Jan 7, 2018. Dynamic Markets

Markets can be much more dynamic than we appear to think.  –Jerome Powell, from the October 2012 FOMC transcripts.  (That’s gold Jerry!  GOLD!)

The Fed just released transcripts from the meetings in 2012.  I have included the link to the October 2012 meeting below.  It’s 246 pages long; I’ve excerpted some salient points.  What I would say is that Powell, at that time, was uneasy about the Fed encouraging risk taking.  He was concerned that when it came time to reverse policy (as is occurring now) the market might not take the hand-off gracefully.

At that time, policy changes were expected when unemployment reached 6 ½ percent, and inflation 2 ½ percent.  At one point it was Powell who, with considerable foresight, mentioned that those values might change over time.

Here are a couple of other Powell quotes:

First the question, why stop at $4 trillion [of QE]?  The market in most cases will cheer us for doing more.  It will never be enough for the market.   Our models will always tell us that we are helping the economy, and I will probably always feel that those benefits are overestimated.  And we will be able to tell ourselves that the market function is not impaired and that inflation expectations are under control.

Specifically addressing the unwinding of the Fed’s MBS position:

 Another way to look at it, though, is that it’s not so much the sale, the duration; it’s also unloading our short volatility position. [The Fed does not hedge its MBS position; the private sector does]


…I think we are actually at a point of encouraging risk-taking, and that should give us pause.  Investors really do understand now that we will be there to prevent serious losses.

So here’s a guy who is circumspect about the Fed coddling the market.  He is thoughtful about how conditions might evolve.  He’s wary of the models.  I would also mention that he seems to be one of the few who noted his personal discussions with hedge fund contacts and other market participants, at one point citing a specific deal being done on loose terms, but then providing a broader context of aggregate deal-making risk.  In short, he’s pragmatic with a healthy respect for the market.

From the snippets above, we might surmise (though it’s a fairly long leap) that Powell would like to inject some risk discipline into the market; i.e. tighten financial conditions while putting the market on notice that the Fed’s backstop has moved, well, further back.

Dudley’s criteria for financial conditions are: short and long term rates, the value of the dollar, equities, and corporate spreads.  From the chart below, we can see that since the middle of 2016, 3 month libor has risen 100 bps, from 70 to 170.  But the ten year yield has never surpassed the high associated with the Dec 2016 hike.  The dollar index has plunged, stocks have soared and corporate spreads have declined throughout 2017.  Various regional Fed Financial Stress Index measures (St Louis, KC) look exactly like a long term chart of implied volatility on the ten year note, that is to say, near all-time lows. (I suppose that the KC stress level went up after Saturday’s wild-card loss).  Can the Fed really tighten financial conditions?  Should that be a goal?

On Friday, comments from a speech by Philly Fed President Harker (non-voter in 2018) scrolled through the news feeds. (link at bottom).  He expects growth of a little under 2.5%; thinks there’s little slack left in the labor market, and is somewhat concerned that inflation will run below target.  Therefore, he favors just two rate increases in 2016.

Harker appears to be a poster child for Powell’s concerns that the models will “tell us that we’re helping the economy… and that market functions are not impaired… and inflation expectations are under control.”  So IF Powell wants to shift to an economy that prices risk more appropriately, (perhaps by indicating that the Fed “put” is being rolled down a few strikes), then he will have to clearly and credibly communicate that intention and drown out other opinions. (The Fed’s website does not list any major upcoming speeches in January, though Bostic and Dudley speak this week).

A quick footnote on a couple of the financial conditions noted above

The run up in stocks since September has been breath-taking, with SPX up about 12% over that time frame.  A good deal of the move is attributed to the cut in the corporate tax rate, and of course foreign repatriation also figures into the equation. There are a myriad of factors that influence flows into the stock market, but if the value of a given stock is the present value of future cash flows, then I thought it might be useful to run through a very simplistic exercise.  I took a stream of annual $10 payments over 30 years and discounted by 2% to arrive at a PV of $224.  Given the tax deal, let’s assume these annual flows now go up to $11.50.  Now the PV is $257, an increase of just under 15%.  But now let’s change the discount rate to 3% and we’re right back to $225.  The point, I suppose, is that Fed hikes should eventually bite into stock market exuberance.  The market is forecasting an increased income stream discounted at low and sticky rates.

