Feb 19. I’ll sit this one out

–In the latter half of yesterday’s session gold jumped over $20, treasuries rebounded, yen pushed a bit higher…all normally associated with risk-off.  Tens fell 5.7 bps to yield just 1.76.  However, stocks held fairly well.  Oil pulled back on inventory numbers and is 49 cents lower this morning with CLJ 32.44.  In eurodollars the big trade was a buyer of 60k EDZ6 9950/9962/9975/9987 c condor for 2.0, a position for a grinding move higher.  Given recent action, I would have just tried to pay 3.0 for the lower call spd (settled 3.0 ref 9923.5) and wait to sell the 100/110.12 cs for 1.0, which will surely happen on the next panic trade…next week.

–All early trades in rates were vol sellers.  At the end of last week the Green and Blue March midcurve atm straddles were trading around 30 bps or a bit higher.  Yesterday 2EH 9900^ settled 21.0 and 3EH 9862.5^ settled 21.5.  It has become a roller coaster ride that is apparently causing some to sit out…open interest in euro$ futures yesterday fell by 91k.

–Walmart was down 3% yesterday as sales were reportedly the worst in 35 years (FT).  Of course, AMZN was also down 1.7%.  There have been many analysts saying that recent market action has little to do with the underlying health of the economy, but WMT is telling a different story.  Isn’t a lower gas price supposed to help strapped consumers buy more?

–March treasury option expiration today.  Relatively large open interest at the 130 strike in TYH had me leaning toward a settlement around that level, however, the contract now trades above the 131 strike.  News today includes CPI expected -0.1% with Core +0.2%.

Feb 17. Never saw it coming…

–Comments yesterday from two new regional Fed Presidents.  Harker of Philadelphia: “…but there are downside risks to my baseline forecast. …we have been below our inflation target for all but two years since 2008.”  “It is also fair to say that risks to my outlook are tilted to the downside.” And then “I believe as we move into the second half of the year with economic activity growing at or slightly above trend, the unemployment rate below its natural rate, and price pressures starting to assert themselves, policy can truly normalize.” Risks to the downside but things will turn around in 4-5 months? Note to self, this guy can safely be ignored.
–Kashkari of Minneapolis. His speech was about breaking up the big banks.  “Options such as these….are transformational – which can be unsettling.”  Also in his speech, “A second lesson for me from the 2008 crisis is that almost by definition, we won’t see the next crisis coming, and it won’t look like what we might be expecting.”  Hmmm.  I see it coming.  And if you layer on the ‘unsettling’ prospect of another major shake-up of the US banking system, it will be quite a doozy.  Right, it’s hard to see any warning signs currently: stocks plunging since beginning of the year.  Energy making new lows.  Energy companies under severe financial stress.  China in flux.  Manufacturing in recession.  …Never saw it coming.  Honestly.
–Having said that, the markets are taking a pause from the latest round of risk-off which culminated last Thursday, and stocks are floating higher.  Implied vol in rates is coming in fairly aggressively.  Precious metals have seen a big pullback from last week’s surge… an engraved invitation to buy.
–I continue to think spillover from China will turn into a torrent but I have no way to quantify it.  I just saw the Big Short, and one line from Burry stands out, that when trouble arises, instances of fraudulent activity jump.  From today’s Business Times (Singapore) comes this headline: China Banks seen hiding losses in “opaque” receivables accounts.  When is an asset not an asset?  Ask anyone who worked with me at Refco…
http://www.businesstimes.com.sg/government-economy/china-banks-seen-hiding-losses-in-opaque-receivables-accounts
The article cites Commerzbank research.  “Chinese banks haven’t provisioned for receivables and those are essentially riskier loans,” said Xuanlai He, credit analyst at Commerzbank in Singapore. “The eventual losses will have significant impact on China’s economy because you could have contagion risk in banking sector.”
–News today includes Housing Starts expected 1.175m, PP expected -0.1 with Core +0.1, Industrial Production +0.4 and the Fed Minutes.

