April 7. Liquidity considerations

–In today’s 10 minute news cycle, the missile launch on Syria was absorbed by the markets without collateral damage.  Though treasuries spiked, gains subsided, and while stocks initially broke, the overnight range doesn’t look like anything out of the ordinary.  Gold made a new high for the year and seems likely to hold, a comforting throwback for hard money aficionados, but a relatively muted move on the whole.

–Now we turn to this morning’s employment report, with NFP expected 175-180k.  Overnight spike highs in treasuries are likely to cap the upside (for the morning anyway).  Then perhaps some news will seep out of the Trump/Xi meeting.  I’m not sure what the implication of the Syrian strike is for N Korea, but odds of something stupid happening are edging higher, and I would suspect there’s an underlying flight to quality bid for UST late Friday going into Easter week.

–One interesting observation from yesterday is that EDM7 closed at the low of 9869.5.  It’s only a change of 1.5 bps, however, the liquidity in the contract seems to have diminished quite a bit, with only a few thousand contracts per side at various points in the day.  Perhaps it’s just related to news that Yellen is giving a previously unscheduled speech on Monday, but it’s also worth giving liquidity considerations some thought before drilling premium into the ground.  (On a related note, as the Czechs dropped the Euro peg, an article on BBG noted that the CB had warned “…that investors may struggle to find counterparties to cash out their positions.”).

–The other aspect about the front end of the curve is July FF’s having closed at 9894.0, a new low which indicates a 2 in 3 chance of a hike in June.  Is it plausible that the Fed, like Trump, is going to be a little less predictable in an effort to stanch the leaks?   Anyway, there are still 840k open 9862 puts in EDM7 against 1.4 million futures.

–Once again weakness in the front translated into new lows in near one-year euro$ calendar spreads.  EDM7/EDM8 closed -1.5 at just 39.5.  A couple of weeks ago all the near one year spreads were clustered around 1/2%, and are now getting comfortable with 3/8%.

April 6. Five year treasury shorts have no friends

–I used to have a friend on the trading floor, Jimmy, who hailed from a farming community and used to write a grain missive, and it would have folksy sayings in it like, “Corn has no friends here” and then would go into some great technical market details.  Well, all I can think of at this point is, five year treasury shorts have no friends here.  It’s not that price changes at settlement were all that large; the five yr yield was only -1.2 to 186.5 and tens were essentially unchanged, closing just over 235. The issue is that the market, with the help of Fed minutes, is shifting to the idea of balance sheet reduction, which could negatively impact longer dated assets including stocks, which keeps fives (and shorter mats) well bid.  And of course, that’s not the only risk to the ‘Trump rally’ as a White House shake-up involving Bannon occurred and a more proactive stance with both N Korea and Syria is on the table. All this just prior to a meeting with China’s Xi, where both sides could use some positive press.

–In any case, open interest in treasuries is strongly suggesting new buyers, right at the top of the [price] range.  Open interest increased 90k in FV, 51k in TY, and 12.5k in US, some fairly large changes against a backdrop of new lows in all near euro$ calendar spreads, (even though ADP was robust at 263k).  For example, the peak one-yr spread is still EDM7/EDM8, but it fell 2.5 bps to a new recent low of just 41 yesterday, barely one and a half hikes over a year.  The peak in this spread was over 60.  The spread that edged to a new HIGH was 5/30, which I marked at 113.7.  A couple of days ago I put out a chart showing that 105 is a critical level, and thought that another hike would cause a cascade lower.  But the shift from tightening with Fed Funds to tightening with the balance sheet is a different dynamic.  So, as the spread from reds to greens (2nd to 3rd year) makes a new low under 30 bps, red/gold is holding and likely worth trying to buy.  In terms of a nearby hike, July FF settled at a new low of 9894.5, which I assign as 63% probability of a June increase.  Further back, all ED 3-month spreads apart from June7/Sept7 are trading in single digits.

