August 7. Return of the Bond Vigilantes
Friday’s payroll report was strong (NFP 255k), resulting in a jump in yields, with the Five year treasury up over 10 bps to 113, and Tens up nearly 8 bps to 158.2. Eurodollars also sold off, with reds through golds -10.25 to -12 bps. Notable was the decline in EDZ17, which fell 10.5 bps to a price of 9893.0, a yield of 1.07%. Notable, because open interest in this contract alone soared by over 52000 contracts, to 1.289m, the second most of any other ED contract aside from EDZ16 at 1.45m. Total open interest in Eurodollars was up 140k. These figures are based on preliminary open interest data, but are likely correct, as the EDZ16/EDZ17 spread traded over 84k on Friday, rising an impressive 6 bps to 15.5. Open interest was also up in all treasury futures besides ultra-tens, providing further confirmation of the move.
Mid-June was the last Summary of Economic Projections released by the Fed. At that time, the dot plot for year end 2017 averaged 1.63%. Given the increase in the spread between Libor and OIS I would say that an appropriate price for EDZ17 would be 9800 if funds were 1.625, as opposed to Friday’s settle of 9893.
Towards the end of last week (pre-payrolls), we had several clients asking about the shape of the curve and vol levels. For several clients we bought out of the money puts on deferred euro$ contracts…not in large size, but there seems to be a nuanced shift in sentiment. However, as one contact said – again, pre-payrolls – “I just don’t know if this is likely to be another false start like so many others we’ve experienced.” The payroll data and market response to it would tend to provide evidence that this is indeed the start of something larger. Additionally, after Friday’s trade, I received this text from a Eurodollar option pit market maker: “the pit is in trouble if we continue to break, extremely short puts!”
At the start of the year, one-year Eurodollar calendars were 60-65 bps. Currently, the curve is MUCH flatter with the first 10 one-year spreads between 13.5 and 16 bps. That’s all the way from Sept’16 Sept’17 to Dec’18/Dec’19. Now let’s go back to the start of the week, and consider William Dudley’s speech. In it, he said that the labor market was slowing, but noted, “…even 150k job gains per month would be consistent with gradually using up any remaining slack present in the US labor market.”
He also said this: “As I noted earlier, I think the medium-term risks to the U.S. economic growth outlook are somewhat skewed to the down side. Thus, this needs to be taken into consideration in terms of the appropriate stance for U.S. monetary policy. With respect to the efficacy of monetary policy, given how close we remain to the zero lower bound for interest rates, I also think the risks are asymmetric. Therefore, we need to be a bit more careful about the risk of tightening monetary policy in a manner that proves to be premature, as compared to the alternative risk of being a little late. If we were to realize that we were slightly late, policy can be adjusted by raising short-term interest rates more quickly.”
Dudley is one of the most important voices on the Fed, and he continues to advise caution in terms of raising rates too soon. Additionally, in some ways the rise in CP yields and Libor has already been a ‘stealth’ tightening. (In April, 3m Libor was around 63 bps, and now it’s 80, so there has already been a change of 17 bps). The deadline for money market reform is October 14, and while there has already been an adjustment, at least one of our clients who is much closer to the issue, thinks there is more to come. Despite El-Erian and others warning that a hike in September is becoming much more probable, the risk-averse Fed can use Yellen’s Jackson Hole appearance on August 26 to guide the market towards an end-of-year move, by which time the Money Market issues will have been sorted.
Having said that, the upward sloping trend in wages can easily justify further steps toward normalization. Below is a chart of average hourly earnings, now at 2.6%. The Atlanta Fed’s Wage Tracker (last released on July 15) is even more pronounced, at a new high of 3.6%. Link at bottom.
While our focus thus far has been on the shorter end of the curve, what might have sparked a change in global sentiment was the jump in JGB yields in the wake of the BoJ meeting. I’m sure it’s premature to resurrect the phrase ‘bond vigilantes’, but the chart below suggests that one shouldn’t ignore the possibility that bonds could lead the normalization charge prior to conferring with central banks.
On the chart, the 10 year JGB yield (in red) has clearly broken out of its downward slope. The German Bund (green) is close to doing the same, and the US Ten year (blue) has trend-line resistance coming in around 1.62 to 1.63, just as the Treasury auctions 3’s, 10’s and 30’s this week. The white line is the British Gilt, which for now still remains in a solid down trend.
One last point with respect to US bonds. It’s pretty clear that recent history displays precious little correlation between a given country’s fiscal situation and its bond yields. However, the US deficit is worsening, and is expected to deteriorate further, according to the CBO. Under the heading, Growing Deficits are Projected to Drive Up Debt, the CBO document says, “This year is likely to be the first since 2009 in which the federal deficit will increase as a share of the nation’s output – from 2.5 % of GDP in 2015 to 2.9% in 2016.” By 2022, the projection is 4.4% of GDP. This MIGHT become important…
Global bond yield breakout around the corner?
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So where does this leave us in terms of strategy? My assumption is that the Fed will be happy to fall slightly behind the curve with respect to tightening. Actually, besides the labor data, other economic releases have been mixed. If inflation does continue to edge higher with solid consumer spending (PPI and Retail Sales on Friday), then the more deferred part of the curve should steepen while near spreads remain flat. Look for outright ways to be short long treasuries. While a geopolitical event could cause another flight to quality, that particular risk can be relatively cheaply hedged with long VIX positions.
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| 7/29/2016 | 8/5/2016 | chg | |
| UST 2Y | 66.3 | 71.8 | 5.5 |
| UST 5Y | 103.3 | 113.0 | 9.7 |
| UST 10Y | 145.8 | 158.2 | 12.4 |
| UST 30Y | 218.4 | 231.2 | 12.8 |
| GERM 2Y | -62.5 | -61.8 | 0.7 |
| GERM 10Y | -11.9 | -6.7 | 5.2 |
| EURO$ Z6/Z7 | 12.0 | 15.5 | 3.5 |
| EURO$ Z7/Z8 | 12.5 | 14.0 | 1.5 |
| EUR | 111.76 | 110.88 | -0.88 |
| CRUDE (1st cont) | 41.60 | 41.80 | 0.20 |
| SPX | 2173.60 | 2182.87 | 9.27 |
| VIX | 11.87 | 11.39 | -0.48 |
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https://www.frbatlanta.org/chcs/wage-growth-tracker.aspx?panel=1
https://www.cbo.gov/sites/default/files/114th-congress-2015-2016/reports/51384-MarchBaseline.pdf
