Optical Accuracy

January 5, 2020 – Weekly Comment

I read a paper this week: ‘On the Optical Accuracy of the Salvator Mundi’.  The paper is by a few computer scientists and concerns whether Leonardo accurately depicted the properties of the translucent orb in the painting in “an optically faithful manner”.  The scientists ran a series of computer simulations to determine the size of the orb, its thickness, whether it is hollow glass or solid calcite, what the light source was, and whether the folds of the robe behind it are faithfully depicted according to light refraction.  The authors note that an 1883 publication of Leonardo’s scientific notes and drawings show that he “…had an understanding of light refraction, glass and crystal materials and diffused, direct and reflected light, the relative position of reflections on a round body…” etc.  Sort of boils down to, “Do you think Leonardo knew what he was doing?’


What this paper did for me personally was remind me of a joke, which I slightly modify here.

Three guys die in an accident and are standing before St Peter at the Pearly Gates.  St Peter inquires of the first, “What’s your IQ?”  He responds, around 175.  “Great!  We can discuss Quantum Mechanics and experiments regarding the wave-particle duality of light.”  St Peter asks the same question of the next man who answers about 125.  “Ah, we can converse about experiments done on the Salvator Mundi and the qualities of light diffusion through a hollow orb.”  “And what’s your IQ?” he asks of the last man.  Around 75.  “How’d your SPOO puts do today?”

In spite of the Thursday evening US strike that killed Iran’s top general Qassem Soleimani, SPX closed down only 70 bps on Friday and was barely changed on the week.  VIX shot up… to 14.  The response in the oil market was also fairly muted.  CLG0 ended at 63.05, above the level from mid-Sept ’19 when Saudi oil installations were attacked, but significantly below the high posted in Oct 2018 (76.90) when Khashoggi was killed and Powell re-affirmed the Fed’s tightening program with QT ratcheting up to $50 billion per month.  Which led to a rapid drop in oil to $45/bbl by year end.  

Of course, monetary policy and liquidity considerations are now of paramount importance in the pricing of financial assets, and in this respect Friday’s release of the Dec 11 FOMC minutes bears comment.  First, as an aside, the minutes discussed results of the “Fed Listens” initiative.  Here are a couple of quotes regarding inflation:

Event participants were asked about monetary policymakers’ concerns regarding overall inflation running persistently below 2 percent; they noted that the Federal Reserve could better communicate its reasons for these concerns.

Regarding inflation, participants recognized that segments of the public generally do not regard the fact that aggregate inflation is running modestly below the Committee’s 2 percent goal as a problem.

Seems like the Fed’s hearing isn’t too good.  I might conclude that the public is NOT CONCERNED about a shortfall of a few tenths in the Fed’s preferred measure of inflation, and is much more anxious about rises in the basic cost of living.  However, SF Fed’s Mary Daly suggested over the weekend that the Fed needs a new policy framework to address persistently low inflation.  Bernanke, in his weekend address to the American Economics Ass’n, said the Fed still has plenty of power to fight a future downturn, falling back on QE and strong forward guidance.  Regarding the QE part, in the minutes the FOMC directs the Desk to continue the purchase of $60B/month T-bills at least into Q2 2020, “to maintain over time ample reserve balances at or above the level that prevailed in early September 2019.”  But another operational note suggests QE “monetization mission creep”:

The manager discussed two operational considerations around policy implementation. The first involved the risk that future Treasury bill purchases could have a larger effect on liquidity in the Treasury bill market in light of expected seasonal declines in bill issuance and the Federal Reserve’s growing ownership share of outstanding bills. If this risk were to materialize, the Federal Reserve could consider expanding the universe of securities purchased for reserve management purposes to include coupon-bearing Treasury securities with a short time to maturity.   

I thought QE and forward guidance were to be used in the event of a DOWNTURN.  Well perhaps Friday’s release of Mfg ISM fits the bill.  At 47.2 it was the lowest reading since 2009. 

My note last week was titled ‘Possible Removal of Liquidity Insurance’.  I thought the Fed would be keen to withdraw some of the extraordinary liquidity injected to cover year-end.  The minutes touch on this:

The manager also discussed expectations to gradually transition away from active repo operations next year as T-bill purchases supply a larger base of reserves. The calendar of repo operations starting in mid-January could reflect a gradual reduction in active repo operations. The manager indicated that some repos might be needed at least through April, when tax payments will sharply reduce reserve levels.

