April 3. The Fed joins the fray in fx wars

The Nikkei is down 15% ytd and was down 3.5% Friday.  We’ll come back to that in a minute.

The big news this week was Yellen’s speech Tuesday, which reinforced the idea of gradual/glacial rate hikes, with the overarching theme that the central bank can and will do whatever it deems necessary to counter any adverse shocks.  Yellen also cites the role of the bond market in transmitting the Fed’s policy goals:

Financial market participants appear to recognize the FOMC’s data-dependent approach because incoming data surprises typically induce changes in market expectations about the likely future path of policy, resulting in movements in bond yields that act to buffer the economy from shocks. This mechanism serves as an important “automatic stabilizer” for the economy. …In addition, the public’s expectation that the Fed will respond to economic disturbances in a predictable manner to reduce or offset their potential harmful effects means that the public is apt to react less adversely to such shocks–a response which serves to stabilize the expectations underpinning hiring and spending decisions.

That last part is a pretty big claim, implying that the public has such faith in the Fed’s steering that hiring and spending decisions needn’t deviate due to disturbances or changes in incoming data, because the maternal Fed will keep us safe.  It’s almost a bit contradictory: Traders will adjust interest rates immediately in response to news, but Main Street doesn’t have to do anything differently.  We’ll see if the FOMC minutes which are released on Wednesday shed additional light on these ideas.

It appears as though the Fed has become more interested in expanding its sphere of influence to global asset prices, and the transmission vehicle of choice is the US dollar.  Clearly, the dovish press conference at the March 16 FOMC weakened the dollar, thus supporting commodity prices, emerging markets, credit, and US equities.  Last week’s speech cemented (some of) those goals.  Indeed, stocks and the dollar took their marching orders, with the dollar index closing at its lowest level since the start of Q4, and stocks threatening new highs.  However, the commodity complex hears the beat of a different drummer.  For example, both oil and copper made their highs 2 days after the FOMC, but this week closed at the lows, significantly below levels associated the dovish Fed conference on March 16. I would also note that junk bond funds are below mid-March levels.

There are also mixed messages coming out of official data.  Friday’s employment report was solid.  However, the employment sub-indices in both Service and Mfg ISM are in notable downtrends.  As mentioned last week, Service employment went from over 58 at the end of last year to 49.7 last month.  Friday’s Mfg employment was only 48.1.  In the past six years there have only been three lower readings in manufacturing, and those have all been within the past six months.  On Tuesday we will get the new Service ISM data for March.  It should bounce, but the divergence is clear.  A piece from JPM suggests that jobs are growing faster than the economy, which implies that productivity is falling, with negative implications for corporate earnings.  All things considered, the jobs picture in the US has been good, but the easy gains have already occurred.

So what are the signals from the interest rate markets?  Market based measures of inflation spiked lower in February and have had decent bounces.  The 5y5y Inflation Swap forward is up about 30 bps from the low of 180 in Feb, and the ten yr note to tip spread is up 43 bps from Feb’s low of 120.  In spite of the strong employment report, bond yields closed much lower on the week with fives down 14.5 to 1.24% and tens down 10 bps to 1.79%.  Over the past 2 ½ years the five year note has ranged between 110 and 180 (having started this year at the upper end of that range), now it’s much closer to the bottom in spite of the round trip in stocks (back to unchanged on the year).  The curve, having steepened immediately after Yellen’s speech, gave back those gains Friday.  For example, 2/10 was 102.6 at the end of last week, went to 107 by Wednesday, but closed back at 103.   So while some measures of inflation have firmed, in general the market is taking more of a weak growth, reach for yield, no inflation posture in the short term.  The peak one-year Eurodollar calendar spread is June’16/June’17 at 27 bps, suggesting just one hike this year.  Red/green, green/blue, and blue/gold pack spreads are all within ½ bp of each other at 25, 25.5 and 25.125.

Back to Japan.  A client summed up the week by saying they’re keeping the financial plates spinning.  Doug Noland’s commentary was entitled “Another Coin in the Fuse Box.”  Everything’s done as a last gasp effort to prop up the financial architecture. There have been a lot of references to central banks running out of ammo.  No where is that clearer than in Japan, and the Fed is making it harder on both the BoJ and ECB to manufacture inflation.  The yen closed at its highest level of the week, near the highest of the past year and a quarter.   As noted at the outset of this missive, the Nikkei is down 15% ytd.  This week’s tankan report was abysmal.  All of the hyper-stimulative efforts in Japan are falling flat.  Why should markets believe the Fed only has to reach deeper into the toolkit to “fix” things?  Indeed, by pushing the USD lower, the Fed is likely harming export dependent economies like Germany and Japan, and is certainly adding to pressures on banks and other financial institutions in both countries.  Global linkages thus create feedback problems for US banks.