April 5. It’s a write-off

–The very front end of the curve is reflecting better than 50/50 odds for a hike at the June FOMC, with FFN7 unch’d yesterday at 9896.  However, ED calendar spreads continue to make new lows, with EDU7/EDZ7 closing at just 9.5 bps (new low) and the peak one-year spread, June’17/June’18 falling another bp to 43.5, lowest since last December.  The red/green pack spread (2nd to 3rd year) also edged to a new low, closing at 30.625.  So, when Gundlach says “the reflation narrative may be fading”, we don’t need an inside tip from Lacker, the same sentiment is already on view in interest rate futures.

–I’ve mentioned auto sales and loans several times recently, but now I am seeing a lot more about it in the form of strident warnings about the upcoming plunge in used car prices, etc.  While it’s clear the auto industry is downshifting, it’s worth a review of aggregate loans.  According to the Consumer Credit report from the Fed, auto loans outstanding are $1.1 trillion, which is a lot, but student loans are $1.4 trillion, and they are already seeing staggering default rates.  I guess the difference is that the gov’t owns the student debt, and to quote Kramer, “they can write it off”.  By the way, mortgage debt is now $9.75T; in 2007, 08, 09, it was $10.5T.  What has grown is business debt outstanding, $10T in 2007 and $13.5T now.  However, spreads to treasuries remain very tight.  Corp debt as % of GDP is close to a record high.

–Although end of the day vol levels in treasuries were only slightly firmer, there was an early reach for calls.  For example, TYM 128c were heavily bought, open interest increased 22k.  Settled 13/64 with a 14d, ref 125-01.  I reckon that strike will equate to somewhere right around or just under 2% yield on the ten year treasury given yesterday’s close of 2.35%.

–News today includes ADP expected 185k vs 298k last.  Service ISM expected 57.0 and Fed minutes this afternoon.

April 4. Safe bonds in high demand

–Near eurodollar calendar spreads were crushed as the market shaved back the odds of forward rate hikes.  While July Fed Funds settled unchanged at 9896 (indicating around 55% odds of a June move), the Sept’7/Dec’7 eurodollar spread closed at just 10 bps, down 2 on the day.  Reds to greens (2nd to 3rd year) closed at 30.875, down 1.625 on the day and a new recent low.  The peak one-year euro$ calendar spread is June’17/June’18, which plunged 4.5 to a new low of 44.5 (high in December had been 61.5).  Most spreads are as low as they have been since December.  Weakness across the commodity sector, though precious metals remain perky, threatening highs of late Feb.

–The ten year also fell to a new recent low, -4.7 bps to 2.346.  There was some talk that the new Japanese year was associated with large treasury buying, (Japan is the largest foreign holder of UST). A client also mentioned that Europe would have negative issuance this month.  I would also note that swap spreads are making new highs; maybe there just aren’t enough high-quality bonds out there…

However, news from the auto industry also continues to cast a shadow on the US economy at large.

April 2. The Usual Stuff Isn’t Working

https://www.bloomberg.com/news/articles/2017-03-31/how-the-yellen-fed-got-religion-over-the-stock-market-and-policy

https://www.bloomberg.com/news/articles/2017-03-28/fannie-freddie-fix-is-focus-of-senators-push-across-party-lines

April 1. Floor story

I believe this story came from the yen pit…or somewhere in FX anyway; one of the smaller pits.  There was a local (independent trader) in this pit, who, from all accounts was disheveled and overweight… a slob.  Which wasn’t all that uncommon to be honest.  And of course, the great thing about the floor is that he might well have also been a genius, because the floor teaches the timeless lesson of not judging a book by its cover.  Anyway, one of the order filling brokers relentlessly heckled the local, mocking his appearance, and calling him all kinds of profane names.   ‘Fat fuck’ comes to mind, but I am talking about really crude, loud language that the whole pit could hear.  If you are a connoisseur of crude insults, the trading floor was unmatched in its day.  In any case, one morning just prior to the open, this filling broker’s clerk comes in and says to him, “Hey there’s a guy in suit waiting for you at the front desk, and he says it’s important that he talks to you immediately.”  So the broker walks out and sees a guy in a suit with a briefcase, who introduces himself and hands him a thick manilla envelope saying, “I am the attorney representing Mr. X (the local).  This is the sexual harassment suit that we have filed against you.  I suggest you retain an attorney as soon as possible.  This is my business card; of course all the information is in the envelope, but have your attorney contact me directly.  Don’t worry about informing the exchange, we are sending a copy of everything to the legal department by courier today, and, as you know, the exchange takes cases of harassment very seriously.  We will be moving ahead quickly on this.  Please make sure your attorney calls me soon.  Have a nice day.”

