Sept 18. A Hawkish Pass

The Fed is not going to hike on Wednesday.  The data has been weak, and the market has been reminded repeatedly of data-dependency, even though the data is utterly unimportant in the context of a shift in both internal central bank polices and external perceptions thereof.  Most importantly it’s a political decision.  The Fed has no desire to insert itself into the political process any more than it already has.  The last thing Yellen wants to be accused of is throwing the election or engendering a large stock market sell off a mere six weeks in front of voting day (from the FOMC announcement).   There has already been a tightening with the rise in Libor, and even though that adjustment is probably significantly over, the money market reform end date is October 14, which is just 4 weeks away.  There’s no upside to tightening now when the market is pricing low odds, as Yellen can simply use the press conference to signal the move in December.

You might recall the above scene from Trading Places, where Mortimer Duke has just enticed Billy Ray Valentine (Capricorn) into his chauffeur driven limousine by waving a bottle and saying “Whiskey!  All you want.”   In the current case, Mr Valentine is the public, the Duke brothers are the Fed and other CBs, and the whiskey is NIRP and QE.

The premise of the movie is a bet between Mortimer and Randolph Duke about the benefits of good breeding versus growing up in disadvantaged circumstances.  A wager on a social experiment of nature vs nurture.  It’s a metaphor for the current state of the markets.  You probably remember that Billy Ray is rather suspicious of the Dukes at the outset, but then he goes along with the plan, not initially understanding he’s being played.  In a similar way, the Fed and other central banks have engineered a grand experiment of negative rates, quantitative easing and forward guidance, on the public that won’t completely take the bait.  Oh of course in some ways they have fun with it.  Billy Ray starts off with a big party.  The corporate hierarchy takes free money, loading up on debt for stock buybacks to juice up earnings per share.  But at the end it’s a big mess as the guests are shown the door.

Bernanke put out a blog this week saying that “Economic THEORY suggests that aggregate demand responds to the real rate of interest, which is the nominal (market) interest rate minus the public’s expected rate of inflation.”  Randolph Duke was similarly taken with pseudo-scientific notions.

Joseph Stiglitz had a somewhat interesting clip explaining his frustration about government debt.  The gist of his argument is that you have to compare debt against assets (as one would ordinarily do in a business) to evaluate the entire picture.  However, with government debt, people simply focus on its growth and nominal level, not at all on the increase in assets like improved infrastructure and more educated people (human capital).  He infers that gov’t ‘investments’ will ‘pay off’.  He says [the gov’t] “can borrow at minus pct, you’ve got a 20-30% real return. It’s foolish not to make those kinds of investments.”  What have we actually seen?   Total debt has exploded, but GDP hasn’t grown that much.  A business might say, it’s not WORTH taking debt to expand capex in this environment.  http://www.businessinsider.com/economist-joseph-stiglitz-on-deficit-fetishism-2016-9

We’re nearing the point where the pseudo-scientific premise of central bank policy is crumbling.  This idea is even more apparent with the Bank of Japan, which also meets this week.  While the US yield curve from 2’s on back has been in a ripping rally this month, a shift by Japan to focus on NIRP as the centerpiece of its policy, while shying away from QE and (perhaps) ETF purchases could further steepen global curves.  Consider the 5/30 spread in Japan.  In February it was as high as 130 bps, and then proceeded to collapse to 37 by the end of June.  As of Friday it’s 76.  5/30 in the US has gone from 104 to 129 this month.  If the Fed passes and the BoJ moves forward on the idea of a reverse twist (relying on NIRP and buying shorter term rather than longer maturities), then short curve positions will be in full on exit mode.

The Dukes’ experiment completely imploded when Valentine and Louis Winthorpe III realized that they were being treated like pawns.   It’s a cautionary tale for the Central Banks of the world.

“Just be yourself sir, they can never take that away from you.”  –Coleman (Winthorpe’s butler) to Billy Ray Valentine.

