Sept 12. Debt fears and online ads

Big trades:

Sept 11. Irma weakens. 9/11 anniversary

–Weekend risks associated with Hurricane Irma and North Korea are unwinding this morning, with stocks bouncing (ESZ +13) bonds and gold slightly lower.  On Friday the low in the ten year treasury yield was just over 201; from the post Brexit low of 137 to the high of this year in March of 262, the 50% retrace is 199.5, which should hold barring a NK surprise.

–While odds for a hike this year are down to around 25% as reflected by January’18 FF at 9878.5, there was buying of both EDU7 and EDZ7 contracts at new recent highs of 9870 and 9863.5.  While Dudley said that the trajectory of rate increases may be slowed by Harvey and Irma, the market has already forecast any increases to a trickle, with most forward one-year euro$ calendar spreads between 15 and 19.  Interesting trade late Friday was EDZ20/EDZ21 spread which traded 17.5 10k.  I read as a buyer though not certain (new position).  There have been a lot of recent option spreads that express a flattening bias from greens to golds.  I would just note that greens to blues as a pack spread is 15.625, while blues to golds is higher at 17.5; a bit surprising for a butterfly on that part of the curve to be negative.

–Perhaps the most interesting news is that the PBoC relaxed hedging margins related to FX forwards.  http://www.zerohedge.com/news/2017-09-10/yuan-about-tumble-after-fridays-shocking-pboc-news-here-goldmans-take

The yuan had been rapidly appreciating, crushing speculators but also negatively impacting China’s trade position.  This move should cause the yuan to either slow its ascent or decline.  Probably won’t see much of a move prior to the National Party Congress ends.  In a broader perspective, weakness in the dollar this year is becoming an issue for many trading partners; DXY made a new low for the year last week.
–9/11 anniversary today.

The Anti-Fed

What is the groupthink of which I speak? It’s a groupthink on monetary policy tactics, tools, governance and strategy, all. Its stated mantra of data dependence causes erratic lurches owed to noisy economic measures. Its statutory medium-term policy objectives are at odds with its myopic compulsion to keep asset prices elevated. Its inflation objectives are far more precise than the residual measurement error. Its preferred output gap models are deeply flawed and troublingly unreliable, obfuscating uncertainty and masking policy bias

 Moreover, the groupthink seeks to fix interest rates and control foreign exchange rates simultaneously. Its forward guidance begets ambiguity in the name of clarity. It licenses a cacophony of communications in the name of transparency. It recasts poor economic results with a high-sounding slogan of secular stagnation. And it expresses grave concern about income inequality while refusing to acknowledge the effect of its policies on more consequential asset inequality.

We should take note of a simple, troubling fact: from the beginning of 2008 to the present, more than half of the increase in the value of S&P 500 occurred on the day of Federal Open Market Committee (FOMC) decisions.

Kevin Warsh – BIS paper –August 2017 [link below]

Above are a couple of excerpts of from a BIS paper by Kevin Warsh.  According to Predictit.com website, he is neck and neck with Janet Yellen to be named the new Fed Chair now that Gary Cohn has been kicked to the curb by Trump.  On Friday, Steve Liesman of CNBC interviewed Bill Dudley of the NY Fed who said the Federal Reserve has a very clear mandate and any new members “…will probably want to follow a pretty similar set of policies to achieve that mandate as the existing team.”  That is, ‘don’t expect any big shake-ups.’   When I read Warsh’s very recent comments, I tend to think that there COULD be a shake-up.  One other note:  from an interview in March 2015, Warsh said, ‘When we instituted QE, the idea was to reverse QE and THEN raise the funds rate.’  The Fed has actually raised rates first, and now is moving to reverse QE.  It’s pretty clear Warsh doesn’t see things exactly the way some current members do.  By the way, Dudley, even allowing for a mark-down in Q3 GDP due to Harvey and Irma, said he doesn’t think “…they’ll have any meaningful effect on balance sheet normalization decision.”  In my interpretation, that means a start at the Sept 20 FOMC, though Yellen always leans to caution.  In terms of further rate increases, he said storms could have an effect on timing.

