Dec 5, 2017. Fangs bite

-Big-cap tech was unimpressed by the Senate’s passage of the tax bill.  As can be seen on the attached chart the NYFANG index closed below November’s range. MSFT -3.8%, AMZN -2.4%, FB -2.1%.  However, interest rates still moved higher as the curve flattened to new lows.  Two and five year notes both rose 3.2 bps to new highs at 180.6 and 214.8 respectively.  Tens were up 1.7 bps; 2/10 fell 1.5 to a new low of 57.3.  5/30 new low of 62.4 and red/gold ED pack slipped 2 bps to a new low of just 31.125. Near eurodollar one-year calendar spreads made new highs, deferred spreads made new lows.  EDZ7/EDZ8 closed 53 and FFF8/FFF9 at 46.5, both more or less priced for two hikes next year.   The Fed’s dot plot projection is 2.1% for 2018, or three hikes, so perhaps -for the first time ever- the dots and actual outcome will sync up.  New projections to be released at next week’s FOMC.  Given steepness in front relative to back, the market is forecasting ‘front-loaded’ hikes that will slow future growth.

–A couple of interesting articles this morning.  FT has an opinion piece ‘Stop worrying about China’s debt’ https://www.ft.com/content/0ca50290-d82c-11e7-9504-59efdb70e12f

Dec 4. Could faster normalization kickstart VIX?

–Given the Senate passage of the tax bill and ABC’s retraction of a key part of the ‘Flynn testifying against Trump’ story, the market reaction is somewhat muted.  Eurodollar contracts made new lows but have bounced.  In late October, TYH put in a low of 123-27, this morning’s low is 123-30.  Stocks are, of course, higher and bitcoin continues its surge.  But with increased institutionalization (CME listing a bitcoin contract on Dec 18) comes increased government scrutiny and intervention.

–EDZ7/EDH8 spread prints 19, so odds of a March hike following December have ratcheted up to better than 3 in 4.  It’s not so much a function of inflation or wages at this point.  Rather, it’s whether or not the Fed has the guts to lean against rampant financial speculation in equities.  If so, then curve inversion won’t be far behind.  And it may well be that improvement in corporate tax flows, compounded into the future, justify increased valuations.  However, the task at hand for the Fed would then be to normalize more quickly.

–Interesting summary of a Jim Grant interview with Alan Fournier.  The condensed version is that ‘volatility’ has become an income generating asset class, and Fournier surmises that many pension funds and other institutional investors have no idea what kind of tiger they’re riding.  Documentary preview:  The camera scans around an investment conference of well-dressed professionals.  The voice-over says, “How could all these intelligent investors, entrusted with the pensions of millions of hard-working Americans, have bought into the schemes pedaled by slick investment banks that volatility would never rise again?”

–Final note, the VIX position of short 12 puts vs long the 15/25 c 1×2 in size of 230k has reportedly been rolled from Dec into Jan.  I need to double check this info, as the open interest levels I see don’t reflect the change yet.  What I will say though, is that Dec 25 calls had a whopping 841k open, and while most vol sellers think they will be happy to see a pop that they can sell into, if and when it actually happens, they might get cold feet on the second leg up.

Dec 3. Teflon Don

Donald Trump was born in 1946.  In an ironic twist of history, that was also the year that Teflon products became commercially available.  From the Chemours website, “Upon checking a frozen compressed sample of tetrafluoroethylene, he [Plunkett] and his associates discovered that the sample had polymerized spontaneously into a white, waxy solid to form polytetrafluoroethelyne (PTFE). PTFE is inert to virtually all chemicals and is considered the most slippery material in existence.”  I am not making this up, check out the Chemours link at bottom.  PTFE was sold under the Teflon trademark name.  In another of its marvelously strange properties, PTFE can be dyed several shades of orange.  OK, I am making that last part up.

This, my friends, is no coincidence.  Rep. Pat Schroeder famously took to the House floor in 1983 and said of Ronald Reagan, “He has been perfecting the Teflon-coated presidency: He sees to it that nothing sticks to him.”  I would say that Trump has taken it up a notch; not even his own crazy tweets stick.

