No Free Lunch

January 19, 2020 – Weekly Comment

On Wednesday, Dallas Fed President and 2020 FOMC voting member Robert Kaplan said this in an interview:

“It’s a derivative of QE when we buy bills and we inject more liquidity, it affects risk assets.  This is why I say growth in the balance sheet is not free.  There’s a cost to it.”

Of course, another new voting member, Minnesota’s Neel Kashkari had this to say on twitter.

“QE conspiracists can say this is all about balance sheet growth.  Someone explain how swapping one short term risk free instrument (reserves) for another short term risk free instrument (t-bills) leads to equity repricing.  I don’t see it.”

I think I’ll go with Kaplan on this one.  By the way, if there’s no effect, why should the Fed even swap nearly identical instruments Neel?

In any case, maybe it’s not causation, but the chart below shows what appears to be a strong response to the Fed’s onset of bill buying in October: SPX has rallied just over 17%.  As the chart also indicates, there was a powerful rally in Q4 2017 through January 2018.  That episode was spurred by the tax package and corporate repatriation.  From September 2017 to January 26, 2018, SPX surged nearly 19%.  What followed was a rather sharp pullback as short vol positions blew up and the VIX exploded to 50, having been around 10 going into the start of 2018.  By the way, at that time, the out-of-the-money VIX call buyer known as ‘50 cent’ reportedly made a quick $200 million in February 2018.   Perhaps unsurprisingly, there was a buyer the week before last of 75k Feb VIX 25c for 49 cents.  (Jan 8).  In any case, spot VIX is now languishing just above 12, although the Feb future settled 14.925.

The chart above would seem to indicate that if one wanted to take a stab at shorting the major stock indices, which have continually posted new record highs in January, that the last week of the month might be the time.  The year’s first FOMC meeting, with our aforementioned new participants, takes place on Wednesday, January 29.

Kaplan said in his interview last week that he would like to pare back the stimulus.  Indeed, it would appear that even a marginal decline in liquidity provision might prove to be a tipping point.  On that score, I would note that the NY Fed this week trimmed two-week term repo amounts to $30 billion from $35 billion starting in February.  Also worth noting is that IOER is expected to be tweaked higher by 5 bps to 1.60%.  The Fed Effective rate has been coming in at 1.54%.  February Fed Funds have already given the nod to a potential move, settling at 98.42 or 1.58%, compared to January at 98.4525 or 1.5475%.  In fact, Feb, March and April FF all settled 98.42.  However, from there forward, contracts gently rise, reflecting an unshakable bias toward further easing.  The October contract (FFV0), which is the last month prior to the election, settled 98.56 or 1.44%, a spread of -14 bps to Feb.  Therefore it’s fair to say that the market is expecting somewhere around a 50/50 chance of a 25 bp cut by then.  While it appears as if no Democratic candidate has a chance to beat Trump, I’ll call that the Bernie effect.   

The Eurodollar curve tells the same story.  EDH20 settled 98.255 while EDU20 settled 98.385, a spread of -13.0.  The spread between EDU20 and FFV20  settled 17.5, a forward proxy for lib/ois.  Many Fed officials have said that policy and the economy are in a good place, and have indicated that the bar for changing the FF target this year is a high one. Even Bullard espouses that view, saying that last year’s eases will “come on board in 2020.” Yet there continues to be accumulation of EDU0 98.875 and 99.00 calls for 3.0 and 2.0 bps respectively.  The call strikes from 98.75 to 99.00 have the most open interest in both June and Sept.  EDU20 9875c settled 4.0 and have 414k open while 98.875’s have 420k. (And no, you can’t buy the EDU0 9875/9887/9900 call fly for zero even though it settled there).  Given where EDH0 is trading, it would take two rate cuts to reach the 98.75 strike in Sept.  Of course, UBS put out a call for three rate cuts in 2020. 

The Fed has indicated it will continue its pace of buying $60b/month in t-bills into Q2, to at least cover the April 15 tax date.  While there are some clues of a coming reversal in liquidity provision, the music is still playing for now.  However, warnings are evident.  For example, KKR is reportedly cutting its exposure to BBB to underweight, fearing a wave of fallen angels.  The Treasury’s announcement of 20-year bond issuance underscores two things.  One, the administration is going to continue deficit spending to support the economy at least through the election and two, if the Fed does trim its reserve building operations sometime in Q2, it’s effectively a double doink with respect to pulling back on liquidity.  More supply financed by repo with less support from the Fed. 


The announcement of renewed issuance of 20-year bonds steepened the curve, which had been flattening since the beginning of the year.   Both 2/10 and 5/30 spreads rallied 3 bps on Friday, to 26.7 and 66.5 respectively.  The Fed’s on hold with the possibility of higher inflation as last year’s stimulus measures take effect, while a degree of uncertainty has been lifted due to the US/China agreement; both of these factors should support the curve.  The extra long-end supply adds another ingredient to the mix.  However, 5/30 has to exceed 80 for confirmation of a renewed steepening trend.

Last week EDM0 and EDU0 both fell 2 bps on the week to close Friday at 9831.5 and 9838.5.  There has been significant covering (buying back) of short EDM0 9825/9812 put spreads.  The weekly change on EDM0 9825/9812ps was 1.25 bps, from 1.5 to 2.75, and open interest fell 90k in the 9825 strike to 634k while the 9812 strike fell 67k to 333k.  Still a lot of paring back possible in this put spread.  I favor a long in EDU0 9825p which settled at 3.75.  This put also has large open shorts due to previous buys of 9837/9825/9812 put flies.  The market treats the downside like Rodney Dangerfield (no respect) but what if Powell sounds a hawkish note on the 29th?

1/10/2020 1/17/2020 chg
UST 2Y 156.8 156.2 -0.6
UST 5Y 163.3 162.9 -0.4
UST 10Y 182.1 183.4 1.3
UST 30Y 228.2 229.4 1.2
GERM 2Y -60.0 -58.9 1.1
GERM 10Y -19.9 -21.5 -1.6
JPN 30Y 43.6 45.8 2.2
EURO$ H0/H1 -21.5 -21.0 0.5
EURO$ H1/H2 3.0 2.0 -1.0
EUR 111.22 110.93 -0.29
CRUDE (1st cont) 58.99 58.58 -0.41
SPX 3265.35 3329.62 64.27
VIX 12.56 12.10 -0.46
Posted on January 19, 2020 at 11:27 am by alexmanzara · Permalink
In: Eurodollar Options

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