Consider this: according the Fed Funds futures curve, the first fully priced rate hike does not show up until April of 2019…that’s nineteen months!  That is, the current front October contract is 9884.5 or a rate of 1.155%, and the first contact that is 25 bps higher in yield is FFJ’19 at 9859.5 or 1.405%.

In last week’s note, I talked about cause and effect between the curve, the dollar, and core inflation, and touched upon models with which we view the economy and the markets.   I used to have a client who polled me every day about what I thought the primary factor was for 30 year bond yields.  “What are we watching today?”  As we all know, sometimes the focus is energy, sometimes stock prices, sometimes other data.  Now we’re in an environment where the catalysts bounce around pretty quickly.  As a result, there hasn’t been much in the way of market follow-through in the past couple of years, conditioning traders (and machines) to take smaller profits even though a huge move might be coming.  For example, it’s f’ing obvious that if a hurricane is going to hit Florida, then there’s a good chance orange trees will be wiped out, and the price of OJ will go up.  You know it, I know it, and the Duke brothers know it.  But orange juice futures barely reflected the possibility with the contract ranging between 130 and 140 through August.  RJO’s own Andrew Geiser suggested buying Oct 160 OJ calls in the middle of last week at just 0.95 offer.  By Friday they were 4.50 with the contract pushing 155.  I would guess there will be gains to follow.  The point here is that there are likely to be some much clearer catalysts for rates going forward.  For example, rebuilding stimulus, price pressures, balance sheet reversal, increase in the deficit, a new politically pressured Fed.

Consider this: On Friday, 3 month libor set at 1.3103.  Late in the day, EDU7 was being bought in good size at 9870, or 1 bp below libor with one week to go.  On the same topic, the three month libor setting is 4.5 bps HIGHER in yield than the 2 year treasury note (1.266%).

I saw an interesting snippet that Harvey, with losses estimated at $180 billion, is about 1% of GDP.   Put Irma in the mix and it’s at least 2% of GDP.  Those are significant numbers in terms of lost wealth, lost wages, and jobs that will be gone for a long period (which may never come back), let alone the extraordinary human trauma.  But these amounts will also represent opportunities for rebuilding for Trump the developer, who may now be linking with Democrats for funding in spite of deficit objections made by Republicans.  The program will depend in part on low rates and a weak dollar.  In this respect, Trump would do well to stick with Yellen.  A Warsh or Taylor Fed might look very different.

Consider this: all one-year Eurodollar calendar spreads from the second year to the third year and from the third year to the fourth year, and from the fourth year to the fifth year are nearly identical, between 15 and 18 bps….not even 3/8^th of one percent.

It will be interesting to see if Bank of Canada’s Poloz rate hike last week will stick, standing up to property speculation in spite of “elevated household indebtedness” [Canada household debt to GDP well over 100%], while justifying the move on the slender reed of global synchronized growth.  My contention is that global growth is a lagged response to the strong dollar seen from mid-2014 through 2016; that tide has turned with DXY at a new ytd low.  There is not a single policy maker that doesn’t make some reference to fx rates, from Dudley to Mnuchin to Draghi (“Not a target but very important to policy”).  It’s critical.

One other thing worth mention.  A Bloomberg piece last week notes that volumes for CDS to protect against corporate bond defaults has recently surged.  [link at bottom]. Along with some other early signs of credit stress, like increases in credit card late payments, these are indications that financial conditions may not remain as buoyant as they’ve been.

In summary, US financial conditions have been very welcoming, with a flat curve, low long term rates, tight credit spreads, firm asset prices.  These conditions may be on the verge of changing with both a new Fed and federal gov’t spending stimulus through 2018. In terms of the Fed, there will either be a head that resists rate increases due to political pressure on the excuse of low wages, or a more hawkish chair that is bound to clash with Trump.  Either way, it’s likely to erode Central Bank confidence by the end of next year.

