Sept 4. Fed hiking schedule still up in the air
Friday’s employment data was tepid with Nonfarms up 151k, but not quite soft enough to take a September hike off the table as the previous month was revised +20k to 275k. On the week, treasury yields fell a few bps, with the two year down just over 5 to 79. The curve edged slightly steeper. Fed Funds contracts marginally shifted the odds further in favor of a December hike. October FF settled 99.545 vs the just expired August contract at 99.603, a spread of 5.8 bps, indicating around 1-in-4 for September. I would note that October has the largest open interest of any FF contract, followed by November and January. The Nov/Jan calendar spread isolates odds of a Dec hike; it settled at 9 bps, so better than 1 in 3 for December. The Sept/Dec Eurodollar calendar spread closed at a new high of 8.25 bps, with EDU6 +1 on Friday, and EDZ6 -1.
Markets have been coiling sideways, spreads are stuck in cement. Every euro$ one-year calendar spread from Dec’16/Dec’17 to Dec’18/Dec’19 is between 13 and 17 bps. Implied vols are low and were further pressured Friday as the week ahead is light on news. (Service ISM Tuesday, Beige Book Wed). One market that did tentatively break out of this year’s downward channel is $/yen (orange line).
Also included on the chart above is the US Five Year Treasury yield in white. Not much of a move this week, but it too has broken this year’s downtrend. Nothing too surprising on this chart except for the extremely close tracking since March. The Fed is looking to hike, so rates push higher and USD strengthens in a welcome development for the BoJ.
Moving from Japan to China, the chart below touches on the Impossible Trinity, which states that out of three policy objectives of setting the FX rate, or the domestic interest rate, or allowing the free flow of capital, only two can be achieved. The chart below suggests that China has chosen to focus on its goals through policies 1 & 2. Chinese Reserves are in white, the yuan in red (inverted on this chart so that down and to the right indicates a weaker yuan), and China’s ten year yield is in green. What’s interesting here is that reserves have been held constant in 2016 and rates have fallen, which makes it appear as if further currency depreciation is in the works. In 2014-15 China was spending reserves to hold the currency relatively steady in the face of a slowing economy. In August 2015 came the overt devaluation which has continued ever since.
While currency depreciation had been associated with capital flows out of China into “relative” stores of value including high end real estate in the US and elsewhere, there are signs that these flows are being staunched.
For example, a Bloomberg article this week noted that high end projects in Manhattan are offering discounts and incentives. “…developers are coping with a luxury condo glut and adjusting to a new reality after years of building to meet seemingly insatiable demand. With the market now sputtering, they’re altering sales plans and making behind the scenes deals…” An FT Alphaville story notes that Swiss watches have seen a sudden drop in demand related in part to a Chinese anti-corruption and gift giving crackdown.
Stephen Roach writes that “…the Chinese economy accounts for fully 18% of world output (measured on a purchasing-power-parity basis). If Chinese GDP growth reaches 6.7% in 2016 – in line with the government’s official target – China would account for 1.2 percentage points of world GDP growth.”
However, if China is attempting to meet those growth targets through fx depreciation, it only adds to global pressures to construct trade barriers. The free flow of goods and services and capital tends to hold prices down, restrictions on those flows will have the opposite stagflationary effect.
Once again, the conclusion is not that US growth is about to accelerate and force rate increases. (However, note that Q3 estimates from the Atlanta Fed and NY Fed aren’t too shabby at 3.5% and 2.8% respectively). It’s that years of weak capex have led to productivity declines (unit labor costs +4.3% in the last quarter), and that trade impediments create higher prices at the margin. Central banks are aware of monetary policy limitations and want to push fiscal initiatives.
_________________________________________________________________
| 8/26/2016 | 9/2/2016 | chg | |
| UST 2Y | 84.3 | 79.0 | -5.3 |
| UST 5Y | 123.7 | 118.8 | -4.9 |
| UST 10Y | 163.1 | 159.6 | -3.5 |
| UST 30Y | 229.2 | 227.0 | -2.2 |
| GERM 2Y | -61.6 | -63.0 | -1.4 |
| GERM 10Y | -7.2 | -4.3 | 2.9 |
| EURO$ Z6/Z7 | 19.0 | 17.0 | -2.0 |
| EURO$ Z7/Z8 | 14.0 | 12.5 | -1.5 |
| EUR | 111.97 | 111.56 | -0.41 |
| CRUDE (1st cont) | 47.64 | 44.44 | -3.20 |
| SPX | 2169.04 | 2179.98 | 10.94 |
| VIX | 13.65 | 11.98 | -1.67 |
_________________________________________________________________
http://ftalphaville.ft.com/2016/08/31/2173711/a-bonfire-of-the-swiss-watches/
Sept 2. Employment day… does ISM matter for the Fed?
