July 27. Blood moon prophecy
July 25. A cap on small caps
July 24. Is China driving the bitcoin rally?
July 24.
–Yields surged in Monday’s session though volume was still below average. Ten year rose 7 bps to 296.2. 30y also up 7 to 310. Blue euro$ pack (4th year out) was the weakest on the strip, falling 7.25 bps. Many near calendar spreads made new highs. The peak one-year spread is front EDU8/EDU9 which closed 55.5, up 5 on the day. The peak one-yr on a constant maturity basis was 63.75, set in mid-May. EDZ8/EDZ9 jumped 4 bps to 37.5. I also have included a chart of the 5yr Inflation Indexed note yield which is 81.5, the highest real yield since 2009.
–The sell off was sparked by concerns that Japan is going to alter its stimulus program at next week’s meeting, and perhaps lift the cap on the 10-year JGB, which has effectively been around 10 bps. Global removal of accommodation and bond buying….except for China, which is actively easing to support its economy. Yuan set a new low this morning and is currently 6.8163. From a ZH article quoting from Monday’s China State Council Meeting: “Domestic demand is being elevated in importance. Fiscal spending will be accelerated…” In response, China’s bonds jumped in yield as well. The slide in the yuan should be negative for US stocks, but a blow-out report from Alphabet yesterday is lifting all boats. News articles also cite high expectations for 2Q GDP out on Friday, expected 4.1%.
–Though not particularly large, one interesting trade yesterday was a buy of EDZ8 9725p 4.0s ref 9733.5, vs a sale of 0EZ 9675p 7.0s ref 9696.0 in EDZ9. Traded 3.0 credit and settled there. Strikes are 50 bps apart, and the extra 3 bp credit effectively makes it a sale of 53’s in the one-year spread (as mentioned above peak spread is 55.5. Z8/Z9 settled 37.5). This trade works on more aggressive near term tightening and flatter spread.
–PMI and 2y auction today.
July 22. Debt Coming Due
Debt coming due & we are raising rates – Really? Donald J. Trump tweet from Friday morning
Yes. Really.
Powell left little doubt that the Fed remains on course to remove accommodation in a well-reasoned argument to keep the economy on track in accordance with the two tasks that Congress has assigned: price stability and full employment. He is also focused on financial stability, and gently reminded Congress several times that it’s important for the Fed to stay in its lane; not to swerve into policy debates outside of the Fed’s mandate. He also pointedly bounced the ball back into the legislative court several times, saying the Fed cannot address certain problems, but Congress CAN.
So this week President Trump swerved into the Fed’s lane, then veered into currency lanes and took the China off-ramp while trying to divert attention from the detour into Russia. “C’mon, it’s Czechoslovakia. We zip in, we pick ’em up, we zip right out again. We’re not going to Moscow. It’s Czechoslovakia. It’s like going to Wisconsin.”* [Except it WAS Moscow]. https://www.youtube.com/watch?v=McZ2H_Iqx4g
Regarding the tweet at the top of the page, here’s a quote from candidate Trump in 2016. “I’m the king of debt. I’m great with debt. Nobody knows debt better than me. I’ve made a fortune by using debt, and if things don’t work out I renegotiate the debt. I mean, that’s a smart thing, not a stupid thing.” The interviewer, Norah O’Donnell, went on to ask, “How do you renegotiate the debt?” and Trump said, “well you go back and say hey guess what the economy crashed, I’m gonna give you back half.” He added, “I like debt… for ME, I don’t like debt for the country.”
The market reacted to Trump’s comments about the Fed and the strong dollar. Having made a new high early in the week, DXY had a sharp pullback on Friday. The curve bounced and there was heavy buying Friday of EDU8 contracts. However, the move in the curve was off the lowest levels of the cycle, made earlier in the week. For example, 2/10 traded just below 25 bps early in the week (new low) and closed at 29.6. It’s going to take much more than a tweet for the Fed to re-evaluate its long term strategy.