In terms of the economy, one of the bright spots had been auto sales, buttressed by low finance rates and incentives, cheap gas, and payments being stretched out further and further.    From BBG:  “All three U.S. automakers posted sales gains that missed analysts’ estimates in March, while Japan’s Toyota Motor Corp. reported a surprise decline. The annualized rate adjusted for seasonal trends fell to 16.6 million, the lowest in 13 months, according to researcher Autodata Corp. The average analyst estimate was for a pace of 17.3 million, up from 17.1 million last March.  …Changes in the way consumers are buying vehicles suggest more people are stretching payments out to make them more affordable. There was an increase in March in the number of people buying cars with six-year loans.”  The peak level of 18 million units is fading into the rearview mirror.

It’s a fairly light news week in the US.  Labor market conditions and Factory Orders on Monday.  Trade and Service ISM Tuesday.  Fed Minutes on Wednesday.  Fed’s Rosengren speaks on cybersecurity Monday.  The Bangladeshis will probably pay special attention to that one, having seen $100 million vanish from their account at the Fed last month due to a breach.

April 1.

March 31. Long bonds are uncomfortable with Yellen’s dovishness

–One of Yellen’s points Tuesday was that, as market perceptions of the trajectory of the Fed Funds rate becomes less steep, bond rates and mortgage rates come down, providing support for the economy.  Yesterday, the five year note yield declined, but the 30 yr bond rose 4.5 bps.  5/30 treasury spread hit a new monthly high just above 139. 2/10 also edged to a new high at 107.  Red/gold pack spread jumped 4.5 bps to a new recent high of 1.375.  In the initial aftermath of the Fed’s dovish lurch, the long end has become suspicious that the Fed Fund trajectory might become too shallow, thus undermining the dollar and strengthening inflation undertows.
–The euro is trading right at the top of this year’s range at 113.64 and is threatening a further breakout in spite of Draghi’s QE program.  Certainly the Fed has complicated things for the ECB and BoJ, both of whom have pursued a path of currency depreciation against the USD to support exports. (What now? Go more negative and destroy the banking system?).  On the other hand, EM currencies benefit from stronger commodity prices, and CNY further strengthened today to 6.4626.   However, the FT reports that Guosen, a state-owned brokerage in China is defaulting on a ‘dim sum’ coupon payment.  “At their most basic level, dim sum bonds are bonds issued outside China, but denominated in renminbi, rather than the currency of the country where they’re issued. (BI)”.  The assumption has apparently been that parent companies would cover the problems of off-shore units, so this action shades that notion.  I would have to put this in the “red flag” category.
–Once again, I would note that there’s barely a basis point between calendar spreads further out the euro$ curve.  Yesterday red/green pack spread settled 27.75, green/blue 27.0 and blue/green 26.625.  While vol continues to be crushed, the blue midcurve straddles still trade at a 1-2 bp premium to greens.
–Today’s news includes Jobless Claims and Chicago PMI, expected to rebound to 50.3 from the dismal 47.6 last time.  Oh, and here’s more good news for Chicago: (Tribune) “As the first quarter of 2016 nears an end, violence in Chicago has reached levels unseen in years, putting the city on course to top 500 homicides for only the second time since 2008.”

March 30. On the one hand, on the other hand… Yellen’s speech one big disclaimer

–That may have been the lamest Fed Chair speech I have ever read.  In the spirit of Dodd-Frank the entire thing was one big disclaimer.  Let me paraphrase, we hiked but I’m not sure that we should have.  There are a lot of risks facing the economy, both internally and from abroad.  We think inflation will eventually go up but we’re not sure, our forecasts haven’t been good, and because of asymmetric risks we’re just going to watch from the sidelines. But don’t worry, because the MARKET prices in fewer hikes when things are crappy, which cushions the fall.  The Fed is impotent.
–The reaction was swift.  Sell the dollar, buy risk, buy gold, buy steepeners, sell vol. The ten year note yield fell nearly 6 bps to 181.2, but the ten year inflation indexed note yield crashed 12 bps to 18.8. (In December the ten year tip yielded 80 bps).
–Once again, one-year euro$ calendars are flat: the first ten one-yr spreads are all between 25 and 27.5 bps.  However, deferred spreads firmed while near spreads declined.  The green pack (3rd yr) rallied by 8.125 bps, while golds (5th yr) were only up 5.375.
–What I found interesting about this speech was how many times Yellen cited the market and interest rate curve.  She still has it wrong, by implying that the long end adjusts to economic data simply by altering the expected path of Fed hikes, as if it all starts and ends with the Fed.  In actuality, the Fed just continues to distort markets and mangle its communication.  Having said that, it felt to me as if early market action indicated that someone selectively communicated the contents of this speech prior to its actual release.

