Dec 17. Stocks have a lot of bad news priced in

–Yields fell Friday as stocks closed near the lowest levels of the year.  The Russell 2k did close at new lows at 1410, off 19% from the year’s high.  The ten year yield fell 2.4 to 288.6.  Greens were the strongest part of the eurodollar curve, closing +4.0.  There was a decent amount of euro$ future rolls Friday as EDZ8 expires today.  

–Headlines on BBG aren’t all that encouraging this morning: China bankruptcies surge; Malaysia bringing criminal charges against Goldman in the 1MDB case; Euro-area inflation revised down.  Not much change in futures prices on what should be a fairly quiet session.  

–Commodity indices are also closing the year near new lows.  The ten year note vs inflation-indexed note is at a new low of 182.7 bps, having started 2018 right at 2% and spending most of the year around 2 1/8% before tumbling back under 2 in late November.  Market measures of inflation expectations are falling. 

–On Friday, EDZ8 to FFF9 spread closed at 42.5 with EDZ 9719.5.  The forward libor/ois proxy is EDH9/FFJ9 which settled  9722 and 9753 or just 31 bps.  If the higher former spread is primarily the result of year-end pressure, then the forward March spread may stay around 30-35 bps, which would imply a settlement of EDH9 somewhere around 9730 at expiration – if the Fed’s final hike is this week.  There was a buyer of EDM9 9725/9737/9750 c tree for just under 1.0 on Friday (settled 1.0 vs 9716.5).  This type of trade will likely remain popular.

Dec 16. Banks and Central Banks

On Dec 10, Urjit Patel abruptly resigned as the head of the RBI (India’s Central Bank).  From the Economist, “Mr Patel’s resignation,and what it says about the government’s attitude towards institutions, is something ‘all Indians should be concerned about’ said [Raghuram] Rajan.”  Rajan was Patel’s highly respected predecessor.  It’s not something that just India should be concerned about.  It’s something that Americans and all spectators of central bank independence should be concerned about.  Modi’s government is intent on juicing up the economy through lax central bank policies, which ultimately led to Patel’s departure.  In fact, Patel was the first EM central banker to publicly plead with the Federal Reserve to end balance sheet reduction. On June 4, Patel wrote in the FT, “Given the rapid rise in the size of the US deficit, the Fed must respond by slowing plans to shrink its balance sheet.  If it does not, Treasuries will absorb such a large share of dollar liquidity that a crisis in the rest of the dollar bond market is inevitable.”  Well here we are six months later.  Patel is out, but his words echo eerily prescient.  If the Fed doesn’t slow its path, “…the possibility will increase for a sudden stop for the global economic recovery.” 

The Fed at this week’s meeting is widely expected to raise the FF target, with an increase in IEOR of just 20bps.  I expect hints of a slowdown in the Fed’s balance sheet reduction program. In any case, Trump will certainly tweet his displeasure with Powell as he has the same incentive to boost the economy as Modi. The Fed’s independence could become a more important topic over the coming year.  

On Friday near the end of the session.I bought shares of Citibank (looking for a relatively quick flip THIS IS NOT A RECOMMENDATION). The financial sector has taken a good thumping this year, with many Systemically Important names closing at new ytd lows this week.  The financial etf, XLF, is down about 18.5%to a new low for the year on Friday.  As the table below shows, some names have suffered much larger declines.  What I have done in the table is roughly note the percentage declines in the banks this year (many had their highs set in Q1)and then compare that to the period of mid-2015 to early 2016.  Recall that the market and the Fed were leaning heavily for a hike in September ‘15, but because of a slide in oil and other commodities, and corresponding turmoil in Emerging Markets, the Fed did NOT hike in autumn, but did move in December. At that time, the large US equity indices were selling off.  Junk spreads were blowing out, due primarily to stress in the energy sector.  In other words, some of the conditions were similar to current events.  Of course, by Q1 2016, US stocks had bottomed, and commenced a solid 24 month run-up, even though the Fed was in a ‘tightening’ mode (the second hike was in December 2016).  So it’s reasonable to compare these two periods in an effort to determine how much the current weakness might have to run.  One thing to note early on is that the present slide in WTI Crude from around 77 to 51 or 33% in a little over two months, is dramatic, but in mid-2014 the front contract was  108 and it fell all the way to 25 by Q1 2016(when stocks also bottomed).  So that sell-off was over 75%.   

