The interaction between bond yields and large government deficits in a low inflation world

Weekly Comment –March 3, 2019

At the end of February, the scientific journal ‘Amphibian & Reptile Conservation’ featured an article “Ecological interactions between arthropods and small vertebrates in a lowland Amazon rainforest”.  I’m sure you saw it. 

If for some reason you missed it, the admittedly dry title refers to a “dinner plate sized” TARANTULA killing and dragging a small possum across the floor of the jungle before eating it!  “It appeared to be the first documented case of a spider eating an opossum.”  Doctoral students Michael and Maggie Grundler, brother and sister, observed and videoed the event and co-authored the paper, noting they were “witnessing something pretty special.”  The Grundler clan really knows how to have a good time.

In the markets, we’d call it a ‘black swan’ event.  You might wonder whether I’m referring to the spider/possum or the Grundlers.  Both.  As an aside, I especially enjoy mangling serious scientific works and badly relating my misconstrued interpretations to the markets, and I have at least one fan of these efforts, for whom I’ve also included the letter to the Smithsonian as an addendum to this missive.

Below is a chart of the 30-year bond yield with some recent peaks tagged, along with unemployment rates that occurred around those highs.  In 2007, when the yield was around 5%, the unemployment rate was 4.5%.  In 2010 and 2011 when yields topped around 4.8%, unemployment rate was 9.5 to 9.0%.  After the mid-2013 taper tantrum where the yield surged to 4.0%, the rate was 7%.  And the peak yield in 2018 was associated with a jobless rate of 4.0%.  Economists are tentatively concluding (are you sitting down for this?) that the Philips curve may be breaking down.  Science.  I, for one, am reeling.

Our chart might indicate either that the unemployment rate should be going up, or that a MUCH higher yield is justified, given the current jobless rate.  The idea of letting the economy ‘run hot’ is gaining traction as there’s no inflation, and Modern Monetary Theory is also being bandied about.  On top of that, there was a Bloomberg article late Friday, ‘Fed Said to Quiz Primary Dealers About New Tool to Manage Rates’, which said the NY Fed “…has sought feedback on how an instrument that keeps money-market rates from rising too far above the central bank’s target range should be designed” as the Fed prepares to halt its balance sheet unwind.  Tantrum??  The Fed is seeking to cap short rates, while letting the long end go where it may in a world of trillion dollar deficits.  To quote market wizard David Bowie, “It’s like putting out fire… with gasoline.” 

Remember, QE had the effect of making risk assets rally, while yields generally increased over those periods.  The end of QT may have that same outcome.

An OECD paper out last week (highlighted by Simon Thorp of Aperture Investors on linkedin) outlines issues in global corporate bond markets and, like our Amphibian example, also has a catchy title: ‘Corporate Bond Markets in a Time of Unconventional Monetary Policy’

Key findings taken from the paper:

A couple of interesting quotes: “Any developments in these areas [global growth, CB policy, record sovereign borrowing in 2019] will come at a time when non-financial companies in the next three years will have to pay back or refinance about USD 4 trillion worth of corporate bonds.”  “Importantly, net issuance of non-investment grade bonds turned negative in 2018 indicating a reduced risk appetite among investors. The only other year that happened over the last two decades was in 2008.”  Of course, the Fed’s shift has caused risk appetite to be whetted in 2019. 

Another interesting point: “The People’s Republic of China has moved from a negligible level of issuance prior to the 2008 crisis to a record issuance amount of USD 590 billion in 2016, ranking second highest in the world.”  For many years people talked about “vendor financing” with respect to China.  The US bought manufactured goods with dollars, which were then recycled into treasuries, increasing China’s reserves.  ‘They send us goods, we give them paper.’  Is it now the case that China is peddling lower quality ‘paper’ rather than manufactured goods? 

There has been a resurgent reach for risk in 2019 as a result of the Fed’s change of heart.  The BBB Corporate Option Adjusted Spread was 140 bps at the start of October 2018. It powered up to 206 bps by the start of this year and has now retraced all the way back to 168.  Retracements of high-yield etfs have been even more dramatic. 

In a capitalistic system, we would expect the findings of the OECD to eventually result in higher default rates, higher spreads, and more circumspect (better) capital allocation.  In a world where central banks find it necessary to coddle investors, those results may be delayed ad infinitum. However, supply in the form of both US sovereign and corporate bond debt may yet overwhelm central banks and cause yields to reach levels which are perhaps unsustainable in the longer term, but extremely painful in the shorter time-frame.  Like a monster spider taking down small mammals.  A “pretty special” event.  


Here’s an update on libor/ois proxies.  I use 3 month quarterly ED contracts vs the average of the next two FF contracts. Over the past two weeks these spreads have compressed by 3.75 to 5.0 bps.

