Trump reversal
Some things are back to pre-election levels: 2/10 treasury spread and USD index. But not stocks….yet
May 16. It’s Lost on Me
–As a result of the Washington Post investigation, Trump has finally discovered the source of White House leaks. (From WaPo: “President Trump revealed highly classified information to the Russian foreign minister and ambassador in a White House meeting last week, according to current and former U.S. officials, who said Trump’s disclosures jeopardized a critical source of intelligence on the Islamic State.”). They’re saying that’s why the euro is making a new high for the year. OK. I’m not quite sure I know why anything is moving the way it is at this point. What I do know is that another tick was removed from most euro$ midcurve straddles yesterday. If implied volatility is like cartilage in the system, then we’re dangerously close to bone on bone at present. It feels ok if you’re sitting down, but if you have to get up and move around, it hurts.
–$57 million for a bronze head. By that metric, not too much looks overvalued. “La muse Endormie counts among the most important achievements in the dawn of a new sculptural language. It is an intense purification of form and emotional resonance.” Still. $57 million? It looks a bit more impressive in yen as shown on this site http://www.artlyst.com/news/constantin-brancusi-head-smashes-artists-auction-record-christies/ ¥5,779,870,800. I once had a lighter that looked a little bit like that. Press the nose and the flame shot out of the head. So…smoke ’em if you’ve got ’em cause it’s going down…
–Continued heavy buying in EDM7 calls. For example, EDM7/EDU7 9875 call calendar 0 paid to buy June 25k. While everything suggests that the ED curve should maintain a positive slope, further flattening could cause some (unanticipated) problems. I don’t think it’s likely, but I will note that market measures of future inflation seem to be edging lower. For example, the spread between the ten year treasury and tip posted a marginal new low of 184.6. Around the time of Trump’s election it was 170, but neared 210 in late January, and has since edged lower.
May 15. Oil upon deal, but treasuries maintain bid
–Solid rally in fixed income Friday with tens down 7 bps tp 233.1. The euro$ curve was slightly steeper from greens back; the green pack (3rd year) was the leader, closing +8.875. Red/gold pack spread edged to a new recent high just under 71 bps.
–July Fed funds closed 9892.0, +2.5 on the day, taking the odds of a June FOMC hike to around 75%.
–Peak one-year ED spread is back to being EDZ7/EDZ8 at 38 bps. The Fed’s projections for rate hikes (the dots, last released at the March FOMC) indicate 70 bps between the end of 2017 and 2018; the market is around half that.
–Large buyer Friday of 0EM 9837.5 calls for 7.5 as the strike went in the money (9939.5). Open interest fell by 19k contracts. Shorts covering, apparent across the curve Friday.
–The Atlanta Fed GDP Now forecast is currently 3.6% for Q2. Blue Chip consensus is 3.1. I give it until the end of May for Atlanta to submerge below 3%.
–The story this morning is oil, which as of this writing is up $1.20 on a deal extending production cuts. It’s getting back to around the halfway point of the large sell off from mid-April to early May, at which point it will likely stall again due to lack of global demand/growth. Copper is also rebounding, but much more modestly. What has seen an extremely strong rally is cotton, going from just over 76 to 82 in the past two sessions (around 7.5%). And what comprises about 75% of US currency? That’s right: Cotton. Coincidence? I don’t think so. Probably have to print up a bunch of bills to pay off the ransonware.
May 14. The Litmus Configuration
It was back in 2003 that Jonathan Mardukas (then at Lehman) first postulated his Litmus Configuration Theory. Recall, this was after the dotcom bubble had burst and followed 9/11. The theory states that too much Central Bank interference can result in markets that exhibit extremely low volatility. He named it after the Litmus test because markets would not go down (litmus paper turns red, or acidic) and also failed to rally (blue, base). His work is often misattributed to Alonzo Mosely, whose pioneering work on money supply showed that excess reserves can often take on the same characteristics of counterfeit bills when ‘currency in circulation’ is the Primary medium of exchange. (1)
We all like a good story as an explanation of why markets behave as they do. I was struck this week by just how many ‘big thinkers’ (no, Donald isn’t in this particular group) have weighed in on the topic of low vol. On Google Trends, when I typed in VIX, I thought the results might show a huge jump, given all the talk about near historic lows in the index. The chart did show that interest in the search was near a recent high, but the results weren’t dramatic. “Volatility Index” showed a similar result. It’s at a new high for the year, but below last September.
