Blue Light Special
On December 27, 2018, a mysterious blue light illuminated the Manhattan skyline, as, reportedly, a power plant electric transformer blew-up in Queens. At the same time, news was circulating that Sears Holdings had just days to stay alive, awaiting a proposal from Eddie Lampert’s, ESL Investments.
Now, stay with me here… Sears bought K-Mart. K-Mart used to run “blue light specials” on sale items, where a blue light bulb would flash over featured products. CNBC ran an article in the beginning of October which noted that “Total real estate sales in Manhattan fell 11% in the third quarter compared with the previous year”…”Prices fell, inventory jumped and discounts were higher and more common.” “The average price of a Manhattan apartment fell 4% during the quarter…” And that’s before stocks fell out of bed in Q4. It was obviously a BLUE LIGHT SPECIAL on Manhattan real estate and the stock market. Or an alien invasion. Take your pick.
There were a few amusing comments, but I especially liked this one by @michelledean
Sort of depressing to know that the apocalypse will begin with people on twitter posting, “What the f**k was that”
There are a lot of people in the financial markets looking at recent activity and asking the same question. It’s not such a stretch to think that markets were already, well, stretched. At the end of Q3 2018, market cap to GDP was 146% essentially at the same level as the Nasdaq inspired peak in Q1 2000. Corporate debt to GDP is at a record (though a Moody’s piece by John Lonski from Sept 2018 notes that NET Corporate Debt to GDP is a more accurate measure and is not flashing any warnings). However, consider this, as of end of July 2018, a CNBC article reported that AAPL had $244b in cash. Having participated in this year’s repatriation tax break, AAPL bought back shares– I would suspect right up to the peak at the end of September. In any case, ‘Cash & Short Term Investment Growth’ reads as follows on the balance sheet: 31-Mar-18, +13.98%, 30-Jun-18, -19.3%, 30-Sept-18, -6.58%. Sequential declines. AAPL was spending cash to buy back shares in a rising market, which, of course, many companies did, some by using cash flow and some by borrowing. In any case, balance sheets weaken at the margin, leading to the largest percentage ever of investment grade debt sitting just above junk. This activity is sort of parallel to the mortgage withdrawals of 2006/2007. Borrow money from an asset (rising home prices) and spend it on other things. Feels good for a while. I am only using AAPL as an example because it was pointed out to me by a client (thanks TW). There was also a NY Times article that noted, “Among companies in the S&P 500, each of the five largest quarterly stock buybacks on record was by Apple” (a total of $43.5 billion in the first half of 2018). As of Friday’s close, every one of those share buybacks in 2018 is a loser.
Now I want to mention a few market indicators. First, EDH19/EDH20 calendar spread plunged 10 bps this week from -3.5 to -13.5. In the past two weeks it has declined by 22 bps from +8.5 on Dec 14. What’s notable is that the market is essentially moving up the timetable for a Fed policy reversal. As of Dec 20, EDZ19/EDZ20 was the most negative one-year calendar at -18. At that time EDH9/H0 was -0.5, M9/M0 -8.5, U9/U0 -15.5. Now U9/U0 is the lowest at -18.5. Z9/Z0 actually firmed by half a bp on the week to -15.5. The Jan’19/Jan’20 FF spread has gone from POSITIVE 11.5 to NEGATIVE 1 in a week.
How does the Fed respond? As I mentioned last week, the fastest ‘hike to ease’ in the modern era was Greenspan, with a hike on Sept 22, 1987 to 7.25%, followed by a cut just one month later on Oct 19, 1987 to 6.75% (the 1987 crash). The current Fed has the face-saving option of altering the balance sheet reduction schedule, rather than overtly admitting a policy era and genuflecting to Trump by cutting the FF target. Now, some people don’t think the $50 billion in balance sheet run-off is important. I would only say that cumulative flows eventually have an impact, and stock market action since October is a case in point. Share buybacks were also important on the way up, but hit a wall of declining efficacy at the margin. The last straw.
