Long Shots
May 8, 2022 – Weekly Comment
__________________________________
You got no time for the messenger
Got no regard for the thing that you don’t understand
You got no fear of the underdog
That’s why you will not survive
–Spoon – The Underdog
Coming into the stretch, Rich Strike was in twelfth place. He was at least five lengths behind the pack.
Usually, I’m trying to pull together a few threads of market action to weave a view on sentiment and determine reasonable odds for various future scenarios.
Instead, I’ve watched about 20 re-runs of the Kentucky Derby. Rich Strike was only entered into the Derby when Ethereal Road scratched. At the start of the race he was near dead last. At the blazing half-mile mark he’s 15th or 16th and has a triangle of horses in front of him. Out of the turn, jockey Sonny Leon made a move to the inside, but was still five lengths behind Messier (who was hugging the rail) and was also trailing six other horses on the outside. With about fifteen seconds left he had astonishingly made up about four lengths and was on Messier’s tail, but easily a length behind Epicenter. Rich Strike took a quick right shoulder check and found daylight between Messier and Epicenter. Boom. Messier immediately faded at the challenge. Rich Strike actually took a sidelong glance at Epicenter as he raced toward the leader’s left flank with about eight seconds left. Then he just put his head forward and turned on the afterburners. “OH MY GOODNESS, THE LONGEST SHOT HAS WON THE KENTUCKY DERBY!” Epic. That must have been the fastest stretch ever.
We’ve lived through a couple of years of long shots and miscalculations. We’ve seen options that might have appeared rich, which languished for a while and then surged to unimaginable levels. About a month ago I had a friend tell me that Dec’23 500 calls were being quoted in WTI futures at about 50 cents. I misheard the year at first, and thought he meant Dec’22. The highest strike I could find on Dec’22 was the 300 call, and I have kept it on my board ever since, watching it hold at around 30 cents even as weeks have passed. On Friday CLZ2 300c settled 0.35 with open interest of 379. CLZ2 250 calls settled 0.59 with 1309 open contracts. That’s the highest settle of the year for CLZ2 300c, the low has been 0.21. While the front contract CLM2 is not at a new high for the year, settling Friday at 109.77, CLZ2 did post a new high settle of 98.73. The point of course, is that the price of fear has again taken its rightful place in this environment…but not across every market.
The event of the week had to be Powell at the FOMC press conference saying that the committee is not actively considering a 75 bp hike. On May 3, the 2/30 treasury spread was 22.2. By Friday it was 50. Front end Eurodollar vol was pasted as the market removed the most aggressive forecasts of policy trajectory. On May 3, EDM2 9812.5 straddle was 21 vs 9810, on Friday it settled 9.5 vs 9816, so it lost more than half its value. The EDU2 9725 straddle was 62.0 vs 9725, and on Friday EDU2 9737.5 straddle settled 42.0 vs 9735.0 (the 9725^ settled 43.5). Red/gold pack spread settled -17, having been -87 at the start of April. So the curve steepened and front end vol declined. However, long end vol remained rather well bid. And, after the Chairman just said that 75 is off the table, Richmond Fed President Tom Barkin opined that “nothing is off the table” when asked about the possibility of a 75 bps hike in an MNI Interview on Friday. Now both Bullard and Barkin are on the “ignore” list in terms of policy.
Also on Friday, Fed Governor Chris Waller gave an interesting post-mortem speech, ‘Reflections on Monetary Policy in 2021’, describing the range of opinions on the committee couched against the Fed’s dual inflation/employment mandate. He essentially argues that those claiming the Fed “was behind the curve” are armchair quarterbacks; he defends the idea that the Fed made appropriate real-time choices in moving towards a more hawkish stance. He backs his argument with data releases. My takeaway, while I respect the main theme of the speech, is that the Fed has become a much more reactive rather than proactive institution. The Fed is perhaps less sensitive to (and cognizant of) policy lags.