The broker is, of course, shell-shocked and as he’s stumbling back to the pit he realizes his financial livelihood is at stake, and he is mumbling to himself, ‘what am I going to tell my wife and kids?’ Of course, it’s just before the opening and his clerk is organizing orders and handing them to him to fill at the bell, but the broker is numb.  In walks the slob, looking up at the boards, unkempt as always, jotting down a note on a trading card as though he doesn’t have a care in the world. Business as usual.  And the broker humbly says, “Hey, can we talk about this?”  And the slob just ignores him for a minute and then says, “Sure.  Happy April Fool’s Day.”

The insults stopped.

Best April Fools I ever heard.  I am sure someone from that pit knows the exact story, and I would be glad to correct it, but I am pretty certain I captured the flavor…

March 31. Financial conditions and the Fed… sounds boring, but it’s IMPORTANT

-In yesterday’s note I mentioned that we were “getting back into conundrum territory where the Fed raises short term rates, but the long end sits.” (www.chartpoint.com)   I mentioned that idea to Bill, who of course had to expound on the topic as if HE thought of it, and he felt compelled to use Financial Conditions in general as a topic of his speech yesterday.  Just kidding of course, but Dudley’s speech yesterday was an important one on several levels.  First, here’s the link, if you want to read it yourself and just skip my missive below.

https://www.newyorkfed.org/newsevents/speeches/2017/dud170330

I already saw a couple of hasty summaries from other market observers that I thought were off track; it’s always best to read the source.  Here are a couple of snippets.

Dudley mentions the 2004/06 hike cycle when long rates didn’t go up.  He cites other examples as well, and in this way is implicitly defending the Fed against the idea of ‘rules based’ decision making.  In fact, on one level you could say that’s what the speech was about: defending the Fed’s decisions and its independence.

–However, for our purposes, we’re more concerned about what this speech means for Fed policy in the near term.  Given that Dudley says the Fed has made progress on achieving employment and inflation goals, and that FF’s are still accommodative, let’s consider policy in the context of the financial conditions cited above.  Short term rates have gone up a bit due to tightening, but long term treasury rates have held steady or declined since the last two hikes.  Credit spreads are extremely tight.  The dollar has pulled off the highs.  Stocks are well higher than they were at the time of the December hike.  In other words, financial conditions really haven’t tightened at all.  Which would argue that the Fed should continue to hike at a steady pace.  Indeed, July Fed Funds had settled 9897.5 at the open-outcry close but traded immediately to 9896 on the speech.  He also talked a bit about the Fed’s balance sheet; too much for a morning comment but I will likely return to it over the weekend.  The CRITICAL takeaway is that both stocks and longer term treasuries may be in the Fed’s cross-hairs in terms of addressing ‘loose’ financial conditions.  That summary might be a stretch, but it’s worth keeping in mind.  Stocks and bonds don’t necessarily trade inversely.  Might have to write that on the chalkboard 100 times before it’s all over.

–One last little comment relating to yesterday’s market and financial conditions.  The May atm TYK straddle traded 1’00 yesterday with three weeks to go until expiry.  A friend (thanks ML) mentioned that he’s never seen the TY straddle trade 1 point this early in the cycle (I marked may vol at just 4.1).  Again, this pricing is somewhat reflective of complacency and loose conditions.

