March 23. Let’s Make a Deal

–The eurodollar curve continues to flatten.  June’17/June’18 closed at 47, down 2.5 on the day, down 11.5 from last week’s high of 58.5.  All spreads are in support areas currently from both a technical and fundamental basis.  On the technical side, most are at the lows since the early part of December.  Fundamentally, they’re a hike cheap to Fed pronouncements (if the Fed says there should be three hikes in a year, why are one-yr spreads all below 50 bps).  The Fed’s year-end projections for FF 2017 and 2018 are 1.4 and 2.1, a difference of 70 bps.  EDZ17/EDZ18 settled 44.  Rather than buying spreads, some are just buying cheap vol puts or targeted put spreads.  For example, buyer yesterday of 40k 0EM 9812/9800/9787/9775p condor for 2.75.  Settled 2.5 ref 9823.0.

–Yellen speaks this morning though there may not be policy implications.

–Health care vote today.  If this president is a dealmaker then I would guess it passes.  Strong arm threats and promises of favors.   If so, perhaps there’s a relief rally in stocks.  However, there’s a succinct post on zerohedge outlining over-valuation, including price/EBITDA, Schiller’s CAPE, Mkt cap to GDP and Margin debt. (link below).

http://www.zerohedge.com/news/2017-03-22/5-charts-scream-it

March 22. Hey… any catalysts for this?

–Risk off.  There are many reasons for yesterday’s sell off in stocks, but the fact is that they have been lurking in the background for some time, and finally coalesced into a ‘correction’.  SPX -1.25%, Nasdaq -1.8, Russell -2.7, KBW bank etf -3.9, and KBW regional banks -5.5%.  The Trump rally has run into political headwinds with the Healthcare vote looming; N Korea plans to pursue nuclear capabilities, punctuated by a failed missile launch; Rosengren warned about potential problems from Commercial Real Estate; Kaplan and Evans talked about more rate hikes; crude oil continues to sell off (CLK as of this writing 47.59, -0.65, at new low for the year); problems with auto loans are getting increased press; and going into quarter end there was a large portfolio re-balancing need.

–Was it a one-day event?  Probably not.  VIX futures contracts had lower lows early in the session, then outside ranges with closes on the highs.  Yields fell with the curve flattening slightly.  2/10 treasury spread eased 1.6 bps to 116.2 as the ten year yield fell 4 bps to 243.  Red/gold eurodollar pack spread fell 3.5 bps to 69.625.  Implied vol firmed slightly in treasuries.  Moves since the election have been pretty powerful.  Yesterday’s activity was an engraved invitation to lock in some profits and pare back positions, though many want to stay at the party.  A friend of mine mentioned that he had bought some cocktail napkins  that had this caption printed on them: “They won’t leave… time to put a Yoko Ono album on.”

–Though not quite at new lows, one-year eurodollar spreads are all below 1/2% with EDM7/EDM8 dropping 1.5 to 49.5.  EDM8/EDM9 is just 3/8% at 37.5.  The more deferred spreads are at low risk buy levels.  A change in Fed rhetoric if stocks continue to press lower could see reds outperforming on the curve.

March 21. Rates slipping lower as Fed taken out of the equation

–Yields drifted lower yesterday in the context of a flattening curve.  The ten year fell nearly 3 bps to 247.0.  The only one-yr eurodollar calendar spread clinging in the thin air above 1/2% is EDM7/EDM8 which settled 51, down 1.5 on the day.  Once again, there was substantial adjustment of option positions, reflecting libor targets that are now 12.5 bps different from where they had been a month ago.  For example, EDZ16 closed near 9900, which would have implied a price in EDH17 at 9875 on a 25 bp hike.  Instead, with the collapse in lib/ois EDH7 expired near 9887.  Which now leaves June’17 targets at either 9862.5 or 9887.5.  Therefore, there was a large exit sale of 80k of EDM7 9887/9875/9862p fly, which settled 3.75.  There is also continued buying of EDM7 9862/9850ps vs EDK7 9862p for 1.25.  Perhaps lib/ois widens again on another hike?

