Nov 18. ‘Exactly’

You choose your battles.

Whenever someone in our office asks what’s driving this market or that, one of my colleagues is fond of launching into his explanation, which invariably starts with this line: “I think the easiest way to think of it is to imagine two armies.  There is the bull army and bear army.  Right now the bull army is overpowering the bear army.”  This point is physically emphasized by holding his arms vertically parallel with one hand imaginarily pushing the other back.  Never gets old.

In 359 BC, Philip took the crown of Macedon.  Through various military exploits, battles and sieges, he subdued many city-states, expanding and consolidating his empire.  He then turned to Sparta.  He sent warnings in advance.  “If I win this war, you will be slaves forever.”  Again, “You are advised to submit without further delay, for if I bring my army into your land, I will destroy your farms, slay your people and raze your city.”  The Spartans laconic reply was one word: “If”.  Both Philip II and Alexander the Great chose to leave Sparta alone.  (Wikipedia)

The war of words and tariffs continues with China, with Vice President Pence holding a hard line while Trump on Friday softened the rhetoric.  Two RTRS headlines Saturday morning: 1) Trump says US may not impose more tariffs on China 2) Pence vows no end to tariffs until China bows. Not exactly Spartan in terms of clarity.

In any case, the bond bull army took control last week, with TYZ closing higher five days in a row with higher highs and higher lows.  The ten year yield dropped 11.7 bps to 3.072% while fives plunged 15.2 to 2.892%.  You see, the bull army pushed back the bear army.  Many reasons for this, including May’s struggle to retain power as cabinet members resigned over Brexit, weakness in equities, continued issues between the EU and Italy’s budget.  All messy affairs.

A couple of days ago mainstream media (NBC news for one) highlighted a NY Fed Microeconomic Data report saying the household debt hit a RECORD HIGH of $13.5 trillion last quarter.  Sounds worrisome. But not when one considers that it merely surpassed the nominal peak set in 2008, ten years ago, while GDP has consistently climbed.  I.e., ratios have continuously improved. What’s amazing is this: (data from Fed’s Z.1)  HH Mortgage debt at $10.2T in Q2 2018 still has not exceeded the record of $10.6T in 2007! In fact, homeowner’s equity in real estate has rebounded from the plunge to 36% at the bottom, back to the pre-crisis level of 60%. Consumer Credit was $2.644T in 2008 and now stands at $3.901, a gain of $1.257T.  But $925 billion of that increase is Student Loan Debt, now at $1.56T, owed mostly to the US Gov’t.  In actuality, one could say that households have been extremely conservative with credit since the crisis.  Perhaps one concern in the report is that aggregate delinquency rates worsened to 4.7%, the largest in seven years.  From the report: “This increase was primarily due to a large increase in the flow into delinquency for student loan balances during Q3 2018.” If the Federal gov’t changed the rules and said that borrowers only needed to pay $10 month on all student loans, the delinquency rate would instantly disappear and no one would notice the blip in red ink on the Federal budget relative to the current hemorrhage.

While HouseHold debt isn’t much a concern, the rest of this note concerns corporate debt.  The advice here:  PANIC.  We’ll start with an IMF alarm this week on Leveraged Loans (only $1.3 T but the issues plaguing this segment spill into other corporate lending). From the IMF blog (link below), “This year, so-called covenant-lite loans account for up to 80% of new loans arranged for nonbank lenders (so-called ‘institutional investors’) up from about 30% in 2007.  Not only the number, but also the quality of covenants has deteriorated.”  The report adds that central banks have been monitoring banks’ exposures, but much of the activity has shifted to institutional investors, which may pose different risks.

Last week both Paul Tudor Jones and Jeff Gundlach gave warnings on the same topic, following Guggenheim’s Scott Minerd tweet on Tuesday that was sparked by GE:  “the slide and collapse in investment grade credit has begun.”  From PTJ,”We’re going to stress our whole corporate credit market for the first time.” “From a markets perspective, it’s going to be interesting.  There probably will be some really scary moments in corporate credit.”  Gundlach noted tight spreads, which are starting to widen, but said “…spreads are tighter than you think, because quality has been systematically going down.” “Spreads and debt levels are out of sync with one another.”  From ZH, “The BBB rated market, which has the lowest rated corporate bonds, is two-times bigger than the hi-yield market.  If those bonds are downgraded to junk, Gundlach said, it will ‘flood’ the high yield market.   John Mauldin has also been consistently writing about high corporate leverage and the inevitable reset.  Almost Daily Grant’s has similarly highlighted egregious examples of loose credit lending with the possibility (and actuality) of haunting results.

