Feb 17. Is March live? (or is it memorex)

–Yesterday reversed recent trends; the 5 year yield led the way lower, dropping 6.2 bps to 193.8, while tens fell 5.3 to 244.7 and bonds 4 to 305.  There was a decent amount of put liquidation in dollars, for example, EDZ7 9825/9800 put spread sold at 4.5 in about 50k over the past two sessions, and 0EH 9825p were sold at 2.5 in equal size.  There were also large exits of option steepeners (buying back 0EH 9837p and selling 2EH 9800p and 3EH 9762p), contributing to a slight flattening of the front end of the curve. Odds of a March hike declined in spite of Lockhart saying it’s live, with March and April funds around 28%.  Many front month puts will cease to have value if the Fed doesn’t move in March; the market will become more confident of a 2 hike scenario for 2017.  For example. EDU7 9825p settled 0.75.  The Fed would have to hike three times to hit strike.  EDU7 9837p settled 2.5.  Again, without a move in March, it’s hold on life is tenuous.  My personal opinion is that the Fed should move, both for reasons of potential inflation and to quell excessive speculation, however, Yellen’s recent ‘run hot’ comment is sticking in my mind.

–In any case, what we saw is more modest bearish plays further out the curve.  For example, Short April and Short May (both based on EDM8, 9819.5s) 9800/9787.5 p spreads AND Green April and May (based on EDM9 9782.0) 9750/9737.5 p spreads were bought as a strip for 8-8.5 bps in 50k.  Settles in shorts 1.5 and 2.25 and greens 1.25 and 2.0 so strip settled 7.0.  The point is, these are all 12.5 wide for low premium, and even without a March move, have a chance due to possible curve moves.

–One final technical note: Yellen will be giving a speech in Chicago on March 3, the first Friday of the month, which ordinarily coincides with the Employment report.  However, the march jobs number release is the following Friday, March 10.  Timing is somewhat interesting as March midcurves expire on employment day; Yellen will have an(other) opportunity to solidify a March hike or tiptoe around the subject on March 3.

Feb 16. Inflation pops, interest rate futures yawn

–CPI prints +0.6 with Core yoy equal to last year’s high of +2.3, but market response was fairly muted.  Yesterday I mentioned the possibility of accelerating inflation but I would have thought rates would have jumped higher.  Euro$ calendars (near spreads) made new highs, but EDM7/EDM8 was only +2 to 56.  There was an adjustment in FF futures, but both March and April contracts only indicate about 37% odds of a hike in March.  May FF settled 9919.5 (with an FOMC meeting on May 3).  If there were a hike in March then FFK should trade 99.095.  if no hike in March but a hike in May then 9911.5/12.

–The lack of downside enthusiasm was also apparent in the options market, with vols lower in treasuries across the curve.  TYM7 closed down 2/10’s at 5.0, and I marked the TYJ straddle at just 4.6.  USM 149 straddle closed 6’12, down from 6’26.  A Bloomberg piece today notes that a couple of shops ratcheted up their Core PCE price measure (the Fed’s preferred), and noted that the Fed may have already reached the price mandate.  Market response, ‘so what?’

–Once again belly led, with fives up 4.2 bps to 2.00 and tens up 3.2 to 2.50.  In dollars greens were weakest, closing -4.875.

–There were a few large ED trades.  Over the past few sessions EDZ7 9837/9812/9787p fly bought from 4.25 to 5.5.  Yesterday another large EDZ7 trade:

+50k 9837p/ -200k 9825p / +200k 9812p / -50k 9800p/ -100k 9787p / -100 9875c.  According to Open interest, the 9812p were an exit, as were 9787p.  Which leaves +50 9837p/ -200 9825p/ -50 9800p and -100 9875c.  If there were any chance of 4 hikes this would sting a little. Speaking of stings, there were reports of a short vol fund in equities buying back significant amounts of calls on S&P’s.  Price action corroborates, but appears for now to be one day blip.

