August 19, 2018. THINK

“You better think about the consequences of your actions.” Aretha Franklin to Matt Guitar Murphy.

*old youtube link of Matt Murphy at bottom, who also passed this year.

“Ma’am you gotta understand that this is a lot bigger than any domestic problems you might be experiencing.”  Elwood.

No Merchandising. Editorial Use Only. No Book Cover Usage.
Mandatory Credit: Photo by Universal/Kobal/REX/Shutterstock (5885886l)
John Belushi, Aretha Franklin, Dan Aykroyd
The Blues Brothers – 1980
Director: John Landis
Universal Pictures

In the famous diner scene in the Blues Brothers, Aretha Franklin admonishes Matt Guitar Murphy to think about the consequences of his actions before going back out on the road with the band.  Elwood eloquently appeals to the broader context of the situation.  And then Aretha belts out the song THINK.

The Central Banks of the world were forced into action after the GFC, perhaps without thinking through the [unintended] consequences of policy actions.  Now the ‘dollar shortage’ being experienced by several emerging markets is leading some Elwoods to advise Jay Powell that international issues are larger than the domestic problems of normalization and inflation stability.

In a speech on May 8 about international capital flows, Powell preempted those concerns, and more or less dismissed the impact the Fed would have, saying that clear communication about forward policy would allow other economies the chance to adjust, though he added that the Fed would be sensitive to risks.  From the speech:

All that said, I do not dismiss the prospective risks emanating from global policy normalization. Some investors and institutions may not be well positioned for a rise in interest rates, even one that markets broadly anticipate.

Nevertheless, risk sentiment will bear close watching as normalization proceeds around the world. What can the Federal Reserve do to foster continued financial stability and economic growth as normalization proceeds? We will communicate our policy strategy as clearly and transparently as possible to help align expectations and avoid market disruptions.

The main event of the upcoming week will likely be Powell’s speech at Jackson Hole on Friday.  His previous speech on June 20 was ‘Monetary Policy at a Time of Uncertainty and Tight Labor Markets’.  The title refers to ‘tight labor markets’, NOT ‘tight funding conditions for EM dollar borrowers’.  His speech has this excerpt: “Unemployment was below 4 percent from February 1966 through January 1970. During that time, inflation as measured by the price index for personal consumption expenditures increased from below 2 percent in 1965 to about 5 percent in 1970. In hindsight, unemployment is now widely thought to have been unsustainably low at that time and to have contributed to escalating inflation.”  Will Powell focus on domestic or international risks?

In any case, there has been increased speculation that the Fed may have to consider scaling back balance sheet normalization in light of dollar strength.  Additionally, the narrative early in the year of synchronized global growth has devolved into a patchwork of slowdowns and crises.

It’s somewhat interesting to note that exuberance in the beginning of the year was tied not only to Trump’s tax program, but also linked (coincidentally?) with a surge in China’s Total Social Financing in January.   China’s financing growth has since stalled, although the FT reports that “Beijing orders banks to boost lending to exporters.”

August 13 – Bloomberg: “China’s broadest measure of new credit slowed, underlining concerns about the economy that have prompted authorities to start doing more to support growth. Aggregate financing stood at 1.04 trillion yuan ($151bn) in July… That was slower than the 1.39 trillion yuan in June, using the central bank’s new calculation method for this data.  (From Noland’s Credit Bubble Bulletin)

During previous periods of QE, bonds didn’t do all that well, it was the equity market that recognized bullish ramifications of increased liquidity.  Amazingly, the taper has done little to dent sentiment regarding US stocks.  If anything, recent weakness out of China has been a bigger factor, with big tech stocks performing poorly (TENCENT made a new low for the year this week, BIDU and BABA are near the low end of the range for the past 12 months). Shanghai Comp was down 4.5% on the week.

The question is, what if Powell hints at a change in balance sheet normalization (which was supposed to run on autopilot in the background)?  Is the market going to suddenly realize that the Fed has changed its assumptions about domestic growth prospects?  In that case, bonds could see an explosive rally, fueled in part by Gundlach’s tweet this weekend: ‘Massive increase this week in short positions against 10 & 30 yr UST mkts.  Highest for both in history, by far.  Could cause quite a squeeze.”

But what of stocks?  Again, the initial reaction would surely be a surge, but it might be taken as a selling opportunity. What we’ve ignored so far is the Bank of Japan.  An article on Reuters Friday said: BOJ may be ‘stealth tapering’ in stock markets, analysts say.

The BOJ has already slowed bond buying, and a removal of support in the form of ETF purchases may reverberate globally.  Since the last BOJ meeting, the 10y JGB has held around 10 bps, but the thirty year adjusted up from below 70 to around 85 bps, and has since remained there.

So what are markets signaling currently?  In the US, a September hike is priced in the FF market with October Fed Funds at 2.145% (9785.5) vs current Fed Effective 1.91 to 1.92%.  A spread of 23 bps indicates nearly full odds of a hike.  A spread of 16.5 between Nov and Jan Fed Fund contracts puts odds for another hike in December at about 2/3rds. However, prices on the euro$ curve from the end of next year forward are inverted and spreads are quite stable, an omen that growth will have ceased by then. For example Dec’19 to Dec’20 euro$ spread closed -1 bp, and spreads just beyond are even more negative.  Though Turkey has taken some steps to stabilize, large European banks with exposure remain near their lows.  BNP is down 26% since late Jan and BBVA is down 28%, while UniCredit is down 29% since April with the Italian Bank Index down 27% since May.  Italy 5y CDS went from about 100 bps at the start of the year to 265-270 in late May, and is now 242 bps, compared to Spain at 71.  The German 10y bund closed the week testing support at 30 bs, having been above 75 in Q1.  A break of this support area would point back to single digits.

There are hopes that the US and China can resolve trade differences with low level talks occurring as a roadmap for a possible Trump-Xi meeting in November (post-elections), but the signs of fraying across many financial markets casts a shadow on the US as a sole pillar of solid global growth.





8/10/2018 8/17/2019 chg
UST 2Y 259.6 261.6 2.0
UST 5Y 273.1 275.0 1.9
UST 10Y 285.9 287.1 1.2
UST 30Y 301.9 302.9 1.0
GERM 2Y -63.5 -65.0 -1.5
GERM 10Y 31.7 30.5 -1.2
JPN 30Y 83.5 84.7 1.2
EURO$ Z8/Z9 34.5 36.5 2.0
EURO$ Z9/Z0 -0.5 -1.0 -0.5
EUR 114.12 114.38 0.26
CRUDE (1st cont) 66.94 65.21 -1.73
SPX 2833.28 2850.13 16.85
VIX 13.16 12.64 -0.52

Posted on August 19, 2018 at 12:10 pm by alexmanzara · Permalink
In: Eurodollar Options

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