June 21. Not ALL yields are low…

June 20. Mixed messages from Central Banks and markets

–Here’s a headline from NY Fed’s Dudley yesterday: ‘We haven’t tightened financial conditions very much.”  In a speech a few months ago, Dudley mentioned a few items that indicated tighter financial conditions – short rates, long rates, the dollar, equity values, and corporate spreads.  I have attached a few charts below that highlight some of these conditions.  We all know that the Fed began raising FF in December 2015.  At that time the 10y yield was around 2.29%, it ended yesterday at 2.19.  Easier.  In December 2015 the Dollar Index was 9836, and now it’s lower at 9753.  Easier (helps exports).  And of course SPX was at 2075 and is now 15% higher at 2450.  Easier.  So easy in fact, that the Nasdaq index had traded over 15% above its 200 day moving average, which seems to be an area from which corrections occur.  I would also mention that crude oil closed on new contract lows ytd, down 14% from the start of the year.  Not exactly supportive of the reflation theme.

–In any case, it’s pretty clear that the market and the Fed aren’t on the same page.  There are a few interesting notes from the Fed Fund futures.  For example, Jan’18 to Jan’19 as a spread settled at exactly 1/4%, so that’s the market projection of tightening over 2018 – ONE hike.  The two prices are 98.73 and 98.48.  From last week’s Fed projections, the expected end of 2017 FF rate is 1.4%, and the expected end rate for 2018 is 2.1%, or a difference of 70 bps.  SOMEBODY’S going to have to make up that discrepancy.  But wait (as they say on the TV ads on the channel I watch) THERE’S MORE!  The contracts FFQ18 and FFU18 settled at the exact same price of 9860.5.  The spread market is -0.5/0.0.  Inversion in interest rates??  This particular spread was stable around +5.0 for the first three months of the year.  But when the Fed released its calendar for 2018, the September meeting was later in the month than expected, on 9/26/18 rather than 9/20/17.  The extra week makes a big difference if one is betting on a hiking schedule.  But STILL…. ZERO offer??  This small example of inversion is likely meaningless, but China’s inversion from 1 year rates to 10 year rates is a bit more ominous for growth in Asia.

–A couple of other quick notes: 5/30 traded sub 100 bps but ended right at that level.  Technically weak, but greens/golds actually edged up 0.25 to 0.5 bp.

–Fischer early this morning talked about financial instability and efforts to prevent it, while BoE’s Carney said now is not the time to raise rates.  Fed’s Rosengren and Kaplan on tap today at 8:15 and 3:00.

June 19. Dudley today…got some splaining to do…

–On Friday, the peak one-year eurodollar calendar spread settled at a new low for the calendar year of just 28.5 bps (Dec’17/Dec’18).  As a point of reference, the peak one-year had gotten to 60-65 bps in December after the election surge.  Pre-election the one-year spreads were more like 15-18 bps.  Pre-election SPX was around 2150 to 2200, and is now around 250 higher.

–Dudley speaks today at 8:00, as most market measures of forward inflation continue to fall.  Ten year treasury to tip spread ended the week at 168.5, about 30 bps below the start of the year.  The June ED contract expires today; using Sept contracts for the new packs, I marked reds/golds (starting EDU8 and EDU21) at just 55.5 bps.  Now using October FF as an indicator for tightening odds at the September meeting; FFV7 settled 9880.5 or around 16%.  If the Fed chose to ignore weakening inflation signals as transitory and is now focused instead on trying to stem the rise of equity prices, it’s not working.

–EDM’20 will become the last green contract tomorrow. It settled at 98.00 and the 98.00 straddle (long-dated) settled at 87 bps.  It had been the case in recent history that the last green comes onto the board with a straddle price of 105-110 bps.  Like everything else at this point, the last long green straddle is forecasting a summer of little movement on the rate front.

