Now 22. Weekly summary

Nearly everything I thought or wrote last week just after the Paris attack was wrong last week. I thought that the US would see safe have flows into 2 year notes and that German/US 2 yr spread would decline. I thought VIX would continue to move higher after the previous Friday’s strong close. I thought 30 year treasury vol was likely to move higher.   Instead the US two year note ended at a new high yield of nearly 91 bps. German/US 2yr spread went from 123 to 130. VIX fell back to just 15.5 from over 20, nearly the same levels from two weeks ago.   SPX gained 3.25% on the week. Treasury vol remained pressured.

On the other hand, there have been many surprising market moves that have found the ‘wrong’ (or early) camp in good company. For example, swap spreads continue to collapse into deeper negative territory. Industrial commodities are making new lows. Flows did go into the USD, but appear to have favored longer term assets (both bonds and stocks) as the short end remains under the cloud of an impending rate hike.

I had also thought the odds for a Fed hike in December might lessen. However, there is a (closed) meeting Monday at the Fed to review and determine the advance and discount rates to be charged by the Federal Reserve Banks. At the last couple of such meetings, there were “requests by six Reserve Banks to maintain the existing rate; request by one Reserve Bank to decrease the primary credit rate; and requests by five Reserve Banks to increase the primary credit rate.”* Minneapolis of course, was the bank voting for a decrease. But Kocherlakota is leaving, and it’s quite likely in my opinion, that the vote could swing to 7 for an increase and 5 for maintaining existing. I am not sure if that would instantly change the rate. But it’s a pretty clear precursor for a rate hike. The new Minneapolis head, Neel Kashkari is taking over starting Jan 1.

I suppose the other thing likely to occur with Kocherlakota’s replacement by Kashkari is that the average dots in the Fed’s SEP (Summary of Economic Projections) are likely to move up. According to a Bloomberg article, Kashkari referred to previous monetary accommodation as “morphine” and is likely to favor monetary restraint just because of financial stability concerns. Of course, the broad picture has little to do with the MN Fed, and everything to do with a change in sentiment about an initial rate hike. However, once over that hurdle, the question becomes trajectory.   The nearby one-year Eurodollar calendar spreads at around 5/8% (peak EDH16/EDH17 closed at 61.5 bps) forecast hikes of two to three 25bp moves per year. Boston’s Rosengren, in a recent FT interview, said he thought the market had it about right, and that the Fed’s SEP would be important as a communication tool. SF’s Williams said this weekend that there’s a strong case for a December hike, and also referenced the SEP and dot plot.

From September, if one throws out the low dot of -0.125% and the high of 2.875%, the mean projection for the FF target at the end of 2016 as determined by the dots was 1.5%. EDZ’16 settled at 98.905 or 1.095%, so there’s clearly a disconnect which will likely continue. Even with the shallower path expected by the market, the curve is pushing to new recent lows. For example, the red/gold Eurodollar pack spread closed at just 106 bps. Seems more consistent with a Fed that has already been tightening, which in this case the onset of the taper.

red-gold Nov15


To conclude the section about the path of hikes, the question is, are we going to get Donald or Jeb? Full steam ahead and hike at every meeting? Or plod along cautiously? The market says the latter.

There have been several trades in the near part of the dollar curve to peg the FF rate next year. But let’s just consider the 150k position taken in the 2EG 9787/9775/9750/9737 put condor, bought for 1.5. This condor expires in Feb 2016, but has EDH’18 as an underlying contract (98.255s) and would max its payoff with a settle between 9775 and 9750, or 2.25 to 2.5%. These levels are consistent with a FF target perception of around 2% to slightly higher (as opposed to a Sept dot plot of 2.7% for the end of 2016).


On the broader topic of asset markets in general, El-Erian wrote this weekend, “…two factors have consistently been major price setters since the global financial crisis: corporate cash and central banks.” He tepidly concludes that these factors will continue their influence, with M&A continuing and Draghi pledging to do what the ECB can to hit 2% inflation. On a more restrained note, the ECB’s Coeure said this weekend that “the capacity of the global economy to generate growth is under question” and that “there is a risk monetary policy may become ineffective.” Pick your poison.

What I would note is that the US Fed is moving towards less accommodation, and corporate buyback strategies are feeling it, with high yields moving higher and debt markets becoming less welcoming. For example, JNK on Friday had its lowest settlement since 2009. That’s not the case for HYG, but the trend is the same.

David Stockman on his Contra Corner blog refers to FANG stocks, FB, AMZN, NFLX and GOOG, and notes that their combined market cap is up $450 billion this year (!), and that without these four stocks total stock market cap FELL by nearly 2.5%.

Stock market breadth has been narrow. No secret. Financial conditions are tightening. The renewed USD bid is a restraint on US exports. But for the time being, it’s steady as she goes. As for possible negative catalysts, there are, as always, plenty of them.   Terrorist events in Paris and Mali, with additional threats in Brussels are at the top of the list. Japan may send warships into the South Sea. Puerto Rico is on the verge of default. The point is that asset markets are a major determinant of economic activity, and risks abound.

In terms of trades, in the big picture I favor fading the commodity vs stocks trend, and like the former over the latter. The dollar may have already priced the tightening cycle and a pull back could help support commodities in dollar terms. At the Robin Hood gathering, Boone Pickens said oil could hit $70 next year; one could be in worse company than that.

In terms of the pace of Fed hikes and picking a target, my scenario is two to three hikes between now and the end of 2016. One in December, and the next not until June. I think that puts EDM’16 at 9922.5 at around the right price, and considering the EDM6 9925 straddle at 23, I am more inclined to be a seller than buyer. Last week I suggested buying EDJ 9925/9937/9950 call fly for 2.25. Possible grind higher if data disappoints. I wouldn’t exactly call front end downside trades crowded, but if I were looking to buy puts, it would be on the bond.  Vol is low and the curve is flat. I think 3% is too low of a yield for the long bond going forward.


Net changes in selected markets below:

11/13/2015 11/20/2015 chg
UST 2Y 85.5 90.9 5.4
UST 5Y 166.8 168.5 1.7
UST 10Y 228.0 226.2 -1.8
UST 30Y 305.8 302.1 -3.7
GERM 2Y -37.0 -38.9 -1.9
GERM 10Y 55.8 47.9 -7.9
EURO$ H6/H7 64.0 61.5 -2.5
EURO$ H7/H8 51.5 51.0 -0.5
EUR 107.74 106.47 -1.27
CRUDE (1st cont) 42.00 41.90 -0.10
SPX 2023.04 2089.17 66.13
VIX 20.08 15.47 -4.61



Posted on November 23, 2015 at 5:19 am by alexmanzara · Permalink
In: Eurodollar Options

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