May 7. Overbought…financial stability

Employment data was released Friday.  The chart below is the unemployment rate, which is just 4.4% as of April.  The last time we touched this level was in May 2007, a decade ago.  The Fed Fund rate at that time was 5.5% (the end of the last hike cycle).  We also had a period from 1999 to early 2001 when the rate was below 4.4%, having bottomed at 3.8% in April 2000.  At that time,  (in June 2000), Fed Funds had topped at 6.5%.  Besides those two periods, one has to go back to March of 1970 to find a rate as low as 4.4%.  So in the past 47 years, or 564 months, we’ve only had  28 months at a rate below 4.4%, around 5% of the time.

The Fed has attained the employment mandate.

There has been a lot more discussion recently of rules based decision making regarding Federal Reserve policy, and the rules say rates should be quite a bit higher.  With Friday’s data release, it’s no surprise that market expectations for a hike at the June FOMC ratcheted up to a new high, with July FF at 9892.0 pricing about 75% odds of a hike, and June Eurodollars at 9869.5, pricing slightly lower odds.  On the other hand, the Eurodollar curve is loath to price in a series of hikes, in part because the economic data has been coming in on the soft side and the reflation narrative has sputtered.  For example, EDM18, one year forward, is 9830.5, only 39 bps higher in yield than EDM17.  I have seen two notes recently from large Eurodollar option market makers that essentially said the same thing: Euro$ puts are unfathomably cheap and open interest is huge.  “I have NEVER seen put skew as cheap as it is now.” Another friend referred to it this way: “Every day [the mkt makers] are getting choked by a giant pillow.” I am sort of paraphrasing and inferring the following, but there has obviously been recent variability in libor/ois (though all one way, down), and some of these options have a long time to go.  For example, EDU7 9837p trade 0.5 with 4 months to go and have 926k of open interest.  EDZ7 puts: 9825p 2.0 settle with 826k, 9812p 0.75s with 388k and 9800p 0.25s (0.25/0.5) with 565k. Just as a point of comparison, open interest in futures is EDM7 1.45m, U7 1.40m and Z7 1.65m.

However, the low vol theme could cover almost all markets.  It’s obvious in Eurodollars, treasuries, fx and stocks.  Three weeks to go and the TYM 125.25 straddle settled at exactly 1’00.  Barrons noted that VIX had slipped below 10 during the week and named the London investment firm Ruffer as the consistent buyer of 50 cent VIX call options.  An article on ZeroHedge noted that 1yr implied vol on USDCNY had dropped from about 8% in the beginning of the year to just 4.7%, and cited BBG as saying the last time it happened, China devalued in August 2015.  It’s this latter point which I would like to explore a bit further in terms of a possible catalyst, but first I will digress to the (related) subject of commodities.

It’s well known that industrial commodities, led by oil, have been under severe pressure, with Crude dropping over $3/bbl this week.  Iron ore has plunged by about a third from its high two months ago.  Though copper had a technical bounce Friday, it’s well off the ‘reflation narrative’ high set in February.  Silver has had 15 straight down days and is down 12.5% from the high in mid-April.

On the topic of crude, I’ve seen the latest sell off referred to as a ‘capitulation’ trade, but I am not so sure.  The chart below shows open interest at a record even with the price drop, (as friend JJ has pointed out).  To me, it’s unlikely that this configuration leads to a gentle recovery in prices.

My own theory is that some of the commodity price action is spurred by China.  I further suspect that some of the treasury market selling is coming from China, though a Bloomberg story this weekend notes that  “China’s foreign-exchange reserves rose for a third month in April, beating estimates, as tighter capital controls kept money from flowing out of the country and the yuan was stable.”  I very much doubt reserves will increase in May.  President Xi recently gave a speech on financial stability in China, and it seems pretty clear that the rise in rates in China is having a direct effect on commodities.

While regulatory enforcement sprees are not new to China, investors fear there may be no let up in a new wave of tightening soon after President Xi Jinping last week made a rare speech on financial stability.

Kyle Bass has noted the surge in the duration mismatch in WMPs.  There have been many articles outlining the huge growth in debt in China, but most think that the PBoC and Chinese Gov’t have the resources to handle it.  It’s remarkably reminiscent of the US subprime crisis, where officials almost all said that subprime just wasn’t large enough to create a systemic problem.  The problem is that China has become a much larger part of the global economy.  IF Chinese authorities aren’t able to gracefully tamp down on excesses, then the low vol financial world is going to blow up.  Of course, the warnings from experts have been sounded, but they’ve been early (as they always are) so they’ve now faded into the background cacophony as the can is kicked along.

In an effort to get a sense of magnitude, I am adding a chart below.  It shows the extraordinary growth in debt levels over the past few years as a percent of GDP.  While total non-financial debt as a % of GDP in the US is about the same level at 255%, business debt in the US is only about 73% of GDP (which is still a record), while corporate debt to GDP in China has exploded from 130% to 156% in just the past five years.  This is an accident waiting to happen.

It’s often said that the Fed can’t raise rates too aggressively because of bloated debt levels.  But rates are increasing in China.  3m Shibor has moved up from around 2.85 in Q4 2016 to 4.36 now.  Of course, growth rates are also higher, but China faces many of the same demographic headwinds as other advanced economies do, and has become a much larger share of the global economy.  Since the end of 2008 China’s GDP has increased 2.4x from $4.6T to 11.1T.  In the US it rose 22% from $14.7T to $18T.  In 2008, China was 7.3% of Global GDP, now it’s 14.9%.  In 2008 the US was 23.2% of Global GDP, versus 24.2% now.

US stocks are posting all-time highs in an environment of low volatility, while the Fed is set to gingerly continue removing accommodation, and cracks are appearing in the commodity sector.  While fears of European contagion have been swept to the side with the French election, it’s important to note that risks from Asia are larger than ever, and could easily upend US complacency.

Fed speakers all week long as the treasury auctions 3’s, 10’s and 30’s beginning on Tuesday.  The week ends with CPI and Retail Sales on Friday.

Posted on May 7, 2017 at 5:26 pm by alexmanzara · Permalink
In: Eurodollar Options

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