My conclusions from the above with respect to positioning are the following.  The curve, while extremely flat now, will be steeper by the end of next year.  Implied volatility, in both equities and in rates, will increase.  There will probably not be another rate hike this year, Yellen will defer to the next Fed Chair (even if it’s her).

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http://www.bis.org/publ/bppdf/bispap92.pdf

https://www.cnbc.com/2017/09/08/cnbc-exclusive-cnbc-transcript-new-york-fed-president-william-dudley-speaks-with-cnbcs-steve-liesman-on-squawk-on-the-street-today.html

https://www.bloomberg.com/news/articles/2017-09-06/cracks-emerge-in-top-tier-corporate-debt-confidence

September 7. News for another day

–Many bits of news yesterday:  Fed’s Vice-Chair Fischer announced his resignation, and Trump took Cohn out of the running for Fed Chair (for now).  Canada raised rates amid a reported slowdown in Toronto real estate (reports that sales have fallen 35%).  Brazil cut rates 100 bps.  Hurricane Irma is causing vast damage in the Carribean as it moves towards Southern Florida.  Trump unexpectedly agreed to a debt limit extension with Democrats.  It’s almost enough to push North Korea out of the headlines.

–Today is the ECB meeting with Draghi slated to talk about tapering purchases as bond supplies dwindle.  Euro is higher again this morning at 119.80.  A Bloomberg article noted particular concern about EUR strength, with the currency up nearly 6% in trade weighted terms and 13% vs the USD.

–The debt extension plan caused an immediate reaction in the market.  Notable was straddle spread buying in eurodollar midcurves: selling October and buying December, as the date for wrangling was extended to Dec 15th.  That date coincides with Dec midcurve expiration, and the Dec FOMC is just two days prior on Dec 13th.  About 12-15k straddle spreads traded in red, green and blue mids.  Below are changes from atm straddle spreads Tuesday to Wednesday:

0EV/ 0EZ 9837 straddle spread 6.5 on Tuesday and 7.5 Wednesday.

2EV/2EZ 9825 straddle spread, 9.5 to 10.5  (10.5 paid 5k)

3EV/3EZ 9812 straddle spread, 11.5 to 12.0  (12 paid 4k)

There was also long premium exits in TYX options which expire October 27.

–Interesting story about a major investor throwing in the towel on a bearish China bet.  Yuan has strengthened this year vs the USD by 6%.  (As almost everything has).

https://www.bloomberg.com/news/articles/2017-09-07/down-240-million-on-his-seven-year-short-a-china-bear-gives-in

Sept 6, 2017. Low R* means low rates

–“In the environment of the last few years, markets have become very comfortable in interpreting the lack of official guidance on the policy normalization as a green light to increase financial bets on the continuation of a low volatility journey, delaying the important consideration of (and positioning for) the destination.” This quote is from an El-Erian piece this morning on Bloomberg regarding Thursday’s ECB meeting tomorrow.

https://www.bloomberg.com/view/articles/2017-09-06/what-the-ecb-will-and-won-t-do-this-week

–“By constraining the amount of policy space available to offset adverse developments using our more effective conventional tools, the low neutral rate could increase the likely frequency of periods of below-trend inflation. In short, frequent or extended periods of low inflation run the risk of pulling down private-sector inflation expectations.”  From Brainard’s speech yesterday.

–El-Erian suggests that CB reticence to move towards normalization is spurring financial engineering.  Brainard is concerned about the low neutral rate [R*] and low inflation expectations which are self-reinforcing.  The central bank problem is a circular one, made more complex by currency trends which affect inflation through import/export prices.  While the ECB meets tomorrow, the FOMC is in two weeks, and will include the ‘dots’ which may shift lower in the longer run.