The market drama on Friday is a case in point, with a plunge in equities as ABC “News” announced that Flynn was ready to testify against Trump regarding Russian collusion.  Since that time, ABC retracted the story, saying that President-elect (as opposed to candidate) Trump asked staff to reach out to Russia.  ABC suspended reporter Brian Ross for the erroneous story, and a top FBI agent working for Mueller’s election probe was fired for anti-Trump texts.  How to respond?  Simply throw up… throw up your hands that is, and say, ‘Trump single-handedly created $5 trillion of market cap since he was elected, there’s no reason to think we can’t get another $5 trillion next year.   Get in there and BUY.’

Apparently, Goldman doesn’t quite see it that way, noting that global market cap was $74 trillion in June and has now soared to $93 trillion.   (So actually, Trump is responsible for nearly $20T of increased mkt cap, but humbly only takes credit for the US).  Anyway, the chart is reproduced below, from Business Insider.  From the article: ‘Goldman Sachs international analyst Christian Mueller-Glissmann and his colleagues think the “bull market in everything” is about to come to an end. “The average valuation percentile across equities, bonds and credit is the highest since 1900,” they write, and it will produce two likely medium-term scenarios: “Slow pain” or “fast pain” as a correction creates a bear market.’

Now this bear market that Goldman speaks of is probably also tied into the idea that the Fed will hike four times next year.  Deutsche Bank also modified its projections, and has jumped on the 4 hike bandwagon.  However, DB’s Capital Markets Outlook says stocks could continue to rise through 2018, while bonds won’t. “We expect interest rates to continue rising at both the short end and long ends of the yield curve in the US and the Eurozone.” (link at bottom)

At the start of the year, the ten year yield was 2.45%.  In the week just passed it popped just above 2.40%, but came back to close 2.32.  In other words, NO CHANGE.  The two year started 2017 at 1.20% but has seen a steady climb in the past three months, from 1.27 on Sept 8 to 1.78 this week, ending Friday at 1.73.  The five-yr has also seen a surge since September, from the year’s low of 1.64 to a new high for the year just above 2.14, (which was also the high in March) and closed 2.04%.

In September, as yields were making their lows, concerns about North Korea were at their peak.  Since then, growth prospects related to the just-passed tax legislation seem to have been the main driver.  Since early September, SPX is up about 7%.  Some members of the Fed have been fretting about frothy asset prices, and the short end is responding with wider near term calendar spreads.  In Eurodollars, the Dec’17/Dec’18 spread closed out the week just over ½% at 51 bps.  In Fed Funds, the Jan’18/Jan’19 spread closed at 45.  Both suggest that the market is comfortable with 2 hikes next year.  However, more deferred spreads remain compressed.  The red to green pack (2^nd year to 3^rd year) spread is just 14 bps, and green/blue (3^rd to 4^th) and blue to gold (4^th to 5^th) are both below 10 bps.  The 5yr to 10yr treasury spread clocked a new low beneath ¼% (closed at 24.6).  So there is very little concern that inflation is going to flare up; the market has embraced the idea of a terminal rate of 2.5% or so.  The 5yr 5yr forward expected inflation rate according to the St Louis Fed website is only 199 bps, having been as high as 220 in Q1.

If the new, genetically-modified Fed DOES hike rates at a more aggressive pace in 2018, then many commentators (including some on the Fed itself) fear that the curve will invert, signaling recession.  Indeed, given that the ten year in 2017 was pretty much unchanged, a new Fed Effective of 2.4% at the end of 2018 (4 more hikes assuming that a hike in 2 weeks is a done deal) would exceed today’s ten year rate.

What no one really seems to talk about is whether an inverted curve at rates of 5.25% is the same thing as an inverted curve with rates at less than half that level.  I am not sure if the implications are similar, but clearly there will be less room to maneuver in the event of a downturn.  It’s likely that the more dominant force will be credit spreads, and there have been preliminary signals that concerns are developing in that area.  For example, sell offs in hi-yld etfs are faster and associated with higher volume than rallies.  Additionally, while stocks didn’t really change much when all was said and done on the week, VIX  did close higher.

This week features the Employment Report on Friday.   Tax bill reconciliation between the House and Senate may also cause some market wiggles.