                                                                                                ___________________________________________3/1/2019               2/15/2019

EDM9 9738.5 vs avg(FFN9+FFQ9) 9759.0 =            20.50                     24.25         

EDU9 9737.0 vs avg(FFV9+FFX9) 9758.25 =            21.25                     24.50

EDZ9 9732.5 vs avg(FFF0+FFG0) 9759.75 =             27.25                     31.00

EDH0 9738.5 vs avg(FFJ0+FFK0) 9761.75 =              23.25                    27.50

EDM0 9742.5 vs avg(FFN0+FFQ0) 9765.75=           23.25                     27.25

EDU0 9746.5 vs avg(FFV0+FFX0) 9769.75 =            23.25                     28.25

There was a large new buyer (+65k) Friday of USM9 140/139 put spread for 8-10/64’s.  Settled 10 with 5 delta.  With USM 143-26 vs the 30-yr yield of 3.124%, the 140 strike is a bit over 21 bps away, or 3.33-3.34%.  At this yield, a 1 point move in USM is approx. 5.6 bps (Increases as the yield goes up).  In November the peak yield for 2018 was 3.455% and the stock-plunge-inspired low yield in Jan was 2.903%.  The halfway mark is 3.18%, about a point lower, with the 0.618 Fibonacci at 3.24%.  Next Friday is the employment data, and the following week features 3, 10, 30 year bond auctions.  If the yield moves to  3.24 in two weeks then the put spread should be worth about 19 (at 141-22).

This Friday the employment report is released with NFP expected 185k vs 304k last and Avg Hourly Earnings +3.3% yoy vs +3.2 last.  On Thursday, 7-March, the Fed’s Z.1 summary of Financial Accounts of the US is released, which features a quarterly snapshot of household, corporate, and gov’t debt flows and levels (along with the headline-grabbing Household Net Worth data).

2/22/2019 3/01/2019
UST 2Y 248.3 255.7 7.4
UST 5Y 246.3 255.6 9.3
UST 10Y 265.4 275.3 9.9
UST 30Y 302.1 312.3 10.2
GERM 2Y -56.5 -50.8 5.7
GERM 10Y 9.6 18.3 8.7
JPN 30Y 57.5 62.1 4.6
EURO$ Z9/Z0 ** -18.0 -14.0 4.0
EURO$ Z0/Z1 -0.5 -1.0 -0.5
EUR 113.35 113.68 0.33
CRUDE (1st cont) 57.26 55.80 -1.46
SPX 2792.67 2803.69 11.02
VIX 13.51 13.57 0.06


Paleoanthropology Division
Smithsonian Institute
207 Pennsylvania Avenue
Washington, DC 20078

Dear Sir:

Thank you for your latest submission to the Institute, labeled “211-D, layer seven, next to the clothesline post. Hominid skull.” We have given this specimen a careful and detailed examination, and regret to inform you that we disagree with your theory that it represents “conclusive proof of the presence of Early Man in Charleston County two million years ago.” Rather, it appears that what you have found is the head of a Barbie doll, of the variety one of our staff, who has small children, believes to be the “Malibu Barbie”. It is evident that you have given a great deal of thought to the analysis of this specimen, and you may be quite certain that those of us who are familiar with your prior work in the field were loathe to come to contradiction with your findings. However, we do feel that there are a number of physical attributes of the specimen which might have tipped you off to its modern origin:

·  1. The material is molded plastic. Ancient hominid remains are typically fossilized bone.

·  2. The cranial capacity of the specimen is approximately 9 cubic centimeters, well below the threshold of even the earliest identified proto-hominids.

·  3. The dentition pattern evident on the “skull” is more consistent with the common domesticated dog than it is with the “ravenous man-eating Pliocene clams” you speculate roamed the wetlands during that time. This latter finding is certainly one of the most intriguing hypotheses you have submitted in your history with this institution, but the evidence seems to weigh rather heavily against it. Without going into too much detail, let us say that:

It is with feelings tinged with melancholy that we must deny your request to have the specimen carbon dated. This is partially due to the heavy load our lab must bear in it’s normal operation, and partly due to carbon dating’s notorious inaccuracy in fossils of recent geologic record. To the best of our knowledge, no Barbie dolls were produced prior to 1956 AD, and carbon dating is likely to produce wildly inaccurate results. Sadly, we must also deny your request that we approach the National Science Foundation’s Phylogeny Department with the concept of assigning your specimen the scientific name “Australopithecus spiff-arino.” Speaking personally, I, for one, fought tenaciously for the acceptance of your proposed taxonomy, but was ultimately voted down because the species name you selected was hyphenated, and didn’t really sound like it might be Latin.

However, we gladly accept your generous donation of this fascinating specimen to the museum. While it is undoubtedly not a hominid fossil, it is, nonetheless, yet another riveting example of the great body of work you seem to accumulate here so effortlessly. You should know that our Director has reserved a special shelf in his own office for the display of the specimens you have previously submitted to the Institution, and the entire staff speculates daily on what you will happen upon next in your digs at the site you have discovered in your back yard. We eagerly anticipate your trip to our nation’s capital that you proposed in your last letter, and several of us are pressing the Director to pay for it. We are particularly interested in hearing you expand on your theories surrounding the “trans-positating fillifitation of ferrous ions in a structural matrix” that makes the excellent juvenile Tyrannosaurus rex femur you recently discovered take on the deceptive appearance of a rusty 9-mm Sears Craftsman automotive crescent wrench.

Yours in Science,

Harvey Rowe
Curator, Antiquities
Posted on March 3, 2019 at 11:23 am by alexmanzara · Permalink
In: Eurodollar Options

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