–The session started with weakness in treasuries, with data on Jobless Claims and Productivity about as expected, but Unit Labor Costs were +4.3%, not exactly great for corporate profits. However, the market reversed on much weaker than expected ISM of 49.4 vs 52 expected. Rates were mostly unchanged across the curve.
–While ISM caused shorts to cover, it won’t necessarily stay the Fed’s hand in terms of a hike, especially if Payroll data today is robust. I would note that there was a late seller of 14k FFV6 at 9954.0, risking 6-6.5 to make 18-19 on a Fed hike in Sept. Open interest in FFV was +18k.
–Payrolls expected 175k. The market is not looking for much with all Sept midcurve atm straddles 14.5 or lower with two weeks to go.
–Oil has had a fierce sell off in the last two weeks, falling over 10% from the high around $49 in CLV6. It’s seeing a small bounce this morning, currently over 43.50.
August 31. Surprise policy path
–Little net change in rates yesterday. USD strengthened, having bounced against the yen to over 103 from below 100 last week. Today’s news includes ADP expected 175k and Chicago PMI at 55.2. The big report is Friday’s employment situation, with NFP expected 175-180k.
–Quotes from both Chicago’s Evans and Boston’s Rosengren hint at a faster pace of tightening (Reuters). Even though Evans appears to be more in the secular stagflation camp he said, “Long-run expectations for policy rates provide an anchor to long-run interest rates. …So lower policy rate expectations act as a restraint on how much long-term rates could rise following a surprise over the near-term policy path.” A surprise over the near term path?? Rosengren is more explicit,
“A somewhat faster move to rate normalization may defer somewhat how quickly we achieve the dual mandate goals of full employment and price stability, but could reduce the risk of a larger divergence from the dual mandate in the next downturn,” Rosengren, a voter on policy this year, said in prepared remarks to be delivered in Beijing. While Fischer’s comments yesterday morning were met with a yawn, the idea of a slightly more aggressive hike pace seems be in the Fed’s playbook, and clearly is NOT priced into euro$ calendar spreads.
–An interesting side note since Evans and Rosengren were both addressing a finance conference in Beijing, the yuan continues to appear as if could test new lows over the short term (now at 6.68), and China’s ten year bond yield has had a 17 bp jump from last week’s low of 263. Recall that last August was the Chinese devaluation that sent a shiver through global risk assets; what we are seeing now is more of a slow drip, but at the margin the pressure is the same.
August 29. Don’t fight the Fed?
–In past history, the market adage was ‘Don’t fight the Fed’. On Friday, after a small tussle at the release of Yellen’s speech, Fischer was unequivocal about the chance of a near term hike and possibly two this year. The market took the message and fixed income markets sold off with blue euro$’s (4th year) the weakest part of the curve, down 9 bps. The ten year yield rose 5.6 bps to just above 163. However, even with increased odds of a hike having been priced in, there’s plenty of uncertainty about truly trusting in the Fed’s message. Perhaps that’s because the message has been muddled, perhaps it’s partially because a stronger dollar as a result of even modest tightening will be perceived as a restraining influence on the economy. My thesis has been that the Fed’s consistently lame expectation for an increase in inflation will finally come to pass this year, due to yoy comparisons in energy, slower global trade that snuffs out price competition through regulatory impediments, and the possibility of fiscal stimulus, perhaps by government plugging the hole of private capital expenditure shortfalls with an infrastructure plan. Clearly there are cross currents. China is still fragile and the yuan is again weakening against the USD. Oil is down again this morning as stability in the energy sector proves elusive.
–In any case, Friday’s employment report will loom large (NFP expected 175k) in terms of cementing rate hike odds. Today’s news includes Personal Income and Spending, expected +0.4 and +0.3, with Core PCE prices 1.6 yoy. Also Dallas Fed mfg is released.
