January 17. Behind the Curve
Wait ‘til next year. Sort of a motto for Chicago. In this case though, it’s the Eurodollar calendar spreads sending the message of no more rate hikes. Near one-year calendars plunged right along with stocks, with March’16/March’17 down 15 bps on the week to just 32.5 and June’16/June’17 down 12.5 to 35.0. The peak one-year has shifted further back on the curve to Dec’16/Dec’17, but even that one’s only 38.5. The first two three-month calendars closed at new lows of only 7.5. Fed officials have said the first rate hike was a sign of confidence in the economy. The stock market and curve are sending a different signal. It’s not that the Fed has been all that bad about communicating, it’s that they have underestimated China and energy weakness. The US-centric models need to be revised. Late Friday the Atlanta Fed released an updated forecast to Q4 GDP at just 0.6. Remember, this started out at 2.5%. JPM revised its Q4 estimate to just 0.1 (from 1.0) and called retail sales “shockingly weak”. Reuters had a weekend headline, ‘Fundamentals could resurface after wrenching sell-off’. Uh-oh. As mentioned last week, the warning signs had been piling up, in the form of high yield, energy prices, weak economic data. Now Fed officials have locked onto the concern of “inflation expectations”. The charts of 5y5y inflation forwards and ten yr treasury /tips, (market-based indicators of inflation expectations), are moving into the lower right hand corner in search of the x-axis. Maybe the Fed will squeeze out one more hike this year, but I doubt it. The back-tracking has already begun: DUDLEY: IF ECONOMY WEAKENED, WOULD CONSIDER NEGATIVE RATES
I don’t personally think we need to spend too much time thinking about economic conditions. We know they’re anemic, even though the household sector is in pretty good shape. Now it’s all about the odds of various policy-maker responses. For example, ZH had an article saying the Dallas Fed had meetings with banks with high exposure to energy, asking them not to force bankruptcies, but to encourage asset sales. This article further said the outcome of the meetings was suspension of “mark-to-market on energy debts, and as a result no impairments are being written down.” Macro-prudential policy in reverse. There’s no way for me to know whether this article is true, but there’s likely a grain of truth in it, and it’s certainly the case that stress in the system is increasing. For example, I noted some issues with auto loans last week, and this week Ford 5yr CDS is the highest in two years and GM is getting close. Autos have been a bright spot in the economy, but the market continues to raise red flags.
The core concern is that of a negative spiral of asset prices. QE programs are meant to boost asset prices and thus instill confidence in the economy. Now prices are falling, even in Japan which is still involved in QE, where the Nikkei is off 18% since the high of last year. I have maintained that the end of QE in the US is one of the main reasons that repressed spreads have blown out. Even if conditions worsen, it’s hard to imagine the Fed going back to QE. So my base case is that the Fed simply won’t hike again and will try to jawbone the Federal government into fiscal stimulus, and maybe relax some rules, as alluded to above with the Dallas Fed.
In terms of trading strategies, I favor being long EDH18 and short anything behind it. On a week where a lot of spreads collapsed, it’s worth noting that reds to greens (2nd to 3rd year) held steady, closing 36.75 Friday from 35.875 the previous week. A lot of trades have been built on the premise of the Fed being in a tightening cycle, i.e. flatteners. If the Fed is NOT in a hiking cycle, then the curve will steepen, simple as that.
The global geopolitical situation does not seem to be improving. The election of pro-independence candidate Tsai in Taiwan is a reminder that tensions can easily flare up in Asia even excluding N Korea. China is facing economic headwinds and has reacted clumsily; a push from another direction could elicit unexpected responses.
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| 1/8/2016 | 1/15/2016 | chg | |
| UST 2Y | 94.4 | 84.2 | -10.2 |
| UST 5Y | 157.6 | 144.9 | -12.7 |
| UST 10Y | 213.1 | 203.0 | -10.1 |
| UST 30Y | 292.4 | 281.1 | -11.3 |
| GERM 2Y | -39.5 | -39.4 | 0.1 |
| GERM 10Y | 51.4 | 54.0 | 2.6 |
| EURO$ H6/H7 | 47.5 | 32.5 | -15.0 |
| EURO$ H7/H8 | 40.5 | 38.5 | -2.0 |
| EUR | 109.26 | 109.17 | -0.09 |
| CRUDE (1st cont) | 34.32 | 30.39 | -3.93 |
| SPX | 1922.03 | 1880.33 | -41.70 |
| VIX | 27.01 | 27.02 | 0.01 |
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