–Here are speech excerpts noting the influence of the market:
“In part, the baseline outlook for real activity and inflation is little changed because investors responded to those developments by marking down their expectations for the future path of the federal funds rate, thereby putting downward pressure on longer-term interest rates and cushioning the adverse effects on economic activity. In addition, global developments have increased the risks associated with that outlook.”

“But those effects have been at least partially offset by downward revisions to market expectations for the federal funds rate that in turn have put downward pressure on longer-term interest rates, including mortgage rates, thereby helping to support spending.”

“Financial market participants appear to recognize the FOMC’s data-dependent approach because incoming data surprises typically induce changes in market expectations about the likely future path of policy, resulting in movements in bond yields that act to buffer the economy from shocks. This mechanism serves as an important “automatic stabilizer” for the economy.”

Why bother with Fed policy if the long end of the market preempts policy?

And here are the disclaimers:
“That said, this assessment is only a forecast. The future path of the federal funds rate is necessarily uncertain because economic activity and inflation will likely evolve in unexpected ways.”

On inflation: “too early to tell if this recent faster pace will prove durable.”

“Given the risks to the outlook, I consider it appropriate for the Committee to proceed cautiously in adjusting policy. This caution is especially warranted because, with the federal funds rate so low, the FOMC’s ability to use conventional monetary policy to respond to economic disturbances is asymmetric.”

And to wrap it all up: “As has been widely discussed, the level of inflation-adjusted or real interest rates needed to keep the economy near full employment appears to have fallen to a low level in recent years.”

March 29. Everyone else is concerned about inflation. Is Yellen?

–Atlanta Fed’s GDP Now forecast for Q1 tumbled from 1.4% on March 24 to just 0.6% yesterday, as Personal Spending for January was revised lower from an initial +0.5 to +0.1.  The next forecast is, fittingly, on April Fool’s day, which coincides with the employment report.

–The big event today is Yellen’s speech to the Econ Club of NY (12:20 EST).  Yesterday’s data supports a dovish outlook, although concerns about increasing inflation are becoming more prevalent. “We like inflation-linked bonds and gold as diversifiers.” BUY GOLD! Sounds like something lifted from ZeroHedge, right?  Nope, it’s from BBG quoting a BlackRock report. http://www.bloomberg.com/news/articles/2016-03-29/blackrock-joins-pimco-warning-investors-to-seek-inflation-hedge
–Activity yesterday was unsurprisingly muted.  Fitch downgraded Chicago’s debt to one notch above junk, due to the Illinois Supreme Court striking down pension reform legislation.  According to BI, S&P is also one notch above junk and Moodys is already there.  Yields in general were down a couple of bps across the curve.  Good selling yesterday in 2EJ 9862 straddle at 17 (settled there, expires April 15) and in TY week 2 (April 8 expiry) 129.5^ at 62 to 61.
–Interesting story on BI notes that IPO activity ytd is running about 25% of last year.  http://www.businessinsider.com/top-wall-street-bankers-on-in-the-ipo-market-2016-3
The article trots out five experts, who give boilerplate excuses for the slow activity: ‘markets hate uncertainty’, ‘activity in Q2 will increase’, (though SPX is right around where it was in Q1 last year).  But there’s an alternate explanation in a Vanity Fair piece citing VC investor Chamath Palihapitiya: “The reality is, great companies can go public in any market. When we talk about the I.P.O. slowdowns what we’re really saying is that there really just aren’t that many good companies being built.” 

http://www.vanityfair.com/news/2016/03/chamath-palihapitiya-interview-says-start-ups-are-mostly-crap?utm_source=fark&utm_medium=website&utm_content=link

Serious under performance of the Broker/Dealer Index

Since the new lows of Feb 11, SPX rallied a bit over 12% at last week’s high.  Compare that with the US Broker Dealer Index (XBD) which has only gone up 6.7%, and remains below the low of late September.  Not exactly the picture of a broad based bull market.  (Idea noted from Doug Noland’s Credit Bubble Bulletin).

