August 31. Fischer and the China Shock

THEMES:

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8/21/2015 8/28/2015 chg
UST 2Y*new 62.5 72.8 10.3
UST 5Y*new 143.6 152.6 9.0
UST 10Y 205.0 218.8 13.8
UST 30Y 274.4 291.0 16.6
GERM 2Y -25.4 -20.8 4.6
GERM 10Y 56.4 74.2 17.8
EURO$ H6/H7 ** 68.5 72.5 4.0
EURO$ H7/H8 51.5 55.5 4.0
** peak one-yr spd
EUR 113.89 111.85 -2.04
CRUDE (1st cont) 40.45 45.22 4.77
SPX 1970.89 1988.87 17.98
VIX 28.03 26.05 -1.98
     
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I think there are only three voices that matter on actual timing of the US rate hike: Yellen, Fischer and Dudley. Yellen is seen as more dovish, Dudley walked back from a Sept rate increase this week, which leaves Fischer, and my belief is that if he says no to a hike in September, then it won’t occur at that meeting.

From Fischer’s comments on CNBC Friday and his speech Saturday, it’s pretty clear that his main concern is about China and international developments. He also continues to see factors holding down inflation as transitory, but clearly global stability and US inflation are intertwined, notably through the dollar, which he highlighted in his speech Saturday.

On the CNBC interview with Steve Liesman, Fischer pointed clearly to China as the cause of renewed volatility. Here are some excerpts:

THE CHANGE IN THE CIRCUMSTANCES WHICH BEGAN WITH THE CHINESE DEVALUATION IS RELATIVELY NEW AND WE ARE STILL WATCHING HOW IT UNFOLDS. [US wealth effect?]

WE HAVEN’T SEEN MUCH EVIDENCE OF THOSE DANGERS INCREASING [of staying at zero]. WE ARE OBVIOUSLY WATCHING THEM VERY CAREFULLY BECAUSE WE ARE BEING TOLD ALL THE TIME THAT THEY ARE THERE, BUT WE HAVEN’T SEEN THEM IN A MAJOR WAY.

IT WAS A REACTION TO SOMETHING WHICH HAD THE POTENTIAL TO BE VERY BIG, AND WHICH WE’RE STILL LOOKING AT. CHINA HAS BECOME THE SECOND LARGEST ECONOMY IN THE WORLD.

http://www.cnbc.com/2015/08/28/cnbc-exclusive-cnbc-transcript-federal-reserve-vice-chairman-stanley-fischer-speaks-with-cnbcs-steve-liesman-on-cnbcs-squawk-alley-today.html

And here are a couple of quotes from Saturday’s speech:

Thus, it is plausible to think that the rise in the dollar over the past year would restrain growth of real GDP through 2016 and perhaps into 2017 as well. The rise in the dollar since last summer, of about 17 percent in nominal terms, with its associated declines in non-oil import prices, could plausibly be holding down core inflation quite noticeably this year.

At this moment, we are following developments in the Chinese economy and their actual and potential effects on other economies even more closely than usual.

In terms of inflation being transitory, the first big leg lower in crude oil was in January. The dollar index topped in March. One would think that by Q1 of next year, inflation measures associated with both oil and with import prices due to dollar strength would dissipate. If not for China’s devaluation, the case for a rate hike would be clear.

In terms of policy choices for China, it appears they can either use reserves to try to stem capital outflow, or let the yuan slowly depreciate in a controlled manner. Of course they are also taking other policy steps, for example (Reuters) “China’s parliament approved on Saturday a cabinet plan to cap total outstanding local government debt at 16 trillion yuan.”

Another interesting Reuters story has this passage: http://www.reuters.com/article/2015/08/27/china-yuan-idUSL4N1102SL20150827

An influential economist at a top government think-tank said policymakers may have underestimated the global impact from the yuan devaluation, which happened when jitters about China’s slowdown had intensified due to a stock market plunge.

“You chose the timing as the economy weakened and the stock market plunged, sending out a wrong signal to foreign countries that you want to spur the economy through devaluation and leading to competitive devaluations,” said the economist, who last month discussed policy issues with Premier Li Keqiang. “This put us on the defensive; it looks like China is the trigger.”

Just one other note that was NOT directly mentioned by Fischer, the “change in circumstances” includes a potentially large drop in US stocks, which we’ve had a taste of in the past two weeks. BAML notes that the US is 52% of global market cap, and the second largest country by market cap is Japan. US $19T and Japan at $3T. http://www.businessinsider.com/map-countries-scaled-to-equity-market-capitalization-2015-8

IF US equities continue their volatility due to uncertainty about CHINA’S policy choices and the related responses of other countries, then the Fed will be patient. Whether the hike occurs in September or not, the key will be a gradual trajectory. Again from the CNBC interview, “WE’D BE ADJUSTING THE KNOB SLIGHTLY AND WILL PROBABLY WAIT AWHILE BEFORE DOING SOMETHING ELSE.”

In terms of trading strategies, there have been many trades that have become focused on the odds of a hike at the Oct 28 FOMC rather than September. For example, over 100k traded in the EDV/EDX 9950 put calendar, paying 1 for November. This trade settled 1.0 with EDZ5 9953.0. If there’s no hike in Sept, then Oct puts should expire worthless, leaving the November puts long from a cost of 1 going into the Oct FOMC. Even if there is a hike in Sept, EDZ could easily hang around the 9950 strike, allowing at least a scratch on the position. In a similar trade, Oct/Nov Fed Fund spread went out Friday 4.0/4.5. After the initial stock market volatility, this spread was trading only 1.5. The bid in this spread is predicated on no hike in Sept and a chance in October. With the FOMC on Oct 28, the FFV can only price about 13% of the hike, or about 3.25 bps given a move of 25, and November gets the whole enchilada, or 25 bps. The spread would probably be 0.5 bp without any Fed odds, so a 4 bid represents odds of about 16-17% that the Fed skips Sept but goes in October.

With regard to the longer end of the curve, there was week over week steepening, for example red/gold pack spread gained 10 bps on the week. Once again, eyes are on the Chinese, as the concern is that they have sold long dated treasuries and may have considerably more to go. The nearly $5 jump in oil on the week is another factor which tempers the deflation argument and erodes the support for the long end.

On the other hand, if China were to signal further yuan depreciation, the market would likely conclude that currency wars could accelerate, with rather deflationary consequences. The fact that USZ vol remains at the upper end of its range, over 13%, is likely a reflection of that uncertainty, and will probably retain a bid even after Friday’s NFP. Employment is, of course, the big data point of the week, expected 223k with a rate of 5.2%.

Posted on August 31, 2015 at 5:02 am by alexmanzara · Permalink
In: Eurodollar Options

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