Dear Mr Fantasy

Feb 24, 2019

Dear Mr. Fantasy play us a tune
Something to make us all happy
Do anything, take us out of this gloom
Sing a song, play guitar, make it snappy

You are the one who can make us all laugh
But doing that you break out in tears
Please don’t be sad if it was a straight mind you had
We wouldn’t have known you all these years  – TRAFFIC  1967

My mom told me to always have some cash on me.  The reason is because she knew a guy in Chicago who was jumped, and, because he had no money with him, the thugs were mad enough to beat him to within a hair of death.  It’s one of those little insurance policies. “Take some money with you honey.  So you don’t get your ass kicked.”  Nice. 

JK sent me a link from the Fed about the Fed’s balance sheet and liabilities.

Now here’s something I am personally amazed by:  “Since the start of the Financial Crisis, notes in circulation have more than doubled and, as of the end of 2018, stood at about $1.67T…about 8% of US GDP, implying that accommodating demand for currency alone requires a larger balance sheet than before the crash.”  As a comparison, in the mid-1980s currency was about 5% of GDP.  How can it be?  The youth of today never have any currency on them, they just wave their phones around. A clue is in another sentence.  “…with heavy usage of US currency overseas, changes in global growth as well as in financial and geopolitical stability, can also materially affect the rate of currency growth.” There you go.  In other countries, they know having an easy, portable store of value can go a long way in case of instability.  As they say, there are more $100 dollar bills circulating in Russia than in the US.  The Fed’s discussion of balance sheet goes on to note that banks may have a higher demand for reserves for several reasons, including “an increased focus on liquidity risk management in the context of regulatory changes.”  So, the banking system is following the Demetra Rule.  Have a little extra on hand.  Don’t get your ass kicked.  Quarles essentially said the same thing Friday.  He “favors sizable reserves as buffer against most shocks.”  In this business we call it “Risk Management.”

Now I move loosely into the Mr Fantasy reference. I chose it right after I read the Clarida speech on revising the Fed’s policy framework.  But I don’t really mean to single out Clarida.  Mr Fantasy refers to  Central Banking and Monetary Policy and the Green New Deal and… the list could go on and on. 

Clarida first asserts that the neutral rate has fallen both here and abroad:    

Perhaps most significantly, neutral interest rates appear to have fallen in the United States and abroad.2 Moreover, this global decline in r* is widely expected to persist for years. The decline in neutral policy rates likely reflects several factors, including aging populations, changes in risk-taking behavior, and a slowdown in technology growth.  

Huh?  Slowdown in tech growth?  Why, I can go into McDonalds, order on a kiosk, and I don’t even have to TALK to anyone. And… I don’t need cash.  Now that’s progress.  On a more nuanced note, Lael Brainard had this to say as recently as September [‘What Do We Mean By Neutral’, Sept 12, 2018]  

This year, the unemployment rate has fallen further, and job market gains have gathered strength, at the same time that the federal funds rate has increased. This combination suggests that the short-run neutral interest rate likely has also increased.  If, instead, the neutral rate had remained constant as the federal funds rate increased, we would have expected to see labor market gains slow. That inference is consistent with the formal model estimates, which indicate that the shorter-run neutral rate has gone up as the expansion has advanced.

As I said in my note ‘Brainard the Bear’ 9/16/2018, “the neutral rate is a moving target and it’s going up”.  The neutral rate RISES with the EXPANSION and with a higher FF rate.  The end of Q3 2018, was a time of peak hawkishness, when even Chicago’s uber-dove Evans said he was comfortable with the inflation outlook and rate hikes.

So, Brainard had neutral moving up, just about perfectly top-ticking the peak of the rate cycle in late Oct/early Nov.  Clarida now has neutral moving down.  Does neutral go up as the Fed hikes and go down with an institutional flip to dovishness?  Perhaps this comment is a little unfair; I think all Fed members would allow that, in the short term, neutral can move around.

Clarida continued Friday’s speech with 3 questions. First, should the Fed overshoot inflation to make up for past shortfalls (inflation averaging).  Second, should the Fed’s tool kit be expanded to allow for BOJ style yield capping, for example. Third, can the Fed’s communication be improved. 

On point number three, a variant of monetary rules listed below were posted in Friday’s Monetary Report to Congress.  How much more communication could you ask for?  Equations.  They KNOW what they’re doing!

Taylor rule: RTt=rLRt+πt+0.5(πt−π∗)+0.5(yt−yPt)RtT=rtLR+πt+0.5(πt−π∗)+0.5(yt−ytP)
Balanced-approach rule: RBAt=rLRt+πt+0.5(πt−π∗)+(yt−yPt)RtBA=rtLR+πt+0.5(πt−π∗)+(yt−ytP)
ELB-adjusted rule: REadjt=maximum{RBAt−Zt,ELB}RtEadj=maximum{RtBA−Zt,ELB}
Inertial rule: RIt=0.85Rt−1+0.15[rLRt+πt+0.5(πt−π∗)+(yt−yPt)]RtI=0.85Rt−1+0.15[rtLR+πt+0.5(πt−π∗)+(yt−ytP)]
First-difference rule: RFDt=Rt−1+0.1(πt−π∗)+0.1(yt−yt−4)

On points number one and two, Clarida notes that policy stances have to be CREDIBLE to the public.  You know, like the EURCHF peg. Or like the equations above.  For years, central banks have been hand-wringing about just hitting the 2% inflation target.  Now we’re going to fine-tune over- and under- shoots?  I, for one, enthusiastically support that (fantasy) policy choice.  It almost certainly will lead to busy markets.  Optimal policy?  No.  But busy. As my friend George used to say: Vote like a Democrat.  Live like a Republican. 