March 28. Core PCE prices today; last impediment to a more aggressive Fed

–Today’s news includes Personal Income and Spending, both expected +0.1, and also Core PCE prices, which hit 1.7 yoy in the last release.  Another firm showing would make it much more difficult for Yellen to maintain her dovish stance in the face of opposition within the FOMC; she speaks tomorrow at 12:20 EST to the Economics Club of NY.  Employment data is released Friday.
–International Trade also out this morning, expected -62.5b amidst declining global trade data.  From Reuters this weekend, “China’s industrial profits returned to growth in the first two months of 2016, despite weakening business conditions and slowing economic growth in the world’s second-largest economy.”  Perhaps not too surprising, as China has allowed the currency to weaken to gain back export market share as the transition to a service economy remains bumpy.
–While the curve is quite flat measured by the 2/10 treasury spread at just 102.6 bps, or red/gold pack spread at 74, near the lowest level since 2008, some of the near eurodollar calendar spreads edged up this week.  For example, June’16/June’17 rose 2.5 bps to 33 on Friday (this is the peak one-yr spread).  However, given the dot forecast for 2 hikes this year, and the possibility that a decline in inflation is removed as the last excuse to begin more aggressive rate hikes, these spreads still appear somewhat underpriced.

March 24. Fraying at the edges

–Treasury option expiration today with TYM threatening the 129.5 strike going into the long holiday weekend.  Only 55k open coming into the day (in TYJ 129.5 call).  Implied vol firmed yesterday as call buying was a theme, though overall volume remains light.  Economic news today includes Durables, expected -3.0% bot only -0.2 ex-Transportation.  Jobless Claims expected 268k.
–The ten year yield fell 6 bps to 187.2.  Curve was slightly flatter with red/gold euro$ pack spread falling 2.5 bps to 73.625, less than 1 bp off the lowest level of the year.
–The safe haven of treasuries is gaining more appeal, as fraying around the edges appears in all corners of the globe.  In the US, focus in the markets is on a supposed mutiny against Janet Yellen’s dovish stance at the FOMC press conference, as several officials opine that the Fed should get on with the job of rate hikes.  There is now speculation that a hike could come as soon as April, though April/May FF spread settled at just 2.5 (was 2.5/3.0 during the day).  Certainty of a hike in April would put that spread at 20 bps.  The terrorist attacks in Brussels have increased odds of Brexit…does the Fed want to raise US rates at the June 15 FOMC just prior to the UK referendum?  The world appears much less certain.  If there were to be a Brexit, tariffs on UK goods would slow trade.  But the idea of tariffs is also an issue in the US going into the election.  Increased security is another factor that slows down global trade at the margin.  In other disquieting news, some EU multinational corporate bonds now trade zero or slightly negative, Canada is likely to legislate bank bail-ins, where debt is converted to equity (might as well just buy the equity portion of the capital structure then, right?).  And Japan is looking at giving low income people gift cards that can only be used for spending.  I don’t know why that last bit should sound odd, the US already does it, but in the US it’s not a program specifically to juice the economy.  (Though a day ago there was a story of a man in the US trying to buy a BMW with food stamp cards). http://www.nydailynews.com/news/crime/fla-man-buy-60k-bmw-food-stamps-steals-article-1.2570550

March 23. Robotic reaction

–The market has become anesthetized to terrorist attacks, as shown by the muted reaction to yesterday’s events in Brussels.  Even gold, which rallied yesterday and was able to close slightly positive, is down about $14 this morning and appears to be forming a top.  The safe haven rally in treasuries quickly fizzled, with yields closing higher by a few bps.  Tens were up 1.4 to 193.3.  Volume was light.
–There was a buyer yesterday (adding) of about 40k EDK 9912/9937 combos, paying 0.25 to 0.5 for the put (0.75s put and 0.25s call).  This trade is predicated either an April hike, or more certainty of a move in June.   The Fed remains on course for gradual tightening.
–Article on ZH citing Goldman notes the high and increasing rate of delinquencies on subprime auto loans.  http://www.zerohedge.com/news/2016-03-22/could-be-problem-losses-deep-subprime-auto-double-industry-average
I know that the average age of all auto loans has extended and that standards have become looser, though I don’t know if there will be much of a spillover effect from auto subprime.  However, in the UBER economy, it’s worth thinking about from several aspects.  Auto sales are near a record 18 million units, on the back of cheap financing (and leases) and a decline in fuel costs.  Those are the factors that support car services.  What if lending standards tighten and rates edge higher?  At the same time, the trend of cheaper gasoline may have run its course.  Auto sales have been a bright spot for US manufacturing.  About to turn?
–New Home sales today expected 510k.

March 22. Terrorist blasts in Brussels; limited short term impact

–One last note.  AAPL, having rallied for the last month, made a new high early, but had an outside range day and closed nearly unchanged as it announced product changes and price cuts.  Possible short term trend change.

• 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.