In the event of Fed tightening, one would also think the dollar would appreciate.  But the dollar exhibited renewed weakness last week and is near the lowest level since the start of 2015.  Some of this move is, of course, a reflection optimism regarding Eurozone growth and the related rally in the Euro.

The discussion now flows to the Eurodollar curve (and I’ll tie in a couple of large trades which occurred Friday).  The near one-year calendar spreads closed at new highs.  For example, the front 1-yr ED spread, March’18 to March’19, settled 47.5 (+3 on the week), essentially supporting Harker’s call for 2 hikes this year.  The front 1-yr Fed Fund spread, Jan’18/Jan’19, settled at a new high of 57.25.  Same story.  However, the NEXT year forward, EDH19 to EDH20, only settled up +0.5 on the week to settle at 14.  So the H/H/H fly settled 33.5 (47.5-14.0), and we have to go back to the 2004-06 hiking cycle to see these elevated levels in flies.  As of Friday’s settles, the one-year calendars from 2019 to 2020 (reds to greens) averaged just 9 bps, and from 2020 to 2021 (greens to blues) just over 5 bps.

Stocks and the dollar are content to continue trending, in part taking their cues from the forward Eurodollar curve, which continues to flatten, signifying easy conditions ahead.  So, Mr. Fed Chairman Powell, if you want to break the circle, start selling greens!  (joking of course).

The big trade Friday relates to the above discussion.  There was a seller of approximately 125k EDZ18/EDZ19/EDZ20 butterflies from 15.5 to 14.5.  100k was sold in one piece on a block, the largest trade I have seen for this type of structure.  The fly settled 14.5; EDZ8/9 settled 20.0 and EDZ9/0 settled 5.5.  According to prelim open interest figures, the trade is new. OI in EDZ8 +90k, EDZ9 +84k and EDZ0 +117k.  Since September, this fly has rallied from -1.0 to Thursday’s settle of 16.5.  When looking at a chart, it looks like an extreme.  However, keeping in mind that the near one-yr fly settled 33.5, there is significant negative roll to overcome.

There was another interesting block of 20k:  A sale of the 9 month double butterfly, EDH19/EDZ19/EDU20/EDM21.     This breaks down as a sale of EDH19/M21 at 13.5 vs buying 3x as many EDZ19/EDU20 for 2.0.  The standout in both of these trades is, 1) they are both buying EDZ19 and 2) the back spreads are very flat.  In the regular fly the deferred spread, EDZ19/Z20, traded just 5.5 and in the double, a nine month spread, EDZ19/EDU20. traded for just 2.0 (settled 3.0).

Monday includes comments from several Fed officials.  Rosengren and Williams on a panel discussing the 2% inflation target, and a speech from Bostic (voter in 2018).  Dudley speaks on the economic outlook on Thursday.  Auctions of 3’s, 10’s and 30’s  Tuesday – Thursday.  PPI Thursday, CPI and Retail Sales on Friday.

Here’s to the possibility of dynamic markets in 2018!




12/29/2017 1/5/2018 chg
UST 2Y 188.7 195.8 7.1
UST 5Y 221.0 228.4 7.4
UST 10Y 240.9 247.4 6.5
UST 30Y 274.1 281.0 6.9
GERM 2Y -62.7 -60.5 2.2
GERM 10Y 42.7 43.9 1.2
JPN 30Y 80.8 81.5 0.7
EURO$ H8/H9 44.5 47.5 3.0
EURO$ H9/H0 13.5 14.0 0.5
EUR 120.03 120.32 0.29
CRUDE (1st cont) 60.42 61.44 1.02
SPX 2673.61 2743.15 69.54
VIX 11.04 9.22 -1.82




Posted on January 7, 2018 at 11:30 am by alexmanzara · Permalink
In: Eurodollar Options

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