 

 

_________________________________________________________________

	11/24/2017	12/1/2017	chg
UST 2Y	175.7	177.4	1.7
UST 5Y	207.2	211.6	4.4
UST 10Y	233.8	236.2	2.4
UST 30Y	276.0	275.7	-0.3
GERM 2Y	-69.6	-70.5	-0.9
GERM 10Y	36.5	30.5	-6.0
JPN 30Y	83.2	83.2	0.0
EURO$ H8/H9	35.0	39.0	4.0
EURO$ H9/H0	14.0	15.0	1.0
EUR	119.32	118.96	-0.36
CRUDE (1st cont)	58.95	58.36	-0.59
SPX	2602.42	2642.22	39.80
VIX	9.67	11.43	1.76

 

https://www.chemours.com/Teflon/en_US/products/history.html

http://www.businessinsider.com/global-market-cap-is-about-to-hit-100-trillion-2017-12

https://www.db.com/newsroom_news/2017/capital-markets-outlook-2018–deceptive-calm-coming-to-an-end-en-11728.htm

Nov 30. Crypto rollercoaster

–Curve steepened slightly from depressed levels as yields rose.  Tens +3.9 bps to 237.4.  Red/gold pack spread +1 bp to 34.5, but still at the low for the past decade.  Wild action in bitcoin which hit a $2000 air pocket taking it from $11k to $9k but it bounced off the low and is now near $10k.  Total size of the crypto market is about $300 billion with Bitcoin a bit over half.  As a comparison FANG stocks lost $60 billion yesterday.

–Big trade in eurodollars was put roll down, details below.  Overall vol continues to compress.  With just over two weeks to go 2EZ 9775 straddle trade 10 bps (settled there ref 9778.5 in EDZ9).

–Marvin Goodfriend nominated as Fed Governor.  Carnegie Mellon professor; from a BBG piece:

In testimony before a congressional subcommittee in March, Goodfriend spoke of “the Fed’s failure to secure the credibility of its inflation target” and the risks that created for policy and the economy.

–News today includes Personal Income and Spending, both expected +0.3, with Core yoy PCE prices expected +1.4 from 1.3 last.

Trade below was exiting higher strikes, rolling into 20 delta puts (0EM 9762p 25d ref 9786.5, 2EM 9737p 20d ref 9775 and 3EM 9725p 20d ref 9764)

-40k 0EM8 97.875/97.625 put spread with
-40k 2EM8 97.625/97.375 put spread at 14.5
-25k E3M8 97.375/97.25 put 5 x 4 at 21 sold 97.375 put (5x)

Run for the Sidelines

–I don’t usually use sports analogies because they’re a bit cliche.  But here’s a guy that saw danger spilling over the sidelines and took spectacularly evasive action, and came out standing.   Let’s hope their are a few ‘wealth managers’ that are as nimble.

https://www.secrant.com/georgia-sports/georgia-coach-jumping-and-hovering-in-air-over-sideline-play-is-not-of-earth/73771769/

–China’s stocks continue to face selling pressure, and the spillover is affecting other markets.  Copper down 7 cents this morning.  Aussie dollar topped in September and it’s been going down ever since (interesting note on ZH about stretched housing metrics and loads of debt).  Crude oil pulled back from the highs yesterday and is lower this morning.  Dollar index saw a small rally yesterday.

–Powell has a confirmation hearing this morning.  Text of opening remarks were released late yesterday.  More of the same.  I had high hopes the Fed might do away with the ‘dot-plot’ but Powell appears to be concerned about protecting the Fed’s independence and thus wants to communicate with even more transparency.  TRANSPARENCY.  Overrated.

–Some measures of curve at new lows. Red/gold ED pack spread new low at 33.25 (-1.0 on day).  2/10 at 58.6.  These are decade lows.  Red/green ED pack spread closed just 12.875.  1/8% for forward one-year spreads should be a concern to the Fed.

–Junk bond etf’s saw renewed outflows.  After the Fed hike in December these guys are going to come barrelling towards the sidelines.

–7 year auction today.

Nov 26 weekly wrap. What if the market gets a toothache?