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Sept 16. Sept rate hike odds have evaporated

–This morning Deutsche Bank is down 7% as the bank balked at a $14 billion levy by the US Dept of Justice.  An article on BBG says that large banks are resisting Basel III regulations: “Some European officials went so far as to say they wouldn’t adopt the proposals on the table, according to the people, who asked not to be identified because the deliberations were private. If the European Union — home to nearly half of the world’s most systemically important banks — balks at implementing the Basel Committee’s rules, it could undermine the global regulator’s authority and contribute to fragmentation of the industry.”

http://www.bloomberg.com/news/articles/2016-09-15/europe-said-to-threaten-revolt-over-bank-capital-rule-overhaul

Uncertainty in the banking system due to regulations and central policies is likely an impediment to the larger economy.

–Crude oil is pressing lower this morning and testing the low of the month, now at 43.40 after having been as high as 4900 in mid August.  The Mexican Peso has also been crushed, now at 19.33, making it ever more enticing for companies to move manufacturing south. Announced yesterday: Ford moving all small car production to Mexico.

–In the US, economic data was bad yesterday with Retail Sales -0.3% and Industrial Production -0.4%.  The curve continued to steepen as odds of a Fed hike for September are all but eliminated (FFV6 trades 9958.5 this morning).  2/10 made a new high at 97 bps and 5/30 rose 3.8 bps to a new high of 128.5.  Today CPI is released expected +0.1 with Core +0.2.  Yields are lower across the board this morning, but the longer end of the curve is vulnerable to being buffeted by central banks, with both the FOMC and BoJ next week.  Midcurve options and equity options expire today.

Sept 15. Theory vs Reality

–Yields fell yesterday with the ten year easing 4.3 bps to 168.9.  However, the curve continues to steepen as shorter maturity yields fell faster.  This month’s move in the 5/30 spread has been spectacular, running straight up since the beginning of the month from 103 bps to yesterday’s 124.7.  2/10 treasury spread was 75 bps at the end of August; it ended yesterday at 93.5.  These moves are indicative of longer term bottoming price action.

–Interestingly, the November to January Fed Fund spread declined 1.5 bps yesterday to 8.5, trimming odds of a December hike to around 1 in 3, partially in response to a drop in oil of over 1.30 yesterday to 43.58.  Next week brings the FOMC and BoJ meetings.

–There is a lot of economic data today, including Empire State expected -1.0, Retail Sales expected -0.1 and ex-auto and gas +0.3.  PPI expected +0.1 both headline and core.  Philly Fed 1.0.  Industrial Production -0.2.

–Here’s a line from Bernanke’s latest blog, a discussion of negative rates vs higher inflation targets.  “Comparing a strategy based on a higher inflation target with the use of negative rates is natural because, as just mentioned, they work through the same channel. Economic THEORY suggests that aggregate demand (consumption and investment) responds to the real rate of interest, which is the nominal (market) interest rate minus the public’s expected rate of inflation.”  This points out the main problem with central bankers and models.  In theory, consumption and investment respond, but in reality, the public loses confidence in an environment of negative rates and central banks that appear to be out of touch.  There’s a joke about the difference between theory and reality…oh, just look it up Ben (though you might not understand it)

Sept 14. Keeping up with the Joneses, risk parity style

Sept 13. Brainard throws cold water on Sept hike; greenlights steepeners

–Brainard’s speech yesterday caused the market to defer expectations of a hike from next week to December.  October Fed Funds settled up 2 at 9957, indicating less than 15% odds of a hike in Sept, while Nov/Jan FF spread rose 0.5 bp to a new high at 10.5, odds of about 42% for December.  While stocks celebrated continued easy money with a blistering rally that erased a large part of Friday’s sell off, the longer end of the treasury market was more circumspect.  In comments this weekend I noted the 2/10 treasury spread was breaking out to the upside; yesterday it hit a new recent high of 90 bps, up 1.5 on the day.  In eurodollars, the red/gold pack spread rose 2 bps to 47.875, also a new high, though still muted.  5/30 treasury spread rose 2.7 bps to a new high of 119.4.  Today brings the 30 year bond auction.