Feb 14. Imagine

Themes:

• Yellen disappointment
• Institutional bias and lack of conviction/imagination
• China/ Kyle Bass and the roadshow
• Declining faith in policy makers

“Imagination is more important than knowledge. For knowledge is limited, whereas imagination embraces the entire world, stimulating progress, giving birth to evolution.” Einstein

Given this week’s discovery that yet another of Einstein’s theories was correct, gravitational waves, I thought it appropriate to start with one of his quotes. This first section of this week’s note is written more for me than for you. It’s a reminder to myself about trading strategy. I’ve now seen a few quotes from famous investors, one just this weekend from Horseman’s Chief Investment officer, Russell Clark, “I spend most of my time, while looking at current prices, thinking about and trying to live six months to one year in the future. Thinking about what will be the reaction to what is happening now, and then thinking about what that means future prices might look like. Generally that has worked well for me.” I have seen this theme expressed repeatedly by star investors. For example Druckenmiller, ” Try and imagine the world 18-24 months from now and not the way it is today. Then think about where securities prices will be to reflect that view.”  Julian Robertson says the same thing.

http://www.zerohedge.com/news/2016-02-12/one-worlds-top-performing-hedge-funds-just-went-record-short-explains-why

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Markets were somewhat disappointed with Yellen’s testimony last week as it wasn’t seen as dovish enough. She repeatedly said that monetary policy isn’t on a preset course. Clearly all central banks are grappling with similar problems, and the tone appears to have shifted to one of less confidence in policy makers. Japan is a prime example, where the Nikkei has lost 25% since the beginning of December and the yen has strengthened appreciably. The efficacy of negative rates is being openly questioned.

One of the goals of negative rates is supposed to be increased consumer spending. But forced consumer spending, even if central banks are able to spur it, will fall flat without underlying confidence. In the US, QE was supposed to generate low rates and low risk premiums that would cause businesses to invest in capex. They didn’t, instead engaging in stock buybacks and financial engineering. Now negative rates are supposed to make consumers spend. If QE didn’t spark the preferred theoretical outcome, why should sub-zero rates? The prospect of bank bail-ins across Europe as financial stocks crumble is probably a more visceral reason to pull money out from banks (and spend it?) than a small negative rate. But an uncertain future deters spenders.

Much of this uncertainty emanates from China. Many are calling for further devaluation of the yuan, which will likely cause global tremors, but appears unavoidable. For example, Kyle Bass is now appearing on media outlining the problems, and a friend told me he is visiting other investors to make the case against China. This isn’t like subprime where it’s one big investor against another. It’s against a country that doesn’t necessarily play by the same rules. That’s why the case must be built airtight and repeated incessantly to build the pressure. Note: G20 meeting in Shanghai is Fed 26/27.

Going back to the Fed, I think Yellen just isn’t strong enough. She should just say, ‘the Fed knows there are international uncertainties. We think therefore, that assets have to bear an increased risk premium to reflect these risks. AND…we think the adjustment is either well under way or has substantially occurred.’ She should say that policy isn’t on a predetermined course, but should categorically rule out negative rates. That would send a message to all central bankers and the markets as a whole, and would also perhaps put the US gov’t on notice that fiscal investment policies to spur the economy might be necessary.

Instead she cites things like strong auto sales. A long time ago I read a book titled Beating the Street (1993) by Peter Lynch (famous Fidelity Magellan mutual fund manager) who referred to Chrysler’s research on auto sales vs trend, which identified sales under or over trend based on a statistical model incorporating demographics, previous sales, etc. I looked for the research currently and couldn’t locate it. The point is though, auto sales have been on a steady and strong increase for 6 years; 18 million units is likely the top of the cycle. The Fed seems to show little imagination about the future apart from extrapolating forward. This institutional bias was also reflected in some of the bullet points from Dudley Friday: DELEVERAGED HOUSEHLDS MUCH BETTER ABLE TO ABSORB SHOCKS and HHLD SECTOR IN GOOD SHAPE, FINCL SYSTEM MUCH STRONGER. Right, the household sector is in better shape than 2008. But the Fed is focused on the last battle. Now it’s the business and corporate sector, not households, that we’re worried about. Just because the hh sector is in good shape, doesn’t mean households will consume more and in the same way as before. And, as shown last week, US consumption as a % of GDP is near a record high.