In the news this week was an item about the famous man-eating lions on display at the Chicago Field Museum.  The story begins in 1898, when two male African lions killed 35 people in the Tsavo region of Kenya, dragging them out of their tents in the dead of night.  After months of attacks, they were shot by Col John Patterson of the British Army and ultimately ended up stuffed in Chicago.

One lion was apparently out-eating the other by 2 to 1. This week, scientists are x-raying the skulls to determine if the cats are mislabeled in the display.  But that’s not the issue I want to focus on.  Earlier research tackled the issue of why these lions, with an ordinary diet of wildebeest and antelope, would target humans.  The answer is that one of the lions had a severe tooth abscess that led to the preference of easier prey with softer flesh.  In other words, an unhealthy situation caused a shift in the normal ecosystem that led to slaughter on ‘soft’ prey (as pictured below).

Now I want to shift again to a topic that I mentioned last week, from Russell Clark of Horseman Capital.  He cited the IMF’s Global Financial Stability Report, and noted that “BBB bonds now make up nearly 50% of the index of investment grade bonds, an all time high. BBB bonds are only one notch above high yield, and are at the greatest risk of becoming fallen angels, that is bonds that were investment grade when issued, but subsequently get downgraded to below investment grade, or what is known these days as high yield.” An unhealthy ecosystem which has given rise to soft prey?

While the IMF report says that the global recovery is improving, the paper is jammed with warnings about possible dislocations.  On page 25: Credit and market risks are increasingly being mispriced.  ‘Low yields, compressed spreads, abundant financing, and the relatively high cost of equity capital have encouraged a buildup of financial balance sheet leverage as corporations have bought back their equity and raised debt levels. This means that the share of lower-rated companies in major US, European and global bond indices has increased.”

A couple of weeks ago, there were large junk bond outflows, which seems, like every market ‘correction’ in the US, to have had a run for a good 30 seconds; HYG has recovered around half the pullback, and SPX has launched to a new high.

When thinking about ‘high yield’, it’s inevitable to think of the father of junk bonds, Michael Milken.  Perhaps surprisingly, one of his themes was, “Risk in capital structure should vary inversely with business risk and volatility.”  Milken’s ascendancy, which took Drexel to powerhouse status, was in the late 1970’s to 1980’s.  Between 1976 and 1982 the DJIA bounced between 600 and 1000, finally breaking through once and for all in late ‘82.  Amazingly, this breakout occurred when the ten year yield had peaked just under 16%.  Milken was unlocking value in balance sheets and spurring leveraged buyouts in a period of incredibly high rates and high inflation.

Here are a couple of Milken quotes:

The optimal capital structure evolves constantly, and successful corporate leaders must constantly consider six factors — the company and its management, industry dynamics, the state of capital markets, the economy, government regulation and social trends. When these six factors indicate rising business risk, even a dollar of debt may be too much for some companies. [I guess there’s NO risk now]

The new law [from 2009] is also helpful for companies that made the mistake of buying back their stock with new debt or cash in the years before the market’s recent fall. These purchases peaked at more than $700 billion in 2007 near the market top — and in many cases, the value of the repurchased stock has dropped by more than half and has led to ratings downgrades. Particularly hard hit were some of the world’s largest companies (i.e., General Electric, AIG, Merrill Lynch); financial institutions (Hartford Financial, Lincoln National, Washington Mutual); retailers (Macy’s, Home Depot); media companies (CBS, Gannett); and industrial manufacturers (Eastman Kodak, Motorola, Xerox). [This from 2009, link below]

How starkly different is today’s environment.  Stocks are at all-time highs.  Volatility is at all-time lows.  Corporate spreads are at historic tights.  Debt levels have increased appreciably on a global basis.  Most importantly, China has become a major player.  Nowhere have the warnings been more severe and consistent than in China; nowhere have the debt ratios grown rapidly to such unsustainable levels.  From a Reuters piece this week:  “…analysis shows the debt pile at Chinese firms has been climbing, with levels at the end of September growing at the fastest pace in four years.” “By some estimates, China’s overall debt is now as much as three times the size of its economy.”

