Lifting the Lid. Weekly comment, Jan 14, 2018

Last week I discussed Dudley’s definition of financial conditions in conjunction with some old Powell quotes, and concluded that a Powell Fed might be more inclined to tighten financial conditions by, for example, stepping back from the Fed put. The idea is that one of the Fed’s goals should be to make sure currently benign conditions don’t sow the seeds of amplified future instability.  The Fed forced a move into risk assets post-GFC; now it must attempt to gracefully inject risk pricing back into the markets without lifting the lid of Pandora’s box.

Dudley, in a previous speech, defined financial conditions as being related to short and long term interest rates, corporate bond spreads, and the value of the dollar and equities.  It’s fascinating.  While short term rates have risen, rates at the long end have done very little.  The dollar fell throughout 2017 and on Friday neared a new low.  Corporate bond spreads are historically tight; the BAML Hi-Yield option adjusted spread closed at 340 bps according to the St Louis Fed, equaling the low of 2014 which itself was the lowest since 2007.  Equities have, of course, surged.  “The US mean value of wealth to GDP is 3.8, and I note that wealth is now in excess of 5 times GDP in the US; i.e. total wealth will have to drop 25–30% for equilibrium to be reestablished.” Niels Jensen.

Along with these factors, and obviously related, implied volatility is low across asset classes.   Some time ago I suggested that implied vol was like cartilage, providing cushion for the market’s bones.  In a larger sense, higher prices for risk, be they option premia, wider corporate spreads, a steeper yield curve, lower CAPE adjusted PE ratios, all provide a cushion.  Premium these days has lost its meaning, it’s been pounded flat, from Tiffany’s to the Dollar Store.

The natural world has provided numerous examples of sudden disasters over the past year, causing unexpected gov’t spending and increasing insurance premiums. However, the forward projection of markets is a permanently stable plateau.

Dudley gave another speech on Thursday.  He is resigning this year and has been a leading voice on the Fed; his departure is a loss for the institution.  He warned of a near term risk of overheating.  But perhaps of more interest were his long term concerns, specifically with regard to the nation’s finances.  Fed chairs at least since Greenspan have warned of unsustainability, but Dudley’s comments are worth citing.  Here’s a key quote (link to speech at bottom)

In fiscal year 2007, federal debt service costs totaled $237 billion on $5 trillion of federal debt held by the public.  By fiscal year 2017, although federal debt held by the public had nearly tripled to almost $15 trillion, debt service costs were $263 billion, only modestly above where they were 10 years earlier.  Over the past decade, the sharp decline in short- and long-term interest rates has kept a lid on debt service costs—that lid is now being lifted. 

Think about that: DEBT LEVEL WENT UP 3x and DEBT SERVICE COSTS WERE UNCHANGED.  Some might say, ‘Don’t worry about it, that’s why rates CAN’T go up’.  But here’s something else to put in your pipe and smoke: At the end of 2007 total business borrowings were $10.1tn.  As of Q3 2017 this amount is $14.1tn.  Obviously the growth rate is much lower (just under 4%), as the gov’t essentially transferred private debt into public hands during the GFC.  But the idea of stable nominal debt servicing costs over this ten year time frame still applies, and the lifted lid will still create a challenge.

Regarding gov’t finances (from a Goldman report): “… as a result of these factors [increased deficit from tax bill, treasury cash balance build, Fed balance sheet runoff] we expect net marketable borrowing to increase from $488bn in FY2017 to $1030bn in FY2018, and we expect a similar level of net borrowing in FY2019.  The increase in financing needs is likely to be addressed through increases in bill and coupon issuance.” [to be outlined at the Feb quarterly refunding statement at the end of this month]

Conclusion: higher rates on more debt in an environment of increased inflation, due to both tight labor markets and a weaker USD.

Now let’s shift to a note from Claudio Borio of the BIS, one of my favorite reads.  It’s not just government that expanded debt levels with the free lunch of lower rates.  It’s also the business sector, as noted above.  And here, the loss of cushion is a bit more nuanced.

Below are a few excerpts from Borio’s speech last week. (A blind spot in today’s macroeconomics?) Link at bottom.

…I will highlight the interaction between interest rates and the financial cycle and will also present some intriguing empirical regularities between the growing incidence of “zombie” firms in an economy and declining interest rates.