Powell and Williams already softened the neutral rate risk by saying we’re now at the lower bound. Last Friday (Dec 21) Williams said the Fed could change the balance sheet reduction schedule, or stop it. On the administration’s side, Trump tweeted that he had made good progress on a phone call with Xi this weekend. He also opened the door to a lesser sum than $5 billion for border security. This is an important point: Markets are increasingly calling the policy shots. It harkens back to Clinton in 1994, when Greenspan said that a credible deficit reduction plan was necessary to placate markets. From Bob Woodward’s book The Agenda: “Clinton’s face turned red with anger and disbelief. ‘You mean to tell me that the success of the program and my reelection hinges on the Federal Reserve and a bunch of ——- bond traders?’” [Result, credible budget] On Friday CNBC’s Scott Wapner reported that a senior Trump admin official called a large investor asking what needed to be done to turn the market, characterizing the tone of the inquiry as ‘desperate’. The advice was 1) stop criticizing Powell, 2) stop turnover in the WH ranks 3) cut a deal with China.
The circular nature of policy meddling presents a bit of a conundrum. If Trump starts cutting deals to push stocks up, it strengthens the hand of the Fed to continue policy normalization, and lean against (artificial?) asset appreciation.
I can envision the following scenario: Early January: deal struck with China. A Trump ‘win’ and softening of border wall demands leads to an end of the gov’t shutdown. Stocks stabilize or rally, giving the Fed some breathing room. At the January 30 FOMC the Fed announces changes to the balance sheet reduction program. This lends further support to stocks, but yields on longer maturities rise. (Shouldn’t yields decline? Well, when the Fed announced QE programs, it was stocks that rose, and bonds that fell. The same could happen here).
Of course, it could be that a China deal proves elusive, with XI pressing his advantage now that Trump appears weaker. There were some large treasury call spread buyers on Friday that seem to reflect concern that this stock rally won’t last: +40k FVG 114.25/115.25 cs bought from 20.5 to 22 (New position, settled 22 vs FVH9 114-14). And, +50k TYG 121.5/123.5 cs bought from 30 to 33 (New position, settled 33 vs 121-20). The 115.25 strike in FV is approx. 17 bps away, and the 123.5 strike is approx. 25 bps away.
OTHER MARKET/TRADE THOUGHTS
Feb/April FF spread settled 1.5, a new low, -2.5 on the week. May/July settled +0.5 and August/October -0.5. As mentioned above Jan’19/Jan’20 FF settled -1.0. I.e. no hikes in 2019.
A few updates: 3EU 9800c (EDU22 underlying, 9737.5s) settled at 8.75, plus 2.5 on the week, with the total long 250k (These were bought 3.5 to 5.5; the market may never get to strike, but otm calls still make money). 0EJ 9712/9737c 1×2 settled -6.0 (original rec to buy +0.25). This latter trade is the sort of disaster that has fueled the bid on a scramble to exit.
As cited during the week, three month libor is at a rate (2.792%) which is now above EDH9 and EDF9 for that matter. EDF9 closed 9724.75 or 2.7525% and EDH9 9729 or 2.71%. Therefore, convergence would suggest limited upside for these two contracts. (Chart is 3m libor vs the rate on EDH9, now inverted).
The chart below is the ten year yield. It has broken a trendline from mid-2016. The 38.2 retrace is 2.52%, which would approximately equate to TYH9 123-08.
The chart below shows the red to green euro$ pack spread (2nd to 3rd year). As noted, it hasn’t been positive since August. On Thursday it finally settled 0, though on Friday it went back to -1.125. Reds have led the way higher as stocks fell and near calendar spreads imploded. This and other spreads are now indicating that the Fed may have to ease. Interestingly, the steepening move at the start of the year was due to tax stimulus and the idea of strong forward inflation and growth. But the end-of-year rebound telegraphs an opposite macroeconomic backdrop. My interpretation is more uncertainty and volatility.
HAPPY NEW YEAR to all.