One last excerpt from Clarida’s speech:

As is well known from the research literature, makeup strategies, in general, are not time consistent because when the time comes to push inflation above 2 percent, conditions at that time will not warrant doing so. Because of this time inconsistency, any makeup strategy, to be successful, would have to be understood by the public to represent a credible commitment. That important real-world consideration is often neglected in the academic literature.

“Real-world.”  Thanks Rich.  Williams also sought to clarify Fed thinking:  “We must be equally vigilant that inflation expectations do not get anchored at too low a level.  This persistent undershoot of the Fed’s target risks undermining the 2 percent inflation anchor.”  You can’t find neutral.  Can’t quite hit 2%.  Better keep a little cash in your pocket.

Conclusions from above:  Balance sheet reduction will end later this year.  The Fed won’t hike.    


From a review of markets last week one would say there’s not much really going on.  VIX slipping into quicksand again, stocks bid, treasury yields tightly coiling around mid-range with implied vol probing new lows.  Dollar index pretty much sideways since last summer.  Then you start to skim through the news, and, maybe it’s just me, but there appears to be an absolute flood of upcoming uncertainty. Fed policy.  US debt limit.  US/China trade issues. (These last two have Friday, March 1 ‘deadlines’). Brexit.  Parliamentary elections in May in Europe.  China’s monetary policies. 

Regarding China, there was a story on Bloomberg that Qinghai Provincial Investment Group (Q-PIG), 2/3rds owned by the provincial gov’t, missed a USD coupon payment Friday.  This struggling aluminum producer was seen as “a bellwether for assessing gov’t support” and may send tremors through other LGFVs (Local Gov’t Financing Vehicles).  I don’t know how to assess ramifications, if any.  It’s well known that defaults have been increasing in China (coming to a theatre near you in the USA), but this one also comes just after a huge surge in Total Social Financing in January.  Are the PBOC’s efforts designed to mitigate increasing fall-out? On Friday, February 15, the South China Morning Post ran a story that Premier Li Keqiang warned the PBOC on credit expansion, “This will not only lead to arbitrage and inefficient circulation of capital, it will also bring new potential risks.”  From the article: “Li’s unusual comments suggest concern among some policymakers that the recent modest easing in policy by the PBOC has allowed a resurgence in financial activity akin to speculation that does not benefit the real economy and creates unacceptable financial risks in the longer term.”  That ALMOST sounds like the original Chairman Powell, before he submitted to the market’s pressure and turned tail.  Now he wears running pants.

In any case, given looming uncertainties, I think the easiest call to make is that vols are too low in the US.  Buy some cheap insurance.  Might not need it, but It may prevent a true ass-kicking.  VIX was 35 a couple of months ago and is now 13.5.  April US 30-year bond vol is around 6% with the Fed talking about allowing an overshoot of inflation and a tsunami of treasury issuance.  We don’t even know what the benchmark rate is going to be a few years from now, but Blue June Eurodollar 9750 straddle on EDM22 is just over ¼% at 27 bps with 109 days until expiration. 

Finally I’ll leave off with a quote from fashion designer Karl Lagerfeld, who passed last week.

“Whoever wears running pants has lost control over his life.”

Upcoming events (source Bloomberg)

Monday Clarida speaks in Dallas

Tuesday Powell testifies to Senate, followed by an appearance at the House on Wednesday (I hope Maxine Waters and AOC don’t disappoint us.  Dear Mr Fantasy, play us a tune)

Thursday Fed speakers Clarida, Bostic, Harker, Kaplan, Mester

On Monday the Treasury borrows.  A lot.

$48 B 3-month bills

$39 B 6-month bills

$40 B 2-year notes

$41 B 5-year notes

And on Tuesday
$26 B 52-week bills

$32 B 7-year notes

Q4 GDP on Thursday

Friday: Personal Income/Spending and Core PCE. ISM Mfg.


Here’s an update on libor/ois proxies.  I use 3 month quarterly ED contracts vs the average of the next two FF contracts. On the week these spreads have compressed by 2.25 to 3.50 bps.

                                                                                                2/22/2019            2/15/2019

EDM9 9739.5 vs avg(FFN9+FFQ9) 9761.5 =            22.00                     24.25

EDU9 9740.0 vs avg(FFV9+FFX9) 9762.0 =             22.00                     24.50

EDZ9 9738.0 vs avg(FFF0+FFG0) 9765.75 =             27.75                     31.00

EDH0 9746.0 vs avg(FFJ0+FFK0) 9770.0    =             24.00                     27.50

EDM0 9751.5 vs avg(FFN0+FFQ0) 9776.0 =            24.50                     27.25

EDU0 9756.0 vs avg(FFV0+FFX0) 9780.75 =            24.75                     28.25

2/15/2019 2/22/2019
UST 2Y 251.8 248.9 -2.9
UST 5Y 249.3 246.6 -2.7
UST 10Y 266.4 265.4 -1.0
UST 30Y 299.7 302.1 2.4
GERM 2Y -55.6 -56.5 -0.9
GERM 10Y 10.2 9.6 -0.6
JPN 30Y 59.2 57.5 -1.7
EURO$ H9/H0 -3.5 -6.8 -3.3
EURO$ H0/H1 -12.5 -13.0 -0.5
EUR 112.98 113.35 0.37
CRUDE (1st cont) 55.98 57.26 1.28
SPX 2775.60 2792.67 17.07
VIX 14.91 13.51 -1.40

Posted on February 24, 2019 at 8:09 am by alexmanzara · Permalink
In: Eurodollar Options

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