July 5. New highs, new lows
–New lows this morning in: Sterling, US treasury yields, yield curve (5/30 at 120), DB. New highs: silver, gold, yen (almost), the amount of debt with negative yields, and USD vs CNY, which is 6.6712. While the Brexit vote is having sudden impact on some things, for example ZH reports that Standard Life in the UK has halted redemptions from some property related funds, the situation that is being pushed into the forefront is weakness in Italy’s banking system. Non-performing loans are reportedly €360bn. Of course, China also has a tremendous problem with bad debt, however, China has the option to depreciate the currency, which is the policy they are pursuing, thus blanketing the world with a disinflationary cloud. Italy needs a banking bailout of significant size, and a weaker euro would probably help.
–Dudley speaks this afternoon at a roundtable discussion.
July 3. Let’s have an intervention
“All manipulation comes to an end when the manipulator cannot make a stock do what he wants it to do. When the stock you are manipulating doesn’t act as it should, quit. Don’t argue with the tape. Do not seek to lure the profit back. Quit while the quitting is good—and cheap.”
From Reminiscences of a Stock Operator
At the end of the day Friday the US ten year inflation indexed note was at a yield of -0.012 bps, the lowest it has been since April of 2015. This seems to be a critical area, as indicated on the chart below. It’s right at the midpoint of the ‘whatever it takes’ low in 2012, to the ‘taper tantrum’ high in the middle of 2013. A healthy economy almost by definition has a real rate above zero. I would think the Fed wants real rates above zero. When the rate you are manipulating doesn’t act as it should, quit.
A degree of publicity has surrounded Kyle Bass and his latest interview on Real Vision. One important story he relates is that he was talking privately to a central banker who said, in a moment of cosmic clarity, “QE only works when you’re the only one doing it.” My money is on Stanley Fischer as the one who uttered those words, as his comments, typically delivered in understated style, are honest and on point. For example, on Friday he was interviewed on CNBC and there were several telling exchanges. When asked about the possibility of negative rates in the US, he essentially dismissed that scenario, but, in an echo of the above, said, “…it’s certainly worked – well, it certainly worked early in its usage in Europe and Japan, but lately there have been some questions about it and we are appraising the most recent empirical results…and we haven’t changed our minds…” [about trying to avoid ever having to use negative rates]. Another interesting and direct answer came when the interviewer asked, “How do we get out of this sub 2% or 2.5% level?” Fischer: “technically we have to get something moving on productivity growth AND THAT’S NOT SOMETHING WE’RE GOOD AT DOING. We don’t know precisely how to do it. And we’re all trying to find out whether what’s going on is a long term change or a result of the cyclical situation. We’ll get that right at some point and when that changes we’ll go back to higher rates of growth. But it really turns on productivity… We’re looking for more investment to help get productivity going.” [Likely requires some changes in fiscal policies]
The problem with current central bank policies is that they have created an overabundance of reserves that seek to squeeze out every basis point of extra yield, encouraging financial speculation while repressing volatility with a vast offer in premium.
Another interesting overlap between the Bass and Fischer interviews regards China. (Bass and Fischer, sort of reminds me of Bassmasters www.bassmaster.com which is a heckuva lot more appropriate than this on a holiday weekend). Anyways, Bass goes on at length about how everything in China leads to the conclusion that the currency MUST depreciate. “… they [China] are putting off the final day of just realizing a loss cycle.” Indeed, the yuan is making new lows, which is likely to exacerbate global deflationary pressures. Fischer, when asked about China’s currency said, “…an unexpected change in something frequently has larger effects.” Now… “It’s clearer. There’s much less uncertainty. There’s much less concern…policies look more coherent.” In other words, we expect continued and controlled depreciation rather than a sharp unexpected devaluation like last August.
Maybe controlled, but still deflationary as shown on chart below of CNY (inverted in red) to 5y5y inflation indexed swap… Tracks pretty closely.