–Bloomberg noted a gaping divergence between the CBOE’s SKEW index and VIX, as the skew index surges, indicating wing protection for le Pen? N Korea? additional signs of problems with the european banking system?  In any case, the purchase of premium is NOT occurring in the interest rate arena.  Late in the day there was a seller of 9k 3EJ 9750 straddle at 17.5; vol in general is shifting down.  Nasdaq is near new highs this morning, and the Euro is also firming as the Fed is taken out of the equation for now.

–In the weekend notes, I mentioned deterioration in auto loan statistics and recovery rates, citing Mizuho’s Steve Ricchiuto.  This theme is corroborated by a ZH article which notes that used car prices are crashing ‘the most since 2008’.

http://www.zerohedge.com/news/2017-03-20/used-car-prices-crash-most-2008

–April treasury options expire Friday.  A couple of Fed speakers today, though some occur after the close.  Esther George of KC at noon EST.

March 19. Risks balanced, but large in both directions

American girl, she tell a lie/ She say ‘til then’, she mean goodbye.

–Chuck Berry, Havana Moon

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

One of the great things about Chuck Berry is that, in the early days, he insisted on being paid in cash for performances:  “Due to being burned early on in his career, and occasional run-ins with the IRS, Chuck always gets paid in cash. A notable occasion in Australia 1975 saw Berry caught at Sydney Airport with $50,000 in an attaché case.”* Currency restrictions on travelers were instituted after this incident…and in general, have been accelerating ever since.

Now that’s the story of a guy who had a clear understanding of credit risk.  Given the smothering influence of central banks, the concept of credit risk falls in and out of favor, and it seems currently that risks of all sorts are being priced at the low end of the spectrum.  For example, the BAML BBB spread had ramped up to 290 bps in mid-2012 with the sovereign spread blowout in Europe, went back to the low of 143 bps two years later with the help of CBs, back up to 300 last February when the oil bust was shaking up the high-yield energy sector, and is now 155, having touched 150 earlier this month. **

In some quarters, the Chuck Berry quote above, ‘American girl, she tell a lie’, could refer to Janet Yellen.  After guiding the market to last week’s hike with fairly hawkish forward rhetoric, the tone was softened on the actual move, leading to rapid unwinding of bearish fixed income bets in the US.  On the table below I usually mark one-week changes, but this time I included the previous week.  From March 3 to March 10, US yields jumped up in anticipation of the Fed meeting.  But by Friday they had come right back down to two Fridays ago, especially on shorter maturities.  For example, the two year yield went from 2.01 on March 3, to 210.3 on March 10, and right back to 201.8.  Tens from 248 to 258 to 249.9.  EDM8/EDM9 spread from 40.5 to 44.5 to 40.5.  EDM7/EDM8 spread compressed even further, going from 57 to 58 and then down to 52.5.  This is the peak one-yr Eurodollar spread, barely above ½% even though the Fed ‘dots’ still indicate three hikes per year.  By the way, the Fed’s year-end FF projections remained at 1.4 for end of 2017, and 2.1 for end of 2018.  As a comparison, Jan 2018 Fed Funds settled at 9869.5 or 1.305, 9.5 under the dot, and Jan 2019 settled 9822.5 or 1.775, 32.5 under.  Two weeks ago EDZ7 settled 9838.5 and the 9837.5 straddle at 26.5; on Friday Z7 settled 9840.5 and the straddle was down to just 24.0.

The summary of the current environment is as follows: Markets had expected robust growth due to Trump’s victory, with associated fiscal stimulus and tax/regulatory relief.  For example, the NFIB small business optimism index simply exploded after the election.  Stocks, of course, reflected the same sentiments.  The Fed won’t buy into the story until there’s proof, and given recent data the plot looks a bit suspect.  With the Fed’s dovish hike, financial assets re-energized and the dollar declined, leading for example, to a new high in EEM, the Emerging Mkt etf.  However, there are a myriad of overhanging risks, including widening sovereign spreads in Europe, the North Korean situation, etc.  Against this is a general increase in inflation, and what appears to be global central bank acceptance that higher rates in the context of firmer inflation would make policy decisions a lot easier going forward.

