June 5. Under water
http://www.aliunderwater.com/history.htm
This is one of my favorite shots of Ali, posing underwater in a pool. And, it’s pretty easy to tie into the commentary as it was widely reported that $10 trillion of sovereign bonds are yielding negative rates. Cement shoes. As a comparison, global GDP in 2014 was reported at $78 trillion.
After Friday’s employment report yields plunged. The German ten year yields just 6.8 bps, a new low. In April of 2015, the bund was yielding a bp or two higher, and Bill Gross tweeted this:
Gross: German 10yr Bunds = The short of a lifetime. Better than the pound in 1993. Only question is Timing / ECB QE 9:17 AM – 21 Apr 2015
A good call, also articulated by Gundlach. But no one seems to be saying that this time around. The EUR rally is likely to make things more difficult in the Eurozone. For example, the FTSE All Italia bank shares index has been cut in half from last year’s high. (Chart below). The Italian 2-yr yield is also underwater with a negative yield.
And of course, yen strength is problematic for the Japanese economy. Now, attention shifts to Yellen’s speech on Monday. The market had already dismissed June for the timing of the 2016 hike, but after Friday, even July’s odds were significantly cut. The July/August Fed Fund spread went from 10.5 Thursday to just 6 on Friday. If there were certainty of a hike the spread would go to 21 or 21.5. At 6 bps the spread is indicative of 28%, from nearly 50/50 before NFP. While one-yr Eurodollar calendar spreads didn’t make new lows, they are all clustered around 25 bps. For example EDU6/U7 fell 6.5 bps on the week to 26, signifying just one hike over a year.
After the data, Loretta Mester didn’t retreat from her rate hike stance, saying, “The timing of actually when the rate hikes would occur and the slope of that gradual path is data-dependent.” More importantly Lael Brainard advised caution, and noted that the labor market appears to have slowed. (Corroborated by non-mfg ISM employment component which was a dismal 49.7). While Brainard had recently been overruled on her dovish outlook, her view is likely to carry weight with Yellen. With regard to the Fed’s other mandate, she said this: “…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.” On the positive side, she noted a pick-up in consumption, and pointed to an increase in auto sales.
I would like to expand a bit on the latter point. It’s been well reported that leases are taking a bigger share of auto sales, and that loan maturities have lengthened. From JPM’s Jamie Dimon last week, “Auto is clearly a little stretched, in my opinion. …Someone is going to get hurt. … We don’t do much of that.” According to the Fed’s Consumer Credit report, Auto Loans are $1.05T. (As a comparison, student debt is $1.35T. The difference is that the market expects repayment on auto debt). Clearly, auto sales have been supported by loose standards. And, in my opinion, the following story from BBG is accentuating this “positive” sign of consumer spending. “In a deal led by Goldman Sachs, Xchange [Uber’s finance arm] received a $1 billion credit facility to fund new car leases, according to a person familiar with the matter. The deal will help Uber grow its U.S. subprime auto leasing business and it will give many of the world’s biggest financial institutions exposure to the company’s auto leases. The credit facility is basically a line of credit that Xchange can use to lease out cars to Uber drivers. …Xchange caters to people who have been rejected by other lenders.” I’m not passing judgment on the merits of this deal, just noting that it juices auto sales to unsustainable levels. I’m sure the Fed knows this.
One other piece of data which came out Friday was Internat’l Trade (-$37.4b). It has also been widely reported that global trade has been slowing. I would just like to quickly note that both US exports and imports are down around 8% from their highs in 2014. From the standpoint of getting away from the zero percent bound, the Fed missed the boat.
