Dec 10, 2017. A Nice Place to Visit

Rocky Valentine, a small time 1950’s gangster robbing a pawn shop is shot dead by police. He awakens to find himself in a lavishly appointed suite where his guide, Mr Pip, is there to cater to his every desire. Beautiful women surround Rocky as he gambles at the casino in impeccably tailored suits and never loses. Whatever he wishes, the portly butler jots it in his notepad and it occurs. But it all begins to wear thin. Rocky is bored by riches without effort and gambling without uncertainty. Anxiously running his hands through his hair, he tells Mr Pip, “If I gotta stay here another day I’m gonna go nuts! Look, I don’t belong in heaven, see? I want to go to the other place.” Mr Pip replies, “Heaven? What ever gave you the idea you were in heaven, Mr Valentine? This IS the other place.” As Rocky futilely tries to open the apartment door, the bemused Mr Pip starts to laugh…

“A scared, angry little man who never got a break. Now he has everything he’s ever wanted- and he’s going to have to live with it for eternity, in the Twilight Zone” –From the 1960 episode, A Nice Place to Visit. https://www.youtube.com/watch?v=77ueTRaYTwg

When the market died in 2008/2009, the Central Banks came in to provide every comfort, and squelch every uncertainty. Passive investing has made the lives of macro and value investors a living hell. Stocks only rise, without even a 3% pullback. As noted in last week’s Z1 report from the Federal Reserve, Household Net Worth is at a new record $96.9T, having increased every year since 2008’s nadir of $56.2T. Long dated interest rates are low, with the curve as flat as it’s been in a decade. US equities are near record highs, at the high end of valuations according to many observers. Volatility measures are low across markets. Corporate spreads are extremely tight. But these conditions can’t continue for eternity.

We are now entering the realm of balance sheet roll-off at the same time that new tax laws threaten to increase the deficit. [Good piece on QT by Wolf Richter; link at bottom]. Swap spreads have rallied all year, notably since September, as the regulatory environment on banks is likely to be relaxed, and due to end of year demand for long dated assets by pension funds. Since Sept 1, the ten year swap spread has gone from -5 to +1 (it was as low as -15 this year) and the thirty year has gone from -35 to -20. So perhaps the extra treasury supply from QT and increased issuance can be easily absorbed. (Perhaps not). There is also a pervasive bias (which we heard just this week from a wealth manager) that the government won’t allow long rates to increase appreciably.

Certainly, with data like Friday’s yoy Avg Hourly Earnings growth of just 2.5%, there doesn’t seem to be undue pressure on the Fed to continue tightening after this week’s upcoming hike. The market is not reflecting a particularly aggressive Fed. For example, in the first half, there is slightly more than one hike priced: EDZ7 to EDM8 closed just above 30 bps and Jan’18 to July’18 Fed Fund spread closed at 28.5 (FFF8/FFN8). Both of these spreads capture the March and June FOMCs. Full year pricing is for two hikes: EDZ7/EDZ8 is 48.75 and Jan’18/Jan’19 FF is 46. Spreads beyond that are very tight, with the red/green (2^nd year to 3^rd year on the Euro$ strip) closing at 12.375 bps, less than 1/8%.

While the Fed’s dot plot from September projects 3 hikes in 2018 to a FF target of 2.1%, and further tightening in 2019 to 2.7%, the market isn’t buying into it. I don’t anticipate much change in projections at this week’s FOMC, though perhaps GDP for 2018 will be ratcheted up slightly from 2.1.

In terms of the flatness of the curve, I think the market has it wrong. Two factors have recently accentuated the flatter bias. One has been year-end pension demand for longer dated assets, and the other has been turn of the year pressure for funding. This latter effect is clearly seen in the weakness of EDZ7 which pressed to new lows going into next Monday’s expiration. As of Friday, there were 5 bps of convergence between EDZ7 and the 3month Libor setting, a huge difference with only a week to go. EDZ7 settled 9840.25, and the now actively traded 9837.5 puts settled at 0.5, with 985k contracts still open. Going into 2018, these factors will abate. And while US wage inflation doesn’t appear to be accelerating, there are some other signs that prices may firm. For example, Bloomberg notes that the Baltic Dry Freight index has surged 72% this year. “The United Nations’ Food & Agriculture Organization expects the world food bill to be the second-highest on record this year, driven by more expensive freight and rising demand for foodstuffs.” [link at bottom] Note that PPI is released Tuesday, and CPI Wednesday morning, prior to the Fed announcement. With QT and increased treasury issuance, along with the possibility of increasing prices, an inflation premium may well return to the long end in 2018.

One last small note about year-end funding. There is a large conglomerate in China, HNA. This company owns a 10% stake in Deutsche Bank and had bought a 25% stake in Hilton Worldwide Hotels in 2016. According to BBG, HNA Group’s financing costs put it in the ranks of the world’s largest corporate debtors, and those financing costs are growing by the minute. The company has been issuing short term, high interest rate debt, (8.875% for one year) though it claims those rates are simply due to ‘year-end tightness’. According to a Dec 8 piece by BBG, HSBC will no longer pursue deals with HNA due to its huge debt load. Beware of reverberations from China’s stricter stance on financial leverage; there’s potential spillover in global stock markets.

Bitcoin

I was going to skip any mention about bitcoin, but it’s simply impossible as futures contracts are about to be listed. Clearing firms are understandably concerned about being involved: Friday’s range was over $3000 on one bitcoin, which would equate to a swing of $15.000 for a one lot on the CME contract. There’s an amusing post on ZeroHedge over the weekend, saying that Bulgaria’s government now owns 213,519 bitcoins (approx. value of $3 billion) due to police seizure of an organized crime cache. [link at bottom] The article suggests that the Bulgarian gov’t may become a natural hedger…but I would guess that other governments are salivating at the prospect of seizures as well.

One last bitcoin note/chart. Idea lifted from theMacroTourist.com Below is a chart of bitcoin and the Shanghai Comp. The scales are, of course, much different. But there was a time when China stocks were also parabolic.

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	12/1/2017	12/8/2017	chg
UST 2Y	177.4	179.4	2.0
UST 5Y	211.6	214.5	2.9
UST 10Y	236.2	238.1	1.9
UST 30Y	275.7	277.3	1.6

GERM 2Y	-70.5	-73.9	-3.4
GERM 10Y	30.5	30.7	0.2
JPN 30Y	83.2	81.9	-1.3
EURO$ H8/H9	39.0	37.5	-1.5
EURO$ H9/H0	15.0	13.0	-2.0


EUR	118.96	117.74	-1.22
CRUDE (1st cont)	58.36	57.36	-1.00
SPX	2642.22	2651.50	9.28
VIX	11.43	9.58	-1.85