*********************************************
| 12/21/2018 | 12/28/2018 | chg | |
| UST 2Y | 263.3 | 253.4 | -9.9 |
| UST 5Y | 265.5 | 257.0 | -8.5 |
| UST 10Y | 279.0 | 273.4 | -5.6 |
| UST 30Y | 302.7 | 304.1 | 1.4 |
| GERM 2Y | -60.2 | -60.9 | -0.7 |
| GERM 10Y | 25.0 | 24.2 | -0.8 |
| JPN 30Y | 74.2 | 70.4 | -3.8 |
| EURO$ H9/H0 | -3.5 | -13.5 | -10.0 |
| EURO$ H0/H1 | -11.0 | -9.0 | 2.0 |
| EUR | 113.70 | 114.43 | 0.73 |
| CRUDE (1st cont) | 45.59 | 45.33 | -0.26 |
| SPX | 2416.62 | 2485.74 | 69.12 |
| VIX | 30.11 | 28.34 | -1.77 |
Dec 28. A year-end for the books
–Massive late rally in stocks saw ESH surge from 2400 to 2475 just after the 7 year auction. Further gains this morning with a current print of 2510. Yields responded mildly to the monster rally, yet still finished much lower on the day with tens down 5.2 bps to 274.3. The Japanese ten-year has slipped below zero again this morning. Implied vol firmed across the curve, as the prospect of large unexplained price changes necessarily filters into option premium.
–Near eurodollar calendar spreads notched new lows, with the nadir moving forward to EDU19/EDU20 wihich settled -18.5. EDZ9/EDZ0, which had previously been the lowest, settled at -15.0. The market appears to be thinking the Fed will move fairly aggressively to contain damage, not necessarily through an ease in FF target, but through a cessation of balance sheet reduction.
–Most importantly, the longer part of the curve steepened. Once again reds led the way higher: reds +7.375, greens +7.125, blues +6.625, golds +5.625. There was a new buyer of 40k 0EJ 9800/9825 call spread for 2.5 ref EDM0 9747. Red/gold pack spread new high at 22.25 bps. Steeper curve should be welcomed by the financial industry.
–Market forecast of tightening in 2019 is ZERO. January’19/January’20 FF spread is -1.0 (9760 and 9761). April’19/April’20 (just after the March FOMC) is -6.0 (9760 and 9766).
Dec 27. Staggering rallies!
–Just your run-of-the-mill 5% gain in SPX to end the year. All stock index futures made new lows in the morning, posted outside days and closed at the highs, normally a sign of a bottom. However, these key reversal days were notoriously fickle when they occurred at new highs. So take everything with a grain of that new pink Himalayan salt.
–This morning stocks have unsurprisingly given back some of the rally with a decline of 1.4%. Extraordinary volatility. Quite a change in 2018 from 2017, when, according to an article on MarketWatch “…there were just eight sessions with a 1% move.”
–Near eurodollar and FF calendar spreads didn’t reflect much change in sentiment. In Fed Funds, Jan/Jan settled 3.5 (up just 1.5) and April’19/April’20 still closed negative, at minus 2.5 also +1.5 on the day. However, the longer snapshot of the curve was steeper. Red/gold pack spread popped to a new high of 20.5, rising nearly 3 bps. The interest rate market is accepting the idea that hikes aren’t happening…so the curve is steepening. If Fed officials begin to confirm that view, then the flattening might be over for good. Red/green pack spread yesterday closed at a new high as well, at minus one-quarter bp. This spread has been inverted since August.
–New Home Sales and 7 year treasury auction today. The last day of the year is Monday, which, unlike Christmas eve, will provide a regular, full day session of volatility and year-end price marking. Trim positions accordingly.
Dec 25. Merry Christmas
–Mnuchin’s efforts to calm the markets early Monday morning failed. DJIA -2.9%. SPX -2.7, Nasdaq -2.2 and Russell -1.95. Now attention has shifted to a possible removal of Powell as Fed Chair. I am sure every fan of Central Bank independence is imploring Powell not to resign; I am not even sure it would be seriously considered except that RBI’s Patel recently quit and Tim Duy brought up the scenario in a BBG opinion piece.