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Back to Friday. Last week I noted some prices from late Friday following Yellen’s remarks giving the ‘all-clear’ for a hike. The table below shows same, noting the large week over week moves:
| EDU6 | EDU7 | EDU8 | |
| 27-May settle (early settle) | 9916.50 | 9884.00 | 9860.00 |
| 27-May late, post Yellen | 9913.00 | 9878.50 | 9854.50 |
| 3-June settle, post weak NFP | 9923.50 | 9897.50 | 9876.00 |
| Change Friday low to Friday settle>>> | 10.5 | 19.0 | 21.5 |
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June 3. Curve at new lows in front of employment data
–Yields fell yesterday and the curve flattened to new lows in front of today’s employment report. 2/10 treasury spread is barely above 92 bps. The ten year yield fell 3.3 bps to 180.9. An article in Reuters suggests that concerns over Brexit are growing within the Fed and will forestall a hike in June, noting comments by Tarullo yesterday. As mentioned, a comparison of FFM vs FFN/FFQ spread indicates that the market had already come to that conclusion, with odds for a rate increase at the July meeting nearing 50% (July/August spread settled at 10.5 bps). The FT reports that sovereign debt with negative yields has hit a staggering $10 trillion.
–Lots of data today. NFP expected 160k with a rate of 4.9%. Internat’l Trade expected -$41.0b. Factory orders 2.0% and non-Mfg ISM 55.5. Yesterday’s NY ISM number was stunningly low at 37.2, lowest since April 2009. Jamie Dimon warned yesterday that some banks are likely to see problems from auto lending. I would extend that line of thought slightly further and note that car sales are likely to decline due to tightening lending/leasing standards.
–Continued accumulation of TYU 132 calls, another 7500 yesterday. The long end of the market trades as if today’s data will be weak; there has been an unrelenting underlying bid. The short end is forecasting a hike in spite of soft conditions. The decline in global yields as indicated by $10T negative debt suggests capital flows into the USD which flows to both stocks and bonds.
–This afternoon Brainard speaks. Almost certainly she will lean dovishly, and is an important voice on the Fed.
–Soybeans explosively extended the recent rally yesterday and are higher yet this morning. The BBG Commodity Index bottomed in January and has been trending higher, mostly due to oil, but now is also being supported by the grain complex. “Bad” inflation in terms of higher food costs, higher insurance premiums, and slightly rising energy costs are going to start to weigh on the household budget.
June 2.
–Red/gold euro$ pack spread (60.0), 2/10 (94.3) and 5/30 (124.2) all right on the lows. Below is chart (over the past two years) of 5/30 at 123. In a support area but looking vulnerable. ISM data was stronger than expected at 51.3 and prices paid were high at 63.5. Additionally the beige Book noted some wage pressures. However, construction spending was quite weak at -1.8% and Atlanta Fed downgraded their Nowcast from 2.9 to 2.5%. May auto sales were down 6%.
May 29. Mad Cows
From Bloomberg, May 25. “In the creative world of Chinese lending, there’s a new trade in town: the cow leaseback. …China Huishan Dairy Holdings Company, which operates the largest number of dairy farms in the country, is selling about a quarter of its herd –some 50000 animals – to Guangdong Yuexin Finance lease Co. for [pinkie to corner of mouth] 1 BILLION yuan ($152 million) and then renting them back.” The article goes on to helpfully point out, “It’s not very common to use cows as collateral.”
Of course, it’s likely that Live Cattle Futures were also met with skepticism from the general public when they were introduced. And I recall being pretty surprised when David Bowie securitized future income streams from his music. So perhaps there’s nothing to see here.
However, there IS something to see in terms of credit since mid-February. In March, several things happened to accentuate the rebound from the drubbing seen in the first six weeks of the year. First, the ECB announced on March 10 an expansion of its QE program including purchases of investment grade non-financial corporate bonds. Second, the FOMC press conference in March was dovish and was punctuated in late March by an accommodative speech by Yellen. The dollar eased, oil rallied, as did stocks. Importantly, junk bonds staged a powerful rally as well, as can be seen by the precipitous decline in the spread chart below:
A report by Evergreen/Gavekal notes that bonds of US companies with European operations are eligible to be purchased under the ECB plan, and that there has been a surge of US firms issuing euro debt (further noting that MCD and JNJ were able to issue at 0.25% and 0.50%). The Fed minutes cited the accommodative tone in March as a factor that eased financial conditions. So once again, the central banks used their influence to dampen risk (and support fertile financial engineering conditions with cow pies as the fundamental underlying asset).