I am leaning one way in the following notes simply to point out some pitfalls, which is not to say that the Fed will be idle; I think the Fed will continue to reduce stimulus due to renewed inflationary pressure (including financial asset prices) and a stated purpose of reaching ‘normalization’.  Normalization means the Fed won’t always be there to catch the falling asset, or at least it might mean that.  And without Tarullo pursuing macroprudential policies (this was his last meeting), perhaps the Fed will rely on more conventional tightening measures.

Stocks are likely overvalued.  GDP data is getting revised down.  Industrial production is soft.  Auto loans are beginning to go sour, and since the industry is coming off near record sales, that may loop back to reduced industrial production.  Trump policies aren’t being embraced by the deficit hawks in Congress.  Retail sales aren’t as strong as expected.   Global long end rates are edging higher and sovereign spreads in Europe are increasing.

First, GDP.  In late Feb the Atlanta Fed GDP Now forecast was 2.5%.  Now with two weeks left in the quarter, it’s just 0.9%.  The NY Fed’s last Nowcasting report forecasts Q1 at 2.8%, and 2.5% for Q2.  In late Feb, NY was forecasting 3.4% for Q1.  As an article on ZeroHedge points out, the chasm between ATL and NY is huge.  For me, it’s not the size of the discrepancy that’s important, it’s the direction.  Both down from late Feb, by 1.6 point and 0.6 point.  (An amusing note in the NY Fed’s FAQs is: “Why should we trust the model?”  And the first sentence of the answer is: “Extensive back-testing of the model, research, and practical experience have shown that the platform is able to approximate best practices in macroeconomic forecasts.”  That’s some good weed.  WTF does it even mean?  I think I might have been more comfortable with this: “The model’s results are highly correlated to actual readings of quarterly GDP data, +/- 0.2 within two weeks of the end of the quarter.”  But that’s not what it says.

Second, here’s an IP chart lifted off ZeroHedge, with this note: “Industrial Production has never declined on a 24-month basis without the US economy being in recession.”

From Mauldin Research citing David Rosenberg: “…all these recent juicy ISM manufacturing releases have only managed to squeeze a string of 0.2% MoM gains in manufacturing output.”

Third, auto sales are beginning to turn.  Seriously delinquent loans have bottomed and are turning higher.  I’ve attached a footnote link from the NY Fed’s Household debt report, but more to the point is Business Insider citing Mizuho’s Steven Ricchiuto.  Losses on subprime have jumped from 7.9% to 9.1% yoy in January.  Recoveries are falling.  From Ricchiuto: “Auto sales have exceeded all other consumer-related purchases and account for the bulk of the economy’s upside since the turn in 2009.”

Even with these factors, the household sector as a whole probably doesn’t represent a huge risk.  However, the corporate sector might be a different story.  While the growth in C&I loans from commercial banks has decelerated, going from growth of 12.3% in the beginning of 2015 to just 5.4% by the end of last year, corporate bond issuance has been on a record tear.  A BBG article notes, “Investment-grade firms are on track to complete the busiest first quarter for debt sales since at least 1999. Firms from Apple Inc. to Morgan Stanley have pushed new issues to more than $360 billion so far in 2017, closing in on the previous record of $381 billion from 2009, according to data compiled by Bloomberg. That puts bond sales 14 percent ahead of last year’s record pace.”  According to the Fed’s Z.1 report, Total business debt outstanding, including Corporate, was a record $13.47T at the end of 2016.  The Bloomberg article ends with this quote: “I’m not sure we’re at a point where the market is compensating investors for all the risk.”

Credit spreads are tight, debt levels are high, and lofty equity prices that always seem to quickly rebound from turbulence have lulled investors into complacency.