–While Brainard is concerned about depressing inflation expectations, it’s somewhat interesting that the back end of the euro$ curve is finally displaying a bit of curvature.  For example, red/green/blue butterfly settled -2.375.  Closing one year pack spreads are as follow: red/green 13.875 bps, green/blue 16.25 and blue/gold 17.75.  My bias is to interpret increased steepening along the back end as a slight increase in term premium/inflation.  Perhaps grasping at straws, but worth a mention.

Sept 12. Why, he stubbed his TOE!

–Pneumonia?  She’s been coughing for months.  Who’s her doctor?  Phil?  In any case uncertainty is rising in front of the US election.  In Europe, following up on Draghi’s comments last week that ‘structural reforms need to be substantially stepped up’, Dijsselbloem came up with this solution:(Reuters)  “Times are changing. You need to pay your taxes in a fair way. Part of that would be in the U.S., part of that would be in Europe. So get ready to do that,” Dijsselbloem added.  Is that what Mario meant?

Abby Normal

The central theme of this week’s note is that IF the change in perception of central bank policies is edging toward a tipping point, then violent re-pricing is possible across many asset classes.  The market has become so used to the idea of central bank backstops that there’s institutional amnesia about how things *could* shake out.  Once again, IF perceptions change, then economic data like the weak Service ISM released Tuesday won’t make much of a difference, as seen on Thursday and Friday (as tens rose 14 bps and SPX fell 2.5%).  “But,” one might argue, “the Fed continues to talk about ‘data-dependency.’”   Right, that’s something you’re going to have to ignore. This note may seem a bit long, but there are plenty of pictures and charts.

Is it too late for a ‘Young Frankenstein’ tie-in in honor of Gene Wilder?  I think not.

You are talking about the nonsensical ravings of a lunatic mind.  Dead is dead. –Dr Frederick Frankenstein.

Dr Frederick Frankenstein: [to Igor] Now, that brain you gave me.  Was it Hans Delbruck’s?

Igor: [pause, then] No.

Dr. FF: Ah! Very good. Would you mind telling me whose brain I DID put in?

Igor: Then you won’t be angry?

Dr FF: I will NOT be angry.

Igor: Abby someone

Dr FF: Abby someone.  Abby who?

Igor: Abby… Normal

Dr FF: [pause, then] Abby Normal?

Igor: I’m almost sure that was the name.

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

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On Thursday, much attention was focused on the unexpected scheduling of a speech to be given Monday by Fed Governor Lael BRAIN-ard.  (See how cleverly I worked that in?)  As Barron’s noted,” It’s not often that a simple press release announcing that a Fed governor will be delivering a speech the following week is enough to spark a selloff in Treasuries.  But that’s apparently what happened Thursday.”  The theory is that Brainard has been quite dovish, and if she signals comfort with the idea of normalization (just prior to the Fed’s blackout period) then the market will HAVE to price increased odds of a hike, even for September.   Note that Oct FF settled 99.550 Friday; the lowest settle was 99.520 on the Friday of Jackson Hole.  At 99.550 the odds of a Sept hike are just north of 20%.

Below are a couple of quotes from Brainard’s last speech on June 3.  (Emphasis added)

The fragility of the global economic environment is unlikely to resolve any time soon. Growth in the advanced economies remains dependent on extraordinary unconventional monetary policy accommodation, while conventional policy continues to be constrained by the zero lower bound. Conventional policy, whose efficacy is more tested and better understood than unconventional policies, can respond readily to upside surprises to demand, but presently would be constrained in adjusting to downside surprises. This asymmetry in the capability of policy effectively skews risks to the outlook to the downside.

“DEPENDENT on extraordinary unconventional monetary policy.”  You might even call it Abby Normal.

Thus, although some signs point to a firming of inflation going forward, I view the persistently low level of inflation during the recovery together with some signs of a deterioration in inflation expectations as suggesting that the risks to the return of inflation to our 2 percent target over the medium term are weighted to the downside.

