April 9. In Real Life

We learned from past financial crises, including the 2008 financial crisis, that nothing beats equity for absorbing losses. Equity holders have long taken losses in the United States and thus expect that outcome. Moreover, equity holders cannot run during a crisis. In contrast, debt holders of the most systemically important banks in the United States and around the world have repeatedly experienced bailouts and likely will expect such an outcome during the next financial crisis.

-Neel Kashkari, in response to Jamie Dimon’s annual shareholder letter

The peak of the market cycle is generally characterized by a perverse relationship between volatility and leverage.  Volatility tends to be low, as investors are complacent about the near future. The value of collateral (equities, real estate, etc.) has risen, so investors are able to apply more leverage to their overall portfolios.  This implies that the risk in the system, the potential for a futures collapse, is rising, while observed volatility is declining.

–Hari Krishnan, The Second Leg Down

(I recommend the above book by Hari, which details many practical real world strategies for handling risk through option markets, and importantly, for CONTAINING risk once damaging moves have already started.  Link on Amazon at the bottom of the page).

A bank runs into trouble; then either regulators or the courts trigger a conversion of debt to equity. Bondholders take losses. The firm is recapitalized and taxpayers are spared. Systemic risk is neutralized and bailouts are avoided. It sounds like an ideal solution. The problem is that it almost never actually works in real life. –also in Kashkari’s note.

I appreciate that Neel Kashkari wrote a rebuttal in response to Jamie Dimon’s letter.  Kashkari’s main focus has been on TBTF banks, and he consistently suggests that banks be required to have more of a cushion to absorb stress.   I also appreciate that several Fed governors have warned about risks in commercial real estate.  The problem though, is that the Fed accentuated several of the issues they now confront.  I think Kashkari might have worded the first passage above differently… the fact is, equity holders in the broadest sense do NOT generally expect to take losses, because the central bank has smothered risk.  The central bank compounded the problem of debt being substituted for equity by keeping rates down, and by forcing investors into riskier assets.  The financial architecture of the US encourages leasing; everything is now ‘pay as you go’.

Now, we might be on the verge of the Fed trying to undo some of the psychology that has become embedded in the system.  Dudley has twice said that the onset of balance sheet reduction may start later this year or the beginning of next.  Yellen’s term as Fed Chair ends in January 2018, and Fischer’s term as Vice Chair ends in June 2018.  If the Fed wants to begin a program to trim the balance sheet, it’s probably best to institute it this year and have it in place for new leadership.

On Friday, Dudley further solidified the idea of the Fed removing accommodation with this comment: “I think some people misconstrued what I said last week.  I said the words ‘little pause.’  A pause is pretty short already, and I think a little pause is even shorter than that.”  He was talking of course, about a pause in the rate hike schedule.  Treasuries immediately sold off, though net changes on the week were fairly small, within a few bps of the previous Friday.  However, the 2/10 treasury spread closed at a new low for the year of 109 bps, off about 25 bps from the high in December of last year.

On Monday, (late in the day at 4:10 ET) Yellen will speak, allowing for the opportunity to guide the market more clearly on the Fed’s policy alternatives of removing accommodation, and on timing.  The Fed is, of course, mindful of the potential for another ‘taper tantrum’ which it would like to avoid, as evidenced by another comment by Dudley on Friday, “…you might want to forego the decision on short term rates just to make sure that the balance sheet doesn’t turn out to be a bigger decision than you thought you were making.

Against this broad backdrop, we have yields which are near the lower end of the range of the last 4 months.  The US ten year has been more or less between 230 and 260, while the 30 year has been 295 to 320.  Friday’s closes were 237 and 299.6. (Treasury auctions of 3, 10, and 30 year paper Monday, Tuesday, Wednesday in the holiday shortened week).  Eurodollar calendar spreads have continued to compress.  While near one-year Eurodollar calendars were around 5/8% last December, the peak EDM7/EDM8 spread closed Friday at 43, having bounced from Thursday’s low mark of 39.5.  In other words, over the last quarter, about 25 bps of forward tightening expectations have been wrung out of the market.  At the same time, FFN7 settled at a new low of 9894 on Friday, indicating a 2 in 3 chance of a hike in June.  Perhaps the forward flattening shouldn’t be particularly surprising, given that the Atlanta Fed GDP Now forecast for Q1 has dwindled from 2.5% in late February to just 0.6% (a new low) on Friday.

One other comment about year spreads.  On Friday, EDZ7/EDZ8 closed at 41.5, +4 on the day, but -4.5 on the week.   Volume was enormous at 133k; prelim open interest shows +30k EDZ7 contracts and +53k EDZ8, so it would appear to be new buying.  The Fed’s year end FF projections released in March are 1.4% for the end of 2017 and 2.1% for the end of 2018, a difference of 70 bps, which suggests that Z7/Z8 is 28.5 bps ‘cheap’.  However, if one’s trading strategy were simply centered around Fed projections, it would have long ago led to panic and bankruptcy.  To paraphrase Kashkari, it sounds good in theory, but in real life, not so much.

I hesitate to comment on the geopolitical situation, because events rarely seem to have any type of impact on markets besides a brief flutter.  For now, it seems as if Trump’s order to bomb Syrian airfields has been a policy ‘win’.  However, as US warships move towards N Korea the stakes are raised.

 

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3/31/2017 4/7/2017 chg
UST 2Y 125.4 128.2 2.8
UST 5Y 192.8 191.0 -1.8
UST 10Y 239.3 237.1 -2.2
UST 30Y 301.6 299.6 -2.0
GERM 2Y -74.0 -80.7 -6.7
GERM 10Y 32.8 22.8 -10.0
JPN 30Y 84.5 84.7 0.2
EURO$ M7/M8 49.0 43.0 -6.0
EURO$ M8/M9 38.0 35.0 -3.0
EUR 106.56 105.91 -0.65
CRUDE (1st cont) 50.60 52.24 1.64
SPX 2362.72 2355.54 -7.18
VIX 12.37 12.87 0.50

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https://www.amazon.com/Second-Leg-Down-Strategies-Profiting/dp/1119219086/ref=sr_1_1?ie=UTF8&qid=1491651834&sr=8-1&keywords=the+second+leg+down

https://www.newyorkfed.org/newsevents/speeches/2017/pot170405

Posted on April 9, 2017 at 12:58 pm by alexmanzara · Permalink
In: Eurodollar Options

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