Regarding the curve, consider this snippet:
Although macroeconomic forecasting is fraught with hazards, I would not interpret the currently very flat yield curve as indicating a significant economic slowdown to come, for several reasons. First, in previous episodes when an inverted yield curve was followed by recession, the level of interest rates was quite high, consistent with considerable financial restraint. This time, both short- and long-term interest rates–in nominal and real terms–are relatively low by historical standards. Second, as I have already discussed, to the extent that the flattening or inversion of the yield curve is the result of a smaller term premium, the implications for future economic activity are positive rather than negative. Finally, the yield curve is only one of the financial indicators that researchers have found useful in predicting swings in economic activity. Other indicators that have had empirical success in the past, including corporate risk spreads, would seem to be consistent with continuing solid economic growth. In that regard, the fact that actual and implied volatilities of most financial prices remain subdued suggests that market participants do not harbor significant reservations about the economic outlook.
This paragraph captures the current environment quite nicely, though it neglects to mention malinvestment and extraordinary debt growth in China. However, the KEY line is the first one: “…forecasting is fraught with hazards.” Because this comment isn’t about the current environment at all. It’s from a 2006 speech by Ben Bernanke (he seems to have slightly miscalculated the longer term forecast in 2006). Taking a page out of Trump’s playbook he doubled up this week saying that ‘Distortions mean an inversion does not necessarily point to recession’ (Financial Times, July 19, 2018).
https://www.federalreserve.gov/newsevents/speech/bernanke20060320a.htm
If rates are low and term premium and corporate spreads are compressed, what happens if the latter conditions change? Regarding my addendum about China, it’s conceivable that “the debt coming due” is more relevant to China than the US. There have been high profile problems with large acquisitive corporations (HNA, Anbang). Credit Suisse notes that China has “…accounted for an average 36% of annual global GDP growth over the past five years.” There are already many signs of serious problems. Shanghai Composite is down just over 20% from January’s high. The currency has been in a sharply weakening trend. Imagine for a second that SPX was down 20% from January’s high of 2870 (which would put it at 2300) rather than the current lofty level of 2800. It’s not just China, other parts of Asia are also reflecting stress, with weakness in Indonesia rupiah, India rupee, and even recent sell offs in Korea won and Aussie dollar. Obviously the slide in commodities is another clear signal. Institutional observers (the Fed, IMF, etc) think that China can handle financial dislocations and indeed there have been steps taken to increase liquidity (the gov’t asked banks to lend more and to help reduce financing costs for small firms, depreciated the yuan, cut the 7 day rate). In January China’s ten year yield was over 4%, it’s now 3.5%. This, at the same time the BOJ is considering steps to mitigate side effects of yield curve control.
In the US financial crisis, the problem was that too much debt was layered onto the US housing market, and as short rates rose, eventually that debt couldn’t be serviced, sparking a daisy chain of liquidations. It’s not clear when the tipping point arrives and how much has to be subsequently unwound. But it appears to be occurring in China now and is being exacerbated by trade/currency war tensions. Europe is slowing as well. The tipping point: “when borrowers say guess what, the economy crashed and you’re getting back half.” Asset markdowns.
So, while the Fed is more or less locked into a September rate hike, further tightening is less certain. We’re moving into what will be an extremely contentious election cycle which is not likely to instill confidence in, well, anyone (except for those who sell political advertising spots).
MARKET THOUGHTS AND POSITIONING
This is what I wrote last Sunday (Late Cycle Behavior) “Many one-year Eurodollar calendar spreads made new recent lows, for example, EDM19/M20 settled at a new low of just 8.5. This spread is one year forward, and more or less indicates that the Fed’s tightening campaign will be over by then. If there’s any doubt as to timing, the next spread, EDU19/U20 is only 2 bps, and then… depression set in.” Well, someone obviously thought these spreads were too low, with 40k EDU9/EDU0 bought for 2.5 on Monday and 25k EDM9/M0 bought for 10 (Settled Friday at 4.0 and 11.0 respectively). There were also a couple of 40k block buys of both EDU9 9737/9775/9812 call tree and same in EDZ9 for 4.0 and 3.5. These latter trades look for slow rallies with diminishing call skew.