–What is unambiguously true is that the market is pushing easier monetary policy onto the Fed. The Fed will be forced into admitting, quickly, that it has made a policy error. Jan’19/Jan’20 FF spread closed at 2 bps, telegraphing NO hikes in 2019 as opposed to a Fed forecast of 2 hikes. EDH19/EDH20 imploded to minus 9 bps. Odds of a hike at the June FOMC are reflected by May/July FF spread which settled +1.0, the Sept meeting is August/Oct which settled MINUS 1. All the buyers of near calls and sellers of red and green midcurves have been carried out, as the reds have bulldozed higher to lead the strip. Consider this: on Nov 8, red June, EDM20, settled 9670, and on Monday it settled 9741.5, a move of 71.5 bps (or nearly three EASES). On Monday reds +9.625, greens +7.875, blues +6.5 and golds +5.5.
–What if Trump is able to fire Powell? Almost certainly the curve would steepen, as term premia would explode and confidence in the treasury market, especially at the long end, would probably evaporate. Gold is already sniffing it out, with GLD at its highest level since summer, and almost exactly at the midpoint of the year’s range.
–Can the Fed wait for the Jan 30 meeting to announce an end to Balance Sheet Reduction? Will strong guidance suffice at this point? The Fed can point to external factors (besides Trump) for a change in course, including huge treasury supply and an oil market which is also in free-fall (WTI down $3 bbl Monday to a new low near $42.50), taking market measures of expected inflation to ever lower levels (10yr treasury/tip breakeven sank to 175 bps on Monday). Implied vol surged in rates and of course, in stocks. VIX closed above 36; while it traded higher in the February episode I believe this is the highest settle.
The dealings of my trade…
Being that it’s Christmas week, I was
going to run with a theme from ‘It’s a Wonderful Life’. Our hero George Bailey is pleading with the
townsfolk not to force a run on the Building and Loan:
Can’t you understand what’s happening
here? Don’t you see what’s happening?
Potter isn’t selling. Potter’s
buying! And why? Because we’re panicky and he’s not. That’s why.
He’s pickin’ up some bargain.
Now, we can get through this thing all right. We’ve got to stick together though. We’ve got to have faith in each other.
There’s just one problem though. Potter IS selling!
There were some extraordinary gains in the two-plus years from the start of 2016 to the highs in 2018, and we’ve given back around half. In SPX, from the low in 2016 to the high made earlier this year, the 50% mark is 2375, vs a close Friday of 2416.62. In Russell 2k we’re through the halfway back level and in the Nasdaq it’s around 6191 vs 6333 on Friday. The DJIA is similarly coming close; Transports are through. This has been a year which featured the withdrawal of central bank liquidity, both through rate hikes and balance sheet roll-off. Two things happened in the beginning of October to accelerate the selling: first, Powell’s now famous utterance “…we’re a long way from neutral” and second, the increase in “auto-pilot” balance sheet roll-off to $50 billion per month. Powell walked back the neutral comment, which has now been softened to allow that we’re at the lower band of neutral. However, the Fed considers the balance sheet run-off to be rolling along swimmingly. No change anticipated according to last week’s FOMC. The Fed delivered a 25 bp hike in the FF target range, with a rise of only 20 bps in IOER, but the Quantitative Tightening schedule was left on auto-pilot, and risks to the domestic economy, while acknowledged, weren’t emphasized, in what was termed a strong economy.
John Williams, President of the NY Fed and FOMC Vice-Chair, was interviewed by CNBC’s Steve Liesman on Friday. At the outset, in defense of the Fed’s hike, he said several times that the economy is strong, primarily falling back on the [lagging] employment indicators. Liesman’s core line of questioning concerned whether the Fed appreciated signals the market was sending. Williams emphasized that the Fed is now data-dependent, and expects a healthy economy in 2019, but is attuned to growing risks. Most importantly, he said, “…if there’s a material deterioration in the economic outlook, obviously we will reconsider our path for the short term interest rate and would adjust policy to best achieve our goals. But we also said we would reconsider the balance sheet normalization and may even end that process…if that’s appropriate to achieve our goals.” Williams agreed with Powell that “we’re now basically at the bottom end of the range of neutral interest rates in terms of our best estimates.” He also said, “…you and others have noted we only lowered our forecast for growth by 0.2 for 2019 but that’s in the context of a much shallower path for the fed funds rate.”