So who are the big thinkers? First, Ray Dalio, in a new post on Linked In, tacitly embraces the Bullard ‘steady state’ thesis: “The major economies right now are in the middle of their short term debt cycles and growth rates are about average. …As a result, volatility is low now, as it typically is during such times. Regarding this cycle, we don’t see any classic storm clouds on the horizon.” However, he goes on to cite longer term issues in the form of debt and non-debt obligations like pensions and entitlements, and concludes: “So we fear that whatever the magnitude of the downturn that eventually comes, whenever it eventually comes, it will likely produce much greater social and political conflict than currently exists.”
https://www.linkedin.com/pulse/big-picture-ray-dalio
Ben Hunt of Epsilon Theory frames the issue in this way: “…the one Big Question: as the Western status quo political system collapses into Something Else, how is it possible that our capital markets are not similarly gripped by volatility and stress? What is responsible for breaking the transmission mechanism from political risk to market risk?”
While I love Ben Hunt’s writing, he summarizes the situation (in his first ‘macro’ section) as others have previously. “In the absence of an active and effective fiscal policy authority, global monetary authorities will fill the policy void.” [Leading to] Low growth. Financial asset inflation and Low Volatility.
He concludes: “That’s my macro story for the divorce of political risk from market risk, and I’m sticking to it. Where does it break down? Not with a funky German or Italian election, but with Janet and Mario declaring victory and taking away the punchbowl. That’s what will bring political risk back to markets.”
http://www.epsilontheory.com/notes/westworld/
Doug Noland of the Credit Bubble Bulletin summarizes: “There’s a major Reflexivity component at work. Cheap market “insurance” spurs risk-taking. Why not push the envelope with risk and employ added leverage, confident that inexpensive protection is readily available? This ensures that loose financial conditions spur Credit expansion, asset inflation, spending, corporate profits, rising incomes and government receipts/spending. Perceived wealth inflates tremendously, if not equitably. Rising price levels throughout the economy support the view that the future is bright, encouraging reinforcing flows into financial assets – further depressing the price of market “insurance.” Moreover, a prolonged period of low market yields boosts the relative return appeal of myriad variations of writing market protection (selling flood insurance during a drought).” [Hey, this guy ought to be on the Fed board].
http://www.safehaven.com/article/44360/the-vix-and-the-scheme
Lloyd Blankfein put it this way (in contrast to Ray Dalio). “I don’t know what brings us out of the doldrums, but I do know this is not a normal resting state.” He further mentioned we might be in a “bubble of confidence.”
And so we have this phenomenon of low volatility across markets. We have people scratching their heads over it. How does the central bank view it? Well, I am not going to claim that Philadelphia Fed President Harker speaks for the Fed, and he certainly contradicted a couple of other Fed officials who have suggested putting balance sheet reduction on auto-pilot, but here’s a quote from Harker that sort of crystallizes the Fed’s paralysis regarding market reaction (from Reuters):
“We can slow the pace of that or accelerate the pace of that depending on how the market reacts,”
“We just have to be cautious and very clear in our communication,” [Harker] added. If “we are willing to adjust if things change, we can minimize disruption to the markets, and that’s exactly the plan.”
Facepalm.
Look, as a situation unfolds, people in general CREATE a narrative as an explanatory tool. Often, these narratives violate causation versus correlation and tilt dangerously close to the edge of superstition, while falsely citing fantasy academic studies. The latest narrative concerns indexing and passive investing. I sure as heck am not going to dismiss it, but I think it’s more of a symptom than a cause.
The argument goes this way: In a world of a sub 2.5% ten year note, and spotty hedge fund and other ‘active investor’ strategies, it doesn’t make any sense to pay high management fees. No one can time the market so it’s much better to just find a low fee index fund. This investing style dampens volatility.
Hey, it’s a reasonable story. In the same way that UBER is a reasonable story. Don’t pay the high taxi fare that comes with the medallion and insurance. Use GPS and private drivers. It’s actually a GREAT idea. Now I don’t drive that much, but I was stuck in Chicago city traffic last Wednesday afternoon, (and I mean stuck, in a low movement, low vol position), and I noticed that all the cars around me had back seat passengers. My personal narrative is that UBER is slowing down traffic significantly. There are advantages to being a first mover, a certain excitement with the new thing, but then it starts to morph back into the old pattern…maybe that’s where we are now with fiscal policy.
