There was some degree of surprise associated with yesterday’s jump in rates. Could the bond market be getting away from the fed after Powell lavished praise on current economic performance? All yields made new highs on the year with tens up 10.3 bps to 315.7. It reminds me of an old favorite country song that starts like this:
.
Put another log on the fire
Cook me up some bacon and some beans
And go out to the car and change the tire
Wash my socks and sew my old blue jeans
Come on baby, you can fill my pipe and then go fetch my slippers
And boil me up another pot of tea
Then put another log on the fire babe
And come and tell me why you’re leaving me
.
The bond market has been doing some of the heavy lifting with respect to easy financial conditions. Why are rates going up? End of the pension break in mid-Sept that had created demand for longer dated assets. Increase in the Fed’s balance sheet normalization to $50b/month. Extra supply associated with massive fiscal deficits. Jump in cross-currency basis as 3-month terms covered the turn (reflects funding pressures in terms of foreign buyers’ demand for US paper according to Bill Gross). Brainard’s speech 2 weeks ago about the rising neutral rate that the Fed maybe actually not only have to catch up to, but exceed (echoed by other Fed officials including Powell). Maybe it’s because oil is surging and other commodities are following suit despite a firm dollar. Put another log on the fire.
–Perhaps this Friday’s employment report will show softer conditions and a smaller rate of increase in wages than expected. In that case, it’ll be like a country song played in reverse: You get your wife and your pick-up truck and your dog back (in reverse order of importance as well). But the breakout in yields yesterday is unlikely to completely vanish. Open interest on all treasury contracts surged with tens +90k and 30’s +33k, helping to confirm direction. All near euro$ calendar spreads made new recent highs with EDZ8/EDZ9 for example, leaping 6.5 bps to settle 53. The curve bear steepened, which the market is NOT set up for. 2/10 up nearly 6 bps to a new recent high of 30 bps. Selling continued after the floor settlements. For example, reds and greens settled -7.0 and -8.625 and were offered -8.75 and -10.75 before the electronic close. The ten year inflation indexed (real) yield rose 7 bps and almost touched 1% for the first time since 2011.
–There was a huge seller of 2EZ 9675 puts, >150k at 8.5 covered 9679.5 (or 21.5 in the straddle) that held vols down early in the session and looks to be an exit with OI -65k. This straddle settled 22.0 vs 9676.5, but was 22.5/23.5 late with futures through the strike at 73.5. USZ straddle back above 7%, but the Nov atm 138.5^ settled just over 2 points at 2’02 with the futures down exactly 2 points on the day. Earlier in the week the Nov atm straddle was more like 1’54.
–Sit back and watch the conflagration.
.
Now don’t I let you wash the car on Sunday
And don’t I warn you when you’re gettin’ fat
Ain’t I a gonna take you fishin’ with me someday
Well, a man can’t love a woman more than that
.
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Pop Goes The Country. 1975
www.youtube.com
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–It was late 2015, early 2016 when the energy rout was causing high-anxiety in the high-yield market and in stocks in general. The Fed had passed on a hike in September 2015 because of emerging market volatility. At the time, the decline in energy prices and related suppression of inflation was considered a “one-off” event. Indeed, in December the Fed initiated the first hike. High yield and EEM (emerging mkt etf) bottomed in early 2016. “I got better.”
–Currently oil is making new highs. An article in BBG has this quote: “A dearth of fresh supply, as well as continued investor inflow and rising US government debt yields, helped push the yield spread on sub-investment grade US bonds over benchmark treasuries to 3.09 percentage points Monday – the lowest since July 2007.”
While there is currently some degree of stress in EM, it’s less than 2016. However, the current oil market rally may not be ‘one-off’. Additionally, the percentage of investment grade debt hovering just over junk ratings is at its highest levels. Grant’s posted an article yesterday “They ate the cake”, outlining risks to high levels of private equity debt. They might be eating cake, but it’s not coming in a Blue Apron box, which closed at 1.47 yesterday from an IPO price around $10 a little over a year ago.
–In 2007/8, it was an avalanche of mortgage rate resets that tipped the apple cart. Then, as now, the Fed’s hiking campaign operated with a lag. Tight corporate spreads indicate that problems are somewhere off in the future, and certainly the new DJIA high reflects an economy that Powell refers to as bright.
–Treasury yields eased a couple of basis points yesterday and the curve flattened. Volume was low. Commodities had a nice bounce. Today Italy is backing off on its budget, apparently scaling back to 2% of GDP, which is alleviating a source of concern. Today’s US news includes ADP and Service ISM, expected 58 from 58.5.
This past weekend I highlighted the divergence between stocks and commodities.
