Villains and Heroes
June 6, 2021 -Weekly Comment
“I guess when one’s young, it seems very easy to distinguish between right and wrong. But as one gets older, it becomes more difficult. The villains and the heroes get all mixed up.” Rene Mathis – Quantum of Solace (James Bond)
The bond market is bulletproof. It has absorbed all types of bearish news: high inflation data, increasing government deficits, labor shortages. The ten year yield hasn’t deviated far from 1.60% since March, ending Friday at 1.56%. down 2.6 bps on the week. This, despite the highest ISM Service number ever at 64.0, ADP payroll growth of 978k followed by a “disappointing” NFP of 559k with an unemployment rate of 5.8%. Suzanne Clark, President and CEO of the US Chamber of Commerce said, “The worker shortage is a national economic emergency, and it poses an imminent threat to our fragile recovery and America’s great resurgence.”
The argument that inflation is unsustainable is winning the day, with analysts like David Rosenberg and Lacy Hunt citing high debt levels, etc. Of course, the most powerful voice in favor of continued monetary accommodation in the face of transitory price pressures and slack in the labor market is that of the guy pulling the levers, Chairman Powell.
For the sake of historical curiosity, see the chart below from the mid-1970’s, prior to birth of most of our trading community. Unemployment was over 11% as inflation began to accelerate, from about 5% in late 1976 to a high of 14.7% in March of 1980. Unemployment bottomed at 5.7 in June of 1979. Two takeaways from this chart. First, inflation WAS “transitory”, it only accelerated for three years. Second, inflation was able to increase, even with the unemployment rate well above Friday’s reading of 5.8%. Of course, you wouldn’t have wanted to maintain long positions in fixed income during this particular transitory period, as the ten year yield went from 7% at the start of 1976 to over 13% in 1980.
Again. I remind you that the current ten year yield is 1.56%, with a real yield as defined by the ten-year tip of negative 90 bps, and even more negative than that if you use the last CPI data of 4.2%.
David Rosenberg, in making his argument for price increases merely being a one-time shift, often repeats that there is no “regime change”. The election of Obama, which some thought might produce inflation, didn’t. Bernanke’s unorthodox (at the time) QE policies didn’t spark inflation, nor did Trump’s tax cut package.
My personal feeling is that “regime change” indeed occurred, specifically with the change in the Fed’s framework in August of last year. That’s when curves started to steepen. Commodity prices had already bottomed prior to August, but never looked back since September. I’ll note one more thing about regime change which concerns data that will be released this week on the tenth, the Fed’s Z.1 flow of funds report. In 2007, on the cusp of the GFC, total Household debt was $10.577 trillion. Total Business debt was $10.678T and the Federal Gov’t came in at $7.376T. Roughly a third each, with the Federal Gov’t lagging. The last report is from Q4 2020. Household debt nearly unchanged at $10.935T. Total Business debt $17.719T (which the Fed sometimes refers to as being on the high side of historical norms as compared to GDP). And then there’s the Federal Gov’t at $23.621T, about three times higher than 2007. In my opinion, these shifts represent regime change, though not in the sense of being abrupt. If the footprint of the Federal Gov’t were about to become significantly smaller, it would likely have disinflationary consequences. In fact, that’s part of Rosenberg’s thesis, that Biden’s hand will be constrained by a new Congress following the 2022 elections. Maybe so, but sometimes markets operate with lags. One other note, the Fed’s Household Debt and Financial Obligations ratio is last at 14.71%. That is one of the lowest ratios ever, and why Fed officials often say that the Household balance sheet is in good shape, in aggregate.
The next quarterly Z.1 report is released on Thursday. Of more immediate concern to the bond market is CPI, also released on Thursday, expected 4.7% yoy from 4.2% last, with Core expected 3.4%. Again, this is with the ten year yield at just 1.56%. Additionally, the market will need to fund approximately $99 billion above maturing amounts with this week’s auctions of $58b 3-yrs, $38b 10-yrs and $24b 30-yrs.
