Feb 4. The dance between stocks and bonds

“No mistakes in the tango Donna, not like life.  It’s simple. That’s what makes the tango so great.  If you make a mistake, get all tangled up, just tango on.”  –Lt Col Frank Slade

It was a pretty important week, so I was just going to stick to the big market moves, without any corny movie references, but… I just couldn’t shake the idea of a dance between stocks and bonds out of my head.  So of course it brings me to one of my favorite movies, Scent of a Woman, and the tango scene between Frank and Donna.  Frank Slade of course, is the blind cantankerous retired Lt Col from the army, played by Al Pacino. A youtube link is at the bottom.  What does this have to do with the market?  Nothing really, but there’s some tension between stocks and bonds right now; how will they respond to each other’s steps?  As an aside, Chris O’Donnell is the main character in the movie; his brother was a filling broker in the euro$ options pit, as charming of a guy as you’ll ever meet in the business.

Are markets spooked by the new Fed?  Over the last few weekly notes, I mentioned the risk that the Fed may move the strike on the ‘Fed put’ down a bit.  A friend put it more succinctly to me Friday: “Now they’re afraid that the Fed won’t come to the rescue.”  When’s the last time anyone talked about the PPT (Plunge Protection Team)?  Last week I cited Ray Dalio, who specifically linked financial asset prices to the rate used to discount the stream of future cash flows to their present value: “It just takes a little change in interest rates to have a bear market.” Dalio said it’s important how the Fed responds to changing conditions…that the amount of tightening priced into the curve wasn’t much, but that if we were to get more hikes than priced, it would have a large impact. While Dalio wasn’t concerned about inflation, I suggested last week that price acceleration may become a problem for markets. Dalio’s main focus (in this particular interview) was on the Fed, but other famous investors are looking at market action itself.  For example, Gundlach pointed out relative weakness in junk bond ETFs way before this week’s bloodbath. Both HYG and JNK had huge purges this week, taking out the spike lows of last November.  In terms of forward pricing reflected in the curve, the market was aggressive in forecasting higher rates, as all euro$ calendar spreads made new highs and the ten year yield jumped 19 bps to 2.85%.  January’19 FF contract settled 9789.5, 68.25 bps below Feb’18, so 3 hikes are essentially priced.

This is where the dance comes in.  Will stocks see follow through from Friday’s break?  If so, will yields begin to decline?  Or are bonds so weighed down by issues of supply and possible inflation acceleration that even asset price drops won’t have much impact?  Who’s leading?  Will markets force the Fed’s hand?

I believe the Fed won’t blink on the QT schedule, and wants to lean against inflation given consistent gains in employment data.  Furthermore, the new Fed may feel it’s building credibility as its projections on hikes for the year finally hit target.  On Friday, Dallas Fed President Kaplan said he’s concerned tax cuts will leave the US more leveraged, and “If we wait to see actual inflation, we’ll be too late.”  From Wednesday’s FOMC statement: “Market-based measures of inflation compensation have increased in recent months but remain low” an upgrade from December’s announcement.  Prices paid in Mfg ISM last week were at a new high of 72.7, “…indicating higher raw materials prices for the 23rd consecutive month”, and of course, Friday’s 2.9% yoy gain in Average Hourly Earnings was the icing on the cake.  I contend that the bond market is leading this dance, and will turn a blind eye to stocks.  After all, besides rates, other ‘financial conditions’ are only just now beginning to turn, namely stocks and perhaps the dollar. Of even greater importance might be the other factor with respect to financial conditions, credit spreads.  There’s relatively high leverage in the corporate sector, and borrowers have enjoyed tight spreads which perhaps take the edge off market discipline. The decline in junk prices bears watching…

Let’s take brief look at some changes.  The five year yield rose 14.7 bps this week, while tens were up 19 and bonds 18.3.  Big moves.  The Dow lost 2.5% and other indexes were down around 2% on Friday, with a related jump in the VIX to 17.3.  The easy trades of buying stocks, selling VIX for the *inevitable* ride down the curve and buying bitcoin are one by one being shredded.

While the move this week has been strong, it’s worth looking a bit further back. Since the September low in yields (related to peak N Korea concerns) the five year yield has risen nearly 100 bps, from 1.62% to 2.597% on Friday.  On the Eurodollar curve, all near one-year calendar spreads rose to new highs and were higher every single day for the past six sessions.  I’ll just focus on the most heavily traded spread for the moment, which is EDZ18/EDZ19.  It started January at 19 and closed Friday at 36.  A week ago Thursday it was 26.  Just looking at both prices in relation to the Fed dots is interesting as well.  The projected FF rate by the Fed for the end of 2018 is 2.1%.  EDZ18 is 9758.5 or 2.415%, more or less consistent with a spread of 31.5 bps.  EDZ19 is 9722.5 or 2.775%, while the Fed’s projection is 2.7%.  Getting close.  By the way, the Fed’s 2018 projection for PCE Inflation is 1.9%, and it’s beginning to appear as if we’ll exceed that level.

This week we have supply in the form of 3, 10 and 30 years, which may be more important than usual as the treasury’s borrowing needs are increasing.  We could easily see a further concession in bond prices in the early part of the week, and a rally out of the third leg.

Interesting footnote to Yellen’s last day were the ‘macroprudential’ restrictions on Wells Fargo’s growth.  The bank won’t be allowed to grow assets until it cleans up its act.  Is this a sign of things to come at the Powell/Quarles Fed?  Or is it the last vestige of regulation that’s likely to be scaled back?  It’s also worth noting Deutsche Bank, which again reported a yearly loss (3rd consecutive) and saw the stock close down over 6%.  Several factors including DB and the upcoming March 4 Italian elections could weigh on the euro this month.


1/27/2018 2/2/2018 chg
UST 2Y 211.6 215.1 3.5
UST 5Y 247.0 259.7 12.7
UST 10Y 266.0 285.1 19.1
UST 30Y 291.1 309.4 18.3
GERM 2Y -54.4 -54.0 0.4
GERM 10Y 62.4 76.7 14.3
JPN 30Y 81.0 81.7 0.7
EURO$ H8/H9 57.0 60.5 3.5
EURO$ H9/H0 21.5 31.0 9.5
EUR 124.27 124.59 0.32
CRUDE (1st cont) 66.14 65.45 -0.69
SPX 2872.87 2762.13 -110.74
VIX 11.08 17.31 6.23




Posted on February 4, 2018 at 3:39 pm by alexmanzara · Permalink
In: Eurodollar Options

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