I had hypothesized that the end of QE in the US would spur a shift to more realistic pricing of risk. And, with additional restraint in the form of the first Fed hike, that appeared to be the case. But the ECB is leaning in the opposite direction. Perhaps the Fed is striking the right policy balance in light of other central bank actions. However, there is an unsettled undertone, as articulated by Soros, Druckenmiller, Gundlach, Icahn etc. Last week it was Bill Gross who said “the entire system is at risk.” In April of 2016, Gross was interviewed by Barrons and talked about selling strangles to augment bond yields. From that article: “…my premise is that central bankers will do anything possible to contain interest-rate fluctuations. The sale of volatility is producing the predominant amount of return in my fund.” In an interview last week he takes a diametrically opposed viewpoint. May 26 summary from Bloomberg: “Gross …said he expects corporate-bond prices to fall in part because they’ve risen so fast since mid-February but also because he believes a day of reckoning will come when central banks will no longer be able to prop up assets and investors will withdraw from markets.” As Gross himself notes, it’s quite a transformation in psychology. “Eliminating credit as an investment means ‘not buying stocks, not buying high-yield bonds,’ Gross said. ‘It means going the other way, which comes at a price.’” I would add, it means withdrawing volatility offers at these cheap levels.
Andy Xie, the former chief economist for Morgan Stanley in Asia, penned an op-ed with a view that is even more dour than Gross’. Just a couple of lines: “…China’s overcapacity bubble will kill global capex for many years to come.” “All indications are that China wants to export the overcapacity. …China’s strategy would lead to de-industrialization in most of the world, in particular middle income emerging economies. Weak capital expenditure would lead to weak employment and labour income. The resulting bankruptcies may further weaken the global credit system.” [link at bottom]
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OK, let’s get back to the immediate issue at hand, that of data-dependency. On Friday, Yellen allowed that the Fed could hike “in the coming months.” More on that below. The problem will be if the releases this week don’t clear the ‘data dependent’ bar. Mfg ISM threatens to be weak and has been holding just over 50 (last at 50.8). I had previously put out a chart that showed that the Fed never hikes with Mfg ISM sub 50, but of course was proven wrong in December. Nov ISM 48.4, Dec 48.0 and Jan 48.2. What if we go sub 50 again? Also, NFP (Friday) is only expected 160k due to a Verizon strike.
Delving a bit deeper, Andrew Zatlin’s (Moneyball Economics) Vice Index has gotten some play in the past week, and it’s not particularly encouraging for consumer spending going forward. The Vice Index tracks prostitution, gambling, booze… i.e. the little luxuries in life. “If someone is going to go out and spend a day or two of wages, then what you are seeing is that they really feel good about today and they really feel good about tomorrow… it’s a very economically sensitive barometer …it leads consumer spending by a few months.”
“Right now it’s saying steady as you go for a couple of months and then when we come out of the summertime, it looks like there’s going to be some belt-tightening that’s going to happen.
The Vice Index is in red and is lagged.
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Back to Friday. As Yellen conferred her imprimatur on a hike in coming months, the short end reacted immediately. For example, here are the settlements Friday (due to the early floor close) and some late (post Yellen) prices. EDU6 9916.5s, post-Yellen 9913.0. EDU7 9884.0s. to 9878.5. EDU8 9860.0s, to 9854.5. Also, August Fed Funds settled at 9946.5 and then traded 9944.5. This contract captures both June and July FOMC meetings, and at 19 bps below the front May contract, it indicates over 75% odds of a hike at one of those two meetings. The October contract traded 9940 late (also captures the Sept FOMC). At 9913.0 EDU6 is 24 bps above the prevailing 3mo libor setting before renewed hiking rhetoric started. In short, the Fed has prepared the market for a hike. The curve remains flat and is likely to get flatter. Stocks absorbed the news without mishap and closed at the highs. As one client said, there’s no one left to sell. Shorts based on high profile warnings had already been placed, and the prospect of a stronger dollar attracts foreign capital to US assets. However, volume at the highs is quite low and is not providing confirmation of the move.
