August 28. USD under assault
–Friday’s Jackson Hole speeches resulted in a weaker dollar and flatter curve. The ten year yield declined 2.4 bps to end at 216.6, with a new recent low in 2/10 to 83.4 bps (-1.8 on the day) and a new ytd low in red/gold euro$ pack spread to just 52.375. Dollar index making new low, not only due to differences in interest rate policy, but because of mounting issues confronting the US, including the debt ceiling and budget, Trump’s threat to pull out of NAFTA. I suppose Afghanistan, Venezuela and N Korea also play into the equation, as does Tillerson’s “Trump speaks for himself” comment. EUR currently 119.33, a new ytd high, having started the year below 105. USD also at a new low vs China yuan at 6.6270. The weaker USD should be considered as a positive for US manufacturers, but the flatter curve suggests an utter lack of forward inflation. Though it’s not particularly predictive, I would also note that the ten yr tip to treasury spread notched a new recent low of 175.7. New highs in EEM indicate a search for better growth opportunities.
–Obviously huge damage in Houston will require federal stimulus. Oil this morning is lower, likely due to storage problems, while RBOB is at a new high. Gold is again above 1300 this morning. Shorts in interest rate futures will likely be squeezed going into Friday’s employment release.
LET’S LEAVE NOW; DON’T WANT TO MISS THE FLIGHT
In the big picture, Janet Yellen’s tenure as head of the Federal Reserve has been stable and successful. Unemployment has declined steadily. Inflation is not quite at target, but talk of deflationary risks has subsided. My belief was that the market always tests a new Fed chair, but since February of 2014 when Yellen began her term, stocks (SPX) have never gone lower (although there was a test in early 2016), and the highest the ten year yield ever got during her chairmanship has been 280, a couple of months into her term. Greenspan was quickly tested with the 1987 crash, and Bernanke, of course, with the great financial crisis. Yellen pretty much sailed through without any major squalls. Many analysts have said that Friday’s Jackson Hole speech, a defense of strong regulation of the financial system, makes it unlikely that Trump will re-nominate her, given the administration’s deregulatory zeal. I’m not so certain of that. While I personally think that higher rates, higher volatility, and higher risk premia in general, act as cushions in a dynamic economy, stability in the financial world is generally applauded as a worthy goal. In any case, the next Fed chair will almost surely encounter rougher seas.
I would just like to take a couple of quotes from the speech.
And yet the discussion here at Jackson Hole in August 2007, with a few notable exceptions, was fairly optimistic about the possible economic fallout from the stresses apparent in the financial system. [acknowledgment that many financial experts were wrong].
The vulnerabilities within the financial system in the mid-2000s were numerous and, in hindsight, familiar from past financial panics. [the Fed mistakenly didn’t get in front of the situation].
Preeminent among these domestic and global efforts have been steps to increase the loss-absorbing capacity of banks, regulations to limit both maturity transformation in short-term funding markets and liquidity mismatches within banks, and new authorities to facilitate the resolution of large financial institutions and to subject systemically important firms to more stringent prudential regulation. [this is the solution; risk premia by definition decline]
To be sure, [current] market-based measures may not reflect true risks–they certainly did not in the mid-2000s–and hence the observed improvements should not be overemphasized. [the Fed should now avoid overconfidence]
Greenspan’s bias in the late 1990’s was this: The Fed may perceive dislocations and risks in the market, but will not unilaterally stand against the decisions of millions of investors. The blind buying of many tech stocks is sure to lead to a shake out and large losses, but the Fed will simply provide the clean-up and liquidity if/when the bubble bursts.
Yellen is, instead, falling back on the macroprudential approach. Depend on the regulatory framework to ensure that there is plenty of capital at financial institutions in case of problems. Use regulations to keep financially large players from pursuing too much risk. This cautious policy framework shouldn’t be surprising. It’s been written that Yellen arrives at the airport three hours before flights.
The questions now are 1) whether the low rate regime has let risks amass under the surface and 2) with the US being a smaller percentage of the global economy can crises overseas overwhelm the US financial structure? After all, the US exported the mortgage crisis to the rest of the world. Since 2008 the US economy has grown about 26%, China’s economy has more than doubled and the size of the shadow banking system there has supposedly grown faster by magnitudes.
