June 18. Getting Snowed in June

Back in the 1990’s there used to be a pretty good market in snow futures on the CME floor.  This wasn’t a CME sanctioned product, it was a bunch of guys that would trade the amount of snowfall at O’Hare in a given month, $1 an inch per contract.  So, if you bought 5 inches and as of Dec 31 it snowed 7.5 inches, you collected $2.50 per contract.  Of course, if you paid 5 and someone comes along and bids 8, you can sell, and just like any other futures contract, you’re out.  The key difference: everyone settles up at the end of the month.  So you’re not really ‘out’.  Back in 1996 or 1997, this market sustained a lethal snag.  One clerk was long something like 1000 futures for December from 10 inches, and it only snowed 1.2 inches for the entire month.  He didn’t pay.  There had been an entire edifice of trading that had gone on, back and forth deals marked on trading cards and the big debit failed.  So if I sold 10’s to the doofus, and bought 8’s from someone else, do I pay the guy that’s long the 8’s?  That was the end of THAT market.

It’s a pretty simple little story, repeated endlessly in business dealings, but it concentrates focus on two things: credit risk and ‘arbitrage’ across products.  With the explosion of etf’s and other vehicles, some market makers might consider themselves to be more or less ‘flat’ or ‘out’ in terms of risk, having sold in one product and bought something very similar as an offset, but it doesn’t always work out that way.

There’s just a huge amount of material with market ramifications that can be considered given the current environment.  For example, I believe China is quite important, and both the BoE and Bank of Canada jolted longs in short end markets, with June’18 Short Sterling down around 20bp from the previous week and June’18 BAs down 10 bps from Wednesday’s high.  However, I will just mention three things: First, the Fed’s Balance Sheet Reduction plan as compared to the taper tantrum.  Second, the lack of risk premia.  Third, Illinois.

Was Wednesday’s FOMC hike a mistake given low and declining inflation levels?   In and of itself, perhaps not.  However, the curve remains quite flat.  It’s pretty clear that the markets don’t currently believe there’s a need to continue hiking. Note that the Fed ITSELF trimmed the Core PCE Price projection from 1.9% in March to 1.7% now.  It’s an admission of failure on reaching inflation targets. The ten year note yield actually fell 4 bps on the week, to end just over 2.15%.  The peak one-year eurodollar calendar spread, a rough proxy for expected tightening over a given year, settled at a new recent low of just 28.5 bps, barely above ¼ pct and well off peak highs in the post-election euphoria when the one-year peak spread was nearly 70 bps.  So let’s talk about the other part, the blueprint for balance sheet reduction that was also attached to Wednesday’s FOMC.  The basic thing to keep in mind is this:  episodes of QE have generally resulted in HIGHER bond yields and HIGHER equity prices.  As a rule, one would say, “Central Bank buying bonds, then yields go down.”  But look at the chart below, it’s the opposite.  I have shown the onset of QE programs with the green vertical lines, and the end with red lines.  The amber line is the ten year treasury yield (left scale) and the white line is the SPX.  Yields and stocks generally rise on QE in the US; stocks tend to falter at the end of QE.  So think of it this way: QE programs are designed to support STOCKS.

The interesting move is in 2013, when the yield surged from around 1.75% in May when Bernanke suggested the idea of tapering bond purchases, to 3% by the end of the year.  The Taper Tantrum.  In this case, the central bank’s hint of withdrawal had an immediate and dramatic effect on bond yields.  Why isn’t the proposed tapering of reinvestment having the same outcome currently?  Well in late 2011, Operation Twist was started.  [link to Calculated Risk at bottom shows timeline of QE programs].  QE3 was announced a year later in 2012 at $40 billion a month and expanded to $85 billion a month in December!  Stocks were continuing to advance and the idea of losing $85 billion a month threw the market into a tailspin.  The actual tapering program began in Dec 2013 and ended in October 2014; over the period of actual tapering the yield went from 3% to around 2.5%.  In the current plan of balance sheet reduction, the non-reinvested amounts are $10 billion per month (between Treasuries and MBS), and will expand by $10 billion every 3 months until they cap at $50 billion per month.  I personally doubt we ever get to the $50 billion even though it’s supposed to get up to that rate in 1 ¼ years.  By that time we’ll have a new Fed Chairman.  The point is, even $50 billion a month isn’t stupendously large by today’s standards.  All it will take is a whiff of equity market weakness and the schedule will be altered.