The other extremely large theme is occurring in long dated euro$ options, buying ratio put spreads. Last week I highlighted positions and thoughts in note and so I won’t repeat it here (email me at amanzara@rjobrien.com for a copy). An example of one of these trades was a buy last Thursday of 25k EDZ20 9600/9550 put spread 1×4 for flat premium (5.0 and 1.25). So this trade added 100k new shorts to the 9550 strike at 1.25 with 875 days until expiration. While it’s quite true that most expectations of the terminal rate barely exceed 3%, leaving the 9550 put *worthless* that put is still a tail risk and it’s not going to decay and it’s not going to be easy to buy back should it become necessary. On Friday the 9600 put settled 5.0 and the 9550p at 1.5, so the 1×4 settled -1.0.
Here’s a little picture of how these long dated otm puts can trade: Sits, sits, sits, then boom. Explodes higher.
These puts should be bought, not sold (Out of the money long-dated in general). At these compressed vols they provide cheap protection with little decay, and leave opportunities to create other trades in strikes above with shorter maturities. My personal bias is that rates are likely to go lower, but I am still more inclined to buy these puts with an underweighted delta.
I had specifically recommended buying EDM0 9625/9600 put 1×3 (pay 1 for the 3 legs) last week. That settled 2.0 for the three legs on Friday on a relatively small futures move.
Another big theme on Friday was buying of EDU8. At least 100k EDU8 9750/9762 call 1×2 bought for 3.0 to 3.25, settled 3.25 ref 9755.5 (OI -40k and +78k). In futures, EDU8 was the top volume contract, closing +1.5 at 9755.5 with OI +46k. EDU8/EDZ8 spread closed at its high of 21.5, and EDU8/EDU9 closed at a NEW high of 50.5. I am more inclined to buy EDZ8 or EDH9 if I think the Fed is near the end; I see little chance of a Sept pause followed by a December hike. Much more likely is a Sept hike followed by a period of much less certainty with regard to future hikes. Referring back to earlier mention of EDU9/EDU0 spread at 4.0, the EDU8/9/0 butterfly closed at 46.5.
Long flies: EDH9 9725/9750/9775c fly 4.0s ref 9720.5 (I paid 4 vs 10d in EDU8 at 9754.5). 0EU 9712/9725/9737c fly 1.25s vs 9701.0. 0EU 9725/9750/9775c fly 1.75. 0EH 9712/9737/9762 call tree settled 2.50 from 0.5 three Fridays ago.
Large outstanding trade in TY: TYU 120/122 c spread settled 29 (33 and 4) ref 119-31+. There’s a long of at least 150k in this.
| 7/13/2018 | 7/20/2018 | chg | |
| UST 2Y | 258.2 | 259.5 | 1.3 |
| UST 5Y | 272.7 | 276.3 | 3.6 |
| UST 10Y | 282.9 | 289.1 | 6.2 |
| UST 30Y | 293.3 | 303.0 | 9.7 |
| GERM 2Y | -66.3 | -61.8 | 4.5 |
| GERM 10Y | 28.0 | 37.0 | 9.0 |
| JPN 30Y | 67.9 | 68.5 | 0.6 |
| EURO$ Z8/Z9 | 31.0 | 33.5 | 2.5 |
| EURO$ Z9/Z0 | -2.0 | 0.0 | 2.0 |
| EUR | 116.85 | 117.22 | 0.37 |
| CRUDE (1st cont) | 69.96 | 68.26 | -1.70 |
| SPX | 2801.31 | 2801.83 | 0.52 |
| VIX | 12.18 | 12.86 | 0.68 |
https://www.politico.com/story/2016/06/trump-king-of-debt-224642
https://www.youtube.com/watch?v=McZ2H_Iqx4g *
July 20. Market indicators of inflation are easing
–Yields eased Thursday with tens -2.8 bps to 284.5. In euro$’s reds rose 2.125, greens and blues +2.50. Trump said he wasn’t happy with the Fed’s rate increases, causing a brief pop in futures. I assign no predictive power to the spread between ten year treasury and inflation indexed note (tip), but in passing it’s worth mention that this spread closed at a new recent low of just 2.076%. It’s been in a fairly tight range all year between 200 and 220 bps, a sign of steady inflation expectations. Stronger dollar (and weakening yuan) help to squelch inflationary impulses.