Tin foil for this last bit. When they say the only choice is to inflate out of debt, it becomes clear that what they’re talking about is a government bailout of government. Oh sure, the government shifted some private debts from business and households to its balance sheet after the GFC. The response due to COVID has been extraordinary. Now the government needs to save itself with inflation. Sure, there’s a concern that if inflation jumps rates will rise, and the interest burden will become onerous. But not if rates can be held artificially down and higher price levels help expand nominal GDP in order to lessen the debt-to-GDP ratio. Perhaps I am being cynical here, mixing up villains and heroes, but if you thought the government’s response to help the public get through covid was heroic, just wait until you see the lengths to which the government will go to help itself.
OTHER MARKET THOUGHTS/TRADES
The popular trade of the week was buying put spreads and selling call spreads. Of note, 2EZ 9900/9787ps was bought vs selling 2EZ 9925/9937ps. 2EZ options have EDZ’23 as the underlying future and expire on 10-Dec-2021. Open interest in the 9900p rose about 160k on the week; the package traded around 100k. Settlements on Friday: 9900/9787.5ps 4.25 and 9925/9937.5cs 4.25, so flat with EDZ3 9906.5. That is, a put spread just 6.5 out of the money settled at the same price as a call spread 18.5 out of the money. This is available due to skew. For example, the 9937.5c settled 4.5, 31 out of the money, while the 9875p settled 8.0, 31.5 out of the money. One might conclude that the demand for puts represents insurance purchases for the case of higher rates, and that since the risk has been adequately addressed and priced, it’s not quite as likely. That’s what the Fed is telling you. Weakness in USD might be telling you something else.
Related to buying of put spreads in greens rather than further out points up another somewhat interesting aspect of the week’s trade: The steepest part of the curve has been greens to blues, or contracts in the year 2023 vs contracts in 2024. The peak one year spread has been EDM23/EDM24 which closed the week at 66.5. These elevated one-year spreads are partially due to the June 2023 end of libor and partially due to the idea of Fed hikes commencing two or so years hence. Consider the September expiration contracts: EDU’21 settled 9988.0, up 0.5 on the week. EDU’22 at 9974.0, up 1.0 on the week, EDU’23, 9921.0 up 1.5 on the week, EDU’24 9862.5 up 4.5 on the week. The one-year spreads are as follow, EDU’21/22 14.0, down 0.5, EDU’22/23 53.0, down 0.5 and EDU’23/24 58.5, down 3.0. All yields declined slightly on the week, but the year 2022/2023 spreads held up better than the year behind. Small moves, but it could be that the market is thinking removal of Fed accommodation could be slightly sooner than previously expected.
Nearing the July 1 date of the 100th year anniversary of the China Communist Party. The yuan eased slightly this week with the increase in FX required reserve ratio, the ten year yield rose just over 4 bps to 3.13%. Things in China will likely be as tightly scripted as a Biden news conference, but there are probably some actors who wish to cause disruption on such a momentous occasion.
| 5/28/2021 | 6/4/2021 | chg | ||
| UST 2Y | 14.1 | 14.9 | 0.8 | |
| UST 5Y | 79.5 | 78.4 | -1.1 | |
| UST 10Y | 158.6 | 155.9 | -2.7 | w/I 156.2 |
| UST 30Y | 226.2 | 223.8 | -2.4 | w/I 224.2 |
| GERM 2Y | -66.2 | -67.1 | -0.9 | |
| GERM 10Y | -18.3 | -21.3 | -3.0 | |
| JPN 30Y | 66.8 | 69.0 | 2.2 | |
| CHINA 10Y | 308.7 | 313.0 | 4.3 | |
| EURO$ U1/U2 | 14.5 | 14.0 | -0.5 | |
| EURO$ U2/U3 | 53.5 | 53.0 | -0.5 | |
| EURO$ U3/U4 | 61.5 | 58.5 | -3.0 | |
| EUR | 121.92 | 121.68 | -0.24 | |
| CRUDE (active) | 66.32 | 69.62 | 3.30 | |
| SPX | 4204.11 | 4229.89 | 25.78 | 0.6% |
| VIX | 16.76 | 16.42 | -0.34 | |
https://www.federalreserve.gov/releases/z1/20210311/html/d3.htm
https://home.treasury.gov/system/files/221/TBACRecommendedFinancingTableQ22021-05052021.pdf
In: Eurodollar Options
Payroll day
June 4, 2021
–Yields rose modestly in front of today’s employment report. Tens +3.2 bps to 1.623%. Curve steepened with twos up only 1.3 to 15.8. NFP expected 650 to 675k. Yesterday’s ADP was 978k and ISM Services were at a record high 64.0. The bond market has been tremendously resilient in the face of rising commodity prices, pockets of dislocation in stocks, and robust economic data. The 1.60% yield level has been like a magnet. However, as the June 16 FOMC meeting draws nearer, bringing the prospect of a modicum of restraint with respect to policy, I think a move to higher yields is probable. The “risk management” reason for extreme accommodation has been the possibility of a covid variant resurgence, which appears to be less likely as time goes on.
