Downside Risk Bandwagon

March 10, 2019 (weekly comment)

The past week was a full-on compendium of global downside risks.  First I will briefly highlight some of the comments and events.  Then I will have a note on MMT and the increasing trend of government policy-makers implicitly making the assumption that they are the driving economic force.  Finally, I’ll relate a couple of these thoughts to markets.

On Sunday, Powell will appear on the news show 60 Minutes, another effort to enhance the Fed’s communication strategy.  The acronym TMI was coined for a reason.  Sometimes it’s simply too much information.  Continuing discussion about the usefulness or lack thereof regarding the Fed’s ‘dot-plot’ is a case in point.  It probably creates more confusion than it clears.    

In the US, speeches by both Brainard on Thursday and Powell on Friday outlined risks.  Williams did the same in an interview on Wednesday, saying he expected growth to slow considerably relative to last year. Brainard’s conclusion tells the story:

The most likely path for the economy appears to have softened against a backdrop of greater downside risks. Our goal now is to safeguard the progress we have made on full employment and target inflation. Prudence counsels a period of watchful waiting. And with balance sheet normalization now well advanced, it will soon be time to wind down our asset redemptions.

Powell was less explicit about downside risks, concluding, “With nothing in the outlook demanding an immediate policy response and particularly given muted inflation pressures, the Committee has adopted a patient, wait and see approach…”  A large part of Powell’s comments concerned the idea of an inflation ‘overshoot’ policy to make up for past shortfalls:

The simplest version goes like this: If a spell with interest rates near the ELB leads to a persistent shortfall of inflation relative to the central bank’s goal, once the ELB spell ends, the central bank would deliberately make up for the lost inflation by stimulating the economy and temporarily pushing inflation modestly above the target. In standard macroeconomic models, if households and businesses are confident that this future inflationary stimulus will be coming, that prospect will promote anticipatory consumption and investment. This can substantially reduce the economic costs of ELB spells.

This paragraph implies that the Fed can fine-tune inflation, which I think is an heroic assumption.  The unconventional policy tools that have been in use since the crisis aren’t even completely understood with respect to intended and unintended outcomes.  Both Brainard and Powell mention QE, with Brainard saying while “…estimates vary, most conclude asset purchases were successful in supporting the recovery.”  Powell said nearly the same: “There is a range of views, but most studies found these tools provided significant support for the recovery.” I.e. we think it worked but cannot quantify with any accuracy.   

Bank of Canada said “…the slowdown in the fourth quarter was sharp and broadly based… it now appears that the economy will be weaker in the first half of 2019 than projected in January.”  And of course, the ECB downgraded growth and instituted a new round of TLTROs sparking a sharp fixed income rally Thursday.  Adam Smith’s invisible hand seems to be invisible, while the heavy hand of gov’t is pretty apparent everywhere.

To summarize US growth prospects in Q1 2019, the Atlanta Fed’s GDP Now is at 0.5% and the NY Fed’s Nowcast is 1.4%.  The OECD downgraded global growth.  

The policy of making up for lost inflation idea seems to be taking hold.  At the same time MMT is also gaining traction.  Stephanie Kelton, the main proponent of MMT, is logical, articulate and completely reasonable in describing the importance of consistently running government deficits, but once again, the implicit ideas are that lack of inflation means there’s unused slack in the economy which can be utilized through government creation of currency and debt. An actual surge in inflation due to maximum demand for resources would supposedly cause a scaling back in gov’t spending under MMT.  The fact that growth rates historically decline (with a lag) when the gov’t deficit is reduced, doesn’t necessarily mean that going the other way, i.e. accelerating deficit spending, juices the economy without negative effects.      

Doug Noland’s summary of the Fed’s Z.1 report released last week indicates the increasing role of government. “On a percentage basis, Non-Financial Debt increased 4.51% in 2018, up from 2017’s 4.10%. Federal [gov’t] debt grew 7.58%, almost double 2017’s 3.74%, to the strongest percentage growth since 2012 (10.12%). Household debt growth slowed to 3.22% (from 3.90%), with Mortgage borrowings up 2.83% (from 3.19%) and Consumer Credit growth easing slightly to 4.88% (from 5.04%). Total Corporate Debt growth slowed meaningfully from 2017’s 5.71% to 3.69%.”