Anyway, regarding indexing, there was this article: There Are Now More Market Indexes Than Stocks https://www.bloomberg.com/news/articles/2017-05-12/there-are-now-more-indexes-than-stocks
A further separation of the underlying asset, a discounted stream of future earnings of a company, to an ‘investing vehicle’ that likely has a larger influence on the price of the underlying than actual earnings. Wag the dog.
Finally, on the topic of indexing, I have these two quotes. First from Jack Bogle, “If everybody indexed, the only word you could use is chaos, catastrophe.” Hey Jack, that’s TWO words. [From Midnight Run: ‘Jack you’re a grown man, you have control of your own words.’… ‘Here come two words for you’…] https://www.youtube.com/watch?v=qfTg0SQVvwE
The second quote comes from the FT. “Short term asset price declines have been reversed by the wall of money coming out of active investment managers and into the accounts of low-cost index products. But this comes at the expense of making the eventual decline in a broad range of asset values not just painful, but catastrophic.”
Now that I’ve looped myself into a stream of Midnight Run clips, I’ll summarize with the litmus configuration. We don’t know whether or not the money out there (and the pyramid of assets that rest upon it), is fake or real. We have a low vol environment that Dalio seems to suggest will unravel under its own weight. Ben Hunt thinks it will happen due to Central Bank mistake. I think the catalyst may come from Asia, or, as Trump refers to it, Jina. Or maybe the catalyst will be some sort of giant ransomware attack. Nah… Can’t happen.
https://www.youtube.com/watch?v=HxQrE0BpixI
(1) I am making this up. And Midnight Run is from 1988.
May 12. ‘Tis but a scratch
https://www.youtube.com/watch?v=zKhEw7nD9C4
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May 11. Oh SNAP
–Financial conditions getting more air time… Goldman also notes that conditions have eased in the wake of previous hikes, not the response the Fed intended. However, BBG reports that the rates on student loan debt are increasing going forward, up 0.69% from 3.76 to 4.45. I believe that’s for new loans, not for the $1.4 TRILLION outstanding. Math problem: how much will the increase in interest rates leave me for spring break and beer?
–Snapchat also felt a tightening of financial conditions with the evaporation of $6 billion in market cap, almost 1/4 of its previous value. And a friend (thanks JW) sent an article noting that Moody’s was downgrading Canadian banks as the value of underlying assets may become impaired. BOC’s Poloz said the CB can’t use interest rate policy to affect housing in just one city (Toronto)… but doesn’t it all come back to lending standards and macroprudential policies that were all the rage in the past few years?
–Hartford CT prepares for bankruptcy as high-income taxpayers either leave the state or report less income.
–In futures markets the easing of conditions is apparent in the collapse of libor/ois and buying in front EDM7. Although odds of a hike as represented by FFN7 haven’t really changed (settled 9889, around 85% odds of a June hike), EDM7 is only about 13 bps lower in price than where EDH17 expired. According to open interest sheets, 67k puts were exited in EDM, though the futures barely show any change at all for the past 2 days, so that data is suspect.
–Oil rallied over $1 bbl yesterday and is continuing to add to gains this morning. Today features the 30 year auction, preceded by Jobless Claims (245k) and PPI, expected +0.2 both headline and core.
May 10. When all you have is a hammer….
–If your only tool is a hammer, then every problem looks like a nail. If you’re a volatility seller, then you hammer the bid. For example, Green March 9775 straddles sold in size of 8k yesterday at 54.5, new position, with 311 days to go. USM straddle closed under 2 points with 17 days to go.
–Though volumes were light, yesterday’s modest sell off still caused new highs in some near euro$ calendar spreads. For example EDM7/EDM8 rose 2.5 to a new high of 43.0 (on heavy buying of EDM7). And EDZ7/EDZ8 rose 2 to 42.5. Red/green pack spread (2nd to 3rd year) also made a new high to just above 30, but ranges have been extremely tight. For example, red/gold pack spread has, on a closing basis, only had a range of 4.75 in the past month!