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It was an amazing week. The Brexit vote not only exposed cracks in the framework of the European Union, but also the divide between markets and financial authorities. By Thursday, the EC relaxed rules allowing an Italian bank bailout, the European Central Bank said that it might change its policy regarding buying bonds in proportion to members’ economies, and Carney said the BoE is considering an ease. The pound didn’t recover, but the FTSE 100 made new highs, and US equities took a round trip and closed at the high of the week, just under pre-Brexit levels. US 10’s and 30’s hit new record low yields. The 5/30 yield spread closed at the low of the week under 124 bps. Precious metals soared, with silver a standout performer, up 25% over the past month. While gold was also bid, the gold silver ratio collapsed to 69.3, revisiting a level last seen in early 2015. October Fed Funds, which traded as high as 9971 after the vote, came back to close at 9962, indicating unchanged Fed policy (rather than a near term bias towards ease). In fact, December 2017 FF settled 9950.5; less than 50% odds of a hike through next year. All of the nearby one-year euro$ calendar spreads trade around 3/16’s of a percent, with EDU6/EDU7 closing at just 14 bps. EDZ16/EDZ17, which saw unusually heavy trade, settled near the low at 16.0.
Trade thoughts
While I thought that buying treasury calls was a fine idea well in advance of the Brexit vote (it was), I thought buying puts or put flies on the long end was a good idea last week. It wasn’t. I think the euro will soon revisit 105 and will probably break that level, and that USD strength will temper further buying in US equities. While the US public is conditioned to look to the US stock market as a barometer of economic health, the move to lower global yields is a much more worrisome condition.
Dudley speaks Tuesday afternoon. Friday brings the US employment report, which will be carefully dissected for information on whether last month’s weak release was an anomaly or true sign of a labor market slowdown. No specific trades this week, as conditions are evolving quite rapidly and I have little desire to toss a coin in front of NFP.
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| 6/24/2016 | 7/1/2016 | chg | |
| UST 2Y | 64.9 | 59.3 | -5.6 |
| UST 5Y | 109.1 | 100.1 | -9.0 |
| UST 10Y | 157.9 | 145.1 | -12.8 |
| UST 30Y | 243.3 | 223.7 | -19.6 |
| GERM 2Y | -64.3 | -64.9 | -0.6 |
| GERM 10Y | -4.7 | -12.6 | -7.9 |
| EURO$ U6/U7 | 19.0 | 14.0 | -5.0 |
| EURO$ U7/U8 | 23.0 | 18.0 | -5.0 |
| chg to Sept | |||
| EUR | 111.17 | 111.40 | 0.23 |
| CRUDE (1st cont) | 48.31 | 49.65 | 1.34 |
| SPX | 2037.40 | 2102.95 | 65.55 |
| VIX | 25.76 | 14.77 | -10.99 |
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July 1. Yields plunge
–Plunge in US yields to new lows on the long end with tens getting just under 138 bps vs yesterday’s close of 148.7. The ‘authorities’ responded the only way they know how yesterday, with looser, or the promise of looser policies. The European Commission apparently approved Italy’s plans to support its banking system with €150 bn. (probably too small). BoE’s Carney hinted at easing measures. The ECB said it’s “considering looser rules for bond-buying that might include moving away from a link between purchases and the size of a country’s economy.” In other words, anything goes. This is either an over-reaction, or a tacit admission that the financial industry is hanging by a thread. Somewhat unnerving in either case. Precious metals have responded by exploding higher. The silver contract started this June around $16 oz and is starting July 20% higher, (now around 19.25).
–There was heavy buying in EDZ16/EDZ17 yesterday morning up to 18.5, but by the end of the day it had settled right at its low of 15, and has pushed lower yet this morning, around 13.5.
–ISM today expected 51.5. However, the ‘economic fundamentals’ have gone out the window in terms of their relationship to market moves. However, it’s worth noting an item by Nick Colas of Convergex, in his Off the Grid indicators:
“Large pickup truck sales are down year-over-year. This is one of our favorite indicators of small business growth in “Real America” (i.e. not coding the latest food delivery or dating app). May sales were down 3.1% from last year, one of the worst comparisons since mid 2011.”
