EASE. Or we’ll do it for you

June 2, 2019. – Weekly comment

This week, the markets eased.  The two year note fell just over 21 bps to yield 1.944.  October Fed funds, which is the contract just after the September FOMC, settled 97.885 or 2.115% against the current Fed Effective rate of 2.38%, a spread of 26.5.  The market has fully priced one cut by the September FOMC.  January 2020 Fed funds settled 98.145 or 1.855%, 52.5 bps below the current Fed Effective.  So there are two cuts priced by the end of the year.  Volumes were huge, implied vol exploded; the market likely got a bit ahead of itself.  However, the message the eurodollar curve has been sending for months is crystal clear: we expect rate cuts.  That sentiment was punctuated at the end of the week/month as the red euro$ pack (2nd year forward) closed up 14.5 bps on Friday alone at a price of 98.29375.  That, by the way, is over 75 bps lower in yield than EDM’19 at 97.53, which will expire in two weeks.  The Great Oz has spoken.

This is what Oz said to Scarecrow who was in search of a brain:

“Why, anybody can have a brain. That’s a very mediocre commodity. Every pusillanimous creature that crawls on the Earth or slinks through slimy seas has a brain.  Back where I come from, we have universities, seats of great learning, where men go to become great thinkers.  And when they come out, they think deep thoughts and with no more brains than you have.  But they have one thing you haven’t got: a diploma.”

On Friday these headlines came across:

And, within a couple of minutes, this comment on bbg IM from a large eurodollar player: “These Harvard educated economists are geniuses…futures rally 50 bps in 2 weeks, so they change their calls…so brave of them.  They deserve medals and/or Blue Peter badges.”

Now, I didn’t even have to look up Blue Peter badges to know that this was sarcasm.  Really.  (Blue Peter badges are actually awards from a BBC children’s show).  The point is, our official thinkers are simply playing catch-up with the markets.  By the way, I also had to look up “pusillanimous”.  That word fits too. 

It’s an odd time.  At first,  it was Trump doing everything he could to juice up the stock market (and take credit for it).  The Fed saw this as an opportunity to “normalize” and lean against the tide of asset price appreciation.  And of course, the Fed got a little TOO normal.  We’ve now reached the point where Trump is damaging stocks with trade policies.   He’s using tariffs like the only hammer in the toolbox.    And it’s the Fed that is going to have to save the stock market. 

In terms of the Fed, the speech that I will focus on is Clarida’s from last week.  Of course, he went to Harvard. (“He was wearing my Harvard tie.  Can you believe it?  Oh sure, like HE went to Harvard”).*    My take-away is that the Fed is now simply backwards-looking and reactive.  After tightening and tapering a bit too much, the Fed has thrown up its hands and said now we’re just data dependent.  On the fiscal policy front, it’s hard to tell what comes next. I have a friend who works at a nationwide broker, a firm that was growing very strongly in terms of asset gathering (management) and other product lines.  The top-brass had planned for two hikes in 2019, i.e. further expansion, and this company makes a lot more money when there is a positive yield curve and fat rates at the short end.  But this year, she told me, growth has stopped cold.  Now it’s all about cost cutting.  Clearly, official projections, by the Fed, and by many large banks and other financial institutions, have proven wrong.  Businesses now have to adapt to a new reality and more uncertainty.  Of course, higher rates are good for some businesses, and low rates good for others, but it’s hard to find a lot of firms that benefit from funding costs that are higher than expected longer term revenue flows, and that’s the environment that an inverted curve forecasts.

I never realized that Clarida put out an album called Time No Change in 2016.  I’ve posted a youtube link at bottom.  I like it.   We could simply describe Fed policy with song titles from this album: ‘Gone Too Far’ [with rate hikes and taper].  ‘Just Can’t Wait’ [to start easing].  Time No Change [an inverted curve is never good, and this time’s no different].  But turning to the speech….he starts by saying the Fed has pretty much achieved maximum employment and price stability.  He reviews where we are: strong growth, low unemployment, but muted inflation.  Then there’s a line which starts, “As we look ahead…”  where he falls back on the woeful SEP projections.  Looking for 2% growth and PCE inflation, and a gradual increase to 3.9 unemployment over next few years.  Then it’s back to the tired re-tread of structural changes:  Low neutral rate.  Falling unemployment. A small pick-up in productivity.  Price inflation that’s less responsive.  Then we get to the meat of the topic, the outlook on monetary policy.  And we’re left with, “We’re going to let the data inform us.”  Dude, the market is giving you a LOT of data that is NOT squaring with previous or current projections.  Then it’s back to the Taylor rule, allusions (illusions?) to the Phillips curve, inflation expectations, and. ‘We need more study’.  In sum,  ‘The economy is in a good place, we’re at an appropriate funds target, declines in inflation are transitory.’  If this speech is representative of the Fed’s new communication initiative, we’re in trouble.  It’s like the thin gruel served to Oliver Twist and his mates.  “Please sir, I want some more.”  The interest rate markets are desperate with hunger [for rate cuts] and reckless with misery. 