…not only do credit booms undermine productivity growth…they do so mainly by inducing shifts of resources into lower productivity growth sectors

Cyclical variations aside, the mean share of publicly quoted zombie firms across these economies has steadily trended up, from close to zero [in 1987] to above 10%…

Zombies are defined as companies that don’t generate enough profit to cover interest, are at least ten years old, and not in high growth businesses.  In essence Borio’s paper isn’t about the loss of cartilage, it’s the additional problem of increased fat.  But the key concept of mispricing due to CB policies is expanded. The issue with persistently low interest rates is that they allow misallocation of capital.  Then, when combined with the tsunami of passive investing, the idea of ‘value’ diverges from ‘price’.  Of course, if that’s the case, then one might say…”Great!  That’s what provides short sellers with stellar ideas!  That is, zombies that have been carried with the tide of indexed funds but whose fundamentals just don’t make sense.”  The fight has been with enormous liquidity provided by CBs, crystallized by the ECB’s Steinhoff episode. If the CBs directly and indirectly buy everything, then what’s the use of shorting?

However, the tide is shifting, the lid is lifting.  The Fed’s QT schedule is in place.  The ECB has cut buying and said that continued reflation may cause a change in forward guidance.  Japan is trimming longer term duration buys.  China has warned treasuries aren’t as attractive.  The US needs to issue more debt.  We have one rock of evidence piling up on another which could coalesce into a rapid shift in sentiment.


23-26 Jan.  Trump is going to Davos for the World Economic Forum.  A downbeat message for global trade?  From Politico: “The annual gathering …will be choking with the kind of people who disdain Donald Trump and genuinely regard his presidency as a menace to the planet.  In other words, exactly the kind of party Trump loves to crash.”

End of Jan (29th?) Treasury forward borrowing estimates, likely at the end of the month.

31-Jan.  FOMC meeting.

9-25 Feb. Winter Olympics in South Korea

4-March Italian elections

A FEW MARKET NOTES (Charts at bottom)

The dollar sold off throughout 2017 and closed near new lows on Friday.  A weaker dollar should work its way through to higher inflation.

All near Eurodollar contracts through Sept’21 made new lows on Friday.

The US 2yr yield closed just shy of 2%.

5/30 treasury spread made a new low for the move, ending just above 50 bps.  Lowest since 2007.

The German bund yield closed at 58 bps, testing a downward sloping trendline from 2008

WTI at new highs with CLG8 64.30.

Gold is testing resistance (1355-1375).  Above this level look for 1500.  Long suffering bulls have enviously watched bitcoin go parabolic.  Brethren in gold, the day is coming.

A great resource for Gold and gold forward rates is Monetary Metals.  The firm also pays interest in gold on gold deposits.  For more info contact Keith Weiner, CEO.

There was huge buying last week of EDM8 9787/9775/9762p fly, up to 1.75.  EDM8 9787p settled 2.0 and 9775p 0.25 ref 9797.0.  The 9787p now has 950k open interest.  This trade looks for hikes in March and June, with odds of March now priced over 85%.

Other trades targeting Fed hikes further out are also popular, for example, EDZ8 9750/9737/9725p fly, which settled 1.75 ref 9774.0.



1/5/2018 1/12/2018 chg
UST 2Y 195.8 199.8 4.0
UST 5Y 228.4 234.7 6.3
UST 10Y 248.2 255.0 6.8
UST 30Y 281.0 285.4 4.4
GERM 2Y -60.5 -56.8 3.7
GERM 10Y 43.9 58.1 14.2
JPN 30Y 81.5 83.0 1.5
EURO$ H8/H9 47.5 49.0 1.5
EURO$ H9/H0 14.0 15.5 1.5
EUR 120.32 122.00 1.68
CRUDE (1st cont) 61.44 64.30 2.86
SPX 2743.15 2786.24 43.09
VIX 9.22 10.16 0.94

*definition of “zombie firms” that the OECD has employed…firms that are at least 10 years old and whose profits (EBIT) are insufficient to cover interest payments.  Then they further refine the definition by restricting zombie firms to be those with comparatively low expected future growth potential, i.e. those that also have below median Tobin’s Q… the more restrictive definition is intended to excludes the Tesla’s of the world.

Posted on January 14, 2018 at 9:37 am by alexmanzara · Permalink
In: Eurodollar Options

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