August 17. The price of risk



8/7/2015 8/14/2015 chg
UST 2Y 72.1 72.6 0.5
UST 5Y 158.2 159.4 1.2
UST 10Y 217.3 219.4 2.1
UST 30Y 282.8 284.0 1.2
GERM 2Y -26.2 -27.0 -0.8
GERM 10Y 66.1 66.0 -0.1
EURO$ Z5/Z6 ** 79.0 77.5 -1.5
EURO$ Z6/Z7 59.0 60.0 1.0
** peak one-yr spd
EUR 109.67 111.09 1.42
CRUDE (1st cont) 43.87 42.50 -1.37
SPX 2077.57 2091.54 13.97
VIX 13.39 12.83 -0.56


Here’s what we know, and it’s all been exhaustively covered in the financial press and blogs:

It’s amazing that net changes in treasury yields were extremely small on the week.

Rather than include a bunch of charts to review things that we all pretty much know, I will just show this BAML BBB Corporate bond spread (below) and add a couple of interesting links. By the way, a BAML study cited on ZH notes that the difference between the high yield spread and the third VIX contract is at the highest level since just before Bear Stearns blew up…i.e. the stock market is complacent.

BAML BBB sprd fredgraph



The above spread is up 40 bps from the year’s low, and 75 bps from last year’s low.  Hi-yield spreads have, of course, blown out even more.

Bloomberg piece about credit. “Credit is the warning signal that everyone’s been looking for” said Jim Bianco, founder of Bianco Research LLC in Chicago. “That is something that’s been a very good leading indicator for the past 15 years.” Another quote, “All of this has corporate-bond investors concerned enough that they’re demanding 1.64 percentage points above benchmark government rates to own investment-grade notes, the highest since July 2013, Bank of America Merrill Lynch index data show.”

And here’s a good piece on China from the Telegraph’s Ambrose Evans Pritchard: “Few dispute that China is in trouble. Credit has been stretched to the limit and beyond. The jump in debt from 120pc to 260pc of GDP in seven years is unprecedented in any major economy in modern times.” Concluding: “One day China will pull the lever and nothing will happen. We are not there yet.”

Now we’ve gotten to the point where there is a lot of micro-analysis going on. Like the idea that a 10% rise in the trade weighted dollar reduces GDP by 50-100 bps after two years. Or that a 1% move in EM causes a 1% move in US GDP.  I have seen several estimates based on the dollar and on commodities that attempt to QUANTIFY cause and effect. The problem is that there are many changing variables, occurring simultaneously. So…”the model WOULD have been right, if not for the oil collapse which caused cascading bankruptcies…”

Here is how I see it. The plunge in oil and other commodities reflects a drop in global demand, which is also evident by the fall in global trade. The bond market sees the idea of Fed tightening as a policy mistake, causing dollar strength and flattening the curve. China is falling under its own weight, and its response is acceleration in overt state intervention, most recently by depreciating the yuan. We’ve had a series of rolling devaluations, starting with US QE, followed by Japan, which took JPY from 80 to 125, followed by the ECB which took EUR from around 140 to 110. Now it’s China’s turn. Because of bloated debt levels, the net positive effect declines with every new policy implementation, no matter where it occurs geographically.

At the same time, the US, with a lag, is feeling the effects of the end of QE3. Outright purchases ended in October 2014. The purpose of QE is to hold down longer term treasury yields and force investors into riskier assets so that companies can take advantage of lower borrowing rates to build up capital infrastructure and expand. You can see by the BBB bond chart above that the nadir in the spread was in 2014 just prior to the end of QE3. We also know that a lot of this cheap funding went into stock buybacks, in order to juice earnings per share. I don’t know how to quantify the amount of lag in monetary policy. I don’t know how to quantify the impact of dollar strength, or oil weakness.   What I do know is that the window for financial engineering is closing, and that companies are still trying to lock in cheap funding, and that corporate debt in absolute dollars is at an all-time high. (From Fed’s Z.1 report).  Without QE the market is forced to actually put a realistic price on risk.

Therefore I think stocks are likely to see selling pressure with risks of a sharp break. I think the Fed will continue to talk tough, but will not be able to pull the trigger at September’s meeting. Asymmetric risks will stay the Fed’s hand.

Current low volatility belies strains on the global financial system, in my opinion. We have a fairly light news week, with CPI and FOMC minutes Wednesday and Philly Fed Thursday. No matter what else occurs, the price of risk is likely to firm.

Posted on August 17, 2015 at 5:28 am by alexmanzara · Permalink
In: Eurodollar Options

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