It’s not me. It’s you.

Aug 4, 2019. Weekly Comment

Consider the Sept’19 copper chart.  In Q4 it slid to a low of around 2.60 as risk assets tanked, partially in response to the Fed’s last hike in December.  As the Fed made a u-turn on policy at the start of the year, it ramped up to 3.00.  In the month and a half from late April to early June, it crashed all the way back down to 2.60.  This period was, of course, during difficult China/US trade negotiations which ultimately broke down, and Trump had also threatened Mexico with tariffs in late May.  From the start of May until June, SPX fell from 2950 to 2730.  But while SPX subsequently recovered to a new high of 3025, copper traded sideways at best, and, with Trump’s Thursday tweet of new tariffs on China, copper plunged to a new low for the year of 2.57.  Stocks, although they traded lower in response to new perils for global trade, have been extremely resilient with SPX still up 17% ytd.  Given the transformation to a digital economy, I’m not entirely sure if Dr Copper should maintain its vaulted economic status.  Perhaps it should be relegated to Member-Emeritus like that old guy Katz who used to shuffle around the CME floor.  

The German bund traded at -50 bps this week. The chart below shows ERZ0/ERZ2, a forward 2-year euribor calendar spread.  It has done nothing but compress, falling 50 bps since the start of the year, to its current level of 17.5.  The banking system in Europe remains vulnerable; a friend sent a note last week citing new lows in Allied Irish Banking Group (thanks RL).  On the other hand, Mayo advanced to the semi-finals in the GAA.  So that pretty much offsets the bad news.  Are these overseas developments the Fed’s fault?    

ERZ0/ERZ2 euribor 2y calendar spd

At his press conference, Powell said the US economy has been resilient in the face of global downside risks. These risks are not only evident in Europe, but also in Aisa.  Kospi is testing the lows for the year as trade frictions with Japan intensify.  The Australian dollar is making multi-year lows vs USD (though not quite to the crisis low of 2008).  Of course, the big event of the week was Trump’s tweet piling more tariffs on China. That’s what sent stocks lower and caused yields to plunge.  On the week, the ten year yield fell almost one-quarter pct, (-22.4) to 1.855%. 

While Powell can be blamed for his less than dovish press conference, he has to navigate global issues related to trade flows and financial risks.  The biggest of these come from the US/China relationship.  From this week’s Credit Bubble Bulletin (link at bottom) “Let there be no doubt: Chinese developments have become the critical factor for global markets. And the issue is not the possibility of 10% tariffs on an additional $300 billion of Chinese imports. The critical issue is Chinese financial and economic fragilities, and the very real possibility that an escalating trade war pushes a vulnerable China over the edge.” (CNY closed near a new low at 6.94).

I am no expert on China.  However, the combination of Hong Kong protests, friction with Taiwan, regional bank failures and the continuing pressure building with the US certainly qualify as a top risk.  Hong Kong has GDP of around $350 billion, about the same size as Ireland.  While Trump boasts about the amount of tariff money pouring into the US, the US budget deficit continues to widen, unabated.  The point is, it’s not Powell that is causing volatility.  It’s Trump.  Dissent at the Fed is an inevitable outcome; a sign of the times. 

Regarding the US budget, there were a couple of interesting snippets in the latest TBAC minutes, released on July 31.  (link at bottom).   First, the FOMC was no surprise: “The majority of primary dealers expected the Fed to make a 25 bp cut to the target range for the fed funds rate and to end balance sheet normalization early.”  Exactly what occurred.  The minutes noted that ytd FY2019 gov’t receipts totaled $2.6T, 3% higher than the previous year comparable period, while outlays totaled $3.4T, 7% higher than last year. [how long can that go on?]  One other interesting line: “Pietrangeli estimated that reinvestment of maturing MBS proceeds into Treasuries and potential Federal Reserve balance sheet growth could reduce financing needs from the public by an additional $100 to $200 billion annually over the next several years.”  The minutes summary didn’t elaborate, but my personal conclusion is that means $100-200 billion MBS flowing into the private market annually.  And while the Fed didn’t hedge convexity risk, private holders do.  Which means that implied vol on treasuries should likely increase at the margin. 

From the TBAC borrowing estimates released July 29, “During the July-Sept 2019 quarter, Treasury expects to borrow $433 billion in privately-held net marketable debt… The estimate is $274 billion higher than announced in April 2019.”  This week the Treasury auctions 3’s, 10’s and 30’s in the amount of $38b, $27b and $19b, raising $26.66 billion in new cash.   It took the Fed a bit over 7 months to shift from hike to ease.  If it takes the same amount of time to go from balance sheet selling to balance sheet buying, expect another round of QE to start in March. 

The Kansas City Fed’s Jackson Hole conference is in two and a half weeks, Aug 22-24, appropriately titled Challenges for Monetary Policy.  Central banks can only respond to events like Brexit, China tariffs, tensions with Iran.  Monetary policy is not a cure-all.


I am personally looking to buy wing puts into next year on HYG.  That is not a recommendation. Just a thought that high yield may be coming closer to an event which causes forced selling. 

There were a couple of 100k lot trades Friday.  Buyer of EDU9 9812c with EDV 9825/9850c 1×2, both new.  Settled 1.75 in EDU 9812c vs 9792.5 and 2.0 in EDV 9825/9850c 1×2 vs 9804.5 in EDZ9. (traded at 3.5).  That’s a high price for EDU9 calls 20 out of the money, given that the FOMC is after EDU9 expiration. What is interesting about Friday is this:  in Fed Funds, the Aug/Oct spread, which prices the Sept FOMC, actually went more negative by 3.75 bps to -29.0.  This indicates certainty of another 25 bp cut and increasing odds for 50!  However, the Oct/Nov spread, which prices the Oct 30 FOMC, settled -12.5, and Nov/Jan, which captures the Dec FOMC settled at -11.5 from -13.5.  The implication is that this market, at least on Friday, embraces the idea that the Fed may become even MORE aggressive in terms of ‘front-loading’ eases.  The buying in EDU9 calls and bidders chasing the outright contract higher shows the same.  EDU9 was the strongest thing on the board on Friday, rising 5 bps.

5/30 fell nearly 4 bps Friday to end at 72.2.  Still holding in a tight 69 to 78 range and still above the upward sloping trend line.  If the short end is right about the Fed being pushed into faster easing, then the high should be taken out.  If it’s more of a midcycle reaction, then this spread should retrace. 

I believe auctions are becoming more important.  While demand for safe assets was on full display last week, with new recent highs also posted in implied vol in treasuries, current low yields may stifle demand to some degree.  Sept treasury options expire the Friday of the Jackson Hole conference.  Cheap September put spreads make sense in treasuries.

7/26/2019 8/2/2019 chg
UST 2Y 186.8 171.8 -15.0
UST 5Y 186.0 167.0 -19.0
UST 10Y 207.9 185.5 -22.4
UST 30Y 259.9 239.2 -20.7
GERM 2Y -75.0 -78.8 -3.8
GERM 10Y -37.6 -49.5 -11.9
JPN 30Y 35.1 32.1 -3.0
EURO$ Z9/Z0 -40.0 -43.5 -3.5
EURO$ Z0/Z1 1.0 -1.5 -2.5
EUR 111.28 111.09 -0.19
CRUDE (1st cont) 56.20 55.66 -0.54
SPX 3025.86 2932.05 -93.81
VIX 12.16 17.61 5.45

Posted on August 4, 2019 at 11:41 am by alexmanzara · Permalink
In: Eurodollar Options

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