Feb 15. Escalating asset and price inflation

–Rates rose on Yellen’s comments yesterday, as she warned about ‘waiting too long’ to raise rates.  I calculate about 25-28% odds of a hike in March according to March and April FF settle.  The ten year yield rose 3.6 to 246.8.  The green euro$ pack (3rd yr) was weakest on the board closing -5.0, while blues were -4.625 and golds -3.875.  5/30 treasury spread immediately flattened on Yellen’s comments, dropping over 2 bps below 110, but I marked just above 110 at open outcry close.  Stocks pushed to new highs.  EDU7/EDZ7 settled at a new recent high of 16, helped along by bearish option plays in EDZ7 (below).

–Just a couple of additional comments about Yellen’s speech.  She said the committee maintained an unch’d target throughout most of last year “against the backdrop of headwinds weighing on the economy… including financial market stresses that emanated from developments abroad.”  Could stress from abroad stay the Fed’s hand through the first half of this year?  Against this argument, she said “waiting too long to remove accommodation would be unwise, potentially requiring the FOMC to eventually raise rates rapidly…”  Does asset price inflation ever figure into the Fed’s deliberations?   Gives a nod to Trump by obliquely referring to fiscal policy changes “aimed at improving productivity.”

–Headline PPI was a strong +0.6, and the NFIB edged higher from last month’s explosion.  From the report: “The stunning climb in optimism after the election was significantly improved in December and confirmed in January.”  Today’s news, aside from another round of Yellen, includes CPI expected +0.3, Retail Sales expected +0.1, but +0.3 excluding autos and gas, and Industrial Production 0.0.

–Targeted option plays for Fed hikes are still popular, for example late in the day there was a buyer of EDZ7 9837/9812/9787 p fly for 5.5.  It’s a three hike play by the end of the year.  There has also been a decent amount of buying in EDZ7 9825/9800p 1×2.  Sort of makes me feel as if EDZ7 9800p are cheap at 1.5 just on the idea that inflation is already accelerating, and could pick up further steam, notwithstanding all the major economists that say demographic headwinds make such an outcome impossible.

Feb 14. Is it a ‘reflation’ trade or an easy credit trade?

–Yellen will be the main event today.  I find myself agreeing with DB’s LaVorgna …the Fed is close to achieving the dual mandate, but likely won’t jawbone for a March hike.  On the inflation side of the mandate, it’s worth a mention that the NY Fed survey found consumer expectations of 1 year ahead inflation rose to 3.0% and 3 year ahead to 2.8%.  One inflation indicator after another has indicated acceleration, though perhaps modestly.  So even if Yellen comes out on the dovish side, underlying inflation pressures should continue to put a floor under rates.  Additionally, every one-year euro$ calendar spread from Sept17/Sept18 on back is below 50 bps; further compression will be hard to come by barring an exogenous event.

February 12. Managing Expectations

It is a tale told by an idiot, full of sound and fury, signifying nothing

I am starting this week with a link to a speech by Vice-Chairman Stanley Fischer, as it’s quite informative about the sausage making of Fed policy.  This speech was given on Saturday.

https://www.federalreserve.gov/newsevents/speech/fischer20170211a.htm

The Macbeth quote at the top by the way, does NOT refer to Fischer.  I was thinking more generally about the times we find ourselves in.  However, there is a linkage between Fischer’s speech and our current political environment.  You can draw your own analogies, but mine has to do with expectations.

FISCHER , YELLEN and EXPECTATIONS

Fischer’s speech touches upon the modeling of the US economy that the Fed uses to shape its decisions (using the FRB/US framework, an “estimated, large-scale, general-equilibrium, New Keynesian model.”).  One key point is that monetary policy transmission works primarily through expectations: “…the expectations of decisionmakers, be they households, firms, or investors, are at the center of how monetary policy works–both in the real world and in FRB/US.”

Fischer then gives an example of Fed policy at work in the August 2011 meeting.  He notes that the “economic outlook had darkened considerably” over the summer, and that the Committee judged it merited a response, which ultimately took the form of a time schedule…the funds rate would remain low “at least through mid-2013.” What he doesn’t mention is this: Why had the outlook darkened?  Why didn’t the model capture this outcome?  Of course, perhaps those questions were considered, but were outside the scope of his brief speech.  There are other profound themes buried in the text, which I believe are becoming more important, for example, the difference between correlation and causation.

