Downside Risks

Jan 13, 2019

The week was dominated by the sentiment change engineered by both Powell’s appearances and the release of the FOMC minutes: the Fed can afford to be patient.  Clarida’s speech on Thursday evening helped to cement the idea of a Fed on hold.  Clarida noted all the solid backward-looking data, and said the economy was on track for further growth, but the attendant risks he mentioned all leaned the other way: “…inflation has surprised to the downside recently, and it is not yet clear that inflation has moved back to 2% on a sustainable basis.”  “…growth of capital spending slowed notably in the third quarter…”  “…growth prospects in other economies around the world have moderated somewhat in recent months, and overall financial conditions have tightened materially.”  He echoed Powell on balance sheet normalization: if it no longer promotes dual mandate goals “we will not hesitate to make changes.”  There’s no chance that such a change occurs before the Jan 30 FOMC, and the Fed has perhaps bought enough time to wait until March.

The broad strokes of the turmoil seen in the fourth quarter are now being suppressed by the central banks and perhaps even by the administration softening its stance slightly on China.  I tend to watch one-year calendar spreads on short-term rate futures to get a sense of magnitude of rate change expectations.  In the US, it’s clear that the market shifted from the idea of hikes to eases as a spread like EDM9/EDM0 went from being above POSITIVE 25 bps in November to a low of MINUS 28 on January 3.  But the peak one-year spreads in euribor and short sterling have also declined.  In the latter, March’19 to March’20 started Q4 above 35 and is now 21, having spent most of last week in the upper teens.  In euribor, rate hike expectations are reflected farther back on the curve, but from early October to now, ERH0/ERH1 went from above 40 to 23.5 and ERH1/ERH2 from 39 to 28.5. (The front ERH’19/ERH’20 is only 11 bps).  Also perhaps worth a mention is that China’s ten year started the year around 4% and is now 3.10%.  The yield spread between China and the US has narrowed from 150 bps in January to a current level just above 40.  Rate markets are painting the picture of a slowing global economy.    

The NY Fed’s UIG (Underlying Inflation Gauge, released Friday) has turned sideways to lower.  The full data set declined from 2.92% in Nov to 2.80% in Dec.  Both the prices-only and full-set have fallen in the second half of the year, reflecting the softening of the CPI.   Powell assured the markets of patient and flexible policy.  Not surprisingly, premium sales ensued along the interest rate curve.    

On Friday morning it was no different.  There was an immediate seller of 15k FVG 114.5 straddles at 29.5, vs a settle Thursday of 32.0.  EDU9 9725 straddle sold at 26.0 in size of 10k.  However, in the last twenty minutes of floor trading there was a flurry of large orders which all involved the purchase of long dated at-the-money euro$ calls.  Approximately 250k atm calls traded, adding over 170k in new positions.  Trades are summarized below.  The ‘Premium’ column shows Friday’s settlements.

Strike                 Volume OI Chg   Prem     Delta                     Trade

EDH0 9737c         36650    +31.5     24.75     0.52  (-12k 9600/9737c 1×3 67 to 65)

EDM0 9750c        39714    +14.4     26.50     0.47   (-30k M0/U0 9700/9750c spd stupid 55.5, 55.0)

EDU0 9750c         47266    +29.3     33.25     0.49   (see above, long 9700 strike rolled up)

EDZ0 9750c          40427    +26.8     37.25     0.50    (-17k 9675c 82.0/+32k 9750c 38.0 BLOCK)

EDH1 9750c         49234    +34.6     42.50     0.51      (outright buys up to 46.0!!!)