There’s a pretty long section in the IMF paper on China, but the bit that stood out for me was this.  Debt to GDP ratios in the US and China in 2016 were similar, at 259% for the US and 254% for China, However, the ten year change for the US was 225 to 259 and the change for China was 142 to 254. And where was the largest gain?  China’s non-financial corporates, from 105 to 165% (while the US went from 65 to 72%).

While financial conditions haven’t really tightened in the US, in China they have, and it might be starting to bite.  3 month Shibor is up about 140 bps from the start of the year, but unlike the US, the ten year government yield has also risen; it’s up about 90 bps on the year.  This week there was a pretty good pullback in Shanghai Comp, shown below with SPX.  From the chart, it’s obvious that declines in SHCOMP don’t necessarily impact the US.  However, if China does experience a “Minsky moment” as the PBOC’s Governor Zhou warned last month, then there will surely be global spillover.

Consider this snippet from the IMF report: “Marginal demand has been especially pronounced among Asian investors, with flows from insurance and pension funds from Japan and Taiwan accounting for almost two-thirds of all foreign institutional flows into US investment-grade credit over the past 3 years.”  Just remember, when the going gets tough, you sell what you CAN, which suggests US corporate spreads could widen significantly.

The topics above are longer tern in nature, and may not have much discernible impact on US rates for some time.  However, flatness in the US curve (which has been correlated with a decline in USD), suggests the market suspects global growth may encounter turbulence.

***********************************************************************************

Dudley speaks on Monday evening (and Tuesday morning and Wednesday morning).  Yellen is in front of the Joint Economic Committee on Wednesday speaking about the outlook.   Note that the Employment Report is not THIS Friday, but one week later on Dec 8.

 

Market notes and trade thoughts

Week to week changes show continuing themes.  Flatter curve (2y up 1.9 bps and 30yr down 3.1).  New highs in stocks.  Strong jump in EUR (Dollar index declining again).  VIX in the gutter.  The standout is crude oil which rose over $2/bbl on the week to close at the highest level of the year, CLF 58.95.

I saw a note from Merrill that I am basically reproducing here with a bit more data.  One year ago, on Nov 27, 2016 there were 89 dte for March treasury options.  Today there are 89 days left for March’18 treasuries.  One year ago: TYH7 124-18+ and 124.5^ 2’59.  Today, (Fri settle) TYH8 124-23 and 124.5^ 1’50 (From 6.0 vol to 3.6).  USH7 151-14, 152^ 7’28. Now: USH8 153-04 and 153^ 4’32.  In dollars, EDH20 9778.5s, 3EH0 9775^ 46.5 with 103 dte.  Now, EDH21 9768.5, 3EH 9775^ 28.5 with 110 dte.  In 2016 of course, it was right after the election and there was volatility associated with that event.  Still, taking it back another year to 2015, TYH6 was 126-11+ and the 126.5^ was 2’25.  3EH9 was 9790 and the 9787.5^ was 40.0. At that time emerging markets were under pressure as were energy markets.

By the way, in 2016, EDH17 was 9894.5 and the 9900^ was 10.5 with 106 dte.  Now EDH18 is 9828 and the 9825^ is 10.5 with 113 dte.

 

_________________________________________________________________

	11/17/2017	11/24/2017	chg
UST 2Y	172.5	174.4	1.9
UST 5Y	206.0	206.4	0.4
UST 10Y	235.2	233.8	-1.4
UST 30Y	279.1	276.0	-3.1
GERM 2Y	-71.3	-69.6	1.7
GERM 10Y	36.1	36.5	0.4
JPN 30Y	81.4	83.2	1.8
EURO$ H8/H9	33.5	35.0	1.5
EURO$ H9/H0	15.5	14.0	-1.5
EUR	117.93	119.32	1.39
CRUDE (1st cont)	56.71	58.95	2.24
SPX	2578.85	2602.42	23.57
VIX	11.43	9.67	-1.76

 

https://chicago.suntimes.com/chicago-politics/a-matter-of-pride-unraveling-lion-mystery/

http://www.sciencemag.org/news/2017/04/why-did-these-lions-eat-35-men-bad-teeth

https://www.imf.org/en/Publications/GFSR/Issues/2017/09/27/global-financial-stability-report-october-2017#Chapter%20Three

https://www.reuters.com/article/china-markets-debt/graphic-chinas-debt-pile-growing-fast-despite-years-of-efforts-to-contain-it-idUSL3N1NU37E

http://www.milkeninstitute.org/publications/view/383

https://www.reuters.com/article/china-markets-debt/graphic-chinas-debt-pile-growing-fast-despite-years-of-efforts-to-contain-it-idUSL3N1NU37E

Nov 22. Thankful for a flatter curve?

