Lift the curtain and act the play
December 13, 2020 – Weekly comment
Lift the curtain and act the play
Weekly Comment – December 13, 2020
Alex Manzara/ RJO-Interest Rate Strategy and Execution/ amanzara@rjobrien.com
The final FOMC meeting of the year takes place this week. Does it make any difference? Oh there’s going to be some additional chart information immediately released with the Summary of Economic Projections rather than that data being delayed three weeks. There will perhaps be changes in bond buying composition. But for the most part, it’s just shuffling chairs around the deck.
I think there could be parallels between the current environment and the taper tantrum which followed Bernanke’s comments in Congressional testimony May 22, 2013. Not in terms of an instant bond sell off, but more in terms of a longer term earth-shaking reaction to the hubris of global central bank control. From a Reuters piece, here’s the May ’13 quote and its outcome:
“If we see continued improvement and we have confidence that that’s going to be sustained then we could in the next few meetings… take a step down in our pace of purchases.” Bond yields rocketed higher and stock prices dropped. Financial conditions over the ensuing months tightened, surprising the Fed.
This week I reviewed the transcript of the FOMC meeting just before that event, which sparked that jump in yields – from late May to Sept the 10-year yield went from 2% to 3%. A surprising amount of commentary at that meeting concerned the BoJ’s expansion of its QE program. Here’s Simon Potter:
Meanwhile, equity gains in Japan were particularly pronounced, with the TOPIX up over 11 percent in local currency terms in response to the BOJ’s new measures aimed at ending Japan’s persistent history of deflation. Specifically, the BOJ will now seek to achieve 2 percent inflation within two years by doubling the monetary base by the end of 2014, mainly through a sharp increase in purchases of longer-duration Japanese government bonds (JGBs).
There it is again, the elusive holy grail of 2% inflation being discussed seven years ago, through the mechanism of long-term bond buying. And there it is again, a liquidity boost directly injected into stocks. The definition of insanity. Potter continues:
While investors were expecting some shift of purchases to longer-dated JGBs, the size of the shift was significantly larger than had been expected. ..yields on 10-year and 30-year JGBs initially declined 12 to 30 basis points. Subsequently, JGB yields have retraced, though, on net, 10-year and 30-year yields remain 15 to 30 basis points below their late-February levels, when expectations for longer-duration asset purchases began to firm. There is likely a range of contributing factors to the retracement, though it is difficult to quantify them or even rank their importance.
You squeeze on one part of the liquidity tube of toothpaste and it bulges somewhere else. You want it to come out of the tip and be deposited on the toothbrush where it can do some beneficial work. But if the cap is on it just moves around. Former Dallas Fed President Fisher had this to say in the meeting:
I just want to reiterate my mantra: Unless fiscal and regulatory policy incents business to use the cheap and abundant capital we’ve made available, it will not be used to create jobs to the degree that we desire. It will be used to set the stage, but it cannot lift the curtain and act the play.
There was an interesting statement by Rahm Emanuel after he was installed as mayor of the City of Chicago following his stint in the Obama administration. “I don’t create jobs. I create the environment, the atmosphere and the platform for success in the private sector.” [which creates jobs]. The Tribune article of May 13, 2013 from which this quote is taken has this additional snippet: “Setting the stage for job growth has been a major component of Emanuel’s agenda, including development of a 10-point plan, the wooing of 14 company HQ’s and the launch of programs aimed at cutting city red tape.” When Emanuel was Obama’s Chief of Staff, it was all about political infighting: ”You never want a serious crisis to go to waste.” But as a big city mayor, it’s all about delivering jobs and services and infrastructure and incenting the private sector. At least it used to be. I hope he joins the new administration to lend that perspective.
Amazingly, it was Kocherlakota that was spot on in terms of anticipating the market reaction to a hint of tapering:
The Committee raised the target at the June [2004] meeting by 25 basis points, and then proceeded to do the same at the next 16 meetings before stopping two years later. The parallel in the current circumstances is that tapering would be the first step of the exit process and would be followed in relatively short order by the Committee’s raising the fed funds rate. These types of beliefs mean that there is a risk that any tapering of our purchases could be seen as the signal of a rapid decrease in the level of accommodation, and it follows that tapering could generate a much sharper tightening of financial conditions than we currently anticipate.
Fast forward to 2020. The central bank playbook is now all about controlling bonds, though it is shifting more focus on currency movements as Lagarde alluded to on Thursday. Here’s a clip from Bloomberg’s ‘5 things’ on Friday:
The European bond market is all but dead. The latest action from the ECB – which has extended its pandemic bond buying program and added another 500 billion euros – is another nail in the coffin. Even before Thursday’s decision, investors were feeling muscled out of the market. Volumes in bund futures have slumped more than 60% since the ECB started buying bonds and yield ranges have collapsed across the region… The ECB will own roughly two-fifths of each of its two largest sovereign markets, Germany and Italy, by the end of next year…
Of course, the BoJ has further extended asset ownership, becoming the biggest owner of the nation’s stocks with a portfolio of 45.1 trillion yen ($434 B) surpassing holdings of the Gov’t Pension Investment Fund (BBG). None of it seems to be generating self-sustaining growth or consistent 2% inflation. (So let’s do more).