June 30. Implied vol sinks…no worries
–Yesterday began with a surprising end-of-month bid in the long end of the market, but ended on a weak note as yields pushed higher at the end of the day, in part due to a $14b bond deal by ORCL. While the ten year treasury yield was only up 1 bp at the floor close to 149, it’s 153 this morning, as risk assets continue to rally from the Brexit plunge. A BBG article today features Soros continuing to warn about Brexit’s impact: “Continental Europe’s banking system hasn’t recovered from the financial crisis and will now be “severely tested.,” Soros said. …And, “This has been unfolding in slow motion, but Brexit will accelerate it. It is likely to reinforce the deflationary trends that were already prevalent” http://www.bloomberg.com/news/articles/2016-06-30/soros-says-brexit-has-unleashed-a-financial-markets-crisis
–The US banking system was given a clean bill of health in Fed stress tests, with only DB and Santander failing. As a result, an avalanche of “shareholder friendly” dividend increases and stock buybacks were announced. Wouldn’t it be ironic if the smartest bank guys in the room announced buybacks just at the peak of the post-Brexit bounce? And wouldn’t it be even more ironic if a banking crisis was sparked in the heart of the EU, with DB? From an IMF report: “Among the G-SIBs, Deutsche Bank appears to be the most important net contributor to systemic risks, followed by HSBC and Credit Suisse.”
–In any case, the absolute implosion in interest rate implied volatility was stunning yesterday. “The futures went down, but at least my puts performed, right?” The answer to that is, not so much. For example, FVU fell 4/32’s but the atm Sept put (FVU 122p) was up 0.5/64. EDU9 fell 2.5 bps to 9883.5, but 3EU 9887.5p was unchanged at 17.5. Straddles came in by several bps, leaving Sept TY vol at 5.2, after having surged above 6% last week. So, while warnings about financial stresses still abound, implied vol suggests the market is handcuffed.
–In terms of deflationary winds, there’s this from Reuters: “China’s yuan sank to a six-month low against the dollar in offshore trade on Thursday and the Australian dollar fell almost one percent after Reuters reported the People’s Bank of China is willing to let the Chinese currency weaken to 6.80 per dollar.” Taiwan cut rates this morning by 12.5 bps to 1.375. Finally, a diamond of 1109 carats called Lesedi la Rona failed to sell at auction, not having met the reserve price. “Prices for rough diamonds slumped 18 percent last year, the most since the financial crisis in 2008, amid lower demand and an industrywide credit crunch.” http://www.bloomberg.com/news/articles/2016-06-29/biggest-diamond-in-more-than-a-century-fails-to-sell-in-london
June 28. It’s about the financial system
–A few quick observations about yesterday’s trade. All eurodollar contracts settled at a new high for the year, exceeding February’s settlements. Near calendar spreads made new lows, for example Sept16/Sept17 closed at 13.5 and Dec16/17 at just 15. The pressure is on very front-end calendars, as thoughts of any tightening over the next year evaporated. Red/gold euro$ spread did NOT make a new low, though it fell 3.625 bps to 63.75 (58 has been the recent low). However, 2/10 treasury spread DID make a new low, plunging over 7 bps to just under 86.
–Financial stocks are approaching extreme stress. For example, DB and CS (as examples) are well below the lows experienced in 2012, when Draghi had to utter his famous “whatever it takes” phrase to support the existence of the Euro. While the stocks are below 2012 crisis lows, I looked at 5yr CDS and they aren’t quite through the highs from just this February, which seems a bit of a disconnect to me. However, a story in the Telegraph notes that Italy may circumvent EU rules against sovereign bank bailouts with a €40bn package for its banks. In the US, financial stocks have fared better, though still vulnerable. For example GS closed below 140, the lowest since 2013. A comment on the Across the Curve website was pretty insightful (and/or inciteful?). “I remind you of what really forced Bear, Lehman and Countrywide out of business…short term funding issues: the inability to fund themselves.”