–Interest rate markets were fairly quiet yesterday in the face of increased tensions with North Korea and potential damage from Hurricane Irma.  The ten year yield dropped 8.5 bps to 207 (from Friday’s close).  2/10 treasury spread closed at 78.4, down 2.7 on the day to a new low.  Nearly all eurodollar calendars made new lows on the year.  EDH18/EDH19 was crushed to 17 from a settle of 21 on Friday.  Both Brainard and Kashkari suggest that rate hikes should be deferred.  In Fed Funds, Jan’18/Jan’19 settled 15…roughly a 60% chance of just one hike for all of next year.  It was a steady and controlled shift to an environment of lower rates.

–Implied vol firmed, but only modestly.  A jump in VIX was hammered down like an errant nail by the close.  There were some wingy buys, for example, +40k each 0EZ 9900c for 1.0 and 9912.5c for 0.5 (settled 0.5 and 0.25).

–Today’s news includes Internat’l Trade, non-Mfg ISM expected 55.8, and the Beige Book.

Unintended Inventory

I took an economics class from Robert Eisner, a nationally distinguished professor who was an expert on Keynes.  About the only thing I remember from college (it was a long time ago) is this: Investment doesn’t necessarily equal intended investment.  This idea is at the heart of Keynesianism.  Previously, if unsold product built up, classical economists thought that rates would decline, investment would be spurred, hiring would pick-up and inventories would be worked down to intended levels. Self-correcting. In Keynes’ model, cause and effect of various actions were viewed differently; he concluded that in the classical model, unemployment would not necessarily get back to previous levels, especially in a liquidity trap, hence government spending could be used to fill the gap.  I know I’ve muddled the story, but the main point is that we often mistake cause and effect; attribute a particular market action to something that might just be correlation, not causation.  Our internal model doesn’t allow for a quirk that might give perennially bad results.  Has the dollar declined because Core PCE inflation has declined this year?  Has the yield curve flattened to near multi-year lows because the Fed is too tight?  If the Fed is tight then why is the dollar declining?  Is the dollar falling BECAUSE the curve is flattening?

In terms of unintended inventory, I recall a floor story told to me in great detail by a front month euro$ pit broker, in the days when the near month contracts MOVED, long before electronic trading.  This was also prior to dual trading rules, so he traded his own account as well as filling orders, and it was in the time before 0.5 bp price increments.  He was short in a rising market and yelling out an offer: “3000 at 8; 3000 at 8.” Good size in those days; most people would think he was representing a ‘desk order’ but in this case he was trying to personally hold the market down (also in the days of pre-spoofing rules).   Once again, “3000 at 8!” and a local just looked over, said ‘buy ‘em’ and never even glanced back at the broker, just looked down, carded the trade up, and bid 8 to follow.  “Buy ‘em”….that’s the whole order.  The narrator said all the air was just sucked out of his body at that moment.  A visceral case of unintended inventory.

One would think in our current world of computer networks and just-in-time methods of product delivery, there could almost never be an unintended inventory issue.  Yet I saw a few articles that suggested Hurricane Harvey, with its widespread destruction, went a long way in ‘solving’ the auto industry’s inventory problem. [Estimates of 500k cars damaged; cash-for-clunkers in 2009 led to 700k vehicles traded in].  Sure, there will be re-building to spark growth, but there has also been a huge loss in wages, in production, in sales.  What will the net effect be?

“The public has been conditioned by frequent natural disasters to think that nobody has to eat the losses, so that in effect loss doesn’t exist, just as the nation’s central bank has engineered the belief that risk no longer exists in the management of capital.” (Howard Kuntsler).

In tying together the idea of inventory and management of capital, I would guess that many investors don’t have much sense of how much ‘short vol’ is in their inventory, and little idea of the total magnitude of capital committed to the trade.   But we do see that items of limited supply, like bitcoin, can ramp up in price quite powerfully.