The larger point is, a reduction in balance sheet is, perhaps, more consistent with a DECLINE in bond yields and in stocks and in other risk assets.

The next topic concerns implied vol and corporate spreads.  Vol’s low.  I know it, you know it, the UBER drivers know it.  Corporate spreads are also tight.  [Chart below].  For example the BBB spread to treasuries below is 145 bps.  The low was 125 in 2014, and in the beginning of 2016 when oil market angst was on full display, the spread got to a little over 200.  The point I’ll repeat is that there is no cushion for safety.  Corporate debt levels are at a record of GDP and stocks are at all time highs.



Of course, with all of today’s technological prowess, why should we price risk?  Distribution networks across both markets and across the world for goods and services are extraordinarily efficient.  That’s the outcome of operations like UBER and AMZN.  However, the promise of extracting returns from UBER is getting dicier, with continued capital burn as the management structure implodes.  Actual income to drivers has been squeezed through competition.  And AMZN’s purchase of Whole Foods is another example of relentless pressure on margins.  Everything is great, but in aggregate the debt still has to be serviced; there’s more of it, and margins are scarce.

Which brings me to the final topic: Illinois.  Illinois has GDP (or Gross State Product) of about $800 billion.  That’s the fifth largest, about 1/3 of California at $2700B, and half of NY and Texas, $1535B and $1640B and just under Florida at $960B.  It’s about to be downgraded to junk.  Here’s a quote from the state’s comptroller, Susana Mendoza (from the AP)  “I don’t know what part of ‘We are in massive crisis mode’ the General Assembly and the governor don’t understand. This is not a false alarm,” said Mendoza, a Chicago Democrat. “The magic tricks run out after a while, and that’s where we’re at.”

(AP) “Now Comptroller Susana Mendoza is warning that new court orders in lawsuits filed by state suppliers that are owed money mean her office is required to pay out more than Illinois receives in revenue each month. That means there would be no money left for so-called “discretionary” spending — a category that in Illinois includes school buses, domestic violence shelters and some ambulance services.”

Illinois has sent a letter to contractors warning that it may not be able to pay road construction bills, and the multi-state Powerball and Mega Millions lottery have said they may have to drop Illinois.  Some people are scratching their heads wondering how there can be social instability when unemployment is so low and growth is steady if not spectacular.  This is how.  Rising taxes, less service, less opportunity.

Illinois is yet another can that’s been kicked down the (pot-holed) road for a long time.  But it may end up being the catalyst that focuses the markets in general on credit risk and on excessive debt levels.  That’s right.  It may not be China.  It may not be a big corporate deal that goes bad.  It might not have to do with the circus of geopolitics.  It might not be the debt ceiling negotiations.  It might just be Illinois, the guy that couldn’t pay his snow debt.

The early part of the week is quiet, dominated by a few Fed speakers.  Dudley on Monday at the Business Roundtable 8:00am.  Evans in the evening (inflation’s too low).  Fischer at 3:15am on Tuesday.  Kaplan at 3:00 pm.  The Fed will release Dodd-Frank stress test results Thursday, June 22 at 4:30.



6/9/2017 6/16/2017 chg
UST 2Y 133.5 131.5 -2.0
UST 5Y 176.1 174.3 -1.8
UST 10Y 219.7 215.5 -4.2
UST 30Y 285.4 278.1 -7.3
GERM 2Y -72.9 -65.8 7.1
GERM 10Y 26.4 27.6 1.2
JPN 30Y 82.1 81.4 -0.7
EURO$ Z7/Z8 31.0 28.5 -2.5
EURO$ Z8/Z9 22.5 22.0 -0.5
** EDZ7/Z8 now peak 1-yr
EUR 111.97 111.98 0.01
CRUDE (1st cont) 46.15 44.97 -1.18
SPX 2431.77 2433.15 1.38
VIX 10.70 10.38 -0.32




Posted on June 18, 2017 at 11:45 am by alexmanzara · Permalink
In: Eurodollar Options

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