Jan 1, 2017. Reminiscences

I was in the CME member breakroom at around 9:30.  The breakroom was in the southeast corner of the building, with large windows looking out onto the corner of Wacker and Monroe, a small retreat from the cavernous, windowless trading room.  There were a few CQG and newsfeed computers tucked just to the north, on the perimeter of the actual trading floor.  That’s where the disheveled, elfin Indian clerk with long wavy black hair would run his charts and mutteringly dispense ideas to anyone that would listen.  For some reason there was a Quotron in the actual lounge and I was in line to get a couple of stock quotes, with other people sitting around having a coffee or watching Sports Center.   Behind me was MA, a filling pit broker in eurodollars, also waiting to get quotes on stocks…because this was the year 2000, at the height of Nasdaq mania, (but you still couldn’t just punch up an instant quote on your phone).

————————————————————————————————————————————-

At this time of year a lot of analysts go through the exercise of reviewing last year’s trends and making predictions for the coming year — trying to identify the next cliché, I mean, black swan.  I’ve already read a few of those missives.  Some are thought provoking, but on the whole a bit B-O-R-I-N-G.

It sort of reminds me of Wayne’s World At The Movies review segment on SNL, with a synopsis of films including ‘Remains of the Day’.  Wayne: “I thought it was a tour de force portrayal of the repressed emotions of the English psyche, set against the backdrop of Fascistic pre-war Britain. …I thought it was breathtaking!  Garth?”  “Sucked”.  Most of the prediction lists can be tossed into Garth’s bucket.  However, a concise, informative review of the past year by Doug Noland can be found here:  http://www.safehaven.com/article/43360/2016-year-in-review

Back to my reminiscing.  Does it have anything to do with today’s markets?  Maybe not…but maybe so. Note: names and acronyms are changed below.

___________________________________________________________________________________

I had started at Refco just before the turn of the century, in late 1999.  The Refco Eurodollar desk was on the east side of the floor, all the way at the top level of the tiered desks that surrounded the pit.  Lehman was next to us, Chicago Capital was immediately below.  There were about eight of us at the desk occupying three booths, probably 30 sq ft of floor space.  Front month Eurodollars were directly in front, back months stretching to our left (south) and the ED option pit to our right.  The shape of the connected pits was roughly a rectangle that spanned nearly a full city block, with back month dollars at the south end, then the 3^rd and 4^th contracts, then the second and then the front month, with the back months at a higher elevation to provide straight sightlines, down to ground level in the front months, and again slightly elevated at the north end, the option pit.  On either side of this rectangle were desks, tiered up like a stadium.

Although the turn of the century was punctuated by concerns about Y2K computer problems and banks had curtailed trading activity because of possible computer system issues, the Nasdaq boom was in full force.  In the year from March 1999 to March of 2000, Nasdaq went from just below 2000 to just above 4800.   In the meantime, rates were increasing fairly aggressively.  It was way back in 1996 when Greenspan had opined “But how do we know when irrational exuberance has unduly escalated asset values, which then become subject to unexpected and prolonged contractions as they have in Japan over the past decade?”  Though that line got widespread notice, it was a bull market that shrugged off warnings from Central Bankers and everything else.

From mid 1999 until May of 2000, the FF rate went from 4.75% to 6.5%.  I know there’s a lot of talk of the ‘Greenspan put’ but compared to current CB policies designed to instantly countervail any ill winds that buffet the market, Greenspan used his power sparingly.  I would simply note that the Fed kept the FF target at 6.5% from May 2000 to December 2000 when a LOT of air was rapidly coming out of the Nasdaq bubble.  I recall one of my old clients from Bankers Trust (then at DB) telling me, “It doesn’t matter what rates do, these Nasdaq companies have no debt.  It’s all equity.  Higher rates don’t affect them.  And I would say “I don’t think that’s quite right.”  But he was long a ton of stock and was riding the Nasdaq bull.  Hard.  Just to think of it makes me smile, because I have a few stories about this individual, who embodied everything right and funny about this particular business.  Those stories are for later, in a more extensive format.