March 30. The Fed wants to let the air out of equity prices; bonds understand that

–Yesterday Rosengren said that gradual rates hikes won’t jeopardize progress, and that the economy is strong enough to withstand four hikes per year.  Williams said the economy will grow at a ‘healthy’ pace amid hikes (even though his own growth forecast according to his speech is about 1.6% longer term, with 1% productivity growth. “Combining that near 1 pct figure with labor force growth of 0.5 pct yields my trend growth estimate of 1.6 pct.”  So these Fed guys are front and center saying the economy easily absorbs hikes, but the 5/30 chart below is saying “I’m not so sure.”  This 105 level where 5/30 currently sits is pretty much the low over the last decade, and it’s poised to visit double digits on the next hike, or perhaps even the next hint of hikes…and that’s where Mester and Kaplan come in today.  I sort of think of a positive yield curve as a lubricant for a profitably functioning financial sector.  We’re getting back into conundrum territory, where the Fed raises short term rates, but the long end sits.  And perhaps that’s the reason that June bond vol is mired at 9%… because the 30 yr bond yield is anchored to 3%.   Note that 2/10 notched a marginal new low at 111.

March 29. hope vs reality

-Yields rose yesterday as the Fed auctioned fives and stocks rebounded.  The ten year yield was up 3.6 to 240.7.  Using the new 2 year, 2/10 treasury spread posted a new low of 111.3, and 5/30 is at its low of 105.  It was a classic ‘turnaround Tuesday’.  However, the frothiness of the stock rebound was only faintly echoed by a bounce in yields.  For example, from the post FOMC sell off in stocks from 2388.75 to 2317.75, ESM (as of yesterday) attained the 61.8% retrace of 2362.  However, in TYM the same move was from 122-205 to 124-295 as tens rallied post-FOMC.  A pull back of 38.2 would have been 124-015; yesterday’s low was only 124-085.  In other words, treasuries appear to have underlying support and aren’t as enthusiastic about economic prospects as equities.

–This price action is related to an article citing Morgan St research, which notes a disconnect between “hard data” and “soft data”.  MS notes that the discrepancy between soft data like consumer confidence and hard data like actual sales is quite wide.  This accounts for the vastly different forecasts of the Atlanta Fed and the NY Fed for Q1 growth (1.0% vs 3.0%), as NY includes confidence measures. Fischer touched upon the same subject during his CNBC interview yesterday, and noted that productivity growth has been low and the rate of investment is at a very low level at present.  He characterized risks as balanced.  Another interesting article from GS yesterday said that after the election, the stocks of high tax paying corporations rallied, but have since given back those gains and more, suggesting that tax reform may not be smooth sailing.  The triumph of hope vs reality…  perhaps that is the story of stocks vs bonds, and perhaps it’s also a metaphor for Trump vs Congress.

–There are a few more Fed speakers today.  Chicago’s Evans, Rosengren on the economic outlook at 11:30 EST (he continues to be concerned about commercial RE) and Williams at 1:15, with a speech titled “From sustained recovery to sustainable growth.  What a difference four years makes.”  The mush. There will also be Q&A.  7 year auction today as well.

March 26. Regime change?

Now is the winter of our discontent made glorious summer by this sun of York.  –Richard III

It was a spectacularly ‘Chicago’ day on Friday.  Having been chilly earlier in the week, it was slightly grey in the morning, but then the glorious sun warmed the city into the summery 70’s under a crystal blue sky by midday, with office workers pouring out of buildings to eat lunch outside as riverboat tours plied the Chicago river.  However, by early evening the temperature dropped 25 to 30 degrees within an hour and it began to drizzle.

It seemed like an old mid-summer CME floor day as well, without much to do before results of the healthcare vote were due.  In the old days in the Eurodollar pit when prices stalled, someone would occasionally blow up a huge beach ball and start bouncing it around.  It would start in the front month, pop up to the option pit, across to the upwardly sloping tiers of desks, back down to the pit, with clerks and traders enthusiastically punching it skyward (to cheers) soaring 25 feet in the air to the back months, while CME security guards comically chased after this brightly colored ball in order to restore some decorum to the market, while all the while becoming an integral part of the show.  Like Congress.  When they finally did capture the ball, a round of booing ensued.  Friday was a beachball day.

The Trumpian summer of deregulation and a government that gets things done had the air seep out as the health care vote to repeal Obamacare was withdrawn; a chill once again descended on the body politic.

