July 31. Buy short end puts for insurance

It was an interesting last week of the month.  On Tuesday there was a Morgan Stanley piece (all links below) suggesting that the gov’t streamline home refinance for any homeowner who is current on their mortgage to (lower) market rates.  There would be no need for credit analysis because the gov’t already is backing principal.  There is really no need to even find out if someone is working etc…it is explicit recognition that the gov’t is already on the hook.  (Currently many refis aren’t available due to bad credit scores, low LTV, etc).  The authors estimate a flow of $46 billion/yr to consumers.  Even if these new loans default, it would certainly be at a lower rate than currently.  And almost certainly it would take some homes off the market as those who are on the edge and feel compelled to sell might just be able to squeak by with lower payments.  In effect it is a transfer from lenders to borrowers, but in this case the lender is most probably the US gov’t anyway since it owns FNM, FRE and Federal Home Loan Bank.  Those who do own MBS need to race to replace yield, hence the treasury rally.
Nomura put out a piece saying the Fed may use the Aug 10 FOMC to send a message of more QE (QE lite).  This dovetails with the proposal above in that the Fed would be a buyer of treasuries.  Citi apparently made the case that the MS proposal wouldn’t save as much as thought because rates would rise at the long end.  Not if the Fed is buying… 
The other big story was Bullard’s (St Louis Fed) idea that the US could avoid a Japanese style outcome by raising rates at the short end to a still low but stable rate, and engage in QE.  This would have the effect of convincing the market that the Fed will create inflation, perhaps putting a floor under asset prices (housing and equities), and it might further cause corporate cash hoards to loosen.  In the financial sector banks might be forced to lend into the real economy instead of riding the treasury curve, and non-financial companies might engage in investment expenditure now, before prices increase.  The curve would flatten significantly in the short term. 
There was another ZH piece citing David Rosenberg…Ten things that would make me bullish.  On that list are two things that might occur if the above proposals occur.  1) An increase in the money multiplier/ velocity and 2) improvement in housing inventory that would put a floor under home prices.  The transfer from mortgage lenders to homeowners would certainly boost the money multiplier, and also help with home inventories. 
Transitioning from policy to actual market movements, I would note that food commodities are strengthening impressively.  The CRB has bounced from 248 to 274 in the past two months; the high since the oil related crash is around 295 in March 2010.  Oil is a pretty big component of the CRB.  In 2008 crude rose to $140/bbl.  From 2000 to 05 the range was 20 to 40, from 2005-06 from 40 to 80, then the explosive run up and denouement.  CLU is now around 78.40.  In other words, at high end of range excluding the spike.  Grains are exploding.  Wheat is on a holy tear having moved from just under $5 to just under $7 this month. Nov Beans made new highs. Oct sugar is at new recent high. Sept Coffee made a new high, from 135 to 175 in a month and a half.  Copper is strong.  The point is that commodity prices are not indicating deflation.  Ten year note to tip spread at 1.8% isn’t indicating deflation.  In March 2009 this spread spiked down to 85 bps.  There are reports of wage increases in China that are also likely to feed into slightly higher consumer prices here. 
The GDP report confirms renewed slowing and I think it’s pretty clear from data that we’re hitting a wall as previous stimulus measures fade.  However, I think there is now some pent-up demand, and perhaps the upcoming midterm election will re-introduce the concept of gov’t gridlock which has been favorably viewed before. 
From a trading perspective I think there is short term risk of a MUCH flatter curve.  But the outlier is that something like the Bullard idea comes to pass and the curve flattens due to higher SHORT rates.  With Fed Fund contracts around 19-25 bps and near eurodollar contracts 40-60 bps, there is a ton of downside risk, especially as people have sold puts thinking that a spike higher in LIBOR rates has become a more remote possibility.  A shift to bearishness in the short end could catch fire for several reasons. 1) Bullard’s thoughts convince others on the Fed that zero short rates aren’t appropriate  2) Commodity markets continue to run, igniting inflation concerns 3) Equity markets rally smartly due to QE rumors 4) a Gov’t sponsored refi program convinces the market that consumer spending rebounds consistently 5) Bush tax cuts are extended.
I would strongly consider insurance in the form of buying FF puts and/or buying euro$ puts (in 2011 contracts).  Buy puts outright or buy the ratios…buy wings. 

Posted on July 31, 2010 at 9:08 am by alexmanzara · Permalink
In: Eurodollar Options

Leave a Reply