I am focusing mostly on the banks because I think we’re in for a dovish hike and the prospect that balance sheet reduction could be slowed significantly. As a sector, financials are now about 13.7% of the SPX.  If the banks remain weighed down, it’s going to be pretty difficult to get a general rally.

From this rudimentary table one could surmise that there’s a bit more selling to come.  In terms of a broader picture, in 2015 to early 2016 the decline in SPX was about 15%. In February’s VIX blow-up, SPX had a pull back of a bit over 11% and the current decline has also been a little over 11%, from 2940 to 2600. 

While SPX closed on the low of theday/week, VIX fell week over week (possible bullish divergence).  Below I am also including a list of domestically important banks.  The decline in leveraged loans, the decline in credit quality and corresponding increase in corporate spreads, and the flatness of the curve are all conspiring to present challenges to the financial sector. Of the 19 stocks, 15 are down 20% or more.

These charts are ugly.  And the banking stocks in Europe are just as bad.  The question is whether there’s a lot more to come. Despite the decline in stocks, yields closed a bit higher on the week. Will the Fed bend to stresses in financial markets and signal easier policy to come?  The Eurodollar curve is certainly pushing for that scenario.  The one year spread between EDH19 and EDH20 closed POSITIVE 8.5 bps, but six months forward the EDU19/EDU20 spread settled MINUS 8.5: same magnitude, different sign.  Within six months the market forecasts a possible hike to a possible ease.  It’s rather extraordinary. 

In a world where new forms of energy are being developed, is it still only about oil?  I looked at a constant maturity chart of what will now be the first three-month Eurodollar calendar spread, March’19 to June’19.  It reminded me of the WTI chart so I put them together (below).   Fairly strong relationship.  There’s no question that the implosion of oil and the commodity index has sucked market measures of inflation into the vortex of the toilet, and with it, expectations for forward hikes.  There’s one other thing to note,and that’s this: the highs in both oil and the calendar spread occurred in early October.  SPX also peaked in early October.  On October 2, journalist Jamal Khashoggi was killed, and on October 3, Powell made his now famous, “…we’re a long way from neutral” comment.  TheMacroTourist (link below) shows that real yields accelerated higher in the wake of that comment, spreads widened, stocks broke. It might have been the last straw relating to Patel’s omen of a dollar liquidity crisis.  Colleague LM mentioned that the Saudis probably flooded the market with oil to put the Khashoggi episode behind them.  In any case, the beginning of October was an inflection point.  

The Fed already has walked back the harsh rhetoric, and will likely seek to smooth roiled markets at Wednesday’s press conference.  Here’s the problem:  After the 2^nd hike in Dec 2016,the five year treasury was around 1.90%. It’s now 2.73%.  The BBB-Corporate spread was 160, it’s now 190.  Rates that companies pay to roll over the debt they’ve gorged on are going to be higher.  A JPM report suggests “the downgrade and fallen angel risks look pretty elevated at the moment for both US and European high grade corporates, raising the prospect of disorderly transfer of risk between HG and HY markets over the coming year.”  Using bank stocks as a proxy for the generosity of financial markets in terms of accommodation, the welcome mat has been yanked.  The Fed has to be sensitive to that, while at the same time not appearing to have completely caved in to Trump.  I expect both stocks and fixed income to rally coming out of the FOMC (if not before), with the red pack (2^nd year) being the strongest part of the Eurodollar strip, i.e. I expect red/green and red/blue pack spreads to strengthen from their currently negative levels,and perhaps even go positive.

Other events which may impact the week are President Xi’s major speech on Tuesday to mark the 40^thanniversary of China’s reforms, and the possibility of Mueller/Trump bombshells.  In terms of China, the news has been mostly bad, with many negative articles in the financial press.  So far, gov’t stimulus measures haven’t helped housing and autos, but Xi may indicate more powerful forces to come.

Dec 14. Financials weak globally.