One personal note on this Memorial Day weekend. One of the cool things about being on the CME trading floor in the glory days was that celebrities would tour the floor. And I had the privilege of being there when a Congressional Medal of Honor recipient visited. Trading basically stopped. The reception and applause from the trading community, was nothing short of awe inspiring. (You won’t get that from a screen).
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| 5/20/2016 | 5/27/2016 | chg | |
| UST 2Y | 88.4 | 87.9 | -0.5 |
| UST 5Y | 137.0 | 135.7 | -1.3 |
| UST 10Y | 184.7 | 183.4 | -1.3 |
| UST 30Y | 263.8 | 263.9 | 0.1 |
| GERM 2Y | -50.6 | -52.3 | -1.7 |
| GERM 10Y | 16.5 | 13.8 | -2.7 |
| EURO$ U6/U7 | 31.0 | 32.5 | 1.5 |
| EURO$ U7/U8 | 23.5 | 24.0 | 0.5 |
| chg to Sept | |||
| EUR | 112.26 | 111.15 | -1.11 |
| CRUDE (1st cont) | 48.41 | 49.33 | 0.92 |
| SPX | 2052.32 | 2099.06 | 46.74 |
| VIX | 15.20 | 13.12 | -2.08 |
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http://www.barrons.com/articles/bill-gross-why-interest-rates-must-rise-1460178139
http://www.zerohedge.com/news/2016-05-28/dont-listen-ruling-elite-world-economy-real-trouble
http://politicalhumor.about.com/library/jokes/bljokecowspolitics.htm cows explain ideology
The Financial Crisis Explained
Note: I do not know who the original author of this work is. I rec’d it in an email in August of 2013.
The financial crisis explained in simple terms:
Heidi is the proprietor of a bar in Berlin. In order to increase sales, she decides to allow her loyal customers – most of whom are unemployed alcoholics – to drink now but pay later. She keeps track of the drinks consumed on a ledger (thereby granting the customers loans).
Word gets around and as a result increasing numbers of customers flood Into Heidi’s bar.
Taking advantage of her customers’ freedom from immediate payment constraints, Heidi increases her prices for wine and beer, the most-consumed beverages. Her sales volume increases massively.
A young and dynamic customer service consultant at the local bank Recognizes these customer debts as valuable future assets and increases Heidi’s borrowing limit.
He sees no reason for undue concern since he has the debts of the alcoholics as collateral.
At the bank’s corporate headquarters, expert bankers transform these customer assets into DRINKBONDS, ALKBONDS and PUKEBONDS. These securities are then traded on markets worldwide. No one really understands what these abbreviations mean and how the securities are guaranteed.
Nevertheless, as their prices continuously climb, the securities become top-selling items.
One day, although the prices are still climbing, a risk manager (subsequently of course fired due his negativity) of the bank decides that slowly the time has come to demand payment of the debts incurred by the drinkers at Heidi’s bar.
However they cannot pay back the debts.
Heidi cannot fulfill her loan obligations and claims bankruptcy.
DRINKBOND and ALKBOND drop in price by 95%. PUKEBOND performs better, stabilizing in price after dropping by 80%.
The suppliers of Heidi’s bar, having granted her generous payment due dates and having invested in the securities are faced with a new situation.
Her wine supplier claims bankruptcy, her beer supplier is taken over by a competitor.
The bank is saved by the Government following dramatic round-the-clock consultations by leaders from the governing political parties.
The funds required for this purpose are obtained by a tax levied on the non-drinkers.
Finally an explanation I understand . . .
May 27. Yellen today. G R A D U A L
–Yields fell fairly dramatically on the short end yesterday, with the two year note falling nearly 5 bps to 86.7. Green pack was the star performer, +5.875. While the headline durable goods number was a healthy +3.4%, on a month over month basis Core Capital Goods was -0.8% and yoy -5.0%. Ex-transportation was -1.8% yoy. Auctions concluded with the 7 year, with solid demand seen throughout the week.