June 18. Getting Snowed in June

Back in the 1990’s there used to be a pretty good market in snow futures on the CME floor.  This wasn’t a CME sanctioned product, it was a bunch of guys that would trade the amount of snowfall at O’Hare in a given month, $1 an inch per contract.  So, if you bought 5 inches and as of Dec 31 it snowed 7.5 inches, you collected $2.50 per contract.  Of course, if you paid 5 and someone comes along and bids 8, you can sell, and just like any other futures contract, you’re out.  The key difference: everyone settles up at the end of the month.  So you’re not really ‘out’.  Back in 1996 or 1997, this market sustained a lethal snag.  One clerk was long something like 1000 futures for December from 10 inches, and it only snowed 1.2 inches for the entire month.  He didn’t pay.  There had been an entire edifice of trading that had gone on, back and forth deals marked on trading cards and the big debit failed.  So if I sold 10’s to the doofus, and bought 8’s from someone else, do I pay the guy that’s long the 8’s?  That was the end of THAT market.

It’s a pretty simple little story, repeated endlessly in business dealings, but it concentrates focus on two things: credit risk and ‘arbitrage’ across products.  With the explosion of etf’s and other vehicles, some market makers might consider themselves to be more or less ‘flat’ or ‘out’ in terms of risk, having sold in one product and bought something very similar as an offset, but it doesn’t always work out that way.

There’s just a huge amount of material with market ramifications that can be considered given the current environment.  For example, I believe China is quite important, and both the BoE and Bank of Canada jolted longs in short end markets, with June’18 Short Sterling down around 20bp from the previous week and June’18 BAs down 10 bps from Wednesday’s high.  However, I will just mention three things: First, the Fed’s Balance Sheet Reduction plan as compared to the taper tantrum.  Second, the lack of risk premia.  Third, Illinois.

Was Wednesday’s FOMC hike a mistake given low and declining inflation levels?   In and of itself, perhaps not.  However, the curve remains quite flat.  It’s pretty clear that the markets don’t currently believe there’s a need to continue hiking. Note that the Fed ITSELF trimmed the Core PCE Price projection from 1.9% in March to 1.7% now.  It’s an admission of failure on reaching inflation targets. The ten year note yield actually fell 4 bps on the week, to end just over 2.15%.  The peak one-year eurodollar calendar spread, a rough proxy for expected tightening over a given year, settled at a new recent low of just 28.5 bps, barely above ¼ pct and well off peak highs in the post-election euphoria when the one-year peak spread was nearly 70 bps.  So let’s talk about the other part, the blueprint for balance sheet reduction that was also attached to Wednesday’s FOMC.  The basic thing to keep in mind is this:  episodes of QE have generally resulted in HIGHER bond yields and HIGHER equity prices.  As a rule, one would say, “Central Bank buying bonds, then yields go down.”  But look at the chart below, it’s the opposite.  I have shown the onset of QE programs with the green vertical lines, and the end with red lines.  The amber line is the ten year treasury yield (left scale) and the white line is the SPX.  Yields and stocks generally rise on QE in the US; stocks tend to falter at the end of QE.  So think of it this way: QE programs are designed to support STOCKS.

The interesting move is in 2013, when the yield surged from around 1.75% in May when Bernanke suggested the idea of tapering bond purchases, to 3% by the end of the year.  The Taper Tantrum.  In this case, the central bank’s hint of withdrawal had an immediate and dramatic effect on bond yields.  Why isn’t the proposed tapering of reinvestment having the same outcome currently?  Well in late 2011, Operation Twist was started.  [link to Calculated Risk at bottom shows timeline of QE programs].  QE3 was announced a year later in 2012 at $40 billion a month and expanded to $85 billion a month in December!  Stocks were continuing to advance and the idea of losing $85 billion a month threw the market into a tailspin.  The actual tapering program began in Dec 2013 and ended in October 2014; over the period of actual tapering the yield went from 3% to around 2.5%.  In the current plan of balance sheet reduction, the non-reinvested amounts are $10 billion per month (between Treasuries and MBS), and will expand by $10 billion every 3 months until they cap at $50 billion per month.  I personally doubt we ever get to the $50 billion even though it’s supposed to get up to that rate in 1 ¼ years.  By that time we’ll have a new Fed Chairman.  The point is, even $50 billion a month isn’t stupendously large by today’s standards.  All it will take is a whiff of equity market weakness and the schedule will be altered.