The Central Banks have accomplished the goal of sucking the life out of interest rate markets. Below is a table of CME Group open interest in selected interest rate products. It shows declines across the curve, although the positive changes in blue and gold euro$ midcurve options (E3 and E4) indicate a pulse after 2 to 3 years in the ZLB desert. A decline of 25% in five year futures open interest when the government is running gargantuan deficits? Sure, the Fed will buy that stuff, and yields won’t move.
| CME OI | 12/10/2020 | 1 yr ago | % change | |
| ED FUTS | 10.153 | 12.486 | -18.7% | |
| TY FUTS | 3.229 | 3.679 | -12.2% | |
| FV FUTS | 3.176 | 4.257 | -25.4% | |
| TY OPTS | 2.358 | 3.676 | -35.9% | |
| ED OPTS | 24.542 | 46.592 | -47.3% | |
| E0 | 2.793 | 7.875 | -64.5% | |
| E2 | 2.780 | 3.693 | -24.7% | |
| E3 | 3.375 | 1.821 | 85.3% | |
| E4 | 0.215 | 0.085 | 152.9% |
When I was on the CBOT floor ages ago, standing in front of the 30 year bond pit, which was then the most heavily traded interest rate contract, I used to watch the Dean Witter desk at around 10:35 to 10:40 a.m. Why then? Because that was Fed time, when the Fed engaged in matched sales or repos. John Fife at that desk would invariably flash large orders into bonds which were based on these Fed actions. There were no announcements. If the Fed unexpectedly did matched sales, it could be a signal of tightened policy. Dealers had dedicated “Fed watchers” to interpret the actions of the desk. Now, as Frances Donald at Manulife said on a BBG interview Friday, the central banks are concerned with climate change, racial diversity and affordable housing. My question is whether continually communicated guidance on central bank policy, leading to complacent certainty on rates and stocks, is valuable economic dynamics. Is the hand a little TOO visible? Could it lead to unexpected outcomes, as Kocherlakota prophesied?
Donald forecasts weaker upcoming labor numbers, followed by a jump in official inflation data by April as base effects kick in. She thinks the market will look past those numbers, but still suggests wildly asymmetric inflation outcomes between goods and services.
https://www.bloomberg.com/news/audio/2020-12-11/surveillance-fixed-income-with-holland-podcast
The markets convey valuable signals, and their unfettered functioning provides for both profit and risk mitigation. These days the Fed worries about “smooth functioning” of markets, but seems to have relegated risk signals to the back seat. However, surges in industrial metals and other commodities suggest that liquidity is seeping out to unexpected places.
OTHER MARKET THOUGHTS/ TRADES
Door Dash and Airbnb went public this week with a combined valuation somewhere around $160 billion. It’s not the food delivery service that has value, it’s the coding that optimizes every aspect of that service with a recurring revenue stream. Airbnb isn’t selling hotel rooms, it has harnessed technology to allow individuals to monetize their real estate for lodging. Bitcoin has a current market cap of about $350 billion. It’s the value of the code. Of course, at one time radio was all the rage:
In the five years prior to the Great Crash of 1929, RCA stock soared from about $11 to its September 1929 high of $114 (adjusted for the 5 for 1 stock split in February of that fatal year). That’s an appreciation of 936% in only five years — equal to an annual compound return of a monumental 60%. Also unbelievingly incredible was the fact it never paid a cash dividend! Investors didn’t care, since the stock value increased almost daily. At its 1929 peak RCA boasted an astronomical price/earning ratio of 72:1. By 1931 it was $10.
Short end yields declined fairly sharply last week. EDH1 +3.5 from 9979.5 to 9983.0. EDH2 +5.0 from 9976.0 to 9981.0 and EDH3 +6.0 from 9966.5 to 9973.5, as Mark Cabana from BofA suggested that a huge balance in the Treasury’s General Account could lead to a lack of t-bill supply with yields going negative in the first part of the year. The Fed would likely prevent SOFR from going negative. The two-year yield fell 3.2 to 11.9 bps, and the thirty year bond declined 10.6 to 162.4. I wouldn’t be surprised to see a rebound in long end rates following the Fed meeting.
Given the yield declines this week and the prospect for higher official inflation numbers, again look to blue or gold June midcurve puts. The expiration of December will serve to make these more liquid.
| 12/4/2020 | 12/11/2020 | chg | ||
| UST 2Y | 15.1 | 11.9 | -3.2 | |
| UST 5Y | 42.1 | 35.9 | -6.2 | |
| UST 10Y | 97.2 | 89.1 | -8.1 | |
| UST 30Y | 173.0 | 162.4 | -10.6 | |
| GERM 2Y | -74.7 | -78.3 | -3.6 | |
| GERM 10Y | -54.7 | -63.6 | -8.9 | |
| JPN 30Y | 65.0 | 61.1 | -3.9 | |
| EURO$ H1/H2 | 3.5 | 2.0 | -1.5 | |
| EURO$ H2/H3 | 9.5 | 7.5 | -2.0 | |
| EURO$ H3/H4 | 30.5 | 29.0 | -1.5 | |
| EUR | 121.21 | 121.12 | -0.09 | |
| CRUDE (active) | 46.26 | 46.57 | 0.31 | |
| SPX | 3699.12 | 3663.46 | -35.66 | -1.0% |
| VIX | 20.79 | 23.31 | 2.52 | |
https://www.federalreserve.gov/monetarypolicy/files/FOMC20130501meeting.pdf
https://www.bloomberg.com/news/audio/2020-12-11/surveillance-fixed-income-with-holland-podcast