Here are a couple of quotes from Neil Howe:

Fun fact: From 2014 to 2015, the dollar value of global GDP actually declined. Historically, this doesn’t happen often. But when it does, it typically sets up a global recession year—like 1983 and 2009. If you’re a poor country, it means that hard-currency liquidity is disappearing. If you’re American, it means no one else can afford what we sell. Either way, it’s not a good sign.

The world has fundamentally shifted over the last decade, especially since we’ve emerged from the Great Recession. We are seeing slower demographic growth, overleveraging, a productivity slowdown, institutional distrust, policy gridlock, and geopolitical drift. But the professional class has been very slow to understand what is going on, not just quantitatively but qualitatively in a new generational configuration that I call the Fourth Turning. They don’t accept the new normal. They keep insisting, just two or three years out there on the horizon, that the old normal will return—in GDP growth, in housing starts, in global trade.

But it doesn’t return.

It was a wild week in interest rate markets. From the end of December EDH’18 rallied over 100 bps (over 110 to Thursday’s spike high). Implied vol screamed higher. Eurodollar calendar spreads imploded. During the day on Thursday I saw EDZ16/EDZ17 as low as 13.5 bps. It ended Friday at 22.5. In Fed Funds, the one year spread June’16/June’17 was briefly offered as low as 3.5 bps, it settled at 14.0 on Friday. Some nearby FF spreads actually inverted, and March’16/April’16 (FFH6/FFJ6) ended the week at -0.5, pointing to a higher chance of an ease in March then a hike. The Fed wonders why the market has dismissed its dot plot, but at the same time timidly indicates it might follow other central banks down the rabbit hole of negative rates.

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Feb 12. Black holes and gravitational waves

“The colliding black holes that produced these gravitational waves created a violent storm in the fabric of space and time, a storm in which time speeded up, and slowed down, and speeded up again, a storm in which the shape of space was bent in this way and that way,” Caltech physicist Kip Thorne said.
http://www.reuters.com/article/space-gravitywaves-idUSKCN0VK1RT

Feb 11. Aint got no brakes, it’s freewheelin’

–Thanks to colleague TonyP for the summary to the day’s end from Little Rascals… (go to 3:00).  https://www.youtube.com/watch?v=bewsgoidxsA
–Apparently, the market wanted Yellen to be more overtly cognizant to the risks facing the US economy from global turmoil.  She wasn’t.  “Testimony’s over?  OK…where are the 100 calls?”  (EDZ7 100c traded 7 bps late). By the end of the day TYH had closed at a new high settlement.  Vol was surprisingly sold heavily on the day; sales which are likely to be unwound over the next few sessions.
–Once again euro$ calendar one-year spreads made new lows and are getting to levels indicative of crisis.  For example, EDZ6/EDZ7 (Dec/Dec) made a new low of 19 bps, down 2 on the day, and traded 17.5 before the electronic close.  I had recommended a long here, but a close below 15 stops me out.
–$/yen has plunged over the last few sessions, 111.71 as of this writing, got as low as 110.99 today (!) from 120.99 on February 1.  Gold is now zooming higher (up $28) and stocks are tanking.  Sweden cut their key rate to -50 bps.  (Even as OECD’s White said yesterday that negative rates are dangerous).  Kyle Bass out with a report that China is a lot worse than 2008 subprime crisis.  Shipping giant Maersk also says conditions are worse than in 2008.  Freewheelin’.
–On the plus side, the Mexican Peso continues to plunge, so travel there is reasonable.  MXN over 19 this morning vs 13 in the middle of 2014.  On the other hand, the Director of National Intelligence says that “…falling energy and commodity prices will foster instability across the world.”  He also warns of cyber terrorist threats.  The report is in this link Hillary, in case you missed the original memos.  http://www.businessinsider.com/these-are-the-main-global-threats-for-2016-2016-2

–On top of it there’s this article from AEP in the Telegraph yesterday:

http://www.telegraph.co.uk/finance/economics/12149114/Europes-doom-loop-returns-as-credit-markets-seize-up.html
“People are scared. This is very close to a potentially self-fulfilling credit crisis,” said Antonio Guglielmi, head of European banking research at Italy’s Mediobanca.

