August 14. In crypto-currencies we trust
–Markets have rebounded, having made it through the weekend without major surprises regarding N Korea. Stocks rallied, bonds are lower, as is gold. However, bitcoin has exploded to a new high above 4000. The dollar has also firmed, though a headline in today’s WSJ says ‘USD weakness could be boost the economy needs.’ While Trump moves toward trade retaliation against China, a ‘free-market’ publication hails currency weakness as a growth strategy. I guess it worked for Japan, which reported 4% GDP, surpassing expectations on improved private consumption. China, however, reported softening growth.
–Friday’s session featured new lows in many euro$ calendar spreads with EDZ7/EDZ8 closing at a new low of 24.0. Prior to the election, one-year calendars were around 15-19 bps. With the expectation of loosened regulation and a tax cut package, peak spreads soared to the mid 60’s in Dec/Jan. But a lack of inflation has dialed down Fed expectations (Core CPI +0.1 on Friday), and of course, a fluid geopolitical landscape has also introduced uncertainty, not to mention flailing domestic politics.
–Some large exits Friday. 0EU 9825/9837 risk reversal and 2EU 9800/9825 risk reversal were both liquidated, buying back the calls in size of 20k. Back month eurodollars posted new highs, with reds +4.875 on the day and greens +4.75. 5/30 treasury spread steepened, with 5’s down 4 bps to 174, and bonds essentially unchanged. The spread is 104.6, around a long term pivotal area. A close above 110 would likely signal a new leg higher.
August 13. Limit to the Level of Skirmishes
The violence that erupted at the ‘Unite the Right’ rally in Charlottesville is a demonstration of how growing tensions can spin out of control in a hurry. In the global arena, Trump now is threatening trade retaliation against China in an attempt to force Xi’s hand on North Korea. At the same time, China is involved in a border dispute with India which could devolve into military conflict. The South China Post suggests an “…aim to limit any conflict to the level of skirmishes”, while the Times of India says “…diplomatic and military channels are being utilized in a bid to defuse the almost 2-month old crisis.” As China prepares for its National Congress, goals of strength and stability are being tested.
Global markets reacted this week to geopolitical events, with N Korea at the top of the list. A Google Trend search for “Military options” unsurprisingly has shown an increase to a new high, with Trump now casually tossing out the phrase in connection with Venezuela (Chicago is next). It’s clear that the odds of a mistake, somewhere, are increasing. So VIX, for example, jumped from 10 to 15.5 on a Friday to Friday closing basis. While treasuries didn’t make new highs, Eurodollar contracts from EDH19 to EDU20 (essentially the last 2 reds and greens), posted their highest levels since the November election. Odds of Fed hikes are being further squeezed out. All near Eurodollar calendar spreads are making new recent lows. For example, EDZ17/EDZ18 closed at 24.0 on Friday, on heavy volume of 75k, down 5.5 bps on the week, but down 15 from the high of 39 set in early July. In Fed Funds, the Jan’18/Jan’19 spread closed at 20.5, just better than 80% odds for just ONE hike next year. It’s getting to the point that the possibility of an EASE is going to have to enter into the equation. If I’m short Jan’19 FF at Friday’s close of 9856.5, just how confident can I now be that the upside risk is only 28 bps to 9884.5?
Adding to the mix were disappointing inflation data on Thursday and Friday, with Core PPI -0.1 and Core CPI +0.1 and +1.8 yoy. What is somewhat interesting is that while some inflation measures are muted, industrial metals are quite strong. Copper last week hit its highest level since June 2015. Aluminum since late 2014. Zinc is testing highs made late last year and in February and Nickel has had a strong bounce. Is this just a reflection of strength in just aerospace and defense, or a larger manufacturing rebound? Gold (GCZ7) has rallied 6.5% since the low close in July, reacting to both N Korea and a softer USD. Continuing on the topic of inflation and the missing link, i.e. wage inflation, note that the Fed unceremoniously dropped its Labor Market Conditions index (LMCI). From the Fed website: “…the measurement of some indicators in recent years has changed in ways that significantly degraded their signal content… average hourly earnings as an indicator did not provide a meaningful link between labor market conditions and wage growth.” I don’t know exactly what that means, but the Atlanta Fed wage tracker, while having decelerated to a small degree this year, still seems to be in an uptrend (+3.3 in July as 3-month MA), and a trade war with China will almost certainly be inflationary at the margin. If the Fed isn’t certain that wages are being properly measured, is it fair to say that inflation in general might also be in question? There have been several high profile recommendations of US treasury inflation-indexed bonds recently. Ten year tip ended the week at 39 bps, while the spread to 10y UST was 180 bps.