It’s not going to take much of a change in tone from the cautiousness LB expressed in the beginning of summer to convince the market of a sentiment change.  In that speech she talked about risks related to Brexit and China, from which fallout so far seems negligible.  GDP estimates from Atlanta and NY for Q3 are still solid, at 3.3% and 2.8% respectively.

Perhaps more important than Brainard’s speech was this item from Reuters: The Bank of Japan is studying several options to steepen the bond yield curve that might be debated at this month’s rate review as part of measures to fine-tune its massive stimulus programme, say sources familiar with its thinking.  They are brain-storming ways to cut short- to medium-term bond yields, which affect corporate borrowing costs the most, while pushing up super-long yields from undesirably low levels, the sources said on condition of anonymity. (Link to article at bottom)

“Brain-storming”.  Very reassuring.  Note that 10 yr JGB yields have already jumped over the last month from around -30 bps to just under zero at -2 bps on Friday.  As Draghi this week declined to add stimulus through additional bond buying, the German ten year bund yield crossed the zero axis to close at +1.1.  There’s a chance this whole monetary experiment that’s been cooked up and stitched together in the castle laboratory may run amok.

Earlier in the month Bloomberg noted that Blackstone was shunning long term Treasuries:   “We think the Fed is likely to allow inflation to run hotter than its target for a while,” Rick Rieder, the chief investment officer of global fixed income in New York, wrote in a report Sept. 2. “While we have believed that there was more value in longer-end interest rates over the past year or so, we are more comfortable holding shorter, or belly, interest rate exposure.”

Take a look at the chart below of the ten year treasury yield.  On a technical basis, a double bottom has formed with lows in 2012 of 1.39% and in July of this year at 1.36%.  The two lows look quite similar in terms of formation, and in 2012, the yield ran up to 2% by the beginning of the next year.  In the current rendition, the 2% area is where a descending trend line comes in; approx. 127-24 basis TYZ6.

However, the key take-away is what happened in the middle of 2013, the infamous “Temper Tantrum” as Bernanke hinted at an end to bond buying.  Once again, the point to be aware of is that in the current case, it’s not simply the Fed that’s trying to ‘fine-tune’ policy, it’s also the ECB and the BoJ, and to some extent the BoE, where Carney ruled out negative rates in August:  “I’m not a fan of negative interest rates,” said Carney. “We see the negative consequences of them through the financial system; we’ve seen that in other jurisdictions; we see the issues with savers.”

Note as well the incipient break out of the 2/10 treasury spread.

There’s a tendency to think that stocks and bonds will continue being negatively correlated.   Actually, in 2013 as bonds sold off, stocks were able to trade higher throughout the year.  However, all asset classes have since been supported by central banks.  If that support looks fragile, it can all come down together.

And finally, to wrap up with another brain reference (supposedly from an actual trial):

Attorney:  Doctor, before you performed the autopsy, did you check for a pulse?

Doctor: No.

Q: Did you check for blood pressure?

A: No.

Q: Did you check for breathing?

A: No.

Q: So, then it is possible that the patient was alive when you began the autopsy?

A: No.

Q: How can you be so sure, Doctor?

A: Because his brain was sitting on my desk in a jar.

Q: But could the patient have still been alive, nevertheless?

A: Yes, it is possible that he could have been alive, practicing law somewhere.

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http://www.reuters.com/article/japan-economy-boj-options-idUSL3N1BL2RK

Sept 9. When faith in Central banks crumbles, stocks and bonds will fall together

–Draghi spurred a sell off yesterday as he quashed hopes that the ECB would be more aggressive in terms of stimulus.  The ten year yield rose to 161.3, up nearly 8 bps, almost a complete reversal of Tuesday’s rally associated with weak Service ISM and Labor Mkt Conditions.  Euro$ calendar spreads firmed.  For example, red/gold pack spread rose 3.375 bps, however, it’s still below 43.

