Oct 25. Q: Low to negative rates not working? A: More

Some free-flowing thoughts this weekend, covering the PBoC and ECB easing, Valeant and stocks in general, the FOMC meeting, Business Insider’s most important charts, Illinois/pension problems.


What accentuated the fall of stocks in August? It was the Chinese devaluation and the fear of a new wave of disinflationary pressure. The world has seen rolling waves of attempted currency devaluation with the Japanese really pouring it on in the beginning of 2013, followed by the ECB, and then by China.

This week Draghi signaled more accommodation and the Euro dropped from 113 to 110, the Schatz fell from -27 bps to -32 bps, and China eased. It seems as if the world is depending on the US consumer to suck up all the cheap[er] imports. Is it working? I don’t know if it’s causation or coincidence, but Walmart (WMT), probably China’s biggest customer, has lost a third of its value from the high of this year. Maybe that’s because AMZN is crushing the competition. Maybe it’s because higher wages are compressing profit margins…more on that later.

What happened to the most important commodity in the world? Oil fell to a new monthly low, down 6.5% on the week, partly related to dollar strength. Not exactly a sign that China’s ease is going to pull the world out of the global trade doldrums. Copper also closed at the low on Friday and was lower on the week.

However, stocks have soared this month as the weak employment data in the beginning of October apparently took Fed tightening off the table, and in the week just ended major tech companies posted better than expected earnings. Here’s a tidbit from USA Today:

Five of the best known executives in tech, Jeffrey Bezos of Amazon (AMZN), Larry Page and Sergey Brin of Alphabet (GOOGL), Bill Gates of Microsoft (MSFT) and Mark Zuckerberg of Facebook (FB), all together hauled in more than $10 billion in gains Friday from their stocks following astounding earnings reports. That’s a big slice of the $90 billion in total market value creation minted on Friday for all investors who own these shares.

Sort of points out a connection between Fed policy and income inequality. It also highlights the narrow scope of the stock market rally, which, by the way, was also the case in 2006/07. Nasdaq is within spitting distance of a new high. The Russell 2000 is still 10% below the high made in late June AND below September’s bounce. Maybe the generals will lead the whole army into new higher territory. But it’s an open question. The other aspect of low rates and a quest for return is the Valeant (VRX) strategy of growth through acquisition. Like a lot of things, it works until it doesn’t. From late last year the stock doubled through August; in the past 3 months it was cut in half with a vicious sell off last week. Sort of looks like the Shanghai Composite, maybe we can just throw the non-believers and accountants in jail. [VRX to hold conference call explaining its accounting on Monday].

Switching gears, there was notable put buying in Eurodollars over the past week. For example, on Friday January 9950 puts were bought in size of about 60k (open interest up 53k to 190, settled 5.5 ref 99.51 in EDH6). A bit over $8 million paid in premium on those. There has also been significant accumulation of red midcurve Dec 9900 and 9887.5 puts. There was a new seller of 25k 2EF 9812p at 4.5, so perhaps the front January puts are a simple flattening play. Why are we seeing all the front put buying? Either someone thinks the Fed is going to be hawkish and indicate it stands ready to hike in order to stop financial recklessness, or the wage and employment data is going to have a wicked rebound this month. My bet is on the latter. However, I don’t care how many regional Fed banks are requesting a discount rate hike (8), the Fed leadership cannot pull the trigger, especially with Draghi running in the other direction. The market may be considering the possibility, with the spread between Schatz and UST 2 yr up 8 bps on the week, but the odds are against a move by the Fed this year. Recall, there was also major put buying in December options for the hike in September. There are 3,604,115 EDZ5 puts of open interest, and the only ones that are likely to finish in the money are the 650 lots of 9975 puts.

In any case, the wage story is fluid. Business Insider regularly has a feature called “The most important financial charts” (link at bottom). There are 70 charts, 7 point to wage growth,  6 indicate profit and sales growth slowdown (in part due to higher wages, think WMT), and 3 say the bull market is still in place. I have never seen more space devoted to wage analysis. There was a think tank paper out this week which apparently also cited wage pressures.  Jobless Claims are low, JOLTS data points to better labor markets. Wage strength should be the last piece of the puzzle for the Fed, but as David Rosenberg also points out in BI charts, the Fed mentioned “downside risks” in the Sept minutes more (12x) than any time since June of 2012. Having said that, a large part of the downside risk is due to China. This weekend news outlets carried headlines that Yellen is to give congressional testimony Dec 3, just two weeks prior to the FOMC. Big deal. The Fed is having an impossible time projecting US growth and inflation with the most up to date data in the world, let alone having to handicap China’s policies with murky data.

Speaking of downside risks, an article on Reuters about the financial disaster that is Illinois is worth a look. (Link at bottom).   The state has unpaid vendor bills of $7 billion, over $100 billion in unfunded pension liabilities with another $63 billion just for Chicago, and is not paying lottery winners (even though sappy ads continue to run on tv featuring potential awestruck winners for the seasonal Halloween games). The article states that the governor proposed selling the State of Illinois building in order to save $12 million annually in operating costs. Hmmm…unpaid bills of SEVEN BILLION and we might save 2 tenths of 1% of that. Good call. I’ll tell you what’s spooky…not getting paid.   Unfunded liabilities along with an aging demographic that is more dependent on medical care is a major downside disinflationary risk for the economy, and of course, it’s not just Illinois. Low stock and bond returns, uncertain pensions, higher medical costs. Not exactly encouragement for consumer spending.

In terms of trade strategy, I continue to favor steepeners over the long term, as the Fed can only move gradually, if at all. My larger view has been that risk assets have topped and are moving lower, that junk spreads need to widen further to correctly price risk, that the yen would trade higher to reflect the waning effects of QE. Things haven’t really worked out that way, so it makes sense to use options to limit risk.

Net changes in selected markets below:

10/16/2015 10/23/2015 chg
UST 2Y 60.9 63.7 2.8
UST 5Y 134.7 141.1 6.4
UST 10Y 202.5 208.1 5.6
UST 30Y 286.5 289.6 3.1
GERM 2Y -26.9 -31.9 -5.0
GERM 10Y 54.8 51.2 -3.6
EURO$ H6/H7 53.5 54.5 1.0
EURO$ H7/H8 50.0 51.0 1.0
EUR 113.50 110.18 -3.32
CRUDE (1st cont) 47.72 44.60 -3.12
SPX 2033.11 2075.15 42.04
VIX 15.05 14.46 -0.59






Posted on October 25, 2015 at 11:34 am by alexmanzara · Permalink
In: Eurodollar Options

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