In the past couple of weeks, commodities are jumping with BCOM +6%. New high in crude oil is the main factor, however, today Gold is up $20, Silver +39 cents, copper appears to be bottoming. Even beans and corn are seeing a bounce as are coffee and sugar. This, in the context of a stable (actually strengthening in the past week) USD.
–The Nafta agreement with Canada got stocks off on the right foot yesterday, but gains faded late in the session with the Russell displaying particular weakness, closing down 1.4% (SPX was +0.36%). This morning attention has shifted away from N America, with comments out of Italy relating to its budget taking center stage. Bund/btp spread is blowing out, nearing 300 bps. Italy bank index (IT8300) is at a new low for the year, down about 13% from the high last week; -2.7% today alone. EUR is 1.1523, and although it was lower in August (1.1302), it is nearing the late May low of 1.15 when stress related to Italy last peaked.
–It’s not just Europe. The US/China trade war threatens to become something more intimate as warships apparently came within 45 feet of each other in the South China Sea yesterday. Not exactly groping, but certainly an invasion of the safe zone. Well, maybe it WAS a grope. In addition, the Indonesian Rupiah is at a new low vs USD, with additional weakness in the ringgit. IMF’s Lagarde says the world economic outlook is ‘dimming’.
–Oil exploded higher yesterday with CLX8 up over $2/bbl to 75.30, a new high for the year. This exceeded the front contract high set in early July by a small margin, but the rally in Brent has proven much more powerful.
–All of these factors have caused a bounce in US treasuries this morning and a pull back in stock indices. If a full-blown risk-off episode develops, I prefer shorts in the latter rather than longs in the former, though the curve will surely steepen.
–A couple of weeks ago recall the >250k buy of 0EH 9687/9662/9637p fly 1x3x2. Since then 0EH options have been heavily traded, with a buy of over 50k 0EH 9662/9637p spread yesterday for 5.0 covered 9682.5. Total volume in each strike was over 100k but prelim sheets indicate little change in open interest. Total open positions in 0EZ and 0EH options are huge, with EDZ19 the peak futures contract in terms of open interest. This part of the curve could become more volatile.
–News today includes testimony by Quarles (text already released on Fed website) and a speech by Powell at the NABE.
Speech – Chairman Jerome H. Powell
The Outlook for Employment and Inflation
At the 60th National Association for Business Economics (NABE) Annual Meeting, Boston, Massachusetts
–Stocks are rallying and bonds are down as a new Nafta agreement was inked. Canada dollar is seeing a strong run higher while gold is below 1190 and appears vulnerable to new lows.
–Rates eased on Friday though net changes were small. Curve steepened late. For example, 5/30 jumped 2.7 bps to 25.1, as the 5y fell 1.5 bps and the 30y rose 1.2. USZ8 is pressing lower, now 139-25 against a low last week (low of the move so far) of 139-17. The Fed’s balance sheet normalization program kicks up another $10 billion per month in Q4 to $50 billion per month, while the ECB further pares back its buying. The 3.25% yield level on the 30-year bond has acted as a cap since 2015. See chart below. A close above should cause the yield to vault to 3.50/3.55 quickly. If this action should develop, red/green and red/blue pack spreads will certainly move from negative to positive values.
–ISM Mfg today expected slightly lower at 60.3 from 61.3. Bostic and Rosengren speak.
The top chart is SPX divided by the Bloomberg Commodity Index; financial assets versus physical things. Clearly, as the service sector has expanded, commodities have become less important. The lower chart shows the two asset classes individually. When just considering BCOM, it almost seems that one could make a case for still being mired in slow growth or recession as this index is below the crisis low of 2009.
Of course, in a general way that’s understandable. For example, even though UBER isn’t public, increased cash flows (and an increase in GDP) on a given stock of vehicles due to sophisticated software and (less-sophisticated) driver services is being constantly replicated in various parts of the economy. Driving yourself adds nothing to GDP, but taking a car service does. In the military arena it may be the case that cyber-security is becoming more important than physical hardware.
The question becomes whether the amount that is being paid for potential streams of income (stocks) is too high relative to necessary commodities. For example, WTI crude oil was up $2.50/bbl on the week and is nearing the high of the year for the front contract on a rolling basis. Perhaps the BCOM chart simply reflects a transfer of wealth to developed economies from underdeveloped ones that rely more on the latter. It’s an open question, but I would think the turn in commodities is closer than it appears in the rearview mirror. If the acceleration of wages occurs simultaneously, then an ironic shift of sentiment could emerge: that inflation is too high relative to target. Note that after having decelerated in 2017, the Atlanta Fed’s wage tracker has shown a solid rebound this year. On Friday the employment data will contain yoy average hourly earnings, expected +2.8%, which is perhaps the most important piece of data on the week.
