Dec 6. Expectation Reversal

The week just ended was instructive in terms of just how much the market is dependent on Central Bank largesse. Thursday’s ECB disappointment sparked a stock market sell off and a jump in yields, along with a surge in the euro to over 109 from 105 early in the day. Draghi’s efforts to cushion the response on Friday (with comments that the ECB has more tools available and that potential growth in the balance sheet isn’t limited) reversed some of the moves, with US equities snapping back completely. However, EUR remained close to 109, closing the week at 108.85.

Friday’s employment report (NFP 211k) gave the Fed all the cover needed to raise rates on December 16. However, it’s worth noting that the only Eurodollar contracts that traded below the previous lows set at the November employment release were the front two contracts, EDZ’15 and EDH’16. One-year Eurodollar calendar spreads barely moved on the week and in fact declined on Friday, with peak spreads at only 5/8% (March’16/March’17 closed at 63.5). The red/green pack spread is still sub-50 bps. While German yields soared Thursday with bunds up 20 bps, the US Ten Year was up less than 5 bps on the week to 2.27%. The market is NOT expecting a stream of aggressive rate increases. If it were, then one-yr spreads would be closer to 100.

A while ago I recall JPM’s Jamie Dimon saying that if China says their GDP will be 7%, then it will be. The implication of course, is that the government can deliver any growth numbers that it wants to. Obviously, China is falling short. Over the weekend Ray Dalio said the ECB can reach its 2% inflation objective. Same implication. A headline on the Financial Times site read, “ECB head signals that he will get what he wants — higher inflation.” Certainly, Draghi’s comments on Friday suggest that he, at least, has the resolve. However, there was an article on Reuters over the weekend that said Thursday’s muted ECB action was due to a push back by the Governing Council:

(RTRS) “Hints by Mario Draghi ahead of last Thursday’s ECB rate meeting that the euro zone may need another big injection of money backfired, stiffening the resolve of more conservative central bankers who criticized him for raising expectations too high, sources familiar with the discussions said.

One source with direct knowledge of the situation interpreted Draghi’s public stance ahead of the meeting as trying to pressure the Governing Council to take bigger action.

“Draghi raised expectations too high, on purpose, and attempted to paint the Governing Council into a corner,” the source said. “This was problematic and he was criticized for this by several governors in private.”

http://www.reuters.com/article/us-ecb-policy-draghi-exclusive-idUSKBN0TO0L520151205

After reading Draghi’s comments Friday, I was left with the thought that the ECB might eventually overshoot its inflation target. By a lot. However, the Reuters article is a reminder that while Draghi may be the world’s most influential central banker, his powers can still be curtailed. I also would note that the Bank of Japan, with zero rates, a huge QE program, and purchases of ETFs hasn’t been able to spark inflation. Efforts to depreciate currencies to generate export growth are being met with competition, lately by China with a weakening yuan. The risk is more of a disinflationary cycle.

As the Fed moves closer to lift-off, attention is shifting to increased stress in the US corporate bond market.   For example there’s this from the FT:

More than $1tn in US corporate debt has been downgraded this year as defaults climb to post-crisis highs, underlining investor fears that the credit cycle has entered its final innings.

Analysts with Standard & Poor’s, Moody’s and Fitch expect default rates to increase over the next 12 months, an inopportune time for Federal Reserve policymakers, who are expected to begin to tighten monetary policy in the coming weeks.

A Bloomberg piece, $49 Billion Leveraged-Loan Hangover Awaits Wall Street notes that the demand to buy leveraged loans has diminished just as the supply has increased. “The financing glut comes as the appetite for riskier debt is drying up, with a growing number of debt offerings being pulled or postponed. Values of the lowest rated debt are plummeting… Speculative-grade bonds have declined 2.1% this year, putting the debt on pace for its first annual loss since 2008.”

https://research.stlouisfed.org/fred2/graph/fredgraph.png?hires=1&g=2OzF

Several analysts and central bank representatives have noted that the tightening in financial conditions has already served as a proxy for central bank rate hikes. Certainly deterioration has been obvious when looking at junk bond etfs, or at the chart above. However, broader indications as measured by regional Fed banks, for example Chicago’s Financial Conditions Index or St Louis’ Financial Stress, while having edged higher, don’t seem to be flashing warning signals. But the risk is increasing, and it’s not just due to troubles in the oil patch (January Crude down $1.74 on the week to below $40/bbl). The big question is whether compressed profit margins can cover increased debt service costs.

Data this week includes Consumer Credit on Monday and Retail Sales Friday. The Fed releases its quarterly Financial Accounts Z.1 report on Thursday. (Interesting summary of debt levels and growth rates for various economic sectors).

 

 

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11/27/2015 12/4/2016 chg
UST 2Y 92.2 94.3 2.1
UST 5Y 168.5 171.0 2.5
UST 10Y 222.4 226.9 4.5
UST 30Y 300.1 300.6 0.5
GERM 2Y -41.7 -30.3 11.4
GERM 10Y 46.0 67.8 21.8
EURO$ H6/H7 61.0 63.5 2.5
EURO$ H7/H8 49.0 50.0 1.0
EUR 105.92 108.85 2.93
CRUDE (1st cont) 41.71 39.97 -1.74
SPX 2090.11 2091.69 1.58
VIX 15.12 14.81 -0.31

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Posted on December 7, 2015 at 4:06 am by alexmanzara · Permalink
In: Eurodollar Options

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