OK, let’s get back to the Quotron line and MA.  I’m in my grey mesh trading jacket and he’s in green.  VO is snoring in the lounge chair next to us with vending machine wrappings in his lap, having filled a bazillion options in the last 2 hours.  I punched up a couple of quotes and Mike says, ‘hey Alex, do you own any of this?’  And I said, ‘what?’  ECNC.  Now this was in February of 2000.  I said I didn’t.  He replied, ‘Everyone on the floor owns this thing.’  So I wandered back to my trading desk, having jotted down my quotes on a trading card and having ECNC on my mind.  And when I got to the desk, it wasn’t busy at all, and I said, “Hey, you guys ever hear of ECNC?” And I think Scooter was first to say he owned some, and someone else said I have some, and Doyle, just a junior clerk at the time said “I own a couple thousand shares.”  I, of course, was incredulous.  How had I not heard of this?  So I turned around and logged into my account and bought a few thousand shares myself, but it had already been moving.  Just to give you a flavor of the time, I didn’t know what the company DID.  I don’t think anyone at the desk knew.  The name of the firm (I learned later) was actually E-connect.

I don’t recall the exact price, but I paid something like 1.60.  It was then that I realized that our pit clerk in the third and fourth option (3^rd and 4^th contract months) owned something like 50k shares (his relative in NY at Merrill had given him the tip while it was still under $1).  I learned that traders in the option pit were also loaded up.  Crazily, within a few days, my shares had doubled.  I think I sold out half at something like $4.  And then it just kept running.  In hindsight I thought this took a MUCH longer time, but literally within about another week the shares had doubled again.  I sold the rest of mine at a price just below 10.  And of course, I was happy… for about a day.  But this thing had taken on a life of its own.  Chuck, the futures clerk who worked for UGG, was riding the whole position as I recall.  Next thing I know the stock is around $14 and moving higher, ultimately shooting over 20.  And I am saying to myself, “I am a F*$%&G idiot!  Why didn’t I just hold out?”  But I also remember thinking, unless these guys have cured cancer there is no reason this stock should be flying like this.  In any case, my self-loathing was short lived, because the stock was halted in mid-March due to creative financials.  It turned into a total loss for the guys that held it. In April, Zack told me his story.  He was a jovial clerk on the other side of the pit.  He said he owned it while he had gone to Florida on a vacation with the family, and was checking the stock from there.  He was having a grand old time, saying “So THIS is how the big guys do it, printing money while sitting on the beach drinking cocktails.”  He of course, returned home to a halted stock, worthless, but was laughing about it and enjoyed telling the tale.

So, how does the ECNC story tie in to today?  Well, maybe it doesn’t…but it’s better than a few half-baked predictions right?  While ECNC was one of many flame-out dotcom companies, its demise came just a couple of weeks prior to the ultimate Nasdaq top.  People were just buying into the story of untapped potential, riding the wave without really thinking it through.  It’s a crude analogy, but that’s what we’ve done with Trump as well, bought into the sales pitch without having much in the way of details about WHAT THE COMPANY DOES.   And, yes, monetary policy still matters.

Oh, by the way.  When looking back and doing some ‘research’ for this piece, I found out what E-connect did.  From a blog: Econnect Holdings in the spring of 2000 at $0.96 had a quizmo to attach to your computer that you could swipe your credit card through and pay for purchases on line. Seemed to be a good idea to me….

As another addendum, this is from a Bloomberg article dated December 27, 2016. (Vince Golle): “The last time Americans’ optimism about the stock market registered such a dramatic one-month surge was during the dot-com boom. As stocks reached a record, the share of households anticipating higher equity prices a year from now surged to 44.7% in December from 30.9% a month earlier, the biggest monthly advance since November 1998…”

__________________________________________________________________________

In terms of trade ideas, last week I pointed out that stocks had massively outperformed commodities, and as a prediction, I thought that trend would not continue.  An interesting side note comes from Doug Noland:  “Remember the fears for Glencore and other companies highly leveraged to commodities?  Well, Glencore’s stock ended 2016 up over 200%.”

Dec 30, 2016. Happy New Year!

