August 16. Weaker USD. Key to a steeper curve?

–Yields pushed a bit higher yesterday with tens up 3.6 bps to 155.1.  Volume was light.  Economic data continues to disappoint with Empire State -4.2 vs expected +2.5.  SF Fed’s Williams said yesterday in a paper posted on the website that monetary policy can’t do it all, suggested raising the inflation target [which isn’t being hit now] and instituting stronger (automatic) counter cyclical fiscal measures.

http://www.frbsf.org/economic-research/publications/economic-letter/2016/august/monetary-policy-and-low-r-star-natural-rate-of-interest/

–This morning, partially in response, is a weaker dollar, with $/yen on top of the Brexit low at 100.19.  Precious metals are seeing a bounce and crude oil is adding to strong gains made yesterday.  In some ways, the Williams paper argues for a steeper curve, almost in contradiction to other recent comments where he suggests pre-emptive tightening.  This paper is more aligned with the idea of letting inflation and the economy run a bit hot before acting.

–In any case, the curve did steepen modestly yesterday, with red/gold ED pack spread bouncing 4.375 from the low set Friday.  There are isolated signs of inflation picking up in Sweden and Norway, and UK inflation is also showing a pulse coming in at yoy +0.6 today.  The point is that even with sluggish growth data in the US, an ever more gradual-leaning Fed will weaken USD and steepen the curve from extremely flat levels.

–News today includes Housing Starts expected -0.8.  CPI expected 0.0 with Core +0.2, and yoy Core of 2.3.   Industrial Production expected +0.3.

August 15. Serenity now

–Yields fell Friday as both Retail Sales and PPI disappointed.  Retails Sales were 0.0 vs +0.4 expected and Core PPI fell 0.3.  The ten year yield eased nearly 6 bps to 151.5.  The tow year yield was down 4 to 70.6.  The eurodollar curve from reds back flattened to new lows.  Red/Green (2nd to 3rd) pack spread is sitting just above 12 bps.  According to the FF market, odds for a Sept hike are below 10%, while December is around 30%.  Both Atlanta and NY Federal Reserve bank forecasts for GDP in Q3 were revised down by 0.2 on Friday, ATL to 3.5 from 3.7 and NY to 2.4 from 2.6.

–Implied volatility is low and grinding down.

“Technically one should note that volatility is extremely low and that is usually a reason to be on your toes.” From a Reuters piece this morning quoting  SEB investment management head of global asset allocation Hans Peterson.

http://www.reuters.com/article/us-global-markets-idUSKCN10Q024

Aug 14. Smothered

There’s an interesting article on Bloomberg about US life insurance companies unintentionally holding increased amounts of distressed debt. These were once high quality energy bonds which went pear-shaped.  “Even if distressed holdings are largely accidental now, regulators are considering proposals that could ease the amount of capital life insurers can use to fund junk bonds, which makes it more profitable for the companies to increase their investment risk. …Under current rules, a bond with a rating four steps below junk needs to be funded with capital equal to at least 10% of the bond’s value before taxes.  The NAIC is considering a proposal to lower that to around 6%.”  Can, meet foot.  By the way, funding junk bonds with a smaller sliver of capital doesn’t make it ‘more profitable to increase investment risk’ which is especially apparent if the bonds default.

http://www.bloomberg.com/news/articles/2016-08-12/distressed-assets-pile-up-at-life-insurers-and-more-are-coming

I had seen a previous piece which pointed out that High Yield ETFs were ironically edging up in credit quality, because some bonds dropped out of the indexes due to defaults. In a way, of course, it makes these products much less valuable in terms of their usefulness in understanding the bigger picture.  On the other hand, if standards are constantly relaxed and Central Banks continue to force investors out the risk curve, what is there to understand? The can keeps being kicked.

The link below has a similar theme, this one about agricultural credit conditions.  “Nearly 75% of surveyed bankers [in the Tenth District] reported farm income was less than a year ago… Respondents also noted that agricultural producers continued to reduce capital and household spending as profit margins generally remained weak.”

http://www.zerohedge.com/news/2016-08-12/farmland-prices-continue-fall-central-us-farmer-credit-conditions-deteriorate

The chart below is the SPX divided by the Bloomberg Commodity Index BCOM.  It shows that stocks are in a parabolic bull market compared to commodities since the low of the financial crisis.  Obviously declines in crude oil and in grains are a big reason for this.  But is there more?  Is it that our need for physical goods has now become a miniscule part of GDP?  Is it that intellectual capital is the primary value in the economy?  Is it that income being generated by more valuable assets really isn’t going anywhere?   That central banks have simply forced down yields on financial assets by chasing more money into risk, thus smothering returns on all assets?  It may be a little hard to see the scale of this chart, but the current level near 26 is close to the high; nearly double the high seen in the 1999 dotcom boom, and up 5 times from the low in 2008.  Asset PRICES levitate, asset RETURNS languish.  By the way, my personal rule of thumb for extreme overvaluation is 3.5 to 4 doubles off the low within 10-12 years.  On this chart, 5 to 10 is 1, 10 to 20 is 2, 20 to 40 is 3.  So, for max craziness look for 60 to 80 by 2020.

