July 23. Central Banks Retreat

What if Trump and Yellen are working hand in hand? Trump: “I’ll throw outlandish claims on my Twitter account. Janet, you make sure nothing takes stocks down….together we’ll work to weaken the dollar. That will help (or at least give the appearance of helping) US manufacturers. It will also keep oil somewhat stable so that US shale producers can continue to displace supply from the MidEast. I’ll be the volatile one, you keep market volatility low. I’ve found that the best form of manipulation is to make patently false claims, and then walk them back over time. Often the secondary reaction is even greater than the initial misdirection. For example, your initial threat to remove accommodation in the name of financial stability was a nice touch. The way you ignored that theme at your testimony was huge. New highs in financial markets and a weaker dollar. Keep up the good work.”

Clearly I am jesting in the above paragraph, however, the dollar closed at its low, stocks are at new all-time highs, and the MOVE (volatility) index closed at an all-time low.   Draghi helped, by leaning against his Sintra comments: “the last thing that the Governing Council may want is actually an unwanted tightening of the financing conditions that either slows down this [recovery] process or may even jeopardise it; and that’s why we retain the second bias, or let’s call it, reaction function”   The German bund fell 10 bps this week to 50.6 and the US 10y treasury dropped 8.5 to 223.2. VIX closed at 9.36.

In Eurodollars, calendar spreads tightened. The EDZ17/EDZ18 spread closed at 28.5, down 4 on the week. The white/red pack spread (1st year to 2nd year) closed just above ¼% at 27.375, while red/green closed less than a bp above the year’s low at 21.0. (Post-election high was in mid-40’s; we’re right back to the one-hike a year mantra). There was a large, 60k, buyer of EDZ18/EDH19 three-month spread on Friday for 5 bps which appeared to be a new position. The spread in front, EDU8/EDZ8 settled 8.0, but most 3-month spreads are between 4 and 6. Several trades recently have faded year-end money market pressures embedded in December contracts, and that’s the theme here, to fade relative weakness in EDZ8, capture roll and squeeze out year-end premium.

The central banks dampen risk. At the same time, the nano-second trading algos keep the bid/ask tight across correlated markets. Why no volatility? That’s why. The price of risk dwindles away in the face of excessive stability. As they say on the black-and-white mystery movies while piping in ‘smoke’ from dry ice, “It’s almost TOO quiet.”

So what could change things? The Fed meeting for July is Wednesday, with possible hints of balance sheet adjustment implementation. (No press conference). On Thursday, the Senate holds hearings on Randal Quarles as a new Fed board member.* Recall that he leans more towards models as the basis for central bank decision making, rather than the discretionary approach favored by the current Fed. Questioning along those lines at the hearing would not be surprising.  Perhaps it wouldn’t much matter, except that Yellen’s term is up in half a year, and there’s speculation that Fischer could resign before next summer. In other words, the composition of the Fed could change, and with labor markets tight, it might tilt the balance towards the more hawkish posture suggested by, for example, the Taylor Rule.  Not much in early August, but the Jackson Hole symposium is August 24-26. (Sept treasury options expire August 25). Then in September, the FOMC is on the 20th, and the debt ceiling fight should be in full swing. The kink in the bill curve in mid-October already is testament to this issue (mid Oct bills are 5-6 bps higher than Sept and 3 higher than Nov). Another event to keep in mind is the 19th Nat’l Congress of the Communist Party of China, which is in autumn.  Any chance that China’s data takes a turn for the worse into the end of the year?  From a Bloomberg article July 12: “President Xi Jinping told the politburo in April that ‘financial security’ was a top policy priority for the year. That led the central bank to tighten liquidity, while the ambitious new banking regulator unleashed a ‘regulatory windstorm’ that sent shockwaves through the banking system. The storm appears to be passing, as the People’s Bank of China has become more generous with cash injections while the China Banking Regulatory Commission has delayed implementation of a significant new directive.”  Both the Shanghai Composite and Copper have been in uptrends since early May. Kospi is up 20% since the beginning of the year and Hang Seng is up nearly 25%. Loose monetary conditions to keep the economy humming into the Nat’l Congress may reverse in its wake.

Here’s a guy with a view that things may change:  On Friday there was a buyer of 262k October VIX 15/25 call 1×2 vs 12 put. (Sold the put to finance the call spread). I am not sure of actual premium, but mid-markets were 15c 1.40, 25c 0.40 and 12p 0.80. These prices suggest a small credit; the link below suggests the trade was entered at flat premium. (Thanks Andy O’Kelly for the tip).


Given that spot VIX is 9.36, the 12 put appears to be the risky leg, though a quick move above 25 would also be problematic. (Oct 35c could cap upside risk for 0.20). The point is, this is a huge trade that would benefit by an upside move in vol, and as noted above there are several possible catalysts.

The Fed, the ECB and China have all pulled back from hinting that less accommodation is on the horizon. Stability sows the seeds of instability. We just haven’t had any rain yet.

Selected option expiration dates:

TYU7 August 25 corresponds to Jackson Hole

Oct ED Midcurves October 13 Debt ceiling fight

Oct VIX October 18

TYX7 October 27

Nov ED midcurves November 10

Posted on July 23, 2017 at 3:22 pm by alexmanzara · Permalink
In: Eurodollar Options

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