So, our President tweets tales that shape economic expectations (does the FRB/US model capture that?) and this week, Yellen testifies in front of Congress, with the opportunity to more clearly outline her thoughts on the path of monetary policy.  After the February FOMC meeting, the market reduced odds of a hike at the March meeting.  While wage pressures contained in the last employment report were subdued, other measures of inflation are clearly on the rise.  As a small example, yoy import prices released this week were +3.7%.  This series was MINUS 11.6 in Sept of last year, and has risen in spite of a strong dollar. [Chart below] What is also somewhat interesting in the chart is that it covers the August 2011 FOMC that Fischer references.  I might add that in 2011 oil had marched back up over $100/bbl, having been as low as $40 in ‘09 right after the crisis.  This week, oil closed at the high on Friday, and has more than doubled off last year’s lows, copper cleared major resistance (more on that below), and stocks closed at new highs. There are 20-odd thousand reasons for Yellen to feel comfortable about steering the market towards a March hike, but I just don’t think she will guide expectations clearly.

TARULLO

While I jotted down many topics to cover this week, I didn’t think I would give as much time to Fischer, but what is also quite important with respect to the Fed’s mechanics is the resignation of Daniel Tarullo, who has been at the forefront of financial regulation.  A Reuters story (linked at the bottom) notes that the banking industry is glad to see Tarullo go, as, according to the article, “Bankers had long complained he and his staff kept changing the stress tests and balance-sheet reviews in ways that arbitrarily ratcheted up capital requirements behind closed doors.”

It’s important to note that there will now be 3 vacancies on the Federal Reserve Board, and the President (that’s right, The Donald) is the one to appoint these members.  All seven members are voters, and March will be Tarullo’s last vote.  The four remaining are Yellen, Fischer, Brainard, and Powell.  So, while there has been a lot of talk about the dovish composition of the FOMC’s term in 2017, it may not stay that way.  Of course, it will likely become much MORE dovish with respect to macroprudential policy, yet another reason the current Fed might want to be proactive with respect to FF policy.

From American Banker March 2016  “Filling only the minimum number of positions on the Fed board and waiting ever-longer periods to do so is a further sign of the dysfunction of the U.S. political system. It unnecessarily puts the economy at greater risk.”

ECONOMIC DATA

It’s somewhat interesting that NFIB (small business) Optimism index, which simply exploded in the wake of Trump’s victory, comes out just prior to Yellen’s testimony.  Last at 105.8, expected 104.5.  From the last report: “Small business optimism rocketed to its highest level since 2004, with a stratospheric 38-point jump in the number of owners who expect better business conditions” the highest reading since 2004.

We also have PPI on Tuesday, a speech by Lacker (preceding Yellen) , and then comments by Lockhart, and Kaplan.  CPI is Wednesday, as are Retail Sales. Industrial Production, and Atlanta Fed Business Inflation expectations.  Then another round of Yellen with Rosengren and Harker to follow.   The end of the week has little US data.

COPPER / GOLD ETC

This note is already a bit long, so I will just briefly cite a few more items.  The chart below is the copper/gold ratio with the ten year note yield.  Gundlach mentioned copper/gold as a good indicator for rates.  Copper exploded to a new high Friday, and the ratio to gold is nearing last year’s high.

There are some that think the Fed can’t hike much due to enormous corporate debt levels.  This past week Moody’s issued a report noting that “US five-year corporate refunding needs reach an all-time record of $2T”. From 2004 to 2006 FF went from 1% to 5.25% in spite of the Fed knowing (and encouraging) a huge amount of variable rate mortgages.  Think they can’t make the same mistake twice?