There’s one other little quote that’s of interest in Yellen’s speech:
In addition, algorithmic traders and institutional investors are a larger presence in various markets than previously, and the willingness of these institutions to support liquidity in stressful conditions is uncertain.
This all gets back to my topic of a couple of weeks ago. It’s not the trade, it’s the size. She is not blind to risks, just wants to make sure there’s plenty of cushion in the form of capital and regulatory structure in TBTF in case things go awry. Perhaps partially as a result of this institutional bias from the Central Bank, markets themselves are not correctly pricing risks and have removed shock absorbing cushions in the form of spreads and implied volatility. Maybe we’ll discover an alternate reality with the next Fed chair.
Whatever the longer term ramifications are of Central Bank philosophy, the short term outcome from Jackson Hole was fairly clear. The euro ended at a new high for the year. DXY made a new low; $/yen close to new lows (DXY chart below). Yields eased with tens down about 3 bps on the week to 216.6. New ytd lows in some measures of the curve. Red/gold euro$ pack spread (2nd to 5th year) closed just over 52 bps, essentially cut in half from the high last December. 2/10 and 5/30 made new lows on the week at 83.4 and 99, not quite at the year’s low made after the June FF hike of 79.0 and 93.2. Spot VIX fell 3.0 over the week, from 14.26 to 11.28. Bitcoin leapt to new highs.
The real rate as defined by the 10 year inflation-indexed note closed solidly in the middle of the range defined by Yellen’s chairmanship term, ending at 41 bps.
The early part of the coming week is likely to be defined by damage estimates regarding Hurricane Harvey. Clearly there will be large costs, met in part by resources of the US Federal Gov’t. In the context of already lower than expected cash balances of the US treasury going into the debt ceiling fight, I would think that short term t-bill issuance will explode –after ‘last-minute’ heroics to fund the gov’t.
Employment report is Friday, with NFP expected 180k. Treasury auctions 2’s and 5’s on Monday and 7’s on Tuesday.
Aug 25. Often wrong, NEVER in doubt
–Both Yellen and Draghi speak today, with Yellen setting the pace at 10:00 EST. Recently it seems as if the Fed is going through a period of self reflection, with the only conclusions being that R* has come down (belatedly aligning with the market, which reflected that sentiment long ago), and that the Phillps curve isn’t working too well. The only one who seems to have stayed on a pretty steady path is Dudley, who maintains that inflation will work its way higher towards target. Over time. If Yellen highlights financial stability as a goal, it will likely be somewhat bearish. However, against that backdrop are some more immediate concerns: Hurricane Harvey, the debt ceiling negotiations, etc.
–Activity was light yesterday, with yields edging up a couple of bps. Tens ended at 219. 30 year bonds have settled in around 2.75%. 5/30 yield spread posted a new recent low, closing just below 100 bps. On the interest rate side, things are sickeningly stable. For example, friend CF pointed out that the week-1 Sept US straddle was awfully cheap, going as it does, through Jackson Hole and then expiring on the employment report. I looked at US1U 154.5/155.0 strangle which was quoted late 1’13/1’15. DV01 is $209. So a bit under 6 bps for a strangle 2.4 bps wide. And the question still arises….could bonds REALLY move 10 bps?
–Back to the immediate concerns. Gasoline was up, oil was down as Harvey confronts Texas. Katrina created a strong rally in treasuries, which ultimately was short lived. The debt ceiling seems to be creating a bit of weakness in the very front end of the curve, with EDZ7 closing down 1.5 at 9856.5. There is talk of significant bill issuance once the ceiling is lifted; that may cap the front end over the short term. Late buyer of 30k EDZ7 9825p for 0.25.
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–Finally, in the category of ‘things aren’t always how they appear’ there’s this:
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www.sfgate.com
Award-winning actor Samuel L Jackson and NBA legend Magic Johnson are two of the world’s most famous faces. But it Tuscany, where they were recently on a luxury vacation, the men were mistaken for “lazy immigrants” on social media. Johnson posted this photo on Twitter of the two sitting on a bench surrounded by luxury shopping bags in Forte dei Marmi in northern Tuscany.