In looking back at the history of Fed actions (link below) the shortest time frame I found between a hike and an ease was in 1987 for the stock crash. This was the start of the Greenspan era; a hike on Sept 22, 1987 to 7.25%, followed by a cut just one month later on Oct 19, 1987 to 6.75%. Amazingly, the low in that cycle was only 6.5%, in February 1988. Prior to Greenspan, FF’s jumped around constantly. In 1980 for example, the year started at 15%, was jacked to 20%, and ended at 18%. Besides the crash, the next shortest period between a hike and a cut was February 1, 1995 to July 6, 1995, from a FF target of 6% to 5.75%, a little over 5 months.
A MarketWatch article (thanks Aldo) notes a current similarity to the 1987 crash period: the average daily moves for DJIA, SPX, and Russell have been the worst in this month of December since October of 1987. SPX average daily move -0.80%, DJIA -0.78% and RTY -1.05%.
I think the Fed will deliver an ‘ease’ by the beginning of next year, in the second quickest turnaround since the crash of 87. They will probably try to wait for the January 30 FOMC. Using the cover of enormous treasury supply, the Fed will announce either a trimming of the balance sheet reduction to something like $20 billion per month, or a complete cessation, most likely the latter.
Last week I wrote about Banks and Central Banks, as the financial backbone of monetary transmission is of the utmost importance. They bail out the banks for a reason. Weakness continues globally. The XLF financial etf is down 25% from the high set at the start of the year. Individual names are down significantly more, as I wrote last week. For example GS is down 42%. In Europe DB Is down over 50% and CS is close to having been cut in half. The Eurostoxx bank index is down 33% while the Italy bank index is down 40%.
This week has seen an amazing amount of turmoil. There have been whispers of collateral shortages and hoarding, funding issues, etc. Obviously stress has increased significantly. The VIX closed just above 30, not quite at levels seen in the great blow-up of February, but definitely in the warning zone, up from around 16 at the start of December. However, I am going to consider some market signals (along Liesman’s line of inquiry) that paint a mixed picture. I’ve looked at the weekly closing spread between the new SOFR (Secured Overnight Funding Repo) contract and EDH8, and it has been stable since November between 29.5 and 32. Not much sign of crazy stress there. In terms of forward proxies for Libor/OIS, spreads are also pretty unremarkable. While the FFF9 to EDZ8 spread got out to 41 to 43 bps prior to EDZ8 expiry, the current readings are: FFJ9 to EDH9 33.0, FFN9 to EDM9 28.5 and FFV9 to FFU9 26.5. Then, FFF20 to EDZ9 is 29.0, reflecting well known weakness in the EDZ9 contract.
Implied vol in interest rate products remains low, though it firmed last week. In fact, while yields dropped across the board, with the greatest decline in the 30 year bond at 11.4 bps to 3.027%, a real flight to quality in the sense of a mad grab for treasury calls didn’t really occur.
Of more concern is the rise in corporate spreads. We know that corporate debt as a percent of GDP is at a record high; during the years of ZIRP, companies were incentivized to borrow for takeovers, or to buy back their own shares. EPS gained, balance sheet measures suffered, all the more apparent at higher rates when the aforementioned debt needs to be rolled. Clearly, problems surfaced in the energy/emerging market rout of late 2015 and early 2016. Currently, spreads have been rising but are well below the spike of early 2016. However, just looking at the spread is a bit disingenuous. Consider the chart below, which shows the five year treasury yield in amber, now at 2.64%, and the CDX 5y High Yield Spread in white. In 2016 the five-year yield was over 100 bps lower than it is now (1.60 vs 2.65). So while the spread is a bit over 100 bps beneath the crisis level in 2016, actual borrowing costs for debt rollover are about the same, in the context of a slowing economy. Data from the St Louis Fed shows the same picture, US Corp BBB Effective Yield topped a bit below 4.6% in 2016, fell to 3.25% in the middle of that year, and is now 4.7%. That is, more cash flow is needed to service debts, in an economy where earnings are likely to be challenged. We NEED inflation, not in terms of wage gains, but in terms of pricing power. However, that’s not too likely. “It was a disappointing Christmas, on many levels.” (Vinnie Antonelli). *
This week, near Eurodollar one-year calendars all made significant new lows. The near part of the Eurodollar strip is telling this story: ‘The early 2018 tax cut and repatriation provided the economy with a sugar high. Economic vigor was stolen from the future, and the future is now. Fed eases are coming.’ The lowest one year spread is Dec’19/Dec’20 which settled -16, having traded as low as -19.5. This is now the 4th to 8th contract spread, and as I mentioned last week, at the end of 1994 this spread traded minus 23 and at the end of 2006, it traded -26.5. So we approached historic lows. The nearest one-year spread is now March’19 to March’20, which plunged 12 bps on the week to -3.5. However, in FF’s, the Jan’19/Jan’20 spread settled +11.5, still clinging to the idea of a hike in 2019 rather than an ease.