–Yields again moved lower Thursday, with tens down 3 bps to 247.5.  Green and blue euro$ packs rose 4.625 bps.  While longer yields adjusted very quickly to the upside after the election, it’s somewhat surprising how little is being priced into nearer contracts in terms of Fed activity.  Trump is (in my opinion) choosing cabinet members who share his conviction that the US economy can and must release untapped potential.  Yet, EDF7, the January euro$ contract, settled yesterday right at the libor setting – 3m libor 0.9979 and EDF7 settled 9900.25.  In spite of a couple of large sales early in EDH7 at 9895, the contract settled yesterday at 9895.5.  The market is only pricing around 1 in 5 odds of a move in March.  There was an article yesterday in the WSJ about new Fed voting members Harker (Philly), Kashkari (Mnpls), Kaplan (Dallas), and Evans (Chgo).  Evans is quite dovish, and most analysts characterize the new FOMC as edging a bit more in his direction, which is by no means a certainty.  Tarullo, who is probably most involved in banking regulation is expected to leave shortly.  The point is that there may be more action in the front end of the curve than the market currently prices.

–On the other hand, the five year note has, just since the election risen 83 bps from 123 to 206.  A retracement of 0.382, would be 176 vs current 196.  There’s still room for yields to drift lower in the short term even in the context of a bear market.

–Yesterday’s trade deficit was wider than expected at $65.3b.  This should slightly trim GDP forecasts for Q4, and is a fresh reminder that global trade uncertainty can easily ratchet up volatility across markets. To wit….

–‘Flash’ move in the euro sent futures to a high of 106.93 this morning, though as of this writing we’re a handle off the high at 105.91 (still up 0.70 from yesterday’s close).  Obviously conditions will remain thin today.

–All the best in 2017!

Alex Manzara

Dec 29. Re-allocation

–Yields declined yesterday as the 5 year auction saw solid demand, 7 yr today.  The ten year yield fell 5.5 bps to 250.6, as talk of large asset allocation trades resurfaced.  Stocks finally saw small declines for the same reason.  Volumes remain very light.

–News today includes Jobless Claims and Internat’l Trade, expected $62 billion.  The dollar has given away some of yesterday’s gains, with GBP yesterday making a new low for December, and and EUR testing new lows for the move, both have seen small bounces today.

–What appears to be gaining more attention is cash controls in both India and China.  India is still feeling reverberations from its demonetization and China is struggling with capital flight.  According to reports, a $50000 limit to convert yuan occurs/resets in the beginning of the year.  The Chinese Lunar New Year (year of the Rooster) begins Jan 27.   It’s likely that some of the weight on treasuries has come from China selling reserves to support the yuan, but another sharp move like August of 2015 (China devalued) would probably remove a seller from the treasury market.

http://www.zerohedge.com/news/2016-12-28/china-facing-currency-liquidity-crises-ex-pboc-official-urges-use-nuclear-option

And for those making NY resolutions to exercise more…

http://www.nytimes.com/2016/12/28/sports/ed-whitlock-marathon-running.html

Dec 27. OTM put buying in April Five Year Notes…a Trump default? :-)

–Quiet session Friday with an uneventful January option expiration.  Yields edged lower with a slight flattening bias.  Ten year yield fell 1.3 bps to 253.5 while 2’s closed 120, up a fraction of a bp, as supply comes this week with 2’s today, followed by 5’s and 7’s Wednesday and Thursday.  The standout feature of Friday’s trade was a new buyer of 150k April 5y 94 puts for Cab-7.  That’s a bit over $1mm in premium for puts that are nearly 22 points out of the money.  (There was also a buyer of 39k TYJ 92p for cab-7). The current five year cash yield is around 2%, and these puts are at least 4.5% out of the money.  Think of it this way, the contract is based on a notional 6% coupon, so par is right around a 6% yield.  I don’t know the reason for this trade, but if you have any more to do please feel free to call.  Total open interest in April 5yr put options is now 260k, more than in February and March.