It now seems to be the case that even if the situation in Korea de-escalates, tensions are likely to remain elevated between world powers, and there are negative implications for global trade. For example, we hadn’t heard much about China building military islands in the South Sea for a while, but that issue is likely to flare up again. Additionally, it’s not clear that US domestic politics are getting more cooperative with respect to the Trump agenda. The debt ceiling problem is right around the corner, the US deficit is worsening, and an infrastructure and tax package is murky at best. At the same time, Mueller is turning up the heat on his investigation.
With markets having been priced for steady growth and low volatility until this past week, it’s little wonder that relatively small moves are creating pockets of angst. A fairly large move in VIX has shaken the idea of complacency, though US treasury vol was more or less immune. US hi-yield ETF’s took a large tumble, though I saw a chart that indicated that European junk yields had basically converged (prior to this week) to US treasury levels! There hasn’t been much in the way of ‘risk-cushion’ priced into assets, and the re-set can be jarring. Some time ago there was hand-wringing over the idea that China could roil US bond markets with sales of reserves. Headlines that have been shunted aside can return to the main track rather quickly.
What does tend to happen in periods of uncertainty is that markets trade technically. An old high or low will be tested and instantly rejected. Fibonacci retracements become more important guides. The opportunities for scalping gamma increase.
This week’s news includes Retail Sales Tuesday, FOMC minutes on Wednesday, Philly Fed Thursday.
Aug 11. First out the door….
–Yields fell as stocks sold off on N Korea worries. SPX -1.45%, Nasdaq -2.1% and ten year yield -3 bps to 221. While VIX leapt to 16 late in the day, treasury vol was subdued, with TYZ7 126 straddle closing 2’16 or 4.15%. Green and blue midcurve straddles were mostly up 0.5 tick. August midcurves expire today.
–There were several euro$ ‘disaster’ trades, including new buys of 0EV and 0EX 9862c as a strip for 2.5 vs EDZ8 9829.0. (settled 1.0, 1.25 vs 9828.5). The curve flattened, with red/gold pack -1.375 to a new recent low of 54.75. Some of the one-year spreads also closed at new lows: EDZ7/Z8 at 26.5 and EDH8/H9 at just 23.0 (22.5/23.0 late). Jan’18/Jan’19 FF spread settled 22.5, down 1 on the day.
–The question now is how to de-escalate the N Korea situation. It would seem that China has a major role (according to Trump), but China’s Air Force Chief today said that Tokyo does not own the Sea of Japan… Chinese assistance in N Korea will likely come with other issues further down the road.
–CPI today expected +0.2 both headline and core, but data takes second billing to position exits. Hi yield etf’s closed just through 200 day moving averages, as did Dow Transports. EEM was -2.4% having just made a new high 3 days ago. Financial advisors will all be on tv today counseling not to panic, a reminder of the classic line in Margin Call: “If you’re first out the door, that’s not called panicking.” It’s likely that there will be pre-weekend nervous selling today, punctuated by machine buys to squeeze day shorts. VIX related trading will be key, as a scramble for protection seems overdue. Recall, a recent trade, I believe Oct VIX 12p vs 15/25cs (+ cs) in size of 250k around flat premium. On a quick look this morning that trade looks like it’s worth about 1.00. Note that Oct 25c have 600k open interest…
Aug 12. VIX vs TY Vol
Last time VIX was above 15% in May, TY Vol was 4.67. Today, TYZ 126 straddle settled 2’15 or 4.15 vol. If it were 4.7, then the straddle would have settled 2’34.
Aug 9. Trump intent on destroying the rally he takes credit for
Aug 8. Slight shift in Junk
–Net changes in interest rates were small yesterday, with yields edging lower and a bias towards flattening. The action can be summarized by a couple of trades: Buyer of 60k 0EZ 9812/9800 put spread for 3.25 (settled 3.0 ref 9825.5 in EDZ8). The underlying Dec’18 contract had the largest open interest change on the strip, +21k. This trade caused EDZ8/EDZ9 to close on the low at 19.5 (lowest since the election in November). On the long end, a buyer of 7k TYZ 128c for 21. Settled 23 ref 125-27 in TYZ. This trade marks the return of a program buyer that typically buys 20 delta calls every day. TYZ 128c open interest rose 10k to 24.6k; the position will likely grow to 150k or more. Open interest in TY was +31k.
–Once again, there are warnings about overvalued assets, this time from Gundlach, who says it’s time to move towards the exit. Any warning signs? There were a few headlines saying that CREDIT CARD DEBT IS AT A NEW HIGH! But that’s not really a big deal; it’s just over $1 trillion with GDP of 18.6T, while it first hit that level in 2008, when GDP was $14.7T. Add in student loans at 1.4T and maybe there’s an issue, but maybe not. However, what is perhaps more important is corporate and junk debt. Yesterday we mentioned a Bloomberg story on increased put buying on IG CDX. There’s a NYT article on Tesla tapping the junk bond market for $1.5b as it burns through $1b per quarter. https://www.nytimes.com/2017/08/07/business/dealbook/why-tesla-motors-is-fueling-up-on-debt.html
I also noticed IBM made a new low yesterday (increases debt to buy back shares regularly), and that TEVA was getting crushed (took on heavy debt to fund an acquisition). Probably just isolated cases, however, it’s also the case that junk bond etfs (HYG and JNK) appear to be turning lower after torrid rallies. Possible omen of credit spread widening? By the way, corporate debt issuance is running at a record pace this year….