Looking further out on the ED curve is somewhat interesting. While talk of inversion in treasuries was rampant, I’ve previously noted that the first inversion to occur was in Eurodollars. The chart below tells the story. The red to gold pack spread, 2nd year forward to 5th year forward, inverted in the summer. But look what happened this week as the Dec’19 contract dropped out of the reds. Red/gold broke a two year trend line and closed POSITIVE 13.5. The curve steepens when the market thinks the Fed will start easing. Is the red/gold pack spread an early indicator? Probably.
There’s one other chart I want to show, though this note is already a bit long. While most stock indexes, outside of utilities, are significantly lower on the year, I like to look at a chart of stocks as compared to commodities once in a while. The chart below shows SPX priced in terms of the BBG Commodity Index. Still up on the year, but it has broken a four-year trend in spite of the plunge in Crude Oil.
Finally, one of the most important events of the week might have been the resignation of General Mattis. The lack of adult-supervision at the White House with both Kelly and Mattis gone is a big concern. Friday’s comments by Peter Navarro that China needs a “full overhaul of trade practices” and is “…trying to steal the future of Japan, the US and Europe by going after our technology” is a case in point. Talk that Trump wants to fire Powell (denied by Mnuchin) is another.
******************
“Business!” cried the ghost, wringing its hands again. “Mankind was my business. The common welfare was my business; charity, mercy, forbearance, and benevolence, were, all, my business. The dealings of my trade were but a drop of water in the comprehensive ocean of my business.”
-Charles Dickens, A Christmas Carol
OTHER MARKET/TRADE THOUGHTS
Feb/April FF spread settled 4.0, a new low, -3.5 on the week. May/July settled 3.5 and August/October barely positive at 0.5. Jan’19/Jan’20 FF 11.5 and April’19/April’20 which is just past the march FOMC, settled 3.5. The Fed has two hikes penciled in for 2019. Interest rate futures are an eraser.
The main takeaways are this: even with a big plunge in stocks on Friday, fixed income didn’t have much of a move. Supply concerns are a looming overhang. We’re going into a holiday week with thin conditions. Anything can happen
| 12/14/2018 | 12/21/2018 | chg | |
| UST 2Y | 273.0 | 264.1 | -8.9 |
| UST 5Y | 272.6 | 264.0 | -8.6 |
| UST 10Y | 288.6 | 279.0 | -9.6 |
| UST 30Y | 314.1 | 302.7 | -11.4 |
| GERM 2Y | -60.9 | -60.2 | 0.7 |
| GERM 10Y | 25.2 | 25.0 | -0.2 |
| JPN 30Y | 77.5 | 74.2 | -3.3 |
| EURO$ H9/H0 | 8.5 | -3.5 | -12.0 |
| EURO$ H0/H1 | -9.5 | -11.0 | -1.5 |
| EUR | 113.09 | 113.70 | 0.61 |
| CRUDE (1st cont) | 51.20 | 45.59 | -5.61 |
| SPX | 2599.95 | 2416.62 | -183.33 |
| VIX | 21.63 | 30.11 | 8.48 |
https://www.themacrotourist.com/posts/2018/12/05/lowerrates/
https://www.thebalance.com/fed-funds-rate-history-highs-lows-3306135
https://www.americanrhetoric.com/MovieSpeeches/moviespeechitsawonderfullifaddresstothepeople.html
https://fred.stlouisfed.org/series/BAMLC0A4CBBBEY
https://www.youtube.com/watch?v=6n2l9BCoGNo&start_radio=1&list=RD6n2l9BCoGNo
Dec 21. Couldn’t sleep last night
–Early yesterday morning, David Tepper: “Powell basically told you the Fed put is dead.” Dudley in the afternoon: “The Fed’s not there to take away the market’s pain.”
