April 19. What’s the point?

–Yields plunged yesterday to new lows for the year, with tens down 7.5 bps to 217.5.  Curve flattened to a new low with 2/10 down 4 bps on the day to 101.3.  Nearly all euro$ calendar spreads made new lows; peak 1-yr spread is EDZ7/EDZ8 at just 33 bps which was down 2.5 on the day.  It feels like a squeeze and that’s the term most people are using to describe the price action, yest open interest continues to rise in 5’s and 10’s, up 77k and 23k respectively.  Clearly, the Fed has encouraged shorts with the constant chatter about raising rates and trimming the balance sheet, with Esther George chiming in yesterday.  While several Fed  officials including Dudley have termed balance sheet reduction as a substitute for rate increases, George apparently doesn’t see it that way and wants to trim the balance sheet on autopilot (after having pointed out all the uncertainties about what the Fed is doing).  She says, “The key challenge for monetary policy today is to unwind this large balance sheet in the least disruptive manner.”  Why is that the KEY challenge?  She only gives two flimsy reasons, to move towards normalization, and to give the market access to more ‘highly liquid and safe securities.’ Huh?  We already have stocks.  Her speech reminds me of my favorite Neal Page quote: “When you tell a story, have a POINT.  it makes it SO much more interesting for the listener.”

–July FF settled 9900, now indicating just over 40% odds of a hike in June.  In mid December of last year just prior to the last two hikes, EDZ7 was 9850-56.  It settled yesterday at 9858.5.  Financial conditions are generally easing rather than tightening.  January 2018 FF settled 9882 or 118 bps vs the current Fed effective of 91, a difference of 27 bps.  The market is looking for ONE more hike prior to the end of the year, not THREE.  Rosengren will likely split the difference today and call for 2 more.  Beige Book this afternoon to summarize conditions prior to the May 3 FOMC.

April 18. Policy surprise: Markets don’t believe the Fed

April 16. What would become of the bomb makers?

What would become of the glaziers, if nobody ever broke windows?  Frederic Bastiat

I’m sure most people know Frederic Bastiat’s parable of the broken window, where the shopkeeper pays a glazier for a new pane of glass, and in that way benefits the economy, which hums along as money circulates.  Bastiat refutes this theory by comparing the visible effects of an action as opposed to unseen costs which may more than counterbalance the initial good. “It is not seen that as our shopkeeper has spent six francs upon one thing, he cannot spend them upon another.”  What is less well known is that the fourth chapter of Bastiat’s treatise is on Taxes.  He might have been right at home with the Freedom Caucus in the US House of Representatives…  “When James B. gives a hundred sous to a Gov’t officer, and receives nothing for them unless it be annoyances, he might as well give them to a thief.”

Well, it’s tax time in the US, due this year on April 18.  Since Trump is apparently seeking more accountability regarding US spending, it might be useful to review a few figures relating to national spending and receipts.  Let’s start with MOAB, the bomb dropped in Afghanistan.  According to some stories, this bomb cost $300 million to develop.  Other news sources cited a price tag of $16 million per unit.  But Business Insider reports that the 22000 pound bomb costs about $170,000 per unit, having received the information directly from the US Air Force.  Does that make sense?  About $7.75/lb.  In comparison, the curb weight of a Ford F-150 is about 4100 lbs, and costs about $30,000 (depending on the model).  Right around $7.31 per pound.  So that price seems to make sense; it doesn’t seem like the taxpayer is getting nicked by that particular purchase.  However, you can drive your Ford F-150 to the Nascar race or use it to tow your bass boat to the lake, while the bomb simply sits idly by like an insurance policy, awaiting a valid target.

I have no idea how to ascertain this figure, but news reports said that 36 had been killed by the bomb.  So that’s right around $4700 per individual (excluding transportation costs).  By comparison, a death penalty in the US apparently costs around $3 million.  So in that sense, it also offers value, and compares to forty murders in Chicago in the month of March.  Absurd?  Yes, because that seem to be the world we are living in now.

We can see the numbers, but we can’t foresee the reverberations on foreign policy.  We can’t know the ultimate responses.  What we do see as knock-on effects in the markets is that uncertainty is on an upswing, whether measured by VIX, or by implieds on other products like gold, or by treasury yields which are at new lows for the year (Ten Yr at 2.23%).  It may have nothing to do with US policy, but stress is also apparent in Europe, for example, the German/Italy ten year spread closed at a new recent high of 213 bps.

