Expedient Exaggeration

June 30, 2019 – Weekly comment

‘Ah, Maggie, in the world of advertising, there’s no such thing as a lie, there’s only the expedient exaggeration. You ought to know that!” — Cary Grant as Roger Thornhill, protagonist in Alfred Hitchcock’s North by Northwest (1959).

There was an article on ZeroHedge which featured all of the overly zealous market predictions that the site is known for, but this one also featured a twitter post from Raoul Pal, relating the story of the “greatest macro trade I’ve ever seen.”  The premise of this anecdote is that the current interest rate set-up is similar to that of 2000-2001, when this macro trader went limit long one trade and one trade only, EDZ01, right after the Fed cut rates by 50 bps on Jan 3, 2001.  “His bet was that after a massive equity bull market, a tech bubble, Y2K inventory unwind and over confidence, the economy was likely to be very fragile and the Fed were going to have to massivley cut rates.”  Nice ending, as this trader added to longs and it ended up being a “career trade”.   


Here’s an excerpt from Pal:
I strongly believe we have the near exact same set up now, with the added kicker that if the dollar goes up, there is a gigantic tailwind to the trade, making it an extremely skewed risk reward. Maybe one of the best I’ve ever seen. This set up has been in place for 9 months now and is why I’m very long Eurodollar interest rate futures. Options were ultra cheap and the dollar hasn’t yet made its move. Vol is too low compared to the potential upside in these as we head to negative rates, if the dollar squeezes higher. This makes an asymmetric trade crazily asymmetric.

To Pal’s credit, he says that he’s been long eurodollar futures for quite some time, and further, he loosely quantifies the idea by saying rates are going negative.  But there are some key differences, which I will outline below.    

First though, I’ll note that this same ZH post also contains the following chart, which I have now seen several times, indicating a ferocious gap between stocks and the ten year yield.  I have reproduced it below.  Since the end of May, stocks have soared yet yields have declined.  There MUST be a huge macro trade here, right?  [On the following charts, SPX in white and 10-year treasury yield in green].  The problem is, as the second chart reveals, that over a longer term time frame (the first chart is two months, the bottom is over one year) it’s not really clear that there’s any conclusion to draw at all, except that, as rates fall, stocks become more attractive, and the present value of the future stream of earnings becomes greater.  Sure, maybe things are a bit stretched currently, but it’s more micro than macro.

Like a lot of other market commentary, mine included, there can be a lot of expedient exaggeration to sell the story.  So let’s get back to the big picture and compare 2001 to 2019. 

On Dec 31, 2000, the FF rate was 6.5%.  On Dec 31, 2001 it was 1.75%.  This was indeed a massive and rapid cut in rates of 475 bps.  The protagonist in Pal’s story thus knocked the cover off the ball.  Let’s recall that previous to this episode, the low in FF was 3%, so it took a bit of imagination to think about rates moving toward zero.  Currently, it takes no creativity whatsoever to conjure up a scenario of negative rates, as they have become mainstream.    In 2000, the US gov’t deficit as a percent of GDP was…oh, wait a second, it wasn’t a deficit.  There was a surplus of 1.2%.   Now, it’s a deficit of around 5% and getting worse.  In Sept 2001, 9/11 occurred. The Nasdaq had topped in March 2000, having nearly doubled in the previous year.  Perhaps there’s some similarity presently as Nasdaq went up 60% from around 5000 in late 2016 to 8000 in Q3 2018.  But a reverse wealth effect isn’t likely to have the same bite as the dotcom unwind.  The chart above shows that tens have already sunk 100 bps over the past three quarters to end at Q2 ‘19 at 2%.  The Fed has not yet begun to lower rates, but EDH20 has rallied over 150 bps since last October and EDH21 (the peak contract on the curve) has surged over 175.  Is it really the same set-up now?  Is the FF target going to simply change sign to achieve the 475 bp move to take us from +2.375% to -2.375%?  Pal mentions one other aspect of the trade, and that is the US dollar, implying that a (likely?) move higher in DXY will spur lower rates.  Perhaps so, but DXY appears to be probing the downside as the prospect of lower official US rates looms. 

What’s the point of this exercise?  (“…when you’re telling these little stories, here’s a good idea:  Have a point.  It makes it SO much more interesting for the listener”).  My point is that this set-up is much more conducive to a curve trade rather than outright.  The chart below is the red/blue euro$ pack spread from 1999 to 2002.  That’s the second year forward vs the fourth year forward.  The curve had already started to steepen from 0 to 45 bps prior to the first cut.  But then ran another 140 bps through 2001. 

The chart below is the current constant maturity red/blue pack spread.  It too, has perked up a bit, from -5 bp to +25 since March.

I agree that the Fed will cut.  However, it’s not at all clear that the dollar will rally, it may continue to decline.  Additionally, US government deficits are set to increase, which, in my opinion will temper any gains in the longer end of the curve.  Wage increases are set to continue even if the labor market loses a bit of luster.  Of course, the faster and more aggressively the Fed cuts, the more likely that the curve continues to steepen.   I think the steepener is still in the early stages.

In Hitchcock’s classic movie North by Northwest from which I quoted to start this missive, Cary Grant plays Roger Thornhill, a Madison Avenue ad executive mistaken for a secret agent named George Kaplan.  Kaplan doesn’t actually exist, he was a fictitious diversion created by US spies led by the Professor, hoping to ensnare the suave villain Phillip Vandamm (played by James Mason).

Our story could also see twists in the plot if Kaplan, in this case the very real Robert Kaplan of the Dallas Fed, holds sway with his thoughts outlined last week: “I am concerned that adding monetary stimulus, at this juncture, would contribute to a build up of excesses and imbalances in the economy which may ultimately prove to be difficult and painful to manage.”

If the Fed were to remain on the sidelines at the July meeting, the curve would flatten viciously.  If a magical US/China deal had been inked this weekend, it might be a different story.  But it’s more of the same, an agreement to keep working on the last 10%, with the China Daily editorializing on Sunday:
“Agreement on 90 percent of the issues has proved not to be enough, and with the remaining 10 percent where their fundamental differences reside, it is not going to be easy to reach a 100-percent consensus, since at this point, they remain widely apart even on the conceptual level.”

Early Monday morning Clarida speaks.  Then ISM Mfg is released, expected 51.0 with Prices 53.0.  China’s Mfg PMI released this weekend was 49.4, still weak and slightly lower than 49.5 expected.  On Wednesday, ADP and Service ISM, expected 55.9.  After Thursday’s holiday, the employment report is released Friday, with NFP 165k from last at 75k, and yoy earnings 3.2%. 

6/21/2019 6/28/2019 chg
UST 2Y 175.0 173.9 -1.1
UST 5Y 180.7 175.5 -5.2
UST 10Y 206.4 199.8 -6.6
UST 30Y 258.9 252.7 -6.2
GERM 2Y -73.7 -75.0 -1.3
GERM 10Y -28.5 -32.7 -4.2
JPN 30Y 32.8 35.4 2.6
EURO$ Z9/Z0 -33.0 -35.5 -2.5
EURO$ Z0/Z1 9.0 6.0 -3.0
EUR 113.70 113.72 0.02
CRUDE (1st cont) 57.43 58.47 1.04
SPX 2950.46 2941.76 -8.70
VIX 15.40 15.08 -0.32
Posted on July 1, 2019 at 4:46 am by alexmanzara · Permalink
In: Eurodollar Options

Leave a Reply