–Even more unsettling: General Mattis resigned yesterday. The two top generals, Kelly and Mattis, in August of 2017 vowed to coordinate travel plans so that one would always be in the US to baby sit “monitor orders coming from the White House.” Now they’re both out. (link below). In other countries, the military seizes power when the country becomes unstable. “It could never happen here, right?” *Nervous laughter and downcast eyes as we look around the conference table for assurances.* While that’s a huge stretch, it’s completely realistic to believe that the top of the US military will give full support to the Mueller investigation and findings. Not good for US assets.
–In the meantime, QT is on autopilot. It’s not going to be on auto-pilot for much longer. Sometimes the Fed is criticized for being slow to respond to deteriorating conditions. When the complaints against the Central Bank come from the executive branch, there might be a tendency to bristle against the incursion into the bank’s independence. An economic slowdown engineered by a loss of confidence will blow-up the deficit. There’s no way the Fed will be able to continue rolling off $50/billion a month while the treasury’s borrowing needs balloon. Unless, of course, the Fed slashes rates so that the carry is simply irresistible. My guess is that the balance sheet roll-off will come to an end sooner rather than later. Rate cuts: curve steepener. QT end: curve flattener.
–Yesterday’s action included new lows in stocks, and new lows in most one-year euro$ calendar spreads. EDZ19/EDZ20 is lowest on the curve; settled -18.0, but was -19.5/-19.0 during the day. In the 2006 end-of-year inversion, the 4th to 8th bottomed at -26.5. At the end of 1994, it bottomed at -23.0, but of course rates were much higher then. (In both instances). Red/green euro$ pack spread settled -7.0 yesterday, but green/blue settled +7.0. Flows favor strength in the green pack (for now). For example, a new buyer yesterday of 60k 2EM 9800/9825 call spread, settled 2.25 ref EDM21 9739, versus an exit of 0EH 9737/9775 call condor, settled 2.0 ref EDH20 9723.5. Several sources pointed out the suffocating agony of negative carry possibilities, (thanks DW). Another comment came from Bill Sokolis of MNI, who noted that 3 month libor is now above the ten year yield. Ruh-roh.
–Stocks lower again this morning, and the dollar generally a touch stronger. Gold is lower (probably a safe-haven gift here). Also note that bitcoin has had a nice bounce from the recent low and now trades around $4000. If only there was some decentralized asset outside the purview of government authorities where I could store wealth safely…
NEGATIVE EURO$ 1-YR SPREAD
The lowest one-year euro$ spread is Dec’19/Dec’20, which has made a new low of -19.5 today. The bid side, -19.5 is down 4 on the day. Attached chart shows constant 4th to 8th contract spread which is now Z9/Z0. In 2006, the lowest this one-year spread got was -26.5.
A trade that went through today is a synthetic buyer of this spread +EDZ9 9725/9737cs vs -0EZ 9762/9775cs, paid 1.0 for the front Dec call spread. Not shown on this chart is a spike low from the very end of 1994, when the spread traded briefly at -23.0
Dec 20. A bad year for stocks gets worse- blame shifts from trade wars to Fed
–Curve flattened hard as the Fed hike wasn’t particularly dovish. In his press comments, Powell acknowledged signals of possible headwinds, but said that the committee hadn’t fundamentally altered its favorable view of the economy. In the Implementation Notehttps://www.federalreserve.gov/newsevents/pressreleases/monetary20181219a1.htm balance sheet reduction is slated to continue at $50 billion/month, and in the press conference Powell said it would remain on autopilot. It doesn’t really matter that the ‘dots’ came down to a forecast of two hikes for 2019 vs the last estimate of three. The balance sheet reduction represents a dollop of tightening every single month.