Both the Fed and the ECB are talking about balance sheet reduction.  For example, I posted what I considered this important headline on Friday. *NOWOTONY: ECB TO DISCUSS REDUCTION IN QE MIDDLE OF THE YEAR.  To which a friend immediately responded.’ His friends call him MONOTONY.’  (thx JK)

A client mentioned that if an exogenous event causes stocks to begin selling off, that VIX might explode to unheard of levels because the underlying futures will not sport the liquidity needed for option shorts to cover gamma. (Not just forward call shorts on the VIX, but also shorts embedded in other structures).  There have been some large well-publicized purchases of VIX calls just above the 20 strike, but there are now a huge amount of instruments with embedded vol.  Doug Noland of the Credit Bubble Bulletin says this in his latest missive:  The VIX is low because of extraordinary confidence in counterparties.  Something to think about…

Feb 10. Trump on/ Trump off

–Interest rate futures reversed Wednesday’s gains yesterday, with the ten year yield rising 5 bps to 239.5 as the market digested this week’s auctions and Trump vowed a big announcement on taxes.  Stocks ramped to new highs.  Curve saw little change as rates parallel shifted higher.  Markets now face the uncertainty of ‘tweets’ in the context of probability and timing, as earlier reports pushed back the idea of tax reform into 2018.

–Trump reportedly affirmed the one-China policy on a call with Xi though a close encounter between military aircraft of the two countries is a reminder of potential issues.

–Large trade yesterday was a buyer of 100+ 0EM 9812/9800 put spreads vs 9850/9862 call spreads, paying 0.5 for the downside.  New position; adding.  The EDM7/EDM8 spread had settled 47.5 Wednesday but moved back up to 50 with the pressure on EDM8.  However, euro$ calendars in general remain quite flat, with the only one-year spread higher than June/June being March/March, and that’s still only 54.   Chicago Fed’s Evans yesterday said three hikes in a year were reasonable; the market doesn’t buy it.

–Swap spreads continue to press higher.  I would target the five-year, shown on chart below, to reach 20-25 bps from just below 9 currently.

–Though Japanese stocks are moving higher with the global herd (and a weaker yen) I continue to see news articles regarding Tepco’s Number 2 reactor.  News reports generally assure us it’s stable, but a robot was halted yesterday by high radiation levels… 1000 sieverts (!?!!).  Something to be aware of as this story has potential to dwarf all others.

http://www.globalresearch.ca/new-radiation-level-at-fukushima-dwarfs-the-highest-peak-at-chernobyl/5573370

Feb 9. “Disheartened”? Well sure, just look at all the debt coming due…

–There’s a whiff of flight to quality buying in the US as yields continue to fall, featuring a powerful bid in front of the ten year auction yesterday that took the yield down 4.4 bps to 234.4 (auction was 233.3).  Green euro$ pack closed +5.0. Blues +5.75 and Golds +6.25.  Precious metals were also strong with Gold (GCJ) now 1244, up over $100/oz from the low in late December.  However, stocks remain buoyant as global demand for USD assets is underpinned by stress in Europe.  High yield etf’s HYG and JNK give no trace of worry, having generally marched higher since the oil patch scare of early last year; they’re both near new highs.  However, Moody’s put out a note yesterday warning that “An all-time record $2 trillion of US corporate debt comes due in the next five years,”  and further noting “US spec-grade non-financial companies have a total of $1.063 trillion of debt maturing between 2017 and 2021, with $933 billion, or nearly 90%, of this due in 2019-21.”   As companies have loaded up on debt to buy back shares and pay dividends, balance sheets have become diluted, causing some analysts to speculate that the Fed will be constrained from rate hikes as the corporate sector depends on cheap finance.

https://www.moodys.com/research/Moodys-US-five-year-corporate-refunding-needs-reach-all-time–PR_361862

–While it might be unclear in the US as to whether the Fed keeps dripping morphine, the BoJ has no shame…“I believe it’s most important that the BOJ persistently pursue powerful monetary easing.” from BoJ Deputy Gov Nakaso.  Reuters summed up his speech this way. “Bank of Japan Deputy Governor Hiroshi Nakaso said Japan’s economy still needs massive monetary support given overseas uncertainties and stubbornly weak price growth, shrugging off market speculation it may raise its bond yield target this year.”

–On the other hand, China is pursuing tighter polices in order to stem capital flows.

–In the US today we have a 30 year auction.  Fed speakers Bullard and Evans also make comments in the morning 9:10 and afternoon, 1:10.  Since Bullard shifted to his ‘rates will never rise because we’re in a static regime’ speech I have no idea why anyone would ask him to give a speech, but Evans is sure to channel the BoJ mantra that Central Banks are the only salvation of other economic agents.

