October 19, 2020 – Weekly comment

The Fed’s Vice Chair for Supervision Randal Quarles, gave remarks last week about the financial system’s response to the “COVID event”.  The main purpose of the speech was, I think, to explain the decision to extend the share buyback suspension and continued limitation of dividends for banks in order to preserve capital.  He noted that additional rigorous stress tests had been applied to the system.  Importantly, he said, “For monetary policy to fully support Main Street we need a well-capitalized stable banking system that is lending to credit worthy households and businesses.”   He noted that the Fed “temporarily” exempted Treasury securities from the Supplementary Leverage Ratio so that banks could absorb [massive] and growing treasury issuance.  It seems to me that an unsaid necessity of this strategy is a reasonably positive sloped curve, so that banks can generate income to fortify capital. 

He also said that the non-bank financial intermediation (NBFI) sector is now almost 50% of total financial intermediation, and alluded to increased macroprudential tools to contain fall out from adverse events. 

My point in bringing this up is that as the curve has become tilted in favor of a steepening bias, there is some concern that the Fed could still step in with YCC and arrest a possible march to higher yields.  I think that Quarles’ speech indicates the Fed would tread lightly with this option.  Clearly, financial shares have been a huge market underperformer.

In terms of macroprudential policies, several Fed officials have referred to excessive risk-taking recently, notably Boston Fed’s Rosengren over the weekend in comments to the FT:  “If you want to follow a monetary policy …that applies low interest rates for a long time, you want robust financial supervisory authority in order to be able to restrict the amount of excessive risk-taking occurring at the same time.”  SF Fed’s Mary Daly earlier in the week said much the same thing to the Washington Post when asked what was at the top of her list in terms of unintended consequences from the Fed’s actions.  She said the Fed took action to settle financial markets, but financial markets “get a sense that things are better than they are” so the Fed must be mindful of excesses. 

I’m not sure that this nervousness about financial stability and stock speculation given the Fed’s vow to keep rates low is permeating the thoughts of all policy makers, but it seems to have gained traction.  Chicago’s Evans recently said that keeping rates low even as inflation increases may be “uncomfortable”.  In a way, the Fed may welcome an increase in yields at the long end of the curve to do the heavy lifting in terms of providing a brake on equity speculation with an increasingly competitive return.  In any case, we are likely moving towards a heavier regulatory hand to counter the looseness of short end rates.

On Monday Clarida speaks on the Economic Outlook and may give more of a clue on the macroprudential front.  On Tuesday Quarles speaks again on Financial Stability.  Beige Book is released on Wednesday.  Prior to that, treasury auctions $22 billion in 20-year bonds on Wednesday, followed by $17 billion in 5-year tips on Thursday.   Monday is the anniversary of October 19, 1987, Black Monday, when the Dow Jones Industrial average plunged 22.6%.


Both Philly Fed and Retail Sales were much stronger than expected last week.  New business formations are soaring. Cass Transportation reports that North American Freight volumes are back near 2019 levels.  The US Federal Budget Deficit was an astounding $3.1 trillion in fiscal 2020, with more to come after the election. 

There continues to be heavy volume trade in 3EH1 puts (blue March midcurves).  The large core trade is -3EH1 9975/9987.5 call spread vs +3EH1 9912.5/9900 put spread.  Call spread settled 1.0 and put spread 1.25 vs EDH’24 9950.  The 9925/9912.5 put spread alone settled 2.25 which is a nice simple trade on its own, risk 2.25 to make 10.25.  The call spread vs put spread total is around 160k, primarily done at pay 0.25. 

The libor/SOFR transition is scheduled for the end of 2021.  I’ve not followed this as closely as I should have, but apparently the switch to using SOFR as a discounting mechanism on swaps went smoothly on Friday.  In any case, the eventual shift has been noticeable in pricing on the Eurodollar curve.  For example, as shown on the chart below, EDZ1/EDH2/EDM2 three-month butterfly has rallied from -3.0 to +2.0 over the past month.  Any ‘turn’ effect on EDZ21 associated with credit concerns embedded in libor has been priced out.  EDU21 to EDZ21 settled +3.5 and EDZ21 to EDH22 settled 3.0.  This is also the case with the Dec’23 contract. 

UST 2Y15.114.3-0.8
UST 5Y33.331.7-1.6
UST 10Y77.274.2-3.0
UST 30Y157.4152.7-4.7
GERM 2Y-71.4-77.5-6.1
GERM 10Y-52.7-62.2-9.5
JPN 30Y63.261.6-1.6
EURO$ Z0/Z1-0.5-1.0-0.5
EURO$ Z1/Z29.58.0-1.5
EURO$ Z2/Z315.514.5-1.0
CRUDE (active)40.9141.120.21

Posted on October 18, 2020 at 8:40 am by alexmanzara · Permalink
In: Eurodollar Options

Leave a Reply