It’s pretty clear that rate increases are going to make car leases and loans more expensive, and home loans more expensive. Final demand will unequivocally be reduced. According to the Nat’l Association of Realtors, the high median home price in 2019 was $285,000. The current figure is $375,000. So, in 2019, with a home price of $280k, a 30-yr loan at 3.75% and 20% down, the mortgage amount of $228,000, yielded a monthly payment of $1056. In 2021, at $363k and a mortgage rate of 3% with 20% down, the monthly payment is $1234, so only $178 more per month, even as the house price increased by 29%. However, at this year’s median price of $375k, with 20% down and 5.25% mortgage, the monthly payment is $1656. That’s $432/month higher than last year, or 35% more, and it also required an additional $2500 for the down payment. In this new scenario, the homeowner pays down just under $14000 in principal over the first three years. If the price of the home declines back to median price in 2021, it’s a reduction of $12000, just about the same amount as the paid-up principal reduction. What does that do to demand? Might as well rent.
On the chart below, the white line is the Median Existing Home price, and amber is the 30 year conventional mortgage rate, as of 2010.
The chart below, which shows the decades long bull market in bonds (shown in terms of yield, log scale) doesn’t suggest immediate relief in the march to higher rates. The most recent high in 2018 was 3.45%, versus the current 3.22%. If 3.45 is taken out, then we will have clearly shifted to a pattern of higher lows and higher highs.
Five years ago in June 2017, then Fed Chair Janet Yellen said banks were much stronger than before, and that she did not believe there would be another financial crisis in our lifetimes. While the US banking sector appears robust, a financial crisis could be very close. Indeed, a BBG interview with Jamie Dimon on May 4 was illuminating. He’s obviously worried about energy and advocates a national (western) industrial/energy policy. Here are a couple of interesting quotes: “The Fed’s job would be easier if we had rational thoughtful economic policy…” “…global energy is precarious. And if oil goes to $185 it’s a huge problem for people and we should do everything we can today. We need to pump more oil and gas…” His point is that we need to cooperate and prepare right now for the possibility that things get much worse. “National security is the most important thing.” “I don’t think a slowdown in the global economy is a disaster…but I think potential outcomes in Ukraine are.” In listening to Dimon, it’s mostly about taking prudent steps to protect against the worst outcomes while hoping of course, that they don’t occur. He’s metaphorically buying the rich strikes. Think CLZ2 300 calls.
OTHER MARKET THOUGHTS/ TRADES
This week features several Fed speakers on Tuesday. NFIB Small Business Optimism plunged to 93.2 last; it’s released on Tuesday and could test the 2020 low of 90.9, which would instantly elevate the stature of the report. Wednesday and Thursday bring CPI and PPI with headline yoy on CPI expected 8.1% from the eye-popping 8.5 last. Core expected 6.0 from 6.5.
Auctions feature 3s, 10s and 30s Tuesday, Wednesday and Thursday. I would expect a bit more of a concession in the early part of the week, with the prospect of lower inflation numbers providing midweek support.
| 4/29/2022 | 5/6/2022 | chg | ||
| UST 2Y | 269.6 | 271.6 | 2.0 | |
| UST 5Y | 291.6 | 304.0 | 12.4 | |
| UST 10Y | 288.7 | 312.1 | 23.4 | WI 311.2 |
| UST 30Y | 294.7 | 321.8 | 27.1 | WI 319.2 |
| GERM 2Y | 26.1 | 32.0 | 5.9 | |
| GERM 10Y | 93.8 | 113.2 | 19.4 | |
| JPN 30Y | 96.2 | 100.8 | 4.6 | |
| CHINA 10Y | 284.0 | 283.0 | -1.0 | |
| EURO$ M2/M3 | 168.5 | 175.0 | 6.5 | |
| EURO$ M3/M4 | -39.0 | -30.5 | 8.5 | |
| EURO$ M4/M5 | -16.5 | -8.5 | 8.0 | |
| EUR | 105.46 | 105.48 | 0.02 | |
| CRUDE (active) | 104.69 | 109.77 | 5.08 | |
| SPX | 4131.93 | 4123.34 | -8.59 | -0.2% |
| VIX | 33.40 | 30.19 | -3.21 | |