–By the way, new low settles yesterday in near ED one-year spreads with June/June at 47.5, down 1.5 and the lowest since the post-election surge.

Feb 7. Swap spreads and european sovereign spreads widen, indicating increased stress

Feb 5, Testing for weakness

Janet Yellen:  Yes, yes, yes. That’s why we’re taking extreme precautions.

Markets:  That’s right, but they never attack the same place twice. They were testing the fences for weaknesses, systematically. They remember.

Actually, the quote above is NOT from Janet Yellen, though it might as well have been as she seems always inclined to err on the side of caution.  It’s actually this exchange from the movie Jurassic Park:

https://www.youtube.com/watch?v=0qMa_PadKEA
John Hammond: Yes, yes, yes. That’s why we’re taking extreme precautions.
Dr. Alan Grant: Do they show intelligence? With their brain cavity…
Muldoon: They show extreme intelligence, even problem-solving intelligence. Especially the big one. We bred eight originally, but when she came in she took over the pride and killed all but two of the others. That one… when she looks at you, you can see she’s working things out. That’s why we have to feed them like this. She had them all attacking the fences when the feeders came.
Dr. Ellie Sattler: But the fences are electrified though, right?
Muldoon: That’s right, but they never attack the same place twice. They were testing the fences for weaknesses, systematically. They remember.

https://www.youtube.com/watch?v=0qMa_PadKEA

Yellen and Central Bankers in general, are a little like John Hammond, the brainchild of QE… Jurassic Park.  If you are unaware of the movie, Jurassic Park was created as an attraction with live dinosaurs and raptors reincarnated from old economics textbooks  DNA suspended in amber.  OK, maybe the analogy is a bit over the top, but if we’re going to go overboard with manufactured drama, might as well do it on SuperBowl Sunday.  Consider this:

February 2 – Bloomberg (Chikako Mogi and Masaki Kondo): “The Bank of Japan whipsawed markets as it fought to assert control over rising bond yields. The Japanese central bank first disappointed with a smaller-than-expected increase in bond purchases Friday morning, which spurred the 10-year yield and the yen to advance. Its unscheduled offer later to buy an unlimited amount of debt for some maturities sent rates and the currency falling.” [Just ask the Swiss National Bank how to gracefully withdraw a peg].

It’s worth noting that the 30 year JGB closed at a new high rate of 86.7 bps, a fairly impressive move from last summer’s low near zero, and up 4 bps on the week.

In the US, the markets have been testing the idea of a series of rate hikes in 2017.  After the FOMC announcement Wednesday, odds for a move in March were lessened.  Some trades were adjusted as a result, for example, the large long position in EDM7 9862/9850 put spread was rolled higher into the 9875/9862 put spread.  However, the Friday to Friday changes in almost all Eurodollar contracts were essentially zero:  Friday to Friday change EDZ7 9847.5 to 9847.5.  EDZ8 9800.0 to 9799.5, EDZ9 9766.0 to 9766.5.  The very near contracts did edge up a couple of bps in price, as the employment data , while showing an impressive increase in payrolls (NFP +227), didn’t do much to provide the last piece of the puzzle in terms of wage growth, which was only +0.1.   However, it’s worth mention that the Prices Paid categories in both Mfg and Service ISM were at new highs last week, with Mfg 69.0, highest since late 2011 and Service 59.0, highest since early 2014.  So, while the FOMC didn’t guide the markets to more certainty of a March move, it is by no means off the table.  That point was driven home by SF Fed’s John Williams in an interview late on Friday.  The quote that captured the market’s attention was, “Williams can see arguments for a rate hike in March.”  While that line was taken slightly out of context, he indicated that he preferred to move sooner rather than later, and said if the economy runs “…too hot too long, we could see imbalances develop.” [Link of this short interview is below]  Fairly aggressive selling ensued.