It’s Never the Trade, It’s Always the Size
The title is one of the favorite sayings of a friend of mine (WHM). Obviously, a bad trade of small size can be absorbed. But a large trade coupled with a sudden evaporation of liquidity can be a disaster. Especially when there’s leverage involved.
On Thursday, the TY straddle expiring on unemployment day traded a new low 21/64’s. On what used to be the biggest data release of the month, the breakeven in the underlying TYU7 contract was only 10.5/32’s either way from the strike price of 126-08. Ultimately, the sellers were proven correct, with net change on the day of -9/32’s to 126-02.5.
We’re in a period of steady growth, low unemployment, moderate inflation, low rates. Risk has been squeezed out of all markets. Implied vol has followed realized vol lower. The curve implies lack of Fed action, and little expectation of increased inflation. Corporate spreads are tight. The US savings rate is dropping. Asset prices have pressed higher to capture ‘yield’ and are overvalued by many metrics. https://www.advisorperspectives.com/dshort/updates/2017/08/03/market-remains-overvalued
The market has rewarded and continues to reward those that sell volatility. The chart below is a good representation of the year; it’s the 5yr treasury yield. The recession indicator of an inverted curve is unlikely as the market prices out future tightening –in spite of Friday’s strong employment report with a rate of only 4.3%. The spread of January 2018 to January 2019 Fed Funds settled 24.5 Friday and has been bouncing around ¼%, suggesting just one hike next year.
When markets price out potential risk, they also price out cushion for loss. The natural tendency is to increase the size of the trade in order to make the same income. That’s when position unwinds can overwhelm fundamentals and cause dramatic overshoots. There are probably more potential catalysts than ever that could upset the current ‘equilibrium’, but as a client said to me Friday, “the first disturbance will be sold.” It’s really the secondary effect that we have to be concerned about. Even in the political realm, there is clamp-down on volatility with the new Chief of Staff, General Kelly.
An interesting question posed last week by a client was this: If there were a nuclear incident involving North Korea, what would be the best trade? I responded with a variety of ideas; I won’t go into specifics, but some were pretty obvious. Buy VIX, buy gold calls, buy treasury calls, buy swiss. It’s simply an exercise to consider what COULD happen, and the catalysts aren’t black swans, they’re fairly well known. It’s just that the odds are low. In addition, timing is everything. For example, Greenspan is calling our current rate environment abnormally low; a ‘bubble’, and further added that when rates DO rise, they may do so rather rapidly. Of course, his famous ‘irrational exuberance’ speech in 1996 preceded the equity market top by years.
My bias is to side with Greenspan. As the TBAC warned last week, the Fed’s balance sheet adjustment has the potential to be messy. “More importantly, the TBAC also warns that with IG corporate net leverage near all time highs, the result of ‘expectations of permanently lower rates and tight spreads’, they are “more sensitive to higher rates.” In other words, a sharp, or even gradual, rise in yields will impact corporate debt disproportionately.” (ZH) In addition, the treasury’s borrowing schedule has increased, with $500 billion expected to be auctioned in Q4. Given that some of the tax package was supposed to be financed with savings from health care reform, the prospects of the former have been severely curtailed by the failure of the latter.
While many analysts point to an inverted curve as the best predictor of recession, perhaps this time it might come as a result of longer rates moving higher. It might not be the result of household balance sheets coming under stress; it may be more likely to arise from pressure on corporate balance sheets. From Q1 2014 to Q1 2017, debt outstanding of households has risen only a total of about 9% (to $14.88T) while total business debt has increased 20% (to $13.74T).
There are just a couple of other quick observations I would make, without necessarily drawing any conclusions. First, there are some small signs of dislocations in the corporate world. For example, IBM (the company Druckenmiller once described as the posterboy for excessive financial engineering) has fallen around 19% from this year’s high, lopping >$20 billion of market cap, which is now down to $135B. GE has fallen by a similar percentage, and has seen > $50B evaporate from the high.
BBG had a story noting a recent disconnect between large and small cap stocks. The chart below gives an indication. It may not be of particular concern at the moment, but bears watching. It shows the DJIA in blue, and the Russell in white. In the last couple of weeks, the Dow has soared while Russell has turned down.