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Aug 24. Surprising decline in yields
–Yields fell Wednesday, with the ten year -4.4 bps to 216.9. Some back month euro$ contracts made new highs for the move, for example in the 2022 contracts (last golds… 5 years hence). In the near part of the curve, calendar spreads made new lows. For example, EDZ17/EDZ18 settled at a new low of just 23.5, and January18/19 Fed fund spread settled at just 20. The treasury rolls were much more active as well, and those spreads also declined. For example FV U/Z went from 9.5 to 8.75 trade late in the day, and TY from 9.75 bid first thing in the morning to 9.0 trade late.
–Longer yield curve spreads also declined. New recent low in 2/10 to 86 bps (-3.1 on the day), and the red/gold pack spread in dollars settled just above 53.
–There was one notable block buyer of a calendar: EDZ19/EDZ20, buyer of 40k for 17.0. The spread settled there, and the position appears new, with an open interest increase in both contracts, up 31k in EDZ20. On the option side, there were several trades that are synthetically long spreads with a bias toward the Fed remaining on hold. For example, variations on +EDZ7 9862c and selling 2EZ 9850c.
–While stocks didn’t give impetus to ‘flight to quality’ buying, it appears as if the political theater and attendant risks of a gov’t shutdown are creating uncertainties. Typically, directional moves are confirmed on heavy volume, increases in open interest and steady to higher vol. While volume was light, open interest rose across the curve and implied vol firmed slightly.
–Jackson Hole conference starts today. Yellen speaks tomorrow. Sept treasury options expire tomorrow (large replacement of expiring wings occurred yesterday, with +30k TYZ 114p and +100k FVZ 112.25p for cab-7 on each).
–Below is chart of 2/10 in white and red/gold ED pack spread in amber. Red/gold at a post election low of 53. 2/10 traded sub-80 bps after the June FOMC hike, bounced, but is now back to just 86.
Aug 23. Copper–> rates higher. Grains–> rates lower
–Quiet session yesterday as stocks rebounded. Ten year yield rose 3.3 to 221.3. In euro$ options there were a couple of trades which modestly favor a steeper curve/widening calendar spreads in the context of an idle Fed. +20k EDH8 9862/9875cs to sell the same in EDM8 for flat premium. March call spread settled 2.0 and June at 2.5; EDH8/M8 settled 5.5. Also a buyer of EDZ7 9862c vs 2EZ 9850c for 0.5; another play for Fed paralysis. EDZ7 call settled 3.25 with 38 delta and 2EZ 3.0 with 15 delta.
–I’ll bet Mnuchin’s glad he ignored his classmates as Trump threatened to shut down the government over the border wall. The threat of a shutdown over the debt ceiling limit is growing.
–While copper surged to a new high above 3.00 before pulling back, December Corn and Wheat both closed at new lows for the year, having suffered huge sell offs from the early July spike.
–Sept treasury options expire Friday, coinciding with Yellen’s Jackson Hole address. Treasury futures roll activity picking up, with TYU/Z settling 9.5. TYZ open interest now up to 300k vs 3.1m in TYU.
August 22. Tentative safe haven bid
–As stocks appear increasingly vulnerable, safe haven markets butt up against resistance levels without quite being able to break through. Chart below shows gold, TY future and JY (used future for purpose of the chart). All are near the highs of the calendar year; right around previous highs in April and June.
–In terms of interest rate trading, there was heavy volume buying in EDZ18. Likely short covering as prelim open interest shows a decline of 45k. In fact, EDM8, U8, Z8 and H9 all showed OI drops (-25k, -22k, -45k and -13k) as reds were the strongest part of the curve closing +2.0. This caused EDZ7/Z8 to close -1 bp at 24.5, and EDH18/H19 to close at a new low of 21.0.
