March 25. Say… What’s THIS doing here?


Say…why’s the dollar getting pasted?  Say…why is this libor/ois spread so elevated?  Say…why is the back end of the Eurodollar curve so flat?  Why have stocks fallen out of favor?

There are a lot of market prices that don’t quite seem to make sense.  When a price appears to be out of whack, but it’s been there for a while, there’s usually a pretty good reason for it.  For example, last week I said, “One would think this [yield] widening should support the USD, and, the prospect of increased pressure on the short end could provide a further push.  However, think of the converse for a second.  What if something happens that causes the US front end to rally?  Then USD may be subject to another hard leg down.”  While the dollar didn’t go down hard, it certainly isn’t perking up, and it’s starting to appear as though weakness in equities could limit the downside in the front end.  Perhaps the real risk in USD is much, much lower.

I saw a note from a guy named Rick Bensignor titled SIF’s, which stands for Supposedly Irrelevant Factors.  This missive was presciently calling for a stock sell off, but what struck me was the idea of SIF, a term I hadn’t been aware of.  In the footnote, it says “SIF is a term…in the behavioral and economics world that is associated with the introduction of human psychology and emotions into financially related decisions.”  Though I wasn’t familiar with the term, we’ve seen the concept many times.  For example, Malcolm Gladwell’s ‘The Tipping Point’, or John Mauldin’s highlight of simulated sand piles which create hidden ‘fingers of instability’.  Below is a link and excerpt.  One grain of sand is ‘supposedly irrelevant”.

Imagine peering down on the [sand] pile from above, and coloring it in according to its steepness. Where it is relatively flat and stable, color it green; where steep and, in avalanche terms, ‘ready to go,’ color it red. What do you see? They found that at the outset the pile looked mostly green, but that, as the pile grew, the green became infiltrated with ever more red. With more grains, the scattering of red danger spots grew until a dense skeleton of instability ran through the pile. Here then was a clue to its peculiar behavior: a grain falling on a red spot can, by domino-like action, cause sliding at other nearby red spots. If the red network was sparse, and all trouble spots were well isolated one from the other, then a single grain could have only limited repercussions. But when the red spots come to riddle the pile, the consequences of the next grain become fiendishly unpredictable.

My thesis here is that red spots, or fingers of instability, are now riddling the economic (and political) landscape.  Whether one wants to concentrate on the myriad political comedies, or the financial ones, it’s quite plausible that we’re seeing the onset of tightened conditions and higher risk.  The libor/ois spread is an example.  I believe it will remain elevated and likely push higher, despite swap lines between central banks.  While the plunge in DB stock may not in and of itself presage a Bear Stearns (soon to culminate in Lehman) disaster, it’s interesting to note just how slender the capital base is for European banks.  All I can recall hearing over the years is that the European banking system plays a much bigger role in the EU’s financial world, and that one of the problems in the crisis was that EU banks were over-levered.  Well, even after hard sell offs this week, the combined market cap of JPM, BAC, WFC and C is over $1 T.  DB has a market cap of about $25B.  Throw in Lloyd’s and Barclay’s, BNP, SocGen and Credit Ag, UBS and CS, ING and Danske, Santander, BBVA, Intesa Sanpaolo, and the combined 13 banks reach about ¾’s of the market cap of the 4 US banks mentioned.

Jeffrey Snider of Alhambra is focused on weakness of the Hong Kong dollar and possible break of the peg.  Some are concerned about covenant lite agreements and the possibility that loan roll-overs won’t be easy.  A GS piece earlier in the week noted that dominant trading strategies of the day encompass “…more speed and less capital” and markets are thus vulnerable to illiquidity.  The Shanghai Composite gapped lower Friday; China is trying to tame the shadow banking system.  HYG and JNK hi-yld etfs had new low closes for the year (though they’re well above the lows marked in 2016 with the energy wash-out).

Powell’s Fed is concerned about over-heating and is trying to separate the stock market from the real economy.  Therefore, the posture of gradual tightening appears to be warranted.  For example, the NY Fed’s Underlying Inflation Gauge (UIG) continues to edge higher and was released this week at 3.06%.  However, financial conditions are cinching ever tighter.  The back end of the euro$ curve reflects this dynamic.  Reds to greens (2nd to 3rd year) closed just under 10 bps, greens to blues and blues to golds (3rd to 4th and 4th to 5th), both closed below 4 bps.  The red to gold pack spread settled just over 17, within 8 bps of the low set during the 2004/2006 tightening cycle.

In terms of front spreads, “Say…why are the peak one-year euro$ spreads below 40 bps if the Fed is telling us they are going to tighten 75 bps per year?”  Well of course it’s due to the libor surge.  But don’t worry, it doesn’t represent a funding crunch, it’s simply “technical”.  That’s what they’re saying.  All I know is that mountain goats don’t just pop out of the clouds.

Below is a chart of Investment Grade CDS.  A move of 20 bps off the lows doesn’t seem very important.  But is it breaking out?


While stocks make new lows, the flight to quality reaction in fixed income appears to be increasingly muted.  That’s not to say that a cataclysmic decline in equities won’t force a large drop in yields, it’s only to say that the supply of US debt in an environment of tariffs and trade wars and possible inflation acceleration is starting to appear problematic.  The $1.3T spending bill that Trump signed is a case in point.  From a May 5, 2016 interview, “I’m the king of debt.  I love debt.”

Alas that love, so gentle in his view/ Should be so tyrannous and rough in proof.

I know….Shakespeare doesn’t quite fit with Trump. The absurd and comical truths of the Far Side (which I led off with) are much more appropriate. Sometimes the idea that looked great previously goes horribly wrong. If US debt buyers make themselves scarce, then the whole house of cards comes down.


3/16/2018 3/23/2018 chg
UST 2Y 229.1 225.8 -3.3
UST 5Y 264.3 260.6 -3.7
UST 10Y 284.6 282.3 -2.3
UST 30Y 308.0 306.9 -1.1
GERM 2Y -59.1 -61.1 -2.0
GERM 10Y 57.1 52.7 -4.4
JPN 30Y 75.3 73.6 -1.7
EURO$ Z8/Z9 34.5 32.5 -2.0
EURO$ Z9/Z0 6.0 7.5 1.5
EUR 122.91 123.56 0.65
CRUDE (1st cont) 62.41 65.88 3.47
SPX 2752.01 2588.26 -163.75
VIX 15.80 24.87 9.07


Posted on March 25, 2018 at 8:35 am by alexmanzara · Permalink
In: Eurodollar Options

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