Finally, I would like to add a chart noting the explosive growth in open interest of the Ultra Bond contract, symbol WNA on Bloomberg. There were several large block buys of WNU7 this past week, beginning Wednesday at a low price of 165-22. The DV01 on the contract is $292, so every one point move is ~ 3.4 bps. Why the demand for an especially long duration contract? Contract price in white, open interest in green. Since last year open interest has risen by 45%.
August 4. Duration wanted
–Payrolls expected 180k and avg hourly earnings 0.3%, with a rate of 4.3. Yields fell once again yesterday as vol and the USD declined. Late in the day $/yen was below 110 having been as high as 114.50 in mid July and mid May. Once again there was early large buying of WN and TY. Open interest wasn’t up much in TY at +6.4k, but in the ultra bond it rose 15.6k. Someone wants long duration. Open interest in the ultra bond exceeds that of the classic USU contract by over 12%. Ultra has 844k open. 2/10 edged to a slight new low just under 89 bps.
–AMZN’s Job Fair with gargantuan lines suggests that the ‘full employment’ environment suggested by official data is somewhat suspect.
August 3. When in doubt….sell vol
–Vol was hammered in treasuries as yields slipped and the curve flattened slightly. Tens -1.2 bp to 225. The drop in premium was especially notable in USU, where the 154 straddle opened the day trading 2’32 and closed at 2’22, taking implied from 8.2 to 7.6. The fall in vol is somewhat directional with the curve as, for example, 5/30 dropped 2.6 bps to 102.8. There were early block buys of TYU and the Ultra Bond (WNU7), the latter at a price of 165-22 for just under 7.5k ($2.18mio bp). The contract settled at 166-09, a move of about 2 bps. Open interest in the contract rose by 6895, suggesting new long, although some of that was in WNZ as a Sept/Dec roll was sold late in the day.
–There were other trades that also suggest a flatter curve/ narrowing ED calendar spreads. For example +30k 2EH 9800/9825/9850 call fly bought for 4.5. (Settled 4.5 ref 9802 in EDH0). Like almost all other calendar spreads in dollars, EDH8/EDH0 (front March/Green March) is as low as it’s been since November at 44.5 bps. The high in this spread in the Trumpian afterglow in December was 84.5, so there’s already been significant flattening.
–DXY made a new lows as the Euro exploded as high as 1.1910. It’s especially strong against CHF; EURCHF was 1.1015 on July 24 and was 1.1510 yesterday, a move of 4.5% in a little over a week. Interesting side note (thanks AOK), EM FX vol is below that of G7.
–An article on ZH noted that the Treasury Borrowing Advisory Committee has some concerns that the Fed’s balance sheet adjustments might not be as smooth as advertised. According to the TBAC, the “amplification from normalization could possibly come from wider credit spreads and be transmitted to equity buybacks and valuations.” This is pretty much an overt recognition that stock buybacks have been a major prop, and they’ve been financed with cheap debt.
–Saw several stories yesterday that AMZN was hiring 50k seasonal workers starting now. Will it kick up payroll data? Ironically, I also saw a story that China’s largest ‘smart warehouse’ is manned by robots, working day and night (Alibaba). Perhaps the days of ‘seasonal hiring’ are coming to an end. http://www.dailymail.co.uk/news/article-4754078/China-s-largest-smart-warehouse-manned-60-robots.html
–Jobless Claims, Factory Orders +2.7 and Service ISM 56.9 expected.
Aug 2. Yields ease
–Yields dropped yesterday, in part due to weak auto sales, with 10s down 4.1 bps to 225. Many euro$ calendar spreads made new lows, for example EDZ7/EDZ8 closed at 27.0, -1.5 on the day. Red/green ED pack spread closed at exactly 20, -1.875. EDH8/EDM8 settled 5.5, lowest since last November. FFF8/FFF9 settled 23.5, less than 1 hike priced for next year. And at a close of 9874 in FFF8, the odds for another hike this year are only around 40%.
–While yields eased, implied vol remained bid on heavy put buying. TY week 2 (Aug 11 expiry) 125/124.5ps was bought for 2 in size of 45k. Settled 1 ref 126-075. TYU 125.25p gained 23.7k in open interest on new buying; settled 11. TYU7 126.25 straddle settled 63 (same as atm on Friday). TY2Q 125/127 strangle settled 8.
–There was a large early buyer of 25k 2EZ 9850c for 2.5 which was a close, as OI fell 17k.
–Keeping an eye on 2EH/3EH straddle spread as 2021 is the libor end period. 2EH 9800^ 41.0s vs 9804 EDH20, and 3EH 9787^ 45.5s vs 9785 in EDH21. Might expect this spread to widen slightly.
–EUR at a new high this morning 118.40, and CLU7 is up just slightly after yesterday’s outside day and close -1.01 at 49.16. AAPL’s results have given a boost to Nasdaq, but ESU only modestly higher.
–ADP today expected 173k.