Let’s consider the ‘smothered’ thesis with respect to implied volatility.  The top chart is the 10 and 30 day historical vol of the SPX.  And the bottom panel is Ten Year treasury vol, both over the past ten years.  Both of these appear compressed, especially right now.  SPX 30-day vol is 7.3.

And of course, the yield curve has been smothered as well.  In Eurodollars, reds (2^nd year out) to greens (3^rd), blues (4^th) and golds (5^th) are at new lows in terms of spreads.  Reds/golds settled the week at just 42.625 bps, a nine year low.  Remember, the last time it was this low was when funds were 5.25%.  The long bond yields 2.25%.  Prices jump, income falls.

As a friend remarked:  Vols are ridiculous,  “Nobody can afford to own options anymore or, said differently, sees no reason to given how skimpy the yield or potential return is on what they own.  But their risk is ever greater.”

When does it start to matter again?  When will risk be priced appropriately?

Bernanke’s latest post from the Brooking’s Institution is a case in point.  This guy must now get paid by the word.  I’ll summarize:  the Fed has been consistently wrong on the natural rate of unemployment, the neutral rate and the growth rate.  The Fed has moved down their estimates of above parameters based on empirical evidence.  And now that their thinking is becoming more aligned with actual outcomes (while still shoe-horning the data into the old models), it means that Fed moves are likely to be gradual.  Great post, but now I’ve ruined it for you.  Actually he could have stopped with the last sentence in the first paragraph,  “…Fed watchers should probably focus on incoming data and count a bit less on Fed policy makers for guidance.” [Of course, I too could have substantially shortened this post with: Fed crushes returns and vols, and simply ended there]

https://www.brookings.edu/2016/08/08/the-feds-shifting-perspective-on-the-economy-and-its-implications-for-monetary-policy/

The problem is that Fed policy makers, or more to the point, global Central Banks, have altered the pricing of risk.  By changing the price of risk, they alter actual outcomes of economic data, perhaps in unintentional ways.  So, ‘focusing on incoming data’ becomes a less valid signpost.  It’s almost like the premise of the movie Back to the Future.  One fundamentally changes something in the past and ends up with flying DeLoreans.  Or, in the alternate ending, Marty McFly is permanently erased out of the picture.

Aug 12. Yields rise, but still depressed

–Yields pushed higher yesterday with the ten year up 6.6 bps to 157.3, as auctions concluded with the 30 yr.  Crude oil more than reversed Wednesday’s sell off on Saudi comments that suggested support for the market; crude looks set to close at the high of the week.  Eurodollar calendar spreads bounced from extremely depressed levels.  For example, Dec’16/Dec’17 rose 3 bps to 15.   Attached is the Nov/Jan Fed Fund spread which settled at 8 in a 7.5/8.0 market, near a new high.  This spread isolates odds of a Fed hike at the Dec FOMC, now around 30%.  In an interview with the Washington Post, SF Fed’s Williams was asked “…does the gradual path of interest rate increases include any this year?”  Williams: “In my view, it does.” No mention in this interview of already tightened conditions due to the increase in libor.

Yields and inflation are negatively correlated, right?

I don’t usually watch Norway, but the divergence between inflation and yields is a prime example of broken markets….  1% ten year yield with 3.7% inflation.

August 11. Strong payrolls? So what?

–Amazingly enough the US ten year note has almost completely retraced the sell off from last Friday’s employment report, and at 173-15 settle, USU is actually higher than it was one week ago on Thursday, just prior to the NFP report (173-05). The German Bund contract (RXU6) closed at a new high settlement of 167.84.

–Three month libor on Wednesday was 0.8176, or in futures terms 99.1824.  EDQ6 expires on Monday to the Libor setting.  It settled yesterday at 99.175 or ¾ bp difference.