–Implied vol in treasuries is unsurprisingly at recent highs. For example, the US 30-yr bond contract saw relatively heavy option trade, and the atm Sept straddle closed at 7’00, or 12.5 vol. I would note that Friday’s range alone was 8 points. In eurodollars, there was a roll from long EDZ6 100 calls into EDZ7 100 calls; the latter settled at 3.0.
–This morning the pound and equities are seeing a bounce, but treasuries maintain a firm bid. USDCNY at 6.65 as China’s currency continues to weaken, with associated deflationary implications.
June 27. Uncertainty and safety
–Uncertainty. The word used most in skimming this morning’s news (and it’s not just about Brexit). Stocks are once again lower, treasuries higher, with the US ten year yield around 1.46%, just a shade under the ten year yields of Italy and Spain. While China’s Premier Li said Britain’s vote “has showed its impact on the international market and further increased uncertainties in the global economy” (RTRS). Perhaps another big uncertainty relates to a new low in the Chinese currency this morning, with USDCNY at a new high of 6.6423. As noted over the weekend, “Beijing has stopped all communication with the main Taiwan liaison office after President Tsai Ing-wen’s refusal to endorse the concept of a single Chinese nation since her inauguration in May.” (Shanghaiist) Though attention is now focused on the EU, China also represents risk for global markets, on several levels.
–From this morning’s WSJ: “Restaurant visit growth has completely stalled in the last three months, signaling that consumers, jittery over economic uncertainties, are retrenching.” From Business Insider, “Restaurant sales are virtually flat, and they’re expected to remain weak for the rest of the year, according to The NPD Group, an industry research firm.”
–The BIS offered a fresh warning about Central Bank impotence. From BBG “Monetary policy is running out of room for maneuver,” said Hyun Song Shin, head of research at the BIS, in an interview. “It is not clear how much further stimulus of the real economy can be achieved using monetary-policy tools alone without inviting unwanted distortions.”
–In terms of US central bank policy, the markets have priced a move out of this year’s forecast, with January 2017 Fed funds trading 9964.5, slight inverted to July (FFN6) which trades 9963.25. According to the last prints, EDU16/EDU17 one year euro$ calendar is now only 13.5 bps.
–International trade this morning, expected -59.3b from -57.5. PMI Services 51.2 last, and Dallas Fed Mfg.
All the king’s horses and all the king’s men
The big institutions all warned about negative consequences from Brexit. Obama’s “back of the bus” line was especially ill-advised in my opinion, but whether it was the US President, the IMF, or former prime ministers, the warnings were explicit. I’ve seen many explanations that the people simply didn’t know what they were voting on, but the fact is that dire projections were shrill and constant. And exit still won. The majority decided that current institutions might be serving someone, but certainly not them. Whatever else you might think of Trump, he has been on the correct side of that sentiment shift.
It was only 8 days ago that Bullard released the St Louis Fed’s new and improved characterization of the US economy, projecting regimes as stable and “persistent”. I don’t know what the ramifications of Brexit will be over time, but conditions are likely to change. An easy analogy is the subprime crisis, when many so-called experts calmly advised that such mortgages were but a small fraction of total debt markets, and that problems would surely be contained. We know how that turned out.
The topic of contagion is demonstrated by research that I first saw in a John Mauldin letter, about a computer simulated program which dropped single grains of sand on a hill. Which sand grain causes collapse? The researchers couldn’t tell, but what they did note was that larger piles of sand hid “fingers of instability” and that the extent and proximity of these pockets were the key warning sign. http://www.mauldineconomics.com/frontlinethoughts/fingers-of-instability-mwo040706
“To find out why [such unpredictability] should show up in their sandpile game, Bak and colleagues next played a trick with their computer. Imagine peering down on the pile from above, and coloring it in according to its steepness. Where it is relatively flat and stable, color it green; where steep and, in avalanche terms, ‘ready to go,’ color it red. What do you see? They found that at the outset the pile looked mostly green, but that, as the pile grew, the green became infiltrated with ever more red. With more grains, the scattering of red danger spots grew until a dense skeleton of instability ran through the pile. Here then was a clue to its peculiar behavior: a grain falling on a red spot can, by domino-like action, cause sliding at other nearby red spots. If the red network was sparse, and all trouble spots were well isolated one from the other, then a single grain could have only limited repercussions. But when the red spots come to riddle the pile, the consequences of the next grain become fiendishly unpredictable. It might trigger only a few tumblings, or it might instead set off a cataclysmic chain reaction involving millions. The sandpile seemed to have configured itself into a hypersensitive and peculiarly unstable condition in which the next falling grain could trigger a response of any size whatsoever.”
