March 26. Regime change?

Now is the winter of our discontent made glorious summer by this sun of York.  –Richard III

It was a spectacularly ‘Chicago’ day on Friday.  Having been chilly earlier in the week, it was slightly grey in the morning, but then the glorious sun warmed the city into the summery 70’s under a crystal blue sky by midday, with office workers pouring out of buildings to eat lunch outside as riverboat tours plied the Chicago river.  However, by early evening the temperature dropped 25 to 30 degrees within an hour and it began to drizzle.

It seemed like an old mid-summer CME floor day as well, without much to do before results of the healthcare vote were due.  In the old days in the Eurodollar pit when prices stalled, someone would occasionally blow up a huge beach ball and start bouncing it around.  It would start in the front month, pop up to the option pit, across to the upwardly sloping tiers of desks, back down to the pit, with clerks and traders enthusiastically punching it skyward (to cheers) soaring 25 feet in the air to the back months, while CME security guards comically chased after this brightly colored ball in order to restore some decorum to the market, while all the while becoming an integral part of the show.  Like Congress.  When they finally did capture the ball, a round of booing ensued.  Friday was a beachball day.

The Trumpian summer of deregulation and a government that gets things done had the air seep out as the health care vote to repeal Obamacare was withdrawn; a chill once again descended on the body politic.

The question is, of course, after the Trump stock rally, and the Trump increase in inflation expectations, and the Trump surge in small business optimism, does this very public defeat bode a reversal?  Already, Mnuchin was trying to take the sting out by saying that tax reform is going to be a much easier and more streamlined process.  I am sure some in the markets will spin it this way: “Well if Trump couldn’t get this through, it also means that he won’t be able to institute protectionist measures.  And a weaker dollar will be constructive for US exports.  Ergo, BULLISH for stocks!”

If fiscal policy measures to support assets are a bit more uncertain, what about monetary policy?  With increasing frequency, the topic of balance sheet adjustment is creeping into the public discussion.  Kashkari mentioned it Friday (while trying to hint that a stock market sell off wouldn’t necessarily elicit a response from the Fed) and Bullard had balance sheet reduction as a major theme of his latest presentation, also on Friday.  For all the contradictory and seemingly random headline quotes from Bullard, his slide show presentation is quite lucid. The summary of the presentation is below.

https://www.stlouisfed.org/~/media/Files/PDFs/Bullard/remarks/Bullard_Economic_Club_of_Memphis_24_Mar_2017.pdf?la=en

The US economy has arguably converged to a low-real-GDP-growth, low-safe-real-interest-rate regime.

Because of this, the Fed’s policy rate can remain relatively low while still keeping inflation and unemployment near goal values.

The new fiscal policy could impact productivity growth and therefore improve the pace of real GDP growth.  (The Fed can wait to see how the new fiscal policy evolves).

Ending balance sheet reinvestment may allow for a more natural adjustment of rates across the yield curve as normalization proceeds.

Though Bullard is not one of the top voices on the Fed, his desire to see a more naturally positive yield curve is likely aligned with mainstream Fed thinking, and he believes that balance sheet size and reinvestment is keeping a lid on long end rates.  Indeed as the curve flattened with this week’s stock market decline, financial stocks took a large hit, with the banking index down nearly 5% in the context of a 1.4% decline in the SPX.  A strong financial sector is critical to the transmission of monetary policy, and a steeper curve is a key pillar of support.

Below is a footnote from a Janet Yellen speech of January this year:

Based on estimates generated using the term-structure model developed by Li and Wei (2013) and the procedure discussed in Ihrig and others (2012) and extended by Engen, Laubach, and Reifschneider (2015), the Federal Reserve’s holdings of Treasury securities and agency mortgage-backed securities continue to put considerable downward pressure on longer-term interest rates. However, this pressure is estimated to be gradually easing as the average maturity of the portfolio declines and the end-date for reinvestment draws closer. Over the course of 2017, this easing could increase the yield on the 10-year Treasury note by about 15 basis points, all else being equal. Based on the estimated co-movement of short-term and long-term interest rates, such a change in longer-term yields would be similar to that which, on average, has historically accompanied two 25 basis point hikes in the federal funds rate.

Footnote 17 … https://www.federalreserve.gov/newsevents/speech/yellen20170119a.htm

Implicit in Yellen’s footnote is the idea that FF increases tend to flatten the curve.  The natural shortening of the portfolio should raise longer term rates, and the end-date for reinvestment has been on the Fed’s radar since the beginning of the year.  What is worth keeping in mind is this: previous cessations of QE have been associated with declines in inflation premia and less robust equity market performance.   The topic isn’t one just for the US, as signaled by the final round of the ECBs TLTRO program (Targeted Long Term Refinancing Operations).  As Draghi said in a report (BBG) “The banking sector’s capacity to fully support the euro area’s recovery is curtailed by its low profitability.  …It is up to the banks themselves to find appropriate answers to these challenges.”

In the final analysis, the odds of easy passage to key tenets of the Trump agenda have to be lessened.  The Fed has acknowledged upside risks of fiscal policy, so at the margin, odds of more aggressive Fed policy also have to be slightly shaved, a process which has already begun.  Asset prices have already bought into the Trump narrative, and are likely to re-adjust downward, tempered by a Fed that may tone down the ‘normalization’ rhetoric.  Fed fund rate hikes are likely to be better absorbed by the market than balance sheet adjustments, though a flatter curve may result.

Plots have I laid, inductions dangerous / By drunken prophecies, libels and dreams

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3/17/2017 3/24/2017 chg
UST 2Y 131.3 124.4 -6.9
UST 5Y 201.8 192.8 -9.0
UST 10Y 249.9 239.6 -10.3
UST 30Y 311.0 299.8 -11.2
GERM 2Y -77.3 -74.1 3.2
GERM 10Y 43.5 40.3 -3.2
JPN 30Y 83.4 82.8 -0.6
EURO$ M7/M8 52.5 49.5 -3.0
EURO$ M8/M9 40.5 37.5 -3.0
EUR 107.38 108.00 0.62
CRUDE (1st cont) 49.31 47.97 -1.34
SPX 2378.25 2343.98 -34.27
VIX 11.28 12.96 1.68

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Posted on March 27, 2017 at 4:04 am by alexmanzara · Permalink
In: Eurodollar Options

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