–Yields fell across the board, and while the flattening was slight, it was enough to cause new lows in red eurodollars to deferred contracts.  For example, reds greens settled at 12.25… less than 1/8th percent! (down 0.5 on the day)

–30 year auction today; the demand for duration continues unabated. The ten year note yesterday was auctioned at 1.50, the lowest since 2012.  This is only tangentially related, but in 2012, Core CPI in Norway was around 1% yoy.  Yesterday it was 3.7%, a new high.  Is it simply impossible for inflation to accelerate in the US?  Perhaps so, as…

…Oil was very weak again yesterday, plunging 1.27 late to 41.50.  Again, using a continuous contract, 50% of the year’s move is 38.86, which provided support in the beginning of this month and should continue to do so.

–Still heavy buying of front ED puts, though both EDU6 and EDZ6 closed higher on the day.  EDU 9912/9900ps which was bought fairly heavily for 4 on Tuesday was bought for 3 yesterday and settled 2.75.

–The increase in libor has been a tightening.  However, in terms of an actual increase in the FF target by the Fed, the Dec FOMC is still the meeting favored by the market.  Nov/Jan FF spread closed at 6.5, so around a 25% chance of a hike at the Dec meeting.  However, consider the outright price of April 2017 Fed Funds: 9948.5.  There are 5 FOMC meetings prior to this contract, yet there’s a spread of less than 12 bps to the front August contract.  As an aside, October FF were the most heavily traded FF contract yesterday with featured buying at 9957.5…open interest was up nearly 6k.

August 10. CB’s backstop the USD funding crunch?

–The main feature of Tuesday’s trade was huge put spread buying on EDU6 and EDZ6 contracts.  (Details below).  EDU6 at 99.10 and EDZ6 at 99.055, are the only interest rate contracts that closed lower on the day.  Several research pieces came out yesterday suggesting that the 50 bp penalty on foreign currency swap lines ought to cap libor around 90-95 bps; essentially right where the first two ED contracts are trading.   Yesterday’s setting was 0.816.  From BBG, “…FRA-OIS should have an ‘upper bound’ of ~50bp, which is the penalty rate on the Fed’s dollar swap lines with central banks” according to Credit Suisse.  The money market reform deadline is October 14.  As Pimco noted, 3 month libor is now above the two year treasury note yield, and indeed is almost identical with the new three year note that was auctioned yesterday at 85 bps.

–Once again, central banks have to become the backstop for the system.  However, several news outlets note that yesterday, the bank of England ran into problems because UK insurance and pension firms are loathe to sell long gilts for QE, as they then have to try to replace those assets.  Though the issues of money market reform (which is the primary driver of the USD funding crunch) and the UK QE program are in different currencies, the theme becomes one of reduced carry due to higher funding costs, and lower long end yields, i.e. a flatter curve.

–This is highly obvious when looking at the eurodollar curve.  The red pack (2nd yr) to deferred packs made new lows.  Red/green (2nd/3rd) settled at just 12.75 bps.  Red/gold (2nd/5th) is pictured below, having closed below 44 bps, the lowest in nine years.  Ordinarily the flattening occurs as a result of central bank tightening; note that the FF target was 5.25% in 2006-2007.  The search for long dated ‘assets’ extends into the stock market, which breezily pushes to higher levels, despite the 3rd quarter in a row of lower productivity (yesterday released at -0.5%).  Supposedly higher unit labor costs should be squeezing profits, and indeed that does seem to be the case, but in a world of zero the old rules crumble.

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Large trades:  EDU6 9912/9900ps bought in size of around 70k, paid 4.0.

EDZ6 9900/9887ps 3.75 paid for 50k.

EDZ6 9912/9887p 1×2 with 9900/9875p 1×2 12.75 to 13 paid for over 50k (appears to be cover of top strikes)
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Chart below goes back to 2006.  Red line is red/gold pack spread and white line is 2/10 treasury spread.  The recent divergence is about as wide as it gets….

August 8. Hedging costs destroy carry

–Interesting article on Bloomberg today notes that currency hedging costs for overseas investors buying treasuries has increased to such an extent as to eliminate positive carry. “We’re at a point now where investors have to start thinking about this,” said Sachin Gupta, a foreign-bond fund manager at Pimco, which oversees $1.51 trillion. “As the cost of hedging rises to such an extent, there’s no extra carry to be had. That itself will slow down the demand — and, at some point, even reverse the demand — for Treasuries.”

http://www.bloomberg.com/news/articles/2016-08-07/bond-market-s-big-illusion-revealed-as-u-s-yields-turn-negative

–The immediate reversal of demand for treasuries occurred after Friday’s 255k Payroll report.  The ten year yield jumped nearly 8 bps to 158.2, and the belly was hit even harder, with 5’s up just over 10 bps to 113.  The green (3rd year) eurodollar pack fell nearly 13 bps.  Eurodollar calendar spreads widened, notably Dec’16/Dec’17 which surged 6 bps on heavy volume to 15.5.  However, the Dec’17 contract is not quite through the post-Brexit low of 9889, having settled Friday at 9893.  A close below the late July lows would significantly strengthen the downward trend.