As noted many times, the grains of sand keep raining, and words of cautionary advice are repeated. On Friday there were two specific instances that were compelling. First, in monotone logic, was Greenspan, perhaps discredited in some ways but still extremely sharp at 90, who said he had thought the 1987 crash was a huge crisis, but then added , “This is the worst period I recall since I’ve been in public service… has a corrosive effect that will not go away.” This description is somewhat reminiscent, though of course in completely different context, of Jim Cramer’s famous rant of August 3, 2007 when describing conditions related to Bear Stearns. “BERNANKE HAS NO IDEA HOW BAD IT IS OUT THERE. NO IDEA!” Clip is well worth watching, even if only for Erin Burnett.
https://www.youtube.com/watch?v=rOVXh4xM-Ww
Yesterday’s other example was also on CNBC, but now it’s Melissa Lee, accusing Doubleline’s Gundlach of having a “bunker portfolio”, and him, with a frustrated quaver in his voice almost on the verge of a rant of his own, trying to explain that sometimes it’s the best course to sit on the sidelines, and take a paltry return while waiting for true opportunity. “The markets take the stairs up and the elevator down. Avoid being on the elevator.” Melissa’s giving him the eye-roll as if he has no idea how to put money to work.
A couple of quick thoughts on markets. Yes, it was an awful day for GBP, but taking a step back, the high in 2014 vs the USD was 170, and it was around 136.50 late Friday, for a total decline of about 20%. In 2014 EUR was around 139 and was 111 late Friday, also a loss of about 20%. Does the value of GBP represent catastrophe? A more overt sign of damage is in shares of the financial sector, with many new lows on Friday. DB and Barclays fell 17%, CS down 16%, UBS 13%. As a comparison, MS fell 10%, GS and JPM down 7%. (SPX -3.6%). The ECB is depending heavily on banks as the transmission mechanism for their sketchy policies. Instead the banks are holding shards of glass and trying to reflect SOS signals. The bund is trading at -5 bps. What else do people need to perceive danger? Thor’s hammer to crash down on their heads? Oh yeah, Swedish short rates are also negative.
Besides the news on Brexit, it’s worth noting that US Core Capital Goods Orders, (released Friday) were -3.6%, another bad omen relating to productivity. Also, the Chicago Fed National Activity Index came out weak at -0.51, with the three month moving average the lowest since late 2012, when Europe’s peripheral crisis was in full swing. Finally from Reuters: “China said Saturday (Jun 25) that communications with Taiwan had been suspended after the island’s new government failed to acknowledge the concept that there is only ‘one China’.” Just a reminder that issues can also easily flare up in Asia…
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| 6/17/2016 | 6/24/2016 | chg | |
| UST 2Y | 70.7 | 64.9 | -5.8 |
| UST 5Y | 113.7 | 109.1 | -4.6 |
| UST 10Y | 161.6 | 157.9 | -3.7 |
| UST 30Y | 243.1 | 243.3 | 0.2 |
| GERM 2Y | -60.7 | -64.3 | -3.6 |
| GERM 10Y | 1.9 | -4.7 | -6.6 |
| EURO$ U6/U7 | 21.0 | 19.0 | -2.0 |
| EURO$ U7/U8 | 19.0 | 23.0 | 4.0 |
| chg to Sept | |||
| EUR | 112.77 | 111.17 | -1.60 |
| CRUDE (1st cont) | 48.56 | 47.64 | -0.92 |
| SPX | 2071.22 | 2037.40 | -33.82 |
| VIX | 19.41 | 25.76 | 6.35 |
June 22. The best laid schemes…
The best-laid schemes o’ mice an’ men
Gang aft agley
-Robert Burns
–Yellen maintained a cautious stance in yesterday’s congressional testimony. Kuroda said “monetary policy doesn’t always turn out as expected.” Asset purchases have expanded CB balance sheets and whatever economic activity could be pulled forward has likely already occurred, blunting the impact of new stimulus.