–July WTI (CLN1) is above $69 bbl this morning. Commodities generally remain in strong uptrends. Here’s how you’re going to know that inflation is NOT transitory. When Fed officials start blaming speculators for price increases. (Until then, they can keep discussing core Fed objectives of equality and climate change). Here’s an idea: how about doing something about the incredible pressure on short end rates due to massive excess reserves, a situation which is making some think that the low funding party will never end?
–New recent high in EDU1/EDU2 yesterday at 15.5, up 1 on the day. Also quite a bit of buying of put spreads vs call spreads in dollars, most notably a new buyer of approx 50k 2EZ 9900/9887.5ps vs 9925/9937.5cs for 0.5 to 1.0. Settled 1.25 with the put spread 5.0 and call spread 3.75, but the put spread is at the money, with EDZ2 settling 9900.5. I’m probably guilty of trying to fit these trades into my bias toward higher rates and a faster response by the Fed, but action on the eurodollar curve does seem to be moving slightly forward.
In: Eurodollar Options
Bulls and bears
June 3, 2021
–Bull market: hacking for ransom. Bear market: NFTs. On the first topic, the FT has a headline, ‘Biden to rebuke Putin over hack of meat processor JBS.’ Oh good, I feel better now. On the second, I provide the link below with this interesting quote, “The NFT market has imploded over the past month, with sales in every single category almost entirely drying up.”
https://protos.com/nft-market-bubble-popped-crypto-collectibles-are-over
Perhaps the hackers are becoming a bit more discriminatory with regards to spending their ransoms. Maybe now they are prudently accumulating Soybean Oil (new highs). Or maybe global liquidity is drying up around the edges. ZH reports that the Fed intends to wind down the Secondary Market Corporate Credit Facility, or SMCCF, which “holds about $13.7 billion in already outstanding corporate bonds.” Given that the Fed is buying $120B in treasuries and MBS per month, shedding $13.7B into a frothy market should be a snap, and I am sure it will be. But even this change at the far margin is a symbol (finally) of some restraint out of the central bank.
–The ten year sees the 1.60% yield as a magnet, falling 2.4 bps yesterday to 1.591%. However, option trades in dollars were slanted to the downside (for higher yields). For example, a new buyer of 20k 2EZ 9900/9875/9862/9837 p condors for 4.75. Max profit on this trade occurs at expiration if EDZ3, which settled 99.055, is between the middle two strikes, i.e below 9875 and above 9862.5. That would be consistent with a FF target of 1.0 to 1.25% by December of 2023, but the options expire at the end of this year.
–This morning there is a buyer of 2EZ 9900/9887ps vs selling 9925/9937cs, paying 0.5 for 17k. This trade makes a max of 12 bps below the bottom strike of 9887.5. (thanks NovaSatus Trading and Pricing Monkey). Same idea as the condor above.
https://twitter.com/G65/status/1400375084930502656
While there have been a lot of put buyers further out the curve in blues and golds, these trades are moving the idea for potential hikes closer in time.