–New longs were visible on the longer end of the curve, with large buying of November TY calls. Interestingly, Nov being bought rather than Oct; expiration dates are Sept 22 and Oct 27. TYX 127.5/129cs 22/23 paid 30k (OI +23k, 24s ref 126-17+). Also buying in TYX 127/129/131 c fly (new position 25k, 24s). The 127 strike is approx 2.12% and 127.5 206.5% versus ten year close of 218, which was -1.4 bps on the day. DV01 of TYZ is $81.50.
–Taking it together, ‘abandon shorts as the Fed sits on hands, but enter capped longs in tens for continued curve flattening.’ At least, that’s what the activity of Monday suggested.
August 20. Eclipsed
It’s slicing the US in half. Bannon’s dismissal? The sudden flare-up in race relations and stark divide in political dogma? No. It’s the path of Monday’s eclipse, which begins in Oregon, passes over the heart of the country in Lincoln, NE, and exits in Charleston, NC.
All of our ancestors had myths about eclipses. “The ancient Greeks believed eclipses occurred when the gods were angry with humans, and the Babylonians believed it signified the death of a ruler.” “The indigenous Pomo of N. California envisioned a cranky bear ambling through the heaven and biting the sun when it refused to move out of the way.”
The Babylonians, as usual, might have been on to something. From Bannon, “…that presidency is over.”
It’s interesting to note that Bannon’s world view is informed in part by The Fourth Turning, the fascinating 1997 book by Strauss and Howe. It’s not a political manifesto, it’s a work that suggests history isn’t linear, but rather is a repetition of seasonal patterns led by similar generational archetypes. We’re currently in winter. From the authors’ prophecy in Chapter 10:
Sometime around the year 2005, perhaps a few years before or after, America will enter the Fourth Turning.
One of their scenarios (and remember, this is 1997) is: A global terrorist group blows up an aircraft and announces it possesses portable nuclear weapons.
Another is this:
An impasse over the federal budget reaches a stalemate. The president and Congress both refuse to back down, triggering a near total government shutdown. The president declares emergency powers. Congress rescinds his authority. Dollar and bond prices plummet. The president threatens to stop Social Security checks. Congress refuses to raise the debt ceiling. Default looms. Wall Street panics.
Not so far-fetched in our current political climate. Treasury Sec’y Mnuchin has consistently stayed on message -unlike others – warning that the debt ceiling must be quickly and cleanly passed, and has decided to continue in the administration. “As long as I am Treasury secretary I will do the best job I can for the American people and provide the best advice I can to the president.” Admirable. However, the t-bill curve still has its kink reflecting concerns about the debt ceiling, with 9/28/17 bills at 95.3 bps, 10/12 at 108.5 and 11/2 back down to 101.0.
The new mood and its jarring new problems will provide a natural end point for the Unraveling-era decline in civic confidence. In the pre-Crisis years, fears about the flimsiness of the social contract will have been subliminal but rising. As the crisis catalyzes, these fears will rush to the surface, jagged and exposed. Distrustful of some things, individuals will feel that their survival requires them to distrust more things. This behavior could cascade into a sudden downward spiral, an implosion of societal trust. If so, this implosion will strike financial markets – and, with that, the economy.
The Chicago superstition could run along these lines: The eclipse goes over Lincoln, Nebraska. Pete Ricketts is the governor of NE. His brother is Tom Ricketts, who owns the Cubs. The Cubs won the World Series. Everyone knows there’s gotta be an equal and opposite reaction. Something bad’s gonna happen. Let’s play some Buddy Guy. https://www.youtube.com/watch?v=3hjqqa5tq5k&list=PLaOHsXB9l-g9YpkEpH3bw2SXZmQEAlBlU
Enough of the broad strokes of societal decline. The main economic event this week is the Central Banking Symposium held at Jackson Hole, amusingly titled ‘Fostering a Dynamic Global Economy.’ Yellen is slated to give her address on Friday, at 10:00 EST. According to an article on Reuters (linked below) her topic will be financial stability. Dudley has probably been the most prominent voice on the Fed regarding financial conditions, and has expressed concerns they’ve been too easy in spite of increases in the fed funds target.