–Another day, another new high in the 2 yr note yield.  Yesterday 2’s rose 2.1 bps to 177.1, while the ten year yield fell 1 bp to 236.  Obviously, this led to new lows in the curve, with 2/10 below 60 bps and red/gold pack spread below 34.  As I mentioned a couple of days ago, even though flat or inverted curves are good indicators of recession, in the 2004/2006 tightening campaign, many curve measures inverted right at the beginning of 2006, yet the Fed continued to hike until June as stocks continued to climb.  There was an interesting note on ZH yesterday that cited changes in the tax code as a reason underfunded pension funds are buying bonds before the end of the year (leading to further pressure on the curve).  (Short note, link below).

If you are a corp with an underfunded pension fund, you get a tax incentive to fund the pension THIS YEAR vs in the future when the corp tax rate drops to 20% [from 35%]. Why? Because contributions to the pension plan are tax deductible.

–Currencies in Turkey, Zimbabwe, Venezuela are falling or have already crashed and many more countries are on the brink.  No wonder that bitcoin is $8300.

–In euro$’s, a few profit taking sales.  One interesting example: Seller of 60k EDU8 9800/9762ps at 10.0.  A while ago, he had exited long 0EZ put spreads to roll into both June and Sept put spreads. EDU was 9775/9800, but then he rolled the 9775p into 9762p for an extra 0.75, and now launched the 9800/9762ps.  With EDZ7 at 9845 (on a nearly 100% odds of a Dec hike), additional hikes in March, June and Sept would put EDU at 9760 to 9770.  Currently, FFG/FFJ is 13.5 (so slightly better than 50/50 for March move) and FFK/FFN is 10.5, so not quite 50/50 for June.  Note that every deferred ED one-year calendar from EDU18/EDU19 on back is below 25 bps, most are at new lows under 1/8%.

–In treasuries, huge replacement of teeny puts.  Cab 7 paid for 140k TYH 108.5p and FVH 114 and 113.5 puts (total 140k between them).

–Have a Happy Thanksgiving holiday  (“Thanksgiving’s very big in Sicily”), Alex

http://www.zerohedge.com/news/2017-11-21/real-reason-why-treasury-curve-has-been-collapsing-month

 

 

Historical curve perspective

A lot of charts attached, mostly treasury curves and also 3m libor vs 5y.  At the bottom is the FF target rate and SPX.

According to people who have seen Grant’s, he has mentioned curve inversion a couple of times recently.

Here is the summary of charts:  Curves flattened throughout hiking cycle of June 2004 to June 2006.  Every meeting rates were jacked by 25 bps, from 1% to 5.25%.  Curves inverted in Dec-2005 to Feb-2006 as FF target was 4.25 to 4.5%.  The Fed kept on going, as did stocks.  When the Fed got to the END of its campaign stocks pulled back, but then soared 26% into mid-2007!!  Recall it was early in 2007 when the Bear Stearns mortgage funds failed, the clearest bell ringing in history….but stocks kept going up.  Things can remain irrational longer than some of us can remain solvent, as Keynes once said….

 

2Y to 5Y…inversion at the end of 2005.  Fed had hiked at 13 meetings.  Funds at 4.25%

 

5 to 10y.  Inverted in Feb 2006, 14 hikes to 4.5%

 

2y to 10y.  Invert in January/Feb 2006.  14 hikes to 4.5%

 

 

 

5/30 inverted in Feb 2006

 

3 month libor vs 5 year treasury.  By the end of the tightening the 5y yld had peaked

 

 

RED/GOLD ED PACK SPREAD.  NEVER WENT NEGATIVE. LOWEST WAS 11.5.  CURRENT 38. 

