July 22. Debt Coming Due

Debt coming due & we are raising rates – Really?  Donald J. Trump tweet from Friday morning

Yes.  Really.

Powell left little doubt that the Fed remains on course to remove accommodation in a well-reasoned argument to keep the economy on track in accordance with the two tasks that Congress has assigned: price stability and full employment.  He is also focused on financial stability, and gently reminded Congress several times that it’s important for the Fed to stay in its lane; not to swerve into policy debates outside of the Fed’s mandate.  He also pointedly bounced the ball back into the legislative court several times, saying the Fed cannot address certain problems, but Congress CAN.

So this week President Trump swerved into the Fed’s lane, then veered into currency lanes and took the China off-ramp while trying to divert attention from the detour into Russia.  “C’mon, it’s Czechoslovakia. We zip in, we pick ’em up, we zip right out again. We’re not going to Moscow. It’s Czechoslovakia. It’s like going to Wisconsin.”* [Except it WAS Moscow].  https://www.youtube.com/watch?v=McZ2H_Iqx4g


Regarding the tweet at the top of the page, here’s a quote from candidate Trump in 2016.  “I’m the king of debt. I’m great with debt. Nobody knows debt better than me.  I’ve made a fortune by using debt, and if things don’t work out I renegotiate the debt. I mean, that’s a smart thing, not a stupid thing.”  The interviewer, Norah O’Donnell, went on to ask, “How do you renegotiate the debt?” and Trump said, “well you go back and say hey guess what the economy crashed, I’m gonna give you back half.”  He added, “I like debt… for ME, I don’t like debt for the country.”

The market reacted to Trump’s comments about the Fed and the strong dollar.  Having made a new high early in the week, DXY had a sharp pullback on Friday.  The curve bounced and there was heavy buying Friday of EDU8 contracts.  However, the move in the curve was off the lowest levels of the cycle, made earlier in the week.  For example, 2/10 traded just below 25 bps early in the week (new low) and closed at 29.6.  It’s going to take much more than a tweet for the Fed to re-evaluate its long term strategy.

Regarding the curve, consider this snippet:

Although macroeconomic forecasting is fraught with hazards, I would not interpret the currently very flat yield curve as indicating a significant economic slowdown to come, for several reasons. First, in previous episodes when an inverted yield curve was followed by recession, the level of interest rates was quite high, consistent with considerable financial restraint. This time, both short- and long-term interest rates–in nominal and real terms–are relatively low by historical standards.  Second, as I have already discussed, to the extent that the flattening or inversion of the yield curve is the result of a smaller term premium, the implications for future economic activity are positive rather than negative. Finally, the yield curve is only one of the financial indicators that researchers have found useful in predicting swings in economic activity. Other indicators that have had empirical success in the past, including corporate risk spreads, would seem to be consistent with continuing solid economic growth. In that regard, the fact that actual and implied volatilities of most financial prices remain subdued suggests that market participants do not harbor significant reservations about the economic outlook.

This paragraph captures the current environment quite nicely, though it neglects to mention malinvestment and extraordinary debt growth in China.  However, the KEY line is the first one: “…forecasting is fraught with hazards.”  Because this comment isn’t about the current environment at all.  It’s from a 2006 speech by Ben Bernanke (he seems to have slightly miscalculated the longer term forecast in 2006).  Taking a page out of Trump’s playbook he doubled up this week saying that ‘Distortions mean an inversion does not necessarily point to recession’ (Financial Times, July 19, 2018).


If rates are low and term premium and corporate spreads are compressed, what happens if the latter conditions change?  Regarding my addendum about China, it’s conceivable that “the debt coming due” is more relevant to China than the US.  There have been high profile problems with large acquisitive corporations (HNA, Anbang).  Credit Suisse notes that China has “…accounted for an average 36% of annual global GDP growth over the past five years.”  There are already many signs of serious problems.  Shanghai Composite is down just over 20% from January’s high.  The currency has been in a sharply weakening trend.  Imagine for a second that SPX was down 20% from January’s high of 2870 (which would put it at 2300) rather than the current lofty level of 2800.  It’s not just China, other parts of Asia are also reflecting stress, with weakness in Indonesia rupiah, India rupee, and even recent sell offs in Korea won and Aussie dollar.  Obviously the slide in commodities is another clear signal.  Institutional observers (the Fed, IMF, etc) think that China can handle financial dislocations and indeed there have been steps taken to increase liquidity (the gov’t asked banks to lend more and to help reduce financing costs for small firms, depreciated the yuan, cut the 7 day rate).  In January China’s ten year yield was over 4%, it’s now 3.5%.  This, at the same time the BOJ is considering steps to mitigate side effects of yield curve control.

