Rate hike chance moves up

June 18. 2021

–Spectacular moves in many markets yesterday as players try to digest Powell’s upbeat economic summary and more hawkish outlook for monetary policy.  (I think “players” may be a more appropriate word than “investors” for this type of volatility).   Interest rate curves were one of the most visible reflections of changing positions, where 5/30 fell another 9.8 bps yesterday to a recent low of 122; down 19 in two days.  Commodities and precious metals hit hard, USD bid, curves crushed like falling timber.  In some ways, the curve moves represent a mini-taper-tantrum.  On the eurodollar strip, prospects for tightening were jolted forward.  As an example, I have attached a chart of the EDU2/EDU3/EDU4 butterfly (thanks DK).  Yesterday, EDU2/EDU3 one-year calendar ROSE 4 bps to 63.0, while EDU3/EDU4 FELL 7.5 bps to a new recent low of 50.5.  The fly rose 11.5 on the day to 12.5.  As is evident on the chart, a swing from -13 to +13 in a month is rather unusual.  I suppose these wild moves are partially explained by all the loose money sloshing around, as reflected by the RRP operation which totaled a record  $756 billion as the rate was raised to 5 bps.  Today’s equity option expiration could also drive some volatile trades, and Powell is slated to further explain the Fed’s thinking in front of Congress on Tuesday, as we approach quarter end. 

–The peak one-year eurodollar calendar is now EDH23/EDH24 at 64.5, but the nearer spreads are catching up as an actual hike could move forward and news sources report that many on the Fed are getting restless with the new framework.  What has appeared to be stability has been orchestrated by relentless Fed stimulus– even a change at the margin can have unintended consequences.  After the Fed there were two large block buys, 20k each EDU2/U4 and EDZ2/Z4 at 121.5 and 118.  Yesterday these settled 113.5 and 109.5, but there was another 20k block selling EDU3 and buying EDZ4, so perhaps rolling the short EDZ4 leg forward to U23. 

–I’m not sure how much to trust (or interpret) the prelim open interest figures, but the big changes were in EDH23, down 45.7k contracts (ending price 9942, -4.5), EDZ23 down 49.3k contracts (ending price 9890, -4.0) and EDZ25 down 38.5k contracts (ending price 9816.5, UP 12 bps).  The guy with the long EDZ23/EDZ25 spread did NOT have a good day.  On the EDZ25 contract, the decline in open interest represented nearly 19% of total positions.  I guess we can roughly say that every 10k exit of a green/gold calendar can move the spread around 4 bps. Follow the science, right? 

Steepness shifts to front end in wake of FOMC

June 17, 2021

–The five year note was crushed as the Fed indicated a couple of rate hikes by the end of 2023.  Five-year (at futures settlement) was up 9.2 bps to 0.876%, while tens rose 6.1 bps to 1.558% and thirties actually fell a fraction of a bp.  5/30 spread easily made a new recent low, plunging 9.4 to 132 bps.  Steepness shifted to the front end of the curve as all near euro$ one-year calendars made new recent highs.  As an example, EDZ’21/EDZ’22 rose 4 to 24.5, while EDZ’22/EDZ’23 jumped 7 to 61.5.  While Fed dots indicate 2 hikes, the market is looking for more.  On the eurodollar curve, the blue pack (4th year) was the weakest, closing down 15 on the day at an average price just below 98.35, or a yield of 1.65%.  Prior to the announcement there was a buyer of 3EN 9850 puts for 3.5 bps, these closed at 9.75 as the underlying EDU’24 settled at the money at 9851 (-15) and traded as low as 9846.5.  Powell said that even though growth in 2022 was forecast to be very strong at 3 to 3.5%, the Fed would remain highly accommodative and intimated the central bank would lag the curve.  While IOER was raised 5 bps. near ED contracts only fell 1.5 on the day. 

–Post-Fed there were a couple of 20k block trades which appear new from this morning’s open interest report.  EDU’22/EDU’24 bought for 121 bps and EDZ’22/EDZ’24 bought for 118.5.  Both of these two-year calendars settled 117.  Five or more 1/4 percent hikes over two years?  Seems reasonable.  I suppose that in a broader context, trades like these signal a change in sentiment from large asset managers: the Fed has shifted its stance.  The dollar jumped and precious metals have been shellacked.  Stocks are showing early weakness this morning, which could accelerate due to Friday’s option expiration.   