The question is, of course, after the Trump stock rally, and the Trump increase in inflation expectations, and the Trump surge in small business optimism, does this very public defeat bode a reversal?  Already, Mnuchin was trying to take the sting out by saying that tax reform is going to be a much easier and more streamlined process.  I am sure some in the markets will spin it this way: “Well if Trump couldn’t get this through, it also means that he won’t be able to institute protectionist measures.  And a weaker dollar will be constructive for US exports.  Ergo, BULLISH for stocks!”

If fiscal policy measures to support assets are a bit more uncertain, what about monetary policy?  With increasing frequency, the topic of balance sheet adjustment is creeping into the public discussion.  Kashkari mentioned it Friday (while trying to hint that a stock market sell off wouldn’t necessarily elicit a response from the Fed) and Bullard had balance sheet reduction as a major theme of his latest presentation, also on Friday.  For all the contradictory and seemingly random headline quotes from Bullard, his slide show presentation is quite lucid. The summary of the presentation is below.

https://www.stlouisfed.org/~/media/Files/PDFs/Bullard/remarks/Bullard_Economic_Club_of_Memphis_24_Mar_2017.pdf?la=en

The US economy has arguably converged to a low-real-GDP-growth, low-safe-real-interest-rate regime.

Because of this, the Fed’s policy rate can remain relatively low while still keeping inflation and unemployment near goal values.

The new fiscal policy could impact productivity growth and therefore improve the pace of real GDP growth.  (The Fed can wait to see how the new fiscal policy evolves).

Ending balance sheet reinvestment may allow for a more natural adjustment of rates across the yield curve as normalization proceeds.

Though Bullard is not one of the top voices on the Fed, his desire to see a more naturally positive yield curve is likely aligned with mainstream Fed thinking, and he believes that balance sheet size and reinvestment is keeping a lid on long end rates.  Indeed as the curve flattened with this week’s stock market decline, financial stocks took a large hit, with the banking index down nearly 5% in the context of a 1.4% decline in the SPX.  A strong financial sector is critical to the transmission of monetary policy, and a steeper curve is a key pillar of support.

Below is a footnote from a Janet Yellen speech of January this year:

Based on estimates generated using the term-structure model developed by Li and Wei (2013) and the procedure discussed in Ihrig and others (2012) and extended by Engen, Laubach, and Reifschneider (2015), the Federal Reserve’s holdings of Treasury securities and agency mortgage-backed securities continue to put considerable downward pressure on longer-term interest rates. However, this pressure is estimated to be gradually easing as the average maturity of the portfolio declines and the end-date for reinvestment draws closer. Over the course of 2017, this easing could increase the yield on the 10-year Treasury note by about 15 basis points, all else being equal. Based on the estimated co-movement of short-term and long-term interest rates, such a change in longer-term yields would be similar to that which, on average, has historically accompanied two 25 basis point hikes in the federal funds rate.

Footnote 17 … https://www.federalreserve.gov/newsevents/speech/yellen20170119a.htm

Implicit in Yellen’s footnote is the idea that FF increases tend to flatten the curve.  The natural shortening of the portfolio should raise longer term rates, and the end-date for reinvestment has been on the Fed’s radar since the beginning of the year.  What is worth keeping in mind is this: previous cessations of QE have been associated with declines in inflation premia and less robust equity market performance.   The topic isn’t one just for the US, as signaled by the final round of the ECBs TLTRO program (Targeted Long Term Refinancing Operations).  As Draghi said in a report (BBG) “The banking sector’s capacity to fully support the euro area’s recovery is curtailed by its low profitability.  …It is up to the banks themselves to find appropriate answers to these challenges.”

In the final analysis, the odds of easy passage to key tenets of the Trump agenda have to be lessened.  The Fed has acknowledged upside risks of fiscal policy, so at the margin, odds of more aggressive Fed policy also have to be slightly shaved, a process which has already begun.  Asset prices have already bought into the Trump narrative, and are likely to re-adjust downward, tempered by a Fed that may tone down the ‘normalization’ rhetoric.  Fed fund rate hikes are likely to be better absorbed by the market than balance sheet adjustments, though a flatter curve may result.

Plots have I laid, inductions dangerous / By drunken prophecies, libels and dreams

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• 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.