Stay in your lane, bro

Weekly – May 12, 2019

“Relax amigo, it’s gonna look ok.”

There’s a fairly amusing recent AT&T commercial set in a tattoo parlor.  The tattoo artist is a big gruff guy, and the first-time client is nervously asking questions. “Just ok?”

The artist simply warns as he’s getting ready to ink, “Stay in your lane bro.”

The tattoo artist

I was going to write about the controversial Kentucky Derby last week, but I was out of town.  I watched the race in the friendly environment of the Dublin House on 79th Street in NYC, and while it was missing the extravagant atmosphere of  flouncy women’s hats and mint juleps, it was a jovial crowd. Although it’s a week old now, I can’t resist the political metaphor of what was an exciting race.  Maximum Security led wire to wire, but was disqualified for drifting out of his lane and impeding War of Will, leaving second place Country House to claim the roses. Trump’s core theme has been Maximum Security with respect to both borders and trade.  It’s a War of Wills between Trump and Xi.  Now China has more or less told the US to respect its sovereign dignity and “Stay in your lane” and Trump has appealed to the Country House: “Make products in the US and avoid tariffs.”

There’s another powerful figure fond of the “Stay in your lane, bro” analogy, and that’s Chairman Powell.  Many times he’s been asked about trade and fiscal matters with regard to monetary policy.  Here’s a typical response from July of last year, “Part of the independence that we have, is to stick to our lane, to our knitting, so really [ the Fed ] wouldn’t want to comment on fiscal policy… or trade policy.”

However, we’re now in a world where fewer and fewer players are inclined to respect the lanes, from China and the US in trade negotiations and South Sea differences, to Brexit, to Iran and N Korea testing missles, to Turkey calling an election ‘do-over’ because the results didn’t square with Erdogan’s objectives.  Trump (and Kudlow’s) incursion into the Fed’s independence is another instance.  The market has been prodding the Fed in the same direction as Trump, if not in magnitude.  For example, in mid December, nearby one-year eurodollar calendars all inverted, and they have stayed that way despite the stock market recovery into the end of April.  The first three 1-yr calendars are now all around -28.5 while the admin has called for cuts of 50 to 100 bps.  Below is a picture of the 2nd to 6th contract on a constant maturity basis.  The lower panel of the chart is the spread.  In December of course, stocks and commodities were falling hard.  The Fed hiked on December 19, and that was the switch that sent spreads from the light of a positive curve to the darkness of inversion, signifying a central bank that is too tight.  Ironically, pressure by the administration may prevent the Fed from taking out an insurance policy ease, even if some of the deflationary impulses we’ve recently encountered are indeed transitory.

2nd to 6th ED calendar spread. Red area denotes inversion

Both China and the US face domestic considerations with respect to indebted companies.  Bloomberg highlighted conditions in both countries.  One article from May 7, notes that missed bond payments in China quadrupled in 2018 from 2017, and are on pace to make 2019 a record default year.  I’ve repeatedly posted US corporate debt charts, but below is a good one from BBG, that clearly shows the increase as a percent of GDP.  Growth in corporate debt coincided with QE2 and QE3 and the explosion of the Fed’s balance sheet.  That’s exactly what the Fed was looking for: debt growth to finance productive capacity.  But share buybacks are not the same thing as productive capacity.

US Corp Debt as % of GDP (Bloomberg)

So we’re left with the prospect of large amounts of debt needing to be rolled in an environment which is getting a little more discriminating.  This is simply my own take, and not backed by any hard data, but it seems to me that venture capitalists are using this period to cash out of holdings and distribute shares of money-losing enterprises to the public.  There was an interesting late April interview on CNBC with Alan Patricof, legendary vc founder of Greycroft.  At least since March, he has been warning that because many of the upcoming IPOs are “household names”, like Lyft, Uber, WeWork, etc. that the public isn’t focused on metrics like profitability and sustainability of growth.  The public is focused on investing in companies that have permeated the economic landscape.   A clear red flag was seen in early January, when Softbank trimmed a planned investment of $12 billion in WeWork down to just $2 billion as Saudi backers balked at throwing more money into a huge cash burner.    

In the late 1990’s, Fed Chair Alan Greespan said that many tech companies in the Nasdaq frenzy would undoubtedly fail, leading to an inevitable shake-out, but that it wasn’t the Fed’s job to interfere with the decisions of multitudes of individual investors.  We now have venture capitalists who have essentially subsidized consumers in order to build market share and turn unicorns into “household names”.   They’re using this window of time to monetize their investments.  So far, it’s been an inauspicious start with Lyft, Uber and Beyond Meat.  Pinterest has fared well but its metrics are arguably better as losses have narrowed over time.  Beyond Meat’s S-1 spelled it out: “We have a history of losses, and we may be unable to achieve or sustain profitability.” [let me add… That’s because people don’t generally like fake meat].  So, these companies have subsidized consumers by pricing their products at levels which don’t generate profits.  Eventually, the public markets won’t be quite as forgiving as they are now.  Think TSLA.  And note that Illinois is thinking of taxing electric car owners $1000 per year because they don’t pay gasoline taxes but still use the infrastructure of roads.  If there’s a “transitory” aspect of inflation, this is a BIG one.  These companies will end up raising prices in an attempt to achieve profitability, or go out of business, allowing survivors the luxury of pricing power.  Of course, the new central banking ‘third mandate’ is to keep zombie companies on life support.     