–The interesting thing about yesterday’s price action is that there was a slight steepening of the curve. Red/gold euro$ pack spread had been churning around 60 bps, but settled yesterday at 66, up 2.5 on the day. If the UK stays, the expected response in US markets will be that tightening odds increase, and given recent trading history, one would think a flatter curve would result. However, given Yellen’s dovish and gradual inclinations, the curve may actually begin to steepen, which I would take as a signal to jump on board. Back month eurodollar premium is rather inexpensive currently; worth owning some puts.
–Another feature of yesterday’s trade was that JPY had an outside day and closed higher. Yen’s strength is partially interpreted as a ‘risk-off’ signal, but the pressure for a stronger yen, (lower $/yen) appears to have been stemmed for now, with short term target of around 110.
June 21. Yellen today
–Yellen gives semi-annual testimony today. Reuters notes that uncertainty is now the Fed’s new mantra, “At Wednesday’s quarterly [FOMC] news conference Fed officials’ doubts were in plain view, with Yellen using the term “uncertain” or its variations 13 times, more than twice as often as in March.” It’s unlikely that Yellen will provide more clarity, though she will likely face critical questions about the Fed’s forecasting ability, particularly in the wake of Bullard’s speech, where he swore off forecasts.
–Yields rose as Brexit fears eased, with tens up 5.2 bps to 166.8. The curve edged slightly steeper; implied volatility fell. For example, on Friday, Blue July 9875 straddle settled 23.5, while yesterday the 9862 straddle settled 21.0. In the ten year, there is still a consistent buyer of covered calls, in the past few days it’s been the TYU 135c. There is now open interest of over 50k in TYU 134 and 135 calls, and 74k in TYU 132c (also a strike that had been accumulated). It will be interesting to see if this buyer attempts to exit longs if the UK votes to stay. There will almost certainly be a vol implosion on a stay vote.
–In Fed Funds, the odds of a hike in September rose, as the Aug/Oct calendar spread rose from just 3.5 on Friday to 6.0 yesterday. 100% certainty of a hike would put the spread at 25. However, the July/August spread, which captures the idea of a hike at the July 27 FOMC meeting, settled at just 2.0.
–In spite of many risk measures pulling back yesterday, $/yen fell below 104 during the day. It’s currently back to 104.45, but clearly the policies of Japan are under increasing strain. Nikkei is down nearly 20% on the year.
June 19. Every new beginning comes from some other beginning’s end…
Crunch time for Brexit, with the IMF declaring such an event will permanently lower UK incomes. Is that a certainty? The institutional ‘remain’ camp is injecting fear wherever possible. As Doug Noland wrote, “The Brexit vote is a serious potential “risk off” catalyst. Significant amounts of currency and risk market hedging have transpired. This portends a period of unstable markets.” Now, it’s either an unwind or a whole new set of market dynamics; prices have to move.
In some ways, this particular time was odd for Bullard to release his new framework for the St Louis Fed. He pretty much threw in the towel on the idea of central bank forecasting. He’s like the guy with bad investing results that goes in to see a financial advisor. The advisor says, “Look, you’re never going to able to time or forecast the market. You have the classic emotional behavior of selling at the low and buying at the high. Just accept that there’s some volatility and buy indexed funds.” (So he pours his money into the SPX at the top, avoiding bonds, commodities, etc). Recall, it was Bullard who wanted rate hikes, but whenever the stock market sold off, he was the first one to say ‘hey, maybe we should wait’. Now he’s come up with the idea of “regimes”, which “are generally viewed as persistent”. He says that the Fed can identify the current environment, but can’t forecast into the future. So we’ll just call the current state of low rates, modest growth and low productivity a “regime” and project those same conditions out into the future. I’ll just shift my dot down to reflect no more rate hikes, et voila, now you won’t have James Bullard to kick around anymore.