(In September, the Federal Fund projection for 2019 was 3.1 and in 2020 3.4. At this meeting the projections were shaved back to 2.9 in ’19 and 3.1 in ’20).
–In any case, EDH9/EDH0 fell to zero, down 2.5 on the day. Not a single one-year euro$ calendar spread is positive out to EDZ20/EDZ21. The lowest one-year remains EDZ19/EDZ20 which settled -15.5, a new low. So the difference between the 2019 and 2020 dot is POSITIVE 20 and the market forecast is NEGATIVE 15.5. Feb/April FF spread closed at +4, but the forward spreads are just barely above zero. Bloomberg has a headline suggesting a Fed ‘Mistake’ and the market is certainly leaning towards that opinion.
–Crude oil continues to get crushed and is at new lows this morning with CLG9 under 46.50. Stocks are quite heavy. New lows for the year yesterday in DJIA, RUSSELL (by a lot), SPX, though Nasdaq just held the low of February. Sweden’s Riksbank also hiked this morning.–As the stock market pain spreads, does Trump fire Powell? A Forbes article from a few months ago indicates it’s possible citing Section 10 of the Fed’s rules: https://www.forbes.com/sites/patrickwwatson/2018/09/06/how-trump-could-fire-powell-and-rebuild-the-fed/#579f1de586c2
An older WSJ article says in 1965 President Johnson wanted to fire McChesney, and deputy Attorney General Ramsey said no, outlining several reasons. No matter, it’s a virtual lock that Trump will bring it up, and create a bit more volatility.
Dec 19. FOMC day
–FOMC decision with strong expectations of a dovish hike. Feb/April FF spread settled at a new low of just 4 bps, and May/July settled at the same level of 4, so March and June hikes have been shaved to odds of less than 20%. In euro$’s near spreads made new lows, with EDH9/EDH0 collapsing by 4 bps to 2.5; now the only one-year spread that has a PLUS sign in front of it until Dec20/Dec21 which settled +0.5. The nadir is EDZ9/EDZ0 at -12.0 (though there was decent buying in that spread yesterday at -9.5). Red ED’s led the move higher yesterday, closing +8.5 with Greens +7.875 and Blues +5.75. The ‘new’ red/gold euro$ pack spread settled at a new high of 11.375, gaining 4.25 on the day (New because both packs now start with March contracts). In short, the market is telegraphing a dovish hike: near calendar spreads have flattened considerably and the more deferred part of the curve has steepened.
–Yields continue to move lower as oil plummeted and stocks fell. Ten year is on support around 2.80% yield. The spike lows in yields in late May were associated with the Italian turmoil and the possibility of leaving the Euro. Treasuries have held that level, but back month ED’s are through those levels from EDM0 back. Oil was down $4 bbl at one point, with CLG8 closing -3.60 at 46.60.
–Vols jumped in euro$’s ahead of today’s FOMC and stock market volatility.
–Below are charts of five and ten year treasury yields. Holding low spikes in May.
It’s beginning to feel like Sept 2015; a hike was priced, but didn’t happen
–Jerome Powell is getting a real-time test of whether the economy and the stock market are one and the same. Just prior to tomorrow’s FOMC, two- and five-year notes are making new highs, even though US stock futures are seeing a small bounce. There’s a bit more uncertainty as to a hike; January Fed funds settled 9763.0 and ticked 9764.5 this morning (63-63.5 indicates about 85% chance of a hike). Red eurodollars leading the charge higher, +5 this morning. WTI crude continues to make new lows, last -1.50 at 48.70. If there’s a pause, the Fed can blame diminished inflation expectations due to the implosion in commodities.
–President Xi gave his speech today marking 40 years of reform, noting that China, while continuing to always press forward, ‘may face unimaginable difficulties.’ Nothing in the speech about smoothing over trade frictions. Best to plan for tougher times ahead, and communicate the concerns. On that note, friend TS mentioned that trading in the US may be driven by hedge funds raising cash for redemptions. Performance numbers aren’t that great, and calls for the return of capital are likely to be large. Forced selling is likely to become even more difficult into thin end-of-year conditions.
–Housing starts and building permits today.
