Sugar crash
May 26, 2019 – Weekly comment
In March of 2018, the Wall St Journal published an op-ed by Kevin Brady and Lawrence Lindsey, ‘Tax Reform is No ‘Sugar High’’. There were all sorts of analysts claiming otherwise, that such stimulus, coming at a time when unemployment was near record lows, would shortly fizzle. Indeed, there were many arguments both ways, but in hindsight, it appears as if the economy peaked in summer of last year. Whether that was due to the fading effects of legislation, (from BAML, “In the US, the double dose of caffeine from tax cuts and spending increases is already starting to wear off”), or due to companies building inventory to avoid trade tariffs, or due to the lagged influence of tighter monetary policy, it’s hard to argue with charts like the one below. Both Manufacturing (blue line) and Service (white line) PMIs peaked in summer of 2018, as did Core PCE prices (lower panel green). The latest readings from last week are flirting with 50 (50.6 and 50.9) and were quite a bit weaker than expectations. The last time Markit PMIs were this low was in mid-2016 when yields were at their lows. This Friday we’ll get Core PCE yoy prices which were just under 1.6% at last reading. From the chart below I’d forecast slightly softer Core PCE. Perhaps the larger issue is whether or not price weakness is transitory, but a plunge of $4 in the price of crude oil last week doesn’t augur well for a quick rebound. Dr Copper which has dropped 10% in the past month isn’t giving a vote of confidence either. The latest NY Fed GDP Nowcast was 1.4% for Q2, down from 1.8% on May 17 and 2.2% the week prior. The Atlanta Fed was at 1.6 in mid-May and is now 1.3%. JPM slashed Q2’s estimate from 2.25 to 1.0%. AP Moller-Maersk, “the world’s larget shipping company said estimated global container trade grew 1.7% in Q1, down from 3.6% in 2018.” (Biz Insider).
Quoting Lacy Hunt, or rather re-quoting Lacy Hunt from the latest Mauldin missive, “Federal debt accelerations ultimately lead to lower, not higher, interest rates. Debt funded traditional fiscal stimulus is extremely fleeting when debt levels are already inordinately high. Thus additional and large deficits provide only transitory gains in economic activity, which are quickly followed by weaker business conditions. With slower economic growth and inflation, long-term rates inevitably fall.”
The economy seems to be adhering to that script. And given that in mid-2018 we might have had an overshoot of growth due to stimulus and inventory build, is it crazy to think we could get an undershoot in the other direction? I think not.
Trends change. In the picture at top, nearly every man is wearing a hat. I think I first saw this topic in the book Freakonomics. But a more recent article in Esquire notes, “…people who dared to walk bare-headed in hat-making towns were abused by workers who saw their livelihoods being threatened.” In the picture underneath, every woman is looking at her cell phone. Well, now everyone is buying eurodollar calls. Sometimes, as in the case of hat wearers, the trend just runs out of steam. And some trends appear unstoppable. In the case of eurodollar calls, the shorts are being abused.
Regarding euro$ call buying, I would note the new-found popularity of the 9800 or 2% strike as a long. Week over week on EDZ9, the 9800c went from 454k to 508k open positions, an increase of over 50k. Trades placed were mainly long 9800/9837 call spreads and 9800/9837/9862 call butterflies. The 9837 strike is 100 bps lower in yield than the recent target which had been 9737.5, a libor mark of 2.625%. It’s worth noting that the midcurve December 0EZ 9800c also saw a weekly open interest jump of nearly 40k contracts. EDZ9 settled at 9769 and EDZ0 settled 9805.5, for a close in the one-year spread of -36.5. A new low for that particular spread was posted this week on Thursday at -37, also when EDM9/EDM0 settled at a new low for any one-year calendar in this cycle of -52.75.
According to the Bloomberg WIRP page (World Interest Rate Probability) the expectation for a rate cut by the Jan 2019 FOMC is 85%. According to January 2019 Fed funds, the probability of an ease by the end of the year (Dec 11 meeting) is a lock. FFF0 settled 9793.0 or 2.07%, more than 30 bps below the current Fed Effective rate. EDM9/EDZ9 settled -21.25. so taking that value over 25 yields 85%. In any case, option traders are saying “buy ‘em”. The Fed is being discounted.