EDM1 9750c        42674    +27.3     46.25     0.51    (outright buys up to 49.5)

EDU1 9750c          9800      + 2.8      49.75     0.51                       

EDZ1 9750c          10200    + 5.0      51.25     0.50

What creates an urgent need to buy high vega premium at the end of a sleepy Friday?  If the idea was that premium is about as cheap as it gets, then one could have patiently entered bids early in the morning and likely would have been given. But these buys came late and were aggressive.  One floor broker told me the EDM1 calls were bought 3 bps through the initial offer (though to be fair the size was for 30k).  An initial quote on the EDH1 9750 c was 40.5/41.5 and the high price traded was 46.0.  This means that the EDH1 9750 straddle synthetically traded 88.5 (46.0’s vs 9753.5) vs a settle of 81.0 on Thursday.  On Friday the call settled 42.5 for a straddle settle of 82.5, low given actual trades.  The long dated Green 9750 straddle strip on Thursday settled 361.75 and on Friday settled 371.25.  The strip traded 370 late Friday and 372 right after the floor close, but was offered lower late. A friend who is a pit market maker said his group doesn’t even trade out in the long greens, but was compelled to become significantly involved on Friday due to the prices.

I half expected to wake up Saturday morning to a headline of a disaster or a large policy announcement that would justify these orders.  It simply seems like this is another episode somewhat analogous to a risk-off ‘flash crash’.  For example, a week ago it was the safe-haven yen which had a brief surge.  Before that it was the VIX.  It’s probably a stretch to put Friday’s activity into the same category, but it’s not a stretch at all to say that liquidity is not necessarily available at all times in all products.

On a tangentially related note, there are anecdotal stories that capital access for cash-burning enterprises is suddenly in short supply.  For example, Softbank cut a planned $16 billion injection into WeWork down to $2 billion.  SpaceX is cutting 10% of its workforce.  In the auto industry, Ford is cutting jobs in Europe, and the ECB’s Nowotny expressed concern that Germany’s flagging auto industry might have structural problems. Maybe Mnuchin was just a little early with his “Liquidity is ample at the big banks” announcement.  At least he’s had a dry practice run for next time.

This week features Retail Sales (pending shutdown) and the Beige Book on Wednesday.  Earnings season is kicking off with Citibank Monday, JPM and Wells on Tuesday and Alcoa Wednesday.  There are various Fed speakers, but that message has already been delivered and needs no finer embellishment (except I’m sure Kashkari will find a way). 


The current Fed Effective rate (the FF target) is 2.40%.  Every FF contract out to April 2020 is within 5.5 bps of that rate.  The lowest contracts are July and August 2019 at 9754.5 (slight nod towards the chance of hike at the June FOMC) and the highest is April 2020 at 9765.5.  More deferred contracts lean toward odds of easing.  In euro$’s all of the near one-year calendar spreads are inverted.  The lowest has shifted back to EDU9/EDU0 at -18.5.  The lowest settlement of any one-year spread recently was -28 in EDM9/EDM0 on Jan 3.  Once again I will note near 3-month SOFR settlements: March’19 97.56, June’19 97.515, Sept’19 97.54 and Dec’19 97.595.  All right around 2.55%, just higher than 2 and 5 year treasury yields at 2.54% and 2.52%.  Positive carry has vanished.   

When could there be an actual ease of the FF target?  Further deterioration in Europe (although Tria helpfully upgraded Italy from ‘recession’ to ‘stagnation’) and China along with a bad Brexit outcome could make an ease plausible by late summer. 

Perhaps worth a mention is that WTI crude rallied with other risk assets since the end of last year.  However, on Friday CLG9 put in a possible top, with a new high, but then lower low on an outside day with a lower close.  Possible negative signal for stocks?

When Gundlach says the US economy is floating on an ocean of debt, and credit agencies are warning of ramifications if the government remains closed, and vol is sub 7% in USH, long bond puts and put spreads make sense.     

1/4/2019 1/11/2019 chg
UST 2Y 248.4 254.3 5.9
UST 5Y 248.1 252.4 4.3
UST 10Y 266.0 269.7 3.7
UST 30Y 297.3 303.5 6.2
GERM 2Y -59.5 -58.7 0.8
GERM 10Y 20.8 23.9 3.1
JPN 30Y 65.2 69.6 4.4
EURO$ H9/H0 -19.5 -10.5 9.0
EURO$ H0/H1 -11.0 -12.5 -1.5
EUR 113.98 114.69 0.71
CRUDE (1st cont) 47.96 51.59 3.63
SPX 2531.94 2596.26 64.32
VIX 21.38 18.19 -3.19
Posted on January 13, 2019 at 8:14 am by alexmanzara · Permalink
In: Eurodollar Options

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