There is also some ‘hard’ data to consider.  Retail sales, reported Friday, were lower than expected at -0.2.  Headline CPI was  -0.3%, leaving yoy Core CPI at just 2%.  In response, the Atlanta Fed revised their Q1 GDP Now forecast to just 0.5%, having been as high as 2.5% in late February.   What is also pretty extraordinary is that while the Federal Gov’t collected a record amount of individual and payroll taxes in the first six month of the fiscal year which ended in March, the amount of Corporate Tax collected plunged by nearly 18% (!), from $121,907m in 2016 to $100,234m in 2017 (Circled in red below).  That’s likely a lagging piece of data, but it’s also a splash of cold water for the reflation-istas.

In fact, many markets have given back all of the post-election trade.  For example, the Mexican Peso was 18.52 on Oct 25, declined to 21.95 to the USD in January, and is now back to 18.58.  It’s the same for spreads like 2/10 treasury spread which was around 100 at the start of November, went to 135.5 by the end of December and has been oozing blood ever since, closing the week at 103. Full round turns on the Trump trade.  Industrial commodities like iron ore and copper have also been trending lower since their peaks this year set in February, perhaps having more to do with China than the US, but again, the reflation narrative is being squelched by a variety of conditions.

What hasn’t given back election gains is the stock market.  While warning signs abound, it’s still a fact that SPX was around 2100 just prior to the election, and closed Friday at 2329.  Of course, it may be that because Q1 was so weak, there has to be a strong rebound.  Or that Q1 was so weak, that the Fed can’t possibly continue to remove accommodation.  On the latter, I would note that July FF still indicate just north of 50/50 odds of a hike in June, and that Fed officials continue to prep the markets for balance sheet reduction later this year.

It’s a reasonably quiet upcoming week in terms of economic data.  There are Fed speakers every day, the most important of which is likely to be Fischer on Monday after US markets close.  Industrial Production Tuesday,  Beige Book on Wednesday.

Trade thoughts

In 2001 the Fed had already begun easing in 50 bp increments right from the start of the year, and I thought there might be an inter-meeting cut.  I was long calls, which expired just prior to Easter, but on April 18, just after the holiday (and option expiration), the Fed surprised the market with another 50 bp cut, from 5% to 4.5%.  I cite this time for a few reasons.  First, I think 2001 was the last time the Fed changed the FF target between meetings (though it wasn’t this particular cut, it was later in the year after 9/11).  Second, it shows just how much room the Fed had in those days to change policy to stimulate the economy: in late 2000 the rate was 6.5% and by the end of 2001 it was 1.75%.  Third, the reason for the intermeeting cut:

The severe slowdown in capital spending by big corporations “threatens to keep the pace of economic activity unacceptably weak,” the central bank said in its statement. “As a consequence, the (Open Market) committee agreed that an adjustment” in rates was needed before the Fed’s next regular meeting in May.

While we are currently in a ‘tightening’ cycle, nearly every Fed speaker decries the lame pace of capital spending and productivity.  Again, these factors may be altered by changes in policy, if the Trump administration can put them through.  It’s an open question.

_________________________________________________________________

_______________________________________________________

http://bastiat.org/en/twisatwins.html#SECTION_G004

https://www.bloomberg.com/news/articles/2017-04-13/five-charts-that-show-fear-is-rearing-its-head-in-global-markets

April 13. Fearless?

–USD/JPY down to 109 this morning, with the press pointing to Trump’s comments yesterday that the dollar is too strong.  Obviously there is a flight to quality aspect as well as US tens make new highs, gold is also at a new high for the year.  Somewhat surprising that traders would choose to embrace the currency of N Korea’s neighbor as it threatens to test a nuclear weapon on the [blotted out due to nuclear fallout] Day of the Sun.  The ten year yield was nearly unchanged yesterday at just over 229 at the close of open outcry, but trades 222 this morning.  Eurodollar calendar spreads are imploding with EDM7/EDM8 having settled 37.5 yesterday but printing just 35 currently.

–TYM 127c added another 16k longs bringing open interest to 193k.  While there were examples in both TY and euro$’s of call sellers and put or put spread buyers, to take advantage of elevated skew, those trades are rather dangerous without underlying longs, and can still go pear-shaped pretty easily if market uneasiness turns into panic.  I’ll just give a little example from euro$’s… there had been a reasonable amount of +EDK 9875c vs -2EK 9825c at flat, with some even taking 0.5 credit to sell the green.  As of yesterday’s close with futures 9871 and 9801, the call settles were 2.0 and 3.75, so now greens are over by 1.75.  This morning EDM7 is +1.5 to 9872.5, but EDM9 is +7 at 9808.