March 17. Green midcurves get hammered for St Pat’s Day

–Vol continues to be pounded in the aftermath of the Fed.  Libor/ois continues to compress.  Open interest in EDM7 puts declined by 108k with a buyer of 40k 9875/9862/9850p flies for 4.  9862p settled at 2.75 ref 9868 and still have 838k open.

–The eurodollar strip was nearly unchanged, though the ten year yield rose 2.5 to 252.  In futures, a reflection of declining swap spreads is that TUM7 (June 2yr) was down 1/32 which is about 1.4 bps and the 2yr eurodollar bundle (or strip) was up 1.25 bps.  This is also apparent in back Fed Fund contracts vs euro$’s, for example, FFZ7 and FFF8 were -2.0 and -1.5 respectively, while EDZ7  closed unchanged.  Long vol positions continue to be unwound after the Fed, or said another way, the bid for premium has substantially pulled back.  For example, in green midcurves, 2EJ 9775^ closed at 16.0 from 17.0 on Wednesday, 2EM 30.0, from 31.5, 2EU 9762^ 43.5 from 45.5 and 2EZ 55.5 from 57.5. (Green pack was +0.75).  TYM 123.5^ from 2’05 to 2’00.

–However, there was still buying of TYK puts yesterday.  TYK 122.5 and 122p settled 18 and 12 respectively with 26 and 18 deltas, open interest up 15k and 7.3k.  The large buys of TYJ 122p pre-FOMC from 9 to 11/64’s didn’t pan out, however, 2’s were paid yesterday in 40k; one week to go for April expiry.

–One year eurodollar spreads Sept17/Sept18 and Dec7/Dec8 both closed -1 at 50.5, solidly in the ‘two hikes per year’ camp.

–Today’s news includes Industrial Production expected+0.2 and Leading Indicators +0.4.  Trump has resurrected the old ‘guns vs butter’ economics debate.  Republicans are balking, an indication that upside economic risks associated with aggressive fiscal stimulus might be tamped down.

March 16. Moving to neutral

–The Fed hiked and maintained the forecast of 3 hikes in 2017.  April Fed Funds settled 9911 and July at 9898.5, exactly 12.5 lower, so essentially 50/50 for a June hike.  Fed’s end of 2017 FF projection is unch’d at 141 or 9859, but FFF18 settled 9871.5, +4.5 on the day, a rate of 128.5.  Once again, the market won’t quite take the Fed at its word (understandably so as some data indicate softness, for example Atl Fed GDPNow down to just 0.9 for Q1).  Shorts looking for a more confident outlook by the Fed were squeezed out.  USD fell, gold is up $24 this morning, and near euro$ calendar spreads declined, with June/June, Sept/Sept and Dec/Dec clustered just above 1/2% at 53.5, 51.5, and 51.5.  Late in the day we traded EDM7/EDZ7 at 26.0; hard to see the risk as it barely prices one hike in that six month period.   Implied vol was crushed, with TYM 123.5 straddle at 2’05, 4.7 vol.  There was an article on BBG yesterday highlighting Runestone capital, which trades volatility with just a one-day horizon.  The article implies it’s mostly equity vol, but treasury vol was being sold aggressively in front of the FOMC.  Quick hit vol sellers just prior to known events seems to be a strategy of increased importance recently.

–While Brainard had recently noted that risks were to the upside, Yellen said that data hadn’t strengthened appreciably.  The message was steady, slow growth.  Ten year yield slipped back below 2.5%, down nearly 10 bps on the day.  In terms of other central banks, the WSJ has these headlines on its home website:  ‘ECB Walks fine line as it prepares to signal possible end to stimulus’ and ‘BoJ sticks with policy’.  In China, repo rates were raised by 10 bps, which may or may not reflect an official policy change.