So the Fed wants to reduce market dependence on constant large repo ops, but is already sweating the April tax date.  The directive to keep buying bills to maintain ample reserves above early Sept 2019 shows just how searing a scar the mid-Sept repo spike caused.  However, there is one other important passage that DOES suggest the Fed’s discomfort with endless liquidity: 

As reserves remain ample, the manager noted that it may become appropriate at some point to implement a technical adjustment to the IOER rate and the offered rate on overnight reverse repurchase (ON RRP) agreements. Should conditions warrant this adjustment, the IOER rate could move closer to the middle of the target range for the federal funds rate, and the ON RRP rate could be realigned with the bottom of the target range.

This excerpt had an immediate effect on the market.  Feb20 Fed Funds (FFG0) closed down 1.5 bps on the day at 9842.5 or 1.575% while  FFG21 closed +7.0 on the day at 9871.5 or 1.285%. An eight and a half bp swing in the one-year calendar! One Fed official after another has emphasized that current policy rates are in the right place, but this possible tweak in IOER (potentially priced for the Jan meeting) along with increased international uncertainty, conspired to cause profit taking in long curve trades.  Trump has adopted Bernanke’s forward guidance dictum to inform Iran that any response will be met with specific and goal-oriented measures by the US.  However, Reuters reports that Iran’s army chief said the US “lacks the courage for military confrontation.” The geopolitical situation has translated once again into a bid for longer dated treasuries. The 2/10 spread closed Dec 31 at the high of the year, 35.2.  On Friday it fell 4.3 to 26.5.

There have been several twitter posts now about how the extraordinary liquidity supplied in 1999 to get the world through Y2K coincided with a huge rally in Nasdaq, while the subsequent withdrawal resulted in an instant decline in Nasdaq at the start of the year 2000, with the implication being that the same pattern might play out in 2020.  The issue is that even though some Fed members are worried about future dislocations…

A few participants raised the concern that keeping interest rates low over a long period might encourage excessive risk-taking, which could exacerbate imbalances in the financial sector. primarily in response to a somewhat higher projected path for equity prices.

…the overwhelming theme of the minutes is to avoid a repeat of the Sept repo squeeze at any cost.   

I’ll end with a chart of SPX priced in gold.  This is where our 75 IQ guy sidles past St Peter and mutters, “But I’m also long gold.”     


Last week I ended my note with “It seems as if gold might be the safest harbor no matter what happens in the beginning of 2020.”  GCG0 rose $34 last week. 

This week brings auctions of $38b 3-yrs, $24b 10’s and $16b 30’s starting on Tuesday.  Safe haven supply.  The employment report is Friday with NFP expected 162k from 266k last. 


The combination of the turn being in the rearview mirror and the US statement to Iran’s leadership led to a rally in near contracts.  EDF0 rallied as high as 9820 before coming back to settle 9818.75 post-minutes.  EDH0 traded to 9829.5 but settled 27.0.  If IOER is moved up by 5 bps to 1.60%, this might suggest forward lib/ois in the mid-teens. On Friday, EDH0 9825 straddle was bought for 8.5 having been trading at 7.5 early in the week.  EDM0 9825^ settled 16.0 versus 9835.0 in EDM0, and the 9837.5^ settled 18.0.  

With the flight-to-quality rally in treasuries I would expect some high gamma put buys before NFP, with a likely candidate being Green Jan puts which expire Friday.  2EF0 9837.5p settled 1.0 ref 9849.5 in EDH22, while 9850 puts settled 5.25.  In tens, Jan week-2 TY (TY2F0) 129p settled 11 vs 129-12+. 

I would assume that Iran responds at the margin by not directly attacking US installations, but rather targeting soft targets of allies in the hopes of creating divisiveness while avoiding further military incursions by US forces.  This will likely underpin a bid in five year treasuries.   5/30 remained buoyant at 66.3 by week’s end.  I would expect 5/30 to test last year’s high of 80 this month. 

12/27/2019 1/3/2020 chg
UST 2Y 158.5 152.3 -6.2
UST 5Y 167.6 158.8 -8.8
UST 10Y 187.2 178.8 -8.4
UST 30Y 231.0 225.1 -5.9
GERM 2Y -63.0 -61.9 1.1
GERM 10Y -25.6 -27.8 -2.2
JPN 30Y 43.2 41.1 -2.1
EURO$ H0/H1 -19.5 -25.5 -6.0
EURO$ H1/H2 4.0 3.0 -1.0
EUR 111.76 111.60 -0.16
CRUDE (1st cont) 61.72 63.05 1.33
SPX 3240.02 3234.85 -5.17
VIX 13.42 14.02 0.60
Posted on January 5, 2020 at 4:51 pm by alexmanzara · Permalink
In: Eurodollar Options

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