–US stock indexes are weaker overnight, with most of the blame attributed to weak data out of China and Europe.  With the ECB halting bond purchases, one commentator said ‘Draghi is tightening policy into a downturn’.  Even before this morning’s sell off, financial shares traded weak yesterday, with several large names making new lows: Wells (WFC), US Bank (USB), BofA (BAC).  The financial etf XLF is not only at a new low settle for the year, it’s getting close to the price at the beginning of 2017.  Germany is helping with the combination of Deutsche and Commerzbank.  Like tying an anchor to an anvil.

–In spite of weakness in equities, there was not much of a bid for fixed income as the market digests this week’s auctions.  Vol hit across the curve as Dec midcurves expire today.  As of this writing EDZ9 is threatening the 9712.5 strike (current 9711) while EDZ0 and EDZ1 are nearing the 9725 strikes (9721 and 9723).  The dollar is stronger with EUR just under 1.13 and poised to close the year at a new low. –Today’s news includes Retail Sales expected +0.1, ex-auto and gas +0.4. 

Dec 13. Quick note

–Yields pushed a bit higher yesterday with a slightly steeper curve; tens +2.2 bps to 290.4.  Volume was fairly light, though there was a seller of 50k TYF 120 calls on exit, as open interest fell 30k.  TYF 120c settled 28 vs 120-075.  30 year bond auction today.  

–December euro$ midcurve options expire Friday with 9712.5 the strike of choice.  Largest remaining open interest that has a shot is the 9700 strike.  0EZ 9700p have 294k open ref 9705.5.  In the greens, both the call and put have significant open positions, with calls at 267k and puts 250k ref 9714.  By comparison the 2EZ 9712 call and put have 71k and 62k.  

–No bounce in crude oil with CLF9 still below 51 (slightly lower this morning).  Minor bounce in GBP despite May winning the no confidence vote.  Soybeans also see only tepid buying despite China purchases.  Markets don’t appear to be enthusiastic about embracing ‘good’ news.–ECB meeting today ends asset purchases.  

Dec 12. If only there were some clues

–Highlighting a few disaster trades from yesterday:  EDZ19 9850/9900cs 0.5 paid for 11k and EDZ20 9850/9900cs 4.0 paid for 30k, both new positions.  Continued buying of 3EU 9800c, yesterday at a price of 6, but only 1500 trade (now near 240k open).  These appear to be disaster trades, anticipating economic malaise or worse, with an eventual return to Japan-style QE, and rates hovering near zero.  It’s not difficult to identify omens that could lead to such a scenario.  GE, once the largest market cap stock, continues to slide toward zero.  European bank shares won’t get off the mat, for example, Credit Suisse is down nearly 50% from the high of the year made in February.  The British Pound is sinking as May’s future faces a cold December.  An article on Bloomberg cites Moody’s Analytics research which shows that in China, “a measure of expected default frequency has risen above early warning levels for about 25% of corporate borrowers”  “…This share has been rising steadily for the past two years and now sits near the highs last seen in 2005.”https://www.bloomberg.com/news/articles/2018-12-12/china-default-risk-jumps-to-2005-high-says-moody-s-analytics?srnd=premium–In short, there’s no shortage of market signals that might be construed as warning flags, and while the global political circus has an entertaining side (and it’s here that the US remains an undisputed leader), it also brings about a sense of growing unease.  However, they’re not scrambling to buy gold, bitcoin is no longer being used as a crypto flight to quality, and treasuries are capped by an endless supply with the prospect of another government shutdown looming next year.  So we’re left with the sort of lame, long time-frame euro$ call spread trade.  Let’s start the Santa Claus rally. 

Dec 11, 2018. Confidence crumble

Dec 10, 2018. Broken Windows

Dec 9, 2018. Overkill

I watched a fascinating documentary last week on bodies that had been excavated from peat bogs in Ireland and Denmark from the Iron Age (2000 BC).  These bogs preserve the tissue and it remains pliable thousands of years later.  This show specifically dealt with Cashel Man, found in a bog near Cashel in County Laois, Ireland.  The forensic science is astounding, but to cut to the chase, many of these bog bodies appear to have been ritualistic killings of kings due to conditions having gone badly under their reigns.  The program refers to ‘triple killing’, noting bodies that have had throats cut, been stabbed by sword through the heart, and axed in the head. In short, ‘overkill’.