–Powell will be testifying before Congress on Tuesday to further massage his message and quell undue volatility. 

Current Conditions

June 16, 2021

–Former NY Fed President Dudley often spoke about financial conditions.  In a speech from March 2017, he mentioned 5 key inputs, short term treasury rates, long term treasury rates, credit spreads, the value of the dollar, equity prices.  Going into today’s Fed meeting, 3-month libor is at a record low and bill rates are zero.  Then ten year yield is 1.5%.  Excluding the COVID plunge of 2020 it’s at the lowest level in five years.  Credit spreads are record lows.  DXY is near the year’s low. Stocks are record highs.  Housing is on fire with mortgage rates extremely low.  Federal deficits are at a record.  The financial press continues to talk about the dot plot.  My question is whether current financial conditions represent stability, or could be silently breeding instability.

–Regarding the dots, in March, 4 members saw one hike and one saw 2 hikes in 2022.  In 2023 there is 1 dot at 0.375, 1 at 0.625, 3 at 0.875, and 4 at 1.125.  Because these are end of year forecasts, it’s worth looking at Dec/Dec eurodollar spreads for comparison.  EDZ21/EDZ22 is 20.5 bps, not quite indicating one hike.  Jan’22/Jan’23 FF spread is 14.5, about a 50/50 chance for one hike in 2022.  So those spreads are more or less consistent with the plot.  EDZ’22/EDZ’23 is 54.5, about 2 hikes over that year which I would also terms as consistent with the plot.  Of course, “longer term”, the Fed expects the FF target to be around 2.5%, and nothing in the rate market is consistent with that.  Nothing.  If we compare that target to long term inflation expectations as represented by the ten year note to tip spread, which is 240 bps, then we might conclude that the Fed expects slightly negative real rates for the next ten years.  If we look at an average of the 4 euro$ contracts in year 2025, the avg price is 98.3075, which would be reasonable in the context of a FF target of 1.50.  About 100 bps BELOW the Fed’s longer term projections.

–In the March projections, the Fed looks for Core PCE Inflation at 2.2 in 2021, 2.0 in 2022 and 2.1 in 2023.  I’ll take the over, but the market has easily absorbed shockingly high prints.  The market trades as if Powell can gracefully transition to an initial conversation about tapering and eventual tightening.  I suppose the Fed should take that as a merit badge for guidance.  Enjoy it while it lasts.  

Bats*** crazy

June 15, 2021

–Curve bounced with the ten year yield rising 4.5 bps to 1.497% and 2/10 up 3.3 to 133.8.  On Monday, 3-month libor set at a new record low of 11.8 bps, leading to the highest ever final settle of a euro$ contract, EDM1 at 99.8820.  Coincidentally, Nasdaq made a new all-time high.  And the Fed’s RRP was a record high $584 billion.  I don’t know if any of these factors will filter into a discussion of financial stability at tomorrow’s FOMC, but it would seem as if tapering should be high on the agenda (again, it would only be slowing the growth of the Fed’s balance sheet, not reversing it).

On Monday Paul Tudor Jones was interviewed by Andrew Ross Sorkin and PTJ said the world is bat-s crazy.  His comments were centered around the Fed but for a concrete example of crazy consider that the Greek Five Year note printed a negative yield on Monday, having been 20% just six years ago. 

Summarizing PTJ, he said that this FOMC might be the most important in the past four or five years in terms of how they react to the data.  He says the Fed is now operating with a single mandate, that of full employment.  So, this Fed has a different reaction function [which of course was articulated by the Fed in August of 2020 with the announced change of framework].   He cites the extraordinary fiscal and monetary accommodation as being outside the bounds of orthodoxy, and said it all started with Trump’s 2017 tax cut that resulted in a 5% peacetime deficit.  Mohamed el-Erian made similar comments yesterday, saying that even with the economic car rolling downhill, the authorities have the “pedal to the metal”.  The Fed has said several times that tapering will precede rate hikes, and it seems as though the tapering discussion must occur now, as the next FOMC is in late July.