While near one-year Eurodollar calendar spreads remain pegged around 50**, indicating only two hikes in a year, Friday’s price action saw most Eurodollar contracts with outside days and lower closes.  Treasury supply comes this week in the form of 3’s, 10’s and 30’s in an otherwise fairly quiet week.  Near treasuries, like Eurodollars, had marginal changes on the week, but it’s worth noting that the 30-year bond was up 5.2 bps to 311.2, and 5/30 closed at a new high on the week just over 118 bps.  Astonishingly, March bond vol (US) is still just under 10%, with March treasury option expiration on Feb 24^th, AFTER Yellen’s semi-annual testimony on Feb 14 and 15.  While traders have been systematically testing the front end for rate hike resolve, they now might target the long end of the fence.

While I’m on the analogy, I’d tend to extend it further and say it’s not just the central banking fence, it’s the geopolitical world order that’s getting an electrified jolt from our new President’s haphazard tweets.  There are all sorts of fissures globally, widening like the crack in Arizona. [“A gaping, 2-mile-long crack has opened in the barren earth in Arizona, and it will likely continue to grow, geologists say.”]  http://www.livescience.com/57663-giant-crack-opens-in-arizona-desert.html

Nations and voters are going to continue to poke and prod other nations and their own leaders.

One last little note on stress testing…  It’s well known that hedge funds have been lining up against the Bank of China and the yuan, and the following snippet reflects defensive moves by that central bank.  February 3 – Wall Street Journal (Shen Hong): “China’s central bank raised key interest rates in the money market Friday, reinforcing a shift toward tighter monetary policy aimed at deflating asset bubbles and reducing long-term financial risk. The latest effort by the People’s Bank of China follows a similar decision shortly before the weeklong Lunar New Year holiday to increase the borrowing cost on special loans to a select group of commercial lenders, a move widely interpreted as an effective policy interest-rate increase.”

To conclude, here’s a final thought from Jurassic Park.

John Hammond: When we have control again…
Dr. Ellie Sattler: You never had control, that’s the illusion! I was overwhelmed by the power of this place. But I made a mistake, too, I didn’t have enough respect for that power and it’s out now.

Or, as the Bank of England’s Mark Carney said, “‘In many respects we’re coming to the last seconds of central bankers’ fifteen minutes of fame which is a good thing.”

It might be a good thing, but it might get messy.

_________________________________________________________________

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http://www.msn.com/en-us/money/companies/fed%E2%80%99s-williams-sees-some-arguments-to-hike-rates-in-march/vp-AAmAFOH

**EDM7/8 settled 53.0, EDU7/8 51.0 and EDZ7/8 48.0

Feb 3. Bank of Japan the weak link of Central Banking?

–Yields have edged higher in front of today’s payroll data, with NFP expected +180k and hourly earnings +0.3.  Yesterday’s net changes in rates were small, though I marked 5/30 at a slight new high of 116.3.  Odds of a March hike have slipped from around 1 in 3 to 1 in 4, leaving the longer end as a more interesting trade.  However, there was a buyer of 80k EDM7 9875/9862/9850p flies for 1.5 (settled there ref 9876.5).

–Implied vol remains soft.  During the day March TY vol eased under 5%.  TYH 124.25 straddle settled 1’14 or 5.0.  Atm TY straddles with only ONE week to go (rather than THREE) trade around or just under 1 point.  Also note that TYH options expire Feb 24, after Yellen semi-annual. Late in the day TYH 123.5p were 18 ask ref 124-12.  Low of the contract (TYH) in Dec was 122-14, so just on that basis 3 to 1 risk/reward.  Barring a geopolitical ftq event, growth and inflation prospects still argue for higher rates.

–BoJ is apparently having trouble pegging tens near zero, and, according to a Bloomberg item, bid today for unlimited quantities above the asking price.  The central bank is being tested, and with Japan having been ground zero for zero rates, a run on the BoJ wil reverberate globally, should it occur.
https://www.bloomberg.com/news/articles/2017-02-03/bank-of-japan-offers-unlimited-bond-buying-to-reassert-control

• BOJ first disappoints with lower-than-expected debt purchases
• Central bank then offers to buy unlimited amount at fixed rate

• ABOUT:
  Former member of the CME specializing in interest rate options and yield curve strategies.

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