–ADP and Jobless Claims today expected 650k and 387k respectively. ISM Services 63.1. Yesterday 3-month libor finally edged a touch higher at 13.4 bps, but BSBY3m, the BBG bank funding index, sank to a new low of 8.805 bps. No signs of reduced liquidity there. In fact, EDM1/EDU1 three month calendar spread settled negative 0.5, a new recent low.
In: Eurodollar Options
QE risks vs benefits
June 2, 2021
–The purpose of $120 billion per month in QE is to bring employment back to full capacity, which I suppose means that all service businesses that closed during Covid should be re-opened. At this point, QE appears to be a blunt tool, working against a counterforce of extended unemployment benefits. Yesterday Bullard said the US job market is tighter than it looks. We’ll get more information on Friday, as the employment report is released (NFP expected 650k). The gains on employment from additional QE appear marginal at best, however, downward pressure on money market rates is increasing due to QE, with $448 billion in RRP yesterday. Short rates continue to make new lows, with 3 month libor setting below 13 bps yesterday. Rock bottom short term yields are fostering speculation; moving investors further out the reddit risk curve. I would personally judge that benefits of QE are now completely outweighed by risks to financial stability that will ensue with an unwind of complacency. Perhaps some clues will come with today’s release of the Beige Book, exactly two weeks before the June 16 FOMC announcement.
–Are price pressures increased by continued hacks? Yesterday JBS beef plants were hit, with ramifications to US meat supplies. Security enhancements and redundancies are likely not transitory in nature. But if that’s conceptually hard to quantify, WTI prices above $68/bbl aren’t.
–The curve edged a bit steeper yesterday, with tens +2.9 bps to 1.615% and bonds +3.2 to 2.294%. Relatively quiet in dollars, though red/gold pack spread rose 4 bps to 162.25. In late March I marked this spread as high as 182.
In: Eurodollar Options
One more straw
June 1, 2021
–Reflation trade this morning with July WTI over $68/bbl at a new high. China raised the FX required reserve ratio from 5 to 7% in order to stem the strength of the yuan and it is having the intended effect with CNY now 6.38. Eurozone Markit Manufacturing PMI released this morning at 63.1, a new high, with input prices at 87.1 from April’s reading of 82.2, “easily the highest on record”. US rate futures are lower this morning with TYU down 8 at 131-22.
–US Manufacturing ISM today expected at 60.9 with prices 89.8. Thus far rate futures have absorbed every straw of high inflation data without budging in price, but the weight of evidence is growing. Even if inflation isn’t sustained at the current levels, extraordinary accommodation seems misplaced. The employment report is slated for Friday morning, with NFP expected 650k.
–The peak one-year eurodollar calendar spread is EDM’23/EDM’24 which settled Friday at 69 bps. It’s less than 10 off the high settle of the move which was 78 in early January. For the sake of comparison, the spread was around 15 when the Fed announced its change of framework in August. Of course, June of 2023 is when libor ends, thus making this spread a bit higher than others, but EDU’23/EDU’24 is still 61.5 bps. Compare these spreads with June’22/June’23 at just 38 bps. Rate hikes are currently priced more aggressively further out the curve, but may move more forward as inflation and economic data continues to strengthen.
In: Eurodollar Options
Can zero rates in an inflationary environment foster destabilization?
May 28, 2021
–Front eurodollar futures are making new historic highs, with the June’21 contract settling 99.8825 or just 11.75 bps. The July and August contracts settled 99.885. Three month libor has been making a new low every day as the Fed’s RRP is flooded; yesterday’s operation totaled a record $485 billion. At the same time, stocks are near all time highs, and one article noted that Memorial Day gas prices are the highest in seven years. The Q1 GDP Price Index from yesterday’s data was 4.3%, a new high, though I only looked back to 2006. The zero-rate regime is almost certainly creating distortions that are unlikely to unwind gracefully. Yesterday’s price action featured a steeper curve, with tens up 3.4 bps to 1.608% and twos unchanged at just 14.5 bps. So 2/10 ended at 146.3, while the red/gold pack spread (2nd to 5th years on the euro$ curve) rose 3.25 bps to 158.5. Option trades favored the downside, with new put buying vs call selling occurring yesterday. There were also a few outright large futures sales, for example, 60k EDZ2 sold at 99.615 on a block. One hike before the end of next year puts this trade in the money; the contract settled 99.62 yesterday. Just 38 bps by the end of next year. I have a feeling the world will look very different by that time. Will USD continue to attract backers with yields this low against an increasingly inflationary backdrop? (Even if transitory). China yuan at a new high vs USD 6.365. The trade weighted dollar made a new low for the year but DXY has seen a small bounce in the past three days.