One interesting thing about PTJ talk was about commodities:  He said that Asset Managers have about $88 trillion under management, and of that about $670 billion is committed to commodities, or about 0.75%, with inflation at 4.9%.  He compared that to 3% inflation of 2011, when asset managers had about 1.2% of assets in commodities.  To bring the percentages back would cause a flow of about $400 billion into commodities, which he says could double or triple commodity indexes.   Elucidating further he says, “They’re SHORT”. 

Inflated Household Net Worth

June 13, 2022

The ten year yield dropped 11 bps on the week to 1.45%, with CPI clocking in at 5% yoy.  JOLTS data last week was off the charts at 9286k, indicating powerful demand to fill job openings. 

This week features the June FOMC meeting.  The Fed has apparently won the “inflation is transitory” argument, because a ten year yield below 1.5% simply does not make sense with inflation at 5% (or at 3% or at 2% for that matter).  Nor does a new record low in hi-yield at 4.08%.  The G7 meeting found common ground in the need to continue shoveling fiscal support. Certainly, the conversation to begin tapering should occur, but any action will occur at a later date.  An adjustment to IOER higher by 5 bps is likely to be the only tangible outcome of the meeting.

The Fed’s Z.1 flow of funds report was released last week.  Focus is typically on the Household Net Worth number, which of course hit a new record high of $137 trillion, up $5T on the quarter.  Yes, we’re all getting “richer”, (isn’t that simply fantastic?)  What I would note is that the “getting richer” slope over the past four or five quarters is quite a bit steeper than the trend from 2011 to 2018.

 
The Credit Bubble Bulletin has these comments relating to Z.1:  “Household Assets inflated $5.184 TN, or almost 14% annualized during Q1 to a record $154.2TN… Household Assets-to-GDP ended the quarter at a record 699% of GDP – up 100 percentage points in 14 quarters.”  Further, “HH Net Worth surged $4.997 T during Q1 to a record $136.9T.  For perspective, growth in Net Worth averaged $830 billion quarterly over the 20-yr period prior to 2019.  Net Worth inflated $31.4T over five quarters.  HH Net Worth ended March at a record 621% of GDP.  This was up from previous cycle peaks 491% (Q1 2007) and 445% (Q1 2000).” 

I would put this data in the inflation category.  Moreover, I would also have to characterize these ratios as transitory.  While growth has clearly come roaring back, my opinion is that Net Worth to GDP is at an unsustainable level.  What I haven’t read much about recently, (though I have personally observed it) is the wealth effect on consumption.  I believe it operates with a lag and is likely to be a large support for consumption over the next several quarters.  My thesis is that the Fed, in concert with fiscal spending, has over-inflated the value of financial assets relative to GDP.  What is comforting, at least on the household side, is that total liabilities (the red bars on the above chart) have barely increased at all.  In fact, on the quarter, liabilities increased less than $200 billion to $17.24T.  These assets are being blown up by someone’s debt, but it’s not that of the HH sector, it’s the government.  I suppose one might surmise that a moderating influence on consumption would be future tax liabilities on households, but that’s been pushed to the back burner by Modern Monetary Theory.

The chart above has bearing on household net worth, yield levels, and the taper discussion.  Note that in 2013, when yields surged in response to Bernanke’s suggestion of taper, the balance sheet was, in fact, growing the entire time.  Another fun fact is that while the FF target was exactly the same then as it is now, the starting point for the tantrum surge in tens was the exact same level as it is now. 

There is, of course, a lot of focus on the tapering schedule, but current concerns seem rather overblown because in this case, the Fed won’t actually be decreasing the balance sheet, but merely slowing its growth rate, though of course changes at the margin matter.  It was in 2018 when the Fed was both hiking AND actually cutting the size of the balance sheet that proved too much for financial markets, as stocks tanked in Q4 2018 and bond yields followed suit.  On the chart above, yields would appear to have significant room to the upside even with a slight decrease in the trajectory of balance sheet growth.  Of course, the narrative is that without the Fed buying every bond, yields have to increase.  I think a taper at this point will have a more significant effect on equities than bonds. 

