Nov 29. A Simple Framework

Moving into the last month of the year let’s just take a step back and look at the big picture. The dollar index is near a new high, testing the high from March of this year, which is the highest in a dozen years. Commodities are at new lows, with the BBG Commodity Index 20% lower than the crisis low in 2009 and only 1/3rd the price of the peak in 2008 (associated with the oil spike to $140). Stocks are near all-time highs, especially some of the large tech companies. The divergence between commodities and stocks is nothing short of stunning.

Maybe it’s just this simple: The world, especially China, wants a safe haven for wealth, and that translates into a bid for longer dated USD assets. So the dollar goes up, stocks go up, and long dated treasuries find a bid relative to short dated ones as the Fed has fully telegraphed its intention to hike. Commodities are going down because of overcapacity built on the assumption of Chinese demand which has now withered. Fracking technology in the US has contributed to energy over supply. The beginning of December will likely see more accommodation from the ECB and tightening from the Fed, underpinning USD strength and exacerbating all of the above trends.

When considered in that simple framework, other things fall into place. CNY (yuan) fell to its lowest level since the August devaluation. Chinese stocks were hit last week and appear vulnerable to further weakness. Bitcoin is near the highest level of the year (~360), except for the November spike above 430. I would judge the move in bitcoin as another safe haven indicator, at least in part. Junk bond spreads continue to widen. “That is underscored by the extra yield that investors are demanding to hold CCC rated credits relative to those rated BB. This spread has jumped to the most in six years.”

There is now more open interest in the Ultra Bond future than there is in the US 30 year contract, i.e. more interest in long dated assets. (669k in the Ultra and 522k in the US contract). In the ten year note (TY), there are 2805k contracts open. Actually, on a dv01 basis, there is almost as much open interest in the Ultra as there is in tens (the CME is using a ratio of 3 to 1).

Measures of the curve are pretty much at the lows of the year. 2/10 treasury spread is just 130 bps, having been as high as 175 in the summer. The area from 110 to 120 bps represents the low since 2008. As highlighted in last week’s note, the red/gold Eurodollar pack spread just above 100 bps (103.25 settle Friday) its lowest level since the beginning of 2009. [red Eurodollar pack is 2nd year, gold pack is 5th year]. In looking at the US curve, one would be more inclined to view monetary policy as somewhat tight rather than loose. In fact, the red to green Eurodollar pack spread settled at a new low of just 46.5 bps on Friday, suggesting only 50 bps of tightening between 2017 and 2018.

None of the above illustrates underlying strength in the US economy.  Maybe the bid in stocks does to some degree, though I would note that the Russell is still 7% off June’s highs, even with the rally of the last two weeks in the wake of the Paris terrorist attacks. The US job market is reflecting strength, though that may be in part due to the transition to a “gig” or UBER economy. Perhaps it represents flexibility of the US workforce, which may be a longer term benefit. In any case, the Atlanta Fed GDPNow estimate for Q4 fell to 1.8% on Nov 25, from 2.3% on Nov 18.

Weakness in primary manufacturing still has the potential to spill over into the broader economy.  Here are a couple of weekend snippets.

Copper smelters in China, the world’s biggest producer of the refined metal, are weighing cuts in production next year as they respond to prices that have tumbled to six-year lows, according to people with knowledge of the matter. (1)

The US [energy exploration and production] sector could be on the cusp of massive defaults and bankruptcies so staggering they pose a serious threat to the US economy. Without higher oil and gas prices — which few experts foresee in the near future — an over-leveraged, under-hedged US E&P industry faces a truly grim 2016. (2)

Looking forward to this week, it will likely be more of the same. Yellen is slated to speak both Wednesday at the Economic Club of Washington, and Thursday in testimony to the Joint Economic Committee. Beige book summary released Wednesday afternoon in preparation of the Dec 16 FOMC. The ECB meeting is Thursday with high expectations for further accommodation. The US Employment report is Friday.

In terms of setting up for the potential lift off, there has been a tremendous amount of put spread and put butterfly buying in the last two weeks, which was absorbed fairly easily. In keeping with the “simple” framework, in the early part of this year prior to the idea of Fed hikes, three month Eurodollar contracts were settling around 9975. Now with lift-off expected in December, EDZ5 is near 9950. If one assumes “gradual” to mean one hike per quarter, then that would put EDH6 at 9925, EDM6 at 9900 and EDU6 at 9875. Perhaps unsurprisingly, those are the put strikes with the most open interest (H6 9925p 602k, M6 9900p 346k and U6 9875p 270k) as those strikes have been sold as the midpoint of put butterflies in simple target strategies. (For example EDM6 9925/9900/9875 put fly, which settled 6.75).

In a slightly longer view, there has been continued discussion about the “terminal rate” for Fed funds. According to the last dot projection in September, the terminal rate is around 3.5%. In reviewing the last hiking cycle, from 2004 to 2006, the terminal rate was fairly accurately forecast by the ten year treasury yield, which was around 4-4.5% for the first year of hikes and moved to a bit over 5% by the middle of 2006. The actual high FF rate was 5.25%. Currently, the ten year yield is around 2.25 and hit a high of 3% at the end of 2013, associated with tapering prospects. Probably makes sense to target the terminal rate from 2.75% to 3%.

I often find that year end can provide turning points in markets, and the upcoming year has potential for several reversals, as some markets appear stretched and new money comes in with the new year, with perhaps a bit of a cushion to express contrary views. A friend sent me this snippet that may contribute to a bounce in swap spreads: “At an annual private meeting between industry participants and the US Treasury Department last week, discussion focused on a proposed solution of placing repo trades between banks and investors, such as money market funds, into a clearing house.” Conclusion: the dislocations in the repo market are likely to be addressed, which could alleviate swap spread pressure.

In terms of the dollar and commodities, the Dollar Index made a high of 121 in 2001, went all the way down to 70.70 in 2008, and is now right around 100, near a 12 ½ year high. The 61.8% retrace is 101.80, which I would expect to hold. If the dollar does stall as Fed hiking prospects are trimmed, then commodities also have a chance to bounce from low base levels.



Net changes in selected markets below:

11/20/2015 11/27/2015 chg
UST 2Y 93.7 92.2 -1.5
UST 5Y 169.5 168.5 -1.0
UST 10Y 226.2 222.4 -3.8
UST 30Y 302.1 300.1 -2.0
GERM 2Y -38.9 -41.7 -2.8
GERM 10Y 47.9 46.0 -1.9
EURO$ H6/H7 61.5 61.0 -0.5
EURO$ H7/H8 51.0 49.0 -2.0
EUR 106.47 105.92 -0.55
CRUDE (1st cont) 41.90 41.71 -0.19
SPX 2089.17 2090.11 0.94
VIX 15.47 15.12 -0.35


Posted on November 29, 2015 at 12:58 pm by alexmanzara · Permalink
In: Eurodollar Options

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