Feb 17. Heisenberg Uncertainty

The Heisenberg Uncertainty says that the position and velocity of an object cannot both be measured exactly, at the same time, even in theory. (Werner Heisenberg).  The very concepts of exact position and exact velocity together, in fact, have no meaning in nature.(1) “Any attempt to measure precisely the velocity of a subatomic particle, such as an electron, will knock it about in an unpredictable way, so that a simultaneous measurement of its position has no validity.” Nor does position and velocity have meaning at the Federal Reserve.

Of course, Heisenberg was dealing with sub-atomic particles.  (Yes, I watched a fascinating physics documentary on Nova, and now I am taking a topic that vastly exceeds my comprehension and trying to  apply it to monetary policy and markets, which vastly….well, you know the rest).  Anyway, the very act of observing and measuring these particles affects their behavior.  Powell at the start of the year, changed course on monetary policy after being put under the microscope by Trump and becoming the subject of intense criticism.  Now it’s hard to tell where the Fed is going, let alone how fast.

A couple of weeks ago in my note ‘Blue Sky’, I cited the TBAC (Treasury Borrowing Advisory Committee) minutes.  One sentence is key: “The presenting member outlined the potential for a significant financing gap over the next ten years in the context of the potential need for domestic investors to participate more if foreign reserves were to grow at a slower pace.”  Clearly, increased US deficits, projected to be $1 trillion this year, in the context of slower global trade that requires less official recycling of dollars into foreign reserves, is perceived as a possible problem. 

At the end of last week Zoltan Pozsar of Credit Suisse released a note discussing, in part, this funding gap.  According to people that saw the note, he said that as official foreign buyers are less of a demand factor, private foreign buyers will become more important at the margin.  The difference?  Private buyers hedge out fx risk through cross-currency swaps.   The argument is that a couple of years ago, the US curve was the steepest globally (providing carry to both domestic and foreign buyers) and now is the flattest due to the Fed’s hiking regime.  This creates a situation where cross ccy bases make it uneconomic to fund longer dated purchases of US treasuries.  Indeed, USD three-month libor is around 2.69% and the ten year yield on Friday was 2.664%.  This pulls the prospect of a “significant financing gap” quite a bit forward in terms of time. 

One of the conclusions that Pozsar draws is that libor-ois will tighten significantly and may even go negative this year!!  Xccy bases will go from negative to positive.  In order to fill the ‘financing gap’, funding costs will need to drop on the front end, which may require the Fed to cut rates.  These potential cuts aren’t to address falling inflation and growth expectations, they will be necessary to clear treasury supply.  Of course, much higher yields on the long end relative to current funding costs would accomplish the same thing, but implications for stocks are very different.

Now we draw into the discussion recent activity and economic trends.  After a weak Retail Sales report this past week, the Atlanta Fed GDP Now forecast for Q4 2018 was slashed from 2.7 to 1.5%.  The NY Fed’s Nowcast fell to 2.23% for Q4 from 2.4%, and the estimate for Q1 2019 was cut in half to 1.08% from a previous stab of 2.17%.  Also of note is the University of Michigan’s 5 to 10 year inflation expectations survey which came out last week.  From BMO: the data “…declined 0.3% to tie an all-time record low at 2.3%.  Although drops of similar magnitude have occurred in the past, this is only the third time we’d seen this size of a change this decade.”  As mentioned during the week, the Baltic Dry Freight Index has crumbled by 2/3rds over the past year.

The ten year note to inflation-indexed breakeven is now 1.87%, down 20 bps from early November, and the 5y5y forward inflation swap is 2.19% having spent most of 2018 above 2.4%.  These market-based indicators support the idea of a stagnant economy where inflation runs below target.  But is that justification for Fed easing? 

As discussed in previous notes, some of the trades going through Eurodollar options appear predicated on the idea that one or two eases take place by autumn.  For example, there is a consistent buyer of EDU9 9775/9787.5 call spreads for just under 1 bp (ref EDU9 9735). On Friday there was a buyer of 50k EDZ9 9850c for 0.75.  Of course, if position and velocity are uncertain due to what almost seems to be the mundane problem of treasury supply, then why is implied volatility being crushed to new lows?  There is relentless selling of EDZ9 straddles, on Friday the 9725 line was sold at 26.5 and the 9737.5 line sold at 27.0, with settles of 26.0 and 27.0… with 300 days until expiration.  EDZ9 settled down 1.5 bps at 9732.0; the 9725p settled DOWN 0.25 and the 9712.5p settled DOWN 0.5 at 5.0.  Market maker ML noted it’s the earliest he’s seen the atm TY straddle below 1’00.  With 5 weeks to go, TYJ 122.5^ settled 0’62.  Here’s a visual:

So we have a flat curve sucking the air out of premium.  Near one-year Eurodollar calendar spreads are all negative (the lowest being EDZ9/EDZ0 at -16.5) suggesting that the next Fed move will be an ease.  The FF curve through 2019 is within 1 bp of the current Fed Effective of 2.40% with Jan 2020 at 97.62, a demure tilt toward a looser Fed.  The euribor curve is flattening.  Global ten year yields have all been declining.  From the start of Q3 the US ten year has fallen from around 3.20 to 2.67.  China from 3.60 to 3.07 (both just over 50 bps).  Bunds from 55 to 10.  Japan from 14 bps to -3. The rate environment again points to TINA… there is no alternative besides stocks, a theme further enhanced by the prospect of a US/China trade deal.  The very scenario that Powell was supposedly leaning against is now settling over the financial landscape like a wet blanket: Financial speculation without cushion; a flimsy backdrop of growth; earnings that can only be juiced by buybacks which further erode corporate balance sheets.  To layer it on even thicker is the emergence of Modern Monetary Theory (or debt monetization) and the left’s Pyrrhic victory of forcing Amazon’s withdrawal from NY. 



I’ll leave it with another profound physics comment, this one from Albert Einstein.  “The difference between genius and stupidity is that genius has its limits.”


FOMC minutes on Wednesday.  Philly Fed, Durables and Existing Home Sales Thursday.

I don’t know how much I can buy into the idea of lib/ois going to zero or negative, but here’s the nearby forward proxies represented by futures.  I use 3 month quarterly ED contracts vs the average of the next two FF contracts.  All around 25 bps.

EDM9 9736.0 vs avg(FFN9+FFQ9) 9760.25 =            24.25

EDU9 9735.0 vs avg(FFV9+FFX9) 9759.5    =             24.50

EDZ9 9732.0 vs avg(FFF0+FFG0) 9763.0     =             31.00

EDH0 9739.5 vs avg(FFJ0+FFK0) 9767.0     =             27.50

EDM0 9745.0 vs avg(FFN0+FFQ0) 9772.25 =            27.25

EDU0 9749.0 vs avg(FFV0+FFX0) 9777.25 =              28.25

2/08/2019 2/15/2019 chg
UST 2Y 246.1 251.8 5.7
UST 5Y 243.9 249.3 5.4
UST 10Y 263.0 266.4 3.4
UST 30Y 297.4 299.7 2.3
GERM 2Y -57.9 -55.6 2.3
GERM 10Y 8.7 10.2 1.5
JPN 30Y 57.5 59.2 1.7
EURO$ H9/H0 -9.5 -3.5 6.0
EURO$ H0/H1 -13.0 -12.5 0.5
EUR 113.26 112.98 -0.28
CRUDE (1st cont) 53.09 55.98 2.89
SPX 2707.88 2775.60 67.72
VIX 15.72 14.91 -0.81
Posted on February 17, 2019 at 9:14 am by alexmanzara · Permalink
In: Eurodollar Options

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