A couple of words about commodities and the inflation debate.  Some have pointed to the hard break in lumber off May’s high, which accelerated this past week, as evidence that high prices are unsustainable.  We are not seeing the same sort of price action in grains, and certainly not in oil.  Both the near WTI contract and deferred calendar spreads made new highs.  CLN1 closed at 70.91, highest since Q4 2018 (when Fed hikes and balance sheet reduction hit oil and stocks simultaneously).  CLZ1/CLZ2 ended the week at the highs of 5.53, having started the year at 1.31.  CLZ1 100 calls have drawn some attention, and now show nearly 16k in open interest, settling at 27 cents vs 67.84.  Dec Corn ended the week at 609 ¾, near the high of the year.  Hot and dry weather is underpinning strength in grains.  I like to refer back to Sue Martin’s interview on Feb 26 of this year with Iowa PBS, where she forecasts extremely high prices in 2023 as a result of tight stocks:  “I think it’s possible that in 2023, we can see, and I’ll pace it, we could see $30 beans.  I think corn, maybe 18-19, and wheat goes to 42 to 45.”  If she’s correct about $19/bushel corn next year, it will be mighty interesting to see where we are on the broader inflation question.     
https://www.iowapbs.org/mtom/story/38230/market-plus-sue-martin
(start around 9 min mark)

OTHER MARKET THOUGHTS/TRADES

The 2yr/5yr treasury spread topped at 77.5 in March.  This week it made a low of 56.2 and ended at 59.  The two-year note under 15 bps indicates not much of a hike chance over the period, though EDH’22/EDH’23 at a settlement of 26 forecasts at least one hike over that period.  I continue to believe that the Fed will be forced into a hike in late 2022, as high inflation persists and financial stability is imperiled.  I do not think Biden will retain Powell next year, and instead will move to Brainard, who may not bring as strong of a hand to the table in terms of Fed board allies. 

While the long end rally has compressed many spreads, the trend toward steepening remains intact.  There might be a bit more of a pull back, but my thought is that the August change in the Fed’s framework sparked a move that will continue, unless trendlines off August lows in spreads are broken.  Using 2/5 as an example, the spread began the year at 25, and the August trendline comes in around 40 currently.     

	6/4/2021	6/11/2021	chg
UST 2Y	14.9	14.7	-0.2
UST 5Y	78.4	73.9	-4.5
UST 10Y	156.2	145.2	-11.0
UST 30Y	224.2	213.8	-10.4
GERM 2Y	-67.1	-68.3	-1.2
GERM 10Y	-21.3	-27.3	-6.0
JPN 30Y	69.0	65.1	-3.9
CHINA 10Y	313.0	315.0	2.0
EURO$ U1/U2	14.0	14.0	0.0
EURO$ U2/U3	53.0	50.0	-3.0
EURO$ U3/U4	58.5	53.5	-5.0
EUR	121.68	121.11	-0.57
CRUDE (active)	69.62	70.91	1.29
SPX	4229.89	4247.44	17.55	0.4%
VIX	16.42	15.65	-0.77

https://www.federalreserve.gov/releases/z1/dataviz/z1/balance_sheet/table/

Bureau of Weights and Measures

June 11, 2021

–A blockbuster inflation report was met with a shrug, as 5% yoy CPI caused the curve to make new lows and SPX to hit an all-time high.  It’s incorrect to say the report “caused” the curve to make new lows, but that’s what occurred in any case.  Core CPI was +3.8% yoy.  2/10 spread fell 2.5 bps to just over 130 bps, with 115-120 as next large support level, which would test the trendline from August, when the Fed changed its framework. The ten year yield fell 2.9 bps to 1.457%.  A couple of other related notes: the Fed’s RRP operation set a new record of $535 billion, and Household Net Worth rose $5 trillion in Q1, according to Bloomberg.  When I look at the Fed’s Z.1 report, I see an increase in net worth of ‘only’ about $4 trillion (maybe Bloomberg is including NFT’s).  Just joking about the NFT’s, but according to this link. I see Total Assets at $154.2T vs $150T in Q4, and Total Liabilities $17.2T vs $17T. 

https://www.federalreserve.gov/releases/z1/dataviz/z1/balance_sheet/table/
The chart link is revealing as well, as it shows acceleration in ‘assets’.
https://www.federalreserve.gov/releases/z1/dataviz/z1/balance_sheet/chart/

So, assets are levitating in value, while liabilities edge just a tiny bit higher…for households.  Government debt has, of course, soared.  To me, the conclusion is that the measuring stick, that being the value of the dollar, is suspect.  It reminds me of the Tin Man scam, where the salesman would cut a few inches from the center of the old wooden yardstick, glue it back together, and hold his hand over that part when measuring a job.  “No one ever checks to see how long a yardstick is.”  The record RRP numbers just sort of confirm the idea of A LOT of excess liquidity.  I suppose yield levels tell the same story.  