–Bearish factors for fixed income include the surge in Crude Oil to a new high in the month of September.  CLV6 settled up 2.12 to 47.62 as inventory levels saw a substantial draw.  Additionally, US Treasury auctions of 3, 10 and 30 year paper occur in the beginning of next week, with both 3’s and 10′ s on Monday and 30 year bonds on Tuesday.

–It’s worth noting that ESZ (mini SP) had an outside day and closed lower, though the range wasn’t particularly large.  The true change in trend will likely be a result of repudiation of central bank policies; Gundlach did his part in his quarterly review yesterday. News in the US is light today with Wholesale Inventories.  German trade data reported this morning, was weak.  From Reuters “German exports fell sharply in July, shrinking the overall trade surplus for the fourth consecutive month — something not seen since 1992…”

Sept 8. FOMC Conditions, Sept 2015 to Sept 2016

Just a couple of thoughts about the FOMC meeting on Sept 21. Going into the September 2015 FOMC on Sept 17, the Fed had been prepping the market for the possibility of a hike.  Ultimately, the Fed passed on a move in September and instead hiked in December.  We’re facing a similar situation now.  However,  as can be seen on the chart samples below, there was a degree of stress in 2015 which is not evident today.

For example, in August of 2015 China devalued. The idea of tighter financial conditions weighed on US equities (SPX was around 1950 as opposed to 2180 now), and was an especially unwelcome prospect for emerging markets.  As can be seen in the second panel, EEM and hi-yield had been selling off from June until September of 2015.  In contrast, both markets have now been rallying since June.  The third panel below shows that the Five Year Treasury yield was around 1.50% in Sept of 2015, but is now only 1.20%, in spite of the intervening hike.  The 4^th panel below is the spread of the 2^nd red to 2^nd green eurodollar one-year calendar.  Note that in September of 2015 this spread was around 55 bps, now it’s less than one quarter of that level at a mere 12 bps.

From a cursory review of these charts, there appears to be nothing which would stop the Fed from hiking now. Risk markets are faily well juiced, and the five year yield indicates an expansive policy.  The odd man out would appear to be the flatness of the eurodollar curve, as inflation expectations just don’t seem to have taken hold as yet.  Most other indicators provide a green light for a rate hike now.

CHART 1 is SPX…look how much higher we are now!

CHART 2 is EEM and HYG …both higher now that in 2015

CHART 3 is DXY (dollar index) and Five Year Treasury Yield

CHART 4 is 2nd Red to 2nd Green Euro$ calendar spread (Now EDZ17/EDZ18)… flat

Sept 7. Persistent regime….persistently weak

–Yields plunged as Service ISM sank to its lowest level since 2010 at just 51.4.  The Fed’s Labor Market Conditions Index also fell to -0.7.  The ten year lopped off 5.5 bps to 154.1.  Even more ominously, some of the deferred one year eurodollar calendar spreads made new lows, with June’17/June’18 at just 11 bps.  It’s not just that odds for a near term hike are being squeezed out, it’s that the interest rate market perceives a stalled economy way out into the future.  Maybe Pravda has it right: “The US Economy is Clinging to Life”  http://www.pravdareport.com/business/finance/02-09-2016/135510-us_economy_debt-0/

This article also helpfully points out that the US has run out of money to pay for any large scale global conflicts.

–In any case, precious metals soared on the news, with Gold jumping over $27 /oz and Silver vaulting back over $20, gaining 72 cents.  On the other hand, crude oil gave away much of Monday’s gains associated with potential production cuts.  CLV settled just under $45 having been well above $46 on Monday.

–The Fed’s communication policy thus faces more challenges.  For example, a few days ago SF Fed’s Williams suggested the Fed should increase its inflation target.  Larry Summers made a similar point yesterday, saying that the Fed should stand pat until the economy is on much more solid footing.  However, Williams yesterday said it “makes sense to get back to a pace of gradual rate increases, preferably sooner rather than later,” in remarks prepared for delivery to the Hayek Group. (RTRS)  Maybe Bullard has it right, we’re in a persistent regime and might as well just act as though it’s going to continue.

–Beige Book this afternoon.  

• 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.