One of the problems of course, is that the Brexit vote could be a game changer, and has already had the effect of focusing the market on the next possible dislocation in Europe. This may be the time when central bankers and other institutions have to make difficult decisions about what the future might look like and how to counteract extreme volatility. And it’s not just the EU; China’s depreciating currency is on the back burner.
In a way, Bullard’s essay echoes Greenspan’s thoughts. Paraphrasing…”the Fed alone can’t say that markets are in a bubble, because the market is comprised of the collective wisdom of a huge number of participants. IF there’s a popped bubble, the Fed has the tools to mop up.” The current issue is that the Fed, the ECB, the BoJ have all used their tools, and the last and best one, that of instilling confidence in the markets, has been revealed as a man pulling levers behind a curtain. However, one of the most widely respected central bankers who DID steer a prudent and influential path, India’s Raghuram Rajan, has announced he’s stepping down, apparently partially due to political pressures. An academic who understands the markets…we could use him here.
There are many analysts, including some Fed members, who feel that the economy has become too dependent on an endless stream of support from monetary accommodation. We need a little tough love for the kid who has come home from college and stays for the next eight years. It reminds me of the scene in Wedding Crashers, with Will Ferrell as Chazz, the guy who lives at home: “hey Ma, the MEATLOAF! We want it NOW!” and as an aside to John Beckwith “I just never know what she’s doing back there.” That’s the market to Janet Yellen. We want more meatloaf. “I’m just livin’ the dream.”
This week Yellen testifies in front of Congress. I doubt that she will give an endorsement to Bullard’s framework, but the dovish shift to a lower terminal rate has already been enunciated at the FOMC press conference.
How does that leave markets? Gold is at the high of the year, just over $1300. VIX is elevated, having closed at 19.4 on Friday. The ten year treasury hit a new low yield of just over 1.5% on Thursday, before backing off Friday. Implied vol in treasuries hit a new recent high. The German bund traded negative for the first time. Early on, we had said that buying treasury calls was the easiest and ‘cleanest’ way to hedge against Brexit risks. That trade played out, and it’s now about how to capture the unwind and determine the magnitude of reversals if the ‘remain’ vote wins.
The first ten one-year Eurodollar calendar spreads closed between 18.5 and 21 on Friday. The curve is amazingly flat, and can barely be called a “curve” because it’s damn near linear. Back in February, with near panic lows in stocks, oil and high yield bonds, the near one year spreads were around 16 to 18 bps (i.e. the 1st to 5th or 2nd to 6th quarterlies). The reds to greens were more like 28-30 bps. In other words, the front one-yr butterflies were around -10. Now, the one-yr flies are around zero. For example, EDU16/EDU17 closed at 21 and EDU17/EDU18 at 19, so the fly settled at +2. What changed? The reds to greens absolutely cratered. As a pack spread, I marked reds to greens at just 18.75 Friday, and during the week there was a close below 17 bps!
Over this timeframe, from February to June, oil generally firmed, as did stocks. So it is surprising that the back end of the curve has flattened, but the idea of declining inflation expectations and lower term premium has worked its magic. I would also argue that both stocks and the long end of the US curve have benefitted from safe haven flows, and that BOTH have a chance for substantial pull backs on a remain vote.
Note that in 2012, when Europe was pulling apart, the front one year butterfly was well negative except for a period in March, when it traded around +6. In July 2012, when Draghi said “Whatever it takes…” the fly was around -9. I would think that selling flies is one of the few trades that might work out either way in terms of Brexit, though the first reaction on the status quo will be to ratchet up odds for a September Fed hike (current odds are only about 15%, with Aug/Oct FF spread closing at 3.5).