–A couple of trades to note:  Seller of ~75k 0EU 9975/9950 p spreads at 3.5, settled 3.0 vs 9975.5.  Looks like a roll down in strike as OI rose 72k in the 9950p and fell 63k in 9975p.  Open interest in the contract fell just under 28k.  In tens, pre-data there was a buyer of TYQ 133/132p 1×2 for -1 to +1, settled 3 (43 and 20) with delta of +0.06 as vol was crushed in treasuries.

Can’t find the yardstick scene, but Life Magazine gives the flavor:

CPI… already in the rearview mirror

June 10, 2021

–Nearly all eurodollar calendar spreads etched out new recent lows as the ten year auction was well received, with tens closing just under 1.5%.  2/10 at a new low of 133.3, down 4 on the day, while 5/30 ended at 142.4.  Red/gold pack spread closed -4.375 at 146.25, just below 50 bps per year on average over those three years.  That is, red/green (2nd to 3rd year) at 49 bps, green/blue (3rd to 4th) 55.5 bps and blue/gold (4th to 5th) at 41.75.  One could conclude that the market is roughly forecasting two hikes per year starting in the second half of 2022.

–The big number today is CPI, with yoy expected 4.7%.  Whether it’s lower or higher doesn’t seem to be the issue, the market trades as if inflation simply can’t be sustained.  Jobless claims expected 350k, and the treasury issues 30 year bonds as the Fed’s RRP totaled a record $502 billion.  My view is that the extraordinary amount of excess reserves reflected by RRP could be somehow linked to what appear to be some pretty dumb investments.  Of course, if that’s the case, then one would have to conclude that the Fed is slightly derelict on the whole “financial stability” function.  And that conclusion would run counter to another report released today, which is the Fed’s quarterly Z.1 flow of funds report.  This report will surely show a new record high in American’s net worth.  How could net worth be making record highs if the Fed isn’t doing its job?

                         
–Even before the last hike in December of 2018 (to 2.50/2.75%), the market had signaled that the Fed was too tight.  From Q4 2018 to Q3 of 2019, as the Fed reversed course and began to ease, the ten year went from over 3% to around 1.5%, where it is now.  In Q4 as the Fed made its last cut of the year (to 1.5/1.75%) and tens were trading around 1.75 to 1.9%.  Now we have drifted back down to the low yield of 2019 again, almost as if bad things are on the horizon…  

Risk free rates

June 9, 2021

–The ten year note yield dropped 4 bps to 1.526% yesterday in front of today’s $38 billion auction, and futures are slightly higher yet this morning.  Various reasons given for continued strength in bonds.  I saw one article surmise that taper bets are receding, while another said that inflation concerns are receding.  An article in the FT suggests that the Fed risks “reacting too slowly if inflation keeps rising.”  China’s PPI was released at a blistering 9% yoy, while Chipotle is raising prices by about 4% to cover rising labor costs.  Perhaps one of the big and simple reasons for continued strength in bonds is reflected by the settlement of the front July eurodollar contract at 99.89, which I believe is a record high ED settlement at just 11 bps.  Yesterday’s RRP operation was also a record, at $497 billion.  Everything appears to be floating on a sea of endless liquidity with near zero carry costs.  They used to warn that the Fed was intentionally pushing people farther out on the risk curve due to low rates.  I don’t hear that much any more, now that the “risk curve” has extended past the far horizon with a new crypto every five minutes.

–I didn’t read details, but also saw an article noting angst at the possible end of the student loan moratorium.  Let’s say for a minute that the reason bonds are bid is because the rent moratorium will end, unemployment benefits will end, and the government infrastructure plan will be significantly trimmed back.  In short, that government support, which has been pumping up the balloon, will be sharply curtailed.  If that is the case do stocks belong near record highs?  In any event, none of the forward scenarios seem particularly supportive for the dollar, and a weaker dollar is inflationary.