–On Friday there was a large buyer of EDZ6 9875p for 0.75, closing as open interest fell 41k. There was also a large buyer of EDZ17/EDZ19 spread at 26.5. This appears to have been a roll as Red Dec was down 13k in OI and Blue Dec rose 17k. The spread settled 28, but if there is a true change in sentiment, just over 1/4% for a two year spread seems quite cheap. Note that near one-year euro$ calendars made new highs, with EDZ16/EDZ17 up 3.5 bps to 19. The curve was flatter further out, with 2/10 edging half a bp lower to just under 79.
Re-pricing of risks?
A friend of mine went to see a wealth manager last week. This particular individual isn’t particularly comfortable with stocks at their current levels; I would say prudently risk averse. Therefore, one recommendation was high quality corporate bonds, which makes sense. What I would note is that the market is rather selectively pricing risk. For example, one year libor has shot up to 153 bps, up 40 bps since February, nearly as high as the ten year note which ended the week at 163. But the BAML BBB option adjusted spread is near the low of the year around 183. Sure, the rise in libor is mostly regulatory in nature, but it really boils down to risk aversion. Institutional investors are shifting over to government money market funds, because they don’t want to take the risk that these accounts break the buck or are gated. At the same time we continue to hear about the insatiable reach for yield. Is it about yield or about beating your benchmark? In a way, the switch in money market funds shows that pricing of risk and liquidity can be a fickle thing. We reach for yield with YOUR money (to match benchmarks) but not with ours. In a broader perspective, it’s an indication that when official support is withdrawn, either through QE or rate changes, or through the erosion of central bank credibility, then prices adjust to new risk, and not necessarily in a graceful way. We had a taste of that adjustment at the start of the year, after December’s rate hike. By mid February, communications shifted dovishly and “stability” was restored.
Now the Fed is taking another step toward removal of accommodation. Yellen on Friday said, “…I believe the case for an increase in the federal funds rate has strengthened in recent months.” Followed by Fischer, “We’re reasonably close to what is thought of as full employment. [The] inflation rate this year is higher than last year’s. It’s still not up to 2 percent. But it’s been growing.” When asked if there could be a hike in September and possibly more than one this year Fischer replied: “I think what [Yellen] said today was consistent with answering yes to both your questions, but these are not things we know until we see the data.” Well yes, actually these are things we do know, or at least this: The Fed will NOT hike two times before the end of the year. However, the pricing for one hike by year end is nearly there, as reflected by January 2017 Fed Funds. That contract settled at 9941.5, or a rate of 58.5, versus the Fed effective rate of 40 bps. As mentioned previously, both the gradual acceleration of wage data and the coming yoy comparisons with respect to inflation will bolster the rate hike argument. However, economic data is likely to continue mixed, and may even tend to disappoint over the medium term.
Having covered the boilerplate Jackson Hole summary quotes, let’s shift to a tangentially related topic. There has been a lot of press about european bank shares. Recently I have noticed a bit more attention being given to Saudi bank shares. For example, the Tadawul All Share Banking Index is at a new low of 12830, even lower than the start of the year when oil was plunging. Note that one year ago the level was around 19500, a decline of around 1/3 since last August. The largest bank is National Commercial Bank, said to be a proxy for the royal family’s wealth. New low, down 50% from the high of last year.
There was an article in the Wall Street Journal noting that the world’s largest oil companies have taken on huge amounts of debt as the price of oil has fallen. For example, Exxon and Chevron had no debt in 2013, now Exxon has $40b and Chevron is close. BP is about stable, but still has $30b, and Shell’s borrowings have exploded to over $70 billion. According to the article, these four have“…net debt of $184 billion—more than double their debt levels in 2014.” “The companies spent more than 100% of their profits on dividends last year. …Just a decade ago, these four companies were hauled before Congress to explain ‘windfall profits’ but now can’t cover expenses with normal cash flow.” http://www.wsj.com/articles/largest-oil-companies-debts-hit-record-high-1472031002
What do Saudi bank shares and oil company debts have to do with the US curve? Well, Yellen and other Fed officials have repeatedly referred to weakness in energy prices as a restraining factor on inflation. I’m no expert, but I think the Saudis are still thought of as a swing producer in terms of setting marginal prices (though perhaps now N American shale producers are in that role). In any case, though they have publicly stated they want to move away from oil as their prime source of income, they desperately need higher prices, as do the oil companies. Even without further price boosts, yoy comparisons are going to have a big influence on inflation data, and my conclusion is that oil prices will edge higher. The question is, will an inflation premium again be a feature of the long end? And after the first hike, will the curve steepen or flatten?