Feb 10. Yellen to pull us back from the brink?

–Highlight of the day will be Yellen’s testimony.  Prepared remarks will be released at 8:30 EST, an hour and a half before the 10:00 appearance.  Data dependent.  My own rule of thumb over the years is that the Fed errs on the side of dovishness.  The market has given an unambiguous signal that the Dec hike was a mistake.  Is it reasonable to expect a ‘steady as she goes’ message?  The Fed really can’t do anything about what has been one of the big catalysts in all markets, the drop in oil, though a dovish message would likely weaken the dollar and help commodities in general.

Feb 9. Panic! at the disco. Victorious….NOT!

Panic time.  Is it close to peaking, or can central banks save the day?
Indicators, in no particular order:

–Swap spreads moving higher, 5yr +2.75 to -0.06, 10yr +2 to -6.63
–Treasury yields crashing, tens -11.3 to 173.3 and fives -10.1 to 114.7 (through major yield support)
–Japan ten year hits zero
–Japan stocks -5.4% today, led by financials
–$/yen pounded to 114.25, lowest since 2014
–Global bank shares getting crushed, with DB having to issue a statement to calm the market (a cry for help)
–VIX nearing August levels
–EDH6 heavily sold, closed -2 at 9934.  Open int fell in H6 by 78k, M6 -59k, U6 -23k
–Implied vol in interest rates exploding higher, most ED straddles up 3 bps.  Example, EDH6 9937^ had been trading 6, settled 9 yesterday.  EDM6 9900 put settled 1.25 on Friday, settled 2.0 yesterday with EDM6 +1.0!
–Junk bond etfs making new lows (JNK lowest since mid-2009)
–Barclay’s notes demand for distillates down 18% yoy in January, associated with recession

It all falls on Yellen’s shoulders tomorrow.  I hope she doesn’t fall into a Rubio-like repetitive loop (Rubo-loop).  The Fed always claims they’re not all that worried about drops in equity prices, until they actually drop.  The message will be that the Fed is on hold until stability reappears, and if forced to ease, it will.  The message will be that the Fed is on hold….

Does the market believe central banks can ride to the rescue?  Gold surged $40 yesterday…suggests healthy skepticism.

Feb 8. What do the models say?

NFP weaker than expected at 151k but yoy wage growth of 2.5% resurrected the idea of a tightening campaign.  The front end saw selling pressure in response, with EDU6 and EDZ6 (weakest contracts on the day) falling 3.5.  However, the curve flattened, with EDU8 and EDZ8 unchanged on the day, and further contracts in positive territory. The ten year yield eased 1.4 bps to 184.6.  Equity markets aren’t particularly enthused about the idea of further rate hikes, with SPX -1.85% and Nasdaq -3.25% on the day; much of the losses coming after Obama took a victory lap touting improvements in the labor market.
–Once again, calendar spreads in dollars made new lows.  Red/green pack spread (2nd to 3rd year) fell 1.875 bps to a new low of just 33.25.
–China reported a monthly decline of nearly $100 billion in fx reserves.  I’m not sure what the ramifications are, but my guess is that a similar amount of money flowed out of the country into investment markets globally, probably indirectly benefiting treasuries.  What happens on a devaluation? Does that flow stop?
–Focus this week will be on Yellen’s Congressional testimony beginning Wednesday.  We’ll probably get a nice summary of what the models say.  Just remember, the models also went with Carolina.