–Yesterday featured new recent lows in many curve measures, with 2/10 at 137.5, down 3.9 bps and 5/30 at 144.3, down 1.3.  The red/gold eurodollar pack spread closed down 3.125 bps just over 150.  This, in front of a CPI number expected to be north of 4.5%.  Buyer yesterday of 2EZ 9912/9900/9887p fly for 1.0, with EDZ3 trading 9909.0.  Time until expiration is 184 days; it’s a bit early to be pegging the price of green Dec.  On the other hand, midcurve June options expire Friday, with 2EM 99.4375^ settling 4.25.  Breakeven 99.48 on the upside and 99.395 on the downside.  So 8.5 bps window for profit on the June midcurve straddle in 2 days if sold, with a 23 bp window of profit on the 2EZ fly if bought, with 184 days.  Of course, a short straddle has open ended risk (but not with the Fed in charge, right?)

Operation Bitcoin

June 8, 2021

–Little net change in fixed income yesterday as the treasury kicks off with the three year auction.  Tens were up less than 1 bp at 1.567%.  Implied vol declined, especially in ED’s.  June midcurve options expire on Friday.  The green midcurve 99.4375 straddle on EDM’23, which settled 9943, settled 4.75 and the blue midcurve 9875 straddle on EDM’24 (9876.5s) closed at 7.0.  Reasonably priced, though perhaps slightly on the complacent side give CPI on Thursday.  

–The action is in bitcoin, where the CME contract is 33000 this morning, down around 2650.  Maybe those guys at the DOJ should be given a bit more credit.  They apparently recovered the bitcoin ransom paid by the Colonial Pipeline, and immediately sold it, thereby pressuring all crypto.  If bitcoin has become the safe haven alternative relative to USD, and USD has been weakening due to unrestrained gov’t spending and growing Fed balance sheet, then pushing down bitcoin will test the psychology of the market, and perhaps re-engineer confidence in the reserve currency. (DXY sub-90 yesterday).  Next phase: make sure that bonds are solidly bid even in the face of a monster CPI number.  Brilliant!  Now they can let gold reclaim the mantle of safe haven… it’s a lot easier to manipulate. 

–All joking aside, a Company called MicroStrategy is seeking to raise $400 million in a debut junk-bond sale at 6.25 to 6.5% yield.  The funds will be used to buy more bitcoin.  Let’s get this straight: I lend you money to buy bitcoin.  Check.  You promise to pay me 6.5%.  If bitcoin doubles, I get 6.5% on my dollars.  If bitcoin drops by 70%, you go out of business and I lose my principal.  WHERE DO I SIGN UP?  Now I see why it’s called Micro Strategy, because the macro amount of funds borrowed becomes micro.  See, in Greek, micro means small.  From big, to small, get it? it IS a joke!  Maybe the whole DOJ crashing bitcoin idea isn’t so far-fetched.

     

Plus

June 7, 2021

–Front Soybean oil is at a new all-time high this morning at 72.77.  Stocks and bonds have given back some of Friday’s gains which saw tens end at 1.56%, down over 6 bps. as a solid payroll number at 559k was lower than expected and well under whisper numbers.  This week brings auctions of 3’s, 10’s and 30’s, which raise $99 billion of new cash.  On Thursday, CPI will be released, which is expected +4.7% yoy.  In my formative years, if you would have asked me for an over/under on the FF target with yoy CPI over 4% and NFP over 500k, I would have made you 5.5% (and been worried I set it too low).  Now, I hear that Janet Yellen said over the weekend that “…a slightly higher interest rate environment would actually be a plus for society’s point of view and the Fed’s point of view.”  OK.  Got it.  

–I was in a brief conversation Friday where I was told that inflation can’t be sustained because labor has no power.  This is one of the few times where everyone can see help-wanted signs.  Reports that businesses can’t find appropriate workers are widespread.  Cheap labor for China’s manufactured goods also seems to be in the rearview mirror, and strength in the yuan is inflationary at the margin for the US.  I saw a friend over the weekend who works for a construction firm that does a lot of business with Chicago Public Schools (CPS).  He said it’s a requirement that CPS gets three bids for every job, but now oftentimes his firm is the only one that provides a bid, and there is a special designation that now allows for fewer than three bids in order to get work done.  Cost management of subcontractors has become a challenge.  It’s a plus for society, I guess.     

• ABOUT:
  Former member of the CME specializing in interest rate options and yield curve strategies.