–Today’s news includes Housing Starts, Job Claims, JOLTS and Philly Fed, with the latter expected to pull back to 30.0 from 43.3 last.

https://www.bloomberg.com/news/articles/2017-03-14/hedge-fund-sees-30-gain-by-betting-only-on-tomorrow-literally

March 15. FOMC day. Hike is priced; watch the ‘dots’

March 14. Pre-FOMC adjustments

–Yields edged higher Monday on light volume, as pre-FOMC adjustments occurred.  The ten year rose 2.6 bps to 260.6.  Open interest was mostly lower in treasuries, though there was a large buyer (100k) TYJ 122p for 9 to 11.  Settled 11 ref 122-255, 24 delta, expires one week from Friday, a bit over 10 bps out of the money.  While eurodollar straddles were down by 0.5 to 1.0, treasury vol remained steady.

–News today includes PPI expected +0.1 with Core +0.2.  NFIB small business optimism as well, though the last 2 readings were extremely strong in the wake of the election and thoughts of reduced regulation and taxes; a pullback would appear to be in order.  July Fed Funds settled 9896.5, projecting about 50/50 odds for another move in June after tomorrow’s hike.   There was a good size buyer of EDZ7 9812/9800p 1×2 for 0.5 (looks new).  EDZ7 settled 9835.5; this trade appears to be pinpointing a 4th hike for the year.  Probably reasonable, but I prefer open ended protection by just buying EDZ7 9800p for 1.75.

–Interesting story on Reuters (well, in the state of Illinois anyway) that the Illinois state comptroller has suspended paying $27 million for the governor’s computer technology initiative.  Kicking the can down the road?  It wasn’t too many years ago that I went to City hall to file an appeal and they handed me four forms with CARBON PAPER.  “Press hard, so we can read the last sheet, and so it won’t smear when we file it.”  The article notes that the unpaid backlog of bills is now $12.3 billion, and has tripled in 21 months.  It also wasn’t that long ago that the state issued bonds to wipe out what was then about a $7 billion backlog. Are bonds backed by Illinois taxpayers for a dysfunctional gov’t really assets?

http://www.reuters.com/article/us-illinois-budget-idUSKBN16L030

Illinois comptroller stops payments for governor’s computer modernization www.reuters.com Illinois’ state comptroller has suspended $27 million in payments for a computer technology initiative launched by Republican Governor Bruce Rauner, according to a letter seen by Reuters, opening a new front in an ongoing feud over finances.

March 12. Summers’ wisdom

I am not a big fan of Larry Summers and his secular stagnation thesis, “…an excess of savings over investment.”  It sounds a bit like re-heated Keynes, who my old college prof Robert Eisner distilled with this summary: “Investment doesn’t necessarily equal intended investment.”  That was Keynes breakthrough, though it’s now all been bastardized to the simplistic idea that government should spend more to support the economy.  Not to worry, I am not going to try to recite my lame college memories.  Instead, I am going to quote Summers with, for me at least, his most interesting and endearing quote:

“One of the things you learn as a college president is that if an undergraduate is wearing a tie and jacket on Thursday afternoon at three o’clock, there are two possibilities. One is that they’re looking for a job and have an interview; the other is that they are an as$hole. This was the latter case.” 

He was referring to the Winklevoss twins.  The reason I bring up the twins is that they suffered a large setback Friday when the SEC denied their application for the Bitcoin Trust ETF.  After the news late Friday, bitcoin immediately plunged to nearly 1000, having been at 1300 early in the day.  This is actually a minor event for the world of global finance and rates, however, there were other large and significant moves which also occurred this past week, which may have big implications in the near future.

• Crude oil plunged nearly 9% on the week
• German rates exploded higher and the curve steepened hard
• OIS/Libor spread declined (it had soared from 25 at the start of 2016, to 44 bps going into MM reform deadline; started 2017 at 35, and is now down to 23).
• US treasury yields are close to or at new highs.

While bitcoin isn’t all that important, the price of oil is clearly a centerpiece of the reflation trade.  Other commodities like iron ore and steel rebar also posted declines.  Copper, which like other industrial metals, appeared to be breaking out of its three month range to the upside in February, has now slipped below the old highs and is back in the middle of the range.  For now, the BBG Commodity index is still about 13% higher than a year ago.  It’s just above 84, having been between 80 and 90 since Q2 2016.  It’s also worth noting that the Atlanta Fed GDP Now Q1 forecast has dwindled from 2.5% in late February to just 1.2% currently.

