Feb 19. Inflation and swap spreads…going higher




NAPM mfg and service prices/ ATL Fed Wage Tracker / 5y5y Inflation Frd / 10y Tip b-e / CPI yoy / Core CPI yoy / Core PCE

The above chart is comprised of several inflation measures.  The one that the Fed chooses as its preferred measure, is, of course Core PCE prices, the blue sideways laggard at the bottom of the graph.  Every line is generally tracking upward.  A couple of these are at new highs, including the NAPM Price indices and yoy headline inflation (red line, released this past week).  Headline CPI yoy was 2.5% and Core 2.3% (Core equal to the high print of last year).  From a late January posting from the Atlanta Fed macroblog: “As measured by the Atlanta Fed’s Wage Growth Tracker, the typical wage increase of a U.S. worker averaged 3.5 percent in 2016. This is up from 3.1 percent in 2015 and almost twice the low of 1.8 percent recorded in 2010.”  Market reaction to both Yellen and CPI this week was astonishingly lame.

In spite of Yellen warning against ‘waiting too long’ to raise rates, weekly changes were quite modest.  The five year yield was up 2.3 to 190.8 and tens up 1.7 to 242.4.  Since the beginning of 2017, Friday to Friday changes in EDM18 (red June dollars) have been in an incredibly tight range between 9826.0 and 9821.5 (Friday’s settle).

Last week I suggested trying to sell May FF at 9925 which was the settlement, but never got the chance.  This Friday the settle was 9921.5.  I had calculated the chance of a March hike last week at about 20%, and this week odds have pushed a bit higher to just above 25% (using March and April FF prices).  I find it difficult to discern why the Fed would wait to hike, but near euro$ calendar spreads remain languishing around 50 bps, indicating two hikes a year.

Once again it seems as though international headwinds have the potential to buffet the Fed’s decision making, with France to Germany 10 year yield spread around 74 bps, highest since 2013, though well below the high of 146 in 2012.  However, a key indicator that markets may be running out of charitable sentiment towards central banks may be the Japanese 30 year rate, which closed at a new high of 92 bps, up 6.7 on the week.  The BoJ has been successful pegging tens below 10 bps, but the genie is wafting out of the lamp’s spout at the long end.

An interesting note was embedded in a presentation by Grant Williams (link at bottom, thanks DW).  The debt of the Federal Government has more than doubled since 2007, from $6.1T to $15.9T. *Fed’s Z.1.  However, the interest rate expense on the debt has remained nearly constant from $430B in 2007 to $433 in 2016, due to the drop in rates.  Some think that rates can’t go up because of the stress it will cause on the government budget.  I think the opposite.

Another market feature that bears mention is the dramatic widening of swap spreads to the highest levels since 2015.

(Bloomberg) — A proposal to eliminate interest-expense
deductions as part of a Congressional tax overhaul plan is
already causing dislocations in the interest-rate swaps market.
The spread between 30-year U.S. swap rates and government bond
yields has reached the highest level since 2015 and could widen
further, according to a Deutsche Bank AG pricing model
forecasting a 5 basis point jump should the measure be passed.
The model forecasts a slump in corporate issuance of as much as
28 percent, translating into a smaller base for fixed-rate
receivers, which would pressure long-end spreads

Well I guess the DB model is right, on direction anyway, because before the election the 30 year swap spread was at its low around -55 and is now -38.  From the two year to thirty year, swap spreads are all in bullish configurations (widening).  Post-election late November lows to now, 2y 19 to 35.8 currently, 5y -3 to 10.75, 10y -18 to -4.5 and 30y -58 to -38.  For both the ten year and 30y the late Nov levels were record lows, and both spreads are now higher than all data in 2016.  Ten year is pictured below.

10 yr swap spread

There are a variety of reasons for this movement, though my main goal is simply to ride the wave.  A treasury paper from last summer (linked below) explained negative swap spreads with the following observations:  GSE’s had been large fixed payers when they were retaining mortgages, and with the Fed taking GSEs out of the picture, and putting MBS on the balance sheet without hedging, the pay-fixed demand abated. (That factor would seem to be on the verge of reversal as the Fed considers trimming the balance sheet).  Another driver is the Libor to GC spread.  In 2015 General Collateral funding costs exceeded Libor due in part to regulatory reasons.  As libor moves up and regulatory burdens are expected to ease, this factor reverses.  Foreign central bank selling of treasuries also increases supply of collateral.  Finally, there may be issues related to the upcoming debt ceiling.  I am no expert in the intricacies of this pricing, so any comments are appreciated.  However, I would definitely favor long midcurve Eurodollar puts over treasury puts given the strong upward trend in swap spreads.

This week features auctions of two, five and seven year notes.  FOMC minutes are released Wed.

March treasury options expire Friday.

Yellen speaks on March 3, the Employment report is March 10, one week later.  March FOMC is Wednesday, 15-March;  March midcurve ED options expire the PREVIOUS Friday, 10-March, on NFP.


2/10/2017 2/17/2017 chg
UST 2Y 119.4 119.4 0.0
UST 5Y 188.5 190.8 2.3
UST 10Y 240.7 242.4 1.7
UST 30Y 301.0 302.9 1.9
GERM 2Y -78.9 -81.0 -2.1
GERM 10Y 32.0 30.2 -1.8
JPN 30Y 85.3 92.0 6.7
EURO$ M7/M8 50.5 51.5 1.0
EURO$ M8/M9 37.5 37.0 -0.5
EUR 106.42 106.15 -0.27
CRUDE (1st cont) 54.33 53.78 -0.55
SPX 2316.10 2351.16 35.06
VIX 10.85 11.49 0.64






Posted on February 19, 2017 at 3:25 pm by alexmanzara · Permalink
In: Eurodollar Options

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