We already have a large increase in gov’t debt and funding levels.  Wages are growing a bit more strongly than they had been, with year-over-year at 3.4%, the highest since 2009.  The Atlanta Fed’s wage tracker is in an uptrend. As the US election nears in the midst of a first-half slowdown, the theme will be ‘government to the rescue.’  This is perhaps a leap, but the longer term implication would appear to be a steeper curve.  As a marginal crumb of support for this view, note that Brainard said the Fed’s “portfolio has a much longer weighted-average maturity than the current stock of treasury securities outstanding in the market or than our pre-crisis portfolio… When the Fed begins once again purchasing treasury securities we will need to decide what maturities to purchase.  Given how far out of step the System’s current portfolio is from common benchmarks however, it might make sense to weight those purchases move heavily toward Treasury bills and other shorter dated Treasury securities for a time… However I want to emphasize that I do not expect this issue to be addressed for some time.”   

News this week includes:

Monday  Retail Sales for Jan expected 0.0.                           3-year note auction $38b

Tuesday  CPI with Core yoy expected 2.2%.                         10-year note auction $24b

Wednesday PPI Core yoy expected 2.6% Durables           30-year bond auction $16b

Thursday  New Homes Sales

There are also important Brexit votes.  On Tuesday Parliament votes for a second time on May’s Withdrawal Agreement.  If she loses, on Wednesday there will be a vote on whether to remove the option of a no-deal Brexit. Should that happen, then on Thursday Parliament will vote on whether to delay Brexit. (Telegraph)


Since mid-January I wrote of a probable range in tens of 250-255 to 282-287.  We haven’t been outside these levels.  Friday ended closer to the lower end at 2.63.  The high so far this year has been 2.80%.  The bias has been for lower yields as growth has slowed.  Implied vol remains quiescent, though there were some large call spreads purchased in the past week in tens: TYK 122.5/124.5 paid 22/23 80k ref TYM9 122-02; settled 38 vs 122-245.  TYK 123/125 paid ~22 in 40k, settled 26.  The 124.5 strike is approx. yield equivalent of 2.40%.

On the downside, the USM 139/140 put spread, bought in size at 8-10 in the previous week, settled 3 ref 145-31 (settled 10 ref 143-26 on March 1), with 65k still open. From this yield level of about 3% on the long bond, it’s worth owning puts at what continue to be low vols, especially going into the auctions. 

March midcurves expire Friday.  ATM straddles in red, green, blue and gold all settled 7 to 7.5:

0EH 9750^ 7.0 ref 9746.5 EDH0

2EH 9762^ 7.0 ref 9761.5 EDH1
3EH 9762^ 7.5 ref 9760.0 EDH2
4EH 9750^ 7.0 ref 9751.0 EDH3

As mentioned during the week red/green pack spread is as low as it has been since 2000, settling at -8.625.  The new red/green, starting with June contracts, settled Friday at -4.5.  The natural bias of course, is to buy these spreads.  But it’s so obvious that I wouldn’t be surprised to see a blow-up the other way. 

3/1/2019 3/8/2019
UST 2Y 255.7 245.5 -10.2
UST 5Y 255.6 242.0 -13.6
UST 10Y 275.3 262.1 -13.2
UST 30Y 312.3 301.5 -10.8
GERM 2Y -50.8 -55.0 -4.2
GERM 10Y 18.3 6.2 -12.1
JPN 30Y 62.1 57.0 -5.1
EURO$ Z9/Z0 ** -14.0 -19.5 -5.5
EURO$ Z0/Z1 -1.0 -3.0 -2.0
EUR 113.68 112.36 -1.32
CRUDE (1st cont) 55.80 56.07 0.27
SPX 2803.69 2743.07 -60.62
VIX 13.57 16.05 2.48

Posted on March 10, 2019 at 10:05 am by alexmanzara · Permalink
In: Eurodollar Options

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