–Yellen speaks today. Her speech in late March was dovish, and while some data has shown improvement in the last 8 weeks, I would suspect that her cautious, risk-averse style would have her sidelined in terms of a June hike. However, her other trait is inclusiveness, and I believe other members of the Fed have overwhelmed her policy instincts. How to reach a middle ground? Emphasize that rate hikes will be gradual. Continued weakness in CAPEX is worrisome, and international headwinds still linger, as noted by Japan, where Abe is delaying implementation of the sales tax and warning of parallels between now and the 2007/8 crisis.
–US equities remain well bid, but I would note that yesterday was one of the lighter volume days of the year. Typically, strong volume will support the trend, so a lack of activity near the highs is of some concern, though there will likely be a surge in new commitments if SPX breaks into new high territory (though Nasdaq and Russell are lagging significantly).
–Normal electronic close today in spite of the holiday. By the way, today’s TY 129.75 calls were slightly in the money by yesterday’s close, having been offered at 3/64 in the morning, they were trading 9 late in the day ref 129-24.5. Enjoy the long weekend!
May 26. Debt levels on the radar
–Little net change in rates yesterday though the curve edged slightly steeper. Near one-yr euro$ calendars pushed to new highs as EDU6 and EDZ6 closed up 1 on the day. Sept16/Sept17 spread closed up 1 at 35. There was a buyer of about 30k TY 129.75/130.25 call spread for Friday (week 4) for 3/64’s, which was an exit according to this morning’s open interest data. Sort of interesting in that Yellen is speaking Friday afternoon going into the holiday weekend; market conditions could be thin and any surprising comments may see exaggerated moves. (TYU6 settled 129-12).
–Several news services highlighted the G7 meeting, where Japan’s Abe is pushing fiscal stimulus. From Reuters: “Abe presented data showing global commodities prices fell 55 percent from June 2014 to January 2016, the same margin as from July 2008 to February 2009, after the Lehman collapse.”
–Several news sources are coincidentally citing debt levels. WSJ has a big chart outlining consumer debt levels in the US, warning that risks are growing. However, the household debt obligation ratio is not flashing any warning signals as of now. In the US the problem is likely to come from the corporate sector, where non-fin corp debt is near a 30 year high at 45% of GDP (Daily Shot). I would note that much of this debt went to share buybacks, further stressing corporate balance sheets. There is also a note that EM non-fin debt to EBITDA is at 1.7x, right near a 20 year high. Potential Fed tightening, though small in magnitude, may have outsized ramifications.
–Today’s news includes Durables expected +0.3 and +0.4 ex-trans. Jobless Claims 275k (edging slightly higher), and the 7 year auction.
May 25. Summer hike
–Short end of the market remains under pressure. The Fed’s discount rate meeting revealed that four banks wanted to hike the discount rate, underlining the new hawkish sentiment. Near euro$ calendars made new highs, for example, Sept16/Dec16 settled at 11 (+0.5), and Sept16/Sept17 at 34 (up 2 on the day). The market is now pretty much pricing for a summer hike; the spread between May Fed Funds (front expiring contract) and October FF which covers the next 3 FOMC meetings, is 22 bps. If the Fed were to go in June, then it would leave the door open for another hike in Sept, in which case the front end has more downside. However, EDU16 is at 9914, close to pricing in certainty of just one hike, and the option market appears comfortable with that, having hammered the straddle to just 13 bps. There’s a story on BBG today saying that China is going to ask the US for more specifics on tightening timing in order to adjust their own policies (I’m sure that info would never leak out…), but I would note that the yuan is weaker again this morning at 6.5627 and is nearing its recent low from late December. Weaker yuan pressures other Asian exporters and adds to disinflationary pressures, which is what the US curve is reflecting. 5/30 edged to a new low beneath 125 bps. 2/10 is holding just above 95. The curve isn’t projecting inflationary pressure, but the continued rally in oil is certainly alleviating pressure on some sectors of the economy.
–News today includes the 5 year auction and Markit Services PMI, expected 53 from 52.8. Internat’l Trade expected -$60.2b.