The above items would be considered headwinds in the march to higher rates.  However, a rate hike is now completely priced into the very near part of the US interest rate curve for the FOMC meeting on Wednesday.  Given the ‘new’ libor/ois spread of 22-23 bps, and the Fed’s year-end 2017 dot projection of 1.40 for the FF target (3 hikes), one might expect EDZ7 to be around 1.73%, and indeed EDZ7 settled 9835.5 Friday. Jan 2018 Fed Funds (FFF8) settled 98.675 or 1.325%, just 7.5 away from the Fed’s year-end projection.  In my opinion it’s not very likely that the 2017 dot will change much from December, and for that matter, the year end 2018 median of 2.1 probably won’t change much either.  So it’s all transparent and steady sailing for the US….right?

Not so fast.  It was April 21, 2015 when Bill Gross termed German 10 year bunds the ‘short of a lifetime.’  In fairly short order, the yield went from 6 bps to a bit over 100, only to grind back down in the middle of last year to a new low of -19. Since then it’s been up.  The bund yield is now 48.5, a jump of 13.5 bps this week.  Even more impressive was the surge in euribor yields.  Net changes on the week in reds, greens, blues and golds were +7.125, +13.875, +18.375 and +20.25.  The greens (3^rd year out), for example, went from just above a yield of zero (99.96) to 18 bps (99.82125).  In the US, five, ten and thirty year treasury yields rose just over 9 bps, at or through old highs.  These moves are the strongest signal I have seen in terms of a global change in sentiment regarding rates.  Even the 30 year JGB (I watch 30 year rather than 10 as the BoJ is targeting the 10 yr yield), has gone from just above zero in the middle of last year to 86.5 currently.  There is a global change in sentiment.  Are the central banks leading or following?  The Fed would seem to be the leader, but as Jim Bianco says, CB interventions are fungible across markets, and the underlying theme now is cessation or withdrawal of stimulus.

Certainly there are many factors that could arrest or reverse a move to higher rates.  For example, there are continuous warnings about China’s unbalanced credit growth which could lead to an abrupt shock. “Non-financial corporate leverage is too high” according to PBOC Governor Zhou Xiaochuan.  European elections loom.  In the US, C&I loan growth has decelerated sharply of late, with the last reading at a rate of -1.1%, vs 6.6% in Q3 2016 and 4.7% in Q4.*   The last revolving credit number was also negative.  The CEO of Target says he hasn’t seen this many distressed retailers since the crash in 2009.  On top of that, the flow of funds report released Friday shows that the ratio of household wealth to income has never been higher and is at 6.5x.  Of course, much of that wealth is comprised of stocks, and the total market cap to GDP ratio is now just over 130%, the highest since the tech inspired peak of 148% in 2000.

However, it appears as if fear of higher rates and possible inflation acceleration has now gripped both central banks and investors.  It might just be a simple case of rates having been too low, too long.  On a technical basis, I compare the current move in bunds to JPY in 2012 [chart below]

Of course, the two charts above might have exactly nothing to do with each other.  It’s just that markets are sometimes susceptible to large and unexpected moves, and, as I have said before, the current US interest rate structure has entirely dismissed the concept of an ‘overshoot.’

Bonds are counted as valuable assets due to their income streams, derived from disaffected taxpayers or from over-indebted corporations.  Occasionally, generally accepted facts (‘housing prices only go up’) get up-ended.

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https://www.bloomberg.com/news/articles/2017-03-10/mnuchin-said-to-focus-on-currencies-as-g-20-girds-for-trump-era

https://www.federalreserve.gov/releases/h8/Current/

http://www.zerohedge.com/news/2017-03-10/household-wealth-has-never-been-higher-relative-income

March 10. Global change in rate sentiment

• 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.