Dislocations

Weekly note – March 24, 2019

In last week’s pre-FOMC note I said the dots would likely be irrelevant.  That was wrong.  I thought the Fed would trim one hike from the 2019 forecast, and instead, they cut two, now indicating no hikes in 2019.  Apparently, the market was leaning my way, because the strongest contracts on the Eurodollar strip, EDM20 and EDU20, rallied almost exactly one-quarter percent, the size of one (additional) Fed projection.  Both contracts closed up 22 bps on the week.  Net changes on the week: Whites +11 (with EDH0 +18.5), Reds +21.75, Greens +19.75, Blues +17.875, Golds +17.25.  On the treasury curve, fives led the surge, falling 14.1 bps.  January 2020 Fed Fund contract settled 97.80, a new high, indicating around 80% odds of a cut in 2019.

Much was made this past week of inversion of the 3 month t-bill and ten year treasury yield, and its recessionary implications.  Many Eurodollar calendar spreads have long been inverted, and had posted their lowest levels at the beginning of January, following December’s rate hike and stock market swoon.  At that time, the most inverted one-year spread was EDM19/EDM20 with a low settlement of -28.0, just about the size of one Fed move.  On Friday, it was again EDM19/M20 which made the lowest low, this time at -34.0.  Last week, I mentioned that the lowest the 3^rd to 7^th one-year constant maturity spread reached in 2006 was negative 47.5 bps (in December of that year).  Recall that in 2006, the FF target was 5.25%, the peak of the last tightening cycle which had ended in June 2006.  There was a lot of room to cut, but the first ease didn’t occur until September 2007. 

On the Eurodollar curve, the peak contracts are EDH21 and EDM21, which both settled 9787.5, or 2.125%.  The ten year treasury ended Friday’s floor session at 2.453%. right around the same level as 3- and 12-month t-bills.  The thirty year bond ended the week at 2.89%.  Everything from EDM21 back steepened to new recent highs.  Graphically, the chart below is informative.   It shows the 2/10 treasury spread vs red/gold euro$ pack spread.  These had tracked very closely, but since December, a spread has opened up.

The 2/10 treasury spread is near its lowest level at 12.6 bps, while red/gold rallied this week and closed just above 18.5 bps.  The two year is similar to 8 quarterly contracts.  The reds, one year forward, are projecting nearly 2 eases, but the front contracts are held down in a relative sense as it’s hard to pinpoint the first actual ease, making it a bit more difficult for 2’s to rally.

While I’m on the topic of recent ‘dislocations’ the next chart is also of some interest.  It’s the Nasdaq vs small-cap Russell.  As can be seen, in March these two pretty much went in opposite directions. 

One client observed it’s classic late cycle behavior, a reach for safety in the big caps.  I would mention that I think small caps are more dependent on actual economic growth prospects.  In any case, it’s worth noting that some stock indices, like Russell, DJ Transports, XLF (financials ETF) and the KBW banking index failed taking out highs of the beginning of March and now have fallen below the low made in the early part of the month.  Some sectors are trading a lot like a bear market. 

In terms of global synchronization, the chart below features ten year yields from the US, Canada, UK, and Germany, with Japan’s 30 year (as tens are pegged by the BOJ).  All at new lows in well over a year, with sharp drops since October. 

In terms of monetary policy, I’ll quote Charlie McElligott of Nomura, with his succinct description of QE and ZIRP shortcomings:

1) Low interest rates are (ultimately) deflationary, sustaining zombie firms in a “liquidity trap” which weigh on overall economic performance while also weakening investment.
2) Low interest rates and QE are deflationary as you incentivize mal-investment and blow perpetual speculative-asset bubbles, which (ultimately) correct and drive deleveraging – thus the ‘balance sheet recession.’
3) As there is still a lot of debt related “scar tissue,” you can’t push credit on a string.  This then leads to quick “muscle memory” returns to a defensive posture: “If there is no return on capital, capital should not be deployed.”

The Fed is obviously concerned about the shape of the curve and deflationary impulses.  Powell has referenced the idea of letting inflation over shoot to catch up with past shortfalls.  Now Trump has nominated Stephen Moore to the Fed board, who, according to a recent NY Times article, said the Fed should “reverse its disastrous hikes” of September and December.  “He recently pushed the Fed to target commodity prices in setting interest rates, a view rarely advocated by economists and monetary policymakers.”  Here’s a guy who wants to buy reds and sell everything behind.

We’re going into a week without a lot of hard economic data, with auctions of $40b 2’s on Tuesday, $41b 5’s Wednesday and $32b 7’s Thursday.  Core yoy PCE prices on Friday expected 1.8 from 1.9.  However, we have the added twists of the Mueller report and May’s Cabinet mutiny that could both provide a marginal flight to safety.  Will Trump respond to Mueller with a diversionary tactic of highlighting China progress and imminent deal?  Or will those negotiations become more difficult with Trump holding a weaker hand?  There are also a lot of Fed speakers on tap who might now feel compelled to talk up the economy as last week’s FOMC caused many to question whether the Fed knows that something ominous is around the corner.

	3/15/2019	3/22/2019
UST 2Y	244.0	232.7	-11.3
UST 5Y	239.5	225.4	-14.1
UST 10Y	258.9	245.3	-13.6
UST 30Y	301.5	288.9	-12.6
GERM 2Y	-54.1	-56.5	-2.4
GERM 10Y	8.4	-1.6	-10.0
JPN 30Y	57.5	52.2	-5.3
EURO$ Z9/Z0	-21.0	-29.0	-8.0
EURO$ Z0/Z1	-3.5	-1.0	2.5
EUR	113.26	113.05	-0.21
CRUDE (1st cont)	58.82	59.04	0.22
SPX	2822.48	2800.71	-21.77
VIX	12.88	16.48	3.60

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

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