This week, Core PCE yoy price index was released at only 1.4%.  It has declined steadily this year, having started at 1.8%. It’s now way below the Fed’s 2% target.  Also this week, the dollar index (DXY) made a new low for the year.  Many measures of the yield curve flattened to new lows.  2/10 treasury spread closed below 80 bps on Thursday (having been as high as 136 post-election).  Red/gold euro$ pack spread (2yr forward vs 5 yr forward) was 100 bps in January, but closed 52 on Thursday.  Red/green euro$ pack spread (2yr frd vs 3yr frd) is below 17 bps.  All of these spreads are nearing the lows of 2016, before the election of Trump gave hope that stimulus measures would boost wages and infrastructure.  The pre-election lows in 2016 were the flattest the curve has been since 2007/2008, when yields were high and the crisis was starting.  Currently, one-year Eurodollar calendar spreads are all below 25 bps; the market is not pricing forward tightening of more than one hike in any given year.

So we’re back to cause and effect.  Is the government perceived as impotent regarding stimulus at the same time that the Fed has removed a small measure of accommodation, thereby causing inflation to decline, which is flattening the curve due to a lack of inflation premium?  Is the USD simply responding to the curve, weakening as the curve flattens?  Will the weaker dollar eventually spark inflation in USD denominated goods, or is the flip side more ominous, that strength in the euro will slow down progress made in the Eurozone?   As Treasury Secretary Mnuchin said this week, a weaker dollar is somewhat better for US trade.  Everyone wants a weaker currency so someone else can buy their products.

The interest rate market and the dollar seem to be telling us that the economy isn’t all that great and perhaps a slowdown is in the cards.  The short term curve is saying that Fed tightening isn’t necessary and indeed may lead to a negative outcome.  The dollar is softening because it won’t be underpinned by higher rates.  Stocks are firm because, in a slow growth/low inflation economy, investors are drawn to large cap tech stocks as they almost appear to have the safety and liquidity characteristics of bonds.  Which market will give a true signal of change?

We’re in a month where government influence will be on display, center stage (for better or worse).  Congress is back to tackle the debt ceiling and budget.  The Fed meets in two and a half weeks and may initiate the balance sheet adjustment plan.   Most importantly, we may see a more forceful reaction to N Korea’s sixth nuclear test, a hydrogen bomb.

My internal model tells me that 3 day weekends sometimes correspond to trend changes.  (Is that vague enough?)  I will note that on Friday many interest rate contracts made new high prints for the year and then reversed, with outside ranges and lower closes.  That’s a signal that buying in rate futures has been shut off, but given the geopolitical back-drop, a safe haven bid can quickly dominate all else.  Dec Gold settled at a new high on the year, and at $1330, is up over $110 from the low set in July.

Sept 1. Buy ‘Merica

–In the context of Harvey, with 1 million people displaced and 100k homes damaged or destroyed, a swing of 20 or 30k new bartenders and waitstaff in payrolls hardly seems relevant. But, we’re looking for 180k, a rate of 4.3% and 0.3% wage growth. And the algo programs probably don’t know how to account for Harvey yet, or for Irma (with its possibility of making US landfall next week), so there will likely be an opportunity to fade the first reaction.

–Everything rallied yesterday, with Nasdaq posting a new contract high, and the ten year treasury closing at 211.7, down 2.6 on the day and recording a new low in 2017. The 2/10 treasury spread also at a new recent low of 79.5 bps. As mentioned yesterday, the red/green euro$ pack spread closed at 16.75, just under the levels of the election. It’s like Trump never happened…(right?). Red/gold pack spread settled 51, a new low for the year. Mnuchin said that a tax plan is nearly ready, and also mentioned that a weaker dollar is better for trade. We’ve come a long way from Treasury Sec’ys ALWAYS saying that “A strong dollar is in the interests of the United States.” In any case, the market is reacting as if the massive flooding will forestall any tightening by the Fed. The euro$ curve is not projecting any stimulus related to passage of a tax plan, nor to the weaker dollar (spurred on by Mnuchin), which is quite surprising. Of course, increasing military options regarding NK may also be supportive of fixed income.