The larger point is, a reduction in balance sheet is, perhaps, more consistent with a DECLINE in bond yields and in stocks and in other risk assets.

The next topic concerns implied vol and corporate spreads.  Vol’s low.  I know it, you know it, the UBER drivers know it.  Corporate spreads are also tight.  [Chart below].  For example the BBB spread to treasuries below is 145 bps.  The low was 125 in 2014, and in the beginning of 2016 when oil market angst was on full display, the spread got to a little over 200.  The point I’ll repeat is that there is no cushion for safety.  Corporate debt levels are at a record of GDP and stocks are at all time highs.

Of course, with all of today’s technological prowess, why should we price risk?  Distribution networks across both markets and across the world for goods and services are extraordinarily efficient.  That’s the outcome of operations like UBER and AMZN.  However, the promise of extracting returns from UBER is getting dicier, with continued capital burn as the management structure implodes.  Actual income to drivers has been squeezed through competition.  And AMZN’s purchase of Whole Foods is another example of relentless pressure on margins.  Everything is great, but in aggregate the debt still has to be serviced; there’s more of it, and margins are scarce.

Which brings me to the final topic: Illinois.  Illinois has GDP (or Gross State Product) of about $800 billion.  That’s the fifth largest, about 1/3 of California at $2700B, and half of NY and Texas, $1535B and $1640B and just under Florida at $960B.  It’s about to be downgraded to junk.  Here’s a quote from the state’s comptroller, Susana Mendoza (from the AP)  “I don’t know what part of ‘We are in massive crisis mode’ the General Assembly and the governor don’t understand. This is not a false alarm,” said Mendoza, a Chicago Democrat. “The magic tricks run out after a while, and that’s where we’re at.”

(AP) “Now Comptroller Susana Mendoza is warning that new court orders in lawsuits filed by state suppliers that are owed money mean her office is required to pay out more than Illinois receives in revenue each month. That means there would be no money left for so-called “discretionary” spending — a category that in Illinois includes school buses, domestic violence shelters and some ambulance services.”

Illinois has sent a letter to contractors warning that it may not be able to pay road construction bills, and the multi-state Powerball and Mega Millions lottery have said they may have to drop Illinois.  Some people are scratching their heads wondering how there can be social instability when unemployment is so low and growth is steady if not spectacular.  This is how.  Rising taxes, less service, less opportunity.

Illinois is yet another can that’s been kicked down the (pot-holed) road for a long time.  But it may end up being the catalyst that focuses the markets in general on credit risk and on excessive debt levels.  That’s right.  It may not be China.  It may not be a big corporate deal that goes bad.  It might not have to do with the circus of geopolitics.  It might not be the debt ceiling negotiations.  It might just be Illinois, the guy that couldn’t pay his snow debt.

The early part of the week is quiet, dominated by a few Fed speakers.  Dudley on Monday at the Business Roundtable 8:00am.  Evans in the evening (inflation’s too low).  Fischer at 3:15am on Tuesday.  Kaplan at 3:00 pm.  The Fed will release Dodd-Frank stress test results Thursday, June 22 at 4:30.

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http://www.calculatedriskblog.com/2014/10/qe-timeline-update.html

http://www.usgovernmentspending.com/gdp_by_state

A couple of notes on 5/30 treasury spread…

5/30 at 102 this morning (long term chart above), though other curve measures not flattening as much.  Long term 0.618 retrace form 2006 low of -11.5 to 2010 high is 304 is 109. (this period was an easing period). There have been many lows around 100-105 since 2008. I expected a ‘dovish’ hike Wednesday, but it turned out to be hawkish, thus pressuring the curve. Note that late 2006 (after the hiking cycle had ended) is when the 5/30 spread started to rally.

Below is 5/30 from the LAST hiking cycle….June 2004 to August 2006.  The rate went from 1.0% to 5.25% with hikes at every meeting (as opposed to once a year or so…).  The spread went negative in 2006, and US banks were bailed out in 2008…..  Of course, the current Fed effective post the hike this week is only 116.  So the last hike cycle STARTED where we are now. 