On Friday, both 2/10 and 5/30 treasury spreads made new lows, with the former just below 79 bps and the latter at 105.5. This price action indicates that higher rates will restrain the economy and inflation. However, near Eurodollar calendars made new recent highs. For example, Dec’16/Dec’17 closed at 19, having spent the past month between 12 and 16. There was a large buyer Friday of EDZ7/EDZ9 2 year spreads for 26.5 (settled 28). It appears it might have been a roll as EDZ7 open interest declined by 13k and EDZ19 was up 16.7k. In any event, at just above ¼% for two year calendars, there is a lot of room to build in an inflation premium, or a gov’t infrastructure spending premium, or a “Fed no longer has our backs” premium. I am of the opinion that the US faces a stagflationary environment which should produce higher long end rates and higher spreads, at least on the Eurodollar curve from reds through golds. I am again attaching a chart (Global Tens) showing that JGBs, bunds, and finally this week, ten yr treasury yields have all broken downward sloping trendlines. A scenario that features higher yields even as equities decline is hard to envision, but I think we are heading in that direction. Bonds and stocks went up together, they can go down together as well.
Aug 26. Goin’ to Jackson (Hole)
–Yellen is the big event today. Eurodollar contracts pushed lower in anticipation with reds down 2.75 and greens down 3.375. I saw a few news sources saying that odds of a Fed hike had jumped to 1 in 3, but I calculate 25% chance with Oct Fed Funds settling at a post-Brexit low of 9954.5. In any event, odds for a hike prior to year end are over 60% with Jan FF settling 9944.5. I would also note a new high in Sept/Dec eurodollar spread at 6 bps.
–Though economic data has been mixed at best, I think the tide inside the Fed has turned and that Yellen will lean to the hawkish side. (Tide has turned given Fischer saying the Fed is much closer to both jobs and inflation goals, discount rate increase requests up to 8 out of 12, etc). The question of course is how will the curve react? I think the immediate response to hawkish comments might be a slight flattening, but ultimately the curve will steepen. However, treasury call protection occurred yesterday, with a new buyer of nearly 30k TY Week 1 Sept (expiration on unemployment date) 131.5 calls for 23. The 20 delta call buyer with a clip size of just over 7k a day was also back, buying TYZ 134c for 25 covered TYU 132-06. There was also a late buyer (new position) of 8k TYV 131 straddle (settled 1’30).
–An interesting post citing Fasanara Capital notes that 12 month libor is at essentially the same rate as ten year treasuries, signaling headwinds for US banks, given increased funding costs and a lack of curve. Tens closed yesterday at 157.5, +1.7 bps.
https://www.youtube.com/watch?v=nzhzCF77GDo
Aug 22. Getting closer
–Reuters: “We are close to our [inflation and employment] targets,” Vice-Chair Fischer said in prepared remarks for a conference in Aspen, Colorado. In other words, we’re close to hiking. If Yellen indicates the same on Friday then a hike will occur this year. The market still gives greater odds of a December move rather than Sept, though October Fed Funds did trade 9956 today, which indicates around a 17% chance for Sept.
–Interesting interview in Barrons this weekend with Stephanie Pomboy. She forecasts a much weaker US consumer, and notes an overhang of inventories, and thus projects softer growth. “The consensus is forecasting GDP to more than double in the second half, from 1% to roughly 2.5%. We are far more likely to stay in the 1% area or go lower. Nominal GDP growth for the full year should average around 2%. It is currently 2.4%. This will trigger a major move to risk-off: When it becomes clear that the weakness in the second half, and in 2015 and 2014 before that, wasn’t temporary. Investors and the Fed all presumed that the pre-crisis economic framework was still intact. Five years of steadily decelerating growth and inflation demonstrate things are fundamentally different.” She also mentions, as others have, that corporate profits have declined for five consecutive quarters. The Daily Shot notes that dividends as a % of earnings at S&P 500 companies is around 38%, near the peak of 2009. I suppose the other 62% is going into share buybacks (that’s a joke), but in any case it doesn’t seem to be going into capex.