–In a vignette that pretty much sums up everything wrong, the sculptor of Wall Street’s iconic charging bull statue is suing because his statue of the Fearless Girl staring down the bull has changed the context of the original artwork.  Mayor DeBlasio helpfully tweeted, “Men who don’t like women taking up space are exactly why we need the Fearless Girl.”  Really? Trump changes the context of his remarks every five minutes. I guess the original Charging Bull was meant to portray the dynamism of the US capital markets, and underlying brawn of the unfettered US economy.  Somehow, it doesn’t seem as if the stock market currently reflects that picture.  Maybe it’s a symbol for today, a seemingly innocent (but defiant) child deconstructing the US capital markets…

http://www.reuters.com/article/us-new-york-statue-idUSKBN17E27B

http://www.reuters.com/article/us-new-york-statue-idUSKBN17E27B

April 12. Gundlach Indicator…copper/gold ratio

Not a bad time to dust off the [Gundlach favoritie] copper/gold ratio vs the ten year yield.  The reason:  Copper took a tumble today, plunging .0685 to 2.547, the lowest level since early January (and an indication that the ‘reflation’ trade has suspect underpinnings).  June Gold (GCM7) on the other hand, is at a new high for the (calendar) year, at 1277.50.  Likewise, the ten year treasury yield closed at a new low for the year just under 230 bps. 

If one considers the copper/gold ratio as a leading indicator of treasuries, it would portend lower yields, and probably isn’t a great sign for stocks either.

April 12. I musta got lost….now I hold a losin’ hand

–Brief mentions of many changes this morning, as yesterday was a big day indicating a sentiment shift.

–Market is starting to sit up and take notice of geopolitical events. Many signals of a moderate increase in stress.  Implied vol went to new highs for the year in VIX, Gold.  Also, the spread between Italy and German bund posted a new high of 207.7, highest since early 2014.  Skews in treasuries blew out with demand for calls.  For example TYM 124/127 combo  covered 125-16 was 8/9 late in the day….it had been more like 5/6 a week ago, as TYM 127 calls were bought in size.  TYM 127c now claim peak open interest (in calls) at 177k, having added 39k yesterday; settled 30/64 ref 125-155, 29 delta.

–July FF traded up to 9896…a small shave in odds of hike in June.  The move from 9894 to 96 takes odds from about 65% to 57%.  Additionally, many calendar spreads made new lows on the dollar curve.  For example, EDM7/EDM8 plunged 5 bps to settle 37.5.  Interestingly, the peak one-year spread has slid back on the curve to EDZ7/EDZ8 which settled 38.5 and unseated EDM7/M8. So now the nearby 1-yr spreads are clustered at 3/8% and taper from there.  New low in red/green euro$ pack spread at 28.375.  NY Fed’s Simon Potter’s speech last week was pretty concerned with monetary policy transmission signals from FF’s; the market is transmitting a message that it’s back on the ‘one-to-two’ hike a year schedule.

–While equities came all the way back from a morning swoon, fixed income maintained a solid bid, rallying in the face of the ten year auction, with 30’s coming today.  Fives and tens are at the lower bounds of 4 month ranges (in terms of yield).  Either these levels hold, or there’s likely to be a fairly violent adjustment lower.

*The subject title is taken from lyrics of the J Geils Bank
https://www.youtube.com/watch?v=CvM8WV2V998

Leading Indicator for JPY?

On above chart, JPY in white, Red/Green euro$ pack spread (2^nd year to 3^rd year).  It appears as if red/green, which is making a new low, is a leading indicator for JPY

April 11. Sustaining interest…it’s not easy

–When the Fed hiked on Dec 14th EDZ7 settled 9843.0.  The next day it settled 9838.5.  The lowest this contract has settled is 9835.  When the Fed hiked on March 15, EDZ7 settled 9841.0.  It now trades 9849.0.  I guess for the next hike it should settle around 9839?  Think back to Dudley’s ‘financial conditions’ speech a couple of weeks ago…moving FF is not changing conditions.  The NY Times this morning has a story, Yellen Signals Shift from Stimulating Economy to Sustaining Growth.  I suppose that’s a good summary of her comments; I’m not sure.  I started to watch, but as soon as she began to speak it was like an old Batman episode, where sleeping gas sprays out of the TV.  I think I heard her lament about low productivity as I was snoring, but that’s about it.