Dec 26 Weekly. S T R E T C H E D

There have been many times when trends change with the new year.  A notable recent example is 2013 when both the US ten year yield and red/gold euro$ pack spread traded over 300 bps, peaking right at the end of the year and then reversing, tracing lower throughout 2014.  I have never been given to using the turn of the year to forecast new themes, however, there do seem to be several examples of stretched markets at the end of 2016 which I touch upon below… not as a ‘Trade of the Year’ exercise, but just as food for thought.

The first theme is that of stocks priced in something else…a relative value idea.  Again?  Yes.  Again.  But with an additional twist this time.  Below is a chart of SPX divided by the Bloomberg Commodity Index*.  This chart is stark evidence of the dominance of financial assets over commodities.  From the low in 2008 it’s up 4 times, and is ending 2016 pretty much at its high.  I added the Federal Reserve’s balance sheet to this chart (that’s the twist), which appears to show that stocks tend to follow the Fed’s balance sheet with a lag.  Causation or coincidence?  I don’t know.  The interesting aspect of this chart is the last two years.  The balance sheet has flat-lined while stocks divided by commodities appears to have consolidated.  This would be one of my themes for the next year, the idea that commodities will finally begin to outperform stocks.  In terms of trades, I would in general favor long SPX puts vs long BCOM as equity index puts are fairly cheap currently.

In the chart above, I only went back ten years because that’s really when the Fed’s balance sheet came into play.  But just so that it doesn’t appear as though I am data-mining, consider the chart below.  This chart goes back 20 years, and importantly captures the dotcom boom of the late 1990’s.  That’s when the FF target was around 5% and the dollar index was right around its current level. (A higher interest rate means higher carrying costs for commodities, but also reduces the present value of future income streams).  The dotcom boom was when the promise of new technology spawned astronomical valuations.  We are currently nearly double that high!  Think about that for a second.  The BCOM index at the start of 2016 is approximately the same level as it was at the start of 1999!  But the global population is about 20% greater (6.1 to 7.4 billion).   I believe it was in 1998 when Jimmy Rogers started a commodity fund, noting that bull markets in commodities tend to run for years.  Giddyup.

Theme number two:  Corporate spreads to treasuries are likely too tight. The first thing I would note as an aside is that the Baltic Dry Freight Index is at or near its lows from the past five years.  Not exactly a ringing endorsement for the idea of growth in global trade.  But now let’s consider credit quality.  I am attaching a few charts here, some of which aren’t  exactly up to date — I just lifted them from a Business Insider compilation  (link at bottom).  First, from the St Louis Fed’s FRED data base, the BAML Corp BBB Spread to Treasury.

The last reading on this graph is 166.  I have taken it back only 5 years, but since 2008 the spread hasn’t been below 145.  Now consider this chart in the context of a couple of others.

The first chart below shows corporate debt as a percentage of GDP.  Although it’s only updated through June, it’s pretty clear that increased interest rates, should they move that way, will be somewhat problematic with respect to debt servicing.  We already know that government debt as a percent of GDP is near record levels, and is likely to increase in the near term.

 

The second chart, below, ties into both of the themes that we have covered so far.  It shows an increase in corporate defaults.  Obviously, this is partially due to the severe decline in energy prices in the beginning of the year that 1) was responsible for the low level of BCOM 2) caused corporate spreads to widen (the spike to 260 on the right hand side of the BBB spread chart is associated with energy) and 3) has to do with deterioration of balance sheets due to corporates taking on debt to buy back shares.

 

To repeat, the thought here is that credit spreads are most likely to widen.  Sure, a burst in GDP due to new policies unlocking the potential of the US economy would likely justify tight spreads, it just seems prudent to look to the future with a healthy dose of skepticism.  As Mohamed el-Erian said last week “We’ve priced in no policy mistakes.  We’ve priced in no market accidents, and we’ve ignored all sorts of political issues.”  With respect to the last I would just mention that China has said they’re not wedded to the goal of 6.5% growth, and I would further note that Trump’s pivot away from China is raising the odds of conflict, as evidenced by new naval exercises by China’s aircraft carrier and war ships in the South Sea.

