July 26. Weekly summary – It’s not Greece anymore, it’s EM, energy and metals…and debt

THEMES:

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7/17/2015 7/24/2015 chg
UST 2Y 66.5 67.8 1.3
UST 5Y 166.8 162.0 -4.8
UST 10Y 234.7 227.1 -7.6
UST 30Y 308.0 297.4 -10.6
GERM 2Y -22.0 -22.5 -0.5
GERM 10Y 78.8 69.1 -9.7
EURO$ Z5/Z6 ** 82.5 80.0 -2.5
EURO$ Z6/Z7 66.5 64.0 -2.5
** peak one-yr spd
EUR 108.31 109.85 1.54
CRUDE (1st cont) 51.21 48.14 -3.07
SPX 2126.64 2079.65 -46.99
VIX 11.95 13.74 1.79

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Let’s start this week with a chart. Everyone is aware of the commodity price implosion in terms of dollar prices. Here’s a related representation, over a long time period.

SPXCRY.aspx

 

Above is the SPX priced in terms of the CRB. It might be a bit difficult to tell from the image above, but the high was 10.7 in February 1999, and the current level is 10.14. Though I have mentioned this before, it again highlights the advances in technology which reduce the need for as much physical material. The paper “Nature Rebounds” by Jesse Ausubel http://phe.rockefeller.edu/docs/Nature_Rebounds.pdf explains this dynamic in tremendous detail, but there is one graphic in the article that captures the concept perfectly. An i-phone is pictured next to some of the much larger things it replaced: a Bell telephone, a video camera, newspapers, photo albums, a big rectangular clock radio with thin metal numbered flaps that rotate to tell you the time and awaken you to the sound of Sonny and Cher singing I Got You Babe. [Groundhog Day, 1993]

The related and larger issue is that of the value of claims on a future stream of earnings (stocks) versus the value of everyday necessary commodities. And the amount to which both claims are underpinned by debt. For example, if your collection of Beanie Babies is bought and paid for, it’s a shame when you wake up one day to realize they’re worth nothing. But if you’ve borrowed to fund your collecting, it’s a disaster.

The metals and crude oil markets are turning into disasters. For example, copper closed this week at 238, the lowest level since late 2009, and has lost nearly half its value from early 2011 when it hit a high of 465. (The low in early 2009 was 125). Gold as well has lost nearly half its value, from nearly $2000 an ounce in 2011 to $1085 this week. Coincidentally, another chart that has been steadily grinding lower since 2011 (actually since late 2009) is shown below.

China Li Index.aspx

 

 

 

 

 

 

 

 

The chart is China’s Li index, which tracks the annual growth rates in China of outstanding bank loans, electricity production, and rail freight volume. It is a more objective and measurable set of data that reflects the state of China’s economy, giving a more accurate picture than official government data. (thanks JD)

The net effect in the US has been a flattening curve, led by a rally in long bonds. 2/30 fell nearly 11 bps this week to 230 bps. From the beginning of May until now, 5/30 has been in a range of around 133 to 157, having hit the upper end of that range in early July. It closed Friday at 134. The ten year inflation breakeven (Note vs TIP yield) closed at a new recent low Friday of 176, about the midpoint of the year’s range from 154 to 195. Junk bond rates are moving higher, evidenced by new lows for the year in HYG and JNK (high yield ETFs). EM under intense pressure. For example, Brazilian Real lost over 5% this week. http://www.bloomberg.com/news/articles/2015-07-24/emerging-market-currencies-tumble-to-record-low-in-violent-selloff

There was a slight flurry in the market on Friday related to the Fed’s inadvertent leak of staff projections on inflation, rates and growth. As everyone knows, the FOMC dot projections have been wildly different from the market for a long time, though in the past two quarters the Fed has moved its projections much more into alignment. The staff numbers are even closer to the market. In fact, I can just imagine how the fed staff came up with the data:

“Hey Bob, [talking over cubicle wall] …want to call it a day and grab a beer?”

“We can’t Lou, we’re supposed to come up with these economic projections. They were due yesterday.”

“I’m thirsty. Let’s just knock this out in ten minutes. What is the Eurodollar curve projecting? Just take the December contract yields and subtract 10 or 20 bps. And make sure you don’t use round numbers…makes it look like you did more work if you use 1.26 rather than 1.25 for a nominal rate…like you really CRUNCHED the numbers. For our five year inflation forecast let’s just look at the breakeven implied by tips. You can see right there dude, inflation isn’t going above 2% in the next five years. For the ten year treasury yield, just take something close to today and ratchet it up by ½% a year. But not exactly 50 bps…make it 51 in one instance and then 48 in another…like 4 or 5 bps per month. Make it look like you did some exacting work. I’m leaving now. A cold beer will be waiting for you at the bar.”

Let’s just compare the above method to Friday’s prices:

FED STAFF projection Nominal FF rate vs December Euro$ contracts:

2015       0.35%    vs EDZ15 99.455                OR 0.545%           Difference: 19.5 bps

2016       1.26%    vs EDZ16 98.655               OR 1.345%           Difference: 8.5 bps

2017       2.12%    vs EDZ17 98.015                OR 1.985%           Difference: -13.5 bps

Ten year treasury yield: Current 2.27

FED STAFF projection

2015       2.63        Difference 36 bps (from current, or 7 bps a month over the next 5 mos)

2016       3.14        Difference 51 bps (from 2015)

2017       3.62        Difference 48 bps (from 2016)

This week of course, is the FOMC meeting and announcement (Wed). No dots at this one, the above analysis will have to suffice. The market’s not looking for much change. What we know for sure is that whenever the Fed has a chance to really solidify the idea of removing accommodation, they whiff. And in this case, with commodities and EM in freefall, there’s a good reason to take a step back. Janet doesn’t want to be the one blamed for regime change, as EM carnage also fosters political unrest. We also get Durables on Monday, expecting a bounce from the weak -1.8 last time.

In terms of trades, there is a pretty good lean in the market for Eurodollar calendar spreads to stay steady or roll higher. That assumption is starting to look rather shaky. For example, the peak one-year calendar spread on the dollar curve is EDZ5/EDZ6 at just 80 bps, down 2.5 on the week. EDZ6/EDZ7 also fell 2.5 on the week to 64. If there is a large rebound in commodities, or a large sell off in USD, (or both), then the curve will likely bounce off its current support levels. However, it’s hard to imagine a significant reversal of trend in EM or commodities. Even if the Fed were to signal a delay in tightening, the curve may flatten further, and that’s where the real risk comes in, as position unwinds can accentuate the move.

Posted on July 26, 2015 at 7:48 am by alexmanzara · Permalink
In: Eurodollar Options

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