“The killings tend to be excessive,”  Kelly, said “in that more is done to the bodies than would be required to bring about their deaths. Bog bodies may have their throats cut, been stabbed in the heart and have other cut marks. However, it is absolutely not torture, but a form of ritual sacrifice.”  “By using a range of methods to kill the victim, the ancient Irish sacrificed to the goddess in all her forms. This manner of death is peculiar to the ritual killing of kings. It means that a king was being decommissioned.”  

https://www.irishcentral.com/news/bog-bodies-are-kings-sacrificed-by-celts-says-expert-129289548-237410131

When Trump was elected in November 2016, the Corporate BBB option-adjusted spread to treasuries was 179 bps.  It was already in a rapid decline from the energy inspired surge in late 2015, which peaked in February 2016.  In the two years that Trump has been in office the spread never exceeded the election-day level of 175 bps – until this week.  I sent the image below on Tuesday as the spread was just about to make new highs for Trump’s reign.  On Thursday the St Louis Fed marked the spread at 191 bps, and it was obviously higher on Friday.

In late November of 2016, the two-year treasury was around 110 bps and the five-year was around 180 bps.  As of Friday both the 2 and 5 yr were around 270 bps.  Even with the decline in rates seen this week, the record level of corporate debt to GDP means that a crunch of sorts is coming for companies that need to roll debts, especially those that cleverly borrowed in order to buy back shares.

Of course, it’s not just companies that need to borrow.  The Federal Gov’t has become voracious, and this week will auction 3, 10 and 30 year paper in the amount of $78 billion, which will raise $54 billion in new cash.  ‘Crowding out’ of the corporate sector may become a real concern.  Although still relatively low in recent history, FT notes “The US distress ratio [for US junk] – defined as…’the number of distressed credits divided by the total number of speculative-grade issues’ – rose to 7.2% as of Nov 15, up from 5.6% as of mid-October.  S&P cautions that a rising ratio suggests an increased need for capital and signals that defaults could rise.”

Last week the Fed released the Z.1 report for Q3.  None of the borrowing ratios by sector look particularly worrisome, although business borrowing slowed appreciably in Q3 from Q2 from a rate of 6.94% to 3.87%.  The deterioration is longer term in nature and concerns borrowing by the Fed’l Gov’t.  I used to think of Households, Business and Fed’l Gov’t as having comprised about 1/3^rd each of total non-financial domestic debt.  Pre-crisis in 2006 the amounts outstanding were $13.3T for HH (43% of total), $9.0T for business (29%) and $5.8T for the Fed’l Gov’t (19%).  By 2015 it was $14.2T HH (31%), $12.8 business (28%) and $15.2T for the Fed’l Gov’t (36%).  Sure, the Federal Government had to expand to heal the damage and the HH sector was either shut out or self-disciplined with respect to borrowing. The latest figures for Q3 2018 show HH at $15.5T (30% of total), business at 15.0T (29%) and the Fed’l Gov’t $17.8T (35%).  Although the economy has ‘recovered’ and the Fed has withdrawn stimulus, growth is still being heavily supported by the Fed’l Gov’t, which is one reason that fiscal programs enacted earlier in the year were forecast by some as a “sugar-high” temporary boost to growth.

On the week, whatever positive feelings came out of the G20 meeting quickly evaporated, with SPX down 4.6%. On Tuesday the NFIB small business optimism data is released, which has been closely correlated to the Russell, which was down 5.5% this week for a new low close on the year.  We’ll see if NFIB follows suit.  Treasury yields plummeted with a decline of 15 bps in the 5y to 2.69% and 16 bps in tens to 2.845%.  The German bund ended at 25 bps, below important support at 30/31.  China’s ten year also finished at a new low of 3.31%.