–Off topic… you know those crazy preppers that are always telling you to stockpile water, food and ammunition? Count in the government of Germany. (Reuters) “The population will be obliged to hold an individual supply of food for ten days,” the newspaper quoted the government’s “Concept for Civil Defence” – which has been prepared by the Interior Ministry – as saying. ‘…the precautionary measures demand that people “prepare appropriately for a development that could threaten our existence and cannot be categorically ruled out in the future,”
Hey isn’t that sort of like buying out of the money options in case of catastrophe?
–September treasury options expire Friday.
August 19. Dudley, Williams and even Greenspan call for hikes; yields decline
–Crude oil continued its rally, with CLU6 up 150 late to 4829, closing at a new high for August. In related news, high yield ETFs (sensitive to energy companies) easily surged to new highs for the year. Emerging market bonds are also seeing heavy inflows.
–In US rate futures, volume was quite low. On Wednesday EDZ6 traded 533k contracts, yesterday was less than half that at 236k. Total euro$ volume was 1.023m compared to Wednesday’s 2.746m. Yields eased even as Dudley said that strong jobs data had allayed concerns about a slowdown. Greenspan said that interest rates might rise soon, and rapidly. Williams called for a rate hike “sooner rather than later” though he said gradual increases make sense. However, the ten year yield fell 4.2 bps to 153.4, and green euro$’s (strongest) were up 4.125 bps in price.
–Yesterday I heard a couple of warnings about consumer credit, apparently alluding to the precarious state of household finances. The Federal Reserve puts out a series know as the Financial Obligation Ratio, which measures household debt service as a % of disposable personal income. As of Q1 2016, that ratio stands at 15.31, actually the second lowest number since 2000, with only one reading lower at 14.92 in Q4 2012. If there’s a debt blow-up this time around, it’s likely to come from the corporate side, not households.
Year over year Inflation Comparisons….
The top chart is the BBG Commodity Index (blue line), Continuous Crude Oil (green line) and the Fed’s preferred inflation measure, Core PCE yoy (white)
Many analyst have mentioned that yoy comparisons in oil are going to cease to depress inflation data, as the price of oil has stabilized and rallied.
The year ago levels in BCOM and Oil are circled in the charts below. As can be seen, current levels are essentially at year ago levels….
underlining the idea that yoy comparisons will support inflation.
The lower two charts are shorter time frame (2-year) charts of BCOM and Oil. As can be seen on the lower panel (oil), using a continuous contract chart,
the price has held the 50% retrace of the year’s range, and has posted a powerful rally in the past month.
Jobs and wage data has supported the rate normalization argument.
The inflation part of the mandate has been the trouble spot…but it appears as though inflation will begin to firm up.
August 17. Eurodollar calendar spreads are wrong
–Fed minutes today. Some analysts think that this release is important as it could provide clarity on the Fed’s thinking. However, recent comments suggest a lack of consistency even within individual members, let alone the entire committee. For example, in a speech on July 31, Dudley said ‘medium term risks to growth are slightly skewed to the downside’ and that risk management and other considerations “argue for caution in raising US short term interest rates”. Yesterday he said that a rate hike in September is possible. Williams had been relatively hawkish, warning that complacency might put the Fed behind the curve, but in a paper released Monday said that perhaps the inflation target needs to be raised, in other words, he’s not so anxious to tighten. Bullard simply threw in the towel earlier in the year and said forecasts are useless, we’ll simply call current circumstances a ‘persistent regime.’ How are we going to get clarity from the minutes?
–In any case, a relatively strong Industrial Production number yesterday (+0.7) and Dudley’s comments were enough to push yields a few bps higher. Tens ended at 157.6. Odds for a December hike rose, as the Nov/Jan FF spread settled at a new high (since early Jan) of 9 bps, indicating 36% chance of a hike in Dec. October FF traded heavily and settled 9957, down 1 on the day. The Fed effective rate has been 40 bps, so there’s only 3 bps of premium in the Oct price, call it 10-15% chance of a hike in September. What’s interesting is that one-year ED calendars are barely budging off their lows, for example, EDH17/EDH18 settled 15.5, up just 0.5 on the day. I think we’re getting an engraved invitation to buy some of these back month one-year spreads, they’re at least 20 bps cheap (should be in mid-30’s vs mid-teens). Mr Valentine has set the price.