–Back to the December contract.  According to prelim open interest, EDZ7 added 104.5k positions to become the largest open interest contract at 1.64m.  There was huge buying of EDZ7/EDH8 spreads for 9-9.5; the spread settled 9.5 and open interest in March actually fell 20k.  I would also note that the Z7 buying caused considerable pain to those long the EDU7/Z7/H8 fly which settled on the low at -1.0.  This fly looks like a screaming buy, but it also looked that way to me at +1.0, +0.5, 0.0, etc.

–Today we get NFIB small biz optimism.  This data soared higher after the election and has maintained its strength even as market based measures (like euro$ calendar spreads) have retraced the election euphoria.  It’s expected 104.8, but I think risk is to the downside.  Ten year auction also occurs today, with the ten year yield having slipped 1 bp yesterday to 236.  I would finally note that I marked the ten year note/tip spread at a new recent low of 193.5….can’t even maintain 2%.

–Kashkari also speaks today.  There are unsubstantiated rumors that he may talk about TBTF banks.  Better strap in for that one….

April 10. A View from the Top (Yellen speaks this afternoon)

–Market attention is now focused on the Fed’s plans to curtail reinvestment.  Bullard this morning echoed Dudley and said the Fed “…could begin winding down its massive balance sheet sometime later this year in a shift that would make it less necessary to raise the official funds rate,” according to a story on Reuters.  We’ll get to hear directly from the top today as Yellen speaks at 4:10 ET.

–There are two good stories on Bloomberg dealing with this topic:

https://www.bloomberg.com/news/articles/2017-04-09/a-foreign-threat-to-u-s-treasuries-that-dwarfs-fed-s-debt-hoard

https://www.bloomberg.com/news/articles/2017-04-09/fed-s-big-unwind-risks-reigniting-u-s-bond-market-volatility

The first suggests that as foreign bonds emerge from the netherworld of negative yields, investors may me less inclined to park money in US treasuries.  The second talks about the potential for increased volatility, and mentions mortgage securities and the potential for both wider spreads and the need for private holders to hedge mortgage convexity. From the article: There’s also a chance that an increase in term premium triggers a withdrawal from risk assets such as equities… though “the risk asset link is not as certain,” according to Bank of America strategist Mark Cabana.

–I have been inclined to think that the risk asset linkage might be quite powerful; it’s not simply an increase in term premium that might cause a withdrawal from risk, it’s also a pullback in central bank largesse.  Previous ends of QE often had the perverse effect of bonds holding strong because equities faltered.

–Markets are quiet this morning though oil continues to retrace the sell off from March; CLK up 40 cents this morning to 52.64, having hit a low of 47.00 in March.  Three year auction today.  Yellen speaks late.

–There’s also an interesting article on ZH about the deceleration in C&I loan growth.  I have attached an image here from the St Louis Fed website.  However, given record corporate debt issuance I’m not so sure that this level of growth (associated with the last two recessions) is sending the same signal.

April 9. In Real Life

We learned from past financial crises, including the 2008 financial crisis, that nothing beats equity for absorbing losses. Equity holders have long taken losses in the United States and thus expect that outcome. Moreover, equity holders cannot run during a crisis. In contrast, debt holders of the most systemically important banks in the United States and around the world have repeatedly experienced bailouts and likely will expect such an outcome during the next financial crisis.

-Neel Kashkari, in response to Jamie Dimon’s annual shareholder letter

The peak of the market cycle is generally characterized by a perverse relationship between volatility and leverage.  Volatility tends to be low, as investors are complacent about the near future. The value of collateral (equities, real estate, etc.) has risen, so investors are able to apply more leverage to their overall portfolios.  This implies that the risk in the system, the potential for a futures collapse, is rising, while observed volatility is declining.

–Hari Krishnan, The Second Leg Down

(I recommend the above book by Hari, which details many practical real world strategies for handling risk through option markets, and importantly, for CONTAINING risk once damaging moves have already started.  Link on Amazon at the bottom of the page).

A bank runs into trouble; then either regulators or the courts trigger a conversion of debt to equity. Bondholders take losses. The firm is recapitalized and taxpayers are spared. Systemic risk is neutralized and bailouts are avoided. It sounds like an ideal solution. The problem is that it almost never actually works in real life. –also in Kashkari’s note.