 

 

SP 500 had a pullback at the end of the hike cycle EVEN AS THE CURVE WAS INVERTED; rallied another 26% before top

 

 

 

 

 

 

Nov 20. Free the rates

–The story continues to be a flattening curve, with the 2yr note at a new high yield of 172.5 (+1.7 on the day) and tens at 235.2 (-0.7).  2/10 closed 62.7 and red/gold euro$ spread at 38.375.

–The news this morning is that Merkel was unable to form a coalition government.  EUR sold off buy was able to bounce back.  There is an underlying treasury bid as December options expire on a holiday shortened Friday.

–According to last data on Bloomberg: GDP 2.8, CPI 1.5, Unemployment rate 3.6.  Oh, that’s data from Germany…where the 2 yr yield is negative 73 bps.  In the US GDP 2.3, CPI 1.7 and Unemp Rate 4.4.  Yet US 2 yr is 250 bps higher.  Amusing to think about, but perhaps the least government interference in bond markets is China, where the ten year is flirting with 4%.

–Here is a pretty fascinating story about building staggering wealth from scratch.  Spoiler: It doesn’t have anything to do with crypto-currencies.  It’s a bit old but I don’t think I’ve linked it before.  Activity in markets is such that perhaps there’s a few spare minutes for this one…

Nov 19. Are Funding Costs About to Tighten?

There have been many interesting snippets of news this week, making it somewhat difficult to whittle them down to a specific topic and weave in a few anecdotes in support of a thesis.  For example, in the early part of the week, I thought I would run with a couple of stories that foreshadow a top in super-luxury spending.  To wit, a foreclosure at One57, a penthouse on Manhattan’s ‘billionaire’s row’, brought in $36m, 29% below the original sale price in 2014. “Even though it’s a foreclosure auction, “when you have multiple parties fighting for this unit, that’s a credible benchmark for value,” … “It places this type of transaction within the realm of what’s happening in the market.”   In another example, a flawless 163 carat diamond necklace sold for $34m at Christie’s.  “I am disappointed that the Art of De Grisogono didn’t sell for a more dazzling price,” … “This is a worrying sign for the top end of the diamond market.”

Even though the two examples above might indicate deterioration, along comes a mind-boggling sale of $450m for Leonardo Da Vinci’s Salvator Mundi.  Disaster averted.

Certainly the big tech stocks and the meteoric price of bitcoin (near $8000) are not signaling impending demise.  However, there was a temporary spasm of nerves related to outflows in junk bonds last week.  And there are a couple of other stories that suggest recalculation of risk in terms of financial diversification.  For example, Calpers is looking to increase its allocation of bonds relative to stocks.  Norway is selling oil equities from its sovereign wealth fund.  That would be like Warren Buffet selling Dairy Queen and Coke, the very foundations of US capitalism.

Underlying the entire edifice of financial architecture is faith in the idea that debts can always be easily rolled over, bolstered by the benevolent forward guidance of central banks.  There is little evidence of uneasiness associated with a changing of the guard at the Fed.  Overt warnings from the PBOC merit scant attention: “While reining in the total leverage ratio, we shall prioritize reducing the leverage of state-owned enterprises, focus on tackling ‘zombie firms’ and promote the debt-to-equity swap in a market-oriented and law-based manner,” the PBOC said in the report out Friday. [BBG]  Think about that for a second.  The Fed’s policies have encouraged firms to do just the opposite: increase debt to buy back shares.  China realizes that some debts may have to be restructured, and equity will be diluted as a result (in the same “law-based” manner that the Saudis relieved the burden of wealth from some prominent elites).  Loan growth has slowed substantially, and rates have increased, suggesting that China is tackling difficult adjustments right at the beginning of Xi’s new five-year term.

We often hear about financial conditions having eased in the US during the Fed’s ‘tightening’ campaign:  ten year yields have barely moved, stocks are higher, the dollar has weakened, corporate spreads are historically tight, volatility is low.

Horseman’s Capital Russell Clark has the following excerpt in his most recent missive:

What does the most recent issue of the Global Financial Stability Report have to say? It notes that BBB bonds now make up nearly 50% of the index of investment grade bonds, an all time high. BBB bonds are only one notch above high yield, and are at the greatest risk of becoming fallen angels, that is bonds that were investment grade when issued, but subsequently get downgraded to below investment grade, or what is known these days as high yield.