https://www.frbatlanta.org/chcs/wage-growth-tracker?panel=1
Back at the height of the mortgage withdrawal orgy around 2005/06, I recall home equity extraction of about $60 billion per month. Although the economy is larger now than it was then in nominal terms, that monthly amount has always sort of stuck with me as a tipping point of sorts. It’s probably not a valid comparison, but starting this month (October) the Fed’s normalization program increases from $40 billion to $50 billion per month. This, at the same time that the US deficit is projected at around $1 trillion, or $80 billion of new supply per month. Taken together that’s more than double the $60b/month tipping point. Late on Friday, we saw steepening pressure on treasuries, sparked by the Comcast bond offering (this week) tied to the purchase of Sky from Fox. In a repetition of a previous theme, it seems like supply is beginning to matter. In the past week, the ten year yield rejected the year’s high at 3.11%. The next test could come this week prior to Friday’s employment report. Yields have the potential to move significantly higher.
Several times during the FOMC press conference, Powell stated that keeping the financial system sound was of critical importance. Perhaps worth mention is that the US banking index BKX closed the week at its low, near the low of the year, off about 10% from the high set in Q1. Clearly the US banking sector is in good shape, but it’s interesting to note that that the Italy bank index is under the lows associated with the election turmoil in late May. At that time, German and US yields took a big drop. For example, on June 1, I marked the bund at 39 bps, down from 58 two weeks prior. It’s now 47 bps. The US ten year on June 1 was 2.89%, and is now 3.05% having had two rate hikes in the interim. In late May the euro had traded to 1.15. It has since gone sideways, and is now around 1.16. There are still risks to the global financial system related to Italy and its higher-than-projected budget deficit announcement of 2.4% of GDP, along with problems in various emerging market economies. As one paper noted, the Fed has swap lines with developed economies to smooth funding problems, but not with emerging market economies.
Below is a chart of EUR/USD 3month cross currency basis, which reflects an increase in funding pressures. While the big spikes lower in the previous two years were in December, Friday displayed a significant drop which may portend further weakness.
–The curve pressed flatter as the last leg of the auctions wrapped up with the 7 year. Both 2/10 and 5/30 are just above 22 bps; the 2y rose almost 1 bp to 283.1 while tens fell 0.5 to 305.4. Option activity was dominated by premium sellers. Short (0EZ9) 9787 straddle settled 18.5 having been 21 a little over one week ago. 0EZ 9675 puts, which were sold in size of 200k pre-FOMC at 5.5, settled 4.5.
–Just after the close of the floor, Italy announced a budget with an expected deficit of 2.4%, higher than expected. EUR immediately dropped and is lower yet this morning as finance minister Tria, who targeted a deficit of 1.6%, was begged not to resign. EUR now below 1.16 having been 1.18 at the start of the week. Italy bank index is down nearly 6% this morning. The spike rally in fixed income in May was related to Italy turmoil, so this news most likely supports treasuries.
–Today’s news includes the Fed’s preferred measure of inflation, Core PCE prices yoy, expected exactly at the 2.0% target. Personal Income expected +0.4 with Spending +0.3. Chicago PMI 62.5. As an interesting aside, blackhawk helicopters are buzzing around the skies of Chicago, apparently related to a heightened security level concerning the outcome of the policeman on trial for shooting Laquan McDonald, expected next week. Police and fire departments on high alert. Northern Wisconsin is nice this time of year…
Italy bank index
–Curve flattened and stocks reversed with a late sell off and lower close in the wake of the FOMC. The Fed as expected hiked 25 bps. No real change in December odds after the meeting; Nov/Jan Fed Fund spread was 19/19.5 all day but went 19 offer late. Russell was the weak link, down about 1%. Banks were especially unloved, with JPM and MS -1.2%, Citi -1.4, GS -1.5, BofA -1.8 and Wells -2.0. Explanations for late price action included quarter end rebalancing. Also, many (myself included) thought the press conference might be more hawkish than it actually was, which caused position unwinds. Implied vol in rates was crushed. 30 days left in November treasury options and the atm bond straddle is barely above 2 points (USX 140.5^ settled 2’04). Ten year yield fell 3.9 bps to 3.059%, having, for now, rejected the 3.11 high of the year.
–In terms of the economy, Powell said that trade tensions were raising concerns of businesses, based on supply side constraints. On the inflation front, Powell says the Fed sees no real risk of a breakout to higher levels, but said that in general, future forecasts are uncertain. One journalist noted that the Fed had raised growth forecasts for this year 3 times already; somewhat interesting in that the Fed clearly underestimated the tax package boost. These are the Fed’s GDP growth estimates for 2018: March, from 2.5 to 2.7%, in June, 2.7 to 2.8 and yesterday, 2.8 to 3.1. Core PCE prices released tomorrow, expected +2.0%.