I appreciate that Neel Kashkari wrote a rebuttal in response to Jamie Dimon’s letter.  Kashkari’s main focus has been on TBTF banks, and he consistently suggests that banks be required to have more of a cushion to absorb stress.   I also appreciate that several Fed governors have warned about risks in commercial real estate.  The problem though, is that the Fed accentuated several of the issues they now confront.  I think Kashkari might have worded the first passage above differently… the fact is, equity holders in the broadest sense do NOT generally expect to take losses, because the central bank has smothered risk.  The central bank compounded the problem of debt being substituted for equity by keeping rates down, and by forcing investors into riskier assets.  The financial architecture of the US encourages leasing; everything is now ‘pay as you go’.

Now, we might be on the verge of the Fed trying to undo some of the psychology that has become embedded in the system.  Dudley has twice said that the onset of balance sheet reduction may start later this year or the beginning of next.  Yellen’s term as Fed Chair ends in January 2018, and Fischer’s term as Vice Chair ends in June 2018.  If the Fed wants to begin a program to trim the balance sheet, it’s probably best to institute it this year and have it in place for new leadership.

On Friday, Dudley further solidified the idea of the Fed removing accommodation with this comment: “I think some people misconstrued what I said last week.  I said the words ‘little pause.’  A pause is pretty short already, and I think a little pause is even shorter than that.”  He was talking of course, about a pause in the rate hike schedule.  Treasuries immediately sold off, though net changes on the week were fairly small, within a few bps of the previous Friday.  However, the 2/10 treasury spread closed at a new low for the year of 109 bps, off about 25 bps from the high in December of last year.

On Monday, (late in the day at 4:10 ET) Yellen will speak, allowing for the opportunity to guide the market more clearly on the Fed’s policy alternatives of removing accommodation, and on timing.  The Fed is, of course, mindful of the potential for another ‘taper tantrum’ which it would like to avoid, as evidenced by another comment by Dudley on Friday, “…you might want to forego the decision on short term rates just to make sure that the balance sheet doesn’t turn out to be a bigger decision than you thought you were making.

Against this broad backdrop, we have yields which are near the lower end of the range of the last 4 months.  The US ten year has been more or less between 230 and 260, while the 30 year has been 295 to 320.  Friday’s closes were 237 and 299.6. (Treasury auctions of 3, 10, and 30 year paper Monday, Tuesday, Wednesday in the holiday shortened week).  Eurodollar calendar spreads have continued to compress.  While near one-year Eurodollar calendars were around 5/8% last December, the peak EDM7/EDM8 spread closed Friday at 43, having bounced from Thursday’s low mark of 39.5.  In other words, over the last quarter, about 25 bps of forward tightening expectations have been wrung out of the market.  At the same time, FFN7 settled at a new low of 9894 on Friday, indicating a 2 in 3 chance of a hike in June.  Perhaps the forward flattening shouldn’t be particularly surprising, given that the Atlanta Fed GDP Now forecast for Q1 has dwindled from 2.5% in late February to just 0.6% (a new low) on Friday.

One other comment about year spreads.  On Friday, EDZ7/EDZ8 closed at 41.5, +4 on the day, but -4.5 on the week.   Volume was enormous at 133k; prelim open interest shows +30k EDZ7 contracts and +53k EDZ8, so it would appear to be new buying.  The Fed’s year end FF projections released in March are 1.4% for the end of 2017 and 2.1% for the end of 2018, a difference of 70 bps, which suggests that Z7/Z8 is 28.5 bps ‘cheap’.  However, if one’s trading strategy were simply centered around Fed projections, it would have long ago led to panic and bankruptcy.  To paraphrase Kashkari, it sounds good in theory, but in real life, not so much.

I hesitate to comment on the geopolitical situation, because events rarely seem to have any type of impact on markets besides a brief flutter.  For now, it seems as if Trump’s order to bomb Syrian airfields has been a policy ‘win’.  However, as US warships move towards N Korea the stakes are raised.

_________________________________________________________________

_______________________________________________________

https://www.amazon.com/Second-Leg-Down-Strategies-Profiting/dp/1119219086/ref=sr_1_1?ie=UTF8&qid=1491651834&sr=8-1&keywords=the+second+leg+down

https://www.newyorkfed.org/newsevents/speeches/2017/pot170405

• 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.