From a speech by Dudley in March, 2017, “…financial conditions can be broadly summarized by five key measures: short and long term treasury rates, credit spreads, the foreign exchange value of the dollar, and equity prices.”
While there have been minor adjustments in the past couple of weeks, overall financial conditions remain, well, uneasily easy. Taking them in the order of Dudley’s list, short term rates have increased, but the average one-year Eurodollar calendar spread over the next two years is only 21 bps. That is, the market expects MAYBE one hike per year. When the first hike occurred in December 2015, the ten year treasury was 2.29%, now it’s 10 bps lower at 219.4, (within one bp of the close on the previous Friday). The dollar index was 98.40. Though it traded close to 104.00 in the euphoria related to Trump’s election, it’s now 93.40, near a new low for the year. While junk bond spreads have widened slightly (with superb timing by Tesla and Amazon in terms of bond offerings), spreads are still tight. Equities as expressed by the SPX, are obviously up. Before the first hike in December of 2015, the SPX was around 2100, it is now 2425, just 2.6% off the high set a few weeks ago. Ten year treasury to tip spread in Dec 2015 was around 150 bps, it’s now 177, so inflation expectations have just slightly firmed (the intervening high was close to 210). I have included below a chart of the Chicago Fed’s Financial Conditions Index. No red flags waving there….it looks like any old volatility chart.
Over 100 financial indicators. Released weekly. Chicago Fed National Financial Conditions.
We know that some on the Fed are rather concerned that loose financial conditions are bolstering increased risk taking, and that asset prices in real estate and equities, having seen strong increases, can create instability if the air comes out too quickly. The unexpected risk for Yellen’s speech, who always seems to fall back to the dovish idea of weak wage growth, is bearish, i.e that the Fed must continue to remove accommodation. Is it crazy to suggest that turning up the heat with monetary warnings might also serve as a catalyst and enter into calculations regarding the political situation? Well there, I’ve just suggested it.
‘What I’ve gotten a greater appreciation for is how everything is so orchestrated by the authorities,’ she said. ‘The upside is that it creates stability. The downside is that it can create a problem of proportions that people would think is never possible. We’re moving into that territory.’
That’s not a US reference, but the appearance of stability is of paramount importance everywhere. It’s from a WSJ article quoting Charlene Chu. ‘In her latest report, Ms Chu estimates that bad debt in China’s financial system will reach as much as Rmb51tn ($7.6tn) by the end of this year, more than five times the value of bank loans officially classified as either non-performing or one notch above.’ (3)
It’s likely no coincidence that bitcoin is exploding higher as the Chinese monetary foundation appears ever more suspect. I mentioned a few things about China in last week’s piece, but it’s unlikely to unravel prior to the National Communist Conference this autumn.
Maybe it’s the Pomo tribe that has had it right all along. A bear’s about to take a bite out of this market.
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https://www.newyorkfed.org/newsevents/speeches/2017/dud170330
http://www.reuters.com/article/us-usa-fed-stability-idUSKCN1AY211
Aug 17. Increasing challenges
–The Barcelona terror attacks adds to a list of global tensions which have spilled into asset markets. Although flight to quality trades were muted as stocks fell 1.25 to 2%, yields declined, with tens down 3 bps to 219.6. The euro$ curve flattened, with reds to all deferred at new lows. Red/gold pack spread fell below 54 bps, down 2.375 on the day. Red/green pack spread closed just above 18.
–Surprisingly, there were premium sellers in rates. While volatility is correlated to the curve (flatter means less economic and and less price dynamism), a backdrop of vulnerable stocks and a pop in VIX makes sub-4% seem quite cheap in treasuries. Longer dated euro$ straddles fell 0.5 to 1.0 bp. Sept euro$ midcurves have four weeks to go, and straddles are as low as they have been. 0EU 9837^ 9.5, 2EU 9825^ 13.5, 3EU 9800^ 14.0.
–Next week is the Jackson Hole conference for central bankers, ironically titled ‘Fostering a Dynamic Global Economy’. Yellen is scheduled to speak next Friday at 10:00. The US rate structure is projecting a stagnant economy and idle Fed. Jan’18/Jan’19 FF spread closed under 1/4%, at 22.