 

Finally, the spread between German and US yields is going out at the high of the year.  In February, the spread between the Bund to UST 10y was 143 bps.  From March to October it was stable between 155 and 175 bps. Friday it was 230 bps, nearly 100 bps higher than the year’s low.  I have no inclination to fade this particular move.  While there were some measures last week that lessened uncertainty in the financial system, there is by no means resolution of core problems.  By the way, EURUSD is ending the year near the absolute low, and the Dollar Index near the absolute high.  In general, it seems that turning points in the dollar typically occur in the first quarter.  Should be plenty of opportunities in 2017!  Good luck trading.

Dec 23. The airing of grievances

–Happy Festivus.  And to others, a Merry Christmas!  Monte dei Paschi nationalized; Deutsche and CS settle US mortgage grievances, which I suppose ends uncertainty and is thus a weight off the european banking system.  So Italy shifts the burden to taxpayers, but if that ‘burden’ is in the form of newly issued debt and the ECB buys those bonds as part of ongoing QE is there really a problem?  A tree has fallen without a sound.   Perhaps this situation resolves with a lower currency, which has already occurred to some extent, but the euro is slightly higher this morning and gold is steady.

–Speaking of currencies – and BC, you can stop reading right here, as ironically your initials are exactly the same as your favorite virtual investment – Bit Coin has soared above 900 today, up another 5%.  It’s now within shouting distance of the high set in November 2013 which looks to be 979.  Does it say anything about the state of the world when the best investment is a digital currency?  (Which can be used to buy a virtual girlfriend…)

–Maybe it’s mostly about China, as Carl Icahn spoke openly on a CNBC interview yesterday about a trade war… “maybe we should just get it over with…”  It appears as if every day that advances towards the inauguration, tensions with China are going to creep higher.  So far CNY remains below 7, but that cap looks tenuous as 2017 approaches.

–Interest rate futures were quiet yesterday.  Jan treasury options expire today; TYF 123.25 settled at just 13 yesterday.

TLT call buying….comparison with 30 year treasury yield

Below is a chart of TLT etf and the 30 yr Treasury yield.  TLT seeks to track the results of US treasuries with remaining maturities greater than 20 years.  Over the past two sessions there has been reasonably large buying of Feb TLT calls.  Yesterday the Feb 126c were bought in size of 105k and today 50k of the Feb 127 calls bought. The expiration date is 17-Feb.  Currently the Feb 127c are $0.34 with the underlying at 117.70.  According to my (unscientific) chart below, the 127 strike is somewhere around 2.80% vs current yield of 3.13%.  These levels would represent a fairly significant retracement of the recent surge in yields. 

 USH treasury options expire one week later on 24-Feb.  In the USH contract, a move to 2.80% would put us somewhere around the 156 strike, currently 0’33/0’35 ref 148-21.

NOTE: This graph is just for the purpose of exposition; I did not look at specific calculations for yield levels and comparisons between bond futures and the etf.

 

Dec 21. Is back end of dollar curve too flat?

–Though volume was light and net changes relatively small, interest rate futures continue to trade heavy.  The ten year yield rose 3 bps to 256.4, and 2/10 spread notched a new high at 134.4.  Eurodollar contracts were down 1 to 2 bps across the curve, and with sightly lower prices came firmer vol.  Someone is looking for an interesting end of the year, as TY week 5 (expiring Dec 30) 123/121.5 put spreads were bought 10k.  New position, settled 19 ref 123-04.  This Friday’s 123 straddle (TYF expiry) settled at 30, and week-5 settled 52.  Though economic data might be sparse, a combination of thin markets and uncertainty in the Italian banking system almost makes next week’s straddle seem cheap (for those who will be hanging around watching).

–On the eurodollar curve, the red/green/blue pack butterfly settled at 16.25…a fairly robust level.  Red/green (these are one-year spreads, 2nd to 3rd year) settled at 43.25 and green/blue (3rd to 4th) at 27.0.  If forced to make a choice I think I would prefer buying green/blue spreads near 1/4%.  Though current perceptions are that the Fed will be more aggressive over the near term, that’s no where near a certainty.  Additionally, straddle spreads between atm green and blue midcurves indicate healthy fear of more volatility further out the curve.  Blue atm straddles are 5-7 bps higher than greens.  For example 2EM 9775^ settled 53.5 and 3EM 9737.5^ settled 60.5. I suppose the point is (if I have any point at all) is that both calendar spreads and vol spreads have loosened up quite a bit given moves post election and post FOMC.

