April 23. This is Serious Business

On April 13, there was one week to go for May treasury options.  The May 126 straddle settled 41/64’s with futures 126-025.  On Friday, the one week straddle expiring this Friday, April 28, settled  1 08/64’s vs 126-02, or 75% higher!  Still one week to go with the same underlying futures price.  In comparison the price of the TYM7 (June ten year) 126 straddle was 1’52 on Friday.  That is, the four extra weeks between April 29 and May 26, which is June expiration, is only worth 0’44 (1’52 – 1’08).

Another example of odd pricing was in one-week US bond options, pointed out by colleague RW.  USM7 settled 154-05.  This Friday expiry 155/157 call 1×2 settled 1/64, 57 vs 28.  On the downside, the 153/151 put 1×2 settled 26/64, 40 vs 7.  So the 151/157 risk reversal settled at a whopping 21/64s.

Of course, this is the weekend of the French election, so there is nothing we can do now about the above pricing.  However, it does indicate a significant re-pricing of risk.  There was chatter Friday of risk managers requiring position cuts, and/or stopping new trades.  This is somewhat understandable given a known upcoming event.  Typically, higher risk comes hand in hand with reduced liquidity.

In a way, ideas of risk and liquidity tie into comments made by Stanley Fischer on a CNBC interview Friday, where, when asked about repeal of certain features of Dodd Frank, was steadfast in his defense of core of DF provisions with respect to strengthening the financial system and making sure banks don’t engage in overly risky behavior.  “This is serious business. …We seem to have forgotten that we had a financial crisis which was caused by behavior in the banking and other parts of the financial system…  This [crisis] was huge.”

In other words, the Fed in its role as financial regulator will likely lean against loosening of Dodd Frank by tightening alternative requirements.  In the same vein, other aspects of the Trump agenda have also met resistance, and clearly large swaths of the Trump reflation trade have rescinded their enthusiasm. (Curve, DXY, some industrial commodities). Again, I would make note of the fact that financial conditions have actually eased over the past two Fed hikes.  The dollar index is lower than it was at the time of both the Dec and March Fed hikes, the thirty year bond yield was 3.15% at the time of the December hike and 3.21% just in front of the March hike, and is now 2.89%.  The 2/10 treasury curve is flatter: 131 in December, 122 in March and now 105.5.  Equity prices are higher than in December, but about the same as they were in March.  So, if the Fed does want to lean against easier conditions, it’s not just necessary to turn the spigot down a little; at this point another hike in June without a clear timetable on Balance Sheet Reduction (BSR) is likely to further flatten the US curve.

On the shorter end, perhaps no clearer expression of a hike being taken out of the market in the second half is displayed than by the April/January Fed Fund spread.  This spread printed a high of 52.5 in December, and closed yesterday at 29, a decline of very close to ¼%.  The July Fed Fund contract has been bouncing around 50% in terms of odds for a June hike.  And the peak one-year euro$ calendar spread has shifted back from EDM17/EDM18 to EDZ17/EDZ18, with that peak now at just 37 bps.  This may signify that the market perceives near term FF increases as less likely and longer term effects from BSR as more likely.

One other aside about Fischer’s interview comments.  He noted that the first quarter has been weak for the past several years and said there was something the Fed didn’t quite understand about that weakness.  Clearly, last year was in part due to severe problems in the energy patch.  But this year oil was strong and there was a burst of optimism associated with Trump.  I would say that softer data this year is more worrisome in terms of forward growth, whether it’s being restrained by student debt, or increased auto debt or high levels of corporate borrowing.  Surprisingly, this is one thing Fischer noted: ‘Very large decline in the price of cell phone usage.  It was very large, actually had an impact on the overall inflation rate.”

In terms of stress, Fitch late Friday announced a downgrade of Italy’s debt to BBB from BBB+ due to fiscal slippage and persistent weak growth.  While the Germany/Italy ten year yield spread declined this week to about 200 bps, from a recent high of 213 last week, the narrowing is likely short lived even if the Le Pen threat recedes.

In the US, according to the Daily Shot, the debt service ratio of US corporates as a percent of income has been steadily rising from about 3.5% in 2014 to nearly 5.5% now.  No surprise given the amount of stock buybacks financed with debt, but this factor is starting to see a bit more air time.  The situation is much more acute in China, where many stories have recently run about excessive credit creation.  However, according to a Bloomberg story citing a top fund manager He Qian, the risks are not being appropriately priced.  “It’s interesting that investors were paying more attention to credit risks this time last year, when there were not as many credit events,” said He, whose $895 million fund has beaten 99 percent of its competitors since 2014, data compiled by Bloomberg show. “Such risks seem to have faded from investors’ memories.”



In short, besides the clear and present danger associated with the French election, there are many other risks which are unknown in terms of timing but lurking in the not too distant background.  North Korea, increased credit problems in China, US gov’t shutdown.  Are these factors being priced into implied vols?  It can happen fairly quickly.  In the meantime, it takes some patience (and bleeding) as evidenced by the buyer of 50 cent calls on VIX.   “Basically they come in every day and they buy 50,000 VIX calls worth 50 cents. So in other words, they don’t care too much what the strike is; they just pick the option that’s worth 50 cents.” [link below] This activity is pretty obvious from May VIX call open interest.  In May 20, 21, and 22 calls the OI is 418k, 324k and 220k.  VIX futures have open interest of 442k in aggregate, of course the contract is ten times larger.  There are now many contracts and etf’s with embedded equity market vol; how these pair off against one another is only likely to be seen in a large event.  On Brexit the VIX etf shot just above 26 and on the November election, close to 23.

Posted on April 23, 2017 at 1:52 pm by alexmanzara · Permalink
In: Eurodollar Options

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