–Today’s drama surrounds the Italian budget, due to be released shortly, with the Italy bank index (IT8300) seeing a sharp reversal, -2.8%. The deficit may push as high as 1.9% of GDP (frugal by US standards with a 4.2% deficit). Kavanaugh hearings should also provide a little spice.
–Oil flirting with new highs this morning.
–Once again there was heavy buying of long dated put spreads as the previous ratio put spread buyer pays to roll his short strikes lower.
EDH20 9625/9600ps covered 77.5, 10d, 4.0 paid for 50k (3.25s)
EDM0 9600/9575ps 2.75 paid for 50k ref 9679.5 (2.75s)
EDU20 9600/9575ps 3.5 paid for 43k
–Early buyer 0EV 9687/9700 c 1×2 1.5 paid for 75k
–FOMC day. The market has been ratcheting up odds of forward hikes. The most striking adjustments have been further back on the curve. As mentioned previously, as recently as 1 1/2 weeks ago EDZ9/EDZ0 was trading -2.0; yesterday it traded as high as +5.0 on volume of 100k with a clip of 50k bought 4.5. The spread settled 5.0 but came back to a 4.5 offer late. These are new buys , with open interest +58k in EDZ9 and +35k in EDZ9. Steepening on this part of the curve is significant in front of FOMC, although, Fed projections for FF from the June meeting were 3.1 for the end of 2019 and 3.4 for the end of 2020. In other words, the Fed has 30 bps penciled in while the euro$ spread is 4.5. The projections for end of 2018 and 2019 were 2.4 and 3.1, so 70 bps, vs current EDZ8/EDZ9 spread of 49.5 (late sale of 20k there).
–It’s worth noting that Dec’19/Dec’20 euribor spread has also surged. In late May due to Italy concerns, ERZ9/Z0 settled as low as 28. It quickly rebounded to 40 in early June, and then fell back to 28 by mid-August. Yesterday it settled 40.5. Are we in the midst of a synchronised repricing?
–Language in the FOMC statement will likely be altered from “The stance of monetary policy remains accommodative…” to something more restrictive. Not quite neutral but closer to it.
–There were sizable option trades yesterday that also supported the theme of forward steepening (plays noted below). Most conspicuous were large new sales of the 9675 put in both 0EX and 0EZ (thus supporting EDZ9), and put spread buys in EDM20, EDU20 and EDZ20, rolling down shorts from the massive put ratios seen this summer. Simultaneous with the 0EX 9675 put sales at 4.0 were purchases of TYX 118 puts for 19/64’s. Perhaps unrelated, but still fit the steepening narrative.
Player themes: Rolling of long dated puts:
+30k EDM20 9612.5/9587.5ps v 76.0, 10d 4.0
+20k EDU20 9625/9587.5ps v 79.0, 10d 7.5
+70k EDZ20 9587.5/9562.5ps v 76.0, 5d 3.5
(open interest in all upper strikes declined, and rose in lower strikes. As the sell-off has pumped up the open ended put ratios, the shorts are being moved lower)
Possible steepener:
-50k 0EX 9675p vs 83 to 84.5 at 4.0 (open int +42k)
+20k TYX 118p 19/64 (open int +12.7k)
-200k 0EZ 9675p 5.5 vs 83 to 84, 37d (open int +193k to 667k)
–US yields ended modestly higher Monday with the ten year up 1 bp to 307.6. Green and blue euro$ packs also down 1 bp on the day. This morning WTI crude (CLX) is above 72.50. Ten year and 30-yr bond contracts at new lows. Treasury auctions 5 year notes today.
–Draghi said that underlying inflation could see a relatively vigorous pick up, putting pressure on bunds and euribor contracts. ERZ9/ERZ0 spread eclipsed the high of 37.5 in early August, trading 38.5. In dollars, EDZ9/EDZ0 also made a new recent high… at just 3.5 bps. While the bor curve increasingly reflects expected tightening by the ECB in late 2019 to 2020, the US curve has been signaling an end to growth (given flat to negative calendars over the same time frame). However, that part of the euro$ curve is now steepening, albeit slowly.
–Heavy trade in EDZ8 contract with one block buyer of 80k early followed later in the session by chunky sales. At the end of the day, EDZ8 only settled +0.5 and open interest increased by less than 20k. There had also been large buying of the 2-yr contract, but that appeared to be auction related with a decline in open interest. Heavy sales of EDZ9 9725/9750 call spread (40k) appears to have been a roll down of shorts to the lower strike.