May 24. Fed flattens curve
–The market continues to flatten as hawkish rhetoric convinces the market that 1) the Fed is serious about tightening and 2) that a tightening campaign will slow the economy. Red/gold pack spread again flattened to a new low of just 59 bps, down 3 on the day. 2/10 closed at a new low as well at 94. 5/30 spread is hanging right around 125 bps, the midpoint of the coiling range of the past year and a half. Market Mfg PMI was a bit lower than expected at 50.5 vs 51 expected. Today’s news includes the Richmond Fed mfg index, New Home Sales expected 523k vs 511k last, and the 2yr auction.
–Business Insider cites research from MS saying that conditions supporting EM are unwinding. For example, the Fed is hawkish, the dollar is turning higher, commodities outside of oil are softening, China is weakening . Note that copper has been falling even as oil has trended higher; same with the Mexican peso. However, US equities continue to find support in Asian hours, apparently related to a bid for safety.
–There continues to be accumulation of TYN 132c which yesterday settled 8 with 12 delta. Open interest is now 72k, the most of any July call. I would note that July treasury options expire June 24, the day after the Brexit vote. These purchases may or may not be related to Brexit (which is less likely according to experts), but make some sense as an insurance policy.
–On the other hand, if one is becoming convinced the US economy is on firm footing and that rate hikes might even be stimulative (companies may get off the fence and invest in capex etc), then there are many trades to capture that scenario. Implied vol is soft with atm green June midcurve straddle at just 14.5 bps and July at 27. These are both the 9862.5 strike, so on the put side there is the additional kicker of the curve being super flat with reds/greens at just 22 bps. On a pure futures spread, EDH18/EDH19 closed at a new low of just 19.5 bps. The back part of the curve is telling us that Fed hiking will backfire, but it’s not necessarily the right view. I tend to trust the market’s signal, but these spreads are fairly low risk buys.
May 22. Moneyball
The line in the April FOMC minutes that incited a surge to higher yields was this one, with its specific reference to June: “Most participants judged that if incoming data were consistent with economic growth picking up in the second quarter, labor market conditions continuing to strengthen, and inflation making progress toward the Committee’s 2 percent objective, then it likely would be appropriate for the Committee to increase the target range for the federal funds rate in June.”
The minutes are presented with the ‘Staff’ first summarizing the economic and financial situations, followed by the Staff outlook. In the ensuing section, the ‘Committee’ discusses the economic landscape and policy. I can’t help but being reminded of the scene in Moneyball where the GM is listening to several seasoned coaches positively discussing a prospect, and then looks over at Peter Brand who just shakes his head ‘no’. (Peter Brand is a fictional character who crunched all sorts of statistics to assess player value). In this case the Fed staff is Peter Brand, and the Committee is composed of the old school, inside baseball, speech-givers.
Here are a couple of Peter Brand’s comments:
Forward-looking indicators of equipment spending, such as new orders for nondefense capital goods along with recent readings from national and regional surveys of business conditions, continued to be soft. Firms’ nominal spending for nonresidential structures excluding drilling and mining decreased in February. Indicators of spending for structures in the drilling and mining sector, such as the number of oil and gas rigs in operation, continued to fall through early April. The available data suggested that inventory investment moved down in the first quarter.
The risks to the forecast for real GDP were seen as tilted to the downside, reflecting the staff’s assessment that neither monetary nor fiscal policy was well positioned to help the economy withstand substantial adverse shocks. In addition, while there had been recent improvements in global financial and economic conditions, downside risks to the forecast from developments abroad, though smaller, remained.
In general, Peter Brand appears rather downbeat. However, Billy Beane has the final say. There are many interesting and somewhat contradictory passages throughout the minutes, mostly relating to the ‘Committee’. These are in no particular order:
Some participants noted that global financial markets could be sensitive to the upcoming British referendum on membership in the European Union or to unanticipated developments associated with China’s management of its exchange rate.
…the recent depreciation of the dollar and indications of a rebound of economic growth in China appeared to reduce pressures on the renminbi.
