June 7. Weekly summation

WEEKLY COMMENT

Themes:

Week to week changes on selected prices:

5/29/2015 6/5/2015 chg
UST 2Y 60.7 71.7 11.0
UST 5Y 148.6 173.7 25.1
UST 10Y 218.0 240.0 22.0
UST 30Y 288.2 311.1 22.9
GERM 2Y -22.5 -17.8 4.7
GERM 10Y 48.7 84.4 35.7
EURO$ Z5/Z6 * 79.5 90.5 11.0
EURO$ Z6/Z7 56.5 68.0 11.5
*peak one-yr spd
EUR 109.86 111.14 1.28
CRUDE (1st cont) 60.30 58.94 -1.36

 

The employment report was stronger than expected with NFP +280k at a rate of 5.5%. From DB’s Torsten Slok: “…over the past 12 months the Employment Cost Index has been trending higher and we are now also seeing avg hourly earnings growing at the fastest rate in five years.” Avg hourly earnings were +0.3%, with yoy +2.3, but in the past three months an annualized rate of 2.9%.

As can be seen from the above table, yields surged this week, with the 5yr up ¼% to 173.7 (9.6 of that rise was Friday). The belly of the curve led the way to higher yields. 2/10 treasury spread rose an impressive 11 bps on the week to 168.3, though it fell a couple of bps Friday as the market priced more certainty into a September lift off. October Fed Funds settled 99.725 which is 14.5 bps higher than the front FFM5 contract settle of 99.87. So the FF contract indicates approximately 60% odds of a hike in September, as does EDM5/EDU5 spread at a settle of 15.0; EDM5 99.71 and EDU5 99.56. Given Friday’s data and Thursday’s Productivity of -3.1% with Unit Labor Costs +6.7%, I would put the odds of a September hike higher, though perhaps the IMF’s plea for the Fed to hold off until 2016, and EM currency weakness (more on that below) is giving the market pause.

It’s not just the US that is seeing stronger inflation data. On Tuesday the Bund yield jumped 17 bps to 71 as EZ CPI was released at +0.3% vs +0.2 expected with yoy Core +0.9% vs 0.7 expected. Other EU bond yields also jumped, for example Italy rose 15 on Tuesday to 212. The surge in German yields has been breathtaking with a close Friday of 84 bps (having neared 100 bps on Thursday), from a low of 7.5 in April. JGB’s have also broken out of a long term trend, closing near 50 bps from a low around 20 at the beginning of the year.

US companies are clearly increasing debt issuance to take advantage of low rates before the window closes. In the first five months of 2015 the monthly average issuance of IG debt was $118.3b, versus $102.3 in the first five months of 2014, an increase of 16%. On the HY side the gain was 5.4% from a monthly rate of 29.5 in 2014 to 31.1 in 2015. (Data from SIFMA). This is another factor weighing on rates. On a related note both HYG and JNK (hi-yield ETFs) had downside breakouts this week, with both closing at lows last seen in February and March when concerns about energy companies had hit their peaks as crude oil was at its lows, sub $50.

Adding to the sense of trend change in global bond yields is a perhaps subtle shift in central bank communication. Draghi, (not so subtly) said “Markets must get used to periods of higher volatility.” In his speech on June 1, Stanley Fischer said, “…it is not clear that there are sufficiently strong macroprudential tools to deal with all financial instability problems, and it would make sense not to rule out the possible use of the interest rate for this purpose, particularly when other tools appear to be lacking.” FRBNY William Dudley said in a speech on Friday, “…lift-off may not go so smoothly in terms of the impact on financial asset prices. After all, lift-off will represent a regime shift after more than six years at the lower bound.” He goes on to say “…there must be considerable uncertainty about the path for short term interest rates. After all, the economic outlook is uncertain.” The message seems to be that central banks are willing to accept more turbulence in financial markets going forward. If true, and it’s a BIG if, then it’s clearly a game changer in terms of psychology.

Given the increasing odds for the Fed to hike rates this year, perhaps it’s not too surprising that emerging currencies are seeing renewed weakness against the dollar. For example, the Mexican Peso made a new low, as did the SA Rand, and Indonesian Rupiah. Even the yen made a new recent low, with JPY 125.6. However, the euro ended higher on the week versus the dollar, in spite of Greece upping the ante by deferring a June 5 payment to the IMF. Note that in 1998 there was also severe weakness in emerging market currencies and a 50% drop in the price of oil, and in late summer of 1998 the SPX fell 20%. http://www.traderplanet.com/commentaries/view/168117-warning-similarities-between-1998-and-2015/ Both Brainard and Dudley mentioned dollar strength and its restraint on inflation in speeches this past week.

A client on Friday asked for odds on that there could be a mini-panic in red and green Eurodollars (2nd and 3rd years). I would note that the five year treasury faces extremely strong resistance around the 180-185 yield level, which is only 7-12 bps from here. (There have been several highs between 180 and 185 since September 2013.

FIVE YR RESISTANCE 180-185

FIVE YR RESISTANCE 180-185

 

Additionally, from the perspective of possible rate hikes at Fed meetings, I would note that the peak one year spread (EDZ15/EDZ16) is below 100 bps at 90.5, indicating less than 4 hikes of 25 bps per year. Second, if the Fed were to hike in September and December and every quarter going forward, then by September of 2016, there would have been 5 rate hikes, perhaps up to 1.25-1.50%. EDU6 is 9869 or 131 bps, a level consistent with a FF target of around 1%. That leaves downside room of course, but not a tremendous amount. The other clue concerning limited downside comes from the underperformance of otm puts. For example, consider 0EZ 9850/9800 put 1×2. On Thursday, this structure settled 7.0 (20.5/6.25) with 10 delta against a futures price of 98.55. On Friday, with futures down 9 bps to 98.46, it settled 9.25 (and was better bid interday). In other words, with a 10 delta it should have moved about 0.9 tic, but was actually up 2.25, showing underperformance of otm (98.00) puts.  Similar in FV. For these reasons, downside in the first 2 ½ years or so should be limited, or at least that’s what the market is saying. Note as well that 2016 is an election year, so if the Fed is sensitive to political pressures, then the actual pace of tightening might well be slower than otherwise. Additionally, Janet Yellen is skipping the August 25-27 Jackson Hole symposium sponsored by the Kansas City Fed.

On a technical note, the thirty year bond closed just above halfway back (in yield) of the move from the high in 2014 of 397 to the low in 2015 of 222. 50% is 310, and the close was 311. The 61.8 retrace is 330. In tens, the halfway back point is 233.5, and 61.8 is 250. Friday’s close was 240.

 

Posted on June 7, 2015 at 8:03 am by alexmanzara · Permalink
In: Eurodollar Options

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