–Rosengren gave a speech warning about Commercial Real Estate and low cap rates (which are an obvious result of Fed policy) and also touched on GSE reform as GSE’s hold or guarantee 44% of multi unit properties. The Fed’s Sr Loan survey noted, “on balance, banks reported tightening stds on CRE loans,” and had a special set of questions on that topic. Obviously, CRE is a large concern of the Fed. Rosengren also warned that higher rates may negatively impact this sector. Duh.
–Oil is bouncing a bit this morning, though copper is steady, China’s inflation data was mixed, with slightly lower PPI than expected and CPI a shade stronger. SHCOMP closed on the low….I believe it’s the low close for the calendar year.
–From a BBG article this morning:
“Demand isn’t expanding as much as expected, and U.S. shale output is growing faster than forecast, according to Vitol Group.”
–N Korea vows to continue nuclear tests and Trump fired Comey. Not much reaction though treasuries saw a late bid. Ten year auction today.
Simon Potter and the Fed’s policy transmission
From a speech by Simon Potter (head of NY Fed’s Mkt Desk) on April 5, 2017:
https://www.newyorkfed.org/newsevents/speeches/2017/pot170405
The transmission of monetary policy relies on competition within, and integration across, money markets. The FOMC’s policy target is the federal funds rate, which is a measure of what banks pay to take out unsecured overnight loans from other banks and from government-sponsored entities. However, the Federal Reserve does not transact in the federal funds market, and therefore cannot directly impact the federal funds rate.7Instead, it relies on a predictable relationship between rates in the markets in which it does operate, and rates on federal funds borrowings.
So….the chart below shows this ‘predictable relationship’. Fed Funds have gone up by 50 since November. 3m Libor has gone up by 27 bps. The stock market recognizes it: FINANCIAL CONDITIONS HAVEN’T TIGHTENED AT ALL….happy days!
But the Fed absolutely recognizes it as well. And will likely be forced into responding by turning up the jawbone volume on balance sheet reduction. Expect a timetable and plan by the June FOMC.
May 9. Overarching theme…NO RISK
–A couple of themes yesterday. First was the implied volatility crush. Almost every news service trumpeted the fact that VIX is on top of the low from 1993. It’s the same theme in treasuries, where vol is at new recent lows. I marked FVM at just 2.5 and TYM at 3.9 at yesterday’s settle. The USM straddle closed at just 2’08 with 2 and a half weeks to go. The bond contract can move two points on a sneeze. Second is the continued compression in libor/ois. Recall that going into money market reforms last October, this spread had blown out significantly as non-gov’t money market funds for institutions were allowed to float (break the buck). That risk, like many others across the financial landscape, has receded into the nether regions. Another observation, which I highlighted yesterday and is related to the themes above, is that financial conditions have, by and large, eased over the last two Fed hikes.
–Another broader topic of discussion has been the migration to passive investing, and its implications. A large factor in the lower vol environment? Or an investment strategy that divorces the idea of underlying value from money flows? Discuss amongst yourselves.
–Interesting note from Gundlach yesterday. He said he favors emerging market stocks over US, noting that US stock market capitalization as a percentage of global equity market cap is around 50%, while US GDP as a % of the world is around 25%. I’m not sure that’s compelling, given the fact that many countries don’t have developed capital markets, but it’s certainly an interesting tidbit.
–Stories about China are becoming more prevalent in the financial news, as many connect weakness in industrial commodities with credit tightness in China. Several note that the Party Convention is in September (thanks PR) and that China will avoid big changes before then (though perhaps SHCOMP hasn’t gotten the memo, as it’s made new lows for the year).
–Today’s US news includes the three year auction, NFIB small business optimism and JOLTS.
Financial Conditions
On March 30, Dudley outlined the five factors of financial conditions.
https://www.newyorkfed.org/newsevents/speeches/2017/dud170330
Below I have put all 5 (proxies) on a chart. The vertical lines are the last two Fed hikes.
FOUR of the indicators, stocks, ten year yield, the dollar index, and corporate spreads are actually showing LOOSER financial conditions (denoted with a “ + “ sign)
Short term rate as indicated by 3m libor has tightened.
In other words, the Fed really hasn’t tightened… perhaps balance sheet reduction will be more effective.