–A blurb from Ian Lyngen at BMO noted the following from yesterday’s Philly Fed report: “The most important nuance from this report was the spread between prices-paid and prices-rec’d increased to 26.6 from 18.6…this brings the 6 month moving avg to its highest since Oct 2011. This indicates that firms are struggling to pass through higher costs to end users – think profit-compression rather than building inflation pressures.”
–Yesterday more long-dated ratios traded. EDZ20 9600/9550p 1×4 traded flat at least 25k. These are new shorts in that strike. The settles were Z0 9600p 4.75 and 9550 put 1.25. These options have nearly 2 and a half years until expiration. As a comparison, EDZ19 9600 put settled 0.5. So, over one year if nothing changes the EDZ20 puts will decay by 4.25 bps. I prefer outright longs in long dated puts, but with all the recently traded put ratios in long dated options there are over 750k shorts in EDH0, M0, U0 and Z0 from the 9637 strike down. Primary shorts are EDM0 9600 puts and EDZ0 9587 and 9550 puts, all with over 100k short.
Europe. Fixed
No real bounce in either of these….
July 19. Musings
July 18. Cyber-safety bid
–Not much reaction to Powell’s testimony yesterday although some parts of the eurodollar curve notched new lows. For example, red/gold ED pack spread fell 0.25 bp to close at a new low of -1.875. Implied vol continues to be smothered; at or near new lows across the curve. Powell reminds us that he has JUST TWO JOBS, prices and the labor market. Monetary policy on auto-pilot… Ten year yield essentially unchanged at 2.858%.
–Nasdaq floats to new highs despite NFLX stumble, and Bitcoin surged yesterday as well. Flows are somewhat puzzling, not into ‘safety’ because gold is at a new low this morning (as is copper) and treasuries are nearly unchanged. New low in CNY now at 6.7183. China’s stocks under further pressure. Dollar index near new highs. Italian bank index (IT8300) slumping again and appears as if it might re-test lows made in late May/early June. Saw a BAML note yesterday that said SPX would be down on the year if FANNG names were excluded. It’s a cyber-safety bid; not sure if that should make the broader market comfortable or uneasy.
–Focus on the neutral rate for funds is sharpening. Along with Powell’s comments yesterday, Pimco’s missive says it’s “somewhere between 0% and 1% for the real funds rate, which translates to a 2%-3% nominal rate if inflation is at the 2% target.” It continues, “…a new useful table in the Fed’s latest Monetary Policy Report that lists econometric estimates of the neutral real rate from seven studies, mostly by Fed economists, confirms just that, The seven point estimates of the neutral rate range from 0.1% to 1.8% with a median of 0.7%. Assuming 2% inflation, this is very close to FOMC participants’ 2.9% median estimate of the so-called long run fed funds rate…”
–Large trades yesterday include new buy +40k EDU9 9737/9775/9812 call tree for 4.0 (11, 5, 2). There continues to be a large amount of 2×5 put structures trading further out the curve. Example: EDZ0 9637/9600p 2×5 trade flat (+20k and -50k) appears to be rolling short puts to lower strikes. New high settle yesterday in EDU8/EDZ8 at 21.5; large buyer +35k at 21 yesterday.
July 17. Powell and NFLX. We’ve seen this movie before…
–So Kashkari was out saying (again) that the Fed should stop hiking now: “…the bond market is telling us that inflation expectations appear well-anchored, the economy is not showing signs of overheating and rates are already close to neutral. This suggests that there is little reason to raise rates much further, invert the yield curve, put the brakes on the economy and risk that it does, in fact, trigger a recession.” Today, Powell testifies before the Senate panel. If Kashkari’s comments were to seep into Powell’s delivery, then surely steepeners like the euro$ spreads cited above would get the green light. I would note however, that Powell seems much more focused on possible imbalances (including elevated financial asset valuations and a hot labor market) which could grow and overwhelm the system.