–Today’s news includes the Fed’s favorite inflation metric, PCE Core yoy Price, expected 2.9%.
In: Eurodollar Options
Bottlenecks that don’t open
May 27, 2021
–Yields edged slightly higher with tens up just over 1 bp at 1.574%. Once again, three month libor set a new historic record low yesterday at 13.5 bps, as the Fed’s monster RRP operation totaled $450 billion. Huge buyer of 50k EDU1 early at 9986.5 supported a final settle of 9987 or 13 bps, with EDM1/U1 settling at a new low of just 0.25. There was a chaotic trade in the US bond roll, with the June/Sept spread surging from around 1-19 to 2-24 on a massive buy; the exchange let all trades stand but capped the price at 1-26.25. A change of 2/32’s on a day is big. This error was extremely expensive with the spread settling 1-19. Trade was said to be over 200k contracts. 7/32’s on 100k contracts is $22mm.
–Quarles gave a balanced speech on the outlook of the economy, acknowledging economic strength and that inflation is significantly above 2%. His outlook is mostly optimistic about sustained strong growth due to savings and the continued re-opening, but he warned a couple of times on supply bottlenecks that could keep inflation elevated and said it would be appropriate to discuss tapering at upcoming meetings. He noted elevated asset prices and business debt, but also said cash flows were ample. Not as forceful as Kaplan’s comments have been, but his opinion likely carries greater weight within the FOMC.
–With money-market rates at rock-bottom lows, a change in IOER is almost certain to cause a small jolt to the short end. The lower these yields go in a blistering economy, the more likely that Dudley’s warnings about a taper ‘tantrum’ are likely to come true.
–Supplier delays are a form of inflation, and a leading headline from the FT highlights the situation: “Tesla set to pay for chips in advance to overcome shortage. Electric car maker also explores buying foundry but analysts warn of high costs.” When Quarles warns of the risk of continued bottlenecks, here’s a solid example.
–Durables and Capital Goods today, along with Q1 GDP adjustments. Jobless Claims expected 425k, Seven year auction.
https://www.federalreserve.gov/newsevents/speech/quarles20210526b.htm
In: Eurodollar Options
Gaming the system
May 26, 2021
–Another new historic low in 3 month libor yesterday at 13.85 bps. Yesterday’s Fed Reverse Repo operation totaled an astonishing $435 billion. (Going big). Given the magnitude of excess reserves, yields again fell and the curve flattened, with tens down 4.4 bps to 1.562%. The red eurodollar pack was +2.0 on the day (second year forward) while greens, blues and golds (3rd, 4th, 5th years) were +4.25, +5.5 and +5.75. The red/gold pack spread made a new recent low, just over 154 bps.
–They say that the cure for high prices is high prices, and some commodities, like corn, were bashed yesterday. Housing may be undergoing sticker shock which could slow activity, as evidenced by the tumble in New Home Sales which fell 5.9% yesterday. However, the monetary authorities appear to believe that in the case of stocks, the cure for high prices is higher prices. Yesterday, speculative darling Gamestop closed at 209, the highest since March. We’re back baby! After the upward burst to 483 in January, it languished around 50 for much of February. Does GME have anything to do with excess liquidity engineered by the Fed and federal government? Nah. There’s a story that Biden is being urged by the chief of righteous indignation, Elizabeth Warren, to dump Quarles, who is the Fed’s man in charge of bank supervision, because he missed the Archegos blow-up. (By the way, Quarles speaks on the economy at 3:00pm today). Um, Senator Warren, short rates are being pounded to dust and government spending has engendered excess liquidity that could threaten financial stability. Archegos was but one manifestation. Just keep your eyes on that tree.