Feb 7. Yellen before Congress on Wednesday

Themes:

• Capital spending and stocks
• Reaction to employment/stagflation/higher wages lower productivity
• Yellen on Wednesday. In Sept, she thought international situation wouldn’t have much impact

CAPEX

Below is a chart of Core Capital Expenditures. The downturns in this series correlate well with the chart of SPX. Both peaked in 2000, 2008 and in 2014/15. Which one turns down first? The moves appear more or less simultaneous, but the point is that declines in capex aren’t good for longer term growth, and the past year of negative rates in capex (bottom chart) in spite of what had been a strong stock market, and near record high profits as a % of GDP, is certainly not a good sign.

Charts : Core Capex, SPX, and rate of change in Core Capex

So what does this chart remind you of? (Below is chart of SPX, same time frame)

The chart below is the percentage change in Core Capital Expenditures. Negative all last year.

Last week I touched upon the idea that the rest of the world is depending on the US consumer to hold up global growth. However, in the US, consumption as a % of GDP is already at an elevated level. From an article in the Telegraph today: “According to [former chief economist of the IMF] Blanchard’s calculations, a 20% decline in stock markets that persists for more than six months will translate into a decline in consumption of between 0.5 to 1.0pct.” Many stocks are off well over 20%. It could be a tough summer, and the charts above don’t give much hope for investment/ capex resurgence either.

Reaction to employment

Headline NFP was a bit less than expected at 151k, but the wage component was strong, up 0.5% with yoy +2.5%. Last Thursday’s Nonfarm Productivity number was -3%, with unit labor costs +4.5%. The broad picture seems to tilt toward stagflation: falling capex leads to lower productivity, while higher wages eat into corporate profitability. It’s probably about time that labor gets a bigger piece of the pie, but the pie might get a little bit smaller. Feel the Bern.

In any case, the wage gains have major forecasters setting their sights on a June hike rather than March (I saw notes from both JPM and Barclay’s targeting June).   This change to June was readily apparent in the euro$ curve, with March’16/June’16 (EDH6/EDM6) surging 2 bps to 6 (that’s sarcasm) while June/Sept only went up 0.5 to 4. On the week, euro$ calendar spreads continue to be crushed, with new lows in all of the nearby one-yr spreads. For example, EDM16/EDM17 settled at just 21 from 32 last Friday. The red/green (2^nd to 3^rd year) pack spread settled at a new low just over 33 bps. The market continues to squeeze out the idea of hikes with the five year yield falling over 8 bps to just under 1.25%. Yellen might not know it, but persistent weakness in equities will create a negative feedback loop.

YELLEN ON WEDNESDAY, WILL LIKELY FACE SOME HOSTILE QUESTIONING

Yellen testifies on Wednesday. It’s a difficult position to be in. If she takes too much of a step back due to declining global growth and trade, then she might force a wicked rally in the euro, just as Draghi is preparing steps to further depreciate the currency. Improvements in European economic stats appear to be substantially linked to the weaker Euro. On the other hand, a weaker dollar would go a long way in stabilizing commodities, which would likely help some emerging economies. My guess is that she will attempt to characterize softness in China/Asia as transitory (as she did in September), but will vow to vigilantly watch for negative effects on the US economy. Data dependent.

I looked back at a Yellen speech from last September 24, just after the FOMC refrained from an expected hike. A couple of excerpts are below:

Persistently high inflation, if unanticipated, can be especially costly for households that rely on pensions, annuities, and long-term bonds to provide a significant portion of their retirement income. Because the income provided by these assets is typically fixed in nominal terms, its real purchasing power may decline surprisingly quickly if inflation turns out to be consistently higher than originally anticipated, with potentially serious consequences for retirees’ standard of living as they age.

Isn’t this the exact same problem defined by persistently low interest rates?

Inflation that is persistently very low can also be costly, and it is such costs that have been particularly relevant to monetary policymakers in recent years. The most important cost is that very low inflation constrains a central bank’s ability to combat recessions.

That’s the most important cost? I would say the most important cost is that it impedes companies from servicing debts that become ever more onerous with stagnant prices, leading to a negative spiral.

Feb 5. A Lehman moment

• 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.