August 23, 2015. Financial Stability vs Inflation – weekly summary

THEMES:

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8/14/2015 8/21/2015 chg
UST 2Y 72.6 62.5 -10.1
UST 5Y 159.4 143.6 -15.8
UST 10Y 219.4 205.0 -14.4
UST 30Y 284.0 274.4 -9.6
GERM 2Y -27.0 -25.4 1.6
GERM 10Y 66.0 56.4 -9.6
EURO$ Z5/Z6 ** 77.5 68.0 -9.5
EURO$ Z6/Z7 60.0 56.5 -3.5
** peak one-yr spd
EUR 111.09 113.89 2.80
CRUDE (1st cont) 43.11 40.45 -2.66
SPX 2091.54 1970.89 -120.65
VIX 12.83 28.03 15.20
 
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Here’s an excerpt from last week’s note:

Without QE the market is forced to actually put a realistic price on risk.

Therefore I think stocks are likely to see selling pressure with risks of a sharp break. I think the Fed will continue to talk tough, but will not be able to pull the trigger at September’s meeting. Asymmetric risks will stay the Fed’s hand.

Given my world view, I like buying 2 year notes, current yield nearly 73 bps. I think 5/30 will rebound a bit when it becomes apparent the Fed won’t hike. Currently 125, strong support at the 61.8 retrace which is 122. Stop below 115. I like buying EDH7/EDH8 48-50, now 54.

So those were pretty good ideas, though EDH7/EDH8 never hit target; closed 51.5. 5/30 closed at 131.

What’s interesting about this week is although the SPX fell 5.7%, treasury yields didn’t change all that much, especially on Friday, which encompassed 3.2% of that drop. Fives had the biggest drop on the week of nearly 16 bps, as views on the prospect of Fed tightening were scaled back. The two year note fell 10 bps to 62.5. The ten year yield is holding right around the 50% retrace of the year’s low to hi (164.2 to 248.5) at 206…ended Friday at 205. Going forward it will likely range between 195/196 to 220.

To my way of thinking, there are now three major considerations for the market. First, has the equity market changed trend? I believe that it has, and that it will be unlikely to make a new high from here for a substantial amount of time. Second, will the US Federal Reserve begin a tightening cycle? While I do think there’s a chance the Fed will actually change the FF target, I don’t believe it will be construed as a true change in terms of a tightening cycle and change in institutional bias. Third, will the dollar index change trend? I think there is a possibility of a change in trend in the dollar; the door is open on that theme; so far DXY holds the 200 day moving average.

dxy 200day

 

Of course, this week it wouldn’t be a surprise to see a stock rally. Apparently some selling this week was associated with August option expiration on Friday. There will be some bottom fishers. The big issue is whether the trend has changed. If it has, it’s important because of the psychology of the wealth effect, and possibility of more modest consumption going forward. AAPL alone has lost just under 20% in the past month, nearly $150 billion in market cap. That’s a lot of wealth… evaporated.

I saw a very interesting interview this week on BBG (thanks WHM) with Stephen Roach on August 20. He said the trade-off for the Fed is between inflation and financial stability. That is a huge point, and it appeared to me as if Roach was somewhat exasperated that it flew past the Bloomberg panelists unnoticed, like a couple of bats zigzagging through the sky at dusk.

I agree with what I believe to be Roach’s point: the key isn’t the labor market, if that were the case the Fed could have tightened long ago. The problem is one of the Fed’s own making, that of low rates and official encouragement (bribery) for the ‘investing’ community to pour into higher risk assets with newfound liquidity, which caused a mispricing of risk. And now the risk genie is coming out of the bottle. If the Fed wants to make sure the market understands it has changed its tune on excessive risk taking, it will hike. If the Fed just looks at inflation, it must stand down.

I’ve heard precious little lately about ‘macroprudential tools’ that the Fed was going to employ to make sure excessive risk didn’t destabilize the economy. On the other hand, we have companies like MetLife pulling a Bruce Jenner and saying it’s NOT an American company, in order to bypass Dodd-Frank. Now the question is whether the Fed has the fortitude to tighten/normalize even in the face of a risk-off period. It’s pretty obvious to everyone that inflation is not on the verge of a surge, though we all know at some point the price of oil will stop going down and yoy comparisons will show up in inflationary data. I believe the market knows the price of risk was too small, and I further believe that the increases we’re beginning to see are healthy over the long haul. However, as an institution, the Fed likely doesn’t have the courage to tighten and stamp an official imprimatur on a book which shows its views on excessive risk taking have changed.

What does it mean in terms of trading? A Fed on hold means the curve could begin to steepen from reds back. However, Fischer’s Jackson Hole speech on Saturday August 29 will be quite important to reveal the Fed’s thinking. We are at or near attractive long term buying levels, for example, on reds to blues, which closed at 93.375 bps as a pack spread. Aggressive target of 140 to 150 by the end of the year.

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This next section is a bit off the beaten track, and concerns a seven year cycle referenced in the Bible as the Shemitah, which happens to be about relinquishing debts. (And a WSJ article notes that 17% of college loan debt is severely delinquent). I’m not much one for linking religious theories with broad market themes, however, the seven year pattern in the autumn seems to have something going for it. As Dr Ray Stantz tells Winston Zeddemore in Ghostbusters: “Every ancient religion has its own myth about the end of the world.”

However, over recent history this seven year itch, and I’m not talking about the Ashley Madison kind, has a pretty good track record. Let’s start with October 16, 1973. OPEC raised oil prices by 70% and sparked a nasty recession in the US. In 1980, US inflation hit its peak of 13.5% and the Fed under Volcker raised Fed Funds to 12% in September, eventually getting to 20% by the end of the year…recession.  In 1987, on Oct 17, then Treasury Secretary James Baker threatened to devalue the dollar and on Oct 19, Black Monday, stocks crashed 22%. In 1994, the bond market crashed, and on Dec 20, Mexico devalued the peso…the Tequila crisis. In 2001 we had another stock crash and 9/11. On Sept 17th 2001 the Dow lost 684 points. In 2008 on Sept 29, the Dow lost 777 points or 7%. And…here we are in 2015, with the Shemitah on Sept 13, which coincides with a solar eclipse. Whether one looks at Elliott waves or Kondratieff cycles or frames history according to the Fourth Turning (Strauss and Howe), we seem to have a lot of issues currently which fit with warning timeframes.

I am not going to add links for the Shemitah stuff, you end up at a lot of fringe sites. But in terms of other cycle theories, here are a couple of links. Carpe diem.

“So will the period of 2015 to 2020 turn out to be pure hell for the United States?”   http://michaelsnyder.mensnewsdaily.com/2014/05/if-economic-cycle-theorists-are-correct-2015-to-2020-will-be-pure-hell-for-the-united-states/

“On this interpretation, the big meltdown doesn’t begin until 2018-2020”

http://blogs.telegraph.co.uk/finance/jeremywarner/100015715/if-kondratieff-was-right-weve-still-years-of-slump-to-go/

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Posted on August 23, 2015 at 6:54 am by alexmanzara · Permalink
In: Eurodollar Options

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