June 14. ‘Enhanced Leverage’ and the FOMC. Is there a connection?

–Dow, SP 500 and Russell all made new highs yesterday.  At the same time, Bill Gross is warning risks are highest since the 2008 crisis, while JPM’s Marko Kolanovic warns that losses on short vol strategies could be catastrophic, and Jeff Gundlach echoes the same themes. (But euro$ straddles were in another 0.5 bp and TYQ atm trades just 4.0%)

–From Wikipedia: “On June 22, 2007, Bear Stearns pledged a collateralized loan of up to $3.2 billion to “bail out” one of its [mortgage] funds, the Bear Stearns High-Grade Structured Credit Fund, while negotiating with other banks to loan money against collateral to another fund, the Bear Stearns High-Grade Structured Credit Enhanced Leveraged Fund. Bear Stearns had originally put up just $25 million…”.  Just the NAME of that last one makes you wonder how any capital was ever committed by investors.  It SOUNDS fake.  “Enhanced Leveraged”?  Does that sound like it goes with “High-Grade”?  Anyway, I remember reading that story in the WSJ 10 years ago while riding the train into work.  And I thought to myself, this is a BIG problem; the two funds had essentially lost everything.  I thought stocks would crater.  However, after a brief lull, stocks made new highs in October 2007.   We all know what happened next.

–There have been plenty of bearish catalysts, but the sign of a bull market is that it shakes off bearish news.  However, crude oil doesn’t appear to be shaking off the latest inventory build with CLN at $46.00, -0.46.

–Yesterday the US treasury curve again edged to a slight new low, with 2/10 just under 85, 5/30 just under 109.  Red/gold euro$ pack spread eased by 0.25 to 58.375 (not a new low).  Inflation signals continue to grind down, with ten year treasury to tip spread at a new low of 177.5.  It is, of course, FOMC day.  Jan 2018 FF settled unchanged at 9872, which indicates market odds of about 50/50 for another hike by year end; I’ll take the ‘under’.  As an aside, China’s curve inversion is getting more play in news sources; in previous years China was known for ‘exporting deflation’ now it might be ‘exporting declining growth’

–Other news includes CPI expected 0.0 with Core +0.2 (yesterday Core PPI was +0.3).  Retail Sales are also expected 0.0; ex-auto and gas expected +0.3.

–June midcurve options expire Friday, with 2EM 9812.5^ settling 7.0 exactly at strike.  By comparison, 3wk (Friday) FV 118.25^ settled 21/64’s vs 118-07, about 6.5 bps.

June 13. Your conclusions are highly questionable

–Yields edged slightly higher Monday and the curve flattened as 3 year and 10 year auctions went well, with huge indirects (foreign central bank) demand for 3’s.  While the red/gold pack spread didn’t make a new low, 2/10 slipped to a slight now low of 85.8, as did 5/30 at 109, as did the ten year note to TIP spread at just 177.6..  Not too surprising given supply.

–There was a fairly large trade, Buyer of EDZ18 9812/9800/9787/9775 put condor on a ratio of 5x8x2x5 for a credit of 9.5 bps.  (prices 18.0/13.5/9.5/5.5).  This trade was a roll up of a previous butterfly; it appears to now essentially be 9812/9800p 1×2.  So, this trade makes max profit at expiry — just a short 1.5 years away — if we settle right at 9800.

