July 3. Sentiment change. Yellen undermines the Fed

During the initial part of Janet Yellen’s interview with Lord Nicholas Stern last week, she said “We don’t just use models, we also talk to people.”  [Crowd twitters appreciatively].  She proudly pointed out that the Fed talks with a wide range of business contacts, noting that from these communications, the Fed sometimes “learns things that are very important they might otherwise miss.”  I guess this story was supposed to justify the Fed’s current decision making structure over a strict rules based policy.  She then went on to eloquently relate what her contacts were telling her in 2007, in effect completely demolishing her own argument, and by extension, the Fed’s own credibility.  She said in the year prior to the crisis, the Fed was focused on housing, but her business contacts “KEPT SAYING that money was available for absolutely anything.  Banks are throwing money at anything without seriously looking at the prospects…” [She repeated this for emphasis] “And people said they had never seen anything like it in their lifetimes.”  In particular, she said one of her contacts, a director at a private equity firm, crystallized the situation for her.  This firm was contemplating a bid to take a large company private in an LBO, and there was competition to do the deal.  And he first thought it would be impossible; they would need a “huge amount of leverage”, but his partners urged him to write down exactly what type of debt would be needed, and to go talk to the bankers.  “If the economy hit so much as a pothole, they might not be able to make the debt payments.”  In order to sidestep this issue, the banks used a “Payment in Kind” feature.  The investor said that “banks were falling all over themselves to give these terms” and were using the PIK Toggle*, which became a common feature of debt contracts.  Banks were packaging these loans and selling them as higher yielding safe investments.  She finishes with this:  ( ! ! ! )  “This was like bells going off.  Now unfortunately, this was too close to the financial crisis, and it really wasn’t information that we could use to address what lay ahead.”

WHAT?  I had to listen several times.  But here’s the link.  Minutes 8 to 12.

http://www.britac.ac.uk/audio/janet-yellen-conversation-nicholas-stern-presidents-lecture-2017

I’m reminded of Milton Friedman:  “…my conclusion [is] that monetary actions affect economic conditions only after a lag that is both long and variable.”

First you have to identify the problem (usually there’s a lag), then you have to formulate and implement policy (lag) and then it takes time to filter through the economy.  Even with sophisticated business contacts the Fed was late to stage one.   Perhaps model based rules would work just as well.

By the way, it’s different now.  Blue Apron went public last week with this encouraging disclaimer:  “We have a history of losses, and we may be unable to achieve or sustain profitability.”  BUY!

Later in the same Yellen interview, there’s the clip that EVERY news outlet jumped on.  “Would I say — will there never, ever be another financial crisis? Probably that would be going too far. But I do think we’re much safer, and I hope that it won’t be in our lifetimes — and I don’t believe it will be.”

Compare and contrast that with Bernard Arnault, the CEO of LVMH who had previously (6/15) said:

“I don’t think we will be able to globally avoid a crisis when I see the interest rates so low, when I see the amounts of money flowing into the world, when I see the stock prices which are much too high, I think a bubble is building and this bubble, one day, will explode. 

There has not been a big crisis for almost ten years now and since I’ve had a business I have seen crises more than every ten years, so be careful.”

This guy sells the finest champagne as one of his product lines.  I’m betting he knows bubbles and popping a lot better than Yellen.

Now to the markets.  One of the questions illuminated by Yellen’s interview relates to identifying changing conditions.  And THIS was a week for THAT.  I mentioned last week that the German Schatz had closed at a new ytd high, and suggested that this would underpin strength in the euro.  However, I was pretty constructive on US fixed income, noting that euro$ calendars and the US curve in general were near new lows.  Well this week, while maybe not exactly like ‘bells going off’ certainly signalled huge possible changes in conditions.  Draghi said ‘deflationary forces have been replaced by reflationary ones.’  Carney and Poloz are leaning toward hikes.  The German bund yield surged 21 bps on the week to 46.6.  Weidmann on Saturday said, “The ECB is working on moving away from its ultra-easy monetary policy.”

In the US changes weren’t of excessive magnitude, but several measures of the curve made new monthly highs.  For example, 2/10 treasury spread closed near 92, a bounce of 12 bps off the low set on FOMC day.  Same thing with the red/gold pack spread in eurodollars; it closed at a new recent high of 64.25, up 10 from the low set on 20-June.  The US ten year yield closed 2.30%, through a downward sloping trendline from March to May.  The post-Brexit low one year ago was 1.36; the high yield in March was 2.627.  The 0.382 retracement was 2.142 which essentially held in June, so the technical picture suggests higher yields.  Flattening in the wake of the FOMC may have been the final capitulation.

More dramatic were moves in the UK and Germany.  Two-year calendar spreads in both the UK and in Euribor made new highs.  For example, I looked at the 2nd to 10th quarterly spreads on a constant maturity basis in Short Sterling, Euribor, Euro$ and BA’s.  [Now Dec’18 to Dec’20].  In order, the spread values are 46, 45, 57 and 49.  All clustered fairly tight in terms of absolute value, but Sterling and ER are at new highs, having rallied 25 and 22 bps respectively off lows a couple of weeks ago.  In the US, the spread at 57 is only about half of its post-election high made in December of last year.  The point is that interest rate differentials are working against the USD , which is at its lowest level since last October, and is down over 7.5% [DXY] since the start of the year.   In turn, the weaker dollar, at the margin, supports the dollar prices of commodities.   August Crude oil jumped over $3/bbl this week to close just over $46.  Oil is still in a longer term downtrend, but the stark divergence between stocks and the Bloomberg Commodity Index (shown last week) finally indicates a spark of reversal.

The end of this holiday week is chock full of important events.  Unemployment report is Friday.  The Fed will release its Semi-Annual Monetary Policy Report later on Friday (11AM EST).  G20 on 7th and 8th.   FOMC Minutes are released on Wednesday.

**Also, the exchange, in its infinite wisdom, has a regular 5:00pm EST close for interest rate contracts Monday.  If there was ever a day that moves might be exacerbated in thin conditions, this is it.

 

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6/23/2017 6/30/2017 chg
UST 2Y 133.6 138.2 4.6
UST 5Y 175.5 188.2 12.7
UST 10Y 214.2 230.0 15.8
UST 30Y 271.3 283.9 12.6
GERM 2Y -62.4 -57.2 5.2
GERM 10Y 25.5 46.6 21.1
JPN 30Y 80.0 84.0 4.0
EURO$ Z7/Z8 26.0 32.5 6.5
EURO$ Z8/Z9 20.5 24.5 4.0
** EDZ7/Z8 now peak 1-yr
EUR 111.93 114.27 2.34
CRUDE (1st cont) 43.01 46.04 3.03
SPX 2438.30 2423.41 -14.89
VIX 10.02 11.18 1.16

 

http://www.investopedia.com/terms/t/toggle-note.asp

https://ftalphaville.ft.com/2016/09/08/2174362/this-is-nuts-pik-toggle-edition/?mhq5j=e2

Posted on July 3, 2017 at 4:38 am by alexmanzara · Permalink
In: Eurodollar Options

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