May 8. Locked and loaded

“The springs on the San Andreas system have been wound very, very tight. And the southern San Andreas fault, in particular, looks like it’s locked, loaded and ready to go,” Jordan said in the opening keynote talk.

It has been quiet since then — too quiet, said Thomas Jordan, director of the Southern California Earthquake Center.

The above quote is from the National Earthquake Conference last week, held, of course, in Long Beach CA.  (I’ll bet that’s a fun one to go to…)   It is such an obvious comparison to today’s investment landscape that I would bet someone has already made it, but I didn’t find the reference, so I’m just going to run with it.

On the other coast, another event was being held, known as the Sohn Conference.  No less dire of a warning was given by Stanley Druckenmiller.  Quickly summarizing, he mentions several dislocations in the current environment:  1) the peak in profits has passed, but leverage has increased to dangerous levels  2)  the Fed has knowingly borrowed from future consumption 3) debt has not been used productively 4) China is facing similar problems and is at a more precarious stage. (link to speech below) Like the San Andreas fault, the timing of an unwind is uncertain.

It was late 1996 when Greenspan mentioned irrational exuberance.  “But how do we know when irrational exuberance has unduly escalated asset values, which then become subject to unexpected and prolonged contractions as they have in Japan over the past decade?” After a brief hit in response to that comment, SPX promptly rallied from 800 to 1200 within two years.  So, it’s clear that even the experts have a hard time identifying the timing of major moves even when they have accurately assessed the fault lines (and the current Fed can’t even seem to do that).  As Jeffrey Gundlach noted, (paraphrasing) Druckenmiller’s theme doesn’t lend itself to an instantaneous trading position.

I would simply say that the spectrum of risk/reward now appears to be past orange and into the red. Most of the market isn’t using a prism to differentiate, but is just seeing the category of “visible light”.  The question is, why?  After all, it’s not just Druckenmiller providing a ‘heads up’.  Many luminaries of the investment world have been warning about the current DM situation and about China.  For example, from a BBG story on April 20: “Billionaire investor George Soros said China’s debt-fueled economy resembles the U.S. in 2007-08, before credit markets seized up and spurred a global recession.”  …What’s happening in China “eerily resembles what happened during the financial crisis in the U.S. in 2007-08, which was similarly fueled by credit growth,” Soros said. “Most of the money that banks are supplying is needed to keep bad debts and loss-making enterprises alive.”  Kyle Bass has made the same warning with regard to US policies pushing consumption forward (as much as it possibly can) at the expense of the future.  Bass is also a China bear, noting that while China is supposedly transforming into a new economy less dependent on manufacturing, the (bad) debt is still outstanding to the old industries.  Jeffrey Gundlach “…reiterated his view that negative and low interest rates on bonds, especially in Europe and Japan, are deflationary and do not promote growth. “  Bill Gross says to prepare for renewed QE from the Fed.  While these sentiments may not suggest imminent doom, they certainly don’t give confidence that the global financial system is on the bedrock of stability.

There’s a famous quote from Bill Clinton: “You mean to tell me that the success of the economic program and my re-election hinges on the Federal Reserve and a bunch of f’ing bond traders?”  (Supposedly asked of Robert Rubin, who nodded in the affirmative).  Greenspan had counselled Clinton to focus on reining in the deficit. The implication was that the market (and the Fed) imposed a certain amount of discipline on political decisions.  That discipline has been lost and replaced by intransigence.

The US investor or retiree may rhetorically ask a similar question:  “You mean to tell me that my investment results and future income stream hinges on what happens in China?”  It’s hard to assess the information out of China, but over the weekend the news wasn’t particularly encouraging with yoy exports -1.8% and imports -10.8%.  China’s exports to the US fell by 9.3%.  On Friday, there was a BBG story (link below) citing brokerage CLSA Ltd, that estimates, “Chinese banks’ bad loans are at least nine
times bigger than official numbers indicate, an “epidemic” that points to potential losses of more than $1 trillion.”

Last week I mentioned that the SPX had two recent declines of 11-12%, one sparked by the Chinese devaluation in August, and the other at the beginning of the year, following the Dec Fed hike.  Many found these sell offs very unsettling.  Well, look at a stock market chart from 1965 to 1982.

DJIA 1965-82

There are four declines over 25% over a dozen years, the largest coinciding with the oil crisis in 73-74.  By the way, the Saudis just dumped long-time oil minister Al-Naimi, with Mohammed bin Salman consolidating power under his vision to diversify away from energy and into (uh-oh) finance.

The point is that prudent risk posture at this point can only be tempered (or overwhelmed?) by additional central bank gymnastics.  However, on Friday, NY Fed President William Dudley said that it remained a “reasonable expectation” that the Fed would increase the fed funds rate two times this year.  This remark immediately prompted several large sales in the Eurodollar strip (which were nonetheless easily absorbed).  The first 5 ED contracts added more than 50k in open interest, likely new shorts.  However, on the longer end, between Thursday and Friday, open interest in TY increased by over 100k, which suggests a safety migration.  New supply of 3’s, 10’s and 30’s starting on Tuesday will likely sail through without a ripple.

In summary, many have noted the disconnect between market pricing and the Fed’s pronouncements and dot plots.  The market obviously is NOT expecting two hikes this year with January’17 Fed Funds at 9945.5, a spread of only 18.25 to the current May’16 contract.  At the same time, contradiction abounds between stock market pricing and the ever more vocal warnings of respected asset managers.  In any event, a shift toward risk aversion appears to be the prudent stance.

Posted on May 8, 2016 at 12:22 pm by alexmanzara · Permalink
In: Eurodollar Options

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