Financial market conditions improved further, on balance, over the intermeeting period, with investors appearing to respond to Federal Reserve communications that were viewed as more accommodative than anticipated and to somewhat better-than-expected incoming data on foreign economic activity.
Many [participants] also thought that, as had apparently been the case in recent years, a low reading on seasonally adjusted first-quarter GDP growth could partly reflect measurement problems and, if so, would likely be followed by stronger GDP growth in subsequent quarters. However, some participants were concerned that transitory factors may not fully explain the softness in consumer spending or the broad-based declines in business investment in recent months.
Participants generally agreed that the risks to the economic outlook posed by global economic and financial developments had receded over the intermeeting period.
In short, the Committee is dismissive of some of the Staff’s concerns. This, in spite of the fact that the Committee overtly acknowledges that “accommodative” communications in the second part of March helped ease financial conditions (including a further depreciation in the USD). So, what will be the result of less accommodative communications? My guess is that the dollar will strengthen (check), financial conditions will tighten (check), and that measures of net worth may begin to deteriorate (jury’s out, but here’s a pretty fascinating link regarding Net Worth: https://app.hedgeye.com/insights/50884-hedgeye-guest-contributor-thornton-my-scary-chart?utm_campaign=Market+Brief+1463670024&utm_content=Market+Brief+1463670024+CID_62a9e77f8c4c614fd32ae822b3196c77&utm_medium=email&utm_source=campaignmonitor+email
The minutes do NOT present a compelling case for tightening, though the market ratcheted up odds for a near term hike. For example, May/June Fed Fund spread settled 4.0, about a 1 in 3 chance for a hike in June. July/August FF spread settled 7.0, similar odds for a hike in July. EDM6 settled 9927.25, which appears slightly cheap to me given the odds represented by Fed Fund futures.
While near Eurodollar one-year calendar spreads perked up on the week (for example EDU6/EDU7 jumped 5.5 bps to 31), all of the back spreads remain subdued. Every 1-yr spread from EDM17/EDM18 back is below 25 bps. The red/gold ED pack spread (2nd to 5th year) closed at a NEW low of 62 (flattest since 2007). In treasuries, 2/10 closed near a new low at just 96 bps. More importantly, the dollar index has made an outside range month (lower low and higher high than April) and closed near the high of the month. An article on Bloomberg cites DB as saying this USD rally has legs to run further. China’s yuan closed at its weakest level since the start of March. And there was disagreement at the G7 on the Japanese Yen, with US Treasury Sec’y Lew arguing that movements in the yen were not “disorderly”, and Japan’s FinMin Aso saying, “I told (Lew) that recent currency moves were one-sided and speculative.” The Brexit vote still looms. All in all, while it can be technically claimed that global financial risks have “receded”, the magnitude of change has been miniscule.
Now, I don’t want to fight the Fed. After all, many analysts have cited a change in the narrative. It’s not as though the guidance from Central Banks remains constant. For example, Greenspan used the phrase “irrational exuberance” but thought the Fed’s role should be reactive, to mop up after the fallout of asset prices that didn’t appear to make sense. Recently the Fed has turned to macroprudential tools to stem excesses. I should note that the initial section of the minutes deals with just this topic. But here’s an actual line that quickly diminishes any confidence one might have in regulatory fixes: “Participants emphasized the importance of macroprudential tools in promoting financial stability, and they generally expressed the view that such tools should be the primary means to address financial stability risks. However, it was noted that relatively few macroprudential tools are available to financial regulators in the United States and that, for the most part, such tools are untested.”
My own opinion is that there is zero chance of a hike in June due to Brexit concerns, but that there will likely be a hike in July. The dollar index, having been in a 16 month range of 92 to 100, and having just tested the lower end and bounced, will move toward the upper end of the range. Oil will move sideways to lower, as will US equities. Risks from China are probably higher than the Fed acknowledges. The curve will remain flat due to hawkish rhetoric and other factors. While the prospect of better data in the beginning of June could pressure tens, 2% or just above will act as a cap. In futures, the spike to 128-00 which was the March FOMC low in TYM, should be a solid support area.
