December 20. Dislocations


spx v bcom

In this business, we’re always trying to identify market ‘dislocations’ that we can exploit. Sometimes, these are little kinks that market technicians refer to as ‘mean reverting’ (or what Keynes might have referred to as irrational…as in ‘the markets can stay irrational longer than we can stay solvent’). What’s probably one of the biggest dislocations ever is right under our noses, or in this case, pictured in the chart above. SPX versus the Bloomberg Commodity Index. Commodities are at multi-year lows, while stocks tentatively churn near the highs. With energy accounting for about 35% of BCOM, and oil probing ever lower, the lower right hand part of the chart is understandable. However, as has been well-documented, that same dynamic has spilled over into higher (much higher) financing rates for energy companies, and for miners, and has been reflected in prices such as the Canadian dollar vs USD, at a new low of 71.65 cents (1.3957).

I have several times cited a fascinating article that highlights the reduced amount of energy and material used in our modern world for basic functions. For example, an i-Phone can replace a bulky alarm clock, a stereo system, a camera, shelves of records and books, etc. That’s part of the answer. But still, don’t we still need industrial materials to make cars? Or bombs? (both of which are seeing high demand). Not really… instead of B1 bombers, drones. Instead of tanks, cyber warfare. For example, I saw a few links (thanks AOK) noting ‘Turkey under Cyberattack from Russia’* and on CNN, ‘Newly discovered hack has US fearing foreign infiltration’** One U.S. official described it as akin to “stealing a master key to get into any government building.” [Links below]

So obviously, some of the demand for raw material has declined. But there are still companies that produce and transport things, with employees that extract energy and metals. Those companies have debt, money lent which could now be impaired or disappear altogether. So there’s a loopback into financial assets. Note as well that our entire financial infrastructure rests in clouds of ether data. Want to see dislocations? The risk is there.


Finally, last week we had Fed liftoff. Time will tell whether rates and the economy will ascend, or whether this is more like the special delivery Acme Rocket Blaster that the coyote straps on to pursue the roadrunner, only to find himself spiraling down the abyss of the canyon.


acmeSome respected analysts think Fed hikes will come more quickly than currently priced into the market. [Another big dislocation?] For example, Steen Jakobsen, Saxo Bank’s CIO and chief economist: “Fed says four hikes, market says maximum two – I’m with the Fed.”   Or David Kelly, chief global strategist at JPM Funds. (BI) Kelly is of the opinion that the economy is strong enough to sustain not just the rate hike from the Fed seen on Wednesday, but a brisk pace of rate hikes going forward. “That is just a wrong forecast,” Kelly said. “The unemployment rate will come down more than the Fed expects and that will keep their feet to the fire for more rate hikes.”

Well the market isn’t holding anyone’s feet to the fire just yet. As mentioned previously, the peak one-year Eurodollar calendar spread remains below 5/8%. EDH16/EDH17 closed at 59.5 Friday, up just 3 bps on the week. Both the red/gold euro$ pack spread (2nd to 5th years) and treasury 2/10 closed at new recent lows, and near the lows of 2012. Actually the red/gold spread is well below 2012 at just 93.5 bps, and 2/10 at 124 is within shouting distance of the low set earlier this year and the low of 2012. So I’m with the coyote on this one, and will go along with the (interest rates) market. The Fed will have to order something else from the Acme catalog. And the stock market will stop in suspended animation, look directly into the camera for a frame, followed by a descending whistle.


We can get a sense of the odds for a hike in March by looking at near contracts. April Fed Funds closed at 99.525, or 13 bps below the January contract (99.655) and since April is a relatively “clean” month (April 27 FOMC), we can say odds of a hike in March are just better than 50/50. March Eurodollars on the other hand, seem to indicate even higher odds of a hike in Q1.   EDZ5 just expired at 99.4822 having priced the hike. Therefore, one might expect EDH6 to be around 9923 if it were fully pricing a March move, vs the settle Friday of 9929. So EDH6 is reflecting higher odds than FFJ6, more like 3 out of 4. However, some of this could reflect a demand for dollar funding which may abate going into the new year. (Sell FFJ and buy EDH?).

One other thing that people constantly mention, and I’ll admit that I’ve previously been in this camp myself, is that the new generation of traders and investors have never even seen rate hikes, and won’t have any idea how things might unfold. “These kids have never even seen Fed funds at 5.25%.” Well, I’ve met a lot of brainy “kids” in the business that can dance circles around me, and have technology at their fingertips to study and sift historical relationships. New generations come, and while experience provides valuable insights, the drivers of fear and greed are always there, and there’s plenty of data documenting the ebbs and flows. But the one thing I will say is, Trade with the trend. Let’s hope there IS one in 2016. I remember seeing an interview with Tom Baldwin in 1994, at the time the biggest local in the bond market. At the start of 1994 we had three hikes in rapid succession. Bonds tanked. At first Baldwin mentioned that he was trying to fight it. But then he said, “the market went down a few points, and just kept going, so I jumped on.” We’re just not seeing that price action in the current environment. In fact, implied vol in treasuries was hammered this week. For example, last Monday the USH 155 straddle settled 6’08 ref 155-14 (11.5). On Friday, USH 156 straddle settled 5’16 ref 156-12 (10.3). That’s a lot of vanished premium. Where’s the bond bear? Snoozing.

Having mentioned the importance of trend, I will also say that oftentimes the new year brings trend reversals. New money comes in to certain sectors and abandons others. One of the pieces of market history that I buy into is the idea that the dollar strengthens in anticipation of hikes and begins to weaken after the Fed starts. It happened at the onset of the 2004 hike cycle, though the dollar firmed through 2005. On a long term chart of DXY, the high in 2002 (set in the beginning of the year) was 120.50 and the low in 2008 (set in the beginning of the year) was 70.70. The 0.618 retrace is 101.50 and we’ve recently come close just above 100.

DXY 12_2015


If – and it’s perhaps the big question of the year – if the Fed becomes hesitant to hike further, then the USD should begin a decline and the US curve should steepen. It would also likely mark an end to the divergence of the lead-off chart.  In terms of general trading strategy, it’s tough to be short interest rate vol after the drubbing taken this week. Weaker stocks and hi-yield should engender risk aversion which should support green Eurodollars on the curve (small outperformance Friday) and Fives in treasuries. Into the end of the year and holidays, conditions will be thin; no specific trade recs at this time…


12/11/2015 12/19/2015 chg
UST 2Y 89.1 95.6 6.5
UST 5Y 156.9 167.3 10.4
UST 10Y 213.8 219.5 5.7
UST 30Y 287.9 290.6 2.7
GERM 2Y -35.1 -35.4 -0.3
GERM 10Y 54.0 54.8 0.8
EURO$ H6/H7 56.5 59.5 3.0
EURO$ H7/H8 47.5 49.0 1.5
EUR 109.91 108.68 -1.23
CRUDE (1st cont) 37.25 36.06 -1.19
SPX 2012.37 2005.55 -6.82
VIX 24.39 20.70 -3.69



Posted on December 20, 2015 at 3:47 pm by alexmanzara · Permalink
In: Eurodollar Options

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