On a related though separate note, Fed Governor Lael Brainard gave a speech on May 8.  It’s clear that the Fed is thinking an awful lot (one might almost say is pre-occupied with) the idea of a recession and related decline in inflation. 

For a variety of reasons, it seems likely that equilibrium interest rates will remain low in the future. Low interest rates present a challenge for the traditional ways of conducting monetary policy. That is especially true in recessions when, in the past, the Federal Reserve has typically cut interest rates by 4 to 5 percentage points in order to support household spending and business investment. But when equilibrium interest rates are low, we have less room to cut interest rates and thus less room to buffer the economy using our conventional tools.

She then touched upon the inflation “make-up” prescription which has been mentioned by a variety of Fed officials, but also floated a new balloon: Yield Targeting.  Many in the press latched onto her comments as suggestive of long-dated targeting – as the Japanese do with ten year yields.  However, this proposal begins with the idea of pinning shorter term yields:

Another idea I would like to hear more about involves targeting the yield on specific securities so that once the short-term interest rates we traditionally target have hit zero, we might turn to targeting slightly longer-term interest rates—initially one-year interest rates, for example, and if more stimulus is needed, perhaps moving out the curve to two-year rates.     

It’s still in its infancy, but imagine this sort of scenario unfolding.  VCs keep dumping supply on to the stock market at a time when capital is also being sucked into the treasury market to fund increased deficits.  At the same time, China and the US drag out negotiations because neither side feels that they have enough of a concession to claim a ‘win’.  Global trade flows and the stock market suffer.  Inflation remains below target.  The Fed is forced to start easing quickly as China lets its currency weaken to counteract tariffs and support exports, further pressuring US prices.  The Fed starts to target one year yields.  However, domestic prices bottom and start to rise given protectionism, and service companies that have gone public are forced to jack up prices to stop the cash-burn bleeding.  Yields at the long end rise.  The yield curve steepens dramatically. Cats sleeping with dogs.

Or, conversely, maybe it’s just simpler to look at the chart below and say that base metals prices lead the ten year yield by 3 to 6 months and have now almost completely reversed Q1’s rally and look poised to test last year’s lows, which in turn would forecast tens at 2.00-2.25% by Q3.    

BBG base metals index (amber) vs US 10y treasury yield (white)

In any event, what we’ve had over recent history is a “Relax amigo, it’s gonna be ok” attitude about market outcomes. Kick the can down the road and there will never be an ultimate price to pay.  Unexpected shocks never have follow-through, and are used as yield enhancement opportunities to sell premium. My thesis is that one of the next lane changes is going to end up causing a chain-reaction accident.  Or, said another way, that tail risks are increasing.  It’s worth keeping in mind, amigo.

OTHER MARKET/TRADE THOUGHTS

The general structure of the market continues to suggest increasing odds of rate cuts.  Despite Friday’s stock market recovery from the depths of selling pressure, a continued cloud over global trade flows is negative for growth and for equity prices. 

As mentioned above, near one-year Eurodollar calendars remain inverted by a bit more than one-quarter pct. The lowest levels posted in late March were just under -40.  January Fed funds closed the week at 97.85 or 2.15%, vs IOER of 2.35%, indicating about 80% odds of a Fed ease by year-end.  This was the highest settle since late March which posted a high close of 97.91.  Libor/ois spreads have compressed, as indicated by EDM9 vs FFN9 which settled 16 bps and EDU9 vs FFV9 which settled 16.5.  It’s worth noting that euribor calendar spreads have also being declining.  For example, red/blue Dec (ERZ0/ERZ2) settled at a new low for the cycle of 36.0.  It had been over 60 at the start of the year.

I still favor a longer term theme of bull steepening as the long end of the US curve is held down by supply considerations.  Although odds of a market accident appear to be increasing, the Fed will likely be slow to react given criticism of the abrupt u-turn in policy at the beginning of the year.  However, when/if it becomes apparent that the economy has rolled over, the Fed will act swiftly. 

4/26/2019 5/10/2019 chg
UST 2Y 228.6 225.0 -3.6
UST 5Y 229.3 224.7 -4.6
UST 10Y 250.2 245.3 -4.9
UST 30Y 292.5 287.4 -5.1
GERM 2Y -59.5 -61.6 -2.1
GERM 10Y -2.2 -4.5 -2.3
JPN 30Y 55.8 53.4 -2.4
EURO$ Z9/Z0 -27.5 -26.5 1.0
EURO$ Z0/Z1 1.0 1.0 0.0
EUR 111.49 112.35 0.86
CRUDE (1st cont) 61.94 61.66 -0.28
SPX 2939.88 2881.40 -58.48
VIX 12.73 16.04 3.31

Note: Above are TWO week changes as I skipped marking last week’s data

https://www.ispot.tv/ad/IlZP/at-and-t-wireless-ok-tattoo-parlor

https://www.bloomberg.com/news/articles/2019-05-07/china-defaults-hit-record-in-2018-the-2019-pace-is-triple-that

https://www.federalreserve.gov/newsevents/speech/brainard20190508a.htm

Posted on May 12, 2019 at 1:27 pm by alexmanzara · Permalink
In: Eurodollar Options

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