The USD has generally strengthened as the Fed tightened and the curve flattened.  The short end rally last week gives a hint of what could become the elixir of easier financial conditions if/when the Fed actually cuts.  A steeper curve, and a weaker dollar.  The next FOMC is June 19, just over two weeks away.  A rate cut at that meeting would be construed as panic.  However, an announcement of a more rapid end to tapering under the guise of (necessary) technical adjustments to balance sheet policy is very possible.  Note that oil has fallen 20% since April’s high.  This compares to a 40% decline seen from October to December of last year.  Gold surged over $18/oz on Friday, with the gold/silver ratio at 89, a level not seen since  the early 1990’s.  The red/gold euro$ pack spread jumped over 7 bps Friday and is making a series of higher lows and higher highs.  There is stress in the system.

This week brings ISM data, with Mfg on Monday and Services on Wednesday.  On Tuesday, June 4. Vice President Pence gives his Tiananmen Square Protest provocation speech.  Thursday brings the Fed’s Quarterly Z.1 report on Financial Flows and Net Worth.  Friday is the Employment Report. 


In February, when EDZ9 was trading around 9730-35, the at-the-money 9737.5 straddle was trading 26.0.  Now, with over three months having rolled off the calendar, the atm EDZ9 straddle, which mind you, is a strike price 50 bps lower in terms of yield at the 9787.5 strike, is trading 38.0.  They don’t teach that one in the options manual. 

Let’s look at something else on the dollar curve.  Below is a chart of the 2nd to 6th eurodollar one-year calendar spread (constant maturity).  That would now be EDU9/EDU0 which settled -55.5 on Friday, a new low for the move.  The inversion (as the spread became negative), started to occur at the end of last year.  This significantly pre-dates the 3m t-bill to 10y inversion that everyone is now pointing to,  (because that’s the one the Fed watches).  FORGET THE FED.  I’m here to tell you, You CAN fight the Fed.  That’s essentially what Scott Mather of Pimco said on a BBG interview last week.  Central banks have lost their Oz magic.  The man behind the curtain is fiddling with ineffective levers.

So anyway, you can see that the previous inversion, or red shaded part of the graph, was in 2006.  The Fed was in a hiking cycle from mid-2004 to mid-2006.  By late 2006 to mid 2007, the 2nd/6th one-year spread was about where it is now.  The market was saying the Fed had gone too far.  But of course, stocks didn’t get that message, having run up into June of 2007, pulled back, made a new high in Oct 2007, before finally puking.  The thing to recall about 2006 was that the Fed Fund target had gone all the way up to 5.25%.  At that time, when negative one-year ED spreads were indicating that there might be cuts of 50 bps or more, there was a lot of room.  Now of course, the FF target is in a range of 2.25 to 2.50.  A 25 bp cut is a much bigger percent.  And that’s what the Fed keeps saying.  A lower R* means we will be revisiting the zero-bound more quickly.  Oh, great!


So, the Fed’s reactive.  The market is insisting that the Central Bank needs to officially cut (or we’ll do it for you).  The markets NEED a cut in funding costs, which will provide some relief by weakening the dollar.  The curve will steepen.

In terms of trades, June eurodollars and midcurves expire just prior to the June 19 FOMC.  The next chance for concrete improvement in China negotiations is the end of month G20 confab, where Trump may meet with Xi.  Until then, flows will likely favor safe assets.  However, the longer end of the eurodollar curve could still see some selling pressure. 

As Gundlach recently suggested, there has been a nice pop in bond volatility.  It’s probably not over yet.  It’s hard to buy at these levels though, and it’s hard to buy treasuries at these yields, though forced trades could still easily provide a push. 

5/24/2019 5/31/2019 chg
UST 2Y 215.5 194.4 -21.1
UST 5Y 211.0 192.9 -18.1
UST 10Y 232.0 214.2 -17.8
UST 30Y 275.1 258.2 -16.9
GERM 2Y -63.1 -65.9 -2.8
GERM 10Y -11.7 -20.2 -8.5
JPN 30Y 49.8 45.4 -4.4
EURO$ Z9/Z0 -36.5 -40.5 -4.0
EURO$ Z0/Z1 3.5 8.5 5.0
EUR 112.08 111.71 -0.37
CRUDE (1st cont) 58.63 53.50 -5.13
SPX 2826.06 2752.06 -74.00
VIX 15.85 18.71 2.86

https://www.youtube.com/watch?v=lIjqdRiM3Pc  (Winthorp)

https://www.youtube.com/watch?v=u-VTtE37qhY (Clarida)

Posted on June 2, 2019 at 11:59 am by alexmanzara · Permalink
In: Eurodollar Options

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