June 19. Every new beginning comes from some other beginning’s end…

Crunch time for Brexit, with the IMF declaring such an event will permanently lower UK incomes.  Is that a certainty?  The institutional ‘remain’ camp is injecting fear wherever possible.  As Doug Noland wrote, “The Brexit vote is a serious potential “risk off” catalyst. Significant amounts of currency and risk market hedging have transpired. This portends a period of unstable markets.”  Now, it’s either an unwind or a whole new set of market dynamics; prices have to move.

In some ways, this particular time was odd for Bullard to release his new framework for the St Louis Fed.  He pretty much threw in the towel on the idea of central bank forecasting.  He’s like the guy with bad investing results that goes in to see a financial advisor.  The advisor says, “Look, you’re never going to able to time or forecast the market.   You have the classic emotional behavior of selling at the low and buying at the high.  Just accept that there’s some volatility and buy indexed funds.” (So he pours his money into the SPX at the top, avoiding bonds, commodities, etc).  Recall, it was Bullard who wanted rate hikes, but whenever the stock market sold off, he was the first one to say ‘hey, maybe we should wait’.  Now he’s come up with the idea of “regimes”, which “are generally viewed as persistent”.  He says that the Fed can identify the current environment, but can’t forecast into the future.  So we’ll just call the current state of low rates, modest growth and low productivity a “regime” and project those same conditions out into the future.  I’ll just shift my dot down to reflect no more rate hikes, et voila, now you won’t have James Bullard to kick around anymore.

One of the problems of course, is that the Brexit vote could be a game changer, and has already had the effect of focusing the market on the next possible dislocation in Europe.  This may be the time when central bankers and other institutions have to make difficult decisions about what the future might look like and how to counteract extreme volatility.  And it’s not just the EU; China’s depreciating currency is on the back burner.

In a way, Bullard’s essay echoes Greenspan’s thoughts.  Paraphrasing…”the Fed alone can’t say that markets are in a bubble, because the market is comprised of the collective wisdom of a huge number of participants.  IF there’s a popped bubble, the Fed has the tools to mop up.”  The current issue is that the Fed, the ECB, the BoJ have all used their tools, and the last and best one, that of instilling confidence in the markets, has been revealed as a man pulling levers behind a curtain.  However, one of the most widely respected central bankers who DID steer a prudent and influential path, India’s Raghuram Rajan, has announced he’s stepping down, apparently partially due to political pressures.  An academic who understands the markets…we could use him here.

There are many analysts, including some Fed members, who feel that the economy has become too dependent on an endless stream of support from monetary accommodation.  We need a little tough love for the kid who has come home from college and stays for the next eight years.  It reminds me of the scene in Wedding Crashers, with Will Ferrell as Chazz, the guy who lives at home: “hey Ma, the MEATLOAF!  We want it NOW!” and as an aside to John Beckwith “I just never know what she’s doing back there.”  That’s the market to Janet Yellen.  We want more meatloaf.  “I’m just livin’ the dream.”

This week Yellen testifies in front of Congress.  I doubt that she will give an endorsement to Bullard’s framework, but the dovish shift to a lower terminal rate has already been enunciated at the FOMC press conference.

How does that leave markets?  Gold is at the high of the year, just over $1300.  VIX is elevated, having closed at 19.4 on Friday.  The ten year treasury hit a new low yield of just over 1.5% on Thursday, before backing off Friday.  Implied vol in treasuries hit a new recent high.  The German bund traded negative for the first time.  Early on, we had said that buying treasury calls was the easiest and ‘cleanest’ way to hedge against Brexit risks.  That trade played out, and it’s now about how to capture the unwind and determine the magnitude of reversals if the ‘remain’ vote wins.

The first ten one-year Eurodollar calendar spreads closed between 18.5 and 21 on Friday.  The curve is amazingly flat, and can barely be called a “curve” because it’s damn near linear.  Back in February, with near panic lows in stocks, oil and high yield bonds, the near one year spreads were around 16 to 18 bps (i.e. the 1st to 5th or 2nd to 6th quarterlies).  The reds to greens were more like 28-30 bps.  In other words, the front one-yr butterflies were around -10.  Now, the one-yr flies are around zero.  For example, EDU16/EDU17 closed at 21 and EDU17/EDU18 at 19, so the fly settled at +2.  What changed?  The reds to greens absolutely cratered.  As a pack spread, I marked reds to greens at just 18.75 Friday, and during the week there was a close below 17 bps!

Over this timeframe, from February to June, oil generally firmed, as did stocks.  So it is surprising that the back end of the curve has flattened, but the idea of declining inflation expectations and lower term premium has worked its magic.  I would also argue that both stocks and the long end of the US curve have benefitted from safe haven flows, and that BOTH have a chance for substantial pull backs on a remain vote.

Note that in 2012, when Europe was pulling apart, the front one year butterfly was well negative except for a period in March, when it traded around +6.   In July 2012, when Draghi said “Whatever it takes…” the fly was around -9.  I would think that selling flies is one of the few trades that might work out either way in terms of Brexit, though the first reaction on the status quo will be to ratchet up odds for a September Fed hike (current odds are only about 15%, with Aug/Oct FF spread closing at 3.5).

Posted on June 19, 2016 at 11:43 am by alexmanzara · Permalink
In: Eurodollar Options

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