–So…I wasn’t going to talk about the stupid Fed dots but this trade sort of leads down that path.  Wait…did I say “stupid”?  Yes, ok…well that’s what I meant.  As of the last quarterly meeting in March, the Fed was projecting 2017 growth of 2.1 with Core PCE Prices of 1.9 and Fed Funds at 1.4.  Let’s take these in turn.  Q1 GDP was 1.2% according to the second estimate.  Though Fed officials think the Q1 softness was transitory, Q2 doesn’t exactly seem to be going gangbusters.  However, Atlanta Fed is estimating 3.0 for Q2 (but estimates are being revised down with new bits of data).  So, Maybe 2.1 for the year is plausible, but I doubt it.  Core PCE prices aren’t quite getting there…both Brainard and Bullard have voiced concerns that inflation is sluggish.  So then we have FF at 1.4 vs current .91 with an expected hike Wednesday which will take the Fed effective to 1.16.  In FF, that equates to FFN7 at 9884 or 9884.5 given month end discount. Now note that January FF are 9872, or just 12 bps higher in yield than July’s expected value, so we can figure the market’s at about 50/50 for the Fed hitting the FF target.  It seems pretty clear to me that there’s a risk all three variables could be trimmed at this meeting.  They sure as heck aren’t going higher.  So then we get to the 2018 year end projection for FF of 2.1, meaning ANOTHER 3 hikes.  Given current lois, that would mean EDZ8 would be around 2.25% or 97.75.  Obviously that’s a lower price than the condor (or the 9812/9800p 1×2) target.

–The market doesn’t and hasn’t believed the Fed’s longer term projections for a long time.  Why?  Because they’re sloppy.  It’s like the scene in Ghostbusters where Dean Yager says to Professor Venkman (Bill Murray), “Your theories are the worst kind of popular tripe, your methods are sloppy, and your conclusions are highly questionable! You are a poor scientist, Dr. Venkman!”  …”Yeah, but the kids love us.”

–One last item of note, ZH has another article about Illinois sprinting toward its downgrade to junk, including an interesting chart, which shows that IL GO Bonds (5.0%
of 2035) have seen their spread vs treasuries increase from 190 bps to 290 JUST THIS MONTH.  Remember when we were worried about Greece?  Illinois GDP is $791 billion.  That’s almost 4 Greeces.  Maybe IL can just securitize the $14 billion of unpaid bills, and the Fed can buy it and tuck it away in an inconspicuous corner of the balance sheet….

https://www.youtube.com/watch?v=RYBcZrJXfOQ

Ghostbusters – “Venkman Admisters Electric Shock” – (HD) – Scenes from the 80s – (1984) www.youtube.com Daily uploads with thousands of clips on the way. SUBSCRIBE for a taste of the past! CLIP SUMMARY: Dr. Venkman administers electric shock to a subject in a m…

June 11. Throwing a Curve

There is plenty of commentary this week on the Nasdaq plunge that occurred Friday, so one doesn’t have to be a keen market observer to have noticed it.  I will just briefly mention a couple of things.  First, the trend in Nasdaq has been powerful since the election, and really even before that, since Feb of 2016.  Since the low in November, Nasdaq has gained 25%.  Friday can simply be considered an unwind of the ‘long momentum and short the underperformers’ trade.  Doug Noland points out that ‘long tech vs short financials’ had been a big winner until Friday.*  Actually, if you had surfed the Nasdaq wave and just decided to take the 25% gain off the table and park cash in short treasuries for the rest of 2017, who could possibly blame you, especially in a world where many hedge funds have posted disappointing results.

I’m not going to pretend to know exactly what sparked the tech reversal, but do you know what else has been in a strong trend [down] since the beginning of the year?  That’s right Bob, c’mon down and claim your prize…it’s the US yield curve.  Sometimes trends just fizzle out.  However, this week is also the FOMC meeting.  I think there are only 4 more after this with Janet Yellen as Fed Chair.  In terms of a possible catalyst, this is certainly a possibility in terms of the curve.  My opinion is that the curve will steepen (reverse trend) after the Fed hikes Wednesday.  Here are reasons:

First, the economy is likely slowing, and financial fissures are getting wider.  Second, several Fed officials have already said that the trajectory of hikes could be more shallow due to missed inflation targets.  Third, Harker and others have said they don’t want to upset the apple cart with respect to balance sheet adjustments, but that line of reasoning also means the Fed is wary of tightening FF too much too quickly.  Fourth, this week’s release of the quarterly Z.1 report showed that Household Net Worth increased to a record $94.8T.  Household Financial Assets (primarily stocks) rose 8% over last year.  Yet, the consumer appears stretched and retailers besides Amazon are getting crushed.  The Fed believes in the wealth effect, and is afraid to remove support for financial assets lest the consumer becomes even more cautious.  Fifth, most measures of the curve are on the absolute lows, and should have some technical support around these levels.  For example, 5/30 has a very strong support area of 100-105, and is now around 109.