–At the same time, taper talk is heating up again, with Zoltan Poszar saying rates don’t necessarily have to rise due to tapering, if the Fed unleashes the Wells Fargo balance sheet from its regulatory shackles simultaneously. That’s a great solution! Let Wells buy the rich mortgages, being underpinned by record housing prices, so that we can keep asset price plates spinning. Certainly we don’t want the economy to continue to labor under a stifling ten year treasury yield above 1.5% any longer than is necessary. The USD dollar is trying to sidle quietly out of the circus tent, unnoticed. However, CNY is at a new high this morning at 6.3926. June Gold is holding above $1900.
In: Eurodollar Options
RRP
May 25, 2021
–Usage of the Fed’s RRP facility hit a whopping $395 billion as attached chart shows. It’s hard not to conclude something is ‘wrong’ when we see this sort of outlier regarding EXCESSS excess reserves. New historic low yesterday in 3-month libor at 14.088 bps. This morning China yuan is at a new high vs USD around 6.40. Yesterday Brainard said inflation expectations are “extremely” well-anchored (as dollars continue to flood into the system, thereby raising every price). DXY is 89.60 this morning, testing the year’s low.
–Today’s news includes New Home Sales expected 950k, Consumer Confidence and the auction of 2-year notes with when-issued yielding about 15.7 bps, just over 1.5 bps above 3m libor. Curve flattened somewhat yesterday with tens down 2.2 bps to 1.606%. The thirty year bond fell 3 bps to 2.301%.
In: Eurodollar Options
Fed framework change was a catalyst
May 24, 2021
–Over the past month TYM has pretty much traded from 131-28 to 132-20, currently at the upper end of that range at 132-17. On Friday ten year cash yield ended at 1.628% nearly unchanged from Thursday. Implied vol has compressed and is now at the low end with July at 4%. Tremendous usage of the Fed reverse repo operations with $369 billion on Friday, indicate that excess reserves are smothering the system. Three month libor posted a record low on Friday at just 14.7 bps. Against this backdrop of forced liquidity, it’s difficult for risk assets to sustain lower moves. Even bitcoin, which traded as low as 31280 yesterday is back above 36k this morning. Auctions of 2, 5, and 7 year notes this week are likely to see solid demand.
–A post on ZeroHedge outlines David Rosenberg’s thesis that inflation will be transitory, that by Q4 the stimulus surge will wear off at the same time supply chains are being repaired. He notes that M2 money supply growth has not been correlated to inflation and cites longer term inflation breakevens to conclude that higher expectations have not taken hold. All legitimate arguments that could end up being right. I am much more inclined to note that curves began to steepen almost immediately after the Fed changed the policy framework in August. In hindsight one can see that many commodities started their run around that time. Ordinary conversations indicate that inflation expectations have increased. The regulatory burden of the new administration is likely to bolster instincts to hoard, perhaps exemplified by the push for a global corporate tax of 15%. The US previously was under a disinflationary cloud due to a weak yuan and cheap manufactured goods from China. Now US military officials have been repeatedly rebuffed in attempting to communicate with Chinese counterparts. Is that a signal of frictionless global trade? Can we be certain that chip supply out of Taiwan will be completely reliable? The yuan has consistently strengthened against USD for a year, from 7.1 last summer to 6.43 now, and of course USD has lost value against all basic commodities. Fiscal and monetary stimulus in the wake of covid have been overwhelming and have unwittingly been successful in changing consumer and corporate psychology in the US. I think that’s what Rosenberg misses, but even if he’s right, does a ten year yield of 1.63% with deeply negative real rates make sense for the US?
–All I am saying is that this was probably a pretty fun wedding to attend
In: Eurodollar Options