–January Fed Funds settled at 9949, 11.25 bps below the front August contract, approaching 50/50 odds for a hike by the end of the year.  Aug/Oct spread closed 4.25 and Nov/Jan at 7.0, indicating that December is viewed as more likely for a hike.  El-Erian and others are nudging the Fed for a move in September, but speeches by Dudley and Powell urge caution in raising rates too quickly.  Yellen is slated to speak at Jackson Hole on August 26.

–Treasury auctions this week of 3, 10, and 30 year paper starting Tuesday.

August 7. Return of the Bond Vigilantes

Friday’s payroll report was strong (NFP 255k), resulting in a jump in yields, with the Five year treasury up over 10 bps to 113, and Tens up nearly 8 bps to 158.2.  Eurodollars also sold off, with reds through golds -10.25 to -12 bps.  Notable was the decline in EDZ17, which fell 10.5 bps to a price of 9893.0, a yield of 1.07%.  Notable, because open interest in this contract alone soared by over 52000 contracts, to 1.289m, the second most of any other ED contract aside from EDZ16 at 1.45m.  Total open interest in Eurodollars was up 140k.  These figures are based on preliminary open interest data, but are likely correct, as the EDZ16/EDZ17 spread traded over 84k on Friday, rising an impressive 6 bps to 15.5.  Open interest was also up in all treasury futures besides ultra-tens, providing further confirmation of the move.

Mid-June was the last Summary of Economic Projections released by the Fed.  At that time, the dot plot for year end 2017 averaged 1.63%.  Given the increase in the spread between Libor and OIS I would say that an appropriate price for EDZ17 would be 9800 if funds were 1.625, as opposed to Friday’s settle of 9893.

Towards the end of last week (pre-payrolls), we had several clients asking about the shape of the curve and vol levels.  For several clients we bought out of the money puts on deferred euro$ contracts…not in large size, but there seems to be a nuanced shift in sentiment.  However, as one contact said – again, pre-payrolls – “I just don’t know if this is likely to be another false start like so many others we’ve experienced.”  The payroll data and market response to it would tend to provide evidence that this is indeed the start of something larger.  Additionally, after Friday’s trade, I received this text from a Eurodollar option pit market maker:  “the pit is in trouble if we continue to break, extremely short puts!”

At the start of the year, one-year Eurodollar calendars were 60-65 bps.  Currently, the curve is MUCH flatter with the first 10 one-year spreads between 13.5 and 16 bps.  That’s all the way from Sept’16 Sept’17 to Dec’18/Dec’19.  Now let’s go back to the start of the week, and consider William Dudley’s speech.  In it, he said that the labor market was slowing, but noted, “…even 150k job gains per month would be consistent with gradually using up any remaining slack present in the US labor market.”

He also said this: “As I noted earlier, I think the medium-term risks to the U.S. economic growth outlook are somewhat skewed to the down side. Thus, this needs to be taken into consideration in terms of the appropriate stance for U.S. monetary policy. With respect to the efficacy of monetary policy, given how close we remain to the zero lower bound for interest rates, I also think the risks are asymmetric. Therefore, we need to be a bit more careful about the risk of tightening monetary policy in a manner that proves to be premature, as compared to the alternative risk of being a little late. If we were to realize that we were slightly late, policy can be adjusted by raising short-term interest rates more quickly.” 

Dudley is one of the most important voices on the Fed, and he continues to advise caution in terms of raising rates too soon.  Additionally, in some ways the rise in CP yields and Libor has already been a ‘stealth’ tightening.  (In April, 3m Libor was around 63 bps, and now it’s 80, so there has already been a change of 17 bps).  The deadline for money market reform is October 14, and while there has already been an adjustment, at least one of our clients who is much closer to the issue, thinks there is more to come.  Despite El-Erian and others warning that a hike in September is becoming much more probable, the risk-averse Fed can use Yellen’s Jackson Hole appearance on August 26 to guide the market towards an end-of-year move, by which time the Money Market issues will have been sorted.

Having said that, the upward sloping trend in wages can easily justify further steps toward normalization.  Below is a chart of average hourly earnings, now at 2.6%.  The Atlanta Fed’s Wage Tracker (last released on July 15) is even more pronounced, at a new high of 3.6%.  Link at bottom.