I should note that trading decisions made on the back of perceived broad economic trends is rather difficult.  I make trade suggestions below to play for a reversal in the flattening trend, but mainly through the use of options to limit risk.

With regard to point number one above, troubles with auto loans have been pretty well documented in terms of increased subprime delinquencies and falling used car prices.  However, total state and local tax collections have also been quite disappointing.  Quoting from the May report from the Rockefeller Center (linked below) “State taxes grew only 1.2% in fiscal year 2016 and actually declined slightly after adjusting for inflation —the weakest performance since 2010…”  Consumer Credit for April released last week shows annual growth of only 2.6% (vs 5.0 for Q1 2017, 6.5 for Q4 2016, 6.5 for Q3 and 6.1 for both Q1 and Q2 2016).  Credit card delinquencies are inching up.

A note from MUFG rate strategist John Hermann said after an expected hike at this week’s meeting, there will “…likely [be] another hike at the Sept 19-20 meeting.”  The note goes on to say “…our models forecast a flatter curve going forward.”

If the Fed DOES signal another hike in September, then the curve will flatten further…I don’t need a model to tell me that (though it sounds impressive).  However, if recent economic trends persist, and especially if Friday’s tech stock reversal is a sign of more to come, then there is no way the Fed will hike again.  Hence, bull steepener.

I couldn’t find the exact quote, but a friend of mine mentioned an interview (I believe with Doug Cifu of Virtu) who said the “volatility ripple” from a given event used to last for weeks, and now lasts for only a few hours.  In searching for that particular interview, I stumbled upon another from last year, where Cifu said that given the explosion of product offerings, investors can choose among a variety of futures,stocks, etfs, etc, to express a view.  Given the electronic network, a company like Virtu “…distributes the volatility more efficiently.”  Of course, when there is very little vol to distribute, even the ripples become smaller…as mentioned a couple of weeks ago by JPM’s CFO Marianne Lake, “There haven’t been that many idiosyncratic events, and we need a few more of them.”  Well, perhaps we’re close to the ‘Be Careful What You Wish For’ moment…

THIS WEEK: Besides the Fed, we have auctions of 3 and 10 year notes on Monday, and 30 yr on Tuesday.  PPI on Tuesday.  CPI and Retail Sales Wednesday.  Philly Fed and Industrial Production on Thursday.

Other FED DATES to be aware of: Dodd-Frank stress tests Thursday, June 22 at 4:30 NY time.  Fed stress test Comprehensive Capital Analysis and Review (CCAR) released Wednesday, June 28, also at 4:30.

https://www.federalreserve.gov/newsevents/pressreleases/bcreg20170601a.htm

Also, from TD Securities: Congress must pass a funding bill before Sept 30 in order to avoid a gov’t shutdown.  The debt ceiling will need to be raised before October/November.  “…Speaker Ryan recently indicated that the House is unlikely to consider the debt limit during the summer, confirming our [TD] expectation that the showdown on the debt ceiling may only come after the August recess. This creates a potential risk for derailing tax reform.”

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http://www.safehaven.com/article/44494/crowded-longs-shorts-and-a-new-z1

http://www.rockinst.org/pdf/government_finance/2017-05-08-By-numbers-brief-no9.pdf

June 8. Political risk eases but economic growth concerns linger

–Political risk in US equities appears to have lifted as Comey’s remarks were released.  However, crude oil plunged over $2/bbl yesterday to its lowest settlement price of the year.  At the end of 2015/beginning of 2016 it was the oil market that threw high-yield into turmoil, however, few signs of trepidation are evident from hi-yield etf’s (just slightly lower yesterday).  In 2007, China’s Li Keqiang, said he preferred to look at just three measures to get an underlying sense of the Chinese economy as most data was sketchy.  Those items were electricity production, rail car loadings, and bank loans, and became known as the Li Index.  Although oil was reacting to a build in inventory, I would say that its price reveals something about the US and global economy (like electricity production).  Yesterday, Consumer Credit was released for April and showed an annual growth rate of just 2.6%, with non-revolving at 2.8%.  This data is somewhat analogous to bank loans, and indeed C&I loans at US banks have also slowed considerably.  In terms of rail car loadings, I don’t have data handy, though I would note that Federal Express made a new all-time high yesterday, at odds with other indicators.