Dec 20. Flows favor USD and US assets…for now

–Curve edged flatter on relatively light volume yesterday, with the ten year yield falling over 5.5 bps to 253.3 and 2/10 treasury spread down 2.7 to 131.3.  Red/gold pack spread (new, starting with March contracts) fell 2.5 to 89.125.  One of the trades that was supportive of the back end of the curve was a partial unwind of a red/blue option steepener.  The original trade was selling 0EH 9837p to buy 3EH 9762p for 3 and 3.5 (though there were a few permutations).  On its own the original trade settled 10.5 (16.5 and 27). Yesterday, there was a buyer of 50k 0EH 9837/9787p 1×2 vs selling 3EH 9762p at 15 to 14.5.  The selling of blue puts put a bid into the back end of the dollar curve while simultaneously pushing down vol.  Green and blue midcurve straddles eased 1-2 bps and, of course, treasury vol also compressed slightly on the rally.  EDM7 9875 straddle settled at just 15.5 on selling of the put with 182 days to go.

–Later in the session Yellen’s comments regarding the strength of the labor market (…”best job market in nearly a decade for college grads”) caused a pullback in futures.  However, the assassination of the Russian Ambassador to Turkey and a terrorist attack in a Berlin market kept safe-haven treasuries on notice for geopolitical tensions.  It’s also worth mention that Italy appears to be preparing for a state bailout of the banking system.  All of the above contribute to a stronger dollar and weaker euro, and this morning EUR is below 104.  There was also an item on Bloomberg noting that the Malaysian ringgit is at its weakest level since the 1998 Asian crisis and yesterday Indonesia was reportedly considering lopping several zeroes off its currency to maintain some semblance of decency.  Probably just a matter of time before CNY breaks 7.00.

–Currently curve is reversing a small part of yesterday’s flattening.

Dec 19. In 2013, yields pushed higher right up to the end of the year…then started to decline

–Front end of the curve has seen steepening since the FOMC.  For example, in euro$’s, March/June closed 19.5 on Friday, the peak three month spread. [Note that EDH7 expiry is 13-Mar and the FOMC is 15-Mar.  We will NOT know the outcome of the FOMC for March expiry]. Recall that in October, three month spreads were more like 3-4 bps.  Some of the one year calendars posted new highs as well, with the peak remaining March’17/March’18 at 66.5 bps, forecasting a bit closer to three Fed hikes in the new year rather than two.  As a contrast, consider the 5/30 treasury spread.  Just prior to the Fed it was posting new highs of 127 bps, but on Friday it closed at 110.  I marked it roughly at 106 on Thursday.

–In terms of another near term Fed hike, the Feb/April FF spread settled 6, so about one in four chance of a hike in March.  (The Jan/April spread settled 7, and Jan/Feb at just 1.  So there’s really nothing priced for the chance of a hike at the Feb FOMC meeting, or even a soft turn).

–Implied vol reflects the curve dynamics.  Five year vol remains solidly above the midpoint of its recent range, while the longer end premium had some air let out, and is now closer to the low end of the recent range.  Having seen stocks surge and oil remain well bid after the election, the long end of the market is, perhaps, becoming a bit more circumspect with regard to actual inflation prints.  Obviously, recent moves have all been on changes in perception.   Some analysts are leaning against this tide.  For example, here’s a snippet from David Rosenberg, “The economy isn’t that strong and anyone who thinks one man can reverse on his own the structural forces that led to the multi-year disinflation trend — and I’m talking about excessive debt, globalization, aging demographics and technology — needs to go back to economics school right away.”  It’s true that strong headwinds articulated by Rosenberg still remain.  But it’s also true that the lessons from ‘economics school’ are being re-written due to recent history.

–Yellen speaks about labor markets this afternoon (victory lap?).  January treasury options expire Friday.

• 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.