In a week when US yields were under significant pressure, the dollar index held fairly strong. The trend has been higher for the past year, and YTD highs were tested Thursday. Friday saw a pullback in USD, but of course many countries want the trade benefits bestowed by weaker currencies. That probably includes China. Rather than support their currency by selling US treasuries, which is what many financial commentators are wringing their hands over, the larger concern would be if US equity markets keep going lower. The US population will have a hard time accepting that outcome. Another risk is that if China were to curtail the export of rare earth minerals, the tech industry would suffer. All those cell phones in the picture above use rare earth elements. The Semi-conductor SOX index is already off 18% from the 2019 high marked just one month ago. The rare earth etf, REMX, had a surge in volume if not in price. An increase in treasury yields is not the worry, it is rather a decline in stock prices. Threats to the technology industries accentuate that risk.
The G20 meeting is in Osaka on June 28-29. China is downplaying the possibility of a meeting between Xi and Trump. The June FOMC is a bit over one week prior on June 19. It’s highly unlikely that the Fed would make a move that could be construed as political just in front of negotiations on the number one risk facing global markets.
Now for notes on weekly changes in some yield levels. The 2 year treasury fell 3.4 bps to 2.166%, tens and bonds fell 7.3 bps to 2.320 and 2.751. EDZ9 rose 4 bps on the week, but the red euro$ pack surged just over 9 bps in price (lower in yield) and the green euro$ pack rose 7.375 bps. Just a few comments about these levels. In November of last year the two-year note almost hit 3%, so it has fallen more than 80 bps since then. At the September 2018 FOMC the Fed raised the target funds rate to 2.00 to 2.25%. The two-year yield is now right in that wheelhouse. The December 2018 rate hike has been reversed, and the market is calling, like Kudlow, for another 50. The ten year yield at 2.32% is right around the 50% retracement level from the low in 2016 to the high in November of last year. There should be strong support from 2.07 to 2.17 which would mean resistance in TYU around 126-16.
In terms of the strength in the eurodollar strip, it’s worth noting that all swap spreads are making new lows. The two-year is holding just above the water line at 3.6 bps, the five year just under the surface at -0.5 and the ten year is -5.0. Except for the ten year, the last time we were at these levels was in 2016, and nothing particularly good was happening at that time. A couple of analysts have noted firming of corporate spreads over the past several weeks. However these moves have been relatively modest. Since April the BBB spread has gone from 148 to 163 and the BAML High Yield from a low of 364 to 422. Of course, due to compressing swap spreads its fair to say that corporate spreads in general (using swaps as the benchmark) are widening a bit more.
On Tuesday, 2 and 5 year notes are auctioned, followed by 7’s on Wednesday. Q1 GDP revision on Thursday and Personal Income and Spending, with PCE prices, on Friday to close out the month.
OTHER MARKET/TRADE THOUGHTS
Last week I had suggested that TYM would test 125-00 as that was the call strike with the most open interest. Indeed, TYM traded over that price and the strike pretty much acted like a magnet at the end of the week.
Nearer in time on the curve, consider this: EDZ9 settled 9769.0. EDZ9 9775/9800 call 1×2 settled -0.25 (12.75 and 6.5), while the equally out of the money 9762/9737p 1×2 settled +7.0 (11.5 and 2.25). These prices highlight the skew (and fear) in the market. There is little to no concern about the possibility of rate hikes.
| 5/17/2019 | 5/24/2019 | chg | |
| UST 2Y | 220.0 | 216.6 | -3.4 |
| UST 5Y | 217.8 | 211.9 | -5.9 |
| UST 10Y | 239.3 | 232.0 | -7.3 |
| UST 30Y | 282.4 | 275.1 | -7.3 |
| GERM 2Y | -64.6 | -63.1 | 1.5 |
| GERM 10Y | -10.4 | -11.7 | -1.3 |
| JPN 30Y | 52.4 | 49.8 | -2.6 |
| EURO$ Z9/Z0 | -31.0 | -36.5 | -5.5 |
| EURO$ Z0/Z1 | 1.0 | 3.5 | 2.5 |
| EUR | 111.59 | 112.08 | 0.49 |
| CRUDE (1st cont) | 62.92 | 58.63 | -4.29 |
| SPX | 2859.53 | 2826.06 | -33.47 |
| VIX | 15.96 | 15.85 | -0.11 |
https://www.wsj.com/articles/tax-reform-is-no-sugar-high-11553727809
https://thehill.com/opinion/finance/403251-what-sugar-high-economy-has-pent-up-energy-to-burn
https://www.businessinsider.com/trump-tax-cut-trade-war-2019-gdp-goldman-sachs-baml-2018-11
https://www.esquireme.com/style/why-did-men-stop-wearing-hats