–ECB and the UK election also on tap, with the ECB expected to nudge growth estimates higher but trim forward inflation expectations.  Hence, no policy change.  In terms of Fed policy, July Fed Funds are essentially fully pricing a hike next week.  EDM7/EDZ7 settled just under 16 bps and FFN7/FFF8 at 13.5 bps, so it appears as if the market considers another hike by the end of the year (after June) at just better than 50/50.  Beyond that, the curve remains quite flat, though peak one-year ED calendars managed once again to poke above 30 bps.  EDZ7/EDZ8 +1.5 to 31.0.

June 4. Collateral Damage

From 1999 until 2005 I worked at Refco, a global futures firm.  For me, it was a great place to be.  While notorious for its freewheeling style in the early days  -for example, when Hillary Clinton, completely of her own accord, decided to trade cattle futures through the firm- when I was there it was becoming more corporate.  There were long term, knowledgeable professionals throughout the firm in every department, however, there were also legendary stories of  -ahem- less than professional behavior that are much more amusing to relate.  But I am not going to tell those stories today, I am just going to touch upon the meteoric crash shortly after the IPO.

Refco went public in August of 2005.  It was a successful IPO.  By October 2005, the company was bankrupt.  The reason for the bankruptcy was an undisclosed debt that was being transferred around internal entities like a hot potato.  From Wikipedia [link below]:

Apparently, [CEO, Phil] Bennett had been buying bad debts from Refco in order to prevent the company from needing to write them off, and was paying for the bad loans with money borrowed by Refco itself.

…anonymous sources cited by the WSJ and other publications have stated that the debt stemmed from losses in as many as 10 customer trading accounts, including that of Ross Capital, and the widely reported October 27, 1997, trading losses of hedge fund manager Victor Niederhoffer.

Now I don’t want to go into detailed fact checking regarding this event, though I think I saw that the amount of the ‘bad asset’ in question was about $430 million.  Now considered an almost “quaint” sum of money.  What I’d like to consider are aspects of this episode that relate to our current environment.

Take a look at a chart of SP500 in the late 1990’s. From 1995 to 2000 SPX went from 500 to 1500. On a long term chart it’s sort of difficult to even see the blip related to October 27, 1997.  It was the year of the Asian crisis, twenty years ago.  From one article: “The tipping point was the realization by Thailand’s investors that its property market was unsustainable, which was confirmed by Somprasong Land’s default and Finance One’s bankruptcy in early 1997.” There were runs on the Thai Baht, Malaysian Ringgit, etc.  And on October 27, the DJIA fell 7.18%.

So, according to the Wikipedia story, the hole in Refco’s books was a direct result of that day.  However, it took EIGHT years for this bad debt to sink Refco.  Good things and bad things can all be happening at the same time, but it usually comes down to collateral, to asset values.  The timing of the last straw regarding overvaluation and the subsequent realization that asset values didn’t provide the same level of cushion in terms of collateral that was modelled at the outset is extraordinarily hard to anticipate.

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It should be noted that the Fed will release stress test results related to Dodd-Frank on June 22^nd, and will follow that with its own stress test results for the banking sector on June 28^th.  The outcome of these reports will almost certainly reveal rather minor (if any) concerns.  Even Kashkari has been muted recently.  The Fed has mostly been a cheerleader for stocks, with Harker last week doing his utmost to assure the market that nothing bad will come from balance sheet reduction: “…it will be slow, steady, incredibly boring, and essentially on autopilot.”