The Eurodollar curve saw a massive re-pricing.  The one-year spread between the 3^rd and 7^th quarterly contracts inverted after having been as high as +42 in February.  This is now June’19/June’20 which settled -3.5 (9716 and 9719.5).  Some forecasters had been predicting recession in late 2019 and the euro$ curve generally had been on the same page, with EDZ19/EDZ20 hovering between +5 and -2 since summer.  However this spread, Z19/Z20, plunged to a new low of -12 on Friday, and the inversion of nearer spreads like EDM9/EDM0 puts the timetable for recession much closer.  What a difference a week makes.  EDZ19 was up 12 bps on the week on huge volume, while the middle 2 greens, EDH21 and EDM21 were up a whopping 22.5 bps (strongest part of the curve).  No matter how the ‘dots’ come out at next week’s Dec 19 Fed meeting, the ED curve is currently looking at a terminal rate of around 2.5%.  In Fed Funds, the Jan’19/Jan’20 spread went from 31 to 19.5 on the week…over/under on the prospects of just one hike over next year.  EDZ19 has the most open interest of any contract on the board, but 49K were liquidated on this week’s rally, from just over 2 million to 1.954m.    On the other hand, EDZ20 rose in OI from 1.189m to 1.246m.  Note that midcurve December options expire Friday so there will be quite a bit more adjustment this week.  On Friday Nov 30, 2EZ 9700 straddle settled 10.5 with a settlement right on strike at 9700 in EDZ0.  With just 5 trading days until expiry, 2EZ 9725^ settled 10.0 vs 9721.5 (and needless to say, the 9700 straddle doubled).

The other powerful move was inversion in the very front part of the ED curve, with EDZ18/EDH19 closing at negative 1.  Partially this is due to year-end funding concerns, as libor/ois widens.  The December Eurodollar to January’19 FF spread closed at a new high of 43 bps.  EDZ8/EDH9 was as high as +15 in early November.  A nice trade that occurred to play the inversion was a buyer of EDZ/EDF 9725 call calendar for 1.0.  Settled 2.25 on Friday, 0.5 in Dec and 2.75 in January.

The interest rate market is sending SOS flares for relief from the Fed’s austerity campaign, and stocks are now also begging for help, but problems are geopolitical rather than simply financial.  In some cases there are regulatory issues.  For example, DB closed at a new low.  GS closed at a new low, off a third from the year’s high.  In fact, in the past month, the market cap of GS declined by the same amount as the total current market cap of DB (about $18B).  XLF, the financial etf, closed at a new low, down 17% from the high of the year.  Tensions with China went from a brief sigh of relief on Monday to a white-knuckle grip with the arrest of Huawei Technologies CFO.  The rioting in France seems to be expanding outward.  Conditions under the leadership of Trump, Macron and May are deteriorating.  Are markets warning of a glancing blow without lasting damage, or are we marching down to the bog for ritual overkill? CNBC commentators will obviously echo the Black Knight, “Tis but a scratch”.  On the other hand, with problems piling up globally, we might close out the year with, “Alright, we’ll call it a draw.”  Which would be a bloodbath, a combination of under-statement, and over-kill.

Besides the auctions, this week includes inflation data, PPI Tuesday and CPI Wednesday.  Retail Sales on Friday.

OTHER MARKET/TRADE THOUGHTS

Feb/April FF spread settled 6.0, down another 5.0 on the week and effectively taking down the odds of a March hike to 1 in 4.  May/July settled 4.5, down 1.5.  Fed fund spreads have chopped odds of further hikes, but in the front end, funding libor/ois is front and center with EDZ8/EDH9 INVERTED at minus 1.0, down 6.25 on the week, and EDZ8/FFF9 at 43.0.

https://home.treasury.gov/system/files/276/TBACRecommendedFinancingTableQ42018.pdf

https://www.federalreserve.gov/releases/z1/20181206/html/d3.htm

Dec 5. You’re drunk camel. Go home.

DEC 4. EDZ9 starts and ends the year with action

• ABOUT:
  Former member of the CME specializing in interest rate options and yield curve strategies.

  The risk of loss in trading futures and/or options is substantial and each investor and/or trader must consider whether this is a suitable investment. Past performance, whether actual or indicated by simulated historical tests of strategies, is not indicative of future results.