japanese 30y yield is at a new low of 57 bps. 

In Eurodollars, option trades Friday pursued the theme of a stagnant economy which may require rate cuts by Q3.  For example, there was a buyer of 60k EDU9 9775/9787 call spreads for 1.0 (actually just under 1 as the trade was done covered).  For this call spread to fill out, the Fed would likely have to cut by 50 bps.  In addition, there was a new buyer of 50k EDN9 9762/9787 call spreads for 1.75 to 2.0. The EDM9 9737 straddle is trading 10.5 (settled 11) and someone is willing to pay 2 for a two-ease call spread in July?  While the EDN 9762.5 call settled 3.0, the equidistant 9712.5 put settled 1.25 (EDU9 9738).  As of Friday, FFF0 settled 9766.5, or 6.5 bp discount to the current Fed Effective, indicating odds of 1 in 4 for a rate cut by year end.

There was also a large buy of EDZ9 9737/9750/9762/9787 broken call condor for 1.0 (70k).  This trade would perform best with a slow grinding rally and perhaps 1 cut into the end of the year.  Nothing dramatic, but nothing to suggest a new round of economic buoyancy.  Positive return at expiry between 9738.5 and 9774.0.  Same in EDM9 is 2.25 and EDU9 is 1.75.

It’s becoming somewhat difficult to separate the markets from domestic and global political decisions.  When looking at the ten year yield since Trump, it’s pretty clear that increases in rates have been driven by the President.  In 2016, the yield surged on Trump’s election, as the market expected economic acceleration due to removal of regulatory shackles and growth policies.  2017 was sort of a sideways trade, [red rectangle on the chart below].  Q1’17 saw yields range between 240 and 260…there was a downward lull in the middle of the year, and then Q4 was again 240 to 250.  However, in the beginning of 2018, the tax package sparked another yield rise, this time up to 310, eventually culminating in a high just under 325 in September.  Now the market is forecasting a yield drift lower, indicating that the Fed stepped too hard on the brakes and that the tax stimulus has ended, so perhaps a re-visit of late 2017 yields. 

Whatever one’s opinion of Trump, he seems able to snatch victory from the jaws of defeat.  Over the balance of this month are two large deadlines: the government shutdown of Feb 15 and the China tariff of March 1.  Imagine for a minute that Trump accepts other measures besides a wall for border security, and then puts a softened proposal in front of Xi.  In other words, that he makes two deals rapidly, removing uncertainty. Stocks would likely build on January’s gains and yields would sit up and take notice of a new surge of growth prospects, especially if the Fed announces plans to taper balance sheet run-off in March (perhaps also a partially politically motivated act).  The odds don’t seem particularly high, and bond markets are thought to send more appropriate signals than stocks, but this outcome is not priced at all. 

One other topic I’d like to cover relates to Consumer Credit which was released last week.  While the press wrings its hands over household debt and student loans, I would simply say that the Household Sector is in good shape and that Student Loan debt perhaps needs to be thought of in a different way. 

In Thursday’s Consumer Credit report, student loans were reported at a record $1.569 Trillion, a pretty amazing number.  That debt is primarily the asset of the US government.  At the end of 2008, student debt was $639 million, so the increase has been nearly $1 trillion over the last 10+ years.  According to the Fed’s Z.1 quarterly report, Total Consumer Credit debt at the end of 2008 (of which student debt is a subset) was 2.644T and at the end of Q3 2018 was 3.938T, an increase of $1.294T.  I can’t quite get the numbers to exactly match from the NY Fed’s data on student loans to that of the main Fed website, but the point is that almost all of the consumer credit increase in the past ten years can be attributed to student loans!  Over the same time period US Gov’t Federal debt went from $7.377T to $17.754T, an increase of $10 trillion. 

In some ways the student loan program has been a big economic transfer program. Think of it as investment in human capital.  At the same time, college facilities have expanded, athletic and recreation opportunities have exploded.  It has likely led to university staff increases at all levels.  The wealthier families pay full freight for tuition and the very wealthy make donations to endowments and facilities.  Imagine for a second that all student debt was cancelled. A loss to the federal revenue stream of perhaps $100 billion per year in foregone interest?  Perhaps not even that much as a significant percentage isn’t being serviced as it is.  An increase the Federal Debt?   No one seems to care much about that any more.  Would the increases in expenditures on housing and consumption offset the cost?  Possibly.

Of course, it’s not fair.  Not fair to the people who skrimped and saved to pay their tuition.  Not fair in that some of the school loans didn’t finance education at all, but rather paid for spring break. But debt jubilees are coming, one way or another.

2/1/2019 2/8/2019
UST 2Y 248.8 246.1 -2.7
UST 5Y 250.7 243.9 -6.8
UST 10Y 268.7 263.0 -5.7
UST 30Y 303.2 297.4 -5.8
GERM 2Y -58.1 -57.9 0.2
GERM 10Y 16.6 8.7 -7.9
JPN 30Y 60.2 57.5 -2.7
EURO$ H9/H0 -7.5 -9.5 -2.0
EURO$ H0/H1 -10.0 -13.0 -3.0
EUR 114.59 113.26 -1.33
CRUDE (1st cont) 55.26 52.72 -2.54
SPX 2706.53 2707.88 1.35
VIX 16.14 15.72 -0.42
https://www.newyorkfed.org/studentloandebt/index.html
https://www.federalreserve.gov/releases/z1/20181206/html/d3.htm
Posted on February 10, 2019 at 2:06 pm by alexmanzara · Permalink
In: Eurodollar Options

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