So with regard to asset values, here are a few back of the cocktail napkin calculations, and snippets from news stories [linked at the bottom].  First, total market cap of the ‘five horsemen’ Alphabet, Apple, Amazon, Facebook and Microsoft, is about $3T, “…not far from the market value of all the other components of the Nasdaq 100.”  These five have added $612 billion in value to the stock market this year. (Reuters).  Now, total stock market cap to GDP is about 133%.  So if GDP is $19T, then total cap is about $25T.  Subtract out the five mentioned above and it leaves $22T.  The same Reuters article notes that “investors are currently paying $18.50 for every $1 in earnings expected over the next twelve months in the [tech] sector….compared to $20-plus seen during the most recent market peak in 2007.”  So, that’s about 5.4% (1/18.50).  Probably not that bad in comparison to ten year treasuries yielding 2.16%.  Now here’s where the math gets a little fuzzy (on the third napkin).  The St Louis Fed has a chart showing that Total Credit to Non-Financial Sector is at [a record] 255.7% of GDP (includes household, business and govt).   From the Z.1 Fed report, total business debt is $13.47T.  Obviously, there are many private businesses that are not a part of stock mkt cap.  But when one looks at growth in GDP of, let’s optimistically say 2%, that’s growth of about $380 billion.  Now let’s call the interest rate on the business debt 3.5% (BBB corp sprd is 1.51).  So the interest cost is $471B. Excluding the 5 big guys, market cap is $22T…just a bit bigger than GDP.  Probably hard (or maybe even mathematically impossible) to see growth in all companies better than GDP.  At best, running in place, and at worst, not keeping pace.  ZeroHedge ran a great article highlighting SocGen research from Andrew Lapthorne.  http://www.zerohedge.com/news/2017-06-01/one-banks-surprising-discovery-debt-party-finally-over

Lapthorne calculates that S&P1500 ex financial net debt has risen by almost $2 trillion in five years, a 150% increase, but this mild in comparison to the tripling of the debt pile in the Russell 2000 in six years. He also notes, as shown previously, that as a result of this debt surge, interest payments cost the smallest 50% of stocks in the US fully 30% of their EBIT compared with just 10% of profits for the largest 10% and states that “clearly the sensitivity to higher interest rates is then going to be with this smallest 50%, while the dominance and financial strength of the largest 10% disguises this problem in the aggregate index measures.”

So we see that large cap tech outperforms, because smaller companies are saddled with debt that is chewing into the bottom line, even at these very low rates.  But with total GDP growing slowly, it’s hard to make up ground.  And then we have pension funds penciling in 7% returns.  Is it any wonder the Fed is so preoccupied with ramping up inflation?

OK, what else is going on?  Two weeks ago, China and Brazil were downgraded.  Last week Illinois was cut to within a notch of junk. There are constant articles about bad debts in China.  In the US, bank warnings started last week with JPM CFO Marianne Lake indicating trading revenue was down about 15% in Q2, echoed by other major banks. https://www.bloomberg.com/news/articles/2017-05-31/jpmorgan-bofa-trading-revenue-on-pace-to-drop-at-least-10   The growth rate of C&I loans has plunged from 12% in 2015 to 2.6% now.

So (of course) stock indices in the US continue to reach new highs.  This, against a backdrop of a yield curve that reflects anything but robust growth and inflation.  Crude oil is near the year’s low and down over 15% from the start of the year.   With Friday’s weaker than expected employment data many curve measures hit new lows.  The 2/10 treasury spread ended the week at 87 bps.  All ED one-year calendar spreads made new lows.  The peak is still EDZ7/EDZ8, now at only 29 bps, down 5.5 bps on the week.    Red/gold euro$ pack spread closed at 56.5bps, down 8 on the week and barely above ½% for the three years between 2018 and 2021.  The dollar index made a new low.  All of these are at pre-Trump levels.

And that’s the tie-in between Refco, asset values, and collateral underlying loans.  It’s the hope that Trump would be able to hide or overcome the bad stuff.  And the bad stuff is record debt which is stifling growth.  All the markets besides stocks appear to have shed that hope.

Economic data this week pretty sparse.  However, Comey testimony is scheduled for Thursday and the House is slated to vote on the repeal of Dodd-Frank, also on Thursday.

• 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.