While our focus thus far has been on the shorter end of the curve, what might have sparked a change in global sentiment was the jump in JGB yields in the wake of the BoJ meeting.  I’m sure it’s premature to resurrect the phrase ‘bond vigilantes’, but the chart below suggests that one shouldn’t ignore the possibility that bonds could lead the normalization charge prior to conferring with central banks.

On the chart, the 10 year JGB yield (in red) has clearly broken out of its downward slope.  The German Bund (green) is close to doing the same, and the US Ten year (blue) has trend-line resistance coming in around 1.62 to 1.63, just as the Treasury auctions 3’s, 10’s and 30’s this week.  The white line is the British Gilt, which for now still remains in a solid down trend.

One last point with respect to US bonds.  It’s pretty clear that recent history displays precious little correlation between a given country’s fiscal situation and its bond yields.  However, the US deficit is worsening, and is expected to deteriorate further, according to the CBO.  Under the heading, Growing Deficits are Projected to Drive Up Debt, the CBO document says, “This year is likely to be the first since 2009 in which the federal deficit will increase as a share of the nation’s output – from 2.5 % of GDP in 2015 to 2.9% in 2016.”  By 2022, the projection is 4.4% of GDP.  This MIGHT become important…

Global bond yield breakout around the corner?

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So where does this leave us in terms of strategy?  My assumption is that the Fed will be happy to fall slightly behind the curve with respect to tightening.  Actually, besides the labor data, other economic releases have been mixed.  If inflation does continue to edge higher with solid consumer spending (PPI and Retail Sales on Friday), then the more deferred part of the curve should steepen while near spreads remain flat.  Look for outright ways to be short long treasuries.  While a geopolitical event could cause another flight to quality, that particular risk can be relatively cheaply hedged with long VIX positions.

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http://www.macleans.ca/economy/economicanalysis/dont-look-now-canadas-economy-is-getting-ugly/?utm_source=fark&utm_medium=website&utm_content=link&ICID=ref_fark

https://www.frbatlanta.org/chcs/wage-growth-tracker.aspx?panel=1

https://www.cbo.gov/sites/default/files/114th-congress-2015-2016/reports/51384-MarchBaseline.pdf

August 4. Comparison of Eurodollar Calendar Spreads

–In May of 2013, then Fed Chairman Ben Bernanke suggested the Fed could begin tapering its bond purchases.  So began the infamous ‘taper tantrum’.  In early May of 2013, pre-tantrum, near one-year euro$ calendar spreads were near their lows (they had been a bit lower during the height of the European sovereign bond crisis in 2012, but I am just looking from the start of 2013 forward).  Note that as of yesterday’s close, nearly all one-year ED calendar spreads are close to their lows since 2013.  For example, EDU6/7 settled at 11.5 yesterday; EDZ6/7 settled 11.5.  Moving out a year, EDZ7/8 settled 13.5, and EDZ8/9 at 16.5.   So let’s go back to pre-taper tantrum.  The low in the 1^st to 5^th spread on May 2, 2013 was 7.0 (corresponds to Sept16/17).  The 2^nd to 6^th was 9.0, which compares to EDZ6/7 now at 11.5.  However, the 6^th to 10^th spread in May 2013 was 24.0 bps, compared to 13.5 now.  And the 10^th to 14^th spread was 49.5 ( ! ) compared to just 16.5 now.   In other words, the reds to greens and greens to blues were massively steeper at the start of 2013 than in the current situation.  Note that in May of 2013, the Unemployment Rate was 7.5%, as opposed to sub-5% currently.  Additionally, wages are starting to firm up.  According to the Atlanta Fed Wage Tracker ( https://www.frbatlanta.org/chcs/wage-growth-tracker.aspx?panel=1 ) the growth rate in 2013 was 2.2% and currently it’s 3.6%.  The point is, that it’s awfully difficult to justify the flatness in the back end of the curve unless the market believes we’re on the verge of another deep recession.

–By the way, the intervening highs in the one year spreads occurred in 2014.  The 2nd to 6th went to 105, 6th to 10th to 122.5 and 10th to 14th to 119.5.

–Let’s also consider the level of the SPX in 2013 compared to now, 1600 vs 2150.  Net worth was $76.6t and is now $88t.  Of course, it’s growth rates and not absolute levels that are the primary concern of the back end of the curve.  And central bank intervention is also a major factor, as the market awaits the BoE’s rate cut and expansion in the APF.  To conclude, the back end of the curve appears expensive, and vol cheap given current US prospects.

• 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.