–News is sparse today. Focus on stocks. Note that December Gold is up nearly $9 this morning above 1300/oz at a significant resistance area. It’s not bitcoin, but it could still have a powerful run…
Aug 16. ECB carefully scripts next moves….like Trump!
-From Reuters this morning- “ECB President Mario Draghi will not deliver a new policy message at the U.S. Federal Reserve’s Jackson Hole conference, two sources familiar with the situation said, tempering expectations for the bank to start charting the course out of stimulus.” The article goes on to say Draghi wants to avoid policy discussions until later in autumn, most likely in October. Jackson Hole Conference is at the end of next week.
–Yields rose yesterday, partially due to stronger than expected retail sales. Ten year rose 4.7 bps to 226.4. Eurodollar curve also steepened slightly. One-year spreads remain clustered around 1/4%. EDZ7/Z8 +2.5 to 27.0. EDH8/H9 +2 to 23.5. FFF8/FFF9 +2 to 23.0. There was continued buying in 0EZ 9812/9800 put spread, approx 100k bought yesterday at 2.75. Open interest in the two strikes: 397k and 381k…buys have been from 3.5 to 2.25. As mentioned yesterday, there is also continued accumulation of 2EZ 9775p vs 4EZ 9725p, paying 0.5 for Green in 8k. Bear flattener trade; EDZ19/EDZ21 settled 38.0.
–NY Fed released a report of household debt yesterday, link at bottom. The fact that total household debt has now exceeded the previous peak is probably inconsequential given growth in the economy. However, one interesting stat concerns student loan debt: “11.2% of aggregate student loan debt was 90+ days delinquent or in default in 2017Q2”. Most of this debt is owned by the US Gov’t, so again, perhaps it doesn’t really matter, but possibly leads to more treasury issuance? Corporate debt is likely a larger concern as it has also reached a record at $13.7T (business + corp), and a growing % of GDP. AMZN issuing $16b to fund Whole Foods purchase.
–BAML warns that expectations of increased earnings are falling in possible worrying sign for stocks relative to bonds.
–Fed minutes this afternoon.
–Article on study of low vol/
–NY Fed household debt report
https://www.newyorkfed.org/medialibrary/interactives/householdcredit/data/pdf/HHDC_2017Q2.pdf
Aug 15. Relief rally
–As the worst fears of war with N Korea receded, stocks staged a strong relief rally and VIX took a swan dive. Safe haven trades gently reversed, with gold and treasuries both lower; the latter coming under additional pressure from Dudley comments: “Market expectations not unreasonable on Sept balance sheet move; inflation to move somewhat higher; backs another hike in 2017 if economy evolves as expected.” He also again referred to easy financial conditions. “The stock market’s up, credit spreads have narrowed, dollar has weakened…”
–While it’s clear that fear trades were abandoned, dependency on central bank largesse may still be an issue for asset markets. Jackson Hole is 24-26 August and may provide evidence of changing central bank tactics. Additionally, trade friction with China is continuing. And while N Korea fades, Iran steps forward with plans to move warships to the Atlantic, and Rouhani warned that Iran could quit the nuclear deal if further sanctions are imposed.
–Ten year yield rose 3 bps to 221.7. Eurodollar calendar spreads were little changed. Good buying of EDZ7 9850/9837p spd for 3.0 with futures settling at 9855.5. August ED contract final settle was 9868.58, so a hike in December would perhaps put the Z7 contract around 9844. Late in the day there was a large liquidation sale of EDH8 9837/9825/9812 put fly (1.5s). Implied vol fell. TYV7 126 straddle settled 1’19, or 3.9%.
–Today’s news includes Retail Sales, expected +0.3 with Core (ex-auto and gas) expected +0.4. A story on ZeroHedge notes that restaurant sales are deteriorating: “… in July both same-store sales and foot traffic declined once again, and this time the slide was more pronounced, tumbling by -2.8% and -4.7%…”
http://www.zerohedge.com/news/2017-08-14/us-restaurant-industry-stuck-worst-collapse-2009