–Speaking of taxes, the Chicago Tribune reported that Bloomberg spent $3 million on advertisements supporting the $0.01 cent per ounce tax on pop. (We call it pop here). That’s after having already spent $2 million on the same project. Hey Einstein, why don’t you just give $5 million to the city of Chicago so it can put a dent in the unfunded pension liability for the ghost payrollers on Streets and San?  It’s almost (can I say it?), ‘adorably out of touch’

Aug 30. NYSE Margin Debt as % of GDP

Chart is NYSE margin debt as % of GDP.  It’s near a record at 2.85%.  Previous spikes in 2000 and 2007 corresponded with stock market sell offs.

August 30. BTFD

-Beware the False Demagogue? Behold the Future Development? I know BTFD means something. I just can’t put my finger on it. Oh well, on to the markets.

–In the spirit of Brexit and the surprise of Trump’s election, markets responded to N Korea lobbing a missile over Japan for a few hours, and then initial moves fizzled. $/yen made a new low but rapidly snapped back. VIX jumped but reverted back to its comfort zone, closing at 11.68. Millions of lives altered by Hurricane Harvey with staggering loss of property and the market reverts to the Broken Window Fallacy. Or maybe just figures the Fed will never hike in the face of adversity.

–Yields closed lower on the day with tens -2.2 bps to 213.3. Red and green euro$ packs were up 2.5 and 3.0. Once again, new lows were set in many near calendar spreads with EDZ7/EDZ8 closing at 19.5. All one-year spreads are below 1/4% and forward ones are below 3/8%. The euro$ curve is NOT projecting forward growth and is NOT expecting inflation as a result of rebuilding efforts. Jan’18/Jan’19 FF spread closed at 16.5. On the other hand there was buying of some 200k out of the money Dec 5yr puts. FVZ 113.75, 113.5, 113.25 and 113p all bought for 1/64 (~50k each). Current DV01 of the FV contract is around $51, so roughly 19.5 bps per point. FVZ7 settled 118-165 with the cash yield 1.707, so the top strike is over 90 bps away, 2.60%.
–At the same time, the Green Sept 9825 straddle with just over 2 weeks until expiration settled at 10 bps in front of Friday’s employment data. Maybe, one day, there will be a big move. But ED premium isn’t forecasting this week.

August 29. The Last Straw

–So THIS missile launch by N Korea is the last straw? It’s all risk-off this morning, though stock indexes have not quite taken out recent lows. Interest rate futures, by contrast, have exceeded recent highs. Part of the move was evident even before the NK provocation, as the Houston storm and flooding also entered into the equation. As of yesterday’s close, many back month euro$ contracts had made new highs for the year (from EDZ8 back through the golds-5th year). The five year note for example, was 174 at the floor close, just above the low yield in June of 171.5. This morning it’s 169, even in front of the seven year auction today. EUR at a new high; $/yen near a new low at 108.63. Gold has added to yesterday’s breakout gain.

–While the ten-year yield only fell 1 bp during yesterday’s session to 215.5, the curve flattened with many euro$ calendar spreads making new lows. For example, EDZ7/EDZ8 made a new low for the year at just 22 bps. Reds to greens (2nd to 3rd year) closed at 17.625 bps. 2/10 treasury spread at 82.6. The curve is amazingly flat given the supposed narrative of a growing global economy.

–Implied vol edged lower in treasuries, though there is still program call buying of TYZ 129c. Settled 20/64 ref 126-235 with 20 delta; open interest in that strike is now 80k. I suspect there will be some reaching for higher calls (from the bunkers). Speaking of reaching, it was just back in springtime, in March, when bitcoin first exceeded the price of gold at around $1270. Now GCZ7 $1325 (new high for the year and up a solid 12% or so), while bitcoin is 4350, 3.3x the price of gold…

• 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.