Dec 27. Spectrum of outcomes widening

It was a fairly quiet week. Treasuries added 4-6 bps in yield and stocks shook off the Fed rate hike and pushed higher. VIX and other volatility measures declined, while commodities had a tentative bounce with WTI up $2 on the week (CLG6 settle 38.10).

However, on the year, both tens and SPX are about where they started. A quick skim of hedge fund performance data reveals many results with negative signs. We know that commodities have had a brutal year, and that equity earnings have declined, and junk bond rates have surged in an environment of crashing energy prices and generally tightening financial conditions. While tens ended the year unchanged (2.22% on 12/29/14 vs 2.26% Friday), the two year note reflected the tighter Fed, ending Friday at 1% vs year ago at 72 bps. Similarly, stock indices were mixed with the Russell down about 4% and Nasdaq up around 5%. Just a quick footnote here, many underfunded public pension plans (and Illinois is the poster child with less than 40% funded), assume returns of 7.25 to 7.5%. The gap is supposed to be filled by taxpayers. Those gaps grew.

One of the important events of the week was the downgrade in the Q4 Atlanta Fed GDP Now forecast on Wednesday from 1.9% to 1.3% with the release of this week’s data.  Apart from some labor indicators, data has been coming out soft, a challenge for the Fed. One of the most important events of the year was the Chinese devaluation in August, with CNY having been around 6.21 prior to the devaluation, and ending the year at a new low of 6.48.

This is where I am going to veer off from quantitative and ramble a bit about more qualitative concerns. I am often chastised for being negative on stocks and on the US economy, etc. It doesn’t particularly bother me as long as I think I am bringing up salient and thought-provoking points. However, colleague JA suggested I should consider the other side: What if the rout in commodities has ended? What if junk bonds stabilize and begin to turn higher? What if the dollar doesn’t push higher? (the implication being that deflationary forces will abate considerably). What if the labor market continues to improve and spurs wage gains? Might it not be the case that stocks take another leg up and the Fed is thus encouraged to embark on a slightly more aggressive rate hike path? All clearly possible.

Actually I do think the commodity rout is close to its end. And I do think the dollar weakens into the early part of the year. However, I think the extreme divergence between stocks and commodities is likely to close to some degree, a negative for stocks.

What I often remember is Stanley Druckenmiller saying that central bank liquidity is the most important consideration in investing, and outweighs earnings, etc. This is a quote from a speech SD gave Jan 18, 2015. “…earnings don’t move the overall market; it’s the Federal Reserve Board. And whatever I do, I focus on the central banks and focus on the movement of liquidity. Most people in the market are looking for earnings and conventional measures. It’s liquidity that moves markets.” On a more personal level but more succinctly, the most successful individual trader I know (who I happen to have met on the CME floor) told me around the time of the crisis, “The Fed is going to cut and stocks are going to go up, just like always.” And he was right, although it took a while to play out.

So who is going to be the liquidity provider in 2016? Doesn’t seem like it will be the Fed, and the rally in the euro after Draghi disappointed on his stimulus announcement suggests that the market is wary of putting too much faith in the ECB. We know China has been trying to spur growth; the devaluation of the yuan is an overt sign (and likely quite deflationary for the US and other global manufacturers). We know that China was responsible for the seemingly insatiable demand for raw materials that has now stopped, sending emerging economies into tailspins. There’s a chart on BI from Chinese analyst Charlene Chu that puts growth for China’s Secondary Industry at just 1.2% this year. Is China just like the US, ease financial conditions and a positive feedback loop takes hold? I don’t know, but I think it depends an awful lot on the degree and quality of previous growth. Japan’s stimulus after its crash in the 1980’s never really hit the mark, and seems to have problems with effectiveness even to this day. And I would say that actions like detaining financial executives and militarily staking territorial claims isn’t exactly a sign that the leadership in China thinks they have full control. When it looks like things are getting a bit shaky economically, provoke your neighbors and instill nationalism.

Here are a couple of interesting snippets from George Friedman (formerly Stratfor): “Last week the South Korean president called for the development of an economic contingency plan to brace for a possible crisis” He adds, “Exporters of industrial goods are hostages to their customers… problems can rapidly move from economic issues to political and social instability.” Friedman also of course, talks about Germany facing export dependency challenges. And he ends with, “This is not an economic problem in itself by any means. It is a social, political, and cultural shift of the first order.”

How does the above fit into US interest rate markets? Perhaps it doesn’t. However, I would note that the US curve remains quite flat, especially given the low nominal level of rates across the curve. Eurodollar one year calendars are holding below 5/8% (2 to 3 hikes a year). I would suggest that the red/gold Eurodollar pack spread at a new low Friday (for the year) of just 93 bps is dismissive of inflationary possibilities, and embeds a forecast of tepid growth. Liquidity policies are seen to have run their course.

When there’s a virtuous feedback loop, gains in employment feed gains in consumption and production. Asset prices like homes and stocks hold or rise in value because of growth prospects. Public finances improve due to increases in collected taxes. There are many reinforcing aspects. It is, of course, the same way on the downside.   Drops in the prices and/or volumes of goods sold causes layoffs and bankruptcies, and risk aversion in credit markets. We’re seeing some aspects of both positive and negative recently, the latter in US manufacturing. The rates market seems to be tilting that way in spite of the Fed’s vote of confidence. Maybe it all just muddles along.

However, if Friedman is right and we’re on the 2016 cusp of social, political and cultural shifts, then institutional responses may prove ineffective. I think this may be a year of significant political upheaval globally, providing the main source of risk in financial markets. Probably not much of a forecast; we’ve obviously been in a period of geopolitical uncertainty for some time. The point is that such uncertainty may accelerate beyond the abilities of official responses, while the world appears to be up against liquidity constraints. The spectrum of outcomes has widened. From a market perspective it seems as if implied vols should generally be firmer and risk aversion may continue to trend higher. On that score we saw good buying Friday in TYG 128c for 7/64’s with open interest rising 9500. It might just be that we’re seeing hedge replacement purchases given the expiration in Jan options. Again, at this time of year it’s probably not worth reading much into particular trades or recommending new ones.



Here is a very interesting link on cyber attacks relating to the power grid.



12/18/2015 12/24/2015 chg
UST 2Y 95.6 99.8 4.2
UST 5Y 167.3 171.6 4.3
UST 10Y 219.5 224.1 4.6
UST 30Y 290.6 296.2 5.6
GERM 2Y -35.4 -33.2 2.2
GERM 10Y 54.8 64.1 9.3
EURO$ H6/H7 59.5 61.5 2.0
EURO$ H7/H8 49.0 48.5 -0.5
EUR 108.68 109.67 0.99
CRUDE (1st cont) 36.06 38.10 2.04
SPX 2005.55 2060.99 55.44
VIX 20.70 15.74 -4.96


Posted on December 27, 2015 at 1:03 pm by alexmanzara · Permalink
In: Eurodollar Options

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