So let’s take a look at a concrete example of tightening conditions.  The chart below is the US 2yr note yield.  Just since the beginning of September it has surged over 40 bps, from 1.30% to this week’s yearly high of 1.725%.  From the Brexit low in summer of 2016, the yield has tripled.  On the week, the 2y went up just over 7 bps, while the 30-yr bond yield declined by 8.7.  The curve flattened to new ytd lows, not seen since 2007.

On a related note, China’s 10 year government yield has increased by 90 bps this year, starting 2017 at 3.06 and reaching 3.99 this week.

This is when rolling over shorter term debt begins to bite.  In 2007 and 2008 it was adjustable-rate mortgage resets that sparked problems.  In the current environment, both individuals and firms have an incentive to lock in long term funding at these levels.  Refi the 30 year mortgage…  But Mnuchin passed on the idea of issuing 100 year bonds, citing subdued interest from market participants.  Meanwhile, Canada this week sold 100-yr bonds and a Dutch energy firm had a 1000-yr hybrid issue with a coupon of 2.25%.

There was a post from the NY Fed’s Liberty Street Economics (The Low Volatility Puzzle: Are Investors Complacent?), which considered the idea that low volatility might actually be the normal state of affairs, and that ‘reversion to the mean’ of much higher vol levels might be a pipe dream.  Are gargantuan CB balance sheets ‘normal’ too?  I might have re-named this paper: The Low Vol Puzzle: Is the Fed Complicit?  In any case, while the paper’s conclusion is non-committal, there is one particular passage of note:

In contrast to mean reversion, the macro-finance literature has raised a more nuanced argument for why low volatility may lead to a buildup of risks to financial stability. In Brunnermeier and Sannikov (2014) and Adrian and Shin (2013) , decreased volatility during business cycle expansions may lead to lower value-at-risk constraints for investors as well as lower margin and collateral requirements. If investors respond by increasing leverage, small shocks to asset prices may suddenly make constraints bind, which can force investors to sell assets, raise volatility, and tighten constraints further. This feedback loop creates risk endogenously, meaning that low volatility in itself can be a catalyst for high future volatility.

The argument is so “nuanced” that it’s a blatant re-hash of Minsky’s decades old “stability breeds instability.”  Our question of the moment is this:  Does a ‘small shock to asset prices’ come as the result of an exogenous event?  Or does the ‘shock’ come in the initial form of a mild handshake buzzer where rising funding rates at the short end cause lenders to think twice about odds of payback, pushing BBB borrowers over the edge?

 

_________________________________________________________________

	11/10/2017	11/17/2017	chg
UST 2Y	165.4	172.5	7.1
UST 5Y	205.1	206.0	0.9
UST 10Y	239.7	235.2	-4.5
UST 30Y	287.8	279.1	-8.7
GERM 2Y	-74.6	-71.3	3.3
GERM 10Y	41.0	36.1	-4.9
JPN 30Y	80.3	81.4	1.1
EURO$ H8/H9	32.5	33.5	1.0
EURO$ H9/H0	17.5	15.5	-2.0
EUR	116.65	117.93	1.28
CRUDE (1st cont)	56.98	56.71	-0.27
SPX	2582.30	2578.85	-3.45
VIX	11.29	11.43	0.14

 

http://markets.businessinsider.com/news/stocks/veolia-successfully-issues-a-3-year-bond-with-a-negative-yield-1008324867

https://www.bloomberg.com/news/articles/2017-11-14/one57-foreclosure-shatters-price-dreams-at-billionaires-tower

https://www.bloomberg.com/news/articles/2017-11-14/flawless-163-carat-diamond-reaps-34-million-in-geneva-auction

https://www.bloombergquint.com/global-economics/2017/11/17/china-will-keep-prudent-and-neutral-monetary-policy-pboc-says

http://libertystreeteconomics.newyorkfed.org/2017/11/the-low-volatility-puzzle-are-investors-complacent.html?mod=djemCentralBanksPro&tpl=cb

• 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.