In the US financial crisis, the problem was that too much debt was layered onto the US housing market, and as short rates rose, eventually that debt couldn’t be serviced, sparking a daisy chain of liquidations.  It’s not clear when the tipping point arrives and how much has to be subsequently unwound.  But it appears to be occurring in China now and is being exacerbated by trade/currency war tensions.  Europe is slowing as well.  The tipping point: “when borrowers say guess what, the economy crashed and you’re getting back half.”  Asset markdowns.

So, while the Fed is more or less locked into a September rate hike, further tightening is less certain.  We’re moving into what will be an extremely contentious election cycle which is not likely to instill confidence in, well, anyone (except for those who sell political advertising spots).


This is what I wrote last Sunday (Late Cycle Behavior) “Many one-year Eurodollar calendar spreads made new recent lows, for example, EDM19/M20 settled at a new low of just 8.5.  This spread is one year forward, and more or less indicates that the Fed’s tightening campaign will be over by then.  If there’s any doubt as to timing, the next spread, EDU19/U20 is only 2 bps, and then… depression set in.”  Well, someone obviously thought these spreads were too low, with 40k EDU9/EDU0 bought for 2.5 on Monday and 25k EDM9/M0 bought for 10 (Settled Friday at 4.0 and 11.0 respectively).  There were also a couple of 40k block buys of both EDU9 9737/9775/9812 call tree and same in EDZ9 for 4.0 and 3.5.  These latter trades look for slow rallies with diminishing call skew.

The other extremely large theme is occurring in long dated euro$ options, buying ratio put spreads.  Last week I highlighted positions and thoughts in note and so I won’t repeat it here (email me at amanzara@rjobrien.com for a copy).  An example of one of these trades was a buy last Thursday of 25k EDZ20 9600/9550 put spread 1×4 for flat premium (5.0 and 1.25).  So this trade added 100k new shorts to the 9550 strike at 1.25 with 875 days until expiration.  While it’s quite true that most expectations of the terminal rate barely exceed 3%, leaving the 9550 put *worthless* that put is still a tail risk and it’s not going to decay and it’s not going to be easy to buy back should it become necessary. On Friday the 9600 put settled 5.0 and the 9550p at 1.5, so the 1×4 settled -1.0.

Here’s a little picture of how these long dated otm puts can trade:  Sits, sits, sits, then boom.  Explodes higher.

These puts should be bought, not sold (Out of the money long-dated in general).  At these compressed vols they provide cheap protection with little decay, and leave opportunities to create other trades in strikes above with shorter maturities.  My personal bias is that rates are likely to go lower, but I am still more inclined to buy these puts with an underweighted delta.

I had specifically recommended buying EDM0 9625/9600 put 1×3 (pay 1 for the 3 legs) last week.  That settled 2.0 for the three legs on Friday on a relatively small futures move.

Another big theme on Friday was buying of EDU8.  At least 100k EDU8 9750/9762 call 1×2 bought for 3.0 to 3.25, settled 3.25 ref 9755.5 (OI -40k and +78k).  In futures, EDU8 was the top volume contract, closing +1.5 at 9755.5 with OI +46k.  EDU8/EDZ8 spread closed at its high of 21.5, and EDU8/EDU9 closed at a NEW high of 50.5.  I am more inclined to buy EDZ8 or EDH9 if I think the Fed is near the end; I see little chance of a Sept pause followed by a December hike.  Much more likely is a Sept hike followed by a period of much less certainty with regard to future hikes.  Referring back to earlier mention of EDU9/EDU0 spread at 4.0, the EDU8/9/0 butterfly closed at 46.5.

Long flies: EDH9 9725/9750/9775c fly 4.0s ref 9720.5 (I paid 4 vs 10d in EDU8 at 9754.5).  0EU 9712/9725/9737c fly 1.25s vs 9701.0.  0EU 9725/9750/9775c fly 1.75.  0EH 9712/9737/9762 call tree settled 2.50 from 0.5 three Fridays ago.

Large outstanding trade in TY: TYU 120/122 c spread settled 29 (33 and 4) ref 119-31+.  There’s a long of at least 150k in this.


7/13/2018 7/20/2018 chg
UST 2Y 258.2 259.5 1.3
UST 5Y 272.7 276.3 3.6
UST 10Y 282.9 289.1 6.2
UST 30Y 293.3 303.0 9.7
GERM 2Y -66.3 -61.8 4.5
GERM 10Y 28.0 37.0 9.0
JPN 30Y 67.9 68.5 0.6
EURO$ Z8/Z9 31.0 33.5 2.5
EURO$ Z9/Z0 -2.0 0.0 2.0
EUR 116.85 117.22 0.37
CRUDE (1st cont) 69.96 68.26 -1.70
SPX 2801.31 2801.83 0.52
VIX 12.18 12.86 0.68




https://www.youtube.com/watch?v=McZ2H_Iqx4g     *

Posted on July 22, 2018 at 1:37 pm by alexmanzara · Permalink
In: Eurodollar Options

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