While spreads remain fairly tight and well below levels associated with the energy and EM blow-up of late 2015/early 2016, the ICE BAML High Yield spread from the St Louis Fed website prints 411 bps, the highest since early 2017.  (shown below)

Other indicators of stress are similarly at or near new recent highs.  Both IG and HY 5yr CDS made new yearly highs this week.  The BBB/Baa spread to ten year treasuries closed at 162 bps, just under the year’s high.  The chart below is a long term plot of the BBB spread in white, with SPX in amber.  Though it would likely be more instructive with SPX as a log chart, the rise in the spread in 2015 was clearly associated with a stall in equities, and of course energy market problems induced a couple of sharp corrections in late 2015, early 2016.

Action now is similar, except that SPX is over 25% higher now than it was in late 2015.

The question going forward is whether the Fed considers incipient signs of stress as enough to change the trajectory of normalization. Aside from market levels, there are other warning flags.  For example, from last week’s NY Fed Business Leaders Survey: “Optimism about the six-month outlook was noticeably lower. The index for future business activity dropped 15 points to 17.3, its lowest level in a year, and the index for future business climate fell to zero, a nearly 40 point drop from its level at the beginning of 2018.  The index for planned capital spending rose to 34.2, a multiyear high.”  In terms of the Fed’s response, Vice Chairman’s Clarida interview Friday on CNBC was especially instructive.  He allowed for 2 to 3 hikes next year, but said that the Fed should now be much more ‘data-dependent’ in setting policy [rather than pursuing  a one-track goal of normalization].  Steve Liesman clearly noticed the change and specifically followed up by asking “Is this a shift?” to which Clarida laconically replied “EXACTLY”.  (He should have stopped there).

The eurodollar strip has been pricing a fairly ‘tight’ Fed and forecasts a slowdown in late 2019, with EDZ19 and EDH20 being the lowest priced contracts on the curve at 9691.5 or 3.085%.  The comments from Clarida were a bell-ringing indication that the Fed is aware of risks to the economy due to tightening financial conditions, and Clarida also noted evidence of a slowdown in the global economy.  Those who think the Fed will blindly continue to tighten on a set program until something “breaks” may be on the wrong track… notwithstanding Cramer’s childish admonition late Friday that the Fed ‘doesn’t do its homework’ and that he ‘has better information than the Fed.’  For shame.

The lowest any euro$ contract out to five years has traded has been EDZ0 which printed 9666.5 in early October.  Just for the sake of comparison, the low print in EDZ9 has been 9671, in EDZ1 9670, EDZ2 9669 and EDZ23 9663.5.  So this area from 9665 to 9670 is powerful support, 3.30 to 3.35%, consistent with a ‘terminal FF rate’ of 3% or so.  So with current Fed Effective 2.20, that would indicate 3 more hikes in total.  Of course, with this week’s rally, the lowest contract is more than ¼% higher in price, which is more consistent with 2 to 2.5 more hikes.  Right in the zone Clarida mentioned.

It’s pretty obvious that if the Fed prematurely pauses, then the treasury curve will likely steepen.  I would have liked Liesman to have asked Clarida “If the Fed changes trajectory, will the first change be in balance sheet normalization or FF targets?”  I personally think it will be the latter, but that question will surely come up at the December FOMC, now just 21 trading sessions away.  What will also happen is that Trump will complain about the December hike, because he simply can’t help himself.  The Fed is already thinking about a change in trajectory, but may be wary of large alterations in the message lest it’s mistaken for buckling to political pressure.  It should be an interesting end to the year.


Feb/April FF spread settled 13.5, down 3.5 on the week and moving closer to 50/50 odds of a hike in March.  May/July settled 9.5, also down 3.5.   The front end of the curve is already paring back expectations of further Fed hikes.  EDH9/EDH0 closed at a new low of just 24.5, which signifies just one hike over that one-year period.  Obviously, firmness in libor/ois has something to do with weakness in the front end, but a decline in hike expectations is dominant.

5/30 year treasury spread closed at a new recent high of 43.5 bps, up 8.8 on the week.  The two-year note fell 12.4 bps on the week, so it’s hard to chase the market to the upside, though probably appropriate to buy dips.  Five year vol in January appears expensive relative to US.  Look to play steepeners by selling FVF puts and buying USF puts.  Call for pricing.


11/9/2018 11/16/2018 chg
UST 2Y 293.2 280.8 -12.4
UST 5Y 304.4 289.2 -15.2
UST 10Y 318.9 307.2 -11.7
UST 30Y 339.1 332.7 -6.4
GERM 2Y -59.7 -58.5 1.2
GERM 10Y 40.7 36.7 -4.0
JPN 30Y 88.4 85.4 -3.0
EURO$ Z8/Z9 48.5 35.0 -13.5
EURO$ Z9/Z0 0.5 -2.0 -2.5
EUR 113.36 114.18 0.82
CRUDE (1st cont) 60.36 56.68 -3.68
SPX 2781.01 2736.27 -44.74
VIX 17.36 18.14 0.78

Posted on November 18, 2018 at 7:05 pm by alexmanzara · Permalink
In: Eurodollar Options

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